the economics of discrimination by professor tom carroll...4/16 where have all the criminals gone?...

The Economics of Discrimination

By Professor Tom Carroll Econ 180

Spring Semester 2013

BEH 106

8:30—9:45 AM

ECO 180 The Economics of Discrimination Professor Tom Carroll

Page 1

Spring 2013 Tu Th 8:30AM-9:45AM BEH 106 Office: BEH 504 Phone: 895-3652 Fax: 895-1354 E-mail: [email protected]

Office Hours: TTh: 7:45-8:15 AM; 10:00-10:30 AM; 4:15 – 5:15 PM and by appointment.

Afternoons: phone 263-8044, fax: 263-8740, web site: thomascarrollandassociates.com

Required Texts:, Thomas Carroll, The Economics of Discrimination, Revised 2013, emailed to your rebel mail account in pdf format.

Steven D. Levitt and Stephen J. Dubner, Freakonomics: A Rogue Economist Explores the Hidden Side of Everything, Revised and Expanded Edition, Morrow, 2006.

Robert Reich, Beyond Outrage, Vintage 2012.

Course Objectives The objective of the study of the economics of discrimination is to learn to use economic insights and economic measurement techniques to evaluate objectively the economic treatment and status of different economic groups, particularly the treatment of women and minorities. We will also endeavor to determine the benefits and costs of remediation programs, including affirmative action, progressive taxation, and anti-poverty programs.

Disabilities: If you have a documented disability that may require assistance, you will need to contact the Disability Resource Center (DRC) for coordination in your academic accommodations. Disabilities Services is located within Learning Enhancement Services (LES), in the Reynolds Student Services Complex, Suite 137. The phone number is 895-0866 or TDD 895-0652. The e-mail address is [email protected].

Semester Grade Exam #1* 10% Exam #2* 15% Exam #3* 20% Exam #4* 25% Final Exam** 30%

Total*** 100%

Explanation of Grading Policy

*75-minute multiple-choice exams will be given approximately every third Thursday during regular class time. They will be actual multiple choice exams, not one choice, multiple option (guess) exams. Each question will have between 1 and 5 (typically 2) correct answers. Students will receive one point for each correct answer and will lose one point for each incorrect answer (correct or incorrect answers not selected count as 0). Some questions will cover in-class discussions, so arrange for a colleague to take notes if you miss class. There is a severe penalty for guessing because error is more serious than ignorance. The answer sheets include a comment sheet to explain any answers you wish. Exams will increase in importance since the ultimate measure of success is how much you understand at the end of the course. Students who make arrangements to miss exams will be given a make-up essay exam the following Tuesday. I will email the answers to exams after I have graded them; you will keep your exams to learn from your mistakes.

**The final exam is scheduled for Thursday May 16, from 8:00 – 10:00 AM. There will be 60 questions on the final, approximately 40 covering material from the first four exams, and 20


Page 2

covering material from my chapter 13 and Paul Krugman’s book, End This Depression Now! There will be no material from Freakonomics on the final exam.

***Preliminary grade guarantees: 88-100%, A; 75-87%, B; 63-74%, C; 50-62%, D; less than 50%, F. Under no circumstances will a student’s semester grade be lower than one point below the final exam grade; e.g., to guarantee a B, get an A on the final; to secure a passing grade, get a C on the final. Otherwise, there will be no extra credit activities.

Tentative Class Schedule

Date(s) Topic Carroll Freakonomics Reich

1/22 What is Economics Ch 1

1/24 Scarcity and Options Ch 2

1/29 Scarcity and Options Ch 2

1/31 Economic Interactions Ch 3

2/5 School Teachers and Sumo Wrestlers Ch 1

2/7 Exam #1 Ch 1‐3 Ch 1

2/12 Supply and Demand Ch 4

2/14 Supply and Demand

2/19 Competitive Markets Ch 5

2/21 Competitive Markets

2/26 Monopoly and Inefficiency Ch 6

2/28 Real Estate Agents and the KKK Ch 2

3/5 Exam #2 Ch 1‐6 Ch 2

3/7 Economics of the Family Ch 7

3/12 Labor Markets and Income Ch 8

3/14 The Economics of Education Ch 9

3/19 Why Do Drug Dealers Live with Mom? Ch 3

3/21 Exam #3 Ch 1 ‐ 9 Ch 3

3/26 Spring Break

3/28 Spring Break

4/2 Economic Inequality Ch 10

4/4 Poverty and Redistribution Ch 11

4/9 Poverty and Redistribution Ch 11

4/11 The Economics of Discrimination Ch 12

4/16 Where Have all the Criminals Gone? Ch 4

4/18 Exam #4 Ch 1 ‐ 9 Ch 4

4/23 Macroeconomics Ch 13

4/25 Macroeconomics

4/30 Part I: The Rigged Game pp. 1‐64

5/2 The Rise of the Regressive Right pp. 65‐106

5/7 Beyond Outrage: What You Need to Do pp. 107‐140

5/9 Review for Final Exam ch 1‐13 pp. 1‐140

5/14 Study Day: Good Luck on Other Exams

5/16 Final Exam (8:00 10:00 AM) Ch 1‐13 pp. 1‐140

Assigned Reading


Page 3

Notes:

The class schedule is tentative; exam dates are firm, so plan to attend those days. In the event of an excused absence from an exam (e.g., a documented near-death experience), the student will receive a different essay exam when they return to class.

Since I wrote the text, it is redundant for me to lecture out of that text. I expect students to come prepared to discuss the text. I will entertain questions from the class, and if there are none, I will use the end-of-chapter discussion questions. Exams will cover material from the text and class discussions and place a premium on analysis, rather than parroting the text.

The Economics of Discrimination Preface Page i

In 2000 I designed ECON 180, the Economics of Discrimination for social work majors who were required to pass our principles of macroeconomic course, despite my opinion that most of the problems in their professional lives would involve microeconomic problems. After I successfully convinced not only my colleagues at UNLV but those across Nevada to place microeconomic principles (ECON 102) ahead of macroeconomic principles (ECON 103), and we made ECON 102 a prerequisite to ECON 103, social work professors complained that we were unfair to their students.1 So I designed ECON 180 as a Principles of economics for social work students; however, I decided to call it “the economics of discrimination.” Of course, that meant I had to write my own textbook.

Originally I provided the textbook free to students in the pdf form that you have received. Being typical UNLV students, my enrollees postponed reading the text until the night before the exam, complaining that their low grades reflected the many typos in the PDF text. Thinking this was my fault, I contracted with a different publisher, Kendall Hunt, to proofread and publish the text. Imagine my dismay when I experienced déjà vu all over again: the text they produced was bland (a black and white paperback) and fraught with typos.

I now hold the opinion that my publisher breached its contract with me. Therefore, I am reverting to the PDF form which at least has colors. The 18 month delay between the initial publication and this revision allowed me to spot many typos that I would have missed immediately after writing the previous draft.

Therefore I hired my daughter’s former boyfriend, William Garnes, then a UNLV English major,2 to proofread this version of the text. Since my daughter Jennie is beautiful, William was well motivated. I trust any remaining problems are due to my inadequate exposition and not to William’s attention to detail.

A Word about My Exams

Going back to my student days I have always had difficulty with “multiple choice” exams. First, the label is misleading. The typical “multiple choice” exam allows only one choice per question; they are “multiple‐option, single‐choice exams.” What bothers me even more is the incentive for students to guess. Since these exams are graded by merely adding up all the right answers, the probability of missing a question if you pick none of the options is 100%; if there are five options, the chance of getting an extra point is 1/5. Indeed, Kaplan and other exam‐prep rent seekers actually teach students how to guess strategically. Apparently their goal – and the goal of parents who pay for their services – is to distort the diagnosis of student aptitudes, thereby allowing high school youngsters to gain admission to prestigious colleges and universities from where they are likely to fail! Imagine what happens to the typical multiple‐option, one‐choice, and guessing‐is‐good graduate when they confront their first problem at work. It is inevitable that their boss, a client, or a co‐worker will confront them with a problem whose solution they do not know. The prudent answer would be “I don’t know, let me find out and I will get back to you.” Instead, the typical multiple‐option, one‐choice, and guessing‐is‐good graduate will guess and get fired.

1 This turned out to be a unique counterexample that “unfair” means “less for me!” Here, we were being unfair because social work students would require two courses before getting to the topics their department required of them. 2 William received his BA in English at the May 2012UNLV graduation.

The Economics of Discrimination Preface Page ii

It is my experience from 39 years of professing3 at the college level that multiple‐guess exams encourage group think. For each question there is only one answer and the person in authority (the teacher or professor) knows what that answer is. I was particularly bothered by those questions where “all of the above” is the correct answer. In fact, as an undergraduate student I enrolled in a money and banking course whose instructor (not an effective professor) wrote his own multiple choice questions which invariably had three viable options (A, B, and C), with option D being “none of the above” and option E being “all of the above.” Even if I had not been enrolled in a logic course the same semester, it would have been obvious that option E could never be the correct answer, since it would be impossible for A, B and C to all be correct and none of them be correct at the same time. Since the instructor designed his tests so that (his) correct answers were uniformly distributed, the best I could hope for was an 80%, a low B. I nearly got my only other B in an economics class (my earned B was in intermediate microeconomic theory, which we called price theory at the time) in money and banking. I avoided that sad fate by appealing to the chairman of the department, who agreed with my logic. I never learned whether that lawyer who drove from Cincinnati to Oxford Ohio to teach money and banking continued to instruct at Miami University.

My tests are designed to have multiple right answers – the average question will have two right answers and three wrong answers, although it is possible that some questions will have more than two right answers and some will have only one (which will often be “none of the above”). Students get 1 point for each right answer and lose one point for each wrong answer. On average, the expected value of a guess is ‐0.2 (there is a 40% chance you get a point and a 60% chance you lose a point), while not circling a correct answer counts as zero. It is time to learn, or, barring that, be retrained: It is better to say “I don’t know, let me get back to you,” than it is to defraud your professor, and later your boss, your clients, or your coworkers.

Because there will be multiple right answers, I cannot use the Scranton to grade the exams. All answers will appear on the test form: you will circle all right answers for each question and leave wrong answers unmarked (I recommend taking exams in pencil in case you change your answer, which usually is a bad strategy). At the end of each exam I will leave two pages for comments that allow you to explain your answers if you believe your interpretation of a question may be different from my own. After either I or a member of my staff grades your exam, I will go through your comments. In a small number of cases I will agree that an option that I thought was wrong is right or vice‐versa. I will adjust your exam score accordingly before recording it. Your score on the exam will be the number of right answers minus the number of wrong answers.

Finally, about that “I’ll get back to you.” The goal of this class is for you to learn and remember economics – that means successfully transferring concepts from short‐term memory into long term memory. I believe that the efficient way to accomplish this goal is for you to learn economics gradually, one concept and one chapter at a time. I recommend that you come to class prepared, having read the text and prepared to ask questions when you fail to understand or disagree with the logic of the text. After each exam is graded and returned the following Monday, I will entertain questions about right and wrong answers (all correct answers will be e‐mailed to you over the weekend). Since overcoming bad

3 I have often told students that “I am a professor, not a teacher.” My wife majored in elementary education and worked as a teacher. Teaching is hard; if the students do not learn, it is the teacher’s fault. A professor professes (to declare oneself skilled or expert in; claim to have knowledge of; make (a thing) one's profession or business). If my students don’t learn, it is their fault! I have found that the greatest impediment to learning is indifference to knowledge.

The Economics of Discrimination Preface Page iii

habits requires effort,4 the weight of each exam increases over the five week period. That is, the first exam counts for 10% of your grade, the second exam for 15%, the third for 20%, the fourth for 25%, and the final counts for 30%. Your semester grade will be the weighted average of your five exams, or one grade below your final exam grade, whichever is higher. It is theoretically possible (although yet to be empirically verified) that a student could enter the final with a 0% on the first four exams, receive an A (90%) on the final and receive a B for the course, even though the semester average would be .3(.9) = 27% (otherwise an F).

The production function for education requires student effort and professorial effort; while the former may substitute for the latter, the latter cannot compensate for lack of the former.

Good luck. You will need it if your strategy is to cram the night before the exam and guess on the exam.

Good fortune. You will receive it if you read the text ahead of time. Ask questions and join in class discussions. Answer only those questions where the likelihood the answer is correct is significantly higher than the likelihood that the answer is wrong.

Dedication

This book is dedicated to my wife Regina and our oldest son Mike. I also dedicate this book to our daughter Jennie, who graduated with a BA in dance production from UNLV in May 2012. Jennie has been accepted into the master’s program in dance and movement therapy at Leslie University in Cambridge, Massachusetts (next door to the Harvard University campus). Jennie has deferred her admission for a year to pursue he dreams as chorographer and member of cast in Evil Dead the Musical, and as a member of the cast of Awesome 80’s Prom, both playing at Planet Hollywood in Las Vegas. Finally, I dedicate this book to the loving memory of our son John who passed away at age 24 on May 8, 2009, after a life‐long battle with cystic fibrosis. John was a graduate of the University of Redlands with a major in mathematics and a minor in computer science. He was a student in the Ph. D. program in applied statistics at the University of California Riverside (from which he received his master’s degree) when he learned he needed a double‐lung transplant that he received July 21, 2008. If you wonder why I set such high standards for my students, ask me more about my son John.

4 See Gary Becker, “Habits, Addictions, and Traditions,” Kyklos 45 no.3 (1992):327‐46, reprinted in Ramón Febrero and Pedro S. Schwartz, The Essence of Becker, Hoover Press, 1995. This will be the textbook for my ECON 402 (Topics in Microeconomics) Section 2, course this fall.

What Is Economics and How Does It Relate to Discrimination?

By Professor Tom Carroll Page 1

Lincoln and Slavery

I have long been fascinated with world and American history, particularly the life of Abraham

Lincoln. To understand where I am coming from, I recommend an excellent book by historian Eric

Foner, The Fiery Trial: Abraham Lincoln and Slavery.1 According to Foner,

“Early in life, Lincoln decided he did not want to live like his father, who in his son’s eyes

exemplified the values of the pre‐market world where people remained content with a

subsistence lifestyle. From age twenty one, Lincoln lived in towns and cities and evinced no

interest in returning to the farm or the manual labor. He held jobs – shopkeeper, lawyer,

and surveyor – essential to the market economy. The storekeeper brought manufactured

goods from afar to isolated communities. The bulk of legal work revolved around land

titles, business arrangements, bankruptcy cases, and the credit and debt that oiled the

market revolution. The surveyor transformed land into private property with clearly

identified boundaries, ready to be bought and sold. Lincoln was so enmeshed in market

society that during the 1840s and 1850s, even while pursuing his legal and political careers,

he provided credit reports about his Springfield neighbors to the Mercantile Agency, a

credit rating company founded in New York City by the abolitionist Lewis Tappan.”2

Another of Foner’s insights crystalizes my admiration for the Great Emancipator:

“Lincoln came of age as two great transformations unleashed by American independence –

the market revolution and the democratic revolution – reached fruition, and he embraced

them both. Many conservative Whigs3 retained a distaste for popular democracy inherited

from the old Federalists. They preferred government by a ‘natural aristocracy’ and

disapproved of the elimination of property qualifications for voting, which occurred in

nearly every state between 1800 and 1828. Lincoln was part of a younger generation of

‘New School Whigs’ comfortable with a mass political democracy, and was convinced that

the party could compete head‐on with the Democrats for votes of humble citizens.

By the time of Andrew Jackson’s presidency, the axiom that the people ruled had become a

cliché of American politics. When he ran for reelection to the legislature in 1836, Lincoln

took this principle further than most of his contemporaries by issuing a politic letter stating

that he favored ‘admitting all whites to the right of suffrage, who pay taxes or bear arms

(by no means excluding females).’”4

1 Norton, 2010. You can find this book on Amazon.com, in hardback, paperback, or used. 2 Foner, page 37. 3 The Whig Party was the precursor of the modern Republican party, having spun off from the Democratic‐Republican Party, which had essentially been the only political party from 1800 when Thomas Jefferson defeated the last Federalist president, John Adams, until the Whig party was founded in 1834, in reaction to the perceived authoritarian rule of President Andrew Johnson. The Whig party got its name from the anti‐royalist faction in British politics (who opposed the Tories, or pro‐monarchy conservatives). See http://www.u‐s‐history.com/pages/h279.html 4 Foner, page 39.



As the previous sentence indicates, Lincoln was progressive for his time, but a creature of his time

nonetheless. While few politicians entertained the notion of female suffrage, Lincoln was willing to

extend the franchise to women, but with a catch. Women did not serve in the militia, the way most

men did, and few women (except for widows) paid taxes in their own name. Many would consider

Lincoln sexist by today’s standards; men would represent the interests of their wives when they voted,

but women without husbands, who paid taxes (demonstrating their personal responsibility), could be

trusted to represent their own interests. The theme of Foner’s book was to trace the evolution of

Lincoln’s attitude toward slavery from enlightened self‐interest to moral cause.

Lincoln was born into a society in which slavery thrived in one part of the country, and was seen as

an economic threat in the rest of the USA. Born on a small farm, without a formal education, Lincoln

understood that “free labor” (white men without property) could not effectively compete with slave

labor. During colonial times, slavery existed both in the north and the south, and many white migrants

to North America arrived as indentured servants – contract workers who owed seven years labor to men

or businesses that financed their passage from Europe to North America. After fulfilling their financial

obligations, former indentured servants could hope to advance by learning a trade, financing their own

education (by saving or being self‐taught like Lincoln), or by purchasing property (also by saving). Slaves,

however, were property for life – indeed, the offspring of slaves were also slaves, even though their

fathers were slave masters or overseers. Slave owners spent just enough on food and other necessities

to keep their slaves in good working order. Slave owners often rented their slaves to farmers or other

businesses for the cost of the upkeep of the slave plus a small profit. Free men, competing with slave

wages, could expect to receive slave wages themselves. Therefore, it was critical to Lincoln and other

free whites, to prevent slavery from expanding into the Free States.

In 1857, the Supreme Court upset the status quo, in its infamous Dred Scott decision. Dred Scott

was a slave born on a plantation in Missouri, a slave state by virtue of the Missouri Compromise of 1821.

By that compromise, slavery was outlawed in the Nebraska territory. Congress carefully balanced the

admission of slave and free states to maintain equality of representation in the US Senate. However,

because opportunities were superior in the North, the House of Representation was dominated by free

states. When Dred Scott’s master brought him to the free state of Illinois, Dred Scott claimed that he

was no longer a slave. When his case (financed by abolitionists), reached the US Supreme Court, the

simplest decision would have been for the Court to rule that, as a non‐citizen, Dred Scott had no

standing to sue. Instead, the Court overreached, ruling that (1) no black people, including freed slaves,

were US citizens, and (2) Congress had no authority to prohibit or otherwise regulate slavery in any US

territory. This decision energized anti‐slavery forces, leading the Republican Party to nominate Abraham

Lincoln, who won 180 (59%) of the electoral votes even though he won just 40% of the popular vote in a

four‐party election: Lincoln, 40%, Breckinridge (Southern Democrat) 18%; Bell (Constitutional Union),

13%; and Douglas (Northern Democrat) 29%.

As an economist I am perplexed by the behavior of those Southern whites who owned no slaves.

Since importing slaves was banned was banned by Congress in 1808, the only way to obtain slaves was

to inherit them, typically by inheriting a plantation. This meant that the South was an aristocracy, with

slave owners (the haves) and everyone else (the have nots) lived in an economy wherein slave wages



blocked upward mobility. By fighting for slavery, southern whites were dying to preserve an economic

institution that was contrary to their economic self‐interest. Sometimes people oppose their self‐

interest out of a sense of altruism: parents support young children, children support aging parents, and

people contribute to charity without expecting a monetary return. But, as we will learn throughout this

course, people also often behave against their self‐interest because of malevolence or hatred. The

altruist is willing to incur a cost to make someone else better off; the villain is willing to incur a cost to

hurt another.

Are We Hard Wired to Be Conservative?

As we will discover later, economics deals with how people make choices in the face of scarcity.

Choice involves selecting from available options; scarcity means that selecting one option implies

sacrificing all others. Poor people typically have few options, and choosing the wrong option may

threaten one’s survival. Rich people typically have many more options; the consequences of bad

choices are typically not fatal to the rich, and some rich people can escape the consequences of their

own shortcomings. s one is rich or poor is partly a matter of luck – being born to rich parents in an

affluent country, as opposed to being born poor. But some people become poor through hard work,

frugality, and temperance. Some rich people become poor through laziness, squandering their

endowment, or simple bad luck. Since it is better to be rich than poor, the rich typically fight to preserve

the status quo; that is, the rich are conservative because it is their self‐interest to prevent change that

would threaten their privileged position. The poor, by contrast, face more of a dilemma.5Given their

dire circumstances, change is likely to improve their circumstances. However, wrong choices by poor

people could be life‐threatening.

We will occasionally discuss three political philosophies: libertarianism, conservatism, and

liberalism. Because we believe that free (competitive) markets are efficient, we economists are

naturally libertarians in our outlook. We believe that people are the best judges of their own wellbeing,

so that society should interfere with individual choices only if a compelling case can be made for

intervention. Intervention typically implies that the use of government force to limit options or punish

choices. Conservatives typically approve of more intervention than libertarians do, usually to prevent

change, thereby protecting the privileged. Liberals also prefer more intervention than libertarians do,

usually to encourage change to improve the lot of the less fortunate.

Economists understand why the rich are conservative and the poor are liberal; rational self‐

interest implies that change is more likely to reduce the wealth of the rich and improve the economic

prospects of the poor. Exit polls indicate that approximately 40% of the richest Americans (e.g., those in

the top 1% of the income distribution) voted for Barack Obama in 2008 and 2012. Even more startling is

that 40% of the least fortunate voted for John McCain in 2008 and Mitt Romney in 2012. To predict the

5 People tend to use the words “dilemma” and “problem” interchangeably. Technically, a dilemma is a problem for which each of the proposed solutions has a down side. A parent in a burning home faces the problem of rescuing her children; a mother who realizes she can save only one child faces a dilemma – if she saves one child, the other will die. In the first case, a mother who saves neither child is a bad parent, and perhaps homicidal. In the second instance, a good mother may become catatonic and all three people may perish.



percent of a state’s vote President Obama received in 2012, we need know only two factors: the percent

of the vote he received in 2008 and the proportion of the adult population who are college graduates.6 I

believe (and there is plenty of evidence to support me7) that the rich who vote for liberals are altruistic;

they are willing to incur some cost (higher taxes, more regulation, scorn at the country club) in order to

help the less fortunate. I fear that the poor and uneducated who vote for conservatives are malevolent;

they are willing to incur a personal cost (lower income, reduced upward mobility) in order to hurt others

(racial minorities).

I write this introduction to communicate where my heart is. As an economist, I am naturally a

libertarian. I am skeptical of the use of government power to accomplish either conservative goals

(religious conformity, racism, sexism) or liberal ones (attempting to mandate egalitarian outcomes

instead of expanding economic opportunity). As a religious agnostic, I have no supernatural agenda. I

hope I do my best to overcome malevolent urges. Nevertheless, I do believe the words of Scripture:

"For everyone to whom much is given, of him shall much be required." ‐‐ Luke 12:48. To me, this is the

essence of Christianity, not John 3:16.8As we encounter controversial topics in the economics of

discrimination, it will be impossible to ignore our endowment of our beliefs and values. However, we

cannot use our personal disagreements to excuse ignorance or error. I expect you to learn economics,

and to pass examinations revealing your understanding. I will not require you to agree with my beliefs

or values to pass the course.

Economists have long taught that economics is a science that studies how people allocate scarce

resources to satisfy their most important wants. Students take introductory economics courses because

they are required to do so; if they become interested they may take more advanced economics courses.

Students are often more interested in those topical courses than in the principles that they learn by

rote, if at all. Some economics principles texts are crammed with real‐world applications, often at the

expense of students understanding fundamental economic concepts. Alternatively, and especially at

“better” universities that screen students on their willingness and ability to delay gratification, students

are told that interesting applications courses are the prize for enduring the cost of focused principles

6 Data from the fifty states plus the District of Columbia predicts the proportion of the vote received by John

McCain as 12 08ˆ .6 .69O O CG . In blue (majority Democratic) states, 29.2% of adults are college graduates; in

red (majority Republican) states, only 23.3% of adults are college graduates. Despite all the attention the swing states received, Obama received approximately the same proportion of the votes in those states in 2012 that he had received in 2008. 7Bling.com gives three definitions of belief. Those who ignore empirical evidence are consistent with the first definition; I am relying on the third definition:

1. acceptance of truth of something: acceptance by the mind that something is true or real, often underpinned by an emotional or

spiritual sense of certainty

2. trust: confidence that somebody or something is good or will be effective

3. something that somebody believes in: a statement, principle, or doctrine that a person or group accepts as true

8“For God so loved the world that he gave his one and only Son, that whoever believes in him shall not perish but have eternal life.” I reject this quote, not because of what it says about Jesus, but because of what it says of his (alleged) Father. A perfect creator who punishes his imperfect creation for eating from the Tree of the Knowledge of Good and Evil is the ultimate example of the conservative parent. Don’t even get me started on the story of Abraham and Isaac.



courses. Alas, too often students infer that those applied courses are likely to be just as boring as the

principles course and decide never to take another economics course.

Economists who purport to understand incentives should know that the “my way or the

highway” philosophy to economics instruction is inefficient. I propose to combine principles of

economics and one sustained application. The advantage of this approach is that students requiring a

specific topic course—for example, the economics of discrimination—can learn the principles of

economics they need as they explore their chosen application. The disadvantage—and in economics

there is never a benefit without a cost—is that there may be some duplication of topics for students

taking multiple economics courses. But we’ll worry about that problem after exploring the success of

this approach for the economics of poverty and discrimination.

What Is Economics?

The great economist Frank Knight stated:

[I]t ought to be the highest objective in the study of economics to hasten the day when

the study and the practice of economy will recede into the background of men’s

thoughts, when food and shelter, and all provision for physical needs, can be taken for

granted without serious thought, when “production” and “consumption” and

“distribution” shall cease from troubling and pass below the threshold of consciousness

and the effort and planning of the mass of mankind may be mainly devoted to problems

of beauty, truth, right human relations, and cultural growth.9

An idealist might attribute these sentiments to any profession. Physicians wish to eradicate all

disease and police officers dream of life without crime. Psychiatrists labor for a future in which all are

sane. Lawyers yearn for a judicial system so fair and transparent that anyone can negotiate a contract

without legal assistance. Social workers dream of a world inhabited by functional families whose

incomes exceed the poverty level. Accountants dream of a tax system so simple and logical that

complex accounting rules will become obsolete.

Cynics may scoff: “If a person’s livelihood is derived from helping people cope with a persistent

problem, doesn’t that person have an interest vested in perpetuating that problem?” Recall that usually

left‐leaning social workers voted overwhelming for Richard Nixon in 1972 after his opponent George

McGovern proposed a negative income tax that would have eliminated the role of social workers in

enforcing the rules of the Aid to Families with Dependent Children program.10 Why should economists

behave any more nobly than other professionals? The answer lies in the nature of what economists

9 Frank H. Knight, “Social Economic Organization,” in The Economic Organization (New York: Harper & Row, 1951); quoted in Thomas M. Carroll, Microeconomic Theory: Concepts and Applications (New York: St. Martin’s Press, 1983), 2. 10 Technically, this argument relies on a post hoc ergo propter hoc logical fallacy—literally “after this, therefore because of this.” We know that McGovern proposed a welfare reform program that many social workers complained would cost their jobs. We know that almost everybody voted for Nixon in 1972 (who carried 49 of 50 states). However, the one is not necessarily dependent on the other.



study and what economists do. Why it is necessary for people to earn their living is one of the central

concerns of economic inquiry. Because goods are scarce we must expend effort to obtain them,

although we can never have all we want. If there were no scarcity, people would work only for

recreation; imagine all those professional stair steppers and power lifters. So what would economists

do if there was no economic problem? Why, anything they wanted, including economics, if they

thought it was fun.11

The word economics is of both humble and practical origins: It is derived from the ancient Greek

word oikonomia, which literally means “household management”. Home economics is redundant. Greek

philosophers, like Plato and Aristotle, believed that issues like balancing the household accounts or

whether to plant figs or dates were too mundane to occupy a philosopher’s attention. After all, there

were more important issues to be considered: beauty, truth, proper human relations, and cultural

growth. Yet with all its disease and starvation, not to mention the enslavement of most of humanity,

classical Greece can hardly be characterized as a golden age of plenty.

In this book we return to these ancient roots, studying how economics embraces both

household behavior – the allocation of time between work, household production, and leisure – and the

behavior of business – which purchases the services of land, labor and capital owned by households to

produce goods and services they sell to households, ideally at a profit. Households and firms interact

through markets that set the price and quantity exchanged of goods and services. Within households,

behavior is best explained by altruism: from each according to ability, to each according to need. Within

firms, behavior is best explained by command – while employment is a voluntary contract, workers

agree to obey the commands of owners and executives in exchange for wages and salaries. Markets

work by balancing the best in us (altruism) with the worse (selfishness) and the worst (malevolence).

What Economists Do

Figure 1‐1 relates economics inquiry to the physical and social sciences. The circle on the left

depicts economic resources—land, labor, capital, and entrepreneurship—and the circle on the right

depicts human desires. The “resources” circle is substantially smaller than the “wants” circle because of

scarcity. People generally want more than they can have. The resources circle is also labeled physical

sciences—disciplines such as physics, chemistry, biology, engineering, and mathematics— which explore

properties of inanimate objects to find ways of bending those properties to serve humanity. The

“wants” circle is also labeled social sciences—disciplines like sociology, anthropology, philosophy, not to

mention marketing and education—which explore how people behave.

The overlapping area of these circles is labeled Economics; economists try to reconcile means

(resources) with ends (human wants). Economics does not lay claim to the entirety of either sphere.

Physics, chemistry, and engineering study explore physical laws that are outside the purview of

economics. Economists do not ask why two atoms of hydrogen and one atom of oxygen combine to

11 No doubt, one of the things that makes the Star Trek science fiction series so attractive is replicator technology, which morphs garbage into food, clothing, and entertainment. The only scarce factors of production are di‐lithium crystals, whose acquisition has injected economics into the plots of a few episodes.



form one molecule of water. Economists understand that hydrogen, oxygen, and energy are often

scarce.

A similar restriction rests on how economists treat human wants. Economists do not record

history, but they can provide insights into historical events.12 Economists do not specify the rules of

government, but they do investigate their implications.13 Today economists typically take what people

want as given, instead of rendering moral or ethical judgments about what people want. This was not

always the case. Originally economics was a branch of moral philosophy that preached why some

desires are good and others are bad.14 Today the overwhelming majority of economists are more

concerned with how to allocate resources efficiently than how to restrict choices.

Two important intellectual documents were created in 1776: Thomas Jefferson’s Declaration of

Independence and Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations. In the

Declaration of Independence, Thomas Jefferson declared that “all men are endowed by their creator

with certain inalienable rights, among them life, liberty, and the pursuit of happiness.” In his Wealth of

Nations, Smith argued that the “wealth” of a county reflects the standard of living of the population.

Although Adam Smith was a moral philosopher by training, he asserted that the role of the economist

was to help people attain what they want rather than preaching about what people should want. With

the Wealth of Nations, economics shifted focus from justifying ends to understanding means. And,

straddling the physical and the social sciences, economists choose the scientific method over theology

as their guide to understanding human behavior.

Economics spans the social and the physical sciences. Like the other social sciences, economics

studies the causes and effects of human behavior through the special lens of scarcity. Like the other 12 That intersection of economics and history is called cleometrics. For a cleometric analysis of American slavery, see http://oyc.yale.edu/history/civil‐war‐and‐reconstruction/content/transcripts/transcript‐2‐southern‐society‐slavery‐king‐cotton. 13 This branch of economics is called public economics or public choice. 14 Most economists still do this, but now in our role of parents.

Wants

Social science

topics

Resources

Physical

Sciences

Economics

Figure 1‐1



social sciences, economists try to understand “what is” and contrast it with “what ought to be.” Like

most people, I have strongly held opinions about what works and what is broken and some ideas of how

to fix broken things. I strive to separate my opinions (what ought to be) from my objective side (what

is). Like other humans, what I believe filters the evidence I see. I try, however imperfectly, to confirm or

refute my beliefs by perusing evidence and listening to those whose world views differ from mine. I

strive to structure my exam questions so that your performance depends on your ability to use

economic logic, not whether you agree with me about economic policy. To this end, I provide comment

sheets on your exams; if you think that any of my questions are biased or unfair, tell me!

Like the other physical sciences, economics depends on the scientific method in its pursuit of

the truth. Economists use well‐tested theories to predict how people respond to incentives.

Economists test their theories by contrasting real world events with the predictions of their theories.

Unlike the physical sciences, and like the social sciences, economists cannot conduct controlled

experiments. Instead, we rely on statistical analysis of actual events. Instead of controlling the

experiment, we take into account the diverse influences on behavior through large samples drawn

randomly from a population of interest. In this text, I will make extensive use of The Current Population

Survey, a database collected by the U.S. Department of Commerce containing approximately 58,000

households, spanning the period between 1962 and 2011.

Scarcity and Economic Behavior

Scarcity exists because people want more than they can have. Anyone who has escorted a five‐

year‐old child down a candy aisle appreciates the fact that “what I want” is substantially greater than

“what I can have.” Mothers, confronted by a crying child, face a dilemma15 of buying candy for the

child, temporarily securing quiet at the cost of encouraging future tantrums, or saying “no” and

prolonging the current tantrum.

Any time we use scarce resources to satisfy one desire, we simultaneously sacrifice something

else of value.16 Reducing the number of undocumented migrants means not catching some child

molesters. Studying economics for two hours means not earning $20 by working overtime. Actions

always have consequences, and those consequences are not always the ones that we expect. The

decision to execute convicted murderers may reduce the number of people who commit murder

(because the potential price of the first murder is infinite), only to increase the number of murders per

offender (since after incurring the liability of execution, subsequent murders are free). Whether capital

punishment actually reduces the number of murder victims is an empirical question: we have to

evaluate the data. If an employer offers on‐site child care for working parents, she may have to reduce

the wage offer to continue to earn a profit. One good (on‐site day care) requires the sacrifice of another

good (the wage rate). Workers will find they face a trade‐off. Those who prefer higher wages will take

15 Many people use the words dilemma and problem interchangeably. This is a mistake; a dilemma is a problem where all available options have undesirable aspects. How to rescue children from a burning building is a problem; deciding which of two children to save when there is only time enough to save one is a dilemma. 16 Choices are not dilemmas when one option is efficient and the other is inefficient; choosing the efficient option creates more for all!



other jobs for higher pay. Those who value child care will take the job, placing a greater burden on the

employer’s resources. The unintended consequence of the employer’s “free” daycare is to attract

working mothers and repel employees who do not have pre‐school‐aged children.

Economic activity can be organized in three ways. The oldest system is tradition,17 whereby

people inherit their jobs and social status from their parents and everyone’s standard of living socially

(or divinely) ordained. There is little social mobility in a traditional system; traditional societies tend to

stagnate. The unequal distribution of wealth, authoritarian political and social structure, and repressive

theocracy create many of the problems of poor countries resulting from a traditional system. A second

method of social organization is command, where people are rewarded for their submission to authority

and where the social climate is also one of repression. Many of the current and former communist

regimes are command economies, as were the economies of Nazi Germany, Fascist Italy, and Imperial

Japan, which change incentives and society quickly, albeit more often for the worse than for the better.

The third approach to economic organization is the most successful.18 In a market economy people

(usually through families or households) own the factors of production whose services they exchange

for money (income). Households, in turn, spend their money to buy the goods and services businesses

provide at a profit. In a market economy one’s standard of living depends on (1) one’s endowment—

what he or she inherits from one’s relatives, and (2) one’s effort. This text emphasizes how the market

process causes three related but distinct outcomes: economic inequality, poverty, and discrimination.

Economics explores how people choose to satisfy some of their wants with resources available

to them. But economists go further. We have developed theories that are based on efficient or

optimizing behavior, whereby people attempt (not always successfully) to satisfy the desires they

consider most important. People respond to incentives, shying away from activities whose prices (in

money, time, or self‐esteem) increase, and leaning towards activities whose prices decrease. The

incentives people face may not always be obvious to the outside observer (such as the social worker).

Economics teaches us to pay much more attention to what people do than to what they say, especially;

people are more likely to lie in what they say than in what they do.

Economics of Discrimination

We have seen that economics is a science that studies the relation between scarcity and human

choice. The word discrimination typically has three meanings—one bad, one good, and one somewhat

neutral—as shown in the following definition from the Microsoft® Encarta® definition:

discrimination

dis·crim·i·na·tion [di skrìmmə náysh'n]

noun

17 Catch the History Channel series, Mankind: The Story of All of Us, which has a remarkable amount of economic content. 18 As if to illustrate that change is not always progressive, the authoritarian regimes in Iran, Iraq, and Egypt have been replaced by theocratic Islamic (theocratic) govedrnments.



1. treating people differently through prejudice: unfair treatment of one person or group, usually because of prejudice about race, ethnicity, age, religion, or gender

2. ability to notice and value quality: the ability to appreciate good quality or taste

3. awareness of subtle differentiation: the ability to notice subtle differences 19

The first definition is the one you probably use on a day‐to‐day basis: Discrimination has a

negative connotation of unfairness in the treatment of a group (or a person who belongs to an “inferior”

group). Prejudice in turn has to be defined. Here is its definition from the same source:

Prejudice, strictly defined, a preformed and unsubstantiated judgment or opinion about

an individual or a group, either favorable or unfavorable in nature. In modern usage,

however, the term most often denotes an unfavorable or hostile attitude toward other

people based on their membership in another social or ethnic group. The distinguishing

characteristic of a prejudice is that it relies on stereotypes (oversimplified

generalizations) about the group against which the prejudice is directed.20

So “bad” discrimination is unfair treatment based on inaccurate information that resists

correction.21 But “good” discrimination is the ability to recognize quality. The third definition

refers ability to notice subtle differences; a synonym would be “nuanced,” which was used to

slander presidential candidate John Kerry during the 2004 election.

As a person living in a condition of scarcity, you are forced to make choices, most of

which require the ability to notice subtle differences in the options you confront that allow you

to be a discriminating consumer. However, if you are intellectually lazy or just plain pigheaded,

you make some of your decisions based on inaccurate information that discriminates against

others because of their gender, race, ethnicity, or religion.

In order for a market economy to operate, scarce resources—land, labor, capital—must

be privately owned, meaning that owners have the right to exclude (discriminate against) others

in the use of their property. Without property rights, societies invariably confront the tragedy

of the commons, whereby resources are inefficiently allocated and both renewable and

nonrenewable resources are squandered. But, with an irony that will become a hallmark of this

text and this course, property rights are exchanged in a market that is all‐inclusive. When sellers

have the ability to exclude potential competitors from the market, they possess monopoly

power which reduces overall economic well‐being. When potential buyers have the ability to

exclude potential competitors, they possess monopsony power which reduces overall economic

well‐being.

19Microsoft® Encarta® 2006. © 1993–2005 Microsoft Corporation. All rights reserved. 20Microsoft ® Encarta ® 2006. © 1993–2005 Microsoft Corporation. All rights reserved. 21 My apologies for the anthropomorphism; technically, it is employers or other discriminators who rely on inaccurate information they refuse to correct.



Economics and the Scientific Method

One of the most important aspects of economics is that it is a social science. As scientists,

economists develop theories that are abstract generalizations of reality. Typically, economic theories

begin with a hypothesis—that individuals behave rationally, that firms attempt to maximize profits, that

income is distributed according to the contributions of different factors of production to the value of

output. These hypotheses in turn lead to testable predictions—that the increase in the price of a

commodity will reduce its consumption that increases in the supply of money will cause inflation, or that

decreases in tax rates will stimulate economic growth.

Scientists admit their fallibility and entertain evidence contrary to their beliefs. But they wish to

discriminate between their beliefs that are supported by the evidence and beliefs that are contradicted

by the evidence. For instance, the theory of evolution predicts that random mutations will tend to

persist if and only if those mutations improve the ability of a species to survive. If one found that a

random mutation decreased the ability of a species to survive, yet that trait persisted, then the theory of

evolution would be compromised. Formally, the evidence would disverify (contradict) the theory. Once

the evidence was verified, the theory should be modified, or in the extreme, abandoned.

By contrast, consider the so‐called theory of intelligent design (aka, creationism). This argument

purports to explain that which evolution allegedly cannot—the complexity of nature. According to the

argument, the world (or the universe) is too complex to have arisen by accident. Therefore, an

alternative explanation is called for; the world must have been created or designed by an intelligent

being. Presumably, this intelligent being was/is also complex, and so, by this argument, must have been

created. And the creator of the creator must have been created, and so forth back into infinity. There is

no way to prove the statement wrong, because each step backwards invokes another creator. But, if

the creator is God, who was not created, then the infinite regression is short circuited.

But none of this is science; this is faith.

Faith is a set of the beliefs we maintain in the absence of clear evidence. Sometimes faith goes

so far as to deny evidence that contradicts beliefs. As we shall see, there are many people who treat

economics as a type of faith. Marxists believe that since labor creates all value, labor should receive all

value. There is no way to test this theory, so Marxists continue to believe that their way is the only

way.22 Libertarians place so much faith in free markets that they believe that markets are perfect;

however, their definition of perfection is “anything that markets create.” Since markets function

perfectly, the only role libertarians allow government is to create an environment for markets to thrive.

Conservatives often place the interests of the elite above economic efficiency, marshaling government

force to protect the privileged.23 Political liberals also seek to use government force to override market

outcomes arguing that they wish to help the less fortunate. Ironically, when liberals work against

22 Ultimately the unworkability of Marxism was its undoing. People in Marxist countries observed that, even if they were all equal, they had much lower standards of living than people in capitalist countries. This, in a way, was a kind of scientific outcome. 23 An example of such conservative policies include Jim Crow laws that denied economic opportunity to southern blacks and prevented employers the right to hire the most qualified workers.



markets rather than with them, they may actually hurt their clients more than they help. Simply put, all

people who put their faith in a political ideology and who refuse to learn from experience and ignore

evidence that contradicts their beliefs have much to learn from economics.

Scientific economics is ultimately an ethical standard. A good economist should be self‐critical.

A good economist, like any good scientist, should be willing to specify: “Here is what I predict, and this is

the kind of evidence that would prove me wrong.” This is an ethical standard I will try to maintain in this

text, as I do in my professional life. I will often express my opinion; but when I do, I will also provide a

basis for proving myself wrong. If you will do me the same courtesy, we can learn much from each

other.

Virtually every society has a creation myth about how a super being shaped the world, plants,

animals, and people from raw material available. According to polytheistic religions (e.g., ancient Egypt,

Greece, and Rome before Emperor Constantine, as well as Hinduism and pre‐Columbian Native

American beliefs), creation and human history involve an ongoing struggle between good gods and bad

gods, the creators and the destroyers. I always found Greek mythology particularly entertaining

because Greek gods were as imperfect and as unpredictable as humans. Eventually the Greeks and

Romans outgrew their religions and largely converted to the major monotheistic religions—Judaism,

Christianity, or Islam. Unfortunately, differences of opinion about religious beliefs cannot be resolved

by logic or evidence because believers refuse to doubt their “holy” book (Talmud, Bible, or Koran),

because that book assures them that their god will punish nonbelievers. The prerequisite of science is

doubt, which is sinful to religious zealots.

Summary

1. While I am politically liberal and religiously agnostic, you do not need to agree with me to perform well in this class. However, as a conservative, you may be hostile to ideas that contradict your prejudices. Alas, if you registered for a grade, you will be required to understand economic theory, particularly as it relates to economic inequality, poverty, and economic discrimination.

2. Economics is a social science that investigates the impact of scarcity on human behavior.

3. Modern economics concentrates on assisting people in attaining their goals by using scarce resources efficiently, instead of making judgments about what those goals should be.

4. Economics straddles both the social sciences and the physical sciences. It is similar to the social sciences because it seeks to understand human behavior. It is similar to the physical sciences because it employs the scientific method to produce and test theories. However, like the other social sciences, economists rely on statistical analysis, rather than controlled experiments, to test their theories.

5. Economists seek not just to understand problems, but also, by concentrating on efficiency, to solve those problems as well.

6. As scientists, economists attempt to develop objective, testable theories. What separates science from religion is the willingness to admit error.



7. In contrast to the scientific method, religion requires unquestioned adherence to a set of beliefs contained in some holy book. It really is not surprising that religion is the root of much discrimination.

Glossary

Economics: The social science that studies how people make decisions in the face of scarcity.

Physical sciences: Disciplines that focus on the discovery of natural laws including economics, physics,

chemistry, biology, geology, and mathematics. Physical sciences tend to focus on physical, as

opposed to human or social, phenomena.

Social sciences: Disciplines that focus on human behavior including economics, psychology, sociology,

political science, history, and anthropology.

Scientific method: A method of inquiry that strives for objectivity, with the ultimate goal of learning

truth. The scientific method relies on observation and logic to develop theories, typically

expressed in mathematical form. Theories generate testable hypotheses, which are compared

to actual events (controlled experiments or statistical analysis) to determine if the theory

accurately predicts or explains reality. A theory that is refuted by real events is discarded or

modified in such a way to take account of the contradictory evidence.

Scarcity: A condition encountered when people want more than they can have. Scarcity implies

choice—people make priorities and (ideally) use scarce resources to satisfy their most important

wants first, understanding that at some point they must “do without.”

Resources: In economics labor (human time), capital (commodities that produce other commodities),

land (and other natural resources), and risk taking are combined to achieve desired goals (or

products).

Tradition: The oldest form of economic organization where one’s standard of living depends on family

and conformity to social norms.

Command: The form of economic organization whereby success depends on conformity to authority.

Market: The form of economic organization based on exchange and mutual advantage; bakers make

bread and butchers slaughter animals so that together they can have baloney sandwiches.

Discrimination: A word that has three, potentially contradictory meanings: (1) unfair treatment of

people or groups based on prejudice, (2) the appreciation of quality, or (3) the ability to

recognize small differences.

Chapter 2 Scarcity and Options


Scarcity and Options

Chapter 1 introduced the science of economics as the study of how people make choices in the face of scarcity. There are two aspects of choice that are often confused: understanding the set of options and choosing an option. An option is one possible out-come of a decision; a fairytale princess with three suitors; each prince represents an op-tion; she can choose only one of them, unless bigamy is a legal practice in that kingdom! When a friend takes you to lunch, the waiter brings you that menu; the menu represents options, not choices. If you chose everything on the menu, you lose a friend, and perhaps pay the bill by washing dishes.

The reality of scarcity means that we cannot choose all the options on the menu. A choice situation typically represents a fleeting opportunity to select one option from a menu of several mutually exclusive options. After the princess selects one suitor, the other two will go away, disappointed at best, homicidally angry at worst.1 The rejected suitors will pick other princesses, or even commoners. Picking one option means sacri-ficing the other options. When you select a dinner from a restaurant menu your money and your appetite fade away; you will have to wait until your next visit to that restaurant to try other delicacies.

This chapter concerns options in an environment of scarcity. Typically people combine scarce resources to produce goods and services that they or others value. In a market economy (presented in more detail in Chapters 3 and 4) people and businesses typically specialize in the production of goods and services so that they exchange what they produce for what other people produce. Even command or traditional economies, where one’s rewards depend more on conformity or family ties, the economic system must find some way to distribute the goods and services that the economy produces. How those goods and services are distributed is typically an issue of discrimination; in a world of scarcity, are winners and losers chosen by endowments (tradition), loyalty (command), or productivity (market)? Finally, there is the issue of consumption, whereby people use (and use up) goods and services to create their ultimate satisfaction or utility.

For over two hundred years economists have assumed that people make decisions by attempting to maximize their utility. According to Jeremy Bentham, an eighteenth-century philosopher, economist, and legal scholar, any action can be judged as good if it increases utility or pleasure (or reduces pain) or bad if it reduces utility (or increases pain). It follows that people will choose options that increase pleasure or avoid pain. A major problem is who decides? In an autocracy, the king, tribal chieftain, or other ruler decides. In a theocracy, nominally a god decides, but usually the decider is an autocrat who claims to speak for the deity. In a democracy, the majority decides for all, including the minority. In a libertarian society, people are the masters of their own fate and treat others with a “live and let live” attitude. Economists are generally libertarians who dif-fer only modestly about how great the scope of individual choice ought to be. They as-sume that people are the best judges of their own well-being, and reject this assumption only in the face of strong logic or evidence.

1 If you have seen a performance of Into the Woods, you know that both of the princes in that play regretted their choice, an outcome commonly known as buyer’s remorse.



Production Possibilities and Opportunity Cost

We now develop production possibilities, an important economic tool that de-picts the consequences of allocating scarce resources efficiently. Consider a farmer who has five different plots of land that have different production potentials. While each plot could produce a maximum of 200 tons of corn per acre if all that resource is planted with corn, each plot differs in the potential for wheat production, also measured in tons per acre. Table 2-1 presents the production possibilities for each plot of land.

Table 2-1 Maximum Maximum Opportunity Opportunity

Plot Wheat Corn Cost/Corn Cost/Wheat (tons) (tons) 500 200 2.5 0.4 400 200 2 0.5 300 200 1.5 0.67 200 200 1 1 100 200 0.5 2

Maximum 1500 1000

Although each plot of can produce the same amount of corn, they do not all pro-duce corn efficiently. Producing 200 tons of corn on plot means giving up 500 tons of wheat, so each ton of corn on plot has an opportunity cost of 2½ tons of wheat. By contrast, growing 200 tons of corn on plot means sacrificing only 100 tons of wheat, or ½ ton of wheat per ton of corn. The opportunity cost of growing wheat on plot is only 0.4 tons of corn per ton of corn, while the opportunity cost of growing wheat on plot is 2.0 ton of corn per ton of wheat.

Land is a scarce resource. There is a limited amount available (five plots), and using land for one crop means sacrificing the other. To grow wheat, the farmer must sac-rifice corn; to grow corn, the farmer must sacrifice wheat; and if he grows nothing, he sacrifices either wheat or corn, whichever has a higher value to him.2 If he is to produce efficiently, the farmer should prioritize resources according to comparative advantage. A resource has a comparative advantage in the production of one commodity if it produc-es that commodity at a lower opportunity cost than another resource can. Hence, plot has comparative advantage in the production of wheat (relative to plots through ), while plot has a comparative advantage in the production of corn (relative to plots through ). Do not think that comparative advantage always means that a resource has an absolute advantage. While plots and can produce 200 tons of corn, plot has the comparative advantage in corn. In the United States, Hawaii has a comparative ad-vantage in tourism, while New York has a comparative advantage in banking. Neverthe-less, while New York clearly has more banks than Hawaii does, New York also has more tourists, simply because New York has a larger population and more hotel rooms than Hawaii does.

2 By producing nothing, it would seem that the farmer sacrifices both wheat and corn, and in a sense he does. Had he grown wheat, he would have sacrificed corn; by growing neither wheat nor corn, he sacrific-es both (since he gets neither). However, it was never possible to get both maximum wheat and maximum corn; using land for one crop implied the sacrifice of the other crop.



By allocating resources in order of their comparative advantage3 the farmer can maximize the output of wheat for each rate of output for corn (or vice versa). We call the menu of efficient output combination a production possibility table. In Table 2-2 be-low, we start with combination A, whereby only wheat is produced on each plot of land. Combination A is efficient because, given the decision to produce no corn, we maximize the production of wheat. One efficient combination is A (0, 1500). If the farmer decides to produce 200 bushels of corn instead of 0, he must sacrifice some wheat. Transferring plot from wheat to corn minimizes the opportunity cost. Using plot to produce corn, we lose only 100 bushels of wheat. Our second efficient combination is B (200, 1400). For each efficient combination, we increase corn by 200 units by using the remaining plot in wheat production that has the lowest opportunity cost (that is, has a comparative ad-vantage in corn). Hence, our remaining efficient points are C(400, 1200), D(600, 900), E(800, 500), and F(1000, 0).4

Combination Wheat Corn A 1500 tons 0 B 1400 tons 200 tonsC 1200 tons 400 tonsD 900 tons 600 tonsE 500 tons 800 tonsF 0 1000 tons

Table 2-2

A picture of the production possibility table, Table 2-2, is the production possi-bility curve in Figure 2-1. We pick corn as the independent variable and plot alternative corn harvests on the horizontal axis. This decision makes wheat production the depend-ent variable because, given the available resources (five plots of ground), and efficient production, increasing the output of corn implies decreasing the output of wheat. The most distinguishing characteristic of a production possibility curve is its negative slope: as corn increases, wheat decreases. Note also that the slope of the production possibil-ity curve changes as we move left to right along the horizontal axis. This is because we start producing corn with the resource that has the lowest opportunity cost, so as we pro-duce more and more corn, the opportunity cost of producing the last unit of corn in-creases. This bowed-out shape of the production possibility curve is also known as the law of increasing (relative) opportunity cost. That is, if economies use resources effi-ciently, they will discover as the output of the commodity plotted on the horizontal axis increases, the opportunity cost of the other becomes greater, making the slope of the pro-duction possibility curve become progressively steeper.

3 That is, plot has a comparative advantage in wheat production relative to all other plots, and plot has a comparative advantage in corn relative to all other plots. However, plot has a comparative advantage in corn relative to plot , and a comparative advantage in wheat relative to plots , , and . 4 Note that Table 2-2 represents a menu of options, showing the maximum amount of wheat that can be produced for each combination of corn. Once crops were actually planted, however, changing the mix of crops would be much more difficult, given that he would spend labor ripping out seeds or seedlings, then replowing and replanting.



Figure 2-1 also depicts point G, which can be produced using plots and for wheat and,, and for corn, yielding 600 tons of corn and 600 tons of wheat. Point G is clearly possible since it is within the confines of the production possibility curve. How-ever, because it is inside of the production possibility curve, not on the curve, point G is inefficient. The dashed arrows through point G show that it is inefficient because it would have been possible to produce more wheat (corn constant), or more corn (wheat constant). By producing inefficiently the farmer would produce less output (revenue) without reducing his resource use (cost).

Every collection of people—families, businesses, governments, schools, coun-tries, or the world—confronts the ubiquitous condition of scarcity. If the organization responds efficiently to scarcity, it will fashion incentives that push production or con-sumption to its production possibility curve. Inefficient organizations always produce or consume less than they would if they were organized efficiently. While conflict within organizations typically involves the distribution of the resources of the organization, the study of economics helps us understand how changes in distribution affect incentives and the efficiency of that organization. While distribution determines the relative size of the slices of pie people receive, ultimately it is efficiency that determines the size of the pie.

0, 1500

200, 1400

400, 1200

600, 900

800, 500

1000, 00

200

400

600

800

1000

1200

1400

1600

0 200 400 600 800 1000 1200

An

nu

al W

hea

t P

rod

uct

ion

Annual Corn Production

Production Possibilities for Corn and Wheat

A B

C

D

E

F

Figure 2-1

G



Production Possibilities and Profit Maximization

Next we turn to the issue of economic efficiency and profit maximization. We as-sume that each of the five points in Figure 2-1 require an equal outlay for land (all five plots are used), labor (all must be planted, tilled, and harvested), and equipment (rental payments for tractors, harvesters, and so forth). Since profit equals revenue minus cost, the farmer would wish to produce that combination of corn and wheat that maximizes revenue. If we know the prices of wheat and corn, we can also measure the opportunity cost of wheat in terms of dollars, since each ton of corn not produced is equivalent to an amount of money that is sacrificed. Table 2-3 adds extra columns showing the revenue from each combination of corn and wheat and different potential prices.5

Table 2-3 Production Possibilities and Revenue Scenarios

1 2 3 4 5 6

Combination Wheat Corn Pw = $300 Pw = $300 Pw = $300 Pw = $300 Pw = $300 Pw = $300

tons tons Pc = $100 Pc = $200 Pc = $350 Pc = $500 Pc = $700 Pc = $1000 A 1500 0 $450,000 $450,000 $450,000 $450,000 $450,000 $450,000 B 1400 200 $440,000 $460,000 $490,000 $520,000 $560,000 $620,000 C 1200 400 $400,000 $440,000 $500,000 $560,000 $640,000 $760,000 D 900 600 $330,000 $390,000 $480,000 $570,000 $690,000 $870,000 G 600 600 $240,000 $300,000 $390,000 $480,000 $600,000 $780,000 E 500 800 $230,000 $310,000 $430,000 $550,000 $710,000 $950,000 F 0 1000 $100,000 $200,000 $350,000 $500,000 $700,000 $1,000,000

Scenario #1 in Table 2-3 assumes that the price of wheat (Pw) is $300 and that the price of corn is only $100 per ton. Producing only wheat (A) would maximize revenue, and hence, on the assumption that all combinations have the same cost, combination A would also maximize profit. Although the farmer could produce 200 tons of corn by re-ducing wheat by only 100 bushels (that is, producing combination B instead of combina-tion A), the corn gained would have a lower market value than the wheat sacrificed. In mathematics, we cannot compare quantities of different products unless we have a com-mon denominator; in economics that common denominator usually is price.

In scenario #2 we imagine that corn sells for $200 per ton and the price of corn (Pc) is $300 per ton. The value of combination would still be $450,000 since a change in the price of corn does not affect revenue if no corn is produced. If the farmer produced combination A, he would realize $450,000 (1,500 times $300) in revenue. However, by producing combination B instead of combination A, the same cost would have generated more revenue, $460,000 instead of $450,000. Sacrificing 100 tons of wheat (worth $30,000) implies a gain of 200 tons of corn (worth $40,000); this choice makes economic sense. The farmer would prefer combination B to combination A because combination B generates more revenue and no more cost. Under the prices depicted in column 4, com-bination B would not maximize profit. Notice that I have also computed the revenue for prospects C, D, G, E, and F. Simple economic logic can show that these prospects are inferior to prospect B. Producing combination C instead of combination B implies sacri-

5 As we will see in Chapter 5, farmers are typically price takers whose prices are set by the competitive market for wholesale agricultural commodities.



ficing $60,000 worth of wheat ($300 x 200) to produce an extra $40,000 worth of corn ($200 x 200). Producing D, G, E, or F would mean sacrificing more than $60,000 in wheat to produce an extra $40,000. By comparing the opportunity costs of the different prospects to their relative prices6, the profit-maximizing producer can easily determine the best (profit-maximizing) prospect (combination).

Scenario #3 in Table 2-3 posits that the price of corn has increased to $350, while the price of wheat remains at $300. In this case producing prospect B would no longer maximize profit. This is because prospect C now generates $500,000 of revenue, while prospect B produces only $490,000; sacrificing $60,000 worth of wheat ($300x200) gen-erates $70,000 worth of corn ($350 x 200), increasing revenue, and profit, by $10,000. Switching from prospect C to prospect D would not be profitable, since the farmer would sacrifice $75,000 of wheat revenue to generate $70,000 in corn revenue. And since switching from C to D would not be profitable, switching from C to E, F or G would not be profitable either. In fact, switching to prospect G would never be profitable.

Scenario #4 involves yet another increase in the price of corn, in this case to $400 per ton. Now prospect D is better than prospect C; sacrificing 300 tons of wheat, worth $90,000, allows the farmer to produce 200 tons of corn worth $100,000; it’s not the phys-ical quantity of the commodities that determines which prospect is most important, it is the relative market value of those commodities. Under scenario #5, when the price of corn has increased to $700, prospect E is now the best prospect; it is worth sacrificing 400 tons of wheat to get 200 tons of corn, since corn sells for more than twice as much as wheat.

Finally, in scenario #6, we imagine that corn sells for $1000 per ton, while wheat sells for $300. Since the price of corn is more than three times the price of wheat, the farmer is willing to sacrifice 500 tons of wheat to produce 200 tons of corn. If the price of corn is high enough, the farmer will specialize in corn; if the price of wheat is high enough (relative to corn), the farmer would specialize in wheat. There are scenarios that favor each of the points on the production possibility curve, but none of these scenarios would ever favor prospect G, the point inside the production possibility curve in Figure 2-1. Whenever it is possible to produce more of one commodity without sacrificing the other, that prospect is inefficient and inefficient production can never maximize profit.

Production Possibilities and Discrimination

Now we address the relation between production possibilities, profit maximiza-tion, and discrimination. Table 2-4 presents the production potential of 26 job applicants for the ECONO Motel. Based on infallible aptitude tests, the personnel manager predicts the number of rooms the applicant could clean and the number of guests the applicant could register for the 180-room motel each day. While each applicant is equally adept at registering guests at 10 per day, they differ markedly in their aptitude for cleaning. For instance, Alice could clean 26 rooms per day or register 10 guests; the opportunity cost of each guest registered would be 2.6 rooms not cleaned. By contrast, Zorro could clean only 1 room in the time he could register 10 guests; his opportunity cost of registering 1 guest is only 0.1 room. It follows that Zorro has the lowest opportunity cost, while Alice 6 Relative prices are the ratio of prices; in column 4, the relative price of corn is $200/300 or 2/3 or 67%. Purchasing 3 tons of corn means not buying 2 tons of wheat.



has the highest opportunity cost of guest registration, and that Zorro has the highest op-portunity cost of room cleaning (10 guests not registered per room cleaned), while Alice has the lowest opportunity cost of room cleaning (10/26 or 0.385 guest not registered per room cleaned).

In Figure 2-2, I depict the production possibilities for the 26 job applicants, plot-ting the number of rooms cleaned on the horizontal axis and the number of guests regis-tered on the vertical axis. If they registered no guests, the 26 job applicants could clean a total of 351 rooms (26 + 25 + … +1 = 351), although there are only 180 rooms to clean. The point (0, 351) would be technically efficient, but not economically efficient, since the staff would end up cleaning 171 rooms that had already been cleaned and would have no people in them. Assigning people to guest registration in ascending order of their oppor-tunity cost of guest registration allows us to complete the other points on the production possibility frontier. The key point on the production possibility curve that registers 180 guests into 180 cleaned rooms would maximize profit. I have labeled that point P.

Table 2-4 Predicted Productivity of Motel Staff

Potential Potential Opportunity Cost Employee Cleaning Registration per guest registeredAlice 26 10 2.6 Bob 25 10 2.5 Cathy 24 10 2.4 Don 23 10 2.3 Ellen 22 10 2.2 Fred 21 10 2.1 Gwen 20 10 2 Harry 19 10 1.9 Irene 18 10 1.8 John 17 10 1.7 Karen 16 10 1.6 Larry 15 10 1.5 Molly 14 10 1.4 Nate 13 10 1.3 Olivia 12 10 1.2 Paul 11 10 1.1 Qiana 10 10 1 Ralph 9 10 0.9 Susan 8 10 0.8 Tom 7 10 0.7 Ula 6 10 0.6 Vincent 5 10 0.5 Wanda 4 10 0.4 Xerxes 3 10 0.3 Yolanda 2 10 0.2 Zorro 1 10 0.1

If the manager were an economist, he would understand that incentives rule be-havior. Suppose that all the male job applicants require at least $150 per day to agree to work for the ECONO motel, while the female applicants require $100 per day; we call



these minimum daily wage rates each gender’s reservation wage. If the manager offered $19 per guest registered or $10 per room cleaned, the job applicants would sort them-selves out on the basis of their own self-interest. Each applicant could expect to earn $190 per day working in guest registration, which would exceed the reservation wage of either men or women. Alice ($260), Bob ($250), Cathy ($240), Don ($230), Ellen ($220), Fred ($210), and Gwen ($200) would earn more per day by cleaning rooms than by registering guests. These applicants would prefer to work cleaning rooms if those jobs were otherwise equally desirable or undesirable.7 Presumably Harry would be indifferent between the two jobs, since he could earn $190 per day at either. Allowing workers to sort themselves out would staff the eight workers with the lowest opportunity costs to work as room cleaners (cleaning 180 rooms per day), leaving 18 workers to register 180 guests per day. If each room rents for $50 per day, renting 180 rooms would generate $50*180 = $9,000 per day. Total wages for 18 registration clerks at $190 per day plus $10 per room for 180 rooms would be 18*$190 + 180*$10 = $3420 + 1800 = $5220. Subtracting labor costs from revenue generates gross profit of $9,000 – $5,220 = $4,780.

Now suppose that instead of allocating labor on the basis of comparative ad-vantage and worker choice, the manager is convinced that guest registration is a man’s job and room cleaning is a woman’s job. He decides to hire each applicant at his or her reservation wage, so that 13 men receive $150 each, and 13 women receive $100 each. This wage discrimination—paying workers based on their reservation wages, rather than on the basis of their productivity—would reduce the motel’s wage bill to $150(13) + $100(13) = $3250. However, assigning women to room cleaning without regard to productivity would reduce the number of rooms cleaned to 157, and the number of guests registered to 130. With only 130 rooms rented, revenue would fall to 130(50) = $6500, causing gross profit to decline to $6500 – $3250 = $3250. So Figure 2-2 gives the first

7 We will see in Chapter 9 that, when jobs are relatively unattractive, economists predict that workers in those occupations will require compensating wage differentials to counteract work in undesirable jobs.

0

20

40

60

80

100

120

140

160

180

200

220

240

260

280

300

320

340

360

0 20 40 60 80 100 120 140 160 180 200 220 240 260

Ro

om

s C

lean

ed p

er D

ay

Guests Registered per Day

Figure 2-2Produciton Possibilities for ECONO Motel

Production Possibilities Discrimination Point

P, Maximizes Profit

D, Discrimination Point



glimpse of what will be a recurring theme—discrimination based on prejudice, like as-signing jobs based on sexual stereotypes instead of on relative ability makes both workers and employers worse off. In this case, even the men, who appear to benefit from discrim-ination because they earn $50 more per day than women do, actually end up losing at least $40 per day because of the inefficiency of discrimination.

Other Applications of Production Possibilities

Production possibility curves are useful for depicting many types of economic trade-offs that result from scarcity. Even when resources are used efficiently it is impos-sible to produce more of one good unless some other good is sacrificed. Because produc-tion possibility curves are two-dimensional, we can only depict trade-offs of two goods at a time. Nevertheless, if we make the types of trade-offs mutually exclusive and exhaus-tive, we find that production possibility curves efficiently depict many types of economic choices.

Scarcity and Student Time

If you are a college student, a more relevant issue is the choice between study time that produces good grades, and other uses of time that produce other forms of happi-ness.8 For the student, we will consider the allocation of time between studying and other activities: market work, household production, leisure, and personal maintenance. Fortu-nate is the student who enjoys education, for education time can also serve as leisure time. Lucky is the student with an understanding employer (the intern), since education time may also count as work time, allowing the student to learn without sacrificing in-come. Ultimately, the student must confront the fact that education has an opportunity cost; the greatest cost of education is the opportunity cost of time.

Table 2-5 presents a hypothetical production function for a student whose edu-cational output is measured in her GPA, calibrated in a 4.0 scale. The first column shows the hours of study and the second column shows the maximum GPA the student can ex-pect from studying efficiently. She apparently is taking no crib courses, because the most she can produce from 0 study time is a GPA of 0.0.9 As the time spent studying increas-es, GPA increases, albeit at a decreasing rate.10 The first five hours of study increase the GPA from 0 to .76, for study productivity (increase in GPA per hour spent) of 0.15. In-creasing study time to 10 hours increases GPA (study time has a positive marginal product), but the change in GPA is smaller (only 0.14 points per hour). Eventually, if the student spends 50 hours studying, her GPA reaches 4.0. The last 5 hours had a posi-tive, but very small marginal product: only .04 points overall, or about .01 per hour.

8 My first article, published when I was a Ph. D. economics student at Syracuse University, “Education and Income: Analysis by Fable,” The American Economist, Fall1972, hypothesizes that students are best moti-vated by making education an enjoyable experience. By the time they get to college, they’re hooked on learning! 9 If we count class attendance as study time, a 0 means never showing up for class, thereby missing all ex-ams and scoring 0% in all classes. Such an outcome is clearly possible, and, if our “student” places no val-ue on education, that outcome would be efficient. 10 That is, she experiences diminishing returns to study time, which also implies increasing opportunity cost. Diminishing returns to studying reflects efficiency; studying the most important concepts first implies studying concepts of lesser importance as more time is spent studying.



However, if she spent more than 50 hours, her GPA would actually decline, as fatigue and confusion scrambled her brain!

Hours Best Study Hours Best StudyStudying Grade Productivity Studying Grade Productivity

0 0.005 0.76 0.15 55 3.96 -0.01

10 1.44 0.14 60 3.84 -0.0215 2.04 0.12 65 3.64 -0.0420 2.56 0.1 70 3.36 -0.0625 3.00 0.09 75 3.00 -0.0730 3.36 0.07 80 2.56 -0.0935 3.64 0.06 85 2.04 -0.140 3.84 0.04 90 1.44 -0.1245 3.96 0.02 95 0.76 -0.1450 4.00 0.01 100 0.00 -0.15

Table 2-6 rearranges the information in Table 2-5, now relating hours of leisure (168 hours per week minus study hours) to the resulting grade. Table 2-6 depicts the stu-dent’s options as involving two goods, leisure time and the GPA (and the underlying ed-ucation the GPA measures). Because a student must devote some time to personal maintenance, say 68 hours per week, I subtract 68 hours from the 168 available to reach 100 hours that could be allocated between leisure and study.11 According to Table 2-6, as leisure time increases from 0 to 50, the student’s GPA also increases. Devoting less than 50 hours to leisure would be inefficient, since as leisure time increases, the GPA also in-creases. If one does not experience a trade-off, one is not allocating resources efficiently. Since increasing leisure increases the GPA, the opportunity cost of leisure is actually negative from 0 to 50 hours. How could opportunity cost be negative? When I gain one good thing by doing another good thing, I am clearly better off and the choice between goods is moot. Only with 55 or more hours of leisure time (118 or more hours of non-study time) does the trade-off between studying and leisure become economically rele-vant.

Table 2-6 Production Possibilities: Leisure versus Grades

Leisure Best Opportunity Leisure Best Opportunity

Time Grade Cost Time Grade Cost

0 0.00

5 0.76 -0.15 55 3.96 0.01

10 1.44 -0.14 60 3.84 0.02

15 2.04 -0.12 65 3.64 0.04

20 2.56 -0.1 70 3.36 0.06

25 3.00 -0.09 75 3.00 0.07

30 3.36 -0.07 80 2.56 0.09

35 3.64 -0.06 85 2.04 0.10

40 3.84 -0.04 90 1.44 0.12

45 3.96 -0.02 95 0.76 0.14

50 4.00 -0.01 100 0.00 0.15

11 If the student is earning tuition or spending money by working outside of class time, then some of the available 100 hours are not leisure, unless the job is so enjoyable that she would do it for free.

Table 2-5



In Figure 2-3 we plot efficient combinations of non-study time and the GPA. Not studying at all and earning a GPA of 0 is an efficient allocation of time as long as the student has spent her available time doing something beneficial to her. Be careful not to mistake disagreement over the desirability of activities as disagreement about efficiency. Parents frequently finance their children’s education with the expectation that students will allocate sufficient time to earn good grades, and more importantly, actually learn something. Parents, however, cannot directly acquire the education for their children; the students must allocate time to study. If the student takes the opportunity to party and flunks out of school, they clearly allocated their time differently than their parents had hoped. But did the student really “waste” time? Not if they enjoyed the parties! Parents should give some thought to the incentives students face when they attend college. At good universities, students encounter true academic freedom for the first time in their lives. All students learn from the experience—some in the classroom and others in the barroom.

In our example, spending 100 hours studying would have also produced a GPA of 0, but that allocation of time would not be efficient. Assuming that she does not like con-fusion, she literally wasted 100 hours that she could have spent in other pursuits, like par-tying or earning an income. Spending more than 50 hours studying would never be effi-cient; hence, the minimum non-study time is 118 hours (168 hours per week minus 50 hours studying). Because of the decreasing marginal productivity of study time, the slope of the production possibility curve is bowed out from the origin. The 118 hours of non-study time and the minimum GPA implies 168 hours of non-study time.

The diagram suggests that there are two possible reasons why students may not achieve a 4.0 GPA. First, and most likely, they do not know how to study efficiently—they spend upwards to 50 hours per week staring at books and doodling on paper, only to squeak by with a 2.0. At point P, a student comes to class unprepared, sleeps through class (because of inadequate personal maintenance), then rushes to cram for a test the night before an exam. He barely passes, but is frustrated because there is no extra time available. If he (1) read the text before lectures, (2) actively participated in class discus-sions, and (3) joined a study group that reviewed material as the class progressed, he could (4) get a good night’s sleep the night before the exam. That is, from point P, the student could increase his grade without spending any less time on non-study activities, or could achieve the same grade and allow much more time for non-study activities. Or, if satisfied with a 2.0, efficient studying would “create” an extra 35 hours of leisure.

I suspect that many students are frustrated, not because of the reality of the trade-off between education and other uses of time, but because their inefficient use of their time results in a suboptimal combination of both non-study time and grades. There is no doubt that some students achieve low grades because they study too little. But I suspect most students receive low grades because they study inefficiently. In past semesters, I allowed students to bring prepared notes to class, believing that they would spend less time trying to memorize material (true), and spend more time learning the material (false). Last semester a majority of the class failed their exams because of inadequate (and I believe, inefficient) preparation. To the extent that my allowing them to bring notes to class was part of the problem, I have tried to rectify that problem. However, I still encourage you to spend time understanding the material rather than memorizing it.



Consumption, Investment, and Economic Growth

Figure 2-4 shows one of the trade-offs between the production of consumption goods—goods that are used to generate satisfaction in the year they were produced—and capital goods, which are commodities that produce other commodities. We draw pro-duction possibility curves following two assumptions: (1) that available resources are fixed, and (2) that technological possibilities are fixed during the period in question. Given that a country’s land is fixed by international boundaries, the two important varia-ble factors of production are capital (any output of the production process that is also an input into the production process in later periods) and labor (human time devoted to market production instead of one of the other three uses of time).12 For the time being, we will treat the labor force (the number of person-hours available for work) as fixed. We will also assume full employment.13 We also assume away obviously inefficient out-comes, like producing only capital goods, so that the population starves.

If the economy is operating at point D, its resources are being used inefficiently. Perhaps farmers are trying to program computers, while computer scientists are attempt-ing to grow crops from silicone. In a market economy both types of operations would fail; farmers would return to growing crops, while computer scientists would return to writing computer code. Merely by encouraging each person to pursue his or her self-interest, the market would allocate resources efficiently. In other systems of economic

12 Household production, personal maintenance, or leisure 13 Full employment does not mean that every person who wants to work actually has a job, since some un-employment always exists in a free-market economy in which employers can fire unproductive workers and workers can quit dead-end jobs. So throughout this text we will refer to full employment as a condition when the number of available jobs equals the number of people looking for jobs.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

118 123 128 133 138 143 148 153 158 163 168

GP

A

Non-Academic Activities (Hours)

Figure 2-3A Student's Production Possibilities

P



organization efficiency might not be achieved so easily. In a traditional economy, one typically follows the father’s (boys) or mother’s (girls) occupation. How many computer geniuses were squandered raising crops because they were born into the wrong caste? In a command economy, good jobs are often rewards for loyalty; need we mention recent debacles in the Bush administration?14

Figure 2-4

Figure 2-5 adds two additional production possibility curves to depict alternative futures resulting from the current choice between consumer goods and investment goods. We start with the production possibility curve AA', which depicts the position of the pro-duction possibility curve in the first year of the analysis. Suppose further that the country in question produced at point A', which is the horizontal intercept of the original produc-tion possibility curve, with Cmax of consumer goods and no investment goods. In this case, the production possibility curve would shift toward the origin, from AA' to DD' (“D” for decline) because failure to replace worn-out capital goods would reduce the re-sources available for production in the next year. Since capital goods automatically de-preciate just through the passage of time, any business, and the economy as a whole, must replace worn-out or obsolete equipment or the production possibility curve will shift in-wards.

At point A', the economy produces Cmax, so that capital production is zero.15 The next year, the production possibility curve shifts inward as machines wear out and are not replaced. At point P0 the economy produces just enough capital goods to keep the pro-duction possibility curve stationary. At point P1, the economy reduces the production of

14 When I took a political quiz at http://www.theadvocates.org/quiz.html, I rated 100% on personal issues and 50% on economic issues, placing me on the boundary between libertarian and liberal. Try the quiz for yourself; are you comfortable with your label? 15 Here we are assuming a closed economy, which does not rate with other economies. An open economy could produce Cmax, but trade some of its consumer goods for another economy’s capital goods, thereby investing.

Cap

ital

goo

ds

A

A’

D

B

Consumer goods

C

E



consumer goods and produces enough net investment. The next year the production pos-sibility curve shifts to the right.

To retain the position of the production possibility curve at AA', the economy

would have to reduce the output of consumer goods from Cmax to C0, which would free enough resources to produce I0 units of consumption goods.16 American tax law recog-nizes the depreciation of plants and equipment as a necessary cost of doing business and allows companies to deduct the cost of (depreciate) their capital goods from their taxable income, based on various formulas. A prudent company will set aside (save) money to buy new equipment (that is, invest) when it is timely to do so. Companies that do not re-place capital equipment are companies that are headed for bankruptcy; unscrupulous owners of such companies will often unload those businesses on unsuspecting buyers (who are definitely not investors!) right before those companies fail.

A country that replaced only its depreciated capital goods would invest resources to produce I0 units of capital goods, which would imply a reduction of consumer goods (saving) equal to Cmax – C0. The value of its gross domestic product would equal GDP0 = pcC0 + pkI0, where pc is the price of a consumer good and pk is the price of a capital good.17 Gross domestic product is the current market value of all goods and services produced in an economy during a calendar year, measured in current prices. Hence, pc is the average price of consumer goods and pk is the average price of capital goods. Since

16 We label the production of capital goods as I0 because society would have invested I0 worth of capital goods in replacing depreciated equipment. Since the capital stock remains constant, this would represent gross investment of I0, but net investment (investment minus depreciation) of zero. 17 Note that some of the consumer goods would actually be government services such as fire protection (a consumer service) or highway construction (an investment good). Furthermore, some of the output of con-sumer goods might be sold to other countries (exports) and some goods consumed by households might have been produced in other countries (imports). Finally, pc and pk are really averages (indexes) of the many different types of consumer and capital goods.

G A

D

I0+ In

I0

0

Consumer Goods Production

Cap

ital

Goo

ds P

rodu

ctio

n

P0

C1 C0 Cmax

D' A' G'

Figure 2-5

P1



businesses would save just enough funds to pay for the pkI0 investment in capital goods, households would be spending all their income on consumer goods.18

Suppose that some households wished to spend more on consumption than their current income would allow, while other households wished to put aside a share of their income for future consumption, say after retirement. These desires give rise to a demand for loanable funds (by would-be borrowers) and a supply of loanable funds (by would-be lenders). In Chapter 4, will learn how the demand and supply of loanable funds deter-mines the market interest rate At this point, we note that if this lending and borrowing activity is restricted to households the distribution of consumption will change, but the total level of consumption would be constant. Debtors would consume more than their present income and would have to reduce their future consumption to pay back the prin-ciple and the interest on their loans. Lenders would consume less than their income to-day, but more than their income in the future. Reallocating a fixed amount of goods be-tween the thrifty and the squanderer would not change the total available to all consum-ers.

If higher income households wish to save, while lower income households cannot borrow because they have poor credit, the net saving in the household sector (saving mi-nus borrowing) would be positive. Intended consumption spending would decline, from C0 to C1. By reducing the production of consumer goods, resources are available to in-crease investment from I0 to I1. By moving from point P0 (C0, I0) to P1 (C1, I1), net in-vestment (production of capital goods minus depreciation) would equal In. Next year, when new equipment comes online, the production possibility curve would shift out from AA' to GG' (depicting economic growth). Hence, by reducing consumption in the present (delaying gratification), saving allows for positive net investment and economic growth (the payoff).

