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BUS505-RobertC.Guell-IssuesinEconomicsToday-McGraw-HillHigherEducation20175409.pdf
Issues in Economics Today
Eighth Edition
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Issues in Economics Today
Eighth Edition
ROBERT C. GUELL Indiana State University
ISSUES IN ECONOMICS TODAY, EIGHTH EDITION
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Library of Congress Cataloging-in-Publication Data
Guell, Robert C., author.
Issues in economics today/Robert C. Guell, Indiana State University.
Eighth edition. | New York, NY : McGraw-Hill Education, [2018]
LCCN 2017003633 | ISBN 9781259746390 (alk. paper)
LCSH: Economics.
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vi
About the Author
Dr. Robert C. Guell (pronounced “Gill”) is a professor of economics at Indiana State University
in Terre Haute, Indiana. He earned a B.A. in statistics and economics in 1986 and an M.S. in
economics one year later from the University of Missouri–Columbia. In 1991, he earned a Ph.D.
from Syracuse University, where he discovered the thrill of teaching. He has taught courses for
freshmen, upper-division undergraduates, and graduate students from the principles level, through
public finance, all the way to mathematical economics and econometrics.
Dr. Guell has published numerous peer-reviewed articles in scholarly journals. He has
worked extensively in the area of pharmaceutical economics, suggesting that the private
market’s patent system, while necessary for drug innovation, is unnecessary and inefficient
for production.
In 1998, Dr. Guell was the youngest faculty member ever to have been given Indiana
State University’s Caleb Mills Distinguished Teaching Award. His talent as a champion of
quality teaching was recognized again in 2000 when he was named project manager for the
Lilly Project to Transform the First-Year Experience, a Lilly Endowment–funded project to
raise first-year persistence rates at Indiana State University. He was ISU’s Coordinator of
First-Year Programs until January 2008, when he happily stepped aside to rejoin his depart-
ment full time.
Dr. Guell’s passion for teaching economics led him to request an assignment with the larg-
est impact. The one-semester general education basic economics course became the vehicle
to express that passion. Unsatisfied with the books available for the course, he made it his
calling to produce what you have before you today—an all-in-one readable issues-based text.
vii
Brief Contents
Preface xviii
Issues for Different Course Themes xxviii
Required Theory Table xxx
1 Economics: The Study of Opportunity Cost 1
2 Supply and Demand 19
3 The Concept of Elasticity and Consumer and Producer Surplus 40
4 Firm Production, Cost, and Revenue 56
5 Perfect Competition, Monopoly, and Economic versus Normal Profit 68
6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression 79
7 Interest Rates and Present Value 98
8 Aggregate Demand and Aggregate Supply 107
9 Fiscal Policy 119
10 Monetary Policy 131
11 Federal Spending 145
12 Federal Deficits, Surpluses, and the National Debt 155
13 The Housing Bubble 168
14 The Recession of 2007–2009: Causes and Policy Responses 177
15 Is Economic Stagnation the New Normal? 186
16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities 193
17 International Trade: Does It Jeopardize American Jobs? 201
18 International Finance and Exchange Rates 213
19 European Debt Crisis 222
20 Economic Growth and Development 231
21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us? 238
22 The Line between Legal and Illegal Goods 248
23 Natural Resources, the Environment, and Climate Change 258
24 Health Care 271
25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program 283
26 The Economics of Prescription Drugs 296
27 So You Want to Be a Lawyer: Economics and the Law 304
28 The Economics of Crime 310
29 Antitrust 319
30 The Economics of Race and Sex Discrimination 327
31 Income and Wealth Inequality: What’s Fair? 339
32 Farm Policy 349
33 Minimum Wage 358
34 Ticket Brokers and Ticket Scalping 366
35 Rent Control 373
36 The Economics of K–12 Education 379
37 College and University Education: Why Is It So Expensive? 390
viii Brief Contents
38 Poverty and Welfare 400
39 Head Start 411
40 Social Security 418
41 Personal Income Taxes 429
42 Energy Prices 440
43 If We Build It, Will They Come? And Other Sports Questions 455
44 The Stock Market and Crashes 467
45 Unions 478
46 Walmart: Always Low Prices (and Low Wages)—Always 488
47 The Economic Impact of Casino and Sports Gambling 494
48 The Economics of Terrorism 499
Index 505
ix
Table of Contents
Preface xviii
Issues for Different Course Themes xxviii
Required Theory Table xxx
Chapter 1
Economics: The Study of Opportunity
Cost 1
Economics and Opportunity Cost 1
Economics Defined 1
Choices Have Consequences 2
Modeling Opportunity Cost Using the Production
Possibilities Frontier 2
The Intuition behind Our First Graph 2
The Starting Point for a Production Possibilities Frontier 3
Points between the Extremes of a Production
Possibilities Frontier 3
Attributes of the Production Possibilities Frontier 5
Increasing and Constant Opportunity Cost 5
Economic Growth 6
How Is Growth Modeled? 6
Sources of Economic Growth 7
The Big Picture 7
Circular Flow Model: A Model That Shows the
Interactions of All Economic Actors 8
Thinking Economically 8
Marginal Analysis 8
Positive and Normative Analysis 8
Economic Incentives 9
Fallacy of Composition 9
Correlation ≠ Causation 10
Kick It Up a Notch: Demonstrating Constant and
Increasing Opportunity Cost on a Production
Possibilities Frontier 10
Demonstrating Increasing Opportunity Cost 11
Demonstrating Constant Opportunity Cost 11
Summary 11
Appendix 1A
Graphing: Yes, You Can. 15
Cartesian Coordinates 15
Please! Not Y = MX + B . . . Sorry. 16
What on God’s Green Earth Does This Have
to Do with Economics? 18
Chapter 2
Supply and Demand 19
Supply and Demand Defined 20
Markets 20
Quantity Demanded and Quantity Supplied 20
Ceteris Paribus 22
Demand and Supply 22
The Supply and Demand Model 22
Demand 22
Supply 23
Equilibrium 24
Shortages and Surpluses 25
All about Demand 25
The Law of Demand 25
Why Does the Law of Demand Make Sense? 25
All about Supply 26
The Law of Supply 26
Why Does the Law of Supply Make Sense? 26
Determinants of Demand 27
Taste 28
Income 28
Price of Other Goods 28
Population of Potential Buyers 29
Expected Price 29
Excise Taxes 29
Subsidies 29
The Effect of Changes in the Determinants of Demand
on the Supply and Demand Model 29
Determinants of Supply 31
Price of Inputs 31
Technology 32
Price of Other Potential Outputs 32
Number of Sellers 32
Expected Price 32
Excise Taxes 33
Subsidies 33
The Effect of Changes in the Determinants of
Supply on the Supply and Demand Model 33
The Effect of Changes in Price Expectations on the
Supply and Demand Model 35
x Table of Contents
Kick It Up a Notch: Why the New Equilibrium? 35
Summary 37
Chapter 3
The Concept of Elasticity and Consumer
and Producer Surplus 40
Elasticity of Demand 41
Intuition 41
Definition of Elasticity and Its Formula 41
Elasticity Labels 42
Alternative Ways to Understand Elasticity 42
The Graphical Explanation 42
The Verbal Explanation 43
Seeing Elasticity through Total Expenditures 44
More on Elasticity 44
Determinants of Elasticity of Demand 44
Elasticity and the Demand Curve 44
Elasticity of Supply 46
Determinants of the Elasticity of Supply 47
Consumer and Producer Surplus 49
Consumer Surplus 49
Producer Surplus 49
Market Failure 50
Categorizing Goods 50
Kick It Up a Notch: Deadweight Loss 51
Summary 52
Chapter 4
Firm Production, Cost, and Revenue 56
Production 57
Just Words 57
Graphical Explanation 58
Numerical Example 58
Costs 59
Just Words 59
Numerical Example 60
Revenue 62
Just Words 62
Numerical Example 63
Maximizing Profit 64
Graphical Explanation 64
Numerical Example 64
Summary 65
Chapter 5
Perfect Competition, Monopoly, and
Economic versus Normal Profit 68
From Perfect Competition to Monopoly 69
Perfect Competition 69
Monopoly 70
Monopolistic Competition 70
Oligopoly 71
Which Model Fits Reality 71
Supply under Perfect Competition 73
Normal versus Economic Profit 73
When and Why Economic Profits Go to Zero 73
Why Supply Is Marginal Cost under Perfect Competition 74
Just Words 74
Numerical Example 74
Graphical Explanation 75
Summary 76
Chapter 6
Every Macroeconomic Word You
Ever Heard: Gross Domestic Product,
Inflation, Unemployment, Recession,
and Depression 79
Measuring the Economy 80
Measuring Nominal Output 80
Measuring Prices and Inflation 81
Problems Measuring Inflation 83
Real Gross Domestic Product and Why It Is Not
Synonymous with Social Welfare 86
Real Gross Domestic Product 86
Problems with Real GDP 86
Measuring and Describing Unemployment 87
Measuring Unemployment 87
Problems Measuring Unemployment 89
Types of Unemployment 90
Productivity 90
Measuring and Describing Productivity 90
Seasonal Adjustment 91
Business Cycles 92
Kick It Up a Notch: National Income and Product
Accounting 94
Summary 95
Chapter 7
Interest Rates and Present Value 98
Interest Rates 99
The Market for Money 99
Nominal Interest Rates versus Real Interest Rates 99
Present Value 100
Simple Calculations 100
Mortgages, Car Payments, and Other Multipayment
Examples 101
Table of Contents xi
Future Value 102
Kick It Up a Notch: Risk and Reward 104
Summary 104
Chapter 8
Aggregate Demand and Aggregate
Supply 107
Aggregate Demand 108
Definition 108
Why Aggregate Demand Is Downward
Sloping 108
Aggregate Supply 109
Definition 109
Competing Views of the Shape of Aggregate
Supply 109
Shifts in Aggregate Demand and Aggregate
Supply 110
Variables That Shift Aggregate Demand 110
Variables That Shift Aggregate Supply 113
Causes of Inflation 114
How the Government Can Influence
(but Probably Not Control) the Economy 115
Demand-Side Macroeconomics 115
Supply-Side Macroeconomics 115
Summary 116
Chapter 9
Fiscal Policy 119
Nondiscretionary and Discretionary
Fiscal Policy 119
How They Work 119
Using Aggregate Supply and Aggregate Demand
to Model Fiscal Policy 120
Using Fiscal Policy to
Counteract “Shocks” 121
Aggregate Demand Shocks 121
Aggregate Supply Shocks 122
Evaluating Fiscal Policy 123
Nondiscretionary Fiscal Policy 123
Discretionary Fiscal Policy 123
The Political Problems with Fiscal Policy 124
Criticism from the Right and Left 125
The Rise, Fall, and Rebirth of
Discretionary Fiscal Policy 125
The Obama Stimulus Plan 126
Kick It Up a Notch: Aggregate Supply
Shocks 128
Summary 128
Chapter 10
Monetary Policy 131
Goals, Tools, and a Model of Monetary Policy 132
Goals of Monetary Policy 132
Traditional and Ordinary Tools of Monetary Policy 132
Modeling Monetary Policy 133
The Monetary Transmission Mechanism 134
The Additional Tools of Monetary Policy Created
in 2008 135
Central Bank Independence 137
Modern Monetary Policy 138
The Last 30 Years 138
Summary 143
Chapter 11
Federal Spending 145
A Primer on the Constitution and Spending Money 146
What the Constitution Says 146
Shenanigans 146
Dealing with Disagreements 147
Using Our Understanding of Opportunity Cost 148
Mandatory versus Discretionary Spending 148
Where the Money Goes 149
Using Our Understanding of Marginal Analysis 151
The Size of the Federal Government 151
The Distribution of Federal Spending 151
Budgeting for the Future 151
Baseline versus Current-Services Budgeting 151
Summary 152
Chapter 12
Federal Deficits, Surpluses, and the
National Debt 155
Surpluses, Deficits, and the Debt: Definitions
and History 156
Definitions 156
History 156
How Economists See the Deficit and the Debt 159
Operating and Capital Budgets 159
Cyclical and Structural Deficits 159
The Debt as a Percentage of GDP 160
International Comparisons 160
Generational Accounting 161
Who Owns the Debt? 161
Externally Held Debt 162
A Balanced-Budget Amendment 162
Projections 165
Summary 166
xii Table of Contents
Chapter 13
The Housing Bubble 168
How Much Is a House Really Worth? 168
Mortgages 170
How to Make a Bubble 172
Pop Goes the Bubble! 173
The Effect on the Overall Economy 174
Summary 175
Chapter 14
The Recession of 2007–2009: Causes
and Policy Responses 177
Before It Began 177
Late 2007: The Recession Begins as Do the
Initial Policy Reactions 180
The Bottom Falls Out in Fall 2008 181
The Obama Stimulus Package 182
Extraordinary Monetary Stimulus 183
Summary 184
Chapter 15
Is Economic Stagnation the
New Normal? 186
Periods of Robust Economic Growth 187
Sources of Growth 187
Causes and Consequences of Slowing
Growth 187
Causes 187
Consequences 188
What Can Be Done to Jump-Start Growth,
or Is This the New Normal? 189
Summary 191
Chapter 16
Is the (Fiscal) Sky Falling?: An
Examination of Unfunded Social Security,
Medicare, and State and Local Pension
Liabilities 193
What Is the Source of the Problem? 193
How Big Is the Social Security and Medicare
Problem? 194
How Big Is the State and Local Pension
Problem? 196
Is It Possible That the Fiscal Sky Isn’t
About to Fall? 198
Summary 199
Chapter 17
International Trade: Does It Jeopardize
American Jobs? 201
What We Trade and with Whom 201
The Benefits of International Trade 204
Comparative and Absolute Advantage 204
Demonstrating the Gains from Trade 205
Production Possibilities Frontier
Analysis 205
Supply and Demand Analysis 206
Whom Does Trade Harm? 206
Trade Barriers 207
Reasons for Limiting Trade 207
Methods of Limiting Trade 208
Trade as a Diplomatic Weapon 209
Kick It Up a Notch: Costs of Protectionism 210
Summary 210
Chapter 18
International Finance and Exchange
Rates 213
International Financial Transactions 213
Foreign Exchange Markets 215
Alternative Foreign Exchange Systems 217
Determinants of Exchange Rates 219
Summary 220
Chapter 19
European Debt Crisis 222
In the Beginning There Were 17 Currencies
in 17 Countries 222
The Effect of the Euro 223
Why Couldn’t They Pull Themselves Out?
The United States Did 226
Is It Too Late to Leave the Euro? 228
Where Should Europe Go from Here? 229
Summary 229
Chapter 20
Economic Growth and Development 231
Growth in Already Developed Countries 231
Comparing Developed Countries and Developing
Countries 233
Fostering (and Inhibiting) Development 234
The Challenges Facing Developing Countries 235
What Works 236
Summary 236
Table of Contents xiii
Chapter 21
NAFTA, CAFTA, GATT, TPP, WTO:
Are Trade Agreements Good for Us? 238
The Benefits of Free Trade 239
Why Do We Need Trade Agreements? 239
Strategic Trade 240
Special Interests 240
What Trade Agreements Prevent 240
Trade Agreements and Institutions 241
Alphabet Soup 241
Are They Working? 242
Economic and Political Impacts of Trade 243
The Bottom Line 245
Summary 245
Chapter 22
The Line between Legal and Illegal
Goods 248
An Economic Model of Tobacco, Alcohol,
and Illegal Goods and Services 249
Why Is Regulation Warranted? 249
The Information Problem 249
External Costs 250
Morality Issues 252
Taxes on Tobacco and Alcohol 253
Modeling Taxes 253
The Tobacco Settlement and Why Elasticity
Matters 254
Why Are Certain Goods and Services
Illegal? 254
The Impact of Decriminalization on the Market
for the Goods 254
The External Costs of Decriminalization 255
Summary 255
Chapter 23
Natural Resources, the Environment,
and Climate Change 258
Using Natural Resources 259
How Clean Is Clean Enough? 259
The Externalities Approach 260
When the Market Works for Everyone 260
When the Market Does Not Work for Everyone 260
The Property Rights Approach to the Environment
and Natural Resources 262
Why You Do Not Mess Up Your Own Property 262
Why You Do Mess Up Common Property 262
Natural Resources and the Importance
of Property Rights 262
Environmental Problems and Their Economic
Solutions 263
Environmental Problems 263
Economic Solutions: Using Taxes to Solve
Environmental Problems 265
Economic Solutions: Using Property Rights
to Solve Environmental Problems 265
No Solution: When There Is No Government
to Tax or Regulate 267
Summary 268
Chapter 24
Health Care 271
Where the Money Goes and Where
It Comes From 271
Insurance in the United States 272
How Insurance Works 272
Varieties of Private Insurance 273
Public Insurance 273
Economic Models of Health Care 274
Why Health Care Is Not Just Another Good 274
Implications of Public Insurance 275
Efficiency Problems with Private Insurance 276
Major Changes to Insurance Resulting from PPACA 277
The Blood and Organ Problem 279
Comparing the United States with the Rest
of the World 279
Summary 281
Chapter 25
Government-Provided Health Insurance:
Medicaid, Medicare, and the Children’s
Health Insurance Program 283
Medicaid: What, Who, and How Much 284
Why Medicaid Costs So Much 285
Why Spending Is Greater on the Elderly 286
Cost-Saving Measures in Medicaid 287
Medicare: Public Insurance and the Elderly 287
Why Private Insurance May Not Work 287
Why Medicare’s Costs Are High 288
Medicare’s Nuts and Bolts 289
Provider Types 289
Part A 289
Part B 290
Prescription Drug Coverage (Part D) 290
Cost Control Provisions in Medicare 291
xiv Table of Contents
The Medicare Trust Fund 292
The Relationship between Medicaid and
Medicare 293
Children’s Health Insurance Program 293
Summary 294
Chapter 26
The Economics of Prescription Drugs 296
Profiteers or Benevolent Scientists? 297
Monopoly Power Applied to Drugs 297
Important Questions 299
Expensive Necessities or Relatively
Inexpensive Godsends? 299
Price Controls: Are They the Answer? 301
FDA Approval: Too Stringent or Too Lax? 301
Summary 302
Chapter 27
So You Want to Be a Lawyer: Economics
and the Law 304
Private Property 304
Intellectual Property 305
Contracts 305
Enforcing Various Property Rights and Contracts 305
Negative Consequences of Private Property Rights 306
Bankruptcy 306
Civil Liability 306
Summary 308
Chapter 28
The Economics of Crime 310
Who Commits Crimes and Why 310
The Rational Criminal Model 311
Crime Falls When Legal Income Rises 311
Crime Falls When the Likelihood and Consequences
of Getting Caught Rise 312
Problems with the Rationality Assumption 312
The Costs of Crime 312
How Much Does an Average Crime Cost? 313
How Much Crime Does an Average Criminal
Commit? 313
Optimal Spending on Crime Control 314
What Is the Optimal Amount to Spend? 314
Is the Money Spent in the Right Way? 315
Are the Right People in Jail? 315
What Laws Should We Rigorously Enforce? 315
What Is the Optimal Sentence? 316
Summary 317
Chapter 29
Antitrust 319
What’s Wrong with Monopoly? 319
High Prices, Low Output, and Deadweight
Loss 319
Reduced Innovation 320
Natural Monopolies and Necessary Monopolies 320
Natural Monopoly 320
Patents, Copyrights, and Other Necessary
Monopolies 321
Monopolies and the Law 322
The Sherman Anti-Trust Act 322
What Constitutes a Monopoly? 323
Examples of Antitrust Action 323
Standard Oil 323
IBM 324
Microsoft 324
Apple, Google, and the European Union 325
Summary 325
Chapter 30
The Economics of Race and Sex
Discrimination 327
The Economic Status of Women and Minorities 327
Women 327
Minorities 328
Definitions and Detection of Discrimination 330
Discrimination, Definitions, and the Law 330
Detecting and Measuring Discrimination 331
Discrimination in Labor, Consumption, and
Lending 332
Labor Market Discrimination 332
Consumption Market and Lending Market
Discrimination 333
Affirmative Action 334
The Economics of Affirmative Action 334
What Is Affirmative Action? 335
Gradations of Affirmative Action 335
Summary 336
Chapter 31
Income and Wealth Inequality:
What’s Fair? 339
Measurement of Inequality 339
Income Inequality 339
Wealth Inequality 342
The Shrinking Middle Class 343
Table of Contents xv
Causes of Household Income and Wealth Inequality 344
Costs and Benefits of Income Inequality 345
Summary 347
Chapter 32
Farm Policy 349
Farm Prices Since 1950 349
Corn and Gasoline 350
Price Variation as a Justification for Government
Intervention 351
The Case for Price Supports 351
The Case against Price Supports 352
Consumer and Producer Surplus Analysis
of Price Floors 352
One Floor in One Market 352
Variable Floors in Multiple Markets 353
What Would Happen without Price Supports? 353
Price Support Mechanisms and Their History 353
Price Support Mechanisms 353
History of Price Supports 355
Is There a Bubble on the Farm? 355
Kick It Up a Notch 356
Summary 356
Chapter 33
Minimum Wage 358
Traditional Economic Analysis of a Minimum
Wage 359
Labor Markets and Consumer and Producer Surplus 359
A Relevant versus an Irrelevant Minimum Wage 360
What Is Wrong with a Minimum Wage? 361
Real-World Implications of the Minimum Wage 361
Alternatives to the Minimum Wage 362
Rebuttals to the Traditional Analysis 362
The Macroeconomics Argument 362
The Work Effort Argument 363
The Elasticity Argument 363
Where Are Economists Now? 363
Kick It Up a Notch 364
Summary 364
Chapter 34
Ticket Brokers and Ticket Scalping 366
Defining Brokering and Scalping 367
An Economic Model of Ticket Sales 367
Marginal Cost 367
The Promoter as Monopolist 367
The Perfect Arena 368
Why Promoters Charge Less Than They Could 369
An Economic Model of Scalping 369
Legitimate Scalpers 370
Summary 371
Chapter 35
Rent Control 373
Rents in a Free Market 373
Reasons for Controlling Rents 374
Consequences of Rent Control 375
Why Does Rent Control Survive? 377
Summary 378
Chapter 36
The Economics of K–12 Education 379
Investments in Human Capital 379
Present Value Analysis 380
External Benefits 380
Should We Spend More? 381
The Basic Data 381
Cautions about Quick Conclusions 383
Literature on Whether More Money Will Improve
Educational Outcomes 385
School Reform Issues 385
The Public School Monopoly 385
Merit Pay and Tenure 386
Private versus Public Education 386
School Vouchers 387
Collective Bargaining 387
Summary 388
Chapter 37
College and University Education:
Why Is It So Expensive? 390
Why Are the Costs So High? 390
Why Are College Costs Rising So Fast? 392
Why Have Textbook Costs Risen So
Rapidly? 393
What a College Degree Is Worth 395
How Do People Pay for College? 396
Summary 398
Chapter 38
Poverty and Welfare 400
Measuring Poverty 400
The Poverty Line 401
Who’s Poor? 401
xvi Table of Contents
Poverty through History 402
Problems with Our Measure of Poverty 403
Poverty in the United States versus Europe 404
Programs for the Poor 404
In Kind versus In Cash 404
Why Spend $789 Billion on a $96 Billion
Problem? 406
Is $789 Billion Even a Lot Compared to
Other Countries? 406
Incentives, Disincentives, Myths,
and Truths 406
Welfare Reform 407
Is There a Solution? 407
Welfare as We Now Know It 408
Is Poverty Necessarily Bad? 408
Summary 408
Chapter 39
Head Start 411
Head Start as an Investment 411
The Early Intervention Premise 411
Present Value Analysis 412
External Benefits 412
The Early Evidence 412
The Remaining Doubts 412
The Head Start Program 413
The Current Evidence 414
Evidence that Head Start Works 414
Evidence that Head Start Does Not Work 415
More Evidence Is Coming and Some Is In 415
The Opportunity Cost of Fully Funding
Head Start 416
Summary 416
Chapter 40
Social Security 418
The Basics 418
The Beginning 418
Taxes 419
Benefits 419
Changes over Time 419
Why Do We Need Social Security? 420
Social Security’s Effect on the
Economy 421
Effect on Work 421
Effect on Saving 421
Whom Is the Program Good For? 422
Will the System Be There for Me? 424
Why Social Security Is in Trouble 424
The Social Security Trust Fund 424
Options for Fixing Social Security 425
Summary 426
Chapter 41
Personal Income Taxes 429
How Income Taxes Work 429
Issues in Income Taxation 434
Horizontal and Vertical Equity 434
Equity versus Simplicity 434
Incentives and the Tax Code 434
Do Taxes Alter Work Decisions? 435
Do Taxes Alter Savings Decisions? 435
Taxes for Social Engineering 435
Who Pays Income Taxes? 435
The Tax Debates of the Last Two Decades 436
Summary 437
Chapter 42
Energy Prices 440
The Historical View 440
Oil and Gasoline Price History 440
Geopolitical History 441
A Return to Irrelevancy 442
OPEC 445
What OPEC Tries to Do 445
How Cartels Work 445
Why Cartels Are Not Stable 445
Back from the Dead 446
Why Do Prices Change So Fast? 446
Is It All a Conspiracy? 447
From $1 to $4 per Gallon in 10 Years? 447
Electric Utilities 449
Electricity Production 449
Why Are Electric Utilities a Regulated Monopoly? 450
What Will the Future Hold? 451
Kick It Up a Notch 452
Summary 453
Chapter 43
If We Build It, Will They Come?
And Other Sports Questions 455
The Problem for Cities 455
Expansion versus Luring a Team 455
Does a Team Enhance the Local Economy? 457
Why Are Stadiums Publicly Funded? 458
Table of Contents xvii
The Problem for Owners 458
To Move or to Stay 458
To Win or to Profit 459
Don’t Feel Sorry for Them Just Yet 460
The Sports Labor Market 461
What Owners Will Pay 461
What Players Will Accept 461
The Vocabulary of Sports Economics 461
What a Monopoly Will Do for You 464
Summary 465
Chapter 44
The Stock Market and Crashes 467
Stock Prices 468
How Stock Prices Are Determined 468
What Stock Markets Do 469
Efficient Markets 470
Stock Market Crashes 470
Bubbles 470
Example of a Crash: NASDAQ 2000 471
The Accounting Scandals of 2001 and 2002 472
Bankruptcy 473
Why Capitalism Needs Bankruptcy Laws 473
The Kmart and Global Crossing Cases 473
What Happened in the Enron Case 474
Why the Enron Case Matters More Than
the Others 475
Rebound of 2006–2007 and the Drop
of 2008–2009 475
Summary 476
Chapter 45
Unions 478
Why Unions Exist 478
The Perfectly Competitive Labor Market 478
A Reaction to Monopsony 479
A Way to Restrict Competition and Improve Quality 480
A Reaction to Information Issues 481
A Union as a Monopolist 481
The History of Labor Unions 482
Where Unions Go from Here 485
Kick It Up a Notch 486
Summary 486
Chapter 46
Walmart: Always Low Prices
(and Low Wages)—Always 488
The Market Form 488
Who Is Affected? 490
Most Consumers Stand to Gain—Some Lose Options 490
Workers Probably Lose 491
Sales Tax Revenues Won’t Be Affected Much 491
Some Businesses Will Get Hurt; Others Will Be
Helped 491
Community Effects 491
Summary 492
Chapter 47
The Economic Impact of Casino
and Sports Gambling 494
The Perceived Impact of Casino Gambling 494
Local Substitution 494
The “Modest” Upside of Casino Gambling 495
The Economic Reasons for Opposing Casino
Gambling 495
Sports Gambling and Daily Fantasy 496
Summary 497
Chapter 48
The Economics of Terrorism 499
The Economic Impact of September 11th and
of Terrorism in General 499
Modeling the Economic Impact of the Attacks 500
Insurance Aspects of Terrorism 501
Buy Insurance or Self-Protect or Both 502
Terrorism from the Perspective of the Terrorist 502
Summary 503
Index 505
xviii
Preface
This book is designed for a one-semester issues-based general education economics course,
and its purpose is to interest the nonbusiness, noneconomics major in what the discipline of
economics can do. Students of the “issues approach” will master the basic economic theory
necessary to explore a variety of real-world issues. If this is the only economics course they
ever take, they will at least gain enough insight to be able to intelligently discuss the way eco-
nomic theory applies to important issues in the world today.
Until the first edition of this book was published, instructors who chose the issues approach
to teaching a one-semester general economics course had to compromise in one of the follow-
ing ways: they could (1) pick a book that presents the issues but that is devoid of economic
theory; (2) pick a book that intertwines the issues with the theory; (3) ask students to buy two
books; or (4) place a large number of readings on library reserve.
Each of these alternatives presents problems. If the course is based entirely on an issues text,
students will leave with the incorrect impression that economics is a nonrigorous discipline that
assumes that all of the issues are relevant to all students in the course. In fact, some issues are not
relevant to some students and others are relevant only when the issue makes news. For example,
at Syracuse my students never understood why farm price supports were interesting, whereas at
Indiana State no student that I have met has ever lived in a rent-controlled apartment. The prob-
lem associated with using multiple books is the obvious one of expense. Having multiple reserve
readings, still a legitimate option, requires a great deal of time on the part of students, teachers,
and librarians and is usually not convenient to students.
The eighth edition of this book meets both student and instructor needs simultaneously. By
making the entire portfolio of chapters available for instructors to select and include in a print
book as they see fit within McGraw-Hill’s CREATE platform, we allow instructors maximum
flexibility to design a product that keeps students interested.
HOW TO USE THIS BOOK
Issues in Economics Today includes 8 intensive core theory chapters and 40 shorter issues
chapters. The book is designed to allow faculty flexibility in approach. Some colleagues like
to intertwine theory and issues while others like to lay the theoretical foundation first before
heading into the issues. Some faculty will choose to set a theme for their course and pick is-
sues consistent with that theme while others will let their students decide what issues interest
them. There is no right way to use the book except that under no circumstances is it imag-
ined that the entire book be covered.
McGraw-Hill CREATE
To address the recommendation that no instructor should assign the entire book to be cov-
ered in their course, the eighth edition takes advantage of the capabilities in McGraw-Hill’s
CREATE platform (www.mcgrawhillcreate.com) to give instructors the flexibility to easily
design a print product customized to their issues course: instructors can easily add chapters to
their product in the same way someone might add purchases to their cart when online shop-
ping. Once the table of contents is set, the instructor can easily view the net price of their
Preface xix
course text (often much lower once extraneous chapters have been removed). When the prod-
uct is approved by the instructor, the system will generate an ISBN for the customized product,
which can be provided to the bookstore. Once an order is placed, the copies will be printed
on demand for each institution. The process is very straightforward; however, a McGraw-Hill
representative can assist instructors or build products based on syllabi if required. This work-
flow makes it feasible for an instructor to revisit their product and make tweaks every time
they teach the course. It also makes it a possibility for me to author and make available chap-
ters that address current economic issues in a timely manner as events arise.
Organization of the Issues Chapters
There are 40 issues chapters that I have divided into the following categories: Macroeco-
nomic Issues (Chapters 9–16), International Issues (Chapters 17–20), Externalities and Market
Failure (Chapters 22–23), Health Issues (Chapters 24–26), Government Solutions to Soci-
etal Problems (Chapters 27–31), Price Control Issues (Chapters 32–34), and Miscellaneous
Markets (Chapters 36–48). These groupings will be helpful as you navigate through the
Contents looking for a particular topic. To help you decide which issues chapters to cover,
see the table on pages xxx–xxxi, entitled “Required Theory Table.” It shows at a glance
which theory chapters need to be covered before pursuing each of the issues chapters. On
pages xxviii–xxix, the table entitled “Issues for Different Course Themes” includes my
recommendations for courses that focus on social policy, international issues, election year
issues, or business. Within the CREATE platform these different course structures are al-
ready assembled into ready-made Express Books to make it easy for you to customize your
text according to these themes.
CHANGES TO THE EIGHTH EDITION
Due to the CREATE-delivery of the eighth edition, issues chapters that have previously been
hosted on the website have now moved back within the table of contents so instructors can
more easily add them to custom products. These chapters include:
• Chapter 21 NAFTA, CAFTA, GATT, WTO: Are Trade Agreements Good for Us?
• Chapter 28 Antitrust
• Chapter 35 Rent Control
• Chapter 39 Head Start
• Chapter 48 The Economics of Terrorism
Furthermore, many instructors have requested with previous editions that we provide assign-
able material within Connect, McGraw-Hill’s online assessment platform. We are happy to
report that Connect is now available with the eighth edition including an adaptive reading ex-
perience, assignable homework (with additional quantitative and graphing problems beyond
what is found at the end of each chapter), test bank content, and a host of instructor resources.
For more information, please review the Connect portion of this preface.
Chapter 1: An entire section has been added on modeling economic growth using a pro-
duction possibilities frontier. Both generalized and specialized growth are depicted in both
a world of increasing and constant opportunity cost. In addition, the sources of economic
growth are explicated.
Chapter 2: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 3: Added to the discussion of substitutes by describing the inclination to use goods
already in our possession longer when newer substitutes increase in price. Added an entire
section on the determinants of elasticity of supply. Added a description of network goods.
Chapter 5: Content and data updates have been made as needed to reflect the most current
information available. Textbox added to illustrate the importance of exit and entry using
oil drilling.
Chapter 6: Content and data updates have been made as needed to reflect the most current
information available. Added textbox that answers frequently asked questions regarding how
particular situations (products made in one year and sold in the next, used cars, equities, and
illegal drugs) are handled in GDP accounting.
Chapters 7–9: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 10: Content and data updates have been made as needed to reflect the most current infor-
mation available. Added a section that described the monetary policies of other countries and how
the unprecedented actions of the Federal Reserve can be undone when the times comes to do so.
Chapter 11: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 12: Content and data updates have been made as needed to reflect the most current
information available. Added World Bank measures of debt-to-GDP measures.
Chapter 13: Content and data updates have been made as needed to reflect the most current
information available. Added a comparison of home affordability in 2006 vs. 2015 for selected
major markets.
Chapter 14: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 15: The chapter reshapes the “Japan” chapter from the previous edition to take on the
broader question of economic stagnation in the U.S. and other western economies.
Chapter 16: Content and data updates have been made as needed to reflect the most current
information available. Extensively revised the section on state and local pension problems
using updated information. Focused particular attention on the intractability of the pension
problem in Illinois.
Chapters 17–18: Content and data updates have been made as needed to reflect the most cur-
rent information available.
Chapter 19: Content and data updates have been made as needed to reflect the most current
information available. Reference made to ECB stimulus and to Brexit.
Chapter 20: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 21: Content and data updates have been made as needed to reflect the most current
information available. References also made to the Trans-Pacific Partnership.
Chapter 22: Content and data updates have been made as needed to reflect the most current
information available. The impact of the availability of e-cigarettes as substitutes for tobacco
is discussed, particularly as it relates to tobacco elasticity.
xx Preface
Chapter 23: Content and data updates have been made as needed to reflect the most current
information available. The responsiveness of average temperatures to changes in CO 2 concen-
trations is also discussed in the context of climate change.
Chapter 24: Content and data updates have been made as needed to reflect the most cur-
rent information available. Clarifications are included regarding the impact of the PPACA
on Medicaid expansions. International comparisons for five-year survival rates of various
cancers are included.
Chapter 25: Content and data updates have been made as needed to reflect the most current in-
formation available. The Congressional action to address the perpetual “Docfix” is discussed.
Chapter 26: Content and data updates have been made as needed to reflect the most current
information available. Issues involving expensive life-saving drugs (Harvoni, Vivitrol, etc.)
and their coverage (or lack thereof) by Medicaid are discussed.
Chapter 27: A discussion of class-action lawsuits and the example of Takata airbags was
inserted.
Chapter 28: Content and data updates have been made as needed to reflect the most current
information available. Significant modifications to the impact of various crime policies on
crime was added stemming from a Brennan Center for Justice report that showed diminishing
returns to increasing levels of incarceration.
Chapter 29: A discussion of the Apple and Google cases before the EU anti-trust agencies
was included.
Chapter 30: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 31: Content and data updates have been made as needed to reflect the most current
information available. A Pew Charitable Trusts monograph on the state of the middle class is
examined. A discussion regarding the economic and political consequences of the shrinking
middle class is offered.
Chapter 32: Content and data updates have been made as needed to reflect the most current
information available.
Chapter 33: Content and data updates have been made as needed to reflect the most current
information available. The textbox on state and local minimum wage statutes is completely
redone. The difference, in terms of consequences, between modest and large increases in the
minimum wage are examined in the context of efforts to raise wages to $15/hr.
Chapter 34: Content and data updates have been made as needed to reflect the most current
information available. The secondary market for tickets is examined through the examples of
StubHub, Ticketmaster, and NFL Ticket Exchange.
Chapter 35: No substantive changes.
Chapter 36: Content and data updates have been made as needed to reflect the most cur-
rent information available. A discussion of the decline in inflation-adjusted K–12 per-student
spending is offered.
Chapter 37: Content and data updates have been made as needed to reflect the most current in-
formation available. Notes drawing attention to the fact that tuition increases at state institutions
or higher education have slowed at the same time that state subsidies to those schools have also
Preface xxi
decreased. Attention is also drawn to the fact that young adults in the United States are now no
longer the likeliest to have a college education. In fact, the United States is now eighth on that list.
Chapters 38–40: Content and data updates have been made as needed to reflect the most cur-
rent information available.
Chapter 41: Content and data updates have been made as needed to reflect the most current
information available. The reform of the AMT is discussed.
Chapter 42: Content and data updates have been made as needed to reflect the most current
information available. Hydraulic Fracturing and directional drilling and the impact of these tech-
nologies on the elasticity of supply of crude oil are examined. The impact of these technologies
and the increase in U.S. capabilities on OPEC are discussed. Data shows the link between U.S.
rig counts and prices is displayed.
Chapter 43: Content and data updates have been made as needed to reflect the most current
information available. The relocation of the Rams to L.A. is discussed. The fact that fewer
constraints on soccer talent exist is related to the dominating position of Spain’s Barcelona and
Real Madrid and the Premier League’s top five teams.
Chapters 44–46: Content and data updates have been made as needed to reflect the most cur-
rent information available.
Chapter 47: Content and data updates have been made as needed to reflect the most current
information available. Daily Fantasy gambling is discussed.
Chapter 48: More recent terror attacks in France, Belgium, and San Bernardino included.
FEATURES
• A conversational writing style makes it easier for students not majoring in economics to
connect with the material. The book puts students at ease and allows them to feel more
confident and open to learning.
• Chapter Outline and Learning Objectives set the stage at the beginning of each chapter
to let the student see how the chapter is organized and anticipate the concepts that will
be covered.
• Key Terms are defined in the margins and recapped at the end of the chapters.
• Summaries at the end of each chapter reinforce the material that has been covered.
• Issues Chapters You Are Ready for Now are found at the end of each theory chapter, so
students can go straight to the issues chapters that interest them once they’ve mastered
the necessary theoretical principles.
• Quiz Yourself presents questions for self-quizzing at the end of each chapter.
• Think about This asks provocative questions that encourage students to think about how
economic theories apply to the real world by putting themselves in the economic driver’s
seat. For example, one Think about This asks, “Suppose you buy a new car. What is the
opportunity cost of doing so?” This feature facilitates active learning so that the students
will learn the concepts more thoroughly.
• Talk about This includes questions designed to trigger discussion.
• For More Insight See sends the students to websites and publications to find additional
material on a given topic. Since economic issues are particularly time-sensitive, this
xxii Preface
feature not only helps students learn to do research on the web but also keeps the course
as fresh and current as today’s newspaper.
• Short Answer Questions are included so that faculty may ask students questions that will
help faculty assess student understanding of complex economic phenomena.
RESOURCES TO SUPPORT LEARNING
The content and reliability of supplements is of primary importance to the users of the book.
Because of this, I am personally involved in crafting and checking all of the following an-
cillaries, which are available for quick download and convenient access via the instructor
resource material available through Connect.
Instructor’s Manual
In addition to a traditional outline of each chapter’s content and updated we references to data
sources for each chapter, the Instructor’s Manual offers key-point icons to emphasize the im-
portance of particular concepts. Another distinctive feature is that each figure is broken into
subfigures with explanations that can be offered at each stage. Solutions to the end of chapter
questions are also provided.
Test Bank
The test bank includes 80–200 multiple-choice questions for the core theory chapters and
60–100 multiple-choice questions for the issues chapters. These questions test students’
knowledge of key terms, key concepts, theory and graph recognition, theory and graph
application, and numeracy, as well as questions about different explanations given by
economists regarding particular economic phenomena.
Computerized Test Bank
TestGen is a complete, state-of-the-art test generator and editing application software that al-
lows instructors to quickly and easily select test items from McGraw-Hill’s test bank content.
The instructors can then organize, edit, and customize questions and answers to rapidly generate
tests for paper or online administration. Questions can include stylized text, symbols, graphics,
and equations that are inserted directly into questions using built-in mathematical templates.
TestGen’s random generator provides the option to display different text or calculated number
values each time questions are used. With both quick-and-simple test creation and flexible and
robust editing tools, TestGen is a complete test generator system for today’s educators.
PowerPoint Presentations
An extensive set of editable PowerPoint slides accompany the text to support instructor lectures.
Assurance of Learning Ready
Many education institutions today are focused on the notion of assurance of learning, an
important element of some accreditation standards. Issues in Economics Today supports as-
surance of learning objectives with a simple, yet powerful solution.
Instructors can use Connect to easily query for learning outcomes/objectives that directly
relate to the learning objectives of the course. You can then use the reporting features of Con-
nect to aggregate student results in similar fashion, making the collection and presentation of
assurance of learning data simple and easy.
Preface xxiii
Required=Results
McGraw-Hill Connect® Learn Without Limits
Connect is a teaching and learning platform
that is proven to deliver better results for
students and instructors.
Connect empowers students by continually
adapting to deliver precisely what they need,
when they need it, and how they need it, so
your class time is more engaging and effective.
Connect Insight® Connect Insight is Connect’s new one-
of-a-kind visual analytics dashboard
that provides at-a-glance information
regarding student performance, which
is immediately actionable. By presenting
assignment, assessment, and topical
performance results together with a time
metric that is easily visible for aggregate or individual
results, Connect Insight gives the user the ability to
take a just-in-time approach to teaching and learning,
which was never before available. Connect Insight presents
data that helps instructors improve class performance in a
way that is efficient and effective.
73% of instructors who use Connect require it; instructor satisfaction increases by 28%
when Connect is required.
Analytics
Using Connect improves retention rates by 19.8%, passing rates by 12.7%, and exam scores by 9.1%.
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SmartBook®
Proven to help students improve grades and study more
efficiently, SmartBook contains the same content within
the print book, but actively tailors that content to the
needs of the individual. SmartBook’s adaptive technology
provides precise, personalized instruction on what the
student should do next, guiding the student to master and
remember key concepts, targeting gaps in knowledge and
offering customized feedback, and driving the student
toward comprehension and retention of the subject
matter. Available on tablets, SmartBook puts learning at
the student’s fingertips—anywhere, anytime.
Adaptive
Over 8 billion questions have been answered, making McGraw-
Hill Education products more intelligent, reliable, and precise.
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READING EXPERIENCE
DESIGNED TO TRANSFORM
THE WAY STUDENTS READ
More students earn A’s and B’s when they use McGraw-Hill Education Adaptive products.
www.mheducation.com
AACSB Statement
McGraw-Hill Global Education is a product corporate member of AACSB International. Un-
derstanding the importance and value of AACSB accreditation, Issues in Economics Today
has sought to recognize the curricula guidelines detailed in the AACSB standards for business
accreditation by connecting questions in the test bank and end-of-chapter material to the gen-
eral knowledge and skill guidelines found in the AACSB standards.
It is important to note that the statements contained in Issues in Economics Today are
provided only as a guide for the users of this text. The AACSB leaves content coverage and
assessment within the purview of individual schools, the mission of the school, and the fac-
ulty. While Issues in Economics Today and the teaching package make no claim of any spe-
cific AACSB qualification or evaluation, we have labeled questions according to the general
knowledge and skill areas.
ACKNOWLEDGMENTS
This text would not have been possible but for the efforts of a number of people. I thank
Indiana State University and its Department of Economics for their continued support of
this project. In particular, I thank my chair, John Conant, for his unflagging support, both
moral and material. I am indebted to the personnel of McGraw-Hill Education for their
work in gathering and compiling peer reviews. Katie Hoenicke, Senior Brand Manager,
Jamie Koch, Product Developer, and Christina Kouvelis, Senior Product Developer, were
always encouraging and willing to help at every stage. Finally, I want to thank Kelsey
Darin. Kelsey, an undergraduate student at Indiana State, spent countless hours updating each
data reference, table, and graph. Her careful and unending attention to detail helped me put
together this edition in a way that I will be relying upon for editions to come. She cheerfully
completed each task at a time when the University (almost inexplicably) assigned me to chair
a department in another college. I will forever be in her debt.
I thank the many participants in McGraw-Hill Symposia who happily offered great insight
on the best way to teach interesting issues. Finally, I thank the following peer reviewers whose
insight substantially enhanced this book:
Alex Aichinger
Northwestern State University
Thomas Andrews
West Chester University
Michael Araujo
Quinsigamond Community College
Lee Ash
Skagit Valley College
Robert J. Bartelli
Labette Community College
Daria J. Bernard
University of Delaware
Roberta Biby
Grand Valley State University
Ann Marie Callahan
Caldwell College
R. Edward Chatterton
Lock Haven University
Russ Cheatham
Cumberland University
Joab Corey
Florida State University
Ann M. Eike
University of Kentucky
Herb Elliott
All Hancock College
John A. Flanders
Central Methodist University
Holly Fretwell
Montana State University
Neil Garston
CSULA
xxvi Preface
E. B. Gendel
Woodbury College
Glenn Graham
SUNY–Oswego
Abbas P. Grammy
California State University, Bakersfield
Sheryl Hadley
Johnson Community College
Suzanne Hayes
University of Nebraska, Kearney
Rolf Hemmerling
Greenville Technical College
John S. Heywood
University of Wisconsin–Milwaukee
Richard Hoogerwerf
Marian College
Scott Hunt
Columbus State Community College
Hans Isakson
University of Northern Iowa
Debra Israel
Indiana State University
Allan Jenkins
University of Nebraska, Kearney
Dick Johnson
Skagit Valley Community College
Gary Langer
Roosevelt University
Tom Larson
California State University–Los Angeles
Raymond Lee
Benedict College
Gary D. Lemon
DePauw University
Alston Lippert
University of South Carolina
Patrick McMurry
Missouri Western State University
Tom Means
San Jose State University
Kimberly Merritt
Oklahoma Christian University
Daniel Morvey
Piedmont Technical College
Richard Newton
Augusta Technical College
Inge O’Connor
Syracuse University
Nathan Perry
University of Utah
Chris Phillips
Somerset Community College
Patrick Price
University of Louisiana at Lafayette
Taghi Ramin
William Patterson University
Michael Ryan
Western Michigan University
John Sabelhaus
University of Maryland
Sue Lynn Sasser
University of Central Oklahoma
Brenda M. Saunders
Somerset Community College
Robert D. Schuttler
Marian University
Millicent M. Sites
Carson-Newman College
Rebecca Smith
Mississippi State University
Arun K. Srinivasan
Indiana University Southeast
Frank Tenkorang
University of Nebraska, Kearney
Tara Thornberry
Maysville Community and Technical College
Michelle Villinski
DePauw University
Darlene Voeltz
Rochester Community and Technical
College
William Walsh
University of St. Thomas
Wendel Weaver
Oklahoma Wesleyan University
Janet L. Wolcutt
Wichita State University
Derek K. Yonai
Campbell University
Ben Young
University of Missouri, Kansas City
Johnson County Community College
Preface xxvii
xxviii
Social Policy
22. The Line between Legal and Illegal Goods
24. Health Care
25. Government-Provided Health Insurance:
Medicaid, Medicare, and the Children’s Health
Insurance Program
26. The Economics of Prescription Drugs
30. The Economics of Race and Sex Discrimination
31. Income and Wealth Inequality: What’s Fair?
33. Minimum Wage
36. The Economics of K–12 Education
37. College and University Education: Why Is It
So Expensive?
38. Poverty and Welfare
47. The Economic Impact of Casino and Sports
Gambling
Election Year
9. Fiscal Policy
11. Federal Spending
14. The Recession of 2007–2009: Causes and Policy
Responses
15. Is Economic Stagnation the New Normal?
16. Is the (Fiscal) Sky Falling? An Examination of
Unfunded Social Security, Medicare, and State
and Local Pension Liabilities
17. International Trade: Does It Jeopardize American
Jobs?
23. Natural Resources, the Environment, and Climate
Change
24. Health Care
27. So You Want to Be a Lawyer: Economics and
the Law
28. The Economics of Crime
30. The Economics of Race and Sex Discrimination
33. Minimum Wage
37. College and University Education: Why Is It
So Expensive?
40. Social Security
International Issues
12. Federal Deficits, Surpluses, and the
National Debt
15. Is Economic Stagnation the New Normal?
17. International Trade: Does It Jeopardize American
Jobs?
18. International Finance and Exchange Rates
19. European Debt Crisis
20. Economic Growth and Development
22. The Line between Legal and Illegal Goods
23. Natural Resources, the Environment, and Climate
Change
32. Farm Policy
42. Energy Prices
Business Issues
10. Monetary Policy
11. Federal Spending
13. The Housing Bubble
14. The Recession of 2007–2009: Causes and Policy
Responses
17. International Trade: Does It Jeopardize American
Jobs?
24. Health Care
26. The Economics of Prescription Drugs
34. Ticket Brokers and Ticket Scalping
41. Personal Income Taxes
42. Energy Prices
44. The Stock Market and Crashes
45. Unions
46. Walmart: Always Low Prices (and Low
Wages)—Always
Issues for Different Course Themes
Issues for Different Course Themes xxix
Social Justice
14. The Recession of 2007–2009: Causes
and Policy Responses
15. Is Economic Stagnation the New Normal?
23. Natural Resources, the Environment,
and Climate Change
24. Health Care
25. Government-Provided Health Insurance:
Medicaid, Medicare, and the Children’s Health
Insurance Program
26. The Economics of Prescription Drugs
30. The Economics of Race and Sex Discrimination
31. Income and Wealth Inequality: What’s Fair?
33. Minimum Wage
35. Rent Control
36. The Economics of K–12 Education
37. College and University Education: Why Is It So
Expensive?
38. Poverty and Welfare
39. Head Start
40. Social Security
Health and Education Policies
11. Federal Spending
16. Is the (Fiscal) Sky Falling?: An Examination of
Unfunded Social Security, Medicare, and State and
Local Pension Liabilities
23. Natural Resources, the Environment, and
Climate Change
24. Health Care
25. Government-Provided Health Insurance: Medicaid,
Medicare, and the Children’s Health Insurance
Program
26. The Economics of Prescription Drugs
30. The Economics of Race and Sex Discrimination
31. Income and Wealth Inequality: What’s Fair?
36. The Economics of K–12 Education
37. College and University Education: Why Is It So
Expensive?
38. Poverty and Welfare
39. Head Start
40. Social Security
The Most Popular Issues Chosen by Students
14. The Recession of 2007–2009: Causes and
Policy Responses
17. International Trade: Does It Jeopardize
American Jobs?
22. The Line between Legal and Illegal Goods
23. Natural Resources, the Environment,
and Climate Change
24. Health Care
28. The Economics of Crime
30. The Economics of Race and Sex Discrimination
33. Minimum Wage
42. Energy Prices
43. If We Build It, Will They Come? and Other
Sports Questions
44. The Stock Market and Crashes
47. The Economic Impact of Casino and Sports Gambling
xxx
Required Theory Table
Core Theory Required
1 2 3 4 5 6 7 8
X X X 9. Fiscal Policy
X X X 10. Monetary Policy
X 11. Federal Spending
X X 12. Federal Deficits, Surpluses, and the National Debt
X X X 13. The Housing Bubble
X X X 14. The Recession of 2007–2009: Causes and Policy Responses
X X X 15. Is Economic Stagnation the New Normal?
X X X 16. Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security,
Medicare, and State and Local Pension Liabilities
X X X 17. International Trade: Does It Jeopardize American Jobs?
X 18. International Finance and Exchange Rates
X X X X X 19. European Debt Crisis
X X X 20. Economic Growth and Development
X X X 21. NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
X X X 22. The Line between Legal and Illegal Goods
X X X X X X 23. Natural Resources, the Environment, and Climate Change
X X X 24. Health Care
X X X 25. Government-Provided Health Insurance: Medicaid, Medicare, and the
Children’s Health Insurance Program
X X X X X 26. The Economics of Prescription Drugs
X X X X 27. So You Want to Be a Lawyer: Economics and the Law
X X X 28. The Economics of Crime
X X X X 29. Antitrust
X 30. The Economics of Race and Sex Discrimination
X X X 31. Income and Wealth Inequality: What’s Fair?
X X X 32. Farm Policy
X X X 33. Minimum Wage
X X X 34. Ticket Brokers and Ticket Scalping
X X 35. Rent Control
X X 36. The Economics of K–12 Education
X X X X X X 37. College and University Education: Why Is It So Expensive?
X 38. Poverty and Welfare
X X 39. Head Start
X 40. Social Security
Required Theory Table xxxi
Core Theory Required
1 2 3 4 5 6 7 8
X 41. Personal Income Taxes
X X X 42. Energy Prices
X X 43. If We Build It, Will They Come? And Other Sports Questions
X 44. The Stock Market and Crashes
X X X X 45. Unions
X X X X X 46. Walmart: Always Low Prices (and Low Wages)—Always
X X X X 47. The Economic Impact of Casino and Sports Gambling
X 48. The Economics of Terrorism
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1
C H A P T E R O N E
Economics: The Study of Opportunity Cost Learning Objectives
After reading this chapter you should be able to:
LO1 Define the key terms of economics and
opportunity cost and understand how a
production possibilities frontier exemplifies
the trade-offs that exist in life.
LO2 Distinguish between increasing and constant
opportunity cost and understand why each
might happen in the real world.
LO3 Analyze an argument by thinking eco-
nomically, while recognizing and avoiding
logical traps.
Chapter Outline
Economics and Opportunity Cost
Modeling Opportunity Cost Using the Production
Possibilities Frontier
Attributes of the Production Possibilities Frontier
Economic Growth
The Big Picture
Thinking Economically
Kick It Up a Notch: Demonstrating Constant and
Increasing Opportunity Cost on a Production
Possibilities Frontier
Summary
This chapter lays the foundation for understanding how to think like an economist. It begins by
defining the discipline of economics and its most basic concept: opportunity cost. Opportunity
cost is modeled and further explained through the use of a diagram called a production possibili-
ties frontier. A road map to the economy and to the remainder of the book is presented in the form
of a circular flow diagram. The chapter continues with a discussion of what “thinking economi-
cally” means. To understand this concept, we look at why economists use marginal analysis, ex-
plore the difference between positive and normative analysis, and examine economic incentives.
We conclude by examining logical traps that obstruct our path to such economic thinking.
Economics Defined
Some define economics as a hard requirement for general education or a major; others, a “dis- mal science”; and still others, the study of the allocation and use of scarce resources to satisfy
unlimited human wants. The reality is that economics is all three. It deserves its reputation as
a difficult course, its practitioners are always disappointing the public by insisting that there
is a cost to everything, and it really is a social science dealing with the fact that humans want
more than resources are capable of satisfying.
Economics and Opportunity Cost
economics The study of the alloca- tion and use of scarce resources to satisfy unlimited human wants.
2 Chapter 1 Economics: The Study of Opportunity Cost
On another level, the study of economics is the application of complicated jargon and
graphs to common sense. You already know a lot of economics. You know, for instance, that
choices have consequences; that having more money is more fun than having less; and that
even though you are rich relative to a starving refugee, you are less rich than you would like
to be. Of course, there are many other economic lessons that you learn simply by being alive.
What you do not have is a systematic way of thinking about those economic ideas, and that is
what this course and this book provide.
In this book all jargon with special meaning to economists will be in bold, with its defini-
tion, sometimes also in jargon, close by in the text as well as in the margin. If the definition is
in “econ-speak” rather than commonsense English, you will also find an English translation
nearby. Two terms in our definition of economics need clarification because they have special
meaning to economists. First, you find the word scarce. Something is scarce when there is not a freely available and infinite source of it. Second, a resource is anything we either consume directly or use to make things that we will ultimately consume.
There are four basic resources that society can allocate: land, labor, capital, and the entre-
preneurship of its people. Any other resource, like oil, steel, or corn, is made available to a
society when it allocates one or more of the basic resources to uncover, create, or harvest it.
Choices Have Consequences
In this course and with this book you will be faced with a choice: Do you read and study, or
do you sleep and party? This choice illustrates the first and most basic concept of economics:
opportunity cost. Opportunity cost is the forgone alternative of the choice made. Translated into English, opportunity cost is “what you would have done had you not done
what you did.” It is important to keep in mind that the “forgone alternative” is the next best
choice. It is not all the things “you could have done had you not done what you did,” but it is
the best of these alternatives because presumably that is “what you would have done.”
If, for example, you decide at some point before finishing your assigned reading to put
down this book, you will be implicitly saying that you would rather do something other than
read this book. In terms of the course you are taking, the “opportunity cost” of such a poor
decision could well be the lower grade that results from lost understanding.
Unfortunately, no matter what you do, you cannot escape opportunity cost. If you stay
responsible and continue to read your text, the opportunity cost would be what you would do
with the time saved. You are giving up the opportunity to watch something on Netflix, play the
latest Call of Duty, Halo, or Assassin’s Creed game, sleep, or study something else. To you,
the preferred one of these would be the opportunity cost of reading the text.
As an aside, professors today see many students trying to avoid opportunity cost by multi-
tasking. Scanning your Facebook account, reading your English, texting your significant other, or
studying your biology during your economics class may seem like you are simply using time that
has no opportunity cost. It is not. Students who attempt it frequently miss details, instructions, or
concepts when they are only partially tuned in. The opportunity cost of the multi-tasking attempt
is the lost understanding that could have been gained had you focused your attention in class.
The Intuition behind Our First Graph
The concept of opportunity cost can be further illustrated by looking at something called a
production possibilities frontier. This graph, Figure 1.1, is the first of more than 100 that you will see in this book. It is an example of a model, a simplification of the real world that we
scarce Not freely available and lacking an infinite source.
resource Anything that is con- sumed directly or used to make things that will ultimately be consumed.
opportunity cost The forgone alternative of the choice made.
production
possibilities frontier A graph that relates the amounts of different goods that can be pro duced in a fully employed society.
model A simplification of the real world that can be manipulated to explain the real world.
Modeling Opportunity Cost Using the Production Possibilities Frontier
Modeling Opportunity Cost Using the Production Possibilities Frontier 3
can manipulate to explain the real world. This
particular one relates the amounts of different
goods that can be produced in a fully employed
society.
Because chalkboards and book pages have
only two dimensions, our explanation is limited.
This gives us the first opportunity to introduce
something called a simplifying assumption. A simplifying assumption is one that may, on its
face, be silly but allows for a clearer explana-
tion. A good one also has the characteristic that
the conclusions that spring from it are valid in
its more complicated scenario. For our produc-
tion possibilities frontier we will make several simplifying assumptions. We will assume that
there are only two goods in the world, that these goods are pizza and soft drinks, and that these
goods will be produced with a fixed number of resources and fixed technology.
For another simplification, suppose that there are five types of people in the world: (1) those
really good at producing pizza but lousy at producing soda; (2) those pretty good at producing
pizza and not so good at producing soda; (3) those sort of OK at both; (4) those good at pro-
ducing soda and not so good at producing pizza; and (5) those really good at producing soda
but lousy at producing pizza.
The Starting Point for a Production Possibilities Frontier
If we imagine that our resource is the time of our workers, it can be consumed directly in the
form of their leisure or it can be combined with other resources to produce goods and services.
This resource is also scarce because there is not an infinite number of people to work, those
people can do only so much work, they will not work without being paid, and there is only
so much soda that can be produced—even if all the people on the planet devote their lives to
the production of soda. Of course this point also holds if we apply the scarce resource to the
production of pizza. There is only so much pizza that can be produced even if everyone on
the planet is producing pizza. This notion of scarcity gives us a starting point and an ending
point for Figure 1.1.
Point S in Figure 1.1 represents the situation where all resources are devoted to the produc-
tion of soda; point P represents the situation where all resources are devoted to the production
of pizza. In both cases all the resources in the world are devoted to the production of a specific
good and production is still limited. It is limited by the ability of people and by the number of
people and machines we have to help those people do their jobs. So that it is clear, remember
that the production possibilities frontier is giving us a series of choices. We can pick only one
of them. We cannot have both S sodas and P pizzas; thus, it is an either–or situation.
Points between the Extremes of a Production Possibilities Frontier
We can have some soda and some pizza, so many points between S and P are possible; we
need to determine them. To proceed, assume you want something to eat with your soda, and
ask yourself what kind of people you would remove from soda production to foster pizza
production. Clearly, you would remove those who are not contributing much to the soda pro-
duction but would contribute greatly to pizza production. That is, those with the attributes of
people in group 1 above: really good at pizza, lousy at soda.
Figure 1.2 shows us what happens if we go ahead and move that group. As you see, this
increases pizza production to a respectable level while not costing society much soda. Point X
in Figure 1.2 represents that new soda–pizza combination. There everyone except those whom
simplifying
assumption An assumption that may, on its face, be silly but allows for a clearer explanation.
S
P
Pizza
S o
d a
FIGURE 1.1 Production
possibilities frontier:
the starting point.
4 Chapter 1 Economics: The Study of Opportunity Cost
we will call the “pizza chefs” are still making soda, and the pizza chefs are efficiently crank-
ing out as many pizzas as they can on their own. The thing is, though we gained a great deal
of pizza production, we lost some soda production. That’s why point X, while to the right of
point S, is also lower than point S.
If we continue this process further, we are not blessed with a similar effect. The reason is that
if we move toward greater pizza production, we do not have those pizza chefs to call on; instead
we have our group 2, who are pretty good at pizza and not so good at soda. What that means is
that even though pizza production rises, it does not rise as much as it did before. On top of that,
our soda production falls more than it had before because when we moved the pizza chefs, they
were “lousy” at soda. Now we are moving workers who are simply not so good at soda. Our soda
losses are growing at an increasing rate. Thus we have point Y in Figure 1.3.
Going further, point M in Figure 1.4 results from moving the workers from group 3 (OK at
both) from soda to pizza, point Z results from moving group 4 workers to pizza, and point P
results from moving group 5 workers to pizza.
Connecting points like this creates Figure 1.5: a production possibilities frontier. This curve
represents the most pizza that can be produced for any given amount of soda or, interpreted
differently, the most soda that can be produced for any given amount of pizza.
XS
P
Pizza
S o
d a
FIGURE 1.2 Production possibilities frontier: moving pizza chefs to their rightful place.
X
Y
S
P
Pizza
S o
d a
FIGURE 1.3 Production possibilities frontier: moving to even more pizza production.
X
M
Z
Y
S
P
Pizza
S o
d a
FIGURE 1.4 All points on a production possibilities frontier.
Unemployment ( just inside the curve)
Unattainable (outside the curve)
S o
d a
Pizza0
Attainable (on the curve and on the inside)
FIGURE 1.5 A fully labeled production possibili- ties frontier: the case when people are different.
Attributes of the Production Possibilities Frontier 5
Of course, if you can produce on the curve, you can produce less than that as well. If you do
produce at points inside a production possibilities frontier, there are unemployed resources, or
unemployment for short. Therefore, all points on or inside the production possibilities frontier are attainable.
Conversely, since the production possibilities frontier represents the maximum amount of
one good that you can produce for a given level of production of another, those points outside
the production possibilities frontier are unattainable. This means that currently available re- sources and technology are insufficient to produce amounts greater than those illustrated on
the frontier. On the graph, everything beyond the frontier is unattainable.
The preceding discussion illustrates something you need to be wary of in this book. Words you
think you know may mean something entirely different to economists. Thus far we have at least
three such words: unemployment, frontier, and good. You think of unemployment as the condition
of someone wanting a job but not having one. Economists do not disagree but expand that defini-
tion to resources other than labor. For example, on the interior of the production possibilities fron-
tier there is unemployment, but that unemployment may be of capital. The word frontier is used to
describe the boundary of production, not a wooded area with bears to avoid. The word good, to an
economist, is a generic term for anything we consume. In the example, soda and pizza are goods.
In the soda and pizza example there were people of different talents at soda and pizza
production. The pizza chef had far different skills from the soda master. If, on the other hand,
everyone were identical in their soda and pizza production capabilities, then points would fall
on the line, as seen in Figure 1.6.
Increasing and Constant Opportunity Cost
Figures 1.5 and 1.6 have important similarities and differences. In both, the points on the
production possibilities frontier are the most of one good that can be produced for a given
amount of the other good. In both, the points on the curve and inside it are attainable and those
on the outside of it are unattainable. In both, the opportunity cost of moving from one point
Attributes of the Production Possibilities Frontier
unemployment A situation that occurs when resources are not being fully utilized.
attainable Levels of production that are possible with the given resources.
unattainable Levels of production that are not possible with the given resources.
S o
d a
0
Unemployment ( just inside the curve)
Unattainable (outside the curve)
Pizza
Attainable (on the curve and on the inside)
FIGURE 1.6 A fully labeled
production possibilities
frontier: the case when
people are the same.
6 Chapter 1 Economics: The Study of Opportunity Cost
to another is the amount of one good you have to give up to get another. They differ in one
important way, however: whether opportunity cost is increasing or constant.
If the production possibilities frontier is not a line but is bowed out away from the origin, then
opportunity cost is increasing. The reason for this is that as we add more resources to the produc-
tion of pizza, we are using fewer resources to produce soda. Compounding that problem, at each
stage as we take the resources away from soda and put them into pizza, we are moving workers
who are worse at pizza production and better at soda production than those moved in the previous
stage. This means that the increase in pizza production is diminishing and the loss in soda pro-
duction is increasing. An economist would call this an example of increasing opportunity cost.
If the production possibilities frontier is a straight line that is not bowed out away from the
origin, then opportunity cost is constant. If every worker possesses identical skill, though you
still have to give up some soda to get pizza, this is not compounded by anything. The resources
you put into producing more pizza are just as good as the resources used to get you to that
point, and the resources taken away from the soda are similarly just as good as the resources
used up to that point. An economist would call this an example of constant opportunity cost.
How Is Growth Modeled?
We can use the production possibilities frontier to model economic growth. In the top-left
frame of Figure 1.7 we see what happens when there is increasing opportunity cost between
pizza and soda, and a new process allows more soda to be produced from the same resources
when that process doesn’t apply to pizza. In the top-center frame the reverse is true: Techno-
logical progress allows for greater pizza production but doesn’t impact soda. The bottom-left
and bottom-center frames show the same thing when there is constant opportunity cost. These
four cases show the result of specialized growth, where there is an increase in the ability to
produce a particular good because there is an increase in, or an increase in the ability of, re-
sources to produce a particular good that does not generalize to other goods.
When there is generalized growth, that is typically the result of an increase in, or an
increase in the ability of, resources to produce all goods. Generalized growth is depicted on
the top-right and lower-right frames of Figure 1.7 for when there is increasing and constant
opportunity cost, respectively.
Economic Growth
Specialized Growth
S o
d a
S o
d a
S o
d a
S o
d a
S o
d a
S o
d a
Generalized Growth
0 Pizza0 Pizza0 Pizza
0 Pizza 0 Pizza 0 Pizza
FIGURE 1.7 Modeling Economic
Growth.
The Big Picture 7
Sources of Economic Growth
In terms of productive capacity of a society, economic growth results from either an increase in
the availability of resources or an increase in the ability of resources to produce goods and ser-
vices. In the first case, a newly discovered source of energy, or a source of energy that had, under
previous technology, not been exploitable would constitute a newly available resource. Reaching
not that far back in our history, having women enter the labor force in large numbers during the
1960s through the 1990s increased the availability of labor. In the second case, sometimes the
resources remain the same but the ability to utilize them to produce goods and services increases.
For instance, when computers and lasers are added to saw mills, the same logs, saw blades, and
labor can produce more lumber. That is, technology makes resources more productive. Similarly,
education makes labor more productive and can be a source of generalized growth in capacity.
Now that we have looked at our first “simplified” model of the economy, it’s time to get an
idea of the “Big Picture.” Think of Figure 1.8 as your road map to the book. This circular flow model is designed to put all of the pieces that follow in perspective. It has firms, workers, investors, savers, buyers, and sellers all interacting in markets and dealing with government. It
The Big Picture
circular flow model A model that depicts the interactions of all eco- nomic actors.
Factor Markets
Goods and Services Markets
GovernmentFirms Households
Foreign Exchange Markets
The Rest of the World
The Rest of the World
Natural Resources and the Environment
Natural Resources and the Environment
Payments (rent, wages, etc.)
Payments (rent, wages, etc.)
Payments (rent, wages, etc.)
Labor, Savings
Labor, Savings
Labor, Savings
Taxes
Taxes
Transfer Payments, Services
Services
Goods and Services
Goods and Services Goods and Services
Payments for Goods and Services
Payments for Goods and Services
Payments for Goods and Services
Exports Imports
Wastes
WastesResources
Natural Beauty
$ $
£
£
FIGURE 1.8 The Circular Flow Model.
8 Chapter 1 Economics: The Study of Opportunity Cost
has humanity taking natural resources from the environment, combining them with domestic
and foreign financial and human resources to produce goods and services, and then buying
and selling those goods and services in domestic and foreign markets.
Circular Flow Model: A Model That Shows the Interactions of All Economic Actors
The ovals in the diagram represent entities of specific kinds: There are households, firms, and
governments. Households provide labor for wages. They use those wages to buy goods and
services and pay their taxes. They receive services from government. Some save, some bor-
row, and many do both. Firms provide wages to households and pay taxes to government while
getting labor from their workers and services from the government.
The rectangles in the diagram represent markets of various kinds: There are factor markets, foreign exchange markets, and goods and services markets. Factor markets are where workers and firms, and borrowers and savers interact to set wages and interest rates. Foreign exchange markets are where holders of various currencies interact to facilitate international trade. Goods and services markets are where consumers and producers interact to negotiate exchange of goods like cars, and services like dry cleaning.
Surrounding the whole thing are “The Rest of the World” and “Natural Resources and
the Environment.” The former allows us to explicitly think about foreign trade and foreign
exchange while the latter lets us think about the use of natural resources and the implications
of economic activity on the environment.
Marginal Analysis
One of the central tools of economics is marginal analysis. Economists typically look at prob-
lems by analyzing the costs and benefits of various solutions. When people buy something,
they have to compare the value of what they purchase to the value of what they give up. When
companies produce goods for sale, they have to compare the money they generate from sales
to the costs they will incur from the production process. When you clean up your dorm room,
you weigh the cleanliness gained against the time required to clean it.
Economists generally make an optimization assumption. This is an assumption that sug- gests that the person in question is trying to maximize some objective. For example, consum-
ers are assumed to be making decisions that maximize their happiness subject to a scarce
amount of money. Companies are assumed to maximize profits. People are assumed to clean
things until the benefits of cleaning more are not worth the time or effort.
Economists see that all of these problems can be looked at using the same framework.
Economists compare the marginal benefit of an action with its marginal cost. Something is worth doing only if the increase in benefits equals or exceeds the increase in costs. If the
marginal benefit of an action steadily decreases and the marginal cost of an action steadily
increases, then a person maximizes net benefit by doing that action until the marginal benefit equals the marginal cost. This is the essence of marginal analysis, and we will see it in action
throughout this book.
Positive and Normative Analysis
When people look at the world they often see things as they are and compare the way things
are to the way they think things should be. They see a major league shortstop sign a con-
tract for a quarter of a billion dollars over 10 years while their high school teachers make
market Any mechanism by which buyers and sellers negotiate an exchange.
factor market A mechanism by which buyers and sellers of labor and financial capital negotiate an exchange.
foreign exchange
market A mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.
goods and services
market A mechanism by which buyers and sellers of goods and services negotiate an exchange.
optimization
assumption An assumption that suggests that the person in question is trying to maximize some objective.
marginal benefit The increase in the benefit that results from an action.
marginal cost The increase in the cost that results from an action.
net benefit The difference between all benefits and all costs.
Thinking Economically
Thinking Economically 9
less than $40,000 a year. Economists, and social scientists in general, distinguish views of
“the way things are” from “the way things should be,” calling the former positive analysis and the latter normative analysis. Although there are economists who utilize both forms of analysis, more economists are comfortable explaining why things are the way they are
than are comfortable suggesting the way things should be. Some critics look at this as self-
delusion on the part of economists, using the argument that we choose which information
to weigh more heavily based on normative beliefs.
Economic Incentives
What kinds of choices we make as individuals and as a society depend on our preferences.
Returning to the soda and pizza example, whether we like soda or pizza, or in what combina-
tions we most like them, will have an important impact on what we choose to produce and
consume. But also high on the list of things that determine what combinations of things we
will produce and consume are incentives. Something is an incentive if it influences a decision we make. Some incentives are part of a market, like prices. Others are put on by an outside
force like a government, and they can positively reinforce behaviors that are desired or deter
behaviors that are not. What this means is that you are still able to produce and consume what
you want, but something—perhaps a tax or a government regulation—is encouraging a par-
ticular choice. For example, by taxing beer and not soda, the government encourages you to
steer toward soda and away from beer.
On a deeper level, an incentive may motivate you to do something you would not or-
dinarily do. For instance, many incentives are offered in the tax system. Tax credits and
deductions for college tuition are considered incentives that will persuade people to get
an education. For many people who would go to college anyway, these are not incentives.
However, to some people who were perhaps considering college but had not made a de-
cision, any influence these tax benefits would have on the decision would constitute an
incentive.
An important and sometimes unfortunate aspect of incentives is that they create unintended
consequences. Taxes are an area where some argue that the unintended consequences can be
predicted from the incentives that arise out of programs. If welfare payments were reduced
when the recipient found part-time employment, some predict the result that the recipient
would not look for part-time employment.
Fallacy of Composition
One of the key traps to thinking economically is assuming that the total economic impact
of something is always and simply equal to the sum of the individual parts. The fallacy of composition is an important logical trap to avoid because invalid economic conclusions will inevitably be drawn.
Outside of economics, cake constitutes a famous illustration of why the fallacy of composi-
tion is just that—a fallacy. Imagine a cake. Now imagine the ingredients that go into making
the cake. Imagine eating the cake and the satisfaction you get from that. Now compare that
level of satisfaction to what you would have if you separately poured flour, sugar, and bak-
ing powder down your throat, washed it down with a couple of raw eggs and some cooking
oil, and then stuck your head in an oven. The baked combination is obviously better than its
individual parts.
As an example within economics, we will learn in Chapter 5 that when many farmers are
making high profits, others will want to join in. If they do join in, will all of the old and new
farmers be making high profits? We will see that the new farmers’ extra production will ul-
timately drive prices down so far that neither the older nor the newer farmers make money.
positive analysis A form of analysis that seeks to understand the way things are and why they are that way.
normative analysis A form of analysis that seeks to understand the way things should be.
incentives Something that influences a decision we make.
fallacy of composition The mistake in logic that suggests that the total economic impact of something is always and simply equal to the sum of the individual parts.
10 Chapter 1 Economics: The Study of Opportunity Cost
What this means is that when we are making economic judgments, we must do so with
care. The sums of the individual parts must not be confused with the whole. The two can be,
and often are, different.
Correlation ≠ Causation
When people are attempting to think economically, another trap they may fall into is assuming
that because two variables changed simultaneously, one caused the other to happen.
For instance, if you weighed all people under age 30 and also asked them how many dates
they had had in their lifetime, you would find a direct correlation, meaning that it appears that the more people weigh, the more dates they have had. This does not imply causation. Heavier people do not necessarily get more dates and dating does not make us gain weight. In this case
the two variables happen to be correlated with age. People in their twenties weigh more and
have had a longer opportunity to have dates than have teens, preteens, and young children.
When politicians attempt to take credit for good economic times with the claim that their
policies caused the good economic times to happen, we must be suspicious. Of course, we
must be equally suspicious if they attempt to pin the blame on their incumbent opponent if bad
economic times existed in their opponent’s time in office. While their claims may be true, it is
perfectly plausible that the policies and the economy were unrelated, or that the economy did
well or did poorly despite the policies.
When economists look at cause and effect, they frequently attempt to generate a counter- factual. A counterfactual is an educated guess about what would have happened had a policy or an event not occurred. A well-constructed and convincing counterfactual can help deter-
mine whether a policy (like the 2008 Troubled Asset Relief Program or TARP) made things
better than they otherwise would have been. It is not enough to say that the economy lost mil-
lions of jobs after a policy was passed and therefore the policy was bad. You have to be able
to construct a scenario of what would have happened had the policy not been enacted. This is
often the reason why economists will disagree and seem absolutely convinced that those with
whom they are disagreeing are wrong. Whether the Bush administration’s TARP program, the
Federal Reserve’s lowering of interest rates through unprecedented purchases of long-term
debt, or the Obama stimulus package made the economic downturn of the time better than it
would have been depends entirely on what your counterfactual is.
Sometimes two variables move in opposite directions. This inverse correlation can also be misinterpreted as being causal. If you were to get season tickets to your college’s football games
and observe the amount of skin (bare arms, legs, and midriffs) showing on the fans and compare
that to the amount of hot chocolate sold during the game, you would find that when people
show more skin they also consume less hot chocolate. If you came to the conclusion that one
caused the other to happen you would, of course, be wrong. Obviously, the weather caused each
to occur.
direct correlation A higher level of one variable is associated with a higher level of the other variable.
causation A change in one variable makes another variable change.
counterfactual An educated guess as to what would have happened had a policy or an event not occurred.
inverse correlation A higher level of one variable is associated with a lower level of the other variable.
DEMONSTRATING CONSTANT AND INCREASING OPPORTUNITY COST ON A PRODUCTION POSSIBILITIES FRONTIER
Economists use the production possibilities frontier to show the concepts of increasing and
constant opportunity cost. If we start with no pizza and only soda but then move in increments
to change our mix, there is opportunity cost. Just how much depends on whether it is increas-
ing or constant.
Kick It Up a Notch
Summary 11
S o
d a
10
9
8
7
6
5
4
3
2
1
0 1 2 3 Pizza
FIGURE 1.9 Illustrating increasing opportunity costs.
S o
d a
9
8
7
6
5
4
3
2
1
0 1 2 3 Pizza
FIGURE 1.10 Illustrating constant opportunity costs.
Demonstrating Increasing Opportunity Cost
For example, in Figure 1.9, if we go from the point on the graph where we are producing no
pizza to the point where we are producing a single unit, a unit whose numbers could be in the
billions, our opportunity cost would be characterized by lost units of soda. On Figure 1.9, the
opportunity cost of going from 0 units of pizza to 1 unit of pizza is 1 unit of soda. Moving
from 1 unit of pizza to 2 units has an opportunity cost that is 3 units of soda. Similarly, moving
from 2 to 3 units of pizza has an opportunity cost of 6 units of soda. As is visually obvious,
the opportunity cost of going from 0 to 1 is smaller than going from 2 to 3. This is why we say
that the opportunity cost is increasing.
Demonstrating Constant Opportunity Cost
Similarly, we can use Figure 1.10 to show constant opportunity cost. The opportunity cost of
moving from producing no pizza to 1 unit is 3 units of soda. Moving from 1 unit to 2 units and
from 2 to 3 units also has an opportunity cost of 3 units of soda. In this case the opportunity
cost of going from 0 to 1 is the same as going from 2 to 3. This is why we say that the oppor-
tunity cost is constant.
What this all means is simple: Choices have consequences. Sometimes those consequences
are great and sometimes they are small. If studying for five hours moves you from an F to a B
on a test, then the higher grade has a low opportunity cost in terms of lost television watching.
Viewed from the other side, the opportunity cost of another five hours of television watching
(instead of studying to get a good grade) could be substantial. Opportunity cost is everywhere
and is a consequence of every decision you make.
In this chapter we learned the definition of economics, that choices have consequences,
and that those consequences are called opportunity cost. We learned how to model choices
using a production possibilities frontier. We also learned that, depending on our assump-
tions, opportunity cost can be increasing or constant. We created a road map to the entire
Summary
12 Chapter 1 Economics: The Study of Opportunity Cost
economy and to the rest of this book by creating a circular flow diagram with all the various
markets, individuals, firms, and governments interacting in society. Last, we explored the
meaning of thinking economically by examining marginal analysis, positive and normative
analysis, incentives, and the flaws of logic that may get in the way of economically accurate
thinking.
Key Terms attainable causation
circular flow model
counterfactual
direct correlation
economics
factor market
fallacy of composition
foreign exchange market
goods and services market
incentives
inverse correlation
marginal benefit
marginal cost
market
model
net benefit
normative analysis
opportunity cost
optimization assumption
positive analysis
production possibilities
frontier
resource
scarce
simplifying assumption
unattainable
unemployment
Issues Chapters You Are Ready for Now
Federal Spending Poverty and Welfare If We Build It, Will They
Come? And Other Sports
Questions
Quiz Yourself 1. Scarcity implies that the allocation scheme chosen by society can a. not make more of any one good.
b. always make more of any good.
c. typically make more of a good but at the expense of making less of another.
d. always make more of all goods simultaneously.
2. A production possibilities frontier is a simple model of
a. scarcity and allocation.
b. prices and output.
c. production and costs.
d. inputs and outputs.
3. The underlying reason that there are unattainable points on a production possibilities
frontier diagram is that there
a. is government.
b. are always choices that have to be made.
c. is a scarcity of resources within a fixed level of technology.
d. is unemployment of resources.
4. The underlying reason production possibilities frontiers are likely to be bowed out (rather
than linear) is
a. choices have consequences.
b. there are always opportunity costs.
c. some resources and people can be better used producing one good rather than another.
d. there is always some level of unemployment.
Summary 13
5. The optimization assumption suggests that people make
a. irrational decisions.
b. unpredictable decisions.
c. decisions to make themselves as well off as possible.
d. decisions without thinking very hard.
6. Imagine an economist ordering pizza by the slice. When deciding how many slices to
order she would pick that number where the enjoyment of the equals the
enjoyment she could get from using the money on another good.
a. first slice
b. last slice
c. average slice
d. total number of slices
7. Of course, all individual students are better off if they get better grades. If you were to
conclude that all students would be better off if everyone received an A you would
a. have fallen victim to the fallacy of scarcity.
b. be right.
c. have fallen victim to the fallacy of composition.
d. be mistaking correlation with causation.
8. If you were to conclude, after carefully examining data and using proper evaluation tech-
niques, that a tax credit for attending college benefits the poor more than a tax deduction
(of equal total cost to the government) would, you would have engaged in
analysis to reach that conclusion.
a. negative
b. positive
c. normative
d. creative
Short Answer Questions
1. Suppose you buy a new car. What is the opportunity cost of doing so?
2. Suppose you decided to study all last week for this exam instead of doing anything fun.
What was the opportunity cost of doing so? Why might the opportunity cost (defined in
terms of fun lost) be expected to increase?
3. Suppose you hear a political candidate claim credit or lay blame for an economic
outcome. How can you tell whether the candidate is correct? What would you need to
know?
4. If you get a 25 percent pay increase, you are better off. Explain why some people would
not be better off if their employer gave them a 25 percent pay increase.
5. Suppose you were to analyze the state and the economy at the moment. You say to
your friends, “The economy has been growing more slowly in the last 10 years than it
did in the previous 20 years. The government should cut taxes to stimulate the econ-
omy.” What portion of that statement is “positive” and what portion of that statement
is “normative”?
Think about This What was your opportunity cost of attending college?
Think about the most expensive thing you have ever purchased. What could you have done
with the money? Which outcome would have made you better off—what you did or what you
could have done?
14 Chapter 1 Economics: The Study of Opportunity Cost
Think about the last time you took a series of tests during a short period of time (high
school or college finals work here). How did you decide how much time to spend on each
subject? How might the study of economics help you make that allocation decision in the
future?
Talk about This Discuss whether you believe people make rational decisions based on the optimization
assumption.
Discuss what kinds of noneconomic (something you would normally not think of as an eco-
nomic decision) trade-offs could be modeled with a production possibilities frontier?
A P P E N D I X 1 A
Graphing: Yes, You Can. Whether you like it or not, graphing is an important part of “getting” economics. If you have ven-
tured to this appendix it is likely that your instructor agrees and wants you to have a firm founda-
tion for what you are about to do. This appendix is geared to the student who never understood
what a graph was trying to tell them; to those poor souls who look at a complex diagram and see
a bunch of stray lines that have no meaning. In the movie Jerry Maguire, Tom Cruise bursts into
his home to offer a long, heartfelt apology to his wife, who finally interrupts him to say, “You
had me at ‘Hello.’ ” Those of us who teach economics have often lost our students at “Hello,” or
at least at the moment we went to the board, overhead projector, or computer display to draw a
graph. Let’s get off on the right foot with learning what a graph is and what it can tell us.
CARTESIAN COORDINATES
As the subheading suggests, Cartesian coordinates are named for their inventor, Frenchman
René Descartes. As the legend goes, he was staring at the ceiling and began following the path
of a fly. He discovered that he could use just two numbers to pinpoint the placement of the fly
on the ceiling every time it landed. So lie back for a moment and look at the ceiling.
Now pick a corner of the room where the ceiling meets two walls; that will be your refer-
ence point. (In math it is called the origin.) Assuming the walls are square to one another, call the wall that runs on your left the y-axis and the wall on your right the x-axis. Now find a spot on the ceiling that stands out; a spider, a small stain, a vent, anything. Draw the shortest pos-
sible imaginary line from your spot to the ceiling to the wall on the right. Call that point A. Do
the same thing for the wall on the left and call that point B. You can identify that point on the
ceiling using just two numbers. The first number is the distance along the x-axis from the cor-
ner to A and the second is the distance along the y-axis from the corner to B. In Figure 1A.1 the
point that is marked is 9 units along the x-axis and 11 along the y-axis, so it is shown as (9,11).
origin The point on the graph where both the variables are zero (0,0).
y-axis The vertical axis.
x-axis The horizontal axis.
y -a
x is
9
10
11
12
8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10
x-axis Origin
(9,11)
FIGURE 1A.1 Graphing a point.
16 Chapter 1 Economics: The Study of Opportunity Cost
PLEASE! NOT Y = MX + B . . . SORRY.
Whether you want to recall the experience or not, you were first exposed to the slope, x-intercept, and y-intercept of a line and the dreaded y = mx + b form of the line in your first algebra class. Whether that was in 7th, 8th, 9th, or 10th grade, enough time has passed that a
refresher on the ideas is in order. The equation y = mx + b is a line because if you get all of
the x, y combinations that come about from plugging in random values of x and computing
what you get for y and then graph them, they end up in a line. That line will cross the y-axis at
b, because if you plug in 0 for x in the y = mx + b equation, mx is 0 (because anything times
0 is 0), so all you are left with is b. Therefore, b is the y-intercept. It will cross the x-axis at
−b/m. Therefore, the x-intercept is −b/m. As you will (perhaps not so vividly) recall, the slope
is the “rise over the run.” That means it is the amount by which y rises divided by the amount
by which x rises. Suppose we let x start at 3 and rise to 4. If that happens, then y goes from
m3 + b to m4 + b. Therefore, y rises by m. The rise is m, the run is 1, so the slope is m. There
is nothing magic about the choice of 3; we could have used any number and we would have
gotten the same result. The slope is m.
If m and b are positive, you get a graph like Figure 1A.2. If m is positive and b is nega-
tive, you get something like Figure 1A.3. If m is negative and b is positive you get a graph
like Figure 1A.4, and finally, if they are both negative, you get something like Figure 1A.5.
If m is large and positive, that means the line is upward sloping and steep; small and posi-
tive means that it is upward sloping and relatively flat. If m is really negative, then the line
is downward sloping and steep, and if it is slightly negative, then the line is downward
sloping and flat.
slope The increase in the value of the y-axis variable for a 1-unit increase in the value of the x-axis variable.
x-intercept The value of the x-axis variable when the y-axis variable is zero.
y-intercept The value of the y-axis variable when the x-axis variable is zero.
y
y
x x
FIGURE 1A.2 Graphing a line
y = mx + b
m > 0, b > 0.
Please! Not Y = MX + B . . . Sorry. 17
y
y
x x
FIGURE 1A.3 Graphing a line
y = mx + b
m > 0, b < 0.
y
y
x x
FIGURE 1A.4 Graphing a line
y = mx + b
m < 0, b > 0.
18 Chapter 1 Economics: The Study of Opportunity Cost
WHAT ON GOD’S GREEN EARTH DOES THIS HAVE TO DO WITH ECONOMICS?
To simplify things some, the only things that matter on our graphs will be those things that
happen in the first quadrant (where both x and y are positive). We will have downward-sloping
lines and upward-sloping lines. We will have some lines that are steep and some that are flat.
Often, what we graph will not be a line at all but a curve (such as Figures 1.5 and 1.8). That
is less important than this: An upward-sloping line or curve means that as the variable on the
x-axis increases, so does the variable on the y-axis; a downward-sloping line or curve means
that as the variable on the x-axis increases, the variable on the y-axis decreases.
This will become apparent when we talk about supply and demand in Chapter 2 and costs of
production in Chapter 4. As you will see in Chapter 2, economists put price on the vertical axis
(the y-axis) and the amount people want to buy or firms want to sell on the horizontal axis (the
x-axis). The upward-sloping line will be supply and will suggest that companies will produce
more stuff if you pay them more for each one, and the downward-sloping line will be demand
and will suggest that consumers will buy less stuff when the price per unit rises.
We will also make a big deal out of two lines or curves crossing. When supply crosses
demand in Chapter 2, when marginal revenue crosses marginal cost in Chapter 5, and when
aggregate demand crosses aggregate supply in Chapter 8, this is going to have particular
significance. It is important that when you get there and you don’t understand why two lines
crossing matters at all . . . ASK!
y
y
x x
FIGURE 1A.5 Graphing a line
y = mx + b
m < 0, b < 0.
19
C H A P T E R T W O
Supply and Demand Learning Objectives
After reading this chapter you should be able to:
LO1 Illustrate and explain the economic model of
supply and demand.
LO2 Define many terms, including supply, demand,
quantity supplied, and quantity demanded.
LO3 Utilize the intuition behind the supply and
demand relationships as well as the variables
that can change these relationships to
manipulate the supply and demand model.
Chapter Outline
Supply and Demand Defined
The Supply and Demand Model
All about Demand
All about Supply
Determinants of Demand
Determinants of Supply
The Effect of Changes in Price Expectations
on the Supply and Demand Model
Kick It Up a Notch: Why the New Equilibrium?
Summary
This is the make-or-break chapter of the book: You cannot understand economics without
understanding supply and demand. Only if you understand this topic will you be able to read
the issues chapters with a good level of comprehension.
You probably are familiar with the words supply and demand through television, newspa-
pers, or conversation. The phrase frequently is used by people in a way an economist would
not use it. This chapter is intended to show you what economists mean when they use the
phrase and how they use the model behind the phrase so you understand the supply and
demand model enough that you will be able to use both the model and the jargon correctly
when we discuss a variety of economic issues.
Arriving at that level of understanding will take some time. We begin by setting out some
of the language we will be using. It may be tempting for you to read too fast, to skim through,
figuring that you have heard all the words before. Don’t. As we discussed in Chapter 1, the
language has precise meaning to economists, and it is not necessarily the same as the meaning
you have associated with it before.
Our next move is laying out the supply and demand model itself, starting with brief expla-
nations of the term demand and then the term supply. We then put them together on one graph
to form our first look at the model and our first look at what economists call equilibrium. We
then step back a moment to examine in detail demand and then supply.
With a rudimentary understanding of the supply and demand model, we explore what
happens in it when demand changes and then explore what happens in it when supply
changes. Our last step shows why supply or demand changes require a change in the
equilibrium.
20 Chapter 2 Supply and Demand
Supply and Demand Defined
Markets
Supply and demand is the name of the most important model in all of economics. Economists use it to provide insight into the movements in price and output. Remember from Chapter 1 that a model is a simplification of a complicated real-life phenomenon. This model assumes
that there is a market where buyers and sellers get together to trade. Consumers are assumed to bring money to the market, whereas producers are assumed to bring goods or services to the market. Consumers want to exchange their money for goods or services while producers want
to exchange the goods or services they have for money.
It is important that you understand that the word market has a very specific meaning
to economists and that it is very different from the business idea of “marketing.” A market
exists anywhere that buyers and sellers negotiate price and perform an exchange. There-
fore, they have to be able to communicate and they have to be able to exchange. Take, as
an example, the market for used midsized sedans. There are people who are looking to
buy them and people who are looking to sell them. Prior to the Internet, most of the com-
munication was geographically constrained. Buyers went to used-car lots or read ads in the
newspaper. People who wanted to unload a car advertised by word of mouth, by newspaper,
or sold to a dealer. With the Internet, the market is greatly expanded because communica-
tion (autotrader.com; craigslist.com, etc.) is easier, but you still are unlikely to buy a car in
Seattle if you live in Miami because the cost of getting the car from Seattle is prohibitive.
Finally, “marketing” is what the used-car sales staff does to convince you to buy their cars.
Try not to confuse the two.
The supply and demand model assumes that there are many consumers and producers, so
that no one of them can dictate price. There is a price at which neither consumers nor produc-
ers leave with less value than they came with; no consumers wish they could have purchased
more goods at the price; no producers wish they could have sold more at that price—in short,
everyone is better off for participating. Economists call such a price an equilibrium price and the amount that consumers buy from producers an equilibrium quantity. The nuts and bolts of this model are the supply and demand curves. The demand curve shows the relationship
between the price consumers have to pay and how much they “want to buy,” whereas the sup-
ply curve shows the relationship between the price firms receive and how much producers
“want to sell.” Economists refer to the amount that consumers want to buy at any particular
price as the quantity demanded and the amount that firms want to sell at any particular price
as quantity supplied.
People participate in markets because markets make their participants better off. Mar-
kets evolved because our ancestors recognized that self-sufficiency, though possible, did
not allow people to take advantage of their particular skills. A social creation of humans,
markets have been shaped by humankind to bring people together to exchange goods and ser-
vices and, because these exchanges have always been voluntary, participants have always left
them content that they have gained from the market’s existence. Thus markets have endured
as a useful social institution because they continue to advance our individual and societal
standard of living.
Quantity Demanded and Quantity Supplied
This is one place where everything you have read, heard, or seen in the media will con-
fuse you because economists use these terms very differently from the way they are used
outside of economics. Economists insist on highlighting the difference between demand
and quantity demanded. If you look carefully at the paragraph that is two above, paying
supply and demand The name of the most important model in all of economics.
price The amount of money that must be paid for a unit of output.
output The good or service produced for sale.
market Any mechanism by which buyers and sellers negotiate an exchange.
consumers People in a market who want to exchange money for goods or services.
producers People in a market who want to exchange goods or services for money.
equilibrium price The price at which no consumers wish they could have purchased more goods at the price; no producers wish that they could have sold more.
equilibrium quantity The amount of output exchanged at the equi- librium price.
quantity demanded The amount consum- ers are willing and able to buy at a particular price during a particular period of time.
Supply and Demand Defined 21
particular attention to the last sentence, the quantity demanded is how much consum-
ers are willing and able to buy at a particular price during a particular period of time.
Demand, on the other hand, shows how much consumers want to buy at all prices. Demand
is a relationship, whereas quantity demanded is a particular point on that relationship. An
identical distinction exists with supply. Quantity supplied is how much firms are willing and able to sell at a particular price during a particular period of time, whereas supply
alone shows how much firms want to sell at all prices.
quantity supplied Amount firms are will- ing and able to sell at a particular price during a particular period of time.
Markets exist whether the underlying economic sys-
tem is capitalist, socialist, or communist. A capi-
talist economy is so-named because in addition to
there being free markets in most goods and services,
there are free markets in financial capital. Whether
people have money to lend because they have saved
it or inherited it, in a capitalist system they control
it. The profit that the capital generates goes to the
owner of the capital. In a communist system, capital
and the profit that it generates are controlled by a
government authority. The government authority de-
cides how the money is used. In a socialist system,
a significant part of the profit generated by financial
capital goes to the government in the form of taxes.
The government then uses the tax money to counter
the wealth impacts of the distribution of profit. No
country is completely capitalist and few (possibly
North Korea) are completely communist. Each coun-
try exists along a spectrum. The politically conser-
vative Heritage Foundation, in conjunction with the
Wall Street Journal, developed an Index of Economic
Freedom that measures the degree to which coun-
tries have free capital flows, minimal government
regulation of business and labor, minimal limits on
trade, and a legal system conducive to business.
Selected countries are listed in the table below.
It is also worth noting that this is the first, but cer-
tainly not the last time that this text will use a source
with a political agenda. That usage, however, will be
balanced.
capitalist economy An economic system where markets, in particular markets for financial resources, are free.
socialist economy An economic system where a significant part (but not all) of the decisions regarding the allocation of financial resources is made by a governmental authority.
communist economy An economic system where governmental authorities determine the allocation, use, and distribution of financial resources.
M A R K E T S B O X
Index of Economic Freedom Table
Top 20 Bottom 20 Other Countries and their Rank
Hong Kong Ecuador South Korea 27 Singapore Bolivia Austria 28
New Zealand Solomon Islands Norway 32
Switzerland Ukraine Colombia 33
Australia Congo, Dem. Rep. Israel 35
Canada Chad Uruguay 41
Chile Kiribati Spain 43
Ireland Uzbekistan Belgium 44
Estonia Timor-Leste Peru 49
United Kingdom Central African Republic Mexico 62
United States Argentina France 75
Denmark Equatorial Guinea Saudi Arabia 78
Lithuania Iran Italy 86
Taiwan Congo, Republic of Brazil 122
Mauritius Eritrea India 123
Netherlands Turkmenistan Greece 138
Germany Zimbabwe China 144
Bahrain Venezuela Russia 153
Luxembourg Cuba
Iceland Korea, North
Source: www.heritage.org/index/Ranking
22 Chapter 2 Supply and Demand
Ceteris Paribus
Social scientists in general, and economists in particular, believe in something called the “sci-
entific method,” one aspect of which suggests that to isolate the effect of one variable on
another you have to separate out the impacts of everything else. Unlike chemistry or biology,
though, economists are rarely able to put their subjects (people) into a lab and experiment
on them. For instance, economists cannot create a capitalist system in one area of town, a
socialist system in another, and a communist system in a third so as to test which economic
system serves society best. Economists have to observe in the context of their models. So, even
though life does not progress one change at a time, our model allows us to focus on one change
at a time. This brings us to the Latin most commonly used by economists: ceteris paribus, which means “other things equal.” This phrase, when added to a definition or a conclusion,
means that though there are many other factors that could affect a phenomenon in real life, this
is focusing on the impact of one while holding those other factors constant.
Demand and Supply
For our demand curve we want to know what the relationship is between price and quantity
demanded. Determining this relationship is difficult because the relationship depends on such
things as whether people are rich or poor, whether the good is in or out of fashion, or how
much rival goods cost. To get around this we assume we are looking at the relationship be-
tween price and quantity demanded in such a way that none of the other things are changing.
Thus, demand is the relationship between price and quantity demanded, ceteris paribus. Precisely the same logic applies to supply. There are many things upon which the relation-
ship between price and quantity supplied depends: how much workers must be paid, the cost
of materials, or the availability of technology. Again we assume these things do not change, so
supply is the relationship between price and quantity supplied, ceteris paribus.
The Supply and Demand Model
Demand
We have put it off long enough—let’s look at the model. To plot a demand curve, let’s first
tell ourselves a reasonable story and put the relevant information in a table. In many city
downtown areas, there are vendors selling food and drink from stands. To simplify the issue,
let’s suppose we are looking at the market for bottled orange juice sold by these street vendors
and that the customers buy the bottles of orange juice from those vendors and consume the
juice throughout the day in their downtown offices. There are obviously lots of things that will
affect the supply and demand for these bottles of orange juice, but for the moment we are
going to assume they are held constant.
We start this inquiry with the price of a bottle of orange juice at zero and ask how many
will be wanted. Probably a lot, but not as many as you might think. People get tired of drink-
ing the same thing over and over again, and even if they were going to get a bunch to save for
later, they still have to carry it to their offices. Suppose, for mathematical simplicity, that there
are only 10,000 people in this downtown area and that at a price of zero each person wants
only five bottles per day. That would mean that, at a price of zero, there would be a quantity
demanded of 50,000 drinks.
Suppose the price were raised to 50 cents per bottle. Each individual would have to weigh
whether they wanted a bottle of orange juice or 50 cents. Let’s say the average person decides
to buy only four per day at that price. As a result of the price increase, the quantity demanded
for the market would be 40,000. Suppose another 50-cent increase would decrease the amount
ceteris paribus Latin for “other things equal.”
demand The relationship between price and quantity demanded, ceteris paribus.
supply The relationship between price and quantity supplied, ceteris paribus.
The Supply and Demand Model 23
wanted by the average person to three. Quantity de-
manded in the market would fall to 30,000. Without
belaboring the point further, price increases would
decrease the amount the average person would buy
until at $2 per bottle the average person wanted only
one, and at $2.50 the average person would buy none.
Table 2.1 depicts the options we have just suggested
in the form of what is called a demand schedule. A demand schedule presents the price and quantity de-
manded for a good in a tabular form.
This information can also be displayed on a graph.
As a matter of fact, that is how you will nearly always
see it from now on. Figure 2.1 is a graph of a demand curve. Note that the vertical axis is
labeled P for price per unit and the horizontal axis is labeled Q/t for quantity per unit time.
You probably anticipated the first label, but the second may require a short explanation. Quan-
tity per unit time is that number of orange juice bottles that the 10,000 people will want per
day. There always has to be a time reference for quantities demanded and for quantities sup-
plied. The dark dots represent the points from our demand schedule, and when we connect the
dots we have a demand curve.
Supply
Now, using the same example, let’s think about the sellers of orange juice bottles. Sup-
pose for the sake of this example that there are 10 completely independent street vendors
selling orange juice bottles, and that there aren’t any brand names of the vendors or for
the orange juice. Now ask yourself how many orange juice bottles a business would at-
tempt to sell at various prices. Obviously they would not want to give any away, so at a
price of zero, quantity supplied would be zero. Even at a very low price, such as 50 cents
a bottle, they might not want to sell any because the cost to the vendor of either buying or
filling the bottle might be more than the 50 cents per bottle they would get. As prices go
up, they would probably be willing to put forth more and more effort to make more and
more money. For the sake of this example, we will assume that at $1.00 per bottle each
business will sell a bottle to anyone who would come up to them but won’t go out of their
way to sell more than that. They will station themselves where there are a lot of people
and simply sell to them.
Suppose that as the price people are willing to pay rises, the vendors hire people to hawk
the orange juice bottles to drum up sales. Let’s say that at $1.50 they will each want to hire
enough hawkers to sell 2,000 bottles per day and that at $2.00, they will hire enough to sell
demand schedule Presentation, in tabular form, of the price and quantity demanded for a good.
TABLE 2.1 Demand schedule for
bottles of orange juice.
Price
($)
Individual Quantity
Demanded
Market Quantity Demanded
(10,000 people)*
0 5 50,000
0.50 4 40,000
1.00 3 30,000
1.50 2 20,000
2.00 1 10,000
2.50 0 0
*This is ceteris paribus at work, holding the number and type of people constant.
$2.50
$0.50
0
$1.00
$1.50
$2.00
10 20 30 40 500
Demand
P
Q/t
FIGURE 2.1 The demand curve.
24 Chapter 2 Supply and Demand
3,000 per day. Finally, suppose that at $2.50 per bottle, they will hire enough hawkers to sell
4,000 per day. Table 2.2 displays this information in what is called a supply schedule, which presents in tabular form the price and quantity supplied for a good.
This information can also be displayed on a graph. Figure 2.2 shows the supply curve
with the axes labeled the same as Figure 2.1: price and quantity over time. Here the dark
dots represent the points from our supply schedule. When we connect the dots we have a
supply curve.
Equilibrium
Table 2.3 combines the supply schedule and
the demand schedule into a single schedule,
and Figure 2.3 combines the supply curve
and demand curve on one diagram. They
both show us that at prices below $1.50 con-
sumers want more orange juice bottles than
vendors are willing to provide and that at
prices above $1.50 they want fewer bottles
than vendors are willing to sell. Where the
supply and demand curves cross, the amount
that consumers want to buy and the amount
firms want to sell are the same. This is called
an equilibrium.
supply schedule Presentation, in tabular form, of the price and quantity supplied for a good.
equilibrium The point where the amount that consum- ers want to buy and the amount firms want to sell are the same. This occurs where the supply curve and the demand curve cross.
TABLE 2.2 Supply schedule for bottles of orange juice.
Price
($)
One Vendor’s
Quantity Supplied
The Market’s Quantity
Supplied (all 10 concession vendors)
0 0 0
0.50 0 0
1.00 1,000 10,000
1.50 2,000 20,000
2.00 3,000 30,000
2.50 4,000 40,000
TABLE 2.3 Supply and demand schedules with shortage and surplus.
Price
($)
Individual
Quantity
Demanded
Market
Quantity
Demanded
One Vendor’s
Quantity
Supplied
Market
Quantity
Supplied
Shortage
(excess
demand)
Surplus
(excess
supply)
0 5 50,000 0 0 50,000
0.50 4 40,000 0 0 40,000
1.00 3 30,000 1,000 10,000 20,000
1.50 2 20,000 2,000 20,000
2.00 1 10,000 3,000 30,000 20,000
2.50 0 0 4,000 40,000 40,000
Supply $2.50
$0.50
0
$1.00
$1.50
$2.00
10 20 30 40 500
P
Q/t
FIGURE 2.2 The supply curve.
FIGURE 2.3 The supply and demand model and equilibrium price and quantity.
Supply
Demand
Equilibrium
Equilibrium quantity
Equilibrium price
$2.50
$0.50
0
$1.00
$1.50
$2.00
10 20 30 40 500
P
Q/t
All about Demand 25
Shortages and Surpluses
When the price is too low we have a shortage. Firms do not want to sell as many goods as consumers want to buy. When the price is too high we have a surplus. Firms want to sell more goods than consumers want to buy.
Imagine that the vendors start to run out of bottled orange juice. There is an obvious short-
age. According to the model of supply and demand, this will have occurred because the price
was too low. With long lines of people wanting to buy bottles in front of them, the vendors
will see that in the face of a shortage, or excess demand, they can raise the price and still sell their product. The opposite will occur if there is a surplus, or excess supply. If the price is too high, the vendors will want to sell more bottles than consumers will want. Instead of long
lines, there will be excess inventory and firms will see that in the face of a surplus they should
lower the price to get rid of it.
With self-interested sellers, shortages and surpluses are short-lived. Firms react to changes
in inventories by changing the price they charge. They react to shortages with price increases
and surpluses with price cuts, and as a result either situation is temporary.
All about Demand
The Law of Demand
We know from this chapter’s section on definitions that demand is the relationship between
price and quantity demanded, ceteris paribus, and we followed a reasonably believable story
about orange juice vendors. That story implied that there was a negative relationship between
price and quantity demanded. Because of the relationship, the demand curve we drew was
downward sloping. The negative relationship between price and quantity demanded is called
the law of demand. This “law” is not really a law but is common sense applied to the following rather constant observation: When prices are higher, we tend to buy less.
Why Does the Law of Demand Make Sense?
Why do we see this negative relationship so often? There are three distinct reasons. First,
when you go to the store and find that the good you want is highly priced, you search for an
acceptable substitute that costs less. If you buy something else, you are substituting another
good for the one that you originally wanted because its price was too high. Economists say that
this is a substitution effect. You buy less of what you originally wanted when its price is high because you use something else instead.
Second, suppose you cannot find an acceptable substitute. In this case, you are stuck buy-
ing less of the good because you cannot afford as much. What has happened is that your real
buying power has fallen (even though the money you have in your wallet is the same) because
prices have risen. This does not necessarily work for all goods (especially basic necessities
like water), but generally economists call this a real-balances effect because when a price increases, it decreases your buying power, causing you to buy less.
The third reason we see a negative relationship between price and quantity demanded
can be explained with either great detail, or a useful, though not always completely accu-
rate, shortcut. You are in this course and your professor has chosen this book because you
do not need the great detail, so you will get the shortcut. It starts from the premise that
what you are willing to pay for something depends on how many you have recently had.
With this in mind, consider the following very silly but illustrative example. Suppose
I give you $10 and I want to know how much you would pay for pizza slices at lunch.
Suppose further that as part of this experiment you are given truth serum so you have
shortage The condition where firms do not want to sell as many goods as con- sumers want to buy.
surplus The condition where firms want to sell more goods than consumers want to buy.
excess demand Another term for shortage.
excess supply Another term for surplus.
law of demand The statement that the relationship between price and quantity demanded is a negative or inverse one.
substitution effect Purchase of less of a product than origi- nally wanted when its price is high because a lower priced product is available.
real-balances effect When a price increases, your buying power is decreased, causing you to buy less.
26 Chapter 2 Supply and Demand
to honestly tell me two things: (1) on a scale from 1 to 10, how happy your belly is; and
(2) how much you valued each slice in terms of money. Starting hungry at a belly happiness
index of 1, suppose that you eat one slice and tell me that it was worth $3 and rated a 5 on the
belly happiness index. Now you eat another slice and tell me it wasn’t worth as much because
you were not as hungry, so you say it was worth $2 and your belly happiness index rose to 8.
You eat the third slice and tell me that, because you were somewhat full at the time you ate the
third slice, your belly happiness index only rose to 9 and the slice was only worth $1.
In this scenario, each time you consume a slice, the value you place on the next slice falls.
This means that the value you place on a good depends on how many you have already had.
Economists refer to the amount of extra happiness1 that people get from an additional unit of
consumption as marginal utility and say that it decreases as you consume more. This law of diminishing marginal utility suggests that the amount of additional happiness that you get from an additional unit of consumption falls with each additional unit. Stated more simply, because
each additional slice increases your happiness less than the previous slice, the most you would
be willing to pay for each additional slice is less than before. The third reason why a demand
curve is downward sloping, then, is that for most goods there is diminishing marginal utility.
It is often helpful to view the demand curve as more than a way of finding how much of a
good a person wants at a particular price. In addition, you can use it to find out how much a
person is “willing to pay” for a particular amount of the good. Whenever you come across this
phrase, think “the most they would be willing to pay.” Of course you would always want to pay
less, but looked at this way the demand curve also represents the most you would be willing
to pay for different amounts of the good, ceteris paribus.
All about Supply
The Law of Supply
We also know from our section on definitions that supply is the relationship between price and
quantity supplied, ceteris paribus, and we followed a story about how many orange juice bottles
a vendor would want to sell in a city. That story implied that there was a positive relationship
between price and quantity supplied. Because of that the supply curve we drew was upward
sloping. The positive relationship between price and quantity supplied is called the law of supply. Like all other laws in economics, this one isn’t a law either but is more like a hypoth- esis that is supported by nearly all the evidence nearly all the time. Stated more simply: When
prices are higher, firms tend to want to sell more.
Why Does the Law of Supply Make Sense?
Although believable intuitively, the technical reason that a supply curve is upward sloping
takes up much of Chapters 4 and 5. What follows is a simplified (though probably not simple)
explanation that will be repeated and expanded in Chapters 4 and 5.
Suppose the downtown area where the vendors are selling orange juice bottles has varying
areas of population density. It is relatively easy to sell where there are more people, like at a
subway exit, and progressively more difficult to sell as you get away from those population
centers. As a result, even if vendors hire hawkers to go out and sell orange juice bottles, it is
marginal utility The amount of extra happiness that people get from an additional unit of consumption.
law of diminishing
marginal utility The amount of ad- ditional happiness that you get from an additional unit of con- sumption falls with each additional unit.
law of supply The statement that there is a positive relationship between price and quantity supplied.
1 This is why this discussion has been an intellectual shortcut. Most economists do not believe that you can measure happiness
in the same way that you measure distance or temperature. This means that though you can say you are happier in one circum-
stance than in another, you cannot say how much happier you are. All is not lost, though, because we can get the same idea
through the concept of indifference. The reason no one-semester course textbooks explain the downward-sloping nature of
demand using the concept of indifference is that it takes too long and gets you no further in your understanding than the last
two paragraphs have. Thus the shortcut of marginal utility nets the same result in a lot less time and is judged by most teachers
of one-semester economics courses as useful.
Determinants of Demand 27
going to get harder and harder to sell a lot when they spread out. Even though it is harder to
sell, as the price rises, it is still possible and even likely that it would be worth it for vendors
to hire hawkers. So even when the last hawkers sent out sell far fewer bottles than the ones
sent out originally, the vendors hire them because they make money doing so. So when the
price is low, the high-cost sales methods aren’t worth it, and when the price is high, they are
worth it. There might even be a price high enough that the vendors would be willing to deliver
individual bottles to individual offices. While this would be very inefficient relative to simply
standing at a subway exit, if the vendors have sold all they can this way and the price is high
enough, it could still be profitable to the vendors to do so.
What this means, and what Chapters 4 and 5 attempt to demonstrate in detail, is that the
reason the supply curve is upward sloping is that it costs more per unit to sell more units. In this
example, the orange juice bottles were not any more expensive, but the cost of hawking them
or transporting them was higher when we sold to more remote areas.
In addition, when firms decide which good to produce, they will want to produce the one
that makes them the most money. Suppose our orange juice vendors have only so much space
in the coolers in their carts. In this case, the vendors do not care whether they sell orange juice
or water; they simply want to make a profit. If consumers are willing to pay more for bottled
water, the vendors will stock their carts with bottled water. What this means is that relative to
water, when orange juice prices are higher, the vendor is willing to take water out of the cart and
replace it with orange juice. When orange juice prices are lower, the vendor does the opposite.
Determinants of Demand
In the previous section we talked about holding other things constant. Now is the time to con-
sider what happens when things change. As we alluded to in the section on definitions, there
are many things that affect the demand relationship for a good. These include how much the
good is liked, how much income people have, how much other goods cost, the population of
potential buyers, and the expectations of the price in the future. These variables will change
how much of the good is wanted as well as how much someone is willing to pay for it. Again
“willing to pay” is shorthand for the most someone is willing to pay. If people want more of the
good, this also translates into willingness to pay prices that they would not have paid before.
Taste
Determinant of whether the good is in fashion or whether con-
ditions are right for many people to want the good.
Income
Inferior goods: You buy less of a good when you have more
income.
Normal goods: You buy more of a good when you have more
income.
Price of other goods
Substitute: Goods used instead of one another.
Complement: Goods that are used together.
Population of potential buyers
The number of people potentially interested in a product.
Expected price
The price that you expect will exist in the future.
Excise taxes
A per unit or percentage tax on a good or service that must be
paid by consumers.
Subsidies
A per unit or percentage subsidy for a good or service that is
granted to consumers.
D E T E R M I N A N T S O F D E M A N D
28 Chapter 2 Supply and Demand
Taste
Taste is the word that economists use to describe whether the good is in fashion or whether
conditions are right for many people to want the good. A high level of taste means that the
good is in fashion or highly desired; a low level of taste means that few people want it.
It works on demand in an obvious way: The more people like the good (the higher the taste
for the good), the more they are willing to pay higher prices for any particular amount and
the more of it they will want. Going back to the orange juice example, the taste for orange
juice would rise during cold and flu season as people were trying to boost their immune
systems believing that orange juice would aid in keeping viruses at bay.
Income
For most goods, an increase in income will lead to an increase in the amount that consumers
want. In cases where you buy more of a good when you have more income, economists call
the good normal. If the good is normal and your income rises, you are able to buy more and
you want to buy more of the good and you are willing to pay more for it.
How much income people have to buy the good also matters but not always in a positive
way. Consider a couple of staples in the college diet, instant ramen noodles and macaroni and
cheese. No matter which of these you eat, you can fill your belly for under a dollar. Now ask
yourself how many pouches, boxes, or bags of this stuff you would buy if your grandmother
died and left you $25,000. Answer: not many, particularly if you have been eating them
because you could not afford other things to eat. This example shows you that it is not always
the case that the more you make, the more you buy. In cases where you buy less of a good
when you have more income, economists call the good inferior. If the good is inferior and
your income rises, you are able to buy more, but you want to buy less of the good and you
will need lower prices to induce you to buy any particular quantity.
Returning to our orange juice example, if people consume more bottles of orange juice as
their incomes rise, then orange juice is a normal good. If they consume fewer bottles of orange
juice when their incomes rise, it is an inferior good.
Price of Other Goods
Similarly, there is no straightforward answer to the question of how you will change your
willingness to purchase a good if the price of another good rises. It is possible that if the price
of a good like Pepsi rises, you will switch to Coke. In that case, you would be willing to pay
more for Coke and want to buy more of it. Likewise, if the price of hot dogs increases, you will
decide to buy fewer of them. Since hot dog buns have little good use other than to surround hot
dogs, you will need fewer of these too. Economists say that goods used instead of one another
(e.g., Coke and Pepsi) are substitutes and that goods that are used together (e.g., hot dogs and
hot dog buns) are complements.
Examples of substitutes and complements abound. Peanut butter and jelly are often consid-
ered complements because they are typically used together to produce sandwiches. Pepperoni
and sausage might be considered substitutes because they are alternative meats for a pizza.
To confuse matters, though, goods can be substitutes to some and complements to others. My
father-in-law considers peanut butter and jelly to be equally good bagel spreads, so to him they
are substitutes. The Meat Lover’s Pizza by Pizza Hut includes both sausage and pepperoni, so
to people who like this pizza the two may be complements.
Once again, returning to orange juice bottles: Orange juice and grapefruit juice are likely
substitutes for one another while orange juice and vodka are likely to be complements because
people (of legal drinking age) may mix them together to form a “screwdriver.”
Determinants of Demand 29
Population of Potential Buyers
The number of people potentially interested in a product will clearly have an impact on the
demand for the product. So, as the downtown population rises, more are potentially interested
in buying bottles of orange juice. Clearly the larger the city, the more people come downtown
to work and shop, and the more people will buy orange juice. Or, for instance, in the dark ages
of the 1970s, when there were only a few computer-literate people, only a few people were
interested in buying computers. Then schoolchildren, and especially college students, began
to rely on computers for their schoolwork, creating a group of potentially interested customers
when they graduated. Economists shorten this concept of the number of people potentially
interested in a product to call it the population.
Expected Price
When the expected price of a good rises, this induces a stock-up effect. Let’s suppose that a
winter freeze destroys a large number of the orange groves. Forward-thinking consumers will
see the impending increase in orange juice prices and be motivated to stock up now before
the price increase takes hold. Similarly, smokers stock up on cigarettes when a tax increase is
expected. Frugal drivers buy gas on Wednesdays, before the nearly universal weekend price
increase. If there is an expectation that an increase in price is imminent, consumers will be
willing to pay more and they will want to buy now rather than later.
Excise Taxes
Sometimes governments want to discourage the consumption of a good and will place a tax
on that good. Such a tax would mean that consumers would have to pay more per unit than
they otherwise would have to and as a result would decrease the amount that they wished to
purchase. Suppose that a city wanted to encourage the recycling of plastic bottles and that
consumers had to pay $1 extra per orange juice bottle that they purchased. That would mean
that the new demand curve would be $1 lower at every quantity than the old one.
Subsidies
Sometimes governments want to encourage the consumption of a good and will create a sub-
sidy for that good. Such a subsidy would mean that consumers would have to pay less per unit
than they otherwise would have to and as a result would increase the amount that they wished
to purchase. Suppose that a city in Florida wanted its citizens to be seen by tourists drinking
Florida orange juice. To encourage consumers to do so it would allow them to pay $1 less per
orange juice bottle that they purchased. That would mean that the new demand curve would
be $1 higher at every quantity than the old one.
The Effect of Changes in the Determinants of Demand on the Supply and Demand Model
Tables 2.4 and 2.5 summarize how the determinants of demand work on the supply and
demand diagram. Table 2.4 indicates the impact of increases in the variables listed above,
whereas Table 2.5 indicates the impact of decreases in those variables. The final column of
each table refers to the figure corresponding to the change. Figure 2.4 shows the impact of
an increase in demand while Figure 2.5 shows the impact of a decrease in demand. In each
figure, the original supply and demand curves are shown in black and the new demand curve
is shown in the gold color. The original equilibrium is shown with the big black dot, and the
new equilibrium is shown with the big gold-colored dot.
30 Chapter 2 Supply and Demand
TABLE 2.4 Movements in the demand curve: increases in the values of the determinants.
An Increase in Causes Demand to
Causes the Demand
Curve to Move to the
And Is Shown
in Figure
Taste Increase Right 2.4
Income, normal good Increase Right 2.4
Income, inferior good Decrease Left 2.5
Price of other goods, complement Decrease Left 2.5
Price of other goods, substitute Increase Right 2.4
Population Increase Right 2.4
Expected future price Increase Right 2.4
Excise Tax Decrease Left 2.5
Subsidy Increase Right 2.4
TABLE 2.5 Movements in the demand curve: decreases in the values of the determinants.
A Decrease in Causes Demand to
Causes the Demand
Curve to Move to the
And Is Shown
in Figure
Taste Decrease Left 2.5
Income, normal good Decrease Left 2.5
Income, inferior good Increase Right 2.4
Price of other goods, complement Increase Right 2.4
Price of other goods, substitute Decrease Left 2.5
Population Decrease Left 2.5
Expected future price Decrease Left 2.5
Excise Tax Increase Right 2.4
Subsidy Decrease Left 2.5
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
New demand
Supply
Q/t
FIGURE 2.4 The effect of an increase in demand on the supply and demand model.
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
New demand
Supply
Q/t
FIGURE 2.5 The effect of a decrease in demand on the supply and demand model.
Tables 2.4 and 2.5 as they apply to Figures 2.4 and 2.5 may seduce you into thinking the
best way of using this information is to memorize it. As the verb seduce suggests, that is a very
bad learning strategy. The best use of these tables and figures is to use them as a check against
your economic intuition. As an example, suppose you are tasked with drawing a supply and
demand diagram for hot dog buns showing the impact of an increase in the price of hot dogs.
First, you would recognize hot dogs and hot dog buns as complements and that when the price
Determinants of Supply 31
of a complement rises, you will consume fewer hot dogs (because the demand for hot dogs is
downward sloping) and so you would need fewer hot dog buns. Second, you would recognize
that as a decrease in the demand for hot dog buns. Third, you would draw a supply and demand
diagram for hot dog buns showing a leftward movement in demand for hot dog buns because a
decrease in demand shows up as demand shifting to the left. You would then check that against
the information in Table 2.4 (because it is an increase in the price of hot dogs impacting hot
dog buns); look down to the “Price of other goods, complement” row then across to see that
your intuition that demand should move left was correct and that the drawing of a figure like
Figure 2.5 is correct.
Determinants of Supply
Again, the definitions section alluded to the types of things that can change the supply re-
lationship. They include changes in the price of inputs, technology, price of other potential
outputs, the number of sellers, and expected future price. Again we are assuming that other
things are held constant.
Price of Inputs
The price of inputs refers to the costs to firms of all the things necessary to produce output.
If an input is used to make a product, then the input costs money and therefore has a price
even though its name may change. Obvious examples of inputs are raw material, labor,
and equipment. The price of a raw material is simply its price. (Though this sounds like a
circular definition, think about our orange juice bottles example. The bottles, the orange
juice itself, and coolers to keep the bottles in each have a price.) The price of labor is the
wage + benefit cost to employers associated with hiring a person. (Everything that employ-
ers pay for that is not paid directly to workers—health insurance, unemployment insurance,
worker’s compensation, and so on—is defined as benefits.) The price of equipment can
affect supply, but just as often, what matters is the rental cost of leased equipment or the
interest + depreciation rates that must be paid on the equipment bought with borrowed
money. (Interest is the price of borrowed money, and depreciation is the rate at which
machines lose value owing to wear and tear.)
Price of inputs
Costs to firms of all the things necessary to produce output.
Technology
The ability to turn input into output.
Price of other potential output
When firms have to decide which good to produce, they will want
to produce the one that makes them the most money.
Number of sellers
The number of firms competing in the same market.
Expected future price
Firms want to hold back sales to wait for higher prices and
unload inventory before prices fall.
Excise taxes
A per unit or percentage tax on a good or service that must be
paid by producers.
Subsidies
A per unit or percentage subsidy for a good or service that is
granted to producers.
D E T E R M I N A N T S O F S U P P L Y
32 Chapter 2 Supply and Demand
Technology
Within economics, the word technology refers to the ability to turn input into output. In our
previous example of selling bottles of orange juice in a city, a technological advance that
would allow vendors to keep the bottles fresh without ice or refrigeration would reduce costs.
This technology would increase output and lower costs. As we are using it here, the technol-
ogy variable can change because of increases in the ability of employees to work harder and
smarter, or it can change because new devices make employees more efficient.
Another example of how increases in technology change markets can be seen in the very
illegal term-paper business. If you wanted to buy term papers in the 1960s, you would have
had to pay people to go to the library to look stuff up in card catalogs of alphabetized index
cards and indices of periodicals to find source material. Because access to copy machines was
limited, they would have then had to read the material in the library. Finally, they would have
had to type the paper on a typewriter, and they would have been able to fix mistakes only with
a pasty liquid called Wite-Out®. Paying people to do this would have been expensive.
In the 1970s, all the steps were the same except copy machines would have allowed the
people you hired to read source material in their homes. In the 1980s, primitive computers
would have allowed them to gather limited quantities of source material on a computer and to
write the paper using a hard-to-use, not very flexible word processor. By the 1990s, writers
of term papers could look up material on the Internet, print it, read it, and write the paper,
all from the comfort of their own bedrooms. In each of these periods, producers of such con-
traband had to find a way to sell their papers. Often informal networks had to be created and
payment had to be in cash. Today, you can go to any number of term-paper sites on the Internet
and download a paper by simply entering a credit card number. You, of course, would never do
this because your college can easily catch you and throw you out of school. But because it is
easier to produce papers in less time than used to be the case, sellers of term papers can charge
lower prices and produce more papers.
Price of Other Potential Outputs
The price of other potential outputs refers to the same idea that we referenced when indicating
why the supply curve is upward sloping, except now we focus on what happens to the exist-
ing supply curve when the price of the other good changes. As we said, vendors have only so
much space in the coolers in their carts. During a hot summer’s day they may discover that
they sell out of bottles of water and have plenty of leftover bottles of orange juice. If consum-
ers are willing to pay more for bottled water, the vendors will stock their carts with bottled
water. They will stock those carts with the combination of water and orange juice that makes
them the most money. As the price of water rises, the supply of orange juice will fall because
vendors want to stock water.
Number of Sellers
The number of sellers, that is, the number of firms competing in the same market, is important
because the more firms there are, the greater is total market production. Using the orange
juice example, we assumed that there were 10 different vendors. If these vendors are all mak-
ing a significant profit, it is likely that other entrepreneurs will want to set up their competing
stands. This raises total market supply. Similarly, if there were losses, some of those vendors
may quit the business, reducing total market supply.
Expected Price
The expected future price should sound familiar because it is also something that will change
demand. In the context of supply, it refers to a firm’s desire to hold back sales to wait for
Determinants of Supply 33
higher prices and its desire to sell its goods and thus lower its inventory before prices fall.
Firms want to sell their goods when they can make the most money regardless of when that
time is. A warning that a hurricane is coming will bid up the current price of gas-powered
generators because firms will want to retain those they have in stock to sell at high prices after
the hurricane hits. Conversely, if firms figure that the goods they hold will be out of fashion
soon, they will want to get rid of them now.
Let’s return to the example of the freeze that decimated the orange groves. Not only will
buyers of orange juice be motivated to stock up to avoid the increase in price, sellers will know
that a price increase is coming and will want to hold on to what they have. As a result, the ex-
pected future price not only changes demand for a good, it changes supply as well. Of course,
it also works in the other direction. If a bumper orange crop is expected, orange juice prices
will be expected to fall and those currently holding orange juice will be motivated to sell their
current inventories before the price falls too much.
Excise Taxes
As we indicated in the context of demand, sometimes a government wants to discourage the
consumption of a good. In so doing it can tax producers or consumers. If it wants the tax to be
collected on the production side, it will place a tax on that good and compel firms to pay the
tax. It should be noted here that it doesn’t matter whether the tax is on the demand side or the
supply side; the impact will be the same and will depend on the Chapter 3 concept of elastic-
ity, not the intention of policy makers. In any event, this tax is modeled by moving the supply
curve vertically higher by the amount of the tax. So a city can encourage recycling of plastic
bottles by charging firms $1 extra per orange juice bottle that they sell. That would mean that
the new supply curve would be $1 higher at every quantity than the old one.
Subsidies
Similarly, subsidies can be applied to the firm producing the good rather than the consumer.
A $1 subsidy would be modeled with the new supply curve $1 lower at every quantity than
the old one.
The Effect of Changes in the Determinants of Supply on the Supply and Demand Model
Tables 2.6 and 2.7 summarize how determinants of supply work on a supply and demand
model. Table 2.6 indicates the impact of increases in the variables listed above, whereas
Table 2.7 indicates the impact of decreases in those variables. It is important to understand
that on the supply side, an increase in supply is shown by a movement to the right in the sup-
ply curve and that a decrease in supply is shown by a movement to the left in the supply
TABLE 2.6 Movements in the supply curve: increases in the values of the determinants.
An Increase in Causes Supply to
Causes the Supply Curve
to Move to the
And Is Shown
in Figure
Price of inputs Decrease Left 2.7
Technology Increase Right 2.6
Price of other potential outputs Decrease Left 2.7
Number of sellers Increase Right 2.6
Expected future price Decrease Left 2.7
Excise Tax Decrease Left 2.7
Subsidy Increase Right 2.6
34 Chapter 2 Supply and Demand
curve. As with Tables 2.4 and 2.5 the final columns of Tables 2.6 and 2.7 refer to the figures
corresponding to the changes. Figure 2.6 shows the impact of an increase in supply while
Figure 2.7 shows the impact of a decrease in supply. Just as it was for Tables 2.4 and 2.5 and
Figures 2.4 and 2.5, the original supply and demand curves are shown in black and the origi-
nal equilibrium is shown with the big black dot. This time the new supply curve is shown in
the gold color with the new equilibrium shown with the big gold-colored dot.
After having read the admonition against memorizing regarding the demand shifts, you
can guess what’s next: Don’t try to memorize Tables 2.6 and 2.7 as they apply to Figures 2.6
and 2.7. The best use of these tables and figures is to use them as a check against your eco-
nomic intuition. As an example, suppose you are tasked with drawing a supply and demand
diagram for gasoline showing the impact of an increase in the price of crude oil. First, you
would recognize that crude oil is the primary input to gasoline so that, when crude oil prices
rise, refineries would have to increase their gasoline prices to make up for those higher pro-
duction costs. Second, you would recognize that as a decrease in the supply of gasoline. Third,
you would draw a supply and demand diagram for gasoline showing a leftward movement in
supply for gasoline because a decrease in supply shows up as supply shifting to the left. You
would then check that against the information in Table 2.6 (because it is an increase in the
price of crude impacting gasoline); look down to the “Price of inputs” row then across to see
that your intuition that supply should move left was correct and that the drawing of a figure
like Figure 2.7 is correct.
TABLE 2.7 Movements in the supply curve: decreases in the values of the determinants.
An Decrease in Causes Supply to
Causes the Supply Curve
to Move to the
And Is Shown
in Figure
Price of inputs Increase Right 2.6
Technology Decrease Left 2.7
Price of other potential outputs Increase Right 2.6
Number of sellers Decrease Left 2.7
Expected price Increase Right 2.6
Excise Tax Increase Right 2.6
Subsidy Decrease Left 2.7
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
New supply
Supply
Q/t
FIGURE 2.6 The effect of an increase in supply on the supply and demand model.
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
New supply
Supply
Q/t
FIGURE 2.7 The effect of a decrease in supply on the supply and demand model.
The Effect of Changes in Price Expectations on the Supply and Demand Model 35
The Effect of Changes in Price Expectations on the Supply and Demand Model
If you have not already noticed, expected future price shows up in both the determinants of
demand and the determinants of supply. This means that if the expected future price changes,
both the supply and demand curves change as well. If the expected future price rises, con-
sumers will want to stock up, thereby increasing demand. Firms, on the other hand, will want
to hold back their inventory to wait for the price increase, thereby decreasing supply. In this
case, we do not know what will happen to equilibrium quantity because the demand shift
will, by itself, increase quantity, whereas the supply shift will, by itself, decrease quantity.
Whether there is a net increase or decrease in equilibrium quantity depends on which shift
is greater. On the other hand, the effect on price is known, and it amounts to a self-fulfilling
prophecy because a credible prediction of a future price increase will lead to an actual current
price increase.
When expected prices rise, we know that the current price will rise, but we do not know
what will happen to the quantity. This is because we do not know whether firms’ desire to
wait for price increases will be stronger than consumers’ desire to stock up. When the price is
expected to fall, firms will want to get rid of their inventory and consumers will want to wait
for the new lower prices.
When expected prices fall we know that the current price will fall, but we again, do not
know what will happen to the quantity. This is because we do not know whether firms’ desire
to unload inventory will be stronger than consumers’ desire to wait for lower prices.
WHY THE NEW EQUILIBRIUM?
When either the supply curve or the demand curve shifts, the equilibrium has to change. If it
does not, one of two things will happen: There will be a shortage where consumers want to
buy more than firms want to sell, or there will be a surplus where firms want to sell more than
consumers want to buy.
To show that this is the case, imagine that there is an increase in the demand for a good
and firms do not increase the price. As shown in Figure 2.8, keeping the price at the old equi-
librium would set up a situation where consumers would want more (40) than firms would
be willing to sell (20). The resulting shortage would not be eliminated unless there was an
increase in the price.
A somewhat different problem would happen if firms did not lower their price in the face
of decreased demand. Figure 2.9 shows that keeping the price at the old equilibrium with a
decrease in demand would set up a situation where consumers would want fewer (0) than
firms would be willing to sell (20). The resulting surplus would not be eliminated unless there
was a decrease in the price.
Just as we needed a new equilibrium when there was a change in demand, we need one
when there is a change in supply. Figure 2.10 shows that keeping the price at the old equilib-
rium when supply increases sets up a situation where consumers want fewer (20) than firms
are willing to sell (40). The resulting surplus will not be eliminated unless there is a decrease
in the price.
Finally, if firms do not raise their prices in the face of decreased supply, there will be a
shortage. Figure 2.11 shows that keeping the price at the old equilibrium in the face of de-
creased supply sets up a situation where consumers want more (20) than firms are willing to
sell (0). The resulting shortage will be eliminated unless there is an increase in the price.
Kick It Up a Notch
36 Chapter 2 Supply and Demand
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
DemandShortage
New demand
Supply
Q/t
FIGURE 2.8 The shortage that is created when demand increases if price and quantity
do not.
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
Surplus
New demand
Supply
Q/t
FIGURE 2.9 The surplus that is created when demand decreases if price and quantity
do not.
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
Surplus
Supply
New supply
Q/t
FIGURE 2.10 The surplus that is created when supply increases if price and quantity
do not.
$0.50
0
$1.00
$1.50
$2.00
$2.50
P
0 10 20 30 40 50
Demand
Shortage
Supply
New supply
Q/t
FIGURE 2.11 The shortage that is created when supply decreases if price and quantity
do not.
What lesson can you draw from all of this? A change in either the supply or demand curve
will change the price at which the quantity consumers want to buy equals the quantity that
firms want to sell. If the price does not change, either a surplus or a shortage will ensue.
There are circumstances when a new equilibrium will not be achieved. For instance, price gouging is the name given to the situation in which a rapid increase in demand is followed by a rapid increase in price. When demand increases, firms do not have to raise prices to cover costs;
they raise prices because they can. Laws preventing price gouging are relatively common.
If you sell ice and have a freezerful to sell, in many states you are not allowed to raise the
price of it more than a specified percentage if your community loses electrical power. Econo-
mists call the maximum price allowed by law a price ceiling. Once the price hits that level, it cannot rise further and you have a shortage for that good. Other examples of price ceilings
involve rent control and laws that prevent ticket scalping.
Similarly, equilibrium will not be achieved if there is a price floor. This exists when a price may not fall below a certain legally proscribed level. In that circumstance, there is a surplus of
the good. Examples of this include farm price supports and the existence of the minimum wage.
Detailed descriptions of the effects of price ceilings and floors are left to their applications
in the chapters on rent control, ticket scalping, farm price supports, and the minimum wage.
price gouging The pejorative term applied to the circum- stance when firms raise prices substantially when demand increases unexpectedly.
price ceiling The level above which a price may not rise.
price floor Price below which a commodity may not sell.
Summary 37
Key Terms capitalist economy ceteris paribus
communist economy
consumers
demand
demand schedule
equilibrium
equilibrium price
equilibrium quantity
excess demand
excess supply
law of demand
law of diminishing marginal
utility
law of supply
marginal utility
market
output
price
price ceiling
price floor
price gouging
producers
quantity demanded
quantity supplied
real-balances effect
shortage
socialist economy
substitution effect
supply
supply and demand
supply schedule
surplus
Issues Chapters You Are Ready for Now
International Finance and
Exchange Rates
The Economics of Race and
Sex Discrimination
Quiz Yourself 1. The supply and demand model examines how prices and quantities are determined a. in markets.
b. by governments.
c. by churches.
d. by monopolists.
2. A change in the price of eggs will impact
a. the demand for eggs.
b. the supply of eggs.
c. the quantity demanded and quantity supplied of eggs but neither demand nor supply.
d. both the supply and demand for eggs.
3. When an economics student draws a supply and demand diagram to model an increase in
the income, she is assuming this change happens
a. semper fidelis.
b. ceteris paribus.
c. ipso facto.
d. de facto.
Summary The supply and demand model is the single most important model in economics. More than
half the issues that you deal with in the latter part of this book will rely on your ability to put an
economics problem into the context of this model. In the course of this chapter we explained the
supply and demand model by providing all of the language up front. We explained both supply
and demand in isolation and then put them together in the form of a coherent model. We then
talked about what variables might change demand and then which ones might change supply.
We showed that prices and quantities sold would have to change to maintain an equilibrium.
38 Chapter 2 Supply and Demand
4. If the supply and demand curves cross at a price of $2, at any price above that there will be
a. an equilibrium.
b. a surplus.
c. a shortage.
d. a crisis.
5. If the supply and demand curves cross at a quantity of 100, then the price necessary to get
firms to sell more than that will have to be equilibrium.
a. above
b. at
c. below
d. within 10 percent either way of
6. An increase in which of the following determinants of demand will have an ambiguous
(uncertain) effect on price?
a. Taste
b. Price of a complement
c. Income
d. Price of a substitute
7. Which of the following will impact both supply and demand?
a. A change in price
b. A change in quantity
c. A change in expected future price
d. A change in income
8. An increase in the income of consumers will cause the
a. supply of all goods to rise.
b. demand for all goods to rise.
c. supply of all goods to fall.
d. the demand for some goods to rise and for others to fall.
9. Without an increase in price, an increase in demand will lead to
a. a shortage.
b. a surplus.
c. socialism.
d. equilibrium.
10. The underlying reason for the upward-sloping nature of the supply curve is that
a. the production of most goods comes with increasing marginal benefits.
b. the production of most goods comes with increasing marginal costs.
c. the consumption of most goods comes with decreasing marginal utility.
d. the consumption of most goods comes with increasing marginal utility.
11. If Midwestern grain farmers can plant either soybeans or corn on their land with equal
profitability and there is an increase in the price of soybeans, which of the following will
result?
a. A movement to the right in the demand for corn
b. A movement to the left in the demand for corn
c. A movement to the right in the supply of corn
d. A movement to the left in the supply of corn
Summary 39
12. Part of the Patient Protection and Affordable Care Act involved a tax on indoor tanning
that tanning salons are required to collect from tanners and send to the federal govern-
ment. Which of the following would be the predicted result?
a. A movement to the right in the demand for tanning
b. A movement to the left in the demand for tanning
c. A movement to the right in the supply of tanning
d. A movement to the left in the supply of tanning
13. As the baby boom generation (born between 1946 and 1964) ages, which of the following
is a likely outcome?
a. A movement to the left in the demand for nursing home beds
b. A movement to the left in the supply of nursing home beds
c. A movement to the right in the supply of nursing home beds
d. A movement to the right in the demand for nursing home beds
Short Answer Questions
1. Use your own demand for pizza to illustrate the notion of diminishing marginal utility.
Explain why that concept means your demand for pizza-by-the-slice is downward sloping.
2. Suppose you have been given money by your friends and sent to get beverages for a party.
Use your demand for those beverages to illustrate why the concept of the “real balance
effect” will mean your demand is downward sloping.
3. If there is an alteration to the price of a complement to a good, why is that a change
in demand when an alteration in the price of the good itself is a change in the quantity
demanded?
4. If there is an alteration in the price of an input used to produce a good, why is that a
change in supply when an alteration in the price of the good itself is a change in the
quantity supplied?
Think about This Using simple supply and demand analysis, think about the system of allocating human kid-
neys. The law that forbids the sale of human organs, but allows their voluntary donation,
means that there is a bigger shortage of kidneys than there otherwise would be. Does this fact
alter your view of the law forbidding the sale of human organs? How about blood?
Talk about This Are markets always right? List some markets that you think get the production or price of a
good wrong. What do these goods have in common?
40
C H A P T E R T H R E E
The Concept of Elasticity and Consumer and Producer Surplus Learning Objectives
After reading this chapter you should be able to:
LO1 Define elasticity as the responsiveness of
quantity to changes in price, recognize its
importance in economics, and apply the con-
cept to various real-world goods and services.
LO2 Connect the relationship between the
concept of elasticity and the appearance of
the demand curve.
LO3 Illustrate that a market equilibrium provides
both buyers and sellers with benefits. Con-
sumers pay less than they are willing to pay
and producers make a profit. Economists call
the former consumer surplus and the latter,
producer surplus.
LO4 Define deadweight loss as the measure of
inefficiency that exists when prices are too high
or too low and apply this to various policies.
Chapter Outline
Elasticity of Demand
Alternative Ways to Understand Elasticity
More on Elasticity
Consumer and Producer Surplus
Kick It Up a Notch: Deadweight Loss
Summary
We now change gears a bit and reconsider the individual supply and demand curves. Our focus
here is on the ability of consumers and producers to react to price changes with changes in the
amounts they wish to buy or sell. That ability to react, called elasticity, will be very important
to us as we prepare to use the supply and demand model for issues. We will see how differently
shaped demand curves will reflect the degree to which price changes affect quantity.
The last third of the chapter is central in our analysis of several issues. We will see how the
supply and demand model can be used to explain why markets are effective in pleasing both
consumers and producers. Though we know that consumers long for low prices and producers
for high prices, we will see that when a consumer buys something from a producer, both can
be pleased with the outcome. We will also see why the net benefit to society is lower when
prices are not at equilibrium than it would be if equilibrium were at work.
Elasticity of Demand 41
Elasticity of Demand
Intuition
In the previous chapter, we saw that a change in supply or demand changes the equilibrium
price–quantity combination, but we did not discuss which one changes more. For instance, if costs
to a firm go up, it is reasonable to ask whether the firm will pass that price increase on to consum-
ers or be willing to accept lower profits. Exploring this question brings in the concept of elasticity.
If the good is one that you need to survive and that has no good substitutes, or if it is one
that you spend very little money on, the firm may be able to pass on its increased costs to you
in the form of higher prices. On the other hand, if it is a luxury, that is, a good you can do
without, if there are many other things that will serve just as well, or if you already spend a
lot of your income on it and could not afford a price increase, you may buy a lot fewer. In this
case the firm’s profits are eaten up.
Definition of Elasticity and Its Formula
There are many kinds of elasticity. In general, elasticity is the responsiveness of quan- tity to a change in another variable. The two most commonly referred to elasticities are
the price elasticity of demand and the price elasticity of supply. Respectively, these are the responsiveness of quantity demanded to a change in price and the responsiveness of quan-
tity supplied to a change in price. Other elasticities include the income elasticity of demand and the cross-price elasticity of demand. The former measures the responsiveness of quan- tity to changes in income, and the latter measures the responsiveness of quantity to changes
in the price of another good.
The price elasticity of demand is measured by looking at how a percentage change in price
affects the percentage change in quantity demanded. The formula for elasticity is:
Elasticity = %ΔQ
_____ %ΔP
= ΔQ∕Q*
_______ ΔP∕P*
where,
% = percent
Δ = change
P* = price (read as “P star”)
Q* = quantity (Q star)
The other elasticities are similar in that the percentage change in either quantity
demanded or quantity supplied is in the numerator and the percentage change in the price,
income, or other price, is in the denominator. Because the bulk of the issues that deal with
elasticity deal with price elasticity of demand, we focus here on this particular form of the
concept.
From here there are two ways of proceeding: We can explain everything in a great deal of
mathematical detail or not. Guessing that the chorus is singing “not,” we will skip the math.
You will need now to follow the “English” explanations to understand and accept the conclu-
sions about elasticity.
When you use the elasticity of demand formula, you will always get a negative number
for it. For our purposes we will simplify things by ignoring the negative sign. The negative
sign appears because the demand curve is downward sloping, and an increase in price will
therefore cause a decrease in quantity. To illustrate, if a 5 percent increase in price leads to a
elasticity The responsiveness of quantity to a change in another variable.
price elasticity
of demand The responsiveness of quantity demanded to a change in price.
price elasticity
of supply The responsiveness of quantity supplied to a change in price.
income elasticity
of demand The responsiveness of quantity to a change in income.
cross-price elasticity
of demand The responsiveness of quantity of one good to a change in the price of another good.
42 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
1
0
2
3
4
5
6
7
8
9
10
11
12
13
P
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Q/t
D1
FIGURE 3.1 At a given price, a flatter demand curve is more elastic than a steeper one.
1
0
2
3
4
5
6
7
8
9
10
11
12
13
P
0 1 2 3 4 5 6 7 8 9 10 11 12 13
D2
Q/t
FIGURE 3.2 At a given price, a steeper demand curve is more inelastic than a flatter one.
10 percent decrease in quantity, the elasticity fraction is –0.10∕.05. Since the important thing
about elasticity is the value of the fraction itself, it is acceptable and less complicated for us
to ignore the minus sign.
Elasticity Labels
This brings us to an important distinction that will be vital when we look at issues that
hinge on whether demand is elastic or inelastic—for example, whether increasing the tax on
cigarettes leads to decreases in teen smoking. Economists say that demand is elastic when the percentage change in quantity is larger than the percentage change in price and inelastic when the percentage change in quantity is smaller than the percentage change in price.
Looking at the formula, if the computed elasticity is greater than 1, then demand is elastic;
when it is less than 1, then demand is inelastic. When the percentage change in quantity is
the same as the percentage change in price (the computed elasticity is exactly 1), demand is
unitary elastic.
Alternative Ways to Understand Elasticity
To see this more clearly let’s look at it using three different thought processes. First we look at
elasticity using the graph of our demand curve. Then we look at it using only words. Last, we
look at it in terms of how much money is spent on the good.
The Graphical Explanation
We first examine the elasticity phenomenon using graphical skills. Figure 3.1 shows that the flat-
ter the demand curve, the greater the elasticity. This is not to say that slope and elasticity are the
same thing; it just means that slope matters. To see that slope matters look at Figures 3.1 and 3.2.
elastic The circumstance when the percentage change in quantity is larger than the percentage change in price.
inelastic The circumstance when the percentage change in quantity is smaller than the percentage change in price.
unitary elastic The circumstance when the percentage change in quantity is equal to the percentage change in price.
Alternative Ways to Understand Elasticity 43
Though they are in separate diagrams, both
go through the point P = $8, Q = 4. Suppose
you were to ask how much price would
have to rise in order to induce a reduction in
quantity demanded to 3. In Figure 3.1, you
can see that it would take an increase to $9,
whereas in Figure 3.2 it would require an
increase to $12. What that implies is that on
the steeper curve (Figure 3.2) demand is less
elastic and on the flatter one ( Figure 3.1) it
is more elastic. In Figure 3.1, a 12.5 percent
increase in prices results in a 25 percent
reduction in quantity.1 In Figure 3.2 it takes
a 50 percent increase in price to generate a
25 percent decrease in quantity.
Figure 3.3 shows that the higher the
price, the greater the elasticity. The price
increase from 2 to 3 causes a decrease
in quantity from 10 to 9. The same size
increase in price from 8 to 9 causes the same size decrease in quantity from 4 to 3. This is
because the slope of this demand curve is the same at all those points. Looking at the formula
again, we see it is the percentage changes that matter and not just the size of those changes.
Even though the price increases and quantity decreases are the same, the percentage changes
are very different.
From point D to C the percentage change in price from 2 to 3 is a sizable 50 percent
while the percentage change in quantity from 10 to 9 is negligible, only 10 percent. Since the
percentage change in the price is greater than the percentage change in the quantity, demand
is inelastic here (elasticity is low). On the other hand, from point B to A the percentage change
from 8 to 9 is only 12.5 percent, whereas the percentage change in quantity from 4 to 3 is large
(25 percent, visually about 33 percent). As a result, demand here is elastic (elasticity is high).
The Verbal Explanation
Although the graphical explanation of elasticity is highly accurate, if it does not make sense
to you, it is useless. Recall the original definition of elasticity (the reaction of quantity to
a change in price). If you really need a product because there are no good substitutes (like
insulin to a diabetic), you will hardly change the amount you buy when the price changes.
Thus there is little, if any, reaction of quantity to changes in price. The demand curve for a
good you “need” is going to be rather steep. If the good is a luxury item, you are more likely to
eliminate it from your budget if it becomes overly expensive. In this case, there is a substantial
reaction of quantity to a change in price. The demand curve for a luxury is likely to be flatter.
In addition, price changes for goods that take up little of your income (like drinking water)
are not likely to lead to big quantity changes. This is because even if their price increases
greatly, you can easily afford those price increases. Goods that take up a significant portion of
your income are more likely to have elastic demand because you are less able to afford large
price increases. In this case, goods with low prices are likely to have inelastic demand and
goods with high prices are likely to have elastic demand.
1
0
2
3
4
5
6
7
8
9
10
11
12
13
P
0 1 2 3 4 5 6 7 8 9 10 11 12 13
A
B
C
D
Q/t
Demand
FIGURE 3.3 The higher the price,
the greater the elasticity.
1 A price increase from 8 to 9 is a 12.5 percent increase because it is the fraction 1∕8. It is a 25 percent decrease in quantity
because it went from 4 to 3 (1∕4).
44 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
Seeing Elasticity through Total Expenditures
If we wanted to, we could use math to show that if the price and the amount you spend both
go in the same direction, then demand is inelastic. If they go in opposite directions, however,
demand is elastic. This total expenditure rule of elasticity also allows us to quickly judge whether demand is elastic or inelastic. For instance, when the price of cigarettes goes up,
smokers usually have to spend more on them. When the prices of luxuries go up, many of us
spend less on them (because we do without them). In this way, we can find out for ourselves
whether our demand for a good is elastic or inelastic. All we need to do is to ask ourselves
whether a price increase will cause us to spend more on that good.
More on Elasticity
Determinants of Elasticity of Demand
Key factors of the three elasticity explanations are important in determining whether a
good is elastic or inelastic. The first is the number and closeness of substitutes. When there
are many substitutes that all serve nearly as well as the good in question, demand is likely
to be more elastic, because price increases induce changes to other goods. Whether price
increases can be easily absorbed into a person’s budget also matters. If price increases can-
not be absorbed—which is likely to be the case if the good takes up a significant portion
of the budget of consumers—when they occur, significant quantity reductions will follow.
And although timing was not mentioned above, given time, close substitutes can be found or
invented, or methods to avoid the price increase will be developed.
One of those substitutes could be the continued use of something the consumer already has.
Cars, for instance, have greater elasticity than razor blades because owners can easily continue
to drive the cars they have until a sale price induces them to buy a replacement, whereas shav-
ers can stretch the use of a razor for only a limited number of days.
Elasticity and the Demand Curve
Elasticity is important because supply changes will have very different results depending on
the elasticity of demand. As you can see from the figures on the next page, an identical supply
change can affect only price (Figure 3.4), only quantity (Figure 3.5), price much more than
quantity (Figure 3.6), or quantity much more than price (Figure 3.7).
total expenditure rule If the price and the amount you spend both go in the same direction, then demand is inelastic, whereas if they go in opposite directions, demand is elastic.
Number and closeness of substitutes
The more alternatives you have, the less likely you are to pay
high prices for a good and the more likely you are to settle
for an adequate alternative.
Portion of the budget
When a good takes up a significant portion of a consumer’s
budget, it is more likely to be elastic.
Time
The longer you have to come up with alternatives to paying
high prices, the more likely it is you will shift to those
alternatives.
D E T E R M I N A N T S O F E L A S T I C I T Y O F D E M A N D
More on Elasticity 45
Q1 = Q2
P
Q/t
D
P1
P2
S2
S1
FIGURE 3.4 Perfectly inelastic demand.
D
Q1Q2
P1 = P2
P
Q/t
S2
S1
FIGURE 3.5 Perfectly elastic demand.
D
P1
P2
Q1Q2
P
Q/t
S2
S1
FIGURE 3.6 Inelastic demand.
D
P1
P2
Q1Q2
P
Q/t
S2
S1
FIGURE 3.7 Elastic demand.
In Figure 3.4 demand curve is perfectly inelastic because price changes have no ef- fect on quantity. In Figure 3.5 the demand curve is perfectly elastic because price cannot change. As we saw in Figures 3.2 and 3.3, a linear demand curve is elastic at high prices
and inelastic at low prices. In Figure 3.6 demand is inelastic over the entire range shown
because at every point the percentage change in price is larger than the percentage change
in quantity. This will be true when the demand curve is nearly vertical. In Figure 3.7
demand is elastic over the entire range, because at every point the percentage change in
price is smaller than the percentage change in quantity. This will be true when the demand
curve is nearly horizontal.
If we look back at the elasticity formula, we can use this explanation to compute the ap-
propriate elasticity numbers for each of these elasticity labels. For perfectly elastic demand the
computed elasticity is ∞ (infinity), while for perfectly inelastic demand the computed elastic-
ity is 0 (zero). Remembering that unitary elastic demand computes to 1 (one), it makes sense
that elastic demand will compute to greater than 1 but less than ∞ and inelastic demand will
compute to less than 1 but greater than 0.
perfectly inelastic The condition of demand when price changes have no effect on quantity.
perfectly elastic The condition of demand when price cannot change.
46 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
Sometimes it is easier to see the importance of elasticity with partic-
ular goods. There are economists who spend their days and nights
estimating the elasticity of demand for particular goods. This is not
because they have nothing else to do. It is because the elasticity
of demand for a good is important information to have if you are
interested in the impact of a price increase or a tax on that good. For
instance, if you take up the chapter on tobacco, alcohol, drugs, and
prostitution later in the course, you will find that the question of how
much impact a tax on cigarettes will have in decreasing smoking
depends greatly on the elasticity of demand for cigarettes.
Consider the goods listed in the following table and their elastici-
ties. You should be able to tell a story about why short-run gasoline
demand is less elastic than long-run gasoline demand. You should be
able to figure out why demand for foreign travel is quite elastic while
demand for food is not. The key to the question of whether a good is
elastic or not is whether there is an acceptable substitute.
SAMPLE STORY 1 There are few substitutes to driving to and from work. Though you
may or may not be able to take public transportation or carpool,
though you may or may not be able to trade in your SUV for a
fuel-efficient car, it would take a substantial change in the price of
gasoline to cause you to make the substitution immediately upon
seeing an increase in gas prices. This is especially true if you did
not anticipate that prices would remain high. On the other hand,
if you did see that gasoline prices were going to remain high, you
might, over the next year or so, consider trading in the gas guz-
zler for something more miserly. Similarly, you cannot easily change
your electric bill, but over time you can replace an inefficient electric
forced-air furnace with an efficient heat pump, and you can decide
to put electronic devices that draw electricity even when they look
like they are off (such as TVs, coffeepots, and even cell phone char-
gers) on switches.
Type of Good Price Elasticity
Inelastic Goods
Consumer electricity (short-run) 0.13
Eggs 0.06
Food 0.21
Health care services 0.18
Gasoline (short-run) 0.08
Gasoline (long-run) 0.24
Highway and bridge tolls 0.10
Unit Elastic Good (or close to it)
Shellfish 0.89
Cars 1.14
Elastic Goods
Luxury car 3.70
Foreign air travel 1.77
Restaurant meals 2.27
Consumer electricity (long-run) 1.89
Sources: Variety of sources combined by author
SAMPLE STORY 2 Suppose you wanted to take your family on an interesting vaca-
tion. Suppose further that your family had narrowed its choices to
hiking in the Grand Canyon or seeing the sights in Paris. Given the
acceptability of the substitute, a relatively small change in the price
of flights and accommodations for the trip to France would have a
significant impact on your choice.
E L A S T I C I T Y : S O M E I L L U S T R A T I V E E X A M P L E S
Elasticity of Supply
Before moving on, we need to stop and say that nearly everything we have just said about the
price elasticity of demand can also be said about the price elasticity of supply. Firms selling
goods may be in a situation where they have already brought goods to market that are quite
perishable and, therefore, must be sold regardless of their price. We may have other situa-
tions where producing more of the goods can be accomplished but only at a sharply increased
price. We can imagine a third circumstance where prices do not have to rise much in order to
motivate further sales and, finally, it is possible that firms may be willing to produce as many
goods as buyers want at the current market price. In the first scenario, the supply curve would
be vertical. In the second and third scenarios, the supply curve would be upward sloping, with
the second being a steeply sloped supply curve, and the third being a relatively flat one. The
final scenario would likely result in a horizontal supply curve. Some examples of goods with
varying elasticities might be helpful here. In the very short run, the elasticity of supply of fresh
fruit at a farmers’ market is perfectly inelastic as long as the fruit will spoil if it goes unsold.
In the relatively short run and in the United States, the supply of gasoline is inelastic because
More on Elasticity 47
Q/t
D1
Q1 = Q2
P1
D2
P2
P S
FIGURE 3.8 Perfectly inelastic supply.
Q/t
P
P2
Q1 Q2
D2
D1
P1
S
FIGURE 3.9 Inelastic supply.
Q/tQ2
D1
D2
S
Q1
P1
P2
P
FIGURE 3.10 Elastic supply.
Q/tQ2
D1
D2
S
P
Q1
P1 = P2
FIGURE 3.11 Perfectly elastic supply.
most refineries are not easily capable of expanding or contracting output. They run 24 hours
per day, seven days a week, and are brought offline only for maintenance. In the longer run,
there are myriad goods where producers can bring new production online. A relatively small
increase in the profit margin on a good can motivate significantly greater production. There
are very few real-world examples of perfectly elastic supply.
Replicating the idea of Figures 3.4 through 3.7 where we had a constant shift in supply and
saw what happened with varying elasticities of demand, Figures 3.8 through 3.11 show what
happens when demand shifts with varying elasticities of supply. In Figure 3.8 the supply curve
is perfectly inelastic and is vertical. As a result of an increase in demand, price rises greatly,
but quantity does not change at all. In Figure 3.9, the supply curve is inelastic and steeply
sloped so the change in demand causes prices to rise quite a bit and quantity to rise, albeit not
very much. If supply is elastic, such as it is in Figure 3.10, the demand increase causes prices
to rise only a little and quantity to rise substantially. Finally, in the case where supply is per-
fectly elastic, as it is in Figure 3.11, the increase in demand causes only an increase in quantity
and no effect is seen on price.
Determinants of the Elasticity of Supply
Just as with demand, supply elasticity has key factors that are important in determining
whether a good has elastic or inelastic supply. The first is the degree to which the relevant
resources used for production are available. That availability can be achieved either by their
48 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
When there are win–win scenarios such as the case outlined, econo-
mists generally favor uninhibited exchange. When there are losers,
economists look to consumer surplus–producer surplus analysis to
weigh the gain to the gainers against the loss to the losers. To you,
whether free trade is a good thing or not depends on whether you
are a Kia owner who saved several thousand dollars on your car or
an unemployed United Auto Workers union member. Whether a new
Walmart Supercenter is good for your town depends on whether
you are a consumer paying lower prices for steak or a meat cutter
unemployed because the Kroger that you worked for closed. Gener-
ally, but by no means universally, economists favor market outcomes
because they make the calculation that the gain to the gainers out-
weighs the loss to the losers. Whether it is trade between the United
States and Korea or Walmart outcompeting Kroger, free-trade econ-
omists insist that lower prices generate a gain in consumer surplus
that is greater than the net loss in producer surplus.
C O M P A R I N G T H E G A I N T O T H E G A I N E R S W I T H T H E L O S S T O T H E L O S E R S
development or by the ability to attract those resources into the industry. For a natural resource
where the location is known and the prospect for finding new deposits is low, supply elasticity
will be smaller than for a resource where finding new deposits is common. Similarly, if higher
prices motivate firms to raise wages and that results in many new applicants for positions,
productive capacity can increase quickly in response to price changes.
The second is the degree to which an industry exhibits some agility in their production or
has the time to respond appropriately to price changes. An industry that requires long periods
of time to increase production will have a lower supply elasticity than one that can quickly
bring in new labor and capital to exploit minor price changes. Here, the energy industry is a
good example in that it took many years to develop the technology associated with hydraulic
fracturing (fracking) and horizontal drilling. As a result, the supply elasticity of oil was low for
many years. When that new technology was on full display, in particular during the doubling
of U.S. oil production in the 2008 to 2015 time frame, supply elasticity increased markedly.
The final determinant of supply elasticity is the degree to which a firm is close to its
production capacity combined with the degree to which it can easily and cheaply use inven-
tories as a buffer. An industry that is always running at full capacity and can’t cheaply store
their output will have very low supply elasticity. The clearest and most frequently observed
example of this is in the gasoline-refining business. Refineries are always running at full
capacity—24/7/365. The only exception to that is when they are down for maintenance, which
they are during the required switch from winter blends to summer blends (in March) and back
again (in October). You see the price at the pump rise in those months because there is no
spare capacity in that business and the cost of storage is quite high.
Availability of Relevant Resources
The easier it is for relevant resources to be developed or attracted
into an industry, the greater will be the supply elasticity.
Time and Agility of Production
The longer an industry has to adjust production, or the ease with
which it can do so, the greater will be the supply elasticity.
Capacity and Inventories
The farther away an industry is to its production capacity combined
with the degree to which it can easily and cheaply use inventories as
a buffer, the greater will be the elasticity of supply.
D E T E R M I N A N T S O F E L A S T I C I T Y O F S U P P L Y
Consumer and Producer Surplus 49
Consumer and Producer Surplus
Consumer Surplus
Most people think that when consumers buy goods, only the firm is better off for the exchange.
They do not often acknowledge that consumers are also better off. It turns out that consum-
ers often get much more value than they part with. Look back to “All about Demand” in
Chapter 2 and recall that the demand curve represents the marginal utility of the good. This
means that the amount each additional unit of the good is worth to the consumer can be read
from the demand curve.
Figure 3.12 demonstrates how it is that consumers win in this exchange and provides a
measure of the degree to which they win. The value the consumers place on each unit of the
good is their marginal benefit for that unit. That is how much they would have paid for that
unit. As a result the total value to the consumer is simply the sum of those marginal benefits
for each unit and is the area under the demand curve from O to Q*. It looks like and is
bounded by the letters OACQ*. The total amount of money they pay for these goods is the
price, P*, times the amount they buy, Q*, so it looks like and is bounded by the letters
OP*CQ*. The difference between the areas is the triangle that represents the value to the
consumers minus the amount they pay the producer. Economists call that consumer surplus; it looks like and is bounded by the letters P*AC.
Producer Surplus
Firms also benefit from exchange. In the Chapter 2 section “All about Supply” the supply
curve is upward sloping because it is the marginal cost curve and marginal cost is increasing.
Just as we added together marginal benefits to get the value to the consumers in Figure 3.12,
we now add together marginal costs for each unit in Figure 3.13 to get the total variable cost
to the producer (which is the difference between all its costs and those it needs to start up its
business). As a result we can measure the total variable cost as the area under the supply
curve from O to Q*, which looks like and is bounded by the letters OBCQ*. The amount
consumers pay producers is the same OP*CQ* rectangle it was in Figure 3.12, . The dif-
ference is what economists call producer surplus; it looks like and is bounded by the letters BP*C.
consumer surplus The value you get that is in excess of what you pay to get it.
producer surplus The money the firm gets that is in excess of its marginal costs.
Q/tQ*
P*
A
C
O
B
Consumer surplus =
Value to the consumer
Amount consumer pays producer
minus
Supply
Demand
=
FIGURE 3.12 Consumer surplus.
50 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
Producer surplus =
P
P* C
A
Variable cost to producer
Amount consumer pays producer
B
O Q* Q/t
= minus
Supply
Demand
FIGURE 3.13 Producer surplus.
Q/t
Supply
Demand
C
Q*O
B
P*
A
P
Consumer surplus
Producer surplus
FIGURE 3.14 Net benefit to society.
The net benefit to society, shown in Figure 3.14, is the consumer surplus plus the pro-
ducer surplus. That is, if the market did not exist, consumers would lose their consumer
surplus and the producers would lose their producer surplus. Because the market exists, both
are better off.
Market Failure
Reread the last sentence of the preceding paragraph. It seems to suggest that the market works
perfectly and that there is never cause for government to intervene. Intuitively you know that
is not true. A market can fail for a number of reasons: The actions of a consumer or producer
can harm an innocent third party, a good may not be one for which a company can profit from
selling even though society profits from its existence, the buyer may not be able to make a
well-informed choice given the complexity of the decision, a buyer or a seller may have radi-
cally different information about a good or service, or a buyer or seller may have too much
power over the price. Each of these problems leads to market failure—the circumstance where the market outcome is not the economically efficient outcome. In the issue chapters to come,
you will explore each of these types of market failures.
When market failure exists, economists use consumer and producer surplus to analyze the
degree of the problem as well as to show how the problem can be solved through the proper
application of taxes, regulations, or subsidies. Whether this is a tax discouraging the consump-
tion or production of a good, a subsidy designed to encourage its production or consumption,
or a regulation against monopoly pricing, economists are not always for or always against
these mechanisms. Most economists favor policies that maximize the sum of producer and
consumer surplus, however that occurs.
Categorizing Goods
Broadly speaking, goods can be classified into four categories on the basis of the degree to
which the consumption of the good can be restricted by a seller to only those who pay for
it—called exclusivity, and the degree to which one person’s consumption reduces the value of the good for the next consumer—called rivalry. A slice of pizza has a high degree of both qualities; the pizza joint can easily prevent you from consuming their pizza if you do not pay
for it, and once you have eaten a pizza, that particular pizza is not available to others. As a
result, economists would label pizza as a purely private good. On the other hand, the army
market failure The circumstance where the market outcome is not the economically efficient outcome.
exclusivity The degree to which the consumption of the good can be restricted by a seller to only those who pay for it.
rivalry The degree to which one person’s consump- tion reduces the value of the good for the next consumer.
purely private good A good with the charac- teristics of both exclu- sivity and rivalry.
Consumer and Producer Surplus 51
protects all citizens from foreign invasion regardless of how much they pay in taxes, and
their success at doing so is not diminished at all by how many people they have to defend.
Economists label national defense as a purely public good because it is one for which there is neither rivalry nor exclusivity.
In addition to those extremes, there are goods that have a high degree of one characteristic
and a low degree of the other. Cable companies can easily exclude their consumers from get-
ting HBO, but one consumer’s viewing of HBO does not affect another’s viewing. HBO is
excludable, but there is no rivalry. Economists call such goods excludable public goods. Simi- larly, a city street is an example of a good for which it would be nearly impossible to prevent
usage by citizens and one for which rivalry is common (think traffic jams).2 Such goods are
what economists call congestible public goods. There is another type of good for which you actually need other people consuming it for it
to have any use to you. Economists call this type of good a network good. The first landline telephones were an early example of this type of good. Social media apps such as Facebook,
Instagram, and Twitter, as well as the more nefarious ones like Yik-Yak, Tinder, and Kik all
require other users to be active in order for the apps to have any value.
2While you may think license plates allow for exclusivity, they do not serve the entire function in that once you have a licensed
car it is very difficult to charge you based on usage. As technology increases, GPS receivers and transmitters may make it pos-
sible to charge drivers based on where and when they drive.
purely public good A good with neither of the characteristics of exclusivity or rivalry.
excludable public good A good with the char- acteristic of exclusivity but not of rivalry.
congestible public good A good with the charac- teristic of rivalry but not of exclusivity.
network good a type of good for which you need other people consuming it for it to have any use to you.
Kick It Up a Notch
DEADWEIGHT LOSS
When the market is not at equilibrium, the consumer surplus plus the producer surplus will
not be as large. This triangle, ABC, is as big as it can be. If consumption is more than Q*, then
consumers are paying more than they think a product is worth, or producers are not meeting
their marginal costs, or both. If consumption is less than Q*, the consumers wish they could
buy more (and they would get more consumer surplus), or firms wish they could sell more
(and they would get more producer surplus), or both. If the triangle is smaller than ABC, then
there is deadweight loss. This deadweight loss is the measure economists use to discuss the inefficiency of markets when a problem like air pollution exists or when government estab-
lishes an impediment to a free floating price, such as the minimum wage.
To see how deadweight loss fits our supply and demand diagram, suppose that for some
reason the price cannot be at P* but is instead at Pʹ (pronounced “P prime”). Figure 3.15
shows the impact of this when Pʹ is greater than P*, and Figure 3.16 shows the impact when
Pʹ is less than P*. In either circumstance, the new quantity will be less than equilibrium
because consumers will not be willing to buy more than Qʹ (pronounced “Q prime”) at the
higher Pʹ in Figure 3.15 and producers will not be willing to sell more than Qʹ in Figure 3.16
at the lower Pʹ.
In Figure 3.15 the price is higher than P*. At that higher price, though producers will want
to sell many more than the previous equilibrium quantity, consumers will want to buy fewer.
Unless the consumers are compelled to buy things they do not want, they will buy only Qʹ.
Given that, we can find the consumer and producer surplus in this market and compare it
to what it was in Figure 3.14. The area under the demand curve represents the value to the
consumer of Qʹ goods and this is OAEQʹ. The price Pʹ times the quantity Qʹ is the amount of
money consumers will pay to get Qʹ, and this is represented by the area OPʹEQʹ. The difference
deadweight loss The loss in societal welfare associated with production being too little or too great.
52 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
O
Demand
Supply A
B
P *
Pʹ
C
F
E
Q*Qʹ
P
Q/t
FIGURE 3.15 Deadweight loss with a price higher than P*.
O
Demand
Supply A
B
P *
Pʹ
C
F
E
Q*Qʹ
P
Q/t
FIGURE 3.16 Deadweight loss with a price lower than P*.
between these, PʹAE, is the consumer surplus. It costs the producer OBFQʹ in terms of variable
costs to make these goods. The difference between the money consumers pay them and their
costs, BPʹEF, is the producer surplus. The sum of consumer and producer surplus in this case
is BAEF, but this is less than ABC, which is what this sum was in Figure 3.14. This means that
the area FEC is lost as a result of being at Pʹ instead of P*, and this is what economists call the
deadweight loss of being at Pʹ instead of P*.
In Figure 3.16 the price is lower than P*. At that lower price, though, producers will not
want to sell as much as they did at the previous equilibrium and consumers will want to
buy more. Unless producers are compelled to sell things they do not want to sell, they will
produce only Qʹ. Again we can find the consumer and producer surplus in this market and
compare it to what it was in Figure 3.14. The area under the demand curve still represents
the value to the consumer of Qʹ goods and is still OAEQʹ. The price Pʹ times the quantity Qʹ
is still the amount of money consumers will pay to get Qʹ, but this is now represented by the
area OPʹFQʹ. The difference between these, the consumer surplus, is now PʹAEF. Whereas
the costs of the producer, OBFQʹ, remain the same, the revenue has fallen so the producer
surplus falls to BPʹF. The sum of consumer and producer surplus in this case is also BAEF,
and this is still less than it was in Figure 3.14. The deadweight loss is again represented by
the area FEC.
This chapter expanded on the supply and demand model by showing the importance of the
responsiveness of quantity to changes in price and how the model can be used to show that
market exchange results in mutually beneficial results for consumers and producers.
In discussing elasticity we began by introducing the formula, deining the terms elastic
and inelastic, and exploring why demand for some goods may be elastic while others may be
inelastic. We then considered how elasticity of demand is determined by the number of close
substitutes and the time available to generate them.
To conclude the chapter, we discussed how we could use the supply and demand model to
show that consumers and producers each beneit from a market transaction, and we showed
how to measure the beneit each gets by deining consumer and producer surplus. Finally, we
showed how we measure the ineiciency of being away from equilibrium by deining and
illustrating the concept of deadweight loss.
Summary
Summary 53
Key Terms congestible public good consumer surplus
cross-price elasticity of
demand
deadweight loss
elastic
elasticity
excludable public good
exclusivity
income elasticity of demand
inelastic
market failure
network good
perfectly elastic
perfectly inelastic
price elasticity of demand
price elasticity of
supply
producer surplus
purely private good
purely public good
rivalry
total expenditure rule
unitary elastic
1. The elasticity of demand is related to the slope of the demand curve
a. and only the slope of the demand curve.
b. but also the (price, quantity) position on the demand curve.
c. but also the slope of the supply curve.
d. and whether the good is normal or inferior.
2. Suppose a firm cannot figure out whether the demand for the good it sells is elastic or
inelastic but discovers that every time it raises its price, its total revenue declines. Their
a. demand is unit elastic.
b. demand is elastic.
c. demand is inelastic.
d. demand is perfectly inelastic.
3. Suppose you observe that minor changes in supply seem to cause dramatic changes in
price. You would conclude that
a. demand is unit elastic.
b. demand is elastic.
c. demand is inelastic.
d. demand is perfectly inelastic.
4. The fact that the demand for eggs is inelastic should not surprise you because
a. they are a very cheap food.
b. the demand for nearly all food products is inelastic.
c. the supply of eggs is inelastic.
d. they are so expensive.
5. Combined, the consumer surplus and producer surplus at equilibrium is
a. lower than it would be at prices below equilibrium.
b. lower than it would be at prices above equilibrium.
c. typically negative.
d. as big as it can get.
6. If supply and demand are lines, then at equilibrium both consumer and producer sur-
plus are
a. equal.
b. shown as squares.
Quiz Yourself
Issues Chapters You Are Ready for Now
International Trade: Does
It Jeopardize American
Jobs?
The Line between Legal and
Illegal Goods
Health Care
Government-Provided
Health Insurance
Farm Policy
Minimum Wage
54 Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
c. shown as trapezoids.
d. shown as triangles.
7. When looking at the impact of a change in trade policy, economists use consumer and
producer surplus to look at the winners and losers. Free-trade economists insist that
a. no one loses.
b. everyone loses.
c. there are winners and losers but that the gain to the winners is greater than the loss to
the losers.
d. there are winners and losers but that the loss to the losers is greater than the gain to
the winners.
8. When a satellite television company gains a subscriber, there is no impact on existing
subscribers. That is, there is no rivalry in the consumption for their service. This is an
example of a
a. purely private good.
b. purely public good.
c. congestible public good.
d. excludable public good.
9. Policy makers have considered putting computer chips in cars that would allow tax col-
lectors to charge people on the basis of how often they drive during rush hours. These
policy makers are dealing with the fact that public roads are
a. purely private goods.
b. purely public goods.
c. congestible public goods.
d. excludable public goods.
Short Answer Questions
1. Give an example of a good that you believe has perfectly inelastic demand for most
people. Then explain why you believe that is the case.
2. Give an example of a good that you believe has inelastic demand (not perfectly inelastic)
for most people. Then explain why you believe that is the case.
3. Give an example of something you hate to do, and imagine that you could pay someone else
to do that thing for you. Explain why both you and the person you pay could end up better off.
4. Give an example of a situation where the government compels you to do something
you do not want to do. Why might that be a reasonable requirement? When might it be
unreasonable?
5. Suppose you hear the following: “They just increased taxes on cigarettes and on high-
priced cigars.” Use the concept of elasticity to describe who will be hurt by those taxes. Is
a change in the price of the good itself a change in the quantity supplied?
Think about This Suppose both gasoline supply and demand are highly inelastic. Knowing that a change in the
expected price of gasoline will shift both supply and demand, explain how these combined
facts can lead you to an understanding of wildly changing gasoline prices.
Talk about This Talk about your alternative choices for colleges. What schools did you consider? Was tuition
a consideration? Does your college’s proximity to other schools imply anything about your
school’s ability to raise revenue by raising tuition?
Summary 55
Behind the Numbers Hirschman, Ira, Claire McKnight, and John Pucher, “Highway and Bridge Toll Elasticities,”
Transportation 22 (May 1995).
Food Demand and Nutrient Elasticities, www.ers.usda.gov/publications/tb1887/tb1887.pdf
Schaller, Bruce, “Transportation Elasticities,” Transportation 26 (1999), pp. 283–297.
Gasoline Elasticities: Hughes, Jonathan E., Christopher R. Knittel, and Daniel Sperling.
Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand (September 5,
2006). Available at SSRN: http://www.nber.org/papers/w12530
56
C H A P T E R F O U R
Firm Production, Cost, and Revenue Learning Objectives
After reading this chapter you should be able to:
LO1 Demonstrate the relationship between produc-
tion and costs and the relationship between
sales and revenues.
LO2 Explain that models of production are
based on the assumption that firms seek to
maximize profit.
LO3 Demonstrate how profit maximization dictates
that firms set production so that marginal cost
equals marginal revenue.
Chapter Outline
Production
Costs
Revenue
Maximizing Profit
Summary
The business of business is making money, and the money business makes is called profit. How it makes that profit is by selling its goods for more than it costs to make them. For this
chapter (and for most of this book) we make the simplifying assumption that nothing influ-
ences business other than maximizing profit. Although this is an exaggeration, it is reasonably
close to the truth, and accepting it as the truth simplifies our task considerably. Nothing about
this chapter is simple, but you may be comforted by the knowledge that it could be more com-
plicated (of course you may not be).
With the simplifying assumption of myopic profit maximization in place, we can break
things down into the cost side and the revenue side. Cost is the expense that businesses must incur to produce goods for sale. Revenue is the money that comes into the firm from the sale of the goods.
It is important to understand why economists focus on costs that are incurred rather than
simply those costs that must be paid. Accountants focus only on expenses that must be paid
for a business to produce, but economists also consider the opportunity cost of choices. To
fully understand the concepts of economic cost and accounting cost, consider an upstart business whose owner quits a $50,000 a year job and cashes in a $100,000 CD (earning
6 percent) to get it off the ground. An accountant would not consider the $50,000 of forgone
job-related income or the $6,000 per year in forgone interest as costs of the business. An
economist would. For the remainder of this chapter and all of the next, all costs refer to
economic costs.
profit The money that a firm makes: revenue – cost.
cost The expense that must be incurred to produce goods and services for sale.
revenue The money that comes into the firm from the sale of goods and services.
economic cost All costs of a business: those that must be paid as well as those incurred in the form of forgone opportunities.
accounting cost Only those costs that must be explicitly paid by the owner of a business.
Production 57
With that said, since profit is the difference between revenues and costs, we will be able to
use what we have developed in these areas to find how much production our profit-maximizing
firm will choose. We then explore the production process and the costs that it generates, move
on to discuss the revenue side, and then put the two together to show how, under different cir-
cumstances, firms choose their production levels. To pull all that off, we carry one example
from the beginning of this explication to the end. Let’s assume that the industry we are talking
about is the computer memory industry, the industry that makes the chips that enable com-
puters to use and quickly access information. Let’s suppose that the production of computer
memory requires three things: expensive machines, highly trained people, and very inexpensive
plastic and metal from which the chips are made. To make things even easier, let’s assume that
the plastic and metal used to make the chips are free.
So far we have had a section entitled “Kick It Up a Notch” in every chapter. The problem
with this chapter is that material presented is already “kicked up” plenty. Complicating mat-
ters further, some students need a verbal explanation, some need to “see” it in the form of a
graph, while still others can only get their arms around a concrete numerical example. To deal
with that, we go through each of them once using just words, once using graphical explana-
tion, and then again with a numerical example.
Production
Just Words
To get a handle on costs we need to know how much money it takes to produce goods. First we
need to know what resources are necessary for production. Then we can construct an input–
output relationship called a production function, and we will do this in the form of a graph. Our graph will show how many resources we need to produce various amounts of output. From
that production function we can find out how much various amounts of production cost. From
this resulting cost function we will be able to figure out how much each one costs on average and how much each additional one costs.
Of course, this is putting the cart before the horse. Before the firm decides how many
to produce, it has to decide what to produce. In our example, the memory chip firm did not
decide to make chips for the fun of it. Early computer designers decided that their computers
would work better if they had a short-term place to store and quickly retrieve information.
Chip-making companies came into existence to provide the computer industry with the parts
to make short-term storage of data possible. For the remainder of this section and this chapter
we assume that the firm is up and running and is simply trying to figure out how many chips
to make at any given time.
