1 Managing Resources

Analysis of firm behavior and the management of resources begins with the firms
production function, which describes how resources are turned into output. There are
three broad categories of resources, which are also sometimes called inputs or factors of
production.
The first category is labor, by which we mean the physical human effort that goes into
production. The second category is capital, which can be subdivided into two
components, physical capital and human capital. Physical capital refers to things like
factories, machines, and equipment that are part of the production process. Human
capital refers to know-how and managerial skills that go into production -- more the
thinking side of human production, compared to the sheer labor effort. Finally, the third
category is thought of as land, particularly when referring to agricultural production.
apital needs a special note. First, in the conte!t of production, economists do not mean
money when they refer to capital. "n common parlance, people may refer to money as
capital, specifically financial capital, when they talk about starting a business, for
e!ample. #owever, money itself does not produce anything therefore is not part of the
production function$ instead it buys the resources that produce things. %econd, both
physical the human capital share some characteristics& both are produced themselves
'human capital being produced by education(, and neither is )used up* in production.
%ometimes economist refer to the production function as the )technology* used to
produce something. +roduction functions take on different characteristics in the short run
and in the long run. The short run refers to the period of time in which some resources
-- especially capital -- are fi!ed. For e!ample, we often may only be able to alter our
employment of labor in the short run. "n the long run, all inputs are variable and nothing
is fi!ed.
The marginal product of an input is a measure on how output changes as more of that
input is added, holding everything else constant. The law of diminishing marginal
product says that although output may go up as an input is added, ceteris paribus, the
rate at which output goes up will decline. "n other words, marginal product will be
positive, but declining, as the input increases. This makes sense& picture a firm with a
given factory si,e 'capital( adding workers. As it does so, output should go up -- but not
at a constant rate, because eventually the limited si,e of the factory becomes a
)bottleneck* inhibiting increased production.
"n the long run, production functions can be characteri,ed by returns to scale. Increasing
returns to scale means that scaling up all inputs by ! percent leads to an increase in
output of more than ! percent. %imilarly, decreasing returns to scale means that
increasing all inputs by ! percent leads to an increase in output of less than ! percent.
-any real-world production functions are characteri,ed by constant returns to scale&
increasing inputs by a certain percent leads to the same percentage rise in output. "t is
important to keep in mind the distinctions between marginal product and returns to scale.
.
The cost functions of a firm are derived directly from its production function. "n the
short run, firms have fixed costs associated with their fi!ed inputs. /ikewise, variable
costs are associated with variable inputs. The sum of fi!ed and variable costs are total
costs. The marginal cost of production is the e!tra cost associated with producing
another unit of output. -arginal cost is directly related to marginal product for the short
run. For e!ample, if labor is the only variable input in the short run, then the law of
diminishing product implies that the marginal cost of production will have to rise
eventually.
Average costs are also used frequently. "n the short run, firms have average fixed costs
and average variable costs, which sum to average total cost. Typically the average
variable and average total cost curves are )0-shaped* meaning that they initially decline
but eventually rise as output increases, at lest in the short run. "n the long run, all costs
are variable. The average total cost curve for the long run is the )lower envelope* of all
the different possible short run averages total costs curves, each typically associated with
a differing amount of capital.
"f the average cost of production declines initially as output increases, the firm en1oys
economies of scale in the long run -- a phenomenon associated with increasing returns to
scale in production. 2conomies of scale are e!hausted at minimum efficient scale.
onstant returns to scale imply constant average total costs in the long run, and
decreasing returns to scale imply rising average total costs in the ling run, or
diseconomies of scale.
-anagers need to employ marginal analysis to ma!imi,e profits for the firm. "n terms of
output, this means comparing marginal revenue to marginal cost. Marginal revenue is
the additional revenue generated by producing and selling another unit of output.
-arginal cost, as noted above, refers to the additional cost of producing that output. "f
marginal revenue is greater than marginal cost, producing another unit of output is
profitable and production should be increased. "f marginal revenue is less than marginal
cost, producing another unit of output is not profitable and in fact output should be
decreased.
"f initially marginal revenue is greater than marginal cost and the firm increases
production, marginal revenue will fall 'e!cept in perfect competition, where it remains
constant for the price-taking firm(, because the firm will have to lower its price to sell
more units. At the same time, increasing output means facing higher marginal costs,
especially in the short run due to the law of diminishing marginal product. Thus as
output increases, marginal revenue falls and marginal cost rises until the two are equal.
At this point the firm will have ma!imi,ed it profits, leading to a very important principle
in managerial economics& a necessary condition for profit maximization is marginal
revenue must equal marginal cost.
3
%imilarly, marginal analysis can be employed in thinking about the optimal employment
of resources. 4nce again, the manager weighs the benefits of employing one more unit
of a resource with the costs. #iring one more unit of a resource resulting in more output,
by the amount of the marginal product of that resource. "f that output is then sold in the
marketplace, the firm earns the value of the marginal product for that resource as
income. 4n the other hand, the firm has to pay for the resource$ this is the marginal
resource cost of the input
The effective manager must compare the value of the marginal product with the marginal
resource cost. %uppose for e!ample that a firm was considering hiring one more worker
for a day, and the worker could produce an e!tra 35 widgets. "f widgets sell for 67 each,
then the value of the marginal product of that worker would be 6.55 '35 ! 7 8 .55(. "f
the marginal resource cost of the worker is, say 695 per day in wages, then the firm will
find it profitable to hire the worker, since 6.55 of revenue coming in more than the 695
of wages e!pended. 4n the other hand, if the worker costs 6.35 per day, it is not worth it
to the firm to hire the worker.
%uppose the firm pays the worker 695 and there fore hires him. The firm then considers
hiring another worker. :ut perhaps the marginal product of labor is declining, and that
workers marginal product is less than 35 widgets. The firm must go through the same
computations, looking at this set of rules& if the value of the marginal product is greater
than the marginal resource cost, hire more workers. "f the value of the marginal product
is less than the marginal resource cost, hire fewer workers. As with output, the optimum
is achieved only when the marginal values are the same. A necessary condition for
profit-maximizing resource employment is the value of the marginal product must equal
marginal resource cost.
;
3 Human Capital
To most people capital means a bank account, a hundred shares of ":- stock, assembly
lines, or steel plants in the hicago area. These are all forms of capital in the sense that
they are assets that yield income and other useful outputs over long periods of time.
:ut these tangible forms of capital are not the only ones. %chooling, a computer training
course, e!penditures of medical care, and lectures on the virtues of punctuality and
honesty also are capital. That is because they raise earnings, improve health, or add to a
persons good habits over much of his lifetime. Therefore, economists regard
e!penditures on education, training, medical care, and so on as investments in human
capital. They are called human capital because people cannot be separated from their
knowledge, skills, health, or values in the way they can be separated from their financial
and physical assets.
2ducation and training are the most important investments in human capital. -any
studies have shown that high school and college education in the 0nited %tates greatly
raise a persons income, even after netting out direct and indirect costs of schooling, and
even after ad1usting for the fact that people with more education tend to have higher "qs
and better-educated and richer parents. %imilar evidence is now available for many years
from over a hundred countries with different cultures and economic systems. The
earnings of more educated people are almost always well above average, although the
gains are generally larger in less developed countries.
onsider the differences in average earnings between college and high school graduates
in the 0nited %tates during the past fifty years. 0ntil the early si!ties college graduates
earned about <7 percent more than high school graduates. "n the si!ties this premium
from college education shot up to almost =5 percent, but it fell back in the seventies to
under 75 percent. The fall during the seventies led some economists and the media to
worry about )overeducated Americans.* "ndeed, in .>?= #arvard economist @ichard
Freeman wrote a book titled The Overeducated American. This sharp fall in the return to
investments in human capital put the concept of human capital itself into some disrepute.
Among other things it caused doubt about whether education and training really do raise
productivity or simply provide signals ')credentials*( about talents and abilities.
:ut the monetary gains from a college education rose sharply again during the eighties, to
the highest level in the past fifty years. 2conomists Aevin - -urphy and Finis Belch
have shown that the premium on getting a college education in the eighties was over =7
percent. /awyers, accountants, engineers, and many other professionals e!perienced
especially rapid advances in earnings. The earnings advantage of high school graduates
over high school dropouts has also greatly increased. Talk about overeducated Americans
has vanished, and it has been replaced by concern once more about whether the 0nited
%tates provides adequate quality and quantity of education and other training.
This concern is 1ustified. @eal wage rates of young high school dropouts have fallen by
ore than 37 percent since the early seventies, a truly remarkable decline. Bhether because
<
of school problems, family instability, or other factors, young people without a college or
a full high school education are not being adequately prepared for work in modern
economies.
Thinking about higher education as an investment in human capital helps us understand
why the fraction of high school graduates who go to college increases and decreases from
time to time. Bhen the benefits of a college degree fell in the seventies, for e!ample, the
fraction of white high school graduates who started college fell, from 7. percent in .>?5
to <= percent in .>?7. many educators e!pected enrollments to continue declining in the
eighties, partly because the number of eighteen-year-olds was declining, but also because
college tuition was rising rapidly. They were wrong about whites. The fraction of white
high school graduates who enter college rose steadily in the eighties, reaching =5 percent
in .>99, and caused an absolute increase in the number of whites enrolling despite the
smaller number of college-age people.
This makes sense. The benefits of a college education, as noted, increased in the eighties.
And tuition and fees, although they rose about ;> percent from .>95 to .>9= in real,
inflation-ad1usted terms, are not the only cost of going to college. "ndeed, for most
college students they are not even the ma1or cost. 4n average, three-fourths of the private
costCthe cost borne by the student and by the students familyCof a college education is
the income that college students give up by not working. A good measure of this
)opportunity cost* is the income that a newly minted high school graduate could earn by
working full-time. And during the eighties this forgone income, unlike tuition, did not
ri9se in real terms. Therefore, even a ;>percent increase in real tuition costs translated
into an increase of 1ust .5percent in the total cost to students of a college education.
The economics of human capital also account for the fall in the fraction of black high
school graduates who went on to college in the early eighties. As #arvard economist
Thomas D. Aane has pointed out, costs rose more for black college students than for
whites. That is because a higher percentage of blacks are from low-income families and,
therefore, had been heavily subsidi,ed by the federal government. uts in federal grants
to them in the early eighties substantially raised their cost of a college education.
According to the .>93 )@eport of the ommission on Eraduate 2ducation* at the
0niversity of hicago, demographic-based college enrollment forecasts had been wide of
the mark during the twenty years prior to that time. This is not surprising to a )human
capitalist.* %uch forecasts ignored the changing incentivesCon the cost side and on the
benefit sideCto enroll in college.
The economics of human capital have brought about a particularly dramatic change in
the incentives for women to invest in college education in recent decades. +rior to the
si!ties American women were more likely than men to graduate from high school but less
likely to continue on to college. Bomen who did go to college shunned or were e!cluded
from math, sciences, economics, and law, and gravitated toward teaching, home
economics, foreign languages, and literature. :ecause relatively few married women
continued to work for pay, they rationally chose an education that helped in )household
7
production*Cand no doubt also in the marriage marketCby improving their social skills
and cultural interests.
All this has changed radically. The enormous increase in the labor participation of
married women is the most important labor force change during the past twenty-five
years. -any women now take little time off from their 1obs even to have children. As a
result the value to women of market skills has increased enormously, and they are
bypassing traditional )womens* fields to enter accounting, law, medicine, engineering,
and other sub1ects that pay well. "ndeed, women now comprise one-third or so of
enrollments in law, business, and medical schools, and many home economics
departments have either shut down or are emphasi,ing the )new home economics.*
"mprovements in the economic position of black women have been especially rapid, and
they now earn 1ust about as much as white women.
4f course, formal education is not the only way to invest in human capital. Borkers also
learn and are trained outside of schools, especially on 1obs. 2ven college graduates are
not fully prepared for the labor market when they leave school, and are fitted into their
1obs through formal and informal training programs. The amount of on-the-1ob training
ranges from an hour or so at simple 1obs like dishwashing to several years at complicated
tasks like engineering in an auto plant. The limited data available indicates that on-the-
1ob training is an important source of the very large increase in earnings that workers get
as they gain greater e!perience at work. @ecent bold estimates by olumbia 0niversity
economist Dacob -incer suggest that the total investment in on-the-1ob training may be
well over 6.55 billion a year, or almost 3 percent of EF+.
Fo discussion of human capital can omit the influence of families on the knowledge,
skills, values, and habits of their children. +arents affect educational attainment, marital
stability, propensities to smoke and to get to work on time, as well as many other
dimensions of their childrens lives.
The enormous influence of the family would seem to imply a very close relation between
the earnings, education, and occupations of parents and children. Therefore, it is rather
surprising that the positive relation between the earnings of parents and children is not
strong, although the relation between the years of schooling of parents and children is
stronger. For e!ample, if fathers earn 35 percent above the mean of their generation, sons
at similar ages tend to earn about 9 percent above the mean of theirs. %imilar relations
hold in Bestern 2uropean countries, Dapan, Taiwan, and many other places.
The old adage of )from shirtsleeves to shirtsleeves in three generations* is no myth$ the
earnings of grandsons and grandparents are hardly related. Apparently, the opportunities
provided by a modern economy, along with e!tensive public support of education, enable
the ma1ority of those who come from lower-income backgrounds to do reasonably well in
the labor market. The same opportunities that foster upward mobility for the poor create
an equal amount of downward mobility for those higher up on the income ladder.
=
The continuing growth in per capita incomes of many countries during the nineteenth and
twentieth centuries is partly due to the e!pansion of scientific and technical knowledge
that raises the productivity of labor and other inputs in production. And the increasing
reliance of industry on sophisticated knowledge greatly enhances the value of education,
technical schooling, on-the-1ob training, and other human capital.
Few technological advances clearly are of little value to countries that have very few
skilled workers who know how to use them economic growth closely depends on the
synergies between new knowledge and human capital, which is why large increases in
education and training have accompanied ma1or advances in technological knowledge in
all countries that have achieved significant economic growth.
The outstanding economic records of Dapan, Taiwan, and other Asian economies in recent
decades dramatically illustrate the importance of human capital to growth. /acking
natural resourcesCthey import almost all their energy, for e!ampleCand facing
discrimination against their e!ports by the Best, these so-called Asian tigers grew rapidly
by relying on a well-trained, educated, hardworking, and conscientious labor force that
makes e!cellent use of modern technologies.
?
; More about Free esources
The problem when resources are )free* is that wrong mi! of goods and services will be
produced. This is a common result when decision-makers do not take into account
some by-product of their actions that burdens or benefits others. A polluter, for e!ample,
considers air or water free. For him, dumping pollutants into their air or water is a cheap
way to dispose of wastes. Get, his actions do involve costs because he affects the
alternatives that others face. The polluter may make others forego clean water. 4ne
could say that the polluter imposes some costs of production on others, although this use
of the word )cost* differs from the normal meaning of cost. Those who bear this cost are
not involved in the choice, and in its pure meaning cost is an alternative foregone in a
choice.
"t is easy to show that when a decision-maker ignores some costs of his decision, his
decision may be economically inefficient. The demand curve represents the marginal
benefit to consumers 'and to firms because they are price takers(. The supply curve
represents the marginal cost to sellers, and because producing the product requires
resources that could be used elsewhere, it also represents a cost to buyers. :ut the
production of the product also generates and unwanted by-product that sellers ignore.
The marginal cost from the point of view of society as a whole includes this by-product
and is thus higher than it seems to the firm.
"f negative e!ternalities cause too much of a product to be produced, positive e!ternalities
should cause too little to be produced. Bhen a person improves his house, his neighbors
benefit. :ecause the decision-maker will not generally consider these spillover
advantages to others, less than the efficient amount of the activity will take place.
Bhen scarce resources are perceived as )free*, there will be potential value that a market
will not capture. "s it possible for a society to capture this value, and if so, howH
A common )solution* to this problem has been to assume it away. This solution is
especially common in plans for utopias, and writers in the -ar!ian tradition frequently
illustrate it. "n some of these arguments, pollution e!ists because capitalistic man is
greedy, but when the new socialist man comes into e!istence, the problem will cease.
%olution by assumption has at times crept into mainstream economic thinking as well.
A more practical solution is to increase private ownership in the system of property
rights. This is an ironic solution in a way, because many environmentalists and
ecologists have argued that the e!istence of e!ternalities proves that a market system is
seriously flawed and should be scrapped for an alternative, generally with greater state
ownership and control. 2conomic analysis, however, shows that e!ternalities e!ist when
property rights are incomplete. @educing the role of private property would make the
e!ternality problem worse. Bhen no one owns the air or water, there is no incentive to
avoid an overuse of the resource.
9
"n a classic e!ample of the problem of the commons, buffalo were hunted almost to
e!tinction in the .>
th
century. "f an individual hunter limited his kills, he was unlikely to
benefit from his restraint. A buffalo that he did not kill would probably be killed by
someone else. Get, from the point of view of buffalo hunters as a group, the optimal
strategy would have been to limit killing so that the industry could maintain itself
indefinitely.
"n contrast with the buffalo, the number of cattle in the American Best increased during
the .>
th
century. The key difference between the different fates of buffalo and cattle was
not that buffalo hunters were greedy and cattle raisers were not. "t was that cattle were
privately owned and buffalo were )free*. +rivate-property rights force people to take into
account all costs and benefits of their actions. A cattlemans decision to kill or not kill
his cattle did not affect other cattlemen in the ay that a buffalo hunters decision to kill or
not kill buffalo affected other buffalo hunters. Bhen a resource is owned by all, when it
is )free,* there is a strong tendency for individuals to misuse that resource.
The e!istence of private property rights allows the law to deal with e!ternality problems.
A person who is harmed by someones actions can ask the courts to decide about
compensation. The courts decision will depend on whether or not he has a right to some
good or service. ourts have established property rights for clean air, clean water, scenic
views, sunshine, and quiet. "f a person is not due compensation, then he does not have
the property rights but the other party may have them. "n this case he can pay the party
harming him to stop the offending activity.
Iictims of pollution seldom band together and sue the polluter, nor do they band together
and pay him not to pollute. The difficulty with legal action is that there are serious
problems 'and thus large costs( in contracting and organi,ing large groups for legal
action. 4ne of these problems is the free-rider problem. @onald oase pointed out that
pollution problems would not e!ist if there were no difficulties and e!penses in making
contracts between polluter and victim. The implication of oases work is that
e!ternalities should not be a small-group problem because legal remedies will e!ist if
only a very few people are involved. "t will only be a large-group problem.
oase shows that private-property rights are not always a feasible way to solve the
e!ternality problem of )free* resources. Another solution is for the government to act as
if it were the owner of these resources. The government does this when it regulates the
number of ducks that hunters can kill. "t says in effect that the government does this
when it regulates the number of ducks that hungers can kill. "t says in effect that the
government owns the ducks, and people cannot kill them without the permission of the
government.
Eovernment can charge for the use of its resources. "t could, for e!ample, charge
polluters for the use of clean water and air. This charge would make polluters take into
account the side effects of their activities 'or in the 1argon of economists, they would
internali,e the e!ternalities(, and would move marginal cost curve in the graph upward.
There is some user fee 'pollution ta!( that would make the decision-makers marginal
>
cost curves coincide with the marginal-cost-to-society curve, and thus correct the
efficiency problem.
Eovernment policy dealing with pollution and negative e!ternalities has largely been one
of regulation. -ost economists believe that this is a less-desirable 'efficient( method of
dealing with the problem than a policy of a pollution ta!.
Finally, there may not be a good solution to the problem of )free* resources for two
reasons. First, the cost of a solution may be greater than the benefits of the solution.
-ost economists believe that there is some )optimal level& of pollution. -any productive
processes produce waste products. These waste products, when considered damaging to
people, are pollution. To remove them or to transform them into a form that no one
considers damaging requires resources, and the use of those resources means that fewer
other products can be produced. Thus the reduction of pollution involves the weighting
of costs and benefits as does virtually all other activity that economists discuss. The
optimal level of pollution becomes that level at which the marginal benefit of any more
reduction 1ust equals the marginal cost of any more reduction "f removing pollution that
causes 6..55 worth of harm costs 6.5.55, it is economically inefficient to remove it. "t is
e!tremely unlikely that the optimal 'economic efficient( level will ever be ,ero.
%econd, there may be e!ternality problems within the government 1ust as there can be
e!ternality problems in the market. Bhen there are e!ternality problems in the market,
we can call on the government as an outside agent to solve them. :ut if there problems
e!ist in the government, there is no one to turn to. For e!ample, suppose that the citi,ens
of a country are split into fifty special interest groups, and each group gets special
benefits from the government. To pay for those benefits, the government must ta! the
citi,ens. The citi,ens end up paying a dollar in ta!es to get eighty cents of special
benefits. ':ureaucracy eats up the other 35J(. Though all would be better off getting rid
of all special benefits, no one group will want to give up its special benefits, and the costs
of organi,ing the fifty different groups to come up with an agreement may be very large.
There may be no solution to this problem of the commons.
.5
< Comparative !dvantage
The reasons why free trade is desirable can be developed by e!tending the discussion of
the rusoe economy that is commonly used to illustrate production-possibilities frontiers.
%uppose that @obinson rusoe, living on an almost deserted desert isle, can either catch
four fish a day or find eight coconuts. 4ne day, he discovers that Friday also lives on the
island. "f Friday can either catch si! fish a day or find seven coconuts, can rusoe and
Friday profit by speciali,ation and tradeH The answer is clearly )yes*. rusoe is the
better coconut gatherer, and Friday the better fisherman.
#owever, suppose that Friday can either catch ten fish or find then coconuts. Friday is
now better than rusoe in both activities. an there be mutual benefit from trade in this
caseH 4r should Friday do all the work and rusoe noneH 4r should Friday refuse to
trade since he is better in bothH "t was a ma1or achievement of Kavid @icardo early in the
.>
th
century to show that in this second rusoe-Friday story both parties could benefit
from trade. #is results contributed to the long reign of relatively free trade in .>
th
century
2ngland, and thus to the prosperity that 2ngland en1oyed in this period.
To see that mutually beneficial trade is possible even though Friday is better in all
activities, one must look to opportunity costs. "ndividually, both Friday and rusoe trade
with nature in the production process. rusoe can get another fish only by giving up time
in which he could find two coconuts, and in getting another coconut he sacrifices one-
half of a fish. Thus, a fish costs rusoe two coconuts and a coconut costs one-half of a
fish. Friday can get another fish by giving up the time during which he can find another
coconut, or one-tenth of the day. Kuring this time, he could find one coconut. For
Friday, trading with nature means that one fish costs one coconut and vice versa.
/ooking at these opportunity costs tells us that rusoe finds coconuts cheaper and Friday
finds fish cheaper. The table below summari,es these results.
4pportunity ost of Fish and oconuts
For Friday& . fish costs . coconut --- . oconut osts . Fish
For rusoe . Fish osts 3 oconuts --- . oconut osts L Fish
Be still have not discovered whether Friday and rusoe could do better trading with each
other rather than with nature. A way to answer this question is to try a few prices.
%uppose that one fish was worth one-half a coconut, or one coconut was worth two fish.
Bith this trading ratio both would find fish cheap and coconuts e!pensive. Therefore,
both would want to sell coconuts and buy fish. #ence at this price no trading would take
place.
%uppose that the trading ratio were one fish for ..9 coconuts 'and thus one coconut cost
7M> fish(. Bith this ratio, rusoe would find fish cheapCrather than spend two coconuts
to catch one, he could spend ..9 coconuts and buy one. #ence, rusoe would be willing
to sell coconuts. Friday would find coconuts cheapCrather than give up one fish by
gathering his own coconuts, he could sell 7M>
th
of a fish and get one. #ence, Friday
..
would be willing to sell fish. Trade will take place because both individuals find that it
improves their well-being.
"n the above e!ample, trade occurs because of comparative advantage. Friday is better in
everything than rusoe, but he is )more better* in catching fish and )less better* in
finding coconuts. rusoe is worse than Friday in everything, but he is )less worse* in
finding coconuts. Though they both benefit from trade, Friday will maintain a higher
standard of living.
The e!ample of rusoe and Friday also illustrates that e!change is not a ,ero-sum game,
but a positive sum game. "n a ,ero-sum game, whatever anyone wins comes at someone
elses e!pense. "n poker, for e!ample, if one person wins 6.55, some other person's(
must have lost 6.55. "f the amount of winnings is added up and the amount of losings is
subtracted away, the result will be ,ero. The term )Nero-sum game* reflects this total. "n
contrast, both parties in a voluntary e!change can benefit. :ecause total winnings e!ceed
any losses, the name )positive-sum* game is appropriate. A negative-sum game, in
which winnings will be less than losses, is also possible. Bar is one e!ample and a bad
marriage is another.
A possible reason that few people prior to Adam %mith seem to have recogni,ed this
mutually beneficial aspect of e!change may be that in his day much e!change involved
bargaining. "n bargaining, the seller tries to get as high a price as he can and the buyer as
low a price as possible. "f the seller can get 63.75 for a product rather than 63.55, he
benefits from the higher price at the e!pense of the buyer. +eople do discuss who got the
)better of the bargain.* This feature of e!change, which is of vital importance to those
involved in a market, can obscure the fact that no e!change will take place unless both
parties believe that they benefit from it. :argaining determines how big the producers
surplus will be relative to the si,e of the consumers surplus, but unless both buyer and
seller each have some surplus, no trade will take place.
rusoe and Friday could be replaced by two nations. The principle of comparative
advantage continues to hold, and it implies that the world as a whole will not be operating
on its production-possibilities curveCthat it will be production inefficientCif each
nation is self-sufficient.
The inefficiency can be illustrated by putting the numbers of the second rusoe-Friday
into production possibilities tables. %uppose that in self sufficiency rusoe chooses three
fish and two coconuts, and Friday chooses five fish and five coconuts. The total island
production is then eight fish and seven coconuts. :ut with total speciali,ation, with
rusoe producing only coconuts and Friday producing only fish, island production would
be ten fish and eight coconuts, which means that under self-sufficiency island resources
were used inefficiently. 4r, suppose that originally rusoe was self-sufficient at one fish
and si! coconuts, and Friday was self-sufficient at five fish and five coconuts. "sland
production is si! fish and eleven coconuts. "n this case, only partial speciali,ation might
be desirable. "f Friday produces three coconuts and rusoe produces eight, island
.3
production could be eleven coconuts and seven fish, which is a gain of one fish compared
to production with no speciali,ation.
+roduction +ossibilities&
rusoe Friday
Fish coconuts fish coconuts
< 5 .5 5
; 3 > .
3 < ? ;
. = 7 7
5 9 5 .5
.;
" #aw of $iminishing eturns
The law of diminishing returns says that adding more of one input while holding other
inputs constant results eventually in smaller and smaller increases in added output.. "f
capital is held constant at two, the marginal output of labor 'which economists usually
call marginal product of labor( is shown in the table below. The first unit of labor
increases production by .;, and as more labor is added, the increases in production
gradually fall.
The -arginal +roduct of /abor
/abor -arginal 4utput
First .;
%econd ?
Third 7
Fourth 7
Fifth <
The law of diminishing returns does not take effect immediately in all production
functions. "t is possible for the first unit of labor to add only four units of output,
the second to add si!, and the third to add seven. "f a production function had this pattern,
it would have increasing returns between the first and third worker. Bhat the law of
diminishing returns says is that as one continues to add workers, eventually one will
reach a point where increasing returns stop and decreasing returns set in.
The law of diminishing returns is not caused because the first worker has more ability
than the second worker, and the second is more able than the third. :y assumption, all
workers are the same. "t is not ability that changes, but rather the environment into which
workers 'or any other variable input( are placed. As additional workers are added to a
firm with a fi!ed amount of equipment, the equipment must be stretched over more and
more workers. 2ventually, the environment becomes less and less favorable to the
additional worker. +eoples productivity depends not only on their skills and abilities, but
also on the work environment they are in.
The law of diminishing returns was a central piece of economic theory in the .>
th
century
and accounted for economists gloomy e!pectations of the future. They saw the amount
of land as fi!ed, and the number of people who could work the land as variable. "f the
number of people e!pended, eventually adding one more person would result in very
little additional food production. And if population had a tendency to e!pand rapidly, as
economists thought it did, one would predict that 'in equilibrium( there would always be
some people almost starving. Though history has shown the gloomy e!pectations wrong,
the idea had an influence on the work of harles Karwin and traces of it still float around
today among environmentalists.
"f one increases all inputs in equal proportions, one travels out from the origin on a ray.
There is no law to predict what will happen to output in this case. "f a .5J increase in all
.<
inputs yields more than a .5J increase in output, the production function has increasing
returns to scale. "f it yields less than a .5J increase in output, the production function has
decreasing returns to scale. And if it yields e!actly a .5J increase in output, to has
constant returns to scale.
@eturns to scale are important for determining how many firms will populate an industry.
Bhen increasing returns to scale e!ist, one large firm will produce more cheaply than
two small firms. %mall firms will thus have a tendency to merge to increase profits, and
those that do not merge will eventually fail. 4n the other hand, if an industry has
decreasing returns to scale, a merger of two small firms to create a large firm will cut
output, raise average costs, and lower profits. "n such industries, many small firms should
e!ist rather than a few large firms.
.7
% &ocialism
%ocialismCdefined as a centrally planned economy in which the government controls all
means of productionCwas the tragic failure of the twentieth century. :orn of a
commitment to remedy the economic and moral defects of capitalism, it has far surpassed
capitalism in both economic malfunction and moral cruelty. Get the idea and the ideal of
socialism linger on. Bhether socialism in some form will eventually return as a ma1or
organi,ing force in human affairs is unknown, but no one can accurately appraise its
prospects who has not taken into account the dramatic story of its rise and fall.
'he (irth of &ocialist Planning
"t is often thought that the idea of socialism derives from the work of Aarl -ar!. "n fact,
-ar! wrote only a few pages about socialism, as either a moral or a practical blueprint
for society the true architect of a socialist order was /enin, who first faced the practical
difficulties of organi,ing an economic system without the driving incentives of profit
seeking or the self-generating constraints of competition. /enin began from the long-
standing delusion that economic organi,ation would become less comple! once the profit
drive and the market mechanism had been dispensed withC)as self-evident,* he wrote,
as )the e!traordinarily simple operations of watching, recording, and issuing receipts,
within the reach of anybody who can read and write and knows the first four rules of
arithmetic.*

"n fact, economic life pursued under these first four rules rapidly became so disorgani,ed
that within four years of the .>.? revolution, %oviet production had fallen to .< percent
of its prerevolutionary level. :y .>3. /enin was forced to institute the Few 2conomic
+olicy 'F2+(, a partial return to the market incentives of capitalism. This brief mi!ture of
socialism and capitalism cam to an end in .>3? after %talin instituted the process of
forced collectivi,ation that was to mobili,e @ussian resources for its leap into industrial
power.
The system that evolved under %talin and his successors took the form of a pyramid of
command. At its ape! was Eosplan, the highest state planning agency, which established
such general directives for the economy as the target rate of growth, the allocation of
effort between military and civilian outputs, between heavy and light industry, or among
various regions. Eosplan transmitted the general directives to successive ministries of
industrial and regional planning, whose technical advisers broke down the overall
national plan into directives assigned to particular factories, industrial power centers,
collective farms, or whatever. These thousands of individual subplans were finally
scrutini,ed by the factory managers and engineers who would eventually have to
implement them. Thereafter, the blueprint for production reascended the pyramid,
together with the suggestions, emendations, and pleas of those who had seen it.
0ltimately, a completed plan would be reached by negotiation, voted on by the %upreme
%oviet, and passed into law.
.=
Thus, the final plan resembled an immense order book, specifying the nuts and bolts,
steel girders, grain outputs, tractors, cotton, cardboard, and coal that, in their entirety,
constituted the national output. "n theory such an order book should enable planners to
reconstitute a working economy each yearCprovided, of course, that the nuts fitted the
bolts, the girders were of the right dimensions, the grain output was properly stored, the
tractors operable, and the cotton, cardboard, and coal of the kinds needed for their
manifold uses. :ut there was a vast and widening gap between theory and practice.
Problems )merge
The gap did not appear immediately. "n retrospect, we can see that the task facing /enin
and %talin in the early years was not so much economic as quasimilitary--mobili,ing a
peasantry into a work force to build roads and rail lines, dams and electric grids, steel
comple!es and tractor factories. This was a formidable assignment, but far less
formidable than what would confront socialism fifty years later, when the task was not so
much to create enormous undertakings, but relatively self-contained ones, and to fit all
the outputs into a dovetailing whole.
Through the si!ties the %oviet economy continued to report strong overall growthC
roughly twice that of the 0nited %tatesCbut observers began to spot signs of impending
trouble. 4ne was the difficulty of specifying outputs in terms that would ma!imi,e the
well-being of everyone in the economy, not merely the bonuses earned by individual
factory managers for )over fulfilling* their assigned ob1ectives. The problem was that the
plan specified outputs in physical terms. 4ne consequence was the managers ma!imi,ed
yardages or tonnages of output, not its quality. A famous cartoon in the satirical maga,ine
Arokodil showed a factory manager proudly displaying his record output, a single
gigantic nail suspended from a crane.
At the economic flow became increasingly clogged and clotted, production took the form
of )stormings* at the end of each quarter or year, when every resource was pressed into
use to meet preassigned targets. The same rigid system soon produced e!peditors, or
tolkachi, to arrange shipments to harassed managers who needed unplannedCand
therefore unobtainableCinputs to achieve their production goals. Borse, in the absence
of the right to buy their own supplies or to hire or fire their own workers, factories set up
fabricating shops, then commissaries, and finally their own worker housing to maintain
control over their own small bailiwicks.
"t is not surprising that this increasingly :y,antine system began to create serious
dysfunctions beneath the overall statistics of growth. Kuring the si!ties the %oviet 0nion
became he first industrial country in history to suffer a prolonged peacetime fall in
average life e!pectancy, a symptom of its disastrous misallocation of resources. -ilitary
research facilities could get whatever they needed, but hospitals were low on the priority
list. :y the seventies the figures clearly indicated a slowing of overall production. :y the
eighties the %oviet 0nion officially acknowledged a near end to growth that was, in
reality, an unofficial decline. "n .>9? the first official law embodying -ikhail Eorbachev
announced his intention to revamp the economy from top to bottom by introducing the
.?
market, reestablishing private ownership, and opening the system to free economic
interchange with the Best. %eventy years of socialist rise had come to an end.
&ocialist Planning in *estern )yes
0nderstanding of the difficulties of central planning was slow to emerge. "n the
midthirties, while the @ussian industriali,ation drive was at full tilt, few voices were
raised about its problems. Among those few were /udwig von -ises, and articulate and
e!ceedingly argumentative free-market economist, and Friedrick #ayek, of much more
contemplative temperament, later to be awarded a Fobel +ri,e for his work in monetary
theory. Together, -ises and #ayek launched an attack on the feasibility of socialism that
seemed at the time unconvincing in its argument as to the functional problems of a
planned economy. -ises in particular contended that a socialist system was )impossible*
because there was no way for the planners to acquire the informationC)produce his, not
that*Cneeded for a coherent economy. This information, #ayek emphasi,ed, emerged
spontaneously in a market system from the rise and fall of prices. A planning system was
bound to fail precisely because it lacked such a signaling mechanism.
The -ises-#ayek argument met its most formidable counterargument in two brilliant
articles by 4skar /ange, a young economist who would become the first polish
ambassador to the 0nited %tates after Borld Bar "". /ange set out to show that the
planners would, in fact, have precisely the same information as that which guided a
market economy. The information would be revealed as inventories of goods rose and
fell, signaling either that supply was greater than demand or demand greater than supply.
Thus, as planners watched inventory levels, they were also learning which of their
administered 'i.e., state-dictated( prices were too high and which too low. "t only
remained, therefore, to ad1ust prices so that supply and demand balanced, e!actly as in
the marketplace.
/anges answer was so simple and clear that many believed the -ises-#ayek argument
had been demolished. "n fact, we now know that their argument was all too prescient.
"ronically, though, -ises and #ayek were right for a reason that they did not foresee as
clearly as /ange himself. )The real danger of socialism,* /ange wrote, in italics, )is that
of a bureaucrati,ation of economic life.* :ut he took away the force of the remark by
adding, without italics, )0nfortunately, we do not see how the same or even greater
danger can be averted under monopolistic capitalism.*
The effects of the )bureaucrati,ation of economic life* are dramatically related in The
Turning +oint, a scathing attack on the realities of socialist economic planning by two
%oviet economist, Fikolai %melev and Iladimir +opov, that gives e!amples of the
planning process in actual operation. "n .>93, to stimulate the production of gloves from
moleskins, the %oviet government raised the price it was willing to pay for moleskins
from twenty to fifty kopecks per pelt. %melev and +opov noted&
%tate purchases increased, and now all the distribution centers are filled with these
pelts. "ndustry is unable to use them all, and they often rot in warehouses before
.9
they can be processed. The -inistry of /ight "ndustry has already requested
Eoskomtsen Othe %tate ommittee on pricesP twice to lower prices, but )the
question has not been decided* yet. This is not surprising. "ts members are too
busy to decide. They have no time& besides setting prices on these pelts, they have
to keep track of another 3< million prices. And how can they possibly know how
much to lower the price today, so they wont have to raise it tomorrowH
This story speaks volumes about the problem of a centrally planned system. The crucial
missing element is not so much )information,* as -ises and #ayek argued, as it is the
motivation to act on information. After all, the inventories of moleskins did tell the
planners that their production was at first too low and then too high. Bhat was missing
was the willingnessCbetter yet, the necessityCto respond to the signals of changing
inventories. A capitalist firm responds to changing prices because failure to do so will
cause it to lose money. A socialist ministry ignores changing inventories because
bureaucrats learn that doing something is more likely to get them in trouble than doing
noting, unless doing nothing results in absolute disaster.
Absolute economic disaster has now been reached in the %oviet 0nion and its 2astern
former satellites, and we are watching efforts to construct some form of economic
structure that will no longer display the deadly symptoms of inertia and indifference that
have come to be the hallmarks of socialism. "t is too early to predict whether these efforts
will succeed. The main obstacle to real perestroika is the impossibility of creating a
working market system without a firm basis of private ownership, and it is clear that the
creation of such a basis encounters the opposition of the former state bureaucracy and the
hostility of ordinary people who have long been trained to be suspicious of the pursuit of
wealth. "n the face of such uncertainties, all predictions are foolhardy save one& no quick
or easy transition from socialism to some form of nonsocialism is possible.
Transformations of such magnitude are historic convulsions, not mere changes in policy.
Their completion must be measured in decades or generations, not years.
.>
? eaganomics
)@eaganomics* was the most serious attempt to change the course of 0. %. economic
policy of any administration since the new Keal. )4nly by reducing the growth of
government,* said @onald @eagan, )can we increase the growth of the economy.*
@eagans .>9. +rogram for 2conomic @ecovery had four ma1or policy ob1ectives& '.(
reduce the growth of government spending, '3( reduce the marginal ta! rates on income
from both labor and capital, ';( reduce regulation, and '<( reduce inflation by controlling
the growth of the money supply. These ma1or policy changes, in turn, were e!pected to
increase saving and investment, increase economic growth, balance the budget, restore
healthy financial markets, and reduce inflation and interest rates.
Any evaluation of the @eagan economic program should thus address two general
questions& #ow much of the proposed policy changes were approvedH And how much of
the e!pected economic effects were reali,ed& @eagonomics continues to be a
controversial issue. For those who do not view @eagonomics through an idealogical lens,
however, ones evaluation of this ma1or change in economic policy will depend on the
balance of the reali,ed economic effects.
+resident @eagan delivered on each of his four ma1or policy ob1ectives, although not to
the e!tent that he and his supporters had hoped. The annual increase in real 'inflation-
ad1usted( federal spending declined from <.5 percent during the arter administration to
3.7 percent during the @eagan administration, despite a record peacetime increase in real
defense spending. This part of @eagans fiscal record, however, reflected only a
moderation, not a reversal, of prior fiscal trends. @eagan made no significant changes to
the ma1or transfer payment programs 'such as %ocial %ecurity and -edicare(, and he
proposed no substantial reductions in other domestic programs after his first budget.
-oreover, the growth of defense spending during his first term was higher than @eagan
had proposed during the .>95 campaign, and since economic growth was somewhat
slower than e!pected, @eagan did not achieve a significant reduction in federal spending
as a percent of national output. Federal spending was 33.> percent of gross domestic
product 'EK+( in fiscal .>9., increased somewhat during the middle years of his
administration, and declined to 33.. percent of EK+ in fiscal .>9>. This part of the
@eagan record was probably the greatest disappointment to his supporters.
The changes to the federal ta! code were much more substantial. The top marginal ta!
rate on individual income was reduced from ?5 percent to 39 percent. The corporate
income ta! rate was reduced from <9 percent to ;< percent. The individual ta! brackets
were inde!ed for inflation. And most of the poor were e!empted from the individual
income ta!. These measures were somewhat offset by several ta! increases. An increase
in %ocial %ecurity ta! rates legislated in .>?? but scheduled for the eighties was
accelerated slightly. %ome e!cise ta! rates were increased, and some deductions were
reduced or eliminated.
35
-ore important, there was a ma1or reversal in the ta! treatment of business income. A
comple! package of investment incentives was approved in .>9. only to be gradually
reduced in each subsequent year through .>97. And in .>9= the base for the ta!ation of
business income was substantially broadened, reducing the ta! bias among types of
investment but increasing the average effective ta! rate on new investment. "t is not clear
whether this measure was a net improvement in the ta! code. 4verall, the combination of
lower ta! rates and a broader ta! base for both individuals and business reduced the
federal revenue share of EK+ from 35.3 percent in fiscal .>9. to .>.3 percent in fiscal
.>9>.
The reduction in economic regulation that started in the arter administration continued,
but at a slower rate. @eagan eased or eliminated price controls on oil and natural gas,
cable TI, long-distance telephone service, interstate bus service, and ocean shipping.
:anks were allowed to invest in a somewhat broader set of assets, and the scope of the
antitrust laws was reduced. The ma1or e!ception to this pattern was a substantial increase
in import barriers. The @eagan administration did not propose changes in the legislation
affecting health, safety, and the environment, but it reduced the number of new
regulations under the e!isting laws. Keregulation was clearly the lowest priority among
the ma1or elements of the @eagan economic program.
-onetary policy was somewhat erratic but, on net, quite successful. @eagan endorsed the
reduction in money growth initiated by the Federal @eserve in late .>?>, a policy that led
to both the severe .>93 recession and a large reduction in inflation and interest rates. The
administration reversed its position on one dimension of monetary policy& during the first
term, the administration did not intervene in the markets for foreign e!change but,
beginning in .>97, occasionally intervened with the ob1ective to reduce and then stabili,e
the foreign-e!change value of the dollar.
-ost of the effects of these policies were favorable, even if somewhat disappointing
compared to what the administration predicted. 2conomic growth increased from a 3.9
percent annual rate in the arter administration, but this is misleading because the growth
of the working-age population was much slower in the @eagan years. @eal EK+ per
working-age adult, which had increased at only a 5.9 annual rate during the arter
administration, increased at a ..9 percent rate during the @eagan administration. The
increase in productivity growth was even higher& output per hour in the business sector,
which had been roughly constant in the arter years, increased at a ..< percent rate in the
@eagan years. +roductivity in the manufacturing sector increased at a ;.9 percent annual
rate, a record for peacetime.
-ost other economic conditions also improved. The unemployment rate declined from
?.5 percent in .>95 to 7.< percent in .>99. The inflation rate declined from .5.< percent
in .>95 to <.3 percent in .>99. The combination of conditions proved that there is no
long-run trade-off between the unemployment rate and the inflation rate 'see +hillips
urve(. 4ther conditions were more mi!ed. The rate of new business formation increased
sharply, but the rate of bank failures was the highest since the thirties. @eal interest rates
increased sharply, but inflation-ad1usted prices of common stocks more than doubled.
3.
The 0. %. economy e!perienced substantial turbulence during the @eagan years despite
favorable general economic conditions. This was the )creative destruction* that is
characteristic of a healthy economy. At the end of the @eagan administration, the 0. %.
economy had e!perienced the longest peacetime e!pansion ever. The )stagflation* and
)malaise* that plagued the 0. %. economy from .>?; through .>95 were transformed by
the @eagan economic program into a sustained period of higher growth and lower
inflation.
"n retrospect the ma1or achievements of @eaganomics were the sharp reductions in
marginal ta! rates and in inflation. -oreover, these changes were achieved at a much
lower cost than was previously e!pected. Kespite the large decline in marginal ta! rates,
for e!ample, the federal revenue share of EK+ declined only slightly. %imilarly, the large
reduction in the inflation rate was achieved without any long-term effect on the
unemployment rate. 4ne reason for these achievements was the broad bipartisan support
for these measures beginning in the later years of the arter administration. @eagans first
ta! proposal, for e!ample, had previously been endorsed by the Kemocratic ongress
beginning in .>?9, and the general structure of the Ta! @eform Act of .>9= was first
proposed by two 1unior Kemocratic members of ongress in .>93. %imilarly, the
)monetarist e!periment* to control inflation was initiated in 4ctober .>?>, following
arters appointment of +aul Iolcher as chairman of the Federal @eserve :oard. The
bipartisan support of these policies permitted @eagan to implement more radical changes
than in other areas of economic policy.
@eagan failed to achieve some of the initial goals of his initial program. The federal
budget was substantially reallocatedCfrom discretionary domestic spending to defense,
entitlements, and interest paymentsCbut the federal budget share of national output
declined only slightly. :oth the administration and ongress were responsible for this
outcome. @eagan supported the large increase in defense spending and was unwilling to
reform the basic entitlement programs. %imilarly, neither the administration nor ongress
was willing to sustain the momentum for deregulation or to reform the regulation of
health, safety, and the environment.
@eagan left three ma1or adverse legacies at the end of his second term. First, the privately
held federal debt increased from 33.; percent of EK+ to ;9.. percent and, despite the
record peacetime e!pansion, the federal deficit in @eagans last budget was still 3.>
percent of EK+. %econd, the failure to address the savings and loan problem early led to
an additional debt of about 6.37 billion. Third, the administration added more trade
barriers than any administration since #oover. The share of 0. %. imports sub1ect to some
form of trade restraint increased from .3 percent in .>95 to 3; percent in .>99.
There was more than enough blame to go around for each of these problems. @eagan
resisted ta! increases, and ongress resisted cuts in domestic spending. The
administration was slow to acknowledge the savings and loan problem, and ongress
urged forbearance on closing the failing banks. @eagans rhetoric strongly supported free
trade, but pressure from threatened industries and ongress led to a substantial increase
in new trade restraints. The future of @eaganomics will depend largely on how each of
33
these three adverse legacies is resolved. @estraints on spending and regulation would
sustain @eagonomics. :ut increased ta!es and a reregulation of domestic and foreign
trade would limit @eaganomics to an interesting but temporary e!periment in economic
policy.
The @egan economic program led to a substantial improvement in economic conditions,
but there was no )@eagan revolution.* Fo ma1or federal programs 'other than revenue
sharing( and no agencies were abolished. The political process continues to generate
demands for new or e!panded programs, but American voters continue to resist higher
ta!es to pay for these programs. A broader popular consensus on the appropriate roles of
the federal government, one or more constitutional amendments, and a new generation of
political leaders many be necessary to resolve this inherent conflict in contemporary
American politics.
3;
+ Canadian and !merican )conomics Compared
The comparison between the economies of anada and the 0nited %tates is generally far
more of a concern to anadian than to American.
anada is under constant pressure to remain competitive with the 0nited %tates. "F it
dows not then forces such as the brain drain will occur, where the top anadians emigrate
to the 0.%. "f anada falls behind corporations will also leave for the 0nited %tates. The
0.%. has far less to fear as any losses to anada can be easily managed.
Kespite the contrasts listed below anada and the 0nited %tates are e!tremely similar
economically. They are both developed countries and are thus vastly closer to each other
than to the ma1ority of the worlds countries. anada also is by almost all economic
indices closer to the 0nited %tates than it is to 2urope.
:oom and bust cycles in anada and the 0nited %tates are closely linked as are many
indices such as inflation and interest rates. Kemographic patterns are also similar, with a
slightly higher birth rate in the 0.%. and a higher immigration rate in anada.
,eography
"n its quest to remain competitive anada starts at an immediate disadvantage. anadas
harsh climate lead to high costs for such things as heating. Borkers are less likely to
immigrate to anada and the wealthy are more likely to leave for tropical climates.
The climate of anada also contributes to higher transportation costs as planes, trains,
and automobiles are all more e!pensive to operate than in much of the 0nited %tates.
anadas low population density also makes transportation costs higher. -ore of a
historical concern was that much of the country lacks natural river systems that could be
easily used for transportation. anadas terrain is also somewhat more rugged than the
0nited %tates. The @ocky -ountains are more of an obstacle, and the mass of the
anadian %hield provides a formidable barrier to any links between 4ntario and
-anitoba.
anada does have some distinct geographic advantages. The large river systems in the
north are sources of cheap hydro-electric power. The main advantage is anadas vast
supplies of natural resources. Bhile the 0nited %tates has large supplies of resources,
these are not enough to meet domestic demands and they are forced to import many raw
materials, a great deal of which come from anada. :y contrast anada is a net e!porter
of resources. This leads to an important difference as increases in the price of resources
boosts the anadian economy while hurting the American. For e!ample a rise in oil
prices generally causes a fall in the Kow Dones but an increase in the T%Q.
,overnment
3<
Kifferences between government intervention in the economies of the two countries is
most closely e!amined in anada, because some feel that policies that more closely
emulate the 0.%. are preferable, while others disagree.
'axation
The average ta! rate in anada is higher than in the 0nited %tates. "n anada total ta!
revenue for every level of government equals about ;=.9J of EK+, in the 0.%. this is
closer to ;5J. There is some regional variation, however. A resident of oil rich Alberta
pays less in ta!es than a resident of high ta! -assachusetts.
The ta!es are applied differently as well. anadas ta! system is more heavily biased
against the highest income earners, thus while anadas ta! rate is higher on average, the
bottom fifty percent of the population is more lightly ta!ed than in the 0nited %tates.
anada also has a national sales ta! of ?J on all purchases, while the 0.%. federal
government relies almost entirely on income ta!es.
anada has no inheritance ta! while the 0nited %tates still does, but the 0.%. ta! is
currently scheduled to be abolished.
&ocial Programs
For its higher ta!es anada has a more complete system of social programs than the
0nited %tates. These differences include having all ma1or universities receive government
funding, having a national broadcaster in the : and, most notably, having a fully
government-funded health care system. The 0nited %tates, however, spends far more on
military than anada.
The greatest difference in social programs is in health care. The 0nited %tates spends far
more of its per capita EK+ on health care than does anada. anadians, however, receive
comparable care and most figures such as life e!pectancy and infant mortality are better
in anada. Another advantage is that the anadian health care system is also very
attractive to employers, as in anada health care is mostly paid through income ta!es,
while in the 0nited %tates most companies have to e!tend health benefits to full-time
employees, something they do not have to do in anada. The main disadvantage of the
anadian system is the long lines and waiting periods, especially for procedures of less
importance.
%ee also& anadian and American health care systems compared
!nti-trust
The 0nited %tates has since the %herman Anti-Trust Act been strongly opposed to
monopolies. "n anada this has been far less of an issue and anada has never had
rigorously enforced rules against monopoli,ation.
37
Fiscal and Monetary Policy
anada is generally forced to follow American monetary policy quite closely$ any large
difference in interest rates could quickly lead to large problems for the anadian
economy. The 0.%. Federal @eserve and the :ank of anada both staunchly believe in
fighting inflation while neither aggressively pursue policies of full employment. 4ne
difference that has emerged recently is that while anada is still hewing closely to the
balanced budgets policies of the .>>5s the 0nited %tates has moved into a heavy deficit, a
policy both countries followed in the .>?5s and .>95s.
Political 'urbulence
4ver the last few decades the anadian economy may have been hurt by the threat of
Ruebec separatism, and Ruebecs economy was almost certainly damaged. "n the earlier
era turbulence in the 0nited %tates from the civil rights movement and Iietnam Bar may
have hurt that countrys economy. This also sometimes benefited anadians as draft
dodgers during the Iietnam Bar created a reverse brain drain that lasted for many years.
Mar.et &i/e
4ne of the most important differences historically between anada and the 0nited %tates
was the si,e of the two markets. Bhen both nations had high tariffs the two countries did
not have a unified market. anadas smaller market led to higher prices and greater
inefficiency.
A good e!ample of this is the automobile industry, which can be clearly demarcated into
two periods& before and after the free trade creating Auto +act of .>=>. :efore anada
had its own production lines creating each of the models that would be sold in anada.
These branch plant factories would only make small production runs of each vehicle,
requiring frequent and e!pensive retooling. The factories would also generally be
smaller. Fewer varieties were available to anadian consumers and prices were generally
higher. #owever, these cars were almost all still made by American companies. After the
Auto +act, the industry was transformed as a unified Forth American market was created.
The anadian factories were rebuilt to be much larger, but to make only one model that
would be sold in both countries creating large economies of scale. The prices of cars fell
in anada as wages and total employment in the automobile sector increased.
After the %econd Borld Bar tariffs between the two countries gradually fell, with full
free trade being established by the .>99 anada-0nited %tates Free Trade Agreement.
%ome industries are still protected, however. These are mostly sensitive areas such
cultural industries including publishing, television, and newspapers, which all of have
stringent foreign ownership rules. 4ther areas such as the transport industry are also
protected with anadian control of the airlines and trains being viewed as in the national
interest.
3=
This tends to create far more monopolies in anada. For instance the air travel industry in
anada is dominated by a single airline, Air anada. anada has long had to make a
trade-off between monopoli,ation and efficiency, which the 0nited %tates has not. The
0nited %tates can support a number of airlines that are big enough to operate efficiently,
and still have a competitive market. anadians are forced to choose between small
inefficient airlines that would be competitive, or one monopolistic airline that will
generate its own inefficiency.
Another e!ample of this trade off is the book industry, which has recently switched
models. 0ntil the .>>5s anada had many small and fairly inefficient bookstores. Then
hapters entered the market and quickly created a near monopoly, eliminating the
inefficiencies of smaller stores but potentially leading to a monopolistically set price and
limited choice of books.
The larger market of the 0nited %tates also contributes to the brain drain. Top anadians
will often find greater opportunities in the 0nited %tates. An e!ample of this is the
entertainment industry. "f Dim arrey had remained in the anadian entertainment
industry, he would have made far less money and would not be world famous. The
anadian film industry will never be able to match the American one because anadas
thirty million people cannot buy enough tickets to allow hundred million-dollar budgets
and stars that earn twenty million dollars per film.
(an.ing
anada and the 0nited %tates have long had very different banking systems. The 0nited
%tates was copied from 2ngland while anadas was taken from %cotland. The 0nited
%tates traditionally has had a plethora of banks, all with very few branches. This has lead
to a competitive but unstable system, with many thousands of banks having collapsed
during 0.%. history. anada has always had far fewer banks per capita, but the banks
have been larger and quickly became nationwide. anadian banks have many branches
and distributed assets and anada has only had one ma1or bank, the #omestead :ank,
collapse in its history. This disbursement has continued to this day. "n 3553 in anada the
si! largest banks controlled >5 percent of anadian domestic assets, while the five largest
0.%. banks controlled only >.? percent of their domestic assets.
"n real terms anadian banks are much smaller. "n 355; the three largest banks in
America had assets equal to the entire =? banks 'only .< domestic( operating in anada.