There is an important distinction that often confuses many students. The act of saving occurs among households when consumption spending is less than disposable in-come (i.e., income after taxes). Saving can take several forms, including hoarding (e.g., stuffing money into a mattress), or lending, which means that the saver transfers the pur-chasing power to a borrower, who typically pays interest, to direct investment by plowing profits into the family business.19 People must pay interest and repay the principle by reducing future consumption. Lending money is not, by itself, an investment. An in-vestment occurs when economic agents use funds to purchase commodities that produce other commodities. Often, when a saver makes a loan, they are actually assuming the creditor position of another lender. When I buy a corporate bond, I am actually buying an IOU issued by a business and initially sold to another person. The investment oc-curred when the business used the proceeds of that initial public offering (the only time the business receives money from the sale of stock) to expand its plant, buy new equip-ment or inventories, or hire researchers to develop new products. If we call the purchase of the bond an investment, we must call the sale of the bond by another person a disin-

18 Of course, part of the purchase of consumer goods would be financed in the form of taxes paid to the government. We assume that the government budget is balanced—more later. 19 In the hopes of avoiding confusion, economists typically treat this transaction as two steps; the household lends money to the family business, and then the business invests those funds to purchase commodities that produce other commodities.



vestment, and an investment plus a disinvestment would cancel each other. To me, this is more confusing than simply attributing saving (and lending) to households and investing (and borrowing) to businesses.20

Public Goods versus Private Goods

Another important application of production possibility curves shows the alloca-tion of resources between the private sector (businesses and households) and the govern-ment. The United States and most of the world are mixed economies with a dominant private sector and a public sector that supports the private sector and sometimes modifies market outcomes, redistributing income or modifying incentives.

Two indispensable functions of government are the protection of property rights and the enforcement of contracts. Unless these services were equally available to all, the economy would degenerate into loot and pillage causing little or nothing to be produced. Economists refer to commodities that are consumed by everyone once produced as pure public goods. Technically, pure public goods are scarce before they are produced, in that scarce resources (e.g., for police services to protect property and for judicial services to dispense justice) must be allocated to produce these services. However, once these ser-vices are produced, they are available to all residents of the economy, regardless of whether they pay for them or not. Businesses cannot sell pure public goods because they cannot withhold the commodity from people who refuse to pay. Whether you believe the war in Iraq (or the war on terror) is a good or a bad idea, it is clear that all Americans share in those benefits or costs. The Iraq war is financed by a combination of taxes and borrowing; the cost of the war is not the money used to finance it, but the alternative ben-efits that resources used to fight the war could provide (finding Osama bin Laden, univer-sal health care in the United States, dispatching economists to Mexico to improve that economy, using financing from China to expand American businesses). The government must finance the war; however, the government could turn the fighting of the war entirely to private contractors like Halliburton.

By contrast, private goods are scarce in both production and distribution. Deliv-ering an apple to market requires land, labor, capital, and entrepreneurship. If I purchase an apple and eat it, that apple is no longer available to others. Other examples of private goods are food, clothing, shelter, cardiac bypass surgery, or a personal computer. The market does a particularly good job at producing and distributing private goods. If peo-ple like Jonathan apples more than they like Granny Smith apples, the price of Jonathan apples will increase and the price of Granny Smith apples will decrease. Eventually ap-ple orchards will cut down their Granny Smith trees and plant Jonathan apple trees.

Imagine an economy trying to operate at point A in Figure 2-6, producing only private goods. Private firms could not sell property protection or contract enforcement, so these activities would not occur.21 Trade would require barter for lack of a universally acceptable form of money. While it would be possible for people to carry weapons to protect their own property, it is likely that those with the most lethal weapons would turn

20 There are times when people can invest: They can buy additional computers for their own business, or they can invest in human capital, such as an education, which we will discuss in Chapter 8. 21 While private security companies do augment government police services, an economy with only private security services would degenerate into loot and pillage, as discussed in chapter 3.



to larceny. If people could hire judges to produce a favorable verdict, would the outcome constitute justice? Hence, Figure 2-6 shows that increasing the production of public goods would also increase the production of private goods; a system of anarchy, where everyone protected their own property and enforced their own contracts, would not con-stitute an efficient allocation of resources.

At the other extreme, suppose we imagine a Marxist paradise, where all property is held in common and all output is shared equally.22 There is a broad consensus that the social experiment in “communism” was a miserable failure, and that not only was it im-possible to operate a system by distributing income equally, but that so-called communist countries produced fewer goods and services for everyone than would a comparable capi-talist economy. Nevertheless, there have been some attempts—such as medieval monas-teries and Israeli kibbutzim—where groups at least try to overcome egoism and live a life of applied altruism. In fact, as I will argue in Chapter 6, the ideal family is organized ac-cording to the Marxist dictum, “From each according to ability, to each according to need.” So, we imagine point X, where there is a zero output of private goods and a posi-tive quantity of public goods. The point is that by allowing unequal distribution of con-sumption—that those who produce more get more—increases total output of both public and private goods from point X to point Y.

Note that a society composed of egoistic economic agents would not wish to op-erate along the segment AB or the segment XY, because either scenario would allocate resources inefficiently. The appropriate production possibility curve would imply at least P0 units of private goods and at least G0 units of public goods. Hence, the origin of the appropriate production possibility curve has its origin associated with positive rates of output of both public and private goods. This implies that radical egalitarians—those who wish to treat all goods as public goods in the sense that all people consume equally (or consume enough to have the same standard of living)—will necessarily sacrifice some of both public and private output to achieve their goal. On the other hand, anarchists would also strive for an inefficient allocation of resources. I wonder how much radical ideology stems from an actual willingness to impose huge sacrifices on society to achieve ideological purity and how much radical ideology springs from a basic ignorance of eco-nomic reality.

Except for ideological extremists, conservatives and liberals have honest disa-greements over the proper sizes of the public sector and the private sector because: (1) many goods are neither purely private goods nor purely public goods, and (2) govern-ments distribute commodities (especially services) differently than markets do. Consider education: Is education a public good or a private good? Well, the answer is both. Clear-ly public schools and private schools coexist; education can be financed with tax revenue and made available to all children, or financed by tuition and restricted to students based on ability to pay, race, gender, or religion. Today few people argue that elementary edu-cation should be a pure private good, limited only to families that can pay tuition; such a

22 I once suggested to an economics class that “pure communism” would be a good definition of “heaven.” One of my students, who styled himself as a non-ordained fundamentalist Christian minister, claimed that heaven would have to be a capitalist system, since communism is evil. When I asked him how this squares with scripture, he got very angry, dropped the course, and complained to the dean. Thank (somebody) for academic freedom.



policy would drive a nail into the image of the United States as the land of equal oppor-tunity. However, libertarians23 and statists24 differ strongly about how education should be produced. Libertarians argue for vouchers or other payment schemes that place a premium on educational choice. They believe that competition among schools will en-courage students to achieve educational excellence, much as such competition drives pri-vate, not-for-profit universities. Statists (some of whom are employed by public schools) argue that government is necessary to standardize education and that vouchers would benefit the rich more than the poor. They often care more about control than about edu-cational success.

Figure 2-6

Next, consider health care. Some aspects of health care are pure public goods; smallpox could only be eradicated when all vulnerable populations were vaccinated, re-gardless of willingness or ability to pay. The more people are vaccinated, the lower is the incentive by the remaining vulnerable population to get treated, since few people remain who can pass the disease along. Most medical care is clearly a private good since physi-cians treat patients one at a time, drugs or transplants consumed by one patient are not available to others, and so forth. In some countries, particularly authoritarian ones, phy-sicians and other health professionals work directly for the state and can be fired by the state medical monopoly if they run afoul of the government. Canada and most European countries have a system of public finance and private production for health care. The

23 “LIBERTARIANS support maximum liberty in both personal and economic matters. They advocate a much smaller government; one that is limited to protecting individuals from coercion and violence. Liber-tarians tend to embrace individual responsibility, oppose government bureaucracy and taxes, promote pri-vate charity, tolerate diverse lifestyles, support the free market, and defend civil liberties.” http://www.theadvocate.org/quiz/html 24 “STATISTS want government to have a great deal of power over the economy and individual behavior. They frequently doubt whether economic liberty and individual liberty are practical options in today’s world. Statists tend to distrust the free market, support high taxes and central planning of the economy, oppose diverse lifestyles, and question the importance of civil liberties.” http://www.theadvocate.org/quiz/html

Private Goods (P)

Pmin P0 Pmax

Gmax

G0

Gmin

Pmax

Gmax

0

Pub

lic

Goo

ds(G

)

Pub

lic

Goo

ds (

G)

Private Goods (P) (Pmin, Gmin)

(Pmin, Gmin)



government uses tax revenue to finance health care on an urgency of need basis; it is unu-sual for a Canadian to wait long for cardiac bypass surgery, but face lifts are another mat-ter. The United States is also a mixed system, but much more health care is financed by private sources. Senior citizens, the poor, and government employees receive govern-ment-financed health care; members of the military and veterans receive government-produced health care. Everyone else must pay for their health insurance from employer-provided insurance or out of pocket. Recently, some major American companies, most notably General Motors, have begun to falter as the cost of employer-provided health care has priced their products out of the market.

Financing Public Goods

Figure 2-6 shows that not all possible combinations of public goods are economi-cally efficient. Henceforth, we will concentrate on efficient options, where producing more public goods implies producing fewer private goods, and vice versa.25 Along the production possibility frontier between the maximum amount of public goods (given the minimum level of private goods) and the maximum amount of private goods (given the minimum level of public goods), producing more private goods implies producing fewer public goods, and vice versa. Suppose we consider point (Pmax, Gmin) as the ultimate lib-ertarian point (maximum size of the private sector) and point (Pmin, Gmax) the ultimate statist point (the largest government sector the economy could tolerate). The ultimate libertarian point would rely on private schools, private health care, no government-sponsored income transfers. The extreme statist point would entail socialized medicine, government-produced education for all children26 regardless of parental income, and suf-ficient government transfers to eradicate poverty and perhaps even allow for equal eco-nomic opportunity from birth, which the government also regulates. The point is that there would still be some public goods in the (efficient) libertarian economy and much economic inequality (resulting from unequal effort or merit) in the (efficient) statist economy. Hence, it will always be necessary to finance public and private goods togeth-er.

Chapter 4 will discuss supply and demand, the means by which markets allocate private goods through competitive markets. The process of determining the amount of public goods to produce is called public economics, public finance, or public choice. The basic idea is that citizens select government decision makers who decide on the level of public goods to be provided. Taxation is the coercive transfer of purchasing power from the private sector (households and firms) to the public sector (national, state, and local governments). Democratically elected governments typically buy factor services in much the same way that businesses do; the most obvious exceptions are eminent domain,

25 Recent cries to shut down the federal government by TEA party demonstrators is an example of ideology trumping common sense. A federal shutdown that compromised the government’s ability to pay interest on government bonds would destroy the credit of the USA and create another Great Depression, devastating the world’s economy. 26 This phrase begs the question: equal educational inputs (i.e., the same quality teachers and classrooms) or equal educational outcomes (college graduation for everyone).



whereby the government “takes” property for public use, but must pay “just compensa-tion,” and the draft, whereby the government confiscates labor services.27

Figure 2-7 reprises Figure 2-6 by assuming that the economy is operating at the libertarian bliss point (Pmax, Gmin). Next, suppose that voters elect a liberal government that proposes increasing government services from Gmin to Gc. By imposing taxes equal to the market cost of resources used to generate those services, the government first re-duces consumption (from Pmax to Pc), and then transfers those resources to government use by hiring land, labor, capital and entrepreneurial services necessary to produce the Gc goods. Note: public goods require government finance, not necessary government pro-duction. Government-financed student loans allow students to attend private universities, while public universities employ college professors directly. Medicare and Medicaid fi-nances private-sector produced health care, in contrast to Veterans’ Administration (VA) hospitals that operate as government entities.

Figure 2-7

Efficiency vs. Fairness: Efficiency Matters

In chapter 10 we will address economic inequality in more detail. At this point I wish to put the issue of efficiency vs. fairness into context for our discussions from chap-ter three through chapter nine. I have been known to quip that in 33 years of parenting, none of our three kids ever complained “Dad, it’s not fair; I got too much.” While this is not actually true; we managed to raise three altruistic human beings, it seems true. If one has too much, one can remedy the situation by voluntarily giving some of his/her excess to another. However, if one feels (s)he has too little, the only remedies are to beg, bor-row, or steal.

It is nevertheless possible to use the production possibility frontier to consider the issues of efficiency and fairness. In Figure 2-8 we plot the income of southern blacks on the horizontal axis and the income of southern whites on the vertical axis. As we will see throughout the course, Southern segregation, that denied education, employment and

27 The Vietnam War was particularly unpopular because of the use of the draft, whereby young men were given the choice between military service and prison. While the government no longer employs a military draft, it still requires citizens to serve on juries with little or no compensation.

(Pmax, Gmin)

Private goods and services

B

C

Pc

Gc

Pmin, Gmax

Pub

lic

good

s an

d se

rvic

es

Taxes

Val

ue o

f go

vern

-m

ent s

ervi

ces



business opportunities to African-Americans by suppressing market competition. Jim Crow laws pushed the south inside of its production possibility curve, reducing the earn-ings of both blacks and whites below their potential. Without understanding what they were doing, white southerners reduced their own incomes (23.5%) in order to reduce black incomes by a greater proportion (50.7%). After Congress passed the Civil Rights Act, both southern black and southern white incomes increased relative to their respective incomes in the rest of the country. Bigots have long harbored the notion that income dis-tribution is a zero-sum game; that more for the least fortunate implies less for everyone else. We will discover that reality is more complex, and more interesting. Whenever government policy – or social evolution – removes impediments to efficiency, it is possi-ble to make everyone better off.

Figure 2-8

Income in the Pre-Civil-Rights South;

When Unfairness Was Also Inefficient

Conclusion

In this chapter we have seen how scarcity limits the options people and firms may pick. When a scarce resource has alternative—but mutually exclusive—uses, the oppor-tunity cost of using that resource to produce one commodity is sacrificing the other commodity or commodities that might have been produced instead. By allocating re-sources in reverse order of their opportunity costs, economists generate production possi-bility curves that are negatively sloped and bow outward. Market incentives allow indi-viduals to maximize their own well-being and generally result in efficient allocation of resources. Discrimination typically distorts economic incentives and results in inefficient resource allocation. An important trade-off exists between the production of consumer goods (that provide immediate satisfaction) and capital goods, which increase the produc-tion of goods in the future, and therefore stimulate economic growth. Another important trade-off exists between private goods (sold in markets) and public goods (financed by government and available to all). We now turn our attention to how households and firms decide among the options available.

Black income

White income

1962



Summary

1. Economists illustrate scarcity with a production possibility table or diagram, which shows the maximum output of one good that can be produced from each rate of out-put for the other good.

2. The opportunity cost of producing any good is the value of the best alternative sacri-ficed.

3. A resource has a comparative advantage in the production of one good if it has a lower opportunity cost than some other resource has for producing the same commod-ity.

4. Typically, production possibility curves are negatively sloped (due to scarcity) and bowed out from the origin due to increasing opportunity costs.

5. Firms cannot maximize profit unless they allocate resources efficiently. Profit-maximizing firms will pick that point from their production possibility frontier that maximizes the difference between revenue and opportunity cost.

6. Students allocate study time efficiently when they achieve the maximum possible ed-ucation (GPA) for each allocation of non-study time. Many students do not achieve high grades because they spend their study time inefficiently.

7. The production possibility curve between consumption and investment shows that the economy can grow only if some resources are allocated to the production of invest-ment goods instead of being allocated to the production of consumption goods.

8. Because some public goods are necessary markets to function, and because some pri-vate goods are necessary to generate work incentives, the production possibility fron-tiers between public goods and private goods are likely to have positively sloped por-tions. Rational libertarians and statists would operate only on that portion of the pro-duction possibility frontier between public goods and private goods where producing more of one type of good implied producing less of the other.

9. Public goods can be financed by taxation, which reduces consumption, or by borrow-ing, which reduces investment either domestically or in other countries.

Glossary

Production possibilities: A table or graph, showing the maximum output of one good or service for each rate of output for another. Production possibilities require that all available resources be used efficiently.

Efficiency: A state of affairs wherein it is impossible to produce more of any commodity unless one decreases the output of some other commodity.

Comparative advantage: Having the lowest opportunity cost in the production of a commodity among all the resources available.

Increasing opportunity cost: Production possibility frontiers are negatively sloped be-cause as one produces more of a particular commodity, the opportunity cost of the re-sources available to produce more of that commodity increases.



Production function: A rule, table, or diagram that shows how the output of a commodi-ty is related to the amount of input(s) used to produce that commodity.

Marginal product: The additional output obtained from the last unit of input used, with other inputs constant.

Consumption goods: Commodities used by households to generate immediate utility.

Capital goods: Commodities that produce other commodities.

Investment: The diversion of scarce resources into the production of capital goods.

Pure public good: A commodity that, once produced, must be consumed by everyone. Examples include property right protection, contract enforcement, and national de-fense.

Pure private goods: Commodities that are diminished by distribution, such that con-sumption by one person reduces the amount available for other people. Examples in-clude food and clothing.

Group consumption goods: Commodities falling between the extremes of pure public goods and pure private goods, which can be provided either by the government or by markets. Examples include education, research (information production), and health care.

Comparative advantage: Being the low opportunity cost producer of a particular com-modity, compared to one or more other countries.

Comparative disadvantage: Being the high opportunity cost producer of a particular commodity.

Chapter 3 Economic Interactions


The Circulation of Economic Activity

We revisit the two fundamental economic institutions: the household and the firm. In a private enterprise economy, scarce factors of production—land, labor, capital, and entrepreneurship—are privately owned by people who live in households. A household could be a person living alone, a nuclear family composed of one or more adults with or without children, or an extended family with three or more generations. The household is the basic consumption unit, which also supplies the services of scarce factors of produc-tion to the business sector. In primitive economies, households were typically both con-sumers and producers, growing crops and raising animals, and trading any surplus for goods produced by other households. In market economies like the United States, commodity production takes place in firms—business institutions that hire factors of production and buy the products of other firms—to earn revenue selling their output to members of the household sector. There is still some household production that in-volves combining human time, raw materials (e.g., food), and appliances (e.g., micro-waves) to produce the final good (a meal).

Figure 3-1

Figure 3-1 depicts a simple flowchart of economic activity. The inner flow of ac-tivity (indicated by the bold, black print) depicts the ultimate interaction of an economic system—the transformation of scarce factors of production into goods and services. Households supply land, labor, capital, and entrepreneurship1 services that they own to the business sector, and the business sector turns those scarce factors into valuable outputs—goods (tangible commodities) and services (commodities that are consumed the moment of production). Households acquire factors of production two ways: endow-ments that are bestowed upon a household through inheritance or gifts, and through ac-cumulation such as saving a portion of one’s income to acquire land or capital, or by al-

1 The word entrepreneurship comes from the French entrepreneur, the person who organizes production and assumes the risk of failure in the hopes of obtaining a profit. Often, for simplicity, we will include entrepreneurship as a form of labor, since assuming risk requires the expenditure of time and energy.

Households Firms

Wages, Rent, and Interest (Production Costs) and Profit

Consumer Spending (Business Revenue)

Labor, Land, Capital, and Entrepreneurial services

Goods and Services



locating time to acquire education or other job-related skills. This inner flow of real eco-nomic activity (land, labor, and capital into goods and services), depicted as flowing in a counter-clockwise direction, is matched by a monetary flow (in green) that moves in the clockwise direction. In exchange for factor services, households receive money income in the form of wages (for labor), rent (for land), interest (for capital), and profit (for en-trepreneurship). They exchange this money income for the goods and services that they desire. The spending by households represents revenue to businesses; the income of households represents costs to businesses.2 Economists typically assume that business owners attempt to maximize profit—the difference between revenue and factor payments to others (i.e., wages, rents, and interest).

In Chapter 2 we briefly discussed the three types of economic organization: tradi-tion, command, and market. In Figure 3-1, markets operate at the interface between the household sector and the business sector. We use markets to procure food, clothing, shel-ter, transportation, entertainment, medical care, and most other commodities we con-sume. It does us no good to beg for food at the grocery store, or to order a gas station operator to fill up the tank unless we are prepared to pay. Yet children beg for food all the time, albeit typically not the healthy food their mothers would prefer that they eat. Households typically function as traditional economies. Parents and children are as-signed their roles by biology and bonds of affection; however, when affection fails, par-ents and even children have been known to revert to threats and punishment, which char-acterize a command economy. The typical business functions under a well-defined command structure; you might have been hired through a labor market, but your day-to-day interaction with the boss is one of fear or loyalty.

In order for a market system to function, scarce resources must be privately owned. Ownership gives owners the right to exclude. Every right implies a duty by others; the right to exclude by property owners corresponds to a duty of non-owners not to steal. This land is my land because I can evict you if you trespass. When land is not privately owned, the tragedy of the commons3 occurs. During medieval times in Eu-rope, landless peasants had the right to graze their flocks on common pasture land, often nominally owned, but not controlled, by the Church. No one—neither peasant nor noble nor cleric—had the right to exclude anyone else from using common pastureland. This may sound egalitarian, but the commons creates a free-rider. Any grass that my sheep do not eat, your sheep will eat later. Therefore, I have no incentive to preserve the grass—I allow my sheep to consume not only the grass, but the roots as well. Before long, the commons is a grassless, muddy field. Any public-spirited peasant who planted grass on the commons would watch in dismay as someone else’s flock munched the ten-der emerging shoots.

2 One factor service, entrepreneurship, yields profit. Technically, profit is the difference between revenue and (opportunity) cost. We treat profit as a cost because (1) it is the payment for a factor service, and (2) it ultimately ends up in the household sector. 3 Garret Hardin, “The Tragedy of the Commons,” Science (December 1968), 1243–1248.



The North American version of this tragedy occurred on the open range where cattlemen and shepherds competed for grassland.4 Since no one owned the prairie, no one had the legal right to police its use. That did not stop the cattlemen from resenting the encroachment of the shepherds (and vice versa). Nor did that did stop cattlemen and shepherds from shooting each other. But until the invention of barbed wire, which al-lowed owners to mark off their property and post no trespassing signs, the American West continued its reputation as a lawless, chaotic place.

Government and the Market Economy

This discussion highlights an important omission from Figure 2-1. In order to fa-cilitate the transformation of resource services into commodities, a third entity—the gov-ernment—must define and enforce property rights. A market economy cannot operate in a state of anarchy, where households and businesses spend so much time defending their property that they have little time to use it productively. If someone has the strength and ability to exclude you from using his property, he probably has the strength and ability to prevent you from using your property. The importance of property rights is that all own-ers have the right to exclude, even if they do not have the muscle to enforce those rights themselves. To be effective, the government must defend the property rights of the weak and the strong alike. Otherwise, loot and pillage is likely to prevail.

According to one version of the genesis of private property, a number of enlight-ened and reasonable people agree that communal access to scarce resources is incon-sistent with the efficient allocation of resources. They unanimously agree to respect the de facto property rights of each person in the community. The group allows each mem-ber to keep his or her own production and to arrange a mutually advantageous exchange of property rights with anyone else. Without the right to exclude, there can be no right to exchange. Only if you must obtain my permission to use my property (because socie-ty will punish you if you take it without my permission) will you be willing to give me something in exchange if I transfer my property right to you. Since exchange is volun-tary—either party can cancel the exchange if the terms of trade are not to his or her lik-ing—both parties gain from trade, as long as each is adequately informed and consents to the exchange.

Another fable from economic mythology is more plausible and also illustrates the superior incentives of property rights over the commons. Members of a band of maraud-ers, operating under the “might makes right” principle of social interaction, discover the flaw of loot and pillage. As long as it seems easier to take what someone else has pro-duced than it is to produce for oneself, the strong will specialize in plunder. The weak might specialize in producing, since they have no skill for theft, but they come to under-stand that any resources they possess will eventually be taken. So the weak decide to live a hand-to-mouth existence, gathering only what food they can immediately swallow. Be-fore long, with the gatherers eating all they find, the looters will have nothing to plunder.

4As hunter-gatherers, Native Americans relied on religion and custom to avoid the tragedy of the commons; the fact that Native Americans had considerably less population density also helped avoid conflicts within tribes, although inter-tribal conflicts, essentially involving property disputes, were common.



Our story continues with a warlord riding at the head of his men into an apparent-ly deserted village, with no domestic animals or crops in sight. “Not again!” moan his hungry and rebellious followers.

The warlord thinks for a moment and has a flash of insight. “Loot and pillage is not working very well; we need to try a new system.” he proclaims. “No longer will a person’s property be seized by those stronger than he! From this day forward, a man may keep what he produces with his own effort and his own tools and his own land. And eve-ryone, be he rich or poor, strong or weak, soldier or peasant, must pay to use someone else’s property. We will call this system private enterprise!”5

“Huh?” exclaim his confused followers, who are much more used to action than to words. He patiently explains the intricacies of private property and voluntary ex-change.

Slowly the peasants emerge from the edge of the forest, where they have warily been stuffing their mouths with roots and berries. “What a wonderful idea! No more starvation! Oh, wise lord, return to us our property that we may get back to our planting!”

“What do you mean your property?” replies the warlord, with an innocent shrug. “We stole your farmland fair and square under the loot-and-pillage system. We will start the new free enterprise system where the old system left off. Only now, when we take your crops, we will no longer call it plunder. We shall now call it rent.”

Not surprisingly, libertarians use the first fable to extol the efficiency gains of pri-vate property over the commons, while statists cite the unfairness of initial endowments to challenge the fairness6 of a system that bases a person’s or family’s ownership on wealth rather than on effort or merit. But the efficiency gains of a private property sys-tem do not imply, nor do they depend upon, an equitable distribution of property. The incentives for efficient resource use created by a system of property rights can exist even when the distribution of property rights is grossly unfair. Indeed, slavery involves prop-erty in human beings, yet the system is very unfair, not only for the slave, but also for property-less free workers, who find it difficult to sell their labor in a slave economy.

Accordingly, Figure 3-2 expands economic interactions by inserting a government between households and firms. I have also added the box labeled “factor market” in the flow of resource services and income at the top of the diagram and the box labeled “product market” in the flow of goods and services from the business sector to the house-hold sector. Markets occur at the economic interface between buyers and sellers. Households exchange land, labor, capital, and entrepreneurial services for rent, wages, interest, and profit, not because they like pieces of paper with dead politicians, but be-cause this money income gives them access to goods and services. And firms do not sell goods and services to the household sector because the owners of firms are altruistic.

5 Notice that my warlord is much more articulate than the characters in either Conan the Barbarian or the HBO series, Deadwood. 6 Economists have trouble with the concept of fairness, which is difficult to define in a way that everyone can accept and still be consistent with the concept of scarcity. In twenty-four years as parents, neither Re-gina nor I have ever heard one of our three children complain: “It’s not fair, I got too much!” Alas, the operational definition of fairness always comes down to more for me! But in a world of scarcity, where giving more to one person usually implies giving less to someone else, it is simply impossible to be fair.



Economists assume that the owners and firms are egoists who seek to maximize the one particular type of income, namely profit, which is the difference between the revenue and the opportunity cost of resources used to produce those goods.

Exchange is based on a quid pro quo (something for something [else]) principle. Private goods and services bought and sold in markets are subject to exclusive use. My labor time is scarce because I cannot be in two places at once, and rarely can I accomplish more than one task at a time. If a business wishes to use my time for its7 own ends, then it must pay me, or I will take my labor elsewhere. And, if the employer is to continue to pay me, I must continue to perform, or our relationship is terminated. Similarly, house-holds have limited savings to lend to businesses (banks), limited land to rent to tenants, and limited reservoirs of risk-taking and organizational talent (entrepreneurship). Stores (businesses) can sell apples because it is easy to withhold the merchandise if I do not pay the price. However, businesses cannot sell property rights, contract enforcement, or na-tional security directly to households.

The relation between households and governments is different from the relation between households and firms, however. For the most part, government services are not bought and sold like most other commodities. One important government service is the protection of property rights (essentially, police functions) and must be available to all, without regard to ability to pay. Indeed, paying police for “fair” (more for me!) protec-tion is illegal. Similarly, paying for judicial services, at least before the verdict is ren-

7 Note, to avoid gender confusion, I will treat the business firm as an “it,” even though the person giving orders could be “he” or “she.”

Business sector

Households Govern-ment

Factors of pro-duction

Product Market

Land, labor, capital, and entrepreneurial services

Cost Rent, wages, interest, profit

Consumer spending

Revenue

Goods and services

Goods and services

Figure 3-2

taxes

services

Spending Goods & Services

Factor Market



dered, constitutes bribery and is illegal.8 Government services are financed by tax reve-nue, by which households9 are required to pay money lest the government cease enforc-ing property rights (that is, the government will confiscate money, lands, or time by send-ing tax evaders to jail). In “exchange”10 for their tax payments, households receive pub-lic goods such as police and fire protection, a “just” court system, national defense, and public health. Education is a government service that could be privately produced but is subsidized by tax payments to break the link between educational attainment and house-hold wealth.11 Nevertheless, when it comes to employing land, labor, and capital, gov-ernments largely participate in factor markets as buyers. The exceptions are the military draft (the government confiscates labor for a submarket wage) and eminent domain, whereby the government confiscates land for just compensation.

When governments12 acquire resources to produce public goods, they typically hire land, labor, capital, and entrepreneurial13 services much as a business would. Hence, we treat government enterprises as if they were part of the business sector, financed by tax revenue. Economics implies that public goods must be financed by government, since businesses could not sell these services, since exclusion is impossible, difficult, or undesirable. However, government finance does not (necessarily) imply government production. Since schools can exclude students who do not pay tuition, the government could foster equal educational opportunity by dispensing tuition vouchers to parents who send their children to private schools. On the other hand, most citizens are uneasy with governments hiring mercenaries to fight wars or police their streets.14

Monetary Flows versus Commodity Flows

We emphasize again that there are two circular flows in Figure 3-1 and Figure 3-2. The more important flow is shown moving clockwise and involves the movement of 8 In a civil court case, wherein a business or person (the plaintiff) sues another business or person (the de-fendant), court costs are assigned to the losing party in certain circumstances to discourage nuisance suits and to encourage parties to settle out of court. However, these costs are uniform across cases and are a payment for resources used, not for the (in)justice rendered. 9 While some taxes are nominally levied on businesses, economists believe that all taxes are ultimately paid by members of the household sector, either as consumers (e.g., sales taxes are added to the purchase price of merchandise) or resource supplies (workers receive lower wages because employers must pay Social Security and Medicare taxes). 10 Note, the word exchange is set off by quotes—a literary device I try to use sparingly—because people are able to “enjoy” (there I go again) government services whether they pay for them or not. However, there are many services that have restricted distribution—students in state colleges must satisfy admission requirements, drivers pay fee to register their car, and one’s day in court is predicated upon listing on the court calendar. 11 Obviously, this link may be weakened by public education, but it is not broken. 12 The United States and Canadian systems of federal, state (provincial), and local governments allow lim-ited choice in service level and tax rate combinations, as people vote with their feet, moving to high service jurisdictions when their children are in school, and moving to low tax jurisdictions when they retire. 13 Note that politicians provide entrepreneurial services by running for office, risking impeachment, recall, or forced retirement. The controversy over campaign finance reform is whether these entrepreneurial ser-vices should be for sale to the highest bidder. 14 One of the features of The Gangs of New York was that street gangs often coalesced around fire depart-ments that competed to be the first on the scene by violent clashes. Alas, it was a small step between com-petition for business and arson. A more comical version of privatized warfare is presented in the movie War, Inc.



factor services from the household sector, through factor markets, to the business (or government) sector, and the movement of commodities (goods and services) from the business sector, through product markets, to the household sector or directly from the government sector to the household sector. Without the flow of food, clothing, and shel-ter, members of the household sector would not survive. Furthermore, it is precisely the process of deciding which goods to produce, how to produce them, and who will receive those goods that society confronts the problem of scarcity.

It would be possible, albeit very difficult, for an economic system to function without money. Such a system is called barter, whereby people trade one commodity for another directly. For instance, rural patients often paid their doctors bills with chick-ens15 or pigs. Medieval students paid their professors in firewood, clothing, or food. Even today, some tax evaders avoid the paper trail of their purchases by bartering through the underground economy.16 The major drawback of barter is the double coin-cidence of wants. If I am an economist with a sore tooth living in a barter economy, I must find a dentist willing to fill a tooth in exchange for an economics lecture. It is much easier to sell my services to UNLV in exchange for a paycheck and then to spend the money out of my checking account on things I want, such as paying money to a dentist to fix the cavity in my aching tooth.

Another name for the monetary flow is finance, literally the study of how to pay for goods or services, particularly investments (see chapter two). While financing is very important, do not mistake money used to pay for goods and services with those goods themselves. The goal of a business is not to make money – unless the business is a bank (which makes or creates money when it makes a loan), or a counterfeiter, which (at-tempts) to create fraudulent money. One of the most important public goods a govern-ment provides is the stability and integrity of the economy’s financial sector. Further-more, much of the financial market has more in common with a casino than a commodity market. When a business finances investment, it can issue debt (bonds; literally, IOUs) or sell shares of the business itself (stock). The investment is financed as part of the ini-tial public offering. Unless the company issues new stock, the day-to-day trades in those shares are merely transfers of financial assets for money among financial speculators; the former hope to receive capital gains if the price of their shares increase, while the latter are cashing in their prior gambles. Whether the stock market rises or falls only affects business investment only to the extent that businesses are encouraged to issue additional debt to finance new investments. Money, then, is nothing more (or less) than a financial asset which earns no income, but is easiest to exchange for goods, services, or income-earning financial assets.

15 Recall that nostalgia for chicken-health care barter may have been instrumental in dooming one Republi-can’s bid for her party’s Senate nomination in 2010. 16 Most criminal activity does not involve barter, but cash. How many chickens would it cost to bribe a politician or to hire a professional killer? Most money is deposited in bank accounts and financial transac-tions involve bookkeeping and electronic movements of money from one account to another. The ad-vantage of bank accounts for legal transactions—that they maintain a clear record or paper trail of money transmissions—is a disadvantage for illegal transactions. Hence, drug dealers trade illicit drugs for cash, which they must secure and launder before they can spend it.



Money plays three important functions in a market economy. Money is a medi-um of exchange, meaning that people can exchange the services of factors of production they own for money, and then they can spend that money income on goods and services they desire. Another important function of money is as the unit of account; by translat-ing factor services and commodities into their monetary equivalents, we can add them together to compute total household income, the total household budget, business reve-nue, business costs, and ultimately, business profit.

Without money as a medium of exchange, there would be fewer exchanges be-cause rarity of the double coincidence of wants would require lengthy search time. Even if I were lucky enough to find a dentist who was willing to fill my tooth in exchange for an economics lecture, exactly how long a lecture would she be willing to accept or would I be willing to give? And how much longer would I have to talk to receive Novocain? Using dollars in exchange for dentist services, I can receive an immediate quote via a phone call or Internet visit from a large number of dentists and eventually find the best deal. Nevertheless, $500 is not the same as having a tooth filled. It is important that we not mistake the medium of exchange for the goods and services that money buys.

The third use of money, as a store of value, blurs this distinction between ends (commodities) and means (money) a bit more. One of the desirable aspects of money is that it is durable—this is why coins are made of durable metal, paper money is treated with preservatives, and banks keep permanent records of deposits. Farmers who harvest their crops in the fall can use money to buy commodities as they need them, rather than having to store everything they need at the farm. Both households and businesses require a certain amount of money balances to facilitate their transactions.

When there is a sudden and unexpected decrease in the amount of money availa-ble (e.g., due to bank failure between 1929 and 1933, and the financial collapse of 2008-2009), the entire economic system may grind to a halt. This insufficiency of the money supply results in deflation17 (generally falling prices), which is associated with wide-spread unemployment and business failure. When the supply of money increases faster than the flow of goods and services, the economy experiences inflation—the deteriora-tion in the value of money that manifests as an increase in average prices. Despite the critical role of money in the circular flow of economic activity, money is a means rather than an end. Business owners want monetary profit for the stuff that they can buy with that money; households want money for the goods and services that money can buy.

The Goals of Firms

We pause a moment from our description of the circular flow of economic activi-ty to address motivation. Since economics is about how individuals and groups allocate scarce resources, it is crucial that we have some notion of what motivates households and firms. We start with an assumption that is essentially uncontroversial—we assume that

17 Economists measure inflation and deflation with the consumer price index, which is currently based on average consumer prices between 1982 and 1984. In October, 1929, when the Stock Market crashed, the consumer price index was 17.3; by May 1933, the consumer price index had declined to 12.6, an overall decrease of 27.16%, constituting an annual deflation rate of 8.85% per year. In July 2008, the consumer price index was 219.964; by January 2009, the consumer price index had fallen to 211.143, a 4.01% decline over a six month period, constituting a deflation rate of 8.19% per year.



the owners of firms (proprietors, partners, or shareholders) wish to maximize profit. Economists define profit as total revenue (price times number of units sold) minus op-portunity cost. It is not unusual for business owners and accountants to confuse profit with taxable income. Profit is revenue minus the cost of generating that revenue, while taxable income is revenue minus deductible costs of generating that revenue. For in-stance, a proprietor is the sole owner of a business, and therefore has any claims on the profit that firm generates. Typically, the proprietor uses his or her own labor, capital, land, and entrepreneurial talent to generate the company’s revenue at the lowest feasible cost. The proprietor may pay herself rent,18 wages, and interest or may simply lump eve-rything into profit. The proprietor doesn’t reduce her tax liability by explicitly paying herself a wage, so she typically lumps all income together as profit.19

When accountants compute tax liability, it is appropriate to define profit as reve-nue minus tax-deductible costs. Economists use the concept of profit to predict how re-sources move between industries or markets. Accordingly, economic profit is defined as revenue minus the cost of generating that revenue, whether that cost is out of pocket (tax deductible) or realized in the form of foregone income (e.g., working for my consulting firm instead of earning a salary from UNLV).

While the distinction between economic profit and accounting profit may seem strange, our assumption that business proprietors attempt to maximize profit is not partic-ularly controversial. But it is important to distinguish between profit maximization as a goal, and maximum profit as an outcome. Maximum profit means that there is nothing the business can do to increase profit. Maximizing profit first requires using resources efficiently. Maximizing profit also means making no mistakes. Maximizing profit means never being diverted by other goals—love or hate; kindness or cruelty.

The economic theory of the firm (microeconomics) prescribes what business owners should do to maximize profit. The theory does a very good job predicting how business decision makers change their behavior as profitable opportunities are discovered or lost. Nevertheless, since life is rarely perfect and people are rarely single-minded, whether businesses achieve maximum profit is another issue entirely.20

The assumption that businesses attempt to maximize profit goes back at least to Adam Smith, who states eloquently in The Wealth of Nations:

18 Unfortunately, the English language evolved in a less enlightened era when masculine pronouns were typically used for individuals of indeterminate gender. While I decry this practice, always using “him or her” gets stilted, and no one would buy this book. Therefore, I will use male and female pronouns more or less arbitrarily, but I hope, consistently. 19 By way of evidence, self-employed respondents to the March 2003 Current Population Survey reported labor earnings that were, on average, 65.8% lower than the earnings reported by other respondents to the survey. By contrast, the total income (including rent, dividends, interest, and profits) by the self-employed were only 27% less than the income reported by equivalent respondents who worked for someone else. Therefore, we can conclude that “being one’s own boss” is apparently a good thing, since people are will-ing to give up 27% of their potential earnings to work for their favorite employer. I doubt, however, that being one’s own boss is really worth 65.8% of potential salary. 20 A moment’s pause should convince us that this distinction between what firms ought to do to maximize profit, and what firms actually do in realizing profit below potential is precisely how economists are able to parley their theory into income. So, just as accountants earn an income by advising clients on how to re-duce tax liability, economists earn an income by advising business clients on how to increase profit.



As every individual, therefore, endeavors as much as he can both to employ his capital [i.e., money] in the support of domestic industry, and so to direct that industry that its produce may be of the greater value; eve-ry individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own se-curity; 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 some many other cases, led by an invisible hand to promote an end which was no part of his intention.21

This is Adam’s Smith’s famous invisible hand metaphor; the most important fea-ture of markets competition. The market mechanism is an admirable and effective means of allocating scarce resources because it works when people care only about their own self-interest. Communism, by contrast, is based on the premise that people are essentially altruistic. I find no fault with Karl Marx’s noble sentiment “From each according to abil-ity, to each according to needs,” but as a basis for allocating scarce resources, it leads in-evitably to the tragedy of the commons. If what I (or my family) receive is independent of my effort, I will do only what I have to do to avoid punishment. It is not surprising that communist societies quickly lapsed into dictatorship. Unless someone punishes shirking, people will shun work. Economists teach that voluntary exchange through competitive markets achieves efficiency through self-interest and incentives.

We will return to the theory of how firms maximize profit in later chapters. Nev-ertheless, this is a good point to introduce an important concept that will punctuate the rest of the text, the agency problem. Note that Adam Smith’s invisible hand refers to a proprietor—an individual who takes all the risk in a business and can claim the gain or experience the loss. Hence, a profit-maximizing proprietor could be considered an ego-ist, a person who cares only about his own welfare and gives not a damn22 for anyone else’s welfare. As we will see, a businesswoman could attempt to maximize profit and be altruistically inclined towards members of her family—the greater the profit, the better her husband’s and children’s standard of living. Don’t assume that because private en-terprise allows egoists to function, that it necessarily requires that economic agents be interested in no one but themselves.23

But consider what happens to the profit maximization assumption when we con-front businesses with multiple owners. Partners are each liable for the entire debts in-curred by the business. Would not a self-interested partner pursue their own happiness at

21 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Li-brary, 1994). (Originally published in 1776.) My spell-checker made me get rid of the English spellings. 22 In this context, damn refers to a tinker’s damn, as evident in this quote from famous entrepreneur Henry Ford: “History is more or less bunk. It’s tradition. We don’t want tradition. We want to live in the present and the only history that is worth a tinker’s damn is the history we make today.” Microsoft® Encarta® Reference Library 2003. © 1993–2002 Microsoft Corporation. All rights reserved. 23 Similarly, proprietors may be malevolent, incurring personal costs to make other people worse off. They may wish to maximize profit to provide more resources to support their wicked ways.



the expense of her partners?24 Or consider corporations, which are owned by a large number of stockholders, but actually run by a much smaller group of executives, who typically own only a tiny fraction of the company’s stock. In the infamous Enron case, nefarious executives looted the business and bilked stockholders, putting their own short-term interests ahead of the long-term interest (and profits) of shareholders. Economists do not find it unusual that executives steal from shareholders; they find it odd that it does not happen more frequently.25

Agency problems exist when one person acts on behalf of another. Corporations have a large number of shareholders because the financial requirements of “big business” exceed the personal fortunes or credit of most people. The advantage of corporations to shareholders is that corporations are “legal persons,” able to incur and discharge debt on their own, thereby limiting the liability of individual shareholders to their outlay for the stock.26 Stockholders are passive owners in that they have a claim on future profits though dividends.27 They delegate the running of the business to corporate executives, under the guidance of a board of directors. Either executives are altruistic in putting the interest of shareholders ahead of their own financial well-being, or they calculate that the benefits of embezzlement are less than the expected costs of detection.28

Entrepreneurship, Profit, and Economic Discrimination

In Chapter 1 we learned that “discrimination” can have good, bad, or neutral con-notations. A successful entrepreneur is able to distinguish between profitable and unprof-itable ideas, productive and unproductive investments, productive and unproductive workers, and between good and bad credit risks. Such discrimination is a key to business success. Indeed, many businesses fail because a would-be entrepreneur operates on faith rather than on skepticism. He believes the owner of a failing business who assures him that the motive for selling the business is retirement, rather than incipient bankruptcy. He believes his wife that his brother-in-law has turned over a new leaf and will be a consci-entious employee. He believes the supplier that a hand shake is a sufficient foundation for a business relation; friends don’t bother with contracts.

24 If partners can so easily cheat each other and escape the full cost of their own inefficiency, why would so many professionals form partnerships? The answer is the agency problem in reverse; doctors, lawyers, and accountants working in partnership with each other are saying “You can trust us because we trust each oth-er!” 25 Apparently, the Enron looting was a rational decision: The billions stolen exceeded the fines and jail sen-tences meted out to Enron executives by at least three orders of magnitude. 26 Corporations receive funds for their startup through an initial public offering, whereby shares are sold directly to the public. Those who buy those shares have no right to recover their money from the corpora-tions; they can turn their shares back into cash by selling them to another “investor.” Hence, nearly all the day-to-day activity in financial markets involves the buying and selling of used ownership shares (stocks) or used IOUs (bonds). The impact of the ups and downs in the stock market on business operation is only indirect, indicating how the market values their business and determining the cost of capital should the business wish to expand in the future. 27 People often buy stocks and bonds in the hopes of capital gains, which result from selling a financial asset for more than what you paid for it. Note that capital gains usually do not result from company pur-chases of stock, but from other “investors’ ” beliefs that the future dividends and capital gains are greater than in the past. 28We will have more to say about decision making under uncertainty later.



Because business owners are human, they often make bad decisions, often relying on prejudice and stubbornly refusing to modify their views of the business world or the people in it. Before the Civil War, Southerners and many Northerners believed that black people were suited only to slavery. After the Civil War, the former slave owners knew that their God mandated the exploitation of share croppers. Many blacks, and some whites, died in chain gangs, when southern businesses and government contractors liter-ally worked convicts to death. Ironically, because slave owners bore the economic cost of mistreating their “property,” physical abuse of slaves was the exception, rather than the rule. A poor white was no more likely to abuse a rich man’s slave than he would abuse that rich man’s horse. After the end of the Civil War, the North eventually grew weary of protecting the civil rights of freed slaves, and the Ku Klux Klan and other vio-lent organizations (including southern governments) increased the incidence of lynching and other racist atrocities.

We shall learn throughout this course that economic discrimination often involves the central conflict within free-market economics—property is exclusive whereas mar-kets are inclusive. The end of slavery left former slaves as independent agents without property and without a corresponding duty by former slave owners and other whites to recognize the few rights blacks were supposed to have. Rights without enforcement are not rights at all. Because the end of slavery left many freed slaves in a state of anarchy, the economic advance of blacks, along with those of Native Americans, Asians, and Mexicans, and women, was retarded. Poverty also retarded the accumulation of capital and other property, meaning that minority populations have smaller endowments than non-Hispanic whites do.

Not-for-Profit Firms and Government

Not all businesses are organized to earn profits, let alone attempt to maximize them. An increasingly important group of firms are designated as “not-for-profit” institu-tions. Private schools, such as Harvard, Yale, or Stanford, do not limit student enroll-ment to the children of the rich who can afford to pay the highest tuition. Instead, they redistribute economic opportunity by charging high tuition to rich students of average intelligence in order to subsidize low-income students with above-average ability and who improve the intellectual climate and contribute to the institution’s diversity. That religious institutions cater to rich but evil contributors is an aberration, rather than con-sistent profit-maximizing behavior. Hospitals bear the name of rich donors, whose gifts are used to improve the health care of the less fortunate.

What do not-for-profit firms actually do? First, they typically have well-defined, often altruistic, missions, fostering education, salvation, health, culture, or social justice. Second, they rely on voluntary contributors (including government grants) to cover the difference between revenue (tuition, tithes, patient fees, and ticket sales) and expenses. Third, they rely on employees who often have their own agendas, which conflict with the announced goals of the institutions that employ them: lazy professors, abusive clergy, quacks, and prima donnas. Accordingly, these institutions have a long apprenticeship program (tenure track), intended to weed out bad apples (to mix a metaphor) before they are granted tenure. Of course, this presupposes that those who grant tenure are them-selves committed to the institution’s mission.



So we reach the issue of government. The oldest form of government is proprie-tary—monarchs who make the decisions and reap the rewards. Indeed, this form of gov-ernment is still prevalent in the world today. Needing allies and to secure their claim to power, monarchies often give rise to oligarchy—rule by the few. Note how oligarchy—the Roman Senate—often gives rise to corruption (a manifestation of agency problems), which leads back to monarchy—the Roman Empire.

The other side of government—that closest to the commons—is pure democracy, in which citizens vote directly on important matters. Athens birthed democracy, although women and slaves were precluded from voting, and the system frequently lapsed into oli-garchy. We live in a representational democracy, or republic, in which voters select rep-resentatives and executives who make day-to-day governmental decisions. A major de-bate continues to rage about whether politicians—governmental entrepreneurs—are pub-lic-spirited altruists or power-mad meddlers concerned only with feathering their own nests. Indeed, Democrats and Republicans agree that their own party is described by the former and the other party is described by the latter. Apparently, voters believed the Re-publicans in 1994 and the Democrats in 2006 and 2008, and then Republicans again in 2010. While Democrats retained the presidency, added to their majority in the Senate, and received more votes for the House of Representatives, Republicans maintained con-trol of the House through gerrymandering; that is, by cheating.

Summary

1. The three major institutions of the market economy are households, which own scarce factors of production; firms, which turn factors of production into final goods and services; and government, which maintains an environment conducive to eco-nomic freedom and voluntary exchange.

2. The factors of production are land, labor, capital, and entrepreneurship. These factors are privately owned by people who reside in the household sector. House-holds provide the services of factors of production in exchange for money income: rent (for land), wages (for labor), interest and dividends (for capital), and profit (for entrepreneurship).

3. Households acquire factors of production through endowments (what they are given by nature or ancestors) and acquisition (through saving and investment).

4. In exchange for goods and services, sold to the household sector, businesses receive revenue. Economists assume that (the owners of) firms attempt to maximize profit, the difference between revenue and opportunity cost.

5. In order for a market to exist, people must have property rights—the legally en-forced right to exclude others from using one’s property without permission. The right to exclude gives rise to the right to exchange whereby people trade property rights for other forms of wealth.

6. Without government to enforce property rights and contracts, the market cannot ex-ist. Government provides public goods (services) to households and firms collective-ly. The government hires factor services through markets, financing this expenditure by taxes or by borrowing money (selling bonds).



7. In factor markets, the services of land, labor, or capital are exchanged for rents, wages, or interest, respectively. The entrepreneur assumes the risk of receiving profit if revenue is sufficient to cover all factor payments, but will incur a loss if revenue is inadequate. In factor markets, households are sellers and firms are buyers.

8. In product markets, firms sell commodities (goods and services) to households in exchange for revenue (expenditure).

9. Money is a means to an end and not an end in itself in the circular flow diagram. Money serves as a medium of exchange, unit of account, and store of value.

10. When there is an inadequate amount of money to facilitate transactions, the economy experiences deflation (too little money) or inflation (too much money).

11. There is an important distinction between accounting profit that is defined as a measure of tax liability for businesses, and economic profit that is defined to predict whether firms will enter or exit a particular market. Economic profit equals ac-counting profit minus the opportunity cost of all inputs owned by the owner(s) of the firm.

12. The agency problem exists when people making decisions are different from those who benefit from that decision. An important agency problem exists within corpora-tion, where executives make critical business decisions while the owners of corporate stock nominally own the firm. The agency problem exists because the interests of executives may run contrary to the interests of the stockholders.

13. Not-for-profit institutions, including government, are organized to achieve goals other than profit. Typically, these institutions engage in altruism but agency prob-lems often lead employees or contributors to pursue their own egoistic goals.

14. Economic inequality results from unequal effort and unequal endowments. Gov-ernment policies meant to mitigate the former often compromise the latter.

Glossary

Production function: An equation, a table, or a diagram that shows how the output of a commodity is related to the amount of factors of production used to produce that commodity.

Consumption goods: Commodities used by households to generate immediate utility.

Capital goods: Commodities that produce other commodities.

Investment: The diversion of scarce resources from producing consumption goods into the production of capital goods.

Factors of production: Land, labor, capital, and entrepreneurship that can be used to produce goods and services.

Land: A non-human factor of production that is not produced—includes space, location, and raw materials. The owner of land receives rent in exchange for land services.

Labor: Human time allocated to producing goods and services; workers receive wages or salaries for their labor time.



Capital: A factor of production that was produced in the current or a previous year. Stu-dents should take care to distinguish between capital goods, which are factors of pro-duction, and “capital,” which is often used interchangeably with a person’s wealth.

Entrepreneurship: The factor of production that involves the taking of risk to organize and run a business firm. The entrepreneur receives any economic profit, or incurs any economic loss that the firm experiences. In the government sector, entrepreneurs are called politicians.

Endowments: Things of value that are given to an individual by relatives or nature.

Acquisition or accumulation: The addition to wealth or ability by using scarce re-sources for “investment” rather than for “consumption.”

Ownership: The legal right to exclude that means that a person or household can com-mand an income for supplying a factor service, because, unless the person receives payment, they have the legally enforceable ability to refuse to supply that service.

Right to exclude: The ability to prevent others from using land, labor, capital, or entre-preneurship services unless they make an income payment.

Right to exchange: The legal ability to exchange the property right to a scarce resource or commodity to another in exchange for something of value (money or another commodity).

The tragedy of the commons: The ironic consequence of the inefficient use of resources when no one has the right to exclude or the right to exchange those resources.

Endowment: The starting point for a person or household, including the same amount of time for everyone, but very different amounts of non-labor factors of production.

Money income: The sum of factor payments—rent, wages, interest, and profit—expressed in monetary terms, also known as the budget constraint.

Opportunity cost: The true (or economic) cost of using a scarce resource for one activity is the goods or services that must be sacrificed (e.g., the opportunity cost of studying economics is not studying another subject, not sleeping, not earning an income, or not having fun, whichever is greatest).

Money: The medium of exchange between buyers and sellers that facilitates transactions by avoiding the double coincidence of wants.

Double coincidence of wants: The fortunate but unlikely event when a seller of a com-modity finds a buyer who is willing to trade of the commodity he or she ultimately wants, making it unnecessary for either party to use money.

Barter: The direct exchange of one commodity for another, without the use of money.

Medium of exchange: The most obvious function of money, whereby a seller exchanges a good or service for currency or a checking deposit, and then later can exchange the money for the goods or services that he intends to buy.

Unit of account: The role of money as the common denominator to add up income, rev-enue, or cost.



Store of value: The characteristic of money that it can be held for some time before it is spent. Inflation causes money to lose value over time; deflation causes money to accumulate value.

Deflation: A general decrease in average prices, caused by too little money in circula-tion. Deflation is accompanied by widespread unemployment and business failure known as depression (severe) or recession (milder).

Inflation: A general increase in average prices, caused by too much money in circula-tion.

Economic profit: Revenue minus opportunity cost.

Agency problem: A conflict of interest created when one person acts on behalf of anoth-er. That Enron executives stole from stockholders (including employee pension funds) is an example of an agency problem.

Not-for-profit institution: A firm or other organization with a goal other than profit maximization. Examples of not-for-profit institutions are schools and universities, hospitals, religious organizations, museums, symphony orchestras, and most govern-ment agencies.

Utility: An abstract concept used by economists for that which households seek to max-imize. We know that utility increases when people are better off, and utility decreas-es when people are worse off.

Marginal utility: The change in satisfaction due to one more unit of some commodity or activity. Economists believe that as consumption of a good increases, marginal utility tends to decrease. In the extreme, marginal utility can become negative, at which point the “good” becomes a “bad” (literally, too much of a good thing).

Egoism: The condition whereby people experience utility only from their own material well-being. Whether other people are better off or worse off does not affect them.

Altruism: The condition of feeling better off when someone else is better off; parents are altruistic towards their children.

Malevolence: The condition of feeling worse off when someone else is made better off (and vice versa). Racism is a form of malevolent behavior.

Chapter 4 Market Choices


Economists use the associated models of supply and demand to explain how market price and quantity exchanged are determined and to predict how prices and quan-tities change across time and space. Demand refers the plans of buyers to purchase dif-ferent commodities; the quantity that (potential) buyers are willing and able to purchase is inversely related to price, given other influences (1) money income, (2) the size of the household, (3) the prices of other goods they might have bought instead, and (4) their tastes and preferences. The law of demand states that, other factors (1–4) remaining con-stant, buyers will purchase less of a commodity at a higher price than they would have purchased at a lower price. In a competitive market all potential buyers are price takers, meaning that they have the option of buying as little or as much as they want at the pre-vailing price, but they individually do not directly influence that price. Hence, since dif-ferent prices might prevail at different times or places, it behooves the purchaser to have a plan of action, a list of contingent purchases that would occur at different prices.

A Household’s Demand for Apples

Table 4-1 depicts the Adams family’s (that is, Abigail Adams’s) demand schedule for apples. A demand schedule is a list of the alternative quantities demanded at alterna-tive prices.1 For this household, apples are priced out of (their) market at any price of $1 or more. We represent this algebraically as: for all P $1, qd = 0. If the price were $0.95, Abigail would wish to purchase 1 apple a day, perhaps dividing it among five fam-ily members by making a small quantity of applesauce. If the price were $0.90 instead of2 $0.95, she would attempt to purchase 2 apples. The first apple would be worth $0.95, but the household buys it for only $0.90, receiving a nickel of consumer surplus. At a price of $0, the household decides to “purchase” 20 apples, not an infinite number. That is because at some point, goods become bads—apples spoil, take up scarce shelf space, and eating too many apples causes tummy aches.

The first column shows the price, the independent variable since the price is de-termined by forces beyond the Adams family’s control. The second column shows the quantity demanded—the amount that Abigail would like to buy, per day, at that price. Abigail maximizes her satisfaction3 from the consumption of apples by purchasing apples so that they break even on the last apple purchased. That is, at $1.00, they buy no apples since do not believe any apple is worth $1.00. At $0.50, they buy 10 apples, since the last apple provides as much satisfaction as would $0.50 spent on some other commodity.4

1 Another way of depicting consumer demand is with an equation. In this case, 20 .5dQ P (read quan-

tity demanded equals 20 minus one-half the price), where Qd is the quantity of apples the household would purchase each day, and P is the price (in dollars per apple). 2 This highlights the fact that the demand schedule refers to what the consumer would do at different prices at the same time and place, and not necessarily what would happen over time (since, over time, other fac-tors like incomes, other prices, the size of the family or their tastes for apples might change). 3 Throughout this text, we assume that Moms are altruistic – that is, they obtain happiness when either they or their family have “more”; the mark of altruism is the willingness to sacrifice one’s own consumption to increase the consumption of another. 4 This is how the law of diminishing marginal utility translates into a law of demand. If the satisfaction from the last unit decreases with the amount consumed, and since consumers have limited income, they will stop consuming when the last dollar spent on the commodity in question gives them just as much satis-faction as spending that dollar on some other commodity instead. Hence, once the household has allocated



Since the first nine apples provide greater satisfaction than the tenth apple does, the con-sumer receives a consumer surplus on infra-marginal units of the commodity. Hence, the column total value is computed by adding the bid price5 for the first apple, plus the bid price for the second apple, and so forth. The actual expenditure is the price (of all the apples) times the quantity purchased. Hence, the consumer surplus is the difference be-tween the total value of the commodity and the total expenditure.

Demand Schedule

Price per Quantity Total Total Consumer Apple Demanded Value Expenditure Surplus

per Day $1.00 0 $0.00 $0.00 $0.95 1 $0.95 $0.95 $0.00 $0.90 2 $1.85 $1.80 $0.05 $0.85 3 $2.70 $2.55 $0.15 $0.80 4 $3.50 $3.20 $0.30 $0.75 5 $4.25 $3.75 $0.50 $0.70 6 $4.95 $4.20 $0.75 $0.65 7 $5.60 $4.55 $1.05 $0.60 8 $6.20 $4.80 $1.40 $0.55 9 $6.75 $4.95 $1.80 $0.50 10 $7.25 $5.00 $2.25 $0.45 11 $7.70 $4.95 $2.75 $0.40 12 $8.10 $4.80 $3.30 $0.35 13 $8.45 $4.55 $3.90 $0.30 14 $8.75 $4.20 $4.55 $0.25 15 $9.00 $3.75 $5.25 $0.20 16 $9.20 $3.20 $6.00 $0.15 17 $9.35 $2.55 $6.80 $0.10 18 $9.45 $1.80 $7.65 $0.05 19 $9.50 $0.95 $8.55 $0.00 20 $9.50 $0.00 $9.50

Table 4-1

The demand curve is another way to depict the inverse relation between price and quantity demanded. We plot the quantity on the horizontal axis; technically, the good we are plotting on the vertical axis is the bid price. This means that, for any quantity, the area of the trapezoid between 0 and the number of units (consumed) is the total value, the area of the rectangle (price times quantity) is the total expenditure, so consumer surplus is the area of the triangle below the demand curve and above the prevailing price. Note that Figure 4-1 depicts a prevailing price of $0.50, and the household responds by purchasing

their budget, the economist can infer that for any two goods, x and y purchased, yx z

x y z

MUMU MU

p p p ,

where MU stands for “marginal utility,” p stands for price, and z is some commodity the household could have purchased, but did not. 5 While price is the independent variable, the bid price is treated as the dependent variable, since, as quanti-ty increases, the amount bid for the next unit decreases.



10 units. The total expenditure is $5.00 ($0.50 times 10 apples). The consumer surplus is the area of the triangle: CS = ½(10 – 5)(10) = $25.6

Figure 4-1

Table 4-1 and Figure 4-1 predict that the household would achieve maximum sat-isfaction if apples were free. However, as long as resources are scarce, apples will not be free. If the market price of apples really were zero, no apple producers would deliver ap-ples to the market, and the household’s demand for apples would go for naught. To truly understand the nature of the market, it is important to understand supply as well as de-mand.7

Supply Decisions by a Price-Taking Apple Producer

Consider Johnny Appleseed, whose apples are ready for harvest. Some apples are within an arm’s reach, and can be harvested with little effort, costing, say $0.05 per ap-ple. Other apples are just out of arm’s reach, and cost $0.10 to pick, and so forth. To maximize profit, Johnny should start with the least costly apples, and continue to pick apples until the cost of the last apple picked (its marginal cost) equals its selling price. The marginal cost of a commodity is the opportunity cost necessary to produce the last

6 The difference between the arithmetical calculation of consumer surplus as $2.25 in Table 4-1, and the $2.50 geometric calculation in Figure 4-1 is that quantity is treated as a discrete variable in the table, and a continuous variable in the diagram. 7 In the early days of “communist” Russia, Lenin proclaimed that bread should be free. The government bought all grain and distributed free bread on a first-come, first-serve basis. Ironically, farm animals ate bread (which had fewer nutrients) instead of grain, which had positive opportunity costs. It took the Soviet Union 70 years to realize that peasants knew more economics than the government bureaucrats did!

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Pri

ce p

er A

pp

le

Quantity of Apples Demanded per Day

To read a demand curve, find the price on the vertical axis, fol-low a perpendicular line to the demand curve (d), and drop a perpendicular line to the horizontal axis. When price is $0.50, quantity demanded is 10 apples a day.

d

Consumer expenditure = .5(10) = $5.

Consumer surplus = $2.50



unit. We imagine that today’s marginal cost of apple harvesting is given by Table 4-2.8 The first column gives the (hypothetical) price per apple, and the second column gives the number of apples Johnny would pick for delivery to market. The third column ap-pears identical to the first, except that the first column is labeled price (the independent variable, since Johnny is also a price taker), and the third column is marginal cost (which is dependent on the quantity produced). By harvesting that quantity for which marginal cost equals price, Johnny’s total revenue equals price times quantity, given in column 4. The variable cost is the sum of the marginal cost for all the units harvested.

Price per Quantity Marginal Total Variable Producer

Apple Supplied Cost Revenue Cost Surplus

per Day

$0.00 0 0 $0.00 $0.00 $0.00

$0.05 50 $0.05 $2.50 $1.25 $1.25

$0.10 100 $0.10 $10.00 $5.00 $5.00

$0.15 150 $0.15 $22.50 $11.25 $11.25

$0.20 200 $0.20 $40.00 $20.00 $20.00

$0.25 250 $0.25 $62.50 $31.25 $31.25

$0.30 300 $0.30 $90.00 $45.00 $45.00

$0.35 350 $0.35 $122.50 $61.25 $61.25

$0.40 400 $0.40 $160.00 $80.00 $80.00

$0.45 450 $0.45 $202.50 $101.25 $101.25

$0.50 500 $0.50 $250.00 $125.00 $125.00$0.55 550 $0.55 $302.50 $151.25 $151.25

$0.60 600 $0.60 $360.00 $180.00 $180.00

$0.65 650 $0.65 $422.50 $211.25 $211.25

$0.70 700 $0.70 $490.00 $245.00 $245.00

$0.75 750 $0.75 $562.50 $281.25 $281.25

$0.80 800 $0.80 $640.00 $320.00 $320.00

$0.85 850 $0.85 $722.50 $361.25 $361.25

$0.90 900 $0.90 $810.00 $405.00 $405.00

$0.95 950 $0.95 $902.50 $451.25 $451.25

$1.00 1000 $1.00 $1,000.00 $500.00 $500.00

Table 4-2

Producer surplus is also called gross profit: revenue minus variable cost. Since all the other costs of apple production have already been incurred by the time the apples are harvested, the only way to recover those costs (e.g., leasing the land, renting the trac-tor, wages for planters, interest on the bank loan, property taxes) is to sell the harvested apples. Since these other costs are fixed, maximizing producer surplus also maximizes economic profit. In Figure 4-2, we imagine that the market price is $0.50 per apple. The producer delivers 500 apples to market, receiving revenue of $250 = ($0.50 x 500). Vari-able cost is the area underneath the supply curve [$125 = ½(500)($.50)], so producer sur-plus is revenue minus variable cost: Surplus = $250 – $125 = $125. In this example, the

8 The equation for marginal cost in dollars is MC = .001q, where q is the number of apples harvested. The average variable cost equals ½ MC, so that variable cost equals .0005q2.



apple producer would maximize profit by expanding output until marginal cost (equal to .001q) equals price, P. Substituting, we get .001q = p, or qs = 1000p.

Figure 4-2

Market Supply and Market Demand

So far we have seen how a mother’s attempt to manage the family budget gener-ates her demand for apples and how an apple producer’s attempt to maximize profit gen-erates his supply of apples. Next we address how individual demand curves are aggregat-ed into market demand. Suppose that the Adams family is a statistically representative household, meaning that its demand for households is representative for a population of, say, 100,000 households. Since an apple eaten by one person is one less apple for every-one else,9 we obtain the market demand by adding the quantities demanded at alternative prices by all households. Given that the Adams’s demand is given by qd = 20 – 20p, where qd is the number of apples demanded per day, and p is the price per apple (in dol-lars), market demand is:10

100,000

1

100,000(20 20 ) 2,000,000 2,000,000i

i

d di

Q q p p

The market demand curve has its price intercept at $20, where no apples are purchased, and has its quantity intercept equal to 2,000,000.

Similarly, individual supply curves are aggregated into market supply. In our ex-ample, Johnny Appleseed’s apple supply equation is qs = 1000p. If his is a statistically

9 Recall that a pure private good is consumed by one person or family, while pure public goods are con-sumed by all people. Many goods fall between these two extremes. Two hundred people may watch the same movie, but there are limits to how many people can fit into the same theater. 10 This forbidding equation is really quite logical. We use capital letters to represent market quantities and lower case letters to represent individual quantities. When we add the quantity demanded for each house-hold at each price, it is equivalent to multiplying the demand equation for the statistically representative household by the number of households in the population.

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

$1.10

0 100 200 300 400 500 600 700 800 900 1000

Co

st o

f L

ast

Ap

ple

Quantity Produced per Day

Marginal Cost of Harvesting Apples

S

Producer surplus

Variable costs



representative firm in a market with, say, 2000 apple produces, the market supply equa-tion would be given by:

2,000

1

2000(1000 ) 2,000,000js s

j

Q q p p

As the individual firm’s supply curve is positively sloped, it follows that the market sup-ply curve also has a positive slope.

In a competitive market, all buyers willing and able to purchase the commodity and all sellers willing and able to deliver the commodity can participate.11 Furthermore, if the commodity is homogeneous, like apples, then all buyers and sellers will be price takers. Buyers will seek out apple bargains; any sellers holding out for higher prices will (eventually) sell no apples. The market demand curve is the sum of the quantities de-manded by all (potential) buyers at each possible price. The market supply curve is the sum of all the quantities supplied by all (potential) producers. Because the supply and demand curves are relevant only for a specific time and place, we treat all other factors (called exogenous variables) as predetermined constants.

Table 4-3 shows the independent responses to buyers and sellers to different mar-ket prices.

Price per Quantity Quantity Market Price

Apple Supplied Demanded Situation Change $0.00 0 2,000,000 Excess demand positive $0.05 100,000 1,900,000 Excess demand positive $0.10 200,000 1,800,000 Excess demand positive $0.15 300,000 1,700,000 Excess demand positive $0.20 400,000 1,600,000 Excess demand positive $0.25 500,000 1,500,000 Excess demand positive $0.30 600,000 1,400,000 Excess demand positive $0.35 700,000 1,300,000 Excess demand positive $0.40 800,000 1,200,000 Excess demand positive $0.45 900,000 1,100,000 Excess demand positive $0.50 1,000,000 1,000,000 Equilibrium stable $0.55 1,100,000 900,000 Excess supply negative $0.60 1,200,000 800,000 Excess supply negative $0.65 1,300,000 700,000 Excess supply negative $0.70 1,400,000 600,000 Excess supply negative $0.75 1,500,000 500,000 Excess supply negative $0.80 1,600,000 400,000 Excess supply negative $0.85 1,700,000 300,000 Excess supply negative $0.90 1,800,000 200,000 Excess supply negative $0.95 1,900,000 100,000 Excess supply negative $1.00 2,000,000 0 Excess supply negative

Table 4-3

11 See Thomas M. Carroll, David H. Ciscel, and Roger K. Chisholm, “The Market as a Commons: An Un-conventional View of Property Rights,” Journal of Economic Issues, 13 (June 1979), 605–627.



If apples were free (p = $0), households would demand 2,000,000, but apple or-chards would supply no apples – this is an extreme case of excess demand, a price at which quantity demanded exceeds quantity supplied. Disappointed would-be apple buy-ers will offer to pay higher prices to obtain apples. As the price rises, the quantity de-manded decreases and the quantity supplied decreases. If the price rose gradually, it would come to rest at $0.50 per apple, the equilibrium price. The equilibrium price is that price at which the market quantity demanded equals quantity supplied; when the market price equals the equilibrium price, there is no tendency for the price to change.

If we start at the other extreme, at a price of $1.00 per apple, the quantity of ap-ples demanded would be zero, while the quantity of apples supplied would be 2,000,000. At this price we have excess supply: the quantity supplied exceeds quantity demanded. In this case, the (would-be) apple sellers are disappointed. Johnny and other apple-proprietors fear spoilage, so in desperation they begin cutting their price. If the price cuts are gradual, we would again observe convergence on the equilibrium price. As price fell, quantity demanded would increase and quantity supplied would decrease until, at $0.50 per apple, the quantity of apples demanded equals the quantity of apples supplied. All this works without government or other external interference, which leads most econ-omists and other libertarians to support a policy of laissez faire – literally, let it be.

Figure 4-3

At the equilibrium price buyers can purchase all they wish to buy at that price; they have no incentive to bid the price higher. Also, at the equilibrium price, sellers are able to sell that quantity of apples that maximizes their profits; they have no incentive to reduce their price. Market equilibrium is analogous to the concept of inertia in physics: an object at rest tends to remain at rest unless acted upon by an outside force. A market in equilibrium tends to remain in equilibrium unless acted upon by an outside force. We now turn to how markets respond to the buffeting by changes in market demand and/or market supply

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

0 500,000 1,000,000 1,500,000 2,000,000 2,500,000

Market Supply and Demand For Apples

Supply Demand

S

D



Changes in Demand or Supply

When a market is in equilibrium, the plans of buyers and the plans of sellers, all contingent on the value of the market price, are reconciled. Because the demand curve is negatively sloped and the supply curve is positively sloped, the market equilibrium price is unique for any given market demand curve and a corresponding market supply curve. As long as the demand and supply curves remain where they are, the equilibrium price and equilibrium quantity retain their unique values.

In a competitive market we refer to market price and market quantity as the en-dogenous variables; endogenous is derived from the Greek endo for “inside.” The forc-es of supply and demand cause price to adjust to that level where the quantity demanded equals the quantity supplied. Market equilibrium is stable in the sense that a market in equilibrium tends to remain in equilibrium unless acted upon by an outside force. Those outside forces are called exogenous variables, literally, those variables that are deter-mined outside of the market in question (here, the apple market). Changes in exogenous forces would shift either the supply curve, the demand curve, or, possibly, both curves. In our example of the apple market, the most important variables influencing the position of the demand curve include (a) household income, (b) the price of other types of food, (c) the number of households, and (d) household preferences. The exogenous variables influencing the position of the supply curve would include (a) the price of variable factors of production (e.g., the wages of apple pickers or the rental rate for apple-picking ma-chines), (b) the number of apple firms, (c) weather, and (d) other costs, such as the cost of transportation.

In Figure 4-4 we depict a market in equilibrium with the price of apples at $0.50 each, and the quantity of apples exchanged equal to 1 million per day. Now, suppose that an article in a leading medical journal reports that a controlled experiment at a prestigious medical school confirmed the old saw,12 “An apple a day keeps the doctor away.” The good news is that apples are effective alternatives to visits to the doctor’s office. The effect of this news is an increase in demand at the household level. The typical household doubles the quantity of apples demanded at each price. We call this change an increase in demand because one of the external variables—in this case, medical information that underlies household preferences—has changed.

When the demand curve shifts from D0 to D1, the former equilibrium price, p0 = $0.50, now generates excess demand. Quantity demanded increased from 0.5 million to 1 million, while quantity supplied remains at 0.5 million at the prevailing price of $0.50. Buyers, are no longer able to buy all the apples they wanted for $0.50 each. Apple grow-ers find that they have twice as many orders for apples as they care to fill at $0.50. In order to ration the available quantity, Johnny Appleseed and the other orchard owners raise the price of apples. As the price of apples increases, two reactions occur. The quantity of apples supplied rises along the stationary supply curve, S0. The quantity of apples demanded decreases along the new demand curve, D1. When the price reaches $0.67 per apple, the quantity of apples demanded and the quantity of apples supplied both stabilize at 1,333,333, and the market returns to equilibrium, although at a higher price.

12 Would this constitute one of the famous “apple saws”?



An increase in demand, supply constant, turns an equilibrium market into a seller’s mar-ket, meaning that price will rise, enriching sellers, until the new equilibrium is estab-lished at a higher price and a higher quantity. A market in disequilibrium only remains in disequilibrium until the price reaches the intersection of the new demand curve and the old supply curve, where quantity demanded once again equals quantity supplied.

Figure 4-4

A Short Exercise

Economists place great stock in learning by doing. Here we will test your under-standing of supply and demand analysis by having you draw your own diagram. In the space on page 62, draw a horizontal axis and label it “quantity” and a vertical axis and label it “price.” Next, draw a negatively sloped line (i.e., from a high price on your verti-cal axis, corresponding to the good being priced out of the market to a point on the verti-cal axis corresponding to the amount people would want if the good were free); label the curve D0 (for original demand curve). Next, draw a positively sloped line from a low price on the price axis; label this curve S0 (for original supply). Locate the point of inter-section and label the corresponding price and quantity P0 and Q0, respectively. Finally, connect the point of intersection and the equilibrium price and quantity with dotted lines. This is the starting point for any supply and demand analysis. Now we imagine that an increase in the number of produces shifts the supply curve from S0 to the right; label the new demand curve S1. Note that the original price p0 is no longer the equilibrium price. Identify the excess supply, then find the new equilibrium price and quantity (hint: they will be on the demand curve, which did not shift). These two examples show that when one curve shifts (moves to the right for an increased demand or supply, or moves to the left for a decreased demand or supply), the equilibrium price will occur along the curve that did not shift. Hence, a change in demand causes price and quantity to change in the same direction: an increase in demand increases equilibrium price and equilibrium quan-tity, while a decrease in demand decreases both equilibrium price and equilibrium quanti-

$0.00

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

0 200000 400000 600000 800000 1000000 1200000 1400000 1600000 1800000 2000000

Do

llars

per

Ap

ple

Quantity of Apples per Day

Increase in Demand

Original Demand New Demand Original Supply

P1

Q0 Q1 Q'

S0

D1D0



ty. By contrast, a change in supply changes the equilibrium price and quantity along the supply curve (because it does not shift). An increase in supply (the supply curve shifts to the right), causes equilibrium quantity to increase, but equilibrium price decreases. A decrease in supply (the supply curve shifts to the left) decreases equilibrium quantity but increases equilibrium price.



Shifts in Curves versus Movement along Curves

The events in Figure 4-4 depict an important distinction between a change in de-mand and a change in quantity demanded. At any time and place, the market price will tend to equal the equilibrium price, since neither buyers nor sellers have any incentive to change that price. However, a change in an exogenous variable will shift the effected curve causing what was once the equilibrium price to become a temporary disequilibrium price. If that disequilibrium is excess demand, the price will rise as anxious buyers offer to pay higher prices; if that disequilibrium is excess supply, the price will fall as desper-ate sellers compete to sell their merchandise by lowering price. A change in demand (the shift in the entire curve) occurs before the change in price. Once the price changes, both buyers and sellers will react to the change in price by changing the quanti-ties demanded or supplied, respectively. A decrease in price (due to a decrease in de-mand or an increase in supply) would increase quantity demanded and decrease quantity supplied until the new equilibrium was reached. An increase in price (due to an increase in demand or a decrease in supply) would cause quantity demanded to decrease and quan-tity supplied to increase, until the new equilibrium were reached.

Distinguishing between Supply and Demand Changes: The Identification Problem

To many students, the distinction between a change in demand and a change in quantity demanded seems like hair-splitting. Perhaps, if you put yourselves into the shoes of the professional economist, the distinction ought to become clearer. Imagine that you are an economist investigating the market for apples and you decide to collect information on that market on July 10, 2012, in Las Vegas, Nevada. You record the price, $0.50, and the quantity exchanged 1 million. The next day, you record the price, $0.50, and the quantity exchanged 1 million. Until either the supply or the demand curve shifts, you would be unable to identify either the demand curve or the supply curve for apples: A market in equilibrium tends to remain in equilibrium until acted upon by an outside force.

$/Q S0

D1

D0

P1 P0

Q0 Q1 Q/ut 0

Figure 4-5

S1

Q2 Q3



Now, suppose on the tenth day of data collection, the price increased to $0.67 (p1) and the quantity exchanged increased to 1,333,333 (Q1). What happened? Perhaps you read the article on apple consumption and health and correctly identified this as a cause of an increase in apple demand. Even if you didn’t see the article, however, it is pretty obvious from the pattern of price and quantity changes that a change in demand upset the market equilibrium. That’s because while the price of applies increased by $0.17 per apple, people consumed more apples. This violates the law of demand. It must be the case that an increase in demand (a rightward shift in the demand curve) caused a tempo-rary excess demand, which was resolved by a price increase. The new equilibrium price and quantity are on the original supply curve, and two points are enough to identify that curve as S0.

13

Suppose that you spend another week or so collecting data on the apple market and consistently register a price of $0.67 per apple and daily apple sales of 1,333,333. Suddenly, the price of apples drops back to $0.50 and you record apple sales at 1.5 mil-lion. Now we record a violation of the law of supply – in theory, when price falls, sellers produce less. However, when supply increases, quantity supplied increases due to some factor other than price – in this case, the higher priced (and more profitable) apples at-tracted additional apple sellers into the market. The quantity supplied increased to Q3, although this quantity went unobserved in sellers’ inventories. The excess supply reduc-es price to $0.50, where the new equilibrium quantity of Q2. Now we can connect the dots and identify the second demand curve, D1.