To make any product, you typically have fixed and variable inputs. That is, you have resources that you cannot change and resources that you can. In our example, the plant and
the equipment in the plant are called fixed inputs because they are not easily changed, added
to, or subtracted from. On the other hand, the person power to operate those machines is eas-
ily changed. You can hire and fire more easily and quickly than you can replace a machine.
People and other resources that can be easily changed are called variable inputs.
The first step in our process of figuring out how many memory chips to make is to map out
how many resources are needed to produce various numbers of these chips. Of course, without
any personnel there is no production. If there are only a few workers, as at point B in Figure 4.1,
production is not very great because workers are not able to specialize in particular parts of the
production process. They waste time moving from one part of the process to another, and they
take time to build momentum, working at each stage of production only to find that when they
get good at it, it is time to move on to another stage.
production function A graph that shows how many resources are needed to produce vari- ous amounts of output.
cost function A graph that shows how much various amounts of production cost.
fixed inputs Resources that do not change.
variable inputs Resources that can be easily changed.
58 Chapter 4 Firm Production, Cost, and Revenue
The addition of a few more workers solves that problem and production levels increase
greatly. Workers divide the tasks in such a way that each can build momentum and does not
have to switch jobs. This specialization is called the division of labor, and its impact is such that for a small increase in labor we can get a dramatic increase in output.
At some point, though, there are enough workers to get the job done, as at point D, and
more workers do not add much to production. Some jobs, too, just cannot be easily divided.
Although it is usually the case that having more workers increases output, workers find that the
existing plant and equipment are too limiting for them to get the most out of new employees.
As a result, output increases but not as fast as it had before. This phenomenon, referred to by
economists as diminishing returns, is a central assumption of this chapter as well as the next.
Graphical Explanation
Using the same ideas just presented, let’s walk through Figure 4.1. Point A begins at the origin
because, as was pointed out in the preceding section, if you have no workers you have no out-
put. Where there are too few workers to staff the plant, they have to waste time moving from
one stage of production to the next, so the increase in production associated with the first group
of workers is relatively low. That gives us point B. The curve is bowed to the right between
points A and C because of the division of labor. That is, as you add the same number of workers,
you get the benefits from those workers specializing and production increases at an increasing
rate. Once you get to point C, though, there is not enough plant and equipment to accommodate
more workers efficiently. The curve is then bowed to the left because of diminishing returns to
the existing plant and equipment.
Numerical Example
Now, let’s consider the same concept using the numbers that comprise Table 4.1. Continuing
with the memory chips example, suppose the first column represents the groups of workers,
the second column represents the total output produced, and the third column represents the
extra output added with the inclusion of the group. Because memory chips cannot make them-
selves, zero labor corresponds to zero output. Suppose that the first group of workers hired
initially produces 100 units, but when a second group is added a total of 317 units is produced.
That is, the second group adds 217 units to production. Suppose the third group adds some-
what less, 183 units, so that the total becomes 500. If it takes 5 groups of workers to produce
division of labor Workers divide the tasks in such a way that each can build momen- tum and not have to switch jobs.
diminishing returns The notion that there exists a point where, because there are some fixed inputs like plant and equipment, the addition of resources increases production, but does so at a decreasing rate.
FIGURE 4.1 A production function.
Workers
O u
tp u
t
Production function
D
C
A
B
Labor
Total
Output
Extra Output
of the Group
0 0
1 100 100
2 317 217
3 500 183
4 610 110
5 700 90
6 770 70
7 830 60
8 870 40
9 900 30
13 1,000
TABLE 4.1 Numerical example: production function.
Costs 59
700, 9 to produce 900, and 13 to produce 1,000, then we have a story similar to what we saw
in the graphical explanation. That is, as we added workers we got more production. The first
group of workers was not very efficient because they could not specialize, whereas the second
group was efficient because they could. In each case as more groups were added, efficiency
waned because the workers were limited by the existing plant and equipment.
We have now explained production in terms of how a varying number of workers can be
combined with a fixed amount of plant and equipment to make computer memory chips. We
work next on how much it costs to hire those workers and pay for that machinery.
Costs
Just Words
Once we know how many workers it takes to produce our memory chips, we can find out
how much it costs to make those chips. The first thing to consider is that there are costs of
production that we cannot change. In our example these fixed costs are the costs of the plant and equipment that we own. Costs that we can change, like the number of workers we hire for
our plant, are called variable costs. The task now is to compare the number of memory chips we make against the costs of making those chips.
To accomplish this we need four cost concepts: marginal cost, average total cost, average
variable cost, and average fixed cost.
Marginal cost (MC) is the increase in cost associated with a one-unit increase in produc- tion. Because total cost always rises, marginal cost is always positive. Because total cost
rises quickly at low levels of output, marginal cost is high at low levels of output; however,
total cost rises much more slowly at moderate levels of output, so marginal cost is much
lower there. Last, because a rapid rise in total cost resumes at high levels of output, marginal
cost is high in this range. Thus marginal cost starts high, decreases for a while, and then
increases again.
Average total cost (ATC) is the per unit cost of production. Because this includes fixed cost, which can be very high, average total cost will be high at low levels of production. It will
shrink as production gets more efficient and the fixed costs become spread over greater levels
of output. As production rises to higher levels where marginal costs are increasing, these two
effects will begin to counteract each other and the drop in average total costs will slow. Even-
tually the increases in marginal cost will overwhelm the effect of spreading fixed costs over
higher levels of output and average total cost will rise again.
The average variable cost (AVC) is dictated by the same changes in efficiency that gave us the marginal cost curve. Because it is an average, however, the movements are dampened; the
highs are not as high and the lows are not as low.
Average fixed cost (AFC) falls continuously because the fixed costs of production are being spread over greater and greater levels of production. In addition, graphically, average fixed
cost is the vertical distance between average total cost and average variable cost.
These cost concepts serve as the basis for much of what follows in this chapter, the next
one, and our subsequent study of issues.
Looking back at Figure 4.1, you can see that at point A we will not have to pay anything
to our workers (because we have no workers to pay), but we still have to pay fixed costs.
As a result, point A in Figure 4.1 corresponds to point A in Figure 4.2. We have workers at
point B whom we have to pay, and they are not all that productive. Remember that this is not
their fault, because there are too few of them to allow specialization. Point B in Figure 4.2 is
therefore higher than point A (because we have to pay them) but not much farther to the right
(because they are not making that many chips).
fixed costs Costs of production that cannot be changed.
variable costs Costs of production that can be changed.
marginal cost (MC) The addition to cost as- sociated with one addi- tional unit of output.
average total
cost (ATC) Total cost divided by output, the cost per unit of production.
average variable
cost (AVC) Total variable cost divided by output, the average variable cost per unit of production.
average fixed cost
(AFC) Total fixed cost divided by output, the average fixed cost per unit of production.
60 Chapter 4 Firm Production, Cost, and Revenue
Point C in Figure 4.1 indicates that the workers were quite productive; so for the same
amount of an increase in our costs we see a significant increase in production. Thus, point C
in Figure 4.2 is also higher than point B but is significantly farther to the right. Point D in
Figure 4.1 shows us where extra workers did not add much to production. Again they cost
money, so point D in Figure 4.2 is higher than point C, but is not that much farther to the right.
Connecting these points, we have a total cost function. Our graph shows how the function helps
us understand and make decisions about the cost of production and the amount produced.
Thus far we have focused on finding the total cost of producing various amounts of output.
When we get total revenue, we will be able to find the profit. Before we go there, though, we
are going to need four other cost functions: marginal cost, the average variable cost, the average
fixed cost, and the average total cost. In higher-level economics courses, students are required
to derive these other cost functions from the total cost function. When you derive one function
from another, you graphically manipulate the parent function (in this case total cost) to draw its
descendants (in this case marginal cost, average variable cost, and average total cost).
Numerical Example
Again we are dealing with concepts that may be easier to comprehend when there are numbers
attached. Following the numerical example used in Table 4.1, consider Table 4.2 (on the next
page). The first column represents output. The second, Total Variable Cost, is based on the
$2,500 per unit of labor from Table 4.1 that is required to produce that output. The third, Total
Fixed Cost, is the cost of plant and equipment and is unchanging. The fourth, Total Cost, is
the sum of total variable cost and total fixed cost. The fifth, Marginal Cost, is the increase in
total cost from each level of production. The sixth, Average Total Cost, is the per unit cost; the
seventh, Average Variable Cost, is per unit variable cost; and the eighth, Average Fixed Cost,
is per unit fixed cost.
These derivations take economics majors several class periods to understand. We’ll skip that
but outline why Figure 4.3 looks the way it does. Starting with the easiest one, average fixed
cost, it is constantly decreasing because the same costs are being spread over more and more
output. Marginal cost, average total cost, and average variable cost all start high, decrease, and
then increase. The manner in which they do that, though, is somewhat complicated.
Marginal cost is the increase in costs associated with a one-unit increase in production.
That means it is the “rise over the run” in the total cost curve, which means it is the slope of
the total cost curve. You can see in Figure 4.2 that total cost rises rapidly at the beginning,
flattens out, and then rises rapidly again.
FIGURE 4.2 Total cost function.
T o
ta l c o
s t
Output
Total cost function
D
C
A
B
P
FIGURE 4.3 Marginal cost, average total cost, and average variable cost.
AFC
AVC
ATC
MC
P
Q/t
Costs 61
Average total cost and average variable cost are both U-shaped because they start high and
decrease. The difference between the two curves is average fixed costs. Because average fixed
cost diminishes as production increases, the gap between the two curves diminishes. They are
both cut from below by the marginal cost curve at their respective minimums. This happens
when, because of diminishing returns, marginal costs increase to the point where, first, aver-
age variable cost, then average total cost, starts to rise as well.
TABLE 4.2 Numerical example: cost functions.
Output
Total
Variable
Cost
Total
Fixed
Cost
Total
Cost
Marginal
Cost*
Average
Total
Cost
Average
Variable
Cost
Average
Fixed
Cost
0 0 8,500 8,500
100 2,500 8,500 11,000 25 110 25 85
200 3,800 8,500 12,300 13 62 19 43
300 4,800 8,500 13,300 10 44 16 28
400 6,000 8,500 14,500 12 36 15 21
500 7,500 8,500 16,000 15 32 15 17
600 9,500 8,500 18,000 20 30 16 14
700 12,500 8,500 21,000 30 30 18 12
800 17,000 8,500 25,500 45 32 21 10.6
900 22,500 8,500 31,000 55 34 25 9.4
1,000 32,500 8,500 41,000 100 41 32.5 8.5
*Change in total cost/change in output.
TABLE 4.2 Numerical example: cost functions.
Output
Total
Variable
Cost
Total
Fixed
Cost
Total
Cost
Marginal
Cost*
Average
Total
Cost
Average
Variable
Cost
Average
Fixed
Cost
0 0 8,500 8,500
100 2,500 8,500 11,000 25 110 25 85
200 3,800 8,500 12,300 13 62 19 43
300 4,800 8,500 13,300 10 44 16 28
400 6,000 8,500 14,500 12 36 15 21
500 7,500 8,500 16,000 15 32 15 17
600 9,500 8,500 18,000 20 30 16 14
700 12,500 8,500 21,000 30 30 18 12
800 17,000 8,500 25,500 45 32 21 10.6
900 22,500 8,500 31,000 55 34 25 9.4
1,000 32,500 8,500 41,000 100 41 32.5 8.5
*Change in total cost/change in output.
If you are inclined to replicate Figure 4.3 yourself (or are required to
in your course) try the following:
1. Draw a sweeping check-shaped MC curve.
2. Draw a symmetrical U-shaped AVC curve that bottoms out
on MC.
3. Draw an asymmetrical U-shaped ATC curve that also bottoms out
on MC (a bit higher than the AVC curve bottoms out) where the
vertical distance between ATC and AVC is longer on the left than
it is on the right side of the diagram. (For the mathematically
inclined among you, this is what you get if you have a cubic total
cost function.)
D R A W I N G T H E A T C - A V C - M C D I A G R A M
MC
Step 1
P
Q
Step 2
AVC
MC
P
Q
Step 3
AVC
ATC
MC
P
Q
62 Chapter 4 Firm Production, Cost, and Revenue
To see how each column in Table 4.2 is computed, let’s look at a production increase from
400 to 500. The variable costs associated with producing 400 are $6,000. Variable costs rise
to $7,500 when output rises to 500. Fixed costs are $8,500 in both cases. That means that
total cost is $14,500 ($6,000 + $8,500) for 400 and rises to $16,000 ($7,500 + $8,500) for
500. The increased cost for the increase of 100 units is $1,500, so each one increased cost
by $15, so marginal cost is $15. Average total cost for 400 units is $36 ($14,500/400) and
$32 ($16,000/500) for 500 units. The average fixed cost is $21 ($8,500/400) for 400 units and
$17 ($8,500/500) for 500 units.
If you plot the last four columns against output, you will see that the curve for marginal
cost is indeed check-shaped, that those for average total cost and average variable cost
are both U-shaped, and that average fixed cost decreases steadily. You can also see that at
300 units of output marginal cost is at its minimum. Further, you can see that the curve
depicting marginal cost cuts average variable cost at its minimum (at 500 units of out-
put) and that the marginal cost curve cuts the average total cost curve at its minimum
(at 700 units of output).
Revenue
Just Words
The other side of any production decision is the amount of money that will come in from
the sale of the goods. To get a handle on this revenue side we will need to know whether the
business has competition and, if so, how much. For instance, if a business faces many other
competitors that produce goods like the ones it produces, its behavior will be different from
what it would be if it had the market to itself.
In some industries, like agriculture, the price that the firm receives remains unchanged
regardless of how much it has to sell. In other industries, like those that supply electric power,
the amount sold affects the price. To explore this difference let’s first assume our memory
chip maker is one of many chip makers. Then we will see what happens when we assume
that it is the only one.
If our chip-making firm has many competitors, the price is set in a market that it cannot
control. The supply of and the demand for chips determine how much the firm can charge
for its chips. To see the futility of trying to set its own price, imagine that it tried to have
a price higher than the market price. If it did, computer makers could and would buy all
their chips from our firm’s competitors. The firm could, of course, set a price lower than
the market price. If it did, it would get to sell all it produced. On the other hand, it could
do that at the market price. Because our firm wants to maximize profit and because it can
always sell as much as it wants at or below the market price, it will always want to charge
the market price.
Figure 4.4 shows how the market generates the price for the firm. This price also hap-
pens to be the additional revenue the firm receives from the sale of each unit. To see why
this marginal revenue (MR) is the same as the price, consider a thought experiment. If the market price is 5, how much will revenue be if our firm sells one? Answer: 5. How much
will revenue be if it sells two? Answer: 10. The increase in revenue associated with any
sale is therefore 5. This is true whether you let the price be 5, 10, or 600; the price is the
marginal revenue.
If, on the other hand, we are the only ones selling computer chips, computer makers have
to buy their memory chips from our firm. This situation is quite different from the case where
there were many competitors. Instead of just taking a price given to it by the market, it is
setting the price. Instead of being a small, insignificant part of the market, it is the market.
marginal revenue (MR) Additional revenue the firm receives from the sale of each unit.
Revenue 63
TABLE 4.4 Numerical example: revenue when there are no competitors.
Q Price TR MR*
0 75 0
100 70 7,000 70
200 65 13,000 60
300 60 18,000 50
400 55 22,000 40
500 50 25,000 30
600 45 27,000 20
700 40 28,000 10
800 35 28,000 0
900 30 27,000 –10
1,000 25 25,000 –20
*Change in total revenue/change in output.
Unfortunately, to sell more, the firm has no recourse other than lowering the price it charges.
For instance, if it is currently selling 1 million chips a week and it wants to increase its sales
to 2 million a week, it must lower the price to everyone, even those who would have bought
1 million at the higher price. This means that in Figure 4.5 the marginal revenue is not graphed
with a flat line; it falls as we increase sales.
Numerical Example
Using the same numerical example that we have been using, suppose that our firm is one of
many and has no control over price. Suppose further that the price in the market for memory
is $45 per unit. This means that the total revenue (TR) increases by $45 for each unit sold and
the marginal revenue is thus $45 for each unit sold. This is illustrated in Table 4.3.
If there are no competitors, then the market demand for memory is simply the demand
for our firm’s memory. This means that our firm must lower its price to induce consumers to
buy more memory. Another way of looking at precisely the same thing is to notice that a firm
without competition can force the price higher by restricting its output. As before, total rev-
enue is price times quantity, but because price does not remain the same, the marginal revenue
falls. This is illustrated in Table 4.4.
P* P* = Marginal revenue
Output
Market for memory
Output
Our firm
P P S
D
FIGURE 4.4 Setting the price when there are many competitors.
P
MR
Output
D
Market for memory
FIGURE 4.5 Marginal revenue when we have no competitors.
TABLE 4.3 Numerical example: revenue when there are many competitors.
Q Price TR MR*
0 45 0
100 45 4,500 45
200 45 9,000 45
300 45 13,500 45
400 45 18,000 45
500 45 22,500 45
600 45 27,000 45
700 45 31,500 45
800 45 36,000 45
900 45 40,500 45
1,000 45 45,000 45
*Change in total revenue/change in output.
64 Chapter 4 Firm Production, Cost, and Revenue
Maximizing Profit
Graphical Explanation
As mentioned, the level of output for the business that will maximize profit very much
depends on whether the business is in perfect competition—that is, one of many producing the same thing—or is a monopoly—that is, it has no competitors. Regardless of whether it has many competitors or it has the market to itself, we assume firms produce and sell the
amount that will make them the most money possible. In economic terms this ends up mean-
ing that every firm should produce an amount such that marginal revenue equals marginal
cost (MR = MC). Recall the Chapter 1 concept of marginal analysis; this is our first oppor-
tunity to see it at work.
This is not as difficult as it seems. Remember that marginal revenue is the amount the
firm brings in from selling one more, and the marginal cost is the amount of money that it
costs to produce one more. To illustrate, suppose you start by selling a fixed number, say,
10. If you sell an eleventh and you make money on that sale (MR > MC), you should do
it again and sell at least one more. If you sell an eleventh and you lose money on that sale
(MR < MC), you should reduce sales by at least one. Since marginal revenue is less than
marginal cost for the eleventh chip, you should not have produced it. To maximize profit
you could repeat this one-by-one process until you have found the production that makes
the most money. On the other hand, you now know that it is only when marginal cost equals
marginal revenue that you have exhausted the profit potential on the good you are trying
to sell.
Of course it is possible that our entire business is a loser. In the age of word processors
and cheap personal computers, the manual typewriter business would be a loser even if ours
were the only firm in this industry. The exception to the rule that a firm should produce
where marginal cost equals marginal revenue occurs when the best alternative is to do noth-
ing; that is, sometimes the best decision is to shut down the business. This occurs when
the amount that you sell a good for is not enough to cover the variable costs that went into
the production of the good. The firm should shut down if the price is less than the average
variable cost (P < AVC).
Numerical Example
To illustrate profit maximization when there are many competitors, we need to combine the
information in Tables 4.1 and 4.3; when there are no competitors, we need to combine the
information in Tables 4.3 and 4.4. In either case we need to pick a quantity to maximize
profit. This is done where marginal cost equals marginal revenue. Table 4.5 illustrates this
for the case where there are many competitors, and Table 4.6 does it for the case where there
are no competitors. In Table 4.5 we see that the firm that has many competitors has its profit
perfect competition A situation in a market where there are many firms producing the same good.
monopoly A situation in a market where there is only one firm producing the good.
A firm should produce an amount such that marginal
revenue equals marginal cost (MR = MC).
A firm should shut down if the price is less than the
average variable cost (P < AVC) at the quantity where mar-
ginal revenue equals marginal cost.
T H E R U L E S O F P R O D U C T I O N
Summary 65
maximized at $10,500, and this happens when the firm produces 800.1 In Table 4.6 we see
that the firm that has no competitors has its profit maximized at $9,000, and this happens
when it produces 600.
Q Price TR TC MR MC Profit
0 45 0 8,500 0 0 −8,500
100 45 4,500 11,000 45 25 −6,500
200 45 9,000 12,300 45 13 −3,300
300 45 13,500 13,300 45 10 200
400 45 18,000 14,500 45 12 3,500
500 45 22,500 16,000 45 15 6,500
600 45 27,000 18,000 45 20 9,000
700 45 31,500 21,000 45 30 10,500
800 45 36,000 25,500 45 45 10,500
900 45 40,500 31,000 45 55 9,500
1,000 45 45,000 41,000 45 100 4,000
TABLE 4.5 Numerical example:
profit maximization
when there are many
competitors.
Q Price TR TC MR MC Profit
0 75 0 8,500 0 0 −8,500
100 70 7,000 11,000 70 25 −4,000
200 65 13,000 12,300 60 13 700
300 60 18,000 13,300 50 10 4,700
400 55 22,000 14,500 40 12 7,500
500 50 25,000 16,000 30 15 9,000
600 45 27,000 18,000 20 20 9,000
700 40 28,000 21,000 10 30 7,000
800 35 28,000 25,500 0 45 2,500
900 30 27,000 31,000 −10 55 −4,000
1,000 25 25,000 41,000 −20 100 −16,000
TABLE 4.6 Numerical example:
profit maximization
when there are no
competitors.
Key Terms accounting cost average fixed cost (AFC)
average total cost (ATC)
average variable cost (AVC)
cost
cost function
diminishing returns
division of labor
economic cost
fixed costs
fixed inputs
marginal cost (MC)
marginal revenue (MR)
monopoly
perfect competition
production function
profit
revenue
variable costs
variable inputs
This chapter has illustrated production, costs, revenues, and profit maximization. For each
concept and relationship, we considered both graphical explanations and numerical examples.
We assumed that businesses choose production to maximize profit and that, as a result, they
set it where marginal cost equals marginal revenue.
Summary
1In the next chapter we will see that firms with many competitors see their profits disappear because new firms enter, thereby
increasing market supply and lowering the price.
66 Chapter 4 Firm Production, Cost, and Revenue
1. When firms add workers and get more efficient, they are benefiting from
a. the division of labor.
b. diminishing returns.
c. the law of large numbers.
d. diminishing marginal utility.
2. When firms add workers and find that the additional workers add less to output than their
predecessors did, they are experiencing
a. the division of labor.
b. diminishing returns.
c. the law of large numbers.
d. diminishing marginal utility.
3. Suppose a firm has $1,000,000 in fixed costs and variable costs equal to $100; for every
unit they produce,
a. their marginal costs are decreasing.
b. their fixed costs are decreasing.
c. their average costs are decreasing.
d. the marginal costs are increasing.
4. The average total cost curve will be cut by the marginal cost curve from below as long as
a. fixed costs are rising.
b. average costs are decreasing.
c. marginal costs eventually increase.
d. marginal costs continually decrease.
5. Whether marginal revenue is constant or decreasing depends on
a. whether the firm is benefiting from the division of labor.
b. whether the firm is dealing with diminishing returns.
c. how much the firm sells.
d. whether the firm faces competition.
6. When a firm chooses to shut down, it is
a. making a poor decision because it should always produce where marginal cost equals
marginal revenue.
b. making a poor decision because it should always produce where average costs exceed
average revenue.
c. making a good decision as long as the price it is getting is less than its average costs.
d. making a good decision as long as the price it is getting is less than its average
variable costs.
7. The result that a firm should produce where MC = MR except when the shutdown con-
dition is met is based on the assumption that it is attempting to
a. maximize profit.
b. maximize market share.
c. minimize marginal costs.
d. minimize average costs.
Quiz Yourself
1. What key assumption for perfect competition would lead you to believe that fast food is
not a perfectly competitive industry? Explain why.
2. Suppose your favorite sports team is losing by an insurmountable score. What does the
shutdown condition suggest the team should do? Explain why.
Short Answer Questions
Summary 67
3. Does raising the price always increase revenue for the firm raising the price?
4. If your college leadership sought your advice on setting tuition, why would it matter if
your college was the only college for miles?
Think about This Why is it that when a firm has no competition it typically must lower the price to all consum-
ers in order to sell more? What would have to happen for it to be able to lower the price only
to new consumers?
Talk about This We assume that the price to all consumers is the same. List the cases where the price to one
person is different from the price to another. Why might a firm do this?
68
C H A P T E R F I V E
Perfect Competition, Monopoly, and Economic versus Normal Profit Learning Objectives
After reading this chapter you should be able to:
LO1 Distinguish between perfect competition and
monopoly and between normal and economic
profit.
LO2 Demonstrate and explain why economic profit
disappears under perfect competition but not
under monopoly.
LO3 Illustrate why, under perfect competition, the
supply curve from Chapter 2 is marginal cost.
Chapter Outline
From Perfect Competition to Monopoly
Supply under Perfect Competition
Summary
This chapter builds on Chapter 4 to describe firms in different competitive situations; it shows
why, when there are many firms competing against one another, substantial profits are unsus-
tainable; and it concludes by demonstrating why the supply curve from Chapter 2 was upward
sloping.
Some firms, such as family farms, are among millions of firms in an industry, whereas
other firms completely dominate their industry. In the middle of this continuum are numer-
ous firms with definable sets of competitors. Some industries lend themselves to many
competitors while others lend themselves to only a few; we explore examples along this
continuum.
In Chapter 4 we operated under the assumption that firms were out to maximize profits.
What we want to do now is to determine how well various-sized firms will manage. For
instance, we may want to know why it is that family farmers cannot seem to make consis-
tently high profits, whereas Microsoft can. We approach this by separating profit into two
categories: the profit that is necessary for firms to stay in business and the profit that is above
that level.
Last, we see that the supply curve laid out in Chapter 2 was indeed upward sloping for a
reason. We will show that under perfect competition, an upward-sloping supply curve stems
from the check-shaped marginal cost curve from Chapter 4.
From Perfect Competition to Monopoly 69
From Perfect Competition to Monopoly
As we discussed in Chapter 4, the shape of the marginal revenue curve depends on whether
there are many competitors or no competitors. Figure 5.1 lays out these extreme cases. On the
left, the cost curves from Figure 4.3 are applied to the marginal revenue curve from the case
where there are many competitors. On the right, we see the same for the case where there are
no competitors. The amount they pick in each case is labeled Q*. The price they charge is
labeled P*.
Perfect Competition
The key difference between the cases just outlined is the number of competitors. When the
number of competitors is large, the firm (e.g., a dairy farm) simply has to take the market price
as given but can sell as many goods as it wants at that price. When there are no competitors,
the firm (e.g., Microsoft) can set any price it wants but can sell only the number that consumers
want to buy at that price. Of course, not every firm is faced with the stark either–or difference.
Some firms (e.g., Exxon) have only a few competitors in markets of similar or identical prod-
ucts, and other firms (e.g., McDonald’s) have many competitors in markets where each has its
own signature brand.
When a firm faces a large number of competitors, such that no one firm can influence the
price, when the good a firm sells is indistinguishable from those its competitor sells, when
firms have good sales and cost forecasts, and when there is no legal or economic barrier to
its entry into or exit from the market, then we have what economists call perfect competition.
This may seem like an odd name given that the best examples of it are of sellers that do not
really “compete” in the way noneconomists normally think of “competition.” Whether it is
Midwestern grain farmers; Western ranchers; Florida or California vegetable growers; Wis-
consin, New York, or California dairy operations; or Georgia peach growers, the common
conception of competition does not seem to apply. As individuals, they do not advertise. A
conversation with any of these farmers would reveal that their best friends are their neighbor
farmers. When one farm’s equipment breaks down or a farmer has a significant health crisis
at a critical planting or harvesting time, the neighborhood farmers come to help. That sounds
more like cooperation than competition. So why do economists call this “perfect competition”
when there does not seem to be any true competition? The reason this is “perfect” goes back
to the first characteristic of perfect competition: No one firm has any control over price. No
farmers, or any farm product, have any control over the price of their produce when they sell it
on the wholesale market.1
P
QQ*
P* P* = MR
ATC AVC
MC
Many competitors
QQ*
P*
P
MR Demand
No competitors
ATC AVC
MC
FIGURE 5.1 Picking the quantity to
maximize profit.
1 Though they may be able to charge any price they want at a local farmers’ market, they are not perfect competitors there. In
that setting they are one of a few farmers selling that particular produce.
70 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
Monopoly
Monopolies exist at the other end of the spectrum, when we have markets in which there is
only one firm. The important thing to know about the concept of monopoly is that the exis-
tence of many firms does not necessarily mean the firms are in competition. For instance,
Consolidated Edison was the exclusive provider of residential electrical power to New York
City, and Commonwealth Edison still is the exclusive provider of residential electrical power
to Chicago. There are hundreds of power companies in the United States, but very few of them
compete with one another. They are not competitors because they cannot sell in another’s area.
Another way of looking at this is to say that while there are many power companies, they are
not competing in the same market. The reason is that it costs the companies too much to get
the electricity to the consumer in the distant market. Just as a cement contractor in Little Rock,
Arkansas, is not competing with a cement contractor in Miami for roadwork in south Florida
because of transportation costs, electric companies do not compete with one another because
they cannot access the same buyers. For monopoly, all that is necessary is that one firm and
only one firm sells to the customers in a given market.
Some firms get their monopoly power because the law prevents others from entering the
market. An example of a legal barrier to entry is a patent. For example, the manufacturer of
Clarinex is the only firm that can produce and sell this drug. On the other hand, some firms get
their monopoly power by attaining such a huge size that competing against them is impossible.
The frustration that consumers have with monopolies is the lack of choice that results from
there being only one seller. While many may understand and accept the lack of choice when
the good being sold is a utility with very high fixed costs, and others may understand and ac-
cept the need for patents and copyrights to motivate innovation, monopolies where the barriers
to entry are simply associated with the size of the one monopolizing company often create
anger and frustration. Consider the PC operating system business. Microsoft developed DOS
in the early 1980s and various iterations of its Windows operating system after that. There
have been at least two operating system genres (IBM’s OS2 and Linux) that were considerably
more stable, more secure, and less glitchy than the Windows version against which they at-
tempted to compete. Without question, had Microsoft not been the dominant firm when these
competitors entered the market, either of these operating systems would have easily beaten
Windows to become the preferred platform for personal computing. Because Microsoft had
the leading position, it could maintain the position. Whether or not all of Microsoft’s tactics
were legal has certainly been questioned, but its ability to keep people buying its products has
not. It maintains a dominant position because it has a dominant position.
Monopolistic Competition
One of the areas of middle ground is monopolistic competition, in which many firms sell slightly different products. In the fast-food market there are quite a few firms (McDonald’s,
monopolistic
competition A situation in a market where there are many firms producing similar but not identical goods.
• A large number of competitors, so that no one firm can
influence the price.
• The good a firm sells is indistinguishable from those its
competitor sells.
• Firms have good sales and cost forecasts.
• There is no legal or economic barrier to entry into or exit
from the market.
C H A R A C T E R I S T I C S O F P E R F E C T C O M P E T I T I O N
From Perfect Competition to Monopoly 71
Wendy’s, Burger King, etc., in burgers; KFC, Taco Bell, etc., in various niches), but they do
not sell exactly the same good. McDonald’s has a monopoly on the Big Mac and Happy Meal,
but its competitors offer many close substitutes. This means that each firm has a monopoly
on its particular menu, but the demand curve for the product is quite elastic. (Remember from
Chapter 3 that the number of close substitutes determines elasticity.)
Oligopoly
Another area of middle ground between perfect competition and monopoly is oligopolistic markets, in which there are very few discernible competitors. In the cell phone business, for example, there are major companies like AT&T, Sprint, and Verizon Wireless. In the soft
drink business there are Coke and Pepsi. In some markets firms sell exactly the same thing,
whereas in other markets firms sell close substitutes. In either case, firms are acting in oli-
gopolistic ways and referred to as oligopolies.
Which Model Fits Reality
Tables 5.1 and 5.2 summarize these market forms by providing examples and distinguishing
characteristics of each type. That does not mean we will spend a great deal of time in the
issues chapters worrying about market forms. Recall that in Chapter 2 we implicitly assumed
that all markets were perfectly competitive. It turns out that very few markets meet the extreme
criteria necessary to be labeled perfect competition. Most of the products that meet the criteria
of perfect competition are agricultural; few products outside this area can make that claim. It
may strike you, then, as somewhat curious that we will assume that most markets are perfectly
competitive when we move into the issues. We do this because the supply and demand model
is simple enough so that it can be used to explain and describe most markets where there are
several competitors and the products are similar. You should understand that your instructor
and I (the author) make this simplifying assumption reluctantly but knowingly.
Finally, you should be prepared for a high level of ambiguity in how particular markets fit
into these forms. For instance, long-distance telephone service used to be a monopoly, became
an oligopoly in the 1980s, and saw significant expansion in the number of companies offering
service in the 1990s. Perhaps now it fits best under monopolistic competition. The personal
oligopolistic market A situation in a market where there are very few discernible competitors.
TABLE 5.1 Examples of different
market forms. Perfect Competition
Monopolistic
Competition Oligopoly Monopoly
Agricultural products Fast food Smartphones Operating systems
Lumber Clothing Soft drinks Local residential
electric power
TABLE 5.2 Distinguishing
characteristics between
market forms.
Characteristic
Perfect
Competition
Monopolistic
Competition Oligopoly Monopoly
Number of firms Many (often Several* Few* (usually One thousands or two to five) even millions)
Barriers to entry None Few Substantial Insurmountable,
at least in the
short run
Product Identical Similar but Similar or NA
similarity not identical identical
*There is dispute about the line that separates monopolistic competition and oligopoly.
72 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
computer business is similar in that there was only one firm, IBM, for many years, but today
there are a dozen or more selling laptops and desktops. They all sell essentially the same thing
but have a monopoly over their brand. The smartphone operating system industry is domi-
nated by Apple and Google, with the device industry being dominated by HTC, Apple, and
Samsung. Similarly, if you want to fly from New York to Los Angeles, you have a number of
alternatives, perhaps not so many that it would be perfect competition but certainly enough to
classify this service as monopolistic competition. On the other hand, if you want to fly directly
from Indianapolis to Atlanta, you have two choices for nonstop flights (Southwest and Delta).
If you want to fly directly from Syracuse to Detroit, you have only one choice (Delta). Where
airline travel fits depends greatly on to where, and from where, you are traveling. In particular,
it depends on who has a hub in the respective airports.
Further, there is no magic line that separates oligopoly from monopolistic competition.
Economists who study these things will often look to something called a concentration ratio that measures the percentage of total market sales for the top firms (from 4 firms to 100 firms).
So even though there are several tobacco companies selling cigarettes, one company, Philip
Morris, holds nearly half the market, and the top four hold all but 1 percent of the market. Sev-
eral equally competitive firms would suggest monopolistic competition, but these concentra-
tion ratio data suggest that oligopoly may be a better fit. Table 5.3 presents 4-, 8-, and 50-firm
concentration ratios for specific industries.
Another index that economists, particularly those in the antitrust division of the Depart-
ment of Justice, use is the Herfindahl-Hirschman Index (HHI). Instead of just adding together the market shares of the largest firms, this adds the square of the market shares. What that
does is distinguish a market where five firms have equal shares from one in which the big
firm has a large proportion of sales and the others simply split the rest. If the market share
is between 0 and 100 percent and there are N firms, the HHI ranges between 10,000/N and
10,000. A number between 1,000 and 1,800 is considered moderately concentrated while an
index value greater than 1,800 is considered highly concentrated. The index value for break-
fast cereals is above 2,500 and the one for cellular service is so high that the census bureau
(that regularly published the statistics) must suppress the actual number to “protect the iden-
tity of any business. . . .” Essentially the industry is so concentrated that reporting how much
provides the largest businesses information on others.
concentration ratio A measure of the market power held by the top firms in an industry. For a specific number of firms (n), it is the per- centage of total sales in the industry accounted for by top n firms.
Herfindahl-Hirschman
Index A measure of market concentration developed by adding the sum of squared market shares.
TABLE 5.3 Concentration ratios and Herfindahl-Hirschman indices for various industries, 2012.
Concentration Ratios
Industry Group 4 Largest Firms 8 Largest Firms 50 Largest Firms Herfindahl-Hirschman Index
Breakfast cereals 79.2 93.7 100.0 2,332.5 Ice cream 45.9 64.6 94.0 665.8 Beer 87.8 90.8 95.9 3,560.7 Wine 45.3 58.0 75.2 785.3 Clothing 10.3 15.0 38.3 54.0 Computers and peripherals 31.5 46.0 80.6 421.9 Furniture 23.7 30.9 52.8 233.7 Automobile manufacturing 60.2 88.7 99.7 1,177.90
Cellular service 89.1 95.2 98.8 *
*This industry is so concentrated that the Census Bureau cannot report exactly how concentrated it is because doing so would provide competing firms with sales information
of their individual competitors.
Not published for service providers.
Source: United States Census Bureau, http://factfinder.census.gov/ ID: EC1251SSSZ6.
Supply under Perfect Competition 73
Supply under Perfect Competition
Normal versus Economic Profit
Let’s return to the example we used in Chapter 4: the business of selling memory chips. If
we are one of many firms competing in this industry, it stands to reason that making money
will be difficult. Because of our assumption of free entry into and exit from this market,
any time there are abnormally large profits, other firms will want to start making memory
chips. Remember that Chapter 2 presented evidence that an increase in the number of sellers
will move the supply curve to the right, thus lowering market price. If that happens, our
marginal revenue curve will fall. As a matter of fact, it will fall all the way to where profit is
normal. Normal profit is the level of profit that business owners could get in their next best alternative investment. The next best alternative would be whatever investment an owner
would choose if he or she decided to go out of business. Any profit above normal profit is
called economic profit. If business owners do not make their normal profit, they will quit the business and
move into another. This means that we might think of normal profit as the salary the
business owners pay themselves and, as such, part of the “cost of doing business.” If they
make less than normal profit, then the salary they can pay themselves is too low to keep
them in the industry. On the other hand, if profits are routinely more than that, others will
want to enter the industry. This means that in the long run profit will shrink to normal
levels.
When and Why Economic Profits Go to Zero
Fortunately for our chip maker, although the firm cannot make long-run economic profits,
it is not going to lose money for long either. When firms lose more money than their fixed
costs, they shut down. In the short run firms will continue to produce when they lose less than
their fixed costs, but as time passes these firms will also want to shut down. So, though our
chip maker can make economic profit in the short run and lose money in the short run, the
effect of free entry and exit in this market will cause the marginal revenue curve to settle at
normal profit The level of profit that business owners could get in their next best alternative investment.
economic profit Any profit above normal profit.
A nearly perfect example of the importance of entry and exit in ex-
plaining why and when economic profits go to zero is the crude oil
industry and the experience from 2014 to 2016. Prior to mid-2014,
hydraulic fracturing and horizontal drilling, though invented, hadn’t
had a dramatic impact on world oil supplies. Because of that, OPEC
countries had tight control over supplies and the market was largely
oligopolistic (with OPEC operating like one enormously powerful
firm and few other large producers). The benefits to them were high
prices and enormous profits. Further, without the new technology,
those high prices and profits could not generate profit-killing entry.
Starting in August of 2014, that technology created a boom in
production levels. North Dakota’s production took off and once-idled
oil fields in Texas and Oklahoma resumed production. The result
was a dramatic decline in crude prices. From $107 per barrel in mid-
2014, to below $30 per barrel in early 2016, the economic profit
was completely wrung out of the industry. Economic losses replaced
economic profits. Exit started to occur as firms ceased production
from unprofitable wells.
When entry is possible, as it is now in oil, economic profits mo-
tivate it. When production increases too much, economic losses
motivate exit. When entry is impossible, economic profits can go on
forever—a state of the world that OPEC nations can now only look
back upon as their “good old days.”
A N E A R LY P E R F E C T E X A M P L E O F T H E I M P O R T A N C E O F E N T R Y A N D E X I T
74 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
the minimum of the U-shaped average total cost. What this means in everyday English is that
any short-run profit or loss will evaporate in the long run because new competitors will come
in or old ones will leave. This will drive the price toward the minimum of average total cost
where profit is normal.
Though profit also shrinks to its normal level under monopolistic competition, there is
no mechanism for profits to shrink to normal levels under oligopoly or monopoly. This is
because the mechanism that shrinks profit is entry. Because entry is almost insurmountable
under monopoly and substantially difficult under oligopoly, new firms do not come in to put
the pressure on the price to fall.
At this point we need to back off our discussion to define more explicitly what economists
mean by short run and long run. To an economist the distinction between the two centers on
the ability of a firm to change its fixed inputs. We have assumed all along that we cannot
change things like plant and equipment, and this is true in what we call the short run. In the long run there is enough time to change plant and equipment. We can either buy more plant and more equipment, or we can sell what we have. The distinction is thus not one of time but
of flexibility; in the long run we are more flexible and in the short run less flexible.
Why Supply Is Marginal Cost under Perfect Competition
Showing that, under perfect competition, supply and marginal cost are interchangeable is
important for several of the issues that follow, but it is also notoriously difficult. That is why
we will go back to the three approaches used in Chapter 4. We’ll do the “Just Words,” and
“Numerical Example” approaches first and end with the “Graphical Explanation.”
Just Words
In order to see that, under perfect competition, supply and marginal cost are interchangeable,
you need to recall two key facts from Chapter 4: (1) All profit-maximizing firms will choose to
produce where marginal cost equals marginal revenue (as long as price is greater than average
variable cost); and (2) under perfect competition price and marginal revenue are the same. With
that in your head, imagine that a firm is trying to decide how much to produce. It will take the
price that is given to it by the market (which is also the firm’s marginal revenue) and set produc-
tion where that price equals its marginal cost. If the price rises or falls, it will do the calculation
again. In every case, the quantity at which marginal revenue equals marginal cost is the same as
the quantity at which price equals marginal cost. That means that in every case the relationship
between quantity produced and the marginal cost of producing it (the marginal cost curve) is
the same as the relationship between the quantity produced and the price at which it is sold (the
supply curve). So, under perfect competition, supply and marginal cost are interchangeable.
Numerical Example
Using the memory chips example again, you can see from Table 4.2 that the average variable
cost reaches a minimum at $15 per unit at the quantity of 500 units. This is important because
at any price below $15 the firm will choose not to produce. To see that, suppose the price
were $12 per unit. Marginal cost equals marginal revenue ($12) at 400 units, but at 400 units
the firm’s total revenue will be $4,800 ($12 × 400) while its total cost will be $14,500, and
it will lose more money ($9,700 = $14,500 − $4,800) than it would if it simply shut down
($8,500).
At every price above $15 the firm either makes money or at least loses less than $8,500, and
therefore it makes sense for the firm to produce where marginal cost equals marginal revenue.
If the price were exactly $15, the firm would produce 500 units, have $7,500 ($15 × 500) in
total revenue, $16,000 in total cost, and lose exactly its fixed costs. If the price were $20, the
short run The period of time where a firm cannot change things like plant and equipment.
long run The period of time where a firm can change things like plant and equipment.
Supply under Perfect Competition 75
firm would produce 600 units, bringing $12,000 in revenue while costing $18,000, and the
loss is $6,000. The firm would rather lose $6,000 than $8,500, so it produces 600 units.
As the price rises to $30, it produces 700 units, has both revenue and cost of $21,000, and
breaks even. At a price of $45 it produces 800 units, has revenue of $36,000, costs of $25,500,
and makes a profit. At a price of $55 it produces 900 units, has revenue of $49,500, costs of
$31,000, and its profit increases. Finally, at a price of $100, it produces 1,000, has revenue of
$100,000, costs of $41,000, and its profit increases further. Putting it all together, the firm’s
supply curve is its marginal cost curve (out of the minimum of average variable cost) because
it sets production by noting the price and using the marginal cost figure to set production.
Therefore, the relationship between its marginal cost and its production (its marginal cost
curve) is the same as the relationship between the price it will receive and its production (its
supply curve).
Graphical Explanation
Figure 5.2 shows our ATC-AVC-MC cost curve diagram with four potential marginal revenue
curves. For each, if there is pressure on the price to change in the short run, this is indicated
with a short arrow in the direction of the pressure. If there is long-run pressure, this is indi-
cated with a long arrow. At the first price–marginal revenue, MR1, the loss is so big that firms
want to leave in both the short and the long run. This will reduce the number of sellers and the
market price will rise in both the short run and the long run. At MR2 the chip maker is losing
money but not enough for it to close down. So, though the firm does not want to shut down in
the short run, it will want to shut down rather than invest money in new equipment as the old
equipment wears out. Therefore, the long-run pressure is for the price to rise. At MR4 our chip
maker is making an economic profit. If this happens, others will want to join the chip-making
industry and there will be short- and long-run pressure for the price to fall. It is only when the
price is at MR3 that there is no pressure on the price.
Now to why under perfect competition a firm’s supply curve is its marginal cost curve out
of the minimum of its average variable cost. In Figure 5.3 the arrows from Figure 5.2 have
been taken away and the points where the firm will produce are indicated by a dot. These
points appear where marginal cost crosses marginal revenue, a circumstance that will come
about only if firms do not shut down.
MR1
MR2
MR3
MR4
MC
ATC
AVC
P
Q
FIGURE 5.2 In perfect competition the market price is under pressure to move to where economic
profit is zero.
MR1
MR2
MR3
MR4
MC
ATC
AVC
P
Q
FIGURE 5.3 Points where MC = MR in perfect competition.
76 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
This chapter built on the previous one in which costs and revenues were defined and illus-
trated. We saw the distinction between perfect competition and monopoly and that they are
the endpoints of a continuum. We said that most markets operate somewhere in the middle of
this continuum. Further, we distinguished between normal and economic profit, and showed
why economic profit disappears under perfect competition but not under monopoly. Last, we
saw that under perfect competition, the supply curve from Chapter 2 is the part of the check-
shaped marginal cost curve from Chapter 4 that is above average variable cost and is therefore
upward sloping.
Summary
Key Terms concentration ratio economic profit
Herfindahl-Hirschman
Index
long run
monopolistic
competition
normal profit
oligopolistic market
short run
Issues Chapters You Are Ready for Now
The Economics of
Prescription Drugs
Ticket Brokers and Ticket
Scalping
The Economics of K–12
Education
Energy Prices
Unions
Walmart: Always Low
Prices (and Low
Wages)—Always
The Economic Impact of
Casino and Sports
Gambling
In our final manipulation of the figure we
get one of the most important implications
of perfect competition. Connecting the dots
of Figure 5.3 makes clear the relationship
between the price of the chips our firm is
selling and the number of chips our firm is
willing to produce. If that sounds familiar,
it is because that is exactly the definition of
supply. As a result we now know that sup-
ply, under perfect competition, is marginal
cost out of the minimum of average variable
cost. This, of course, also demonstrates why
the supply curve is upward sloping: Mar-
ginal cost is increasing.
Although more difficult to show than it
is worth, it is important to state that there is no supply curve under monopolistic competition,
oligopoly, or monopoly. To understand the reason, note that Figure 5.4 generates the supply
curve by finding the production levels with a variety of different prices. Recall from Figure 4.4
that these horizontal price lines also represent perfectly elastic demand curves for a particular
firm’s output. This same derivation does not work for the other market forms because the
elasticity of demand for a firm’s output is not perfectly elastic and demand curves of different
elasticities result in different profit-maximizing firm output.
MC
Supply
ATC
AVC
P
Q
FIGURE 5.4 Derivation of supply:
marginal cost out
of the minimum of
average variable cost.
Summary 77
1. An industry in which there are many competitors with specific marketing niches is likely
to be characterized by
a. monopoly.
b. oligopoly.
c. monopolistic competition.
d. perfect competition.
2. An industry in which there are a very limited number of large firms is likely to be char-
acterized by
a. monopoly.
b. oligopoly.
c. monopolistic competition.
d. perfect competition.
3. Owing to its usefulness and relative simplicity, the supply and demand model is often used
a. because nearly every major industry in the United States is governed by perfect
competition.
b. because nearly every major industry in the United States is governed by monopoly.
c. even though, strictly speaking, few industries in the United States are governed by
perfect competition.
d. even though it has no connection to economic reality.
4. Whether a firm stays in business or shuts down depends heavily on the concept of
a. economic profit.
b. actual profit.
c. market share.
d. concentration ratios.
5. Economic theory would suggest that the profitability of an industry would be
a. directly related to the number of firms competing in the industry.
b. inversely related to the number of firms competing in the industry.
c. unrelated to the number of firms competing in the industry.
d. zero in the long run, regardless of market structure.
6. Under perfect competition, the supply curve is
a. the marginal cost curve for all price quantity combinations.
b. the marginal cost curve, but only that portion that is downward sloping.
c. the marginal cost curve, but only that portion that is upward sloping.
d. the marginal cost curve, but only that portion that is above the minimum of average
variable cost.
7. An indicator of the degree of competition in an industry is the concentration ratio. It measures
a. the percentage of sales in the industry by the largest firms.
b. the percentage of profit in the industry by the smallest firms.
c. the sales in the industry as a percentage of all consumption in the United States.
d. the profitability of the industry.
8. Local telephone service was once an area in which consumers had no choices. Many
young people today no longer use “landlines,” preferring instead to use their cell phones.
This means that the market has moved toward
a. monopoly.
b. oligopoly.
c. perfect competition.
d. monopsony.
Quiz Yourself
78 Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
1. Imagine an owner of a firm is thinking about raising prices. Describe the consequences
of doing so as a monopolist, oligopolist, monopolistic competitor, and perfect competitor.
2. What are the key differences between monopolistic competition and perfect competition?
3. Describe why there is pressure on the price to fall when P > ATC. Is there a long- and
short-run distinction in the answer?
4. Describe why there is pressure on the price to fall when P < ATC. Is there a long- and
short-run distinction in the answer?
Think about This One of the concerns about Walmart’s entry into the grocery business in the latter part of the
1990s was that it would set low prices, drive little stores out of business, and then raise prices
to monopoly levels when it had no competition. That hasn’t happened, but that doesn’t mean it
couldn’t happen. Under what conditions, and in what industries, might such a strategy work?
Talk about This List the monopolies that used to exist when you were growing up that are now facing increased
competition. Compare that list to a list provided by your instructor (who is presumably older
than you). What current monopolies are likely to be threatened with entry in the future?
Behind the Numbers Concentration ratios for largest 4, 8, and 50 firms in various industries—
www.census.gov/econ/concentration.html
9. In a diagram of perfect competition, the marginal revenue line moves up and down when
there is exit and entry, respectively, because
a. the market demand for the good rises and falls when there is exit and entry,
respectively.
b. the market demand for the good rises and falls when there is entry and exit,
respectively.
c. the market supply for the good rises and falls when there is exit and entry,
respectively.
d. the market supply for the good rises and falls when there is entry and exit,
respectively.
10. If MR > MC, then when an additional unit is sold, the firm’s
a. profit will be positive.
b. profit will increase.
c. profit will be negative.
d. profit will decrease.
Short Answer Questions
79
C H A P T E R S I X
Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression Learning Objectives
After reading this chapter you should be able to:
LO1 Define the basic vocabulary of
macro economics.
LO2 Describe how the economy is measured.
LO3 Describe how gross domestic product, our
national measure of output, is calculated.
LO4 Calculate inflation using a price index.
LO5 Describe real gross domestic product as the
inflation-adjusted value of economic activity
and judge its use as the measure of the
economy’s health.
LO6 Describe how unemployment is measured and
enumerate the types of unemployment that
economists recognize.
LO7 Define and apply the vocabulary of the
business cycle.
Chapter Outline
Measuring the Economy
Real Gross Domestic Product and Why It Is Not
Synonymous with Social Welfare
Measuring and Describing Unemployment
Productivity
Seasonal Adjustment
Business Cycles
Kick It Up a Notch: National Income and Product
Accounting
Summary
80 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
We shift gears now to talk about the economy as a whole rather than the consumption or pro-
duction of specific goods. What we covered in Chapters 2 through 5 is called microeconomics, because it deals with individual markets and firms. The prefix micro, meaning small, applies
here because of the narrow scope of microeconomics. The opposite prefix, macro, means
large, so macroeconomics deals with the economy as a whole. When you read or hear “eco- nomic news” you more often than not get macroeconomic news. In that context you hear the
same words over and over again. This chapter attempts to define and explain the vocabulary
of macroeconomics.
We begin the chapter by examining the methods by which we measure the macroeconomy.
In that process we define and explain gross domestic product, inflation, and how and why
the gross domestic product is adjusted for inflation. We move from there to explain how un-
employment is measured, and we finish with a discussion of the business cycle. You will see
that all of these economic measures have flaws that economists recognize and study and that,
though real gross domestic product is an accepted measure of the economy’s health, it is not a
perfect measure of our nation’s overall health.
This is by far the most easily understood chapter of all the theory chapters, but you should
make sure that you understand the terms and the concepts behind them thoroughly. Chapter 8
and the more macro-oriented issues chapters rely on them heavily.
Measuring the Economy
Measuring Nominal Output
To keep tabs on how well or how poorly the economy is doing, we measure economic ac-
tivity by adding up the dollar value of all of the goods and services produced for final sale
in the United States in a year. The gross domestic product (GDP) is the primary measure of the health of the economy, and some important concepts within this definition need to
be highlighted:
1. This measure is a dollar measure that is subject to price variability.
2. Only “final” sales are counted.
3. The goods that are studied must be goods produced within the United States.
The fact that the GDP is influenced by changes in prices must be dealt with at length, but
this discussion must be delayed until we explore inflation at length. Moreover, besides infla-
tion, two other fairly straightforward issues should be addressed. The first of these is the issue
of double-counting intermediate sales; the second is how to count the production of multi-
national companies.
To avoid the double-counting of certain economic activity, only final sales are counted.
Suppose that you are talking about the production and sale of two loaves of bread. Suppose
the first loaf is produced by a woman who grows and grinds the wheat, mixes the dough, bakes
the loaf, and sells it all by herself. Suppose another loaf begins with a farmer who grows the
wheat and sells it to a miller, who grinds it into flour and sells the flour to a baker, who mixes
the dough, bakes the loaf, and sells the loaf to a retailer, who sells the loaf to a customer. If
both loaves are of equal quality, then both should be sold for the same price: say, one dollar.
Clearly both loaves contribute the same to the amount of bread available to society, so both
should count the same when we measure economic activity. If you summed all sales along the
way, however, the second loaf would count more than the first.
The other aspect of this measure is that it counts production only if it takes place within the
borders of the United States. This means the Fords produced in Mexico are not counted in the
U.S. GDP, but the Hondas produced in Ohio are.
microeconomics The part of the disci- pline of economics that deals with individual markets and firms.
macroeconomics The part of the disci- pline of economics that deals with the economy as a whole.
gross domestic
product (GDP) The dollar value of all of the goods and serv- ices produced for final sale in the United States in a year.
Measuring the Economy 81
The actual computation of the GDP is done in two distinct ways. One way is to count all
those things for which people pay money. This is called the expenditures approach. The expen-
ditures approach adds up all of the following: consumption, investment, government spending
on goods and services, and exports; then it subtracts imports. The other approach, which counts
all those ways in which people earn money, is called the income approach. This approach adds
up employee compensation, interest, rents, profits, and depreciation and then subtracts income
earned in other countries and indirect business taxes (such as sales taxes). Both approaches yield
the same result because the money that the buyer “spends” is, by definition, the seller’s “income.”
Therefore, adding up everyone’s income and everyone’s spending yields the same sum.
The sources that the government uses to compute this information are wide and varied.
They are known as the National Income and Product Accounts, and compiling them is com-
plicated and time-consuming. For instance, while the government knows quickly and reliably
how much it spends on goods and services, nearly every other piece of information included
in the GDP has to come from forms that businesses send to the government: tax forms, un-
employment insurance forms, reports of sales and sales taxes, and other documentation. It
is therefore obvious, but it warrants noting, that trying to produce the final GDP quickly is
difficult. What actually happens is that government economists use sampling techniques to
produce preliminary estimates that are repeatedly updated as more information is submitted.
When all information is in, sometimes more than a year after the first preliminary estimate is
made, a final GDP value is published.1
1 Even then, some components are estimates.
Measuring Prices and Inflation
As we said in the previous section, measuring price changes is important. Whether price
changes account for changes in the GDP or whether actual production changes account for
those changes is vital to the question of whether we are better off in one period than we were
H O W D O E S I T C O U N T I N G D P ?
Issue How It Counts in GDP (C + I + G + X − M)
A product made in one
year but sold a
later year
GDP counts the value of the product made but not yet sold as an increase to
business INVESTMENT (I), of which inventories are a part. So if it is made
in December, investment goes up. When it is sold, investment drops but
either CONSUMPTION (C) or EXPORTS (X) goes up. Typically a good goes
into inventories at its wholesale value so when it is sold, the increase in
consumption or exports is greater than the decrease in inventories.
A used car is sold The only part of a used car sale that counts is the markup from its purchase price
from the previous owner to the sale to the next owner. That is the value the
used car dealer created in cleaning and preparing the car for sale.
Stock sold in a
stock market
Personal investment and business investment are two different things. It is only
when a business uses the sale of (initial public offering) stock to raise money
to buy equipment and inventory that there is any crossover.
How illegal drug sales
are counted
The simple fact is they aren’t, and it isn’t because they shouldn’t be. Only
recorded sales that are part of the system of business reporting to state
and federal governments count.
82 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
in a previous period. A GDP number that increases because prices rise is less desirable than
a GDP that increases because people are actually buying products in greater quantities. For
instance, let’s make the simplifying assumption that there is only one good in society, cheese,
we produce 10 trillion tons of cheese in one year, and cheese is sold at a price of $1/ton. That
is vastly better than if we produce only one ton of cheese and it is sold at a price of $10 trillion.
Clearly, to discuss the value of production we have to discuss how we measure prices.
The way that government economists measure prices is intricate. Under their direction,
employees of the Bureau of Labor Statistics (BLS) go shopping for a market basket of goods and services in an effort to see if the total cost of that market basket has changed in the cur-
rent year from what it was in the previous year. To do this they have to establish what should
go into that market basket through a process of figuring out what average people buy and in
what quantities they buy it. This market basket then makes up a kind of “grocery list” of things
that government employees go out and find prices on. With the rapid expansion of available
products, the BLS has recently chosen to update the market basket every two years. Their old
practice of updating the market basket only every 10 years led to significant problems.2
The “list” of items for which government employees go out every month to find prices
is very specific, not only indicating what model number or UPC code to look for but also
specifying stores in which the goods need to be located. Frequently, especially with electronic
equipment, the item that the employee is supposed to find no longer exists or no longer exists
at the specified store. In that case employees must use their best judgment to find a suitable
substitute and record key attributes of the good.3
For each month for which the list is in effect, including the first month of the first year,
called the base year, Bureau of Labor Statistics employees find the prices of everything on the list. When they finish, a national average is computed. The result constitutes the first key
piece of information necessary to compute future inflation: It is the national average of the
total cost of the market basket. It is called the price of the market basket in the base year. In succeeding months a revised national average is generated on the basis of new information
on prices.
To use this information to measure any inflation that may have arisen in any given year, we
have to go through three distinct steps:
1. We find the price of the market basket in the relevant years.
2. We compute a price index for the relevant years.
3. We compute the percentage of change in the relevant price indices.
After arriving at the price of the market basket in the base year, we also have to get the
price of the market basket in any of the other years in question. For instance, if you ultimately
wanted to know the inflation rate for 2015, you would need the price of the market basket in
the base year, 1998, the price of the market basket at the beginning of 2015, and finally the
price of the market basket at the beginning of 2016.
Next, a price index, which centers the price of the market basket around 100, is computed for the beginning of 2015 and 2016. For instance, the consumer price index (CPI) for 2015 is
CPI in 2015 = Price of the market basket in 2015
__________________________________________ Price of the market basket in the base year of 1998
× 100
market basket Goods that average people buy and the quantities they buy them in.
base year Year to which all other prices are compared.
price of the market
basket in the base year National average of the total cost of the market basket.
price index A device that centers the price of the market basket around 100.
consumer price
index (CPI) The price index based on what average consumers buy.
3 The BLS then constructs a “hedonic price” for these goods. A hedonic price is an educated guess at what the price of the
original good would have been given its characteristics. The BLS constructs hedonic prices for clothes dryers, microwave ovens,
refrigerators, camcorders, consumer audio products, DVD players, and college textbooks.
2 In 1996, the Boskin Commission established that measuring inflation the original way overstated the true inflation rate by
1.1 percentage points. In response to this criticism and in recognition of these problems, the Bureau of Labor Statistics
corrected some of these flaws by going to a two-year cycle on market basket updates.
Measuring the Economy 83
This formula can be interpreted to mean that in the base year the CPI is 100. At other times,
as prices rise, the CPI will rise above 100. If prices eventually become twice what they were
in the base year, the CPI will be 200.
The last step is to compute the percentage change in the price index. To do this, you take
the CPI at the beginning of the year and the CPI at the beginning of the next year and plug
them into the formula
Inflation during 2015 = CPI on January 1, 2016 − CPI on January 1, 2015
CPI on January 1, 2015 × 100%
As a practical matter the CPI is important for another reason. For economists it is important
because it is used to generate not only an inflation rate, the percentage increase in the CPI, but also the cost-of-living adjustment, or COLA. This adjustment compensates people for the fact that changes in inflation also change the spending power of their income. For social security
recipients and others on pensions that pay a COLA, as well as union members with contracts
that are tied to a COLA, this represents the extra income they get each year to compensate
them for inflation.4 Table 6.1 presents a historical picture of the CPI.
Problems Measuring Inflation
We now have a measure of inflation that gives us helpful information on how the total price
of a given market basket changes. For several reasons, however, it does not do a very good
job in measuring the true impact of inflation. The first way in which the CPI can estimate
inflation inaccurately derives from the two-year period between changes in the market basket.
Specifically, large price decreases that occur in the first two years after the introduction of a
product are ignored. For instance, the iPhone was originally marketed for $600 and two years
after its introduction sold for less than $200 at Walmart. When the market basket updates were
inflation rate The percentage increase in the consumer price index.
cost-of-living
adjustment (COLA) A device that compen- sates people for the fact that changes in inflation change the spending power of their income.
Year CPI
Inflation
Rate (%) Year CPI
Inflation
Rate (%) Year CPI
Inflation
Rate (%)
1920 19.4 1988 120.7 4.4 2002 181.8 2.5
1930 16.1 1989 126.3 4.6 2003 185.5 2.0
1940 14.1 1990 134.2 6.3 2004 191.7 3.3
1950 25.0 1991 138.2 3.0 2005 198.1 3.3
1960 29.8 1992 142.3 3.0 2006 203.1 2.5
1970 39.8 1993 146.3 2.8 2007 211.4 4.1
1980 86.4 12.4 1994 150.1 2.6 2008 211.4 0.0
1981 94.1 8.9 1995 153.9 2.5 2009 217.4 2.8
1982 97.7 3.8 1996 159.1 3.4 2010 220.5 1.4
1983 101.4 3.8 1997 161.8 1.7 2011 227.1 3.0
1984 105.5 4.0 1998 164.4 1.6 2012 231.1 1.8
1985 109.5 3.8 1999 168.8 2.7 2013 234.7 1.5
1986 110.8 1.2 2000 174.6 3.4 2014 236.3 0.7
1987 115.6 4.3 2001 177.4 1.6 2015 237.8 0.7
Note: CPI is year-end figure.
Source: Bureau of Labor Statistics, www.bls.gov/cpi/home.htm (Series ID: CUSR000SA0)
TABLE 6.1 CPI and inflation
in selected years,
1920–2015; base years
1982–1984.
4 Social Security uses the end of June CPI to compute the COLA. By law, Social Security checks to individuals cannot fall, which
means that if prices fall, the Social Security Administration simply does not increase benefits until the CPI rises to above its previous
higher level. Because the June 2008 to June 2009 CPI fell and because the June 2010 level did not rise to the June 2008 level,
Social Security recipients received no COLA for two years. The same thing happened in 2015 when plummeting gasoline prices
held the CPI down so much that overall inflation was zero.
84 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
on a 10-year cycle, VCRs, personal computers, cell phones, DVD players, iPods, flat-screen
TVs, and TiVo boxes/DVRs did not come into the market basket until several years after their
introduction. In all of these cases large price decreases and significant quality improvements
occurred long before their inclusion. Flat-screen TVs used to be priced at more than $10,000
and can be found now for less than $300. Though the CPI methodology will eventually pick
up the final fall in prices once they are included, it will fail to pick up the initial drop in price.
The second way in which the CPI may assess inflation inaccurately relates to quality im-
provements in electronics, which may occur so quickly that by the end of the final year of the
market basket, the good that was originally included no longer exists. The best example of
this is the personal computer. Recognizing this, in 2006 the BLS began to adjust for quality
improvements in certain goods.
Third, people have significantly changed the places in which they buy goods. For instance,
in the 1950s television sets were, by and large, purchased in department stores or small appli-
ance stores. Although the personal service customers received during this period undoubtedly
exceeded the level of service we now get at large discount stores or warehouse clubs, the price
we pay when we make our purchases at discount stores is also much lower. Today we buy from
stores where service is low but prices are also very low. If you remember, the government em-
ployees who go looking at prices do so at the specific stores designated at the beginning of the
life of the market basket. Because they change the store to match consumer behavior only when
they change the market basket, they may fail to capture a significant source of price decreases.
In this way, the BLS has lagged behind actual behavior regarding Internet shopping.
Fourth, when prices change dramatically people look for substitutes. Because the market
basket is fixed for a two-year period, it is implicitly assumed that people mindlessly buy ex-
actly the same amount of everything, every period, regardless of prices. This is surely a silly
assumption for economists to make, given that much of Chapter 2 was devoted to how people
react to price changes. For an example of how failing to account for substitution can overstate
the effects of an increase in the price of one good, consider energy prices. In 2008, gasoline
An interesting aspect of inflation is that it creates its own set
of winners and losers. People living on fixed incomes will be
highly sensitive to inflation, and because people who borrow
money are paying it back with dollars that are less valuable
than the money they borrowed, both they and the lending in-
stitutions from whom they borrow will have a stake in the rate
of inflation.
Anyone receiving a fixed amount of money per month or per
year through an investment or having a fixed amount of cash that
they must stretch over a long period of time will be unambiguously
hurt by inflation. They will see their buying power drop incremen-
tally over time. To see how important that is, suppose a 65-year-old
new retiree sets up an annuity so that she gets $20,000 a year
until she dies. If she lives 20 additional years and inflation is run-
ning at 5 percent per year, the buying power of that money will be
62 percent lower. Even if inflation is running at a modest 2 percent
per year, her buying power will be 33 percent lower. While good
financial planners will account for this when setting up such
annuities for their clients, retirees who forgo investment advice
can get caught in this trap.
In the arena of borrowing and lending there are also winners
and losers. Here the important question is not necessarily whether
there is inflation but whether inflation is greater than was expected
by the respective parties. If inflation is greater than was expected
when the interest rate on the loan was established, then borrowers
are winners because they are paying the loan back using less valu-
able dollars than they anticipated. If borrowers are the winners, then
lenders are clearly the losers in that they are receiving less valuable
dollars in return. Of course, each “dollar” is still worth a dollar, but
with inflation running above expectations, each dollar buys less than
it was expected to be able to buy when the loan was set up.
On the other hand, if inflation runs less than was expected, the
lender is the winner and the borrower is the loser. The borrower is
paying the loan back with dollars that have more spending power
than they were anticipated to have and the lender is receiving those
more valuable dollars.
I N F L A T I O N ’ S W I N N E R S A N D L O S E R S
Measuring the Economy 85
O T H E R P R I C E I N D I C E S
19 97
19 98
19 99
20 00
20 01
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
20 10
20 11
20 12
20 13
20 14
20 15
20.00%
15.00%
10.00%
5.00%
0.00%
–5.00%
–10.00%
–15.00%
–20.00%
–25.00%
A n
n u
a li z e
d i n
fl a
ti o
n r
a te
Year
CPICore CPI Core PCE
FIGURE 6.1 CPI, core CPI, and core PCE.
Because inflation is damaging to an economy and
extreme inflation can be very dangerous, the Federal
Reserve Board keeps close tabs on it. As we will see
in Chapters 8 and 12, the Fed, for short, adjusts short-
term interest rates to keep inflation in check. If you
look behind the numbers of the CPI you find that it is
highly variable. That is why the Fed looks at two more
stable price indices. Both are called the core rates
because they eliminate the impact of highly volatile
food and energy prices. The core CPI is based on the
traditional CPI, while the core PCE strips out the costs
of food and energy from a different price index, called
the Personal Consumption Expenditures deflator. You can see from Figure 6.1 that the core CPI and the
core PCE are much more stable than the CPI itself.
Because the Fed does not want to overreact to rapid
changes in volatile sectors, it focuses its attention on
these core measures.
Finally, there is also an index of input items for firms,
called the Producer Price Index. It is often useful as a look ahead at what inflation will be in a few months as
firms turn those inputs into goods that they sell.
prices climbed from $2 per gallon to more than $4.20 per gallon. Many people sold their
SUVs and bought more fuel-efficient cars, or simply drove less.
In response to this criticism and in recognition of these problems, the Bureau of Labor
Statistics began an effort to correct some of these flaws. First, as mentioned above, they make
an explicit effort to account for the consumer electronics quality problem. Second, they now
reestablish the market basket every 2 years rather than every 10 years. This allows for new
goods to enter the market basket much more quickly and have at least a portion of the initial
drops in price count. It also allows the BLS to account for substitution between goods when
there are long-term changes in prices, such as the increase in gas prices that began in 1998
and culminated in $4.20 gasoline in 2008. This chain-based index represents progress as far as economists are concerned.
chain-based index A price index based on an annually adjusted market basket.
core CPI The consumer price index that has had the impact of food and energy costs removed.
core PCE The Personal Con- sumption Expenditures deflator that has had the impact of food and energy costs removed.
Personal Consumption
Expenditures deflator A chain-based price index that adjusts for the substitution problem.
Producer Price Index A price index based on what firms buy.
86 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
Still, these efforts have not solved the problem entirely. In a summary of the issues, David
Lebow and Jeremy Rudd reported that the degree of error in the consumer price index has
been cut to less than a percentage point. Though better than before, their 0.8 percentage point
estimate for the overstatement is significant. Over the course of 30 years, tax brackets and
CPI-adjusted benefits will be overadjusted by 27 percent.
Real Gross Domestic Product and Why It Is Not Synonymous with Social Welfare
Real Gross Domestic Product
Having examined inflation and how it is measured, we can now come back to gross domestic
product. As we said, one of the concerns with GDP measurement is that changes in prices
can affect the GDP just as easily as changes in output. To cleanse our GDP measure of the
price changes, we use a price index called a GDP deflator (GDPDEF). This inflation-adjusted mea- sure of GDP is called the real gross domestic product (RGDP). Real GDP is computed by taking current production of goods and services and multiplying those by their previous year prices and
then adding these up across different goods and services. The current production of new goods
and services is then added to this figure. This process is different from that which creates the
CPI in that the market basket changes from year to year so the choice of a base year is somewhat
arbitrary. Still, it allows for a comparison of total production from one year to the next while
eliminating the effects of inflation. Further, many economists feel more comfortable computing
inflation using the GDP deflator approach (which is the annual percentage increase in the GDP
deflator) than the CPI approach (which is the annual percentage increase in the CPI). Figure 6.2
shows the trajectory of real GDP since World War II using 2009 as the base year.
Problems with Real GDP
Even with its adjustments, real GDP does not do everything right. Besides having the GDP
deflator suffer from many of the problems that the CPI suffers from, real GDP has several
other problems.
First, it does not give your mother or father much credit. When either one does things around
the house—laundry, cooking, yard work, and the like—the value created in the process is not
GDP deflator (GDPDEF) The price index used to adjust GDP for infla- tion, including all goods rather than a market basket.
real gross domestic
product (RGDP) An inflation-adjusted measure of GDP.
17,500
15,500
13,500
11,500
9,500
7,500
5,500
3,500
1,500
R G
D P
$ b
il li o
n s ( 2
0 0
9 )
Year
19 4
7
19 5
0
19 5
3
19 5
6
19 5
9
19 6
2
19 6
5
19 6
8
1 9
7 1
19 7
4
19 7
7
19 8
0
19 8
3
19 8
6
19 8
9
19 9
2
19 9
5
19 9
8
2 0
0 1
2 0
10
2 0
13
2 0
0 4
2 0
0 7
FIGURE 6.2 Post–World War II real
gross domestic product
by quarter, billions of
2009 dollars.
Source: Bureau of Economic
Analysis, www.bea.gov
Measuring and Describing Unemployment 87
counted in GDP. It is not counted because it is not sold. Much work gets done and much value is
created without sales. I, for instance, installed a large wooden fence around my backyard. Had I
gotten a contractor to do it, it would have cost $8,000. Since I built it myself, it cost only $3,000
for supplies and the GDP missed as much as $5,000 of the value that was created.
Second, real GDP does not see that leisure is valuable. If we all worked ourselves to the bone
and never took days off, we would cause GDP to rise, but we would be worse off for it. Clearly,
in a fully employed society, people who retire voluntarily reduce GDP by the amount of work
they would have done. Just as clearly, people retire voluntarily because they are happier fishing,
golfing, lollygagging, or volunteering than working.
Third, what people buy is not considered important in the computation of GDP. The sub-
stantial increase in government spending on homeland security that resulted from the terrorist
attacks of 2001 and beyond was quite likely necessary given the threat, but we are not better off
as a society for having to spend this money. We spend it in an attempt to re-create the old sense of
security. Spending more money on something that used to require less does not make us better off.
Fourth, the population of the United States is always growing. If real GDP does not grow
at the rate that the population does, then the per capita real GDP (the inflation-adjusted goods
and services going to the average person) will fall.
Fifth, we can sacrifice environmental quality of life for economic gain, but again we would
not necessarily be better off. There is untapped crude oil under the coral reefs off the coast of
Florida and under the vast tundra of northern Alaska. As the summer of 2010 made clear, drilling
for oil in environmentally sensitive areas comes at a cost. When the process of “fracking” opened
up vast quantities of natural gas for use throughout western Pennsylvania in 2008–2011, GDP
was clearly and positively affected. In 2012, President Obama rejected the path of the Keystone
pipeline and was criticized by Republicans for doing so. Their argument was that he was con-
straining GDP. In both cases, both sides are essentially correct. More drilling does increase GDP
and reducing that new drilling does decrease GDP, but in both cases those concerned for the
environment have a serious point. If the environmental concerns expressed turn out to be valid,
this increase in GDP should be offset by the impact on the environment. No one in the govern-
ment makes this adjustment. We would increase real GDP if we pumped this oil and gas, but the
price of doing so would have to include its impact on the environment.
Sixth, just as the laundry and yard work your parents do does not count because the service does
not get sold in a market, goods or services sold under the table do not get counted either. The illegal
drugs that people buy do not get recorded anywhere. Similarly, if you mowed lawns or babysat as a
teenager, it is unlikely you reported any of that income to the government. If you do not report the
income on your taxes and your employer does not either, this economic activity does not appear as
part of the GDP. This omission is especially important when it comes to the effect of higher tax rates.
Studies reflect the obvious: When taxes are higher, people do more of their work under the table.
For all of these reasons, real GDP cannot be considered a perfect measure of social welfare.
Still it remains the primary measure of the economic health of the country. Any attempt to
account for the problems outlined above would subject the measure to value judgments about
the intrinsic worth of certain goods for which there is little agreement. Therefore, economists
generally accept real GDP for what it can tell us while remaining aware of its limitations.
Measuring and Describing Unemployment
Measuring Unemployment
Losing one’s job is the most traumatic thing that a person can go through short of the loss of a
loved one. Economists therefore consider the unemployment rate to be one of the most important
indicators both of the economy and of well-being in general. When people who want and need
to work cannot find suitable employment, they lose not only income but also self-esteem. The
88 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
problem for economists is distinguishing in a meaningful way between stay-at-home parents
who might work outside the home if they were paid $50,000 a year and unemployed auto
workers who refuse to go from $20 an hour assembling cars to the minimum wage flipping
burgers. At what point does the lack of a job go from being the economy’s fault for not gen-
erating good jobs to being the person’s fault for not having realistic expectations? This is an
important question, but it is nearly impossible to answer.
The government measures unemployment by conducting phone surveys. The first thing the
people making the surveys do is to make sure they are speaking to a person age 16 or over.
(This is because people under 16 are not counted, whether they are working or not.) Second,
they ensure that the person they are talking to is not in the military. (Those in prison, in mental
health facilities, and in the active duty military do not count.) Third, they ask if the person has
done work for pay or worked more than 15 hours a week in a family business during the previ-
ous week. If the answer to that question is yes, then the person is considered employed. If the
answer to that question is no, then the person is asked if he or she looked for work during the
week, that is, whether he or she filled out an application or made a job inquiry. If the answer
to that question is yes, then the person is considered unemployed.
As mentioned previously, not everyone counts. For instance, the total U.S. population in
2013 was 317 million. Of those, 66 million were under the age of 16, 1.4 million were in the
military, 2.2 million were incarcerated, and 1.8 million were institutionalized in mental health
facilities (with about half of those being over 85 years old and in homes for the aged). As a
result the civilian, noninstitutionalized population of working age was 246 million.
The percentage of the civilian, noninstitutionalized population that is either employed or
searching for a job—called the labor force participation rate—increased substantially between the end of World War II and the turn of the century. Figure 6.3 shows that the rate increased
from 59 percent after the war to 67.3 percent in 2000. While there were multiple causes, the
biggest cause dwarfed all others: women. In 1948 the labor force participation rate for men in
their prime working ages (25–54) was 98 percent, while it was only 34 percent for women. By
April of 2000 when the aggregate number peaked, the rate had fallen to 91 percent for men but
58.0
59.0
60.0
61.0
62.0
63.0
64.0
65.0
66.0
67.0
68.0
19 4
8 19
5 0
19 5
2 19
5 4
19 5
6 19
5 8
19 6
0 19
6 2
19 6
4 19
6 6
19 6
8 19
7 0
19 7
2 19
7 4
19 7
6 19
7 8
19 8
0 19
8 2
19 8
4 19
8 6
19 8
8 19
9 0
19 9
2 19
9 4
19 9
6 19
9 8
2 0
0 0
2 0
0 2
2 0
0 4
2 0
0 6
2 0
0 8
2 0
10 2
0 12
2 0
14 2
0 15
FIGURE 6.3 Labor Force
Participation Rate.
Source: http://www.bls.gov/cps/
labor force
participation rate The percentage of the civilian, noninstitution- alized population that is either employed or searching for a job.
Measuring and Describing Unemployment 89
had risen to 77 percent for women. At the end of 2015, the aggregate labor force participation
rate was 62.6 percent, the rate for men ages 25–54 had fallen further to 88 percent and the rate
for women in that age group had fallen to 74 percent.
From those surveys the government creates two numbers, the labor force and the unem-
ployment rate. The labor force is generated by adding the employed to the unemployed. The unemployment rate is the unemployed divided by the labor force and should be interpreted as the percentage of people in the workforce who do not have jobs and are actively seeking them.
Both of these numbers are announced on the first Friday of every month.
Problems Measuring Unemployment
This measure of the unemployment rate has some flaws. First, it does not count as unemployed
any people who are so discouraged that they stop looking for work. Second, it counts as un-
employed those people who are (correctly or incorrectly) encouraged by positive economic
news to look for work before there really is any work. Third, it fails to recognize the plight of
workers who are working significantly below their skill level or those who would like to work
full time but are stuck in part-time jobs. Those suffering from either of these last two problems
are referred to as underemployed. The first two flaws are important because they subject the unemployment rate to incorrect
interpretation. For example, if there are 10 people, 8 who work and 2 who are looking, then
the unemployment rate is 20 percent. If things turn bad, so that one of the two decides to stop
looking, the unemployment rate falls to 11 percent (1/9). Thus, bad news in this case causes the
unemployment rate to fall. This is called the discouraged-worker effect, a process that can be reversed. That is, good news causes people to look for work before there is any, and the unem-
ployment rate rises back to 20 percent. This is called the encouraged-worker effect. Figure 6.4 offers a historical perspective on unemployment.
These two effects were prominent during the 2007–2009 recession and beyond. The clear-
est examples of the discouraged-worker effect were in the January and February 2011 reports
(for December and January unemployment, respectively). During that two-month period,
three-quarters of a million people left the labor force, due in large part to the fact that their
unemployment compensation had run out. The unemployed are required to look for work while
they collect unemployment compensation. Once the benefits ran out, with no opportunities
labor force All those nonmilitary personnel who are over 16 and are employed or are unemployed and actively seeking employment.
unemployment rate The percentage of people in the workforce who do not have jobs and are actively seeking them.
underemployment The state of working significantly below skill level or working fewer hours than desired.
discouraged-worker
effect Bad news induces peo- ple to stop looking for work, causing the unem- ployment rate to fall.
encouraged-worker
effect Good news induces people to start looking for work, causing the unemployment rate to rise (until they succeed in finding work).
20.0
R a
te ( %
)
Year
18.0
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
Civilian unemployment rate
Civilian UR plus discouraged workers
Civilian UR plus DW and underemployment
1 9
4 8
19 5
2
19 5
6
19 6
0
1 9
6 4
19 6
8
1 9
7 2
1 9
7 6
19 8
0
1 9
8 4
19 8
8
19 9
2
19 9
6
2 0
0 0
2 0
0 4
2 0
0 8
2 0
1 2
FIGURE 6.4 Post–World War II un-
employment rates: the
civilian unemployment
rate (UR) and the rates
as they would be if we
include discouraged
workers (DW) and the
underemployed.
Source: Bureau of Labor Statis-
tics, http://data.bls.gov/cgi-bin
/srgate
Series: LNS12000000; LNS
14000000; LNS12032194;
LNU05026645.
90 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
out there, many unemployed simply gave up their search. When they did, the unemployment
rate fell dramatically (from 9.6 percent to 9.0 percent).
Toward the end of a long employment dry spell, there is a predictable phenomenon where
good news causes a significant increase in job seekers. In May 2003, as the economy started
picking up after a slow “jobless” recovery, 500,000 people joined the labor force and only
250,000 got jobs. The result was, although this was a better-than-average month for new job
creation, the unemployment rate rose from 6.1 percent to 6.3 percent.
Types of Unemployment
Economists further divide the unemployed by reasons for unemployment. If people lose
their jobs because of a temporary downturn in the economy, economists call them cyclically unemployed. The seasonally unemployed are those people who lose their jobs predictably every year at the same time, like lifeguards in Michigan.
A third type of unemployment is more problematic and permanent. If people lose their jobs
because of a change in the economy that makes their particular skill obsolete (either because
the industry ceases to exist or because it moves to another country), they are referred to as
structurally unemployed. These are typically the most difficult people to re-employ because their wage expectations are higher than the positions that remain in the economy that they can fill.
Conversely, a fourth type of unemployment often results from good things in the economy. If
things are going well and people get better jobs or at least are encouraged to go out and look for bet-
ter jobs, they sometimes add to the unemployment rate. For instance, if people hear there are better
jobs out there and quit their jobs to devote time to looking for them, they might be surveyed when
they are unemployed. Still others may be part of a two-earner family where one gets a promotion that
requires that the family move to another city and the spouse who does not get promoted quits to find
work in the other city. During the time that such people are looking for work, they are categorized
as frictionally unemployed. These people are unemployed for a short time, but they have skills that employers will want. It just takes time to find the appropriate job. Thus, this type of unemployment
exists in any smoothly functioning economy as long as it takes time to find similar or better work.
Typically between a quarter and a third of unemployed people are laid off subject to re-
call (cyclically unemployed), an equal number voluntarily leave their jobs (frictionally unem-
ployed), and the remainder are let go involuntarily without being subject to recall (though not
all of this latter group should be referred to as structurally unemployed).
Productivity
Measuring and Describing Productivity
As described in Chapter 1, an economy can grow because more resources are available or be-
cause the ability to turn those resources into output has improved. Productivity speaks to the
latter source of growth. Labor force productivity is the total amount of output per worker hour, whereas total factor productivity, otherwise known as multifactor productivity, is the increase in output that cannot be explained by an increase in labor, capital, or materials. It is measured
as the difference between actual output and what output would have been had inputs remained
constant. For this reason it is called a “residual” and is named for the Nobel Prize–winning
economist Robert Solow, who came up with the measure.
The annual changes are displayed in Figure 6.5 as dashed lines. Because those annual changes
are so clearly volatile, the five-year moving average of those changes is displayed in solid lines and
it is those that are more valuable to inspect. What is clear is that the rapid increase in productivity
that occurred during the post–World War II period up to the late 1960s was dramatically higher
cyclical unemployment State that exists when people lose their jobs because of a tempo- rary downturn in the economy.
seasonal
unemployment State that exists when people lose their jobs predictably every year at the same time.
structural
unemployment State that exists when people lose their jobs because of a change in the economy that makes their particular skill obsolete.
frictional
unemployment Short-term unemploy- ment during a transition to an equal or better job.
labor force productivity Output per labor hour.
Multifactor productivity/
Total factor productivity The increase in output that cannot be explained by an increase in labor, capital, or materials.
Seasonal Adjustment 91
FIGURE 6.5 Annual Changes (AC) and Five-year Moving Averages (5 yr MA) of Labor Productivity and Multifactor Productivity. Sources: www.bls.gov/bls/productivity.htm; www.bls.gov/mfp/trends_in_multifactor_productivity.pdf
8.0
6.0
4.0
2.0
0.0
–2.0
LP AC (5 yr MA)Labor productivity Multifactor productivity MFP AC (5 yr MA)
19 4 8
19 5 0
19 5 2
19 5 4
19 5 8
19 6 0
19 6 2
19 6 4
19 6 6
19 6 8
19 70
19 7 2
1 9 7 4
19 7 6
1 9 7 8
19 8 0
19 8 2
19 8 4
19 8 6
19 8 8
19 9 0
19 9 2
19 9 4
19 9 6
19 9 8 20
00 20
02 20
04
19 5 6
20 06
20 08
2 0 10
2 0 12
2 0 14
than that which occurred during the 1980s and early 1990s. A brief spike in productivity occurred
during the late 1990s and early 2000s when manufacturing firms began to utilize robotic produc-
tion and many service-based firms began to substitute automation for human interactions (e.g.,
ATMs and phone-trees). During and after the Great Recession those productivity gains evaporated.
Seasonal Adjustment
Almost all economic data published by the U.S. government comes in two forms, season-
ally adjusted and nonseasonally adjusted. Seasonal adjustment takes into account predict-
able, calendar-based changes. For instance, in the run-up to the Christmas shopping season,
employment increases. First it increases at those manufacturing facilities that produce goods
and then through the wholesale and retail trade sector as those goods are transported for sale
and ultimately sold. When the season ends there is typically a one-percentage point increase
in the nonseasonally adjusted unemployment rate from December to January. The seasonal
adjustment takes that into account. The good thing about seasonal adjustment is that it allows
you to better understand what the change in the unemployment rate is telling you about the
state of the economy. Without it, you may hear that the unemployment rate increased by half
a percentage point from December to January and mistakenly view that as a troubling sign
92 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
regarding the economy. If the typical increase is a full percentage point and the actual increase
is less than that, that is actually a good sign.
The same thing is true regarding prices. Fresh fruits and vegetables are cheaper when they
are in season and more expensive when they are out of season. When they are out of season,
they must be imported from another country where they are in season or, at the very least,
brought in from a warm-climate area like California or Florida. Gasoline prices are typically
higher in March and October because that is when refineries are required to switch from pro-
ducing winter formulations to summer ones or vice versa. The dip in refining capacity during
that time creates temporary price spikes. Seasonal adjustment takes that into account.
Business Cycles
Over the years there has been such a regular pattern of ups and downs in the economy that
economists have put a name to it: the business cycle. Figure 6.6 shows the general pattern of the economy over time. Though the general trend is up, you can see that the path is rarely a straight
line. With real gross domestic product on one axis and time on the other, you can see that a busi-
ness cycle has five main components. The trough is the lowest point in the business cycle. The recovery is the period of growth in RGDP from the trough to the previous peak, that is, the period where RGDP gets back to where it was before the recession began. The expansion is the period of growth in RGDP from the previous peak to the new peak. The peak is the period where the growth in RGDP slows and eventually stops. Traditionally, a recession has been defined as a pe- riod of at least two consecutive quarters when the RGDP falls. This definition has, at times, been
ignored as the National Bureau for Economic Research’s Business Cycle Dating Committee has
attempted a more commonsense approach to establishing the beginning and ending dates for
recessions. The 2007–2009 recession, for instance, was determined to have begun in late 2007
despite there being a slightly positive first quarter and significantly positive second quarter of
2008. This was because the downturn clearly started in late 2007 and the first half of 2008 was
aided by a stimulus package that provided rebate checks to millions of Americans. By the time
those rebates worked their way through the system and the financial crisis of fall 2008 took hold,
it was apparent to these economists that the recession began in late 2007.
Between 1950 and 2011 there were nine recessions that lasted an average of nine and a
half months. Some economists have argued that absent a major precipitating event, such as the Sep-
tember 11 terrorist attacks, the potential for a recession has been lessened by the globalization
of the U.S. economy. Typically, a recession is accompanied by a steep rise in the unemployment
rate, a moderation in the inflation rate, and a reduction in real gross domestic product in the range
of 2 percent to 3 percent. Many times in the last
half-century economists wondered whether the
business cycle had been “repealed” only to find
that it had not. With the possible exception of the
recession of 2007–2009, the worst recession since
World War II occurred in the early 1980s. At that
time the unemployment rate went from around
7 percent to nearly 11 percent and the inflation
rate went from 13 percent to less than 4 percent.
The recession that occurred in 1990 as a result of
Iraq’s invasion of Kuwait had muted effects, in
that it lasted only eight months. Its effect on un-
employment, inflation, and output was not nearly
as stark as that of the recession of 1981–1982.
business cycle Regular pattern of ups and downs in the economy.
trough The lowest point in the business cycle.
recovery The part of the growth period of the business cycle from the trough to the previous peak.
expansion The part of the growth period of the business cycle from the previous peak to the new peak.
peak The highest point in the business cycle.
recession The declining period of at least two consecutive quarters in the business cycle.
R G
D P
Time
Peak
Recession
Trough
Recovery
Expansion
Peak
FIGURE 6.6 The business cycle.
Business Cycles 93
The recession of 2001 began with the uncertainty of the 2000 presidential election and ended in
November of 2001. At this writing, the length and depth of the recession that began in late 2007
has not yet been determined. However, it clearly ended the string of short and shallow recessions.
Figure 6.7 shows the three business cycles from 1981 to 2008.
The potential for a recession has been lessened in some economists’ eyes by the globaliza-
tion of the U.S. economy. Those who argue from this point of view suggest that with greater
international trade, countries moving into recessions are bolstered by international demand
for their products. Conversely, countries that are in strong recoveries have that impact damp-
ened because purchases that were once domestic often are made from foreign sources.
On the other hand, other economists warned that the Asian–Russian–Latin American
finan cial crisis of the late 1990s shows how one region’s economy can begin a domino effect
that is destabilizing. Just as a string of dominoes is more stable when barriers are strategically
placed between dominoes, economies may be more stable if the troubles in one country are
insulated from the troubles in another. The health of the U.S. economy during the period did,
in the end, stabilize the world economy.
Unfortunately, there were few corners of the globe that stood in the way of the 2007–2009
recession. Begun by declining demand in the United States and rapidly increasing world en-
ergy prices, it got an unwelcome shot in the arm with the collapse of real estate markets around
the world and the subsequent foreclosure-induced financial crisis of late 2008. Whether
From 1970 through the late 1990s, the predominant
concern over prices was their propensity to rise too
rapidly. Inflation concerns reached their peak in the
late 1970s and early 1980s as prices were rising at
or near 10 percent per year. Given that, why would
it be a problem for prices to decline? The answer is
actually somewhat simple. People delay buying big-
ticket items when they are certain it will be cheaper
if they are patient.
When inflation is running between 1 and
2 percent per year, it is not in anyone’s interest to not
buy things in hopes that prices will decline, because
they won’t. On the other hand, if prices are falling,
then there is such a motivation. If consumers do not
buy goods in anticipation of price declines, then the
people who make those goods will see demand fall.
They cut costs by cutting wages and benefits, or
worse, by laying people off. When profits decline, the
value of stocks declines. With less wealth, stockhold-
ers spend less on consumer goods. The final straw is
when housing prices start to fall. When that happens,
people can easily owe more on their house than their
house is worth. That results in a dramatic contraction
in their willingness to maintain it and the elimination
of their ability to borrow money against its equity
(since they now have none).
From the late 1980s until 2003 Japan experi-
enced a significant deflation in asset prices with the
Japanese stock market, as measured by its principal
index, the Nikkei 225, falling from nearly 40,000
to less than 8,000. Beginning in 2003 it recovered
so that by early 2007 it was above 18,000. During
that 13-year period, Japanese real estate values also
plummeted. So, though Japan’s economy was once
the envy of the Western world, its deflation-led eco-
nomic slump lasted much longer than a typical re-
cession. More recently, the bursting of the housing
bubble in the United States in 2007, the demise of
the commercial real estate market, and the dramatic
drop in world oil prices from mid-2008 through 2009
caused many economists to worry that this same fate
would strike the United States.
It was precisely this concern that kept the
Federal Reserve focused on ensuring that the frag-
ile recovery of 2010 and 2011 kept going. The Fed’s
overriding fear was that a deflationary spiral would
be nearly impossible to stop. This led the Fed to
policies, like the much discussed second round of
quantitative easing (dubbed QE2), that under normal
circumstances would have been viewed as disas-
trously inflationary. The goal of these policies was
to prevent deflation.
deflation A general reduction in prices.
I F I N F L A T I O N I S B A D , H O W C A N D E F L A T I O N B E W O R S E ?
94 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
globalization dampened or amplified the recession will be a matter for future macroeconomic
historians to determine.
A phenomenon that has not visited the United States in nearly 60 years is depression. Although there is no formal economic distinction between a recession and a depression, there
certainly is little doubt that we have not experienced a depression since the 1930s. Depressions
are severe recessions usually characterized by any one of the following problems: financial
panic and bank closures, unemployment rates exceeding 20 percent, prolonged retrenchment
in RGDP on the magnitude of 10 percent or more, and significant deflation.
Lessening the likelihood of depression are the economic and social safety nets (e.g.,
unemployment insurance, welfare) that exist in most modern economies. The recessions that
occur when people lack the confidence to buy things can be prevented from becoming de-
pressions by governments that move to alter interest rates and government spending poli-
cies. Further, as things worsen and unemployment rises, unemployment insurance and other
policies exist now to lessen the effect. Thus people who are unemployed at the beginning of
the 21st century have much more spending power than those unemployed at the beginning
of the twentieth century. This in turn lessens the likelihood that a recession will turn into a
depression.
depression Severe recession typically resulting in a financial panic and bank closures, unemploy- ment rates exceeding 20 percent, prolonged retrenchment in RGDP on the magnitude of 10 percent or more, and significant deflation.
Year
1 9
8 1
19 8
2
19 8
3
19 8
4
19 8
6
1 9
8 7
19 8
8
19 8
9
1 9
9 1
19 9
2
19 9
3
19 9
4
19 9
6
1 9
9 7
19 9
8
19 9
9
2 0
0 1
2 0
0 2
2 0
0 3
2 0
0 4
2 0
0 6
2 0
0 7
2 0
0 8
R G
D P
$ b
il li o
n s ( 2
0 0
0 )
Peak
Peak
Peak
Recovery
Recovery
Recovery
Expansions
Recessions
Trough
Trough
Trough
11,500
12,500
10,500
9,500
8,500
7,500
6,500
5,500
4,500
FIGURE 6.7 An example of three
business cycles: 1981
to 2008.
Source: Bureau of Economic
Analysis, www.bea.gov
NATIONAL INCOME AND PRODUCT ACCOUNTING
All the data described in this chapter come from multiple sources and can be accessed
from a variety of government and academic web pages. Whether from tax reports, sales
tax records, surveys, or reports firms are required to supply the government, the data are
collected, analyzed, and published. As we saw early in this chapter we can get to GDP
using the expenditures approach or the income approach. The formulas are complicated
and needlessly tedious for a book such as this, but you can get an idea of what is needed
for GDP from the table below. You should also note that for a variety of statistical and
methodological reasons the numbers don’t add up to be precisely equal, so a “statistical
discrepancy” is always present.
Kick It Up a Notch
Summary 95
Alternative
Calculations for Gross
Domestic Product in
Billions, 2014.
Expenditures Approach Amount Income Approach Amount
Personal consumption 12061.4 Employee compensation 9434.7
Gross private investment 2937.2 All profits 4489.4
Government consumption and
investment expenditures 3162.5 Indirect business taxes 1169.5
Net exports −545.2
Depreciation 2784.2
Statistical discrepancy −261.8
Gross domestic product 17615.9 Gross domestic product 17,616*
Expenditures Approach: Table 1.1.5; Income Approach: Table 1.10.
* Rounding error
Source: Bureau of Economic Analysis, www.bea.gov
This chapter presented the basic vocabulary of the macroeconomy and explored many of the
measures of it—measures that are not without flaw. We saw that the measure of output is gross
domestic product, that prices and inflation are measured using a price index, and that the most
frequently referred to price index is the CPI. Moreover, we discussed why GDP is adjusted for
inflation to create real GDP and that this, though also flawed, is a key measure of economic
health. Further, the chapter explained how unemployment is measured, that this measure is
subject to some concern, and that economists divide the unemployed into types depending on
how they got that way. We concluded by discussing the language of the business cycle.
Summary
Key Terms base year business cycle
chain-based index
consumer price index (CPI)
core CPI
core PCE
cost-of-living adjustment
(COLA)
cyclical unemployment
deflation
depression
discouraged-worker effect
encouraged-worker effect
expansion
frictional unemployment
GDP deflator
(GDPDEF)
gross domestic product
(GDP)
inflation rate
labor force
labor force participation rate
labor force productivity
macroeconomics
market basket
microeconomics
multifactor productivity
peak
Personal Consumption
Expenditures deflator
price index
price of the market basket in
the base year
Producer Price Index
real gross domestic product
(RGDP)
recession
recovery
seasonal unemployment
structural unemployment
total factor productivity
trough
underemployment
unemployment rate
Quiz Yourself 1. In measuring gross domestic product, goods produced by foreign firms in the United States are
a. counted, and so are goods produced by American firms in foreign countries.
b. counted, but goods produced by American firms in foreign countries are not counted.
c. not counted, but goods produced by American firms in foreign countries are counted.
d. not counted, and goods produced by American firms in foreign countries are also
not counted.
96 Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
2. Gross domestic product is counted using two methods: one that counts all the ways
people money and another that counts all the ways people
money.
a. earn, spend
b. spend, save
c. earn, save
d. loan, borrow
3. Inflation is measured using in a price index.
a. the absolute increase
b. a multiyear weighted average increase
c. the percentage year-to-year increase
d. logarithm-adjusted absolute increase
4. In early 2005, inflation increased unexpectedly because of an increase in oil prices. This
helped
a. borrowers.
b. lenders.
c. people on fixed incomes.
d. workers.
5. The consumer price index (CPI) is a heavily criticized measure of inflation because
a. the government does nothing to fix its known deficiencies.
b. it consistently understates the increase in the cost of living.
c. it consistently overstates the increase in the cost of living.
d. the government constantly makes adjustments in it without warrant.
6. One problem with using real gross domestic product as a measure of social welfare is
that
a. it fails to count home production.
b. it fails to count services, a growing part of the economy.
c. it double, triple, and sometimes quadruple counts goods that are produced in stages.
d. it fails to account for imports, a growing part of the economy.
7. In 2005, General Motors announced a 20 percent reduction in its staffing levels
and the closure of many assembly plants. Those laid off as a result would likely be
classified as
a. seasonally unemployed.
b. cyclically unemployed.
c. frictionally unemployed.
d. structurally unemployed.
8. On a graph of real gross domestic product over time, recessions appear as
a. relatively short and shallow drops on an otherwise increasing path.
b. long, sharp declines on an otherwise increasing path.
c. the dips on a path that increases and decreases equally.
d. the periods where the rate of growth, while still positive, slows.
9. Of these, economists consider this the worst:
a. inflation of 5 percent.
b. recession.
c. deflation of 5 percent.
d. depression.
Summary 97
Short Answer Questions
1. Explain why an economist would focus on real GDP rather than nominal GDP.
2. Suppose you walked into an unemployment office and found the following people: a laid-
off mall Santa Claus, an unemployed auto-industry worker (who is subject to callback by
their company), a woman who lost her job at a manufacturer because the company relo-
cated to Mexico, and a nurse who just moved to town because his wife recently started a
new job. Assign the following labels to the people above: cyclically unemployed, friction-
ally unemployed, structurally unemployed, and seasonally unemployed. Then, explain
your assignment of the terms to each person.
Think about This Economists have argued for many years that the CPI overstates the cost of living. The degree
of that overstatement has been the subject for significant economic research. Part of the prob-
lem in resolving the agreed-upon problems is that any correction has the effect of reducing
Social Security checks and increasing taxes. Should economic measures be subject to political
debate?
Talk about This Economist Joseph Schumpeter once argued that people are too often lulled into an unpro-
ductively comfortable state when they have continuous employment. His conclusion was that
recessions (more accurately, depressions, in his era) were good because they forced people to
be creative and entrepreneurial. He labeled this “creative destruction.” Do you agree with the
premise of his argument? Do you agree with his conclusion?
For More Insight See Hausman, Jerry. “Sources of Bias and Solutions to Bias in the Consumer Price Index.” Journal
of Economic Perspectives 17, no. 1, pp. 23–44.
Lebow, David E., and Jeremy B. Rudd. “Measurement Error in the Consumer Price Index:
Where Do We Stand?” Journal of Economic Literature XLI, pp. 159–201.
“Measuring the Economy”—www.bea.gov/national/pdf/nipa_primer.pdf
Behind the Numbers U.S. Gross Domestic Product and Recessions—www.bea.gov
Unemployment rate—www.bls.gov/cps
98
C H A P T E R S E V E N
Interest Rates and Present Value Learning Objectives
After reading this chapter you should be able to:
LO1 Describe what interest rates are and
differentiate nominal from real interest rates.
LO2 Describe the use of present value calculations
in determining the value of a payment stream.
LO3 Apply the tool of present value when thinking
about economic decisions where the costs
and benefits of decisions happen at different
times.
Chapter Outline
Interest Rates
Present Value
Future Value
Kick It Up a Notch: Risk and Reward
Summary
Many economic decisions take place over time. That is, the time at which the benefits of a
given decision are gained is different from the time the costs are incurred. For instance, when
you save money, you put off the ability to buy something now so that you have even more
money to spend in the future. When you borrow, you get to consume a good before you have
sufficient means to pay for it. Thus we agree to give up a single sum now for a larger amount
that we will receive later, or we agree to pay a certain amount per month over a series of
months rather than pay a single sum now. In this market, as in any market, there is a price and
there is a quantity, and there is a buyer and there is a seller. In this chapter we explore borrow-
ing, lending, investing, and saving decisions.
We begin by exploring interest rates, the price of money, and how they are determined.
We look at the importance of anticipated inflation in this decision so as to draw a distinction
between nominal and real interest rates, a distinction that is important to economists.
We conclude by looking at financial decisions. We will see that any particular decision to
borrow, save, lend, or invest depends on what economists call present value. We will examine
scenarios in which we save or borrow a sum of money now in order to get a larger sum of
money later. We will also provide more complicated examples in which the payments we
make or receive are spread over time.
Interest Rates 99
Interest Rates
The Market for Money
When people lend or borrow money, we call the price at which they do this the interest rate. A useful way to think of this market for money is to imagine yourself renting a moving van.
When you rent such a vehicle, the owner is letting you use it for a predetermined period of
time at a predetermined price. Now, instead of renting a van, think about renting money. The
owner of the money is letting you use the money for a period of time at a predetermined price.
The period of time is typically denoted per year and so the price is an annual interest rate.
This means that when you are borrowing money to buy a car or home or seeking money from
investors, you must pay interest.
Of course you could be on the other side and be the owner of money that you put in a bank
or use to buy a bond. You are now “renting” the money to someone else. In all cases the rate of
interest is an important component in your transaction. In this market that we are discussing,
the seller is the one with money and the buyer is the one seeking the money.
Figure 7.1 depicts a market like one we saw in Chapters 2 and 3. Here, though, the price is
the interest rate and the quantity is the amount that the lender/saver extends to the borrower.
The supply curve is upward sloping because the lender/saver will be motivated to lend more if
he or she can get a higher return, and the demand curve is downward sloping because at higher
interest rates the borrower will view borrowing as less advantageous. As in any other market,
an equilibrium interest rate and amount borrowed or lent will result.
The equilibrium interest rate will depend on a number of factors. For instance, the inter-
est rate for people with good credit histories is typically lower than it is for people with poor
ones. The bank interest rate for car loans is usually higher than the interest rate for home loans.
Credit card interest rates are very high. The reason for this is the degree of risk. A lender can-
not assume that a borrower will pay every loan back in full. Lenders are taking a risk and part
of what goes into their decisions is the likelihood that the borrowers will pay back the loans
and the consequences if they do not. Credit cards are typically not secured by anything, and,
as a result, credit card interest rates are higher than home loans. If a buyer defaults on a home
loan, the lender can take possession and ultimately sell the house.
Nominal Interest Rates versus Real Interest Rates
When the interest rate for a certificate of deposit (CD) or car loan is advertised publicly,
that is referred to by economists as the nominal interest rate. Though this is the rate of in- terest referred to in Figure 7.1, it is not as interesting to economists as what they refer to as
the real interest rate. The real interest rate is the rate of interest after inflation expectations have been taken into account. Inflation, which was
explained in Chapter 6, is the increase in prices in
percentage terms. Inflation matters for our discussion
of interest rates because both borrowers and lenders
consider the benefits and costs of their decisions in
terms of the consumption gained and lost. Since the
borrower is presumably going to take the money to
buy something now and pay the money back later to a
lender who will then buy something with the money,
the change in prices is important. Let’s consider a
concrete example.
Suppose you agree to lend a friend $500 if he agrees
to pay you back next year with 10 percent interest. This
interest rate The percentage, usu- ally expressed in annual terms, of a balance that is paid by a borrower to a lender that is in addition to the original amount borrowed or lent.
nominal interest rate The advertised rate of interest.
real interest rate The rate of interest after inflation expectations are accounted for; the compensation for wait- ing to consume.
FIGURE 7.1 The market for money.
r*
$*
Demand
Money borrowed /saved ($)
In te
re s t
ra te
r
Supply
100 Chapter 7 Interest Rates and Present Value
means that next year you will get $550. Suppose that both of you will end up buying iPads with
the money and that today it costs exactly $500. If the price of these devices goes up to $600
by the time you get your money, then you have lost out. He got his iPad and you did not have
enough for one even after waiting a year to get it. On the other hand, if iPads increased only
to $525, then you could afford one when you got your money and would have $25 extra for
waiting the year to get it. What this means is that inflation matters in this borrowing/ lending
decision. This is especially true if we know what the rate of inflation will be.
Although no one knows for sure what inflation will be in the coming year, people are able to
use recent experience as a guide. As a result borrowers and lenders form inflation expectations.
If you require $25 compensation for waiting a year to buy your iPad and you expect the price
to increase by $25, then you will require $550 be paid to you. The first $25 compensates you
for the higher prices that will exist when you go to buy yours, and the second $25 compensates
you for waiting the year to buy it.
What this means for economists is that the nominal interest rate is equal to the sum of infla-
tion expectations and the real interest rate.1
Present Value
It is easy to see that $100 is more than $50. It is much more difficult to compare $50 today
against $100 six years from now. To put dollar values on an even playing field, we compare
monies using a concept called present value. Using an appropriate interest rate, though, you can compare money paid at two different times. We say that two amounts paid apart from
one another in time are equal in present value if the money paid now could be invested at an
appropriate interest rate and generate an amount that turns out to be equal to a higher amount
that is paid later.
Simple Calculations
The math required to fully understand present value is somewhat complicated and is displayed
below:
Present value = Payment
________ (1 + r)n
where
payment = payment to be received in the future
r = interest rate
n = number of years before payment is received
Fortunately, the concept and its conclusions are not as complicated as the math. The idea is
that the payment in the future needs to be deflated by a factor equal to 1 plus the interest rate
for every year that is to pass before the payment is made. If the interest rate is 10 percent and
10 years are to pass, then the payment is deflated 10 times by 1.10.
To use a particular example, consider what $200 paid 10 years from now is worth in
present value if the interest rate is 10 percent. To compute this we need to multiply 1.1 by
itself 10 times. The result is 2.5937, so the present value is $200/2.5937, or approximately
$77.11. This means that if you had $77.11 today, and you invested it at 10 percent interest
for 10 years, you would have $200. Stated differently, if 10 years from now you were going
to receive $200 and wanted to borrow against it and the going rate was 10 percent, you could
borrow only $77.31.
present value The interest-adjusted value of future payment streams.
1 There is a mathematical cross-product term as well, but it is very small when the inflation and real interest rates are low.
Present Value 101
As mentioned, the factor 2.5937 was computed by multiplying 1.1 by itself 10 times (a pro-
cess called compounding). Table 7.1 provides factors for several different interest rates for sev-
eral different periods. The interest rate appears at the top, and the left column indicates the
number of years between the time when the borrower gets the money and the time he or she pays
it back. The body of the table displays how much money the borrower will have to pay back for
every dollar borrowed. For instance, every dollar you borrow on a 20 percent credit card that you
fail to pay back within five years costs you $2.49, the original dollar plus $1.49 interest.
Mortgages, Car Payments, and Other Multipayment Examples
We can use this concept to calculate how much house or car we can afford. Here, instead
of borrowing a single sum and paying it off with a single payment, we are borrowing a
single sum and paying it off in small increments. Of course we could think of situations
where we save in small increments to generate a single sum, like saving for a vacation, or
situations where we save in small increments to generate other increments, like saving for
retirement and getting a monthly check in retirement. These are simply extensions of the
same principle.
For each of these examples there is a wonderfully elegant formula that would allow us to
plug in various numbers and get results. These formulas, while interesting to those who study
financial management issues, are not necessary for us to understand how we might use the
present value idea in these other contexts.
For that, let’s turn to Table 7.2, where we will try to evaluate whether a particular business
deal is a good idea. Suppose that an investment of $100 each year for five years will, starting
in the sixth year, return a payout of $100 a year that will continue for the next seven years.
Though the total of benefits is greater than the total of costs, whether this is a good business
deal depends on the interest rate. If the interest rate is 5 percent, the present value of benefits is
larger than the present value of costs. At 8 percent and 10 percent the present value of benefits
is less than the present value of costs. That means that a business whose goal was to maximize
profit would go ahead with the investment if interest rates were 5 percent and not if the inter-
est rate was 8 or 10 percent. The interest rate where the present value of costs and benefits are
equal is called the internal rate of return. In this case it is about 5.8 percent. Generally, when the interest rate that must be paid is less than the internal rate of return, then the present value
of benefits exceeds the present value of costs.
All mortgages and car payments are similarly calculated, though these are somewhat more
simple because there is only one up arrow, the value of the house or car loan, and the multiple
down arrows, the payments that are required. To give you some perspective on how much you
would have to make in monthly payments on a variety of loans, consider Table 7.3, a very
abbreviated set of present value factors. Again at the top are the various yearly interest rates
and in the left column are the various loan durations. Thus a $1,000 computer purchased on
a 20 percent interest credit card will cost the buyer $26.49 every month for five years. This
translates into $1,589.63 in total payments over the five-year loan.
internal rate of return The interest rate where the present value of costs and benefits is equal.
Interest Rate (%)
Year 20 10 5 2 1
30 237.38 17.45 4.32 1.81 1.35
10 6.19 2.59 1.63 1.22 1.10
5 2.49 1.61 1.28 1.10 1.05 1 1.20 1.10 1.05 1.02 1.01
TABLE 7.1 The amount payable
for every dollar
borrowed for several
interest rates and
several loan durations.
102 Chapter 7 Interest Rates and Present Value
We can use Table 7.3 to figure out what typical monthly payments will be on purchases
that you might make in the coming years. We just saw that if you purchase a $1,000 computer
using a typical credit card, you will have to pay $26.49 per month for five years to pay off
the loan. If you buy a $30,000 car with a five-year payoff period and get a 10 percent interest
bank loan, you will have monthly payments of $637.50 (30 × $21.25). If you buy the same
car during a financing promotion when the car company loans you the cost of the car at only
2 percent interest, your payments will be only $525.90 (30 × $17.53) per month. Last, if you
purchase a $100,000 home with a 30-year mortgage at 5 percent interest, it will cost you $537
(100 × 5.37) per month.
Future Value
The present value formula can be algebraically rearranged to become a future value formula. Future value is the interest-adjusted value of past payments. Using the same variables from
the present value formula,
Future value = Payment × (1 + r)n
This calculation is useful when you are looking to save an amount now for an expense that
will occur at a later time. If, for instance, you had $10,000 and wanted to save it to give to your
newborn daughter upon her high school graduation, you might put it in an 18-year certificate
of deposit earning 4 percent. If you plug in those numbers (n = 18, r = .04), you will find that
she could cash it in for $20,258.17.
future value The interest-adjusted value of past payments.
TABLE 7.2 Present value of costs and benefits at alternative interest rates.
Year Cost Benefit
PV Cost
@5%
PV Benefit
@5%
PV Cost
@8%
PV Benefit
@8%
PV Cost
@10%
PV Benefit
@10%
1 100 100.00 100.00 100.00
2 100 95.24 92.59 90.91
3 100 90.70 85.73 82.64
4 100 86.38 79.38 75.13
5 100 82.27 73.50 68.30
6 100 78.35 68.06 62.09
7 100 74.62 63.02 56.45
8 100 71.07 58.35 51.32
9 100 67.68 54.03 46.65
10 100 64.46 50.02 42.41
11 100 61.39 46.32 38.55
12 100 58.47 42.89 35.05
500 700 454.59 476.04 431.20 382.69 416.98 332.52
Interest Rate (%)
Year 20 10 5 2 1
30 16.71 8.78 5.37 3.70 3.22
10 19.33 13.22 10.61 9.20 8.76
5 26.49 21.25 18.87 17.53 17.09
1 92.63 87.92 85.61 84.24 83.79
TABLE 7.3 Monthly payments
required on a $1,000
loan for various
interest rates and
various loan durations.
Future Value 103
Spreadsheet programs, such as Microsoft’s Excel®, allow for quick
and easy processing of complicated financial calculations. For in-
stance, the PMT function allows users to calculate the payment that,
when made over several periods, will pay off a loan. The PV function
allows users to calculate how much they can borrow to buy a home
or car when they can afford a particular payment. The FV function
allows users to know how much money they will have when they
retire or when they are ready to put a child through school if they
were to save a particular amount per pay period. The IRR function
allows users to calculate the internal rate of return on an investment
that takes the form of a flow of uneven payments. The RATE function
allows users to calculate the rate of return they are earning on an
investment that promises to pay a particular amount in the future
should the user save either a fixed amount now or follow a regular
savings plan.
Function Form of the Function Example Problem Example Solution
Payment
(PMT)
@PMT (r,N,PV,FV) How much would you have to pay per month on a
four-year $30,000 car loan when the bank charges
you 5%?
@PMT (.05/12,4*12,30000)
How much would you have to save per month if you
wanted to have $20,000 for a car five years from
now if you could earn 3% interest?
@PMT (.03/12,5*12,0,20000)
Present Value
(PV)
@PV (r,N,PMT,FV) How much could you borrow if you could afford
$500 per month payments on a house on a
30-year 4% mortgage?
@PV (.04/12,30*12,500)
How much could you borrow at 7% if you were
going to receive $10,000 in two years and use
that money to pay all of your loan at that time?
@PV (.07,2,0,10000)
Future Value
(FV)
@FV (r,N,PMT,PV) How much would you have in an account in
20 years if you saved $1,000 per month and
earned 1% on those savings?
@FV (.01/12,20*12,1000)
How much would you have in an account in
15 years if you put $15,000 into an account
that earned 9%?
@FV (.09,15,0,15000)
Internal Rate
of Return
(IRR)
@IRR (range on the
sheet)
What is the internal rate of return for an investment
that costs $100 the first year, $50 the second,
but earns $200 in the third year and $40 in the
fourth?
–100
@irr(C1:C4)
200
40
–50
C
@Rate (N,PMT,PV,FV) What is the internal rate of return for an investment
that costs $10,000 but returns $4,000 for
three years?
@Rate (4,4000, −10000)
What is the internal rate of return for an investment
that costs $1,000 per year but returns $15,000
after 10 years?
@Rate (10, −1000,0,15000)
S P R E A D S H E E T S M A K E C O M P L I C A T E D C A L C U L A T I O N S Q U I C K A N D E A S Y
104 Chapter 7 Interest Rates and Present Value
Both present value and future value calculations are central to problems in business, the
discipline of finance in particular. They require a calculator with a yx key or a spreadsheet pro-
gram to make the exponential calculations. Before calculators and computers were common,
car dealers and real estate agents used a shortcut, called the Rule of 72, which allowed them to estimate these calculations in their head relatively quickly. Note from the preceding calcula-
tion that the $10,000 CD roughly doubled when saved at 4 percent for 18 years. The Rule of 72
allows you to estimate the time it would take for an investment to double by dividing 72 by the
annual interest rate (72/4 = 18).
Rule of 72 A shortcut that allows you to estimate the time it would take for an investment to double by dividing 72 by the annual interest rate.
RISK AND REWARD
Investing is risky business. Some investments do not pay off as expected. Economists look
at risk as the possibility that the investor will not get those anticipated payoffs. There are two basic types of risk, the default risk, where the borrower doesn’t pay the debts, and market risk, where the market value of a stock or bond changes in an unanticipated manner. To compensate
the investor, a greater reward is offered. Economists call that greater reward the risk premium. Because longer-term predictions are often less accurate than shorter-term ones, there is also a
relationship between the reward an investor receives and the length of time the investor must
wait to get that reward. Economists call that relationship between reward and the time you have
to wait to get it the yield curve. A sample yield curve for loaning money to the federal govern- ment is shown in Figure 7.2.
risk The possibility that the investor will not get anticipated payoffs.
default risk The risk to the investor that the borrower will not pay.
market risk The risk that the market value of an asset will change in an unantici- pated manner.
risk premium The reward investors receive for taking greater risk.
yield curve The relationship between reward and the time until the reward is received.
Kick It Up a Notch
0
0.5
1.5
2.0
2.5
3.0
1.0
2 0
16
2 0
17
2 0
18
2 0
19
2 0
2 0
2 0
2 1
2 0
2 2
2 0
2 3
2 0
2 4
2 0
2 5
2 0
2 6
2 0
2 7
2 0
2 8
2 0
2 9
2 0
3 0
2 0
3 1
2 0
3 2
2 0
3 3
2 0
3 4
2 0
3 5
2 0
3 6
2 0
3 7
2 0
3 8
2 0
3 9
2 0
4 0
2 0
4 1
2 0
4 2
2 0
4 3
2 0
4 4
2 0
4 5
FIGURE 7.2 Yield curve for U.S.
treasuries, January
2016, with maturities
to 2046.
This chapter introduced the concept of interest rates and showed that the market for money is no
different conceptually from the market for any other good. The interest rate was explained as the
price of borrowing money. The difference between real and nominal interest rates was explained,
highlighting the notion that real interest rates account for anticipated inflation. These concepts
were expanded to explain present value and future value and how those concepts can be used to
evaluate economic decisions where payments are made or received over a span of time.
Summary
Summary 105
Key Terms default risk future value
interest rate
internal rate of return
market risk
nominal interest rate
present value
real interest rate
risk
risk premium
Rule of 72
yield curve
Issues Chapters You Are Ready for Now
The Economics of Crime
The Economics of K–12
Education
College and University
Education: Why Is It So
Expensive?
Social Security
Personal Income Taxes
The Stock Market and
Crashes
Quiz Yourself 1. When evaluating a business decision, an economist will often resort to the use of present value because
a. the profits may not be large enough to warrant the time and attention of the investor.
b. the investment occurs in one time period and the profits in another.
c. the investment is often in one currency and the profits in another.
d. the investment is often under one set of managers and the profits under another.
2. In the market for loanable dollars, an increase in the profitability of investments overall
will be revealed in
a. an increase in the supply of loanable dollars.
b. an increase in the demand for loanable dollars.
c. a decrease in the supply of loanable dollars.
d. a decrease in the demand for loanable dollars.
3. When evaluating whether or not to make an investment, one should focus on the
__________ because doing so takes into account anticipated inflation.
a. nominal interest rate
b. real interest rate
c. exchange rate
d. junk bond rate
4. Suppose your grandmother told you (today) that she had set aside an amount of money
in a savings account bearing 3 percent interest that was sufficient to give you a $5,000
graduation present in exactly four years. How much would she have had to set aside?
a. $5,000
b. $5,000 × (1.03)4
c. $5,000/(1.03)4
d. $5,000/(1 + 0.034)
5. Using an interest rate of 5 percent, which figure has the largest present value?
a. $5,000
b. $5,050 to be received two years from now
c. $5,075 to be received three years from now
d. $5,500 to be received 10 years from now
6. Using an interest rate of 5 percent, which figure has the smallest present value?
a. $5,000
b. $5,050 to be received two years from now
c. $5,075 to be received three years from now
d. $5,500 to be received 10 years from now
106 Chapter 7 Interest Rates and Present Value
7. The present value of a $1,000 payment received two years from now at 5 percent annual
interest will be less than $900 because of
a. taxes.
b. compounding.
c. withholding.
d. double jeopardy.
8. A 60-month car loan (where no down payment was made) with a 6 percent interest rate
and a monthly payment of $500 would allow the borrower to buy a
a. $35,500 car.
b. $30,000 car.
c. $25,863 car.
d. $28,200 car.
Short Answer Questions
1. Why is the present value of money to be paid in the future less than the amount to be
paid, but the future value of money invested now and withdrawn later is greater than the
original investment?
2. Why is it that $400 per month paid over five years will not be enough to buy a $24,000
car?
3. Why is there usually a positive relationship between the time a bond will mature (how
long the investor has to wait to get her money) and the interest rate on that bond?
Think about This The amount of principal paid in the early stages of a mortgage is relatively modest. On a
$100,000 loan, at 6 percent for 360 months, the first payment is almost exactly $600 with $500
going for interest and $100 going toward principal. Before 2008’s financial meltdown, many
new homebuyers were getting “interest-only” mortgages. (They paid $500 per month for the
first five years and then $644 per month thereafter.) Do you think this was a good idea?
Talk about This College students and young people generally get themselves into credit problems because they
do not fully understand the consequences of borrowing and overestimate their ability to pay
loans back. Should your college censor campus bulletin boards and remove credit card offers
from mail you receive in residence halls?
Bankruptcy laws prevent people from defaulting on student loans, which means even if you
do declare bankruptcy on your credit card debt, you cannot get out from money you owe in
student loans. Were you aware of this when you took out a student loan, and would that impact
your decision to take out a student loan?
107
C H A P T E R E I G H T
Aggregate Demand and Aggregate Supply Learning Objectives
After reading this chapter you should be able to:
LO1 Apply and manipulate the aggregate
supply and aggregate demand model of
macroeconomics.
LO2 Explain why the aggregate demand curve is
downward sloping and why there is controversy
over the shape of the aggregate supply curve.
LO3 List the variables that shift these curves and
understand how the shifting translates into
price and output impacts.
LO4 Discriminate between demand-pull and
cost-push inflation.
LO5 Summarize what is meant by supply-side
economics.
Chapter Outline
Aggregate Demand
Aggregate Supply
Shifts in Aggregate Demand and Aggregate
Supply
Causes of Inflation
How the Government Can Influence
(but Probably Not Control) the Economy
Summary
Now that we have laid out the language of macroeconomics and some of the measurement
issues, it is time that we turn our attention to modeling the macroeconomy. Just as we used the
supply and demand model in Chapter 2 to help us understand what would happen in a particu-
lar industry if certain variables changed, we use the aggregate supply and aggregate demand
model to help us understand how other variables affect the economy as a whole.
Remember that models are not perfect. They rest on simplifying assumptions that allow us
to boil down the essentials of what we are looking at in a way that clarifies the big picture.
In microeconomics, supply and demand is a well-understood and relatively well-accepted
framework with which to look at particular industries. Regrettably, in macroeconomics no
such comparable model exists.
The closest we come to finding a workable model that is relatively easy to use and that is flex-
ible enough to encompass a variety of differing viewpoints is the aggregate supply and aggregate
demand model. It also has the virtue of mirroring the supply and demand model that we studied
in Chapter 2, so the concepts are less foreign than they would be with a completely new model.
The reason for caution with regard to macro models is that, unlike microeconomic
models, where there is only one market, many interrelated goods and services are combined.
108 Chapter 8 Aggregate Demand and Aggregate Supply
Whereas we can readily list five important things that influence the price of apples, we
would need more than five pages to list the important things that affect the economy as a
whole. The macro economy is just much bigger and much more complex than any particular
market. With this caution in mind we proceed in this chapter with the aggregate supply–
aggregate demand model knowing that, although not perfect, it is reasonably suited to the
purpose at hand.
Following the method of presentation in Chapter 2, we explain this model by first exam-
ining aggregate demand and aggregate supply individually. Then we look at them together,
as part of one model. Just as in Chapter 2, where we then looked at why supply and demand
might change, we examine why aggregate supply and aggregate demand might change and
what happens when they do. Last, we use the aggregate supply–aggregate demand model to
explain, albeit very briefly, supply-side economics.
Aggregate Demand
Definition
Aggregate demand (AD) is a measure of the amount of goods and services that will be pur- chased at various prices. It shows the quantities of real domestic output that domestic consum-
ers, businesses, governments, and foreign buyers collectively will desire to purchase at each
possible price level. As a practical matter we map this on a graph (Figure 8.1) with our mea-
sure of real goods and services sold, real gross domestic product (RGDP), on the horizontal
axis and our measure of all prices, the price index (PI), on the vertical axis.
Just as in Chapter 2, when we asserted that the demand curve was downward sloping and
then discussed why this makes sense, we do the same now. As shown in Figure 8.1, the aggre-
gate demand curve does, in fact, relate all prices to real output in a negative or inverse manner.
This makes sense for three reasons: the real-balances effect, the foreign purchases effect, and
the interest rate effect.
Why Aggregate Demand Is Downward Sloping
The real-balances effect is the idea that any wealth that you may have in the form of cash or securities becomes less valuable as prices rise. Also, if you have less ability to buy real goods
and services when prices are higher, then the two are negatively related.
The second reason why the aggregate demand curve is downward sloping is the foreign purchases effect. The argument here is that as prices rise in the United States, Americans will be more willing to buy imports and less willing to buy American-made goods. Foreigners will
also be less willing to buy U.S. goods, thus reducing our exports to them. If you remember the
expenditures approach from Chapter 6, you will recall
that any increase in imports reduces U.S. GDP.
The interest rate effect is that higher prices lead to in- flation. This in turn leads to less borrowing and a lowering
of RGDP. The definition of aggregate demand will help
explain the significance of interest rates as they relate to
the downward-sloping nature of the aggregate demand
curve. Recall from Chapter 6 that, using the expenditure
approach, aggregate demand is calculated by adding total
consumption, business investment, government spending
on goods and services, and exports and then subtracting
imports from that sum. Two of those items, consumption
aggregate demand (AD) The amounts of real domestic output that domestic consumers, businesses, governments, and foreign buyers col- lectively will desire to purchase at each possible price level.
foreign purchases effect When domestic prices are high relative to their imported alternatives, we will export less to for- eign buyers and we will import more from for- eign producers. There- fore, higher prices lead to less domestic output.
real-balances effect Because higher prices reduce real spending power, prices and output are negatively related.
interest rate effect Higher prices lead to inflation, which leads to less borrowing and a lowering of RGDP.
PI
RGDP
AD
FIGURE 8.1 Aggregate demand.
Aggregate Supply 109
and business investment, are interest-sensitive. When people buy homes, cars, home furnishings,
or any good expected to last longer than three years (what economists call durable goods), they
often do it by borrowing the money. When interest rates are high, the payments people can expect
to make on the consumption of these goods will be higher than they are when interest rates are
lower. When businesses borrow money to build a new plant or buy new equipment, the payments
they must make to their creditors are also determined by the interest rate. Any time the interest rate
rises, the volume of both large-dollar-item consumption and business investment will fall because
the interest rates have caused costs to be greater. Recall from Chapter 7 that inflation increases in-
terest rates, so if prices rise, inflation rises; if inflation rises, interest rates rise; if interest rates rise,
consumption and investment fall; if consumption and investment fall, then RGDP falls.
Aggregate Supply
Definition
Aggregate supply (AS) is a measure of the level of real domestic output available at each possi- ble price level. The accommodations for differing viewpoints take place in the aggregate sup-
ply curve. The differing viewpoints hinge on what is called full employment. Most economists
say that full employment exists when cyclical unemployment is zero, so that there are still
unemployed people at “full employment.” Specifically, the so-called structurally unemployed,
the people whose industry has moved or no longer exists, are without work. In addition, the
frictionally unemployed, those who quit because they are looking for better jobs or because
their spouse found a better job in a new location, are out of work during what is referred to
as “full employment.” These differences of opinion are displayed in the various ranges of the
aggregate supply curve shown in Figure 8.2.
Competing Views of the Shape of Aggregate Supply
We have a serious divergence of opinion among macroeconomists on several important defi-
nitions. The following questions separate the two main camps of economists: What constitutes
full employment and how are voluntary unemployment and involuntary unemployment de-
fined? While what follows may seem like “airing out dirty laundry in public,” it also serves as
an excellent “teachable moment” in your general education curriculum. Profound differences
of opinion exist in all disciplines, and one of the most profound differences of opinion in mac-
roeconomics centers on these issues. Accepting that there is not a single right answer to every
question is an important step in becoming an educated person. So, given that caution. . . .
Classical economists believe in the ability of all markets to generate good outcomes with-
out government involvement. They believe that if minimum-wage jobs are available and un-
employed steel workers choose not to take them, they are not involuntarily unemployed, just
deluded about their prospects. As a result, they believe
that cyclical unemployment is zero and therefore we
will, by definition, always be at full employment be-
cause changes in the labor market will ensure that each
person who wants a job will have one. If people are not
willing to work for the market equilibrium wage, then
they do not count anyway—at least within the defini-
tion of full employment held by classical economists.
Keynesian economists take the opposite view. These
economists, followers of the early 20th-century econo-
mist John Maynard Keynes, argue that there are always
more people willing to work than there are jobs available
aggregate supply (AS) The level of real domestic output available at each possible price level.
PI
RGDP
Keynesian range
Classical range
Intermediate range
AS FIGURE 8.2 The aggregate supply
curve.
110 Chapter 8 Aggregate Demand and Aggregate Supply
and that, as a practical matter, we have never actually reached full employment. To Keynesians the
concept of full employment is irrelevant. Thus, however many people are employed, Keynesians
argue there could always be more and increases in aggregate demand are needed to employ them.
To depict these differing views on a graph, classical economists believe that the aggregate
supply curve is vertical all the time. They believe that prices and wages will constantly equili-
brate all markets, so increases in aggregate demand will only bid up prices, and the underlying
real gross domestic product will remain unchanged. As an example, recall the memory chip–
making firm we studied in Chapters 4 and 5. Suppose it has many competitors that are identi-
cal to it. If aggregate demand increases, leading to an increase in demand for computers and
therefore memory chips, our firm will want to expand output. Classical economists argue that
since all markets are at full employment to begin with, our firm will have to raise the wage it
pays to attract more employees to produce those extra chips. Whether or not the firm succeeds
in luring away the workers from the competition, total industry output will remain the same,
since the total number of workers will not have changed. The only thing that will change if the
classical economists are right is that prices will rise.
On the other hand, Keynesian economists believe that prices and wages are rigid and
that unemployment results from that fact. The only way to employ these people, so the
Keynesians’ argument goes, is to increase aggregate demand. Moreover, since prices do not
change, the aggregate supply curve should be thought of as horizontal. Again, using our
chip maker as an example, if there are many unemployed workers available for hire into the
chip-making business, then increasing output to meet increased demand does not require
that wages rise.
A reasonable middle ground between these two models is that some industries are at full
employment while other industries are not. If this is the case, an increase in aggregate demand
may simply bid up prices in some industries and simply increase output in others. Thus, in the
aggregate, real GDP rises a little and prices rise a little. If some industries, like computer chip
makers, are at full employment and others, like steel, are not, then an increase in aggregate
demand that increases demand for these two products will cause only inflation in the chip
industry and only an increase in output in the steel industry.
The aggregate supply curve and the differences among economists are shown in Figure 8.2.
As you can see, the vertical portion corresponds to what classical economists believe and is so
indicated because any increase in aggregate demand will simply increase prices and not out-
put. Similarly, the horizontal region corresponds to what Keynesian economists believe and
is labeled as such because any increase in aggregate demand will simply increase output and
not prices. The middle ground, labeled the intermediate range, connects the two ideological
extremes and does so on the assumption that the classical economists may be right for some
industries and the Keynesians for others.
You should understand that the representation of aggregate supply in Figure 8.2 is not one
that most economists would embrace as perfect. For our purposes, though, it allows us to deal
with the differences of opinion among the major schools of thought within macroeconomics
in a way that is as uncomplicated as it can be. (This is not to say that you will necessarily find
it to be uncomplicated.)
Shifts in Aggregate Demand and Aggregate Supply
Variables That Shift Aggregate Demand
Just as we saw in Chapter 2, where there were factors that shifted demand, there are factors
that will shift aggregate demand. If you look at the elements of aggregate demand, you will
find clues to what these might be. Anything that affects people’s willingness to consume,
Shifts in Aggregate Demand and Aggregate Supply 111
government’s desire or need to spend money on goods and services, a business’s desire to in-
vest in new plant and equipment, or net exports (exports minus imports) will affect aggregate
demand.
For instance, taxes on personal or business income will affect consumption and investment,
respectively. With higher tax rates, consumers have less take-home income to spend on things.
With higher business or corporate tax rates, prospective business ventures are not as attractive as
they might otherwise be. Thus any increase in personal or business taxes will lower aggregate
demand, shifting it to the left on the graph, and any decrease will raise it, shifting it to the right
on the graph.
Any increase in interest rates will have a similar effect. As we saw in Figure 7.1 and as
we described in the previous discussion on the interest rate effect, increases in interest costs
diminish individuals’ and businesses’ willingness to borrow money. The result is that aggregate
demand decreases and moves to the left on the graph.
Any increase in business and consumer confidence will be followed by an increase in,
and a movement to the right in, aggregate demand. This result occurs because as consum-
ers become more confident in their own financial situation, they are more willing to take on
There is something vaguely unpatriotic about saying there are prob-
lems with a “strong dollar.” Nevertheless, it is true. As an example
take the euro (€)–dollar ($) relationship and apply it to the hypo-
thetical case where a German and an American are car shopping.
Suppose each person is looking to buy a midsized sedan and each
is comparing a German-made car with an American-made alterna-
tive. Each, after extensive research, has decided they are of equal
quality and overall appeal and that each will simply buy whichever
one is cheaper.
Keeping in mind that the euro was created in the 1990s to
replace various European currencies and its value was originally
pegged to equal one U.S. dollar, then if they are of equal value, the
exchange rate is 1–1 (one euro equals one U.S. dollar). That would
mean that if each of the cars was equally priced in both the United
States and Germany, both cars would cost $30,000 in the United
States and both cars would cost 30,000€ in Germany.
Now suppose that American dealers of German cars must buy
those cars from Germany for 25,000€ and that German dealers
of American cars must buy those cars from the United States for
$25,000. That means that American dealers pay $25,000 to a bank
to get 25,000€ and German dealers pay 25,000€ to a bank to get
$25,000.
If the dollar gets substantially stronger so that the exchange
rate moves to 1.00–0.75 (one euro equals 75 cents), then German
dealers of American cars would have to pay 33,333€ to a bank to
get $25,000 to buy the car from America. To maintain the 5,000€
margin they had been making at the old exchange rate, they would
have to raise the price of American cars in Germany to 38,333€. The
American dealer of German cars would now need only $18,750 to
get the 25,000€ and could therefore maintain the $5,000 margin by
charging a price of $23,750 for German cars. Thus, the American is
now more likely to buy the imported (German) car and the German is
more likely to buy the domestic (German) car. Thus, a stronger dollar
increases imports and decreases exports in the United States.
Before the United States, as well as the rest of the world, plunged
into a deep recession in 2007–2009, the dollar was very weak rela-
tive to the euro ($1 equaled around 0.64 euros). This was one rea-
son why, until fall 2008, it seemed possible the United States might
avoid a recession. American exports were rising at such a rapid pace
that it seemed possible that the United States might avoid the deep
recession that had already begun in Europe. When the financial crisis
of fall 2008 arrived, that hope faded. Though the crisis began with
American banks buckling under the weight of massive home foreclo-
sures, the United States was still seen as a safer place to ride out the
recession. Foreign investors sought out dollars to invest in United
States government bonds. This resulted in a rapid strengthening of
the dollar relative to the euro. In the course of 80 days between
August and November, the dollar rose to being worth 0.81 euros,
a nearly 25 percent appreciation. While this may have been good
for American morale, it was not at all helpful to American exporters.
As the recoveries in Europe and the United States plodded along
through the first half of the next decade, the value of the dollar con-
tinued to fluctuate relative to the euro. It fell to as low as $1 equaling
0.68 euros only to rise to $1 equaling 0.81 euros during the first crisis
over Greek debt. As the U.S. tightened its monetary stimulus between
2014 and 2016, the Europeans were doing the opposite such that the
euro fell in value to near par with the dollar. That, in turn, dampened
American exports to Europe.
W H Y A S T R O N G D O L L A R I S N ’ T N E C E S S A R I L Y G O O D
112 Chapter 8 Aggregate Demand and Aggregate Supply
debt to buy durable goods. As businesses have more confidence in their ability to sell their
products, they will invest more in their productive capacity. Any reduction in that confidence
will, of course, have the opposite effect. It will lessen aggregate demand and move the curve
to the left on the graph.
The effect of foreign exchange rates on aggregate demand is complicated by the fact that
though exchange rates are widely published, the fashion in which they are published is often
confusing. The Japanese yen typically is expressed in terms of how many yen it takes to
buy a U.S. dollar, whereas the British pound typically is expressed in terms of how many
dollars it takes to buy the pound. It is as if you went into one bakery looking to buy a dozen
donuts and they quoted prices in terms of the number of donuts you can buy for a dollar
and another bakery quoted prices in terms of the money you needed to buy a single donut.
With a bit of arithmetic you can do the comparison; it just takes a minute. This aside, we
can say that if the dollar becomes stronger, exports will fall and imports will rise. Thus a
strong dollar reduces aggregate demand, moving it to the left on the graph. Of course, a
weaker dollar has the opposite impact. Aggregate demand increases and moves the curve
to the right on the graph.
The only variable that impacts aggregate demand directly, one that needs little explanation,
is government spending. Because government spending on goods and services is a direct part
of the addition that makes up aggregate demand, the impact is direct. An increase in govern-
ment spending causes an increase in aggregate demand, and a decrease in government spend-
ing causes a decrease in aggregate demand. Therefore, an increase in government spending
will move the aggregate demand curve to the right and a decrease in government spending will
move the curve to the left.
These impacts are summarized in Table 8.1. The effect of an increase in aggregate demand
is shown in Figure 8.3, and the effect of a decrease in aggregate demand is shown in Figure 8.4.
Recall, if you will, the Chapter 2 admonition against trying to memorize Table 8.1 as it ap-
plies to Figures 8.3 and 8.4. Here, as it was in Chapter 2’s discussion of supply and demand
determinants and curve shifts, the advice is to use these tables and figures as a cross-check
against your own intuition and understanding. For example, if you were faced with the problem
of analyzing a tax increase, you would understand that taxes take money out of the hands of
consumers and business and thereby reduce the ability of these groups to buy goods and ser-
vices. That decreases aggregate demand. An aggregate demand decrease is depicted as leftward
movement of aggregate demand. Were you to follow that intuition and understanding, you
could check your conclusion against Table 8.1 and Figure 8.4.
Variable
Part of Aggregate
Demand Affected
Effect of an Increase
in Variable on
the Movement of
Aggregate Demand
Effect of a Decrease
in the Variable on
the Movement of
Aggregate Demand
Taxes Consumption
Investment
Decreases AD
so curve moves left
Increases AD
so curve moves right
Interest rates Consumption
Investment
Decreases AD
so curve moves left
Increases AD
so curve moves right
Confidence Consumption
Investment
Increases AD
so curve moves right
Decreases AD
so curve moves left
Strength of
the dollar
Exports and
imports
Decreases AD
so curve moves left
Increases AD
so curve moves right
Government
spending
Government
spending
Increases AD
so curve moves right
Decreases AD
so curve moves left
TABLE 8.1 Determinants of
aggregate demand.
Shifts in Aggregate Demand and Aggregate Supply 113
Variables That Shift Aggregate Supply
Just as there are factors that will change aggregate demand, there are important factors that
will change aggregate supply. These are factors that are important to business. Any change
that increases business costs will be important in terms of aggregate supply. Other factors that
matter are government regulations and factors affecting productivity.
Any factor that will increase costs of production will hurt aggregate supply. That is, an in-
crease in labor costs or other input costs will decrease aggregate supply and shift the curve to
the left, whereas a decrease in those costs will increase aggregate supply and move the curve
to the right. Along with any or all other costs of doing business, interest rates also impact the
aggregate supply curve in that they affect borrowing costs on lines of credit used to keep cash-
flow problems at a minimum.
Similarly, if government regulations increase costs of production in some way, then ag-
gregate supply will decrease and the curve will shift to the left. Deregulation will have the op-
posite impact because firms can eliminate costs of complying with regulations. Last, if firms
become more productive perhaps through the use of better technology, then aggregate supply
will increase and the curve will shift to the right.
Table 8.2 summarizes these impacts; Figures 8.5 and 8.6 summarize the impacts of
these shifts on an aggregate supply–aggregate demand diagram. Figure 8.5 shows the
impact of an increase in aggregate supply, and Figure 8.6 shows a decrease in aggregate
supply.
Now apply the admonition against memorization to Table 8.2 as it applies to Figures 8.5
and 8.6. For example, if you were faced with the problem of analyzing a productivity
increase, you would understand that productivity increases enhance the ability of firms
to produce goods and services. That increases aggregate supply. An aggregate supply
Variable
Effect of an Increase in the
Variable on the Movement
of Aggregate Supply
Effect of a Decrease in the
Variable on the Movement
of Aggregate Supply
Input prices Decreases AS
so curve moves left
Increases AS
so curve moves right
Productivity Increases AS
so curve moves right
Decreases AS
so curve moves left
Government regulation Decreases AS
so curve moves left
Increases AS
so curve moves right
TABLE 8.2 Determinants of
aggregate supply.
PI
AD
PIʹ
PI*
ADʹ
AS
RGDPRGDPʹ RGDP*
FIGURE 8.4 Aggregate demand decreases, causing it to move to the left on the graph.
PI
PIʹ
ADʹ
PI*
AD
AS
RGDPRGDP* RGDPʹ
FIGURE 8.3 Aggregate demand increases, causing it to move to the right on the graph.
114 Chapter 8 Aggregate Demand and Aggregate Supply
increase is depicted as a movement down and to the right for aggregate supply. Were you to
follow that intuition and understanding, you could check your conclusion against Table 8.2
and Figure 8.5.
Causes of Inflation
As can be seen in Figures 8.3 and 8.6, increases in prices can result from demand-side impacts
or supply-side impacts. Anything that causes the aggregate demand curve to move to the
right increases prices. Economists refer to the inflation caused for this reason as demand-pull inflation. Anything that causes the aggregate supply curve to move to the left also increases prices. Economists refer to the inflation caused for this reason as cost-push inflation.
Many of the things that move the aggregate demand curve to the right are things that
government manipulates. If government spending is increased or taxes are decreased, aggre-
gate demand is increased and demand-pull inflation occurs. In addition, monetary policy—
government decisions about the money supply—purposefully influences interest rates. If the
impact of that policy is the lowering of the rates, then the aggregate demand increases as a
result of the increase in interest-sensitive consumption and investment.
During the 1960s, when President Lyndon Johnson was simultaneously carrying on the
Vietnam War and attempting to wage a war on poverty, there was a substantial concern of
demand-pull inflation. Government spending was increasing rapidly, and though taxes during
this period also increased, inflation increased from 1 percent in 1965 to 6 percent in 1970.
Input costs are important influences on the aggregate supply curve. For example, an in-
crease in wages that comes about because of either market actions or legislation will move the
aggregate supply curve to the left, thereby increasing prices. Increases in such things as oil
prices will have a similar effect on the aggregate supply curve.
The inflation of the late 1970s was largely attributable to increases in oil prices. Oil, a
significant input to production throughout the economy, increased from $5.21 per barrel
in 1973 to $35.15 per barrel in 1981. This, in turn, contributed to inflation rising from
3 percent in 1972 to 18 percent in the first quarter of 1980. Similarly, the short spike in
inflation during 2007 through early 2008 was due, in large part, to the tripling of world
oil prices during the same period. The impact of the revolutions in the Middle East during
early 2011, from Tunisia, Egypt, Libya, and elsewhere, caused many to be concerned that
oil-related inflation would choke off the slow recoveries taking place in the United States
and Europe.
demand-pull inflation Inflation caused by an increase in aggregate demand.
cost-push inflation Inflation caused by a decrease in aggregate supply.
PI
PIʹ
AD
PI*
ASʹ
AS
RGDPRGDP* RGDPʹ
FIGURE 8.5 Aggregate supply increases causing it to move to the right
on the graph.
PI
PIʹ
AD
PI*
ASʹ
AS
RGDPRGDP*RGDPʹ
FIGURE 8.6 Aggregate supply decreases causing it to move to the left
on the graph.
How the Government Can Influence (but Probably Not Control) the Economy 115
How the Government Can Influence (but Probably Not Control) the Economy
In looking at the determinants of aggregate demand and the determinants of aggregate supply,
it is clear that government can influence the economy in a number of ways. Taxes, interest
rates, the strength of the dollar, and government spending make up four of the five determi-
nants of aggregate demand outlined in Table 8.1, and these are quite clearly areas where the
government can exert influence. Input prices and government regulation show up as deter-
minants of aggregate supply in Table 8.2. The latter is quite obviously under the control of
government, and there are aspects of the former in which influence is possible.
Demand-Side Macroeconomics
While Chapters 9 and 10 offer more detail on how government policy makers can influ-
ence the economy via the demand side, it is worth mentioning here as well. By raising or
lowering taxes or by raising or lowering spending, Congress and the president can influence
aggregate demand and thereby influence prices and output. Similarly, by raising or lowering
target interest rates, the Federal Reserve can influence aggregate demand. To a lesser extent,
governments—through their ability to buy or sell world currencies—can influence the value
of their own currency. These are the means by which government can steer an economy out
of a recession. The rapid reductions in interest rates that occurred between January 2001 and
summer 2003, the cut of short-term interest rates to nearly zero in late 2008, the large-scale
purchase of mortgage-backed securities by the Federal Reserve in 2008 and again from 2010
into 2013, the tax rebate checks generated in 2001, 2003, and 2008, as well as the Obama-era
stimulus plan were all attempts to jump-start the economy on the demand side.
Supply-Side Macroeconomics
During the late 1970s a new way of thinking about government’s ability to influence the
economy began to arise. Basically, the new way of thinking involved policy actions that
would influence the aggregate supply curve. We have already seen that government spend-
ing and interest rate policy influence the aggregate demand curve. Figures 8.3 and 8.4 show
that any movement in the aggregate demand curve will either increase RGDP but also in-
crease inflation, or decrease RGDP but also decrease inflation. Movements in the aggregate
supply curve to the right have only good consequences: Inflation is reduced and RGDP is
increased.
Supply-side economics involves influencing the aggregate supply curve by lowering input costs, reducing regulation, and increasing incentives for hard work and innovation. Though
advocates of supply-side economics usually advocate for changes in the tax code, such
changes are not necessary. Only some of the actions the Reagan administration (1981–1989)
took are properly understood as supply-side actions: Tax cuts aimed at businesses (the in-
vestment tax credit and accelerated depreciation schedules), tax code changes that signifi-
cantly reduced marginal tax rates, attempts at deregulation and lax enforcement of existing
regulations, and vetoing of increases in the minimum wage are clearly supply-side policies.
These policies, advocates suggest, increased the incentive to innovate, take risks, and work
hard by increasing after-tax rewards or by removing impediments. On the other hand, de-
tractors argue, the large part of the tax cuts to individuals that resulted from higher standard
deductions, and the even larger defense buildup, are properly thought of as typical aggregate
demand-side policy.
The biggest supply-side impact in the 1980s was that the price of a barrel of oil fell
from $40 to less than $10. More recently, the tax cuts proposed by President Bush in
supply-side economics Government policy intended to influence the economy through aggregate supply by lowering input costs and reducing regulation.
116 Chapter 8 Aggregate Demand and Aggregate Supply
2003 to eliminate the taxation of corporate dividends are properly thought of as supply-
side economics. The argument he was making was that eliminating the double taxation of
corporate dividends would stimulate businesses to invest in productivity increasing assets.
Whether or not his logic was on target or flawed, the 2003 tax cut did not eliminate double
taxation, though it did reduce the top tax rates on capital gains, an objective of supply-side
economists. These tax cuts were a major point of difference between President Obama
and Senator McCain during the 2008 campaign and between him and Governor Romney
during the 2012 campaign. When Republicans won significant electoral victories in 2010,
Obama agreed to extend those cuts through 2012—all because he believed that allowing
taxes to rise at that time would have negative supply and demand–side impacts. When the
president won reelection in 2012, he had his way with tax rate increases for certain high-
income earners.
This chapter introduced the aggregate demand and aggregate supply model that we will use
when discussing the macroeconomy and macroeconomic issues. We first examined aggregate
demand and aggregate supply in isolation, explaining why aggregate demand is downward
sloping. We also looked at the shape of the aggregate supply curve in the context of the differ-
ences between classical and Keynesian views of both aggregate supply and full employment.
When they were combined as one, we were able to show what happens when certain macro-
economic variables change. In that way we used them to explain the concepts of cost-push and
demand-pull inflation and of supply-side economics.
Summary
Key Terms aggregate demand (AD) aggregate supply (AS)
cost-push inflation
demand-pull inflation
foreign purchases effect
interest rate effect
real-balances effect
supply-side economics
1. Any event that creates a “crisis in confidence” is likely to lead to
a. higher aggregate prices.
b. higher aggregate output.
c. lower aggregate prices.
d. inflation.
2. Use the aggregate supply–aggregate demand model to determine which of the following
will lead to higher prices.
a. A tax increase
b. A fall in world oil prices
c. An increase in interest rates
d. An increase in government spending
Quiz Yourself
Issues Chapters You Are Ready for Now
Fiscal Policy
Monetary Policy
Federal Deficits, Surpluses,
and the National Debt
The Housing Bubble
Is Economic Stagnation the
New Normal?
Summary 117
3. Use the aggregate supply–aggregate demand model to determine which of the following
will lead to higher aggregate output.
a. A tax increase
b. A spike in world oil prices
c. A cut in interest rates
d. A cut in government spending
4. Congress and the president have control of the tax system and government spending. As
a result, their policies will directly impact
a. aggregate supply.
b. aggregate demand.
c. residual demand.
d. the demand for loanable dollars.
5. The Federal Reserve has indirect control over short-term interest rates, and, as a result,
their ability to control economic activity is through
a. aggregate supply.
b. aggregate demand.
c. residual demand.
d. the exchange rate.
6. An economist worrying about the economic impact of environmental regulations would
model that impact with a
a. decrease in aggregate supply.
b. increase in aggregate supply.
c. decrease in aggregate demand.
d. increase in aggregate demand.
7. Disagreements about the shape of the aggregate supply curve focus on the degree of
___________ in the economy.
a. unemployment
b. inflation
c. fraud
d. confidence
8. The use of a backward L–shaped aggregate supply curve allows us to _______________
in a way that other shapes would not.
a. consider various levels of prices
b. consider different macroeconomic points of view
c. deal with shifting curves
d. create an equilibrium
Short Answer Questions
1. Of the reasons that the aggregate demand curve and the demand curve are downward
sloping, each has one labeled the “real balance effect.” How are they different?
2. If we want our president to “do something” about the economy, what do we usually have
in mind? How can we use the aggregate demand–aggregate supply model to show that
what we have in mind will work?
3. Suppose a president says: “We are in a crisis and on the verge of another Great Depres-
sion. We need to increase government spending to give the economy a boost.” What
determinant of aggregate demand is the president counting on to keep us out of that
depression? What determinant of aggregate demand is the president hoping you do not
respond to?
118 Chapter 8 Aggregate Demand and Aggregate Supply
4. Explain the chain of events that connect an overall price increase to a decrease in aggre-
gate demand using the interest rate effect.
5. Define aggregate demand. Then, list and explain the intuitive reasons why aggregate
demand is downward sloping.
6. Discuss the shape of the aggregate supply curve by listing and explaining the reasons
behind the various ranges.
7. List and explain the three ways that the Federal Reserve controls the money supply (i.e.,
tools of the monetary authority).
Think about This President Harry Truman once lamented that he wanted a “one-handed economist” because we
economists have a tendency to say “on the one hand . . . but on the other hand. . . .” Economists
have never made very good presidential aides because we respect the uncertainty of things; we
rarely give straight answers because there are rarely simple, straight answers to give. Macro-
economics generally, and the aggregate supply–aggregate demand model specifically, embrace
that uncertainty. If you were a political leader, would you want a “one-handed” economist?
Talk about This The aggregate supply–aggregate demand model can be useful in predicting macroeconomic
consequences of policy actions (like tax cuts, government spending increases, regulatory ac-
tions, interest rate adjustments). It does not tell you about the distributional aspects of policy
actions. For instance, a regulatory requirement that all employers offer health insurance would
shift the aggregate supply curve to the left, increasing prices and decreasing real GDP. Does
that make it a bad idea? Would the impact of such a regulation on health care availability
counteract these macroeconomic consequences in your mind?
C H A P T E R N I N E
119
Fiscal Policy Learning Objectives
After reading this chapter you should be able to:
LO1 Describe and model discretionary and nondiscretionary
fiscal policy using an aggregate supply and aggregate
demand diagram.
LO2 Distinguish between aggregate demand and aggregate
supply shocks.
LO3 Acknowledge and enumerate the problems associated with
discretionary fiscal policy.
LO4 Describe nondiscretionary fiscal policy as the mainstay of
our current macroeconomic system.
Chapter Outline
Nondiscretionary and Discretionary Fiscal Policy
Using Fiscal Policy to Counteract “Shocks”
Evaluating Fiscal Policy
The Obama Stimulus Plan
Kick It Up a Notch: Aggregate Supply Shocks
Summary
When you want government to “do something” about
the economy, you are typically referring to fiscal policy, which was considered a vital tool in macroeconomics
at one time. Fiscal policy is the purposeful movements
in government spending or tax policy designed to direct
an economy. In the United States, fiscal policy is deter-
mined by the Congress and the
president.
Fiscal policy is not simply
one idea; it is really two. Dis- cretionary fiscal policy consists of actions taken at the time of a
problem to alter the economy of
the moment. Nondiscretionary fiscal policy is that set of policies that are built into the system
to stabilize the economy when
growth is either too fast or too
slow.
Discretionary and nondis-
cretionary fiscal policy are de-
scribed first. Then we consider
the benefits of nondiscretionary
fiscal policy and explain why
some argue that discretionary fiscal policy cannot claim
similar benefits. We use that discussion to examine why
policy makers had abandoned discretionary fiscal policy
for many years. We finish by discussing the two Bush
tax cuts, and specifically the child-credit rebates, in the
context of reviving discretionary fiscal policy.
Nondiscretionary and Discretionary Fiscal Policy
How They Work
The difference between nondiscretionary and discretion-
ary fiscal policy is that one is automatic and the other
is not. Nondiscretionary fiscal policy, for example, in-
cludes government policies that stimulate the economy
when it needs stimulus and dampen it when it needs to be
dampened. Under discretionary fiscal policy, Congress
and the president agree on a course of action to stimulate
or dampen the economy at a specific time.
Nondiscretionary fiscal policy is at work every day
as a result of policies enacted years ago. Every time
you get a raise, move to a better job, or make a killing
in the stock market, the government takes a portion of
fiscal policy The purposeful move- ments in government spending or tax policy designed to direct an economy.
discretionary fiscal
policy Government spend- ing and tax changes enacted at the time of the problem to alter the economy.
nondiscretionary
fiscal policy A set of policies that are built into the system to stabilize the economy.
120 Chapter 9 Fiscal Policy
your improved income in taxes. The effect on your as-
sets becomes more pronounced as you advance in the
tax brackets, because when you make more money you
pay a higher percentage of that income in taxes. If you
happened to have been a welfare recipient and you have
found a job, the effect is even greater. Not only is the
government now not providing you with money, but also
is withholding taxes from your pay. In both cases, the
effect of nondiscretionary fiscal policy is dampening the
increase in your income.
Of course, nondiscretionary fiscal policy can have the
opposite effect as well. If you lose your job, get demoted,
or lose a lot of money in the market, your tax burden
falls. If you lose your job and go back on welfare, the
effect is again magnified. The government is not taking
money from you but is giving money to you. This stimu-
lates the economy somewhat, and it thus has the effect of
helping to counteract the loss you incurred.
Because our progressive income tax system in-
creases the percentage that you pay in taxes as you
make more money and because federal and state pro-
grams are in place that offer economic assistance when
you need it, nondiscretionary fiscal policy is constantly
working to stabilize the economy. No one has to use
any discretion—that is, make any decisions—to make
it work. Therefore, it is called nondiscretionary fiscal
policy. Because the actions are built into the system,
nondiscretionary fiscal policy is often referred to as a
built-in stabilizer.
With discretionary fiscal policy, on the other hand,
action is required by Congress and the president. When
each decides that the economy is in need of a specific ac-
tion that will properly stimulate or dampen it, the usual
actions that they consider involve changes in taxes or
spending policies. Historically, fiscal policy has been
used to stimulate an economy in recession but rarely to
dampen an economy that is running too hot.1
The specific policy actions used in the past were tax
cuts and funding of public works projects to give jobs to
people who were unemployed. In the middle 1970s, for
example, President Gerald Ford sought to provide each
taxpayer with a tax rebate of $50. During the Great De-
pression many unemployed workers found jobs in gov-
ernment programs that built roads, dams, and bridges.
During his 2008 campaign, President Barack Obama
promised a middle-class tax cut while promising to re-
peal tax cuts passed during the prior administration that
went primarily to those wealthy Americans earning more
than $250,000. President Obama’s election in the midst
of the financial crisis of fall 2008 was quickly followed
by the worst holiday shopping period in 40 years. In
this context, the incoming Obama administration spent
considerable time during the transition contemplating a
fiscal stimulus package. What emerged was a package
that included tax cuts for individuals, an extension of and
an increase in unemployment benefits, aid to state and
local governments both to account for the expected in-
creases in Medicaid enrollment and to forestall the need
for significant state and local budget cuts, spending on a
series of projects that were priorities for Democrats, and
spending on what were called “shovel-ready” infrastruc-
ture projects.
The individual tax cuts were structured differently
from the 2001, 2003, and 2008 rebates in that they were
implemented through short-term changes to withholding
tables. The Bush rebates came first with paper checks,
then with a combination of paper checks and direct de-
posits to banks. With each rebate there was a period of
time from the passage of the package to the time when
the money was in the hands of the consumer. The econ-
omists advising President Obama were convinced that
there were two significant problems with the Bush-era
rebates. They took too long to get into taxpayers’ hands
and too much of the money was saved rather than spent.
They believed that by changing withholding tables they
could speed up the process as well as induce more spend-
ing by giving average taxpayers smaller amounts per
week rather than a large amount at once.
Using Aggregate Supply and Aggregate Demand to Model Fiscal Policy
Our aggregate supply and aggregate demand model
is a useful tool for examining the effect of both forms
of fiscal policy. Both discretionary and nondiscretion-
ary fiscal policy work to move the aggregate demand
curve. Figure 9.1 shows the effect of expansionary fiscal
policy and Figure 9.2 shows the effect of contraction-
ary fiscal policy. Expansionary fiscal policy options,
such as increased government spending and decreases
in taxes, are reflected in an aggregate demand curve that
moves to the right. Contractionary fiscal policy options,
including decreased government spending and increases
in taxes, are seen in an aggregate demand curve that
moves to the left.
It should be noted that there is considerable debate
over whether any fiscal policy will have a real impact
1A one-year 10 percent surtax was added to income taxes in the Lyndon Johnson
administration. Some justified this action as an effort to combat inflation.
Using Fiscal Policy to Counteract “Shocks” 121
on the economy. A useful but relatively simplistic way
of thinking about this argument is to frame it in terms of
where on the aggregate supply curve the economy lies.
Those who believe that we are on the vertical portion of
the curve argue that any expansionary fiscal policy will
be completely ineffective. It will merely create inflation
without bolstering output.
It is worth mentioning that the money necessary to
engage in expansionary fiscal policy does not come out
of thin air. The increased government spending and the
reduced tax revenue generate a shortfall that must be
made up with either borrowing or printing the requisite
money. Economists do not consider the latter option a
good one in that inflation is nearly always the result.
Thus deficits financed through borrowing money tend to
be the result of expansionary fiscal policy.
Using Fiscal Policy to Counteract “Shocks”
Aggregate Demand Shocks
Neither expansionary nor contractionary actions happen
in a vacuum. They happen because the economy moves
unexpectedly to make RGDP much higher or much lower
than policy makers think is healthy. Figures 9.3 and 9.4
show the impact of these shocks, or unexpected moves. In each
we suppose that aggregate de-
mand is what moves unexpect-
edly, and in each we start with it at AD1. Because of a
shock it unexpectedly moves to AD2. If a slump in ag-
gregate demand causes a recession, like Figure 9.3, then
shock Any unanticipated economic event.
FIGURE 9.1 Expansionary fiscal policy.
PI
PIʹ
ADʹ
PI*
AD
AS
RGDPRGDPʹRGDP*
FIGURE 9.2 Contractionary fiscal policy.
PI
PIʹ
AD
PI*
ADʹ
AS
RGDPRGDPʹ RGDP*
FIGURE 9.3 A negative aggregate demand shock.
Pl
Pl*
Shock
AS
RGDPRGDP*
AD1
AD2
FIGURE 9.4 A positive aggregate demand shock.
Pl
Pl*
Shock AS
RGDPRGDP*
AD 1
AD2
122 Chapter 9 Fiscal Policy
the aggregate demand curve moves from AD1 to AD2.
When people lose their jobs, welfare spending will have
to rise and tax revenue will fall. As Figure 9.5 shows, this
nondiscretionary fiscal policy moves the aggregate
demand curve partially back to AD3. Expansionary dis-
cretionary fiscal policy (either increases in government
spending or decreases in taxes) can move aggregate
demand all the way back to AD1.
If a jump in aggregate demand causes an overheated
economy, like Figure 9.4, then the aggregate demand
curve moves from AD1 to AD2. When people get bet-
ter jobs or raises, welfare spending will fall and tax
revenue will rise. As Figure 9.6 shows, this nondiscre-
tionary fiscal policy moves the aggregate demand curve
partially back to AD3. Contractionary discretionary fis-
cal policy (either decreases in government spending or
increases in taxes) can move aggregate demand all the
way back to AD1.
Nondiscretionary fiscal policy (NDFP) moves it
back toward AD1 to AD3, and discretionary fiscal pol-
icy (DFP) can move it all the way back to AD1 again.
In theory, whether the economy experiences a positive
demand shock or a negative one, the government can use
both discretionary and nondiscretionary fiscal policy to
return us to a healthy economy.
We need to ask at this point how it is that aggregate
demand can move unexpectedly. There are a number of
reasons and each involves the reaction of people to their
predictions of the future. If people’s positive view of the
health of the economy spurs them to buy new cars or fur-
nishings, an aggregate demand curve will move to the
right. If the opposite happens and people decide to delay
buying these expensive items because of negative feel-
ings about the economy, the ag-
gregate demand curve will move
to the left. Tracking the “feeling”
that people have about the econ-
omy is not easy and therefore
large, unexpected swings can
upset the economy. Economists call these swings
aggregate demand shocks.
Aggregate Supply Shocks
Along with aggregate demand shocks, we must also
deal with the problem of aggregate supply shocks. Usu-
ally an aggregate supply shock involves an important natural re-
source. It should come as no sur-
prise that recent supply shocks
have all involved the price of oil.
During the 1973 Arab–Israeli war, for example, the price
of oil climbed dramatically. During the Iran–Iraq war, the
price of oil fell dramatically as both sides increased pro-
duction to pay for war material. The tripling of world oil
prices from 2007 to mid-2008 and the dramatic plummet-
ing of those prices from summer 2008 through early 2009
each had dramatic aggregate supply impacts.
Even more recently, the early 2011 uprisings through-
out the Middle East illustrated the uncertainty effect of
these supply shocks. Crude oil prices, which were below
$80 per barrel in January 2011, rose above $100 per bar-
rel with the Libyan uprising, even though Libya itself
is a relatively minor producer of oil (3 percent of world
production).
Whether drastic changes are positive or negative, pol-
icy makers are frequently called upon to do something to
aggregate demand
shock An unexpected event that causes aggregate demand to increase or decrease.
FIGURE 9.5 Nondiscretionary and discretionary fiscal policy as it combats a recession.
PI
PI*
AD1 AD3AD2
NDFP
DFP
Shock
AS
RGDPRGDP*
FIGURE 9.6 Nondiscretionary and discretionary fiscal policy as it combats an overheated economy.
PI
PI*
AD1
AD3
AD2
NDFP
DFP
Shock
AS
RGDP
aggregate supply shock An unexpected event that causes aggregate supply to increase or decrease.
Evaluating Fiscal Policy 123
counter that aggregate supply shock, and, because they
very frequently have little control over the events that
cause those shocks, they may wish to use discretionary
fiscal policy to mitigate the economic impact.
Evaluating Fiscal Policy
Nondiscretionary Fiscal Policy
Nondiscretionary fiscal policy serves to get output mov-
ing back toward the desired level, RGDP*, but it works
much better when the shock is to aggregate demand
rather than to aggregate supply. In addition, even though
previous Congresses and presidents developed tax and
spending policies to get the country out of a recession,
such discretionary fiscal policy just does not work as
well as does nondiscretionary policy.
Since the Great Depression of the 1930s, the U.S.
economy has successfully avoided the sorts of boom and
bust cycles that plagued the 19th century. The degree to
which the built-in stabilizing effect of a welfare state and
a progressive tax system generated this state of affairs is
debated by economic historians. The two most significant
post–World War II recessions, the one in 1982 and the
one that extended from late 2007 to mid-2009, were far
less onerous than any of the financial panics of the 1800s.
Discretionary Fiscal Policy
You might think that discretionary fiscal policy would
work as well. If you did, you would be wrong, but you
would be in good company. By the 1950s and 1960s,
most economists were confident that discretionary fis-
cal policy would essentially eliminate the instability of
recessions. By 1980 most economists had given up on
discretionary fiscal policy. Coincidentally or not, during
the 20 years that followed, the United States experienced
half the usual number of recessions.
What transformed economists from overconfident dis-
cretionary fiscal policy champions in the 1960s to ardent
detractors in the 1980s was the very poor performance of
these policies during the 1970s. The preceding aggregate
demand and aggregate supply analysis is nice to look at,
and the nondiscretionary fiscal policy part does work as
advertised, but discretionary fiscal policy was more of a
fantasy of economists. In the 1950s and 1960s, econo-
mists were confident that Congress could know exactly
how much stimulus or dampening would be necessary to
get the economy back to a desired level of RGDP. Con-
gress would then pass a bill that the president would sign
to implement that policy. As a practical matter, it just did
not work in the ways economists predicted it would.
The reasons discretionary fiscal policy does not work
as well as advertised (or perhaps at all) are threefold.
First, the failures can be attributed to lags in recognizing,
administering, and operating fiscal policy. Second, the
failures can result from political motivations overwhelm-
ing economic reason, and third, there can be immediate
counter-effects with both aggregate demand and aggre-
gate supply, which partially or completely eliminate the
positive intent of the policies.
On the issue of the lags, the
first of these is the recognition lag, which means that the econ- omy in general, and RGDP in
particular, is measured with a
considerable lag. The second,
the administrative lag, results because it takes time for Con-
gress and the president to agree
on a course of action. The third,
the operational lag, results be- cause it takes quite awhile for
the full impact of a government
program or tax change to have
its effect on the economy.
The recognition lag results from the fact that gross do-
mestic product is not easily and immediately measured.
Quarterly GDP is first estimated using reasonably good
predictors that are available soon after the end of the
quarter. Later, more data are brought to bear and GDP is
reestimated. Only after many months is a final GDP fig-
ure given. Thus we do not know for sure whether we are
in a recession until months after it begins. Similarly, we
do not know when we are out of a recession until months
after it ends. The problem this creates was highlighted by
the 2007–2009 recession. It was late fall 2008 before the
National Bureau of Economic Research Business Cycle
Dating Committee identified fall 2007 as the beginning
of the recession. While it was clear by late summer 2008
that the economy was slowing dramatically, it was a full
year after the recession began before it was universally
acknowledged. At the end of the 2001 recession, the
economy was growing so slowly that it took until sum-
mer 2003 for economists to declare the recession had
actually ended in the fall of 2001. This meant that by
the time they had declared a recession had started, it was
almost over and by the time they had declared it over, it
had actually been over for a year and a half. The reces-
sion of 2007–2009 was not declared to have ended in
recognition lag The time it takes to measure the state of the economy.
administrative lag The time it takes for Congress and the president to agree on a course of action.
operational lag The time it takes for the full impact of a govern- ment program or tax change to have its effect on the economy.
124 Chapter 9 Fiscal Policy
June 2009 until September 2010. The stimulus package
had not yet spent more than 10 percent of the allocated
funds by that time.
The administrative lag results from the inherent inef-
ficiency of American democracy. We have two legisla-
tive bodies that must first agree with each other and then
must agree with the president. The president, the House,
or the Senate can delay or derail fiscal policy. Even if
they choose to work on a given problem, Congress never
solves a problem without disagreements. They may agree,
for example, that we are in a recession but will not be able
to decide whether to engage in discretionary fiscal policy
through tax cuts or through spending programs. Even
when they agree on that, they may argue over the kinds
of tax cuts to make, who should get them, what kinds of
spending programs would be appropriate, and the con-
gressional districts that should be benefited. By the time
they finally agree, of course, more time has passed.
This is quite well illustrated by the political wrangling
over the 2008 financial system rescue plan and the 2009
stimulus package. Both presidential candidates were
in agreement that the Troubled Asset Relief Program
(TARP) was necessary, but it took nearly a month for
the plan to pass. Even with significant majorities in both
houses and two and a half months from his election to
his swearing in, it took President Obama five additional
weeks to get a stimulus plan through Congress. Much of
the disagreement surrounded the size and composition
of the package. Conservative economists and members of
Congress were concerned about the budget deficit impli-
cations of the package. Liberal economists and members
of Congress were concerned that the package would be
of insufficient size to have the desired impact. These are
perfectly legitimate differences of opinion, but the debate
took time.
The operational lag offers the final roadblock to ef-
fective discretionary fiscal policy. Even supposing that
Congress and the president agree on time that a policy
is needed and they agree on the type of policy, it takes
months, if not years, for discretionary fiscal policy to
have its desired effects.
If the discretionary fiscal policy takes the form of
increases in highway construction, a program that in-
creases the numbers of jobs available, federal contracts
usually do not pay the entire amount up front. Contrac-
tors are paid in the stages of building, and it takes quite
awhile to go from the beginning of a large construction
project to its end. To avoid this delay, the Obama stimu-
lus package hoped to include mostly “shovel-ready” in-
frastructure plans. The idea was to take plans that had
already gone through the design phase. In so doing, the
hope was to get these projects started the moment funds
became available. It bears repeating that when the reces-
sion of 2007–2009 ended in June 2009, less than 10 per-
cent of the stimulus funds from the bill that had passed
that February had been spent.
As for the tax aspects of fiscal policy, the vast major-
ity of the money going to taxpayers went to them well
after it was needed. The 2001, 2003, and 2008 summer
rebate checks and the change to withholding tables in
2009 are evidence that tax cuts can make their way into
the economy somewhat more quickly. In the pre-2009
cases, the laws generating the rebates were passed at
least six months before the money was fully in the hands
of consumers. The downside to these relatively quick tax
cuts is that their impacts are often muted by those who
use the extra money to save or to pay down existing debt.
The Political Problems with Fiscal Policy
Another argument against discretionary fiscal policy is
that even if it worked, vote-obsessed politicians would
not use it properly. Aside from the bias toward expan-
sionary fiscal policy alluded to in the introduction, there
is the question of who will be affected by any changes
in taxation or spending policies. In addition, there is the
complication caused by politicians too concerned with re-
election. They seek to expand the economy in presidential
election years only to act responsibly after the election.
The first of these issues raises questions of political
motivation. Whether large-scale, federally funded build-
ing projects are needed is one question; where they will
go is quite another. For instance, whether the revamped
Boston mass transit system, referred to by many as the
“big dig,” was motivated by purely engineering reasons
or because influential members of Congress lived in the
area is debatable. Similarly, critics have charged that
political influence alone was behind the placement of a
majority of highway demonstration projects in the early
1990s in West Virginia. While these are examples of
Democrats engaging in steering tax dollars, Republicans
too have engaged in such practices. Between 1995 and
2001, the GOP majority leader and the chair of the Sen-
ate Appropriations Committee made certain that dispro-
portionate dollars were spent in their home states. The
infamous “bridge to nowhere” in Alaska provides an
excellent example of politically motivated infrastructure
projects. Noted economist James Buchanan and others
have suggested that all federal spending, but in particular
that spending that is done in the name of fiscal policy, is
susceptible to this kind of problem.
Evaluating Fiscal Policy 125
There is also the problem of the political business cycle. It is suggested that politicians, particularly presi-
dents, will add new spending
and tax policies to their pre-
election-year budgets to boost
the economy in time for their
own or their party’s reelection.
Table 9.1 suggests that this might be the case, given that
the average of growth rates in the fourth year of presi-
dential terms of office is slightly higher than that of first-
year growth rates.
Criticism from the Right and Left
There were many economists, mainly on the conserva-
tive end of the spectrum, who advised against a fiscal
stimulus of any kind and then were only too happy to say
“I told you so” when, by their calculations, the impact of
the 2009 stimulus package was less than the Obama ad-
ministration had predicted. John Cogan, John Taylor, and
others argued that the impact was, if anything, small and
temporary, and quite possibly negative. They argued that
the only way to truly stimulate consumption and invest-
ment is to make long-term structural changes to tax rates
in ways that consumers and businesses can confidently
predict that their future after-tax income will be higher.
Liberal (and Nobel Prize–winning) economist Paul
Krugman was just as derisive of the stimulus package as
political business cycle Politically motivated fiscal policy used for short-term gain just prior to elections.
these conservative economists, yet his point of attack was
that it was predictably too small to have any of its desired
impacts. While dismissing the conservative economists’
estimation of the importance of, as he called it, “the con-
fidence fairy,” he and others argued as early as December
2008 that policy makers were understating what was nec-
essary by a factor of at least two. Since that time Krugman
repeatedly pointed to the fact that total government spend-
ing declined in 2010 and 2011 because state and local
governments were cutting back on spending by more than
the federal government was increasing spending.
The Rise, Fall, and Rebirth of Discretionary Fiscal Policy
In the 1970s it became apparent to policy makers that
discretionary fiscal policy was not up to the task of sta-
bilizing the economy. The lags were just too important to
ignore, and the recessions of the 1970s had been too short
for these recessions to be recognized, laws to be passed,
and money spent in time to have any effect on them.
Despite the preceding cautions about the effectiveness
of discretionary fiscal policy, its arguments have been
used to bolster particular programs. President Clinton
used the discretionary fiscal policy argument in 1993 to
bolster a $16 billion investment program. Critics defeated
his proposal, suggesting that we were already out of the
recession and its size was too small to have any impact.
President First Year Second Year Third Year Fourth Year
Truman −0.5 8.7 8.1 4.1
Eisenhower I 4.7 −0.6 7.1 2.1
Eisenhower II 2.1 −0.7 6.9 2.6
Kennedy/Johnson 2.6 6.1 4.4 5.8
Johnson 6.5 6.6 2.7 4.9
Nixon I 3.1 0.2 3.3 5.2
Nixon II/Ford 5.6 −0.5 −0.2 5.4
Carter 4.6 5.6 3.2 −0.2
Reagan I 2.6 −1.9 4.6 7.3
Reagan II 4.2 3.5 3.5 4.2
Bush GHW 3.7 1.9 −0.1 3.6
Clinton I 2.7 4.0 2.7 3.8
Clinton II 4.5 4.5 4.7 4.1
Bush GW I 1.0 1.8 2.8 3.8
Bush GW II 3.3 2.7 1.8 −0.3
Obama I −2.8 2.5 1.6 2.2
Obama II 1.5 2.4 2.4 Average 2.9 2.8 3.5 3.7
Source: Bureau of Economic Analysis, www.bea.gov
TABLE 9.1 Real growth rates by presidential terms.
126 Chapter 9 Fiscal Policy
An odd coincidence happened on the way to the grave
for discretionary fiscal policy. When the 2001 Bush tax
cut passed in May of that year, it was not known then that
we were already in a recession. In addition, instead of
implementing the tax cut prospectively, it was made ret-
roactive to the beginning of the year, and instead of hav-
ing taxpayers wait until they filed their tax forms in 2002
to claim their money, rebate checks were sent out in an-
ticipation of those cuts. These checks started arriving in
August and September of that year and were nearly fully
dispersed when the terrorist attacks of September 11 oc-
curred. Together with a series of interest rate cuts, these
tax cuts had the fortunate coincidence of stimulating the
economy at precisely the time the stimulus was needed.
When the economy had not picked up much steam
through early 2003, President Bush proposed another
tax cut. What he proposed was not at all what passed,
but what did pass was remarkably similar to what had
passed in 2001. Again, rebate checks began arriving in
taxpayers’ mailboxes in late summer 2003.
The Obama Stimulus Plan
The clearest sign that discretionary fiscal policy was back
as a policy tool under active consideration came with the
election of Barack Obama as president of the United
States. Prior to that, it had been more than 30 years since
policy makers actively sought to increase aggregate de-
mand through increases in government spending rather
than through tax rebates.
As shown in Table 9.2, the plan itself had four basic
elements. The first was to shore up the state-run un-
employment, welfare, and Medicaid systems. Though
the money had to be appropriated through an act of
Congress, this is best labeled as nondiscretionary fiscal
policy as it is a regular part of the federal government’s
response to economic difficulty. The second element in
the plan is not as readily categorized because though it
was “discretionary” in that the federal government could
have chosen to let states ride out the recession on their
own, it was intended to allow states to make it through
the 2009 and 2010 fiscal years without having to cut
budgets and raise taxes. In essence, this portion was
designed to allow states—that often are constitution-
ally prevented from borrowing—to engage in their own
form of nondiscretionary fiscal policy. The remainder
was clearly discretionary as it was motivated by a desire
to speed a recovery rather than to simply mitigate the
impact of it. It remains to be seen whether the stimulus
package passed in 2009 was too large, too small, solved
the problem, or created other problems. It also remains
to be seen, after the 2010 political season when “stimu-
lus” became a dirty word to many across the political
spectrum, whether discretionary fiscal policy goes back
into the hole it was in between 1980 and 2000.
Stimulus Plan Element Amount in $ Millions
Nondiscretionary $135,832
fiscal policy: Unemployment,
welfare, Medicaid
Aid to states 53,600
Discretionary fiscal policy: 301,135
Tax cuts
Discretionary fiscal policy: 300,047
Spending increases
Source: www.recovery.gov/Transparency/fundingoverview/Pages/fundingbreakdown.aspx
TABLE 9.2 The Obama stimulus plan as originally enacted.
The question of whether the Obama stimulus package worked or
not depends entirely on what you assume the counterfactual to be.
Recall that a “counterfactual” to a policy is a story associated with
what the result would have most likely been had there been no
change in policy. Had there been no stimulus package of any kind,
had there been no assistance to states to cover higher unemploy-
ment and Medicaid claims, had there been no extension of Bush-
era tax rates, had there been no “Making Work Pay” credit, had
there been no money for shovel-ready projects, Cash-for-Clunkers,
or for alternative energy development, what would have been
the result? The judged effectiveness of the stimulus package as a
whole, therefore, depends on how you create the counterfactual.
There are, generally speaking, two branches of counterfactu-
als: Keynesian ones and Ricardian equivalence ones. Keynesian
counterfactuals assume that the $787 billion stimulus was all new
money being spent and was not displacing any money that would
D I D T H E O B A M A S T I M U L U S W O R K ?
The Obama Stimulus Plan 127
have been spent elsewhere, by someone, even perhaps by another
level of government. Ricardian equivalence counterfactuals assume
that people foresee that current and temporary increases in the defi-
cit will ultimately necessitate future tax increases or spending cuts
to pay for it, or that federal grants received by states are offset by
reductions in what states would have otherwise borrowed. In this
way, currently higher deficits and the private and other level govern-
ment reactions to those deficits completely wipe out any effect of
the policy.