"n relative si,e anadian banks are more competitive. The largest anadian bank has
.;55 branches while in the 0.%. the four largest banks have 1ust over 3555 branches each.
anadas banks have traditionally been much fiercer competitors internationally. "n part
this is rooted in anadas smaller market. For anadian banks international e!change
was always a central concern. For American banks domestic banking was paramount. "n
the .>35s in the American economic center of Few Gork anadian banks dominated the
international banking sector due to greater e!pertise and focus. Thus anadian banks
came to have far wider spread networks. -uch of the banking system in the Best "ndies
3?
is controlled by the anadian banks. anadian banks also have far more of a presence in
the 0nited %tates than American firms do in anada. "n part this is because American
firms cannot buy anadian banks, but anadian banks have, at times, been able to buy
American ones. %ince the large anadian banks already operated nationwide chains of a
thousand or more branches, they find it relatively easy to integrate smaller chains of
American banks into their systems. "n recent years this advantage has disappeared as
American banks have also grown substantially in si,e and today have many branches.
Kespite these foreign ownership rules, anadian banks have been far less strictly
regulated than their American counterparts. anadian banks are far freer to participate in
the financial planning and insurance industries than their American counterparts.
anadian banks have not faced laws against usury, or interest guarantees on deposits.
+rofits for anadian banks are generally higher.
#owever, service charges are also lower in anada, and anadas banking system also
provides better service by most measures. anada has more branches and more AT-s
per capita than the 0nited %tates. heques take less time to clear, as do most other
transactions. anadian banks have been far more active in promoting debit cards and
internet banking, and both services are used far more often by anadians.
Prices
"n anada prices have long tended to be higher. This is partly because of structural issues
in anada such as low population density and harsher weather, and partly due to
anadas ta! system, which depends more heavily on sales ta!es relative to income ta!es
than the 0.%. This has contributed to problems such as cross-border shopping and a
reduced standard of living. %ince the early .>>5s this has not been the case, as the
anadian dollar had fallen low enough that it more than made up for price differences.
Today prices are somewhat lower in anada$ the :ig -ac "nde! shows that in 355; a :ig
-ac cost 63.=7 in the %tates and only 63.<. in anada 'both figures in 0%K(.
Fuel prices have always been higher in anada, even though anada is a net e!porter of
energy. This is partly for the same reasons as above and partly because of environmental
ta!es levied specifically on fuel. 0nlike many oil producers, particularly those in the
developing world, anada does not heavily subsidi,e fuel, so prices are based on the
world market price.
Productivity
:y most measures anadian workers are less productive, although some of this
difference is caused by Americans tending to work longer hours. anadian level of
mechani,ation are also not always as high.
For the last thirty years the productivity gap has been closing, in large part because of the
elimination of the smaller market problem through free trade. From .>=. to .>?; labor
39
productivity rose annually by ;.; percent in anada and ..? percent in the 0nited %tates.
From .>?; to .>>7 it was ... percent in anada and 5.9 percent in the %tates.
0nemployment
anada has a higher unemployment rate than the 0nited %tates with the anadian number
being around ? to 9J while the 0.%. tends to be around 7J. Kuring the .>95s when this
gap first emerged it was a controversial issue. anadas higher income ta!es and more
generous benefit programs were blamed. "t has recently been noted that about half of the
difference is caused by the two countries measuring the unemployment rate differently.
arig @iddel, a 0: economist, found that the unemployment gap had averaged about
3J over the last several years. #is numbers show that 5.>J of the difference was caused
by differing measurement systems. 4ther factors e!plaining the remaining difference are
the large number of seasonal workers in trades such as fishing and logging who are
employed for a portion of the year. anadas more restrictive labor laws, increased role
of unions, and greater unemployment benefits have also all been blamed for creating
some or the difference. #owever, when unemployment insurance and welfare were
sharply cut in many parts of anada during the .>>5s there was little gain relative to the
Americans.
(alance of trade
Bhile the 0nited %tates has in recent years had a large trade deficit anada has recently
maintained a trade surplus. The anadian surplus is almost entirely due to trade with the
0nited %tates. anada has trade deficits with the countries of 2urope and Asia, 1ust as the
Americans do. "n 3553 anada e!ported about .55 billion dollars worth of goods more
than they imported to the 0.%. Bith the rest of the world it had a trade of 69; billion
creating an overall surplus of some 6.? billion.
Income
anadian EK+ per capita is lower than that in the 0nited %tates, but median income is
very similar in the two countries. Bealth in the 0nited %tates is more highly concentrated
and the higher per capita EK+ is almost entirely a difference among the wealthiest .J of
the two countries.
The EK+ gap has also been shrinking. From .>=. to .>?;, real EK+ grew at an average
annual rate of 7.7 percent in anada and <.5 percent in the 0nited %tates. From .>?; to
.>>7 it was 3.=J in anada and 3.;J in the %tates.
&tandard of #iving
%tandard of living is perhaps the hardest measurement to make since a wide array of
factors have to be taken into account. The 0nited Fations #uman Kevelopment "nde! has
traditionally listed anada higher than the 0nited %tates, with only a few e!ceptions.
3>
4ther independent groups, such as the 2conomist rank anadian cities as better places to
live than American ones.
anada ranks higher than the 0.%. in statistics such as life e!pectancy, infant mortality,
and literacy. The 0nited %tates has more ma1or consumer goods per capita than anada.
For instance, while anada had only ?.< televisions per .555 people in .>>=, the 0nited
%tates had 957.
The income gap in the 0nited %tates is larger. There is sometimes a racial element to
poverty in the 0nited %tates. African-Americans and #ispanics, on average, have a lower
standard of living than the rest of the population. anadas French-anadians also used to
be a much poorer group, but since the Ruiet @evolution in the .>=5s this has mostly been
remedied. anadas First +eoples, a comparatively smaller percentage of the population,
have a far lower standard of living than the ma1ority

;5
1 'he #ion2 the $ragon2 and the Future
"n the .>95s, a select group of economies in Asia came to be known as the )Asian tigers*
because of their aggressive approach to economic growth. Among the tigers were
%ingapore, -alaysia, Thailand, and "ndonesia. All took the view that a combination of
low wages and high export sales represented the fast track to economic growth and
prosperity. Fow these tigers are being overtaken by the )dragon* of AsiaChina Swhich
is following the same path, with perhaps even more success.
For decades after the ommunists rise to power in .><>, hina was best known
for poverty and repression, and its aggression came mostly on the military front. :ut in
recent years, economic aggression has become the byword. Although both poverty and
repression are still the norm, both are changing for the better. hina, it seems, is trying to
learn from capitalism, even if not converting to it.
hinas economic offensive began almost thirty years ago in its southeastern
province of Euangdong. The hinese leadership decided to use this province as a test
case, to see if capitalist direct foreign investment could stimulate economic growth in a
way that could be politically controlled. The e!perience was deemed a successC
economic growth soared amid political stability. Bhat the government learned from the
e!perience helped it smooth the .>>? transition of #ong Aong from :ritish to hinese
control. -ost important in terms of hinas long-term economic aspirations, many
foreign investors came to view the Euangdong e!periment as solid evidence that they
could invest in hina without fear that the ommunist government would confiscate their
capital. :eginning about .>>3, foreign investment in hina began to soar. The annual
rate of such investment is more than ten times greater than it was at the beginning of the
.>>5s.
There are two powerful forces that are attracting economic investment to hina&
demand and supply3 4n the demand side, ..; billion people live there, some 35 percent
of the worlds population. Although per capita income is still low by world standards, it
has been increasing by more than = percent per year, after ad1usting for inflation. At that
rate, the standard of living for the hinese peopleCand hence their purchasing power in
world marketsCis doubling every decade or so. hina is already the worlds largest cell-
phone market, with 355 million customers. Bithin a few years, it is estimated, hina will
account for 37 percent of the worlds purchases of personal computers. "ndeed, hina
now spends over 6=5 billion per year on information technology and services, and this
amount is growing at a rate of nearly ;5 percent per year. :y 35;5, the hinese economy
will likely have replaced the economy of the 0nited %tates as the worlds largest.
Bith its population of ..; billion, china also offers attractions on the supply side.
#ighly skilled workers have been plentiful in the hinese labor market. hinas
universities produce more <75,555 engineering graduates each year, including 75,555 in
computer science. ':y comparison, there are about ;5,555 new computer science
graduates each year in the 0nited %tates.( "n many cities, the fact that the hinese
workforce is generally well educated and often 2nglish-speaking has helped make the
country attractive to foreign employers. ollaborative scientific ventures between
hinese researchers and 0. %. firms are becoming increasingly common. A research team
at :ei1ing 0niversity played a role in deciphering the genetic makeup of rice, for
e!ample. American computer hardware and software firms "ntel, ":-, 4racle, and
;.
-icrosoft have shifted some key components of their research to hina in recent years.
American firms are even setting up customer-service call centers in hina. -icrosoft
customers from the 0nited %tates who call for help may well find themselves talking with
one of that companys four hundred engineers who are located in %hanghai.
-alaysia, Thailand, and %ingapore are increasingly concerned by the growing
competition they face from their neighbor to the north. hinese medium- and high-tech
industries are starting to cut into the mar.et share of the very sectors that have helped
fuel the growth of the Asian tigers in recent decades. The situation is even more critical
in Dapan, where wages are much higher than in hina but whose technological lead over
hina is gradually eroding. )Are we to become a vassal of the hinese dynasty againH*
asked one Dapanese official, clearly concerned that his nations manufacturing firms were
having trouble competing with hinese firms. 2ventually, Dapan and hinas other
neighbors will ad1ust to the growing economic presence of hina, but the transition may
be unpleasant.
-ost Americans, however, are more concerned about the likely impact on the 0.
%. economy of hinas capitalist ambitions. Bill the dragon consume American firms
and 1obs as it growsH The short answer is no. The long answer has two elements. To this
point, a key element of hinas competitiveness has been the low wages there. 2ven
though American and 2uropean firms operating in hina choose to pay their workers
more than state-owned enterprises pay, this has still yielded considerable savings. As
recently as five years ago, unskilled and semiskilled labor in hina cost only 37 percent
as much as in 2urope. -oreover, foreign firms have been able to hire engineers for
salaries that are only .5 to 35 percent of the cost of hiring engineers in the Best.
/abor markets in hina are changing rapidly, however. Average wages are rising
at = to 9 percent per year, with bigger increases among higher-skilled workers, and
migration into the cities has slowed due to a sharp cut in agricultural ta!es. -any firms
have been unable to hire as many workers as they would like, and most firms have had to
upgrade their fringe benefits and other on-the-1ob amenities 1ust to retain e!isting
workers. 2ven so, turnover has soared as firms compete for a pool of talent that is no
longer growing. Bages are still well below American and 2uropean levels, but the gap is
closing steadily, thereby cutting the competitive advantage of many hinese firms.
@ising wages in hina will also translate into higher demand for goods produced
by American and 2uropean firms. hina, like all nations, must in the long run import
goods equal in value to those it e!ports 'unless hina intends to give its e!ports away,
which so far no one is claiming(. This means that 1ust as hina has become a potent
supplier of many goods and services, it is at the same time becoming a potent demander
of still other goods and services.
Thus far, the hinese demand for goods has not been as visible in American
markets because American firms tend to produce goods and services designed for higher-
income consumers, and hina has, as yet, relatively few of those. "n the meantime, the
demand-side influence of the hinese economy is already showing up, albeit in odd
places. To take one e!ample, right now hinas most important import from the 0nited
%tates is trash. @anging from used newspapers to scrap steel, hinese companies buy
billions of dollars worth of the stuff every year to use as raw materials in the goods they
produce. "n addition to yielding profits 'and employment( in these 0. %. e!port industries,
;3
this e!portation of 0. %. trash reduces the burden on 0. %. landfills and, by pushing up the
prices of recyclable scrap, encourages more recycling in the 0nited %tates.
2ventually, of course, wed like to be sending hina more than our rubbish, and
that time is coming. As hinas economy grows, so will the number of affluent hinese,
and with ..; billion potential candidates, that ultimately means plenty of consumers for
Americas high-end goods. Thus the long-run effects of hinas growth will mean a
different American economyCwell be producing and consuming different mi!es of
goods and servicesCbut America will also be a richer nation. Ioluntary e!change, after
all, creates wealth, and the hinese dragon is big enough to create a lot of wealth.
Dust to hinas southwest, another giant is stirring. Around .>>5, the lion of "ndia
began to throw off the self-imposed shackles of nearly a half-century of markets largely
closed to international competition. The central government, for e!ample, began opening
many of its state-owned companies to competition from private-sector rivals. Fed2! and
0nited +arcel %ervice '0+%( have made huge inroads on the "ndian postal service, and
numerous foreign firms are now competing with the state-owned telephone service,
which had long been a complete monopoly3
2ntry into the "ndian market brought familiarity with its workforce, many of
whose members are fluent in 2nglish. The technical capabilities of graduates of top
"ndian universities, combined with their 2nglish skills are low wages, made them perfect
staffers for a proliferation of call centers that have opened throughout "ndia. Tens of
thousands of technical and customer-relations 1obs that used to go to -iddle America are
now held by the growing middle class in "ndia. As we discussed in hapter .<, )A
Farewell to Dobs,* it was in many respects this very movement that brought outsourcing
to the forefront of the American consciousness.
:ut "ndia, too, is struggling with growth. The talent pool at the top is thin& 4nly a
do,en or so of "ndias seventeen thousand universities and colleges can compete with
Americas best, and the wages of graduates of these top schools are soaring. -oreover,
"ndia suffers from overwhelming infrastructure problems& -uch of its road system is
either overcrowded or in disrepair, and its port facilities are in desperate need of
moderni,ation. For the time being, such transportation problems are likely to keep "ndia
from becoming a ma1or manufacturing powerhouse. "ndia has also been hampered by its
huge and seemingly permanent government bureaucracy. For e!ample, despite the fact
that the postal service there has lost more than half of its business to newcomers such as
Fed2! and 0+%, none of the 775,555 postal service employees can be fired.
At least "ndia is a democracy, and its legal system, inherited from the :ritish, who
ruled there for so long, is in close conformity with the legal systems of most developed
nations. -atters are rather different in hina. As noted in hapter <, )The -ystery of
Bealth,* political and legal institutions are crucial foundations for sustained economic
growth. Kespite the advances hina has made over the past thirty years, its wealth-
creating future may be clouded unless it can successfully deal with two crucial
institutional issues.
First, there is the matter of resolving the tension inherent when a ommunist
dictatorship tries to use capitalism as the engine of economic growth. apitalism thrives
best in an environment of freedom and itself creates an awareness of and appreciation for
the benefits of that freedom. Get freedom is antithetical to the ideological and political
tenets of the ommunist government of hina. Bill the government be tempted to
;;
confiscate the fruits of capitalist success to support itselfH 4r will growing pressure for
more political freedom force the government to repress the capitalist system to protect
itselfH 2ither route would likely bring economic growth in hina to a swift half.
The second potential long-run problem faced by hina lies in that nations
cultural attitude toward intellectual property3 "n a land in which imitation is viewed as
the sincerest form of flattery, it is routine to use the ideas of others in ones own pursuits.
As a result, patent and copyright laws in hina are far weaker than in Bestern nations.
-oreover, actions elsewhere considered to be commercial theft 'such as software piracy(
are largely tolerated in hina. "f foreign firms find that they cannot protect their
economic assets in the hinese market, foreign investment will suffer accordingly, and so
will the growing dragon that depends on it so heavily.
;<
45 &upply-&ide )conomics
%upply-side economics provided the political and theoretical foundation for a remarkable
number of ta! cuts in the 0nited %tates and other countries during the eighties. %upply-
side economics stresses the impact of ta! rates on the incentives for people to produce
and to use resources efficiently. A persons marginal ta! rateCthe ta! rate she pays on an
additional dollar of incomeCdetermines the breakdown between ta!es, on the one hand,
and income available for personal use, on the other. %ince they directly affect the
incentive of people to work, to save and invest, and to avoid and evade ta!es, marginal
ta! rates are central to supply-side analysis.
An increase in marginal ta! rates reduces the share of additional income that earners are
permitted to keep. This adversely affects output for two ma1or reasons. First, the higher
marginal rates reduce the payoff that people derive from work and from other ta!able
productive activities. Bhen people are prohibited from reaping much of what they sow,
they will sow more sparingly. Thus, when marginal ta! rates rise, some people, those
with working spouses for e!ample, will opt out of the labor force. 4thers will decide to
take more vacation time, retire earlier, or forgo overtime opportunities. %till others will
decide to forgo promising but risky business opportunities. These reductions in
productive effort shrink the effective supply of resources and thereby retard output.
%econd, high marginal ta! rates also encourage ta! shelter investments and other forms of
ta! avoidance. As marginal ta! rates rise, investments that generate paper losses from
depreciable assets become more attractive. %o, too, do business activities that present
opportunities to deduct e!penditures on hobbies 'for e!ample, collecting antiques, raising
horses, or traveling( and personal amenities 'lu!ury automobiles, plush offices, and
various fringe benefits(. Thus, people are directed into activities because of ta!
advantages rather than profitability. %imilarly, they are encouraged to substitute less
desired ta!-deductible goods for more desired nondeductible goods. Baste and inefficient
use of valuable resources are a by-product of this incentive structure.
"t is important to distinguish between a change in ta! rates and a change in ta! revenues.
:ecause higher ta! rates discourage work effort and encourage ta! avoidance and even
ta! evasion, the ta! base will shrink as the rates increase. Bhen something is ta!ed more
heavily, you will get less of it. Therefore, an increase in a ta! rate causes a less than
proportional increase in ta! revenue. "ndeed, economist Arthur /affer 'of* /affer curve*
fame( populari,ed the notion that higher ta! rates may actually cause the ta! base to
shrink so much that ta! revenues will decline.
This inverse relationship between a change in ta! rates and the accompanying change in
ta! revenues is quite likely when marginal ta! rates are high, but unlikely when rates are
low. An analysis of the incentive effects for different ta! brackets illustrates why this is
true. %uppose that a government with progressive income ta! rates ranging from a low of
.7 percent to a high of ?7 percent cuts ta! rates by one-third. The top ta! rate would then
fall from ?7 percent to 75 percent. After the ta! cut, ta!payers in the highest ta! bracket
who earn an additional 6.55 would get to keep 675 rather than 637, a .55 percent
;7
increase in the incentive to earn. +redictably, these ta!payers will earn more ta!able
income after the rate reduction, and the revenues collected from them will decline by
substantially less than a third. "n fact, given the huge increase in their incentive to earn,
the revenues collected from ta!payers confronting such high marginal rates may actually
increase.
The same ;; percent rate reduction will cut the bottom ta! rate from .7 percent to .5
percent. #ere, take-home pay per 6.55 of additional earnings will rise from 697 to 6>5,
only a 7.> percent increase in the incentive to earn 'compared to the .55 percent increase
in the top bracket(. :ecause cutting the .7 percent rate to .5 percent e!erts only a small
effect on the incentive to earn, the rate reduction has little impact on the ta! base.
Therefore, in contrast with the revenue effects in high ta! brackets, ta! revenue will
decline by almost the same percent as ta! rates in the lowest ta! brackets. The bottom
line is that cutting all rates by a third will lead to small revenue losses 'or even revenue
gains( in high ta! brackets and large revenue losses in the lowest brackets. The share of
the income ta! paid by high-income ta!payers will rise.
Kuring the great ta! debate of .>?7 to .>9=, the opponents of the supply-side view
argued that it was unrealistic to e!pect lower ta! rates to lead to increased ta! revenues.
According to the critics an increase in the ta! base that was large enough to increase
revenues would require an unrealistically large elasticity of labor supply 'increase in
hours worked due to higher after-ta! wages(. "n response the supply-side proponents
stressed that reductions in ta! avoidance activities, as well as labor-supply effects, would
enlarge the ta! base when the rates were reduced. According to the supply-side view the
combination of a decline in ta! avoidance and increase in business activities would
permit lower rates with little or no loss of revenues in the top ta! brackets. At the same
time, most supply-side economists, though perhaps not all, noted that reductions in low
ta! rates would lead to revenue losses.
2mpirical studies of ta! cuts that happened during the twenties and si!ties buttressed the
supply-side position. +rodded by %ecretary of the Treasury Andrew -ellon, three ma1or
ta! cuts reduced the top marginal ta! rate from ?; percent in .>3. to 37 percent in .>3=.
in addition, the ta! cuts eliminated or virtually eliminated the personal income ta!
liability of low-income recipients. The results were quite impressive. The economy grew
rapidly from .>3. through .>3=. After the rates were lowered, the real ta! revenue 'in
.>3> dollars( collected from ta!payers with incomes above 675,555 of income declined
by <7 percent. Thus, as the ta! rates were cut, the revenues collected from high-income
ta!payers rose, while those collected from lower-income ta!payers declined. The ta! cuts
of the twenties substantially increased the percent of ta!es paid by the wealthy.
The results of the Aennedy-Dohnson ta! cuts of the midsi!ties were similar. :etween
.>=; and .>=7, ta! rates were reduced by appro!imately 37 percent. The top marginal ta!
rate was cut from >. percent to ?5 percent. %imultaneously, the bottom rate was reduced
from 35 percent to .< percent. For most ta!payers the lower rates reduced ta! revenues.
"n real .>=; dollars the ta! revenues collected from the bottom >7 percent of ta!payers
fell from 6;..5 billion in .>=; to 63>.= billion in .>=7, a <.7 percent reduction. "n
;=
contrast, the real ta! revenues collected from the top 7 percent of ta!payers rose from
6.?.3 billion in .>=; to 6.9.7 billion in .>=7, a ?.= percent increase. As in thecase of the
ta! cuts of the twenties, the rate reductions of the si!ties reduced the ta! revenue
collected from low-income ta!payers while increasing the revenues collected from high-
income ta!payers.
-a1or ta! legislation passed in .>9. and .>9= reduced the top 0. %. federal income ta!
rate from ?5 percent to appro!imately ;; percent. The performance of the 0. %. economy
during the eighties was impressive. The growth rate of real EF+ accelerated from the
sluggish rates of the seventies. 0. %. economic growth e!ceeded that of all other ma1or
industrial nations e!cept Dapan.
The critics of the eighties ta! policy argue that the top rate reductions were a bonan,a for
the rich. The ta!able income in the upper ta! brackets did increase sharply during the
eighties. :ut the ta!es collected in these brackets also rose sharply. -easured in .>93-9<
dollars, the income ta! revenue collected from the top .5 percent of earners rose from
6.75.= billion in .>9. to 6.>>.9 billion in .>99, an increase of ;3.? percent. The
percentage increases in the real ta! revenue collected from the top . and top 7 percent of
ta!payers were even larger. "n contrast, the real ta! liability of other ta!payers 'the
bottom >5 percent( declined from 6.=..9 billion to 6.<>.. billion, a reduction of ?.9
percent. These findings confirm what the supply-siders predicted& the low rates, by
increasing the ta! base substantially in the upper ta! brackets, caused high-income
ta!payers to pay more ta!es. "n effect, the lower rates soaked the rich.
+robably the most detailed study of the ta! changes in the eighties was conducted by
/awrence /indsey of #arvard 0niversity. /indsey used a computer simulation model to
estimate the impact of the eighties ta!-rate changes on the various components of
income. #e found that after the ta! rates were lowered, the wages and salaries of high-
income ta!payers were appro!imately ;5 percent larger than pro1ected. %imilarly, after
the rate cuts capital gains were appro!imately .55 percent higher than pro1ected, and
high-income ta!payers business income was a whopping 355 percent higher than
e!pected. /indsey concluded that the main supply-side effects resulted from 'a( people
paying themselves more in the form of money income rather than fringe benefits and
amenities, 'b( increases in business activity, and 'c( a reduction in ta! shelter activities.
#is findings undercut the position of those supply-side critics who had assumed that
substantial supply-side effects were dependent on a large increase in labor supply.
%tudies liking rate changes with changes in ta! revenue measure the short-term effects of
ta! policy. :ut because ta!payers take time to ad1ust, revenues are even more responsive
to rate changes in the long run. Dames /ong and " conducted a study that found that
ta!payers in states with lower marginal ta! rates had much lower deductions and much
lower e!penditures on ta! shelters than ta!payers in states with higher marginal rates. Be
found that when the combined federal-state marginal ta! rate rises above 75 percent, the
governments ta! revenues decline. /indsey estimates that the governments revenue
begins declining at even lower ta! rates, appro!imately ;7 percent.
;?
%upply-side economics influenced ta! policy throughout the world in the late eighties. 4f
eighty-si! countries with a personal income ta!, fifty-five reduced their top marginal ta!
rate during the .>97->5 period, while only two '/u!embourg and /ebanon( increased
their top rate. ountries that substantially reduced their top marginal ta! rates include
Australia, :ra,il, France, "taly, Dapan, Few Nealand, %weden, and the 0nited Aingdom.
@eflecting the dominant Aeynesian view at the beginning of the eighties, most
economists thought that ta! changes influenced output and revenue primarily by
changing the demand for goods and services. :oth research and the ta! policy changes of
the eighties, however, indicate that supply-side incentive effects are quite important.
Bhile controversy continues about the precise magnitude of the supply-side effects, the
view that marginal ta! rates in e!cess of <5 percent e!ert a destructive influence on the
incentive of people to work and use resources wisely is now widely accepted among
economists. This was not true prior to the eighties. An important piece of evidence for the
shift in thinking is a .>9? statement by the ongressional :udget office ':4(, which
had been critical of the supply-side claims and had always assumed in its revenue
pro1ections that ta!payers did not respond at all to changes in ta! rates. The :4 wrote&
)The data show considerable evidence of a very significant revenue response among
ta!payers at the highest income levels.* This change in thinking is the ma1or legacy of
supply-side economics.

;9
.. The Production Possibilities Frontier
&carcity2 Choice and the Production Possibilities Frontier
'he )conomic Problem of &carcity 6
%carcity occurs because human wants e!ceed the limits of available resources.
2conomics deals with the basic fact that scarcity e!ists in our everyday lives and in our
economy. "magine for a minute that a messenger suddenly knocks on your door. #e
greets you with the delightful information that a previously unknown distant relative has
carefully monitored your progress through life. The relative is pleased with your
progress and as a test has decided to give you 67 million. There is one stipulation,
however$ you must spend this money within three months.
Bould you have any trouble spending the moneyH 0nless you are already smothered in
wealth, you should have no trouble coming up with a list of e!penditures. A car, a
beachfront apartment, a ski chalet, a boat, a vacation in paradise, a new computer, TI,
and stereo. E%- ellular phone, +% wireless, satellite uplink, personal messaging
system, AK%/, cable modem and "%KF "nternet access, your list suddenly grows longer
than you e!pected. The money would be e!hausted in no time. Bake up$ a survey of the
worn bills in your wallet reveals the basic fact that you face a scarcity of money in
relation to the list that we 1ust constructed.
The same idea applies to the economy as a whole. @esources such as raw materials are in
finite supply and must be allocated to their best use. For e!ample, in the western 0nited
%tates, water is a relatively scarce resource. The water that originates in olorado flows
westward into the olorado @iver, eventually providing cities in %outhern alifornia with
drinking water. "n years when rainfall is below normal, regional water restrictions come
into effect and users may be prevented from certain activities such as washing their cars.
Iirtually all resources are scare, meaning that more of them are desired than is available.
Choice
Eiven the presence of scarcity, choices must be made as to how resources are allocated.
4ur lives are filled with wide range of choices regarding the use of limited personal
funds. Advertisers constantly inform consumers of their consumption possibilities and
the choices available. The same principle applies for the economy as a whole. Be elect
politicians who work with policy makers to allocate government e!penditures. Together
they make difficult choices concerning how ta!es will be spent. 4r if a ta! reduction is
desired, a decrease in government e!penditures should accompany the ta! cut.
+roblems arise when government try simultaneously to reduce ta!es and maintain a high
level of e!penditures. As pointed out, the 0.%. government must take the choice between
;>
reduced e!penditures today or run the risk of 1eopardi,ing future economic growth and
prosperity.
The tradeoff between consumption today and consumption tomorrow deals with the
concept of opportunity cost.
7pportunity Cost
The relevant cost of any decision is its opportunity cost S the value of the ne!t-best
alternative that is given up.
:y making choices in how we use our time and spend our money we give something up.
"nstead of reading this material, what else could you be doingH Gour best alternative may
involve sports, leisure, work entertainment, and more. "f you choose to go to a restaurant
this evening, the money that you spend on dinner will not be available for other uses,
even saving.
:usinesses and government also deal with opportunity costs. As noted, by choosing to
maintain large deficits today, the federal government may reduce future economic
growth. 4r laws that protect wilderness areas and endangered species will ensure a better
environment tomorrow at the opportunity cost of reduced access to resources today.
:usinesses must choose what type of goods to produce and the quantity. Eiven limited
funds, the opportunity cost of producing one type of good will arise from not being able
to produce another.
'he Production Possibilities Frontier 8PPF9
Introduction to the Production Possibilities Frontier 8PPF9
The production possibilities frontier is used to illustrate the economic circumstances of
scarcity, choice, and opportunity cost.
To describe the concept of the production possibilities frontier, assume that we live on an
island that has only two cities '%eattle and Ketroit(, and two industries 'automobiles and
airplanes(. Eiven the resources available on our island economy, the table below shows
how labor and capital can be allocated to the production of autos and airplanes.
<5
'he Production Possibilities
for a &ingle Country
4ption Automobiles Airplanes
A .75 5
: .37 <
95 >
K ;5 .=
2 5 37
The table fives five production possibilities, option R through 2. 2ach option shows
what alternative mi!es of automobiles and airplanes that society can choose to produce.
4ption A is one where our island dedicates all or its resources to the production of
automobiles, entirely forsaking production. 4ption : shows a preference for the
production of a few airplanes, but giving up some automobiles in the process. The
tradeoff of airplanes for autos continues to point 2, where our country dedicates itself to
the production of airplanes '37(, producing ,ero automobiles.
The table presented here can be used to describe the economic problems of scarcity,
choice and opportunity cost. %carcity is present because finite amounts of each good can
be produced. Be may want a combination of .75 autos and 37 airplanes, but given the
limited labor and capital inputs available, this is not a feasible combination. To produce
.75 autos requires that all labor and capital available be used in the assembly of
automobiles, leaving nothing for the production of airplanes.
4nly by giving up some autos 'moving from 4ption A to 4ption :( do we gain airplanes.
"n a practical sense, labor and capital is switched from producing automobiles to
airplanes. This presents opportunity cost S the best alternative that we give up 'autos( to
increase airplane output.
Finally, choice is demonstrated by the five options of the table. #ow are choices madeH
+erhaps the firm or the market will determine the combination of autos and airplanes that
are produced. There can be a central planning agency that makes this determination or
the democratic process will let citi,ens vote for their preferences.
!utomobiles .75
37
!
i
r
p
l
a
n
e
s
Figure 4-4 'he Production Possibilities Frontier
<.
Figure .-. is a graphical representation of the information presented in the table above.
The boundary presented in the graph represents the different possibilities that society has
in the allocation of resources. The frontier boundary and its interior represent what is
achievable given our islands currently available resources. "n contrast, points outside the
frontier are not attainable given the resources and technology present.
Fote two characteristics of the production possibilities frontier. First, it slopes downward
to the right. This represents the tradeoff present in production. :y producing more
automobiles, workers and capital must migrate from %eattle to Ketroit. An increase in
auto production necessitates a reduction in the output of airplanes.
"n addition, the production possibilities frontier is )bowed outward.* The curvature of
the production possibilities frontier reflects the increasing opportunity cost when
substituting one type of production for another. This situation is caused by the
speciali,ation of workers. "f society initially favors auto production over airplanes so that
we are located in the southeast portion of the frontier, workers become skilled in auto
production. :ut as we move to the left along the curve, increasing airplane output and
decreasing auto production, some workers switch to building airplanes. For many
workers, the skills used in producing autos are not perfectly transferable. "n addition, the
machinery used for auto production may not be well suited to making airplanes. As a
result, the output per worker falls as they are relocated to making goods in which they are
less skilled.
Dust as the previous table described the economic problems of scarcity, choice and
opportunity cost, the ++F does the same. +oints outside the frontier may be desirable, but
are not obtainable given the inputs of labor and capital available to society. As we
change out preferences and move to the Forth Best along the frontier, airplane
manufacturing increases at the opportunity cost of automobile assembly.
<3
.3 Canada:s Free Health Care has Hidden Costs
+roponents of the anadian model praise its universal coverage and its apparent low cost.
Total 'private and public( health e!penditures are only .5J of gross domestic product in
anada, compared to .<J in the 0. %. A study published last August in the Few
2ngland Dournal of -edicine claimed that a third of this difference is e!plained by lower
administrative costs in the anadian system. :ut, among its other faults, this accounting
ignores the hidden economic costs of anadian health care.
The anadian system is built around a compulsory public-insurance regime that provides
most medical and hospital services free. 4f course, it is not free for the ta!payer, who
finances the system at a rate of 33J of all ta!es raised in anada. The anadian
government pays about ?.J of total anadian health care e!penditures, compared to
<<J paid by the government in the 0. %. This translates into public health e!penditures
of ?J of EK+ in anada and =J in the 0. %.Ca rather small difference. The difference
in total e!penditures is due to higher private e!penditures in the 0. %. Bhy are private
health e!penditures so low in anadaH The main reason is that they are illegal, which gets
us to the heart of the systems hidden costs.
anadian public health insurance is not only compulsory, it is also monopolistic. The
system is administered by provincial governments under strict guidelines imposed by
federal law and federal subsidies. +rivate insurance covering publicly insured services is
illegal. +hysicians are forbidden to accept private payments above the fees billed to the
government. #ospitals are public or non-profit, and tightly regulated. +hysicians fees are
determinedCor )negotiated*Cby provincial agencies. +rices of drugs are controlled. "n
short, the public supply of medical services is rationed, and there is little private
alternative. #ence the apparent low cost of the system.
The hidden costs include the poor quality of services, and the costs imposed on customers
'aptly called )patients* in this case( who have to wait in queues.
Ruality is sub1ective and can only be evaluated through consumer choices, but the
government wont let consumers make choices and vote with their feet if they are not
satisfied. Anecdotal evidence of questionable quality is everywhere. "n a recent piece in
-ontreals Ea,ette, a anadian related her own e!perience, and contrasted the )kindness,
discretion and professionalism* of staffing 0. %. hospitals, with the frequent rudeness of
unioni,ed personnel in the anadian system.
/ong waiting lines are a fi!ture of the system. The Fraser "nstitute, a Iancouver think
tank, has calculated that in 355;, the average waiting time from referral by a general
practitioner to actual treatment was more than four months. Baiting times vary among
specialties 'and, less wildly, among provinces(, but remain high even for critical diseases&
The shortest median wait is =.. weeks for oncology treatment$ e!cluding radiation, which
is longer. 2!treme cases include more than a years median wait for neurosurgery in Few
:runswick. The median wait for an -@" is three months. %ince .>>;, waiting times have
increased by >5J
<;
Baiting lines impose a real cost, which is appro!imated by what individuals would be
willing to pay to avoid them. Baiting costs include health risk, lost time 'especially for
individuals whose time is most valuable(, pain and anguish. %ocialist systems are
notoriously oblivious to anguish, discomfort, humiliation and other sub1ective factors
which bureaucrats cannot measure or dont value the same way as the patient does.
A Ruebec physician, Kr. Dacques haoulli, is suing the government for not allowing
patients to pay for better care. The %upreme ourt of anada will hear his appeal of
lower-court rebuttals in Dune. /ast month, a class-action case was launched against
Ruebec hospitals on behalf of .5,555 breast cancer patients who, since 4ctober .>>?,
have had to wait more than eight weeks each for post-surgery radiation therapy.
/iberali,ation proposals are met by the )two-tier system* bogey manCthat if choice is
allowed an unequal system will develop. :ut if directly paying a doctor is illegal, there
are legal ways to 1ump the queues. As pointed out by +rofessor /ivio Ki -atteo of
/akehead 0niversity in 4ntario, what now e!ists is a three-tier system. The very rich
'like @obert :ourassa, the /ate +remier of Ruebec( go to the 0. %. for rapid,
personali,ed, high-tech treatments. The second tier is made of )the well informed and
aggressive, who can push their way to the front of the treatment line.* The poor and those
with no connections get stuck in the queue.
At least two "ndian groups are now considering building private clinics or hospitals on
their landC1ust as other sorts of illegal-elsewhere trade thrive on "ndian reserves. Get,
anadians who patroni,ed such clinics would still be prohibited from purchasing private
insurance to cover the service, leaving the opportunity only to the wealthiest.
As noted by Bharton professor +atricia Kan,on, another hidden cost of the anadian
system comes )from forcing everyone to have the same level and type of insurance,*
whatever their individual preferences are.
4ne last cost should not be ignored& the loss of personal responsibility and the habit of
dependence on the state. 4pinion polls show that anadians are generally proud of their
public health insurance. "ndeed, for most people, any basis for comparison has been made
illegal. Auberon #erbert, a libertarian -ember of +arliament in late .>
th
century 2ngland
wrote, )"f government half a century ago had provided us all with dinners and breakfasts,
it would be the practice of our orators today to assume the impossibility of our providing
for ourselves.*
<<
.; (aseball Players and 7pportunity Costs
4n Kecember 3., 3553, the Toronto :lue Days decided not to offer salary arbitration to
outfielder Dose ru,, one of there more popular players. :y not offering arbitration, ru,
became a free agent and could sign a contract with any of the other 3> teams in ma1or
league baseball. 0nder the rules of arbitration, any team signing ru, would not have to
give the :lue Days any players, money, or draft picks in return.
The reaction in Toronto by many in the media was rather predictable. aller after caller
on local sports talk shows asked, )#ow could we get rid of one of our best players and
get nothing in returnH* The hosts of these shows seem to do little to try and answer these
questions. "f radio talk show hosts were required to take an introductory course in
economics, they would understand the concept of opportunity cost and would be better
able to answer these questions posed by their callers.
Money
Be need to e!amine two important resources which ma1or league baseball teams have in
order to understand the personnel decisions they make. The first resource at their disposal
is the money that they use to sign players. Teams generally do not have enough money to
sign every player they want to a contract, although the Few Gork Gankees are trying to
prove otherwise. #ad the :lue Days offered salary arbitration to Dose ru,, his salary for
355; would have been decided by an arbitrator. The best estimates available suggest that
ru, would have received 67 million for 355; if his salary was determined by an
arbitrator. "f we believe this estimate and if the Days had offered ru, arbitration, the Days
would be required to retain ru, and pay him 67 million for the season. This would be 7
million dollars that the Days could not use for other purposes.
"f we look at the moves the :lue Days have made over the winter, it seems that they used
this 67 million to sign other players. The :lue 1ays have signed = players to contracts
who played elsewhere in 3553. the players and the salaries they will be paid in 355; are
as follows&
Former
+layer +osition %alary Team
:ordick,
-ike %hortstop 6.,555,555 :altimore
atalanotto,
Frank 4utfielder 63,355,555 Te!as
reek,
Koug +itcher 6 ?55,555 %eattle
-yers
Ereg atcher 6.,555,555 4akland
%turt,e,
Tanyon +itcher 6.,555,555 Tampa
Tam,
Deff +itcher 6 =55,555 4akland
Total = players 6=,755,555
<7
%o the Days have spent 6=.7 million on players during this off-season. "t is likely that, if
the Days were paying Dose ru, 67 million for 355;, they would not have spent this 6=.7
million on these si! players.
'he Ma;or league oster
The second important resource a team has is the 37 spots on their ma1or league roster. :y
-a1or /eague :aseball rules a team can only carry 37 players at one time. "f a team is at
this limit 'which teams almost always are( and they with to add a player to the roster,
they must first take a player off. %o the cost to the :lue Days of signing these = players is
not simply the money they have to pay for there services, but it is also in the roster spots
the players take up.
"f the Days had not signed these = players, they would have had to find other players to tae
up these si! roster spots. 4ne of those players probably would have been Dose ru,. The
other 7 would have probably been players from the minor leagues with little or no ma1or
league e!perience. First year players typically make the ma1or league minimum salary of
6;55,555. if the Days had kept ru, and called up 7 minor league players, the si! roster
spots would look as follows.
+layer %alary
ru,,
Dose 67,555,555
-inor
/eaguer . 6 ;55,555
-inor
/eaguer 3 6 ;55,555
-inor
/eaguer ; 6 ;55,555
-inor
/eaguer < 6 ;55,555
-inor
/eaguer 7 6=,755,555
This option is now directly comparable to what the Days did over the winter, as both take
up = roster spots and cost 6=.7 million&
<=
4ption A 4ption :
+layer %alary +layer %alary
:ordick, ru,,
-ike 6.,555,555 Dose 67,555,555
atalanotto, -inor
Frank 63,355,555 /eaguer . 6 ;55,555
reek, -inor
Koug 6 ?55,555 /eaguer 3 6 ;55,555
-yers, -inor
Ereg 6.,555,555 /eaguer ; 6 ;55,555
%turt,e, -inor
Tanyon 6.,555,555 /eaguer< 6 ;55,555
Tam, -inor
Deff 6 =55,555 /eaguer < 6 ;55,555
Total 6=,755,555 Total 6=,755,555
4ne of the most commonly used principles in economics is opportunity cost. The
opportunity cost of something is simply the highest valued alternative that must be
foregone when a choice is made. #ere "ve presented two choices the Days could have
make. 4f course the :lue Days had other alternatives& they could have signed = minor
leaguers and kept the leftover money, or signed a different set of players. :ut it is likely
the Days felt that these two options were their best choices. %o the opportunity cost of
choosing the A set of players is the foregone opportunity to sign the : set of players.
%imilarly, the opportunity cost of the set of players : is simply the set of A players.
%o we wee that the Days did not give up Dose ru, for )nothing*. "nstead they gave up
Dose ru, and the opportunity to play 7 minor league players and received the
opportunity to play :ordic, atalanotto, reek, -yers, %turt,e, and Tam instead. %o
when a team decides not to retain the services of the player, they always receive two
things in return& the money it would have taken to retain the player, and the spot on the
37 man roster that the player would have taken.
<?
4< ationing Health Care
Americans spend a larger share of national income on health care- more than .< percent S
than any other people of the world. -oreover, for almost every one of the last twenty-
five years, the price inde! for medical care has increased more rapidly than the price
inde! for all goods and services in general. Bith spending on health care at record high
levels, it is little wonder that some political leaders have labeled health care in the 0nited
%tates a )crisis,* arguing we should implement government-mandated universal health
care coverage. "t is thus instructive to look at what has happened in other countries that
have adopted some form of a national health care system.
Be obviously cannot cover every aspect of health care here, nor can we demonstrate that
one system of health care delivery is better than another one. Bhat we can do, however ,
is to note the consequences of this critical point& "n a world of scarcity, some form of
rationing is inevitable. "n the market system, that rationing is done by prices. 0nder the
systems of government-mandated universal health care that now e!ist 'or are likely to
e!ist in the future(, prices are not permitted to ration demands. "nstead , these systems
rely on another system of rationing& "t is called rationing by waiting, because people are
forced to wait S for weeks or months S for whatever level of medical care is offered them.
The most common form of government-mandated universal health care coverage found
in the world today is the single-payer health care system that in essence offers universal
health care to consumers at a money price of ,ero. 'The term single-payer is used because
the government writes the checks for the medical bills.(
:ritain offers a typical e!ample. The :ritish Fational #ealth %ervice 'F#%( has been in
e!istence since .><9. 4nce touted as one of the worlds best national health care
e!amples, the F#% has deteriorated dramatically. onsider hospital beds& "n .><9 there
were ten hospital beds per thousand people. Today there are about five per thousand
people, since .><9 about 75 percent of :ritains hospitals have been closed for
)efficiency* reasons S meaning that the :ritish government cannot or will not afford to
keep them open. :ritain now has fewer hospital beds per capita than every Bestern
2uropean country e!cept +ortugal and %pain.
:ecause patients in :ritain do not pay directly for the services they receive, some other
means of rationing must be used. "n :ritain, the rationing device is waiting, and as the
number of hospital beds and other medical facilities have been cut relative to the
population, it is little surprise that waiting times have increased. urrently more than a
million :ritish patients are waiting for hospital admission. -any others do not show up
on waiting lists because they simply do not apply, knowing that the wait is so long. "n
some /ondon hospitals, individuals routinely spend more than .3 hours waiting to see a
physician.
The total staff in the F#% has, in contrast, skyrocketed. Bhereas in .><9 the staff-to-bed
ratio was .?; to . for each hospital bed, today it is ;.. to . for each hospital bed$ even
with the drop in beds per capita, there are now twice as many staff members for each
<9
patient as thee were in .><9. one would e!pect this would enhance medical care.
0nfortunately, however, the staff, for the most part, do not deal directly with the
treatment of patients. @ather, they have become part of the F#% bureaucracy. This is
because the government-run F#% adds a new department or committee for every new
aspect of medicine that develops. The F#% consists of a bureaucratic network unknown
in the decentrali,ed medical system in the 0nited %tates.
"n fairness to the F#%, some of the changes in the system over the last fifty years have
been mirrored in health care systems elsewhere. For e!ample, improvements in surgical
techniques and pharmaceuticals have shortened hospital stays in most nations, resulting
in a reduced demand for hospital beds. This surely helps e!plain at least some of the
sharp cuts in F#% beds per capita. Fevertheless, horror stories of bungled operations and
patients left untended in hospital hallways have become a regular feature in :ritish
newspapers. Things got so bad by 3553, that :ritains /abor +arty S the initial creator
and steadfast supporter of the F#% S proposed that the poorest-performing F#% hospitals
be handed over to the private sector.
The national health care system in anada offers another e!ample of the effects of non
price rationing. "n essence, under the anadian system the government picks up the
entire tab for all covered medical procedures. urrently, only .. percent of anadas
national health care spending goes to administration, compared to 3< percent in the
0nited %tates. anada devotes >.7 percent of its national income to health care, about a
third less than in the 0nited %tates. +erhaps because of the seemingly low cost of the
anadian system, many supporters of health care reform in the 0nited %tates often point
to anadas system as one that the 0nited %tates should emulate.
4ne impact of the lower level of spending in anada is that their system does not provide
the latest in medical technology. Although anada ranks fifth highest among developed
nations in health care spending as a share of income, it ranks in the bottom third of those
countries in availability of technology. For e!ample, compared to the 0nited %tates, on a
per capita basis anada has far fewer AT scan and magnetic resonance imaging '-@"(
machines, critical in performing sophisticated, difficult diagnostics. %imilarly, anadian
medical facilities have almost none of the medical devices needed to remove kidney
stones without painful and dangerous surgery. -oreover, operating rooms in anada
operate on strict financial budgets and are allowed to continue operating only if they are
within those monthly budgets. Bhat happens if an operating room e!hausts its budget
on, say, the 35
th
of the monthH "t shuts down until the beginning of the ne!t monthly
budget cycle.
The costs to the users of the anadian system show up in other ways as well. Two
anadian economists, ynthia @amsay and -ichael Balker of The Fraser "nstitute in
:ritish olumbia, have studied the waiting times across a variety of medical specialties.
They discovered that many anadians each year were not permitted to enter the hospital
when they or their physician deemed best$ instead they had to wait until facilities became
available. -oreover, anadians typically were not even able to get in to see their doctors
when they wanted. @amsay and Balker measured the delay from
<>
Table ..-. Average waiting time for treatment by a %pecialist in anada
'"n weeks(
&pecialty &hortest wait #ongest wait Canada !verage
4rthopedics .5.; ;>.? 37
+lastic %urgery >.. <5.7 .>.9
4phthalmology 9.. ;> 33.;
Eynecology 7.7 3?.3 .;..
4tolaryngology 9.; 3= .<.<
0rology 9.3 3>.3 .3.=
Feurosurgery .5 ;. .?
Eeneral %urgery =.3 33.; >.3
"nternal -edicine <.= ?.3 =.<
ardivascular .3.7 ;..7 .?.>
the time that a primary care physician referred a patient until a specialist actually treated
the patient$ they found that the demand for health care was rationed by waiting. /isted in
Table ..-. are the average waiting times in weeks for the serviced of various medical
specialists. The tree columns show the waiting times for anada as a whole and the
waiting times in individual anadian provinces that had, respectively, the shortest and
longest waiting times.
Two facts are apparent from Table ..-.. First, it is common place for anadians to have
to wait three or four months to receive health care that is anything beyond that offered by
a nurse of primary care physician. %econd, the anadian system produces huge
inequalities in the way people are treated, not only across illnesses, but also across
provinces for the same illness. These long waits, and the e!tent of unequal treatment,
have produced a regular stream of anadians who come to the 0nited %tates and spend
their own money for medical care here, rather than await their fate at home. The waiting
in anada has gotten so bad that some provincial governments ship heart bypass patients
and cancer patients needing radiation over the 0% border to receive treatment. Although
this is politically unpopular with the anadian federal government, the alternative, it
seems, is to let the patients die at home waiting.
Another e!ample of government-controlled health care involves the Fetherlands. The
government there decides on global budgets to control hospital e!penditures. "t also
limits the number of doctors who may speciali,e in a give area and caps the number of
patients they may see. "n addition, the government controls physician fees. To help the
government meet its budgets, many medical specialists have simply stopped working as
much as they used to work. "t is commonplace for highly trained surgeons to work only
half days or to take weeks off at the end of the year. The result is that typically there is
about a three-month waiting list for coronary bypass surgery. 4ver .7 percent of the
patients on the waiting list die before the operation can be performed. Kiabetics wait a
average of three months to obtain laser treatment for retinal hemorrhaging-and risk
blindness in the process. The average wait for removal of gallbladder stones and repairs
75
of hernias is from four to eight weeks. %ome forms of reconstructive surgery require
waits of up to four years.
0nder Kutch law, companies must pay employees salaries for the first two to si! weeks
of an illness, depending on the si,e of the company. This has generated an interesting
incentive& The companies have discovered that they can reduce their costs by renting
hospital rooms that they keep open for their employees. The companies thus do not have
to pay employee salaries while they wait Sdisabled- for treatment. Although the Kutch
system is supposed to provide equal treatment for all, treatment in fact has come to
depend on the si,e and influence of the company for which a person works.
Although our analyses have involved three foreign countries, we need go no further than
our own Ieterans Administration 'IA( to find similar e!amples. The Ieterans
Administration operated a .55 percent government-owned and financed health care
system. "t is the largest health care system in our country and one of the largest in the
world. "t has .=; medical centers with over 95,555 beds. "t operates ;=3 outpatient and
community clinics that receive <; million patient visits a year. "n addition, it has .;?
nursing homes with over 9?,555 patients. All of the states, plus the Kistrict of olumbia
and +uerto @ico, have at least one IA medical center, and the IA boasts almost 375,555
employees nationwide.
The Eeneral Accounting 4ffice 'EAF( did a study of the IA a few years ago, concluding
that the IA system faces a growing demand for )free* medical services. #erein lies the
rub-the quantity demanded of most services at a ,ero price will almost always e!ceed the
quantity supplied. onsequently, because price is not used as a rationing device, some
other method must be used to ration the scarce resources. Fifty-five percent of the
patients who use the IA for routing medical problems wait three hours or longer and
sometimes an entire day in order to be seen for a few minutes by a IA general physician.
2ven among patients requiring urgent medical care, one in nine must wait at least three
hours. +atients in need of speciali,ed care cannot even be seen by a specialist for =5 to
>5 days. They wait months more if surgery or other special procedures are required.
Bhether the location is :ritain, anada, #olland, or even the 0% Ieterans
Administration, when prices are prevented from clearing the market for medical care,
waiting time is the most commonly used means of rationing demand. As one
unidentified 0% veteran told the EA4, )" pack a lunch and take a book.* Another
veteran, retired => year old Army -a1or 2lmer 2rickson, stated, ):e prepared to spend
the day there. Gou will eventually see a doctor.
7.
.7 Foreign Investment in the 0nited &tates
"ntroduction
"n the short run, foreign capital invested in the 0nited %tates raises 0. %. gross domestic
product 'EK+(. This means that 0. %. residents are better off than they would be without
foreign capital. %till, long-run scenarios of foreign ownership trouble many critics& Bhat
payment will foreigners e!act for our use of their capitalH Bill sustained inflows of
foreign capital give foreigners control of the 0. %. capital stock, reduce 1ob quality, or
distort 0. %. investment and researchH Fortunately, these concerns can be dispelled by
reviewing the e!tent of foreign investment in the 0. %. economy vs. 0. %. investment
abroad, considering the motivations for foreign investment, and computing the negligible
potential for foreign control.
Foreign Investment in the 0nited &tates=how Much> 7r *hat> (y *hom>
:etween .>93 and .>>5 0. %. current account deficitsCthe amount by which imports of
goods and services plus foreign aid e!ceeded 0. %. e!ports of goods and servicesC
totaled over 6>55 billion. The deficits were financed by net capital inflowsCforeign
investment in the 0nited %tates less 0. %. investment abroad. Although 0. %. holdings of
foreign assets rose, foreign holdings of 0. %. assets rose by 6>55 billion more. 0. %.
assets abroad minus foreign assets in the 0nited %tates went negative in .>97 for the first
time since .>.<.
These data, however, are based on historic cost, the cost at the time the investment was
made. The proper measure of any investment is its current market value, not its historic
cost. @ecogni,ing this, the 0. %. ommerce Kepartment switched to market valuation in
its Dune .>>. report. -easured by market values, the net foreign investment position of
the 0nited %tates remained positive until .>9?, and reached minus 6;=5.= billion in .>>5,
about <5 percent smaller than the number computed on an historic cost basis.
At the end of .>>5, about .= percent of foreign assets in the 0nited %tates were owned by
foreign governments, while 9< percent were privately owned. '%imilarly, .< percent of
foreign assets owned by the 0nited %tates were official, and 9= percent were private.(
"n contrast, as a share of total investment, 0. %. direct investment abroad 'comprising
equity holdings of .5 percent or more of any firm( is substantially larger than foreign
direct investment abroad still e!ceeded .>>5, and by a wider margin than in .>97--6.9<
billion versus 6.73 billion.
Kespite the notoriety of Dapanese investors, the :ritish have the largest 0. %. direct
investment holdingCwith the Kutch not far behindCas has been the case since colonial
times. "n .>>5 the 0nited Aingdom held about 3? percent of foreign direct investment in
the 0nited %tates, significantly greater than Dapans 3. percent. The 2uropean 2conomic
ommunity '2( collectively holds about 7? percent. -oreover, according to research by
2ric @osengren, between .>?9 and .>9?, Dapanese investors acquired only >< 0. %.
73
companies, putting them fifth behind the :ritish '=<5(, anadians '<;7(, Eermans '.75(,
and French '..;(.
*hy $o foreigners Invest in the 0nited &tates>
Bith no restrictions on movements of labor or capital, each tends to flow to any host
country where wages or returns are higher than at home. Kuring the eighties laborers
migrated to western 2urope from eastern 2urope, southern 2urope, and Turkey, and to
the Arab Eulf states from Africa and southern Asia because of higher wages. apital
migrated to the 0nited %tates because of higher returns. The 0. %. stock markets annual
appreciation of over .7 'not counting dividends( was e!ceeded among the ma1or Bestern
industrial countries only by the Dapanese stock markets rise of nearly 35 percent. "n
comparison, average stock market increases were 7 percent in anada, about .. percent
in France .3 percent in Eermany, .< percent in "taly, and .3 percent in the 0nited
Aingdom.