When Demand and Supply Both Shift: Predictability vs. Ambiguity

When only one of the two curves – market supply or market demand – shifts, the new equilibrium price and quantity will change unambiguously along the curve that did not shift. Often, however, either by coincidence or by a series of predictable events, a market might experience simultaneous shifts in both the demand and the supply curve. In the last section we observed an increase in demand that temporarily increased price and also increased equilibrium quantity. The increase in price was temporary because the in-crease in supply was a predictable response of profit-maximizing sellers to an increase in apple profits. The increase in supply further increased the increase in equilibrium quanti-ty, but reversed the change in equilibrium price. Lest you panic at the prospect of sorting out the net effect of multiple events, I present Table 4-4 to help you. The first column shows the four possible ways the two curves – supply and demand – could shift inde-pendently of each other. The second column shows the effect of that change in market conditions on the equilibrium price. For instance, an increase in demand increases the equilibrium price. The third column shows the corresponding change in equilibrium quantity: an increase in demand also increases equilibrium quantity. Table 4-4 clearly shows the effect on the market equilibrium price and equilibrium quantity when one curve shifts and the other remains stationary. When both curves shift, we simply treat each event separately and determine whether the combined effect of those shifts is clear or ambiguous. For instance, an increase in demand and an increase in supply both cause the equilibrium quantity to increase; hence, when both demand and supply increase, equi- 13 Recall from geometry that two points are sufficient to identify a straight line. However, since it is possi-ble that the supply curve might be curved instead of straight, an econometrician would require additional information to determine the likely shape of the line.



librium quantity unambiguously increases. However, the effect on equilibrium price is ambiguous. The increase in demand increases equilibrium price, while the increase in supply decreases equilibrium price. Hence, the net effect on the change in price is un-clear: the price could increase, decrease, or remain the same.

Market Event Change in Equilibrium Price Change in Equilibrium Quantity

Increase in demand Increase Increase

Decrease in demand Decrease Decrease

Increase in supply Decrease Increase

Decrease in supply Increase Decrease

Table 4-4: Effects of Changes in Demand or Supply

on Market Equilibrium Price and Quantity

What if both demand and supply curves shift? In this case, we analyze the effect of each curves shift independently, and then combine the effects of both curves. If price changes in the same direction due to the combined shifts, the change in price will be un-ambiguous; if the shift in one curve causes price to increase, and the other causes price to decrease, then the change in price will be ambiguous. In Table 4-5, an increase in de-mand and an increase in supply change price in different directions; the change in equi-librium price is ambiguous. If both demand and supply increase, both the increase in demand and the increase cause the quantity to increase; the change in quantity is unam-biguous – it increases. If demand decreases and supply increases, again the change in equilibrium price is ambiguous, while equilibrium quantity decreases. An increase in demand and a decrease in supply both cause equilibrium price to increase, while the in-crease in demand increases quantity and the decrease in supply decreases quantity; the change in quantity is ambiguous. A decrease in demand and an increase in supply reduc-es equilibrium price, but also has an ambiguous effect on quantity. In short, when de-mand and supply change in the same direction, equilibrium quantity changes in that di-rection, while the change in price is ambiguous. When demand and supply change in op-posite directions, the change in price changes in the direction that demand does, while the change in supply is ambiguous.

Demand Price Quantity Supply Price Quantity

change change change change change change Price Quantity

Increase increase increase Increase decrease increase ambiguous increase

increase increase increase decrease increase decrease increase ambiguous

decrease decrease decrease Increase decrease increase decrease ambiguous

decrease decrease decrease decrease increase decrease ambiguous decrease

Net change in

Table 4-5: Effect of Simultaneous Change in Demand and Supply

on Equilibrium Price and Quantity

Before we leave this discussion, I wish to remind you of the discussion of the effi-cient way to learn economics from chapter 2. For many of your courses the obvious strategy seems to involve memorizing definitions and concepts. Alas, this tendency is often reinforced by professors who design exams that reward regurgitation. Further, if



those exams do not revisit previously tested concepts, then students succeed by cramming information into short term memory, and then discard it. Anticipate their dismay when they discover – often too late – that employers or clients expected them to remember and understand important concepts. Because economic theory has so many relevant applica-tions, we soon encounter too much detail to digest successfully, let along remember. However, if we take the time to master the few underlying concepts, the details will take care of themselves. Even if you forget the contents of Table 4-4 and Table 4-5, you can always refresh your memory with your understanding – simply sketch the changes in de-mand and/or supply and viola! – instant recall.

Economics and Financial Markets: If We’re So Smart, Why Aren’t We Rich?

During the run up in the financial meltdown of 2008, many economists lost mon-ey, just like everybody else.14 In retrospect, the real-estate and financial-market bubble was caused by speculative pressures that drove the prices of financial assets above their sustainable levels. Indeed, many of those assets turned out to be so worthless they have been dubbed “toxic.” Many economists knew the stratospheric real-estate prices would not last forever, but knowing precisely when to sell that house or cash in one’s stock is a matter of guesswork. And the reason why financial markets keep even economists (and financial analysts) guessing is partly because neither the supply nor the demand curve for financial assets can be identified using market data.

Returning for a moment to our discussion of the apple market, it is possible to identify some variables, such as weather, that would cause the supply curve to shift with-out changing the demand curve for apples. Similarly, it is possible to predict variables that would cause the demand for apples to change—say, a change in the price of orang-es—that would not change the supply of apples.15 However, in financial markets, the buyers and sellers turn out to be the same people—households and institutions with wealth portfolios. It follows that any change that would influence willingness to buy a share of stock (demand) would also affect the willingness to sell a share of that stock (supply). Hence, financial markets take a random walk; they are inherently unpredicta-ble.16

Should this lack of ability to predict stock price fluctuations be a cause for alarm? Perhaps it should. Because the science of economics (and related disciplines like fi-nance) cannot predict the path of stock prices, many unscrupulous (or just plain ignorant) “experts” write and sell all types of advice on how to beat the stock market. But the next time you are tempted to buy a book from a financial expert who promises to unlock the secrets of the stock market for $29.95, remember the concept of opportunity cost. If this expert is so good at predicting financial markets, why did they take time away from play-ing the market to write the book in the first place?

Some Applications of Supply and Demand

While economists are nearly unanimous in their trust of market competition to allocate scarce resources efficiently, there are many social critics who advocate govern- 14 In 2009, the average economist received only 52% of the non-labor income (s)he had received in 2008. 15 That is because apples and oranges require very different climates to thrive. 16 Economists have a test for whether a time-series, such as the price of a financial asset, follows a random walk by whether it fits an equation of the form yt = yt-1 + εt where εt is an unpredictable stochastic term.



ment policies to remedy unfair market outcomes. Politicians are often willing to promise the impossible to win election, hoping that the voters will forget the promise by the time of the next election. Alas, although intelligence and integrity are both scarce commodi-ties, neither crooks nor fools are.17

One form of political chicanery is rent control. Since there are more tenants than there are landlords, and because landlords often reside (and vote) outside of the city where they supply apartments, politicians may seek to curry favor with big-city tenants by freezing rents at what are considered “fair” levels. In Figure 4-6, we imagine that the market for rental housing is initially in competitive equilibrium at rent level R0, with the equilibrium quantity of housing equal to Q0. Suppose that an increase in population, or an increase in income, results in a rightward shift of the demand curve. The temporary result is an excess demand for housing: The quantity of housing demanded increases to Q', while the quantity of housing supplied (at price p0) remains at Q0. The natural effect of the housing shortage would be an increase in average rents from R0 to R1, and an in-crease in the quantity of housing supplied from Q0 to Q1. In the short run, the increase in rents might be quite steep, since it is hard to increase the supply of housing without con-structing new buildings (supply is inelastic) and there are few substitutes for rental hous-ing (demand is inelastic).18

Figure 4-6

If, at rent R1, landlords are making greater than normal profits,19 existing and newly established apartment-rental companies will increase the number of units under

17 My father was a life-long Democratic committeeman in Dayton, Ohio. I’ll never forget his distinction between the two parties. “Tommy,” he said, “you rent Democrats and buy Republicans. And we journal-ists just don’t earn enough money to buy politicians.” 18 The supply of housing could be increased by subdividing large apartments, and refurbishing apartments that would have been retired had rents not increased. Tenants could cope with higher rents by moving back to their parents’ house. 19 We will return to this issue in Chapter 5.

Ren

tal r

ate

R' R1

R0

Q0 Q1 Q' Quantity of Housing/Month

D0

D1

S0

0

S1



construction, ultimately increasing the supply of rental housing to supply curve S1, result-ing in an increase in the number of rental units to Q', and a return of equilibrium rents to R0. However, if rents are frozen at R0, there is a permanent excess demand of Q'–Q0; an-other name for the excess demand for housing is homelessness. It is no accident that the cities with the highest homeless rates—New York, Washington, Boston, Los Angeles, and Santa Monica also have rent controls.

Usury Laws

The term usury has a long and noble history, going back at least to the thirteenth-century church scholar, Thomas Aquinas, who proclaimed that a virtuous person would lend money and not charge interest. It has long been a problem for the Roman Catholic Church20 that the absence of virtue is treated as a sin. Hence, Christians, all of whom were Catholics at the time, risked eternal damnation if they loaned money at interest. Since the Koran has also been interpreted as prohibiting the charging of interest, devout Muslims were also reluctant to lend money. In Hamlet, Polonius poetically recites Chris-tian dogma as practical advice:21

Neither a borrower nor a lender be; For loan oft loses both itself and friend,

And borrowing dulls the edge of husbandry [Act 1, Scene 3]

Unfortunately for both Aquinas and Polonius, market economies require borrow-ing by businesses and lending by households if businesses are to grow. While the Protestant Reformation later modified that bit of theological foolishness,22 there is still a tendency for governments to regulate maximum interest rates in the name of helping the poor. Las Vegas, like most cities, has a plethora of payday-loan outlets, where desperate people borrowed money at interest rates of up to 520%.23 It is sad that people are so des-perate that borrowing money at 520% seems like a good deal. The last time I checked, I counted 60 companies offering check-cashing services in the Las Vegas area. With this many firms, market competition would have reduced the equilibrium interest rate to the lowest sustainable level. Apparently, the 10% per week is the cost of doing business; for every 12 people borrowing $100 each, 11 borrowers repay their loan ($1210 in revenue) and 1 defaults (a $100 cost). That is a net gain of $10, which hardly seems excessive.24 20 I learned this from 13 years of Catholic school, which included nine years of elementary school (I was held back in the third grade because of difficulty reading), and four years at an all-boys’ high school. 21 The darker side of the Christian and Muslim prohibition against lending at interest meant that Jews, who suffered no such religious prohibition against money lending, developed a comparative advantage in bank-ing. Alas, it is often easier to cancel a loan with a pogrom than it is to change one’s theology. Aquinas’s dictum against lending money at interest is, at least in part, partly responsible to the scourge of anti-Semitism to this day. 22 That is, Martin Luther and the other protestors to papal authority found no scriptural prohibition against the charging of interest. 23 A borrower writes a check for $110 and receives $100. The lender then cashes the check the next pay-day, unless the borrower pays another $10 to renew the loan. A loan of 10% per week amounts to 520% per year. This is simple interest because the borrower makes regular interest payments. If the interest of 10% per week were compounded, the annual percentage rate would be (1.1)52 – 1 = 14,104%. 24 A $10 return to $1200 at risk for a week is 0.83% per week or 53% per year. Out of this revenue, the proprietor must pay rent, salaries, and debt collection services.



Placing a price ceiling on the interest rate that lenders can charge has the coun-terproductive effect of drying up legal sources of high-interest loans, driving poor-risk borrowers to true loan sharks, who break knees in the event of loan defaults. It is diffi-cult to understand how people with no other sources of loans are made better off by tak-ing options away. Maybe the churches, who often lead the call for anti-usury laws, should provide low-interest loans to the poor. Of course, they should also be prepared to replenish loan funds with subsidies from Sunday collections when those once grateful borrowers are never seen in church again.

Minimum Wage Laws

Rent controls and usury laws both represent price ceilings, whereby governments attempt to prohibit mutually beneficial terms of trade whose prices exceed what is thought to be fair.25 A price floor is a price control that prohibits prices below a specified level. For instance, it is a violation of federal law for an employee and an employer to agree on a wage rate below $7.25 per hour. In Figure 4-7, we confront a demand for la-bor curve and a supply of labor curve for unskilled workers (e.g., inexperienced high school dropouts). In this case, the supply and demand curves intersect at We. The mini-mum wage law states that any worker can sue if he or she is paid less than Wmin.

26 If em-ployers are forced to pay the legal minimum, the quantity of labor demanded decreases from the market-clearing level of Le to L1. At the same time, students who would have remained in school at wage rates of We mistakenly drop out of school in anticipation of earning Wmin. The result is that minimum wage rates cause two types of unemployment. Some workers, shown by Le – L1, lose their jobs because their skills do not command a wage rate of Wmin. Other workers, shown by L' – L1, are unemployed school dropouts, who enter the labor force but cannot find jobs at wage rate Wmin and are prohibited from working for We.

Figure 4-7 25 In reality, rent controls favor longtime tenants over landlords and new residents, who are mostly young. Old tenants benefit from rent controls by subleasing their apartments for rents that are higher than they would be in the absence of rent controls. And, as is so often the case, no one is quite so tenacious at de-fending the status quo than those who receive privileges they neither earned nor deserve. 26 The enforcement of minimum wage rates through civil action means that minimum wage laws are not enforced for undocumented workers.

SL

DL

L/ut

$/L

Wmin We

L1 Le L'

Job losers

Frustrated jobseekers



Employment Discrimination

In a competitive market, we expect employers to discriminate in favor of the most productive workers and we expect households to discriminate in favor of the jobs that provide the most satisfaction. In Figure 4-8 the supply curve S0 depicts the market supply curve in which all qualified workers are free to offer their labor services for the going wage, and D0 would be the demand curve if employers hired all qualified workers. How-ever, assume that employers in market A refuse to hire women for, say, construction jobs. Hence, they hire only along supply curve Sm raising the wage rate for male construction workers from W0 (the wage rate from competitive markets) to WA. Because they cannot obtain construction jobs, female would-be construction workers are crowded into the market for clerical workers. Although firms in market B hire all qualified job applicants, regardless of gender, the increase in the supply of female workers shifts the supply curve in market B from S0 to S1, reducing the wage rate in market B to WB.

Market A Market B

Figure 4-8

If labor markets were truly competitive, Lm0 workers in the construction industry would be male and the remainder (L0 – Lm0) would be female. Excluding females from the market would create an excess demand of L0 – Lm0 at wage rate W0; the excess de-mand would cause employers to bid up the wage rate to WA, which attracts an additional Lm1 – Lm0 male workers into the market. In the market for clerical workers, the displace-ment of L0 – Lm0 women into the market B would shift the supply curve to S1, which will reduce the wage rate to WB. Some of the workers originally employed at W0 drop out of market B, most likely male former clerical workers who enter the market for construction workers.

The consequence of employment discrimination on the relative income of the pre-ferred group (men) and the victims of discrimination (female) is independent of what mo-tivates discrimination. For instance, employers in market A may be prejudiced—they be-

0 L0' L0 LB

S0

Sf

Sm

S0

WA W0

Lm0 Lm1 L0

W0 WB

WW

0Construction workers

Clerical workers

D0 D0



lieve that women make poor construction workers, and so they refuse to hire them; likely they would complain that they have nothing against women, in fact, most of the men in market A are married to women. But, if women are not hired as construction workers, the employer prejudice will be a self-fulfilling prophecy. Alternatively, the construction un-ion may exclude women from apprenticeship programs, possibly due to prejudice, but also because unions wish to maximize the dues they can collect from male construction workers. The point is that discrimination in one market (A) reduces the wage rate in market B, even if no employers in market B discriminate against women.

Medical Costs

With a feeling of déjà vu, health care costs are once more a major campaign issue in the 2008 presidential election, leading the Obama Administration to pass the Afforda-ble Care Act of 2009. Now, as in 1993 when the Clinton Administration previously tack-led the issue, the consensus is that the price of health care is too high and the quantity of health care provided is too low. One major problem is that most people do not pay the direct cost of their health care, relying on insurance companies, or the government, to pay that cost. Another little-noted problem is that medical care and medical care commodities – particularly pharmaceuticals – are sold in monopoly markets. Fewer residents of the USA attend medical school than in other developed countries – and even many less de-veloped countries. As we will see in chapter five, monopolies raise price by reducing output. Each physician commands a higher salary if there a fewer physicians offering services. Drug companies can charge $1 each for pills that cost a penny to manufacture because they have patents.

Figure 4-9

We have seen that the market price and quantity of health care will be established where the demand curve intersects the supply curve, shown at P0 and Q0, respectively in Figure 4-9. As long as the supply curve remains at S0 and the demand curve remains at D0, the market price will remain at P0. Any attempt to increase the number of people covered by insurance will merely increase the demand for health care, raising the price above P0. If the government were serious about making health care more affordable, it

S0

S1

Q0 Q1 Q2

$/Q

Q/ut D0

P0 P1



would introduce policies to shift the market supply curve to the right. For instance, sup-pose the government encouraged medical schools to double the number of medical stu-dents. Eventually the supply curve of medical services would shift, say from S0 to S1. If the price of medical care (largely dependent on physician’s fees) remained at P0, there would be an excess supply of Q2 – Q0 hours of available medical services. Competition among physicians would reduce their pay, eventually reducing the price of health care to P1. At this price, some physicians would leave medicine for other occupations (becom-ing medical school professors, taxidermists, or funeral directors), while the quantity of health care demanded would rise to Q1. Gradually health care professionals could be re-ferred to as ambulance chasers because they are so desperate for work that they actually show up at automobile accidents and offer their services to the injured. What a concept!

By Way of Review

Supply and demand are crucial components of a market economy and understand-ing them is vital to understanding and passing an economics course. Demand refers to the contingent plans of buyers, reflecting their willingness to buy more of a commodity at a lower price than they would have been willing to buy at a higher price. Supply refers to the tendency of sellers to offer more for sale at higher prices than they would be will-ing to sell at lower prices. The price and quantity where the supply and demand curves intersect identifies the market equilibrium. A price higher than the equilibrium price causes excess demand; excess demand causes the price to rise until the equilibrium price is reached. A price lower than the equilibrium price causes excess supply; excess supply causes the price to fall until the equilibrium is achieved.

In order for competitive markets to allocate resources efficiently, market price and quantity must be free to adjust to changing market conditions. An increase in demand means that consumers are willing to buy more of a good at every price; an increase in demand transforms the market equilibrium into excess demand. The excess demand causes the price to rise, and as the price rises, sellers increase their quantity supplied along the supply curve. Equilibrium is restored where the new demand curve intersects the original demand curve. A decrease in demand means that consumers wish to pur-chase less of a commodity at each price (including the former equilibrium price); a de-crease in demand transforms market equilibrium into excess supply. The excess supply causes the price to fall until equilibrium is restored where the new demand curve inter-sects the original supply curve.

An increase in supply means that sellers offer more of a commodity for sale at each price, including the former equilibrium price. An increase in supply transforms market equilibrium into excess supply. The excess supply decreases the price until equi-librium is restored where the new supply curve intersects the original demand curve. An increase in supply causes equilibrium price to decrease and equilibrium quantity to in-crease. A decrease in supply means that sellers offer less of a commodity for sale at each price, including the former equilibrium price. A decrease in supply transforms mar-ket equilibrium into excess demand. The excess demand increases the price until equi-librium is achieved where the new supply curve intersects the original demand curve. A decrease in supply increases equilibrium price and decreases equilibrium quantity.



Summary

1. Probably the most useful tool in the economist’s analytical tool kit is the theory of supply and demand, which shows how competition among buyers and sellers estab-lishes a stable price.

2. The law of demand implies that the quantity of a good that households are willing to buy each time period decreases as the price of that good increases, other factors con-stant. Some of the other variables that are held constant (influences that cause a change in demand) include household income, the preferences of household mem-bers, the prices of substitutes and complements, and the number of households.

3. The law of supply implies that the quantity of a good that firms are willing to buy each time period increases as the price of that good increases, other factors constant. Some of the other variables that are held constant (influences that cause a change in supply) include technology, the prices of factors of production, and the number of firms in the market.

4. Market equilibrium occurs where market demand intersects market supply. At that price, there is no tendency for the price to either increase or decrease.

5. An increase in demand causes a rightward shift in the demand curve, which leads to an excess demand because the quantity demanded exceeds the quantity supplied. The shortage causes the price to rise until the new equilibrium price and quantity are reached along the stationary supply curve.

6. An increase in supply causes a rightward shift in the supply curve, which leads to an excess supply because the quantity supplied exceeds the quantity demanded. The surplus causes the price to fall until the new equilibrium price and quantity are reached along the stationary demand curve.

7. Consumer surplus is the difference between the total value consumers place on a commodity (the area under the demand curve) and the amount they actually pay for the good (price times quantity).

8. Producer surplus is the difference between what sellers receive for the good (price times quantity) and total variable costs (the area under the supply curve).

9. A competitive market equilibrium maximizes the sum of consumer and producer sur-plus.

10. Neither economists nor everyone else can predict financial markets because whenever the supply curve for a financial asset changes, so does the demand curve (and vice versa) because buyers and sellers respond to the same influences.

11. Rent controls set maximum rents by law. The consequence is a permanent excess demand for housing. Rent controls are among the major causes of homelessness.

12. Usury laws are similar to rent controls in that they set legal limits on interest rates that lenders can charge borrowers. Since market interest rates include premiums for risk, usury laws make it impossible for potential borrowers with the worst credit to obtain legal loans, driving them into underground markets where loan sharks break the legs of delinquent borrowers.



13. Minimum wage laws are price floors, legal minimum wage rates that employers and employees can agree upon. The result of minimum wage laws is that some unskilled workers lose their jobs and other frustrated job seekers (e.g., high school dropouts) cannot find employment. If the demand for labor is wage inelastic, higher minimum wages will increase the total income of the unskilled, but at the cost of job loss and increased high school dropout rates.

14. If the goal of health care reform is to reduce the price and increase the quantity, then policy should concentrate on increasing supply, rather than subsidizing demand.

15. Because the government is a monopsony, it tries to circumvent the laws of supply and demand by drafting reluctant volunteers or surprising reservists when the artifi-cially low pay for military recruits results in a permanent shortage of military person-nel.

Glossary Demand: Refers to the quantity that (potential) buyers are willing and able to buy at al-

ternative prices, given other influences on their behavior including (1) their money income, (2) the number of people in the household, (3) the prices of other goods they might have bought instead, and (4) their tastes and preferences.

Law of demand: Other factors remaining constant, buyers will (try to) purchase less of a commodity at a higher price than they would have purchased at a lower price.

Competitive market: A market in which all buyers and sellers are price takers so that the price and quantity are determined by the interaction between supply and demand.

Supply: Refers to the quantity that sellers are willing to sell at each price, other factors (number of firms, prices of factors of production, technology) held constant.

Law of supply: As the price increases, the quantity supplied increases, other factors re-maining constant.

Consumer surplus: The area under the demand curve, above the price.

Producer surplus: The area under the price and above the supply curve.

Change in demand: The entire demand curve shifts to right (increase in demand) or to the left (decrease in demand).

Change in supply: The entire supply curve shifts to the right (increase in supply) or to the left (decrease in supply)

Change of quantity demanded: The amount that buyers are willing to purchase changes in response to a price change (a movement along the demand curve).

Change in quantity supplied: The amount that sellers are willing to sell changes in re-sponse to a price change (a movement along the supply curve).

Market equilibrium: The price and quantity identified by the intersection of the market demand curve and the market supply curve intersect. At the market equilibrium, there is no tendency for price to change, as it would if there were a shortage (quantity demanded exceeds quantity supplied) or if there were a surplus (quantity supplied ex-ceeds quantity demanded).



Excess demand: A condition when the quantity demanded exceeds the quantity supplied at the prevailing price. Excess demand causes the price to rise until equilibrium is re-stored. Typically an increase in demand or a decrease in supply causes excess de-mand.

Excess supply: A condition when the quantity supplied exceeds the quantity demanded at the prevailing price. Excess supply causes the price to fall until equilibrium is re-stored. Typically an increase in supply or a decrease in demand causes excess supply.

Endogenous variables: The variables determined inside the market—price and quantity.

Exogenous variables: The variables determined outside the market. For the demand curve, important exogenous variables are number of households, household income, consumer tastes, and the prices of substitutes and complements. For the supply curve, important exogenous variables are number of firms, technology, and prices of factors of production.

Financial markets: markets in which IOUs (bonds) and ownership shares (stocks) are sold, typically among households maintaining financial portfolios.

Rent control: The government enforcement of maximum rents, which cause permanent housing shortages and homelessness.

Usury laws: The government enforcement of maximum interest rates, which causes a shortage of loans to the worst credit risks, driving them to illegal markets, where the consequences of loan default can be physical injury or even death.

Minimum wage laws: The government enforcement of the lowest legal wage rate reduc-es the employment of the least skilled and may actually encourage high school drop-outs to pursue nonexistent jobs.

Employment discrimination: When the market wage is set above the market clearing level, employers or employee associations will have to ration jobs among applicants. When this rationing device is anything except the wage rate, qualified applicants will be turned away, often due to race, gender, or some arbitrary characteristic.

Chapter 5 Competitive Markets and Economic Efficiency


Introduction Now that we have discussed circular flow, production possibilities, individual choice, and competitive markets, we now turn our attention to what happens inside the business sector. This chapter explores competitive markets; chapter 6 discusses monopo-ly. We will explore the workings of the household sector in chapter 7. The business sec-tor is composed of firms that purchase the services of factors of production owned by the household sector through factor markets and transform flows of land, labor, capital, and entrepreneurial services into final goods and services, which they sell in the product market. The goal of the firm is to maximize profit, which is the difference between the revenue earned from selling goods and services, and the opportunity cost of the input services used to produce those commodities.

Production and Cost

In chapter four we derived the firm’s supply curve from its attempt to maximize profit. The price-taking firm maximizes its profit by producing that rate of output for which marginal cost equals price. Marginal cost is the cost of producing the last unit of output. In Table 5-1 we return to the apple orchard example of chapter 4. The marginal cost of apples is given by the linear equation MC = 0.001q, where q is the daily harvest of apples. The variable cost is the sum of the marginal cost for all the apples produced. Since marginal cost begins at $0, the shutdown price is also zero. In addition to the vari-able cost of labor we add the overhead of $125 per day, to cover the mortgage ($50/day) on the orchard and Johnny Appleseed’s foregone wage ($75/day). Producing nothing would produce zero revenue and zero variable costs, but having to pay overhead means average cost is infinite. As output expands, average costs decline as overhead is spread over more units. Producing 50 apples generates variable costs of only $1.25. Fixed costs and variable costs generate total costs of $126.25. Dividing total cost by 50 yields the average cost of AC = $126.25/50 = $2.53. Since fixed costs occur even if output is zero, the cost of producing 50 units of output is only $1.25, not $126.25. As output expands, average costs decline as overhead is spread over more units, even as marginal cost in-creases. When output reaches 500 units, average fixed costs have reached $125/500 = $0.25, and average variable costs have risen to $0.25. Average costs (the sum of average variable costs and average fixed costs) reach their minimum at this rate of output. This is no accident, because when q = 500, mc = ac. Since marginal cost is the change in the last unit, average costs decline when ac > mc; marginal costs pull average costs down. On the other hand, above q = 500, marginal cost exceeds average cost (mc > ac) and marginal cost pulls average cost up. It follows that when marginal cost equals average cost, average cost is neither increasing nor decreasing; when ac = mc, ac achieves its minimum value.



Rate of Fixed Variable Marginal Average

Output Cost Cost Cost Cost

0 $125 $0.00 $0.00 50 $125 $1.25 $0.05 $2.53

100 $125 $5.00 $0.10 $1.30

150 $125 $11.25 $0.15 $0.91

200 $125 $20.00 $0.20 $0.73

250 $125 $31.25 $0.25 $0.63

300 $125 $45.00 $0.30 $0.57

350 $125 $61.25 $0.35 $0.53

400 $125 $80.00 $0.40 $0.51

450 $125 $101.25 $0.45 $0.503

500 $125 $125.00 $0.50 $0.500

550 $125 $151.25 $0.55 $0.502

600 $125 $180.00 $0.60 $0.51

650 $125 $211.25 $0.65 $0.52

700 $125 $245.00 $0.70 $0.53

750 $125 $281.25 $0.75 $0.54

800 $125 $320.00 $0.80 $0.56

850 $125 $361.25 $0.85 $0.57

900 $125 $405.00 $0.90 $0.59

950 $125 $451.25 $0.95 $0.61

1000 $125 $500.00 $1.00 $0.63

1050 $125 $551.25 $1.05 $0.64

1100 $125 $605.00 $1.10 $0.66

Table 5-1: Production and Cost for Johnny Appleseed’s Orchard

Figure 5-1 shows the unit costs for this example. The average total cost curve is U-shaped, declining until MC and ATC intersect, at which point ATC and MC increase together. The point where marginal cost intersects the average cost curve identifies the firm’s break-even price. Recall from chapter four that when p = $0.50, this firm maxim-ized profit by producing where marginal cost equals marginal revenue, in this case, 500 units of output. At that output, total revenue equals $250 (price times quantity), variable cost equals $125 (the sum of marginal cost over all units produced), generating a produc-er surplus of $125. When we subtract overhead from producer surplus, we obtain eco-nomic profit. When p = $0.50, overhead exactly absorbs producer surplus, implying an economic profit of zero. This does not mean Johnny Appleseed is destitute. Part of his overhead is the opportunity cost of time; if the market wage for orchard managers is $75 per day, Johnny is able to pay himself exactly what he would earn by working for another employer. Given that Johnny has already passed up jobs with other employers, whether he is able to cover the opportunity cost of his time is irrelevant to his output decision. If the price of apples fell to $0.40, he would reduce his apple production to 400 apples per day. His revenue would fall by $90 ($0.10 less for each of the 400 apples he does pro-duce and $0.50 each for the 100 apples he no longer can afford to produce), while his



(variable) costs decline by only $45, causing an economic loss of $45. Now, after paying his $50 mortgage, he has only $30 to pay his own wage.

The Firm, the Household, and the Market

Figure 5-2 presents a stylized diagram of a typical firm operating in a perfectly competitive market. Economists refer to perfect competition as a market in which firms can freely enter a market and produce a standardized or homogenous product. Apple production is a fairly good approximation of a perfectly competitive market. Grocery shoppers rarely inquire about the identity of which orchard produced their apples, alt-hough they may distinguish between organic and chemically produced apples.1 Hence, all apples sell for close to the same price. Further, anyone willing to incur the costs of growing apples can truck them to market and sell them to produce whole-sellers. So we will continue to assume that apple prices are set by the impersonal forces of supply and demand.

In Figure 5-2, the market supply curve and market demand curve for apples inter-sect at price p0. Johnny Appleseed, like other apple producers, sets output where margin-al cost equals price. In this case he is lucky, since price p0 > ac at qi

*, Johnny’s profit-

1 Unless they bring a chemical testing kit to the grocery store, most produce buyers cannot determine if the produce they buy is organically grown. Without government or equally effective private regulation (Wal-Mart often enforces truth in labeling), non-organic producers, who incur lower costs, are likely to fraudu-lently claim that their chemically grown produce is organic.

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 9501000

Figure 5‐1: Marginal and Average Cost for Small Firm

marginal cost average cost

MC

AC



maximizing rate of output. His producer surplus (area p0pminB) more than covers his overhead, generating a positive economic profit. Because the market is in competitive equilibrium, the Adams family, like every apple-consuming household, is able to pur-chase as many apples as they want (which is qj

*), they maximize their consumer surplus (area pmax-p0A). In fact, the perfection of perfect competition comes from the prediction that when buyers and sellers allocate resources through a competitive market, the market equilibrium price, by maximizing the quantity exchanged, maximizes the sum of total consumer surplus (pmaxp0C) plus total producer surplus (pminp0C).

The Market

Figure 5-2

Profit Maximization and Market Equilibrium

Long-Run Competitive Equilibrium

Figure 5-2 shows the short-run outcome of a competitive market. In Figure 5-3 we plot the transition to long-run market equilibrium. As in Figure 5-2, the typical firm is earning a positive economic profit at price p0. However, this outcome cannot last for-ever. One important characteristic of a competitive market is the free entry of new firms. Recall from Chapter 2 that potential entrepreneurs are always casting about looking for ways of shifting resources to more profitable areas. Positive economic profits in this market mean that the typical firm owner is receiving a higher net income from the re-sources he or she owns that would be possible in any other market. So it is only a matter of time before proprietors in this market begin to brag to would-be entrepreneurs cruising cocktail parties to find profitable ventures. The result will be an influx of firms into this market, so that the rate of birth of new firms exceeds their rate of death, increasing the number of firms over time.

$/qi

MC ATC MR P0

S0

p0

$/Q $/qj

D0

P0

qi*

dj

Typical Firm (i) Typical Household (j)

Qe qj

0 q/ut

0 0 Q/ut q/ut

pmin

B A

pmax

C

pmax

pmin



The short-run equilibrium price p0 reconciles quantity demanded and quantity supplied for the number of firms in the market at that time. The existence of economic profit signals new firms to enter the market, which has the effect of reducing price to pe, which is the efficient firm’s break-even price. Competitive markets use the lure of eco-nomic profit to maximize consumer surplus, equal to the area pmaxpeA. The resulting pro-ducer surplus, pmaxpeA, equals the sum of all firms’ fixed costs.

,

Figure 5-3

The idea of long-run equilibrium explains how technological advances spread throughout competitive markets. In Figure 5-4, we start with a competitive market in long-run equilibrium. Suppose the product in question is accounting services and the firms in question are small-scale consulting firms. Initially, the equilibrium price is set at p0, which is just sufficient for accounting firms to cover their fixed and variable costs in a world of pen-and-ink accounting ledgers. Along come computers, which substantially reduce the cost of accounting services.

If a company does not innovate, its costs of production remain at MC0 and ATC0, and the firm receives zero economic profit at price p0. However, there will be some firms whose supply of pen-and-ink ledgers are fully depreciated and are investigating innova-tive accounting techniques. If they discover that their average total costs of the new technology are less than their average variable costs with the old technology, the innova-tion will appear to be a profitable venture. They scrap their ledger book technology and adopt the computerized accounting software. Each (computer-literate) accountant be-comes more productive, and the marginal cost curve shifts down from MC0 to MC1. At the output q0, the firm finds that p0 exceeds the new, lower marginal cost, and so the firm expands output to q0'. Accounting entrepreneurs flush with new profits expend their

$/qi

MC ATC

S0 S1

p0 pe

$/Q

D0

q0 q1 Q0 Q1 Q2

Typical Firm The Market

q

ut Q

ut

pmax

p0 pe A

pmin



newfound fortunes on throwing parties during which they brag about their fortunes to their stodgy colleagues.

Figure 5-4

Before long, all firms either adopt the new technology or face extinction. As more firms expand their rate of output, a market glut of accounting services develops. Price begins to fall. Those firms who do not innovate find that price is less than their av-erage costs. Eventually the market supply curve shifts from S0 (composed of old tech-nology firms) to S1 (composed of new technology firms). But if long-run equilibrium is to be achieved, then economic profit must be zero for the efficient firm. Hence, price falls from p0 to the new long-run equilibrium price p1, and eventually all the benefits of the innovation have accrued to consumers.

Competitive Markets and Employer Discrimination

The events depicted in the previous section illustrate the most important conclu-sion that economists draw about competitive markets. The free-entry characteristic of these markets implies that at any particular time and place, competitive prices will tend toward their lowest sustainable level: the minimum point on the average cost curve. The prospect of positive economic profits entices producers into competitive markets. Ironi-cally, the process of market entry eliminates economic profit. The market mercilessly fa-vors the efficient and discards the inefficient, whether inefficiency comes from poor tim-ing, lack of foresight, or pursuit of other motives. As we saw in chapter 2, discriminating employers are less efficient and have higher costs than efficient, non-discriminating em-ployers do. In this section we apply this lesson to the competitive market.

In Figure 5-5, Billy Bob Bigot depicted on the left has higher costs of production than does Jacob Ableman. We imagine that the market is in short-run equilibrium at p0, which is just sufficient for the discriminating firm to earn zero economic profit, while the equal-opportunity firm earns a positive economic profit. Under a regime of free entry,

$/qi

p0

p1

S0 S1

p0 p1

$/Q

P0 P1

Innovating Firm The Market

MC0

ATC0

MC1 ATC1

D0

q0 q1 q0' Q0 Q1



equal-opportunity firms will enter the market, rotating the market supply curve from S0 to S1, until the equilibrium price equals P1. Both firms cut their output to where P1 equals their own marginal cost. The equal-opportunity firm now earns zero economic profit, while the discriminating firm experiences an economic loss equal to qd1(AC1 – p1). This example helps explain why racial or gender discrimination requires anti-competitive laws, such as the Jim Crow laws in the pre–civil rights South.

$/q $/Q $/q

Figure 5-5

This is a point that many non-economists—both political liberals and political conservatives—have difficulty understanding. Competitive markets discriminate against inefficient firms and in favor of efficient firms. Hiring workers on the basis of their gen-der, their race, or their religion puts firms at a competitive disadvantage. Ultimately dis-crimination cannot be sustained in a competitive market.

Rent Controls Revisited

Burt Lance of the Carter Administration (1977-1981) is credited with coining the phrase “If it ain’t broke, don’t fix it.”2 Other liberals would do well to learn this lesson; attempts to improve on competitive markets always turn out disastrously. The market for apartments in a large city is a paramount example of a competitive market. There are a large number of apartment buildings owned by profit-maximizing proprietors. The cost of supplying apartments involves substantial overhead (the mortgage on the building plus the landlord’s foregone income on time and money invested in his business). While not actually homogeneous, apartment rents vary predictably by the size and location of the apartment complex. Hence, the typical landlord faces a “U-shaped” average cost curve whose minimum point (where atc=mc) identifies the lowest sustainable rent.

Figure 5-6 depicts an apartment market in long run equilibrium, with (average) rents at re and equilibrium quantity at Q0. Now we imagine that the city grows unexpect- 2 http://www.phrases.org.uk/meanings/if-it-aint-broke-dont-fix-it.html

ATCd

AC1

P0 P1

P0 P1

P0 P1

q1 q0 q/ut Q0 Q1 Q/ut qe1 qe0 q/ut

Efficient Producer (Jacob Ableman)

Competitive Market Discriminating Producer (Billy Bob Bigot)

D0

S0

MC ATC

MCd



edly, resulting in a “housing crisis.” The increase in demand for apartment units leads to an excess demand at rental rate re, causing desperate apartment seekers to bid the average rental rate to r1, which is the market clearing rental rate for new tenants willing and able to pay this rate. Long accustomed to the former equilibrium, long-term tenants consider r1 “unfair” (i.e., less for them) and petition the city council to pass rent controls, prohibit-ing landlords from charging more than re. As we saw in chapter 4, rent controls turn a temporary housing shortage into a permanent one. Indeed, tenants find they can sub-lease the Q0 at rental rate r*

. Ironically, those who sub-lease those apartments pay the clearing rent r2 which is greater than the equilibrium rent r1. Rent controls transfer prop-erty rights from landlords to the original tenants, who exploit other tenants.

Housing Market Landlord

Now we are prepared to examine what would happen in a competitive housing market in the absence of rent controls. Suppose that an enlightened city council, includ-ing one or more economists or social workers educated in economics, reject the rent con-trol proposal and put their faith in the market. Allowing rents to increase to r1 mean that landlords earn temporary economic profit on their units. This leads them to build more units and other landlords to enter the market. The result of additional apartment units shifts the supply curve to the right, creating a (temporary) excess supply of apartments until the equilibrium price (rental rate) returns to the long-run equilibrium level at re. The attempt to fix a competitive market – which was not broken – breaks it, causing a housing shortage and a shift in wealth from landlords (who would construct more units) to the original tenants, who pocket the excess rent.

Q0 Q1 Q2

D1

$/Q

rmax

r2 r1 re

S0 S1

mc ac

q0 q1

r1 re

Q/ut 0 q/ut

$/q

D0



Summary

1. The total cost of production is the sum of the fixed cost and the variable cost.

2. Marginal cost is the cost of producing the last unit of output; marginal cost equals a factor’s price divided by its marginal product.

3. Minimum average cost (total cost divided by output) occurs at that rate of output where marginal cost equals average cost. Minimum average cost equals the firm’s breakeven point.

4. The price-taking firm maximizes profit by producing that rate of output where mar-ginal cost equals price (marginal revenue).

5. The existence of short-run economic profit encourages more firms to enter the mar-ket, increasing market supply and reducing equilibrium price to the lowest sustainable level.

6. The competitive equilibrium maximizes the sum of consumer and producer surplus.

7. A technical innovation creates temporary economic profit that attracts additional firms to the market, increasing supply and reduces long-run equilibrium price to the minimum point on the efficient firm’s average cost curve.

8. Since discriminating employers will have higher costs of production than will effi-cient, non-discriminating firms, a competitive market will eliminate inefficient dis-crimination over time.

9. Rent controls are undesirable because they are both inefficient and inequitable. Ra-ther than allowing temporary rent increases to generate economic profits, which en-courage an expansion of a city’s apartment stock, rent controls cause a permanent housing shortage and higher rents for new apartment seekers. Without rent controls, economic profit would increase the supply of units, eventually returning the rental rate to its lowest sustainable level.

Glossary

Economic profit: Total revenue (price times quantity) minus economic (opportunity) cost.

Fixed cost: A minimum purchase requirement that stipulates that the firm must pay cer-tain costs (e.g., rent, mortgages, equipment payments, property taxes), whether it pro-duces any output.

Variable cost: The cost that changes with the rate of output.

Marginal cost: The cost of producing the last unit of output.

Shutdown price: The lowest price necessary for the firm to produce. If the market price falls below the shutdown price, the firm produces zero output, limiting its loss to neg-ative fixed cost.

Price-taking firm: A firm, whose price is set by a competitive market, causing the firm’s marginal revenue to equal price.



Profit-maximization rule: The price-taking firm maximizes profit by producing that rate of output where marginal cost equals price (marginal revenue)

Consumer surplus: The difference between the value consumers place on a commodity and the amount they spend to purchase that commodity, depicted as the area below the demand curve and above the market price.

Producer surplus: The difference between the total revenue and total variable cost equal to the area below the market price and above the market supply curve. In long-run competitive equilibrium, producer surplus equals total fixed cost.

Chapter 6 The Inefficiency of Imperfect Competition


The Evolution of Markets

Chapter 5 explored the efficiency of perfectly competitive markets. Firms maximize profit by setting output so that marginal cost equals marginal revenue. Since the market sets the price, marginal revenue equals price. Setting output so that marginal cost equals price is economically efficient since the opportunity cost of resources used to produce the last unit of output exactly equals the value of that output to the consumer. Finally, in the long run, positive economic profit leads new firms to enter the market, to increase market supply, and to drive prices to their lowest sustainable level. Some people treat perfect competition as if it was created by divine power like some economic Garden of Eden.1 More sophisticated economists understand that, like most human institutions, competitive markets evolve out of a more primitive form of economic organization, namely monopoly.

Monopoly

The opposite of competition is monopoly, a market with one seller. Sometimes a market has one seller because there is only one producer, like most local newspaper publishers, electric power companies, cable television providers and the first producer of a new commodity. Typically, the first firm into a small market is a monopoly. Small towns may have one gas station, one pharmacy, and one grocery store. We need to understand monopolies if we are to understand how markets evolve from a primitive form of consumer exploitation to a mature form of economic efficiency. Like competitive producers, monopoly producers also maximize profit by producing that rate of output for which marginal cost equals marginal revenue. However, since a monopoly selects its price and quantity from the market demand curve, its marginal revenue is less than its price. A numerical example can illustrate.

Table 6-1 presents the simplest example of a monopoly business – a monopoly movie theater which has a zero marginal cost.2 Because she owns the only movie theater, the proprietor confronts a negatively sloped demand curve. The maximum price is $20; at that price (or higher) the quantity of tickets demanded is zero. In this stylized example, there is one patron who would pay $19.98 for a ticket. The second patron would purchase a ticket for $19.96. Since the theater owner cannot determine who is willing to pay each price, she must charge the same price to all patrons.3 The marginal revenue – the change in revenue from the second ticket is only $19.94, since selling the second ticket requires a $0.02 reducing in the first ticket. Mathematically, if the inverse demand equation is p = $20 - .02Q, marginal revenue is MR = $20 - .04Q; for a linear (inverse) demand curve, marginal revenue falls at twice the rate as price does.4

As with the perfectly competitive firm, the monopoly maximizes profit by setting output so that marginal revenue equals marginal cost. Unlike the price taker, however, a monopolist’s 1 The religious cult The Family, infamous for the C Street house in Washington DC that sheltered Senator John Ensign during his extra-marital affairs, teaches that “the invisible hand” is Jesus, bestowing economic blessings on the elect, who are not required to follow conventional morality. 2 Once the projector is running, one more patron can be seated without increasing the owners’ costs, as long as some seats are unfilled. 3 Later we will relax this condition when we discuss price discrimination: charging different prices to different groups of customers. Movie theaters typically charge lower prices for children’s tickets and senior citizen’s tickets than they charge for working-age adults. However, since my wife and I are over 60, we receive the senior discount, despite the fact that we have three incomes between us. 4 Marginal revenue equals the price of the last unit minus the discount to all (previous) buyers. In this example, p = $20 - .02Q. Hence, the discount is .02Q, making MR = $20 - .02Q - .02Q = $20 - .04Q.



marginal revenue is less than price. Since the marginal cost of selling movie tickets is zero (that is one more patron can be seated without increasing cost), this monopolist would set quantity at 500, which implies setting the ticket price at $10.00 each. At this price, producer surplus equals revenue, namely $5,000. Subtracting fixed costs of $2,000 yield economic profit of $3,000. The last column in Table 6-1 presents a measure of consumer responsiveness to price changes, price elasticity, defined as the percent change in quantity demanded divided by the percent change in price. At a price of $20, ticket sales are zero, and total revenue is zero. Dropping the price by just $0.02 would increase the quantity sold to 1 ticket – literally an infinite percent change in quantity in response to a 0.1% decrease in price. At the price intercept of a demand curve, demand is infinitely price elastic. At a price of $19, the percent change in quantity divided by the percent change in price equals -19. That is, quantity demanded is very responsive to price; the decrease in price (by 5.26%) increases quantity demanded by 100%, causing revenue to increase. As price falls, price elasticity approaches 0. When p = $10 (exactly ½ of pmax), price elasticity equals -1. At this price we say that demand is unit elastic, which is that price at which total revenue is maximized and marginal revenue is zero. At prices above $10, we say that demand is price elastic; a decrease in price increases revenue, implying that marginal revenue is positive. Finally, at prices below the midpoint of the (linear) demand curve, demand is price inelastic. Cutting price by, say, 1% leads to a smaller percent increase in quantity, causing total revenue to decline. Hence, the monopoly producer could not maximize profit if demand were price inelastic, because this would cause marginal revenue to be negative.

Table 6-1

Monopoly Movie Theater

Tickets Tickets Total Total Economic Marginal Marginal Price

Price Sold Revenue Cost Profit Revenue Cost Elasticity

$20.00 0 $0 $2,000 ‐$2,000 $20 $0 -¥

$19.00 50 $950 $2,000 ‐$1,050 $18 $0 ‐19.00

$18.00 100 $1,800 $2,000 ‐$200 $16 $0 ‐9.00

$17.00 150 $2,550 $2,000 $550 $14 $0 ‐5.67

$16.00 200 $3,200 $2,000 $1,200 $12 $0 ‐4.00

$15.00 250 $3,750 $2,000 $1,750 $10 $0 ‐3.00

$14.00 300 $4,200 $2,000 $2,200 $8 $0 ‐2.33

$13.00 350 $4,550 $2,000 $2,550 $6 $0 ‐1.86

$12.00 400 $4,800 $2,000 $2,800 $4 $0 ‐1.50

$11.00 450 $4,950 $2,000 $2,950 $2 $0 ‐1.22

$10.00 500 $5,000 $2,000 $3,000 $0 $0 ‐1.00

$9.00 550 $4,950 $2,000 $2,950 ‐$2 $0 ‐0.82

$8.00 600 $4,800 $2,000 $2,800 ‐$4 $0 ‐0.67

$7.00 650 $4,550 $2,000 $2,550 ‐$6 $0 ‐0.54

$6.00 700 $4,200 $2,000 $2,200 ‐$8 $0 ‐0.43

$5.00 750 $3,750 $2,000 $1,750 ‐$10 $0 ‐0.33

$4.00 800 $3,200 $2,000 $1,200 ‐$12 $0 ‐0.25

$3.00 850 $2,550 $2,000 $550 ‐$14 $0 ‐0.18

$2.00 900 $1,800 $2,000 ‐$200 ‐$16 $0 ‐0.11

$1.00 950 $950 $2,000 ‐$1,050 ‐$18 $0 ‐0.05

$0.00 1000 $0 $2,000 ‐$2,000 ‐$20 $0 0.00



Before we generalize on monopoly producers that have positive marginal costs, consider the case of the inefficient monopolist. Suppose that a rival of this owner proposed a theater of half the capacity, where fixed costs were only $1,000. With two movie theaters, the market would constitute a duopoly (two sellers) instead of a monopoly (one seller). If the second theater charged more than $10 per ticket, it would sell no tickets, since movie patrons already have the option of seeing movies for $10 at the incumbent theater. If the second theater charged less than $10, it would force the first theater to match its price cut. If the would-be entrant expected the erstwhile monopolist to maintain its output of 500 tickets and match the second theater’s price, the second firm would essentially claim all potential movie patrons who would only purchase movie tickets for less than $10 each. The inverse demand curve confronting the second firm would be p = $10 - .02Q2, implying MR = $10 - .04Q2. With a capacity for 500 movie patrons, the second theater would set its output where MR = MC = 0, that is, selling 250 tickets at $5.00 each. With $1025 in revenue and $1000 in (fixed) costs, the second theater would realize economic profit of $250 per day. The original monopoly’s price would also drop to $5, cutting its revenue to $2,500 and its profit would decline to $2500 – $2000 = $500. As with perfect competition, entry by additional sellers decreases consumer prices and increases consumer surplus at the expense of producer surplus.

Table 6-2 Demand and Profit Conditions Confronting Potential Duopolist

If two firms could fit profitably into this market, what about a third? Under perfect competition, entry would continue until all prospects for economic profit were eliminated. At a $5 price, a total of 750 tickets would be sold (500 by theater #1 and 250 by theater #2). If a third theater opened with only 125 seats, thereby experiencing only $250 in fixed costs, it could expect to face a residual demand curve, p3 = $5 - .02Q3, so that MR3 = $5 - .04Q3. MR3 = MC3 = 0 implies that the profit-maximizing number of tickets would be $2.50 per ticket. The third theater would sell 875 – 500 (firm1) - 250(firm2) = 125. Firm 3’s revenue would be $2.50(125) = $312.50; subtracting fixed costs of $250 yields economic profit of $62.50. Eventually the limited size of the market would deter further entry even while (relatively small) economic profits remained for incumbent firms. As the city grows, there will be increased demand for movie tickets. The larger theaters can accommodate more patrons, but new theaters will enter

Tickets Tickets Total Total Economic Marginal Marginal Price

Price Sold Revenue Cost Profit Revenue Cost Elasticity

$10.00 0 $0 $1,000 ‐$1,000 $10.00 $0 -¥

$9.00 50 $450 $1,000 ‐$550 $8.00 $0 ‐9.00

$8.00 100 $800 $1,000 ‐$200 $6.00 $0 ‐4.00

$7.00 150 $1,050 $1,000 $50 $4.00 $0 ‐2.33

$6.00 200 $1,200 $1,000 $200 $2.00 $0 ‐1.50

$5.00 250 $1,250 $1,000 $250 $0.00 $0 ‐1.00

$4.00 300 $1,200 $1,000 $200 ‐$2.00 $0 ‐0.67

$3.00 350 $1,050 $1,000 $50 ‐$4.00 $0 ‐0.43

$2.00 400 $800 $1,000 ‐$200 ‐$6.00 $0 ‐0.25

$1.00 450 $450 $1,000 ‐$550 ‐$8.00 $0 ‐0.11

$0.00 500 $0 $1,000 ‐$1,000 ‐$10.00 $0 0.00



when profit potential develops. Theaters will compete by advertising, which they can co-ordinate as movie distributors develop their own chains of movie theaters. Today, most cities’ movie theater markets are characterized by oligopoly – a few theater chains that compete by location, advertising, and indeed, price.5

Persistent Monopoly: Economies of Scale

The previous monopoly was merely a transitory phase as additional sellers responded to the economic profit of incumbent firms. Without barriers to entry, competition would gradually decrease price and squeeze out inefficient firms. A natural monopoly occurs when the monopoly price is sufficiently low, relative to would-be entrants’ average costs and market demand, to deter competition. In Table 6-3 we consider the prospect of a daily newspaper in a medium sized city like Las Vegas. The demand curve is negatively sloped, in this case the equation is p = $1 – 1/1,000,000Q, where p is the circulation price of a daily paper and Q is daily circulation. We further assume that marginal cost – the cost of paper, ink and deliver – is $0.25 per paper, while daily fixed cost is $300,000. Since marginal cost is positive, a monopoly paper would not wish to maximize revenue, since maximizing revenue would require marginal revenue equal zero. Reducing output to where MR = MC = $0.25 means setting output in the elastic region of its demand curve. As shown in Table 5-3, the profit-maximizing circulation occurs where circulation = 375,000 papers per day, at a price of $0.63. With fixed costs of $100,000 per day6, economic profit is $40,625 per day.

Table 6-3

Monopoly Local Daily Newspaper

5 Most movie theaters practice price discrimination – charging different prices to different customers based on their price elasticity of demand. Typically, the demand for tickets by senior citizens and children is more price elastic than the demand for working-age adult tickets, since the opportunity cost of time is lower for those whose wage rate is zero. Price discrimination allows the monopolist to reduce the price where demand is price elastic (children and seniors) while raising the price where demand is price inelastic (working-age adults). 6 We can identify fixed costs as total costs when output (daily circulation) is zero.

Price per Daily Marginal Marginal Price Total Total Economic

Paper Circulation Revenue Cost Elasticity Revenue Cost Profit

$1.00 0 $1.00 $0.25 -¥ $0 $100,000 ‐$100,000

$0.95 50,000 $0.90 $0.25 ‐19.00 $47,500 $112,500 ‐$65,000

$0.90 100,000 $0.80 $0.25 ‐9.00 $90,000 $125,000 ‐$35,000

$0.85 150,000 $0.70 $0.25 ‐5.67 $127,500 $137,500 ‐$10,000

$0.80 200,000 $0.60 $0.25 ‐4.00 $160,000 $150,000 $10,000

$0.75 250,000 $0.50 $0.25 ‐3.00 $187,500 $162,500 $25,000

$0.70 300,000 $0.40 $0.25 ‐2.33 $210,000 $175,000 $35,000

$0.65 350,000 $0.30 $0.25 ‐1.86 $227,500 $187,500 $40,000

$0.63 375,000 $0.25 $0.25 ‐1.67 $234,375 $193,750 $40,625

$0.60 400,000 $0.20 $0.25 ‐1.50 $240,000 $200,000 $40,000

$0.55 450,000 $0.10 $0.25 ‐1.22 $247,500 $212,500 $35,000

$0.50 500,000 $0.00 $0.25 ‐1.00 $250,000 $225,000 $25,000

$0.45 550,000 ‐$0.10 $0.25 ‐0.82 $247,500 $237,500 $10,000

$0.40 600,000 ‐$0.20 $0.25 ‐0.67 $240,000 $250,000 ‐$10,000

$0.35 650,000 ‐$0.30 $0.25 ‐0.54 $227,500 $262,500 ‐$35,000

$0.30 700,000 ‐$0.40 $0.25 ‐0.43 $210,000 $275,000 ‐$65,000

$0.25 750,000 ‐$0.50 $0.25 ‐0.33 $187,500 $287,500 ‐$100,000

$0.20 800,000 ‐$0.60 $0.25 ‐0.25 $160,000 $300,000 ‐$140,000

$0.15 850,000 ‐$0.70 $0.25 ‐0.18 $127,500 $312,500 ‐$185,000

$0.10 900,000 ‐$0.80 $0.25 ‐0.11 $90,000 $325,000 ‐$235,000

$0.05 950,000 ‐$0.90 $0.25 ‐0.05 $47,500 $337,500 ‐$290,000

$0.00 1,000,000 ‐$1.00 $0.25 0.00 $0 $350,000 ‐$350,000



Figure 5-1 presents a graphical depiction of the numbers in Table 6-3. The publisher’s (inverse) demand curve7 is given by the equation p = $1.00 – 0.000001Q, which generates the marginal revenue function MR = $1.00 – 0.000002Q. Setting marginal revenue equal to

marginal cost implies: 2 2

$1 0.25 0.75 375,0001,000,000 1,000,000

MR Q Q Q .

Proceeding perpendicularly from the profit maximizing rate of output to the demand curve, we find that the profit maximizing price for 375,000 newspapers is $0.625 (rounded to $0.63).

Charging $0.63 for a newspaper that costs $0.25 to print is economically efficient. One way that newspapers cover their overhead is by selling advertising. It stands to reason that advertisers will pay higher advertising rates as newspaper circulation increases. If it could earn greater profit from advertising than from marking-up newspaper prices, it would pay the publisher to reduce the price of newspapers themselves to their marginal cost – here $0.25, thereby increasing newspaper circulation to 750,000.

Maximizing Profit vs. Monopolizing the News

The combined effect of increased competition from the 24-hour cable-television/talk-radio news cycle and the “free” (if somewhat unreliable) internet news sources, daily newspapers 7 Recall that a demand function depicts quantity demanded as a function of price. The monopolist determines its output, and consumers determine the market-clearing price. Hence, the monopolist’s price-quantity relation is obtained as the mathematical inverse of the market demand curve.

$0.00$0.05$0.10$0.15$0.20$0.25$0.30$0.35$0.40$0.45$0.50$0.55$0.60$0.65$0.70$0.75$0.80$0.85$0.90$0.95$1.00

0 100000 200000 300000 400000 500000 600000 700000 800000 900000 1000000

Figure 6‐1: Profit Maximization for a Natural Monopolist

Price (Inverse Demand) Marginal Revenue marginal cost Average Cost

Pm

ACm

Qm



are undergoing a competitive squeeze. It is rare to see competing daily newspapers in any cities except the largest media markets – New York, Los Angeles, Washington. In fact, the consolidation of daily newspaper publishing has been ongoing for centuries. In 1946, the year before my birth, my parents both worked for the Dayton Daily News, the flagship newspaper of the Cox newspaper chain.8 The publisher, and their boss, was James M. Cox, former Democratic governor of Ohio and unsuccessful presidential candidate in 1920.9 A few years after I was born The Daily News bought out the morning Journal Herald, which had a moderately conservative-Republican editorial policy. One might expect that a newspaper owned by a staunch Democrat would modify the editorial policy of the Republican paper. But this did not happen. Until it recently ceased publication, the Dayton Journal Herald maintained its Republican-leaning editorial policy. As a family interested in both points of view, our household subscribed to both papers, as did about 40% of Dayton-area households. Those that did not subscribe to one paper typically subscribed to the other, giving the two papers much higher circulation (and advertising revenue) than would have been the case had they colluded on reporting slanted news. More recently we have seen collaboration between the Conservative Las Vegas Review Journal and the moderate Las Vegas Sun. If newspaper publishers wish to maximize profit, they should provide a comfort zone for all potential subscribers.

Persistent Monopoly: Patents and Occupational Licensing

In chapter two we learned that clear, exclusive property rights are crucial to the functioning of a market economy. If people can trespass on my land without fear of eviction, they have no incentive to pay rent for the use of that land. If theft is legal, “customers” have no incentive to pay me for what I produce. In order for markets to exist, police arrest thieves and sheriffs evict trespassers. There are classes of productive resources which are not so naturally excludable. For instance, governments award patents to people and companies who register new ideas. Without exclusive rights to their ideas, poachers would “steal” those ideas, denying inventors the chance to recover their research and development costs. But patents do not actually provide exclusive rights to ideas. Indeed, in order to receive (that is, register) a patent, the claimant must publish the idea so that potential users of that idea would know that they had to pay for the privilege. In fact, patents represent the legal right to exclude potential competitors from the market in which that idea is used. Patents “cure” one problem – property failure – by creating another – monopoly, which is a form of market failure.

In Figure 6-2 we present the output and price decision for a patent holder. The only legal seller of ColdBGone (CBG), a cure for the common cold, the patent holder faces a negatively sloped demand curve, which is based on the willingness of cold suffers to pay for relief. Since the idea is a profitable one, the demand curve for the product exceeds the average cost curve over some range. In order to maximize profit, the monopolist sets output where the marginal revenue curve intersects the marginal cost curve, then sets the price according to the demand curve. The marginal cost is close to zero – the ingredients that go into a CBG pill probably would cost a few pennies. As a monopolist, the patent holder would set output at Pm where its marginal revenue curve intersects the market demand curve. The price would be set at Pm, no doubt at several

8 This is the parent company of Cox Cable. 9 James M. Cox lost to Warren G. Harding, then an incumbent Republican US Senator from Ohio. Cox’s running mate for vice-president was a little known politician from New York, one Franklin Delano Roosevelt.



dollars a pill. Part of the markup10 covers overhead, and the remainder, (Pm-ACm)Qm. At the monopoly price, consumer surplus equals area PmaxPmA. Area ABC represents the excess burden of the monopoly.11 Pharmaceutical companies are quick to argue that the economic profit from successful drugs are justified by the expenditures on research and development on unsuccessful drugs, plus, ironically, the large amount of marketing expenses used to convince patients to continue to use brand-name drugs, instead of generic equivalents. One proposal would transfer the costs of research and development to government-sponsored research in medical schools and other universities. Any successful drugs would qualify academic researchers for Nobel prizes or other honors. Once a drug was found to be safe and effective, the government would license the right to produce the drug to all drug companies whose only qualification would be the certification of quality control.

Figure 6-2

Price and Output for a Patent Monopolist: Why Monopolies Are Inefficient

Monopoly certainly seems like a wonderful racket: Monopolies earn higher profits by producing less (than competitive firms would). However, monopolies create an excess burden on society because, in reducing output, they increase producer surplus by less than they reduce

10 Remember the markup price is1m

EP MC

E

, where E = the price elasticity of demand and E < -1.

11 The break-even price would be Pr, where the average cost curve (AC) intersects the inverse demand curve D-1; by setting the monopoly price, the monopolist “destroys” the consumer surplus on the Qr-Qm units that are not produced. Ideally, a government-subsidized monopoly would charge the economically efficient price Pe, but would require tax revenue to cover the difference between the economically efficient marginal-cost price and average cost.

AC

MC

MR

Qm

D-1

Pm

$/Q

Q

ut

Pe

AC(Qm)

Pr

Pmax

A

BC



consumer surplus. In Figure 6-11 we depict what happens if a competitive market were successfully organized into a cartel, collusion among sellers that agree to restrict output in order to generate a monopoly price. The left panel shows the market supply and demand curves, while the right panel shows the output of a typical producer.

Figure 6-3

In competitive equilibrium, the price settles at Pc, and consumers enjoy a surplus equal to the area of triangle ACPc and the producer surplus, equal to the area of triangle PcEC is exactly equal to total fixed costs. If all the firms conspired to charge a monopoly price, they would try to reduce output to Qm, where (cartel) marginal revenue intersects the supply (collective marginal cost) curve. The increase in price would increase producer surplus to the combined areas of EBG + (Pm – B)(Qm). Also as a result of the price and output change, consumer surplus decreases to the area of triangle APmF. The excess burden is the sum of the lost consumer and producer surpluses for the output Qc – Qm; because this output was not produced, the net loss to society from the monopoly is the area of triangle FGC.

The good news for consumers is that successful cartels are just about as rare as honest politicians. Consider how forming a cartel affects the typical member firm. Before the cartel, the firm is in long-run competitive equilibrium, producing where MC = Pc. In order to reduce total output from Qc to Qm, each firm’s output must be decreased, in this case from qc to qm.12 By producing and selling this amount, the individual plant owner’s profit increases from 0 to , shown as [Pm – ATC(qm)]qm. However, if the owner believed he could increase output undetected (for a multi-plant monopoly, this would be embezzling), he would prefer to produce q*, where MC = Pm. Of course, what one cheater could do, all would try to do. If all firms increased their output, total output would equal Q*, and price would actually fall below the competitive level.

There is a fallacy of composition at work here. While one firm might hope to increase profit by cheating on a cartel agreement, if all firms cheat, the agreement is destroyed. Once

12 A multi-plant monopolist (a single monopoly firm with multiple production facilities) would allocate output so that the marginal cost from each plant equaled the monopoly’s marginal revenue.

MC

ATC

q/ut

$/q $/Q

Q/ut 0

S

D MR

Qm Qc Q*

A Pm Pc B

C

E

qm qc q*

Pm Pc

The Market/Cartel The Firm

F

G



upon a time, groups of firms could draw up contracts (called trusts) promising to reduce output and agreeing to pay penalties if they cheated (and were caught). The Sherman Anti-Trust Act took the courts out of the business of enforcing cartel agreements, and went so far as to make such agreements evidence of a crime. Nevertheless, the desire for firms to collude to obtain monopoly profits (egoistic businesspeople have little concern for consumer or social welfare) causes them to try other means. Ironically, if they cannot use the judicial branch of government to achieve their monopolistic ends, they can often use the legislative branch. Much of so-called government regulation is actually government cartelization. The requirement that casinos be licensed by the government gives incumbent casino companies the ability to exclude competitors; this is especially true when they contribute to gubernatorial and legislative campaigns. The Taxi Cab Authority punishes “gypsy cabs,” which would otherwise cut taxi fares below government-mandated minimums. The list is virtually endless. But what if the government is not interested in protecting incumbents from competition? Then firms turn to organized crime. The Nevada casino industry has always been a cartel, only now it is the Nevada Gaming Commission, rather than the Gambino Crime Family, that punishes cartel cheaters.

Regulating Monopoly

Figure 6-4 depicts the demand for an average cost of mail delivery. Since 1972, when the U.S. Postal Service was set up as an autonomous corporation, private companies—such as Federal Express and the United Parcel Service—have been whittling away at the government’s monopoly position. Figure 6-4 imagines a not-so-distant future when the combination of e-mail and private competition have moved the market demand curve for “snail mail” everywhere below the average cost of mail delivery. In this example, we imagine that the Postal Service was previously breaking even, charging a price of P0 for delivering a letter, and receiving just enough revenue to cover all costs, including the cost of capital. Now, as more people switch from snail mail to e-mail, the demand curve shifts from D0 to D1. Since the Postal Service is mandated to cover its costs, the temptation would be to seek congressional approval to increase the cost of a stamp from P0 to P1. However, this higher price would reduce the quantity demanded to Q1, which, in turn, would increase average total cost, resulting in another loss. You follow the bouncing lines to see how the Postal Service could price itself out of the market.

Libertarians may proclaim “good riddance!” but the question remains whether society would be better off with or without a postal service. Because of the position of the demand curve and the average cost curve, the private sector would not deliver the commodity, since there is no price-quantity combination along D1 that would allow a firm to cover the opportunity cost of all factors of production. The government, however, could reduce the price from P0 to Pe, using revenue to cover only the marginal cost of mail delivery. The “loss” of A – B per unit could be covered out of general tax revenue. As a result, consumer citizens would receive a net consumer surplus equal to max1

1 0 0 02 ( ) ( )e eP P Q P P Q . As we learned in the theory of perfect

competition, the price that maximizes the sum of the producer surplus and consumer surplus is the price where the marginal cost curve (supply curve) intersects the market demand curve. In this case, the efficient producer surplus would be negative, so if consumer surplus is to exist at all, it must occur partly at public (taxpayer) expense. But remember, the claims we make for market efficiency under competition are no longer valid if the market is monopolist.



Figure 6-4

Monopolistic Competition: Free Entry and Differentiated Products

One way that a seller can exercise limited control over its market and, hence, the price that it charges, is by having a unique name—a brand name that is protected by the government. Consider a wonderful new drink, Carroll Cola, which imbues the drinker with a temporary knowledge of economics sufficient to pass the next economics exam. Unfortunately, there is a drawback. While the drink is quite tasty and has few calories, it is quite addictive, since who wouldn’t want to spend all their time in blissful economic genius. Carroll Cola comes in a distinctive gray bottle (matching the hair color and personality of its inventor), which is easily copied. What is to stop some sociologist from substituting her worthless cola drink for Carroll Cola? Well, if Carroll Cola is a registered brand name, and the design of the bottle is protected by a trade mark, then Carroll Cola is a protected monopoly. But just how protected is it?

In Figure 6-5, we imagine a negatively sloped demand curve for Carroll Cola—some people value the drink so highly that they would pay almost as much as Pmax, but, as with any product, the greater the output, the lower the price. Hence, given the inverse demand curve, P = Pmax – bq, the marginal revenue curve is given by MR = Pmax – 2bq. We further imagine that Carroll Cola is an initial success, so that Pm(or P*?), the monopoly price for that rate of output where MC = MR, exceeds average cost, resulting in profit.

Short-Run Profit Passive Reaction to Competition Figure 6-5

MC ATC

q* MR

Pmax $/q P* ATC*

q1 q0 mr0

D0 0 q/ut

d0 d1 mr1

q/ut P0 P1

MC ATC

P2

P1

P0 Pe

Q2 Q1 Q0

ATC MC

$/Q

D0

D1

max0

max1

P

P

A B

q/ut

$/q $/q



The maker of Carroll Cola has a monopoly; no other firm can sell a product called Carroll Cola. But a new firm might be allowed to market Saul’s Soda, which promises to reward the drinker with religious ecstasy. Another firm might sell Paul’s Pop, which promises to balance the drinker’s checkbook. In all likelihood, the courts13 will rule that those products do not infringe on the Carroll Cola recipe (patented), trade name or trade mark (both registered). Since the “imitators” are not exact replicas of Carroll Cola, market entry will not cause the maker of Carroll Cola to become a price taker; the seller will still face a negatively sloped demand curve. Some consumers will still buy Carroll Cola at a higher price, while others will buy only at a lower price.

Market entry causes an inward shift of the firm’s demand curve. First, some consumers may have bought Carroll Cola because they believed that knowledge of economics would help them balance their checkbook. When Paul’s Pop hits the market, former buyers of Carroll Cola who merely want to balance their checkbooks will switch. So might other customers who decide that they want religious ecstasy and, hence, buy Saul’s Soda, instead of Carroll Cola. Further, at least initially, the rival colas are likely to sell at lower prices; recall that a decrease in the price of a substitute reduces the demand for a good. The right-hand panel in Figure 5-13 shows the effect of a passive resistance to market entry. If Carroll Cola does nothing but change price along the new demand curve, eventually the demand curve will become tangent to the average total cost curve, so that, where mc = mr, price equals average total cost. This so-called monopolistic competition (monopoly pricing but competitive entry) results in zero economic profit, just like perfect competition.

Now, suppose that Carroll Cola aggressively resists market entry. When new producers tout the wonders of their products, Carroll Cola increases its advertising budget. When new colas differentiate their products, Carroll Cola provides new flavors: micro cola, macro cola, and the ever-popular econometric cola. These increased expenditures may actually prevent the firm’s demand curve from shifting, but at a cost. The average total cost curve will shift up until it becomes tangent to the demand curve. Granted, the price does not necessarily fall, but the drinkers of Carroll Cola have more variety.

Figure 6-6

13 Like the laws of trespass, trademark protection is enforced by civil law. The owner of the patent or trade name must sue in court, proving that the offending product is intended to confuse the consumers. If the plaintiff is successful, the judge will issue a cease and desist order.

MC ATC1

ATC0

q* MR

Pmax P* ATC*

$/q

D0 q/ut



In Figure 6-6, we show the other possible outcome to the imitators in a market with differentiated sellers. The entry would tend to push the demand curve to the right; offsetting expenditures—product redesign and aggressive advertising—counteracts that pressure. While the demand curve does not shift, those actions increase fixed costs, resulting in a shift of the average total cost curve from ATC0 to ATC1, until profit becomes zero at price P*.

There is a continuing debate among economists about whether the product differentiation reduces economic efficiency. In Figure 6-5 and Figure 6-6, the long-run equilibrium price exceeds the break-even price. Prices are higher and output is lower under monopolistic competition than would be the case if all firms were price takers. However, as long as consumers have the option of purchasing generic products whose prices are determined by supply and demand, purchasing branded products at higher prices reflects consumer preferences. Consumers pay higher prices only if they believe that they are being made better off by that product. Others may wish to debate whether consumers really know what is good for them. However, as we saw in Chapter 1, economists do not usually concern themselves with what humans want, but with whether they are using scarce resources efficiently.

Conclusion

The problem economists have with monopoly is that it generates economic inefficiency – by restricting output to where marginal revenue = marginal cost (since marginal revenue is less than price) drives a wedge between the market price (on the demand curve) and the cost of production. As long as monopoly is a transitory phenomenon – the first producer of a new product is, by definition, a monopolist, the market will evolve into a competitive market as the market grows. However, when a monopoly is persistent, as in the case of protracted economies of scale or legal protections against competition, then the inefficiency of monopoly – by which monopoly pricing reduces consumer surplus more than it increases producer surplus – becomes problematic. The solution to such inefficiency is government regulation that sets the maximum price a monopolist can charge, or finding more efficient alternatives to patents and other monopoly restrictions on competition.

In the case of monopolistic competition we face a trade-off between consumer desires for variety, which confront sellers with negatively sloped demand curves for their products, and economic efficiency. As in the case of perfect competition, economic profit under monopolistic competition draws additional firms into the market, thereby eliminating economic profit in the long run. Unlike perfect competition, the tangency of the firm’s demand curve and its average cost curve does not coincide with the minimum point on the firm’s average cost curve. Ultimately, the premium that consumers pay for differentiated products reflects the resources that are required to prevent poaching on the incumbent firm’s brands – the cost of copyrights, brand registration, and other market imperfections ultimately required to prevent the property failure of successful producers’ reputations.

Summary

1. Monopoly markets confront sellers with a negatively sloped demand curve. Because monopoly sellers must cut price to all buyers to sell additional output, marginal revenue is less than price.

2. Like competitive firms, monopolies maximize profit by setting output so that marginal revenue equals marginal cost. Monopoly then sets price equal to the market clearing price of the profit-maximizing rate of output.



3. Monopolies stay in business as long as producer surplus, total revenue minus variable cost, exceeds zero. Like competitive firms, monopolies would cease operation when revenue for that output where marginal cost equals marginal revenue is less than variable cost.

4. When producer surplus exceeds overhead (or fixed costs) the monopolist receives positive economic profit. As with perfect competition, the existence of economic profit attracts new firms to the market. However, barriers to entry may prevent new firms from entering the market. Barriers to entry can be natural (economies of scale) or artificial (franchises, patents or copyrights).

5. Government may attempt to regulate natural monopolies by setting a ceiling price. The efficient ceiling price is the level where the marginal cost curve intersects the market demand curve; setting the efficient ceiling price typically requires a subsidy to cover the monopolist’s overhead. A more prevalent – but less efficient – ceiling price occurs where the monopoly’s average cost intersects the market demand curve, generating zero economic profit (normal accounting profit) when the monopolist produces the rate of output where marginal revenue equals average cost.

6. When firms can enter into a formerly monopoly market, the market is contestable. A contestable market will undergo evolution from duopoly (two firms) to oligopoly (a few firms) to monopolistic competition (many firms producing a differentiated product) or perfect competition (many firms producing a generic product).

7. Under duopoly and oligopoly, entry proceeds until the residual demand curve confronting a would-be entrant is tangent to (or everywhere below) that firm’s long-run average cost curve.

8. Under monopolistic competition, long-run equilibrium price and quantity occur where the firm’s demand curve is tangent to its long-run average cost curve. This tangency comes about through a combination of entry by new firms (which shifts the demand curves for incumbent firms to the left) and entry-deterring strategies (such as product innovation, pre-emptive location, and persuasive advertising) that increase the incumbent firms’ costs.

Glossary

Monopoly: A market with one seller, which may be a single producer or a group of producers.

Cartel: A monopoly composed of two or more producers conspiring to charge a monopoly price.

Marginal revenue: The revenue from the last unit produced. Under perfect competition, marginal revenue equals price. Under imperfect competition, marginal revenue is less than price.

Duopoly: A market with two sellers, typically resulting from the entry of a second seller into a former monopoly market.

Oligopoly: A market with a few sellers; a duopoly is a special case of an oligopoly with just two competitors.

Contestable market: A monopoly market with room for a second firm.

Barrier to entry: A natural or artificial impediment to the entry of additional sellers into a market.

Natural monopoly: A monopoly with protracted economies of scale such that the residual demand curve for a would-be competitor is everywhere below the average cost curve of that firm.



Artificial monopoly: A monopoly protected by legal barriers to entry, such as patents, franchises, or copyrights.

Monopolistic competition: a market with many firms producing differentiated products. Monopolistically competitive firms set output and price like a monopoly, but experience zero economic profit in the long run, like perfectly competitive firms do.

Chapter 7 Inside the Household Sector


The Nature of the Household

In this chapter we look inside of the household sector and investigate how the universal force of scarcity encourages rational intra-household decisions, starting with household formation, the allocation of resources within households, and sometimes the destruction of households. We join the story already in progress: People are born into households, which have endowments of land, capital, labor, and entrepreneurial skills. They are nurtured through their formative years, encouraged to develop altruistic atti-tudes, and somehow make it through their teenage years, when egoism and hedonism re-bel against parental authority.

The Rational Consumer

Economists typically assume that rational consumers maximize their personal sat-isfaction by reconciling what they want with opportunity cost. Their personal prefer-ences allow them to rank consumption prospects. Their wealth endowments and labor earnings determine their income, which constrains the consumption prospects they can afford. They maximize their satisfaction by purchasing commodities such that they get the same satisfaction on the last dollar spent1 on each commodity. If this were not the case, they could improve their satisfaction by cutting back on the consumption of com-modities with small additions to satisfaction per dollar spent and consume more commod-ities that provided the most satisfaction per dollar spent. They decide whether to save or borrow by comparing the satisfaction from consumption today with the satisfaction from delayed gratification. Rational people allocate their time between market work, house-hold work, personal maintenance, and leisure so that the last hour spent on each activity provides the same satisfaction either directly (leisure) or indirectly (e.g., the amount of satisfaction an hour’s income can buy). When authorities such as governments or em-ployers want to modify behavior, they must understand how incentives affect behavior or rue the consequences.

Intra-Household Choice: Interpersonal Comparisons of Utility

One of the most important features of a market economy is that markets work when people are selfish. What we tend to forget is that markets also work when people care about the welfare of others. While economic theorists typically assume that eco-nomic agents are egoists, who are indifferent to the welfare of others, the typical family contains altruistic people who care very much about each other. In this chapter we focus on interpersonal relationships within families, between friends, and among strangers. Most people are born and reared in households in which group decisions affect the wel-fare of several people. In the Carroll household, Tom earns most of the income and Re-gina spends most of the income and Jennie is a full-time dance major at UNLV.2 Alt-hough she earns little income, Jennie does not starve. Tom earns most of the family in-come from his professorship at UNLV and his consulting practice. Regina works part-time as the chief financial officer of Thomas Carroll and Associates, Ltd., Consulting

1 Remember, costs do not have to be out-of-pocket; if my consulting business bills my time at $450 per hour, taking a couple of hours off to catch a movie while I have a case pending is much more expensive than the $7.00 (I’m a senior citizen!) that I spend on a ticket. 2 Our son Mike is married and lives with his wife Wendy; our son John died soon after he married his wife Ashley.