For instance, if you assume that people only bought the cars
they did because of the Cash-for-Clunkers program so that all
spending on those cars, including the subsidy, was induced by
the program, you would, by the evidence, be wrong. In fact, most
of the cars purchased during that period were by people who
happened to be in the market for a new car anyway and had a
“clunker” to trade in. Similarly, if you assume that states would
have chosen not to borrow money to provide for Medicaid cover-
age for those people who were forced on to the program because
of their lost jobs, you would count the extra money provided to the
states for that purpose by the federal government as extra money
that was spent that wouldn’t have been. That is probably wrong in
some states and correct in others.
However, sometimes the money spent as part of the stimulus
was clearly new money that resulted from the stimulus. Even the
most strident anti-stimulus economists acknowledge that unem-
ployment benefits were extended and made more generous using
federal money and that money was available only through the stimu-
lus. The fact that almost all that money was spent by relatively poor
recipients has a stimulatory impact. Some economists would still
quibble with this as stimulus because they would argue that those
who were unemployed and receiving long-term benefits were less
likely to accept the reality of lesser jobs at lower wages and that
the benefits merely extended their ability to convince or even de-
lude themselves that their old jobs would reappear at their old wage
levels.
The stimulus plan’s supporters point to the relatively short
period of economic distress in the United States relative to ongo-
ing challenges in Europe where there was relatively little appe-
tite for stimulus. They argue that the United States emerged from
the Great Recession to rates of growth that were, while slow,
generally more brisk than were European nations’. Detractors
simply point to the very slow recovery in real GDP and very slow
drop in unemployment in the United States. They point to invest-
ments in companies that ultimately went bankrupt or to shovel-
ready projects that had little infrastructure-enhancing purpose.
They point to large decreases in the percentage of the population
working or seeking work, the primary driver for reduced rates of
unemployment.
There is no consensus on this topic. Noble Prize winners are
on both sides of the debate. If the measure to be used to judge
its overall effectiveness is the median estimate of its ultimate im-
pact, then the impact was modestly effective. Several economists
have prepared estimates of the impact of the stimulus. A simple
summary of the studies done on the topic is included below.
Given that the term stimulus became a political “dirty word”
shortly after the package’s passage, it appears that academic
economists have a greater appetite for discretionary fiscal policy
than does the public.
Study Authors Conclusions
“Did the Stimulus Stimulate? Real Time Estimates of the
Effects of the American Recovery and Reinvestment Act”
James Feyrer, Bruce Sacerdote Significantly positive
“Does State Fiscal Relief during Recessions Increase Em-
ployment? Evidence from the American Recovery and
Reinvestment Act”
Gabriel Chodorow-Reich, Laura
Feiveson, Zachary Liscow,
and William Gui Woolston
Significantly positive
“Estimated Impact of the American Recovery and Rein-
vestment Act on Employment and Economic Output
from January 2011 through March 2011”
Benjamin Page
and Felix Reichling
Mostly Positive
“Targeted Transfers and the Fiscal Response to the Great
Recession”
Hyunseung Oh and Ricardo
Reis
Mildly Positive
“The American Recovery and Reinvestment Act: Public
Sector Jobs Saved, Private Sector Jobs Forestalled”
Timothy Conley and Bill Dupor No Impact
“An Empirical Analysis of the Revival of Fiscal
Activism in the 2000s”
John B. Taylor No Impact
A more detailed summary of these and other papers can be found at www.washingtonpost.com under the title “Did the Stimulus Work? A Review of the Nine Best
Studies on the Subject.” It was authored by Dylan Matthews.
128 Chapter 9 Fiscal Policy
AGGREGATE SUPPLY SHOCKSKick It Up a Notch
In both Figures 9.7 and 9.8 we start out with AS1 crossing
AD1 so that prices are at PI* and output is at RGDP*. A
hypothetical shock moves aggregate supply to AS2. If the
supply shock is negative and it raises input prices sub-
stantially, as in Figure 9.7, people will lose their jobs as
RGDP falls. Nondiscretionary fiscal policy will kick in at
this point, though, because the loss of jobs will mean an
increase in welfare spending and a decrease in taxes. This
will cause aggregate demand to shift to the right to AD2.
If the president and Congress then decide to go further
with discretionary fiscal policy in an effort to get out-
put back to RGDP*, they will have to cut taxes or raise
spending to do so. The problem is that the shock itself
and the nondiscretionary fiscal policy that was imple-
mented have already created high inflation. Discretion-
ary fiscal policy can only serve to worsen the problem.
On the other hand, if the supply shock is that input prices
have fallen, as depicted in Figure 9.8, output increases.
Nondiscretionary fiscal policy is such that taxes go up and
welfare spending goes down. When this happens, aggre-
gate demand falls to AD2. In this case there is no need for
discretionary fiscal policy because, even though there is
a shock, it is only for the good. Both the shock and the
nondiscretionary fiscal policy also serve to calm inflation.
PI
PI*
AD1
AD3
AS1AS2
AD2
NDFP
DFP
Shock
RGDPRGDP*
FIGURE 9.7 Nondiscretionary and discretionary fiscal policy in the wake of a negative aggregate supply shock.
FIGURE 9.8 Nondiscretionary fiscal policy in the wake of a positive aggregate supply shock.
PI
PI*
AD1
AS1
AS2
AD2
NDFP
Shock
RGDPRGDP*
Summary
You now understand the difference between discretion-
ary and nondiscretionary fiscal policy and know how to
model them using an aggregate supply and aggregate
demand diagram. You understand that different policies
are used to counteract aggregate demand and aggregate
supply shocks. You also now understand that though
there are considerable problems associated with discre-
tionary fiscal policy, it has seen a recent revival. Still,
nondiscretionary fiscal policy remains a mainstay of our
current macroeconomic system.
Key Terms
administrative lag
aggregate demand shock
aggregate supply shock
discretionary fiscal policy
fiscal policy
nondiscretionary fiscal policy
operational lag
political business cycle
recognition lag
shock
1. The existence of the federal income tax and the
welfare system serve as the primary elements of
a. discretionary fiscal policy.
b. nondiscretionary fiscal policy.
c. monetary policy.
d. exchange rate policy.
2. Adjustments to tax and spending policies serve as
primary elements of
a. discretionary fiscal policy.
b. nondiscretionary fiscal policy.
c. monetary policy.
d. exchange rate policy.
3. Discretionary fiscal policy is the purview of
a. Congress only.
b. the president only.
c. Congress and the president collectively
through law.
d. the Federal Reserve.
4. Nondiscretionary fiscal policy has its impact by
a. magnifying the economic ups and downs
already occurring.
b. purposefully adjusting interest rates.
c. congress focusing its constant attention.
d. dampening the economic ups and downs
already occurring.
5. The aggregate demand–aggregate supply model
examines the impact of discretionary fiscal policy
and nondiscretionary fiscal policy by focusing on
movements of
a. interest rates.
b. aggregate supply.
c. aggregate demand.
d. regulatory policies.
6. One typical response to a recession for those
interested in discretionary fiscal policy is to
a. raise taxes and cut spending.
b. lower taxes and cut spending.
c. raise taxes and increase spending.
d. lower taxes and increase spending.
7. One typical response to an overheated economy
for those interested in discretionary fiscal policy
is to
a. raise taxes and cut spending.
b. lower taxes and cut spending.
c. raise taxes and increase spending.
d. lower taxes and increase spending.
Quiz Yourself 8. Discretionary fiscal policy as a tool for making things better is
a. universally applauded as being helpful.
b. universally derided for never being effective.
c. considered by many to be effective but subject
to several concerns over timing and motive.
d. inconsistent with the aggregate demand–
aggregate supply model.
9. The oil price increases of 2002–2005 are an exam-
ple of a
a. positive aggregate demand shock.
b. negative aggregate demand shock.
c. positive aggregate supply shock.
d. negative aggregate supply shock.
Short Answer Questions
1. Which lag described in this chapter is the concept of
“shovel-ready” intended to combat.
2. Explain how the built-in economic stabilizers work
in the U.S. economy.
3. Assign the correct label to the corresponding events/
policy actions that occurred during the 2007–2011
time period.
Events/policy actions: TARP, the 2009 stimu-
lus package, the 2010 extension of the Bush tax
cuts, the reduction in taxes most Americans paid
because they had less income than they would
have had.
Label: discretionary fiscal policy, nondiscretionary
fiscal policy.
Think about This
Concerns over the recognition, administrative, and op-
erational lags as well as the concern that discretionary
fiscal policy is subject to political biases have caused
some economists to believe Congress and the president
should do nothing in the face of a recession. Even if they
are correct, is it realistic to expect the public to embrace
elected officials who do nothing?
Talk about This
The third and fourth years of presidential terms have
higher average rates of real growth than the first and
second years. Do you think this is a coincidence or is it
a reflection of political reality that politicians are more
concerned about reelection than about creating long-run
economic growth?
Summary 129
130 Chapter 9 Fiscal Policy
For More Insight See
Journal of Economic Perspectives 14, no. 3 (Summer
2000). See articles written by Alberto Alesina, John
B. Taylor, Alan Auerbach, and Daniel Feenberg, and
Douglas Elmendorf and Louise Sheiner.
Any textbook entitled Intermediate Macroeconomics
will have a chapter on fiscal policy.
Behind the Numbers
Gross domestic product.
U.S. Bureau of Economic Analysis; gross domestic
product; historical data—www.bea.gov
Early estimates of GD.
U.S. Bureau of Economic Analysis; news release—
www.bea.gov/newsreleases/rels.htm
C H A P T E R T E N
131
Monetary Policy Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the role of the Federal Reserve of the United
States.
LO2 Define macroeconomic stability as the Fed’s primary goal
while noting that controlling inflation has typically been the
means by which it has measured its success.
LO3 Integrate an understanding of the tools of monetary policy
with their application utilizing an aggregate supply–
aggregate demand model.
LO4 Describe the recent history of monetary policy and the
Federal Reserve’s role in the 2007–2009 recession.
Chapter Outline
Goals, Tools, and a Model of Monetary Policy
Central Bank Independence
Modern Monetary Policy
Summary
Throughout the 2007–2009 recession and beyond, the
role of the Federal Reserve—usually called the Fed—
in shaping the economy of the United States has grown
from mysterious yet important to absolutely central,
with politicians, the media, and, on some days, ordi-
nary Americans glued to its actions. No more impor-
tant aspect of our daily lives is run by people with as
little accountability as those who are its executive offi-
cers. The Federal Reserve began in 1913 as a response
to the boom and bust nature of the financial world of
the late 19th and early 20th centuries. It has become
a government institution every bit as important in the
lives of people as the three branches of government
we learn about in school. In a matter of a couple of
hours, one person, the chairman of the Federal Re-
serve Board, can influence stock prices by 5 percent,
cause mortgage interest rates to rise or fall by a full
percentage point, and set in place a course of action
that will raise or lower the unemployment rate by a
point or more. The chairman can do this, moreover,
without the approval of or even consultation with any
elected person. Fortunately, the chairmen appointed by
presidents and confirmed by the Senate have all been
people of impeccable character. Even if their wisdom
has been clouded at some points, a hint of corruption in
this area of government would be devastating to world
financial markets in particular and, by extension, to the
whole world economy.
We will use the context of the 2007–2009 reces-
sion, and the very slow recovery from it, to explore the
goals of monetary policy and then move to discuss the
tools the Federal Reserve has to meet those goals. We
will begin the discussion of those tools by first focus-
ing on the traditional and ordinary tools of monetary
policy and then discuss the extraordinary ones that
were first employed in 2008 as the Federal Reserve at-
tempted to stabilize first the financial markets and later
the overall economy. As we move through the chap-
ter, we will consider why the Fed exists and why its
independence from political winds is important. Next
we review some of the history of the pre-2008 use of
monetary policy and then move to an examination of
Fed policy during and after the 2007–2009 recession.
We conclude by describing the process by which the
Fed is likely to unwind those policies and return to its
traditional function.
132 Chapter 10 Monetary Policy
the late 1970s, targeting the federal funds rate proved to be
impossible. Keeping the rate down required a continuous
increase in the supply of money. As more money chased
limited goods, those increases created even greater infla-
tion. This caused interest rates to rise rather than fall. In
October 1979, as the rate of inflation continued to rise,
the Fed formally gave up on the federal funds rate as its
target and shifted to targeting M2. M2 is what is known as a monetary aggregate. M2 is a broader measure of money because it includes cash, checking accounts, sav-
ings accounts, and small certificates of deposit (CDs).
M1 includes only cash and checking accounts.1 By the summer of 1982, inflation had subsided just as M2 be-
came unstable and too difficult
to target. In response the Fed
reverted to targeting the federal
funds rate.
The European Central Bank
currently targets inflation rather
than a monetary aggregate or
interest rate. Inflation target- ing is relatively new as a con- cept and involves publishing
a desired range of a specified
inflationary measure and then
using the tools of monetary
policy to bring that measure of
inflation into that desired range.
Many argue that from the time
Benjamin Bernanke took over as
Fed chair in 2006 to the begin-
ning of the financial crisis in the
fall of 2007, the Fed engaged in
de facto inflation targeting. The
Fed made clear through its regu-
lar announcements that it was
closely monitoring the core PCE
deflator described in Chapter 6.
Whatever is targeted, the
mechanism by which the Fed
keeps day-to-day tabs on the target is open-market operations. Open-market operations result when the Fed buys and sells government debt. The Fed owns approxi-
mately half a trillion dollars of the national debt, and it
sells a portion of that reserve of bonds when it wants
to get money out of the system. It buys bonds when it
wants to add to the money that is in circulation.
Goals, Tools, and a Model of Monetary Policy
The Federal Reserve has never had a “tool” that would
directly impact the economy. Its goals have to be met
using an intermediate target with the hope and expecta-
tion that the end result of hitting the intermediate target
will be satisfaction of the ultimate goal. What follows
then is a description of the goals of monetary policy, the
tools of monetary policy that until 2008 were considered
adequate to the task of meeting those goals, and a model
that explains why the tools work under typical circum-
stances. We proceed to an explanation of why those tools
failed in 2008 and then to a discussion of the extraordi-
nary tools that the Federal Reserve, under Chairman Ben
Bernanke, created to deal with the 2007–2009 recession
and the tenuous recovery in 2010 and 2011.
Goals of Monetary Policy
The most important historical role for monetary policy
and its implementing institution, the Federal Reserve,
has been to prevent boom and bust cycles by regulat-
ing banks and other financial institutions. While the
role of dampening the boom and bust cycle remains an
important part of the job, the mechanism has changed
dramatically. At first the Fed simply ensured the finan-
cial soundness of institutions. Now it also directly ma-
nipulates interest rates to change the borrowing habits of
banks, businesses, and consumers. In this way it seeks to
maintain low levels of inflation and sustainable levels of
real GDP growth.
Traditional and Ordinary Tools of Monetary Policy
For the better part of the last 50 years, the Federal Re-
serve and other similar central banks around the world
have been conducting monetary policy by picking an
intermediate target variable and utilizing the basic tools
at their disposal to hit that target. If the target variable
was outside the desired range, the Fed used its tools to
nudge the variable back within the range. At times the
Fed has had to abandon its target because the policies
necessary to stay within the desired range had undesir-
able effects.
In the 1970s the target was
the federal funds rate—the rate at which banks borrow from one
another to meet reserve require-
ments. As inflation heated up in
federal funds rate The rate at which banks borrow from one another to meet reserve requirements.
M2 M1 + saving accounts + small CDs.
monetary aggregate A measure of the quan- tity of money in the economy.
M1 Cash + coin + checking accounts.
inflation targeting A policy whereby a central bank publishes a desired range of a specified inflationary measure and then uses the tools of monetary policy to bring that measure of inflation into that desired range.
open-market
operations The buying and sell- ing of bonds, which, respectively, increases or decreases the money supply, thereby influ- encing interest rates.
1In 2006 the Fed abandoned its use of M3 as a useful measure as it was
becoming unstable and therefore an unreliable measure.
Goals, Tools, and a Model of Monetary Policy 133
Banks can also borrow directly from the Fed rather
than borrowing from each other. Banks with sufficient
creditworthiness can borrow unlimited amounts from
the Fed at the primary credit
rate. The primary credit rate or discount rate is typically one percentage point higher than
the federal funds rate. Banks
with lesser credit ratings face
higher rates.2
The last way that the Federal
Reserve can impact interest rates
is by altering the proportion that
the bank can lend from the de-
posits it takes in. The reserve ratio, at 10 percent in 2011, requires that a specific per- centage of every dollar deposited be placed in a Federal
Reserve bank. If the ratio is lowered, the bank has more
money to lend, whereas if the ratio is raised, the bank has
less money to lend.
Modeling Monetary Policy
The way monetary policy is supposed to work is through
what is called the monetary transmission mechanism.
The Federal Reserve can use any of its tools to impact
the left panels of Figures 10.1 and 10.2. That is, through
an increase or decrease in the supply of loanable funds,
it can have a decisive impact on short-term interest rates.
The only real question is whether the causation arrow
that connects the left and right panels of these two dia-
grams is operating.
Let’s begin by showing that each of the Fed’s tools can
impact interest rates. If the Federal Reserve uses open
market operations to buy bonds, it increases the amount of
money that banks and other financial institutions can loan.
This increases the supply of loanable funds in Figure 10.1
and decreases the interest rate in this market. The Fed can
just as easily have an opposite desire and want to increase
interest rates. The left panel of Figure 10.2 shows what
happens when the Fed sells bonds in an effort to increase
interest rates. The increase in interest rates is accomplished
when the Fed reduces the supply of loanable funds.
2Prior to 2003 the Federal Reserve utilized another key interest rate to sig-
nal its intentions, the discount rate. This was the interest rate at which the
Fed itself loaned money to banks, usually buying a portion of a bank’s loan
portfolio. The discount rate was below the federal funds rate, but banks were
reticent to use this service too often because it brought with it the potential
for extra scrutiny from auditors.
FIGURE 10.1 Expansionary monetary policy: buying bonds, lowering the discount rate, or lowering the reserve ratio.
RGDPLoanable funds
r
S
Sʹ
D
rʹ
Price level AS
AD1
AD2
Interest rates
One of the lessons that economists routinely teach students in
courses designed for economics and business majors is the notion
of “money creation.” The banking system can create more “money”
than physically exists in the form of coin and cash. This was implied
in our definitions of the monetary aggregates (M1, M2, etc.) because
if money were only currency, then there would be no need to add
checkable accounts and CDs.
The banking system creates money by a series of loans. To
see how, let’s assume that there are several people (John, Paul,
George, Ringo, Simon, Randy, and Paula) and several banks
(1st National, 2nd National, 3rd National, and 4th National [the
Midwest is home to an actual bank called “Fifth-Third”]). Suppose
John makes a $1,000 deposit at 1st National, and that bank loans
Paul $900 (10 percent, or $100, must be held as part of the re-
quired reserve). Suppose Paul buys something from George, who
deposits that $900 at 2nd National. Then suppose that Ringo
borrows $810 (again 10 percent, or $90, must be held at the Fed)
from 2nd National to buy something from Simon, who deposits
that money in 3rd National. If Randy borrows $729 (10 percent,
or $81, must be held at the Fed) from 3rd National to buy some-
thing from Paula and Paula deposits that money in 4th National
and . . . You get the point—this could go on forever. In the end
there are deposits totaling $10,000 ($1,000 + $900 + $810 +
$729 + . . .) that resulted from that initial $1,000.
M O N E Y C R E A T I O N
primary credit rate or
discount rate The rate at which banks with excellent credit can borrow from the Federal Reserve.
reserve ratio The percentage of every dollar deposited in a checking account that a bank must maintain at a Federal Reserve branch.
134 Chapter 10 Monetary Policy
rise as a result of increases in investment and interest-
sensitive consumption. This is shown in the right panel
of Fig ure 10.1. An identical but opposite story can be
told concerning a tightening of the money supply. Less
is available for banks to lend, a circumstance that allows
them to raise the interest rates they charge to ordinary
borrowers. Raising such rates causes a reduction in in-
vestment and interest-sensitive consumption. This in
turn causes aggregate demand to fall, as is shown in the
right panel of Figure 10.2.
The Monetary Transmission Mechanism
Now we get to the question of whether changing
short-term interest rates impacts the overall econ-
omy in the desired fashion. That is, does the change
in the left panel of Figure 10.1 cause the change in
the right panel of Figure 10.1, and does the same
work for Figure 10.2? The
process by which the use of a
monetary policy tool impacts
the overall economy is called
the monetary transmission mechanism.
Economists disagree about the effectiveness of mon-
etary policy, especially its effectiveness in the long run
and in circumstances of extreme economic uncertainty.
Let’s take the first of these two concerns. Whereas there
is some doubt among economists about whether the Fed
has the ability to alter short-term economic outcomes
in normal economic circumstances, the doubt is much
more widely held concerning its long-term ability to in-
crease output through sustained increases in the money
supply. The underlying reason for the skepticism is that
sustained increases in the money supply will be factored
in by investors, who will anticipate that substantial infla-
tion will result from such a policy. Thus, though it may
look as if the Fed could use the logic from Figure 10.1
to continuously foster long-run rapid growth, not many
economists believe the Fed has this power. As a result,
Figures 10.1 and 10.2 should be taken as relevant only
in the short term.
The reason conventional monetary policy is less
effective in times of extreme economic uncertainty
than Figures 10.1 and 10.2 suggest is that borrowers’
confidence is so shaken by actual unemployment, the
threat of unemployment, or slack demand that any small
modifications to borrowing costs are trivial compared to
these underlying problems. This was certainly the case
during the Great Depression, but you don’t have to go
back that far for a clear example of what economists call
Because the federal funds rate is determined by mar-
ket forces between banks and is not determined directly
by the Fed, the way the Fed can influence that rate is by
increasing or decreasing the supply of generally available
funds for loans. Its rationale is that this action will indi-
rectly influence the federal funds rate. There is enough
linkage between the quantity of money that is generally
available for loans and the interest rate that banks charge
each other so that this seems to work fairly well.
As we noted, the Federal Reserve can impact interest
rates by changing the reserve ratio. If the ratio is lowered,
the bank has more money to lend and the supply of loan-
able funds moves to the right, as it does in the left panel of
Figure 10.1. If the ratio is raised, the bank has less money
to lend and the supply of loanable funds moves to the left,
as is indicated in the left panel of Figure 10.2.
As you saw in Chapter 8, one of the determinants of ag-
gregate demand is interest rates. The influence of interest
rates stems from the fact that investors want to borrow
more to buy plant and equipment when interest rates are
lower. In addition, consumers are more willing to buy
expensive durable goods like cars and home furnishings
when interest rates are lower. For the person who pays
cash, the lower interest rate effect is indirect in that buyers
sacrifice less interest income when they take money out of
savings to buy something. The person who buys a car and
gets a shiny new payment book with the shiny new car is
more likely to buy that car and more likely to buy a nicer,
more expensive car because of the lower interest rate.
A loosening of the money supply or a lowering of the
federal funds or discount rate allows banks to make more
loans. These are loans that they can make only if they
lower interest rates to ordinary borrowers. The lowering
of interest rates causes the aggregate demand curve to
FIGURE 10.2 Contractionary monetary policy: selling bonds, raising the discount rate, or raising the reserve ratio.
RGDPLoanable funds
rʹ
S
Sʹ
D
r
Price level AS
AD1
AD2
Interest rates
monetary transmission The process by which the use of a monetary policy tool impacts the overall economy.
Goals, Tools, and a Model of Monetary Policy 135
Reserve paid a modest interest rate on these deposits, the
risk-adjusted profits the banks could earn by depositing
their excess reserves with the Federal Reserve were suf-
ficient to have them do that rather than loaning it to busi-
nesses and consumers.
The Additional Tools of Monetary Policy Created in 2008
The Federal Reserve recognized before many the poten-
tial severity of the 2008 financial crisis, and well before
it became evident to others, the Fed began contemplating
other tools it might use to fight a global slowdown. First,
it created a new discount window for investment banks,
and second, it began buying corporate paper, effectively
lending money directly to nonbank corporations. Finally,
it contemplated buying longer-term debt such as 30-year
treasuries and mortgage-backed securities from banks and
other institutions in a frantic attempt to lower long-term
interest rates and halt the slide of the housing market.
Investment banks were a creation of post–Great
Depression policies that sought to separate commer-
cial banks, which took deposits and made loans from
those deposits, from investment banks, which simply
served as intermediaries to large financial transac-
tions. These investment banks were capitalized with
their own equity and their own borrowing and did not
take deposits. The discount window that was created
for investment banks allowed these entities to borrow
money from the Fed in much the same way that com-
mercial banks do through the discount rate or primary
credit rate facility. The effort was for naught as the fi-
nancial crisis of 2008 sent one, Lehman Brothers, into
liquidation and threatened the health of the remaining
two, Morgan Stanley and Goldman Sachs. In the end,
the Federal Reserve needed both entities to become
commercial banks so that they could assist the Fed in
saving other commercial banks.
a liquidity trap. A liquidity trap exists when even zero or near
zero interest rates do not stimu-
late borrowing.
With a global economic slow-
down under way in 2008 and 2009, firms had more than
adequate capital to produce the significantly reduced
volume of goods and services consumers were ready to
purchase. As a result, the reduction in interest rates that
might have motivated them to borrow money to buy new
capital in 2006 and 2007 did not motivate them in the
slightest. Furthermore, consumers who might have been
persuaded to borrow money to buy cars, homes, or home
furnishings were more concerned about the likelihood
that they would keep their jobs. Moreover, the bursting
of the housing bubble, which reduced home prices by an
average of more than 20 percent, gave many pause when
it came to taking on more debt.
The supply side of the liquidity trap can be demon-
strated with the help of the data on required and excess
reserves of banks (see Figure 10.3). As previously de-
scribed, large banks are compelled to hold 10 percent
of their deposits in the form of required reserves at the
Federal Reserve. They can loan the other 90 percent as
they see fit. During normal economic times, that is ex-
actly what they do. With the quite obvious and notable
exception of September of 2001, bank reserves were what
were required. Upward of 95 percent of their reserves
were required while the remainder were simply viewed
as a cushion against unusual daily activity. The excess
reserves were loaned overnight in the federal funds mar-
ket. In late 2008, as the financial crisis hit in full force,
the proportion of reserves that were considered “excess”
went from 5 percent of the total to 90 percent of the total,
and this occurred over a short three-month window. That
these proportions did not revert to normal through mid-
2013 suggests that, at least from the banks’ perspective,
the liquidity trap was in full effect. Because the Federal
liquidity trap A situation where zero or near zero interest rates do not stimulate borrowing.
Imagine a world without money. While you may think that would
be utopian, it would actually be a pain in the neck. Money allows
us to exchange the goods or services we have to offer so that we
may get the goods or services we want. Without it we would have
to barter. Money allows us to avoid this by serving as a medium
of exchange.
Money also holds its value. Suppose the good you had to offer
was subject to spoilage. If you could not find someone who had a
good you wanted and wanted what you had to offer within a short
period of time, your good would be worthless. With money you can
sell your goods and hold on to the cash until such time that you find
the goods you want to buy.
T H E R O L E O F M O N E Y
136 Chapter 10 Monetary Policy
FIGURE 10.3 Proportion of bank reserves held by banks that are required and excess.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm
100
80
70
60
50
40
30
20
10
0
90
Required reserves Excess reserves
2 0
0 0
-0 1
2 0
0 0
-0 5
2 0
0 0
-0 9
2 0
0 1-
0 1
2 0
0 1-
0 5
2 0
0 1-
0 9
2 0
0 2
-0 5
2 0
0 2
-0 9
2 0
0 2
-0 1
2 0
0 3
-0 5
2 0
0 3
-0 9
2 0
0 3
-0 1
2 0
0 4
-0 5
2 0
0 4
-0 9
2 0
0 4
-0 1
2 0
0 5
-0 5
2 0
0 5
-0 9
2 0
0 5
-0 1
2 0
0 6
-0 5
2 0
0 6
-0 9
2 0
0 6
-0 1
2 0
0 7 -0
5 2
0 0
7 -0
9
2 0
0 7
-0 1
2 0
0 8
-0 5
2 0
0 8
-0 9
2 0
0 8
-0 1
2 0
0 9
-0 5
2 0
0 9
-0 9
2 0
0 9
-0 1
2 0
10 -0
5 2
0 10
-0 9
2 0
10 -0
1
2 0
11 -0
5 2
0 11
-0 9
2 0
11 -0
1
2 0
12 -0
5 2
0 12
-0 9
2 0
12 -0
1
2 0
13 -0
5 2
0 13
-0 9
2 0
13 -0
1
2 0
14 -0
5 2
0 14
-0 9
2 0
14 -0
1
2 0
15 -0
5 2
0 15
-0 9
2 0
15 -0
1
Additionally, the Fed began buying corporate paper
when even well-capitalized and well-run corporations
were having difficulty finding buyers for their short-term
debt. Corporate paper is the name given to short-term debt offered by large corpora-
tions. These corporations rou-
tinely borrow billions of dollars
for inventory- building purposes
or to deal with uneven sales knowing that they will eas-
ily be able to pay off the debt with the proceeds of future
sales. Without this market, many corporations could not
operate. Because the financial system was not working
properly in the fall of 2008, the Fed stepped in to make
these loans possible.
At times during this 2008–
2013 period, the Federal Re-
serve began buying long-term
debt in a process called quan- titative easing. This process referred to making much more
money available to the economy
through the purchase of 20- and
30-year U.S. treasuries and
mortgage-backed securities. A
mortgage-backed security is a financial asset that is the aggre-
gation of mortgages where the
holder of the security is paid
from the combined mortgage
payments of homeowners. This
was done to directly impact long-term interest rates to
stimulate business investment and to re-ignite the hous-
ing market.
For perspective on the relative importance of the
traditional tools and the new tools of monetary policy,
consider Figure 10.4. The traditional security hold-
ings of short-term treasuries, the result of open-market
operations and the lending to financial institutions
via the discount window, constituted the entirety of
the $860 billion Federal Reserve holdings. In very
late 2008, the Federal Reserve began its still tradi-
tional loaning of large amounts to financial institu-
tions, but when that was insufficient to prevent the
panic in the financial markets, it followed up only a
corporate paper Short-term debt offered by large corporations.
quantitative easing The process by which the Federal Reserve buys long-term securi- ties in order to decrease long-term interest rates to directly stimulate business investment and housing markets.
mortgage-backed
security Financial asset that is the aggregation of mortgages where the holder of the security is paid from the combined mortgage payments of homeowners.
Central Bank Independence 137
FIGURE 10.4 Federal Reserve holdings 2007–2015.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm F
e d
e ra
l R
e s e
rv e
h o
ld in
g s ( m
il li o
n s o
f d
o ll a
rs )
35,00,000
45,00,000
40,00,000
50,00,000
30,00,000
25,00,000
20,00,000
15,00,000
10,00,000
500,000
0
Liquidity to key credit markets
Federal agency debt mortgage-backed securities purchases
Lending to financial institutions
Traditional security holdings Long-term treasury purchases
1/ 3/
20 07
1/ 3/
20 08
1/ 3/
20 09
1/ 3/
20 10
1/ 3/
20 11
1/ 3/
20 12
1/ 3/
20 13
1/ 3/
20 14
1/ 3/
20 15
matter of weeks later with nontraditional purchases of
short-term commercial paper. Beginning in 2009, the
Federal Reserve tried to overcome the liquidity trap by
embracing the nontraditional tools fully. From early
2009 through 2013, it was buying both long-term trea-
suries and mortgage-back securities in such volume
that by March 2013, the total Federal Reserve hold-
ings had nearly tripled. In order to avoid the percep-
tion that this was simply flooding credit markets with
cheap money, “operation twist” was employed during
2011 and 2012 in which the Federal Reserve sold tra-
ditional short-term securities while using the proceeds
to purchase long-term treasuries. This can be seen
clearly in that the bottom two portions of Figure 10.4
total roughly the same amount ($1.6 trillion) from mid-
2011 through all of 2012 while the total holdings held
steady at $2.75 trillion. The pause was broken in late
2012 when the Fed restarted the purchase of mortgage-
backed securities in order to keep the economy from
sliding back into recession.
Central Bank Independence
The Fed’s power over the economy is substantial because
it can do what it thinks is best without fear of being con-
tradicted. Its independence from political control gives it
awesome power and awesome responsibility to use that
power judiciously. The Fed is so independent that it can
slow growth or even put the nation into a recession in an
effort to stamp out inflation. Economists generally agree
that the Fed must be free from political control in order
to take the necessary action to fight inflation. Experience
across nations in the latter half of the 20th century pro-
vides rather powerful evidence that this is true.
Long-run economic growth requires that the financial
markets have faith that money invested in a country will
not lose value as a result of excessive inflation. When
people are concerned about inflation, interest rates in-
crease. Higher interest rates make investments more ex-
pensive. Since growth occurs only when investments in
the future take place, long-term growth depends on the
138 Chapter 10 Monetary Policy
individual private bank. With its authorizing of the printing
of money during and after the Civil War, prices fluctuated
so fast that three significant financial panics in the span of
60 years convinced Congress to create the Federal Reserve.
If Congress became sufficiently motivated, it could return
to the business of controlling the supply of money and, indi-
rectly, interest rates. Under ordinary circumstances, the con-
tinuous consultations between Federal Reserve Chairman
Bernanke, Treasury Secretary Paulson, and then New York
Federal Reserve Bank Chairman and Obama Treasury Sec-
retary designate Geithner that occurred in the fall of 2008
would have raised concerns about the degree to which this
independence might have been compromised. Clearly, the
circumstances were anything but ordinary at the time.
Modern Monetary Policy
The Last 30 Years
The history of monetary policy in the second half of the
20th century is one of increasing importance and self-
confidence, and its effect on interest rates can be seen
in Figure 10.5. In the late 1970s the Fed attempted to
existence of a believable monetary authority. Monetary
authority, by the way, is the general name for institutions
like the Federal Reserve. While a politically controlled
monetary authority could generate that faith if it never
wavered from potentially unpopular policies, experi-
ence tells us this does not happen. We know this because
those countries with a history of independent monetary
authorities have experienced lower inflation rates, lower
interest rates, and higher real growth rates than countries
without that history of independence. The United States,
Germany, Switzerland, Japan, Canada, and the Nether-
lands are examples of countries with such independence,
whereas Spain and Italy are examples of countries with-
out it. For the stability we enjoy, we are willing to accept
the risk of having an independent monetary authority.
It is worth a small historical interlude to note that
Congress could, by simply passing a law, regain complete
control over the Federal Reserve. Article I, Section 8, of the
U.S. Constitution gives the Congress control over the power
to coin money. It never took the role of monetary policy very
seriously, however; and before the Civil War paper money
was usually a banknote, typically backed by gold, of an
FIGURE 10.5 Key interest rates from 1955 to 2015.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm
18
16
14
12
10
In te
re s t
ra te
8
6
4
Year
2
0
Fed funds 1-year 10-year 20-year 30-year
19 55
19 59
19 63
19 67
19 71
19 75
19 79
19 83
19 87
19 91
19 95
19 99
20 03
20 07
20 11
20 15
Modern Monetary Policy 139
combat the oil-price shocks and a stagnating economy
with increases in the money supply. Unfortunately, these
efforts served only to add to inflation. In 1981 the Fed
changed course with a high-stakes war on inflation. It
sent interest rates soaring. Its grip on M2 was such that
the federal funds rate went to nearly 20 percent while the
discount rate went to 13 percent. By most measures the
resulting recession of 1981–1982 was the worst in post–
World War II history. The unemployment rate peaked
higher, real GDP fell more, and the reduction in inflation
was greater than in any of the other post-1946 recessions.
It also had the distinction of being the only recession
caused intentionally by the Fed.
Since that time the Fed has had a little better luck
and has learned from its mistakes. For one thing, since
the recession of 1982 it has not had to fight a signifi-
cant inflation battle. In part this has been because it
has been vigilant about not contributing to inflation.
After 1984 the highest inflation rate has been 5 per-
cent. Not having to wring out double-digit inflation but
only having to keep it under control has made the Fed’s
job a little easier. In 1988, 1995, and again in 1999 and
2000, the Fed preemptively kept inflation in check by
quickly increasing interest rates to slow an economy on
the verge of creating inflation. It also worked to pre-
vent a recession in 1994 by quickly pushing interest
rates down.
Its response to the 1990 recession was slow, but it was
probably forgivably slow. In the months leading up to
Iraq’s invasion of Kuwait, real GDP growth was slow,
inflation was picking up, and consumer indebtedness
was starting to peak. On top of that, the Fed was deter-
mined to wait for the outcome of a budget deal. At the
time, the federal deficit was more than $250 billion, it
was headed toward $400 billion, and the Fed wanted to
hold President Bush’s (George Herbert Walker) and the
Democratic leadership in Congress’s collective feet to
the fire and force them to act.
Unfortunately, Saddam Hussein’s Iraq did not wait
for the completion of the budget deal. After the invasion
of Kuwait, gasoline prices increased sharply, and these
circumstances precipitated an equally sharp decline in
consumer confidence. Had the Fed acted immediately, it
might have had better success keeping the United States
out of the 1990–1991 recession, but its focus was on
the deficit. It was also wary of duplicating the mistakes
of the late 1970s by trying to battle cost-push inflation
(inflation caused by movements in aggregate supply to
the left) with increases in the money supply.
Whether explicitly or by chance, the Fed simply let
the recession happen. It appeared to decide that there
was little it could or should do to prevent it. Fortu-
nately, however, the 1990–1991 recession was one of
the shortest and the least disruptive recessions on re-
cord. Inflation never became a significant problem in
part because consumer credit card debt was so high.
Thus, except for a short spike in gas prices, inflation
was negligible during this period. Unemployment rose
but it came nowhere near 1982’s modern record of 11
percent. During the first 18 months of the recovery,
from June 1992 through the end of 1993, the econ-
omy was so weak, however, that it was unclear at the
time whether it was a recovery or just an extension of
the recession. In 1992 and 1993 the Fed stepped in
with a significant reduction in interest rates, and by
the last quarter of 1994 the economy was humming
along nicely.
From 1994 on, the Fed kept a vigilant eye on inflation.
Where necessary, as in 1995, the Fed let its guard down
enough to prevent a slowdown from becoming a reces-
sion. By 1998 Fed governors were feeling rather proud
of themselves. Unemployment was at a 30-year low, in-
flation was nowhere in sight, and longtime Fed chairman
Alan Greenspan had successfully kept the stock market
in check by offering advice against “irrational exuber-
ance.” In 1998 the economy was doing fine. It was in no
need of increases or decreases in interest rates. Then the
Asian financial crisis hit.
The Asian financial crisis resulted from a series of
bad loans made in the Pacific Rim nations of Thailand,
Malaysia, South Korea, and Indonesia, and from failed
attempts by these countries to hold their foreign ex-
change rates constant.
The Fed’s response to the crisis was guarded at first.
It wanted to prevent the crisis from spreading but did not
want its action to have the effect of importing the crisis
to the United States. Stock prices in the United States
did fall 20 percent in three months, and many econo-
mists began to predict that a recession would occur in
the United States within a year. The Fed lowered inter-
est rates a full percentage point, enough of an action to
increase U.S. demand for imported goods. This helped to
stabilize Asia. In turn, the dollar got so strong relative to
Asian currencies that the relative price of imports pur-
chased by Americans fell enough to offset any domestic
price increases.
The recession of 2001 served as another example of
monetary policy, its uses and its limitations. Beginning
140 Chapter 10 Monetary Policy
2002 and picked up considerable steam through 2003
and 2004. In response, the Fed raised interest rates to
more normal historical levels in 10 steps through mid-
2005. As mentioned repeatedly through this chapter,
the Federal Reserve’s response to the financial crisis
of 2008 was swift, if not entirely effective. It lowered
short-term interest rates to nearly zero in an attempt
to forestall, or at least dampen, the impact of the
recession.
Economists will debate whether these interest rate
changes had the desired impact, but consider this: Be-
tween June 2003 and June 2004, and again in 2008
and 2009, the Fed was pretty much out of bullets. The
Fed can’t make businesses borrow money to invest in
new plant and equipment and can’t make consumers
borrow to buy expensive consumer durables. Once the
interest rate has been driven to nearly zero, these deci-
sions to borrow money are determined by the confi-
dence that the borrower has in his or her ability to pay
the money back.
Also worth noting was the Federal Reserve’s dif-
ficulty in “talking down” skyrocketing home prices
and questionable home lending practices in 2005. Fed
increases in short-term interest rates during 2005 had
little impact on mortgage rates, which remained low
during that year.
with the ambiguous nature of the 2000 presidential elec-
tion, the recession of 2001 was met with 12 separate
cuts in interest rates by the Federal Reserve. By 2003
the federal funds rate was at its lowest level in more than
40 years. For a time, in the spring of 2003, 30-year fixed
mortgage interest rates were below 5 percent for the first
time ever.
As can be seen from Figure 10.6, the crowning pe-
riod of this aggressive monetary policy was between
1999 and 2006. The Federal Reserve Board’s Open-
Market Committee aggressively moved their federal
funds rate target to combat economic circumstances.
In mid-1999 the Fed aggressively raised interest rates
six separate times to combat what Greenspan termed
the “irrational exuberance” of the stock markets. These
actions had little impact themselves in stemming the
overheated stock market. The tech-stock bubble burst
on its own in 2000, prompting the Fed to begin to
lower interest rates.
The Fed was in the process of easing credit condi-
tions in 2001 when the attacks of September 11, 2001,
occurred. When stock markets opened the following
Monday, it was with a Federal Reserve announcement
that it was aggressively moving interest rates lower.
With 13 rate cuts in a period of two-and-one-half
years, the sluggish economy slowly rebounded through
In the late 1980s and through the decade of the 1990s, criticism
started to be heard from the left and right that the Fed was overly
concerned about the reappearance of inflation and not sufficiently
concerned about the average person. Whether it has admitted it
in public or not, since the late 1970s and early 1980s the Fed had
considered inflation public enemy number one. This had been true
whether inflation was really a problem, as it was in 1979 and 1980;
had the possibility of being a problem, as in 1988, 1995, and 1999–
2000; or was just a theoretical threat on the distant horizon.
Only when the country or the world was in trouble and inflation
was less than 3 percent, as in the United States in 1993 and 2001
and the world in 1994, has the Federal Reserve relaxed its vigilance
against inflation. In being focused on inflation it has cut recoveries
short or starved them of sufficient cash to really get going.
In late 2002–early 2003, and again in late 2008 and 2009,
a new public enemy number one had begun to come into view:
deflation. Recall from Chapter 6 that deflation is the opposite
of inflation but is no less of a concern. Deflation has the ef-
fect of encouraging people not to buy now. This is because they
know that if they wait, they will save money. This can be self-
perpetuating in that by not buying, consumers force businesses to
cut prices. This causes profits to fall and layoffs to occur, and buy-
ing diminishes even further. Even moderate deflation is worse than
inflation in this regard. The Japanese experience with deflation in
the late 1980s and 1990s offered very slow growth and stagnant
employment. The Fed understood this potential quite well in 2003
when it again began to consider further interest rate cuts. It also
understood this well when it drove short-term interest rates to zero
in the fall of 2008. We will not know for some time whether it real-
ized the threat too late. The deflation of 2008 was confined mostly
to housing (20 percent), energy (60 percent), and to some producer
commodities such as corn (40 percent), soybeans (40 percent), and
raw metal prices (20 percent to 50 percent). Core PCE did not de-
crease during the period.
P U B L I C E N E M Y # 1 : I N F L A T I O N O R D E F L A T I O N ?
Modern Monetary Policy 141
FIGURE 10.6 Aggressive monetary policy between 1999 and 2015.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/fomc/fundsrate.htm
7
6
5
4
R a
te
3
2
1
0
Se p-
99
Se p-
98
M ar
-9 9
M ar
-0 0
M ar
-0 1
M ar
-0 2
M ar
-0 3
Se p-
00
Se p-
01
Se p-
02
M ar
-0 4
Se p-
03
M ar
-0 5
Se p-
04
M ar
-0 6
Se p-
05
M ar
-0 7
Se p-
06
M ar
-0 8
Se p-
07
M ar
-0 9
Se p-
08
M ar
-1 0
Se p-
09
M ar
-1 1
Se p-
10
M ar
-1 2
Se p-
11
M ar
-1 3
Se p-
12
M ar
-1 4
Se p-
13
M ar
-1 5
Se p-
14
Se p-
15
FIGURE 10.7 Selected yield curves on federal funds and U.S. debt.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/econresdata/statisticsdata.htm
In te
re s t
ra te
18
16
14
12
10
8
6
4
2
0
Maturity
1-yearFed funds 10-year
19931981 2000 2002
20-year 30-year
Though Figure 10.5 makes it look like short- and long-
term interest rates move in lockstep, they do not. Though
they typically move together, it’s useful to remember
Chapter 7’s definition of the yield curve. Figure 10.7
notes yield curves from different periods of recent his-
tory. What appears is that at times the yield curve is up-
ward sloping (the usual case), while at other times it is
flat, and at still other times it is downward sloping.
142 Chapter 10 Monetary Policy
At no time in world history have central banks engaged in such sus-
tained efforts to keep interest rates so low for so long. As can be
seen in Figure 10.8, the U.S. Federal Reserve was hardly alone in
its massive purchases of financial assets. Both the Federal Reserve
and the Bank of England quintupled the size of their respective port-
folios. The European Central Bank started along the path the Fed
was on and abandoned the effort at the same time the Fed doubled-
down. The Bank of Japan, late to the show, tripled its holdings in the
span of three years.
In the case of the U.S. Federal Reserve, it purchased nearly
$2 trillion in mortgage-backed securities and nearly $2 trillion in
long-term treasuries in three separate stages. The result is that
$3.7 trillion is now in the economy with most of it in bank reserves
(typically held at the Fed as excess reserves) and in the hands of
investors. In late 2014 the Fed stopped pushing new money into the
system and in late 2015 it began the long process of pulling it out.
The toe in the water was the December increase in the targeted Fed
Funds rate. Recalling Figure 10.3, because nearly every bank has its
own high level of excess reserves, few have any need to borrow in
that market so the impact is likely muted.
Still, the real work of removing that money has to be done even-
tually, and it appears that the way it will be done is simply through
the process of lettering the instruments that were purchased ma-
ture. When the mortgages that make up a mortgage-backed secu-
rity mature, the Fed can simply not use the money to purchase a
replacement security. When the long-term treasuries reach maturity,
the same thing can occur. That could be a two-decade process. In
the interim it can alter the interest rate that it pays on deposits that
banks make at the Federal Reserve. By increasing the rate paid to
banks on excess reserves, it can constrain commercial and con-
sumer loans, and by decreasing the rate paid to banks on those ex-
cess reserves, it can do the opposite.
W A S T H E U N I T E D S T A T E S A L O N E I N T H I S ? C A N I T B E U N D O N E ?
600
500
400
300
200
100
0
Euro zone Bank of Japan Bank of England US Fed. Res
20 0 7.
1
20 07
.5
20 07
.9
20 08
.1
20 08
.5
20 08
.9
20 09
.1
20 09
.5
20 09
.9
2 0 10
.1
20 10
.5
20 10
.9
2 0 11
.1
2 0 11
.5
2 0 11
.9
2 0 12
.1
20 12
.5
20 12
.9
2 0 13
.1
20 13
.5
20 13
.9
2 0 14
.1
20 14
.5
20 14
.9
2 0 15
.1
20 15
.5
20 15
.9
20 15
.11
FIGURE 10.8 Central Bank assets relative to 2007 (=100).
Summary 143
Key Terms
corporate paper
federal funds rate
inflation targeting
liquidity trap
M1
M2
monetary aggregate
monetary transmission
mortgage-backed security
open-market operations
primary credit rate or
discount rate
quantitative easing
reserve ratio
1. The Constitution of the United States grants to Con-
gress the power of monetary policy in Article 1,
Section 8. Since 1913, Congress has
a. jealously guarded this power.
b. granted this power to the president.
c. delegated this power to the Federal Reserve.
d. ignored this power.
2. When engaging in monetary policy, the impact
of ex pansionary policy on an aggregate demand–
aggregate supply model is to
a. increase aggregate demand.
b. increase aggregate supply.
c. decrease aggregate demand.
d. decrease aggregate supply.
3. The most precise tool of monetary policy is
a. the adjustment of the federal funds target.
b. the adjustment of the discount rate.
c. the adjustment of the reserve requirement.
d. the use of open-market operations.
4. Federal Reserve independence is
a. completely fictitious.
b. totally complete.
c. subject to Congress’s desire to keep it independent.
d. subject to the Supreme Court’s desire to keep it
independent.
5. The “creation” of money is
a. entirely the purview of Congress.
b. entirely the purview of the Federal Reserve.
c. formally the purview of the Federal Reserve,
constitutionally the purview of Congress,
but banks have a practical means of creating
money.
d. entirely subject to the whims of the banking
system.
6. During 1999 through 2006, the Federal Reserve
a. was passive and simply let things happen.
b. reacted actively to quell potentially inflationary
expansions but did nothing to deal with the
recession.
c. reacted actively to deal with the recession but
did nothing to quell potentially inflationary
expansions.
d. reacted actively to deal with the recession and
to quell potentially inflationary expansions.
7. The ability of the Federal Reserve to control interest
rates is
a. limited almost entirely to short-term rates.
b. limited almost entirely to long-term rates.
c. limited almost entirely to intermediate-term
rates.
d. unlimited.
8. Which of the following tools would have likely had the
impact of raising short-term interest rates the most?
a. Cutting the federal funds target by one-quarter
point
b. Buying $1 million in bonds
c. Raising the reserve requirement from 8 percent
to 15 percent
d. Raising personal income tax rates by 1 percent-
age point each
Quiz Yourself
Summary
With your newfound wealth of knowledge, you now under-
stand the role of the Federal Reserve of the United States
and its primary goal to maintain macroeconomic stability.
You see that the Fed’s own apparent measure of success
in meeting this goal has been the ability to control infla-
tion. You know the tools of monetary policy, understand
how they work, and are able to apply that knowledge to
an aggregate supply–aggregate demand model. You know
the recent history of monetary policy and know how it has
shaped the Federal Reserve’s current fixation with infla-
tion. Finally, you understand the debate among economists
over whether inflation or deflation is a greater concern.
144 Chapter 10 Monetary Policy
Short Answer Questions
1. Explain how open-market operations work.
2. Explain the difference between the discount rate and
the federal funds rate.
3. Explain how lowering the reserve ratio affects the
economy.
4. Explain how the 2010–2013 quantitative easing
through the Federal Reserve purchase of mortgage-
backed securities is different in style from what it
usually does.
Think about This
Because the chairs of the Federal Reserve Board can
have an enormous impact on policy decisions of the Fed
and thereby the economy, their selection has been the
subject of great political interest. Politically motivated
monetary policy could be ruinous economic policy.
Previous Fed chairs have understood that their functional
independence from congressional interference depends
on the apolitical nature of their decisions. What would
the economic consequences be if this balance was upset
by a president who nominated a Fed chair dedicated to
protecting the president’s political party?
Talk about This
Presidents tend to nominate Fed chairs on the basis of
advice from those working daily in the financial markets.
Who should have an impact on the choice of the Fed
chair? Specifically, Fed policy can favor financial inter-
ests or the interests of workers. Should unions or others
with a claim to represent workers have an impact on the
selection of the Fed chair?
For More Insight See
Colander, David, “The Stories We Tell: A Reconsid-
eration of AS/AD Analysis,” Journal of Economic
Perspectives 9, no. 3 (Summer 1995), pp. 169–188.
Ramo, Joshua Cooper, “The Three Marketeers,” Time,
February 15, 1999, pp. 34–42.
Steiger, Douglas, James H. Stock, and Mark W. Watson,
“The NAIRU, Unemployment and Monetary Policy,”
Journal of Economic Perspectives 11, no. 1 (Winter
1997), pp. 33–50.
Behind the Numbers
Consumer price index and historical U.S. inflation rates.
Bureau of Labor Statistics—www.bls.gov/cpi
U.S. interest rates 1955–2015.
Federal Reserve Board; statistics: releases and his-
torical data—
www.federalreserve.gov/econresdata/statisticsdata.htm
C H A P T E R E L E V E N
145
Federal Spending Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the process that goes into creating the federal
budget of the United States.
LO2 Show that mandatory spending—the portion of the budget
that is devoted to spending on items for which no annual
vote is taken—has steadily increased because of various
entitlement programs and interest on the national debt.
LO3 Summarize how 30 percent of the federal budget is al-
located almost equally to domestic spending and defense,
with a relatively small amount going for foreign aid
and for dues to international organizations such as the
United Nations.
LO4 Explain how to use marginal analysis when looking at
federal spending.
LO5 Distinguish between current-services and baseline
budgeting.
LO6 Conclude that the idea of opportunity cost is at the heart
of federal spending.
Chapter Outline
A Primer on the Constitution and Spending Money
Using Our Understanding of Opportunity Cost
Using Our Understanding of Marginal Analysis
Budgeting for the Future
Summary
The federal government of the United States of America
spends more than $4 trillion each year on everything
from welfare to national defense. This chapter focuses at-
tention on how the government spends that money, a per-
fect example of how, in public policy, we use the concept
of opportunity cost that was introduced in Chapter 1.
We start with a brief primer on what the Consti-
tution requires before money can be spent. We then
discuss the difference between mandatory and discre-
tionary spending and how the balance between the two
has shifted over the years. Next we lay out where the
money was budgeted in the 2014 fiscal year, how that
budget reflects on our priorities, and how the shift in
distribution over the years reflects a shift in priori-
ties. We focus our attention, in particular, on health,
Social Security, and defense spending, which make up
the bulk of the federal budget. We use the Chapter 1
notion of marginal analysis to discuss both the size of
federal spending and the distribution of it among vari-
ous programs. Finally, we describe baseline and cur-
rent-services budgeting and use Medicare and defense
to discuss the differences.
As can be seen in Figure 11.1, federal spending as
a percentage of GDP stayed between 18 percent and
22 percent for 22 years. After peaking in 1952 as a re-
sult of the Korean War, this measure trended up from
16 percent in 1955 to a peak at 23.5 percent in 1982 as
spending on social programs increased. The Reagan
years saw a slow decline only to rebound in the George
Herbert Walker Bush years as billions were spent
in a bailout of failed savings and loan associations.
Since that time the size of the federal government,
146 Chapter 11 Federal Spending
The Congress often uses that budget as a blueprint upon
which it bases a budget plan of its own. It uses its version
as it debates and negotiates with the executive branch of
government. When both sides reach agreement on a final
budget, Congress passes appropriations bills to actually
spend the money that has been budgeted.
All of this work must be completed by October 1 be-
cause the government’s fiscal year starts then and goes to
September 30 of the following year. (So the 2017 fiscal
year began October 1, 2016, and ended September 30,
2017.) When these bills are passed and signed by the
president, they become law and money can be spent.
Otherwise, money cannot be spent.
Shenanigans
This process has a myriad of places for shenanigans.
Chief among these are actions taken by the various
subcommittee and committee chairs and in the House–
Senate conferences. The chairs of the appropriations
subcommittees and the chairs of the full committees
can and do influence how much gets spent and where
it gets spent. Whereas spending on social insurance
programs like Medicaid, Medicare, and Social Secu-
rity cannot be easily altered, highway spending and
defense spending are prime targets for spending on
items of local rather than national interest. The chair
of a subcommittee like the one on highway spending
measured as a percentage of GDP, fell to its lowest
point in 25 years only to rise again in the wake of the
September 11, 2001, attacks, and the subsequent wars
in Afghanistan and Iraq. The $750 billion Troubled
Asset Relief Program (TARP) passed in October 2008
and the $787 billion Obama stimulus law passed in
February 2009 greatly altered this figure. After the
Great Recession peak of 25.2 percent, federal spend-
ing as a percentage of GDP is projected to stabilize at
around 22 percent.
A Primer on the Constitution and Spending Money
What the Constitution Says
According to the Constitution of the United States of
America, “No money shall be drawn from the treasury,
but in consequence of appropriations made by law.”
This means that unless Congress passes an appropria-
tions bill and the president either signs it or has a veto
overturned, no money can be spent. The president and
Congress thus must reach either an agreement or a com-
promise on spending priorities so that Congress will pass
an appropriation bill that the president will sign.
Under normal procedures, the president sends a pro-
posed budget to Congress in late winter or early spring.
19 47
19 51
19 55
19 59
19 63
19 67
19 71
19 75
19 79
19 83
19 87
19 91
19 95
19 99
20 03
20 07
20 11
20 15
20 19
F e
d e
ra l s p
e n
d in
g /G
D P
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Year
Federal spending/GDP 2014–2018 est.
FIGURE 11.1 Federal spending as a percentage of GDP.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
A Primer on the Constitution and Spending Money 147
review. Promises to quell this type of spending are
rarely kept.
Dealing with Disagreements
The appropriations process seldom moves smoothly,
and the process is particularly rough when the political
party in control of the White House is not in control
of Congress. Disagreements abound when this is the
case, and rarely can one party “have its way” with the
budget. While the Obama administration was elected to
office with large majorities in both the House of Repre-
sentatives and Senate, Senate budget rules required that
Obama garner 60 votes for his stimulus package. He
could do that only with Republican votes. Even then,
he was in a considerably more advantageous position
than Presidents Clinton and Bush. Neither could count
on his own party to back his budget priorities, and both
dealt with periods when Congress was in the hands of
the other party. It has been a truly rare circumstance in
recent American history where a president had suffi-
cient political party and ideological majorities in Con-
gress to get his way. Thus the usual case for much of the
late 20th century featured long and protracted budget
debates.
When Congress either does not pass appropriations
bills that are acceptable to the president or passes bills
the president does not want, there are only four choices:
1. Congress can give in.
2. The president can give in.
3. The government can shut down.
4. Congress can pass a continuing resolution and the
president can sign it.
If either side gives in, a bill gets passed. Shutting down
the government becomes a battle of chicken until the
sides reach compromises. A continuing resolution con-
stitutes an agreement to disagree that lets the government
continue functioning.
Specifically, a continuing resolution is a bill passed by Congress and signed by the president that allows the
government to spend money temporarily in a fashion
identical to the previous year. This usually happens when
Congress does not meet the Oc-
tober 1 deadline. More often than
not, it is for only a few of the 13
appropriations bills and for only
a few weeks, but in 2013, almost
the entire budget was passed as a
continuing resolution.
can fund the building of bridges and highways in his
or her district much more easily than anyone else can.
As with roads and bridges, defense is also an area
where the powerful chairs of the subcommittees and
the full committees work to ensure that federal money
is spent in their districts. Recent history is replete with
examples of weapons systems that are not wanted by
the military but that are being built anyway because
the production facilities are in districts or states of
powerful members of Congress.
Even worse, members of the conference committees,
who are charged with putting together good compromise
bills, have been known to spend significant time mak-
ing sure money is included for their states or districts
and less time making sure the bill is a good one for the
country. Members of Congress who have seniority over
other members are the ones who are assigned to such
committees. Such appointments are considered rewards
for years of service. The most egregious products of the
conferences are usually found in parts of the final bill
that were not in the original House or Senate version of
the bill. These are items that conference members knew
they could not get passed in their own houses. Knowing
they were going to end up on a conference committee,
they just waited and made the inclusion of the item they
wanted passed a condition of their support for the bill in
conference.
Another element of budgetary shenanigans comes
when members of Congress agree to support spending
programs in each other’s districts. This vote trading,
called logrolling among economists, increases spend- ing in ways that raise eyebrows. A senator from Ver-
mont got his colleagues to declare Lake Champlain a
Great Lake so that it would qualify for an environmen-
tal program. The emergency
spending legislation approved
after the attacks of September
11, 2001, included billions for
wholly unrelated items. The
infamous Alaskan “bridge to
nowhere” was tucked into
emergency spending following Hurricane Katrina by
then Alaska Senator Ted Stevens. The 2013 Hurricane
Sandy relief bill included $33 billion in spending en-
tirely unrelated to the storm. Bridges, roads, univer-
sity studies, and memorials to obscure local celebrities
tend to grow on spending bills in direct proportion to
the need to move the legislation quickly as members
of Congress take advantage of the situation and agree
to spending that would otherwise require extensive
logrolling The trading of votes used to generate sufficient support for projects that are not in the general interest of the country.
continuing resolution A bill passed by Con- gress and signed by the president that allows the government to tempo- rarily spend money in a fashion identical to the previous year.
148 Chapter 11 Federal Spending
spending. You can see that the broadest of its distinctions
is the difference between mandatory and discretionary
spending. Mandatory spending delineates those items for which a previously passed law requires that money be
spent, while discretionary spend- ing is subject to annual appropri- ations decisions. For instance,
current law states that people are
entitled to certain benefits that
must be paid without regard to
any other budget details. Future
laws could overturn those now
in existence, but the benefits that
are currently provided through
Social Security, Medicare, Med-
icaid, and welfare are so firmly
entrenched in our society that in
reality the money spent on them
is untouchable. These four areas
of the budget are often referred
to as entitlement spending be- cause the people for whom they are intended are entitled
to the money they receive based on their poverty or age.
Entitlement spending is a subset of mandatory spending,
which also includes interest on the national debt.
The appropriations for defense, student loans, the
courts, and so on, occur annually. While these budgets
rarely change drastically from the previous year, a failure
to pass an appropriations bill can significantly affect the
operations in these areas.
On the discretionary side of the budget there are
three main components: defense, international policy
and foreign aid, and everything else (broken out in
Table 11.1). The most misunderstood and controversial
of these is international policy. Of the $46 billion spent
Using Our Understanding of Opportunity Cost
The federal budget of the United States is an object lesson
in opportunity cost. Whenever money is spent in one area,
it cannot be spent in another. Although more money can be
spent in all areas, this also has an opportunity cost. When
money is taken from taxpayers, their ability to enjoy pri-
vate consumption is reduced. Deficit spending is also not
without opportunity cost. Interest payments add up into
the future and money for private investment is reduced.
Some economists argue that the opportunity cost of
government deficit spending is such that for every dol-
lar the federal government borrows and spends, a dollar
is removed from private investment. If these economists
are correct, this phenomenon, called crowding out, is an example of opportunity cost at work: Government cannot
just spend money and make everyone better off. In the
process, someone is being made
worse off. Other economists
suggest that crowding out is less
than complete, which means
that for every dollar of govern-
ment spending something less
than a dollar of private spending is lost. In either case
there is an opportunity cost to the money spent.
The remainder of this section describes the choices
that must be made by Congress and the president when
setting out a spending plan.
Mandatory versus Discretionary Spending
Although the actual budget proposal of the president
runs to more than 1,000 pages and is incredibly detailed
and precise, Figure 11.2 offers its basic distribution of
crowding out The opportunity cost of government deficit spending such that private investment is reduced.
mandatory spending Budget items for which a previously passed law requires that money be spent.
discretionary spending Budget items for which an annual appropriations bill must be passed so that money can be spent.
entitlement A program where if people meet certain income or demo- graphic criteria they are automatically eligible to receive benefits.
TABLE 11.1 Nondefense domestic discretionary spending, Fiscal Year 2016.
Income Security, $528, 13%
Medicaid and SCHIP, $407, 10%
Medicare, $595, 15%
Social Security, $929, 24%
Discretionary domestic, $628,
16%
International A�airs and Aid,
$46, 1%
Defense and Homeland Security,
$604, 15%
Interest, $240, 6%
FIGURE 11.2 Fiscal Year 2016 spending (in billions) and percentage of federal budget.
Category of Domestic
Discretionary Spending
2016 Spending
($ billions)
Science and space 30.8
Natural resources/environment 42.6
Agriculture 25.6
Transportation 92.4
Education and training 113.9
Veterans 178.2
Justice 64.4
Using Our Understanding of Opportunity Cost 149
future Congresses and presidents as less and less of the
budget can be devoted to other priorities.
Where the Money Goes
As you can see from Figure 11.2, defense, Social Security,
Medicare, Medicaid, and net interest take up $2.8 trillion
of the $4 trillion spent each year. The rest is either in the
form of other welfare programs such as Temporary Assis-
tance for Needy Families (TANF) or food stamps, or it is
spent in the relatively smaller amounts listed in Table 11.1.
The biggest of these areas of spending are under the De-
partment of Education and its education and training pro-
grams. Of the $114 billion spent on education and training,
$39 billion is spent on student loans, grants, and the federal
work–study program. The remainder is spent as a supple-
ment to state and local spending on primary and secondary
education. With the wars in Iraq and Afghanistan, spend-
ing on veterans’ benefits has increased to $178 billion. In
2016, transportation spending was budgeted at $92 billion
with $64 billion for the federal justice system.
Figure 11.4 indicates that the mix of spending has dra-
matically changed over the years. Half or more of the fed-
eral budget once was devoted to national defense; today
the amount is less than 16 percent. While Social Security
once took up only 15 percent of the budget, today it is ap-
proximately 23 percent. Net interest paid increased from
less than 10 percent to more than 15 percent only to fall
to 9 percent as a result of the surpluses of the late 1990s
in this area, $14 billion is spent to maintain the State
Department and its embassies in other countries and to
pay our dues to the UN and other international organiza-
tions. The remaining $32 billion goes to other countries
in foreign aid.
As you can see from Figure 11.3, the proportion
of the budget devoted to discretionary spending has
decreased from over 65 percent to just over 30 percent,
while the proportion devoted to mandatory spending has
skyrocketed. This led President Clinton in 1993 to decry
the fact that under projections valid at the time, by 2010
Congress would convene each year to debate less than
10 percent of the annual budget. This troublesome trend
was halted in the late 1990s, but was on track to resume
before the financial crisis of 2008 and coincident reces-
sion began. The massive increase in discretionary spend-
ing that resulted from the 2009 stimulus plan briefly
interrupted this trend. However, aging baby boomers
will soon balloon Social Security and Medicare spend-
ing, and the massive deficits of 2009 through 2014 and
likely beyond will surely increase interest obligations
such that President Clinton’s prediction may come true,
a few years after he thought it would.
This brings us back to the inescapable notion of op-
portunity cost. Every time a new entitlement program
comes on board, such as the prescription drug coverage
for Medicare recipients, it not only costs money now and
in the future but also reduces the amount of flexibility of
FIGURE 11.3 Mandatory and discretionary spending as a percentage of total federal spending, 1962–2021.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
80%
70%
60%
50%
40%
30%
20%
10%
0%
Discretionary
Discretionary est. 2016–2021
Mandatory
Mandatory est. 2016–2021
Year
P e
rc e
n ta
g e
o f
fe d
e ra
l s p
e n
d in
g
19 62
19 65
19 68
19 71
19 74
19 77
19 80
19 83
19 86
19 89
19 92
19 95
19 98
20 01
20 04
20 07
20 10
20 13
20 16
20 19
150 Chapter 11 Federal Spending
Federal Reserve has used its power to buy this debt to
temporarily reduce the interest rate.
An area of spending that has increased remarkably
since 1970 is federal spending in support of health care.
As seen in Figure 11.5, adjusted for inflation, federal
and early 2000s and the historically low interest rates of
2001 through 2004. As deficits grew during 2005–2007
and then exploded during and after the 2007–2009 re-
cession, it is once again more than 10 percent. The only
reason it has not already exceeded that amount is that the
19 62
19 65
19 68
19 71
19 74
19 77
19 80
19 83
19 86
19 89
19 92
19 95
19 98
20 01
20 04
20 07
20 10
20 13
20 16
20 19
Year
50
P e
rc e
n ta
g e
o f
fe d
e ra
l s p
e n
d in
g
40
45
35
30
20
25
10
15
5
0
Social Security Net interest
Soc. Sec. 2016–2021 est. Net int. 2016–2021 est. Means tested entitlements National defense
Nat. def. 2016–2021 est.M.T.E 2016–2021 est.
FIGURE 11.4 Composition of federal spending.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
600
700
400
500
200
300
100
0
Total
Total 2016–2021 est.
Medicaid
Medicaid 2016–2021 est.
Medicare
Medicare 2016–2021 est.
Year
R e
a l $
b il li o
n s
19 62
19 65
19 68 19
71 19
74 19
77 19
80 19
83 19
86 19
89 19
92 19
95 19
98 20
01
20 04
20 07
20 10
20 13
20 16
20 19
FIGURE 11.5 Real health spending by the federal government, 1962–2021 billions of 2000 dollars.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
Budgeting for the Future 151
marginal analysis compares the marginal benefit of an
action with its marginal cost. In particular, that marginal
cost is its opportunity cost.
The Size of the Federal Government
In judging the proper size of the federal government,
an economist using marginal analysis would attempt
to decide if the benefits resulting from additional tax
money would outweigh the benefits that would other-
wise accrue to private citizens if they were not taxed
that amount. A government that purports to be “of, by
and for the people” should seek to take only that money
needed to fund programs whose marginal benefit is
greater than or equal to their marginal cost. Thus it is
not enough to say that we are getting $4 trillion in value
for our $4 trillion; we need to be able to say that we are
getting a dollar’s worth of value for the last dollar of
those $4 trillion dollars.
The Distribution of Federal Spending
Just as government should seek to maximize the net
benefit to society by picking the optimal size of gov-
ernment, it should ensure that the distribution of spend-
ing between various priorities is optimal as well. Once
the optimal size is established, the opportunity cost of
money spent by one program is that it cannot be spent by
another. For instance, the choice to build an aircraft car-
rier could come at the cost of expanding student grants
and loans to cover several thousand more college stu-
dents. Thus money spent on a program with only modest
evidence of success could be viewed as wasteful, even
if it is spent with good intentions and does no harm,
because the money could be spent elsewhere to greater
effect.
Budgeting for the Future
Baseline versus Current-Services Budgeting
The yearly budget debate in Washington is replete with
claims about who is making what cuts. For instance, dur-
ing the debate over the 1996 budget, Republicans sug-
gested that spending on Medicare increases yearly at a
rate of 9 percent rather than the 14 percent requested by
President Clinton. Since another aspect of their program
was a broad-based tax cut, they were accused of “cut-
ting Medicare to pay for a tax cut for the rich.” This kind
of debate is annoying because politicians often redefine
simple words such as “cut” or simple phrases such as
spending on health care has risen 1,000 percent over that
time. This is because Medicare and Medicaid spending
has risen dramatically. When these programs were intro-
duced in the late 1960s, spending on both was trivial. In
the 2016 federal budget more than $407 billion was spent
on Medicaid and the State Children’s Health Insurance
Programs, and $595 billion on Medicare. Together this
is more than is spent on any program other than Social
Security.
Again we are faced with the fact that there are always
trade-offs. The trade-offs that we have made until now
have clearly been in favor of entitlements. Social Secu-
rity, Medicare, Medicaid, and various welfare programs
have driven the budget for many years. The combined
budget for all non-defense domestic spending, which in-
cludes everything from the federal judiciary to student
loans, is exceeded by just one program, Social Security.
The choice that we have made to ensure that elderly peo-
ple and persons who are disabled have steady and reli-
able incomes comes at a cost.
Another choice that we have made is to exercise our
military power in other parts of the world. Though some
would argue that we had no real choice being the world’s
only superpower, it does, nonetheless, absorb resources
and have an opportunity cost. As can be seen from
Table 11.2, we spend a higher percentage of our GDP on
military expenditures than our allies.
Using Our Understanding of Marginal Analysis
Federal spending is a prime arena to utilize marginal anal-
ysis. We can use this form of thinking to discuss whether
the federal government spends too little or too much and
whether the distribution of spending on various spend-
ing priorities is appropriate. Recall from Chapter 1 that
TABLE 11.2 International comparisons of defense spending as a percentage of GDP, 2014.
Source: The World Bank, http://data.worldbank.org/indicator/MS.MIL.XPND.GD.ZS
Country Defense Spending/GDP
United States 3.5
United Kingdom 2.0
France 2.2
Germany 1.2
Japan 1.0
152 Chapter 11 Federal Spending
to ensure that government services are available to
everyone who is eligible to receive them. There is no
guarantee that baseline budgeting will provide enough
money. A reasonable question to ask in budgeting is one
that Democrats tend to ask: “How much will it cost to
perform services this year in a manner identical to last
year?” This is referred to as current-services budgeting. Current-services budg et ing takes into account such
things as overall inflation, inflation in the specific sec-
tor, and an increase in the num-
ber of people being served. If
you want to guarantee enough
money to provide identical ser-
vices in the future, then merely
starting with the previous year’s
baselines may not work. This
has been particularly true in the health care field because
new, more effective treatments become available. Thus
the question is whether the new spending required to
meet the old standard of care will be sufficient to meet
the new standard.
Using current-services budgeting, President Clinton
criticized Republicans in 1995 for their plan to “cut
Medicare.” Republicans countered, using baseline
budgeting, that there was no cut at all. By using jar-
gon with technical definitions to further their own posi-
tions, each party was telling the truth. In this case the
truth depended on the standard that had been set. If the
agreed-upon standard had been baseline budgeting,
then the Republicans were right; if it had been current-
services, then the Democrats were right. Because a
standard had not been set, they were both right and they
were both wrong.
“broad-based” to suit their argument. It is indisputable
that Democrats wanted more money for Medicare and
Republicans, less. Moreover, Republicans wanted a re-
duction in taxes in rough proportion to taxes paid, and
Democrats did not.
Had each side used straightforward and agreed-
upon definitions, the debate would have been easier
to understand. For instance, Democrats often define
a broad-based tax cut as one that goes to everyone
equally, whereas Republicans define it as one that
goes proportionally to those who pay income taxes.
Republicans argue that most of a tax cut should go
to those making the most money since they pay the
most taxes. (See Chap ter 41 on personal income tax.)
Democrats, on the other hand, define broad-based
tax cuts as those that are given to everyone in similar
amounts.
The language problem on spending cuts is equally
exasperating. The problem is that when you formulate
a budget and you compare it to other years’ budgets,
there is an open question as to how the comparison
should be done. If you simply look at last year’s bud-
geted figure and compare it to this year’s budgeted fig-
ure, you are engaging in what is
referred to as baseline budget- ing. If you are budgeting more than you did last year, that is an
increase; if you are budgeting
less, that is a decrease. This is
a commonsense approach and it is one that Republicans
typically take.
This approach, however, misses an important point
that is vital to interests Democrats support. They wish
Summary
You now understand the process that goes into creating
the federal budget of the United States. You know that in
percentage terms a large and increasing part of the bud-
get is devoted to spending on items for which no annual
vote is taken. You now see that this mandatory spend-
ing goes mostly to Social Security, Medicare, Medic-
aid, various welfare programs, and the costs of interest
on the debt. You understand that the rest goes almost
equally to spending on domestic concerns and spending
on defense. You see that a relatively small amount goes
for foreign aid and other obligations to international or-
ganizations such as the United Nations. You understand
the difference between current-services and baseline
budgeting and why this difference is at the heart of many
political debates. Most important, you now understand
that the idea of opportunity cost—choices have conse-
quences, and money spent in one area cannot be spent in
another—is at the heart of budgeting.
baseline budgeting Using last year’s budgeted figure to set this year’s budgeted figure.
current-services
budgeting Using an estimate of the costs of providing the same level of services next year as last.
Key Terms
baseline budgeting
continuing resolution
crowding out
current-services budgeting
discretionary spending
entitlement
logrolling
mandatory spending
1. Federal spending is typically
percent of GDP.
a. less than 10
b. between 18 and 22
c. between 25 and 30
d. more than 30
2. The FY 2016 federal budget was around
a. $4 million.
b. $4 billion.
c. $4 trillion.
d. $4 quadrillion.
3. Disagreements between the Congress and the presi-
dent about the federal budget occur frequently.
When they cannot agree on a budget but want to
keep the government running, they
a. use the president’s budget.
b. use Congress’s budget.
c. use a budget created by an independent budget
commission.
d. pass a continuing resolution.
4. Mandatory spending implies spending that is
a. required by a previously passed set of laws.
b. required by the U.S. Constitution.
c. needed more than discretionary spending.
d. off-limits for any cuts at any time.
5. The largest single item in federal spending is
a. international aid.
b. welfare.
c. interest on the debt.
d. Social Security.
6. Total federal spending on health care, after adjusting
for inflation, has been
a. growing.
b. relatively constant.
c. declining slowly.
d. declining rapidly.
7. In determining whether the federal government is the
right size, an economist would determine whether
a. the first dollar spent produced $1 worth of
social good.
Quiz Yourself
b. the average dollar spent produced $1 worth of
social good.
c. the last dollar spent produced $1 worth of
social good.
d. an amount of social good was created equal to
the amount spent.
8. In determining whether the distribution of federal
spending among various agencies was correct, an
economist would want to make sure
a. that each agency manager got what (s)he
thought was needed in that area.
b. that the last dollar spent in each area produced
the same amount of social good.
c. that the average dollar spent in each area
produced the same amount of social good.
d. that the total amount of money spent in each
agency produced the same level of social good.
9. If a program’s cost rises only with inflation and in-
creases in those that qualify for the program, this
represents
a. an increase in spending using baseline
budgeting.
b. a decrease in spending using current-services
budgeting.
c. no increase or decrease in spending using
current-services budgeting.
d. a and c are both correct.
Short Answer Questions
1. Explain how mandatory spending comes about
relative to discretionary spending. Then assign the
following programs to each: interest payments on
the debt, national defense, Social Security, food
stamps.
2. In order of magnitude, rank the following spending
from greatest to smallest: Social Security, national
defense, Medicare, federal support for education,
space exploration, and foreign aid.
3. Explain what would transpire for new government
expenditures to crowd out other economic activity.
Summary 153
154 Chapter 11 Federal Spending
For More Insight See
Lee, Ronald, and Jonathan Skinner, “Will Aging Baby
Boomers Bust the Federal Budget?” Journal of Eco-
nomic Perspectives 13, no. 1 (Winter 1999).
Lynch, Thomas, Public Budgeting in the United States
(Englewood Cliffs, NJ: Prentice Hall, 1979).
Behind the Numbers
Historical data.
Federal spending.
Mandatory and discretionary spending.
Composition of federal spending.
Federal government health spending.
Budget of the United States Government; historical
tables—www.whitehouse.gov/omb/budget/Historicals
World Bank; data and statistics—http://data.worldbank.org
4. One political party believes government spending is
too high; another party thinks it is too low. Which party
will argue for current-services budgeting as a practice
for setting government budgets? Explain why.
Think about This
The Medicare prescription drug benefit passed dur-
ing 2003 comes at a significant long-term cost (at least
$720 billion over 10 years). Consider the opportunity
cost of this spending in terms of tax cuts, deficit reduc-
tion, or spending on other priorities. Would you have
committed the federal government to this spending?
Talk about This
When Congress and the president do not agree on a spend-
ing package and cannot agree on a continuing resolution,
the government shuts down all but emergency services.
What, in your mind, should be considered under the um-
brella of “emergency”?
C H A P T E R T W E L V E
155
Federal Deficits, Surpluses, and the National Debt Learning Objectives
After reading this chapter you should be able to:
LO1 Explain how economists look at the federal budget deficits
and surpluses and the national debt.
LO2 Associate significant deficits as resulting from wars and se-
vere recessions/depressions.
LO3 Conclude that economists are interested less in raw num-
bers than in more sophisticated measures of the burdens
that deficits and debt place on us.
LO4 Compare the U.S. national debt-to-GDP ratio relative to U.S.
history and to other countries.
LO5 Explain that the federal government owns much of the debt
and list what agencies own that debt.
LO6 Summarize the different positions taken by economists
on the issue of a balanced-budget amendment to the U.S.
Constitution.
LO7 Conclude that the deficit and debt picture has changed
substantially since 1990 and articulate why deficit projections
are so often wrong.
Chapter Outline
Surpluses, Deficits, and the Debt: Definitions and History
How Economists See the Deficit and the Debt
Who Owns the Debt?
A Balanced-Budget Amendment
Projections
Summary
This chapter could have had a simpler title: “Deficits and
the National Debt.” That is, except for a brief period in
recent history, from 1998 to 2001, the federal govern-
ment has spent more than it has taken in. The purpose of
this chapter is to discuss the history of the deficits, those
few surpluses, and the national debt of the U.S. federal
government. (Particular attention will be paid to the debts
coming out of the 2007–2009 recession and the budgets
of President Obama.) After a brief history of these, we
discuss the main causes of deficits and debt through
time. We examine how economists look at the federal
debt and how they compare the current state of affairs
with other countries and U.S. history. When we discover
who actually owns the federal debt, you will be surprised
to see that a significant portion of it is owned by the fed-
eral government itself. We discuss whether a balanced-
budget amendment to the U.S. Constitution makes sense
as economic policy, and we conclude by looking at the
rosy projections of surpluses and the national debt made
by the Office of Management and Budget and the Con-
gressional Budget Office and comparing them with much
less rosy projections made by others.
156 Chapter 12 Federal Deficits, Surpluses, and the National Debt
Confederation, before the Constitution was ratified, the
country had a considerable debt (more than $75 million)
from the American Revolutionary War and no money to
pay it off. In fact, because the Continental Congress had
no power to tax during the war, almost all of the money
necessary to fight and win it was borrowed. In the first
58 years of constitutional government in the United States,
from 1791 to 1849, there were more years of surplus (36)
than deficit (23), and over that time the country ran a net
surplus of $60 million. As a matter of fact, in 1836 the
debt had all been repaid and President Andrew Jackson
got Congress to give states money. Congress missed the
mark and gave away $37,000 too much. The only alterna-
tive to giving the money to the states—investing in the
private sector—was considered inappropriate.
The American Civil War ended notions that the coun-
try would ever again go without a national debt. Two
billion dollars was borrowed to fight that war, and even
though in the 35 years after the war there were more
years with a surplus (21) than a deficit (14), the debt
remained at $2 billion by 1900. As a matter of fact, in
the first 30 years of the 20th century, there were almost
as many years of surplus (13) as deficit (17). The debt
during that period grew because the deficits during the
two-year U.S. involvement in World War I were twice
the size of the combined surplus in the other years. The
longest uninterrupted period of debt reduction began just
after World War I and lasted until 1930, the first full year
of the Great Depression. Surpluses ruled for 11 consecu-
tive years. In general, U.S. economic history prior to the
Great Depression can be summarized as one in which
the expenses of wars created the debt and steady efforts
were made to eliminate the debt when the wars ended.
Since 1930, however, deficits have been more the rule
than the exception. During the 86 years from 1930 to 2015,
there were only 12 years with surpluses (three years in the
1940s, three in the 1950s, two in the 1960s, two in the
1990s, and two in the 2000s), whereas there were 74 with
deficits. Also during that time the national debt grew from
$50 billion to $18.1 trillion. Adjusting the deficits and sur-
pluses for inflation, we can compare the relative size of
the various years, and this is shown in Figure 12.1.
Figure 12.1 also portrays an important division be-
tween the total budget and the off-budget surpluses and
deficits. Recall that the total budget is the combination
of the on- and off-budget numbers. In recent times, espe-
cially after changes in Social Security in 1982 that saw a
hefty increase in taxes in anticipation of the large num-
ber of retirements among baby boomers, the off-budget
surplus has been substantial. In all but 12 of the 82 years
Surpluses, Deficits, and the Debt: Definitions and History
Definitions
Defining budget deficit, budget surplus, or national debt ought to be simple, but because of the way the federal
government does its accounting,
the definitions are not as simple
as they could be. For instance,
you would think that if you did
the math, a surplus would result
when the total amount of tax rev-
enue that came in was greater
than the total amount that you
spent. If spending exceeded the
revenue, the result would be a
deficit, and the debt would be
the sum of the deficits minus the
sum of the surpluses.
The problem is the usual
definitions are not quite right,
and it is because the deficit or
surplus for a year is the combi-
nation of what are referred to as
the off- and on-budget deficits
and surpluses. Social Security,
Medicare, and other parts of the
budget that have trust funds at-
tached to them complicate the
matter because they are con-
sidered off-budget. The part of the federal budget that operates
from year to year without a trust
fund is on-budget. So, in 1998, when revenues exceeded expenditures and there was a $60 billion surplus for the
total budget, we still added to our national debt because
of a deficit in the on-budget part of the equation. When-
ever we have an on-budget deficit, we have more debt.
Since the off-budget part of the system had a greater
surplus than the on-budget part had a deficit, the total
budget was in net surplus, yet our debt grew.
History
The annual budget of the United States is never actually
balanced. The closest we ever came to a strictly balanced
budget was a $3,800 deficit in 1835. Why is the budget
not ever balanced? Congress passes the budget before
it knows exactly how much money is going to come in.
When the United States operated under the Articles of
budget deficit The amount by which expenditures exceed revenues.
budget surplus The amount by which revenues exceed expenditures.
national debt The total amount owed by the federal government.
off-budget Parts of the budget designated by Congress as separate from the normal budget. Programs that operate with their own revenue sources and have trust funds; Social Security, Medicare, and the Postal Service are examples.
on-budget Parts of the budget that rely entirely or mostly on general revenue.
Surpluses, Deficits, and the Debt: Definitions and History 157
depicted in Figure 12.1, the off-budget part of the sys-
tem was in surplus, and nine of these were from the late
1970s and early 1980s, before Social Security taxes were
raised substantially. This continues to be the case with
the surpluses in the Social Security system. These off-
budget surpluses masked the severity of budget deficits
in the late 1980s and created the illusion of surpluses in
the late 1990s. It was only in fiscal years 1999 and 2000
that the on-budget side was showing a surplus. Deficits
surged after the Bush-era tax cuts and spending increases
resulting from the terrorist attacks of September 11,
2001, and the subsequent wars in Iraq and Afghanistan.
The deficits were slated to hover in the $400 billion per
year range when, in 2008, the recession and financial
collapse took place.
Figure 12.2 displays the trend in deficits as a per-
centage of GDP. On the left side of the graph, the
large annual deficits were for the expenses of war, just
as 19th- century deficits were. In addition to all of the
other upheaval caused by the Great Depression and
World War II, budget deficits, measured in 1996 dollars
in Figure 12.1 and measured as a percentage of GDP in
Figure 12.2, peaked at more than $400 billion a year, or
nearly a third of GDP.
The deficits of the 1980s and 1990s were caused
by a confluence of events. In 1981 President Ronald
Reagan took office on a platform dedicated to decreas-
ing the size of the federal government and to lessening
the threat of communism. Part of this meant that he
worked to reduce federal income taxes. Tax rates were
slashed and important deductions and exemptions were
indexed1 for inflation to prevent bracket creep2 from rais-
ing taxes later. The part of the equation that focused on
quelling communism resulted in an increase in federal
spending on national defense from $157 billion in 1980
to $303 billion in 1988. All of this might have meant a
budget with historically typical deficits had President
Reagan been successful in convincing Congress to cut
or even substantially slow the rate of increase in domes-
tic spending. Though the rate of increase in spending on
those programs that were on-budget did slow, they did
400
200
0
Year
–400
–600
–800
–200
–1,000
–1,200
O�-budget O�-budget est.Total Total est.
19 4 3
19 4 7
1 9 5
1
19 5 5
19 5 9
19 6 3
19 6 7
1 9 7 1
19 75
19 7 9
19 8 3
19 8 7
1 9 9
1
19 9 5
19 9 9
20 03
20 07
2 0 11
2 0 15
2 0 19
FIGURE 12.1 The total and off-budget deficits and surpluses since 1940, in billions of 1996 dollars.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
1Recall from Chapter 6 that indexing is adjusting a dollar amount for inflation.
It is called indexing because an index, in this case the consumer price index,
is used to perform the adjustment. 2When inflation occurs and incomes rise exactly in line with inflation, then,
unless the tax brackets are adjusted for inflation, people pay a higher per-
centage of that income in taxes even though the real spending power of their
income has remained unchanged. This is called bracket creep.
158 Chapter 12 Federal Deficits, Surpluses, and the National Debt
not slow enough. In addition, spending on Social Security
and Medicare increased substantially faster than before.
While revenues grew quickly despite the cut in income
taxes, this growth was insufficient to keep pace with the
spending increases. With spending growing in nearly all
sectors of the budget and revenues not keeping pace, the
deficits during this period were inflation-adjusted, larger
than the deficits it took to win World War I but smaller
than the deficits it took to win World War II.
Despite incurring the huge deficits, many argue in
President Reagan’s defense that the victory over the
Soviet Union in the Cold War
and the peace dividend (money that was freed up for other
spending priorities when the
Cold War was over) that en-
sued was worth the investment.
To back up this position, they claim that the inflation-
adjusted military budget in 2000 was smaller than at
any other point since World War II and about half of its
1980s peak. If you accept the proposition that the Rea-
gan defense buildup caused, or at least contributed to, a
more rapid ending of the Cold War, then those respon-
sible for allowing the deficits of the 1980s are no more to
be criticized than those responsible for the deficits from
either of the two world wars.
The dramatic turnaround in the deficit picture that
occurred between 1996 and 2001 resulted from a nearly
50 percent increase in taxable income. About a third of that
increase resulted from a skyrocketing stock market. From
1991 to 2000 taxable capital gains income increased from
just over $100 billion to more than $630 billion. As a re-
sult, a deficit that had been approaching $300 billion in
1992 turned into a $236 billion surplus in 2000.
Beginning in 2000, things began to unravel. In
March, the stock market reached its peak (12,000 on
the Dow Jones and 5,000 on the NASDAQ) and began a
two-and-a-half year decline (7,500 on the Dow and 1,200
on the NASDAQ). Taxable capital gains income was cut
by more than half in that time. In November of 2000 we
had an election where it took a month of court battles
to decide who won the presidency. By the time George
W. Bush took office, the economy was in recession and
unemployment was on the rise. He delivered on a prom-
ised tax cut in the spring of 2001 that further diminished
revenues. The attacks of September 11 resulted in vast
increases in government spending for reconstruction as
well as military and domestic security. More tax cuts,
undisciplined federal spending unrelated to defense, and
the wars in Afghanistan and Iraq further swelled the def-
icit such that by 2005 the total budget deficit was more
than $239 billion.
In 2006 and 2007, the lack of progress in Iraq forced
President Bush to choose between withdrawing or increas-
ing forces. His surge strategy, combined with a weakening
housing market, caused deficits to rise again. The 2008
tax cuts and weakening economy in early 2008 further
exacerbated the deficit, resulting in predictions of $500
to $600 billion deficits that would greet a new president.
Then, of course, the bottom dropped out of the financial
sector in the fall of 2008. This created four strains on the
deficit. First, the weakened state of the economy caused
Year
–35
–30
–25
–20
–15
–10
–5
0
5
10
D e
fi c it
/G D
P ( %
)
Deficit/GDP Estimated
19 4 0
19 4 4
19 5 2
19 4 8
19 5 6
19 6 0
19 6 4
19 6 8
1 9 7 2
1 9 7 6
19 8 0
19 8 4
19 8 8
19 9 2
20 00
19 9 6
20 04
20 12
20 16
20 20
20 08
FIGURE 12.2 Deficits as a percentage of GDP: 1940–2021.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
peace dividend Money that was freed up for other spending priorities when the Cold War was over.
How Economists See the Deficit and the Debt 159
tax revenues to slow. Second, that weakening resulted in
increases in unemployment compensation, Medicaid, and
other welfare spending. Third, the financial collapse re-
sulted in the appropriation of $750 billion to the Troubled
Asset Relief Program (TARP) in an attempt to prevent a
global depression. Finally, a month after President Obama
was sworn in, he signed a $787 billion stimulus package.
Though not all of the money was spent in FY2009, defi-
cits surged past $1 trillion for that year and stayed above
that level until FY2012. The lack of agreement between
President Obama and Republicans in Congress resulted
in no significant deficit reduction. The tax increases
on high-income taxpayers and the sequester (automatic
budget cuts) of 2013 combined with a modestly growing
economy had the effect of reducing trillion dollar per year
deficits by 30 to 50 percent between 2013 and 2016.
How Economists See the Deficit and the Debt
As you know by now, economists see things differently
from the way many other people see them. Nothing is
more emblematic of that different viewpoint than the way
economists look at deficits and the national debt. When
noneconomists see that we have spent more than we have
paid in taxes, they see it as a problem. Only a minority of
economists believe that the current U.S. national debt rep-
resents a significant threat to current or future economic
health. This differs substantially from the position most
economists took in the early 1990s when the deficit was
large and growing and the debt and its interest obligations
were becoming rapidly burdensome. We next examine
why economists hold differing views on this matter.
Operating and Capital Budgets
To see things from an economist’s perspective, consider
first that the debt is made up of a series of budget defi-
cits over time. The next thing to realize about the budget
is that, again from an econo-
mist’s viewpoint, it is figured
all wrong. It should be divided
between operating and capital budgets. Things that are big, expensive, and will last several
years ought not be accounted
for in the same way as federal
purchases of toilet paper. High-
ways, dams, and buildings are
certainly going to be around for
a while, and it makes little economic sense to account for
them as though they are going to disappear at the end of
the year.
Away from government, what businesses normally do
with such large investments is to create a capital budget.
An investment in an asset with a long life simply has to
be able to generate profits over the years that are more
than sufficient to make payments on the asset. The ex-
penses of the business that go to pay for items that are
used up soon after they are paid for, like labor, paper,
and phone calls, go into an operating budget. As long as
the revenue of the firm is sufficient to cover the operat-
ing budget and make the appropriate payments on the
capital previously purchased, the business is fine, even
if it is carrying a large debt. If big corporations did their
accounting the way the federal government does, they
would rarely show a profit. When they did show a profit,
it would be a great deal smaller than usual.
One problem with separating a capital budget from an
operating budget is trying to figure out what spending is
an investment that should go into the capital budget and
what spending is not. Liberal politicians tend to argue
that nearly all social spending should be included in the
capital budget. Conservatives, on the other hand, usually
say that nearly all military spending should be included
in the capital budget. Each would label its spending rec-
ommendations as investments in the future and the oth-
er’s as spending on today. This distinction is important
because getting the budget to balance is harder as more
goes into the operating side. Moreover, balancing the
operating budget is more a political shell game than an
exercise grounded in fundamental economic principles.
Cyclical and Structural Deficits
Another way in which economists look at the defi-
cit differently from other people is that we divide it
between its structural and cyclical components. In
Chapter 6 we broke unemployment into three parts—
frictional, cyclical, and structural. We can do a similar
thing here. The part of the deficit that is attributable to
the economy’s not being at full
employment is called the cyclical deficit, and the part of the defi- cit that would remain even if
we were at full employment is
called a structural deficit. If the deficit is large because the econ-
omy is not doing well, then the
whole economy is the issue, not
the deficit. If the deficit is large
operating budget That part of the fed- eral budget devoted to spending on goods and services that will be used in the current year.
capital budget That part of the fed- eral budget devoted to spending on goods that will last several years.
cyclical deficit That part of the deficit attributable to the econ- omy’s not being at full employment.
structural deficit That part of the deficit that would remain even if the economy were at full employment.
160 Chapter 12 Federal Deficits, Surpluses, and the National Debt
even when the economy is doing relatively well, then the
deficit is a problem. Economists who think deficits can
be used to stimulate a lacklus-
ter economy consider that part
of the deficit attributable to the
“stimulus package” useful and
label it functional finance.
The Debt as a Percentage of GDP
There are other reasons why most economists did not
view the national debt (as it stood during the pre-2008
periods) as all that troubling. Among these was that,
as a percentage of national income, the national debt
was not anywhere near as high as it had been. If you
look at Figure 12.3, you will see that the ratio of na-
tional debt to the GDP was greater than 1 after World
War II and, while it increased to near .70 in the 1990s,
it fell sharply when in the late 1990s deficits turned
into surpluses. Of course, that lasted only a short time
as burgeoning deficits resumed bringing the debt-to-
GDP ratio back near the 70 percent level. With the
global economic downturn and the subsequent TARP
and stimulus plans all occurring in relatively short
order, the debt shot up to near 100 percent of GDP by
2011. Current projections suggest a debt level above
100 percent of GDP will exist through 2020.
Gross domestic product measures what we can afford
as a nation, and Figure 12.3 shows that we were in a
position that was similar to the average of our recent
history; yet with the debt above 100 percent of GDP,
a level not seen in quite some time, and with Medicare
and Social Security spending certain to rise much faster
than their funding sources, more economists are con-
cerned about the debt picture going forward.
International Comparisons
There is an even more compelling argument that the
state of the national debt has changed markedly in the
last five years. Though the relevant measure of debt dif-
fers among countries,3 what is clear is that government
debts have increased throughout the developed world.
As can be seen in Table 12.1, the U.S. debt-to-GDP ratio
was well within the norms of the rest of the world for the
period between 1970 and 2005. Though still nowhere
near the levels of Italy and Japan, this debt-to-GDP
ratio that had been significantly better than Canada’s
and Germany’s, and only somewhat worse than that of
the United Kingdom, is now noticeably worse than any
of those countries. The country that has really begun
to tread close to its ability to manage its debt is Japan.
Once held up as an example of fiscal rectitude, Japan,
functional finance That part of the budget attributable to programs designed to get an econ- omy out of a recession.
3OECD and World Bank definitions of public sector debt differ. The OECD
discontinued its published series. World Bank Gross PS includes all public
sector debt (including state/provincial/local). World Bank-Central includes only
the central government debt. These numbers differ greatly in more federal
systems (e.g., U.S. and Canada) and less in centralized systems (e.g., the U.K.).
19 40
19 44
19 48
19 52
19 56
19 60
19 64
19 68
19 72
19 76
19 80
19 84
19 88
19 92
19 96
20 00
20 04
20 08
20 12
20 16
20 20
140
120
100
80
60
40
Year
20
0
D e
b t/
G D
P ( %
)
Publicly held debt
Publically held debt (est.)Total debt (est.)
Total debt
FIGURE 12.3 Debt as a percentage of GDP: 1940–2021.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
Who Owns the Debt? 161
has seen its national debt balloon from 10.6 percent of
GDP in 1970 to more than 244 percent in 2015.
Generational Accounting
Some economists look at the deficit and surplus in a
completely different fashion. These economists, led by
Alan Auerbach and Laurence Kotlikoff, argue that, in-
stead of looking at the deficit as a meaningful number,
we should look at the “net tax rate” that the current
policies imply for future generations. To understand
their argument, recall the discussion of present value
from Chapter 7. These economists and others argue
that if you look at the difference between the pres-
ent value of what people of different generations pay
in taxes and the transfers that they get in government
benefits, you can compute a net tax rate. They claim
that this number has been getting steadily worse for
younger generations and that future generations will
face a terrible tax burden because of the deficits of the
1980s and 1990s and the entitlement crises of Social
Security and Medicare.
Who Owns the Debt?
The question of who owns the bonds that a nation sells
to finance its debt is an important aspect of any na-
tion’s debt. Although this may seem like an irrelevant
issue, you may be surprised to know that the U.S. gov-
ernment owes itself more than a quarter of the debt.
That is what separates the “Total” and “Public” debts
in Figure 12.3 and is the point of Figure 12.4. There
are two ways in which the federal government lends
itself money:
1. The Federal Reserve uses federal debt for purposes of
open-market operations.
2. The federal trust funds invest their money by lending
it to other parts of the federal government.
As you may see in the issues chapter on monetary
policy, the Federal Reserve of the United States (the
Fed) has three options for moving the economy: open-
market operations, changing key interest rates, and
changing the reserve ratio. Open-market operations are
activities that result in the Fed buying or selling bonds.
To get money into the economy, it buys bonds, and to
remove money from the system, it sells bonds. Since
the role of the Federal Reserve is to keep inflation
on an even keel, it must steadily increase the money
supply to keep pace with the growth in the economy.
Doing so requires that the Fed constantly buy bonds. In
this way the federal government owes itself a growing
amount of money. If you think that is silly, consider
that when the federal government borrows money from
itself it also pays itself interest, and, as a matter of fact,
in the early 1990s it was borrowing money from itself
to pay interest to itself.
The government also owes itself money through
the various trust funds it maintains for Social Security,
Medicare, highways, airports, and other smaller parts
TABLE 12.1 International comparisons of debt-to-GDP ratios.
Sources: www.oecd.org; databank.worldbank.org
Year Canada U.S. U.K. Germany Italy Japan
OECD
World
Bank
Gross
PS
World
Bank
Gross
Central OECD
World
Bank
Gross
PS
World
Bank
Gross
Central OECD
World
Bank
Gross
PS
World
Bank
Gross
Central OECD
World
Bank
Gross
PS
World
Bank
Gross
Central OECD
World
Bank
Gross
PS
World
Bank
Gross
Central OECD
World
Bank
Gross
PS
World
Bank
Gross
Central
1970 54.1 44.5 78.0 17.5 38.1 10.6
1975 44.9 42.8 62.1 23.1 57.4 20.2
1980 45.6 39.8 54.5 30.2 58.0 47.9
1985 66.3 53.5 59.4 41.6 82.1 64.2
1990 74.5 66.6 33.0 41.5 103.7 68.6
1995 100.3 131.2 74.9 74.2 83.1 70.0 52.7 49.0 46.8 57.2 125.5 87.1
2000 82.1 108.1 56.1 55.2 61.5 53.0 45.6 42.3 41.3 60.4 58.9 37.7 121.6 105.1 101.9 136.7 136.5 101.0
2005 70.3 94.5 42.9 62.4 78.5 56.3 46.5 43.7 42.4 71.1 66.9 40.8 120.5 101.9 96.8 177.3 182.1 143.6
2010 84.4 105.3 49.5 92.8 116.0 85.6 81.3 79.7 77.9 79.9 81.0 51.6 131.3 115.3 108.5 198.4 212.5 174.6
2015 113.1 47.1 124.4 97.0 94.3 92.8 71.9 45.9 134.6 129.4 244.4 207.0
162 Chapter 12 Federal Deficits, Surpluses, and the National Debt
19 40
0
10
20
30
40
50
60
70
80
90
19 44
19 48
19 52
19 56
19 60
19 64
19 68
19 72
Year
P e
rc e
n ta
g e
f e
d e
ra l d
e b
t
19 76
19 80
19 84
19 88
19 92
19 96
20 00
20 04
20 08
20 12
20 16
20 20
Trust funds Federal Reserve Public (non-Fed)
FIGURE 12.4 Who owns our debt? Percentage of the debt held by the public, trust funds, and the Federal Reserve.
Source: The Office of Management and Budget, www.whitehouse.gov/omb/budget/Historicals
of the government entities. By law, these trust funds
are allowed to invest their money in federal bonds only.
Given that these bonds are the safest investment on the
planet, this makes sense, but the bonds also return among
the lowest interest rates available. In any event, when
these programs bring in more money than they spend,
the excess is lent to other parts of the government and is
money that the government will not have to borrow on
the open market.
From Figure 12.4 we see that the amount of federal debt
that is held by the public tends to fall unless the deficit and
debt are rising quickly. When these are rising quickly, the
Federal Reserve is reluctant to buy a great amount of debt
in a short period of time because injecting large quanti-
ties of new money in the system can create inflation. Any
time large deficits are rung up, they have to be sold to the
public, and the overall proportion held by the public rises.
When the deficit is not large or we have a surplus, the per-
centage held by the public will fall. It is conceivable that if
we ran many years of large surpluses, the bulk of the debt
would be owed to the government itself.
On a more dreary note, we should remember that
the portion of the debt that the Medicare system owns
began to be sold to the public beginning in 2010.
That was when the expenses of the hospital portion of
Medicare first exceeded the tax payments that fund it.
That debt was transferred to the Treasury and then sold
to the public. Though the effect was slight at the time,
as the process continues, we can expect that the portion
of the debt held by the public will rise. Because of the
way we do the accounting now, the national debt will
not rise, but the amount that is important, the amount
held by the public, will.
Externally Held Debt
A concern that has arisen from time to time is the degree
to which our national debt is owed to foreigners. At points
in American history our national debt has been owed to
citizens of other nations. While we could consider this
flattering, in that these non-Americans view the United
States as a safe place for their savings, it can also be a
problem if too much of our debt is owed to foreigners.
Figure 12.5 demonstrates that, in large measure, the
Japanese and Chinese have loaned us much of the money
we have used to go on the federal spending and tax cut
spree of the 2000s. Our debt to citizens of Japan has
more than doubled since 2000 while our debt to Chinese
citizens has increased 14-fold. Of the nearly $18 trillion
in debt, 59 percent is owed to real people and of that
58 percent is owed to non-U.S. entities.
This presents a problem for the future in that even-
tually these investors will want their money back in the
form of goods and services. Foreigners are no different
than the rest of us: They save in order to buy something
later. When one U.S. citizen owes another U.S. citizen
money, the future state of the economy is not necessarily
threatened. On the other hand, when the U.S. taxpayer
owes money to foreign investors, part of the taxes that we
pay in the future will go to pay them interest rather than
to pay for schools, defense, or our criminal justice system.
A Balanced-Budget Amendment
One of the important debates of the final quarter of the
20th century was whether we need an amendment to the
U.S. Constitution requiring a balanced federal budget.
A Balanced-Budget Amendment 163
Year
Japan Mainland China
United Kingdom Caribbean banking centers
All others OPEC
2000
2,500
3,000
3,500
2,000
1,500
1,000
500
A m
o u
n t
o f
U .S
. T
re a
s u
ry ( b
il li o
n s )
0 2001 2002 2003 2004 2005 2006 2007 2009 2010 2011 2012 2013 20142008
FIGURE 12.5 U.S. debt owed to foreign entitites.
Source: www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfhhis01.txt
Economists are on both sides of this issue, but the major-
ity believe it is not a good idea. Those who are opposed
reason that an inflexible amendment could cause reces-
sions to turn into depressions because the provisions of
the amendment would mandate tax increases and spend-
ing cuts at precisely the time when just the opposite
would be needed. Those in favor of the amendment argue
that the politicians’ performance in the latter half of the
20th century is evidence of Congress’s inability to show
the discipline necessary to bring budgets into balance.
Balancing the federal budget, it is argued, is necessary to
generate low interest rates, which bring about long-term,
investment-led growth.
Opponents of balanced budgets and of a constitu-
tional amendment that makes them mandatory offer
their best argument against a balanced-budget amend-
ment by appealing to the aggregate supply–aggregate
demand model that was explained in Chapter 8. The left
panel of Figure 12.6 depicts this model and what would
happen if we entered a recession. If aggregate demand
were to shrink from AD1 to AD2 and a balanced-budget
amendment were not required, two things would happen:
(1) People would make less money and therefore pay less
in taxes, and (2) people would require more assistance
from government and spending would have to rise. This
would happen without any new laws having to be passed.
This nondiscretionary fiscal policy is built into the sys-
tem and is called a built-in stabilizer. This stabilizer
would result in aggregate demand’s getting a boost back
in the direction it came from, perhaps AD 3 . If a balanced-
budget amendment were in place, we would be without
the built-in stabilizer and the movement back to AD3
would not happen. A recession would thus be worse than
it would be if it were to come along now.
Of course the opposite could happen, and the right
side of Figure 12.6 depicts that eventuality. Because
spending on welfare programs and unemployment ben-
efits would fall and tax revenues would rise, an increase
in aggregate demand would result in surpluses. With-
out a balanced-budget requirement (that might force the
money to be spent or taxes cut), aggregate demand would
fall back to AD3. With such a requirement, aggregate
164 Chapter 12 Federal Deficits, Surpluses, and the National Debt
demand would not bounce back and the economic
boom would be more extensive than otherwise. What
this means is a balanced-budget
amendment would be procyclical because good times would be even
better and bad times even worse
than they would be without such a
requirement. This “boom or bust” phenomenon was part
of the economic landscape of the 19th century. Avoiding
that outcome has been one of the successes of the eco-
nomics profession in the post–World War II era.
The best argument for mandating a balanced budget
in some way, however, is that an elimination of federal
borrowing would go a long way to reducing interest rates.
The results of the 1990s support the idea that reducing the
deficit can create a virtuous cycle in which lower defi-
cits create lower interest rates. With lower interest rates
the economy grows, tax revenues increase, the deficit de-
creases even more, and so on. While this occurred without
a balanced-budget amendment in the late 1990s, the 1960s
through the early 1990s was a period of extensive borrow-
ing with little fiscal discipline by either political party.
In the 1990s both the Republican and Democratic par-
ties claimed that reducing the federal deficit was impor-
tant. Both parties, under President Bush (George Herbert
Walker) with a Democratic Congress and President Clin-
ton with a mostly Republican Congress, attempted to re-
duce the deficit. Each did it with means consistent with
their own party’s philosophy. They were successful be-
cause a reduction in the demand for loanable funds by the
federal government translated into lower interest rates. In
particular, mortgage interest rates were lower during this
period than they had been in 30 years. Lower interest rates
meant more business investment as well. What ensued
was the most dramatic drop in the deficit and the longest
peacetime expansion since the end of World War II.
Both proponents and opponents of such an amend-
ment point to the behavior of the states during the 1990s
and early 2000s. Opponents note that the fiscal crises the
states experienced between 2002 and 2006, and again in
2009, were a direct result of the constitutional require-
ments to have balanced budgets. Though the constitu-
tions of the states are varied in this regard, they generally
suggest that they can spend no more than the revenue
for that year plus their built-up reserve. This essentially
requires that they have a cyclically balanced budget, one
that is in balance over the business cycle. An annual
balanced-budget requirement would not let a state cre-
ate or utilize a reserve. What occurred in many states,
though, was that the shortfall in revenues lasted longer
than the reserve. Many states raided their state employee
pension funds and delayed payments to local school dis-
tricts and state universities, forcing them to borrow to
meet their needs, all in an effort to have a “balanced bud-
get.” Opponents argue that governments will resort to
these and other “smoke and mirror” tactics when forced
to render any balanced-budget amendment meaningless.
The arguments relating to a balanced budget amend-
ment were rendered moot when, in 2008, the federal
government borrowed hundreds of billions of dollars
for the spring 2008 stimulus and especially after the fall
2008 TARP plan required the federal government to bor-
row nearly a trillion dollars to save the financial system
from meltdown.
procyclical Situation that renders good times better and bad times worse.
AD2 AD3
AD1
AS
RGDP
P ri
c e
l e
v e
l
AD2
AD3 AD1
AS
RGDP
P ri
c e
l e
v e
l
FIGURE 12.6 Built-in stabilizers at work.
Projections 165
The initial Obama budget, curiously if not ironically
named “A New Era of Responsibility,” called for annual
deficits of more than $1 trillion for 2009 and 2010 and
deficits above $700 billion for many years after that.
It has turned out that the deficit picture was somewhat
worse than that with trillion dollar deficits extending into
2012. It is important to understand, though, that the ma-
jority of economists would acknowledge that imposing a
balanced budget in this period would have seriously di-
minished the government’s ability to stabilize the econ-
omy. Economists, even those among a group that might
be called deficit “hawks,” were not upset by the record
deficits of 2009 and 2010. The fear of these economists
is that without a serious reduction in the deficit over the
course of the next few years, when the large Medicare
and Social Security bills due to retiring baby boom-
ers come due, there will be little ability of the federal
government to make good on those promises, even with
borrowed money.
Economists are all over the map in terms of how and
when these deficits should be closed. Some, like Paul
Krugman, believe that the real concern is down the road
and that tax increases (especially on the wealthy) will be
enough to close the deficit to manageable levels. Others,
like John Taylor, believe that it should not only be sooner
rather than later but should be accomplished with entitle-
ment reform. Still, almost no economist of any reputa-
tion believes that a balanced budget requirement would
have been helpful during the 2008–2011 period.
Projections
In the movie Major League, a 1989 baseball comedy,
the character played by real-life Milwaukee Brewers
announcer Bob Uecker suggests that a pitch that ends
up in the stands was “juuuuuust a bit outside.” In terms
of projecting the deficit/surplus picture, the Congres-
sional Budget Office and the Office of Management
and Budget have similarly missed the target. In 1990
both were projecting “deficits as far as the eye could
see.” In 1995 they each projected a shrinking deficit.
Five years later they projected that “we would be debt
free by 2010.” Two years after that, it was deficits now,
surpluses later.
Figure 12.7 illustrates the rapidly changing projections,
but the year 2005, in particular, illustrates the degree of
misestimation. In 2000, the prediction for 2005 was that
there would be a surplus approaching $402 billion. The
year actually came to a close with a deficit of more than
$400 billion. As a result, the estimates produced in 2000
missed the mark by $800 billion (or one-third the size of
the federal government).
How could they get it so wrong, so often, and still be
given any credibility? In an April 2003 report, the Congres-
sional Budget Office makes a pretty good case that it wasn’t
their fault. They argue that taking into account the things
that occurred during this period, they did a pretty good job
in short-term projections. They also argue that longer-term
projections are given more weight than they are due.
–1,500
–1,000
–500
0
500
1,000
Year
1985 Outlook
2000 Outlook
1995 Outlook
2010 Outlook2005 Outlook
1990 Outlook
Actual2015 Outlook
19 8 5
19 8 7
19 8 9
1 9 9 1
19 9 3
19 9 5
19 9 7
19 9 9
2 0 0 1
20 0 3
20 0 5
20 0 7
20 0 9
2 0 11
2 0 13
2 0 15
20 23
20 25
2 0 2 1
2 0 19
2 0 17
FIGURE 12.7 Deficit and surplus projections of the past.
Source: “The Budget and Economic Outlook: An Update,” 1985–2015, Congressional Budget Office, www.cbo.gov
166 Chapter 12 Federal Deficits, Surpluses, and the National Debt
Consider these factors: No one foresaw that the
economy would grow at twice the projected rates in
the late 1990s. No one projected that the stock markets
would grow as quickly as they did during this period
such that taxable capital gains income would increase
700 percent. No one projected that the 2000 presiden-
tial election would insert so much uncertainty into the
economy and push it into a recession in 2001. They
had no way of knowing in 1995 that George W. Bush
would take over as president and get a tax cut enacted
in 2001 and 2003. They certainly could not have taken
into account in 2000 that Al-Qaeda would attack the
United States or that we would respond by going to
war in Afghanistan and Iraq in 2002 and 2003. Finally,
few saw the economy of 2008 and 2009 “falling off a
cliff,” as Berkshire Hathaway chairman Warren Buffett
described it. Still, the “outlook” lines on the graph are
all upward sloping, meaning that the OMB and CBO
are always projecting a better future when the reality is
that there are ups and downs.
Summary
You now understand how economists look at federal
budget deficits and surpluses and the national debt.
You know that deficits have been more often than not
caused by wars and that economists are less interested
in the raw numbers of the debt and deficits than in more
sophisticated measures of them. You now are aware of
U.S. economic history and that comparisons with other
countries indicate that the United States had a relatively
moderate national debt-to-GDP ratio, but that the defi-
cits of the period from 2008 to 2012 have raised debt
concerns dramatically. You know that the federal gov-
ernment actually owns much of the debt, and you should
understand why economists are mostly against an
amendment to the U.S. Constitution that would mandate
that it maintain a balanced budget. Finally, you now see
that the deficit–surplus picture changed substantially
between 1996 and 2001 and changed again as a result
of the 2001 recession, the September 11, 2001, terrorist
attacks, the wars in Afghanistan and Iraq, and the reces-
sion of 2007–2009.
Key Terms
budget deficit
budget surplus
capital budget
cyclical deficit
functional finance
national debt
off-budget
on-budget
operating budget
peace dividend
procyclical
structural deficit
Quiz Yourself
1. In 2015 the national debt was approximately
a. $18 million.
b. $18 billion.
c. $18 trillion.
d. $18 quadrillion.
2. The off-budget–on-budget distinction
a. is important because two large programs, Social
Security and Medicare, largely run off-budget.
b. is a historical fiction.
c. deals with long-lasting products of government
(like roads and bridges).
d. is important because defense is run off-budget.
3. The U.S. budget
a. is required to be balanced.
b. is never truly balanced, but historically
surpluses are more common than deficits.
c. is never truly balanced, but historically
surpluses are less common than deficits.
d. is typically balanced except in time of war.
4. The $400 billion deficits of 2005 were
a. accurately forecast by the Office of Management
and Budget in 2000.
b. accurately forecast by the Office of Management
and Budget in 2002.
c. accurately forecast by the Office of Management
and Budget in 2003.
d. much higher than any previous Office of
Management and Budget forecast.
Summary 167
5. The portion of the national debt owed to citizens of
other countries
a. is economically irrelevant however big it is.
b. is economically important, but it has been
falling in recent years.
c. is economically important and it has been rising
in recent years.
d. is practically inconsequential because it is so
small.
6. When looking at a balanced-budget amendment to
the U.S. Constitution, economists
a. are universally opposed to it.
b. are universally in favor of it.
c. are of two minds with opponents concerned
about its procyclical nature.
d. are of two minds with proponents excited about
its procyclical nature.
7. By way of international comparison, recent U.S.
deficits have increased the ratio of debt to GDP
a. such that the United States has the highest ratio
in the industrialized world.
b. but every other industrialized nation’s ratio is
much worse.
c. but the United States ratio is still lower than that
of Germany, Canada, and Japan.
d. such that only Japan’s ratio is worse.
Short Answer Questions
1. If you ranked eras in terms of times in which the na-
tional debt was the biggest, what measures could you
use and why? How would the measures differ when
ranking the deficits of the 1940s, 1980s, and 2010s?
2. Why might you distinguish between borrowing to
rebuild roads and bridges and borrowing to increase
food stamp allocations?
3. Suppose the deficit were to be $300 billion during nor-
mal times, but increases to $500 billion because we are
in a recession, then increases again to $600 billion be-
cause the government attempts to stimulate the econ-
omy. Which of these amounts are the structural deficit
and the cyclical deficit and which amount represents
functional finance?
4. Explain why to whom a country owes its money
matters in terms of the true burden a national debt
will have on future generations.
5. Explain why what deficit spending buys matters in
terms of the true burden a national debt will have on
future generations.
Think about This
The United States and China have had foreign policy dis-
putes in the past. The most problematic situation could
arise over the status of Taiwan. Does owing Chinese
investors nearly $1 trillion make this problem more or
less likely to come to a head? Does economic interdepen-
dence promote peace?
Talk about This
What is the opportunity cost of running a high deficit?
How might this opportunity cost depend on the shape of
the supply curve for loanable funds? What does it tell
you about the supply curve for loanable funds when in-
terest rates remained low even while the United States
went from a $200 billion surplus to a $1.5 trillion deficit
over 15 years?
For More Insight See
Journal of Economic Perspectives 10, no. 1 (Winter
1996). See articles by Alan J. Auerbach, Ronald Lee,
Jonathan Skinner, and Douglas Bernheim.
Ronald, Lee, and Jonathan Skinner, “Will Aging Baby
Boomers Bust the Federal Budget?” Journal of Eco-
nomic Perspectives 13, no. 1 (Winter 1999).
Behind the Numbers
Total United States off-budget, on-budget and total deficit,
surplus, debt, debt sources 1940–2012.
Budget of the United States Government, historical tables—
www.whitehouse.gov/omb/budget/Historicals
U.S. GDP 1940–2006.
Bureau of Economic Analysis—www.bea.gov
International comparisons of gross debt-to-GDP ratios.
Statistical Abstract of the United States; comparative
international statistics—www.oecd.org
CBO projections.
Congressional Budget Office; The Budget and Economic
Outlook: an update, multiple years—www.cbo.gov
C H A P T E R T H I R T E E N
168
The Housing Bubble
In this chapter you will learn about the U.S. housing mar-
ket, mortgages, and lending practices. Specifically, you
will learn how, fundamentally, housing prices are deter-
mined, and how housing prices are determined in a hot,
bubble market. Finally, you will learn how the bursting
of such a bubble in 2006 and 2007 was only the first wave
of housing foreclosures and how the combination set off
the worst economic spiral in at least 27 years.
How Much Is a House Really Worth?
As you can see from Figure 13.1, between 1997 and mid-
2006 housing prices in many major urban areas rose much
faster than overall inflation (as measured by core PCE)
and much faster than housing prices in other areas. This
housing price index, created by economists Karl Case
and Robert Shiller, has a base year of 2000 and measures
the increase in prices in major metropolitan areas. While
the price of all goods consumers buy (excluding food and
energy) increased about 13 percent between 2000 and
2006, and while home prices in Dallas and Cleveland
increased a mere 25 percent, home prices in Miami and
Los Angeles had almost tripled. Starting in mid-2006, the
housing market in many metropolitan areas collapsed.
Learning Objectives
After reading this chapter you should be able to:
LO1 List the fundamental determinants of housing prices.
LO2 Compare and contrast the components of a traditional
mortgage, an interest-only mortgage, and a negative
amortization mortgage.
LO3 Discuss how a bubble can be created in a market based on
unrealistic expectations.
LO4 Summarize the consequences of a burst housing bubble on
the U.S. economy.
Chapter Outline
How Much Is a House Really Worth?
Mortgages
How to Make a Bubble
Pop Goes the Bubble!
The Effect on the Overall Economy
Summary
Home prices in Phoenix dropped 41 percent, while those
in Las Vegas and Miami dropped 39 percent and 38 per-
cent, respectively. To understand why this happened, we
need to remember some fundamentals from the definition
of opportunity cost, from supply and demand, and from
interest rates and present value.
The key ingredients in what a house is fundamentally
worth pertain to the opportunity cost of the land upon
which the home sits, the cost of labor and materials in
the community, the characteristics of the home itself,
and the income of the likely potential buyers.
Referring back to Figure 13.1, the reason Dallas’s home
prices never increased at the rate of those in other areas is
that buildable land is abundant in north-central Texas. The
area is flat, with relatively few alternative uses. Unlike Los
Angeles, San Francisco, or Miami, Dallas has almost no
physical barriers to expansion. This means that the supply
of buildable land is quite elastic. That doesn’t mean land
is created, but rather land use is changed from ranching to
residential use and this can be done very easily. So even
if there is a significant increase in the demand for homes,
the price of an existing house can, therefore, not increase
beyond that of the alternative of building a new one. While
building farther away from the city center (and there are
actually two city centers because Ft. Worth is practically
How Much Is a House Really Worth? 169
the cities are not randomly distributed geographically.
California has 17 of the top 20 least affordable cities and the
Midwest is home to 15 of the top 20 most affordable.
Population growth also figures into the equation. The
city of Detroit is the only city in the world to have gone
from a population exceeding 2 million to a population of
less than 1 million. This means that for every new home
that is built, more than one home will go vacant. In grow-
ing areas, new neighborhoods spring up constantly. The
Atlanta metropolitan area has seen an increase in home
prices based almost entirely on its increase in population.
Though the housing bubble of the early 2000s burst
later in the decade, the result of the last few years has
been a slow increase in home prices in those cities that
experienced it. The cities of Los Angeles, Miami, and
Washington, D.C., have each experienced significant re-
coveries from their lows. After increasing to 275 percent,
280 percent, and 250 percent of their January 2000 level,
respectively, when the bust ended houses were priced at
only 160 percent, 139 percent, and 175 percent of their
2000 levels. The recovery from 2010 to 2015 allowed for
each to regain about half their respective losses.
next door) can be inconvenient, resulting from the longer
commute, most home buyers would gladly drive 10 to
20 minutes longer per day if they can save tens of thou-
sands of dollars on the price of the home.
The supply of buildable land in Los Angeles, San
Francisco, and Miami is quite inelastic because there are
oceans, beaches, environmental regulations, and either
swamps or mountains that render some land unsuitable
for residential building. An increase in demand for homes
in these cities will inevitably result in higher prices.
The next biggest factors in explaining home prices are
demand-side factors such as the characteristics of the home
and the income of the buyers. That a home with all modern
amenities will sell for more than an older one in need of
repair is obvious. Similarly obvious is that the income
of a community’s potential buyers matters as well. The
Department of Housing and Urban Development estimated
median family income in San Francisco and Washington
D.C. is substantially higher (nearly $100,000) than median
family income in Dallas and Cleveland (about $60,000).
Table 13.1 ranks cities on housing affordability using the
ratio of median housing prices to median income. Clearly,
FIGURE 13.1 Case-Shiller indices.
Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2
Phoenix
Miami
Dallas
Los Angeles
Las Vegas
Composite-10
Washington
Cleveland
Core PCE
0.00
50.00
100.00
150.00
200.00
250.00
300.00
C a
s e
-S h
il le
r h
o m
e p
ri c e
i n
d e
x ( J a
n 2
0 0
9 =
1 0
0 )
Ja n-
97
Ja n-
98
Ja n-
99
Ja n-
00
Ja n-
01
Ja n-
02
Ja n-
03
Ja n-
04
Ja n-
05
Ja n-
06
Ja n-
07
Ja n-
08
Ja n-
09
Ja n-
10
Ja n-
11
Ja n-
12
Ja n-
13
Ja n-
14
Ja n-
15
170 Chapter 13 The Housing Bubble
Mortgages
As we learned in Chapter 7’s review of present value
and interest rates, the mathematics of amortization are
relatively straightforward. In determining a car payment
or a mortgage payment, you find the monthly payment
that will pay off the debt, at a particular interest rate,
over a particular period of time. A mortgage, besides
being a formal piece of paper, is a payment scheme de-
signed to bring the original debt to zero over a period
of time. In the good old days, when your grandparents
bought a home, mortgages were all structured the same.
The home buyer would be required to pay 20 percent
of the value of the home, and the bank would loan the
remaining 80 percent. On top of that, your grandparents
were compelled to provide verifiable documentation
of their income, assets, and debts. Even if they had the
20 percent to put down on the home, if their mortgage
payment, their estimated annual property taxes, and
home owners insurance were more than 30 percent of the
verifiable income, your grandparents’ banker would have
been reluctant to lend them the money. They would have
counseled your grandparents to buy a smaller home. A
final aspect of “old-fashioned” mortgages was that your
grandparents’ banker would have held the mortgage.
This meant that if your grandparents defaulted on their
mortgage, their hometown bank would take the loss.
To understand how your grandparents’ mortgage would
work, look at Table 13.2. In a traditional mortgage the pay-
ment lasts for 30 years. Though home prices have risen
substantially from the time they bought their first home
and interest rates have fluctuated between 4.5 percent and
12 percent during that time, to be clear, let’s do an apples-to-
apples comparison as we compare the old-fashioned mort-
gage with the newer ones. Let’s assume a loan of $250,000,
for 30 years, at 5 percent interest. A financial calculator or a
spreadsheet program can help you compute the payment to
be $1,342 per month. That is $1,342 the first month, the last
month, and every month in between.
Now let’s turn to the evolutionary and revolutionary
changes that have occurred in the mortgage market. The
first significant change came in 1968 when Congress spun
off the Federal National Mortgage Association (more com-
monly known as Fannie Mae) and
authorized it as a government-
sponsored enterprise to buy home
mortgages from banks and other
financial institutions that wrote
them. It would securitize them; that is, it bundled those mortgages
TABLE 13.1 Most affordable and least affordable places to live.
Sources: National Association of Home Builders, www.nahb.com
Least Affordable Most Affordable
1 San Francisco–San Mateo–Redwood City, CA 1 Glens Falls, NY
2 Los Angeles–Long Beach–Glendale, CA 2 Sandusky, OH
3 Santa Ana–Anaheim–Irvine, CA 3 Syracuse, NY
4 Santa Cruz–Watsonville, CA 4 Kokomo, IN
5 Salinas, CA 5 Springfield, OH
6 San Jose–Sunnyvale–Santa Clara, CA 6 Rockford, IL
7 Napa, CA 7 Lima, OH 8 Santa Rosa–Petaluma, CA 8 Monroe, MI
9 New York–White Plains–Wayne, NY–NJ 9 Elizabethtown, KY
10 San Diego–Carlsbad–San Marcos, CA 10 Binghamton, NY
11 San Luis Obispo–Paso Robles, CA 11 Utica–Rome, NY
12 Oxnard–Thousand Oaks–Ventura, CA 12 Mansfield, OH
13 Oakland–Fremont–Hayward, CA 13 Battle Creek, IM
14 Santa Barbara–Santa Maria–Goleta, CA 14 Fairbanks, AK
15 Honolulu, HI 15 Lansing–East Lansing, MI
16 Riverside–San Bernardino–Ontario, CA 16 Springfield, IL
17 Stockton, CA 17 Youngstown–Warren–Boardman, OH–PA
18 Fresno, CA 18 Cumberland, MD–WV
19 Modesto, CA 19 Salisbury, MD
20 Bend, OR 20 Harrisburg–Carlisle, PA
securitize The process of bundling nonfinancial assets (typically mortgages) together and then resell- ing them as either shares or as financial instru- ments to investors.
171
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172 Chapter 13 The Housing Bubble
mortgage converts to a standard type and the balance is
paid off over the remaining years.
Now let’s compare the tradi tional mortgages to the
interest-only mortgages and negative-amortization mort-
gages. Again, comparing apples to apples, suppose the
home owner is borrowing $250,000, for 30 years, at 5 per-
cent interest. Looking at Table 13.2 you see that an interest-
only mortgage saves the buyer $300 per month for however
long the interest-only period lasts, but the payment increases
substantially once the mortgage converts to a traditional
version. Because with most negative-amortization mort-
gages, the borrower gets to choose how much to pay during
the initial payment period, let’s assume they take an option
of paying half the interest they owe each month. As a result
the outstanding balance rises, so the payment rises, albeit
very slowly until the point were it converts to a traditional
mortgage, and then the payment nearly triples.
These interest-only and negative-amortization mort-
gages were popular with home buyers because they al-
lowed someone of modest means to get into a home they
might otherwise not be able to afford. What is unclear
is the degree to which borrowers adequately understood
the terms of these mortgages. They may have simply not
read their documentation, or they may have been convinced
that regardless of how high their mortgage payments rose,
the ever-increasing value of their home would allow them
to take out a second mortgage with a home equity line
of credit. Of the interest-only and negative-amortization
mortgages issued during 2006 and 2007, approximately
half came with built-in home equity lines of credit.
How to Make a Bubble
As NASDAQ investors of the late 1990s discovered,
bubbles are created by the expectation of higher prices
causing people to buy assets based on that expectation
rather than fundamentals. When you are told to “buy now
before the price goes up” and you do, you only add to the
volume of the bubble. People buy on the expectation that
prices will rise faster than their ability to afford those
same assets later so they become convinced to buy now.
What really gets a bubble going is borrowed money. If
you had to put 20 percent down on a home, the increased
price would affect your ability to react to that expecta-
tion. With the ability to put nothing down, and pay only
half the interest, the buyer’s ability to continue fueling
the bubble is sustained, not diminished.
As NASDAQ bubble-riders remember, bubbles are
fun when they go up. Why? Suppose you bought that
$250,000 home in Miami in January 2002. Suppose you
together and then sold shares of itself to investors. In so
doing, it spread the geographic risk of mortgages that re-
sulted from banks holding a significant portion of the
portfolios in local markets. This reduced the risk to any
one bank of going bankrupt as a result of a local economic
downturn. In so doing, this reduced the risk to investors and
thereby reduced home mortgage interest rates. Its sister or-
ganization, the Federal Home Loan Mortgage Corporation
(commonly known as Freddie Mac), was founded in 1970
and did much the same thing except that it focused on sell-
ing these bundled mortgage-backed securities to other in-
vestors. Neither the principal nor the profits of either entity
was explicitly guaranteed by the federal government, but
investors believed there to be an implicit understanding that
should these entities have difficulty, the federal government
would back them.
Beginning in the late 1980s, mortgages began to
spring up where the buyer would have to put down only
5 percent or 10 percent. Though they would have to pay
for an insurance policy (that would pay the bank in case
of default), this opened up home buying as an option for
millions of Americans. In the early part of this decade,
zero-down mortgages became
common. Only paperwork costs
would be charged when the
house was sold.
Beginning in 2002, interest- only mortgages and even negative-amortization mortgages began to spring up. An interest-
only mortgage, as the name sug-
gests, has the buyer paying only
interest for the first few (typically
5 or 10) years of a mortgage and
then paying off the balance over
the remainder of the mortgage. A
negative-amortization mortgage
does much the same thing, except
that buyers get to choose how
much they want their payment
to be in the first few years of
the mortgage. These pick-a-pay mortgages (also known as pay option adjustable rate mortgages)
would typically have the buyer
paying about half the interest
accrued each month on the mort-
gage so the outstanding balance
on the mortgage would rise over
time. After a few years, the
interest-only mortgage A mortgage that allows the buyer to pay only the interest portion of the typical payment for the first few years of a mortgage. The mortgage would reset to a tradi- tional mortgage after that period, typically at a higher payment.
negative-amortization
mortgage A mortgage that allows the buyer to pay less than the interest portion of the typical payment for the first few years of a mortgage. The mortgage would reset to a traditional mort- gage after that period, typically at a higher payment.
pick-a-pay mortgage A variety of negative amortization mortgage that allows the buyer to choose a payment for the first few years of a mortgage.
Pop Goes the Bubble! 173
borrower might better under-
stand the features of a mortgage
(such as the tripling of the re-
quired payment after year 5).
Some in the financial system began to openly worry
about the impact of a collapse of the mortgage market. This
fear created an instrument that, perversely, only added to
the bubble. By the middle of the decade, it became more
difficult to sell the securitized mortgages because of the
growing fear of foreclosures. The same entities that bought
the mortgages, securitized them, and then sold them to
investors, now offered to sell the investors credit default swaps. In this case, the credit default swap acted like an insurance policy that promised to pay the holder of the se-
curitized mortgage should the borrowers fail to pay their
debts. This satisfied the investors’ concern for security and
kept the bubble going. The problem was that these insur-
ance policies were not regulated like typical insurance
policies. A typical home owners or auto insurance com-
pany is compelled to have sufficient capital to pay claims
and is often required to carry reinsurance. Though credit
default swaps are, most certainly, insurance policies, those
that sold them were not regulated as if they were. Though
some in Congress and others in regulatory bodies began
to question these practices, the underlying feel-good story
of record rates of home ownership and increasing home
owner wealth (at least paper wealth) overwhelmed these
voices of concern. This was the now infamous AIG’s most
profitable line of business for several years prior to its
needed bailout by the Federal Reserve.
Pop Goes the Bubble!
What the feel-good story relies upon heavily is the fiction
that home prices only go up. Home prices can fall. Imag-
ine this story somewhat differently. Suppose the price of
the home falls from $250,000 to $200,000 because the home
was only 1,500 square feet to begin with, had few amenities,
and was in a relatively unattractive neighborhood. That is,
suppose the fundamentals start to take over and the specula-
tive demand to buy a house at any price goes away, meaning
that the only reason its price exceeded what was rational for
its location was a bubble mentality (like NASDAQ in 1999
and 2000). Now the poor home owner, who paid $250,000
for a home that is worth only $200,000, must pay $1,656
per month because he or she owes $283,250.
What are the options? Not many. First, if the home
owners sell the home they are in, they will owe $83,250
plus real estate fees of approximately $12,000 more, and
put nothing down and took out a negative-amortization
mortgage. In Miami, from January 2002 to January
2007, the average home more than doubled in value.
So you may owe $283,250 on the house you bought
for $250,000, but who cares? It’s now worth $500,000.
Having trouble making the payments that have now in-
creased from $589 per month to $1,656? No problem.
You now have $216,750 in equity in that home and since
you signed up for a home equity line of credit when you
signed up for the mortgage, you can use your home like
an ATM. You can even buy an SUV and take a vacation!
While that explains the demand side of the housing
bubble, bubbles require calamitous mistakes on both the
demand side and the supply side. So you may be asking
why banks would lend money to these borrowers. This
takes us back to the first of the evolutionary changes in
the mortgage market: securitization. While your grand-
parents’ mortgage was owned by their local bank, these
mortgages were immediately sold. It was no longer part
of the local banker’s job to counsel home buyers against
borrowing more than they could afford. Remember that
old 30 percent rule? The banker no longer cared that you
could not afford the payment because the banker was going
to sell the mortgage within days of writing the mortgage.
If you defaulted on the mortgage, it was someone else’s
problem. In addition, about half of negative-amortization
mortgages were “liar loans” in that the bankers who wrote
the mortgages purposefully did not verify the income or
assets of the borrower. They merely consulted the credit
agencies. If your credit was good enough that they could
sell your mortgage to Fannie Mae or Freddie Mac, they
wrote the mortgage and sold it within days.1
There is one other aspect of the modern mortgage mar-
ket that may have contributed to the mess, and that is the
noticeable absence of the intimidation involved in the clos-
ing process. Your grandparents sat across the table from a
banker who went through each piece of paper associated
with the mortgage. Your grand parents paid very close at-
tention, in part because they were afraid that if they didn’t,
somehow the mortgage would not go through. Today, a
click here or a phone call there, and you can be approved
by a mortgage company with no local interests whatso-
ever. That means that you get a package of papers that you
simply have to take down to a notary public (a designation
of a person that certifies that the person signing is indeed
the named party) and sign where the “sign here” tabs are
located. This eliminates one of the places where a
1They may still take your payment every month, but they are only servicing it.
They send that payment to the true owner.
credit default swap Insurance on a mortgage-backed security.
174 Chapter 13 The Housing Bubble
taxes would be well above 30 percent of their income
in the “bubble” cities. One estimate in 2008 suggested
that 1 in 6 households in the United States was above this
30 percent guideline and that 1 in 20 was paying more
than half of its income in housing costs. Given that, it is
no wonder that home prices stopped rising in 2006.
The shakeout after the collapse in housing has had a
notable impact on the ability of the median-income fam-
ily to afford the median home in these markets. At the
peak of housing prices in 2006, with a 6 percent mortgage
a median family would have to spend 43 percent of their
income on housing in Las Vegas. In 2015, that was down
to 32 percent. There are three basic reasons housing was
more affordable in 2015 than 2006: prevailing mortgage
interest rates were 4 percent rather than 6 percent, hous-
ing prices were lower by about 20 percent, and median
incomes were at least near their 2006 level.
The Effect on the Overall Economy
At the beginning, the bursting of the housing bubble had
a modest impact slowing the rate of growth of the overall
economy in 2006 and 2007 by about 1 percent. By late
2007 and into 2008, as foreclosures ballooned, the im-
pact snowballed. It was not until the fall of 2008 that the
true impact of the crisis came to light. In order to avoid
a massive financial meltdown, the Treasury Department
took ownership of both Fannie Mae and Freddie Mac, the
Federal Reserve took a significant ownership stake in the
insurance giant AIG, and Congress passed the Troubled
Assets Relief Program (TARP) to save the nation’s largest
banks from the consequences of their ill-advised practices.
they will have no home. If they do not have that in savings,
they will have to negotiate some other noncollateralized
loan to pay off that amount before they can buy another
home. Their only option to get out from under the massive
debt is bankruptcy. This is a very bad option because they
not only lose the home in which they live but they become
unable to buy another home for years to come. Of course,
they also eliminate their ability to buy cars, furniture, or
anything else on time as well. Their ability to go on vacation
is quashed by their inability to qualify for credit cards, and
their ability to pay off their existing credit card debt is elimi-
nated because they no longer have equity in their home.
People who used this form of negative-amortization
loan to purchase a home did so either because they be-
lieved their income in a few years would be sufficient to
cover the increased mortgage payment, or they believed
that housing prices would continue to rise, or they believed
that a combination of the two would cause everything to
turn out in the end. Unfortunately, it didn’t “turn out in
the end” for many borrowers. Beginning in 2006 foreclo-
sures and near foreclosures (homes more than 30 days in
arrears) began to skyrocket. In 2007, foreclosures were
up 51 percent, and in 2008 they were up 82 percent. In
Nevada in early 2009, 1 in 14 homes was in some sort of
foreclosure process. In one month alone, November 2008,
1 in 76 homes in Nevada received foreclosure paperwork.
The hardest hit states were California, Nevada, and Flor-
ida. It is not hard to see why. Consider Table 13.3 and
the ability of the median family, with median income, to
buy the median house in those locations we examined in
Figure 13.1. Even if they chose a conventional mortgage,
their 2006 mortgage payments, insurance, and property
Median
Family
Income1
Median Sale
Price of an
Existing Single-
Family Home2
Approximate
Annual Mortgage
Payments
(30 years)
Approximate
Home Owners
Insurance*
Approximate
Property Tax*
Total Annual
Housing
Costs
Home Costs as
a Percentage
of Income
2006 2015 2006 2015 2006 (6)% 2015 (4)% 2006 2015 2006 2015 2006 2015 2006 2015
Phoenix $64.0 $64.2 $218.8 $257.4 $12.5 $18.5 $2.0 $2.0 $4.0 $4.0 $18.5 $24.5 38.2% 29.0%
Los Angeles 63.0 59.8 506.8 589.2 29.0 42.4 2.0 2.0 4.0 4.0 35.0 48.4 80.9 55.6
Washington 109.2 97.2 388.6 430.8 22.3 31.0 2.0 2.0 4.0 4.0 28.3 37.0 38.1 25.9
Miami 49.9 49.2 290.0 365.5 16.6 26.3 2.0 2.0 4.0 4.0 22.6 32.3 65.6 45.3
Las Vegas 59.2 63.9 221.5 297.7 12.7 21.4 2.0 2.0 4.0 4.0 18.7 27.4 42.9 31.6
Cleveland 66.1 62.1 132.0 130.0 7.6 9.4 2.0 2.0 4.0 4.0 13.6 15.4 24.7 20.5 Dallas 70.4 65.0 210.0 150.9 12.0 10.9 2.0 2.0 4.0 4.0 18.0 16.9 25.9 25.6
TABLE 13.3 Measuring housing affordability in major cities.
*Author estimate.
1Source: HUD estimated from Home Mortgage Disclosure Act reports
2Source: National Association of Realtors
Summary 175
that the recovery in housing, if
it has occurred at all, has been
very slow. One issue that slowed
the process of the housing mar-
ket finding its “bottom” was the
difficulty in selling homes for
which more was owed than the
home was worth. Part of that
problem is that with securitization it is a difficult, time-
consuming, and lawyer-filled process to engage in what
is called a short sale. A short sale involves a buyer and a seller agreeing to a price and the mortgage company
agreeing to write off the difference between the price of
the home and what is owed on the mortgage. Until all
such “underwater” homes are sold we will continue to
live with one in seven homes in Nevada, for instance,
being vacant.
It will be left to Chapter 14 to review the effectiveness
of TARP and the 2009 stimulus package as well as the
Federal Reserve’s attempt to stabilize markets by buying
long-term treasuries and mortgage-backed securities.
From September 2008 through the end of that year,
credit markets were almost entirely frozen. This meant
that institutions that were otherwise healthy could not
access credit markets in a normal and necessary fash-
ion. As the news of that fall was almost entirely bad,
consumers simply stopped buying anything that was not
absolutely necessary. Depending on the automaker, car
purchases fell between 40 percent and 67 percent, and
by December, GM and Chrysler required TARP funds to
survive. The year culminated with the worst Christmas
shopping season in more than 40 years.
The final post-mortem has not been written on what
the ultimate impact of the housing bubble was. It cer-
tainly caused the steepest decline in economic activity
since the Great Depression. It certainly led to relatively
modest government deficits obliterating all post–World
War II deficit records (whether in real or nominal terms)
and states having to cut billions from their own bud-
gets. Because of the timing of many of the ARMs, the
ultimate bottom of the housing market did not occur
until 2011 or 2012. A look back at Figure 13.1 shows
short sale A sale of a home where the amount owed is more than the sale price and in which the seller seeks to have the remaining balance forgiven.
Summary
You now understand the fundamental elements that
determine housing prices, how homes are typically fi-
nanced, and that new types of mortgages are replacing
traditional 20 percent-down, constant-payment mortgages.
You also understand that unrealistic expectations in hous-
ing prices can create spiraling price increases and that
such bubbles inevitably burst and can have a significant
economic impact.
Key Terms
credit default swap
interest-only mortgage
negative-amortization mortgage
pick-a-pay mortgage
securitize
short sale
Quiz Yourself
1. The type of mortgage that allows you to make the
lowest possible payment is called a
a. zero-down mortgage.
b. a traditional constant-payment, 20 percent-down
mortgage.
c. an interest-only mortgage.
d. a negative-amortization mortgage.
2. In which type of mortgage do you build equity the
fastest?
a. zero-down mortgage.
b. a traditional constant-payment, 20 percent-down
mortgage.
c. an interest-only mortgage.
d. a negative-amortization mortgage.
3. In which type of mortgage do you neither build nor
lose equity?
a. zero-down mortgage.
b. a traditional constant-payment, 20 percent-down
mortgage.
c. an interest-only mortgage.
d. a negative-amortization mortgage.
176 Chapter 13 The Housing Bubble
get your hands on the fourth edition’s web chapter on
this subject, you can see that I thought it was one, but
because prices were stabilizing when I wrote it, I wasn’t
sure.) The same thing was true with the stock market in
1929 and 2000. Fast-forward 30 years and imagine your-
self in a position of trying to manage your retirement
savings. How are you going to tell if your portfolio is
really worth what your 401(k) statements say or whether
it is a bubble all over again?
Talk about This
We are in a post–housing bubble world in which millions
of families owe substantially more money on their homes
than they can sell them for. Recent changes to bankruptcy
laws make it more difficult to declare bankruptcy, which
leaves many fully employed, hard working people trapped
in their homes with no means of financial escape. As we
reconsider financial regulation, should we treat negative-
amortization mortgages and interest-only mortgages like
cocaine: banned to prevent you from making a lifetime
mistake?
4. Fundamentally, housing prices are a function of the
home’s
a. location and amenities.
b. amenities only.
c. location only.
d. interest rates only.
5. A housing bubble occurs when _______________
drive(s) prices more than fundamental factors.
a. the price of gasoline
b. a home’s expected future price
c. interest rate changes
d. property tax increases
6. A bursting of a housing bubble could create more
problems than the NASDAQ crash in 2000 because
the housing bubble involves
a. assets, and NASDAQ was about debts.
b. risky forms of debt.
c. more people.
d. fewer people.
Short Answer Questions
1. Explain how mortgage securitization makes it easier
to borrow money to buy a house but harder to deal
with when a house is sold for a loss.
2. Explain why securitization contributed to the prob-
lem of people buying homes using mortgages for
which they did not know all the details (such as the
negative-amortization mortgages referred to in the
text).
3. Explain why the Federal Reserve felt it necessary
to bail out AIG and what result it was attempting
to avoid.
4. Explain the role of the credit default swap and why
the attempt to make things safer for investors made
things worse for everyone.
Think about This
Bubbles are a great deal easier to identify after they
burst. Believe it or not there were many who did not be-
lieve that the housing market was in a bubble until well
into 2008 when it was obvious to everyone. (If you can
C H A P T E R F O U R T E E N
177
The Recession of 2007–2009: Causes and Policy Responses Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the housing crisis and overall consumer indebted-
ness as the cause of the 2007–2009 recession.
LO2 Enumerate the consequences of the recession including
a record drop in housing prices, a significant increase in
the unemployment rate, a substantial drop in real gross
domestic product, and a long string of job losses.
LO3 Describe and model the discretionary and nondiscre tionary
fiscal policy, monetary policy, and TARP program to combat
the recession.
LO4 Enumerate and describe the components of the fiscal
stimulus package passed in the early days of the Obama
administration.
Chapter Outline
Before It Began
Late 2007: The Recession Begins as Do the Initial Policy
Reactions
The Bottom Falls Out in Fall 2008
The Obama Stimulus Package
Extraordinary Monetary Stimulus
Summary
The recession of 2007–2009 was one of the most, if
not the most, severe recessions in post–World War II
history. In terms of peak unemployment, it was the
second worst since the Great Depression. In terms of
the drop in real GDP and in terms of how long it took
for real GDP to recover to its prerecession peak, it was
the worst. It began in the fall of 2007 looking very
much like the short and shallow recessions of 1991
and 2001. Then in the fall of 2008 the bottom fell out
as the bursting of the housing bubble and the decima-
tion of the financial sector set off a series of events
whose consequences are not yet fully understood.
This chapter will begin with a look at economic ac-
tivity in 2005 and 2007, discuss the most significant
cause of the recession—the bursting housing bubble—
the attempts in early 2008 to make it another short and
shallow one, the financial sector meltdown of the fall
of 2008, and the policy responses from the Federal Re-
serve, the Congress, and Presidents Bush and Obama.
The chapter will conclude with a summary of the debate
surrounding whether these policies were effective in ei-
ther shortening or mitigating the impact of the recession.
Before It Began
As can be seen in Figure 14.1, real economic growth was
progressing at about the 20-year average (2.7 percent
annually) until the final quarter of 2007. As you can see
in Figure 14.2, this was despite gasoline prices that had
nearly doubled from their early 2005 levels. What was
providing the steam behind this growth? Housing.
While a full discussion of how the housing bubble
was created (and subsequently how it burst) can be found
178 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses
rate of appreciation in homes averaged 14.2 percent. At
that annual increase in prices, it was erroneously thought,
even if the borrower defaulted on the loan, the bank would
lose no money because they could unload the house for
more than the loan value.
This housing price escalation fueled two distinct
housing booms: home building and home equity lines
of credit. As you can see in Figure 14.4, housing
starts, though fluctuating with the weather, steadily
in Chapter 13, we’ll provide a much briefer version here.
As can be seen from Figure 14.3, the price of homes
(as measured by the Case-Shiller Home Price Index
Composite-10) was also increasing at an astonishing
rate. While this may have made buying a home difficult
under normal circumstances, these were anything but nor-
mal circumstances. Lenders were eager to make loans of
almost any amount to people wanting to buy a home. This
was because between early 2000 and late 2005, the annual
G D
P ( b
il li o
n s , 2
0 0
0 )
11,700.0
11,600.0
11,500.0
11,400.0
11,300.0
11,200.0
11,100.0
11,000.0
10,900.0
10,800.0
20 05
.1
20 05
.2
20 05
.3
20 05
.4
20 06
.1
20 06
.2
20 06
.3
20 06
.4
20 07
.1
20 07
.2
20 07
.3
GDP in billions of chained 2000 dollars RGDP at long-run expected growth
FIGURE 14.1 Real GDP (billions, 2000) 2005.1–2007.3.
Source: Bureau of Economic Analysis, www.bea.gov/national/xls/gdplev.xls
P ri
c e
o f
g a
s o
li n
e i n
c e
n ts
350
330
310
290
270
250
230
210
190
150
170
1/ 3/
20 05
3/ 3/
20 05
5/ 3/
20 05
7/ 3/
20 05
9/ 3/
20 05
11 /3
/2 00
5
1/ 3/
20 06
3/ 3/
20 06
5/ 3/
20 06
7/ 3/
20 06
9/ 3/
20 06
11 /3
/2 00
6
1/ 3/
20 07
3/ 3/
20 07
5/ 3/
20 07
7/ 3/
20 07
9/ 3/
20 07
FIGURE 14.2 Average price of gasoline in cents.
Source: http://tonto.eia.doe.gov/oog/info/twip/twipmgvwall.xls
Before It Began 179
increased between 2001 and 2007, and as you can see in
Figure 14.5, nonrevolving credit, which includes home
mortgages, home equity lines of credit, and car loans,
increased at a 7.1 percent annual clip. Credit card debt
increased at a 5.2 percent rate.
During this period the most significant policy con-
cern of the Federal Reserve was the increase in infla-
tion that was resulting from rapidly increasing energy
prices and overall increases in demand. As you can see
from Figure 14.6, the Federal Reserve increased its tar-
geted federal funds rate 14 times between June 2004
and June 2006 from 1 percent to 5.25 percent. At one
point in January 2006 the concern over inflation was so
great the Fed increased the federal funds rate 1.25 per-
centage points in one step. Given that the vast majority
of increases and decreases in the federal funds rate have
been limited to one-quarter of a point changes, this was
considered a very aggressive action to quell inflation.
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
Ja n-
00
Ju l-0
0
Ja n-
01
Ju l-0
1
Ja n-
02
Ju l-0
2
Ja n-
03
Ju l-0
3
Ja n-
04
Ju l-0
4
Ja n-
05
Ju l-0
5
Ja n-
06
Ju l-0
6
Ja n-
07
Ju l-0
7
FIGURE 14.3 Case-Shiller Price Index (Composite-10).
Source: www.macromarkets.com/csi_housing/sp_caseshiller.asp
500
450
400
350
300
250
20 07
.3
Year.Quarter
H o
u s in
g s
ta rt
s i n
t h
o u
s a
n d
s
20 01
.1
20 01
.3
20 02
.1
20 02
.3
20 03
.1
20 03
.3
20 04
.1
20 04
.3
20 05
.1
20 05
.3
20 06
.1
20 06
.3
20 07
.1
FIGURE 14.4 Single family housing starts.
Source: U.S. Department of Commerce, www.census.gov/const/www/newresconstindex.html
180 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses
Late 2007: The Recession Begins as Do the Initial Policy Reactions
We know now that the National Bureau of Economic
Research Business Cycle Dating Committee has pinned
the beginning of the recession as late fall 2007. It was
evident to policy makers that a slowdown was about to
occur in late 2007. As can be seen in Figure 14.7, the
Federal Reserve began cutting its federal funds rate in
September 2007 and didn’t stop cutting the rate until it
was at zero in December 2008.
The Bush administration began lobbying in early 2008
for a stimulus package. Its preferred mechanism was to
make its tax cuts of 2003 permanent as well as to provide
tax rebates to taxpayers. It failed in securing the former
but succeeded in garnering the latter. By early spring
D e
b t
in $
m il li o
n s
1,800,000
1,600,000
1,400,000
1,200,000
1,000,000
800,000
600,000
Revolving credit Nonrevolving credit
20 0 0.
0 1
20 00
.0 7
2 0 0 1. 0 1
20 0 1.0
7
20 02
.0 1
20 02
.0 7
20 0 3.
0 1
20 03
.0 7
20 0 4.
0 1
20 04
.0 7
20 05
.0 1
20 05
.0 7
20 06
.0 1
20 06
.0 7
2 0 0 7. 0 1
20 07
.0 7
FIGURE 14.5 Revolving and nonrevolving household debt.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/g19/hist
6
4
5
3
2
1
0
Ju n-
07
Date
R a
te
Ju n-
03
Se p-
03
D ec
-0 3
Ju n-
04
Se p-
04
D ec
-0 4
M ar
-0 4
Ju n-
05
Se p-
05
D ec
-0 5
M ar
-0 5
Ju n-
06
Se p-
06
D ec
-0 6
M ar
-0 7
M ar
-0 6
FIGURE 14.6 The federal funds rate.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/fomc/fundsrate.htm
The Bottom Falls Out in Fall 2008 181
2008 the rebate plan was enacted and by early summer,
millions of Americans received $600 per individual,
$1,200 per married couple. For most this money was
deposited directly into their checking accounts by early
summer. For the rest, rebate checks were mailed before
summer was out. If you look at Figure 14.8, you can see
that this $158 billion package had a significant short-run
impact. Economic growth in the third quarter of 2008
was consistent with a healthy economy, but the economy
was not at all healthy. Oil prices were rising to $145 per
barrel and home foreclosures were increasing rapidly.
The Bottom Falls Out in Fall 2008
In the late summer and early fall 2008, a crisis of confi-
dence in the financial sector threatened to freeze capital
markets in a way not seen since the Great Depression
of the 1930s. During the summer the rating agencies,
Moody’s and Standard and Poor’s, were downgrading
mortgage‐backed securities and the companies that held
them in significant amounts. The Federal Reserve created
several loan programs to assist various bank and non‐
bank entities to cope with the difficult credit markets.
6
4
5
3
2
1
0
1/ 3/
20 09
9/ 3/
20 07
10 /3
/2 00
7
11 /3
/2 00
7
1/ 3/
20 08
2/ 3/
20 08
3/ 3/
20 08
12 /3
/2 00
7
5/ 3/
20 08
6/ 3/
20 08
7/ 3/
20 08
4/ 3/
20 08
9/ 3/
20 08
10 /3
/2 00
8
11 /3
/2 00
8
12 /3
/2 00
8
8/ 3/
20 08
FIGURE 14.7 Federal funds rate September 2007–December 2008.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/h15/data.htm R
G D
P $
b il li o
n s ( 2
0 0
0 )
Year
11,750.0
11,700.0
11,650.0
11,600.0
11,550.0
11,500.0
11,450.0
11,400.0 2007.3 2007.4 2008.1 2008.2 2008.3 2008.4
FIGURE 14.8 Real GDP 2007.2 to 2008.3.
Source: Bureau of Economic Analysis, www.bea.gov/national
182 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses
On September 7, 2008, the Treasury Department
placed Fannie Mae and Freddie Mac in conservatorship,
because it realized that these government-supported en-
tities were essentially bankrupt. Within a week Lehman
Brothers filed for bankruptcy, and two days later, the
Fed lent the insurance giant AIG $85 billion (which
ultimately became $182.5 billion). Two weeks later, then
Treasury Secretary Paulson and Federal Reserve Chair-
person Bernanke went to Congress seeking $700 billion
for their planned Troubled Asset Relief Program. Two
weeks after that, Wachovia teetered on the edge of bank-
ruptcy and was purchased by Wells Fargo.
Within the span of two months, from Labor Day week-
end to election day 2008, the financial system was on the
verge of collapse. The terrible news, repeated on a daily
basis, produced such a crisis of confidence that Christmas
2008 was the worst holiday shopping season in 40 years.
As can be seen in Figure 14.9, a fair unemployment picture
through mid-2008 turned sharply worse, and as can be seen
in Figure 14.10, job losses mounted rapidly during the fall
of 2008 with more than 2 million jobs lost in the third and
fourth quarters of 2008. Particularly disturbing was that
the number, including those working part time when they
would like to be working full time, almost doubled.
The Obama Stimulus Package
Even before President Obama took the oath of of-
fice, he was deeply involved in negotiations with the
incoming Congress to produce a stimulus package.
While President Bush had engaged fiscal policy in the
form of tax rebates, as the Obama plan emerged, it was
not confined to tax changes but included significant
spending.
As you can see in Figure 14.11, the aggregate demand–
aggregate supply model can be used to model both the
recession as well as the built-in and discretionary policy
reactions. As the initial crisis of consumer confidence
took hold, aggregate demand contracted markedly. As
unemployment rose, the welfare state kicked into high
gear with substantial increases in unemployment insur-
ance, food stamps, and Medicaid spending. This non-
discretionary fiscal policy (NDFP) dampened the initial
impact of the decrease in demand. A stimulus package
passed by Congress and signed by the president is, by
definition, discretionary and as you read in Chapter 9 is
called discretionary fiscal policy (DFP). Whether or not
the Obama plan has had or will have the desired impact
will be known only with the passage of time.
16
12
14
10
8
6
2
4
Unemployment rate UR + DW UR + DW + Under
20 06
.0 1
20 06
.0 3
20 06
.0 5
20 06
.0 7
20 06
.0 9
20 06
.11
20 07
.0 1
20 07
.0 3
20 07
.0 5
20 07
.0 7
20 07
.0 9
20 07
.11
20 08
.0 1
20 08
.0 3
20 08
.0 5
20 08
.0 7
20 08
.0 9
20 08
.11
20 09
.0 1
FIGURE 14.9 Unemployment rates 2006–2009.
Source: Bureau of Labor Statistics, http://data.bls.gov/cgi-bin/srgate
(LNS12032194; LNU05026645; LNS12000000; LNS14000000)
Extraordinary Monetary Stimulus 183
The stimulus package passed by Congress and
signed by the president was entirely discretionary since
they had to pass a law to make it happen. Still, as you
read in Chapter 9, a portion of the spending was to
shore up the nondiscretionary fiscal policy spending on
welfare and unemployment insurance that is typically
run through the states. The details of the Obama stimu-
lus plan can be seen in Figure 14.12. As you can see,
a roughly equal portion went to tax cuts (38 percent)
and spending programs (39 percent) with the remainder
going to shore up Medicaid, welfare, and unemploy-
ment programs.
You can also see in Figure 14.12 that the bulk of the
tax cuts went to individuals, with some additional tax cuts
going to energy-conservation programs. For instance, in
2009, the purchase of energy-efficient appliances was
given preferential treatment. About half of the aid to in-
dividuals came in the form of money to states to help
them provide Medicaid, given the anticipated increase
in enrollment caused by the recession. About a quarter
of the individual aid went to increase unemployment
benefits by $25 per week and to extend benefits beyond
the already approved 26 weeks. The final portion of the
spending was broken into many pieces for many different
priorities of the new administration.
Extraordinary Monetary Stimulus
At the same time the Obama administration was attempt-
ing a fiscal stimulus, the Federal Reserve was engaging
in the most expansive monetary stimulus in its history.
When the fiscal stimulus ended, the monetary stimulus
continued. For a detailed look at the monetary stimulus
of this period, it would be worthwhile to read (or reread)
Chapter 10’s discussion of the “The Additional Tools
of Monetary Policy Created during 2008” and to exam-
ine Figure 10.4. The short version is this: The Federal
Reserve’s portfolio of assets nearly tripled between 2008
and 2013, and that tripling meant that there was available
to the banking system three times more money in 2013
400
0
200
–200
–400
–600
–800
Year.Month
N e
t c h
a n
g e
i n
j o
b s ( 0
0 0
)
20 06
.0 1
20 06
.0 4
20 06
.0 7
20 06
.10
20 07
.0 1
20 08
.0 1
20 09
.0 1
20 08
.0 4
20 08
.0 7
20 08
.10
20 07
.0 4
20 07
.0 7
20 07
.10
FIGURE 14.10 Net change in employment (2009).
Source: Bureau of Labor Statistics, http://data.bls.gov/cgi-bin/srgate (LNS12000000)
Pl
Pl*
Shock
NDFP
AS
RGDPRGDP*
AD1
AD2
AD3 DFP
FIGURE 14.11 Modeling the impact of nondiscre- tionary fiscal policy and the Obama stimulus package
(discretionary fiscal policy).
184 Chapter 14 The Recession of 2007–2009: Causes and Policy Responses
than there was in 2008. Moreover, the stimulus contin-
ued through 2013 as the Federal Reserve was purchasing
$40 billion in mortgage-backed securities and another
$40 billion in long-term treasuries each and every month.
This dramatic increase in loanable money kept interest
rates extraordinarily low for the whole period. In 2012
and 2013, home mortgage interest rates were below 3 per-
cent for those with good credit. That allowed those who
refinanced their mortgages to lower payments or shorten
the terms on those mortgages, or in many cases, both.
Whether this monetary stimulus was effective is also
open for debate and will likely not be settled among econ-
omists until the stimulus has been reversed. As the textbox
at the end of Chapter 10 indicates, there were significant
risks associated with this policy, that, at this writing in the
spring of 2013, have neither been proven nor disproven.
Spending Total, $311,339, 39%
Total Stimulus Package (millions, %)
Aid Total, $178,140, 23%
Tax Cuts Total, $301,135, 38%
Individual Tax Cuts, $232,426, 77%
Bus and Manu Tax Cuts,
$8,000, 3%
Energy Tax Cuts, $19,963, 7%
Other, $40,582, 13%
Tax Cuts (millions, %)
Individual Aid (millions, %)
Unemployment/ Welfare,
$45,788, 26%
Health Insurance Subsidy,
$24,749, 14%
Medicaid to States,
$90,044, 50%
Computerizing Medical Records,
$17,559, 10%
Other, $19,219, 6% Outdoors, Indian
Reservations, Arts, $10,950, 4%
Commerce, Science and Justice, $15,920, 5%
Farming and Food,
$26,466, 9%
Environment and Energy,
$50,825, 16%
Aid to States, $53,600, 17%
Transportation and Housing, $61,795, 20%
Labor, Health, Education,
Volunteering, and Social Security, $72,564, 23%
Spending Total (millions, %)
FIGURE 14.12 The Obama stimulus plan in detail.
Source: www.cbo.gov
Summary
The recession of 2007–2009 was set off by a confluence
of events surrounding the bursting of the housing bubble.
The housing bubble resulted in dramatic losses in the
financial sector and a tightening of credit. This tighten-
ing was despite repeated attempts by the Federal Reserve,
the Bush administration, and the Obama administration
Summary 185
Quiz Yourself
1. Which of the following was not likely a contributing
factor to the recession of 2007–2009?
a. The bursting of the housing bubble
b. The 2008 tax rebates
c. The failure of major financial service
companies
d. The drop in oil prices from $150 to $40 per
barrel in late 2008
2. In the years prior to the recession the economy was
growing
a. at about its typical rate.
b. at a rate much slower than typical.
c. at a rate much faster than typical.
3. Gasoline prices in late 2007 through
mid-2008.
a. spiked
b. increased relatively slowly
c. remained constant
d. plunged
4. The Federal Reserve’s response to the recession of
2007–2008 was
a. clearly effective in shortening the recession.
b. quick but not obviously effective in shortening
the recession.
c. slow and subject to criticism for being rather timid.
d. procyclical in that it had precisely the opposite
impact as intended.
5. The Obama administration’s stimulus package was
a. almost entirely made up of tax cuts.
b. almost entirely made up of spending on
“shovel-ready” projects.
c. a balance between tax cuts, spending on
projects, and shoring up the unemployment and
welfare systems.
d. almost entirely spent on welfare programs.
6. The job losses during this recession were
a. typical of a short recession.
b. nonexistent.
c. significant and rapid.
Short Answer Questions
1. Explain each of the following in terms of whether
they were discretionary fiscal policy, nondiscretion-
ary fiscal policy, or monetary policy: TARP, the
AIG bailout, the 2009 stimulus package, the rapid
increase in unemployment compensation spend-
ing, the rapid reductions in state sales, and income
tax revenues resulting from people having lower
incomes.
2. How was “quantitative easing” different from what
the Federal Reserve normally does?
3. Which lag described in Chapter 9 did the concept of
“shovel-ready” intend to combat?
Think about This
Nobel Prize–winning economist Paul Krugman repeat-
edly warned through 2008 and 2009 that it was far worse
for Congress to be too timid than too aggressive. In ret-
rospect, was he correct? What would have been the result
of a $1.5 trillion stimulus package?
Talk about This
What lessons would you draw from the recession of
2007–2009? What could have realistically been at-
tempted in the middle of the housing boom to forestall
the bust that came after?
to revive the financial sector. The resulting loss of jobs
and shrinking of GDP made this recession quite likely
the worst since World War II. The attempts by the Federal
Reserve to shore up the financial sector and by the Obama
administration to stimulate the economy were breathtak-
ing in their magnitude, though uncertain in their impact.
C H A P T E R F I F T E E N
186
Is Economic Stagnation the New Normal? Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the historical rates of per capita real GDP growth
from 1950 to 2015.
LO2 Enumerate the sources of economic growth and explain why
some of those sources cannot be repeated and why others
may be repeated.
LO3 Describe the causes and consequences of slowing economic
growth and describe the debate as to whether a shrinking
middle class is best labeled a cause or a consequence.
LO4 Describe and model the alternative suggestions for jump-
starting economic growth.
Chapter Outline
Periods of Robust Economic Growth
Sources of Growth
Causes and Consequences of Slowing Growth
What Can Be Done to Jump-Start Growth, or Is This
the New Normal?
Summary
In the United States and around the globe there is a de-
pressing concern expressed among economists that the
era of sustained, standard-of-living-enhancing economic
growth is coming to an end. For decades the U.S. econ-
omy grew at a healthy and steady pace. While interrupted
by recessions, that pace was considered sustainable.
Whether measured in terms of real GDP growth, or per
capita real GDP growth, Table 15.1 shows that during the
period from 1950 to 2000, economic growth was pretty
constant. The annualized rate of growth in per capita real
GDP was approximately 2 percent.
Since 2000, however, the “new normal” is a phrase that
has crept into the economic lexicon to both describe and
accustom people to the unpleasant realization that growth
can no longer be expected to increase standards of living
across the board. The outlook for economic growth pro-
duced by the Organization for Economic Cooperation and
Development (OECD) across the world’s richer countries
shows just how slow growth is projected to be. The United
States is the leader in terms of projected 2017 economic
growth at a paltry 2.39 percent. The United Kingdom,
Germany, and Canada are also clustered between
2 percent and 2.33 percent. France, Italy, and Japan are
predicted to grow at rates of 1.62, 1.40, and 0.53 percent,
respectively. This chapter puts these slow growth numbers
in historical context, offers an explanation for why they are
so low, and concludes with how this state of affairs could
easily become the “new normal.”
TABLE 15.1 Real growth in the United States.
Decade
Annualized Growth
in Real GDP
Annualized Growth
in Per Capita Real GDP
1950s 3.33 1.74
1960s 4.24 3.06
1970s 3.19 2.23
1980s 3.14 2.23
1990s 3.03 1.90
2000s 1.40 0.71
2010s 1.69 0.77
Causes and Consequences of Slowing Growth 187
increased from 36 percent to 77 percent. All those extra
workers clearly boosted overall economic output.
Technological growth also played an important role
in increasing economic output. The use of carbon-based
energy to power manufacturing and electric lighting to
elongate the production day produced incredible gains.
As a result of these technological innovations, labor
productivity increased at a rapid pace for much of this
period. Looking back at Chapter 6’s statistics on pro-
ductivity, the five-year moving average of labor produc-
tivity exceeded 2 percent (for all but a select few years)
during the period from 1950 to 1975. Though it slowed
dramatically, to below 2 percent for most of the period
from 1975 to 2000, it once again rose rapidly in the
pre–Great Recession 2000s as robotic- and computer-
assisted manufacturing once again boosted production.1
Workers also became more productive, in part, be-
cause of increases in worker educational attainment.
Though explored more deeply in Chapters 36 and 37,
it is worth noting here that the percentage of Americans
ages 25 to 64 with at least a high school diploma in-
creased from 45 percent just after World War II to around
85 percent by 1980. That figure stabilized until 2000
when it increased further to in excess of 90 percent by
2015. The college completion rate for that same popula-
tion increased from under 5 percent prior to World War
II to more than 30 percent in 2015.
Another source of growth during the period was glo-
balization. International trade created new markets for U.S.
goods while also creating new goods for American mar-
kets. Of course, globalization also contributed to job losses,
particularly for manufacturing workers, but economists are
consistent that the impact on output was positive.
Causes and Consequences of Slowing Growth
Causes
Slowing economic growth, on both a real GDP basis and
a real per capita GDP basis, has several causes and con-
sequences. In terms of causes, the two most significant
of these have been the slowing of production-related
technological improvements and the general reversal of
the increases to the Labor Force Participation Rate. De-
mographic changes have also occurred that are teeing up
slower growth. The population is not only growing at a
slower rate; it is aging. The lingering consequences of the
Periods of Robust Economic Growth
Estimates of real GDP growth for the pre–Civil War era
vary, but they clearly show that the United States grew
at rather modest rates (on a per capita basis). A startling
statistic generated by economic historians suggests that
between 1300 and 1750 per capita real economic growth
was essentially zero. Another suggests that growth
between the Revolutionary War and the Civil War was
not much better at 1 percent. Pre–Industrial Revolution
growth was limited by modest improvements in tools
and animal-based energy (i.e., mules, horses, and oxen
pulling plows). Though the cotton gin created a 50-fold
increase in the amount of lint that could be separated
from seed on a cotton plant, it was still operated by a
hand crank with the energy of a slave. What ignited
the years of growth after the Civil War was the use of
carbon-based energy (i.e., oil, natural gas, and coal),
which fueled the Industrial Revolution’s assembly-line
manufacture of goods. Electric lighting added to this
productivity by opening up the entire day for produc-
tion. This torrential rate of growth created not only cars,
airplanes, and useful home appliances; it created middle-
class jobs for those who produced those goods. Those
jobs created incomes that were then used to purchase
those goods. The virtuous cycle of growth enabling more
growth made it such that from the end of the U.S. Civil
War to the beginning of the Great Depression, annual
growth in real per capita GDP averaged 1.75 percent.
Toward the end of the pre–World War II portion of
the Industrial Revolution, political change and economic
growth also brought about unionization of employees,
the substantial raising of wages, the dramatic improve-
ment in working conditions, the ending of child-labor
practices, a minimum wage, and the standardization of
the 40-hour workweek. Laws protecting workers’ rights
to organize, collectively bargain, and strike were passed.
That growth and those laws created a broad U.S. middle
class. Though conservative, pro-business economists
would give more of the credit to growth and liberal,
pro-labor economists would give more credit to labor-
friendly laws, it is clear that the combination created a
large, healthy, and stable middle class.
Sources of Growth
From 1950 to 2007 per capita real GDP growth averaged
2.16 percent. That latter growth had several “mothers.”
During the 1950s through the 1990s the Labor Force Par-
ticipation Rate for women of prime working age (25–54)
1Multifactor productivity, though notably slower overall, showed essentially the
same pattern and timing.
188 Chapter 15 Is Economic Stagnation the New Normal?
Great Recession are also not to be discounted. Tighter
credit standards and greater financial regulations have
made it more challenging for small businesses to operate
and grow. We will take each of these, in turn.
Though technological improvements have been
dramatic since 2000, few of the inventions of the last
15 years have been particularly important to production.
The cell phone and its offspring, the smartphone, have
enabled us to do things as we walk from one place to
another or as we wait in line somewhere, but we don’t do
much of anything that is productive with those devices.
While some of us may write or respond to work-related
e-mail, most of us are reading for entertainment (e.g., a
book in our Kindle app), participating in social media
(e.g., Facebook, Pinterest), or playing a mind-numbing
game (e.g., Candy Crush). The smartphone, the tablet,
and all the applications to which we are addicted do not
increase the productivity of the workforce in the way that
the electric light did. The DVR, the smart TV, and the
proliferation of streaming media outlets that feed them
may increase the joy associated with our leisure time, but
they do not add to production.
The bump in labor productivity of the 1990s and early
2000s was due to the application of computer technol-
ogy to manufacturing, agriculture, retail, wholesale,
and service providers. Auto companies now use robotic
spot welders thereby increasing the consistency of those
welds. Sawmills use laser imaging and computerized
cutting programs to increase the amount of lumber that
can be produced from each log. Hyper-accurate GPS-
driven planters have increased yields in farm fields. Self-
scanning checkouts have sprung up allowing one cashier
to monitor several lanes at once. Interconnected supply-
chain management software has allowed Walmart and
others to order goods, load trucks, and restock shelves
with greater efficiency. Banking and payment processing
efficiency has increased dramatically because of com-
puterized processes and electronic transfers.
On the other hand, Netflix, Facebook, Twitter, Pinter-
est, Candy Crush, and the myriad simulation game apps
do absolutely nothing positive for production.
Another significant cause related to slowing growth
is the significant decline in the Labor Force Participa-
tion Rate. Whereas men in their prime working ages
used to participate at rates nearing 98 percent, that rate
has fallen to 88 percent. Though still high, consider
this: The percentage of men NOT working or look-
ing for work while in their prime working years is six
times higher than it was in the 1950s. Women in this age
group, who constituted one of the “mothers” of earlier
growth, have also departed the labor force albeit at a
much slower rate. At 36 percent in 1950, the rate for
women ages 25 to 54 peaked at 77.3 percent in 2000. By
2015 the rate had fallen to 73.4 percent. Young people
have also left the labor force. In the early 1950s, ap-
proximately 60 percent of those between the ages of 16
and 24 were in the labor force. That number increased
to a peak of 69 percent in the middle 1980s but dropped
to 55 percent by 2015.
Another major cause of declining real GDP growth
is the slowing increase in the population. This is one
reason to focus on the per capita statistic. From 1950
to 1964, the U.S. population grew at between 1.4 per-
cent and 2.2 percent per year, largely due to the post-
war baby boom. The birth control pill slowed that rate
such that it ranged between 0.8 percent and 1 percent
from 1966 to 2009. The slowing since 2010 to less than
0.75 percent is attributable to out-migration of South
and Central Americans and to a continued slowing
of births.
A related cause is the changing demographic mix of
the population. The percentage of the U.S. population
under the age of 25 and over the age of 65 has changed
dramatically over time. In 1970 46 percent of the popu-
lation was under the age of 25 and 9.8 percent was over
the age of 65. By 2010, 33 percent of the population was
under 25 while 13 percent was over 65. That is, the popu-
lation in 2010 in their peak earning years was 54 percent.
That number is now falling. By 2014 it had fallen to
53.6 percent and is projected to continue falling to under
50 percent by 2040.
The Great Recession was not just an economic prob-
lem for those who suffered through it; it created myriad
problems that lingered far longer than the recession.
Chapter 13 described the extraordinary measures un-
dertaken by the Federal Reserve. Those artificially low
interest rates should have caused an increase in business
investment. The reality is that business investment did
not revive, and that is likely because of the higher stan-
dards that banks applied to commercial and industrial
loans. Those higher standards are at least somewhat at-
tributable to new financial regulations imposed on banks
shortly after the Great Recession.
Consequences
One of the elements that is a cause to some, a conse-
quence to others, and to still others both a cause and
a consequence, is the declining middle class (a subject
explored in some depth in Chapter 31, “Income and
Wealth Inequality: What’s Fair?”). The longer-term
What Can Be Done to Jump-Start Growth, or Is This the New Normal? 189
consequences relate to the overall social and economic
health and welfare of the American population. In par-
ticular, with incomes growing more slowly than that
projected by the Medicare and Social Security Trustees,
the financial viability of those programs could be called
into question.
The percentage of Americans in the middle class has
seen a recent and troubling decline. The Pew Charitable
Trust defines the middle class as those households with in-
comes between 67 percent and 200 percent of the median
household income by household size. For 2014, a three-per-
son household with income between $42,000 and $126,000
would qualify as being in the middle class. As Table 15.2
shows, the middle class has been shrinking since the 1970s,
but much of that shrinkage was because those near the top
boundary of the definition had their incomes rise pushing
them into the “upper-middle” category. Now it is shrinking
because households nearest the bottom boundary of the def-
inition are having their incomes fall into the “lower-middle”
category and those at the bottom of the “lower-middle” cat-
egory are falling into the “lowest” category.
Though a shrinking middle class can be viewed as
merely a consequence of a slowly growing economy, it
can also be viewed as a cause of that slowly growing
economy. That perspective, that the distribution of in-
come is contributing to the lack of income, is typically
held by economists on the left. Their view is that because
people in the lower and middle classes use most of their
income for the purpose of bolstering their consumption
and because those at the top of the income distribution
use their income for the purpose of making more income
for themselves, there is a macroeconomic impact to the
change in distribution. Those in the bottom 80 percent
use their income to buy things produced, typically, by
those in the bottom 80 percent. When they buy, their
spending is someone else’s income and their income is
generated by someone else’s purchases of the goods and
services they produce. At the very least the money in
the hands of the highest-income individuals is spent or
invested much more slowly than money in the hands of
those not in the highest strata. In this way, the conse-
quence can also be a cause.
Where economists generally agree, because it is sim-
ply math, is that when growth runs at 1 percent per capita
rather than 2 percent per capita, the average newborn child
today can count on having about half as much income
when they retire. That is because growth is mathemati-
cally exponential. It isn’t just 65 years of 1 percent lost
for a 65 percent difference, it is 1.0165, or a 191 percent
difference. The result is that everybody simply has a
whole lot less. There are fewer opportunities, fewer jobs,
lower pay, and lower tax revenue. This means that com-
mitments that were made years ago, such as Social Secu-
rity and Medicare, will become increasingly difficult to
keep. It also means that new promises, perhaps to offer
government-subsidized child care or to provide universal
paid family leave, not only can’t be kept; they can’t even
be responsibly considered. A society with twice as much
income can do many more things for its citizenry. Growth
not only helps those who earn the money; it also helps
those who depend on government because government
depends on revenue growth to support social programs.
One startling statistic that jolts and depresses at the
same time is one that relates to suicide. According to the
Centers for Disease Control and Prevention, between 2000
and 2014 the suicide rate for those between the ages of 45
and 64 increased from 13.5 to 19.2 per 100,000. This in-
crease has been more pronounced among whites than other
ethnicities. Already twice the rate for whites as for African
Americans, the suicide rate for whites increased from 11.3
per 100,000 to 14.7. When growth is slow and good-paying
jobs are hard to come by, depression can lead to suicide.
What Can Be Done to Jump-Start Growth, or Is This the New Normal?
Just as the cause of the slow-growth predicament is
subject to debate, the conclusions economists draw
are also subject to debate. There are essentially
Year Lowest Lower Middle Middle Upper Middle Highest
1971 16 9 61 10 4
1981 17 9 59 12 3
1991 18 9 56 12 5
2001 18 9 54 11 7
2011 20 9 51 12 8
2015 20 9 50 12 9
TABLE 15.2 Pew Charitable Trust
income classes.
Source: http://www.pewsocialtrends.org/2015/12/09/the-american-middle-class-is-losing-ground/
190 Chapter 15 Is Economic Stagnation the New Normal?
two camps: “get used to it, this is the new normal”
and “we can do better.” Within the “we can do better”
camp there are also two camps with two vastly differ-
ent solution sets. Liberals suggest a massive increase
in stimulus to jump-start aggregate demand. Conser-
vatives suggest an equally massive change to the regu-
latory system and tax structure.
Chief among the “new normal” group of economists
is Robert Gordon. In his book, The Rise and Fall of
American Growth, Gordon makes the case that the
sources of economic growth of the post–Civil War pe-
riod through 2000 have all but evaporated. Specifically,
there isn’t a large new workforce sitting by waiting
to be tapped. Women entering the workforce in great
numbers can only happen once. There is no significant
portion of the day to be turned to productive use like
there was when electric lighting allowed for round-the-
clock manufacturing. The conversion to carbon-based
energy from human or animal energy happened, and
its benefits can’t be repeated. Even if we can convert
completely to non-carbon-based energy sources, that
will not increase output. Such a conversion may save
the planet from climate change, but it will not increase
production because electrically powered equipment
does not run any better just because the source of that
electricity has changed.