Ta! differences also influence international capital flows. :oth defenders and critics of
the @eagan administrations .>9. ta! cuts agree that they caused increased capital
inflows during the eighties. Kefenders argue that 0. %. investments became more
profitable after ta! than non-0. %. investments, both to 0. %. investors and to foreign
investors, while critics argue that large federal deficits drew the capital inflows.
onsistent with the defenders view, 0. %. investors were selling off foreign assets in the
early eighties to finance domestic investment. 0. %. direct investment abroad, valued at
historic cost, declined from .>9. to .>9<$ in market value it declined during .>9; and
.>9<. orrespondingly, 0. %. nonresidential fi!ed investment rose substantially in .>9;
and .>9< and peaked in .>97, following publication of the 0. %. Treasurys ta! reform
proposals in the fall of .>9<. "n .>97 0. %. direct investment abroad began to rise again.
-eanwhile, foreign investment in the 0nited %tates grew somewhat faster in the early
eighties than in the late eighties. #igher ta! rates on capital gains became effective in
.>9=, and from the end of .>97, the rise in 0. %. foreign direct investment has e!ceeded
that of foreign direct investment in the 0nited %tates. -oreover, the pattern of the rise
and fall of the 0. %. dollarCappreciating between .>95 and .>97 and depreciating from
.>97 to .>9?Ci9s also consistent with the defenders view.
The 0nited %tates attracts capital not only because of lower ta!es, but also because of
greater 0. %. consumer wealth and labor productivity. At purchasing power parityCEK+
ad1usted for differences in e!change rates and pricesC0. %. wealth 'per capita EK+( was
one-fourth greater than Dapans in .>>5 and one-third greater than Eermanys. -oreover,
e!cept for Dapan the other main industrial countries did not narrow this margin between
.>95 and .>>5. 4n a production-per-employee basis, the message is the same& 0. %. labor
is the most productive in the world.
Is Foreign Investment ,ood or (ad>
7;
Foreign investment increases the amount of capitalCequipment, buildings, land, patents,
copyrights, trademarks, and goodwillCin the host economy. The increase in the quantity
and quality of tools for labors use in converting one set of goods 'labor and other inputs(
into another 'finished output( raises labor productivity and EK+. :ecause about two-
thirds of EK+ goes to labor as wages, salaries, and fringe benefits, rising output means
higher wages or more employment. Thus, foreign investment raises labor productivity,
income, and employment. Borkers are better off with more capital than with less and are
usually indifferent to the nationality of the investor.
+oliticians generally overlook labors benign attitude toward foreign capital, sometimes
at their peril. "n the .>99 presidential campaign the Kemocratic candidate, -ichael
Kukakis, told a group of workers at a %t. /ouis automotive parts plant& )-aybe the
@epublican ticket wants our children to work for foreign ownersTbut thats not the kind
of a future /loyd :entsen and " and Kick Eephardt and you want for American.*
Kukakiss advance staff failed to tell him that the workers Kukakis was addressing had
been employed by an "talian corporation for eleven years.
*hat !re the #ong-'erm Conse?uences of Foreign Investment in the 0nited
&tates>
The availability of foreign capital lowers the cost of capital to corporations. This makes
additions to plant and equipment cheaper, permits some investment pro1ects that
otherwise would not be profitable, and raises the value of firms. Thus, even though most
foreign capital inflows do not substantively alter the ownership of 0. %. firms, they
benefit asset owners as well as labor by lowering interest rates and the cost of capital.
Get some critics, such as -artin and %usan Tolchin, warn of desperate long-run
consequences from foreign capital even while conceding its short-run benefits. They
worry about loss of skilled employment opportunities, loss of technological advantage,
slower growth, and a declining standard of living. All of these worries are based on two
implicit assumptions. First, they assume that foreigners will obtain control of the 0. %.
economy. %econd, they assume that, unlike 0. %. investors abroad, foreigners will use
this control to systematically reduce the efficiency of the host economy. :oth
assumptions are false.
The probability of foreign investors obtaining control of the 0. %. economy is negligible.
:etween .>93 and .>9>, according to estimates by the 0. %. ommerce Kepartment, the
0. %. stock of nonresidential capital rose from 67.> trillion to 69.< trillion. At the end of
.>9>, the 0. %. net international investment position was estimated to be - 63=?.? billion,
or only ;.3 percent of this capital stock.
2ven sustained net capital inflows of 6.55 billion per year, as happened during the
mideighties, would not shift control of the 0. %. capital stock to foreigners. At that rate
foreign investors share of the fi!ed 0. %. capital stock would rise to about 9.< percent in
the year 3555, but decline to ?.9 percent in 35.5 and to 3.9 percent in 3535.
7<
The second concern is finessed by competitive forces in a market-based capitalist
economy. "f foreign owners of a 0. %. firm reduced its efficiency by not using employees
in the most advantageous way, the owners would lose wealth. They also would lose
employees and, eventually, the firm. /abor, management, and technology would be hired
away by other e!isting firms or by new firms eager to use them in the most profitable
way feasible. The firms decline in market valueCdue to the inefficiency of its
incumbent managementCalso would make it an attractive takeover target, as its price
would be lower than its value under efficient resources utili,ation. 2ither way, foreign
owners could not sub1ugate an industry through perverse management, even if they were
willing to sacrifice profits to do so.
77
.7 Foreign )xchange Mar.ets
2ach country in the world has its own currency. Bhen individuals or firms import a good
or service they need to purchase the currency of the e!porting country. 2qually e!porting
firms generally e!pect to be paid in their own currency. "n some cases e!porting firms
would prefer to be paid in a hard currency i.e. one that is generally acceptable world-
wide. #owever, in most cases importing and e!porting can only operate effectively if
there is a system whereby countries can e!change currencies. The foreign e!change
market enables this to happen. The foreign e!change market is made up of all the
institutions that buy and sell foreign currencies. "ndeed when you buy foreign currency
prior to going on holiday at the bank you are involved in transactions on the foreign
e!change market. Gour bank must buy the currency of the country you are intending to
visit at the relevant e!change rate. A currencys e!change rate represents the value of a
countrys currency e!pressed in terms of another countrys currency.
The rate at which a countrys currency can be e!changed for that of another countrys is a
very important factor when considering the trading position of a country. There are two
systems that can determine the value of a countrys currency&
A fi!ed e!change rate system where a countrys government determines the
value.
A floating e!change rate regime where the value of the currency is determined
by supply and demand for the foreign currency.
"n addition there are a number of intermediate systems. For e!ample, the e!change rates
were allowed to float or be market determined between a ceiling and a floor.
Fixed )xchange ates
Bith a fi!ed e!change rate system the government, often acting through its agent the
entral :ank, fi!es or pegs the value of the currency to another currency such as the 0%
dollar. 4fficial e!change rates are then usually quoted in terms of 0% dollars. "t shows
the value of 0% dollars in terms of another countrys currency and vice versa.
"f the pegged value coincides with the equilibrium price for foreign e!change there is no
need for the government to act. The problem arises when the foreign e!change market go
into disequilibrium.
Bhere e!cess demand for foreign currency e!ists the central banks have three options
open to them if the official e!change rate is to be maintained&
They can accommodate the shortage by using up reserves of foreign currency
or borrowing foreign currency from overseas incurring foreign debt.
They can deal with the balance of payments deficit through reducing the
demand for imports such as operating protectionist measures such as tariffs,
quotas and licences.
7=
They can attempt to ration the amount of foreign e!change made available to
those people they consider should have it through e!change controls.
Floating )xchange ates
Bith a floating system the e!change rate between the local currency and a foreign
currency is determined when the demand for and available supply of foreign currency is
the same. Bhen the economy is e!periencing a balance of payments deficit and there is
e!cess demand for the foreign currency the e!change rate of the local currency falls or
depreciates. This may have the effect of automatically restoring equilibrium. "n this case
the foreign currency value of e!ports falls making them less attractive locally. :oth could
lead to an improvement in the balance of payments situation.
"f however there is a balance of payments surplus and an e!cess supply of foreign
currency the value of the local currency will rise, again restoring a balance in the foreign
e!change market and the balance of payments.
Any changes in the conditions of demand and supply of foreign currency such as a
change in the demand for imports and e!ports or change in capital flows, such as foreign
direct investment from multinationals, will bring about a change in the market e!change
rate.
"f the demand for foreign currency increases, the demand curve for foreign currency
shifts to the right from K. to K3. The effect of this will be for the value of the foreign
currency to appreciate.
:alance of payments deficits caused by increases in the demand for foreign currency or
reductions in the available supply of it will always lead to a depreciation of the value.
)ffects of a Floating )xchange ate &ystem
!rguments in favor of floating exchange rates
.. :alance of +ayments on current account disequilibrium will automatically be restored
to equilibrium.
Thus, in theory, governments need not worry about having to manage their balance of
payments situation. "f the e!change rate is allowed to fluctuate freely any disequilibrium
will automatically be restored to equilibrium. The need to resort to overseas borrowing to
finance balance of payments deficits is therefore less. The attention of government can
then be focused on achieving other government ob1ectives such as inflation,
unemployment, economic growth and poverty reduction.
3. @educes inflationary pressures and international uncompetitiveness
7?
4ne argument is that a floating e!change rate will reduce the level of inflation. Allowing
the e!change rate to float freely should ensure that e!ports do not become uncompetitive.
This is embodied in the +urchasing +ower parity theory. A high rate of inflation would
tend to make e!ports uncompetitive. Their demand would fall and the foreign e!change
flowing into the country would also fall. The supply curve of available foreign currency
would in turn shift to the left causing its value to increase. This would lower the price of
e!ports making them more competitive.


79
.? )?uilibrium !nalysis
"n many aspects of economic analysis, we tend to assume that a condition of equilibrium
e!ists with respect to key economic variables. ommon e!amples include different
models of market behavior known as %upply and Kemand analysis.
"n these models of the market, we define the behavior or sellers based on the goal of
profit ma!imi,ation in the production andMor sale of a particular good. #igher selling
prices allow a traderMseller to reap a gain over and above the price initially paid for a final
good or asset. "n the case of business firms, the production of additional units of a
particular good involve increasing opportunity costs in drawing resource inputs away
from other productive uses. #igher prices are necessary to cover these increasing costs of
production. Thus, these types of behaviors on the selling side of the market typically lead
to a positive relationship between market price 'the dependent variable( and quantity
supplied 'the independent variable(.
%eparately, we define the behavior of buyers based on the goal of ma!imi,ing the utility
gained from the purchase and consumption of this same good. As prices fall, holding
income constant, the buyer finds that hisMher purchasing power has increased allowing for
buying greater quantities of a particular good. "t is also the case that, for the consumer,
additional quantities of a good consumed provide less additional satisfaction relative to
previous units consumed. This notion known as diminishing marginal utility implies that
the consumer is willing to pay less for these additional units as it becomes more efficient
to use hisMher income for the purchase of other goods. For the buyer, these types of
behaviors typically lead to a negative relationship between the market price 'dependent
variable( and quantity demanded 'another independent variable(.
These relationships are demonstrated numerically in the table and graphically in the
diagram in Figure .. +ress any of the U+lot buttons.
Figure . S %upply and Kemand
-arket Ruantity Ruantity %urplusM
+rice Kemanded %upplied %hortage
69.55 =.5 .=.5 - .5.5
6?.55 >.5 .<.5 - 7.5
6=.55 .3.5 .3.5 5.5
67.55 .7.5 .5.5 7.5
6<.55 .9.5 9.5 .5.5
"n these models, we assume that one unique price e!ists such that the Ruantity %upplied
by sellers is e!actly equal to the Ruantity Kemanded by buyers. This unique price +V is
defined to be the equilibrium price.
7>
Figure 3 S A %imple -arket -odel
+rice
%upply
A
+V
Kemand
4 RV
RMtime
The %upply and Kemand framework represents an analytic tool that assists in the
understanding of how markets operate. 2ach curve represents the separate behavior of the
sellers '%upply( and the behavior of buyers 'Kemand( in a particular market.
This notion of 2quilibrium tends to be a rather strong assumption in these economic
models.
"n the physical world we often observe equilibrium conditions or situations resulting from
the influence of physical laws. For e!ample& a piece of chalk resting on a table is in
equilibrium. This situation is the result of the effects of gravity and the e!istence of a flat
and level surface. Eravity helps to maintain and even restore this equilibrium condition if
this position of rest is disturbed. "n our market models, we need to ask is& where does the
gravity come from to establish and maintain an equilibrium price? The answer is in the
reaction of sellers and buyers to disturbances in the market.
For e!ample, it could be the case that the market price has been forced above equilibrium
such that supply decisions by +roducers with respect to output e!ceed the amount
demanded by consumers. "n this case a surplus is the result. This surplus is often first
recogni,ed by the sellers through the accumulation of inventories.
These sellers would react by cutting the price of their product relative to competing
sellers 'price-cutting is how sellers compete( and by reducing the rate of production.
O+ress +rice Ad1ustmentP :uyers would react to the presence of lower prices by
increasing their rate of consumption. This process would be e!pected to continue until the
e!cess inventories have been eliminated.
"f the market price differed from the equilibrium price such that the quantity demanded
e!ceeded the quantity supplied, a different disequilibrium condition known as a shortage
would result. 4ften, but not always, shortages are first recogni,ed by buyers in the form
of empty shelves, queuing, and general difficulty in making a desired purchase.
=5
These consumers react by bidding prices up in competition with other buyers 'bidding is
how buyers compete( much like an auction for a single piece of art. As these prices are
bid upwards, some buyers drop out of the market reducing the overall rate of
consumption. O+ress +rice Ad1ustmentP %ellers react to the presence of higher prices by
allocating resource inputs from other uses towards production of this particular good.
Thus in our models of the market place. ompetition provides the gravity to maintain or
restore the equilibrium price. if surpluses e!ist, competition among sellers force prices
downwards. "f shortages e!ist, competition among buyers force prices upwards.
"n typical market models surpluses are the result of market prices e!ceeding the
equilibrium prices such that price-cutting behavior helps restore this equilibrium price.
shortages are the result of market prices taking values below the equilibrium price such
that bidding restores the equilibrium price.
"n reality, surpluses and shortages are caused by changes or shifts in either the demand or
supply functions. These shifts are the result of shocks to other 'e!ogenous( variables that
affect supply decisions by producers or demand decisions by consumers. Typically,
outward shifts in demand will lead to an increase n both the equilibrium price and
quantity due to movement along an upward sloping supply curve. "nward shifts of
demand will have the opposite effect 'a decrease in equilibrium quantity and price(.
outward shifts in supply 'along a downward sloping demand curve(will lead to an
increase in equilibrium quantity and a reduction in equilibrium price.
=.
.9 How 'ariffs )ffect 'he )conomy
The upcoming book Advanced "nternational Trade& Theory and 2vidence by @obert
Feenstra gives three situations in which governments often impose tariffs&
To protect fledgling domestic industries from foreign competition.
To protect aging and inefficient domestic industries from foreign competition.
To protect domestic producers from dumping by foreign companies or
governments.
Kumping occurs when a foreign company charges a price in the domestic market
which is )too low*. "n most instances )too low* is generally understood to be a
price which is lower in a foreign market than the price in the domestic market. "n
other instances )too low* means a price which is below cost, so the producer is
losing money.
The cost of tariffs to the economy is not trivial. The Borld :ank estimates that if all
barriers to trade such as tariffs were eliminated, the global economy would e!pand by
9;5 billion dollars by 35.7. The economic effect of tariffs can be broken down into two
components&
The impact to the country which has a tariff imposed on it.
The impact to the country imposing the tariff.
"n almost all instances the tariff causes a net loss to the economi9es of both the country
imposing the tariff and the country the tariff is imposed on.
Impact to the economy of a country with the tariff imposed on it3
"t is easy to see why a foreign tariff hurts the economy of a country. A foreign tariff
raises the costs of domestic producers, which causes them to sell less in those foreign
markets. +roducers cut production due to this reduction in demand, which causes 1obs to
be lost. These 1ob losses impact other industries as the demand for consumer products
decreases because of the reduced employment level. Foreign tariffs, along with other
forms of market restrictions, cause a decline in the economic health of a nation.
'he )ffect of 'ariffs on the Country Imposing 'hem
2!cept in all but the rarest of instances, tariffs hurt the country that imposes them, as their
costs outweigh their benefits. Tariffs are a boon to domestic producers who now face
reduced competition in their home market. The reduced competition causes prices to rise.
The sales of domestic producers should also rise, all else being equal. The increased
production and price causes domestic producers to hire more workers which causes
consumer spending to rise. The tariffs also increase government revenues that can be
used to the benefit of the economy.
=3
There are costs to tariffs, however. Fow the price of the good with the tariff has
increased, the consumer is forced to either buy less of this good or less of some other
good. The price increase can be thought of as a reduction in consumer income.
Eenerally the benefit caused by the increased domestic production in the tariff protected
industry plus the increased government revenues does not offset the losses the increased
prices cause consumers and the costs of imposing and collecting the tariff. Be havent
even considered the possibility that other countries might put tariffs on our goods in
retaliation, which we know would be costly to us. 2ven if they do not, the tariff is still
costly to the economy. Tariffs cause consumers to alter their behavior which in turn
causes the economy to be less efficient. Adam smiths The ealth of !ations showed
how international trade increases the wealth of an economy. Any mechanism designed to
slow international trade will have the effect of reducing economic growth. For these
reasons economic theory teaches us that tariffs will be harmful to the country imposing
them.
Thats how it should work in theory. #ow does it work in practiceH
)mpirical )vidence on the )ffect of 'ariffs on the Country Imposing 'hem
%tudy after study has shown that tariffs cause reduced economic growth to the country
imposing them. A few of e!amples&
.. The essay on Free Trade at The oncise 2ncyclopedia of 2conomics looks at the issue
of international trade policy. "n the essay, Alan :linder states that )one study estimated
that in .>9< 0. %. consumers paid 6<3,555 annually for each te!tile 1ob that was
preserved by import quotas, a sum that greatly e!ceeded the average earnings of a te!tile
worker. That same study estimated that restricting foreign imports cost 6.57,555
annually for each automobile workers 1ob that was saved, 6<35,555 for each 1ob in TI
manufacturing, and 6?75,555 for every 1ob saved in the steel industry.*
3. "n the year 3555 president :ush raised tariffs on imported steel goods between 9 and
;5 percent. The -achinac enter for +ublic +olicy cities a study which indicates that the
tariff will reduce 0. %. national income by between 5.7 to ..< billion dollars. The study
estimates that less than .5,555 1obs in the steel industry will be saved by the measure at a
cost of over 6<55,555 per 1ob saved. For every 1ob saved by this measure, 9 will be lost.
;. The cost of protecting these 1obs is not unique to the steel industry or to the 0nited
%tates. The Fational enter For +olicy Analysi9s estimates that in .>>< tariffs cost the 0.
%. economy ;3.; billion dollars or 6.?5,555 for every 1ob saved. Tariffs in 2urope cost
2uropean consumers 6?5,555 per 1ob saved while Dapanese consumers lost 6=55,555 per
1ob saved through Dapanese tariffs.
These studies, like many others, indicate that tariffs do more harm than good. "f these
tariffs are so bad for the economy, why do governments keep enacting themH
=;
If 'ariffs !re (ad For 'he )conomy2 *ho $o *e Have 'hem>
&tudy after study has shown that tariffs2 whether they be one tariff or hundreds2 are
bad for the economy3 If tariffs do not help the economy2 why would a politician
enact one3 !fter all politicians are reelected at a greater rate when the economy is
doing well2 so you would thin. it would be in their self interest to prevent tariffs3
@ecall that tariffs are not harmful for everyone, and they have a distributive effect. %ome
people and industries gain when the tariff is enacted and others lose. The way gains and
losses are distributed is absolutely crucial in understanding why tariffs along with many
other policies are enacted. To understand the logic behind the policies we need to
understand The /ogic of ollective Action. -y article titled The /ogic of ollective
Action discusses the ideas of a book by the same name, written by -ancur 4lson in
.>=7.
4lson e!plains why economic policies are often to the benefit of smaller groups at the
e!pense of larger ones. Take the e!ample of tariffs placed on imported anadian
softwood lumber. Bell suppose the measure saves 7,555 1obs, at the cost of 6355,555
per 1ob, or a cost of . billion dollars to the economy. This cost is distributed through the
economy and represents 1ust a few dollars to every person living in America. "t is obvious
to see that its not worth the time and effort for any American to educate himself about
the issue, solicit donations for the cause and lobby congress to gain a few dollars.
#owever, the benefit to the American softwood lumber industry is quite large. The ten-
thousand lumber workers will lobby congress to protect their 1obs along with the lumber
companies that will gain hundreds of thousands of dollars by having the measure enacted.
%ince the people who gain from the measure have an incentive to lobby for the measure,
while the people who lose have no incentive to spend the time and money to lobby
against the issue, the tariff will be passed although it may, in total, have negative
consequences for the economy.
The gains from tariff policies are a lot more visible than the losses. Gou can see the
sawmills which would be closed down if the industry is not protected by tariffs. Gou can
meet the workers whose 1obs will be lost if tariffs are not enacted by the government.
%ince the costs of the policies are distributed far and wide, you cannot put a face on the
cost of a poor economic policy. Although 9 workers might lose their 1ob for every 1ob
saved by a softwood lumber tariff, you will never meet one of these workers, because it is
impossible to pinpoint e!actly which workers would have been able to keep their 1obs if
the tariff was not enacted. "f a worker loses his 1ob because the performance of the
economy is poor, you cannot say if a reduction in lumber tariffs would have saved his
1ob. The nightly news would show a picture of a alifornia farm worker and state that he
lost his 1ob because of tariffs designed to help the lumber industry in -aine. The link
between the two is impossible to see. The link between lumber workers and lumber
tariffs is much more visible and thus will garner much more attention.
=<
The gains from a tariff are clearly visible but the costs are hidden, it will often appear that
tariffs do not have a cost. :y understanding this we can understand why so many
government policies are enacted which harm the economy.
=7
.> Protectionism
The fact that trade protections hurts the economy of the country that imposes it is one of
the oldest but still most startling insights economics has to offer. The idea dates back to
the origin of economic science itself. Adam %miths The Bealth of Fations, which gave
birth to economics, already contained the argument for free trade& by speciali,ing in
production instead of producing everything, each nation would profit from free trade. "n
international economics it is the direct counterpart to the proposition that people within a
national economy will all be better off if all people speciali,e at what they do best instead
of trying to be self-sufficient.
"t is important to distinguish between the case for free trade for oneself and the case for
free trade to improve one nations own welfare 'the so-called )national-efficiency*
argument(. The latter is an argument for free trade to improve every trading countrys
welfare 'the so-called )cosmopolitan efficiency* argument(. 0nderlying both cases is the
assumption that price are determined by free markets. :ut government may distort
market prices by, for e!ample, subsidi,ing production, as 2uropean governments have
done in aerospace, electronics, and steel in recent years, and as all industrial countries do
in agriculture. 4r governments may protect intellectual property inadequately, causing
underproduction of new knowledge. "n such cases production and trade, guided by
distorted prices, will not be efficient.
The cosmopolitan-efficiency case for free trade is relevant to questions such as the design
of international trade regimes. For e!ample, the Eeneral Agreement on Tariffs and Trade
oversees world trade among member nations, 1ust as the "nternational -onetary Fund
oversees international macroeconomics and e!change rates. The national efficiency case
for fee trade concerns national trade policies$ it is, in fact, Adam %miths case for free
trade. 2conomists typically have the national efficiency case in mind when they talk of
the advantage of free trade and of the folly of protectionism.
This case, as refined greatly by economists in the postwar period, admits two theoretical
possibilities in which protection could improve a nations economic wellbeing. First, as
Adam %mith himself noted, a country might be able to use the threat of protection to get
other countries to reduce their protection against its e!ports. Thus, threatened protection
could be a tool to pry open foreign markets, like oysters, with a )strong clasp knife,* as
/ord @andolph hurchill put it in the late nineteenth century. "f the protectionist threat
worked, then the country using it would gain doubly& from its own free trade and from its
trading partners free trade as well. #owever, both %mith and later economists in :ritain
feared that such threats would not work. They feared that the protection imposed as a
threat would be permanent and that the threat would not lower the other countries trade
barriers.
The trade policy of the 0% today is premised on a different assessment& that indeed 0%
markets can, and should, be closed as a means of opening new markets abroad. This
premise underlies sections ;5. through ;.5 of the .>99 4mnibus Trade and
==
ompetitiveness Act. These provisions permit, and sometimes even require, the 0%
government to force other countries into accepting new trade obligations by threatening
tariff retaliation if they do not. :ut those )trade obligations& do not always entail freer
trade. They can, for instance, take the form of voluntary quotas on e!ports of certain
goods to the 0%. Thus, they may simply force weak nations to redirect their trade in
ways that strong nations desire, cutting away at the principle that trade should be guided
by market prices.
The second e!ception in which protection could improve a nations economic well-being
is when a country has monopoly power over a good. %ince the time of Dohn %tuart -ill,
economists have argued that a country that produces a large percentage of the worlds
output of a good can use an )optimum* tariff to take advantage of its latent monopoly
power and, thus, gain more from trade. This is, of course, the same as saying that a
monopolist will ma!imi,e his profits by raising his price and reducing his output.
Two ob1ections to this second argument immediately come to mine. First, with rare
e!ceptions such as 4+2, few countries seem to have significant monopoly power in
enough goods to make this an important, practical e!ception to the rule of free trade.
%econd, other countries might retaliate against the optimum tariff. Therefore, the
likelihood of successful 'i.e., welfare-increasing( e!ploitation of monopoly power
becomes quite dubious. %everal economists have recently made their academic
reputations by finding theoretical cases in which oligopolistic markets enable
governments to use import tariffs to improve national welfare, but even these researchers
have advised strongly against protectionist policies.
4ne may well think that any market failure could be a reason for protection. 2conomist
did fall into this trap until the fifties. 2conomists now argue, instead, that protection
would be an inappropriate way to correct for most market failures. For e!ample, if wages
do not ad1ust quickly enough when demand for an industrys product falls, as was the
case with 0% autoworkers losing out to foreign competition, the appropriate government
intervention, if any, should be in the labor market, directly aimed at the source of the
problem. +rotection would be, at best, an inefficient way of correcting for the market
failure.
-any economists also believe that even if protection were appropriate in theory, it would
be )captured* in practice by special interests who would misuse it to pursue their special
interests who would misuse it to pursue their own interests instead of letting it be used for
the national interest. 4ne clear cost of protection is that the country imposing it forces its
consumers to forgo cheap imports. :ut another important cost of protection may well be
the lobbying costs incurred by those seeking protection. These lobbying activities, now
e!tensively studied by economist, are variously described as rent-seeking or directly
unproductive profit-seeking activities. They are unproductive because they produce
profit or income for those who lobby without creating valuable output for the rest of
society.
=?
+rotectionism arises in ingenious ways. As free trade advocates squelch it in one place, it
ops up in another. +rotectionist seem to always be one step ahead of free traders in
creating new ways to protect against foreign competitors.
4ne way is by replacing restrictions on imports with what are euphemistically called
)voluntary* e!port restrictions 'I2@s( or )orderly* market arrangements '4-As(.
"nstead of the importing country restricting imports with quotas or tariffs, the e!porting
country restricts e!ports. The protectionist effect is still the same. The real difference,
which makes e!porting nations prefer restrictions on e!ports to restrictions on imports, is
that the I2@s enable the e!porters to charge higher prices and thus collect for themselves
the higher prices caused by protection.
That has been the case with Dapans voluntary quotas on e!ports of cars to the 0%. The
0% could have kept Dapanese car imports in check by slapping a tariff on them. That
would raise the price, so that consumers would buy fewer. "nstead, Dapan limits the
number of cars shipped to the 0%. %ince supply is lower than it would be in the absence
of the quotas, Dapanese auto producers to find the funds to make investments that made
them yet more competitiveW
The growth of I2@s in the eighties is a disturbing development for a second reason as
well. They selectively target suppliers 'in this case Dapan( instead of letting the market
decide who will lose when trade must be restricted. As an alternative, the 0% could have
provided 1ust as much protection for domestic automakers by putting a quota or tariff on
all foreign cars, letting consumers decide whether they wanted to buy fewer Dapanese cars
or fewer 2uropean ones. Bith I2@s, in other words, politics replaces economic
efficiency as the criterion determining who trades what.
+rotectionism recently has come in another, more insidious form than I2@s. 2conomists
call the new form )administered protection.* Fearly all industriali,ed countries today
have what are called )fair trade* laws. The stated purpose of these laws is twofold& to
ensure that foreign nations do not subsidi,e e!ports 'which would distort market
incentives and hence destroy efficient allocation of activity among the worlds nations(
and to guarantee predatory fashion. Fations, therefore, provide for procedures under
which, when subsidi,ation or dumping is found to occur, a countervailing duty 'IK(
against foreign subsidy or an antidumping 'AK( duty can be levied. These two )fair
trade* mechanisms are meant to complement free trade.
"n practice, however, when protectionist pressures rise, )fair trade* is misused to work
against free trade. Thus, IK and AK actions often are started against successful foreign
firms simply to harass them and coerce them into accepting I2@s. +ractices which are
thoroughly normal at home are proscribed as predatory when foreign firms engage in
them. As one trade analyst put it, )"f the same anti-dumping laws applied to 0%
companies, every after hristmas sale in the country would be banned.*
-uch economic analysis shows that in the eighties )fair trade* mechanisms turned
increasingly into protectionist instruments used unfairly against foreign competition. 0%
=9
rice producers got a countervailing duty imposed on rice from Thailand, for e!ample, by
establishing that the Thai government was subsidi,ing rice e!ports by less than . percent-
and ignoring the fact that Thailand also slapped a 7 percent ta! on e!ports. Be usually
think a foreign firm is dumping when it sells at a lower price in our market than in its
own. :ut the 0% government took an antidumping action against +olands e!ports of
golf carts even though no golf carts were sold in +oland.
Therefore, economists have thought increasingly about how these )fair trade*
mechanisms can be redesigned so as to insulate them from being )captured* and misused
by special interest. "deas include the creation of binational, as against purely national,
ad1udication procedures that would ensure greater impartiality, as in the 0%-anada Free
Trade Agreement. Also, greater use of EATT dispute settlement procedures, and readier
acceptance of their outcomes, has been recommended.
"ncreasingly, domestic producers have labeled as )unfair trade* a variety of foreign
policies and institutions. Thus, those who find Dapanese commercial success hard to take
have ob1ected to its retail distribution system, its spending on infrastructure, and even its
work habits. 4pponents of the 0%--e!ico Free Trade Agreement have claimed that free
trade between the two nations cannot be undertaken because of differences in -e!icos
environmental and labor standards. The litany of ob1ections to gainful, free trade from
these alleged sources of )unfair trade* 'or its evocative synonym, )the absence of level
playing fields*( is endless. #ere lies a new and powerful source of attack on the
principles of free trade.
=>
35 'he @A"52555 &teelwor.er
"n even-numbered years, particularly years evenly divisible by <, politicians are
apt to give speeches about the need to protect 0. %. 1obs from the evils of foreign
competition3 Be are thus encouraged to buy American. "f further encouragement is
needed, we are told that if we do not voluntarily reduce the amount of imported goods we
purchase, the government will impose 'or make more onerous( either tariffs 'ta!es( or
imported goods or ?uotas 'quantity restrictions( that physically limit imports3 The
ob1ective is to save 0. %. 1obs.
0nlike black rhinos or blue whales, 0. %. 1obs are in no danger of becoming
e!tinct. There are an infinite number of potential 1obs in the American economy, and
there always will be. %ome of these 1obs are not very pleasant, and many others do not
pay very well, but there will always be employment of some sort as long as there is
scarcity3 Thus when a steelworker making 6?3,555 per year says that imports of foreign
steel should be reduced to save his 1ob, what he really means is this& #e wants to be
protected from competition so he can continue his present employment at the same or
higher salary rather than move to a different employment that has less desirable working
conditions or pays a lower salary. There is nothing wrong with the steelworkers goal
'better working conditions and higher pay(, but it has nothing to do with saving 1obs.
"n any discussion of the consequences of restrictions on international trade, it is
essential to remember two facts. First, we pay for imports with exports. "t is true that in
the short run, we can sell off assets or borrow from abroad if we happen to import more
goods and services than we e!port. :ut we have only a finite amount of assets to sell, and
foreigners do not want to wait forever before we pay our bills. 0ltimately, our accounts
can be settled only if we provide 'e!port( goods and services to the trading partners from
whom we purchase 'import( goods and services. Trade, after all, involves quid pro quo
'literally, something for something(. The second point to remember is that voluntary trade
is mutually beneficial to the trading partners. "f we restrict international trade, we reduce
those benefits, both for our trading partners and for ourselves. 4ne way these reduced
benefits are manifested is in the form of curtailed employment opportunities for workers.
"n a nutshell, even though tariffs and quotas enhance 1ob opportunities in import-
competing industries, they also cost us 1obs in e!port industries$ the net effect seems to be
reduced employment overall.
Bhat is true for the 0nited %tates is also true for other countries& They will buy
our goods only if they can market theirs, because they too have to e!port goods to payfor
their imports. Thus any 0. %. restrictions on importsCvia tariffs, quotas, or other means
Cultimately cause a reduction in our e!ports, because other countries will be unable to
pay for our goods. #ence import restrictions must inevitably decrease the si,e of our
e!port sector. %o imposing trade restrictions to save 1obs in import-competing industries
has the effect of costing 1obs in e!port industries.
"mport restrictions also impose costs on 0. %. consumers. :y reducing
competition from abroad, quotas, tariffs, and other trade restraints push up the prices of
foreign goods and enable 0. %. producers to hike their own prices. +erhaps the best-
documented e!ample of this is the automobile industry.
Kue in part to the enhanced quality of imported cars, sales of domestically
produced automobiles fell from > million units in .>?9 to an average of = million units
?5
per year between .>95 and .>93. Profits for 0. %. automobile manufacturers plummeted
as well, turning into substantial losses for some of them .0. %. automakers and
autoworkers unions demanded protection from import competition. They were 1oined in
their cries by politicians from automobile-producing states. The result was a voluntary
agreement by Dapanese car companies 'the most important competitors of 0. %. firms(
that restricted 0. %. sales of Dapanese cars to ..=9 million units per year. This agreement
Cwhich amounted to a quota even though it never officially bore that nameCbegan in
April .>9. and continued into the .>>5s in various forms.
@obert B. randall, an economist with the :rookings "nstitution, has estimated
how much this voluntary trade restriction has cost 0. %. consumers in terms of higher
care prices. According to his estimates, the reduced supply of Dapanese cars pushed their
prices up by 6.,=55 apiece, measured in 3557 dollars. The higher price of Dapanese
imports in turn enabled domestic producers to hike their prices an average of 6=<5 per
car. The total tab in the first full year of the program was about 6? billion. randall also
estimated the number of 1obs in automobile-related industries that were saved by the
voluntary import restrictions at about 3=,555. Kividing 6? billion by 3=,555 1obs yields a
cost to consumers of about 63?7,5555 per year for every 1ot saved in the automobile
industry. 0. %. consumers could have saved over 63 billion on their car purchases each
year if instead of implicitly agreeing to import restrictions, they had simply given
6?7,555 to every autoworker whose 1ob was preserved by the voluntary import restraints.
The same types of calculations have been made for other industries. Tariffs in the
apparel industry were increased between .>?? and .>9., saving the 1obs of about
..=,555 0. %. apparel workers at a cost of 6<7,555 per 1ob each year. At about the same
time, the producers of citi,ens ban radios also managed to get tariffs raised.
Appro!imately si! hundred workers in the industry kept their 1obs as a result, at an
annual cost to consumers of over 697,555 per 1ob.
The cost of protectionism has been even higher in other industries. Dobs preserved
in the glassware industry due to trade restrictions cost 6355,555 apiece each year. "n the
maritime industry, the yearly cost of trade protection is 63?5,555 per 1ob. "n the steel
industry, the cost of preserving a 1ob has been estimated at an astounding 6?75,555 per
year. "f free trade were permitted, each worker losing a 1ob could be given a cash
payment of half that amount each year, and consumers would still save a lot of money.
2ven so, this is not the full story. Fone of these studies estimating the cost to
consumers of saving 1obs in import-competing industries have attempted to estimate the
ultimate impact of import restrictions on the flow of e!ports, the number of 1obs lost in
the e!port sector, and thus the total number of 1obs gained or lost.
Bhen imports to the 0nited %tates are restricted, our trading partners can afford to
buy less of what we produce. The resulting decline in e!port sales means fewer 1obs in
e!porting industries. And the total reduction in trade leads to fewer 1obs in e!porting
industries. And the total reduction in trade leads to fewer 1obs for workers such as
stevedores 'who unload ships( and truck drivers 'who carry goods to and from ports(. 4n
both countsCthe overall cut in trade and the accompanying decline in e!portsC
protectionism leads to 1ob losses that might not be obvious immediately.
%everal years ago, ongress tried to pass a domestic content bill for automobiles.
"n effect, the legislation would have required that cars sold in the 0nited %tates have a
minimum percentage of their components manufactured and assembled in this country.
?.
+roponents of the legislation argued that it would have protected three hundred thousand
1obs in the 0. %. automobile manufacturing and auto parts supply industries. Get the
legislations supporters failed to recogni,e the negative impact of the bill on trade in
general and its ultimate impact on 0. %. e!port industries. A 0. %. Kepartment of /abor
study did recogni,e these impacts, estimating that the domestic content legislation would
actually cost more 1obs in trade-related and e!port industries than it protected in import-
competing businesses. ongress ultimately decided not to impose a domestic content
requirement for cars sold in the 0nited %tates.
-ore recently, when +resident :ush decided in 3553 to impose tariffs of up to ;5
percent on steel imports, the adverse effects on the economy were substantial and soon
apparent. To take but one e!ample, prior to the tariffs, the +ort of Few 4rleans relied on
steel imports for more than <5 percent of its revenues, in part because once steel coming
into the port is offloaded, the ships are cleaned and refilled with 0. %. grain for e!port.
:y reducing imports, the tariffs slashed economic activity at the port and cut 0. %. grain
e!ports. :usinesses and farms all up and down the -ississippi @iver were adversely
affected. -ore broadly, the higher costs of imported steel produced a decline in
employment in 0. %. industries that use steel as an input. "ndeed, one study estimated that
due to the tariffs, some two hundred thousand people lost their 1obs in 3553 in these
industries aloneCa number that e!ceeded the total number of people actually employed
by the steel manufacturing firms protected by the tariff.
"n principle, trade restrictions are imposed to provide economic help to specific
industries and to increase employment in those industries. "ronically, the long-term
effects may be 1ust the opposite. @esearchers at the *orld 'rade 7rgani/ation 8*'79
e!amined employment in three industries that have been heavily protected throughout the
world& te!tiles, clothing, and iron and steel. Kespite stringent trade protection for these
industries, employment declined during the period of protection, in some cases
dramatically. "n te!tiles, employment fell 33 percent in the 0nited %tates and <= percent
in the 2uropean 0nion. The clothing industry had employment losses ranging form .9
percent in the 0nited %tates to 7= percent in %weden. Keclines in employment in the iron
and steel industry ranged anywhere from .5 percent in anada to 7< percent in the
0nited %tates. "n short, restrictions on free trade are no guarantee against 1ob losses, even
in the industries supposedly being protected.
The evidence seems clear& The cost of protecting 1obs in the short run is huge.
And in the long run, it appears that 1obs cannot be protected, especially if one considers
all aspects of protectionism. Free trade is a tough platform on which to run for office. :ut
it is the one that yields the most general benefits if implemented. 4f course, this does not
mean that politicians will embrace it, and so we end up )saving* 1obs at a cost of
6?75,555 each.
?3
B4 )conomic Indicators
An economic indicator is simply any economic statistic, such as the unemployment rate,
EK+, or the inflation rate, which indicate how well the economy is doing and how well
the economy is going to do in the future. "nvestors use all the information at their
disposal to make decisions. "f a set of economic indicators suggest that the economy is
going to do better or worse in the future than they had previously e!pected, they may
decide to change their investing strategy.
To understand economic indicators, we must understand the ways in which economic
indicators differ.
elation to the (usiness CycleC)conomy
2conomic "ndicators can have one of three different relationships to the economy&
ProcyclicD A procyclic 'or procyclical( economic indicator is one that moves in
the same direction as the economy. %o if the economy is doing well, this number is
usually increasing, whereas if were in a recession this indicator is decreasing. The Eross
Komestic +roduct 'EK+( is an e!ample of a procyclic economic indicator.
CountercyclicD a countercyclic 'or countercyclical( economic indicator is one
that moves in the opposite direction as the economy. The unemployment rate gets larger
as the economy gets worse so it is a countercyclic economic indicator
!cyclicD An acyclic economic indicator is one that has no relation to the health of
the economy and is generally of little use. The number of home runs the -ontreal 2!pos
hit in a year generally has no relationship to the health of the economy, so we could say it
is an acyclic economic indicator.
Fre?uency of the $ata
"n most countries EK+ figures are released quarterly 'every three months( while the
unemployment rate is released monthly. %ome economic indicators, such as the Kow
Dones "nde!, are available immediately and change every minute.
'iming
2conomic "ndicators can be leading, lagging, or coincident which indicates the timing of
their changes relative to how the economy as a whole changes.
#eadingD /eading economic indicators are indicators which change before the
economy changes. %tock market returns are a leading indicator, as the stock market
usually begins to decline before the economy declines and they improve before the
economy begins to pull out of a recession. /eading economic indicators are the most
important type for investors as they help predict what the economy will be like in the
future.
?;
#aggedD a lagged economic indicator is one that does not change direction until a
few quarters after the economy does. The unemployment rate is a lagged economic
indicator as unemployment tends to increase for 3 or ; quarters after the economy starts
to improve.
CoincidentD A coincident economic indicator is one that simply moves at the
same time the economy does. The Eross Komestic +roduct is a coincident indicator.
"n the ne!t section we will look at some economic indicators distributed by the 0. %.
Eovernment
-any different groups collect and publish economic indicators, but the most important
American collection of economic indicators is published by The 0nited %tates ongress.
Their 2conomic "ndicators are published monthly and are available for download in +KF
and T2QT formats. The indicators fall into seven broad categories&
Total 4utput, "ncome, and %pending
2mployment, 0nemployment, and Bages
+roduction and :usiness Activity
+rices
-oney, redit, and %ecurity -arkets
Federal Finance
"nternational %tatistics
2ach of the statistics in these categories helps create a picture of the performance of the
economy and how the economy is likely to do in the future
'otal 7utput2 Income and &pending
These tend to be the most broad measures of economic performance and include such
statistics as&
Eross Komestic +roduct 'EK+( OquarterlyP
@eal EK+ OquarterlyP
"mplicit +rice Keflator for EK+ OquarterlyP
:usiness output O quarterlyP
Fational "ncome OquarterlyP
onsumption 2!penditure OquarterlyP
orporate +rofits OquarterlyP
@eal Eross +rivate Komestic "nvestment OquarterlyP
The Eross Komestic +roduct is used to measure economic activity and thus is both
procyclical and a coincident economic indicator.
The "mplicit +rice Keflator is a measure of inflation. "nflation is procyclical as it tends to
rise during booms and falls during periods of economic weakness. -easures of inflation
?<
are also coincident indicators. onsumption and consumer spending are also procyclical
and coincident.
)mployment2 0nemployment2 and *ages
These statistics cover how strong the labor market is and they include the following&
The 0nemployment @ate OmonthlyP
/evel of ivilian 2mployment OmonthlyP
Average Beekly #ours, #ourly 2arnings, and Beekly 2arnings OmonthlyP
/abor +roductivity OquarterlyP
The unemployment rate is a lagged, countercyclical statistic. The level of civilian
employment measures how many people are working so it is procyclic. 0nlike the
unemployment rate is a coincident economic indicator.
Production and (usiness !ctivity
These statistics cover how much businesses are producing and the level of new
construction in the economy&
"ndustrial +roduction and apacity 0tili,ation OmonthlyP
Few onstruction OmonthlyP
Few +rivate #ousing and Iacancy @ates OmonthlyP
:usiness %ales and "nventories OmonthlyP
-anufacturers %hipments, "nventories, and 4rders OmonthlyP
hanges in business inventories is an important leading economic indicator as they
indicate changes in consumer demand. Few construction including new home
construction is another procyclical leading indicator which is watched closely by
investors. A slowdown in the housing market during a boom often indicates that a
recession is coming, whereas a rise in the new housing market during a recession usually
means that there are better times ahead.
Prices
This category includes both the prices consumers pay as well as the prices businesses pay
for raw materials and include&
+roducer +rices OmonthlyP
onsumer +rices OmonthlyP
+rices @eceived and +aid :y Farmers OmonthlyP
These measures are all measures of changes in the price level and thus measure inflation.
"nflation is procycli9cal and a coincident economic indicator.
?7
33 Price as a ationer
There have been many cases throughout history in which governments have been
unwilling to let markets ad1ust to market-clearing prices. "nstead, they have established
either price ceilings, which are prices above which it is illegal to buy or sell, or price
floors, which are prices below which it is illegal to buy or sell.
"f a price ceiling is placed below the market-clearing equilibrium price becomes illegal.
At the ceiling price, buyers want to buy more than sellers will make available. :ecause
they cannot buy as much as they would like at the legal price, buyers will be out of
equilibrium. The normal ad1ustment that this disequilibrium would set into motion in a
free market, an increase in price, is illegal$ and buyers or sellers or both will be penali,ed
if transactions take place above the ceiling. :uyers are faced with the problem that they
want to buy more than is available. This is a rationing problem.
+rice ceilings are not the only sort of price controls governments have imposed. There
have also been many laws that establish minimum prices, or price floors. At the price
floor, buyers are in equilibrium, but sellers are not. They would like to sell a higher
quantity, but buyers are only willing to take a lesser price. To prevent the ad1ustment
process from causing prices to fall, government may buy the surplus, as the 0%
government has done in agriculture and in precious metals. "f it does not buy the surplus,
government must penali,e either buyers or sellers or both who transact below the price
floor, or else price will fall. :ecause there is no one else to absorb the surplus, sellers
will.
@ationing is necessary to deal with scarcity. Bhen an item is scarce, people must
sacrifice something in order to get as much of the item as they would like to have. There
are some goods that are not scarce. Air is an e!ampleCit is free to all who want to
breathe it. "ce is not scarce in Ereenland. :ut almost all other goods are scarce. +rice is
a way to ration goods. "t deprives those who do not have enough income or desire for a
product. The function of price as a rationer is most clearly seen when price is prohibited
from acting as a rationer, so that some other method of rationing 'such as queuing or
coupon rationing( must emerge or be developed.
Fon-+rice @ationing
Rueuing is a commonly-used way to solve the rationing problem caused by price
ceilings. A queue is a waiting line that solves the rationing problem by a )first com, first
served* solution. Though price ceilings fi! the monetary cost that buyers can pay so that
buyer equilibrium cannot be restored by higher prices, they do not limit the monmonetary
cost of waiting.
0nder a system of queuing, waiting time changes to restore buyer equilibrium. A person
who is willing to buy five items for 6..55 each with no waiting time may be unwilling to
buy any if the price is 6..55 with a two-hour wait. Baiting time rises until enough
?=
buyers drop out of the market to restore the match between the amount available and the
amount people are willing to buy.
Although queuing is a rarity in the 0%, it was part of daily life in 2astern 2urope and the
%oviet 0nion before .>>5. #edrick %mith e!plained&
)The only real taste of social shopping vigils in recent American history were the pre-
dawn lines at service stations during the gasoline crisis in the winter of .>?;-<T :ut it
was temporary and only for one item. "magine it across the board, all the time, and you
reali,e that %oviet shopping is like a year round hristmas rush. The accepted norm is
that the %oviet woman daily spends two hours in line, seven days a weekT" noted in the
%oviet press that @ussians spend ;5 billion man-hours in line annually to make
purchasesT;5 billion man-hours alone is enough to keep .7 million workers busy year-
round on a <5-hour week.
%mith noted that coping with shortages and queuing required a different approach to
shopping than that with which Americans were familiar. +eople tended to carry large
amounts of cash and a bag or briefcase whenever they went out, 1ust in case they found
some desirable good. Bhen they saw a line, they 1oined it because there usually was
something worthwhile at the front. +eople shopped not 1ust for themselves but for friends
and kin, and as a result )know by heart the shoe, bra, pant and dress si,e, waist and length
measurements, color preferences and other vital particulars for a whole stable of their
nearest and dearestT&
"n another reading selection we noted that it was possible to e!plain the gasoline shortage
and the resulting queuing in the early .>?5s in terms of a good-versus-bad model, but that
economists did not use this model. @ather, economists consider the shortages the direct
result of price controls in e!istence at the time. A move by certain oil-producing nations
caused the supply curve for gasoline to shift to the left. Bhen 0% government price
restrictions kept pump prices from rising to equilibrium, shortages resulted. These
shortages were predictable because price is a rationing device in this model. "n contrast,
the only function of price in a good-versus-bad model is to take money from one group
and give it to another.
A second system of non-price rationing is with coupons. "n this system, the government
distributes coupons that must be presented along with money in order to buy a product.
oupons restore buyer equilibrium because they change the cost of a product, though in a
different way than queuing does. 0nder the system of queuing, the cost of a product is its
price plus waiting time$ under a system of coupon-rationing, the cost of a product is its
price in money plus its price in coupons.
The e!istence of price ceilings is often accompanied by illegal transactions, or a black
market. :lack markets e!ist when people try to )beat the system, either the system of
coupons or queuing. "n an economy of free markets, there can be no black markets.
??
BE Immigrants and )conomic ,rowth
Fobody can deny that the 0nited %tates is a land of immigrants. %hould anyone try,
simply point them in the direction of the %tatue of /iberty, a gift from the citi,ens of
France in recognition of Americas role as a haven for )tiredT..poorT.huddled masses
yearning to breathe free.* Get both before and after the statues .99= dedication, the
immigration that it celebrates has had a darker side, for not everyone who comes to the
0% does so legally. This nation has always had a flow of illegal undocumented aliens3
-any of these individuals are tourists who overstay their visas and take 1obs. -any are
from -e!ico and other /atin American countries. The 0% ensus :ureau estimates that
about > million illegal aliens now live in the 0% permanently, with another 755,555
arriving each year. :ut no one, not even the ensus :ureau, knows for sure how many
there are. %ome observers argue that as many as .7 to 35 million illegal aliens may
reside in the 0%, with a million or more coming in each year.
'he #egislation of Immigration
+eriodically, the federal government has attempted to reduce illegal immigration. The
"mmigration @eform and ontrol Act of .>9=, for e!ample, imposed severe penalties on
employers who willfully hire illegal aliens 'with fines ranging from 6375 to 6.5,555 for
each offense(. 2mployers who repeatedly violate this law can be 1ailed for up to si!
months.
The .>9= law also included an amnesty program. From the summer of .>9? to the
summer of .>99, illegal aliens who could prove that they had been in this country
continuously for at least five years could apply to obtain temporary legal residency status.
2ighteen months later, they could apply for permanent residency. 2ventually, they could
apply for citi,enship.
The most recent legislation attempting to stem illegal immigration was the .>>=
"mmigration @eform Act, but immigration policy remains the focus of a continuing
debate in the 0%, and there may be more legislation by the time you read this. -any
Americans strongly believe that immigrants, especially illegal immigrants, take 1obs that
0% citi,ens would other wise have and thereby lower Americans wages. These critics
also fear that new waves of immigrants will have difficulty fitting in with present day
society.
%upporters of immigration point out the obvious& At one time or another, all of us were
immigrants 'even Fative Americans, whose ancestors are believed to have come in over
the %iberian land bridge many thousands of years ago(. "mmigration has made the 0%
what it is today. Therefore, ask immigration advocates, how can we arbitrarily decide
that immigration today is )bad for America*H Today, 1ust as in .99= and before, many
new immigrants start on the first rung of the economic ladder by taking the low-paying
1obs deemed least attractive by e!isting Americans. -oreover, now as before, most
immigrants pay ta!es and ad1ust rapidly to the requirements of life in their new country.
'he )conomics of Immigration
?9
From the point of view of a potential immigrant 'or emigrant, as viewed from his or her
country of origin(, there is an implicit economic equation& Anyone who seeks to come to
the 0% presumably believes that the economic benefits outweigh the economic costs.
These costs are significant. They include the cost of travel, the cost of learning a new
language if one does not already speak 2nglish, and the cost of giving up whatever
degree of social and economic certainty in a new country. -any persons who attempt
legal immigration encounter substantial bureaucratic hurdles and high legal costs. The
e!penses involved can loom particularly large when considered relative to income levels
in the country of origin. Finally, of course, there is the often considerable noneconomic
cost of leaving ones family and friends for a faraway land.
4n the positive side, the e!pected economic benefits of immigration equal the net
lifetime e!pected increasing income compared to what one could make in ones country
of origin. "n addition, of course, there is the little matter of freedom, which we
Americans take for granted but is often the beacon that burns brightest for the potential
newcomer to our shores. learly, the continuing flow of immigration informs us that the
benefits of emigrating to the 0% have outweighed the costs for literally millions of people
from other countries. Bhether the motive is economic or not for any given immigrant,
the package offered by America has been sufficiently attractive that our reputation as the
land of immigrants is amply 1ustified.
'he #in. between Immigration and 0& economic ,rowth
"magine you are doing a survey. Gou stop typical men and women in the street and ask
the following question& "f we admit more immigrants, will the 0% be better off, worse
off, or about the sameH %imilar questions have been asked in numerous opinion polls.
As you might e!pect, the ma1ority of 0% residents today often answer that more
immigration will make the 0% worse off. Their reasoning is simple& -ost often, they
argue that immigrants take 1obs away from 0% residents. -oreover, they say,
immigrants are a )drain on the system& in that they use government services without
paying their fare share.
The reality has been largely the opposite, though, even in recent decades when the debate
over immigration has been so heated. From .>>5 to 355=, some .= million immigrants
entered the 0%. 4f those .= million, about .. million 1oined the labor force. "ndeed, the
enter for /abor -arket %tudies at Fortheastern 0niversity discovered that during this
time, over 75 percent of new wage earners who 1oined the labor force were immigrants.
2ven more striking, eight of ten new male workers during the .>>5s were newly arrived
immigrants. "n contrast, during the .>95s, immigrants accounted for 37 percent of labor
force growth, and during the .>?5s they accounted for only .5 percent.
Kespite what the opponents of immigration would have you believe, this influ! of
newcomers was associated with more, not less, economic vitality. Bhen we look at
economic growth during the .>>5s, we find that it averaged ;.3 percent per year, higher
than in typical decade and higher than in the .>?5s and .>95s, when growth averaged
between 3.9 and 3.> percent per year. Dust as important, during the .>>5s, immigrants
prevented population loss in many cities and rural areas and reduced what would have
been far greater losses in other areas of the country.
?>
Then there is the matter of innovation, one of the key drivers of economic growth over
time. @ecent studies have found that since the mid .>>5s, some 37 percent of all
technology and engineering startup companies in the 0% have been founded by
immigrants. These companies employed <75,555 workers and generated over 675 billion
in sales in 3557. "mmigrants were also responsible for almost one of every four patent
applications in the 0%. Fewcomers from "ndia were most likely to be involved in
innovative activity, but immigrants from the 0nited Aingdom, china, Taiwan, and Dapan
also played key roles. #ad these individuals not come here, this innovation either
wouldnt have happened or would have happened elsewhere, and American firms and
workers would be competing with it instead of using it.
'he !dvantages of Having &o Many Immigrants
According to the enter for /abor -arket %tudies, the rate of 0% economic growth
would have been lower in the .>>5s and early 3555s had there not been so many
immigrants. -oreover the authors of the study discovered the immigrants contribute
more in ta!es than they use in services. This pattern is particularly true for illegal
immigrants, who are unable to avail themselves of any social services offered by local,
state, or federal governments. onsequently, when they work, they typically pay ta!es
and receive few, if any, government services in return. -oreover, illegal immigrants are
ineligible for %ocial %ecurity and other benefits if they stay in the 0%.