Economists.3 As a full time Mom, Regina is an altruist: she receives satisfaction from knowing that other family members are better off.

Because Regina is human, her satisfaction depends on her own consumption of com-modities and on her perception of Tom’s and Jennie’s satisfaction. We assume that no one directly perceives the well-being of other family members; the altruist’s happiness ultimately reflects her belief about the well-being of others. People with perverse belief systems may do considerable harm, even when they claim that they have someone else’s interests at heart. And, of course, teenage rebellion reflects a profound difference of opinion between moms and teenagers about what is best for the teens.

What constitutes an altruist, at least in theory, is their demonstrated willingness to incur personal costs to improve the (perceived) satisfaction of another. Altruism may be as simple as allowing a person with a few groceries to proceed you in the supermarket checkout line, or it may be as profound as sacrificing one’s life for another. A person could be altruistic towards some people (the members of my family), indifferent to the welfare of some (rich people whom I believe to have enough), and malevolent towards others (child molesters). Indeed, the American culture wars are fought over disagree-ments over altruism (should we help the poor?) and malevolence (are they undocumented workers or illegal aliens?)

So, within a household we expect parents to allocate resources among family members so that the last dollar spent on each person provides the same level of satisfac-tion for the altruist. This typically does not result in equal distribution of resources: Adults require more food than children do. Parents who work outside the home require more expensive clothing than do infants. Those who are sick require more medical care than those who are well, and so forth. In my opinion, the functional family personifies Karl Marx’s ideal “from each according to ability, to each according to need.”

Household Formation

According to Nobel laureate economist Gary Becker,4 households are formed to facilitate joint production and consumption, particularly the production and rearing of children. There are uncounted romantic novels, poems, movies, and television scripts about the chaotic process of mating. Partly this is because what makes mating interesting is the apparent unpredictability of romance or love. But do people really fall in love, or do they plan their plunge? Individuals must choose where to search for a mate: One can imagine very different futures for those who search out mates in church and those who search out mates in brothels. Regina and I met in the meat-cutters’ union hall in Dayton, Ohio, in 1968. What brought us together was not our love of meat, but our service as volunteer campaign workers for a Democratic candidate to the United States Senate.5

3 Check out our web site, www.thomascarrollandassociates.com. 4 Much of this chapter is taken from Gary S. Becker, A Treatise on the Family, Harvard University Press, 1981, and his more recent book, Gary S. Becker and Kevin M. Murphy, Social Economics: Market Behav-ior in a Social Environment, Belnap/Harvard, 2000. 5 John Gilligan, Democratic candidate for the U.S. Senate, lost. Regina and I won. John Gilligan was later elected governor of Ohio in 1970. He is the father of Kathleen Sebelius, former Democratic governor of Kansas and current Secretary of the US Department of Health and Human Services.



Becker calls the process of household formation the marriage market. Potential spouses6 are scarce, and so we invest resources (time and money) to find the person who is right for us. Typically a courtship (dating) allows people to compare likes and dislikes. A positively sorting trait is a characteristic that couples tend to have in common, which typically allows them to enjoy joint consumption. One of the most obvious positively sorting traits is age: Most couples meet when they are young and, if they are lucky, grow old together. When couples divorce, they tend to subsequently marry people of approxi-mately the same age as themselves. In Figure 7-1, we plot the respondent’s age on the horizontal axis, and the spouse’s age on the vertical axis. We can discern a positive rela-tionship in both sets of points: Young men tend to have young wives, while older men tend to have older wives.

A useful measure of the strength of an association between two variables is the correlation coefficient. The correlation coefficient simply measures how closely two var-iables – in this case the ages of spouses – change from observation to observation. In theory, if we took the age of one partner, subtracted the average age, and then performed the same calculation for his/her spouse, we would obtain the covariance between those

two variables as

1h s

N

h a s ai i

hs

a a

N

, where ah is the age of the first person (ar-

bitrarily called the “head” of the household, and as is the corresponding age of his/her spouse. The term

ha is the average age of all “heads” of household and sa is the aver-

age age of all spouses. A positive covariance means that hh aa and

ss aa tend to

have the same sign; if the “husband’s” age is above average, his wife’s age tends also to be above average. N is simply the size of the population of all couples, with i designating specific couples. A negative covariance would occur if older people picked younger spouses and vice versa. A covariance of zero would mean that the two variables were unrelated or independent of each other. In order to standardize the covariance, we divide it by the product of the standard deviations:

1

2 2

1 1

h s

h s

N

h a s ai i hs

N Nh s

h a s ai i

a a

a a

The population correlation,, ranges from -1 (perfectly inversely related) to +1 (perfectly positively related), with 0 indicating no relation. In order to estimate the population cor-relation we take a random sample from the population of interest. I use the Current Pop-ulation Survey, which the US Bureau of the Census uses to estimate the monthly unem-ployment rate. Using the household identifier, I sorted the monthly sample from January 1984 through December 2011 (336 months). The sample of 2,489, 165couples generated

6 By spouse I mean life-partner. Spouses could be married or cohabiting in a monogamous relationship. Polygamous unions are beyond the scope of this chapter, although Becker deals with that topic in his Trea-tise on the Family.



a sample correlation of 0.9257, which shows a high degree of positive association be-tween the ages of spouses.7

Another positive sorting trait is education: Most people pick a spouse with ap-proximately their level of schooling. One reason is universal preference: The higher one’s schooling, the greater is one’s expected earnings. Therefore, other factors constant, everyone would pursue a well-educated mate. Another reason is opportunity: People of-ten meet and fall in love in school. High school dropouts become pregnant together; high school graduates both leave school for work; college students marry soon after graduation and graduate students meet while in doctoral or professional schools. Checking the same source, I find that the correlation between the educational attainment of spouses is 0.6337; not as high as for age, but still strongly positive.

You might protest that educational attainment may not be a universally valued trait; poorly educated people often prefer poorly educated spouses so that they do not feel inadequate. But this insight merely strengthens the likelihood that education is a posi-tively sorting trait; people with low educational attainment also get selected; one does not necessarily settle for a poorly educated spouse if one prefers a spouse with similar schooling.

Ethnicity tends to reflect common experiences, both positive and negative, and people usually feel closer to others who understand them. Because of housing and school segregation, one is more likely to meet someone of the same ethnicity than a person with different racial or ethnic characteristics. And, alas, there are few stigmas that generate more active hatred than marrying someone of different ethnicity. Marrying someone “dif-ferent” can cost people their friends, their family, and sometimes, their lives. So, for good or ill, most people go with the flow and settle down with spouses like themselves.

Table 7-1 relates the ethnicity of respondents8 and their spouses. First, we find that white, non-Hispanic husbands constitute 66.4 percent of the sample of husbands, and marriages between two white, non-Hispanics constitute 63.1 percent of all marriages. Hence, the conditional probability that a white, non-Hispanic man is married to a white, non-Hispanic wife is 63.1/66.4 = 95.08 percent. The probability that a white, non-Hispanic wife has a white, non-Hispanic husband is 93.7 percent. Black men have a 90.48 percent probability of marrying a black woman; however, the probability that a black woman has a black husband is 95.38 percent. Other non-whites (Asians, Native Americans, and mixed ethnicity) have the lowest propensities for marrying someone of their same ethnicity. The probability that a Hispanic man is married to a Hispanic woman is 84.55, which is slightly lower than the 86.7 percent probability that a Hispanic woman is married to a Hispanic man. The point is that the concentration of “same-ethnicity cou-ples” is much greater than what we would expect from chance.9

7 We can use statistics to test the hypothesis that the ages of spouses are unrelated, which indicates that the probability that the ages of spouses are unrelated (random with respect to one another) is less than 1 in 10300. 8 Households that agree to participate in the Current Population Survey designate one member of the household as the respondent, and his or her spouse is designated as “spouse of the respondent.” 9 For both men and women, the probability of obtaining such ethnic concentrations among couples if pair-ing were random is less than 1 in 10999, based on a chi-square statistic of 59,000 with nine degrees of free-dom.



Table 7-1 Ethnicity of Spouses

Husband's

Ethnicity White Black Othernonwhite Hispanic Total

White 1,980,112 3,795 29,620 30,199 2,043,726

Black 8,652 138,673 1,899 2,072 151,296

Othernonwhite 18,991 626 89,939 1,931 111,487

Hispanic 27,467 1,138 2,293 151,758 182,656

Total 2,035,222 144,232 123,751 185,960 2,489,165

Wife's Ethnicity

According to this table, 82.1% of husbands were white and 81.8% of wives were white. If ethnicity were uncorrelated, we would expect (.821)(.818) = 0.671 = 67.1% of couples to have a white husband paired with a white wife. In fact, 79.5% of couples were both white. So, while ethnicity is not a quantitative variable like age or years of school com-pleted, we can nevertheless conclude that ethnicity is also a positively sorting trait.10

There are some other important positively sorting traits that are not recorded in my data base. Religion is a set of shared beliefs; it is rare to fall in love with someone one believes to be damned; even if you do marry, that marriage is not likely to last. My wife and I have common political philosophies; we both cheer Rachel Maddow and Jon Stewart and jeer Glenn Beck and Ann Coulter. What about beauty; beauty would seem to be a positively sorting trait? Two beautiful people are more likely to be married, as are two ugly people, than we would predict from chance. Is beauty truly in the eye of the be-holder or is there a positive association? Popular media would have us believe that eve-ryone desires a beautiful partner, and the hours squandered preening seem to confirm this. If beauty is a universally desired trait, then we have an excess demand for beautiful people (like Regina) and an excess supply of ugly people (like me). Perusal of fan maga-zines and web sites confirms that beautiful people win the competition for beautiful part-ners, unless some beautiful people are willing to settle for other universally desirable traits like wealth or charisma.

There are many other positively sorting traits that we could mention: desire for children, city or country of residence, and the preference for sports teams. The evidence presented here should suffice to show that positively sorting traits fundamentally reflect the tendency of people to share consumption activities with those who like the same thing they do. Whereas marital competition resolves the inequality between supply and de-mand in favor of those ranking highest in the universally desired trait.

Negatively sorting traits are characteristics that are likely to differ between a wife and her husband. The most obvious negatively sorting trait is gender: Most men pick women for their life partner and most women pick men. Table 7-2 shows the relation

10 The chi-square (γ2) statistic is 5,224,323; with 9 degrees of freedom, the probability of obtaining the pat-tern in Table 7-1 is less than 1 x 10-300. The proportion of marriages involving both white (non-Hispanic) husbands and wives declined from 84.7% in 1984 to 73.1% in 2011.



between the gender of the respondent and the gender of his/her spouse from the 2011 Monthly Earner Study. Each household respondent reports whether the respondent is male or female. Here we find 58.72% of households report that the respondent is male, and 41.28% percent report that the respondent is female. Slightly less than 1% of couples were both male, 1.31% were both female; men tend to marry women and women tend to marry men, but not always. Clearly gender (as opposed to sexual preference), is a nega-tively sorting trait.

Table 7-2 Distribution of Respondents and Spouses by Gender

Spouse of Respondent

Respondent Male Female Total

Male 0.99% 57.41% 49,911

Female 40.29% 1.31% 35,555

Total 35,284 50,182 85,466

Aptitude for household services and opportunity cost of household production are major negatively sorting traits in household formation. If both husband and wife detest housework, the housework does not get done, and families wallow in less than optimal environment. If both love housework, their relationship degenerates into obsessive-compulsive nesting. If one person detests cleaning less than the other person does,11 there is mutual gain if they pair.

Since market earnings are the opportunity cost of household production, they are also negatively sorting traits. Consider two couples that each have the potential to earn $100,000 per year. Mr. and Mrs. Brown each earn $25 per hour, while Mr. Smith earns $10 per hour and Mrs. Smith earns $40 per hour. The opportunity cost of household production is $25 per hour in the Brown household, regardless of whether Mr. or Mrs. Brown takes time away from work for household husbandry.12 In the Smith household however, the opportunity cost of household production differs substantially, depending upon who chooses to perform the work. Every hour that Mr. Smith spends in household production, he could have been earning $10 per hour; every hour that Mrs. Smith spends in household production, she could have been earning $40 per hour. Mr. Smith has a comparative advantage in household production, and Mrs. Smith has a comparative ad-vantage in market production. Mr. Smith might insist that Mrs. Smith mind the kids while he brings home the bacon, but their low standard of living will likely strain the marriage beyond the divorce point. In 1961, each additional dollar a husband earned re-duced his wife’s earnings by $0.02. In 2011, however, the relation between husbands’ and wives’ labor earnings had turned positive, since most households require multiple earners, and since education and age, which are both are positively correlated with earn-ings, are positively sorting traits.

11 A recent article on the Internet suggests that men’s minds are wired differently so that they just “don’t see the dust.” 12 Remember that the opportunity cost of leisure is the market wage; so even if Mr. or Mrs. Brown sacrifice leisure to clean the house, the opportunity cost is still $25 per hour for each of them.



How do we explain the apparent failure of Becker’s theory to predict that wage rates are actually a (weak) positively sorting trait? First, recall that economic theory is based on the premise that people maximize satisfaction, given their constraints. Since selecting a mate requires balancing negatively and positively sorting traits, it is likely that positively sorting traits are more important during courtship. People find mates based on important considerations like age, ethnicity, and education, and then work out the details of negatively sorting traits (other than gender) later on. One interesting statistic, howev-er, is that the probability of divorce increases as a woman’s earnings increase,13 while the probability of divorce decreases as a man’s income increases.14

The second reason why we fail to find an inverse relation between the earnings of husbands and wives is explained by the distinction between absolute advantage and com-parative advantage. For a college educated couple, if he earns $20 per hour and she earns $40 per hour, he has a comparative advantage for household production and she has a comparative advantage for market work. If we compare to a high-school educated cou-ple, she earns $15 per hour and he earns $7.50 per hour, again we find that he has a com-parative advantage in household production. However, when we compare across couples, we find a positive correlation; the wife with the higher wage rate has the husband with the higher wage rate.

Intra-Household Decisions

Now we have established that a household is begun with the pairing of adults, who select mates partly to be complementary—find a mate who can share consumption—and partly to be substitutes—decide who will work inside the home and who will work outside the home. Figure 7-1 shows a production possibility curve for the Smith family. On the horizontal axis is “market income,” which shows the potential income that the husband and wife can earn if they work between 0 and 3120 hours per year. Assume that Adam Smith earns $20 per hour at his primary job (40 hours per week) and $15 per hour at his part-time job (up to 20 hours per week) and that Eve Smith earns $30 per hour at her primary job and $10 per hour at her part-time job. The vertical axis shows “standard of living,” which includes the combined effect of market income (purchase raw materials like food, clothing, and entertainment), household durables (the house, the car(s), and ap-pliances), household production time (cooking food, cutting the grass, driving to the movies), and leisure time (eating meals, cuddling). Note that income increases at a de-creasing rate; for the first 2000 hours, Mrs. Smith can earn $30 per hour—the slope is $30/hour. Between 2001 and 4000 hours, Mr. Smith can earn $20 per hour—the slope decreases to $20 per hour after the best earning opportunity is exhausted. Note that it would be inefficient (place the family inside its production possibility frontier) for Mr. Smith to work and for Mrs. Smith not to work; they would give up $10 per hour in in-come potential. Eventually the slope decreases to $15 per hour (Mr. Smith’s part-time job), and finally to $10 per hour (Mrs. Smith’s part-time job).

13 If the earnings of an average woman (earning $5,530) increase by $1,000, the probability that she is di-vorced increases by 0.13 percent. While not large, the relation is statistically significant. 14 For a man with an average income of $21,509, an extra $1,000 in income reduces the probability that he is divorced by 0.0089 percent, again, small, but statistically significant nonetheless.



The green curve, labeled “standard of living,” places a money value on the total satisfaction the Smiths “share” resulting from each allocation of time.15 Note that if in-come is zero, the Smiths’ standard of living will also be zero—it’s hard for even a loving couple to survive without food or shelter. As money income increases, standard of living initially increases faster, because even with an austere income, the Smiths have free time to enjoy their lives. As money income increases, their standard of living increases as they qualify for automobile loans and mortgages, and can even plan for children. Even-tually, at some quantity of market time, t*, the Smiths’ standard of living is maximized. While their money income would increase if they worked more hours, their standard of living would decrease, as their time together became scarcer and their market-working fatigue caused friction between them.

If this couple allocated 6,000 hours to market work, their combined income would be $125,000, but the opportunity cost of household production time would be only $10.00 per hour. If Eve Smith quit her part-time job and spent that time in household production, their market income would fall, but their standard of living would rise. At 5,000 hours of market work and 1,000 hours of housework, household income would be $115,000, and the opportunity cost of household time would be $15.00 per hour—the wage rate for Adam’s part-time job. If Adam and Eve are equally skilled and have the same like (or dislike) for household production, it would be inefficient for Eve to work two jobs while Adam worked only one job. If Adam quit his part-time job, money in-come would again fall, while standard of living would rise. Note, at t*, Eve is working full time, while Adam is working part-time at his primary job. Their income is about $85,000 and their standard of living is maximized.

15 The diagram shows the earnings from each amount of market time; we assume that non-market time is allocated efficiently between household production and leisure time.

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

0 1000 2000 3000 4000 5000 6000

Ho

url

y C

ost

of

Ho

use

ho

ld P

rod

uct

ion

Ear

nin

gs

and

Sta

nd

ard

of

Liv

ing

Total Hours of Market Work

Figure 7-1Market Work and Standard of Living

Standard of Living

Money Income

t*

Opportunity Cost of Household Time



The Demand and Supply of Children

Probably the most important decision that members of a household will make is when to have children and how many children to have. For much of human history, chil-dren were a joint product of sex. In primitive societies that did not understand the biolo-gy of human reproduction, children were seen as a gift from God. Henry VIII of England blamed his first wife, Catherine of Aragon, for her inability to produce a son, although we now know that it is the father who contributes either the X chromosome (producing a girl) or the Y chromosome (producing a boy) to the mother’s X chromosome. Since many children died in infancy, and since children would work on the farm from an early age, the idea of birth control was rarely considered, even for the first 150 years of the American republic. The Comstock Act of 1873 outlawed interstate commerce for all obscene material and commodities used to commit immoral acts, which included the use of birth control by married couples.16 Under this act, authorities arrested and imprisoned Margaret Sanger in the early decades of the twentieth century.17 Indeed, it wasn’t until 1965 that the US Supreme Court finally ruled the Comstock Act unconstitutional.

State and federal governments were anti-choice de facto from 1787 to 1873, and de juro from 1873 to 1965. Only in 1965 did the United States Supreme Court rule that state laws that interfered with the practice of birth control were an unconstitutional viola-tion of the Fourteenth Amendment to the Constitution. It was only eight years later that a divided Supreme Court extended the ban on state interference with reproductive deci-sions to the more controversial issue of abortion. In Roe v. Wade, the Court ruled (1) that a woman has a constitutional right to an abortion during the first six months of pregnan-cy, and (2) that state regulation of abortion was limited to the last three months of preg-nancy when the fetus was considered viable outside the mother’s womb. In 1968 Pope Paul VI wrote his encyclical18 Humanae Vitae, which proclaimed that all forms of birth control, save abstinence, violated Catholic cannons. The Catholic Church greeted the Roe v. Wade decision with dismay and condemnation. Sometime later conservative Protestant groups embraced the “pro-life” cause, and many opponents of abortion parrot the Catholic Church’s opposition to all forms of birth control.

While the issue of reproductive rights is likely to remain controversial for a long time,19 since it is probably the major wedge issue between Democratic and Republican voters, it is nevertheless a major discrimination issue. Those who are pro-choice are will-ing to discriminate in favor of the pregnant woman and against the potential or actual fe-tus; those who are pro-life are willing to discriminate against the pregnant woman in fa-vor of the fetus. Even the nomenclature is loaded; pro-life people always refer to the “baby,” never the “fetus”; pro-choice people generally refer to the fetus until he or she is born. Probably the most controversial economics discussion of abortion is Chapter 4 of

16 See http://www.britannica.com/EBchecked/topic/130734/Comstock-Act. 17 http://www.time.com/time/time100/leaders/profile/sanger.html 18 “A Papal Encyclical is the name typically given to a letter written by a Pope to a particular audi-ence of Bishops. This audience of Bishops may be all of the Bishops in a specific country or all of the Bishops in all countries throughout the world.” http://www.papalencyclicals.net/encyclical.ht 19 Those who romanticize the era when theocratic government outlawed birth control information should read Ann Fessler’s The Girls Who Went Away: The Hidden History of Women Who Surrendered Children for Adoption in the Decades Before Roe v. Wade.



Freakonomics by Steven Levitt and Stephen Dubner, which attributes much of the de-cline of the crime rate in the 1990s to legalized abortion 20 years earlier.

Despite one’s attitudes toward the desirability of abortion,20 economists and eco-nomic students should agree that government interference with reproductive choices does have economic costs. Like any crime, prohibiting abortion would require allocating scarce resources to the detection, apprehension, conviction, and punishment of abortion-ists. One curious statistic is that the incidence of abortion is fairly high among young Catholic girls, who seem to reason that since birth control (and indeed, pre-marital sex) are “mortal sins,” which would send her to hell if she fails to confess than sin, an abortion is just another mortal sin. This is an interesting example of moral hazard.

Economist Gary Becker devoted several chapters to his Treatise on the Family to the economics of reproductive choice. According to Becker, the demand for children is like the demand for any other good: ( , , )d cQ D p I t , where Qd is the number of children

demanded, pc is the price of children (most importantly, the opportunity cost of time for the mother), I is household income, and t is “tastes.” He predicts that children are normal goods,21 which follow the law of demand.22. Some important “taste” proxies are really supply variables. For instance, younger women are more fertile than older women are, and women with more education are more likely to practice birth control than are women with less education.

Table 7-3 shows a multiple regression printout that tests Becker’s theory of the demand for children. The dependent variable, children, is the number of children under the age of 18. The results predict that, as the parents age, the number of children decreas-es at a decreasing rate. The coefficient on xfrwage (the mother’s predicted wage23) is positive, implying that the number of children in the household increases as the mother’s wage rate increases. The father’s wage also has a positive, but smaller effect. Finally, as the schooling of the mother (fschool) or father (mschool) increases, the number of chil-dren decreases; schooling may be a proxy for knowledge of birth control. This variable could directly proxy the mother’s access to birth control information, or it could also proxy the potential earnings of a stay-at-home mom. Either way, the results in Table 7-3 contradict Becker’s theory that the number of children will decrease as the opportunity cost of time increases.

20 Is abortion a good that allows women who failed to prevent pregnancy determine if they want to be mothers; or is it a bad that takes an innocent life? The objective economist answers “yes.”

21 0dQ

I

22 0d

c

Q

p

23 We observe the mother or father’s wage rate only if they have accepted a job offer; if their reservation wage exceeds the wage offer, they will specialize in household production. The variables xfrwage is the wife’s predicted wage, based on her age and education; the variable xmrwage is the equivalent wage rate for her husband.



Table 7-3 Estimated Demand Equation for Children

Source | SS df MS Number of obs = 2542151 -------------+------------------------------ F( 9,2542141) = 97002.8 Model | 458330.425 9 50925.6028 Prob > F = 0.0000 Residual | 1334601.3 2542141 .524991084 R-squared = 0.2556 -------------+------------------------------ Adj R-squared = 0.2556 Total | 1792931.782542150 .705281665 Root MSE = .72456 ------------------------------------------------------------------------------ children | Coef. Std. Err. t P>|t| [95% Conf. Interval] -------------+---------------------------------------------------------------- xfrwage | .0221084 .0003431 64.45 0.000 .021436 .0227808 xmrwage | .0010528 .000315 3.34 0.001 .0004355 .0016701 fage | -.0146334 .0003426 -42.71 0.000 -.0153049 -.013962 fagesq | .0000174 3.52e-06 4.95 0.000 .0000105 .0000243 mage | .0023419 .0004427 5.29 0.000 .0014742 .0032095 magesq | -.0000572 4.50e-06 -12.71 0.000 -.000066 -.0000484 fschool | -.0347501 .0005043 -68.90 0.000 -.0357385 -.0337616 mschool | -.0060877 .0004171 -14.60 0.000 -.0069051 -.0052703 time | .0452107 .0000573 788.74 0.000 .0450984 .0453231 _cons | .3564806 .0082674 43.12 0.000 .3402768 .3726845 ------------------------------------------------------------------------------ Another interesting aspect of Becker’s theory is that he explicitly considers the trade-off between the quantity of children and the quality of children. For instance, cer-tain religions (Church of Latter Day Saints) place a premium on family size while others (Roman Catholics) prohibit birth control, and so some households prefer many children. However, the more children one has, the less one can spend on each child. For parents, children are often forms of conspicuous consumption. Instead of having eight children and sending them all to the community college, the family may opt to have one child and send her to Stanford. This substitution of quality for quantity may help explain the gen-eral failure of Malthusian population theory, which predicted that as income grows, popu-lation grows unchecked, until, a generation later, the increase in the labor force reduces the wage rate to near subsistence levels. If families generally prefer to have a few “high-quality” children, they can reduce the total time input of the mother, at the same time al-lowing the parents to show off among similarly situated couples.

Allocating Time: Market Work, Housework, Leisure, and Personal Maintenance

It should be obvious that the allocation of time between market work, household work, and leisure is likely to change if the Smiths produce (or adopt) children. Biology requires that the mother actually bear the children, which typically requires a break from the labor market while she undergoes a different form of labor. In this case, with Eve working 40 hours per week, and Adam working about 12.5 hours per week, the oppor-tunity cost of Adam rearing the children is lower than if Eve became a full-time mom. But, although economists are reluctant to admit it, economic considerations are not the only considerations. Eve may have a nesting urge to stay home and watch little Abel, and keep his brother Cain out of mischief. Adam may be incompetent at changing diapers (or attempt to convince Eve that he is incompetent if he fears being a stay-at-home dad). They may opt for day care, or a full-time nanny. All that economics can say is that as the opportunity cost of time increases, the time spent raising children is likely to decrease.



Before one can perform market work, one must participate in the labor force, meaning that he or she actively looks for a job, or is employed. Table 6-8 relates the probability of labor-force participation of both husbands and wives to their own past earnings as well as those of their mates.

To find the general tendencies, we return to market data. Table 7-4 relates the hours worked in 2010 by the husbands and wives.24 We find that the higher one’s own wage rate, the more hours one is likely to work. We find that the hours men work start at 33.06 hours, then increase with their age, their own years of schooling, the number of children in the household, their own wage, and the potential wage of their spouse.25 Note that the probability that the results are due to chance is remote. For the wives, the nega-tive constant term implies that if we compare a husband and wife with similar character-istics, the wife tends to work fewer hours. The number of hours a woman works in the market decreases as the number of children in the household increases. The higher her husband’s potential wage rate, the fewer hours a wife is likely to work. In fact, her wage rate has virtually no impact on her hours of work.26

Table 7-4 Seemingly unrelated regression ---------------------------------------------------------------------- Equation Obs Parms RMSE "R-sq" chi2 P ---------------------------------------------------------------------- mhours 38700 8 12.52832 0.0248 985.39 0.0000 fhours 38700 8 12.32642 0.0345 1378.49 0.0000 ---------------------------------------------------------------------- ------------------------------------------------------------------------------ | Coef. Std. Err. z P>|z| [95% Conf. Interval] -------------+---------------------------------------------------------------- mhours | fage | .2096026 .0507053 4.13 0.000 .1102221 .3089832 fagesq | -.0027002 .0005844 -4.62 0.000 -.0038456 -.0015548 fage65 | 1.280847 .5692352 2.25 0.024 .165167 2.396528 mage65 | -4.510968 .393022 -11.48 0.000 -5.281277 -3.740659 mschool | -.0478594 .0505007 -0.95 0.343 -.1468389 .05112 xfwage | -.0006614 .015764 -0.04 0.967 -.0315582 .0302354 xmwage | .3089223 .0314415 9.83 0.000 .247298 .3705466 mchldnm | .1751646 .0656167 2.67 0.008 .0465582 .303771 _cons | 33.06728 1.079076 30.64 0.000 30.95233 35.18223 -------------+---------------------------------------------------------------- fhours | fage | .6250498 .0518562 12.05 0.000 .5234135 .7266862 fagesq | -.0076969 .0005897 -13.05 0.000 -.0088526 -.0065412 fage65 | -.5119314 .5590338 -0.92 0.360 -1.607618 .5837548 mage65 | -2.225751 .3768218 -5.91 0.000 -2.964308 -1.487194 fschool | .1637763 .0700934 2.34 0.019 .0263957 .301157 xmwage | -.2321095 .0170425 -13.62 0.000 -.2655122 -.1987068 xfwage | .2017585 .037311 5.41 0.000 .1286303 .2748868

24 I use seemingly unrelated regressions to estimate the model. First, I estimated the potential wage rate for men and women, based on their age and education, then I used this potential wage to predict earnings, us-ing similarities in unmeasured variables between husbands and wives to improve the estimation precision. 25 Does this imply that men, having “won” a wife with high potential earnings, must work harder to keep her? 26 The wife’s working hours typically reflect “need” (a low wage from her husband) rather than “desire” (a high potential wage for herself).



fchldnm | -1.6322 .0652974 -25.00 0.000 -1.76018 -1.504219 _cons | 24.76278 1.289895 19.20 0.000 22.23463 27.29093

Table 7-5 presents the evidence that my graduate intern, Aruna Abeyakoon, and I learned about hours of household work by husbands and wives, based on information gained from the Panel Study on Income Dynamics. According to the table, the number of hours men spend in household work increases to age 58, then declines. The husband re-duces his household work by 0.06 hours for each hour spent working outside the house-hold. A man’s household work increases until there are three children in the household, then decrease. Note that years of schooling increase a man’s household work; is it possi-ble that education sensitizes husbands to empathize with their wives? His own and his wife’s potential wage each has a negative effect on a man’s household hours, although her wage has a stronger effect.

Note that women’s work also increases until age 54, then declines. Each addi-tional child increases a mother’s household work by 114 hours per year; there are no “diminishing returns to children” as far as women are concerned. As with men, her spouse’s wage actually has a stronger effect on hours worked than her own wage does.

Table 7-5

Derivative Probability of Chance Optimal

husband's household hours NumberAge 8.452 2.00% 58.14Age Squared -0.073 3.70%Meals as Family 5.529 6.70%Own Home 47.938 1.20%Husband's job hours -0.059 0.00%Wife's job hours 0.026 0.10%Years of Schooling 12.715 2.70%Number of Children 51.247 0.10% 3.16Number of Children Squared -8.098 3.60%Husband's Potential Wage -4.690 12.80%Wife's Potential Wage -5.245 4.80%Constant Term -71.330 65.50%

wife's household hoursAge 45.170 0.00% 53.76Age Squared -0.420 0.00%Meals as Family 24.490 0.00%Own Home 36.941 11.40%Husband's job hours 0.076 0.00%Wife's job hours -0.229 0.00%Years of Schooling -2.617 68.00%Number of Children 113.917 0.00%Husband's Potential Wage -19.833 0.20%Wife's Potential Wage -9.666 0.00%Constant Term -335.352 0.80%

Table 7-6 breaks down the activities for male and female respondent from the American Time Use Survey, reported between January 2003 and December 2010. Ex-cept for a few insomniacs, nearly everyone spends personal time – sleeping, preening and



having sex;27 on average, women spent about 25 more minutes per day on personal ac-tivities than men did. Women spent nearly an hour more per day on household services (cooking, cleaning, repairing, lawn maintenance) than men did Women spent 20 more minutes per day caring for household members (spouse, children, elderly relatives) than men did. Men spent more time in market work, travel, and eating. Note that the sum of all activities was slightly less than 24 hours per day, implying either that respondents failed to record some activities,28 or there were activities for which no category existed in the survey.

Activity variable Minutes Hours

minimum maximum

Personal Care act_pcare 583.03 9.72 0 1440

Household Services act_hhact 144.13 2.40 0 1310

Care of Household Members act_carehh 42.46 0.71 0 1151

Care of non‐relatives act_carenhh 10.64 0.18 0 1129

Market Work act_work 131.54 2.19 0 1395

Education act_educ 16.72 0.28 0 1090

Purchasing goods or services act_purch 31.30 0.52 0 875

Purchasing professional services act_profserv 5.71 0.10 0 1060

Overseeing household help act_hhserv 0.89 0.01 0 620

Receiving government services act_govserv 0.31 0.01 0 470

Eating act_food 65.82 1.10 0 735

Social activities act_social 276.49 4.61 0 1434

Sports activities act_sports 13.68 0.23 0 900

Volinteer activities act_vol 10.23 0.17 0 1315

Telephoning act_phone 10.00 0.17 0 870

Travel (including commuting) act_travel 70.86 1.18 0 1420

Total 23.56

Activity Variable Mean Hours minimum maximum

Personal Care act_pcare 558.05 9.30 0 1440

Household Services act_hhact 92.11 1.54 0 1190

Care of Household Members act_carehh 22.83 0.38 0 1065

Care of non‐relatives act_carenhh 9.19 0.15 0 980

Market Work act_work 200.09 3.33 0 1430

Education act_educ 16.63 0.28 0 1051

Purchasing goods or services act_purch 20.87 0.35 0 700

Purchasing professional services act_profserv 3.37 0.06 0 780

Overseeing household help act_hhserv 0.99 0.02 0 630

Receiving government services act_govserv 0.31 0.01 0 380

Eating act_food 70.34 1.17 0 895

Social activities act_social 307.24 5.12 0 1395

Sports activities act_sports 27.39 0.46 0 1073

Volinteer activities act_vol 9.00 0.15 0 1095

Telephoning act_phone 4.23 0.07 0 635

Travel (including commuting) act_travel 76.52 1.28 0 1440

Total 23.65

Women: Average Daily Activities

Range (minutes)

Men: Average Daily Activities

Range (minutes)

27 Men (age 16 and above) reported average sexual activity of 0.96 minutes per day, while women reported sex activity equal to 0.52 minutes per day; I’ll let the reader decide why these two average amounts of time are significantly different from each other. 28 For instance, 98.8% of respondents reported zero sexual activity. Since respondents reported their activi-ties for only one 24-hour period, it is possible they transferred their time from personal pleasure to filling out the forms for the American Time Use Survey.



Recent Trends in Marriage

Figure 7-2 shows the historical trend in marriage for men and women over 18 be-tween 1962 and 2011. In 1962, nearly 78 percent of men, and nearly 70 percent of wom-en were married (because women live longer than men do, a smaller proportion of wom-en are married compared to men). By 2011, the marriage rate for men had declined to 59.3 percent for men and 53.8 percent for women. Over this period, the marriage rate declined by 0.39 percent per year for men and by 0.33 percent per year for women.

Figure 7-3 shows the marriage rate by age between 1962 and 2010 for both men and women. First, we notice that both men and women delayed marriage in 2010 com-pared to 1962. In 1962, 70 percent of women and 50 percent of men were married at age 20; in 2010, 60 percent of men and women are married by age 30. Most men remain married well into their 70s, while the probability of marriage for women begins dropping dramatically in the mid-50s. Finally, the probability that men and women over 65 are married is higher in 2010 than in 1962, a tribute to the longer life expectancy for both men and women.

MRM = ‐0.0039t + 0.7784R² = 0.9244

MR = ‐0.0033t + 0.6942R² = 0.9185

50%

55%

60%

65%

70%

75%

80%

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Figure 7‐2: Proportion of Adults Married

men women Linear (men) Linear (women)



Figure 7-4 shows the female proportion of the population at each age for 1962 and 2011. There is a higher proportion of teenage girls 1in 1962. The two lines track each other very closely from age 25 until age 75, after which females as a percent of the popu-lation dips in 1962, and then increases with age, peaking at slightly more than 60 percent. In 2011 the proportion of the population who are women remains above 60 percent after age 75, reaching roughly two-thirds of the population beyond age 80.

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

15 20 25 30 35 40 45 50 55 60 65 70 75 80 85

Proportion of March 1962 CPS Sample

Figure 7‐3: Probability of Being Married by Age 1962 and 2010

Men 1962 Women 1962 Men 2011 Women 2011

40.00%

45.00%

50.00%

55.00%

60.00%

65.00%

15 20 25 30 35 40 45 50 55 60 65 70 75 80 85

Figure 7‐4: Proportion of Population Female

1962 2011



Finally, in Figure 7-5 we plot the distribution of households by marital status, and the gender of single household heads. In 1968, 88% of multi-person households were headed by married couples; that proportion fell to 74% in 2011. The proportion of households headed by single women increased from 10% in 1962 to 19% in 2011. The greatest percentage increase were households headed by single men, from 2% in 1962 to 7% in 2011.

Investing in a Home

Buying a home is typically the largest single consumption expenditure that a household makes. Home equity is often the most important asset in a household’s wealth portfolio. So, given that a family has to live somewhere, what does economic theory tell us about housing choices? Figure 6-8 presents a supply and demand analysis for rental housing. The quantity axis measures the quantity of housing to square feet of living space. There are obviously many other dimensions to housing, such as location, age, amenities, and neighborhood characteristics. We will discuss those issues later.

As usual, we assume a competitive market in long-run equilibrium. The demand for housing is negatively sloped: the higher the rent, the lower the number of square feet households are willing to rent. At any particular time, the quantity of housing available is fixed, here at Q0.

29 Now, suppose that an increase in the number of households (or, per-haps, an increase in household income) increases the demand for housing from D0 to D1. As usual, an increase in demand causes a shortage (since quantity demanded increases to Q2, while quantity supplied remains at Q0). Allowing rents to increase means that, in the

29 Actually, housing equilibrium is similar to labor-market equilibrium: At any time, there are likely to be some vacant housing units, and there are likely to be some households seeking housing units (e.g., living with parents). Hence, equilibrium exists there are only “frictional vacancies”—when the number of availa-ble units equal the number of people willing to rent those units.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Figure 7.5: Distribution of Households by Marital Status of Head

Married Unmarried Men Unmarried Women



short run, the rental rate increases to R1 per square foot, which seems unfair30 since renters end up paying more rent for the same quantity of housing. The temptation is for local governments to freeze (or control) rents at R0, so that rents are fair (meaning that more tenants vote than landlords do). Rent controls create a permanent housing shortage of Q2 – Q0, or worse;31 another name for a housing shortage is homelessness.

Suppose that rents were free to adjust to market conditions. Over time, the supply

curve would rotate from S0 to S1 as existing landlords expand their operations (build new buildings, turn nonrevenue space like lobbies into apartment units, and so forth). The increase in supply in turn reduces the equilibrium rent from R1 to R2. However, this may not be the end of the story; market entry shifts the supply curve from S1 to S2, and if apartment renting is a constant cost industry, eventually rents return to their former level.

Equilibrium rents reflect the monthly value of housing space to households. Any-thing that increases the demand for housing (like higher-quality schools, reduced com-muting time to work) will tend to increase the short-run rent and the quantity supplied. Anything that increases the supply of housing units (absence of rent controls, efficient wages for construction workers, market-oriented zoning regulations) will tend to reduce the equilibrium rent while increasing the quantity of housing demanded.

So, given this theory of rents, when should households buy houses rather than rent them? The answer is when they find it more efficient to rent from themselves than from a landlord. In equilibrium, the rental payment to the landlord covers the landlord’s cost of providing housing services (most importantly, the interest cost of investing wealth in buildings instead of other financial assets). Suppose a family is paying $1000 per month in rent. At the end of, say, 30 years, they will have consumed $360,000 worth of housing

30 Unfair to tenants but fair to landlords; since “fair” means “more for me!” 31 Quantity supplied could eventually fall below Q0 if landlords fail to maintain apartments (a decrease in quality), or even torch their buildings if insurance coverage exceeds the flow of net rental income.

Q/ut

S0

S0 S1

$/sqft

R1 R2

R0

Q0 Q1 Q2

D1 D0

Figure 7-6

S2



services, but their wealth will not have changed because of that rental payment. Suppose they have $40,000 to put down on a new home and agree to pay off the balance of $200,000 at the rate of $1,200 per month for 30 years.32 At the end of 30 years, they will have a home worth $200,000 (plus appreciation or minus depreciation). Had they saved the $40,000, continued to pay $1,000 rent per month, and deposited an additional $200 per month at 4% interest, at the end of 30 years they would have $369,086 in the bank. So, while buying one’s own home is considered an investment, it may not be the best in-vestment.

Buying a home is an investment in the economic sense of the word—the use of funds to acquire commodities that produce other commodities (in this case, housing ser-vices). The reason why so many households purchase their own homes is (1) because everyone else does (so-called bandwagon effects); (2) because the appreciation of one’s home is typically not taxed, while interest on saving is taxed; (3) owning a home is often (but not always!) a good hedge against inflation; and (4) because home ownership gives tax advantages.

When a household chooses to buy or rent housing, it simultaneously selects a neighborhood. In addition to the quality of the house itself, neighborhood effects are im-portant amenities for which households are willing to pay. Typically one must live in a neighborhood to benefit from local parks, local school, and police and fire protection. These services may vary by political jurisdiction or simply because the best teachers, po-lice officers, and fire fighters work in the best neighborhoods. An increase in the quality of service would increase the demand for housing, which would increase the equilibrium rent. So, even if a household had no children, an increase in the quality of schooling would increase their property values because it would increase the amount of money an-other household would pay to live there. Hence, it is efficient for the local government to use a property tax to pay for schools, parks, and fire or police services. The effect of the tax would be to reduce the quantity of housing services demanded. The optimal level of service would maximize the net value of the property (i.e., increase service until the last dollar increase in value was matched by exactly one dollar of cost).

Finally, consider amenities that are not produced by the government but occurred naturally. For instance, suppose that homeowners prefer to live in a neighborhood with high-income neighbors, as opposed to a neighborhood with low-income neighbors. If this is true for both low-income and high-income households, then high-income house-holds will outbid low-income households, resulting in housing segregated by income. This tendency toward income segregation is often reinforced by building codes and home owner association restrictions on property modifications that favor high-income house-holds.

The Housing Bubble: Investment vs. Speculation

I have repeatedly attempted to distinguish between investment and financial spec-ulation. An investment is a research using activity, wherein the investor incurs costs in the present with the uncertain hope of being able to produce more in the future. In this sense the purchase of a house is an investment in that the homebuyer purchases a com- 32 This assumes a loan of 6 percent and ignores property taxes. Note, since the mortgage interest is tax de-ductible, the tax advantages of “owning” one’s own home can be considerable.



modity which will generate housing services into the future. However, there is a wide-spread belief that a home purchase represents a lucrative financial move that allows the speculator to flip the house – that is, by purchasing and holding the house, the speculator can realize a capital gain. This mentality led to the self-fulfilling prophecy. When the demand for housing, driven by speculative fever, outpaced the supply of housing, prices rose dramatically. However, in order to feed the housing frenzy, banks, real estate agents, housing appraisers and the speculators themselves crossed the line separating prudence from herd mentality. In 2007, when my barber told me he had just purchased his fourth house with borrowed money, I knew that the housing bubble was about to burst.

Figure 7-7 shows the trend lines for new houses (blue) and a house constructed in 1962 (red). I extracted the data behind this diagram from the Clark County Tax Asses-sor’s data base, which records the sale price of all residential homes sold in Clark Coun-ty, Nevada. Based on the date of sale, location, and the size (square footage) of single-family homes, I calculate that between 1963 and 2001 the average sale price of a 3000 square-foot house appreciated at a rate of 4.92% per year. Of course the trend in new house prices is only a benchmark for tracking the cost of housing for people who want to move into a home no one else has lived in. If one wishes to consider housing as an in-vestment, we must consider the impact of depreciation – that is the loss of value as a pro-ductive asset ages. By tracking the age of homes I compute that a house built in 1963 (that was still occupied in 2002) appreciates at 3.8% per year. Since the data base does not include information about the upkeep costs of a home, a 3.8% gross return is less than half of the return for a random portfolio of stocks, which would have grown at an average

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Predicted Selling Price

Figure 7‐7: Housing Trends for Henderson, NV Home (3000 square feet)

New House, No Bubble Used House, No Bubble

New Houses, With Bubbles Used House, With Bubble



annual rate of 9.85%.33 In 2002, the return on “holding” a used house for a year declined to 2.4%; this reduction might have led people who owned “investment”34 houses to sell them, perhaps purchasing a 10-year Treasury bond, with a yield of 4.61%. In mid-2003 the price of single-family house increased by 7.61%. During 2004 the average price of a single-family home increased by 37.53%, followed by 60.11% in 2005, and 60.62% 2006. In 2007 the appreciation of a used house grew by 40.29%. In 2008 “bubble” in housing prices burst; in January 2008 the average price of a new house was 5.95% lower than it had been in 2007. The declines continued: -37.56% in 2009, -41.5% in 2010, -50.53% in 2011, and -55.47%. In March 2012, a new house sold for 57.13% less than it would sold for had the housing bubble never occurred. Since the trend line ultimately reflected the cost of producing new houses, this meant that developers suffered substan-tial losses in 2008 to 2012. The house we purchased in Henderson in August 2005 for $200,500 (the predicted price was $204,271), now has a market price of $142,068.

Table 7‐7

Housing Price Trends

Year(s) New Vintage Inflation Stock Government

Houses House Rate Market Bonds

1962‐2001 4.92% 3.87% 5.34% 7.75% 7.43%

2002 3.43% 2.40% 1.46% ‐16.56% 4.61%

2003 8.69% 7.61% 2.11% ‐1.25% 4.02%

2004 38.91% 37.53% 2.99% 18.05% 4.27%

2005 61.72% 60.11% 3.17% 6.81% 4.29%

2006 60.62% 59.03% 4.15% 8.59% 4.79%

2007 40.29% 38.90% 2.36% 12.81% 4.63%

2008 ‐5.01% ‐5.95% 5.60% ‐17.17% 3.67%

2009 ‐37.56% ‐38.18% ‐2.10% ‐18.84% 3.26%

2010 ‐41.35% ‐41.93% 1.24% 21.86% 3.21%

2011 ‐50.03% ‐50.53% 3.63% 11.63% 2.79%

2012 ‐55.03% ‐55.47% 2.30% 3.12% 2.01%

Table 7-7 shows how Southern Nevada real estate appeared to be a much better “investment” in 2003 than the stock market (-1.25%) or government bonds (4.02%). The longer one delayed jumping into the market, the greater the disparity; by 2007, all quali-fied buyers had purchased homes, only by expending credit to “sub-prime” borrowers did the financial industry hope to maintain the housing frenzy. By 2008 the housing market turned, and prudent speculators sold their houses; however, the stock market was also tanking. The safe haven was government bonds. By 2010 the stock market had recov-ered, thanks to the bank bailout. Negative returns to housing mean current owners are under water – they owe more than their houses are worth, with little help of freeing them-selves of their imprudent speculation.

33 See http://www.moneychimp.com/features/market_cagr.htm. 34 In keeping with my distinction, an investment house was purchased as an income earning asset: one could purchase a dilapidated house, fix it up, and sell it for a gain, or one could purchase a house and rent it for income. By contrast, a speculator merely purchases a house (or any other asset) in hopes of a capital gain, never employing resources to improve the value of that asset.



Explaining Housing Segregation

While income-segregated neighborhoods35 tend to perpetuate income inequality by segregating education and other public services by income level, racially segregated housing tends to perpetuate racial discrimination and prejudice borne of ignorance. Prior to the 1964 Civil Rights Act, courts enforced restrictive covenants, whereby white home-buyers agreed by contract not to sell their home to an African American buyer. American blacks were crowded into ghettos like European Jews before World War II. Ironically, because of restricted supply of housing, blacks (and Jews) often paid higher prices for housing than white (and gentile) homeowners did.

Economists find it intriguing that housing segregation still persists 40 years after civil rights legislation made discrimination illegal. Of course, just because something is illegal doesn’t mean that it will not happen. Based on Gary Becker’s path-breaking work,36 people decide whether or not to commit crimes based on the expected benefits of crime (which depends on whether one is apprehended, prosecuted, and punished) minus the cost (including the opportunity cost of time). For the most part, antidiscrimination laws are enforced by civil law, meaning the (alleged) victim must sue the (alleged) perpe-trator, and prove that the defendant harmed the plaintiff, and demonstrate measurable damages. Given the cost of litigation, it is unlikely many home buyers could successfully sue homeowners for failure to sell them a house. The defendant could simply argue that someone else made a better offer. Further, damages would be small—probably the dif-ference between the value of the household to the family minus the selling price.

While housing segregation often begins with the failure of whites to sell to blacks, integrated housing often turns out to be an unstable disequilibrium outcome in a housing market. Suppose that neither blacks nor whites wish to live in a predominantly black neighborhood, but whites, having higher average household income, outbid blacks for houses in a new development, resulting in an all-white neighborhood.37 After the devel-oper sold all the houses available, the resale market takes over. In this case, each home-owner decides whether to continue to reside in their home, and if they choose not to re-side in their home, whether to sell the home or to rent the home. From the point of view of neighbors, to whom a homeowner sells a home has external effects. That is, part of the cost or benefits of selling one’s home will be experienced by neighbors who remain behind. How do the preferences of neighbors determine (1) whether one sells to a white or a black, and (2) whether neighbors themselves sell their home to a white or a black?

Table 7-8 presents two different scenarios for bid and ask prices by white home-owners in an all-white neighborhood. In Table 7-8a and Figure 7-8a, blacks outbid whites if the neighborhood was less than 20 percent black, and whites would outbid

35 An interesting, if embarrassing, experience occurred when a parishioner at our former church called on God to keep apartment construction out of her neighborhood during a public prayer session. 36 “Crime and Punishment: An Economic Approach,” Journal of Political Economy, 76, no. 2 (March-April, 1968), 169–217. 37 This outcome could also occur if the developer refused to sell houses to blacks, either because the devel-oper had a taste for discrimination (would only sell to a black family if they paid substantially more for a house than a white family would), or because the developer was responding to consumer preference (the developer believed—unfortunately, probably accurately—that selling houses to blacks would reduce the prices that subsequent homebuyers would be willing to bid, be they black or white).



blacks if the neighborhood was more than 20 percent black. These sets of contrived indi-vidual preferences would create a stable equilibrium when neighborhoods are 20 percent black. Suppose that a neighborhood of 20 houses were all white and a white family de-cided to sell its home, say, because of a job change. A black family would offer $195,000 (since purchasing the home would make the neighborhood 5 percent black), and a white family would offer only $187,500. An egoistic homeowner would sell to the black bidder, and the neighborhood would indeed become 5 percent black. The next white family to sell would receive a bid of $187,500 from a white bidder or $190,000 from a black bidder; again, the black bidder would win the auction. Casual sales would increase the proportion of black homeowners until the equilibrium proportion of 20 per-cent were reached. At this point, if a black family sold a home, whites and blacks would each bid $180,000; selling to a black would maintain the proportion, while selling to a white family would reduce the proportion of blacks, causing blacks to again outbid whites at the next sale. If a white family sold to a black family, the proportion of blacks would increase, and a white family would outbid a black family at the next sale; the pro-portion of 20 percent blacks would tend to prevail in the long run.

Table 7-8a Table 7-8b Percent of Bid Price/Ask Prices Percent of Bid Price/Ask Prices

Neighborhood Whites Blacks Neighborhood Whites Blacks Black Black 0% $190,000 $200,000 0% $200,000 $190,000

10% 185,000 190,000 10% 190,000 185,00020% 180,000 180,000 20% 180,000 180,00030% 175,000 170,000 30% 170,000 175,00040% 170,000 160,000 40% 160,000 170,00050% 165,000 150,000 50% 150,000 165,00060% 160,000 140,000 60% 140,000 160,00070% 155,000 130,000 70% 130,000 155,00080% 150,000 120,000 80% 120,000 150,00090% 145,000 110,000 90% 110,000 145,000100% 140,000 100,000 100% 100,000 140,000

$100,000

$110,000

$120,000

$130,000

$140,000

$150,000

$160,000

$170,000

$180,000

$190,000

$200,000

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Bid

Pri

ce

Proporiton of Black Families in Neighborhood

Figure 7-8aStable Equilibrium: Integration

White Bid Price Black Bid Prices



In Table 6-11b and Figure 6-9b are mirror images of Table 6-11a and Figure 6-9a, whereby whites outbid blacks when the proportion of blacks is below 20 percent, and blacks outbid whites when the proportion of blacks is greater than 20 percent. Since whites outnumber blacks, a profit-maximizing developer would sell only to whites, who would outbid blacks to live in a predominantly white neighborhood. Anytime a white family sold, they would sell to whites, and the neighborhood would remain segregated. This, of course, would require a neighborhood for blacks. If land in the black part of town were cheaper than in the white part of town, a developer could earn a profit by sell-ing homes for $140,000 in the all-black neighborhood. If a neighborhood happened to be 20 percent black, it would tip to all black or all white, depending on whether a white or black (each of whom bid $180,000) actually purchased the property. Selling to a white would encourage whites to outbid blacks when blacks sold their houses; selling to a black would encourage blacks to outbid whites. The only stable equilibriums would be 0 per-cent black with an average price of $200,000, or 100 percent black with an average price of $140,000.

This example assumed that all blacks have the same bid function, Pb = $190,000 – $500PCb, and all whites have the same bid function, Pw = $200,000 – 1,000PCb. It is more realistic to assume that different black and white households have a different toler-ance for living in a neighborhood with blacks or whites. Suppose that one white family will sell its home at a loss when one black family moves into the neighborhood, a second white family sells when the second black family moves in, and so forth. If the whites fleeing their neighborhood (trying to sell before their property depreciates) sell to blacks, a neighborhood would tip from white to black even more rapidly than in our example. Since real estate agents (as explained in Freakonomics) gain more from rapid property turnover than for achieving the maximum price for a client, unscrupulous agents or other speculators would profit from a visible tipping phenomenon; they would take a loss on the first few houses sold to blacks, but eventually they would gain considerable profit through buying at the white ask price and selling at the black bid price.

$100,000

$110,000

$120,000

$130,000

$140,000

$150,000

$160,000

$170,000

$180,000

$190,000

$200,000

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Bid

Pri

ce

Proportion of the Neighborhood Black

Figure 7-8bUnstable Equilibrium

White Bid Prices Black Bid Prices



Is this situation unjust or unfair? Obviously, your answer depends on who you empathize with—the white homeowners, the black buyers, or the real estate speculator. White homeowners clearly lose; their taste for discrimination may cost them as much as $200,000 in reduced property values. The blacks who buy before the neighborhood be-comes segregated also lose, in this case, as much as $50,000 (the difference between the value of a nearly all-white neighborhood and the value of an all-black neighborhood). The speculator, of course, makes a handsome profit.

How can such a situation be remedied? For one, fair housing legislation may ac-tually prevent neighborhood tipping, because if blacks have the ability to purchase homes in any neighborhood, whites have no “safe haven.” Second, the greater the income equality between whites and blacks, the less likely neighborhoods will be segregated to start with. Third, the greater the equality of experience between blacks and whites living in the same neighborhood, the more they will learn to tolerate each other.

Conclusion

In this chapter we looked inside of the household sector, extending our model of one-person consumption decisions developed in Chapter 4 into a model of altruistic be-havior. Families function because the parents (and the children) consider the well-being of all family members when deciding how to allocate time and income among competing activities. We found that households are formed through a process of sorting whereby individuals look for potential mates with similar characteristics (positive sorting) when it comes to consumption and dissimilar characteristics (negative sorting) when it comes to production. Positively sorting traits seem to be more highly correlated than negatively sorting traits, with the exception of gender. Perhaps a major reason for the culture wars is a profound disagreement whether sex is a consumption activity or a production activity.

Summary

1. Household formation is a sorting process by which people search and compete for lifetime mates. Economists treat households as institutions that facilitate the joint consumption (sharing) and production (comparative advantage). These two functions of households create some tension in household formation and stability.

2. The most important positively sorting traits are age, education, and ethnicity. Other important positively sorting traits are religion and desire for children. A positively sorting trait is one for which individuals seek partners like themselves.

3. The most important negatively sorting traits are gender and wage rates. Negatively sorting traits assist in household production; having complementary genders allows for the production of children. Having different wage rates allows a more clear-cut comparative advantage in allocating time between market production and household production.

4. To maximize a household’s standard of living, the time of adults should be allocated so that the marginal utility of the last hour spent, divided by the relevant wage rate is



the same for market production, household production, personal maintenance, and leisure.

5. The family allocates its resources according to the Marxist rule: from each according to ability (adults produce more income than children do), and to each according to need (consumption does not depend upon earnings).

6. Marriage, in addition to being a religious rite, is also a legal contract that provides economic protection for the economically vulnerable partner and the children of the marriage.

7. Household decision makers (typically, the parents) do not attempt to maximize household income, but maximize the standard of living by allocating only enough time to market and household production to provide enhanced return to personal maintenance and leisure time.

8. Hours worked at a job are positively related to a person’s potential wage rate; hours of household work are inversely related to the market wage, and therefore negatively related to the number of hours on the job.

9. Marital rates have been declining over the last 35 years. Because women typically live longer than men do, the proportion of women who are married peaks when wom-en are in their 40s, then declines. The proportion of men who are married remains at about 80 percent from age 40 on.

10. Typically the most important purchase a family makes is its home. Families purchase houses when the expected present benefits (the savings on rent and the appreciation of the house) exceed the cost (the down payment and present value of mortgage pay-ments).

11. Property values reflect not only the value of the house itself, but also the value of neighborhood amenities. Better-quality schools, parks, and police and fire protection increase local property values. Using property taxes to finance local government ex-penditures is an efficient form of benefit taxation.

12. One of the most persistent problems in race relations is housing segregation, where-by neighborhoods tend to be all white or all black. Housing segregation can reflect unstable housing-bid functions for blacks and whites, whereby whites outbid blacks when the proportion of blacks in the neighborhood is low, and blacks outbid whites when the proportion of blacks in the neighborhood is high. The fact that whites have higher income and better credit than blacks do, along with white tastes for discrimi-nation, contributes to continued housing segregation.

Glossary

Endowments: The resources, advantages, or disadvantages that a person starts with. Typically, middle- and upper-income children are endowed with loving parents and the opportunity for a quality education. Too often poor children’s endowments in-volved a stressed-out single mom, a crowded school system, and a dearth of positive role models.



Utility: Technically, the usefulness of an item, but an economic metaphor for the com-plex goals of households. Utility is a synonym for satisfaction, and economists as-sume that consumers wish to maximize utility.

Egoist: A person who obtains satisfaction only from his or her own consumption; an ego-ist is indifferent to the welfare of everyone besides himself or herself.

Marginal utility: The satisfaction derived from the last unit of a good or service con-sumed. Economists believe that as the consumption of one good increases, the con-sumption of all other goods constant, marginal utility decreases.

Bad: A commodity whose marginal utility is negative.

Rational consumer: A consumer who allocates income so that the marginal utility of each good consumed is proportional to its price, and that the marginal utility per dol-lar spent of those goods exceeds the marginal utility of the first dollar spent on each commodity not purchased.

Impulsive consumer: An irrational consumer who spends his or her income randomly until it is exhausted.

Compulsive consumer: An irrational consumer who attempts always to consume the same commodities, regardless of their relative prices.

Consumption possibility frontier: The consumer’s budget line divides possible combi-nations of goods between those that are possible (inside and on the budget line) and those that are impossible (above the line). The rational consumer picks that point on the consumption possibility frontier that maximizes total utility.

Altruist: A person who obtains positive satisfaction from the prospect that others (e.g., family members) are better off. An altruist would be willing to reduce her own con-sumption to increase the consumption of someone else.

Malevolence: The opposite of altruism—the increase in satisfaction from the prospect that some other person is worse off. A malevolent person would sacrifice his or her own consumption to harm someone else.

Sorting process: A system whereby individuals are divided into larger groups. Marriage is a sorting process, since singles seek out mates, and they, in turn, produce children similar to themselves.

Positively sorting trait: A characteristic where one seeks a mate similar to oneself. In marital sorting, positively sorting traits include age, education, ethnicity, religion, and wealth.

Negatively sorting trait: A characteristic where one seeks a mate dissimilar to oneself. In marital sorting, negatively sorting traits include gender, the hourly wage rate, and aptitude for household production.

Regression line: A statistical estimate of a linear relation between two variables. A re-gression line is obtained by finding the equation that minimizes the squared differ-ence between the points representing actual data and the line fitted to those points.



Unconditional probability: The likelihood of a particular outcome (e.g., having a white, non-Hispanic spouse) that does not account for any of one’s own characteristics.

Conditional probability: The opposite of unconditional probability. The conditional probability of having a white, non-Hispanic spouse is higher if one is also white and non-Hispanic than if he or she is black, Asian, Native American, or Hispanic.

Bandwagon effects: The phenomenon whereby consumers increase the value they place on a good or service because it is popular. Bandwagon effects create fads.

Amenities: Things of value in addition to the major purpose of a good or service. For instance, in addition to being the location of one’s house, neighborhoods create amen-ities including local schools, parks, and police and fire protection. Other amenities could include how well neighbors maintain their property, peace and quiet, the amount of vehicular traffic, or the presence or absence of churches.

Civil law: A law, such as laws against discrimination, which are enforced when the al-leged victim sues the alleged perpetrator for damages. The opposite of civil law is criminal law, which is enforced by the state on behalf of citizens, and typically in-volves state-sanctioned punishment—fines, imprisonment, or execution.

Segregation: The legally mandated (de jure) or the result of unregulated behavior (de facto) separation of a population based on a given characteristic. The two most preva-lent forms of segregation are racial segregation (blacks and whites live in neighbor-hoods and attend school with others of the same race) and income segregation (zon-ing ordinances and homeowners’ associations that discourage homes of different price ranges in close proximity to each other).

External effects: When the market transaction between a buyer and a seller affects third parties who are not part of the transaction. External effects could be either beneficial; for instance, the more people who are vaccinated against smallpox there are fewer people to catch smallpox from. Typically, external effects that are negative catch people’s attention, including pollution and deteriorating property values when hous-ing integration causes panic selling.

Arbitrage: The practice of making a profit by purchasing a good or service at a low price then reselling it at a higher price.

Taste for discrimination: The willingness to incur a higher financial or other cost to avoid associating with someone from another group. The combination of unequal wealth distribution by race gives rise to unstable housing-neighborhood bid functions, which in turn cause neighborhood segregation.

Chapter 8 Factor Markets and Income Determination


This is the last chapter that introduces standard principles of economics; the re-maining chapters of this text will largely apply the concepts of the first eight chapters to economic inequality, poverty, and discrimination. Recall that in factor markets, house-holds are sellers of factor services—labor time, entrepreneurial risk taking, land services, and the services of capital goods (for business owners) or the services of money used to buy capital goods (stockholders and bondholders).1 We assume that households supply resource services to maximize their satisfaction, subject to the constraints of scarce time and net worth (wealth minus debt). Firms buy factor services in the hope that revenue exceeds opportunity cost, resulting in profit—which “belongs” to the firm’s owner(s).

Household Allocation of Time Decisions

In Chapter 7, we considered household decisions and the critical choice of how much housing a household buys and where the household locates. Because household decisions affect the well-being of related people, we need some way to compare the pref-erences of household members. One convenient analytical approach is for one member of the household to function as dictator. In a patriarchal system, the father decides; in a matriarchal household, the mother is decisive. The democratic family reaches a consen-sus and acts. If the dictator is a perfect altruist, who values the well-being of each fami-ly member as equivalent to her own,2 then dictatorial and democratic decisions would reach the same outcome, assuming perfect knowledge.

We can imagine a family whose harmony springs from the famous dictum “from each according to ability, to each according to need.” While this rule is a very inefficient means of social economic organization (as so-called communist countries have discov-ered), it works reasonably well in a functional family with altruistic members or with an altruistic dictator.3 We’ll call the dictator “Mom”4 and imagine that Mom oversees the family welfare, W, which increases whenever at least one member of the family is made better off without making any other member of the family worse off.5 In Chapter 6, we saw how two adults would consider the opportunity cost of market time in deciding how much time to spend in household production, and vice versa. For simplicity, assume that each adult has 80 hours per week available for production work, meaning they each spend 88 hours per week in personal maintenance (say, 70 hours) and leisure (18 hours). Adding an hour to working time increases household income by wd for Dad and wm for

1 Technically, stockholders “own” shares of the company, but in practice they are merely residual claim-ants—that is, they have the right to the firm’s assets if the firm is liquidated (they stand last in line), and they have the expectation of dividends (depending on the decision of the Board of Directors). They do not have the right to exclude employees from the business’s premise (in fact, they will probably be arrested for trespass if they wander about the premises) or sell the business outright. 2 Note how difficult it is to imagine a perfect male altruist. Only Buddha and Jesus Christ come to mind, but not to the minds of paternalistic religious fundamentalists. 3 In his Treatise on the Family, economic Nobel laureate Gary S. Becker developed his “rotten kid theo-rem.” According to Becker, if family resource allocation decisions are under the control of an altruistic dictator (the mom) who adjusts the consumption levels of each family member to compensate for cheating (i.e., sibling rivalry), the egoistic (or even malevolent) rotten kid will seek to maximize the total resources of the family, since any action on his part that reduced a sibling’s consumption more than it increased his own would result in his sharing the net loss. 4 What does that tell you about decisions in the Carroll household? 5 This is the Pareto criterion that economists typically use for social welfare functions, presumably be-cause to dissent from this criterion implies that one is malevolent.



Mom, their respective market wage rates, and reduces the labor input in household pro-duction by 1 hour. The optimal allocation of time occurs when the increase in family welfare from the last hour of household production is exactly equal to wd or wm, whichev-er is less. We can easily extend this analysis whereby personal maintenance time and lei-sure time are both increased until the value of last hour of each type of time by each indi-vidual i is equal to his or her wage rate wi.

6

Each member of the household will develop a labor supply function. Since w is the opportunity cost of non-labor time, we would expect labor time, L, to increase with the wage rate. This tendency is called the substitution effect of a wage rate change. Since the wage rate is the opportunity cost of leisure, workers tend to reduce their leisure (i.e., substitute income for leisure) as that wage rate increases. However, leisure is con-sidered a normal good, meaning that, as household income tends to increase, the time devoted to leisure pursuits tends to decrease, ceteris paribus. Consider the impact of non-labor income on labor time. When was the last time you heard of a happy lottery winner proclaiming “I’m glad a won a quadrillion dollars, because now I can take a sec-ond job!”7 First, as non-labor earnings increase, there is more money to be spent in the same amount of time, so households tend to buy more appliances or hire household help to economize on time allocated to household production. Second, they tend to substitute commodity-intensive consumption for time-intensive consumption activities. For in-stance, a lawyer billing $100 per hour (and paid $51.23 per hour) tends to have a much nicer television than does a professional dishwasher who earns $10.16 per hour. Howev-er, the dishwasher probably watches more hours of television per week, since he only works 28.32 hours per week, compared to 44.61 hours for the lawyer. Table 8-1 shows the average wage rate, average hours of work, and the change in hours worked as the wage rate changes8 for eight occupations.

Table 8-1

Hours per Average

Occupation Week Wage

dishwasher $10.16 28.32

hotel clerk $12.86 35.45

carpenter $23.46 38.41

social work $27.04 38.58

professor $39.91 36.90

economist $50.17 43.37

lawyer $51.23 44.73

physician $53.45 50.59

6 In her professional paper for her UNLV master’s degree, economist Meron Tilahun documented how the worked performed by boys on family farms in her native Ethiopia actually rose as family wealth increased. That is, as the family acquire more livestock, boys become more productive, which increases the oppor-tunity cost of sending them to school. Eventually, when the family acquired sufficient wealth, the father became sufficiently productive, families could afford to send their sons to school. 7 One quadrillion = 1000x1 trillion = 1015. 8 The data in Table 8-1 were drawn from the Monthly Earner Study of the Current Population Survey, Jan-uary 2011 to December 2011. Using all occupations, I confirmed that hours worked increased at a decreas-ing rate as the wage offer increased.



Figure 8-1 plots the typical individual labor supply curve for men and women, taken from the 2011 Monthly Earner Study of the Current Population Survey. Hours worked by male and female workers follow the same path until, at approximately $20 per hour, average hours worked by women peak at 35 hours per week. Above $20, women tend to work fewer hours as their wage rate increases; the income effect (buying more leisure time with higher wage income), tends to dominate the substitution effect (the ten-dency to substitute income for leisure as the price of leisure increases). The hours worked by men continue to increase until peaking at 50 hours per week at a wage rate of approximately $35 per hour. The points for dishwashers and hotel clerks tend to lie be-low the labor supply curve for both men and women. Carpenters, social workers, and college professors tend to have a more pronounced leisure preference than the average man or woman does. Economists and lawyers tend to be on the backward bending por-tion of the supply curve for all workers, while physicians are on the backward bending supply curve for men.

Figure 8-2 juxtaposes the individual labor supply curve with the market supply curve for a particular occupation. The left-hand diagram shows the individual labor sup-ply curve, which shows a net substitution effect as the wage rate approaches w* and then a net income effect for wage rates above w*. The right-hand diagram shows two hypo-thetical labor supply curves. The labor supply curve Sic is the sum of backward bending supply curves that assumes a closed labor market; there are n (identical) individuals in the labor market, so that Lic = nLi. Below w* each member of the labor force increases the quantity of labor supplied as the wage rate increases. As the wage rate increases, the income effect becomes stronger until, at w*, each individual supplies less labor, so that

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

$70.00

$80.00

0 10 20 30 40 50 60 70

Average W

age Rate

Average hours worked per week

Figure 8‐2: Labor Supply By Gender and Occupation

Men and Women Men Women dishwasherhotel clerk carpenter social work professoreconomist lawyer physician



the quantity of labor supplied to the market also decreases. By contrast, the labor supply curve Sio is the labor supply curve for an open labor market. At low wage rates, some people who are willing to work for low wage rates (they have low reservation wages) supply labor services, while the individual depicted on the left would not supply labor services until his or her minimum wage was reached. At wage rate wmin, this individual enters this labor market; at very low wage rates, a person with a medical degree might prefer a less stressful job, like washing dishes. As the wage rate continues to rise, the quantity of labor supplied increases for two reasons: (1) individuals offer more labor hours as long as the substitution effect is stronger than the income effect, and (2) more individuals enter this labor market when the market wage exceeds their (minimum) reser-vation wage.

Individual Worker Market Supply

Figure 8-2

The Firm’s Demand for Labor

Now we turn our attention to the buyers’ side of the labor market—the profit-maximizing firm’s decision of how much labor to hire. Table 8-2 shows the relation be-tween labor time (in 40-hour increments) and the total weekly output for a price-taking and wage-taking firm.9 Note that total output would be maximized were the firm to hire 500 labor hours (12 full-time workers and 1 half-time worker). It is impossible to pro-duce more than 2,000 units of output per week, no matter how many workers were hired, because of diminishing returns to the variable input, labor. Recall that average product measures output per worker, while marginal product is the more relevant change in out-put due to the last unit (hour) of labor. Note that the wage rate is a constant $10.00 per hour, and the price is a constant $4.00 per unit. The value of marginal product is the product of the price times marginal product, and indicates to the employer the revenue generated by the last labor hour hired. It follows that hiring 500 labor hours (maximizing 9 The production function used for this example is q = 8L – .008L2, where L is measured in hours/week. It

follows that 8 .016L

qMP L

L

.

Lmax

Si

w*

Sic

Sio

iL

ut 0 iL

ut

w*

Lmax,c L*o

wmin

$/L $/L



output) would result in a marginal product of labor equal to zero. Although revenue ($8,000) exceeds labor cost ($5,000), resulting in a positive producer surplus10 of $3,000, hiring 500 labor hours would not maximize profit because the marginal cost of labor ($10) would exceed labor’s marginal revenue product ($0).

Labor Output Average Marginal Value of Wage Price Marginal Revenue Labor GrossProduct Product Marginal Rate Cost Cost Profit

Product0 0 $0 $0 $0

40 307 7.68 7.36 $29.44 $10.00 $4.00 $1.36 $1,229 $400 $82980 589 7.36 6.72 $26.88 $10.00 $4.00 $1.49 $2,355 $800 $1,555120 845 7.04 6.08 $24.32 $10.00 $4.00 $1.64 $3,379 $1,200 $2,179160 1075 6.72 5.44 $21.76 $10.00 $4.00 $1.84 $4,301 $1,600 $2,701200 1280 6.4 4.8 $19.20 $10.00 $4.00 $2.08 $5,120 $2,000 $3,120240 1459 6.08 4.16 $16.64 $10.00 $4.00 $2.40 $5,837 $2,400 $3,437280 1613 5.76 3.52 $14.08 $10.00 $4.00 $2.84 $6,451 $2,800 $3,651320 1741 5.44 2.88 $11.52 $10.00 $4.00 $3.47 $6,963 $3,200 $3,763

343.8 1805 5.2496 2.4992 $10.00 $10.00 $4.00 $4.00 $7,219 $3,438 $3,781360 1843 5.12 2.24 $8.96 $10.00 $4.00 $4.46 $7,373 $3,600 $3,773400 1920 4.8 1.6 $6.40 $10.00 $4.00 $6.25 $7,680 $4,000 $3,680440 1971 4.48 0.96 $3.84 $10.00 $4.00 $10.42 $7,885 $4,400 $3,485480 1997 4.16 0.32 $1.28 $10.00 $4.00 $31.25 $7,987 $4,800 $3,187500 2000 4 0 $0.00 $10.00 $4.00 undefined $8,000 $5,000 $3,000520 1997 3.84 -0.32 -$1.28 $10.00 $4.00 $7,987 $5,200 $2,787560 1971 3.52 -0.96 -$3.84 $10.00 $4.00 $7,885 $5,600 $2,285600 1920 3.2 -1.6 -$6.40 $10.00 $4.00 $7,680 $6,000 $1,680640 1843 2.88 -2.24 -$8.96 $10.00 $4.00 $7,373 $6,400 $973680 1741 2.56 -2.88 -$11.52 $10.00 $4.00 $6,963 $6,800 $163720 1613 2.24 -3.52 -$14.08 $10.00 $4.00 $6,451 $7,200 -$749760 1459 1.92 -4.16 -$16.64 $10.00 $4.00 $5,837 $7,600 -$1,763

Table 8-2

Instead of maximizing output, the firm should hire labor only to the point where the marginal revenue from labor equals the marginal cost of labor. Hiring 343.8 labor hours (8 full-time workers, 320 hours; plus one college student working part time, 23.8 hours) would maximize profit. When we divide the wage rate (the cost of one more worker) by the marginal product of labor, we get the marginal cost of output.11 Hiring 343.8 labor hours implies producing 1,804 units of output, which is where marginal cost equals price.

Figure 8-3 presents the firm’s demand for labor. The marginal revenue product (the green line) shows the addition to revenue the firm receives from hiring an additional worker. The marginal cost of labor (the red line) shows the addition to cost of hiring an-other worker. It follows that the firm maximizes its gross profit (revenue minus variable cost) when it hires labor up to the point where the firm breaks even on the last labor hour hired.

10 Gross profit is revenue minus variable cost (in this case, revenue minus labor cost). Economic profit is gross profit minus the opportunity cost of “fixed” factors.

11 /

/LMPdC dC dL

MCdq dq dL w



Figure 8-4 traces the impact of a wage rate change on the firm’s simultaneous output and employment decisions. Note that the value of marginal product curve is the price times the marginal product of labor. If the wage rate changes, there is no direct im-pact on the marginal product or the product price; the labor demand curve does not shift. However, after the wage increases from w0 to w1¸ the firm is no longer maximizing profit with L0 workers, and the owner cuts employment to L1 to maximize profit. In the right-hand panel, the increase in the wage rate shifts the marginal cost curve from MC0 to MC1. Although the price did not change, a decrease in the firm’s supply curve reduces the quantity produced from q0 to q1. A change in the wage rate shifts the supply curve in the product market.

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

0 50 100 150 200 250 300 350 400 450 500

Dollars per Labor Hour

Labor Hours Employed

Figure 8‐3: Firm's Demand for Labor

Marginal Revenue Product (Demand) Marginal Cost of Labor (Supply)

Wage bill = $10(343.8) = $3,438

Producer surplus = $3,781



Employment Decision Output Decision Figure 8-4

In Figure 8-5, we trace the effect of a price increase on the employment and out-put decisions, under the assumptions that the wage rate and marginal product schedule do not change. In this case, the increase in the price of the output shifts the firm’s demand for labor curve to the right (upwards proportional to the change in p), resulting in an in-crease in employment, even when the price remains unchanged. This is consistent with moving to the right along the firm’s supply curve in response to a price change.

$/L

w1 w0 0

MCL1 MCL0

p0 mr

L1 L0 L/ut

0 q1 q0

q/ut

MRPL

w0

P0MPL

MCL P1MPL P0

P1

$/L $/q MC

L0 L1 L/ut 0

q0 q1 q/ut 0

Employment Decision Figure 8-5 Output Decision

$/L

MC1 MC0



Market Equilibrium Wage Rate

By now you should understand that after we develop the demand for labor by the individual firm and the supply of labor for the individual household, we next combine these concepts to arrive at market equilibrium. Figure 8-5 repeats the long-run competi-tive equilibrium in the product market for apples, showing the market in the middle pan-el, with the representative firm on the left and the representative household on the right. Recall that the negatively sloped market demand curve results from summing the quanti-

ties demanded by all households at each price. In equilibrium,1

N

i d ei

q Q Q

there are

N households in the population.12 Similarly, the positively sloped market supply curve results from adding up the profit-maximizing output for each firm at each price; at equi-

librium, n

i s ei j

q Q Q

. Furthermore, in long-run equilibrium, total revenue is just suf-

ficient to cover all variable cost (the area underneath the marginal cost curve) and fixed costs (the area between price and the marginal cost curve). Ultimately, the competitive market maximizes consumer surplus, the difference between the total value households place on the good (the area beneath the demand curve) and what they actually pay for the good.

Firm j Market

Figure 8-6

If the typical household demand for apples were to increase, say from d0 to d1, price would rise to p1 in the short run, but in the long run, more firms would enter the market, and price would return to pe. Figure 8-7 shows the parallel events in the labor market for apple pickers. In this case the firm’s demand curve for labor is the apple price times the marginal product of labor. The negatively sloped market demand curve reflects

12 An econometrician (an economist who uses statistics to estimate numerical relationships to test the valid-ity of economic theory) would select a random sample of households, and relate quantity demanded from each household to household characteristics (e.g., number of family members, household income), and market variables (e.g., price of apples, prices of other types of fruit), then use the statistical equation to es-timate the population equation.

$/qj

pe

mc atc

qe 0jq

ut

Qe Q1 Q2 Q/ut 0

Pexqie

Consumer surplus

variable costs

fixed costs

p1

mr pe

p1

pe

qie q1 q2

qi/ut

Household i

$/Q $/q

S0

S1

D0

D1 d0 d1



the negatively sloped demand curves at the firm level. The positively sloped market sup-ply curve reflects (1) the substitution effect whereby hours of market work increase as the wage rate increases and (2) the tendency for more workers to offer labor services in the apple market (instead of other labor markets requiring similar skills) as the wage rate in-creases. The equilibrium wage rate results where the market demand curve intersects the market supply curve, meaning that there is a job available for all potential apple work-ers.13 In the household, the wage rate w0 compensates the worker for the opportunity cost of (1) taking a job in another market, (2) spending an additional hour in household pro-duction, (3) enjoying more leisure time, or (4) allocating more time to personal mainte-nance (e.g., sleep, non-enjoyable exercise). For the firm, the last (marginal) worker hired exactly earns his or her wage; the difference between the value of output (the area under the VMPL curve) and wage payments are just sufficient to cover the opportunity cost of fixed (i.e., non-labor) factors of production.