A group Gordon labels “techno-optimists” disagrees
with his assertions that the days of robust growth are
behind us. They point to driverless cars and trucks as
an example of productivity enhancements that are only
a few years away from having a dramatic impact. If all
the labor devoted to over-the-road trucking were to be re-
placed with driverless vehicles, that labor could be used
to produce other goods and services. Further into the fu-
ture, it is not hard to imagine that artificially intelligent
robots could engage in home production in much the
same way that current robots have increased productivity
in factories. People might be able to engage in produc-
tive activities rather than cooking, cleaning, shopping, or
doing laundry. These techno-optimists imagine a world
in which technology increases growth at once-again
robust rates.
Back in the real world where we do our own cooking
and cleaning, conservative and liberal economists debate
what can be done to get the United States back on track.
Liberals typically advocate for policies that increase ag-
gregate demand while conservatives look to aggregate
supply increasing actions. Figures 15.1 and 15.2 show
these alternatives.
Liberals/Democrats would use the Chapter 8 levers
of middle-class tax cuts and increases to government
spending to shift aggregate demand rightward. It is
argued that that would stimulate the virtuous cycle.
Greater demand would foster more business invest-
ment and more jobs (both to produce the greater
number of goods and services and to increase the jobs
associated with building new businesses). That would
create more income and even greater middle-class de-
mand. An abrupt rightward shift in aggregate demand
would generate faster future rightward shifts in ag-
gregate demand. This assertion is based on the notion
AD
ADʹ
AS PI
PIʹ
PI*
RGDPRGDP* RGDPʹ
FIGURE 15.1 Growth through increases in aggregate demand.
AD
ASʹ
AS PI
PIʹ
PI*
RGDPRGDP* RGDPʹ
FIGURE 15.2 Growth through increases in aggregate supply.
Summary 191
shores, so companies simply leave those profits over-
seas because stockholders are better off when they do.
Lowering the corporate income tax would also keep
U.S. companies from wanting to sell themselves to
smaller foreign companies. This shell game, called
inversion, reduces corporate income tax obligations
dramatically thereby increasing share prices for stock-
holders. Conservatives would also simplify the tax
code to remove most of the tax breaks associated with
favored types of behavior. These economists argue that
deductions and credits for everything from college
expenses to energy-efficient windows creates a level
of needless complication in the personal income tax
system and discourages productive activity in favor of
tax-reducing activity.
that there is a level of growth that must be achieved
to be self-sustaining. That is because consumer con-
fidence is bolstered by increasing growth, and that
increased consumer confidence is itself a cause of
economic growth.
Conservatives/Republicans would argue that a re-
duction in the U.S. corporate income tax rate and a
reform and simplification of the U.S. personal income
tax system would generate aggregate supply increases.
The U.S. corporate income tax (considering both state
and federal tax systems) places one of the highest busi-
ness tax burdens on U.S. companies. It also motivates
companies with large international divisions to locate
and hide those profits in foreign countries. Profits are
only taxed in the United States when they reach U.S.
Summary
The rapid slowing of U.S. real economic growth from
2 percent per capita to less than 1 percent per capita is
a significant problem not only for the near term but also
the long term. Caused by both demographic shifts and
a decline in productivity-enhancing technological im-
provements, the decline in growth has led to a decline
in the U.S. middle class and to reduced expectations for
the future. If the “new normal” ends up being the correct
description of this slow growth, economic opportunities
for today’s generation of young people will likely lead to
many more of them living below their parent’s economic
station for the first time in more than 150 years. Perhaps
even more depressing is that there is no consensus solu-
tion to this quandary.
Quiz Yourself
1. Per capita real economic growth during the pre–
Revolutionary War era was
a. negative.
b. zero.
c. 1 percent.
d. 2 percent.
2. Per capita real economic growth during the Indus-
trial Revolution through the mid-1970s was
a. negative.
b. zero.
c. 1 percent.
d. 2 percent.
3. The impact of slowing economic growth over a long
period of time is
a. negligible.
b. the lost growth times the number of years.
c. substantial because of the exponential aspect
of growth.
4. The large increase in the Labor Force Participa-
tion Rate that occurred between 1950 and 2000 was
because
a. women’s participation in the labor force
doubled.
b. men’s participation in the labor force increased.
c. the proportion of the population over 65 increased.
d. young people’s participation in the labor force
doubled.
5. The large increase in the Labor Force Participation
Rate is ________ source of growth.
a. a duplicatable
b. an unduplicatable
6. What source of rapid (1950–1975) growth is not
duplicable?
a. Electrification of lighting
b. Increases in education
c. Increases in productivity
192 Chapter 15 Is Economic Stagnation the New Normal?
1. Why is it that some believe that slowing growth is a
cause of a declining middle class and others believe
the causality is reversed? Could it be both?
7. One issue that some call a consequence and others
call a cause of slowing growth is
a. a slowing rate of increase in the population.
b. a change in the demographic mix of people to
nonworking populations.
c. a declining middle class.
d. an increase in the Labor Force Participation
Rate among women.
8. To counter the slowing rate of economic growth,
liberal economists would recommend
a. taxation and spending policies that decrease
aggregate demand.
b. taxation and spending policies that increase
aggregate demand.
c. corporate and personal income tax policies that
decrease aggregate supply.
d. corporate and personal income tax policies that
increase aggregate supply.
9. To counter the slowing rate of economic growth,
conservative economists would recommend
a. taxation and spending policies that decrease
aggregate demand.
b. taxation and spending policies that increase
aggregate demand.
c. corporate and personal income tax policies that
decrease aggregate supply.
d. corporate and personal income tax policies that
increase aggregate supply.
Short Answer Questions
2. Why would a cut in the rate of growth from 2 per-
cent to 1 percent have more than a 10 percent impact
if it lasted 10 years?
Think about This
Part of the reason that the economy is slowing is that
both men and women in their prime working years are
decreasing their Labor Force Participation Rate. This
could be because more couples are choosing to sacrifice
income for the benefits associated with having one stay
at home during the period when their children are young.
If this is the case, is it a problem? Is it merely a conse-
quence of a choice that individuals are making?
Talk about This
Bernie Sanders and Donald Trump both tapped into
a 2016 electorate troubled by the same thing: a slow-
ing economy pinching the middle class (or a pinching
middle class slowing the economy). Both targeted trade
deals, but neither noted any of the causes cited by econo-
mists (left and right). What is your explanation for why?
For More Insight See
Gordon, Robert, The Rise and Fall of American Growth
(Princeton University Press).
Behind the Numbers
Pew Charitable Trust—http://www.pewsocialtrends.org
/2015/12/09/the-american-middle-class-is-losing
-ground/
193
Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the source of the problem of the largest fiscal chal-
lenges facing the federal and state and local governments as
those associated with Social Security, Medicare, and pensions
for state and local government employees.
LO2 Compare and contrast defined benefit and defined
contribution pension plans and explain why defined ben-
efit plans can be unfunded or underfunded but defined
contribution plans cannot.
LO3 Describe the scope and degree of underfunding of each of
the sources of fiscal problems.
LO4 List and evaluate the likelihood of each of the scenarios in
which the underfunding of Social Security, Medicare, and
pensions for state and local government employees presents
smaller problems than expected.
Chapter Outline
What Is the Source of the Problem?
How Big Is the Social Security and Medicare Problem?
How Big Is the State and Local Pension Problem?
Is It Possible That the Fiscal Sky Isn’t About to Fall?
Summary
The story of “Chicken Little” is one in which the lead
character claims that “the sky is falling” though the
only thing that fell was an acorn. This chapter examines
whether the fiscal sky is falling and uses the concept
of present value to consider the question of whether
the promises made by politicians of the past with re-
gard to Social Security, Medicare, and defined benefit
pensions to employees of state and local governments
can be kept.
What Is the Source of the Problem?
As you may go on to read in Chapters 25 and 40, Medicare
Part A and Social Security are funded through a system of
payroll taxes. Working 40 quarters and paying taxes en-
titles people to subsidized hospital care as well as a pen-
sion based on the highest 35 years of earnings. For many
employees of state and local governments, a system simi-
lar to Social Security, albeit one in which instead of both
C H A P T E R S I X T E E N
194 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities
spend their careers with one private employer and be-
cause a large number of public employees do stay with
their original employer, it is now the norm for employees
in the private sector to have defined contribution plans
and for public employees to have defined benefit plans.
Defined benefit plans, because they involve employers
investing money on the behalf of employees, require either
a degree of trust or a degree of regulation. Employee Retire- ment Income Security Act of 1974 (ERISA) provides regula- tion for defined benefit plans offered by private employers.
The rules require that the funds in the accounts meet the
actuarial requirements to keep
them fully funded. This simply
means that, accounting for ex-
pected returns on investments, life
expectancy of pensioners, and so
forth, the assets of the investments
must be able to meet the liabilities, which to the fund are the
pension payments to retirees. They also must make pay-
ments to the Pension Guaranty Trust Corporation, which
operates as a public insurance company in cases where the
pension fund cannot meets its obligations and the company
that is supposed to pay in goes bankrupt. This guarantees
pensioners that their defined benefit plans will pay pensions
if the company that sponsored them does not survive.
Another thing that ERISA requires private companies
to do is that when they offer health benefits to retirees,
those funds also have to be fully funded. So if a private
company, for whatever reason, wants to guarantee its
employees that when they retire the company’s health
insurance will follow them until they get to Medicare
eligibility, they have to put enough aside to pay for that.
How Big Is the Social Security and Medicare Problem?
It is important to understand that ERISA applies most
stringently to private pensions, and the public pensions,
namely Social Security and state and local pensions, do
not have to be fully funded. This is the crux of the prob-
lem. Social Security is, in present value terms, under-
funded by more than $12 trillion dollars, state pension
funds are underfunded by $3 trillion, and local govern-
ment pension funds are underfunded by more than one-
half trillion. On top of that, though it is not a pension
fund, Medicare is underfunded by another $4 trillion.
Let’s begin at the federal level. The Social Security and
Medicare system had one gigantic, and perhaps even fatal,
operational assumption: Current employees could pay for
current retirees. This assumption was necessary so that
Employee Retirement
Income Security Act
of 1974 (ERISA) A regulatory system for defined benefit plans.
employers and employees paying equal shares, states and
local governments make most of the investments, provides
pension benefits, typically based on the last three to five
years of salary.
All three systems are either entitlements or defined benefit programs in that if you participate for the re- quired period of time, you get a benefit according to a
set of rules and a formula. For
instance, defined benefits plans
frequently have a rule defin-
ing retirement eligibility that is
structured around the variable
years-of-service + age. When
this number exceeds a particular
level (often 85), the person is eligible to retire. This is
why a teacher who began teaching in a school district at
age 25 can retire at full benefits at 55.
This plan differs from a
defined contribution program. In a defined contribution pro-
gram, those enrolled, as well as
their employer, contribute to an
account according to a formula
(which can be 100 percent em-
ployee, 100 percent employer, or
some mix), and the investment
of that account is under the con-
trol of the employee. Under defined contribution systems,
retirees only get what their account accumulates.
Under a defined benefit program, because you pay ac-
cording to a formula and you receive benefits according to
a formula, there is the possibility that the formula will be
wrong (on either side), resulting in a surplus (more than
enough has been collected to pay the promised benefits)
or a deficit (not enough has been collected and invested to
pay the benefits). As is probably obvious, politicians would
love the former because they can increase benefit payouts,
but the latter is more likely. It is the latter that has occurred
and now plagues the public pension system. Because you
only get to reap what you sow in a defined contribution
plan, there are no surpluses or deficits in those programs.
Defined benefit programs used to dominate the world
of employee retirement systems, but they quickly fell
by the wayside as fewer and fewer workers spent their
entire careers with one firm. This is important because
under most defined contribution plans there is a mini-
mum years-of-service requirement and people who work
15 years with three different employers would usually
get nothing or at least substantially less in aggregate
pensions than they would if they worked 45 years with
one employer. Because significantly fewer employees
defined contribution
program A pension plan in which those enrolled, as well as their employer, con- tribute to an account according to a formula, and the investment of that account is under the control of the employee.
defined benefit
program A pension plan that defines eligibility for retirement and benefits according to a set of rules and a formula.
How Big Is the Social Security and Medicare Problem? 195
people could begin collecting benefits when the programs
passed. Otherwise, the programs would have been col-
lecting taxes and providing nearly no benefits for several
years. Unfortunately for both systems, that mechanism
requires that the number of babies born in a year remain
roughly stable or grow at a steady rate so that eventually
the ratio of workers per retiree can remain roughly con-
stant. With the dearth of babies born between 1931 and
1945, due first to the scarcity of food during the Great De-
pression, which made many women at least temporarily
infertile, and, second, World War II, which made young
men temporarily scarce, and the subsequent baby boom of
the postwar era, that assumption did not hold.
The result was that in 1982 analysts anticipated that
beginning in 2008, as the first baby boomers became
eligible for early-retirement Social Security benefits,
and extending until around 2040, both Social Security
and Medicare would have insufficient funds to pay for
the anticipated benefits. In that year a compromise was
worked out that significantly raised payroll taxes in order
to create the Social Security and Medicare trust funds
and raised the full-benefit retirement age from 65 to 67.
As of 2011, those accounts remain seriously under-
funded. As can be seen in Figure 16.1, the annual deficits in
these programs alone will, very soon, reach very high lev-
els. Because these deficits will occur mostly in the future,
there are two reasonable ways of looking at them. The first,
presented in Figure 16.1 displays them by discounting using
the present value methodology of Chapter 7. Using an inter-
est rate associated with long-term U.S. treasuries, 2.8 per-
cent,1 the annual deficits are discounted and plotted below.
The area between the 0-line and the Social Security line is
the degree of the problem with regard to that program going
out 75 years.2 It is $36 trillion. Similarly, between the 0-line
and the Medicare line is the degree of the deficit in that pro-
gram, which is $10 trillion. For perspective, at this writing
the sum of those two numbers is nearly three times GDP.
That means that the total liabilities of the United States are
more than $64 trillion (the sum of the national debt and the
unfunded liabilities of Social Security and Medicare).
To compound the problem, there will be a decreasing
percentage of the population working to pay that enormous
bill. As can be seen in Figure 16.2, the dependency ratio, the
ratio of the population dependent on others to support them
to the population supporting them, will rise from around
25 percent currently to more than 38 percent in the next
20 years and to nearly 44 percent within the next 75 years.
1 The zero-coupon bond yield at this chapter’s writing (March 2016). 2 This is the length of time the Social Security and Medicare trustees are
required to consider and report upon.
0
2 0
15
2 0
19
2 0
2 3
2 0
2 7
2 0
3 1
2 0
3 5
2 0
3 9
2 0
4 3
2 0
4 7
2 0
5 1
2 0
5 5
2 0
5 9
2 0
6 3
2 0
6 7
2 0
7 1
2 0
7 5
2 0
7 9
2 0
8 3
2 0
8 7
2 0
8 9
–1200
–1000
–800
–600
–400
–200
200
Social Security Medicare
FIGURE 16.1 The present value of the annual Social Security and Medicare deficits: 2015–2090.
Source: www.ssa.gov/oact/TR/2012/tr2015.pdf
196 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities
0.45 2
0 10
2 0
15
2 0
2 0
2 0
2 5
2 0
3 0
2 0
3 5
2 0
4 0
2 0
4 5
2 0
5 0
2 0
5 5
2 0
6 0
2 0
6 5
2 0
7 0
2 0
7 5
2 0
8 0
2 0
8 5
2 0
9 0
0.20
0.25
0.30
0.35
0.40
D e
p e
n d
e n
c y r
a ti
o (p
o p
u la
ti o
n o
v e
r 6
5 /p
o p
u la
ti o
n 2
0 –
6 4
) FIGURE 16.2 The dependency ratio: 2010–2090.
Source: www.ssa.gov/oact/TR/2012/tr2015.pdf
The other way of looking at the size of these problems is
to consider that the earning capacity of the next generations
will be greater than the earning capacity of today’s genera-
tion, and through immigration and birth, the U.S. popula-
tion continues to grow, making it somewhat likely that the
problem could present less of a burden than these figures
imply. In Figure 16.3 we see that we could pay for these
deficits with an amount of money equal to around 1 percent
of payroll over the next decade. Though, by this measure,
these deficits as a percentage of payroll rise to 5 percent in
rapid order between 2020 and 2035, they only grow by an-
other 1.5 percentage points in the ensuing 40 years.
How Big Is the State and Local Pension Problem?
State and local governments provide their own pensions in
addition to Social Security. They do so, by and large, using
defined benefit plans. The tumult in Wisconsin in 2011
0
–6
–5
–4
–2
–1
S o
c ia
l S
e c u
ri ty
a n
d M
e d
ic a
re d
e fi c it
a s
a p
e rc
e n
ta g
e o
f ta
x a
b le
p a
y ro
ll
–3
2 0
10
2 0
15
2 0
2 0
2 0
2 5
2 0
3 0
2 0
3 5
2 0
4 0
2 0
4 5
2 0
5 0
2 0
5 5
2 0
6 0
2 0
6 5
2 0
7 0
2 0
7 5
2 0
8 0
2 0
8 5
2 0
9 0
FIGURE 16.3 Social Security and Medicare deficits as a percentage of projected payroll.
Source: www.ssa.gov/oact/TR/2012/tr2015.pdf
How Big Is the State and Local Pension Problem? 197
each state by looking at 2010 pension liability data in
Table 16.1. Produced by economists Robert Novy-Marx
and Joshua Rauh, their methodology began by looking at
the liabilities that these states acknowledge and the assets
they claimed, but then made adjustments to the discount
rate that these states use to establish those liabilities. Find-
ing those discount rates unreasonably high, they instead
chose to use what they determined to be a more reasonable
rate—the rate that you would get on U.S. Treasury bonds.3
What they found was that in 2010 states had roughly
$3 trillion in unfunded liabilities in their state-funded
pension plans. When they updated the aggregate number
using 2013 data, they found that the problem was growing
and that the gap was as much as $3.3 trillion.
was in large part due to conflicts between its Republican
governor and the public employees. The budget standoff in
Illinois in 2015 and 2016 was a direct result of the unfunded
pension liability problem there. The Republican governor
and the Democratic state legislature could not agree on a
budget because of, among other things, the pension issue.
That standoff was made substantially worse when the
Illinois Supreme Court ruled that Illinois public pensions
were “inviolate”—meaning they could not be lower than
promised—and that this extended to everyone currently
or previously working for state or local government in
Illinois. The consequences of that standoff included little
things, like cancelling spring break at Chicago State Uni-
versity in 2016 and closing interstate rest areas for unpaid
sewer bills; and really big things, like failing to honor state
scholarships at public universities across the state and fur-
loughs to several employees of those institutions.
How big is the problem of state pensions? You can see
the degree to which these unfunded liabilities will affect
TABLE 16.1 State pension liabilities, 2010.
Source: Robert Novy-Marx and Joshua Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?” Journal of Finance, 2011.
State Name
Liabilities,
Stated
Liabilities,
Treasury
Rate
Pension
Assets State Name
Liabilities,
Stated
Liabilities,
Treasury
Rate
Pension
Assets
Alabama 42.0 61.8 21.4 Montana 9.1 12.4 5.3
Alaska 15.3 21.7 12.4 Nebraska 8.4 11.6 5.5
Arizona 43.6 73.5 24.8 Nevada 25.4 36.3 18.8
Arkansas 21.5 30.4 14.6 New Hampshire 8.5 12.5 4.3
California 518.1 699.7 329.6 New Jersey 132.8 191.2 67.2
Colorado 57.3 86.2 28.8 New Mexico 28.8 39.8 15.9
Connecticut 45.3 69.1 20.1 New York 239.8 325.7 192.8
Delaware 7.6 10.9 5.8 North Carolina 74.9 101.8 64.0
Florida 136.4 186.3 96.5 North Dakota 4.4 6.3 2.7
Georgia 75.8 110.1 53.1 Ohio 197.5 281.4 114.7
Hawaii 17.5 24.2 8.1 Oklahoma 33.6 45.9 15.8
Idaho 11.7 16.6 8.7 Oregon 57.5 80.7 42.9
Illinois 151.0 233.0 65.7 Pennsylvania 110.6 164.5 64.3
Indiana 37.3 49.8 19.6 Rhode Island 13.9 20.5 6.6
Iowa 26.0 35.0 18.0 South Carolina 42.4 63.5 20.3
Kansas 21.3 30.3 10.2 South Dakota 7.4 10.3 5.6
Kentucky 45.2 63.4 21.1 Tennessee 36.7 49.6 26.4
Louisiana 36.8 54.8 18.4 Texas 191.2 268.4 126.1
Maine 14.4 20.1 8.3 Utah 22.6 31.2 14.7
Maryland 52.7 72.1 28.6 Vermont 4.0 5.7 2.4
Massachusetts 59.7 86.9 32.7 Virginia 69.1 89.6 41.3
Michigan 73.2 103.1 39.5 Washington 62.3 86.4 43.5
Minnesota 60.6 91.0 35.9 West Virginia 13.7 18.3 7.2
Mississippi 31.4 44.2 15.5 Wisconsin 79.7 114.6 58.4
Missouri 53.5 75.2 33.1 Wyoming 7.0 9.8 4.4
3 The technical reasons for this consideration are beyond the scope of this
text; however, from Chapter 7 you understand that higher rates of discount
mean that liabilities far off into the future will have a smaller present value.
The authors argue that the discount rates on the liabilities are overstated for
political purposes to mask the actual size of the problem.
198 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities
To put a bow on this, imagine a household in Chicago
wanted to pay off its share of all unfunded Social Security,
Medicare, and pension liabilities (completely ignoring
the other portions of the national debt); they would have
to come up with more than $215,000, of which one-third
would be their state and local liabilities. If this fiscal
“sky is falling” prediction is accurate, the fiscal sky will
fall in the next 20 to 25 years. That is the period in which
the Medicare problem will hit its present-value peak, the
state and local pension problem will peak, and the Social
Security problem will still be increasing.
Is It Possible That the Fiscal Sky Isn’t About to Fall?
It is at least plausible that the preceding overstates the
actual problem that Americans will face. Optimists point
to a number of factors that could make these problems
These same scholars duplicated this analysis for county
and municipal pensions. Using a comprehensive (but not
universal) list of cities and counties and their pension plans,
they performed similar calculations for those local gov-
ernments. What they found, as shown in Table 16.2, was
that for those counties and cities they could include in their
database, there was $383 billion in unfunded liabilities
on pensions, and if that was extrapolated to the remain-
ing population of local governments, they have a total of
$574 billion in unfunded pension liabilities. Some of those
cities had laughably large unfunded liabilities. For instance,
the city of Chicago had so many outstanding liabilities that
if every household in the city contributed $40,000 to the
city, it would still be insufficient to entirely eliminate the
gap. Even worse, because the state of Illinois had not con-
tributed anywhere near enough money to its pension funds
for state employees (such as teachers, college professors,
state highway patrol, prison guards), it would take almost
an additional $30,000 to cover those liabilities.
TABLE 16.2 County and municipal pension liabilities, 2010.
Source: Robert Novy-Marx (University of Rochester and NBER) and Joshua Rauth (Kellogg School of Management and NBER), www.kellogg.northwestern.edu/faculty/rauh
/research/nmrlocal20101011.pdf
Name (Number of Plans)
Liabilities,
Stated
Basis,
June 2009
($B)
Liabilities,
Treasury
Rate
Net
Pension
Assets
($B)
Unfunded
Liability
($B)
Unfunded
Liability/
Revenue
Unfunded
Liability
per
Household
($)
Chicago 46.3 66.6 21.8 44.8 763% 41,966
New York City 155.8 214.8 92.6 122.2 276 38,886
San Francisco 16.3 22.6 11.9 8.7 306 34,940
Boston 7.4 11.0 3.6 7.5 430 30,901
Detroit 8.1 11.0 4.6 6.4 402 18,643
Los Angeles 34.6 49.3 23.2 26.1 378 18,193
Philadelphia 9.0 13.0 3.4 9.7 290 16,690
Cincinnati 2.2 3.2 1.2 2.0 321 15,681
Baltimore 4.4 6.4 2.7 3.7 260 15,420
Milwaukee 4.4 6.7 3.3 3.4 687 14,853
Fairfax County 8.3 11.1 5.5 5.6 169 14,415
Hartford 1.2 1.6 0.9 0.7 249 14,333
St. Paul 1.5 2.2 0.8 1.4 464 13,686
Jacksonville 4.1 6.0 2.0 4.0 278 12,994
Dallas 7.4 10.8 4.6 6.3 298 12,856
Contra Costa County 6.3 8.7 3.7 5.0 425 12,771
Santa Barbara County 2.3 3.3 1.4 1.8 329 11,995
Kern County 4.2 5.6 2.0 3.6 612 11,919
San Jose 5.4 7.5 3.4 4.1 321 11,391
Houston 11.1 16.4 7.2 9.1 356 10,804
Nashville Davidson 2.9 4.1 1.8 2.3 151 10,048
Arlington County 1.5 2.0 1.2 0.8 103 10,000
Summary 199
substantially smaller in scope. First, the analysis is predi-
cated on the ability of the authors of the Social Secu-
rity and Medicare trustees’ reports to predict wages, life
expectancy, GDP, interest rates, and other economic
variables 20, 30, 50, 75 years in advance. Additionally,
there are any number of changes that could make the
next 20 years only slightly uncomfortable with regard to
these underfunded programs. Incomes could grow at a
more rapid, but still historically reasonable, rate, or the
programs’ benefits could be curtailed.
Aside from the possibility that the forecasts are just
wrong, consider the most likely and most important
source for potential optimism. Taxable incomes could
grow at the rate they did in the 1980s and 1990s and
do so for a sustained period. Similarly, productivity and/
or technological increases could be sufficient to raise
real GDP growth expectations from the 2.5 percent to
3.5 percent they have been to 3.5 percent to 4.5 percent.
A one percentage point increase in growth would make
the U.S. real GDP 28 percent higher in 25 years than it is
now projected to be at that time, and that would be more
than enough to make the funding of those particular pro-
grams substantially less onerous.
Second, programmatic changes could be made,
especially to Social Security, that could take the larg-
est part of the long-term problem off the table. For
instance, some combination of tax increases (either
eliminating the maximum taxable earnings for So-
cial Security, increasing tax rates 1 percent across the
board on both employers and employees, or extending
Social Security taxes to unearned income) or benefits
changes (eliminating the option for taking benefits at
62, raising the retirement age to 70, using price infla-
tion rather than wage inflation to adjust benefits for
the cost of living) could be enacted. If these were en-
acted in the next five years, most of the problem in
Social Security could be eliminated.
Whether state and local governments can break the
promises they have already made to their teachers,
firefighters, police, and other workers is another story.
There would certainly be political and even legal chal-
lenges to such changes. As governors around the coun-
try were seeing between 2011 and 2016, it is politically
difficult to require public workers to contribute (more)
to their pensions; so, though there could be a political
solution that would require higher contribution levels
by the workers themselves, if that does not occur soon,
such a solution will not be enough to solve the state and
local pension problem. That would leave state and local
governments needing to cut benefits to current retirees
(which would ignite an even more furious political and
legal challenge) or to seek a bailout from higher levels
of government.
The biggest challenge to optimists has to be Medi-
care. Its problems were almost completely ignored
within the Obama administration’s health care plan.
That plan’s focus was on expanding eligibility and not
on realistic cost control. Second, Medicare’s fiscal
challenges will be front and center earlier than the other
programs.
Summary
Whether or not you believe the “sky is falling” on fiscal
issues relating to Social Security, Medicare, and the pen-
sions systems for state and local government workers, you
should now understand the source of the problem. Com-
bined, various levels of government have underfunded
their programs for retirees by trillions of dollars. You
understand that the Medicare challenge will occur first,
followed shortly thereafter by the state and local pension
challenge. The Social Security shortfall will not become
acute until the late 2030s but remains the largest fiscal
challenge. You understand that because these liabilities
will occur so far in the future that the rate at which you dis-
count them and the rate at which the economy will grow
can significantly alter the estimated scope of the problem.
Key Terms
defined benefit program defined contribution program ERISA
200 Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities
Quiz Yourself
1. In terms of magnitude, which of the following has
the greatest fiscal shortfall?
a. State pension funds
b. Local pension funds
c. Medicare
d. Social Security
2. In terms of when these fiscal shortfalls are likely to
require significant changes to budgets or program
rules, which of the following is likely to occur first?
a. State pension funds
b. Local pension funds
c. Medicare
d. Social Security
3. Using a higher rate of discount
a. makes no difference when calculating the pres-
ent value of future liabilities.
b. raises the present value of future liabilities.
c. lowers the present value of future liabilities.
4. The dependency ratio in the United States is
a. growing.
b. steady.
c. falling rapidly.
d. falling slowly.
5. State and local pensions for government employees
are usually
a. defined benefit plans.
b. defined contribution plans.
c. entitlements.
d. determined year to year.
6. Deficits cannot occur in
a. defined benefit plans.
b. defined contribution plans.
c. entitlement budgets.
d. state and local budgets.
Short Answer Questions
1. Why does the discount rate matter when evaluat-
ing the future liabilities of defined benefit pension
plans?
2. Why does it matter whether you have a defined con-
tribution plan or a defined benefit plan in terms of
whether there is a degree of underfunding that your
boss might not be telling you about?
3. Why would a schoolteacher be a better candidate
for a defined benefit pension than a computer
programmer?
4. Why would the Pension Guaranty Trust or some-
thing like it be necessary in defined benefit plans?
5. Is Social Security closer to a defined benefit plan or
a defined contribution plan?
Think about This
When you go into the voting booth, which type of politi-
cian appeals to you: the optimistic sort that seeks to as-
sure you that brighter days are ahead or the pessimistic
sort that seeks to warn you of impending disaster? Are
voters the source of the problem?
Talk about This
Suppose nothing is done about state and local pension
issues and state and local governments face a choice
of either paying their retired teachers what they were
promised in terms of pensions or paying current teach-
ers enough to ensure an adequate education for children.
(Suppose for the purpose of this discussion, you are con-
vinced at the state level if you impose a tax increase, too
many citizens will leave to go to another state, rendering
the tax rate increase ineffective.)
Behind the Numbers
Social Security and Medicare—
www.ssa.gov/oact/TR/2010/tr2010.pdf
State and local pensions—
http://www.pewtrusts.org/en/projects/public-sector
-retirement-systems
Novy-Marx, Robert, and Joshua Rauh, “Public Pension
Promises: How Big Are They and What Are They
Worth?” Journal of Finance, 62, pp. 2123–2167.
Novy-Marx, Robert (University of Rochester and
NBER), and Joshua Rauth (Kellogg School of Man-
agement and NBER)—www.kellogg.northwestern
.edu/faculty/rauh/research/nmrlocal20101011.pdf
C H A P T E R S E V E N T E E N
201
International Trade: Does It Jeopardize American Jobs? Learning Objectives
After reading this chapter you should be able to:
LO1 Name the principal trading partners of the United States and
the goods that are most often traded.
LO2 Illustrate how international trade benefits both trade
partners.
LO3 Define the principles of absolute and comparative advantage
and utilize these definitions to prove the benefits from trade.
LO4 Compare and evaluate the reasons given for limiting trade
and illustrate the mechanisms for doing so.
LO5 Conclude that limiting trade protects some industries and
jobs, but at a very high cost.
LO6 Enumerate attempts to use trade as a diplomatic weapon
and evaluate the success of those attempts.
Chapter Outline
What We Trade and with Whom
The Benefits of International Trade
Trade Barriers
Trade as a Diplomatic Weapon
Kick It Up a Notch: Costs of Protectionism
Summary
One of the more important economic developments of
the last 35 years is the increased globalization of our
economy. Whereas the world used to be made up of
more than 150 countries whose economies were mostly
independent of one another, nearly all of the economies
of the nations of the world now depend heavily on one
another.
As you can see from Figure 17.1, exports make up
approximately 14% of the U.S. economy while imports
make up more than 17%. Though there was a significant
decline in both as a consequence of the global recession
in 2009, there has also been a general recovery in both.
One thing that does appear to have happened is that both
have stabilized after more than 30 years of consistent
growth. The increasing importance of the international
sector has led some to worry about whether this trend is
a good one. Are American jobs being unfairly taken by
workers from other countries? If so, is this trend toward
globalization avoidable?
We address these questions first by explaining why
economists generally believe that international trade is
good for both parties. Then we discuss the reasons for
limiting international trade, distinguishing between rea-
sons that economists embrace and those that they do not.
Next we discuss the methods by which trade is limited.
To wrap up, we consider whether trade can be used as a
tool in political or diplomatic disagreements.
What We Trade and with Whom
Trade in the United States is not only growing; it is also
encompassing a diverse area of goods and services, as
seen in Table 17.1. We trade in the obvious goods and
202 Chapter 17 International Trade: Does It Jeopardize American Jobs?
exporting others. Similarly, though we export and import
computers, this also shows the degree to which many
products are made all over the globe.
If you open up any computer, you will find compo-
nents that were made in a variety of places. The memory
comes from one country, the hard drive from another,
and the CPU from still another. Your computer may have
been assembled in the United States, but it was made
the not so obvious goods. We import TVs, computers,
and other electronics, as well as cars and oil. We export
industrial equipment and airplanes. You probably would
have guessed this. We simultaneously export and import
large quantities of automobiles, computers (electrical
equipment), and services. While that may sound some-
what odd, it is not as strange as it may sound. There are
myriad types of cars, and we are importing some and
TABLE 17.1 U.S. exports and imports of goods and services.
Sources: International Trade Administration, www.trade.gov; TradeStats Express (TM), http://tse.export.gov
Exports Imports
Transportation equipment 273.6 Computer and electronic products 365.8
Computer and electronic products 209.1 Oil & gas 263.2
Chemicals 200.2 Transportation equipment 355.7
Machinery, except electrical 152.6 Chemicals 205.7
Petroleum & coal products 116.9 Machinery, except electrical 160.8
Primary metal mfg. 64.0 Miscellaneous manufactured commodities 111.4
Miscellaneous manufactured commodities 81.9 Primary metal mfg. 101.2
Agricultural products 72.9 Petroleum & coal products 82.0
Food manufactures 70.7 Electrical equipment, appliances & components 99.8
Electrical equipment, appliances & components 60.6 Apparel manufacturing products 86.6
Special classification provisions, NESOI 43.8 Fabricated metal products, NESOI 66.2
Services 710.6 Services 447.4
Total 2343.2 Total 2851.5
FIGURE 17.1 Increasing importance of international trade.
Source: United States Census Bureau, www.census.gov/foreign-trade/statistics/index.html
20
0
2
4
6
8
10
12
14
16
18
Year
P e
rc e
n ta
g e
o f
G D
P
Exports/GDP Imports/GDP
19 60
19 64
19 68
19 72
19 76
19 80
19 84
19 88
19 92
19 96
20 00
20 04
20 08
20 12
What We Trade and with Whom 203
from components that could have been produced in 10
other countries. You can see that it is difficult to decide
where it was really made. In part this is one reason why
the trade deficit we have with China is so high. China is
the final assembly point for significant consumer elec-
tronics, and it is the final assembly point that gets credit
(in our trade data) for their export to us.
There is one good on the list of exports that also may
intrigue you—“petroleum and coal products.” In this in-
dustrial group is coal and the United States is a signifi-
cant exporter of coal. It also includes refined products,
so any oil imported to the United States as crude oil into
the refineries around Houston, Texas, and is then sold
in Mexico, would show up as an export of a petroleum
product of the United States. Recent legislation has also
allowed for the exportation of crude oil.
The final item in Table 17.1 that also might also seem
out of place is the trade in services. It is hard to imagine
that we would import babysitting and lawn-mowing ser-
vices, but it is much more plausible in areas of financial
services and, specifically, in insurance. An American
insurance company can easily sell life insurance to
Canadians, and vice versa. Services make up a large and
rapidly growing area of trade, and it is one area where
the United States has a substantial trade surplus.
Table 17.2 may also surprise you in that few
Americans realize how important Canada is as a U.S.
trading partner. In trade it is roughly equal in importance
to all of Europe. Figure 17.2 shows the degree to which
these deficits continue to burgeon.
FIGURE 17.2 Trade balances with selected partners.
Source: United States Census Bureau, www.census.gov/foreign-trade
50
T ra
d e
b a
la n
c e
( $
b il li o
n s )
19901985 1995 2000
Year
2004 2012 20152009
–100
–150
–200
–50
0
–350
–450
–300
–250
Canada
Mexico
Japan
China
Middle East
European Union
Africa
TABLE 17.2 U.S. exports, imports, and trade balances of goods with selected countries and regions of the world, 2015.
Source: United States Census Bureau, www.census.gov/foreign-trade
Country
Exports
($ billions)
Imports
($ billions)
Balance
($ billions)
Canada 280.3 295.2 −14.9
Mexico 236.4 294.7 −58.4
Japan 62.5 131.1 −68.6
China 116.2 481.9 −365.7
OPEC 72.8 66.2 6.6
Europe 320.6 490.6 −170.0
Africa 26.9 25.4 1.5
World 1504.9 2241.1 −736.2
204 Chapter 17 International Trade: Does It Jeopardize American Jobs?
their individual production of two goods. We will sup-
pose that the two countries are the United States and
Brazil and the two goods are apples and coffee.
In Table 17.3 we will suppose that the United States
is better at producing apples than it is at producing
coffee and Brazil is better at producing coffee than it is
at producing apples. We will assume that a single unit
of labor is capable of producing two units of coffee in
Brazil but only one unit of apples. In the United States
that situation is reversed. A unit of labor produces two
units of apples but only one of coffee. Clearly, since
a unit of labor in the United States can produce more
apples than a unit of labor in Brazil, the United States
has the absolute advantage in apples. Similarly, it is
clear that Brazil has an absolute advantage in coffee.
To analyze comparative advantage we need to mea-
sure what is given up when the two countries allocate
a unit of labor. For instance, when Americans produce
an additional unit of coffee, they are giving up two
apples. When Brazilians produce an additional unit of
coffee, they are giving up only one-half a unit of apples.
Brazilians therefore have the lower opportunity cost of
producing coffee. Similarly, when Americans produce
an additional unit of apples they give up one-half a unit
of coffee, and when Brazilians do so they give up two
units of coffee. As a result Americans have a lower op-
portunity cost for apples. What this means is that in addi-
tion to having an absolute advantage in coffee, Brazilians
also have a comparative advantage in coffee. Similarly,
Americans have a comparative advantage as well as an
absolute advantage in apples.
These advantages need not be in line. Consider
Table 17.4, which shows where the Americans are as-
sumed to have an absolute advantage in the production
of both goods. A single unit of American labor can pro-
duce more apples and more coffee than a single unit of
Brazilian labor. As a result, Americans have an absolute
advantage in the production of both goods. Comparative
advantage is another story. The opportunity cost of an
additional unit of coffee to Americans is two-thirds of
a unit of apples. For Brazilians the opportunity cost of
an additional unit of coffee is only half a unit of apples.
Thus Brazilians have the lower opportunity cost of pro-
ducing coffee and therefore have a comparative advan-
tage in coffee. In apple production the Americans have
an opportunity cost of one and a half units of coffee while
the Brazilian opportunity cost is two units of coffee.
Americans therefore have the lower opportunity cost of
apples production and, as a result, the comparative ad-
vantage in apples.
The Benefits of International Trade
Comparative and Absolute Advantage
To illustrate the benefits of trade it is useful to distin-
guish between two kinds of “advantages” that people
can have. Consider a brain surgeon and her secretary.
Suppose that the surgeon worked her way through school
by typing papers and that she types faster than her cur-
rent secretary. If she is better at both typing and surgery,
would it be better for her to do both and fire her secre-
tary? The answer is no; she will be better off having her
slow-typing secretary do the typing. Making the decision
relies on the notion of opportunity cost that we discussed
in Chapter 1.
To review, opportunity cost is what you give up by mak-
ing the choices that you do. In the case of the secretary and
the surgeon, if the surgeon does her own typing, she must
give up at least some of her lucrative surgeries. On the other
hand, if she delegates the typing,
she will pay the secretary only a
small fraction of the money she
would earn doing extra surgeries.
In this case she has an absolute advantage in both surgery and typing, because she is better at
both things than the competition.
Her secretary has a comparative advantage at typing because the secretary has a lower opportunity
cost of doing the typing than does the surgeon.
As a simple example of how this applies to interna-
tional trade, consider Tables 17.3 and 17.4. We can il-
lustrate comparative and absolute advantage and the
benefits from trade for each of two countries by relating
absolute advantage The ability to produce a good better, faster, or more quickly than a competitor.
comparative advantage The ability to produce a good at a lower opportunity cost of the resources used.
TABLE 17.3 Production: Absolute and comparative advan- tage are the same.
Coffee Apples
United States 1 2
Brazil 2 1
TABLE 17.4 Production: Absolute and comparative advantage are not the same.
Coffee Apples
United States 3 2
Brazil 2 1
The Benefits of International Trade 205
apples and produce 60 units. The Brazilians will ship
30 units of coffee to the United States in exchange for
30 units of apples, and in the end each will be able to
consume 30 units of each and be better off with trade
than without it.
Trade is also beneficial when one country has the
absolute advantage in both goods. Turning back to
Table 17.4 we can show that there are gains from trade
here as well. Prior to trade the Brazilian situation is un-
changed from the preceding example, but the American
situation is such that 12 Americans are producing 36 units
of coffee and 18 Americans are producing 36 units of
apples. Again if both focus more on the good for which
they have a comparative advantage, coffee for Brazilians
and apples for Americans, and the terms of trade adjust
appropriately, then the Americans will again ship apples
to Brazil for coffee, and both will be better off.
Production Possibilities Frontier Analysis
We can show the gains using our Chapter 1 production
possibilities frontier as well. Recall that a production
possibilities frontier shows the output combinations that
a country can accomplish on its own. If we assume either
of the scenarios presented above, then the production
possibilities frontiers for the two countries, shown in
Figure 17.3, would have different slopes. The Brazilian
Demonstrating the Gains from Trade
In either case the gains from trade can be illustrated. Start-
ing with the situation where the gains from trade are more
obvious, look back at Table 17.3. If Americans focus their
production on apples and Brazilians on coffee, then for
every unit of labor that Americans move to apples and
Brazilians move to coffee, there is a worldwide increase in
total production of one unit of apples and one unit of coffee.
To see that each is better off with trade than without
it, suppose there is a total of 30 units of labor in each
country and each prefers apples and coffee in equal
amounts. Before trade there will be 10 Americans pro-
ducing 20 units of apples and 20 Americans producing
20 units of coffee. Similarly there will be 10 Brazilians
producing 20 units of coffee and
20 Brazilians producing 20 units
of apples.
To see that trade makes both
better off, we need to know how
the terms of trade, the amount of one good required to get the
other, between the two countries
will come out. If we suppose that it comes to one unit
of apples for one unit of coffee, then we have our an-
swer. The Brazilians will produce only coffee and make
a total of 60 units, and the Americans will produce only
terms of trade The amount of a good one country must give up to obtain another good from the other country, usually ex- pressed as a ratio.
FIGURE 17.3 Increased consumption possibilities with trade.
Production possibilities frontier
United States
A p
p le
s
Co�ee
Production possibilities frontier
Brazil
A p
p le
s
Co�ee
A p
p le
s
Co�ee
Consumption possibilities frontier
206 Chapter 17 International Trade: Does It Jeopardize American Jobs?
production possibilities frontier would be flatter and the
United States’ steeper.
If we again assume the one-for-one terms of trade, per-
fect specialization would improve the situation for both the
Americans and the Brazilians, in that the Americans would
now have to give up only one unit of coffee to get a unit of
apples instead of the two they had to give up before. The
Brazilians would benefit, too. They would have to give up
only one unit of apples instead of two to get a unit of coffee.
This is specifically illustrated in the bottom panel
of Figure 17.3, which uses the production possibili-
ties frontier of both to create a new line that shows the
consumption possibilities with trade. We saw in Chapter
1 that a production possibilities frontier farther away
from the origin implies that more production is possible.
You can see that the consumption possibilities with trade
are greater for both the Brazilians and the Americans
than their individual production possibilities without
trade. When the Brazilians concentrate on coffee and the
Americans concentrate on apples, and they trade, each
country is better off. Each produces what it produces best
and trades for what it does not produce particularly well.
Supply and Demand Analysis
We can demonstrate the same general conclusion, that
Americans are better off because of trade than without
it, using supply and demand. Using Figure 17.4, suppose
there is a market for domestically produced coffee (from
Hawaii perhaps). In a world without trade, the market
price of coffee is P domestic
and the amount that the domes-
tic industry produces is Q’ d . If there is trade and there
is a lower world price of coffee, domestic producers re-
duce the amount they produce to Q’ s . The domestic pro-
ducer surplus falls by P domestic
P world
CF. This shows up as
lower profits in the domestic coffee business and losses
to domestic coffee workers from having to look for other
work. The consumer surplus to domestic coffee consum-
ers rises by P domestic
P world
CE. In the end, the gain to con-
sumers is larger than the loss to producers.
Whom Does Trade Harm?
Even though we have seen that both countries are clearly
better off than before, there still are people who would
not necessarily like the development of trade. Specifically,
American coffee makers and Brazilian apple growers
would not necessarily find the idea of trade good. Inter-
national trade would cause workers in these industries to
lose their jobs because the competition would drive their
employers out of business. This simple model assumes
that the unemployed could find new work in the expand-
ing industries in their respective countries or in other in-
dustries generally. This assumption, however, while not
FIGURE 17.4 Gains from trade.
P P
A
B
Qs Qd Qd Q/t Q/t
Pdomestic
Pworld Pworld
S
C
EF
S
DD
Domestic market World market
Trade Barriers 207
bad in the long run, ignores the pain of people losing
their jobs and needing to attain new skills. In addition,
these displaced workers are likely to get jobs at wages
below those they were previously earning.
A relatively recent phenomenon is the development of
outsourcing. The term is generally understood by econo-
mists to narrowly apply to a firm’s use of foreign contrac-
tors to perform services that were previously performed
within the firm. So, if a computer peripheral company that
used to have a technical support line in the United States
now contracts to have this service provided by a foreign
company, this would be outsourcing. The popular press
often refers to anything that used to be done domestically
that is now done off-shore as outsourcing. Economists
refer to this as off-shoring. An example here would be a
manufacturer, like Ford, that used to assemble all of its
F-150 pickup truck line in the United States, moving
a portion of that operation to Mexico. In either case,
the same issue arises. Domestic workers are required
to find new jobs.
It is important to note, though, that in a typical non-
recession year 30 million of approximately 140 million
jobs are eliminated and about 31 million new jobs are
created. While some of the 30 million jobs that are
eliminated are eliminated because companies engage in
outsourcing or off-shoring, more jobs are created than
are lost.
Trade Barriers
Reasons for Limiting Trade
Because it is possible that with free trade some businesses
go under and some workers lose their jobs, it is useful
to summarize some of the questionable and some of the
good reasons to limit trade. The questionable reasons
begin with protecting jobs within the industries that are
being affected by better or cheaper imports. The good rea-
sons are as numerous as they are narrow. We may choose
not to trade with other countries in certain goods because
those goods may be important to our national security or
national identity. Producing such goods at home is there-
fore important in and of itself. We may choose not to
trade with countries that gain their comparative advantage
through lax worker safety rules, lax environmental laws,
or because they allow businesses to employ child labor.
Though there are clearly short-run costs to free trade,
when people lose their jobs to foreign competition and
need retraining to get new ones, the long-term benefits
usually outweigh these. When labor unions argue against
free trade, it is often because the industry that they rep-
resent has lost its comparative advantage to other coun-
tries. Though this comparative advantage is sometimes
lost because of labor or environmental protections, it is
usually because the other country has come up with a
better or more cost-effective method of producing the
good. Protecting an industry in such circumstances is not
beneficial for two reasons:
1. For capitalism to work, not only must success be
rewarded, but failure must be punished. If companies
see that the government will prevent international
competition, they will become lax, and they will not
produce the best goods for the lowest prices.
2. If other countries see that we protect our firms from
competition, they will certainly feel free to do the
same. Instead of everyone benefiting from trade, we
will return to the days before trade and lose consump-
tion possibilities. We will lose our ability to export our
goods to countries where our products are better and
cheaper than domestic goods.
The preceding points notwithstanding, there are still
good and legitimate reasons for limiting trade even
when other countries produce better or cheaper goods.
If, for instance, a country other than the United States
produced the best and cheapest combat aircraft and it
also happened to be a potential wartime enemy of the
United States, the United States would be seriously mis-
guided to shut down its own combat aircraft industry
and buy planes from the other country. For national se-
curity reasons, guaranteed access to war material is im-
portant for countries.
Countries also limit trade for reasons that are similar to
national defense. If a nation’s identity is tied to a particular
commodity the way the Japanese identity is tied to rice,
for example, it makes sense for the government to limit
imports of the commodity so that its domestic producers
can survive. Though there is enough productive capacity
in the south-central United States to supply the entire rice
consumption needs of Japan, and though the Japanese con-
tinue to pay more than five times the world market price
for rice to maintain a domestic industry, this economi-
cally inefficient trade restriction can be justified on two
grounds. First, Japan without a rice industry is not Japan;
and second, in case of a naval war in the Pacific, it is hard
to imagine the United States or any other country devot-
ing significant naval resources to protect rice shipments to
Japan. It is not a coincidence that as the Cold War waned,
the Japanese began to allow at least limited rice imports.
208 Chapter 17 International Trade: Does It Jeopardize American Jobs?
A final reason for limiting trade is that other countries
may get their comparative advantage by using production
processes that indirectly harm other countries or that other
countries find offensive. If a country lowers its production
costs, for example, by polluting in a way that would not be
allowed in the United States, the United States might rea-
sonably decide not to let that country sell its products here.
This is especially true if the pollution ultimately causes
health problems here. The United States might not want to
allow the importation of chemicals and other environmen-
tally onerous products from Mexico if, as a by-product of
their manufacture, they pollute the Rio Grande.
In addition to environmental objections, countries
may find certain labor practices so immoral that they
do not allow importation of goods from countries that
engage in them. For instance, it is against U.S. law to
import any good made with slave labor or with prison
labor. Additionally, the United States will not knowingly
allow the importation of goods made with forced or in-
dentured child labor, and the U.S. government requires
that its contractors certify that no child labor was used
in the production of its goods.1 Several countries allow
children as young as eight to work in factories several
hours a day. For example, if you own a soccer ball, it
was probably made outside the United States, and the
production involved at least one child who would not
be allowed to work in the United States. The garment
industry joins sporting goods in utilizing child labor and
engaging in other labor practices that are not legal in the
United States. Child labor has existed in nearly every
country at some point, and its use is attributable al-
most entirely to high rates of poverty. In addition, some
economists argue that laws outlawing child labor are not
necessarily good for the children involved if their only
alternative is abject poverty. Despite this, many see the
issue less in economic terms and more in moral ones.
Other reasons for limiting trade have appeal to only
a limited number of economists. The first of these, the
infant-industry argument, says that trade protection is
required to give an industry in a country time to get on
its feet. In theory, there may be an argument for tempo-
rary shelter from competition, but in practice, it often
happens that trade is permanently limited.
The second of these limited-
appeal arguments is the anti-
dumping argument. Dumping occurs when international
competitors charge less than their cost in order to drive
out competition. The argument is that competitors do
this to gain a monopoly in the long run. The problem
with this argument is ascertaining the true mar-
ginal cost of the international competitor. Inefficient
domestic producers’ assertions of dumping often hinge
on the notion that since they cannot produce at such low
costs, it must be impossible. The crux of the dumping
argument is the attempt at generating a monopoly, and
there are few if any industries in which such a strategy
has prevailed.
Methods of Limiting Trade
Once a nation has decided to limit trade, it must choose a
method. There are three main methods for limiting trade:
A country can put a tax on imported goods, limit the
quantity of a good that can be imported, or put regula-
tions on goods that are imported to make it more difficult
for the goods to be imported.
The most widely used method for limiting trade is
the use of a tax on imports, called a tariff. Figure 17.5 shows that if a country wants to limit the amount of a
good imported to Q limit
, a tax can be put on the good
that is sufficient to move the supply curve to where it
intersects the demand curve at that output. With such
a tariff the price increases to P limit
, where domestic
producers have a better chance of competing. In ad-
dition, the government gets CP limit
AB in tax revenue
that it can use to retrain work-
ers or to provide other sorts of
compensation.
The second method of limit-
ing trade, a quota, places a legal restriction on the quantity of a
dumping The exporting of goods below cost to drive com- petitors out of business.
FIGURE 17.5 The efect of tarifs and quotas.
Qlimit Q*
Plimit
P
P*
C
D
Q/t
F
A
B
E
S
Sʹ
Tari�
1See Executive Order 99-06-12, Executive Order on Child Labor,
www.fedworld.gov.
tariff A tax on imports.
quota A legal restriction on the amount of a good coming into the country.
Trade as a Diplomatic Weapon 209
good coming into the country. Also shown in Figure 17.5,
this method is popular in that it has the effect of rais-
ing the price that domestic producers can charge to
P limit
. The main difference between a quota and a tar-
iff is that with a quota the government of the import-
ing country receives no tax revenue. Importers get
to raise their prices and they get to keep the extra
money as profit. Even though it appears this method
would seem to be much worse than a tariff for the
importing country, quotas sometimes provide politi-
cal advantages. Often it is less of a diplomatic prob-
lem for a country to impose a quota on the imports of
another country. Also, as has happened before in the
automobile business, it is sometimes possible to get
an exporting country to agree to limit its exports vol-
untarily. While this operates exactly like a quota, the
exporting country retains the power to end the action
rather than ceding that power to the importing coun-
try. In the early 1980s Japan willingly limited exports
of cars to the United States when congressional action
was threatened.
The final method by which a country can limit the
imports of another country utilizes a recognized right
of a country to inspect goods coming in. If you do
not want a particular good coming into the country,
you can set up rules for its import that effectively
make the importation too costly. This method is ef-
fective, it is nearly impossible to get around, and it
becomes apparent only when the rules become silly.
The method is seen mostly with the importation of
agricultural products. Although it is perfectly legiti-
mate for a country to want to inspect a shipment to
look for certain diseases, bugs, or parasites, countries
will sometimes use such inspection as an excuse to
limit imports. Because the goods themselves are usu-
ally perishable, this can raise the cost to prohibitive
levels and effectively prevent any attempts to break
into a new market.
Many examples of these nontariff barriers exist. Some are perfectly logical; others are dubious. An
outbreak of mad cow disease
began to affect English herds
in 1999, resulting in a ban on
English beef sold in Europe.
A concern over the potential
of allergic reactions in genetically altered corn re-
sulted in a similar European ban on Starlink corn.
The European ban on milk from cows that had been
given bovine growth hormone (BGH) and the Japa-
nese ban on American apples in the 1980s appear to
be examples of the use of nontariff barriers for strictly
protectionist reasons.
Trade as a Diplomatic Weapon
There are countless examples in the last 50 years of
international trade being used to make a diplomatic
point or to solve a diplomatic problem. Since the late
1950s, the United States has imposed trade sanctions
against Cuba to destabilize Fidel Castro. In 1979, in
response to Iran’s refusal to free American diplomats
being held hostage in its embassy, the United States
made it illegal to trade with Iran. In 1980, in response
to the Soviet invasion of Afghanistan, the United
States imposed a grain embargo, making it illegal to
sell wheat to Russia. In the middle 1980s, in response
to a series of terrorist acts by the Libyan government
and its surrogates, the United States declared it illegal
to buy Libyan oil. In the early 1990s, after Iraq invaded
Kuwait, the United Nations imposed economic sanc-
tions against Iraq in hopes that Iraq would retreat. Iraq
did not retreat, the Gulf War was fought, and afterward,
further economic sanctions were used in attempts to
pressure Iraq into giving up its weapons of mass de-
struction. This too failed.2 In 2012 and 2013, both Iran
and North Korea were sanctioned by the United States
and other allies for refusal to give up nuclear weapons.
Neither budged.
Manipulating trade simply has not been particularly
effective as a method of influencing diplomacy. Cas-
tro has outlasted nine U.S. presidents; the Iranians did
not buckle to such pressure; the Soviets, the Libyans,
and the Iraqis followed their lead. The main reason that
cutting off trade has not worked as a diplomatic tool
is that it has been impossible to implement adequately.
There have always been other avenues that the countries
in question could use for trade. The Iranians had never
sold much oil to the United States, and they found
few problems selling their output to other countries.
Argentinean and Australian farmers were only too
happy to sell their grain to the Soviets, and the Libyans
and the Iraqis had few problems breaking the sanctions
imposed on them because many other countries felt free
to break them. In theory, the limiting of trade appears to
be a powerful diplomatic tool. In reality, it has not been
very effective.
2Recently released interrogations of Saddam Hussein show that he failed to com-
ply with these UN directives because Iraq had no such weapons after 1995, but
that he wanted the Iranians to believe Iraq was stronger militarily than it was.
nontariff barriers Barriers to trade result- ing from regulatory actions.
210 Chapter 17 International Trade: Does It Jeopardize American Jobs?
COSTS OF PROTECTIONISM
Reasons and mechanisms for limiting trade are available,
but their use incurs substantial economic costs. We can
examine those costs using Figure 17.5 and our consumer
and producer surplus analysis from Chapter 3. Whatever
the mechanism is for limiting trade, if the price of the
imported good increases to P limit
and the quantity is re-
duced to Q limit
, then there are winners and losers from
the protectionist measures. The losers are consumers
because their consumer surplus falls by P*P limit
AE. Do-
mestic producers are winners because they get a higher
price, and foreign producers are losers because their
sales are limited. The net gain to producers from a quota,
or alternatively the net gain to producers plus the tariff
revenue to the government, is CP limit
AB − BFE. In any
event there is a net loss to society from the protectionist
measures of ABE.
In practice this loss can be very substantial. Table 17.5
illustrates the net loss to the United States from trade
protection in certain industries. It also demonstrates the
net loss per job that the protectionist measures save. This
table clearly shows the efficiency costs to American
consumers from tariffs and quotas. We pay a few dollars
more for many goods, but these figures add up to more
than $32 billion to save 191,664 jobs. At $169,000 per
job saved, trade protectionism is one of the worst jobs
programs in place.
absolute advantage
comparative advantage
dumping
nontariff barriers
quota
tariff
terms of trade
Key Terms
Kick It Up a Notch
TABLE 17.5 Total cost of trade protectionism.
Source: Gary Hufbauer and Kimberly Elliott, Measuring the Costs of Protection in the United States. Washington, D.C.: Institute for International Economics, 1994.
Industry
Total Cost to Consumers
($ millions) Jobs Saved
Cost per Job Saved
($)
Food and beverage $ 2,947 6,035 $ 488,000
Textiles and light industry 26,443 179,102 148,000
Chemical products 484 514 942,000
Machinery 542 1,556 348,000
Miscellaneous 1,895 4,457 425,000
Total 32,311 191,664 169,000
Summary
You now understand that the United States trades in many
goods and with many partners and that we have a mas-
sive trade deficit, but that both we and our trading part-
ners benefit from our international trade. You are now
able to use the principles of absolute and comparative
advantage as well as a production possibilities frontier to
demonstrate why that is the case. You know the reasons
for limiting trade and alternative mechanisms for doing
so and that limiting trade comes at a very high cost. Last,
you now see that the use of trade as a diplomatic weapon
has been largely a failure.
Summary 211
Quiz Yourself
1. America’s most significant trading partner is
a. Saudi Arabia.
b. Canada.
c. China.
d. Japan.
2. In 2015, which country had the largest trade surplus
with the United States?
a. Saudi Arabia
b. Canada
c. China
d. Japan
3. Theoretically speaking, all trade is based on
a. comparative advantage.
b. absolute advantage.
c. numerical advantage.
d. political advantage.
4. The trends in U.S. international trade are such that
a. imports are increasing and exports are decreasing.
b. imports are decreasing and exports are
increasing.
c. both imports and exports are decreasing.
d. both imports and exports are increasing.
5. Using simple linear production possibilities fron-
tiers in a simple two-good, two-country model,
comparative advantage is evident when
a. one country can make more of both goods than
the other.
b. the slopes of the two production possibilities
frontiers are identical.
c. the slopes of the two production possibilities
frontiers are different.
d. one country is incapable of producing one good.
6. Using simple linear production possibilities fron-
tiers in a simple two-good, two-country model, ab-
solute advantage is evident when
a. one country can make more of a good than the
other country can.
b. the slopes of the two production possibilities
frontiers are identical.
c. the slopes of the two production possibilities
frontiers are different.
d. one country is incapable of producing one good.
7. Of the following justifications for limiting trade,
which one would economists be least likely to
endorse? Some goods should not be imported because
a. they are important for national defense
(e.g., tanks, fighter airplanes).
b. they are important for national identity
(e.g., television programs).
c. their production employs many people
(e.g., cars).
d. other countries use child labor to gain a com-
parative advantage (e.g., clothing).
8. When choosing to limit trade, a country can impose
a tax on imported goods. This is called
a. an estate tax.
b. a tariff.
c. a quota.
d. a capital gains tax.
9. Economists are concerned about nontariff (regula-
tory) barriers when they are used to prevent imports
when a good
a. is produced via questionable means (e.g., ban-
ning milk produced from cows injected with
bovine growth hormone).
b. is produced via more efficient use of labor.
c. may spread disease (e.g., banning beef from
countries that have experienced mad cow
disease).
d. violates local standards for decency.
Short Answer Questions
1. Use the concept of comparative and absolute advan-
tage to illustrate why a fast-typing business execu-
tive might dictate letters on a digital audio recorder
for her secretary to type rather than type them
herself.
2. List some reasons why the United States might im-
port and export cars, airplanes, chemicals, and pe-
troleum products.
3. Construct an argument against “energy indepen-
dence” as a policy goal for the United States using
the notion of comparative advantage.
4. Explain why a tariff on imported oil would be better
than an import quota as a means by which to achieve
energy independence.
Think about This
Today’s transportation infrastructure makes international
trade more efficient than intra-U.S. trade was 100 years ago.
What this means is that it is easier today for a shirt made in
China to get to California than it was for a shirt made in
Georgia to make it to Missouri in 1900. The U.S. Constitu-
tion has always banned states from regulating trade between
states. This amounted to a within United States free-trade
212 Chapter 17 International Trade: Does It Jeopardize American Jobs?
Journal of Economic Perspectives 9, no. 3 (Summer
1995). See articles by J. David Richardson and Adrian
Wood, pp. 57–80.
Krugman, Paul R. “Is Free Trade Passe?” Journal
of Economic Perspectives 1, no. 2 (Fall 1987),
pp. 131–144. Any text with a title like International
Economics.
Behind the Numbers
Country comparisons—
www.census.gov/foreign-trade/balance/index.html
Industry comparisons—
www.trade.gov
agreement. Can we use the experience of the United States
between 1900 and 2000 to predict what would happen in
world trade if there was free trade across the globe?
Talk about This
Simple trade theory suggests that a country should not
import and export the same good. It should either import
the good or export the good, but not both. Reality is that
intraindustry trade is common. What might explain this?
For More Insight See
Journal of Economic Perspectives 12, no. 4 (Fall 1998). See
articles by Dani Rodrik; Maurice Obstfeld; and Robert
C. Feenstra and Jeffrey G. Williamson, pp. 3–72.
C H A P T E R E I G H T E E N
213
International Finance and Exchange Rates Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the importance of international financial
transactions in the global economy.
LO2 Discuss how foreign exchange markets work to facilitate
trade.
LO3 List the determinants of foreign exchange rates.
LO4 Analyze how alternative foreign exchange systems operate.
Chapter Outline
International Financial Transactions
Foreign Exchange Markets
Alternative Foreign Exchange Systems
Determinants of Exchange Rates
Summary
If you have studied the chapter “International Trade:
Does It Jeopardize American Jobs?,” you know that
globalization is one of the central historical facts of the
late 20th and early 21st centuries. In the United States
alone, as a percentage of GDP, exports have more than
doubled and imports have more than tripled. Since
1970, U.S. investment abroad as a percentage of GDP
has increased 10-fold and foreign investment in the
United States as a percentage of GDP has increased
15-fold. What the previous two sentences imply is that
a massive accumulation of trade deficits has resulted
in the transition of the United States from the world’s
largest creditor nation to the world’s largest debtor na-
tion. In addition to discussing the financial implica-
tions of increasing trade, increasing American trade
deficits, and increasing globalization, this chapter dis-
cusses the exchange of the world’s currencies.
International Financial Transactions
In order for international trade to occur, international cur-
rencies have to be transacted to allow for that trade. There
is almost no barter left in the world. Because of that, there
is no guarantee that the value of what is imported will
equal the value of what is exported. There is also no guar-
antee that the amount of money Americans invest abroad
will equal the amount of money others invest in America.
To understand international finance, you have to begin
with three basic accounting concepts: balance of trade,
current account balances, and capital account balances.
When Americans buy iPads, though the iPad is made
by an American-owned company, Apple, it is assembled
in China, with components manufactured in several coun-
tries. We will wait to talk about currency exchanges until
the next section, but we know that the Chinese company
needs yuan, the currency of China, in order to pay its
employees. Ignoring that detail for the moment, suppose
that there is American currency, say $100,000,000, that
has left the United States. Whoever ends up with that
$100,000,000 can buy things that are made in the United
States: They can buy financial assets, like U.S. govern-
ment debt; they can buy physical assets that remain in the
United States, like land, buildings, or manufacturing fa-
cilities; or they can simply hold on to the cash. This latter
option is rarely chosen unless the holder lives in a country
where the dollar is a better form of money than the home
currency, or the holder is engaged in an internationally
214 Chapter 18 International Finance and Exchange Rates
illegal activity where holding cash makes them less trace-
able. In short, that $100,000,000 has to return to the
United States somehow. The “how” is the key question.
Table 18.1 lays out the balance of payments, the accounting system for how money moves
between countries to facilitate
the purchase of goods, ser-
vices, financial instruments,
and physical investments. What
“balances” with the balance
of payments is the current ac-
count and the capital account.
The current account represents the impacts of trade, short-
term investment payments, and
American payments of foreign
taxes, foreign payments of
American taxes, and the net
transfer of private money. This
latter item is most often seen
when migrant workers send
money home to their families who live outside the
United States. As you can see, mostly because of the
enormous trade deficit, there is a massive current ac-
count deficit of $470 billion.
Over time the current account and the balance of
trade mirror one another quite closely. Figure 18.1 maps
both as a percentage of GDP from 1960 to 2010. For
all but one of the last 33 years, the balance of each has
been negative. The exploding trade deficits of the 1990s
and the 2000s can be seen as trade and current account
deficits that had reached previous records in the middle
1980s and grew to in excess of 5 percent of GDP from
2003 to 2008. Both of these def-
icits fell rapidly during the re-
cession as Americans cut import
demand signficantly.
The capital account repre- sents the changes in holding
of longer-term financial and
balance of payments The accounting system for how money moves between countries to facilitate the purchase of goods, services, financial instruments, and physical investments.
current account The portion of the balance of payments ac- counting that represents the impacts of trade, short-term investment payments, and American payments of foreign taxes, foreign payments of American taxes, and the net transfer of private money.
Major Accounting Item Sub Accounting Item Sub Accounting Component
Component
Amount
Sub Accounting
Balance Balance
Current Account Balance of trade Exports 3,306,574 −389,526 −277,636
Imports 3,696,100
Balance of short-term
investment income
Income to the United States 816,445 231,076
Payments from the United
States
585,369
Net Transfers (taxes, private payments) −119,186
Capital Account Change in the ownership
of assets
U.S.-owned assets abroad 792,145 185,276 277,636
Foreign-owned assets in the
United States
977,421
Financial derivatives net −54,372
Statistical discrepancy & net derivatives 146,732
TABLE 18.1 Balance of payments, United States, 2012 ($ millions).
Source: Bureau of Economic Analysis, www.bea.gov/international
2.00
0.00
–2.00
–1.00
1.00
–6.00
–5.00
–4.00
–3.00
–7.00
P e
rc e
n ta
g e
o f
G D
P ( %
)
Current account (surplus/deficit)/GDP
Balance of trade/GDP
19 6 0
19 8 4
19 75
19 7 8
1 9 8 1
19 72
19 6 9
19 6 6
19 6 3
19 8 7
19 9 0
19 9 3
19 9 6
19 9 9
20 08
2 0 1 1
2 0 14
20 05
20 02
FIGURE 18.1 Current Account and Balance of Trade as a Percentage of GDP (1960–2014).
Source: Bureau of Economic Analysis, www.bea.gov/international
capital account Represents the changes in holding of longer- term financial and physical assets by citizens of one country in another country.
Foreign Exchange Markets 215
so at a local store, the $500 goes several places. The first
place it goes is to the store owner, who uses some of it
to pay employees and other business expenses, and some
to pay Apple. The rest is profit. Apple Inc. contracted
with a company in China (Foxconn) to assemble the iPad
from parts made all over the world and here is where
the issue of foreign exchange comes up. Those in China
want to be paid in their own currency called the yuan
(to say “yuan,” say “u-wan,” which is also known by its
other name, the “renminbi”).
Let’s look at this U.S. dollar-for-yuan exchange.
Figure 18.3 looks like any ordinary supply and demand
diagram except that the labels are more confusing. The
confusion stems from the fact that in a typical market
you are exchanging a form of currency for a good or a
service. Here you are exchanging a form of currency
for another form of currency. In this particular case
the demand for yuan is also the supply of U.S. dollars,
and the demand for U.S. dollars is really the supply
of yuan. The price is confusing. Typically the price is
quoted in terms of dollars per unit of the good. Here it
is U.S. dollars per unit of yuan. It could just as easily
be yuan per unit of U.S. dollars. For this reason we
have renamed the curves using somewhat roundabout
language.
The vertical axis of Figure 18.3 is labeled “Yuan to
U.S. dollar” because it is the number of U.S. dollars
that must be given up to get a quantity of yuan. The
horizontal axis is the amount in yuan exchanged. What
would normally be called a demand curve is the “curve
that represents the willingness of those who have U.S.
dollars to trade them for yuan.” It is downward sloping
because people would be less willing to trade their U.S.
physical assets by citizens of one country in another
country. The most significant elements of this are the
amount of foreign investment in the United States and
the amount of investment by Americans in other coun-
tries. Recall that when iPads are sold, the holders of dol-
lars have to do something with the money. For the most
part, they buy U.S. financial and physical assets. The
balance of the capital account, plus or minus a statistical
discrepancy, is the opposite of the balance of the current
account.
As can be seen in Figure 18.2, the globalization of asset
holding has grown markedly. From less than a percentage
point of GDP for much of the 1960s to 10 to 15 times
those levels today, the international ownership of finan-
cial and physical assets is quite clearly a sign of the times.
Figures 18.1 and 18.2 are directly related in that the level
of the current account deficit line in Figure 18.1 is the
difference between the two lines in Figure 18.2.
The other feature of Figure 18.2 that is worth noting
is that though the economy recovered from the Great
Recession, the financial turmoil it caused continues to
be reflected in these international transactions with ex-
traordinary fluctuations in the annual changes in invest-
ment positions.
Foreign Exchange Markets
To understand the importance and the complexity of
dealing with foreign exchange, consider the simple act
of buying a low-end iPad. When you plunk down $500 or
18.00
14.00
10.00
12.00
16.00
2.00
4.00
6.00
8.00
–4.00
–2.00
0.00
A n
n u
a l in
v e
s tm
e n
t a
s a
% o
f G
D P
U.S.-owned assets abroad Foreign-owned assets in the United States
19 60
19 84
19 75
19 78
19 81
19 72
19 69
19 66
19 63
19 87
19 90
19 93
19 96
19 99
20 08
20 11 20
14 20
05
20 02
FIGURE 18.2 Foreign purchases of U.S. assets and U.S. pur- chases of foreign assets as a percentage of GDP (1960–2014).
Source: Bureau of Economic Analysis, www.bea.gov/international
A curve that represents the willingness of those who have U.S. dollars to trade them for yuan
A curve that represents the willingness of those who have yuan to trade them for U.S. dollars
Equilibrium exchange rate
Quantity of yuan
Price of yuan
in U.S.
dollars
FIGURE 18.3 Yuan to U.S. dollar.
216 Chapter 18 International Finance and Exchange Rates
dollars for yuan if they had to give up more U.S. dollars
to do it. What would normally be called a supply curve is
the “curve that represents the willingness of those who
have yuan to trade them for U.S. dollars.” It is upward
sloping because people would be more willing to trade
their yuan for U.S. dollars if they could get more dollars
from them.
Going back to our iPad example, this simple pur-
chase involves a number of different currencies that
must be exchanged because the components are pro-
duced throughout Asia. If currency exchange is as easy
as going to the bank with a $20 bill and asking for 20 $1
bills, then foreign exchange is not an obstacle to trade. In
most of the Western world, it
is a relatively simple proposi-
tion for a corporation to get the
currencies it needs. There are foreign exchange markets
in all large cities that have stock markets. If you need
a special permit to exchange currency, however, the
transaction is far more cumbersome. Moreover, if that
special permit is given only to those who support the
ruling party, the ease of trading ranges from difficult
to nearly impossible. Who gets hurt by such obstacles
to trade? Lots of people. With too many barriers your
iPad either will not be manufactured or will cost much
more. You will be forced to choose to pay more or to
do without it. The store owner will lose profit and the
store salesperson will lose commissions. The distribu-
tor, Apple, and the Chinese worker will be hurt too;
one will not make a sale; the other will not have a job.
In most places in the world, exchange rates are like
any freely traded asset. The price, or in this case the
exchange rate, changes over time. A look at Figure 18.4
foreign exchange The conversion of the currency of one coun- try for the currency of another.
1.70
U.S. dollar per euro
U.S. dollar per British pound
Japanese yen per U.S. dollar
Chinese Yuan per U.S. dollar
140
130
120
110
100
90
80
70
Y e
n /D
o ll a
r Y
u a
n /D
o ll a
r
D o
ll a
rs /E
u ro
D o
ll a
rs /B
ri ti
s h
P o
u n
d
8.50
8.00
7.50
7.00
6.50
6.00
1.60
1.50
1.40
1.30
1.20
1.10
1.00
0.90
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1/ 3/
20 00
1/ 3/
2 0 0 1
1/ 3/
20 02
1/ 3/
20 03
1/ 3/
20 04
1/ 3/
20 05
1/ 3/
20 06
1/ 3/
20 0 7
1/ 3/
20 08
1/ 3/
20 09
1/ 3/
2 0 10
1/ 3 /2
0 11
1/ 3/
2 0 12
1/ 3/
2 0 13
1/ 3/
2 0 14
1/ 3/
2 0 15
1/ 3/
2 0 16
1/3 /2
00 0
1/ 3/
20 01
1/3 /2
00 2
1/3 /2
00 3
1/3 /2
00 4
1/3 /2
00 5
1/3 /2
00 6
1/3 /2
00 7
1/3 /2
00 8
1/3 /2
00 9
1/ 3/
20 10
1/ 3/
2 0 11
1/ 3/
20 12
1/ 3/
20 13
1/ 3/
20 14
1/ 3/
20 15
1/ 3/
20 16
1/3 /2
00 0
1/ 3/
20 01
1/3 /2
00 2
1/3 /2
00 3
1/3 /2
00 4
1/3 /2
00 5
1/3 /2
00 6
1/3 /2
00 7
1/3 /2
00 8
1/3 /2
00 9
1/ 3/
20 10
1/ 3/
2 0 11
1/ 3/
20 12
1/ 3/
20 13
1/ 3/
20 14
1/ 3/
20 15
1/ 3/
20 16
1/ 3/
20 00
1/ 3/
2 0 0 1
1/ 3/
20 02
1/ 3/
20 03
1/ 3/
20 04
1/ 3/
20 05
1/ 3/
20 06
1/ 3/
20 0 7
1/ 3/
20 08
1/ 3/
20 09
1/ 3/
2 0 10
1/ 3 /2
0 11
1/ 3/
2 0 12
1/ 3/
2 0 13
1/ 3/
2 0 14
1/ 3/
2 0 15
1/ 3/
2 0 16
FIGURE 18.4 Exchange rates between the dollar and four major currencies.
Source: Board of Governors of the Federal Reserve System, www.federalreserve.gov/releases/h10/hist
Alternative Foreign Exchange Systems 217
shows the exchange rate between the dollar and other
key currencies around the world. As the previous sec-
tion suggested, any exchange rate between any two
currencies can be expressed either as the amount of
country A’s currency you need to buy one unit of coun-
try B’s currency, or vice versa. They are commonly
expressed in both ways, as they are in Table 18.2, but
there are times when a conventional method of expres-
sion dominates. For instance, the yen–dollar exchange
rate is almost always expressed in terms of the number
of yen it takes to get a dollar, whereas the dollar–pound
exchange rate is typically expressed the other way.
There is no functional difference, as one is always the
reciprocal of the other.
A strengthening of the dollar relative to the currency
in each graph is shown as a decrease in the dollar per
other currency line and an increase in the other currency
per dollar line. So between July 2008 and November
2008 the dollar strengthened relative to the euro and
pound and weakened relative to the yen.
It is important to note that the Chinese government does
not let its currency move at the whim of market forces.
It was not until 2005 that the Chinese let their currency
move, and even then it was only slowly, and not nearly as
fast as free market forces would have had it move.
In 2010 China began a slow process of letting the
yuan float with other currencies in a managed way. In
2015 and early 2016, the yuan actually began decreasing
in value as the slowdown in the Chinese manufacturing
economy began to impact exchange rates.
Alternative Foreign Exchange Systems
Throughout modern history, currencies have been ex-
changed in order to facilitate trade. During that time
there have been three models for setting those exchange
rates. As suggested by Figure 18.4, most exchange rates
are determined by market forces. An increase in the de-
mand for a currency will strengthen it relative to another
currency. While this is the system that dominates today,
it has not always been that way and as intimated above
with reference to the Chinese yuan, market forces can be
controlled by governments.
Though we have already dis-
cussed the market, let’s quickly
review the role of the market in
determining exchange rates. In
a floating exchange rate system, there is no government control
floating exchange
rate system Foreign exchange rate system where there is no government control over exchange rates.
TABLE 18.2 Exchange rates between several currencies and the U.S. dollar, February 3, 2016.
Source: http://www.x-rates.com/table/?from=USD&amount=1
Foreign Currency
Amount of
Currency
Needed to
Get $1
Amount of U.S.
Dollars Needed
to Get One Unit
of the Currency
Argentine Peso 14.145009 0.070696
Australian Dollar 1.396831 0.715906
Bahraini Dinar 0.377095 2.651852
Botswana Pula 11.482067 0.087092
Brazilian Real 3.894941 0.256743
British Pound 0.685333 1.459145
Bruneian Dollar 1.414138 0.707144
Bulgarian Lev 1.76236 0.567421
Canadian Dollar 1.378635 0.725355
Chilean Peso 704.795996 0.001419
Chinese Yuan Renminbi 6.575946 0.152069
Colombian Peso 3373.5 0.000296
Croatian Kuna 6.91826 0.144545
Czech Koruna 24.383567 0.041011
Danish Krone 6.734442 0.14849
Emirati Dirham 3.673 0.272257
Euro 0.902379 1.108182
Hong Kong Dollar 7.794381 0.128298
Hungarian Forint 281.001131 0.003559
Icelandic Krona 129.49 0.007723
Indian Rupee 67.828047 0.014743
Indonesian Rupiah 13735.33119 0.000073
Iranian Rial 29950 0.000033
Israeli Shekel 3.938317 0.253916
Japanese Yen 118.041073 0.008472
Kazakhstani Tenge 370 0.002703
Kuwaiti Dinar 0.30165 3.3151
Latvian Lat 0.634192 1.57681
Libyan Dinar 1.36 0.735294
Lithuanian Litas 3.115733 0.320952
Malaysian Ringgit 4.174 0.239578
Mauritian Rupee 36.055 0.027735
Mexican Peso 18.169871 0.055036
Nepalese Rupee 108.991944 0.009175
New Zealand Dollar 1.502725 0.665458
Norwegian Krone 8.57476 0.116621
Omani Rial 0.3845 2.60078
Pakistani Rupee 104.85 0.009537
Philippine Peso 47.875 0.020888
Polish Zloty 3.989091 0.250684
Qatari Riyal 3.6409 0.274657
Romanian New Leu 4.07219 0.245568
Russian Ruble 76.709769 0.013036
Saudi Arabian Riyal 3.74962 0.266694
(Continued )
218 Chapter 18 International Finance and Exchange Rates
Foreign Currency
Amount of
Currency
Needed to
Get $1
Amount of U.S.
Dollars Needed
to Get One Unit
of the Currency
Singapore Dollar 1.414138 0.707144
South African Rand 15.925171 0.062794
South Korean Won 1201.51151 0.000832
Sri Lankan Rupee 144.153287 0.006937
Swedish Krona 8.452912 0.118302
Swiss Franc 1.006031 0.994005
Taiwan New Dollar 33.29 0.030039
Thai Baht 35.695587 0.028015
Trinidadian Dollar 6.4202 0.155758
Turkish Lira 2.915752 0.342965
Venezuelan Bolivar 6.305 0.158604
remained constant for an extended period of time. In that
system, depicted in graph A of Figure 18.5, an increase
in demand for yuan must be met immediately with an
increase in the supply of yuan by the Chinese govern-
ment. That is not difficult for a country to maintain.
It can always print more of its own currency. Graph B
shows the opposite problem. Were the demand for yuan
to decrease, the Chinese government would have to re-
duce the supply of its own currency. This can be done
by its supplying the necessary dollars to buy the yuan,
or as graph B shows, pulling yuan out of the system,
typically through exchanging other currencies or gold.
If, once again, you focus on Figure 18.4 you note that
from early 2006 to early 2009, the Chinese government
let the yuan strengthen in value from 8 yuan to the dol-
lar to a new set level of 6.8 yuan to the dollar. It has
subsequently been allowed to strengthen to 6.5 yuan to
the dollar. The Chinese government is clearly engaging
in market transactions to ensure that the yuan does not
become so strong that it eliminates the cost advantages
that Chinese firms have in producing goods for the U.S.
market. Many economists would consider this currency
manipulation.
The third alternative is
a managed float exchange rate system. In this system governments decide the range
of exchange rates they will
allow the market to create, and
act only when either the top end
or the bottom end of that range
is breached. In this circum-
stance the government need not
change the supply of its currency by the amount nec-
essary to bring about the target exchange rate. It must
only do enough to bring it back into the desired range.
Graphs C and D work exactly like graphs A and B ex-
cept that the government(s) managing the exchange
rate must increase or decrease the supply of the cur-
rency by a smaller amount so as to maintain the desired
range.
In post–World War II history the world has seen its
major currencies exchanged in all three fashions. As
we indicated above, immediately after World War II
the fixed exchange rate system dominated. The system
became untenable in the early 1970s, and from that
point to today, the system has been mostly a floating ex-
change rate system with periods of managed float when
exchange rates changed too markedly for politicians to
stomach.
over exchange rates. The market for various currencies
is determined solely by the forces of supply and demand.
Shifts in the curves from Figure 18.3 are determined by
the factors outlined in the next section. That is, trade im-
balances, differences in real interest rates, and changes
in the relative safety of investments in the two countries
will cause changes to exchange rates.
We now turn our attention to the system that was
common between World War II and the early 1970s.
One of the perceived ills of the exchange rate system
of the 1920s and 1930s was that, because it was deter-
mined by markets, it created uncertainty for traders. In
the days before options markets (where traders could
lock in exchange rates for the future), the concern was
that uncertain exchange rates dampened trade and that
dampened trade was bad for the
world economy. As a result,
after World War II a fixed ex- change rate system was enacted. Under a fixed exchange rate
system, the country (or group
of countries) that wishes ex-
change rates to be fixed relative
to other countries’ currencies
must stand ready to purchase
or sell its currency in exchange
for foreign currencies or gold
so that any excess demand or excess supply is immedi-
ately eliminated. (The gold standard is simply one way
in which a country can achieve a fixed exchange rate.)
For instance, if you look at the yuan–dollar exchange
rate from Figure 18.4, you note that the exchange rate
fixed exchange
rate system Foreign exchange rate system whereby the country (or group of countries) must stand ready to purchase or sell its currency in exchange for foreign currencies or gold so that any ex- cess demand or excess supply is immediately eliminated.
managed float ex-
change rate system Foreign exchange rate system whereby govern- ments decide the range of exchange rates they will allow the market to create, and act only when either the top end or the bottom end of that range is breached.
TABLE 18.2 (Continued )
Determinants of Exchange Rates 219
A decrease in the desire of either to have U.S. dol-
lars will weaken the U.S. dollar, causing the price of
yuan—the U.S. dollar-to-yuan exchange rate—to rise.
So what specific factors determine the desirability of
various currencies?
The first and typically most important factor for ex-
change rates is the trade imbalance between the two coun-
tries. The United States has a significant trade deficit relative
to China. If the yuan and dollar are determined in markets
(and we know from the above discussion of exchange rate
systems they are not), the yuan will strengthen relative to
the dollar. This is because there will be more dollars in the
foreign exchange markets going after yuan.
The second factor influencing exchange rates is the
relative real interest rate being offered on investments in
the two countries. This combines two ideas, because the
real interest rate is the difference between nominal in-
terest and expected inflation. If inflation is expected to
be the same in the two countries, because investors will
seek the maximum return on their investment regardless
Determinants of Exchange Rates
Recall from our discussion of supply and demand in
Chapter 2 and from our discussion of aggregate supply
and aggregate demand in Chapter 8, we presented the
models and then presented the reasons why each of the
curves might shift. We need to replicate that here except
that we need to remember that there really is no distinc-
tion between supply and demand, so we will look at the
factors that will strengthen or weaken an exchange rate.
Since each exchange rate applies only to the two countries
involved, the factors are expressed relative to one another.
So returning to our discussion of the U.S. dollar and
Chinese yuan, the dollar can get stronger or weaker
relative to the yuan if either the desire of yuan holders
to acquire U.S. dollars changes or the desire of U.S.
dollar holders to acquire yuan changes. An increase in
the desire of either to have U.S. dollars rather than yuan
would strengthen the U.S. dollar, causing the price of
yuan—the U.S. dollar-to-yuan exchange rate—to fall.
Price of yuan
in dollars
D1
S1
S2
D2
Yuan* Yuan
ERfixed
A
C
B
D
Price of yuan
in dollars
D1
S1 S2
D2
Yuan* Yuan
ERtarget
ERceiling
ERdoor
Price of yuan
in dollars
D1
S1
S2
Yuan* Yuan
ERtarget
ERceiling
ERdoor
D2
Price of yuan
in dollars
D2
S2
S1
D1
Yuan* Yuan
ERfixed
FIGURE 18.5 Alternative exchange rate systems.
220 Chapter 18 International Finance and Exchange Rates
of where that happens, they will seek the currency of the
country with the highest interest rate. As a result, the
currency of the country with the higher interest rate will
strengthen relative to the one with the lower interest rate.
If the interest rates of the two countries are the same, the
country with the lower anticipated rate of inflation will
see its currency strengthen relative to the country with
the higher anticipated inflation rate.
The third factor is the relative safety of assets held
in a particular country. This is why the dollar nearly
always strengthens in times of international strife. The
U.S. government, though in significant debt, holds the
distinction of being the one government that has paid
every debt it has ever incurred. Being a haven for in-
ternational investors seeking safety means that the dol-
lar strengthens even when strife was triggered in the
United States. The dollar strengthened slightly in the
wake of 9/11 and strengthened mightily relative to
the euro and pound during the fall 2008 financial crisis
(which started in, but was not confined to, the United
States). There was also a relatively short-lived strength-
ening of the dollar during the European sovereign debt
crisis of 2010. This occurred despite the United States
having its own debt issues because investors were more
concerned about the euro-denominated debt of Spain,
Greece, and Ireland.
Summary
For foreign trade to exist, currencies must be traded.
Whenever trade between two countries is not balanced,
the money that is not returned to the country maintain-
ing a trade deficit will have to return eventually and will
be used to buy assets in that country. As a result, trade
balances, which are augmented by short-term invest-
ment flows, will be balanced by longer-term asset own-
ership exchanges. In this way the current account and
capital account balance. The United States runs a large
trade deficit and as result runs a large current account
deficit. This is balanced by a substantial capital account
surplus. The markets in which these currencies are ex-
changed can be allowed to function freely and without
government intervention, or they can be managed by
governments to maintain either fixed exchange rates
or exchange rates within an acceptable range. Whether
a currency is strong or weak typically depends on the
trade balance between the two countries, the relative
inflation rates, the relative interest rates, and the rela-
tive safety of investments in the countries.
During the 2012 presidential election, there was political bom-
bast on several issues, but one of the issues where both sides
were in agreement was that “we” needed to get tough on Chi-
nese currency manipulation. Is there evidence that the Chinese
manipulate their currency? Of course, there is. That is what hap-
pens when you have a fixed exchange rate system. You pick your
desired exchange rate and you manipulate the market by buying
and selling your currency in exchange for some other currency
(or gold) in an attempt to achieve your desired exchange rate.
In order to maintain the 6.22 yuan per dollar exchange rate, the
Chinese have had to print more of their currency to sell into the
market than they would otherwise have to print to maintain a
functioning economy.
However, the United States is hardly innocent of the same charge.
The United States has weakened its currency relative to every other
currency by the unprecedented monetary policy of the Great Recession
era (2008–2013). This can be seen most clearly in the upper right graph
of Figure 18.4, which maps the value of the dollar relative to the value
of the Japanese yen. From its peak in 2008, the dollar had been worth
110 yen. By early 2012, the dollar was only worth 76 yen. This made
Japanese exports to the United States much less competitive, and by
that time the Japanese had tired of it and began a manipulation to
counter the U.S. monetary policy. In so doing, they raised the exchange
rate (by weakening the yen) to 96 yen to the dollar by March 2013.
The lesson here is that the charge of currency manipulation can
be hurled at many countries, the United States included.
A R E T H E C H I N E S E M A N I P U L A T I N G T H E I R C U R R E N C Y ? A R E W E ?
Summary 221
Key Terms
Short Answer Questions
1. Explain why the current account and the trade bal-
ance are so closely aligned.
2. Explain or illustrate why it is that if $1 will buy you
.8€ that 1€ must equal $1.25.
3. If you had $1,000 and wanted to get the most for it
and you believed that the dollar would get weaker
relative to the yen by 10 percent and that you could
earn 5 percent in the United States and only 1 percent
in Japan, show that you would still want to invest in
a yen-denominated asset.
4. If you were a U.S. politician seeking to strengthen
the dollar, how might you accomplish that, and what
would the consequence be of the attempt?
Behind the Numbers
Exchange rates.
Current: www.x-rates.com
Historical: www.federalreserve.gov/releases/h10/hist
Balance of trade, current account, and capital accounts
www.bea.gov/international
balance of payments
capital account
current account
fixed exchange rate system
floating exchange rate system
foreign exchange
managed float exchange rate
system
Quiz Yourself
1. What two numbers “balance”?
a. The current account and exports
b. The capital account and the current account
c. Exports and imports
d. Short-term investment income and short-term
investment payments
2. From one country’s perspective a strong currency is
a. always good.
b. always bad.
c. good for some people and bad for others.
3. The dollar to yuan exchange rate will equal
a. the yuan to dollar exchange rate.
b. the reciprocal of the yuan to dollar exchange
rate.
c. the yuan to euro exchange rate.
d. the square of the yuan to dollar exchange rate.
4. If one country determines it wants a fixed exchange
rate with another
a. it can do nothing on its own but must have the
cooperation of the other country.
b. it only needs to announce its desired exchange
rate, and that will result.
c. it must stand ready to purchase or sell its own
currency in the market to maintain the exchange
rate.
5. An increase in the expected inflation rate in one
country will
a. strengthen its currency.
b. weaken its currency.
c. have no impact on the exchange rate between its
currency and other currencies.
222
European Debt Crisis Learning Objectives
After reading this chapter you should be able to:
LO1 Understand that the creation of the euro integrated
monetary policy across member nations without effective
integrating fiscal policies.
LO2 Understand that the integration of the monetary systems in
the European Union allowed for the influx of relatively cheap
capital into poorer European nations.
LO3 Understand that the causes of the Irish and Spanish crises
differed markedly from the Italian and Greek crises.
LO4 Understand that the policies that the United States used to
mitigate the Great Recession were largely unavailable to
those European nations faced with crises.
LO5 Understand that the exit of individual countries from the
euro could have set off a Europe-wide banking crisis had it
occurred during the crisis.
Chapter Outline
In the Beginning There Were 17 Currencies in 17 Countries
The Effect of the Euro
Why Couldn’t They Pull Themselves Out? The United States Did
Is It Too Late to Leave the Euro?
Where Should Europe Go from Here?
Summary
From late 2008 through all of 2016 (and perhaps be-
yond), the world economy was either in free fall
or recovering at a painfully slow rate. The United
States experienced the Great Recession (the subject
of Chapters 13 and 14) and experienced an extraor-
dinarily weak recovery (the subject of Chapter 15).
Meanwhile China’s growth slowed and Europe stum-
bled from one crisis to the next. In the process, there
was a constant threat that Europe’s troubles would/
could drag the world into another, perhaps even deeper,
global recession. This chapter explores the causes of
Europe’s problems during this period by going back to
the scene of the crime—the creation of the euro. The
chapter continues with an analysis of the impact of
the euro’s creation on housing markets in Ireland and
Spain and on the borrowing habits of Italy and Greece.
The chapter then describes why the existence of the
euro made it very difficult for governments in the most
hard-hit countries to recover and why there is so much
disagreement over the austerity policies many coun-
tries were compelled to employ to secure the help of
healthier European economies. The chapter concludes
by recognizing that some countries may be better off
in the future if they leave the euro, and those countries
that remain with that currency may be better off if the
weaker ones do leave.
In the Beginning There Were 17 Currencies in 17 Countries
After World War II when country borders were redrawn
by the allied powers, each of the countries of Europe
reestablished their individual currencies. Germany had
the mark; France had the franc; Italy had the lira; Greece
had the drachma; and so on. Very quickly it became
clear to the various governments that the European
C H A P T E R N I N E T E E N
The Effect of the Euro 223
The Effect of the Euro
The effect of the creation of the euro and these provisions
was that the poorer members, some southern European
countries, in particular, saw relatively rapid growth. As
can be seen in Figure 19.1, growth in Ireland, Spain, and
Greece exceeded that of the euro area and the United
States from 2001 through 2007.
As can be seen in Figure 19.2, there was and is a
considerable discrepancy between the per capita GDP
of these countries. With the European Union-27 mem-
ber nations indexed as 100, the interpretation of the
data below is that in 2001 Greece had a per capita GDP
50 percent lower than the Netherlands and Germany.
Spain was 15 percent poorer than Germany.
That these countries were growing faster than the
richer countries promoted considerable lending to poorer
member countries largely because interest rates to poorer
member countries converged to the already low rates of
the richer member countries. This was because investors
believed that a loan to a euro-member country or a fi-
nancial institution in a euro-member country was largely
the same regardless of whether that nation was relatively
rich or poor. As can be seen in Figure 19.3, the interest
rates on 10-year government debt were, during the pe-
riod from 2001 to 2007, largely identical across Europe’s
largest governments.
These low interest rates and the relatively attractive
weather of Ireland and Spain generated housing bub-
bles in those two countries that were even more inflated
than those in the United States. Figure 19.4 shows that,
between 2000 and 2009 and relative to the first quarter
in 2000, housing prices doubled in the United States,
but increased by 125 percent in Spain and by 150 per-
cent in Ireland. The sources of those mortgage loans,
however, differed. In the United States, Fannie Mae
and Freddie Mac bought and securitized mortgages as
mortgage-backed securities (MBS). In Europe, the in-
strument was the “covered bond.” In that method, the
loans remained with the originating banks (unlike in
the United States where the originating bank sold the
mortgages within days) and then sold bonds that were
backed by those mortgages. As a result, a bank in the
United States that did not purchase MBS for its own
portfolio could have largely escaped the housing cri-
sis. In Europe, however, any bank that made the loans
and any financial institution that purchased the covered
bonds were vulnerable to this crisis. In both Ireland
and Spain, the bursting of the housing bubble severely
damaged banks in those countries but also threatened
economies would recover more quickly with a free-
trade union allowing freight to travel between the coun-
tries without having to stop at each border crossing. In
1958 the European Union’s predecessor, the European
Economic Community, was created to establish travel
and trade rules throughout the member nations.1
Through the years, the movement for European integra-
tion intensified, culminating in a series of referendum
votes in the 1990s approving the Maastricht Treaty that
created a common currency for 16 countries.2 The cur-
rency was in use in financial markets only from 1999 to
2001 and has circulated as the currency of the member
states since.
By joining the euro, countries gave up a major sym-
bol of their sovereignty, their currency. They also gave
up the ability to use monetary policy (described in
Chapter 10) as individual countries because they had to
cede that authority to the European Central Bank (the
counterpart to the United States’ Federal Reserve). It
was for these reasons that some European Union nations,
most notably the United Kingdom, refused to join. The
transition process was remarkably smooth. Bank bal-
ances were converted from home currencies to euro-de-
nominated balances at specified rates, and actual paper
and coin currency was recalled and exchanged. This
typically occurred when businesses would deposit their
local currency at local banks. At that time they would
receive credit for those deposits in euros.
Several other provisions of the Treaty on the Func-
tioning of the European Union were put in place to avoid
the kind of economic catastrophe that we have seen in
Greece and Spain. One such provision, Article 126,
was that countries were required to maintain a deficit-
to-GDP ratio of less than 3 percent and work to a debt-
to-GDP ratio of less than 60 percent. Another, Article
123, stated that the European Central Bank could not
purchase member nation debt. A third, Article 125, pro-
hibited bailouts of one country by the union or by any
member state unless it was viewed as necessary to avoid
a systemic financial collapse of the entire union.
1 Current members: Austria, Belgium, Bulgaria, Cyprus, the Czech Republic,
Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland,
Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland,
Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United
Kingdom. Bold = original members 2 There are now 17 countries that are part of the currency union. They are
Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland,
Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and
Spain. Estonia joined in 2010 and was not part of the original 16. Further, mil-
lions more live in countries with currencies whose value is pegged to the euro.
224 Chapter 19 European Debt Crisis
FIGURE 19.1 GDP growth in euro countries and the United States.
Source: European Central Bank, www.ecb.int/stats/html/index.en.html
Euro area (changing composition) Ireland
Greece France Netherlands United States
GermanySpain United KingdomItaly
8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
2
0
–2
4
6
–10
–8
–6
–4
Euro area (17 countries) Ireland
Greece France Netherlands United States
GermanySpain United KingdomItaly
160
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
130
120
110
140
150
70
90
80
100
FIGURE 19.2 Per capita GDP across Europe and the United States relative to EU-27.
Source: Eurostat, http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home
The Effect of the Euro 225
FIGURE 19.3 Long-term interest rates.
Source: European Central Bank, http://sdw.ecb.europa.eu
25
20
15
30
35
5
0
10
GreeceGermany Ireland
FranceSpain
United KingdomNetherlands
Italy
Ja n-
01
Ju n-
01
N ov
-0 1
A pr
-0 2
Se p-
02
Fe b-
03
Ju l-0
3
D ec
-0 3
M ay
-0 4
O ct
-0 4
M ar
-0 5
A ug
-0 5
Ja n-
06
Ju n-
06
N ov
-0 6
A pr
-0 7
Se p-
07
Fe b-
08
Ju l-0
8
D ec
-0 8
M ay
-0 9
O ct
-0 9
M ar
-1 0
A ug
-1 0
Ja n-
11
Ju n-
11
N ov
-1 1
A pr
-1 2
Se p-
12
Fe b-
13
Ju l-1
3
D ec
-1 3
M ay
-1 4
O ct
-1 4
M ar
-1 5
A ug
-1 5
FIGURE 19.4 Housing prices in Spain, Ireland, and the United States.
Sources: www.statcentral.ie; www.standardandpoors.com
250
200
150
300
350
0
50
100
20 00
Q 1
20 00
Q 4
20 01
Q 3
20 02
Q 2
20 0 3Q
1
20 03
Q 4
20 04
Q 3
20 05
Q 2
20 06
Q 1
20 06
Q 4
20 07
Q 3
20 08
Q 2
20 09
Q 1
20 09
Q 4
20 10
Q 3
2 0 11
Q 2
2 0 12
Q 1
USIreland Spain
226 Chapter 19 European Debt Crisis
also high. Politically, Italy’s prime minister was a self-
aggrandizing, womanizing media mogul with no desire
to tackle difficult structural issues such as reforming a
pension system for a declining population.
In Greece, the origins were far worse. Its debt was
always high and its deficits were worse. If it is possible,
they were actually worse than the data show them to be
because it is widely believed that the true deficit picture
in Greece is worse than they reported to the European
Union. This is because tax evasion by individuals and
businesses in Greece is so pervasive as to be intractable.
Everyone uses as their excuse for cheating on their taxes
that others are too and that when others start paying their
share, they will too.
Why Couldn’t They Pull Themselves Out? The United States Did
Though the start of the decline in economic activity
among powers began in the United Kingdom, it got its
first major push in the United States with the collapse of
larger German and French banks because this is where
the money originated. Had there been no covering of
the Irish and Spanish bonds by German and French
banks, there would have been insufficient funds for
Irish and Spanish banks to lend to people buying
homes in Ireland and Spain and there would have been
no housing bubble.
In Italy, the recession and fiscal crisis had a very dif-
ferent origin. Italy’s economy is simply and steadily on
the decline and has been for some time. In 2000, its per
capita GDP was 18 percent higher than the EU-27 av-
erage. By 2010, it was at the EU-27 average. That is,
on a relative basis, the Italians spent the decade getting
poorer. This has structural and political origins. The
structural origin was twofold. First, Italy is aging more
rapidly than any other major European economy be-
cause the birthrate has plummeted for the better part of
40 years. Fewer births translate to fewer workers sup-
porting its pension system. Second, it began with a rela-
tively high debt. As can be seen in Figure 19.5, the Italian
national debt was relatively high for the period prior to
the crisis, and its deficits, as shown in Figure 19.6, were
FIGURE 19.5 Debt to GDP.
Source: Eurostat, http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home
180
100
80
60
120
140
160
200
0
20
40
GreeceGermany Ireland
Portugal
France
SpainNetherlandsItaly
1 9 9 0
1 9 9
1
1 9 9 2
1 9 9 3
1 9 9 4
1 9 9 5
1 9 9 6
1 9 9
7
1 9 9 8
1 9 9 9
20 00
2 0 0 1
20 02
20 03
20 04
20 05
20 06
20 07
20 08
20 09
2 0 10
2 0
1 1
2 0 12
2 0 13
2 0 14
Why Couldn’t They Pull Themselves Out? The United States Did 227
FIGURE 19.6 Deficits to GDP.
Source: Eurostat, http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home
5
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
–10
–15
–20
–5
0
–35
–30
–25
EU (27 countries)
GreeceGermany France Netherlands
Euro area (17 countries)
Ireland Spain United KingdomItaly
the American housing bubble in late 2008. The United
States did three big things to counter the impact of the
Great Recession: (1) TARP (the bank bailout), (2) acts of
monetary policy on an unprecedented scale, and (3) fiscal
policy–induced explosions in deficits in the form of Bush
and Obama stimulus packages. The United Kingdom and
France did the latter; Germany did not. The deficits in
Germany in 2009 and 2010 were on the scale of their
2001–2005 deficits, whereas the deficits in the United
States and France were two to three times those levels.
As for monetary policy, as Chapters 10, 13, and
14 noted, the Federal Reserve of the United States cre-
ated and exercised authority in the area of monetary
policy well beyond what any previous Federal Reserve
chairperson would recognize. As a result of those actions,
interest rates throughout the United States were at or near
all-time lows. The Treasury was borrowing money on the
short-term market for nearly zero interest. In the long-
term market, interest rates were so low that 15-year mort-
gages were being offered for less than half of previous
1960s era records. These were directly the result of the
Federal Reserve’s purchasing U.S. debt at record rates.
Why did European nations not do the same thing? Sim-
ply put, they couldn’t. They couldn’t do so individually
because interest rates were too high, and they couldn’t do
so collectively because of the Article 123 provision that
prohibited the purchase of member- nation debt by the
European Central Bank. Italy, Ireland, Greece, and Spain
did not have any tools of monetary policy, let alone the
expanded ones, because just like the state of Maryland
doesn’t have its own central bank, neither do individual
EU countries.
Further, at its creation, the European Central Bank
had one and only one mission—inflation control—and
it is governed by the Germans, the Dutch, the French,
and the Belgians, who have little interest in generating a
threat of inflation for themselves by engaging in mone-
tary policy that would help the Greeks, Spanish, Italians,
and Irish. To make things worse, the individual coun-
try’s governments had limited ability at best to engage in
their own version of TARP, though the Irish tried. They
would have had to borrow the money to do so and, as
can be seen by Figure 19.3, the interest rates they faced
on borrowing was prohibitive. Further, and for the same
reason, they could not engage in fiscal policy to stimu-
late their economies on their own because, again, they
would have to borrow the money to do it. The bottom
line is that everything the United States did to minimize
228 Chapter 19 European Debt Crisis
the impact of the Great Recession was unavailable to the
weaker economies of Europe, largely because they had
no control over the value of their currency and had no
ability to borrow at reasonable interest rates.
Because there was a growing recognition among the
Germans and French that their economies were threat-
ened by the instability of weaker ones, there was a will-
ingness among the Germans and French to help the
Greeks, Spaniards, Irish, and Italians. This formal recog-
nition of the threat to the EU, generally, allowed for the
cross-national bailouts because the systemic risk clauses
of Articles 123 and 125 were invoked. For political and
economic purposes, though, the Germans and French in-
sisted that the weaker economies reform their budgets
before they received the assistance. In each case the
demand was for spending cuts and tax increases. These
austerity policies had consequences. Figure 19.7 shows
that unemployment rose everywhere but rose more dra-
matically in these weaker economies. Governments laid
off employees, cut pensions, and increased taxes.
From a Keynesian economist’s point of view, this
is a predictable result of austerity. As can be seen from
Figure 19.8, a decrease in government spending and an in-
crease in taxes will result in a decrease in aggregate demand.
That will result in a decrease in economic activity, and that
will result in an increase in unemployment. Austerity could
even be self-defeating. The loss of jobs would increase de-
mands on the social safety net and decrease tax revenues.
Austerity can ultimately lead to a larger deficit if the austere
FIGURE 19.7 Unemployment rates in Europe.
25
20
15
30
0
5
10
2000 2001 2002 2003 2004 2005 2006 2007 2008 20102009 2011 2012 2013 2014 2015
EU (27 countries)
Greece
Germany
France
Ireland
Spain
United KingdomItaly
actions of budget cuts and tax increases plunge the econ-
omy into such a poor state that the impacts on the economy
generate larger revenue losses than the deficit reductions
resulting from the budget cuts and tax increases.
Is It Too Late to Leave the Euro?
For much of 2011 and 2012, speculation was rampant that
Greece would leave the euro. The reasons why Greece
would want to leave the euro should now be obvious. If
you want to regain the ability to print your own currency
FIGURE 19.8 Result of austerity.
AD
AS
ADʹ
PI
PI*
PIʹ
RGDPʹ RGDPRGDP*
Summary 229
either. Thus the threat of a Greek exit both increased the
likelihood of a Greek exit and diminished the viability
and desirability of a Greek exit. It also made it harder
for the rest of Europe to keep them in. The problem was
made worse because if the Greeks left, it would be diffi-
cult to contain the concerns of Spaniards that their coun-
try would be next. That would jeopardize Spanish banks.
Spain would topple Italy and, if Italy was toppled, the
euro would be a memory. As a result, as difficult as it
was to achieve, the Germans and French felt compelled
to keep Greece in the euro. It was a mess that only got
better very slowly.
Where Should Europe Go from Here?
The irony of the situation is that Greece needed to leave the
euro at a time that it could not, and Germany and France
needed Greece to be out of the euro but could not allow it
to happen out of fear of what the consequences might be.
Though a second collapse has not yet occurred, the
European economies have been crawling for the better
part of this decade. The EU was in recession through
much of 2011 and 2012. Even out-of-recession growth
has been anemic. It was not until 2015 that the European
Central Bank began to engage in the massive monetary
stimulus that the Federal Reserve of the United States had
a few years prior. Even with 80 billion euros a month in
monetary stimulus and negative interest rates, Europe’s
economy only grew at 1.6 percent in early 2016.
All of this economic upheaval led to a political up-
heaval in non-euro member Great Britain as it voted to
leave the European Union in June 2016. The sentiment
growing throughout Europe is that economic and politi-
cal integration failed to pay the dividends promised. At
this writing (the day after that referendum) it is unknow-
able where this will lead.
and engage in monetary policy, you have to have your
own currency to do it. Creating their own currency would
not be difficult. Getting people to accept it would be dif-
ficult. However, if the Greek government were to order
all Greek banks to convert euro-denominated accounts
into drachma-denominated accounts, the effect would be
quick. Though the Greek government could easily issue
this order, they would have little power to maintain the
value of the drachma, and its value would almost cer-
tainly plummet. The inflation in Greece would be dra-
matic. From some perspectives, that would be a good
thing. That’s because it would operate as an across-the-
board tax on everyone. Your 1,000 euro account would
have 1,000 drachmas in it, and then the drachma would
lose half its value. You would be able to buy about half
as much from the rest of Europe as you had been able to
buy, and you would look to Greek providers of the goods
or services because their drachma-denominated prices
would look relatively more attractive. The attractive as-
pect of the idea of the “Grexit” (Greek exit from the euro)
is that it would fairly quickly stabilize the Greek situation
by taxing each Greek by half their wealth as inflation of
100 percent cuts the buying power of wealth in half.
But, alas, it isn’t that easy. Smart Greeks had already
anticipated the change. They became convinced that it
would eventually happen just this way, so they closed their
euro-denominated banks accounts in Greece and took
those accounts to other countries. They converted their
euros into assets out of the reach of the Greek government.
As a result, the only people with any euro-denominated
accounts in Greece were those who were either poor (and
therefore couldn’t afford to do their banking with a foreign
bank) or unaware (and therefore vulnerable).
This bankrupted Greek banks because they simply
did not have the euros to pay off their depositors. Under-
stand that no American bank could withstand a demand
by a large number of its depositors for a cash withdrawal
Summary
From late 2008 through all of 2012, the United States
experienced and made its way through the Great Re-
cession while Europe stumbled from one economic
crisis to the next. The origin of European difficulties
was in that they created a currency, the euro, thereby
unifying their monetary systems without unifying
their fiscal systems. As a result, whether it was Ireland
and Spain with housing-bubble-related crises or Italy
and Greece with fiscal crises, the challenge for stron-
ger EU countries was how to save the euro without
the tools the United States used to weather the Great
Recession.
230 Chapter 19 European Debt Crisis
1. The cause of the European financial crisis had its
origins in
a. the creation of the euro.
b. vast overspending in Germany.
c. uncompetitive tax collections in Greece.
d. speculative home buying in Belgium.
2. The proximate cause of the Spanish problem was
a. vast overspending during the previous decade.
b. lax tax collections during the previous decade.
c. a burst housing bubble.
d. both a and b.
3. The proximate cause of the Greek problem was
a. vast overspending during the previous decade.
b. lax tax collections during the previous decade.
c. a burst housing bubble.
d. both a and b.
4. The reason the Greeks didn’t use a plan similar to
TARP to save their banks was that
a. the Greek Central Bank had no funds.
b. the interest rates Greece would have had to pay
on the loans would have been unaffordable.
c. banks weren’t a problem in Greece.
d. there was no political will in Greece to borrow
that kind of money.
5. The reason the European Central Bank (ECB) didn’t
engage in the kind of expansionary monetary policy
that the Federal Reserve did for the United States
was that
a. the ECB didn’t view the problem as serious.
b. the ECB could not raise the capital.
c. the provisions of the treaty that created the ECB
did not allow for it to buy the debt of member
nations unless there was systemic risk.
d. there was no debt for the ECB to buy.
6. The reason the ECB did not want the Greeks to exit
the euro was that
a. Greece was viewed as a valuable member in
temporary distress.
b. Greece was viewed as so unimportant that it
did not want the perception that countries were
leaving for any reason.
Quiz Yourself c. Greece was a founding member, and political friendships were important to the ECB leaders.
d. Greece was viewed as the first domino in a
series of dominos that, if Greece left, it would
jeopardize the whole euro system.
Short Answer Questions
1. What should the Maastricht Treaty have included to
allow for an adequate response to the various Euro-
pean economic crises?
2. When would be the right time and what would be
the correct mechanism for getting a country out of
the euro?
3. What would be the problems associated with the
ECB being allowed to purchase the debt of member
nations?
Think about This
For full integration of the European Union, some argue
that the nations should be like states of the United States
with the central government having limited and enumer-
ated powers. What would those powers be?
If Greece is analogous to Mississippi (relatively
poor) and Germany is analogous to New York (relatively
rich), what is present in the United States that makes it
relatively easy for Mississippi to be in the same country
as New York that is absent that makes it relatively hard
for Greece and Germany to imagine themselves in the
same country?
Talk about This
The bursting of the housing bubble hit Phoenix and
Miami much harder than Dallas/Ft. Worth. Why should
the taxpayers of Texas have consented to programs that
helped only citizens of Phoenix and Miami? Why, then,
should Germans care if the Irish housing bubble caused
problems in Ireland?
Behind the Numbers
European economic data—http://ec.europa.eu/eurostat
European interest rates—http://sdw.ecb.europa.eu
231
Economic Growth and Development Learning Objectives
After reading this chapter you should be able to:
LO1 Identify why some already developed countries grow faster
than others.
LO2 Explain why creating an environment for economic growth
in a developing country is a very different and much harder
challenge than fostering growth in an already developed
country.
LO3 List what legal, political, and institutional factors have
historically limited growth in many developing countries.
Chapter Outline
Growth in Already Developed Countries
Comparing Developed Countries and Developing Countries
Fostering (and Inhibiting) Development
Summary
Economists have been trying to figure out economic
growth and development for as long as there have been
economists. Why, for instance, does a country such as
the United States command nearly one-quarter of the
world’s yearly economic output while having less than
5 percent of the world’s population? Why did the United
States grow faster than France during the last decade?
Why can’t sub-Saharan Africa catch an economic break?
Why has politically repressed China grown so rapidly
for more than a decade, while India, a democracy for de-
cades, grew much more slowly? Why has South Korea
blossomed from a developing country to a developed
one? This chapter is a little bit macroeconomics, a little
bit international trade, a little bit government policy, and
frankly, a little bit guesswork. Economic development is
one of the least well-settled areas of economics in part
because even the Nobel Prize–winning models perform
poorly.
Let’s start by dividing the question of economic
growth and development into two very different ques-
tions: Why do already developed countries grow at
different rates? Why do underdeveloped countries rarely
reach a point where they can emerge from their meager
circumstances?
Growth in Already Developed Countries
If we go back to our Chapter 8 aggregate demand–
aggregate supply model, we can begin to think about how
already developed countries grow. An economy can grow
because of sustained increases in aggregate demand but
only when there is a simultaneous sustained increase in
aggregate supply. To see why, remember the shape of the
aggregate supply curve. It starts out flat, begins to slope
upward, and finally becomes vertical. If aggregate sup-
ply does not grow, then eventually increases in aggregate
demand have no impact on real economic growth be-
cause sooner or later we will hit the vertical portion of
the aggregate supply curve and real GDP growth will
stop. We also learned in Chapter 8 that deflation can
be a very dangerous economic circumstance, so without
increases in aggregate demand, increases in aggregate
supply can conceivably bring a developed economy to
C H A P T E R T W E N T Y
232 Chapter 20 Economic Growth and Development
and lower prices. Note that the word “harder” was not on
the previous list of ways to increase productivity over the
long run. People can work harder, but at some point you
reach the end of human endurance. Getting more output
from workers usually requires providing them with the
education, tools, and technology to produce more.
What this means is that the economy can grow or
contract in the short run for a variety of reasons mostly
having to do with changes in aggregate demand, but the
ultimate source of long-term growth in already developed
countries is increases in worker productivity. As can be
seen from Figure 20.3, from 1990 to 2004 developed
countries that experienced higher levels of productivity
increases also experienced higher GDP increases. The
relationship is not one to one, but it does exist. For these
countries, a one percentage point increase in productiv-
ity growth is associated with a 0.3 percent increase in per
capita GDP growth. Remember that this does not mean
that workers have to work longer hours, or that they have
to work at a faster pace, or that we need bosses intoler-
ant of anything but the bottom line. Increases in worker
productivity usually come about because of an increase
in the education of workers and an improvement in the
tools with which they work.
What feeds the worker productivity engine? Worker
productivity is driven by policies that contribute to
long-term capital formation and worker education and
training. If saving is discouraged and consumption is
encouraged beyond that which is sustainable, there is
not a plentiful supply of loanable funds. If the benefits
from saving money are exorbitantly taxed, then the mo-
tivation to save money is diminished. Growth requires
a standstill as deflationary pressures diminish people’s
willingness to buy big-ticket items. What this implies
is that economic growth over the long term results from
increases in aggregate demand caused by sound fiscal
and monetary policy (covered in Chapters 9 and 10, re-
spectively) and sustained increases in aggregate supply.
What fosters increases in aggregate demand? Again
Chapter 8 gives us a clue, but a deceptive one. If we
just look at the determinants of aggregate demand
and what might be done to increase it, we note we
can increase government spending, increase consumer
confidence, decrease interest rates, decrease taxes,
or weaken the dollar. As Figure 20.1 indicates, each
will have the desired impact. The problem is you can-
not do these in a sustained fashion. First, we cannot
continually decrease interest rates or taxes. Zero is an
absolute lower bound for each. We cannot continually
increase government spending or eventually deficits
will drive up interest rates. Consumer confidence is
unlikely to grow without bound. This leads us to the
conclusion that the ultimate determinant of economic
growth in developed countries is likely to come from
the aggregate supply side. Increases in aggregate de-
mand simply keep it going.
What fosters increases in aggregate supply? Govern-
ment regulation can’t continuously decrease and neither
can wages or other input prices. What can continue to
increase without bound is worker productivity. Workers,
aligned with the right machines and technology, can al-
ways produce more than they produced the previous year if
they work smarter, better, and more ef ficiently. When they
do, we get the results shown in Figure 20.2: more output
FIGURE 20.1 Increases in aggregate demand.
PI AS
AD
ADʹ
PIʹ
PI*
RGDP* RGDPʹ RGDP
FIGURE 20.2 Increases in aggregate supply.
AS PI
ASʹ
AD
RGDP
PIʹ
PI*
RGDP* RGDPʹ
Comparing Developed Countries and Developing Countries 233
a healthy capital market on the demand side as well.
This means that rates of taxation on the gains from
that capital must be at levels so that after-tax returns to
businesses are sufficiently motivating for investment.
A developed and motivated workforce is also a prereq-
uisite to economic growth. Workers must be motivated
to get the right amount of education and to then pro-
ductively apply that education in the workforce. With
moderate marginal tax rates, rates of interest and in-
flation, reasonable regulatory policies, a sound educa-
tion system, and a sound welfare system that does not
overly compensate the unemployed, developed econo-
mies will continue to grow.
Comparing Developed Countries and Developing Countries
Besides the obvious, income, what is different about
rich and poor countries? Table 20.1 brings this all into
stark relief. The countries listed on the top of the table
have per capita gross national income (GNI)1 of more
than $20,000, while the countries at the bottom of the
table have per capita gross national income of less than
$2,000. There are some other stark differences that ap-
pear on this table. While those at the top of the table gen-
erally have a large “middle class,” those at the bottom do
not. The Gini index, a measure of overall income disparity, is gen-
erally higher in poorer countries
than richer ones. Those at the top have very little of their
GNI coming from agriculture and a significant portion
coming from services, while those at the bottom have
the reverse. If you go all the way back to Chapter 2’s ref-
erence to the Heritage Foundation’s Index of Economic
Freedom, you will also note that those at the top also
tend to be the most economically free, while those at the
bottom tend to be classified as the most unfree.
There is also an accounting issue that we need to
discuss. In Chapter 6 we noted that real GDP and so-
cial welfare are not synonymous. One of the reasons
that is true is the existence of the underground econ-
omy. Though the primary example in that discussion
was the United States, consider the notion of the un-
derground economy in a developing country like the
Sudan. While many people in the United States engage
in a little “cash-on-the-side” business (lawn mowing,
babysitting, marijuana buying) where the efforts are
not counted, most people in the Sudan make their own
clothing, grow or raise their own food, or trade one
good or service for another. As a result, whereas the
underground economy is 10 percent of the U.S. pro-
duction, as much as half a developing country’s econ-
omy can be in nonmarket transactions. This is why the
comparable figures for each country shown in Table
20.1 are adjusted using the no-
tion of purchasing power par- ity. Economists have estimated what it costs to purchase a
similar market basket of goods
and services in each country
and used that to estimate gross
national income.
FIGURE 20.3 Annual productivity increases and annualized GDP growth rates (1990–2004).
Netherlands
5.0
4.5
4.0
3.5
3.0
2.5
2.0 0.00 0.50 1.00
Annual productivity increase (%)
A n
n u
a l G
D P
i n
c re
a s e
( %
)
1.50 2.00 2.50 3.00
Italy
Switzerland
Germany
Canada
Belgium
UK
Australia Sweden
Greece
U.S.
France
Japan
Gini index A measure of overall income disparity.
purchasing power
parity Using the cost of a similar market basket of goods across countries to compare an economic variable like gross national income.
1Gross national income modifies gross domestic product by adding in income
earned abroad and makes other relatively small adjustments. For the most part
GNI is a better number for comparing incomes across development categories.
234 Chapter 20 Economic Growth and Development
The remainder of this chapter will focus on how a
country might move from below the line in Table 20.1 to
above it and what might prevent it from doing so. First, we
need to appreciate that the challenges for policy makers in
developing countries are substantially different and often
substantially more difficult than the challenges of devel-
oped countries. Those at the top of the table attempt to use
sound fiscal, monetary, and regulatory policies within an
overarching democratic political structure to foster long-
term increases in labor productivity; low levels of infla-
tion; moderate levels of taxation; and reasonable labor,
safety, and environmental regulations. That is difficult
enough, but all too often policy makers in countries at the
bottom of the table don’t typically have a political, gov-
ernmental, or banking structure to do any of these things.
Further, they are faced with choices that go beyond simply
Fostering (and Inhibiting) Development
Modern models of economic development, like the Solow
Growth Model, named after its Nobel Prize–winning
author, provided the basis for much discussion on this
subject of how economies would grow. The central pre-
diction of that model, and of many others that it spawned,
was that economies would converge in their levels of eco-
nomic development. That is, poor countries would grow
faster than rich ones to the point where levels of per capita
GDP would not differ substantially. Even a brief look at
Table 20.1 shows that this has not been the case.2
TABLE 20.1 International comparisons.
Source: The World Bank DataBank, http://databank.worldbank.org
Country Name
2014 Gross
National Income
per Capita (PPP)
1990–2014
Annualized Rate
of per Capita
GDP Growth
Distribution
of Family
Income—
Gini Index
GDP—Composition by Sector Inflation Rate
(consumer prices)
2014Agriculture Industry Services
Australia 64,540 1.74% 30.3 2.4 27.1 70.5 1.4
Belgium 47,260 1.23% 25.9 0.7 22.1 77.2 0.7
Canada 51,630 1.33% 32.1 1.8
France 42,960 0.98% 30.1 1.7 19.4 78.9 0.6
Germany 47,640 1.37% 27.0 0.7 30.3 69.0 1.7
Greece 0.59% 34.4 3.8 15.8 80.4 −2.2
Japan 42,000 0.78% 37.9 1.6
Korea, Rep. 27,090 4.36% 30.2 2.3 38.2 59.4 0.6
Netherlands 51,890 1.45% 25.1 1.8 21.2 77.0 0.8
Singapore 55,150 3.53% 46.4 0.0 24.9 75.0 0.2
Spain 29,440 1.16% 34.0 2.5 22.4 75.1 −0.4
Switzerland 0.71% 28.7 0.8 26.3 73.0 −0.7
United States 55,200 1.43% 45.0 1.5
United Kingdom 43,430 1.61% 32.4 0.7 21.0 78.4 1.7
Bangladesh 1,080 3.55% 32.1 16.1 27.6 56.3 5.7
Congo, Dem. Rep. 380 −2.38% 21.2 33.2 45.7 1.3
Cote d’Ivoire 1,450 −0.15% 41.5 22.4 21.1 56.5 0.9
Ethiopia 550 3.33% 33.0 41.9 14.7 43.4 11.0
Kenya 1290 0.71% 42.5 30.3 19.4 50.4 7.5
Madagascar 440 −0.79% 47.5 26.5 15.9 57.6 5.7
Malawi 250 1.55% 39.0 33.3 17.0 49.6 20.9
Mozambique 600 4.50% 45.6 25.2 21.1 53.7 3.6
Senegal 1,050 0.74% 40.3 15.8 23.5 60.7 0.1
Tanzania 920 2.09% 37.6 31.5 25.0 43.5 4.7
Uganda 670 3.31% 39.5 27.2 22.0 50.8 2.3
2That is not to say that these models are without value. They provided the
basis for much of what we know about economic development, but in all
honesty, this is an area of economics for which little consensus exists.
Fostering (and Inhibiting) Development 235
are all too often corrupt, unstable, or both. Take Ni-
geria, for example. Sitting on one of the largest de-
posits of oil in the world, its long-standing civil war
has prevented it from taking ultimate advantage of its
resource. You may be able to get low-wage labor to get
the oil out of the ground, but you have to pay bribes
to the various warring factions to avoid having your
equipment stolen, damaged, or destroyed, and you
have to worry about your skilled engineers being kid-
napped. Do you locate there or do you attempt to make
your money elsewhere?
Corruption
Even when a government is stable, the concern that the
political leadership will simply take invested property is
paramount. Take Uzbekistan, for example. It is also sit-
ting on significant oil and natural gas reserves, but its po-
litical leadership is so corrupt that you never know from
one year to the next whether the leadership will national-
ize those assets. Countries such as these have a culture
that expects and accepts this type of corruption. Manag-
ers coming from the cultures of developed economies are
not, for the most part, comfortable investing in countries
where bribery is common or expected.
Lack of Independent Central Banking
If you look at the list of countries on the top of
Table 20.1 and compare them with those at the bot-
tom, you will note that the United States, Europe, and
the economically successful countries of East Asia
all have systems in place to control inflation. As de-
scribed in Chapter 10, each has a central bank that
sets interest rate policies, and in each case there is a
degree of central bank independence from political
control. In developing countries these banks are not
only not independent, in some cases they do not exist.
That means that when there is a central bank, it is often
under the control of the ruling party, king, general, or
junta. When no central bank exists, banking crises are
common. In fact, the United States was without a func-
tional central bank for much of the 1800s and saw sev-
eral banking crises result.
Without an independent central bank in a developing
country, when its ruler wants to print money to build a
new palace or to pay soldiers for protection, he or she
can and will. There are myriad examples of indepen-
dent central bankers fighting inflation at the expense
of an elected leader’s popularity. Leaders in countries
with democratic traditions and independent central
future consumption versus present consumption, but of
future consumption versus present survival.
The Challenges Facing Developing Countries
To see why developing countries face such challenges, put
yourself in the position of an open-minded company man-
ager with a decision to make. Do you locate a manufactur-
ing facility in a developed country or a developing country?
Your goal, of course, would be to bring as much profit home
to the stockholders as possible. You would probably be en-
ticed by the low cost of labor and land in the developing
country. Hourly wages in developed countries are almost
always 5 to 10 times higher and at times 20 to 100 times
higher than in a developing one. On the other hand, you
would also have to recognize the potential pitfalls.
Low Rates of Basic Literacy
It’s hard to find a quality labor force in a developing coun-
try because, though wages are low, the typical resident has
little formal education. They may not be able to read or
do rudimentary mathematics. Without the basic ability to
follow written instructions, the workers in the developing
country will have to be managed much more closely than
workers who can read and follow instructions.
Lack of Infrastructure
Second, even if you can adapt your production processes
to take advantage of the low-skill, low-wage work-
ers, you still do not have the basic financial, physical,
or legal infrastructure in place to keep it going. Local
banks are necessary for access to credit, and to transmit
profits out of the country. They may not exist or may
be constrained in their ability to provide the financial
services necessary for your business. Roads, bridges,
rail lines, and ports are all necessary to transmit goods
around the country and around the world. Without an
ability to quickly move your finished products to the rest
of the world, any cost advantage you had in wages might
evaporate because of your inability to move your prod-
ucts. Finally, legal protections are necessary for the own-
ers of invested property. Whether those protections are
based on social conventions, law enforcement, or trust-
worthy governments, a social infrastructure protecting
investments is necessary for those investments to occur.
Political Instability
Trustworthy governments are hard to find in the devel-
oping world. This can be because these governments
236 Chapter 20 Economic Growth and Development
banks understand that the long-term effect of fight-
ing inflation is far more important than the short-term
benefit that is gained from being able to spend newly
printed money.
Inability to Repatriate Profits
Your ability to move money out of a country can also
be limited by government policies. In many developing
countries you can bring as much hard currency (dollars,
euros, etc.) into the country as you wish, but you cannot
reverse the transaction as easily. So, if you were mak-
ing a profit in the currency of the host country, you may
not be able to convert that into hard currency. This is
less of a problem if you are manufacturing in a develop-
ing country for sale in a developed country, but it is a
problem if you are selling goods in the developing coun-
try and wishing to turn those profits into hard currency.
Knowing that, you will be less likely to invest in the de-
veloping country.
A Need to Focus on the Basics
Developing countries, especially the ones listed in the
bottom half of Table 20.1, must focus on the very basic
necessities of life. Even a well-meaning government
would have a difficult time choosing between expend-
ing resources on education or health care or food. The
opportunity cost of extra spending on making education
more widely available could well be a lack of adequate
food or health care for others. With so many people en-
gaged in subsistence agriculture, with so little capital
with which to work, and with live births per adult woman
above five, these countries are not in a position to invest
in their future because their present is so bleak.
In addition, health concerns in these countries can
be overwhelming. The countries on the bottom of
Table 20.1 are predominantly from sub-Saharan Africa.
These countries have been ravaged by HIV/AIDs to such
a degree that notions of long-term economic develop-
ment have become secondary to survival.
What Works
The best examples of countries rising above their 1960s
economic status to become newly developed countries
are the countries of East Asia. China and South Korea,
in particular, have grown at a rather brisk pace for very
long. Both got to their present position in different ways.
South Korea’s success economically coincided with its
liberalization politically, while China’s success occurred
while it was relatively unfree politically. It is not just
about natural resources either. Though Saudi Arabia and
Kuwait have grown almost entirely as a result of enor-
mous oil wealth, Japan’s growth through the 1970s and
1980s was despite the fact that it has no natural resources
upon which to build.
The basic building blocks for what works tend to begin
with education, a low or manageable level of government
corruption, and a level of political and financial stability
that creates confidence among foreign investors. Coun-
tries that have grown have created political and financial
stability, have created physical and social infrastructures
that generate confidence, and have predictable, if not
democratic, governments. Foreign direct investment in
China, for example, continues to grow because inves-
tors have some degree of confidence that the government
will not confiscate their investments and will let them
repatriate profits. South Korea’s economy continues to
grow because their reaction to the late 1990s Asian fi-
nancial crisis created confidence among investors that
their banking system could adapt to challenges.
Summary
You now understand that economic growth in already
developed countries is mostly a function of their abil-
ity to increase worker productivity and that economic
growth in developing countries is often hampered by the
lack of social, political, financial, legal, and economic
institutions that are prerequisite to economic growth.
You understand the magnitude of the gap between de-
veloped and developing countries and that the countries
that have moved from developing to developed did not
follow a single path.
Key Terms
Gini index Purchasing power parity
Summary 237
1. For developed economies, sustained increases in ag-
gregate demand, absent increases in aggregate sup-
ply, will result in
a. growth for a while, but ultimately, they will re-
sult in only inflation.
b. continuous economic growth.
c. deflationary risks.
d. a boom and bust cycle.
2. For developing economies, sustained increases in
aggregate demand, absent increases in aggregate
supply, will result in
a. growth for a while, but ultimately, they will re-
sult in only inflation.
b. continuous economic growth.
c. deflationary risks.
d. a boom and bust cycle.
3. In order to sustain economic growth in a developed
economy, it is important for
a. taxes to continuously decrease.
b. government spending to continually increase.
c. worker productivity to increase.
d. worker productivity to decrease.
4. One of the biggest problems for developing coun-
tries is that they all too often
a. are ruled by representative democracies.
b. are populated by people unwilling to work hard.
c. lack the financial, physical, and social infra-
structure to grow.
d. indulge in wasteful consumption.
5. For the ruler of a developing country, the opportu-
nity cost of a choice to invest in universal education
a. is the reduction in health care spending.
b. does not exist because food is a necessity.
c. is much lower than a similar choice for the ruler
of a developed country.
d. cannot be measured.
6. Which advantage does a typical developing country
have in attempting to draw foreign investment?
a. Very low wages
b. Poor education
c. Easy profit repatriation
d. Independent central banks
Quiz Yourself Short Answer Questions
1. What does Mexico have to do in order to grow eco-
nomically? What does Germany need to do to grow
economically? Why are those likely to be different
answers?
2. What is the long-term consequence to U.S. eco-
nomic growth of having an education system that
lags behind that of other countries?
3. What issues will China face if it wants to continue
to grow?
Think about This
Go to the CIA Factbook web pages cited below and ex-
plore the economic statistics of the following countries:
Brazil, Egypt, India, Malaysia, and South Africa. Each
has a per capita GDP between $3,000 and $15,000 per
year. What country in that list do you believe is most
likely to move into the class of “developed” countries?
That is, which is likely to have its per capita GDP rise the
fastest and why?
Talk about This
Suppose you had to decide whether or not to invest in
formal education for the masses, but the opportunity cost
of doing so was reducing health expenditures for the sick
and aged. What choice would you make?
Behind the Numbers
CIA Factbook 2012—https://www.cia.gov/library
/publications/the-world-factbook/
World Bank—http://data.worldbank.org
238
C H A P T E R T W E N T Y - O N E
NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us? Learning Objectives
After reading this chapter you should be able to:
LO1 Conclude that economists generally believe free trade is
better than restricted trade.
LO2 Show how trade agreements facilitate the opening of trade and
why such agreements are sometimes necessary.
LO3 Describe the function of NAFTA, CAFTA, GATT, TPP, and WTO
as trade agreements and institutions.
LO4 Evaluate whether trade agreements are working as
advertised.
LO5 Enumerate the economic and political concerns that free-
trade agreements generate.
LO6 Conclude that, for most economists, trade agreements are
good policy.
Chapter Outline
The Benefits of Free Trade
Why Do We Need Trade Agreements?
Trade Agreements and Institutions
Economic and Political Impacts of Trade
The Bottom Line
Summary
One of the central tenets of
economic policy during the
Clinton administration was
that free trade is good for the
United States. The reasoning
was that Americans can and
routinely do outcompete their
international trade partners. The
jobs that were gained and the in-
creases in living standards from
such trade would thus outweigh
any losses. The foundation for
this argument relies heavily on
the theory of international trade
that we addressed in Chapter 17,
“International Trade: Does It
Jeopardize American Jobs?”
NAFTA, the North American Free Trade Agreement; CAFTA, the Central America Free Trade
Agreement; GATT, the General Agreement on Tariffs and Trade;
and the WTO, the World Trade Organization, are the spearheads of this free-trade policy.
The TPP, Trans-Pacific Partnership, which came under
attack by both major-party candidates in the 2016 presi-
dential election is an agreement between 12 countries.
Though the United States appears to be backing away, the
NAFTA North American Free Trade Agreement involving the United States, Mexico, and Canada.
CAFTA The Central America Free Trade Agreement involving the United States and five Central American countries: Costa Rica, El Salvador, Guate- mala, Honduras, and Nicaragua.
GATT General Agreement on Tariffs and Trade, a world trade agreement.
WTO The World Trade Orga- nization, an institution that arbitrates trade disputes.
Why Do We Need Trade Agreements? 239
Table 21.1 shows that it takes one high-skill U.S.
worker to make one HT good, that one high-skill
Mexican worker can produce three LT goods, and so
on. The suggestion here is that high-skill workers in
the United States are more proficient than anyone else
at all forms of production and that Mexican low-skill
workers are less proficient across the board. The low-
skill American worker is assumed to be better at HT
production than the high-skill Mexican worker (perhaps
because the American is working with better machines),
but the two are equal in LT production.
If 100 American low-skill workers were to shift
from the production of LT to the production of HT and
120 Mexican workers were to shift from HT to LT,
then there would be 50 more HT goods and 300 fewer
LT goods produced in the United States. In Mexico
there would be 40 fewer HT goods and 360 more LT
goods produced. The world (limited in this case to the
United States and Mexico) would have a net addition
of 10 HT goods and 60 LT goods. Given a fair distri-
bution of these gains from trade, each side would be
better off.
As a result of the increased competition from
Mexican LT firms, the workers in LT firms in the United
States would lose their jobs. They would quickly get new
jobs in the HT firms, however, as increased demand for
American HT goods increases demand for laborers capa-
ble of such production. While there are more than a few
places where the argument that trade is good for all can
be criticized, it remains the basic position of economists.
Most economists are convinced that trade provides in-
creased standards of living and regardless of how many
workers are displaced, they will always be absorbed into
the growing industries.
Why Do We Need Trade Agreements?
You may instinctively distrust this economists’ view of
trade. You may be asking, “If free trade is so good, why
do we need agreements to keep it in place?” The answer
is twofold: one economic, the other political.
other countries1 will likely continue their participation.
This chapter explains the purposes of each and reviews
the arguments for and against them. As a first step we
summarize the theoretical argument for free trade. We
then explicate some of the details of the several agree-
ments just mentioned. Finally, we examine in some detail
the effect of these agreements on trade, income inequal-
ity, workers’ wages, and environmental health.
The Benefits of Free Trade
The economic benefits from trade are so often assumed to
be obvious that economists do not feel the need to explain
them. Most noneconomists, however, assume that trade is
a zero-sum game that can be characterized by the phrase
“your win is my loss.” Nothing could misrepresent trade
more thoroughly. Nowhere in the field of economics is
there such a discrepancy between what economists know
and what noneconomists consider to be the conventional
wisdom. If the explanation that follows does not lay out
the economists’ argument on the benefits of international
trade in sufficient detail, you will find additional infor-
mation in Chapter 17, which cover international trade.
Suppose that the United States and Mexico are the
only countries in the world and that they produce only
two goods: low-tech (LT) and high-tech (HT). Further,
suppose that U.S. workers can make both LT and HT
more quickly and in greater numbers than Mexican
workers. Why would the United States want to trade with
Mexico when it can produce both goods itself? To see the
possibilities, assume that workers in the United States
and Mexico are divided between high skill and low skill
and that everyone is fully employed in both countries. To
see how effective they are, assume that Table 21.1 repre-
sents the number of workers needed to produce specific
amounts of each good in each country.
TABLE 21.1 Production of workers: number of workers needed to produce a number of goods.
High Tech Low Tech
High Skill Low Skill High Skill Low Skill
United States 1 produces 1 2 produce 1 1 produces 4 1 produces 3
Mexico 3 produce 1 4 produce 1 1 produces 3 1 produces 1
1 Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand,
Peru, Singapore, and Vietnam.
240 Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
Strategic Trade
Strategic trade policies are poli- cies designed to get more of the
benefits from trade in a coun-
try than would exist under free
trade. On the economic front,
there are circumstances under
which a country can increase its share of the free-trade
benefits. That is, a country can increase its benefits from
trade by putting on tariffs, quotas, and the like; if it does,
however, the sum of the benefits from trade to the two
trading partners deteriorates.
Although the circumstances under which strategic
trade is better for a country than free trade are somewhat
complicated, one example might shed some light. Sup-
pose a large country is the dominant world player in the
production of a particular good and another large country
is a much smaller player. The monopoly power of the
large company can overwhelm the other country’s small
company. Economists have shown that, at least theoreti-
cally, the country with the small company can subsidize
its exports and increase its profits by more than the sub-
sidy. The typical example of this has been the Boeing–
Airbus competition in the manufacture of large aircraft.
In practical terms, Airbus’s subsidy from France and
Britain has been greater than its profits.
Special Interests
Whenever there is trade, there are individuals who see
themselves as the losers. Typically, these are the folks
who are the most visible. When a plant closes in an
American town to move production to a facility in an-
other country, the job losses from trade are obvious for
all to see. The jobs created by trade are more difficult for
the average worker to see. As a result, workers left with
pink slips become vocal opponents of trade, and those
who benefit from it do not see that they benefit from it.
An even greater political problem occurs if the loser
from trade has sufficient political strength to convince
elected officials that restricting trade is in the officehold-
ers’ electoral interest. Again, because many of the benefi-
ciaries of free trade—consumers paying lower prices and
workers having better jobs—do not see these gains as at-
tributable to trade, they are far less vocal in favor of trade.
There are two groups whose voices are typically raised in
favor of trade, business interests and farmers. As a result,
it appears to the political world as though free trade is
a battle between workers on one side and big business
and farmers on the other. In such a circumstance, though
free trade is rather obviously the better outcome to econo-
mists, it is not so obvious to elected officials.
What Trade Agreements Prevent
To see how misplaced self-interest can lead to a deteri-
oration of trade benefits let’s return to our hypothetical
example of trade between Mexico and the United States.
If the low-skill, LT workers in the United States fear
that trade will cost their jobs,
they can seek a tariff (a tax on imports) or a quota (a limit on imports) from the U.S. govern-
ment. Each would raise the price
of imported goods and the former would bring tax rev-
enue to the U.S. government. If Mexico does not retaliate
by levying its own tariffs or quotas, our exports of HT
goods will remain unchanged. This will be good for the
United States, but less so than it will be bad for Mexico,
and it will be worse for the world as a whole. If Mexico
does retaliate, it can make itself better off than if it does
not retaliate. It will do so with tariffs or quotas of its own.
Again, the degree to which Mexico will make itself bet-
ter off is outweighed by the damage done to the United
States, which will retaliate further. Soon there will be no
gains from trade because there will be no trade.
Trade agreements prevent countries from starting
on the slippery slope of trade retaliation. Because a
country is better off with free trade than with no trade,
free trade wins. The problem is that countries will always
be tempted to raise some barriers in hopes no one will
retaliate. When countries get into a tariff war and retali-
ation is met with more retaliation, not only are any small
advantages lost, but all other advantages from trade are
lost. Countries thus need trade agreements to keep them-
selves from the temptation of creating trade barriers.
The history and politics of trade are somewhat strange.
The first Republican president, Abraham Lincoln, ran for
his first U.S. House seat on a platform that called for high
tariffs. Such protectionist trade policy was a staple of
Republican political philosophy, and it was exemplified
by the disastrous Smoot-Hawley tariff law of the 1930s.
Not until the 1950s did Republicans begin to change
and to embrace free trade, and they did so because their
constituents in business argued that they could be more
profitable with trade than without it. During the same
time, Democrats, the party most identified with labor
unions, switched from being the free-trade party to the
protectionist party, and they did so because the unions
saw trade hurting their members. In 1993, Democratic
president Bill Clinton started to move his party back
strategic trade policies Policies designed to get more of the benefits from trade in a country than would exist under free trade.
tariff A tax on imports.
quota A limit on imports.
Trade Agreements and Institutions 241
to a free-trade position just as some Republicans were
moving back to their traditional protectionist position.
In 2005, most Democrats in Congress remained sym-
pathetic to the protectionist concerns of labor and most
Republicans remained free traders. It was in this context
that President George W. Bush brought the CAFTA to
Congress with an eye toward spreading the idea of free
trade throughout the Americas. It passed by one vote.
During the 2008 presidential campaign, then candi-
date Obama argued that NAFTA and similar trade pacts
should be reopened and renegotiated to provide more
protections for labor. In the late stages of that campaign,
as the global financial crisis was turning into a global re-
cession, President Bush attempted to tie a trade pact with
Chile to an automaker rescue package being advanced
by congressional Democrats. The rescue package failed
Congress, prompting President Bush to use Troubled
Asset Relief Program (TARP) money to assist the auto-
makers. In the end the Chilean trade pact failed to gain
congressional support. In 2010, President Obama ex-
pressed a goal of doubling exports from the United States
by 2015. Doing so would require a reduction of trade
barriers around the world, and it was with that in mind
that in that same year he worked to resolved the concerns
he had with a trade agreement with South Korea. That
agreement, signed by President Bush, had been held up
over concerns President Obama had for the impact that
the agreement might have on U.S. auto manufacturers.
Trade Agreements and Institutions
Alphabet Soup
The North American Free Trade Agreement, NAFTA, was
first proposed by President Ronald Reagan, negotiated
by President George Bush (George Herbert Walker),
and, after being amended, pushed through Congress and
signed by President Bill Clinton. It created a geographical
area of free trade in which the United States, Canada, and
Mexico agreed to (1) very low tariffs and (2) procedures
whereby some tariffs could remain in place. An impor-
tant element in the agreement was a formalized grievance
process whereby disputes could be aired.
The General Agreement on Tariffs and Trade, GATT,
is another agreement negotiated across the terms of many
presidents. GATT set out the conditions under which sig-
natory nations could set tariffs and quotas. GATT came
into existence just after World War II, but its most re-
cent version, the Uruguay Round, has had the greatest
free-trade bent. Even under stretched definitions, GATT
cannot be called a free-trade agreement, but it has moved
nations in that direction. In reality it simply makes the
rules for tariffs and retaliation more explicit.
The rules of GATT require that retaliation be pro-
portional. When in 1999, for example, much of western
Europe gave favorable treatment in banana sales to its
former colonies, the United States, at the behest of major
fruit companies like Dole, retaliated by threatening a tar-
iff on European leather goods. Although the connection
between bananas and purses is tenuous, it was deemed
acceptable retaliation under GATT. It makes sense under
GATT because the trade in question is roughly the same.
In operational terms GATT is an agreement that says
“there are ways you can impose tariffs and other ways
you cannot impose them.”
The Uruguay Round also took up the issue of intellec-
tual property rights and restrictions. The laws of China,
South Korea, and other Asian nations at this time had not
recognized the right of people to own ideas the way that
copyright and patent laws allowed them to in Western
countries. They engaged in copying and selling copy-
righted materials like CDs, books, and computer software
with impunity. In addition, much to the consternation of
the U.S. government and the industries whose markets
were affected, many nations whose television and movie
industries were unable to compete with Hollywood lim-
ited the importing of American shows and movies.
On the issue of copyright infringement, Asian govern-
ments promised a crackdown on entrepreneurs’ openly
making and selling copies of widely distributed music
and software CDs. At one time there were more illegal
than legal copies of Windows 95 (the predecessor of
Windows XP and 7) in China. It was the position of the
United States that this represented a theft from American
artists, producers, record companies, and software pro-
ducers and, as such, it should be banned. On this issue,
GATT recognized copyright infringement as an area wor-
thy of tariff retaliation.
Another priority for the United States was the distri-
bution of American-made movies and television shows.
The American entertainment industry sells its output
throughout the world, and shows like Baywatch got very
high ratings in Europe during the 1990s. Many countries,
however, have “domestic content” rules that require that at
least a certain percentage of all movies shown in a theater
and programs shown on television be produced (1) in the
home country and (2) with domestic actors. The United
States objects to these rules because they have the effect
of limiting U.S. exports. Even though movies and televi-
sion programs represent an important area of American
242 Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
export, the final negotiations leading up to the conclusion
of the Uruguay Round of GATT in 1997 did not ultimately
resolve this issue in favor of the United States.
One aspect of GATT that did go our way was the power
given to the WTO, the World Trade Organization. Until
1997 trade disputes involving countries reverted to no
more than “yes, it is fair” versus “no, it is not fair” spats.
There were no institutions charged with the task of find-
ing the truth in such disputes. The WTO’s job is now to
resolve those disputes. Although the WTO has no greater
power than to suggest who is in the right and who is not,
it is hoped that complaints with and without merit will be
separated and that disputes will be resolved more easily.
Are They Working?
From the outcomes of NAFTA, GATT, and the WTO,
it is hard to tell which side was more wrong in its pre-
dictions, those who suggested a “giant sucking sound”
would be heard as jobs left the country or those who
suggested a great export employment boom would result.
While trade has grown rapidly among the United States,
Canada, and Mexico after NAFTA, it had grown rapidly
before NAFTA. While some jobs were lost as firms left
to go to Mexico, the overall economy created more jobs
in a shorter period than at any time in U.S. history. So
what was the impact of these agreements?
Take a look at Figure 21.1. In inflation-adjusted terms,
exports to, and imports from, both Canada and Mexico
have been rising steadily. Whether NAFTA had anything
to do with these increases is the question. To investigate
that, let’s compare annualized inflation-adjusted rates of
growth in trade among the United States, Canada, and
Mexico and compare those to similar rates for trade in
general. From Table 21.2 we see that inflation-adjusted
exports to Mexico were rising at 10.2 percent per year
prior to NAFTA and rose at 12.9 percent immediately
after NAFTA. Subsequently, exports to Mexico and im-
ports from Mexico have been rising at a somewhat faster
FIGURE 21.1 NAFTA trade.
Source: U.S. Census Bureau, https://www.census.gov/foreign-trade/data/index.html
400,000
300,000
350,000
250,000
200,000
150,000
100,000
50,000
0
Year
19 9
0
R e
a l m
il li o
n s ( $
2 0
0 9
)
19 9
1
19 9
2
19 9
3
19 9
4
19 9
5
19 9
6
19 9
7
19 9
8
19 9
9
2 0
0 0
2 0
0 1
2 0
0 2
2 0
0 3
2 0
0 4
2 0
0 5
2 0
15
2 0
14
2 0
13
2 0
12
2 0
11
2 0
10
2 0
0 9
2 0
0 8
2 0
0 7
2 0
0 6
U.S. imports from MexicoU.S. exports to Mexico
U.S. imports from CanadaU.S. exports to Canada
TABLE 21.2 Percentage of annual real growth rates of U.S. exports and imports, Canada, Mexico, and world.
Source: U.S. Census Bureau, www.census.gov/foreign-trade/statistics/index.html
1990 to 1994 1995 to 1998 1999 to 2007 2008 to 2015
U.S. exports to Mexico 10.2% 12.9% 2.7% 3.7%
U.S. imports from Mexico 8.2 9.8 5.0 6.8
U.S. exports to Canada 4.3 4.1 2.1 3.0
U.S. imports from Canada 4.9 3.5 3.2 3.8
U.S. total exports 3.5 2.9 3.6 4.9
U.S. total imports 3.3 4.1 4.9 6.7
Economic and Political Impacts of Trade 243
rate than they have been for the United States with the
entire world. The experience with Canadian trade is dif-
ferent. Both exports and imports grew at slower rates
after NAFTA than prior to it. All trade, and in particular
trade within NAFTA, was significantly altered by the
2007–2009 recession, and it remains to be seen whether
prerecession patterns resume. However, between 1999
and 2007 worldwide trade was rising at the rate of
5.3 percent per year.
It is also worth noting that it was not until 2011 that
NAFTA was indeed fully implemented. The last piece
hinged on whether Mexican truckers, driving Mexican-
licensed trucks would be allowed on U.S. highways.
Though Canadian trucks were allowed to drive on
American roads, it had not been the case that Mexican
trucks were afforded the same right. The concern among
the trucking industry and its main union, the Teamsters,
was that they would be forced to compete with companies
paying their drivers much less than union wages. While
that concern was not dealt with, the president vowed to
hold the Mexican trucks themselves to the same safety
and inspection standards as U.S. trucks.
The impact that NAFTA has had on jobs is also in
dispute. Before the program ended, the U.S. Department
of Labor certified more than 100,000 workers as eligible
for retraining benefits as a result of NAFTA-induced job
losses, but these figures are hotly debated. Some argue
that these figures are inflated and represent jobs that
would have been lost to non-NAFTA–related competi-
tion. Two economists, Gary Hufbauer and Jeffery Schott,
estimated the impact in 2005 to be slightly positive,
while a well-known think tank opposed to NAFTA, the
Economic Policy Institute (EPI), estimated that though
1 million jobs were created as a result of the rising
exports, 2 million were lost due to more rapidly rising
imports. The EPI estimated that this caused a $7.6 billion
net drag on employee wages with the hardest hit states
being in the industrial Midwest.
Economic and Political Impacts of Trade
Of much greater concern to those objecting to free-trade
agreements than its effects on trade in general is its im-
pact on workers’ wages, wage inequality, labor treat-
ment in general, and the environment. Before we discuss
whether worries about these variables have been borne
out as a result of the trade pacts we have been discussing,
it will be useful to look at them individually to explain
the specific concerns.
Average manufacturing wages in the United States are
substantially higher than those in Mexico, Canada, and
nearly every other nation. If the productivity of workers
were the same worldwide, you would expect that cor-
porations would move their operations to places where
there is cheaper labor. As long as the cost reduction to a
company exceeds the increased costs of shipment and as
long as there are not any trade barriers, you would expect
jobs to leave the United States.
If workers in the United States are more productive
but are not sufficiently more productive to make up for
the difference in wages, then it is still the case that com-
panies will make more money producing elsewhere and
importing the goods into the United States. This can be
prevented if trade protections are in place to prevent or
to at least discourage imports. For the workers whose
livelihoods are tied to the exiting industry, it is nearly im-
possible to argue that they will not be hurt by free trade.
What advocates of free trade suggest is that there are
enough gains from trade to finance a retraining program
for workers who are displaced.
We need only to look at the number of workers and
the quantity of imports in certain industries to get an
idea of the magnitude of worker displacement that is
involved. Since 1960, industries involved with cars, car
parts, steel, electronics, apparel, and textiles have lost
significantly to imports. Unfortunately, these industries
(with the exception of textiles) provided the best pay-
ing low- to semi-skilled jobs around, and their loss con-
tributed to one of the main problems of the second half
of the 20th century, the lack of employment prospects
for people without a college education.2 Using the CPI,
real wages for production workers in the United States
have fallen since 19703 while wages for high-skill work-
ers increased. This increasing gap between the haves and
the have-nots has increased the tension concerning trade
tremendously.
Free trade benefits workers only if they keep their
jobs. By and large the educated have kept their jobs and
even gotten better ones. For such people the prices of
goods they purchase are cheaper than they would be if
they were produced in the United States, and, with jobs
that pay well, they have enjoyed a sharp increase in their
standard of living. Many people who have lost their jobs,
2 The extent to which trade exacerbates this is debated because this trend
may have been inevitable. 3This is accurate unless you modify the CPI as suggested in Chapter 6, in
which case the real wages for production workers have risen slightly.
244 Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
in comparison, have found new ones, but the new ones
do not allow them to maintain their previous standard of
living. The loss of steel production in Pennsylvania, auto
production in the Midwest, and electronics production
throughout the United States has seriously lessened the
number of high-paying jobs. It is therefore not surprising
that professionals and some highly educated people are
in favor of free trade and that people who have been hurt
by it, frequently those without a college education, are
against it.
If our trade policy is to move forward on the premise
that everyone can be a winner, we will have to ensure
retraining benefits are available to those who lose out.
To do this, some of the benefits accruing to those who
benefit from trade will have to be transferred in the form
of spending on temporary income assistance and retrain-
ing for the unemployed.
Another area of significant concern with regard to
trade agreements is the treatment both of child labor and
of labor in general. If industries that were once in the
United States have to compete with industries that hire
eight-year-olds and pay them a dollar or less an hour,
then either American workers have to be 10 times more
efficient or the industry will move. Not only do many
Americans consider child labor immoral, but they think
anything that promotes its existence is immoral as well.
If they perceive free trade as responsible for promoting
child labor, they may very well consider free trade itself
to be immoral.
It is not just the treatment of children that is of con-
cern. Labor costs are kept down in impoverished coun-
tries in large part because workers fear losing even a bad
job. The concentration of wealth is so great among the
few people who control the industries that employers can
get away with threatening workers with an inability to
work anywhere. The employers collude to keep wages
down. Workers have few rights and, even if they have
legal rights, they are unwilling to invoke them against
an employer for fear that they will lose the job they
have. Such fundamental rights as freedom from physical
torture, breaks for regular meals or bathroom visits, a
40-hour workweek, and collective bargaining are but
dreams to many of the world’s workforce.
Free trade gives countries with such a paucity
of workers’ rights a competitive advantage against
American and European firms that must pay higher
wages and accord workers better rights. To compete,
these Western firms must have efficiencies that their
competitors cannot achieve with a poorly trained work-
force. This is not difficult for high-skill areas such as
software development, but it is nearly impossible for tex-
tile and apparel production. When a job takes very little
skill or is not intellectually challenging, then a poorly
treated, poorly trained, or poorly paid worker can keep
up. It is only when the job requires complex thinking
that workers who are well treated, highly trained, and
handsomely paid are going to outproduce the poorly
treated, poorly trained, and poorly paid by enough to
justify those who hire them keeping production in the
United States.
A last area where free-trade agreements are criticized
is the environment. The maquiladoras, concentrations of
industries on the Mexican side of the border with the
United States, produce some of the most toxic substances
in the world. Those toxic substances are produced wher-
ever the manufacturing takes place, but their handling,
an important factor, differs. For instance, in the United
States the wastewater from these manufacturing plants
would have to be cleaned to a near-drinkable standard.
In Mexico, however, less than 10 percent of industrial
wastewater is treated with that degree of stringency. This
is an obvious example of how the comparative advantage
gained and exploited through free trade is not wanted
or good. Since much of the waste travels along the Rio
Grande and affects Texans directly, it would be better
for them if production were in the States, even though it
would cost more.
Free-trade agreements can deal with these issues.
Whereas it is impossible to impose U.S. labor and
environmental standards on other countries, it is pos-
sible to set forth principles in the accords that require
that the less-developed countries continually increase
standards in designated areas. Although neither NAFTA
nor CAFTA does all of this, they do work toward that
end. And GATT, while less strict than either NAFTA
or CAFTA, also requires that signatories adhere to
the international treaties on labor rights that they have
already signed.
The election of Donald Trump as president in 2016
dramatically altered the politics of the free-trade
movement. His opposition to the Trans-Pacific Part-
nership and his pledge to put tariffs on imports from
China and other countries as leverage to negotiate bet-
ter trade deals for the United States were important
hallmarks of his campaign. Whether the politics of
trade return to their previous form (with Republicans
in favor of free trade, with moderate Democrats in
favor of modest restrictions, and with liberal Demo-
crats opposed to free trade) is certainly up in the air
after the 2016 election.
Summary 245
The Bottom Line
The bottom line on international trade pacts is this: Most
economists favor them for two basic reasons:
1. Economists generally favor allowing people to buy what
they want from whom they want and to sell what they
want to whomever they want, without restriction, as
long as doing so does not harm an innocent third party.
2. More to the point of this chapter, they favor trade
pacts because, if they are negotiated with care, such
pacts enhance global economic well-being.
While free trade eliminates some jobs in some areas,
it creates more jobs in other areas. Some countries with
high poverty rates and low wages will gain jobs in areas
where training and education are relatively unimportant.
Other countries, including the United States, will benefit
by being able to sell goods that require highly skilled
workers to produce.
With regard to free trade, what economists insist
is true is that with income support and retraining, the
gains from trade are nearly always sufficient to offset the
losses of the people made worse off by trade. What we
need to understand is that if the people who gain from
trade get all of the benefits and the people who get laid
off are forgotten, then free trade is going to be seen and
will in fact become just another
way the rich get richer and the
poor get poorer.
One interesting spin on those
who lose their jobs is the no-
tion of creative destruction
introduced by Joseph Schumpeter. Schumpeter’s thesis
is that workers’ desire for job security and their com-
placency when they have it is such that they do not seek
out better opportunities unless they are forced to. If this
logic is to be believed, then free trade does such people
a favor by sending them into unemployment. Because
most economists firmly believe that people do what they
think is in their best interests, it may be that they know
that there are better opportunities out there but are sim-
ply more comfortable where they are. This would sug-
gest that unemployment is not really a favor. However, it
is just not as bad as many fear because the massive and
burgeoning service sector in the United States has ab-
sorbed many of those whose jobs were lost due to trade.
Whether or not we have NAFTA, CAFTA, GATT, or
any other trade agreement, what labor unions, workers,
and young people in general have to understand is that
the days are over when a high school diploma ensured
that the holder of a job could earn middle-class wages.
The trends toward more mechanized manufacture are in-
exorable. The jobs that are available now are in operating
or designing the new machines. These jobs, moreover,
require training and higher education.
In addition to the economic side, NAFTA’s diplo-
matic benefits cannot be missed. Not since the Panama
Canal treaty has Latin America been treated as well by
the United States as it has as a result of negotiations with
NAFTA. In the past the sovereignty of Latin American
countries was threatened by the United States on more
than a few occasions. Now NAFTA implicitly recognizes
Mexico as a partner with both the United States and
Canada in the development of the Western hemisphere.
Summary
As a result of completing this chapter you now understand
that economists generally see that free trade is better than
restricted trade and that trade agreements that facilitate
the opening of trade are seen by most economists as a
good thing. You understand why economists insist that
free trade is good and why it is that agreements to main-
tain it are sometimes necessary. You are familiar with
NAFTA, CAFTA, GATT, TPP, and the WTO as trade
agreements and institutions, and you know some of the
thinking about whether they are working as advertised.
You understand the economic and political concerns that
free-trade agreements generate, and you know that the
bottom line for most economists is that such agreements
are good policy.
Key Terms
CAFTA
creative destruction
GATT
NAFTA
quota
strategic trade policies
tariff
WTO
creative destruction The notion that people need to lose their jobs involuntarily in order to seize better opportunities.
246 Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
Quiz Yourself
1. Trade agreements are often necessary because
a. free trade is in no one’s best interest.
b. limiting trade is in no one’s best interest.
c. limiting trade helps those doing the limiting
but typically by less than it hurts those who are
limited.
d. limiting trade helps those doing the limiting
and typically by more than it hurts those who
are limited.
2. Trade agreements are enforced
a. militarily by the United States.
b. militarily by the United Nations.
c. by the consent of the parties to abide by the
judgment of the arbitrators.
d. only by the willingness of the parties to respond
favorably to each other.
3. Which concept from Chapter 1 can be used to ex-
plain how it is possible for it to be in the individual
interest of each nation to engage in protectionist
policies but for everyone to be worse off if they all
engage in protectionist policies?
a. The fallacy of composition
b. That correlation does not necessarily equate to
causation
c. That all resources are scarce
d. That the right policy option is one chosen at the
“margin”
4. Free-trade agreements
a. are just that, about tariff and quota-free trade.
b. have very little to do with the trade of goods
and services and more to do with currency
exchange.
c. are about making trade freer than it was before
and rarely about making it completely free.
d. only impact the trade of goods and rarely
impact the trade of services.
5. When one country objects to the trade restrictions
of another, the provisions of trade treaties typically
a. allow it to militarily exact retribution against
the offending party.
b. require that it submit its objections to an adju-
dication body to determine whether the practice
is allowed.
c. require that the offending country immediately
stop the action pending a review of the case by
an adjudication body.
d. provide no form of relief.
6. The World Trade Organization governs the provi -
sions of
a. NAFTA.
b. GATT.
c. CAFTA.
d. SHAFTA.
7. From the perspective of the United States, a major
accomplishment of the 1999 round of GATT was
a. the complete banning of “domestic content”
provisions in movie and television
production.
b. the creation of major restrictions on child
labor.
c. the worldwide adoption of U.S. environmental
practices.
d. the recognition of copyright protection for
software, music, and movies.
8. The consensus among economists is that NAFTA’s
impact on the U.S. economy is
a. enormously positive.
b. enormously negative.
c. marginal in net though it has increased both
imports and exports.
d. marginal in net because it has affected neither
imports nor exports.
9. Joseph Schumpeter coined the phrase “creative
destruction.” The idea of creative destruction
is that
a. people need to be forced from their comfort
zone in order to make crucial decisions that
enhance their economic prospects.
b. unemployment affects society more nega-
tively than thought because it breeds social
discontent.
c. unemployment is good because it keeps prices
down.
d. competition for resources is inherently
destructive.
Short Answer Questions
1. Why might it be easier to see a job lost because of
NAFTA than to see a job created by it?
2. Why might an agreement like NAFTA increase
GDP but not be favored by union members?
3. Why would free-trade agreements be easier to nego-
tiate between similar countries than with ones that
had very different methods of production, safety
standards, and wages.
Summary 247
Think about This
Look at the ingredients list on the next nondiet soda
you buy. The second ingredient behind water, is high-
fructose corn syrup. If you do the same thing in Canada
or Mexico, the second ingredient is sugar. The reason for
the difference is that the United States imposes a quota
on cane sugar imports (to protect sugar beet growers in
Minnesota and California). Is this good policy?
Talk about This
Protesters insist that the economic benefits of trade have
social costs that go unrecognized. Whether or not you
agree with them, make a list of those social costs. Open
your closet and look at the labels on your clothing. Look
for the labels on your consumer electronics to see where
they were made. Are you, individually, better off with
cheap clothing and electronics? In that context do we
owe something to those who bear those social costs?
For More Insight See
“China and the WTO,” Economist, April 3, 1999,
pp. 14–15.
Hufbauer, Gary, and Jeffery Schott, NAFTA Revisited:
Achievements and Challenges. Institute for Interna-
tional Economics, 2005.
Husted, Steven, and Michael Melvin, International Eco-
nomics (Reading, MA: Addison-Wesley, 1997), esp.
Chapter 8.
Krugman, Paul R., and Maurice Obstfeld, Interna-
tional Economics: Theory and Policy (Reading, MA:
Addison-Wesley, 1997), esp. Chapter 11.
Scott, Robert, Carlos Salas, and Bruce Campbell, Revis-
ing NAFTA: Still Not Working for North America’s
Workers, Economic Policy Institute Briefing Paper
#173, September 2006.
The Seattle Times, December 4, 1999, and the Seattle Times
WTO Web page, http://old.seattletimes.com/special/wto/
Whitelaw, Kevin, “Banana-Trade Split,” U.S. News &
World Report, January 11, 1999, p. 49.
Behind the Numbers
U.S. Trade—http://www.census.gov/foreign-trade/index
.html
248
C H A P T E R T W E N T Y - T W O
The Line between Legal and Illegal Goods Learning Objectives
After reading this chapter you should be able to:
LO1 Apply the supply and demand model and the concepts of
consumer and producer surplus to the markets for tobacco,
alcohol, and illegal goods and services.
LO2 Conclude that economists endorse interference in a market
for reasons related to the information and costs to innocent
third parties.
LO3 Utilize the concept of elasticity of demand to analyze who
gets hurt by taxes on tobacco and alcohol.
LO4 Analyze the impact of drug legalization.
Chapter Outline
An Economic Model of Tobacco, Alcohol, and Illegal Goods
and Services
Why Is Regulation Warranted?
Taxes on Tobacco and Alcohol
Why Are Certain Goods and Services Illegal?
Summary
Let’s face it. No mother wants her child to start smok-
ing or drinking, or to engage in illegal activity. These
are not healthy activities. Nevertheless, economists
are generally reticent to suggest that a good or service
should be banned outright just because it is not good for
you. This chapter uses the tools of supply and demand,
elasticity, and consumer and producer surplus to look at
these particular goods and services and the reason some
are regulated, some are taxed, and still others are illegal.
Seventeen percent of the American population
smokes, and the average American consumes nearly
26.3 gallons of beer a year. With that much smoking and
drinking going on, tobacco and alcohol are obviously
important parts of the American economy. The tobacco
industry employs 12,714 people a year, and it has an-
nual shipments of $37.3 billion. The alcohol industry
employs 75,247 people, and its annual sales amount to
$63.4 billion. Because certain goods and services are il-
legal, it is impossible to know exactly how much money
is spent on them or how many people are employed in
their production. What is known is that nearly half of all
adults under 35 have violated the law when it comes to
their consumption of an illegal good or service.
Before looking closely at the economics of these goods
and services, we will review the fundamentals of sup-
ply and demand to remind ourselves of how equilibrium
within a market serves the interests of both the consumer
and the producer. Then we will turn to reasons why selling
and using these goods are regulated, taxed, or banned and
why economists might back such restrictions. Along the
way, we’ll focus not only on secondhand smoke, drunk
driving, the spread of disease, and increases in crime but
also on the issues of age restrictions, warning labels, and
prohibition. After a brief discussion of the importance of
elasticity, we’ll use the concept within our supply and de-
mand model to indicate who gets hurt by the considerable
taxes that are levied on both tobacco and alcohol. Finally,
we’ll discuss why tobacco and alcohol are legal, why
other goods and services are not, and what decriminaliza-
tion of these goods and services would likely bring.
Why Is Regulation Warranted? 249
As a result of this analysis, we can state that the sale of
this offending good makes both consumers and producers
better off than they would have been without the sale. The
sum of the consumer surplus and the producer surplus is
CAB. If it were illegal to buy and sell these goods and
services, and if everyone obeyed the law, all of the above-
named parties would be worse off. Before you have a fit
at this conclusion, though, remember that it was arrived
at only after we made some fanciful assumptions.
Why Is Regulation Warranted?
It is now time to recognize reality and to deal with the very
real problems of tobacco, alcohol, and illegal goods and
services. The goods themselves are very addictive. There
are harmful effects to innocent third parties from second-
hand smoke, drunk driving, and the spread of disease. In
addition, the use of any one of these goods or services
negatively affects spouses and children. Their presence has
caused experts in public health to persuade legislators to
implement restrictions, regulations, taxes, or outright bans.
When people argue for government intervention in a
market, they do so from many points of view. Economists,
who tend to decry unwarranted intervention, generally
categorize reasons into three broad areas. First, they
deem it possible for people to suffer from a lack of
knowledge or an inability to think clearly. When that is
the case, it may be appropriate for the government to step
in with information or with warnings of danger. It may
even be appropriate for government to make decisions for
people. Second, they accept that the good or service may
have adverse impacts on people other than the consumer
or producer. Those costs, which are ignored in a market,
must be taken into account by the government. Last, and
least appealing among economists, is that consumption
or production of the good may be immoral. That is, even
though buying or selling the good may not hurt anybody
in a physical sense, its production or consumption hurts
society in general.
The Information Problem
For legal goods, advertising is intended to draw people to
a product, and advertisers want their ads to be memora-
ble. When the advertising is for products like tobacco and
alcohol, we sometimes bemoan the effectiveness of the
ads. For children of the 1950s and 1960s, the Marlboro
Man™ was the image of health and rugged individualism.
For children of the 1980s and 1990s, the R. J. Reynolds’
Joe Camel™ was as recognizable as Mickey Mouse.
An Economic Model of Tobacco, Alcohol, and Illegal Goods and Services
We’ll use the market that was presented in Chapter 2 as
the basis for our analysis of these goods. To be general,
we’ll just call the good or service in question, “the of-
fending good.” You can substitute whatever example
you wish because the analysis is exactly the same. As
we did with the market in that chapter, we will assume
that there are many buyers and sellers, that the demand
curve for each is downward sloping, and that the supply
curve for each is upward sloping. For the time being, we
will pretend that there are no negative consequences to
innocent third parties. We will also pretend that all the
people who engage in these activities know exactly what
they are getting themselves into. While these are fanciful
assumptions, the approach gives us a jumping-off point
that we can use to look at these markets. To prove that the
markets benefit both the consumers and the producers,
we have to refer to the consumer and producer surplus
analysis that was presented in Chapter 3.
We start with a few facts that are presented in
Figure 22.1. Consumers buy Q* goods and pay P* for
each. This means that consumers pay producers an
amount of money that is simultaneously less than the
value the consumers place on the good and more than it
cost the producers to provide it. That is, consumers are
happier with the good or service than they were with the
money they gave up, and producers make a profit. The
gain to the consumers is P*AB and is called their con-
sumer surplus. The profit to the producer is CP*B and is
called their producer surplus.
The o�ending good/tO
S
P
D
B
A
C
Q*
P *
FIGURE 22.1 Market for an offending good.
250 Chapter 22 The Line between Legal and Illegal Goods
In 1998, tobacco advertising was ended as part of a legal
settlement. Still, Anheuser-Busch’s series of Budweiser
and Bud Light ads have been quite effective with Super
Bowl audiences for decades. Though economists recog-
nize the role of advertising in markets for goods that
are legal, they debate the usefulness of advertising bans
when the goods are legal for only a specified group.
For illegal goods, advertising is not an issue; the real
“information” problem is the degree to which people do
not adequately weigh the likelihood or impact of addic-
tion. Government’s reaction to this can be one of edu-
cation, one of restriction, or one of prohibition. In the
United States we use education to dissuade young people
from using drugs and reinforce that with prohibition. In
all but certain counties in Nevada, the government’s
response to prostitution is simply one of prohibition.
The addiction argument clearly applies to cocaine,
ecstasy, and methamphetamine. The reasoning is that
potential users may not know or fully comprehend that
these drugs can be addictive and what the impact of
that addiction will be on users. The argument as it ap-
plies to prostitution is somewhat different. When pros-
titutes get started in the sex business, they may not fully
realize the consequences of their actions. Some advo-
cacy groups that seek to maintain and strengthen the
ban on prostitution, for instance, claim that prostitutes
generally begin their trade as children. Estimates place
the number of U.S. prostitutes under the age of 18 at be-
tween 300,000 and 600,000, with 100,000 new victims
per year. People engaged in prostitution, especially at an
early age, might not realize that sex workers are sexually
assaulted on a regular basis or that the illegal drugs pro-
vided to them when they get started are used as a means
to keep them under control and dependent. Further, there
is widespread concern of a growing market for sexual
slaves. The girls caught up in this horrific practice are
not convinced to participate but are either abducted or
told that they have been chosen to live in the West be-
cause of their academic potential or because there is a
market for live-in child-care workers. Only after their ar-
rival in the West do they learn their fate. Finally, these
groups also make the point that more than 80 percent of
prostitutes are the victims of childhood incest and that
the sex industry capitalizes on this sense of degradation.
In general, then, economists suggest that the infor-
mation problem can be dealt with using education, age
restrictions, or prohibition. The appropriate tool de-
pends on the degree of the problem. For example, the
government requires that packages of cigarettes and bot-
tles of alcohol display warning labels that describe the
consequences of smoking and drinking. Thus, requiring
warning labels and banning tobacco or alcohol advertis-
ing on the grounds that these promotions serve only to
cloud the judgment of consumers is acceptable to econo-
mists. We take the “providing knowledge” a step further
when we ensure that every new generation knows the
addictive nature of smoking and drinking through pro-
grams in the schools.
Of course, there are times when we simply do not
trust young people to make good decisions, even when
they have all the information. In these cases we either
make it illegal to buy the goods or services or we re-
quire that people reach a certain age before they can buy
them. Economists are not at all uncomfortable forbidding
children from consuming tobacco products for two rea-
sons. First, the vast majority of smokers began their nico-
tine addictions well before becoming adults. Second, there
is evidence that the tobacco companies aided their becom-
ing addicted through their marketing efforts. Because only
a tiny fraction of smokers began smoking as adults, pre-
venting children from having ready access to cigarettes is
in society’s interest and in the child’s long-term interest.
Ultimately, the reason many economists embrace the
prohibition of cocaine, ecstasy, and methamphetamine is
that for these the addiction problem is often permanent.
External Costs
Few economists object when government interferes in
a market in which someone other than the consumer or
producer is hurt by the consumption or production of a
good. These externalities are important considerations
for market regulation because the point of market ef-
ficiency is that everyone either benefits from, or is left
unaffected by, a transaction. If that does not happen, then
standing by and allowing the market to take care of itself
is not always acceptable.
The externalities that result from the use of tobacco
are the illnesses and deaths associated with second-
hand smoke and the increased health care expenditures
incurred by people who do not smoke but must pay
increased premiums for health insurance to cover the
expenses of smokers. It is not the concern of most econ-
omists that (knowledgeable) smokers hurt themselves
by smoking. It is the concern of economists that those
smokers tend to pass on costs to others.
The sale of drugs often affects someone other than the
buyer or seller of the drug. As a result, at least some of
the costs of that market are not being accounted for by the
buyer or seller. If addicts are more likely to commit crime
Why Is Regulation Warranted? 251
than nonaddicts, then neither the addict nor the dealer is
accounting for the rising number of innocent victims when
they sell their goods. Similarly, if a person gets a venereal
disease from a visit to a prostitute and passes that disease
on to an unsuspecting third party, then there is an external
cost. Someone who is not part of the original transaction
is being affected because of the transaction.
Establishing who should be counted as an innocent
victim, though, is not as easy as it might sound. Chil-
dren clearly are innocent victims, but are nonsmoking
spouses? Some economists suggest that as part of the give
and take of a marriage, smokers and their nonsmoking
partners negotiate the rules for smoking in a household.
If they decide it is all right for one to smoke and the other
to be negatively affected, then smoking and its implica-
tions do not constitute an externality; it is simply one
of the costs of the marriage. Other economists disagree.
They suggest that regulations are needed to protect any
people who are not consumers themselves.1
However you decide the issue of who is an innocent
victim, those who are subjected to secondhand smoke
have higher rates of lung-related illness than exist in the
general population. Children in the presence of smokers
are much more likely to die from sudden infant death
syndrome (SIDS), asthma, and other lung illnesses.
Servers in restaurants, bartenders, and a variety of others
who have been exposed to others’ smoke also report rates
of lung illness that are not only higher but beyond those
that might have occurred by chance. The costs of treating
these innocent victims are ignored by both smokers and
tobacco companies. Economists abhor ignored costs.
Whether economists support corrective actions when
there are such costs depends on the degree of those costs
and whether eliminating them is worth the loss of private
benefits. In addition, there are more smokers on Medic-
aid than their proportion within the general population
warrants. They, of course, produce some rather sub-
stantial costs to the program. If they were not smoking,
Medicaid would cost taxpayers less. Here the innocent
victim is the taxpayer.
Externalities also exist in less likely places. Since
smokers typically die 10 years earlier than comparable
nonsmokers, if they have group life insurance policies
whose rates are the same for both smokers and nonsmok-
ers, the expected net payout for smokers’ beneficiaries is
more than for nonsmokers’ beneficiaries. Life insurance
rates are therefore higher for nonsmokers than they should
be and the rates for smokers are lower than they should be.2
These facts combine to suggest that when smokers
buy cigarettes, the full cost of their smoking not only is
There are a few facts on crime that we ought to consider when deal-
ing with drugs in particular. First, 24 percent of all violent crimes
(13 percent for rapes) are committed while the perpetrator is on
drugs. Second, 55 percent of inmates in jail, detention, or prison
used drugs during the month leading up to their arrest. Last, we
spend $3.9 billion on drug interdiction at the federal level, another
$21.8 billion in other drug control expenses, and $73.3 billion on
incarceration in this country every year. One-quarter of those in-
carcerated now are there for drug- related offenses. What effect
would legalization have on these statistics? We would save a lot
of money—one-fifth of the incarceration costs and all of the inter-
diction costs. If overall use increased, as it probably would, vio-
lent crime would increase as those who were not addicts before
legalization became addicts after legalization and, once addicted,
became violent.
BATTLING NEGATIVE EXTERNALITIES WHILE CREATING OTHER PROBLEMS Solving the externalities associated with a good by enforcing a pro-
hibition strategy creates a problem. Sometimes the solution can
be worse than the problem it was intended to solve. Much drug
violence exists only because of laws criminalizing drug use. If co-
caine, methamphetamine, and marijuana were legal and inexpen-
sive, there would be less of a need for addicts to rob in order to
get money to buy them. There would be no drive-by shootings to
protect turf. There would be no need for the hundreds of thousands
of prison beds devoted to drug offenders. It is for this reason that
you find a significant number of economists, even very conservative
economists, favoring drug legalization. They appreciate that drugs
carry with them externalities but see the solution as worse than the
problem.
E X A M I N I N G T H E E X T E R N A L I T I E S
1This is the same argument that some economists use to suggest that
government need not regulate workplace safety. Risk takers must be com-
pensated adequately or they would not take the risk.
2This externality is avoided when life insurance companies differentiate their
premiums for smokers and nonsmokers. The degree of the employer subsidy
would have to depend on this as well.
252 Chapter 22 The Line between Legal and Illegal Goods
not paid at the cash register but is not even fully incurred
by the smoker. Most estimates of the external expenses
that are paid by the general public come to around a dol-
lar per pack of cigarettes.
This is not to say that economists hold unanimous
opinions in these matters. Some suggest that there is a
benefit to nonsmokers when other people smoke. These
benefits come from two separate but related aspects of
smoking. First, as mentioned previously, people who
smoke for long periods of time die several years earlier
than comparable people who never smoked. Smokers
and nonsmokers pay into Social Security and other pen-
sion plans, but nonsmokers have some of their retirement
essentially subsidized by smokers, because the smokers
die before they have collected the benefits to which they
were entitled.
A second form of subsidy that smokers grant non-
smokers is that not only do they die early, but they
die more suddenly than nonsmokers. When smokers
over the age of 60 become ill, their lifetime of smok-
ing has so depressed their immune systems that they
die of illnesses that nonsmokers are more likely to
survive. They also succumb to those illnesses much
faster and less is spent attempting to save them. Even
though the money is spent sooner, it is much less. It
is grimly ironic then that by dying more quickly than
nonsmokers, smokers sometimes cost the health sys-
tem less than do nonsmokers. By dying early and
quickly, smokers avoid expenses that nonsmokers
eventually need to pay. Because more than one-quarter
of Medicare expenses are incurred during the last year
of elderly people’s lives, hastening their deaths saves
money. If this gruesome fact is taken into account, the
net external costs of smoking become negligible in the
eyes of some economists.