"t is true that immigrants are more likely to collect cash and noncash welfare benefits
than native residents of the 0%. -uch of the difference in welfare receipt rates is
attributable to two groups of immigrants& political refugees 'as from the former %oviet
0nion( and immigrants who are very young or elderly. @eceipt of -edicaid assistance
and enrollment in subsidi,ed school lunch programs, for e!ample, are significantly higher
among immigrants than among native residents. :ut as suggested by the employment
figures noted earlier, most working age immigrants generally find employment quickly
and contribute substantially to the nations economic well being.
Be also know from prior studies that immigrants lower the wages of e!isting workers
only modestly, perhaps by < to 9 percent. They chiefly take unskilled, low paying 1obs
that e!isting Americans refuse to take at e!isting wages. This is precisely the pattern that
has been observed at least since the early nineteenth century in America. This years
wave of immigrants steps into the shoes of last years wave, who in turn move up to fill
the shoes of those who came in the year before. "t is a process that fuels economic
growth and prosperity throughout the country.
Immigration after 1C44
Fumerous press accounts have reported that 0% "mmigration and ustoms 2nforcements
has cracked down on both legal and illegal immigration into the 0s since the terrorist
attacks on %eptember ..,355.. Fevertheless, according to the enter for "mmigration
%tudies in Bashington, K.K., the pace of immigration into the 0% has barely slowed.
"ndeed, the ensus :ureau notes that since the census was taken in 3555, more than ;
million additional immigrants have arrived in the 0%.
95
%o it would appear that immigration, as always, is here to stay. As long as labor markets
are free to ad1ust to changing conditions, this country can continue to absorb immigrants
with few negative consequences. "n fact, if what has happened since .>>5 is any
indication, more immigration will make the 0% better off, not worse off which is surely
good news for current and prospective Americans alike.
9.
3< 'he Pseudo )conomic Problems of Immigration
Kuring the past five years more new immigrants came to the 0nited %tates than ever
before in our historyCnearly 9 million, according to a new study by the enter for
"mmigration %tudies. This influ! has stirred much public debate. :ut before we adopt
new policies, politicians need to distinguish clearly between the real problems caused by
immigration and non-problems based on popular myths.
+robably the number one misconception about immigration is that it harms our economy.
"n reality, conservative estimates put the net gain to the 0. %. economy from current
immigration at about 635 billion. "nstead of recogni,ing this overall gain, immigration
critics typically claim that immigrants take away American 1obs, depress wages and drain
our ta! dollars by consuming social services.
A fundamental truth about our economy is that as long as we desire more goods and
services than we have, the number of 1obs is practically unlimited. "n fact, when we have
more workers, we create more 1obs. Total employment and the si,e of the labor force
have tracked each other fairly closely over the past 75 years despite dramatic changes in
immigration flows.
"ts a well-known fact that many of the 1obs immigrants come here to fill are 1obs
Americans are not taking. And when we prevent immigrants from taking those 1obs,
American producers and consumers suffer the consequences. For e!ample, due to labor
shortages caused in part by increased border controls, only ;5 percent of last falls lettuce
crop in Ari,ona was harvested. /osses were nearly one billion dollars. There simply were
not enough 0. %. workers willing to pick the crops at prices that would have made it
profitable.
/ess well known is that many 1obs immigrants take are 1obs that would have otherwise
been outsourced. Fearly one-third of 0. %. garment workers are immigrants. "ncreasingly,
we are turning to international trade to secure our clothing. "f it were not for immigration
wed likely be importing even more clothing. %imilarly, in high-skill occupations, such as
software engineering, when companies are not allowed to bring immigrants to America,
they send the 1ob to the worker. -icrosofts :ill Eates has said that eliminating caps on
#.-: visas would encourage his company to outsource fewer 1obs.
Bhat about wagesH "mmigration increases the supply of domestic labor. :asic economic
reasoning shows that when you increase the supply of any good, holding other things
constant, its price should go down. #owever, immigration brings many secondary effects
that offset the increased supply. -ost immediately, when immigrants earn money, they
demand goods and services. This increases the demand for labor, which in turn creates
more 1obs and pushes wages back up.
A less obvious, but no less important, consequence of immigration is that with a greater
supply of labor, more goods and services are produced. This leads to lower prices, and an
increase in the purchasing power of e!isting American wages. Finally, a larger labor
93
force can raise the profitability of capital investment. "f increased capital flows match the
increased labor force, wages are not pushed down. 2ven #arvard economist Eeorge
:or1as, a prominent critic of immigration, admits that if the capital stock increased
enough to keep returns constant, immigration would not lower the earnings of natives on
average.
The secondary consequences of immigration are born out in the professional economics
literature. A comprehensive survey of the immigration literature, published in the Dournal
of 2conomi9c +erspectives reached the following conclusion& )Kespite the popular belief
that immigrants have a large adverse impact on the wages and employment opportunities
of the native-born population, the literature on this question does not provide much
support for the conclusion.*
The economic case for open immigration is not fundamentally different than the case for
free trade or free capital mobility. Allowing goods and services, capital, and labor to
flow freely allows them to be channeled to their most efficient uses and brings overall
benefits to the domestic and world economies.
The ob1ection that immigration costs ta! dollars has some merit. %ince many of the ta!-
funded services immigrants consume are funded at the local level and much of the ta!es
that immigrants pay goes to the federal government, immigration is a ta! burden on some
communities. This is fundamentally a problem of public policy, not economics. +olicy
reforms could fi! this by decreasing the social services that immigrants and their children
are eligible to consume.
Be need not fear that immigrants will burden our economy, take more 1obs than they
create, or depress our wages. Ruite the contrary, immigration brings economic benefits,
so it should not be artificially limited. urrent guest worker proposals by president :ush
and the %enate do not go far enough. A truly beneficial reform would concentrate on
creating an open immigration policy while dealing with real problems that increased
immigration could bring. This would involve limiting entitlement spending and may
require more restrictions on immigrants ability to eventually vote.
9;
37 Productivity and )conomic ,rowth
2conomists have estimated that over half of the increase in labor productivity growth in
the 0% economy during the past decade can be attributed to the massive investment in the
proliferation of information technology. :ut it was the globali,ation of "T hardware
production that drove down price and enabled "T utili,ation to spread.
The "nstitute for "nternational 2conomics atherine -ann calculates that globali,ed
production and trade reduced the cost of "T hardware by upwards of ;5 percent. The
result was higher productivity growth and an e!tra 63;5 billion in EK+. Bith "T
software and services spending now twice that of "T hardware, analysts conclude that a
)second wave* of productivity growth is underway in the 0%. /ike "T hardware in the
last decade, globali,ation of "T software and services will fuel this trend by making "T
more affordable and consequently more widespread.
For much of the .>>5s economist fretted that a heated economy could spark inflation.
#owever, it is now generally recogni,ed that the 0% was able to en1oy strong, sustained
economic growth in the U>5s without serious inflation because productivity kept a lid on
it Elobal "nsight, "nc. estimates that increasing "T offshoring during the .>>5s resulted in
a 5.= percent reduction in the overall price level by 355;. E"" e!pects the price level to
be 3.; percent lower by 3559 due to "T offshoring than it otherwise would be.
For e!ample, upward spiraling health care costs continue to place mounting stress on
employee and employer alike 'as well as the ta!payer(. Further diffusion of "T into the
health sector-where it has lagged in comparison to other sectors-would help put
downward pressure on prices. Kirect importation of health care services would help keep
costs in check. +harmaceuticals could offshore portions of their @XK to more
economical locations abroad or Q-rays could be simply transmitted via broadband to
well-trained radiologists in "ndia to read.
"ncreasing labor productivity, falling inflation, rising spending, and growing e!ports
induced by the continued globali,ation of services add up to a stronger, more vibrant
economy. As this globali,ation of services gains steam the economic benefits will grow
and multiply. Elobal "nsight forecasts an additional 6.3<.3 billion in 0% EK+ by 3559
from "T software and services offshoring alone. "ncremental wage gains ad1usted for
inflation would reach 5.<< percent.
Keloitte @esearchs arl %teidtmann accurately sums it all up&
The benefit of importing services is the same benefit that comes from importing goods.
The most important benefit is an improvement in productivity. The buyer is able to get
more for less. "ncreased trade also forces domestic producers to be more productive in
order to remain competitive. "mproving productivity raises the standard of living, puts
downward pressure on prices and gives a boost to profitability and wages.
9<
Dobs
The media have been erroneously fi!ated on the pro1ected gross loss of 1obs due to
services importation. Get, it is simply impossible to obtain an accurate picture of the
situation without e!amining the net effect of offshoring. Elobal "nsight, "nc. estimates
that because of "T software and services offshoring, .>;,555 new 1obs were created by
355;-for a net increase of over >5,555 1obs. Eoing forward, E"" estimates that 79>,555
1obs will be created, for a net gain of ;.?,555 by 3559.
There has been quite a fuss over the prospect of America )losing* white-collar "T 1obs.
#owever, atherine -anns review of the :ureau of /abor %tatistics prognostication for
future 1ob trends shows that this hand wringing is unfounded. :/% forecasts that .5 of
the 35 top occupations in terms of future growth require "T skills. 4f the .5 1ob
categories pro1ected to reali,e the largest growth, three are computer-related occupations
'computer support specialists, computer software applications engineers, and computer
software systems engineers(. -ann writes, )onsidering all occupations pro1ected to
35.5 by :/%, .; percent of the total number of 1obs created in the economy will be "T-
related, and the growth in these occupations will be <; percent, compared with an
economy-wide 1ob growth rate of .; percent.* "t is certainly worth mentioning that many
of the 1obs not pro1ected to see e!pansion-bank tellers, switchboard operators, and
telephone operators-will be casualties of technology and automation rather than
offshoring. And, these are not e!actly high-paying, high-skill 1obs to begin with.
:ut the benefits of services importation also accrue to occupations not commonly thought
of as "T-intensive. Further diffusion of "T is the economy 'spurred on by offshoring5 will
propagate 1ob growth in other sectors not commonly associated with "T, such as the
previously discussed health care field. Traditionally non-"T sectors such as education,
transportation, construction, utilities, financial services, and retail and wholesale trade are
all e!pected to reali,e net 1ob growth. And, many of the 1obs in these sectors will
demand "T skills. As companies across all sectors of the economy integrated "T into their
businesses during the .>>5s, 1obs requiring "T skill increased at a rate of 355 percent-
twice that of the economy as a whole. This trend will continue.
"ndeed, there will be those that suffer the loss of their 1obs. #owever, the 0nited %tates
has the highest rate of reemployment in the developed worldCnearly twice that of the
ne!t highest countryCdespite having the least stringent 1ob protection laws. "t is in fact
this fle!ibility in the labor market, combined with our more entrepreneurial economy,
that makes such reemployment possible.
0sing :/% data from .>?>-.>>>, the -cAinsey Elobal "nstitute calculated that almost
?5 percent of 0% workers who lost 1obs due to trade were reemployed. 4f these
reemployed workers, the average wage recapture was >=.3 percent. Eiven that service
workers tend to be reemployed faster than manufacturing workers, rising service
importations should not disturb these trends.
97
-oreover, trade-induced redeployment of labor creates a si,eable amount of e!tra value
for the economy. -E" reports that, )Far from being bad for the 0%, offshoring creates
net additional value for the 0% economy that did not e!ist before, a full .3-.< cents on
every dollar offshored. "ndeed, of the full 6..<7 to 6..<? of value created globally from
offshoring 6..55 of 0% labor cost, the 0% captures 6...3 to 6...<, while the receiving
country captures, on average, 1ust ;; cents.*
Kuring a recent online chat set up by The Bashington +ost, -arc Andreessen, co-
founder of Fetscape ommunications and now hairman of the %ilicon Ialle-based
software company 4psware, offered insight into how this value recapture works to our
benefit. Andreessen acknowledged that it has become common for companies to relocate
portions of their tech operation offshore to save on costs. #owever, he notes that these
companies )are taking many of the dollars that 'offshoring( frees up and spending them
on new development pro1ects, including hiring new developer, often in the 0%.
9=
B% 7utsourcing and )conomic ,rowth
4ne +rominent business commentator keeps a )hit list* of corporations that send 1obs
overseas. %uch actions are decidedly un-American, he opines, whenever he gets a chance
to e!press his views against outsourcing. The 355< Kemocratic presidential nominee
had a name for heads of companies that outsourced telemarketing pro1ects, customer
services, and other white-collar 1obs to foreign countries& #e called them ):enedict
Arnold 24s*.
ongress recently tried to pass a bill to prevent any type of outsourcing by the
Kepartment of %tate and the Kepartment of Kefense. @epublican representative Kon
-an,ullo of "llinois said, )Gou cant 1ust continue to outsource overseas time after time
after time, lose your strategic military base, and then e!pect this ongress to sit back and
see the 1obs lost and do nothing.* Bhen an adviser to +resident Eeorge B. :ush publicly
stated that the foreign outsourcing of service 1obs was not such a bad idea, numerous
politicians lambasted him for even the suggestion that outsourcing could be viewed in a
positive light.
*hat Is 'his 7utsourcing>
The concept of outsourcing is straightforward& "nstead of hiring American workers at
home, American corporations hire foreign workers to do the same 1obs. As 1ust one
e!ample, some these foreign workers are in "ndia and they do call center work, answering
technical questions for computer purchasers. Another 1ob such workers do well 'and
cheaply( is software development and debugging. :ecause of low cost communication,
especially over the "nternet, software programmers can be 1ust about anywhere in the
world and still work for 0% corporations.
:esides the fear that outsourcing )robs Americans of 1obs,* there is also a claim that
outsourcing reduces economic growth in the 0%. '+resumably, that must mean that it
increases economic growth in, say, "ndia.( :ecause outsourcing is part and parcel of
international trade in goods and services, the real question becomes, can the 0% have
higher growth rates if it restricts American corporations from )sending 1obs abroad*H
As we set out to answer this question, we must keep on simple fact in mind& 4utsourcing
is nothing more or less than the purchase of labor services from the residents of a foreign
nation. Bhen the Ketroit @ed Bings host the Iancouver anucks, fans at the game are
outsourcing. They are purchasing labor services from anadians. "n this sense, anadian
hockey players are no different from "ndian %oftware engineers$ they are citi,ens of
foreign nations who are competing with citi,ens of the 0% in the supply of labor services.
Dust as important, outsourcing is no different from any other form of international trade.
'he #in. between )conomic ,rowth and 7utsourcing
"nternational trade has been around for thousands of years. The means that the concept of
outsourcing is certainly not new, even though the term seems to be. After all, the
e!change of services between countries is a part of international trade. "n any event, if
we decide to restrict this type of international trade in services, we will be restricting
9?
international trade in general. 2!perts who study economic growth today have found that
the openness of an economy is a key determinant of its rate of economic growth. Any
restriction on outsourcing is a type of trade barrier2 one that will reduce the benefits we
obtain from international trade.
There is a clear historical link between economic growth and trade barriers. Figure 7-.
shows the relationship between the openness of an economy fewer or more trade barriers
and the rate of economic growth. At the bottom of the graph is a trade barrier inde!,
which for the 0% is equal to .55. 4n the vertical a!is, you see the average annual growth
of per capita income in percentage terms.
"t is evident from this graph that countries that have fewer international trade barriers
have also had higher rates of economic growth. The lesson of history is quite clear&
"nternational trade increases economic growth, and this in turn boosts economic well
being. Eovernment efforts to restrict outsourcing will restrict international trade, and this
will make Americans poorer, not richer.
*ill the 0nited &tates (ecome a 'hird *orld Country>
"n spite of the evidence 1ust shown, +aul raig @oberts, a former @eagan administration
treasury official, declared at a :rooking "nstitution conference that )the 0nited %tates
will be a Third Borld country in twenty years.* #is prediction was based on the idea the
entire classes of high wage service sector employees will eventually find themselves in
competition with highly skilled workers abroad who earn much less than their 0%
counterparts. #e contended that 0% software programmers and radiologists, for e!ample,
will not be able to compete in the global economy. Thus, he argued, the 0% will lose
millions of white collar 1obs due to outsourcing of service sector employment to "ndia
and hina.
Deffrey 2. Earten, former dean of the Gale %chool of -anagement, reiterated and
e!panded on this prediction. #e believes that the transfer of 1obs abroad will accelerate
for generations to come. #e argues that in countries from hina to the ,ech @epublic,
there is a )virtually unlimited supply of industrious and educated labor working at a
fraction of 0% wages.* %imilarly, according to raig :arrett, chief e!ecutive of the chip
marker "ntel, American workers today face the prospect of ;55 million well educated
people in "ndia, hina, and @ussia who can do effectively any 1ob that can be done* in
the 0%.
%till other commentators have claimed that "ndia alone will soak up ; to < million 1obs
from the 0% labor market by 35.7. %ome even believe that this number may e!ceed .5
million. "f true, one might e!pect American software developers and call center
technicians to start moving to "ndiaW
&ome 7verloo.ed Facts
-uch of the outsourcing discussion has ignored two simple facts that turn out to be
important if we really want to understand what the future will bring
.. 4utsourcing is the result of trade liberali,ation in foreign nations. After decades
of isolation, the markets in hina, "ndia, and eastern 2urope have begun to open
99
up to international trade. As is often the case when governments finally allow
their people to trade internationally, these governments have pushed hard to
stimulate e!ports of labor services as well as goods. :ut this cannot be a long
term equilibrium strategy because the workers producing those goods and
supplying those services are doing it because they want to become consumers.
%oon enough, and this is already happening, they want to spend their hard earned
money on goods and supplying those services are doing it because they want to
become consumers. %oon enough, and this is already happening, they want to
spend their hard earned money on goods and services, many of which are
produced abroad. Thus todays outsourcing of 1obs to those nations must
eventually turn into e!ports of goods and services to those same nations.
3. +rices ad1ust to keep markets in balance. The supply curve of labor is upward
sloping. Thus as 0% corporations hire foreign workers 'either directly by
outsourcing or indirectly by importing goods(, market wages in foreign lands
must rise. :etween 355; and 355=, for e!ample, "ndian labor outsourcing
companies saw wages rise almost <5 percent. 4ver a longer span, real wages in
southern hina 'which has been open to trade far longer than "ndia( are now si!
times higher than they were 1ust twenty years ago. %uch wage ad1ustments
obviously reduce the attractiveness of foreign suppliers. -oreover, it is not 1ust
wages that ad1ust& The relative values of national currencies move, too. :etween
355; and 355<, the value of the dollar fell more than 35 percent, and by 355? it
had dropped another 7 percent, making foreign goods 'and workers( more
e!pensive here and making 0% goods and workers more attractive in foreign
markets.
Fone of these ad1ustments are instantaneous. -oreover, they are occurring because some
American firms are moving output and employment abroad& hence at least some 0%
workers are having to move to lower paying 1obs, often with a spell of unemployment
along the way. #ow big is the impact in the short run, before all of the price ad1ustments
take placeH According to the :ureau of /abor %tatistics, in a typical recent year, the
number of 1obs lost to outsourcing is measured in the thousands out of a workforce of
over .75 million. %o if you are currently a 0% software developer, you dont have to
worry about packing your bags for -umbai, at least not soon.
Insourcing by Foreign Firms
0% firms are not the only ones that engage in outsourcing. -any foreign firms do the
same. Bhen a foreign firm out sources to the 0%, we can call it insourcing3 For
e!ample, -e!ican firms routinely send data to 0% accounting businesses for calculation
of payrolls and for maintaining financial records. -any foreign hospitals pay our
radiologists to read Q-rays and -@" images. Foreign firms use American firms to
provide a host of other services, many of which involve consulting. Also, when a foreign
automobile manufacturer builds an assembly plant in the 0%, it is in effect outsourcing
automobile assembly to American workers. Thus American workers in the %outh
arolina :-B plant, the Alabama -ercedes :en, plant, or the Toyota or #onda plants
in Tennessee and 4hio are all beneficiaries of the fact that those foreign companies have
9>
outsourced 1obs to the 0%. "ndeed, all across the country and around the world, hundreds
of millions of workers are employed by )foreign* corporations although its getting
difficult to tell the nationality of any company, given the far flung nature of todays
global enterprises.
*hat eally MattersD 'he #ong un
"f you own the only grocery store in your small town, you are clearly harmed if a
competing store opens across the street. "f you work in a small telephone equipment
store and a large company starts taking away business via "nternet sales, you will
obviously be worse off. "f you used to be employed at Bal--art and have 1ust lost your
1ob because Bal--art outsourced to a cheaper "ndian firm, you will have to look for a
new 1ob.
These kinds of )losses* of income or 1obs have occurred since the beginning of
commerce. They will always e!ist in any dynamic economy. "ndeed, if we look over the
American economy as a whole, roughly one million workers lose their 1obs every week.
:ut slightly more than one million people find a new 1ob every week. %o on balance,
employment in the 0% keeps growing, even though the average person will change 1obs
every three years, some of them, no doubt, because of international competition. :ut 1ob
turnover like this is an essential component of a labor market that is continually ad1usting
to economic change. "t is a sign of health, not sickness, in the economy. "f you find this
hard to believe, you can look west or east. "n Dapan, efforts to )protect* workers from
international trade resulted in economic stagnation and depressed real income growth
from .>9> to 355=. "n 2urope, similar efforts to )preserve* the 1obs of e!isting workers
have resulted in higher, not lower unemployment, because firms are unwilling to hire
people that they cannot fire later.
"f you are still wondering, simply look back at Figure 7-.. The lessons of history and of
economics are clear& Trade creates wealth and that is true whether the trade is
interpersonal, interstate, or international. The reality is that labor outsourcing is simply
part of a worldwide trend toward increased international trade in both goods and services.
As international trade e!pands assuming that politicians and bureaucrats allow it to
e!pand the result will be higher rates of growth and higher levels of income in America
and elsewhere. American workers will continue to en1oy the fruits of that growth, 1ust as
they always have.
>5
3? 'he )ffect of Income 'axes on )conomic ,rowth
"ncome Ta!es S /ooking at 2!treme ases
4ne of the most commonly discussed issues in economics is how ta! rates relate to
economic growth. Advocates of ta! cuts claim that a reduction in the ta! rate will lead to
increased economic growth and prosperity. 4thers claim that if we reduce ta!es, almost
all of the benefits will go to the rich, as those are the ones who pay the most ta!es. Bhat
does economic theory suggest about the relationship between economic growth and
ta!ationH
"n studying economic policies, it is always useful to study e!treme cases. 2!treme cases
are situations such as )Bhat if we had a .55J income ta! rateH*, or )Bhat if we raised
the minimum wage to 675.55 an hourH* Bhile wholly unrealistic, they do give very stark
e!amples of what direction key economic variables will move when we change a
government policy.
First suppose that we lived in a society without ta!ation. Bell worry about how the
government finances its programs later on, but for now well assume that they have
enough money to finance all the programs we have today. "f there are no ta!es, then the
government does not earn any income from ta!ation and citi,ens do not spend any time
worrying about how to evade ta!es. "f someone has a wage of 6.5.55 an hour, then they
get to keep that 6.5.55. if such a society were possible, we can see that people would be
quite productive as any income they earn, they keep.
Fow consider the opposing case. Ta!es are now set to be .55J of income. Any cent you
earn goes to the government. "t may seem that the government would earn a lot of money
this way, but thats not likely to happen. "f " dont get to keep anything out of what " earn,
why would " go to workH "d rather spend my time reading or playing baseball. "n fact,
going to work would risk my ability to survive. "d be much better off spending my time
trying to come up with ways to get the things " need without giving them to the
government. "d spend a lot of my time trying to grow food in a hidden garden and
bartering with others for the things " need to survive. " wouldnt spend any time working
for a company if " didnt get anything from it. %ociety as a whole would not be very
productive if everybody spent a large portion of their time trying to evade ta!es. The
government would earn very little income from ta!ation, as very few people would go to
work if they did not earn an income from it.
Bhile these are e!treme cases, they do illustrate the effect of ta!es and they are useful
guides of what happens at other ta! rates. A >>J ta! rate is awfully like a .55J ta! rate,
and if you ignore collection costs, having a 3J ta! rate is not much different from having
no ta!es at all. Eo back to the person earning 6.5.55 an hour. Ko you think hell spend
more time at work or less if his take home pay is 69.55 rather than 63.55H "d bet you that
at 63.55 hes not going to spend a lot of time at work and he is going to spend a lot of
time trying to earn a living away from the prying eyes of government.
>.
"n the case where government can finance spending outside of ta!ation, we see the
following&
+roductivity declines as the ta! rate increases, as people choose to work less.
The higher the ta! rate, the more time people spend evading ta!es and the less
time they spend on more productive activity. %o the lower the ta! rate, the
higher the value of all$ the goods and services produced.
Eovernment ta! revenue does not necessarily increase as the ta! rate
increases. The government will earn more ta! income at .J rate than at 5J,
but they will not earn more at .55J than they will at .5J, due to the
disincentives high ta! rates cause. Thus there is a peak ta! rate where
government revenue is highest. The relationship between income ta! rates and
government revenue can be graphed on something called a /affer urve.
4f course, government programs are not self-financing. Bell e!amine the effect of
government in the ne!t section.
>3
39 )ducation
"n considering the elementary and secondary level, we look at how much money is spent
on education and attempt to determine whether ta!payers are getting what they pay for.
To that end we plot measures of cost, and we look at the ratio of the numbers of students
to teachers. Fe!t we e!amine measures of success such as students performances on
standardi,ed tests and the numbers of degrees that are granted. Finally, we ask why
college costs so much and whether it is worth it to get a degree.
2!ternal :enefits
4f course, A-.3 education is public and it has been for so long that we may not even
think of asking why. There are social as well as economic reasons for having free public
education. %ocietally, benefits accrue to us all from having children become educated,
whether or not they are our own children. 2conomically, benefits accrue to us because
people who are educated are less likely to be on welfare or commit crimes against us and
are more likely to be productive citi,ens who pay more in ta!es than they cost in
government benefits. An additional benefit that we derive from public school education
is that having children of all races, ethnic groups, religions, and income classes in the
same schools may foster social stability. Thus the e!ternal benefits of A-.3 education
1ustify having a considerable subsidy to that education.
%#40/K B2 %+2FK -4@2H
The :asic Kata
As of .>>> the 0% was spending more than 6;9> billion to educate <? million elementary
and secondary students. "n e!ploring whether this amount of money is 1ustified, we can
look at how inflation-ad1usted spending per pupil has tracked over time and compare the
amounts that have been spent with outcomes such as test scores and graduation rates. "t
is important that we look at things in this way because as the number of students rises, the
number of classrooms needed rises too. This not only raises construction and
maintenance costs$ it also increases the number of teachers that are needed. Thus,
whether or not spending increases, it is spending per pupil that matters. "n addition,
because inflation makes a .>=5 dollar more valuable than a .>>> dollar, we need to
ad1ust the spending figures for inflation. Though a flawed measure, the +" is what we
typically use to perform that ad1ustment.
. Although it leveled off in the .>>5s, there is, nonetheless, a marked increase from
63=55 per student in .>=5 to 6?,977 in .>>> in inflation ad1usted spending per child .
Bhile that spending went for many other things as well, it served to decrease average
class si,e dramatically. "n .>=5 there were more than 3= students per class$ there are
currently .=. "f the demands on what needs to be taught have remained constant, such a
significant reduction in the number of students in a class would be e!pected to have a
>;
similarly significant impact on the success of students. :y some measures it has, and by
others, it has not.
%tudents scores on the %ATs over the same period did not respond in proportion to the
reductions in class si,es, and there is no clear evidence that reducing class si,e led to an
improvement in %AT scores for college-bound students. "f anything, the opposite
happened. Bhile average math %ATs rebounded after .>95, they remained more than .5
points below where they had been in .>=5. The decline in verbal %ATs bottomed out
later and the rebound was less dramatic. These scores are more than ;5 points below
where they had been <5 years earlier.
4n the other hand, high school graduation rates have been rising dramatically. This is
especially true for African Americans and #ispanics. #igh school graduation rates
showed marked increases over the last <5 years, doubling for whites and #ispanics and
more than tripling for blacks.
/iterature on whether -ore -oney Bill "mprove 2ducational 4utcomes
2ric #anushek, a leading economist on the issue of education, summari,ed ;?? studies
where one or more measure of input like student-to-teacher ratio 'the quantity of
teachers(, teacher education, and teacher e!perience 'the quality of teachers( was used to
e!plain test scores. #e reported that most of these studies found no relationship between
test scores and these inputs and that nearly as many found a negative one as a positive
one. This stunning conclusion, however-that money does not matter and that spending
more is a waste of ta!payer resources-is in some dispute by other economists. These
economists contend that test scores are less important than the earnings of the graduates.
They state that over the last century graduates of schools in states that spent more had
more earning power than those who graduated in states that spent less. All economists
who study the issue have found, moreover, that educational outcomes are determined
mostly by factors that are largely beyond the control of schools, such as family income
and family structure.
These results are not as contradictory as they might seem. "t might very well be that the
structure of public schools has been such that more money had a significant impact in the
.><5s through the .>=5s because we were spending so little and were on the steep,
upward-sloping part of the curve. The argument that #anushek and others make is that it
appears that we are now )on the flat of the curve,* meaning that we have done all we can
do with more teachers. Fow we need to look at something else.
The +ublic %chool -onopoly
Be e saw that in industries dominated by monopolies prices are higher and output is less
than it would be under perfect competition. +ublic schools operate in most communities
as a monopoly. Though there are private schools and home schooling, these are not real
options to most parents. 2ven more interesting is that this monopoly charges you, in the
form of state and local ta!es, whether or not you use the schools. "t would be as if your
><
electric company could continue sending you a bill even after you decided to buy your
own electric generator.
There are reasons for this. "f you believe that the e!ternal benefits of A-.3 education are
so great that they 1ustify being subsidi,ed, then parents who choose to send their children
to private schools should have to continue paying school-related ta!es because they are
getting those e!ternal benefits.
0ltimately, the problem that seems to come to the fore with a monopoly is that it
becomes unresponsive to the needs and desires of its customers. "n the case of public
schools, there is no compelling monetary incentive for the school to help a child with a
particular need or to foster e!cellence in another child. onsider the following problem
that e!ists at the beginning of every school year in nearly every school in the country.
2very school has teachers of varying quality and many parents know who the better ones
are. +arents want the teachers they consider to be better, and the principal must
disappoint some of these parents. 0nder competition, a disappointed parent could
threaten to move to another school. 0nder competition, the principal would have at least
a budgetary incentive to make bad teachers better. 0nder the current system in most
school districts, the parents are simply told, )Thats the way it is.*
-erit +ay and Tenure
4ne of the areas that distinguish teachers from other professionals is the lack of economic
performance incentives and lifetime 1ob security. The reason is that most teachers in the
0% are represented by a union that is an independent union, an affiliate of the Fational
2ducation Association, or the American Federation of Teachers. 0nions in general and
teachers unions in particular, prefer that pay be based solely on education and seniority.
This means that a poor teacher with more e!perience earns more than a good teacher with
fewer years in the classroom. This is a problem because energetic teachers can become
discouraged by the lack of monetary recognition for their efforts. Any time pay is based
strictly on who you are rather than what you do, there is an incentive to do as little as
possible.
The other serious obstacle to rewarding good teachers and getting rid of bad ones is
teacher tenure. -uch like the institution of tenure in colleges and universities, A-.3
educators are often granted tenure after they have successfully met certain criteria and
taught for a set number of years. This means that, short of some abusive behavior, they
cannot be fired. This further adds to the lack of performance incentives in older teachers.
-any teachers and their union representatives argue several points in defense of this
system. First, they argue that as professionals they are above economic considerations
and teach to the best of their ability all the time. %econd, they argue that granting a
principal the power to fire senior teachers and hand out merit pay would foster cronyism.
4nly those that did the principals bidding would keep their 1obs or get large pay
>7
increases. /ast, they argue that pay in general is low relative to other professionals and
that any additional money should raise all teachers pay to a higher level.
+rivate versus +ublic 2ducation
"n the presence of failed or failing public schools, many have come to ask whether private
schools should be allowed to receive public funds. "n general, students from private
schools perform dramatically better and have far fewer discipline problems than students
in public schools. This happens even though most private schools e!ist with funding that
is far less than that of public schools.
Bhen private schools outperform public schools it can be attributed to a variety of
factors. :ecause the parents, we can surmise that the students come from homes where
education matters, they are wealthier on average than their counterparts in public schools,
and it is unlikely they possess academic or physical disabilities.
The question is whether, after separating out these factors, private schools do outperform.
The answer is an equivocal )yes*. "f you look at public school students who fit a profile
similar to private school students, private schools do a little more with a little less. The
difference is not as dramatic as it is without this filter, but it still e!ists. The primary
reason is that parent involvement is higher and administrative costs are lower in private
schools.
%chool Iouchers
The question raised by the preceding analysis is whether parents should be allowed to
take their children out of a public school and have them placed in another public school
or a private school that is then given the ta!payer money that would have gone to educate
the child in the first public school. This would amount to about 63755 per year for an
)able* student. Bith cost savings and a general dislike of teachers unions in mind, this
option is popular among @epublicans. Kemocrats, strict believers in the )public* part of
public education, generally oppose attempts at privati,ation.
There are, however, ongoing e!periments with school vouchers. The school system in
-ilwaukee, Bisconsin, for e!ample, has been operating a school choice program since
.>>5. "n this system low-income parents can obtain vouchers to send their children to
secular 'i.e., nonreligious( private schools. The degree of parental disgust with public
schools can be seen in the fact that there was space for only a third of those who applied
for the vouchers.
The results of this e!periment and others like it are mi!ed. 0ntil recently, only a research
team at the 0niversity of Bisconsin had access to the data and they concluded that,
compared to all other -ilwaukee public school students, children did no better. @esearch
that ensued after the data were released to the general academic community suggest that
those in the program for three or more years did better '; to 7 percentile points on reading
and 7 to .3 on math(
>=
3> ,ross $omestic Product
"n economics, the gross domestic product 'KE+( is a measure of the amount of the
economic production of a particular territory in financial capital terms during a specific
time period. "t is one of the measures of national income and output. "t is often seen as an
indicator of the standard of living in a country, but there are some problems with this
view.
Kefinition
EK+ is defined as the total value of all goods and services produced within that territory
during a specified period 'or, if not specified, annually, so that )the 0A EK+* is the
0As annual product(. EK+ differs from, gross national product 'EF+( in e!cluding
inter-country income transfers, in effect attributing to a territory the product generated
within it rather than the income received in it.
Bhereas nominal EK+ refers to the total amount of money spent on EK+, real EK+
refers to an effort to correct this number for the effects of inflation in order to estimate
the sum of the actual quantity of goods and services making up EK+. The former is
sometimes called )money EK+,* while the latter is termed )constant-price* or )inflation-
corrected* EK+ S or )EK+ in base-year prices* 'where the base year is the reference year
of the inde! used(. %ee real vs. nominal in economics&
A common equation for EK+ is&
"#$ % consumption & investment & exports % imports
2conomists 'since Aeynes( have preferred to split the general consumption term into two
parts$ private consumption, and public sector spending. Two advantages of dividing total
consumption this way in theoretical macroeconomics are&
a. +rivate consumption is a central concern of welfare economics. The private investment
and trade portions of the economy are ultimately directed 'in mainstream economic
models( to increases in long-term private consumption.
b. "f separated from endogenous private consumption, Eovernment onsumption can be
treated as e!ogenous, so that different government spending levels can be considered
within a meaningful macroeconomic framework.
Therefore the standard EK+ formula is e!pressed as&
EK+ 8 private consumption Y government Y investment Y net e!ports 'or simply EK+ 8
Y E Y " Y FQ(
>?
Kefinition of the components of EK+
The breakdown of EK+ into the variables , ", E, and FQ helps economists define each
part more e!actly&
is private consumption 'or onsumer e!penditures( in the economy. This is
sometimes clarified as& consumer e!penditures on final goods and services. All
the variables in the EK+ equation measure final goods and services e!penditures
rather than total e!penditures$ the distinction removes from total e!penditure
those items which are primarily assets. For instance, buying a @enoir doesnt
boost EK+ by 635m. '"f it did, buying and selling the same painting repeatedly to
a gallery would imply great wealth rather than penury.( Fote that the @enoir
purchase would effect the EK+ figure, but not as a 635m receipt, the auctioneers
fees would appear in E2+ under onsumer e!penditure, because this is a final
service.
V " is defined as business investments in infrastructure, or any other spending
intended to generate a subsequent return through business activities. 2!amples of
investment are& training , @XK, marketing, and recruitment. The work Uinvestment
here is meant very specifically as non-financial product purchases. :uying financial
products is classed as saving in macroeconomics, as opposed to investment 'which, in
the EK+ formula is a form of spending(. The distinction is 'in theory(' clear$ if
money is converted into goods or services, without a repayment liability it is
investment. For e!ample, if you buy a bond or share the ownership of the money has
only nominally changed hands, and this transfer payment is e!cluded from the EK+
sum. Although such purchases would be called investments in normal speech, from
the total-economy point of view, this is simply swapping of deeds, and not part of the
real economy or the EK+ formula.
VE is the sum of all government e!penditures. The ratio of this to EK+ as a whole is
critical in the theory of crowding out, and the Aeynesian cross.
FQ are )net e!ports* in the economy 'gross e!ports S gross imports(. EK+
captures he amount a country produces, including goods and services produced
for overseas consumption, therefore e!ports are added. "mports are subtracted
since imported goods will be included in the terms E, ", or , and must be
deducted to avoid counting foreign supply as domestic. This is the concept of
Eross value added.
"t is important to understand the meaning of each variable precisely in order to&
@ead national accounts
0nderstand Aeynesian or neo-classical macroeconomics.
>9
2!amples of EK+ component variables
2!amples of , ", E, X FQ& "f you spend money to renovate your hotel so that occupancy
rates increase, that is private investment, but if you buy shares in a consortium to do the
same thing it is saving. The former is included when measuring EK+ 'in "(, the latter is
not.
"f the hotel is your private home your renovation spending would be measured as
onsumption, but if a government agency is converting the hotel into an office for civil
servants the renovation spending would be measured as part of public sector spending
'E(.
"f the renovation involves the purchase of a chandelier from abroad, that spending would
also be counted as an increase in imports, so that FQ drops and the total EK+ is
unaffected by the purchase. 'This highlights the fact the EK+ is intended to measure
domestic production rather than total consumption or spending. %pending is really a
convenient means of estimating production.
"f you are paid to manufacture the chandelier to hand in a foreign hotel the situation
would be reversed, and the payment you receive would be counted in FQ 'positively, as
an e!port(. Again, we see that E2+ is attempting to measure production through the lense
of e!penditure$ if the chandelier you produced had been bought domestically it would
have been included in the EK+ figures 'in or "( when the spending receipts of the
purchaser was sampled, but because it was e!ported it is necessary to Ucorrect the
amount consumed domestically to give the amount produced domestically. 'As in Eross
Komestic +roduct(.
A/0/AT"4F
The EK+ is calculated by the :ureau of 2conomic Analysis ':2A(.
ross-border comparison
EK+s of different countries may be compared by converting their value in national
currency according to either
urrent currency e!change rate& EK+ calculated by e!change rates prevailing on
international currency markets
+urchasing power parity e!change rate& EK+ calculated by purchasing power
parity '+++( of each currency relative to a selected standard 'usually the 0nited
%tates dollar(.
The relative ranking of countries may differ dramatically between the two
approaches.
>>
The current e!change rate method converts the value of goods and services
using global currency e!change rates. This can offer better indications of a
countrys international purchasing power and relative economic strength. For
instance, if .5J of EK+ is being spent o buying hi-tech foreign arms, the
number of weapons purchased is entirely governed by current e!change rates,
since arms are a traded product bought on the international market 'there is no
meaningful Ulocal price distinct from the international price for high
technology goods(.
The purchasing power parity method accounts for the relative effective
domestic purchasing power of the average producer or consumer within an
economy. This can be a better indicator of the living standards of less
developed countries because it compensated for the weakness of local
currencies in world markets. The +++ method of EK+ conversion is most
relevant to non-trade goods and services.
There is a clear pattern of the purchasing power parity method decreasing the disparity in
EK+ between high and low income 'EK+( countries, as compared to the current
e!change rate method. This finding is called the +enn effect.
For more information see measures of national income.
+@4:/2-%
Although EK+ is widely used by economist, its value as an indicator has also been the
sub1ect of controversy. riticism of EK+ include&
Iery often different calculations of the EK+ are confused among each other. For
cross-border comparisons one should especially regard whether it is calculated by
purchasing power parity method or current e!change rate method.
EK+ doesnt take into account the black economy, where the money isnt
registered, and the non-monetary economy, where no money comes into plan at
all, resulting in inaccurate or abnormally low EK+ figures. For e!ample, in
countries with ma1or business transactions occurring informally, portions of local
economy are not easily registered. Also, bartering may be more prominent than
the use of money, even e!tending to services '" helped you build your house ten
years ago, so now you help me(. "n uba this even goes so far that everyone owns
the house they live in, but people are only allowed to swap houses, not sell them.
"n Upoor countries, it may 1ust be that everything is cheap, e!cept for a few
western goodies. %o one may have little money, but if everything is cheap that
evens out nicely. Thus, the standard of living may be quite reasonable, its 1ust
that there are, say, fewer tv-sets, meaning people have to share them 'which may
actually increase the quality of life in a social sense(.
The quality of life is determined by many other things than physical goods
'economic or not(. 'The best thing in life are free, if theyre things at all.(
"f many products are of low quality in terms of durability then people will have to
'unnecessarily( buy them again and again, thus boosting the EK+ without
.55
increasing their satisfaction. '4n the other hand, if products were very durable
then that would hamper innovation because people would be less inclined to buy
new products, giving producers less of an incentive to develop them.( %imilarly, if
many products are of low quality in terms of usability and people dont know
beforehand which products are the best choice for them, then they will either have
to make do with an inferior product or buy again and again until they find
something more satisfying. Furthermore, if products have a short lifespan in the
market 'eg because of fast innovation of fashion( then this process starts all over
again when people need a replacement. Fote that in a capitalist society these
factors working together can easily cause a very high EK+ combined with low
customer satisfaction.
EK+ doesnt measure the sustainability of growth. A country may achieve a
temporary high EK+ by overe!ploiting natural resources. 4il rich states can
sustain high EK+s without industriali,ing, but this high level will not be
sustainable past the point that the oil runs out.
EK+ counts work that produces no net change. For e!ample, if a factory pollutes
a river, that boosts EK+, and when the ta!payers pay to have it cleaned up, that
boosts EK+ again. %ee parable of the broken window,
Fegative e!ternalities arent subtracted from the EK+ figure.
As a measure of actual sale prices, EK+ does not capture the economic surplus
between the price paid and sub1ective value received.
The annual grow of EK+ is corrected by using the )EK+ deflator*, which tends to
under-estimate the ob1ective differences in the quality of manufactured output
over time. 'The deflator is e!plicitly based on sub1ective e!perience when
measuring such things as the consumer benefit received from computer-power
improvements since the early .>95s(. therefore the EK+ figure may
underestimate the degree to which improving technology and quality-level are
increasing the real standard of living.
.5.
;5 Using National Income Data to Measure
Poverty and Living Standards
2conomic growth is measured by an increase in the real EK+ per capita. an the same
measure be satisfactory used to indicate povertyH
The Borld :anks uses a EK+ per capita benchmark of 0%6;?5 as an indicator of
absolute poverty. #ow reliable is this measureH an we conclude that people living in
countries with a EK+ per capita of less than 6;?5 live in povertyH "ndeed, should
measures of national income such as EK+ per capita be used to measure poverty levels at
allH Are there alternative measures that provide better indicators of povertyH
There are a number of problems that should be considered if national income statistics
such as EK+ per capita are used as indicators of poverty and living standards.
Failure to consider the distribution o Income
As with all mathematical averages, per capita income data does not take into account how
the EK+ is distributed amongst the population. "f the income is unevenly distributed,
then increases in the EK+ per capita may disproportionately benefit a small group of high
income earners and have little impact on reducing poverty. "f EK+ per capita data is to
be used then its distribution must also be taken into account.
Failure to consider the eect o inlation
0sing any monetary data, such as EK+ per capita over time, must recogni,e that output
and incomes measures can increase for many reasons other than the country producing
more goods. "t is an increase in goods and services that is necessary if poverty is to be
alleviated or peoples livings standards raised.
4utput and incomes measures may increase because the rate of inflation has simply
increased the money value of goods and service produced rather than their real value.
@eal EK+ per capita would be a better indicator as this is a measure of the physical value
of goods and service produced. Although the measure is e!pressed in money terms, it
has been ad1usted to take into account only the actual increase in goods and services
produced and to disregard the effect on inflation increasing the money value of output.
Failure to include non mar!eted out"ut
"t should be remembered that E%+ only included output that involves a financial
transaction i.e. is marketable. A considerable amount of Nambias agricultural output is
produced on small-scale communal farms for subsistence purposes. "t is currently
estimated that only 37J of production on communally owned land involves monetary
transactions. The rest is not included in any national income calculations. /ikewise the
output of the informal sector will not be included.
.53
Failure to include environmental degradation
"ncreasing national income and growth may occur at the e!pense of the environment.
@apidly growing economies may result in negative e!ternalities. An agricultural sector
that increases productivity by intensive use of pesticides and fertilisers or deforestation
may reduce future fertility and worsen the level of poverty for future generations.
Failure to consider the ty"es o goods "roduced
EK+ includes all goods and services produced. -uch production is not concerned with
producing goods and services that reduce poverty or raise current living standards.
"ncreases in the production of capital goods and military goods will raise EK+ per capita
however may well reduce living standards as the opportunity cost of such production is
the consumer goods foregone.
#lternative Indicators o Poverty
2conomists use a wide range of variables as indicators if the level of poverty. %ome of
the more common are given below. Thos listed fall into two categories. The first is
#ealth and 2ducation "ndicators and the second measures of access to and the impact of
education.
43 Measures of ,ood Health
Infant mortality
The number of live born babies who do not survive to their first birthday
out of each thousand babies born in total.
#ife expectancy 8at birth9
The average number of years a new born baby can e!pect to live if
conditions remain the same.
Calorie per day
The main cause of malnutrition, which means the body has insufficient
energy to maintain good health. -any countries have improved over the
last ;5 years however many in African countries have deteriorated.
Protein per day
/ack of protein causes malnutrition and lack of mental development as
protein deficiency when the mother is pregnant has an effect on the
intellectual development of the foetus.
Fumber of doctors per 4552555 of the population
This is an indicator if the level of health care available. The higher the
number of doctors per .55,555, the better the level of health care should
be.
Fumber of hospital beds per 45552555
This also is an indicator of the standard of health care. The more beds
available per .55,555 of the population, the better the access to health care
for the people.
B3 Measures of !ccess to and Impact of )ducation
.5;
#iteracy rates
The percentage of the population over the age of .7 whom can read and
write a simple sentence about their lives.
Primary school enrolment rate
The number of children of primary school age who are enrolled at school
as J of age group.
&econdary school enrolment rate
The higher the enrolment rate, the more children have access to secondary
education and therefore the higher the overall educational standards are
likely to be.
"ndividual indicators invariably fail to consider all the characteristics of poverty.
2conomists have consequently attempted to construct measures of indices that combine
several of the individual indicators together. These are called composite indicators.
$om"osite Indicators o Poverty and Living Standards
Kevelopment is more than simply increasing economic output i.e. EK+ per capita. "t is a
wider concept than economic growth. 2ven is a countrys economy e!periences real
growth of EK+ it does not mean that economic development is taking place.
Fevertheless, wider more meaningful indicators of development are often correlated with
EK+ per capita.
There are a number of single indicators that can be used to measure the e!tent to which
the inhabitants of a country are e!periencing poverty. These all focus on one area$ either
health, education, or income. A number of composite indicators have been developed
that allow several indicators to be aggregated together to give a more general measure of
poverty and living standards.
The Physical %uality o Lie Inde& 'P%LI(
"n this inde! three single indicators were combined together$ life e!pectancy at birth,
infant mortality and literacy rates. For each indicator the performance of individual
countries were rated on a scale of . to .55 where . represents the worst and .55 the best.
There was a correlation with the EK+ per capita however it was not as close as might be
e!pected.
The )uman Develo"ment Inde& ')DI(
This inde!, produced by the 0nited Fations Kevelopment +rogramme '0FK+(, includes
indicators of longevity, knowledge and income. "t combines life e!pectancy 'at birth(, an
average of literacy rates and number of years of education and EK+ e!pressed in terms of
its purchasing power in the domestic economy. %ome countries have shown rapid
economic growth but have not shown correspondingly high #K" inde!.
.5<
Gears #uman Kevelopment "nde! @eal EK+ per capita '.>9? prices(
.>?7 .>>? .>?7 .>>?
Dapan 5.97. 5.>3< .;937 3759<
%wit,erland 5.>.< 335<; 3=<<.
Fetherlands 5.97= 5.>3. .37>> .9;=>
0nited Aingdom 5.9< 5.>.9 >;.5 .<5>=
France 5.9<9 5.>.9 .3?=; .977<
0nited %tates 5.9=7 5.>3? .=?7= 3.7<.
Nambia 5.<7; 5.<;. <;9 ;55
Aenya 5.<7; 5.7<< ;33 ;?3
"ndia 5.7<7 37. <=7
The )uman Suering Inde& ')IS(
The inde! ranks people according to the level of human suffering based on .5 measures
/ife e!pectancy
Kaily calorie supply
Access to clean water
"nfant immuni,ation
%econdary school enrolment
+er capita EK+
@ate of inflation
ommunications
Technology
+olitical freedom
ivil rights
)uman Poverty Inde&
The 0nited Fations defines poverty as the )denial of choices and opportunities most
basic to human development-to lead a long healthy, creative life and en1oy a decent
standard of living, freedom, self esteem and the respect of others.*
Bhilst the #uman Kevelopment "nde! measures the progress of the country in achieving
development the human +overty "nde! is more aimed at reflecting on how the progress is
distributed and the level of deprivation and poverty being e!perienced " the country.
There are two #+" indices most commonly used. #+"-. is a measure of absolute poverty
used in /ess Keveloped ountries and #+"-3 is a measure of relative poverty used in
-ore Keveloped ountries.
.57
#+"-. measures poverty in /ess Keveloped ountries. The variables used are&
The percentage of people e!pected to die before age <5
The percentage of adults who are illiterate
Keprivation in overall economic provisioning-public and private-reflected by
the percentage of people without access to health services and safe water and the
percentage of underweight children under five.
#+"-3 measures human poverty in industrial countries. :ecause human deprivation
varies with the social and economic conditions of a community, this separate inde! has
been devised for industrial countries. "t focuses on deprivation in the same three
dimensions as #+"-. although with an ad1usted set of criteria and one additional one,
social e!clusion measures by low incomes and long term unemployment.
The variables are the percentage of people likely t die before age =5, the percentage of
people whose ability to read and write is far from adequate, the proportion of people with
disposable incomes of less than 75J of the median and the proportion of long-term
unemployed '.3 months or more(.
.5=
.5?
;. Hyperinflation
"n economics, hyperinflation is a condition in which prices increase e!tremely rapidly as
a currency loses it value. "t is inflation out of control. Formally, it is )an inflationary
cycle without any tendency towards equilibrium.*
haracteristics of hyperinflation
"n .>7=, +hillip agan wrote )-onetary Kynamics of #yperinflation*, generally
regarded as the first serious study of hyperinflation and its effects. "n it he defined
hyperinflation as a monthly inflation rate of at least 75J.
"nternational Accounting %tandard 3> describes four signs that an economy may be in
hyperinflation&
.. the general population prefers to keep its wealth in non-monetary assets or in a
relatively stable foreign currency. Amounts of local currency held are immediately
invested to maintain purchasing power$
3. the general population regards monetary amounts not in terms of the local currency but
in terms of a relatively stable foreign currency. +rices may be quoted in that currency$
;. sales and purchases on credit take place at prices that compensate for the e!pected loss
of purchasing power during the credit period, even if the period is short$
<. interest rates, wages and prices are linked to a price inde!$ and the cumulative inflation
rate over three years approaches, or e!ceeds, .55J.
@ates of inflation of several hundred percent per month are often seen.
2!treme e!amples include Eermany in the early .>35s when the rate of inflation hit ;.37
million percent per month$ Ereece during its occupation by Eerman troops '.><.-.><<(
with 9.77 billion percent per month$ and #ungary after the end of the B. B. ii. At <..>
quadrillion percent per month '<..> ! .5
.=
J(. 4ther more moderate e!amples include
2astern 2uropean countries such as 0kraine in the period of economic transition in the
early .>>5s, in /atin American countries such as :olivia and +eru in .>97 and .>99-
.>>5, and :ra,il in the early .>>5s.
#yperinflation did not directly bring about the Fa,i takeover of Eermany$ the inflation
ended with the introduction of the @entenmark and the Beimar @epublic continued for a
decade afterward. The inflation did, however, call into question the competence of liberal
institutions. "t also produced resentment of Eermanys bankers and speculators 'many of
them Dewish( who were blamed for the inflation.
#yperinflation is generally associated with paper money because the means to increasing
the money supply with paper money is the simplest& add more ,eroes to the plates and
.59
print, or even stamp old notes with new numbers. "t also it the most dramatic. The history
of paper money is replete with episodes of hyperinflation, followed by a return to )hard
money*. 4lder economies would revert to hard currency and barter when the circulating
medium became e!cessively devalued, generally following a )run* on the store of value.
0nlike inflation, which some economists feel can be a 1ustifiable policy choice,
hyperinflation is always regarded as destructive- it effectively wipes out the purchasing
power of savings held as paper assets of the country afflicted with it, distorts the
economy in favor in favor of e!treme consumption and hoarding of real assets S causes
the monetary base, whether specie or hard currency S to flee the country, and makes the
afflicted area anathema to investment. #yperinflation is met with drastic remedies,
whether shock therapy of slashing government e!penditures or altering the currency
basis. An e!ample of the latter is placing the nation in question under a currency board as
2cuador has now in 3557, which allows the central bank to print only as much money as
it has in foreign reserves.
The aftermath of hyperinflation is equally comple!, as hyperinflation has always been a
traumatic e!perience for the area which suffers it, the ne!t policy regime almost always
enacts policies to prevent its recurrence. 4ften this means making the central bank very
aggressive about maintaining price stability as is the case with the Eerman :undesbank,
or the move to some hard basis of currency for e!ample the gold standard or a currency
board. -any governments have enacted e!tremely stiff wage and price controls in the
wake of hyperinflation, which is in effect, a form of forced savings& goods become
unavailable, and hence people hoard cash, as was the case in the +eoples @epublic of
hine under )Ereat /eap Forward* and ultural @evolution*.
@oot causes of hyperinflation
"n general, hyperinflation is associated with fiat money andMor very rapid debasement of
currency such as the .9;<-.9;> debasement of the akce, the standard silver coin of the
4ttoman empire, which saw its value drop by five fold- increasing the nominal amount of
circulating medium. 2pisodes of hyperinflation produce staggering increases in price S
and bank notes denominated in millions, billions and trillions, coins denominated in the
millions, or withdrawn from circulation all together. The vicious cycle of borrowing to
meet all e!penses begins and the monetary authority does not act to contain the cycle and
may indeed accommodate it. #yperinflation is often the result of governments using
unbacked currency during was time to pay the e!penses of the conflict, such as the
0nited %tates in the .??5s and the @epublic of hina in the .><5s.