Firm Labor Market Household

Figure 8-7

If the demand for apples increases, the resulting shortage of apples causes the price of apples to increase from Pe to P1 in Figure 8-5. In Figure 8-7 the change in the price of apples shifts the value of labor’s marginal product from P0MPL to P1MPL—that is, the demand for labor at the firm level increases. The resulting increase in the price of apples also increases the market demand for apple pickers from D0 to D1 in the center di-agram. The shortage of apple pickers increases the wage rate from w0 to w1; this causes the worker depicted in the typical household to increase hours of work (from L0 to L1), since the substitution effect of the change is stronger than the income effect. However, the resulting economic profit at price P1 causes an increase in the number of firms in the market. Although the resulting price decrease reduces the firm’s demand curve back to P0MPL, the fact that there are more firms in the industry keeps the labor demand curve at D1.

13 Realistically, frictional unemployment might exist while job seekers (who may have recently entered this labor market) are matched with available jobs (from new firms or to replace workers who exited the apple-picker market).

$/L

w1 w0

w1 w0

w1 w0

P1MPL

P0MPL

si

S0 S1

L0 L1 L2 L/ut L0 L1 L2 L0 L1

L/ut

0 0 L/ut

$/L$/L

D0

D1



However, in order for the price to return to P0 and firms continue to receive nor-mal profits, the wage rate must eventually return to w0.

14 If the market supply of labor reflects the number of labor hours offered by all available workers, an increase in labor supply means an increase in the number of available workers. For instance, as new apple orchards are planted, job opportunities develop for workers who previously had lived too far to profitably commute. Further, some workers could migrate to apple or-chards, either intranationally (from one state to another) or internationally (crossing in-ternational borders). As more workers become available, the labor supply curve shifts from S0 to S1, ultimately reducing the wage rate to w0, and the market has once again achieved long-run equilibrium.

Imperfect Competition in the Product Market

While an agricultural product like apples, and a generic skill like apple picker may fit the competitive model (free entry of labor and firms, a uniform price for the product, and a uniform wage rate for labor), not all markets are quite so simple. We will list some real-world complications now, deciding which of these complications render our competitive model irrelevant. Recall from Chapter 1 that economists make assump-tions to simplify the analysis; a simplifying assumption is one that can be relaxed without changing the predictions of the model.

Suppose that the product in question isn’t produced under perfect competition, but under monopolistically competitive conditions. If the firm faces a negatively sloped de-mand curve for its product, the firm sets output where marginal revenue equals marginal cost. In Figure 8-8, we depict a restaurant with a negatively sloped demand curve, and the associated marginal revenue curve that declines twice as fast as price. The firm sets output at qm where MC = MR and price at pm, the market-clearing price of qm. If we as-sume that restaurant workers are hired in a competitive labor market, the firm still faces a horizontal supply of labor at the market wage rate, w0. Producing where mc = mr implies hiring labor so that MR(MPL) = w0. The firm is shown in long-run equilibrium because the average cost curve is tangent to the firm’s demand curve. So, while workers are paid less than the market value of what they produce, this “excess revenue” for the employer ultimately covers the costs of product differentiation (e.g., persuasive advertising, special uniforms for employees). As long as there is free entry into the market, whether the product is homogenous or differentiated has no material effect on the nature of equilibri-um.

14 Notice, all discussions are in real, that is, constant dollar terms. In other words, the wage rate must re-turn to w0 after adjusting for changes in the cost of living, just as the price P0 is also adjusted for changes in the cost of living.



Imperfect competition in the product market reduces the quantity of labor de-manded at each wage rate, given the demand for the product. This result is not really surprising. Since imperfect competition in the product market causes the firm to produce less output (in order to charge a higher price), it follows that the firm will also hire fewer workers.

Labor Cartels

Imperfect competition in the labor market occurs when either buyers or sellers are not wage takers. Monopoly occurs when there is only one seller in a labor market. Two examples of labor-market monopoly are labor unions and professional associations. Of-ten labor market monopoly stems from occupational licensing, whereby established members of a profession screen new entrants into that profession. Recall that the essence of monopoly is that a single seller is able to exclude competitors from the market.

In Figure 8-8, we present a market for carpenters. Under competitive conditions, the wage rate would be Wc and employment would settle at Le. Suppose the carpenters decide that they want a higher wage rate. Like any monopoly, a carpenters’ union—aka a carpenters’ cartel—could set the wage at any level up to Wu by controlling the number of carpenters certified to provide labor services. For instance, carpenters might succeed in passing a restriction that only carpenters graduating from the union’s apprenticeship pro-gram could legally hold carpenter’s jobs. What wage would the carpenters’ union wish to set? If it wished to maximize the number of carpenters, the union need do nothing—the competitive market would already maximize employment at Le when the wage rate equaled Wc.

15 The union might wish to maximize economic rent, the difference between the wage rate paid and the lowest wage rate the worker would accept to perform that job. Indeed, the difference between the union wage and the workers’ reservation wages could be a lucrative source of union dues. 15 At any wage above Wc, employment would contract because Ld < Le < Ls. At any wage below Wc, em-ployment would contract because Ls < Le < Ld.

0

L

wMC

MP

ATC PmMPL w0

mr d

$/q $/L

pm

Variable costs

Overhead costs

wages

Other factorpayments

LMR MP LP MP

qm q/ut 0

Lm Lc

Production Decision Employment Decision Figure 8-8



Figure 8-9

In Figure 8-9 we imagine that the carpenters’ union wishes to set the wage rate at Wu, which is where the marginal wage intersects the supply curve for labor (whose height is the reservation wage of the last worker). The problem for the union is that, at Wu, Ls workers wish to supply labor, while employers will only hire Lu workers. Free entry of labor would result in a surplus and wage competition would eventually cause wage rate Wc to prevail. That is why a labor cartel must control labor supply. One approach would be to increase union dues so that the net wage would exactly clear the market. In this case, union dues would be set equal to Wu – Wr, so that the last worker hired, worker Lu, would be indifferent between holding a union job or working in an alternative market. Of course, with a net wage of Wr, carpenters would be worse off with a union than without one. Another approach would be to screen union members by gender, religion, race, or some other characteristic. That is, job discrimination is one basis by which a labor car-tel can clear the market. However, discrimination would not maximize the income of the union bosses.

Figure 8-9 could also be used to evaluate a professional association. Before the turn of the twentieth century, many physicians learned their trade through an apprentice-ship to an experienced physician. This type of training resulted in considerable variabil-ity in physician skill and a competitive wage for physicians. In fact, some physicians earned so little, they actually made house calls! About that time, the American Medical Association lobbied state medical boards to require that physicians possess degrees from accredited medical schools. Since the AMA accredited medical schools, the AMA had a direct control over the number of physicians. Reducing the number of physicians from Lc (where an investment in medical school generates a “normal” rate of return), to Lu in-creases the market-clearing physicians’ wage rate. However, the higher wage increases the labor supply. In this case, Ls college graduates apply for medical school, while only Lu students are admitted. Medical schools could charge market-clearing tuition, but in-stead, medical schools typically set high qualifications for applicants without connec-tions, and lower qualifications for the sons of physicians and alumni. Discrimination has

SL

MRPL

Lu Le Ls

MRL

Wu Wc Wr

$/L

L/ut



long been an issue in medical school admissions, going back to the famous Bakke case, which we will discuss in Chapter 11. However, there have been few allegations of dis-crimination in admissions to Ph. D. programs in economics.

Monopsony Employers

The opposite of labor monopoly (one seller) is employer monopsony, literally, one buyer. The classic case of monopsony is local government, which is the only em-ployer of police, fire fighters, garbage collectors, or elementary educators. Table 8-3 pre-sents the hypothetical market for garbage collectors. With limited information about workers’ reservation wages, the city sanitation department naively requests volunteers to collect garbage for no pay. After all, hospitals recruit candy stripers to carry bed pans for a pleasant “Thank you.” According to Table 8-3, the quantity of labor supplied when the hourly wage rate is 0 is precisely 0. By offering $1.00 per hour,16 the sanitation depart-ment attracts 100 job applicants. If the department hires the 100 applicants, the total wage bill will be $100 per hour (100 workers at $1 each). By focusing work on the most productive garbage removal, the marginal revenue product of the 100th worker is $23.00 per hour. Obviously, it is efficient to hire at least 100 workers. But, if workers can be hired at only $1.00 per hour, the employer wishes to hire 2,300 workers. There is a shortage of 2,200 workers. When the employer faces a positively sloped labor supply curve, the only way to increase the quantity of labor hired is to offer a higher wage rate.

Now we imagine that the sanitation department offers to pay the second batch of workers $2.00 per hour. An additional 100 workers come forward and agree to work for $2.00 per hour. What do you suppose the first 100 workers do? They demand $2.00 per hour, or else. If the employer says, “Okay, take a hike,” the sanitation department loses 100 workers, worth $22 per hour (remember diminishing marginal revenue product), who could have been retained for $2 per hour. An efficient employer would acquiesce and pay the first 100 workers $2 per hour as well.

Because hiring the second 100 workers increases the wage bill from $100 to $400; it actually costs more than $2 per worker because hiring the additional workers im-plies giving raises to workers who otherwise would have accepted a lower wage.17 What distinguishes a monopsonist from a wage-taking employer is that the marginal factor cost exceeds the wage rate. Through trial and error, the employer discovers that when the wage offer is $8.00, 800 workers apply for jobs, and after adjusting the wages of the pre-vious workers hired, the employer breaks even on the 800th worker, whose marginal fac-tor cost is $16 per hour, and whose marginal revenue product is also $16 per hour. At that wage, the employee surplus is the difference between the wage offer ($8 per hour) and each worker’s reservation wage (from $0.01 to $8)—the area of the triangle formed between the wage offer and the labor supply curve. At $8.00 per hour, labor’s surplus (also called economic rent) is $3,200. Ordinarily, the employer’s surplus would be the area between the marginal revenue product line and the marginal cost of labor (which,

16 Pretend there is no minimum wage law. 17 Mathematically, the labor supply function is Ls = 100W, where W is the hourly wage rate. Hence,

.01W L , and WL = .01L2. The marginal factor cost of labor is( )

.02L

WLMFC L

L

. So, while it

costs $300 to hire the second 100 workers, the cost of hiring the 200th worker is .02(200) = $4.



under competitive conditions, would be the market wage). However, by virtue of the monopsonist’s control over the wage rate paid to workers, monopsony profits equal the difference between the marginal revenue product of labor and the wage rate, times the quantity of labor hired. In this case, monopsony profit is ($16 – 8)(800) = $6,400 per hour, in addition to the usual monopsony profit of ($24 – 16)(800)/2 = $3,200.

Table 8-3

Labor Marginal Marginal Wage Hours Wage Revenue Factor Employer Employee Total Offer Supplied Bill Product Cost Surplus Surplus Surplus

$0.00 0 $0 $24.00 $0.00 $0 $0 $0 $1.00 100 $100 $23.00 $2.00 $2,250 $50 $2,300 $2.00 200 $400 $22.00 $4.00 $4,200 $200 $4,400 $3.00 300 $900 $21.00 $6.00 $5,850 $450 $6,300 $4.00 400 $1,600 $20.00 $8.00 $7,200 $800 $8,000 $5.00 500 $2,500 $19.00 $10.00 $8,250 $1,250 $9,500 $6.00 600 $3,600 $18.00 $12.00 $9,000 $1,800 $10,800 $7.00 700 $4,900 $17.00 $14.00 $9,450 $2,450 $11,900 $8.00 800 $6,400 $16.00 $16.00 $9,600 $3,200 $12,800 $9.00 900 $8,100 $15.00 $18.00 $9,450 $4,050 $13,500

$10.00 1000 $10,000 $14.00 $20.00 $9,000 $5,000 $14,000 $11.00 1100 $12,100 $13.00 $22.00 $8,250 $6,050 $14,300 $12.00 1200 $14,400 $12.00 $24.00 $7,200 $7,200 $14,400 $13.00 1300 $16,900 $11.00 $26.00 $6,050 $8,250 $14,300 $14.00 1400 $19,600 $10.00 $28.00 $5,000 $9,000 $14,000 $15.00 1500 $22,500 $9.00 $30.00 $4,050 $9,450 $13,500 $16.00 1600 $25,600 $8.00 $32.00 $3,200 $9,600 $12,800 $17.00 1700 $28,900 $7.00 $34.00 $2,450 $9,450 $11,900 $18.00 1800 $32,400 $6.00 $36.00 $1,800 $9,000 $10,800 $19.00 1900 $36,100 $5.00 $38.00 $1,250 $8,250 $9,500 $20.00 2000 $40,000 $4.00 $40.00 $800 $7,200 $8,000 $21.00 2100 $44,100 $3.00 $42.00 $450 $5,850 $6,300 $22.00 2200 $48,400 $2.00 $44.00 $200 $4,200 $4,400

Figure 8-9 is a graphical depiction of Table 8-3. The marginal factor cost line in-tersects the marginal revenue product line where 800 workers are willing to work. The firm pays a wage of $8.00 per hour and reaps the normal employer surplus (used to cover non-labor costs) plus a monopsony profit. Although the firm would like to hire 1,600 labor hours at this wage, the firm settles for 800, since hiring even one more worker would mean giving 800 workers already employed a wage increase.



Is monopsony “fair”? Obviously, the answer depends on whom one asks. The employer receives greater profit under monopsony than it would under competition, so the employer believes the system is fair (more for me!). All 800 workers are paid their reservation wage or more and, while workers always prefer more, are they really being cheated? Economists are less concerned with the issue of fairness than they are with the issue of efficiency. Is monopsony efficient? Most economists would say no, because, under monopsony, too few workers are hired. As shown in the table and the diagram, the last worker hired has a marginal revenue product of $16 per hour, but is only paid $8 per hour. Under competitive conditions, employers would be wage takers, and a situation where the last worker hired produced $8 more than he was paid would generate wage competition among employers. Eventually the wage rate would be set at $12 per hour, and the marginal revenue product of the last (1,200th) worker hired would also be $12. While competition would reduce the employer’s surplus to $7,200, competition would increase labor’s surplus by more, up to an identical $7,200.18 As we saw in product mar-kets, the competitive solution maximizes the sum of both seller (employee) and buyer (employer) surpluses.

So, on efficiency grounds, economists prefer competitive markets to either em-ployee monopoly (which raises employee surplus by less than it reduces employer sur-plus) or employer monopsony. But the necessary structural condition for a competitive market to exist is that there are many buyers and sellers in the market due to free entry. Workers may be able to prevent entry by controlling the labor certification process. Em-ployers may exercise market power because of structural conditions (there is only one local government hiring sanitation workers and city employees are required by law to re-

18 The symmetry of the employers’ and workers’ surpluses is a result of the fact that the slopes of the labor supply and demand curves have the same slope (in absolute value). We would not expect this coincidence of surpluses in most cases.

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

$22.00

$24.00

0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400

Do

llars

per

ho

ur

Number of Labor Hours

Figure 8-9Employment Decision Under Monopsony

MFCSL

MRPL



side within city limits), or because of legal restrictions. One criticism of the Bush admin-istration’s recently proposed migrant labor reforms is that allowing Mexicans into the country under the sponsorship of employers give those employers undue control over the worker’s fate—“Either take what I offer, or I’ll call the Department of Homeland Securi-ty and have you deported.”

Bilateral Monopoly: The Economics of Collective Bargaining

About 50 years ago, American economist and future ambassador John Kenneth Galbraith coined the term countervailing power, to describe a market in which a single monopoly union would bargain with a single employer association. His conclusion, for-malized by other economists as the general theory of the second best was that collec-tive bargaining in a bilateral monopoly setting could actually result in more efficient eco-nomic outcomes than would occur either under one-sided monopoly or one-sided monop-sony.

Returning to Table 8-3, suppose that the 800 workers decide to form a labor un-ion, which actually is a labor cartel in which workers say, “Pay us the wage rate we de-mand or we strike—the quantity of labor supplied will be zero.”19 Note that the wage rate that would maximize the workers’ surplus would be $16 per hour, which just happens to be the highest wage rate that the sanitation department would pay for 800 workers. Being self-interested, the workers’ bargaining representatives are told to “Obtain the highest wage possible, consistent with the 800 union members retaining their jobs.”

In Figure 8-9, the bargaining range for collective bargaining would range from $8.00 (the monopsony profit-maximizing wage) and $16 (the workers’ maximum surplus wage). Suppose, for sake of argument, that the union totally caved; then the employer would welcome the 800 workers back at the pre-union wage of $8.00. Any threat to pay less than $8 per hour as punishment would not be a credible threat, since the employer would end up reducing profit. On the other hand, suppose the employer gave the union everything it wanted. A contract wage of $16 per hour would confront the employer with a horizontal marginal factor cost line at $16; since the marginal factor cost of labor did not change, the employer’s profit-maximizing employment level would still be 800 workers. Only, after collective bargaining, the employer’s surplus would decline to $3,200, and labor’s surplus would increase to $9,600. All that changes is that monopsony profits are transformed into monopoly (union) profits. The union would be confronted with a problem; with a contract wage of $16 per hour, 1,600 workers want jobs, while only 800 are hired. This helps explain why unions prefer seniority agreements, which give preferential employment to union members who bear (potential) costs of organiza-tion and/or strikes. The union bosses might raise union dues to the point where the union bureaucracy, rather than the workers, reaps the monopoly profit; this result would be sta-ble, since those who worked for $8 per hour before the union are the only ones willing to

19 Not long after the passage of the Sherman Anti-Trust Act of 1890 that outlaws “conspiracies in restraint of trade,” pro-business administrations used the provisions the act to prosecute labor conspiracies (labor unions). In 1914, under the Democratic Wilson administration, Congress passed the Clayton Antitrust Act, which exempted labor unions from antitrust prosecution. However, courts weakened the act, and it was not until the National Labor Relations Act of 1935 that employers were required to bargain with labor unions in good faith. The National Labor Relations Board now governs employer-union issues for the federal gov-ernment.



work for a net wage of $8 per hour after the union. Of course, the union may have diffi-culty explaining to workers exactly why they should vote “No” in a union-decertification election.

In a typical collective bargaining situation, it is unlikely that either the employer or the union will completely prevail in the negotiating process.20 Bargaining typically means compromise. The stronger the union’s threat of shutting down operations and re-ducing employer profits is, the higher the likely wage. The stronger the employer’s threat of securing strike breakers and imposing economic hardship on union members, the low-er the likely wage. Unlike the competitive equilibrium wage rate, the contract wage is unpredictable, although it is bounded by the monopsony profit-maximizing wage below and the labor-surplus maximizing wage above. It is when collective bargaining achieves an intermediate, compromise outcome that bilateral monopoly gets interesting.

Suppose that, after a protracted strike that imposes costs on unions and the em-ployer alike, a deal is finally struck to set the union wage at $12 per hour. Note that workers gain $4 per hour, increasing labor’s surplus (economic rent) by $3,200 per hour for the 800 striking workers. It follows that the employer loses $3,200 in monopsony profit, so the result appears to be a zero sum game; that is, the gain to the winner equals the loss to the loser. However, by confronting the employer with a horizontal labor sup-ply curve at $12 per hour, the marginal factor cost actually falls from $16 to $12. Conse-quently, the employer could increase profit by hiring an additional 400 workers, since MRPL = $12 for the 1,200th worker. Furthermore, there happen to be 400 additional workers who apply for jobs at $12 per hour. Hiring those workers would, as if by magic (actually by coincidence), result in the competitive-labor market outcome. Returning to Table 8-3, collective bargaining has the potential of maximizing the total surplus at $14,400.

Many economists, some of whom put ideology ahead of professional compe-tence,21 have a difficult time with the competing theories of labor unionism. The general theory of the second best (aka the theory of countervailing power) states that the best outcome is typically a competitive market.22 Hence, monopolizing an otherwise competi-tive labor market will result in inefficiency: While workers may attain higher wages,23 the increase in labor’s surplus is smaller than the loss of employer’s surplus—another case of

20 One important issue in the bargaining process is whether all workers to be covered by the contract in fact belong to the union. So called “right-to-work” (RTW) laws prohibit mandatory union membership clauses in collective bargaining contracts. The National Labor Relation Act requires that all workers in a bargain-ing unit receive contract benefit, regardless of whether they belong to unions or not. Unions argue that mandatory union membership clauses are necessary because otherwise non-union workers will free-ride, receiving benefits without paying for them with dues or engaging in strikes. Economists have documented that fewer workers belong to unions in right-to-work states, although they continue to debate whether this is because of RTW laws themselves, or that the population was already hostile to unions before RTW passed, since the enabling legislation was the 1947 Taft-Hartley Amendments to the National Labor Relations Act. (Taft-Hartley was passed by a Republican Congress over President Harry S. Truman’s veto). 21 One such colleague once proclaimed “An open mind is an empty mind.” He refused to answer what a closed mind is full of. 22 John Kenneth Galbraith would seem to dissent from this prospect, because he believed that ideally com-petitive markets are rarely achieved in practice. 23 Although these wages may be absorbed in excessive union dues.



excess burden. Further, if fewer workers are hired (e.g., by competitive supermarkets), then consumer prices would increase, making consumers worse off.

Unions and Non-Union Wage Rates

However, if the pre-union state of the labor market were a monopsony, then in-troducing collective bargaining probably24 will improve the economic efficiency of that market. Economic theory is neither consistently pro-union nor anti-union. In fact, most economists would argue that unionizing grocery clerks is probably inefficient, since there would be sufficient competition among grocery stores to achieve a competitive outcome. On the other hand, introducing collective bargaining and free-agency into professional sports (whose stars can make millions of dollars a year) is efficiency enhancing because it spreads the talent around and increases the number of professional baseball players.

The ultimate test of the efficiency impact of labor unions on labor market effi-ciency is how union wages affect the wages received by non-union workers. If collective bargaining increases employment in the union sector, it follows that non-union wages would increase as the migration of labor into union jobs reduced the quantity of non-union labor supplied. On the other hand, if unions reduced employment in an otherwise competitive labor market, non-union workers would be crowded into non-union jobs, re-ducing the wage rate as the surplus of labor was absorbed.

To test the impact of unionization on non-union wages, I recently completed a pa-per that compares union and non-union wages in right-to-work states (where the extent of unionization is weak), and union-shop25 states (where unionization is stronger). If non-union wages are higher in right-to-work states, then the competitive model is supported, and we can conclude that unions are, on balance, inefficient. If non-union wages are lower in right-to-work states, other factors constant, then the evidence supports the bilat-eral monopoly model. Figure 8-1026 shows a map of the states which have passed right-to-work laws, including Indiana and Michigan, which passed right-to-work laws after Tea-Party Republicans took over the state legislatures in those states. Essentially right-to-work laws allow workers to receive union benefits (as mandated by the National Labor Relations Act of 1935) without paying union dues or supporting union-sanctioned strikes. By allowing free riding, right-to-work laws reduce union membership, making it more difficult for unions to win employer concessions through collective bargaining or to in-crease union wage rates through controlling labor supply.

Note that most of the right-to-work states are concentrated in the southeast, the agricultural states, and the mountain west; with the exception of Michigan, which passed

24 I say “probably” because (1) we could have the extreme outcomes of monopoly or monopsony ineffi-ciency, and (2) the transaction costs for employers (maintaining personnel knowledgeable about collective bargaining) and for workers (union dues and strike-related costs) could exceed the efficiency gains of col-lective bargaining. 25 A union-shop is a job site (bargaining unit) where employers agree to discharge any worker who refuses to join the union that represents him or her after some probationary period. Mandatory union membership is not automatic in union-shop states; the absence of right-to-work laws means the courts in those states will enforce the contract (e.g., find against a worker discharged for not joining a union, if that worker brings a wrongful termination suit). In practice, governments rarely agree to mandatory union membership requirements, even in union-shop states that allow such contracts. 26 The source for Figure 8-10 is the National Right-to-Work Committee, http://www.nrtw.org/rtws.htm.



its right-to-work law after the 2012 election, the only right-to-work states voting for Barack Obama were Nevada, Iowa, Virginia, and Florida; the only union-shop states vot-ing for Romney were Montana, Missouri, Kentucky and West Virginia. Republicans tend to represent the interest of employers, and hence are anti-union. Democrats rely on union support to counteract the spending of the rich and corporations, and tend to support unions. What is interesting is the attitude of non-union workers toward right-to-work laws. If unions increase union pay by operating as labor cartels, increased unionization would tend to decrease non-union wage rates; anti-union sentiment among working class red-state residents would be consistent with self-interest. If, however, unions tend to counteract employer monopsony, then increasing unionization would increase the aver-age wage rate received by non-union workers. In this case, anti-union workers would sacrifice their income in support of an ideology contrary to their economic self-interest.

Figure 8-10

Figure 8-11 presents the trends in union membership among workers in union-shop states and right-to-work states.27 Two conclusions are obvious: (1) the proportion of adults who belong to labor unions is about twice as great as the proportion for RTW states, and (2) both proportions are decreasing through time. Less obvious, but nonethe-less significant, is the fact that union membership is declining more rapidly in union-shop states (0.28 percent per year) than in RTW states (0.16 percent per year). At these rates, union membership would fall to zero in 2048 in right-to-work states and would fall to zero in 2063 in union-shop states.

27 Data come from the outgoing rotation of the Current Population Survey, January 1983 to December 2011. The samples contain 3,171,631 residents of union-shop states and 1,863,274 residents of right-to-work states.



Figure 8-12 presents the relation between the strength of union membership and the average, inflation-adjusted wage rate received by workers who belong to unions. Since union organizing is more difficult in right-to-work states – unions cannot bargain for mandatory union membership contracts – we expect unions to be in a weaker bargain-ing position. Indeed we find that union workers in right-to-work states earn about $0.56 less per hour than they earn in union-shop states.

Figure 8-13 addresses the ultimate issue of this natural experiment: how does un-ion bargaining strength, as measured by the proportion of workers who belong to unions, affect the average wage rate received by nonunion workers. The labor-cartel theory im-plies that unionizing an otherwise competitive labor market crowds reduces employment in the unionized sector, crowding workers into non-union jobs. This increase in the sup-ply of non-union labor would depress non-union wages. Hence, if the labor-cartel theory is generally true, we should find that non-union wages are higher in right-to-work states relative to union-shop states. By contrast, the collective-bargaining theory implies that if

u = ‐0.0028t + 0.226R² = 0.9618

u = ‐0.0016x + 0.1052R² = 0.8988

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Percent of Non‐m

anagerial workers in

unions

Figure 8‐11: Union Membership and Right‐to‐Work Laws

union‐shop states right‐to‐work states

Linear (union‐shop states) Linear (right‐to‐work states)

$17.50

$18.00

$18.50$19.00

$19.50$20.00

$20.50$21.00

$21.50$22.00

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Average

wage rate in

2011 dollars

Figure 8‐12: Average Wage Rates for Union Members




unions counteract employer monopsony power, collective bargaining increases both the union wage and employment in the unionized sector. As a result of workers migrating from the non-union to the unionized sector of the economy, average wage rates should be higher in union-shop states relative to right-to-work states.

The evidence in Figure 8-13 is fairly clear. Non-union workers in right-to-work states consistently earn $1.20 per hour less in right-to-work states than in union-shop states.28 As in many other issues involving “red”(right-to-work) and “blue” (union-shop) states, workers in states with anti-union states suffer lower wage rates as a result of their prejudice against “collective” activity.

Summary

1. In factor markets, households sell the services of factors of production—labor, capi-tal, land, and entrepreneurship—to firms in exchange for income—wages, interest, rent, and profit (dividends). Households allocate resources between market and household production to maximize satisfaction; firms allocate resources to maximize profit.

2. In allocating time between market production (a job), personal maintenance, house-hold production, and leisure, individuals tend to increase the quantity of time working as the wage rate increases (the substitution effect) until, at some point, further in-creases in the wage rate tend to reduce the number of hours worked (the income ef-fect).

3. Market supply curves tend to be positively related to the wage rate for two reasons: (1) as wage rates increase, individuals increase the number of hours they work, and (2) higher wage offers attract additional individuals into the market. Even if the indi-vidual labor supply curves eventually bend backward, migration into an open labor market keeps the market labor supply curve positively sloped.

28 Controlling for age, gender, education, and occupation, the inflation-adjusted wage difference is $1.12 per hour lower in right-to-work states.

$10.00

$11.00

$12.00

$13.00

$14.00

$15.00

$16.00

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Average W

age Rate in

2011 Dollars

Figure 8‐11: Average Wage Rates for Non‐Union Workers




4. The demand for labor is negatively sloped because of the law of diminishing marginal productivity; as more workers are hired, the output generated by the last worker hired gets smaller and smaller. The price-taking firm maximizes profit when it hires labor so that the value of labor’s marginal product ( LP MP ) equals the wage rate (includ-

ing fringe benefits and employer-imposed taxes).

5. A competitive factor market reaches equilibrium when the price of the factor (e.g., wage rate, rental rate, or interest rate) equates the quantities supplied and demanded. The competitive market maximizes employment in that market, as well as the sum of the employers’ surplus and the factor owners’ surplus (economic rent).

6. Since producers in imperfectly competitive product markets produce less output (where MC = MR) than they would if those markets were competitive (where MC = P), those employers tend to higher less labor than they would if they functioned in a competitive product market.

7. Labor monopoly exists when a trade union or professional association controls labor supply to create a higher market wage. If employment and wages would have been set by a competitive market, labor monopoly reduces employment, while increasing the quantity of labor supply. The job rationing problem can give rise to excessively high dues (reducing the after-dues pay to the reservation wage of the last worker hired), or require nepotism or some other form of job discrimination to determine what applicants acquire the high-paying jobs.

8. Employer monopsony exists when an employer faces a positively sloped supply curve for labor. Unless the employer can practice wage discrimination, the marginal expense of labor will exceed the wage rate. The monopsonist will maximize profit by setting the marginal expense of labor equal to labor’s marginal revenue product, then pay the market-clearing wage rate for that quantity of labor.

9. Bilateral monopoly exists when the wage rate is set through negotiation between a monopoly labor union and a monopsony employer (or employers’ association). The wage negotiation we take place in a bargaining range between the monopsony wage and the marginal revenue product for the last worker hired. In the case of a compro-mise solution within this range, the average cost of labor will rise, but the marginal expense of labor will fall, causing employment to expand.

10. How labor unions affect the wages of non-union labor depends on whether unions counteract competitive markets—job-crowding from workers displaced from union-ized markets decreases non-union wages—or if unions operate under conditions of bi-lateral monopoly—higher union wages reduces the supply of labor in the competitive sector, raising the wages received by non-union workers.

11. Empirical evidence indicates that non-union wages are significantly higher in union-shop states (states where unions can bargain for mandatory union membership con-tracts) than in right-to-work states, where unions tend to be weak. This evidence sup-ports the bilateral monopoly model and contradicts the competitive model of union-ism.



Glossary

Patriarchal system: A social system in which men (fathers) function as (benevolent) dictators

Matriarchal system: A social system in which women (fathers) function as benevolent dictators

Household production: The allocation of time, capital (appliance) services, and land to turn market goods into final goods and services consumed jointly by household mem-bers.

Market production: The allocation of time to a job in exchange for wages used to pur-chase commodities from the business sector.

The substitution effect: As wage rates increase, households tend to offer more labor time as the price of leisure (and household production) increases.

The income effect: Since leisure is a normal good, eventually higher wage rates tend to result in fewer labor hours offered by individuals and households.

Commodity-intensive consumption: Consumption activities that economize on time by using many market goods—a restaurant meal is more commodity-intensive than a home-cooked meal.

Time-intensive consumption: The opposite of commodity-intensive consumption, con-sumption activities that use much time and little market goods; reading is more time-intensive than watching a play (since the actors’ time are commodities for the audi-ence).

Backward-bending labor supply: The tendency for the quantity of labor supplied to eventually decrease at high wage rates, caused by the income effect overtaking the substitution effect of the wage increase.

Closed labor market: A labor market that has restrictions to entry, such that the market supply curve may actually display backward-bending characteristics.

Competitive labor-market equilibrium: The wage rate that equates the quantities of labor supplied and demanded, maximizing employment and the sum of the employ-ers’ surplus (gross profit) and workers’ surplus (economic rent).

Value of marginal product – a worker’s marginal product times the price of the product; the worker’s contribution to the revenue of a price-taking firm.

Marginal revenue product: A worker’s marginal product times the marginal revenue from the units produced; the contribution to the revenue of the price-searching firm.

Labor cartels: Imperfections in labor markets where sellers can set the market wage by limiting labor supply

Monopsony: A market with one buyer, who sets wages below competitive levels in order to obtain monopsony profit

Bilateral monopoly: A market, such as collective bargaining, with one buyer and one seller, where the market price is set within the bargaining range between the monop-



sony and monopoly prices, and may result in more efficiency than markets dominated by market power on one side and competition on the other

The general theory of the second best, or, countervailing power: Names given to the prospect that bilateral monopoly is more efficient than unchallenged labor cartels or employer monopsony

Wage discrimination: Paying unequal wages to equally productive workers. Wage dis-crimination is unlikely in a competitive market since it would reduce employer prof-its. Wage discrimination is more likely under employer monopsony if one group (e.g., men) can be hired at a higher wage rate without paying higher wages to another group (i.e., women).

Job discrimination: Using gender, ethnicity, or other irrelevant characteristic to ration jobs in the face of a labor surplus, typically encountered in markets dominated by la-bor cartels.

Union shop: An employment agreement whereby all covered employees must join the union that represents them as a condition of continued employment

Right-to-work laws: State laws that render union-shop contract clauses unenforceable.

Closed shops: Employment situations in which only union members can be hired, which were declared illegal by the 1947 Taft-Hartley Amendments to the National Labor Relations Act.

Union-threat effect: The prediction that non-union employers may pay closer to union-scale wages as a strategy to prevent their employees from ratifying a union to repre-sent them in collective bargaining.

Chapter 9 Human Capital and the Economics of Education


A Review of Financial Markets and Investment Decisions

In Chapter 3 we discussed household saving and the role of financial markets in delivering those funds to borrowers. Depositing money in the bank is virtually riskless today because of federal bank-deposit insurance. I deposit my money; the bank provides services (security, record keeping, and funds transfers) and pays modest interest. I can spend the money directly by writing checks, or transfer my money to a savings account or a certificate of deposit. In return for sacrificing liquidity,1 I receive a higher interest rate. The stock market pays a higher average rate of return than bank deposits do because there is a greater risk of financial loss in the stock market, and because there are greater trans-action costs in buying and selling stocks or bonds (paying brokerage commissions) than there are in withdrawing funds from a saving or checking account.

Economists abstract from risk by defining the expected value of a financial asset. Depositing $1000 in a certificate of deposit is essentially riskless. If the CD pays 2.5 percent per year, next year I will have $1,025; in two years I would have 1000(1.025)2 = $1050.63. However, suppose that I decide to buy $1,000 worth of stock in a start-up company, Flybynight.com. The company representative promises that I’ll get 20 percent per year on my investment. After checking with a trusted financial advisor2 I learn that there is an 80-percent chance that the stock will “take off” and be worth $1,440 in two years (a 20-percent return, compounded), but that there is a 20-percent chance that the stock will be worthless. The expected value in two years is the average of the two sce-narios, where each scenario is weighted by its probability: .2(0) .8(1440) $1,152EV . Now, since I have the option of investing my money for two years at 2.5 percent, the pre-

sent expected value is 2

1,152$1,096.50

(1.025)PEV . The expected return to Fly-

bynight.com is only $96.50 better than depositing my money in a CD; this difference is called the risk premium. Would you be willing to risk a 20-percent loss of $1000 in ex-change for $96.50? If not, then you are risk adverse; a risk-adverse person suffers disu-tility from bearing risk, and therefore must be paid a positive risk premium if she is to bear risk. If your behavior were consistent, you would pay more than $96.50 (pay a risk premium) to avoid a loss. Risk-adverse people tend to buy insurance, even when they know that the present expected insurance payment (which occurs only if something bad happens) is less than the present value of premiums.3

If you would prefer to put the $1,000 into the stock market for a $96.50 risk pre-mium, then you might be (1) a risk lover, who would actually pay a premium to take a risk (i.e., a gambler who keeps playing, even knowing that the odds favor the house); (2) a risk-neutral person, who always prefers the option with the highest expected return,

1 Liquidity is the ease with which wealth can be transformed into cash. Money (cash plus checking depos-its) are 100 percent liquid; savings deposits are less liquid. Houses and cocaine are very illiquid. 2 Is this an oxymoron? 3 Life, of course, is more complicated than theory. Insurance agents have found a way of coercing people to buy life insurance as a sign of affection for one’s family; try as I might, I have never been allowed to talk to a life insurance agent without Regina being present. Then I have to explain to Regina why I only want $500,000 of insurance instead of $1,000,000; stating the obvious, that I wouldn’t be around to enjoy it, is construed by the agent as a deficit of affection on my part.



regardless of risk;4 or (3) a risk-averse person who demands a risk premium smaller than $96.50. A risk-loving person will tend to prefer prospects with a chance of a big payout, even if the expected value of that prospect is smaller than the expected value for a less risky prospect. A risk-neutral decision maker will prefer the prospect with the highest expected value. A risk-averse person prefers a certain prospect to a risky one, and would pay a risk premium to avoid risk.

Recall that economists distinguish between loaning money at interest, and an in-vestment, which is a resource-using activity whereby a person or a business incurs an opportunity cost in the present (foregone income, research costs, machine or building purchase costs) with the hope of increased productivity (and hence, increased income) in the future. If I deposit my money in a bank account, I am lending my money to the bank; the bank leases my money by paying interest. If the bank lends the money to a business, the business leases the money from the bank by paying interest; the bank earns a profit by charging their borrowers higher interest than the banks pay their depositors (the bank bears the risk of loan default). If and only if the business purchases plant, equipment, or otherwise uses the money to purchase resources does the loan lead to an investment.

Human Capital Investments

One of the true investments that people can make (as opposed to lending money to a business that purchases plant and equipment) is the investment in human capital. Capital is a produced means of production; human capital is an investment that is intend-ed to make people more productive. The two most important types of human capital in-vestments are formal education (which should be self-explanatory) and on-the-job training, which occurs when workers devote time and effort to learning on the job. Oth-er types of human capital investments include exercise and diet that increase stamina, changing locations to take a higher paying job (presumably because the person is more productive at the new location), and even plastic surgery.5

The difference between on-the-job training and formal education is often a differ-ence in convenience. Carpenters can best be trained by other carpenters by watching and learning by doing. Accountants are trained in college before being set loose on account-ing firms, but often much of the time they spend as neophyte accountants is learning the ropes. The movie Master and Commander: Far Side of the World has several scenes where the captain schools the midshipmen in seafaring arts.

Generally speaking, the student learns how to think in formal education, while he or she learns to apply that aptitude for learning to a specific task on the job. Many occu-pations, most notably medicine, have a formal internship program following the comple-tion of formal education. Assistant professors and associate attorneys are also expected

4 Large organizations—countries, corporations, banks, and insurance companies—act as if they are risk neutral because of the law of large numbers. The more chances one takes, the smaller will be the departure from the expected value, as long as the risks are independent of each other. Hence, an insurance company will insure homes against random events, like lightning strikes, but charges much more to insurance against war, acts of terrorism, or widespread natural disasters. 5 A few years ago after an exotic dancer’s breast-augmentation surgery increased her bust size from 36 inches to 72 inches, she was allowed to deduct the cost of her operation after the tax judge ruled that such an operation provided no personal benefits.



to learn on the job, without neglecting their formal job requirements. Failure to learn by doing implies termination (not achieving tenure or not making partner).

So far we have investigated the market for a simple labor skill, apple pickers, which people can easily learn by watching other workers. However, the theory of com-petitive labor markets is relevant to a large number of markets, including the market for economists. However, it takes years of study and experience to become a professional economist. Recall that economists refer to human capital as those skills that are created through investment-like activities.6

Figure 9-1 shows the relation between average wage rate (in 2009 dollars) and years of schooling, using data from the March 1962 Current Population Survey. Each blue point represents the average male wage rate, expressed in 2010 dollars,7 while the blue line represents the fitted regression line. According to this line, each year of schooling from the first through the eleventh grade and for the thirteenth through the fif-teenth grade increases a man’s wage rate by nearly $0.58 per hour. Completing the 12th grade increases earnings by $1.65 and completing college increases earnings by $5.18 per hour. These two jumps are known as the sheepskin effect: completing a course of study is worth more to employers than is completing a year of schooling that does not lead to a degree. Employers value workers who can complete tasks.

6 In my first publication, “Education and Income: An Analysis by Fable,” The American Economist, Fall 1973, I argued that success in schooling is more likely for students who like learning and are good at it. Hence, education is a consumption activity (an activity that generates immediate rewards) with investment-like payoffs. 7 I use the consumer price index to translate wage rates computed from 1962 (wage and salary earnings in 1961 divided by total hours worked in 1961), times the ratio of the consumer price index for 2009 (218.056) to the consumer price index in 1961 (29.9). In other words, we multiply the wage rate in 1961 dollars by 7.3 to obtain wage rates in 2009 dollars.

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

0 4 8 12 16 20

Average W

age Rate in

2010 Dollars

Years of Schooling Completed

Figure 9‐1: Education and Wage Rates in 1962

Male Wage Rates Female Wage Rate

Predicted Male Wage Predicted Female Wage



What is remarkable about the earnings patterns for men in 1962 is that completing a post-graduate degree could reduce a man’s earnings. Men with masters degrees earned an average of $24.17, compared to $23.14 per hour for a college graduate. Completing a Ph D, law degree, medical degree, or another advanced degree reduced the hourly wage rate to $21.62 per hour, 6.6% less than a bachelor’s degree and 10.6% less than a masters’s degre. Each year of schooling except for the 12th and 16th increased a woman’s wage rate by only $0.34 per hour; she gained $1.78 with a high school diploma and $4.21 per hour with a college diploma. However, after the 16th grade an extra year of schooling increased a woman’s pay by $1.94 per hour, so that a woman with an advanced degree earned as much as a man with an equivalent education.

Figure 9-2 jumps ahead in time to 1987, about the time most of you were born. According to Figure 9-2, the average wage rate for men with zero education started at $12.21 per hour and increased by only $0.10 per hour for each additional year of school-ing through the eleventh grade, rising by $3.83 per hour with a high-school diploma. By contrast, the first eleven years of schooling added nothing to the hourly earnings of a woman, who earned an average of $9.05 per hour. Women gained $2.61 from high school graduation. A reversal of the pattern in 1962, men gained $0.95 per hour per year of graduate school, while women received only an additional $0.21 per hour. Hence, the relative earnings of men and women diverged after college.

Figure 9-3 plots the relation between the wage rate and the years of schooling in 2011. Here we find that the relation between the wage rate and schooling is flat for both men and women through the 12th grade. A person without a high school diploma earned about the same wage rate in 2011 as a comparable person earned in 1987. If a student considered the prospects of graduation slim, there would be no incentive to continue through the 12th grade only to receive a “certificate of attendance” if she did not pass her

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

0 4 8 12 16 20

Average W

age Rate in

2010

Dollars

Years of schooling completed

Figure 9‐2: Wage Rates and Schooling: 1987

Male Wage Rates Female Wage Rates

Predicted Male Wage Predicted Female Wage



proficiency exam. Both men and women receive a small bump from high school gradua-tion and roughly the same gain for each year of school after high school, so that the small gap between male and female wage rates is roughly constant over all education levels.

The evolution in the human capital market between 1962 and 2011 shows the ef-fect of the transition of the American economy from manufacturing to service and infor-mation technology. Part of this evolution reflects the sheepskin effect, which predicts that employers have an incentive to embellish that ability, and the prudent employer under-stands this incentive. Therefore, employers seek documentation of education, such as school transcripts, standardized test scores, professional certifications, and letters of rec-ommendation from former employers.8 A transcript documenting that the student dropped out of high school in the 11th grade not only reports the level of education, but also communicates to the employer that the job seeker failed to complete his or her edu-cation.

The Choice of a College Major: Human Capital Investment Decisions Under

Uncertainty

Most students pick their college major based on a number of factors: their enjoy-ment of the subject matter, their aptitude for that major (how hard the subject is compared to other students, their perception of the monetary and non-monetary aspects of the occu-

8 Another recent trend in our litigious society is for job seekers to sue their former employers for adverse letters of recommendation. As a result, corporate attorneys are recommending that their clients write very terse letters of the form “John Smith was employed here from January 1 to December 31, 2001.”

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

0 4 8 12 16 20

Average W

age Rate in

2011

Years of school completed

Figure 9‐3: Educational Attainment and Average Wages Rates in 2011

Average Male Wage Rate Average Female Wage Rate

Predicted Male Wage Rate Predicted Female Wage Rate



pation(s) associated with the major, and the riskiness of the occupations. The 2010 Amer-ican Community Survey9 collected information about the undergraduate major (field of degree) for all subjects with a bachelor’s degree or better. Using these data we can com-pare the average earnings and the variability in earnings for each major. Table 9-1 shows the data for selected college majors, based on tentative choices by members of the sum-mer 2012 ECON 180 class. The last line shows the data for all majors; we use this line as a reference. For the 28,171 graduates with bioscience degrees,10 the average earnings are $64,250, with a standard deviation of $90,299.11 Compared to the average college gradu-ates, bio-science majors earn about 29% more than average, and experience a standard deviation about 37% higher than for the typical graduate. I measure a major’s riskiness as the ratio of the standard deviation to the mean. So while the average riskiness for all ma-jors is 1.32, being a bio-science major is riskier. If risk is bad (the prospect of earnings well above average is matched by the prospect of earnings substantially below average), then we would expect riskier occupations to pay more. We find that a typical business major (excluding the business-economics major) earns slightly more than the average, and experiences slightly less risk.12 By comparison, economics majors earn about 16.7% more than (other) business majors, but experience greater risk. Note that engineering ma-jors, while earning substantially more than the average college graduate have a smaller risk factor – roughly comparable to social work majors. Hospitality majors earn less than (other) business majors, and experience greater risk. Of all the majors listed, social work majors earn the lowest average pay and tie engineers for the least risk. Let’s hear it for altruism!

Table 9-1

Earnings Statistics for Selected College Majors

Undergraduate Number Mean Stdev riskiness maximum

Major 25th 50th 75th

Bio‐science 28,171 $64,250 $90,299 1.41 $8,000 $37,800 $80,000 $641,000

Business 76,747 $58,844 $70,867 1.20 $7,000 $45,000 $75,000 $641,000

Economics 15,830 $68,681 $99,230 1.44 $5,400 $35,000 $84,000 $641,000

Engineering 51,253 $66,941 $71,627 1.07 $12,600 $60,000 $95,000 $641,000

Hospitality 1,726 $45,948 $58,655 1.28 $9,600 $35,000 $60,000 $568,000

Social Work 4,954 $33,220 $35,615 1.07 $1,800 $30,000 $50,000 $499,000

All Majors 628,589 $49,726 $65,806 1.32 $100 $35,000 $70,000 $641,000

Percentile

9 In 1999 to Bureau of the Census decided to collect a sample of approximately 3,000,000 people, usually collected every 10 years as part of the decennial census (the long-form) every year. They called the survey the American Community Survey; this week (May 21-May 25, 2012) the Republican House of Representa-tives voted to discontinue (that is, defund) the ACS (the savings would be trivial). Many American busi-nesses have complained that they use the ACS for their economic and marketing decisions; perhaps, after they defeat Barack Obama, the House will relent. 10Biology, biochemical sciences, botany, molecular biology, ecology, genetics, microbiology, pharmacolo-gy, physiology, zoology, or miscellaneous biology. 11 Average earnings are computed by adding all annual earnings and dividing by the sample size; the stand-ard deviation is obtained by subtracting the sample mean from the individual’s earnings, squaring, dividing by the number of observations (minus 1), and taking the square root. 12 The risk for all professions reflects differences in the difficulty of the major, non-monetary benefits, pres-tige, and other factors not likely to vary within majors.



The last four columns in Table 9-1 show the values for the 25th, 50th (median) and 75th percentiles. Note in each case, the median annual earnings are substantially less than the average annual earnings. This reflects the skewness of earnings data. The lowest wage or salary a person can receive13is $0, and the wage and the maximum salary report-ed is $641,000.14 Figure 9-4 shows that it is more likely that a college graduates will be close to zero (below average) than close to $600,000, compared to the blue reference line, which depicts how the data would look if earnings were normally distributed.

Figure 9-4

Table 9-1 contrasts the earnings of bio-science and economics majors according to the highest degree they attain. If a bio-science major obtains a professional (most like-ly a medical) degree, they earn considerably more than economics majors who receive a professional (most likely a law) degree. However, for the roughly 50% of bio-science and economics majors who do not advance beyond the bachelor’s degree, economics ma-jors earn considerably more, on average, than do bio-science majors. Similarly, if bio-science majors settle for a master’s degree, they can expect to earn less than an econom-ics major who obtains a master’s degree. Finally, economists with academic doctorates

13 A rich person might be willing to pay a substantial amount to obtain a prestigious or enjoyable job; clear-ly Mitt Romney, should he win the presidential election, will earn less than the amount of his own fortune he is spending in pursuit of the Republican nomination and the presidential election. However, were he sampled in the 2013 American Community Survey (his first year as president), he would report only his wage and salary, and would not report how much he had bet to improve his chances of winning the presi-dency. The lowest individual earnings reported in the 2009 ACS is $0 for someone who worked without pay. 14 The earnings data are top-coded to avoid violating respondent confidentiality.

02

.0e-

06

4.0

e-0

66

.0e-

06

8.0

e-0

61

.0e-

05

Den

sity

0 200000 400000 600000annual wage and salary income

Source: 2009 American Community Survey

For All Subjects Reporting College Major and Positive EarningsAverage Wage and Salaiy Income



(Ph.D.’s) earn considerably more, on average, than do bio-science majors who settle for an academic, as opposed to a professional, doctorate. What Table 9-2 are the tournament aspects of the bio-science major. Slightly less than 25% of bio-science receive a profes-sional degree; these winners earn approximately three times what the bio-science major earns who stalls at the bachelor’s degree; this reflects the fact that only a fraction of bio-science majors who apply to medical school are admitted. By contrast, nearly every eco-nomics major who desires a Ph. D. in economics or a law degree gains admission; hence an economics major with an advanced degree earns 50% to 60% more than a bachelor’s degree economist earns.

Table 9-2

Average Wage and Salary Income by Degree and Major

Highest

Degree earnings percent earnings percent

bachelor's $32,678 46.64% $61,906 49.85%

masters $54,648 18.87% $65,802 38.33%

professional $124,626 23.71% $110,730 8.33%

doctorate $84,864 10.78% $96,736 3.49%

Total $64,250 100.00% $68,681 100.00%

Bioscience Economics

To complete this section on the riskiness of human capital investments, Figure 9-5 depicts the risk-return tradeoff for 171 college majors. The horizontal axis depicts the riskiness of alternative majors, measured as the coefficient of variation (standard devia-tion divided by average wage and salary income), ranging from the safest occupation (electrical and mechanic repairs and technologies) to the riskiest (general social sciences). The trend lines show that as the riskiness of a college major increases, the average earn-ings (the return) decreases. This finding contradicts the convention in finance literature that riskier financial “investments” generate greater return. According to finance theory, people are generally risk averse; if they purchase a stock or bond, they less risky assets to assets with a greater coefficient of variation. Suppose there were 2 shares of stock, both selling for $20 at their initial public offering. After a few years, purchasers of shares in company A received an average dividend of $2 per year, while experiencing wide swings in the value of their shares from $1 to $39. Over the same period, purchasers of shares in company B also receive dividends of $2 per year, but the price of their shares fluctuate only between $18 and $22. As a result, shareholders would sell shares in company A (causing the price to fall, to say, $15), and would attempt to purchase shares in company B, causing their shares to rise (to say, $25). If both companies continued to pay divi-dends of $2 per year, and holders of company A stock would receive a 13.3% return, while the holders of company B stock would receive an 8% return.

There are several possible explanations that can possibly explain why human cap-ital investments exhibit a negative relation between risk and return. First, there is no sec-ondary market for human capital; those who mistakenly pick the wrong major (in terms of their own interests) cannot sell their education to another. Second, while financial markets are highly competitive, allowing individuals to purchase shares in any company for roughly the same commission rate, many occupations (such as medicine) are not



competitive. Hence whether one wins the lottery at age 22 largely determines whether a bio-science major will receive a high or low income. Third, there is essentially no effort involved in purchasing financial assets; whether one’s education pays off depends largely on how much effort one puts forth later in life. Rewards in engineering do not vary great-ly by the amount of effort the engineer puts forth; there is a very different outcome for economists. One can become an economics professor and have a comfortable life, or one can be a hedge fund manager and have a frantic but (potentially) lucrative life. Further-more, some majors (economics, bio-science) are relatively difficult while others (social work and hospitality) are relatively easy. Hence, there is likely to be a greater range of outcomes for easy majors than for difficult ones.

Specific versus General Human Capital Investments

Another concern with human capital investments relates to whether skills are portable (general human capital) or not (specific human capital). By portable we mean that skills rewarded by one employer are also rewarded by other employers. Formal ed-ucation creates general human capital, meaning that the worker can use those skills (lit-eracy, mathematics, statistical analysis) in many different kinds of jobs for many different employers. The student bears the costs of formal education because the employer must pay the market wage for those skills, or the worker will “walk,” taking his or her skills along. A moment’s reflection will indicate that many skills created through on-the-job training are also portable. Learning to be an electrician, or a plumber, or an accountant would enhance one’s productivity with many alternative jobs. Accordingly, apprentices

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

0.00 0.50 1.00 1.50 2.00 2.50 3.00

Average Earnings in

2009

Riskiness (coefficient of variation)

Figure 9‐5: Risk and Return for 171 College Majors

average earnings Sample Mean

Unweighted Prediction Weighted Prediction

ELECTRICAL AND MECHANIC REPAIRS AND TECHNOLOGIES

EARLY CHILDHOOD EDUCATION

GENERAL SOCIAL SCIENCES

COSMETOLOGY SERVICES AND CULINARY ARTS



typically are paid less per hour than journeymen are, not only because they don’t know as much, but also because part of their “working time” is actually learning time.

The presence of minimum wage laws and other employment regulations may ac-tually deter on-the-job training. Suppose that a carpenter’s apprentice is worth $10 per hour when she works, but adds nothing to output when she learns (typically by watching a master carpenter). If she “clocks” 40 hours per week, the government requires that she be paid $8.25 per hour, even though she produces only $10 x 20/40 = $5 per hour in av-erage output. The result, the minimum wage law, prices her out of the market, making her ineligible for on-the-job training.

By contrast, specific education is applicable to only one employer. A manage-ment trainee who learns intricate organization charts and operating procedures specific to a company would not become more productive with another employer, unless that second employer could benefit from learning company secrets.15 In fact, he would likely be barred from revealing company secrets by a covenant not to compete. When workers in-vest their time to acquire specific human capital, they are usually compensated for that time. Paying workers more than they produce during the learning (investment) phase generates a positive return for the firm, which pays the worker less than he produces in the future. The cost of losing or replacing specific human capital investments helps ex-plain why businesses typically retain managerial workers during economic downturn, while laying off workers with general human capital. Finally, it is possible that specific human capital investments yield some monopsony power to the employer, who, by defi-nition, is the only buyer of those worker skills.

The Production of Education

Most financial investments involve an arm’s length relation between the creditor (e.g., bond owner) and debtor (company selling the bond). If the company’s use of those funds is profitable, the lender will receive promised interest (bonds) or a share of the profits (stocks). A person who invests in human capital is directly involved in the pro-duction of skills and knowledge. Indeed, the production function for human capital in-volves labor time by both students and instructors, in addition to capital (computers, classrooms), and land (the college campus). Students have the options of securing pure knowledge (studying at the library without matriculating, auditing classes, informal web-based learning), or formally registering for a course of study, agreeing to fulfilling certain academic requirements in exchange for reported grades (the transcript) and, if successful, the diploma.

Like other investments, investments in human capital are risky. Students who fail to learn required material or have an ideological or personal clash with the professor re-ceive a failing grade for the course and a blot on their record (transcript). As they learn

15 When employers fear that employees will divulge company secrets to competitors, they often require those employees to sign a covenant not to compete as part of their employment contract. The employer waves the right to fire the worker at will and usually pays a higher wage; in return, the employee promises not to work for a competitor for some specified time after his or her current employment terminates. Breach of that covenant can leave both the employee and the new employer liable for damages to the origi-nal employer’s profits.



more about their chosen major, they may find they do not enjoy that topic.16 Changing majors may postpone graduation; many students are reluctant to change majors because they have too much time and effort invested in their major. It is good to remember an important economics lesson: Bygones are bygones; do not continue to invest resources in a losing cause, or your losses are likely to increase.

The production of education is fraught with asymmetric information problems. First, before students possess the information their education is to provide, they lack the ability to estimate its value. After they have acquired that information, they have lost the incentive to pay for it.17 For this reason, a college degree is contingent on students ful-filling a fairly rigorous set of degree requirements. Students who fulfill these require-ments receive a diploma, and according to the sheepskin effect, a substantial increase in earning potential. Those who fail to meet those requirements receive low grades and a transcript that stigmatizes them as quitters or failures.

But exactly what is the university’s objective function? We learned in Chapter 2 that universities, like most religious organizations, hospitals, and artistic companies, are not-for-profit institutions. Hence, most universities do not seek to maximize the differ-ence between tuition (and grant) revenue and costs. Typically, universities wish to achieve prestige. But not everyone can be the best, so schools look for their niche. To be a great university requires an elite faculty. The University of Chicago has on its faculty more than half of the Nobel laureates in economics in the world. Yale can boast that both 2004 presidential candidates—George W. Bush and John F. Kerry—are Yale grads, alt-hough each was a heritage student, who received special consideration as sons of Yale alumni. UNLV can boast of being the best (and only) four-year public university in the city of Las Vegas.18

When picking a university, most people with academic doctorates consider many aspects of their job—the pay, the climate, the prestige, the research facilities, and the quality of the students. Private universities typically practice price discrimination by charging higher tuition to rich but mediocre students, in order to offer scholarships to middle- and lower-income promising students. Today, a high-income college applicant with low test scores has approximately the same academic prospects as a low-income student with high test scores. Also, the student’s progress is monitored by grades on the off chance that the university’s admissions department erred in the student’s admission or financial reward or that the student slacks off or is a diamond in the rough.

An interesting tale, which may be true or merely an academic legend, illustrates an adverse selection problem for universities aspiring to attract the “best” students. Ru-mor has it that during the 1930s, when the economy was already undergoing a major de-

16 As a student at Miami University, I changed majors four times: from journalism to English, from English to mathematics, from mathematics to political science, and finally, from political science to economics. As an economist, I combine all those skills: data collection and analysis (journalism), writing (English), prob-lem solving (mathematics), and logic (political science). 17 Economics Nobel laureate Kenneth Arrow popularized this conundrum, which has become known as Arrow’s paradox. 18 You take your glory where you can find it. Actually, the UNLV campus is outside the Las Vegas city limits, and the existence of Nevada State College in Henderson, UNLV is no longer the only four-year col-lege in Clark County.



pression, Harvard University experienced a rash of student suicides. Harvard admitted only straight-A students who were the top student in their preparatory or high school. But once at Harvard, which graded on a curve, many of those students received C’s, D’s, or even F’s. Unable to handle the humiliation or confront disappointed parents, some stu-dents tragically took their own lives. A decade later Harvard undergraduates were pre-dominantly World War II veterans, attending school on the GI bill. For survivors of Pearl Harbor, D-Day, Okinawa, and Bastogne, receiving a grade of C was trivial. There-after, Harvard and other universities appreciated the value of diversity.

Recently Princeton University announced a faculty policy of reducing the per-centage of A’s awarded to undergraduates from 73 percent to 35 percent. Many students decried the reduction in the reward for their educational effort, but the Princeton faculty has been steadfast in its remediation of grade inflation. While price inflation results from too much money chasing too few goods, grade inflation occurs when too many high grades chase too little educational excellence. This is a pernicious problem at UNLV, which measures faculty performance by polling students a week before final exams and asking, essentially, “Are you happy?” Students confronting unfinished semester projects, uncertain final exams, and low grades tend to reply “No,” and their instructors can be de-nied tenure, promotion, or “merit” pay increases. Those who have aced their exams are allowed to submit plagiarized papers from online term-paper mills and whose instructor has waived the final exam reward their instructors with rave reviews. Good instructors leave UNLV in disgust; mediocre instructors are promoted to full professorships.

To make matters even worse, UNLV, along with other institutions that have opted to maximize the number of students enrolled in classes early in the semester when the state allocates university budgets, has a very lax course drop policy. Universities typical-ly allow students to adjust their course schedules in the first week of the semester, drop-ping courses that they do not need or that conflict with a modified work schedule, and add courses on a space-available basis. After the first week, however, courses are closed and students may no longer add them. Nevertheless, students are free to drop their cours-es ten weeks into the semester. These drops do not appear on the student’s transcript. So a student can craft a high grade point average by consistently registering for six to eight courses, then dropping the most difficult two or three courses, receiving A’s and B’s in the remaining easy courses. This type of incentive system is known as moral hazard: When people are shielded from the consequences of undesirable behavior, they are less inclined to avoid that behavior. This policy further penalizes rigorous instructors who experience excessive drops (a mark of incompetence to some department chairs). Good instructors and good students are driven from UNLV, a consequence of adverse selec-tion. UNLV’s drop policy exacerbates the asymmetric information problem between graduates and potential employers. Word has it that while Las Vegas hotels and casinos hire UNLV graduates for entry-level (e.g., front-desk) jobs, they hire upper management candidates from more selective universities.

Suppose that Sally graduates from UNLV in four years, with a GPA of 3.8, hav-ing registered for 288 credit hours, and having completed the required 180 credit hours. Nowhere do employers learn that Sally bailed out of three of eight of her classes, follow-ing a strategy of over-committing and underperforming. This work ethic may show up in her employment interview, but perhaps she will get the job based on her superb (if coun-



terfeit) academic record and sterling letters of recommendation from mediocre profes-sors. It is unlikely that Sally will be able to hide her lack of education and poor work habits forever, however. Eventually, Sally is terminated and leaves her first job with a scarred resume. Following old Scottish expression, “Fool me once, shame on you; fool me twice, same on me,” this employer will give little credence to high GPAs from UNLV again. Accommodating poor students ultimately hurts good students. Since good stu-dents have more options than poor students, good students will flee UNLV.

Because potential employers understand that some UNLV students have inflated grades, they will reduce their wage offer to all UNLV graduates. Students with rigorous educations will avoid these employers, who will receive job applications only from sub-par students. Eventually poor students drive out good, and the UNLV president wonders why UNLV has failed to become the UCLA of Nevada. Students who desire an educa-tion should seek out exceptional departments—like economics and architecture—who maintain high standards despite the lack of administration support. And serious students should petition their student government for an immediate change whereby UNLV posts drops on student transcripts, or moves the drop deadline to the first week of the semester.

Discrimination in Education19

Nearly every school rewards educational success and punishes educational failure. This discrimination starts in kindergarten and continues through graduate or professional schools. Successful students receive A’s, gold stars, and encouraging words from their teachers. Unsuccessful students receive F’s, black marks, hostile parent-teacher confer-ences, and, in the extreme, failure (having to repeat a grade). I myself started school as an unsuccessful student; I could not read, particularly orally. I still remember humiliating sessions when nuns in the first and second grades ridiculed my stammering and encour-aged my classmates’ derision. In the third grade I had a lay teacher, Miss Koogler, who recommended to my parents that I repeat the third grade. My parents concurred and so I repeated the third grade, the second time with a nun as my teacher and my oldest younger sister as a classmate. Luckily, I learned to read and I learned to love schooling. By the eighth grade I was accompanying several of my male classmates to algebra and English courses at the parochial high school. In high school I took honors classes and graduated sixth out of 333.

Having grown up in a white, mostly Catholic neighborhood, I did not meet a black student until high school. Dayton (Ohio) Chaminade, my high school, was the premier college-preparatory high school in the city, due mostly to the fact that the same order of religious brothers (male nuns) who taught at my high school also staffed the University of Dayton. Since most of my high school teachers were taking graduate courses to obtain Ph. D.’s so they could teach college, they instilled in us a yearning to attend college and succeed. And because the Dayton public high schools were racially segregated, the richest black families sent their sons (mostly Baptist) to study at my high

19 Much of this section is inspired by Charles J. Ogletree, Jr., All Deliberate Speed: Reflections on the First Half-Century of Brown v. Board of Education, Norton, 2004.



school. In my narrow experience, black students were more affluent than white stu-dents.20

Racial and gender discrimination have been ubiquitous in the educational system since the inception of our country. Slave owners were forbidden by law from teaching their slaves to read or write. Even freed slaves were banned from Southern schools, so free blacks and escaped slaves migrated north prior to the Civil War to achieve an educa-tion. Although blacks had access to schools in the North, those schools were usually re-served for blacks only. After the Civil War, slavery was replaced by Jim Crow laws that denied civil rights to former slaves. The Fifteenth Amendment to the Constitution, rati-fied in 1870, stated:

The right of citizens of the United States to vote shall not be denied or abridged by the United States or by any State on account of race, color or previous condition of servitude.21

So Southern states prohibited blacks from voting, or interacting with whites on an equal basis (including attending integrated schools) based on their grandfather’s condition of servitude. This racist loophole was formally upheld in the United States in 1896 in Ples-sey v. Ferguson, wherein the Supreme Court ruled, 7-1, that racial segregation in the form of separate but equal accommodations for blacks and whites was constitutional.

From the end of the Civil War until the middle of the twentieth century were schools segregated de juro in the South and de facto in the rest of the country. The Ples-sey rule of separate but equal emphasize the separation of the races, and governments cared little that black schools were inferior to white schools; after all, blacks could not vote. “On May 17, 1954, an otherwise uneventful Monday afternoon, fifteen months into Dwight D. Eisenhower’s presidency, Chief Justice Earl Warren, speaking on behalf of a unanimous Supreme Court, issued a historic ruling that he and his colleagues hoped would irrevocably change the social fabric of the United States. ‘We conclude that in the field of public education the doctrine of separate but equal has no place. Separate educa-tional facilities are inherently unequal.’”22

The Supreme Court’s decision in Brown v. Board of Education did not end segre-gation or discrimination in American education. However, the Brown decision did turn school segregation from an unchallenged fact of life in the country into a wedge issue separating liberals (the majority) and conservatives (then, the minority). A price for the unanimous Supreme Court decision was the inclusion of the words “all deliberate speed” in the Court’s order to offending school districts that were not defendants in the Brown v.

20 Ironically, our oldest son had the same experience in the first grade. I was teaching at Memphis State in 1985 when our son Michael was six years old. Like most children of Memphis State faculty, Mike attended campus school, which was staffed by master teachers from the School of Education. Because the Memphis City Schools were virtually all black (whites having fled to the suburbs or white-Christian academies in the face of court-ordered bussing), the black families with political or economic clout sent their sons and daughters to campus school. After about a week in the first grade, Mike came home and announced “Dad-dy, I know why our neighbors don’t like black people; black people have a lot more money than white peo-ple do!” 21 Microsoft ® Encarta ® 2006. © 1993–2005 Microsoft Corporation. All rights reserved. 22 Ogletree, All Deliberate Speed, p. 3.



(Topeka, Kansas) Board of Education. In the South, Democratic politicians like George Wallace, Lester Maddox, and Bull Conner curried favor with the white supremacist ma-jority by using state and local police to defy desegregation orders. With the passage of the Civil Rights Act in 1964, the Democratic Party split, between the pro-civil rights North and West, and the anti-civil rights south. Slowly, but inexorably, white suprema-cist politicians either switched to the Republican Party or were replaced by Republicans at election time. Today, the South is solidly Republican and blacks are one of the key core constituencies of the Democratic Party. For those who claim that racial equality has been achieved, how do you explain that the Republican Party became the dominant polit-ical party by pandering to racism?

Evidence of Educational Advances by Minorities

Table 9-3 shows the average inflation-adjusted wage rate for whites and blacks by level of educational attainment. For those who do not complete high school, the infla-tion-adjusted wage rate decreases by 0.56 percent per year for whites and 0.65 percent per year for blacks. For those with the least education, the typical black worker nearly earns 98 percent per hour of what the average white worker earns. For high school grad-uates without college, the inflation-adjusted wage rate also declines for both blacks and whites – 0.14% per year for whites and -0.26% per year for whites. Among those who attempt, but do not complete, college, white wage rates are essentially flat23 while black inflation-adjusted wage rates decline by 0.24 percent per year. Among college graduates, the rate of increase for whites is 0.63%, substantially greater than the 0.5% rate of in-crease in the black inflation-adjusted wage rate. Finally, for those with post-graduate de-grees, white wages grew at 1.07% per year, nearly twice the rate of 0.64% for blacks with advanced degrees. For high school graduates and above, blacks earn approximately 90% of what whites earn per hour, while white wage rates are declining less or increasing by more than black wage rates are.

We find that the gap between the earnings of blacks and whites tends to increase with education, and that that gap has been widening since 1979. There are several possi-ble explanations. First, schools in segregated neighborhoods typically afford better edu-cational opportunity for white and upper-income students than for black and lower-income students. Second, discrimination by teachers who expect blacks to underperform relative to whites often creates self-fulfilling prophecies. Third, there is a well-documented anti-intellectual culture among black youth, a culture that both Bill Cosby and Barack Obama have been working to overturn.

23 The rate of growth of 0.02 percent for whites is not significantly different from zero, with time explain-ing only 0.78 percent of the variation in the inflation-adjusted wage rate. The declining rate of change of -0.23 percent for blacks is significant at the 0.01-percent level, with time accounting for 42.36 percent of the change in the average real wage rate for blacks with less than four years of college.



Less than 4 years college Post Graduate DegreeYear white black white black white black white black white black

1979 $13.91 $13.27 $16.77 $15.32 $16.81 $16.29 $18.63 $18.21 $21.83 $21.57

1980 $13.23 $12.55 $15.82 $14.52 $16.04 $15.54 $17.88 $17.91 $21.19 $21.99

1981 $12.89 $12.58 $15.50 $14.24 $15.89 $15.52 $17.54 $16.58 $20.99 $19.42

1982 $12.64 $12.24 $15.38 $14.05 $15.66 $14.98 $17.95 $16.95 $20.66 $19.86

1983 $12.44 $12.21 $15.33 $14.11 $15.62 $14.97 $17.83 $17.69 $21.41 $19.95

1984 $12.22 $11.98 $15.09 $13.83 $15.49 $15.26 $17.72 $17.09 $21.18 $21.44

1985 $12.07 $11.64 $15.12 $13.50 $15.64 $14.83 $18.22 $17.99 $22.19 $20.33

1986 $11.96 $11.84 $15.15 $13.84 $15.76 $15.46 $18.38 $17.92 $22.02 $21.09

1987 $11.69 $11.55 $15.08 $13.70 $15.76 $15.13 $18.75 $17.92 $22.10 $20.70

1988 $11.59 $11.29 $14.92 $13.45 $15.50 $14.91 $18.85 $17.83 $22.10 $20.61

1989 $11.65 $11.21 $14.72 $13.16 $15.62 $14.89 $18.92 $17.94 $22.10 $20.26

1990 $11.37 $11.13 $14.54 $13.04 $15.67 $15.02 $19.15 $17.91 $22.64 $21.39

1991 $11.29 $11.03 $14.38 $12.90 $15.61 $14.88 $18.66 $18.42 $23.32 $19.95

1992 $11.09 $11.01 $14.38 $12.81 $15.14 $14.33 $19.06 $17.92 $23.94 $22.68

1993 $10.88 $11.04 $14.30 $12.79 $15.11 $14.06 $19.19 $17.98 $24.52 $20.99

1994 $10.67 $10.91 $14.54 $13.26 $15.22 $14.33 $19.76 $18.80 $27.21 $22.15

1995 $10.33 $10.48 $14.45 $12.90 $15.11 $14.20 $19.77 $18.75 $25.51 $23.89

1996 $10.17 $10.18 $14.23 $12.72 $15.08 $13.67 $19.30 $17.79 $25.65 $22.70

1997 $10.26 $10.08 $14.28 $12.78 $15.25 $14.02 $19.65 $17.76 $25.65 $20.64

1998 $10.66 $10.33 $14.61 $13.11 $15.58 $14.67 $20.39 $19.03 $26.76 $23.92

1999 $10.59 $10.37 $14.69 $13.27 $15.75 $14.46 $20.96 $20.20 $27.12 $23.95

2000 $10.70 $10.48 $14.80 $13.37 $15.80 $14.92 $21.07 $19.63 $27.05 $24.12

2001 $10.88 $10.62 $15.00 $13.60 $16.11 $14.78 $21.49 $19.78 $27.81 $22.55

2002 $11.07 $10.87 $15.17 $13.64 $16.20 $14.85 $21.47 $19.98 $28.21 $24.93

2003 $11.05 $10.81 $15.17 $13.74 $16.20 $14.92 $21.25 $20.45 $27.70 $23.57

2004 $10.94 $10.52 $15.02 $13.55 $16.07 $14.70 $21.15 $19.57 $27.82 $23.93

2005 $10.86 $10.34 $14.90 $13.23 $15.95 $14.34 $20.95 $20.07 $27.63 $25.64

2006 $10.87 $10.35 $14.90 $13.24 $15.92 $14.56 $21.04 $19.91 $27.37 $23.20

2007 $11.08 $10.55 $14.92 $12.98 $15.97 $14.54 $20.89 $19.69 $27.39 $24.17

2008 $10.99 $10.20 $14.78 $12.80 $15.84 $14.08 $20.96 $20.12 $27.45 $25.16

2009 $11.20 $10.63 $15.09 $13.30 $16.02 $14.49 $21.14 $19.48 $27.78 $22.95

2010 $11.00 $10.60 $14.91 $13.21 $15.86 $14.46 $20.96 $19.51 $27.43 $23.04

2011 $10.96 $10.34 $14.68 $12.79 $15.53 $14.00 $20.44 $19.26 $27.45 $24.14

Average $11.59 $11.35 $14.96 $13.42 $15.72 $14.64 $19.98 $18.95 $25.16 $22.71Black/White 97.87% 89.70% 93.13% 94.80% 90.24%Growth Rate ‐0.56% ‐0.63% ‐0.14% ‐0.26% 0.02% ‐0.24% 0.63% 0.50% 1.07% 0.64%

Table 9-3

Average Wage Rates (in 2011 dollars) by Ethnicity and Educational Attainment

Less than High School High School Graduates College Graduates

Figure 9-6 shows the return to education for whites and blacks in 1961, based on the same procedures used in Figure 9-1. The black trend line24 is flatter than the trend line for whites,25 implying that an extra year of schooling was a “better investment” for whites compared to blacks. White earnings and black earnings diverge except at high school and college graduation.

24 The equation for whites is ˆ 7.27 0.376 1.33 .64( 12) 4.59w w wW S HSG S cg which im-

plies each year of schooling increases the wage rate by $0.376 through the 11th grade, $1.60 for the 12th year, and $0.64 after high school, except for the 16th year that adds $5.23 per year. 25 The trend line for blacks is ˆ $5.61 0.23 2.29 6.16bW S HSG CG , which implies that every

year of schooling adds $0.23 per hour to a black person’s wage rate, except for the 12th grade ($2.52) and the 16th year ($6.39).



In Figure 9-7, we revisit the relation between schooling and the average wage rate using data from 1987. Up to the 12th grade, the average wage rate for whites declines and is flat for blacks. Upon high school graduation, both black and white earnings rise with the number of years of school completed, with divergence occurring after college gradua-tion.

Figure 9-8 shows the most recent data for 2011. Notice that both the black and the white trend lines are flat below twelve years of schooling. For all the economic ad-vantage that education gives them, high school dropouts might as well have dropped out in kindergarten. The return to a year of schooling after high school is constant for blacks but increases for whites after college, causing wage rates to diverge.

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

0 4 8 12 16 20

Average W

age Rate in

2010

Dollars

Years of Schooling Completed


White wage rates Black wage rates White trend line Black trend line

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

0 4 8 12 16 20Average W

age Rate in

2010

Dollars


White Wage Rate Black Wage Rate White Trend Line Black Trend LIne



Educational Opportunity and Affirmative Action:

From Brown to Griggs to Bakke and Beyond

In the wake of the Brown case in 1954, most schools evolved from segregated de juro to segregated de facto. As we have seen, black educational attainment has lagged behind white educational attainment, and blacks are paid less per hour than are whites with the same educational attainment. Whether the lower educational attainment of blacks is due to choice (the conservative contention) or due to lack of opportunity (the liberal contention) is one of many wedge issues politicians use to raise money and votes from their political bases, but neither side wishes to resolve, lest the party lose a partisan advantage. Another important wedge issue is affirmative action, which has come to mean reverse discrimination to conservatives, while liberals continue to interpret the words in their original intent, that is, to take steps to find and nurture minority and female applicants for the best schools and the best jobs.

While we already discussed employment discrimination in the last chapter, we re-introduce the topic here because of the critical connection between educational attain-ment and economic opportunity. When Congress debated the Civil Rights Act, a major concern voiced by opponents was that the act would interfere with the right of an em-ployer to hire the most qualified job applicants. Both in debate and in the text of the act itself, Congress made it clear that a law against racial discrimination would not directly interfere with the interests of the employer to hire the most qualified applicants. At the same time, some proponents of the Civil Rights Act expressed reservations that this qual-

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

0 4 8 12 16 20

Figure 9‐8: Education and Wage Rates, 2011

Average White Wage Rates Average Black Wage Rates

Predicted White Wage Rates Predicted Black Wage Rates



ification would be used as a loophole by segregationist employers. Events soon proved that those fears were well founded.

In 1971 a black laborer employed by the Duke Power Company of North Carolina sued his employer for racial discrimination under the provisions of the 1964 Civil Rights Act. Duke Power Company required a high school diploma for any job above laborer, but would waive the requirement for job applicants who were recommended by a supervisor. When Griggs sued, there were many whites who did not have a high school diploma in higher-level jobs, but no blacks. The lower court ruled in favor of Duke Power because Griggs had not demonstrated that Duke Power Company intended to discriminate. A unanimous Supreme Court (then headed by Chief Justice Warren Burger, a Nixon ap-pointee) overturned the lower court and ruled that when employment test result in an un-derrepresentation of a protected demographic group, the burden falls on the employer to demonstrate that that test is related to productivity. 26

In the Griggs case the Court set a two-step standard for employment discrimina-tion cases: (1) the plaintiff bears the burden of proof to show that an “employment test” (e.g., an educational requirement) falls disproportionately on a protected group; and (2) if the plaintiff demonstrates adverse treatment, the burden of proof shifts to the employer who must then show that the employment test is relevant to the job. In the case of Duke Power, statisticians retained by Griggs’s attorneys showed that there was no statistically significant difference between white Duke Power employees who had high school diplo-mas and white Duke employees who did not. Therefore, the employment test functioned just like a grandfather clause—that is, a criterion (was a person’s grandfather a slave?), that was highly correlated with race, which had the effect of circumventing the law against racial discrimination.

The decision in the Griggs case had profound repercussions for employers in gen-eral and for schools in particular. Employers and schools that had an under-representation of women, blacks, or other minority employees realized that they would have difficulty defending against a discrimination suit. Many employers and schools un-dertook affirmative action programs to identify and promote women, blacks, and other minority applicants. That leads us to the interesting and controversial case of Alan Bakke. Imagine you were the chancellor at the University of California, Davis, and you realized that the demographic profile of medical students would pass the legal standard for discrimination:

The Medical School of the University of California at Davis opened in 1968 with an entering class of 50 students. In 1971, the size of the entering class was increased to 100 students, a level at which it re-mains. No admissions program for disadvantaged or minority students ex-isted when the school opened, and the first class contained three Asians but no blacks, no Mexican-Americans, and no American Indians. Over the next two years, the faculty devised a special admissions program to in-crease the representation of “disadvantaged” students in each Medical

26 See http://people.eku.edu/palmerj/319/Griggs%20vs%20Duke%20Power.htm.



School class. The special program consisted of a separate admissions sys-tem operating in coordination with the regular admissions process.