Though there is a morbid economic upside to smok-
ing, there is no such benefit to drunk driving. There are
more than 1 million arrests a year for driving under the
influence of alcohol. While that number has come down
substantially over the last decade, it is still more than
high enough to represent a significant problem. Of the
roughly 30,000 accidents that result in 32,675 traffic fa-
talities each year, 31 percent involve at least one person
whose blood alcohol level is over the legal limit. Another
5 percent involves someone who has a legal, but still
measurable, blood alcohol content. Even when someone
does not die, alcohol is a contributing factor in nearly a
third of a million automobile accidents a year.
Despite these troubling statistics, it is time to try to
look at the issue from a dispassionate viewpoint. To
model the problem of the externalities that are associ-
ated with people who drive under the influence of al-
cohol, we need to alter our supply and demand diagram
to account for the extra costs for which their behavior
is responsible. To understand Figure 22.2, you need to
recall that under perfect competition the supply curve is
the marginal cost curve to the firms in the business. Any
costs that are borne by neither the seller nor the buyer
must be added to these costs to create the social cost of
the good. On the assumption that the only people who
benefit from the consumption of the good are the con-
sumers themselves, the demand curve is the social ben-
efit curve. So instead of coming to the market solution
of a price–quantity combination P*–Q*, the socially op-
timal combination is P–Qʹ. That is, if there is a market
for a good where some of the costs spill over to others,
then the market will produce too much of the good and
charge too little for it.
Morality Issues
We have looked now at the first two circumstances
under which economists consider it acceptable for gov-
ernment to intervene in the market. Besides lack of in-
formation and externalities in which innocent people
may be harmed, a final reason why government might
regulate a free market is that the market may be for a
good or service that is considered to be immoral. For
believers in certain major world religions, alcohol, to-
bacco, drugs, and prostitution are accorded this status.
While appeals to righteousness are not particularly
meaningful to economists on an academic level, they
are certainly important to many other people. Many re-
ligions consider drinking a sin, and a few feel the same
way about smoking.
External cost
Social cost
S (marginal cost)
D (marginal benefit)
The o�ending good/tO Qʹ
Pʹ
P
Q*
P*
FIGURE 22.2 Modeling externalities.
Taxes on Tobacco and Alcohol 253
Taxes on Tobacco and Alcohol
Modeling Taxes
To correct an externality, we can tax the offending
good, we can limit its use, and we can forbid its use. Of
these options, taxes are the most appealing to econo-
mists, as they allow people who are willing to pay all
of the costs of their consumption to go ahead and con-
sume. Using taxes in this way has the positive effect of
discouraging those people who are not willing to pay
the costs from becoming consumers of the undesirable
or unhealthy good.
The taxes that the United States imposes on tobacco
and alcohol are a $1.01 per pack tax on cigarettes and a
33-cent per six-pack tax on beer. The federal taxes on to-
bacco raise approximately $15.4 billion a year, while the
taxes on alcohol raise $10 billion. States also tax these
goods, collecting $18 billion in tobacco taxes and nearly
$6.5 billion in alcohol taxes.
Figure 22.3 shows that the effect of the federal taxa-
tion on cigarettes and alcohol is to raise the price from
P* to Pʹ and to lower consumption from Q* to Qʹ. An
important thing to notice about this effect is that smok-
ing and drinking do not stop. This means that the del-
eterious effects of secondhand smoke and drunk driving
do not stop either. They are simply reduced. If the tax is
set equal to the dollar value of such externalities, then
in theory the tax revenue raised is sufficient to cover the
costs of the externalities. One problem, though, is that
the tax hits the considerate and rude alike. Smokers who
light up alone do not cause secondhand smoke, whereas
smokers who blow it in your face do. A per-pack tax hits
both equally.
In any event, a policy short of prohibition implies
that there are an economically acceptable number of
expected drunk driving deaths and of childhood sec-
ondhand-smoke-induced illnesses. The idea is that as
long as we have an adequate sum of money available to
compensate the people who are affected, it is accept-
able for smokers to smoke, for drinkers to drink, and
for people to be influenced in negative ways by their
behavior.
People who are not economists have a very difficult
time with the “acceptability” of deaths and illnesses. The
basic idea is that people drink and smoke because they
enjoy doing so. If we take taxing and regulating too far,
the reduction in enjoyment by users would outweigh the
effect of the reduction on innocent victims.
The notion of acceptable deaths is a difficult one for
many to accept. Consider this though: The Brain Injury
Association reports that approximately 5 children die
each year on playgrounds as a result of falls and other
injuries. We continue to send our children out on recess
because we weigh what is to be gained with what is to
be lost and judge the risk of injury or even death to be
tolerable. We drive to work because we see that what is
gained—income—is greater than what is lost—a small
risk of injury or death.
One consequence of the national battle against methamphet-
amine has been that over-the-counter cold medications are no
longer simple to purchase. The manufacturers had to decide
whether to alter their formulas or put those medications behind
the pharmacy counter. Those manufacturers that chose to keep
the key ingredient that could be extracted to produce metham-
phetamine lost sales because consumers were required to provide
identification to pharmacists. Others changed their products to in-
clude ingredients that are somewhat less effective. Externalities
occur all over.
W H E R E D I D M Y S U D A F E D G O ?
Social cost
S (marginal cost)
D (marginal benefit)
The o�ending good/tO Qʹ
Pʹ
P
Q*
P*
Tax = External cost
FIGURE 22.3 Modeling taxes.
254 Chapter 22 The Line between Legal and Illegal Goods
The Tobacco Settlement and Why Elasticity Matters
For quite some time legislators have given particular
consideration to raising the taxes on tobacco. The settle-
ment between several states and the big tobacco compa-
nies that was reached in 1998 requires that the companies
pay the states more than $250 billion over 20 years to
compensate them for Medicaid expenses the states paid
that were created by smoking. The companies will then
pass on those taxes to the smokers who buy their prod-
ucts. To see how a sequence like this works, we need to
look at the supply and demand curve for tobacco.
First, it should be remembered that when someone is
addicted to a product, as smokers are to cigarettes, the de-
mand curve for the good is highly inelastic. If you look at
Figure 22.4, you see that a tax will again raise the price
from P* to Pʹ. If you compare the size of the tax (Pʹʹ to Pʹ)
to the amount of the price increase, you see that smokers
will be paying for most of this tax increase and that tobacco
companies will pay comparatively less (P* to Pʹ versus P*
to Pʹʹ). Since smokers are far poorer than the average of the
general population, this tax is as regressive as any tax we
can imagine. Since consumption falls only from Q* to Qʹ,
it is also disturbing that the tax will not have a significant
influence on how much people smoke either.
When you look at teen smoking, the picture is not
quite so bleak. Because the habit of smoking takes up a
much larger portion of teenagers’ than adults’ incomes,
the elasticity of demand for cigarettes by young people is
much greater. That is, demand is more elastic and the de-
mand curve is flatter. If you were to draw such a demand
curve, you would see that the burden of the tax would
still fall mainly on consumers. You would also see that
tobacco companies would be paying a greater proportion
of the amount of compensation. Further smoking, at least
teen smoking, would be reduced by more. Until quite
recently economists’ estimates were that elasticities for
cigarettes were as low as .2 for adults and as high as .5
for children. Under these circumstances this means that
an increase of a dollar in cigarette prices would dimin-
ish adult smoking by 10 percent, but it would diminish
smoking by children by 25 percent. More recent studies
of cigarette elasticity put adult elasticity at .8 for adults.
This is quite likely the result of electronic cigarettes and
the degree to which they provide an alternative to users.
On beer, a study of the elasticity of demand put it at
0.53, which suggests a tax that adds 10 percent to the price
of a six-pack would reduce consumption by 5.3 percent.
Why Are Certain Goods and Services Illegal?
The debate over whether drugs and prostitution should
be legal usually comes down to a comparison of the neg-
ative consequences of what is currently legal, tobacco
and alcohol, with what is currently illegal. Clearly a case
can be made that the aggregate impact of tobacco and
alcohol is much greater than the aggregate impact of
illegal drugs and prostitution. As you can tell by now,
economists are less interested in “aggregate” impacts
than “marginal” ones. Here, the case can be made that
the negative externalities associated with one person pur-
chasing one more unit of the illegal goods are greater
than the negative externalities associated with one person
purchasing one unit of a legal good. The other argument
that could be made to justify the current state of the law
is that the unknown or underestimated consequences to
the consumer of using drugs or engaging in prostitution
are substantially greater than those with regard to alco-
hol. Of course, the opposite case could be made as well.
The Impact of Decriminalization on the Market for the Goods
Given the previous discussion, suppose a good or service is
currently illegal. What would result from making it legal?
The first thing that would likely happen as a result of mak-
ing a good legal is that the concerns of both consumers and
producers about getting caught would evaporate. Because
getting caught would not be a problem any longer, any shift
to the left of supply that resulted from clandestine operation
would cease to exist. Similarly, any shift to the left in the Q/t
S
Tax
P
D
Qʹ Q*
P*
Pʹ
P ʺ
S + tax
FIGURE 22.4 Tax on tobacco with inelastic demand.
Summary 255
demand curve by those who might have wanted to partake
of the illicit good but did not because it was illegal would
cease to exist. The net result of legalizing a previously il-
legal activity would be a movement in the demand curve to
the right and a movement in the supply curve to the right.
Another impact of decriminalization would occur on
the elasticity of demand and, to a lesser degree, supply.
When a good is illegal, it is often the case that the con-
sumers of the good are addicted to it in some sense. The
demand curve for a good for which a consumer is addicted
is likely to be very inelastic. Similarly, once people have
made the decision to become a seller of an illicit good,
the price they sell it for is not usually a stimulus to sell
it in great quantities. This is because the risks of getting
caught may prevent sellers from expanding their operation
quickly as prices rise. Therefore, from either side, the
supply and demand curves are less elastic when the good
or service is illegal than when it is legal. The net result
here is that both curves flatten out when the good is made
legal. Figure 22.5 depicts the effect of legalizing a previ-
ously illegal good. The demand curve flattens and moves
right, and the supply curve flattens and moves right. If the
supply curve movement is more than the demand curve
movement, as it is in Figure 22.5, the net result is a low-
ering of price. Not shown, but equally plausible, is the
case where the demand curve movement is greater than
the supply curve movement and the price rises.
Thus, the direction of a price change as a result of
decriminalization depends on whether the reduction in
risk to dealers or prostitutes is greater than the increase
in interest by consumers. Because the conventional wis-
dom is that legalization would lower the price, conven-
tional wisdom is just that: The supply curve shift will be
greater than the demand curve shift.
The External Costs of Decriminalization
Ultimately, whether legalization makes sense to you de-
pends on whether you believe the external costs of these
activities are significant enough to pay the significant
costs of punishing users and dealers. One potential solu-
tion that many pro-legalizers suggest is that we tax and
regulate drug sales and prostitution in order to take into
account and pay for the externalities.
Looking back to Figure 22.3, you see that we simply
added a tax equal to the external cost that was examined in
Figure 22.2 to get the Pʹ, Qʹ result. That is, a proper taxa-
tion scheme can make up for the problems of an externality.
There is money to educate against the use of the illicit good
or to compensate victims of users of the questionable good.
The problem is that if the external costs are very
great, the tax will have to be very high. If the tax is very
high, there will be a motivation to have a black market in
untaxed goods. As evidence of this, consider that in Canada
a prohibitively high tax created a black market for ciga-
rettes. In this case people drove to the United States, bought
cigarettes, took them back to Canada, and sold them. In
another similar case, while prostitution is legal in Nevada,
it is highly regulated. That regulation leads to prostitutes’
avoiding regulation by working on their own outside the
regulated brothels. Whenever a tax is too high or regulation
too severe, a black market will exist beside a legal market.
P
Plegal
Qillegal
Sillegal
Dillegal
Pillegal
Qlegal
Slegal
Dlegal
Q/t
FIGURE 22.5 Making an illegal good legal or vice versa.
Summary
You now understand how we can apply a supply and de-
mand model and the concepts of consumer and producer
surplus to tobacco, alcohol, drugs, and prostitution. You
understand that there are reasons that economists en-
dorse interference in a market, reasons that have to do
with information and costs to innocent third parties. You
have seen how the question of who gets hurt by taxes
on tobacco and alcohol is dependent on the elasticity of
demand for these goods. Finally, you have seen the ar-
gument for the current state of the law with regard to
the treatment of these goods and the economic conse-
quences of decriminalization.
256 Chapter 22 The Line between Legal and Illegal Goods
Quiz Yourself
1. When examining the question of tobacco taxes,
economists focus almost entirely on
a. the cost to cigarette companies of production.
b. the cost to cigarette smokers for the cigarettes
themselves.
c. the cost to cigarette smokers for their extra
health care expenses.
d. the costs to nonsmokers (like secondhand smoke).
2. When discussing an addictive drug, an economist is
likely to focus on
a. both the external costs and the “information
problem” associated with addiction.
b. the moral costs totally.
c. the cost of the drug to the user.
d. the costs of production.
3. If you became convinced that marijuana was neither
addictive nor contributed to externalities, then ban-
ning it creates
a. a social benefit without social cost.
b. what economists call deadweight loss.
c. what economists call a vacuum.
d. a social benefit with an exact countering social
cost.
4. Decriminalizing a drug is likely to lead to a price
decrease if
a. the anticipated supply effect is greater than the
anticipated demand effect.
b. the anticipated demand effect is greater than the
anticipated supply effect.
c. the anticipated demand effect is exactly equal to
the anticipated supply effect.
d. both demand and supply decrease.
5. Compared to a recreational user of a drug, an ad-
dicted user’s elasticity of demand is
a. much more elastic.
b. much less elastic.
c. much less.
d. flatter.
6. If policy makers were to attempt to set a tax equal
to the external costs of alcohol, one would have to
evaluate
a. the cost of production.
b. the price paid by consumers.
c. the value of innocent lives lost to drunk
driving.
d. the value of the shortened lives of alcoholics.
7. When examining the “right tax” on a good that
produces an externality, the tax should be such
that
a. it is greater than the externality.
b. it is less than the externality.
c. it is exactly equal to the externality.
d. it makes consumption prohibitively expensive
for anyone.
8. One unsettling consequence of setting a tax on to-
bacco sufficiently high to reduce consumption
would be that
a. it would likely reduce Medicare costs.
b. it would likely increase tobacco revenues to
farmers.
c. it would likely increase tobacco company profits.
d. it would make Social Security’s financial out-
look worse.
9. The introduction of e-cigarettes provides a substi-
tute for regular cigarettes. The result is likely that
the
a. elasticity of supply increases.
b. elasticity of supply decreases.
c. elasticity of demand increases.
d. elasticity of demand decreases.
Short Answer Questions
1. If the United States is able to continue reducing the
incidence of children smoking, how might that end
up costing more in the long run in terms of health-
related expenses?
2. If the United States were to legalize marijuana pro-
duction, what might the negative externalities be and
what current negative externalities might be lessened?
3. If the United States were to eliminate the drinking
age, what might you predict the outcome to be in
terms of externalities?
4. What does the “legalize and tax” method of dealing
with currently illegal drugs imply about how propo-
nents of this approach view the ability to put a dollar
value on human life?
Think about This
There are considerate smokers and inconsiderate smok-
ers. Secondhand smoke is not an issue when smokers are
considerate (in that they smoke where no one is around
to breathe it). Should these smokers be taxed when they
are producing no harm to society?
Summary 257
Talk about This
As unsavory as it sounds, there are travel agents who book
“sex tours” in parts of Asia. Travelers visit prostitutes in
various locations. While some of the brothel operators man-
date “safe” practices, others allow the patrons to pay extra
if they wish to participate in “unsafe” practices. Should you
be able to pay someone to risk their lives in this manner?
For More Insight See
Grossman, Michael, Jody Sindelar, John Mullahy, and Rich-
ard Anderson, “Alcohol and Cigarette Taxes,” Journal
of Economic Perspectives 7, no. 4 (1993), pp. 211–222.
Thorton, Mark, The Economics of Prohibition (Salt Lake
City: University of Utah Press, 1991).
Behind the Numbers
State and local taxes on tobacco and alcohol.
Tax Policy Center of the Urban Institute and Brook-
ings Institution.
Tobacco—www.taxpolicycenter.org/taxfacts
/displayafact.cfm?Docid=403
Alcohol—http://www.taxpolicycenter.org/statistics
/alcohol-tax-revenue
Receipts—http://www.taxpolicycenter.org/statistics
/excise-tax-receipts
Employment and value of shipments.
Survey of manufacturers—http://www.census.gov
/programs-surveys/asm.html
Violent crimes and drug use.
U.S. Dept. of Justice; Criminal Victimization in the
U.S., 2008; statistical tables—http://bjs.gov/content
/pub/pdf/cvus08.pdf
Federal spending on crime control.
Federal drug control spending, 2011.
Office of National Drug Control Policy; drug con-
trol funding tables—www.whitehousedrugpolicy
.gov/publications/policy/11budget/fy11budget
Traffic fatality and blood alcohol statistics, 2009—
www.nhtsa.dot.gov
Incarceration statistics—http://bjs.gov/content/pub/pdf
/p11.pdf
258
C H A P T E R T W E N T Y - T H R E E
Natural Resources, the Environment, and Climate Change Learning Objectives
After reading this chapter you should be able to:
LO1 Apply the principles of present value to natural resource
development.
LO2 Apply marginal analysis to answer the question of how clean
is clean enough.
LO3 Apply the concept of externalities to explain why pollution
warrants government intervention in the market.
LO4 Demonstrate why pollution is much more likely to occur on
publicly owned property than on private property.
LO5 Summarize the variety of environmental problems that exist
in the world as well as the economic solutions that exist to
address these problems.
Chapter Outline
Using Natural Resources
How Clean Is Clean Enough?
The Externalities Approach
The Property Rights Approach to the Environment and Natural
Resources
Environmental Problems and Their Economic Solutions
Summary
Maintaining a stewardship over the natural resources of the
country and protecting the environment are increasingly
popular positions for politicians to take. On the surface
the solution to the first of these is to create a system of
usage that leaves resources for the next generation, while
the solution to the second problem seems rather simple:
Stop polluting. For an economist, though, not only is the
problem more complicated, but so also is its solution. The
environmental problems of modern society are substan-
tial and varied: unsustainable usage of natural resources,
pollution of the water and air, the potential extinction of
1,799 species of plants and animals, acid rain that puts for-
ests and fish in jeopardy, and greenhouse effects that are
probably responsible for rapidly rising global temperatures.
To most environmentalists solving these problems in-
volves strict questions of right and wrong. Economists,
on the other hand, want to look also at costs and bene-
fits. Economics may be central to solving environmental
problems because in dealing with the environment we
will need to reallocate our resources in directions that
generally move from consuming and growing in positive
economic ways to preserving and living with economic
slowdowns. Where economics can be particularly help-
ful is in the area of efficiency. Coming up with a plan
that reduces pollution is not difficult, but it is hard to
come up with a plan that reduces pollution in a way that
will minimize the economic costs. That is what econo-
mists bring to the discussion.
How Clean Is Clean Enough? 259
its marginal benefit to its user. If an additional unit of oil is
going to be utilized now, it has a decreasing marginal ben-
efit to the refiner because there is a decreasing marginal
utility for gasoline among consumers. The refiner must
reduce the price to sell the extra gasoline. The question
for the oil company is whether it is worth it to drill for oil
now and refine more gasoline now when doing so requires
that you reduce your price of gasoline now. In doing so,
you give up the opportunity to wait and sell that gasoline
later at a price that is likely higher. Though those later
profits will have to be discounted, they can well outweigh
the profits from producing and selling now.
An upward-sloping supply curve can also aid in moti-
vating conservation. Continuing with the example of oil,
the shale oil of the North Dakota area has been known
to exist for half a century and yet went largely untapped
even when oil prices peaked in 1980 and again in 2008.
That is because it is very expensive to tap. The marginal
cost of producing more oil, if that oil is from a location
such as that, is very high and so few companies tried to
extract it until recently. As a result there is conservation
of difficult-to-extract resources, because the marginal
costs are greater than the marginal revenues.
What this means is that market forces, both on the de-
mand and the supply side, will lead to some degree of con-
servation. The greater the discount rate, the lesser will be
the degree of conservation, and the lower the discount rate,
the greater will be the degree of conservation. This leads
some environmentalists to conclude the morally correct
discount rate is zero. Economists typically would not go so
far as to say that. Economists would more frequently assert
that the rate of utilization should be socially optimal for
everyone involved, those present and those in the future.
These economists would suggest, in the case of oil, that
the rate of utilization should also factor in the likelihood
that with greater scarcity of oil, alternatives to oil will be-
come more profitable to develop and that history tells us
that when society requires an alternative, prices adjust so
that an alternative becomes profitable.
How Clean Is Clean Enough?
For many of you, when you were 10, your bedroom was a
wreck. When asked whether a room is clean, a 10-year-old
will respond with a reply that is pure economics: “Clean
enough.” With that reply, 10-year-olds are saying that to
them, further cleaning is simply not worth the effort. In
the language of economics, children are saying that the
marginal benefit of cleaning more (the value they place
Using Natural Resources
The earth is a bounty of limited natural resources such as land, oil, natural gas, coal, mineral ores (iron, cop-
per, etc.), and renewable natural resources such as fresh water, wood, and wildlife. The ques-
tion for a society is how to de-
ploy those resources in such a
way that maximizes their long-
run usefulness. For a society to
do that, it must weigh the value
of those resources to those who
are living now against the value
of those natural resources to
generations to come. The issue
can be summarized as one of
stewardship, which is the management of resources in a fashion that weighs their value through time.
In the simplest sense, suppose you have a resource
that you can use now or you can leave unused and pre-
serve it for later. Suppose you also know what people
will pay for it now and you have a good estimate of
what they will pay for it in the future. In order to de-
termine whether you should use it now or leave it until
another time, you have to use the Chapter 7 concept
of present value. To keep things simple, suppose the
resource is costless to find, extract, and process and
produces a constant value per unit in each time and that
there are a fixed number of units. Any positive interest
rate will yield a conclusion that
you should use it all now—the
exact opposite of sustainability. Sustainability is the idea that
you should only use renewable
resources at the rate at which
they can be replaced, and it means that you use limited
natural resources at the lowest possible rate in order to
preserve them for future generations.
However, the simple introduction of a downward-
sloping demand curve for that resource brings about
the result that there is a trade-off between present use
and future use that will result in a motivation among
resource owners to conserve even with a positive dis-
count rate. The downward-sloping demand curve ac-
complishes this because increasing the present use
decreases its marginal benefit.
Suppose, for the purpose of illustration, the resource
is oil and that oil is used to produce gasoline. Recall from
Chapters 2 and 3 that the demand for gasoline represents
limited natural
resources Resources that cannot be replaced.
renewable natural
resources Resources that can be replaced.
stewardship The management of resources in a fashion that weighs their value through time.
sustainability The idea that you should only use renewable resources at the rate at which they can be replaced.
260 Chapter 23 Natural Resources, the Environment, and Climate Change
on additional cleanliness) is less than the marginal cost of
cleaning more (the value they place on Facebook time).
Economists apply the same standard to environmen-
tal issues—merely on a larger scale than a child’s bed-
room. The opportunity cost of a cleaner environment is
lost economic satisfaction. We can use marginal cost–
marginal benefit analysis to look at this problem, but
only if we make some simplifying assumptions.
Let’s assume for the moment that we have a gener-
ally accepted measure of environmental quality. Let’s
further assume that the really dirty stuff is relatively easy
to clean up but that achieving higher levels of cleanli-
ness is harder and harder. Using the dirty room analogy,
you know that the quickest way to make your room look
cleaner is to pick up the dirty clothes, which can be done
in seconds. Once you get down to straightening and dust-
ing the knickknack shelves, the benefits are slight and the
time required is great. What this implies is that the mar-
ginal cost of achieving greater cleanliness is increasing
while at the same time its marginal benefit is decreasing.
As shown in Figure 23.1, this means that the maximum
net benefit of environmental cleanup is EQ*, where the
marginal benefit equals the marginal cost.
The Externalities Approach
We created many environmental problems in the first
place when we produced and consumed goods and were
concerned only with the costs and benefits that directly
affected us. As we saw in Chapters 2 and 3, doing this
is usually fine, but problems often arise when the ac-
tions we take impose costs on or present benefits to
others. Economists call costs or benefits that are in-
curred by someone other than the producer or consumer
externalities. We begin this chapter by reviewing why a mar-
ket without externalities serves
everyone. We then explore why
there is a problem with markets
when externalities are present. After that, we examine
the specific environmental problems discussed above.
We conclude with a look at what economics can offer in
the way of solutions.
When the Market Works for Everyone
As we learned in Chapter 3, a market works very well
in a world where all the costs and benefits of production
are confined to producers and consumers. Figure 23.2
depicts in graphical form that the market price–quantity
combination, P*–Q*, provides benefits to consumers,
OABQ*, at a cost to them of OP*BQ*. The difference,
P*AB, is called consumer surplus, that is, what consum-
ers get in net benefits. Similarly, for the producer, the
variable costs of production, OCBQ*, are lower than
revenue generated from sales, OP*BQ*. The differ-
ence, CP*B, is called the producer surplus. Thus when
the market does not generate costs or benefits to anyone
other than consumers and producers, both benefit and no
one loses.
When the Market Does Not Work for Everyone
The main problem with the model just described is that
it does not take into account that there are nearly always
indirect costs to others in either the production or con-
sumption of a good. There are, for example, very few
goods that do not require some form of energy for their
FIGURE 23.1 Clean enough.
EQ*
Marginal cost
Marginal benefit
Environmental quality/t
Marginal cost Marginal benefit externalities
Effects of a transaction that hurt or help people who are not a part of that transaction.
FIGURE 23.2 When the market works.
O
S
P
D
B
A
C
Q*
P*
Q/t
The Externalities Approach 261
unaccounted for costs in the market. The existence of
such costs is unacceptable to an economist. The funda-
mental flaw with the market is that unless all costs are
accounted for, it will produce too much and charge too
little. To find the true cost of production and consump-
tion of a good that includes the
effects on innocent bystanders,
called the social cost, you need to add the external cost to the
private costs (measured on the
supply curve). When these costs
are accounted for, the price is to be P′ rather than P*, and
the amount produced is Q′ rather than Q*.
Unless you believe that a pristine environment is a
matter of right and wrong, allowing no compromises to
your position, you will have to accept the existence of
some environmental problems even when you account
for all the costs. For example, Figure 23.2 does not dis-
play a thoroughly clean environment, but it does show
how the costs of pollution are weighed against the ben-
efits of consumption. We may decide, for instance, that
even though some pesticides threaten certain species,
they so enhance food production that using them is worth
the cost. The species are still threatened, but at least the
cost is recognized. Similarly, we may decide that refor-
mulating gasoline to reduce emissions by 80 percent is
worth 20 cents per gallon but that reducing it another
10 percent is not worth the dollar a gallon it would take
to accomplish that level of reduction. Here the costs of
pollution are weighed, but so are the benefits of con-
sumption. There are substances for which the optimal
level is zero. This occurs when the marginal benefit of
the production or use of even one drop of the good is less
than its social cost.
production. Whether that energy is generated from the
direct combustion of a steel mill’s smelting facility or
electricity generated from burning coal, some fossil fuel
is used in nearly all production. Even when the power is
hydroelectric, nuclear, wind, or solar, there are environ-
mental and possibly aesthetic costs that are not always
considered.
Using fossil fuels like oil or coal creates a number of
environmental problems from beginning to end. In each
of the stages of getting energy to the user, people or ani-
mals are affected. In extraction, land is either temporarily
or permanently altered. The 2010 oil spill in the Gulf of
Mexico clearly points out that extraction creates a nega-
tive externality. Transporting oil, natural gas, and coal
consumes energy. Transporting the first two carries with
it the potential for an environmental catastrophe like the
rupturing of the Exxon Valdez disaster and the resulting
massive oil spill in Alaska’s Prince William Sound. By far
the greatest problem, though, is created when fossil fuels
are burned. Particulate matter creates breathing prob-
lems that are unpleasant for some and life- threatening
for others. Burning coal releases sulfur into the air and
it produces acid rain. If current scientific predictions of
the United Nations Intergovernmental Panel on Climate
Change are found to be true, greenhouse gases will cause
significant changes in the world’s climate.
You may believe that alternatives like hydroelec-
tric, wind, or solar power offer externality-free energy,
but, like fossil fuels, each has its own problems. As the
Japanese experience of 2011 points out, though nuclear
power is potentially clean, it is also potentially disastrous
and even accounting for disasters ignores the problem of
how to store nuclear waste. Hydroelectric power requires
the destruction of river valleys, eliminating habitat as
rivers flood the area behind the dams. While wind and
solar power are clean in that they do not pollute the air or
water, the sheer number of collectors needed to produce
an amount of electricity that is equal to the amount pro-
duced by coal at the present time is vast. Therefore, this
option has the potential of destroying thousands upon
thousands of acres of land that we now consider to have
great scenic beauty.
Figure 23.3 depicts the problem as an economist
would see it. Whereas firms pay attention to the costs
of production of their goods, unless forced to, they tend
to ignore the environmental costs of their production.
Similarly, consumers pay attention to how much a good
costs them, but it often serves their purposes to ignore
the costs to those around them. Costs to people other
than the producers and consumers are considered to be
FIGURE 23.3 When a market does not work.
External cost
Social cost
S (marginal cost)
D (marginal benefit)
O Qʹ
Pʹ
P
Q*
P*
Q/t
social cost The true cost of produc- tion and consumption of a good that includes the effects on innocent bystanders.
262 Chapter 23 Natural Resources, the Environment, and Climate Change
may consider the individual benefit to be worth one-
hundredth of the cost of this regular maintenance, often
no one will view maintenance for the entire neighbor-
hood as worth the time or money. The ultimate problem
is that no one owns the property. As a result, while the
social benefit of the maintenance is greater than its cost,
the benefit to an individual is much lower than its cost to
that individual.
Natural Resources and the Importance of Property Rights
Economists use many of the same tools to explore the use
of natural resources as we use when dealing with pollu-
tion. Whether the resource in question is mineral, tim-
ber, energy, or the oceans’ bounty, economists note that
the extraction, cutting, removal, or harvesting imposes
costs on someone other than the producer or consumer. It
doesn’t matter whether this results from the fact that the
land is owned by the government or not owned by anyone
at all, or because the process of garnering the resource is
itself polluting. What matters is that all of the costs must
be acknowledged.
Economists also bring another element to the table:
the notion of present value. The value of an untapped
resource to its owner is the present value of the profit
associated with exploiting it over a period of time. In
this way there is an optimal rate of exploitation, which is
the rate that maximizes the present value. Suppose you
owned a resource such as a forest of timber. You could
clear-cut it and sell all of it at once. Then you would have
to plant new trees, wait for the trees to grow tall enough
to harvest, and repeat the cycle. On the other hand, you
could cut only those trees that had achieved an optimal
height and leave the rest for another year. In this way you
would have a few trees to cut every year. An economist
would look at this and say that whichever rate of exploi-
tation maximizes the present value of the profit emanat-
ing from that timber would be the optimal exploitation
rate. Assuming that no timber company can influence
prices, then there is no value to waiting to harvest trees
unless some are relatively immature. The motivation to
wait comes from the fact that trees grow, and thereby
grow more valuable. If the interest rate is high (and ex-
ceeds the rate of tree growth), then that favors the cut-it-
now rate, while if the interest rate is low, that favors the
let-them-grow rate.
The problem comes when no one owns the resources
that are being harvested. For instance, the oceans are no-
toriously overfished because there is no value to leaving
The Property Rights Approach to the Environment and Natural Resources
A Nobel Prize–winning economist by the name of Ronald
Coase came up with a completely different method of
dealing with pollution. His widely cited theorem states
that markets with externalities can be made to be effi-
cient. This can be done by simply assigning rights to the
polluted property, but it requires that bargaining costs not
be prohibitive. To see why this is so, we need to first look
at why ownership matters.
Why You Do Not Mess Up Your Own Property
Consider a relatively simple problem. Why is it that you
are much more willing to litter in a park than you are to
litter in your own residence hall, apartment, or house?
The reason is that you have property rights in the place
you live and you make your own place less valuable
when you litter in it. You do not own the park. Though
your littering diminishes the value of the park, it does not
diminish your own wealth.
This explains why people treat many forms of com-
mon property worse than they treat their own. If you
have ever lived on a cul-de-sac, you will have noted that
the circle of grass in the center of the turnaround was
in demonstrably worse shape (or at least less well land-
scaped) than the surrounding lawns. People tend to treat
their own property better than they do public property.
Why You Do Mess Up Common Property
Common property is property that is without a discernible individual owner. This property is usually owned by the
government, a neighborhood association, or some other
collective group. The problem
with common property is that
even though it may be worth
a great deal to the group, the
benefits of treating the property
well are not worth the costs to
any one individual. Economists refer to this as the “trag-
edy of the commons.”
Consider again the problem of a neighborhood park.
Suppose that a city agrees to pay the up-front costs of
a park for a neighborhood of 100 homes. It buys the
playground equipment, plants trees and grass, but then
turns the park over to the neighborhood. What happens
when the grass needs to be cut, a tree falls and needs to
be taken out, or the surface under the playground equip-
ment needs to be rejuvenated? While each neighbor
common property Property that is not owned by any individual but is owned by govern- ment or has some other collective ownership.
Environmental Problems and Their Economic Solutions 263
the fish to grow bigger. Similarly, when logging compa-
nies buy the right to harvest trees on federal land, those
contracts need to be well specified and well enforced or
the company will have no motivation to leave the smaller
trees for a later date, especially if the contract expires
before the trees grow to maturity. This is much less of
a problem on private property because the owner must
weigh the present value of the profit from taking an im-
mature tree against the present value of the profit from
taking it a few years later. It is often the case that the
logging company that owns the property it is working
on will leave the smaller trees because it is in its interest
to do so.
Environmental Problems and Their Economic Solutions
Environmental Problems
We face many environmental problems, some obvious
and others not so obvious. Specific problems include
water and air pollution, plant and animal species that
face extinction, the effects of acid rain, landfills that are
overflowing, limited natural resources that are being
used up, and global warming. In this section we look
briefly at each.
When humans are affected by the economic activ-
ity of other humans, the problem is relatively easy to
solve. People complain when they are being hurt. When
producers pollute the air or water, there are concerned
people who have to breathe the affected air or want to
drink or swim in the affected water. They will lobby their
representatives for pollution regulations. In fact, the En-
vironmental Protection Agency was created in 1969 in
response to pleas that environmental regulations be en-
forced. The Clean Air Act of 1970 and the Clean Water
Act of 1972 were additional responses to people’s per-
ceptions that problems existed and their desire to have
them addressed.
By most measures, these laws have been effective.
The nation’s air and water are much cleaner than they
were 40 years ago. Air pollution has been addressed with
regulations that range from requirements that smoke-
stack emissions be “scrubbed” before being released
to requirements that cars have catalytic converters and
burn unleaded gasoline. Since the Clean Air Act’s incep-
tion the amount of sulfur dioxide (SO 2 ) in the air has been
reduced by 84 percent, carbon monoxide by 67 percent,
particulate matter by 20 percent, and lead by 99.6 percent.
As can be seen in Figure 23.4, even since 1980, the Clean
Air Act has resulted in significant reductions in all mea-
sured forms of air pollution.
FIGURE 23.4 Pollutant concentrations.
Source: Environmental Protection Agency, www.epa.gov
1000
900
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
400
500
600
700
800
300
0
100
200
P o
ll u
ta n
t c o
n c e
n tr
a ti
o n
s ( 2
0 0
0 =
10 0
)
CO Particulate matter
Ozone
SO2
LeadNOx
264 Chapter 23 Natural Resources, the Environment, and Climate Change
In the area of water pollution, municipal wastewater
facilities now have to return untreated water to rivers and
streams in nearly drinkable form. Companies can no lon-
ger discharge waste materials into rivers or lakes, either.
Though some of the damage to these bodies of water
is permanent, most are improving. Classic examples of
this include the Cuyahoga River near Cleveland, Ohio,
which was so polluted that it once actually caught fire.
Now it is clean enough that people can eat its fish. Other
areas, though, have not yet fared as well. On the bottom
of Onondaga Lake in Syracuse, New York, for example,
there remains several feet of toxic sludge, and, on the of-
ficial map of the city, there is a piece of shoreline labeled
the “Allied Waste Beds,” where Allied Chemical simply
dumped its toxic waste.
When air and water are unacceptably dirty, the prob-
lem is fairly obvious. However, it is more difficult to see
damage to wildlife and it is harder to address the problem.
Plants and animals do not object as they become extinct.
Fortunately for them there are scientists who monitor
their health. To illustrate the difficulty of convincing
people of problems with wildlife, though, it took threat-
ening of our national symbol, the bald eagle, to bring
about legislative action. The Endangered Species Act of
1973 has resulted in lists of plants and animals that are
either threatened or, more serious, endangered. Currently
there are in the United States alone 198 threatened and
489 endangered animal species, as well as 165 threatened
and 733 endangered plant species. Since the inception of
the act, 33 species have been removed from the lists and
a number, including the bald eagle, which in 2007 was
deemed fully recovered, have been delisted entirely.
Although 34 North American species of birds and
mammals have become extinct since the 1500s, none that
has been listed since 1973 has succumbed. Some species
would have become extinct without the help of humans,
but the rate of extinction is estimated to have increased
at least 10-fold since the time of the first known human.
It is discouraging, moreover, that for the listed species
whose habitat is government land, there are 1.5 on the
decline for every 1 on the rebound. On private land,
where regulation is less stringent, the figure is 9 to 1.
The key to keeping plant and animal life from ex-
tinction is to prevent the loss of habitat. This is why
the Endangered Species Act is a problem for economic
growth. The lost logging associated with preserving
a single mating pair of spotted owls in the American
Northwest amounts to $650 million. While strict en-
vironmentalists push for the preservation of species,
regardless of the economic costs of doing so, the costs
are foremost in the minds of the people whose liveli-
hoods are threatened by this law’s requirements.
A piece of environmental legislation that combines
protections for both wildlife and habitat is the Clean
Air Act of 1990. In this legislation, the targeted prob-
lem is acid rain. Acid rain is created when power plants
burn high-sulfur coal and the SO 2 emissions from that
burning combine in the atmosphere with various nitro-
gen oxides (NO 2 , NO
3 , etc.) to create a dilute form of
sulfuric acid. In particular, the coal that is burned in
the Midwest creates an acid that travels to the north-
eastern states in clouds, and the rain that subsequently
forms has caused trees to die and lakes to become
deadly for fish.
The legislation limits the quantity of sulfur that in-
dustry can put into the air. To comply with the law’s pro-
visions, firms can buy more expensive low-sulfur coal,
they can buy equipment to clean up the emissions, or
they can buy another firm’s pollution permits. Offering
options like the trading of pollution permits is consid-
ered to be very innovative. It allows companies to clean
up the environment in the cheapest way possible, and, as
we will discuss later, this innovative way of dealing with
pollution has earned economists a place at the table in
discussing environmental problems.
An additional environmental problem is that landfill
space is being used up faster than new space is created.
The problem here is less an environmental problem than
a location problem. Modern landfills are required to
prove that no contamination leaks into groundwater. No
homeowners want garbage in their neighborhoods, and
Congress has steadfastly refused to allow states to keep
others from exporting their garbage. A consequence
of this stance is that more New York City garbage is
put in out-of-state landfills than in those in New York.
Because the interstate commerce clause of the U.S. Con-
stitution prevents states from refusing to let out-of-state
garbage in, and because of the way the U.S. population is
distributed, the burden of siting new landfills has shifted
from the East to the Midwest.
The economic implications of changes in Earth’s cli-
mate are what we will discuss last in this chapter. It is fairly
well-settled scientific fact that the globe is warming. The
warmest years on record are concentrated after the 1980s.
The problem is that unless they were told by a scientist
that this is bad, most people would neither have noticed
nor objected to the change in temperature. Though sum-
mers have been somewhat warmer, winters— especially at
night—have been still warmer. Who is likely to object if
winter weather is milder than usual?
Environmental Problems and Their Economic Solutions 265
Meteorologists tell us that the earth’s temperature has
risen about 1.5° Fahrenheit in the entire 20th century.
The average, though, is 2.5° higher in 1999 than it was in
1970. It is a change that is simply too small for the typi-
cal person to detect. Over time, however, the problems
with global warming will become more obvious. With
temperatures that are anywhere from 5° to 10° higher by
the end of the 21st century, several things may happen.
The bad things include a thawing of the polar ice caps,
which scientists say will be accompanied by a flooding
of coastal cities and islands. Soils may become dry, mak-
ing it more difficult to grow grains. People will use more
refrigerants for air conditioning. Warm-weather diseases
like malaria and yellow fever may proliferate, and certain
areas of the world will become deserts, in a process la-
beled with the frightening word desertification.
On the other hand, some good things will happen if
global temperatures rise. Growing seasons will lengthen
in northern climates, less energy will be needed to heat
homes and businesses in those areas, and the impact of
cold-weather diseases like colds and the flu will dimin-
ish. A good way of imagining the positive impact is to
realize that though there will be places where the climate
will get “too hot,” some places that were once “too cold”
will now be “just right.”
This is not to suggest that there will necessarily be an
even-up trade by any means. While temperature zones
will change relatively quickly, forests can move only ex-
tremely slowly. Thus some forests whose trees require
a specific temperature band to be healthy will die out
long before new ones appear. There is also new research
suggesting that only about half of the increased carbon
dioxide, which may be good for some species of plant
life, can be absorbed.
A statistic of vital importance to environmental
economists is the responsiveness of climate to CO 2 con-
centrations. One estimate suggests a doubling of CO 2
leads to an increase in global temperatures anywhere
from 1º Celsius to 4.5º Celsius (relative to preindustrial
levels).
Economic Solutions: Using Taxes to Solve Environmental Problems
To solve the environmental problems that we face, we
have to encourage or require clean behaviors, or we must
discourage unclean behaviors or render them illegal.
To varying degrees, all these methods work. America’s
history of environmental regulations clearly indicates
that we have been moving successfully from forms of
regulation that concentrate on punishing people to forms
where we provide incentives that make clean behavior
profitable.
Most environmental regulation still prohibits certain
actions that damage the air, water, or wildlife. For instance,
the Clean Water Act prohibits dumping of untreated in-
dustrial waste into a river. Mandating that the environment
be protected, however, is not necessarily the best way to
deal with all environmental issues. For instance, it is hypo-
thetically possible that production of a cure for a terrible
disease may turn out to be very dirty. In such a case it
might be in society’s best interest to sacrifice the environ-
ment. Instead of an outright ban, a polluting activity could
be heavily taxed. Activities that were sufficiently profit-
able to cover whatever tax was levied could continue.
A tax could conceivably be used to discourage any pol-
luting activity, including the creation of garbage or the use
of fossil fuels. As Figure 23.5 indicates, a tax would be
set that was equal to the external cost, that is, the dollar-
denominated value of the pollution. Production of the good
would fall to Q′, its socially optimal level, and the price
would increase to P′. There would be enough tax revenue
to compensate those affected by the pollution resulting
from a garbage dump or, perhaps, to fund research on non-
polluting technologies. Assuming a connection between
energy use and global warming and between global warm-
ing and hurricane flooding, such a fund might also be used
to deal with flood relief from hurricanes.
Economic Solutions: Using Property Rights to Solve Environmental Problems
Coase’s theorem holds that it does not matter if you
grant the property right to the polluter or the victim
of the pollution. If you say that people have a right to
FIGURE 23.5 Solving the problem with a pollution tax.
Social cost
S (marginal cost)
O Qʹ
Pʹ
P
Q*
P*
Tax = External cost
Q/t
D (marginal benefit)
266 Chapter 23 Natural Resources, the Environment, and Climate Change
clean air, then Coase suggests that the polluter would
buy the right to pollute from the people; if you say
that polluters have the right to do what they want, then
Coase suggests that the people will pay polluters to be
cleaner. Either way, the right amount of production and
pollution will result.
An interesting adaptation of Coase’s ideas was the
Clean Air Act of 1990 and its use of effluent1 permits.
The law provides that each emitter of certain restricted
pollutants can be granted a fixed number of permits ced-
ing the right to pollute a specific amount. In 1990, the
quota of polluted emissions was slightly less than the
historical levels of pollution. Any firm that polluted less
than that amount could sell its remaining rights to pollute
to those that polluted more than their permits allowed. In
2000, in the second phase of the Clean Air Act of 1990,
emission rights were reduced further, and when the act
is reauthorized, it is likely that further reductions will
be required. In this way pollution is reduced over time,
while polluters have options that allow them flexibility
in meeting the reductions.
In 2008, the Supreme Court compelled the EPA to
regulate greenhouse gases (GHG) as pollutants and
though the outgoing Bush administration chose not to
rush into this area, the Obama
administration was quite will-
ing to jump in. Its preferred
method was to use this same
cap-and-trade method. Cap- and-trade gets its name from
the process by which the gov-
ernment sets a “cap” on the
level of pollution that is allow-
able and then allows polluters to “trade” the right to
pollute. By giving the rights away each year, and in di-
minishing amounts, the reductions are achieved in the
most economically efficient manner possible. Specifi-
cally, we get the most output (usually electrical power)
subject to our societal goal of pollution reductions.
This happens because power companies have different
opportunity costs associated with reducing pollution.
Those that have a high opportunity cost will buy per-
mits from those that have a low opportunity cost. Con-
sider the following uncomplicated example. Suppose
there are only two electrical companies and both have
older coal- powered generators that generate a great
deal of pollution. Each one will have to reduce pollu-
tion slightly unless it wishes to buy permits from the
other. Suppose one is close to a natural gas pipeline,
but the costs of switching to cleaner-burning natural
gas have been heretofore just beyond what would have
made economic sense for the firm. Suppose the op-
tions to the other are much more prohibitive. Suppose,
finally, that electrical power demand is increasing, so
each will be expected to produce more electricity and
will therefore generate more pollution in the future.
Because they cannot both increase pollution, the firm
that has the lower cost option of reducing pollution
will do so and be compensated for doing so by selling
its permits to the firm with the higher cost option. In
this way, society’s goal of both meeting the increase in
electrical demand and reducing pollution is furthered.
For the purposes of acid rain reduction under the
1990 Clean Air Act, each permit grants its holder ap-
proximately a ton of SO 2 emissions. Total emissions of
SO 2 over the life of this provision of the 1990 act have
been cut 78 percent to 5 million tons per year. Surpris-
ing as it may seem, the price of those emission permits
was falling through the 1990s and mid-2000s from $200
to $100. Though those prices spiked in 2006 at more
than $1,500, today they are less than $8. At first this
was because power companies have found it a profitable
sideline to find ways to reduce pollution. And though
the reduction in the number of available permits and
the increase in electrical power demand put pressure
on the permit prices to rise, electric utilities are using
new, cleaner technologies either to reduce the number
of permits they have to buy or to make money selling
their rights. More recently, though, the biggest driver in
clearing the air of SO 2 and nitric oxides has been the re-
duction in natural gas prices. A brief look at Figure 23.6
shows that after 2008 it became much less expensive to
operate a natural-gas-fired electrical peaking plant, and
as a result utilities began converting from coal to natural
gas for those facilities. Natural gas, being a much cleaner
burning fuel, allowed utilities to reduce their purchases
of permits substantially. Thus the pressure on the price
of these permits to decrease that has resulted from this
innovation has greatly outweighed the pressure to rise.
Though the cap-and-trade idea was originally one cre-
ated by economic conservatives in the 1980s as a way to
use market forces to deal with environmental challenges,
it became a useful political target in 2010. Dubbed “cap
and tax,” the policy option designed by conservatives in
the 1980s to avoid inflexible regulatory frameworks, in-
stead became something conservatives could pin on po-
litical opponents in 2010. It worked so well that even with
a 60 to 40 majority in the U.S. Senate, Democrats were
cap-and-trade The method of reducing a pollutant whereby the government gives to polluters, or auctions, a capped amount of pol- lution permits and then allows those permits to be sold in a market.
1Effluent is the general term for the stuff that comes out of a smokestack.
Environmental Problems and Their Economic Solutions 267
registered to the same owner in the previous two years,
and as long as a new car was purchased that got 10 mpg
more than the one traded in, this $4,500 meant that an
old car that might have been worth only $1,000 in trade,
became worth substantially more. Though economists
debate how many of the used cars would have been
junked anyway and how many of the newly purchased
cars would have been purchased anyway, there was likely
some modest, pollution-reducing effect. Economists in-
fluence environmental regulations and legislation pre-
cisely because we offer suggestions like cap-and-trade
and cash-for-clunkers, thus aligning self-interest with
environmentalism.
No Solution: When There Is No Government to Tax or Regulate
Let’s assume that the problems of global warming exceed
the benefits. What can be done? When an environmental
problem is confined to one jurisdiction, the government,
whether it be local, state, or national, can enact legislation
to tackle the problem. When the problem is international,
such as with global warming, there is no government to
impose a regulatory or tax-based solution.
The Kyoto Protocol is a treaty to which the United
States is a signatory. Such treaties require U.S. Senate
approval, so President Clinton’s signature was point-
less from the start because there were not 20 votes for
ratification and he knew that when he signed it. Shortly
after his election, President Bush formally pulled the
unable to muster the votes to pass cap-and-trade as part
of their energy bill, which subsequently stalled as a result.
The reasons conservatives opposed cap-and-trade were
not all purely political. The acid-rain producing pollutants
were clearly identifiable as to their source—specifically,
power plants and other large combustion units with obvi-
ous smokestacks. The problem with using cap-and-trade
for CO 2 and other greenhouse gases is that there are many
more polluters to monitor and regulate. It is relatively
simple to monitor the two gases that overwhelmingly
come from a few sources. It would be impossible to ac-
curately monitor GHGs emanating from every car, home,
business, and farm.
Another area where economists use the property right
idea to help with air pollution is with the offset. Cars pol-
lute, and old cars pollute much worse than newer ones.
In California, polluters can either reduce their direct pol-
lution or they can buy enough old cars and get those off
the road. Similarly, across the United States, there are
foundations that seek to reduce air pollution by buying
emission permits so that they cannot be used by a busi-
ness planning to pollute.
In 2009, as the Obama administration was pushing to
reduce pollution, decrease U.S. dependence on foreign
oil, and breathe life into the auto industry, it introduced
an adaptation of this idea. Called “cash-for-clunkers,”
the program paid auto dealers up to $4,500 per car as
long as they agreed to destroy them rather than resell
them in the used car market. As long as the car was
FIGURE 23.6 Price of natural gas.
Source: U.S. Energy Information Administration, www.eia.gov/dnav/ng/hist/rngwhhdM.htm
6
7
8
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
5
4
3
0
1
2
P ri
c e
p e
r m
il li o
n B
tu (r
e la
ti v e
t o
C P
I)
268 Chapter 23 Natural Resources, the Environment, and Climate Change
carbon-based energy would have to quadruple in order
to get that 25 percent reduction in the short run though
a doubling would be sufficient to accomplish the same
thing in the long run. That is likely the upper bound of
what is necessary because a doubling of carbon-emitting
energy prices would induce energy consumers to look
to nonemitting sources. Accounting for the substitution
to these other sources, some economists have estimated
that the tax on emissions necessary to reduce GHG by
13 percent could be as little as $36 per ton of GHG to as
much as $70 per ton. For perspective, a typical car pro-
duces a little less than 1 pound of GHG per mile driven,
and if you do a bunch of algebra, that translates to an
appropriate tax of as little as 20 cents per gallon to as
much as $1.75 per gallon. The experience of 2008 sug-
gests that 20 cents wouldn’t be sufficient. Had the $2
gasoline price increase been sustained through 2008 and
2009 and had the economy not slipped into a deep re-
cession, the shift from large SUVs to small cars would
likely have been sufficient to have a significant long-run
impact on U.S. GHG production.
Regardless of who is right, the issue illustrates the
difficulty in dealing with international environmental
problems. There is little economic motivation for a sin-
gle country to impose high costs on itself, and there is no
world government to impose those high costs on everyone.
So while the politics in the United States have changed
with regard to American participation in the Kyoto GHG
reduction process, neither the Chinese nor the Indian gov-
ernments have changed their views. As a result, if those
warning of the consequences of global warming are cor-
rect, this could be one of the more calamitous examples of
the Chapter 3 notion of market failure.
United States out of the agreement noting the signifi-
cant economic impact compliance would have. He also
noted that the agreement did not limit China or India,
two rapidly growing energy consumers, in any mean-
ingful way. China now produces two and one-half times
the amount of greenhouse gases as it did when the pro-
tocols were created, and India produces nearly twice
as much. In terms of GHGs per dollar of GDP, these
countries now rival the United States.
With the election of President Obama, the position of
the U.S. government toward GHG regulation changed.
There will, of course, be economic consequences. The
extent of those consequences is debated among econo-
mists. The United States is currently producing about
13 percent more GHG than it promised to produce. If
you refer back to Figure 23.5, you can see how econo-
mists might propose to deal with the issue. A tax would
need to be placed on the production of GHG sufficient to
reduce the amount produced by a quarter. Energy usage
would have to either become more efficient, become less
prevalent, or come from nonemitting sources such as
wind, hydroelectric, solar, or nuclear.
The rapid increase in gasoline prices during 2008 can
aid us in figuring out how much that tax would need to
be; this is where elasticity comes into play. If the only
thing we could do was reduce energy usage, we could
estimate the tax on energy using the elasticity of de-
mand for carbon-based energy. Clearly energy demand
is inelastic. As the price of gasoline spiked in 2008, in-
creasing 75 percent, gasoline consumption fell 6 percent.
This suggests a short-run elasticity of .08. Studies of
the long-run elasticity of demand for gasoline suggest
it is 0.24. Extrapolation would imply that the price of
You now understand how to use the concept of externali-
ties to explain why pollution warrants government inter-
vention in the market. You understand why pollution is
much more likely to occur on publicly owned property
than on private property, and you have a cursory under-
standing of the variety of environmental problems that
exist in the world. You now also have an understanding
of some economic solutions to these problems.
Summary
cap-and-trade
common property
externalities
limited natural resource
renewable natural resource
social cost
stewardship
sustainability
Key Terms
Summary 269
6. The evidence on most environmental pollutants
(lead in the air and water, sulfur in the air, etc.) is
that
a. they are not nearly as harmful as once thought.
b. they are increasing at an alarming rate.
c. they have decreased substantially in the last
20 years.
d. they have stabilized in the air at their all-time
high.
7. An environmental economist would likely recom-
mend which of the following policies?
a. Eliminate fossil fuel consumption
b. A tax on gasoline equal to the environmental
damage caused by a gallon of gasoline
c. A tax on gasoline greater than the environmen-
tal damage caused by a gallon of gasoline
d. Voluntary limits on driving
Short Answer Questions
1. Why would an increasing marginal cost of produc-
ing oil lead to a more spread-out utilization plan?
2. Why would saving some species be worth the cost
of saving them while another species might not be?
3. Why would “cap-and-trade” be more aligned with
those who wish to use private market innovations
to solve environmental problems than a regulatory-
based environmental system?
Think about This
Fossil fuels were the “clean” alternative to wood burn-
ing and overcame wood as a source of fuel only when
it became cheaper to use than wood. If left unchecked,
this will happen to fossil fuels as well because this lim-
ited resource will eventually become more scarce than
its alternatives (solar-, wind-, hydroelectric-, or biomass-
generated power). Should we just wait it out?
Talk about This
Every power source entails some environmental conse-
quence. Nuclear power leaves behind waste that is danger-
ous for thousands of years. Hydroelectric power destroys
the habitat of valley-dwelling animals. Wind and solar
power require vast spaces for collection devices. Combus-
tible fuels typically leave a heat-trapping gas. Currently,
the dominant U.S. fuel sources are fossil based (coal, oil,
natural gas). While other countries have turned toward
nuclear power, we have not. Given that our power needs
are continuously growing, what are your solutions?
Quiz Yourself
1. The notion of “clean enough” is
a. appealing to an economist thinking about
average benefit and average cost.
b. appealing to an economist thinking about
marginal benefit and marginal cost.
c. appealing to an economist thinking about total
benefit and total cost.
d. completely rejected as a concept by an
economist.
2. If a chemical does environmental damage but is used
in the production of a good that provides satisfaction
to the consumer and profit to the producer, an
economist
a. will insist that the market be left alone.
b. will insist that the chemical be completely
banned.
c. will seek to impose a tax on the good so that
the net benefit to society (including the environ-
mental damage) is maximized.
d. will suggest that consumers voluntarily cut back
their consumption.
3. An example of an externality that we see every day is
a. people paying high prices for gasoline.
b. people enjoying their ability to drive to work.
c. oil companies making record profits.
d. the emissions from a car’s tailpipe.
4. When tackling local environmental problems, taxes
and regulations can be useful. The reason that global
problems (like global warming) are more difficult to
control is that
a. it is in every countries’ aggregate interest to
ignore the problem.
b. it is in no country’s interest to address the
problem.
c. there is no ability to enforce those taxes or
regulations.
d. the “marginal” country is unknown.
5. Overfishing certain parts of the ocean and certain
species of fish has been a problem for centuries with
countries actually going to war over fishing dis-
putes. Ronald Coase would suggest that there would
be no problem if
a. someone owned (and could control) the ocean.
b. people stopped eating fish.
c. people reacted according to the golden rule.
d. countries agreed to voluntary restrictions on
fishing.
270 Chapter 23 Natural Resources, the Environment, and Climate Change
Behind the Numbers
Air quality and emissions data.
Outdoor air pollution.
Environmental Protection Agency; environmental
indicators—www.epa.gov/Envindicators/roe/pdf
/tdAir.pdf
Emissions prices and trading.
Environmental Protection Agency; clean air
markets—www.epa.gov/airmarkets
Global temperatures.
History and projections.
Environmental Protection Agency; global warming—
www.epa.gov
Average surface temperature.
World Meteorological Organization—www.wmo.int
Threatened, endangered, and delisted species.
U.S. Fish and Wildlife Service; publications—
www.fws.gov/endangered
For More Insight See
Joskow, Paul L., A. Denny Ellerman, Richard
Schmalensee, Juan Pablo Montero, and Elizabeth
M. Bailey, Markets for Clean Air: The U.S. Acid Rain
Program ( Cambridge, U.K.: Cambridge University
Press, 2000).
Journal of Economic Perspectives 12, no. 3 (Sum-
mer 1998). See articles by Gardner M. Brown Jr.,
and Jason F. Shogren; Andrew Metrick and Martin
Weitzman; Robert Innes, Stephen Polasky, and John
Tschirhart; and Richard Schmalensee, pp. 1–88.
Journal of Economic Perspectives 9, no. 4 (Fall 1995).
See articles by Michael E. Porter and Claas van der
Linde; Karen Palmer, Wallace E. Oates, and Paul R.
Portney, pp. 97–132.
Journal of Economic Perspectives 7, no. 4 (Fall 1993).
See articles by Richard Schmalensee; William D.
Nordhaus; John P. Weyant; James M. Poteba and
Gacielka Chichilinsky; and Geoffrey Heal, pp. 3–86.
Any environmental economics textbook, for instance,
Economics and the Environment by Eban Goodstein.
C H A P T E R T W E N T Y - F O U R
271
Health Care Learning Objectives
After reading this chapter you should be able to:
LO1 Summarize how the system of health care finance seriously
alters the market for health care services.
LO2 Conclude that in the United States 45 percent of the health
care tab is picked up by the taxpayer with the remainder
being paid either directly by patients or by their insurance
companies.
LO3 Analyze the health care industry using the supply and
demand model and discuss the limitations of the model
when applied to this industry.
LO4 Demonstrate that both private insurance and taxpayer-
financed health care systems increase the overall price of
health care.
LO5 Compare and contrast privately financed and single-payer,
taxpayer-financed health care systems by noting their re-
spective advantages and disadvantages.
Chapter Outline
Where the Money Goes and Where It Comes From
Insurance in the United States
Economic Models of Health Care
Comparing the United States with the Rest of the World
Summary
Health care in the United States has two characteristics
that seem to be fundamentally inconsistent. No other
country on earth can match the United States in terms
of the quality of care that is available, but no developed
country has our infant mortality rate. Additionally, in
no other country are doctors as skilled, and in no other
country are doctors as highly paid. In no other country
is the quality of care as high, but in no other developed
country is care denied so often because patients are un-
able to pay for it. At its root, the problem of having high-
quality care that is not available to everyone who needs
it is attributed only to the way we finance health care.
In this chapter we explain health care in the United
States by first detailing the money spent and by whom
it is spent. We discuss how private and public insurance
work in the United States and discuss the problems as-
sociated with each. We then turn to why the economics
of health care differs so much from the economics of
any other good. Along the way we compare our health
care financing system with the model used in most other
developed countries and hit the high points of the Patient
Protection and Affordable Care Act (PPACA).
Where the Money Goes and Where It Comes From
In defeating the health care plan that the Clinton adminis-
tration attempted to implement, Republicans claimed that
Democrats were trying to take over one-sixth of the econ-
omy. Indeed, while in 2014 one-sixth of the gross domes-
tic product ($3.03 trillion of $17.35 trillion) was spent on
health-related goods and services, the government’s portion
was already nearly half (45 percent, or $1.4 trillion) of health
272 Chapter 24 Health Care
will happen to you. You spend a little money on insurance
that will cushion the effects of the bad prospect, should it
occur. In other words, you pay a premium so that if the bad
thing happens, the insurance provider (whether it be the
government or an insurance company) will pay to make
things better. In the case of health insurance, people pay
premiums so that when they get sick their provider pays
most of the expense of dealing with their illnesses.
It is perfectly rational to buy insurance even when the
average expense you would face is less than the cost of the
insurance. The reason is that most
people are risk averse: They pre- fer to be guaranteed a particular
outcome, even when the odds are
that for the average person, over
an average lifetime, insurance is
more expensive than the prob-
lem they are insuring themselves
against. As an example, suppose
there is a 1 percent chance that
you will have a major health-
related expense of $100,000 and a 99 per cent chance that
you will have only $1,000 of typical health expenses. A
risk-neutral person would look at the expected expense, $1,990,2 and not be willing to pay any more than that for
full insurance coverage. People who are risk averse, on the
other hand, would be willing to pay more than that to guar-
antee themselves that they would not have to pay any more.
Nearly all private health insurance plans have a number
of characteristics in common. You owe a premium that, for
most Americans, is paid partly by you and partly by your em-
ployer.3 Insurance companies use premiums for three things:
(1) to pay doctor and hospital bills of their patients, (2) to
cover administrative expenses, and (3) to provide profit for
the owners (usually shareholders) of the insurance company.
If you get sick and have a health expense, it is usually
the case that both you and your insurance company will
pay part of the bill. There are four key pieces of vocabu-
lary that determine who pays how much. The deductible is the amount of health spend-
ing a year that you have to pay
before the insurance company
pays anything. This very much
depends on the type of plan
you have but can be as low as
care expenditures. President Clinton and his Democratic
supporters were merely attempting to federalize the pri-
vate portion of health care expenditure.
Of the $1.4 trillion that government spent on health
care in the United States in 2014, some $619 billion was
spent on Medicare (the govern- ment health insurance program
for the elderly) and $496 bil-
lion was spent on Medicaid (the government health insur-
ance program for the poor). The
remainder was spent by all levels
of government on local, state,
and veterans’ hospitals and in
support of medical research.
Of the $1.67 trillion that was spent on health
care in the private sector in 2014, some $991 billion
came from premiums paid to insurance companies by
businesses, households, or governments (or to employers’
self-insured systems). People paid an additional
$330 billion in out-of-pocket expenditures, and the re-
mainder was spent by private medical research companies.
In general, of the $3.03 trillion spent on health care in
the United States in 2014, $972 billion went to hospitals
and $603 billion went to doctors. Drugs accounted for
$298 billion and medical research spending accounted
for $45 billion.
Insurance in the United States
Most people in the United States are covered by some
form of health insurance for at least part of the year. In
2014, for example, 83 percent of the 320 million people
in the United States had coverage all year, another 7 per-
cent had coverage for part of the year, and 10 percent had
no coverage at all. The coverage during that year came
from a variety of sources. The largest group, 175 mil-
lion people, was covered by group insurance policies,
46 million had individual policies, 51 million were on
Medicare, 62 million were on Medicaid,1 and of those,
8 million were on both.
How Insurance Works
Whether we are discussing health insurance, life insurance,
or auto insurance, private insurance of any kind works like
this. There is a small chance that something bad will hap-
pen to you, and there is a large chance that nothing bad
Medicare Public health insurance in the United States that covers those over age 65.
Medicaid Public health insurance in the United States that covers the poor.
1Because Medicaid’s enrollment is fluid, as many as 73 million have Medicaid
at some point during the year.
risk averse A characteristic of a person who would pay extra to guarantee the expected outcome.
risk neutral A characteristic of a person who would not pay extra to guarantee the expected outcome.
deductible The amount of health spending a year that you have to pay before the insurance company pays anything.
2.99 × 1,000 + .01 × 100,000 = 1,990. 3This aspect is actually an artifact of World War II. Because of inflation fears
during that time, it was against the law to raise wages to attract workers.
Instead, companies increased benefits in the form of group insurance
subsidies, and the practice survived the war.
Insurance in the United States 273
nothing and as high as several thousand dollars. Typically,
the deductible for a plan is between $1,000 and $1,800
per person and between $2,300 and $3,800 per fam-
ily per year. For instance, if you have an insurance plan
with a $1,000 deductible and you have a covered medical
expense that totals $2,500, you will have to pay $1,000
before your insurance company pays anything.
The co-payment is either a set amount or the percent- age of the bill, after the deductible has been taken out, that
you have to pay. Typical office
visit co-payments are around
$25 for per visit. Co-insurance
rates, the percentage version of
co-payments, range between
10 percent and 40 percent. The
national average is 20 percent.
The maximum out of pocket is the most that a person or family
will have to pay over a year for
all covered health expenses. This
means that a $500,000 health ex-
pense will not bankrupt the typi-
cal person because the maximum
out of pocket is usually between
$2,000 and $10,000 a year.
Some companies offer what are called mini-meds. Mini-med insurance policies are usually only offered to
young people, have fairly low premiums and, as one of
the features, have low (usually no more than $10,000)
annual maximum amounts that the insurance company
will pay. These limits are illegal, in general, but these
policies serve a niche market that the Obama administra-
tion did not want to harm when they banned the general
practice of capping health insurance company liabil-
ity. The fear was that by outlawing all mini-meds, they
would reduce health insurance coverage for many young
people in their first jobs.
Varieties of Private Insurance
There are several types of private insurance plans out there,
but they boil down to three large groups: (1) fee for service,
(2) health maintenance, and (3) preferred provider. A fee-
for-service provider allows sick people to go to any doctor
they want, wherever they want, for whatever ails them.
The doctor then bills the insurance company, the insurance
company pays its share, and the doctor bills the patient for
the remainder. Because there are few controls on spending
in a system like this, it is very costly. Patients and doctors,
however, have few complaints.
A health maintenance organization (HMO) requires that
people see specific doctors at the beginning of any prob-
lem. These doctors are referred
to as primary care physicians (PCP) or, familiarly, as gatekeep- ers. Patients can see specialists
only after their primary care
physician makes a referral, and
the PCP, or gatekeeper, has the
job of making sure that his or her
patients get the appropriate care as inexpensively as pos-
sible. Usually HMO PCPs receive a fixed fee for every
patient assigned, and specialists are either salaried or also
have fixed fees for every referral. Patients and doctors
complain about the controls on spending in HMOs, but
these serve to keep costs down.
A preferred provider organization (PPO) is somewhat
of a hybrid. People can choose the doctor they want from
a list of doctors. The doctors agree to charge a specific
amount per procedure or disease, and they take a lower
fee than usual in order to be guaranteed a large number
of potential patients.
Table 24.1 outlines the advantages and disadvan-
tages of each of these private insurance options from the
patient’s standpoint.
Public Insurance
Public insurance, provided by the government, is di-
vided into three main programs: Medicare, Medicaid,
and the Children’s Health Insurance Program. Medi-
care is available to eligible citizens who are 65 years
old and older. It works very much like a generous fee-
for-service health insurance plan, except that the bur-
den for high premiums is placed on the taxpayer rather
than the patient or the patient’s employer. The tax that
funds Medicare appears on your paycheck in the same
place your Social Security tax does; they are both under
FICA (Federal Insurance Contributions Act). The por-
tion that is used for Medicare is 1.45 percent of your
salary, wages, and tips; you and your employer each pay
that rate. For part of Medicare, money is also taken from
the general tax revenues of the government.
Medicare is generous in the following sense: By pri-
vate health care standards its premiums are very low, and
the co-payments and the deductibles are also low. In truth
Medicare is really two programs, a compulsory program
that covers hospital-related expenses and a voluntary pro-
gram that covers doctors’ charges. In 2013, those who were
eligible for the compulsory version, Medicare Part A, and
co-payment Either a set amount or the percentage of the bill, after the deductible has been taken out, that you have to pay.
maximum out of pocket The most that a person or family will have to pay over a year for all covered health expenses.
mini-med Low premium health insurance with a low annual maximum.
primary care physician
(PCP) Physician in managed care operations charged with making the initial diagnosis and making referrals. Also called a gatekeeper.
274 Chapter 24 Health Care
sense that they may be able to afford insurance but are
healthy and therefore choose not to purchase it. A recently
emerging group of people without health insurance is
those who retire early and are waiting for Medicare to kick
in when they turn 65.
Among the uninsured for at least some portion of the
year are the nearly 8 million who are under 18. It was in
reaction to more than 16 million children living with-
out health insurance that the Children’s Health Insurance
Program was created in the 1990s. Its function is like
that of Medicaid, but it is focused, as the name suggests,
on children who live in families where the breadwinners
do not have insurance through their employer and do not
make enough to purchase it themselves.
Economic Models of Health Care
We can use our supply and demand model to look at
what happens when the good in question is not something
tangible, like an apple, but intangible, like health care. Ad-
ditionally, in the context of this model, we can explore how
the health care finance system alters people’s behavior.
Why Health Care Is Not Just Another Good
Health care is not like any other good. You can look at an
apple grown in 1998 and say that it is comparable to an
apple grown in 1995 or 1885. An apple is pretty much the
same through time. On the other hand, health care tends
to be changeable. The medical CPI has risen at or above
the overall rate of inflation for several years. However, we
cannot be sure how much of this increase is an increase in
worked between 30 and 39 quarters paid a $226 monthly
premium. Those who worked less than 30 quarters paid
$411 per month, and for those who worked more than
40 quarters, it was free. The voluntary version, Medicare
Part B, cost beneficiaries between $121.80 and $389.80
per month depending on their 2016 income, and covered
doctor-related expenses. Elderly people who are eligible
for the primary welfare program for the old and poor,
Supplemental Security Income, have Medicaid pick up
the Part A premium and often the Part B premium as well.
In contrast with Medicare, Medicaid is a no-premium,
no-deductible, very low or no co-payment health plan for
the poor.4 Under Medicaid, doctors are reimbursed at rates
that are low relative to what Medicare pays and extremely
low relative to what private insurance pays. Hospitals and
doctors can and do refuse to treat Medicaid patients when
they judge the reimbursement rates to be too low.
In 2011 there were 49 million Americans who sur-
vived, at least part of the year, without any health insur-
ance at all. Many of these are people who move from
one job to another and whose insurance runs out while
they are unemployed.5 On the other hand, a 1994 study
by Katherine Swartz indicated that 21 million Americans
were without any health insurance for more than a year.
Of the uninsured, 18 million are between the ages of 18
and 34. Their lack of insurance may be voluntary in the
TABLE 24.1 Advantages and disadvantages to patients of diferent forms of private insurance.
Source: Medicare, www.medicare.gov
Insurance Type Advantages Disadvantages
Fee for service Maximum physician choice
Little insurance company meddling in
doctors’ decisions
Highest premiums, deductibles, and
co-payment rates because of little
control over expensive and unnecessary
procedures
HMO Maximum control over expensive and
unnecessary procedures so premiums,
deductibles, and co-payment rates are low
Minimal physician choice
Significant meddling in physician
decisions, especially when differing
procedures have significant cost
differences
PPO Some physician choice
Moderate premiums, deductibles,
and co-payment rates
Some control over expensive procedures
Minor meddling in physician decisions
4States may impose small co-payments to discourage abusive overuse. 5Workers have the right to continue their employer-sponsored health
insurance even after they quit or are fired. The problem is that most
employers do not continue subsidizing the premiums, which means people
are not likely to be able to afford to exercise this right.
Economic Models of Health Care 275
Another key problem with using a supply and demand
model for health care services is that one of the assump-
tions that we made for such a model to work was perfect
knowledge. One of the reasons we go to the doctor in the
first place is that we do not know what is wrong with us.
We go not only to stop the pain but also to find out why
the pain exists. This is distinctly different from buying an
apple. We know what an apple is, we know why we want
it, and we know what it costs to get one. In health care
we have to trust the seller (the doctor) to tell us what we
need and how much it will cost.
Implications of Public Insurance
Though considerations such as these are important, we
can still examine the effect of our financing system on
the supply and demand model for health care services.
As you can see in Figure 24.1, if there were no pro-
gram to provide health care services to the poor, the
nonpoor would get many services and the poor few.
If D poor
is the demand for health care by the poor and
D nonpoor
is the demand for health care by the nonpoor,
then D poor + nonpoor
is the market demand for health care
services. This is arrived at by adding the two demand
curves together horizontally. Specifically, at each price,
the quantity demanded of the poor is added to the quan-
tity demanded of the nonpoor. If the supply curve is as
shown, then the price is P* and the poor consume Q poor
,
much less than the nonpoor, Q nonpoor
.
On the other hand, if the poor were to get the services
at no cost, then the situation might be quite different.
Figure 24.2 shows that in this case, the market demand
is the amount that the poor would consume if it were
prices, how much is an increase in quality, and how much
is the availability of new procedures or treatments.
To illustrate, let’s discuss the treatment of acquired
immunodeficiency syndrome (AIDS). In 1985 there
was no standard treatment for AIDS. Morphine was
sometimes given to ease pain—a terribly ineffective but
“cheap” treatment compared to today. In 2001 the treat-
ment became a “drug cocktail” of zidovudine (AZT)
and a group of protease inhibitors. Newer drug cocktails
cost more than $30,000 per patient per year, but they can
sustain a good quality of life for several years. Which
“treatment” costs more? You do not have to answer the
question because you know that you are not pricing the
same thing. The quality of the treatment has improved
so greatly that to say that the price of the treatment has
increased is simply wrong. The quality of the treat-
ment has improved, and because there was no effective
treatment to compare the current one to, the “price” has
fallen from infinity.
Many of the complaints about the increase in the
cost of health care over the past few years are misdi-
rected. The cost of things that do not change in quality
(syringes, bandages, etc.) has surely gone up. But, just
as surely, we cannot measure the price of things whose
quality is constantly changing. A night in a hospital,
for instance, is not the same in 2011 as it was in 1985.
Though some definitions are the same (semiprivate has
meant and still means two beds in a room, for example),
other aspects of the night’s stay are different. Today
television sets and other creature comforts and sophis-
ticated medical equipment, including beds that monitor
vital signs, are standard. Not long ago these were either
optional or simply unavailable.
There are three significant provisions of the PPACA that serve to ex-
pand coverage to those who have been without it. First, beginning
in 2014, employers of more than 50 full-time employees are now re-
quired to provide their employees with at least a minimal insurance
plan or else pay a tax. Second, Medicaid was expanded in states
where the state agreed to pay a small portion of the extra cost. That
expansion, where it occurred, allowed health insurance coverage
for everyone (rather than just the children) in families earning under
133 percent (which because of an income exemption amounted to
138 percent) of the poverty line. Third, subsidies are now paid to
those earning under 400 percent of the poverty line when they pur-
chase health insurance through an approved exchange.
These provisions are not without controversy. The first provision
forces employers that do not provide at least minimal health insur-
ance to pay a fine if even one of their employees is given a sub-
sidy to buy insurance. This provision has some economists worried
that the PPACA lessens the incentive that firms have to employ new
workers by raising the cost of that worker. The Medicaid expansion
worried governors and legislatures regarding its impact on state
budgets so much that only 31 states have agreed to the expansion
with two others organizing an alternative using a waiver process.
Finally, because the PPACA was such a charged political issue for so
long, only 20 states have agreed to create the exchanges.
P P A C A P R O V I S I O N S T O E X P A N D C O V E R A G E
276 Chapter 24 Health Care
FIGURE 24.2 Health care: who gets it with subsidies.
QA
PA
5PA
Qʹ Q/t
S
B
A
C
D
Aʹ
Dʹ
P
Pʹ
FIGURE 24.3 The efect of co-payments on the market for health care.
Dpoor
Qpoor
Dnonpoor
Qnonpoor
Dpoor+nonpoor
Qpoor+nonpoor Q/t
S
P
P*
Pʹ
FIGURE 24.1 Health care: who gets it without subsidies.
Dpoor
Qpoor
Dnonpoor
Qnonpoor
Dpoor+nonpoor
Qpoor+nonpoor Q/t
S
P
P*
free to them, Q poor
, plus the demand by the nonpoor. As
you can see, the poor would consume much more, Q poor
,
while the nonpoor would consume less. Prices would
also be higher.
Efficiency Problems with Private Insurance
What private insurance does to the market for health care
is as disruptive as public insurance. Recall the idea of
co-payments: After the deductible is met, for every dollar
of covered medical expense, a low percentage (usually
20 percent) is paid by the patient and the remainder is
paid by the insurance company. How does that affect the
demand for health care? For simplicity’s sake, assume
the deductible has either been met or is zero.
Figure 24.3 shows that the demand curve will rotate out
to the right and that this will cause a greater consumption
of health care services and higher prices. Let’s look at why
the curve rotates out to the right. Take the equilibrium
point prior to any insurance; call that point A. A person
is willing to pay P A and consumes Q
A medical services
prior to insurance. Suppose that person now has insurance
with a 20 percent co-payment rate. If that is the case, that
person would be willing to consume Q A medical services
even if the price were five times that of P A . This is because
the effective price to the insured person is 20 percent of
5P A , or just P
A . The reason it rotates out of the horizontal
intercept of the demand curve is that if health care ser-
vices were free, the effect of co-payments would not mat-
ter. Twenty percent of nothing would be nothing and five
times of nothing would still be nothing.
Whenever there is a situation where someone other
than the consumer is paying the bill, economists call this
other entity a third-party payer. When this happens, the usual
role of keeping costs down is
taken out of the hands of the
consumer.
Since our demand curve rotates out, we buy more
health care services and pay more for them. The good
news here is that this effect is lessened if the underly-
ing demand curve D is itself inelastic. It can certainly
be argued that the demand for health care services is
relatively inelastic, and the evidence from an extensive
study started in the late 1970s and published in 1987
suggests just that. This is because we would not have an
unnecessary operation even if it got less expensive, and
most people will have a necessary operation even if the
price is high. This study suggests that patient sensitivity
third-party payer An entity other than the consumer who pays part of the costs.
Economic Models of Health Care 277
to price is greater for visits to doctors than for hospi-
talizations. Overall health elasticity estimates from this
study indicate that a 10 percent increase in the out-of-
pocket expenses of the patient is associated with a 1 per-
cent to 3 percent reduction in health care utilization.
The increase in health care utilization also has an ef-
ficiency implication. Recall from the Chapter 3 discussion
of consumer and producer surplus that the deadweight loss
is the yardstick by which economists measure inefficiency.
Here the triangle ABC is the amount of the inefficiency.
Another area of inefficiency with health care insur-
ance in particular comes in the form of moral hazard. People who have insurance con-
sume more health care. This is
a problem with all forms of in-
surance, and the clearest exam-
ple is in automobile insurance.
If you drive more recklessly when you have insurance
than when you do not, having insurance makes you more
likely to need insurance. In the field of health care, if
having insurance makes you more likely to get tested
for certain diseases, or even worse, fail to exercise or eat
right, then moral hazard is a problem.
A final area of inefficiency in the health insurance
market is the greatest threat to its existence, and that is
adverse selection. Adverse se- lection arises when, instead of a
true cross-section of the popula-
tion buying insurance, those in
most need of insurance are the
most willing to pay for insur-
ance and drive up the price of
insurance with their illnesses to
such a degree that those people
who are not as sick leave the
market altogether.
To understand the problem, suppose there are three types
of people who initially do not know their own health status
and their own need for health insurance. Unbeknownst to
them, they are the “healthy,” “somewhat healthy,” or “un-
healthy.” Suppose the healthiest category of people have
no serious illnesses in the offing and face few risks other
than accidents that are equally likely to occur throughout
the population. Suppose the unhealthiest category of peo-
ple face many risks associated with expensive treatments
as well as those same injury risks. Now suppose there are
two periods: now and later. If no one knows his or her
health status “now” and everyone is risk averse, everyone
will likely buy insurance “now.” They will pay the costs
of that insurance (through premiums), which will equal
the average cost of care plus the administrative costs plus
the profit for the insurance company. In that sense, when
no one knows anything, insurance works fine. Once they
know their health status, they will be able to compare the
premiums to their expected costs by going it alone. If the
difference is dramatic, the healthiest group may drop out.
Doing so will raise the average costs to everyone else left
in the insurance pool. It may raise it so much that the some-
what healthy people drop their insurance. This has been
labeled by some as the “insurance death spiral.”
You can solve this particular problem of adverse se-
lection in one of three ways: charging unhealthy people
more than healthy people (which is what we do with car
insurance in that bad drivers pay more), having a system
in which everyone gets insurance through some means
other than individual choice (which could be through
their employer or through the government), or we can
mandate that people buy health insurance. The first
method is considered, by many, unethical because lack
of coverage is frequently translated as lack of care and
lack of care for the sick is considered immoral.
The second method, which is what most of those in
group insurance live with, is the system that existed in
the United States prior to health care reform in 2010.
Prior to that time most Americans either got insurance
through the government or through their employer, while
some purchased it as individuals; and some of those in
the individual market who were sick were denied cov-
erage by insurers. The PPACA changed that. Insurance
companies were required to cover them without con-
sidering their health status. Closing that option off for
insurance companies, though, left the companies vulner-
able to adverse selection.
The resolution to this problem and the final method of
dealing with adverse selection is mandation. Mandation is the requirement that everyone buy insurance. By requir-
ing the healthy to buy insurance
(forcing them to pay a tax or fine
if they do not), the problem of
adverse selection disappears.
Major Changes to Insurance Resulting from PPACA
Several provisions of the bill change how the health in-
surance industry operates. Under laws existing prior to
the enactment of PPACA, health insurers could cut off
dependent children from coverage under their parents’
health insurance the first year after their children reached
23 and were free to consider, charge more for, and deny
moral hazard Having insurance increases the demand for the insured good.
adverse selection Those in most need of insurance are the most willing to pay for insurance and drive up the price of insurance with their illnesses to such a degree that those people who are not as sick leave the market altogether.
mandation The requirement to purchase insurance.
278 Chapter 24 Health Care
someone else’s problem. While that is good for you, it is
not necessarily good for society.
All of these other provisions have a similar problem
associated with them. Again the benefits to those not cut
off, or not charged more, or not denied coverage will
be greater. However, those costs and burdens will go
somewhere. They will not disappear. Take another ex-
ample. Women, on average, are more costly than men
throughout the health care life cycle because they face
cancer risks—specifically, ovarian, breast, and uterine
cancer—that men either do not face or, in the case of
breast cancer, do with much less frequency. Just as in the
auto insurance industry teenage boys pay more for car
insurance than teenage girls because boys get in more
serious accidents than do girls, women used to have to
pay more for individual health insurance, and groups that
were disproportionately women paid more than groups
of the same size that were disproportionately men. What
does that mean with regard to this provision? Men will
pay more because women are paying less.
The aforementioned provisions affecting insurance
that present the greatest challenge to the health insurance
industry itself are the provisions that prevent insurance
companies from denying coverage to the people based
on pre-existing conditions. This, by itself, could (were
it not accompanied with another provision requiring
that everyone buy health insurance or have it provided
to them) lead to the end of all private health insurance,
through the aforementioned death spiral.
The resolution to the death spiral imagined by the
PPACA is through a combination of provisions that ex-
pand coverage. Through a large expansion of Medicaid
through state-run insurance exchanges, and through an
employer requirement (all explained later in this chap-
ter), coverage will likely be extended to three-quarters of
those who are currently uninsured. Still, those provisions
alone would likely not be enough to forestall the death
spiral. It is mandation that does this. Mandation is the re-
quirement that everyone buy insurance if insurance is not
provided to them. Requiring the healthy to buy insurance
(forcing them to pay a tax or fine if they do not) makes
the problem of adverse selection disappear.
In the individual health insurance market, insur-
ance companies will have significantly less freedom
to charge differential prices to buyers. They will be
allowed to charge older customers no more than three
times what they charge younger ones (though younger
ones typically cost one-fifth or less than what older
ones cost), and only be able to charge 50 percent more
to tobacco users. They may set up broad geographic
coverage for any medical condition a prospective client
had prior to purchasing insurance through the company.
They were free to set annual and lifetime limits on
how much they would cover. They were free to set prior
conditions by which they could rescind coverage, and
they were free to raise the rates of those who became
ill (and therefore expensive to the company). They were
free to charge rates that were different for men and
women. They were free from most government interven-
tion when it came to premiums, profit, and the propor-
tion of premiums taken up with administrative costs.
Much of this ended or was scheduled to end with the
passage of PPACA.
The law as it stands (or in some cases as it will soon
stand) will require that health insurers allow depen-
dent children to stay on their parents’ health insurance
through age 26, that the insurers accept everyone without
regard to health status, charge the same to healthy and
the unhealthy alike, and charge the same for men and
women. They can no longer set lifetime limits, and after
2014, they can no longer set annual limits. They can no
longer rescind coverage or raise rates on the sick.
To the untrained eye and ear, each of these provisions
might be considered unambiguously good, but consider
the fact that each one of them will come with a cost that
will, in all likelihood, be passed on to the people who
pay the premiums for health insurance, the people who
work for companies who provide them with health insur-
ance, and the people who buy goods and services from
those companies. Take the simplest of these provisions,
the extension of dependent coverage to children through
age 26. This provision means that you (because the ma-
jority of those reading this book are college students
under age 26) will be able to go to graduate school and/
or have some time to find that first good job. However,
your parents’ employer will face extra costs associated
with having you on their health insurance plan. How will
they react? Depending on the elasticity of demand and
supply for labor, the elasticity of demand for the good
or service your parents’ employer produces, and some
other factors, that means your parents’ paychecks will be
smaller than they would otherwise be, your parents’ em-
ployer may employ fewer workers than they might have
and will have smaller profits than they might have had,
the people who buy the goods or services your parents
produce will have to pay more, or some combination of
these. The cost of providing you with health insurance,
or the cost of paying whatever health-related bills you
face as a 24-, 25-, or 26-year-old will go from being
your problem (perhaps with your parents’ help) to being
Comparing the United States with the Rest of the World 279
other if the price were right. However, you might under-
estimate the likelihood that you will ultimately need that
other kidney. The sale of organs may be a poor idea, but
selling blood may not. There is little economic reason to
ban the sale of blood for medical purposes because, un-
like organs, blood is self- replenishing.
Comparing the United States with the Rest of the World
Every industrialized nation on earth has a distinct health
care system. The one thing that is common throughout
the rest of the developed world, though, is that govern-
ment is the health care provider, insurer, or insurer of last
resort. There are distinct advantages to the way the rest of
the world does this, but there are disadvantages as well.
Having a single-payer system, where the government col- lects significantly high taxes to
pay for everyone’s health care,
benefits those who could not af-
ford health care any other way. It
creates serious shortages as well.
In Canada, England, and much of Europe, being
a citizen of the country grants you unlimited rights
to necessary health care that is either free or close
to it. While the financial arrangements (shown in
Table 24.2) in these countries differ, the citizenry
need not worry about access to basic health care re-
gardless of their ability to pay. This helps explain the
very low occurrences of infant mortality and rela-
tively long life spans in these countries, as seen in
Table 24.3. The unemployed and the employed, the
working and the retired, the young and the old, the
rich and the poor are treated with a degree of equality
that cannot be claimed in the United States. In ad-
dition, because the doctors are paid salaries by the
government instead of fees for seeing patients, they
do not have an incentive to order expensive tests and
perform costly surgeries. Further, as government
employees, they are usually protected from lawsuits.
Thus universal access is accomplished at lower over-
all costs than in the United States.
This, however, comes at a cost. These countries have
severe doctor shortages because, in an effort to keep
costs down, physicians are paid much less than they are
paid in the United States. One principal reason why you
see many foreign-born physicians in the United States is
that they can make a great deal more money here than in
their own countries. Additionally, there is no monetary
price differences and may charge more for larger fami-
lies than smaller ones. This all is opposed to few, if
any, federal limits that had been in place with regard
to market segmentation. Remember that, under normal
circumstances, insurers maximize profits by charging
premiums based on actual experience.
There is one other, in the grand scheme of things,
relatively minor provision change that is potentially im-
portant to young people; that is the provision that re-
quires that administrative costs and profits make up not
more than 20 percent of premiums. It is this provision
that affects those in the relatively low-wage restaurant
and retail industries. Full-time employees are fre-
quently offered the ability to buy mini-med policies that
provide, for a low premium, some minimalist benefits.
These policies tend to be very expensive to administer.
The Blood and Organ Problem
One problem associated with our current system is the
scarcity of blood and organs. To an economist, the short-
age of blood and organs is directly and unambiguously
determined by the fact that it is illegal for people to sell
these items for medical use. The ban on the sale of blood
and organs for medical use is almost entirely justified on
moral grounds. For instance, it is not illegal to sell your
blood for use in cosmetics.
If a price can be forced to be zero, the quantity
supplied will be reduced and the quantity demanded
enhanced. This offers another moral dilemma. If a mar-
ket were allowed, there would be people who would not
be able to pay the price for a needed organ, and, as a
result, they would die while someone else who could
afford that organ would live. On the other side of that
moral debate, though, is the fact that if there were a
legal market, more organs would become available and
more people would live.
Note that although both the supply and demand for
organs are inelastic, neither is perfectly inelastic.6 There
are people who would choose not to pay an exorbitant
price to live, and there are people who would be more
likely to sign their donor cards if there were a high re-
ward that they could bestow on their heirs by doing so.
The downside of such a market is similar to the down-
side of the market for tobacco. Poor information can cause
people to make life-altering mistakes. For instance, you
can live on one kidney, and therefore you could sell the
single-payer system The government collects (usually very high) taxes to pay for everyone’s health care.
6If both were perfectly inelastic at different quantities, there would be no
market-clearing price.
280 Chapter 24 Health Care
Though some waiting periods have shortened, this is in
part due to the recognition by physicians that expensive
procedures must be rationed. In the United States the
elderly with kidney disease will be given dialysis as
long as they are physically able to stand it (lengthening
life by a year or more). A similar English patient cannot
schedule routine dialysis treatments under the British
government-run system.
Another important area that would be lost if the
United States were to go to a single-payer system would
be innovation. Prescription drug, medical device, and
medical procedure innovation has been highly con-
centrated in the United States, largely because the
innovator makes money that cannot be made in the
single-payer countries. Furthermore, the innovation
incentive to become a doctor when you cannot get rich
by being one. The effect of having doctors on salary also
is seen when these doctors are reluctant to put in long
hours. Physicians are among the hardest-working people
in the United States. You can also see the effect of this
public health provision in the five-year survival rates of
breast and prostate cancers. The United States enjoys the
highest survival rates among these countries. Another
factor weighing in favor of the U.S. system is immedi-
ate access to procedures that require long waiting periods
elsewhere.
In the United States a 50-year-old man with blocked
arteries is hospitalized and operated on within hours
of being admitted, whereas the waiting period for by-
pass surgery in Canada has been as high as six months.
TABLE 24.2 International health care inance schemes.
Source: OECD Health Data, www.oecd.org
Country
Public Expenditures
as a Percent of
Total, 2009–2013 Hospitals Physicians
Function
of Private
Insurance
Australia 68.7 Mostly public A a
Canada 70.3 Mostly private A, B a
France 78.4 Mostly public A b
Germany 75.8 Mix of public and private A a
Japan 82.3 Mostly private A, B None
United Kingdom 87.6 Mostly public trusts C a
United States 48.2 Mostly private A c
A—mostly private fee for service.
B—government-imposed fee schedule.
C—public employees.
a—option to purchase private insurance for all expenses.
b—option to purchase private insurance for noncovered expenses.
c—all non-Medicare, non-Medicaid.
TABLE 24.3 International comparisons of health expenditures, infant mortality, and life expectancy.
Sources: databank.wor.ldbank.org; stats.oecd.org; www.thelancet.com/action/showFullTableImage?tableId=tbl4&pii=S0140673614620389
Country
Health Expenditures/ GDP, 2013
Infant Mortality Rate per 1,000 Births, 2013
Life Expectancy, 2013
Five-Year Survival Rates
Prostate Cancer
Breast Cancer
Ovarian Cancer
Cervical Cancer
Colon Cancer
Leukemia (Adult)
All Childhood Cancers
United States 16.4 5.9 78.8 97.2 88.6 40.9 62.8 64.7 51.8 87.7
United Kingdom 8.5 3.8 81.1 83.2 81.1 36.4 60.2 53.8 47.4 89.1
France 10.9 3.6 82.3 90.5 86.9 39.0 58.9 59.8 59.2 89.2
Germany 11.0 3.3 80.9 91.2 85.3 39.7 64.9 64.6 53.6 91.8
Japan 10.2 2.1 83.4 86.8 84.7 37.3 66.3 64.4 18.9 81.1
Summary 281
Last, because doctors are typically immune from law-
suits in countries with single-payer systems, accountabil-
ity for mistakes is left to professional standards boards.
While these mechanisms can work, very often they end
up being a system for physicians to protect their own.
that takes place abroad is likely motivated by profits
that can be made in the United States. As a result, very
few health care economists believe that turning the
United States into a single-payer environment would
be good for health care innovation.
4. If you have a $2,000 covered health expense, a de-
ductible of $500, and a 20 percent co-pay, then you
pay __________ and the insurance company pays
____________.
a. $1,500, $500
b. $1,000, $1,000
c. $800, $1200
d. $700, $800
5. Which of the following forms of private insurance is
likely to have the lowest premiums and least doctor
choice flexibility?
a. Medicare
b. An HMO
c. A PPO
d. A fee-for-service plan
6. Medical care inflation is likely to be easily over-
stated (if you look simply at the increase in the cost
of a hospital stay) because that calculation ignores
a. the original costs.
b. the new costs.
c. quality increases.
d. quality decreases.
Quiz Yourself
1. The primary motivation for the purchase of any
insurance lies in the fact that most people are
a. risk lovers.
b. risk averse.
c. risk neutral.
d. risk tolerant.
2. The risk-averse person will buy health insurance
a. only if the expected health costs equal the
insurance premium.
b. only if the expected health costs are greater than
the insurance premium.
c. even if the expected health costs are less than
the insurance premium.
d. under no circumstances.
3. The government, in the form of Medicare, Medic-
aid, and the Children’s Health Insurance Program,
pays for _____________ of health care costs.
a. less than 10 percent
b. slightly less than half
c. about 75 percent
d. all
Summary
You should now understand how the system of health
care finance seriously alters the market for health care
services. You also understand that in the United States
45 percent of the health care tab is picked up by the tax-
payer, with the remainder being picked up either by pa-
tients directly or through their insurance companies. You
understand why health care is not like most other goods
that economists study but that we can look at it using the
same supply and demand tools discussed earlier. You un-
derstand that both taxpayer-financed health care and pri-
vate insurance–financed health care increase the overall
price of health care. Last, you understand why a single-
payer, taxpayer-financed health care system would have
both advantages and disadvantages.
Key Terms
adverse selection
co-payment
deductible
mandation
maximum out of pocket
Medicaid
Medicare
mini-med
moral hazard
primary care physician (PCP)
risk averse
risk neutral
single-payer system
third-party payer
282 Chapter 24 Health Care
cases the patient, or the spouse, is the one who makes
that decision (either with prior instructions or by mak-
ing his or her wishes known to the health care provider).
In the United Kingdom, the government can, and does,
limit the availability of extraordinary medical treatment.
Thus, though care is free (or nearly free) to the patient, it
can be limited against their will. The U.K. government’s
contention is that health care resources are scarce and
they would be wasted extending the life of a terminally
ill patient by a few days. Which is worse, the aspect of
the U.S. system where people are denied care when they
are unable to pay, or the U.K. system where they are
denied care because their treatment would not lead to a
significant increase in the quality of life?
For More Insight See
Health Care Finance Association statistical tables—
www.hcfa.gov
Phelps, Charles E., Health Economics (Reading, MA:
Addison-Wesley, 2009).
www.census.gov/prod/2004pubs/04statab/health.pdf
International Comparisons of Types of Health Care
Finance Systems—www.nao.org.uk/publications
Behind the Numbers
International comparisons of vital statistics and health
care expenditures.
Statistical Abstract of the United States; comparative
international statistics—www.census.gov/compendia
/statab
Health care expenditures.
Centers for Medicare and Medicaid Services; historical
tables—www.cms.gov/NationalHealthExpendData
Health insurance coverage.
Coverage type—
www.census.gov/hhes/www/hlthins/hlthins.html
Lack of coverage.
Centers for Disease Control and Prevention—
www.cdc.gov/nchs/nhis.htm
Medicare premiums.
Centers for Medicare and Medicaid Services—
www.cms.hhs.gov
7. The problem of the “third-party payer” arises in
health care in the form of
a. doctors having to pay part of their own expenses.
b. government and/or private insurance paying a
significant part of the costs.
c. patients having to pay a significant part of the
costs.
d. hospitals not being able to collect from many
patients.
8. One significant feature of a “single-payer” system
lacking in the U.S. system is
a. government involvement in health care.
b. coverage for the elderly.
c. coverage for the poor.
d. universal coverage.
Short Answer Questions
1. Why would eliminating the ability to deny coverage
to those with pre-existing conditions require manda-
tion to accompany it?
2. Why would risk-averse people be more likely to buy
insurance?
3. For whom would a mini-med health insurance policy
be a good policy to have relative to the alternative
and why?
4. Why is it more likely that health expenses will rise
faster in the United States than in Canada or the
United Kingdom?
5. How might you apply the notion of “moral hazard”
to decisions you make about exercise?
Think about This
List the pros and cons associated with the U.S. system of
financing health care relative to the U.K. system. Do the
same relative to the Canadian system. Use your under-
standing of opportunity cost to think about why we can’t
have “the best of both worlds.”
Talk about This
In the United States a terminally ill patient can decide
to decline extraordinary medical treatment, but in all
C H A P T E R T W O
283
Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program Learning Objectives
After reading this chapter you should be able to:
LO1 Describe Medicaid as a program that covers medical
expenses for many of this nation’s poor.
LO2 Describe Medicare as a public insurance program for the
elderly.
LO3 Distinguish Medicaid from Medicare and understand their
relationship.
LO4 Describe the Children’s Health Insurance Program as one
that serves the children of the working poor.
Chapter Outline
Medicaid: What, Who, and How Much
Why Medicaid Costs So Much
Medicare: Public Insurance and the Elderly
Medicare’s Nuts and Bolts
The Medicare Trust Fund
Children’s Health Insurance Program
Summary
Since the early 1900s, the United States has been subsidiz-
ing medical care for citizens whose incomes are extremely
low. The number of people who were covered by some
form of federal medical care increased until 1967, when
the Medicaid program came into full fruition. From that
point on, millions of Americans have benefited from free
medical care. In 2014, 44 million children and another
27 million adults had nearly all of their medical expenses
paid for by Medicaid and its companion program, the
Children’s Health Insurance Program.
In this chapter we describe the Medicaid program in
full, and we provide information about the people who
are eligible for its benefits and what coverage they re-
ceive. We also discuss the groups that draw most heav-
ily on Medicaid benefits. We describe the relationship
between the federal government and the states in fund-
ing and administering the Medicaid program. We out-
line how doctors and hospitals are reimbursed when
they work with patients whose costs are paid through
Medicaid. We move on to use our supply and demand
model to explain why Medicaid costs so much, and we
focus attention on Medicaid’s treatment of two very
different populations: the very old and the very young.
Then we consider provisions in Medicaid that are in-
tended to keep costs down.
Medicare and Social Security are the centerpieces
of the United States’ policy toward its elderly. Social
Security ensures an income for the retired, and Medi-
care guarantees heavily subsidized health insurance for
everyone over 65, retired or not. Social Security began in
C H A P T E R T W E N T Y - F I V E
284 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
that poverty line were also eligible, as were relatively
few others who were affected by a variety of other rules.
Under the rules prior to 2014, adults who did not have
children under the age of 19 could have very little in-
come and not be covered by Medicaid because their
wealth made them ineligible for TANF or SSI.
The PPACA, as originally passed, required states
to expand Medicaid eligibility to include anyone in
the household if the household income was less than
133 percent1 of the poverty line unless the states were
willing to forgo all federal money for Medicaid. The Su-
preme Court decision that validated many parts of the act
invalidated this provision. This meant that states could
decide whether or not to participate. This also meant that
although Medicaid enrolled more than 61 million, and
CHIP enrolled another 7.9 million, only half of those
whose incomes were below 150 percent of the poverty
line received its benefits. Approximately half of states
had formally declined the Medicaid expansion or were
leaning that way in 2013, despite the provision that the
federal government would pick up the vast majority of
the extra costs. Whether this was rationally or politically
motivated, the impact on Medicaid eligibility remained
cloudy through 2013.
Medicaid pays for nearly everything that is consid-
ered necessary from a medical standpoint, and it pays for
some things that can be questioned. Doctor visits, emer-
gency room visits, surgery, outpatient procedures, medi-
cines, birth control pills, permanent and semipermanent
birth control procedures and devices, eye care, long-term
care—you name it, Medicaid probably pays for it. Liter-
ally, the only things that are not covered are most abor-
tions, cosmetic surgeries, and drugs for weight loss and
hair growth. Abortions are paid for by Medicaid in only
a few states, and in those states the state must pay the
whole fee. Whenever a pregnancy is the result of rape or
incest, or threatens the life of the mother, Medicaid pays
as it would for any other procedure.
Far more women and young people are served by
Medicaid than their proportion in the general popula-
tion. Whereas 51 percent of the population is female,
nearly 53 percent of the Medicaid population is. Only 23
percent of the population is under 18, yet 48 percent of
the Medicaid population is under 18. If you look simply
at the adults on Medicaid, 57 percent are female. Addi-
tionally, though the population of Medicaid recipients is
disproportionately young, we will show that the dollars
the New Deal 1930s; Medicare in the second great wave
of social programs during the Johnson administration’s
Great Society of the 1960s. In its first full year in opera-
tion, 1967, the cost of its benefits totaled $2.7 billion; by
2015 it cost $630 billion.
Medicare comprises two programs: Medicare Part A,
a mandatory program that covers expenses derived from
hospital stays; and Medicare Part B, a voluntary pro-
gram that covers doctor visits. This section begins by
laying out why a government health insurance program
for the elderly makes economic sense, and reviews the
problems that such health insurance programs inevitably
face. After discussing how each part of Medicare works,
we focus on ways that each part has attempted to control
costs. We then look at the Medicare Trust Fund and its
projected problems in staying solvent, and we suggest
ways Medicare can stave off bankruptcy. As part of that
discussion, we talk about the relationship between Med-
icaid and Medicare, the program for Americans 65 or
older.
Finally we take up the relatively new Children’s Health
Insurance Program and its function of providing health
insurance to the children of working families where the
parents have no employer-provided health insurance.
Medicaid: What, Who, and How Much
Medicaid was established in 1964 to consolidate and
expand existing programs that had been charged with
providing health care to those who could not otherwise
afford it. In 2014 the program cost the federal and state
governments $496 billion. We begin our discussion of
the Medicaid system by describing who is eligible, what
is covered, who is enrolled, which groups cost the most,
what relationship the federal government has to the
states, and how doctors and hospitals are reimbursed.
People who are eligible for Medicaid must meet one
of many criteria. In general, anyone who is in a fam-
ily that is eligible for cash assistance under Temporary
Assistance to Needy Families (TANF) or Supplemen-
tal Security Income (SSI) is automatically eligible for
Medicaid. Eligibility standards were altered by the
Patient Protection and Affordable Care Act (PPACA)
such that in 2014 many more adults were to have been
covered by Medicaid. Prior to that act’s passage, any
children under 19 whose parents’ income was less than
133 percent of the appropriate poverty line for their fam-
ily size or pregnant women and children under a year
old whose family income was less than 185 percent of
1Though technically the cutoff is 133 percent of the poverty line, there is an
income exemption in the calculation, which makes the effective percentage
138 percent.
Why Medicaid Costs So Much 285
spent are disproportionately allocated to care for the
elderly.
In racial makeup, Medicaid recipients mirror the
population of those who live in poverty nearly perfectly:
43 percent white, 21 percent black, and 19 percent
Hispanic.
Medicaid is a cooperative effort of federal and state
governments. The federal government mandates that the
states enroll all people who are eligible, and it gives them
guidelines to use if they wish to enroll others. States have
the option of covering or denying coverage of certain
specified expenses (like the previously mentioned abor-
tions), as they wish.
The federal mandates are partially covered by federal
matching money, and states are reimbursed according to
their relative GDPs. Poorer states are given greater re-
imbursement rates, and richer states are given smaller
ones. Thirteen states get the minimum 50 percent
matching percentage from the federal government,
while seven other states and the District of Colum-
bia get at least a 70 percent match. To motivate state
participation in Medicaid’s eligibility standards, the
PPACA temporarily raised these rates 7.6 to 15 per-
centage points to assist states’ transition. The differ-
ential rates make Medicaid less of a burden for poorer
states to fund.
Whether or not they participate in the expanded Med-
icaid provisions, some states make it easier to get on
Medicaid than others. States have different income and
wealth standards for TANF, and people who are eligible
for Medicaid in New York and Wisconsin, for example,
would not be eligible in states like Texas and Arkansas.
This difference is effective only for adults, since children
under one year of age are eligible, regardless of the state
they live in, under a federal standard that makes them eli-
gible if their family’s income is less than 185 percent of
the poverty line. All other children are similarly eligible
as long as their family income is less than 133 percent of
the poverty line.
When they treat patients whose bills are paid by Med-
icaid, doctors and hospitals are reimbursed at widely
varying rates. States pay different amounts for the same
procedures. These variations come about because Med-
icaid payments start at the state level with the federal
government matching the state’s payments. States must
set reimbursement rates high enough that there are
enough physicians and hospitals in all areas to treat Med-
icaid patients adequately. When many physicians are in
competition with one another, rates can be lower; when
there are few, rates must be higher.
For doctors and hospitals, Medicaid is an all-or-
nothing proposition. When doctors and hospitals agree
to take Medicaid patients, they agree to accept the state
reimbursement rate as payment in full. They also agree
to take any and all Medicaid patients who show up for
treatment. They cannot limit their practice to a certain
percentage, and they cannot accept patients with one
disease and not another. Finding these restrictions to be
unreasonable and reimbursement rates too low, many
private hospitals and prestigious doctors do not take
Medicaid patients.
Why Medicaid Costs So Much
Medicaid is an expensive program. To examine why it
costs as much as it does, it will be helpful to put it into
our supply and demand context. In 2013, the federal and
state governments spent $471 billion to provide health
care for 67 million Americans of Medicaid and Medic-
aid’s companion program, the Children’s Health Insur-
ance Programs (CHIP). Netting out the CHIP enrollment
and costs, that amount translates to just under $7,000 per
recipient. People not on Medicaid spend about the same
as that. As a matter of fact, until quite recently those on
Medicaid accounted for substantially greater per capita
expenditures than those not on Medicaid. Why is it that
the expenses of people who pay for their own health care
are almost identical to the expenses of people whose
health care is paid through Medicaid?
Let’s turn to our supply and demand model for an ex-
planation. As it is with any other good, the demand for
health care is downward sloping. This is because when
the price is high, people forgo care for ailments that are
not all that troubling. Although price is always a con-
cern, there are ailments that people will have treated
pretty much regardless of cost. Keeping our upward-
sloping supply curve makes sense because it takes more
money to get doctors and hospitals to provide the greater
quantities of care we desire and the higher quality of care
that we also desire.
Figure 25.1 differs from every other supply and de-
mand diagram you have seen, though, in that we have
separated the demand by people in poverty from the de-
mand by the people whose incomes are above the pov-
erty line. The demand curve D nonpoor
for the nonpoor is
farther to the right than the demand curve D poor
for the
poor. To get the market demand curve D poor
+ nonpoor
, we
must add the quantities of care that both the nonpoor and
poor want at each price. At some prices the poor cannot
286 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
afford any health care, and they therefore do not demand
any health care. As prices fall, the poor begin to demand
health care, and the nonpoor begin to demand more
health care. To find where the market demand curve cuts
the horizontal axis, you add the quantity of health care
that each would want if it were provided free of charge.
This horizontal adding of demand curves gives us the
market demand curve.
Where the market demand curve D poor + nonpoor
crosses the
market supply curve S, we get the equilibrium price P* and
quantity Q poor + nonpoor
. When we take that price over to the
nonpoor person’s demand curve, we can read off the quan-
tity of health care the nonpoor person will get as Q nonpoor
.
Taking it further, to the poor person’s demand curve, we can
read off what the poor person wants as Q poor
. If the health
care system is such that the poor cannot get access to care
at affordable prices, there will be a disparity between the
health care received by the nonpoor and that received by
the poor that some people will consider to be unacceptable.
If the poor are provided health care free of charge,
as they are with Medicaid, a different problem arises.
The market demand curve does not stay as it was in
Figure 25.1 but moves to its position in Figure 25.2. This
new demand curve is made up by adding the quantity
Q poor
of care poor people will want if it is free to the de-
mand curve D nonpoor
for the nonpoor. At the intersection of
market supply and market demand, the price rises to P′,
which is substantially above its old price at P*. It also re-
sults in greater access for the poor and less access for the
nonpoor. Figure 25.2 exaggerates this effect, but in the
real-world Medicaid recipients consume slightly more
health care than those who have private insurance.
Why Spending Is Greater on the Elderly
In terms of expenses, Medicaid dollars are spent dispro-
portionately on the elderly. This stands to reason in that
older people need care that tends to be more expensive,
and they need it more often than do those who are younger.
The average Medicaid recipient utilized about $7,000 in
medical care in 2013. In 2013, the average child who was
covered by Medicaid cost the government only $2,807,
while the average covered person over 65 cost $15,483.
Thus, though children make up slightly less than half of
Medicaid’s population, they account for only 20 percent
of the bills, and although those over 65 (and not disabled)
make up less than 10 percent of its population, they ac-
count for 20 percent of the bills. This is in addition to the
$575 billion that they account for in Medicare bills.
As mentioned previously, the central reason for Med-
icaid’s spending more on the elderly than it does on the
young is that older people tend to get illnesses that cost
more than those of younger people. However, there is a
reason that comes in a close second: nursing home care.
Nursing home care is not part of either Medicare Part
A or Part B. People who are elderly must therefore pay
for this care themselves, unless, of course, they cannot.
When elderly people’s incomes are low enough that they
qualify for assistance, Medicaid will pick up the tab for
nursing home care. This can cost anywhere between
$43,000 and $91,250 a year, constituting a substantial
outlay for Medicaid. In the final analysis, Medicaid
spends 25 percent of its total budget on long-term care,
of which about three-quarters is on care for the aged.
The problem that this generates for elderly Americans
is that they have to qualify for Medicaid before Medicaid
Dpoor
Qpoor
Dnonpoor
Qnonpoor
Dpoor+nonpoor
Qpoor+nonpoor Q/t
S
P
P*
FIGURE 25.1 The supply and demand for health care without Medicaid.
Dpoor
Qpoor
Dnonpoor
Qnonpoor
Dpoor+nonpoor
Qpoor+nonpoor Q/t
S
P
P*
Pʹ
FIGURE 25.2 The supply and demand for health care with Medicaid.
Medicare: Public Insurance and the Elderly 287
will start paying. For widows and widowers this is not that
difficult; they simply pay all their medical and nursing
home expenses until their money is gone. Then Medic-
aid starts paying. Oftentimes, adult children with power
of attorney try to hasten the point at which Medicaid pays
their parents’ medical expenses by draining the wealth of
their parents by making gifts of it to themselves and their
own children. It is legal to do this but only up to a point.
Any money that is given to children and grandchildren in
the name of the elderly relatives in the two-year period
leading up to their enrollment in Medicaid is treated as a
semifraudulent way of avoiding paying for nursing home
care. The government monitors this and takes back any
money that was given away within that period.
Giving away an elderly person’s assets does not solve
the nursing home problem entirely, in any case, because
many times an elderly married couple has one partner
who needs care and another who does not. This is es-
pecially true when an otherwise healthy person gets
Alzheimer’s disease. Medicaid used to require that the
entire household’s wealth be spent down before it would
pay anything to a nursing home. This left many healthy
spouses destitute because of the need to finance health
care for their partner. At the time, the only alternative for
the couple was to file for divorce the minute one of them
was placed in a nursing home. That way, the assets were
divided in half so that only half would be spent down,
and the other half would be available for the healthy
spouse. The needless emotional trauma of divorcing a
longtime spouse is now avoided because the law now al-
lows the assets of the couple’s household to be divided
equally between what will be spent down and what will
be left untouched when one member of the married cou-
ple is admitted to a nursing home.
Cost-Saving Measures in Medicaid
During the early 1990s Medicaid costs were rising by
more than 10 percent a year. This trend, coupled with
other welfare concerns, motivated many of the welfare
reform measures of the middle part of that decade. Dur-
ing that time states began to shift their Medicaid sys-
tems from individual doctors reimbursed for expenses to
health maintenance organizations (HMOs). From 1990
to 2004, doctors in HMOs went from treating fewer than
5 percent of Medicaid patients to treating 60 percent of
them.
When HMOs are in place, people are denied coverage
unless it is authorized by the doctors who have been des-
ignated as their primary care physicians. Under HMOs,
primary care physicians are charged with providing basic
care, and they are the only people who can refer patients
to specialists. The use of HMOs has stemmed the unfor-
tunate practice of Medicaid patients’ use of emergency
room treatments for basic care. Nonemergency Medic-
aid patients are now counseled that if they show up at
an emergency room for treatment of nonserious matters,
they may be turned away. They are also counseled about
the benefits of having a physician who follows their par-
ticular health needs. In this way HMOs are saving the
state and federal governments money and, at the same
time, are helping to improve the health of the people they
are serving.
One other way in which states began cutting their
Medicaid budgets in 2011 was to drop many optional
coverages. Specifically, states that covered eyeglasses
began to consider dropping such coverage for Medicaid
recipients.
Medicare: Public Insurance and the Elderly
Why Private Insurance May Not Work
There are two main arguments for government provision
of health insurance for the elderly: equity and efficiency.
While it was appropriate in earlier times to argue that
it was only fair to provide for the elderly in that the el-
derly were poorer than younger people, such arguments
are less appropriate today. Today’s elderly are among the
least likely of our citizens to be in poverty, due in some
measure to these programs. What remains are arguments
that the market cannot provide health insurance effi-
ciently to people who are not in groups.
The problem with health insurance, in general, is
that people who really need it, those who are sick, are
more than willing to pay very high prices for it; and
those who are healthy are only willing to pay low prices.
Most people have in mind two kinds of health expenses
when they are thinking about buying insurance, the ex-
penses they are rather sure they will incur and expenses
of which they are not as certain. They will buy insurance
readily if the expenses they expect are greater than the
premiums they have to pay. People will pay for insur-
ance that covers them in areas they are not certain they
will need, but if premiums are too high, only the sickest
will want to buy insurance. If this group were to become
the only one that buys insurance, the expenses to the in-
surance company would be greater than the premiums
received and premiums would have to rise. This would
make the problem worse, as only the sickest of the sick
288 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
would buy the insurance. This problem is referred to by
economists as adverse selection.
This vicious cycle would go on and on until there was
no insurance at all. Fortunately, this is not much of a
problem in the United States because most private health
insurance is group insurance that employers buy for their
employees. In each group there are undoubtedly some
people who are sick, some who are healthy, and many
who are somewhere in between. The healthy subsidize
the sick. Because being part of a group affords such im-
portant benefits both to the insurance companies and to
members of the group, people who buy health insurance
as individuals always run into problems not encountered
by people who buy into group health insurance.
This would not be a problem if the elderly were still
with their employers. They are not; they are retired, and
many employers do not offer membership in company
health groups to retirees. With the efficacy of offering
health plans to people in groups, and with millions of
individual retirees needing health insurance, it has made
sense for the government to offer such insurance, and it
does so through Medicare.
What remains debatable about Medicare is who pays
for it—its beneficiaries (as with normal health insur-
ance), or all taxpayers, or a combination of these groups.
At the outset it was intended that the cost split would
be about 50–50, proportions that offered the elderly a
substantial subsidy. Today the subsidy is such that about
three-quarters of the total expenses are paid out of tax
dollars and only about a quarter by its beneficiaries.
Why Medicare’s Costs Are High
All government health insurance programs suffer
from problems of cost control, problems that are com-
pounded in an era of rapid advances in medical technol-
ogy that vastly improve health care but increase costs as
well. Anytime the consumption of a good is subsidized
via insurance, several basic problems ensue. The first
problem is that you risk increasing its consumption to
an inefficient level. The second problem, referred to by
economists as the third-party payer problem, is that by
insuring consumers and thereby insulating them from
costs, neither consumers nor producers have incen-
tives for holding down costs. These and other insur-
ance problems were explained in detail in Chapter 24
on health care.
As with all other government health insurance pro-
grams, then, the costs of Medicare have escalated dra-
matically. Figure 25.3 shows the increase in the costs of
Medicare since its inception in 1967.
500
600
700
400
300
200
100
0
Year
M e
d ic
a re
s p
e n
d in
g ( $
b il li o
n s )
Medicare spending Medicare spending 2016–2021 est.
19 6 7
19 7 0
19 7 3
19 76
19 7 9
19 8 2
19 8 5
19 8 8
19 9 1
19 9 4
19 9 7
20 00
20 03
20 06
20 09
2 0 12
20 15
20 18
20 21
FIGURE 25.3 Medicare spending in billions of 2009 dollars.
Source: Refer to Table 8.6: www.whitehouse.gov/omb/budget/Historicals
Medicare’s Nuts and Bolts 289
For most programs, spending can rise only because
prices rise or beneficiaries become more numerous.
Medicare spending has risen for these reasons and one
other: increases in numbers of available medical services.
Medicare beneficiaries are not limited to the medical pro-
cedures that existed in 1967. They can avail themselves
of the best that medical science has to offer in the 2000s.
This means that some patients who would have died
20 years ago, and who therefore would no longer be draw-
ing on Medicare’s resources, are now given medicines and
procedures that are allowing them to live much longer.
It would be unconscionable to deny medical treatment
to Medicare patients, even if it would be expensive, to
improve their life or their life span. Moreover, it would
be unrealistic to assume that they would deny themselves
expensive treatments in the name of cost savings. Thus,
as treatments for health problems continue to become
more effective and life expectancies increase, we will
see a continued escalation of Medicare spending. As you
will see in our section on the Medicare Trust Fund, it is
this quickly increasing expense that has put Medicare on
a course that is likely to lead it to bankruptcy.
One of the ways to deal with this kind of problem is to
transfer the incentive to save money from the consumer
to the producer. While it is usually consumers who
want to limit the amount of money they pay, with insur-
ance this incentive is either drastically reduced or even
eliminated. As discussed above, if no one has an incen-
tive to keep expenses down, no one will keep expenses
down. It is possible, though, to make producers the cost-
conscious parties by paying them prospectively rather
than retrospectively.
Retrospective payment is what people are used to when
they buy services. When a person has a car repaired, a ga-
rage worker finds the problem, asks whether the customer
wants it fixed, tells what it will cost, and fixes it. At that
point the retrospective payment is made. Under normal
circumstances, this is not a problem because the customer
still has the incentive to keep costs down. Problems arise
when retrospective payments are used with insurance.
When you have an accident that is someone else’s fault, it
is the other person’s insurance that is paying the bill. Here
you want everything fixed perfectly, with original parts,
and the repair shop is only too happy to oblige because the
mechanic can rack up the charges. If you had to pay for
the repair, you would be more likely to be satisfied with
“good enough” and to accept substitute parts. That is why
either you are required to get two or three estimates before
the work starts, or the single estimate and the repairs must
be preapproved by an insurance adjuster. Both multiple
estimates and insurance adjusters’ oversight serve to keep
repair shops competing with one another and prevent or
lessen overbilling.
In health care it is unusual for an insurance company
to have you go to several doctors to get estimates, though
some may require second opinions. This is why some
insurance companies and Medicare have gone to a sys-
tem of prospective payments. Prospective payments are
made prior to the service being performed. The hospital
gets paid up front to treat its patients, and it then has an
incentive to keep costs below what it has been paid. In
the private arena, HMOs are designed to take advantage
of such payments. Gatekeeper doctors, who are usually
family practice physicians, pediatricians, or obstetri-
cian/gynecologists, are paid specified sums per patient
under their care, and they are paid the sums whether
the patients require a great deal of care or no care at all.
Medicare HMOs work this way as well, and, as we will
see, so does Medicare Part A.
Medicare’s Nuts and Bolts
As we discussed before, Medicare is divided into two
categories. Medicare Part A is mandatory for people
over age 65, and it covers hospital care. Medicare Part B
is voluntary, and it covers doctor visits. No part of Medi-
care covers common out-of-the-hospital prescription
drugs or long-term nursing home care.
Provider Types
The first choice a Medicare recipient has to make is
whether to choose traditional Medicare or a Medi-
care HMO. Medicare HMOs are approved by the
government, and doctors who participate in them are
paid per patient under their charge. The government
pays less per HMO patient than per non-HMO patient
on average, probably because healthy elderly people
are more likely to enroll in an HMO. The cost controls
that HMOs offer are usually enough that HMO pre-
miums are significantly lower than normal Medicare
premiums. People who opt for traditional Medicare are
automatically enrolled in Part A; they may choose to
enroll in Part B.
Part A
For people who work 10 years before reaching 65, Medi-
care Part A has no premium. For everyone else, the pre-
mium charged for Medicare Part A differs, depending
on how long they worked. In 2016 the deductible was a
290 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
relatively high $1,288 for the first day in the hospital. The
costs for the next 60 days were paid by Medicare. After
60 days in the hospital, patients paid $322 per day, Medi-
care paid the rest, and after 90 days patients paid $644
per day. From day 91 on, patients have a 60-day reserve
of days upon which to draw. When that reserve is gone,
patients must pay the rest themselves.
From the hospital’s position, Medicare is paying
amounts that it has settled on for specific diagnoses.
These payments, and they are prospective payments, are
determined by where the patients’ ailments put them on
a list of more than 500 diagnosis-related groups (DRGs).
All Medicare patients who enter the hospital are placed
in a DRG, and rather than paying for specific expenses
that are incurred, Medicare pays the hospital a prede-
termined amount that is considered appropriate for that
DRG. This motivates the hospital to keep costs down.
Medicare had paid for every bandage, meal, and service
until the mid-1980s, when it found that hospitals were
racking up costs of questionable medical value just to
increase their profit margins. Under fixed payments for
DRGs, Medicare has kept much better control of cost in-
creases. This policy has also led to a significant shorten-
ing of average hospital stays for specific problems. The
current system also provides an incentive for hospitals to
discharge patients as soon as possible.
This system for reimbursement is not without its crit-
ics. Specifically, President Obama derogatorily labels
this prospective payment system as paying hospitals
based on what the patients have when they walk in the
door not for what the hospitals do to make the patients
better, or even by what services they perform. This criti-
cism is not new, but the balance that was struck when
the DRG-based prospective reimbursement was insti-
tuted was that paying hospitals on performance (how
much patients improve from when they were admitted)
will cause hospitals to specialize in low-mortality, low-
risk treatments, and that paying hospitals based on the
services they provide will motivate hospitals to over-
treat patients, thereby running up the costs. Though not
without its critics, the current system is favored by most
health economists as being one that keeps costs down,
and with Medicare costs rising rapidly in the near future
due to the aging of the baby boom generation, this is of
primary concern.
Part B
Medicare Part B, the voluntary insurance program that
pays for visits to doctors, has a monthly premium and
an annual deductible. In 2016, the premium depended
on your income. For those with incomes under $85,000
($170,000 for married couples filing joint tax returns),
the premium was $121.80 and the deductible was $166.
Because neither the premium nor the deductible has
increased at the rate of medical inflation, this part of the
program is now being subsidized at a rate approaching
75 percent. What this means is that for every dollar a
patient pays, Medicare Part B pays $3 out of tax rev-
enues. Accordingly, there is virtually no reason for an
elderly person not to enroll in Part B. For those who can-
not afford the premium, Medicaid, the parallel program
that provides health insurance for the poor, typically
steps in. For everyone else, that $121.80 premium is a
small enough amount that nearly 100 percent of the non-
Medicaid eligible elderly are enrolled.
From a doctor’s perspective, Medicare Part B pays
a regional standard for each treatment. Unlike Part A,
Part B is billed expense by expense with retrospective
payment. Medicaid pays a fixed amount for each service,
but each service is billed individually rather than being
grouped in a DRG.
The reason that prospective payments do not work for
non-HMO Medicare Part B is that, with a huge range of
possible ailments, there are many potential doctors a pa-
tient may want to see. In a Medicare HMO, a gatekeeper
is in charge of referrals to specialists, but non-HMO pa-
tients can go at any time to the doctors of their choice. It
would be impossible to predict such choices in advance,
and since no single doctor, HMO, or hospital is in total
charge of their care under Part B, prospective payments
cannot be made to work.
Prescription Drug Coverage (Part D)
As part of the 2003 reauthorization of Medicare, the
costs of prescription drugs are now covered. Prior to
this change, health care economists were of two minds.
First, they saw a distortion of the market when surgery
was covered but medicines were not. Second, they noted
Medicare’s precarious financial state and worried that
the additional benefit would make it that much worse.
As expensive as most drugs are, drug-based treat-
ments are less expensive than their surgical alternatives.
Because Medicare did not cover prescription drugs and
it did cover surgery, patients may have elected surgery
even though it may have been more expensive.
On the other side of the debate were the concerns
over the cost of any prescription drug program. Initial
estimates in the 2003 Medicare reauthorization placed
Medicare’s Nuts and Bolts 291
the cost of such a program at $400 billion over 10 years.
Those estimates were quickly revised. Currently the
program is anticipated to cost at least $1 trillion over
10 years. The Congressional Budget Office estimated
(in its Outlook for 2015 to 2025) that “[n]et federal
spending per beneficiary for Part D, which accounts
for a small share of total Medicare spending, [was]
projected to grow much more—by 77 percent—
largely because of rising drug costs combined with
provisions in the ACA that expand the extent of cov-
erage for some prescription drugs.” What must be
understood about any such estimates is that they are
highly sensitive to assumptions about price elasticity
for drugs. If the estimator uses data on the number of
prescriptions filled and multiplies that number by the
cost per prescription covered by the government (as-
suming perfectly inelastic demand), this would seri-
ously underestimate costs. There are people who will
benefit from prescriptions who did not go to the doc-
tor because they knew they would get a prescription
slip they could not afford to fill. Additionally, there
were elderly who used to get multiple prescriptions
and fill only a fraction of them because they could not
afford to fill them all. Taking this into account, cost
estimates are likely to be exceeded and higher deficits
will ensue.
The 2003 reauthorization also introduced means
testing to Medicare. The Republican-authored bill
made premiums and coverage dependent on income
and required most seniors to pay as much as $3,600 out
of pocket. Medicare Part D is not really a national plan
but was intended to foster many private alternatives
with substantial government subsidies. Premiums,
deductibles, and co-pays are features of each plan
and are highly localized, and as a result much more
confusing to beneficiaries than Medicare Part A or B.
Democrats, who had sought a government-run program
akin to the other parts of Medicare, generally opposed
the plan. Republican defenders sought to introduce
private market incentives to keep costs under control.
Neither seems to have the upper hand on this issue as
the system was initially very confusing, but the most
recent estimates suggest that it will cost the govern-
ment 50 percent less than it was originally projected to
cost. A particularly troubling part of the original law
was the existence of a “donut hole,” where coverage
began at one level of individual spending, then stopped
until another higher level of spending was arrived at,
and then began again. The donut hole is slated to be
reduced under the PPACA.
Cost Control Provisions in Medicare
Medicare has been attempting to keep costs under con-
trol since its inception, but, unfortunately, it has enjoyed
little success. Ultimately the reasons for this lack of suc-
cess boil down to two:
1. Medical care is increasingly sophisticated, with con-
tinually improving success rates, and it is therefore
more costly.
2. There is no economic incentive for either patient or
doctor to control costs.
While the aforementioned DRGs have helped con-
trol costs in Part A, and Medicare HMOs have helped
control costs in Part B, neither has been foolproof. The
DRGs, however, have succeeded in doing a couple of
important things with regard to costs. First, basing the
payments on DRGs has given hospitals the incentive to
take many procedures that used to require one night in
the hospital and turn them into outpatient procedures.
Second, hospitals have put pressure on doctors and pa-
tients to shorten the average length of stay of many mul-
tiday procedures.
Given that DRGs pay a fixed amount for a procedure,
hospitals have the incentive to cut costs. Since one of
a hospital’s greatest costs is keeping someone in a bed
overnight, converting a procedure that formerly involved
a hospital stay to one that is done on an outpatient basis
helps to raise profits. Heart bypass surgery is not likely
to be an outpatient procedure anytime soon, but many
other procedures are candidates. While many people are
concerned about the health consequences of turning out
patients who would have stayed a night, there has been
little medical evidence that sending people home right
away has had adverse effects.
A second area where costs have come down is the
shortening of the length of stay for many multiday proce-
dures. Surgeries that used to require a three- or four-day
stay in the hospital to recuperate now require only two or
three. In part this is because surgeons are better at limit-
ing the trauma to the body from surgery, and in part it is
because postsurgical rehabilitation has improved.2
2While the data on length of stay have not shown a decline, this is misleading
because of the aforementioned outpatient substitution. Since the length-of-
stay data are based on the number of days a patient stays in a hospital, the
procedures that are now outpatient do not count at all. If length of stay for
the other procedures had remained the same as it was before the outpatient
substitution, then the overall average would have risen substantially since
whenever you remove short stays and leave only the longer stays, the aver-
age rises. Since the overall average has remained constant, we know the
length of stay for longer-stay procedures has fallen.
292 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
The Medicare Trust Fund
One of the greatest concerns today is the fiscal health of
the Medicare program that provides for our elderly’s phys-
ical health. The Medicare Trust Fund enjoyed assets of
$266 billion in 2014. This trust fund was set up to handle
the anticipated medical expenses of the baby boom gen-
eration. Like the Social Security Trust Fund, it deliber-
ately collected more in taxes than was necessary in order
to build savings for the period between 2015 and 2035,
when it was anticipated that the high numbers of the baby
boom generation were likely to strain the system. Like the
Social Security Trust Fund, the Medicare Trust Fund is
invested only in U.S. government debt. In 1997, however,
the trustees of the Medicare Trust Fund issued an alarming
report. They estimated that long before the serious crisis
hit, the trust fund would be bankrupt. While later trustees’
reports have been somewhat more optimistic about the fis-
cal health of the program, eventual bankruptcy remains its
conclusion. In fact, in 2008 the balance of the trust fund
began to shrink for the first time in its history.
The annual reports of the trustees have been based
on three different projections of the future: one very op-
timistic, the second very pessimistic, and the third on
what the trustees judged to be the most realistic assump-
tions. Assumptions have been made about two economic
variables and two demographic variables. The eco-
nomic considerations have been the growth in inflation-
adjusted wages and the real interest rate. The demographic
variables have been the fertility rate and life expectancy.
The higher the projected growth rate in wages, the more
projected tax revenues would be; the higher the projected
real interest rate, the better return on the trust fund would
be; and because it is held that greater numbers of children
will produce more tax revenue, the higher the projected
fertility rate, the greater the projected tax revenues. Last,
longer projected life expectancy would be anticipated to
create greater Medicare expenses.
Figure 25.4 shows the actual balance of the Medicare
Trust Fund from 1970 to 2011 and the projected balance
of the trust fund until 2021 under the alternative assump-
tions just outlined. The estimates of low costs are based
on the following assumptions: Real wages will grow
quickly, at a rate of 1.6 percent; real interest rates will
be a high rate of 3.7 percent; and fertility will be high, at
2.2 children per woman. The figures that reflect the esti-
mate of high costs are just the opposite: Real wages will
grow at 0.6 percent; real interest rates will be 2.2 per-
cent; and fertility will be 1.7 children per woman. The
intermediate cost projections are that real wages will rise
at 1.1 percent; real interest rates will be at 3.0 percent;
and the average woman will have 1.95 children.
If the assumptions leading to high costs are correct,
Medicare is genuinely on the verge of bankruptcy. If the
costs turn out to be low, the year of bankruptcy is beyond
the immediate projections of the report, but it still hap-
pens in the middle of the 21st century. The 1997 report
used the intermediate assumptions and projected bank-
ruptcy in 2008. The 1999 update of the report projected
that the system would be bankrupt in 2015. The 2000
High cost
Intermediate cost
Actual balance
Low cost
–400
–200
0
200
400
600
800
1,000
Year
T ru
s t
F u
n d
b a
la n
c e
( $
b il li o
n s )
19 70
1 9 7 3
19 7 6
19 79
19 8 2
19 8 5
19 8 8
1 9 9 1
19 9 4
19 9 7
20 00
20 03
20 06
20 09
2 0 12
20 15
2 0 18
20 21
20 24
FIGURE 25.4 The Medicare Trust Fund under alternative assumptions.
Source: Medicare Trustees Report
Children’s Health Insurance Program 293
through 2008 versions have produced a relatively stable
projection for around the 2020s.
The 2009 report was significantly less optimistic,
while the 2010 report returned to projections of difficul-
ties in the 2020s. These estimates have become somewhat
political in that they were used to justify the need for
the PPACA, and assumptions were made in them that
most political observers understood would never actually
take place. Specifically, the rate at which Medicare reim-
burses hospitals and doctors was, by previous statute sup-
posed to decline 20 percent as a result of cost estimates
exceeding previously established benchmarks. Every year
after the benchmarks were surpassed, Congress acted to
waive those rate reductions. As unrealistic as it was, the
trustees were required to assume that Congress would not
change the law, which meant that they were supposed to
assume that the last time Congress waived the rate reduc-
tions would be the last time they ever did. This silliness
was finally ended in 2015.
To forestall the projected bankruptcy, it seems rea-
sonable to consider simply raising taxes along the way
in a pay-as-you-go format. This would presuppose that
nothing is done to alter the current program. If we go to a
pay-as-you-go system where taxes have to increase each
year to meet the health care needs of the elderly, tax rates
may rise substantially.
Under current law, the payroll tax that funds Part A of
Medicare is 2.9 percent. That is, you and your employer
each contribute 1.45 percent of everything you make on
the job. (The self-employed contribute the full 2.9 percent.)
Under the most likely scenario, the rate would more than
double to 3.3 percent each.
If raising taxes to the necessary levels is unacceptable,
other solutions may be explored. The age at which people
become eligible could be raised, premiums and deduct-
ibles could be raised to their inflation-adjusted 1970 level
or beyond, all beneficiaries could be required to have gate-
keeper physicians (as in HMOs), and it could be mandated
that at certain income or wealth levels the elderly would
get reduced subsidies. Many people are dissatisfied with
these alternatives, and none meet with the approval of the
main lobbying organization for the elderly, the American
Association of Retired Persons.
The Relationship between Medicaid and Medicare
Besides beginning with the same act of Congress and
besides sharing the first six letters of their eight-letter
titles, Medicare and Medicaid share other features. The
most significant is a commingling of tasks when people
are both old and poor. Medicare was set up to deal with
only the aged and Medicaid was set up to deal with only
the poor. When someone is both old and poor, both pro-
grams come into play.
When a person is of an age to be eligible for Medicare
and is also poor and qualifies on that ground for Medic-
aid, the first to pay is Medicare. Medicaid is the payer
of last resort. Since Medicare has two parts and since
Medicaid’s costs are shared by both the federal and state
governments, the story gets even more complicated.
All elderly are required to participate in Medicare Part
A, which covers hospital expenses, and they can elect to
participate in Medicare Part B, coverage for doctors’ vis-
its. When people are poor as well and qualify for Medic-
aid, the Medicare premiums and deductibles for Part A
are paid by Medicaid and the remainder are paid by Medi-
care. For Part B, the state can then elect to pay the Medi-
care Part B premiums and deductibles and have Medicare
Part B pick up the bulk of the expenses. In any event,
when elderly people are eligible for Medicaid, there is
significant overlap between Medicare and Medicaid.
Children’s Health Insurance Program
In 1997 the Children’s Health Insurance Program was cre-
ated to help the children of the working poor. It allowed
states either to expand Medicaid coverage to those mak-
ing less than 200 percent of the poverty line or to create a
separate program to serve that population. The states have
chosen a variety of strategies to implement their programs.
In general, though, when a child’s low-income parents have
no insurance through their employer, they can purchase
highly subsidized health insurance. Though the premiums
vary from state to state, they are below $40 per family per
month in all but two states (and are zero in 20 states), a
tiny fraction of what they would be for private insurance.
Similarly, the deductibles and co-payments are low as well.
An interesting feature is that well-baby visits and immuni-
zations are required to be free for children in the program.
The program is structured very much like Medicaid
in that there is a matching rate for states depending on
their per capita income and minimum coverage expecta-
tions to ensure that all covered children are given ad-
equate care regardless of where they live. The matching
rates are closely tied to the regular Medicaid matching
rates but are, on average, 23 percentage points higher.
The program now serves more than 8.1 million children
at a cost of more than $13 billion per year.
294 Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children’s Health Insurance Program
Summary
At this point you understand that Medicaid is a program
that covers medical expenses for a subset of this nation’s
poor. You understand that eligibility for Medicaid ben-
efits is tied to family income and the age of dependent
children, and, as a result, there are many people who
are in poverty and not covered by the program. You
understand that the beneficiaries are disproportionately
women but that in other demographic dimensions they
mirror those who are in poverty. You understand how
much the program costs, and you know why those costs
are high relative to the costs of those who are covered
by private insurance. You know that a disproportionate
amount of money is spent on the elderly, and you are
able to articulate why that is the case. You understand
the relationship between Medicaid and the companion
program for the elderly, Medicare. Last, you are aware
of the cost-saving measures that have been put in place
for Medicaid.
Quiz Yourself
1. In 2014, unless a state was willing to forgo all fed-
eral money for Medicaid, a member of a family
earning less than 133 percent of the poverty line is
a. ineligible for any health care assistance.
b. eligible for Medicare’s prescription drug plan
only.
c. eligible for all of Medicare.
d. eligible for Medicaid.
2. When a 65-year-old goes to the hospital, the part of
Medicare that pays for the hospital bill is
a. Part A.
b. Part B.
c. Part C.
d. Part D.
3. When a program like Medicaid is introduced, the
market demand curve for health care will
a. increase and flatten.
b. increase and become more steep.
c. decrease and flatten.
d. decrease and become more steep.
4. Medicaid spending per recipient is
a. twice that of the average citizen’s use of health
care.
b. somewhat less than the average citizen’s use of
health care.
c. somewhat greater than the average citizen’s use
of health care.
d. half that of the average citizen’s use of health
care.
5. The DRG system controls Medicare expenses by
a. preventing doctors from using particular
procedures.
b. paying hospitals after they submit bills.
c. paying hospitals on the basis of a disease or
injury rather than expenses.
d. paying the patient who then pays the hospital.
6. The Medicare Trust Fund is necessary because
a. current expenses are greater than current
revenues.
b. current expenses are less than current revenues.
c. future expenses will be greater than future
revenues.
d. future expenses will be less than future
revenues.
7. Medicare’s prescription drug coverage will likely
a. cost substantially more than it was estimated to
cost in 2003.
b. cost substantially less than it was estimated to
cost in 2003.
c. cost slightly less than it was estimated to cost in
2003.
d. cost about what it was estimated to cost in 2003.
Short Answer Questions
1. How might the elasticity of demand for a health care
service be used to estimate the demand created for a
health care service when there is a new program for
government coverage?
2. Why is the Medicare Trust Fund estimated date of
fund exhaustion so dependent on the assumption
made with regard to economic growth, interest rates,
and political changes?
3. What are the benefits and costs associated with re-
imbursing hospitals based on their actual services
performed rather than based on the problems the pa-
tients have when they come to the hospital?
Think about This
One of the suggestions for providing the working poor
with health insurance has been to require employers
to provide health insurance benefits for all workers by
Summary 295
having employers “buy them into Medicaid.” Requiring
this would raise the cost to employers of hiring new work-
ers. Under what circumstances would this be good for
workers? Under what circumstances would it not be good?
Talk about This
When public provision of health care is discussed
in most political arenas, providing more coverage
(e.g., prescriptions and long-term care) for the elderly
typically garners more attention than expanding cover-
age to the working poor. Why is that? Is this the right
priority in your mind?
For More Insight See
Garrett, Major, “Medicare: Healthier for Now,” U.S.
News & World Report, April 12, 1999, p. 29.
Lee, Ronald, and Jonathan Skinner, “Will Aging Baby
Boomers Bust the Federal Budget?” Journal of Eco-
nomic Perspectives 13 (Winter 1999), pp. 117–140.
Miller, Matthew, “Premium Idea,” The New Republic,
April 12, 1999, pp. 24–27.
Newhouse, Joseph, “Policy Watch: Medicare,” Jour-
nal of Economic Perspectives 10 (Summer 1996),
pp. 159–168.
Phelps, Charles, Health Economics (Reading, MA:
Addison-Wesley, 1997), esp. Chapter 13.
“Survey: Health Care,” The Economist, July 6, 1991.
2000 Annual Report of the Board of Trustees of the
Federal Hospital Insurance Trust Fund.
Behind the Numbers
Historical data.
Federal Medicare spending.
Budget of the United States Government; historical
tables—
www.whitehouse.gov/omb/budget/Historicals
Matching rates to the states—
http://aspe.hhs.gov/health/fmap11.pdf
Historical and projected Medicare Trust Fund assets,
1970–2019.
Centers for Medicare and Medicaid Services;
Trustees Report—
www.cms.gov/Research-Statistics-Data-and
-Systems/Statistics-Trends-and-Reports/Reports
TrustFunds/downloads/tr2012.pdf
Medicaid spending and population characteristics,
Medicaid and Medicare recipients, eligibility, and
costs; Centers for Medicare and Medicaid Services—
www.cms.hhs.gov
www.cms.gov/ActuarialStudies/downloads/Medicaid
Report2010.pdf
www.cms.gov/MedicaidDataSourcesGenInfo
Health, United States, 2010, with chartbook on trends
in the health of Americans, National Center for Health
Statistics—www.cdc.gov/nchs/data/hus/hus10.pdf
C H A P T E R T W E N T Y - S I X
296
The Economics of Prescription Drugs Learning Objectives
After reading this chapter you should be able to:
LO1 Apply the concepts of monopoly as well as consumer and
producer surplus to the economics of prescription drugs.
LO2 Summarize why most health economists view prescription
drugs as relatively inexpensive, even while most nonecono-
mists view them as very expensive.
LO3 Explain why it is that most health economists do not favor
price controls on prescription drugs.
LO4 Identify the consequences of an approval process that is too
stringent or too lax.
Chapter Outline
Profiteers or Benevolent Scientists?
Monopoly Power Applied to Drugs
Important Questions
Summary
When people go to the doctor because they are sick
or injured, they want the doctor to make them better.
For certain injuries they may expect active treatments,
like surgery. It is just part of the human psychologi-
cal makeup to want to know that “everything is being
done” to restore the patient’s health. The same holds for
the treatment of illnesses. Nothing is more frustrating
to patients than to be told they have a “virus,” because
they accurately translate that to mean “go home and
go to bed because there is nothing we can do for you.”
On the other hand, if patients go home having filled a
prescription for a drug, they feel better simply because
they think that taking medicine will make them well.
In part they think this because the prescription drug
industry has been so successful in treating everything
from infections to impotence. When we have a virus
and there is no prescription forthcoming, we lose hope
for a quick end to our illness. In this sense we go to the
doctor hoping for prescriptions because it is usually a
drug the doctor prescribes, rather than something the
doctor actually does, that makes us better.
It seems all the more strange to economists, then,
that prescription drugs get as much criticism as they
do when it comes to expense. The amount of money
spent on prescription drugs is actually trivial relative
to all health spending. In 2014, for example, all U.S.
health spending amounted to more than $3.03 trillion
dollars, and 10 percent of that was spent on prescrip-
tion drugs.
This chapter has several purposes. We look at the
degree to which prescription drug manufacturers are
prof iteers or Good Samaritans. We use our monop-
oly model to discern why drugs are so costly, and we
examine some of the new drugs and discuss whether
they are expensive necessities or relatively inexpen-
sive godsends. In doing this we will see the funda-
mental reasons why prescription drug companies are
likely to remain unpopular even as they continue to
provide important medicines. Last, we look at how
other countries control prescription drug prices, and
we offer a perspective on whether the United States
should follow suit.
Monopoly Power Applied to Drugs 297
in turn, that there are no other companies producing the
particular drug. When the drug is one-of-a-kind, as AZT
was in the early 1990s, and it is the only hope a patient
has, its monopoly power is dramatic. It is all the more
dramatic when the disease it treats is fatal. Since most
drugs cost very little to produce but may, as in the case
of AIDS drugs, cost billions to discover and test, we are
conflicted about high prices. We know that companies
need to be rewarded for their investments, but we also
find it troublesome that money has the power to deter-
mine whether a person gets a drug and lives or does not
get a drug and dies.
On the other hand, when the drug is one of many,
and it treats a non-life-threatening condition, as do the
anti-heartburn medications Nexium and Zantac, we are
not at all conflicted. The problem is not life and death,
and the power the companies have to charge high prices
is limited only by competition and consumers’ willing-
ness to suffer through ailments that are merely annoying.
Whether we view drug companies as profiteers or
benevolent scientists rests on whether they, in the end,
do good and whether they charge what are perceived
to be fair prices. Drug companies make a great deal of
money, but they incur a great deal of risk. Much eco-
nomic research has gone into studying whether their
profits are out of line in comparison with those of simi-
lar industries. Although that research has not settled on
a definitive answer, it does suggest that the rate of return
to stockholders in the pharmaceutical industry is either
at or slightly above that of similar industries. What is
clear is that prescription drugs have both improved the
quality of life for millions and made companies billions
in profit.
Monopoly Power Applied to Drugs
As stated previously, the key economic attribute of the pre-
scription drug industry is monopoly. While patents do run
out and competition takes place in the form of generic drugs,
monopoly reigns for several years at least. Fig ure 26.1 is
the same graph that we saw in Chapter 5 for a monopo-
list’s decision on price and production. As you know, a mo-
nopolist is the only seller of a good. This means that the
demand curve that a monopolistic firm faces for its goods
is the entire market demand curve. For such a firm, this has
good and bad aspects. In contrast to perfect competition,
the seller does not have to worry about other firms. On the
downside, if the firm wants to sell more goods, it not only
has to lower the price to the people who will buy the extra
goods; it has to lower the price to everyone else as well.
Profiteers or Benevolent Scientists?
Among the more interesting advertisements of the
1990s were the pharmaceutical industry’s feel-good
television spots that focused on a variety of hardwork-
ing scientists endeavoring to conquer a disease. These
ads differed somewhat from the ads that commonly try
to get us to go to the doctor to ask about problems like
hair loss, seasonal allergies, or other afflictions. Just as
McDonald’s wants to sell burgers, so also the pharma-
ceutical ads are trying to sell us a particular drug. The
feel-good ads are there, not to have us buy any particu-
lar product, but to persuade us to feel better about the
industry in general.
Usually, the earlier ads discussed an emotional attach-
ment the scientists had with curing the disease they were
working on. A friend, spouse, relative, or parent had the
disease and this, we were supposed to believe, motivated
the scientist to spend long nights crouched over a micro-
scope in search of a cure. With no attempt to criticize the
scientists’ sincerity, however, we know deep down that
whether or not something altruistic motivates the scien-
tist, what motivates the drug company is profit.
As with any invention, the fundamental economic
problem is how to reward the inventor. Unless the inven-
tor is given exclusive rights to his or her idea once the
item has been invented, copycats can steal it. Knowing
this, inventors will have little economic incentive to in-
novate. This is why we have laws that govern copyrights
and patents. Within existing laws, a patent-holding in- ventor is the only person who can sell the invention for
as long as the patent exists.
Monopoly power is particularly important in the so-
called orphan drug industry, an industry that deals with diseases that afflict few people.
Therapies that benefit small num-
bers of patients cannot hope to
generate sufficient profits during
normal patent lives for companies
to justify research. For this rea-
son drugs that are labeled orphan
drugs are granted very long patent
lives so that profits, though small,
can be expected to last long into
the future. Without this aspect of
the patent law, research on such diseases would never be in-
stituted by scientists working in the private sector.
In economic terms what this monopoly power does is
give the inventor total control. As you recall from Chap-
ter 5, monopoly means that there is one seller. It means,
patent A right granted by gov- ernment to an inventor to be the exclusive seller of that invention for a limited period of time.
orphan drug A drug that treats some- one with a disease that afflicts few people.
298 Chapter 26 The Economics of Prescription Drugs
supply curve would be if the market were under per-
fect competition.
In Figure 26.2, monopoly is compared with perfect
competition. The perfectly competitive market would
produce Q PC
at a price of P PC
, because this is where
supply crosses demand. The monopolistic producer
charges much more, P monop
, and produces less, Q monop
,
because this is where marginal cost equals marginal
revenue. Our consumer and producer surplus analysis,
then, allows us to show that companies profit not only
at the expense of sick people, but also at the expense
of society as a whole.
Figure 26.2 indicates that the consumer surplus (the
area under the demand curve but above the price line)
at the perfectly competitive price–quantity combination
is P PC
AC, and the producer surplus (the area above the
supply curve but under the price line) is FP PC
C. Under
monopoly, the consumer surplus shrinks to P monop
AB,
and the producer surplus rises to FP monop
BE. This means
that producers are better off but not by as much as con-
sumers are worse off. Stated
differently, the deadweight loss, or loss to society of producing
at the wrong price–quantity
combination, can be shown as
the difference between the sum
of consumer and producer surplus between the perfect
competition and monopoly situations. That area is de-
picted as EBC in Figure 26.2.
This includes the people who would have purchased their
goods at high prices, so the money gained from increasing
sales is partially offset by the money that is lost from having
to lower prices. The good news for the firm is that raising
the price does not cause all customers to leave, as it does
under perfect competition.
Figure 26.1 depicts a drug company that is the sole
provider of a certain drug. It indicates that the marginal
revenue curve, the curve that represents the additional
revenue to the firm associated with the sale of one more
unit of the good, is downward sloping rather than flat, as
it would be under perfect competition.
Using the tools of consumer and producer surplus,
we can show that with the price equal to P* and the
quantity equal to Q*, relative to the societal optimum,
the price is too high and the quantity too low. This can
be seen by looking at Figure 26.2 and the assumptions
that go along with it. For a moment suppose that the
proper comparison to make with regard to the mo-
nopolistic production of prescription drugs is perfect
competition.1 As you saw in Chapter 5, the marginal
cost curve for a perfect competitor—out of the mini-
mum of average variable cost—was the supply curve.
If you adapt that notion here, the marginal cost curve
for this monopolist in Figure 26.1 is also what the
FIGURE 26.1 The prescription drug monopolist.
Marginal cost
Demand
Sales ($)
Marginal revenue
Q*
P*
Q/t
FIGURE 26.2 Comparing monopoly and perfect competition in prescription drugs.
Marginal cost = Supply
Demand
Qmonop QPC
Pmonop
PPC
F
A
B
C
E
Sales ($)
Marginal revenue
Q/t
1Because of the large innovation costs, this is a poor assumption for the indus-
try at all stages of production but a reasonable one after the drug has been
invented and approved.
deadweight loss The loss in social welfare associated with production being too little or too great.
Important Questions 299
on how long a drug company has monopoly power over
a drug is somewhat complicated, but we will assume that
the company has that power for 10 years; after that, perfect
competition takes hold and all economic profits disappear.2
Add to this scenario the fact that few drugs make it from the
scientist’s lab to the pharmacy. Drug companies claim that
the number of unsuccessful attempts is very high and that
this is an additional reason for high costs.
Let’s examine a hypothetical situation drug compa-
nies might face. Assume for every five drugs that reach
the testing phase another five do not make it that far. Fur-
ther, suppose that only one of every five that is tested is
shown to be safe and effective. Thus for every 11 that
incur invention costs, there are five that also incur test-
ing costs. Only one produces revenue. Suppose at the
very beginning of this process the manufacturer does not
know which of these 11 plausible ideas will pay off, but
it does know that one of them will. Also suppose that the
manufacturer has a good idea that marginal production
costs will amount to $10 per patient per year. Given all
that, at a 10 percent real rate of return, the anticipated
profit to the manufacturer from this one drug would
have to be $520 million per year for the drug company
to make back its initial investment. Thus, even if you
ignore all of the markups that wholesalers and retailers
charge from the manufacturer to the patient, the price per
patient per year for our hypothetical example will have to
be $530 ($520 million in profit/1 million patients + $10
in production costs).
In addition to all the preceding considerations,
drug prices are made higher by our society’s propen-
sity for suing pharmaceutical companies. Americans
sue each other more than any other group of people.
Pharmaceutical firms have deep pockets. They pro-
duce products that do not work all the time and that
sometimes do more harm than good. In the last 15
years, Vioxx and other Cox-2 inhibitors were approved
and later had their safety called into question because
they were shown to cause heart problems. Subsequent
multimillion-dollar lawsuits were filed against their
makers and, if upheld, they will completely wipe out
the profit from the sale of these drugs. With the fear
of such judgments in mind, pharmaceutical firms will
increase their prices so they have enough money on
Important Questions
Expensive Necessities or Relatively Inexpensive Godsends?
In addition to the fact that we can show prices to be
“high” in a theoretical sense, the data show they are also
high in real life. In the United States in particular, drugs
are often priced at 10 times their marginal production
costs. In addition, drug prices are increasing far more
rapidly than the overall inflation rate. As a matter of
fact, from 1986 to 2015 drug prices went up more than
268 per cent at a time when overall inflation increased
general prices 116 percent. While some difference could
have been expected, this difference is remarkable given
that nonprescription drugs declined from 2009 to 2016.
The reasons for increased prescription drug prices are
many and varied, but they boil down to a few impor-
tant issues: development costs, regulation, and litigation.
There is also a problem with the mismeasurement of in-
flation in drug prices.
Development of new drugs costs a great deal of money,
and drug companies need to recoup costs before they can
make a profit. Since the “easy” diseases already have cures
or treatments, we are left with some very difficult diseases
to research. The training required to even understand how
to start researching drug therapies takes several years after
a researcher has earned a doctorate or a medical degree.
People who get that kind of education for that long a period
of time are going to command very high salaries once they
start working. In addition to high labor costs, the equipment
needed for this kind of work is specialized and expensive.
The capital and labor costs of drug research are extended
even further by the years required to take a drug from suc-
cessful trials to government approval. Typically, new drugs
are first tested on small animals. They are then tested on
primates. These tests are followed by small-scale human
trials, designed primarily to gauge safety. Finally, a large-
scale human trial requires that the drug be shown to work
effectively while not causing unacceptable side effects.
This lengthy process is expensive and it significantly ex-
tends the time before the company’s revenue stream starts.
The concept of present value can shed light on how this
contributes to the high costs of drugs. Let’s use a numeri-
cal example to illustrate these issues. Assume a drug com-
pany sees that 1 million patients with a particular ailment
are willing and able to pay for a treatment. Suppose it costs
$10 million a year for 10 years to invent a drug. Suppose it
then takes another $10 million a year for another five years
to test it and get it through the approval process. The law
2Manufacturers typically will make some economic profits on drugs after
the expiration of the patent because of brand loyalty among physicians and
patients. Drug company representatives encourage that loyalty with gifts.
Sometimes these gifts are as innocuous as drug company pens while at other
times they are expensive company-sponsored vacations.
300 Chapter 26 The Economics of Prescription Drugs
still have much behavior-modification work to do and that to
the uninsured it comes at a cost of $1,200 month.
These drugs are obviously very expensive and if they
treated diseases for which the patient was blameless or
treated people who have health insurance, we might not con-
sider these costs a problem. The patients who need these are
usually complicit in their fate and frequently do not have in-
surance. That either leaves them untreated or puts enormous
cost pressure on Medicaid. In 2016, 34 states did not cover
Harvoni and 19 states would not pay for the Vivitrol shot.
To counter some of the preceding negative character-
istics, it must be said that the prescription drug indus-
try can also lay claim to lowering health costs in some
areas and to improving lives in nearly all areas. Drugs
treat some diseases that either used to require surgery or,
worse, that simply went untreated. There are drugs, also,
that improve the quality of life and do so in a number
of important areas. Some nonemergency heart condi-
tions can now be treated with drug therapies rather than
$30,000–$50,000 bypass or $10,000–$20,000 catheter-
ization surgeries. Although the drugs are expensive and
cannot be used when a patient is suffering from near-
complete arterial blockages, they can slowly open up the
arteries, and they have been shown to have a success rate
that is comparable to more invasive alternatives.
In other areas new drugs have simply improved life. From
ailments as irritating as seasonal allergies to those as trivial
as heartburn, to those as debilitating as asthma, new drugs
have made the lives of people of all ages much better. While
seasonal allergies and heartburn are never life-threatening,
people’s lives are changed when they are successfully treated.
Before the invention of nonsedating antihistamines
such as Seldane3 and Claritin, allergy sufferers like me
were hard pressed to accomplish much outdoors in the
spring and fall. These medications let allergy suffer-
ers play golf, mow the lawn, and do many other enjoy-
able and productive things that used to only induce fits
of sneezing. Claritin was also shown to be safe enough
that the FDA allowed the drug to go “over the coun-
ter” (meaning no prescription is required) in 2003. Be-
fore anti-heartburn medications such as Nexium,4 spicy,
high-acid, or rich dishes were simply off-limits for many
middle-aged people. While it may seem trivial to the
young, being unable to eat favorite foods affects people’s
quality of life. Being able to eat pizza, Cajun wings, or a
piquant sauce does not rank high in the sphere of important
hand to account for such judgments and to have profit
left over. In countries where lawsuits and judgments
are limited, the prices of drugs tend to be commensu-
rately lower.
Another phenomenon we must account for in analyzing
the prices of drugs is that drug price indexes suffer from
all of the problems that other price indexes suffer from.
The consumer price index’s lapses, discussed briefly in
Chapter 6, are especially problematic with drugs. For an
illustration of this, you need look no further than birth
control pills. The pills your grandmother took in the early
1960s are nothing like those that are available now. The
side effects of the early pills were much more severe than
they are today. Part of the increase in the current price of
birth control pills can be attributed to the improvement of
quality rather than to the effects of inflation.
Taking all of the preceding into account, we are left
with the fact that either drug prices are high or they seem
to be high. The problem of the high expenses of drug
therapies is shown very clearly in the cost of AIDS treat-
ment. The drugs necessary to keep AIDS under control
cost more than $30,000 a year. The modern HIV/AIDS
therapy is a once-a-day pill that renders the former com-
plicated “drug cocktail,” a combination of AZT and prote-
ase inhibitors, obsolete. The cocktail failed many patients
because they failed to follow its requirements. Those that
did, most notably basketball player and L.A. Dodgers’
owner Ervin “Magic” Johnson, lived with AIDS as a man-
ageable disease. The more expensive once-a-day therapy
eliminates patient error. The advance in AIDS treatment
has proceeded from simply sedating patients as they died
painfully, to the cocktail, to the once-a-day therapy. At
each stage the cost of the therapy has increased, but that
does not imply the price increased. The 1980s price of sur-
vival had been infinite, because the price of something that
doesn’t exist is infinite. The 1990s and 2000s price of an
easy-to-follow therapy for AIDS was similarly infinite.
There are two new drugs that have come to market in re-
cent years that deal with sad facts of modern illicit drug use.
Harvoni (a combination of ledipasvir and sofosbuvir, brand
name Sovaldi) treats hepatitis C. It costs $95,000 for a 12-
week course of treatment. It is highly effective (95 percent
or more) in treating the disease that left untreated can lead
to liver cancer and now kills more Americans than AIDS.
The renewed scourge of heroin addiction is plaguing an
increasing number of Americans. A drug, brand-named
Vivitrol gives addicts an injectable, long-lasting form of a
drug proven to work in blocking the mechanism by which
heroin creates its addiction. It literally gives addicts a chance
to change their behaviors. The downsides are that patients
3This drug was pulled from the market because it was shown to interact in
potentially fatal ways with heart medications. 4In extreme cases this drug has reduced the risk of esophageal cancer.
Important Questions 301
R E S T L E S S L E G S S Y N D R O M E ?
You find the same thing in Detroit relative to Windsor, Can-
ada. The drug is not safer in El Paso or Detroit; it is only
more expensive. As a matter of fact, it is often in exactly the
same package. Prices are lower in other parts of the world,
and one of the reasons is certainly price controls.
Would we be better off if the government controlled the
price of drugs? Probably not. The world’s drug inventors
eye the profit that they get in the United States when they
pour billions into their scientists and laboratories. If they
could not make a profit in the United States, there would
be no place to make one and they would not put the money
into innovation. To mix metaphors, the United States is
the drug industry’s cash cow; by controlling prices, we
would be killing the golden goose just as she is producing
some very important life-improving and life-saving eggs.
The law with respect to prescription drugs is in flux.
It has been against the law for companies to buy pre-
scription drugs in a foreign country and resell them in
the United States. Otherwise, a drug company could sell
its products to a Canadian company at a low price deter-
mined by Canadian law. That Canadian company would
then resell them to a U.S. retailer, thereby avoiding the
high price in the United States. This would have the same
effect as allowing Canada to control U.S. prices. Though
considered throughout the Obama years, reimportation
is still illegal.
FDA Approval: Too Stringent or Too Lax?
The approval for, and the regulation of, prescription drugs
is performed by the Food and Drug Administration (FDA).
medical issues, but being able to indulge once in a while
does make life a little more enjoyable.
These latter cases are also not life-threatening, but they
do represent serious quality-of-life issues. The drugs that
treat these ailments may not be critical to life, but they rep-
resent significant advances for people. Some would classify
them as luxuries, but compared to not having the treatments
available, others consider them to be inexpensive.
Why then do prescription drugs get such a bad rap? It is
the reality that drug prices have increased significantly faster
than inflation along with perceptions that economists claim
are not well founded. Our perceptions tell us that the costs of
prescription drugs are much higher than the actual 10 percent
of medical spending for which they are responsible. For
every dollar of expense incurred in hospital or doctor visits,
there is a corresponding patient out-of-pocket cost (9 percent
and 21 percent, respectively). For prescription drugs, out-of-
pocket costs are much higher, at 35 percent. This leaves the
patient more aware of and sensitive to increases in drug costs
than increases in the costs of hospitals and doctors.
Price Controls: Are They the Answer?
Another of the facts that must be faced with regard to drug
prices is that they are higher in the United States than any-
where else in the world. That is because in most other coun-
tries drug prices are regulated. Whether the drug prices
themselves are controlled or the profits from their sales are
controlled, people in other countries pay much less for drugs
than we do. Go to El Paso, Texas, and price a drug, and you
will find it at half price or less across the border in Mexico.
In 2006, a major pharmaceutical manufacturer, GlaxoSmithKline
(yes, it is all one word) began producing and marketing Requip. The
first thing it had to do was market the disease that Requip treated.
So instead of describing the drug’s ability to solve an obvious medi-
cal problem, like high blood pressure or heart disease, it had to tell
people about “restless legs syndrome.” This is what they say about
this particular malady on their website (www.requip.com).
Are your legs keeping you up at night?® Do you dread long busi-
ness meetings, going to the movies, or traveling on an airplane
because you know your restless legs won’t let you sit still?
You just know you’ll have to get up to relieve the discomfort
in your restless legs—disturbing your work colleagues, other
moviegoers, and fellow passengers.
The drug has made millions for the company because they have
effectively convinced people who can’t stand to sit in confined areas
that they have a curable ailment. They have also succeeded in mar-
keting their product to people who can’t get to sleep or stay asleep
because they feel a compulsion to move. The cynical among us
might suspect that this is an example of marketing a drug to a popu-
lation who has money. Who has trouble on long flights? Who sits in
long meetings? Who can’t get to sleep or stay asleep? Middle-aged
businesspeople with money and prescription drug coverage, that’s
who. Economically speaking, the purpose of advertising is to move
the demand curve to the right. In this case, GlaxoSmithKline may
have created it for themselves.
302 Chapter 26 The Economics of Prescription Drugs
This is a prime example of how the marginal analy-
sis of economics can be used to aid in decision making.
The marginal benefit of increasing FDA stringency is the
decrease in the health problems accruing to those who
take approved drugs that later are found to be unsafe.
The marginal cost of increasing FDA stringency is the
forgone increase in the health of people who could have
been treated but were not. The optimal degree of FDA
stringency is where the marginal cost equals the mar-
ginal benefit.
Whether a particular drug goes over the counter is
also a matter for FDA approval. When a new drug shows
that it is sufficiently safe that it can be used by consumers
with little or no consultation with a doctor, the FDA will
approve it for use over the counter. When that occurs, the
price of the drugs falls precipitously because it can be
more easily mass-marketed. Whether that translates into
consumers saving money is another story. It is ironic that
when Claritin went over the counter in 2003, consumers
without prescription drug coverage on their health insur-
ance saw the price fall from more than $100 per month
to around $35 per month, while those with insurance saw
the cost to them rise because no insurance companies
cover over-the-counter drugs. Former Claritin users with
insurance were then motivated to seek more expensive
prescription solutions such as Allegra. Insurance com-
panies have since responded to this trend by requiring
over-the-counter options to be tried before prescription
options are tried.
In the early 1990s the FDA was under scrutiny for not al-
lowing drugs to come to market quickly enough. The issue
then was magnified by the excruciatingly slow process of
getting AIDS drugs approved. As described earlier, the
FDA’s process is a multistage one where a drug is tested
first for its safety and then for its effectiveness. A drug can
be marketed only if both meet a high scientific standard.
While this sounds very good, the problem is that
people will die of afflictions for which there are already
existing drug therapies. For example, in the early 1990s
the AIDS-combating protease inhibitors had been shown
to be safe, but scientists had not yet had the time to show
their effectiveness. Reasoning that unforeseen drug in-
teractions were the least of their worries, dying AIDS
patients wanted the drugs immediately. The problem of
overly stringent FDA regulation is that people die when
they could be saved with a less-stringent process.
During the middle 1990s the FDA began to experiment
with a fast-track approval process. Here, drugs that are
shown to be safe get an expedited review for effectiveness.
The problem is that the initial safety review is conducted
using a relatively small sample of people, while the effec-
tiveness review is conducted using a much larger one. Ad-
verse drug interactions and relatively rare and unforeseen
safety issues come to light during this effectiveness testing.
Expediting the effectiveness testing causes some safety is-
sues to be missed, and as a result the FDA sometimes has to
subsequently pull drugs off the shelves. This was Fen-Phen’s
fate, and it may end up being the fate of all Cox-2 inhibitors.
Key Terms
deadweight loss
orphan drug
patent
Summary
You are now able to apply the concept of monopoly as
well as consumer and producer surplus to the analysis
of the costs of prescription drugs. You are able to apply
those concepts to see the reasons most health economists
view prescription drugs as relatively inexpensive even
while most noneconomists view them as very expensive.
You also understand why it is that most health econo-
mists do not favor price controls on prescription drugs.
Last, you understand how economists see the issue of
FDA approval and the appropriate degree of stringency.
deadweight loss orphan drug patent
Key Terms
Quiz Yourself
1. The prescription drug industry is characterized by
products that have
a. low fixed costs and low marginal costs.
b. low fixed costs and high marginal costs.
c. high fixed costs and low marginal costs.
d. high fixed costs and high marginal costs.
2. A patent is necessary to motivate innovation in areas
where the innovation is
a. costly to figure out and easily copied.
b. cheap to figure out and difficult to copy.
c. costly to figure out and difficult to copy.
d. cheap to figure out and cheap to copy.
Summary 303
Short Answer Questions
1. What reasons are there for not limiting the price,
or at least the increase in the price, of prescription
drugs that have already been invented?
2. What are the reasons why, even if it is in the best
interests of every other country to limit prescription
drug prices, it might not be in the best interests of
the United States to limit those prices?
3. Why might legalizing drug re-importation be equiv-
alent to limiting drug prices?
4. What is lost in terms of societal welfare if, in the
cause of safety, a drug or medical device has its ap-
proval delayed by a year or two?
Think about This
Vioxx and other Cox-2 inhibitors were invented because the
existing pain medications (when taken for persistent pain)
did damage to the lining of the stomach. After years of clin-
ical trials, they were determined to be safe. It was only after
use by millions of people that we became aware of the fact
that they affected the heart. Under what conditions should
their makers be legally liable for these side effects?
Talk about This
When a disease has no cure, people with the disease have
no options. Suppose a prescription drug is invented but is
so expensive that some patients cannot afford it. Are we
better off with a drug being available but only to those
with insurance? What are the social consequences of this?
For More Insight See
Scherer, F. M., “Pricing, Profits, and Technological Prog-
ress in the Pharmaceutical Industry,” Journal of Eco-
nomic Perspectives 7, no. 3 (Summer 1993), pp. 97–115.
Behind the Numbers
Health, United States—www.cdc.gov/nchs
Overall and prescription drug prices—www.bls.gov/cpi
/home.htm
3. The reason orphan drug laws were created was that
the motivation to invent drugs for these diseases was
a. much greater than normal because prices could
be high.
b. much less than normal because prices would be
too low.
c. much less than normal because firms antici-
pated few sales.
d. much greater than normal because firms antici-
pated high sales.
4. The market form for a new drug in an area where
there are no competitors is
a. perfect competition.
b. monopolistic competition.
c. oligopoly.
d. monopoly.
5. The market form for a new drug in an area that has
one other drug is
a. perfect competition.
b. monopolistic competition.
c. oligopoly.
d. monopoly.
6. The approval process for new drugs, if governed
by economic thinking, should set stringency stan-
dards so that the ____________________ equals
the _________________.
a. total cost; total benefit
b. average cost; average benefit
c. marginal cost; marginal benefit
d. cost of production; revenue from sales
7. When an existing prescription drug goes over the
counter
a. everyone wins.
b. drug companies win but consumers lose.
c. drug companies lose but consumers win.
d. drug companies likely win because of the in-
crease in sales, and consumers may win depend-
ing on whether prescriptions are covered by
insurance.
C H A P T E R T W E N T Y - S E V E N
304
So You Want to Be a Lawyer: Economics and the Law Learning Objectives
After reading this chapter you should be able to:
LO1 Describe private property, intellectual property, and
contracts and relate their importance in enabling
economic growth.
LO2 Explain why a system of bankruptcy laws is necessary
to a thriving economy and show why those laws must be
carefully crafted.
LO3 Describe the role of civil litigation in a society and discuss
how economists participate in that arena.
Chapter Outline
Private Property
Bankruptcy
Civil Liability
Summary
This chapter outlines the importance of government
and a legal environment in promoting economic ac-
tivity. It starts by describing why a system of laws is
a prerequisite to a healthy economy and then lays out
the legal framework for private property, intellectual
property, contracts, and bankruptcy. It ends by describ-
ing a liability and tort system that can either aid or de-
tract from economic efficiency depending on how it is
applied.
As Chapter 3 laid out, there are times when markets
fail and governments are needed to step in to correct
those failures. That was not meant to leave the im-
pression that without those “failure” conditions, the
economy would function well with no government.
Clearly, government is necessary to protect us from
physical harm. We need armies and police forces to
keep others from hurting us. Those services are pro-
vided by government in response to a clear market fail-
ure. This chapter focuses on the legal framework under
which our economy operates.
Private Property
Suppose you have a quiz on this chapter in the next
hour and you are reading this book so you can study.
Now also suppose that you are smart and could get a
decent grade on that quiz without reading carefully
and the friend sitting next to you does not have a
book and is not as smart as you are. He could claim
to “need” it more than you and that the gain to him
of reading it is greater than the loss to you of not
reading it. All that may be true, but the book is your
private property to do with what you wish. You sac- rificed money to buy it. It is yours. If your friend
took it from you, you could have him brought up on
charges of theft. Here government plays the role of pro-
tecting and respecting the impor-
tance of private property.
Why does protecting pri-
vate property foster economic
growth? First, it motivates you
private property Land and other physical items that are owned by individuals or a group of individuals.
Private Property 305
to work hard. If you work hard and produce goods and
services for others, they will pay you. If you make a lot of
money from working hard, you can buy stuff. You cannot
count on getting to enjoy the benefits of that hard work if
your earnings, or the stuff you buy with those earnings,
can be taken by others without consequence. Second, gov-
ernment’s protection of private property motivates you to
save. If you save your earnings rather than immediately
consuming them, you are providing the financial capital
for others to buy productive machinery that they would
otherwise not be able to buy. You get the reward of interest
and they have the opportunity to increase their business’s
profit. If fear of theft caused you to consume everything
you earned right away, you would not save. You would be
worse off because of the forgone interest and the borrower
would be worse off because of the forgone profit.
Intellectual Property
Usually, private property is the product of your hard
work. Once in a while that hard work is a result of your
brain power, your imagination,
your creativity, or your insight.
This intellectual property is also protected from those tempted to
steal it. This book is protected
by a copyright. So is 50 Cent’s (pronounced fiddy cent) music
. . . if that’s what you call it. Sim-
ilarly the recipe to the vaccine
protecting you from HPV and its
cancerous consequences is pat-
ented. For the life of the patent, only the inventing company can
produce it. Finally, if you created
a brand name for a blockbuster
product, like BlockBuster did for
renting videos and games, that
name could not be used without
your consent. The instrument
that protects your intellectual
property is called a trademark.
Contracts
In more advanced economies con-
tracts are necessary to lay out the
promises made by two or more parties. This typically oc-
curs because the exchange between parties is not at the same
time. When I buy a Snickers bar at a gas station, I do not need
to sign a contract because I have paid for the Snickers bar
when I received it. I need a contract with my publisher be- cause I wrote this book several months before you bought it.
I was paid my portion of the amount you paid for it about six
to nine months after you bought it.
Without a contract, the publisher
could simply keep the money,
or perhaps hold on to it for years
rather than months. My contract
protects me from my publisher
should it decide to be dishonest.
That contract also protects my
publisher from my laziness. When
I wrote the first edition, they paid
me money in advance on the condition that I would deliver
on my promise of a book they could sell.
Contracts protect both parties and make their prom-
ises binding by something other than their good word. If
I thought there was a chance that I would not be paid, I
would not have taken the many months to have written it
and the publisher would not have made money on it. If the
publisher could not hold me to our agreement that I would
deliver a book, they would not have paid me in advance.
From our Chapter 3 concepts of producer and consumer
surplus, society is better off when the book is produced.
I make royalties, my publisher makes a profit, and a stu-
dent learns about why contracts are necessary. Everyone
is better off because of the existence of contracts.
Enforcing Various Property Rights and Contracts
Just because we have a law that says you cannot do some-
thing does not mean that it is not done. Someone has to
enforce the law. If someone steals your money, you call
the police. Assuming that person is caught and convicted,
the punishment is jail time. If someone copies your song,
book, drug, or marketing trademark, or violates his or her
part in a contract, you have to appeal to a different part of
government: the civil court system. That means you have
to hire a lawyer and get a court date for a judge and jury
to settle who is in the right and who has to pay whom. If
they agree with your claim, the intellectual property thief
or contract violator is punished by being ordered to stop
the violation and to pay you the money you are owed.
So even when markets are perfectly competitive, con-
tracts and property rights are imperative to an economy’s
intellectual property Written and recorded works, ideas, formulas, and other creative intan- gible property that are owned by individuals or a group of individuals.
copyright A right granted by government to a creator of a written or recorded work to be the exclusive seller of that work for a limited period of time.
patent A right granted by government to an inven- tor to be the exclusive seller of that invention for a limited period of time.
trademark A right granted by gov- ernment to a business to be the exclusive user of a phrase, logo, or name of such a business.
contract Written agreement by which each party is bound to provide other parties with goods, services, or financial consideration in ex- change for other goods, services, or financial considerations.
306 Chapter 27 So You Want to Be a Lawyer: Economics and the Law
success, and government, whether it be the police or the
courts, is needed to enforce those rights. Countries with-
out stable and effective governments are typically not suc-
cessful in fostering healthy economies. During the 1990s,
Somalia’s economy collapsed because of lawlessness. No
one could count on agreements being upheld, and no one
had the incentive to create goods for the market because
they were easily stolen. During more recent times, law-
lessness in Iraq not only prevented the U.S. military from
leaving as quickly as the American people had hoped but
also prevented Iraq’s economy from recovering.
Negative Consequences of Private Property Rights
Though a system of private property rights clearly moti-
vates people to work hard and be creative, it also creates
other ethical and economic issues. If you have discussed
the issue chapters on prescription drugs or the cost of col-
lege textbooks, you have become acquainted with some of
these issues. Ethically, how do we accept a level of global
wealth inequality that arises from our system of private
property? Is it ethical to possess the means by which to
manage the AIDs problem and not allow the poor countries
in Africa to produce the medications to do so? Is it ethical
to charge $125 for a textbook that costs $15 to produce?
Is it economically efficient to have monopoly production,
with the resulting deadweight loss, in these goods? Econ-
omists generally agree that the system of private property
motivates these goods to be produced in the first place and
that removing the property rights protections would seri-
ously reduce the incentive to produce them. The ethical
conundrum and the monopoly-induced inefficiency are
the price we pay for creating those incentives.
Bankruptcy
Sometimes people and firms are unable to meet their
financial obligations. Either because they have come on
hard economic times, have had health issues that turned
into financial troubles, or simply spent more than they
had, sometimes people cannot repay the money they
owe. Bankruptcy allows people to start fresh with their debts. The bankruptcy laws have built-in options. Some
people want to keep homes and
cars by agreeing to continue to
pay mortgage and car payments.
Some people want to get out of
debt altogether.
A perfectly reasonable question to ask at this point is
why, if we need government to enforce contracts, would
it make sense to allow people to not repay their debts?
For the answer we have to appeal to our Chapter 1 notion
of incentives. Suppose you are in great debt and whatever
you earn would go to paying on that debt. You would
have no incentive to work if you knew there was no way
out. Providing a system of bankruptcy that allows people
a way out also reenergizes their incentives to work hard.
Of course, when abused, a system of bankruptcy allows
people to consume without ever intending to pay for it.
In 2005, Congress recognized this concern when it re-
formed the bankruptcy laws to put tighter controls on
who could declare bankruptcy and for what purposes.
Since this is a college textbook and you likely are a col-
lege student, it is also important for you to know that part
of the way society pays for the subsidized interest rates on
student loans is to make it so that you cannot escape them
if you declare bankruptcy. They will follow you forever.
Civil Liability
Sometimes the harm one person does to another is not
from taking something from them but from accidentally,
negligently, or purposefully injuring them. Suppose you
are driving along and crash into me in your car, and I
die. My wife and children are clearly harmed. How much
they have been harmed depends on what their lives are
like without me compared to the way life was with me.
Using this fairly straightforward principle and the no-
tion of liability, we can determine how much my family
should get from you and your insurance company.
Before we get into how much harm you have done,
let’s think about how the accident came about. If you were
driving the speed limit, had adequately maintained your
car, were not impaired by alcohol, and were not talking on
your cell phone, but instead were blinded by the sun when
you came around a corner we can argue that this was an
accident. In most states your liability here is limited be-
cause, though you were at fault, it was an accident. Most
states protect the perpetrator of true accidents with limits
on their liability. If you were drinking, or had neglected
your brakes, or were chatting on your cell phone, it can
overcome this shield of liability and you have now be-
come negligent and your liability is unlimited. Similarly,
if you killed me on purpose because this book had bored
you to tears one too many times, you would not only face
civil liability, but criminal liability as well.
bankruptcy The legal state that allows debtors to be protected from the ac- tions of their creditors.
Civil Liability 307
How much my wife has been harmed, though, is in-
dependent of the degree of your liability. So now let’s
assume that you were drunk and your employer knew it
when he sent you out on a delivery. There is no limit on
your liability or your employer’s. We can now look at
your legal exposure by dividing it into monetary losses
and nonmonetary losses. This division is similar to the
accounting cost versus economic cost division from
Chapter 4.
Let’s start with the monetary losses that are relatively
easy to quantify. Suppose I make $75,000 per year as
a professor at my university and I get pension, health,
and other benefits totaling another $25,000 per year. You
could find the present value of $100,000 per year for the
rest of my working life and, depending on the interest
rate chosen and the length of time I am likely to work,
get a pretty good starting point for how much monetary
damage you have done to my family. The present value
of $100,000 per year for 25 years discounting at 5 per-
cent is a little more than $1.4 million.