The root cause is a matter of more dispute. For both economists of the classical school as
well as monetarists, it is always the result of the monetary authoritys irresponsibility 'or
stupidity(, )running the printing presses.* For neo-liberal economists, hyperinflation is
considered to be the result of a crisis of confidence, where the monetary base of the
country flees, producing widespread fear that individuals will not be able to convert local
currency to some more transportable form S for e!ample gold, or an internationally
.5>
recogni,ed hard currency such as the 0% Kollar. %ee below for more discussion. These
models are based on the neo-classical synthesis and chart the drop in the countrys money
stock against hyperinflation.
#yperinflation can also occur in the absence of a central monetary authority. 4ne case is
when there is )free banking* and banks are allowed to print their own notes without
strong regulatory authority. These episodes are often brief, as there is then a run on
banks, a panic, and a collapse in the money supply leading to a depression and deflation.
An e!ample of this is the -ississippi ompany )bubble* under Dohn /aw.
/ess commonly, hyperinflation may occur when there is debasement of the coinage S
wherein coins are consistently shaved of some of their silver and gold, increasing the
circulating medium and reducing the value of the currency. The )shaved* specie is then
often restruck into coins with lower weight of gold or silver. #yperinflation occurs in
such a circumstance when )token* coins begin circulating, with no relationship to the par
value of gold or silver.
4ne common cause of hyperinflation is warfare, civil war or intense internal conflict of
other kinds& governments needing to do whatever is necessary to continue fighting, since
the alternative is defeat. They cannot cut outlays because the main outlay is for
armaments to fight the war itself. Further, a civil war may make it difficult to raise ta!des
or to collect the e!isting ta!es. "n normal times, a deficit is financed by borrowing, that is
selling government bonds. :ut under conditions of was or civil war, it is typically
difficult and e!pensive to borrow, especially if the was is going poorly for the
government in question. The banking authorities, whether central or not, )moneti,e* the
deficit, printing money to pay for the governments efforts to survive. The hyperinflation
under the hinese Fationalists from .>;>-.><7 is a classic e!ample of a government
printing money to pay civil war costs. :y the end, currency was flown in over the
#imalaya, and then old currency was flown out to be destroyed.
"n the 0nited %tates, hyperinflation was seen during the @evolutionary Bar and during
the ivil Bar, especially on the onfederate 'losing( side. -any other cases of e!treme
social conflict encouraging hyperinflation can be seen, as in Eermany after Borld Bar "
and in Gugoslavia after the death of -arshall Tito.
#yperinflation and the currency
As noted, in countries e!periencing hyperinflation, the central bank often prints money in
larger and larger denominations as the smaller denomination notes become worthless.
This can result in the production of some interesting banknotes, including those
denominated in amounts of .,555,555,555 or more.
:y late .>3;, the Beimar @epublic of Eermany was issuing fifty-million-mark
banknotes and postage stamps with a face value of fifty billion marks. The highest
value banknote issued by the Beimar governments @eichsbank had a face value
of .55 :illion marks '.55,555,555,555,555 or 4ne #undred Trillion 0%M0A(
..5
The largest denomination banknote ever officially issued for circulation was in
.><= by the #ungarian Fational :ank for the amount of .55 quintilllion +engo.
4ne way to avoid the use of large numbers is by declaring a new unit of currency 'so,
instead of .5,555,555,555 Kollars, a bank might set . Few Kollar 8 .,555,555,555 old
Kollars, so the new note would read ).5 Few Kollars*.( Bhile this does not lessen actual
value of a currency, it is called revaluation.
%ome banknotes were stamped to indicate changes of denomination. This is because it
would take too long to print new notes. :y time the new; notes would be printed, they
would be obsolete 'that is, they would be of too low a denomination to be useful(.
...
;3 Consumption tax
For most of the twentieth century, the principal federal ta! on individuals in the 0nited
%tates was on income, whether it is earned from labor 'wages and salaries( or capitals
'interest, dividends, and capital gains(. :ut a growing number of economists and
politicians have concluded that the 0nited %tates should replace the income ta!-partially
or entirely-with a ta! on consumption.
-ost of the political debate over a consumption ta! has centered on whether the 0nited
%tates should adopt a value-added ta! 'IAT( similar to the ones that 2uropean countries
have. Bhile a IAT definitely is a ta! on consumption, it is not the kind that most
consumption-ta! advocates prefer. Bhats more, the debate over weather to add a IAT
to the 0.%. ta! code has obscured the more basic issue of weather to ta! income or
consumption.
A consumption ta!-also known as an e!penditures ta!, consumed-income ta!, or cash-
flow ta!-is a ta! on what people spend instead of what they earn. A IAT does that in the
same way that a sales ta! does. :ut a true consumption-ta! system would entail
something much different from simply layering a IAT on top of the current income ta!.
4ne way to think of a consumption-ta! system is simply as an income ta! that allows
unlimited deductions for savings and those ta!es all with drawls from savings, much like
independent retirement accounts '"@As(.
+roponents of a consumption ta! argue that it is superior to an income ta! because it
achieves what ta! economists call )temporal neutrality.* A ta! is )neutral* if it does not
alter spending habits or behavior patterns and thus does not distort the allocation of
resources. Fo ta! is completely neutral, since ta!ing any activity will cause people to do
less of it and more of other things. Foe instance, the income ta! creates a )ta! wedge*
between the value of a persons labor 'what employers are willing to pay( and what
person receives 'after-ta! income.( as a result, people work less 'and choose more
leisure( than they would in a world with no ta!es.
The theoretical case for a consumption ta! actually is a case against the income ta!.
hampions of a consumption ta! argue that the income ta! does enormous long-term
damage to the economy because it penali,es thrift by ta!ing away part out the return to
saving, less investment, less innovation, and lower living standards than we would en1oy
without a ta! on saving. "n other words, the income ta! creates a bias in favor of current
consumption at the e!pense of saving and future consumption.
2qually important, the result is less saving than society would choose in the absence of
any ta!es. The )social value* of saving is the marker interest rate that borrowers are
willing to pay for the use of resources now. '2conomists are confident this is the value to
society because it is the price society has established by bidding for savings, or offering
savings to borrows, in the marketplace.( "f each potential saver could collect that market
interest rate, the result would be an optimal amount of saving 'that is, an optimal division
of resources between present and future consumption(. 4ptimal in this sense refers to the
..3
amount of saving that individuals deciding freely on the basis of market prices, would
choose to do on their own, rather than the amount of saving that a politician, social
planner, or economist thinks they ought to do. :ut the income ta! creates a wedge& the
after-ta! interest that savers receive is less than the preta! market interest that borrowers
pay. %o we get less than the optimal amount of saving.
"n contrast, a properly constructed consumption ta! can be neutral between consumption
and saving. That is because ta!es fall only on income that is consumed, not on income
that is consumed, not on income that is saved. The results are that the ta! wedge on
saving is ,ero and that total saving in the economy is much closer to the optimal amount.
To see how this works, first consider what happens with the income ta! to a person with
6.5,555 of preta! income. Assume for simplicity that the only ta! bracket is 37 percent.
That the marker 'preta!( interest rate on bonds is 7 percent, and that inflation is ,ero.
0nder the income ta!, the individual pays 3,755 in ta!es no matter what he does, what
then can consume 6?,7555 of goods and services now. 4r he can save 6?,755, investing it
in bonds paying 7 percent interest. "n the first year the individual earns 6;?7 interest '7
percent of 6?,755(, pays 37 percent of that '6>;.?7( in ta!es, and is left with 639..37 of
after-ta! interest income. Added to his original 6?,755, he now can consume 66?,?9..37
of goods and services, or ;.?7 percent more than a year ago. Fote that the market paid the
individual 7 percent to postpone consumption. :ut the income ta! reduced what he
received to ;.?7 percent.

..;
;; #ower Capital ,ains rate will gain revenue
+resident :ushs proposal to reduce the capital gains ta! will once again spark the debate
over capital gains and ta! revenues. This debate is becoming as predictable as the annual
return of the seasons. Be have been through the same debate year in, year out and some
people continue to refuse to learn from American economic history. 4ne year ago, 3
years ago, and even as far back as .>?9, we have heard the very same argument against
reducing the capital gains ta!& That it would somehow lose precious ta! revenues for the
Federal Eovernment.
%keptics said about the .>?9 capital gains ta! cut that it would do little for investment
and do much to erode ta! revenues. " remember then Treasury %ecretary -ichael
:lumenthal asserting that the proposed capital gains rate reduction from 75 to 39 percent
would cost the Treasury over 63 billion in revenue. #e said, )The measure would do
little for capital formation and would waste revenues.*
%ecretary :lumenthal ob1ected. :ut in ongress, cooler economic heads prevailed and
the #ouse and %enate agreed with my distinguished Bisconsin colleague, the late
ongressman :ill %teiger, that it was time to cut the capital gains ta!.
That was a cut in the ta! on capital gains. Bell, what happenedH Kid revenues go downH
Beve been through this time, and time, and time again and you can go through the facts
on this until everyone is blue in the face, but people 1ust dont listen.
The fact is, ta!es paid on capital gains increased from 6>.. billion in .>?9 to 6...?
billion in .>?>, and 6.3.7 billion in .>95. "n .>9., we cut the top rate on capital gains
even further to 35 percent, and capital gains ta! revenues rose to 6.3.? billion in .>9.,
6.3.> billion in .>93, 6.9.7 billion in .>9;, 63..7 billion in .>9< and 63<.7 billion in
.>97. Ta! revenues to the Treasury were .9< percent higher in .>97 than in .>?9.
These are all "@% figures. Fobody denies them. :ut a lot of people insist on ignoring
them and persist in making statements about revenues that are contrary to facts.
Allow me to quote from last weeks Bashington +ost editorial on capital gains&
T*revenues would certainly drop. Taken all together, over a period of several years, the
effect on revenue would be ,ero at best and possibly a substantial loss.* Koes this sound
familiarH "t should its the same old discredited nonsense weve been hearing year in,
year out since .>?9.
This blithe disregard for the facts a disregard which is no doubt ideologically motivated
does nothing to e!pand public understanding of this issue. " would like to take this
opportunity to e!plain to my colleagues once again why lower capital gains rates lead to
higher ta! revenues.
"
..<
This revenue windfall will come from three sources. First, because the ta! cost of selling
equities will be cut in half, lower capital gains rates will lead to greater reali,ations by
stockholders. These greater reali,ations will lead to permanently higher receipts from the
capital gains ta!.
As the historical record shows, capital gains ta!es paid continued to climb several years
after the ta! rate cuts of .>?9 and .>9.. -any econometric studies of capital gains rates
and revenues have quantified this potential reali,ation effect. #arvard +rof. /awrence
/indsey estimates that a flat .7 percent capital gains rate would increase capital gains
ta!es paid by 6;. billion over ; years.
""
%econd, a lower capital gains ta! rate increases the value of stocks. Ta!ing capital gains
at a high rate reduces the potential return on investment and this future return translates
into a lower price for the stock today. onversely, a lower capital gains rate will increase
stock prices, giving the Eovernment more gains to ta!.
"""
Third, and most important, a lower capital gains rate will raise EF+. 2ven the
ongressional :udget 4ffice admits that )lower rates on gains could increase savings and
capital formation and channel more resources into venture capital.* Bhat :4 failed to
recogni,e, however, is that this increased capital formations means that the entire ta!
base will grow even faster resulting in an even greater increase in overall revenues to the
Federal Eovernment.
:ecause of the high capital gains rate, individuals have no incentive to assume the e!tra
risk associated with investment in growth stocks.
As a result, entrepreneurs are finding it more difficult to secure investment funds from
private sources. This shortage of startup capital today threatens to rob our economy of
innovations, productivity gains, and 1ob opportunities in the future.
Bithout startup capital, many of todays dynamic, young companies such as Apple
omputers, Federal 2!press, and ray @esearch, never would have made it from the
blackboard to the marketplace.
4ther countries recogni,e the benefits of encouraging long term investment in fact$ many
do not ta! capital gains at all. Their commitment to long term investment has created
new technologies and new innovations and better products. Be buy their products. They
take our money. And 0% 1obs move overseas.
..7
Table .
apital Eains @ates and the Associated @evenue
'in billions of dollars(
Gear @evenue Ta! rate 'percent(
.>=9 6 7.> 3=.>
.>=> 7.; 3?.7
.>?5 ;.3 ;3.3
.>?. <.< ;<.<
.>?3 7.? <7.7
.>?; 7.< <7.7
.>?< <.; <7.7
.>?7 <.7 <7.7
.>?= =.= <>..37
.>?? 9.. <>..37
.>?9 >.. <>..37
.>?> ...? 39
.>95 .3.7 39
.>9. .3.? 39
.>93 .3.> 35
.>9; .9.7 35
.>9< 3..7 35
.>97 3<.7 35
.>9= <=.< 35
Table 3
omparison of 0% Ta!ation of apital Eains with %ome of 4ur 2uropean and Asian
ompetitors
ountry +ercent3
0nited Aingdom <5
0nited %tates ;;
%weden .9
anada .?.7.
France .=
B. Eermany 5
:elgium 5
"taly 5
Fetherlands 5
#ong Aong 5
%ingapore 5
%. Aorea 5
Taiwan 5
-alaysia 5
Dapan '.(
..=
. Fo apital gains ta! until -ar. ;, .>9> 'e!cept for substantial trading or substantial
shareholders(. After -ar. ;, .>9> shareholder has a choice of a 35 percent national and a
= percent local ta! on net gain at the time of filing, or . percent of sales proceeds
withheld at source 'this option is available only on shares listed for at least . year(.
3 -a!imum long-term capital gains ta! rates.
..?
;< oad to &erfdom
Friedrich A. von #ayek, one the giants of classical free-market economics, warned that
)The @oad to %erfdom* results from the unintended consequences of market
interventions by governments, leading to economic distortions that ultimately lead to
further interventions. #e noted that liberty is lost - gradually, incrementally, and
ine!orably - with each subsequent intervention descending down the road to serfdom.
"s the 0nited %tates heading down such a pathH " hope not, but " have been worrying for
some time that we might be. :y pursuing an ownership society through %ocial %ecurity
reform, ta! reform and tort reform, +resident :ush seems determined that we do not head
further down the road to serfdom but instead get on the e!pressway to economic
freedom.
"n the modern age the road to serfdom may not solely result from anti-market
interventions but may also include the inability - or unwillingness - of political leader to
eliminate anti-market barriers already on the books.
"n his book #ayek e!posed the primary fallacy of central planning& the impossibility that
all knowledge can be brought together in a few genius individuals, )the best and the
brightest.* )conomics2 markets statistics and history conclusively dispel any such
assertion.
+resently the American economy, despite its resilience and our nations entrepreneurial
acumen, is suffering from a ?7-year hangover remaining from a number of failed and
failing socialist pro1ects. The most evident e!amples are our ailing and out-of-date
entitlement programs, our confiscatory ta! code and increasing regulatory burden. As
such, it is not enough to maintain the status quo. Be must reform these systems, remove
barriers and eliminate as mush of this dead-weight loss from our economy as possible.
And that is e!actly what the president has set out to do.
/ast week the Ball %treet DournalM#eritage Foundation released their annual "nde! on
)conomic Freedom, which concluded for the first time that America no longer ranks
among the top .5 freest economies in the world S this despite the fact that our score
remained unchanged from the previous year. "nstead we fell in the ranking because while
we were trending water, hile, Australia and "celand further opened their economies and
surpassed us.
Americas worst inde! category was the )fiscal burden* of government, due to
Bashingtons rapidly growing spending and one of the highest corporate ta! rates in the
world. 2!cessive regulation is another reason the 0nited %tates failed to the make the top
.5.
Bhile not mentioned specifically by the inde!, %ocial %ecurity is a ma1or piece of the
federal governments budget, and due to the well-meaning but flawed pay-as-you-go
structure of the program, %ocial %ecurity reform looms as one of the greatest barriers to
..9
sound budget policy. "ronically, however, this problem also creates perhaps the greatest
opportunity to e!pand economic freedom in our lifetimes.
4n this front we cannot afford to continue to put our heads in the sand. 4F we do
nothing, we will fall behind. Be are already behind. -ore than 35 nations have already
reformed their retirement security programs, replacing pay-as-you-go systems with
personal accounts that workers own and control. "f fact, hile - a nation that passed us
on the inde! this year - was the first nation to create personal accounts.
That said, the ideas for reform reported in the press this week, if acted upon, would
represent another missed opportunity rather than a step in the right direction. Dust as we
cannot afford to do nothing, we cannot afford to take one step forward, two steps back.
Be cannot pass 1ust any reform proposal and call it a day. Be cannot pass a reform
proposal with accounts that are too small to fundamentally reform the system. 4n this
score there can be no compromise.
Another area we are falling behind is in our ta! policy, despite the positive impact the
355; ta! rate reductions have had on economic growth. This year, @omania and Eeorgia
1oined the )flat-ta! club,* bringing the number of nations in 2urope to adopt the flat ta!
to eight. %o far, Eeorgia has the lowest flat ta! of .3 percent on corporate and personal
income.
#ere in America, both the individual income and corporate income ta! codes are in dire
need of reform. Be need to move further toward removing barriers to work, saving,
investing and entrepreneurial risk-taking. 4n this front we definitely cannot afford to
stand still.
At a minimum, we need to make permanent the 355.M355; ta!-rate reductions and inde!
the alternative minimum ta! for inflation. As recent data shows, ta! receipts are on the
rise, and if unchecked through further ta! relief will continue upward to historic levels,
slowly but surely dragging the economy down over the long run.
The presidents new commission on ta! reform, headed by the capable leadership of
onnie -ack, @-Fla., and %en. Dohn :reau!, K-/a., should not waste time e!ploring
)revenue enhancers* of any sort. "f the commission proposes to eliminate credits,
deductions and e!emptions, closing these loopholes must be more than offset by
reductions in the rate structure, both individual and corporate, and eliminate entirely ta!es
on savings and investment. And they should keep a keen eye on international ta!
competitiveness.
"n todays world, the road to serfdom S a road well traveled during the 35th century S is
not only paved with good intentions but also seems to contain a slippery slope left over
from socialist policies from previous administrations that, if left in place, will force us to
run faster and faster 1ust to stand still while other countries continue to pass us as they
ride by in the flat-ta! fast lane.
..>
E" 'ax CutsD *hen 'hey Matter2 *hen 'hey $on:t
All modern presidents have one thing in common& They promise to cut ta!es or at least
not raise them. %ome presidents have even succeeded in keeping their word, for we have
seen numerous ta! cuts over the past half-century. From a fiscal policy point of view,
not all ta! cuts are the same, though. That is, some ta! cuts have had relatively little
effect on the unemployment rate and economic growth, while others have had
significant effects. Bhat we want to know is, why arent all ta! cuts created equalH
'he Importance of the Margin
"n economics, we say that choices are always made )at the margin*. Bhat this means is
that people react to whatever changes their incentive structure in terms of marginal
benefits and marginal costs3 "f the government were to announce a one-time-only
lump-sum tax cut of, say, 6.,555 per family, there would be little, if any, change in the
incentive structure for consumers, savers, and investors. BhyH :ecause the one time
only cut in ta!es would not change the marginal benefit or the marginal cost of any of the
activities of consumers, savers, or investors.
Bhat is important to the incentives-and hence the behavior-of individuals is whether their
actions can affect their income, net of ta!es. As you probably know, the more ta!able
income you make, the higher your tax brac.et and thus the higher the marginal ta! rate
you pay on the last dollar of income earned. %o if you are a single person and your
ta!able income goes from, say, 637,555 to 6<5,555, your marginal ta! rate will 1ump
from, say, .7 percent to 37 percent.
As your ta!able income goes up, you 1ump into higher and higher ta! brackets. "n
general, to make sensible choices about working, people need to evaluate the marginal
benefit of earning more income compared to the marginal cost, where cost is measured in
terms of added effort and forgone leisure activities. The higher the marginal ta! rate, the
lower the marginal benefits from working because less income is kept by the person who
earned it. %o as marginal ta! rates rise, the incentive to work is reduced because the
marginal benefits of work are reduced.
'he Importance of Permanence
A second issue that must be considered when thinking about ta! cuts is their permanence-
or lack thereof. "n general, people are forward-looking creatures. They consider not 1ust
what is happening today but also what is likely to happen later in the year and even
several years into the future. Thus for two reasons, a ta! cut that is e!pected to be short-
lived is much different from one that is e!pected to be long-lived or permanent.
The first reason is that a temporary ta! cut can induce people to make temporary changes
in their behavior that have very little sustained effect. For e!ample, if income ta!es are
cut this year but people know they will be raised again ne!t year, people will respond
.35
quite simply& Theyll work more this year and work less ne!t year. +oliticians may
make headlines by pointing out the e!tra employment and output, this year, but the reality
is that over the longer haul, little will have changed.
The second reason permanence is important has to do with investment. +eople invest
when they get an education, and firms invest when they build new plants or buy new
equipment. "nvestments yield income over long periods of time, and so people worry
about the long-run ta!es on that income. A permanent ta! cut will raise the marginal
benefits of investment far more than a short-lived ta! cut because it ahs a greater impact
on the total value of the ta! bill.
Permanent and Marginal
The upshot of all this is quite simple. A short-lived ta! cut or a one-time tax rebate is
unlikely to affect incentives on the margin and hence is unlikely to affect peoples
behavior. :ut a permanent reduction in marginal income ta! rates can have substantial
effects on how much people are willing to work, save, and invest. "ndeed, there is
considerable evidence that when marginal ta! rates at the highest levels have been
reduced, Americans earning those relatively high incomes have responded by working
more, saving more, and investing more.
onsider also that individuals who take risks in our economy entrepreneurs are sensitive
to the potential net reward to such risk taking. #igher net rewards lead to more risk
taking and in the long run to greater economic growth.
A recent study conducted in France e!amined the implications of the French ta! system.
@esearchers calculated what :ill Eates, founder and chairman of the largest software
company in the world, -icrosoft, would be worth today if he had started that company in
France. #ad Eates been a Frenchman and started -icrosoft in France, he would have
face much higher marginal ta! rates on both his personal income and the gains to his
investments. The researchers estimated that Eatess net worth would be only about 35
percent of what it is today in the 0%. The average French persons response to this
information was, so whatH That 35 percent of many billions of dollars is still a lot of
wealth. An economists response is quite different. :ill Eates, or anybody else taking
risks, would have taken fewer business risks 'and worked fewer nights and weekends and
taken more vacations( had marginal ta! rates been as high as they have been 'and
currently are( in France.
'hree Cases of Marginal 'ax Cuts and 'heir esults
Kuring three important periods in the twentieth century, 0% presidents significantly
lowered marginal ta! rates. The first cuts were the oolidge--ellon marginal ta! rate
cuts of the .>35s. The result was the @oaring Twenties-economic boom years. The
second were the ta! cuts pushed by +resident Dohn F. Aennedy in the early .>=5s and
implemented somewhat reluctantly by ongress after Aennedys assassination. The
result was the prosperous .>=5s. The last ma1or marginal personal income ta! cut was
enacted under the leadership of +resident @onald @eagan in the .>95s. The result was a
boom that lasted from .>9; to .>>5.
.3.
ritics of this analysis of the effects of marginal ta! rate cuts point out that many other
things were happening in the 0% and the world during these periods. Fevertheless, the
fact remains that one variable was the same in each period-ma1or cuts in federal marginal
personal income ta! rates.
'he Problem with (ac.ward-#oo.ing *indfalls
+residents have at times believed they could )1ump-start* a slowly moving or stagnating
economy by sending out ta! rebate checks from the 0% Treasury. "ndeed, rebates have
been used several times in the past twenty years. The result of ta! rebates has always
been nil. %pecifically, very little change in the rates of unemployment and economic
growth has ever occurred after the issuance of a ta! rebate.
The reasons are clear. Ta! rebates are backward looking-they are based on past income
and work effort, both of which are out of the individuals control. Fone of the marginal
benefits or marginal costs associated with work, saving, or investing are affected.
-oreover, such ta! cuts are temporary$ even if they could somehow be linked to future
actions 'such as by offering a ta! rebate on earned over the ne!t years(, there would be no
permanent effects on incentives. -ost notably, any change in incentive to save or invest
would be minimal, implying that the impact on economic growth would be negligible.
'ax Cuts and Phaseouts
+haseouts for personal exemptions and itemi/ed deductions 'such as charitable
contributions and mortgage interest payments( started in .>>5 as a seemingly innocent
way to raise federal government ta! revenues without appearing to do so. 0nder the
phaseout provisions of the current ta! law, as you earn more ta!able income, after a
certain level, the federal government reduces 'phases out( your personal e!emptions and
itemi,ed deductions. The current "nternal @evenue ode slowly but surely takes away
certain ta! breaks as ta!able income goes up. "n 355=, for e!ample, ta!payers filing
single or 1oint returns started losing their itemi,ed deductions and personal e!emptions
when their ad1usted gross income e!ceeded 6.75,755.
The e!istence of phaseouts leads to higher de facto marginal ta! rates, and Americans are
not stupid. Those earning higher incomes understand quite clearly that their marginal ta!
rates are higher than those listed in the government ta! tables. BhyH :ecause the
phaseouts for itemi,ed deductions and personal e!emptions effectively increase marginal
ta! rates by increasing ta!able income by more than the persons additional earnings. 4n
balance, the phaseouts add an e!tra . to 3 percentage points to marginal ta! rates at the
upper end.
The continued e!istence of phaseouts dampens the potential effectiveness of any cuts in
federal marginal income ta! rates, such as those implemented in 355;. For higher
income earning individuals, any given reduction in marginal ta! rates is less because of
phaseouts. #igher income earning individuals react accordingly, correctly treating the
supposed ta! cut as less than the politicians say it is and working and investing less than
one might otherwise e!pect.
Income versus Payroll 'ax Cuts
.33
-ost proposed and enacted ta! cuts have involved federal personal income ta!es. The
federal government, though, likes to play a little game with its ta! revenues. "t labels
some ta!es income ta!es, but it labels other ta!es payroll taxes3 +ayroll ta!es are
supposedly used for %ocial %ecurity, disability, and -edicare e!penses. To keep the
illusion going, the law says that employers and employees share payroll ta!es equally.
There is a saying that a rose is a rose$ among economists, the corresponding saying is that
a dollar is a dollar. These saying s mean one thing only& "t doesnt matter what label a
government puts on a ta!$ what matters is ta! revenues. Bhen the government spends
funds, recipients and ta!payers care not a hoot from which particular ta! revenue
accounts those funds are supposedly derived. Bhether -edicare payments come out of a
fund labeled )payroll ta!es* or are paid from an account called )general fund,* there is no
difference to the economy. Bhat matters to the incentives and thus the behavior of
ta!payers are the dollars left on the margin after the government collects ta!es.
Today, the top <5 percent of income earners in America pay over >> percent of all federal
income ta!es. Almost 75 percent of income earners pay no federal personal income
ta!es. Fot surprisingly, when +resident Eeorge B. :ush presented his 355; plan to
reduce federal income ta!es, 75 percent of American polled did not believe that federal
income ta!es were too high. Bhy should theyH Almost none of them actually pay any
federal income ta!es.
"n contrast, virtually anybody who is self-employed or works for a company pays payroll
ta!es. Bhen payroll ta!es were instituted in the .>;5s, they represented a mere . percent
of federal ta! revenues. Today, they represent about ;7 percent. :ecause so many
people actually pay payroll ta!es, some economists have called for a reduction in these
ta!es. 0niversity of Te!as economist Kaniel #amermesh estimated that a .5 percentage
point reduction in payroll ta!es would lead to a short-term ; percent increase in
employment and a long term .5 percent increase in employment in the 0%. #is analysis
e!plicitly uses marginal thinking. The reward to working would increase permanently,
and the cost of hiring would decrease permanently. The obvious result$ a larger supply
of workers and a greater demand for workers.
Bill wee see a reduction in payroll ta!es soonH Almost certainly not. As long as the
myth that we need to have a separate fund for %ocial %ecurity and -edicare continues to
dominate thinking in ongress, the payroll ta! will remain sacrosanct. "n fact, as we not
in hapter .<, payroll ta!es will probably continue to rise in order to )fund* %ocial
%ecurity and -edicare benefit payments. Kespite the adverse incentive effects of these
ta!es, no politician wants to be accused of )tampering* with %ocial %ecurity or -edicare.
.3;
;= Fair 'ax G Income 'axes vs3 &ales 'axes
'he Fair 'ax proposal
Ta! time is never a pleasant e!perience for any American. ollectively millions and
millions of hours are spent on filling out forms and trying to decipher arcane instructions
and regulations. :y filling out these forms we become painfully aware of how much
money we put into federal coffers each year. This heightened awareness causes a flood of
proposals on how to improve the way governments collect funds. A group known as
Americans for Fair Ta!ation proposes replacing income ta!es with a national sales ta!.
@epresentative Dohn /inder of Eeorgia has even sponsored a bill known as the Fair Ta!
Act of 355;. a fellow guide, @obert /ongley, has written an interesting summary of the
Fair Ta! proposal.
The idea to replace the income ta! with a sales ta! is not a new one. Federal sales ta!es
are widely used in other countries around the world, and given the low ta! burden
compared to anada and 2urope it is at least plausible that the federal government could
obtain enough revenue from a sales ta! in order to completely replace federal income
ta!es. The Fair Ta! movement has come up with a scheme where income, estate, and
payroll ta!es could all be replace with a 3; percent national sales ta!. "t is not hard to see
the appeal of such a system. %ince all ta!es would be collected by businesses, there
would be no need for private citi,ens to fill out ta! forms. Be could abolish the "@%W
-ost states already collect sales ta!es, so a federal sales ta! could be collected by the
states, thus reducing administrative costs. There are a lot of apparent benefits to such a
change.
There are three questions we must ask in order to analy,e such a change&
.. Bhat impact will the change have on consumer spending and the economyH
3. Bho wins and who loses under a national sales ta!H
;. "s such a scheme even feasibleH
Fair 'ax- )ffect on the )conomy and consumer &pending
4ne of the largest effects a change to a national sales ta! system such as Fair Ta! would
have is to change peoples working and consumption behavior. +eople respond to
incentives, and ta! policies change the incentives people have to work and to consume. "t
is unclear if replacing an income ta! with a sales ta! would cause consumption within the
0nited %tates to rise or fall. There will be two opposing forces at play&
.. 'he )ffect on Income
because income is no longer ta!ed, the incentives to work have changed. -any workers
can choose the amount of overtime they work. Take the e!ample of someone who would
make an e!tra 637.55 if he worked an hour of overtime. "f his marginal income ta! rate
.3<
for that e!tra hour of work is <5J, he would only earn 6.7.55 and pay 6.5.55 in income
ta!es.
"f income ta!es have been eliminated, he would get to keep the whole 637.55. "f an hour
of free time is worth 635.55, then he would work the e!tra hour under the sales ta! plan,
but not work it under the income ta! plan. %o a change to a sales ta! plan reduces the
disincentives to work, so workers as a whole will end up earning more. "f workers earn
more, theyll spend more. %o the effect on income suggests that the Fair Ta! plan will
cause consumption to increase.
3. Changes in spending patterns
"t goes without saying that people dont like paying ta!es if they dont have to. "f there is
a large sales ta! on purchasing goods we should e!pect people to spend less money on
those goods. This could be accomplished in several ways&
&pending less and saving more3 4f course, todays savings are likely to
be used for tomorrows consumption, so consumers may 1ust be delaying the inevitable.
They still may wish to save more, as they may believe the sales ta! will not last forever
or they may plan on finding other ways to avoid the ta! in the future.
&pending money outside of the 0nited &tates3 urrently if consumers
wish to spend their money cross-border shopping in anada or on a vacation in the
aribbean, they have already been ta!ed by the Federal government on that money at the
income level. 0nder a sales ta! scheme, they can spend their earnings outside the country
and not be ta!ed on any of it, unless they bring enough goods back into the 0nited %tates.
%o we should e!pect to see more money spent on vacations and outside of the 0nited
%tates, and less money spent within the 0nited %tates.
&pending in a manner which evades taxes3
"f there is an easy way to evade ta!es, it is likely that a large number of people will
participate in it. 4ne easy way to evade sales ta!es is to claim your spending as a
)business e!pense*, even if it is a purchase for personal use. Eoods which are used in
production, known as intermediate goods, are not sub1ect to a regular sales ta!. The
government could close this loophole by making the sales ta! a )Ialue Added Ta!*
'IAT( such as the anadian Eoods and %ervices Ta! 'E%T(. IATs and E%Ts are rather
unpopular with the business community, as they raise the costs of production, so it is
unlikely the 0. %. would want to embark on this path. Bith a high sales ta! rate, ta!
evasion will be prevalent, so this effect will cause a decrease in spending on )ta!ed*
goods.
4verall it is not clear whether consumer spending will increase or decrease. :ut ther are
still conclusions we can draw on what effect this will have on different parts of the
economy.
.37
Fair 'ax-)ffect on Macroeconomic Hariables
Be saw in the previous section that a simple analysis cannot help us determine what will
happen to consumer spending. #owever from that analysis we can see that a change to a
national sales ta! is likely to have the following effects&
+roduction is likely to rise as marginal income ta! rates fall to ,ero which
induces people to work e!tra hours.
Take home income will rise as people are not being ta!ed on income.
%pending within the 0nited %tates may or may not rise.
%aving and spending abroad will increase, which will cause&
A weakening of the 0. %. dollar as Americans who want to buy foreign
goods will need to e!change their 0. %. dollars for foreign currency. Be
should e!pect to see the 0. %. dollar become less valuable relative to other
currencies, particularly the anadian dollar.
The price of investment goods such as bonds will rise as people wish to
save more, so interest rates will fall. The link between interest rates, and
the demand for investments can be seen in my article The Kividend Ta!
ut and "nterest @ates
The after ta! price of consumer goods will go up due to the sales ta!.
#owever, the pre-ta! price of consumer goods is likely to fall since
increased productivity will cause an increase in the supply of goods. Be
have seen that we cannot be sure whether or not there will be an increase
or decrease in demand for consumer goods purchased within the 0nited
%tates. The price of these consumer goods will increase but not by the full
amount caused by the ta! increase.
The price of goods outside of the 0nited %tates 'particularly in anada(
will increase because of this increased demand. ities such as Bindsor,
4ntario should e!pect to see even more American visitors than they do
already.
Fot all consumers will be effected equally by these changes. Bell ne!t look at who will
lose and who will win under a national sales ta!.
Fair 'ax G *ho #oses>
Fot all consumers will be effected equally by these changes. Bell ne!t look at who will
win under a national sales ta! and who will lose. hanges in government policy never
effects everybody equally. Americans for Fair Ta!ation estimates that the typical
American family will be over .5 percent better off than they would be under the income
ta!. 2ven if you believe these claims, not all individuals and families are typical, so some
will benefit more and some will benefit less.
.3=
*ho might lose under a national sales tax>
&eniors. +eople do not earn income at a steady rate during their lifetime. The
bulk of most peoples earnings occur before the age of =7. +eople over the age
of =7 have vastly reduced incomes and live off the savings they earned while
employed.
A switch to a sales ta! will be in effect ta!ing them twice. Theyve already
paid a lifetime of income ta!es and now they have the opportunity to live off
of their savings and consume, theyll be ta!ed on that consumption. 0nless
special consideration is given to the current generation of seniors, they will
end up paying a disproportionate share of ta!es.
'he Poor Eenerally the working poor pay very little 'if any( income ta!.
#owever everybody needs to consume to survive. The poor get hit twice
under such a scheme. urrently the poor pay little ta!, where now theyll have
to pay ta!es on their consumption, so their total ta! bill will rise dramatically.
The poor also spend a larger proportion of their income on consumption goods
to survive, so theyll pay a larger percentage of their income in ta!es than
wealthier individuals. The Fair Ta! advocates reali,e this, so their plan
includes sending each American family a rebate or )pre-bate* check each
month to cover the necessities of life. The si,e of the checks will be designed
so that a family right at the poverty line would not pay a cent in ta!es. 4f
course, the higher the allowance made for the poor, the higher the ta! rate
everyone else will pay in order to cover federal spending.
2conomist Billiam E. Eale at the :rookings "nstitute has determined that most low
income families will pay more ta!es. )0nder the Americans for Fair Ta!ation proposal,
ta!es would rise for households in the bottom >5 percent of the income distribution,
while households in the top . percent would receive an average ta! cut of over 6?7,555.*
Families urrently the income ta! has all sorts of deductions for small
families such as earned income credits and a child care credits. These would
disappear with the elimination of the income ta!. A sales ta!, other than for
purposes of the rebate, would not distinguish between families and
individuals. Eale states that the )enactment of a broad-based, flat-rate
consumption ta! like the sales ta!Twould hurt families with incomes less
than 6355,555, because of the loss of ta! preferences, but would help families
with income above 6355,555, due to the dramatic reduction in the top ta!
rate.* Eiven that the rebates are given based on the poverty line, and the
poverty line does not dramatically increase between a one-person and two-
person family, this is not surprising.
I& )mployees and income 'ax #awyers +art of the appeal of the proposal
is that it will make the "@% irrelevant.
.3?
*ho might win under a national sales tax>
+eople who are inclined to save S A consumption ta! can be avoided by not
consuming. %o it makes sense that people who do no consume a lot will
benefit from the plan. Eale admits that there are savings for a large portion of
the population, stating )"f households are classified by consumption level, a
somewhat different pattern emerges. #ouseholds in the bottom two-thirds of
the distribution would pay less than currently, households in the top third
would pay more. %till households at the very top would pay much less, again
receiving a ta! cut of about 6?7,555*.
+eople who can shop in other countries S This includes people who take a lot
of overseas vacations and Americans living near either the anadian or
-e!ican border who can do their shopping in those countries to avoid ta!es.
The wealthiest one percent S As stated they will see an average ta! cut of
6?7,555 per person.
The ability to get such a ta! plan implemented will depend on the political power
these different groups hold. "t also may not be political feasible because of some
flaws in the proposal. There are a few basic flaws with the Fair Ta! proposal&
The 3; percent ta! rate quoted is a ta!-inclusive rate. #owever ta! rates are
normally quoted as a ta!-e!clusive rate. The Fair Ta! plan has a ta!-e!clusive
rate of over ;5 percent, which may be difficult to sell to voters.
The ease of ta!-avoidance and ta!-evasion S %ince consumers can either make
their purchases in another country, or claim their purchases as business
e!penses, the ta! may not generate the necessary amount of revenue.
The desire for e!emptions S -any desirable goods would be sub1ect to the
Fair Ta!. #ealth insurance is one such good. "t is likely that various political
interests would suggest that certain goods not be ta!ed. "t is likely that some
of these appeals would be successful. "f they are successful however, the ta!
rate would have to be raised even higher, or large deficits would occur.
The possibility of having both an income ta! and a sales ta! S The national
sales ta! is desirable because it replaces income ta!ation. #owever there is
nothing restricting the government from having both a nation sales ta! and an
income ta!. @epeal of the .=
th
amendment would make income ta!es illegal,
but repeal seems incredibly unlikely. "f the government was able to ta!
income, they probably would.
/ike the flat ta! before it, Fair Ta! is an interesting proposal which is unlikely to ever be
implemented. Bhile implementation of the Fair Ta! would have several positive 'and a
few negative( consequences for the economy, groups that lose under the system would
make their opposition felt. The constant need of government to offer rebates and refunds
to segments of the population would cause the rate to rise to levels which are politically
unfeasible. "t is, however, an interesting idea worth discussing.
.39
EA &implifying the Federal 'ax &ystem 8$on:t Hold Iour (reath9
Although the dictum that )nothing is certain e!cept death and ta!es* seems ingrained in
our society today, it wasnt always so. "ndeed, e!cept briefly during the ivil Bar, the
0% had no federal income ta! until after the addition of the %i!teenth Amendment in
.>.;. As one lawmaker pointed out during the debates at that time, with a federal
income ta!, )a hand from Bashington will stretch out to every mans house.* The
%i!teenth Amendment passed nonetheless.
Kespite the intense debate over its initiation, the federal income ta! was not so onerous in
the beginning. ongress e!empted individual incomes below about 675,555 in todays
dollars and married couples incomes below about 6=7,555. -oreover, ta! rates were
low, and the design of the system was quite simple, as reflected in Table .9-., which
shows the very first system we had in .>.;.
"n addition to imposing a low burden even on those who paid ta!es, the federal income
ta! code in the beginning was easy to understand and applied to very few Americans.
Those who did pay filled out a simple one-page form. onsider now how far we have
come from )the good old days.*
'able 4+-4 'he 7riginal Federal 'ax Code2 414E
"ncome /evel 2quivalent "ncome
Ta! @ate in .>.; /evel in 355? Z
.J 0p to 635,555 0p to 6;79,955
3J 635,55.-675,555 6;79,95.-69>=,=75
;J 675,55.-6?7,555 69>=,=7.-6.,;<7,555
<J 6?7,55.-6.55,555 6.,;<7,55.-6.,?>;,375
7J 6.55,55.-6375,555 6.,?>;,37.-6<,<9;,.75
=J 6375,55.-6755,555 6<,<9;,.7.-69,>==,;75
?J 4ver 6755,555 4ver 69,>==,;75
7ur Complex Internal evenue Code
Dust try to grasp the following passage from a page out of the "nternal @evenue ode-a
passage that is not at all atypical&
/ine 35b'.(.-Gou must complete this line if there is a gain on Form <?>?, /ine ;$ a loss
on <?>?, /ine .3$ and a loss on Form <=9<, /ine ;7, olumn 'b('ii(. 2nter on this line
and on %chedule A 'Form .5<5( /ine 33, the smaller of the loss on Form <?>?, /ine .3$
or the loss on Form <=9<, /ine ;7, olumn 'b('ii(. To figure which loss is smaller, treat
both losses as positive numbers.
Fow, if you can figure that out, you are probably a certified public accountant with many
years of e!perience. "ts not 1ust ta!payers who think the ta! code is complicated. Dust a
few years ago, the head of the "nternal @evenue %ervice asked for thirty thousand more
agents because )the ta! system continues to grow in comple!ity, while the resource base
of the "@% is not growing.*
.3>
Bhy is the "nternal @evenue ode so complicatedH The problem is that ongress enacts
change after change in our ta! laws, layering new provisions on top of old ones,
seemingly without much regard for the web it is weaving. From .>>9 through 3553,
ongress enacted over three hundred such changes. "n 355;, ongress went through the
ta! code from top to bottom, making hundreds more changes. To understand our current
complicated ta! code, it helps to appreciate the action-reaction syndrome.
!ction-eaction &yndrome
+eople are not assessed a lump-sum ta! each year$ each family does not 1ust pay 6.555 or
6.5,555 or 635,555. @ather, individuals and businesses pay ta!es based on tax rates3
The higher the ta! rate-the governments claim on a persons earnings in a given year-the
greater the publics reaction to that ta! rate, either by trying to hide income or by
attempting to convince ongress to lighten the burden. "t is all a matter of costs and
benefits.
"f the highest ta! rate 'called the marginal tax rate( you pay on the income you make is
.7 percent, then any method you can use to reduce your ta!able income by 6. saves you
.7 cents in ta! liabilities that you owe the federal government. Therefore, those
individuals paying a .7 percent rate have a relatively small incentive to avoid paying
ta!es. :ut consider individuals who faced a ta! rate of >< percent in the .><5s. They
had a tremendous incentive to find legal ways to reduce their ta! liabilities by >< cents.
4ne way that individuals and corporations facing high ta! rates react is by making
concerted attempts to get ongress to add loopholes to the ta! laws that allow them to
reduce their ta!able incomes. "ndeed, it is commonplace that when ongress changes the
"nternal @evenue ode to impose higher ta! rates on high incomes, it also provided for
more loopholes, either immediately or soon thereafter. For e!ample, special provisions
enable investors in oil and gas wells to reduce their ta!able incomes. 4ther loopholes
allow people to shift income from one year to the ne!t. %till other loopholes permit
individuals to avoid some ta!es completely by forming corporations outside the 0%.
2very loophole means another paragraph or page in the ta! code. Furthermore, because
loopholes lower ta! receipts, the ta! rate imposed on other people has to be that much
higher, if the government wishes to collect a specific amount of ta! revenues.
There are literally thousands of loopholes scattered throughout the ta! code, garnered by
hundreds of interest groups3 As long as one group of ta!payers sees a specific benefit
from getting the law changed and that benefit means a lot of money per individual, the
interest group will lobby aggressively and support the election and reelection of members
of ongress who will push for the loopholes desired by that group. "f the benefits from
influencing ta! legislation are high enough, the affected parties will e!ert such influence-
and will likely get their way. The result& a few more paragraphs or pages in the ta! code
and a slightly higher ta! rate imposed on the rest of the populace.
&ome Possible &implifications in the Federal 'ax &ystem
2very several years, presidential candidates, candidates for ongress, and economists in
and out of academia consider alternatives to the current federal ta! system. /ets look at
some of those possibilities.
.;5
! Halue-!dded 'ax
A ta! on value added is a type of sales ta!, currently used throughout 2urope. "t
involves ta!ing only the value that is added at each stage of production of a good or
service. :y the time this ta! gets around to the ultimate consumer, it averages around 35
percent in 2urope. Gale /aw +rofessor -ichael Eraet, has calculated that a .7 percent
value-added ta! could be used to eliminate the federal income ta! for families earning
less than 6.55,555 a year. Those earning over 6.55,555 a year would still have to pay
some income ta!es, but at a rate lower than today and under a greatly simplified system.
4f course, a proposal such as this might present a few political problems. Bould health-
care e!penditures be sub1ect to the value-added ta!H +robably not, because senior
citi,ens 'who consume most of the nations health-care resources( would convince
politicians that this would impose an )unfair* burden on them. The result would be a few
more paragraphs or pages added to the code and slightly higher value-added ta! on
everything else. Bhat about housing e!penditures-would they be sub1ect to the value-
added ta!, tooH +robably not, because the housing industrys lobbyists are so strong that
they would likely get an e!emption, and we would get a few more pages in the ta! code.
4f course, every time a new e!emption was applied, the value-added ta! would have to
be raised-which would add to the pressure for more loopholes. -oreover, although
young people might like the system retired people would probably ob1ect to the implicit
)double ta!ation* they would face under such a scheme. After all, todays working
people would get lower income ta!es in return for the new value-added ta!. :ut retirees,
who paid income ta!es through out their working careers, would now simply be getting
stuck with the new value added ta!. +oliticians would probably agree that this would be
unfair, and so a few more paragraphs or pages would be added to the new ta! code, and
the rate paid by young people would have to be raised-1ust a bit, of course.
! Fational &ales 'ax
A straightforward national sales ta! sounds simple. 2liminate the federal income ta! and
simply ta! everything that is sold to consumers. The problem is that such a national sales
ta! would have to be over 35 percent to start with. Then, if food, clothing, and health-
care costs were e!empted 'perhaps on the grounds that ta!es on such items would impose
an unfair burden on the poor and the elderly(, the national sales ta! would have to be
even higher. Another issue is how we would transition to a national sales ta!. A massive
one-time shift to the new system would likely generate huge swings in working and
spending behavior as people tried to take advantage of the switch from a ta! on earnings
to a ta! on spending. -oreover, some would argue that low income earners would be hit
harder by a sales ta! because they spend a higher percentage of their income than high-
income earners do. +oliticians responding to this plea would have to add only a few
more pages to the ta! code and perhaps impose 1ust a slightly higher sales ta! on those
not e!empt.

.;.
E+ 'he Myths of &ocial &ecurity
Gou have probably heard politicians debate the need to reform %ocial %ecurity. "f you are
under the age of thirty, this debate has been going on for your entire lifetime. Bhy has
nothing been doneH The reason is that the politicians are debating over )facts* that are
not facts& -ost of the claims made about %ocial %ecurity are myths-urban legends, if you
like. %adly, the politicians have been repeating these myths so often for so long that they
believe the myths, and so do their constituents 'perhaps including you(. As long as these
myths persist, nothing meaningful will be done about %ocial %ecurity, and the problem
will simply get worse. %o lets see if we cant cut through the fog by e!amining some of
the worst %ocial %ecurity myths.
Myth 4D 'he )lderly !re Poor
The %ocial %ecurity Act was passed in .>;7 as the 0% was coming out of the Ereat
Kepression. The unemployment rate at the time was the highest in our nations history.
:ank runs and the stock market crash of .>3> had wiped out the savings of millions of
people. -any elderly people had little or no resources to draw on in retirement, and their
e!tended families often had few resources with which to help them. "n the midst of these
conditions. %ocial security was established to make sure that the elderly had access to
some minimum level of income when they retired. "t was never meant to be the sole
source of retirement funds for senior citi,ens.
Eiven the circumstances of the programs founding, it is not surprising that many people
associate %ocial %ecurity with poverty among the elderly. The fact is that both the %ocial
%ecurity program and the financial condition of older people have changed dramatically
over the years. For e!ample, measured in todays dollars, initial %ocial %ecurity
payments were as little as 6..5 per month and reached a ma! of 6<75 per month, or
about 67,<55 per year. Today, however, many recipients are eligible for payments in
e!cess of 635,555 per year. -ore important, people over age si!ty-five are no longer
among the poorest in our society.
As a result of many years of a strong economy and their own saving habits, todays
elderly have accumulated literally trillions of dollars in assets. These assets include
homes that are fully paid for and substantial portfolios of stocks and bonds. "n addition,
millions of older Americans are drawing private pensions, built up over years of
employment. %ocial %ecurity payments, for e!ample, now provide only about <5 percent
of the income of the average retired person, with the rest coming about equally from
private pensions, employment earnings, and investment income. Far from being the age
group with the highest poverty rate, the elderly actually suffer about 37 percent less
poverty than the average of all 0% residents. To be sure, %ocial %ecurity helps make this
possible, but 1ust as surely, only about .5 percent of the elderly are living in poverty. "n
contrast, the poverty rate among children is twice as high as it is among people over age
si!ty-five.
Myth BD &ocial &ecurity Is Fixed Income
.;3
-ost economic and political commentators and laypersons alike treat %ocial %ecurity
benefits as a source of fi!ed income for the elderly, one that supposedly falls in real
purchasing power as the general price level rises. The myth, too has its roots in the
early days of %ocial %ecurity, when payments were indeed fi!ed in dollar terms and thus
were sub1ect to the ravages of inflation3 :ut this is no longer true. Thirty-five years ago,
ongress decided to link %ocial %ecurity payments to a measure of the overall price level
in the economy. The avowed reason for this change was to protect %ocial %ecurity
payments from any decline in real value during inflation. "n fact, because of the price
level measure chosen by ongress, the real value of payments actually rises when there is
inflation.
Although there are many potential measures of the average price of goods and services,
ongress decided to tie %ocial %ecurity payments to the consumer price index 8CPI9.
The +" is supposed to measure changes in the dollar cost of consuming a bundle of
goods and services that is representative for the typical consumer. Thus a .5 percent rise
in the +" is supposed to mean that the cost of living has gone up by .5 percent.
Accordingly, the law provides that %ocial %ecurity benefits are automatically increased
by .5 percent.
As it turns out, however, as we noted in hapter .., the +" actually overstates the true
inflation rate& "t is biased upward as a measure of inflation. This bias has several
sources. For e!ample, when the price of a good rises relative to other prices, people
usually consume less of it, enabling them to avoid some of the added cost of the good.
:ut the +" does not take this into account. %imilarly, although the average quality of
goods and services generally rises over time, the +" does not adequately account for this
fact. 4verall, it has been estimated that until recently, the upward bias in the +"
amounted to about ... percentage points per year on average. @evisions to the +" have
reduced this bias to about 5.9 percent per year. Thus currently, if the +" says prices
have gone up, say, ..9 percent, theyve really gone up only ..5 percent. Fevertheless,
%ocial %ecurity payments are automatically increased by the full ..9 percent.
Fow, 5.9 or ... percentage points dont sound like much. And if it happened only once
or twice, there wouldnt be much of a problem. :ut almost every year for the last thirty-
five years, this e!tra amount has been added to benefits. And over a long time, even the
small upward bias begins to amount to a real change in purchasing power. "ndeed, this
provision of the %ocial %ecurity system has had the cumulative effect of raising real
'inflation-ad1usted( %ocial %ecurity benefits by over <5 percent over this period. %o
despite the myth that %ocial %ecurity is fi!ed income, in reality the benefits grow even
faster than inflation.
Myth ED 'here is a &ocial &ecurity 'rust Fund
For the first few years of %ocial %ecuritys e!istence, ta!es were collected but no benefits
were paid. The funds collected were used to purchase 0% Treasury bonds, and that
accumulation of bonds was called the %ocial %ecurity Trust Fund. 2ven today, ta!
collections 'called payroll taxes( e!ceed benefits paid each year currently by more than
6.55 billion per year so that the trust fund now has well over 6. trillion in Treasury
bonds on its books. 2ventually, after the fund reaches a peak of around 63.= trillion,
retiring baby boomers will drive outgoing benefits above incoming ta! collections. The
.;;
bonds will be sold to finance the difference$ by around 35<5, all of them will be sold, and
thereafter all benefits in e!cess of payroll ta!es will have to be financed e!plicitly out of
current ta!es.
The standard story told 'by politicians at least( is that the bonds in the trust fund represent
net assets, much like the assets owned by private pension plans. This is false. ongress
has already spent the past e!cess of ta!es over benefits and has simply given the trust
fund "40s. These "40s are called 0% Treasury bonds, and they are nothing more than
promises by the 0% Treasury to levy ta!es on someone to pay benefits. Bhen it is time
for the trust fund to redeem the "40s it holds, ongress will have to raise ta!es, cut
spending on other programs, or borrow more money to raise the funds. :ut this would be
true even if there were no Treasury bonds in the trust fund& All %ocial %ecurity benefits
must ultimately be paid for out of ta!es. %o whatever might have been intended for the
trust fund, the only asset actually backing that fund is nothing more and nothing less than
an obligation of Americans-you-to pay ta!es in the future.
Myth <D &ocial &ecurity *ill (e 'here for Iou
%ocial %ecurity was a great deal for "da -ae Fuller, who in .><5 became the firs person
to receive a regular %ocial %ecurity pension. %he had paid a total of 637 in %ocial
%ecurity ta!es before she retired. :y the time she died in .>?7 at the age of .55, she had
received benefits totaling 63;,555. And although "da -ae did better than most recipients,
the average annual real rate of return for those early retirees was an astounding .;7
percent per year. 'That is, after ad1usting for inflation, every initial 6.55 in ta!es paid
yielded 6.;7 per year during each and every year of that persons retirement.(
+eople retiring more recently have not done quite so well, but everyone who retired by
about .>?5 has received a far better return from %ocial %ecurity than could likely have
been obtained from any other investment. These higher benefits relative to contributions
were made possible because at each point in time, current retirees are paid benefits out of
the ta!es paid by individuals who are currently working. %ocial %ecurity is a pay as you
go systemJ it is not like a true retirement plan in which participants pay into a fund and
receive benefits according to what they have paid in and how much that fund has
cumulatively earned. %o as long as %ocial %ecurity was pulling in enough new people
each year, the system could offer benefits that were high relative to ta!es paid. :ut
membership in %ocial %ecurity is no longer growing so fast, and the number of retirees is
growing faster. -oreover, todays added trickle of new retirees will soon become
tomorrows flood, as the baby boom generation e!its the workforce. The result is bad
news all around.
4ne way to think about the problem facing us-which is chiefly a problem facing you-is to
contemplate the number of retirees each worker must support. "n .><7, forty-two
workers shared the burden of one %ocial %ecurity recipient. :y .>=5, nine workers had
to pick up the tab for each person collecting %ocial %ecurity. Today, the burden of a
retiree is spread out among a bit over four workers. Bithin twenty-five years, fewer than
three workers will be available to pay the %ocial %ecurity benefits due each recipient.