From the year of the increase in class size—1971—through 1974, the special program resulted in the admission of 21 black students, 30 Mexican-Americans, and 12 Asians, for a total of 63 minority students. Over the same period, the regular admissions program produced 1 black, 6 Mexican-Americans, and 37 Asians, for a total of 44 minority students. Although disadvantaged whites applied to the special program in large numbers, none received an offer of admission through that process. In-deed, in 1974, at least, the special committee explicitly considered only “disadvantaged” special applicants who were members of one of the des-ignated minority groups.

Allan Bakke is a white male who applied to the Davis Medical School in both 1973 and 1974. In both years, Bakke’s application was considered under the general admissions program, and he received an in-terview. His 1973 interview was with Dr. Theodore C. West, who consid-ered Bakke “a very desirable applicant to [the] medical school.” Despite a strong benchmark score of 468 out of 500, Bakke was rejected.… In nei-ther year did the chairman of the admissions committee, Dr. Lowery, ex-ercise his discretion to place Bakke on the waiting list. In both years, ap-plicants were admitted under the special program with grade point averag-es, MCT scores, and benchmark scores significantly lower than Bakke’s.

After the second rejection, Bakke filed the instant suit in the Supe-rior Court of California. He sought mandatory, injunctive, and declaratory relief compelling his admission to the Medical School. He alleged that the Medical School’s special admissions program operated to exclude him from the school on the basis of his race, in violation of his rights under the Equal Protection Clause of the Fourteenth Amendment, Art. I, § 21, of the California Constitution, and § 601 of Title VI of the Civil Rights Act of 1964.…27

Before continuing with the Court’s ruling, consider the result if Bakke had sued the American Medical Association, or even the University of California, under an anti-trust statute. By conspiring to maintain an artificially low number of medical school stu-dents, the University of California conspired with the American Medical Association to restrict trade and create a monopoly price for health care. Had the Court ordered that the AMA approve, say, a doubling of the number of medical student slots at all medical schools, there would have been no need for discrimination. Since Bakke did not sue un-der an antitrust statute, the Supreme Court had to limit its ruling to the facts of the case. The Court essentially split a legal hair, finding against the UC-Davis because it used an explicit racial quota, which, by discriminating in favor of racial minorities, could not help but discriminate against Allan Bakke, a white male without connections that would have

27 Justice Powell’s written majority decision in University of California Regents v. Bakke, Microsoft® En-carta® Reference Library 2003. © 1993–2002 Microsoft Corporation. All rights reserved.



earned him a heritage admission.28 The Court explicitly approved of affirmative action programs like that at Harvard University, which included ethnicity as one factor in ad-mission (i.e., accepting lower test scores from minority applicants) without establishing an explicit quota.

To this day, affirmative action continues to be a controversial issue, particularly when used by publicly funded universities. Soon after the Brown case, Harvard Universi-ty granted the second highest number of law degrees to blacks, after Howard University, a traditionally black university. Private schools wish to maximize prestige, not tuition revenue, so Ivy League and other elite universities charge rich applicants (who are mar-ginally qualified) market-clearing tuition in order to use the surplus (dare we say profit) to attract highly qualified, low-income scholarship students. This practice places margin-ally qualified middle-income white students at a disadvantage; they either must mortgage their future with mammoth student loans, or settle for lower-quality public universities.

What is the mission of a public university? Is it to behave just like private schools and admit students on a two-track system, those who can afford to buy their way in must be marginally qualified, and those who need a tuition subsidy must be overqualified? When the UC-Davis medical school tried this, they ended up with a virtually all white, all male medical school class? Should public schools admit only the most qualified? Are test scores the only measure of qualifications? Or, are test scores ultimately a grandfather clause, meant to restrict college enrollment to white supremacists?

Summary

1. People augment their skills by investing in human capital, particularly through formal education and on-the-job training. Statistics show that education has very little effect on average earnings up to the twelfth year of schooling. The decision by some stu-dents to drop out of school may be a rational one if they believe they have a low probability of educational success.

2. Starting with high school graduation, the returns to education are particularly high for completing enough education to receive a diploma or degree. While the return to an-other year of schooling is low, the return to graduating from high school, receiving a two-year college degree, a four-year bachelor’s degree, a master’s degree, an academ-ic doctorate, or a professional degree are much higher. Completing a course of study shows potential employers or clients that one finishes what he or she starts, and demonstrates a mastery of an academic discipline.

3. In 1979 the average wage rate for men increased steadily through until after the eighth grade, then actually declined with additional schooling through the 12th grade, after which the average wage rate increased with additional schooling. The wage rate for women was essentially flat from 0 years of schooling through 12 years of school-ing, then the earnings gap between men and women remained roughly constant. By

28 According to Charles J. Ogletree, Jr., “In 1972, after working with NASA [as an engineer] for six years, Bakke began applying to medical schools. He was thirty-two at the start of his application process. … Over a two-year period, Bakke applied to eleven medical schools. … He was rejected by all of them despite ‘[high] undergraduate grads . . . laudatory recommendation letters, proven motivation and professional background and medical school admission test scores substantially higher than those of the average medical student admitted to Davis that year.’” All Deliberate Speed, p. 152.



2007 neither men nor women gained higher wages from the first 12 years of school-ing, after which both male and female wages increase with additional schooling. Women nearly close the gap on men upon college graduation, after which men gain more from an additional year of schooling than women do.

4. Producing human capital creates asymmetric information problems between gradu-ates and potential employers. Schools who inflate student grades cause employers to discount the achievement of good and poor graduates, which leads to an adverse se-lection problem whereby poor students drive out good students. Finally, the prospect of acquiring a degree by completing only easy courses leads to moral hazard: Good students who graduate from easy universities will find it difficult to prove to employ-ers that they did not gain a diploma without gaining an education.

5. General human capital represents skills that can be used in a wide variety of em-ployment situations. Employers have little incentive to pay for general human capital because workers will be able to demand a market wage for those skills after acquiring them. General human capital is typically acquired through formal education, or on-the-job training, whereby the apprentice is paid only for the time he or she works, and finances training time through a lower wage rate. Unfortunately, minimum wage laws sometimes interfere with a mutually beneficial apprentice relation between trainees and trainers.

6. The United States has had a long history of educational discrimination. Black slaves could not be taught to read under threat of punishment to their owners and death to the slaves. Even freed blacks were rarely permitted to attend school with whites. Af-ter the Civil War freed slaves, blacks were prohibited from going to schools with whites in the South due to Jim Crow laws (de juro, or legal, segregation) and typical-ly went to all black schools in the rest of the country because of housing segregation. In 1954 the United States Supreme Court overturned legal segregation (based on the Plessey v. Ferguson case) in Brown v. Board of Education, although school segrega-tion persists.

7. In 1979 white wage rates declined as education increased, while black wage rates in-creased with education, becoming nearly equal at eleven years of schooling. After high school graduation, white earnings increased more rapidly with education than black wage rates did. By 2007 neither black nor white wage rates increased with ed-ucational attainment through the 12th grade; beyond high school, white wage rates tend to respond more to another year of schooling than black wage rates do.

8. In 1971 the Supreme Court ruled in Griggs v. Duke Power that when employment requirements (including educational requirements) that have an adverse effect on blacks or other groups protected by the Civil Rights Act shifts the burden of proof in discrimination cases from the plaintiff to the defendant. This ruling led many em-ployers and universities to adopt affirmative action programs to defend themselves against charge of race-biased employment.

9. In the Bakke case a divided Supreme Court ordered that the University of California, Davis Medical School to admit Allan Bakke, arguing that the UC-D admission pro-gram was an illegal quota system. However, the Supreme Court allowed schools to



consider race and gender as part of their admissions criteria. Affirmative action re-mains a controversial practice to this day.

Glossary

Human capital: Additions to a person’s skills and knowledge created through education, on-the-job training, or other resource-using activities.

Sheepskin effect: The higher return to completing the last year of study and completing a degree, compared to the return on a year of education that does not culminate in a de-gree.

Present value: The amount of money that must be invested in financial markets today to achieve a particular future value of that money.

Asymmetric information: An exchange situation in which one agent (e.g., the student) has more accurate information about the quality of the good exchanged (labor ser-vices) than does the other agent (the potential employer).

Moral hazard: The tendency of individuals to change their behavior when the adverse consequences of that behavior decrease. For instance, students who can drop their courses 10 weeks into the semester have less incentive to study than do students who are locked into their schedule after the first week.

Adverse selection: A consequence of asymmetric information and moral hazard whereby the quality of the good being exchanged declines because the less informed party re-duces the bid price.

Segregation: The forced separation of races or other groups, using the force of law (de juro segregation) or informal means (de facto segregation).

Adverse treatment: The court or statistical finding that an employment or other test causes a disproportionately low number of successful minority applicants.

Burden of proof: The legal rule of who has to actually prove their case in court.

Affirmative action: A pro-active attempt to identify and promote minority candidates, usually with the goal of heading off a charge of discrimination.

Chapter 10 Economic Inequality


Can Economists Speak of Justice?

In his provocative book Aftershock, Robert Reich investigates the role of US eco-nomic inequality in first causing the recent global financial meltdown and then prevent-ing economic recovery. According to Reich, the richest 1% of American households re-ceived more than 23% of household income and own over half of American wealth. Be-cause speculative income is taxed at a lower rate than labor earnings, the typical rich fam-ily pays only 15% of each additional dollar of income, which a typical middle-class may pay up to 43% of its additional income in income taxes (28%) and payroll taxes (15%). If you are rich – particularly if you are egoistic – this arrangement seems “fair” (more for me!), if you are a middle-class college professor, this seems unfair. But economists want to know if economic inequality is efficient or inefficient. At one extreme, if everybody gets the same income, regardless of how effort they contribute, then output per person would be low. This was one of the major problems of communism: “from each accord-ing to ability to each according to means” may work well for families, but it doesn’t seem to work very well for society as a whole. As we will see later, there are only a few cases of countries whose economic inequality is actually too low.

What seems to be less appreciated is that too much inequality – the level of ine-quality Reich blames for the Great Recession – can also be bad for the economy. An ar-istocracy is an economic system in which wealth and power are concentrated in a few hands, and that one’s parent’s is much more important than effort in determining one’s lot in life. Like communism, aristocracy also divorces one’s pay from effort; the rich get more simply because they are rich. When political and economic power are inherited ra-ther than earned, both the government and the economy tend toward mediocrity.

A meritocracy is the opposite of an aristocracy, wherein one’s rewards depends on one’s own efforts, not on one’s birthright. In chapter eight we learned that a competi-tive labor market operates much like a meritocracy. Each person supplies that labor skill which brings them the most satisfaction; while a few people may seek to maximize mon-ey income, most people are willing to give up some money income for prestige, job satis-faction, or fringe benefits. Depending on the supply and demand for different labor skills, a person may receive a large or small income. In a meritocracy, if the demand for economists rises relative to, say, social workers, students with aptitude for both occupa-tions may choose to major in economics instead of social work.

An aristocracy is more like the Black Disciples drug gang featured in chapter three of Freakonomics. The title of that chapter is “Why Do Drug Dealers Live with their Mothers?” The ironic answer is that the soldiers in that drug gang earned an aver-age of $3.30 per hour (at a time when the minimum wage rate was $5.15); over half of all the income received by the drug gang went to the gang leader, JD. While we could argue that the drug sellers were willing to sacrifice $1.85 per hour for a chance to become the gang leader. At best, those soldiers were misinformed; what set JD apart from other gang members was just his luck, but also his MBA from Northwestern University. What was unfair about the lottery was that it was rigged against the uneducated gang members who faced a 1 in 4 chance of dying in pursuit of their occupation over the four years that Levitt and Dubner followed the gang.



Measuring Inequality

When comparing income or wealth at different places or times, we require a common denominator. A useful metric is per capita gross domestic product (GDP). Gross domestic product is the market value of all goods and services produced within an economy in a given year.Per capita GDP is GDP divided by population.The table in the appendix to this chapter ranks the per capita GDP in current US dollars for 210 counties in 1990, 2000, and 2010. The data on GDP and population are taken from United Na-tions statistics.1In 1990, the USA constituted 4.83% of the world’s population and pro-duced 26.08% of world output. By 2000 (the last year of the Clinton Administration), the US share of world population had fallen to 4.65%, while its share of world output in-creased to 31.38%. In 2010, US population had fallen to 4.53% of world population, while its share of world output had fallen to 23.34%.

The country closest to the world’s average is Mexico, which in 2010 pro-duced1.67 percent of world output with 1.66 percent of the world’s population. Figure 10-1 presents a Lorenz curve, a graphical representation of the inequality among mem-bers of a group. In this case, we plot the cumulative population distribution on the hor-izontal axis, beginning at the origin (0,0), and proceeding from the country with the low-est per capita GDP (Vietnam in 1990, Democratic Republic of the Congo in 2000, and Somalia in 2010) to the country with the highest per capita GDP (Monaco). The red line from the origin to the termination point (100%, 100%) shows what the Lorenz curve would look like if there were total equality among countries. Consider the state of the “world” at the beginning of a Monopoly® game: each player has a token, $1500, no property, and an equal chance to win the game. The dashed blue line shows what the Lo-renz curve would look like if there were perfect inequality; at the end of a monopoly game, one player has all the money and all the property.In all three years, the departure of the actual distribution of per capita GDP from the equality line is quite pronounced. In 1990, 73% of the world’s population lived in countries which collectively produced just 10.2% of the world’s output. There was little change between 1990 and 2000; with the poorest countries being above their level in 1990, but it still was the case that the poorest 70% of the world’s population lived in countries which produced less than 10% of the world’s output. In 2010, however, global economic inequality decreased markedly; the 2010 Lorenz curve (the purple line) is everywhere closer to the (red) equality line than either the green or blue lines are.

Note the dramatic statistics for the world’s largest countries. In 1990, per capita GDP in China was just $359 ($0.98 per person per day). In 2000, per capita GDP had increased to $956.69 ($262 per person per day). In 2010, per capita GDP had risen to $4,354.03 ($11.92 per person per day). While still low compared to the US ($46,545.90, or $127.44 per person per day), the increase in Chinese production is impressive. In 1990 per capita GDP in India was approximately the same as in China ($374). Between 1990 and 2000, India’s per capita GDP increased to $443.86, lagging far behind China. In 2010, per capita GDP in India $1,406.42) was approximately 1/3 of that of China.

1 http://unstats.un.org/unsd/snaama/dnllist.asp



While the Lorenz curve provides a useful picture of income inequality, econo-mists prefer asingle number for describing phenomena like inequality. The Gini coeffi-cient, named for its inventor, Corrado Gini, is the percentage of the area under the 45o equality line that is not covered by the Lorenz curve. In Figure 10-1, the area under the 45o(equality) line is ½ (100%)x(100%)/22 is indexed at 100. If the distribution of income were perfectly equal, then the Lorenz curve would lie along the 45oline, and the value of the Gini coefficient would be 0. If only one person had all of a society’s income, then the area under the Lorenz curve would approach 0 as the population approached infinity; the maximum Gini coefficient would be 1, or 100 percent. All actual distributions would fall between those extremes and we can compare them accordingly. The closer the Gini coef-ficient is to 1, the less equal the distribution of income; the closer the Gini coefficient to 0, the more equal the distribution.

Table 10-1 shows the calculation of the Gini coefficients for three hypothetical income distributions and one actual (empirical) income distribution. Per capita GDP is a measure of average output per person, useful for measuring average economic well-being across countries. Within countries however, economists typically use household income. The three mythical countries each have 200 residents and an average income of $100,000. In paradise3 each household receives $100,000, which is sufficient to purchase eternal bliss.No matter how one sorts the data from Paradise, the cumulative population

2 Recall that the area of a triangle is one-half of the product of the height and the base of the triangle. 3 Which could be the place of bliss for any of the world’s monotheistic religions; others may wish to call it Nirvana, and skeptics may wish to call it Utopia.

0%5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Cumulative GDP Proportion

Cumulative Population Proportion

World Lorenz Curves, 1990, 2000, and 2010

Lorenz Curve 1990 Equality Line Lorenz Curves 2000

Lorenz Curve 2010 Perfect Inequality



distribution and the cumulative income distribution are identical.Since the difference be-tween the Lorenz curve and the 45o line is zero, the Gini coefficient is also zero.

Table 10-1

Paradise Hades Purgatory USA 2009Population PCGDP Difference PCGDP Difference PCGDP Difference HHINC Difference

Percent Percent Percent Percent0% 0% 0% 0% 0% 0.00% 0.00% 0% 0.00%5% 5% 0% 0% 5% 0.48% 4.75% 0.12% 4.88%10% 10% 0% 0% 10% 1.43% 9.00% 0.45% 9.55%15% 15% 0% 0% 15% 2.86% 12.75% 1.00% 14.00%20% 20% 0% 0% 20% 4.76% 16.00% 1.80% 18.20%25% 25% 0% 0% 25% 7.14% 18.75% 2.92% 22.08%30% 30% 0% 0% 30% 10.00% 21.00% 4.32% 25.68%35% 35% 0% 0% 35% 13.33% 22.75% 6.05% 28.95%40% 40% 0% 0% 40% 17.14% 24.00% 8.09% 31.91%45% 45% 0% 0% 45% 21.43% 24.75% 10.52% 34.48%50% 50% 0% 0% 50% 26.19% 25.00% 13.47% 36.53%55% 55% 0% 0% 55% 31.43% 24.75% 16.86% 38.14%60% 60% 0% 0% 60% 37.14% 24.00% 20.84% 39.16%65% 65% 0% 0% 65% 43.33% 22.75% 25.59% 39.41%70% 70% 0% 0% 70% 50.00% 21.00% 30.91% 39.09%75% 75% 0% 0% 75% 57.14% 18.75% 37.36% 37.64%80% 80% 0% 0% 80% 64.76% 16.00% 44.77% 35.23%85% 85% 0% 0% 85% 72.86% 12.75% 53.30% 31.70%90% 90% 0% 0% 90% 81.43% 9.00% 63.39% 26.61%95% 95% 0% 0% 95% 90.48% 4.75% 76.23% 18.77%100% 100% 0% 100% 0% 100.00% 0.00% 100.00% 0.00%

Area 0% 90% 32% 51%Gini Coefficient 0 0.95 0.32 0.51Computer Gini 0 0.952381 0.31746 0.508293

Calculating Gini Coefficients for Alternative Economies

At the other extreme is Hades, where the Greek god of the underworld not only names the place after himself, but also grabs all the income $20,000,000, and everyone else has nothing. As a result, the poorest 95 percent of the population has 0 percent of the income and the top 5 percent has 100 percent. So when we compute the Gini coefficient from the table, we obtain a value of 0.95. When the computer uses the raw data, it more accurately computes the Gini coefficient for Hades as 0.952.

Purgatory, as anyone brought up Roman Catholic should know, is a state between Heaven and Hell, where the souls of sinners reside until purged of their venial sins. In my Purgatory, the poorest soul has $1,000, and each household’s income increases by $1,000. This generates an average income of $10,500. The poorest 5 percent of the pop-ulation has only 0.48 percent of the income, and the richest 5 percent has nearly 10 per-cent. It turns out that Purgatory is closer to Paradise than Hades. The last two columns shows the distribution of household income according to the March 2010 Current Popu-



lation Survey. The Gini coefficient is 0.38 when computed by spreadsheet, or, more ac-curately, 0.426 when the computer crunches the numbers.

Figure 10-3 presents the Gini coefficients for the world from 1970 through 2010. Note that the international measure of economic inequality fluctuates around 0.6, which is approximately as large as that for any individual country.

Figure 10-3

Figure 10-4 shows a histogram depicting the distribution of Gini coefficients for the 120 countries in the appendix for which Gini coefficients were reported. The Gini coeffi-

0%

20%

40%

60%

80%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Figure 10‐2: Lorenz Curves for Different Economies

Paradise Hades Purgatory US Household Income, 2010

0.5

0.55

0.6

0.65

0.7

International Gini coefficient

Gini coefficient



cients for countries range from a low of 19 (Seychelles4) to a maximum of 64.3 (Como-ros5), which slightly larger than the Gini coefficient for the world (62.1). Extremely large and extremely small values of the Gini coefficient are rare, with most countries falling within the midrange between 35 and 45.6 Indeed, the histogram is well approximated by the well-known normal or bell curve, showing a concentration of moderate values and a rarity of extreme values.

Figure 10-4

An interesting pattern occurs when we combine contrast inequality and human development. The United Nations website defines human development as: the “process of enlarging people's choices. Their three essential choices are to lead a long and healthy life, to acquire knowledge and to have access to the resources needed for a decent stand-ard of living. Additional choices, highly valued by many people, range from political, economic and social freedom to opportunities for being creative and productive and en-joying personal self-respect and guaranteed human rights.”7

Figure 10-3 plots the Gini coefficient on the horizontal axis (more inequality as we move to the right), and the United Nations’ human development index on the vertical axis. While the pattern is far from perfect, we find that as economic inequality (the Gini coefficient) increases, human development decreases. While the USA (the green dot) has a high level of per capita GDP, it lags its peers (Western Europe, Canada, Japan and Isra-el) in non-economic indicators like life expectancy, female mortality, and the quality of K-12 education).8

4 Seychelles is a former colony of Great Britain , north of Madagascar, known as a tourist and tax haven. 5 A former French colony, also located in the Indian Ocean near Madagascar. 6 The skewness-kurtosis test for normality implies a 36.8 % probability that the population underlying Fig-ure 10-3 is normal. 7 http://data.un.org/Glossary.aspx?q=Human+Development+Index+and+its+components+ 8 The equation underlying the red line is 2.037 .00032 .302 1.417hdi gini gini usa , which

implies that the human development index for the USA is .302 higher than it would be based on the degree of economic inequality.

05

1015

20

Perce

nt

20 30 40 50 60gini

Source: United Nations Data

Distribution of Gini Coefficients, 2011



Figure 10-3

Republican politicians, particularly Mitt Romney, argue that economic equality discourages work hard and wealth accumulation. The classic Marxist dictum “From each according to ability, to each according to need” implies moral hazard. If everyone is entitled to the same income (consumption), regardless of his or her contribution to socie-ty, then one has little incentive to work, beyond the intrinsic enjoyment of work itself. Nevertheless, I argued in Chapter 7 that the Marxist slogan is a reasonable description of a functional family. Ideally, family members are motivated by altruism whereby each places the “needs of the many over the needs of the one.”9 Gary Becker even cites his rotten kid theorem in his Treatise on the Family, which states that parents and children will maximize the same utility function, even if some of the children are not altruistic (selfish = rotten). Knowing that each gets a share of the family’s output, each will work to increase the “size of the pie,” and will not try to grab an unwarranted share, lest paren-tal retribution reduce the amount that goes to the rotten kid.

I find it fascinating to look at the behavior of individuals in the transition econo-mies in Russia and China. Both lived under oppressive communist regimes, which in theory preached Marxism, but in practice benefited Communist Party hacks at the ex-pense of the average citizens. Both economies stagnated under communism, as the elite became increasingly corrupt and the rank-and-file learned that connections were much more important than competence. After the fall of the USSR and the relaxation of anti-market institutions in China, we find that the Russian oligarchs have replaced the Com-munist bureaucrats, and that China itself has become startlingly polluted and lawless.

Less appreciated are the potential problems of excessive inequality. Endowment problems encourage jealousy and a sense of entitlement by the well-to-do, and envy and hopelessness by the have-nots. In monarchies like Saudi Arabia and theocracies like Af-

9Star Trek fans will recognize the Vulcan equivalent of the Marxist slogan.

.2.4

.6.8

1

Hum

an D

evelopm

ent

Index

20 30 40 50 60gini

hdiFitted values

USA

Source: United Nations Statistics

Human Development and Economic Inequality



ghanistan under the Taliban, the economy comes to resemble a system of loot and pillage. There is little incentive to work hard if all output goes to the elite. Figure 10-4 implies that personal wellbeing decreases as economic inequality increases. Indeed, Figure 10-4 implies that the United States may have too much inequality, at least relative to other de-veloped economies, to maximize its human potential. The perception of where the Unit-ed States should be on Figure 10-4 is probably a major point of contention between polit-ical liberals, who would sacrifice some output to increase equality, and political con-servatives, who would sacrifice some output to increase inequality. By this measure, the U.S. economy is a conservative economy, albeit an inefficient one. A reduction in eco-nomic inequality might actually increase per capita output.

Economic Inequality and Economic Accomplishments: Evidence from OECD

The Organization for Economic Cooperation and Development (OECD) is an as-sociation of developed and developing market economies. In 2009 the OECD presented a study of nine economic indicators for thirty member countries. Table 10-2 presents a summary of their findings. The only category that ranks the USA in the top third is per-capital net national product10, for which the USA ranks third.

Table 10-3 presents the correlations between the country’s Gini coefficient and the other eight measures of economic performance. The second number is the significance of the correlation – the probability that there is a strong positive or negative relation between those measures. Those indicators that are not correlated with economic inequality are the gender wage gap (the percentage difference between the average wage rate earned by women and men), the male life expectancy at age 65, and crime victimization. Those measures that are positively correlated with the measure of economic inequality are (1) the share of students with insufficient reading and (2) infant mortality. Recall that corre-lation does not imply causation. It is equally plausible that poor reading skills reduce economic performance as it is that economic inequality leads to inferior education. Simi-larly, high infant mortality (reflecting poor access to medical care) reduces economic output, and economic inequality causes poor medical outcomes.

10 Net national product is gross national product minus depreciation. Gross national product is similar to gross domestic product in that the latter measures the economic output of citizens of a country and the for-mer measures the economic activity of residents of a country.



Table 10-2: OECD Statistics Social cohesion

Levels 2007 rank Levels 2006 RankLevels 2004-

05Rank Levels 2006 Rank Levels 2006 Rank Levels 2006 Rank

Levels 2006

RankLevels 2005

Rank Levels 2006 Rank

country emp emprank ed edranl gini giniranki w agegap w agerank life liferank infant infrank w ellbeing w ellrank crime crimerank pcnni pcnnirank

Australia 72.9 9 13.4 5 0.30 16 0.17 13 18.3 3 4.7 20 7.4 7 16.3 15 $28,578 14Austria 71.4 12 21.5 19 0.27 4 0.22 22 17.2 14 3.6 9 7.1 13 11.6 5 $30,190 10Belgium 61.6 23 19.4 15 0.27 10 0.11 5 17.0 18 3.7 11 7.4 9 17.7 18 $28,868 13Cada 73.6 8 11.0 3 0.32 19 0.21 19 17.9 6 5.4 24 7.4 8 17.2 16 $31,811 5Czech Republic 66.1 19 24.8 23 0.27 6 0.18 14 14.8 26 3.3 8 6.4 21 $16,926 24Denmark 77.3 4 16.0 9 0.23 1 0.13 8 16.2 24 3.8 16 8.0 1 18.8 21 $30,282 9Finland 70.5 14 4.8 1 0.27 8 0.19 15 16.9 20 2.8 5 7.6 2 12.7 9 $28,175 15France 64.0 20 21.7 20 0.28 13 0.12 7 18.2 5 3.8 13 7.0 14 12.0 6 $27,379 17Germany 69.0 15 20.0 16 0.30 15 0.23 24 17.2 15 3.8 15 6.6 19 13.1 11 $27,584 16Greece 61.5 24 27.7 27 0.32 21 0.22 23 17.4 12 3.7 10 6.4 22 12.3 7 $23,798 21Hungary 57.3 28 20.6 18 0.29 14 0.00 1 13.4 28 5.7 25 5.2 27 10.0 3 $14,312 26Iceland 85.7 1 20.5 17 0.28 12 0.24 25 18.3 4 1.4 1 6.9 16 21.2 24 $29,382 12Ireland 69.0 16 12.1 4 0.33 22 0.14 10 16.8 21 3.7 12 6.0 23 21.9 26 $30,775 8Italy 58.7 27 26.4 26 0.35 25 0.14 9 17.5 11 3.9 17 5.0 29 12.6 8 $24,348 19Japan 70.7 13 18.4 12 0.31 18 0.33 27 18.5 2 2.6 3 6.5 20 9.9 2 $25,847 18Korea 63.9 21 5.8 2 0.31 17 0.38 28 16.1 25 5.3 23 5.7 25 $19,885 23Luxembourg 63.0 22 22.9 22 0.26 3 0.11 4 17.0 17 2.5 2 6.8 17 12.7 10 $55,653 1Mexico 61.1 25 47.0 30 0.47 30 17.2 16 18.1 29 6.7 18 18.7 20 $10,870 29Netherlands 74.1 7 15.1 7 0.27 9 0.17 12 16.7 22 4.4 19 7.6 3 19.7 22 $31,790 6New Zealand 75.4 6 14.5 6 0.34 23 0.10 2 17.8 8 5.2 22 7.4 6 21.5 25 $20,596 22Norw ay 77.5 3 22.4 21 0.28 11 0.12 6 17.7 9 3.2 6 7.5 4 15.8 13 $45,552 2Poland 57.0 29 16.2 10 0.37 26 0.10 3 14.5 27 6.0 26 5.9 24 15.0 12 $12,233 28Portugal 67.8 17 24.9 24 0.42 28 0.21 21 16.6 23 3.3 7 5.4 26 10.4 4 $16,609 25Slovakia 60.7 26 27.8 28 0.27 7 0.26 26 13.3 29 6.6 27 5.2 28 $13,599 27Spain 66.6 18 25.7 25 0.32 20 0.21 20 17.9 7 3.8 14 7.1 12 9.1 1 $24,318 20Sw eden 75.7 5 15.3 8 0.23 2 0.15 11 17.6 10 2.8 4 7.4 10 16.1 14 $31,234 7Sw itzerland 78.6 2 16.4 11 0.27 5 0.19 17 18.5 1 4.4 18 7.5 5 18.1 19 $34,536 4Turkey 45.8 30 32.2 29 0.43 29 13.1 30 22.6 30 4.7 30 $10,805 30United Kingdom 72.3 10 19.0 13 0.34 24 0.21 18 17.0 19 5.0 21 7.0 15 21.0 23 $30,003 11

United States 71.8 11 19.4 14 0.38 27 0.19 16 17.2 13 6.9 28 7.3 11 17.5 17 $38,874 3

NNI per capita, at USD PPPs

Crime victimisation

Self-sufficiency Equity Health

Employment to population ratio, total

Share of students w ith insuff icient reading

Gini coeff icient of income inequality

Gender w age gapLife expectancy at age

65, menInfant mortality Subjective w ell-being

Income

Table 10-3: Correlation among OECD Indicators

Correlation Between

Gini coeff icient of income inequality

employment to ‐0.4547

populaiton ratio 0.0116

share of students with 0.5154

insufficient reading 0.0036

Gender wage gap 0.0978

0.6206

male life ‐0.1528

expectancy at age 65 0.4202

infant 0.6909

mortality 0

Subjective ‐0.4629

well‐being 0.01

crime 0.0229

victimization 0.9116

per capita ‐0.4899

net national income 0.006



The negative correlations are even more telling. The countries with low employ-ment to population ratios tend to have single-earner households, which tend to increase the Gini coefficient (the USA is the exception here). The USA is also the exception with respect to the correlation between per capita net national income and the Gini coefficient; as indicated in Figure 10-4, countries with high per capita income (or output) tend to have more equal income distribution (lower Gini coefficients) than the USA does. When asked to rate their subjective well-being, countries with low Gini coefficients tend to express more overall satisfaction than do countries – like the USA – that have high degrees of economic inequality.

Measuring Income Inequality within the United States

While I have argued that households attempt to maximize utility (or their stand-ards of living) rather than income, we are left with the fact that neither utility nor stand-ards of living are directly measurable. So, when we talk about inequality we typically mean economicinequality, and we typically measure economic inequality by contrasting the income of different households and individuals.

Income is a variable that differs from person to person at the same time, and dif-fers over time for the same person. It is impossible to measure economic outcomes for everyone because such data do not exit.11 Hence, statisticians base their estimates of un-known population characteristics (called parameters) on measured sample statistics. When measuring income, there are three measures of central tendency: the mean (the arithmetic average of all observations), the median (the middle number when all obser-vations are sorted from largest to smallest, or vice-versa), and the mode (the most fre-quent observation or range of observations).

Table 10-4 presents the descriptive statistics for ten categories of household and personal income from the March 2012 Demographic Survey and the 2011 Monthly Earn-er Surveys from the Current Population Survey. We have already discussed the mean, which is computed by adding up all the observations for each category, then dividing by the number of observations, shown in column 2. A person cannot earn less than $0 per hour, and business losses (that can give households and individuals negative income) are truncated at -$9,999 for individuals (-$19,998 for families). Typically, the censored val-ues show up as the minimum and the maximum value, but not always. There are a few people who make very high income; to protect their privacy, large incomes are top-coded. This truncation of the data distorts the computed mean or average. This is not the case with the median; the median is obtained by ranking all respondents and taking the middle number. Hence, it does not matter that very large and very small incomes are censured. Either the mean or the median gives us an alternative measure of what the typi-cal person or household receives.

11 Recall again that data is the plural Latin noun for the singular “datum.” When used as an adjective, it takes the plural form: e.g., a data set.



Table 10-4 Descriptive Statistics for Household12and Personal Income

Type of Income Number Mean Median Min Max Std. Dev. Coefficient Gini

of variation

Household Income (Families) 52,594 $83,238 $63,900 ‐$12,999 $2,099,999 $87,904 1.0561 0.4365

Household Income (Singles) 21,745 $43,963 $30,000 ‐$19,998 $1,534,000 $57,485 1.3076 0.4935

Personal Income (Adults) 144,803 $30,280 $16,600 ‐$9,999 $1,350,000 $53,863 1.7788 0.6548

Hourly Earnings (All Workers) 99,083 $15.61 $12.95 $0.00 $99.99 $9.33 0.5981 0.2869

Weekly Earnings (All Workers) 166,479 $820.59 $654 $0 $2,885 $590.58 0.7197 0.3935

Weekly Earnings (Government) 28,855 $929.56 $808 $0 $2,885 $584.36 0.6286 0.3417

Weekly Earnings (For Profit) 124,434 $793.36 $601 $0 $2,885 $620.94 0.7827 0.4033

Weekly Earnings (Not For Profit) 13,190 $815.39 $692 $0 $2,885 $630.43 0.7732 0.3961

Non‐Labor Income (Adults) 144,803 $6,487 $81 ‐$9,999 $839 $14,478 2.2318 0.8057

Social Security (Recipients) 25,742 $13,073 $12,545 $1 $50,000 $6,463 0.4944 0.2633

Public Assistance (Recipients) 1,520 $3,314 $2,575 $1 $25,000 $3,081 0.9296 0.4500

The standard deviation is a measure of the variability in the sample, which is typi-

cally computed by statistical programs. To obtain the standard deviation, the computer subtracts the sample mean ( x ) from each observation (xi), squares the result, andcom-

putes the square root of the average:

2

1

( )

1

n

ii

x xs

n

.Since the standard deviation is

measured in the same units as the mean, we can compare the relative variation of differ-ent income and earnings distributions by computing the coefficient of variation, which is simply the ratio of the standard deviation to the mean. Since means could be negative and since the standard deviation can be greater than the mean, the range for the coeffi-cient of variation is unbounded. By contrast, the Gini coefficient is bounded by 0 (per-fect equality) and 1 (perfect inequality). In Table 10-4, the correlation between the coef-ficient of variation and the Gini coefficient is 0.985. This means that both measures in-crease with inequality, although not by precisely the same degree.

Causes of Income Inequality

There is considerable variability in actual income due to the interaction of many factors, some of which, like luck, honesty, and connections, are not measured by the stat-isticians collecting the information. In Chapter 9, we learned that the theory of human capital predicts that labor productivity, and hence earnings, tend to increase as educa-tional attainment increases. Table 10-5 presents the average household income in 2011 by the educational attainment of the “head” of the household. Because of the high degree of correlation of the education of spouses, the education of the “head” of the household is a good proxy for the educational attainment of his or her spouse.

12 Household Income, Personal Income, Non-Labor Income, Social Security, and Public Assistance refer to 2011 income and are taken from the March 2012 Demographic Study of the Current Population Survey; Hourly and Weekly Earnings refer to 2011 earnings and are taken from the Monthly Earner Study, Janu-ary–December 2011, Current Population Survey.



Table 10-5

Sample Sample Sample Percent of Gini

Highest Grade Completed Mean Std. Dev. Frequency Sample Coefficient

None $38,192 $41,803 134 0.23% 0.4066Nursery school to grade 4 $36,249 $28,425 412 0.82% 0.4291Grade 5 or grade 6 $39,050 $38,154 863 1.62% 0.3904Grade 7 or grade 8 $38,439 $33,709 1,091 2.09% 0.4182Grade 9 $39,517 $36,624 993 1.99% 0.4087Grade 10 $39,628 $32,865 1,149 2.24% 0.4294Grade 11 $40,703 $39,988 1,498 2.70% 0.4259Grade 12 no diploma $47,580 $57,825 687 1.19% 0.4588High school graduate $60,263 $52,132 15,738 29.21% 0.4018Some college but no degree $70,709 $60,514 10,058 18.62% 0.3919Vo/Tech/Bus school degree $74,188 $53,167 2,668 4.86% 0.3726Associate degree in college $82,160 $66,054 2,841 4.90% 0.3719Bachelor's degree $110,169 $87,267 10,457 18.88% 0.3725Master's degree $130,782 $98,949 4,198 7.61% 0.3790Professional school degree $199,603 $163,979 824 1.65% 0.4226Doctorate degree $168,014 $125,385 837 1.40% 0.3915All Households $80,283 $76,955 54,448 100.00% 0.4365

Household Income by Educational Attainment of “Reference Person”From 2012 Current Population Survey

Note that earnings tend to remain between $36,000 and $41,000 for households whose reference person has less than 12 years of schooling. Not until the reference per-son has more than 11 years of schooling do we find household income significantly above the income for a household with less than 12 years of schooling. The highest Gini coefficient, reflecting the greatest household income inequality, is among those with twelve years of schooling but no diploma. Generally, as education increases, the Gini coefficient decreases.13 The major exception is among households with an adult who has a professional degree; this is because there is a large degree of variation within profes-sions (e.g., attorneys and physicians), and especially between professions (e.g., clergy and veterinarians vs. lawyers and physicians).

As people get older, they generally gain experience and their income increases. However, at some point, income will peak as their health deteriorates, their education de-preciates, and they work fewer hours. Figure 10-6 presents the life-cycle income pattern that plots the age of the reference person on the horizontal axis, and the corresponding average household income (blue) and median household income (red) on the vertical ax-is. Note that the blue trend linefits the data quite well, so that about 93 percent of the var-iation in average household income can be attributed to the age of the “reference person” of that household. This has greater explanatory power than education. People may be “stuck” with their level of education, based on the decisions they made when they were too young to realize the consequences of those decisions. But everyone blessed with a

13 The weighted correlation is -0.7005, which is significant at the 0.0025 level.



normal life span will tend to follow this life-cycle pattern. Hence, we borrow against fu-ture income increases when we are young and we save against the prospect of income decline when our earnings peak at about age 55. Young people who are impatient often have difficulty waiting until those earnings peak, and many middle-aged adults may suf-fer denial about the nearly inevitable decline in those earnings.

Figure 10-6

Table 10-6 shows the relation between average 2011 household income14 by gen-der and the marital status of the household “reference person.” As in Tables 11-2 and 11-3, we compute the 95-percent confidence interval for the population mean for each type of household. We note that the population mean for “male-respondent” households is significantly greater than the average income of “female-respondent” households. For married couples, who is designated as the “respondent” of household is a matter of choice, and the statistics indicate that those that specify male reference personshave slightly higher average income. Note that only households with married heads have av-erage earnings above the likely population means. Part of the explanation is the potential for two earners, but another explanation is the specialization of labor between a spouse who works outside the home and one who specializes in household production at home.

Among one-earner households, we find that households headed by a single female are nearly three times as prevalent as single-male-headed households. Single-women-headed households average only 81.3 percent of the income of equivalent single-male-headed households. Income statistics reinforce information from popular literature. Households with husbands and wives consistently have higher incomes than households with single heads, regardless of whether the husband or the wife is designated as the “head.” Households headed by single men have lower earnings than households headed by married couples. Households headed by single women also have lower earnings than

14 The data come from the March 2012 Current Population Survey, which reports 2011 annual income.

Mean income = ‐49.198xA + 4928.6A ‐ 32171

median = ‐41.718A2 + 4118.5A ‐ 29415

0

20000

40000

60000

80000

100000

120000

0 10 20 30 40 50 60 70 80 90

Household Income and Age of Reference Person

Average houshold income Median household income

Mean Income Trend Median Income Trend



households headed by married couples. And furthermore, being an unmarried head of household has more severe economic consequences for women than for men. Finally, the lowest Gini coefficients occur among households headed by married couples. This rein-forces Becker’s theory of household formation. As household income rises, it is more likely that the husband or wife will specialize in household production, tending to equal-ize earnings with households with lower paid breadwinners.

Table 10-6

Marital Sample Sample Gini

Status Mean Std Dev Size Minimum Maximum Coefficient

Married $96,364 $93,133 22,991 $95,160 $97,568 0.4040

Widowed $60,687 $52,454 307 $54,796 $66,578 0.4180

Divorced $69,071 $75,057 1,301 $64,989 $73,154 0.4051

Separated $52,256 $43,062 310 $47,444 $57,069 0.3912

Never married $58,840 $62,864 1,866 $55,986 $61,695 0.4372

All unmarried $63,851 $74,022 3,954 $61,543 $66,159 0.4227

Average $91,593 $91,308 26,945 $90,502 $92,683 0.4125

Marital Sample Sample Gini

Status Mean Std Dev Size Minimum Maximum Coefficient

Married $94,776 $94,765 15,119 $93,265 $96,287 0.4039

Widowed $53,583 $58,035 1,396 $50,536 $56,630 0.4278

Divorced $53,117 $56,060 3,628 $51,292 $54,942 0.4463

Separated $33,898 $33,873 1,040 $31,837 $35,959 0.4734

Never married $39,245 $45,198 4,020 $37,847 $40,643 0.4499

All unmarried $45,292 $50,579 10,530 $44,326 $46,258 0.4499

Total $74,461 $83,284 25,649 $73,441 $75,480 0.4512

Household Income Distribution by Marital Status and GenderMale Reference Person

Population Mean

Female Reference Person

Population Mean

Historical Trends in Inequality

Figure 10-7 shows the trend in inequality, as measured by the Gini coefficient, from 1968, the first year that household income is reported in the March Current Popula-tion Survey, until 2012. The Gini coefficients refer to income earned the previous calen-dar year. We find a consistent trend towards increasing economic inequality among households, beginning at 0.386 in 1968 and reaching 0.461 in 2010. By contrast, indi-vidual incomes (excluding children and others with zero earnings) tended to decline from 0.606 in 1962 to 0.502 in 1991, and then increasing to 0.548 in 2010. So while the evi-dence implies that the level of inequality in the USA is too high to maximize per capita GDP, and is associated with lower quality of life in general, we find that economic ine-quality is trending worse.



Figure 10-7

Remedying Inequality

Despite the evidence that there is an optimal level of inequality—a “Baby Bear” economy where inequality is not too small (discouraging work and risk taking) but also where inequality is not too large (creating persistent inter-generational inequality that leads to aristocracy) – the trend in the United States is to dismantle the three factors that would counteract the worsening inequality: truly competitive markets, the inheritance tax and the progressive income tax.

The inheritance tax15was intended to be a “reset button” for economic equality. Consider the Parker Brothers game Monopoly®. At the beginning of the game each player receives $1,500, a token to move about the monopoly board, and the right to throw dice in turn. The outcome of the game partly depends on luck (the ability to accumulate a monopoly of two or three related properties and build houses or hotels on them) and part-ly on skill (negotiating) and (perhaps) cheating. My point is that at the end of every game there is a 100% estate tax; the winner relinquishes claim on property and the game starts anew with players in equal, property-less condition. Being without an estate tax – which Congress phased out between 2001 and 201016 -- is like starting each game of monopoly while allowing the winners of the previous game to maintain their hotels. 15 See http://www.irs.gov/pub/irs-soi/ninetyestate.pdf. 16 The repeal of the estate tax was extended through 2012 as part of the bi-partisan agreement to extend the economic stimulus during the “lame duck” session after Republicans captured the House of Representatives and reduced the Democratic majority in the Senate.

GH = 0.0024x + 0.3329R² = 0.946

GP = 0.0001t2 ‐ 0.006t + 0.6026

R² = 0.897

0.30

0.35

0.40

0.45

0.50

0.55

0.60

0.65

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Trends in Income Inequality

Household Income Personal Income

Household Income Trend Personal Income Trend Line



The same year that the Republican Congress repealed the estate tax, it also re-duced the tax rate on income above $373,651 (in 2011 dollars) from 39.6% (that had been established in the first Clinton budget of 1993) to 35%. The resulting tax cut turned the budget surplus – which funded job creation – to an investment-reducing budget defi-cit. There are, in fact, three different federal income tax systems. Payroll (labor) income is taxed at a flat 13.3% rate to support social security (with a cap of $106,800) and a graduated rate – from 10% to 35% to support the federal budget. However, capital gains income – that is, speculative income – is taxed at a maximum rate of 15%. Given that those who receive capital gains are concentrated at the richest 1% of the population, the middle class (those with income between $45,551 and $106,800 pay a marginal tax rate of 38.3%, which is higher than what the rich pay on “regular” income (35%) and substan-tially greater than what the rich pay on their capital gains (speculative) income. Table 10-7 shows the tax system for a head of household in 2011.

Table 10-7

Figure 10-8 shows the relative size of the tax collections from the payroll tax – which is highly regressive – and the income tax which is modestly progressive.17 Note the dramatic jump in personal tax rates in 1941, corresponding to the beginning of World War II and the end of the Great Depression. The average income tax rate remained near-ly constant at 10% of personal income until the Bush tax cuts of 2001. That year the pay-roll tax rate caught up with the income tax rate, although both declined with the Great Recession. As I write this President Obama and Speaker John Boehner are negotiating to avert the fiscal cliff, a term coined by Fed Chairman Ben Bernanke for the automatic tax increases and spending cuts the Republicans passed in 2011 to force a reduction in the

17 A regressive tax takes a smaller proportion of income as income rises; the payroll tax is regressive be-cause (1) it is levied only on labor income, (2) the employer’s share of the tax is shifted to workers (em-ployers simply consider the payroll tax they pay as part of the worker’s wage, and (3) there is a cutoff of $110,600. A progressive tax takes a larger share of income as income rises. The income tax is moderately progressive because the marginal tax rate rises as income does; the progressivity of the income taxes is mitigated by loopholes that reduce taxes, particularly for the rich, and the lower tax rate on capital gain.

income payroll total income payroll total

From to tax rate tax rate tax rate tax rate

tax

rate tax rate

$0 $11,950 10% 13.30% 23.30% 10% 0.00% 10.00%

$11,951 $45,550 15% 13.30% 28.30% 15% 0.00% 15.00%

$45,551 $106,800 25% 13.30% 38.30% 15% 0.00% 15.00%

$106,801 $117,650 25% 0.00% 25.00% 15% 0.00% 15.00%

$117,651 $190,550 28% 0% 28.00% 15% 0.00% 15.00%

$190,551 $373,650 33% 0% 33.00% 15% 0.00% 15.00%

$373,651 no limit 35% 0% 35.00% 15% 0.00% 15.00%

Labor income Capital Gains

Head of Household



deficit. Despite income taxes being at their lowest level since 1941, Republicans refused to raise tax rates even on incomes above $1 million.

Figure 10-8

The third cause of economic inequality is the erosion of competitive markets. The Tea Party call for “free markets” is actually a call for the perpetuation of monopoly mar-kets. Instead of allowing additional firms to enter competitive markets, “conservative” politicians seek to prevent market competition. While these policies ostensibly benefit those who have already made their fortunes, they are supported by lower-middle class voters whose hope of economic advance is precluded by the policies they support.

Ironically, not every rich person supports this conservative ideology which swept the country in the 2010 midterm elections. Warren Buffett, chairman of Berkshire Hath-away and the second richest person on earth, after Bill Gates, expresses this argument clearly. Buffett recently joined Gates in a program to give away most of his personal for-tune, reputed to exceed $25 billion. Here is what Mr. Buffett told Barack Obama in the latter’s book, The Audacity of Hope:

The free market’s the best mechanism ever devised to put re-sources to their most efficient and productive use. The government isn’t particularly good at that. But the market isn’t so good at making sure that the wealth that’s produced is being distributed fairly or wisely. Some of that wealth has to be plowed back into education, so that the next genera-tion has a fair chance, and to maintain our infrastructure, and provide

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%1929

1932

1935

1938

1941

1944

1947

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

Percent of Personal In

come

Average Tax Rate on Income and Payrolls

income payroll total



some sort of safety net from those who lose out in the market economy. And it just makes sense that those of us who’ve benefited most from the market should pay a bigger share.

When you get rid of the estate tax you’re basically handing com-mand of the country’s resources to people who didn’t earn it. It’s like choosing the 2020 Olympic team by picking the children of the winners of the 2000 Games.18

When then-Senator Obama asked Mr. Buffett how many fellow billionaires shared this attitude, Buffett replied:

I’ll tell you, not very many. They have this idea that it’s “their money” and they deserve to keep every penny of it. What they don’t fac-tor in is all the public investment that lets us live the way we do. Take me as an example. I happen to have a talent for allocating capital. But my ability to use that talent is completely dependent on the society I was born into. If I’d been born into a tribe of hunters, this talent of mine would be pretty worthless. I can’t run very fast. I’m not particularly strong. I’d probably end up as some wild animal’s dinner.

But I was lucky enough to be born in a time and place where socie-ty values my talent, and gave me a good education to develop that talent, and set up the laws and the financial system to let me do what I love do-ing—and make a lot of money doing it.19

Where Do We Go From Here?

Earning inequality among individuals and households is inevitable in a market-driven economy in which incentives matter. People differ by their endowments, their tal-ents, and their effort. However, when earnings differ systematically by geography, race, or gender, one can question the underlying justice—and efficiency—of the economic sys-tem. We have seen that 70 percent of the world’s population lives in countries that to-gether produce only 10 percent of the world’s output. The United States has only 4.5 percent of the world’s population but produces nearly one-third of the world’s output. There is greater inequality between countries than there is within any country. Too much or too little inequality within a country appears to interfere with economic output. Among developed countries, the United States seems to have the greatest degree of ine-quality as measured by the Gini coefficient.

In November 2006 Democrats regained control of both houses of Congress, but their razor thin majority in the Senate and a Republican president thwarted social legisla-tion. In November 2008, Illinois Senator Barack Obama defeated Republican John McCain in the election of the 44th president of the United States. The Democrats in-creased their majority in both houses of Congress, to votes in the Senate (a filibuster-proof majority they lost when Scott Brown replaced the late Senator Edward Kenney from Massachusetts) and at least 236 out of 435 seats in the House of Representatives. President Obama and many Democrats ran on a platform to stimulate the economy and

18 Quoted by Barack Obama, The Audacity of Hope(Crown Publishers, 2006), pp. 190–191. 19Ibid, page 191.



improve both health care and education, which would stimulate a more equal economic opportunity. But after two years, the US electorate – displeased at the slow pace of eco-nomic recovery – returned the Republicans to control of the House and reduced the Dem-ocratic Senate majority to two votes.

Summary

1. Our attitudes toward income inequality depend on whether we are egoistic, altruistic, or malevolent.

2. A Lorenz curve comparing per capita gross domestic product to population shows substantial economic inequality in the world. Seventy percent of the world’s popula-tion lives in countries that together produce about 10 percent of world output, while 10 percent of the world’s population live in countries that produce 70 percent of world’s output. Residents of the United States make up 4.68 percent of the world’s population and produce 32.77 percent of the world’s output.

3. A Gini coefficient measures difference between the area covered by the equality line and the area under the Lorenz curve itself. A Gini coefficient of 0 indicates complete equality, while a Gini coefficient of 1 would indicate complete inequality. The Gini coefficient for per capita GDP across the world is 74.26 percent, greater than the Gini coefficient for any country.

4. The Gini coefficients for individual countries range from 8 to 62, on a scale of 100. Countries with very low Gini coefficients are former communist countries, although China’s Gini coefficient (40.3) is roughly equivalent to that of the United States (40.8), and Russia’s (48.7) is higher. Developed countries have Gini coefficients be-tween 20 and 40, with the United States’ Gini coefficient being the highest among comparable countries. Countries with very high Gini coefficients tend to be less de-veloped.

5. Within the United States, we use statistics from The Current Population Survey to estimate average income and to compare Gini coefficients for alternative income sources. Household income, with an average value of $67,419 in 2002, is associated with a Gini coefficient of 39.77 percent among households. Income from labor tends to be slightly less equally distributed (Gini coefficients in the 40s), and property in-come is much less equally distributed (Gini coefficients in the 60s). Private and pub-lic transfers tend to be concentrated in the few households that qualify.

6. Ethnicity has a significant impact on the distribution of income among households. Households with white, non-Hispanic “heads” have significantly higher than average income, while African-American and Hispanic households have income significantly below average. In the middle are “other” households (Asian and Native American), whose average is not significantly different from that for all households.

7. As education of the head of household increases, household income also increases. Both labor income and household income grow very slowly for the first eleven years of schooling, and then grow rapidly with high school graduation and beyond.

8. Household income changes in the lifecycle of the head, growing with experience to the mid-40s, and then tending to decline as age increases.



9. Marriage is a crucial determinant of household income. Households with married men and women have a significantly higher income than households with single heads, regardless of whether the nominal head of the household is male or female. While they have lower average income than households with married heads, house-holds with single-male heads have higher average income than comparable house-holds with female heads.

10. Over time, the distribution of income, as measured by Gini coefficients, tended to be-come between 1947 and 1970 and has been increasing steadily since that time.

11. Attitudes toward inequality tend to differ between conservatives, who attribute ine-quality to individual choice or effort, and liberals, who attribute inequality largely to endowment effects.

12. The trend in the USA is toward greater economic inequality, as the Estate tax disap-peared, the income tax became regressive, and markets became less competitive.

Glossary

Economic agents: Buyer and sellers in product or factor markets.

Egoist: The default economic assumption toward the welfare of others. An egoist is in-different to the welfare of others, being willing to change someone else’s welfare only if he or she personally benefits from that change.

Altruism, benevolence: The willingness to incur a personal cost to make someone else better off. Like any other good, the welfare improvement desired for another is in-versely related to the price one pays.

Malevolence: The willingness to incur a personal cost to make some else worse off.

Common denominator: A basis of comparison common to the phenomena being com-pared.

Per capita gross domestic product: The market value of the total market value of output produced within a country during a year, divided by population. Per capita GDP, ex-pressed in units of a single currency (e.g., dollars) is the common basis of comparing living standards in different countries.

Lorenz curve: A diagram used to depict economic inequality. The horizontal axis measures the cumulative population distribution from the poorest to the richest unit (person or household), and the vertical axis measures cumulative income. The 45° line depicts perfect inequality, and the deviation of the actual Lorenz curve from the 45o line measures the departure from equality.

Gini coefficient: The difference in area between the 45o equality line and the Lorenz curve, divided by the area under the 45° line. The Gini coefficient ranges from 0 (ab-solute equality) to 1 (absolute inequality).

Mean income: Depicted by , population mean income is the ratio of total income to the total number of households or people being compared. The sample mean, X , is the ratio of total income for a statistical sample to the sample size, and is used to estimate the population mean.



Median income: The income at the 50th percentile for all households or people.

Modal income: The largest income class for a population or sample.

Standard deviation: The typical measure of variability of a sample (s) or population (), computed as the square root of the sum of the squared differences between each ob-servation and the respective mean, divided by the sample size minus 1, or the popula-tion size. Using the sample mean and the sample standard deviation allows statisti-cians to compute the confidence interval for likely values of the population mean.

Statistical inference: The process of estimating population parameters (e.g., , ) from sample statistics (i.e., X , s).

Life-cycle income: The tendency for labor earnings to rise with age early in one’s career, then to decline with age later in that career.

Equal opportunity: An ideal state of affairs where every person or household has an equal chance to succeed: a state of affairs with no economic discrimination or en-dowment effects.

Endowment effect: The advantages stemming from inherited wealth, talent, or social connections that increase the probability of economic success.

Fundamentalism: The resistance of beliefs to contradictory evidence, encountered in religion and political ideology.

Chapter

By Profe

Psities sucanswers. Bank defday. Figsevere poAustraliaextreme,

Ternment repress wto availabduction. conduct c

Acase in AThose whpean sett

1Source: ht2Meron TiHerding: Ewhen the o3 See, for inFight Glob

11

essor Tom Ca

eople typicach as food, cl

How muchfines the inteure 11-1 preoverty. Notea, Egypt, Isra

many count

There are manby thieves”

women and pble resourceThere is gro

controlled ex

As scripture sAmerican hisho could notlers found N

ttp://en.wikipelahun, a UNLV

Evidence of theopportunity cosnstance, Abhij

bal Poverty, Ne

T

arroll

ally understalothing, shel

h food, clothiernational poesents a globe that the bluael, Japan, antries sub-Sah

Fig

ny causes ofwhereby aut

prohibit repros; (3) inadeqowing interexperiments t

Def

says, “The pstory. This ct afford pass

Native Ameri

dia.org/wiki/Fi

V master’s stude Wealth Paradst of child laboit V. Banerjee ew York: BBS

The Economi

Poverty

and poverty tlter, or healthing, and houoverty threshbal map of poue areas of thnd South Koharan Africa

gure 11-1: M

f poverty thrtocratic goveoductive righquate educatiest among ecto determine

fining Pover

oor shall alwcountry was age to the neicans who w

ile:Percentage_dent, reports indox,” how Ethior on the familyand Esther DuPublic Affairs

ics of Povert

y in the Wo

to mean thath care. The

using are nechold as $1.25overty rates bhe map – Noorea – all hava have povert

Map of Worl

roughout theernments feehts, continuiion,2 or simp

conomists at e which anti-

rty in the Un

ways be witha haven for pew world wo

were primitiv

_population_lin her professionopian parents oy farm is too gruflo, Poor Econs, 2011.

ty

orld

t a person or definition b

cessary? Wh5 per day (sebased on the

orth Americave poverty raty extreme r

ld Poverty1

e world: (1) ked on their ping the cycleply too manythe World B

-poverty prog

nited States

h you,” and tpoor Europeorked as indeve by their st

iving_on_less_nal paper, “Chioften cannot afreat. nomics: A Rad

a family habegs as manyho decides? evere povertye World Bana, Europe (inates below 2

rates in exces

kleptocraciepeople; (2) the of too many people andBank and in grams are m

s

that certainlyeans seekingentured servtandards; the

_than_$1.25_peild Labor on thfford to send th

dical Rethinking

Page 196

s too little ney questions a

The World y), and $2 p

nk definitionncluding Rus2%. At the oss of 60%.

s –literally “heocracies thny people reld too little pracademia to

most effective

y has been thg a new startvants. The Eeir response

er_day_2009.she Farm and Caheir sons to sch

g of the Way to

eces-as it

er n of ssia), other

“gov-hat lative ro- e.3

he .

Euro-was

vg attle hool

o

Chapter 11 The Economics of Poverty


genocide and confiscation of a continent. The slave labor developed the southern states; Afri-cans enslaved their wretched fellows and sold them to Europeans. As Chapter 2 argued, there is nothing particularly egalitarian about the genesis of property rights, particularly when people are enslaved or exterminated.

Before the 1960s, there were several unofficial definitions of poverty. Any measure of poverty is necessarily subjective, since its definition requires a judgment about what income or consumption level is adequate or acceptable. We have seen that countries that are poor by the World Bank’s standards of $1.25 or $2 expenditure per day tend to have correspondingly low national poverty standards. Many early British economists and statisticians focused on Engel’s law, named for Ernst Engel4 (1821–1896) who developed an empirical rule that as a family’s in-come increases, the proportion of its budget spent on food tends to decrease.5 Since most people agree that food is both necessary for life and a scarce commodity, economists sought to define poverty as (1) what the poor eat, and (2) how much of their budget the poor spend on food.

In 1962 President Kennedy declared war on poverty. Obviously, to fight a war, one must know one’s enemy. Kennedy’s Council of Economic Advisors recommended a standard of $3,000 per year. However, the government soon switched to a definition based on the work of Mollie Orshansky, a statistician with the Social Security administration. She based her definition on the cost of an economy food budget, an amount that a poor woman, who was a careful shop-per and a good cook, could use to support her family for a short period of time. Since a typical poor family spent one-third of its income on food, the official poverty level was set at three times the cost of the emergency food budget. Since 1962 the official poverty threshold has been ad-justed by the consumer price index. Table 11-1 shows the poverty thresholds for 2011, as defined by the U.S. Department of Health and Human Services. Because the cost of living is higher in Alaska and Hawaii, the poverty thresholds for those two states are consistently higher than for the 48 contiguous states.

Table 11-16

Persons 48 Contiguousin Family or Household States and D.C.

1 $10,890 $13,600 $12,540 2 14,710 18,380 16,9303 18,530 23,160 21,3204 22,350 27,940 25,7105 26,170 32,720 30,1006 29,990 37,500 34,4907 33,810 42,280 38,8808 37,630 47,060 43,270

For each additionalperson, add

2011 HHS Poverty Guidelines

Alaska Hawaii

3,820 4,780 4,390 4 No relation to Karl Marx’s colleague Friedrich Engels. 5 In terms of demand theory, food is a normal good (expenditure increases as income increases), but is income ine-lastic (the percent increase in the consumption of food is smaller than the percent increase in income, causing the proportion of the budget spent on food to decease as income increases). 6 Source: http://www.federalregister.gov/articles/2011/01/20/2011-1237/annual-update-of-the-hhs-poverty-guidelines



In theory, classifying a household as poor or non-poor is straightforward. In practice, however, there are a few qualifications. First, if household income falls below the poverty threshold for that family size, should every member of the household be considered poor, or should there be allowances for differences in consumption within households? Second, how should income-in-kind, such as food stamps, medical benefits, or housing subsidies be counted toward diagnosing poverty? Third, should pre-tax or post-tax income be used? In measuring poverty,7 the United States Census Bureau adds the household’s earnings, unemployment com-pensation, Social Security, public assistance, veterans’ payments, survivor benefits, pensions and retirement income, interest, dividends, rents, royalties, income from estates, trusts, educational assistance, alimony, child support, and assistance from outside the household. The only form of cash income that is excluded is capital gains—the difference between the sales value of an asset and its original purchase price. The Census Bureau uses pre-tax income and ignores noncash benefits such as food stamps and housing subsidies. Once a household’s income is computed, that income is compared with the relevant poverty threshold (there are 48 possible poverty thresholds). If household income is less than the relevant poverty threshold, that household, and each individual in the household, is labeled as below the poverty level. Statistically, we assign a “1” as the poverty variable for that household and all individuals within the household. If household income is greater than the relevant poverty threshold, the household and everyone in the household is labeled as non-poor, and we assign a “0” to that household.

Figure 11-1 plots the official poverty levels (calculated backwards to 1959), for single adults, adult couples, and a family of four, against the consumer price index. Note how all four lines move together through time, with the poverty threshold for a family of four tracking the cost of living (consumer price index) almost perfectly. When we translate that poverty threshold into constant 2011 dollars, we find that the inflation-adjusted poverty threshold tracks as a horizontal line.The definition of poverty threshold in 2011was the same as in 1963, except for an adjust- 7 See http://www.census.gov/hhes/poverty/povdef.html

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Figure 11-2: Poverty Thresholds in Current and Constant 2011 Dollars

One Person Two People Four People Four People: 2011 Dollars



ment for the cost of living. In this sense the official definition of poverty is an absolute poverty standard, meaning that combinations of economic growth and/or reductions in economic ine-quality should reduce this standard over time.8

The Incidence of Poverty

The word incidence comes from the word incident, meaning an occurrence or an event. Hence, the incidence of poverty measures where, when, and to whom poverty occurs. As men-tioned above, at the individual level we identify poor households (and the individuals therein) by coding the “poverty” variable as a 1; households that are not poor are coded as a 0. Since every-one in a household is classified as poor if the household is poor, the poverty variable for all indi-viduals residing in a “poor household” is coded as 1; for residents of non-poor households, the poverty variable is coded as 0. The average of this variable is the sample proportion,p, which is an estimate of the unknown population proportion .9

Figure 11-3

8 It is reasonable to ask if the poverty threshold should be multiplied by the consumer price index for food, rather than the consumer price index for all goods. It turns out it does not matter. Between January 1913 and January 2011, the correlation between the CPI for food and the CPI for all goods is 0.9993. In January 2011 the CPI for all goods stood at 220.223, while the CPI for food stood at 222.912. Switching the inflation adjustment to the CPI for food would increase the 2011 poverty threshold by 1.22 percent. 9 The convention in statistics is to designate (unknown) population parameters as Greek letters, and the relevant sample statistic as an equivalent Roman letter. So, we use p for the sample proportion (the ratio of poor households to total households), and the equivalent Greek letter to stand for the population parameter. Unfortunately, this use of (pi) confuses some students because the Greeks used letters to stand for numbers, and so they designated the (constant) ratio of the circumference of a circle to its diameter as , which is a transcendental number approximately equal to 3.14159, or 22/7.

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Percent of Households Below Poverty Th

reshold

Household Poverty Rates

Multi‐Person Singles



Figure 11-1 plots the official poverty levels (calculated backwards to 1959), for single adults, adult couples, and a family of four, against the consumer price index. Note how all four lines move together through time, with the poverty threshold for a family of four tracking the cost of living (consumer price index) almost perfectly. When we translate that poverty threshold into constant 2011 dollars, we find that the inflation-adjusted poverty threshold tracks as a hori-zontal line.The definition of poverty threshold in 2011was the same as in 1963, except for an ad-justment for the cost of living. In this sense the official definition of poverty is an absolute pov-erty standard, meaning that combinations of economic growth and/or reductions in economic inequality should reduce this standard over time.10

Figure 11-4 shows the historical poverty rates for individuals; because the poverty threshold increases with family size, the poverty rate for individuals tends to be higher than the poverty rate for multi-person households. Like the poverty rates for multiple-person households, the poverty rates for all individuals fluctuates, but in 2012 ended up at a slightly higher level than where it started in 1968. The green line, showing the poverty rate for working-age adults, is slightly higher in 2012 than it was in 1968. The most dramatic patterns are for seniors, which dramatically decreased from 1968 to 1986, and then remained below the poverty rate for work-ing-age people. In contrast, the poverty rate for children rose dramatically from 1968 until 1985 and remained high until decreasing slightly in 1996, the year of welfare reform. The poverty rate for children increased again in 2001through the current recession.

Table 11-2 shows the proportion of individuals residing in households with income below the poverty level by marital status. The overall incidence of poverty is 14.8% percent, which varies dramatically by gender. If we selected a person at random in March 2012, without regard to ethnicity or gender, the probability that that person would be a member of a household with

10 It is reasonable to ask if the poverty threshold should be multiplied by the consumer price index for food, rather than the consumer price index for all goods. It turns out it does not matter. Between January 1913 and January 2011, the correlation between the CPI for food and the CPI for all goods is 0.9993. In January 2011 the CPI for all goods stood at 220.223, while the CPI for food stood at 222.912. Switching the inflation adjustment to the CPI for food would increase the 2011 poverty threshold by 1.22 percent.

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Percent of Individuals in Poor

Households

Individual Poverty Rates by Age Group

children adults seniors



below poverty income would have been between 14.64 percent and 14.95 percent. If we learned that the person was male, the probability of poverty declines to between 12.83 percent and 13.25 percent. Alternatively, if we learned the person was female, then the probability that she is a member of a poor household is between 15.43 percent and 15.86 percent. We say that gender has a significant impact on the likelihood of poverty because the two ranges for the poverty rates for men and women do not overlap. In other words, the probability that the differential poverty rates for men and women were due to sampling error, implying that they both have the same likeli-hood of poverty is smaller than 5 percent. The lowest incidence of poverty is for married cou-ples: 6.11 percent overall.Among married members of the armed forces, women have a higher incidence of poverty (6.18%) than their husbands do (2.08%).When a married person’s spouse is absent, the poverty rate among women (33.16%) is nearly twice the rate for men (17.86%). Among legally separated couples, men had a poverty rate of 14.53% and women had a poverty rate over twice as high (34.02%). Widows had a higher poverty rate (16.43%) than widowers did (12.66%). For adults that had never been married, the poverty rate among men was 16.09%, compared to the higher rate for women (21.52%). The key lesson from Table 11-2 is that mar-ried adults are significantly less likely to be poor than are single adults. A corollary to that les-son is that among single adults and those whose partners are absent, women have a significantly higher likelihood of poverty than men do.

Table 11-2

Individual Poverty Rates by Marital Status

Sample Sample Sample

Marital Status/Gender Poverty rate Std. Dev. Size Minimum Maximum

Married 6.26% 24.22% 78,614 6.09% 6.43%

Male 6.27% 24.24% 39,547 6.03% 6.50%

Female 6.25% 24.20% 39,067 6.01% 6.49%

Married, Armed Foces 7.22% 25.91% 540 5.03% 9.41%

Male 3.33% 18.26% 30 ‐3.48% 10.15%

Female 7.45% 26.29% 510 5.16% 9.74%

Married, spouse absent 24.07% 42.76% 2,152 22.26% 25.88%

Male 15.92% 36.60% 980 13.62% 18.21%

Female 30.89% 46.22% 1,172 28.24% 33.54%

Separated 28.44% 45.12% 3,344 26.91% 29.97%

Male 14.26% 34.98% 1,620 12.55% 15.96%

Female 16.68% 37.28% 6,229 15.75% 17.61%

Widowed 16.18% 36.83% 7,849 15.37% 17.00%

Male 15.08% 35.78% 6,162 14.18% 15.97%

Female 21.67% 41.20% 8,808 20.81% 22.53%

Divorced 18.96% 39.20% 14,970 18.33% 19.59%

Male 17.85% 38.31% 1,350 15.81% 19.90%

Female 35.61% 47.90% 1,994 33.50% 37.71%

Never Married 20.51% 40.38% 93,929 20.25% 20.77%

Male 18.90% 39.15% 48,113 18.55% 19.25%

Female 22.20% 41.56% 45,816 21.82% 22.58%

Total 14.80% 35.51% 201,398 14.64% 14.95%

Male 13.42% 34.09% 97,802 13.21% 13.64%

Female 16.09% 36.75% 103,596 15.87% 16.32%

Population Poverty Rate

Ethnicity and Poverty



Table 11-3 presents the incidence of poverty for men and women by ethnicity. Further investigation shows within each ethnic group – except for other-nonwhites (e.g., Asians, Native Americans) – the poverty rates for women are significantly greater than the poverty rates for men. Holding gender constant, whites have the lowest incidence of poverty while blacks have the highest. Differences in poverty rates among ethnic groups are also statistically significant. Finally, we find that US citizens have significantly lower incidents of poverty than do non-citizens.

Ethnic Group Proportion Std Dev Sample Minimum Maximum

White1 9.45% 29.25% 130,919 9.29% 9.61%

Male 8.34% 27.65% 64,179 8.13% 8.56%

Female 10.51% 30.67% 66,740 10.28% 10.74%

Black1 24.50% 43.01% 23,862 23.96% 25.05%

Male 22.26% 41.60% 10,785 21.48% 23.05%

Female 26.35% 44.06% 13,077 25.60% 27.11%

Other Non-white116.24% 36.89% 18,191 15.71% 16.78%

Male 16.16% 36.81% 8,769 15.39% 16.93%

Female 16.32% 36.96% 9,422 15.58% 17.07%

Hispanic 24.43% 42.97% 36,830 23.99% 24.87%

Male 22.62% 41.84% 18,210 22.02% 23.23%

Female 26.19% 43.97% 18,620 25.56% 26.82%

Citizens 12.39% 32.95% 191,736 12.24% 12.54%

Male 12.25% 32.78% 94,255 12.04% 12.46%

Female 13.70% 34.38% 98,793 13.48% 13.91%

Non-Citizens 24.95% 43.27% 15,341 24.26% 25.63%

Male 22.74% 41.92% 7,688 21.80% 23.67%

Female 27.17% 44.48% 7,653 26.17% 28.16%1 Excludes Hispanics

Table 11-3Impact of Ethnicity on Poverty Rates in 2007

Table 11-4 shows the conditional probabilities of poverty by educational attainment. The first column shows the highest grade completed, and the second column shows the relative size of that group in the March 2011Current Population Survey. The incidence of poverty is the sample proportion of people within that educational category whose household income is below the poverty threshold. Children constitute 24.11 percent of the sample; their poverty status de-pends on their parent’s income.11 The standard deviation measures the variation of the poverty measure within each educational category.12 The standard error of the mean is our measure of sampling error, since we are estimating the poverty rate for the entire U.S. population from a random sample of 206,404individuals.13 The confidence interval is the range of most likely val-

11 The incidence of poverty is different for children in this table than in Table 11-2 because here children are those under the age of 15.

12 For a sample, (1 )

1i

p ps

n

, where p is the sample proportion for that group and ni is the number of observa-

tions in each educational category, out of the total sample of 206,639.

13

i

ip

i

ss

n , where si is the standard deviation for that educational group, and ni is the sample size of that group.



ues for the population proportion—that is, we are 95 percent confident that the incidence of pov-erty for the population in that education group is within these two limits.

The strongest inference we can draw from Table 11-4 is that graduating from high school is an important determinant of whether or not someone is poor. For all groups with less than a high school diploma, including children under 15, the incidence of poverty for that group is sig-nificantly greater than for the population as a whole, for whom 14.23% <<14.53%, where is the population incidence of poverty.14Indeed, the poverty rate for high school graduates (who never attended college) is only slightly below the average for all education groups. The confi-dence intervals for all education groups without high school diplomas all overlap and the mini-mum probability for each group is greater than the maximum probability for high school gradu-ates. Table 11-4 also shows that education does not prevent poverty. The incidence of poverty is significantly greater than zero for those who have professional degrees or doctoral degrees.

Table 11‐4

2010 Poverty Rates by Educational Attainment of Survey Respondent

Educational Sample Statistics Population Range

attainment Mean Std. Dev. Freq. minimum maximum

Children

Less than 1st grade 38.89% 48.92% 144 30.83% 46.95%

1st‐ 4th Grade 32.26% 46.80% 434 27.84% 36.67%

5th‐6th Grade 32.07% 46.70% 898 29.01% 35.13%

7th‐ 8th Grade 30.76% 46.17% 985 27.87% 33.65%

9th Grade 34.16% 47.45% 928 31.10% 37.22%

10th Grade 31.01% 46.28% 1048 28.21% 33.82%

11th Grade 32.60% 46.89% 1362 30.11% 35.09%

12th Grade No Diploma 27.04% 44.45% 662 23.65% 30.43%

High School Graduate 14.75% 35.46% 15213 14.19% 15.31%

Some College/No Degree 11.48% 31.88% 9657 10.85% 12.12%

2‐year vocational degree 7.99% 27.12% 2579 6.94% 9.03%

2‐year academic degree 6.74% 25.08% 2937 5.83% 7.65%

Bachelor’s Degree 3.74% 18.96% 10387 3.37% 4.10%

Master’s Degree 2.56% 15.79% 4300 2.09% 3.03%

Professional Degree 2.20% 14.67% 819 1.19% 3.20%

Academic Doctorate 1.70% 12.93% 883 0.84% 2.55%

Total 11.91% 32.39% 53236 11.63% 12.18%

Another important factor in predicting poverty is work status. We have seen that there is a high incidence of vulnerable populations like children, who cannot work, and senior citizens, who have retired. Table 11-5 shows the incidence of poverty by the labor-force participation and employment status of individuals. Those who have jobs are both employed and labor-force par-ticipants. Those who are unemployed do not have a job, but are available for a job, and are (1) awaiting recall while being laid off, or (2) actively looking for a replacement job. Those who are not available for work are nonparticipants, who include (1) retirees, (2) those who are too disa- 14 We infer that two population proportions are different when their confidence intervals do not overlap.



bled to work, or (3) have other reasons for nonparticipation, including full-time household pro-duction or full-time study.

Labor-Force Status Proportion Std Dev Sample Minimum MaximumProportion Proportion

Children 21.12% 40.82% 48,810 20.76% 21.48%Employed, At Work 6.53% 24.71% 88,801 6.37% 6.69%Employed, Not At Work 7.99% 27.12% 2,778 6.98% 9.00%Unemployed, Layoff 15.93% 36.61% 1,042 13.71% 18.16%Unemployed, Looking for Work 27.44% 44.62% 8,062 26.46% 28.41%Not in Labor Force, Retired 11.50% 31.90% 20,556 11.06% 11.94%Not in Labor Force, Disabled 36.65% 48.19% 7,650 35.57% 37.73%Not in Labor Force, Other Reason 24.54% 43.03% 27,284 24.03% 25.05%

Total 14.91% 35.62% 204,983 14.76% 15.07%

Table 11-52011 Labor-Force Status and Probability of Poverty

Children (those under 16) are not labor-force participants, and their poverty status de-pends on the income of their parents or guardians. Employment reduces the probability of pov-erty from 14.38 percent to 6.45 percent; nevertheless, 6.53% of members of the labor force are the working poor. Those who are employed but not at work (e.g., they are on unpaid leave) have a significantly higher incidence of poverty than do those who are working.15 Those who are laid off from their jobs have a still higher incidence of poverty, typically because unemploy-ment compensation covers only about half of their employment earnings, and because the long-term unemployed (those laid off whose jobs disappeared) exhaust their benefits. Those who are unemployed and looking for work (people who were fired, quit, or recently entered the labor force) have an incidence of poverty of over 27 percent. Retirees have a poverty rate of between 11.06% and 11.94%. Those who cannot work because of a disability have a better than 1 in 3 chance of being poor. Finally, those who do not participate in the labor force because they are full-time parents or full-time students have a 24.03 percent to 25.05 percent incidence of poverty.

In short, poverty results from those who do not succeed because they are too young, un-married, uneducated, unemployed, or disabled. It would be wonderful if all children grew up in homes with married, responsible, well-educated, employed and caring parents. It would be won-derful if all ethnic groups experienced equal opportunity to succeed. It would be wonderful if employers could find meaningful work for the disabled. It is wonderful that old age is declining as a cause of poverty. But in a world of economic inequality, some people will not succeed, ra-ther from lack of opportunity, lack of effort, or misfortune.

Approaches to Poverty: Neglect, Prevention, Treatment, or Cure

Speaking of the incidence of poverty is very much like discussing the incidence of a dis-ease. For instance, if babies are born with a disease, physicians look for a genetic cause; if a dis-ease spreads quickly from one person to another, physicians look for an environmental cause. If the disease is based on behavior, physicians recommend behavior modification. Alas, some con-sider disease to be “god’s will,” and refuse to help. Depending upon what they know about the disease and its causes, physicians havefour options: (1) they can neglect the victim, (2) they may

15 That is, the minimum population proportion for those employed but not at work exceeds the maximum population proportion for those who are employed and at work.



treat the symptoms, (3) they can quarantine the victim to prevent spread of the disease, or (4) they may cure the disease.