The problem is that you have not taken into account
any pay increases I might get. You have not figured in
how much this book will earn in royalties that will now
be paid to a substitute author. You have not taken into
account the fact that I might have died from something
else. You have assumed that I will not be fired or will
not just up and quit well before retirement age. You will
have assumed I will retire at the “average” time. You
have assumed an interest rate that is based on an assumed
inflation rate. Economists make assumptions about these
types of variables when testifying in trials, and all go
into creating an expected present value of losses. Let’s
pretend for a moment that your estimates on these vari-
ables are accurate and you can modify your simple pres-
ent value calculation appropriately. Having done so, you
are still missing the nonmonetary losses.
If you go back and review the reasons real GDP is
not synonymous with social welfare from Chapter 6, you
will remember that real GDP only accounts for transac-
tions that take place in markets. My choice to sell my
labor to my university is a market decision, and both my
salary and my benefits count. What does not count there,
and has not counted so far, is my work around the house.
Every day I get up with my children to make them break-
fast and pack them each a lunch. I am a good husband
and father in that I do my share of the cooking, cleaning,
and shopping. I mow the lawn, split firewood, stoke the
fire in the fireplace, help my children with homework,
help them sort through boyfriend/girlfriend issues, and
appropriately discipline them for their errant Internet
usage and excessive text messaging. What’s the loss as-
sociated with all that? What about the loss to my family’s
psychological well-being? These implicit losses are real
but difficult to quantify.
Let’s suppose, for now, that the jury takes all of this
into account and generates a solid, defensible verdict and
jury award. Is it good for the economy? Many would
argue that it is because this type of jury award forces
people to understand and account for the actions they
take that risk harming other people. If you recall from
Chapter 3, markets fail when a person makes an eco-
nomic decision without thinking about the harm done to
an innocent third party. Having people think about all the
economic consequences of their actions helps ensure that
those actions are the correct ones. So if juries get their
awards right, this serves to cause individuals and busi-
nesses to consider all the costs they impose on a society.
The problem is that juries sometimes wildly inflate
the less easy-to-quantify losses. Though I am a good fa-
ther, I am not worth $100 million even if the jury wants
to make a statement against drunk driving or driving
while cell-phone talking. When firms are concerned
that even when they make good-faith mistakes, they will
jeopardize their very existence, they will be overly cau-
tious. A good example of this concern is the arena of
prescription drugs.
When drugs go through the FDA approval process,
they are tested for both their effectiveness in treating the
specific ailment for which they are prescribed as well as
their safety. Assuming they are approved, they are mar-
keted. The advertisements are often humorous without
intending to be. The pitch person talks very calmly about
the drug and its uses, and then someone else talks very
fast about possible side effects. Part of the rationale be-
hind the fast-talking discussion of side effects is to limit
the liability of the drug maker.
Consider Vioxx. It was the first in a line of painkillers
designed for arthritic patients who cannot take aspirin
or Tylenol because these cheap over-the-counter medi-
cations damage the lining of the stomach. After Vioxx
and several other similar Cox-2 inhibitors passed the ap-
proval process, a link between heart problems and these
drugs was discovered. The companies that invented and
marketed them did not immediately pull the drugs at the
moment the first questions were raised, but rather waited
until the links were confirmed. When those ill effects
were confirmed, it was off to the races with civil liability
lawsuits because they waited.
308 Chapter 27 So You Want to Be a Lawyer: Economics and the Law
Why would individuals hire attorneys when they might
lose? The answer is because they don’t have to worry
about losing. Contingency attorneys are lawyers who agree to take a case on the stipulation
that if their client loses, the cli-
ent owes nothing. If they win, the
lawyer typically gets one-third
of the judgment or settlement.
Contingency attorneys take cases
knowing that they may only win
a few of them, but as long as the
payoff to the wins is very high, as
it often is, they can still make a
handsome living.
In other cases, where the
losses to individuals are very
low but where there are many similarly situated victims,
attorneys create class actions. Class actions lawsuits are suits where the concerns of many wronged parties
are grouped into one “class.” A good example here is
my former 2002 Honda Odyssey. For whatever reason,
it is alleged that the odometer on that model overesti-
mated the true distance traveled by 5 percent. The losses
to individuals are likely to be small, but the losses to
the estimated 6 million Honda owners are not small in
total. Because Honda settled the suit, they agreed to pay
for any repairs that they would have paid for had the
odometer reading been accurate. So if I had a 36,000
mile warranty and my engine blew at 37,000 miles, they
would agree to fix it for free. Under the settlement, if I
had already had the repair done, I could submit receipts
to get my money back. Those who leased their minivans
could recover a portion of their mileage overage charges.
What also happened in this case, and what happens in
many class action lawsuits, is that the lawyers get paid,
usually rather handsomely. In the Honda case, the law-
yers netted close to $10 million.
Another example of a class action suit is the Takata
airbag issue. Takata is a Japanese manufacturer of air-
bag components for a variety of automakers (BMW,
Chrysler, Daimler, Ford, General Motors, Honda,
Mazda, Mitsubishi, Nissan, Subaru, and Toyota). At
issue was the tendency (under certain conditions) of
Takata airbags to go off with sufficient explosive force
to turn the airbag housing into lethal shrapnel. By mid-
2016 there were 10 deaths and more than a hundred
injuries attributed to this issue. While there is a national
recall of those airbags, people who own those cars have
to wait, in many cases years, before enough are available
to replace the impacted ones. The loss to those families
directly impacted by a death or injury would be settled
individually. The losses to the owners who experienced
lower-than-otherwise resale value would be dealt with
by class action.
Whether this is good for the economy generally
depends on whether the losses recovered by the wronged
parties are significant, whether firms are more careful to
account for these types of errors, and whether the firms
overcompensate for the fear of losses by not producing
useful goods that might generate such suits. The question
of whether class action suits are, on the whole, useful
devices to protect people and compel businesses to
ensure their products are working properly or whether
the lawsuits and the threat of lawsuits are a drain on the
economy also separates the political parties. Contin-
gency attorneys overwhelmingly favor Democrats while
business interests seeking a limit on their liability over-
whelmingly favor Republicans.
contingency attorney A lawyer who agrees to take a percentage of any judgment or settlement. The attorney is paid only if the client wins the case.
class action lawsuits Suits where similarly harmed people are joined together into one party so as to sue one or more defendants.
Summary
In this chapter we have explored the role of govern-
ment and the law with respect to property, intellectual
property, contracts, bankruptcy, and civil liability. We
have seen that their enforcement adds to economic
efficiency but comes at a cost. We have also seen that
bankruptcy and civil litigation can be used as tools to
enhance economic efficiency but can also be a drag on
the economy.
Key Terms
bankruptcy
class action lawsuit
contingency attorney
contract
copyright
intellectual property
patent
private property
trademark
Summary 309
Quiz Yourself
1. For a market economy to function, economists insist
that government must protect
a. private property.
b. rights to free speech.
c. freedom of assembly.
d. free access to health care.
2. The type of private property that is protected by a
copyright or patent is
a. land.
b. financial capital.
c. intellectual property.
d. personal property.
3. A monopolistic competitor’s brand identity is pro-
tected by a
a. trademark.
b. patent.
c. copyright.
d. bond.
4. Economists insist that bankruptcy laws are always
harmful to a well-functioning economy.
a. True
b. False
5. When one party harms another and the harmed party
hires a lawyer who will collect only if the harmed
party wins the suit, that party has hired a
a. personal injury attorney.
b. contingency attorney.
c. corporate lawyer.
d. disbarred attorney.
6. If an attorney wishes to combine the small claims of
many people into one lawsuit against a defendant, he
or she is engaging in a
a. summary judgment.
b. frivolous tort.
c. pointed claim.
d. class action lawsuit.
Short Answer Questions
1. Mortgages are a form of contract. Why might it not
be in the best interests of the borrower, the lender,
or the house buyer that such a contract be enforced
if the value of the house is much less than the out-
standing balance on the mortgage?
2. What are the potential costs and benefits associated
with allowing for intellectual property rights? Do
they always motivate innovation? Could they inhibit
innovation? How?
3. What are the benefits of having a system that allows
for bankruptcy? What are the costs?
4. In 2011 the Supreme Court heard a case in which
lawyers were attempting to certify that all women
who worked for Walmart were a single class. What
would make you skeptical of such a large “class,”
and why would having a large class such as this
make it more likely that the plaintiffs would get
some settlement in their favor?
Think about This
When an economy creates intellectual property rights,
it must enforce those rights. This is somewhat easy to
do within a country but very difficult to do when the
violator is outside the country. In China copyright in-
fringement runs rampant, and DVDs and CDs are copied
and sold by street vendors for much less than these mov-
ies and albums sell for in the United States. The United
States made this an important part of trade negotiations
and emphasized it more than it emphasized adherence to
international labor standards. Which issue is more im-
portant to you and why?
Talk about This
The Republican and Democratic parties differ greatly
on their view of personal injury and class action law-
suits. Republicans argue that these suits place a signifi-
cant drain on the economy and reduce the motivation
for innovation, especially in the medical arena. Demo-
crats counter that consumers must have recourse when
they are hurt or their interests are damaged by corpora-
tions. Suppose, at some level, they are both right. Where
would you balance the interests of everyone in a grow-
ing but safe economy?
310
The Economics of Crime Learning Objectives
After reading this chapter you should be able to:
LO1 Describe how economics can contribute to the debate over
crime and crime control.
LO2 Describe who generally commits crime and why.
LO3 Conclude that economists who study crime often assume
that criminals are rational.
LO4 Analyze the cost of crime to society and whether we are
currently spending the right amount, focusing on the right
criminals, emphasizing the right crimes, and enforcing the
right sentences.
LO5 Apply the principles of incentives, marginal cost, and
marginal benefit to crime control.
Chapter Outline
Who Commits Crimes and Why
The Rational Criminal Model
The Costs of Crime
Optimal Spending on Crime Control
Summary
Crime is a problem that does not naturally spring to mind
as one for which economists would have much of value
to contribute. Other than early work on crime by Nobel
Prize–winning economist Gary Becker, we have not used
much of our research time and money on this subject.
Still, there are areas where economic analysis is uniquely
suited to deal with the problems of crime. For instance,
a potential criminal makes a decision to commit a crime
based on the income potential of legal work, the booty
to be gained from the crime, and the chance and con-
sequence of getting caught. Couched in different words,
this is not all that different from an investment decision
in which small gains in safe assets are compared to large
gains in risky assets. When looked at this way, econom-
ics and criminology have some important links.
The first thing we do in exploring the economics of
crime is to look at who commits crime. We then see what
a theoretical “investment-like” decision would tell us
about who we should expect will commit crimes. Next,
we use cost–benefit analysis to discuss how the noncrim-
inal public should devote resources in the areas of crime
prevention, detection, apprehension, and punishment.
Last, we use economics to study whether the goals of
life imprisonment and the death penalty have the desired
effects of deterring or preventing future crime.
Who Commits Crimes and Why
Most crime is committed by young men who are socially
and economically disadvantaged. The victims of their
crimes are disproportionately from the same group. Young
black men, for example, overwhelmingly commit crimes
against other young black men. Moreover, when we exam-
ine the disadvantages attributed to racism and compound
them with the economic disadvantage of poor job opportu-
nities, the problem seems to magnify. For instance, in the
latest data where we have the race of both the perpetrator
and victims, white people are killed by other whites in
about the number that would be predicted by the overall
population (82 of 100), whereas 90 of every 100 murdered
blacks are killed by other blacks. In this case the number
C H A P T E R T W E N T Y - E I G H T
The Rational Criminal Model 311
would be just plain stupid to pick the risky and lower-
earning alternative of a life of crime. If you have the skills
to be a doctor or lawyer and have a six-figure salary, the
alternative of clearing $50,000 while selling cocaine is not
all that attractive. Thus the rational criminal theory cor-
rectly predicts that people with high legal incomes are not
likely to be prevalent in the criminal and prison population.
This conclusion may seem trivially easy to come to, but
what is not trivial is how a person with a set of intermediate
skills, earning $10 an hour, or about $20,000 a year, would
treat the issue. To be at that level of income in today’s soci-
ety, most people have completed high school. It is therefore
significant that less than half of those in the prison popula-
tion graduated from high school, and 33 percent were not
working at a legal job just prior to being arrested. Weighing
a $20,000 a year job against a high-risk, high-income crimi-
nal life is hard, and the decision could go either way.
A full-time minimum-wage worker, earning approxi-
mately $14,500 (in 2016), would see the opportunity of
earning a high criminal income as a significantly greater
temptation than would a person making much more. We
would expect that greater economic alternatives in the
legal realm would translate into less crime, and fewer
opportunities would lead to more crime. Why, then, did
crime escalate during the sustained economic growth in
the middle to late 1980s and fall during the sustained
growth of the middle to late 1990s? The answer lies in
the placing of economic opportunities.
If our rational criminal theory is accurate, raising a
middle-, upper-middle-, or high-income person’s economic
prospects should have little to no effect on crime. Even
without a growth in income, such a person would have vir-
tually no incentive to turn to crime. An increase in income
would simply lessen a trivially small temptation and would
have no appreciable impact on crime. On the other hand, if
the economic prospects changed at the low end of the eco-
nomic scale, the effect on crime would likely be substantial.
In the decade and a half from the mid-1970s to the
early 1990s, income inequality rose. Average income
rose because the upper half of the income scale did very
well, while people with little education and few job skills
saw their real spending power remain stagnant or fall.1
What you would expect to see from our rational criminal
model did, in fact, happen. Crime increased substantially
through the period, and it did so more in the lower-
income groups than in the higher-income groups.
predicted by the distribution of the population as a whole
would be 13 out of 100, rather than 90 out of 100.
Crime statistics generally come to us from two sources:
police reports and surveys of crime victims. Those who
view the police to be racially biased may argue that statis-
tics that come from police reports are racially biased, but it
is hard to believe that crime victims would have an interest
in biasing their reports. Falsely reporting an attacker to the
police would diminish the likelihood that the perpetrator
would be caught, and doing so in a survey would not serve
any useful purpose. No matter whether you measure crime
by looking at arrest reports sent to the FBI or by looking at
victimization surveys, the data indicate conclusively that
minorities commit far more crimes than their 38 percent
proportion of the populace. The question is not whether
poor blacks, Hispanics, and other needy members of mi-
nority communities commit more crimes, but why.
The Rational Criminal Model
In the late 1960s, Gary Becker came up with a model
of criminal behavior that explained crime in terms of a
simple investment decision. According to Becker, the
decision to commit a crime is one of risk versus return.
The low-return investment, work at a legal job, has a
low return, but the worker carries no risk of being ar-
rested. On the other hand, the high-return investment,
stealing or selling illegal goods, has a high return, but it
puts the thief or drug dealer at risk of being caught and
punished. In this context, a criminal is no different from
an investment banker who is deciding whether to invest
in tried-and-true U.S. Treasury bonds or a risky initial
public offering of an Internet stock. Just as investors
have a portfolio that contains a mix of risky and safe as-
sets, you would expect to see that most criminals would
have legitimate jobs as well. This is, in fact, the case.
We should take some time to explain what economists
mean when they use the word rational. To an economist,
if people know what it is they want, know the constraints
they face, know the costs of getting what they want, and
choose to proceed with getting it, then they are rational.
This does not mean that these rational people will do
what society thinks is best for them. It means only that
their actions are consistent with their goals, constraints,
and costs. By this standard all but the insane are rational.
Crime Falls When Legal Income Rises
If a person has the potential for earning a higher income
through legal means than illegal ones, then the person
1Of course, the material in Chapter 6 lays out the case that because the CPI over-
states the effects of inflation, real incomes for the poor did not fall but rose slightly.
312 Chapter 28 The Economics of Crime
After the recession of 1990–1991, however, when
crime was at a near-term high, the economic prospects of
low-skill workers began to increase. The minimum wage
was raised from $3.35 to $5.15 during the period, and
both the overall unemployment rate and the unemploy-
ment rate for minorities and for low-skill workers fell. At
the same time, either because of coincidence or because
the model is right, crime fell, and it fell quickly.
The rational criminal model has a more difficult
time explaining the general increase in crime during the
1960s, when incomes rose both in general and within the
poor communities. This highlights an important thing to
keep in mind when it comes to using economics to ex-
plain complex social phenomena. Sometimes a change
in social norms, an area better left to sociologists, or a
change in moral values, an area better left to the clergy,
is at the heart of these social phenomena. Economics is
then less capable of explaining them.
Crime Falls When the Likelihood and Consequences of Getting Caught Rise
The other variable that can change things in this ratio-
nal criminal model is the probability and consequences
of getting caught. We know that crime pays when you do
not get caught. We also know that choosing to become
a criminal becomes less attractive when the chances of
getting away with crime diminish and when the potential
punishment becomes more severe. It is usually true that
if you knew you would get caught, you would choose a
legal occupation. Sometimes, however, this is not true. For
women who possess low levels of education and few mar-
ketable skills, for example, the occupation of prostitute
entails getting caught regularly and going to jail for a few
days as a part of the cost of doing business. The important
thing here is that even given the lost time in jail, for such
women, prostitution pays better than legal work.
To deter potential criminals from committing crimes,
there are two things that we can do. We can make the
chances of meeting punishment greater, and we can make
the punishment more severe. In its simplest terms, the first
implies that by having more police, judges, and jails we
can increase the likelihood that criminals will be caught,
be convicted quickly, and go to jail. The second suggests
that we make the sentences longer or the fines greater.
Though these may seem like two aspects of the same
approach, in part because we are talking about increas-
ing spending on the same kinds of people, they are re-
ally distinct in their intent. The first is intended to make
criminals less confident that they will get away with their
activities. Depending on where in the judicial system the
money is spent, this can provide additional funding for
cops on the street, making detection and apprehension
more likely, or it can provide funds for greater num-
bers of effective prosecutors, who may garner greater
numbers of postarrest guilty verdicts. This differs from
spending more money on prisons and allowing judges to
sentence convicted criminals to longer terms.
Problems with the Rationality Assumption
Criminologists and sociologists have a hard time grant-
ing the assumption that the decision to become a criminal
is a rational economic decision made by people capable
of evaluating complex choices. In support of their view,
you only have to look at the percentage of crime that is
seemingly senseless. School shootings are not explain-
able using economic methods. One of the main criticisms
of economic models is that they assume too much in-
tellectual capacity on the part of humans. For instance,
it might be argued that if criminals could evaluate the
options as rationally as economists claim they can, they
probably would be smart enough not to have to turn
to crime. In any event, economists use the idea of the
“rational criminal” when looking at criminality; and, as
was seen above, the rational criminal model is often con-
sistent with what we know about crime.
The Costs of Crime
In the latest year for which there is comprehensive na-
tional data, 2012, we spent a total of $265 billion on the
police, the judiciary, and prisons. In 2014, 11.2 million
persons were arrested and some 626,644 of that number
got jail time. There were more than 2.2 million Americans
in state or federal jails and prisons. This was all done in
response to the 1.2 million violent and 8.3 million prop-
erty crimes that were reported that year. When we see
these numbers, we wonder whether the money we spend
is worth it, and whether the distribution of spending on
police, justice, and prisons is a good one.
If we put any faith in the model we have been dis-
cussing, we are convinced that by spending money in
this arena, we can change the probability of a crimi-
nal’s being punished and the extent of the punishment.
Of course, we could also talk about spending the money
to raise the legal income potential of people. Some
people argue, for example, that we should take money
that is earmarked for building new prisons and put it
into education and social programs like Head Start and
The Costs of Crime 313
low-crime neighborhoods. This allows economists to cre-
ate a “willingness-to-pay” measure. If people have to pay
$100,000 extra to reduce their likelihood of victimization
by half, then crime “costs” $200,000. This method can
be used to estimate the value of a human life. If someone
is willing to pay $100 to reduce their likelihood of death
from one in 5,000 to one in 10,000, then they are im-
plicitly saying their life is worth $100/.0002 = $500,000.
Another method uses jury awards in wrongful death
and personal injury cases to establish loss estimates. In this
method, the average jury award to the widow of a drunken
driving victim is used as a proxy for the value of the life
lost. The average jury award to a nonfatal accident might
stand in for the intangible loss from a nonfatal assault.
If we simply ignore all of the estimated costs of pain
and suffering and lives lost, then the cost of the average
crime has been estimated at approximately $1,000. Add-
ing the pain and suffering and other intangible costs, some
economists have estimated these costs. For each crime,
the estimates depend on methodology. For murder, the
estimates cluster around $4 million. For rape, estimates
cluster around $100,000. For other assaults, they cluster
around $25,000. Other crimes have much lower estimated
costs, such as $6,000 for car theft and $2,500 for house-
hold burglary. On average, the cost estimates per crime
including pain and suffering cluster around $15,000.
How Much Crime Does an Average Criminal Commit?
We can use these figures to estimate the cost of letting
criminals go free and compare that to the cost of keeping
them in jail. If we know how many crimes the average
criminal commits, we can multiply the average cost per
crime by the average number of crimes committed in a
year to come up with the costs imposed on society by
the early release of a still violent criminal. Looking at
it another way, we can compute the average cost of not
catching and imprisoning a criminal.
Even when we interpret sophisticated criminologi-
cal surveys, we find that the average number of crimes
committed by the average criminal ranges all the way
from 180 down to 10. Most economists are comfortable
with estimates in the range of 10 to 20 crimes. If we as-
sume for a moment that crime would stay the same if
we eliminated all expenditures on law enforcement, the
average savings from keeping average criminals off the
street would range from 10 crimes per criminal times
$500 per crime, or $5,000, to 20 crimes per criminal
times $15,000 per crime, or $300,000.
employment training programs that might help people to
get out of poverty legally. Others point to data that indi-
cate that these programs do not work and suggest that
building prisons is the best of a set of bad alternatives.
On the central questions of whether we are spending
the right amount of money on crime control and whether
we are spending on the right mix of control mechanisms,
we need to examine how much crime there is and how much
it costs us. Using a variety of criminological surveys, we
know that, of the crimes reported annually, more than twice
are actually committed. Though most murders get reported,
robberies, rapes, and other crimes tend not to be universally
reported. Some of this may be attributed to the rationality of
crime victims. If the chances of catching the perpetrator of a
crime are low and the psychological and monetary costs of
testifying are high, then it is quite likely that some victims
will not report crimes committed against them.
How Much Does an Average Crime Cost?
When a crime is committed there are several different kinds
of costs to consider. If we could put a dollar value on the
average crime, we could, at least theoretically, come to an
estimate of the cost of crime in general. The first and most
obvious cost of crime is the value of items taken or stolen.
This is fairly easily measured but it is not always very im-
portant, especially if the crime is a form of assault rather
than a form of theft. Even when the crime is a simple theft,
if the stolen item is replaced with insurance, the cost of the
crime to the victim doesn’t account for the loss to society of
the theft. Insurance rates, for instance, will rise when thefts
are prevalent as will extraneous theft-prevention activities
that add little to actual economic well-being.
As difficult as it is to estimate tangible costs of crime,
it is much harder to estimate the costs of crimes like mur-
der, rape, and assault, because so much of those costs are
intangible. There are some aspects of the loss that are eas-
ier to estimate than others. For example, an assault victim
who cannot work for a few days has a loss that is at least
quantifiable. On the other hand, a sexual assault victim’s
loss in terms of quality of life is not so easily quantified.
Moreover, there is no way of knowing whether having
been a victim of a crime causes people to be less ambi-
tious or productive than they would have been otherwise.
The monetary value of psychological trauma that comes
with victimization is also difficult to estimate.
There are two general methods that are used to
estimate these intangible losses. The first looks at
how much money individuals pay to avoid crimes
by looking at the relative price of homes in high- and
314 Chapter 28 The Economics of Crime
A 2015 study by the Brennan Center for Justice conducted by economists
and criminologists separated out the impact of various policies on the
decline in crime that occurred during the 1990s and 2000s. Their study
looked at the impact of increased incarcerations, increased numbers of
police, the use of CompStat policies that used sophisticated statistics
to deploy resources, the increased prevalence of the death penalty,
and the increased prevalence of right-to-carry laws. They looked at
economic factors such as consumer confidence, income growth, and
unemployment. They looked at social and demographic trends, from
the decreased use of crack cocaine and alcohol, to a decrease in the
percentage of the population in their prime crime years (ages 16–24).
They began by noting the nearly 50 percent drop in the crime rate
since 1991. With violent crime dropping by 51 percent and property
crime dropping by 43 percent, something caused it to happen, and
these scholars wanted to figure out what that was. They wanted to
know whether it was any of the myriad policies that were tried or
whether the drop was caused by something unrelated to crime policy.
One key conclusion was a wonderful example of diminishing re-
turns. At first, during the 1990s, increased rates of incarceration had
a significant impact, explaining as much as 10 percent of the drop in
crime. Later, in the period from 2000 to 2013, rates of incarceration
had no additional impact on crime. They found much the same thing
with the impact of increasing the numbers of police. At first there
was a large impact, but later there was no impact. Those with good
economic intuition should not be surprised that diminishing returns
would show itself in crime reduction.
The state of the local economy was a consistent factor in explain-
ing crime rates as was the drop in the use of alcohol. CompStat also
showed itself to have a positive effect in reducing crime but only as
the methodology was honed in the 2000s.
Two interesting theories appeared during the 2000s (and in this
textbox in previous editions of this book) to explain the drop in crime
in the 1990s; both had their origins in changes that occurred during
the 1970s. The first of these theories was that the legalization of abor-
tion increased the average degree of “wantedness” of the children
who were born in the 1970s and thereby resulted in fewer poorly par-
ented children in the 1980s and 1990s. With fewer poorly parented
children in the 1970s and 1980s, that, it was hypothesized, would
have resulted in fewer crimes in the 1990s. The second of these theo-
ries tied atmospheric lead concentrations to criminal conduct. This
theory offered as proof that the increase in atmospheric lead that
occurred because of increased driving in the 1950s and 1960s was,
20 years later, associated with an increase in crime in the 1970s and
1990s. It further argued that the subsequent decrease in atmospheric
lead because of 1970s-era laws that eliminated it from gasoline led
to decreased crime in the 1990s. The explanation, that lead in young
children inhibits the judgment centers of the brain, seemed plausible.
However, once all factors were taken into account, both of these
theories were held to be without empirical support.
Policy favorites of the political right, increased use of the death
penalty and increased prevalence of right-to-carry laws, were also
shown to be without merit.
T H I N G S T H A T M A T T E R I N C R I M E
Optimal Spending on Crime Control
What Is the Optimal Amount to Spend?
The average cost of holding a criminal in jail is
$31,000 per year, and the total cost of incarcerations,
$82 billion. Assuming that crime rates would rise if we
eliminated all expenditures on law enforcement—either
by the average criminal’s committing more crimes or be-
cause otherwise law-abiding citizens turned to crime—it
is quite clear that the money we spend on prisons is worth
it. Even though more than 1.6 million people are in state
or federal prisons at a cost of approximately $82 billion a
year, this may be a good expenditure.
The question of whether we spend the optimal
amount on keeping people in prisons, however, remains
to be answered. At this time, there are far more than
double the number of felons on the street than in prison.
These are people who have served their sentences, been
released on parole, or were never imprisoned in the first
place. If they are committing crimes at a rate similar to
the 15 to 20 crimes a year that incarcerated criminals
were committing, then we have too few people in prison.
Of key concern to economists is not necessarily whether
the total amount spent on crime control exceeds the total
amount saved from preventing crime, but whether we are
spending the correct amount. At its heart, the problem is
exactly the same as the profit-maximizing problem for a
business firm. The mere fact that a firm’s revenues exceed
its costs does not mean that profit is as high as it could be.
That means we are less interested in the costs and benefits
of capturing, trying, and incarcerating the “average” crimi-
nal than we are in incarcerating the “marginal” criminal.
Think of it this way. Suppose we catch a prolific thief
who costs society $100,000 a year, and it costs $31,000
a year to lock him up. Now suppose we catch a part-
time thief who costs society only $10,000 a year, and it
still costs $31,000 a year to lock him up. The interme-
diate or average thief costs society $55,000 each year,
and we spend $31,000 per year keeping him locked up.
This does not mean we should not have locked up the
Optimal Spending on Crime Control 315
In recent years, particularly as an outgrowth of the Black
Lives Matter movement, critics have called into question
the practice of incarcerating so many people, for so long.
These critics have noted that the increase in incarceration
frequency and duration has impacted the African American
population disproportionately. Those that counter this argu-
ment turn to the data on crime that shows (again, without
regard to whether you use victimization surveys or police
reports) that minorities commit a disproportionate amount
of crime and that the drop in the crime rate that resulted
from these incarcerations is worth the cost. If you accept
their conclusion that the increase in incarcerations in the
1990s decreased crime (which evidence shows occurred)
and in the 2000s (which new evidence suggests did not
occur), that need not require you to accept that the increase
in the cost (both monetary and social) is worth it.
What Laws Should We Rigorously Enforce?
In a formal way, economists look at crime control mea-
sures from a cost–benefit point of view. In Figure 28.1
the vertical axis represents the amount of marginal ben-
efit and marginal cost associated with catching, adjudi-
cating, and imprisoning an additional criminal. We will
make three assumptions:
1. The marginal benefits are decreasing for each addi-
tional criminal.
2. We will deal with serious crimes first and petty
crimes last.
3. The dollar benefits of preventing these crimes will fall.
part-time thief. The marginal benefit to society of lock-
ing him up was less than the marginal cost.
Applying this information to the problem of opti-
mal crime control means that we would need to look at
who the people are who get arrested and put away when
we increase spending on criminal justice. The practi-
cal problem is much harder to figure out than it is for
a firm. In business we can see how much extra material
and labor costs go into producing another unit of output
and judge whether that is greater than the price, but we
cannot easily determine which extra criminals are caught
as a result of our spending more on police. Are these
criminals more or less prolific than the average crimi-
nal caught before the spending increase? For this reason,
much of the research on crime assumes that the “mar-
ginal” criminal is just like the “average” criminal.
Is the Money Spent in the Right Way?
Whether we spend the right amount of money is inter-
esting, but equally interesting is whether we spend the
money in the right way. Again, marginal analysis is of
use. If we spend $265 billion on the system, the allo-
cation between police, justice, and incarceration should
depend on how effective the marginal dollar is in com-
bating crime in each category. If the optimal distribution
is accomplished, the marginal benefit of a dollar should
be equal in the three areas.
Are the Right People in Jail?
Of course there is the related issue of whether the right
people are in jail. Of the 1.6 million people who are in
prisons and 744,600 in local jails, just under half are
there for violent crimes. The remainder are there for
nonviolent crimes such as burglary, drug possession,
and drug distribution. If these prison spaces are being
used for drug offenders rather than violent criminals or
thieves, perhaps the wrong people are in jail. If we re-
lease violent criminals in order to make room in prisons
for drug users, we will have to either build more prisons
or let the drug users go.
In recognition of this choice, state and local govern-
ments decided to go on a prison-building spree. In Texas,
for example, prison capacity during the 1980s and 1990s
was nearly doubling every four years. This phenomenon
was certainly not confined to any one state, as state after
state went to “truth in sentencing” laws that required
criminals to serve at least 85 percent of their sentence.
In Florida and Texas, felons had been serving less than a
third of their sentences, a disparity these states and oth-
ers found unacceptable.
FIGURE 28.1 Marginal cost and marginal benefit analysis and crime.
Marginal cost
Marginal cost Marginal benefit
Marginal benefit
Murderers, Rapists, Drug dealers, Drug users, Jaywalkers
Criminals
316 Chapter 28 The Economics of Crime
committing the crimes they would have committed had
they been left on the streets.
What Is the Optimal Sentence?
One of the major debates of our time is whether criminals
convicted of murder and other of the most heinous crimes
should be put to death or be locked up with no opportunity
for parole. While many religious leaders and laypersons
alike approach this as a moral issue, economists again tend
to look at it from the standpoint of the costs and benefits.
If you sentence men and women to death, the sentences are
carried out only after a long and drawn-out appeal process.
Even then, many death row inmates die on their prison cots
rather than face injection, asphyxiation, or electrocution. In
economic terms we have to decide whether spending a lot
of money over a 10-year period is worth the savings in im-
prisonment expenses. Life sentences, which are routinely
given in murder cases, also have cost issues to face. If a
75-year-old is released from prison, is he or she likely to
again become a menace to society?
To examine whether the death penalty saves money or
costs money we need to recall the Chapter 7 concept of
present value. Suppose it would take $1 million invested
now to make the payments to house, adjudicate appeals,
and put to death a condemned inmate. Suppose it would
cost less than $1 million invested now to simply house
the inmate from the time he or she is sentenced to the
time that inmate would have died if given a life sentence.
In such a circumstance the death penalty costs money.
Otherwise it saves money. This of course assumes that
the death penalty is not a deterrent. It may also be that it
costs $1 million in present value to execute a person and
$900,000 to imprison the same person for life, but we get
$100,000 or more worth of satisfaction knowing that the
worst of the bad guys got his or her due.
The cost–benefit trade-off is important also in estab-
lishing sentence length. Since nearly no crime is commit-
ted by 80-year-olds, does it make sense to sentence people
to life in prison? Why not let them out when the chances
of their committing a crime have gone away? It is not hard
to figure that, as time goes on, a person violent enough to
kill at age 18 is not as likely to commit murder at 50 and
is even less likely to at 70. This point may not be worth
considering since the life expectancy in prison is such that
few inmates sentenced to life live long enough to outlive
their own violent tendencies. Prison life is hard, and the
food and medical care are not geared to keeping people
healthy in their “golden years.” Ironically, this makes the
death penalty even less economically sensible since the
“lifer’s” life is not going to be that long.
Furthermore, we will assume that the marginal cost
of dealing with criminals increases because the petty
criminals violating trivial laws are assumed to be more
expensive to catch and convict than are criminals whose
crimes are more serious. This assumption is predicated
on the idea that we would have to have very many and,
most important, less competent police2 to catch such
violators.
Figure 28.1 indicates that it makes sense to spend the
money to catch, prosecute, and imprison all murderers,
rapists, and high-end drug dealers. It also indicates that
it makes no sense to do the same for jaywalkers, drug
users, and low-end drug dealers. Though this picture
is simplistic in its assumptions, you can see, roughly,
how an economist reasons on the issue of crime control.
Spend the money on the really bad guys and do not spend
it on the not-so-bad guys.
That leaves one last issue to deal with in determin-
ing how we spend our law enforcement dollars: How
do we divide the money among the various sectors?
States, for example, have spent a growing part of
their budgets to deal with crime and in doing so have
changed the percentage that they allocate to the differ-
ent sectors. The increase in resources has gone mainly
to prisons and police, with a smaller percentage of
money allocated to adjudication. Competent police are
more effective in deterring criminals and apprehend-
ing criminals who have not yet been deterred. It also
means that people sentenced stay in jail longer. The
downside of this is that more cases are plea-bargained
than ever before.
Since the increases in spending have not funded all
sectors of the system evenly, criminals are more likely
to be caught, plea to a crime that is less severe than the
one they actually committed, and go to jail. The length
of term they face has probably increased because 85 per-
cent of a short sentence is often longer than 33 percent
of a long one. Part of the reduction in crime since the
early 1990s is also attributable to this policy of sending
greater numbers of criminals to prison. A small minority
of criminals commit a majority of the crime, and they
now must stay in prison longer. Though estimates vary,
an increase of 10 percent in the prison population has
been shown to result in a 4 percent to 6 percent decrease
in crime. Whereas some of this may be deterrence, it is
likely that simply holding criminals prevents them from
2We assume they are likely to be less competent because cities hire the more
competent of their applicant pool first, and these are all gone when it comes
time to hire more.
Summary 317
Summary
You should now understand how economics, and in
particular the use of marginal benefit–marginal cost anal-
ysis, can contribute to the debate over crime and crime
control. Besides knowing who it is that generally commits
crime and why, you have seen that economists often model
criminals as rational human actors who are influenced by
the risks and rewards of their decisions. You have seen
how much crime costs society and how much we spend to
control it. You have seen how an economist looks at issues
of crime control to answer questions about whether we are
spending the right amount on the right criminals and the
right crimes and enforcing the right sentences.
Quiz Yourself
1. If judges had to be trained as economists before tak-
ing their position, they might use ____________
analysis when deciding on the right sentence.
a. marginal
b. punitive
c. religious
d. average
2. The optimal level of police protection would com-
pare the __________________________________
with the _______________________.
a. marginal cost of hiring an additional officer;
marginal benefit of crime reduction
b. average cost of all officers; average benefit per
officer of crime reduction
c. total cost of all officers; average benefit of
crime reduction
d. length of the average sentence; history of sen-
tences, per crime
3. If a crime prevention mechanism works initially, but
increasing it further has no additional impact that is
an example of
a. diminishing returns.
b. downward sloping demand.
c. the division of labor.
d. economic loss.
4. The average cost per crime has been estimated at
between
a. $500 and $2,500.
b. $1,000 and $10,000.
c. $10,000 and $100,000.
d. $100,000 and $1,000,000.
5. To an economist, the correct distribution of money
among police, the justice system, and prisons is one
that
a. sets an equal amount to each.
b. sets the amount each gets equal to its average
benefit.
c. sets the amount each gets so that none is wasted.
d. sets the amount each gets so that no other ele-
ment could get better use (in terms of crime
reduction) of the marginal dollar.
6. The rational crime model explains crimes of
a. passion.
b. stupidity.
c. profit.
d. love.
7. The rational criminal model draws a parallel to the
thought processes of
a. investors.
b. educators.
c. law enforcement officers.
d. politicians.
Short Answer Questions
1. How would you use marginal benefit and marginal
cost analysis to determine the correct sentence
length for a particular crime?
2. How could you use marginal benefit and marginal
cost analysis to determine whether money would
be better spent keeping prisoners incarcerated or on
employing more police?
3. Why is it important to use marginal analysis in ex-
amining crime policies rather than “average” (cost
and benefit) analysis?
4. What other policy changes could you make now that
would have a similarly delayed impact on crime sev-
eral years from now?
Think about This
The rational criminal model is often invoked to ex-
plain the behavior of drug dealers and their pushers.
Economist Steven Levitt disputes this by suggesting
that drug dealers engage in behaviors that are just as
irrational as those who play the lottery. Is drug deal-
ing rational?
318 Chapter 28 The Economics of Crime
Talk about This
Under what circumstances would you engage in a crimi-
nal activity? Would your actions be rational?
For More Insight See
Journal of Economic Perspectives 10, no. 1 (Winter
1996). See articles by John J. DiIulio; and Richard B.
Freeman and Isaac Ehrlich, pp. 3–8.
Cohen, Mark, The Costs of Crime and Justice (New
York: Routledge, 2005).
Levitt, Steven D., “Understanding Why Crime Fell in the
1990s: Four Factors That Explain the Decline and Six
That Do Not,” Journal of Economic Perspectives 18,
no. 1 (Winter 2004).
Reyes, Jessica Wolpaw, “Environmental Policy as Social
Policy? The Impact of Childhood Lead Exposure on
Crime,” The B.E. Journal of Economic Analysis &
Policy 7, no. 1 (2007), Contributions, Article 51.
“What Caused The Crime Decline?” Roeder, Eisen, and
Bowling. Brennan Center for Justice. www.brennan
center.org/publication/what-caused-crime-decline,
2015.
Behind the Numbers
Federal justice system statistics on crime, federal justice
system expenditures; number of arrests and inmates,
Bureau of Justice Statistics; characteristics of vic-
tims, criminals, and types of crime committed, U.S.
Department of Justice; Bureau of Justice Statistics;
crime and victim statistics—www.bjs.gov
Crime in the United States, Federal Bureau of
Investigation—www.fbi.gov/about-us/cjis/ucr
/crime-in-the-u.s
319
Antitrust Learning Objectives
After reading this chapter you should be able to:
LO1 Understand why economists worry about monopolies and
why some monopolies are inevitable and even good for
society.
LO2 Be aware that laws regulate the existence and pricing be-
havior of monopolies.
LO3 See how antitrust law has been applied to specific industries
within the United States.
Chapter Outline
What’s Wrong with Monopoly?
Natural Monopolies and Necessary Monopolies
Monopolies and the Law
Examples of Antitrust Action
Summary
When a business treats us badly, most of us get a high degree
of satisfaction by announcing that we will never be back.
When the business is the phone, gas, electric, or water com-
pany, though, it is frustrating because in most cases we can-
not get our gas, electricity, or water somewhere else. We all
buy goods or services from businesses that are monopolists.
It is likely that you have only one source of cable television,
electricity, water, or natural gas. When a representative of a
monopolistic company makes you mad, you know and the
representative knows that you have no alternatives; you are
stuck. You can scream and complain, but in the end you
have to go back to the same company for service. For capi-
talism to function, these situations work best when there is
both a carrot of high profits and a stick of bankruptcy to
keep firms working in the consumer’s best interest. Without
such incentives, a company’s profit motive tends to work
against consumers rather than in their best interests.
It is for this reason that we have laws that inhibit firms
from becoming monopolies through merger, and we have
laws that prevent the monopolies that do exist from using
their power to the detriment of consumers. That said, this
chapter reviews what it is about monopoly that concerns
economists and we also discuss situations where monopo-
lies may be necessary evils. We then turn to laws that are in
place to protect consumers from the problems that monopo-
lists cause. We attempt to figure out how many competitors
are needed for competition to work, and we provide a few
examples of firms that have been accused of using their mo-
nopoly power to the detriment of their customers.
What’s Wrong with Monopoly?
High Prices, Low Output, and Deadweight Loss
A survey of economists published in 1992 suggests that
72 percent agree, in whole or in part, with the idea that “laws
should be rigorously enforced to reduce monopoly power”1
and that it is a proper role for government to prevent monopo-
lies from charging excessive prices for shoddy products. Fig-
ure 29.1 illustrates the core of the problem with monopolies.
Chapter 5 told us that a monopolist controls an entire
market. That is, when we diagram the monopolistic situ-
ation, the market demand curve will be the demand curve
for the firm’s output. What follows from this is that to sell
more of its good, the firm has to progressively lower the
price it charges. When the firm lowers prices, the resulting
graph shows that the marginal revenue curve is not flat, as
it is under perfect competition, but is downward sloping. In
C H A P T E R T W E N T Y - N I N E
1Alston, Kearl, and Vaughn, American Economic Review 82, no. 2 (May 1992),
pp. 203–209.
320 Chapter 29 Antitrust
above the supply or marginal cost curve, would be FP PC
C
for a combined social benefit of FAC. (See Chapter 3 if
you need to review consumer and producer surplus.) In
an industry that is ruled by just one firm rather than many,
the consumer surplus is much smaller and the producer
surplus somewhat larger. To be precise, the consumer sur-
plus shrinks to P monopoly
AB and the producer surplus grows
to FP monopoly
BE. The combined area is FABE. This is
smaller than the combined area under perfect competition
by the triangle EBC. Economists call this area deadweight
loss because it represents the loss in economic benefits to
society that results from carrying a deadweight—that is,
a monopolist.
The desire to eliminate deadweight loss is at the heart
of why economists, usually reluctant to let government
control markets, generally accept the need for govern-
ment to intervene in monopoly cases.
Reduced Innovation
Another problem with monopolies—both those subject to
price control by government and those that are government-
owned, like the post office—is the reduction in the motiva-
tion to innovate. When there are no competitors to keep a
business on its toes, it can easily get lax. Monopolies like
your local water company are much less likely to engage in
cost-saving or service-enhancing innovation when they are
not threatened with competition. Even worse, since they
use their costs to justify their prices to regulators, they have
an incentive to pad costs that make their own jobs easier.
This problem is not limited to privately held monopo-
lies. The U.S. Postal Service is a government-held mo-
nopoly for letters. It did not consider overnight delivery
important until Federal Express and United Parcel Service
developed the business. Cost-saving or service-enhancing
technology is less likely to come from the U.S. mail than
it is from the private package delivery companies.
Natural Monopolies and Necessary Monopolies
Natural Monopoly
Many of the monopolies that we deal with every day are
inevitable. The utilities—electricity, natural gas, local tele-
phone service, sewers, and cable television—are monopo-
lies where there are very high fixed costs and diminishing
marginal costs. On an intuitive level you understand that
you would not want several hundred wires or pipes coming
in and out of your house. It would be ugly and expensive
particular, it has the same vertical intercept as the demand
curve, and it cuts the horizontal axis at exactly half where
the demand curve does. (Refer back to Chapter 4 and the
discussion of marginal revenue to see why this is the case.)
Assuming that its goal is to maximize profits, a monopo-
listic organization will sell its output at a price that is deter-
mined by the point on the graph at which marginal cost and
marginal revenue are equal. In Figure 29.1 that output level
is Q monopoly
. The price a monopolistic firm would charge for
that output can be found by going up from Q monopoly
to the
demand curve and over to the price axis to get P monopoly
.
To compare this monopoly outcome to what would
exist in an industry made up of many firms in perfect
competition, we need to recall that the supply curve for
each individual perfect competitor is its marginal cost
curve. To find the industry supply curve, we would hori-
zontally add the individual supply curves together. When
we do that we find that we have also created the mar-
ginal cost curve for an industry ruled by one firm. That
is why, in Figure 29.1, the supply curve for the industry
of perfect competitors is also labeled as the marginal
cost curve for the monopolist. It is simply a different in-
terpretation of the same information. It is not, however,
the monopolist’s supply curve. There is no such thing
because monopolists do not take the price as given; they
search for the price that makes them the most money.
Given that, we can say that if an industry is character-
ized by many perfectly competitive firms rather than a
monopolistic firm, then the price–quantity combination
will be where supply equals demand: P PC
, Q PC
.
Under perfect competition we know that the consumer
surplus, depicted as the area under the demand curve but
above the price line, would be P PC
AC and the producer
surplus, depicted as the area under the price curve but
MR
Q/tO
P
D
C
B
F
E
A
PPC
Pmonopoly
Qmonopoly QPC
SPC MC monopoly
FIGURE 29.1 Perfect competition versus monopoly.
Natural Monopolies and Necessary Monopolies 321
curve ATC crosses the demand curve D. It should be
clear that the difference between what an unregulated
natural monopoly would charge, P monopoly
, and what a reg-
ulator would let it charge, P regulated
, is substantial. For this
reason, it is argued that we are better off with one utility
company that is prevented from exploiting its position,
and we know that most local telephone, electrical power,
and natural gas service are provided through regulated
monopolies in the United States.
This need not be the end of the story. Technology and
a revised legal structure are changing the competitive na-
ture of many of these utilities. Satellite dishes are doing
as much to keep cable TV rates down as regulation ever
did. Cable companies are now selling phone and Internet
access that was once provided only by a monopoly tele-
phone company. An additional challenge to local phone
companies is coming from the wireless phone industry.
Many young people no longer have a home phone; they
simply use cellular phones.
Though the poorly thought-out California electricity
deregulation experiment was a disaster, some commu-
nities are deregulating the electric power industry suc-
cessfully. These forms of deregulation have the existing
provider charge a wire access fee. This fee is similar to
the fee that your local telephone company charges you
to use its lines with a different long-distance provider. In
this way there are competing electricity producers that
sell to customers. It may be that in the near future these
once inevitable natural monopolies will face competition.
Patents, Copyrights, and Other Necessary Monopolies
Copyrights and patents are examples of other legalized
monopolies that we have decided are needed for the
economy to work well. The only way singers, authors,
or moviemakers make money on their creative work is
through their exclusive right to sell it. If you electroni-
cally copy a CD, a book, or a movie, you know the cost
is usually much lower than if you buy it in the store at full
retail price. Monopoly power is given to record compa-
nies, publishers, and movie producers so they can make
enough money to inspire their efforts.
Consider the late 1990s and early 2000s history
of file-sharing networks like the original Napster and
Kazaa. For users it was their first introduction to the
Internet and downloaded music. They learned that they
could get all the latest music without paying for it. Many
in the music industry believed that they were in violation
of the copyright laws. They were correct and a federal
for there to be many different electric companies vying
for your business. Changes in technology and reforms of
the regulatory structure are rapidly changing the way these
utilities do business. Still each locale typically has only
one provider of these services.
If you look at Figure 29.2, you can see the problem
in the context of Chapter 4’s cost curves. Instead of the
marginal cost curve’s sloping up and the average total
cost curve’s being U-shaped, both are downward slop-
ing and steadily flattening out. In a typical monopoly,
the fixed costs of stringing wires or burying pipes are so
great that output levels never get to where marginal costs
are rising.
It is the large fixed costs that represent a potentially
insurmountable economic barrier to entry. Recall from Chapter 5 one of the four re-
quirements for perfect compe-
tition is freedom of entry and
exit. When fixed costs are high,
it is nearly impossible for a firm
to get a foothold in the market.
If the fixed costs are significant, then having more than
one firm bearing them is not cost-efficient. A carefully
regulated monopoly in this case may save money for the
consumer. The quality of regulation is definitely the key,
because the company will want to charge P monopoly
and
produce only Q monopoly
. The monopolist wants to exploit
the power it has, and it is part of the government’s job to
provide the regulation that prevents that from happening.
Government regulators will allow monopolies normal
profit, the profit consistent with what a similar invest-
ment would get them in another industry. This is depicted
in Figure 29.2 as the point at which the average total cost
barrier to entry A legal or economic mechanism that prevents firms from competing in an industry.
D
Q/t
P
Pmonopoly
Qmonopoly Qregulated
Pregulated MR MC
ATC
FIGURE 29.2 Natural monopoly.
322 Chapter 29 Antitrust
power in one market to enhance its position in another.3
According to the Sherman Act it is also illegal to attempt
to control a market in all of its stages of production.
As we saw above, there are cases where monopoly
power is a good thing. As a matter of fact, it is the ulti-
mate carrot for a business. If a manufacturer is so good
that it makes a product so much better than that of its
competition, then it will, of course, benefit by having no
competition. As long as the company is that good and as
long as it continues to price its product low enough that
other firms see no point in joining in, there is no demon-
strable harm from having a monopoly. Concomitantly,
there is no violation of antitrust law. Later in the chapter
we will see that Microsoft claims to be a company that
has performed so well that it became a monopoly in the
operating system business.
As we said previously, it is against the law to use mo-
nopoly power in a given area to generate business in an-
other area. For instance, if a telephone company with a
monopoly in a particular region sells cellular telephone
service where it does not have a monopoly, it cannot re-
quire that its local telephone customers subscribe to its
cellular service.
Antitrust law also forbids a company from control-
ling the entire production-to-sales process for a particular
good. This is what got Standard Oil in trouble with the
government in the early 1900s. At one time, Standard Oil
dominated the oil and gasoline industry through its owner-
ship and control of drilling equipment, oil wells, refiner-
ies, pipelines, distribution networks, and gas stations. This
was found at the time to be illegal, and it is still illegal.
Other parts of the law work toward preventing compa-
nies from becoming monopolistic by merging. It is very
much against the law for two separate companies, in an
industry of only a few, to share information or to collude
on setting prices. This is called “price fixing,” and local
gasoline stations are accused of it all the time. Just as
someone realized that companies could fix prices if they
merged, Congress gave power to the Federal Trade Com-
mission (FTC) to allow or to deny proposed mergers.
When two airlines merge and it is a merger that would
lead to a monopoly at an important airport, the FTC
steps in. It can simply say no to the merger, or it can re-
quire that the airline sell its gate access to another airline.
The interesting exception to this general rule is the
case of Sirius/XM radio. Both companies were on the
court shut the original Napster down.2 The economic
issue at the time was how this type of service affected
the motivation to produce new music. What’s interest-
ing now is that downloaded music has become another
interesting antitrust example with Apple’s dominance in
that market area as it has successfully used its iPhone
and iTunes brands to reinforce each other.
Patents are given to inventors of new things for the
same reason that copyrights are given to writers and per-
formers. Patents expire after a number of years, depend-
ing on the type of invention. While the patent is in force,
however, the inventor is the only one who has the right to
sell his or her invention. Whether the invention is a new
drug, or the proverbial better mouse trap, it belongs to
the inventor. In the modern era, scientists usually work
for a big company that retains the right to buy their ideas
for $1 each. Although this may seem unfair, scientists are
often part of a team that jointly creates ideas. In addition,
since inventing is a risky business with inventions only
rarely striking it big in the marketplace, the companies
guarantee the scientist an income. For that, they get to
keep the high returns.
In any event, the exclusive right to sell something cre-
ates the incentive to be creative or innovative, as the case
may be. The author of the book you are reading right
now would like to think he would have written this book
for the good of his own students’ understanding, but the
truth is he is working for money, too. Lest you think I am
the only one, ask yourself whether you too are not moti-
vated to work by money. Writers, singers, moviemakers,
or inventors need the protection accorded monopolies to
make money at their endeavors.
The rationale for other monopolies is that they provide
a social good. The U.S. Postal Service performs the social
service of providing equal mail service at an equal price
to everyone anywhere in the United States. Though its de-
tractors suggest that a privatized system would be more
efficient and cost less, its defenders believe that the “social
good” is sufficient to justify any monopoly inefficiencies.
Monopolies and the Law
The Sherman Anti-Trust Act
Under the law it is not illegal to be a monopoly. It is not
even against the law for a company to establish itself as
a monopoly. The Sherman Anti-Trust Act of 1890, how-
ever, makes it illegal for a company to use its monopoly
2The new Napster sells downloaded music legitimately.
3While a number of important laws amending and clarifying the Sherman Act
have been enacted since 1890, for simplicity and brevity we will consider this
one body of antitrust law.
Examples of Antitrust Action 323
basis of its ability to charge much less than the price that is
currently being charged. What will you do? You keep your
price low in hopes that Southwest will ignore you.
To its firm believers, this
contestable markets hypothesis means that the answer to the
question of how many firms it
takes to have competitive prices
is one, as long as it is one that
is scared.
Examples of Antitrust Action
Standard Oil
When John D. Rockefeller established Standard Oil, no one
knew how petroleum would change the world. By the time
the huge monopoly that was Standard Oil was broken up,
Rockefeller had become the richest man the world had ever
known. If you measure personal wealth as the percentage of
all U.S. wealth, Bill Gates would have to more than double
his to come close to Rockefeller’s. Rockefeller got as rich as
he did by controlling the entire petroleum production pro-
cess. He owned the oil fields, all the drilling equipment, all
the pipelines and trucks that distributed it, and he licensed
all the retail outlets that sold his gas, oil, and kerosene.
This kind of monopoly,
called a trust, involves the sin- gle ownership of all stages of
production, and it has been ac-
complished to this degree only a
few times. A comparable situa-
tion would occur if Bill Gates owned not only Microsoft
but also Intel, Dell, Apple, Hewlett Packard, and all other
computer hardware manufacturers, and he licensed fran-
chises to all of the retail outlets that sold computers.
In Rockefeller’s case he used the total control he had
over the oil production business to gain control over
the pipelines and the retail outlets. He did this by sim-
ply refusing to use pipelines that refused to sell to him,
and he refused to sell his products to stations that he did
not license. He then used this power to make even more
money by buying the pipelines at low prices and by sell-
ing his products to filling stations at high prices. Our
debt to Rockefeller is that much of the law making trusts
illegal simply makes illegal what he did so well.
The breakup of Standard Oil made several companies out
of one. Each competed with the others for pipeline services
and to sign up gas stations. Among others, we know these
companies today as Exxon, Amoco, and Standard Oil. The
verge of bankruptcy before their 2008 merger and only
narrowly avoided it in 2009 afterward. The question be-
fore the anti-trust division of the Justice Department was
not whether having two satellite radio providers was bet-
ter than one; it was whether one was better than zero. It
decided that one was better than zero.
What Constitutes a Monopoly?
One of the new areas of economic research asks an interest-
ing question: How many firms does it take to ensure com-
petition? We have assumed that we needed many, but we
have not produced a number. Some economists have begun
to argue that one is actually enough. They argue that if the
one entity that comprises the monopoly is afraid of potential
competition, and prices its goods low enough that no one
decides to enter the market, we have what ordinarily comes
only with perfect competition. In this hypothetical example,
however, it has come with but a single firm.
To see this at work, imagine an airport that is served by
only one major airline. Speculate on how it will price its
tickets, as a monopolist or as if it had many competitors.
It turns out that under certain conditions, it will be suffi-
ciently frightened at the prospect of another carrier coming
in that it will price its tickets very close to a competitive
level and significantly below the potential monopoly level.
As a concrete example, Southwest Airlines has a repu-
tation of causing other airlines to lower their fares when
they are in competition with Southwest and in some places
where they are not. Southwest is an airline that is always
depicted as being run by a group of happy people working
hard. The man who started the airline pays himself a sal-
ary that is much lower than his counterparts in other air-
lines and he treats his employees well. In return, they have
chosen not to insist on some of the typical union-induced
work-rule inefficiencies that plague other airlines.
You may be able to see examples of Southwest’s ef-
ficiency for yourself. The next time you have a long lay-
over at an airport observe a Southwest gate. Time a plane
from the moment it pulls into the gate to the moment it
leaves again. Then repeat what you have done at Ameri-
can, United, Delta, or USAir. More often than not you will
see a turnaround time for Southwest that is considerably
less than that of any of the others. This means that South-
west can get at least one additional flight, if not two more
flights, out of a plane and crew each day. This means it can
outcompete everyone else on the price of tickets.
Suppose you are in charge of pricing tickets for another
airline and you have a monopoly in a particular city. You
know that Southwest chooses its next target city on the
contestable markets
hypothesis One firm is all that is necessary for competitive prices to exist as long as that firm is threatened by hit-and-run entry.
trust A single company hav- ing ownership of all stages of production in a particular industry.
324 Chapter 29 Antitrust
device, called a mouse, instead of using typed-in
commands to tell the computer what to do. Microsoft
followed shortly thereafter with its own changes that
relied on a mouse. It called its new operating system
Windows. While the first two versions of Windows
were terrible and could have lost Microsoft its advan-
tage in operating systems, Windows 3.1 took over the
industry in short order.
Since that time,Windows (in its 3.1, 95, 98, 2000,
XP, or NT form) has dominated the operating system
market. The only serious threat that Windows faced
during this time was IBM’s introduction of OS/2 and
its follow-on Warp. Both offered multitasking, an at-
tribute that Windows 3.1 did not possess. Multitasking
allows a computer to divide its resources so that it can
work on more than one task at a time. Because that is
what mainframes do, IBM got it working first, Apple
struggled to get it to work, and Microsoft’s Windows
95, which included multitasking, was more than a year
from being released.
If the Justice Department and many of Microsoft’s
critics are to be believed, this made Microsoft very
nervous. Critics charged that it was at this point that
Microsoft began using its preeminence in the industry
to pressure software companies to write exclusively
for the soon- to-be released Windows 95. The Justice
Department also charged that Microsoft pressured the
vendors of such hardware as modems, sound cards, disk
drives, and network cards not to provide software for
OS/2. If Microsoft did those things, it was in flagrant
violation of the law.
In another questionable practice, Microsoft of-
fered manufacturers a low price on its versions of
Windows—but with a catch. The manufacturers
would pay Microsoft a fixed fee per machine it sold,
whether the customer wanted Windows or not. That
way people who bought PCs had to pay for Windows
even if they wanted a different operating system.
Since most people did not have a good reason to pick
another operating system, no other operating system
succeeded in getting past this initial stage. Again if
Microsoft did this to eliminate competition, it was in
violation of the law. In any event, the threat that OS/2
posed to Windows evaporated.
Later Microsoft was to run into other problems. The
Internet grew to a degree that Microsoft had seriously
underestimated, and Netscape grabbed well over three-
quarters of the market for Internet browsers. On top of
that, Sun Microsystems created Java, a programming
language that is compatible with Windows, Apple, or
lessons that Rockefeller taught the world were learned very
well and most developed countries now have laws that make
it illegal to use monopoly pressure to limit competition.
IBM
International Business Machines, better known as IBM,
came into the world as a producer of typewriters and add-
ing machines. Your grandparents may remember working
in an office where the secretary’s IBM Selectric was the
most sophisticated machine in the place, because it could
erase a typo. By the 1960s, however, IBM was well into the
business of computers. Back then a state-of-the-art main-
frame computer with the computational capacity of a cur-
rent Palm Pilot would fill several rooms. Moreover, if you
needed that kind of computing you had one choice, IBM.
As the monopolist in mainframe computers, IBM could
use this power to get a leg up on the companies that produced
mainframe software as well as other hardware. In 1969 the
Justice Department sued, arguing that IBM was using its
monopoly in one area, the central processing units for main-
frames, to develop a monopoly in other mainframe areas.
This lawsuit dragged on in court for years. By 1977
an upstart company, Apple, developed the first personal
computer, and somewhat later IBM decided to join in
this market and began to make computers for the home
and office. These computers were novel and they pos-
sessed far more power than the computers that flew to
the moon. By the early1980s it became apparent that
the mainframe market was dying as the PC’s popularity
grew. In 1982 the case was dropped because even if IBM
had a monopoly in mainframe processors, which it no
longer had, it was no longer an important area.
One of the reasons that IBM had lost any chance of
generating a monopoly in PCs was that it had licensed the
operating system of that original PC, called DOS (disk
operating system), to a little-known company in Wash-
ington State called Microsoft. Further, it was buying its
microprocessors, so named because they were physically
much smaller than the processors developed for the main-
frames, from another little-known company called Intel.
When others found that they too could put parts together
to make a computer and use Microsoft’s DOS to run it, all
chances of an IBM monopoly were gone.
Microsoft
In the mid-1980s, Apple Computer introduced a new
personal computer, called a Macintosh. It used pic-
tures, called icons, on a monitor screen and a pointing
Summary 325
the software that allows applications to talk to the operat-
ing system, he was clearly implying that at some point in
time Microsoft had done both. On appeal to a U.S. Court
of Appeals, the important finding of facts with regard
to the illegal activities of Microsoft was upheld, but the
breakup remedy was not. Prior to September 11, 2001,
the Department of Justice was intently focused on settling
the case and had taken the breakup off the table.
In November of that year, with other matters to attend
to, the Department of Justice ended the fight with Micro-
soft on terms quite friendly to the software giant. While
some of the states that had sued alongside the federal
government stuck to their guns, by 2003, when California
settled for $1.1 billion in vouchers to the state’s citizens
and AOL Time-Warner (the parent of Netscape) settled
for $750 million, the battle was pretty much over.
Apple, Google, and the European Union
Apple and Google have each found themselves in the
European Union’s crosshairs. Both were essentially
charged with the same crime: using its market domi-
nance in one area to gain market dominance in another.
While the U.S. government has yet to claim that either
has run afoul of antitrust laws here, the European Union
has made such claims. In Apple’s case their concern was
that by making it such that iTunes songs only play on
iPods and computers with the iTunes software, they are
using these products to simultaneously reinforce mar-
ket power in both players and the music itself. With the
introduction of the iPhone in 2007, there was a reason-
able fear that Apple could continue to leverage their
dominance in music to dominate cell phones as well.
In Google’s case, it was the allegation that Google was
using its search engine functionality to privilege its own
shopping service.
any other computer. This threatened not only the Win-
dows stranglehold, but the domination of the Windows
Office Suite as well. In reaction to these events, Mi-
crosoft created Internet Explorer as its alternative to
Netscape Navigator and, in Windows 98, integrated it
into the operating system.
Even more troubling to the Justice Department was
its contention that Microsoft was insisting that PC
makers not put any product on their PCs that competed
with a Microsoft product. Specifically, it was alleged
that Microsoft would not sell Windows to PC makers
if they also bundled their PC with Netscape or Corel’s
WordPerfect Suite.
Last, it was believed by many in the industry that
there were secret parts of Windows 98 that made com-
puters using non-Microsoft products crash. If this was
true, users of these non-Microsoft products would con-
veniently blame the makers of those products and want
the “more reliable” Microsoft software.
What the Justice Department charged in the trial of
1998 and 1999 was that Microsoft had used and was
using the tactics of Rockefeller to drive out other com-
petitors. On April 3, 2000, the judge for the case, Thomas
Penfield Jackson, ruled first that the evidence showed
that Microsoft wanted to monopolize a variety of areas of
software, that it used its monopoly in Windows to further
a monopoly in Office Suite, to build one for the Internet
Explorer, and to prevent competition from, among others,
Sun’s Java. He further ruled that Microsoft had harmed
consumers in the process. In his June 7, 2000, ruling or-
dering a breakup of the company into an operating system
business and an applications business, he also showed that
he believed that Microsoft had indeed used secret parts of
Windows to cause other software to crash. By ordering
that it “shall not take any action it knows will interfere
with or degrade the performance of any non-Microsoft”
software and by ordering that it disclose the “interfaces,”
Summary
You now understand why economists worry about
monopolies, and why some monopolies have been seen
as inevitable and even good for society. You know that
laws were enacted to regulate the existence and pricing
behavior of monopolies. Last, you saw how that body of
law was applied to Standard Oil, IBM, and Microsoft.
Key Terms
barrier to entry contestable markets hypothesis trust
326 Chapter 29 Antitrust
6. The suit against Microsoft accused it of
a. using its own innovation to thwart competition.
b. using its Windows monopoly to foster other
monopolies.
c. incorporating more innovations into the Office
Suite.
d. charging more than Windows was worth.
Think about This
Those that opposed the Department of Justice suit against
Microsoft argue that the company was responsible for
great innovation. They argue that the “next Microsoft”
would be reluctant to be as successful. Does this criti-
cism make sense to you? Would a multibillion-dollar
corporation be limited in innovation for any reason?
Talk abo ut This
If Apple used the high market share in iPods to generate
a monopoly in music downloads via iTunes, would that
be a concern to you?
For More Insight See
Journal of Economic Perspectives 1, no. 2 (Fall 1987).
See articles by Steven C. Salop, Lawrence J. White,
Franklin M. Fisher, and Richard Schmalensee,
pp. 3–54.
Online Newshour, “The Microsoft Antitrust Case,”
http://www.pbs.org/newshour/bb/cyberspace
/july-dec99/microsoft_index.html.
1. Antitrust law is designed to limit the impact of
a. monopoly.
b. oligopoly.
c. monopolistic competition.
d. perfect competition.
2. One of the concerns about monopolies is that they
a. reduce the motivation to innovate.
b. reduce the motivation to make a profit.
c. hire people at an excessive level.
d. waste resources in pursuit of the next invention.
3. Monopoly creates prices that are ________________
which would exist under perfect competition.
a. lower than that
b. equal to that
c. greater than that
d. more volatile than that
4. Using the monopoly power in one area to compel
customers to buy goods in another area
a. is a violation of the Sherman Anti-Trust Act.
b. is legal but bad business practice.
c. is illegal but would be bad business practice
anyway.
d. is legal and a recommended strategy.
5. Standard Oil’s trust involved monopolizing
a. gas stations only.
b. oil exploration only.
c. refining.
d. all aspects of the petroleum industry.
Quiz Yourself
327
C H A P T E R T H I R T Y
The Economics of Race and Sex Discrimination Learning Objectives
After reading this chapter you should be able to:
LO1 Describe how economists measure the income disparity
between the races and sexes.
LO2 Define what discrimination is, how it is measured, and how
it is detected.
LO3 Model discrimination in the labor market and summarize
the evidence for its existence in the markets for real estate,
automobiles, and lending.
LO4 Describe what affirmative action is; how, why, and when
it came about; and what forms of it exist today in the
United States.
Chapter Outline
The Economic Status of Women and Minorities
Definitions and Detection of Discrimination
Discrimination in Labor, Consumption, and Lending
Affirmative Action
Summary
African Americans and women have been subjected
to discrimination throughout history. That discrimina-
tion exists is not a surprise, but its precise detection
and measurement are not as simple as they may seem.
Some of the differences in income and wealth are di-
minishing over time but nontrivial gaps remain. This
chapter explores the economic status of women and
minorities, discusses the varieties of discrimination
economists recognize, and moves to explain them. In
so doing, the chapter discusses the means of detect-
ing discrimination and seeks to model its impact on
wages. The chapter moves on to explain why, absent
legally sanctioned discrimination, some economists
thought wage gaps would close quickly and why other
economists correctly predicted that those gaps would
remain, even in the presence of laws forbidding dis-
criminatory practices. Finally, the chapter ends with a
discussion of affirmative action, its economic justifi-
cation and machinations.
The Economic Status of Women and Minorities
Women
Women are becoming an ever-growing part of the U.S.
economy. Economists call the percentage of people in
a particular category who are over 16 and working the
labor force participation rate. The rate for women has been rising steadily for decades, from 38 percent in the
early 1960s to 57 percent today. While the rate for men
is higher than that for women, 69 percent, it has been
steadily decreasing. Demographers, the people who
study population trends, adjust
the labor force participation
rate to reflect the fact that as
the U.S. population ages, more
people are in age groups likely
to be retired from work. For this
labor force
participation rate The percentage of the population of a group that is employed or seeking employment.
328 Chapter 30 The Economics of Race and Sex Discrimination
reason, they suggest that the real importance of women
in the workplace is even greater than the raw participa-
tion rate suggests.
What is also important from an economic perspective
is that though men and women are approaching equality
in income and wealth, men still have 63 percent more
income than women, make 23 percent more in wages
for full-time employment, and are less likely to be in
poverty. Though more couples file for bankruptcy than
single men or single women, the incidence of single
women filing for bankruptcy has increased substantially,
while the incidence of couples or men filing alone has
remained steady. Finally, single men, ages 35–54, have
270 percent more wealth than single women. The differ-
ences are summarized in Table 30.1.
This is not to suggest that the economic status of
women is not improving. Figure 30.1 shows that the
ratio of women’s to men’s weekly wages for full-time
employment and the similar ratio for money income
from all sources continue to increase. Still, as Table 30.2
suggests, even when you look at identical professions,
women currently make less than men.
Minorities
There are two clear trends in the data on economic and
social conditions affecting the races. Inequality within the
races is clearly documented, and the degree of inequality
TABLE 30.1 Economic differences between men and women.
Sources: www.census.gov/hhes/www/income
www.bls.gov/cps/cpsaat39.pdf
www.census.gov/hhes/www/poverty
www.census.gov/hhes/www/wealth
www.financiallit.org/PDF/2010_Demographics_Report.pdf
Men Women
Income from all sources $36,302 $22,240 Median weekly wages for
full-time employment
$895
$726 Mean net worth (singles, 35–54) $238,494 $64,433
Poverty rate 13.4% 16.1% Percentage of single-iling
bankruptcies
48%
52%
TABLE 30.2 Median full-time wage earnings: selected occupations.
Source: www.bls.gov/cps/cpsaat39.pdf
Occupation
Women’s Earnings as
a Percentage of Men’s
Physicians 86%
Lawyers 90%
Managers/Executives 72%
Teachers (elementary) 89%
FIGURE 30.1 Ratio of women’s income to men’s.
Source: United States Census Bureau, www.census.gov
30
40
50
60
70
80
90
19 8 0
19 8 2
19 8 4
19 8 6
19 8 8
19 9 0
19 9 2
19 9 4
19 9 6
19 9 8
20 00
20 02
20 04
20 06
20 08
20 10
20 12
20 14
Year
P e
rc e
n t
Full-time wages Total income
The Economic Status of Women and Minorities 329
is lessening. The clearest sign of this phenomenon of
shrinking-but-not-yet-zero inequality can be seen in the
data on median family income for white and black fami-
lies. Figure 30.2 shows us that since 1967 median fam-
ily income has risen from $8,234 to $70,609 for white
families and from $4,875 to $43,364 for black families.
Figure 30.3 indicates that while the gap in income
between black people and white people is widening in
absolute terms, the ratio of white median family income
to black median family income is narrowing. This means
that while white families still enjoy the benefits of more
income, the income of black families is increasing at a
faster rate than that of white families. The ratio of white
family income to black family income remains signifi-
cantly less than 1.0 (its value if perfect equality existed),
but it has grown from .52 in 1950 to .614 in 2014. It is
worth noting that the 2007–2009 recession was harder
in economic terms on African American families than it
was on white families.
Other economic measures provide us with addi-
tional data on the inequalities that exist between African
Americans and whites. For instance, in 2015, for salaried
and full-time hourly workers, median weekly earnings
are $835 for white workers and $641 for black work-
ers. In this arena, the ratio of .77 shows we are closer to
equality, but this ratio has remained constant for nearly
36 years, and in fact declined following the recession of
2007–2009.
Although there remain many signs of astonishing
economic inequality, there are also signs of signifi-
cant progress. Nevertheless, only 23 percent of African
Americans are in the top 40 percent of income earners,
FIGURE 30.2 Median family income.
Source: United States Census Bureau, www.census.gov/hhes/www/income
10,000
0
20,000
30,000
40,000
50,000
60,000
80,000
70,000
19 4 7
1 9 5
1
19 5 5
19 5 9
19 6 3
19 6 7
1 9 7 1
19 7 5
1 9 7 9
1 9 8 3
19 8 7
1 9 9
1
19 9 5
1 9 9 9
20 03
2 0
1 1
20 07
Year
M e
d ia
n f
a m
il y i n
c o
m e
( $
)
White Black
FIGURE 30.3 Ratio of black to white family income.
Source: United States Census Bureau, www.census.gov/hhes/www/income
0.50
0.52
0.54
0.56
0.58
0.60
0.62
0.64
19 4 7
1 9 5
1
19 5 5
19 5 9
1 9 6 3
19 6 7
1 9 7 1
1 9 7 5
1 9 7 9
19 8 3
19 8 7
1 9 9
1
19 9 5
1 9 9 9
20 03
20 07
2 0 11
Year
B la
c k /W
h it
e m
e d
ia n
fa m
il y i n
c o
m e
330 Chapter 30 The Economics of Race and Sex Discrimination
discrimination rather than just one. If you treat two oth-
erwise equal people differently and do so on the basis
of their sex or race, then this
is called disparate treatment discrimination. If, on the other hand, you do something that
is not necessarily discrimina-
tory on its face but that impacts
some groups more negatively
than others, you are engaging
in what is called adverse impact discrimination.
While both forms of dis-
crimination are usually illegal,
adverse impact discrimination
can be acceptable as long as the persons or compa-
nies doing the discriminating can show that what they
are doing makes sense for their needs. For instance, if
whites sued the National Football League (NFL) on the
basis that defensive backs were disproportionately black,
there would be two legal hurdles. The first hurdle would
be for whites, the group at whom the discrimination had
supposedly been aimed, to show the “adverse impact.”
They could do this easily, by showing that the United
States is 70 percent white and that in 2014 there were
no white cornerbacks. With adverse impact proved, the
burden of proof would be transferred to the accused, in
this case the NFL. The NFL would have to show a “busi-
ness necessity” that led the teams to make the choices
they made. The NFL would win in court if the teams
could then point to their tests of speed, strength, and
conditioning and show that (1) these tests did predict the
ability to cover receivers, and (2) they chose defensive
backs on the basis of these tests. Thus, while differen-
tial treatment discrimination is always illegal, adverse
impact discrimination is illegal only when it cannot be
defended on the grounds that it stems from a business
necessity.
The more common example of differential treatment
discrimination arises when an employer uses a rule-of-
thumb approach to hiring. Rules of thumb are useful
in that they can be simple guidelines for people mak-
ing complex decisions. Some economists who study this
kind of discrimination assert that rules of thumb for hir-
ing are generally perpetuated long past the time when
they are relevant. Furthermore, they suggest that many
of those rules of thumb never really were very good
predictors of performance. One that was propagated in
the world of broadcasting was that men, being gener-
ally more interested in sports, would make better sports
whereas 57 percent are in the bottom 40 percent; more-
over, unemployment rates across age categories are sev-
eral percentage points higher for blacks than whites. A
particularly troubling aspect of the 2007–2009 reces-
sion was that while unemployment was rising across the
board, it was affecting African Americans disproportion-
ately. In particular, black teenage unemployment rose to
49.2 percent in September of 2010. That level was more
than twice white teenage unemployment. Encouragingly,
the growth in the number of businesses owned by mem-
bers of minority groups has been astounding. Between
1987 and 1996 the number of such firms grew by 46 per-
cent and their receipts by 63 percent.
We cannot escape the fact that black children are
more than twice as likely as white children to be in a
female-headed household. Because family structure is
a key determinant of economic well-being, this social
problem of single-parent (overwhelmingly female) house-
holds is a major cause of the economic disparity that
African Americans face.
It must be noted, too, that African Americans are dis-
proportionately the victims of crime. In any given year,
2.25 out of 100 African Americans are victims of violent
crime, whereas only 2 out of 100 whites are so victim-
ized. The racial distinction is greatly highlighted by the
difference in rates of robbery victimization. Blacks are
three times more likely to be victims of robbery than whites.
In the arena of educational achievement, African
Americans are graduating from high school at a much
faster rate than they were in 1960. Unfortunately, the rate
at which African Americans are graduating from college
is not growing with nearly the same rapidity. In part, this
could be because a much higher percentage of African
Americans get their high school diploma with a general
equivalence degree (GED) than whites. Many colleges,
moreover, are less enthusiastic about GEDs than actual
high school diplomas. Further, white or black, the av-
erage incomes of GED recipients are closer to those of
high school dropouts than of high school graduates.
Definitions and Detection of Discrimination
Discrimination, Definitions, and the Law
On the surface, it would seem that defining discrimina-
tion would not be that difficult. If you treat people in a
certain way because they are women, African American,
or Hispanic, you are discriminating. To make matters
more complicated, however, there are two types of
disparate treatment
discrimination Treating two otherwise equal people differently on the basis of race.
adverse impact
discrimination Doing something that is not necessarily discrimina- tory on its face but that impacts some groups more negatively than others.
Definitions and Detection of Discrimination 331
A multitude of studies compare women’s pay to men’s. Many
economists do the comparison by controlling for education, full- or
part-time status, experience, job requirements, and a host of other
factors to determine whether men and women earn the same money
for the same work. Sociologists and nearly all feminists view this as
fallacious because they see these as symptoms of continued mis-
treatment of women, rather than economic phenomena that should
be statistically controlled. The issues are:
• All income versus earned income: As shown in Table 30.1, if you focus
on the broad issue of relative incomes, women earn only 61 percent
of what men do, but if you focus more narrowly on the diferences
between what women and men earn when they both work full time,
the ratio is narrower: Women earn 81 percent of what men do.
• Experience with the same employer: Men have been with their
current employer for a median 4.7 years; the comparable igure
for females is 4.5 years. It is notable that this gap has nearly
been eliminated in recent years.
• Different professions: Only 37 percent of lawyers, 38 percent
of doctors, and 14 percent of engineers are women. On the
other hand, women account for 94 percent of secre taries,
88 percent of nurses, 81 percent of elementary school teach-
ers, 97 percent of day-care workers, and 81 percent of social
workers.
• Pregnancy and child rearing: While it is illegal to discriminate
based on pregnancy, any opportunity that a woman loses and
a man gains can result in young professional fathers being
promoted more quickly than young professional mothers.
Since only women can give birth and 96 percent of stay-at-
home parents are women, women lose opportunities.
• Flexible employment: For reasons that are primarily sociological,
women rather than men pick lexible employment so that they
can deal with their family’s needs. Flexible jobs also happen to
be lower paying.
Are these legitimate economic consequences of choices that
people make freely and knowingly or are they manifestations
of discrimination itself? That is a debate for you to have with
your fellow students and your professors of economics and
sociology.
S O C I O L O G Y O R E C O N O M I C S : W H Y W O M E N E A R N L E S S T H A N M E N
broadcasters. Although it may be true that men watch
more sports, that does not say anything about whether a
particular man or a particular woman would be better for
a particular job. Furthermore, many rules of thumb, like
the notion that men are better drivers, never were good
predictors of performance on the job.
Even when there is a concretely accurate rule of thumb,
discrimination is illegal. This form of discrimi nation is
the economic equivalent of racial profiling, which we
hear about with regard to po-
lice tactics. In economics, such
discrimination is labeled by
some as rational or statistical discrimination because it is based on sound statistical evidence. It
is referred to as “rational” only
because it is consistent with
the recognized goal of firms of
maximizing profit. For instance, it is a fact of life in the
United States that when a bank consults with the best stat-
isticians and economists, it finds that African Americans
were, from 2007 to 2010, 6 percent more likely to default
on a home loan. This is true even when the study holds in-
come, occupation, and a host of other important variables
constant. If lenders use this information to charge blacks
a higher interest rate for mortgages, or if they use this in-
formation to set a higher standard for blacks to qualify for
a loan, they are guilty of “statistical” discrimination.1 Re- gardless of whether it makes economic sense, it is illegal
to use race in any part of the lending decision.
Detecting and Measuring Discrimination
Detecting and measuring the extent of discrimination in
an authoritative way are not always easy. If a Hispanic
female high school dropout and an affluent white male
college professor each went into a bank to ask for a loan,
and the high school dropout was denied the loan and the
professor got one, we would not automatically assume
we were looking at a case of gender or race discrimina-
tion. We would have to separate out the reasons why one
person got the loan and the other did not.
There are two ways that economists try to do this. First,
they use the statistical technique called “regression” to look
rational or statistical
discrimination Unequal treatment of classes of people that is based on sound sta- tistical evidence and is consistent with profit maxi mization.
1Another interpretation of this finding is that it is actually whites who are being
discriminated against since, all else being equal, they are defaulting less fre-
quently than blacks. This implies that they are being turned down too often.
332 Chapter 30 The Economics of Race and Sex Discrimination
for systematic patterns in the data. Once they figure the
appropriate values using a statistical computer program,
regression analysis tells them the impact of one variable on
another, holding the effects of other variables constant. It
allows them to say, with degrees of certainty, that a variable
like race or sex has a specific impact on another variable,
like whether or not a loan was approved, even when they
hold other variables like income constant. When many dif-
ferent people, from many different backgrounds, with dif-
ferent incomes and debt histories seek loans from many
different banks, the regression technique can, when cor-
rectly applied, determine whether being African American
or female makes an applicant less likely to get a loan.
The second technique involves creating fake identities
for people who are exactly alike except for their race or sex.
These “auditors” approach a situation one after the other
to see if they are treated differently. Since every thing other
than race is held constant, any differences in the way the au-
ditors are treated must be related to race. A fascinating ex-
ample of this work was conducted by economists Bertrand
and Mullainathan. They showed that on purely fictitious
and functionally identical résumés, applicants with names
like “Emily” and “Greg” were statistically, substantially,
and depressingly more likely to be called for an interview
than applicants with names like “Lakisha” and “Jamal.”
These two techniques have their critics. This may, at
least in part, be because of the somewhat different con-
clusions the techniques have led economists to make.
Generally, regression techniques expose a smaller race
bias problem across the board than is exposed by audit
techniques. Typically, those who advocate regression
measurement rather than using auditors say that the ficti-
tious auditors themselves may create part of the dispar-
ity by the way they act. They also say that the exactness
of the match is less than reliable. On the other hand, the
advocates of auditing suggest that variables included in
regressions, like intelligence scores, are themselves biased
or indicative of other past discriminatory practices and
therefore always understate the true problem.
Discrimination in Labor, Consumption, and Lending
Keeping these basics in mind, we turn now to three areas
of the economy in which professional economists have
studied discrimination in some depth. These areas are
the labor market, where people sell their labor to firms;
the goods market, where people buy things; and the lend-
ing market, where people borrow money.
Labor Market Discrimination
We can start exploring the effect of discrimination in the
labor market by assuming a world, like the 1960s, where
it is legal and openly practiced. In Figure 30.4, suppose
there are two kinds of jobs: jobs that only whites are
allowed to do and jobs that whites are allowed to do
but blacks must do if they want jobs.2 In a world where
there is no discrimination, the nondiscriminatory sup-
ply curve S ND
crosses the demand curve at a wage W ND
that is equal for blacks and whites. In the world where
such discrimination is legal and binding, the supply of
workers available to perform tasks limited to whites
only (left panel) is less, S D , and therefore the wage that
must be paid to whites is greater. Because blacks must
perform the other tasks, the supply of workers available
in that market (right panel) is greater and therefore the
wage is lower.
Thus with discrimination that is legal, whites make
more than blacks. The question is: If discrimination
is held to be illegal, is that sufficient to eliminate the
wage differential? Beginning with the work of econo-
mist Gary Becker, the profession showed theoretically
that without a legal basis, discrimination and wage
differentials would go away. In the 1960s the econom-
ics profession was confident that profit-oriented but
open-minded business owners would want to make as
much money as possible and would therefore ignore
skin color. If employers employed people to do what
used to be considered “a white man’s job” and were
right in assuming that the only reason blacks had been
2This analysis works the same for modeling sex discrimination.
FIGURE 30.4 The efect of racism on white and black wages.
SD
SD SNDSND
DD
Jobs that blacks are allowed to do
L LJobs only whites are allowed to do
Wblack
WND
Wwhite
W WWhites African Americans
Discrimination in Labor, Consumption, and Lending 333
previously prevented from doing the job before was
racism, then the African Americans would be able
to do the job just as well as whites. That, in and of
itself, however, would not motivate profit- oriented
business owners to hire blacks. What would motivate
them would be that they could offer blacks a little bit
more than their other jobs paid but less than they were
currently paying whites. In Figure 30.4 this would be
between W black
and W white
.
If profit-oriented managers were to hire African
Americans at just above the W black
wage that is depicted
in the right panel of Figure 30.4, they could get all the
labor they need at much lower cost than they would have
had to pay white workers, W white
. Thus the business man-
ager’s desire to make money can serve to narrow the
wage gap, at least a little.
As other managers see the advantage of hiring
lower-paid, equally skilled African American labor,
the wages among African Americans would continue
to rise as firms seeking cheaper labor attempt to outbid
each other. Thus a traditional economist argues that in
time nothing more than removing legal impediments is
required to achieve equality. The idea that greed pre-
vails over bigotry remains steadfast in the minds of
many economists.
Considering that wages are not equal nearly 50 years
after the civil rights movement’s heyday, however, there
must be obstacles that simple economic incentives have
not been able to overcome in equalizing wages. The first
thing to consider with regard to whether economic profit
incentives will overcome racism is that people will pay
extra, when they want to, to satisfy their bigoted nature.
Managers will pay a little extra not to have to work with
“them,” regardless of whether “them” is women, blacks,
gays, whites, or anyone else. Presumably bigots are will-
ing to pay to support their bigotry.
Another problem is that some people will patronize
only businesses where not any of “them” are around.
Even if you are an open-minded, profit-oriented man-
ager, if you see that your business decreases whenever
you hire more African Americans, you may decide to
hire only whites, and you will pay more to attract them.
You may do this even though you know it is illegal
and morally wrong. It is a fact of life that if you are
a manager and your livelihood depends on satisfying
your customers, you may do things you would not oth-
erwise do.
It is for these reasons that, even though the wage gap be-
tween whites and blacks has shrunk, it has not disappeared.
Regression analysis shows that it remains at between
12 percent and 15 percent.3 Remember that the regression
results hold constant things that are supposed to determine
pay such as education and occupation. Because African
Americans have attained a lower average level of education
and because they are less prevalent in high-income occupa-
tions, you would expect that they would be paid less. What
this also means is that the actual difference in pay is much
greater than the 12 percent to 15 percent that these regres-
sion studies indicate. In an apparent contradiction, studies
limited to well-educated professionals show that being a
black woman actually pays a premium. This is interesting,
but it lacks practical significance since most African Amer-
ican women are not well-educated professionals.
Consumption Market and Lending Market Discrimination
While it is easy to imagine discrimination in the labor
market, where people either are denied positions or are
hired for lower pay, it is harder to imagine in the market
for goods. You never see a Walmart charge a white man
$65 for a car battery and then charge a Hispanic woman
$75. There are areas in the goods market, however, and
especially in the services market, where the races can be
and are treated differently.
At first it would seem rather silly for a business to dis-
criminate and turn away profitable sales. What you have
to consider, though, is that audits performed by various
economists and government investigators have shown
that discrimination is in fact quite prevalent in real estate
sales, rentals, and car sales.
In real estate, audits show that real estate agents
of both races tend to show white clients more houses.
Moreover, they show white families houses in all-white
neighborhoods while diverting black families to houses
in black or integrated neighborhoods. The same results
were evident when auditors looked for rentals. Why
would real estate agents do this? Why, in particular,
would black real estate agents do this? There appear to
be a couple of explanations.
The first possibility is that agents are simply trying
to make the clients happy, and they think they are doing
this—and may in fact be doing this—by showing hous-
ing in areas where they think the clients want to live.
3Some economists have found that when they include standardized tests of
intelligence, this remaining difference disappears. These tests and their use in
this context are hotly debated by economists. The economists who employ the
results of the tests believe the tests are truly tests of intelligence, whereas oth-
ers contend that the tests are racially biased and therefore of no value.
334 Chapter 30 The Economics of Race and Sex Discrimination
Salespeople make judgments all the time about what
will make their clients happy, and they do so with very
little to go on. The economists who uncovered this form
of discrimination attribute this behavior to racism and
call it discrimination. If a significant segment of African
Americans really do want to live in already-integrated
neighborhoods rather than move into another neighbor-
hood to become the only minority family in the area, the
economists are incorrect when they label this behavior
as discrimination.
The second possibility is that both the black and
white agents have regular clients in the neighborhoods
that contain the apartments or houses that are available,
and they do not want to anger their regular clients by
upsetting the racial “balance” in the neighborhood. The
audits do not include interviews of the agents, so the
data do not show whether either of these scenarios ac-
counts for the discriminatory practices that exist when
realtors are showing properties to their clients. If you
live in a neighborhood originally developed before
1975, you might be shocked to find the covenants for
your property probably include a line like the one I
found in mine:
No person of any race other than Caucasian shall own,
use or occupy any lot or building in this subdivision,
except that this covenant shall not prevent domestic
servants or employees of a diferent race domiciled with
an owner tenant.
Another area where economists have found race and
sex discrimination in the market for goods is in automo-
bile sales. Auditors found that even when they used the
same bargaining strategy, made it clear they would be
paying cash, and were talking about the same car, dealers
charged blacks and women more. The usual method of
the audit had blacks and whites, men and women going
into the same dealership within a short period of time
and asking a salesperson to tell them the asking price for
a specific car. In each case the auditors would then offer
a price they had previously decided to offer and then they
would use a “split the difference” bargaining technique
until the salesperson and they arrived at a final price.
What happened was that the initial offer made by both
black and white car dealers was lower for whites than
it was for blacks. The dealers also agreed to sell cars to
whites for lower prices than those for blacks. The econo-
mists who performed these audits concluded that, on the
average, black women pay $1,000 more, black men pay
$800 more, and white women pay $400 more for a car
than do white men.
Why would dealers do this? Though the bias was less
evident when the dealers themselves were women or mi-
norities, they still discriminated against blacks and women.
It seems as if either the dealers did not want the sales or
dealers have preconceived notions of sales resistance and
bargaining strategies. It may be they believe they can out-
maneuver African American and female customers.
Another area where economists have investigated and
found serious race discrimination is the area of mortgage
lending. Because it is rare that banks offer anything but
a single interest rate, the question is whether blacks are
more likely to be turned down for loans than are whites.
Again, audits found that given nearly identical economic
characteristics, blacks were somewhat more likely than
whites to be turned down for a loan. It seems likely here
that, short of bigotry, banks, which use both objective
standards and subjective standards in making their deci-
sions, have discriminatory prejudice in their subjective
standards. As we said before, it has been shown that
blacks and whites of equal economic standing have dif-
ferent default rates on mortgage loans. It may be that the
loan officer who denies a mortgage to a black couple that
would have been approved for a white couple is doing so
in a “rational” sense. Nevertheless, this discrimination
remains a violation of law, and banks are currently being
monitored and penalized for such practices.
Some economists claim to have noted sex discrimina-
tion in retirement annuities. Whether it is actually dis-
crimination, men have better choices than women because
women live longer than men by more than half a decade.
Insurance companies that offer annuities have to charge
women more than men, offer fewer benefits to women
than men, or split the difference in some other way so that
women end up paying somewhat more and being paid
somewhat less. Making it illegal to charge women more
than men for such annuities would not change these facts.
It would merely force companies to indulge in what would
amount to a redistribution of wealth from men to women.
Affirmative Action
The Economics of Affirmative Action
As you saw in the preceding discussion, there are condi-
tions under which discriminatory behavior can continue
long after it is declared illegal. Either because employers
may be bigoted or because employers may have custom-
ers who are bigoted, discrimination in employment ex-
ists even in a perfectly competitive market. This means
that the perfectly competitive market may fail to arrive
Affirmative Action 335
at the socially optimal level of employment for minori-
ties. Minorities will be underemployed and underpaid,
and whites and men will be overpaid for the work they
are doing and get jobs for which they are not as qualified.
Anytime a market fails to achieve a situation where
consumer and producer surplus combined are maximized,
economists are interested in actions that can correct that
market’s failure. Though corrective policies for failed
markets have costs, they are seen by economists as nec-
essary investments that will ultimately pay dividends. In
this context the corrective poli-
cies are called affirmative action. Affirmative action is any policy
that is taken to speed up the pro-
cess of achieving equality.
The costs of affirmative action policies range from
the costs of more thorough searches for employees to
the cost of monitoring fair hiring practices with a fully
staffed human resources office. These costs can be seen
in the same context as any costs associated with correct-
ing a failed market. For example, though it costs industry
money to clean up pollution, expenditures to do so by
industry, which are mandated by the government, make
us better off in the aggregate than we would be without
them. When affirmative action is utilized to correct an
inequality that is seen as permanent, affirmative action
supporters view it very much like scrubbers on coal-fired
plants: It is money spent to fix a market failure. If af-
firmative action exists to speed up a transition from in-
equality to equality that would have happened eventually
anyway, these are seen as costs that diminish the market
failure by shortening the time it exists.
On the other hand, if the market differences between
minorities and whites and between men and women only
reflect the differences in the skills of the groups, then
the market is not failing. If this is the case, then any at-
tempt at affirmative action imposes a cost on, rather than
a benefit to, the economy. In such a case, the costs of
affirmative action should be viewed as buying “fairness”
rather than fixing a market failure.
What Is Affirmative Action?
Even if traditional economic models correctly predicted
that pay gaps between men and women and between whites
and minorities would eventually be eliminated without
needing such influences as affirmative action, there is the
problem of time. Affirmative action came about because
proponents wanted to achieve equality more quickly. To
the degree that equality is not arriving fast enough through
economic incentives, advocates have asserted that further
affirmative action be taken to speed up the process.
Gradations of Affirmative Action
Affirmative action’s many forms range from the inconse-
quential to the highly consequential. For instance, many
citizens hold as conventional wisdom that affirmative
action consists of quotas that mandate the number of
people who must be hired, promoted, or admitted. As a
matter of fact, explicit quotas are rare and, unless they
have been ordered through a court decision, they are
illegal. On the other hand, many other policies can be
engaged in that stop far short of quotas.
One form of affirmative action is simply to make sure
that all potentially qualified employees know about a
particular job. So, for instance, if you were hiring produc-
tion workers in a southwestern city, affirmative action
could consist of your advertising in both the English-
and Spanish-language newspapers. If you were hiring in
a city that had a radio station whose audience was pri-
marily African American, under this form of affirmative
action you would advertise there alongside radio stations
where audiences were predominantly white. This form
of affirmative action requires that employers cast the net
wide when looking for new hires. It places very little
burden on employers and it gives no one any sort of un-
fair advantage. The only people who might be perceived
as disadvantaged would be those who previously had an
unfair advantage. These might be those who were less
qualified but got jobs because minorities were not aware
particular jobs were available.
Another form of affirmative action has held that if
two applicants are judged to have equal qualifications for
a position, then the one who is a member of a minority
should automatically be hired. Just as in baseball where
“tie goes to the runner,” this form of affirmative action
suggests that “tie goes to the minority.” The advantage to
the minority group members here is that once they have
shown they are equally qualified, their chance of being
hired goes from 50–50 to 100 percent, and the disadvan-
tage to the member of the majority is that the chance of
being hired goes from 50–50 to 0 percent.
A third, higher level of affirmative action is one in
which an employer sets a level of qualification that is
appropriate for a job, hires all minorities who meet the
standard, and then fills out the remaining slots with
nonminorities. When universities make decisions about
whom to admit, and they use criteria to further affirmative
action, they often conduct them in the following
affirmative action Any policy that is taken to speed up the process of achieving equality.
336 Chapter 30 The Economics of Race and Sex Discrimination
board must file a report justifying the discrepancy. That
means that though there is no specific number that must
be promoted, any deviation from the guideline is suspect.
The final version of strictness associated with affirma-
tive action is quotas. Surprisingly, the quotas that most
people think of when they think of affirmative action are
actually against the law as a general practice. Quotas are
legal only when court-mandated, either through a ver-
dict or a consent decree. Sufficient grounds must exist
to show that a particular employer or university has
been guilty of discrimination in the past to make quotas
legal. What troubles some economists is the degree to
which businesses engage in quota-like hiring practices
designed to protect themselves from legal troubles.
way: A school will decide that an SAT of 1,000 is suf-
ficient to make graduation likely and admit all minorities
who meet that standard. The remainder of the student
body is then generated from the best of the rest, a pool of
students whose SATs may well be above 1,000.
A fourth version of affirmative action, just short of a
quota, is establishing a guideline that employers should
try to meet. The idea behind this is to ensure that employ-
ers can be somewhat flexible while also ensuring that
the proportion of minorities not be allowed to drop too
low. In military promotions, for example, if the racial,
ethnic, and gender proportions of those promoted are
not roughly equal to the racial, ethnic, and gender pro-
portions of those eligible for promotion, the promotions
Economists Roland Fryer and Glenn Loury studied affirmative action
policies and concluded that the mythology of the practice sometimes
overwhelms the reality.
Myth 1: Airmative Action Can Involve Goals and Timetables
While Avoiding Quotas
They argue that because those looking for discrimination cannot see
into the heart of the potential accused, the hiring, loaning, or admit-
ting entity will likely create an “implicit quota” to achieve its goal.
Myth 2: Color-Blind Policies Ofer an Eicient Substitute
for Color-Sighted Airmative Action
They point to reactions in California, Florida, and Texas when af-
firmative action policies were banned in college admissions. They
argue that the attempt to use income or high school location as a
proxy was ineffective and that getting the best, most diverse class
of students is hampered by using proxies for race rather than race
itself.
Myth 3: Airmative Action Undercuts the Incentive
to Invest in Yourself
They argue that though whites may not see as much payoff to edu-
cational investments, African Americans will see a greater payoff to
education. Which effect is greater, they argue, is an unsettled empiri-
cal question.
Myth 4: Equal Opportunity Is Enough to Ensure
Racial Equality
They argue that because social networks (“who you know”) matter
a great deal in hiring practices, previous advantages are likely to
maintain themselves for a very long time.
Myth 5: The Earlier in, the Better
They argue that this is an empirical question where the data have
not yet shown that earlier investments in more equal education will
assist later outcomes in graduation rates.
Myth 6: Many Nonminority Citizens Are Directly Afected
by Airmative Action
They argue that far more whites and men believe they are passed over
because of affirmative action policies than actually are.
Myth 7: Airmative Action Always Helps Its Beneiciaries
They argue that affirmative action has reduced the graduation and
bar passage rates of African American law school students because
they are admitted to schools where they are less likely to flourish.
M Y T H S O F A F F I R M A T I V E A C T I O N
Summary
You now understand the economic implications of
discrimination. You know how economists measure
the impact of discrimination, detect its existence, and
explain its importance. You know how labor market
discrimination can be modeled, which implies that dis-
criminatory pay gaps should close over time, but the
reality is that the rate of closure is slow. You know what
affirmative action is in its various forms.
Summary 337
1. How academics look at the evidence on how much
women make relative to men is an issue that very
much depends on
a. which year you look at.
b. which state you look at.
c. whether you take some variables as “choices”
or as “further evidence of discrimination.”
d. which court you are in.
2. The earnings of African Americans relative to
whites has
a. increased from 40 percent in the 1920s to
90 percent today.
b. increased from 50 percent in the 1950s to
around 60 percent in the 1970s, remaining in
that area since.
c. remained constant since the 1950s.
d. decreased steadily since the 1960s.
3. The method of detecting sex discrimination most
likely to minimize it would be to use
a. simple differences in income between men and
women.
b. simple differences in full-time wages for men
and women.
c. regression techniques.
d. auditing techniques.
4. The method of detecting sex discrimination most
likely to maximize it would be to use
a. simple differences in income between men and
women.
b. simple differences in full-time wages for men
and women.
c. regression techniques.
d. auditing techniques.
5. If a woman does not get an interview for a job re-
quiring heavy lifting because the manager has noted
that the average woman can lift less than the average
man, this is
a. a legal example of statistical discrimination.
b. an illegal example of statistical discrimination.
c. a legal example of adverse impact discrimination.
d. an illegal example of adverse impact
discrimination.
Quiz Yourself
Key Terms
adverse impact
discrimination
affirmative action
disparate treatment
discrimination
labor force participation rate
rational or statistical
discrimination
6. Those who believe that wages paid to minorities
will rise without government intervention believe
that bosses are primarily motivated by
a. profit.
b. religion.
c. doing right.
d. helping the downtrodden.
7. Affirmative action
a. can take many forms.
b. is almost always a racial quota.
c. applies only to women.
d. has typically been declared unconstitutional.
Short Answer Questions
1. Describe the process by which greed, absent sex-
ism or bigotry on the part of business owners, can
lead to the reduction in wage gaps between men and
women and between whites and nonwhites.
2. What are the reasons that income gaps between men
and women and whites and nonwhites may persist even
in the absence of sexism or racism by business owners?
3. Suppose an establishment has absolutely no overt his-
tory of employment discrimination but has a goal of
reducing race or gender gaps in its employment. What
are the legal means by which it may reduce that gap?
Think about This
Think about your chosen major, your favorite restaurant, the
place you live. Are they predominantly male, female, black,
or white? Would you feel comfortable going outside the so-
cial norms in your choices? Are those social norms limiting?
Talk about This
Who is going to raise your children? Who is going to
sacrifice a career for their care, an illness, their after-
school activities, etc.?
For More Insight See
Bertrand, Marianne, and Sendhil Mullainathan, “Are Emily
and Greg More Employable Than Lakisha and Jamal?
A Field Experiment on Labor Market Discrimination,”
America Economic Review 94, no. 4 (September 2004).
338 Chapter 30 The Economics of Race and Sex Discrimination
Blau, Francine, Marianne Ferber, and Anne Winkler,
The Economics of Women, Men and Work, 3rd ed.
(Upper Saddle River, NJ: Prentice Hall, 1998).
Curry, George E., ed., The Affirmative Action Debate
(Reading, MA: Addison-Wesley, 1996).
Feiner, Susan F., Race and Gender in the American Econ-
omy (Englewood Cliffs, NJ: Prentice Hall, 1994).
Fryer, Roland, and Glenn Loury, “Affirmative Action
and Its Mythology,” Journal of Economic Perspec-
tives 19, no. 3 (2005).
Journal of Economic Perspectives 12, no. 2 (Spring 1998).
See articles by John Yinger; William A. Darity, Jr., and
Patrick L. Mason; Helen F. Ladd; and Kenneth J. Arrow,
James J. Heckman, and Glenn C. Loury, pp. 23–126.
Sowell, Thomas, Race and Economics (New York:
David McKay, 1975).
Waldfogel, Jane, “Understanding the ‘Family Gap’ in
Pay for Women with Children,” Journal of Economic
Perspectives 12, no. 1 (Winter 1998), pp. 137–156.
Behind the Numbers
Income and wealth.
Median family income; Income by Race and Gender.
U.S. Census Bureau; historical income tables—
www.census.gov/hhes/www/income
Wealth.
U.S. Census Bureau; historical income tables—
www.census.gov/hhes/wealth
Median earnings and ratio of men’s to women’s
income.
Bureau of Labor Statistics—www.bls.gov/cps
/ cpsaat39.pdf
C H A P T E R T H I R T Y - O N E
339
Income and Wealth Inequality: What’s Fair? Learning Objectives
After reading this chapter you should be able to:
LO1 Understand how income inequality is measured.
LO2 Understand how wealth inequality is measured.
LO3 Explain why income and wealth inequality exists in the
United States.
LO4 Enumerate and explain the costs and benefits of income
inequality.
LO5 Explain income mobility and note its extent in the United
States.
LO6 Explain intergenerational income mobility and compare its
degree across the developed world.
Chapter Outline
Measurement of Inequality
The Shrinking Middle Class
Causes of Household Income and Wealth Inequality
Costs and Benefits of Income Inequality
Summary
In 2011, the Occupy Wall Street movement made head-
lines regarding the concentration of income and wealth in
the hands of the top 1 percent by claiming to represent the
other 99 percent. As a result, there was quite a stir in the
popular culture as well as in the economics literature about
income and wealth inequality generally and the increase in
the percentage of income held by the top 1 percent specifi-
cally. Income inequality has many measures, causes, and
consequences. This chapter will begin by showing narrow
and broad measures of income and wealth inequality and
how those measures have changed through the years. The
focus will shift from measures of the tails (the top 1 per-
cent) to the issues associated with the shrinking middle
class. The chapter will move forward to discuss the causes
and effects of that inequality and conclude by discussing
why some inequality is necessary to reward productiv-
ity and success while excessive inequality has potentially
troublesome social and economic consequences.
Measurement of Inequality
Income Inequality
The popular press measure of inequality looks at the
percentage of total income going to the top 1 percent
of earners. The data available for this type of analysis
are garnered from an IRS publication (Statistics of In-
come: Individual Income Tax). The data only become
available three years after the fact. As can be seen in
Figure 31.1, the same year the inequality issue gained
widespread attention in the United States coincided
with the worst of the financial-crisis-precipitated
recession. This happened for two reasons: First, con-
ventional wisdom placed the blame for the recession
on wealthy financial interests; and second, the IRS re-
port for 2007 became available in mid-2010 and showed
that the “top 1 percent” share of income had risen
340 Chapter 31 Income and Wealth Inequality: What’s Fair?
to 22.49 percent. Those decrying this level of income in-
equality noted that in 1978 that same measure showed
the “top 1 percent” share stood at only 7.55 percent. For
that period and using that measure, the share of the top 1
percent of income earners had tripled.
Clearly, as can be seen in both Figure 31.1 and
Figure 31.2, and using the share of income from more
broadly defined groups, as more data became available,
they showed that the increase from 2001 to 2007 was
largely transitory. It peaked at the time of the tech boom
in the 1990s and peaked again just prior to the financial
crisis. The biggest increase in systemic inequality had
actually occurred during the 1980s and 1990s. The pe-
riod of the 2000s was marked by highly variable income
inequality measures.
As compelling as this may appear, there are problems
using only this measure of income inequality. The first
of these relates to the rapid increase in the proportion of
Americans filing tax returns, while the second relates to
the special tax treatment of capital gains.
Regarding tax filings, Figure 31.3 shows that from
1971 to 1998, there was such a rapid increase in the
number of income tax returns filed that the proportion of
the population completing income tax returns rose from
36 percent to 47 percent. There are three basic reasons
this occurred: (1) More people were filing as “single
head of household” because more people who were not
married or were divorced had children; (2) more young
people (under 24) were working at part-time jobs dur-
ing this period than had been in previous generations;
and (3) the new Child Tax Credit combined with the
refundable1 and greatly expanded EITC was creating a
motivation for low-earning households to file tax returns
when they were not legally required to (because they
could garner a tax refund in an amount vastly exceeding
25%
20%
15%
10%
5%
0%
19 6 8
19 74
1 9 7 1
19 77
19 8 0
19 8 3
19 8 6 19
8 9
19 9 2
19 9 5 19
9 8 20
01
20 04
20 13
20 07
20 10
FIGURE 31.1 Conventionally measured income inequality.
Source: The Internal Revenue Service, www.irs.gov
FIGURE 31.3 Ratio of returns to population.
Source: The Internal Revenue Service, www.irs.gov
0.50
0.45
0.40
0.35
0.30
19 6 8
19 74
1 9 7 1
19 77
19 8 0
19 8 3
19 8 6
19 8 9
19 9 2
19 9 5 19
9 8 20
01
20 04
20 07
2 0 10
2 0 13
FIGURE 31.2 Conventionally measured income inequality.
Source: The Internal Revenue Service, www.irs.gov
1% 10%5% 25%
80%
70%
20%
30%
40%
50%
60%
10%
0%
19 6 8
19 74
1 9 7 1
19 77
19 8 0
19 8 3
19 8 6 19
8 9
19 9 2
19 9 5 19
9 8 20
01
20 04
20 07
20 10
20 13
1A refundable tax credit is one whereby a household can receive more from
the federal government in the form of a return than is owed in tax or withheld.
The Earned Income Tax Credit (which was greatly expanded in both the Rea-
gan and Clinton administrations) and the Child Tax Credit (which was created
in the Clinton administration and doubled in size during the G. W. Bush admin-
istration) are both refundable. Portions of the tax credits to support a college
education are also refundable.
Measurement of Inequality 341
their tax withholding). When filings increase faster than
the population increases, and when nearly all of those
extra filings are in the lower 99 percent, that expands
the 1 percent group to cover more people than it oth-
erwise would. For instance, in 2007, 32 million more
filings were received than there would have been had
only 36 percent of the population filed. With 32 million
more filings, there were 322,000 more in the 1 percent.
Essentially, the conventional measure scooped some of
the 2 percent into the 1 percent. Correcting for that effect
results in a 1.4 percent decrease in the top 1 percent’s
systemic share. This is displayed in Figure 31.4.
Regarding the impact that changes to the tax treatment
of capital gains have had on the measure of inequality,
there is potentially a much larger effect. For the benefit
of those not steeped in finance or tax issues, capital gains
are those gains garnered from selling an asset for more
than was paid for it. In the United States, capital gains
are only taxed on “realization” rather than “accrual.”
This means that taxes are only owed on the gain if the
gain is “realized” in the form of a sale. Further, capital
gains are forgiven at death, which means that if there is
an accrued gain and a person sells, he or she realizes
the gain and owes the tax. If the person dies prior to the
realization, the gain is tax free (except for inheritance
taxes) and the heirs can immediately sell that asset (with
its gains) tax free. It is only if the heirs hold the asset
that any gains are taxed, but even then the “stepped-up
basis” means that its value on the day the person died
becomes its effective purchase price. There are good
economic reasons for this treatment that are beyond the
scope of this chapter, but the upshot is this: Capital gains
realizations, and therefore payments of capital gains
taxes, are almost entirely voluntary and easily avoided.
Higher rates of tax encourage tax avoidance through
nonrealization and lower rates of tax encourage realiza-
tion. Figure 31.5 shows that the rate that high-income
earners pay on those capital gains has changed over the
years. That rate reached a peak in the late 1970s at nearly
40 percent and from 2003 to 2012 was at its all-time low
level of 15 percent. This impacts the measure of income
inequality markedly in that, were capital gains tax rates
as high in 2007 as they were in the late 1970s, far fewer
gains would have been realized, and therefore far fewer
gains reported to the IRS. The accrued income would
have existed, but the measured income would not have.
If tax rates on capital gains had remained the same, pre-
sumably the rate of realization would have remained the
same. Because a higher percentage of capital gains prob-
ably went unrealized during the 1970s, incomes of the
top 1 percent were likely understated. Looked at differ-
ently, if tax rates had remained at their mid-1970s peak,
fewer realizations would have occurred and less income
would have been reported by the top 1 percent. Either
way, a decrease in the capital gains tax rate would be
reflected in an increase in the observed measure of the
share of income of the top 1 percent though inequality
may not have changed at all. A simple analysis of the
impact of a 20 percentage point drop in the maximum
capital gains tax rate suggests that 8 percentage points of
the increase in the share of the 1 percent can be attrib-
uted to the drop in the capital gains tax rate. Accounting
1% Adjusted for returns (base = 1968)
27%
22%
17%
12%
7%
19 6 8
19 74
1 9 7 1
19 77
19 8 0 19
8 3
19 8 6 19
8 9 19
9 2 19
9 5 19
9 8 20
01
20 04
20 07
20 10
20 13
FIGURE 31.4 1 Percent adjusted for the increase in all returns.
Source: The Internal Revenue Service, www.irs.gov and author calculations 50
40
30
20
10
0
19 6 8
19 74
1 9 7 1
19 77
19 8 0 19
8 3
19 8 6 19
8 9
19 9 2
19 9 5 19
9 8 20
01
20 04
20 07
20 10
20 13
FIGURE 31.5 Maximum capital gain tax rate.
Source: The Internal Revenue Service, www.irs.gov
342 Chapter 31 Income and Wealth Inequality: What’s Fair?
for the tax-returns effect and the capital gains effect,
the top 1 percent’s share would have increased from
7.55 percent to 13.09 percent rather than to 22.49 percent.
One consequence of the reelection of President
Obama in 2012 was that he negotiated an increase in the
top capital gains tax rate for 2013 and beyond. For those
holding assets beyond a year, the tax rate (for those in
the highest income bracket) increased from 15 percent
to 23.8 percent.
Wealth Inequality
A parallel issue to income inequality is wealth inequality.
Here there are fewer measurement concerns as there is no
direct tax in the United States on wealth (except perhaps
inheritance taxes that only occur at death). As a result,
there is no issue associated with who is filing and who
isn’t or capital gains accruals or realizations. The data on
wealth concentrations come from a unique dataset: the
Survey of Consumer Finances. These data are garnered
from 4,500 individuals who are carefully selected to
accurately represent the U.S. population’s demographics
(age, gender, household type, etc.) but also to achieve an
appropriate representation of households according to
economic characteristics (homeowners vs. renters, high-
income vs. low-income individuals, as well as those with
defined benefit pensions vs. those with defined contri-
bution pensions). Part of the survey’s usefulness is that
there is what in the statistics world is called “oversam-
pling” of high-income and high-wealth households to get
a more accurate representation of households in those
categories. Those “oversampled” households are then
weighted downward to make sure they do not bias the
results of the survey. Conducted on behalf of the Federal
Reserve by the University of Chicago, it is widely con-
sidered the gold standard of economic surveys.
Its results show that wealth inequality is similarly
high and is higher than it once was. The share of the
top 10 percent, which was 67 percent in 1989, grew to
75.3 percent by 2013. Figure 31.6 shows that the share
of the top 1 percent grew markedly (from 30 percent
to 36 percent) with the rise in the stock market during
the 1990s and has been relatively stable. The relatively
(but not extraordinarily) rich (i.e., the 9 percent in the
top 10 percent but not in the top 1 percent) faired very
well during the period after 1995. Figure 31.7 shows
that the upper-middle class and the bottom half have
seen their relative wealth shares fall. While the bottom
half’s share drop from 2007 to 2013 (from 2.5 percent
to 1 percent) is likely the result of the bursting of the
housing bubble in 2008 through 2010, both household
types have seen systematic declines in their wealth
shares since 1989.
Another measure of wealth inequality is the ratio of
mean wealth to median wealth. Mean (the simple aver-
age of) wealth differs from the median (the mid-point
of) wealth because rich people are very rich, and modest
percentage changes in their wealth are still very large
and as such will change the mean significantly even
if they have no effect on the median person’s wealth.
FIGURE 31.6 Share of wealth: top 10%.
Source: Survey of Consumer Finances
40
38
36
34
32
30 1989 1992 1995 1998 2001 2004 2007 2010 2013
90–99% Top 1%
FIGURE 31.7 Share of wealth: bottom 90%.
Source: Survey of Consumer Finances
35
20
25
30
15
10
5
0 1989 1992 1995 1998 2001 2004 2007 20132010
Bottom half 50–90%
The Shrinking Middle Class 343
Figure 31.8 shows that during the 1989 to 2007 period,
wealth (in inflation-adjusted dollars) rose 60 percent for
the median household, but the mean rose 86 percent;
that is, the rich got richer faster than did others. Again,
most of that effect was a result of the increase in the
stock market from 1989 to 2000. The gains from 2001
to 2007 were more the result of the housing bubble,
and because the average household benefited more (in
net wealth terms) from the increase in housing-related
wealth than did the rich (who have far less of the wealth
tied up in their homes), the relative increase in median
and mean wealth for that period was approximately
equal. When the housing bubble collapsed, however, the
median household’s wealth fell 40 percent, all the way
back to its 1989 inflation-adjusted level, while the mean
value dropped only 15 percent. This caused the mean to
median ratio, which had been rising steadily from 1995
to 2004, to spike to a level of 6.5. This means that the
high end is so high that mean wealth is 6.5 times higher
than the median household’s wealth.
The Shrinking Middle Class
Happening at the same time as the increase in inequality
has been the shrinking of the American middle class.
The two issues are similar but not necessarily identical.
The inequality issue is about incomes of those at the very
top increasing faster than everyone else’s (or increasing
while everyone else’s has remained stagnant or fallen).
The issue of the shrinking middle class is associated,
mostly, with the loss of income by those in the middle.
As mentioned previously in Chapter 15, the Pew Chari-
table Trust defines the middle class as those households
with incomes between 67 percent and 200 percent of the
median household income by household size. In 2014
a three-person household with income between $42,000
and $126,000 would qualify as being in the middle class.
Table 31.1 shows the percentage of households by Pew’s
income classes.
Without regard to definitions, the middle class can
shrink or expand because people near the definitional
thresholds have incomes increase or decrease. For instance,
a surge in earnings of people just under the 200 percent
definitional threshold would shrink the middle class by
moving them into the “upper middle.” That would be an
unambiguously good thing. To some degree that is what
happened in the 1970s through the 1990s. Another unam-
biguously good thing would be if people moved into the
middle class because they were below the lower threshold
and moved above it. That has not occurred at all during the
last 45 years.
On the other hand, if people are falling below the
67 percent definitional threshold into the “lower middle”
group, or worse, moving from the lower middle to the
lowest group, that is unambiguously bad. Not just be-
cause the middle class is shrinking but because of the
way in which it is shrinking.
A graphical display of the income distribution is not
a standard bell curve. It actually looks a great deal more
like the two distributions shown in Figure 31.9. There
are many people at the lower end of the distribution with
an ever-decreasing percentage in each income category
thereafter. The middle class is represented by the shaded
portion. If the middle class shrinks, more of the distribu-
tion is outside the shaded area. In particular, a movement
TABLE 31.1 Pew Charitable Trust income classes
Source: http://www.pewsocialtrends.org/2015/12/09/the-american-middle-class-is
-losing-ground/
Lower Upper
Year Lowest Middle Middle Middle Highest
1971 16 9 61 10 4
1981 17 9 59 12 3
1991 18 9 56 12 5
2001 18 9 54 11 7
2011 20 9 51 12 8
2015 20 9 50 12 9
FIGURE 31.8 Median and mean wealth and their ratio (2010 dollars).
Source: Survey of Consumer Finances
700,000
400,000
500,000
600,000
300,000
200,000
100,000
W e
a lt
h
R a
ti o
Median wealth Mean wealth Ratio
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.00
1989 1992 1995 1998 2001 2004 2007 2010 2013
344 Chapter 31 Income and Wealth Inequality: What’s Fair?
from the black distribution to the brown one would con-
stitute a shrinking of the middle class.
The economic and political consequences of the
shrinking middle class are enormous. When people’s
incomes become less equal and when fewer people
can describe themselves as being in the middle class,
there is more antipathy to a market-based economic
system. On the other hand, as long as people view
the system as fundamentally fair, even those who
find themselves at the bottom of the income distribu-
tion will see their lot in life as a consequence of their
own choices. Increases in income inequality, there-
fore, cause more people to question the fairness of a
market-based economy.
When people question the fairness of a market-based
economy, they will seek policies that insulate them from
the harshness of that system. The British vote to leave
the European Union, for instance, could be viewed as
such a reaction by that population. The popularity of
2016 presidential candidates Donald Trump and Bernie
Sanders and their anti-trade prescriptions is another.
Those insulating policies (reducing immigration or
erecting trade barriers) inhibits the free flow of people,
labor, investments, goods, and services. For those that
argue for such policies, they do not necessarily care
because they assert that the benefits from free trade
and the free movement of those elements only favor
the rich. For those that argue against such policies,
they typically argue that the policies shrink the size of
the economic pie and therefore reduce what is avail-
able to everyone. When market-based systems produce
outcomes that are viewed by the majority as unfair or
“rigged,” as a 2016 poll of Americans said it does, that
system is threatened.
Causes of Household Income and Wealth Inequality
The reasons for the increase in household and wealth
inequality are not particularly contentious. Some econo-
mists and sociologists, however, might debate whether
these increases were avoidable, how the increases might
have been avoided, and even whether combatting the
increases would be wise. Let’s begin with the causes, as
they have been enumerated.
First, there is the decline of the American manufacturing
sector generally and the decline of union-represented
manufacturing employees specifically. Union- represented
manufacturing employment, in autos, steel, and consumer
durables (televisions, household appliances, etc.) has
largely collapsed in the last 40 years. The jobs created by
these sectors (and now lost) were well-paying positions re-
quiring relatively little education. These jobs were, to the
hardworking, a ticket to a middle-class lifestyle.
So why did this happen? Robotic production and in-
ternational competition for the goods produced by these
industries are largely to blame for the elimination of
these manufacturing jobs. Specifically, fewer and fewer
jobs are being performed by physically challenging
labor, and more and more jobs are being performed by
intellectually challenging labor. As a result, the premium
paid to the brightest and most well educated continues
to grow, and the relative wage of those performing
manual labor has diminished. A worker today can be
responsible for the output while supervising the actions
of computer- and robotically driven manufacturing that
once required several workers to perform physically
demanding tasks.
International competition for goods-producing indus-
tries has made it extraordinarily difficult for domestic
manufacturers to compete if and when they have high
wages and generous benefit packages. Domestic steel
and auto production declined in the 1970s and 1980s,
and while their decline continued through to today, the
1990s and 2000s saw a significant decline in the pro-
duction of consumer electronics, appliances, and house-
hold products. Many economists consider this aspect as
having been inevitable. In the immediate aftermath of
World War II, there was no major economy, other than
the American one, with its economy and infrastructure
P e
rc e
n ta
g e
o f
in c o
m e
t a
x fi
le rs
Income
FIGURE 31.9 Income distribution.
Costs and Benefits of Income Inequality 345
more or less intact. For that reason, American manufac-
turing had significant market power relative to the rest of
the world. If someone wanted steel, for the better part of
the 1950s and into the 1960s, he or she had to buy it from the
United States. The same was largely true of automobiles
through the 1970s and for consumer electronics and
durables through the 1980s. With that market power,
companies in the United States could pass on their higher
wage costs to the world’s consumers. American unions
could therefore bargain for higher wages, and because
there was no international competition in these areas,
the manufacturers were motivated to back down and pay
those wages and offer better benefits. Again, because they
could pass on the increased costs, they were not only not
compelled to keep costs under control, but rather it was
more in their interests to avoid sales-reducing strikes. As
time progressed the economies of first, Germany and
Japan, then Korea and China, and perhaps soon, India
and Africa were able to undercut high American prices
with the one advantage they had: lower wages. Short
of walling off the U.S. economy, there was nothing the
United States could have done to stop this pressure. As
a result, downward pressure on American wages, under
the story accepted by many, was an inevitable outcome
of the late twentieth century.
All of this speaks to why incomes (and wealth) of
those at the bottom would remain stagnant or decline,
but what would explain why those at the top did so well?
For this we have to turn to the aspects of global changes
that benefited those at the top. The first of these changes
involves the movement of global capital, while the second
involves changes in the consumption-saving patterns
of those not at the top.
In the aftermath of World War II and through the
1980s, the vast majority of financial capital used to grow
businesses was locally generated. That is, Americans
lent their money to other Americans to build businesses,
finance homes, and so forth. Today, a bond used to fi-
nance a company or a mortgage taken out to buy a home
could very easily have its origins in Saudi Arabia or
China. The foreign entity saves the money from profits
earned in their global enterprises, converts that money
to dollars, and invests it in U.S. markets. Capital markets
have become much more profitable to those engaged in
them and those engaged in them are, almost always, very
wealthy people.
Furthermore, American saving rates have fallen pre-
cipitously since the 1960s. A home that used to require a
20 percent down payment can now be had for 10 percent
(or less) down. A car that used to be purchased for cash is
now far more likely to be financed with a loan or leased
with terms often so generous as to allow the consumer to
simply sign his or her name and drive away with a new
car. What that means is that the savers, who used to come
from all walks of life, are now far more likely to come
from the higher end of the income scale.
To some degree, public policy since the 1980s has
been more favorable to those at the high end of the in-
come and wealth distribution than it was in years prior.
Inheritance tax rates have fallen throughout the United
States relative to where they were in the 1970s. Nation-
ally, in inflation-adjusted terms, inheritance taxes are
collected on fewer households than used to be subject
to them and at lower rates. This is true at the federal
and state levels. If there are two ways of being rich—
inheriting your wealth or earning your wealth—policy
changes are making the former easier.
The other significant tax policy change prior to the
1980s is the treatment of investment-based income.
Capital gains tax rates as well as tax rates on carried in-
terest (a form of income associated with an investment
or hedge fund manager’s exceeding a specified return
goal),which had been treated as ordinary income in the
late 1980s and early 1990s, are now taxed at a lower rate
than other earned income.
Finally, with all of this happening to increase income
inequality, there had existed a counterweight to it in the
1960s through the 1980s: namely, the increasing labor
force participation of women had turned millions of one-
earner households into two-earner households so that the
wage-and-salary earning class had seen rapidly increas-
ing family incomes, especially during the early part of
this period, from the increase in the number of income
earners in those families. As the trend finished running
its course during the end of this period, this particular
counterweight was no longer holding back the move-
ment toward inequality resulting from the other forces.
Costs and Benefits of Income Inequality
Market economies rely on the principle that individu-
als earn an income that is positively related to the value
of what they provide to that society where that value
is measured by what others are willing to pay. If it is
not positively related, some (perhaps many) individuals
will stop doing what they are doing and do something
else more lucrative or less demanding. If physicians and
other professionals that require higher levels of educa-
tion do not earn more than ordinary laborers, then only
346 Chapter 31 Income and Wealth Inequality: What’s Fair?
those who wish to stay in school for long periods of time
to engage in their desired profession will do so. If that
happens, there will be too few people trained to be phy-
sicians, engineers, scientists, and managers. Income in-
equality provides a motivation for both those who wish
to be at the high end of the income distribution to work
to achieve it and those who wish to avoid being at the
low end of the income distribution to work to avoid that
result as well.
To see this in your own life, imagine that the profes-
sion you wish to embark upon paid only the minimum
wage. Would you continue pursuing a degree in order to
engage in that profession? Some of you might, but most
of you would change your degree program to do some-
thing more lucrative—if for no other reason than to pay
off your student loans or make the time in college worth
the expense.
Significant income inequality has a social downside
as well, especially when the level of inequality is viewed
by those in the middle and at the bottom of the distribu-
tion as unjustified by the aforementioned social benefits
associated with meeting market needs. When the poor
believe that their poverty is a result of choices they made
or as a result of things they did or failed to do, income in-
equality does not challenge the social order. On the other
hand, when those in the middle or at the bottom of the
distribution believe that the system is rigged in favor of
the rich remaining rich, social disorder can be the result.
Social disorder can threaten the system that allows for
income inequality in the first place, and as a result, it
is frequently in the interests of those at the top of the
distribution to ensure that those in the middle and at the
bottom believe that the inequality is justified.
A positive view of income inequality by those in the
middle and at the bottom can be achieved as long as
there is the widespread belief that there exists upward
income and wealth mobility in society. It is therefore im-
portant for those at the top of the income distribution to
create the reality of opportunity or at least maintain a
widespread belief in a myth of opportunity. Table 31.2
shows the degree of income mobility from 1987 to 1998
and from 1996 to 2005. What it shows is that 38.9 per-
cent of those in the lowest quintile in 1987 were also in
the lowest quintile in 1996. What it also shows is that
17.9 percent of those in the lowest quintile in 1987 were
in one of the two highest quintiles in 1996. From 1996
to 2005 these figures were largely the same, given that
37.8 percent of the poor in 1996 were also poor in 2005
and that 19 percent of the poor in 1996 were in one of the
top two quintiles in 2005. At the other end, it shows that
55.3 percent (100% − 44.7%) of those in the 1 percent in
1996 weren’t in the top 1 percent in 2005.
Another way of looking at income mobility is the
degree to which the income quintile of parents and the
income quintile of their children are related; that is,
whether or not you inherit your parents’ wealth, you
TABLE 31.2 Income mobility from 1987 to 1996 and from 1996 to 2005.
Source: United States Department of the Treasury, www.treasury.gov/resource-center/tax-policy/Documents/incomemobilitystudy03-08revise.pdf
Lowest Second Middle Fourth Highest Total Top 1%
Lowest 1987–1996 38.9 28.3 14.9 10.6 7.3 100 0.3
1996–2005 37.8 27.1 16.1 11.8 7.2 100 0.3
Second 1987–1996 14.2 33.8 26.4 16.4 9.3 100 0.2
1996–2005 15.8 30.1 28 17.2 9 100 0.2
Middle 1987–1996 6.1 17.4 33.9 28.4 14.2 100 0.3
1996–2005 5.9 14 32.6 31.1 16.3 100 0.3
Fourth 1987–1996 3 7.5 19.4 40.1 30 100 0.5
1996–2005 3.1 5.7 15.5 41.9 33.8 100 0.3
Highest 1987–1996 1.8 2.5 7.3 20.6 67.8 100 5.4
1996–2005 2 2 5.7 17.2 73.2 100 4.8
Top 1% 1987–1996 2.1 0.9 2.5 4.7 89.9 100 46
1996–2005 2.7 1 1.5 4.5 90.3 100 44.7
All Income 1987–1996 11.3 16.5 20.1 24.1 28 100 1.5
1996–2005 11.7 14.7 19.1 24.4 30 100 1.3
Summary 347
often inherit your parents’ values, work ethic, and social
standing and that translates into higher income.2 This in-
tergenerational income relationship has been estimated
by economists for a variety of countries using a variety
of methodologies. Canadian economist Miles Corak
summarized the results that are displayed in Table 31.3.
Higher numbers suggest a stronger relationship between
parental and child income. This analysis shows that the
U.S. claim to be “the land of opportunity” isn’t backed
up by the data, at least not recently.
TABLE 31.3 Cross-country intergenerational income elasticities.
Source: Miles Corak, “Do Poor Children Become Poor Adults? Lessons from a Cross-
Country Comparison of Generational Earnings Mobility,” http://ftp.iza.org/dp1993.pdf
Country Elasticity
Denmark 0.15
Norway 0.17
Finland 0.18
Canada 0.19
Sweden 0.27
Germany 0.32
France 0.41
United States 0.47
United Kingdom 0.50
2For instance, my fraternal grandfather earned a law degree; my father,
brother, and sister (as well as I) earned PhDs; and my daughter is in a PhD
program. That is highly unlikely to be random.
Summary
The United States has significant income and wealth
inequality. Part of the increase in income inequality is
explained by measurement issues. The systemic increase
in income inequality is explainable demographic factors
and factors relating to tax policy. Inequality has benefits
in that a higher income is a market reward for higher
productivity while it has costs related to social discord.
Social discord is a more likely outcome when income
mobility is low or decreasing, and in the present-day
United States, both are the case.
Quiz Yourself
1. Income inequality, when measured as the percent-
age of total income going to the top 1 percent, in-
creased most rapidly during the
a. 1950s.
b. 1960s.
c. 1980s and 1990s.
d. 2000s.
2. Income inequality as conventionally measured is
____ when you ignore the fact that a higher percent-
age of the population is filing tax forms.
a. overstated
b. understated
c. properly stated
3. Income inequality as conventionally measured is
____ when you ignore the decreases in the capital
gains tax rate.
a. overstated
b. understated
c. properly stated
4. Wealth inequality is _____ related to the ratio of
mean to median wealth.
a. positively
b. negatively
c. not
5. Which of the following had the effect of decreasing
income inequality?
a. The increase in the female labor force participa-
tion rate
b. The increase in globalization of capital
c. The increase in globalization of trade in steel,
autos, and consumer durables
d. The increase in robotic production
6. Which of the following had the effect of increasing
income inequality?
a. The increase in the female labor force participa-
tion rate
b. The decrease in globalization of capital
c. The increase in globalization of trade in steel,
autos, and consumer durables
d. The decrease in robotic production
348 Chapter 31 Income and Wealth Inequality: What’s Fair?
Fact 2: Our “liberal” political party, the Democrats, are
frequently more conservative than the members of
European conservative political parties.
Question: Which is the cause and which is the efect?
Think about This
Are the poor adults with whom you are familiar poor
because of things they did (got pregnant at an early age,
committed a crime that prevented them from a getting a
good job), things they failed to do (finish their education,
work hard), things that happened to them (they were the
victim of an accident, or were left with children to attend
to), or is the system rigged against poor people?
What policy would you suggest to a national leader to
increase income mobility?
Behind the Numbers
Income—www.irs.gov/uac/SOI-Tax-Stats-Individual
-Income-Tax-Returns
Wealth—www.census.gov/people/wealth/data/dtables
html; www.census.gov/people/wealth
Income mobility—www.federalreserve.gov/pubs/feds
/2009/200913/200913pap.pdf
International statistics on intergenerational income
mobility.
Corak, Miles, “Do Poor Children Become Poor
Adults? Lessons from a Cross Country Com-
parison of Generational Earnings Mobility,”
ftp.iza.org/dp1993.pdf.
7. The benefits of income inequality are
a. always greater than the costs.
b. always less than the costs.
c. associated with rewarding hard work and work
that society values.
d. associated with the social discord that it creates.
8. Social discord resulting from income inequality can
be lessened if there is (are)
a. high levels of intergenerational income
mobility.
b. high levels of income mobility of individuals.
c. belief that the economic system is rigged in
favor of the rich.
d. a and b
9. The notion that the United States is the “land of
opportunity” where who your parents are and how
much they earn is unrelated to your income is (rela-
tive to other industrial powers)
a. clearly shown in the data to be accurate.
b. clearly shown in the data to be inaccurate.
c. not supported, but there aren’t data to support
the conclusion that it isn’t true either.
Talk about This
Suppose you were rich. How would you structure your
tax and welfare systems to make sure you could stay
rich? Would you try to rig the system in your favor or
could that be self-defeating?
Fact 1: Americans tolerate a level of income inequality
that is higher than it is in much of the rest of the world.
C H A P T E R T H I R T Y - T W O
349
Farm Policy Learning Objectives
After reading this chapter you should be able to:
LO1 Conclude that economists generally are not in favor of price
supports in agriculture.
LO2 Conclude that price variation is the leading economic justifi-
cation for farm price supports, while also concluding that this
is insufficient justification for most economists.
LO3 Apply supply and demand and consumer and producer
surplus analysis to demonstrate economists’ reasoning in
opposing farm price supports.
LO4 Describe and illustrate the mechanisms that are typically
used to enforce price supports and know some of their
history.
Chapter Outline
Farm Prices Since 1950
Price Variation as a Justification for Government Intervention
Consumer and Producer Surplus Analysis of Price Floors
Price Support Mechanisms and Their History
Is There a Bubble on the Farm?
Kick It Up a Notch
Summary
Farm policy in the United States has been schizophrenic.
Sometimes farmers are depicted as strong, independent
men and women who simply need the government to
stay out of their way. At other times they are depicted as
desperate victims in need of help. In political speeches,
family farms are spoken of with the same reverence as
motherhood and apple pie, and to hear politicians talk,
you would think farmers were demigods.
It is ironic, then, that without almost continuous
government grants and low-interest loans, many farm-
ers would have declared bankruptcy long ago. Help for
farmers has come from government in many forms. The
government has bought and stored excess production,
bought and given away excess production, bought live-
stock to prevent oversupply, and paid farmers not to farm.
We look here at the history of farm prices since 1950,
and we draw on that history to discuss why government
has intervened and will probably continue to feel moti-
vated to intervene in agriculture. We use our basic sup-
ply and demand model and our consumer and producer
surplus knowledge to discuss the impact of farm price
supports. In that discussion, as we said, we review the
history of farm price supports and the various ways that
farmers have received assistance.
Farm Prices Since 1950
A look at Figure 32.1 quickly tells you that farm prices
are anything but stable. While beef, hogs, milk, corn,
and soybeans are sold in different units, by displaying
prices relative to where they were in 1982, we can show
all of them on one graph. A number higher than 100 in-
dicates a price in a selected year for that commodity that
exceeds its 1982 level. A number below 100 indicates
the opposite.
Whereas the prices of all the products shown in
Figure 32.1 were higher in 2013 than they were in 1950,
it was not that long ago that several were lower than
they were in 1982. Since, according to the CPI, overall
inflation was 137 percent from 1982 to 2015, farmers
who produced the same crops in the same amounts and
350 Chapter 32 Farm Policy
rise. Corn and soybean meal are frequently used as ani-
mal feed, thus the relationship between corn, soybeans,
and beef and hog prices. Also in Chapter 2 and the no-
tion of “alternative outputs,” recall that when two can
be easily produced from the same inputs, the two prices
will almost always mirror one another. If you have ever
traveled from Ohio through Indiana, Illinois, Iowa, or
Missouri, the farms along the highway are almost always
planted in corn and soybeans. An increase in the demand
for one will cause a decrease in the supply of the other.
Farmers will plant whatever makes them the most profit,
and as a result the prices will move in tandem. What oc-
curred in 2007 and 2008 was a spike in the demand for
corn owing to its potential use in corn-based ethanol.
Corn and Gasoline
Let’s examine that corn–gasoline relationship in greater
detail. What had once been a nonexistent relationship
began to emerge in 2004 as subsidies and mandates for
alternative fuels for cars and trucks became part of the
U.S. energy landscape. Corn-based ethanol was a major
part of President Bush’s energy strategy and played a role
in President Obama’s energy strategy. Flex-fuel vehicles
are an increasing portion of the rolling stock on Ameri-
can roads, and as a result the overall demand for corn has
risen. In addition, ethanol is now an increasing portion of
the total fuel demand, so much so that 38 percent of the
corn grown is now used for that purpose. As can be seen
with the same costs would have experienced a 58 percent
(100/237) loss in real income if they were only able to
get the same price they received in 1982. Hog prices in
particular took a beating between 1998 and 2000, yield-
ing at times less than 45 percent of their 1982 levels. Any
farmers who had not gotten more productive by this time
would have seen a standard of living only 33 percent of
their 1982 level. Until quite recently, prices for most farm
commodities have risen far more slowly than overall con-
sumer prices. Since 2007, farm prices have seen a signif-
icant increase, and two of them, corn and soybeans, saw
such a spike between 2010 and 2013 that their overall
increase since 1982 exceeded that of the CPI.
If you look carefully at Figure 32.1, you will see
that there was a sharp jump in all of these commodity
prices in the early 1970s and again in 2008, and then
again between 2010 and 2013. Corn, soybean, and hog
prices doubled in the four years from 1972 to 1975.
Before 1975, corn, soybean, and milk prices had been
the most stable, but since 1976, corn has joined beef
as a commodity whose price is not stable.1 In 2007 and
2008 most farm commodities doubled or even tripled in
price. By far the greatest increase was seen in corn and
soybeans. Going back to Chapter 2, you will remember
that when one good is an input into another, an increase
in that input price will drive the price of the output to
FIGURE 32.1 Farm prices relative to their 1982 levels.
Source: Bureau of Labor Statistics, www.bls.gov/ppi
20
70
120
170
220
320
270
19 50
19 54
19 58
19 62
19 66
19 70
19 74
19 78
19 82
19 86
19 90
19 94
19 98
20 06
20 02
20 10
20 14
Year
P ri
c e
i n
d e
x ( 19
8 2
= 1
0 0
)
Milk CPISoybeansCorn Beef Hog
1 We are defining stability here as the ratio of the standard deviation of real
prices to their mean.
Price Variation as a Justification for Government Intervention 351
in Figure 32.2, prior to 2004 there was almost no relation-
ship between the two prices, but between late 2004 and
early 2009 the price per bushel of corn more than tripled
in reaction to the tripling of gasoline prices. Going back
to our Chapter 2 discussion of demand and supply deter-
minants, ethanol is a substitute for gasoline and corn is
an input to ethanol. A steadily high gasoline price would
be expected to, and in fact did, lead to an increase in corn
demand and corn prices.
Had gasoline prices remained at their summer 2008
highs, corn probably would have as well. When the de-
mand for gasoline fell dramatically with the declining
economy, the price of corn fell dramatically as well. By
the end of 2008 the price of corn was about half of its
mid-2008 high. The prices once again mirrored each
other in the rise through late 2010 and into 2014.
Because ethanol is only a viable substitute for gaso-
line when gasoline prices are high, with the dramatic
drop in gasoline prices that occurred from 2015 and into
2016, the link between corn and gasoline prices was
largely severed.
Price Variation as a Justification for Government Intervention
Economists agree on few things, but one area where
there is wide agreement is on the inadvisability of gov-
ernment intervention in agriculture. As a result, appeals
for intervention tend to be based on sentiment rather than
analysis. Although such sentimental appeals have not
persuaded many economists, they have swayed politi-
cians. The family farm is so revered in America, even
by people who have never lived on or even near one, that
economists have had little success forestalling farm bail-
outs. That said, there are reasons for government inter-
vention in agriculture that a few academic economists,
particularly agricultural economists, accept.
The Case for Price Supports
The most compelling of the reasons for government in-
tervention in this market is that price variability makes
farming a necessarily economically risky occupation.
Supporters think that farmers whose farms are small
need some government action to survive the aforemen-
tioned variability. The government’s assistance in this
might take the form of buying and storing excess crops
when prices are too low and selling them out of inventory
when prices rebound. This would do nothing to change
the long-term price of crops, but it would stabilize prices.
When the government does this for farmers, it acts as it
does when it controls the value of its own currency.
There are two sources of price instability for any good:
supply uncertainty and demand uncertainty. Sources of
supply uncertainty are obvious: the weather and other
natural phenomena like diseases and insect damage. The
source of demand variability is mostly the unpredictabil-
ity of international markets and whether there is demand
for American crops by other countries.
The weather and other aspects of nature determine
whether crops will do well, and there is not a great deal
FIGURE 32.2 Relative prices of gas and corn.
Source: Bureau of Labor Statistics, www.bls.gov/ppi
0
50
100
150
200
250
300
350
400
20 00
.Ja n
20 00
.S ep
20 01
.J an
20 01
.S ep
20 02
.Ja n
20 02
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20 03
.J an
20 03
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20 04
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20 04
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20 05
.J an
20 05
.S ep
20 06
.Ja n
20 06
.S ep
20 07
.J an
20 07
.S ep
20 08
.J an
20 08
.S ep
20 09
.J an
20 09
.S ep
20 10
.J an
20 10
.S ep
20 11
.J an
20 11 .S
ep
20 16
.J an
20 12
.J an
20 12
.S ep
20 13
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20 13
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20 14
.J an
20 14
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20 15
.J an
20 15
.S ep
R e
la ti
v e
p ri
c e
Year
Corn Gas
352 Chapter 32 Farm Policy
without government help. If farmers do not buy options
or crop insurance, it is because they cost money. Even
when things go well, profit margins on farms are low
enough that some farmers believe they cannot afford
insurance.
Consumer and Producer Surplus Analysis of Price Floors
One Floor in One Market
All of the many forms of support that government can
give to farmers can be modeled with our supply and de-
mand model, and we can discuss their implications using
the consumer and producer surplus language that was in-
troduced in Chapter 3. This section quickly reviews that
language and uses Figure 32.3 to look at the impact of
farm price supports on the economy.
Chapter 3 told us that consumer surplus is the differ-
ence between how much consumers value a good and the
price they have to pay for it. It also told us that producer
surplus is the difference between the amount producers
get from consumers and the variable cost of production.
The demand curve represents what consumers are will-
ing to pay for a good, and we interpret that as how much
they value the good. In Chapter 5, we saw that the supply
curve in a perfectly competitive market is made up of the
marginal cost curves of the many entities that comprise
the market. The area under the supply curve thus repre-
sents the variable costs of production.
farmers can control once the planting is done. They can
plant different varieties of corn and soybeans based on
the lateness of the planting season, but once the seeds are
sown, most of the economic decisions are made. Grain
farmers, for example, are powerless to do anything if
market conditions change after planting. At harvesttime
they will reap what they sowed—no more, no less.
On the demand side, variability comes from the quan-
tities of goods foreigners will buy. In part this is supply-
side variability in other nations. For instance, if the
weather is bad in the other major exporting countries of
Argentina, Australia, Canada, and Russia, then demand
will be high in the importing countries for American
grain. The United States is the largest source in grain
exports to the world, but prices in the United States are
usually somewhat higher than in other countries. For this
reason, food importers buy all they can from these other
countries; then they buy the rest of what they need from
the United States. If the weather in these other export-
ing countries is bad, then importing countries will need
great quantities of U.S. grain. If their weather is good,
importing countries will not need much U.S. grain. With
the weather and other forces of nature as variable as they
are, there are few goods whose prices fluctuate as much
as basic farm prices.
The Case against Price Supports
Though price variability is the most compelling reason
for government interference in agriculture, it is not a per-
suasive reason for many economists. Option markets for
agricultural goods exist and offer many opportunities to
ensure that prices at harvesttime are known in advance.
Such markets serve as insurance to farmers on prices.
To see how using an option market might work, sup-
pose you planted your crop in May and expected it to
yield 10,000 bushels. At planting time in May you can
buy an option to sell 10,000 bushels at harvesttime for
a specific price. If the price at harvesttime is lower than
the price specified in the option, you can exercise the
option and sell your harvest at the higher contract price.
If the price is higher, you do not need the option. This
is comparable to buying automobile insurance. You will
use it if you have an accident; you will not if you avoid
a wreck.
If you fear your crop might fail, you can protect
yourself by buying crop insurance. Crop insurance will
pay off if crops fail. With these two forms of insurance
(options and crop insurance), farmers can deal with
the aspects of farming over which they have no control
FIGURE 32.3 Price floors in a supply and demand model.
Pfloor
P*
O QD QSQ*
P
A
B
I
E
F
C
G
H
J
D
Q
S
Price Support Mechanisms and Their History 353
Vermont rather than Eau Claire produces the dairy for
New York. Thus not only do New Yorkers have to buy
milk at high prices, but the fact that they do tends to re-
ward less efficient means of production. This is, unfor-
tunately, precisely what the Eau Claire Rule does in the
United States.
What Would Happen without Price Supports?
If there were no price supports, how low could prices
go? The first thing to understand is that like everyone
else, farmers have options other than farming. If prices
go low enough, they will sell out and work somewhere
else. In this sense farmers are like any other small
businesspersons who must decide when they have had
enough. While being your own boss has clear advan-
tages, the advantages must also be weighed against
risks and the frayed nerves associated with being in
charge.
For most farmers, the lack of a boss outweighs the
frayed nerves. Even with lower income, they would
rather continue farming than work for someone else.
On the other hand, there is a price for which the rate
of return to farming is just too low. When that point is
reached, farmers auction off their assets, pay their debts,
and move on. As a result, prices cannot fall below the
level where farmers are better off not farming. If they
did, the farmers would leave the market, thereby reduc-
ing the number of sellers, and that would put upward
pressure on the price.
Price Support Mechanisms and Their History
Price Support Mechanisms
As we noted in the previous section, there are many ways
of enforcing a price support. The reason an enforcement
mechanism is required in agriculture and not in other
price floor situations is that production happens and most
costs are incurred well before sales are made or even ar-
ranged. For instance, the minimum wage is a form of
price floor. The buyer of labor, the boss, cannot pay the
seller of labor, the worker, any less than the minimum
wage, just as the buyer of the agricultural product cannot
pay the farmer any less than the price floor. The sup-
ply and demand analysis in the minimum wage shows
that more people want to work than there are jobs avail-
able. This is not as much of a problem in normal work-
ing situations as it is in farming because, unlike farming,
At equilibrium, P* – Q*, consumers have a consumer
surplus of P*AC. Similarly, the producer makes out well,
too. The firms net a producer surplus of HP*C. The
combined surpluses make up the value to society of the
exchange, a value represented as HAC.
If the government sets a price floor of P floor
, it will have
to enforce it somehow. While we will not talk until the
next section about how govern-
ment might enforce the floor,
assume for the moment that it
is possible. Since consumers
will want only Q D , this is all that will be sold to consum-
ers. The consumer surplus will shrink (to P floor
AB) while
firms’ producer surplus will grow (to HP floor
BG), but the
combined surpluses are less than without the floor by
GBC. Economists label this deadweight loss. To see why
this is the case, turn to “Kick It Up a Notch” at the end
of the chapter.
Variable Floors in Multiple Markets
Support for farmers and their price supports dates back
to the Great Depression, when dairy farmers could not
sell their products, and they convinced the government to
set minimum prices. The so-called Eau Claire Rule came
about at this time. Put in place so that farmers outside
Wisconsin could survive and remain in business, the Eau
Claire Rule sets the minimum price for milk as a func-
tion of a farm’s proximity to this small Wisconsin city.
To this day, a dairy farmer in central Wisconsin gets a
substantially lower subsidy than a similar farmer in the
other dairy capitals of central New York or northern
California.
To see the effect of this, consider for illustration that
there are three geographically distinct areas. Suppose
two of these are rural areas where dairy products are
both produced and consumed and the third area is a city
where these products are consumed but not produced.
Suppose one rural area—call it Eau Claire—has a pro-
duction advantage over the other—call it Vermont—and
this advantage overwhelms the fact that a consum-
ing city, say New York, is closer to Vermont than Eau
Claire. In such a circumstance Vermont dairy farmers
would sell only to those living in Vermont, and Eau
Claire farmers would sell to those in New York as
well as Eau Claire. This is the economically efficient
scenario.
If, on the other hand, there is a rule that says that the
lowest price that can be charged in New York is higher
than the market equilibrium, it might be high enough that
price floor Price below which a commodity may not sell.
354 Chapter 32 Farm Policy
that did not prevent others from becoming farmers. It
did not prevent remaining farmers from increasing their
herds, and it did not prevent others from increasing the
productivity of their cows, using artificial hormones.
Grain farmers also experienced this form of price sup-
port. Many were paid to have idle fields, fields that
could be used for hay but not for cash grains like wheat,
soybeans, or corn. In general, the government subsi-
dies have had the effect of persuading significant num-
bers of farmers either to do something else or to limit
production.
An expensive option for the government has been
to let farmers grow all they want and either pay them
the difference between the market price and the price
floor or simply buy up whatever was not purchased by
consumers. Figure 32.3 shows that it is very expensive
for the government to choose either of these options.
If it chooses the former, it will have to pay farmers
the difference between P floor
and the price that Q S will
sell for on the open market, shown in Figure 32.3 as
J, for all Q S . This totals JP
floor EF. If the government
chooses the latter option, it will have to buy the dif-
ference between Q S and Q
D for the P
floor , price. That
totals Q D BEQ
S .
If it buys up what is left by consumers, the govern-
ment still has to figure out what to do with the excess.
There are three options here: let it spoil, give it away,
or store it. The first does not cost anything more than
trucking the surplus to a place where it can be dumped.
Giving the excess away sounds more appealing, but if
you give people something that they would have ordi-
narily paid for, you still are not solving the agriculture
price problem. You are reducing demand even further
by the amount you are giving away. You can only give
the good to people who are so poor they would have
gone without, and you are most likely to find such peo-
ple in the developing world. It may sound somewhat
cynical, but the government of the United States is a
leading contributor of foodstuffs to victims of starva-
tion and natural disaster in the developing world in part
because the United States has an excess that it needs to
dispose of.
Even though the most expensive option for the
government is to store the excess, it has, at various
times, stored milk and grains. Milk has been stored
either as a powder or in the form of block American
cheese. While both can be stored at near room tem-
perature, a cool, dry environment is more conducive
the workers are not working and then looking to see if the
boss will pay them. They are hired and then they do the
work. Farmers, on the other hand, grow and harvest their
crops before they have a known buyer. Raising the price
that farmers get to P floor
will not do farmers any good if
many of them end up having truckloads of grain to sell
and no one willing to buy them. They will have incurred
all of the costs of working, but they will not derive any
revenue from their work.
For this reason, the government has to enforce the
price floor in a manner that makes sure either that
only Q D is produced or that Q
S is wanted. There are
several ways that this can be done. The government
can limit what farmers produce by allocating rights to
sell among farmers. With rights to sell, farmers can
sell only what their rights allow. The government can
pay farmers to participate by allowing anyone to sell
at P* while allowing only those who agreed to limit
production to sell at P floor
. The government can then
buy all that farmers want to produce. At its discretion
it can then give the good away to foreign or domestic
recipients that could not afford to buy it at P floor
, or the
government can buy and store all that farmers want to
produce at P floor
.
The government’s least expensive option to keep
prices high, however, is to limit the amount that a farmer
can produce. It can do this by allowing only licensed
farmers to produce specific quantities. Peanuts and
chewing-grade tobacco are two crops that are produced
under licensing. You cannot grow and sell these products
unless you have a license. If you examine Figure 32.3
again, you will see that by limiting the number of farm-
ers and the amount of acreage that can be devoted to this
production, the P floor
price can be maintained and farmers
will produce only Q D .
The government’s next least expensive option is to
pay farmers not to produce as much as they might oth-
erwise choose to. In the past the government paid farm-
ers not to plant in certain fields, and it even paid them
not to farm altogether. Moreover, to affect the price of
milk, the government bought dairy herds and sent them
off to slaughter. The government, of course, keeps pro-
duction down when it pays farmers not to produce. The
effectiveness of this method is lessened, however, by
increases in productivity and by new people becom-
ing farmers. In the case of milk, farmers who had their
herds bought were not allowed to get back into dairy
farming for several years, even if they wanted to, but
Is There a Bubble on the Farm? 355
to long-term storage. Abandoned salt mines have
served that purpose well.
Storing grain is somewhat easier. It does not require
any processing, the way milk does, but it is still subject
to rotting if it gets wet. However it is stored, storing food
is very expensive.
History of Price Supports
At various times the United States has employed every
imaginable way of supporting agriculture prices. At one
time it could have idled all grain farms in the United
States for a year and still had enough in storage to pro-
cess into food and to feed livestock. In the middle of
the 1982 recession, there was enough excess dairy in
storage that the government gave every poor person who
showed up for it several pounds of cheese and several
boxes of powdered milk. In the middle 1980s, thousands
of dairy farmers around the country went into early re-
tirement when the government paid top dollar to buy up
their herds.
As we said before, the support for agricultural price
supports grew out of the depression of the 1930s. Agri-
cultural prices fell so far so fast that farm bankruptcies
skyrocketed. Politicians reacted by putting price floors
on a number of agricultural products, most notably
dairy. In the middle 1980s, the Reagan administration
tried to lessen the cost of agriculture subsidies by limit-
ing supply, rather than serving as a buyer of last resort.
First it sold off and gave away much of the govern-
ment’s excess stocks of grain and dairy products. Then
it offered farmers payments not to farm. The ultimate
act in this regard was the middle 1980s policy to thin
dairy herds. This led to nearly a 10 percent reduction in
farmland under active cultivation since 1988. While we
proceed down a path of restricting output rather than
buying up excess, many thousands of farmers still are
paid many billions of dollars not to farm many millions
of acres.
The 1996 Freedom to Farm Act began yet another
long phase of practices leading away from agricultural
price supports. By 2002 the United States was supposed
to exist without supports for milk or grain, but alas, sup-
port continued with the federal government spending
$19 billion in 2009. Supports totaled $13.4 billion in
2013 and are projected to climb to $17.7 billion in 2021.
Farming is still considered as sacrosanct as motherhood
and apple pie, so if Mom or the pie gets in trouble, politi-
cians will always be strongly tempted to help them out.
Is There a Bubble on the Farm?
The housing bubble of the 2000s was the result of a more
than doubling of home prices between 2000 and 2006.
When it burst, many people looked around and wondered
why few had recognized the danger. Beginning in 2011, ag-
ricultural economists were expressing concern that a bubble
was forming in agricultural land values. Figure 32.4 shows
why. As corn and soybean prices rose, agricultural land val-
ues rose along with them. The obvious reason for this is that
the value of the land is directly related to the profit that can
be made by growing crops on that land. Higher crop prices
lead to higher farm profits, which leads to increased de-
mand for farmland, which leads to higher farmland prices.
That chain of events is factual and reasonable. The real
or imagined bubble problem comes when either of the fol-
lowing is true: the prices for the crops are artificially high
or the interest rates on the farm loans are artificially low.
It is difficult to argue from Figure 32.1 that crop prices
are artificially high as only corn and soybean prices are
above their inflation-adjusted levels from the 1980s. It is
easy to argue, using Figure 10.5, that interest rates from
2003 to 2006 and from 2009 to 2013 were artificially
low. With Federal Reserve policy pushing interest rates
low during these periods, one outcome has been inflated
farmland prices. When the quantitative easing policy
ends, it is likely that the run-up in farm prices will also
end. Whether that results in a collapse in farmland prices
(akin to the early 1980s collapse that resulted in hundreds
of thousands of farm foreclosures), only time will tell.
FIGURE 32.4 Agricultural land values.
Source: USDA Agricultural Research Services
3,500
2,000
2,500
3,000
1,500
1,000
500
0
P ri
c e
p e
r a
c re
19 9 4
19 9 6
19 9 8
20 00
20 02
20 04
20 06
20 08
2 0 10
2 0 12
2 0 14 20
15
356 Chapter 32 Farm Policy
Kick It Up a Notch
Referring back to Figure 32.3, at equilibrium, P* – Q*,
consumers pay the producers OP*CQ*, but they value
what they get at OACQ*. This means they have a consumer
surplus of P*AC. Similarly, the producer makes out well,
too. The producer receives the OP*CQ* in revenue and the
variable costs are only OHCQ*. This nets the producer sur-
plus of HP*C. The combined surpluses make up the value
to society of the exchange, a value represented as HAC.
If the government sets a price floor of P floor
, consum-
ers will want only Q D . They will pay the OP
floor BQ
D to
producers. Consumers will value this at OABQ D and will
net a consumer surplus of P floor
AB. It will cost producers
OHGQ D , so their producer surplus will be HP
floor BG. The
combined surpluses are HABG. The deadweight loss is
the difference between the combined surpluses with and
without the floor, GBC.
Summary
Now that you have plowed your way through this chap-
ter, you understand why economists generally are not in
favor of price supports in agriculture. You understand
that though price variation is real, there are mechanisms
that farmers can use to compensate for that without
government intervention. You are now able to employ
consumer and producer surplus analysis to demonstrate
the inefficiency caused by price floors. Last, you under-
stand how price floors work in practice, and you have an
appreciation for their history.
1. The economic rationale for farm price supports is
generally
a. weak, but relies on price variability.
b. weak, but relies on the unavailability of crop
insurance.
c. strong, and relies on the fact that prices are too
high.
d. strong, and relies on the importance of Iowa in
presidential elections.
2. Price supports in the United States have
a. always relied on the government paying farmers
to set aside land.
b. always relied on the government buying excess
crops.
c. always relied on forbidding production above
certain levels.
d. utilized a wide variety of means to raise prices
and reduce output.
Quiz Yourself
Key Term
price floor
3. Farm price supports are typically for
a. basic commodities like raw milk and grain.
b. fruits and vegetables.
c. refined products like flour.
d. manufactured products like breakfast cereals.
4. A price support mechanism
a. can only regulate supply.
b. can only regulate demand.
c. must involve government purchases.
d. can involve government manipulation of the
supply or demand of the good.
5. In Figure 32.3, maintaining P floor
as the target mini-
mum price (rather than equilibrium) would
a. raise consumer surplus more than it would
decrease producer surplus.
b. raise producer surplus more than it would
decrease consumer surplus.
Summary 357
c. involve creating deadweight loss.
d. enhance the welfare of consumers and
producers.
6. Looking at Figure 32.3, maintaining P floor
as the
target minimum price (rather than equilibrium) by
having the government purchase how much of the
product farmers wished to produce would cost the
government _____________ dollars.
a. OP*CQ*
b. Q D BEQ
S
c. OP floor
BQ D
d. BCG dollars
Short Answer Questions
1. Given what you know about the relationship be-
tween corn and beef and corn and soybeans and corn
and gasoline, an increase in the price of corn (due to
a new insect that eats the roots out of corn) would
have what impact on soybeans, beef, and gasoline?
2. If the price floor for corn is $3 per bushel and it
is raised to $4 per bushel, what is the impact of
that policy if the market price of corn is $6.50 per
bushel?
3. During the 1980s many considered urban sprawl to
be a serious problem for farmland. What would the
mechanism be for “farm sprawl” reversing that?
Think about This
How much does it matter from the perspective of market
form (monopoly, oligopoly, perfect competition) if there
are 100, 1,000 or 1,000,000 farms producing raw grain?
Talk about This
Farm price supports are intended to help “the fam-
ily farmer” but in reality often help multimillion-dollar
farms. When Congress limited the size of the check that
any particular farm could receive, farmers divided their
farms into separate entities with different family members
owning different farms so that they could continue to col-
lect money. The “family farmer,” defined as a simple farm
with one house and the occupants of that house working
the land, no longer produces a significant portion of the
raw grain, cattle, or milk in the United States. Is the fam-
ily farm more of a social myth than an actual entity?
For More Insight See
Gardner, Bruce L., “Changing Economic Perspectives
on the Farm Problem,” Journal of Economic Litera-
ture 30, no. 1 (March 1992), pp. 62–101.
Behind the Numbers
Farm product prices.
Bureau of Labor Statistics; Producer price index—
www.bls.gov/ppi
C H A P T E R T H I R T Y - T H R E E
358
Minimum Wage Learning Objectives
After reading this chapter you should be able to:
LO1 Apply supply and demand to a labor market.
LO2 Define and describe the purpose of a minimum wage.
LO3 Conclude that the minimum wage must be higher than the
equilibrium wage in order to be relevant.
LO4 Apply consumer and producer surplus to identify real-world
winners and losers of a minimum-wage increase.
LO5 Apply the concept of elasticity to the question of whether a
minimum-wage increase would increase unemployment.
LO6 Describe the Earned Income Tax Credit as an alternative to a
minimum wage.
Chapter Outline
Traditional Economic Analysis of a Minimum Wage
Rebuttals to the Traditional Analysis
Where Are Economists Now?
Kick It Up a Notch
Summary
The minimum wage is the lowest wage that may legally be paid for an hour’s work, subject to government restrictions.
In 1938 the first minimum wage was set at 25 cents per
hour, and the amount has been increased periodically over
the years. As of June 2016, the
federal minimum wage was $7.25.
The minimum wage has tradi-
tionally been justified as a mech-
anism to ensure a living wage, that is, a wage sufficient to keep
a family out of poverty. As you
can see in Fig ure 33.1, the mini-
mum wage was always sufficient to keep an individual
above the poverty line. It has been less successful for fam-
ilies. Since 1985 the minimum wage has been insufficient
to maintain a one-earner, minimum-wage family (consti-
tuting more than an individual) above the poverty line.
For instance, to accomplish the feat of keeping a family
of four above the poverty line, the minimum wage for a
single full-time earner would have to be $11.65 an hour.
Figure 33.2 indicates that although the minimum
wage itself has been increased several times over the last
78 years, its real value, that is, the value adjusted for infla-
tion in 1999 dollars, rose for the first 30 years of its exis-
tence and has steadily fallen since. Since 1950, the lowest
it has been in inflation-adjusted dollars was its early 2007
level. It reached its highest inflation-adjusted level in 1968
at $11 per hour (2016 dollars).1 With solid majorities
gained in the 2006 mid-term elections, Democrats pushed
through a significant increase in the minimum wage.
What had been $5.15 an hour in 2007 became $7.25 per
hour in 2009. Even with that significant increase, in terms
of its inflation-adjusted level, the minimum wage in 2009
was at its long-term historical average. With Republicans
retaking the House of Representatives in 2010, there has
been no increase since the last step increase in 2009.
Over time, economists have tended to argue against
the minimum wage. In this chapter we explain those
arguments along with the reasons why, until recently,
most economists thought raising the minimum wage was
minimum wage The lowest wage that may legally be paid for an hour’s work.
living wage A wage suicient to keep a family out of poverty.
1The poverty line used here is the oicial poverty line, with which there are many
problems. Review the chapter “Poverty and Welfare,” to understand this issue.
Traditional Economic Analysis of a Minimum Wage 359
to work more at higher pay, implying an upward-sloping
supply curve; demand is made up of bosses seeking to
hire that labor. The employers are assumed to want fewer
laborers at higher wages, implying a downward-sloping
demand curve. Without a law that sets its actual dollar
amount, the wage would be set in this market at the point
where the supply and demand curves meet. At this point
there would be no shortage and no surplus. The wage
would be W* and there would be L* work. Being a market
clearing equilibrium, this is a wage at which no one who
wants a job at that wage is without one, and no employers
who want workers at that wage are unable to get them.
In this situation workers would be paid a total
of OW*CL* dollars. When we addressed the notion
of consumer and producer surplus in Chapter 3, we
stated that the consumer surplus is the area under
wrongheaded. We also look at the arguments that suggest
it may have been economists who were wrongheaded.
Traditional Economic Analysis of a Minimum Wage
Labor Markets and Consumer and Producer Surplus
Most economists have had few good things to say about
the idea of establishing a minimum wage, and they have
based that opinion on a traditional supply and demand
analysis of the issue. Figure 33.3 represents a market for
low-skill minimum-wage labor. The good being sold in
this market is labor, and the price at which it is sold is the
wage. The supply is made up of workers who will want
FIGURE 33.1 The ratio of the earnings of a full-time minimum-wage worker to the poverty line for various family sizes.
Sources: U.S. Census Bureau, www.census.gov/hhes/www/poverty/data/threshld; United States Department of Labor, www.dol.gov/dol/topic/wages/minimumwage.htm
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
1 9 5 9
1 9 6
1
1 9 6 3
19 6 5
19 6 7
1 9 6 9
1 9 7 1
1 9 7 3
19 75
1 9 7 7
1 9 7 9
1 9 8
1
1 9 8 3
19 8 5
19 8 7 1 9
8 9
1 9 9
1
1 9 9 3
19 9 5
19 9 7 1 9
9 9
20 01
20 03
20 05
20 09
2 0
1 1
2 0 13
20 07
Year
M in
im u
m w
a g
e /
p o
v e
rt y l in
e
One Two Three Four
FIGURE 33.2 The nominal and real minimum wage, 1938–2016, in 1999 dollars.
Source: United States Department of Labor, www.dol.gov/dol/topic/wages/minimumwage.htm
0
2
4
6
8
19 3 8
1 9 4 1
19 4 4
19 4 7
19 5 0
1 9 5 3
19 5 6
19 5 9
19 6 2
19 6 5
19 6 8
1 9 7 1
1 9 7 4
19 77
19 8 0
19 8 3
19 8 6
1 9 8 9
19 9 2
19 9 5
19 9 8
20 01
20 04
20 07
2 0 10
2 0 13
Year
W a
g e
( $
)
RealNominal
360 Chapter 33 Minimum Wage
the demand curve but above the price line, while the
producer surplus is the area under the price line and
above the supply curve. Of course, in this case the
price is the wage.
The key difference here is that businesses are getting
the consumer surplus W*AC, because it is they who are
buying the good, that is, hiring the labor. We interpret
consumer surplus here as the money that businesses
make from the work of their employees that exceeds the
amount they have to pay workers.
The producer surplus BW*C is also different in that
it is what workers get, since it is they who are doing the
selling. The interpretation here is that it represents the
amount of money that workers get in excess of what
they would have worked for. So, just as in any other
market, the consumer gets something and the producer
gets something.
A Relevant versus an Irrelevant Minimum Wage
If a minimum wage is set below W*, would businesses pay
the minimum wage rather than the higher W*? Surpris-
ingly, the answer is no, they would not: To get workers
in the numbers that are most profitable to the business,
employers have to pay the higher W*. They would rather
pay more than the minimum because, even though their
labor costs then rise at a higher rate, the output of the extra
FIGURE 33.3 Labor market.
Labor
Wage
L*
W *
O
B
A
C
S
D
Because the federal minimum wage remained constant for nearly
a decade, states and cities began to take the initiative to impose a
higher minimum wage within their jurisdictions. As of June 2016, the
29 states (listed below) and several cities have minimum-wage laws
that are higher than the federally mandated minimum wage. More-
over, in an effort to prevent the inflationary erosion of their state
minimum wage, 10 states (noted in bold) index their minimum wage
to some measure of inflation.
AK–$9.75; AR–$8.00; AZ–$8.05; CA–$10.00; CO–$8.31; CT–
$9.60; DC–$10.50; DE–$8.25; FL–$8.05; HI–$8.50; IL–$8.25; MA–
$10.00; MD–$8.25; ME–$7.50; MI–$8.50; MN–$9.00; MO–$7.65;
MT–$8.05; NE–$9.00; NJ–$8.38; NM–$7.50; NY–$9.00; NV–
$8.25; OH–$8.10; OR–$9.25; RI–$9.60; SD–$8.55; VT–$9.60;
WA–$9.47; WV–$8.75.
Throughout 2016 several cities (New York, Seattle, Pittsburgh,
Greensboro, Seattle) and two states (California and Massachusetts)
adopted $15 minimum-wage laws. Most of those laws will phase in
that higher rate over a few years. Many economists, even those for
whom increases in the minimum wage are considered wise, are con-
cerned. That concern is centered on the observation that an increase
to $15 per hour is not, what they call, “modest.” When increases in the
minimum wage are modest compared to the existing wage, there is far
less motivation for business owners to make expensive adjustments
to their production processes. However, when the increases are very
large and when those increases come with built-in adjustments for
future inflation, the motivation is not only high but sustained.
The owner of a prototypical fast-food outlet facing an immodest
increase in the minimum wage must respond. That is because, as the
National Restaurant Association reports, the profit margin at a typical
restaurant is frequently smaller than the projected increased wage
bill. It is not a matter of reduced profits to business owners going
instead to their workers; it is a matter of those businesses closing.
As a result, owners must increase prices or reduce labor. To reduce
labor, they must come up with labor-reducing capital substitutions.
An example of this type of substitution from the past is the moving
of soft drink dispensing to the consumer side of the counter. Likely
innovations in the future will replace order takers with automated
ordering kiosks in much the same way as self-scan machines have
replaced checkers at many large grocery stores. It is not entirely out
of the realm of possibilities that Domino’s and Papa John’s will be
among the first large-scale buyers of driverless cars. Very high mini-
mum wages will surely produce job-saving innovations that will just
as surely undercut the purpose of those increased wages.
C I T I E S , S T A T E S , A N D $ 1 5 P E R H O U R
Traditional Economic Analysis of a Minimum Wage 361
workers will generate enough additional revenue to pay
workers and to produce an increased profit as well. In ad-
dition, it is in their best interests to pay W*, because other-
wise their competitors will outbid them for labor. Thus any
minimum wage set below W* is irrelevant, because firms
make more profit offering W* rather than a lesser amount.
If you are not yet convinced that setting a minimum
wage may be irrelevant, consider what would happen if
your professors told you that you would fail if you showed
up in class naked. Unless you had planned to do this any-
way, an unlikely event since you would be kicked out of
school, the rule would not affect your behavior in the least.
Any rule that tells you that you cannot do something that
you had no intention of doing anyway is not much of a
rule. It does not alter your behavior, and it is therefore ir-
relevant. For the minimum wage to be relevant, it has to be
an amount that is set above the equilibrium wage.
What Is Wrong with a Minimum Wage?
As seen in Figure 33.4, a minimum wage that has been
set above the equilibrium wage has several effects. First,
it raises the wage from W* to W min
. Second, it reduces
the amount of labor sold from L* to L min
. Third, as long
as the money gained from raising the wage to workers is
greater than the money lost as a result of having fewer
people working, workers in general have more money
than they had before. From your earlier study of the
concept of elasticity, you will recognize the condition
for this is that the demand for labor has to be inelastic.
Finally, the imposition of a minimum wage will raise the
unemployment rate for workers in this market. This will
happen because either more workers will want to work or
existing workers will want to work more hours. With a
minimum wage set above the equilibrium wage, workers
want to provide L s labor, whereas they used to want to
work only L*. Further complicating this is that employ-
ers now want to hire labor only up to L min
rather than the
L* they had wanted previously.
In the end, the consumer surplus shrinks to W min
AE
and producer surplus grows. The sum of the consumer
and producer surpluses is less than it was without the
minimum wage, by the triangle FEC.
What this all leads to is that under this economic anal-
ysis of the minimum wage, there are winners and losers.
The winners are those workers who get a wage increase
and who are still able to continue working as much as they
want. The losers are men and women who used to be work-
ing and who are now unemployed (L* – L min
). The impor-
tant part of this analysis is that what is gained by workers
is less than what employers lose. We are thus confronted
with what economists label deadweight loss, the net loss to
society by the area FEC. To see this precisely, go to “Kick
It Up a Notch” located at the end of the chapter.
Real-World Implications of the Minimum Wage
Though rather elegant as a mechanism to analyze the im-
pacts of a minimum wage, consumer and producer sur-
plus analysis does not put it in terms easy for the average
person to see. The winners are the more than 4 million
people who work for the minimum wage and get a pay
increase because they keep their jobs.
The losers are the people who lose their jobs. Re-
search on the subject has led economists to use the rule
of thumb that a 10 percent increase in the minimum wage
results in a 1 percent to 3 percent drop in the number of
jobs held by teens. That translates to a loss of 360,000
to 1,050,000 jobs lost by teens as a result of the increase
in the minimum wage from $5.15 to $7.25 an hour.2
Economists who study those unlucky teens find that they
are disproportionately black, Hispanic, and uneducated.
That is, they are among the very people that an increase
is trying to help. This point must not be missed. An in-
crease in the minimum wage may very well hurt the poor
more than it helps them.
FIGURE 33.4 Minimum wage.
Wage
LaborL*
W*
O
B
A
C
E
G
F
S
D
Wmin
Lmin Ls
2This assumes that at $5.15, the minimum wage was above equilibrium. The
evidence is that the equilibrium wage was higher than $5.15 for much of 2004
and beyond, making $5.15 an irrelevant minimum wage.
362 Chapter 33 Minimum Wage
Other losers include small business owners who have
to pay the higher wage with perhaps a very small profit
margin to do so. Small independent restaurateurs are es-
pecially hard hit because the industry is such that many
such new entrepreneurs constantly teeter on the edge of
bankruptcy and can afford to pay only minimum wage.
That means that an increase in the minimum wage may
destroy not only the jobs these entrepreneurs are creating
but also the entrepreneurs themselves.
Finally, the losers include anyone who buys goods or
services produced by minimum-wage workers, because
part of the increase is passed on to them in the form of
higher prices.
Alternatives to the Minimum Wage
It is for all of these reasons and more that until recently
most economists could not endorse increases in the mini-
mum wage. Those who took the position that the mini-
mum wage was an inappropriate cure for the problems of
poorly paid workers highlighted the fact that most work-
ers who made the minimum wage were under 24. Nearly
a third of these were under 19 and therefore very unlikely
to be supporting a family. Combine this with the fact that
many of those who earn the minimum wage and are over
age 24 are spouses who work only to supplement the in-
come of the family’s primary income producer and are
nowhere near poverty.
In the eyes of many economists a better alternative
is the Earned Income Tax Credit (EITC). Low-income
working families with three or more children are eligible
for up to $6,269 that arrives in the form of a tax refund.
The benefits of the EITC are concentrated on the people
who actually need the money to feed their families. More
than 70 percent of the money goes to households that are
or would otherwise be in poverty. This contrasts dramati-
cally with the minimum wage, where upward of 70 per-
cent of the benefits accrue to households not in poverty.
The EITC, while born in the 1970s, saw great in-
creases starting during the administration of President
Ronald Reagan. It was during this administration that
the minimum wage saw a long period of real decline
in its value. It was President Reagan’s view that the
minimum wage was a poor mechanism to help the poor
and that the EITC could help working poor families
without hurting businesses. While President Clinton’s
first budget increased taxes for many, it also greatly
increased the EITC. Moreover, though he pushed
through an increase in the minimum wage as well, the
increased level of the EITC has had a greater effect on
the working poor.
Rebuttals to the Traditional Analysis
In contrast to the preceding section, important points of re-
buttal to the traditional analysis have gained respectability
in recent years among economists. They center on three
main lines of argument. Macroeconomic analysis sug-
gests, first, that the effect of a decrease in income by
owners of businesses is somewhat offset by the effect of
an increase in income by the lower-income people. Low-
income people spend more and high-income people save
more. A second line of argument is that the good in ques-
tion, labor, is not as definable as most other goods and that
with better pay, workers can be induced to work harder.
If they do so, the increase in the wage becomes less of
a burden on employers. The remaining argument is that
the elasticity of demand for labor may be so low that the
traditional analysis needs to reflect this fact. If it does, the
negative aspects of the minimum wage will be small.
The Macroeconomics Argument
The first argument in rebuttal to the traditional analysis
relies on an aspect of macroeconomics that suggests that if
you track all of the times a particular amount of money is
spent, you can figure up the total impact of new spending.
Or, as is appropriate in this case, you can examine the net
effect of monies being spent by different people. If, for
instance, business owners save most of their profit rather
than spend or invest it, then something less than the entire
profit of the business works its way through the economy
in the form of additional spending. On the other hand, if
the business owners have to relinquish more of that profit
to workers because of the imposition of a higher minimum
wage, then almost all of that money will be spent. Men and
women who are paid the minimum wage save very little,
and they spend nearly all of their additional income. Be-
cause money is spent rather than saved, total consumption
in the economy rises. From a macroeconomic standpoint,
any negative effects of a minimum-wage increase range
from being offset, to being nonexistent, to being positive.
Suppose, for example, that the result of an increase in
the minimum wage is to increase the incomes for work-
ers by $75 while creating a $100 loss in profit to busi-
nesses. Remember that it is not simply a direct transfer;
workers’ gains are offset by losses to business that are
greater. The $25 difference, the deadweight loss, is the
amount of damage to an overall measure of economic
activity like the gross domestic product. This gap can be
made up if the effect of low-skill workers’ spending is
greater than the effect of bosses spending it. If low-skill
Where Are Economists Now? 363
workers spend all of their increased income, and bosses
spend or invest only 80 percent of theirs, the net effect
of raising the minimum wage is that the GDP shrinks
by $5 rather than $25. This is because 80 percent of
$100 is only $5 more than 100 percent of $75. This is, of
course, predicated on the assumption that a higher mini-
mum wage has the net effect of increasing the income of
minimum-wage workers.
The Work Effort Argument
The second argument is probably correct in assuming
that people adjust the effort they put in at work depend-
ing on how happy they are with their employer. This
means that the graphs in Figures 33.3 and 33.4 are not
as stable as we previously thought them to be. The good
“labor” is not as fixed in its meaning as are most other
goods for which we use this supply and demand model.
People can work hard or slack off, and there is not a great
deal that an employer can do to force slackers to work
harder. If higher pay translates into workers who are hap-
pier and who do more work per hour, it may be the case
that some if not all of the impact of forcing wages to
rise will be mitigated. In this way the minimum-wage in-
crease may pay for itself. On the other hand, if it did pay
for itself, we would have to assume that employers were
either ignorant of this fact or not maximizers of profit.
Neither of these assumptions sits well with most econo-
mists. It is more plausible that such an increase merely
lessens the negative impact.
The Elasticity Argument
The last argument used to rebut traditional analysis simply
tweaks the traditional analysis a little to suggest that the
negative impact of an increase in the minimum wage is
very small. Any increase can thus be interpreted as sim-
ply a transfer of money from business owners to workers.
Comparing Figure 33.5 to Figure 33.4, you will find that
the only real difference is that the demand curve is steeper,
that is, more inelastic, in Figure 33.5. The net amount that
workers gain is very great, and the resulting unemploy-
ment of those who had jobs before, L* – L min
, is very low.
As we said when we discussed elasticity in Chapter 3,
there are two things that will influence elasticity: the num-
ber of close substitutes and time to invent them.
Given that in the short run there are very few substi-
tutes for having workers on the job, this rebuttal seems,
of the three mentioned, the most persuasive to traditional
economists. Most economists still believe that the exis-
tence of a minimum wage will reduce employment in the
long run. They maintain that the only reason the gain to
workers is great and the net loss to society is small is that
this is an analysis that works only in the short run.
They argue that in the long run business owners will
search until they find substitutes for labor such as easier-
to-use machines and self-serve devices. If you look at
the fast-food industry and the equipment that it uses, you
will find that the companies involved are always look-
ing for new ways to reduce the need for employees, and
they have had great success in their endeavors. Putting
the drink machines in the lobby and using chain ovens or
broilers that cook the food for exactly the correct amount
of time without needing employee monitoring are just a
couple of examples of how employers of minimum-wage
workers have substituted capital for labor.
Where Are Economists Now?
If the more recent nontraditional analysis is correct, it
is probably because in the short run there is not much
deadweight loss to be made up. The combined impact of
the macroeconomic effect and the harder worker effect
is therefore enough to completely eliminate the problem.
The data on whether recent minimum-wage increases
have had a net negative impact on unemployment for
the 1990 and 1996 increases are mixed. Two influen-
tial economists, David Card and Andrew Krueger, pub-
lished a study of the minimum wage utilizing data on
fast-food employment. They surveyed establishments in
two neighboring states in a period where one increased
FIGURE 33.5 The minimum wage in the short run.
Wage
LaborL*
W *
O
B
C
E
G
F
S
D
Wmin
Lmin Ls
364 Chapter 33 Minimum Wage
its minimum wage and another did not. They found that
the increase did not negatively impact, and perhaps posi-
tively impacted, employment in the state that raised its
minimum wage.