.;<
The coming ta! bill for all of this will be staggering. "f we immediately raised %ocial
%ecurity 'payroll( ta!es from .7.; percent to a bit over .> percent-more than a 3< percent
increase-and kept them there for the ne!t seventy-five years or so, the systems revenues
would probably be large enough to meet its obligations. :ut this would be the largest ta!
increase in 0% history, which makes it e!tremely unlikely that it will occur. Get every
day that ongress delays, the situation gets worse. "f ongress waits until 35;5 to raise
ta!es, they will have to be increased by more than 75 percent. "ndeed, some
commentators are predicting that without fundamental reforms to the system, payroll
ta!es alone will have to be hiked to 37 percent of wages in addition to regular federal,
state, and local income ta!es, of course.
And what form are these reforms likely to takeH Bell, rules will specify that people must
be older before they become eligible for %ocial %ecurity benefits. 2!isting legislation is
already inching the age for full benefits up to si!ty-seven from its previous si!ty-five.
Almost certainly, this age threshold will be hiked again, perhaps to seventy. -oreover, it
is likely that all %ocial %ecurity benefits 'rather than 1ust a portion( will eventually be
sub1ect to federal income ta!es. "t is even possible that some high-income individuals-
you, perhaps-will be declared ineligible for benefits because their income from other
sources is too high.
%o what does all this mean for youH Bell, technically, a %ocial %ecurity system will
probably be in e!istence when you retire, although the retirement age will be higher than
today, and benefits will have been scaled back significantly. "t is also likely that, strictly
speaking, the %ocial %ecurity Trust Fund will still be around when you hit the minimum
age for benefits. :ut whatever else happens to the %ocial %ecurity system between now
and your retirement, you can be secure in you knowledge of one thing& Gou will be
getting a much bigger ta! bill from the federal government to pay for it.
.;7
;> &ocial &ecurity2 and Mar.et Crashes
The recent gyrations in the stock market have led to a chorus of " told you sos from
opponents of social security privati,ation. @esponding to the drop of several months ago,
@obert @eich, the former labor %ecretary, crows that it )has taken the wind out of
privati,ation.* The drop is a )reality check* for those pushing for privati,ation according
to Doe 2rvin, political director of the Fational ouncil of %enior iti,ens. 4pponents of
privati,ation in ongress seem positively gleeful, Dim -cKermott, '@ep., K-Bash.( says
the drop is )serendipitous* and is glad of the )ammunition* it provides for the anti-
privati,ation forces. Fevermind that the market has recently recovered, none of this
should be taken very seriously. The arguments for privati,ation are not based on the short
run movements of the market whether those movements are in the up or down direction.
4ver the past 75 years the annual real rate of return on the %X+ 755 has been >.7 percent.
Kepending on the e!act time period and stock market inde!, returns have been somewhat
higher or lower than on the %X+ 755. :ut a ? to 9 percent rate of return is a reasonable
forecast of what investors in a broad inde! over say a ;5 year time period can e!pect
from a privati,ed social security system. "n contrast, todays young workers can e!pect a
negative rate of return from social security. 4n a present value basis, a young worker can
e!pect a mere 75 cents of benefits for every dollar of ta!es paid into the system. Get even
over the .>39 to .>7? period, the worst ;5 year period for stocks since .>3=, a worker
would have received 67.?> in present value benefits for every dollar paid into the market.
Astoundingly, these figures make social security look even better than it probably will be
because they assume that future benefits will not be lowered and current ta!es not raised,
an outcome now considered to be impossible.
%ome opponents of privati,ation recogni,e that it offers workers much higher rates of
return over the long run but they worry that a market drop could )devastate* a worker on
the verge of retirement. Fo one wants to wake up on their =7
th
birthday to find that their
nest egg has dropped in value by 35J but in a paper for the ato "nstitute -elissa #ieger
and Billiam %hipman calculate that even if a worker were unlucky enough to withdraw
his lifetime savings on the day of a terrible market crash the chances that his total return
would be lower that that offered by social security are almost nil. 2ven more
fundamentally, the tragic figure of the :lack -onday retiree is absurd.
Bhy would anyone liquidate all their savings on a single day, especially on a day like
:lack -ondayH To avoid precipitous declines, investors in a privati,ed system can do
what most financial e!perts advice and slowly reduce the percentage of their assets held
in stocks as they near retirement. -arket risks can be managed through a 1udicious choice
of financial instruments. :ut what concurrent workers do to avoid the risk that politicians
will raise their payroll ta!es, cut their future benefits, or raise the retirement ageH
+oliticians who claim that social security benefits are risk free are selling stock in a more
fraudulent enterprise than any the %2 would tolerate.
Kefenders of the current system like to refer to social security ta!es as )contributions*
which )accumulate* thereby creating the workers )pension savings.* 4f course, all thisis
.;=
nonsense. Bith the e!ception of a small surplus, all of the revenues from social security
ta!es are immediately paid out to current retirees. +rivati,ing social security, however,
will increase national savings. At first the increase in savings will be small because of the
necessity of paying current and some future retirees, but as the transition to a privati,ed
system is completed net savings will increase. A higher savings rate will raise national
income and permanently increase the rate of economic growth. 2conomist -artin
Feldstein of #arvard 0niversity estimates that the higher savings of a privati,ed system
plus the elimination of inefficient payroll ta!es could increase national wealth by .5 to 35
trillion dollars. Fo other policy promises anything like the increase in living standards
made possible by a privati,ed social security system.
The arcane and :y,antine rules governing social security ensure that for most workers
there is little connection between what they pay in ta!es and what they take out as
benefits. 4ne result is that social security reduces the incentive to work another is that
wealth is redistributed in unintended ways which are difficult to defend. Bhy should two
singles pay more of the social security burden than a married couple with the same total
incomeH Bould the ta!payers vote for such a redistribution if they knew of its e!istenceH
+robably not. Get calculations by 2ugene %teurle of the 0rban "nstitute show that social
security will impose a burden on singles more than three times as high as the burden
imposed on the married couple '4n a present value basis, young singles and young
married couples of average income will both pay hundreds of thousands of dollars more
in ta!es than they will ever receive in social security benefits.( arbitrary wealth
redistribution is not an accident of the current system, it is an almost inevitable result of
any system in which workers dont own their savings.
Bhether the stock market is up or down, if we begin the process of privati,ation
now, future generations will remark on our wise planning and foresight. :ut is we throw
away trillions of dollars and the chance to establish a more equitable system because of a
few fluctuations in the market, future generations will wonder incredulously at
.;?
<5 The *nduring Political Illusion o Farm Subsidies
%omething is definitely rotten down on the farm. The Eeneral Accounting 4ffice,
ongress fact-finding agency, released in mid-Dune a study of the 0. %. Kepartment of
Agricultures management of the farm-subsidy program, a multibillion-dollar system of
direct payments to farmers. The findings should horrify lawmakers but probably wont.
The EA4 revealed that government employees are ill-trained and federal laws too vague
to properly monitor the hundreds of thousands of farm-subsidy payments granted each
year. The EA4 found many of the approved recipients were ineligible for subsidies.
'The 0%KA fact-checks only about .,555 applications each year,( A EA4 sample of
0%KA-reviewed and approved subsidies revealed that ;5 percent of even these
scrutini,ed farm subsidies were going to people who shouldnt be receiving them.
The lack of 0%KA oversight is outrageous, given how much America spends on
subsidies. From .>>7 to 3553 the 0.%. ta!payer doled out more than 6..< billion to
farmers, and in 3553 +resident :ush upped subsidies to 6.>5 billion over the ne!t .5
years. For perspective, consider that in the year 3555 alone, 0.%. spending on farm
subsidies e!ceeded the gross domestic product of more than ?5 nations, based on federal
government figures.
Bith so much money being freely handed out, the EA4 report should lead to some
tough questions for 0%KA officials on apital #ill. Get, for all its detail, the ?7-page
report artfully avoids the bigger question that no lawmaker wants to hear& Bhy do we
even have farm subsidiesH
4ne popular misconception that contributes to support for farm subsidies is that because
they result in lower food process, they are a boon to consumers. This ignores that fact
that ta!es pay for these subsidies. Any reduction in supermarket process is paid for by
your ta!es, or someone elses, whether you buy that ear of corn or not.
Farm subsidies are not intended to reduce the cost of food significantly. 4f prices fell too
much, farmers would lose money. To prevent this, ongress also has )environmental*
conservation subsidies that pay for crops that are thus made scarcer. onsequently, from
.>>7 to 3553 we paid 6.< billion for farmland conservation subsidies that increased the
price of out food.
Another myth is that farm subsidies can help 0.%. e!ports, and therefore the 0.%.
economy, because they make our food cheaper for foreigner to buy. This claim ignores
at least two realities. First, 1ust as farm subsidies are wealth transfer from some ta!payers
to some domestic consumers, so they are a wealth transfer to foreign consumers. %econd,
farm subsidies are starting to cost 0.%. e!porters. /ast April, the Borld Trade
4rgani,ation ruled that 0.%. cotton subsidies violated global trade rules, which could lead
to billions of dollars in retaliatory tariffs or fines. The ruling will encourage developing
countries to bring lawsuits against other subsidi,ed 0.%. e!ports.
.;9
"f the 0nited %tates were to stop subsidi,ing agriculture, it could encourage others to do
the same. Fran, Fischler, the 2uropean 0nions agriculture commissioner, announced at
the Koha @ound of international trade negotiations in -ay that, )+rovided we get a
balanced deal, we are ready to put all of O2uropesP e!port subsidies on the table.* Eiven
that 2uropean agriculture subsidies are almost si! times greater per land unit than 0.%.
subsidies, American e!porters would gain tremendously from an end to subsidies.
Farmers in the developing world, who struggle in the face of unfair competition from
crops subsidi,ed by governments of the developed world, would also gain.
The most enduring political illusion is that farm subsidies are necessary to maintain the
small family farmer. "n fact, ?? percent of Americans support giving subsidies to small
family farms, according to a 355< poll by the +"+AMAnowledge Fetwork. %mall family
farmers are not the primary dollar recipient of federal subsidies, however. According to
the subsidy watchdog, 2nvironmental Borking Eroup, ?. percent of farm subsidies go to
the top .5 percent of subsidy beneficiaries, almost all of which are large farms. "n 3553,
?9 farms, none small or struggling, each received more than a million dollars in
subsidies. The bottom 95 percent of recipients average only 69<= per year.
The result of subsidi,ing the rich, more landed farmers is that they can reduce the process
of their goods, making it much harder for small farmers to compete. @ather than being
the small family farmers savior, subsidies work against them.
@ich farmers are a powerful lobby in American politics. "n the last election, crop
producers gave 6...7 million in campaign contributions, according to the enter for
@esponsive +olitics, and they are likely to give much more by this Fovember.
%o dont be surprised that the EA4s report wont be taken too seriously on apital #ill.
Farm subsidies are more than 1ust payoffs for loaded, large landowners. Theyre
subsidies for elected officials, too.
.;>
<. 'he ,raying of !merica
America is aging. The ?9 million baby boomers who pushed the :eatles and the rolling
%tones into stardom are well into middle age. "n twenty years, almost 35 percent of all
Americans will be si!ty-five or older. Dust as the post-Borld Bar "" baby boom
presented both obstacles and opportunities, so does the graying of America. /ets see
why.
Two principal forces are behind Americans )senior boom.* First, were living
longer. Average life e!pectancy in .>55 was forty-seven years& today, it is seventy-eight
and is likely to reach eighty within the ne!t decade. %econd, the birthrate is near record
low levels. Todays mothers are having far fewer children than their mothers had. "n
short, the old are living longer, and the ranks of the young are growing too slowly to
offset that fact. Together, these forces are pushing up the proportion of the population
over age si!ty-five$ indeed, the population of seniors is growing at twice the rate of the
rest of the population. "n .>?5, the median age in the 0nited %tatesCthe age that divides
the older half of the population from the younger halfCwas twenty-eight$ it is now thirty-
eight and rising. ompounding these factors, the average age at retirement has been
declining as well, from si!ty-five in .>=; to si!ty-two currently. The result is more
retirees relying on fewer workers to help ensure that their senior years are also golden
years.
Bhy should a person who is, say, college age be concerned with the age of the
rest of the populationH Bell, old people are e!pensive. "n fact, people over si!ty-five now
consume over one-third of the federal governments budget. %ocial security payments to
retirees are the biggest item, now running over 6755 billion a year. -edicare, which pays
hospital and doctors bills for the elderly, costs around 6;75 billion a year and is
increasing rapidly. -oreover, fully a third of the 6;55 billion-a-year budget for
-edicaid, which helps pay medical bills for the poor of all ages, goes to those over the
age of si!ty-five.
0nder current law, the elderly will consume <5 percent of all federal spending
within fifteen years& -edicares share of the gross domestic product 'EK+( will double,
as will the number of very oldCthose over eighty-five and most in need of care. Bithin
twenty-five years, probably half of the federal budget will go to the old. "n a nutshell,
senior citi,ens are the beneficiaries of an e!pensive and rapidly growing share of all
federal spending. Bhat are they getting for our dollarsH
To begin with, todays elderly are already more prosperous than any previous
generation. "ndeed, the annual discretionary income of Americans over si!ty-five
averages ;5 percent higher than the average discretionary income of all other age groups.
2ach year, inflation-ad1usted %ocial %ecurity benefits paid to new retirees are higher than
the first-year benefits paid to people who retired the year before. "n addition, for almost
thirty-five years, cost-of-living ad1ustments have protected %ocial %ecurity benefits from
inflation. The impact of %ocial %ecurity is evident even at the lower end of the income
scale& the poverty rate for people over si!ty-five is much lower than for the population as
a whole. @etired people today collect %ocial %ecurity benefits that are two to five times
what they and their employers contributed in payroll ta!es plus interest earned.
.<5
Fot surprisingly, medical e!penses are a ma1or concern for many elderly. +erhaps
reflecting that concern, each person under the age of si!ty-five in America currently pays
an average of more than 6.,=55 a year in federal ta!es to subsidi,e medical care for the
elderly. "ndeed, no other country in the world goes to the lengths that America does to
preserve life. %ome ;5 percent of -edicares budget goes to patients in their last year of
life. oronary bypass operations, costing over 6<5,555 apiece, are routinely performed on
Americans in their si!ties and seventies. For those over si!ty-five, -edicare picks up the
tab. 2ven heart transplants are now performed on people in their si!ties and paid for by
-edicare for those over si!ty-five. :y contrast, the Dapanese offer no organ transplants.
:ritains Fational #ealth %ervice generally will not provide kidney dialysis for people
over fifty-five. Get -edicare subsidi,es dialysis for more than one hundred thousand
Americans, half of them over age si!ty. The cost& -ore than 6< billion a year. 4verall,
the elderly receive -edicare benefits worth five to twenty times the payroll ta!es 'plus
interest( they paid for this program.
The responsibility for the huge and growing bills for %ocial %ecurity and
-edicare falls squarely on current and future workers, because both programs are
financed by payroll ta!es. Thirty years ago, these programs were adequately financed
with a payroll levy of less than .5 percent of the typical workers earnings. Today, the ta!
rate e!ceeds .7 percent of median wages and is e!pected to grow rapidly.
:y the year 3535, early baby boomers, born in the late .><5s and early .>75s,
will have retired. /ate baby boomers, born in the early .>=5s, will be nearing retirement.
:oth groups will leave todays college students, and their children, a staggering bill to
pay. For %ocial %ecurity and -edicare to stay as they are, the payroll ta! rate may have to
rise to 37 percent of wages over the ne!t fifteen years. And a payroll ta! rate of <5
percent is not unlikely by the middle of the twenty-first century.
4ne way to think of the immense bill facing todays college students and their
successors is to consider the number of retirees each worker must support. "n .><=, the
burden on one %ocial %ecurity recipient was shared by forty-two workers. :y .>=5, nine
workers had to foot the bill for each retirees %ocial %ecurity benefits. Today, roughly
three workers pick up the tab for each retirees %ocial %ecurity and -edicare benefits. :y
35;5, only two workers will be available to pay the social %ecurity and -edicare benefits
due each recipient. Thus a working couple will have to support not only themselves and
their family but also someone outside the family who is receiving social security and
-edicare benefits.
+aying all the bills presented by the twenty-first centurys senior citi,ens will be
made more difficult by another fact& 4lder workers are leaving the workplace in record
numbers. Be noted earlier that the average retirement age is down to si!ty-two and
declining. 4nly ;5 percent of the people age fifty-five and over hold 1obs today,
compared with <7 percent in .>;5. so even as the elderly are making increasing demands
on the federal budget, fewer of them are staying around to help foot the bill.
+art of the e!odus of the old from the workplace is due simply to their prosperity.
4lder people have higher disposable incomes than any other age group in the population
and are using it to consume more leisure. "mportantly, however, the changing work habits
of older individuals have been promptedCperhaps inadvertentlyCby American
businesses. areer advancement often slows after age fortyCmore than =5 percent of
American corporations offer early retirement plans, whereas only about 7 percent offer
.<.
inducements to delay retirement. /ooking ahead to career dead-ends and hefty retirement
checks, increasing numbers of older workers are opting for the golf course instead of the
morning commute.
@ecently, however, the private sector has begun to reali,e that the graying of
America requires that we rethink the role of senior citi,ens in the workforce. %ome firms
are doing more than 1ust thinking. For e!ample, a ma1or chain of home centers in
alifornia has begun vigorously recruiting senior citi,ens as salesclerks. The result has
been a sharp increase in customer satisfaction& The older workers know the merchandise
better and have more e!perience in dealing with people. -oreover, turnover and
absenteeism have plummeted. +eople with gray hair, it seems, are immune to )surfers
throat* a malady that strikes younger alifornians when sunny weekends are forecast.
4ther firm have introduced retirement transition programs. "nstead of early
retirement at age fifty-five or si!ty, for e!ample, older workers are encouraged to simply
cut back on their workweek while staying on the 1ob. 4ften it is possible for workers to
get the best of both worlds, collecting a retirement check even while working part-time at
the same firm. Another strategy recogni,es the importance of rewarding superior
performance among older workers. At some firms, for e!ample, senior technical
managers are relieved of the drudgery of mundane management tasks and allowed to
spend more time focusing on the technical side of their specialties. To sweeten the pot, a
pay hike is often included in the package.
ongress and the e!ecutive branch have seemed unwilling to face the pitfalls and
promises of an aging America. Although the age of retirement for %ocial %ecurity
purposes is legislatively mandated to rise to si!ty-seven from si!ty-five, the best that
politicians in Bashington, K. ., appear able to do is appoint commissions to )study* the
problems we face. And what changes are our politicians willing to makeH Be got a
sample of this in 355;, with new legislation promising ta!payer-funded prescription drug
benefits for senior citi,ens. 2ven people in favor of the new program called it the largest
e!pansion in entitlement programs in forty years. :efore passage of the law, +resident
:ush claimed it was going to cost 6;7 billion a year, but within a couple of months, that
estimate had been hiked to over 675 billion. "n fact, the benefits of the program will be
less than claimed, and the costs will be even higher, because more than three-quarters of
senior citi,ens had privately funded prescription drug plans before the new law took
effect. These private plans are already disappearing, leaving seniors with fewer choices
and sticking you with a larger ta! bill.
:y now you may be wondering how we managed to commit ourselves to the huge
budgetary burden of health and retirement benefits for senior citi,ens. There are three
elements to the story. First, the cause is worthy& After all, who would want to deny the
elderly decent medical care and a comfortable retirementH %econd, the benefits of the
programs are far more concentrated than the costs. A retired couple, for e!ample, collects
more than 635,555 per year in social %ecurity and consumes another 6.7,555 in
subsidi,ed medical benefits. "n contrast, the typical working couple pays only about half
of this each year in social %ecurity and -edicare ta!es. #ence the retired couple has a
stronger incentive to push for benefits than the working couple has to resist them. And
finally, senior citi,ens vote at a far higher rate than members of any other age group, in
no small part because they are retired and thus have fewer obligations on their time. They
.<3
are thus much more likely to make it clear at the ballot bo! e!actly how important their
benefits are to them.
"t is possible for government to responsibly address the crisis in funding programs
for senior citi,ens. hile, for e!ample, faced a national pension system with even more
severe problems than our %ocial %ecurity system. "ts response was to transform they
system into one that is rapidly 'and automatically, as time passes( converting itself into a
completely private pension system. The result has been security for e!isting retirees,
higher potential benefits for future retirees, and lower ta!es for all workers. Americans
could do e!actly what the hileans have doneCif we chose to do so.
"n the meantime, if social %ecurity and -edicare are kept on their current paths
and older workers continue to leave the workforce, the future burden on todays college
students is likely to be unbearable. "f we are to avoid the social tensions and enormous
costs of such an outcome, the willingness and ability of older individuals to retain more
of their self-sufficiency must be recogni,ed. To do otherwise is to invite a future in which
the golden years are but memories of the past.
.<;
<3 Inner City High Finance
Take a ride through virtually any low-income community and you will see billboards and
other large signs advertising )check-cashing* services. At the beginning of the .>>5s
there were fewer than 3555 check cashers nationwide. Today, there are well over 7555
and the number is growing at a .5 percent annual rate. Along this same ride, you are also
likely to see numerous pawn shops, offering )Ruick /oans* or )"nstant ash.* For many
years in America, the number of pawnshops had been declining$ but between .>9= and
.>>7, their yellow-page listings across the country more than doubled, to roughly >,755.
"s the spread of check-cashing services and the rebounding vitality of pawnshops relatedH
And if so, why is their spread confined to inner-city areas, rather than across middle
America or even into posh areas such as :everly #ills or +alm :eachH The e!planation
for this rapid and peculiar change in the structure of inner-city financial markets can be
found by e!amining some unintended consequences of regulation S specifically,
consequences arising from ongresss e!pressed desire to rehabilitate the inner cities of
America.
4ur story begins roughly 35 years ago. Kuring the .>?5s, many members of ongress
became concerned that the banking system was taking advantage of low-income, inner-
city residents. %pecifically, it was argued, although banks were happy to accept deposits
from people and businesses located in inner-city areas, they were not interested in making
loans to those very same people and firms. :ecause many of these inner-city residents
and business owners were minorities, this behavior by banks was seen as discriminatory.
Dust as important, it was argued, is that the financial capital created in low-income
neighborhoods wasnt getting recycled there$ as a result, inner-city economic
development was being stifled.
"n an avowed effort to stimulate inner-city loans by banks. ongress passed the
ommunity @einvestment Act '@A( of .>??. under the terms of this act, banks were
directed to make e!tra efforts to solicit loans in older and lower income neighborhoods,
so that residents of these areas would be able to participate in, and indeed stimulate, the
economic redevelopment of these inner-city areas.
"nitially, the @A had only a relatively modest impact. 4ver the last .5 years however,
ongress and the key regulatory agencies charged with enforcing the act 'the omptroller
of the urrency and the Federal @eserve( have intensified their efforts to strengthen the
@A, presumably in the hope of stimulating inner-city lending. Get the result of these
changes has been to substantially increase the regulatory burdens of the @A, and to
actually discourage banks from doing any business in the nations inner cities.
For e!ample, regulatory agencies have proposed that banks be required to produce data
on the race, se!, and marital status of the owners of all businesses that request loans. "n a
slightly different vein, banks once received )credit* under the @A for any of a variety of
investments they made in small businesses$ under more recent guidelines, banks are
credited only if the investments benefit )low-and moderate-income geographies and
.<<
persons.* 2ven more important, however, is that when banks seek to e!pand their
operations 'e. g. by opening a branch( the regulatory agencies have begun scrutini,ing in
great detail whether or not e!isting branches of the bank are fulfilling their obligations
under the @A.
+resumably the new information on loan applicants is to be used by regulators to make
sure the individual bank branches are making their quotas of loans to minority groups.
%imilarly, the new investment guidelines are intended to more carefully guide bank
decisions so that quite specific individuals and businesses benefit from the @A. And of
course, by tying e!pansion approval to performance under the @A, the intention is
presumably to put additional teeth into the lows enforcement. "n fact, the actual
consequence of these and other features of the @A has been to discourage banks from
locating branches in low-income areas, and to close any e!isting branches in such areas.
0nder the terms of the @A, if a branchs deposits come from a particular low income
area, then a certain minimum percentage of its loans and investments must go back into
that area- virtually without regard to the profitability or risk associated with those loans
and investments. #ence, any bank that has a branch in an inner-city area runs the risk of
having its loan and investment decisions being made by a federal regulator on political
grounds, rather than being made by its loan and investment officers on the basis of
financial prudence. "f federal regulators are unsatisfied with a banks @A performance,
they can sub1ect the bank to stiff penalties$ 1ust as important is the regulators ability to
prevent banks from e!panding their operations into a new market area if they are
dissatisfied with the banks performance in an e!isting area.
:ecause the law ties loan requirements to areas where banks have deposits, the only sure
way to avoid sanctions for not lending enough in the inner cities is to ensure that no
deposits are coming from inner-city areas. Thus, if a bank has a branch in a low-income
area, it has an incentive to close it$ and if it was thinking of opening one there, those
plans will almost surely be shelved. Although the @A was intended to promote lending
in low-income areas, its effect has been to discourage banks from locating there$ on
balance, it appears that the net effect of the legislation soon will be Sor perhaps even now
isCto actually reduce rather than increase lending in Americas inner cities.
4ne of many e!amples of the laws impact on branch-banking decisions can be found in
a comparison of the inner-city area known as %outh entral /os Angeles with the more
affluent city of Eardena located right ne!t door. :ecause of the massive e!odus of banks
over the last .5 years, there are only 35 bank branches serving the 3?5,555 residents of
%outh entral /. A., but .;; fee-charging, check-cashing outlets. "n neighboring
Eardenia, which ahs a population of only 75,555, there are only a handful of check-
cashing services, but there are 3. bank branches. Across the country in the Few Gork
city, area, .< percent of :rooklyns bank branches closed between .>95 and .>><$ most
of those closures came in the lower-in-come areas of the borough. And in low-income
:edford-%tuyvesant, there are only ; bank branches to serve .3>,555 people.
.<7
"nto the void come check-cashing services. -ost outlets charge ..7 percent to = percent
of the face value of the check to cash it, but their fees can run as high as .5 percent for an
out-of-state or other risky check. 4nce customers receive their money, many of them then
buy money orders S at .75 cents to 6. apiece- to pay their bills. 4verall, check-cashing
patrons can easily pay more than triple the fees they would pay for low-cost checking
accounts at banks. 4ne Few Gork study, for e!ample, found that the typical annual
)banking* services consumed by a person bringing home 6=75 every two weeks would
cost 63;3 if performed by a check-cashing service, but only 6=9 if done by a bank. 4f
course the check casher is in the neighborhood, while the nearest bank may be a thirty-
minute bus ride away, so the apparent economy of the bank is no economy at all. For
those people who find it inconvenient to leave their homes of 1ob sites there is even an
outfit offering )-obile -oney* check-cashing trucks that will come to the customers
location to )turn paper into cash for a fee.
%ome check-cashing outlets have also gone into the lending business-although they
typically dont call it this. They make the loans by taking )post-dated* checks from
customers. ustomers pay a fee to get cash immediately, along with an agreement that
their checks will not be cashed until their ne!t payday. For e!ample, a customer might
write a check for 6;55, receiving in return 6375 in immediate cash, together with an
agreement that the check will be held until the ne!t payday. The 675 fee represents 35
percent of the money loaned. 4n an annuali,ed basis, if the check is held for two weeks,
that represents an interest rate of over 755 percentW
The departure of banks from inner cities has also stimulated borrowing from pawn shops,
which are lending institutions where a person can borrow money on items that are
pawnedCthat is, left with pawnshop as security for the loan. The customer is given a
pawn ticket and a certain amount of cash, say, 75 percent of the wholesale value of the
pawned item. 2very month, the pawnshop charges a )fee* for keeping the pawned item,
so that the amount that must be repaid to reclaim the item increases over time. These
monthly fees can amount to the equivalent of annual rates of interest between .55 and
;55 percent.
The market void created by the ommunity @einvestment Act has turned inner-city high
finance into big business. "ndeed, there are now even publicly traded chains of pawn
shops springing up throughout the country. ash American, started by Dack Kaugherty,
has over 3;5 outlets, generating about 6.75 million in revenues and 6.7 million in net
income. The value or the shares of stock in ash American has increased dramatically in
the decade that the stock has been on the market.
"f the decline in bank branches continues, there are likely to be many more Dack
Kaughertys and -obile -oney trucks providing services in the future. As the depute
superintendent of banks in Few Gork puts it, such institutions )serve a purpose in the real
world.* And what of the high fees and service charges that customers pay for the services
of check chasers and pawnshopsH @ick +rice, whose family runs si! check-cashing stores
in the Few Gork metropolitan area, notes that )Bere no different than people out there
.<=
selling sneakers to kids in poor neighborhoodsT4ur prices are an economic hardship
only if they are compared against Ufree.*
.<?
<E Central (an.
A central bank 'reserve bank or monetary authority( is an entity responsible for monetary
policy of its country 'or in the case of the 20, group of member countries(. "ts primary
responsibility as a central bank is for the stability of the national currency and money
supply, including interest rates$ and acting as a lender of last resort to the banking sector
and the national financial system as a whole. "t may also have supervisory powers to
ensure that banks and other financial institutions do not behave recklessly or fraudulently.
entral bank is usually headed by a Eovernor, +resident in the case of the 2uropean
entral :ank or hief 2!ecutiveM-anaging Kirector in the case of #ong Aong -onetary
Authority and -onetary Authority of %ingapore.
"n most countries the central bank is state-owned and has some degree of autonomy,
which allows for the possibility of government intervening in monetary policy. An
)independent central bank* is one, which operates under rules designed to prevent
political interference$ e!amples include the 0% Federal @eserve, the 0A :ank of 2ngland
'since .>>?( and the 2uropean entral :ank. The Australian central bank is called the
@eserve :ank of Australia, which sets its independent of government policy.
!ctivities and responsibilities
Functions of a central bank 'not all functions carried out by all banks(&
monopoly on the issue of banknotes
the Eovernments banker and the bankers bank ')/ender of /ast @esort*(
manages the countrys foreign e!change and gold reserves and the Eovernments
stock register$
regulation and supervision of the banking industry$
setting the official interest rate S used to manage both inflation and the countrys
currency e!change rate.
The central banks main responsibility is the management of monetary policy to ensure a
stable economy, including a stable currency. "t aims to manage inflation 'rising average
prices( as well as deflation 'falling prices(. "t is the lender of last resort, and will 'at a
price( assist banks in cases of financial distress 'see also bank runs(.
Furthermore, it will hold reserves of foreign currency, usually in the form of sovereign
bonds, and gold and have a range of influence over e!change rates. %ome e!change rates
are managed$ some are market based 'free float( and many are somewhere in between
')managed float*( or 'dirty float(.
Typically a central bank seeks to impose centrali,ed control over interest rates, the price
of credit. These are seen as important, since they influence the stock S and bond markets
as well as mortgages and other credit rates. The 2uropean entral :ank for e!ample
announces its interest rate at the meeting of its Eoverning ouncil 'in the case of the
Federal @eserve, the :oard of Eovernors(.
.<9
:oth the Federal @eserve and the 2: are composed of one or more central bodies that
are responsible for the main decisions about interest rates and the si,e and type of open
market operations, and several branches to e!ecute its polices. "n the case of the Fed, they
are the local Federal @eserve :anks, for the 2: they are the national central banks.
Instruments of monetary policy
7pen Mar.et 7perations
Bith the 4pen -arket 4perations, a : directly influences the money in an economy.
2ach time it buys securities, e!changing money for the security, it raises the money
supply$ conversely, selling of securities lowers the money supply. :uying of securities
thus amounts to printing new money while lowering supply of the specific security.
The main 4pen -arket 4perations are&
/ending money for collateral securities ')@everse 4perations*(. These operations are
carried out on a regular basis, where fi!ed maturity loans 'of . week and . month
for the 2:( are auctioned off.
:uying or selling securities ')Kirect 4perations*( on ad-hoc basis.
Foreign e!change operations such as swaps.
All of these interventions can also influence the foreign e!change market and thus the
e!change rate. For e!ample the hinese entral :ank and the :ank of Dapan have on
occasion bought several hundred billions of 0.%. Treasures, presumably in order to stop
the decline of the 0.%. Kollar versus the @enminbi and the Gen.
Interest rates
A central bank has several interest rates it can set to influence markets.
-arginal /ending @ate 'currently ;J in the 2uro,one( A fi!ed rate for institutions to
borrow money from the :.
-ain @efinancing @ate '3J in the 2uro,one( This is the publicly visible interest rate
the central bank announces. "t is also known as 'inimum (id )ate and serves as a
bidding floor for refinancing loans 'in the 0% this is called the Kiscount rate(.
Keposit @ate '.J in the 2uro,one( The rate parties receive for the deposits at the :.
These rates directly affect the rates in the money market, the market for short-term loans.
eserve re?uirements
2very bank over a minimum si,e needs to delegate a percentage of its deposits '3J in the
2uro,one( as reserves. %uch legal reserve requirements were introduced in the nineteenth
.<>
century to reduce the risk of banks overe!tending themselves and suffering from bank
runs, as this could lead to knock-on effects on other banks. %ee also money multiplier.
(an.ing supervision and other activities
"n some countries a central bank through its subsidiaries controls and monitors the
banking sector. "n other countries banking supervision is carried out by government
department such as The -inistry of Finance, or an independent government agency 'eg
0As Financial %ervices Authority(. "t e!amines the banks balance sheets and behavior
and policies toward consumers. Apart from refinancing, it also provides banks with
services such as transfer of funds, bank notes and coins or foreign currency. Thus it is
often described as the )bank of banks*. The Fed also auctions off Treasuries.
Independence
Advocates of central bank independence argue that a central bank which is too
susceptible to political direction or pressure may encourage economic cycles ')boom and
bust*(, as politicians may be tempted to boost the economy in advance of an election, to
the detriment of the long-term health of the economy. "n addition, it is argued that the
independent central bank can run a more credible monetary policy, making market
e!pectations more responsive to signals from the central bank. @ecently, both the :ank of
2ngland and the 2uropean entral :ank have been made independent and follow a set of
published inflation targets so that markets know what to e!pect.
Eovernments generally have some degree of influence over even )independent* central
banks$ the aim of independence is primarily to prevent short-term interference. For
e!ample, the chairman of the 0.%. Federal @eserve :ank is appointed by the +resident of
the 0. %., and his choice must be confirmed by the ongress.
History
4ne of the oldest banks that performed some of the duties of a central bank was the :ank
of %weden that was opened in .==9 with help form Kutch businessmen. This was
followed in .=>< by the :ank of 2ngland, created by a businessman in the ity of
/ondon at the request of the :ritish government to help pay for a war. The 0% Federal
@eserve was created by the 0.%. ongress through the passing of the Elass-4wen :ill,
signed by the +resident Boodrow Bilson on Kecember 3;, .>.;.
.75
<< Monetary Policy and Interest ates
)The Fed lowers interest rates by one-half point.* That is one of the numerous headlines
seen in the financial press during the early part of the 3555s. The Fed-short for the
F2KA2@A/ @2%2@I2 %G%T2--is Americas central bank. "nterest rates can be
affected by the fed$ when they are, that is part of monetary policy, defined as the use of
changes in the amount of money in circulation so as to affect interest rates, credit
markets, inflation, and unemployment.
The theory behind monetary policy is relatively simple. An increase in the rate of growth
of the money supply by the Fed increases spending on goods and services and thus
stimulates the economy, tending to lower unemployment in the short run and raise
inflation in the long run. '4ne important version of the money supply is compromised of
checking-type account balances and currency in the hands of the public( T flip side is that
a decrease in the rate of growth of the money supply reduces spending, thereby
depressing the economy$ the short-run result is higher unemployment, while the longer-
run effect is a lower inflation rate.
ongress established the Federal @eserve %ystem in .>.;. A :oard of Eovernors
consisting of seven members, including the very powerful chairperson, governs it. All of
the governors, including the chair, are nominated by the president and approved by the
%enate. Their appointments are for fourteen years 'although the chair serves in that role
for only fourteen years at a time(.
Though the Fed, and its Federal 4pen -arket ommittee 'F4-(, decisions about
monetary policy are made eight times a year. The Federal @eserve %ystem is
independent$ the :oard even has its own budget, financed with interest earning on the
portfolio of bonds it owns. The president can attempt to convince the :oard, and
ongress can threaten to merge the Fed with the Treasury or otherwise restrict its
behavior. :ut unless the ongress took the radical step of passing legislation to the
contrary, the Feds chair and governors can do what they please. #ence, talking about
)the presidents monetary policy* or )ongresss monetary policy* is inaccurate. To be
sure, The Fed has, on occasion, yielded to presidential pressure to pursue a particular
policy, and its true that the Feds chair follows a congressional resolution directing him
to report on what the Fed is doing on the policy front. :ut now, more than ever before,
the Fed remains the single most important and truly independent source of economic
power in the federal government.. -onetary policy is Fed policy and no one elses.
Federal @eserve monetary policy, in principle, is supposed to be counter-cyclical. That
is, it is supposed to counteract other forces that might be making the economy contract or
e!pand too rapidly. The economy goes through so-called :usiness cycles, made up of
recessions ' and sometimes depressions( when unemployment is high, and boom times
when unemployment is low and businesses are straining their productive capacity. For
the Fed to stabili,e the economy, it must create policies that go counter to other forces
affecting business activity. Although Fed policy can be put into place much faster than
most federal policies, it still does not operate instantaneously. "ndeed, researchers have
.7.
estimated that it takes almost fourteen months for a change in monetary policy to become
effective. Thus, by the time monetary policy goes into effect, a different policy might be
appropriate.
@esearchers who have e!amined to evidence over the period from .>.; until the .>>5s
have concluded that, on average, the Feds policy has turned out to be pro-cyclical, rather
than counter-cyclical. That is, by the time the Fed started pumping money into the
economy, it was time to do the opposite$ by the time the Fed started reducing the rate of
growth of the money supply, it was time for it to start increasing it. +erhaps the Feds
biggest pro-cyclical blunder occurred during the Ereat Kepression. -any economists
believe that what would have been a severe recession turned into the Ereat Kepression in
the .>;5s because the Feds action resulted in almost a one-third decrease in the amount
of money in circulation, drastically reducing aggregate spending. "t has also been argued
that the rapid inflation e!perienced in the .>?5s was importantly the result of e!cessive
monetary e!pansion by the Fed.
"n the .>>5s, few commentators were able were able to complain about monetary policy.
"nflation almost disappeared by the end of the decade, which also saw the unemployment
rate drop to its lowest level in nearly forty years. Bhy the Fed was successful in the
.>>5s remains unclear. "t could have been due to the uniquely superior insights of its
chair, Alan Ereenspan. 4r, it might simply have bee a run of good luck. :ut whatever the
reason, it is clear that the Fed remains far from perfect. /ate in the decade it tightened
monetary policy sharply, reducing monetary growth and thereby contributing to the
recession that began in 355.. -oreover, some economists are worried that the Fed may
have increased the rate of growth of the money supply too in 355. and 3553 to counter
that recession. "f they are correct, this means that the Fed will have set the stage for
renewed inflation later.
-ost newspaper discussions of Fed policy focus on its decisions to raise or lower interest
rates. :efore we can make any sense out of such discussions, we need to first understand
the relationship between nominal interest rates, that is, the rates that you see in the
newspaper and pay for loans, and the e!pected rate of inflation.
/ets start in a hypothetical world in which there is no inflation and so e!pected 'or
anticipated( inflation is ,ero. "n that world, you might be able to borrow-obtain a
mortgage to buy a home, for e!ample-at a minimal rate of interest of, say, = percent. "f
you borrow the funds and your anticipation of ,ero inflation turns out to be accurate,
neither you nor the lender will have been fooled. The dollars you pay back in the years to
come will be 1ust as valuable in terms of purchasing power as the dollars that you
borrowed, "n this situation, we would say that the real rate of interest 'defined to be the
nominal rate of interest minus the anticipated rate of inflation( was e!actly equal to
nominal interest rate.
ontrast this to a situation in which the e!pected inflation rate is, say, 7 percent.
Although you would be delighted to borrow at a = percent interest, lenders would be
reluctant to oblige you, and based on e!actly the same reasoning you would be using& the
.73
dollars with which you would be repaying the debt would be declining in purchasing
power every year of the debt. /enders would likely insist upon 'and you would agree to(
and inflationary premium of 7 percent, to make up for the e!pected inflation. #ence, the
nominal interest rate would rise to about .. percent, keeping the real rate at its previous
level of = percent.
There is strong evidence that inflation rates and nominal interest rates move in parallel&
Kuring periods of rapid inflation, people come to anticipate that inflation fairly promptly,
and thus higher nominal interest rates are the result. "n the early .>?5s when the inflation
rate was between < and 7 percent, nominal interest rates on mortgages were around 9 to
.5 percent. At the beginning of the .>95s, when the inflation rate was near > percent,
nominal interest rates on mortgages had risen to between .3 and .< percent. :y the
middle of the .>>5s, when the inflation rate was 3 to ; percent, nominal interest rates had
fallen to between = and 9 percent.
Fow lets go back to Fed policy and the headlines. Bhen the chair of the Fed states that
the Fed is lowering )the* interest rate from, say, 7.?7 percent to 7.37 percent, he rally
means something else. "n the first place, the interest rate referred to is the federal funds
rate, or the rate at which banks can borrow e!cess reserves from other banks. Any effects
of Fed policy here will show up in other rates only indirectly. -ore importantly, even
when the Fed decides to try to alter the federal funds rate, it can do so only by actively
entering the market for federal government securities 'usually Treasury bills(. %o if the
Fed wants to lower )the* interest rate, it essentially must buy Treasury bills from banks
and other private holders of them. This action bids up the prices of these bills, and
simultaneously lowers the interest rates on them. This in turn lowers the interest rates at
which banks are willing to lend to each other and to the public. '"n terms of our earlier
discussion, this policy also has the effect of increasing the money supply, and so
increases spending throughout the economy.( onversely, when the Fed wants to
increase )the* rate on interest, it sells Treasury bills, driving their prices down and
pushing interest rates up. The result is a reduction in the money supply and a reduction in
spending throughout the economy. The pre-announcement of the policy change, which
comes in the form of a Fed declaration that interest rates are going to change, simply
serves to alert people that a new policy is on the way.
The other key point to note is that the changes in interest rates we have been talking
about here are very much short-term changes-and are occurring over a period of time
short enough that the e!pected inflation rate is constant. 4nce the effects of the Feds
new policy begin to kick in, however, the e!pected inflation rate will tend to respond,
which can create a whole new set of problems. For e!ample, suppose the Fed decides to
)lower interest rates,* i.e., increase the money supply by buying Treasury bills. "n the
early weeks and months, this will indeed lower interest rates and stimulate spending. :ut
for a given level of productive capacity in the economy, this added spending will
eventually get translated into higher inflation rate. This will soon enough cause nominal
interest rates to rise, as inflationary e!pectations get added onto the real interest rate.
.7;
The fact of the matter is that although the Fed can cause interest rates to move up or
down in the short run via its choice of monetary policy, forces beyond its control
determine what interest rates will be in the long run. The real rate is determined by the
underlying productivity of the economy and the consumption preferences of individuals,
and the e!pected inflation rate is determined by peoples beliefs about future policy.
Thus, when you read that the chair of the Fed has lowered )the* interest rate, you know
that the money supply has been increased. :ut you also now know that whether the Fed
likes it or not, if this policy persists long enough, the eventual result will be more
inflation in the future, and thus higher, not lower, interest rates.
.7<
<7 Controlling InterestD !re Ceilings 7n
Interest ates a ,ood Idea>
Ko ceilings always result in lower ratesH
an ceilings reduce the amount of available creditH
Ko some borrowers tend to benefit from ceilings more than othersH
Fo one wants to pay more interest than is necessary when they use credit. Bhether
shopping for mortgages, business loans, or auto loans, we usually are concerned about
rates and terms and want to make sure we do not pay too much for the use of someone
elses money. Dust as in any other purchase, when we buy credit we want to pay the
lowest price possible.
"n the past, the government often tried to ensure that we pay )a fair rate* of interest by
implementing usury ceilings or limits on the rates that lenders can charge. uring the
.>95s there was a general trend toward eliminating or raising these limits as policy-
makers reacted to the high inflation and record interest rates of the late .>?5s. during the
early .>>5s, however, the trend reversed as some suggested that caps should be placed on
credit card rates, which remained at historically high levels while other key interest rates
declined significantly.
4n the surface, capping interest rates seems to be perfectly logical. To protect people
from paying interest rates that are perceived as )too high,* the government can simply
mandate that rates be kept below a certain level. #owever, interest rate ceilings can have
unintended consequences. This essay e!amines these possible consequences by
discussing the economic theory behind the arguments for and against usury ceilings.
Dust Another -arket
/aws designed to prevent usury, or the taking of )e!cessive* interest, have long been the
sub1ect of controversy. Bhile advocates of usury ceilings claim that such controls protect
consumers from abusive lending practices and enable them to obtain loans at reasonable
rates, their critics argue that they work to consumers disadvantage by restricting credit
flows and distorting financial markets.
"n economic theory, the credit market is viewed like any other market. There are buyers
'borrowers( and sellers 'lenders( of credit$ the price of credit is the interest rate. The
credit market is easily represented in a conventional supply and demand diagram like the
one shown below.
.77
%tandard %upply and As illustrated, the demand curve 'KK(
Kemand urve for indicates the amount of credit borrowers
The redit -arket are willing to purchase at various prices
4r interest rates. %ince borrowers are
"nterest rate typically willing and able to borrow more
At lower prices, the demand curve slopes
Kown and to the right, illustrating that
%% higher prices, in this case interest rates,
result in a lower quantity of credit
of credit demanded and vice versa.
2quilibrium
+rice 'rate(
KK
Ruantity
where supply
and demand
are balances
quantity of credit
the supply curve '%%( reflects the amount of credit lenders are willing to provide at
various rates. The curve slopes upward because lenders costs, including the cost of funds,
increase as more credit is supplied. At the same time, higher rates 'the price of credit(
offer an incentive for savers to provide more funds for lending. That is, lenders are able
and willing to offer more credit at higher rates of interest than at lower rates.
"n a competitive market, as borrowers increase their demands for a limited supply of
credit they compete with one another, thus )bidding up* prices. :ut at prices 'rates( rise,
lenders will want to offer more credit thereby increasing supply and helping to satisfy
demand. "n addition, as prices increase, demand will generally decrease. This )bidding*
process continues until borrowers and lenders eventually establish an equilibrium price
that balances the supply of and demand for credit. This price is called the market rate of
interest, which is represented on the second diagram as the point where the demand curve
and supply curve intersect.
/ower @ates an :e :ad S %ometimes
0sury laws establish a legal ma!imum interest rate 'or price( that lenders may charge for
a loan or e!tension of credit. These laws are, in effect, a form of price control.
.7=
Bhen a usury law is introduced, it may have no impact on the credit market or it may
alter the way in which price and quantity are determined. 2!actly what happens depends
on where the usury ceiling is relative to the market rate.
Bhen the legal ceiling is above the market rate of interest, the law has no effect at all.
The market forces of supply and demand are not bound by the usury ceiling, and the
equilibrium price and quantity of credit are unchanged. #owever, when the legal ceiling
is below the market rate of interest, the regulation can affect the market outcome. %uch a
usury ceiling is said to be binding or effective. A binding ceiling obviously alters the
price of credit S the ceiling rate becomes the rate of interest charged.
:ut, establishing a lower-than-market interest rate by means of a usury ceiling will also
bring about a decrease in the quantity of credit supplied. Eiven lenders costs, the amount
of credit they will provide when the interest rate is held down is limited. /ike any other
business, if a lender does not recoup its costs and earn an adequate return on its resources,
it will put those resources to work elsewhere.
The 2ffect of a :inding eiling
"nterest rate
%%
equilibrium
price 'rate(
usury ceiling
credit crunch KK
%ince the amount of credit offered will not satisfy all those who are willing to borrow at
the ceiling price, e!cess demand is created, giving rise to a situation in which the reduced
amount of credit must be rationed among borrowers by some means other than price.
The diagram above illustrates a binding ceiling. The usury ceiling intersects supply and
demand below the equilibrium price, indicating that the quantity demanded e!ceeds the
quantity supplied at the legal ma!imum rate or price. The gap between the supply and
demand curves represents a )credit crunch,* in which credit is not available despite the
fact that there is demand for it.
Bho Eets #urt and Bho Eets reditH
.7?
-any of the strategies lenders are likely to follow in a )credit crunch,* such as setting
rigid loan terms, screening borrowers more rigorously, or increasing non-interest fees and
charges, tend to concentrate the impact of usury ceilings on certain borrowers. For
e!ample, imposing more stringent loan terms such as shorter maturities and higher
minimum loan si,e reallocates credit toward those who are able to afford larger down
payments or larger monthly payments, generally those with higher incomes. :asing
lending decisions heavily on individual characteristics, such as borrowing history or
income without the fle!ibility of adding risk premiums, can ration credit away from new
or high-risk consumers who might be willing to pay higher-than-ceiling rates. Finally,
adding non-interest charges 'such as higher fees( eliminates from the market those for
whom these e!tra costs are too great.
:y encouraging these lending practices, usury ceilings may fail to give consumers the
protection and benefits that they were intended to provide. That is, usury laws may
actually reduce the amount of credit that is available to low income or ine!perienced
borrowers. /ow-priced credit is not useful to those who cannot meet the requirements for
obtaining it.
Thus, when lenders ration credit by some means other than price, first-time borrowers,
small borrowers, low-income and high-risk borrowers are likely to find it more difficult
to obtain credit. The most creditworthy borrowers, on the other hand, may obtain more
credit than they would have at normal market interest rates.
Furthermore, when lenders institute non-interest charges such as fees to compensate for
interest rate ceilings, they effectively raise the cost of credit for all successful borrowers.
Therefore, while a ceiling may reduce the e!plicit price of credit 'interest rate(, it may not
result in lower overall costs of borrowing even for those able to obtain loans.
Additionally, non-interest charges make it more complicated for customers to
comprehend the total cost of borrowing and more difficult to make well-informed credit
decisions.
Bhile these lending practices and their undesirable consequences may e!ist in the
absence of interest rate ceilings, several studies on the effects of usury ceilings have
established that loan terms do become less favorable to borrowers when usury ceilings
become more restrictive.
"ncreased ompetition and onsumer @esponsibility
A common argument in favor of usury laws is that without them, borrowers would be
forced to pay e!orbitant interest rates, or at least rates that are unreasonable in relation to
the cost of supplying credit.
According to economic theory, a competitive market is sufficient to prevent lenders from
e!ercising power over pricing or earning more than a normal return. The price established
in a competitive market reflects suppliers costs of providing the given amount of that
good. To be sure, removing a binding usury ceiling will result in higher interest rates.
.79
#owever, if credit markets are competitive, the resulting market rate of interest will not
e!ceed lenders costs 'including a fair return( of supplying credit. "t is when competition
is absent that consumers may fact unreasonable interest rates. Thus, the consequences of
not having usury ceilings depend importantly on the competitiveness of credit markets.
"ndeed, the absence of competition is the only reason for imposing a usury ceiling that
can be 1ustified by economic theory.
%ome of the responsibility for ensuring a competitive marketplace must be placed on
borrowers themselves, since knowledgeable, informed borrowers help to foster
competition in credit markets. Bhen consumers do not know or cannot compare rates
being charged by various lenders, each lender has more freedom to charge any rate S fair
or unfair. A high level of borrower awareness can create a natural protection from
unreasonable interest rates, in lieu of the e!ternal constraint of a usury ceiling.
.7>
<% Money2 Credit2 and &ecurity Mar.ets
These statistics measure the amount of money in the economy as well as interest rates
and include&
-oney %tock '-., -3, and -;( OmonthlyP
:ank redit at All ommercial :anks OmonthlyP
onsumer redit OmonthlyP
"nterest @ates and :ond Gields Oweekly and monthlyP
%tock +rices and Gields Oweekly and monthlyP
Fominal interest rates are influenced by inflation, so like inflation they tend to be
procyclical and a coincident economic indicator
%tock market returns are also procyclical but they are a leading indicator of economic
performance.
Federal Finance
These are measures of government spending and government deficits and debts&
Federal @eceipts '@evenue( OyearlyP
Federal 4utlays '2!penses( OyearlyP
Federal Kebt OyearlyP
Eovernments generally try to stimulate the economy during recessions and to do so they
increase spending without raising ta!es. This causes both government spending and
government debt to rise during a recession, so they are countercyclical economic
indicators. They tend to be coincident to the business cycle.
International 'rade
These are measure of how much the country is e!porting and how much they are
importing&
"ndustrial +roduction and onsumer +rices of -a1or "ndustrial ountries
0.%. "nternational Trade in Eoods and %ervices
0.%. "nternational Transactions
Bhen times are good people tend to spend more money on both domestic and imported
goods. The level of e!ports tends not to change much during the business cycle. %o the
balance of trade 'or net e!ports( is countercyclical as imports outweigh e!ports during
boom periods. -easures of international trade tend to be coincident economic indicators.
Bhile we cannot predict the future perfectly, economic indicators help us understand
where we are and where we are going. "n the upcoming weeks " will be looking at
.=5
individual economic indicators to show how they interact with the economy and why
they move in the direction they do.
.=.
<? $on:t ,et into a lather over &weatshops
%AF D4%2, A/"F. S %an Francisco -ayor Eavin Fewsom is pushing the city council to
adopt an ordinance that forbids the use of municipal funds to purchase uniforms and other
clothing made in )sweatshops.* Across the country, colleges often adopt similar
standards for clothing displaying their school logos. Forth American unions, such as
0nite here, the apparel and housekeeping workers union, often lobby to impose working
standards for developing countries similar to %an Franciscos proposed ordinance.
Though these efforts are intended to help poor workers in the third world, they actually
hurt them.
Be use )sweatshop* to mean those foreign factories with low pay and poor health and
safety standards where employees choose to work, not those where employees are
coerced into working by the threat of violence. And we admit that by Bestern standards,
sweatshops have abhorrently low wages and poor working conditions. #owever,
economists point out that alternatives to working in a sweatshop are often much worse$
scavenging through trash, prostitution, crime, or even starvation.
2conomists across the political spectrum, from +aul Arugman on the left, to Balter
Billiams on the right, have defended sweatshops. Their reasoning is straightforward&
people choose what they perceive to be in their best interest. "f workers voluntarily
choose to work in sweatshops, without physical coercion, it must be because sweatshops
are their best option. 4ur recent researchCthe first economic study to compare
systematically sweatshop wages with average local wagesCdemonstrated this to be true.
Be e!amined the apparel industry in .5 Asian and /atin American countries often
accused of having sweatshops and then we looked at <; specific accusations of unfair
wages in .. countries in the same regions. 4ur findings may seem surprising. Fot only
were sweatshops superior to the dire alternatives economists usually mentioned, but they
often provided a better-than-average standard of living for their workers.
The apparel industry, which is often accused of unsafe working conditions and poor
wages, actually pays its foreign workers well enough for them to rise above the poverty
in their countries. Bhile more than half of the population in most of the countries we
studied lived on less than 63 per day, in >5 percent of the countries, working a .5-hour
day in the apparel industry would lift a worker aboveCoften far aboveCthat standard.
For e!ample, in #onduras, the site of the infamous Aathy /ee Eifford sweatshop scandal,
the average apparel worker earns 6.;..5 per day, yet << percent of the countrys
population lives on less than 63 per day.