A History of Neglect

For the first 150 years of our history – from 1776 until 1933 – Americans treated poverty as a reflection of indolence or sinfulness. Poor children were quarantined in orphanages and poor adults were locked up in debtors’ prisons. People who failed often picked up and moved to the frontier, confiscating land from “savage” aboriginals. In fact, the economic theory that pre-vailed from the early 1800’s was based on a self-serving theory developed by Thomas Robert Malthus, an Anglican minister and amateur demographer.16 According to Malthus, the standard of living of the bulk of mankind is governed by an exorable “iron law of wages.” The theory was based on two assumptions, both of which turned out to be false. First, Malthus assumed that people were governed by an insatiable drive to reproduce; that is, population would grow at a geometric rate: two parents have four children, who marry and have eight children, and so forth. Second, Malthus assumed that food and other necessities would increase at an arithmetic rate (i.e., a harvest might increase from 500 to 525, to 550, and so forth. Figure 11-5 shows a popula-tion of P0 and resources of R0 at time zero. Initially, the resources are adequate to support a larg-er population. Over time, however, population grows at a geometric rate17 – Pt = P0(1+r)t – while resources grow at an arithmetic rate – Rt = R0+dt. Eventually, at time t*, population ex-hausts the excess resources, and population growth is held in check by “disease, high infant mortality, famine, war or moral restraint.”

According to Malthus, the British working class population had already pushed up against resource capacity, condemning them to a David Copperfield existence. Many mothers and children died in childbirth and most children died before age seven. If they survived to

16 See http://www.economyprofessor.com/economictheories/malthusian-population-theory.php. 17

In Figure 11-5, the population trend equation is 100(1.1)ttP while the resource equation is 1000 100tR t .

0

200

400

600

800

1000

1200

1400

1600

0 5 10 15 20 25 30 35

time

Figure 11‐5Malthusian population model

resources population

t*



that age, children were apprenticed in a trade or sent to work in a factory, typically working a 12-hour shift. Malthus’s pessimism led Thomas Carlisle to dub economics “the dismal sci-ence.”In 1832 the Wig government in Parliament essentially repealed the 1601 “Poor Laws” designed to feed Britain’s hungry. In supporting the repeal, Malthus and other economists argued that any financial assistance to the poor would simply cause more of their children to survive to working age which would increase the supply of labor and once again depress wages to a subsistence (starvation) level. Given the futility of helping the poor, and since taxes would detour job creation, the best way to help the poor is to leave them alone.

We have already seen that economic growth does not lead families to have more chil-dren; as the opportunity cost of time increases, families tend to reduce the number of children they have, although they tend to spend more resources on the children they have. Further-more, Malthus’s assumption that economic output could only increase at an arithmetic rate has also proved false. When Malthus wrote in the first quarter of the 19th century nearly 90% of Americans lived on farms. Today, less than 1% of the US population is employed in agricul-ture and food is our leading export.

Malthusian population theory is an excellent example of pseudo-science masquerading as truth. It was in the interest of both aristocrats and capitalists to maintain low tax rates. To this end they used Malthusian population theory as an intellectual cover for their stinginess. In our own time political conservatives preach the virtues of self-sufficiency for the poor, alt-hough they continue to practice welfare for the rich. Alas, it was not the empirical refutation of the premises of Malthusian theory that led to its (temporary) loss of popularity, but the widespread economic dislocation of the Great Depression of the 1930’s. What is remarkable to me is that the spirit of Malthus is alive in the Tea Party movement which ironically is a con-servative reaction to the economic dislocation of the Great Recession.

Insurance-Like Anti-Poverty Programs

Workers’ Compensation

The first formal government anti-poverty program was workmen’s compensation, (now known by the gender-neutral term, workers’ compensation) which was enacted in 1907 to pre-vent poverty resulting from on-the-job workers’ injuries. Today, workers’ compensation is ac-ollection of state-administered programs, where states set the standards for eligibility and bene-fits under federal government guidelines.

Like many other anti-poverty programs, workmen’s compensation is designed much like an insurance program, in that it is intended to protect non-poor households from the hazards that otherwise would lead to poverty. Just as one must be healthy (have no preexisting conditions) to get health insurance, a person must first be employed to be covered by workers’ compensation. Second, a beneficiary must be injured while working in that job. Like insurance programs that exclude preexisting conditions (the unemployed) and certain claims (injuries that are not work related), workers’ compensation is a program of targeted benefits. And just as private insurance benefits can vary from company to company, workers’ compensation benefits vary from state to state. That is because, while workers’ compensation programs are based on federal legislation, their basic benefits are set by states, with federal government matching funds.

Any insurance-like program causes two major distortions of economic behavior. First is moral hazard, whereby individuals change their behavior because the harmful consequences of bad choices are reduced. If a worker knows that his or her family’s economic security depends on the worker not having a debilitating injury, that person will be very cautious on the job. Workers’ compensation reduces the risk of economic catastrophe, thereby reducing the workers’



incentive to be careful. One could argue, however, that before the onset of workers’ compensa-tion, employers faced a moral hazard problem if they felt they would not be held responsible for their workers’ injuries. Early workmen’s compensation programs18 placed all employers in the same risk pool—that is, the tax or insurance rate19employers paid to insure their workers were independent of the likelihood that workers would be injured. Over time, states have adapted their insurance programs to correspond more to private insurance, whereby employers whose workers face a higher risk of on-the-job injury also have higher tax and/or insurance rates.

Another insurance-like problem is adverse selection, whereby the riskiest employers tend to drive out the least risky employees. In states in which employers can receive waivers to self-insure their employees, the employers of workers who are least likely to have on-the-job in-juries, say office workers, will elect out of the state-sponsored system. This increases the risk pool, requiring a rate increase to cover the cost of insuring the remaining risk pool. As rates in-crease, more employers opt out of the system, until at last, the fund becomes insolvent.

Table 11-6 shows the average workers’ compensation and unemployment benefits and the proportion of the 2010 CPS sample receiving benefits by state.20 Nation-wide, about 250 workers in 10,000 who worked at least one week in 2010 received workers’ compensation bene-fits. The average benefit was $9,181 and ranged from a low of $2,743 per recipient in Nebraska, to a high of $24,301 per recipient in Nevada. There is a insignificant relation between the aver-age wage rate and the average workers’ compensation benefit.21 Unemployment compensation is awarded to workers who lose their job due to layoff or other reasons beyond their control; workers who quit their jobs or who are fired for any cause are not eligible for unemployment compensation.

Unemployment Compensation

Unemployment compensation was started in the Great Depression, when widespread un-employment not only increased poverty, but also turned what could have been a temporary eco-nomic downturn into an economic pandemic. If one’s wealth has already been lost through the stock market crash and associated bank failure, the loss of employment would immediately plunge the family into poverty. Fearing a similar economic disaster, fellow workers would begin to increase their saving as a means of self-insurance. However, the reduction in consumption increases business inventories, leading to the very layoffs for which the frugal workers were pre-paring. Hence, by replacing a portion (typically 50 percent) of former wages, unemployment compensation should reduce the macroeconomic repercussions of widespread unemployment.

In 1932, Wisconsin became the first state to offer unemployment insurance. The genesis of the federal unemployment insurance program was the Social Security Act of 1935, which used a payroll tax (equally imposed on workers and employers) to replace income lost to retirement or disability. Under the Social Security Act, the federal share of unemployment insurance covers the administrative costs, while state revenue from payroll taxes covers only benefits. Each state

18 The politically incorrect label should indicate that this was a historical problem. 19 State workers’ compensation systems in North Dakota, Ohio, Puerto Rico, the Virgin Islands, Washington State, West Virginia, and for the United States (federal employees) are exclusively operated by the state government. All the other states have private workers’ compensation insurance coverage. Twenty-five states have a mixture of pub-lic and private insurance options, and the remaining states have only private insurance options. 20 Recall, income reported in the March 2010 CPS refers to calendar-year 2009 income. 21 The correlation is 0.0838, which is statistically insignificant at the .559-percent level.



sets its own rules and has charge of program administration for that state. Hence, the benefits, eligibility rules, and number of weeks that benefits can be received vary from state to state. The original unemployment compensation system limited benefits to employees in certain industries, and required a waiting period of between two and four weeks. Since the 1970s however, the scope of unemployment compensation has been increased, with benefits typically limited to 26 weeks (six months). Coverage expands to 39 weeks when unemployment rates become high by historical standards.

Average Per Percent of Average Per Percent of Sample Unemploy- AverageState Benefits Worker Workers Benefits Worker Workers Size ment Rate Earnings

ME $91.18 $15,443 0.59% $265.50 $5,975 4.44% 3,218 9.99% $40,368

NH $25.96 $6,041 0.43% $162.60 $6,654 2.44% 3,724 6.16% $47,025

VT $8.25 $4,450 0.19% $196.43 $5,574 3.52% 2,696 5.70% $38,997

MA $56.31 $18,727 0.30% $300.44 $9,176 3.27% 2,993 6.94% $52,138

RI $66.73 $6,798 0.98% $346.86 $7,023 4.94% 3,260 11.74% $42,250

CT $55.71 $10,121 0.55% $265.84 $7,500 3.54% 4,542 8.44% $56,412

NY $53.46 $11,510 0.46% $240.18 $6,759 3.55% 8,611 8.36% $45,817

NJ $39.03 $12,304 0.32% $497.18 $10,612 4.69% 4,098 8.76% $52,963

PA $45.11 $11,555 0.39% $313.69 $7,248 4.33% 5,892 7.35% $43,665

OH $29.40 $8,894 0.33% $187.92 $6,187 3.04% 4,840 7.93% $39,486

IN $6.19 $3,115 0.20% $129.54 $5,589 2.32% 3,020 8.05% $43,490

IL $26.14 $9,391 0.28% $247.08 $7,831 3.15% 6,466 9.00% $45,322

MI $32.54 $7,143 0.46% $230.71 $6,078 3.80% 4,610 8.74% $40,929

WI $41.55 $8,957 0.46% $230.64 $4,803 4.80% 3,665 8.39% $38,783

MN $21.00 $5,503 0.38% $208.85 $6,235 3.35% 4,717 7.20% $44,512

IA $14.69 $3,642 0.40% $165.99 $5,563 2.98% 3,720 5.32% $38,412

MO $8.36 $4,263 0.20% $137.00 $5,176 2.65% 3,060 7.56% $42,195

ND $8.32 $6,447 0.13% $110.82 $4,953 2.24% 2,324 3.33% $43,476

SD $26.05 $4,611 0.56% $53.97 $3,961 1.36% 3,009 5.37% $36,846

NE $9.75 $2,945 0.33% $115.73 $5,195 2.23% 3,322 3.66% $41,602

KS $29.05 $7,599 0.38% $157.93 $5,223 3.02% 2,877 7.08% $38,798

DE $35.13 $7,965 0.44% $182.19 $6,286 2.90% 3,174 8.81% $40,938

MD $23.97 $14,940 0.16% $182.26 $7,902 2.31% 4,986 8.03% $51,174

DC $54.30 $13,324 0.41% $146.97 $7,346 2.00% 2,699 10.63% $64,147

VA $23.80 $13,136 0.18% $107.23 $6,229 1.72% 4,415 6.77% $48,398

WV $66.45 $10,171 0.65% $204.45 $6,562 3.12% 1,990 7.17% $39,167

NC $25.44 $6,358 0.40% $219.89 $6,979 3.15% 3,999 9.15% $41,138

SC $50.43 $13,319 0.38% $195.83 $6,125 3.20% 2,377 10.03% $32,850

GA $22.53 $8,903 0.25% $170.70 $6,744 2.53% 4,346 9.44% $42,443

FL $23.05 $11,451 0.20% $140.53 $5,698 2.47% 7,947 8.56% $41,274

KY $38.50 $7,469 0.52% $172.37 $5,394 3.20% 2,910 9.10% $35,765

TN $36.27 $23,896 0.15% $168.14 $5,830 2.88% 2,635 7.53% $37,890

AL $33.62 $9,253 0.36% $171.23 $5,627 3.04% 2,202 8.17% $39,548

MS $24.82 $7,480 0.33% $97.87 $3,847 2.54% 1,808 8.45% $37,284

AR $22.67 $8,774 0.26% $118.95 $4,262 2.79% 1,935 7.21% $33,938

LA $47.87 $11,338 0.42% $82.83 $4,616 1.79% 1,895 8.43% $38,407

OK $13.78 $3,760 0.37% $68.68 $4,817 1.43% 2,455 4.58% $43,212

TX $18.99 $5,367 0.35% $145.24 $6,926 2.10% 11,873 6.49% $42,165

MT $26.35 $9,542 0.28% $169.36 $5,112 3.31% 1,811 7.39% $32,681

ID $7.52 $3,607 0.21% $224.41 $5,491 4.09% 2,398 9.42% $34,009

WY $42.12 $9,228 0.46% $136.75 $5,447 2.51% 2,629 6.50% $40,611

CO $26.69 $8,046 0.33% $230.90 $7,353 3.14% 4,522 8.64% $45,949

NM $23.83 $9,110 0.26% $199.30 $7,324 2.72% 1,911 6.68% $39,683

AZ $12.08 $6,308 0.19% $175.27 $7,502 2.34% 2,611 8.54% $40,500

UT $28.91 $7,809 0.37% $135.32 $5,992 2.26% 2,701 7.05% $40,531

NV $17.93 $6,209 0.29% $306.20 $7,695 3.98% 3,116 11.47% $37,469

WA $41.32 $7,022 0.59% $343.03 $7,484 4.58% 3,229 9.58% $44,902

OR $21.33 $5,663 0.38% $319.11 $6,139 5.20% 2,655 9.62% $39,803

CA $58.28 $10,458 0.56% $310.24 $7,702 4.03% 19,738 11.79% $44,421

AK $97.00 $17,388 0.56% $169.41 $4,390 3.86% 2,151 8.19% $45,961

HI $52.36 $9,964 0.53% $227.41 $8,306 2.74% 3,616 5.71% $43,047

Average $34.99 $9,035 0.39% $211.95 $6,705 3.16% 201,398 8.22% $43,170

Table 11-6Workers' Compensation and Unemployment Benefits in 2011 by State

Workers Compensation All WorkersUnemployment Compensation



Like workers’ compensation, unemployment compensation also is plagued by problems of moral hazard and adverse selection. The moral hazard problem results from the distinction between a layoff, a temporary unemployment condition that results from inadequate aggregate demand, and structural unemployment, which occurs because of a change in the supply and de-mand for labor. Unemployment compensation was meant to deal with temporary layoffs: While the economy undergoes a contraction phase, the unemployed have sufficient income to survive until their jobs return during the expansion phase. Structural changes in the labor market may mean that workers are waiting for jobs that no longer exist. For instance, during the recession of 1979–1983, the loss of jobs initially due to the anti-inflationary contraction in the economy un-der President Carter lasted through the increase in real interest rates following large budget defi-cits, which permanently destroyed blue-collar jobs in industries like steel and automobiles. Be-cause their high-paying previous manufacturing jobs paid more than their replacement service jobs, many of the unemployed did not bother to look for work outside of manufacturing until their unemployment benefits were nearly exhausted.

Another problem with unemployment compensation is that employers in low-unemployment industries tend to subsidize firms in high-unemployment industries. Employers who have invested a large amount of specific human capital in their workforce would have to pay wages during economic downturns, lest their workers seek employment outside the industry. With unemployment compensation, those workers can continue to receive half their wages dur-ing high-unemployment periods, in this case at the expense of employers with small investments in specific human capital.

Another complication with state-operated insurance-like programs is that states may ac-tually compete with each other to set low benefits as a strategy of attracting employers. Table 11-6 shows the variation in workers’ compensation and unemployment compensation benefits by state during 2010. The first column gives the state name (postal abbreviation) and the next three columns give workers’ compensation statistics. States with higher worker compensation benefits (a) are more attractive to employers whose workers might be injured on the job and (b) encour-age workers who are injured on the job to take a longer period of time to recuperate.

In 2010, an average of 1 worker in 12 received unemployment compensation benefits. Not all workers receive unemployment benefits; one can receive those benefits only if one is an involuntary job loser, who is not fired for cause. Many economists believe, however, that many employers agree to report that they laidoff their workers for lack of work, rather than firing them for cause, if the employee agrees not to contest his or her discharge. Unemployment compensa-tion ranges from the low of $5,167 in Nebraska to $11,239 in New Jersey; the average per work-er is $301.70, or 1 percent of average annual earnings. Since individual unemployment benefits are a function of pre-unemployment earnings, we expect a stronger positive relation between un-employment benefits and the average wage rate in a state.22

Social Security and Medicare

The two largest and most effective anti-poverty programs are the Social Security program and the Medicare program, both under attack by the Tea Party Congress. Congress enacted the Old Age and Retirement System in 1938, the same year it enacted unemployment compensation. Originally intended to start paying benefits in 1942, the first benefits were actually paid in 1940.

22 The correlation is +.5383, which is statistically significant at the .01-percent level.



The fact that retirees received benefits after little contributions to the system meant that Social Security was a pay-as-you-go system. Nevertheless, there is the widespread belief, fostered by the Social Security administration itself,23 that each person has a separate account with money or other assets set aside for his or her retirement. In fact, the Social Security trust fund is like a bathtub, whose water-level rises when taxes enter the system (like water from the faucet), and falls when benefits are paid out (like water seeping into the open drain). In 1983, Congress in-creased the payroll tax, the cutoff income for that tax, and phased in a delayed retirement age from 65 to 67. The surplus in the Social Security trust fund went to support the rest of the fed-eral budget that was in deficit. In fact, the Social Security Trust Fund is now the largest creditor for the United States Treasury.

In order to qualify for Social Security retirement benefits, a person and his or her em-ployer24 must have paid Social Security taxes for a minimum of 40 quarters. In this sense, Social Security is set up like an insurance system because in order to be protected from poverty due to old age, the person must first have a job to be retired from. Furthermore, retirement benefits are loosely tied to one’s payroll tax history; the more one contributes, the more one expects to re-ceive, although Social Security benefits tend to decrease as a percentage of earned income. Fi-nally, like unemployment compensation and workers’ compensation, old age and survivor’s ben-efits are not means tested. Social Security benefits are independent of non-labor income includ-ing interest, dividends, rents, and private pension income.25

Table 11-7 shows the trend in Social Security benefits and poverty among seniors. The second column shows seniors as a percent of the adult population, which increased from 9.21% percent in 1968 to 12.3% in 1994 before declining to 11.18% in 2012. The poverty rate among seniors is shown in column 3, showing a dramatic decrease from 27.74% in 1968 to only 9.37% in 2012. Expressed in constant 2011 dollars, Social Security benefits averaged $5,332 per senior citizen and $264 for younger people (who may receive disability or survivors’ benefits) in 1967. In that year Social Security benefits averaged 36.96 percent of total income for seniors and only 1.08% for others. Social Security’s share of total senior income 45.64% in 1995, and declined to 37.9% in 2010. Social Security benefits were 1.08 percent of the income of people younger than 65 in 1967, and were 1.74% percent in 2011.

The companion of the Social Security Old Age and Survivor’s Insurance program is the Medicare program. Passed as part of President Lyndon Johnson’s War on Poverty, Medicare was intended to assist senior citizens with their health care expenses. Medicare is an in kind transfer: Instead of receiving a supplement to Social Security income, seniors were given access to a government-administered health insurance program. As an insurance program, Medicare is not means tested; everyone reaching the age of 65 qualifies for Social Security coverage. Like any insurance program, Medicare generates a moral hazard problem; given that their health costs

23 You may have received a letter from the Social Security administration documenting payroll taxes that you and your employer(s) paid, along with predicted benefits if you retire at age 62 or 67. However, Social Security will be able to pay you those benefits only if people working after you retire pay taxes that are sufficient to cover your bene-fits and those of other retirees. 24 Self-employed workers pay the entire payroll tax; economic theory implies that the payroll tax is shifted from employers to workers. 25 However, many companies reduce their pension payments by the amount of Social Security income workers re-ceive.



are subsidized by the government, seniors want the best medical care that (the taxpayer’s) money can buy.

Table 11-7 CPS Senior Consumer

Survey Percent Poverty Price

Year Seniors Rate Seniors Others Seniors Others Seniors Others Index

1968 9.21% 27.74% $5,332 $264 $15,502 $24,461 34.39% 1.08% 33.4

1969 9.29% 24.76% $5,695 $275 $16,993 $25,642 33.52% 1.07% 34.8

1970 9.33% 25.14% $5,566 $259 $17,254 $26,513 32.26% 0.98% 36.7

1971 9.38% 24.71% $6,094 $287 $17,071 $26,386 35.70% 1.09% 38.8

1972 9.62% 21.52% $6,685 $317 $18,108 $26,364 36.92% 1.20% 40.5

1973 9.73% 18.40% $7,468 $367 $19,165 $27,951 38.97% 1.31% 41.8

1974 10.29% 16.09% $8,154 $429 $19,877 $28,593 41.02% 1.50% 44.4

1975 10.26% 15.58% $8,242 $434 $19,443 $27,372 42.39% 1.59% 49.3

1976 10.06% 15.66% $8,365 $331 $19,641 $19,426 42.59% 1.70% 53.8

1977 9.98% 15.61% $8,626 $340 $20,072 $19,955 42.97% 1.70% 56.9

1978 10.15% 14.71% $8,764 $367 $20,433 $20,643 42.89% 1.78% 60.6

1979 10.35% 14.70% $8,859 $379 $20,855 $21,267 42.48% 1.78% 65.2

1980 10.53% 16.01% $8,556 $347 $20,029 $21,311 42.72% 1.63% 72.6

1981 10.59% 16.43% $8,595 $345 $19,893 $20,273 43.21% 1.70% 82.4

1982 10.82% 15.83% $8,911 $360 $21,003 $20,115 42.43% 1.79% 90.9

1983 10.99% 15.14% $9,319 $346 $21,994 $19,945 42.37% 1.74% 96.5

1984 11.03% 14.66% $9,502 $328 $22,345 $20,432 42.53% 1.60% 99.6

1985 11.28% 12.87% $9,630 $324 $23,519 $21,596 40.94% 1.50% 103.9

1986 11.60% 12.92% $9,724 $318 $23,468 $22,203 41.44% 1.43% 107.6

1987 11.65% 13.10% $9,844 $321 $24,068 $22,926 40.90% 1.40% 109.6

1988 11.93% 12.60% $9,543 $324 $24,059 $23,578 39.66% 1.38% 113.6

1989 12.26% 12.32% $9,559 $328 $24,220 $23,782 39.47% 1.38% 118.3

1990 11.96% 11.64% $9,598 $324 $25,522 $24,092 37.61% 1.34% 124.0

1991 12.02% 12.19% $9,539 $315 $25,097 $23,254 38.01% 1.35% 130.7

1992 12.17% 12.55% $9,552 $313 $24,142 $22,861 39.57% 1.37% 136.2

1993 12.29% 12.82% $9,727 $337 $23,535 $22,797 41.33% 1.48% 140.3

1994 12.30% 12.67% $9,901 $345 $23,685 $22,777 41.80% 1.51% 144.5

1995 12.15% 11.76% $10,659 $350 $24,052 $23,364 44.32% 1.50% 148.2

1996 12.07% 11.07% $10,593 $358 $24,786 $24,630 42.74% 1.45% 152.4

1997 12.10% 11.17% $10,658 $361 $25,180 $25,171 42.33% 1.43% 156.9

1998 11.90% 10.84% $10,787 $379 $26,412 $26,145 40.84% 1.45% 160.5

1999 11.96% 10.89% $10,836 $356 $27,478 $26,965 39.43% 1.32% 163.0

2000 11.90% 10.04% $10,908 $367 $27,493 $27,062 39.68% 1.36% 166.6

2001 9.45% 10.85% $10,828 $331 $26,898 $27,174 40.26% 1.22% 172.2

2002 9.47% 10.95% $10,904 $340 $26,403 $27,122 41.30% 1.25% 177.1

2003 9.42% 11.33% $10,893 $352 $26,012 $26,667 41.88% 1.32% 179.9

2004 9.55% 10.94% $10,968 $364 $26,699 $26,720 41.08% 1.36% 184.0

2005 9.76% 10.69% $11,010 $377 $27,032 $26,689 40.73% 1.41% 188.9

2006 9.79% 11.13% $10,855 $384 $27,735 $27,120 39.14% 1.41% 195.3

2007 9.92% 10.35% $11,056 $390 $28,418 $27,733 38.90% 1.41% 201.6

2008 10.15% 10.19% $11,009 $394 $29,306 $27,548 37.57% 1.43% 207.3

2009 10.29% 10.23% $11,219 $405 $29,043 $26,745 38.63% 1.52% 215.3

2010 10.42% 9.68% $11,912 $423 $29,469 $26,205 40.42% 1.61% 214.5

2011 10.71% 9.83% $11,313 $437 $29,420 $25,831 38.45% 1.69% 218.1

2012 11.18% 9.37% $11,344 $454 $29,934 $26,060 37.90% 1.74% 224.9

Total 10.66% 13.52% $9,682 $356 $24,081 $24,510 40.21%

Social Security Average Income

2011 Dollars Social Security Income

Total Income

Figure 11-5 shows the history of Social Security and Medicare benefits as a share of per-sonal income between 1941 and 2011,26with their current growth trends extrapolated to the year 2050. While personal income increased at an annual rate of 7.54% (from 1929 to 2011), Social

26 Medicare benefits were not available in the March 2008 CPS.



Security benefits increased at a rate of 12.35% per year (from 1941 to 2011) and Medicare bene-fits increased at an annual rate of 11.77% (from 1967 to 2011). When benefits grow faster than income, it follows that benefits absorb a greater share of personal income. In 2011, social securi-ty benefits absorbed 5.5% of all personal income. Note that this was substantially less than the combined payroll tax rate of 12.4% on employers and employees because non-labor income and labor income above $110,000 are not taxed. Medicare benefits constitute 4.28% of personal in-come, which exceeds the tax rate of 2.9% imposed on employers and employees (without a cap). It follows that Medicare will face a revenue crisis much sooner than Social Security will. If the relative rates of growth continue, Social Security income will grow to 30% of personal income, and Medicare will represent nearly 20% of personal income by the year 2050. Obviously, either the tax base must increase, or benefits must eventually be scaled back. The greatest problem for reform is that senior citizens have a much higher voting rate than working-aged adults do.

Figure 11-5

The Future of Social Security

Social Security and Medicare are the two most successful anti-poverty programs in American history. Between 1967 and 2012, the incidence of poverty among senior citizens de-creased from 27.74 percent (over twice the national average) to 9.37 percent, which is lower than the incidence of poverty for working-age adults. Because conventional wisdom holds that Social Security is a pension program (although it is pay as you go), and because Medicare looks like a health-insurance program, neither program carries the stigma of welfare. However, the very success of Social Security and Medicare are likely to be their undoing. Because both programs are pay-as-you-go programs, future benefits for today’s workers depend on taxes paid by future workers.

We have already seen that total OASDI benefits are rising much faster than the payroll tax base because (1) retired people are living longer, (2) OASDI benefits are automatically ad-justed to the cost of living (which few pension programs are), and (3) senior citizens are reliable one-issue voters, making it tempting for politicians to “buy” the votes of seniors, who vote, ra-

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

1941

1945

1949

1953

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

2013

2017

2021

2025

2029

2033

2037

2041

2045

2049

Ratio of Benefits to Personal

Income

Relative Size of Social Security and Medicare Benefits

Social Security Share of Personal Income Medicare Share of Personal Income

Historical Social Security Share Historical Medicare Share



ther than the younger citizens, who are less likely to vote. The demographics do not look good for either program.

In 1983, the Greenspan Commission (named for Federal Reserve Chairman Alan Green-span) warned of impending cash shortages. As a result, Congress increased both the payroll tax rate and the maximum taxable earnings level, which was indexed to the cost of living. For the first time, Congress taxed one-half of Social Security benefits on recipients with total incomes in excess of $25,000 annually. In 1993, Congress made 85 percent of Social Security benefits tax-able on individuals with incomes over $34,000 and couples with incomes over $44,000. Note how Social Security revenues increased, relative to Social Security transfers after 1983. Howev-er, the Social Security surplus was merely borrowed by the U.S. Treasury to fund first the Reagan tax cuts and expenditure increases, and now the Bush II tax cuts and spending increases.

Privatizing Social Security would combine the worst aspects of the current Social Securi-ty system and private retirement accounts. George W. Bush proposed that workers be allowed to “invest” a portion of their payroll tax in the stock market (that is, the government would encour-age stock market speculation by picking which casinos workers could gamble their savings in). Although buying stocks and bonds is risky, Bush hoped that those accounts would grow faster than the payroll tax base, allowing for higher benefits without payroll tax increases. Just imagine what would have happened to retirement funds if they had been “invested” in the stock market during the market meltdown in 2008. My proposal: don’t privatize social security; kill it (gen-tly).

The end of Social Security would eliminate a major moral hazard problem. When peo-ple realize that Social Security is dead, they will increase the portion of their income they save and loan to the business sector for capital formation. The death of Social Security will mean new life for United States investment. Indeed, the U.S. deficit is currently bleeding international fi-nancial markets of much needed development funds for less-developed countries. The death of Social Security may, in a small way, improve the lot of the 60 percent of the world’s population that consume only 10 percent of its output.

On the downside, the end of Social Security will increase the incidence of poverty among senior citizens. First, not everyone will prudently save for their retirement, and those too old to work will face a bleak future in what should have been their golden years. Further, since finan-cial markets are risky, some unlucky financial investors will lose some or all of their savings in imprudent get-rich-quick schemes. Since senior citizens vote, it is unlikely that politicians will allow seniors to wallow in the type of poverty they are willing to tolerate in single-mom house-holds. So welfare for seniors may improve the prospects for welfare for children.

So, if Social Security is going to die, how should we kill it: starve it to death (the Bush plan), or by lethal injection? I propose the latter. First, guarantee Social Security benefits to all seniors currently receiving them. That means a phase-out program of approximately 20 years. Over time, pay back to all current workers all their contributions into the Social Security pro-gram. To do this, I propose extending the payroll tax rate of 7.6 percent to all sources of income. The chief beneficiaries of the increase in Social Security taxes since 1983 have been the rich, who received the bulk of the Reagan and Bush tax cuts; it is only fair that these people support the phase out of the program that has served them so well for so long.

In 1935 there was sound reason for a government-mandated retirement system. The stock market and the banking system were reeling from the Great Depression. The consensus



among Keynesian economists was that the household sector saved too much; they believed that the saving disincentive of the Social Security system was a good thing. But if we learn anything in economics, it should be that what was good in the past is not necessarily good for the future. Currently, 48 percent of senior households rely on Social Security to raise household income above the poverty level. Eliminating Social Security would force nearly half of these households into anti-poverty programs. It is to those programs that our attention now turns.

Programs that Treat Poverty’s Symptoms

We have covered those programs designed mostly to keep the non-poor from becoming poor. These programs are typically designed to look like insurance programs, so that no stigma attaches to those who receive benefits. However, like insurance programs, workers’ compensa-tion, unemployment compensation, Social Security, and Medicare are fraught with problems of moral hazard and adverse selection. We now turn to the programs designed specifically to cor-rect poverty. Just as a person with a preexisting medical condition does not qualify for health insurance, a person already in poverty does not qualify for anti-poverty insurance. Hence, anti-poverty programs for the poor tend to be modeled as charity: (1) they are restricted to the truly needy (that is, they are means tested), and (2) there is a stigma attached to receiving benefits.

The oldest and best-known anti-poverty program was Aid to Families with Dependent Children, which was born as Aid to Dependent Children in the Social Security Act of 1935. The inadequacy of ADC payments at combating childhood poverty was instrumental in launching the Kennedy-Johnson administration’s war on poverty, which changed the name to Aid to Families with Dependent Children (AFDC). In 1996 AFDC became TANF (Temporary Assistance to Needy Families), which set time limits of two consecutive years and five total years during which a family could receive TANF payments. Figure 11-6 shows that, for all the publicity al-leging welfare recipients feeding from the public trough, the proportion of households receiving cash welfare assistance was never more than 3 percent of all households. In fact, the proportion of poor households receiving AFDC payments peaked at about 35 percent in 1974. As the pov-erty rate rose from 1974 to 1983, the proportion of poor households receiving AFDC payments consistently fell. When the poverty rate fell from 1983 to 1989, the percent of poor families re-ceiving welfare rose; this apparent anomaly probably reflects the fact that the working poor (who did not receive welfare) had a better chance of escaping poverty than did welfare recipients who faced a strong work disincentive.

Figure 11-7 shows the trend in the average value of payments in constant (2011) dol-lars.27 The average payment per beneficiary reported in 1968 was $8,198 in 2011 purchasing power. Between 1968 and 1974, payment in 2011 dollars increased to $9,045, when real benefit levels peaked. Between 1975 and 2011, inflation-adjusted payments decreased to $3,551 in 2011. The red line shows welfare spending per poor household, which reflects the fact that only a minority of poor families actually received cash benefits in any year. Starting at $2,316 per poor household in 1968, average payments peaked at $5,085 in 1974, and then declined to $473 per poor household in 2010.

27 To translate payments into base year dollars, we divide by the current year’s consumer price index, and multiply by 100. To translates payments into a different year (i.e., 2003), we divide the nominal payment by the CPI, then multiply by the CPI for that year, in this case, CPI2002 = 183.9.



Figure 11-6

It was only during the Clinton Administration, 1993 to 2000, that the poverty rate and the AFDC payment rate tended to decline together. From 1996, when AFDC became TANF, the proportion of total households receiving cash welfare benefits began to decline, not because of a rapid decline of the poverty rate, but because limits on the time recipients could receive benefits cleared the welfare rolls. Indeed, Aid to Families with Dependent Children, whereby the gov-ernment encouraged women to remain outside the labor force, TANF seeks to move welfare moms into the labor force. I can recall a speech by Texas Senator Phillip Graham, onetime eco-nomics professor at Texas A&M University, who proclaimed, “It is time that [welfare recipients] who have been riding in the wagon at public expense, get out of the wagon and push like every-one else.” Indeed, since the majority of welfare recipients were then, as now, children, the miss-ing piece of the welfare reform puzzle was a repeal of child labor laws, so that children without the foresight to pick responsible, financially endowed parents can truly fend for themselves.

The Reagan Administration, on the advice of conservative economist Milton Freidman implemented the Earned Income Tax Credit, which enhances the income of the working poor by supplementing the tax credits (i.e., the deposits in one’s IRS account that provides tax refunds) for households with earned income that is still too low to surpass their poverty threshold. By 1995, the year before welfare reform, the typical poor family received more income from the earned income tax credit ($1900) than from welfare ($1,062). Conservatives had successfully

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Proportion of Households

Poverty and Welfare Rates

Household Poverty Rate Welfare Rate for All Households

Welfare Rate for Poor Households



shamed the majority of the poor into bypassing cash benefits they were entitled to. The Personal Responsibility and Work Opportunity Reconciliation Act made sure that uppity poor folk could receive welfare benefits for no longer than two years in succession and five years lifetime. So much for the idea that a mother’s job was raising her children!

The 1996, Congress passed the Personal Responsibility and Work Opportunity Reconcil-iation Act(PRWORA), which President Clinton signed into law. The law became effective in July 1997, and replaced the Aid to Families with Dependent Children (AFDC) with the Tempo-rary Assistance for Needy Families (TANF) program. PRWORA “changed the nation’s welfare system into one requiring work in exchange for time-limited benefits.”28

The adverse selection and moral hazard problems of cash welfare payments are well known. First, by attempting to restrict cash welfare to the truly needy, welfare programs are means tested, meaning that applicants for welfare must prove their eligibility by submitting to a financial evaluation, typically by the state welfare agency. If a welfare recipient finds a part-time job, her need decreases by a dollar for each additional dollar of earnings. The loss of wel-fare benefits as income increases has the same behavioral effect as a high marginal tax rate. In-deed, a welfare mother’s welfare benefits decreased by a dollar for each pre-tax dollar of earn-ings. Since payroll taxes are paid on each dollar of earnings, and since working increases child-care, transportation, clothing, and other costs, AFDC recipients faced marginal tax rates well in excess of 100 percent. 28 Administration for Families and Children (AFC) Fact Sheet: www.acf.dhhs.gov/news/facts/tanf.html

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Benefits per Household in

2011 Dollars

Figue 11‐7: Average Annual Cash Benefits in 2011 Dollars

AFDC/TANF Recipients

AFDC/TANF per Poor Household

Earned Income Tax Credit Recipients

Earned Income Tax Credit per Poor Household



Once a single mother29 qualified for welfare, she was trapped. The huge marginal tax rate deterred her from either seeking employment in a part-time or entry-level job, or from reporting her income if she did earn it. These disincentives also deterred welfare recipients from develop-ing job skills. Table 11-9 shows the conditional probabilities of receiving welfare and having an income below the poverty threshold before and after welfare reform. Before 1997, the probabil-ity that a poor family would go on welfare was 6.06% if it had not received AFDC payments the year before, and the probability that they would continue on welfare was 77.56%. After welfare reform, first-time welfare rate decreased to 4.35% and the welfare continuation rate declined to 52.25%. For families that were poor the previous year, the probability of going on welfare if they were still poor declined from 17.93% under AFDC to 10.89% under TANF; the welfare continu-ation rate declined from 81.62% under AFDC to 56.82% under TANF. Not only did welfare re-form move people off welfare, it also deterred the poor from applying for welfare benefits.

Table 11-9

Poverty and Welfare Before and After Welfare Reform

all years 1968 to 1997 to all years 1968 to 1997 to

1996 2012 1996 2012Not Poor last year

No welfare 0.48% 0.59% 0.31% 3.83% 3.80% 3.88% Previous welfare 43.62% 49.07% 26.82% 31.79% 31.50% 32.70%Poor last year

No Welfare 5.36% 6.06% 4.35% 45.35% 46.12% 44.23% Welfare 71.28% 77.56% 52.25% 79.62% 80.77% 76.12%

Welfare Rate Poverty Rate

Before welfare reform, there was a 3.8% probability that a household that was neither on welfare nor poor the year before would become poor. This probability increased to 3.88% after welfare reform. There was essentially no change in the probability of poverty for households that had received welfare benefits the previous year, despite not having been poor the previous year. Among households that did not receive AFDC or TANF, welfare reform had little effect on the probability of remaining poor, declining from 46.12% under AFDC to 44.23% under TANF. The only noticeable change involved modest reduction in the probability of remaining poor from 80.77% under AFDC to 76.12% under TANF.

Helping the Working Poor: The Earned Income Tax Credit

TANF created a work incentive by brute force: welfare recipients receive temporary as-sistance for two consecutive years (five years total lifetime eligibility), after which they must work or they (and their children) will starve. The Earned Income Credit provides some assis-tance for poverty level workers by giving them a credit against their income taxes. If their in-come-tax liability is lower than their tax credit, they receive the difference as a tax refund, much the same as if they had been “over-withheld” by their employer. Figure 11-8 shows how the

29 Since part of the means test was the demonstration that her children did not have the financial support of their father, AFDC actually encouraged family breakups. Imagine the drama of an unemployed father leaving home be-cause the state could better provide for his family than he could, but only if he abandons them. In no way was the AFDC program consistent with family values.



earned income tax credit works for a family of four taking a standard deduction.30 Up to $26,000 of income, taxable income is zero and the earned income credit is worth $90. This modest sav-ings is more than offset by the payroll tax – 7.56% imposed on both the employee and the em-ployer, which the employee ultimately pays. Above $26,000, taxable income grows and the earned income credit grows faster than the income tax, causing an increase in take-home pay. The earned income credit reaches its maximum value of $5,036 when taxable income reaches $13,000, where it remains until taxable income reaches $22,000. Above $22,000, the earned in-come credit gradually decreases until it disappears at $46,000 of taxable income.

Figure 11-8

Ironically, the decline in the earned income credit itself functions as an income tax; ironi-cally, the highest marginal tax rate – 51% when we include the effects of payroll taxes, the in-come tax, and the reduction of EIS – is paid just as the family is ready to break into the middle class, at about $44,000 of income (taxable income of $18,000). Because payroll taxes to support social security apply only to the first $110,100 of labor income ($113,700 in 2013), and because capital gains (i.e., speculative income) are taxed a maximum rate of 15%, the US tax system is actually regressive, as shown in Figure 11-9. Effective tax rates rapidly increase from a mini-mum of -25% to +51% between $14,000 and $18,000, drop to 30%, jump back to 40% near $1,000, and eventually rise to 35%. But for speculators – those who gave us the housing bubble and the financial crisis – tax rates never rise above 15%. Indeed, the average tax rate paid by the top 1% of the income distribution is only 17%.

30 To simplify income-tax calculations, a family of four can take a “standard” deduction of $11,400 in addition to their exemption of $3,650 per person; this essentially makes their first $26,000 non-taxable.

($2,000)

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000 $80,000

Income Tax, Payroll Tax, and Earned Income Tax Credit for Family of Four

EITC Payroll Tax Income Tax



Fixing Welfare and the Tax System: The Negative Income Tax

In one of his many speeches that had the effect of demonizing both political liberals and welfare recipients, Ronald Reagan proclaimed: “The War on Poverty is over and Poverty Won.” Actually, the war on poverty, like the Korean War, is in the midst of a long and uneasy armistice. Since 1980, conservative politicians have dismantled the Great Society of Lyndon Johnson and now threaten to destroy the New Deal. The ultimate, if symbolic, indication of the ultimate vic-tory of the neoconservatives will be to remove Franklin D. Roosevelt from the dime and replace his image with Ronald Reagan, who also is quietly replacing Abraham Lincoln as the soul of the Republican Party.

We saw in Chapter 10 that the United States has more economic inequality than does any other developed economy. The consensus of the 1960s and even the 1970s was that the well-to-do should share their largess with the less fortunate, both internationally (the Peace Corps and the United Nations), and intra-nationally (the Civil Rights Act and the War on Poverty). Today we flaunt international organizations and demonize the poor, including poor children, as respon-sible for their own fate.

The neoconservative movement that culminated in the 2001 tax cuts threatens an end to the Social Security and Medicare programs. The natural reaction of liberals is to become con-servatives, to dig in our heels to protect the gains of the past. I recommend that liberals learn from conservatives and embrace markets and democracy as much as possible to solve persistent social problems. We should admit that welfare as we knew it was a failure; any attempt to resur-rect a program that rewards the poor for remaining poor is not only foolish, but cruel. We should admit that the time for the Social Security program is passed; the idea of a pay-as-you go pro-gram, redistributing income from the middleclass and the working poor to those who may or may

‐40.00%

‐30.00%

‐20.00%

‐10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

$500,000

Figure 11‐9: Average and Marginal Tax Rates in 2012

Average Tax Rate Marginal Tax Rate

Average Capital Gain Tax Rate Marginal Capital Gains Tax Rate



not have saved for their retirement is pretty stupid. The moral hazard of Social Security is that Americans fail to save for their future, leading America to borrow from the rest of the world to support our investment and our budget deficits. Eliminate Social Security and the incentive to save will lead households to expand their share of property income, which heretofore has been concentrated among upper-income brackets.

The most impressive thing about senior citizens is their high propensity to vote. America got into this mess by purchasing the votes of seniors with the sweat of future generations. As long as only Democrats played this game we had an interesting divided government, with a lib-eral (and fiscally irresponsible) legislative branch and quasi-racist executive and judicial branch-es. But with the election of William J. Clinton, Democrats became fiscally responsible, leading Republicans to embrace the banner of tax cuts at any costs, resulting in deficits as far as the eye can see.

Republicans have long proclaimed “If it isn’t broke, don’t fix it.”31 Lately, the refrain has been expanded to “Even if it is broke, don’t fix it, as long as we can benefit politically.” The major cause of poverty is lack of education; No Child Left Behind is a cruel joke that does exact-ly nothing. Why not follow Gary S. Becker’s recommendation: get rid of public schools entirely, allowing current schools to be re-chartered as free-standing private schools.32 Middle-income and richer households would pay tuition for their children’s education. Poor households would receive vouchers sufficient to compete for the best schools. This approach would go a long way toward eliminating the endowment effects that trap poor children in poor schools.

Similarly, problems with affordable health care would first be addressed from the supply side. Suppose we decided to increase the number of medical school slots by 10 percent a year for 10 years. Citizens of other countries would come to the United States to study medicine, in-stead of the United States raiding the brain trust of so many other countries. Once medical costs came down, we would then address the problem of insurance for the uninsured. But, in order to cure the malpractice crisis, we should have catastrophic health insurance at birth, covering undi-agnosed birth defects,33 calamitous accidents, and other events that create health care costs be-yond those all but the wealthiest of households could handle. Indeed, private insurance would cover routine healthcare, while anyone with preexisting conditions would be covered by the NCIH (national catastrophic health insurance).

Finally, I recommend that we expand upon the idea of the earned income credit and liter-ally cure poverty by setting the minimum income level at the poverty level. Figure 11-10 shows the average tax rates by year. The last time the federal budget was balanced was in the late 1990’s when the average tax rate was about 12.5% each for the income tax and the payroll tax. It follows that Social Security and Medicare could be folded into the income tax by simply drop-ping the payroll tax and increasing the income tax rate to 25%. Finally, by beginning with an earned income credit of $22,210 (the poverty threshold for a family of four), and setting the mar-ginal tax rate at 33%, a negative income tax could (1) create a work incentive, (2) eliminate pov-

31 Actually, the quote is attributed to Burt Lance, President Carter’s White House Chief of Staff. 32 Think of this as privatization in the Yugoslavian mode, where schools are owned by the parent-teachers associa-tion, who sell their shares to new sets of parents as their own children graduate. 33 Whether parents should be financially responsible for children born with preventable birth defects would throw a new wrinkle into the abortion debate. What about a tax surcharge for all anti-choice individuals to cover these costs?



erty, and (3) balance the budget, and (4) solve the moral hazard and adverse selection problems of Medicare, Medicaid, and Social Security.

Figure 11-11

If a family had zero income – due to disability, lack of education, long-term unemploy-ment, or fulltime parenting – that family would receive tax credits of $22,050. Since it would have no tax liability, its income would also equal $22,050. If one or more family members could secure a part-time job and earn, say, $6,000, their tax liability would be $2,000, leaving them with $20,050 in unused credits, and raising their total income to $26,050. Those who had saved for retirement would have their interest and capital-gains income taxed like any other. Those who had squandered their income would simply qualify for the negative income-tax credit. The break-even income level would be $66,150 – at that income, tax liability would exactly equal the income credit, and tax liability would be zero. As income increased – regardless of the level – families would always keep 2/3 of their additional earnings and pay 1/3 of additional earnings to help the less fortunate.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Average Federal Tax Rate on Income

income payroll income+payroll



Earned Tax Gross Net After‐Tax Effective Earned Tax Gross Net After‐Tax Effective

Income Credits Tax Tax Income Tax Rate Income Credits Tax Tax Income Tax Rate

$0 $22,050 $0 ‐$22,050 $22,050 $22,050

$6,000 $22,050 $2,000 ‐$20,050 $26,050 ‐334.2% $1,200,000 $22,050 $400,000 $377,950 $822,050 31.5%

$12,000 $22,050 $4,000 ‐$18,050 $30,050 ‐150.4% $2,400,000 $22,050 $800,000 $777,950 $1,622,050 32.4%

$18,000 $22,050 $6,000 ‐$16,050 $34,050 ‐89.2% $3,600,000 $22,050 $1,200,000 $1,177,950 $2,422,050 32.7%

$24,000 $22,050 $8,000 ‐$14,050 $38,050 ‐58.5% $4,800,000 $22,050 $1,600,000 $1,577,950 $3,222,050 32.9%

$30,000 $22,050 $10,000 ‐$12,050 $42,050 ‐40.2% $6,000,000 $22,050 $2,000,000 $1,977,950 $4,022,050 33.0%

$36,000 $22,050 $12,000 ‐$10,050 $46,050 ‐27.9% $7,200,000 $22,050 $2,400,000 $2,377,950 $4,822,050 33.0%

$42,000 $22,050 $14,000 ‐$8,050 $50,050 ‐19.2% $8,400,000 $22,050 $2,800,000 $2,777,950 $5,622,050 33.1%

$48,000 $22,050 $16,000 ‐$6,050 $54,050 ‐12.6% $9,600,000 $22,050 $3,200,000 $3,177,950 $6,422,050 33.1%

$54,000 $22,050 $18,000 ‐$4,050 $58,050 ‐7.5% $10,800,000 $22,050 $3,600,000 $3,577,950 $7,222,050 33.1%

$60,000 $22,050 $20,000 ‐$2,050 $62,050 ‐3.4% $12,000,000 $22,050 $4,000,000 $3,977,950 $8,022,050 33.1%

$66,150 $22,050 $22,050 $0 $66,150 0.0% $13,200,000 $22,050 $4,400,000 $4,377,950 $8,822,050 33.2%

$72,000 $22,050 $24,000 $1,950 $70,050 2.7% $14,400,000 $22,050 $4,800,000 $4,777,950 $9,622,050 33.2%

$78,000 $22,050 $26,000 $3,950 $74,050 5.1% $15,600,000 $22,050 $5,200,000 $5,177,950 $10,422,050 33.2%

$84,000 $22,050 $28,000 $5,950 $78,050 7.1% $16,800,000 $22,050 $5,600,000 $5,577,950 $11,222,050 33.2%

$90,000 $22,050 $30,000 $7,950 $82,050 8.8% $18,000,000 $22,050 $6,000,000 $5,977,950 $12,022,050 33.2%

$96,000 $22,050 $32,000 $9,950 $86,050 10.4% $19,200,000 $22,050 $6,400,000 $6,377,950 $12,822,050 33.2%

$102,000 $22,050 $34,000 $11,950 $90,050 11.7% $20,400,000 $22,050 $6,800,000 $6,777,950 $13,622,050 33.2%

$108,000 $22,050 $36,000 $13,950 $94,050 12.9% $21,600,000 $22,050 $7,200,000 $7,177,950 $14,422,050 33.2%

$114,000 $22,050 $38,000 $15,950 $98,050 14.0% $22,800,000 $22,050 $7,600,000 $7,577,950 $15,222,050 33.2%

$120,000 $22,050 $40,000 $17,950 $102,050 15.0% $24,000,000 $22,050 $8,000,000 $7,977,950 $16,022,050 33.2%

$150,000 $22,050 $50,000 $27,950 $122,050 18.6% $25,200,000 $22,050 $8,400,000 $8,377,950 $16,822,050 33.2%

$240,000 $22,050 $80,000 $57,950 $182,050 24.1% $26,400,000 $22,050 $8,800,000 $8,777,950 $17,622,050 33.2%

$360,000 $22,050 $120,000 $97,950 $262,050 27.2% $27,600,000 $22,050 $9,200,000 $9,177,950 $18,422,050 33.3%

$480,000 $22,050 $160,000 $137,950 $342,050 28.7% $28,800,000 $22,050 $9,600,000 $9,577,950 $19,222,050 33.3%

$600,000 $22,050 $200,000 $177,950 $422,050 29.7% $30,000,000 $22,050 $10,000,000 $9,977,950 $20,022,050 33.3%

$750,000 $22,050 $250,000 $227,950 $522,050 30.4% $31,200,000 $22,050 $10,400,000 $10,377,950 $20,822,050 33.3%

$900,000 $22,050 $300,000 $277,950 $622,050 30.9% $32,400,000 $22,050 $10,800,000 $10,777,950 $21,622,050 33.3%

The point of this exercise is to show that persistence of poverty in the United States of America is not because the country lacks resources, but because the nation lacks the will. Elimi-nating income transfers for the privileged (workers’ compensation, unemployment compensa-tion, Social Security) would neutralize the adverse selection and moral hazard programs for a program where federal taxes depended only on family size and income. A variation on this theme would be to exempt savings (including savings for retirement) and convert the negative flat income tax into a negative flat consumption tax. In that case, people would no longer be taxed based on how much they contributed to national income, but to how much they took out of the system.

Figure 11-12

($40,000)

($20,000)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Negative Income Tax

Tax Credits Gross Tax Net Tax After‐Tax Income



Summary

1. Consistent with the data on world income (output) distribution, presented in Chapter 10, we find that some countries are poor because their average income falls below the international definitions of $1 or $2 per day, and other countries (like the United States) have poverty be-cause of the way income is distributed.

2. Starting in 1963, the United States Department of Commerce had defined poverty thresholds as the amount of money necessary for a household to purchase enough raw food for a mother who is a careful shopper and a good cook to prepare healthy meals. This emergency food budget is multiplied by three to obtain the poverty threshold.

3. The Department of Commerce multiplies the basic poverty thresholds for 1963 by the ratio of the current year’s Consumer Price Index to the Consumer Price Index in 1963 to obtain the current year’s poverty threshold.

4. A household is defined as poor if its income (including cash government transfers but ex-cluding income in kind like food stamps, Medicaid, and housing subsidies) falls below its poverty threshold. If a household’s income is below the poverty threshold, all members of that household are considered as poor.

5. The incidence of poverty is the probability that a person will be classified as poor. The un-conditional probability of poverty is the proportion of all households or all individuals who are classified as poor. The conditional probability of poverty relates the probability of poverty to personal characteristics, such as age, gender, education, and marital status.

6. The unconditional probabilities of poverty among households and individuals have remained roughly constant. In 2002, the probability of poverty among households and individuals was below their rates in 1967, but heading toward that rate.

7. The incidence of poverty is approximately the same for households with married male or fe-male “heads” of household. Households with married heads are significantly less likely to be poor than households with unmarried male heads, which in turn are less likely to be poor than households with single females.

8. Children are more likely to be poor than adults, and adults under the age of 65 are slightly less likely to be poor than households headed by persons over the age of 65.

9. Households with white, non-Hispanic, and Asian heads have a lower than average poverty rate than does the average household. Households headed by AfricanAmericans, Hispanics, Native Americans, and Hawaiian/Pacific Islanders tend to have a higher than average inci-dence of poverty.

10. The incidence of poverty tends to fall with educational attainment, most dramatically with the earning of a high school diploma. Children and individuals with less than a high school diploma have a higher than average incidence of poverty. Adults with a high school diploma or better have a lower than average incidence of poverty.

11. Not surprisingly, having a job substantially reduces the incidence of poverty, as does retire-ment. Those who do not participate in the labor force have the highest incidence of poverty. In the middle are those who are unemployed, who have a lower incidence of poverty than nonparticipants do, but a higher incidence of poverty than for those who are employed. For



both households and individuals, the poverty rate declines as the number of weeks worked per year increases.

12. Despite the hopes of Congress and the administration, the passage of the Americans with Disabilities Act (ADA) has done little to reduce the incidence of poverty among the disabled. The poverty rate for the disabled in 2002 was slightly higher than their poverty rate in 1987, three years before ADA was passed. This seems to coincide with a reduced participation rate among the disabled.

13. A number of government transfer programs—workers’ compensation, unemployment, and Social Security (with Medicare)—are designed to imitate insurance programs, in that the non-poor (and their employers) make contributions to the program as long as they are em-ployed, and then receive “earned benefits” when they are injured on the job, lose their job, or reach retirement age. Like insurance policies, these programs have major problems of moral hazard, which increase program costs.

14. Since 1967, the poverty rate among seniors has declined steadily, while the percent that sen-iors rely on Social Security have remained roughly constant at about 40 percent. Because Social Security and Medicare are pay-as-you-go programs, workers contributing today can expect to receive benefits only from payroll taxes levied on future workers. Both Medicare and Social Security benefits have been increasing much more rapidly that the tax base. While the Social Security and Medicare programs have been operating with a surplus, the ability of the government to redeem those IOUs is compromised by the Bush tax cuts of 2001, which Republicans want to make permanent.

15. The most important anti-poverty program, Aid to Families with Dependent Children (origi-nally ADC, latter AFDC), was established in 1935 as part of the Social Security Act. The program was flawed because its implied income tax rate exceeded 100 percent, so that a working mother would have to earn considerably more than a poverty-level income to be bet-ter off by working than by not working.

16. In 1996 Congress passed the Personal Responsibility and Work Opportunity Reconciliation Act that transformed AFDC into TANF (Temporary Assistance to Needy Families). TANF requires recipients to work outside the home as a condition of receiving benefits, and limits benefits to two consecutive years and five total years.

17. Initial experience with TANF indicates a modest success. Between 1989 and 1996, individ-uals on welfare were very likely to remain on welfare and to remain poor. After 1996, the probability of continuing on welfare declined from 71 percent to 54 percent, and the likeli-hood of poverty the next year declined from 82.13 percent to 74.85 percent. However, the poverty rate among individuals who were poor but not on welfare remained approximately the same.

18. Recently the Earned Income Tax Credit (EITC) has become the largest anti-poverty program. EITC is a form of negative income tax, although, unlike other proposals, only the working poor are eligible for benefits. The negative income tax, originally proposed by conservative economics Nobel laureate Milton Friedman, has the advantage of creating a work incentive by reducing benefits gradually as earned income increases.

19. It would be possible to replace the current income tax and transfer system with a negativeflat income tax system that would allow the phasing out of Social Security and would require an



average tax rate of 25 percent. So, the failure of the United States to eliminate poverty re-flects priorities, rather than economic resources.

Glossary

Poverty: The state of not having enough money to take care of basic needs such as food, cloth-ing, and housing.

Engel’s law: The empirical rule stipulating that the proportion of the budget applied to food pur-chases decreases and income increases.

Economy food budget: The basis of Mollie Orshansky’s 1963 definition of poverty.

Poverty threshold: The amount of money a household requires to purchase the emergency food budget, times three.

Absolution poverty standard: A definition of poverty that remains constant from year to year. The official definition of poverty is an absolute standard because it is consistently defined as three times the emergency food budget.

Income-in-kind: Income received as commodities, such as food stamps, Medicaid, Medicare, or housing subsidies, rather than as money.

Incidence of poverty: The probability that someone’s or some household’s income will fall short of the poverty threshold.

Sample proportion: A statistic, p, estimated from a random sample of households or individu-als, used to estimate the unknown population proportion .

Unconditional incidence of poverty: The incidence of poverty for all individuals or households.

Conditional incidence of poverty: The incidence of poverty for a sub-population, based on characteristics such as gender, age, ethnicity, education, or marital status.

Labor-force participants: Individuals who have a job or are available for a job if they do not have a job.

Unemployed: A member of the labor force who does not have a job.

Employment at will: A feature of employment contracts that allows employers to terminate an employee without giving a cause. States with this feature of implied contracts make it diffi-cult for discharged employees to sue for wrongful termination.

Americans with Disabilities Act: A law, passed by Congress in 1990 and became effective in 1992, that (1) requires businesses to make reasonable accommodations for the disabled, and (2) prohibits employers from discriminating against the disabled, requiring employers to make reasonable accommodations to an employee’s disability.

Asymmetric information: A situation in a potential exchange situation where one party has more information about the quality of the good being exchanged than the other party does. Asymmetric information is especially prevalent in insurance policies, where the insured has more information about the hazard involved (e.g., poor health, death, unemployment) than the insurance company does.

Moral hazard: The tendency of individuals to alter their behavior when the consequences of their behavior are reduced, say, through an insurance policy. Health insurance reduces the



incentive for healthy living, and old age insurance reduces the incentive to save for one’s re-tirement.

Adverse selection: Another consequence of asymmetric information, whereby the composition of a group changes in response to the relative costs and benefits of an insurance-like pro-gram. For instance, if a health insurance company raises rates to cover rising medical costs, it will find that it loses its healthiest policyholders and keeps its least healthy ones.

Pay-as-you-go system: A transfer program, like Social Security or Medicare, that taxes the cur-rent generation of workers to provide benefits to the previous generation of workers. Pay-as-you-go programs tend to build up large implied liabilities.

Welfare programs: Historically, programs designed to transfer money or in-kind benefits to the poor. To limit such programs to the poor, they tend to be means tested, which gives rise to high effective tax rates that create a work disincentive.

Means-tested programs: Programs that require that an applicant prove his or her need before receiving benefits.

Effective tax rate: The rate at which benefits are reduced as income is earned. The AFDC pro-gram had an implied tax rate in excess of 100 percent.

Work disincentive: A feature of means-tested program, where earning an extra dollar reduces benefits by a dollar or more, making the working poor no better off than the poor receiving welfare benefits.

Negative income tax: A proposal by conservative Nobel laureate Milton Friedman in the 1960s, where every household receives a basic grant (e.g., a poverty-level income), which is reduced gradually as income grows. Unlike most means-tested programs, a negative income tax would achieve a work incentive, either by allowing families above the poverty level to re-ceive benefits, or by setting basic benefits below the poverty level, so that the break-even point is at or below the poverty level.

Break-even point: The level of income where the tax equals the basic grant, so that the house-hold neither pays a tax nor receives a grant.

Chapter 12 The Economics of Discrimination


Introduction

In 1957, Gary S. Becker published the first edition of his path breaking treatise, The Economics of Discrimination. Becker’s text was published three years after the fa-mous Brown v. Board of Educationcase, wherein a unanimous US Supreme Court ruled that separate but equal school systems were inherently unconstitutional. Prior to Beck-er’s treatise, economists have virtually ignored the fact that blacks and whites failed to engage in mutually beneficial gains from trade. In Becker’s words:

One might venture the generalization that no single domestic issue has occupied more space in our newspapers in the postwar period than discrimination against minorities, and especially against Negroes. This generalization is unquestionably true of the period since the momentous decision by the Supreme Court to outlaw segregation by color in public schools. While much of the discussion has concentrated on discrimination in such non-market activities as church and school attendance and voting, there has also been considerable discussion of discrimination in the market place—in employment, housing, transportation, etc. Such discrimination has assumed importance not only because of its direct economic conse-quences but also because of the belief that by eliminating market discrimi-nation one could eliminate much of the discrimination in non-market are-as.1

Perhaps the most remarkable characteristic of Becker’s introduction was that fact that he cited only one publication prior to his own.2 For a social science that can trace its roots to ancient Greece, and whose metamorphosis in 1776 is literally as old as our coun-try, the lack of interest by economists in discrimination is startling. Nevertheless, since 1957, economists have become preeminent in explaining and measuring racial and gender discrimination.

A Brief History of Discrimination3

Economic discrimination is more difficult to measure than are economic inequali-ty and poverty, because discrimination is a process, while inequality and poverty are out-comes. In Chapter 10, we found that inequality can be depicted with Lorenz curves and measured with Gini coefficients. In Chapter 11, we discussed both international and na-tional definitions of poverty. Measures of inequality and poverty are empirically testable. Once we agree on a definition, we merely compare the measure with the definition and decide whether or not the household is poor, or in the lowest income quintile, or so forth. But a different type of evidence is required for discrimination. Unfortunately, there is no shortage of historical documentation that ethnic discrimination had long been the law of the land.

1 Gary S. Becker, The Economics of Discrimination, 2nd ed. (University of Chicago Press, 1971), Introduc-tion to the First Edition, p. 9. 2 Donald Dewey, “Negro Employment in Southern Industry,” Journal of Political Economy, LX (August 1952), 279–293. 3 You can find an extended list of government discrimination at Diversity Inc., “The History of Race-Based Government Decisions,” www.diversityinc.com/members/43116print.cfm.



We begin with the Constitution: in Article 1, Section 2, Clause 3 of the U.S. Con-stitution, citizens are taxed in proportion to a number “which shall be determined by add-ing to the whole number of free persons, including those bound to service for a term of years, and excluding Indians not taxed, three fifths of all other Persons.” The Constitu-tion counted AfricanAmerican slaves as 60 percent of a person, indentured servants (whites who were temporarily bound in service to a creditor) as whole persons, and treat-ed Native Americans as if they did not exist. Furthermore, women were prohibited from voting, and in some states women could not own property. The Declaration of Independ-ence may have proclaimed “that all men are created equal,” but some men were more equal than others, and women deserved no mention.

Throughout the pre-Civil War period, Congress engaged in a delicate balancing act.The House of Representatives was dominated by free states (despite the fact that non-voting slaves are counted for slave state representation in Congress), but the Senate is balanced. In 1819–21, the Missouri Compromise recognized that territory as a slave state by also admitting Maine as a free state. In 1857, a slave, Dred Scott filed a lawsuit claiming that, because he lived in a free state, he was entitled to his freedom. Chief Jus-tice Roger B. Taney disagreed, ruling that blacks were not citizens and therefore could not sue in federal court. Taney went so far as to argue that Congress had no power to forbid slavery in any part of the country. This inflamed the passions of abolitionists, who detested slavery and put their money on the line by operating the Underground Railroad, which smuggled escaping slaves into Canada.

In 1861 the election of Abraham Lincoln as president of the United States led Southern states to succeed from the Union. The question of succession was not discussed in the Constitution; Southerners compared membership in the United States as equivalent to membership in a gentlemen’s club.4Lincoln and the Northern states saw succession as insurrection, to be suppressed by force of arms. Ironically, it was Southerners who most reveled in the divine sanction for their cause. Rarely, however, did they attribute their loss to divine will.

On January 1, 1863, President Lincoln issued his Emancipation Proclamation: that all “slaves within any State, or designated part of a State ... then ... in rebellion, ... shall be then, thenceforward, and forever free.”5 The change in focus from “preserving the Un-ion” to “freeing the slaves” breathed fresh life into the war effort. Eventually, the Union advantages in population and wealth overcame the South’s initial military successes, and General Robert E. Lee surrendered the Army of Northern Virginia to General Ulysses S. Grant at Appomattox Courthouse on April 9, 1865. Five days later, John Wilkes Booth assassinated Abraham Lincoln, and Andrew Johnson, former governor and senator from Tennessee, became president.

Initially incensed by Lincoln’s assassination, Johnson led the Union government’s retribution against the conspirators, but later Johnson adopted Lincoln’s reconciliation with the former rebellious states. The Thirteenth Amendment to the Constitution, out-lawing slavery, was ratified in December 1865. The Fourteenth Amendment extends the bill of rights to the states, and recognizes the citizenship of all men, save Native Ameri-

4 See, for instance, General Picket’s proclamation in the movie Gettysburg. 5 See: http://plus.aol.com/aol/reference/EmancipaP/Emancipation_Proclamation?flv=1.



cans, thereby undoing the Dred Scott Decision. In 1870, during the administration of President U. S. Grant, the states ratified theFifteenth Amendment, guaranteeing blacks the right to vote. However, the government lost interest in enforcing this amendment.

Founded by former Confederate general Nathan Bedford Forrest,6 the Ku Klux Klan, a terrorist groupof white supremacists, rose up in the South, using violence and in-timidation to suppress the freed slaves. By the 1920s the Ku Klux Klan would enroll 3 million members, who proclaimed their support for white, Christian virtues. The Klan used cross burnings, beating, and lynching to keep blacks, Jews, and Catholics from gain-ing political influence.

In 1896, the United States Supreme Court provided legal support for racial segre-gation in Plessy v. Ferguson, ruling that separate-but-equal accommodations for blacks on railroad cars did not violate the “equal protection under the laws” clause of the Four-teenth Amendment. This ruling ratifiedSouthern Jim Crow7laws, which mandated racial segregation and provided government enforcement of racial discrimination. Asian Amer-icans have also suffered discrimination. The most egregious example was the forced evacuation of Japanese Americans from the West Coast during World War II (1939–1945)—an event upheld by the Supreme Court in 1944 but repudiated by Congress many years later.

The nation continued to evolve, divided by race, with de juro (legally sanctioned) segregation in the South and de facto(actual, but not legally supported) segregation in the rest of the country. In 1954 the United States Supreme Court overturned Plessy v. Fergu-son, ruling in Brown v.(the Topeka, KS) Board of Educationthat separate school systems for blacks and whites are unconstitutional. The ruling paved the way for large-scale de-segregation, culminating in the 1964 Civil Rights Act and the 1965 Voting Rights Act. But those gains did not come easily.

In 1955, Emmett Lewis Till, a 14-year-old black teenager from Chicago, visited his uncle in Mississippi. Unfamiliar with the strict racial taboos of Mississippi, Emmett whistled at a 21-year-old white woman. Despite the attempts by his friends to hide him from whites, Emmett Till’s naked, beaten, and decaying body was found in the Talla-hatchieRiver. The white perpetrators were acquitted by an all-white jury. The national outrage led Congress to include a provision for federal enforcement of civil liberties in the Civil Rights Act of 1957.

Between 1954 and 1964, Americans watched the civil rights struggle play out nightly on their television news programs. In Montgomery,Alabama, in 1955, Rosa Parks, a black woman, refused to give up her bus seat to a white man. The ensuing Montgomery bus boycott thrust Martin Luther King Jr. into national prominence. Under King’s leadership, the Southern Christian Leadership Council, along with the National Association for the Advancement of Colored People, and the Urban League staged peace-ful demonstrations, such as refusing to leave segregated lunch counters until black pa-trons were served or arrested; they were arrested. The southern White establishment won

6 The namesake of Forrest Gump 7 Jim Crow was the name of a character in minstrelsy (in which white performers in blackface used African American stereotypes in their songs and dances); it is not clear how the term came to describe American segregation and discrimination.



most of the battles, but, because of negative publicity, a decisive liberal majority in Con-gress, and a skillful president, the Civil Rights Act of 1964 was ultimately passed, after the Senate broke the longest filibuster in history.

The 1964 Civil Rights Act outlawed discrimination in public facilities and in em-ployment. Essentially, Congress used the interstate commerce clause of the U.S. Con-stitution to trump state Jim Crow laws. The Civil Rights Act was given additional teeth in 1965 with the passage of the Voting Rights Act. Southern states had been effective at denying blacks their civil liberties because they need not fear black retaliation at the bal-lot box. The Voting Rights Act charged the federal government with assisting disenfran-chised blacks in registering to vote and actually voting. Many southern cities had black majorities, and as blacks elected more mayors, sheriffs, and congressional representa-tives, whites fled the cities and the Democratic Party for the segregated suburbs and the sympathetic Republican Party. The Voting Rights Act was extended in 1970 and 1982, the last time over the vigorous opposition of the Reagan administration.

In 1968 President Johnson signed the Civil Rights Act of 1968, prohibiting dis-crimination in the sale, rental, and financing of housing. In 1970 the Supreme Court rati-fied the anti-employment discrimination provision of the Civil Rights Act in its ruling in Griggs v. Duke Power. Willie Griggs was a laborer at the Duke Power Company who was denied promotion because he lacked a high school diploma. Griggs’s lawyers point-ed out that a majority of whites in better paid positions at Duke Power also lacked high school diplomas, and were grandfathered into their positions by virtue of recommenda-tions from white supervisors. Griggs’s lawyers also presented statistical evidence that whites with high school diplomas performed no better than whites without high school diplomas. The Court ruled that the requirement of a high school diploma was not job re-lated and served as a grandfather clause. During Reconstruction, southerners got around the provision in the Fourteenth Amendment that barred discrimination against in-dividuals because of “previous condition of servitude” by disallowing civil liberties to people whose grandfathers had been slaves. Hence, a grandfather clause refers to a rule that has the effect of discriminating on the basis of race, although the stated basis for dis-crimination is some permitted basis, in this case, education.

By ruling that,when there was circumstantial evidence of discrimination, the bur-den of proof rests with the employer to prove that the underrepresentation of blacks, women, the elderly, or other protected groups is related to job performance. We will see that by forcing employers to prove that they were not discriminating led many well-meaning or cautious employers to adopt an affirmative action hiring and promotion strategy.

In 1971, the Supreme Court, in Swann v. Charlotte-Mecklenburg Board of Educa-tion, upheld busing as a legitimate means of achieving integration in public schools. Typically, blacks and whites live in segregated neighborhoods, as explained in Chapter 5. Busing transported black students to white neighborhoods and white students to black neighborhoods. As whites left cities for segregated school districts in the suburbs, or sent their children to segregated Christian academies, busing had a limited influence on the racial composition of schools. To this day, blacks typically attend high schools that are overwhelmingly black (and Hispanic), while whites attend schools with few minority classmates.



In response to the Civil Rights Act and similar legislation from the Johnson era, which continued into the Nixon era, mostly because Richard Nixon was preoccupied with foreign policy, blacks voted overwhelmingly for Democratic candidates. Whites reacted first by voting in large numbers for third-party candidate and former segregationist George Wallace, until, with the coming of the Reagan administration, the Republican Party adopted the interests of angry white males who see the civil rights achievements as an unfair attack on their privileges.

Following conservative Supreme Court appointments, the Griggs ruling was largely overturned in Ward’s Cove Packing Company v. Antonio (1989) which revised the standards established by the 1971 Griggs decision. The Ward’s Cove decision re-quired that employees filing discrimination lawsuits demonstrate that specific hiring prac-tices had led to racial disparities in the workplace. Even if this could be shown, these hir-ing practices would still be legal if they served legitimate employment goals of the em-ployer.8 By placing the burden of proof on the plaintiff (the party complaining of dis-crimination), the Ward’s Cove decision reduced employer reliance on affirmative action as a defensive strategy against discrimination charges.

In 1991, Congress passed and President George H. W. Bush signed the civil rights act of 1991 that, among other things, reinstated the rules from the Griggs case: if there is no pattern of discrimination, the burden of proof rests on the plaintiff in a job discrimina-tion case. However, if there is a statistically significant pattern of under-representation of women or minority workers, the burden of proof shifts to the employer, who then must defend the hiring, retention, promotion or pay regulations that led to the pattern of dis-crimination. Once again, proactive employers would have an incentive to practice af-firmative action if they found themselves with legally indefensible employment practices.

But the Supreme Court recently returned with two more decisions that had the ef-fect of reducing the rights of women and minorities to redress discrimination. Lilly Ledbetter worked for Goodyear Tire Company from 1979 to 1998, when she discovered that she had been paid substantially less than her male peers over that time. “She had no way of knowing that she was being underpaid until just before her retirement when a source that remains anonymous today, slipped a note into her mailbox. The note listed the salaries of three other men doing the same who were being paid $4,286 to $5,236 per month. Lilly was only making $3,727 per month. When she filed a complaint with the EEOC [Equal Employment Opportunity Commission] she was subsequently assigned to lift heavy tires. She was in her 60s at the time but she continued to perform the tasks her ruthless employer required of her. Ledbetter retired early and filed suit ‘asserting, among other things, a sex discrimination claim under Title VII of the Civil Rights Act of 1964.’ A jury awarded Ledbetter about $3.3 million, but the amount was later reduced to around $300,000. November 2006 - May 2007: Goodyear appealed to the U.S. Supreme court who overturned the lower court's ruling in favor of Goodyear. In a 5-4 vote it was decid-ed that Ledbetter was not entitled to compensation because she filed her claim more than

8See http://www.law.cornell.edu/supct/html/historics/USSC_CR_0490_0642_ZS.html.



180 days after receiving her first discriminatory paycheck. (Ledbetter v. Goodyear Tire & Rub-ber Co., 550 U.S. 618; R048; No. 05-1074; Argued 11/27/06; Decided 05/29/07.” 9

Nine days after taking office, on January 29, 2009, President Barack Obama

signed the Lilly Ledbetter Fair Pay Act, “which supersedes the Supreme Court's decision

in Ledbetter v. Goodyear Tire & Rubber Co., Inc., 550 U.S. 618 (2007). Ledbetter had

required a compensation discrimination charge to be filed within 180 days of a discrimi-

natory pay-setting decision (or 300 days in jurisdictions that have a local or state law

prohibiting the same form of compensation discrimination). The Act restores the pre-

Ledbetter position of the EEOC that each paycheck that delivers discriminatory compen-

sation is a wrong actionable under the federal EEO statutes, regardless of when the dis-

crimination began.”10

Another Supreme Court ruling, reminiscent of the Wards Cove case, played a bi-zarre role in the Senate confirmation hearings for Justice Sonia Sotomayor. The New Haven, Connecticut Fire Department used a written exam (65%) and an oral exam (35%) to determine eligibility for promotion to fire lieutenant and fire captain positions. When 19 of 20 candidates passing the exam turned out to be white, with one Hispanic, the City of New Haven withdrew the promotions, following the rules set down in the Griggs case and the 1991 Civil Rights Act. The federal district court ruled in favor of the city, which was consistent with the law at the time. So did the Court of Appeals for the Second Cir-cuit, with the Judge Sotomayor as part of the two judge majority. When President Obama appointed her to replace Justice Suitor on the Court, Republicans criticized Judge Sotomayor for favoring affirmative action. Eventually the Supreme Court overturned the case, finding that the City of New Haven had violated the civil rights of the 20 applicants who had scored highest on the test. The Supreme Court never addressed the issue of whether written or oral tests are legitimate bases for promotion.

Taste for Discrimination

In his seminal work, The Economics of Discrimination, Gary S. Becker intro-duced into economic discourse the possibility that employers, employees, and consumers might not be motivated solely by their own self-interest, as usually assumed in economic theory. Becker introduced his first chapter with the following discussion of the meaning of discrimination, which we quote at length here:

In the socio-psychological literature on this subject [discrimina-tion] one individual is said to discriminate against (or in favor of) another if his behavior toward the latter is not motivated by an “objective” consid-eration of fact. It is difficult to use this definition in distinguishing a vio-lation of objective facts from an expression of tastes or values. For exam-ple, discrimination and prejudice are not usually said to when someone

9 See http://womeninbusiness.about.com/od/successfulwomenprofiles/p/lilly-ledbetter.htm. 10 http://www.eeoc.gov/laws/statutes/epa_ledbetter.cfm.



prefers looking at a glamorous Hollywood actress rather than at some oth-er woman; yet they are said to occur when he prefers living next to whites rather than next to Negroes. At best calling one of these actions “discrim-ination” requires making subtle and rather secondary distinctions. Fortu-nately, it is not necessary to get involved in these more philosophical is-sues. It is possible to give an unambiguous definition of discrimination in the market place and yet get at the essence of what is usually called dis-crimination.

Money, commonly used as a measuring rod, will also serve as a measure of discrimination. If an individual has a “taste for discrimina-tion,” he must act as if he were willing to pay something, either directly or in the form of reduced income, to be associated with some persons instead of others. When actual discrimination occurs, he must, in fact, either pay or forfeit income for this privilege. This simple way of looking at the mat-ter gets at the essence of prejudice and discrimination.11

Becker goes on to develop a simple but elegant theory that we will para-phrase in the remainder of this section. Suppose that an employer is confronted with two types of job applicants, Lw (whites) and Lb (blacks), who, like any other workers, vary in their potential productivity. Following Becker, the employer has a taste for discrimination if he behaves as if the psychic cost of hiring blacks ex-ceeds the psychic cost of hiring whites, (1 )b b ww d w , where dbis the employ-

er’s discrimination coefficient. For instance, if the wb were $5, but the employer acted as if the wage rate were $7.50, then db = 50 percent. Such an employer would hire a white worker, at say $7.00 per hour, assuming that the discrimination coefficient for whites, dw = 0,12 since the psychic cost of hiring whites is lower than the psychic cost of hiring blacks.

Strictly speaking, Becker’s discrimination coefficient is different from prejudice, which is defined as an opinion formed before learning the facts, typi-cally to the detriment of a person or group. The two are closely related because whites who do not like blacks typically convince themselves that blacks are less productive due to stereotyping. Technically, a prejudiced employer may think that he is not hiring blacks because he believes that blacks are less productive, when in fact, he refuses to test this assertion.

An employer with a taste for discrimination will ultimately act on that preference by hiring less-productive whites instead of more-productive blacks. The consequence of a taste for discrimination is higher production costs than what would occur in the absence of that preference. Figure 12-1 reprises the model of a competitive market. In the left-hand panel we show the marginal firm, whose taste for discrimination raises his marginal cost curve and his average cost curve just enough that he makes a zero economic profit. The market is in short-run

11 Gary S. Becker, The Economics of Discrimination, 2nd ed. (University of Chicago Press, 1971), pp. 13–14. 12 Note the effect would be the same if the employer practiced nepotism, whereby he discounted the wage rate paid to family and friends by, say, df = -.333, since the net wage for whites, $7(2/3) = $4.67 <wb.



equilibrium, since the market price is set by the intersection of the market supply curve (the sum of the marginal cost curves for all the firms in the market) and the market demand curve. The right-hand panel shows a firm with an owner whose taste for discrimination is 0, that is,db = dw = 0. Since wb<ww, the non-discriminating employer will hire only black workers, whose wage rate is lower relative to their productivity.