Since this study ran against the conventional wisdom
of labor economists, many were quick to try to dupli-
cate their results. The attempts to replicate the work of
Card and Krueger turned up serious data and methodol-
ogy problems with their work. As a result of the newer
work casting doubt on the Card and Krueger conclusion,
most labor economists have not moved much from their
earlier assessment. In particular, many still use the teen
employment rule of thumb mentioned earlier but concede
that a 10 percent increase in the minimum wage translates
to a 1 percent or 3 percent decrease in teen employment.
In particular, according to Jeffrey Clemens, it is young
workers without a high school degree, those most likely
to be working for a minimum wage, who seem to have
been hit by the greatest reduction in employment oppor-
tunities. The increases in the minimum wage through the
midst of the Great Recession reduced their employment
by 5.6 percentage points. In any event, economists have
expended considerable time rethinking an issue that they
thought they had put to bed a long time ago.
Kick It Up a Notch
Referring back to Figure 33.4, we can firmly establish
the winners and losers and more rigorously defend the
claim that the gain to workers from a minimum wage is
less than the loss to firms and unemployed workers. Re-
member that the benefit to workers from an increase in
the minimum wage is the increase in their producer sur-
plus. Without a minimum wage the producer surplus is
BW*C, while with the minimum wage it is BW min
EF. The
consumer surplus is the benefit to firms hiring the labor.
They go from having a consumer surplus of W*AC with-
out the minimum wage to a consumer surplus of W min
AE
with it. The gain to workers is W*W min
EG – GFC, while
the loss to firms is W*W min
EG + GEC. The net effect is the
gain to workers minus the loss to firms, which is –FEC.
Because the net effect is negative, this is a loss, one that
economists call the deadweight loss.
Summary
After this exploration of the minimum wage, you
understand why it exists in the first place and what
its implications are for our supply and demand model
for labor. You know how to use our consumer and pro-
ducer surplus techniques to identify the winners and
losers of any minimum-wage increase and then apply
real-world observations. You understand the diversity
of opinion among economists on the subject, and you
know the Earned Income Tax Credit is an alternative
to it.
Key Terms
living wage minimum wage
1. Between 1998 and 2007 the real minimum wage
a. rose rapidly.
b. rose slowly.
c. remained constant.
d. fell rapidly.
Quiz Yourself
2. In order for the minimum wage to reach its 1968
high in real terms (1999 dollars), it would have to
rise to approximately _________ per hour.
a. $8
b. $9
Summary 365
c. $10
d. $11
3. The last time the minimum wage alone was sufficient
to keep a family of three above the poverty line was
a. 1979.
b. 1985.
c. 1990.
d. 1998.
4. The argument that the minimum wage is worse than
the Earned Income Tax Credit is based on the idea that
a. the people who earn the minimum wage are
really poor.
b. the minimum wage applies to all workers, not
just the working poor.
c. the Earned Income Tax Credit goes to all workers.
d. the minimum wage applies only to those
younger than 25.
5. The argument that the minimum wage does
not significantly increase unemployment is based on
a. producer surplus.
b. consumer surplus.
c. elasticity.
d. aggregate demand.
6. The argument that the minimum wage hurts society
more than it helps is based on __________________
analysis.
a. consumer and producer surplus
b. production possibilities
c. aggregate supply–aggregate demand
d. marginal
7. The argument that employers would actually not lose
money if the minimum wage were raised is based on
a. the idea that workers would spend the extra
money buying goods from their employer.
b. the idea that workers would work overtime
without having to be paid.
c. the idea that workers would be more productive
if they felt they were adequately compensated.
d. the elasticity of demand for labor.
Short Answer Questions
1. Who is most likely to benefit from an increase in the
minimum wage?
2. Who is most likely to lose from an increase in the
minimum wage? Who of those might have thought
an increase was in their best interests?
3. Suppose you knew that there was going to be 20 percent
inflation between now and five years from now,
and suppose you knew that the minimum wage was
only enough to get a family of three to 80 percent of
the poverty line. How much would you have to raise the
minimum wage over that period in order to make the
minimum wage earn enough to be at that poverty line?
Think about This
Several states have set the minimum wage in their states
higher than the federal minimum wage. If doing so
places them at a competitive disadvantage for new busi-
ness this might be counterproductive. On the other hand,
the minimum wage is typically relevant only in low-paid
service jobs. Who makes the minimum wage in your
community? Would your community be better off with a
higher minimum wage?
Talk about This
One of the principal opponents to minimum-wage in-
creases is the umbrella organization for small business.
Many states with higher minimum wages than the fed-
eral level exempt businesses with few employees. Should
small businesses be exempt from minimum-wage laws?
For More Insight See
Brown, Charles, “Minimum Wages Laws: Are They
Overrated?” Journal of Economic Perspectives 2,
no. 3 (Summer 1988), pp. 133–146.
Brown, Charles, Curtis Gilroy, and Andrew Kohen,
“The Effect of the Minimum Wage on Employment
and Unemployment,” Journal of Economic Literature
20, no. 2 (June 1982), pp. 487–528.
Card, David, and Alan Krueger, Myth and Measure-
ment: The New Economics of the Minimum Wage
(Princeton, NJ: Princeton University Press, 1995).
Behind the Numbers
Historical data.
Minimum wage.
U.S. Department of Labor; Employment Standards
Administration—www.dol.gov/dol/topic/wages
/minimumwage.htm
Poverty line.
U.S. Census Bureau; historical poverty tables—
www.census.gov/hhes/www/poverty/data/threshld/
EITC eligibility and amount.
Internal Revenue Service—www.irs.gov
Adams, Scott, and David Neumark, “A Decade of Living
Wages: What Have We Learned?” Public Policy Insti-
tute of California—www.ppic.org/main/publication
.asp?i=620
366
C H A P T E R T H I R T Y - F O U R
Ticket Brokers and Ticket Scalping Learning Objectives
After reading this chapter you should be able to:
LO1 Define ticket scalping and describe why it exists.
LO2 Conclude that the market form appropriate to analyze ticket
sales to an event is the monopoly model.
LO3 Contrast the marginal cost curve presented in Chapter 4
with the one appropriate for ticket sales.
LO4 Enumerate the reasons why promoters may rationally charge
less for an event than they could, and conclude that the
result of this is a shortage of tickets.
LO5 Describe why the conditions of a shortage typically create
a scalping market, where people buy tickets below, at, or
above their face value and sell them for a profit.
LO6 Conclude that economists generally value the scalping
market, see very little reason to make laws regulating it,
and see very little functional distinction between the legal
and illegal forms of scalping that exist across the country.
Chapter Outline
Defining Brokering and Scalping
An Economic Model of Ticket Sales
Why Promoters Charge Less Than They Could
An Economic Model of Scalping
Legitimate Scalpers
Summary
If 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. Some tickets command
prices that are many times their face value. In the 1990s
scalpers were getting more than $1,000 for a ticket to see
Michael Jordan’s last game as a Chicago Bull and Mark
McGwire’s attempt to break the single-season home run
record. Some events are once in a lifetime, whereas other
reoccurring events like the Super Bowl and the World
Series are events that are important enough to some
people that they are willing to pay more than face value
for a ticket.
While in many cities it is illegal to sell a ticket for more
than face value, in every major city there is a way of getting
such tickets when they are the only ones available. Econo-
mists are almost always against laws that prevent people
from selling things they possess. They reason that if one
person would rather have $500 than a ticket to a game and
another person would rather have a ticket to a game than
$500, then both are better off with the trade than without it.
This chapter defines ticket scalping and offers an
economic explanation for it. We begin that explanation
by using our monopoly pricing model from Chapter 5
to understand the promoter’s ticket-pricing scheme.
We show that for scalping to exist, promoters have to
be underpricing their tickets, and we consider why they
do this. We use our supply and demand model and our
consumer and producer surplus language to see how
An Economic Model of Ticket Sales 367
scalping helps consumers and scalpers alike. We talk
about the mechanism by which scalpers become “legit”
by calling themselves “brokers” or by offering packages
that combine the tickets with other amenities.
Defining Brokering and Scalping
Brokering tickets is the act of buying tickets and selling them at a price higher than face value when such a trans-
action is legal. Scalping tickets is the act of buying tickets and sell-
ing them at a price higher than
face value when such a transac-
tion is illegal. Thus, the practice
is scalping only when it is done
illegally. Regardless 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 and 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
“fixes” pricing that promoters get wrong. As we will
see, scalping can exist 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. If some seats are really good and others are really
terrible, then the good ones, at courtside, say, might be
scalped while those in “nosebleed territory” might re-
main unsold. What is true is that there cannot be unsold
seats right next to seats for which scalpers wish to charge
more than face value. When traditional ticket outlets that
sell for face value have open, decent seats, these will be
sold out before scalpers can sell any.
An Economic Model of Ticket Sales
The question we can pose at this point is, “Why would
a promoter charge less for a ticket than it is worth?” To
answer the question we need to look at what determines
the price a promoter should charge. To model that, we
need to go back to Chapter 5 to see which model of the
market is more appropriate for ticket sales, perfect com-
petition or monopoly. Because there is ultimately only
one seller of the tickets, the promoter, our monopoly
model is clearly more appropriate to this than the perfect
competition model, in which there are many sellers.
Marginal Cost
To complicate things somewhat more, remember the
shape of the marginal cost curve that was introduced in
Chapter 4. It is a check-shaped curve, as seen in the left
panel of Figure 34.1. For ticket sales to a sporting event
or a concert, the marginal cost looks a little different.
The right-hand side of Figure 34.1 shows that up to the
capacity of the stadium, the marginal cost is probably
more likely to be a constant. The costs of printing and
selling the tickets and the costs of cleaning up after each
additional fan remain relatively constant. These extra
costs are likely to be the same for the thousandth fan as
the hundred-thousandth fan. At capacity, however, the
extra cost of selling to another person grows astronomi-
cally, as new construction would have to take place to
add more seats.
The Promoter as Monopolist
When promoters are attempting to maximize 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. Once they have done that, they can look
brokering The act of buying a ticket and legally selling it at a price higher than its face value.
scalping The act of buying a ticket and illegally selling it at a price higher than its face value.
FIGURE 34.1 Marginal cost.
Typical good Tickets to an event
Q/t Q/tQcapacity
MC MC
Marginal cost
Marginal cost
368 Chapter 34 Ticket Brokers and Ticket Scalping
at this problem as any other monopolist would. Recall
that we have always assumed that firms are profit max-
imizers. Though revenue would be maximized where
marginal revenue cuts the horizontal axis, this is not
where the profit- maximizing promoters operate. As
is depicted in Figure 34.2, they project the number of
sales and set the price so that marginal revenue equals
marginal cost. This means that they would sell Q monop
tickets for P monop
each.
An interesting aspect of this is that it may make
sense for promoters to see that the arena is only par-
tially filled. Promoters hold back tickets when they
would have to lower the price too far in order to sell
out the facility. You should not be surprised by this
conclusion, especially if you are at a school that does
not have a popular athletic program. Consider a school
whose men’s basketball team draws between 4,000 and
6,000 fans a game, while the women’s team draws fewer
than 1,000 a game. If the athletic department were to
price tickets to sell out the arena, tickets would be nearly
free for the men’s games and the department would have
to pay people to see the women. That is not a slam at the
women; it is just a fact of life at a school without a na-
tional sports reputation. Clearly, it makes sense for this
university to charge more for the men’s 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 Perfect Arena
To a promoter, the size of the facility is significant. In
a promoter’s eyes, the perfect facility would be rep-
resented as seen in Figure 34.3, where the capacity is
exactly 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 rev-
enue at the quantity that is exactly the capacity of the
facility. Of course, promoters cannot always find the
perfect facility. Most medium and small cities have only
one or two places to hold an event like a concert, and
even in other places, the perfect arena or concert hall
may not be available.
In a big city with many venues of many different
sizes, a promoter should seek the facility whose size en-
sures that the marginal cost will cross marginal revenue
at exactly the capacity. On the assumption that facilities
that are unnecessarily large cost the promoter more to
rent, booking this “perfect” facility maximizes profit.
In 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. Scalping 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 pro-
moter charges less than the profit-maximizing amount.
This is seen in Figure 34.4, where the ticket is priced
at or below the price that would sell out the facility
rather than the price that would maximize profits for
the promoter.
FIGURE 34.2 The profit-maximizing promoter’s choice of price and ticket sales.
Q/tQmonop Capacity
P
Pmonop
MC
MR
D
FIGURE 34.3 The perfect arena.
Q/t
P MC
MR
D
Qmonop = Qcapacity
Pmonop = Pcapacity
Rational capacity
An Economic Model of Scalping 369
Why Promoters Charge Less Than They Could
Why might promoters sell out a facility rather than maxi-
mize profits? 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. Second, there may be some “excitement” factor to
a full stadium that appeals to the performers and that is
worth the loss of profit. Third, the performers may want
a reputation of charging a “fair price” for their events and
be willing to forgo maximum 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 memora-
bilia are important sources of revenue for performers and
promoters alike. Since it may be that the revenue gained
by these sales exceeds that lost by having low ticket
prices, low ticket prices may lead to increasing audience
size and may therefore maximize profit after all. Last,
it may be in the long-run best interest of the performers
to charge a low price for tickets so that the largest pos-
sible audience can provide word-of-mouth advertising
for them and generate interest for their talent.
Sometimes promoters do not have an exact idea of
what price to charge for an event. More often than not,
promoters of a new act must guess what the market will
bear for the ticket. If they guess too low, scalping may
ensue. In addition, promoters may want to play it safe
and not run the risk of pricing too high, thereby purpose-
fully pricing less than even their best guess. This might
also result in scalping.
There is an excitement 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 enjoys it more and the fans enjoy it more. Al-
though 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 pos-
sible. It may be in the promoters’ best interests to cater
to the performer, regardless of what maximizes profit.
Some performers try to establish a closeness with
their fans. Some 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 pro-
moters are willing to accept less money for the good feel-
ing that charging “fair” prices gives them.
Performers may appreciate fans who are willing to
camp out for tickets more than those simply willing to
pay a lot of money. You have to be much more excited
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.
When you go to a concert, you often spend as much
on shirts and other promotional items as you did on the
ticket. If promoters keep you out by charging a price that
is too high, they forgo that important other revenue as
well. In the big picture, low ticket prices may be profit
maximizing after all.
Promoters 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. By setting
low ticket prices early in a performer’s career, they may
be more likely to turn a one-hit wonder into a star.
For any one of the reasons just outlined, promoters
may choose to sell their tickets at prices below their mo-
nopoly market value and perhaps even below the price
that would guarantee a sellout. In 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.
An Economic Model of Scalping
A market characterized by ticket scalping is going to have
a typical demand curve. It will reflect the demand by
those who do not get tickets by normal means. For many
FIGURE 34.4 Capacity versus profit-maximizing prices.
Q/t
P
MC
D
MR Capacity
Pprofit max
Pcapacity
370 Chapter 34 Ticket Brokers and Ticket Scalping
events, such as any home game played by the Green Bay
Packers, tickets only go to those who subscribe or have
had tickets for many, many years. This “right of first
refusal” on tickets is so valuable that married couples’
divorce agreements have been held up over this right. If
you want to go to a single Packers game, you have to
resort to the scalpers’ market.
The demand curve for these tickets is downward slop-
ing just as it is for any other good. If the event is a “must
see,” then you expect a demand curve farther to the right
or perhaps more inelastic, or steeper, because tickets for
a “once-in-a-lifetime event” have fewer substitutes than
tickets for events that will be repeated. The elasticity of
demand will be expected to be less.
The supply curve for this market is upward sloping
(and not vertical), not because the number of tickets is
not limited but because in order to get tickets away from
those who have them, you have to give up more and more
to persuade more and more rabid fans to give up their
tickets. Figure 34.5 reflects the market for scalped tickets.
If the price is required to stay at the face value of the
ticket, then there will be fewer tickets than potential buy-
ers. To an economist this is the very definition of a short-
age. Note that the supply curve may start below P face value
or above it. In Figure 34.5 it starts below. To understand
why, consider that there are people who have tickets for
an event who are willing to sell them for less than they
paid because they do not want to go to the event. Why
would you buy a ticket for an event you did not want to
go to? Suppose you had season tickets to the Los Angeles
Lakers and a ticket to the California 500 NASCAR race.
Suppose the L.A. Clippers were playing the Lakers on
the day of the race. You paid face value for the ticket, and
you are willing to take almost anything for that game’s
ticket because you have decided to go to the race.
If scalping is illegal, only Q face value
, the tickets that
people are willing to unload for the face value will be
sold. If those are the only tickets that are sold, then the
people who are willing to pay more than face value will
not find any to buy. Some people will go to the game
when they would rather have received P market
and stayed
home. Others will stay home, when they would rather
have paid P market
and gone to the game.
Without scalping, there is a shortage and a loss
of societal benefit. That loss, measured by the loss in
consumer and producer surplus, can also be seen in
Figure 34.5. The loss of welfare to people who want
to see the game at the scalper’s price is EFB, while the
loss to people who would like to have sold their tickets
is GEB. The total loss to society when scalping is forbid-
den is GFB.
In this circumstance, is the permission to scalp tick-
ets creating a problem or solving one? Economists posit
that scalpers are solving the shortage by taking tickets
from those who have them and who value them least and
transferring them to those who do not have them and
who value them most. For this the scalper takes a cut.
Performers take a dim view of this. They view it as a
practice in which people profit from something they had
no hand at all in creating.
Legitimate Scalpers
In some states, all forms of scalping are legal; in others,
none are. In 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
event’s 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. It
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. Suppose you want
a ticket to the latest “fight of the century.” If 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
FIGURE 34.5 A scalper’s market.
Q/t
P
Pmarket
Pface value
QmarketQface value
Sby scalpers
D
A
F
BE
G
C
Shortage
Summary 371
After-market ticket exchanges used to be solely in the province of
a perfectly competitive market of individuals who would buy tickets
at ticket counters or on the street and then resell them outside of
events. No longer. StubHub changed that with its web-enabled meth-
ods of connecting buyers and sellers of tickets. Street scalpers still
exist today, but businesses such as StubHub have allowed buyers to
have some assurance of the authenticity of the tickets being sold and
knowledge of the location of those tickets within the event space.
When the sports leagues saw how much money could be made in
the after-market ticket business, they wanted a piece of the profits.
Today, the after-market ticket exchange business has become in-
tertwined with the primary ticket market. StubHub is the official ticket
exchange for Major League Baseball. The official exchange outlet for
the National Football League, NFL Ticket Exchange, is a cooperative
arrangement between the league and Ticketmaster. Ticketmaster
also has the National Hockey League and National Basketball Asso-
ciation business through league-branded websites. These arrange-
ments pay off handsomely for both the leagues and the business
doing the exchange. The leagues can keep their ticket prices lower
than market price levels, yet simultaneously benefit from higher mar-
ket prices because they receive a sizable cut from the exchanges.
How do they enforce the “official” status of their preferred ticket
exchange partner? When generated, there are competing claims
to a seat; for instance, when more than one person claims to have
purchased a particular ticket, the person who bought it from the
“official” website gets the seat. I witnessed how this plays out in
during a 2015 NFL game in Indianapolis. A couple sitting one row in
front of my wife and I were confronted by another couple who had
purchased the same seats on the NFL Ticket Exchange. The usher
escorted the couple who purchased the seats on StubHub aside and
told them (in a voice loud enough that everyone around could hear)
that only official tickets would be honored when there was a dispute.
The usher told the couple they could buy standing-room seats or be
escorted out of the building.
What does this do? It converts the perfectly competitive market
for tickets back to a near-monopoly. There are still street scalp-
ers, but the official websites have gained significant market power
based on these agreements. This clearly benefits the leagues to
the detriment of fans. The leagues can effectively sell individual
game tickets at market prices, while claiming to sell them at low
prices. It may fool those who aren’t familiar with economics but not
those who are.
S T U B H U B, T I C K E T M A S T E R, A N D T H E N F L T I C K E T E X C H A N G E
can combine a $100 ticket with a $100 hotel room and a
$10 cab ride and call it a $500 “excursion.” (Do the math!)
This is legal nearly everywhere, even when “scalping” is
not. It is also what an economist would call a distinction
without a difference.
It must be reinforced, therefore, that economists gener-
ally disapprove of anti-scalping regulations. Whether as
legal brokers or illegal scalpers, the sellers are providing
services. They are not only fixing the market shortage
left over by the promoter; they are also providing conve-
nience. The hours of ticket offices at major arenas are not
always amenable to customer desires. Lines at the ticket
booth or at “will call” windows are often very long the
day of the event. Because scalpers and brokers provide us
with a convenience and harm no one in the process, there
is little economic reason to ban their activities.
Summary
You now understand what ticket scalping is and why it ex-
ists. You understand that the market for tickets falls within
the monopoly model and that the marginal cost curve pre-
sented in Chapter 4 is not appropriate for ticket sales. You
understand why promoters may rationally charge less for
an event than they could and that the result of this is a short-
age of tickets. You understand that under the conditions of
a shortage there is typically a place for a scalping market
in which people buy tickets below, at, or above their face
value and sell them for a profit. Last, you understand that
economists generally value such services, see little reason
to make laws regulating them, and see little functional dis-
tinction between the legal and illegal forms of brokering
or scalping that exist across the country.
Key Terms
brokering scalping
372 Chapter 34 Ticket Brokers and Ticket Scalping
1. Ticket scalping is a symptom of
a. stupid promoters.
b. market prices being greater than the face value
of the ticket.
c. market prices being less than the face value
of the ticket.
d. stupid consumers.
2. Economists ___________________ the activities of
ticket brokers and scalpers.
a. draw no distinction between
b. separately model
c. draw a stark contrast between
d. ignore
3. The optimal venue for an event is one where
a. the number of seats exceeds the number where
marginal cost equals marginal revenue.
b. the number of seats is less than the number
where marginal cost equals marginal revenue.
c. the number of seats is exactly the number where
marginal cost equals marginal revenue.
d. marginal revenue exceeds marginal cost for all
seats.
4. The distinct feature of the marginal cost curve in the
analysis of venues is that it is
a. a vertical line.
b. a horizontal line.
c. a check-shaped curve.
d. a backward L.
5. The model for a promoter is ___________________
whereas the model for scalpers is that of ________
__________.
a. monopoly; monopolistic competition
b. monopolistic competition; perfect competition
c. monopoly; oligopoly
d. monopoly; perfect competition
6. If anti-scalping laws are perfectly enforced, it will
result in
a. deadweight loss.
b. a significant increase in consumer surplus.
c. a significant increase in producer surplus.
d. a significant loss to people who are going
to the event.
Quiz Yourself Short Answer Questions
1. What is the difference between StubHub and a ticket
scalper walking in front of a stadium?
2. Explain why it is not a contradiction for a ticket
scalper to carry a sign that says “Need Tickets”
on one side when it says “Have Tickets” on the
other side (indicating he is both buying and selling
tickets)?
3. Suppose you have a ticket to an event that is on a
very important day to your spouse and you know
it will cost you if you go to the event. How is the
scalper good for you?
4. Suppose you need a ticket to a sold-out event for
which your spouse had asked you to buy tickets a
long time ago (and you forgot). Would you be made
better off with or without anti-scalping laws when
those laws are closely enforced?
Think about This
There are laws in many states and communities against
scalping. Many promoters will let people buy only a
limited number of tickets for fear that the buyer will
simply resell them later. Why would a promoter care
who buys the tickets? If you became a performer, would
you care?
Talk about This
Some scalpers will pay college students who have
camped out for a concert to buy extra tickets for them
so that they can later resell them. Because this is against
the law in some places, there is some risk for the scalper
in that the students could simply resell the tickets them-
selves. If you were standing in line for tickets, what
would you do?
For More Insight See
Happel, Stephen, and Marianne Jennings, “The Folly
of Anti-Scalping Laws,” The Cato Journal 15, no. 1
(Spring/Summer 1995), pp. 65–76.
C H A P T E R T H I R T Y - F I V E
373
Rent Control Learning Objectives
After reading this chapter you should be able to:
LO1 Use the principles of supply and demand to model the effect
of rent control.
LO2 Understand that the reasons for controlling rents are
typically short term in nature.
LO3 See why economists generally oppose rent controls.
LO4 Understand that the consequences of controlling rents vary
with the time horizon: The short-term benefits to the renter
are usually offset by longer-term losses to landlords and
other renters.
LO5 Use the supply and demand model to explain why eliminat-
ing rent control can be in a city’s general interests but not in
the interests of the voters of that city.
Chapter Outline
Rents in a Free Market
Reasons for Controlling Rents
Consequences of Rent Control
Why Does Rent Control Survive?
Summary
Several cities in the United States have enacted laws that
control the amount of rent that a landlord can charge.
Some, like New York City, have laws that date from
World War II and the price controls that were insti-
tuted at that time because of the war. When the general
price controls expired, New York City chose to extend
them for rents in the city. Others, like the more than 100
New Jersey cities with such laws, began their excursion
into rent control by simply extending the price controls
imposed by President Nixon in 1971. San Francisco, Los
Angeles, and San Jose adopted controls when skyrocket-
ing land prices drove rents up in California in the late
1970s and early 1980s.
Rent control laws typically specify how often rents
can be increased and by how much. Some rent control
laws prevent rents from being increased as long as a ten-
ant continues to rent the same apartment. As we analyze
the issue of rent control, the first thing we examine is
how rents are established in a free market. Then we look
at what might motivate governments to control rents, and
we examine the long- and short-term consequences of
preventing rent increases.
Rents in a Free Market
In a free market, rents are determined in the same manner
as the price of any other good or service. The supply of
apartments is determined by how much it costs landlords
to build them and how their profitability compares with
that of other investments. The demand for apartments is
based on the number of people seeking apartments, how
much it costs to rent in the city as opposed to buying or
renting in a neighboring community, and the income of
the potential tenants.
When landlords choose to invest their money in apart-
ment buildings, they are motivated by exactly the same
things that motivate all other investors. They look for
the highest possible rate of return on their investments
subject to a limited amount of risk. The costs associated
374 Chapter 35 Rent Control
close to colleges and universities have higher rents than
similar apartment buildings elsewhere, because college
students value the lower transportation costs and are will-
ing to pay higher rents so they can take advantage of them.
People who are not college students do not value being
close to the school. Because they have a homogeneous
population, a landlord will require security deposits that
are higher than typical for such apartments. This is im-
portant because it would be illegal to have a differential
security deposit for different types of people. For instance,
landlords know that they will have to pay more in repair
costs after a college-age male tenant leaves than they will
after a college-age female leaves. They cannot set rents
that are based on gender, race, religion, or age whether or
not these factors are predictive of repair costs.
Reasons for Controlling Rents
When landlords face increased costs, they need to raise
rents to make the rate of return on their investments of
rental apartments equal to that of other, comparable invest-
ments. Few people begrudge landlords such increases. On
the other hand, like all other owners of businesses, land-
lords want to increase prices to increase profits. What pre-
vents landlords from raising rents is exactly what prevents
any business from raising prices: Their competition will
take their customers. In this area, though, landlords have
an advantage over businesspeople who sell other goods.
with being a landlord are more varied and variable than
they are with most other investments. The most promi-
nent cost is the cost of the building itself. If the investor
borrows money to build or buy the building, the build-
ing’s cost is the interest portion of the monthly mortgage
payment. If the investor buys the building without bor-
rowing, the cost of the building is the interest rate that
the investor could have received in his or her next best
investment. In this sense the costs involved in investing
in rental properties are not all that different from those in
other investments.
Other costs in owning rental property, though, are
considerably more variable than those of other invest-
ments. Landlords have to fix all of the problems in a
building. They have to deal with tenants who do not pay
their rent on time. They have to deal with tenants who
leave before their lease is up and tenants who cause more
damage to their apartments than their security deposits
will cover. It is for this reason that people who are handy
find investing in apartment buildings highly profitable.
They use their skills to save money on maintenance.
People looking for a place to live have a similar set
of concerns. They must decide whether to buy or rent.
If they buy, they need to come up with a down payment,
and they have to pay for their own repairs. If they rent,
they must decide where to rent. In a large city the cost
of renting close to work is greater, but the time and ex-
penses involved in commuting are avoided. If rents in the
city are low, people are more likely to live in the city. If
they are high, people are more likely to live farther away.
Figure 35.1 shows us that a market for rental apart-
ments generates an equilibrium number of apartments
rented Q* and an equilibrium rent R*. Such a market can
be affected by a number of factors. If interest rates rise,
for example, the cost to landlords rises and more people
want to become renters. This is because the home mort-
gage payments that represent the cost of alternatives to
renters increase. Increased costs to landlords and greater
numbers of potential tenants both lead to higher rents.
It is important to insert at this point that there are sev-
eral rental markets for different types of rental housing.
For instance, landlords who rent to young college-age
people anticipate having repair costs at the end of the
lease that landlords who rent to older people do not an-
ticipate. Landlords who rent apartments of low quality
must deal with the probability that some of their tenants
will always be late paying their rent. Landlords who rent
apartments that command higher rents will not.
With such a dichotomy of rents and quality it is often
the case that renters are self-segregating. Apartments
FIGURE 35.1 The market for rental apartments without rent control.
Q*
S
D
Quantity
R*
Rent
Consequences of Rent Control 375
When you switch brands of toothpaste, beer, or any-
thing else, no cost is involved. When you change apart-
ments the costs may be staggering. First you have to find
a new place. This may or may not cost you money, but
since it is a pain in the neck, its opportunity cost is high.
Then you have to disconnect all utilities and have them
reconnected at your new place, you have to inform ev-
eryone of your new address, and you have to pack all
your stuff and move it. Even if you know someone with
a pickup and have buddies to help you move, it still costs
you plenty of time and money to move. Since the threat of
switching apartments is essentially the only leverage you
have against the landlord, the costs of moving diminish
that leverage.
Landlords know your leverage is diminished by mov-
ing costs, and they know they can increase rents each
year by just a little bit less than those costs. If they in-
crease rents by more than the moving costs, you will
move; but if they make sure to keep the year’s increase to
less than moving costs, you will decide it is in your eco-
nomic interest to stay put and pay the extra rent. This pro-
cess cannot continue forever, since that would imply that
rents always go up faster than other prices. If they did,
investors would build new apartments in hopes of get-
ting the higher-than-average return on investment. With
new apartments, there would be a rent war, and renters
would be its winners. On the other hand, it is possible for
a rent war not to start for a few years. This in turn may be
all that is required for politicians to mistake a temporary
situation for one that’s permanent and that can be solved
only through the imposing of rent controls. As we will
see later, once rent control is imposed in a city, it is nearly
impossible to discontinue it.
Consequences of Rent Control
Rent control is a form of price ceiling where the price is not allowed to rise above a specified
level. Once rent control is in
place, the market for rental apartments is no longer gov-
erned by supply and demand alone, but also by the often
obscure rules that politicians have written into the legis-
lation. The consequences of any price ceiling in general,
and of rent control laws in particular, depend on the elas-
ticity of the supply and demand curves. Those elasticities
are dependent on the number of close substitutes and on
time. Since close substitutes can be better developed over
time, the two are closely related. We will subsume them
both under the idea of time and discuss the consequences
in the short run as being different from the consequences
in the long run.
Note that for a price ceiling to be relevant it must be
lower than the equilibrium price. Imagine what would
happen if the ceiling were, in fact, above the equilibrium
price. If landlords charged more than equilibrium, their
renters would move to other landlords’ buildings. Since
landlords do not find it in their best interest to do this, set-
ting rents by law at a rate lower than equilibrium has the
effect of telling landlords that they cannot do something
that is not in their best interests anyway. It is exactly as if a
professor were to tell you that you cannot attend her class
naked. You were not going to partake of class in the buff
anyway, so having her tell you not to do so is irrelevant.
We can analyze the consequences of rent control
more systematically by examining Figure 35.2. First
note that in Figure 35.2 there are two panels. The panel
FIGURE 35.2 The short- and long-run consequences of rent control.
Q
S S
D D
QQ QQ*
R*
Q*Quantity
Rent
Rentcontrol
R*
Rent
Rentcontrol
Quantity
Long runShort run
ʹ ʹ́ ʹ ʹ́
price ceiling The level above which a price may not rise.
376 Chapter 35 Rent Control
Likewise, renters who live in the community are not
likely to want to move to a better apartment immediately
following the introduction of rent control. Renters who
live outside a community, on the other hand, are not
likely to want to move into the community until there is
a substantial difference between their current rents and
those in the rent-controlled city.
With all the preceding having been said, though, the
short-run changes are actually likely to last quite a while,
since most rent control laws do not lower rents but sim-
ply prevent them from increasing. If overall inflation
runs at 2 percent a year and rents are not allowed to rise,
it takes several years for a significant difference between
equilibrium rents and controlled rents to develop. It is
only when that difference becomes large enough so that
landlords do not fix up apartments and tenants start mov-
ing that the full effect of rent control will even start to
be felt.
Once this long-run scenario begins to develop, the se-
rious flaws in rent control begin to overwhelm the ben-
efits. The difference between Q′ and Q* in Figure 35.2
begins to widen significantly as landlords who would
have built or refurbished apartment complexes in the
community decide not to. The gap between Q″ and Q*
also grows as commuters who live outside the commu-
nity seek to rent in town, attracted by the lower rents.
Where the system goes from here depends on its
rules. For instance, one set of problems is generated if
rents can increase by only a fixed percentage each year
regardless of who lives there. If, on the other hand, rents
cannot increase at all for the duration of a tenant’s stay,
another set of problems is created. Rules with regard to
subletting and eviction tend to exacerbate the problems.
Some rent control laws allow modest yearly increases
in rents. Usually, though, these increases do not keep
up with either inflation or what equilibrium would have
been. In New York City, the difference has had more
than 60 years to build up, so that rent-controlled apart-
ments are very inexpensive places to live. They can be
had for a third or less of their free-market rent. This
makes for a perverse scenario in which those looking for
an apartment turn not to the newspaper’s real estate sec-
tion but to the obituaries.
When markets are controlled, they will sometimes go
underground. These shadow markets, as they are called
by some economists, are generated because there are
people who have legal rights to something of value—an
apartment, say, whose rent is below equilibrium—and
there are people who want them. It is illustrative that
in New York City more transactions for rent-controlled
on the left indicates the consequences of rent control in
the short run, while the panel on the right indicates the
consequences in the long run. There are important long-
run and short-run differences because, if you recall from
Chapter 3, an important determinant of the elasticity of
supply and demand is time.
The inelasticity of the supply and demand curves
in the short run makes sense because renters and land-
lords have little time or ability to change what they do.
Apartment owners are going to rent most of their units
regardless of what the rent is. It is only with apartments
that need some attention that landlords will base the de-
cision on getting them ready to rent on the amount of
money they can get for them. Again, in the short run, this
is likely to be a very small percentage of the units under
their control.
Focusing on what they have in common for a mo-
ment, we see that the equilibrium rent R* is being su-
perseded by a legal limit R control
. The first consequence
of this is the one legislators intended: Rents are lowered,
landlords make less than they would without rent con-
trol, and renters either pay less in rent or get more for
their money.
Reducing the rent also results in the quantity de-
manded Q″ exceeding the quantity supplied Q′. The
quantity of apartments rented decreased because a certain
number of apartments (Q* − Q′) that would have been
rented before rent control are not being put up for rent
after rent control. To see why this is the case, imagine
yourself a landlord with a building of apartments of vary-
ing difficulty to maintain. The more difficult ones, say,
basement apartments that require more frequent paint-
ing because humid conditions cause early deterioration,
will not be rented unless at least R* rent is paid. Thus the
second consequence of rent control is that the number of
apartments that would ordinarily be rented is decreased.
The final obvious consequence of rent control, which
happens regardless of whether we are talking about the
short run or long run, is that people will seek apartments
in the rent-controlled community who had not sought
to rent there before. Specifically, there will be Q″ − Q*
apartments demanded at R control
that had not been de-
manded at R*.
The magnitude of these consequences and the reac-
tions of people to the consequences determine whether
they hold for the short or long run. In the short run, for
instance, the rent reduction comes at a fairly small cost.
Only a few people lose out on the ability to rent apart-
ments, however, because in the short run, both the supply
curve and demand curve are likely to be inelastic.
Why Does Rent Control Survive? 377
leaving tenants worse off than if they had not reported
the problem.
Thus one reaction of landlords is to reduce the qual-
ity of the apartment they are renting. Charging the same
rent for a lesser apartment is the same as raising the
rent. As a result, economists suggest that, in the long
run, rent controls are ineffective because landlords
raise rent on the sly, not by explicitly raising rent, but
by lowering quality. Finally, rent control makes racial,
ethnic, age, and other forms of housing discrimination
more likely. If there are more people interested in an
apartment than there are apartments to rent, landlords
can pick, albeit illegally, their next tenant based on their
own bigotry. Under free-market pricing, the landlord’s
bigotry battles the landlord’s wallet. Under rent control,
bigotry has no such countervailing force with which
to contend.
Why Does Rent Control Survive?
With all of these strange long-run consequences, it
makes sense to ask why cities continue controlling rents.
The answer is simple, and it can be traced to the ballot
box. Let’s start with the obvious: You do not get to vote
in a community unless you live there. People who live in
a suburb cannot vote in a city’s election, even though the
result of the election directly affects them. Add the fact
that many of the people who live in the rent-controlled
city benefit from rent control almost by definition.
Figure 35.2 helps to make this clear. The people hurt
by rent control are (1) landlords and (2) people who can
no longer find an apartment in the city (Q* − Q′). The
first group is a minuscule number whose plight is not
treated that seriously by candidates.1 The second group
had to move out of town to find a place to live. Either
way the majority of the people left in the community
(Q′) are simply better off than they would be were rent
control to be discontinued.
In Boston, though, repeal of rent controls led to none
of the problems that rent control supporters had pre-
dicted. Rents in previously controlled apartments did
rise, but new construction ensued. This had the effect of
holding down increases in rents.
apartments happen in the shadow market than out in the
open. The evidence for this is the paucity of rent-controlled
apartments advertised in the newspapers. Though more
than 60 percent of the rental housing in New York is
rent-regulated, only 3 percent of the ads in the major city
newspapers list housing that is rent-controlled.
To illustrate how the shadow market works, suppose
you know someone who has a loved one die and no local
relatives are looking for a cheap apartment. You can go
to the funeral, pretend to be sad, and see if you can get
the dead person’s apartment. Of course everyone knows
this, so, on the sly, the dead tenant’s executers attempt to
sell the right to the apartment to the highest bidder. It is
a common occurrence, in cities with laws such as this,
for people to pay what amounts to a bribe to rent a rent-
regulated apartment.
The law in other communities is even more strict:
Rents cannot increase until the lease expires, and since
the renter can perpetually renew the lease, this happens
only when the owner dies unexpectedly. If the heirs of a
deceased renter can swing it, they sublet with the original
renter’s name still on a lease that is decades old. Again,
the right to sublet an apartment is sold to the highest bid-
der, sometimes through multiple generations.
Typically the only recourse that owners of buildings
whose rents never increase have is to make the build-
ings miserable places in which to live. This is a well-trod
path. Because rents are so low, there is little money for
repairs, and repairs simply are not made. Additionally, if
owners can get every tenant in a building to leave, they
can gut the building and start over again. Refurbished
buildings are treated as new ones, and the owners can
set charges that are subject only to the market. The other
alternative that the owner has once the building is empty
is to refurbish and sell the apartments as individual
condominiums. Renters know this and will fight mov-
ing out as long as they can. They do not do this to spite
the owner. They do it because they know that finding
a rent-controlled apartment is difficult. Without one,
they would be one of many (Q″) wanting to rent one of
the few (Q′) available apartments. This is why in rent
control communities tenants often do their own repairs
or pay for them out of their own pockets. They know
they have a good thing going and they do not want to see
it stop. The only recourse that tenants have against land-
lords who do not pay for necessary repairs is to report
them to the city health department. Sometimes the health
department can get a court order for the landlord to fix
the place up, sometimes they cannot. This sort of pres-
sure rarely works. Owners simply abandon the buildings,
1This is not to say that these landlords have no influence. Through campaign
contributions landlords, particularly the high-profile ones, are able to make
their case and have received consideration on a number of development
issues of concern to them. Nevertheless, this influence has not led to the
undoing of rent control in New York.
378 Chapter 35 Rent Control
Summary
You are now able to use the model of supply and
demand we introduced in Chapter 2 to show the effects
of rent control. You understand that though there are
reasons for controlling rents, these are typically short
term in nature and economists generally are against
rent controls. You understand that the consequences
of controlling rents differ given the time horizon and
that the short-term benefits to the renter are usually
offset by long-term losses to landlords and renters
who cannot get housing in a community. Last, you
are now able to use the supply and demand model to
explain why eliminating rent control can be in a city’s
general interest but not in the interests of the voters
of that city.
1. The principal argument against rent control is that
a. landlords and all tenants are made worse off.
b. landlords and a few tenants are made worse
off by less than the majority of tenants that are
made better off.
c. landlords and a few tenants are made worse off
by more than the majority of tenants that are
made better off.
d. all tenants are made better off, not just poor
ones.
2. In the long run, rent control has _________________
impact because, over time, supply and demand be-
come ____________ elastic.
a. an increasing; more
b. a decreasing; more
c. an increasing; less
d. a decreasing; less
3. Rent control is an example of a _________________
a. price ceiling.
b. price floor.
c. price irrelevancy.
d. price equalization.
4. If the equilibrium rent is ___________ the controlled
level, then rent control laws are ________________
a. above; necessary
b. above; irrelevant
c. below; necessary
d. below; irrelevant
5. Which of the following is likely to occur after sev-
eral years of relevant rent control?
a. Rents exceeding equilibrium
b. An increase in available housing
Quiz Yourself
Key Term
price ceiling
c. A decrease in available housing
d. Rents equaling equilibrium
6. History suggests that rent control laws
a. tend to be declared unconstitutional.
b. tend to be overturned soon after they are
adopted.
c. tend to become a permanent fixture of a
community.
d. are incredibly unpopular.
Think about This
Rent control laws, like minimum-wage laws apply to
everyone, not simply the poor. Should there be provi-
sions to apply rent control only to those who need the
lower rent?
Talk about This
In smaller cities, being a landlord is a way for handy
men and women to invest in property, fix it up, and rent
it out. It allows them to save and invest some of their
own sweat. Should rent control laws exempt these types
of landlords?
For More Insight See
Keating, W. Dennis, Michael Teitz, and Andrejs
Skaburskis, Rent Control: Regulation and the Rental
Housing Market (New Brunswick, NJ: Center for
Urban Policy Research, 1998).
379
C H A P T E R T H I R T Y - S I X
The Economics of K–12 Education Learning Objectives
After reading this chapter you should be able to:
LO1 Analyze education as an investment and as one that not only
pays dividends to the person getting the education but also
positively affects society at large.
LO2 Summarize the debate over whether spending more on edu-
cation will yield more significant returns.
LO3 Summarize the economics behind the school reform issues.
LO4 Describe why many economists argue that the current
structure of education prevents more money from doing any
good.
Chapter Outline
Investments in Human Capital
Should We Spend More?
School Reform Issues
Summary
From a strictly economic perspective, the amount of time
and money we spend on educating ourselves and our fel-
low citizens is amazing. Required to stay in school until
we are at least 16, and in some cases until we are 18, we
are strongly encouraged to graduate from high school,
and when we do, we are offered substantial subsidies
to get some form of higher education. Some of us even
press on to earn graduate degrees. In the end, it is easily
possible that we have spent the first third of our lives
acquiring an education. Our parents and our government
have encouraged us to invest in ourselves even while
contributing nothing of substance to society during that
time. Since most people retire before they die, the typi-
cal postgraduate educated person has fewer than 40 years
to earn enough to pay back, figuratively, what he or she
invested in formal education.
In general, parents and grandparents are staunch sup-
porters of schools, at least financially. People without
children in school have other reasons for supporting
them. In this chapter we explore some of the reasons
people give for supporting education. We try to deter-
mine whether society is getting its money’s worth for
elementary and secondary education.
In considering the elementary and secondary level,
we look at how much money is spent on education and
attempt to determine whether taxpayers 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.
Next we examine measures of success such as students’
performances on standardized tests and the numbers of
degrees that are granted.
Investments in Human Capital
In Chapters 4 and 5 we spoke of capital as though the con-
cept were confined to machines. In this chapter we turn to
another form of capital, human capital. This refers to the ability of a person to create goods and
human capital The ability of a person to create goods and services.
380 Chapter 36 The Economics of K–12 Education
be on welfare or commit crimes against us and are more
likely to be productive citizens who pay more in taxes
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 external benefits of K–12 education justify having a considerable
subsidy to that education.
We can use our supply and
demand diagram to illustrate
the inefficiency of just having
unsubsidized private education.
Consider Figure 36.1 and what it suggests the price of
education should be to the parents of the children to be
educated. The price is the annual tuition, and the quan-
tity is the number of kids educated in a year. At low
tuition rates, more will invest in education, and when it
is free, everyone will take advantage of it. The resulting
demand curve is downward sloping, but if tuition is low,
schools will be willing to educate fewer students.
The equilibrium tuition T* and the equilibrium num-
ber of enrolled students S* are what the unsubsidized
market would yield. If there is an external benefit of
the size shown, then the optimal number of students is
much greater than the market amount. In this case the
optimal number of students is everyone and the opti-
mal price is zero. This means that taxpayers will have to
pay the T′ per student. From a theoretical point of view,
this does not necessarily mean that the school must be
services. Education and training play an important role in
developing human capital.
Present Value Analysis
In Chapter 7’s discussion of present value and invest-
ments, we learned it is possible to invest too little or too
much in anything, including human capital. Determining
the right amount depends on the
value of the net present value, the difference between the pres-
ent value of benefits and the
present value of costs.
The investment we make in the education of our
own children we do out of love for them, but it also
makes sense from an economic point of view. If there
were no “free”1 public schools, we would look first at
the present value of costs of educating a child from
kindergarten through high school. We would then sub-
tract that from the present value of the child’s increased
earning potential because of that education. If at that
point we found that the net was positive, then we would
conclude that, for the parent, the investment would be
a wise one.
Again, from the view of the parent, an even more re-
fined look at this analysis would subtract out those costs
that would occur anyway. Consider the modern family
with two working parents or a single parent. If there were
no public school, they would have day-care expenses
whether or not the child were educated. That means, at
the margin, a cost of educating the child is the difference
between the tuition to the school and the day-care costs.
This reduces the relevant costs, and it makes education
an even better investment.
External Benefits
Of course, K–12 education is public and it has been for
so long that we may not even think of asking why. There
are societal as well as economic reasons for having free
public education. Societally, benefits accrue to us all
from having children become educated, whether or not
they are our own children. Economically, benefits accrue
to us because people who are educated are less likely to
net present value The difference between
the present value of
benefits and the present
value of costs.
external benefits Benefits that accrue to
someone other than the
consumer or producer of
the good or service.
1“Free” is in quotes for two reasons. First, some states require a textbook
rental fee that, in Indiana at least, is between $100 and $200 per student per
year. This fee is waived for students qualifying for the Federal School Lunch
program. Second, the taxpayer pays for this public education. Thus “free”
should be read as “free to the parents except for any fees that might be
involved.”
FIGURE 36.1 External benefits of K–12 education.
S
D
T *
S*
Tʹ
Tuition
Enrolled students
External benefit
Should We Spend More? 381
government-owned and -operated. In the United States,
except for some experiments in Milwaukee and other
cities, this is precisely what it means.
Specific estimates of the magnitude of this exter-
nal impact have started to emerge. Economists Lance
Lochner and Enrico Moretti estimate that the impact of
crime reduction is between 12 percent and 26 percent of
the private benefit to education.
Should We Spend More?
The Basic Data
We spend a great deal of money on elementary and sec-
ondary education. In so doing we are hoping that the
tax money we are spending nets us a return of smart,
educated, and productive future taxpayers. In this sec-
tion we look at how much is spent and how it is spent,
measures of performance, and reasons why our dollars
apparently are not buying us what they used to. We also
explore the alternatives to public elementary and sec-
ondary schools and ask whether the near monopoly that
is our current public school system is serving our inter-
ests adequately.
As of 2014 the United States was spending nearly
$700 billion to educate 62.5 million elementary and sec-
ondary students. In exploring whether this amount of
money is justified, we can look at how inflation-adjusted
spending per pupil has been tracked over time and
compare the amounts that have been spent with outcomes
such as test scores and graduation rates. It 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. In addition, because in-
flation makes a 1960 dollar more valuable than a 2006
dollar, we need to adjust the spending figures for infla-
tion. Though a flawed measure, the CPI is what we typi-
cally use to perform that adjustment.2
From Figure 36.2 you can see that even when it is
adjusted for inflation, spending per student increased
dramatically over the last 56 years. While there was a
leveling off in the period of economic turmoil in the
late 1970s and early 1980s and another during the early
1990s, there was, nonetheless, a marked increase from
$3,544 (2015 dollars) per student in 1960 to its peak of
$13,476 in 2009. The trauma to state budgets caused by
the Great Recession led to a nearly 9 percent decline in
inflation-adjusted per-pupil spending. This constitutes
the first substantial period of decreased real resources
for K–12 education since the Great Depression of the
1930s. While that spending went for many other things
as well, it served to decrease average class size dramati-
cally. As can be seen in Figure 36.3, in 1960 there were
FIGURE 36.2 Spending per pupil in 2012 dollars.
Source: Digest of Education Statistics, http://nces.ed.gov/programs/digest
0
2,000
4,000
6,000
8,000
10,000
16,000
14,000
12,000
Year
R e
a l (2
0 15
) to
ta l s p
e n
d in
g p
e r
s tu
d e
n t
1 9 2 0
1 9 3 4
1 9 4 0
1 9 4 6
1 9 5
2
1 9 5 8
1 9 6 4
1 9 7 0
1 9 7 3
1 9 7 6
1 9 7 9
1 9 8 2
1 9 8 5
1 9 8 8
1 9 9
1
1 9 9 4
1 9 9 7
20 00
20 06
20 09
2 0 12
20 03
2See Chapter 6 for a brief review of this.
382 Chapter 36 The Economics of K–12 Education
number of students in a class would be expected to have
a similarly significant impact on the success of students.
By some measures it has, and by others, it has not.
Figure 36.4 indicates that students’ scores on the
SATs over the same period did not respond in propor-
tion to the reductions in class sizes, and there is no clear
more than 26 students per class; there are currently 15.6.
The resource constraints caused by the Great Recession
also show up here with a 4 percent increase in average
class sizes from their all-time low achieved in 2009. If
the demands on what needs to be taught have remained
constant, such a significant long-term reduction in the
FIGURE 36.3 Student-to-teacher ratios.
Source: Digest of Education Statistics, http://nces.ed.gov/programs/digest
0
5
10
15
20
25
30
Year
S tu
d e
n t-
te a
c h
e r
ra ti
o
1 9 5 5
1 9 6 5
1 9 7
1
1 9 7 3
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8
1
1 9 8
3
1 9 8 5
1 9 8 7
1 9 8
9
1 9 9
1
1 9 9
3
1 9 9 5
1 9 9 7
1 9 9
9
2 0 0 1
20 0 3
20 05
20 07
20 0 9
2 0
1 1
2 0
1 3
2 0 1 9
20 25
2 0 2 1
2 0 2 3
2 0 17
2 0 15
FIGURE 36.4 SATs for college-bound students.
Source: Digest of Education Statistics, http://nces.ed.gov/programs/digest
460
470
480
490
500
510
520
530
540
550
Year
M a
th a
n d
v e
rb a
l S
A T
s
SATV SATM
1 9 6 6
1 9 6 8
1 9 7 0
1 9 7 2
1 9 7 4
1 9 7 6
1 9 7 8
1 9 8 0
1 9 8 2
1 9 8 4
1 9 8 6
1 9 8 8
1 9 9 0
1 9 9
2
1 9 9 4
1 9 9 6
1 9 9 8
20 00
20 02
20 08
2 0 10
2 0 12
2 0 14
20 06
20 04
Should We Spend More? 383
because much of the increase has gone for noninstruc-
tional purposes and special education. Though it is
depressing on the surface, the low SAT scores can be
accounted for in part by the increasing proportion of stu-
dents from low socioeconomic groups taking the SAT.
The high school graduation rate, which on the surface
shows improvement, should be looked at in light of the
fact that General Equivalency Degrees (GEDs) are in-
cluded in the data. In addition, whether it is accurate or
not, the perception is that it is easier to graduate today
because the standards that teachers use to evaluate stu-
dents are not as high as they used to be.
While real spending per pupil has more than tripled
since 1960, an increasing proportion of the amount of
increase has been going for noninstructional needs.
The proportion of dollars spent on people who have
only a tangential impact on student learning, for ex-
ample, has gone from 32 percent of total spending in
1960 to 47 percent in 2013. Employees like janitors,
bus drivers, secretaries, and administrators do not teach
children, and therefore we should not count the money
spent on them as though it has an impact on learning.
The proportion of the total staff in the classroom has
fallen from 70 percent in 1950 to a little more than half
in 2013. If the proportion of total spending on nonin-
structional employees had remained constant, then the
evidence that reducing class size led to an improvement
in SAT scores for college-bound students. If anything,
the opposite happened. Average math SATs plummeted
while class sizes were falling and have rebounded during
the time when class sizes have leveled off. The decline in
verbal SATs bottomed out later and the rebound was less
dramatic. These scores are 53 points below where they
had been 50 years earlier.3
On the other hand, high school graduation rates have
been rising dramatically. As you can see in Figure 36.5,
this is especially true for African Americans and His-
panics. High school graduation rates showed marked in-
creases over the last 56 years, nearly doubling for whites
and Hispanics and increasing 239 percent for African
Americans.
Cautions about Quick Conclusions
Before you draw any conclusions from these figures
about whether schools are doing a good job, you need to
consider some mitigating issues. The data, which on the
surface indicate that there has been more than a doubling
of real spending per pupil, are easily misinterpreted
FIGURE 36.5 High school graduation rates.
Source: United States Census Bureau, www.census.gov/hhes/socdemo/education/data/cps/index.html
0
10
20
30
40
50
60
70
80
90
100
Year
E d
u c a
ti o
n a
l a
tt a
in m
e n
t: h
ig h
s c h
o o
l o
r g
re a
te r
White Black Hispanic
1 9 6 4
19 6 7
1 9 7 0
1 9 7 3
1 9 7 6
1 9 7 9
1 9 8 2
1 9 8 5
1 9 8 8
1 9 9
1
1 9 9 4
19 9 7
20 0 0
20 0 3
20 0 9
2 0 15
2 0 12
20 06
3The 3-test version of the SAT may have had an impact as the scores dropped
markedly for the year in which it was adopted.
384 Chapter 36 The Economics of K–12 Education
and they averaged a combined score of 1,000, is that
better than a class of 10 where the first 5 average
a 1,000 and the 6th, a less-qualified student, gets an
800? Since more people are taking the SAT now than in
1960, and since the quality of the students who would
not have taken it then but take it now is lower than the
quality of students who would have taken it anyway, we
should expect average SAT scores to decrease. Even a
level SAT average would indicate that today’s schools
are doing a better job.
Test scores have fallen as spending has increased,
and we have speculated about why increased spending
has not resulted in higher test scores. Let’s look now at
graduation rates. Though graduation rates have risen
substantially over the decades, there is an open question
as to whether this can necessarily be viewed as an im-
provement. For one thing, prior to 2014 when the exam
changed (becoming substantially more difficult), more
people had earned a GED diploma than at any other time
in history. Some of them had dropped out of school for
various reasons. Others were prisoners who had learned
that completing a GED shaved time off their sentence.
It was admirable that they would do this, regardless of
who they were, but even though the “E” used to stand for
equivalence, few employers considered it to be the equal
of a high school diploma. The best evidence for this
assertion is that the income of GED holders is still far
closer to the income of high school dropouts than it is to
high school graduates who have not gone to college. We
need to consider this when we make positive statements
about the marked increase in graduation rates for African
Americans. Because they hold a vastly disproportionate
number of the GEDs, we have to be careful to interpret
the increases in graduation rates.
Additionally, there is the common perception that
high schools engage in what is referred to as “social
promotion,” that is, the granting of diplomas for sur-
vival rather than for achievement, a trend that critics
say has increased in recent years. In response to laws
such as No Child Left Behind, states began implement-
ing exit exams for students to combat this perception.
The result was a concerning increase in the number
of students who had passed all other requirements for
graduation but could not pass the tests. The response in
many states like California was to suspend the test. Un-
less a significant flaw is found in those tests, it seems
that the evidence shows that standards have indeed been
lowered and that social promotion, rather than anything
to be proud of, is responsible for at least some of the
increased graduation rates.
overall rate of increase could be telling us something
about whether we have been getting what we paid for.
It has not remained constant, so we cannot. It is still
the case, however, that real instructional spending per
pupil has doubled.
Some of the real instructional spending per pupil that
has doubled since 1960 has been devoted to legally man-
dated special education instruction. In 2014, 12.9 percent
of the student population was labeled with disabilities
and thus eligible for help that was subsidized through
various state and federal programs. Most students who
have been labeled as having physical disabilities do not
require many extra resources, but some require quite
expensive services. Although the Americans with Dis-
abilities Act requires that the school provide all neces-
sary assistance to such children while they are in school,
the money that it costs to do so should not be called a
spending increase for purposes of deciding whether an-
nual costs per pupil are too high. Such spending does
not directly benefit students without disabilities, and it
therefore should be netted out of the analysis.
If we include the spending that funds special educa-
tion programs in our analysis, the figures on class sizes
are understated. Because the figures are derived by
simply dividing the number of students by the number
of teachers, and because many of the additional teach-
ers focus on only a few special education children, the
correct number for analysis should be the number of
non–special education students divided by the number
of non–special educa tion teachers.
In the past 56 years real total spending per pupil has
increased, real total instructional spending per pupil
has in creased, and real total instructional spending has
increased for students without eligible handicapping
conditions. The SAT and other test scores are lower today
than they were 50 years ago. While we would not ex-
pect increased spending on bus drivers or students with
severe academic problems to increase SAT scores, we
have every reason to expect a real increase in spending
on instruction of students without disabilities to increase
test scores. Because spending has increased and the test
scores have decreased, it seems logical to conclude that
we are not getting what we pay for in education spending.
That conclusion may not be warranted, though, because
the number of students taking the tests has increased and
the number going to college has increased. If we look at the
entire range of students, moreover, we will see that
greater numbers of those who earn lower scores are
represented than used to be the case. For instance, if
a high school senior class of 10 has 5 going to college
School Reform Issues 385
Literature on Whether More Money Will Improve Educational Outcomes
There is a vast literature written by economists on
whether increases in spending can be counted on to in-
crease educational outcomes. The premise that “you get
what you pay for” and that more money will make things
better can be traced to the production function that we
outlined in Chapter 4. Recall that this function maps the
relationship between inputs and the resulting outputs. We
used workers as the example for that chapter. We showed
that more inputs translated into more outputs until the
point where the limited capital stock or the structure of
the business prevented the new workers from having a
positive impact on output.
Applying that idea to education, let’s assume that the
input is teachers and the output is some agreed-on mea-
sure of education outcomes. Each of these assumptions
requires some clarification. First, whether it is best to hire
more teachers (a higher quantity) to reduce class size or
whether it is best to pay teachers more to get better ones (a
higher quality) or both is certainly an open question. For
the purposes of our graph, we will simply assume quality
and quantity are interchangeable concepts. Second, while
standardized test scores do not necessarily qualify as an
agreed-on measure of outcome, for simplicity of explana-
tion we will assume that they do. Given all that, Figure 36.6
shows the relationship between teachers and test scores.
Eric Hanushek, a leading economist on the issue of
education, summarized 377 studies where one or more
measures of input like student-to-teacher ratio (the quan-
tity of teachers), teacher education, and teacher experi-
ence (the quality of teachers) were used to explain test
scores. He 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
taxpayer resources—is in some dispute by other econo-
mists. 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 in-
come and family structure.
These results are not as contradictory as they might
seem. Figure 36.6 indicates that it might very well be that
the structure of public schools has been such that more
money had a significant impact in the 1940s through the
1960s because we were spending so little and were on
the steep, upward-sloping part of the curve. The argu-
ment that Hanushek 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. Now we
need to look at something else.
School Reform Issues
If we are in fact on the flat part of the educational pro-
duction function and more money will not help until
the structure is changed, it is reasonable to ask what the
structure is and why it is limiting. There are two sepa-
rate issues with regard to the structure that we explore
in this section. The first is that the public education
system operates as a monopoly and as such tends not to
be responsive to the desires of individual students and
parents. The second is that teachers’ salaries are usually
not dependent on their performance. The debate about
whether private schools and vouchers to pay for them
might help to improve formal education makes up the
remainder of this section.
The Public School Monopoly
In Chapter 5 we saw that in industries dominated by mo-
nopolies, prices are higher and output is less than it would
be under perfect competition. Public schools operate in
FIGURE 36.6 Educational production function.
Teacher quality/quantity
Educational production function
T e
s t
s c o
re s
386 Chapter 36 The Economics of K–12 Education
classroom. This is a problem because energetic teachers
can become discouraged by the lack of monetary recog-
nition for their efforts. Any time pay is based strictly on
who you are rather than what you do, there is an incen-
tive to do as little as possible.
The other serious obstacle to rewarding good teach-
ers and getting rid of bad ones is teacher tenure. Much
like the institution of tenure in colleges and universi-
ties, K–12 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.
Many teachers and their union representatives argue
several points in defense of this system. First, they argue
that as professionals they are above economic consider-
ations and teach to the best of their ability all the time.
Second, they argue that granting a principal the power
to fire senior teachers and hand out merit pay would fos-
ter cronyism. Only those who did the principal’s bidding
would keep their jobs or get large pay increases. Last,
they argue that pay in general is low relative to other pro-
fessionals and that any additional money should raise all
teachers’ pay to a higher level.
An additional obstacle facing the current educational
system is the degree to which talented women have fled
teaching jobs. Economists Caroline Hoxby and Andrew
Leigh have identified a frightening degree of movement
of brighter women away from teaching and an even more
frightening shift of less bright women toward teaching.
This, combined with the fact that very few men, bright
or otherwise, choose teaching as a profession, means
that salaries will have to rise in order to reattract bright
men and women to the profession of teaching. Teachers’
salaries, although they have risen with inflation, have
fallen relative to the salaries of equally credentialed oc-
cupations. These economists argue that economics has
overcome the sociological tendency of women to be at-
tracted to teaching as a profession and only more pay will
reverse this trend.
Private versus Public Education
In the presence of failed or failing public schools, many
have come to ask whether private schools should be al-
lowed to receive public funds. In 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 exist
with funding that is far less than that of public schools.
most communities as a monopoly. Though there are pri-
vate schools and homeschooling, these are not real op-
tions to most parents. Even more interesting is that this
monopoly charges you, in the form of state and local
taxes, whether or not you use the schools. It 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. If you believe that the ex-
ternal benefits of K–12 education are so great that they
justify being subsidized, then parents who choose to
send their children to private schools should have to con-
tinue paying school-related taxes because they are get-
ting those external benefits.
Ultimately, 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. In 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 excellence in another child. Consider the follow-
ing problem that exists at the beginning of every school
year in nearly every school in the country. Every school
has teachers of varying quality and many parents know
who the better ones are. Parents want the teachers they
consider to be better, and the principal must disappoint
some of these parents. Under competition, a disap-
pointed parent could threaten to move to another school.
Under competition, the principal would have at least a
budgetary incentive to make bad teachers better. Under
the current system in most school districts, the parents
are simply told, “That’s the way it is.”
Merit Pay and Tenure
One of the areas that distinguishes teachers from other
professionals is the lack of economic performance in-
centives and the presence of lifetime job security. One
recent study has found that individual teacher quality
does matter. Economist Jonah Rockoff, in particular,
found that he could isolate the impact of individual
teachers and found that he could identify the better ones
statistically by carefully matching student achievement
to their past teachers. The reason is that most teach-
ers in the United States are represented by a union that
is an independent union, an affiliate of the National
Education Association, or the American Federation of
Teachers. Unions 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 experience
earns more than a good teacher with fewer years in the
School Reform Issues 387
When private schools outperform public schools, it
can be attributed to a variety of factors. Because the par-
ents pay tuition to private schools out of their own pock-
ets, 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 un-
likely 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.” If 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 exists.
The primary reason is that parent involvement is higher
and administrative costs are lower in private schools.
There is a concern, however, as it relates to private
schools and that is that the schools would be moti-
vated to admit the easiest to educate. By and large, stu-
dents with higher test scores, students from two-parent
households, and students without significant physical
or psychological challenges are
easier to teach than other stu-
dents. Cherry picking, the act of choosing students easy to edu-
cate, would leave the hardest
and most expensive students in
the public schools.
School Vouchers
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 taxpayer money
that would have gone to educate the child in the first public
school. With cost savings and a general dislike of teachers’
unions in mind, this option is popular among Republicans.
Democrats, strict believers in the “public” part of public
education, generally oppose attempts at privatization.
There are, however, ongoing experiments with school
vouchers. The school system in Milwaukee, Wisconsin,
for example, has been operating a school choice program
since 1990. In this system low-income parents can obtain
vouchers to send their children to secular (i.e., nonreli-
gious) 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.4
The results of this experiment and others like it are
mixed. Until recently, only a research team at the Univer-
sity of Wisconsin had access to the data and they concluded
that, compared to all other Milwaukee public school stu-
dents, children did no better. Research that ensued after
the data were released to the general academic community
suggests that those in the program for three or more years
did better (3 to 5 percentile points on reading and 5 to 12
on math) than those who applied but could not get in.
The debate continues on the wisdom of school
vouchers from a variety of perspectives, political, ethi-
cal, and economic. Research conducted separately by
Helen Ladd and Derek Neal suggests that vouchers
and charter schools have not performed so well, or so
badly as to settle the issue from the perspective of ef-
fectiveness. Part of the problem in such analysis is that
parents who show an interest in getting their children
out of failing public schools are likely to nurture their
children in either setting. If those who succeed in get-
ting their children out of the failing schools and into
charter schools are highly motivated parents, then any
success in the charter schools is likely to be overstated
with simple analysis. These researchers found that con-
trolling for that bias, the impact of charter schools is
modest at best.
Collective Bargaining
An issue that developed in the aftermath of the 2010
midterm elections was the degree to which the collective
bargaining rights of teachers had led to, or even contrib-
uted to, a perceived decline in education outcomes in
public elementary and secondary education. States with
Republican governors that also elected solid Republican
majorities, specifically Indiana and Wisconsin, saw
moves to limit the collective bargaining rights of their
teachers (as well as other public employees). The moves
were, at least in part, motivated by the desire to rein in
non-salary-related costs.
If you read Chapter 16 and its discussion of the public
employee pension crisis that is about to hit many states,
you understand that it is not current teachers’ salaries
that are considered the problem, but instead it is their
pensions. These pensions are frequently defined ben-
efit pensions with a “rule of 85” clause that allows any
teacher in a state to retire with full benefits (typically
75 percent of their salary) when their age plus their years
of service equals 85.
The aforementioned legislatures went after the collec-
tive bargaining rights of the public employees (specifically
cherry picking The act of admitting only students who are easy to educate, leaving the harder and more expensive ones for public schools.
4State law mandated that in such a circumstance the awarding of vouchers
would be determined at random.
388 Chapter 36 The Economics of K–12 Education
the teachers in Wisconsin) because it was collective bar-
gaining that led to these types of pension arrangements,
which, because they allowed teachers to retire at full ben-
efits at age 55, were considered (by the Republicans) to be
more generous than the state could afford.
Associated with that same collective bargaining issue
was the realization that state education budgets across
the country were going to be cut, and it was through
collective bargaining that teachers’ unions had negoti-
ated “last in, first out” clauses for layoffs. Those in favor
of significant educational reform felt that these provi-
sions would inappropriately require that excellent young
teachers be let go while poor (yet experienced) teachers
remained. Those opposed to the stripping of collective
bargaining rights for teachers, objected to what they de-
scribed as the vilification of experienced teachers.
Summary
You now understand that education is an investment
in human capital and that this investment not only in-
creases the earnings of the person being educated but
has positive externalities as well. You also understand
that spending more money will not necessarily yield
even more returns. Moreover, you are well aware of
the debate centering on whether, with the current edu-
cation structure, we are on the “flat” of the education
production function. You now understand the econom-
ics behind the school reform issues.
1. The evidence on the impact of spending on K–12
education outcomes suggests that, ceteris paribus,
a. the more a school district spends, the better it does.
b. the more a school district spends, the worse it does.
c. the more a school district spends on expensive
buildings, the better it does.
d. the amount of money a school district spends
has no consistent positive or negative impact
on outcome.
2. The fact that education benefits not just the person
being educated but society as a whole suggests that
there is a
a. positive externality.
b. negative externality.
c. congestion.
d. monopoly.
3. The argument that spending more money on teach-
ers has little impact on educational outcomes in
K–12 is
a. inconsistent with any economic model.
b. consistent with the upward-sloping nature of a
production function.
Quiz Yourself
Key Terms
cherry picking
external benefits
human capital
net present value
c. consistent with the downward-sloping nature of
a demand curve.
d. consistent with the flat part of the production
possibilities frontier.
4. The institution of teacher tenure is meant to
a. ensure job security for teachers with 10 years of
experience.
b. ensure that teachers do not get fired for political
reasons.
c. allow teachers to engage in any behavior they
wish.
d. allow the easy firing of incompetent teachers.
5. The evidence on charter schools is that they
a. have had no impact in any locations they have
been tried.
b. have had an enormously positive impact on
education generally.
c. have had a negative impact on students.
d. have had some impact in some locations,
but there is no generally obvious positive
impact.
Summary 389
6. If all K–12 schools were privately owned with
a constant subsidy paid by the government to the
school for each student enrolled, what would be one
potential and likely negative consequence?
a. Cherry picking
b. Collective bargaining
c. Tenure
d. Vouchers
7. In most school districts, all other characteristics held
constant, an excellent teacher earns ____ a poor
teacher.
a. the same as
b. more than
c. less than
Short Answer Questions
1. Explain how the data in Figures 36.2 through 36.5
(increasing real spending per pupil, decreasing class
sizes, decreasing SATs, and increasing graduation
rates) can be occurring at the same time.
2. Use the production function “flat of the curve” ex-
planation to describe why more money spent on
education may not have a significant impact.
3. Provide an explanation for why it is possible that
average SATs that are declining might be consistent
with the assertion that more people are prepared for
college than ever before.
4. Suppose you were to find yourself between an advo-
cate for education who claimed that you have to pay
teachers more in order to get more qualified teachers
and an advocate for education reform who claimed
that paying the same teachers more money won’t
help. Explain why they both might be correct.
Think about This
As bad as the gender discrimination of the 1950s and
1960s was to the career aspirations of smart women,
there was a silver lining to the dark cloud: School sys-
tems could hire very smart, very capable, and very
motivated women to be elementary schoolteachers and
do so for relatively modest salaries. Suppose you were
a school board member in the 1980s and noticed the
decline in abilities of the new graduates. What would
you have done to reattract great women to the teaching
profession?
Talk about This
Should teachers’ salaries be tied to their performance?
How would you measure their performance? Should the
performance-evaluation mechanisms be strictly based on
quantitative factors (e.g., test scores) or should they re-
flect the subjective judgments of administrators?
For More Insight See
Greene, P., Paul E. Peterson, Jiangtao Du, Leesa Boeger,
and Curtis L. Frazier, The Effectiveness of School
Choice in Milwaukee: A Secondary Analysis of Data
from the Program’s Evaluation. Education and Urban
Society, 1999; http://journals.sagepub.com/doi/abs
/10.1177/0013124599031002005
Hoxby, Caroline M., and Andrew Leigh, “Pulled Away
or Pushed Out? Explaining the Decline in Teacher
Aptitude in the United States,” American Economic
Review 94, no. 2 (May 2004).
Journal of Economic Perspectives 10, no. 4 (Fall 1996).
See articles by Francine D. Blau; Eric Hanushek;
David Card and Alan B. Krueger; and Caroline Minter
Hoxby, pp. 3–72.
Journal of Economic Perspectives 16, no. 4 (Fall 2002).
See articles by Helen Ladd and Derek Neal, pp. 3–44.
Lochner, Lance, and E. Moretti, “The Effect of Edu-
cation on Crime: Evidence from Prison Inmates, Ar-
rests, and Self-Reports,” American Economic Review
94, no. 2 (May 2004).
Rockoff, Jonah E., “The Impact of Individual Teachers
on Student Achievement: Evidence from Panel Data,”
American Economic Review 94, no. 2 (May 2004).
Behind the Numbers
National Center for Education Statistics; Digest of Edu-
cation Statistics—http://nces.ed.gov/programs/digest
C H A P T E R T H I R T Y - S E V E N
390
College and University Education: Why Is It So Expensive? Learning Objectives
After reading this chapter you should be able to:
LO1 Understand why a college education is so expensive and
why those costs have been rising faster than inflation.
LO2 Explain the role of textbooks in those rising costs.
LO3 Apply the principle of present value so as to see why bor-
rowing money to pay for a college education is a wise, if
potentially risky, investment in future income potential.
LO4 Understand that the United States has a greater percentage
of citizens with a college degree than most other devel-
oped countries, though that advantage is rapidly
evaporating.
Chapter Outline
Why Are the Costs So High?
Why Are College Costs Rising So Fast?
Why Have Textbook Costs Risen So Rapidly?
What a College Degree Is Worth
How Do People Pay for College?
Summary
In the preceding chapter, we raised questions about the
costs and effectiveness of education through grade 12.
Here we explore whether students in colleges and uni-
versities are receiving good value for their money. In
2014, a little more than $517 billion was spent educating
20 million college students, which works out to $25,850
per student, per year. Obviously it costs substantially
more for higher education than it does for students in
elementary or secondary schools. Moreover, tuition,
room, and board have increased 702 percent over the last
34 years—a period when overall prices increased only
138 percent. Figure 37.1 shows that both college tuition
and college textbook prices have increased much more
rapidly than has inflation.
To find out why this is so, we examine some of the
economic issues for higher education. We include a
discussion of why it costs more and whether those costs
are worth it to the college student consumer. We proceed
to discuss how higher education is financed in the United
States and finish with a discussion of one of the most
significant expenses in college textbooks.
Why Are the Costs So High?
The reasons why college costs more than high school
per student are both obvious and hidden. First, the obvi-
ous: On the average, college professors earn salaries that
are twice those of elementary and secondary teachers.
Colleges have libraries that dwarf what we might see
in a high school, and librarians have no choice but to
subscribe to wildly expensive journals, including many
Why Are the Costs So High? 391
or to advance from a less prestigious school to a more
prestigious school, research and other scholarly activity are
more important than teaching.
That research is expensive. Research for an English
professor requires a well-stocked library and a state-
of-the-art computer. This is cheap compared to what it
costs to set up a biologist to do advanced research. Not
only do biologists require the well-stocked library; they
require a fully stocked laboratory with equipment that
can separate out DNA and that can magnify samples so
that individual cells can be seen. The cost of some of this
equipment is so high that if you used the money to equip
high schools, you could equip all the high school labs of
a medium-sized city for what it costs to fund the labora-
tory of a single professor at Harvard, MIT, or Stanford.
On the other hand, research brings in a considerable
amount of money to universities. At nearly $46 billion in
2013, the revenue associated with grants and contracts is
the next biggest source of higher education revenue next
to tuition at $70.5 billion.
A final reason why college is so expensive relates to
the subsidies. As shown in the previous chapter about
K–12 education, a college education provides private
benefits to its students as well as external benefits to the
public at large. The private benefits include the higher
in the sciences that have five-figure subscription prices.
If you have not already noticed, college professors teach
far less than high school teachers do. A professor at a
research-oriented university may teach only 3 to 6 hours
a week, while a professor in a teaching-oriented com-
munity college may average 12 to 15 hours a week.
High school teachers are in the classroom from around
8 a.m. to around 3 p.m., with some time off for lunch
and preparation. They may teach five- or six-hour-long
classes, five days a week. In net, a high school teacher
is in class more in a single day than some professors are
in a week.
Exploring reasons for the disparities between K–12 and
college teachers gets us into some less obvious reasons why
per-pupil college costs are so high. Educators at all levels
must maintain a high level of expertise in their field. At the
college level, it is accepted that professors need time for
reading and studying. Professors who teach at the higher
end of a discipline need particularly great amounts of time
for scholarly study. Many professors are also judged by the
degree to which they advance knowledge in their academic
discipline. This research commands most of a professor’s
time at most universities, whether or not they are regarded
as prestigious. A sad fact of life in modern college educa-
tion is that for a professor to advance within an institution,
2 0 12
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2 0 12
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100
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140
160
180
200
240
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College textbooks Tuition CPI
FIGURE 37.1 College costs relative to CPI.
Source: Bureau of Labor Statistics, www.bls.gov/cpi/home.htm
392 Chapter 37 College and University Education: Why Is It So Expensive?
incomes college graduates earn as well as the fun college
students have in and especially out of the classroom. The
external benefits include the fact that the college educated
pay far more in taxes over a lifetime than do those with-
out such an education as well as the increased knowledge
they bring to their voting and leadership activities. Thus,
though perhaps not as significant as the external benefits
of K–12 education, they are still high enough to justify
having a considerable subsidy to that education.
Just as we used our supply and demand diagram in
the previous chapter to illustrate the inefficiency of just
having unsubsidized private K–12 education, we can
apply the same models and principles here. Consider
Figure 37.2 and what it suggests about the price of a
college education. The price is the annual tuition and
the quantity is the number of college students educated
in a year. At low tuition rates, more will invest in a col-
lege education, so the resulting demand curve is down-
ward sloping. However, if tuition is low, colleges and
universities will be willing to educate fewer students.
The equilibrium tuition T* and the equilibrium num-
ber of enrolled students S* are what the unsubsidized
market would yield. If there is an external benefit of the
size shown, then the optimal number of students is much
greater than the market amount. Unlike the K–12 case, the
optimal number of students is likely not everyone and the
optimal price is likely not zero. It does mean that students
should not have to pay all of the costs and that taxpayers
will have to pay a subsidy. Students should pay T from student
,
and taxpayers should pick up the rest so that the school
gets the amount they need, T to school
, to teach S′ students.
Notice, though, what happens to the cost per student (not
just to the student). It rises from the T* to T to school
. Subsi-
dizing something contributes to its higher costs.
Why Are College Costs Rising So Fast?
As can be seen from Figure 37.3, though tuition has been
rising fast, the rise in the revenues to universities has
more to do with their other enterprises than it does with
tuition. Total revenues to public universities increased
by $230 billion over the period 1995 to 2013. Tuition
increases only accounted for $47 billion of that increase.
The staples of a public university’s budget—especially a
public university that is not the flagship of the state—are
its tuition, its state (and to a lesser degree federal and
local) appropriation, and its housing-based auxiliaries
(shown in the figure as “Aux-Non-Hospital”).
There is little doubt, however, that the mix in revenues
has changed dramatically throughout the years, even ignor-
ing the largest part of the increase: that is, the increase in
gift, investment, grant and contract, and affiliated hospital-
derived income.1 Zeroing out those elements, the relative
sizes of the wedges of the pie have changed markedly.
Specifically, from 2007 to 2013, total federal, state, and
local appropriations to public universities fell from nearly
$80 billion to less than $71 billion. At that same time tuition
revenue increased by 26 percent. Figure 37.4 shows that the
share of revenues attributable to appropriations fell from
57 percent in 1995 to 44 percent in 2013, with almost the en-
tirety of that difference being absorbed within tuition. Essen-
tially, public universities are justifying their rapid increases
in tuition on the relative decline in state appropriations.
Another reason for the increase in the cost of higher ed-
ucation is the degree to which student expectations of their
environment have changed. The contrast between post–
World War II student housing and modern student housing
is remarkable. The floor of 40 two-to-a-room 10 × 15-foot
prison cells with a common shower and bathroom facility
has been replaced by suite–style housing with private or
semiprivate showers and bathrooms. According to the Na-
tional Center for Education Statistics IPEDS data, between
2002 and 2014 all of that construction led to a fourfold
increase in long-term debt at four-year public institutions.
Those costs have been passed on to students. Further, while
not always directly demanding modern exercise facili-
ties, students have chosen to enroll on campuses that have
built them. The costs of constructing and equipping these
S
Tuition
Tto school
T *
S*
D
Social benefit
External benefits
Enrolled studentsSʹ
Tfrom student
FIGURE 37.2 External benefits of a college education.
1Some larger state universities operate hospitals as part of their medical
schools, and the revenue from those hospitals significantly distorts the rela-
tive size of the revenue sources.
Why Have Textbook Costs Risen So Rapidly? 393
in-state students, they have largely let institutions charge
out-of-state students whatever they wish.
Why Have Textbook Costs Risen So Rapidly?
The market for college textbooks is a good example of a
great many economic concepts: fixed and variable costs,
the impact of patents and copyrights on the market for
a good, the fuzziness of the line between oligopoly and
monopolistic competition, and the degree to which in-
creased technology increases supply. Before we get too
deep into the analysis, you should understand how a text-
book comes to market.
Either solicited or unsolicited, a faculty member will
write a chapter or two to show a publisher why this new
book would be better than those that exist. Very few of these
prospective books make it past this step. Those sample chap-
ters that meet with the publisher’s expectations are sent out
to faculty who, when the book is published, might consider
using the book for their course. They are compensated for
their feedback and, if the publisher senses from that feedback
recreation centers have been passed on to students either in
the form of dedicated fees or in the form of higher tuition.
Universities have built them largely for enrollment reasons.
As public universities have come to increasingly depend on
tuition revenue, they have become increasingly sensitive to
student desires. In particular, out-of-state and international
students are particularly prized by public institutions. While
state legislatures have placed limits on tuition increases to
$0
$400
$350
$300
$250
$200
$150
$100
$50
P u
b li c d
e g
re e
-g ra
n ti
n g
u n
iv e
rs it
y r
e v e
n u
e ( b
il li o
n s )
19 95
–9 6
19 96
–9 7
19 97
–9 8
19 98
–9 9
19 99
–2 00
0
20 00
–0 1
20 02
–0 3
20 03
–0 4
20 04
–0 5
20 05
–0 6
20 06
–0 7
20 07
–0 8
20 08
–0 9
20 09
–1 0
20 13
–1 4
20 12
–1 3
20 11 –1
2
20 10
–1 1
20 01
–0 2
Appropriations
Total revenue
Other
Tuition Aux–Non–Hospital
FIGURE 37.3 Revenue to public degree-granting universities.
Source: National Center for Education Statistics, http://nces.ed.gov/programs/digest
*2001–2002 and 2002–2003 interpolated from available data
Tuition 29%
Aux–Non–Hospital 14%
Appropriations 57%
1995
Tuition 41%
Aux–Non–Hospital 15%
Appropriations 44%
2013
FIGURE 37.4 Share of university revenue: Appropriations, tuition, and non-hospital auxiliaries.
Source: National Center for Education Statistics, http://nces.ed.gov/programs/digest
394 Chapter 37 College and University Education: Why Is It So Expensive?
To see where the money goes on the sale of a new
book, consider the one you are reading. As shown in
Figure 37.5, the current edition of this book sold for
$200 as a new book in my university’s bookstore. The
book was sold to the bookstore for $160 so its expenses
and profit come out of the store’s $40 markup. I get
15 percent of the amount that the publisher gets, or $24.
The publisher keeps between $126 and $131. The pub-
lisher’s costs include very high fixed costs for such things
as supplements (recent textbooks have all needed to have
expensively produced testbanks, instructor’s manuals,
website materials, study guides, PowerPoints, etc.) as
well as costs associated with editorial staff and market-
ing. The variable costs also include the cost of the paper,
ink, and printing of the book itself. In all, the marginal
production cost of a textbook is less than $10, sometimes
as little as $5. When all is said and done, the $126–$131
margin that the publisher makes must cover all the fixed
costs of production.
Here it gets tricky because the publisher, and by ex-
tension the author, makes money only when a new book
is sold. You do not have to be in college very long to
know that you can buy used textbooks for much less
than new ones and that you can sell your books back
that the book will be successful, a contract is drawn up that
specifies how the author is to be paid. Typically the author
will get a percentage of the sales (in the neighborhood of
15 percent) to bookstores (based
on the wholesale price, net of re-
turns). An advance is usually of- fered to the author against future
royalties. The book takes at least a year to write, revise, edit, and
publish. Often, a first edition takes
much longer than subsequent edi-
tions because it is typically re-
viewed by a different collection of
faculty around the country.
Once available for sale, the
book is mailed, free of charge, to faculty all around the
country that teach a course in which the book might
be used. This could be thousands of books, as is the case
when there is a rollout of a principles of economics book
(that which is appropriate for business and economics
majors) or a few hundred (when the book has a more
limited audience). Faculty place their orders with their
respective bookstores and the bookstores order them in
the month leading up to the beginning of the semester.
Author royalty, $24
Ink, paper, printing cost, $5–$10
Publisher fixed expenses and profit, $126–$131
$200
Bookstore markup, $40
FIGURE 37.5 Where the money goes.
advance The amount of money paid to authors prior to a book’s publication. This is typically counted against future royalties.
royalties The amount of money paid to authors. Typi- cally paid on a percent- age basis.
What a College Degree Is Worth 395
books that really work in this niche. McGraw-Hill has
a monopoly on this book, but it is a competitor in this
niche. The market form best suited to this area is mo-
nopolistic competition.
The market for principles of economics texts is much
greater and there are many more choices. There are four
really big sellers and several scattered players. This is also
an example of monopolistic competition. The differences
between books is quite slight (mostly in presentation and
emphasis), but the publishers still retain their monopoly
rights. For an example of an area in which there are fewer
sellers, consider the market for graduate-level textbooks
in mathematical economics. For all intents and purposes,
there are two. One is older than dirt and the other one is
a few years old. This is an example of oligopoly. Some
areas of economics are so narrow, with such a small mar-
ket, that there is only one book.
A third reason why textbooks have increased rapidly
in price is that, like prescription drugs, in most cases
the consumer doesn’t get to pick a cheaper alternative.
Textbooks are chosen for you by faculty members who
are often completely oblivious to the price that will be
charged for the book because they get the book mailed
to them free. When students go to the bookstore and
get their books, they cannot choose which book to buy
(beyond their choice of used versus new, buy versus
rent, or print versus e-book). They have to decide to
obtain the book or not. Thus the price of the book is
irrelevant in the adoption decision. Under good circum-
stances, the adoption decision is typically made after
a professor has looked at the choices in the area and
selected the one that goes best with the course and the
way the professor teaches. In the end, faculty often pick
books that have the supplements they are looking for,
have illustrations that simplify the subject, and that are
pleasing to the eye. All of these add to the price of the
book, but the price often does not enter into the de-
cision to adopt the book. The student is then made to
choose between buying the book or not.
What a College Degree Is Worth
Now that we have seen a few reasons why college
costs so much, we can ask whether it is worth the ex-
pense. To explore this question, we need again to un-
derstand and to use the concept of present value. If the
interest-adjusted amount of money you spend on your
education, the present value of the costs, is less than
the interest-adjusted amount of the extra money you
to the bookstore at the end of the semester. Typically
a book that sells new for $200 will sell used for $160.
The bookstore will have purchased that used book from
a previous student at the same university for around
$100.2 The bookstore then stocks both new books and
used books and makes a profit on either. There is some
risk for the bookstore in overstocking a new book, since
they have to pay a restocking fee to return new books to
the publisher, but there is enormous risk in overstocking
used books.
The bottom line for publishers is that they are in busi-
ness to make money, and new sales increase profits and
used book sales eat into profits. The break-even point
on a book such as this one is around 5,000 units. The
next 5,000 units can easily generate nearly a half mil-
lion in profits for the publisher. This is why books are
on relatively short production cycles. Calculus books,
though the content hasn’t changed since Newton figured
it out, are revised regularly because publishers and au-
thors make money only when the new edition sells for
the first time.
A second significant cause behind the expense of
textbooks is the market form. The book you are reading
is the intellectual property of its owner. I gave that intel-
lectual property to the publisher in exchange for the roy-
alties they pay me for sales on the book. The copyright
gives McGraw-Hill Education the exclusive right to sell
this material. It also prohibits you from walking down
to FedEx Office and running off copies for your friends.
Copyrights are necessary to bring intellectual property
to market because without them producers of the books,
songs, and inventions would have no financial motiva-
tion to produce them.
In some disciplines there is one standard textbook
that everyone uses, while in others there are multiple
texts that look very much the same. Though there
are hundreds of textbooks on the market, most are
not good substitutes for another. It does little good
to bring your economics text to your poetry class.
In the end, your professor probably had a relatively
small number of books from which to choose. If you
are using this book while taking a general education
economics course for nonmajors, your professor had
to decide whether to cram a bunch of theory in or
do an issues approach. Having chosen this book, your
professor chose the issues approach. There are four
2There are several reasons why a student might get less than the full buy-
back price. Some include the existence of key codes for online content or
custom content, or the fact that the book came in loose-leaf form.
396 Chapter 37 College and University Education: Why Is It So Expensive?
40 years of $18,000 extra a year is roughly $415,000.
The net present value of a college degree is $333,000,
making it so that dropping out of college is likely the
most expensive noncriminal mistake you could ever
make. Conversely, doing well in college may be the most
lucrative thing you ever do.
How Do People Pay for College?
Many college students recognize the benefits of educa-
tion but cannot see themselves paying for them. While
we have just shown that it makes sense to complete col-
lege even if you have to borrow all of the money to
do it, you know that merely racking up student loans
does not mean you get a degree. This means that there
is some risk involved. You have to weigh the risk of
having the only thing you take away from college be
debt against the benefit that you get the $333,000 in net
present value. In addition, according to CollegeBoard,
though it seems as if a college degree costs you a lot
of money, consider the fact that at a regional bache-
lors-only public university you are getting a subsidy of
earn as a result of your education, the present value of
the benefits, then your college education is worth the
money you pay for it.
Assume for a moment that your four years of college
cost you $10,000 a year in out-of-pocket expenses and
you give up another $12,000 a year in what you would
have earned had you worked full time. The total cost
of your education is then $22,000 a year, or a total of
about $88,000. Since the expenses incurred in the sec-
ond, third, and fourth years are in the future, you must
discount them by the appropriate interest rate. Now as-
sume that instead of making $12,000 a year without a
degree, you will earn the degree and then make $30,000
a year. The benefit from going to college is the extra
$18,000 you earn a year. We use $18,000 because this is
roughly the difference in median income of households
headed by people who have college degrees over that
same figure for households headed by people with only
a high school education. We must again discount these
benefits, as they will happen in the future. If we assume
that all of these dollar figures are inflation-adjusted and
the real interest rate is 3 percent, then the present value
of the costs is roughly $82,000 and the present value of
In recent years, there have been three significant changes to the text-
book market that have jolted textbook companies. The first of these is
the advent of a relatively old niche market for textbook rentals. Chegg
and other Internet companies have revived this relatively small market
in a significant way. These companies typically charge approximately
half the retail price of the book but compel you to return the book to
avoid being charged for the other half. To accomplish this, they will
typically take a customer’s credit card information for the sale and, if
the book is not returned, charge it again. This amounts to the same
issue as buying new books and selling them back, but the student
doesn’t take the risk that the book will be out of edition (and therefore
worth much less).
Additionally, companies are beginning to see their e-book
alternatives grow in popularity, in part thanks to the iPad. While some
text-only books work well with e-readers such as Amazon’s Kindle,
graph- and mathematics-laden books with color are ill suited to the
Kindle platform but are well suited to the iPad and PC platform. Again
this is like renting a book but the book does not have to be returned; it
simply becomes inaccessible after a semester (or year, depending on
the seller’s policies).
Finally, an increasing number of faculty who have seen their
students struggle with being able to afford their textbooks have
chosen a path that is both interesting as an economist and trouble-
some as an author. It had been the case that when a new edi-
tion of a textbook came out, nearly every faculty member would
adopt that new edition and the old editions would be of almost
no value in the market. For instance, when the fifth edition of this
book became available in the spring of 2010, it sold in bookstores
for $125 and rented on Chegg for half that. At the same time, the
fourth edition, which had sold in bookstores for $120 the semester
before, was selling for less than $10 on the Internet’s many used
book outlets.
What seems to be occurring now is that some faculty order
the old edition for everyone in their class so everyone in the class
is in the same position. The faculty member has stayed with the
author’s book, but there are no profits for the publisher or roy-
alties for the author. The long-run impact of this strategy will,
however, result in decreasing its viability as a strategy. As more
faculty fail to “roll” to the new edition, the price of old editions will
rise on the Internet as their easy availability shrinks. In addition,
traditional bookstores will have an increasing difficulty finding
and stocking the old editions in sufficient quantity to meet the
demand. This new faculty strategy is both interesting and prob-
ably unsustainable.
A V O I D I N G H I G H T E X T B O O K P R I C E S
How Do People Pay for College? 397
educational income tax deductions and credits. As
a rarely discussed part of the Patient Protection and
Affordable Care Act, President Obama’s legislation
reformed the student loan program to bypass banks.
The loans, instead, will be administered out of the U.S.
Department of Education. Taken together, these trans-
formations have allowed more students to access some
form of aid, but the aid is now more likely to come in
the form of a subsidized loan.
Nationally, between 1992 and 2012, the percent-
age of students on some form of aid increased from
58 percent to 84.4 percent, and the percentage bor-
rowing to pay for college increased from 34 percent
to 56.7 percent, while the percentage receiving feder-
ally funded education grants has slowly increased to
47.4 percent.
Figure 37.6 shows that if we measure the success
of higher education by looking at degrees granted,
there is success. On the other hand, the United States
is rapidly being caught (and surpassed) by other de-
veloped countries in the percentage of adults with a
college education. Until recently the United States led
OCED countries with a third of the adult population
ages 25 to 64 having at least a four-year college edu-
cation. Counting those with some college, including
nearly $0.85 for every $1 you spend. At flagship doc-
toral granting state institutions the subsidy is $0.65.
The subsidy at a private university is less, but it is
still substantial and usually comes in the form of in-
stitutional financial aid and subsidized student loans.
Subsidies to universities are computed from the value
of interest-reduced loans and gifts to the universities.
Whether you are a student at a public or private uni-
versity, you are paying great sums of money, sums that
would be even greater were it not for subsidies from
national, state, and private sources.
One of the interesting changes over the last three
decades has been the change in the way students pay
for their portion of the costs of a higher education. In
the 1940s, World War II veterans received the GI Bill,
which allowed many former soldiers to go to college.
Not only was their tuition paid, but they were also
granted a stipend upon which to live. In the 1960s
and 1970s, the federal government instituted pro-
grams such as the Pell Grant, which provided a simi-
lar benefit to children of poor families. In the 1980s,
President Reagan shifted the focus to making student
loans available at subsidized rates. In the 1990s, Presi-
dent Clinton reformulated the loan process by increas-
ing federal government involvement and sponsored
0
35
30
25
20
15
10
Year
5
E d
u c a
ti o
n a
l a
tt a
in m
e n
t: b
a c h
e lo
r’ s o
r g
re a
te r
19 64
19 67
19 70
19 73
19 76
19 79
19 82
19 85
19 88
19 91
19 94
19 97
20 00
20 03
20 06
20 09
20 15
20 12
White Black Hispanic
FIGURE 37.6 College graduates as a percentage of the 24 and older population.
Source: United States Census Bureau, www.census.gov/hhes/socdemo/education/data/cps/index.html
398 Chapter 37 College and University Education: Why Is It So Expensive?
two-year degrees, Canada has surpassed the United
States. Most disturbing is that the rate for young adults
(24–35) places the United States behind seven other
countries. The United States is not becoming less edu-
cated. It is that others are catching up. The college
attainment rate for Americans has remained steady
through the years, while the rate for other countries
has increased rapidly. This could ultimately threaten
the comparative advantage the United States had held
in this particular area.
Summary
You now understand why a college education is an ex-
pensive thing to provide and why those costs have been
rising faster than inflation over the years. You understand
that a part of that rapidly rising set of costs is associated
with the cost of textbooks. You understand that the prin-
ciple of present value is useful in seeing why borrow-
ing money to pay for a college education is a wise, if
potentially risky, investment in future income potential
and that the source of funds for students has increasingly
moved from grants to loans. Finally, you understand that
though higher educational attainment is higher in the
United States than it is elsewhere, that advantage is evap-
orating as other countries’ citizens are rapidly increasing
their levels of educational attainment.
Key Terms
advance royalties
Quiz Yourself
1. Which of the following has increased slowest?
a. Overall prices
b. College textbook prices
c. College tuition
2. What are the key reasons why college costs are
higher than high school costs?
a. The expenses of research
b. College faculty salaries are higher than K–12
faculty salaries
c. Subsidies to education cause increased demand
for it
d. All of these
3. The textbook production industry has a great deal
in common with the pharmaceutical industry in that
there are __________ fixed costs and ____________
marginal costs.
a. high; high
b. high; low
c. low; high
d. low; low
4. Authors are typically paid for their work
a. based on a percentage of the sales at college
bookstores.
b. based on a percentage of the sales from publish-
ers to bookstores.
c. a fixed amount regardless of sales.
d. on a per-page basis.
5. The economic tool that proves the value of an ex-
pensive college education is
a. production possibilities.
b. the yield curve.
c. supply and demand.
d. present value.
6. The cost of educating a college student
a. is less than the cost of educating a high school
student because college classes are generally
large.
b. is equal to the cost of educating a high school
student because, although college teachers
make more money, their classes are generally
larger.
c. is less than it used to be.
d. is much greater than the cost of educating a
high school student because college professors
make more money and teach fewer hours per
week.
Think about This
Your education, from kindergarten through college, ben-
efited you and it benefited society. The proportion of a
Summary 399
Behind the Numbers
Revenues, expenses, enrollments, sources of financing.
Digest of Education Statistics—http://nces.ed.gov
/programs/digest
Costs relative to other goods—
www.bls.gov/cpi/home.htm
International comparisons—
w w w. c g s n e t . o r g / d a t a - s o u r c e s - i n t e r n a t i o n a l
-comparisons-educational-attainment
Educational achievement—www.census.gov/hhes
/socdemo/education/data/cps/index.html
typical college education paid by the student has risen
in recent years. How much of your college education do
you pay? (Consider the state appropriation to your school
if it is public, the federal and state financial aid that you
get, and the value of the guarantee on any of your student
loans.) Is this the right division of the burden?
Talk about This
How did cost figure into your choice of school? Did you
have lots of options? If you could have gotten a “full
ride,” where would you have gone?
C H A P T E R T H I R T Y - E I G H T
400
Poverty and Welfare Learning Objectives
After reading this chapter you should be able to:
LO1 Describe how poverty is measured, summarize the
demographics of poverty in the United States, and show how
the percentage of the population that is poor has changed
through the last 40 years.
LO2 Enumerate the significant problems associated with the
federal government’s official poverty rate.
LO3 List and describe the myriad programs that exist for
the poor.
LO4 Explain why the government prefers programs that grant the
recipient goods and services rather than money.
LO5 List the incentives and disincentives of welfare.
LO6 Summarize the welfare reform issues that we currently face.
Chapter Outline
Measuring Poverty
Programs for the Poor
Incentives, Disincentives, Myths, and Truths
Welfare Reform
Summary
Welfare and the reforming of welfare have been politi-
cal issues from the time when the first “relief” bills were
passed by Congress in the 1930s. In more recent times,
President Bill Clinton vowed to “end welfare as we know
it,” and in 1996 a compromise was reached between his
administration and the Republican majority in Congress.
Shortly thereafter the welfare rolls were significantly
cut and welfare programs in general were significantly
changed. Even so, there are myriad programs that provide
assistance to people in need, and we review them in this
chapter. Some of these programs, such as TANF, and WIC,
read like an alphabet soup; others have catchy names, like
Head Start and Medicaid; still others have more straight-
forward names, like Food Stamps and the School Lunch
and Breakfast Program. Each program is designed to help
poor people in specific ways. Some disburse cash; others
provide goods or services at little or no cost.
After defining what constitutes a state of “poverty,”
we describe the people who meet the criteria. We
present and discuss some of the modern history of
poverty, and we discuss why the measure of poverty
we outlined might not be adequate to the task of as-
certaining who needs assistance and who does not.
We then describe the programs that are available to
the poor. We divide the programs into those that pro-
vide cash and those that provide goods and services.
We discuss why we make such a division. Last, we
discuss, in general terms, the incentives and disincen-
tives endemic to welfare programs, and we show why
it is so difficult to solve the problems of those who
live in poverty.
Measuring Poverty
What does being “poor” really mean? Are you poor only
if you are on the verge of starvation? This absolutist po-
sition would suggest that poverty in the United States
is almost entirely gone. As we will see later in our dis-
cussion, one of the most significant health problems of
Measuring Poverty 401
were $12,701 for one person, $15,379 for two people,
$18,850 for three people, and $24,230 for four people. The
poverty rate is the percentage of people in households whose
incomes are under the poverty
line. In 2014, the poverty rate
in the United States stood at
14.8 percent.
Another important measure
of poverty is the poverty gap, a representation of the total
amount of money that would
have to be transferred to house-
holds below the poverty line in
order for them to get out of poverty. The poverty gap in
the United States was $96 billion as of 2014.
Who’s Poor?
Table 38.1 displays indicators of who is poor and com-
pares that to their general portion of the population. Many
people think that most poor people are African American.
While many academics are quick to dispel that myth,
they often perpetuate another with a counter-assertion
that most poor people are white. Neither is true if you
separate European Americans from Hispanic Americans.
Table 38.1 shows disproportionate numbers of blacks
and Hispanics are in poverty and that they comprise a
America’s poor is that they are obese rather than starv-
ing. On the other hand, there is the position that pov-
erty is a relative concept. We note that someone who
has the living standard of a median-income Somalian is
in poverty in the United States but not in Somalia, and
an American today with an average income has a living
standard that 100 years from now will likely be consid-
ered unacceptably poor. To see this point, note that the
poor of today live in larger homes than all but the very
richest Americans did in 1900.
The Poverty Line
Surveys have established reasonably well that low- income
families of four spend roughly a third of their income on
food. Defining the poverty line as that level of annual income suf-
ficient to provide a family with a
minimally adequate standard of
living, we created the first pov-
erty line by multiplying the cost
of a minimally sufficient diet by 3, the reciprocal of one-
third. In successive years, the amount has been raised by
the amount of increase in the consumer price index. For
other family sizes, a similar process takes place where the
reciprocal of the fraction of income spent on food by low-
income people of that family size is multiplied by the cost
of the minimally sufficient diet. In 2014, these numbers
poverty rate The percentage of people in households whose incomes are under the poverty line.
poverty gap The total amount of money that would have to be transferred to households below the poverty line for them to get out of poverty.
poverty line That level of income sufficient to provide a family with a minimally adequate standard of living.
Demographic
General
Population
(in millions)
Percentage of
the General
Population
Percentage
of Those
in Poverty
Poverty
Rate (%)
People in
Poverty
White, non-Hispanic 195.2 61.8% 42.1% 10.1 19.7
Hispanic 55.5 17.6 28.1 23.6 13.1
Black, non-Hispanic 41.1 13.0 23.1 26.2 10.8
Male 154.6 49.0 44.4 13.4 20.7
Female 161.2 51.0 55.6 16.1 25.9
Under 18 73.6 23.3 33.3 21.1 15.5
18 to 64 years 196.3 62.1 56.9 13.5 26.5
65 and over 46.0 14.6 9.8 10.0 4.6
Female-headed household,
no husband present
48.0 15.2 34.1 33.1 15.9
High school dropout* 24.6 7.8 15.2 28.9 7.1
High school graduate (no college)* 62.6 19.8 19.1 14.2 8.9
Some college (no degree)* 56.0 17.7 12.3 10.2 5.7
Bachelor’s degree or greater* 68.9 21.8 7.4 5.0 3.4
TABLE 38.1 Who’s poor.
Source: U.S. Census Bureau: Current Population Survey, www.census.gov/hhes/www/poverty/data/index.html
*There are different thresholds for different compositions of each group. These figures are for a single adult under 65, two adults, two adults and one child, and two adults and
two children, respectively.
402 Chapter 38 Poverty and Welfare
majority of the Americans living below the poverty line.
It is obvious that there is a significant degree of racial
and ethnic distinction in U.S. rates of poverty.
The data indicate that women are more likely to be in
poverty than men; and, if we define “families” as not in-
cluding single adults, then of families in poverty, half are
in female-headed households while 39 percent are fami-
lies of married couples. Given that female-headed house-
holds with children make up only 15.8 percent of the
general population, poverty is clearly a women’s issue.
It is also true that children under 18 make up 33 per-
cent of those who are poor, though they comprise only
23.3 percent of the general population. This is a poverty
rate among children of 21.1 percent. Whether this in-
dicates that the poor have more children or that raising
children can itself lead families into poverty can be de-
bated. Clearly, the picture of poverty is this: Minorities,
women, and children are poor in numbers vastly out of
proportion to their numbers in the general population.
Another key indicator of poverty is education or,
more properly, the lack of it. Those with a bachelor’s
degree experience poverty at one-sixth the rate of high
school dropouts. Simply completing high school cuts the
chance of being in poverty by half, and simply attend-
ing college reduces the chance of being in poverty from
14.2 percent to 10.2 percent. Completing college reduces
the rate even further. Only 1 in 20 households headed by
a college graduate is in poverty.
Poverty through History
Figure 38.1 indicates that although the number of peo-
ple in poverty is roughly the same as it was in 1959, the
poverty rate has fallen dramatically. As we will discuss
later, the poverty rate shown fails to account for the many
government benefits. This means that the reduction in
the poverty rate since 1959 can be attributed to an eco-
nomic strengthening for those whose incomes are at the
bottom of the economic scale.
In considering the decline in the general trend in pov-
erty, be aware of the following caveats. The poverty rate
has remained largely unchanged since the middle 1960s
when the “war on poverty” actually began. From that
time to the present it has neither fallen below 11 percent
nor, until the Great Recession, gone above 15.2 percent.
The systemic reduction, as a matter of fact, occurred be-
tween 1959 and 1969, before the enactment of many of
the antipoverty programs. Noting that the shaded bars
in Figure 38.1 indicate recessions, we can see that the
poverty rate has increased during recessions and less-
ened during periods of growth. Democratic presidents
Kennedy and Johnson get much of the credit for the
pre-1969 reduction in the poverty rate. However, this
was a result more of a strong economy’s providing ex-
cellent economic opportunities than anything these ad-
ministrations did for the poor. The bulk of the pre-1969
decline took place prior to 1965 when these programs
first began to become law. Since 1969 Democrats and
1 9 5
9
1 9 6
1
1 9 6
3
1 9 6 5
1 9 6 7
1 9 6
9
1 9 7
1
1 9 7 3
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8
1
1 9 8
3
1 9 8 5
1 9 8 7
1 9 8
9
1 9 9
1
1 9 9
3
1 9 9 5
1 9 9 7
1 9 9
9
2 0 0 1
20 03
20 05
20 09
20 07
2 0 13
2 0
1 1 5
10
15
20
25
30
35
40
45
Year
P e
rc e
n ta
g e
i n
p o
v e
rt y
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
50,000
45,000
M il li o
n s i n
p o
v e
rt y
Poverty rate People in poverty People in families in poverty
FIGURE 38.1 Poverty since 1959.
Source: U.S. Census Bureau, www.census.gov/hhes/www/poverty.html
Measuring Poverty 403
rich but called poor. However, it is important to note that
the poverty line measures only people’s income relative
to a fixed standard that ignores measures of wealth.
Another shortcoming of the formula that is used to
determine the poverty line is that it only includes in-
come that is in cash. Thus programs that the poor take
advantage of that are not cash-driven are incorrectly and
absurdly omitted as if they have no value. For instance, the
$200 in food stamps that a family might get a month is not
counted, and if they found a subsidized rental apartment
and free medical care, these also would not be counted.
Depending on the study you believe, this failure to include
income that is in forms other than cash overstates poverty
by between two and four percentage points.
As we saw in Chapter 6, the consumer price index
that is used to update the poverty line each year has many
shortcomings. Best estimates are that prior to 2008 it has
overestimated the cost of living by a full percentage point
and in subsequent years by eight-tenths of a percentage
point. Since the increase in the poverty line is generated
using this flawed measure, it is likely that the poverty
line has long been overstated relative to its real value in
the 1960s. Figure 38.2 indicates that although the lower
line, the adjusted version, tracks the upper line through-
out the 1960s, the spread is significant enough that if you
take the 1959 poverty line as the base on which to build
the adjusted poverty line, you see that instead of being
$24,230 in 2014 it should have been $15,752.
Besides the possible overstating of poverty that we have
seen up to this point, there are additional problems with
this measure that result in mislabeling some people as
poor and others as not poor. As we mentioned specifically
in the previous paragraph, the general CPI is used to adjust
the poverty line. Because the CPI is a general indicator
of the prices of many goods, it does not necessarily reflect
the goods that are bought by people living in poverty. To
the degree that poor people buy things that have increased
in price more than the overall CPI, the “true” poverty line
probably would fall between the two shown in Figure 38.2.
The way costs of living vary from area to area leads
to yet another source of mismeasurement of the num-
bers of people who live in poverty, and it is a source
about which there is uncertainty of the direction of
the bias. Because it is much more expensive to live in
San Francisco, California, than in Appleton, Wisconsin,
for example, families of four in San Francisco with
incomes that are a single dollar over the poverty line
figure of $24,230 are significantly worse off than
families of four in Appleton with incomes one dollar
under the poverty line. In this way the poverty rate
Republicans have nearly identical records with respect
to poverty. Generally speaking, the poverty rate is a re-
flection of the health of the overall economy.
Problems with Our Measure of Poverty
There is a host of reasons why using three times the cost
of a minimally sufficient diet as a measure of poverty is
inadequate to the task of measuring who is poor. First, it
does not distinguish among families that are intact with
one income earner and families that either are not intact
or for other reasons have day-care costs. Since nearly
34 percent of families living in poverty are headed by
single women with children under 18, this is potentially a
significant problem. Since the one-third fraction that was
used in the original poverty measure came from a survey
conducted when there were fewer such female-headed
households, the poverty line could be understated by all
or part of the cost of day care. According to a 2013 study
by the Census Bureau day-care costs averaged $179 per
week (about $9,300 per year) for a child under five. For
older children the average cost is $93 per week (nearly
$4,900). Ignoring these costs, even if there are many
children in poverty who are watched by grandparents
(30 percent), significantly understates poverty.
Although this indicates that poverty is understated,
there are problems with the measure that indicate that
poverty may be overstated. Robert Rector of the conser-
vative Heritage Foundation repeatedly updates statistics
that purport to show that poverty is not a problem in the
United States.1 He uses government surveys and pub-
lished statistical documents to show that 42 percent of
households considered poor own their homes, 80 percent
have air conditioning, 75 percent own a car, and 31 per-
cent own two or more cars. He notes that the square
footage of living space of America’s poor is greater than
the square footage of the average western European, and
the diet of the average poor American equals or exceeds
the recommended daily allowances of important nutri-
ents. As a matter of fact, one of the singular features
of the poor in the United States is their rate of obesity,
which implies that few are actually starving.
Specifically on the point of wealth, nearly a million
poor families own homes worth more than $150,000.
There are hundreds of thousands of people in the United
States who have little income but who are worth hundreds
of thousands of dollars. Some are even millionaires. Ad-
mittedly, it is a small number of people like this who are
1 A recent version is available at www.heritage.org/research/reports/2015/09
/poverty-and-the-social-welfare-state-in-the-united-states-and-other-nations.
404 Chapter 38 Poverty and Welfare
values, and looked at the percentage of people in vari-
ous European countries who would fall below this line.
Using this measure, he noted that U.S. poverty rates were
higher than eight of the nine countries examined. When
he focused strictly on income inequality, measured by the
percentage of people living on incomes below 40 percent
of a country’s median disposable income, he found that
the United States had the most unequal income of any of
the countries compared.
Programs for the Poor
In Kind versus In Cash
The programs available to the poor are many and com-
plicated. They are better understood as varying from
state to state rather than being one consistent program
across the country. Further, these programs are best
understood as being divided between cash payments
and provisions of goods and services in forms other
than cash. Economists refer
to the latter types as in-kind subsidies. Table 38.2 describes the different programs, the
functions, and the populations they serve, as well as
the restrictions placed on eligibility to receive them.
underestimates both urban poverty and poverty on the
coasts. It overestimates the incidence of poverty in rural
areas, small cities, in the South, and in the Midwest.
There is a final reason to doubt official poverty
numbers, and that is a missing $2 trillion. In Chapter 6,
when we talked about national income accounting, we
briefly explained the sources of the numbers that make
up the gross domestic product. It turns out that data
used by the Census Bureau add up to substantially less,
$2 trillion less, than the source numbers for personal
income used in GDP calculations. While much of the
missing $2 trillion is the in-kind transfers mentioned
above, this certainly does not account for all of it. It
is clearly true that most of that probably goes to the
nonpoor. Some of it must also be in the hands of the
poor, so there are clearly some who are labeled poor
who are not.
Poverty in the United States versus Europe
As referred to in the opening, most countries have their
own measures of poverty and they are not directly com-
parable. Timothy Smeeding, one of the foremost econo-
mists on the subject of poverty and income inequality, has
attempted to create those comparable measures. He used
the U.S. poverty line, adjusted it for different currency
2,000
7,000
12,000
17,000
22,000
27,000
Year
P o
v e
rt y l in
e ( C
P I a
d ju
s te
d )
Poverty line Adjusted poverty line
1 9 5
9
1 9 6
1
1 9 6
3
19 6 5
19 6 7
1 9 6
9
1 9 7
1
1 9 7 3
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8
1
1 9 8 3
19 8 5
1 9 8 7
1 9 8 9
1 9 9
1
1 9 9
3
19 9 5
1 9 9 7
1 9 9
9
2 0 0 1
20 03
20 05
2 0 13
2 0
1 1
20 09
20 07
FIGURE 38.2 Poverty line with and without CPI adjustment.
in-kind subsidies Provisions of goods and services in forms other than cash.
Programs for the Poor 405
Cash or In-Kind
and Annual
Federal +
State Cost Population
Program Function ($ billions) Served Eligibility Requirements
Temporary Cash income Cash, $32 Poor parents Though this varies from state to
Assistance to to the poor and their state, the following
Needy Families (the children generalizations can be made:
(TANF); welfare under 18 Recipients (1) have to have
formerly check) children; (2) cannot have much
called wealth (usually less than $5,000
AFDC net), including house and car;
(3) can remain on the program for
24 consecutive months only
Women, Food, formula, In-kind, $6.3 Pregnant Low wealth and income; cutoffs
Infants and and diapers women and depend on the state
Children (WIC) new mothers
Food Stamps Vouchers that In-kind, $70 All poor Low wealth and income; cutoffs
(now called SNAP) can be spent depend on the state; recipients
only on food can remain on the program for
only 24 consecutive months
Medicaid In-kind, $496 All poor Low wealth and income; cutoffs
depend on the state
Section 8 or Reduced rent In-kind, $45 All poor Low wealth and income; cutoffs
Housing or low-cost depend on the state
Authority housing
Apartment
Head Start Day care; In-kind, $7.7 Poor with First come, first served for
preschool children anyone below 1.25 poverty line
under 5
School Lunch Lunch and In-kind, $16 Poor with Anyone below 1.30 poverty line
breakfast school-age
children
Supplemental Cash Cash, $58 Disabled Someone (a parent, guardian, or
Security assistance and widow- spouse) must be disabled or
Income (SSI) to “deserving (er)s and must have died
poor” orphans
Poor with
school-age
children
Earned Income Negative tax; Cash, $58 Working Based on family size; phases in
Tax Credit (EITC) boost low- poor at incomes up to $13,849, then
pay workers phases out for incomes between
$18,150 and $47,747; family of
four maximum now, $6,242
TABLE 38.2 Programs for the poor and their characteristics, FY2014.
Sources: Data compiled by the author
406 Chapter 38 Poverty and Welfare
more sense to give the adult access to such services rather
than cash. This minimizes the likelihood that the money
will be diverted by adults away from the targeted children.
Third, some welfare benefits seem designed more to
provide those who tender them with a feeling of magna-
nimity than to benefit the poor. If it is our own happiness
we are maximizing and if our happiness is enhanced by
the knowledge that we provided the poor with enough to
survive, it may be even more important to us that we en-
sure that the poor are consuming what we think is good
for them rather than what they want.
Is $789 Billion Even a Lot Compared to Other Countries?
Though the United States spends $789 billion on its
antipoverty programs, the Smeeding analysis puts this
in perspective by noting that European antipoverty
programs are far more aggressive. He notes that after
accounting for taxes and various welfare programs, the
system in the United States reduces poverty (defined by
him as the percentage of people living below 50 per-
cent of median household disposable income) by only
26 percent, whereas the average European country’s pro-
grams reduce their poverty by more than 60 percent.
Incentives, Disincentives, Myths, and Truths
While no one has ever intended this to be the case, many
of the programs designed to help the poor are blamed for
ensuring that people who live in poverty and who receive
benefits have no incentive to become self-sufficient. The
existence of welfare is accused of giving people a reason
not to work. It is blamed for encouraging young women
both to get pregnant and to carry the pregnancy to term.
Welfare is indicted for encouraging recipients to have more
children so that their WIC will be extended and their food
stamps and TANF payments increased. The structure of
TANF’s predecessor, Aid to Families with Dependent Chil-
dren (AFDC), was blamed for breaking up poor families by
giving them the incentive to have the father leave. Together,
these problems created the concern that welfare was be-
coming a way of life and that people were getting used to it.
From a theoretical perspective, each of the preceding
arguments has merit, but the evidence from economic
studies is not one-sided. First, there are several counter-
claims. Birthrates among teenagers climbed steadily from
the 1960s through the early 1990s and leveled off when
the states and then the federal government instituted
Why Spend $789 Billion on a $96 Billion Problem?
Given the preceding information on the extent of poverty
and the dollar costs of poverty programs, the following
should strike you: If the poverty gap is $96 billion, why
do the various levels of government spend more than
six times that on poverty programs? The answer is two-
fold: (1) There are people above the poverty line in need
whom we choose to help; and (2) poverty programs must
be terribly inefficient if it genuinely takes $789 billion to
cure a $96 billion problem.
Table 38.2 shows that billions more are spent on goods
and services than are spent in cash benefits. Including
some minor programs not mentioned in Table 38.2, cash
benefits total around $148 billion, whereas in-kind ben-
efits total $641 billion. Clearly the government spends
far more money on programs that give it control over
recipients’ behavior. For instance, we think the poor do
not have enough to eat, adequate medical services, ade-
quate housing, and so on. Instead of providing them with
enough money to pay for these things, the government
provides them with what it thinks they need.
If there is a family whose members enjoy good health,
it is conceivable they would rather have more money spent
on food and less on medical care. They cannot make that
substitution. People who live in poverty are denied the
ability to make basic decisions when they are given spe-
cific goods and services rather than money. In many stud-
ies of the poor, it is clear that they value cash more than
the goods they are provided. Some food stamp (SNAP)
recipients show exactly how little they value food stamps
and WIC vouchers by selling them on Craigslist/eBay for
50 cents on the dollar.2 Why haven’t programs been de-
signed so that people in need receive cash and are then en-
couraged to make their own decisions on how to spend it?
There are several reasons, but three are obvious. First,
through their elected officials, voters have made it clear
they do not trust the judgment of the people who receive
government benefits concerning what goods they buy.
Many believe that if the poor could make good decisions,
they would not be poor to begin with.
Second, people are more concerned with the welfare of
needy children than with the welfare of adults. If you look at
the programs with this in mind, you will see that nearly all
of them require the presence of a child for an adult to be eli-
gible. If we want to guarantee services for children, it makes
2Replacing the coupons of the food stamp program with the SNAP cards has
significantly reduced fraud by an estimated 67 percent.
Welfare Reform 407
known location of absent fathers to get benefits. Clearly,
whether the need to apply for welfare leads to the breakup
of families that would have stayed together is debatable.
The reason that some welfare programs are contingent
on a parent’s being absent stems from the conviction that
if there are two able-bodied adults in a household, one
of them should be working. Either the problem of absent
fathers is a coincidence or it is the price society is pay-
ing for building welfare requirements around a view that
families with both parents present should not be eligible
for assistance unless one is disabled.
Fourth, under AFDC, that is, prior to the welfare re-
forms of 1996, welfare dependency had been growing
at an alarming rate. Some 26 percent of recipients had
been receiving benefits from the program for 10 years or
more at the same time that the percentage of families that
had been on welfare for very short periods of time was
falling. In addition, daughters of recipients were tending
to become recipients themselves. These circumstances
and others like them led Congress and the president to
agree to change welfare programs to incorporate limits
on the length of time people could receive benefits and to
require that recipients become gainfully employed.
Welfare Reform
Is There a Solution?
To be successful, a social safety net must meet three
goals:
1. The program that is designed cannot be so expensive
that the taxpaying public will not sustain it.
2. The program must have an incentive built in that
makes beneficiaries want to leave it.
welfare reforms designed to curb benefits. The truth is
that the real dollar value of benefits per recipient is lower
today than it was in the late 1960s. Thus, if poor teenag-
ers were really considering the value of welfare in mak-
ing decisions about having children, teen pregnancy rates
would have fallen from the mid-1970s on as the real value
of the benefits fell. It is more likely that the culture and
teen sex drives had more to do with teen pregnancies than
the prospect of receiving welfare checks.
Second, although it was and still is true that the more
children you have, the more benefits you get, there is no
systematic evidence that people on welfare had more chil-
dren because they were on welfare. If welfare mothers
were concerned only for themselves and the benefits they
could get, it would make sense that they would have chil-
dren so they would be eligible for more benefits. What had
to have been evident to them, however, is that the increase
in benefits does not cover any more than the increased cost
of raising an additional child. Unless we want to claim that
the poor do not care about their children, there is little like-
lihood that rational women would get pregnant and do the
work of raising an additional child in order to keep a few
extra dollars a month. They could make more money with
less effort if they cleaned houses on the side.
Third, it is true that families on welfare are far more
likely to have absent fathers, but it is hard to say whether
the father’s leaving was caused by the need to be wel-
fare-eligible or the family became welfare-eligible be-
cause the father left. In order to accept the argument
that welfare caused a rash of absent fathers, you must
hold the cynical belief that a well-meaning father would
abandon his children so they could receive benefits. Al-
though this might have been the case prior to 1996, today,
after welfare reform, the abandonment would have to be
complete. A mother now has to name and state the last
The world of welfare is replete with urban legends. My favorite goes
something like this: “I was standing in line at the grocery store one
day behind a nicely dressed woman who was buying beer, steak,
shrimp, and a whole bunch of stuff I couldn’t afford. She had them
put the steak and shrimp on her food stamp card and used her cash
to buy the beer. She packed up her groceries and went to her brand
new SUV.” In teaching this subject for years, I have heard this story
in countless renditions from students who were either customers or
grocery employees. The story is almost always the same. While the
story may be about fraud, it is also quite likely about their misinter-
preting the actions of a foster parent.
Most states give foster families Medicaid cards and an allotment
on a food stamp card to pay for the food and medical expenses of
the children in their care. That some of these families are wealthy
enough to afford nice meals and nice vehicles does not diminish our
obligation to pay them for the service they are providing us by caring
for orphaned, discarded, or abused children or those children whose
parents are in prison.
W E L F A R E ’ S B E S T U R B A N L E G E N D
408 Chapter 38 Poverty and Welfare
incentives for relinquishing benefits were too expensive.
Instead of being offered incentives to leave the program,
people are now told how long their benefits will keep com-
ing. States are given block grants of money (TANF) that
they are supposed to use to aid their poor. Instead of having
to give it away in cash benefits, as they did under AFDC,
they can now spend it on job training, child care, or tax
breaks for businesses that are willing to hire welfare recipi-
ents. States must set time limits of 24 months or less and
they must establish work requirements for some programs.
Supplemental Security Income rules for disability have
changed such that some people who were once eligible for
full benefits are now eligible for only partial benefits.
By 1999, welfare caseloads had fallen to their lowest
point in three decades. Though it is difficult to tell how
much of this was due to the robust economy of the 1990s, it
is clear that the reforms that were instituted have had some
effect. Economist Rebecca Blank summarized the growing
research that has been conducted on this issue by noting
that through the reforms of providing assistance to work,
monetary incentives to work, and requirements to work,
the current array of programs is raising incomes and in-
creasing employment in ways previous programs did not.
Is Poverty Necessarily Bad?
There are many economists who object to the implied
premise of this entire chapter: namely, that poverty is a
bad thing. Without a carrot—wealth, and a stick—poverty,
these economists believe that people would have little in-
centive to “work hard and play by the rules.”3 If accepted as
valid, this philosophy would suggest that there is a trade-off
between rates of economic growth and rates of economic
inequality. There is evidence from the 1980s through today
that countries with low rates of economic inequality had
low rates of economic growth, but there is much disagree-
ment about whether the former caused the latter.
3. The program must provide enough of a level of basic
necessities that recipients have a socially acceptable
standard of living.
The problem facing policy analysts in the United States
has always been that these goals cannot be satisfied
simultaneously.
Any program must have a phaseout level of income. If
the phaseout is too quick, meaning that for every dollar you
earn you lose significant welfare benefits, the disincentive
to work will be too profound. The AFDC program reduced
benefits by nearly a dollar for every dollar the recipient
earned. This nearly 100 percent take-back rate meant that
without a salary at least twice the minimum wage in a job,
a single parent with two small children requiring day care
would be far better off on welfare than working.
If the phaseout is too slow, then too many people will
be getting welfare benefits and not enough will be paying
taxes. Though this is possible, it violates the first goal, that
of having a program that does not cost too much money.
On the other hand, the phaseout could be slow and of low
cost to taxpayers. The problem would then be that there
would not be enough money for recipients to survive on.
The implicit choice made by policy makers prior to
the reforms of welfare that were instituted in 1996 was to
give up on providing incentives to leave the program. The
increase in long-term dependency on the program can, at
least in part, be blamed on this decision. The near 100 per-
cent take-back rate on AFDC left people with no earned
income better off than people making $10,000 a year. The
result was that only those recipients who could invest in
an education could ultimately afford to leave the program.
Welfare as We Now Know It
In the 1996 reforms, the problem of welfare dependency
was tackled by simply ordering people to leave welfare.
The institution of time limits was an acknowledgment of
the concern that dependency was wrong and that monetary 3This phrase was often used by President Clinton as a political mantra.
Summary
You now understand how poverty is measured, who
is poor in the United States, and how the percentage
of the population that is poor has changed through
the last 57 years. You are able to describe some of the
significant problems presented by the official poverty
rate. You understand the myriad programs that exist
for the poor, note that most of the programs grant the
recipients goods and services rather than money, and
understand why it is that government does this. Last,
you are aware of the incentives and disincentives in the
welfare state, and you know the welfare reform issues
that we currently face.
Summary 409
Key Terms
in-kind subsidies
poverty gap
poverty line poverty rate
Quiz Yourself
1. Poverty is a _____ concept in that a person with that
income in the United States may be considered in pov-
erty, while a person with that same income in Somalia
may be in the upper quarter of income earners.
a. relative
b. absolute
c. irrelevant
d. fictitious
2. In a simple 300 million–person world of all four-
person families, if the poverty line is $12,500 and
half of the 10 million families (with 40 million poor
people) earn $10,000 and the other half earn $7,500,
then the poverty gap is
a. $125 billion (= 10 million * $12,500).
b. $250 billion (= 20 million * $12,500).
c. $150 billion (= 20 million * $2,500 +
20 million * $5,000).
d. $37.5 billion (= 5 million * $2,500 +
5 million * $5,000).
3. In a simple 300 million–person world of all four-
person families, if the poverty line is $12,500 and
half of the 10 million families (with 40 million poor
people) earn $10,000 and the other half earn $7,500,
then the poverty rate is
a. 3.33% (10 million/300 million).
b. 13.33% (40 million/300 million).
c. 16.66% (50 million/300 million).
d. 96.33% ([300 million − 10 million]/300 million).
4. Using a poverty line of $12,500, under the current
system of calculating the poverty rate, which of the
following people is not considered in poverty and
probably ought to be?
a. A rural family whose sole income is from a
minimum wage ($10,300) position
b. A rural family whose combined income is
$15,000
c. A New York City family whose combined
income is $13,000
d. A retired couple whose multimillion-dollar
estate yields them no income
5. Using a poverty line of $12,500, under the current
system of calculating the poverty rate, which of the
following people is considered in poverty and prob-
ably ought not to be?
a. A rural family whose sole income is from a
minimum wage ($10,300) position
b. A rural family whose combined income is
$15,000
c. A New York City family whose combined
income is $13,000
d. A retired couple whose multimillion dollar
estate yields them no income
6. The distribution of aid to the poor between in-kind
and in-cash is
a. roughly equal.
b. weighted heavily toward in-cash benefits.
c. weighted slightly toward in-kind benefits.
d. weighted heavily toward in-kind benefits.
7. The most obvious pattern in poverty rates is the
degree to which they are higher during
a. Democratic administrations.
b. wars.
c. odd years.
d. recessions.
8. The evidence is that welfare reform in 1996 resulted
in _____ welfare rolls.
a. a substantial increase in
b. a slight increase in
c. a substantial decrease in
d. no impact on
Short Answer Questions
1. Compare the data on who is in poverty to whatever
stereotype you may have had prior to reading this
chapter.
2. What do the data suggest with regard to poverty and
the age profile of those in poverty relative to the age
profile generally?
3. What measure of poverty would give you the low-
est possible estimate of the amount of money you
would need to solve the nation’s poverty problem?
Why would only spending that amount not likely be
a good solution to the problem?
410 Chapter 38 Poverty and Welfare
4. If you were to construct a poverty measure, what
would you put into the calculations to deal with the
issues listed in the chapter?
Think about This
The wealth of one person, Bill Gates, is about equal to the
annual poverty gap in the United States in one year, $96 bil-
lion. The United States has a more significantly unequal
division of income than any other industrialized country.
What are the consequences of that unequal distribution?
Talk about This
What other “urban legends” exist about the poor and
welfare? What research could be conducted to dispel
these legends or prove them to be factual?
For More Insight See
Blank, Rebecca M., “Evaluating Welfare Reform in the
United States,” Journal of Economic Literature XL
(December 2002).
Journal of Economic Perspectives 11, no. 2 (Spring 1997).
See articles by Peter Gottschalk; George Johnson;
Robert Topel; and Nicole Fortin and Thomas
Lemieux, pp. 21–96.
Journal of Economic Perspectives 12, no. 1 (Winter
1998). See articles by Dale Jorgenson; and Robert
Triest, pp. 79–114.
Smeeding, Timothy, “Poor People in Rich Nations:
The United States in Comparative Perspective,”
Journal of Economic Perspectives 20, no. 1 (Winter
2006).
Wolff, Edward, “Recent Trends in the Size Distribution
of Household Wealth,” Journal of Economic Perspec-
tives 12, no. 3 (Summer 1998).
Behind the Numbers
Detailed Poverty Tabulations from the Current Popula-
tion Survey—www.census.gov
Historical Poverty Tables, Current Population Survey—
www.census.gov/hhes/www/poverty
Federal Spending on Programs for the Poor, Detailed
Functional Tables—www.whitehouse.gov/omb/budget
Statistics of those in poverty.
The Heritage Foundation; paper by Robert Rector—
http://www.heritage.org/pover ty-and-inequality
/report/how-poor-are-americas-poor-examining-the
-plague-poverty-america
C H A P T E R T H I R T Y - N I N E
411
Head Start Learning Objectives
After reading this chapter you should be able to:
LO1 Understand that Head Start is a program that provides early
childhood education to nearly a million children.
LO2 See that the premise of the program is similar to any
investment premise that money spent now will yield results
in the future.
LO3 Analyze Head Start using present value concepts.
LO4 Understand that evidence that the program works is rather
scant, concentrates on the time the child is in the program,
and cannot be used to affirm that Head Start’s effects last
into adulthood.
LO5 Understand that there is an opportunity cost to the
$8 billion program.
Chapter Outline
Head Start as an Investment
The Head Start Program
The Current Evidence
The Opportunity Cost of Fully Funding Head Start
Summary
Established in 1965, the Head Start program serves
944,581 children under the age of five at an annual cost
of more than $8.2 billion. It began on the seemingly
sound premise that early intervention in the lives of chil-
dren can pay dividends later in the form of improved
educational outcomes, reduced crime rates, and other so-
cially desirable outcomes. Thus Head Start has enjoyed
broad political support, despite a vigorous debate over
whether it has engendered a long-run positive influence.
We explore the premise that undergirds the notion that
early intervention in the lives of children is worth the
investment. We offer a cautionary note concerning the
effectiveness of a short-term investment in early child-
hood education. We fully describe the program and show
the increase in enrollment and funding that Head Start
has enjoyed. Additionally, we describe its mission, its
faculty, and its client children. We examine the evidence
of the success of Head Start as well as the evidence of
its shortcomings, and we offer a final thought on the op-
portunity cost of fully funding it.
Head Start as an Investment
The Early Intervention Premise
When social scientists looked at the problem of pov-
erty in the 1960s, many hoped that with enough money,
poverty could be significantly reduced and perhaps per-
manently eliminated. Early evidence gave them great
hope. The poverty rate fell from more than 20 percent in
1960 to less than 11 percent a decade later, but it never
fell below that. Though nearly $800 billion has been
spent each year on poverty programs, the official pov-
erty rate has continued to hover between 11 percent and
15 percent ever since.
More 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 nonpoor, for example, to drop out of
school, father children or become pregnant as teens, use
illegal drugs, or get arrested. At the inception of Head
412 Chapter 39 Head Start
External Benefits
When people other than the consumer or producer of a
good get a benefit from a good, economists refer to this
as a positive externality. The argument here is that when parents choose the child care for
their child, people other than
themselves, their child, or their
day-care worker are affected.
By choosing a high-quality op-
tion, other parts of society stand to benefit because the
presumption is that the child is more likely to be a pro-
ductive citizen in the future. Whenever there are such
external benefits, economists will generally concede that
some form of subsidy is warranted.
The Early Evidence
The efficacy of the premise underlying the desirability of
early intervention was fortified by studies from the 1960s
through the 1980s that showed how effective early child-
hood education could be. The most prominent of these
studies followed several hundred young, poor children,
half of whom were given an excellent preschool expe-
rience free for two years, and half of whom were given
nothing. The half that got the schooling not only per-
formed better on IQ tests when they entered school, but
also performed better in school, were less likely to commit
crimes as teens, and graduated at far higher rates than the
group that did not get that early education. By nearly every
measure the children given the “head start” stayed ahead.
Advocates of Head Start maintained that for every
dollar spent on early childhood education, five dollars
would be returned in increased tax revenues and reduced
welfare spending. While 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 that early evidence, Head Start began
with great hope that in a generation or two, early child-
hood education would make significant inroads into pov-
erty in the United States.
The Remaining Doubts
Even in the early years, some people questioned the
premise that the investment in early childhood education
could have the kind of return that was projected. 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 Head Start programs are offered for half days during
the school year, even children in the all-day, all-year form
Start 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 skills, 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. By in-
terrupting a cycle of poverty, we save future taxpayers
money. This can be analyzed using the Chapter 7 concept
of present value. What is also implied about this premise
is that people other than the child and the parent benefit
when a child gets high-quality care. We examine this as-
pect as well.
Present Value Analysis
Those who founded Head Start hoped that money in-
vested early in the education of young children would
pay for itself in the long run: Students who were not
judged among the likely to succeed would graduate
from school, live with good standards of hygiene, earn
respectable incomes, and pay taxes. Ideally, using the
economic concept of present value, we would be able to
prove that, like any good investment, such early child-
hood education would pay for itself. As you know, pres-
ent value is arrived at by discounting future payments
by projecting interest rates in a way that puts future and
present dollar figures on an even basis. Because 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 dol-
lars spent on early education is less than the present
value of the stream of benefits, then any such early edu-
cation program is a good investment.
Suppose it could be shown that having a child in
Head Start reduced a child’s likelihood of dropping out
of school, of getting pregnant, and of committing crimes
for which jail time was required. Suppose it could also be
shown that Head Start increased the likelihood that the
child would grow up to be a fully functional taxpayer.1
If all that were true it still would not necessarily justify
the investment. From a strictly economic perspective, the
present value of the increased costs associated with Head
Start would have to be exceeded by the present value of
the benefits as measured by the increased taxes and re-
duced welfare and imprisonment costs.
1Later in this chapter you will see that there is an open debate over whether
Head Start has had any of these effects.
positive externality The benefits that go to someone other than the consumer or producer of a good.
The Head Start Program 413
of Head Start spend only 4,600 hours in the enriching en-
vironment. The rest of their childhood, 153,000 hours, is
spent in poverty-stricken homes, crime-ridden neighbor-
hoods, and educationally deficient schools. Regardless of
how good the 4,600 hours is, it is hard to imagine that its
influences would be strong enough to enable children to
prevail over all the other influences in their lives.
Critics also point to flaws in the original study that
showed the great potential for early intervention. Children
in the original study were placed in a classroom that was
nearly ideal, and their teachers were better equipped, phys-
ically and educationally, than any national program could
ever hope to be. Critics doubted whether the program
could be duplicated and used for the rest of the country.
The Head Start Program
Ever since its beginning in 1965, Head Start has enjoyed
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. In reality there have been long waiting lists in
some cities for Head Start services.
Head Start is much more than day care, and it is not
merely a preschool. Under reforms enacted in the early
1990s, 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 mak-
ing sure parents know of the available social resources
for economically troubled families. The teachers make
sure that immunization and health records are up to date,
and they advise parents on a host of other matters related
to child rearing as well.
The evidence is that Head Start centers are performing
these tasks very well. Professional accreditation agencies
have found that centers are well within the standards for
early childhood education, certifying the vast majority of
centers as “good” or better.
By 2015 there were 944,581 children enrolled in Head
Start, at an average cost per child of nearly $8,681. As
can be seen from Figure 39.1, inflation-adjusted spending
and enrollment stayed relatively flat from 1965 to 1990.
Though enrollment began at nearly 750,000 and fell
through the 1970s to a low of 333,000, it rebounded
through the early 1980s to a half million, where it stayed
until 1990. Similarly, inflation-adjusted spending on the
program stayed between 750 million and 1 billion 1982
dollars from its inception through 1990.
Beginning in 1990 President Bush (George Herbert
Walker) and Congress attempted to change Head Start.
They sought either to fund it fully or to open slots for
many more students. By 1997 enrollment reached
800,000, with the stated goal for 2000 being 1 million
0
100,000
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300,000
400,000
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1 9 6
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Enrollment Real appropriations
FIGURE 39.1 Head Start spending and enrollment.
414 Chapter 39 Head Start
children. While it fell short of that goal, enrollment has
continued to rise. In that same year new standards came
into place that required teachers to attain a higher de-
gree of certification. This in turn was the impetus for in-
creases in teachers’ salaries. These reforms increased the
cost of the program substantially. Though enrollments
increased a substantial 67 percent, spending increases
were even more substantial. Inflation-adjusted spending
increased by more than 204 percent from 1990 to 2001.
It has since stabilized.
The children who are enrolled in Head Start do not
mirror those who are in the general population, and they
do not mirror the population living below the poverty
level. While just about three-quarters of the general pop-
ulation and just under half the people living in poverty
are white, non-Hispanic, 40 percent of the children in
Head Start are white. While only 13 percent of the over-
all population and 23 percent of the poverty population
are black, non-Hispanic, 29 percent of the Head Start
population is black. Similarly, Hispanics are overrepre-
sented, in that they comprise only 18 percent of the gen-
eral population and 28 percent of the poverty population
but constitute 38 percent of the Head Start population.
Groups that are significantly overrepresented in Head
Start are the physically and mentally disadvantaged.
Though fewer than 5 percent of children are disadvan-
taged in this way, children with such disparities represent
13 percent of the children in Head Start.
The families of Head Start children are overwhelm-
ingly poor and their levels of educational attainment are
low. According to data available in 2003, on average they
have more than one child, and they tend to receive some
government assistance besides Head Start. Forty-four per-
cent of Head Start families have yearly incomes that are
lower than $9,000, and 60 percent have incomes below
$12,000. Some 35 percent are headed by women who
never married, and another fifth are headed by women
who are separated, divorced, or widowed. Only 1 percent
of Head Start families are headed by single men. Only
22 percent of the families whose children are in Head
Start have only one child; a fifth have four or more. Only
16 percent of the families exist without any other form of
government assistance than Head Start itself. Two-thirds
are eligible to either receive Medicaid or participate in the
Children’s Health Insurance Program, half receive Food
Stamps (SNAP) or are eligible for the Women, Infants,
and Children (WIC) program, and a quarter get a welfare
check from the Temporary Aid to Needy Families pro-
gram. Taken together, Head Start children are clearly in
need of some sort of help.
In a third of the Head Start families no one in the
household has a job. In these cases Head Start serves
an augmented preschool function only. In one-fifth of
households both parents are present and both have jobs.
In these cases Head Start also provides a significant and
free day-care service. In the remaining half, one parent,
perhaps the child’s only custodial parent, works. Again,
whether the parents view the day-care function as more
important than the preschool function, the child never-
theless gets good care and an education simultaneously.
Moreover, parents are assisted in being better parents.
One of the more disturbing facts of life in the poor
communities that are home to most Head Start children
is that crime rates are much higher than they are in com-
munities that are more affluent. Nearly a third of Head
Start families are within eyesight or earshot of at least
one violent crime every year. A quarter know a recent
violent crime victim, and 6 percent have been victim-
ized themselves by a violent crime that has usually taken
place near home.
The 250,000 paid staff members of the program
closely mirror the racial makeup of the children in
the program. The median teacher is almost certainly
a woman in her forties, she has more than 10 years of
teaching experience, and she has been with Head Start
for more than five years. Two-thirds have at least a bach-
elor’s degree in early childhood education. Typically
the staff are better paid and have a better benefits pack-
age than a typical day-care worker, though the pay and
benefits are somewhat lower than those of kindergarten
teachers with a similar level of education.
The Current Evidence
Evidence that Head Start Works
The evidence that Head Start works comes mostly from
myriad studies that test Head Start children at or near
their exit from the program. Head Start children do
dramatically better on IQ tests than equally situated2
non–Head Start children on entrance into kindergarten.
2Not all studies of Head Start compare children’s abilities adequately. For in-
stance, if you put a child of educated, financially well-off parents in a dilapidated
building with a lousy teacher, you will probably get better results than you will
if you put a poor child of a single, uneducated teenage mother in a new build-
ing with a great teacher. The home environment is remarkably important. This
means that unless you control statistically for home environment variables, you
get study results that are not indicative of the effectiveness of the program.
Good studies of Head Start must compare “equally situated” children.
The Current Evidence 415
Virtually all of the studies that examine the program have
found some significant advantage for these children in
the year or so after they exit 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. In addition, Head Start
children are healthier than equally situated non–Head
Start children, in large measure because part of Head
Start is parental education and because children in Head
Start are fed nutritious meals while they are in the pro-
gram. In the teacher–parent contacts, immunization
records are reviewed and, when necessary, doctor and
dentist referrals are made. Parents of Head Start children
are more aware of the many services available to them
and their children, an awareness which explains, in part,
why 59 percent of them are enrolled in Medicaid.
Individual studies continue to show success of pro-
grams in particular states, in specific areas of short- and
medium-term areas of achievement, or using particular
Head Start curricula. Recently, a study produced by
Oden, Schweinhart, and Weikart showed that children
who participated in a Head Start program in the 1970s in
Colorado and Florida were, 17 years later, less likely to
drop out of high school and less likely to commit crime.
Several others have shown that there is a demonstrable
decrease in repetition of kindergarten and first grade and
early placement in special education. Both of these are
costly to school districts.
Evidence that Head Start Does Not Work
Head Start’s detractors have evidence to support their
position as well. While there are limited studies that
show success for Head Start education that extends be-
yond the second grade, there are companion studies that
show that it does not. As the General Accounting Office
(GAO), the investigative wing of Congress, reported
in 1997, there are no national studies that show, in a
compelling way, that anything long lasting is achieved
in Head Start. A study by Janet Currie and Duncan
Thomas put it quite well: “In summary, despite literally
hundreds of studies, the jury is still out on the question
of whether participation in Head Start has any lasting
beneficial effects.”
Although some studies do show that using some mea-
sures of success, some types of students do better, the
patterns in the literature on Head Start are not consistent.
Some show lasting effects for black children and others
do not. Some show lasting effects for white children and
others do not.
The basic premise of Head Start is that it is liter-
ally 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 suggests that
test scores, dropout rates, graduation rates, or any other
measure of educational achievement in later years is
enhanced when students have Head Start in their back-
ground. Most of the studies that show a waning influence
find that most of the benefit of Head Start is gone by the
third grade and that none is evident by the sixth grade.
Note, however, that the GAO report and the Currie
and Thomas study found that none of the more than 200
academic studies on Head Start used a national represen-
tative sample. Therefore, there are none upon which to
make positive or negative claims.
More Evidence Is Coming and Some Is In
In its 1994 and 1998 reauthorizations of the law that cre-
ated Head Start, Congress commissioned a national study
on the long-term benefits of the program. By 1999 a highly
regarded committee of scholars settled on a methodol-
ogy and a set of goals for collecting the relevant data.
That process is ongoing and a final report went to Con-
gress in 2009. The intermediate reports on Head Start’s
impact do not clearly foretell an answer to the underlying
question of whether the program is achieving its aim. The
positive results are typically for narrowly defined groups
on narrowly defined measures. In the meantime, Janet
Currie, one of the authors of the study pointing to the
dearth of long-term evidence supporting Head Start’s
effectiveness, produced an additional study that shows
that even if there are no long-term benefits to Head Start,
the program may be worthy for its short- and medium-
term benefits. Specifically, even many program detrac-
tors concede the statistical evidence is sufficient to
demonstrate that participants are less likely to have to
repeat kindergarten or first grade and are less likely to
be placed in special education during that time. If you
further concede her point that half of the program’s costs
would be spent anyway on subsidizing day care, then,
Currie maintains, the cost reductions from diminish-
ing grade repetition and the use of special education are
nearly sufficient to cover the other half.
In a newer study she, and other economists, found that
for whites, participation as a child increased their likeli-
hood of graduating from high school and attending college,
as well as increasing their income as young adults. For
African Americans, participation as a child decreased their
416 Chapter 39 Head Start
likelihood of being charged with a crime. Interestingly, the
spillover benefits also extend to the child’s nonparticipat-
ing siblings who also are less likely to be charged with a
crime as young adults.
The Opportunity Cost of Fully Funding Head Start
If tax money had no opportunity cost, Head Start would
not be controversial. In the tradition of the medical pro-
fession’s Hippocratic oath, Head Start clearly does no
harm. Whether it does any good and, if so, whether that
good is enough to justify the costs are other questions.
Head Start costs $8,681 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
Head Start is only four days a week during the school
year. According to the Pew Research Center, day-care
costs per four-year-old child range between $5,000 per
year in the rural south to more than $12,000 per year in
New York.
If the federal government wants to provide free day
care for poor children, it can do it for less money than it
spends on Head Start. If Head Start genuinely provides a
measurable head start, it should show up in the congres-
sionally commissioned study.
Make no mistake about it, the opportunity cost
would exist whether or not Head Start was effective.
The worst billion-dollar-a-year government program
and the best billion-dollar-a-year program have the
same opportunity cost: a billion dollars of other pro-
grams or tax cuts.
What differentiates an effective program from an in-
effective one is that when we fund a program that does
not perform, we do not consider alternatives designed to
meet the same goal that might perform better. The con-
ventional wisdom among politicians is that Head Start
is living up to its billing. They think that it is a good
net present value investment. This 2006 study may prove
that case, but until then this thinking prevents anyone
from coming up with more effective long-term ways of
utilizing the funds. The lost opportunity to experiment
with a better alternative program cannot be ignored.
Summary
You now understand that Head Start is a federally funded
program that provides early childhood education to
nearly a million children at a cost of $8 billion per year.
You are able to use investment and net present value
thinking to understand the premise of the program. You
know that despite the efforts of economists and others
to verify the worth of the program, the evidence that the
program works is rather scant and is the subject of ongo-
ing research. You can see that, as with any other expendi-
ture, there is an opportunity cost to the program.
Key Term
positive externality
Quiz Yourself
1. From an economic perspective the tool one would
use to analyze the costs and benefits of Head Start
would be
a. present value.
b. supply and demand.
c. production possibilities.
d. marginal net benefit.
2. If Head Start were a good long-run investment from
a strictly economic perspective, for current children
enrolled in the program it would
a. make them happier.
b. help their parents with subsidized day care/
preschool.
c. increase the likelihood of future success as
adults.
d. increase the likelihood that they knew the alpha-
bet going into kindergarten.
Summary 417
3. Though the high-quality preschool experience is
a private benefit for the children and their par-
ents, the economic justification for Head Start is
based on
a. external costs.
b. its low total cost.
c. the increase in reading ability of participants
going into kindergarten.
d. the external benefits to society.
4. The early evidence on programs like Head Start made
it clear that
a. the rate of return to these programs was very low.
b. the net present value of the external benefits was
positive.
c. the short-run benefits were not worth the costs.
d. the long-run benefits were not worth the costs.
5. The typical Head Start teacher is
a. an ill-trained minimum-wage worker.
b. a professional credentialed worker making more
than the typical day-care worker.
c. a college graduate making $30,000 a year or more.
d. a professional with a master’s degree or higher.
6. Current evidence suggests that the long-term benefits
of Head Start are
a. sufficiently positive to make the net present value
positive.
b. sufficiently positive such that when added to the
short- and intermediate-term benefits, the net
present value is positive.
c. nonexistent.
d. curiously negative.
7. The intermediate-term external benefits of Head Start
a. focus on reducing the likelihood of the children
ending up in prison.
b. focus on reducing the likelihood that the children
will become pregnant as teenagers.
c. are significant if you know that the children would
qualify for subsidized free day care anyway.
d. are significant in that they reduce the likelihood
of the children needing expensive special educa-
tion in elementary school.
Think about This
The notion of calculating the present value of external
benefits and comparing that to the present value of extra
costs in evaluating Head Start is a purely economic way
of looking at the program. Is this the only way? Is it the
right way? Whether or not society benefits from their
participation, does society owe these underprivileged
children such a program?
Talk about This
Suppose the evidence was that Head Start was com-
pletely ineffective from a present value perspective.
What would you do with the money that is spent on the
program? What programs are we forgoing?
For More Insight See
Congressional Budget Office, Research Provides Little
Information on Impact of Current Program, April
1997.
Currie, Janet, Early Childhood Intervention Programs:
What Do We Know? April 2000, http://www.brook.edu
/dybdocroot/es/research/projects/cr/doc/curie20000
401.pdf.
Currie, Janet, and Duncan Thomas, “Does Head Start
Make a Difference?” American Economic Review 85,
no. 3 (June 1995), pp. 341–364.
Garces, Eliana, Duncan Thomas, and Janet Currie, “Longer-
Term Effects of Head Start,” American Economic Re-
view 92, no. 4 (Sept. 2002).
National Head Start Impact Research, U.S. Department of
Health and Human Services. Head Start Impact Study,
http://www.acf.hhs.gov/programs/opre/hs/impact
_study/ index.html.
Oden, Sherri, Lawrence Schweinhart, and David
Weikart, Into Adulthood (Ypsilanti, MI: High/Scope
Press, 2000).
Behind the Numbers
Head Start enrollment and families, 2015.
Administration for Children and Families; Head
Start Bureau—https://eclkc.ohs.acf.hhs.gov/hslc
/data/factsheets/docs/head-start-fact-sheet-fy
-2015.pdf
Head Start Program Information, 2005.
Administration for Children and Families; Head
Start Bureau FACES 2000 Survey—http://eclkc
.ohs.acf.hhs.gov/hslc/data/rc/ohs-2013-biennial
-report-to-congress.pdf
C H A P T E R F O R T Y
418
Social Security Learning Objectives
After reading this chapter you should be able to:
LO1 Describe what Social Security is and its basic tax and
benefit structure.
LO2 Detail the history of changes to the program since its
inception.
LO3 Explain the economic rationale for having such a system.
LO4 Enumerate the effects of the program on work and savings.
LO5 Show how economists use present value analysis to aid in
determining for whom the program works and for whom it
does not.
LO6 Explain the origin and purpose behind the Social Security
Trust Fund.
LO7 Summarize present estimates of the future financial health
of the Social Security system and evaluate the options for
ensuring its long-run solvency.
Chapter Outline
The Basics
Why Do We Need Social Security?
Social Security’s Effect on the Economy
Whom Is the Program Good For?
Will the System Be There for Me?
Summary
When most people think about Social Security, they en-
vision retirement checks for the elderly. Social Security
has a much broader scope, including benefits for eligible
widows and orphans in addition to medical and disability
insurance. In this chapter we concentrate on retirement
benefits.
We begin by reviewing the history of Social Security
as a government pension program, and we include its
tax, benefit, and structure. We then turn to why it is
needed. We discuss the effects of Social Security on
the economy in general and show that as a retirement
program, it is better for retirees who are poor than for
those who are rich and much better for those who re-
tired before 1960 than after 1980. Last, we discuss why
bankruptcy is likely without reform and what reform
might look like.
The Basics
The Beginning
In 1935 the Social Security Act was passed and signed
into law by President Franklin Roosevelt. The stock mar-
ket crash of 1929 and the Great Depression of the 1930s
had caused great upheavals in people’s financial circum-
stances. Unemployment had reached a high of 25 per-
cent. People who had been wealthy investors before the
crash were lucky if they had a job that would allow them
to at least live from paycheck to paycheck after the crash.
Many banks closed when, as a result of the stock mar-
ket crash, their investments were insufficient to pay their
depositors. In this circumstance, even people who had
saved diligently and invested prudently for their retire-
ment found themselves without savings. Social Security
The Basics 419
Benefits
On the benefit side, eligible retirees get benefit checks
that are based on what they made during their working
years. The average index of monthly earnings (AIME) is the monthly average of the 35
highest earnings years (capped
by the maximum taxable earn-
ings for each respective year)
adjusted for wage inflation. The
AIME is put into a formula that
generates the primary insurance amount (PIA).1 Single people are paid the PIA and married
couples get 1.5 times the highest
of their PIAs, or the sum of their
individual PIAs, whichever is
higher. For full benefits workers
cannot begin to collect until they
reach the retirement age, though they can collect partial benefits
at age 62.
Although the payroll tax structure is such that everyone
with income under the maximum taxable earnings pays the
same rate of tax, the benefit structure is such that, in net,
Social Security redistributes income to the lower end of the
income scale. To see this, consider the following example.
Assume, inflation-adjusted, a person makes $5,000 per
month for 35 years, so that person’s AIME is $5,000. In-
flation-adjusted, the employee and the employer each pay
$382.50 (7.65% × $5,000) per month in taxes. That person
would get a monthly Social Security check of $2,147. If
someone else were in a similar situation with one-fifth the
income, that person and his or her employer would com-
bine to pay one-fifth the tax, but the benefit would be $816
per month. Thus, this employee pays one-fifth the tax but
receives one-third the benefit. This means that the person
at the lower end of the income scale has a benefit dollar–
to–tax dollar ratio that is twice that of the upper-income
person. This is by design, and, as such, the program serves
to redistribute money down the income line.
Changes over Time
Since its inception Social Security has added bene-
fits. Payments to widows and orphans, called survivor
guaranteed a safety net, come good times or bad, to gen-
erations who retired from the late 1930s on. At the time,
it was not intended that Social Security be the only in-
come on which a person lived. In 2014, 35 percent of
recipients received more than 90 percent of their income
from Social Security.
Today, Social Security provides guaranteed retire-
ment benefits averaging about $1,341.77 a month to
40 million American people over the age of 62. Social Se-
curity is a pay-as-you-go pension system where current workers’
taxes are used to pay pensions to
current retirees. This is unlike a
traditional fully funded pension system where, for every ben-
efit dollar it is required to pay in
the future, there is an offsetting
amount currently invested that is
sufficient to pay off that dollar. It
is the pay-as-you-go aspect that
allowed money to go to the el-
derly right away (the first checks
went out in 1936), but, as we will see, it is also this aspect
that currently puts Social Security in the most jeopardy.
Taxes
Social Security taxes (technically called FICA, or Federal
Insurance Contribution Act taxes) are payroll taxes. That is, the amount workers pay is based on what workers earn
from their work. This is different
from an income tax in that inter-
est, dividends, and other forms
of unearned income are not sub-
ject to this tax. In addition, not
all payroll is taxed; taxes are
paid only up to a limited amount
of income called the maximum taxable earnings. In 2016, this amount was $118,500, which
means that workers did not have to pay the old-age por-
tion of the Social Security tax for income they earned
beyond that point. Both the employer and employee pay
an equal amount of this tax so that if you have to pay
$1,000 in tax, so does your employer. The self-employed
pay both parts of the tax.
As part of a temporary stimulus agreement after the
2010 elections, the employee portion was reduced to
4.2 percent from 6.2 percent for the 2011 and 2012
tax years.
pay-as-you-go pension A system where cur- rent workers’ taxes are used to pay pensions to current retirees.
fully funded pension A system that has an amount currently invested that is sufficient to pay every benefit dollar it is required to pay in the future.
payroll taxes Taxes owed on what workers earn from their work.
maximum taxable
earnings The maximum of tax- able earnings subject to the payroll tax.
average index of
monthly earnings
(AIME) The monthly average of the 35 highest earnings years adjusted for wage inflation.
primary insurance
amount (PIA) The amount single retirees receive in a monthly check if they retire at their retirement age.
retirement age The age at which retirees get full benefits.
1 The formula for 2016 was 90 percent of the first $856 plus 32 percent of the next
$4,301 plus 15 percent of the remainder up to a maximum benefit that is computed
using the maximum taxable earnings for each of the work years. This formula is
adjusted yearly for inflation. For more information, see www.socialsecurity.gov.
420 Chapter 40 Social Security
benefits, have been part of Social Security from its in-
ception. Disability insurance, for workers who are un-
able to work for long periods of time, was added in 1956,
and basic, highly subsidized health coverage (called
Medicare) was added in 1966.
Table 40.1 shows how the tax rate, the maximum
taxable earnings, and the retirement age have changed
since the program began. This table shows how Social
Security’s components have been changed to ensure its
survivability. As you can see, tax rates have risen, in
part to pay for the other benefits described previously
but also to guarantee that retirement benefits would be
there for each generation. The tax rate has risen from
1 percent to 7.65 percent while the maximum amount
subject to tax has risen from $3,000 to $118,500. The
retirement age has also risen. People born before 1938
can retire with full benefits at 65; those born after 1960
must wait until they are 67. A somewhat complicated
transition formula determines the retirement age of
those born between 1939 and 1959. In short, in con-
trast to the view that Social Security has been a mono-
lithic and unalterable program, there have been many
changes that have both broadened its scope and ensured
its survivability.
Why Do We Need Social Security?
If you have worked through other issues chapters in this
book by now, you know that it has been mentioned before
that economists believe that government intervention in
private enterprise must be justified on at least one of the
following three grounds:
1. The need to control externalities that is, efects cre- ated by an unregulated market on people other than the
buyer or seller, such as pollution, secondhand smoke,
and drunk driving.
2. Concern about signiicant moral or ethical problems as-
sociated with the good being sold, for example, drugs,
prostitution, and pornography.
3. Sellers or buyers are incapable of making rational deci-
sions, because people either cannot be counted on to do
the smart thing or have inadequate information upon
which to base a decision.
It is a combination of the first
and third reasons that makes
some form of compulsory-saving/
retirement- benefit program nec-
essary in the eyes of economists.
TABLE 40.1 History of Social Security’s components at selected points in time.
Year
Maximum
Taxable
Earnings
($)
Old-Age
and
Disability
Tax Rate
(% of
payroll)
Medicare
Tax Rate
(%)
Total Tax
Rate That
Both
Employers
and
Employees
Pay (%)
Retirement Age*
Year
of
Birth Age Benefits†
1937 $ 3,000 1.000% 0% 1.000% 1937 65 OA, S
1950 3,600 1.500 0 1.500 1950 66 OA, S
1955 4,200 2.000 0 2.000 1955 66 + 2
months
OA, S
1960 4,800 2.250 0 2.250 1960 67 OA, S, DI
1965 4,800 3.625 0 3.625 1965 67 OA, S, DI
1970 7,800 4.200 0.600 4.800 1970 67 OA, S, DI, HI
1975 14,100 4.950 0.900 5.850 1975 67 OA, S, DI, HI
1980 25,900 5.080 1.050 6.130 1980 67 OA, S, DI, HI
1985 39,600 5.700 1.300 7.000 1985 67 OA, S, DI, HI
1990 51,300 6.200 1.450 7.650 1990 67 OA, S, DI, HI
1995 61,200 6.200 1.450 7.650 1995 67 OA, S, DI, HI
2000 76,200 6.200 1.450 7.650 2000 67 OA, S, DI, HI
2016 118,500 6.200 1.450 7.650 2016 67 OA, S, D, HI
*Until 1983 the retirement age was 65. In 1983 the law was changed to increase it depending on year of birth. 1938, => 65 + 2 months; 1939, => 65 + 4 months; 1940, => 65 +
6 months; 1941, => 65 + 8 months; 1942, => 65 + 10 months; 1943−1954, => 66; 1955, => 66 + 2 months; 1956, => 66 + 4 months; 1957, => 66 + 6 months; 1958,
=> 66 + 8 months; 1959, => 66 + 10 months; 1960 on, 67.
†OA = old age; S = survivor; DI = disability; HI = health insurance (Medicare)
externalities Effects created by an unregulated market on people other than the buyer or seller.
Social Security’s Effect on the Economy 421
Social Security’s Effect on the Economy
Effect on Work
Before Social Security was implemented, 51 percent of
men over age 65 worked. Today, that number is 24 per-
cent. While there is much dispute on the degree to which
Social Security itself caused this to happen (in fact, this
number has risen in recent years), Social Security has
clearly made it easier for people to retire. This has good
as well as bad aspects. Though the retired may be happier
being retired, the economy is deprived of their labor and
the fruit of their labor. On the other hand, as more people
retire, positions are opened up throughout the labor scale
as everyone moves up to fill vacated positions. Paradoxi-
cally, this is a circumstance in which the economy is hurt
even though everyone in it is happier. (If this seems odd,
revisit Chapter 6 and the section “Real Gross Domes-
tic Product and Why It Is Not Synonymous with Social
Welfare.”)
Effect on Saving
Most economists believe that if people had to save
for their own retirement, they would save more than
they do now. Though these economists disagree on
the magnitude of this effect, they have concluded that
the existence of Social Security reduces the amount
of money that is saved in the
economy. This is primarily due
to the asset substitution effect. If the government is taxing
you on your earnings now and
promising a pension payment
later, the government is, in ef-
fect, saving for you. If the gov-
ernment is saving for you, you
will save less for yourself.
Two counteracting effects to
this are the induced retirement effect and the bequest effect.
As mentioned, people are clearly retiring earlier than
they did in the past. If Social Security did not exist,
and people had no hope of ever retiring, they might not
save anything. On the other hand, since Social Security
makes retirement a possibility, people may save so as to
retire. The induced retirement effect thus increases na-
tional savings because people need to save more if they
are going to retire earlier than they would have without
Social Security.
Another impact of Social Security is that it may in-
crease national savings if the elderly are putting aside
Ideally, rational and wise people will be able to
save money for their own retirements based on their
own preferences for consuming now versus consum-
ing later. They will realize that money spent now has
an opportunity cost, namely, money that cannot be
spent later. Investment markets allow people to save
or borrow as they please. If all the assumptions about
well-functioning markets are valid in the investment
market, then there is no reason for government to
force people to save. They will save the right amount
for themselves.
In opposition to the rationale put forth by economists
is the contention that people may not be able to save the
right amount for themselves. This is an argument that
has little appeal among economists. Many economists
maintain that if the government were not taxing workers
for this purpose, workers could be saving the money on
their own, and saving or not saving would therefore be
their choice.
On the other hand, two arguments against a com-
pletely free market approach have some appeal among
economists. First, our humanity prevents us from let-
ting others starve. If people do not save for themselves,
someone else will be forced to bail them out. Their
decision not to save affects others. These “others”
could be children, relatives, friends, or government.
Social Security prevents people from not saving the
right amount, and it protects others from having to
bail them out.
Second, our rationality stems from our ability to
learn from our mistakes. In most situations, and espe-
cially in most markets, we learn from our mistakes. For
instance, if the first time you go grocery shopping for
yourself you buy nothing but marshmallows and Red
Bull, you will quickly learn that you need vegetables
and fruits in your diet. If you do not save enough for
retirement, you cannot just decide to live the first 65
years of your life over again. Government often pre-
vents us from this sort of mistake. There are few guar-
antees that we will always do the right thing ourselves.
There are other examples of this: (1) You cannot bor-
row money before age 18 with out a cosignature; (2) you
cannot drop out of school be fore you are 16; and (3)
you cannot drink until you are 21. Society fears that you
might suffer irreparable bankruptcy, poverty, or alco-
holism, respectively; and it wants government to ensure
that you will not make mistakes that cannot be undone.
For these reasons, the question among economists is
not whether some form of government-run retirement
is needed but what form that system takes and how to
fund it so that it is financially stable.
asset substitution
effect Government is saving for you; thus you will save less for yourself.
induced retirement
effect People need to save more if they are going to retire earlier than they would have without So- cial Security.
422 Chapter 40 Social Security
people born in different generations. Though exact esti-
mates vary by marital status, by earners, and by age, the
results show unequivocally that the program was a net win-
ner across the income scale for those retiring before 1980.
However, because of the rapid increases in FICA taxes, this
situation has steadily eroded, leaving only married couples,
with only a single low-income earner, to benefit.
To get a flavor of what this kind of analysis entails,
consider the following example. First, we need to make
some basic assumptions. To estimate the present value of
your Social Security taxes and benefits, we need to know
your age, your marital status, the starting salary you can
expect upon graduation, the rate at which your income will
grow, an assumption of yearly inflation, your age at retire-
ment, and, finally, your age at death. For Table 40.2 we
will assume the following: You are 19; you will graduate at
age 23; you will not get married; you will work until you
are 67; you will die at 88; inflation will be 3 percent every
year; your income will grow at 4 percent per year; and
8 percent is the appropriate interest rate. Though the old
age and disability tax rate is 6.2 percent, the old age part is
only 5.3 percent. This tax is on both the employer and em-
ployee, so we will assume that your old age Social Security
contributions amount to 10.6 percent of your earnings (up
to, of course, the maximum taxable earnings).2
Table 40.2 indicates that today’s 19-year-olds would
do better if their Social Security taxes were invested at
8 percent per year (inflation plus a 5 percent real rate of
return) than they would do under Social Security. The
first column shows the income assumed for the calcula-
tions, and the second indicates the present value, at 8 per-
cent, of all taxes to be paid. The third column shows the
present value, again at 8 percent, of all the benefits that
people will be entitled to from their retirements at age
more money for bequests, that is, money that will go to
younger family members when their elders die. It may
be that Social Security provides a stable enough income
for the elderly that they choose to save enough to pass
on a larger inheritance than they would have if there had
been no such program. The bequest effect thus increases national savings because people
save more so as to give larger
gifts to their descendants than
they would have without Social
Security.
Economists dispute the net effect of Social Security
on savings. Martin Feldstein, in particular, was the first
to estimate the effect of Social Security on savings. In
1974 he concluded that there was a dramatic reduction
in savings. This was disputed by other economists, led
by Alicia Munnell in 1977 and Dean Leimer and Selig
Lesnoy in 1982, all of whom estimated that the net effect
was zero. Not to be silenced, in 1996 Feldstein published
revised estimates for 1992, when personal savings were
actually $248 billion, indicating that it would have been
$646 billion without Social Security. The upshot is that
there is little agreement except for a middle ground that
appears to indicate a small net negative impact of Social
Security on savings.
Whom Is the Program Good For?
With a spreadsheet, a few assumptions, and some spe-
cialized terminology, you can compute whether Social
Security is a good deal for you. To do this you will need
to draw on the present value discussion of Chapter 7.
We can then compare the taxes we pay today with the
benefits we anticipate getting 40 or 50 years from now.
There is much literature on the present value of Social
Security. C. Eugene Steuerle and Jon Bakija provide de-
tailed present value estimates for different categories of
TABLE 40.2 Present value analysis of Social Security.
Income
($)
Present Value of
Social Security
Taxes at 8% ($)
Present Value of
Social Security
Benefits at 8% ($)
Net Present
Value of Social
Security at 8% ($)
Real Rate of
Return (%)
$ 15,000 $ 25,780 $ 11,434 −$ 14,346 2.6
20,000 34,374 13,836 −20,538 2.3
25,000 42,968 16,239 −26,729 2.1
30,000 51,561 18,446 −33,115 1.9
35,000 60,154 19,572 −40,582 1.7
40,000 68,748 20,698 −48,050 1.5
bequest effect People save more to give larger gifts to their de- scendants, thus increas- ing national savings.
2 We assume that employees bear the entire burden of the Social Security tax
because empirical estimates of labor supply elasticity are nearly zero.
Whom Is the Program Good For? 423
of $100,000 a year, at age 90 the present value of this
is around $2,000 a year.
If your parents, grandparents, and great-grandparents
had run these numbers when they were your age, the out-
comes would have been markedly different. For those re-
tiring in 1960, the real rate of return averaged 15 percent
while those retiring in 1980 saw an average 7 percent
real rate of return. The basic reason for the difference
in real rates of return between you and previous genera-
tions is that the Social Security tax rates they paid were
much lower than the rates you can expect to pay. Those
retiring in the 1960s faced tax rates of less than 3 percent
for much of their working lives. Those who retired in the
1980s saw tax rates rise from 1 percent to 5 percent while
they worked. You will face Social Security tax rates (old
age) of at least 5.3 percent for your working life.
In part, Social Security has been viewed as a suc-
cessful program because, until recently, it has been
a good deal for everyone. For people alive when So-
cial Security was introduced, it was an example of the
great things that government can do. For people born
between 1935 and the mid-1950s, Social Security
provides a guaranteed retirement income that is about
equal to, for married average-wage earners, what they
would have gotten in the stock market.4 For those born
after the mid-1950s, the real rate of return on Social
Security is likely to be dwarfed by private investment
opportunities. For those who are single people, for mar-
ried dual-income earners, or for higher income earners,
the year of birth for a break-even status was as long
ago as 35 years earlier. For such people, Social Security
has returned to them much less than private investments
would have.
The whole question of who benefits from Social Se-
curity is often seen as a loaded one. Simply asking it
sometimes causes people to think that you favor its elim-
ination. So given that this section may have struck you as
a sales pitch for its elimination, remember that Social Se-
curity is part of what economists call “social insurance.”
It is not intended to be a good investment. It is intended
to provide a secure source of income during retirement.
As you will see when we discuss the reform question,
that is where the debate centers. Those who favor some
form of privatization judge the program using a yard-
stick, like rate of return, that others reject.
67 until their deaths at 88. The last column indicates the
appropriate real interest rate that equalizes the present
value of taxes and benefits.
As can be seen from the first two columns, as
people make more money, they also pay more taxes.
Starting with people making minimum wage ($7.25/
hour × 2,080 hours in a year) and ending with people
starting their working life with a $40,000 salary, the
present value of their taxes increases from $25,780 to
$68,748.3 Also apparent from the table is that the pres-
ent value of benefits for high-income people is greater
than that for low- income people. This is because the
more you make and contribute to the system, the big-
ger your benefit checks are at retirement. Note here that
although the high earner makes much more than three
times what the lower earner makes, the benefit check
the high earner gets is a little more than twice that of
the lower earner.
The fact that the net present value is negative means
that Social Security will not pay as well as a private
investment making 8 percent. As can be seen from the
fourth column, everyone in your generation will do bet-
ter if your money is privately invested. For those of you
who are going to be high earners, this loss is significant.
The last column shows that, as an investment, Social Se-
curity is a better deal, in terms of the real rate of return,
for a low earner than for a high earner.
Two conclusions can be drawn from Table 40.2:
(1) For no members of the current generation of college
students is Social Security likely to beat their private al-
ternatives; (2) the more money people are likely to make
over their lifetimes, the worse the discrepancy between
private investments and Social Security is likely to be.
There are a couple of logical questions that could
be asking at this point so I’ll ask them for you: (1)
You assumed a 5 percent real interest rate. What would
happen if you assumed something like 3 percent? In
this case, the net present values would be near zero for
the low earner and –$41,693 for the high earner. (2)
What if I live until I’m 100? Can I beat the system?
The power of compounding interest dwarfs your ability
to live long enough to make the system work for you.
Even though a high earner would get benefits in excess
3 The reason that the increase in taxes paid is less than proportional to the in-
crease in income is that people with starting salaries of $40,000 and 4 percent
growth per year will hit the maximum taxable earnings before they retire. So,
whereas the taxes that a poor worker will pay will go up 4 percent every year,
the taxes a richer person will pay will go up only 3 percent a year once they
have hit that limit.
4 Because the system has a built-in transfer from high-income earners to
low-income earners, though the average earner would break even, the
low-income earner would get more than the present value of taxes. A high-
income earner would get less.
424 Chapter 40 Social Security
The Social Security Trust Fund
To combat the demographic problem the Social Security Trust Fund was established in 1982 to collect more taxes
than were needed to pay cur-
rent benefits. In later years there
would thus be money enough
to pay benefits to baby-boom
retirees. In 2014, there was ap-
proximately $2.8 trillion in U.S.
government debt in this fund. As
you may recall from Chapter 10,
“Monetary Policy,” or Chap-
ter 12, “Federal Deficits, Surpluses, and the National Debt,”
the federal government owes itself $7.5 trillion.
Whether this actually constitutes a true trust fund is de-
batable. It is a collection of debt that will either be issued
for the first time or reissued to the public when there is
less in Social Security tax revenues than benefits to pay.
One way of looking at this issue is that the trust fund is
money that was collected using the Social Security tax,
rather than the income tax. This was begun in the 1980s
and early 1990s to reduce what would otherwise have been
a much larger deficit. If you look at it this way, the national
debt that grew to $18 trillion by 2015 actually only grew to
just $13 trillion (and just $11 trillion if you count Federal
Reserve holdings of the national debt). As a result, should
surpluses come in, we would be reducing the true national
Will the System Be There for Me?
Why Social Security Is in Trouble
There has always been a concern about whether Social
Security could survive. Tax rates have always risen faster
than benefits have been added because the retired popu-
lation has grown faster than the working population. In
1982 a significant concern was raised that the pay-as-
you-go system could not handle the demographic bulge
of the post–World War II baby boom. In the years follow-
ing World War II, until around 1960, some 2.5 percent of
all women gave birth each year. The advent of the birth
control pill, the increased availability of abortion, and the
social unrest of the 1960s and 1970s significantly altered
America’s birthrate. By 1976 only 1.5 percent of women
gave birth each year.
As a result, the baby-boom generation, 50 to 68 years
old in 2014, represents 24 percent of the current popula-
tion. A comparable group before them, those between
70 and 85, are now only 8 percent of the population.
Because of this, the number of taxpaying workers per
benefit-receiving retiree will continue to fall precipi-
tously. In 1950, there were more than 16 workers pay-
ing taxes for every retiree who was collecting benefits.
Today, the number is 2.8, and current projections say it
will drop to 2.2 by 2030 and to 2.0 by 2090. Figure 40.1
presents an overview of this situation.
Social Security
Trust Fund A fund established in 1982 to hold govern- ment debt, which will be sold as necessary when tax revenues are less than benefits.
FIGURE 40.1 Workers per retiree history and projections.
0
10
20
30
40
50
W o
rk e
rs /R
e ti
re e
19 45
19 50
19 55
19 60
19 65
19 70
19 75
19 80
19 85
19 90
19 95
20 00
20 05
20 10
20 15
20 20
20 25
20 30
20 35
20 40
20 45
20 50
20 55
20 60
20 65
20 70
20 75
20 80
20 85
20 90
Year
Will the System Be There for Me? 425
of economist and Social Security expert Peter Diamond.
He notes that even if the trust fund is exhausted in 30,
40, or 50 years, the taxes paid will be sufficient to cover
75 percent of benefits. On the other hand, the possible
solutions that we next describe also require several
years to be effective if the goal is to make the program
100 percent solvent into the future.
Options for Fixing Social Security
The options for saving Social Security are plentiful, and
they range from radical to timid. They all include a mixture
of the following elements: raising payroll taxes, raising the
retirement age further, cutting benefits to upper-income re-
cipients, changing the target from indexing benefits using
wage inflation to indexing using price inflation, investing
the trust fund in corporate stocks and bonds, or carving out
some of the payroll tax for privatized individual accounts.
Raising taxes is the option most preferred by those who
like Social Security the way it is. This could be accomplished
by raising the tax rate as well as raising or eliminating the
maximum taxable earnings lid on what an individual has to
pay. Estimates vary, but eliminating this provision so that
the upper-income people would have to pay taxes on more
than just the first of their earnings would solve about a third
of the problem. Raising the overall payroll tax rate for the
old age part from 5.3 percent to 6.3 percent would probably
be sufficient to deal with the remainder.
Another alternative would be to raise the retirement age.
Typically those who like this option argue that Social Secu-
rity’s original retirement age was pegged at life expectancy,
which in 1935 was 65. If the retirement age is exactly life
expectancy, then people who die at or before expectancy
pay a lifetime of taxes and get no benefits. This ensures that
there is enough money to pay for those who die after expec-
tancy. Currently life expectancy is 79. For those who make
it to 65, men can expect to live another 18 years, women
21 years. Though people are living much longer, the prob-
lem is that there is less Social Security retirement money
to go around. Depending on how quickly we did it, raising
the retirement age to 70 would also solve about a third of
the problem. If the retirement age were not raised to age
70 until 2075, as some suggest, it would be of no help in
resolving the problem scheduled to occur in 2033.
One of the great successes of Social Security is that
it has brought the poverty rate among the elderly down
greatly. On the other hand, many retirees have enjoyed
financial success in their own right. Some have succeeded
so well in this area that they are getting Social Security
checks but have no need for them. The median net worth
debt to allow ourselves the ability to borrow much more
later. Either way it is essentially the same. Reissuing debt
and borrowing money are functionally identical.
The Social Security trustees periodically issue re-
ports that attempt to project how long this trust fund will
suffice. They issue three different predictions based on
three different sets of assumptions. The “optimistic” re-
port is based on assumptions that economic growth will
be higher than we have seen in the recent past, life spans
will be shorter than current health trends are likely to
yield, and interest rates will be lower than they are likely
to be. The “pessimistic” report is based on assumptions
of slow growth, long lives, and high interest rates.
The “intermediate” report is the most widely quoted,
and it indicates that the Social Security system generally
(except for 2010 through 2011 when revenues were down
as a result of the recession) collects more in taxes than it
pays in benefits and will likely do so through about 2020.
Between 2020 and 2034 there will be less collected in
taxes than paid in benefits, and the difference will come
out of this fund. By 2034 the fund will run dry and the
annual deficit could be as much as 21 percent of the ben-
efits owed in 2034 and 27 percent of benefits owed in
2086. It is in 2034 that the system will have insufficient
assets to pay off its obligations. This is what some would
describe as bankruptcy, although since the government
could continue to pay the benefits with other revenues or
borrowing, that term is not technically valid.
This intermediate view of whether Social Security
will survive has to be balanced by the fact that much of
it is based on assumptions that may or may not material-
ize. For instance, if the optimistic view holds, and the
economy grows a single percentage point a year more
than predicted, the problem is mostly solved. Changes,
for example, in immigration policies that allow more
workers to enter over the next 20 years, could help solve
the remainder of the problem. Additionally, if inflation
and interest rates are slightly less than predicted, Social
Security bankruptcy is far from certain.
As a matter of fact, an increase in something as unre-
lated as the divorce rate would make the problem worse.
Husbands and wives typically get less in benefits mar-
ried than they do if they are divorced.
The long and the short of it is that economists can-
not be sure that Social Security will be bankrupt. Sig-
nificantly altering what many consider to be the nation’s
greatest social program on the basis of economic as-
sumptions that may or may not come true strikes many as
foolhardy. This is especially true, from the point of view
426 Chapter 40 Social Security
might not do very well. Second, the process of picking
government investments might be unduly politicized.
Given politicians’ penchant for succumbing to special
interests, it is not beyond the realm of possibilities that
such investment would not be in the general interest.
Third, though corporate securities do better in the long
run than government bonds, they are also riskier.
The last option suggests that individuals be al-
lowed to invest part of their taxes themselves. In the
2000 presidential election, candidate George W. Bush
made this a cornerstone of his solution to the Social
Security crisis. The precipitous declines in global
stock markets that began in 2000 and did not abate
until 2003 seriously undercut the political support
such an option was beginning to build, but with his
reelection in 2004, President Bush again pushed this
option front and center. What he suggested was a sys-
tem by which younger workers would have a portion
of their taxes placed in an account under their control.
Opponents of the president’s plan focused on the fact
that the guaranteed Social Security benefit would be
significantly reduced while supporters countered that
the proceeds of the accounts, if investments returned
their normal historical rates, would more than make
up the difference.
In late summer 2005, Hurricanes Katrina and Rita
took over the headlines and the subsequent political
damage to President Bush ended his ability to sell a
major change to Social Security.