"n > of the .. countries we surveyed, the average reported sweatshop wages equaled or
e!ceeded average incomes and in some cases by a large margin. "n ambodia, #aiti,
Ficaragua, and #onduras, the average wage paid by a firm accused of being a sweatshop
is more than double the average income in that countrys economy.
.=3
4ur findings should not be interpreted to mean that sweatshop 1obs in the third world are
ideal by 0% standards. The point is, they are located in developing countries where these
1obs are providing a higher wage than other work.
Antisweatshop activistsCwho argue that consumers should abstain from buying products
made in sweatshopsCharm workers by trying to stop the trade that funds some of the
better 1obs in their economies.
0ntil poor nations economies develop, buying products made in sweatshops would do
more to help their-world workers than %an Franciscos ordinance. :y purchasing more
products made in sweatshops, we create more demand for them and increase the number
of factories in these poor economies. That gives the workers more employers to choose
from, raises productivity and wages, and eventually improves working conditions. This is
the same process of economic development the 0% went through, and it is ultimately the
way third-world workers will raise their standard of living and quality of life.
.=;
<+ !re the ich ,etting icher>
-ore and more in todays media we read about the widening gap between the )haves*
and )have-nots.* The problem the aforementioned reports have is that they dont show if
any particular individuals are staying at the same level, as they dont prove if we are
losing our birthright& a chance at upward mobility. "f upward mobility is in fact being
lost, we would have to show that the poorest remain stuck where they are.
The 0niversity 4f -ichigan did a panel survey on income dynamics, the longest tracking
study ever done on Americans earnings. %ince .>=9, the university collected detailed
information on more than 75,555 Americans. A sample from this database was taken for
.? years, enough to capture the real stories of all hired, being fired, windfalls, financial
setbacks, etc. The survey shows that only 7J of those Americans in the bottom fifth of
income earners in .>?7 were still there in .>>.. A ma1ority of them made it to the top
three-fifths of the income distribution, which is middle class or better. Bhat is the most
ama,ing point of all is that almost ; out of every .5 of the low income earners from .>?7
had risen to the top 35J by .>>.. "n addition, among the second-poorest 35J in .>?7,
more then ?5J had moved to higher bracket in .>>..
Bhat the study found was that wage and salary income was the factor responsible for
pushing people upward in the distribution. Therefore, F4T /0A is the widest path to
upward mobility. The rich may indeed be getting richer, the poor are also getting richer.
/ets take a look at income patterns over our lifetime. "ncome tends to rise rapidly in the
early years, then peaks out during middle age and falls toward retirement. This is due to
the fact that our economy is no longer as industrial as it used to be, when Americans
)worked with their hands and their backs.* Today, Americans owe their paychecks to
their brains, )mental talents continue to sharpen long after muscles and de!terity begin to
falter. "t is our shift from an economy that produces products to an economy that provides
services as to why the peak earning years has shifted to older groups in the past two
decades.
+ut another way. Borkers reap greater rewards for what theyve learned on the 1ob, and
earnings therefore rise with e!perience$ so, its not that the younger workers are falling
behind their counterparts from earlier generations, its that older workers are getting
wealthier than they used to.
Furthermore, the old a!ioms are still true$ data confirm what our elders always told us&
study hard, work hard and save.
.( Eet an education. Fearly =5J of all Americans in the top fifth of income earners
graduated from college. 4nly =J did in the bottom fifth.
3( Bork full time, year round. 95J of Americans in the top earnings bracket work
at least 75 weeks a year. Full-time is the remedy for poverty.
.=<
;( Form a family. "n the bottom fifth income bracket, =<J live in non-family
households. "ts not that poorer Americans dont create families$ to prove that, we
see large families below the poverty line all the time. To be sure, if one creates a
family, there is added responsibility that pushes one to be more serious about
earning a living.
<( :e willing to move. 2mployment opportunities and wages differ from community
and from region to region. Eeographical mobility is one way Americans can find
opportunity and close the income gap.
7( :e willing to retrain. Take the te!tile industry and compares it to the computer
company industry. The number of computer 1obs is rising and the hourly wages
for a computer programmer are almost three times the hourly wages for a te!tile
worker.
=( :ecome computer-savvy. Borkers who know how to operate a computer earn as
much as .7J more than those who dont know, and doing the same 1ob. -achines
made us more productive, so companies would find those that know how to
operate a machine more valuable.
?( %tick to it. Average income tends to rise quickly in life as workers gain
e!perience and knowledge.

9( %ave money. %avings can make a big difference for retirement. For individuals in
the bottom fifth income bracket, 9;J of income comes from %ocial %ecurity,
whereas in the top income bracket, only 35J comes from %ocial %ecurity.
T
.=7
<> &hould Profits (e &hared with *or.ers>
Bhen most people argue that firms should share profits with workers, they are not
interested in the general distribution of business receipts. @ather, they are pointing to
firms e!periencing e!ceptionally high profits and claiming that fairness requires that
most of those profits be passed on to workers. For e!ample, management consultant Alfie
Aohn states, "f a company has had a profitable year, " see no reason those gains should
not be distributed to the employees$ after all, their work is what produced the profits.
At a superficial level, it may seem only right that when a firm is doing well, its good
fortune should be shared with the workers who made it possible. And, indeed, workers do
benefit when their firms are profitable and e!panding because their 1obs are more secure
and opportunities for promotion are greater. :ut shouldnt firms making high profits
directly share some of those profits with their workers by increasing their wages much
more than in leaner timesH Borkers and their union representatives are frequently quick
to use high profits as 1ustification for demanding large wage increases, but is it wise to
acquiesceH
"t is generally true that those fortunate enough to work for highly profitable firms receive
higher wages than those who work for barely profitable firms. :ut this is not the same as
a firm giving its workers a large wage increase whenever it e!periences a large profit
increase. Firms seldom do this for reasons of efficiency, fairness, and the best interest of
their workers.
)fficiency
onsider first the efficiency of sharing profits with workers. Although many people see
profits as nothing more than rich people accumulating more wealth, profits serve a vital
function in creating wealth by allowing consumers to communicate how they want scarce
resources allocated among competing productive activities. A firm earning a large profit
is using resources to create more value 'as measured by what it sells its output for( than
those resources could create elsewhere in the economy 'as measured by what the firm has
to pay for its inputs(. The total value of production can then be increased, with the same
use of resources, by reallocating resources to highly profitable firms and away from less
profitable firms elsewhere in the economy. And this is e!actly the reallocation of
productive resources financed and motivated by high profits. Firms typically reinvest
high profits right back into the productive activity that generated them by bidding
resources, both human and non-human, away from less profitable activities. 4utput
e!pands in the high-profit firms 'driving their rate of return down( and contracts in the
low-profit firms 'driving their rate of return up( until additional inputs are worth no more
in the former than in the latter.
This efficient reallocation would be impossible if a firm that began making high profits,
say because of an increase in the demand for its product, used those profits to increase the
wages of its workers. Firms are forced by competition to pay their workers at least as
much as they are worth in their best alternative employments. "f a firm devoted its high
.==
profits to paying its current workers more than is 1ustified by their productivity, it would
be unable to attract the additional resources it needs to e!pand. The workers receiving the
higher wages would be obviously better off in the short run, but their gains would be
more than offset by the losses 'forgone opportunities( suffered by others in the economy.
Fairness
Ruite apart from the adverse effects on efficiency, paying workers higher wages when
the profits of the firm they work for are high forces firms to behave in ways that will be
widely seen as unfair. "f, because of high profits, a firm offers wages well in e!cess of
their opportunity cost 'the amount needed to attract workers with the appropriate skills
from other employments(, more people will want to work for that firm than it can afford
to hire. This creates a situation where firms find themselves having to choose workers on
the basis of non-economic considerations. @egardless of how firms make those choices,
they will be critici,ed for practicing favoritism and unfair discrimination by those who
are not chosen, and may be with 1ustification. ertainly the fairest approach, and the one
that penali,es discriminating on non-economic grounds, is to give all workers the
opportunity to compete for 1obs on the basis of their productive ability. This opportunity
is denied to most workers when some are being paid more than their productivity
warrants.
:ut even those who would get large wage increases because they work for firms creating
high profits would probably not benefit from a policy of sharing in those profits, and
certainly not if the policy were fairly implemented. "f workers receive large wage
increases when their firm is making large profits, then fairness would require that they
also receive wage cuts when profits decline. "ndeed, if workers favored a consistent
policy of sharing in the profits, then they should be prepared to give money back 'receive
negative wages( when their firm 'as firms often do( loses money. :ut workers obviously
would not be happy with such a policy. "t would e!pose them to all the risks that confront
the owners of the firm, risks that few workers are willing to bear. +eople willing to accept
large risks typically start their own businesses, or invest in businesses that others start, in
return for a higher average, but very uncertain, return.
Borkers are typically more risk averse, as evidenced by the fact that they choose to work
for others for a lower average, but more certain, return in the form of a fi!ed salary or
wage.
'he Free-ider 'emptation
+rofit-sharing arrangements are easily frustrated by the free-rider temptation. Although it
is collectively rational for all employees to work harder in response to profit sharing, it is
not individually rational to do so. 2ach worker will recogni,e that if others work harder,
that he will reap the benefits from higher profits without e!tra effort. 2ach worker also
recogni,es that if others dont work harder, then his share of the additional profit
generated by e!tra effort is too small to be worth the effort.
.=?
For e!ample, assume that there are .,555 workers in a firm, each earning 6.7.55 per
hour. Also assume a profit-sharing plan is established that would increase total worker
productivity, and therefore worker compensation, by 6<5,555 per week if all workers
reduce their shirking on the 1ob by one hour per week. this is clearly a good deal for the
workers, since each one stands to receive 6<5 for putting in 1ust one more hour of
genuine effort. :ut consider the payoff each individual would reali,e from his decision to
shirk an hour less. The individual who puts in one more hour of work would be
responsible for increasing total compensation by 6<5 'assuming that each individuals
impact on productivity is the same as everyone elses, and independent of what others
do(. but since the additional 6<5 is spread over all .,555 workers, his share, in the form of
higher wages is only 6.5<. #ow many would be willing to give up an hour of on-the-1ob
leisure for 6.5<H At that hourly rate a person would have to work an entire <5-hour week
to make enough to buy a small bo! of popcorn at the movies.
%o having workers share consistently in the profits of their firm is not a policy many
workers would find attractive. %uch profit-sharing arrangements do little to motivate
more productive effort, while imposing risk on workers that few are comfortable
accepting. This e!plains why profit-sharing arrangements are often short-lived.
For e!ample, Bal--art %tores has e!perienced some difficulties with its profit-sharing
plan. +robably no other 0. %. company has used stock incentives more than Bal--art to
motivate hard work and loyalty from its workers. And for years it worked as Bal--art
stock steadily increased in value '.55 shares of Bal--art stock, which cost 6.,=75 in
.>?5 when it first went public, were worth 6;.7 million in February .>>;(. :ut then the
stock e!perienced a decline, going from 6;<..37 a share in February .>>; to 635,9?7 on
the first trading day in .>>7. Kuring this decline, the profit-sharing plan became a source
of worker complaints and demands for more pay and union representation. As reported in
the Ball %treet Dournal, The worlds largest retailer is also discovering the risks in a
profit-sharing plan heavily invested in its own stocks.
0nless workers are willing to take the losses that are inevitable in business activity, as
well as the gains, the argument that fairness requires that workers share in the profits of
their firms is an empty one. -any workers, and their representatives who call for sharing
profits with workers, seem to believe that fairness means #eads " win, tails you lose. All
workers are better off, and treated more fairly, when most profits are retained by firms to
e!pand the production of goods and services that consumers are communicating with
those profits that they want more of.
.=9
"53 &ex2 (oo/e2 and $rugs
+rior to .>.<, cocaine was legal in this country$ today it is not. Alcohol 'of the
into!icating variety( is legal in the 0nited %tates today$ from .>35 to .>;; it was not.
+rostitution is legal in Fevada today$ in the other forty-nine states it is not. All these
goods-se!, boo,e, and drugs-have at least one thing in common$ The consumption of
each brings together a willing seller with a willing buyer$ there is an act of mutually
beneficial e!change 'at least in the opinion of the parties involved(. +artly because of
this property, attempts to proscribe the consumption these good have '.( met with less
than spectacular success, and '3( yielded some peculiar patterns of production,
distribution, and usage. /ets see why.
Bhen the government seeks to prevent voluntary e!change, it generally must decide
whether to go after the seller or the buyer. "n most cases-and certainly when se!, boo,e,
or drugs have been involved-the government targets sellers, because this is where the
authorities get the most benefit from their enforcement dollars. A cocaine dealer, even a
small retail pusher, often supplies do,ens or even hundreds of users each day, as did
speakeasies 'illegal saloons( during +rohibition$ a hooker typically services anywhere
from three to ten tricks per day. :y incarcerating the supplier, the police can prevent
several-or even several hundred-transactions from taking place, which is usually much
more cost-effective than going after the buyers one by one. "t is not that the police ignore
the consumers of illegal goods$ indeed, sting operations-in which the police pose as illicit
sellers-often make the headlines. Fevertheless, most enforcement efforts focus on the
supply side, and so shall we.
/aw enforcement activities directed against the suppliers of illegal goods increase the
suppliers operating costs. The risks of fines, 1ail sentences, and possibly even violence
become part of the costs of doing business and must be taken into account by e!isting and
potential suppliers. %ome entrepreneurs will leave the business, turning their talents to
other activities$ others will resort to clandestine 'and costly( means to hide their
operations from the police$ still others will restrict the circle of buyers with whom they
are willing to deal to minimi,e the chances that a customer is a cop. Across the board,
the costs of operation are higher, and at any given price, less of the product will be
available. There is a reduction in supply, and the result is a higher price for the good.
This increase in price is, in a sense, e!actly what the enforcement officials are after, for
the consumers of se!, boo,e, and drugs behave according to the law of demand& The
higher the price of a good, the lower the amount consumed. %o the immediate impact of
the enforcement efforts against sellers is to reduce the consumption of the illegal good by
buyers. There are, however, some other effects.
First, because the good in question is illegal, people who have a comparative advantage
in conduction illegal activities will be attracted to the business of supplying 'and perhaps
demanding( the good. %ome may have an e!isting criminal record and are relatively
unconcerned about adding to it. 4thers may have developed skills in evading detection
and prosecution while engaged in other criminal activities. %ome may simply look at the
.=>
illegal activity as another means of thumbing their noses at society. The general point is
that when an activity is made illegal, people who are good at being criminals are attracted
to that activity.
"llegal contracts usually are not enforceable through legal channels 'and even if they
were, few suppliers of illegal goods would be stupid enough to complain to the police
about not being paid for their products(. Thus, buyers and sellers of illegal goods
frequently must resort to private methods of contract enforcement-which often means
violence. #ence, people who are relatively good at violence are attracted to illegal
activities and are given greater incentives to employ their talents. This is one reason why
the murder rate in America rose to record levels during +rohibition '.>35-.>;;( and then
dropped sharply when liquor was again made legal. "t also helps e!plain why the number
of drug-related murders soared during the .>95s, and shy drive-by shooting became
commonplace in may drug-infested cities. The Thompson submachine gun of the .>;5s
and the -A-.5 machine gun of the .>95s were importantly, 1ust low-cost means of
contract enforcement.
The attempts of law enforcement officials to drive sellers of illegal goods out of business
have another effect. :ased on recent wholesale prices, 675,555 worth of pure heroin
weighs about two ounces$ 675,555 worth of mari1uana weighs about twenty pounds. As
any drug smuggler can tell you, hiding two ounces of contraband is a lot easier than
hiding twenty pounds. Thus, to avoid detection and prosecution, suppliers of the illegal
good have an incentive to deal in the more valuable versions of their product, which for
drugs and boo,e mean the more potent versions. :ootleggers during +rohibition
concentrated on hard liquor rather than beer and wine$ even today, moonshine typically
has roughly twice the alcohol content of legal hard liquor such as bourbon, scotch, or
vodka. After narcotics became illegal in this country in .>.<, importers switched from
the milder opium to its more valuable, more potent, and more addictive derivative,
heroin.
The move to the more potent versions of illegal commodities is enhanced by enforcement
activities directed against users. Fot only do users, like suppliers, find it easier 'cheaper(
to hide the more potent versions, there is also a change in relative prices due to user
penalties. Typically, the law has lower penalties for using an illegal substance than for
distributing it. Bithin each category 'use or sale(, however, there is commonly the same
penalty regardless and a bottle of more e!pensive, more potent hard liquor were equally
illegal. Today, the possession of one gram of >5 percent pure cocaine brings the same
penalty as the possession of one gram of .5 percent pure cocaine. Eiven the physical
quantities, there is a fi!ed cost 'the legal penalty( associated with being caught,
regardless of value per unit 'and thus potency( of the substance. #ence, the structure of
legal penalties raises the relative price of less potent versions, encouraging users to
substitute more potent versions-heroin instead of opium, hashish instead of mari1uana,
hard liquor instead of beer.
+enalties against users also encourage a change in the nature of usage. +rior to .>.< ,
cocaine was legal in this country and was used openly as a mild stimulant, much as
.?5
people today use caffeine. 'ocaine was even included in the original formulation of
oca-ola( This type of usage-small, regular doses over long time intervals becomes
relatively more e!pensive when the substance is made illegal. 2!tensive usage 'small
doses spread over time( is more likely to be detected by the authorities than is intensive
usage 'a large dose consumed at once(, simply because possession time is longer and the
drug must be accessed more frequently. Thus, when a substance is made illegal, there is
an incentive for consumers to switch toward usage that is more intensive. @ather than
ingesting cocaine orally in the form of a highly diluted liquid solution, as was commonly
done before .>.<, people switched to snorting or even in1ecting it Kuring +rohibition,
people dispensed with cocktails before dinner each night$ instead, on the less frequent
occasions when they drank, they more often drank to get drunk. The same phenomenon
is observed today. +eople under the age of twenty-one consume alcoholic beverages less
frequently than do people over the age of twenty-one. :ut when they do drink, they are
more likely to drink to get drunk.
Fot surprisingly, the suppliers of illegal commodities are reluctant to advertise their
wares openly$ the police are as capable of reading billboards and watching TI as are
potential customers. %uppliers are also reluctant to establish easily recogni,ed identities
and regular places and hours of business, because to do so raises the chance of being
caught by the police. "nformation about the price and quality of products being sold goes
underground, often with unfortunate effects for consumers.

Bith legal goods, consumers have several means of obtaining information. They can
learn from friends, advertisements, and personal e!perience. Bhen goods are legal, they
can be trademarked for identification. The trademark may not legally be copied, and the
courts protect it. Eiven such easily identified brands, consumers can be made aware of
the quality and price of each. "f their e!perience does not meet e!pectations, they can
assure themselves of no further contact with the unsatisfactory product by never buying
that brand again.
Bhen a general class of products becomes illegal, there are fewer ways to obtain
information. :rand names are no longer protected by law, so falsification of well-known
brands ensues. Bhen products do not meet e!pectations, it is more difficult 'costly( for
consumers to punish suppliers. Frequently, the result is degradation of and uncertainty
about product quality. The consequences for consumers of the illegal goods are often
unpleasant, sometimes fatal.
onsider prostitution. "n those counties in Fevada where prostitution is legal, The
prostitutes are required to register with the local authorities, and they generally conduct
their business within the confines of well-established bordellos. These establishments
advertise openly and rely heavily on repeat business. #ealth officials test the prostitutes
weekly for venereal disease and every month for A"K%. ontrast this with other areas of
the country, where prostitution is illegal. %uppliers generally are streetwalkers, because a
fi!ed physical location is too easy for the police to detect and raid. %uppliers change
location frequently, to reduce harassment by police. @epeat business is reported to be
.?.
minimal$ frequently, customers have never seen the prostitute before and never will
again.
The difference in outcomes is striking. "n Fevada, the spread of venereal disease by legal
prostitutes is estimated to be almost none!istent$ to date, none of the >555 registered
prostitutes in Fevada has tested positive for A"K%. :y contrast, in some ma1or cities
outside Fevada the incidence of venereal disease among prostitutes is estimated to be
near .55 percent. "n -iami, one study found that .> percent of all incarcerated prostitutes
tested positive for A"K%$ in Fewark, Few Dersey, 73 percent of the prostitutes tested
were infected with the A"K% virus, and about half of the prostitutes in Bashington K..,
and Few Gork ity are also believed to be carrying the A"K% virus. :ecause of the lack
of reliable information in markets for illegal goods, customers frequently do not know
e!actly what they are getting$ as a result, they sometimes get more than they bargained
for.
onsider alcohol and drugs. Today, alcoholic beverages are heavily advertised to
establish their brand names and are carried by reputable dealers. ustomers can readily
punish suppliers for any deviation from the e!pected potency or quality by withdrawing
their business, telling their friends, or even bringing a lawsuit, %imilar circumstances
prevailed before .>.< in this country for the hundreds of products containing opium or
cocaine.
Kuring +rohibition, consumers of alcohol often did not know e!actly what they were
buying or where to find the supplier the ne!t day if they were dissatisfied. Fly-by-night
operators sometimes adulterated liquor with methyl alcohol. "n e!tremely small
concentrations, this made watered-down boo,e taste like it had more kick$ in only slightly
higher concentrations, the methyl alcohol blinded or even killed the unsuspecting
consumer. 2ven in )reputable* speak-easies 'those likely to be in business at the same
location the ne!t day(, bottles bearing the labels of high-priced foreign whiskeys were
refilled repeatedly with locally 'and illegally( produced rotgut until their labels wore off.
"n the .>?5s, more than one purchaser of what was reputed to be high-potency +anama
@ed or Acapulco Eold mari1uana ended up with low-potency pot heavily loaded with
stems, seeds, and maybe even oregano. :uyers of cocaine must worry about not only how
much the product has been cut along the distribution chain, but also what has been used
to cut it. "n recent years the purity of cocaine at the retail level has ranged between .5
percent and >7 percent$ for heroin, the degree of purity has ranged from 7 percent to 75
percent. utting agents can turn out to be any of various sugars, local anesthetics, or
amphetamines$ on occasion, rat poison has been used.
Be noted earlier that the legal penalties for the users of illegal goods encourage them to
use more potent forms and to use them more intensively. These facts and the uncertain
quality and potency of the illegal products yield a deadly combination. Kuring
+rohibition, the death rate from acute alcohol poisoning 'i.e. due to an overdose( was
more than thirty times higher than today. Kuring .>3? alone, .3,555 people died from
acute alcohol poisoning, and many thousands more were blinded or killed by
.?3
contaminated boo,e. Today, about ;,555 people per year die as a direct result of
consuming either cocaine or heroin. 4f that total, it is estimated, roughly 95 percent die
from '.( an overdose caused by une!pectedly potent product, or '3( an adverse reaction
to the material used to cut the drug. learly, caveat emptor 'let the buyer beware( is a
warning to be taken seriously if one is consuming an illegal product.
Be noted at the beginning of the chapter that one of the effects of making a good illegal
is to raise its price. one might well ask, by how muchH Kuring the early .>>5s, the federal
government was spending about 63 billion a year in its efforts to stop the importation of
cocaine from olumbia. 4ne recent study concluded that these efforts had hiked the price
of cocaine by < percent 'yes, < percent( relative to what it would have been had the
federal government done nothing to interdict cocaine imports. The study estimated that
the cost of raising the price of cocaine an additional 3 percent would be 6. billion per
year.
;

The governments efforts to halt imports of mari1uana have been more successful,
presumably because that product is easier to detect than cocaine. Fevertheless, suppliers
have responded by cultivating mari1uana domestically instead of importing it. The net
effect had been an estimated tenfold increase in potency due to the superior farming
techniques available in this country, as well as the use of genetic bioengineering to
improve strains.
Be might also consider the governments efforts to eliminate the consumption of alcohol
during the.>35s and .>;5s. they failed so badly that the 2ighteenth Amendment, which
put +rohibition in place, was the first 'and thus far the only( constitutional amendment
ever to be repealed. As for prostitution S it is reputed to be )the oldest profession,* and
by all accounts continues to flourish today, even in Fewark and -iami.
The governments inability to halt the consumption of se!, boo,e, or drugs does not in
and of itself mean that those efforts have failed. "ndeed, the )successes* of these efforts
are manifested in their consequences S ranging from tainted drugs and alcohol to disease-
ridden prostitutes. The message instead is that when the government attempts to prevent
mutually beneficial e!change, even its best efforts are unlikely to meet with spectacular
success.
;
Federal attempts to prevent cocaine from entering the country are, of course,
supplemented by other federal, as well as state and local, efforts to eradicate the drug
once it has crossed our borders. To date, there are no empirical estimates of the e!tent to
which these other efforts have increased prices.
.?;
"4 ich Fation2 Poor Fation
Bhy do the citi,ens of some nations grow rich while the inhabitants of others remain
poorH Gour initial answer might be )because of differences in the natural resource
endowments of the nations.* "t is true that ample endowments of energy, timber, and
fertile land all help increase wealth. :ut natural resources can be only a very small part
of the answer, as witnessed by many countere!amples. %wit,erland and /u!embourg, for
e!ample, are nearly devoid of key natural resources, and yet decade after decade, the real
income of citi,ens of those lands has grown rapidly, propelling them to great prosperity.
%imilarly, #ong Aong, which consists of but a few square miles of rock and hillside, is
one of the economic miracles of the twentieth century, while in @ussia, a land amply
endowed with vast quantities of virtually every important resource, most people remain
mired in economic misery.
0nraveling the Mystery of ,rowth
A number of recent studies have begun to unravel the mystery of economic growth.
@epeatedly, they have found that it is the fundamental political and legal institutions of
society that are conducive to growth. 4f these, political stability, secure private
'able 4-4 $iffering #egal &ystems
ommon /aw Fations ivil /aw Fation
Australia :ra,il
anada 2gypt
"ndia Eermany
"srael Ereece
Few Nealand "taly
0nited Aingdom -e!ico
0nited %tates %weden
+roperty right, and legal systems based on the rule of law are among the most important.
%uch institutions encourage people to make long-term investments in improvements to
land and in all forms of physical and human capital. These investments raise the
capital stoc.2 which in turn provides for more growth long into the future. And the
cumulative effects of this growth over time eventually yield much higher standards of
living.
+rofessor +aul -ahoney of the 0niversity of Iirginia, for e!ample, has studied the
contrasting effects of different legal systems on economic growth. -any legal systems
around the world today are based on one of two basic models& the 2nglish common law
system and the French civil law system3 ommon law systems reflect a conscious
decision in favor of the 1udiciary in constraining the power of the e!ecutive and
legislative branches of government. "n contrast, civil law systems favor the creation of a
.?<
strong centrali,ed government in which the legislature and the e!ecutive branch have the
power to grant preferential treatment to special interest. Table .-. shows a sample of
common law nations.
'he Importance of &ecure Property ights
-ahoney finds that the security of property rights is much stronger in nations with
common law systems, such as the 0nited Aingdom and its former colonies, including the
0nited %tate. "n nations such as France and its former colonies, the civil law systems are
much more likely to yield unpredictable changes in the rules of the game-the structure of
property and contract rights. This, in turn, makes people reluctant to make long-term
fi!ed investments in nations with civil law systems, a fact that ultimately slows their
growth and lowers the standard of living of their citi,ens.
The reasoning here is simple. "f the police will not help you protect your rights to a home
or car, you are less likely to acquire those assets. %imilarly, if you cannot easily enforce
business or employment contracts, you are much less likely to enter into those contracts-
and thus less likely to produce as many goods or service. Furthermore, if you cannot plan
for the future because you dont know what the rules of the game will be in ten years or
perhaps even one year from now, you are far less likely to make productive long-terms
investments that require years to pay off. ommon law systems seem to do a better 1ob at
enforcing contracts and securing property rights and thus would be e!pected to promote
economic activity now and economic growth over time.
Bhen -ahoney e!amined the economic performance of nations around the world from
.>=5 until the .>>5s, he found that economic growth has been one-third higher in the
common law nations, with their strong property rights, than it has been in civil law
nations. 4ver the years covered b his study, the increase in the standard of living-
measured by real per capita income was more than 35 percent greater in common law
nations than in civil law nations. "f such a pattern persisted over the span of a century, it
would produce a staggering 95 percent differential in terms of real per capita income in
favor of nations with secure property rights.
'he Importance of 7ther Institutions
The economists Billiam 2asterly and @oss /evine have taken a much broader view, both
across time and across institutions, assessing the economic growth of a variety of nations
since their days as colonies. These authors e!amine how institutions such as political
stability, protection of persons and property against violence or theft, security of
contracts, and freedom from regulatory burdens contribute to sustained economic growth.
They find that it is key institution such as these, rather than natural-resource endowments
that e!plain long-term differences in growth and thus present day differences in levels of
real income. To illustrate the powerful effect of institutions, consider the contrast
between -e!ico, with a real per capita income of about 6.5,=55 today, and the 0nited
%tates, with a real per capita income of about 6<<,555. 2asterly and /evine conclude that
.?7
if -e!ico had developed with the same political and legal institutions that the 0% has
en1oyed, per capita income in -e!ico today would be equal to that in the 0%.
'he Historical oots of 'oday:s Institutions
"n light of the tremendous importance of institutions in determining long term growth,
2asterly and /evine go on to ask another important question& #ow have countries gotten
the political and legal institutions they have todayH The answer has to do with disease, of
all things. The seventy-two countries 2asterly and /evine e!amined are all former
2uropean colonies in which a variety of colonial strategies were pursued. "n Australia,
Few Nealand, and Forth America, the colonists found geography and climate that were
conducive to good health. +ermanent settlement in such locations was attractive, and so
the settlers created institutions to protect private property and curb the power of the state.
:ut when 2uropeans arrived in Africa and %outh America, they encountered tropical
diseases such as malaria and yellow fever that produced high mortality among the
settlers. This discouraged permanent settlement and encouraged a mentality focused on
e!tracting metals, cash crops, and other resources. This, in turn, provided little incentive
to promote democratic institutions or stable long-term property right systems. The
differing initial institutions helped shape economic growth over the years, and their
persistence continues to shape the political and legal character and the standard of living
in these nations today.
Fo Property ights2 Fo Property
@ecent events also illustrate that the effects of political and legal institutions can be
drastically accelerated at least in the wrong directions. Bhen Nimbabwe won its
independence from Ereat :ritain in .>95, it was one of the most prosperous nations in
Africa. %oon after taking power as Nimbabwes first 'and thus far only( president,
@obert -ugabe began disassembling that nations rule of law, tearing apart the
institutions that had helped it grow rich. #e reduced the security of property rights in
land and eventually confiscated those rights altogether. -ugabe also has gradually taken
control of the prices of most goods and services in his nation and even controls the price
of its national currency, at least the price at which Nimbabweans are allowed to trade it.
The -ugabe government has also confiscated large stocks of food and most other things
of value that might be e!ported out of or imported into Nimbabwe. "n short, anything that
is produced or saved has become sub1ect to confiscation, so the incentives to do either are
to put it mildly reduced. As a result, between .>95 and .>>= it has fallen by an
additional third. 0nemployment e!ceeds ?5 percent of the workforce, investment is
none!istent, and since 3553 the inflation rate in Nimbabwe has averaged 755 percent per
year. "n only twenty five years, the fruit of many decades of labor and capital investment
has been destroyed because the very institutions that made that fruit possible have been
eliminated. "t is a lesson we ignore at our peril
.?=
73 aising #ess Corn and More Hell
Bhen politician -ary /ease stumped the Aansas countryside in .9>5, she urged the
farmers to raise )less corn and more hell,* and the is 1ust what they have been doing
ever since.
The two decades before BB" witnessed unparalleled agricultural prosperity in the 0%.
This )golden age of American farming* continued through the war as food prices soared.
The end of the war, combined with a sharp depression in .>35, brought the golden age to
a painful halt. 2ven the long economic recovery from .>3. to .>3>-the @oaring
Twenties-did little to help American farmers. 2uropean countries were redirecting their
resources into agricultural production, and new American tariffs on foreign goods
severely disrupted international trade. :ecause food exports had been an important
source of farmers incomes, the decline in world trade reduced the demand for American
agricultural products and cut deeply into food prices and farm income.
The sharply falling food prices of the .>35s led farmers to view their problem as one of
overproduction. Fumerous cooperative efforts were made, therefore, to restrict
production, but virtually all of these efforts failed. -ost crops were produced under
highly competitive conditions, with large numbers of buyers and sellers dealing in
products that were largely undifferentiated& 4ne farmers corn, for e!ample, was the
same as any other farmers corn. Thus producers were unable to enforce collective
output restrictions and price hikes on a voluntary basis. :ut what farmers failed to do by
voluntary means in the .>35s, they accomplished via government directives in the .>;5s.
An effective farm price-support program was instituted in .>;;, marking the beginning
of policy of farm subsidies in the 0% that continues today.
Be can best understand the results of price supports and other government farm
programs by first e!amining the market for agricultural commodities in the absence of
government intervention. "n that competitive market, a large number of farmers supply
any given commodity, such as corn. The sum of the quantities that individual farmers
supply at various prices generates the mar.et supply of a commodity. 2ach farmer
supplies only a small part of the market total. Fo one farmer, therefore, can influence the
price of the product. "f one farmer were to raise the price, buyers could easily purchase
from someone else at the mar.et-clearing, or e?uilibrium2 price3 And no farmers
would sell below the market-clearing price. Thus every unity of output sold by farmers
goes for the same price. The price received for the last 'or marginal( unit sold is e!actly
the same as that received for all the rest. The farmer will produce corn up to the point
that if one more unit were produced, s production cost would be greater than the price
received. Fotice that at higher prices, farmers can incur higher costs for additional units
produced and still make a profit. :ecause all farmers face the same basic production
decisions, all farmers together will produce more at the market-clearing price, which will
equal the costs of production plus a normal profit.
Fow, how has the usual price-support program workedH The government has decided
what constitutes a )fair price*. "nitially, this decision was linked to the prices farmers
received during )good* years--such as during agricultures golden age. 2ventually, the
government-established price was simply the result of intense negotiations between
.??
members of congress from farm states and those from non-farm states. The key point,
decreed by the government has generally been well above the equilibrium price that
would have prevailed in the absence of price supports. This has encouraged farmers to
produce more, which ordinarily would simply push prices back down.
#ow has the government made its price )stick*H there have been two methods. For the
first several decades of farm programs, it agreed to buy the crops, such as corn, at a price,
called the support price2 that was high enough to keep farmers happy but not so high as
to enrage too many ta!payers. As a practical matter, these purchases have been disguised
as )loans* from a government agency-loans that never need be repaid. The government
then either stored the crops it purchased, sold them on the world market 'as opposed to
the domestic market( at prices well below the 0.% support price, or simply gave them
away to foreign nations under the Food for +eace program. "n each instance, the result
was substantial costs for ta!payers and substantial gains for farmers. 0nder the price-
support system, the American ta!payers routinely spent more than 6.5 billion each year
for the benefit of corn farmers alone. %maller but still substantial subsidies were garnered
by the producers of wheat, peanuts, soybean, sorghum, rice, and cotton, to name but a
few.
"n an effort to keep the si,e of the surpluses down, the government has often restricted
the number of acres that farmers may cultivate. 0nder these various acreage-restriction
programs2 farmers wishing to participate in certain government subsidy programs were
required to keep a certain amount of land out of production. About 95 million acres, an
area the si,e of Few -e!ico, have at one time or another been covered by the
agreements. 2nticed by high support prices, farmers have always been ingenious in
finding ways to evade acreage restrictions. For e!ample, soybeans and sorghum are both
e!cellent substitutes for corn as a source of livestock feed. %o farmers agreed to cut their
corn acreage and then planted soybeans or sorghum on the same land. This action
aggravated the corn surplus and forced the government to e!tend acreage restrictions and
price supports to soybeans and sorghum. %imilarly, faced with limitations on the amount
of land they could cultivate, farmers responded by cultivating the smaller remaining land
far more intensively. They used more fertili,ers and pesticides, introduced more
sophisticated methods of planting and irrigation, and applied technological advances in
farm machinery at every opportunity. As a result, agricultural output per man hour is
now twelve times what it was si!ty years ago.
There were a couple of problems with the price-support system. First, because it kept
crop prices high, it kept consumers food bills high as well. +eople were spending an
e!tra 67 to 6.5 billion on food each year. Another problem with the price-support system
was the fact that the surplus crops piled up year after year in government warehouses.
Fot only was storing the surpluses e!pensive, but it also eventually became politically
embarrassing. For e!ample, at one point, the federal government had enough wheat in its
storage bins to make seven loaves of bread for every man, woman, and child in the world.
To help get rid of accumulated surpluses, in the early .>95s the government tried a new
payment-in-kind '+"A( program. "nstead of writing checks to farmers, the +"K scheme
authori,ed the 0% Kepartment of Agriculture to give farmers surplus commodities that
were left in storage due to price supports. Farmers could use the commodities as
livestock feed or simply sell them at the going market price. The +"A program got rid of
.?9
leftover surpluses and encouraged e!ports initially, but many farmers into growing the
same crop year after year, regardless of market conditions. "f farmers didnt plant a
specified percentage of their )crop base* each year, their subsidy payments were
subsequently reduced. The result was huge crop costs for the government in the lucrative
'for farmers( corn and wheat programs.
The federal government also switched to a system in which it set a target price that
was guaranteed to farmers but let the price paid by consumers ad1ust to whatever lower
level it took to get consumers to buy all of the crops. Then the government simply sent a
check to farmers for the difference between the target price and the market price. This
brought consumers food bills down and eliminated government storage of surplus crops,
but it also meant that the cost to ta!payers up to 637 billion per year was painfully clear
in the huge checks being written to farmers.
The original price-support program hid its subsidies by making it appear as though the
crop surpluses were the result of American farmers simply being )too productive* for
their own good. Bith the direct cash payments made under the target-price system,
however, it became apparent that the government was taking money out of ta!payers
pockets with one hand and giving it to farmers with the other. -oreover, the target-price
system, like our other agricultural programs, geared the si,e of the subsidies to the
amount of output produced by the recipients. Thus small farmers received trivial
amounts, while giant farms-agribusinesses-collected enormous subsidies. The owners of
many huge cotton farms and rice farms, for e!ample, received payments totaling more
than 6. million apiece.
This fact illustrates who actually benefits from federal farm programs. Although these
programs have traditionally been promoted as a way to guarantee decent earning for low-
income farmers, most of the benefits have in fact gone to the owners of very large farms,
and the larger the farm, the bigger the benefit. "n addition, all of the benefits from price
supports ultimately accrue to landowners on whose land price-supported crops are grown.
"n the mid-.>>5s, the @epublican-controlled ongress made what turned out to be
a futile attempt to reduce agricultural subsidies. 4n April 7, .>>=, a Few Gork Times
headline read, )linton %igns Farm :ill 2nding subsidies,* reflecting the fact that
ongress had enacted and linton signed the seven-year Freedom to Farm Act. The .>>=
reforms were supposed to increase farmer fle!ibility and remove market distortions by
moving away from price-support payments for wheat, corn, and cotton. "n their place,
farmers would receive )transition payments.* The ta!payer was supposed to save billions
of dollars.
"t was not to be. :eginning in .>>9, ongress passed large farm )supplemental
bills* each year, each costing billions of dollars per yearCin money that goes directly
from your paycheck to the bank accounts of the largest agribusiness corporations in
America. Then, in 3553, ongress passed the most e!pensive farm bill in the history of
the 0nited %tates, with an advertised price tag of over 6.>. billion for a ten-year period.
'The actual price tag is turning out to be even higher.( +resident :ush said, when he
signed the bill, )This nation has got to eat.* #e further said, )4ur farmers and ranchers
are the most efficient producers in the worldT. Be are really good at it.*
.?>
Be are also really good at subsidi,ing farmers, and most of them are not poor. "n
one recent year, when farm profits were 6?3 billion, the federal government handed out
637 billion is subsidies to farmers, almost 75 percent more than it spent on welfare
payments for poor families. -illionaires such as Ted Turner and Kavid @ockefeller
receive hundreds of thousands of dollars a year in ta!payer-financed agricultural
subsidies. Bhen you add to the 6.>. billion of direct subsidies to the almost 6;55 billion
of higher food prices that will result over the ten years of the program, you will see that
the average American household will pay almost 6<,<55 in higher food prices and higher
ta!es. As always, two-thirds of all farm subsidies will go to the top .5 percent of farms,
most which earn over 6375,555 annually. Thus, large agribusinesses continue to be the
chief beneficiaries of our generous agricultural policy.
Farmers can now receive payments for growing crops they used to grow but dont
grow anymore. "n fact, if they sell their land to someone else, the right to receive these
payments goes with the land. %o in many cases, even if the land is subsequently carved
up into lots on which people build homes, the happy home owners are eligible for such
)direct payments,* made because years ago the land was used to grow, say, rice. The
price tag in one recent year& 6..; billion. Farmers also receive payments to compensate
them for losses they dont actually incur. To see how this works, lets suppose the
governments target price for corn is 63.55 per bushel and that a farmer manages to sell
his crop for 63.;5 per bushel during a period of the year when prices were a bit higher
than 63.55, say, to 6..95, the farmer can claim a )deficiency payment* from the
government. "n this case, he would be eligible for 35 cents per bushel '8 63.55 - 6..95(
for every bushel produced, even though he actually sold his corn at 63.;5.
+erhaps we should not complain too much about farm programs in the 0nited
%tates, for at least we dont have Dapanese farm programs. "n Dapan, a combination of
subsidies for domestic farmers and tariffs on imported food have pushed farm incomes to
a level roughly double the average income in the country as a whole. They also have
driven up the price of an ordinary melon to 6.55 'yes, one hundred dollars(. 2ven the
2uropeans seem to find lavishing largesse on farmers irresistible. "n recent years,
Americans have been shelling out about 6<5 billion a year for farm subsidies. The
2uropean 0nion '20( has been spending more than 6.;5 billion a year on farm
subsidies. To be sure, the 20 is about 75 percent more populous than the 0nited %tates,
but even ad1usting for this, the huge spending there means that the average 20 citi,en is
spending twice as much subsidi,ing farmers as we spend here.
+oliticians from the farming states argue that we cannot abandon our farmers
because the 0nited %tates would end up with too many bankrupt farms and not enough
food. :ut there is evidence from at least one country that such a scenario is simply not
correct. "n .>9<, Few Nealands /abor government ended all farm subsidies of every
kind, going completely )cold turkey* without any sort of transition to the new era of free
markets for food. Agricultural subsidies in Few Nealand had accounted for more than ;5
percent of the value of agricultural production, even higher than what has been observed
in the 0nited %tates. The elimination of subsidies in Few Nealand occurred rapidly, and
there were no e!tended phaseouts for any crops. Kespite this, there was no outbreak of
farm bankruptcies. "ndeed, only . percent of farms have gone out of business in Few
.95
Nealand since .>9<. "nstead, the farmers responded by improving their techniques,
cutting costs, and aggressively marketing their products in e!port markets.
The results have been dramatic. The value of farm output in Few Nealand has
increased by more than <5 percent 'in constant-dollar terms( since the subsidy phaseout.
The share of Few Nealands total annual output attributed to farming has increased from
.< percent to .? percent. /and productivity has increased on an annual basis a little over
= percent. "ndeed, according to the Federated Farmers of Few Nealand, the countrys
e!perience thoroughly debunked the myth that the farming sector cannot prosper without
government subsidies.



.9.
7; &hortages under ent ControlD 'he Few )vidence
Bhat happens to price and availability of unregulated housing in a rent-controlled
marketH To determine this, this author collected data on all the available apartments
advertised in eighteen ma1or cities around Forth America. The advertised prices were
taken from a single %unday edition of the largest paper in each city during the month of
April .>>?. The advertised price of every listed apartment was recorded. 'Three
newspapers were used for Few Gork.( @ented houses were also included. %ome older
urban areas [ hicago, leveland, Few Gork, +hiladelphia [ have very few rental
houses, while in %unbelt cities such as Kallas, #ouston, +hoeni!, and %an Kiego, they
make up a large portion of the rental market. To make sure this regional phenomenon was
not distorting the figures, rental houses were omitted in two cities, Atlanta and +hoeni!.
%i! of the surveyed cities have rent control[ /os Angeles, Few Gork, and %an Francisco,
%an Dose, Toronto, and Bashington. "n addition, :oston ended rent control in Danuary
.>>?. The median rent shown on each graph is based on the .>>5 0.%. ensus.
The most striking observation is that the graphs of rents in free-market cities follow a
standard bell curve. The vast ma1ority of advertised rents cluster around the median, with
between ;; and <5 percent below the census median. The median advertised rent is rarely
more than 675 above the census median. This may be because the very cheapest
apartments are not likely to be advertised in the newspaper and because landlords often
raise rents when apartments become vacant. The mode [the number where the graph
peaks [usually occurs below both medians. haracteristically, there is a steep climb on
the low-rent side of the curve, followed by a long tail toward the )lu!ury* end of the
market.
"t is also striking how affordable housing is in most free-market cities. "n +hiladelphia,
the nations fifth largest city, the most common advertised then, the mode, is between
6<75 and 6755[below both the advertised and census medians. "n hicago, the mode was
6755 to 6775., also below both medians. 0nregulated cities such as +hiladelphia,
hicago, %an Kiego, +hoeni!, and %eattle seem to have almost perfectly competitive
housing markets, with housing available at every price level but clustered at the low end.
The two cities with strict rent control are glaring e!ceptions to this pattern. "n both Few
Gork and %an Francisco, advertised rents peaked at 63,555[more than triple the 0.%.
ensus median rent for each city. The median advertised rent in Few Gork was 6.,;75,
in %an Francisco, 6.,<55[both more than double the census median. -ore important,
there were almost no rental units available at the low end of the market. "n both %an
Francisco and Few Gork, less than .5 percent of advertised rents were below the census
median. 'The Few Gork figures also included listings from the #aily !ews and the !ew
*or+ $ost, which are slanted toward the lower end of the market.( @ent control in both
these cities appears to make housing spectacularly unaffordable.
%an Dose and :oston both show strong symptoms of the rent control disease. %an Dose
rents peak at 6.,755, with rents pushed more toward the e!pensive end. :oston shows the
usual )median hump,* but displays overtones of the rent-control effect at the upper end.
.93
/os Angeles, Bashington, and Toronto [all of which practice milder forms of rent
control than Few Gork and %an Francisco [show little or no signs of the rent control
effect.
Bhat is going on in these marketsH The e!planation seems fairly straightforward. @ent
control splits the housing market into two sectors, the regulated segment and the shadow
market. A% prices in the regulated sector are forced lower, prices in the shadow market
go higher. At a certain point, the differential between the two markets becomes so stark
that tenants in the regulated sector begin hoarding their apartments. They hardly ever
move. "n Few Gork, 99 percent of tenants living in pre-war, rent-controlled apartments
have not moved in more than 37 years.
"f they do abandon their apartments, regulated tenants pass them on to friends or
relatives, or sell them to strangers through )key money* that reflects their true market
value. As a consequence, a regulated apartments are essentially withdrawn from the
market. "n Few Gork, where regulated apartments make up =; percent of the market,
only 97 or ; percent of the 3,955 listings in the !ew *or+ Times, #aily !ews, and !ew
*or+ $ost, were identified or identifiable as rent regulated.
Bith the regulated portion market locked away, all new demand is funneled into the
unregulated sector[the shadow market. 2ventually the competition for these limited
number of apartments creates highly inflated prices. "t is like squee,ing a balloon at one
end[the pressure will simply create a bulge at the other end.
.9;
"< ! Farewell to Kobs
/ets take a trip back to the late .>95s. The foremost problem on some economists
minds is the merciless competition that American firms face from Asian manufacturers.
)Dapan, "nc.* and its neighbors, for e!ample, have started turning out computer memory
chips at ever lower prices. The result is sharply declining profits for 0. %. chipmakers
andCaccording to chipmakers and their political supportersCa dire threat to 0. %. 1obs.
The issue of looming 1ob losses in this and other industries dominates the political scene.
hip industry leaders try to persuade members of ongress that the 0nited %tates will
lose its technological edge unless the federal government steps in to protect 0. %.
chipmakers. 2!pects are even prophesying that without government protection and help,
0. %. microelectronics will be )reduced to permanent, decisive inferiority within ten
years.
Fow flash forward to the mid-3555s, when the most frequently recurring issue in
domestic-policy debates has been much the same. To be sure, the detailsCwhich country
is )stealing* 1obs from which industryChave changed, but not by much. "ndeed, as early
as the presidential election of 355<, so-called foreign outsourcing of white-collar ;obs
had become as un-American as desecrating our flag. A well-known TI business analyst
on FF, /ou Kobbs, even began a listing of all of the )unpatriotic* 0. %.-based
companies that were )sending this countrys 1obs overseas.* The #ouse of
@epresentatives tried to pass measures to prevent any type of outsourcing for the
Kepartment of %tate and the Kepartment of Kefense. @epresentative Kon -an,ullo '@.-
"ll.( said, )Gou 1ust cant continue to outsource overseas time after time after time, dilute
the strategic military base, and then e!pect this ongress to sit back and see the 1obs lost
and do nothing.* 'This was from a member of the same #ouse of @epresentatives that,
twenty years earlier tried to outlaw competition from foreign automakers because the 0.
%. auto industry supposedly faced )imminent collapse.*(
According to raig :arrett, 24 of "ntel 'the worlds largest chipmaker(,
American workers today face the prospect of );55 million well-educated people in "ndia,
hina, and @ussia who can do effectively any 1ob that can be done in the 0nited %tates.*
"n a similar vein, Forrester @esearch has predicted that ;.; million service 1obs will
)move offshore* by 35.7. Five hundred thousand of those 1obs will supposedly be in
computer software and services. The 355< Kemocratic presidential nominee, Dohn Aerry,
had a name for the leaders of companies that )e!port* such 1obs& ):enedict Arnold
24s.* And when the chair of the ouncil of 2conomic Advisers publicly stated that
foreign outsourcing of service 1obs wasnt such a bad idea, numerous politicians
lambasted him, arguing that foreign outsourcing of domestic service 1obs was the biggest
plague ever to hit the 0. %. economy.
To understand the hot-button issue of outsourcing service employment to workers
located abroad, you have to go back to our chapter-opening scenario. Bhat actually
happened after the )Asian invasion* of computer chips and other high-tech items in the
late .>95sH The result was not the demise of %ilicon Ialley. @ather, American high-tech
companies responded to the challenge by identifying the things at which they were best
and leaving the rest to foreign competitors. They became innovative. They led the way in
personal computing and the development of the "nternet. They became the engine of 1ob
creation throughout the .>>5s. "ndeed, we can look back through American business
.9<
history and find numerous other periods in which foreign competition has threatened a
particular sector of the economy. "n spite of that competitionCand regardless of the
outcome for the sector involvedCthe American economy has continued to prosper.
This was not the first time the resilience of the labor market surprised people.
:ack in the .>=5s, for e!ample, numerous e!perts predicted that the rise of the computer
and robots for use in businesses was going to lead to mass 1oblessness and poverty.
"nstead, computers and automation have produced staggering productivity increases
throughout nearly every industry. They have helped make possible the ?3 million 1obs
created over the past forty years and the doubling of real per capita income over that
span. This is hardly the outcome predicted by e!perts in the .>=5s, but then, predicting
the future of the labor market has never been easy. onsider the track record of the
:ureau of /abor %tatistics ':/%(, recogni,ed as Americas foremost source of
information and e!pertise on the labor market. Twenty years ago the :/% predicted that
the number of gas stations attendants and travel agents in America would rise sharply$ in
fact, employment in both occupations has fallen. And of the twenty occupations that the
:/% predicted would suffer the greatest 1ob losses over those twenty years, fully half of
them have grown, often robustly.
Bhat we have witnessed is a continual testing of a concept that is central to all of
economics& comparative advantage3 The nineteenth century economist Kavid @icardo
got it right two centuries ago, and no one has disproved him sinceCalthough 0. %.
corporate e!ecutives facing stiff foreign competition try to do so all the time. "n a
nutshell, the principle of comparative advantage says that if an individual, firm, or nation
is singularly good at doing one thing 'has low costs of doing it(, it must, by definition, be
less good at doing other things 'face higher costs of doing them(. omparative advantage
implies that there is a niche for every one and that those niches can best be filled 'and our
wealth increased the most( if we permit unfettered freedom of trade, both domestically
and internationally, and allow all participants to focus on what they do best.
onsider the current situation& like their counterparts in the 0nited %tates,
engineers and technicians in "ndia have the capacity to provide both computer
programming and innovative new technologies. "ndian programmers and high-tech
engineers earn one-quarter of what their counterparts earn in the 0nited %tates.
onsequently, "ndia is able to do both 1obs at a lower dollar cost than the 0nited %tates$
"ndia has an absolute advantage in both. "n other words, it can produce a unit of
programming for fewer dollars than the 0nited %tates, and it can also produce a unit of
technology innovation for fewer dollars. Koes that mean that the 0nited %tates will lose
not only programming 1obs but innovative technology 1obs, tooH Koes that mean that our
standard of living will fall if the 0nited %tates and "ndia engage in international tradeH
Kavid @icardo would have answered no to both questionsCas we do today.
Bhile "ndia may have an absolute advantage in both activities, that fact is irrelevant in
determining what "ndia or the 0nited %tates will produce. "ndia has a comparative
advantage in doing programming in part because such activity requires little physical
capital3 The flip side is that the 0nited %tates has a comparative advantage in technology
innovation partly because it is relatively easy to obtain capital in this country to undertake
such long-run pro1ects. The result is that "ndian programmers will do more and more of
what 0. %. programmers have been doing in the past. "n contrast, American firms will
shift to more innovation$ "ndia will speciali,e in programming. The business managers in
.97
each country will opt to speciali,e in activities in which they have a comparative
advantage. As in the past, the 0.%. economy will continue to concentrate on what are
called the )most best* activities.
The principle here is no different from what we regularly observe among world-
class athletes. Typically, they have the physical and mental skills that would enable them
to beat virtually anyone else in any of several sporting activities. They have an absolute
advantage in athletics. Get they invariably end up speciali,ing in one sport, the one in
which they have a comparative advantage. They do this because they are so good in that
sport relative to other sports that their earnings would be lower if they )wasted* their
time in those other sports. 2!actly the same thing is happening with the "ndian engineers
and technicians, 1ust as it happens in all other endeavors.
/ets return to the general issue of outsourcing services to foreign workers.
omputer programming is 1ust one area in which such outsourcing is occurring. This
outsourcing also e!tends, somewhat ama,ingly, to 0. %. income ta! return preparation.
The fact is that accounting firms small and large use workers in "ndia to prepare returns
for 0. %. clients. At least a quarter of a million returns each year are being prepared by
"ndians in :angalore and -umbai. -oreover, 0. %. hospitals are sending 'via the
"nternet, of course( computer-image Q-rays to "ndia for physicians and medial
technicians there to prepare before the images are resent to the 0nited %tates for a final
diagnosis.
%ending overseas white-collar 1obs that are labor-intensiveCanswering simple
complaints, taking orders over the phone, e!plaining basic computer setup, and reading
simple medical-test resultsCis no different from what we did when we bought lower-
priced computer chips from Dapan and other Asian countries in the .>95s. For is it
fundamentally different from what we did when we started importing more labor-
intensive te!tiles in the .>95s and .>>5s. :ecause of foreign competition, specific
industries throughout time have been forced to be more innovative and cost-conscious,
but overall, the number of 1obs in the 0nited %tates has consistently grown, decide after
decade. "ndeed, at least for the high-tech industrial sector, the aftermath of the )Asian
invasion* of the .>95s was a productivity boom.