In the labor market, it follows that wb(1+D) = ww, where D is the market discrimination coefficient. Since we assume that D = di, the marginal firm on the right should be indifferent between hiring black or white workers.Hence, wb = ww/(1+D), and since D> 0, wb<ww.

Figure 12-1

After nearly a semester of studying economics you should have led to a healthy skepticism that leads you to ask “What is wrong with this picture?” The discriminating firm at the left is earning zero economic profit, so that there is no incentive for similar firms to enter the market. However, the non-discriminating firm on the right is earning a positive economic profit, since, as Becker showed, non-discriminating firms are more efficient. In the long run, the competitive market should eliminate the inefficient dis-criminating firms. So, why doesn’t the firm on the left disappear?

Now we have the economic explanation for Jim Crow laws that make it illegal for non-discriminating firms to enter or survive in the market. Those familiar with the civil rights era will recall that Southern whites not only denounced “uppity blacks,”13 but also “outsiders,” especially Jews. Perhaps stemming from a long history as victims of discrimination themselves, and also because Jewish theology has long resisted the temp-tation to remake God in the image of a bigot, Jews tend to have tastes for discrimination near 0. Because of that, they are denounced as “money grubbers,” which, of course, is a derisive term for “profit-maximizer.” So, by threats of fines and police-sanctioned vio-lence, Southern governments protected discriminating firms from the entry by non-

13 Unfortunately, they typically invoked the “n” word in voicing their personal tastes for discrimination.

$/q

MCAC S

D

MC AC

Pe Pe Pe

$/Q

q 0 0 0 q Q qd>0 Q qd = 0

Discriminating Firm Competitive Market Non-Discriminating Firm

$/q



competitive firms. Interestingly, during Reconstruction, when Northern occupation forc-es were unsympathetic to Southern tastes for discrimination, the Ku Klux Klan emerged as an extra-governmental organization to intimidate blacks and the whites (non-Christians) who would hire them. During World War I, when labor shortages threatened to undermine the enforcement of Jim Crow laws, the Ku Klux Klan emerged from obscu-rity, disguising itself as a patriotic organization in defense of Christian virtues, especially the purity of Southern women. Indeed, there was a renewed resurgence of Klan activity during and immediately after the civil rights movement, particularly after voting rights neutralized local governments as agents of economic inefficiency. Nevertheless, illegal means are more expensive than governmental means of enforcing collective discrimina-tion, and so the Civil Rights and Voting Rights Acts unleashed the competitive forces of the market.

Next, consider the case of employee discrimination. An employee reveals a taste for discrimination by discounting the wage rate offered from a black employer, or the wage offer for a job that would involve black supervisors or coworkers. If wwwis the wage offer for a job in an all-white establishment, and wwb is the wage offer to a white from an establishment that also hires blacks in the same or higher positions,14 the worker would prefer the wage offer www if wwb>wwb(1-dj), where dj is the discrimination coeffi-cient by the jth job applicant. Even if employers had no taste for discrimination, they would not wish to pay a wage premium to white workers to work alongside black work-ers. Therefore, employee discrimination tends to promote labor-force segregation. If both the employer and the employee have tastes for discrimination, then unequal wage rates (the result of employer discrimination) will reinforce labor-force segregation (the result of employee discrimination). Note that a segregated school system, with inferior schools for blacks reinforces both employer and employee discrimination, by preventing blacks from preparing for well-paying, but white-dominated, occupations. Also, discrim-ination creates a self-fulfilling prophecy for blacks. If, for instance, architecture firms will not hire black architects, then blacks will not prepare for careers in architecture. Then, when the Civil Rights Act removes impediments to discrimination, employers will shrug their shoulders and proclaim, “We would like to hire black architects, but noneap-plied.”

The third type of market discrimination consistent with competition is consumer discrimination. When whites buy manufactured goods, they typically neither know nor care whether the workers who created those goods are black or white. Similarly, when hiring servants, whites may prefer blacks because they feel this places them (the whites) in an advantaged social position. However, whites will typically prefer white profession-als, such as doctors, lawyers, and architects, as well as rolemodels like entertainers and athletes.15 Indeed, until 1947 (the year that I was born), Major League Baseball teams had no AfricanAmerican players. In 1997, professional baseball celebrated the fiftieth anniversary of Jackie Robinson’s breaking the color barrier. What is telling is that teams

14 Many whites had no qualms about working in establishments wherein blacks worked in lower status jobs, since the ability to “look down on” blacks was part of the mystique of being white in the South. 15 Minstrel shows, popular in the late nineteenth century, featured white entertainers in dark makeup (black-face) playing black entertainers, who were barred from performing in the shows.



that added blacks to their roster tended to fare better in competition with all-white teams, who had substituted inferior white players for more qualified black players.

A consumer who has a taste for discrimination would behave as if the price of buying a product from a black (say, a store clerk) is greater that the price of buying the same product from a white: Pb(1+d) >Pw. Since consumers will gravitate to firms charg-ing lower psychic prices, employers without tastes for discrimination will be reluctant to hire blacks for “consumer-sensitive” positions. Becker illustrates the importance of dis-crimination in various professions with the following observation:

This analysis also partly explains why Negroes and whites choose different occupations. It is more difficult for Negroes to acquire formal education because they are poorer than whites; since engineering requires less formal schooling than medicine, dentistry and the law, one might ex-pect relatively more Negroes to enter engineering. The data … show that relatively fewer Negroes are in engineering that in the other professions. A large fraction of the dentists, doctors and lawyers are self-employed, while most engineers are employed by private firms. This implies that en-gineers are employed in relatively large establishments; therefore, even if the average taste for discrimination was the same against all Negro profes-sional men, Negro engineers would suffer more actual discrimination, and consequently there would be less incentive for Negroes to enter this pro-fession.

Although roughly the same amount of education seems to be re-quired for dentistry, medicine, and law, relatively more Negroes are in dentistry and medicine than in law. If there are tastes for discrimination, the differences between the professions become relevant, one of them be-ing that lawyers must argue in white courts. Members of the court are, as it were, a complementary factor, and if they prefer white lawyers, the de-mand for Negro lawyers will be curtailed.16

To summarize, the existence of a taste for discrimination, or prejudice based on inaccurate information, which resists empirical correction, places discriminating employ-ers at a competitive disadvantage. Jim Crow laws and other legal impediments to market competition protect discriminating firms from competition, but they do not overcome the inherent inefficiency of discriminating firms. Furthermore, white employees will accept lower wages to work with whites than to work with blacks, a factor that would tend to depress the wage rates for southern whites. Finally, consumers who pay higher prices to avoid contact with black salespeople or professionals will have a lower standard of living than would equivalent consumers without racial hang-ups. Ironically, it was the willing-ness of the South to erect an elaborate system of segregation that kept the standard of liv-ing of all southerners lower than those of residents of other parts of the country.

The economic effect of the Civil Rights Act was to remove state governments as protectors of segregated firms from market competition, and allowed blacks to sue dis-criminatory employers or businesses. The Voting Rights Act solidified the gains made

16The Economics of Discrimination, pp. 90–92.



by blacks by making them a force to be reckoned with in Southern elections. In Griggs v. Duke Power, the Supreme Court placed the burden of proof on employers who had to show that they were not discriminating. In the 1980s, the Republican Party broke the bi-partisan consensus in favor of equal rights and encouraged the ideological, gender, and racial divisions that still plague the country.

Figure 12-2 shows that, in 1963, the typical black adult earned 50% of what the typical white earned both in the South and outside the South. We also find that the typical southerner – white or black – earned about 75% of what a non-southerner earned. With the passage of the Civil Rights Act in 1964, black income rose relative to white income faster in the south than outside the south. If racial equality were a zero-sum game, we would expect the gains to blacks to come at the expense of whites. How-ever,the average earnings of white southerners reached parity with the earnings of whites outside the south by the mid 1980’s. Note that Southern blacks did not reach that mile-stone until 2009. The move toward equal economic opportunity, embodied in the civil rights legislation of the 1960s, was a rising tide that lifted all boats—black and white to-gether—because equal economic opportunity is consistent with economic efficiency.

The Trend in the Market Discrimination Coefficients

We have seen that Becker traced black-white earnings differentials to the exist-ence of a taste for discrimination by white employers, employees, and customers against dealing with black workers. If potential employer i has a personal discrimination coefficient of di, that employer behaves as if the wage rate paid to black workers is wb(1+di); that is, the employer inflates the monetary wage wb to a psychic wage wb(1+di). Among equally qualified white job applicants (with reservation wage ww) and black job applicants (with reservation wage wb), the white employer will nevertheless hire the white job applicant if wb(1+di) >ww, even though ww>wb. Supply and demand will clear

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Figure 12‐2: Rise in Relative Earnings

White Earnings: South to Non‐South Black Earnings: South to Non‐South

Black to White Earnings: Non‐South Black to White Earnings: South



the market, generating the market discrimination coefficient, b

w

wMDC

w , where wb and

ww are the equilibrium wage rates for white and black workers, respectively.

All employers whose personal discrimination coefficient exceeds the market dis-crimination coefficient hire only white workers and incur larger wage costs than do those employers whose personal discrimination coefficients are less than the market discrimi-nation coefficient, will hire only black workers, resulting in a segregated labor force.17 However, because discriminating employers would have higher labor costs than would non-discriminating employers, competitive-market forces would eventually displace dis-criminating employers, causing the market discrimination coefficient to decrease over time. Until 1964, however, state anti-competitive Jim Crow laws deterred employers with low discrimination coefficients – blacks, Jews, Catholics and non-Southerners – from entering southern labor markets. With the passage of the Civil Rights Act we should observe a gradual decrease in the market discrimination coefficient.

Figure 12-3

The pink line shows the average annual wage and salary earnings for white work-ers. The black line shows the average wage and salary earnings for black workers, both in constant 2011 dollars. The grey line shows what black workers would earn if they re-ceived the same pay by age, education, and occupation that white workers receive. For instance, in the March 1962 CPS, black workers earned an average of 60.44% of what the average white workers earned. Had black workers been paid the same as white workers with the same age, occupation, and education, that discrepancy would have been reduced by half; black earnings would have received 78.74% of what white workers received. 17 Segregation resulting from employer discrimination is reinforced by employee discrimination, whereby white workers demand a wage premium, wwdj for working with black co-workers (or supervisors). Even if an employer had a relatively low personal discrimination coefficient, they would hire only white workers or only black workers to avoid paying the “integration premium” to white workers.

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

Labor Earnings in

2011 dollars

CPS March Survey Year

Black and White Earnings, with Non‐Discrimination Prediction

blacks whites Black Earnings Without Discrimination



That is, about half of the earnings difference between the earnings of black and white workers could be attributed to lower education and selection of lower paying occupa-tions. By 2012, the average black worker earned 70.99% of what the average white worker earned. Because of gains in education and occupations, blacks would have been paid 94.21% of what white workers earned. So while pay discrimination is gradually de-clining, black workers continued to earn less than white workers.

Figure 12-4 shows a similar comparison between the earnings of male and female workers. In 1962, the typical female worker earned only 24.36% of what the typical male worker earned. Had she been paid the same rate as men were for hours worked, educa-tion, age, and occupation, the average woman would have earned 81.36% of what the av-erage man earned. That is, nearly three-force of the male/female wage discrepancy was due to unequal pay for equal characteristics. By 2012, female earnings had increased to 55.36% of male earnings; had women been paid the same rate as men earned, they would have earned 94.95% of what men earn. This continuing earnings discrepancy works to the benefit to families wherein the husband is the sole or chief earned – namely high in-come families. This discrepancy works to the detriment of two-earner families and fami-lies headed by women – typically low income families.

Figure 12-4

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

Average Earings in

2011 Dollars

Trend in Male and Female Earnings: With and Without Discrimination

Average Male Earnings Average Female Earnings

Female Earnings Without Discrimination



Litigating against Discrimination

As we noted in earlier chapters, discrimination is a process, meaning that people are excluded from product or factor markets or trade at a disadvantage due to the tastes of discrimination by the economic majority. Economic discrimination causes economic in-equality, whose extreme consequence is poverty. However, discrimination is not the only cause of economic inequality, or even poverty. Indeed, documenting discrimination, let alone eliminating it, has been a major issue of the civil rights movement. Without access to the courts and without the ability to vote, African Americans, Native Ameri-cans, AsianAmericans, and femaleAmericans had to suffer their discrimination in silence.

Before the Civil Rights Act, discrimination was documented by journalists and historians, whose photographs depicted lynchings and grinding poverty. There were a few noteworthy counterexamples, including the case of African slaves and the Armistead case, argued by former President John Quincy Adams and depicted in the movie by the same name.18 We should not overlook the Civil War, when 70 percent of the population fought 30 percent over the issue of slavery. That the Brown case was decided in favor of racial justice by a unanimous Supreme Court in 1954 was nothing short of remarkable. But it was the 1964 Civil Rights Act, whereby the United States Constitution trumped state laws, when blacks, other racial minorities, and women gained recourse to the courts.

In the early 1960s, the backlog of clear-cut discrimination cases began to filter through the court system. When Southern white males believed they could murder blacks with impunity, they had no worries that a court would find them guilty of employment or consumer discrimination. It was the Griggs case, however, that set the precedent for how the federal and state courts would weigh the evidence in anti-discrimination suits.

In Griggs v. Duke Power (1971), Willie Griggs was the plaintiff—the party bringing the complaint—and Duke Power was the defendant—the party answering the complaint. Griggs and his attorneys alleged that Duke Power had discriminated against Griggs because of his race.The defendant responded that Griggs was not promoted be-cause of his lack of education, which was perfectly permissible under Title VII of the 1964 Civil Rights Act,which dealt with discrimination in employment. Griggs’s attor-neys countered that the requirement that promotion beyond laborer required a high school diploma was unfairly applied to Griggs, since many white employees did not meet that qualification. In ruling for the plaintiff, the Supreme Court held that “Title VII bans ‘not’ only overt discrimination but also practices that are fair in form but discriminatory in op-eration.” In order to avoid discrimination lawsuits under Title VII, public and private em-ployers began to adopt hiring policies designed to recruit more minorities. The Equal Op-portunity Act of 1972 expanded Title VII protections to educational institutions, leading to the extension of affirmative action to colleges and universities.”19

The ruling in the Griggs case informed employers that circumstantial evidence of discrimination—that is, the statistical underrepresentation of a protected demographic group shifted the burden of proof to the employer, who then had to show that the out-

18 The case was admitted to the courts because there were several different claimants to Amistead’s cargo, namely human beings, not because American courts were sympathetic to the plight of African slaves. 19Microsoft® Encarta® Reference Library 2003. © 1993–2002 Microsoft Corporation. All rights reserved.



come of inequality was not the result of discrimination. It is a well-known precept of logic that one cannot prove a negative; I cannot prove I did not discriminate. However, an adequate defense would be to show that the process I used in hiring was nondiscrimi-natory. It would not do for employers to argue “no qualified applicants came forward,” since discrimination creates a self-fulfilling prophecy. If Duke Power discriminates against blacks in general, blacks with high school diplomas are not likely to apply to Duke Power.

As a legal defense, most employers adopted an Affirmative Action employment policy. The term was first used, in 1961, by President Kennedy in an executive order de-signed to encourage companies doing business with the United States government to hire the most qualified workers available, taking positive steps (i.e., affirmative action) to find qualified minority candidates if underrepresented groups had not applied. In a 1965 speech to Howard University, President Johnson set the tone for Affirmative Action when he said: “You do not take a person who, for years, has been hobbled by chains and liberate him, bring him up to the starting line of a race and say, ‘you are free to compete with all the others,’ and still justly believe that you have been completely fair.”20

So, imagine you were the chancellor at the University of California, Davis, and you realized that the demographic profile of medical students would pass the legal stand-ard for discrimination:

The Medical School of the University of California at Davis opened in 1968 with an entering class of 50 students. In 1971, the size of the entering class was increased to 100 students, a level at which it re-mains. No admissions program for disadvantaged or minority students ex-isted when the school opened, and the first class contained three Asians but no blacks, no Mexican-Americans, and no American Indians. Over the next two years, the faculty devised a special admissions program to in-crease the representation of “disadvantaged” students in each Medical School class. The special program consisted of a separate admissions sys-tem operating in coordination with the regular admissions process.

From the year of the increase in class size—1971—through 1974, the special program resulted in the admission of 21 black students, 30 Mexican-Americans, and 12 Asians, for a total of 63 minority students. Over the same period, the regular admissions program produced 1 black, 6 Mexican-Americans, and 37 Asians, for a total of 44 minority students. Although disadvantaged whites applied to the special program in large numbers, none received an offer of admission through that process. In-deed, in 1974, at least, the special committee explicitly considered only “disadvantaged” special applicants who were members of one of the des-ignated minority groups.

Allan Bakke is a white male who applied to the Davis Medical School in both 1973 and 1974. In both years, Bakke’s application was considered under the general admissions program, and he received an in-

20Microsoft® Encarta® Reference Library 2003. © 1993–2002 Microsoft Corporation. All rights reserved.



terview. His 1973 interview was with Dr. Theodore C. West, who consid-ered Bakke “a very desirable applicant to [the] medical school.” Despite a strong benchmark score of 468 out of 500, Bakke was rejected.… In nei-ther year did the chairman of the admissions committee, Dr. Lowery, ex-ercise his discretion to place Bakke on the waiting list. In both years, ap-plicants were admitted under the special program with grade point averag-es, MCT scores, and benchmark scores significantly lower than Bakke’s.

After the second rejection, Bakke filed the instant suit in the Supe-rior Court of California. He sought mandatory, injunctive, and declaratory relief compelling his admission to the Medical School. He alleged that the Medical School’s special admissions program operated to exclude him from the school on the basis of his race, in violation of his rights under the Equal Protection Clause of the Fourteenth Amendment, Art. I, § 21, of the California Constitution, and § 601 of Title VI of the Civil Rights Act of 1964.…

Before continuing with the Court’s ruling, consider the result if Bakke had sued the American Medical Association, or even the University of California, under an anti-trust statute. By conspiring to maintain an artificially low number of medical school stu-dents, the University of California conspired with the American Medical Association to restrict trade and create a monopoly price for healthcare. Had the Court ordered that the AMA approve, say, a doubling of the number of medical student slots at all medical schools, there would have been no need for discrimination.Since Bakke did not sue under an anti-trust statute, the Supreme Court had to limit its ruling to the facts of the case. The Court essentially split a legal hair, finding against UC-Davis because it used an explicit racial quota, which, by discriminating in favor of racial minorities, could not help but discriminate against Allan Bakke, a mediocre white male. However, the Court explicitly approved of affirmative action programs, like that at HarvardUniversity, which included ethnicity as one factor in admission (i.e., accepting lower test scores from minority appli-cants) without establishing an explicit quota.

S

D L/ut

$/L

W* Wc Wr

L* LcLs

Figure 12-7



Figure 12-7 presents the dilemma facing medical schools, whose admissions are artificially restricted by a powerful labor cartel, in this case, the American Medical Asso-ciation.21 The demand curve shows the demand for physician’s services; it is negatively sloped because, the higher the wage rate, the fewer physician visits patients will make. The demand curve is relatively steep (price inelastic) because physicians often provide life-and-death services, and, more importantly, most medical bills are paid for by private insurance (with a nominal copay), or by government programs like Medicaid (for the poor) or Medicare (for seniors). The supply of physicians is positively sloped because medicine is a stressful occupation, and because the required four years of college, four years of medical school, plus another four or more years of internship and residence be-fore doctors can earn substantial income (and start paying off those student loans) is ex-pensive. Nevertheless, judging by the ratio of medical school applicants to admissions, the restriction on medical school admissions creates a labor surplus.22 Overall, there are Ls individuals who apply to medical schools, but only L* slots available. The conse-quence of restricting the number of slots in medical school is that the wage rate for physi-cians is W* instead of Wc, the competitive-market clearing wage. But the university is left with a rationing problem. The AMA prefers a balance of two conflicting goals: keep-ing AMA members happy, by guaranteeing that their sons and nephews are admitted, and keeping society happy by restricting admission to the most qualified.

You should recognize the model of a labor cartel operating in an erstwhile com-petitive labor market. If admission to medical school was completely left to competitive markets, Lc applicants would be admitted (after some screening for minimum qualifica-tions), and physicians would earn a market-clearing wage rate of Wc. That was essential-ly the status quo at the end of the nineteenth century, when most physicians received their training through apprenticeships. When the American Medical Association gained con-trol of physician certification,23 the number of physicians (as measured by their percent of the population) fell from Lc to L*, resulting in a substantial increase in the wage rate from Wc to W*. But the higher-than-competitive wage rate for physicians means that medical schools must ration L* slots to Ls applicants. In Chapter 9, we reviewed three alternative rationing schemes. If universities wished to clear the market, they could set tuition so high that only L* students applied. Note that Wr is the reservation wagefor the L*th ap-plicant. A tuition level that confiscated W* – Wr would eliminate the surplus of appli-cants and make medical schools more profitable for universities than NCAA football or basketball. In fact, those with the lowest reservation wages would likely be women and minorities, so medical schools would simultaneously increase their tuition coffers and remove the circumstantial evidence of racial and gender discrimination.

Obviously, charging market-clearing tuition was not the screening technique that UC-Davis or most other medical schools adopted. Typically, elite universities set their

21 One urban legend that I heard as a student at SyracuseUniversity in the 1970s, told of a threatened disac-creditation of the Johns Hopkins medical school that had proposed a night program, using medical school faculty serving with the Department of Health, Education, and Welfare. 22 More relevant empirical evidence of an artificial shortage of medical-school slots is the fact that while American colleges and universities export education, particularly post-graduate education, in virtually eve-ry field, a significant portion of physicians in the USA were trained in other countries. 23 The fox assumed control of the henhouse!



tuition to raise sufficient revenue from rich, qualified applicants24 in order to offer schol-arships to overqualified poor applicants, who otherwise could not attend that university and make life at the university more pleasant for elite faculty members. So, the affirma-tive action program adopted by UC-Davis did not eliminate discrimination, it merely shifted the discrimination away from minority and female applicants to academically av-erage white male applicants without connections.

So, as a remedy against the charge of discrimination in a competitive market, af-firmative action works to identify minority candidates, and, eventually, transform the demographic profile of an occupation to more closely match that of the relevant popula-tion. However, when applied to an imperfectly competitive labor market, like medicine, affirmative action does not eliminate discrimination; it merely changes who the victim is. Affirmative action has become another wedge issue the Republican and Democratic Par-ties use to divide the country.

In 1989, after several successful conservative Supreme Court appointments, in-cluding the elevation of William Rehnquist to Chief Justice, the Court reversed the Griggs decision. In Wards Cove Packing Company v. Antonio, Native Americans sued because they were underrepresented among managers in other white-collar positions and overrepresented in laborer positions (pulling guts out of salmon along a conveyor belt):

The Supreme Court’s ruling in Wards Cove Packing Company v. Antonio (1989) revised the standards established by the 1971 Griggs deci-sion. The Wards Cove decision required that employees filing discrimina-tion lawsuits demonstrate that specific hiring practices had led to racial disparities in the workplace. Even if this could be shown, these hiring practices would still be legal if they served “legitimate employment goals of the employer.”25

After Wards Cove, employees had to prove that employers intended to discriminate; they mustpresent a written record where employers explicitly state that they did not hire an applicant because of race, gender, age, or nationality. Now most discrimination suits are dismissed for lack of proof; those that pass the hurdle of correlating the underrepresenta-tion of specific groups to the firm’s hiring practices still must answer the question of why they know the employment goals of the firm better than the employer does. It follows that employers have less of an incentive to maintain affirmative action policies.26 How-ever, the burden of proof was shifted back to employers in the Civil Rights Act of 1991.

24 When professors at private liberal arts colleges explain the performance of their academically challenged students, the label they use is “full-pay” students. 25Microsoft® Encarta® Reference Library 2003. © 1993–2002 Microsoft Corporation. All rights reserved. 26 Much of the material for this chapter comes from a website, Diversity Inc., sponsored by such prominent companies as Starbucks, Marriott, Ford, and Mercedes Benz. The stated mission of Diversity Inc. is to assist human resource corporate officers and small business employers appreciate and further the diversity within American business. Is it possible that the Republican Party has not kept pace with its key constitu-ency? Check out http://www.diversityinc.com



Did the Americans with Disabilities Act Work?27

In 1990, during the first Bush administration, Congress passed the Americans with Disabilities Act. The ADA took effect two years later in mid-1992. The ADA has two major provisions. First, owners of public buildings are required to make those facili-ties accessible to the disabled, by adding ramps, modifying restrooms, and so forth. Sec-ond, employers had to make reasonable accommodation to hire and retain the disabled. This second effect is more relevant to our purposes; if employers are required to accom-modate the disabled, we should see a significant decrease in the poverty rate among disa-bled individuals.

The Americans with Disabilities Act is a noble but flawed experiment. Like min-imum wage laws and rent controls, the ADA is an attempt to be altruistic with other peo-ple’s money, causing a market distortion and economic inefficiency. Just as minimum wage laws say “We want to help unskilled workers, but we want employers to bear the cost,” the Americans with Disabilities Act says the same thing about disabled individuals. If a worker became injured and was able to continue with his same employer, that worker is generally better off, because the employer is familiar with the worker. However, if an individual is congenitally disabled, or can no longer continue in his or her pre-injury oc-cupation, ADA has the perverse effect of reducing the individual’s employment pro-spects. In hiring a new employee, an employer values the option to dismiss the employee if he or she fails to perform adequately. That is why many states, including Nevada, have employment at will laws that give the employer the right to terminate a worker for any cause. Many employers waive their right to terminate without cause after the worker has proved himself or herself after some probationary period. Nevertheless, the employer prefers to have the option to terminate workers if their performance differs from their promise.

The problem with the ADA is that the act prohibits discrimination against the dis-abled, by requiring employers to make only reasonable accommodations to change the worksite to one more conducive to work by the disabled. Ambiguity about what consti-tutes a reasonable accommodation has led to a spate of litigation, culminating in the U.S. Supreme Court’s relatively narrow enforcement of the ADA. Before ADA, a disabled job seeker would have to battle employer prejudice and the possible resentment of fellow workers who might have believed that disabled workers would not pull their own weight. Indeed, to the extent that ADA has provided employers and fellow employees with the opportunity to get to know disabled colleagues, the law may have had a useful public re-lations role to play. Indeed, workers whose aptitude and honesty are known to an em-ployer tend to benefit from ADA, in that the law makes it difficult for an employer to fire disabled workers. However, if the worker cannot perform his or her pre-injury job, she must re-enter the labor force in a condition of asymmetric information—the job-seeker knows more about her ability to perform than the potential employer does, but the job-seeker is inclined to overstate that ability. Indeed, people sometimes fool themselves about how much they can accomplish until they have actually tried to do the job. If the employer has the option to fire, she may take a chance on a disabled employee, since the 27 This section is based on “The Impact of the Americans with Disabilities Act on Labor Market Outcomes: Lessons for Forensic Economists,” National Association of Forensic Economics Session, Southern Eco-nomics Association Meetings, San Antonio, Texas, November 22, 2003.



cost of that person’s inability to perform can be mitigated by dismissal. It follows that an employer will try to find an excuse, other than disability, for not hiring a disabled job-seeker. Of course, the job-seeker has the right to sue under ADA. However, as we will see in the next chapter, the party that bears the burden of proof in a discrimination case generally loses.

Table 12-1 presents the annual data for the subset of 310,726 respondents to the March CPS who answered “Yes” to the disability question between 1988 and 2012. The first column shows the year of the survey, and the second is the disability rate for all in-dividuals each year (a sample of 3,349,678). The growth rate at the bottom of the page indicates the average annual percent change in that variable. Significance is the probabil-ity that the actual growth rate is zero. The effect of ADA measures the percent change in the variable after the passage of the Americans with Disabilities Act; the significance of that effect is the probability that the ADA had no effect on the variable in question.

Disability Poverty Participation Employment

year rate rate Rate Rate Able‐Bodied Disabled Able‐Bodied Disabled Able‐Bodied Disabled

1988 9.08% 23.06% 27.50% 67.63% $34,162 $18,581 $18.04 $14.47 $31,784 $19,446

1989 9.13% 22.75% 27.47% 67.30% $34,049 $18,153 $17.87 $13.83 $32,092 $19,081

1990 9.10% 22.82% 28.53% 68.63% $34,612 $18,614 $18.08 $14.42 $32,791 $19,728

1991 9.14% 24.72% 27.47% 66.95% $33,543 $17,868 $17.64 $14.07 $31,827 $19,130

1992 9.18% 24.59% 27.91% 67.74% $33,041 $18,413 $17.57 $14.05 $31,108 $18,987

1993 9.55% 24.85% 27.35% 67.82% $33,467 $17,234 $17.68 $13.52 $31,130 $18,348

1994 10.63% 25.17% 25.06% 67.47% $33,672 $17,346 $17.77 $14.26 $31,440 $18,304

1995 10.55% 24.53% 24.95% 66.81% $34,733 $17,921 $18.11 $14.59 $32,097 $18,583

1996 10.58% 23.06% 24.54% 68.43% $37,027 $20,654 $18.53 $15.65 $33,802 $19,300

1997 10.44% 23.69% 25.07% 69.53% $37,520 $19,295 $18.63 $14.69 $34,417 $18,802

1998 9.75% 24.10% 24.28% 69.54% $38,199 $18,125 $18.74 $14.23 $35,725 $19,116

1999 9.57% 24.30% 23.82% 71.11% $39,549 $20,128 $19.37 $15.08 $36,812 $19,635

2000 9.65% 22.42% 24.53% 71.12% $39,309 $21,154 $19.65 $15.94 $36,697 $20,364

2001 8.93% 23.71% 25.61% 69.60% $41,914 $20,794 $20.23 $15.82 $38,303 $19,832

2002 8.88% 24.26% 24.90% 69.24% $42,568 $21,431 $20.67 $16.68 $38,078 $19,258

2003 8.74% 25.13% 23.35% 68.47% $42,492 $20,950 $20.78 $16.41 $37,339 $18,650

2004 9.00% 24.89% 23.31% 69.46% $42,340 $20,868 $20.88 $16.38 $37,398 $18,453

2005 9.06% 24.97% 22.28% 69.09% $42,314 $20,558 $20.67 $15.99 $37,368 $18,654

2006 9.25% 24.86% 22.15% 69.89% $42,590 $20,362 $20.59 $15.71 $37,829 $18,928

2007 8.64% 24.44% 21.94% 69.80% $43,302 $19,976 $20.78 $15.79 $38,512 $19,112

2008 8.57% 25.05% 21.89% 68.79% $43,008 $19,754 $20.92 $16.09 $38,180 $18,922

2009 9.04% 25.01% 21.30% 68.47% $42,137 $18,273 $20.81 $15.58 $37,216 $18,183

2010 8.96% 25.16% 20.24% 66.91% $41,594 $18,903 $21.20 $15.69 $36,508 $18,478

2011 9.02% 26.00% 19.40% 67.05% $41,080 $18,293 $21.05 $16.05 $35,870 $18,025

2012 9.37% 26.39% 18.41% 65.52% $41,875 $17,842 $20.94 $16.65 $36,240 $17,695

Total 9.28% 24.49% 23.88% 68.48% $39,342 $19,293 $19.69 $15.28 $35,545 $18,876

ate of chang ‐0.06% 0.08% ‐0.37% ‐0.02% 1.31% 0.58% 0.83% 0.74% 1.10% 0.22%

Significance5.01E‐108 5.96E‐108 2.61E‐161 29.60% 0 1.16E‐07 0 4.34E‐29 0 0.22%

3.39E‐08

ffect of AD 1.00% 0.28% 0.46% 1.31% ‐0.80% 0.22% ‐2.97% ‐1.91% ‐0.54%

Significance 2.81E‐67 32.30% 9.50% 0.40% 1.20% 91.60% 4.82983E‐52 13.30% 11.10% ‐1.40%

abor Earnings in 2011 $ Real Wage Rate Total Income in 2011 $'s

The disability rate increased from 1988 to 1997 and then declined. Overall, the

disability rate declined by 0.06% per year, but jumped by 1% upon the passage of ADA. The poverty rate among the disabled increased at a rate of 0.08% per year, and was not did not depart from that path upon the passage of the ADA. The ADA was intended to



increase the labor-force activity rate of the disabled, who were expected to become more optimistic about their employment prospects; the labor-force participation rate actually declined at a rate of 0.37% per year, and the passage of ADA barely offset one year’s de-cline in the labor force participation of the disabled. The employment prospects of the disabled did improve marginally; while the employment rate did not change from year to year, the employment rate for the disabled did increase by 1.31% the year after ADA passed. The annual earnings of the disabled increased during the 1990’s, but then de-clined from 2000 to 2012; overall, the rate of increase was only half that experienced by able-bodied workers. There was a drop of less than one year’s earnings growth for able-bodied workers’ earnings in 1991, compared to an insignificant departure from the growth trend for disabled workers. The inflation-adjusted wage rate for wage rate grew only slightly less for disabled workers than for able-bodied ones; this reflects a reduction in the average hours worked per year by the disabled. Finally the average income able-bodied individuals grew at five times the rate as did the income of the disabled.

The Americans with Disabilities Act was at best a partial success at increasing the lot of the disabled. Most successful were the architectural accommodations at places of business and hotel accommodations. Today it would be more expensive to construct of-fices that did not comply with ADA than to build ones that comply; ADA compliant ar-chitecture is now standard. Less successful were the employment provisions. For work-ers who become disabled but are able to perform their pre-injury jobs with modest ac-commodations by their employer were made better off by ADA. For workers who are unable to continue in their pre-injury occupation, the ADA probably makes their em-ployment prospects worse. Recall the asymmetric information problem from chapter two of Freakonomics; such a problem bedevils the employment decision. Job seekers typical-ly know more about their abilities than prospective employers do, and often job seekers exploit this ignorance, hoping to fool their employer, and perhaps even themselves, claiming skills they do not possess. To counteract this problem, most states, including Nevada, have employment-at-will statutes, which give employers the right to terminate employment at will – that is, without giving a reason or the employee the right to sue.

By forbidding employment discrimination against the disabled, the Americans with Disabilities Act may actually deter prospective employers from hiring the disabled. Being sued for terminating a disabled worker is bad publicity at best and may result in paying damages. As long as an employer has a record for accommodating the disabled workers he knows, the burden would be on a disabled job applicant to prove that he could have performed a job if he had been hired. In short, employers may decide that it is less risky not to hire disabled job applicants than to hire them, find that they cannot perform their job, and lose a court battle in a wrongful termination suit.

The premise behind antidiscrimination laws is that minority and female job appli-cants are likely to be as productive as white, non-Hispanic male job applicants are. Prej-udice is not a defense; an employer with a history of discrimination must prove that his hiring, retention, promotion and pay practices are related with actual worker perfor-mance. With disabled and older job applicants, prejudice may be accurate; disabled and older workers are often less productive than their able-bodied and younger counterparts. Imposing anti-discrimination rules that result in lower business profits turns employers into enemies rather than allies in the struggle for equal economic opportunity. That is



why it is so important that society erect a strong economic safety net – such as a negative income tax – which provides better support for young, disabled, and elderly citizens than a competitive market could.

Conclusion

The United States has had a long, shameful history of de juro discrimination against African Americans, Native Americans, Asians, Hispanics, and women of all eth-nicities. From a Constitution that did not count Native Americans, and treated black slaves as three-fifths of a person, the nation limped along until the Civil War finally unit-ed the country as an unbreakable union of Free states. But the nation was reconstructed under the separate-but-equal banner of Plessy v. Ferguson, until Brown v. Board of Edu-cation proclaimed that separate but equal was an oxymoron. The Civil Rights Act of 1964 and the Voting Rights Act of 1965 wiped away the formal discrimination of Jim Crow laws in the South, although housing segregation, and segregated education, both forms of de facto discrimination, persist to this day.

The national consensus favoring equal rights eroded in the 1980s, first with the rejection of the Equal Rights Amendment for women, and then with Republican Ronald Reagan’s embracing the white backlash and giving the country a kinder, gentler form of racism. Today, affirmative action, reproductive rights, and civil rights for gays and lesbi-ans are wedge issues, splitting the country along fundamentalist versus libertarian lines.

From an economic perspective, discrimination is economically inefficient because discriminating firms incur higher production costs than non-discriminating firms would. Market competition would eliminate economic discrimination if pro-discrimination laws did not exist. Jim Crow Laws were cartel protections for discriminators, and the imple-mentation of the Civil Rights Act was sufficient to set competitive markets back on the path to economic efficiency. However, economic efficiency does not lead employers to hire minority workers if they would have to pay higher wages to other workers with tastes for discrimination. Nor do employers hire minority employers if consumers with a taste for discrimination would shun the firm. By giving victims of discrimination the right to sue firms that practice employment discrimination or charge higher prices or re-fuse to deal with minorities for damages, civil rights legislation deterred discrimination even when firms themselves were otherwise following profit-maximizing strategies. When the Supreme Court placed the burden of proof on employers in employment dis-crimination cases, many firms and governments adopted affirmative action strategies to (1) assure that their employees’ demographic characteristics matched those of the general population, or (2) failing equal employment outcomes, document equal employment op-portunity by taking proactive steps to identify and nurture qualified minority applicants.

When the inaugural class at the University of California, Davis medical school contained few minority members, the school adopted an affirmative action policy that set aside a number of slots for minority applicants. When Allan Bakke sued the medical school for reverse discrimination, the Court ruled that explicit quotas, like that adopted by UC-Davis, were violations of the Fourteenth Amendment’s equal protection clause in that they denied due process to white-males, like Allan Bakke. In reaffirming affirmative action programs that do not involve strict quotas, the Court unknowingly bowed to eco-nomic reality. When markets, like that for physicians, are not competitive, some form of



discrimination will always exist. Society’s tolerance for pockets of monopoly means that affirmative action has become another wedge issue splitting the country.

Economists use statistical analysis to explain away earnings differences. By computing what black workers would have earned if they received the same rate of pay based on age, education, and occupation, we see that the proportion of the difference of the earnings between black and white workers attributed to human capital and occupa-tional differences has actually decreased over time. We find a similar pattern for the dif-ferences between female and male earnings.

The one anti-discrimination program that has been at best a modest success has been the employment discrimination section of the Americans with Disabilities Act. The requirement that employers accommodate the impairment of their workers increased the demand for disabled workers, but the adverse selection problem has not helped the em-ployability of the disabled. Because of access to Social Security disability payments, the participation rate among the disabled actually declined after the implementation of the ADA.

Summary

1. Unlike economic inequality and poverty, which are outcomes of factor markets, dis-crimination is a process, which makes discrimination difficult to measure.

2. Gary S. Becker was the first economist of note to analyze discrimination. According to Becker, whites who discriminate act as if the psychic cost of trading with blacks exceeds the money price.

3. The United States has had a long, unfortunate history of de facto discrimination, be-ginning with slavery, continuing through Reconstruction, the genocide against Native Americans, and the shameful internment of Japanese Americans during World War II.

4. The Supreme Court’s historic decision in Brown v. Board of Education in 1954 over-turned the judicial approval of separate-but-equal treatment of blacks, codified in Jim Crow laws, which protected discriminating firms from competition with more effi-cient non-discriminating businesses.

5. With the Civil Rights Act of 1964 and the Voting Rights Act of 1965, Congress inval-idated Jim Crow Laws. In Griggs v. Duke Power, the Supreme Court placed the bur-den of proof on employers in employment discrimination cases. Many firms adopted affirmative action strategy to document their anti-discrimination employment poli-cies.

6. Allan Bakke successfully sued the University of California-Davis medical school for admission, arguing that quota programs that set aside positions for minority appli-cants violate the Fourteenth Amendment’s guarantees of due process.

7. In 1989, in the Wards Cove Cannery case, the Supreme Court overturned Griggs, ar-guing that employees must prove that employers intended to discriminate. This deci-sion reduced popular support for affirmative action.

8. The 1991 Civil Rights Act reversed the decision of Wards Cove, allowing plaintiffs to use statistical evidence to prove adverse treatment in hiring decisions. However, by



allowing for compensatory and punitive damages, the 1991 Civil Rights Act shifted focus to discriminatory termination decisions. Some economists have argued that the 1991 Civil Rights Act had the perverse effect of discouraging employers from hiring marginal female and minority employees.

9. Because firms with a taste for discrimination are less profitable than non-discriminating firms would be, the market will tend to eliminate discriminating firms, unless those firms are protected by anti-competitive institutions like Jim Crow laws or the Ku Klux Klan.

10. When labor markets are not competitive, job discrimination is a natural consequence of employee cartels rationing a shortage of jobs, and wage discrimination as a natural consequence of employer monopsony.

11. Evidence indicates that Southern white wage rates increased relative to white wage rates in the rest of the country, validating Becker’s prediction that discrimination hurts both the perpetrator and the victim of discrimination in competitive markets.

12. Because discrimination is a process that is difficult to document, in a civil suit in which the plaintiff alleges discrimination and the defendant responds to that charge, the party that bears the burden of proof tends to lose.

13. The Americans with Disabilities Act imposed an obligation on employers to hire the disabled. The act has had little impact on the wage rates earned by the disabled, ap-parently because the working-disabled already possessed better than average endow-ments. Although ADA made it easier for the newly disabled to keep their pre-disability job, the act created an adverse selection problem for the disabled who had to change employers, since ADA compromised the employers’ options to terminate unproductive employees.

Glossary

Taste for discrimination: Behaving as if the psychic cost of dealing with a black ex-ceeds the monetary cost.

De juro: Something that is true by force of law; the Thirteenth Amendment gave legal support to Lincoln’s emancipation proclamation.

De facto: Something that is true in fact, without regard to legal status. Jim Crow laws caused de juro segregation; northern housing patterns created de facto discrimina-tion.

Discrimination coefficient: Factor d in the following equation, wb(1+db), which gives the psychic cost of a white dealing with a black.

Racial prejudice: Having an erroneous idea about the characteristics of people against which one has a taste for discrimination; typically racial prejudice is resistant to evidence to the contrary.

Market discrimination coefficient: The equilibrium discrimination coefficient that equates the equilibrium wage rates for blacks and whites: wb(1+D) = ww.

Jim Crow laws: Laws named for a minstrel character that mandated segregation and ra-cial discrimination in the pre-civil rights era south.



Grandfather clause: A stipulation in law or contract that a person could not enjoy cer-tain privileges if his/her grandfather had been a slave. This clause was a shame-ful, but legal, legal maneuver around the Fifteenth Amendment’s prohibition of denial of voting rights based on “previous condition of servitude.”

Employer discrimination: When an employer uses his/her taste for discrimination, hir-ing less-qualified white or male workers over more qualified minority or female job applicants.

Employee discrimination: When an employee demands a higher wage to work with fel-low workers or supervisors against whom he has a taste for discrimination. Em-ployee discrimination leads to labor market segregation.

Consumer discrimination: When consumers will pay a higher price to avoid dealing with a minority employee of a firm. Consumer discrimination leads employers to fail to hire minority applicants, even if the employer does not have a taste for dis-crimination.

Psychic cost: A factor, like a taste for discrimination, which causes people to act as if market prices are higher than they in fact are.

Stereotyping: A form of racial prejudice in which all members of a demographic group are assumed to have the real or imagined characteristics of individuals in that group.

Abortion on demand: The policy preferred by radical feminists where the state has no say in abortion, even after the fetus becomes viable.

Civil rights: Access to the rights of citizenship: the right to vote, to sue in court, to serve on juries, and to compete in markets.

Civil suit: A court case in which the plaintiff accuses the defendant of a careless or inten-tional action that inflicts harm. Civil suits are based on juries deciding for the party favored by the preponderance of the evidence, compared to criminal cases, where the prosecution must prove guilt beyond a reasonable doubt.

Plaintiff: The party, like a person alleging employment discrimination, who brings the suit and demands restitution from the defendant.

Defendant: The party alleged to have harmed the plaintiff, who can choose to settle the dispute out of court, or litigate the case, asking a judge or jury to decide.

Circumstantial evidence: Evidence consistent with the alleged action by the defendant; for instance, a significantly lower proportion of black employees than their num-ber in the population of qualified applicants is circumstantial evidence of discrim-ination.

Burden of proof: In a discrimination suit, the plaintiff bears the burden of proof if he must demonstrate that the employer intended to discriminate when the plaintiff was not hired, not promoted, terminated, or paid less than another employee who is equally productive. If the employer bears the burden of proof, he must show that the lack of employees from protected demographic group is not due to inten-



tional discrimination. From 1969 to 1989, the employer bore the burden of proof; after 1989, employees have borne the burden of proof.

Compensatory damages: Measurable economic damages, such as lost pay and attor-ney’s costs.

Punitive damages: Monetary awards to the plaintiff designed to punish the defendant beyond compensatory damages. While deterring undesirable behavior by defend-ants, punitive damages may encourage excessive or frivolous lawsuits by plain-tiffs and plaintiffs’ attorneys.

Affirmative action: The employment or recruiting strategy that proactively seeks to identify and hire (admit) minority or female applicants, with the goal of making the firm’s labor force or the school’s student body consistent with the demograph-ic characteristics of the population.

Chapter 13 Macroeconomics


Unemployment

In January 2007, with the presidential election 23 months in the future, the national

unemployment rate was 4.6%, which was close to what economists call the natural rate of

unemployment, defined as the state of the labor market when the number of people seeking jobs is

approximately equal to the number of jobs available. When the unemployment rate equals its natural

rate, there are two causes of unemployment. Frictional unemployment is the most benign type of

unemployment, meaning that potential employers are screening job applicants and job seekers are

considering alternative job offers. Some frictional unemployment is economically efficient in a market

economy, it provides time for employers and workers to find the best matches. Some frictional

unemployment is also necessary to send the appropriate signals to market participants. If workers have

unrealistically high reservation wages, a spell of unemployment may give them the incentive to reduce

their wage demands or to exit the labor force. If employers’ wage offers are too low, it will take time for

wage competition among potential employers to increase the equilibrium wage rate for those jobs.

The second type of unemployment is more troubling, and is particularly important to social

workers. Structural unemployment exists when there is a mismatch between the skill requirements of

available jobs and the human capital of job seekers. Structural unemployment is prevalent when there

are structural changes in the economy. During the 1980s the Reagan and Bush I administrations, with

the cooperation of Congress, relaxed restrictions on imported goods, which led to outsourcing, whereby

American companies substituted foreign manufacturing workers for American manufacturing workers.

American workers, who lost their manufacturing jobs in the double‐dip recessions from 1979 to 1983, or

during the short recessions of 1992 or 2001, found that their experiences in manufacturing jobs were ill‐

suited for more human‐capital intensive service jobs. In the case of structural unemployment, whose

skills are no longer in demand must undergo retraining, or, in the case of older workers, accept early

retirement. Creating more jobs does not alleviate structural unemployment if available job seekers do

not have the skills those jobs require. Social workers can help their clients diagnose the reason for their

inability to find a job and help them secure job training.

Figure 13‐1 traces the trend in the unemployment rate from the sixth year of the Bush II

Administration through November 2012, when Barack Obama was reelected as President of the USA.

Note the gentle increase in the unemployment rate during 2007; by the end of the year the

unemployment rate stood at 5%, which was well below the historical average of 6.2%. Some

construction workers and real estate brokers were losing their jobs as the housing bubble burst. If

those people could employ alternative job skills, they should have matched up with new job

opportunities. If there was a mismatch between the skills of the newly unemployed and the

requirements of available jobs, then the duration of job search would increase.



Figure 13‐1

Figure 13‐2 shows the duration of unemployment over the same time period. From January

2007 through mid‐2008 the average duration of unemployment remained roughly constant at 17.8

weeks, only slightly above the long‐run average of 13.5 weeks. Note that by the time of the November

election in 2008 it was clear that both the unemployment rate and the average duration of

unemployment were increasing rapidly. This is an illustration of the unemployment rate as a lagging

indicator. During bad time, employers are reluctant to terminate workers, both because of a touch of

altruism and because replacing those workers would require expensive investments in specific training.

Alternatively, when the economy recovers, employers don’t want to hire workers until they are assured

the upturn is permanent.

Figure 13‐2

46

810

Percent of L

abo

r Force

Willing to W

ork bu

t With

out J

obs

2007m1 2008m1 2009m1 2010m1 2011m1 2012m1time

Source: Bureau of Labor Statistics, www.bls.gov

January 2007 to November 2012Unemployment Rate

15

20

25

30

35

40

ave

rage

dur

atio

n of u

nem

ploym

ent, in w

eek

s

2007m1 2008m1 2009m1 2010m1 2011m1 2012m1time

Source: Bureau of Labor Statistics, www.bls.gov

January 2007 to November 2012Average Duration of Unemployment



When Barack Obama was inaugurated on January 20, 2009, it was clear to objective observers

that the American economy had entered an economic recession, defined as a pause in the growth of the

economy. In fact, The Great Recession was technically a depression – an actual decline it economic

output, which persisted through 2009. Because the US population is growing, the number of new job

seekers entering the labor market (e.g., recent graduates and mothers returning to the labor force when

their children start school) exceeds the number leaving the labor force, typically due to retirement.

Unless the economy grows, job seekers begin to exceed the number of available jobs, leading to cyclical

or demand deficient unemployment, which exists when the number of job seekers exceeds the number

of jobs available. The problem of cyclical unemployment is that the economy grinds to a halt, literally

dropping inside of its production possibility curve. And something very strange happens. Employers cut

back on their hiring plans because they are not selling all that they produce; as inventories build up

because production exceeds sales, firms reduce their job offers and layoff current workers. Layoffs

result when optimistic employers reassure their employees that, while they cannot afford to pay them

in the short term, they will recall those workers when business picks up. Workers who lose their jobs

through no fault of their own can apply for unemployment compensation, which pays them a fraction of

their monthly wage until business conditions improve. During normal times, 26 weeks of

unemployment benefits suffice; but, as figure 13‐2 shows, the average duration of unemployment

exceeded 26 weeks in mid‐2010, and continued to increase until plateauing at 40 weeks in early 2011.

To fight the recession President Obama proposed and the Democratic Congress passed a

stimulus package. Because Democrats needed 60 votes in the Senate, they added enough tax cuts to

the stimulus package to attract the 3 Republican votes needed to end a Republican filibuster. As history

was to show, the stimulus was too little to push the economy out of a recession. Republicans exploited

the continued worsening of the economy by exploiting the frustration of their political base – 60% of the

top 2% of the income distribution, along with Southern whites angered over the election of the first

African‐American president. As President Obama took his oath of office for the first time, Republican

members of Congress met to devise a strategy to deny Barack Obama a second term. This meant that

Republican Senators filibustered virtually every law the Republican House of Representatives passed,

and blocked most of Obama’s judicial and sub‐cabinet level appointments. Senator Mitch McConnell,

the minority leader of the Senate, Republicans first priority was to deny Barack Obama a second term as

president. It was clear this meant that Republicans were willing to prevent an economic recovery to

achieve their political ends. As the economy worsened, it was President Obama, rather than the

Republicans, whom the public blamed. In the mid‐term elections of 2010 the Republicans took over the

House of Representatives and narrowed the Democrats’ majority in the Senate. Republicans also took

many governorships and state legislatures, which allowed them to rig congressional districts to assure

Republicans would control the House for the next ten years (until reapportionment in 2020). Indeed,

although Republicans received fewer votes than Democrats in the 2012 House races, Republicans kept

control of the House as planned, although the Democrats picked up two additional Senate seats,

extending their majority to 55 to 45, which is insufficient to overcome future Republican filibusters.



Gross Domestic Product and the Business Cycle

I hope you appreciate the importance of measurement in objective economic analysis. If

economic theories are to serve as something other than stories, we must compare real world events

with the predictions gleaned from our theories. If our theories do not conform to reality, we must

modify the theory. When people seek to modify the data to conform to their theories, they are violating

the scientific method; they are more like religious zealots willing to fight for their version of the truth

rather than humble scientists pursuing an elusive truth. In 1929 economists developed the gross

domestic product to measure the total output generated in the economy during a calendar year.

To calculate GDP the Bureau of Economic Analysis adds together the total production of four

distinct categories of goods and services: consumption, investment, government, and net exports.

Recall from chapter 2 that households purchase goods and services using their disposable income – that

is, income after taxes. The value of consumption includes durable goods (like automobiles and personal

computers: commodities that last more than a year), nondurable goods (like food and clothing:

commodities that last less than a year), and consumer services (like haircuts, education, and medical

care: commodities that are consumed at the moment of production). The rule for defining consumer

goods is simple: all commodities purchased by the household sector (except for new houses themselves)

are defined as consumer goods. Since we want to count all production, but count all production only

once, investment goods must exclude consumer goods. Investment goods include structures (both

residential and commercial), equipment, and computer software. In addition, goods intended for

consumers, but not sold in the year produced, are inventory investments. Since many government

expenditures are transfer payments (e.g., social security, Medicare, Medicaid, unemployment and

workers compensation), those payments are not counted as government production, since those funds

were used to purchase consumer goods or services, and no production is to be counted twice. Finally,

some commodities are consumed in the US, but produced in other countries – these imports are part of

some other country’s GDP, and are deducted from consumer goods, investment goods, or government

goods. However, goods produced in the USA but sold to residents of other countries are exports and

are included as part of the US GDP.

A few details about how the GDP is calculated and how it is used to measure the health of the

overall, or macro economy. To make sure we count only final goods in GDP, and that we count them

only once, GDP is calculated by summing the value added of each business and government entity. For

instance, a loaf of bread proceeds through several transactions on its way to market. A farmer grows

grain, which he sells to the miller for $0.70. The miller grinds the wheat, adds some ingredients, and sells

the flour to the baker for $1.50. We subtract the $0.80 the miller paid the farmer and other suppliers,

and calculate the miller’s value added at $1.50 ‐ $0.80 = $0.70. Baker further increases the value of the

flour by baking bread worth $2.25. If she sells the bread to a grocery store chain, we subtract her

material costs of $1.50 from the selling price of $2.25, producing $0.75 to obtain the baker’s value

added. If the grocery store chain marks up the price to $2.50, then its value added to the bread is $0.25.

If the process stops at any point at the end of the year, the production to that point is part of the

inventory of the farmer, the miller, the baker, or the grocery chain, and counted as an inventory

investment. If the transactions result in a consumer purchase, the bread is treated as a consumer good.



Ultimately the Gross Domestic Product is the value of consumer goods (C), investment goods (I),

government purchases (G), and net exports (X):

t t t t tGDP C I G X

Obviously each year’s GDP is computed using the price for which each good is sold for that year. This

creates a potential problem when comparing one year’s GDP with another. The dollar value of GDP can

increase either because more goods are produced, or because those goods sell for higher prices, due to

price inflation. In order to neutralize the effect of inflation and to measure the change in economic

activity in comparable prices, government statisticians use the GDP price deflator. Early in 20131

government statisticians will compute price each component of the 2012 GDP in terms of the base year,

currently 2005. For the aggregate of all goods, the GDP price deflator is computed as:

2012 20122012

2005 2012

P QPI

P Q

.

That is the GDP price deflator weights each price by its respective quantity; so gasoline prices count for a

lot, the price of bacon for considerably less.

Figure 13‐3 plots the nominal GDP (GDP in current prices: the blue line) and in constant 2005 prices;

note that the two lines intersect in 2005. Since we wish to compare changes in output, not prices, we

will hereafter consider real, or inflation‐adjusted GDP, unless otherwise indicated. In 1929, nominal

GDP was $103.6 billion in 1929 dollars, or $976.1 billion in 2005 dollars; this implies that prices in 2005

were 9.42 times their level in 1929. Nominal GDP was $15,075.7 billion ($15.0757 trillion) in 2012, but

only $13,299.1 billion in 2005 dollars (2012 prices were 13.3% higher than in 2005.

Figure 13‐3

1 I am writing this chapter on December 30, 2012.

0500

0100

00150

00

1920 1940 1960 1980 2000 2020year

Gross domestic product in current dollarsGross Domestic Product in Constant 2005 Dollars

source: Bureau of Economic Analysis, www.bls.gov

in billions of current and 2005 dollarsNominal and Real Gross Domestic Product



Figure 13‐4 plots real GDP against its underlying exponential growth trend. Between 1929 and

2011 inflation‐adjusted real GDP grew at a compound rate of 3.6% a year. There are stretches when the

actual GDP is below the growth line. The period 1929 to 1939 was the Great Depression following the

stock market crash and associated banking failures that caused real GDP to decline at a rate of 9.14%

per year from 1929 to 1933, requiring growth of 6.75% per year to return to the growth path. Real GDP

then grew by an average of 12.3% per year through the World War II years, followed by a modest

recession in 1946 and as the economy returned to civilian production. What followed were nearly thirty

years of prosperity (1947 to 1975), when real GDP remained above its long‐run trend line, and there was

an expanding middle class. In the late 1970’s the great prosperity gave way to regressionary economics

of the Reagan era, when tax cuts for the rich were followed by large deficits and retarded economic

growth. After a brief period of growth during the Clinton Administration, due to tax rate increases and

government spending cuts, George W. Bush cut taxes to their lowest levels since the Great Depression,

but growth was anemic and, at the end of his term, nonexistent.

Figure 13‐4

Keynesian Economics and Fiscal Policy

The Great Depression was a profound surprise to economists at the time. The classical

economists – from Adam Smith through economists of the 1920s – believed religiously that economic

downturns would be self‐correcting. If more workers sought employment than there were jobs

available, the obvious remedy was declining wages. As we saw in chapter eight, a reduction in the

demand for labor means that wage rates should increase so that labor market equilibrium would be

established at a lower employment level, after workers whose reservation wages exceeded the market

wage exited the labor force. The 1930s, however, showed the folly of this belief. Declining wage rates

0500

0100

00150

00200

00

Billio

ns o

f 200

5 Dolla

rs

1920 1940 1960 1980 2000 2020year

Real (inflation-adjusted) Gross Domestic ProductTrend Line (3.6% annual growth)

Source: Bureau of Economic Analysis: www.bea.gov

Annual Data: 1929 to 2011Inflation-Adjusted Gross Domestic Product



meant declining household income, which in turn reduced demand for goods and services, decreasing

the price of those goods, and the demand for labor.

In 1936 John Maynard Keynes, a British economist, wrote his General Theory of Employment,

Money and Interest that explained why the macro economy is not self‐correcting in the face of

devastating financial crises such as those who caused the Great Depression (1929‐1939) and the Great

Recession (2007 to the present). Consumption is pro‐cyclical explained Keynes because consumption

depends most heavily on disposable personal income: household income after taxes. Figure 13‐5 shows

how inflation‐adjusted consumer spending nearly parallels the GDP – when the latter declines, so does

the former.2 We cannot depend on consumers to spend us out of a recession.

Figure 13‐5

Keynes also showed that investment spending is correlated with GDP, although investment

spending is much more volatile than real GDP is. Remember from chapters 2 and 3 that investment

means incurring a cost in the present with the uncertain hope that increased production capacity will

increase future profits. When the economy is expanding, businesses are keen to invest, and when the

economy is contracting, businesses reduce their investment spending, further magnifying the recession.

To make matters worse, precautionary saving by businesses3 and households further reduce

consumption. The only recourse, argued Keynes, is for the federal government to borrow those funds

that businesses and households do not wish to spend.

2 The correlation between inflation‐adjusted GDP and inflation‐adjusted consumer spending is 0.9985. 3 Businesses save by retaining profits, rather than paying the owners dividends. When the economy is bad, corporate executives are reluctant to increase dividends, lest those payments be unsustainable.

0500

0100

00150

00

Bill

ions

of 2

005

dolla

rs

1920 1940 1960 1980 2000 2020year

rgdp rcon

Source: Bureau of Economic Analysis

1929 to 2011Inflation-Adjusted GDP and Inflation-Adjusted Consumption



Fiscal policy is the practice of using the federal budget to stimulate the economy during

economic downturns and facilitating investment during economic expansions. Recall from chapters 2

and 3 that taxes reduce household consumption, freeing resources to finance essential government

services like enforcement of property rights and contracts. If government purchases or transfers exceed

tax revenue, then the government borrows the difference. If the economy is operating at full

employment (on its production possibility curve), then government borrowing raises interest rates and

crowd out investment. During a recession, however, the economy operates inside the production

possibility curve; it is possible to increase government spending without decreasing either consumption

or investment. As shown in Figure 13‐6a, the economy starts at point D, inside its production possibility

curve. Increasing government purchases from G0 to G1 allows unemployed people to accept

government jobs. They then spend their disposable income on consumer goods and set aside some of

their income as savings, which they deposit in banks. The increase in consumer spending leads

businesses to hire additional workers.

By the time the Roosevelt Administration took office in 1933, the Great Depression had already

lasted three and a half years; Herbert Hoover’s cheerful reassurance that “prosperity is just around the

corner,” rang hollow. Between 1929 and 1933, investment fell from 15.9% of GDP to only 2.2% of GDP

in 1932. While the government share increased from 9% to 14.8% of GDP, the sum of government and

investment spending fell from 25% to 17% of GDP. Since business was not borrowing for investment, it

would have productive for government to borrow household and business savings, returning that

money to circulate in the economy. However, Herbert Hoover, state governors, and city mayors strove

to balance their budgets, which required raising taxes or cutting government spending. By 1932 the

nominal GDP had fallen by 45.56% from its 1929 level (from $103.6 billion to $58.7%). After controlling

for price decreases of 25.8%, inflation‐adjusted GDP had declined by 26.67%. In other words the typical

household’s income in 1932 had declined by 25% since 1929.

Figure 13‐6

0%

10%

20%

30%

40%

50%

60%

Percent of Gross Domestic Product

Relative Size of Government and Investment: 1929 to 1949

government share of GDP Investment Share of GDP



Between 1933 and 1940, the government spending share of GDP remained roughly constant at

15% of GDP, which proved inadequate to offset the decline in investment. In 1940 nominal GDP was still

below its 1929 level; real GDP 4.5% higher in 1940 than in 1929. In one year alone (1941) inflation‐

adjusted GDP increased by 17% government purchases increased from 14.8% to 21% of GDP. Fairly

soon the rapid increase in government spending (and the federal deficit) threatened to overheat the

economy. To avoid inflation, the government rationed key commodities, especially gasoline, and

imposed wage and price controls. Ironically, these controls led to a practice that bedevils the economy

today. Because defense contractors could not offer higher wages to attract the engineers and other

professional workers they needed, American companies began offering fringe benefits, particularly

health insurance benefits for workers and their families. After World War II, when European countries

and Canada established government financed (single‐payer) health care systems, the US continued to

rely on private insurance coverage, with all the associated problems of adverse selection, fraud, and

bureaucracy.

After World War II, Congress passed and President Truman signed the Employment Act, which stated “The Congress hereby declares that it is the continuing policy of the Federal Government … to promote maximum employment, production and purchasing power.”4 This law was a watered-down version of the 1945 Full Employment bill that promised that all Americans “are entitled to an opportunity for useful, remunerative, regular and full-time employment… To this end the Federal Government shall provide such volume of Federal investment and expenditure as may be needed,…, to assure continuing full employment.”5 The Employment Act allowed the Federal government to do what the Full Employment Bill would not have: a deliberate and sustained reduction of the share of government spending from 41.7% in 1945 (down from a high of 47.9% in 1944) to only 15% in 1946, which is where government spending was in 1933. Liberals and progressive politicians and even Keynes himself feared that such a massive reduction in government spending would return the economy to depression. What they overlooked, however, was that the backlog of investment and consumer spending during the war would take over for government spending. While there was a slight reduction in real GDP from its peak in 1944, the return of women to household production made way for returning war veterans in the labor force, assisted by the GI Bill of Rights, which financed the college education of millions of veterans, thereby delaying their labor-force participation.

Despite brief interruptions in 1946-1948 (when Republicans controlled both the House of Representatives and the Senate), the Congress was dominated by Democrats who kept the unemployment rate to an average of 4.7% and the inflation rate to an average below 3%. During the 1960’s Democrats controlled both the Presidency and both houses of Congress, passing the Civil Rights Act, Medicare, and declared war on poverty. Unfortunately, the War in Vietnam destroyed liberal support for the Johnson Administration, and an opportunistic Richard Nixon used a white backlash against Civil Rights to claim the White House in 1968. Ironically, the passage of liberal legislation continued; it was during the Nixon Administration that Congress passed (and Nixon signed) laws establishing the

4 http://research.stlouisfed.org/publications/review/86/11/Employment_Nov1986.pdf 5 Ibid.



Environmental Protection Agency, the Equal Employment Opportunity Commission, and the Civil Rights Administration. Nixon supported the Equal Rights Amendment, even though enough conservative state legislatures, including Nevada, did not.6 Since conservatives did not actually have an economic policy to counter the activist Democratic policy, Richard Nixon declared, “We are all Keynesians now.”

Although the Johnson Administration had partly offset the cost of the Vietnam War with a tax surcharge in 1968, Nixon and the Democratic Congress cut taxes in 1969, generating a budget deficit at full employment. This situation led to a classic excess demand inflation. Government borrowing pushed up the interest rate, which is consistent when the demand for loanable funds (from business, government, and household borrowing) exceeded private saving. In an attempt to maintain his popularity with business, Nixon’s Federal Reserve Chairman, Arthur Burns, embarked on a policy of monetary policy. This resulted in The Great Inflation, and a rethinking of the efficacy of Keynesian fiscal policy.

The Federal Reserve and Monetary Policy

Semester after semester, students in ECON 180 seem to have the most difficulty understanding the nature of money and monetary policy. Most obviously, money includes coins (minted by the Treasury) and currency, actually Federal Reserve notes. The Federal Reserve Act of 1913 established a central bank disguised as twelve regional banks. The “Fed” is established as a bank for banks. Most money in the USA is actually in the form of bank deposits. When you write a check on your account with, say, the Bank of America, to a merchant who has a checking account at Wells Fargo, the Fed simply credits the (reserve) account of Wells Fargo and debits the account of Bank of America; the majority of the money supply (M1) is actually a series of computer records. When bank customers want cash, the bank obtains cash from its reserve account. The Fed carefully regulates the ratio of reserves (vault cash and deposits with the Fed) to prevent explosions in the money supply, which would generate inflation.

Think for a moment what happens when a bank loans money to a customer, say a student buying a new car. The bank writes a check to the customer, which is an increase in the money supply. Obviously, the customer will spend that check almost immediately, but the dealership will deposit the check in its checking account – money changed hands, but the money the bank created with its loan still exists. Table 13-1 shows the balance sheet for a hypothetical bank, which belongs to the Federal Reserve and faces a 10% required reserve ratio for checking deposits and 5% for savings deposits. The bank’s liabilities are the $100 million that it owes to its depositors, who have deposited $60 million in checking accounts (also known as demand deposits7) and $40 million in savings accounts (also

6 States failing to ratify the Equal Rights Amendment were Alabama, Arizona, Arkansas, Florida, Georgia, Illinois, Louisiana, Mississippi, Missouri, Nevada, Oklahoma, South Carolina, Utah, and Virginia. Of this group, only Illinois, Nevada, and Virginia voted for Barack Obama in either 2008 or 2012. 7 The term demand deposits means that depositors can withdraw their deposits any time they want – by writing a check or using a debit card.



known as time deposits8). On the asset size, the bank holds $50 million in consumer loans, $30 million in government bonds, and $20 million in reserves ($5 million in vault cash and $15 million in deposits with the Federal Reserve.

Figure 13-1: Bank with Excess Reserves

Assets Liabilities Loans $50 million Demand deposits $60 million Government bonds $30 million Time deposits $40 million Legal Reserves Vault Cash $5 million Deposits with Fed $15 million Total $100 million Total $100 million

Required reserves equal .1($60 million) + .05($40 million) = ($6 + $2) million = $8 million. Subtracting required reserves from legal reserves yields excess reserves of $12 million. If the bank decides to loan $12 million to the public (businesses, households, or local governments), then the money supply would increase accordingly. The bank has an incentive to loan its excess reserves because vault cash and deposits with the Fed earn no interest income. However, the bank may decide to purchase (federal) government bonds instead of making loans. In periods of potential inflation (if the money supply threatens to grow faster than real gross domestic product), the Fed may fight inflation by selling government bonds. If banks buy those bonds with excess reserves, then potential money growth is prevented. If members of the public purchase those bonds, they write checks to the Fed from their checking accounts, reducing bank reserves.

Figure 13-2 shows the position of a bank immediately after loaning its excess reserves. Its demand deposits increase by $12 million, as do its assets; remember, assets and liabilities must always be equal.9

Figure 13-2: Immediately After Loaning Excess Reserves


Technically the bank in Figure 13-2 would still have excess reserves: required reserves would have increased by 10% of the $12 million loan. Meaning that excess reserved

8 Time deposits typically earn interest and can be withdrawn only upon conditions stipulated by the bank. Because of competition for customer business, most banks allow depositors to freely transfer funds from time deposits to demand deposits. 9 Figures 13‐1 and 13‐2 are simplified balance sheets, which do not include such items as net worth and claims by shareholders.



declined from $12 million to $10.8 million. However, this state of affairs would not last long. Borrowers would spend their loans almost immediately, paying interest over the life of their loans.10 Figure 13-3 shows that after the borrowers have spent those loans, the bank is loaned up (has no excess reserves). However, the banking system still has excess reserves of $10.8 million. As those excess reserves move from bank to bank,11 the money supply can continue to expand until all excess reserves are (1) loaned out, (2) withdrawn as cash by bank customers, or (3) used to purchase bonds.

Figure 13-3: After Excess Reserves have left the bank


The Federal Reserve (Fed) uses monetary policy to control the monetary base, and with it, the money supply. When the economy is overheating and inflation threatens, the Fed is very effective at absorbing excess reserves by selling government bonds. The Fed sells government bonds by offering them at a discount to banks; by purchasing government bonds at less than their market value, the bank realizes a capital gain when it sells the bond later, and receives a higher rate of interest. In 1979 President Jimmy Carter appointed Paul Volker as chairman of the Fed, who announced that the Fed would no longer allow the money supply to expand as fast as nominal GDP. When the economy was starved for money, a severe (double-dip) recession developed. Eventually, inflation was brought under control, but not before Carter lost re-election and the Reagan Administration embarked on tax cuts which largely shifted the tax burden from the rich to the middle class.

In theory the Fed should be able to stimulate the economy by purchasing government bonds from banks and the public. For instance, if the bank in Figure 13-3 sold $30 million in bonds to the Fed, it would suddenly have excess reserves of $30 billion, which it could lend to businesses for investment or to households to finance consumer durable goods. Alas, when the economy suffers an economic downturn, banks are reluctant to loan lest their borrowers fail to repay loans. Furthermore, neither businesses nor households are interested in borrowing money when they are uncertain whether they could repay the debt.

10 If you are familiar with the perennial Christmas favorite, It’s a Wonderful Life, the Baily Savings and Loan nearly failed when depositors demanded their funds immediately, and George Baily used his honeymoon savings to stave off the crisis. He reminded depositors that they had agreed to wait 90 days for their money, since that money was tied up in the mortgages. Today many banks bundle their mortgages as “mortgage backed securities” and “collateralized debt obligations,” which they sell to other banks or other speculators around the world. This moral hazard problem – banks don’t worry about the credit worthiness of borrowers if they can sell those loans to naïve “investors” – was one of the factors leading to the debt crisis. 11 When the merchants who received the spending from loans deposit their receipts, the Fed credits the receiving bank with the former excess reserves, which means the receiving bank can make loans if it so choose



Figure 13-7 shows this state of affairs dramatically. From January 1959 through December 2007, each 10% increase in the monetary base (vault cash plus deposits with the Fed) increased the money supply (currency in circulation plus demand deposits) by 8%. Notice the nearly vertical jump in the monetary base (red line) in 2009, while the money supply (the blue line) grew less modestly. Starting in January 2008, through November 2012, each 10% increase in the monetary base increased the money supply by 3.8%; the banking system is awash with cash, but that money isn’t moving, meaning that households, businesses, state and local governments, and other countries, are not buying. During a severe recession, only fiscal policy seems to be effective at pushing the economy out of recession, back to its production possibility curve.

Figure 13-7

What about the National Debt?

We appear to be faced with a dilemma: when the economy is operating at less than full employment; that is, when the number of job seekers exceed the number of jobs available, household spending, investment spending, state and local government spending, and even export spending all are pro-cyclical. The only sector of the economy that can afford to operate in a counter-cyclical fashion is the federal government. By operating a budget deficit during periods of high unemployment, the federal government borrows savings that other sectors of the economy refuse to borrow. Cutting taxes increases household income, which in turn encourages household consumption. The drawback here is that households may use their disposable income to reduce their own debt. When households repay debt, banks receive excess reserves. If banks fail to loan out those

0100

0200

0300

0

bill

ions

of d

olla

rs

1960m1 1970m1 1980m1 1990m1 2000m1 2010m1time

M1 (demand deposits and currency), not seaonally adjustedMonetary base; not seasonally adjusted, break adjusted

Source: Federal Reserve Board of Governors, http://www.federalreserve.gov

Before and After The Great RecessionMoney Supply and Monetary Base



excess reserves, the economy stagnates. This is apparently what happens with the 40% of the Obama stimulus that took the form of tax cuts. Furthermore, another large portion of the stimulus was spent on propping up state and local government budgets. These transfers softened the impact of the Great Recession during 2008-2010 while the Democrats controlled Congress and many state legislatures; Republicans successfully used the relative wellbeing of government employees as a wedge issue against Democrats in the Tea Party revolt of 2010. As I write this on January 2, 2013, Congress temporarily avoided the fiscal cliff by extending the Bush-era tax cuts for all but the richest 2% of households,12 but Republicans are promising another battle over the debt ceiling.

Figure 13-8 shows the national debt by year from 1790 through 2010; because of the huge change in the absolute size of the national debt – from $71 million ($21.04 per capita) in 1790 to $13.5 trillion ($44,068 per capita) in 2010 – I have measured the national debt on a logarithmic scale. The straight line actually reflects a compound growth rate of 6.5%. Note that the debt starts above the trend line in 1790, reflecting the debt from the Revolutionary War. Between 1790 and 1945 increases in the national debt largely reflect war debt, which spike during years of conflict and gradually decline during extended periods of peace. Note that the instead of dipping below the trend line after World War II, the national debt joined the trend line in the 1960s, then began growing beyond the trend line in the 1980s, although the growth in the national debt declined during the late 1990s, then began accelerating again with the Bush tax cuts in 2001.

Figure 13-8

12 Tax rates were returned to the Clinton‐era maximum rate of 39.6% for individual taxable incomes above $400,000 and joint taxable income above $450,000, and the capital gain tax rate was increased to 20%.

-10

-50

510

1800 1850 1900 1950 2000year

Natural logarithm of Natinal Debt (in billions of current dollars)Exponential Growth Path

Source: Department of the Treasury

Logarithmic ScaleGrowth in National Debt: 1790 to 2010



The national debt is a symptom, rather than a problem. During economic downturns, declines in tax revenue, and automatic increases in government spending are reflected in growth in the national debt. The time to attack the national debt is not when times are bad – unless your agenda is to make the economic downturn more severe to get rid of a pesky black president. Starting with Ronald Reagan in 1981, Republicans bought into the theory that cutting tax rates would increase tax revenue. In 1964, the top tax rate declined from 91% to 70%, and the economy grew. In 1981, the top tax rate decreased from 70% to 28%, and tax revenue declined and the deficit became a permanent fixture of the American economy – a structural deficit that continued even when the economy returned to full employment. In 1992 Bill Clinton ran on a platform to fight the then modest recession with typical Keynesian fiscal-policy tools: tax cuts to stimulate consumption and government spending to create jobs for the unemployed. But after his election, Clinton learned that the recession had ended by the time he took office on January 20, 1993. He reversed course and presented Congress with a budget that increased the maximum tax rate to 39.6%, and reduced government spending. Not a single Republican in either the House of Representatives or the Senate voted in favor of the budget. In 1994, Republicans recaptured the Senate (which they lost in 1982) and captured the House for the first time in 42 years. The lesson for Democrats was clear; if you dare be fiscally responsible, voters will punish you.

Conclusion

The Republican Party strove to become America’s permanent majority party by catering to the worst: residual racism from the Civil Rights era, misogyny from the sexual revolution, anti-science, and inability to perceive one’s economic self-interest. In 2010, it looked like they won again, successfully preventing the second round of stimulus by the Obama Administration. Then they lost the 2012 election and caved to tax increases for households with taxable income above $450,000. Ultimately we end the economics of discrimination by asking: how can we discriminate between truth and falsehood, policy and bullshit?

Summary

1. Unemployment occurs when people who want jobs do not have them. There are three types of unemployment. a. Frictional unemployment: a state of the economy when the number of available

jobs equals the number of qualified job seekers. In a dynamic economy, there will always be a frictional unemployment rate of about 4%.

b. Structural unemployment: a situation when there is a miss‐match between the skill

requirements of available jobs and the skills possessed by job seekers; a solution to structural

unemployment typically requires job training is the type of unemployment that social workers

can diagnose and treat c. Cyclical (or demand deficient) unemployment: the number of job seekers exceed the

number of available jobs; the economy is operating inside its production possibility curve, and solving cyclical unemployment requires job creation.



2. As cyclical unemployment persists, the duration of unemployment also increases, often leading to a

structural unemployment problem as the human capital of job seekers deteriorate. 3. Job creation is a serious problem during a period of prolonged unemployment because all sectors of

gross domestic product are pro‐cyclical: Consumer spending, investment spending, state and local

government spending, and net exports all tend to decrease when the GDP decreases; only federal

government spending is structured in such a way that it can behave in an anti‐cyclical manner,

expanding during economic downturns and decreasing during periods of economic expansion. 4. On order to distinguish between real and phantom changes in economic output (GDP), economists

compute real GDP, which is GDP expressed in one year’s (currently 2005’s) prices. Real GDP

removes the effect of inflation from current (nominal) GDP. 5. A recession occurs when real GDP stops growing, thereby falling below its long‐run growth path.

Technically, the US economy was in depression in 2008 & 2009 because real GDP actually

decreased. 6. Fiscal policy is the use of the federal government budget to stimulate or dampen economic growth.

During economic downturns, running a budget deficit stimulates the economy by encouraging

consumption (through an increase in transfers or a decrease in tax collections) or by creating jobs

through increases in federal government purchases. The Obama Administration pursued fiscal

policy by continuing the bank bailouts started by the Bush Administration and through economic

stimulus. Unfortunately, much of the economic stimulus, in the form of temporary tax cuts, resulted

in increased saving, which failed to stimulate the economy. When the Tea Party Republicans took

over the US House in 2011, focus changed from economic stimulus to attacking the deficit.

However, economic austerity (cutting spending and/or increasing taxes) tends to dampen economic

growth. 7. The national debt is the total amount of money the Federal Government owes. When the federal

government runs a deficit, it issues government bonds that increase the national debt; the national

debt decreases when the government runs a budget surplus, which last occurred in 2000, the last

year of the Clinton Administration. 8. Monetary policy involves the use of purchases of US Treasury bonds by the Federal Reserve System

(the Fed). Purchasing bonds creates excess reserves that banks can loan to business and/or

households, thereby expanding the money supply. Unfortunately, since bank lending is pro‐cyclical,

monetary policy increased bank reserves, but did not increase bank lending. Monetary policy is

more effective as an anti‐inflation tool: when banks sell bonds, they absorb excess reserves,

reducing bank lending and preventing (or fighting) inflation. Contractionary monetary policy

succeeded in ending the great inflation of the 1970’s and early 1980’s.

the economics of discrimination by professor tom carroll...4/16 where have all the criminals gone?...

Documents