The fact is that there is little evidence that well-paying 1obs are being )sent
overseas.* The average unemployment rate for college-educated workers in the
postrecession year 355;,was only ; percent. The average for .>>3, the last postrecession
year, was higherC;.3 percent. And since 355;, employment growth among college-
educated workers has been si! times greater than for less educated workers.
Dobs disappear in this economy and everywhere elseCnormally, because of
technological change3 'Actually, 1obs disappear in the 0. %. economy at the rate of .
million per week as workers quit or are fired$ but in a typical year, slightly more than a
million 1obs per week are created as workers accept new employment.( "t is also true that
manufacturing employment in America continues to shrink. :ut the decline in
manufacturing 1obs is not unique to the 0nited %tates. "ndeed, despite talk of )losing*
manufacturing 1obs to hina and elsewhere, the number of manufacturing 1obs in foreign
countries such as china is shrinking faster than it is in the 0nited %tatesW
Bealth-enhancing technological change is relieving human beings of the
necessity of performing mind-numbing, repetitive, dangerous factory 1obs. "t is making us
.9=
more productive, and we are collectively better off as a result, even thought some
individuals may be worse off. :ut the only way to protect everyone form the effects of
technological change is to prevent all technological change. Fot only would this
impoverish us if we tried it, but we would fail in our attempts because other nations
would gleefully step into the technology-leading shoes we had vacated.
"ndeed the reason that 0.%. companies can outsource service 1obs to "ndia, china
and elsewhere is because of technological change-dramatic improvements din
telecommunications and computing. 4ne thing you can be absolute certain of is this& The
political brouhaha over )e!porting* 1obs will eventually die out, but technological change
will never stop. Be dont know what the ne!t great innovation cycle will be or which
sectors will be affected. Bhen they are affected, though, some politicians will 1ump on
the bandwagon and declare that a new threat to the American economy has emerged.
Goull then hear much pontification about how foreigners are destroying the 0.%.
economy. :ut remember this& for the past 375 years, technological change is what has
enabled us to become richer as a nation$ indeed in the 0nited %tates, every generation
over this span has been roughly 75 percent richer than one that preceded it. "t is that along
the way, some people in the whale blubber-rendering and buggy-whip industries have
had to move on to other employments. :ut as long as humans con think technology will
change, and 1obs along with them. 4ur only option is to decide whether we want to get
rich by embracing these changes or get poor by re1ecting them.
.9?
77 'o $rill or Fot to $rill
#et the )nvironmentalists $ecide
#igh +rices of gasoline and heating oil have made drilling for oil in Alaskas Arctic
Fational Bildlife @efuge 'AFB@( an important issue. AFB@ is the largest of Alaskas
si!teen national wildlife refuges, containing .>.= million acres. "t also contains
significant deposits of petroleum. The question is, %hould oil companies be allowed to
drill for that petroleumH
The case for drilling is straightforward. Alaskan oil would help to reduce 0. %.
dependence on foreign sources sub1ect to disruptions caused by the volatile politics of the
-iddle 2ast. Also, most of the infrastructure necessary for transporting the oil from
nearby +rudhoe :ay to ma1or 0. %. markets is already in place. Furthermore, because of
the e!perience gained at +rudhoe :ay, much has already been learned about how to
mitigate the risks of recovering oil in the Arctic environment.
Fo one denies the environmental risks of drilling for oil in AFB@. Fo matter
how careful the oil companies are, accidents that damage the environment at least
temporarily might happen. 2nvironmental groups consider such risks unacceptable$ they
argue that the value of the wilderness and natural beauty that would be spoiled by drilling
in AFB@ far e!ceeds the value of the oil that would be recovered. For e!ample, the
Fational Audubon %ociety characteri,es opening AFB@ to oil drilling as a threat )that
will destroy the integrity* of the refuge.
%o, which is more valuable, drilling for oil in AFB@ or protecting it as an
untouched wilderness and wildlife refugeH Are the benefits of the additional oil really
less than the costs of bearing the environmental risks of recovering that oilH 4bviously,
answering this question with great confidence is difficult because the answer depends on
sub1ective values. Dust how do we compare the convenience value of using more
petroleum with the almost spiritual value of maintaining the )integrity* of a remote and
pristine wilderness areaH Although such comparisons are difficult, we should recogni,e
that they can be made. "ndeed, we make them all the time.
Be constantly make decisions that sacrifice environmental values for what many
consider more mundane values, such as comfort, convenience, and material well-being.
There is nothing wrong with making such sacrifices because up to some point the
additional benefits we reali,e from sacrificing a little more environmental )integrity* are
worth more than the necessary sacrifice. "deally, we would somehow acquire the
information necessary to determine where that point is and then motivate people with
different perspectives and preferences to respond appropriately to that information.
Achieving this ideal is not as utopian as it might seem$ in fact, such an
achievement has been reached in situations very similar to the one at issue in AFB@. "n
this article, " discuss cases in which the appropriate sacrifice of wilderness protection for
petroleum production has been responsibly determined and harmoniously implemented.
:ased on this discussion, " conclude that we should let the Audubon %ociety decide
whether to allow drilling in AFB@. That conclusion may seem to recommend a foregone
decision on the issue because the society has already said that drilling for oil in AFB@ is
unacceptable. :ut actions speak louder than words, and under certain conditions " am
willing to accept the actions of environmental groups such as the Audubon society as the
.99
best evidence of how they truly prefer to answer the question, To Krill or Fot to Krill in
AFB@H
+rivate +roperty hanges 4nes +erspective
Bhat a difference private property makes when it comes to managing multiuse resources.
Bhen people make decisions about the use of property they own, they take into account
many more alternatives than they do when advocating decisions about the use of property
owned by others. This straightforward principle e!plains why environmental groups
statements about oil drilling in AFB@ 'and in other publicly owned areas( and their
actions in wildlife areas they own are two very different things.
For e!ample, the Audubon %ociety owns the @ainey Bildlife %anctuary, an
3=,555 acre preserve in /ouisiana that provides a home for fish, shrimp, crab, deer,
ducks, and wading birds, and is a resting and feeding stopover for more than .55,555
migrating snow geese each year. :y all accounts, it is a beautiful wilderness area and
provides e!actly the type of wildlife habitat that the Audubon society seeks to preserve.
:ut, as elsewhere in our world of scarcity, the use of the @ainey %anctuary as a wildlife
preserve competes with other valuable uses.
:esides being ideally suited for wildlife, the sanctuary contains commercially
valuable reserves of natural gas and oil, which attracted the attention of energy
companies when they were discovered in the .><5s. clearly, the interests served by fossel
fuels do not have high priority for the Audubon %ociety. Fo doubt, the society regards
additional petroleum use as a social problem rather than a social benefit. 4f course, most
people have different priorities& they place a much higher value on keeping down the cost
of energy than they do on bird-watching and on protecting what many regard as little
more than mosquito-breeding swamps. 4ne might suppose that members of the Audubon
%ociety have no reason to consider such )anti-environmental* values when deciding how
to use their own land. :ecause the society owns the @ainey %anctuary, it can ignore
interests antithetical to its own and refuse to allow drilling. Get, precisely because the
society owns the land, it has been willing to accommodate the interest of those whose
priorities are different and has allowed thirty-seven wells to pump gas and oil from the
@ainey %anctuary. "n return, it has received royalties of more than 6.7 million ':aden
and %troup .>9.$ %nyder and %how .>>7(.
:ack to AFB@
Bithout private ownership, the incentive to take a balanced and accommodating view
toward competing land-use values disappears. %o, it is hardly surprising that the Audubon
%ociety and other ma1or environmental groups categorically oppose drilling in AFB@.
:ecause AFB@ is publicly owned, the environmental groups have no incentive to take
into account the benefits of drilling. The Audubon %ociety does not capture any of the
benefits if drilling is allowed, as it does at the @ainey %anctuary$ in AFB@, it sacrifices
nothing if drilling is prevented. "n opposing drilling in AFB@, despite the fact that the
precautions to be taken there would be greater than those required of companies
operating in the @ainey %anctuary, the Audubon society is completely unaccountable for
the sacrificed value of the recoverable petroleum.
.9>
The evidence is overwhelming that the risks of oil drilling to the arctic
environment are far less than commonly claimed. The e!perience gained in +rudhoe :ay
has both demonstrated and increased the oil companies ability to recover oil while
leaving a )light footprint* on arctic tundra and wildlife.
"mprovements in technology now permit hori,ontal drilling to recover oil that is
far from directly below the wellhead. This technique reduces further the already small
amount of land directly affected by drilling operations. 4f the more than .> million acres
contained in AFB@, almost .9 million acres have been set aside by ongressC
somewhat more than 9 million as wilderness and >.7 million as wildlife refuge. 4il
companies estimate that only 3,555 acres would be needed to develop the coastal plain.
This carefully conducted and closely confined activity hardly sound like a
sufficient threat to 1ustify the rhetoric of a righteous crusade to prevent the destruction of
AFB@, so the environmentalists warn of a detrimental effect on arctic wildlife that
cannot be gauged by the limited acreage directly affected. Eiven the e!perience at
+rudhoe :ay, however, such warnings are difficult to take seriously.
:efore drilling began at +rudhoe :ay, a good deal of concern was e!pressed
about its effect on caribou herds. As with many wildlife species, the population of the
caribou on Alaskas Forth %lope fluctuates 'often substantially( from year to year for
completely natural reasons, so it is difficult to determine with confidence the effect of
development on the caribou population. "t is noteworthy, however, that the caribou
population in the area around +rudhoe :ay has increased greatly since that oil field was
developed, from appro!imately ;,555 to a high of some 3;,<55 'see )4il Kevelopment on
the oastal +lain of AB@B* at http&MMwww.anwr.org.case.htm(. %ome argue that the
increase has occurred because the caribous natural predators have avoided the areaC
some of these predators are shot, whereas the caribou are not. but even if this argument
e!plains some or even all of the increase in the population, the increase still casts doubt
on claims that the drilling threatens the caribou. For has it been shown that the viability
of any other species has been genuinely threatened by oil drilling at +rudhoe :ay.
onclusion
" an not recommending that AFB@ actually be given to some consortium of
environmental groups. "n thinking about whether to drill for oil in AFB@, however, it is
instructive to consider seriously what such a group would do if it owner AFB@ and
therefore bore the costs as well as en1oyed the benefits of preventing drilling. Those costs
are measured by what people are willing to pay for the additional comfort, convenience,
and safety that could be derived from the use of AFB@ oil. 0nfortunately, without the
price communication that is possible only by means of private property and voluntary
e!change, we cannot be sure what those costs are or how private owners would evaluate
either the costs or the benefits of preventing drilling in AFB@. #owever, the willingness
of environmental groups such as the Audubon %ociety and the Fature onservancy to
allow drilling for oil on environmentally sensitive land they own suggests strongly that
their adamant verbal opposition to drilling in AFB@ is a poor reflection of what they
would do if they owned even a small fraction of the AFB@ territory containing oil.

.>5
7= )thanol Madness
#enry Ford built his first automobile in .9>= to run on pure ethanol. "f ongress has its
way, the cars of the future will be built the same way. :ut what made good economic
sense in the late nineteenth century doesnt necessarily make economic sense in the early
twenty-first centuryCalthough it does make for good politics. "ndeed, the ethanol story is
a classic illustration of how good politics routinely trumps good economics to yield bad
policies.
2thanol is made in the -idwest 1ust like moonshine whiskey is made in
Appalachia& orn and water are mi!ed into a mash, en,ymes turn starch to sugar, yeast is
added and heat ferments the brew. 4nce this is distilled, the liquid portion is ethanol and
the solids are used as a high-protein animal food. The high-proof ethanol is combustible
but yields far less energy per gallon than gasoline does. Kespite this inefficiency, the
2nergy +olicy Act of 3557 requires that ethanol be added to gasoline, in increasing
amounts through 35.3. This requirement is supposed to conserve resources and improve
the environment. "t does neither. "nstead, it lines the pockets of American corn farmers
and ethanol makers and incidentally enriches some :ra,ilian sugarcane farmers along
the way.
Federal law has both encouraged and subsidi,ed ethanol as a so-called alternative
fuel for more than thirty years. :ut it was not until 3557 that ethanol really achieved
national prominence. The use mandates of the 2nergy +olicy Act, combined with surging
gas prices and an e!isting 7.-cent-per-gallon federal ethanol subsidy, created a boom in
ethanol production. :y 355=, ethanol refineries were springing up all over the -idwest,
and imports of ethanol from :ra,il reached record-high levels.
Three factors are typically used to 1ustify federal use mandates and subsidies for
ethanol. First, it is claimed that adding ethanol to gasoline reduces air pollution and so
yields environmental benefits. That may have been true fifteen or twenty years ago, but
even the 2nvironmental +rotection Agency acknowledges that ethanol offers no
environmental advantages over other modern methods of making reformulated gasoline.
#ence neither the congressional mandate to add ethanol nor the 7.-cent-per-gallon
subsidy for its use as a fuel additive can be 1ustified on environmental grounds.
A second argument advanced on behalf of ethanol is that it is )renewable,* in that
fields on which corn is grown to produce ethanol this year can be replanted with more
corn ne!t year. This is true enough, but we are in little danger of running out of
)nonrenewable* crude oil any time in the ne!t century. "ndeed, proven reserves of oil are
at record-high levels, and the price of oil would have to e!ceed 695 per barrel to match
the inflation-ad1usted level of twenty-five years ago. +erhaps more to the point, the
production of ethanol uses so much fossil fuel and other resources that under most
circumstances, its production actually wastes resources overall compared to gasoline. "n
part, this is because ethanol is about 37 percent less efficient than gasoline as a source of
energy. :ut it is also because the corn used to make ethanol in the 0nited %tates has a
high opportunity costD "f it were not being used to make fuel, it would be used to feed
humans and livestock. -oreover, because ethanol production is most efficiently
conducted on a relatively small scale, it must be transported by truck or rail, which is far
more costly than the pipelines used for gasoline.
.>.
The third supposed advantage of ethanol is that its use reduces our dependence on
imports of oil. "n principle, this argument is correct, but its impact is tiny, and the likely
consequences are not what you might e!pect. Total consumption of all biofuels in the
0nited %tates amounts to less than ; percent of gasoline usage. To replace the oil we
import from the +ersian Eulf with corn-based ethanol, at least 75 percent of the nations
total farmland would have to be devoted to corn for fuel. -oreover, any cuts in oil
imports will likely not come from +ersian Eulf sources. anada and -e!ico are the two
biggest suppliers of crude oil to the 0nite %tates, and both countries send almost .55
percent of their e!ports to the 0. %. market.
All of this raises an interesting question& if ethanol doesnt protect the
environment, conserve resources, or have any compelling foreign policy advantages, why
do we mandate its use and subsidi,e its productionH The answer lies at the heart of
political economy2 the use of economics to study the causes and consequences of
political decision making. "t is true that a critical component of what the government does
'such as providing for national defense and law enforcement( provides an institutional
structure necessary for the creation and retention of our total wealth. Fevertheless, the
essence of much government policy making has nothing to do with making the si,e of the
economic pie larger than it otherwise would be. "nstead, many government policies are
directed at dividing up the pie in new ways so that one group gets more resources at the
e!pense of some other group. To do this successfully, politicians must be adept at
concentrating the benefits of policies among a few favored recipients while dispersing the
cost of those policies across a larger number of disfavored individuals.
At first blush, such an approach sounds completely at odds with the essence of
democracy. After all, under the principle of )one person, one vote,* it seems like benefits
should be widely spread 'to gain votes from many grateful beneficiaries(, and costs
should be concentrated 'so that only the votes of a few disfavored constituents are lost(.
The concept of rational ignorance e!plains what is really going on. "t is costly for
individuals to keep track of e!actly how the decisions of their elected representatives
affect them. Bhen the consequences of political decisions are large enough to outweigh
the monitoring costs2 voters swiftly and surely e!press their pleasure or displeasure, both
in the voting booth and in their campaign contributions. :ut when the consequences to
each of them individually are small relative to the monitoring costs, people quite sensibly
dont bother to keep track of themCthey remain )rationally ignorant.*
"n the case of ethanol, almost one-fourth of all ethanol for fuel is made by one
company& Archer Kaniels -idland 'AK-(. learly, even small changes in the price of
ethanol are important to AK-. :ecause federal use mandates and the federal ethanol
subsidy both increase the profitability of making ethanol, AK- has strong incentives to
ensure that members of ongress are aware of the benefits 'to AK-( of such policies.
%imilarly, corn farmers derive most of their income from sales of corn. Federal ethanol
policies increase the demand for corn and thus increase its price$ again, because the
resulting benefits are highly concentrated on corn farmers, each has a strong incentive to
ensure that his or her members of ongress understand the benefits 'to the farmer( of
such policies.
ontrast this with the typical ta!payer or consumer of gasoline. "t is true that the
6; billion or so spent on ethanol subsidies each year must come out of ta!payers
pockets. Fevertheless, this amount is spread thinly across tens of millions of federal
.>3
ta!payers. %imilarly, although the mandated use of ethanol in gasoline is estimated to
raise the cost of gas by about 9 cents per gallon, this amounts to no more than 675 per
year for the typical driver. Feither ta!payer nor motorist is likely to spend much time
complaining to his or her senator.
Thus it is that farmers and ethanol producers are quite rationally willing to lobby
hard for use mandates and subsidies at the same time that ta!payers and drivers put up
little effective resistance to having their pockets picked. "t may make for bad economics,
but it is classic politics. And for the producers, farmers and politicians involved, it 1ust as
surely turns corn into )yellow gold.*
.>;
7? Heavenly Highway
"f youve ever been caught in a rust-hour traffic 1am, you understand what happens when
a scarce good has a price of ,ero. "n this case, the scarce good is highway travel, and
when the money price of travel is ,ero, something else must be used to ration the quantity
of the good demanded. Kuring rush hour 'and much of the rest of the day in places such
as /os Angeles, Few Gork, %eattle, and Atlanta(, the )something* that rations travel
demand is timeCthe time of the motorists caught in traffic.
Bhenever a person drives a car, he or she generates a variety of costs. First are
the private costs of driving& fuel, oil, vehicular wear and tear, and the value of the drivers
time.
.
These are all borne by the driver, so when deciding whether and how much
highway travel to consume, the driver weights these costs against the benefits of that
travel. "f these were the only costs of drivingCand on some roads at some times they are
Cthis discussion would end here. Krivers would bear the full cost of their activities, 1ust
as the consumers of pi,,a do, and there would be no further issues to consider. :ut in
most places in the world, during parts of most days, driving generates another costC
congestionCthat is not borne by the individuals responsible for it.
4n any road, after traffic volume reaches some level, additional cars entering the
road slow the flow of traffic. 4nce this process of congestion occurs, every additional car
entering the road slow the flow of traffic. 4nce this process of congestion occurs, every
additional car slows traffic even more. 2ventually, traffic may come to a complete halt.
0nder these circumstances, each driver is implicitly using, without paying for it, a
valuable resource that belongs to other peopleCthe time of other drivers. 0nless drivers
are made to bear the congestion costs they generate, we know two things must be true&
first, the money price of traveling on the road is too low, and second, the value of
motorists time spent in traffic must be rationing the quantity of travel demanded.
Bhy do economists worry about congestionH :ecause its e!istence raises the
possibility that the people using the road could actually be made better off if they were
charged a money price for using the road. This money price would induce fewer
motorists to drive because some would carpool, others would use public transit, and still
others might telecommute rather than come into the office at all. The reduced driving
would reduce congestion and so conserve the valuable time of those people who
continued to drive. "n fact, it is even possible that by charging drivers a monetary fee or
toll to drive on a road, more people would succeed in reaching their destination in any
given time period. "t is easiest to see this when traffic is so bad that it comes to a halt. The
toll would discourage some people from entering the road and so permit the remaining
traffic to move and thus reach its destination. :ut the general principle holds true even
when traffic is 1ust greatly slowed down by the congestion& @oad tolls can both improve
traffic flow and make drivers better offCsurely a heavenly combination for those sick of
being stuck in traffic.
Bhy, then, do we not see more widespread use of tolls on highwaysH There are
three reasons. First, toll collection is not free, and until recently, the costs were often
large enough to offset many of the benefits. "f youve ever traveled on older toll roads,
such as the +ennsylvania or Few Dersey turnpikes, you have some notion of these costs.
The toll booths there must be constructed and then manned twenty-four hours a day, and
.><
traffic must come to a halt to pay the toll. The result is that the tolls are creating some of
the congestion they are supposed to relieve.
:ut over the past couple of decades, electronic toll collection systems have been
developed that reduce these costs substantially. %mall, ine!pensive electronic devices
called transponders can be installed in cars that will be using the toll road. The
transponders transmit identifying information to receivers at the toll stations, which are
suspended above the roadway. 'The toll stations are also equipped with cameras to record
the license plate number of anyone passing through with a missing or malfunctioning
transponder.( ars need not even slow down from cruising speeds to have their
identification recorded as they pass through. At the end of the month, each motorist
receives a bill in the mail for the toll charges 'or a ticket if the driver tried to avoid the
toll(. learly, such a system is designed for roads or bridges heavily trafficked by regular
commuters, but in these circumstances, such as on the bridges in the Few Gork ity area,
electronic toll collection has drastically lowered the costs of using monetary prices to
ration roadway use. The result has been reduced congestion and improved economic
efficiency. Krivers are better off, and local governments have e!tra revenue to spend on
other services.
alifornia, Te!as, and -innesota all offer e!amples of how modern toll collection
technology can be used to speed highway travel, even during the heaviest traffic periods.
Along stretches of multilane roads in 4range ounty, %an Kiego, #ouston, and
-inneapolis, specified lanes are designed as high-occupancy toll '#4T( lanes. These are
limited access highway lanes that provide ,ero- or reduced-price access to qualifying
high-occupancy vehicles '#4Is( and also provide access 'at a price( to other vehicles
not meeting passenger occupancy requirements. "n %an Kiego, for e!ample, a driver
alone in a transponder-equipped care can pay a toll of 75 cents to 6<.55 'depending on
traffic conditions( to use the #4T lane on "nterstate "-.7. "n doing so, the motorist can
e!pect to travel at or near the speed limit even when traffic in ad1acent lanes is bogged
down during rush hour. "n 4range ounty, alifornia, the #4T lane charges on %tate
@oute >. range from 6...7 in the middle of the night to 69.75 during the worst of the
afternoon rush. As in other locations where #4T lanes are in use, the result is smooth
sailing for a fee, even as drivers in the regular lanes spend their time playing stop-and-go.
And it is not 1ust the high-income crowd that gets to en1oy the trip. %urveys reveal that
drivers at all points in the income distribution are users of the #4T lanesCbecause the
value to them of the time saved is worth the added monetary cost.
Kespite such successes, tolls are sometimes eschewed because pricing highway
travel can yield radical and unpredictable consequences of changes in the cost of travel.
0nlike a typical privately provided good, each road is part of a network of roads$ a
change in costs on one segment of the system can sometimes have striking and
substantial consequences elsewhereCconsequences that can largely or completely offset
the benefits of the tolls.
The island nation of %ingapore, for e!ample, has some of the worst traffic in the
world. As a result, its government has been e!perimenting with pricing roads since .>?7,
charging a special fee for vehicles entering the central business district during peak traffic
periods. Bhen combined with other traffic-control measures, the fee helped cut traffic in
central %ingapore by <7 percent during peak hours, enabling traffic speed to almost
double, to about 33 miles per hour. :ut these positive effects in the central city between
.>7
?&;5 and >&;5 A.-. were accompanied by deleterious effects elsewhere. For e!ample,
1ust outside the central city, traffic 1ams got worse as drivers sought routes they could use
without paying. -oreover, on the roads leading into the central city, the drop in rush-
hour traffic was nearly matched by a sharp increase in traffic 1ust before ?&;5 and after
>&;5.
Tolls dont always have to have such adverse side effects, however, as illustrated
by a successful implementation in /ondon, 2ngland. :eginning in 355;, drivers entering
the central area of /ondon were charged a fee of ,7 'about 6.5 at recent e!change rates(,
with fines ranging in e!cess of ,355 if they failed to pay. The result has been a 35
percent reduction in traffic and about a 7 percent increase in average speedsCwhich
doesnt sound like much until you reali,e that average traffic speeds in /ondon actually
fell during the twentieth century as cars first replaced horses and then simply got in each
others way. The big difference between %ingapore and /ondon seems to be the
magnitude of the charge& /ondon got it roughly right, but %ingapore tried to charge too
muchCa point to which we shall return.
+erhaps the biggest impediment to efficient pricing of roads is that roads are
typically operated by governments rather than by private-sector firms. Kecisions to price
roads must pass through the political process, which necessarily means that the efficiency
concerns of the economist are often outweighed by political concerns over who shall pay
how much for what. +ublic opinion polls from densely populated and heavily congested
#ong Aong help us understand the consequences.
Although almost identical proportions of drivers and nondrivers in #ong Aong
agree that traffic congestion is a serious problem '9<.7 percent and 93.5 percent,
respectively(, they differ sharply on what they think should be done about it. Krivers
favor new road construction, presumably because this would shift to ta!paying
nondrivers part of the cost of relieving congestion. "n contrast, nondrivers believe that
financial disincentives to driving 'such as tolls and licensing fees( should be given the top
priority, presumably because this would shift more of the burden to drivers. These
divergences of public opinion have slowed the use of private-sector remedies for the
congestion on publicly owned roads, 1ust as they have elsewhere in the world. The result
is too many roads on which monetary prices are too low 'or none!istent( and congestion
is correspondingly too high.
Dapan offers us an illustration from the other end of the spectrum on the ha,ards
of having politicians set prices. 0nlike in the 0nited %tates, where )freeways* are
commonplace, all <,;75 miles of e!pressways in Dapans national highway system are toll
roads. The nation began building the e!pressways in .>7= with loans from the Borld
:ank, imposing tolls to pay off the loans. The loans are long-since paid off, but the tolls
remainCgenerating 6.7 billion a year to help the national government pay off its 6;=5
billion debt for other public-works pro1ects. Get the government is so addicted to tolls as
a revenue source that many of its citi,ens think it has gone off the deep end. Tolls are so
high that if you were to drive the length of Dapan 'a nation smaller than alifornia(, you
would rack up 6;;5 in tolls. Dust making the ten-minute trip across Tokyo :ay from the
airport will set you back 637, which is actually an improvement over the 6<3 that drivers
used to pay. Bith fees like this, you can imagine the response& +eople buy airline tickets
rather than drive when making trips of 355 miles, and trucking companies devise
elaborate routing schemes for their trucks to keep toll costs down. And hows trafficH
.>=
Bell, along many of the pricier portions of the Dapanese highway system, you may find
yourself alone on the road.
The message is quite simple. For a variety of reasons, highways, unlike
hamburgers, are tricky things to price correctly. :ut as the e!periences of congestion
pricing in central /ondon and the #4T lanes in America attest, modern technology
combined with political gumption can produce a heavenly trip. "t is a lesson that could be
profitably applied in many other locales.
.>?
"+ 'ic.et (ro.ers and 'ic.et &calping
"f you want to see a concert, a game, a race, or any other event that is sold out, you
probably know that you can always get a ticket for a price. %ome events are )once in a
lifetime* while others are 1ust something many people want to see. "n recent years,
tickets to events like -ichael Dordans last game as a hicago :ull and the game in
which -ark -cEwire hit his home run number =3 in %t. /ouis commanded prices many
times their face value. There are other events, not once in a lifetime, where demand
continues to be e!traordinarily high. The %upper :owl, the Borld %eries, and the
Kaytona 755 are events that are important enough to some people that they are willing to
pay more than face value for a ticket.
Bhile many cities it is illegal to sell a ticket for more than face value, in every ma1or city
there is a way of getting such tickets when they are the only ones available. 2conomists
are almost always against laws that prevent people from selling things they possess.
They reason that if one person would rather have 6755 than a ticket to a game and
another person would rather have a ticket to a game than 6755, then both are better off
with the trade than without it.
K2F"F"FE :@4A2@"FE AFK %A/+"FE
:rokering tickets is the act of buying a ticket and selling it at a price higher than its face
value when such a transaction is legal. %calping tickets is the act of buying a ticket and
selling it at a price higher than its face value when such a transaction is illegal. Thus the
practice is scalping only when it is done illegally. @egardless of semantic differences, for
many fans and performers, scalpers and brokers are the worst form of predator$ they
obtain large blocks of tickets before other people get them, then they sell the tickets at
prices that net them a profit. They do not produce anything. Those who engage in this
trade view themselves as simply providing a service from which they make a living. To
others, they are simply leeching off the talents of others.
For economists, scalpers perform a function that )fi!es* pricing that promoters get
wrong. As we will see, scalping can e!ist profitably only when enough fans are willing
to pay more for tickets than the face value of the ticket and there are more buyers willing
to pay face value than there are seats.
This does not necessarily mean the performance is a sellout. "f some seats are really
good and others are really terrible, then the good ones, at courtside, say, might remain
unsold. Bhat is true is that there cannot be unsold seats right ne!t to seats for which
scalpers wish to charge more than face value. Bhen traditional ticket outlets that sell for
face value have open, decent seats, these will be sold out before scalpers can sell any.
The +romoter as -onopolist
Bhen promoters are attempting to ma!imi,e profits and are trying to figure out what
price to charge for events, they have to gauge what the demand will be for the event.
.>9
4nce they have done that, they can look at this problem as any other monopolist would.
@ecall that we have always assumed that firms are profit ma!imi,ers An interesting
aspect of this is that it may make sense for promoters to see that the arena is only partially
filled. +romoters hold back tickets when they would have to lower the price too far in
order to sell out the facility. Gou should not be surprised by this conclusion, especially if
you are at a school that does not have a popular athletic program. onsider a school
whose mens basketball team draws between <555 and =555 fans a game, while the
womens team draws fewer than .555 a game. "f the athletic department were to price
tickets to sell out the arena, tickets would be nearly free for the mens games and the
department would have to pay people to see the women. That is not a slam at the
women$ it is 1ust a fact of life at a school without a national sports reputation. learly, it
makes sense for this university to charge more for the mens games and to charge
something for the women. The university makes the most money possible that way, even
with only one sellout per decade.
The +erfect Arena
To a promoter, the si,e of the facility is significant. "n a promoters eyes, the perfect
facility would be where the capacity is e!actly the number of seats that the promoter
wants to sell anyway. That is, the facility with perfect capacity is the one where marginal
cost intersects marginal revenue at the quantity that is e!actly the capacity of the facility.
4f course, promoters cannot always find the perfect facility. -ost medium and small
cities have only one or two places to hold an event like a concert hall may not be
available.
"n a big city with many venues of many different si,es, a promoter should seek the
facility whose si,e ensures that the marginal cost will cross marginal revenue at e!actly
the capacity. 4n the assumption that facilities that are unnecessarily large cost the
promoter more to rent, booking this )perfect* facility ma!imi,es profit.
"n each case mentioned so far there is no market for scalpers because the face value of the
ticket is the price at which it is sold. %calping makes sense only if the market price of the
ticket is greater than the face value. The only way for that to happen is if the promoter
charges less than the profit ma!imi,ing amount.
B#G +@4-4T2@% #A@E2 /2%% T#AF T#2G 40/K
Bhy might promoters sell out a facility rather than ma!imi,e profitsH First, they may not
have good information on the price they ought to charge. This uncertainty might
motivate them to err on the safe side and charge a lower price. %econd, there may be
some )e!citement* factor to a full stadium that appeals to the performers and that is
worth loss or profit. Third, the performers may want a reputation of charging a )fair
price* for their events and be willing to forgo ma!imum profit in order to further that
reputation. Fourth, the performers may want some mechanism other than price to
separate the )real fans* from those who go to events simply because they have money.
Fifth, ancillary sales of shirts and other memorabilia are important sources of revenue for
.>>
performers and promoters alike. %ince it may be that the revenue gained by these sales
e!ceeds that lost by having low ticket prices, low ticket prices may lead to increasing
audience si,e and may therefore ma!imi,e profit after all. /ast, it may be in the long-run
best interest of the performers to charge a low price for tickets so that the largest possible
audience can provide word of mouth advertising for them and generate interest for their
talent.
%ometimes promoters do not have an e!act idea of what price to charge for an event.
-ore often than not, promoters of a new act must guess what the market will bear for the
ticket. "f they guess too low, scalping may ensue. "n addition, promoters may want to
play it safe and not run the risk of pricing too high, thereby purposefully pricing less than
even their best guess. This might also result in scalping.
There is an e!citement to being at a sold-out event in a large arena. The sound and feel
are different for a sold out event than for one in a half-full auditorium. The performer
en1oys it more and the fans en1oy it more. Although this may not seem like an important
function for a promoter, consider that promoters are hired by athletes or performers to
promote the event as effectively as possible. "t may be in the promoters best interests to
cater to the performer, regardless of what ma!imi,es profit.
%ome performers try to establish closeness with their fans. %ome try to signal their
empathy by making sure ticket prices are low enough that )ordinary* fans can afford to
go. This means that performers and promoters are wiling to accept less money for the
good feeling that charging )fair* prices gives them.
+erformers may appreciate fans that are wiling to camp out for tickets more than those
simply willing to pay a lot of money. Gou have to be much more e!cited about a band to
camp out than to simply buy tickets. The people who are willing to camp out to get
front-row seats are far more likely to convey enthusiasm for performers than those with
deep pockets.
Bhen you go to a concert, you often spend as much on shirts and other promotional items
as you did on the ticket. "f promoters keep you out by charging a price that is too high,
they forgo that important other revenue as well. "n the big picture, low ticket prices may
be profit ma!imi,ing after all.
+romoters of new bands may decide that it is in their long run interest to keep ticket
prices low so that the band is seen by as many people as possible. :y setting low ticket
prices early in a performers career, they may be more likely to turn a one hit wonder into
a star.
For any one of the reasons 1ust outlined promoters may choose to sell their tickets at
prices below their monopoly market value and perhaps even below the price that would
guarantee a sellout. "n any event, a price below what they see as the free market value
will cause scalpers to buy tickets at the lower price in order to sell them at a higher price.
355
/2E"T"-AT2 %A/+2@%
"n some states, all forms of scalping are legal$ in others, none are. "n a growing number
of states scalping remains illegal but )brokers* are allowed to sell tickets for more than
they pay for them. The only difference between a scalper and a broker is that the scalper
walks around an events perimeter trying to sell tickets, while the broker does it from a
desk and a phone. The scalper demands cash$ the broker takes credit cards.
Another way that scalpers have become legitimate is by pairing their services with that of
a travel agent. "t is legal in nearly every state for travel agents to create packages with
hotel rooms, cab rides, and the like, and then offer these along with the tickets. %uppose
you want a ticket to the latest )fight of the century.* "f it is in a no scalping state and you
cannot get tickets the normal way, you can still get the ticket because travel agents now
can combine a 6.55 ticket with a 6.55 hotel room and a 6.5 cab ride and call it a 6755
e!cursion. 'Ko the mathW( This is legal nearly everywhere, even when )scalping* is not.
"t is also what an economist would call a distinction without a difference.
"t must be reinforced, therefore, that economists generally disapprove of anti-scalping
regulations. Bhether as legal brokers or illegal scalpers, the sellers are providing
services. They are not only fi!ing the market shortage left over by the promoter$ they are
also providing convenience. The hours of ticket offices at ma1or arenas are not always
amenable to customer desires. /ines at the ticket booth or at )will call* windows are
often very long the day of the event. :ecause scalpers and brokers provide us with a
convenience and harm no one in the process, there is little economic reason to ban their
activities.
35.
7> Head &tart
2stablished in .>=7, the #ead %tart program serves nearly 955,555 children under the age
of five at an annual cost of more than 6< billion dollars. "t began on the seemingly sound
premise that early intervention in the lives of children can pay dividends later in the form
of improved educational outcomes, reduced crime rates, and other socially desirable
outcomes. Thus #ead %tart has en1oyed broad political support, despite the almost total
absence of evidence that it has engendered a long run positive influence.
#2AK %TA@T A% AF "FI2%T-2FT
The 2arly "ntervention +remise
Bhen social scientists looked at the problem of poverty in the .>=5s, many hoped that
with enough money, poverty could be significantly reduced and perhaps permanently
eliminated. 2arly evidence gave them great hope. The poverty rate fell from more than
35 percent in .>=5 to less than .. percent a decade later, but it never fell below that.
Though more than 6;55 billion has been spent each year on poverty programs, the
official poverty rate has continued to hover between .. percent and .7 percent ever since.
-ore troubling has been the degree to which people whose annual incomes are lower
than the poverty line have settled into habits that almost guarantee they will remain in
poverty permanently. The poor are far more likely than the non poor, for e!ample, to
drop out of school, father children or become pregnant as teens, use illegal drugs, or get
arrested. At the inception of #ead %tart people thought that early intervention in the lives
of children could lessen or even eliminate some of the sources or causes of poverty.
Theoretically, children given academic skill, life skills, and health care to promote a
)head start* on life would be more likely to succeed.
The early intervention premise suggests two things about money spent on a quality early
education. :y interrupting a cycle of poverty, we save future ta!payers money. This can
be analy,ed using concept of present value. Bhat is also implied about this premise is
that people other than the child and the parent benefit when a child gets high-quality care.
Be e!amine this aspect as well.
+resent Ialue Analysis
Those who founded #ead %tart hoped that money invested early in the education of
young children would pay for itself in the long run& students who were not 1udged among
the likely to succeed would graduate from school, live with good standards of hygiene,
earn respectable incomes, and pay ta!es. "deally, using the economic concept of present
value, we would be able to prove that, like any good investment, such early childhood
education would pay for itself. As you know, present value is arrived at by discounting
future payments by pro1ecting interest rates in a way that puts future and present dollar
353
figures on an even basis. :ecause human nature is to want things now rather than later,
dollars paid now are more valuable to people than dollars paid in the future. Therefore, if
the present value of the dollars spent on early education is less than the present value of
the stream of benefits, then any such early education program is a good investment
%uppose it could be shown that having a child in #ead %tart reduced a childs likelihood
of dropping out of school, of getting pregnant, or committing crimes for which 1ail time
was required. %uppose it could also be shown that #ead %tart increased the likelihood
that the child would grow up to be a fully functional ta!payer. "f all that were true it still
would not necessarily 1ustify the investment. From a strictly economic perspective, the
present value of the increased costs associated with #ead %tart would have to be
e!ceeded by the present value of the benefits as measured by the increased ta!es and
reduced welfare and imprisonment costs.
2!ternal :enefits
Bhen people other than the consumer or producer of a good get a benefit from a good,
economists refer to this as a positive e!ternality. The argument here is that when parents
choose the child care for their child, people other than themselves, their child, or their
daycare worker are affected. :y choosing a high quality option, other parts of society
stand to benefit because the presumption is that the child is more likely to be a productive
citi,en in the future. Bhenever there are such e!ternal benefits, economists will
generally concede that some form of subsidy is warranted.
The 2arly 2vidence
The efficacy of the premise underlying the desirability of early intervention was fortified
by studies from the .>=5s through the .>95s that showed how effective early childhood
education could be. The most prominent of these studies followed several hundred
young, poor children, half of whom were given an e!cellent preschool e!perience free for
two years, and half of whom were given nothing. The half that got the schooling not only
performed better on "R tests when they entered school, but they performed better in
school, they were less likely to commit crimes as teens, and they graduated at far higher
rates than the group that did not get that early education. :y nearly every measure the
children given the )head start* stayed ahead.
Advocates of #ead %tart maintained that for every dollar spent on early childhood
education, five dollars would be returned in increased ta! revenues and reduced welfare
spending. Bhile not reported in present value terms, recalculating it that way using
reasonable interest rates suggests that such an investment would be a good one. Armed
with threat early evidence, #ead %tart began with great hope that in a generation or two,
early childhood education would make significant inroads into poverty in the 0%.
35;
The @emaining Koubts
2ven in the early years, some people questioned the premise that the investment in early
childhood education could have the kind of return that was pro1ected. These doubts were
based mainly on the implausibility that a few years of preschool could enable children to
overcome the effect of poverty and other social problems. Although most #ead %tart
programs are offered for half days during the school year, even children in the all day,
all-year for of #ead %tart spend only <=55 hours in the enriching environment. The rest
of their childhood, .7;,555 hours is spent in poverty stricken homes, crime ridden
neighborhoods, and educationally deficient schools. @egardless of how good the <=55
hours is, it is hard to imagine that its influences would be strong enough to enable
children to prevail over all other the influences in their lives.
ritics also point to flaws in the original study that showed the great potential for early
intervention. hildren in the original study were placed in a classroom that was nearly
ideal, and their teachers were better equipped, physically and educationally, than any
national program could ever hope to be. ritics doubted whether the program could be
duplicated and used for the rest of the country.
T#2 #2AK %TA@T +@4E@A-
2ver since its beginning in .>=7, #ead %tart has en1oyed significant growth in
appropriations but has never had a budget sufficient to be called )fully funded.* A fully
funded program would have enough money, staff, and facilities to handle all children
who are eligible for the program. "n reality there have been long waiting lists in some
cities for #ead %tart services.
#ead %tart is much more than day care, and it is not merely a preschool. 0nder reforms
enacted in the early .>>5s, it has become a center of learning for the entire family.
Teachers are charged not only with creating a wholesome environment for children, but
also with making sure parents know of the available social resources for economically
troubled families. The teachers make sure that immuni,ation and health records are up to
date, and they advise parents on a host of other matters related to child rearing as well.
The early evidence is that #ead %tart centers are performing these tasks very well.
+rofessional accreditation agencies have found that centers are well within the standards
for early childhood education, certifying the vast ma1ority of centers as )good* or better.
:y .>>? there were nearly 955,555 children enrolled in #ead %tart, at an average cost per
child of nearly 67,555. "nflation-ad1usted spending and enrollment stayed relatively flat
from .>=7 to .>>5. Though enrollment began at nearly ?75,555 and fell through the
.>?5s to a low of ;;;,555, it rebounded through the early .>95s to half million, where it
stayed until .>>5. %imilarly, inflation-ad1usted spending on the program stayed between
?75 million and spending on the program stayed between ?75 million and . billion .>93
dollars from its inception through .>>5.
35<
T#2 0@@2FT 2I"K2F2
2vidence that #ead %tart Borks
The evidence that #ead %tart works comes mostly from myriad studies which test #ead
%tart children at or near their e!it from the program. #ead %tart children do dramatically
better on "R tests than equally situated non-#ead %tart children on entrance into
kindergarten. Iirtually all of the studies that e!amine the program have found some
significant advantage for these children in the year or so after they e!it the program.
The improvements can be seen in lower numbers of children being retained in the first
grade and in higher reading and verbal test scores. "n addition, #ead %tart children are
healthier than equally situated non-#ead %tart children, in large measure because part of
#ead %tart is parental education and because children in #ead %tart are fed nutritious
meals while they are in the program. "n the teacher-parent contacts, immuni,ation
records are reviewed and, when necessary, doctor and dentist referrals are made. +arents
of #ead %tart children are more aware of the many services available to them and their
children an awareness which e!plains, in part why =5 percent of them are enrolled in
-edicaid.
2vidence that #ead %tart does Fot Bork
#ead %tarts detractors have evidence to support their position as well. Bhile there are
limited studies that show success for #ead %tart education that e!tends beyond the
second grade, there are companion studies that show that it does not. As the Eeneral
Accounting 4ffice 'EA4(, the investigative wing of ongress, reported in .>>?, there
are no national studies that show, in a compelling way, that anything long lasting is
achieved in #ead %tart. A study by Danet urrie and Kuncan Thomas put it quite well&
)"n summary, despite literally hundreds of studies, the 1ury is still out on the question of
whether participation in #ead %tart has any lasting beneficial effects.*
Although some studies do show that using some measures of success, some types of
students do better, the patterns in the literature on #ead %tart are not consistent. %ome
show lasting effects for black children and other do not. %ome show lasting effects for
white children and others do not.
The basic premise of #ead %tart is that it is literally an educational )head start* and that
the students who graduated from it ought to do better down the road than similarly
situated students who did not participate. There is very little evidence, however, that
suggest that test scores, dropout rates, graduation rates, or any other measure of
educational achievement in later years is enhanced when students have #ead %tart in their
background. -ost of the studies that show a waning influence find that most of the
benefit of #ead %tart is gone by the third grade and that none is evident by the si!th
grade.
357
T#2 4++4@T0F"TG 4%T 4F F0//G F0FK"FE #2AK %TA@T
"f ta! money had no opportunity cost, #ead %tart would not be controversial. "n the
tradition of the medical professions #ippocratic 4ath, #ead %tart clearly does no harm.
Bhether it does any good and, if so, whether that good is enough to 1ustify the costs are
other questions. #ead %tart costs 67,555 per year per student, more than most day-care
centers charge for a year of service, even though most day care is nine hours a day, all
year, and #ead %tart is only four days a week during the school year. According to the
census bureau, day care costs per child approach 67,555 per year, though costs vary
widely by location.
"f the federal government wants to provide free day care for poor children, it can do it for
less money than it spends on #ead %tart. "f #ead %tart genuinely provides a measurable
head start, it should have showed up in long term studies in an unmistakable and
consistent fashion. 4n the other hand, some of the impact of #ead %tart is such that it
will not show up in educational achievement data, but is still important. Bhen #ead
%tart works with parents, they may become less abusive, they may be more likely to deal
effectively with their childrens other problems, and they may be more likely to succeed
themselves. Then again, there is no solid evidence, positive or negative.
4n the issue of long term impacts, there is no evidence that #ead %tart alone improves
graduation rates, decreases teen pregnancies, or lowers crime rates. There is no evidence
that it has any long-term impact on any other long term measures of social or academic
success either. 2ven #ead %tarts staunchest advocates now suggest that the premise of
#ead %tart, that a short boost in the early years would remain throughout a lifetime, was
overly optimistic. Their view now is that programs like #ead %tart need to be carried on
throughout childhood, and they also need to be implemented in schools. #ead %tarts
detractors suggest this is sending good money after bad.
35=
=5 Poverty2 Capitalism2 and ,rowth
Fifty years ago, nearly half of the worlds population lived in poverty$ today, the
proportion is about .? percent. "n fact, compared to fifty years ago, even though the
worlds population has doubled, there are actually fewer people now living below the
poverty line. Kespite the human misery that is evident to varying degrees in virtually
every nation of the world, there is little doubt that economic prosperity has made great
strides.
'he &weep of History
The past half-century is but a small part of a story that has evolved over the course of 375
years. "n the middle of the eighteenth century, perhaps >5 percent of the worlds
population lived in a state of ab;ect poverty2 subsisting on the equivalent of less than 6.
per person per day, measured in todays terms. "n fact, for most of human history, ab1ect
poverty-including inadequate nutrition and rudimentary shelter-were the norm for almost
everyone, everywhere. This began to change in the eighteenth century with the
Industrial evolution and its associated mechani,ation of tasks that had always been
laboriously done by humans or animals. %timulated in the early years by the invention
and application of the steam engine, the "ndustrial @evolution initiated a massive cascade
of innovations in transportation, chemistry, biology. This continuing process of invention
and innovation has made little headway in many parts of the world, but where it has taken
hold, there has been a sustained rise in average real per capita income and a
corresponding decline in poverty. :y .935, the e!tent of ab1ect poverty had fallen from
>5 percent to 95 percent$ by .>>5, it had dipped below ?5 percent$ and it has continued to
decline since. :efore the "ndustrial @evolution, more than five out of si! people lived in
ab1ect poverty$ today, it is one out of si!.
0neven Progress
This story of human progress has been uneven across countries, 2urope, Forth America,
and a few other locations have witnessed the greatest increases in real per capita income
and the greatest decreases in poverty in most nations in Africa have changed little over
the past 375 years. 2ven within given countries, progress has sometimes been erratic. "f
we go back ninety years ago, for e!ample, the standard of living in Argentina was the
si!th highest in the world$ today, that nation ranks seventieth in living standards. "n
contrast, thirty years ago, 375 million people in hina lived in ab1ect poverty$ that
number has since been cut by >5 percent.
"n hapter ., )@ich Fation, +oor Fation,* you saw the key institutional factors that
determine average levels of per capita income3 %ecure property and contrast rights
and the rule of law were the institutions under which the "ndustrial @evolution flourished
best, and it is thus in nations that have embraced these institutions that people are most
likely to be prosperous. These same institutions are the ones typically associated with
capitalism, economic systems that depend primarily 'Though not necessarily completely(
on markets to allocate scarce resources3 4f course, no country in the world is
35?
completely capitalist$ in the 0%, for e!ample, less than two-thirds of resources are
allocated by the private sector, while the rest are allocated by federal, state, or local
government. At the other end of the spectrum, even in ommunist countries such as
uba, Iietnam, and Forth Aorea, markets play at least some role in allocating resources.
Kespite some ambiguities, then, it is possible to measure the degree of capitalism 'or, as
some would term it, economic freedom( in each country around the world. Koing so
yields measures that seem to correspond reasonably well with what many people would
think is true about the economies of those countries. For e!ample, using the measures
constructed by anadas Fraser "nstitute, #ong Aings economy is rated the most
capitalist, while the 0% is tied for third 'with %wit,erland and Few Nealand(. %ingapore,
anada, "reland, and Australia are some other nations whose economies are 1udged
among the ten most capitalist in the world. "f you know much about economic prosperity
around the world, you will be aware that these countries are also among the world leaders
in real per capita income. "ndeed, the association of capitalism with prosperity is
everywhere quite strong.
Capitalism and Prosperity
"t is convenient for our purposes to divide all the nations in the world into five groups,
ranging from )most capitalist* to least capitalist.* Kata limitations prevent doing this
with every single nation in the world. Fevertheless, it is possible to do it for about .37 of
them, putting 37 nations into each of the five groups. Thus among the top 37 )most
capitalist* nations, in addition to the countries we mentioned earlier, many 'but not allW(
of the original members of the )uropean 0nion 8)09 would be included, along with
hile, osta @ica, and Auwait. At the other end of the spectrum, the economies of
@ussia, Algeria, Iene,uela, and Nimbabwe would all fall into the group of the 37 )least
capitalist* nations.
As we suggested earlier, people who live in the most capitalist nations in the world also
tend to have the highest average income. For e!ample, average per capita income for
people living in the group including the 37 most capitalist nations averages over 63;,555
per year. For people living in the ne!t most capitalist group of nations, per capita income
averages about 6.;,555 per year. 4nce we get down to the 37 least capitalist nations,
average income has dropped to but 6;,;55 per year. And because rates of economic
growth are also higher in more capitalist nations, the difference in income between the
most and least capitalist nations are growing over time.
4f course, this is a chapter about poverty, and the average income in a nation may bear
little relation to the income earned by its poorest residents. -any people believe, for
e!ample, that capitalist nations promote e!cessively competitive behavior so that people
who are not good at competing end up much poorer in capitalist than in non-capitalist
nations. "f the rich get richer in capitalist countries while the poor get poorer, then even
if the average person in capitalist nations is doing well, the same might not be true for
people at the bottom of the income distribution. As it turns out, however, the poor do not
do worse in capitalist countries$ in fact, they do better.
Capitalism and Poverty
359
onsider the 37 most capitalist nations in the world. 4n average, the poorest .5 percent
of the population receives about 3.7 percent of total income in these countries. "ndeed, if
we look across all countries, we see that although there is some variation from nation to
nation, the poorest .5 percent of the population typically gets between 3.5 and 3.7
percent of total income. 4ne way to put this is that on average, capitalism does not lower
the share of total income going to the people at the bottom of the income distribution.
apitalist or ommunist, in Africa or in the Americas, the per capita income of the
poorest .5 percent of the population in a nation ends up being about one-quarter of what
it is in the middle of the income distribution for that country.
Fow if you followed the numbers earlier about average income and capitalism, you may
already have figured out the ne!t point& :ecause capitalism raises total income in a
nation without reducing the share of income going to the poor, capitalism ends up raising
income at all points in the income distribution. Thus for the poorest .5 percent of the
population in highly capitalist countries, average per capita income is about 67,>55 per
year ' or 1ust under 63<,555 per year for a family of four(. For the poorest .5 percent of
the population in the least capitalist countries, average income is under 6?75 per year
'about 6;,555 for a family of four(. 2!pressed somewhat differently, poor people in the
most capitalist nations can e!pect average income levels eight times higher than poor
people in the least capitalist nations.
The radically higher standard of living e!perienced by the poor in capitalist nations is
reflected in many other statistics indicative of quality of life. For e!ample, life
e!pectancy in the 37 most capitalist nations is about seventy-seven years$ in the least
capitalist, it is about fifty-seven. %imilarly, infant mortality rates are eight times higher in
the least capitalist countries than in the most capitalist. -oreover, because people at the
top of the income distribution have access to health care in both rich and poor nations,
these differences in life e!pectancy and infant mortality are chiefly due to differences
among people at the bottom of the income distribution. "n capitalist nations, compared to
non-capitalist countries, it is the poor whose newborns are surviving infancy and whose
adults are surviving to old age.
There is another compelling difference between capitalist and non-capitalist countries
that sheds light on what the future may bring. "n the 37 most capitalist countries of the
world, fewer than . percent of children under the age of fifteen are working rather than in
school. "n the 37 least capitalist nations, one child of every si! under the age of fifteen is
working rater than in school a rate nearly twenty times higher. Thus in capitalist nations,
children are much more likely to be getting the education necessary for them to learn the
skills of the future. This in turn means that economic growth is likely to be higher in
capitalist than in non-capitalist nations, and this is e!actly what we observe. Erowth in
per capita income in the 37 most capitalist countries averages about 3.; percent per year,
enough to double income at all levels over the ne!t thirty years. "n contrast, average per
capita incomes are actually falling in the least capitalist countries, implying that the
misery of todays poor in these nations is likely to get worse.
More than Fumbers
"t is easy to get too wrapped up in numbers, so it may be useful to make a few simple
head to head comparisons. onsider Forth Aorea and %outh Aorea. :oth emerged from
35>
BB"" with shattered economies, only to fight each other in the Aorean Bar. Bhen the
war was over, %outh Aorea embraced capitalism, building and economy based on the rule
of law, secure property rights, and a reliance on the market as the primary means of
allocating scarce resources. Forth Aorea re1ected all of these, choosing instead a
ommunist system that relied on centrali,ed command and control to allocate resources a
system ruled not by law but by one man at the top. %outh Aorea became a world
economic powerhouse, with per capita income of almost 63;,555 per year. Forth Aorea
stagnated and, with a per capita income of only 6.,?55 per year, must now rely on
foreign aid to feed many of its people.
"f we were to look at 2ast Eermany and Best Eermany between BB"" and the fall of the
:erlin Ball in .>9>, we would see the same story repeated. Best Eermany embraced the
central principles of a market based capitalist economy and prospered. 2ast Eermany
re1ected those principles, and its people were impoverished. A similar tale of two
countries can be told in comparing the economies of Taiwan and hina between .>75
and .>95& apitalist Taiwan prospered while ommunist hina stagnated and people at
the bottom of the income distribution suffered the most there.
"ndeed, as noted in hapter ;, hina itself presents us with a tale of two countries& the
ommunist version before .>95 and the increasingly capitalist one of the years since.
After decades of post BB"" stagnation under communism, the gradual move toward
market-based resource allocation in hina since .>95 is transforming life for people at all
levels of income. 4verall, real per capita income is now roughly doubling every decade.
-oreover, at least in those areas of the country where the ommunist have let the
capitalist try their hand, this economic progress has been widespread and sustained. %o
even though political freedom in hina is not yet to be had, the growing economic
freedom in that nation is having the same impact it has had around the world and over
time& Bhen people are able to en1oy secure property rights, the rule of law, and a
reliance on markets as allocators of scarce resources, people at all points in the
distribution benefit.
3.5