During his 2008 presidential campaign, Barack
Obama rejected all forms of privatization and instead
suggested that the 6.2 percent old-age portion of the
Social Security tax be reimposed on incomes over
$250,000. President Obama never offered a solution
during his eight years in office and President Trump’s
campaign doubled down on this inaction by pledg-
ing not to make any of the adjustments that econo-
mists insist are necessary to maintain full retirement
obligations.
for a Social Security recipient is currently about four times
that of a nonrecipient. One proposed solution to Social
Security’s problems is to subject
its beneficiaries to a means test. Those with high incomes or
great wealth would get less of
their PIA than those who depend
on the monthly check. Depend-
ing on how much a wealthy person’s check is reduced, this
could go a long way to staving off bankruptcy. Denying
Social Security to anyone whose other income is greater
than $50,000, for example, would eliminate the solvency
issue altogether. Less radically, means testing could be in-
troduced into the system by using a hybrid form of index-
ing espoused by economists Pozen, Schieber, and Shoven.
They suggest indexing benefits for upper-income retirees
using price inflation rather than wage inflation. Since
the former is usually one percentage point lower than the
latter, this would have the effect of slowly reducing the
benefits paid to upper-income retirees. On the other hand,
this could create problems. If benefits to the wealthy are
reduced too much, this could seriously discourage sav-
ings among the upper- and upper-middle-income earners.
Also, political support for the program might be seriously
jeopardized, as it would resemble a welfare program more
than a universal retirement program.
Another way to save the system would be to invest
the Social Security Trust Fund in corporate invest-
ments that yield higher rates of return. As mentioned
above, the trust fund buys government debt and this
debt “yields” between 2 percent and 3 percent. In this
sense the government (the Treasury) owes the govern-
ment (the trust fund) money and has to pay itself in-
terest. Proponents of this solution contend that if the
government invested the money in corporate stocks
and bonds, the higher rates of return would generate
enough to pay retirees’ benefits.
There are problems with the approach. First, gov-
ernment would be in the business of picking stocks and
means test Determination of the amount of one’s govern- ment benefit on the basis of income or wealth.
Summary
You now understand what Social Security is. You know its
basic tax and benefit structure as well as the changes that
have been made to the program since its inception. You
understand the economic rationale for having the system
to begin with, and you know the effects of the program on
work and savings. You understand how economists use
present value analysis to aid in determining for whom the
program works and for whom it does not. You understand
that, under present estimates, the system will be bankrupt
by 2034, what the Social Security Trust Fund is, and what
the options are for fixing the system so that it will not only
be there for you but be good for you as well.
Summary 427
Key Terms
asset substitution effect
average index of monthly earnings
(AIME)
bequest effect
externalities
fully funded pension
induced retirement effect
maximum taxable earnings
means test
pay-as-you-go pension
payroll taxes
primary insurance amount
(PIA)
retirement age
Social Security Trust Fund
Quiz Yourself
1. Social Security’s revenue emanates from taxes on
a. all income.
b. payrolls.
c. capital.
d. estates.
2. One of the reasons a government-run annuity sys-
tem such as Social Security may be better for society
than simply relying on private savings is that
a. no one would save for themselves.
b. people, being overly risk averse, will save too much.
c. people, being risk neutral, will save too much.
d. people, having imperfect foresight, will save too
little.
3. The average index of monthly earnings is indexed
a. for wage inflation.
b. for consumer price inflation.
c. for producer price inflation.
d. via a combination of wage and price inflation.
4. Since its inception, the portion of earnings that has
been subject to the Social Security tax has
a. remained roughly intact.
b. increased substantially.
c. decreased slightly.
d. decreased substantially.
5. In 2013, a worker who earned $125,000 would have
in Social Security taxes taken out of
his or her pay and would also be paid
by the employer.
a. $17,396; $17,396 (both equal to $113,700*.153)
b. $8,860.45; $8,860.45 (both equal to
$113,700*.0765+.0145*$11,300)
c. $8,470.65; $8,470.65 (both equal to
$113,700*.0765)
d. $9,562.50; $9,562.50 (both equal to
$125,000*.0765)
6. The asset substitution effect implies that Social
Security will from where it would
have been without it.
a. increase savings
b. increase work
c. decrease work
d. decrease savings
7. The question of whether Social Security increases
or decreases savings depends mostly on whether the
effect outweighs the
effect or vice versa.
a. bequest; asset substitution
b. bequest; induced retirement
c. asset substitution; induced retirement
d. interest; asset substitution
8. When compared to people of your grandparents’
generation, you can expect the net present value of
Social Security to be
a. much better.
b. about the same.
c. slightly worse.
d. much worse.
Short Answer Questions
1. Why would comparing the benefit and tax structure
of Social Security to what might be achieved in
a private investment alternative be valid, and why
might it not be valid?
2. How would a change in immigration policy affect the
projected solvency of the Social Security system?
3. How much would an individual receive in benefits
if she had a constant (wage-inflation adjusted)
monthly income of $6,000, and how would that
compare to someone who had an income one-third
that size?
4. What economic concept do you use to compare ben-
efits received in the distant future with taxes paid in
the past, currently, and in the near future?
Think about This
How much risk is appropriate for a government-run an-
nuity system? Is there an appropriate risk-return calcula-
tion to be made? Is Social Security risk free? What about
political risk?
428 Chapter 40 Social Security
Hyman, David, Public Finance: A Contemporary Appli-
cation of Theory to Policy, 7th ed. (11th Ed. Cengage,
2013).
Journal of Economic Perspectives 10, no. 3 (Summer
1996). See articles by Edward M. Gramlich; and Peter
A. Diamond, pp. 85–88.
Leimer, Dean, and Selig Lesnoy, “Social Security and
Private Saving: New Time Series Evidence,” Jour-
nal of Political Economy 90, no. 3 (June 1982),
pp. 606–642.
Pozen, Robert, Sylvester J. Schieber, and John Shoven,
“Improving Social Security’s Progressivity and
Solvency with Hybrid Indexing,” American Eco-
nomic Review 94, no. 2 (May 2004).
Rosen, Harvey S. and Ted Gayer, Public Finance (New
York, NY: McGraw-Hill/Irwin, 2010).
Steuerle, C. Eugene, and Jon M. Bakija, Retooling Social
Security for the 21st Century: Right and Wrong
Approaches to Reform (Washington, DC: Urban Insti-
tute, 1994).
Behind the Numbers
Social Security information.
Components, taxes, and bankruptcy.
Social Security Administration—
www.socialsecurity.gov
History and projections.
Social Security Administration; 2012 Trustees Report—
www.ssa.gov/oact/tr/2012/tr2012.pdf
Talk about This
Defenders of the status quo in Social Security note the
extremely low administrative costs of the system rela-
tive to those associated with private investment houses.
Critics of the status quo note that the real rate of return
to future recipients is so much less than the long-term
historical average of stocks that paying the extra ad-
ministrative costs would be worth it. Who’s right?
Given the methods of saving Social Security described
in this chapter, which combination would you employ
to save it?
For More Insight See
Aaron, Henry, “The Myths of Social Security Crisis:
Behind the Privatization Push,” NTA Forum 26
(Summer 1996).
Clark, Robert, “Social Security Financing: Facts, Fanta-
sies, Foibles, and Follies,” American Economic Re-
view 94, no. 2 (May 2004).
Cogan, John F., and Olivia S. Mitchell, “Perspectives
from the President’s Commission on Social Secu-
rity Reform,” Journal of Economic Perspectives
17, no. 2 (Spring 2003).
Diamond, Peter, “Social Security,” American Economic
Review 94, no. 1 (March 2001).
Feldstein, Martin, “Social Security and Saving: New
Time Series Evidence,” National Tax Journal 49,
no. 2 (June 1996), pp. 151–163.
C H A P T E R F O R T Y - O N E
429
Personal Income Taxes Learning Objectives
After reading this chapter you should be able to:
LO1 Explain the rudiments of federal income taxes.
LO2 Describe the concepts of horizontal and vertical equity
and how they apply to the issue of taxation.
LO3 Summarize the trade-off that exists between simplicity
and horizontal equity when people are making tax policy.
LO4 Describe how taxes can alter the incentives of people to
work and save.
LO5 List examples of where taxes are used to motivate
socially desirable outcomes.
LO6 Summarize the debates over taxes that took place during
the 1990s and continue today.
Chapter Outline
How Income Taxes Work
Issues in Income Taxation
Incentives and the Tax Code
Who Pays Income Taxes?
The Tax Debates of the Last Two Decades
Summary
In 2015 income taxes accounted for $1,541 billion of
the $3,250 billion that made up federal revenue. As Fig-
ure 41.1 suggests, the rest came from payroll (FICA),
corporate, customs, excise, estate, and miscellaneous
taxes. Personal income taxes make up almost a majority
of the revenue government takes in. These taxes also pro-
voke many of the disagreements between Republicans
and Democrats. Each party fights for policies it believes
are best for the nation and that help its constituencies.
Usually the political fights surrounding the personal
income tax code boil down to whether the rich pay their
“fair share.” To look at these controversies with any in-
sight, we will need to understand the way taxes work and
who pays them before we get into which party has the
better claim on taxes.
This chapter leads off with a discussion of how in-
come taxes work in the United States. Following that, we
discuss whether and how income taxes alter the willing-
ness of people to work and save and how capital gains
fit into this picture. We then introduce surprising news
about who actually pays taxes. At the end we lay out
some of the interesting tax debates of the last decades.
How Income Taxes Work
Federal income taxes in the United States are collected
through a series of guesses that are corrected on April
15 of the year after the tax year. When you get a new
job, you have to fill out a W-4 form on which you
specify how many exemptions you are taking. Usu-
ally, your exemptions are you and the others in your
household, but you can adjust the number by as many
as necessary to improve the guess on the taxes you
will owe. The number you provide is used by your
employer to figure out how
much tax should be withheld
from each of your paychecks.
Withholding is the deduction from your paycheck in which
you and the government es-
timate how much tax you are
going to owe during a year so you can pay it a little
at a time rather than all at once. On April 15 you use
the amount you actually earned, as reported to you on
a W-2 or a 1099 form, to compute what you actually
withholding Deduction from your paycheck to cover the estimated amount of taxes you are going to owe during a year.
430 Chapter 41 Personal Income Taxes
As you can see from Figure 41.2, the amount of tax
you owe looks complicated. In reality tax computations
are simple for most people because, thanks to a 1986
law, most people can skip the most complicated step, the
deductions, and fill out as few as 10 lines on their tax
forms. Still, for many others, tax forms, rules, and proce-
dures are complicated and jargon-filled. To understand
how taxes affect people, we must first take a crack at un-
derstanding those forms, rules, procedures, and jargon.
The tax you owe is, of course, influenced by how
much you earn. The adjusted gross income (AGI) is the total net income from all sources. To get that number,
add together all of your income from the traditional
sources (wages, salaries, tips, interest, and dividends).
Then add in any net profit from businesses and rental
apartments, any profit you have
from asset sales (called capital gains), and, finally, adjust that for net alimony received. (If you
paid alimony, this is a negative.)
To figure out how much
of that adjusted gross income
is taxable, you first have to
owe. People who have had too much withheld get a
tax refund. If they have too little withheld, they have
to make it up by April 15.
Individual income, $1,540.8
FICA, $1,065.3
Estate, $19.2
Corporate income, $343.8
Customs, $35.0
Misc., $147.6Excise, $98.3
FIGURE 41.1 Federal taxes and their sources in billions.
Source: Office of Management and Budget, www.whitehouse.gov/omb/budget
/Historicals
AGI
Adjusted gross income = Wages + Salaries + Tips + Interest + Dividends + Business profit + Rents (received) + Capital gains + Other income.
–
= ⇒ ⇒⇒
–
=
–
Exemptions
Exemptions = $4,000* (the number of people in the household + the number of people over 65 + the number of people who are blind).
Deductions
The Bigger of
Itemized deductions = Medical expenses in excess of 7.5% of AGI + Interest paid on a home mortgage + Unreimbursed business expenses in excess of 2% of AGI + Charitable donations + State and local income and property taxes.
Standard deduction = ($6,300 for a single person and $12,600 for a married couple).
Taxes Owed
What You Owe
Taxable Income
Credits
Credits = Earned income tax credit + College tuition credit + Child-care credit + Dependent child credit.C
o m
p a
re t
o A
lt .
M in
. T
a x
Tax Table 2000 Tax Table—Continued
If line 39 If line 39 If line 39
(taxable And you are— (taxable And you are— (taxable And you are—
income) is— income) is— income) is—
At But Single Married Married Head At But Single Married Married Head At But Single Married Married Head
least less filing filing of a least less filing filing of a least less filing filing of a
than jointly sepa- house- than jointly sepa- house- than jointly sepa- house-
rately hold rately hold rately hold
Your tax is— Your tax is— Your tax is—
32,000 35,000 38,000
32,000 32,050 5,555 4.804 6.117 4.804 35,000 35,050 6,395 5.254 6.957 5.254 38,000 38,050 7,235 5.704 7.797 6.078 32,050 32,100 5,569 4.811 6.131 4.811 35,050 35,100 6,409 5.261 6.971 5.271 38,050 38,100 7,249 5.711 7.811 6.092 32,100 32,150 5,583 4.819 6.145 4.819 35,100 35,150 6,423 5.269 6.985 5.269 38,100 38,150 7,263 5.719 7.825 6.106 32,150 32,200 5,597 4.826 6.159 4.826 35,150 35,200 6,437 5.276 6.999 5.280 38,150 38,200 7,277 5.726 7.836 6.120
32,200 32,250 5,611 4.834 6.173 4.834 35,200 35,250 6,451 5.284 7.013 5.294 38,200 38,250 7,291 5.734 7.853 6.134 32,250 32,300 5,625 4.841 6.187 4.841 35,250 35,300 6,465 5.291 7.077 5.308 38,250 38,300 7,305 5.741 7.867 6.148 32,300 32,350 5,639 4.849 6.201 4.849 35,300 35,350 6,479 5.299 7.041 5.322 38,300 38,350 7,319 5.749 7.881 6.162 32,350 32,400 5,653 4.856 6.215 4.856 35,350 35,400 6,493 5.306 7.055 5.336 38,350 38,400 7,333 5.756 7.895 6.176
32,400 32,450 5,667 4.864 6.229 4.864 35,400 35,450 6,507 5.314 7.069 5.350 38,400 38,450 7,347 5.764 7.909 6.190 32,450 32,500 5,681 4.871 6.243 4.871 35,450 35,500 6,521 5.321 7.083 5.364 38,450 38,500 7,361 5.771 7.923 6.204 32,500 32,550 5,695 4.879 6.257 4.879 35,500 35,550 6,535 5.329 7.097 5.378 38,500 38,550 7,375 5.779 7.937 6.218 32,550 32,600 5,700 4.836 6.271 4.886 35,550 35,600 6,549 5.336 7.111 5.392 38,550 38,600 7,389 5.786 7.951 6.232
32,600 32,650 5,723 4.894 6.285 4.894 35,600 35,650 6,563 5.344 7.125 5.406 38,600 38,650 7,403 5.794 7.965 6.246 32,650 32,700 5,737 4.901 6.299 4.901 35,650 35,700 6,577 5.351 7.139 5.420 38,650 38,700 7,417 5.801 7.979 6.260 32,700 32,750 5,751 4.909 6.313 4.909 35,700 35,750 6,591 5.359 7.153 5.434 38,700 38,750 7,431 5.809 7.993 6.274 32,750 32,800 5,765 4.916 6.327 4.916 35,750 35,800 6,605 5.366 7.167 5.448 38,750 38,800 7,445 5.816 8.007 6.288
32,800 32,850 5,779 4.924 6.341 4.924 35,800 35,850 6,619 5.374 7.181 5.462 38,800 38,850 7,459 5.824 8.021 6.302 32,850 32,900 5,793 4.931 6.355 4.931 35,850 35,900 6,633 5.381 7.195 5.476 38,850 38,900 7,473 5.831 8.035 6.316 32,900 32,950 5,807 4.939 6.369 4.939 35,900 35,950 6,647 5.389 7.209 5.490 38,900 38,950 7,483 5.839 8.049 6.330 32,950 33,800 5,821 4.946 6.383 4.946 35,950 36,000 6,661 5.396 7.223 5.504 38,950 39,000 7,501 5.846 8.063 6.344
33,000 36,000 39,000
33,000 33,050 5,835 4.954 6.397 4.954 36,000 36,050 6,675 5.404 7.237 5.518 39,000 39,050 7,515 5.854 8.077 6.358 33,050 33,100 5,849 4.961 6.411 4.961 36,050 36,100 6,689 5.411 7.251 5.532 39,050 39,100 7,529 5.861 8.091 6.372 33,100 33,150 5,863 4.969 6.425 4.969 36,100 36,150 6,703 5.419 7.265 5.546 39,100 39,150 7,543 5.869 8.105 6.386 33,150 33,200 5,877 4.976 6.439 4.976 36,150 36,200 6,717 5.426 7.279 5.560 39,150 39,200 7,557 5.876 8.119 6.400
33,200 33,250 5,891 4.984 6.453 4.984 36,200 36,250 6,731 5.434 7.293 5.574 39,200 39,250 7,571 5.884 8.133 6.414 33,250 33,300 5,905 4.991 6.467 4.991 36,250 36,300 6,745 5.441 7.307 5.588 39,250 39,300 7,585 5.891 8.147 6.428 33,300 33,350 5,919 4.999 6.481 4.999 36,300 36,350 6,759 5.449 7.321 5.602 39,300 39,350 7,599 5.899 8.161 6.442 33,350 33,400 5,933 5.006 6.495 5.006 36,350 36,400 6,773 5.456 7.335 5.616 39,350 39,400 7,613 5.906 8.175 6.456
33,400 33,450 5,947 5.014 6.509 5.014 36,400 36,450 6,787 5.464 7.349 5.630 39,400 39,450 7,627 5.914 8.189 6.470 33,450 33,500 5,961 5.021 6.523 5.021 36,450 36,500 6,801 5.471 7.363 5.644 39,450 39,500 7,641 5.921 8.203 6.484 33,500 33,550 5,975 5.029 6.537 5.029 36,500 36,550 6,815 5.479 7.377 5.658 39,500 39,550 7,655 5.929 8.217 6.498 33,550 33,600 5,989 5.036 6.551 5.036 36,550 36,600 6,829 5.486 7.391 5.672 39,550 39,600 7,669 5.936 8.231 6.512
33,600 33,650 6,003 5.044 6.565 5.044 36,600 36,650 6,843 5.494 7.405 5.686 39,600 39,650 7,683 5.944 8.245 6.526 33,650 33,700 6,017 5.051 6.579 5.051 36,650 36,700 6,857 5.501 7.419 5.700 39,650 39,700 7,697 5.951 8.259 6.540 33,700 33,750 6,031 5.059 6.593 5.059 36,700 36,750 6,871 5.509 7.433 5.714 39,700 39,750 7,711 5.959 8.273 6.554 33,750 33,800 6,045 5.066 6.607 5.066 36,750 36,800 6,885 5.516 7.447 5.728 39,750 39,800 7,725 5.966 8.287 6.568
33,800 33,850 6,059 5.074 6.621 5.074 36,800 36,850 6,899 5.524 7.461 5.742 39,800 39,850 7,739 5.974 8.301 6.582 33,850 33,900 6,073 5.081 6.635 5.081 36,850 36,900 6,913 5.531 7.475 5.756 39,850 39,900 7,753 5.981 8.315 6.596 33,900 33,950 6,087 5.089 6.649 5.089 36,900 36,950 6,927 5.539 7.489 5.770 39,900 39,950 7,767 5.989 8.329 6.610 33,950 34,000 6,101 5.096 6.663 5.096 36,950 37,000 6,941 5.546 7.503 5.784 39,950 40,000 7,781 5.996 8.343 6.624
34,000 37,000 40,000
34,000 34,050 6,115 5.104 6.677 5.104 37,000 37,050 6,955 5.554 7.517 5.798 40,000 40,050 7,795 6.004 8.357 6.638 34,050 34,100 6,129 5.111 6.691 5.111 37,050 37,100 6,969 5.561 7.531 5.812 40,050 40,100 7,809 6.011 8.371 6.652 34,100 34,150 6,143 5.119 6.705 5.119 37,100 37,150 6,983 5.569 7.545 5.826 40,100 40,150 7,823 6.019 8.385 6.666 34,150 34,200 6,157 5.126 6.719 5.126 37,150 37,200 6,997 5.576 7.559 5.840 40,150 40,200 7,837 6.026 8.399 6.680
34,200 34,250 6,171 5.134 6.733 5.134 37,200 37,250 7,011 5.584 7.573 5.854 40,200 40,250 7,851 6.034 8.413 6.694 34,250 34,300 6,185 5.141 6.747 5.141 37,250 37,300 7,025 5.591 7.587 5.868 40,250 40,300 7,865 6.041 8.427 6.708 34,300 34,350 6,199 5.149 6.761 5.149 37,300 37,350 7,039 5.599 7.601 5.882 40,300 40,350 7,879 6.049 8.441 6.722 34,350 34,400 6,213 5.156 6.775 5.156 37,350 37,400 7,053 5.606 7.615 5.896 40,350 40,400 7,893 6.056 8.455 6.736
34,400 34,450 6,227 5.164 6.789 5.164 37,400 37,450 7,067 5.614 7.629 5.910 40,400 40,450 7,907 6.064 8.469 6.750 34,450 34,500 6,241 5.171 6.803 5.171 37,450 37,500 7,081 5.621 7.643 5.924 40,450 40,500 7,921 6.071 8.483 6.764 34,500 34,550 6,255 5.179 6.817 5.179 37,500 37,550 7,095 5.629 7.657 5.938 40,500 40,550 7,935 6.079 8.497 6.778 34,550 34,600 6,269 5.186 6.831 5.186 37,550 37,600 7,109 5.636 7.671 5.952 40,550 40,600 7,949 6.086 8.511 6.792
34,600 34,650 6,283 5.194 6.845 5.194 37,600 37,650 7,123 5.644 7.685 5.966 40,600 40,650 7,963 6.094 8.525 6.806 34,650 34,700 6,297 5.201 6.859 5.201 37,650 37,700 7,137 5.651 7.699 5.980 40,650 40,700 7,977 6.101 8.539 6.820 34,700 34,750 6,311 5.209 6.873 5.209 37,700 37,750 7,151 5.659 7.713 5.994 40,700 40,750 7,991 6.109 8.553 6.834 34,750 34,800 6,325 5.216 6.887 5.216 37,750 37,800 7,165 5.666 7.727 6.008 40,750 40,800 8,005 6.116 8.567 6.848
34,800 34,850 6,339 5.224 6.901 5.224 37,800 37,850 7,179 5.674 7.741 6.022 40,800 40,850 8,019 6.124 8.581 6.862 34,850 34,900 6,353 5.231 6.915 5.231 37,850 37,900 7,193 5.681 7.755 6.036 40,850 40,900 8,033 6.131 8.595 6.876 34,900 34,950 6,367 5.239 6.929 5.239 37,900 37,950 7,207 5.689 7.769 6.050 40,900 40,950 8,047 6.139 8.609 6.890 34,950 35,000 6,381 5.246 6.943 5.246 37,950 38,000 7,221 5.696 7.783 6.064 40,950 41,000 8,061 6.146 8.623 6.904
*This column must also be used by a qualifying widow(er) (Continued on page 64)
FIGURE 41.2 Federal income taxes, 2015.
adjusted gross
income (AGI) Total net income from all sources.
capital gains Any profit generated by selling an asset for more than was paid for it.
How Income Taxes Work 431
adjust that number by two other numbers. The first, exemptions, is an amount by which AGI is reduced that is determined by the size of your family. These exemp-
tions are similar to, but not the same as, the exemptions
you compute for form W-4. For that form you can es-
sentially create fictitious people in order to make your
withholding correct. Here, the exemptions have to be
real. Each person in the household counts as one. Each
person over 65 counts as one more, as does each blind
person. For the 2015 tax year, each exemption reduced
AGI by $4,000. For example, a married couple, both
of whose members are old and blind, would have had
six exemptions, whereas a husband and wife with two
small children would have had four. In the first case the
total exemption is 6 × $4,000, or $24,000. In the sec-
ond example it is 4 × $4,000,
or $16,000.
Deductions are also amounts by which AGI is reduced. These
are complicated by the fact that
they are the greater of either a
minimum level or the sum of
particular expenditures, the
value of which is money that
will not be taxed. The minimum
level of deduction is called the
standard deduction, and this is the amount that most people
take. Itemized deductions are for particular expenses on which
government does not want taxes
paid. The reason most people
can compute their taxes rela-
tively easily is that they skip
this complicated step. Rather
than itemizing deductions, they
accept the value of the standard
deduction.
When people itemize (that
is, “list”), they add up those things that are deductible (approved types of expenses) and instead of reducing
their taxable income by a fixed amount, they reduce
it by the sum of those expenses. For instance, when
people buy homes, they typically have mortgage pay-
ments. In the early years of paying a mortgage, the
payment is almost entirely interest. That interest is de-
ductible. Other deductible items that are listed include
state and local income and property taxes, charitable
donations, certain employment expenses, and certain
(usually very high) medical expenses.
Most people do not itemize their deductions because
if they did, the total would not equal the standard deduc-
tion. This is especially true for those who rent their resi-
dences, because renters cannot deduct mortgage interest
and property taxes. Only those who own the properties
are entitled to take these deductions.
The standard deduction simplifies taxes for most
people, and it reduces the amount of tax that they owe.
Those people who itemize have at least one, if not many,
more forms than the people who take the standard deduc-
tion. In addition, since the standard deduction gives the
people who take it a larger reduction off income than
they would otherwise get, it reduces their tax burden.
Taxable income is therefore ad- justed gross income minus per-
sonal exemptions minus (the
greater of either the standard or
itemized) deductions.
Another thing people must
know in order to compute the
tax they owe is their filing status. A person’s filing status can be
one of four things: single, mar-
ried filing jointly, married filing
separately, and single head of
household. Single people without
children file as singles, whereas
those singles with kids in the household file as a single head
of household. Almost all married people file jointly, though
those going through a separation or a divorce typically file
separately. Most married couples pay less tax if they file
jointly, though some couples file separately because they
balk at sharing financial information with one another.
In the 2015 tax year, for married couples the standard
deduction was $12,600; for single people it was $6,300.
As a result, for those married couples with two chil-
dren who took the standard deduction, the first $28,600
($4,000 × 4 + $12,600) they earned was tax-free. For
single people the first $10,300 was tax-free.
The tax tables show the amount most people owe in
tax. To read tax tables, find the column that contains the
filing status. Then read the row to find the amount of tax-
able income. As an example, take a single person who
does not own a home and whose only income is salary.
The taxes she or he owes are very simple to compute. Say
such a person earns $52,000 a year and takes the standard
deduction. The taxable income is $52,000 − $6,300
(standard deduction) − $4,000 (personal exemption), or
$41,700. A 2015 tax table is duplicated here in Figure 41.3,
and circled on that form is the tax amount of $6,225.
exemptions An amount by which AGI is reduced which is determined by the size of the family.
deductions Amounts by which AGI is reduced; the greater of either the standard deduction or itemized deductions.
standard deduction The minimum level of deduction.
itemized deductions Deductions for particu- lar expenses on which the government does not want taxes paid.
deductible Approved types of expenses for income tax purposes.
taxable income Adjusted gross income minus personal exemp- tions minus (the greater of either the standard or itemized) deductions.
filing status Classification of taxpay- ers based on household; can be single, married filing jointly, mar- ried filing separately, and single head of household.
432 Chapter 41 Personal Income Taxes
2015 Tax Table
* This column must also be used by a qualifying widow(er).
If line 43 (taxable income) is—
And you are—
At least
But less than
Single Married filing jointly *
Married filing sepa- rately
Head of a house- hold
Your tax is—
39,000
39,000 39,050 5,550 4,931 5,550 5,196 39,050 39,100 5,563 4,939 5,563 5,204 39,100 39,150 5,575 4,946 5,575 5,211 39,150 39,200 5,588 4,954 5,588 5,219 39,200 39,250 5,600 4,961 5,600 5,226
39,250 39,300 5,613 4,969 5,613 5,234 39,300 39,350 5,625 4,976 5,625 5,241 39,350 39,400 5,638 4,984 5,638 5,249 39,400 39,450 5,650 4,991 5,650 5,256 39,450 39,500 5,663 4,999 5,663 5,264
39,500 39,550 5,675 5,006 5,675 5,271 39,550 39,600 5,688 5,014 5,688 5,279 39,600 39,650 5,700 5,021 5,700 5,286 39,650 39,700 5,713 5,029 5,713 5,294 39,700 39,750 5,725 5,036 5,725 5,301
39,750 39,800 5,738 5,044 5,738 5,309 39,800 39,850 5,750 5,051 5,750 5,316 39,850 39,900 5,763 5,059 5,763 5,324 39,900 39,950 5,775 5,066 5,775 5,331 39,950 40,000 5,788 5,074 5,788 5,339
40,000
40,000 40,050 5,800 5,081 5,800 5,346 40,050 40,100 5,813 5,089 5,813 5,354 40,100 40,150 5,825 5,096 5,825 5,361 40,150 40,200 5,838 5,104 5,838 5,369 40,200 40,250 5,850 5,111 5,850 5,376
40,250 40,300 5,863 5,119 5,863 5,384 40,300 40,350 5,875 5,126 5,875 5,391 40,350 40,400 5,888 5,134 5,888 5,399 40,400 40,450 5,900 5,141 5,900 5,406 40,450 40,500 5,913 5,149 5,913 5,414
40,500 40,550 5,925 5,156 5,925 5,421 40,550 40,600 5,938 5,164 5,938 5,429 40,600 40,650 5,950 5,171 5,950 5,436 40,650 40,700 5,963 5,179 5,963 5,444 40,700 40,750 5,975 5,186 5,975 5,451
40,750 40,800 5,988 5,194 5,988 5,459 40,800 40,850 6,000 5,201 6,000 5,466 40,850 40,900 6,013 5,209 6,013 5,474 40,900 40,950 6,025 5,216 6,025 5,481 40,950 41,000 6,038 5,224 6,038 5,489
41,000
41,000 41,050 6,050 5,231 6,050 5,496 41,050 41,100 6,063 5,239 6,063 5,504 41,100 41,150 6,075 5,246 6,075 5,511 41,150 41,200 6,088 5,254 6,088 5,519 41,200 41,250 6,100 5,261 6,100 5,526
41,250 41,300 6,113 5,269 6,113 5,534 41,300 41,350 6,125 5,276 6,125 5,541 41,350 41,400 6,138 5,284 6,138 5,549 41,400 41,450 6,150 5,291 6,150 5,556 41,450 41,500 6,163 5,299 6,163 5,564
41,500 41,550 6,175 5,306 6,175 5,571 41,550 41,600 6,188 5,314 6,188 5,579 41,600 41,650 6,200 5,321 6,200 5,586 41,650 41,700 6,213 5,329 6,213 5,594 41,700 41,750 6,225 5,336 6,225 5,601
41,750 41,800 6,238 5,344 6,238 5,609 41,800 41,850 6,250 5,351 6,250 5,616 41,850 41,900 6,263 5,359 6,263 5,624 41,900 41,950 6,275 5,366 6,275 5,631 41,950 42,000 6,288 5,374 6,288 5,639
If line 43 (taxable income) is—
And you are—
At least
But less than
Single Married filing jointly *
Married filing sepa- rately
Head of a house- hold
Your tax is—
42,000
42,000 42,050 6,300 5,381 6,300 5,646 42,050 42,100 6,313 5,389 6,313 5,654 42,100 42,150 6,325 5,396 6,325 5,661 42,150 42,200 6,338 5,404 6,338 5,669 42,200 42,250 6,350 5,411 6,350 5,676
42,250 42,300 6,363 5,419 6,363 5,684 42,300 42,350 6,375 5,426 6,375 5,691 42,350 42,400 6,388 5,434 6,388 5,699 42,400 42,450 6,400 5,441 6,400 5,706 42,450 42,500 6,413 5,449 6,413 5,714
42,500 42,550 6,425 5,456 6,425 5,721 42,550 42,600 6,438 5,464 6,438 5,729 42,600 42,650 6,450 5,471 6,450 5,736 42,650 42,700 6,463 5,479 6,463 5,744 42,700 42,750 6,475 5,486 6,475 5,751
42,750 42,800 6,488 5,494 6,488 5,759 42,800 42,850 6,500 5,501 6,500 5,766 42,850 42,900 6,513 5,509 6,513 5,774 42,900 42,950 6,525 5,516 6,525 5,781 42,950 43,000 6,538 5,524 6,538 5,789
43,000
43,000 43,050 6,550 5,531 6,550 5,796 43,050 43,100 6,563 5,539 6,563 5,804 43,100 43,150 6,575 5,546 6,575 5,811 43,150 43,200 6,588 5,554 6,588 5,819 43,200 43,250 6,600 5,561 6,600 5,826
43,250 43,300 6,613 5,569 6,613 5,834 43,300 43,350 6,625 5,576 6,625 5,841 43,350 43,400 6,638 5,584 6,638 5,849 43,400 43,450 6,650 5,591 6,650 5,856 43,450 43,500 6,663 5,599 6,663 5,864
43,500 43,550 6,675 5,606 6,675 5,871 43,550 43,600 6,688 5,614 6,688 5,879 43,600 43,650 6,700 5,621 6,700 5,886 43,650 43,700 6,713 5,629 6,713 5,894 43,700 43,750 6,725 5,636 6,725 5,901
43,750 43,800 6,738 5,644 6,738 5,909 43,800 43,850 6,750 5,651 6,750 5,916 43,850 43,900 6,763 5,659 6,763 5,924 43,900 43,950 6,775 5,666 6,775 5,931 43,950 44,000 6,788 5,674 6,788 5,939
44,000
44,000 44,050 6,800 5,681 6,800 5,946 44,050 44,100 6,813 5,689 6,813 5,954 44,100 44,150 6,825 5,696 6,825 5,961 44,150 44,200 6,838 5,704 6,838 5,969 44,200 44,250 6,850 5,711 6,850 5,976
44,250 44,300 6,863 5,719 6,863 5,984 44,300 44,350 6,875 5,726 6,875 5,991 44,350 44,400 6,888 5,734 6,888 5,999 44,400 44,450 6,900 5,741 6,900 6,006 44,450 44,500 6,913 5,749 6,913 6,014
44,500 44,550 6,925 5,756 6,925 6,021 44,550 44,600 6,938 5,764 6,938 6,029 44,600 44,650 6,950 5,771 6,950 6,036 44,650 44,700 6,963 5,779 6,963 6,044 44,700 44,750 6,975 5,786 6,975 6,051
44,750 44,800 6,988 5,794 6,988 6,059 44,800 44,850 7,000 5,801 7,000 6,066 44,850 44,900 7,013 5,809 7,013 6,074 44,900 44,950 7,025 5,816 7,025 6,081 44,950 45,000 7,038 5,824 7,038 6,089
If line 43 (taxable income) is—
And you are—
At least
But less than
Single Married filing jointly *
Married filing sepa- rately
Head of a house- hold
Your tax is—
45,000
45,000 45,050 7,050 5,831 7,050 6,096 45,050 45,100 7,063 5,839 7,063 6,104 45,100 45,150 7,075 5,846 7,075 6,111 45,150 45,200 7,088 5,854 7,088 6,119 45,200 45,250 7,100 5,861 7,100 6,126
45,250 45,300 7,113 5,869 7,113 6,134 45,300 45,350 7,125 5,876 7,125 6,141 45,350 45,400 7,138 5,884 7,138 6,149 45,400 45,450 7,150 5,891 7,150 6,156 45,450 45,500 7,163 5,899 7,163 6,164
45,500 45,550 7,175 5,906 7,175 6,171 45,550 45,600 7,188 5,914 7,188 6,179 45,600 45,650 7,200 5,921 7,200 6,186 45,650 45,700 7,213 5,929 7,213 6,194 45,700 45,750 7,225 5,936 7,225 6,201
45,750 45,800 7,238 5,944 7,238 6,209 45,800 45,850 7,250 5,951 7,250 6,216 45,850 45,900 7,263 5,959 7,263 6,224 45,900 45,950 7,275 5,966 7,275 6,231 45,950 46,000 7,288 5,974 7,288 6,239
46,000
46,000 46,050 7,300 5,981 7,300 6,246 46,050 46,100 7,313 5,989 7,313 6,254 46,100 46,150 7,325 5,996 7,325 6,261 46,150 46,200 7,338 6,004 7,338 6,269 46,200 46,250 7,350 6,011 7,350 6,276
46,250 46,300 7,363 6,019 7,363 6,284 46,300 46,350 7,375 6,026 7,375 6,291 46,350 46,400 7,388 6,034 7,388 6,299 46,400 46,450 7,400 6,041 7,400 6,306 46,450 46,500 7,413 6,049 7,413 6,314
46,500 46,550 7,425 6,056 7,425 6,321 46,550 46,600 7,438 6,064 7,438 6,329 46,600 46,650 7,450 6,071 7,450 6,336 46,650 46,700 7,463 6,079 7,463 6,344 46,700 46,750 7,475 6,086 7,475 6,351
46,750 46,800 7,488 6,094 7,488 6,359 46,800 46,850 7,500 6,101 7,500 6,366 46,850 46,900 7,513 6,109 7,513 6,374 46,900 46,950 7,525 6,116 7,525 6,381 46,950 47,000 7,538 6,124 7,538 6,389
47,000
47,000 47,050 7,550 6,131 7,550 6,396 47,050 47,100 7,563 6,139 7,563 6,404 47,100 47,150 7,575 6,146 7,575 6,411 47,150 47,200 7,588 6,154 7,588 6,419 47,200 47,250 7,600 6,161 7,600 6,426
47,250 47,300 7,613 6,169 7,613 6,434 47,300 47,350 7,625 6,176 7,625 6,441 47,350 47,400 7,638 6,184 7,638 6,449 47,400 47,450 7,650 6,191 7,650 6,456 47,450 47,500 7,663 6,199 7,663 6,464
47,500 47,550 7,675 6,206 7,675 6,471 47,550 47,600 7,688 6,214 7,688 6,479 47,600 47,650 7,700 6,221 7,700 6,486 47,650 47,700 7,713 6,229 7,713 6,494 47,700 47,750 7,725 6,236 7,725 6,501
47,750 47,800 7,738 6,244 7,738 6,509 47,800 47,850 7,750 6,251 7,750 6,516 47,850 47,900 7,763 6,259 7,763 6,524 47,900 47,950 7,775 6,266 7,775 6,531 47,950 48,000 7,788 6,274 7,788 6,539
FIGURE 41.3 Tax table for 2015.
Source: www.irs.gov/pub/irs-pdf/i1040tt.pdf
Take the amount of taxable income, $41,700, and find the column labeled “single.” The person with that taxable income owes $6,225.
How Income Taxes Work 433
The third major credit is the child (and elder) care tax
credit. For the majority of families with child-care ex-
penses, this credit allows for between 20 percent and
35 percent (again, depending on AGI) of those expenses
to come off the tax bill. The last of the major credits is
a tuition tax credit (renamed the American Opportunity
Credit). This allows for up to $2,500 of college-related
expenses to come off the tax bill.
There is an important distinction between tax credits
and deductions. A tax deduction comes off taxable in-
come, so the savings to taxpayers are whatever their mar-
ginal tax rate is times the amount of the deduction. For
example, if a person is in the 15 percent tax bracket, a
$1,000 deduction is worth $150. A $1,000 credit, on the
other hand, is $1,000 off the tax bill. Tax credits are there-
fore better than deductions if the two are in equal amounts.
There is another aspect of the distinction between
credits and deductions that is important. During tax de-
bates there is often a discussion of whether there should
be a tax deduction for something or a tax credit for it.
Since credits are more costly to the government than de-
ductions, we can imagine that the choice facing policy
makers for the tax cut would be a $2,500 deduction or
a $500 credit. For people in the 15 percent tax bracket,
a $2,500 tax deduction is worth between nothing (be-
cause they still end up with insufficient deductions to get
over the standard deduction) and 15 percent of $2,500,
or $375. For people in the 28 percent bracket, a $2,500
deduction is worth up to $700. The net result of this is
that credits are better than deductions when they are in
equal amounts and that for tax reductions of equal cost to
the government, credits are better than deductions for the
poor. For the rich the opposite is true: Tax deductions are
preferred over tax credits.
For people with a variety of income sources and many
deductions, the rules are very complicated. The vast ma-
jority of people are not in this predicament. You have to
own a farm or business, have a significant and actively
changing investment portfolio, have significant medical
expenses that you have to pay yourself, work in an en-
vironment where you get high pay but have to pay for
A part of the tax calculation process that still exists, in
an albeit more limited form, is the alternative minimum
tax (AMT). This tax, invented in the 1960s to prevent the
superrich from accumulating so many deductions that
they could avoid taxes altogether, had begun to hit ordi-
nary middle-class taxpayers. The alternative minimum
tax was doubly frustrating for taxpayers who did their
own taxes because after they had completed their federal
return, if they came under its provisions, they would have
to refigure their taxes using its provisions. There was no
obvious way to know this until you were almost entirely
finished completing your 1040. The creeping nature of
this burden was resolved following the 2012 election.
The AMT was reformed to raise the income threshold
substantially and to index them for inflation.
The tax rates in the United States are progressive in that with higher income you pay a higher rate of tax.
Table 41.1 shows the so-called tax brackets in the United
States for 2015. One result of
President Obama’s reelection
was the creation of a new 39.6
percent bracket in 2013 at the
top end. The marginal tax rate is the percentage of each dol-
lar in that bracket that must be
paid in tax. This means that our
single person making $52,000,
with taxable income of $41,700, has a tax rate of zero
on the first $10,300 of income, pays 10 percent on the
next $9,225, pays 15 percent on the next $28,225, and
25 percent of the remainder.
Even after you have figured your tax, this is not what
you actually owe. There are four important tax credits
that now go into the computation. The first, the earned
income tax credit, is designed for the working poor. This
can be a substantial increase in your take-home pay if you
have children and do not make a lot of money. In 2015,
for those with at least two children, the credit amounted
to as much as $6,242. The second important credit is the
child credit. For those married couples who make less
than $110,000, this credit amounts to $1,000 per child.
TABLE 41.1 Marginal tax rate.
Status 10% 15% 25% 28% 33% 35% 39.6%
Single $0–9,225 $9,225–37,450 $37,450–90,750 $90,750–189,300 $189,300–411,500 $411,500–413,200 $413,200–
Single head of household $0–13,150 $13,150–50,200 $50,200–129,600 $129,600–209,850 $209,850–411,500 $411,500–439,000 $439,000–
Married filing jointly $0–18,450 $18,450–74,900 $74,900–151,200 $151,200–230,450 $230,450–411,500 $411,500–464,850 $464,850–
Married filing separately $0–9,225 $9,225–37,450 $37,450–75,600 $75,600–115,225 $115,225–205,750 $205,750–232,425 $232,425–
progressive taxation Those with higher in- come pay a higher rate of tax.
marginal tax rate The percentage of each dollar in a bracket that must be paid in tax.
434 Chapter 41 Personal Income Taxes
actually have the profit in hand) rather than accrual (when
the asset price increase happened). This undertaxes capi-
tal gains by letting the holder of them defer the tax.
Taxing on realization rather than accrual is simple,
but it creates a different problem whose solution only
creates another problem. Because there is no tax until
an asset is sold, when a person dies while in possession
of an asset, there are capital gains. Perhaps there is no
paperwork to find out when it was bought, so there is no
way of finding out exactly how big the capital gain is. To
solve this, all capital gains, and therefore all taxes owed
on those gains, are forgiven at death. This creates yet an-
other problem. There is an incentive for the elderly to
hold assets with large capital gains rather than sell them,
because doing so avoids the capital gains tax.
Thus the problem is that there is a trade-off between
simplicity and equity. In order to be simple, we will violate
equity, and in order to be fair, this will cost us simplicity.
Incentives and the Tax Code
There is an active debate among politicians and among
economists about the effects of income taxes on the
behavior of people. Two of the most interesting of these is-
sues are how such taxes affect people’s willingness to work
and save. Republican politicians and conservative econo-
mists are convinced that income taxes cause people to
work and save less. Democratic
politicians and liberal economists
are convinced that people do not
work and save any less and may,
in fact, work and save more.
This is because there is a fun-
damental disagreement between
economists concerning the rela-
tive importance of what econo-
mists call the substitution effect and the income effect. Any time you change the price of some-
thing, in this case either the take-
home wage rate or the after-tax
interest rate, you create these two
effects. The substitution effect
moves people toward the good
that is now cheaper or away from
the good that is now more expensive. As an example, if
there are only two goods, apples and oranges, and the price
of apples increases, you would move toward oranges. This
is not the end of the story, though. There is also an income
lots of work expenses (like a truck driver), or have some
other strange source of income in order to have overly
complicated income taxes.
Issues in Income Taxation
Horizontal and Vertical Equity
One question that always arises with regard to income
taxes is whether they are fair. The very definition of
“fair” requires some thought. To be fair, it seems clear
that equal people should be treated equally. This concept,
called horizontal equity, is not much disputed. People who make the same income, from the same sources, with
the same family structure, and who are the same in every
other dimension should pay the
same taxes.
Where the controversy lies
with most people is the issue
of vertical equity. That is, are people across the income scale
treated fairly with regard to their
ability to pay? As you saw with
Table 41.1, people at the upper
end of the income scale pay much more in tax and much
higher percentages of tax than people at the lower end.
Equity versus Simplicity
There is a distinct trade-off between horizontal equity and
simplicity. This is because it is difficult to nail down the
question of “sameness” that is at the heart of the definition
of horizontal equity. Most economists who study the issue
of taxation want the tax code to be neutral. For instance, to ensure neutrality, income earned from work must be treated
the same as income made from investments. The problem
is that in order to accomplish neu-
trality, the tax code would have to
be very complicated. Consider
capital gains income.
When assets are bought and
later sold at a profit, there is cap-
ital gain. Under the principles of
neutrality that capital gain should be taxed—the question
is how much? This question arises because there are prob-
lems with capital gains that do not affect earnings from
work. First, much of the increase in the value of an asset
is simply the compensation for inflation. We tax all gains
rather than just the inflation-adjusted gains because this
is easier. Second, some assets are difficult to evaluate,
so capital gains are taxed only on realization (when you
horizontal equity Equal people should be treated equally.
vertical equity People across the in- come scale are treated fairly with regard to ability to pay.
neutral When applied to a tax code, the implication that it does not favor particular forms of in- come or expenditure.
substitution effect Purchase of less of a product than originally wanted when its price is high because a lower-priced product is available.
income effect An increase in price lowers spending power; if the good is normal, this further lowers consumption; if it is inferior, it can increase consumption back toward where it was (or even further). This effect works in either direction.
Who Pays Income Taxes? 435
effect. This can go either direction and depends on the
Chapter 2 concepts of normal and inferior. If a good is
inferior, the increase in price lowers your real spending
power and you would move back toward that good.
Do Taxes Alter Work Decisions?
One of the most well-researched questions in economics
is the effect of take-home pay on the number of hours
worked. To the untrained observer this may not seem
like a very difficult question, but it actually is. The sub-
stitution effect is the more obviously seen effect. Since
taxes reduce the take-home pay for every hour worked,
the incentive to work, rather than stay home and relax, is
lessened. Thus you reduce your work effort. The other
side of the story, though, is the reduction in income. If
you do the work that is necessary to generate a certain
standard of living, then you will have to work more hours
to have the income to sustain that standard of living. The
empirical research suggests that if taxes do alter the work
decision, it is only very slightly. Most estimates suggest
that the substitution effect is exactly countered by the in-
come effect. That is, an increase in taxes has no effect on
work effort, though some have found the effect to be that
it takes an 8 percent reduction in after-tax wage rates to
generate a 1 percent reduction in work hours. Either way,
taxes do not substantially alter the incentive to work.
Do Taxes Alter Savings Decisions?
A similar result has been found on after-tax interest rates.
Though there is disagreement in methodology that gen-
erates a disagreement in the conclusion, many econo-
mists also believe that an increase in tax rates has little or
no effect on saving behavior. This also suggests that the
substitution effect and income effect completely counter
each other. There are, though, estimates that suggest that
the net is not zero. In particular, Michael Boskin esti-
mated that a 2.5 percent decrease in the after-tax interest
rates results in a 1 percent decrease in savings.
Taxes for Social Engineering
If taxes do not substantially alter the incentive of people
to work or save, then you might think that policy mak-
ers would have given up on using taxes to get people to
do other desirable things. If you thought that, you would
be wrong. President Clinton proposed and Congress en-
acted a plan to use tax credits to provide an incentive to
go to college. Tax deductions and credits for a variety of
desirable outcomes have been tried at a variety of dif-
ferent times. Typically the breaks do not end up causing
more of the desired outcome but simply subsidize the
people who were already engaging in it.1
President Bush was less fond of tax changes of this
type, but President Obama jumped right in with billions of
targeted tax deductions and credits in his 2009 Economic
Recovery Act (i.e., his stimulus package). In that package
there were tax credits for first-time home buyers, for buy-
ers of hybrid cars, and even for buyers of energy-efficient
water heaters. The belief that the federal income tax code
can be used to motivate socially desirable activities is
deeply held in the halls of the capitol, yet there is little
evidence that these tax credits have a significant impact.
Who Pays Income Taxes?
A vastly misunderstood concept of income taxation is who
it is that pays. For years Republicans and Democrats alike
have perpetuated the myth that middle Americans pay
this tax and the rich do not pay their fair share. A look at
Table 41.2 should begin to dispel that myth. The first col-
umn indicates the percentile of tax returns; the second and
third columns indicate the percentage of income earned
and taxes paid by everyone at or below that percentile.
TABLE 41.2 Distribution of taxes, 2013.
Source: Statistics of Income: Individual Income Tax Returns 2013, Internal Revenue
Service, Washington, DC
Percentile of
Taxpayers, Bottom
x% of Returns*
Cumulative
Percentage of
Adjusted Gross
Income
Cumulative
Percentage of
Taxes Paid
10 0.00% 0.00% 20 0.49% 0.02% 30 2.06% 0.11% 40 4.59% 0.39% 50 8.15% 1.06% 60 12.85% 2.33% 70 19.26% 4.84% 80 27.50% 8.92% 90 39.59% 16.99% 100 55.32% 28.56%
100.00% 100.00%
*Example: The bottom 40 percent of taxpayers earn 4.59 percent of adjusted gross
income and pay 1.06 percent of all federal income taxes.
1 If the research on college tax credits that is published in the next few years
duplicates the results of the research on work and savings, the tax deduc-
tions and credits will probably not increase the number of people going to
college but will merely be a special tax break to those who would have gone
to college anyway. Another effect of this subsidy is that it gives colleges and
universities an increased ability to raise tuition.
436 Chapter 41 Personal Income Taxes
For instance, the bottom 40 percent of earners account for
2.33 percent of income and 1.06 percent of taxes paid.
From this table you can draw several myth-breaking
conclusions. First, the bottom half of taxpayers pays only
2 percent of the income tax while the top half pays the
remaining 98 percent. Second, the top 10 percent of tax-
payers accounts for 71 percent of federal income taxes
paid while the rest of us account for only 29 percent.
Third, if it were true that the rich were not paying as
much as the middle class, the second column would not
always exceed the third. It does, and the rich pay far more
tax than do the rest of us.
Figure 41.4 portrays the same information graphically. If
all income and taxes were earned and paid equally, it would
represent a straight line. The degree to which the income
earned, shown as AGI, is bowed is the degree to which in-
come earned is unequal. If taxes were paid mostly by the
middle class, then the tax curve would be above the income
curve. Since the opposite is true, it should be clear that there
is significant effective progressivity in the tax code.
The Tax Debates of the Last Two Decades
One of the central themes of the political debates of the
1990s and 2000s was whether tax cuts should be across-
the-board or targeted. Republican presidential candidates
offered across-the-board tax cuts, whereas Democratic
presidential candidates offered tax cuts that were tar-
geted to specific populations. The difference in philoso-
phy boils down to essentially two differences of opinion:
whether most of the tax cuts should go to the people who
pay most of the tax or whether the tax code should be
used to encourage particular behaviors and help people
with the least income.
On the first difference of opinion, it is clear that any
across-the-board tax cut must go mostly to the rich since
it is they who pay the vast majority of income taxes.
Thus an across-the-board tax cut by definition favors the
rich. Whether this is fair criticism is relative. If you look
at where most of the dollars go in such a cut, it is indis-
putable that the rich get most of the money. On the other
hand, this is because they pay the most. Giving a tax cut
to the poor gives a tax cut to people who do not pay any
federal income taxes to begin with.2
Because of the progressivity of the tax code, simply
reducing the tax rate by a fixed percentage not only
gives more of a tax break to upper-income taxpayers,
but it also changes the income distribution in a way that
favors upper-income Americans. To see how, consider
Table 41.3. The second column indicates before-tax in-
come, showing a circumstance where the upper-income
person makes 10 times what the lower-income person
makes. The third column indicates the tax that would
be paid under the simple hypothetical tax code where
10 percent of the first $50,000 and 20 percent of the
rest is paid in tax. The progressivity of the income tax
is displayed here in that the upper-income household
makes 10 times as much as the lower-income house-
hold but pays 15 times as much tax. The fourth col-
umn shows the after-tax income. Again, note the effect
of the progressive income tax is to reduce the ratio of
spending power of the high-income to lower-income
person from 10 to 1 to 9.44 to 1. The fifth and sixth
columns show the effect of a 10 percent reduction in
tax rates. The 10 percent tax rate becomes 9 percent
and the 20 percent tax rate becomes 18 percent.
Republicans and Democrats will interpret Table 41.3 in
two entirely different ways. The Republicans will say that
under both tax codes the upper-income people are paying
15 times the taxes that the lower-income people are paying.
Moreover, they will claim that any tax cut that helps the
poor will change the distribution of taxes to be even further
0
20
40
60
80
100
0 10 20 30 40 50 60 70 80 90 100
Percentage of tax returns
P e
rc e
n ta
g e
o f
p e
rs o
n a
l in
c o
m e
Returns Adjusted gross income
Taxable income Income tax
FIGURE 41.4 Income and tax distributions.
Source: Statistics of Income: Individual Income Tax Returns, Internal Revenue Ser-
vice, Washington, DC,
www.irs.gov/uac/SOI-Tax-Stats-Individual-Income-Tax-Returns.
2 Tax cuts to the poor typically result from increasing the earned income tax
credit. This credit often exceeds the amount of tax owed by a substantial
amount. Many low-income families pay “negative taxes,” so a tax cut to them
simply makes this more negative.
Summary 437
slanted to upper-income people. Democrats will focus on
the distribution of the after-tax income figure and note
that an across-the-board tax cut increases the ratio of an
upper- income person’s after-tax income to a lower-income
person’s after-tax income from 9.44 to 9.51. As a result,
though an across-the-board tax cut keeps the percentage of
government funded by each group the same, it changes the
after-tax income distribution in favor of the rich.
Another great debate of the last decade centered on
unraveling the 1986 tax reform law that eliminated most
social engineering from the tax code. Prior to that year
thousands of provisions were included to induce people
to do a variety of things. The law passed in 1986 elimi-
nated almost all of them. Slowly, but steadily, the Clinton
administration sought provisions to again urge people in
particular directions. For instance, they sought and got
partial tax deductions and credits for higher education.
After his election in 2000, George W. Bush sought
and got two substantial personal income tax cuts. The
first, in 2001, cut marginal tax rates, phased in an in-
crease in the dependent child credit, and phased out the
estate (inheritance) tax. The second, in 2003, sped up the
timetable on the 2001 tax cuts and reduced the tax rate
on corporate dividends.
Taken together, the beneficiaries of these tax cuts
were middle-income and higher-income families with
children and the wealthy. Middle-income families with
children saw dramatic declines in their effective rates as
the per-child tax credit jumped from $200 per child to
$1,000 per child. The wealthy saw a sizable reduction
in their taxes as well with the reduction in marginal in-
come tax rates by 3 to 5 percentage points (depending on
bracket), the reduction in the rate at which dividends are
taxed, and the phasing out of the estate tax.
One of the central questions of the 2008 presiden-
tial campaign was whether the 2003 tax cuts should be
allowed to expire in 2011. President Bush repeatedly at-
tempted to convince a skeptical Democratic Congress
to make the cuts permanent. Senator McCain vowed to
make them permanent were he elected. Then candidate
and President Obama argued that only those tax cuts
that assisted those making less than $250,000 should be
maintained. As if the point needed more emphasis, he
had a ready response to congressional Republican com-
plaints that only those that paid federal income taxes
should benefit from tax cuts: “I won.” President Obama
and congressional Democrats argued for and ultimately
passed the 2009 stimulus. In it were provisions cutting
taxes for anyone who paid Social Security taxes. This in-
cluded billions of dollars for millions of taxpayers whose
federal income tax liability was zeroed out as part of the
plan. The midterm elections of 2010 constituted a sig-
nificant shift in the other direction as Republicans made
historic gains in both the House and Senate. One conse-
quence of those changes was that the Bush tax cuts were
extended through 2012, setting up an obvious election
issue for both parties. In a democracy such as that which
exists in the United States, elections have consequences,
and regardless of the politics of the time, taxes are al-
ways going to be a focal point for debate.
TABLE 41.3 Hypothetical example of the effect of a 10 percent cut in tax rates on income distribution.
Tax Code where Tax = 10%
of the First $50,000 and 20%
of the Rest
Tax Code after a 10% Cut in
Tax Rates where Tax = 9%
of the First $50,000 and 18%
of the Rest
Before Tax Tax After Tax Tax After Tax
Lower-income person $10,000 $1,000 $9,000 $900 $9,100 Upper-income person $100,000 $15,000 $85,000 $13,500 $86,500 Ratio 10 15 9.44 15 9.51
Summary
You now understand how taxes work and are able
to apply that knowledge and the concepts of hori-
zontal and vertical equity to the U.S. tax code. You
understand the trade-off that exists between sim-
plicity and horizontal equity and understand that
in theory taxes can alter the incentives of people
438 Chapter 41 Personal Income Taxes
to work and save but that little effect has actually
been shown. You know that this has not stopped
policy makers from using taxes to motivate socially
desirable outcomes. Last, you should be able to un-
derstand in a greater context the debates over taxes
that began during the 1990s and continue today.
Key Terms
adjusted gross income (AGI)
capital gains
deductible
deductions
exemptions
filing status
horizontal equity
income effect
itemized deductions
marginal tax rate
neutral
progressive taxation
standard deduction
substitution effect
taxable income
vertical equity
withholding
Quiz Yourself
1. The tax brackets have higher tax rates for more tax-
able income. This makes the federal income tax
a. proportional.
b. regressive.
c. progressive.
d. integrative.
2. Because there are __________________, adjusted
gross income is always __________ taxable income.
a. deductions and exemptions; less than
b. deductions and exemptions; greater than
c. credits; greater than
d. credits; less than
3. The alternative minimum tax has the effect of
limiting
a. income.
b. taxable income.
c. deductions.
d. exemptions.
4. If Congress wants to use $100 billion on tax cuts,
the version that would help a family of four making
$40,000 a year would
a. lower marginal tax rates by one percentage
point.
b. increase the standard deduction by $2,000.
c. increase the child credit by $1,000.
d. index the alternative minimum tax to inflation.
5. If someone is in the 25 percent tax bracket, this
means that _______________ is owed in taxes.
a. 25 percent of his or her salary
b. 25 percent of his or her adjusted gross income
c. 25 percent of his or her taxable income
d. less than 25 percent of his or her taxable
income
6. Which of the following would immediately be more
valuable for most people?
a. A $1,000 increase in the child credit
b. A decrease in the degree to which brackets are
inflation-indexed
c. An indexing of the alternative minimum tax
d. A $2,500 increase in the standard deduction
Short Answer Questions
1. Suppose someone were to say that they earned
$100,000 per year, that they paid less than $10,000
in federal income taxes, but that their marginal tax
rate was 25 percent. Could that be true?
2. Use the tax tables in the chapter to compute the
taxes of someone taking the standard deduction,
having a spouse, three children, and $80,000 in
income.
3. Explain why someone who cared about the poor
and energy savings would advocate for a tax credit
rather than a tax deduction if $100 billion was going
to be devoted to tax cuts to promote energy-saving
changes to behavior.
4. Explain why an across-the-board tax cut would ben-
efit those at the higher end of the income scale more
than it would affect those at the bottom end.
Think about This
If current law is not changed, the alternative minimum
tax will affect 30 percent of taxpayers. The problem
with fixing it is that doing so only helps the top end of
Summary 439
Hyman, David, Public Finance: A Contemporary Appli-
cation of Theory to Policy, 6th ed. (Fort Worth, TX:
Dryden Press, 1999), esp. Chapters 13 and 14.
Slemrod, Joel, “Do We Know How Progressive the
Income Tax Should Be?” National Tax Journal 36,
no. 3 (September 1983), pp. 361–369.
Slemrod, Joel, Do Taxes Matter? The Impact of the
Tax Reform Act of 1986 (Cambridge, MA: MIT
Press, 1991).
Behind the Numbers
Fiscal year
Federal revenue and income taxes.
Budget of the United States Government; histori-
cal tables—www.whitehouse.gov/omb/budget
/Historicals
Federal tax data.
Income and tax distribution.
Statistics of income—www.irs.gov
Tax tables, rates, exemptions, and deductions.
Internal Revenue Service; publications—www.irs.gov
taxpayers. One solution would be to simply index the
current point at which the AMT kicks in. The longer we
wait, the greater the pressure will be to do something
because the impact will start to affect people who are
not that wealthy. This is what happens when you do not
index brackets for inflation. When should they fix this?
Talk about This
The Democrats tend to work toward tax code adjust-
ments that help those at the lowest end of the income
scale; Republicans do the opposite. As a college gradu-
ate you are likely to start at the low end and become part
of the high end. Are your attitudes about a political party
going to stay the same or change as your income circum-
stances change?
For More Insight See
Boskin, Michael J., “Taxation, Saving and the Rate of
Interest,” Journal of Political Economy 86, no. 2, pt.
2 (April 1978).
Citizens for Tax Justice, The Hidden Entitlements
(Washington, DC: Robert S. McIntyre, 1996).
C H A P T E R F O R T Y - T W O
440
Energy Prices Learning Objectives
After reading this chapter you should be able to:
LO1 Define a cartel.
LO2 Model how a cartel can make its members large sums
of money.
LO3 Show why cartels are not typically stable and describe the
conditions necessary for creating cartel stability.
LO4 Evaluate whether OPEC qualifies as a cartel.
LO5 Summarize the history of inflation-adjusted oil and
gasoline prices.
LO6 Model the role of expectations in determining gasoline
prices and explain why events in the Middle East can cause
prices at the pump to change in a matter of days.
Chapter Outline
The Historical View
OPEC
Why Do Prices Change So Fast?
Electric Utilities
What Will the Future Hold?
Kick It Up a Notch
Summary
The world runs on petroleum products. Whether it
is gasoline for automobiles, diesel fuel for trains and
trucks, or home heating oil, modern society could
not survive without oil. With proven oil reserves at
1,656 billion barrels, roughly 565 billion barrels more
believed to be yet undiscovered, and oil consumption
running at a little over 96 million barrels a day, it is
likely that oil reserves will run out in the second half of
the 21st century.
This chapter reviews the history of oil and gasoline
prices and discusses the causes and effects of significant
changes. We consider the Organization of Petroleum
Exporting Countries (OPEC) and how it developed and
collapsed, recovered and re-collapsed as an effective oil
cartel. We also talk about why gasoline prices seem to
rise and fall much more quickly than supplies would jus-
tify and use the 1999–2016 period as our primary focus.
We look at electricity prices and why the industry lends
itself to monopoly, why this has led to government price
regulation, and why the California experience with de-
regulation was so problematic. Last, we look at the future
and try to get an idea of where the oil industry might be
50 to 100 years from now.
The Historical View
Oil and Gasoline Price History
Gasoline prices, which were never stable, skyrocketed
in the 1970s. Although several events coincided during
that decade to increase prices, many politicians declared
that this period was the beginning of a general long-term
“energy crisis.” A brief look at Figure 42.1 suggests that
the crisis was actually short run in nature. As a matter
of fact, by 1998, the prices of crude oil and gasoline had
fallen to a point at or near their 30-year lows. Crude oil
prices doubled in the 1999–2000 time frame, doubled
again in the 2003–2005 time frame, and doubled once
again from 2007 to July 2008. Non-inflation-adjusted
gasoline prices reached all-time highs of above $4 per
gallon during the July 4th weekend of 2008 and began
a six-month plummet that ended with them dropping in
The Historical View 441
world. You can surmise from this that the politics of the
Middle East, and the Persian Gulf in particular, have
been important in determining oil supplies.
The Arab–Israeli wars of 1967 and 1973 generated
a great deal of animosity between Arab nations and the
Western world. The United States in particular was cas-
tigated because it supported Israel. The United States
provided both substantial intelligence and support in
material that helped the Israelis to prevail in taking
(in 1967) and then holding (in 1973) the West Bank of
the Jordan River from Jordan, the Golan Heights from
Syria, and the Gaza Strip and Sinai peninsula from
Egypt.
After this, Arab nations, angered by U.S. aid to Israel,
refused to sell oil to the United States and much of the
rest of the Western world. Though this did not lead to the
rationing of gasoline in the United States, it did in Great
Britain. This embargo also resulted in marked increases
in prices. Figure 42.1 indicates that these first jumps in
oil prices occurred in 1973 and 1974.
The significant price increases that came about
in the late 1970s resulted from the economic power
that OPEC wielded as an oil cartel. How cartels come
about and how they can raise prices substantially will
be thoroughly explained later in this chapter; but suf-
fice it to say, in inflation-adjusted terms, crude oil and
gasoline prices reached record highs during this time.
Gasoline hit $1.40 a gallon, the 2015 equivalent of
$3.65, and crude oil hit $40 a barrel, the 2015 equiva-
lent of $104.
some areas of the United States to below $1.30 per gallon
by Christmas 2008. Crude oil prices fell nearly 75 percent
during that same span. Prices climbed steadily back once
the Great Recession ended and spiked in early 2011 as
turmoil in the Middle East created significant uncer-
tainty about oil availability.
The top curve in Figure 42.1 shows the path of gaso-
line prices (adjusted for CPI-measured inflation) since
the general conversion to unleaded fuel in 1978. The
middle curve tracks the price of domestically produced
crude oil, and the bottom curve shows the price of im-
ported crude. Though oil prices are usually quoted in
barrels, the prices have been converted to gallons for use
here, and the prices have been adjusted for inflation.
Geopolitical History
Some geopolitical history here will provide insight into
why oil prices changed as they did. As you can see from
Table 42.1, oil is not evenly distributed throughout the
FIGURE 42.1 Inflation-adjusted gasoline and domestic and imported crude oil prices, 2015 (2005 dollars).
Source: U.S. Energy Information Administration, www.eia.gov
0
0.5
1
1.5
2
2.5
3
3.5
1 9 7 3
1 9 7 5
1 9 7 7
1 9 7 9
1 9 8
1
1 9 8
3
1 9 8 5
1 9 8
7
1 9 8
9
1 9 9
1
1 9 9
3
1 9 9
5
1 9 9
7
1 9 9
9
2 0 0 1
2 0 0 3
20 05
2 0 0 9
2 0
1 1
2 0
1 3
2 0 15
20 07
Year
P ri
c e
p e
r g
a ll o
n ( $
)
Real gasoline (all grades) Real domestic crude Real import crude
TABLE 42.1 Global reserves by region.
Source: U.S. Energy Information Administration, www.eia.gov
Group
Barrels in
Reserve
(in billions)
Percentage
of World
Reserves
Persian Gulf OPEC 793 48
Non-Persian Gulf OPEC 413 25
Rest of the world 450 27
442 Chapter 42 Energy Prices
During this time in Iran, the Ayatollah Khomeini took
over from the deposed Shah, making neighbors such as
Iraq, Kuwait, and Saudi Arabia very nervous. There is
some dispute as to who the aggressor was, but these fears
proved to be well founded, when in 1980 Iran and Iraq
went to war. Although this war had many impacts more
morally significant than its effect on the price of oil,1
the impact on the price of oil changed the business of
oil forever.
Because modern weapons are expensive, because
both Iran and Iraq were strapped for cash, and be-
cause each country had only one realistic way of rais-
ing money, each began to sell as much oil as it could.
While their official production figures do not show it,
likely because they had to lie to fellow OPEC members,
greater production allowed them to purchase more and
better weapons.
As oil prices rose through the 1970s, Iran and Iraq
began to pump more oil. Additionally, other nations
engaged in efforts to find new sources of oil. New re-
serves were found in the North Sea, in Mexico, and in
many other countries, and these reserves began to be
exploited. In 1982 and 1983 a major recession rocked
the United States and Europe, depressing demand for oil.
As a result of these factors, the price of oil collapsed.
Ultimately, by 1986 the price per barrel of oil fell to less
than $10, and the average price of oil at the end of the
year was $12.51.
When the Iran–Iraq war ended in 1988, oil prices
began to recover but reached only the $15 level—a little
more than 30 cents a gallon. At the end of the war, Iraq
owed Saudi Arabia and Kuwait $40 billion each, as it had
borrowed feverishly to buy weaponry. At $15 a barrel
Iraq could not afford to both pay these debts and rebuild
its war-torn country. Adding to the insult that Iraq felt,
Kuwait and Saudi Arabia were not budging on OPEC
production quotas, and Iraq felt that it had done Kuwait
and Saudi Arabia a favor by fighting Iran in the first
place. As we will see later when we discuss cartels, pro-
duction quotas must be held down to keep prices high.
On August 2, 1990, Iraq invaded Kuwait, and the
United States was convinced it was poised to continue
the attack into Saudi Arabia. The fear of another war in
the Persian Gulf sent oil prices to nearly $30 a barrel
very quickly, which caused the average price for the year
to be $20 per barrel. With the American- and British-led
victory in the Gulf, prices calmed down and until 1998
fluctuated between $10 and $15 a barrel.
Since that time OPEC has reasserted itself with a
series of production cuts that led the price of crude oil to
top $30 a barrel in the spring of 2000. Another po litically
inspired set of price swings occurred in the run-up to and
aftermath of the Iraq war in 2003. Gas prices spiked at
over $2 per gallon in many U.S. cities in the month before
the war. Once the conventional aspect of the war ended
without major petroleum shortages, the price of gasoline
came back to a more normal level. Between 2003 and
2005 the Iraqi insurgency prevented a continuous flow of
oil from that country and, coupled with increased world-
wide demand for oil, prices spiked once again. Historical
highs were set in 2004 and 2005 in nominal terms, and for
the first time in 25 years, the inflation-adjusted record
price for oil began to be challenged. Inflation-adjusted
gasoline prices briefly exceeded record levels in the
weeks following Hurricane Katrina. Events in 2006,
2007, and 2008 propelled prices even higher. In 2006
the Bush administration was warning Iran against pursu-
ing nuclear weapons. Oil markets reacted with signifi-
cant concern that the administration was contemplating
military action. At the same time, continued conflict in
Nigeria and growing world demand from China and India
were driving up prices. In 2007 and into 2008 investors
looking for a place to make money started driving up
world crude oil prices. Their bet was that the growth of
China and India coupled with the flattening of world oil
production would create a severe oil shortage. (Note in
Figure 42.2 that at 85–88 million barrels per day, world
oil production was stagnant from 2005 through 2011.)
The Middle East in general and the Persian Gulf in
particular have proven that they can rival the Balkans in
the old adage that “they produce more history than they
can consume locally.” The price of oil is inextricably tied
to the political, military, and religious tensions of the re-
gion, tensions that are historically significant but would
likely be dismissed in the West were it not for the oil.
A Return to Irrelevancy
Though the Great Recession caused prices to temporar-
ily plummet from $150 per barrel down to below $40
per barrel, the economic recovery of 2009–2014 helped
OPEC restore its long-run price targets of $100/barrel.
What happened next was a repeat of the experience of
the 1980s.
There is a cliché in economics that goes: “The cure
for high prices is high prices.” That economic truism re-
sults from the motivation to innovate. That motivation is
1Iraq first used poison gas on Iranian soldiers and its own citizens, Iranians
recruited children to serve as soldiers, the Reagan administration sold the
Iranians weapons while using the profits to fund the Nicaraguan contras, and
the CIA gave intelligence support to Iraq.
The Historical View 443
the cartel is large, any price-increasing reduction in pro-
duction of the cartel can be quickly matched by price-
decreasing extra production by the outsiders.
The opposite economic truism, “the cure for low
prices is low prices,” can also be seen in Figure 42.3 that
maps 2014–2016 oil prices against data on oil rig counts.
When the price of oil plummeted from $100 per barrel
in 2014 to under $30 per barrel in 2015, many produc-
ers waited to see if the new lower prices would remain.
When they did and after losses mounted, they stopped
drilling. The number of active rigs in the United States
dropped from 1600 to below 400.
The reason for the lag can be explained by the shut-
down condition. Remember that just because a firm is
losing money does not mean it will immediately stop
producing. As long as the price is greater than average
variable cost—which in this case is the cost of running
the rig once you have located the oil—the firm will pro-
duce. It was only when the price dropped below the aver-
age variable cost or when the operators had to move the
rig to another place that drilling slowed down. The long-
run drop in prices eventually reduced production. Lower
levels of supply caused prices to rise to around $50 per
barrel in mid-2016.
One other thing that happened between 2014 and
2016 was that oil production became much more elastic.
For many years, oil production had been stable. Prior to
2014, every well was producing oil as fast as it could and
stoked by high prices. In the early 1980s the high prices
of the day directly motivated the search for and the pro-
vision of oil in places that it was previously known to
exist but thought to be to too difficult to extract: Alaska,
the North Sea, and the Gulf of Mexico. Those new sup-
plies eliminated the prerequisite monopoly power cartels
need to create artificially high prices via the conspirato-
rial restriction of output. Fairly quickly $40 per barrel oil
dropped below $10 per barrel.
In 2014, three technologies came to full fruition:
hyper-accurate seismologic imaging, hydraulic fractur-
ing, and directional (usually horizontal) drilling. The
first allowed oil companies to find mini-pockets of oil
and precisely map their size and location. The second
allowed those companies to, if necessary, break up the
rock in which the oil was located so as to allow it to be
profitably pumped. The third allowed those companies
to go get the oil by drilling one vertical bore and then to
turn their drill bits horizontally to get each mini-pocket
one at a time. From new oil fields in North Dakota to re-
opened ones in Texas and Oklahoma, U.S. oil production
increased markedly.
OPEC could no longer restrict output sufficiently to
increase its profits. An unmercifully complicated eco-
nomic diagram will be mercifully skipped in favor of this
relatively straightforward assertion: In order for cartels
to keep prices high, the production by entities outside
the cartel has to be limited. When production outside
FIGURE 42.2 Worldwide oil production, 1970–2014.
Source: U.S. Energy Information Administration, www.eia.gov
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
1,00,000
90,000
19 70
19 72
19 74
19 76
19 78
19 80
19 82
19 84
19 86
19 88
19 90
19 92
19 94
19 96
19 98
20 00
20 02
20 04
20 08
20 10
20 14
20 12
20 06
Year
P ro
d u
c ti
o n
( th
o u
s a
n d
b a
rr e
ls a
d a
y )
OPEC Non-OPEC World
444 Chapter 42 Energy Prices
By way of illustration on a small and personal scale, look at the
Google-Earth image of my place of employment: Indiana State
University. A dormant and capped oil well on a campus parking
lot inspired the (obviously not-by-coincidence former professor-
of-petroleum-engineering-turned-) university president to have a
company look for oil on campus. Using the new seismological tech-
nology they were able to find several mini-pools of oil on or near
campus. One was below my church, Central Presbyterian (the build-
ing directly below the “H” in “Hulman Center”), and the other was
below a recreation field near our principal first-year residence halls.
As was our fate, the university struck oil just as the price of oil was
on its 2014–2015 run from $100 per barrel down to $30 per barrel.
Still it generates more than $100,000 per year in royalties for the
university.
Though a small-scale example, this occurred all over the United
States during this time frame. Thought to be dormant oil fields were
reopened and U.S. production of oil tripled from its 2004 low. On an
aggregated level, these technologies caused the United States to re-
sume its place as the number one producer of petroleum in the world.
O I L B E N E A T H M Y C H U R C H P E W
Oil Well
Pools of Oil
FIGURE 42.3 Oil prices and rig counts.
Sources: www.aogr.com/web-exclusives/us-rig-count/2011 and www.eia.gov
0 0
20
40
60
80
100
120
200
400
600
800
1,000
1,200
1,400
1,600
1,800
1/ 7/
20 11
4/ 1/ 20
11
6/ 24
/2 01
1
9/ 16
/2 01
1
12 /9
/2 01
1
3/ 2/
20 12
5/ 25
/2 01
2
8/ 17
/2 01
2
11 /9
/2 01
2
2/ 1/ 20
13
4/ 26
/2 01
3
7/ 19
/2 01
3
10 /1 1/ 20
13
1/ 3/
20 14
3/ 28
/2 01
4
6/ 20
/2 01
4
9/ 12
/2 01
4
12 /5
/2 01
4
2/ 27
/2 01
5
5/ 22
/2 01
5
8/ 14
/2 01
5
11 /6
/2 01
5
1/ 29
/2 01
6
4/ 22
/2 01
6
Week
N u
m b
e r
o f
o il r
ig s
W T
I s p
o t
p ri
c e
( $
/b a
rr e
l)
OPEC 445
agreement, prices will rise. Recall from Chapter 5 that in
the long run and under perfect competition the price of
a good will equal both the marginal cost and the average
cost. If prices rise, profits rise and all of the members of
the cartel are happy.
Why Cartels Are Not Stable
This is not the end of the story, though, because cartels
such as these are not stable. Let’s look at an intuitive rea-
son why. Suppose your teacher in this class announced,
at the beginning of the semester, that exams would be
graded on a curve. This would mean that regardless of
how well people did on exams, a predetermined percent-
age of students would be assigned As, Bs, Cs, Ds, and
Fs. A clever class of students would band together to
make a joint promise not to study. They would reason
that if they all studied, they would end up ranking exactly
the same (based on their aptitude for economics) as they
would if they did not study at all.
Let’s add here the outlandish assumption that stu-
dents have no desire to study economics for fun and
that they just want the grade for as little effort as pos-
sible. What would happen then? Would no students
study? The scheme might work for the first quiz, but it
would start falling apart as one or more students even-
tually sneaked off to study. They would see that it was
in their interest to study because they could get bet-
ter grades. Eventually, other students would notice that
some were cheating. They would see their own grades
drop in relation to those of their peers as the cheat-
ers passed them by. Non-cheaters would then start to
cheat—that is to say, they would study. If, as we specu-
late, everyone ends up studying as they would without
the prior agreement, then the agreement has become
meaningless.
This is rather close to what happened with OPEC.
Countries saw that they could make money by cheating
even a little. A country committed to cheating would see
that cheating paid because at their agreed-upon produc-
tion their marginal revenue (the new high cartel price)
was greater than the marginal cost so the country could
make a profit. That profit would greatly exceed the profit
previously received at the cartel’s imposed quota. As in
our previous example, using grading on a curve where
everyone schemed together, individual greed induced
cheating on the collective, and this caused all gains to
evaporate. Cheating by OPEC members led not only
to the disappearance of the large profits but also to the
evaporation of all economic profits.
as fast as the laws of physics would allow. Now there are
oil wells that get turned on at $40 per barrel, still more at
$45, and still more at $50.
OPEC
What OPEC Tries to Do
In the preceding historical survey of the price of oil, we
alluded to the important part OPEC has played. OPEC
is a cartel (an organization of individual competitors that join to
form as a single monopolist) that
is composed of Algeria, Angola,
Ecuador, Indonesia, Iran, Iraq,
Kuwait, Libya, Nigeria, Qatar,
Saudi Arabia, United Arab Emirates, and Venezuela:
countries that export oil. Taken together, they have, as
Table 42.1 shows, 73 percent of the proven oil reserves in
the world. There was a time when this gave them enormous
political power to wield. Through the 1990s, however,
oil prices were such that the cartel seemed to be power-
less, only to be revived in 1999 and 2000. How did all
this happen?
When groups of people, firms, or countries have lit-
tle power as individuals but perceive their joint power
as great, they hypothesize themselves as a joint force.
If something exists or arises that binds them together
and there are not too many of them to organize, there
is a chance they can pull it off. These ingredients were
present when, in the late 1960s and early 1970s, Middle
Eastern oil-exporting countries saw that together they
could punish Israel’s main supporters and make a profit
at the same time.
This turned a loose organization, OPEC, into a pow-
erful oil cartel. Cartels can exist in many different in-
dustries where a small number of competitors make up
the vast majority of the suppliers of a commodity. The
trouble is all cartels have a self-destructive tendency and
OPEC was no different.
How Cartels Work
Cartels work because the individual perfect competi-
tors join forces to act like a monopolist. In order to do
this they must agree on a mechanism to withhold their
goods from the market. In OPEC’s case, that means they
must, together, agree on a plan to reduce oil production.
That plan usually means that each country must limit its
production to a fraction of what it was producing before
they formed the cartel. If they succeed in getting that
cartel An organization of individual competitors that join to form a single monopolist.
446 Chapter 42 Energy Prices
Putting another nail in the coffin of OPEC was the
introduction of other, non-OPEC countries into the
mix. A large importer, Great Britain, motivated by high
prices to find its own sources, found oil in the North
Sea. Moreover, it found enough to both solve its own
problems and become an exporter. Mexico and other
countries also found oil and began selling it in large
quantities. Although OPEC tried to persuade these
countries to join in a larger, more powerful cartel, none
agreed. They reasoned that they could still sell at or
slightly below the cartel price, and they could do so
without any production quotas. Figure 42.2 highlights
this fact by showing that, as a percentage of total world
production, OPEC is no longer the biggest producer.
Other nations are producing oil and taking market share
from OPEC.
Back from the Dead
The 1990s saw oil prices fall dramatically and remain
below historical averages until 1999, when prices took
a sudden jump higher. How did OPEC, which seemed
dead, come back to life? In fact, the potential profitabil-
ity of OPEC never disappeared. It was only the behavior
of the individual countries that dissipated potential prof-
its. Throughout 1998 and 1999, OPEC began a series
of production cuts that eventually totaled 4.3 million
barrels a day. They thus drove up world prices. Unlike
previous oil price spikes, they chose to let up before a
major inflation episode struck the United States. Thus
OPEC was back in the saddle again, controlling world
oil prices.
Why Do Prices Change So Fast?
It takes months for an empty tanker to leave the United
States, arrive in the Persian Gulf, be loaded with crude
oil, arrive back in the United States, be offloaded, and the
crude oil to be refined into gasoline. If that is true, how
is it possible that the price of gasoline at a neighborhood
gas station can change by 20 percent in a week? The an-
swer takes us back to Chapter 2 and the determinants of
supply and demand. Remember that the expectations of
the future price of a good affect both the current supply
curve and the current demand curve.
Remember, too, that if the price is expected to rise,
then on our supply and demand diagram there will be
little to no delay in the demand curve’s moving to the
right and the supply curve’s moving to the left. This
is because consumers will want to stock up before any
price increase fully takes effect and producers will
want to hang on to what they have in hopes of being
able to sell it for more later. The impact of this is that
prices will rise now in anticipation of price increases
later.
To see how this works in the oil industry, recall the re-
action in the United States to Iraq’s invasion of Kuwait.
Within days gasoline prices went up by as much as
25 cents per gallon. How did this happen? Starting with
the oil-importing companies and ending with the gas
stations, each wanted to buy and store all the product
it could before the prices went up. Normally, no one
in gasoline production keeps significant quantities in
storage. It costs money to store oil and other petroleum
products.
The oil companies thus hurried to fill their tankers
before the price went up too far. Refineries got in the act
by rushing to get tankers lined up to sell them their crude
before the price went up too far; distributors did the same
thing, and so did gas stations. At every stage, the demand
for product rose because firms wanted to put as much
cheap input in storage as possible. They would then have
more when the prices rose.
Also true in such circumstances is that at every stage,
firms do not want to sell out of their storage to provide
someone down the line with product to store—that is,
unless the buyer is willing to pay more. Prices rise and
storage tanks fill up. If there were an actual gasoline
shortage, this would not be bad: It would be beneficial to
have the extra oil in storage.
When prices are anticipated to fall, the opposite hap-
pens: Firms attempt to get rid of product. Because firms
will want to get as much as possible for the gasoline that
is in storage and will empty storage tanks only when it
is clear that prices will in fact fall, prices decrease more
slowly than they increase. Prices did fall after the Gulf
War, and they fell by more than the 25 cents they had
increased, but the decrease took much longer than the
increase had taken.
The ultimate example of rapid price swings based on
price expectations occurred the afternoon and evening
of September 11, 2001. In response to concerns, both
real and imagined, over the availability of gasoline,
prices at some stations tripled. Some stations, particu-
larly in the Midwest, were charging $1.40 per gallon
in the morning hours prior to the terrorist attacks and
were charging more than $4.00 per gallon later that
day. While some price increase could be explained by
changes in wholesale prices (they increased between
Why Do Prices Change So Fast? 447
it take only hours for price increases to be reflected
across town? The answer to these questions revolves
around the fact that the industry is governed by oligop-
oly. The neighboring stations must keep their prices at
or below one another so when wholesale prices change
there is a natural tendency for the resulting retail prices
to come out close. In most communities, though there
are many gas stations, there are but a few wholesale
suppliers. The wholesale suppliers face rapidly chang-
ing national spot markets for gasoline and keep their
prices in line with their competitors (few as they may
be) in order to maintain their gas station customer base.
Since only a few wholesalers are selling to the same
set of retailers at the same wholesale price, and since
those retailers are pricing according to the replacement
cost of the gasoline, it should not be surprising that
gas prices seem to change at the same time across a
community.
From $1 to $4 per Gallon in 10 Years?
We need to take a step back to understand something
about the “price” of oil. As Table 42.2 shows, there is
not one price. Every grade and type of crude oil has a
price based on the ease with which you can refine it into
saleable products like gasoline. As a result there can be
a 25 percent difference in the crude oil price between the
output of countries and even within countries. When oil
prices are referred to on the news, they typically choose
a representative type. The most often-quoted oil prices
are Brent Sea, Saudi Light, and West Texas Intermediate.
Still, by whatever measure, the price of oil skyrocketed
between December 1998 and 2008. For data consistency
purposes the U.S. Department of Energy produces a
weighted average of imported oil prices that it calls the
Refiner Acquisition Cost of Imported Oil. Figure 42.4
shows how that measure increased over the 10-year
period from late 1998 to 2008.
5 and 10 cents per gallon that day), the bulk of the price
jump occurred because of a rumor-fed fear that prices
would dramatically rise if refineries were shut down
or oil imports stopped. While consumer advocates
and attorney generals were upset, consumers in par-
ticular were not blameless. Two-hour gas lines were not
uncommon that afternoon and evening fueled by the
same rumor-fed fear that if they did not fill up then, the
price would be higher the next day. But by morning it
became apparent that refineries were not in jeopardy,
and prices fell to previous levels.
Is It All a Conspiracy?
There is a common view in the general public that gaso-
line prices are all a conspiracy and that deals are cut in
back rooms to set the price of gasoline. Were that true it
would be against the law both federally and in every state
in which it occurred. Absent an explicit conspiracy, what
would explain the fact that prices increase not just rapidly
(which is explained by the “expected price” phenomenon
from Chapter 2) but at almost exactly the same time from
gas station to gas station?
When a station gets its supply, the price it pays
changes to reflect changing wholesale prices. Were
that the end of the story, then prices would change
only when stations got a new supply. The twist is that
the cost of the gasoline in the ground is quite literally
“sunk” and therefore ignored. Remember from Chap-
ter 5 that fixed/sunk costs are ignored when setting the
profit-maximizing price. It is only the cost of replac-
ing that gasoline, its opportunity cost, that concerns the
profit-maximizing gas station. Since that price changes
daily, even if the gasoline in the underground tank is
a week old, gas stations will adjust their price daily to
reflect the cost of replacing it.
Why would the prices at neighboring gas stations
change within minutes of one another, and why would
TABLE 42.2 Crude oil prices, various types*.
Source: U.S. Energy Information Administration, www.eia.gov
Price of Oil
Variety of Oil Apr-07 Jul-08 Jan-09 Apr-11 May-13 Mar-16
West Texas
Intermediate $63.98 $133.37 $41.71 $109.53 $94.51 $37.55 Brent Sea (U.K.) $67.49 $132.72 $43.44 $123.26 $102.56 $38.21
Saudi Light $62.65 $116.08 $38.70 $117.81 $101.92 $35.29
*The quoted prices for West Texas Intermediate and Brent Sea are spot prices, whereas the quoted prices for Saudi Light are landed costs.
448 Chapter 42 Energy Prices
What caused this rapid increase in prices? The
short answer is increased world demand coupled with
problems in the world oil supply chain brought about
by increased OPEC discipline, political unrest in oil-
producing countries, and the U.S.-led war in Iraq.
Gasoline prices, which tend to closely follow crude
oil prices, were also impacted by limited U.S. refining
capacity.
The main factors in increasing demand between 2002
and 2008 were the global economic expansion coming
out of the 2001 recession; the significant increase in
miles driven by the typical American; the substitution
by Americans from more fuel-efficient cars to less fuel-
efficient vans, pickups, and SUVs; and the long-term
expansion of demand in India and China.
Americans have steadily migrated to less fuel-efficient
vehicles. Whereas cars made up 70 percent of the U.S.
fleet in the late 1990s, they now make up 60 percent.
Though the fuel efficiency of cars has increased and
the fuel efficiency of vans, pickups, and SUVs has in-
creased, the impact of moving to the larger vehicle has
totally eliminated the benefit of greater gas mileage. As
you can see from Figure 42.5, this increase in demand,
combined with a variety of supply issues, caused gaso-
line prices to spike.
Chinese demand for petroleum has increased mark-
edly as well. Once a net exporter of fuels, China is now
a leading importer. Over the last 16 years while global
petroleum demand has increased 24 percent, China’s
petroleum demand increased 159 percent. Over the next
10 years China is expected to account for 34 percent of
the increase in world oil demand.
Just as there is more than one variety of oil, there
is also more than one variety of gasoline. Gasoline is
not simply “regular,” “plus,” or “premium.” For envi-
ronmental reasons gasoline is formulated for the par-
ticular climate and environmental conditions of local
areas as well as state and local laws. Gasoline prices
are also impacted by state and local taxes. These taxes
average 26.5 cents per gallon, with Pennsylvania,
Washington, and California topping the charts at 51.4,
44.62, and 37.16 cents, respectively, and Alaska, New
Jersey, and South Carolina having the lowest taxes, at
9, 14.5, and 16.8 cents, respectively.
Though gasoline can be imported directly, more than
90 percent of gasoline is produced by a limited number
FIGURE 42.4 Reiner acquisition cost, December 1998–January 2009.
Source: U.S. Energy Information Administration, www.eia.gov
145
105
125
85
65
P ri
c e
p e
r b
a rr
e l
25
45
5
D ec
-9 8
Ju n-
99
D ec
-9 9
Ju n-
00
D ec
-0 0
Ju n-
01
D ec
-0 1
Ju n-
02
D ec
-0 2
Ju n-
03
D ec
-0 3
Ju n-
04
D ec
-0 4
Ju n-
05
D ec
-0 5
Ju n-
06
D ec
-0 6
Ju n-
07
D ec
-0 7
Ju n-
08
D ec
-0 8
1
4
5
6
7
2
3
1—OPEC production cuts; low stocks of oil; bad weather. 2—Release of oil from the Strategic Petroleum Reserve; recession. 3—Political unrest in oil-producing Venezuela and Nigeria; war in Iraq. 4—Hurricanes damage platforms in the Gulf of Mexico. 5—Threatened conflict between the U.S. and Iran; Nigerian civil war heats up. 6—Global commodity speculation given increases in Chinese and Indian demand and stagnant production. 7—Global financial crisis and recession.
Electric Utilities 449
system where, if anything goes wrong, prices escalate
rapidly, and for 10 years many things have gone wrong.
Electric Utilities
Electricity Production
While it took more than a century for Edison to capitalize
effectively on Benjamin Franklin’s dreams for electricity
with his lightbulb, it did not take that long for the United
States to become dependent on it. Similarly, while the
motivation for building the Hoover Dam may have been
economic stimulation, flood control, and irrigation, the
by-product of cheap electricity was credited with allow-
ing millions to live and find work in southern California.
For the most part, electricity is produced by regulated
utility companies. These companies incur substantial
fixed costs that present nearly insurmountable barriers
to entry. These fixed costs include the power plant it-
self as well as the transmission lines and transformers
that get the electricity into homes so that consumers can
use it.
Their variable inputs are sometimes nearly free, as is
the case with hydroelectric, wind, and solar power; but
more typically, oil, natural gas, coal, or nuclear fuel must
be purchased. Where you live often determines how
your electricity is produced. Nationally, burning coal
to produce electricity through steam turbines accounts
for 40 percent of electricity produced. Nuclear power
accounts for 20 percent of electricity production, while
of refineries in the United States from crude oil that is in-
creasingly imported. Figure 42.6 shows the location and
capacity of refineries in the United States. Of significant
note is that the refineries along the Gulf Coast of the
United States are susceptible to hurricanes. The four hur-
ricanes that hit the area in the summer and fall of 2004,
and five more in 2005, highlighted this particular bottle-
neck. In 2004, with the hurricanes coming in one after
the other, ships carrying crude oil from Venezuela and
Africa could not make it to port, thereby constraining
U.S. supplies of gasoline. Hurricane Katrina decimated
the Port of New Orleans and in the process dramatically
affected gasoline prices in the late summer and early fall
of 2005.
Who is to blame for all this? Mostly ourselves. The
U.S. government has chosen to limit new exploration and
the creation of more refining capacity, largely for envi-
ronmental reasons. The BP spill in the Gulf of Mexico
only underscored the doubt many Americans had regard-
ing the potentially enormous consequences of drilling in
environmentally sensitive locations. It also doesn’t help
the situation that Americans generally are to blame for
driving more miles and driving less fuel- efficient cars.
The war in Iraq cut supplies coming from that country,
with Iraqi oil production still not back to pre-invasion
levels. Blaming the Chinese for increasing their appe-
tite for driving is the “pot calling the kettle black,” but
they are, so we can blame them too. Finally, OPEC has
become far more disciplined in its management of cartel
prices. In the end, we are running on a global energy
FIGURE 42.5 Gasoline prices, December 1998–January 2009.
Source: U.S. Energy Information Administration, www.eia.gov
90
140
190
240
290
340
390
440
12 /7
/19 98
6/ 7/
19 99
12 /7
/19 99
6/ 7/
20 00
12 /7
/2 00
0
6/ 7/
20 01
12 /7
/2 00
1
6/ 7/
20 02
12 /7
/2 00
2
6/ 7/
20 03
12 /7
/2 00
3
6/ 7/
20 04
12 /7
/2 00
4
6/ 7/
20 05
12 /7
/2 00
5
6/ 7/
20 06
12 /7
/2 00
6
6/ 7/
20 07
12 /7
/2 00
7
6/ 7/
20 08
12 /7
/2 00
8
Date
P ri
c e
i n
c e
n ts
/g a
l
450 Chapter 42 Energy Prices
natural gas accounts for as much as a third of electricity
production during the summer months and as little as
20 percent during winter months. Hydroelectric power
and other renewables account for the remainder.
The distribution of that reliance varies substantially
across the country. The Pacific and Mountain West regions
produce 15 to 20 times the amount of electricity through
the turbines of their dams than does New England.
Nuclear power provides almost 70 percent of the elec-
tricity usage in Connecticut, but nothing in Washington
State and less than 10 percent in Maine. Not surprisingly,
burning coal is a main source of electricity where coal is
abundant.
Why Are Electric Utilities a Regulated Monopoly?
Because of the high fixed costs of production, the
residential electricity market is characterized by monopoly
because these costs tend to deter entry. Whether or not the
proper model for this market is that of a natural monopoly
or a simple monopoly depends on the type of electricity
produced and the distance of transmission.
A natural monopoly exists when there are high fixed costs and diminishing marginal costs. In nu-
clear and hydroelectric power
the variable costs are low. In
nuclear power the rods them-
selves are cheap, relative to
the amount of coal that would
have to be purchased to produce the same electricity.
On the other hand, the personnel that are required at a
nuclear facility are highly trained and compensated, on
top of which when things go wrong at a nuclear facility,
they can go terribly wrong. In hydroelectric power, the
variable input is free since the water that drives the tur-
bines does so because of gravity. In both cases the cost
of the facility is enormous relative to the costs of the
variable inputs. Even when coal, oil, or natural gas are
burned to generate electricity, the market tends toward
monopoly because of the high fixed costs of the trans-
mission network.
natural monopoly Exists when there are high fixed costs and diminishing marginal costs.
FIGURE 42.6 Reinery locations and capacity in the United States.
Less than 10,000 barrels/day 10,000 to 99,999 barrels/day 100,000 to 250,000 barrels/day 250,000 or more barrels/day
What Will the Future Hold? 451
monopoly. In either case the price is substantially above
the marginal cost. This, combined with the fact that peo-
ple need electricity to live a modern life, led to the wide-
spread regulation of prices for electric utilities.
Figures 42.9 and 42.10 show the likely regulated
prices that would exist if the regulators sought to allow
the electric companies normal profits.
What Will the Future Hold?
Oil reserves are likely to be almost entirely depleted
before the end of the 21st century. What will hap-
pen? Will we revert to the Stone Age once all the oil
is gone? No. There are no perfect substitutes for oil
and gas today, but there are some serviceable ones. We
already use vegetation-based fuels; and we produce
electricity with geothermal and solar power and with
wind. As supplies decrease, more efficient uses of
petroleum will be invented. Why are economists less
worried about the end of fossil fuels than are people
in other fields? Economists, who are not usually ac-
cused of making Pollyanna-ish predictions, are con-
vinced that normal human self-interest will be more
than adequate to spur on the important innovations that
will be needed.
A lot of money will be made as we find substitutes
for fossil fuels. As these fuels become more scarce and
we exhaust all sources of them, they will become more
and more expensive. Moreover, prices will not fall in the
latter half of the 21st century. This will spur investment,
and investment will spur innovation. It always has and it
always will.
Consider this: If you were an oil company and you
anticipated the end of your current form of business,
Figure 42.7 shows what the price-output combina-
tion would be in an unregulated market for electricity in
the case of a simple monopoly while Figure 42.8 shows
the price-output combination for an unregulated natural
FIGURE 42.7 A simple monopoly.
Q/tQmonopoly
Pmonopoly
P
O
MR D
MCmonopoly
FIGURE 42.8 A natural monopoly.
Q/tQmonopoly
Pmonopoly MCnatural monopoly
ATCnatural monopoly
P
O
MR
D
FIGURE 42.9 A regulated simple monopoly.
Q/tQmonopoly Qregulated
Pmonopoly
Pregulated
P
F
O
MR D
MCmonopoly
FIGURE 42.10 A regulated natural monopoly.
Q/tQmonopoly Qregulated
Pmonopoly
Pregulated
P
O
MR
D
MCnatural monopoly
ATCnatural monopoly
452 Chapter 42 Energy Prices
you drilled down and hit the oil, only a small portion
would be recoverable with that method. The oil was
too thick to flow toward the well. In the last 10 years,
horizontal drilling and hydraulic fracturing (dubbed
“fracking”) has unleashed three or more decades’
worth of natural gas in Pennsylvania, and the same
process is just now beginning to be exploited in North
Dakota. The potential is now that this oil could com-
pletely supply U.S. needs that have heretofore come
only from imported oil. It is only because oil prices
rose during the last decade that anyone bothered to
consider this possibility. At $100 per barrel, interest-
ing drilling tactics are profitable that are not so profit-
able at $40 per barrel.
Nearly any problem can be solved with the proper in-
centive, and profit is one of the oldest and most effective
incentives of all.
you would spend as much money as it took to figure
out a way to continue to sell fuels to your current cus-
tomers. You would spend money on a variety of prom-
ising leads. You would try, for example, to figure out
how to use renewable corn or soybeans to fuel existing
cars, and, if that did not work, you would experiment
with high-power, quick-charge batteries that you could
sell so cars could run on electricity without the cur-
rent problems of slow acceleration and long recharge
times.
Evidence of the power of the profit motive is all
around us. It has been known for nearly a half century
that there was thick oil in relatively thin layers of rock
in the Bakken formation, a deposit of oil shale that
runs from North Dakota through eastern Montana and
into southern Canada. It was simply too expensive to
exploit using conventional vertical drilling, because if
Kick It Up a Notch
Going back to the question of how cartels work, con-
sider Figure 42.11. On the left panel is the market for
oil. If the market were governed by perfect competition,
then the price–quantity combination would be P comp
,
Q comp
. This price would be carried over to the right
panel, which would show the cost functions of a repre-
sentative oil- producing country. Recall from Chapter 5
that the long-run equilibrium in such a market would
mean that the price line would come tangent at the
bottom of the average total cost (ATC) curve, where
it would also intersect marginal cost (MC). Thus the
representative oil-producing country would sell q comp
,
because this is where marginal revenue (MR) intersects
marginal cost (MC). At this level of production, they
would make only normal profit, that is, the profit con-
sistent with the return expected in other industries.
If they joined a cartel with other, similar countries, then
the model for the market would be monopoly rather than
FIGURE 42.11 A model of a cartel.
b
MR
Market Representative country
MC
ATC
MRʹ
MR
Q/t q/t
P P
a
d f
e
c g
D
Pcomp
Pcartel
QcompQcartel qcomp
qcheatqquota
Scomp = MCcartel
Summary 453
Summary
Now that you have completed this chapter, you know what
a cartel is, that OPEC is a major oil-producing cartel, why
it is that cartels work to make their members large sums
of money, why it is that they are not stable, and that they
seem to be able to rise again from the dead. You know that,
inflation adjusted, the price of oil and the price of gasoline
have been historically unstable and that this instability has
been a consequence of geopolitics and the inherent instabil-
ity of cartels. You understand why it is that events in the
Middle East can alter prices at the pump within a few days.
1. In order to compare the price of gasoline in the 1970s
with the price in any other year, you have to adjust for
a. the availability of oil.
b. the price of oil.
c. overall inflation.
d. unemployment.
2. The heaviest concentration of proven oil reserves is
found in
a. Alaska.
b. the North Sea.
c. the Persian Gulf.
d. Texas.
3. When a group of competitors joins together to form
a monopoly, they are forming a
a. cartel.
b. coalition.
Quiz Yourself
Key Terms
cartel natural monopoly
c. union.
d. trust.
4. Cartels are considered ________________ because
each participant is motivated to ________________.
a. stable; work with each other cooperatively
b. stable; work in their own interest to produce more
c. unstable; work with each other cooperatively
d. unstable; work in their own interest to produce
more
5. Gasoline prices in early 2007 were above $2.25.
They were
a. the highest nominal prices and highest
inflation-adjusted prices in American history.
b. the highest nominal prices but were not the
highest inflation-adjusted prices in American
history.
perfect competition. If that were the case, then the cartel
would jointly produce only Q cartel
and would charge P cartel
because that’s where marginal revenue (MR) intersects
marginal cost (MC) on the left panel of Figure 42.11.
Since total production of all countries combined would
be less than before, the representative country’s produc-
tion would also have to be less than it was before. Some
negotiations between the member countries would result
in each one being allocated a quota, labeled q quota
. If the
representative country produced q quota
and received P cartel
per barrel, it would make an economic profit, that is,
profit above normal, in the amount of abcd.
Cartels are not stable because cheating pays. The
right-hand panel of Figure 42.11 shows this; see that
q quota
marginal revenue MR′ was greater than the mar-
ginal cost MC. Countries that cheated did so hoping
that no one would notice. A country committed to
cheating would see that cheating paid. Looking again at
Figure 42.11, you see that at the new high cartel price
P cartel
the country would maximize profit at q cheat
. This is
where MR′ equals MC. That profit, gaef, would greatly
exceed the profit previously received at the cartel’s im-
posed quota. As in our previous example, using grading
on a curve where everyone schemed together, individual
greed induced cheating on the collective and this caused
all gains to evaporate. Cheating by OPEC members led
not only to the disappearance of the large profits (gaef),
but also to the evaporation of all economic profits.
454 Chapter 42 Energy Prices
c. neither the highest nominal prices nor the
highest inflation-adjusted prices in American
history.
d. the highest inflation-adjusted prices but were not
the highest nominal prices in American history.
Short Answer Questions
1. There have been other cartels through history: most
notably drug cartels in the 1980s in Colombia and
during more recent times in Mexico. They never
suffered from cheating. Why?
2. At the height of the 2008 financial crisis, in the time
it took a completely full oil tanker to travel from
Saudi Arabia to the United States, the price of oil
fell nearly $50 per barrel. Use the expected price
formulation to explain how that could happen.
3. What would be the principal obstacle preventing a
cartel from emerging in the production of beef?
4. Why might the cartel model still make sense even
when OPEC produces less than half of the world’s oil?
Think about This
All energy consumption involves externalities that are
recognized. Given that we have spent billions of dollars
militarily defending access to oil, should we consider that
an externality too? Aren’t the consumers of energy indi-
rectly compelling increased spending on the military?
Talk about This
Oil prices are highly sensitive to output changes.
Hurricanes, terrorist acts, and other unexpected oc-
currences regularly cause the price of oil to increase
by 10 percent within the course of a month, only to
fall again when the trouble subsides. Should the fed-
eral government use its strategic petroleum reserve to
counter these effects or should it use the reserve only
in a true emergency?
For Moe Insight See
Adelman, Morris, Genie Out of the Bottle: World Oil
Since 1970 (Cambridge, MA: MIT Press, 1995).
Behind the Numbers
Global energy resource data.
Oil consumption per day.
Global oil reserves by region.
World crude oil production.
Energy prices.
Oil and gasoline prices—www.eia.gov
C H A P T E R F O R T Y - T H R E E
455
If We Build It, Will They Come? And Other Sports Questions Learning Objectives
After reading this chapter you should be able to:
LO1 Apply economic principles to issues of sports.
LO2 Conclude that despite the obvious attempts of cities to
acquire sports franchises through league expansion and by
other means, no economic evidence suggests that having a
franchise enhances a city’s economic stature.
LO3 Analyze how owners decide, when negotiating with players,
whether they wish to make more money or win championships,
since it is clear that teams in small markets cannot do both.
LO4 Summarize the basics of sports labor economics history and
the vocabulary that is central to it.
LO5 Apply the concept of monopoly to motorsports.
Chapter Outline
The Problem for Cities
The Problem for Owners
The Sports Labor Market
The Vocabulary of Sports Economics
Summary
Sports offers an interesting venue in which to ask economic
questions. For instance, if you are the mayor of a city whose
citizens want a sports franchise, are you better off if you get
one from another city, or do you mount a campaign to gar-
ner an expansion franchise? If it will enhance the chances
of getting a franchise, do you build a multimillion-dollar
stadium and hope you get a team to put in it? Now suppose
you are a mayor of a city that already has a franchise whose
owner is threatening to leave. Do you build the franchise
owner a stadium, even though the one the team is in is only
25 years old? The question that underlies all these decisions
is whether a sports franchise is an important economic at-
traction for a city. Mayors make deals all the time to attract
other kinds of major employers. Why not a sports franchise?
To change perspective, suppose now that you are an
owner of a franchise. What would make you want to move
your team to a different city or to hold your own city hos-
tage to build you a stadium? How do you decide whether
to bid for high-priced talent? Can you compete in the
financial arena if you do? Can you compete on the field,
the pitch, the ice, or the court if you do not?
These are all questions that arise in all sports, and
they are all economic in their nature. We answer each by
looking at them from two perspectives: the city’s and the
team owner’s. Since no discussion of the economics of
sports today would be complete without a discussion of
labor, we include that, too. We try to figure out how we
went from sports as games to sports as business.
The Problem for Cities
Expansion versus Luring a Team
One of the emerging trends of the 1990s, like the
1950s, was the sudden increase in the desire among
owners of sports franchises to move their teams from
456 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
money because corporations paid hundreds of thousands
of dollars for luxury boxes.2 Nashville has the same story
to tell as the Oilers moved from Houston. In each case, a
city stood in line, was denied a place at the table, and man-
aged to buy its way in anyway.
In its pursuit of a team, a city has to decide whether it
should build a stadium in hopes that a team and a fran-
chise will come. This “if you build it, they will come”
strategy is fraught with uncertain payoffs. St. Louis built
it, and the Rams did come. St. Louis then failed to reno-
vate it, and the Rams left. St. Petersburg built it, and no
one came. In hopes that the Chicago White Sox would
move, the Tampa–St. Petersburg area built a new stadium,
but, at the last minute, the city of Chicago and the state of
Illinois agreed to build the White Sox a new stadium. The
White Sox are still in Chicago. Though the Tampa Bay
area ultimately got an expansion franchise, the wait lasted
10 years, and the city may have to build another new sta-
dium because the facility in which the team plays is con-
sidered one of the worst places to see a baseball game in
the major leagues. Building in hopes of getting a franchise
sometimes works and sometimes does not. Since it rarely
happens that a city gets a franchise without either a good
stadium or one that is already under construction, build-
ing a new facility may be the only chance a city has, even
though it may not be a very good bet.
While these lessons regarding expansion apply to the
American sports world of the NFL, NBA, MLB, and NHL,
they don’t apply to soccer. Quite literally, a city in England
could get its local club team into the Premier League, Eng-
land’s top league, in just a few seasons. Unlike American
sports, where the franchises are in the league as long as
they wish to be and expansion is quite limited, in European
soccer, the teams have to stay out of the cellar in order to
stay in their respective leagues. At the conclusion of each
season, three soccer clubs are “relegated.” That means they
are dropped from the Premier League down to a lower
league, and the three top lower league teams are promoted
to the Premier League for the next season. A city desiring a
place in the Premier League could, theoretically, purchase
enough talent on the open market for soccer players to win
enough games over enough seasons to go from being a local
soccer club to playing Manchester United (the Yankees of
the Premier League). This also leads to the odd result that
one city to another. Compared to other sports, base-
ball has been relatively stable. It has increased in num-
bers of teams, but existing teams have tended not to
move. Other sports, however, have seen teams move
all over the place. Some of that movement, such as
baseball’s movement west, occurred with the Dodgers
and Giants relocating from New York to California
during the 1950s. That made good economic sense
for the sport at the time. The movement of the Rams
and Raiders out of Los Angeles during the 1990s, on
the other hand, made little economic sense for the
National Football League.1 In nearly all of the recent
franchise shifts, movement has resulted from a city’s
offering enticements to owners. In each case, the fran-
chise owner has made millions.
A city has to decide on its strategy when it seeks to
attract a team. While each sport has added new teams
in the last several years, such expansion is not always
the surest way for a particular city to get a team. In part,
this is because there’s no guarantee that a given sport
will expand or will choose that city. Football and base-
ball added only two teams each between 1970 and 1990.
Though the 1990s have seen increased expansion in both
sports, many cities have waited in line for an expansion
franchise, only to be spurned. When cities lose patience,
they may turn their attention to finding teams that are in
financial trouble and offering their owners the lure of
millions of dollars as well as profit guarantees.
Cities that have been spurned in the expansion pro-
cess and have subsequently sought out financially trou-
bled teams. Some have succeeded in getting them, albeit
at a high cost. After St. Louis lost the football Cardinals
to Arizona, it sought, but was denied, an expansion
team while franchises were granted to Jacksonville and
Charlotte instead. It turned, then, to luring an existing
team. The Los Angeles Rams wanted a stadium built in
Los Angeles containing revenue-producing luxury boxes,
and the owner threatened to move if demands were not
met. As part of its expansion bid, St. Louis was already in
the process of building such a stadium. When Los Angeles
refused to build one, the Rams moved to St. Louis. Before
their Super Bowl year, the team drew fewer fans than it had
drawn in Los Angeles. Nevertheless, the owner made more
1The only economic aspect of the decision not to have a team in the second
largest city in the United States that makes sense is that the Rams and Raiders
rarely sold out the Los Angeles Coliseum. This meant that not only were their
games blacked out during that time, but also the network slated to cover the
game could not cover any other game during that time. With no team in Los
Angeles, there are no game blackouts and that means more ad revenue to the
networks, which could potentially mean a higher bid for broadcast rights.
2In 2016 the story was completely reversed. The new owner used the stadium
contract with St. Louis to try to force improvements. That contract required
that the stadium be in the top 25 percent of NFL stadiums and that if it wasn’t,
the city and state would make sufficient renovations so that it was. When the
city and state refused, the Rams relocated back to Los Angeles.
The Problem for Cities 457
in England in 2012–2013, there were six London-area
teams in the Premier League and sizable cities with no
teams.
The magical story of Leicester City being promoted after
the 2013–2014 season, being forced to go on an incredible
winning streak to avoid relegation in 2014–2015, and then
winning the Premier League in 2015–2016 only serves
to make the point that soccer really is different. It should
be noted, however, that in Spain’s LaLiga Barcelona and
Real Madrid have finished one–two in every year but one
from 2008–2009 to 2015–2016. In the Premier League it is
only a little more equitable in outcomes. Since 2000–2001
the top five teams (Manchester City, Manchester United,
Arsenal, Chelsea, and Liverpool) have accounted for all
but three of the 48 top three finishes, and two of those
three occurrences were in 2015–2016.
Does a Team Enhance the Local Economy?
From a rational perspective, a city needs more reasons
for having a franchise than just wanting to have one. To
this end, the justification that most proponents give for
getting a team is that doing so is an investment in the
city’s future. If that were true, the jobs gained, the tax
income generated, and the prestige gained from having
a team would genuinely be enough to pay for the costs
of building the stadium. Because most mayors consider
economic development a vital responsibility of their
terms in office, you might think that enticing a team to
move in would be the same as enticing any other major
employer to move in. Does it not make sense for a mayor
who seeks to draw a major employer to an area to also
seek out a sports franchise that will employ many people?
While the reasoning sounds good, sports franchises
simply do not generate very good jobs for people other than
the athletes. Whether the jobs are created in the facility or
are in surrounding restaurants, their pay scale is relatively
low, and they provide few benefits. Moreover, though each
baseball team has 81 home dates, in basketball the number
is 41, and in football it is a mere 8. You cannot build a local
economy with only a few workdays a year.
It turns out that whether a sports franchise can be an eco-
nomic cornerstone is a well-researched question. You may
be surprised to know, though, that in nearly every study on
the subject, economists have concluded that sports teams
do next to nothing to improve economic activity in a city.
The research has focused on whether cities that have lost
franchises did any worse economically than they would
have had they not lost the team. Research also questioned
whether cities that were granted a franchise did any better
than they would have without one. The conclusion that was
consistently drawn was that a city’s economic activity was
almost totally unrelated to whether it had a franchise.
The reason that sports teams do not add much to
a local economy is that money spent on tickets, park-
ing, and memorabilia is mostly
local. This is referred to as local substitution, and it means that local people are going to games
instead of eating out or going
to movies or other things they
The competition for teams is neither confined to the big-time profes-
sional leagues, nor even professional team sports. Beginning in the
1990s, first in Florida and then years later in Arizona, cities began at-
tempting to lure Major League Baseball teams and their spring training
sites. The threats made by teams became far more real in the 2000s
as many threatened to move to Arizona for their annual training during
the months of February and March. In fact, while at one time there
were fewer than 10 teams in Arizona during spring training, half the
league now trains there. It can be argued that the cities in the compe-
tition to be spring training sites are more rational because (according
to their own market research) more than half of attendees at spring
training games come from outside the area. Some people choose their
spring break vacation site based on where their favorite team locates.
If this is the case, the local substitution effect can be said to be minor.
It is also worth noting that, although college teams do not
threaten to move, the NCAA has. It was once located in Overland
Park, Kansas (a Kansas City suburb), and that city benefited from
garnering a disproportionate number of NCAA men’s basketball
tournaments. In 1999, the NCAA garnered many concessions
from the city of Indianapolis and moved to that city. With it they
brought the ability to locate major tournaments in the city and
state. The men’s Final Four is in that city in every fifth year. In
the other years they get an opening weekend set of games, or
a second weekend round, or get the women’s Final Four. Again,
because the vast majority of the people in attendance are from
out of town, the local substitution argument is negated, and be-
cause it is on a repeating basis, the city’s reasoning is somewhat
more defensible.
S P R I N G T R A I N I N G A N D T H E N C A A
local substitution The effect of the substi- tution of one economic activity for another within a community, so the net effect is zero.
458 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
would have done locally with their money. In the larger
picture, sports is just a branch of the entertainment in-
dustry. Having a team changes how entertainment dollars
are spent, but it does not change the amount that is spent.
To make a somewhat exaggerated point, the Queens Park
Rangers from the Premier League were a relegated team in
2013. As such, their fans had five other London-area Pre-
mier League teams to see when they were relegated. There
was no loss of economic activity, even soccer-related eco-
nomic activity, in London as a result of their relegation. In
this sense, arguing whether a city should attract a sports
team is like arguing whether a city should fight to attract
a Super Walmart. Both produce about the same gross rev-
enue and employ large numbers of people at low wages.
The difference is that for a Walmart, much of the money
leaves the local area in payment for the store’s goods, and
for a team, huge amounts of money go to a few rich stars.
Although some cities may not feel they have “ar-
rived” or are “major league” until they have at least one
baseball, basketball, hockey, or football team, they pay
a very high price for that honor. Some cities grow in
population to the point where a team is justified, but they
have none. Austin, Texas is now the largest Standard
Metropolitan Statistical Area without any major league
football, basketball, hockey, or baseball franchise. When
people in Austin, Texas look at the attention that a small
city of less than 100,000 gets each year with the Packers
in Green Bay, they may conclude that they will not be
living in an important area until they have one. If image
is everything, then it may be worth it to assess citizens
millions in taxes to get a franchise. Otherwise such out-
lays of money are highly questionable.
Why Are Stadiums Publicly Funded?
That outlays for stadiums are questionable as a means of
creating economic growth does not prevent the issue from
coming up. Public funding of stadiums can be explained
in terms of positive externalities and bargaining power. The positive externalities here are the benefits to the
fans of having a team in the city that are in excess of what
they get from going to the games.
There are millions of sports fans
who enjoy having a team in their
city whether or not they ever go to
a game or watch it on television.
They enjoy following the team in the newspaper and talking
about the team with their friends. Because they value that
experience, voters, having decided that they want to keep a
team, are willing to pay taxes to keep the team. This is simi-
lar to their willingness to pay taxes to support the arts when
they do not attend concerts or museums.
Having seen why voters may be willing to pay taxes to
keep a team, we need to look at why they end up having
to pay to keep a team. Because teams have demonstrated
a willingness to move, and cities have demonstrated a
willingness to lure the teams of other cities, all of the
bargaining power belongs to the team owner. One of the
things that we assumed in Chapter 5 when we discussed
perfect competition was that there were many buyers and
many sellers and that none had any market power. Here
the market power is concentrated with the owner, who
can move the team if voters do not pay for the stadium.
The Problem for Owners
To Move or to Stay
Owners are the big winners in sports when teams play
musical chairs with their locations. Owners understand
that an individual team’s worth is based on how much it
can rake in from memorabilia sales, luxury boxes, and, in
the case of baseball, local TV revenue. They also know
that it is to their advantage to have many suitors for their
teams and to do little to discourage talk of moving.
Unfortunately, owners are often at cross-purposes
with their leagues since it may be in the best interests of
the leagues to have stable teams. Each owner knows that
the sport is harmed by movement. Each owner knows
that the owner of the team that is moving makes a great
deal of money. As a result, it is in the communal best in-
terests of sports that teams do not move around too much.
However, it is in every individual owner’s best interests
to consider moving, to threaten to move, and sometimes
to actually move. This is why baseball and football have
ownership rules that require agreement of two-thirds to
three-quarters of the other owners for a team to move
or be sold. Though the owners of the Minnesota Twins,
the Pittsburgh Pirates, and the Chicago White Sox threat-
ened to move their baseball teams, none have. In football,
the owners have seen the money that others have made
in moving. To keep the option open for themselves they
have routinely approved other owners’ moves.3
When teams relocate, it is because the owners want to
make more money. Some relocations lead to the need for
new team mascots; new mascots mean vast increases in
sales of shirts, hats, and other memorabilia. The Browns
reaped such benefits when they moved to Baltimore and
became the Ravens. The Oilers also benefited when they
positive externalities The benefit that a per- son other than the buyer or seller receives as a result of a transaction.
3An exception to this was the refusal of the NFL to let the Seahawks move
from Seattle to Los Angeles. This location was too lucrative to just let some-
one have. It will likely be the location of an expansion franchise, and all own-
ers will get a cut of the franchise fee.
The Problem for Owners 459
moved to Nashville and became the Titans. Even teams
that should have changed their mascots but did not reaped
revenue from the sales of memorabilia. For instance, the
Jazz moved from New Orleans to Utah, and the Lakers
moved from Minneapolis to Los Angeles. Each move
meant sales to a whole new set of fans in the new city.
Football teams usually move to gain stadiums with
luxury boxes. Such boxes provide a significant source of
extra revenue for a team. Though television contracts for
football are admittedly large, the NFL spreads the revenue
equally among the teams. The teams therefore get the same
amount, whether they are in New York or Green Bay. Since
the league’s contract with the players dictates salary costs
for all the teams, owners are left with small margins of
profitability and a motivation to look for alternative sources
of revenue. Luxury boxes make the difference. Because
luxury box revenue is not shared between the teams the
way ticket revenue is, potential revenue from such boxes
has been enough of an incentive for the Rams to move
from Los Angeles to St. Louis, enough for the Oilers to
move from Houston to Nashville, enough for the Browns
to move from Cleveland to Baltimore, and enough for the
New England Patriots to nearly move from the Boston
area to Hartford, Connecticut. Oddly enough, in each case,
luxury boxes improved team finances enough to warrant
movement from a larger metropolitan area to a smaller one.
To Win or to Profit
Some teams are worth very little where they are and would
be worth much more if they moved. The Kansas City Roy-
als and Minnesota Twins are two baseball teams that can-
not simultaneously field consistently competitive clubs
and make a profit. In baseball, team revenues are largely
affected by local television deals. The Yankees’ TV deal,
for example, dwarfs that of the combined size of the Royals,
the Twins, the Mariners, and a number of other “small-
market” teams. The Royals were sold for $96 million in
1996 on the condition that the team not leave Kansas City
for at least 10 years. Had the owners been able to at least
threaten to move to another city, chances are good that they
would have sold for many times $96 million. A move to
someplace like Charlotte, Orlando, or another large, grow-
ing city would generate a lucrative local TV deal. It may
be, however, that the only owner with sensitivity toward
his city and the team’s fans was the late Ewing Kaufman,
whose will required that anyone who bought the team be
required to keep it in Kansas City for a decade. For a pro-
spective owner, nothing can be better than to be able to buy
a struggling team for under $100 million and to sell it 10
years later for a half billion. This is probably a temptation
that a living owner will not pass up. But for a resurgence in
2014 and 2015 the Kansas City Royals could easily have
gone down in history with the Washington Senators, who
moved and became the Texas Rangers, and the Seattle
Pilots, who moved and became the Milwaukee Brewers.
This is not to say a small-market team cannot win. Some
such teams will win if they construct a superior farm sys-
tem and are lucky enough to see their players all mature at
exactly the right time. This happened with the Royals in the
late 1970s, and again in the mid 2010s with the Twins in
the middle 1980s, with the Mariners in the middle 1990s,
and with the Rays in 2008 through 2010. Unfortunately, if
a team is that lucky, free agency will limit the time that the
team can win and remain profitable. The Cubs, Red Sox,
Yankees, and Dodgers will always be ready to buy up the
talent as soon as the players are eligible for free agency. As
further evidence of this problem, a special committee ap-
pointed by the commissioner of baseball noted that, from
1994 to 1999, no team whose payroll was in the bottom
half of major league baseball won a playoff game. Though
the Rays bucked the trend for three years, their roster was
raided prior to the 2011 season.
This is also not to say that a team with money will always
buy the right talent. Table 43.1 shows that a willingness
to bid for free agents helps teams to get into the playoffs,
but also that it is far from a slam dunk. Between 2010 and
2015 there were 56 teams making the playoffs. Twelve
came from the bottom third of team salaries, 22 came from
the middle third, and 22 came from the top third. In terms
of World Series participants during that same period, of
the 12 teams, five came from the top third, six from the
middle third, and one from the bottom third. Not buying
free agents clearly diminishes your prospects of playing in
October and November, but dumping a great deal of money
on free agents is no guarantee of winning a ring.
In early 2009, the NBA, as quietly as possible, bor-
rowed $132 million to help its struggling franchises make
payroll. Though their short-term troubles could be tied to
TABLE 43.1 Salary Ranks and Playoff Appearances.
Year
Number
of Teams
Qualifying
for the
Playoffs
Number of
Playoff Teams
with Team
Salaries in the
Top 10
Number of Playoff
Teams with Team
Salaries in the
Bottom 10
2010 8 4 1
2011 8 2 2
2012 10 5 2
2013 10 3 3
2014 10 5 2
2015 10 3 2
460 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
the state of the economy in late 2008 and early 2009, it is
a long-term challenge for all sports leagues when there is a
marked imbalance in team revenues. Owners face the “win
or make money, but you can’t do both” challenge when
they are at the bottom of the league in team revenues.
Similarly, in NASCAR, the top teams with the top
names and millions in sponsorship money can field teams
that win 90 percent of races. Since 2007, Joe Gibbs Rac-
ing, Hendrick Motorsports, Roush Racing, Stewart-Hass
Racing, and Richard Childress Racing have accounted
for all but seven of the 121 Chase participants and every
single champion.
The ultimate example of this phenomenon occurred
with the Premier League’s Manchester City. Purchased in
2008 by a group from Abu Dhabi who invested millions
in garnering worldwide talent, they were sold in 2009 to
Sheikh Mansour, an individual estimated to be worth
$30 billion from a family estimated to be worth a trillion dol-
lars. With massive investments, the team won Britain’s FA
Cup in 2011 and won the 2012 Premier League for the first
time in 44 years, all while losing nearly $200 million a year.
Don’t Feel Sorry for Them Just Yet
While it may be tempting to feel sorry for the “poor”
owners who lose money each and every year on their
franchises, you can probably leave the Kleenex in
your pocket. As Tables 43.2 and 43.3 indicate, even
TABLE 43.2 Purchase prices, current values, and rates of return on selected Major League Baseball franchises.
Source: Forbes, www.forbes.com
Team
Purchase Price on Most
Recent Sale (Year)
Forbes Magazine 2016
Estimate of Value (millions)
Real Annual
Rate of Return
New York Yankees
$ 10 million
(1973)
$ 3,400 15%
St. Louis Cardinals $ 150 million
(1996)
$ 1,600 13%
Los Angeles Dodgers $ 2 billion
(2012)
$ 2,500 6%
Kansas City Royals $ 96 million
(2000)
$ 865 15%
Washington Nationals $ 450 million
(2006)
$ 1,300 11%
TABLE 43.3 Purchase prices, current values, and rates of return on selected National Football League franchises.
Source: Forbes, www.forbes.com
Team
Purchase Price on Most
Recent Sale (Year)
Forbes Magazine 2015
Estimate of Value (millions)
Real Annual
Rate of Return
Pittsburgh Steelers $ 2,500
(1933)
$ 1,900 18%
Dallas Cowboys $ 150 million
(1989)
$ 4,000 13%
Oakland Raiders $ 180,000
(1966)
$ 1,430 20%
Phoenix Cardinals $ 50,000
(1932)
$ 1,540 13%
New Orleans Saints $ 70 million
(1985)
$ 1,515 11%
The Vocabulary of Sports Economics 461
though baseball and football franchises may claim to
lose money each year, the return on their investment is
still substantial. How? Because history suggests that
the team will sell for substantially more than the owner
paid for it. Economist Rodney D. Fort specializes in
sports economics, even writing a textbook devoted to
it. Having collected financial data on NFL and MLB
franchises over the years, he has come to the conclusion
that it is the capital gain that makes these investments
truly valuable.
You might expect there to be high real rates of return
on owning powerhouse franchises like the Yankees,
Cardinals, and Dodgers in baseball and the Cowboys
and Steelers in football. On the other hand, even teams
without much of a history of success earned substan-
tial profits for their owners. For comparison, it should
be noted that these real rates of return are better than
typical alternatives. Specifically, real stock market re-
turns average between 5 and 8 percent.
The Sports Labor Market
What Owners Will Pay
When we think about the market for talent in any sport,
we have to recognize that it is fundamentally no different
from any other labor market. Firms will hire the marginal
laborer as long as the contribution of the employee to rev-
enue equals or exceeds the money that must be paid to that
employee. This concept, called
the marginal revenue product of labor, is important in any firm. In sports, the marginal revenue
product of labor is the money that
the team generates in revenue because a particular player
is on the team. It would include any increase in revenue
that results directly from their performance as well as all
that revenue that results indirectly, say in the form of mem-
orabilia sales, from the player being on the team. So a star
may make a team win, which causes it to draw more fans.
But the star’s presence may also cause sales of team logo
jerseys to increase. In deciding whether to sign a player to
a large contract, therefore, an owner must decide whether
the player is worth the money. If the player brings in at
least as much in revenue to the team as the salary that the
player commands, then the player is worth it.
What Players Will Accept
The issue for players is whether the pay they are offered to
play for a team exceeds their next best offer. This next best
offer is a player’s r eservation wage. It is the least that the player will
sign for, because anything less
makes an offer from some other
team or some other job more de-
sirable. Before the days of lucrative sports contracts, players
quit their sports before they otherwise would have because
their outside offers were better. Depending on the institu-
tional structure of the sport, a player’s reservation wage can
be very high because he4 will have offers from other teams,
or it can be very low because the player is able to offer his
services to only one team. In the latter case, the reservation
wage is the next best job, but outside of the sport.
The pay that a player will end up getting will thus be
between the most it can be, the marginal revenue prod-
uct, and the least it can be, the reservation wage. This
gap can be enormous.
The Vocabulary of Sports Economics
Franchise owners, of course, spend their time attempt-
ing to increase revenues and fighting increases in ex-
penditures. We have dealt with the revenue side and the
luxury-box solution, but the expenditure side is stickier.
The problem owners face is
players who are free agents. It is increasingly difficult to com-
pete in the major sports with-
out an ability to buy talent. Total gate receipts for the
average “small-market” major league baseball team is
between $60 million and $75 million. The 1997 Florida
Marlins lost millions winning the World Series, and the
owner proceeded to sell all of the team’s high-salaried
players the following year. Though this practice occurs
most often in baseball, it is done in other sports as well.
In basketball, for example, once Michael left the Bulls,
the owner of the now Jordanless team traded, sold, or
decided not to renew contracts on Pippen, Rodman, and
a host of others. As a result, the Bulls became the first
team to win a championship in
basketball and follow that with
a season in which they were eli-
gible for the draft lottery. The draft is a mechanism designed to provide competi-
tive balance. By allowing teams that finished poorly to
draft first, the leagues infuse the poorer teams with the best
of the young talent. One problem with such a draft is that it
marginal revenue
product of labor The additional revenue generated from hiring an additional worker.
reservation wage The least amount that a player will accept because it is the next best offer.
free agent A player who is able to offer services to the highest bidder.
draft The process by which new talent is assigned to teams.
4“He” is appropriate here as long as big money is associated only with men’s
professional team sports.
462 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
motivates teams to play badly to vie for the first pick. This
was the accusation in the NBA when, in hopes of getting
Ralph Sampson with the first pick in the 1983 draft, the
Houston Rockets played very badly. While never proven
conclusively, the concern was they were playing badly in-
tentionally. In 1985 the NBA created a system whereby the
teams that did not make the playoffs were entered into a
lottery. In 1990 the system was changed so that the chance
of winning was higher for the poorer performing teams.5
It is difficult, if not impossible, for a team to win
without great talent; and unless it manages to find that
talent through the draft, it must bid for the talent of
players who are free agents. With the single exception
of the 1998 NBA lockout, the ultimate winners in labor
negotiations during the last several years have been the
players. Athletes have successfully negotiated for greater
access to free markets for their talent. Free agency has
driven average salaries up faster than revenues from TV
or ticket sales so that today, a single player can make
more in a year (though only in nominal terms) than it
cost to build Yankee Stadium in 1923.
Quite often today’s owners must decide whether to
make money or to win games. It is unfortunate that for
more than a few teams, in more than a few sports, these are
conflicting goals. Owners within each of the major sports
have complained about their inability to turn a profit or to
at least break even. Because only a few players are on the
free agent market each year and because many teams con-
sider themselves just a few wins short of either contending
for the playoffs, or better, winning a championship, the
price that players are able to command is quite high.
Sports franchise owners have attempted to institute
salary caps, in order to protect themselves from them- selves. That is, they want to
protect themselves from being
tempted to bid against one an-
other. Other than baseball, each
major professional team sport has some form of salary
cap in place. The owners hope to lessen their costs at
the expense of players by limiting the amount of money
they can bid against each other for talent. Sometimes it
is not in the best interests of the owners to have strict
salary caps. During the 1980s the NBA allowed teams to
have one player’s salary not count against the cap as long
as any further signings were done at the minimum. This
rule, called the Larry Bird exemption, was instituted so
that teams could keep a marquee player.
Another avenue for allowing small-market teams to
succeed is to put into place a general sharing of revenues,
or at least a sharing of the television revenues. Since
football does revenue sharing well and baseball does not, you
would expect a more fluid mix
of winners and losers in football
than in baseball. That is, in fact,
what we saw in the 1990s. Two
baseball teams dominated the decade, the Atlanta Braves
and the New York Yankees, both of which had a “local”
television market via cable that was, in fact, thoroughly
national. Neither, of course, shared the revenue it got
with the other baseball teams, and this gave them an ab-
surd advantage in bidding for high-priced talent.
In a simpler time sports were games played by men
who were happy to be paid at all. Owners were happy to
oblige them by hardly paying them at all. There were no
women’s professional leagues and no laws requiring high
schools and colleges to fund women’s athletics. Without
a doubt there was grumbling among players about their
pay, but not until 1977 did business considerations come
into play. In that year baseball had an epiphany. An arbi-
trator declared two players free agents and the sport was
forever changed. Within a few years other sports also
gained forms of free agency and players who had had
virtually no right to the economic benefits of the free
competitive market began to get rich.
Prior to 1977 all players in all team sports were bound
to the team they played for the previous year. Having this
so-called reserve clause in con- tracts meant that the only choice
players had was to either play for
what the owner offered or retire.
Whereas star players in their
later years had the sort of le-
verage that was afforded by the
support of public opinion, lesser players did not. Even
when Joe DiMaggio, considered by many the best right-
handed hitter of all time, held out for a better contract
by going home to San Francisco to open a restaurant,
he ultimately came back to the Yankees for much less
than he was worth. Going back to our discussion on the
reservation wage, with the reserve clause in place, the
reservation wage for players bound by it was very low.
From 1977 on, each sport has engaged in collective
bargaining agreements that have given players more and
more freedom of movement and contracts that are much
reserve clause A contract clause that requires that players re-sign with the team to which they belonged the previous year.
salary cap The maximum in total payroll that a team can pay its players.
revenue sharing The process by which some revenues are distributed to all teams rather than simply the teams that generate them.
5Specifically, of the 29 teams in the NBA, 13 do not make the playoffs and are in
the lottery as a result. Like the lotto, each team’s logo is printed on Ping-Pong
balls. A team has one ball plus one for each team they were behind in the race
to the playoffs. Thus the worst team in the league has 13 of the 91 balls in the
hopper. As a result, their probability of getting the first pick is 14.3 out of 100.
The Vocabulary of Sports Economics 463
more lucrative in terms of salaries and incentives. These
agreements usually require teams to pay a minimum
salary. Baseball’s minimum salary was set at $300,000
in 2004 and adjusted for inflation thereafter. Hockey’s
minimum salary had been the lowest of the majors sports
and is now the highest, at $575,000. The NBA has a
minimum salary chart that is based on years of service.
For a rookie, the minimum salary for the 2015–2016
season was $525,093 while for a 10-year veteran it was
$1,499,187. The interesting thing about the NBA system
is that it works against veterans who wish to finish their
careers as role players. If you refer to Chapter 33’s dis-
cussion of the minimum wage, this is an example of how
this type of minimum wage can actually hurt someone it
was intended to help.
In each sport players are bound to the team they played
for the previous year for a period of time that ranges from
four to six years, depending on the sport. These collective
bargaining agreements have decidedly raised the reserva-
tion wage of players with the requisite experience to have
earned free agency. For free agents, the reservation wage
is the next best offer from another team. That is usually
very close to their marginal revenue product.
Thus free agency and other aspects of collective bar-
gaining agreements have raised average salaries in all
sports far faster than inflation. Though there is dispute
among economists as to how much credit for this change
goes to free agency, average salaries have ballooned. They
increased sevenfold in 25 years in baseball, sixfold in bas-
ketball in 20 years, and sixfold in football in 20 years. This
increase may be attributed to an increase in the marginal
revenue product of players, which has come about in part
because the sports are more popular, they draw larger gates
and television audiences, and sales of memorabilia have
grown. For whatever reason, consider this: In the 1920s
Babe Ruth became the first player to earn more than the
president. In 2015 the minimum major league salary was
more than $100,000 more than the president’s.
Of course when you change a system, good and
bad outcomes ensue. Along with higher pay and ben-
efits for players arrived at through collective bargain-
ing agreements, professional sports has had to endure
In 2004–2005 the National Hockey League became the first sports
league to lose an entire season to a work stoppage. The NHL own-
ers chose to lock out the players after negotiations failed to produce
an agreement to lower salaries. The players refused an owner de-
mand that the league adopt a salary cap that would have cut players’
salaries by 30 percent. In the end, after a completely lost season,
the owners got almost exactly what they wanted. This stands with
a football strike in the 1980s and a basketball strike in the 1990s
as the only cases in sports history in which owners unambigu-
ously won a labor dispute. Because the owners won, they tried it
again in 2012–2013. In that dispute, however, the season wasn’t
lost, but both sides did. The sport’s following dropped significantly.
T H E N A T I O N A L H O C K E Y L E A G U E ’ S 2 0 0 4 – 2 0 0 5 L O C K O U T
At the completion of the February 2011 Super Bowl, the NFL own-
ers locked out its players. The dispute, like nearly every labor-
management dispute before or after it, was about compensation.
The previous contract gave the owners the right to the first $1 bil-
lion in revenues and 40 percent of the remaining (approximately)
$8 billion. The players got 60 percent of the revenues after the
first $1 billion. Because revenues to the sport grew so rapidly
during the previous contract, the owners felt the old agreement
unfairly enriched the players and wanted the first $2 billion in
revenues and a larger share of the remainder. Although there
were other issues, such as long-term health benefits for players
and the potential for an 18-game schedule, the real issue was
money.
What warrants a side explanation is that the players tried an
interesting tactic: decertification. When a union and an employer
come to loggerheads in a dispute, the players can strike or the own-
ers can lock out the workers (players). When there is no union, a
lockout constitutes a violation of antitrust law. Shortly after talks
broke down, the union decertified. Because it was a transparent at-
tempt by the players to short-circuit the lockout, the owners sued. A
lower court ruling in favor of the players was overturned on appeal,
and the two sides worked out a deal.
T H E N F L L O C K O U T
464 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
strikes and lockouts. Each sport has lost at least part of a season
to this sort of work stoppage.
A strike, a refusal by the play-
ers to work, is usually voted for
when the players want some-
thing in a new contract that is
quite different from the status
quo. A lockout, a refusal by
the owners to let the players work, is usually instituted
when the owners want to make extensive changes in
existing contracts.
Baseball owners have tried other avenues to get around
the competitive nature of bidding on free agents. After
1986, baseball free agents found that owners were no
longer willing to bid on their services. The change was
so abrupt that it caught many off-guard. Subsequently,
players began to suspect that it could only have resulted
from the collusion of the owners not to bid on each other’s
players. In 1987 the first case went to an arbitrator. The
owners offered the “How could we possibly collude?” de-
fense, arguing that such an arrangement would have been
impossible to enforce among themselves. It was not lost on
millions of baseball fans or the arbitrator that, in a different
era, a different set of owners had managed to collude to
keep blacks and Hispanics from the game until 1946. Vari-
ous arbitrators found that baseball owners had in fact col-
luded and were ordered to pay $280 million in damages.
To illustrate how much, or how little, power each side
has, consider the alternatives a player has. If a league has
a structure that prevents owners in the league from bid-
ding against one another, then players have little choice
but to accept what the team offers—that is, unless the
player has value in another league. For most athletes, this
power only exists for two-sport stars. For soccer players,
however, there are myriad other leagues in other coun-
tries willing to pay players. A player on a Premier League
team doesn’t just have options to move to another team;
he has options to move to another league. The Spanish
and German leagues, for instance, regularly sign players
who have played in the Premier League.
What differentiates team sports like baseball, foot-
ball, hockey, and basketball from individual sports like
golf and tennis is that individual sports have no “owners”
with whom to negotiate. Players can make as much as
they want. They just have to win.
One problem with team sports is that it is under the con-
trol of a small number of self-serving owners. They pay the
talented players. Unfortunately, anytime only a few bosses
bid on talent, the bosses are usually satisfied, and the talent
usually grumbles. In golf and tennis there are no owners,
so golfers and tennis players never grumble. They accept
the direct relationship that exists between winning and in-
come. While I am a fan of many sports, auto racing, and,
in particular, National Association of Stock Car Auto Rac-
ing (NASCAR),6 is interesting to me as an economist. It is
something like golf and tennis in that individual achieve-
ment is vital. It is also something like team sports in that an
individual driver must rely on a host of others doing their
jobs. In auto racing there are so many different owners
and so many different drivers that something like perfect
competition exists. Moreover, there is easy entrance and
exit from the market because anybody with sufficient capi-
tal can start a new team and attempt to qualify for major
events like the Daytona 500 or Indianapolis 500. Addition-
ally, there are enough buyers and sellers of talent that the
prices arrived at for talent seem fair to all concerned. The
only issue that could upset this balance would be if NAS-
CAR, Indy Racing League (IRL), or Formula 1 got so lax
with safety that drivers were forced to band together to fix
a problem. Thus they would become adversaries instead of
partners with the owners and sponsors. Unless something
like this happens, racing will probably remain an example
of how, under perfect competition, all parties get what they
are worth and are worth what they get.
What a Monopoly Will Do for You
Motor sports offers an interesting lesson in the power of
monopoly. Three of the major series (NASCAR, the IRL,
and Formula 1) are owned by a single person or fam-
ily. The France family, the Hulman-George family, and
Bernie Ecclestone control their respective series with
iron fists. Moreover, many of the venues in which the
series operate are owned by these people as well. To the
never-ending frustration of the track owners who attempt
to host races at other sites, these series owners control
the destiny of their sport to a degree that no baseball or
football owner can imagine.
The IRL, which drove its principal competitor (CART)
out of business, is owned by the family that controls the
Indianapolis Motor Speedway. In 2002, excepting a race
in Denver, CART’s total attendance was less than that of
the Indy 500. From the time when the two series split in
1996, the IRL was able to use the family-owned Indy 500
to bully CART and television networks.
strike An action by labor to deny employers the services of the employees.
lockout An action by employ- ers to deny employees access to their jobs.
6NASCAR is the governing body of the most notable of several stock car
racing circuits. Stock cars are called “stock” because they look vaguely like
regular passenger cars that you can buy at your local dealer.
Summary 465
The France family, which owns a controlling interest
in International Speedway Corporation (ISC, a holding
company for many tracks where NASCAR runs) and the
track in Daytona, was hounded in court by the owner of the
Texas Motor Speedway until it acquiesced to give that track
a second race. In 2007, Kentucky Motor Speedway’s own-
ers sued NASCAR, attempting to get a race at their track
near Cincinnati. Their legal argument was based on the as-
sertion that because the France family owned NASCAR
and ISC, they were in violation of the Sherman Anti-Trust
Act. They bolstered this argument with the fact that an ISC
track, the California Motor Speedway, received a second
race starting in 2004 though it has yet to sell out a race.
In 2008, a federal judge dismissed the suit and upheld the
authority of NASCAR to set its dates and tracks, thereby
solidifying this family business’s stranglehold on the sport.
Formula 1 racing has rarely been able to maintain
the same race schedule two years in a row. The problem
here is that the owner, Bernie Ecclestone, requires such
a high advance fee to hold a race in a particular location
that promoters cannot afford to build a fan base for this
worldwide form of racing.
As in all economics, market power, and especially mo-
nopoly power, determines who the winners and losers are.
Summary
You now understand how economic principles can be
applied to the issues of sports. In particular you un-
derstand that, despite the obvious attempts of cities
to acquire franchises through expansion and by luring
others, there is no economic evidence to suggest that
having a franchise enhances a city’s economic stat-
ure. You understand that owners are not only on the
opposite side of this particular bargain, but they also
face a problem of their own. They must negotiate with
players; if they are doing so in a small market, they
must often decide whether they wish to make money
or win. Last, you now understand the basics of sports
labor economics history and the vocabulary that is
central to it.
Key Terms
draft
free agent
local substitution
lockout
marginal revenue product
of labor
positive externalities
reservation wage
reserve clause
revenue sharing
salary cap
strike
1. The value of a sports franchise to a city’s economy
depends greatly on
a. the sale of memorabilia to citizens.
b. the degree to which non-ticket-based sales
increase.
c. the degree to which restaurant revenues rise.
d. the degree to which noncitizens spend money in
the city.
2. Most baseball franchises have ____________ over
the years while the sale price of the typical team
has ____________.
a. made a profit; fallen
b. lost money; fallen
c. made a profit; risen
d. lost money; risen
Quiz Yourself
3. The typical problem for generating parity in sports
leagues is that
a. there is no mechanism for bringing in new
talent in a way that helps the bad teams.
b. there is no means by which players on one team
can move to another.
c. with no salary cap and with unlimited free agency,
big city, high-revenue teams have an advantage.
d. no one wants it.
4. The motorsports industry is dominated by indepen-
dent teams running in series operated as
a. monopolies.
b. oligopolies.
c. monopolistic competitors.
d. perfect competitors.
466 Chapter 43 If We Build It, Will They Come? And Other Sports Questions
Motor Speedway. Michelin’s tire was simply too
dangerous for the teams to safely run the 2005 U.S. Grand
Prix. Because there are two competing tire companies
supplying tires to competitor teams, neither would agree
to the other’s posed solutions. This would never happen
in NASCAR or the IRL because they use only one tire
manufacturer. Once a problem was identified, it would
have been in everyone’s interest to find a solution. What
does this tell you about the benefits and costs of oligopoly
over monopoly?
Talk about This
The Indianapolis Colts used an implied threat to move
as a means by which to induce the state of Indiana and
the city of Indianapolis to build them a new stadium.
This is somewhat ironic since the same family used
the fact that Indianapolis built them a stadium in the
1980s to leave Baltimore. To what degree are the com-
bined threats by owners to leave their respective cities a
conspiracy?
For More Insight See
Kahn, Lawrence M., “The Sports Business as a Labor
Market Laboratory,” Journal of Economic Perspec-
tives 14, no. 3 (Summer 2000).
Sheehan, Richard, Keeping Score: The Economics of
Big-Time Sports (South Bend, IN: Diamond Commu-
nications, 1996).
Siegfried, John, and Andrew Zimbalist, “The Eco-
nomics of Sports Facilities and Their Communi-
ties,” Journal of Economic Perspectives 14, no. 3
(Summer 2000).
5. Economists note that a reason exists for policy mak-
ers to subsidize sports stadiums, and it is that
a. they bring in billions of dollars to their
communities.
b. they result in large increases in city payrolls.
c. they result in enormous increases in taxes.
d. the teams make people happy—even those who
don’t go to the games.
6. When the National Hockey League had its 2004–
2005 work stoppage, it was
a. a player strike over salaries that were too low.
b. a player strike over a limited ability to move to
another team.
c. an owner lockout over reducing salaries.
d. an owner lockout over union work rules.
Short Answer Questions
1. How did the reserve clause serve to allow owners to
pay something close to the players’ reservation wage
rather than their marginal revenue product of labor?
2. Use the local substitution argument to consider what
the economic value of your college’s basketball
team truly is.
3. If someone from the arts community were to argue
for a subsidy to garner an arts festival, how would
the local substitution argument apply and how might
the external benefits argument apply?
Think about This
Formula 1 may never compete again in the United States
as a result of a problem with tires at the Indianapolis
467
C H A P T E R F O R T Y - F O U R
The Stock Market and Crashes Learning Objectives
After reading this chapter you should be able to:
LO1 Describe how stock prices are determined and what stock
markets do.
LO2 Apply the concept of present value to the fundamental ele-
ments of stock prices and describe how prices can get out
of line with their fundamental value.
LO3 Explain that bankruptcy is an important feature in corporate
business but that many of the bankruptcies of 2001 and
2002 involved a level of deception on the part of their
accountants that was potentially quite damaging.
Chapter Outline
Stock Prices
Efficient Markets
Stock Market Crashes
The Accounting Scandals of 2001 and 2002
Rebound of 2006–2007 and the Drop of 2008–2009
Summary
Even to many of the people who invest in it, the stock
market is a mystery. Investors buy stocks, that is, shares
of the value of a company. As stockholders they have the
right to vote in shareholders’ meetings and a right to a pro-
rated share of dividends. The questions of what makes the
prices of stocks go up and down in general and why prices
actually soar or plummet on any particular day have per-
plexed both stockholders and economists for many years.
Figures 44.1, 44.2, and 44.3 show the values of three
important measures of the stock market. In each, the level
of each of these indices is in black and the common log-
arithm (the log base 10) is in blue. You can see that the
level of each has grown over time, and though each saw
a major dip in 2000 and 2001, that dip was small, given
the substantial runs of the previous 20 years. You can
also see that the plunge in late 2008 brought each index
back to a level that was similar to its 2001 low. Graphs
such as these are deceiving though, if you just look at
the level, which is why the logarithmic scale is useful.
For instance, when looking at historic swings from 25
or even 70 years ago, what is imperceptible on the level
scale is quite noticeable on the logarithmic scale. So you
probably know that the Dow Jones and S&P 500 each
grew rapidly in the 1920s and then plunged in the 1930s.
It is impossible to see that on the level scale but much
easier to see it on the logarithmic scale.
What could cause stocks to go up by more than
50 percent in four months, as they did in 1982? What
could cause a stock market to lose 20 percent of its value
on a single day, as it did in October 1987? Assuming that
the price of a share of stock does, in fact, represent the
value of that share of the company in question, how can
the value of anything change so fast?
The ultimate question of what actually determines
stock market prices is the focus of this chapter. We ex-
plore what traditional economic theory has to say on the
subject of how stock prices are determined. We discuss
how a stock market can advance economic growth by
helping to transfer financial capital into the hands of the
people who can use it best. We show that if a stock mar-
ket is “efficient,” small investors—investors who invest
relatively small amounts of money—do not need to take
a lot of time thinking about their investments because it
will not do them much good. We move to a discussion of
the causes and effects of some of history’s stock market
crashes and what might be done to prevent them. We fin-
ish with a discussion of bankruptcy and the accounting
scandals of 2001 and 2002.
468 Chapter 44 The Stock Market and Crashes
Stock Prices
How Stock Prices Are Determined
Traditional economic analysis has always suggested that
the value of any asset is based on three things: the flow
of returns that come from the asset, the amount that the
asset is expected to sell for when it is sold, and the rate
at which the future flow of those returns is “discounted.”
To compute the value of a stock, we add up payments
that come in at different times. To put those payments
on an even playing field, we use the concept of present
value that we introduced in Chapter 7.
Although the math for computing present value is
somewhat complicated, the concept is not hard to under-
stand. If there are 1 million shares of a company and the
company profits are exactly $1 million, then the earn-
ings per share is exactly $1. How much would you pay
for a share of stock that would yield earnings of $1/year
FIGURE 44.1 The Dow Jones Industrial Average, 1896–2015.
Source: www.quandl.com
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
0
2,000
4,000
6,000
8,000
10,000
12,000
20,000
Year
D J IA
( le
v e
l)
D J IA
( lo
g b
a s e
1 0
)
16,000
18,000
14,000
DJIA (level) DJIA (log)
1896 1906 1916 1926 1936 1946 1956 1966 1976 1986 1996 2006
FIGURE 44.2 Standard and Poor’s 500, 1870–2015.
Source: www.quandl.com
Year
S&P 500 (level) S&P 500 (log)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
0
500
1,000
1,500
2,000
2,500
S &
P 5
0 0
( le
v e
l)
S &
P 5
0 0
( lo
g )
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Stock Prices 469
FIGURE 44.3 NASDAQ Composite Index, 1980–2015.
Source: www.quandl.com
Year
NASDAQ (level) NASDAQ (log)
0
1,000
2,000
3,000
4,000
5,000
6,000
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
N A
S D
A Q
( le
v e
l)
N A
S D
A Q
( lo
g )
1 9 8
0
1 9 8
2
1 9 8 4
1 9 8 6
1 9 8
8
1 9 9
0
1 9 9
2
1 9 9
4
1 9 9
6
1 9 9
8
20 00
20 02
20 04
20 06
2 0 10
2 0
12
2 0 14
2 0 15
20 08
forever? What it is worth is the present value of that $1
each year. Recall that you learned in Chapter 7 that one
of the components of present value is the interest rate.
Sometimes we change the jargon a bit and refer to it as
the discount rate, but it is the same concept: the amount
by which future payments are discounted. In the previous
example, if you are confident of being paid $1/year/share
forever, the present value is the reciprocal of the inter-
est rate. If the interest rate is 5 percent, then the present
value is $20. If it is 10 percent, the present value is $10.
Since we rarely act as if companies will last forever, we
usually judge the value of a stock to be the present value of
its expected dividend payments plus the present value of its
expected final sales price. Both of these present values are
greatly determined by the discount rate, the interest rate that
is used to translate future payments into present value. As the
discount rate rises, the present value of the payments falls.
You can see from everything we have said so far that the
price of a share of stock can move as a result of a change in
any of the three variables. A change in the profit expecta-
tions will change both dividend expectations and final sale
price expectations. These in turn will change the price of
the stock. A change in interest rates will also change the
stock price. In the end, though, the ultimate long-term
value of a stock is determined
by its profit expectations and the
interest rate. These are known
as fundamentals, elements that go into a stock’s price that make
long-term economic sense.
What Stock Markets Do
Stock markets exist as an efficient way of getting avail-
able financial capital to whichever investors can make
the best use of that financial capital. Stock markets set
share prices, thereby providing investors information
about which companies are doing well and which are
not. Stock markets allow firms that need new influxes of
money to get what they need, and they allow investors to
invest their money in places that provide good returns.
Though most of the shares traded on any particular
day are stock issued many years before, an important
function of a stock market is to support new companies
with investors’ funds. When a company sells stock for
the first time in an attempt to raise money for expansion,
this initial public offering (IPO) turns what is typically a small,
privately held firm into one that
now has stockholders, issues
dividends, and has a board of
directors.1 It allows companies
to grow far beyond what owners can borrow or otherwise
raise themselves. Though such firms can incorporate and
sell stock among a limited number of people,2 an IPO
opens up the possibility that an unlimited number of peo-
ple, or even other corporations, can become its investors. fundamentals Elements that determine stock prices that make long-term economic sense—profit expecta- tions and interest rates.
initial public
offering (IPO) A company’s first sale of stock to the public in an attempt to raise money for expansion.
1 Sometimes IPOs are not so small. When AT&T spun off its hardware division,
Lucent, that IPO was very large. 2 Such an entity is called an S-corporation.
470 Chapter 44 The Stock Market and Crashes
For stocks that are not IPOs, the market has two ef-
fects. First, it has the effect of spreading risk equally
across all stocks to all stockholders. In economic terms,
it equalizes the risk-adjusted rates of return across in-
vestments. If one company is going to yield a return on
equity that is greater than another, the market price of
the share of stock of the better company will rise until
the return is equal to any new investors. In this way the
stock market provides a way of signaling value to all fu-
ture investors.
An additional important effect of the non-IPO market
is that it provides liquidity to those shares of stock that
were previously issued. IPOs only have value when their
owners know that they can sell them if they wish to turn
their investments into cash. Without a market for previ-
ously issued securities, it would be overly costly to issue
new ones.
Efficient Markets
A market is labeled efficient by economists if all avail- able information is accounted for in the market. For in-
stance, if markets are efficient,
the price of a share of stock will
encapsulate everything that in-
vestors know about that stock.
If investors are concerned that a
product that a company sells is likely to generate cum-
bersome lawsuits, for example, the market price will
fall by the value that the market places on the uncer-
tainty it is feeling about the company and on the ex-
pected legal exposure.
What this “efficient market hypothesis” means for
everyday investors is that they do not have to worry
about outsmarting the market. The Wall Street gurus
who spend every waking minute looking for new in-
formation on the market will bid prices up and down in
appropriate ways as new information on profits, risks,
and interest rates comes in. Since all of that information
will be absorbed into the market long before most other
investors find out about it, most other investors cannot
take advantage of it. As unlikely as it may seem, new
investors can simply invest in whatever they like, know-
ing that the chances are good that anything they pick
will have the same chances of doing as well as anything
else a professional outside Wall Street might pick.
While maintaining a diverse portfolio of invest-
ments is less risky than picking a specific stock, inves-
tors do not always have enough money to buy a variety
of different stocks. Such investors can avail themselves
of index funds, which buy stocks in exact proportion
to their value in a commonly
known stock index, like the Dow Jones Industrial, Standard
and Poor’s, and NASDAQ (see
Figures 44.1 to 44.3). Since a stock index is simply a
weighted average of stock prices in a particular group,
buying shares of an index fund provides diversity and an
expected return that is on a par with any other investment
involving similar risk.
The best evidence that markets are efficient is the
stories you hear about how well monkeys do when
picking stocks. Newspapers often compare the hypo-
thetical monetary returns earned from a monkey’s ran-
dom choices with the returns generated by professional
investors. Unhappily for the professionals, monkeys have
been known to hold their own.
Stock Market Crashes
The American stock market “crashed” twice in the 20th
century, once in October 1929 and again in October
1987. In both cases a loss of at least 25 percent of the
stock market’s total value was experienced in a matter
of days. The real question that economists who believe
that stock markets are rational have to answer is this: Is it
possible that expectations of things that are fundamental
can change for everyone simultaneously and by amounts
necessary to change stock prices that much?
If the answer to that question is “no,” that things that
are fundamental cannot change that much or that fast,
then the stock market is not much more socially use-
ful than a casino. On the other hand, if you can explain
everything that goes on in a stock market in terms of
changes in fundamental economic variables, then, as we
explained before, the stock market is socially useful.
Bubbles
It is crucial for us to know how a stock market, or how
any market for anything else, crashes. If people invest
their savings for retirement, college, or anything else,
and their investments are going to be subject to wild
swings, then it is important to
know whether increases in stock
prices happen because of in-
creases in value or because of
what economists call bubbles. A bubble of any kind grows slowly
efficient market All information is taken into account by partici- pants in a market.
stock index A weighted average of stock prices in a particular group.
bubble The state of a market where the current price is far above its value determined by fundamentals.
Stock Market Crashes 471
and looks very nice while it exists, but, when bubbles
break, they break fast and ugly. The metaphor of a bub-
ble is often used to describe an asset market that grows
beyond all economic reason.
The two fundamentals that go into the formula for the
value of an asset are the flow of payments it produces
and the interest rate. The price of a stock can change a
great deal if either of these changes a great deal. Econo-
mists are not overly concerned about this, and their lack
of concern becomes justified when the stock prices of
companies that are believed to generate losses in the
short run and great profits in later years vary quite a
bit with a change in interest rates. This variability does
not bother economists much even if the stock price can
change by a large percentage in a short time. The ex-
pected flow of payments, or profits, also is not likely to
change quickly enough to change the price of the stock
greatly or quickly.
The main source of crashes and the bursting bubbles
is more likely to be abrupt changes in the sale price that
is projected for the future. This is especially true if our
expectations of future prices are based, at least in part,
on current prices. For instance, because today’s price is
$90, you may think the price next year will be $100. If
the price today were $80, you might expect that the fu-
ture price might be $90, and so on.
The bubble bursts when a stock price falls and you
think this indicates that it will be worth less next year.
That makes you think that its value today is lessened.
Now you start thinking that its value will be even less
next year, and its current value becomes even less in your
mind. This vicious cycle spirals the value of the stock
down, and it can all happen very fast. As we discussed
earlier, nearly every stock in the world lost in the neigh-
borhood of 25 percent of its value within hours of the
start of the October 1987 crash.
If stock market crashes had no impacts other than
hurting some of the investors who hung on too long,
there would be no issue of concern. The problem is that
stock market crashes have real impacts on average fami-
lies. When stocks are doing very well, people feel richer,
and they are richer. They do not have to save as much
because their previous savings are doing so well. As a
result, they feel comfortable buying new homes, cars,
major appliances, and furniture that they would not have
purchased if things were not as good.
Homes, cars, appliances, and furniture are all goods
that have to be made by industry, and industry runs on
its workers. When the demand for their labor is high,
workers get more hours, better pay, and a host of other
benefits. With better pay, workers are richer, and they
buy more and more. This is an economically virtuous
cycle in which good times create more good times. A
good stock market causes a good economy, and a good
economy fosters an even better stock market. Unfortu-
nately, we cannot avoid the reality that what goes up
can also come down. When the stock market falls, peo-
ple lose wealth, and they then buy fewer goods. Stock
values fall even lower; consumption drops even further.
The doldrums within Japan’s stock market lasted
for all of the decade of the 1990s. Japan’s equivalent to
the Dow Jones Industrial Average, the Nikkei Index, re-
mained depressed during a time in which the American
stock market values tripled. The virtuous cycle that ex-
isted in the United States during the 1990s and the vi-
cious cycle that existed in Japan during the same period
give testimony two important conclusions: (1) A stock
market’s health influences the rest of the economy and
(2) stock prices can rise and fall very quickly.
Example of a Crash: NASDAQ 2000
In 1999 the NASDAQ (National Association of Se-
curities Dealers Automated Quotations) increased
84 percent from 2,208 to 4,069 on the back of a tech-
nology sector that seemed to grow without bound. By
March 10, 2000, the NASDAQ was above 5,000. The
NASDAQ did not finally bottom out until October
of 2002 when it reached a low of 1,114. What could
have happened that an entire market index would lose
78 percent of its value in 31 months (see Figure 44.4)?
There are a number of explanations. Some of them
revolve around our notion of the bubble, while oth-
ers are more fundamental. The technology sector in
general, and some of the hottest companies in particu-
lar, were operating with staggering losses while being
touted as leaders of the “new economy.” As a matter
of fact, for the dot-coms, making a profit was a sign
of “stagnant thinking.” New-economy thinking led
firms to plow everything they made into improving
name recognition and market share. To this end, the
1999 and 2000 Super Bowl broadcasts were filled with
elaborate multimillion-dollar-per-minute dot-com ads.
Expectations for these companies were that losses
now would be more than made up for with massive prof-
its later. If you do the math, and we will avoid that here,
you will see that anytime you have losses early on and
profits much later, the net present value of this invest-
ment can change quite rapidly with reasonably small
changes in interest rates or profit expectations.
472 Chapter 44 The Stock Market and Crashes
To see this, take a hypothetical dot-com that is ex-
pected to lose $1 per share for 10 years and then make
$5 per share thereafter. If the appropriate interest rate on
a comparably risky investment is 10 percent, then, using
the fundamentals, the stock would be worth $14.44. If
you increase the interest rate to 11 percent, the stock’s
value would drop to $11.23. A 10 percent increase
(1 percentage point) in the interest rate would translate
to a 22 percent drop in the value of the stock. If the ex-
pected profit to the company had been spread out evenly
throughout the lifetime of a company of equal value, an
increase in the interest rate of 1 percentage point would
only decrease the value of the stock to $13.13. Thus, one
explanation of the drop in the NASDAQ is that interest
rates rose during the period.
A second explanation of the drop in the NASDAQ is
diminished profit expectations. Again, because the profits
were expected to come much later in the process, small
changes had large effects. Continuing with our hypothetical
dot-com, a drop in profit expectations to $4 per share, even
keeping interest rates constant at 10 percent, would drop
the value of the share of stock to $10.22. Thus, a 20 percent
drop in profit expectations drops the share price 29 percent.
The final explanation for the 1999 run-up and the
2000–2001 tumble is the bubble explanation. Recall
that a bubble is the metaphor for an asset whose value
has stretched far beyond its fundamental value, based
on the notion that expected increases in the asset price
are self-fulfilling. Whether the NASDAQ in March
2000 was in a bubble state is in some dispute because
of the aforementioned changes in fundamentals that
occurred during the period. On the other hand, there is
little doubt that the buying frenzy among investors in
1999 and early 2000 was fed by the desire by many not
to be left out of “the next Microsoft” or “the next Intel.”
Thus, if people buy without regard to the fundamentals,
a bubble is created, and when fundamentals are reexam-
ined, bubbles burst.
The Accounting Scandals of 2001 and 2002
In the aftermath of the September 11, 2001, attacks
on New York City’s World Trade Center buildings
and the recession of 2001, the Enron Corporation de-
clared bankruptcy. Enron, which at the time was the
United States’ seventh-largest corporation in terms
of revenue, declared bankruptcy, owing more than $5 billion and lacking the abil-
ity to pay the interest on that
debt. Companies or individuals
declare bankruptcy when they
lack the necessary funds to pay
their creditors. While Kmart and Global Crossing also de-
clared bankruptcy during the
same period of time, the Enron
bankruptcy made far more
news. Why? Kmart served many more customers, and
Global Crossing was more in debt ($12 billion), but
Enron’s demise was potentially far more damaging.
FIGURE 44.4 NASDAQ Composite Index, 1999–2003.
Source: MSN Money, http://money.msn.com 1/
4 /9
9
5 /4
/9 9
9 /4
/9 9
1/ 4
/0 0
5 /4
/0 0
9 /4
/0 0
1/ 4
/0 1
5 /4
/0 1
9 /4
/0 1
1/ 4
/0 2
5 /4
/0 2
9 /4
/0 2
1/ 4
/0 3
5 /4
/0 3
Date
6,000
5,000
4,000
3,000
2,000
1,000
0
N A
S D
A Q
c o
m p
o s it
e
bankruptcy A legal status entered into when a company or individual cannot pay its debt.
creditors The people or institutions to which a company or individual owes money.
The Accounting Scandals of 2001 and 2002 473
The Kmart and Global Crossing Cases
When Kmart and Global Crossing filed for Chapter 11
bankruptcy in 2002, economists found the reasons to be
familiar and not all that troubling. Kmart, in the middle of
a discount store sandwich with Walmart and Target, went
bankrupt because it was not able to discount as deeply as
Walmart, nor was it able to market to upscale consumers
as effectively as Target. Global Crossing took a gigan-
tic gamble borrowing billions to string fiber-optic cable
under the oceans, connecting Europe, Asia, and North
America with Internet-friendly broadband connections.
Bankruptcies like these do not trouble economists in the
way they appear to disturb people in the press, bankers, and
shareholders. Economists hold that when companies get
outcompeted, it’s right that they lose money. Further, when
they do it long enough, they should go out of business. They
maintain that capitalism works only when the promise of
profit is countered by the threat of bankruptcy. Incompe-
tence and risky business decisions that turn out badly must
have consequences, and in the cases of Kmart and Global
Crossing this is exactly what happened. Kmart suffered
from management and marketing strategies that were not
up to those of the competition. Global Crossing operated on
the premise that intercontinental bandwidth would be a hot
commodity, and it used debt to finance its decision. AT&T,
which is in the same market and raised its money with
sales of stock and reinvested profits, also made little money
in this market. It survived because its losses resulted only in
disappointing earnings to stockholders. Global Crossing, on
the other hand, could not generate enough profit to pay the
interest on its $12 billion debt.
Both Kmart and Global Crossing declared bankruptcy
even though they possessed more in assets than they owed
their creditors. Kmart had $16 billion in assets and $2 billion
in debts while Global Crossing had $22 billion in assets and
$12 billion in debts. There were two problems, though: The
assets were listed at book value rather than market value, and
the assets were not such that they were producing revenue.
Two examples may illustrate the problem. When
Kmart builds a store and outfits it with the Kmart logo
and colors, it may cost $10 million, but there is no one
who will pay $10 million for it after it is built. Similarly,
it may have cost Global Crossing $20 billion to lay fiber-
optic cable from one end of the ocean to another, but
that by no means suggests that anyone will buy it from
Global Crossing for that amount of money.
To illustrate further the circumstance in which there are
many assets and no revenue from those assets with which
to pay creditors, suppose someone is worth $5 billion
Bankruptcy
When a corporation cannot pay its creditors, it must
either renegotiate the repayment schedule that it has
with its creditors or it must declare bankruptcy. When a
company declares bankruptcy, it has two choices: It can
try to reorganize and go forward or it can simply give
up. The former, called Chapter 11 bankruptcy, protects
a company from its creditors so as to give the company
time to get its financial affairs back on track. The latter,
called Chapter 13 bankruptcy, lets the company sell off
its assets in an orderly fashion so as to preserve as much
value as possible for the last-in-line stockholders. Nearly
every case of corporate bankruptcy you hear on the news
is of the Chapter 11 variety.
When a company declares bankruptcy, a judge is
appointed to oversee its financial affairs. Major financial
decisions, such as the sale of assets, must first be ap-
proved by the judge.
Why Capitalism Needs Bankruptcy Laws
While on the surface it may seem strange that the abil-
ity to avoid debts would be viewed as a “good” thing,
under capitalism bankruptcy laws actually aid eco-
nomic efficiency. Without the ability to seek protec-
tion from your creditors, even a temporary inability to
pay your debts would make it so that any one of them
could foreclose on the business. This could reduce
or even eliminate the business’s ability to turn things
around. It would happen because, while it would be in
the collective interest of the creditors for the company
to get back on its feet, it would be in their individual
interest to be the first in line to get their money back.
Suppose, for example, that a company owes money
to three different banks. Suppose, too, that the company
has insufficient funds to pay these creditors this year
but that, given the chance, it can probably make enough
money over the next few years to pay them what it owes.
Further suppose that if the company sells its assets, it
can pay what it owes to only two of the three banks.
Without the protection of Chapter 11 bankruptcy, it
would be in the interests of each of the banks individu-
ally to foreclose because each would not want to be the
one bank that wasn’t paid. In an apparent contradic-
tion, it might easily also be in the banks’ interests for
the company to be allowed to continue without anyone
foreclosing. Bankruptcy laws enable firms to continue
under judicial supervision and afford all concerned the
hope that they will pay off their debts.
474 Chapter 44 The Stock Market and Crashes
and borrows $10 billion to buy gold coins. The person
has an asset worth $10 billion but has no revenue coming
in to pay the interest on the debt. Now suppose the per-
son takes those coins and drops them one by one in the
ocean between New York and London. Our hypothetical
person now has $15 billion in assets on his or her books,
but the coins that are apparently worth $10 billion may
actually be worth next to nothing. There is genuinely $10
billion worth of debt with no revenue in sight to pay for
the interest that is accruing on it.
What Happened in the Enron Case
Usually it is not that difficult to say what a business
does. Walmart, for example, is a discount retailer; GM
makes cars; and State Farm sells insurance. To get a
handle on what happened in the Enron case, you have
to understand Enron’s actual business activities. What
did Enron do to make money? It was an energy trading
company. It bought electricity, oil, natural gas, gasoline,
and other energy sources from producers, with the intent
of reselling them to industrial companies and utilities.
It made money by “buying low and selling high.” It did
this rather well for several years during the 1990s. Later
it started getting into sideline businesses such as the buy-
ing and selling of bandwidth for the Internet.
“Buying low and selling high” is always good business
practice, but it is hard to sustain because economic profit
always induces entry (i.e., new competition), especially
when there are few barriers. Enron had few competitors in
this industry in the early 1990s, but when other companies
saw that profits were achievable in this arena, they jumped
in. With no barriers against getting into the arena, Dynegy
Inc., Reliant Energy, El Paso Energy, Duke Energy North
American, and Calpine Corp. joined the competition, and
they raided Enron for valued employees who knew the
game. Had this been the end of the story, there would not
have been much of a story at all. It would have been the
typical “company has idea, milks it for as long as it can,
and then settles in for a run of normal profits.”
What happened with Enron was that its management
wanted to keep things going and its executives were
paid almost exclusively in stock and stock options. One
of the classic problems in cor-
porate capitalism is called the
principal–agent problem, a prob- lem that occurs when the owners
of the company (the sharehold-
ers) are motivated by long-term
profitability for the company
and the managers are motivated
by monetary gain for themselves. When chief executive
officers (CEOs) are paid high salaries, they may avoid
potentially lucrative business avenues that might be ac-
companied by some level of risk. The problem is that
the agent, in this case the CEO, is not making decisions
consistent with the principals’ (in this case the stockhold-
ers’) wishes. The primary concern in this example of the
principal–agent problem is that salaried CEOs will avoid
risking their jobs and will err on the side of caution.
For years it has been taken on faith that the best way
for stockholders to get the CEO to do their bidding was
to tie the CEO’s compensation to stock performance.
One version of this has the CEO paid only in stock.
Thus, when stock prices are low the CEO is paid less
than when the stock price is high.
An extreme version of this scheme is in place when
management is paid in stock options. Stock options are
authorizations that allow those who hold them to buy a
specific number of shares of stock at the price stated on
the option. They are enormously valuable when the stock
price is above the option price but have no value when
the underlying stock price is below the option price. En-
ron’s compensation package for its managers was a com-
bination of stocks and options.
Enron’s management compensation was thus tied to
stock performance, and in the eyes of Enron sharehold-
ers, this was good. Their perception was that management
decisions that affected the company in good ways were re-
warded while those that affected the company in bad ways
were punished. It unfortunately also put management in
a position such that if it could deceive the markets into
thinking that it was doing better than it actually was, then
management could enrich itself. This is not new. This is
the primary reason why accounting firms exist. They are
supposed to guard against such deception by going over
the corporate financial statements of the companies they
audit so as to certify to the public that when a company
says it earned $1 billion, it actually did.
Enron’s deception took the form of high-debt, off-the-
books gambles. Enron created several subsidiaries, named,
for whatever reason, for “Star Wars” characters, and it
saddled each with millions in debt. Each subsidiary had a
high-risk, high-return niche market. None of this would be
interesting except for the fact that the debt of these firms
was secured by assets of the larger corporation. That in
turn would not be interesting except that this debt was de-
ceptively noted in Enron financial statements.
Enron would state that it was owed money by other
companies; it would report this as an asset but would
not mention that it was also a debt. Even more troubling,
principal–agent
problem The problem that occurs when the owner of an asset and the manager of that asset are differ- ent and have different preferences.
Rebound of 2006–2007 and the Drop of 2008–2009 475
the smaller subsidiaries would borrow from banks to pay
Enron the interest, thus raising Enron’s reported profits.
In the final analysis, Enron was overstating its profits by
$1.2 billion and its assets by even more.
When the whole thing collapsed in the fall of 2001,
there were two fatally wounded companies: Enron and
its accounting firm, Arthur Andersen. Andersen had cer-
tified Enron’s books to be accurate when they demon-
strably were not. It had participated in the creation of the
subsidiaries and had gone along with the attempt to cover
things up by issuing a reminder to employees working
on the Enron account to shred “unneeded” documents.
Though this “reminder” was technically a simple restate-
ment of company policy, everyone at Andersen who
worked on the Enron case knew that it meant to shred
the evidence. Why would an accounting firm participate
in such fraud? It again boils down to the principal–agent
problem. The lead accountant in any firm wants to please
his or her clients. The clients pay the firms millions in fees
per year for which the lead accountants are handsomely
rewarded. The principal, the accounting firm, must trust
the action of its agent, the lead accountant. Their inter-
ests are sometimes at odds because the accounting firm is
worthless without a reputation for honesty. That reputa-
tion was effectively sold by the lead accountant, without
Andersen’s knowledge or consent. The upshot of all this
was that Andersen was destroyed by the actions of its
lead accountant in the Enron case.
Why the Enron Case Matters More Than the Others
The Kmart and Global Crossing cases really do not have
much influence on the economy as a whole, but the
Enron debacle is an ominous sign of a systemic problem.
Economically speaking, Kmart’s loss is Walmart’s and
Target’s gain. Global Crossing rolled the dice and it came
up “snake-eyes.” The risk associated with buying Global
Crossing stock was pretty well understood, and if interna-
tional bandwidth markets had taken off, Global Crossing
stockholders would have made a fortune. Because they
did not, and because the firm was very much in debt, the
stockholders were left with nearly worthless stock. Enron
stockholders were simply lied to. Investors must be able
to rely on the veracity of financial statements.
Investors take calculated risks. They assemble the in-
formation and make decisions based on that information.
The area of uncertainty that investors expect is that of
the return to be received from their investments. Some
companies make a profit and others do not. They seek
to avoid the uncertainty over the veracity of financial
reports by insisting on independent audits. If account-
ing firms aid the company’s deceptive tactics rather than
uncover them, then investors are left with two areas of
uncertainty: (1) Will the company make money? and
(2) Will the financial statements tell me the truth? The
additional uncertainty about the accuracy of audits raises
the required rate of return on stocks and results in inhib-
iting some profitable business avenues.
As a direct result of problems evidenced by Enron and
Andersen, other companies began to reveal their own
“overstatements” of profits. One by one, Xerox, World-
Com, and other corporate giants came out with earn-
ings “corrections.” As a result, investors continued to
lose confidence through 2002, and stock values dropped
an additional 20 percent from levels that were already
20 percent to 60 percent below the levels of March 2000.
It was not until the early spring of 2003 that the markets
began to shake off the effects of these scandals.
Rebound of 2006–2007 and the Drop of 2008–2009
As the economy grew out of the 2001 recession, stocks
were slow to recover. By mid-2008, however, the DJIA
and S&P 500 had reached or exceeded their March 2000
levels (though the NASDAQ stood at barely half its all-
time high). What was behind this resurgence? Profits and
persistently low long-term interest rates, fundamental de-
terminants of stock market value, reasserted themselves
during 2006 through early 2008.
It was another bubble, the housing bubble, described in
Chapter 13, that then came crashing down on the heads of
investors in 2008. Companies, especially financial services
companies, with significant exposure to housing finance
were the first to drop. By Labor Day 2008, it was clear that
the problems of the housing and financial services indus-
try would not be confined to just those industries.
Not all drops in the stock market result from bursting
bubbles. When the automakers and their parts suppliers
experienced a dramatic drop in sales and losses topped
$10 billion per quarter at General Motors, few econo-
mists were calling it a bubble in this area. These changes
were part of the fundamental aspect of what stock mar-
kets do. When profit expectations fall because of poor
sales, stock prices fall.
Bank and insurance stocks were hit by a very high level
of uncertainty. The across-the-board drop in these stocks
was due to investor concern about their ability to distinguish
476 Chapter 44 The Stock Market and Crashes
between healthy and vulnerable financial institutions. The
concern was magnified by the fact that the rating agencies,
Standard and Poor’s and Moody’s, had failed to forecast the
problems with housing generally and AIG in particular.
As 2009 was moving into 2010 and beyond and the
economy began to recover (albeit at a painfully slow
pace), the stock market made handsome gains. These
gains, it must be said, were driven by the two funda-
mentals: profit expectations and interest rates. Corporate
profits increased much faster during this period than did
any other economic measure. The reason was that em-
ployers of all varieties found that once they got past the
recession’s bottom and had made adjustments to their
labor force, the remaining workers were quite produc-
tive. Sales increased while, for the most part, costs did
not. The result was higher profits, and those higher prof-
its created expectations of higher future profits. Com-
bined with low interest rates, the result was a 174 percent
rise in the Dow Jones Industrial Average from its March
2009 lows to its level in June 2016.
Summary
You now understand how stock prices are determined
and what stock markets do. You should understand
the fundamental elements of stock prices and under-
stand how prices can get out of line with their funda-
mental value. You were able to see these concepts
at work as you read stock market declines in 2000.
You understand the economic need for bankruptcy
law and the consequences of the accounting scan-
dals and bankruptcies of 2001 and 2002. Finally, you
understand that the drop in stock market prices dur-
ing 2008 and 2009 resulted from fundamental changes
to profitability.
Key Terms
bankruptcy
bubble
creditors
efficient market
fundamentals
initial public offering (IPO)
principal–agent problem
stock index
Quiz Yourself
1. The fundamental value of a share of stock is based
on the present value of expected future
a. dividends.
b. revenues.
c. profits.
d. costs.
2. A stock index is
a. essentially the weighted sum of stock prices.
b. the simple sum of stock prices.
c. the geometric average of stock prices.
d. the consensus view of professional economists.
3. If you invested in 20 different companies and chose
those companies at random, you would be counting
on the ________________________ market hypoth-
esis and its implication that you would do as well as
you would with any other investment strategy.
a. random
b. complete
c. stock
d. efficient
4. Stock market crashes tend to result when stocks
get _______________ their fundamental values.
a. too far below
b. too close to
c. too far above
d. confused with
5. A stock market exists
a. only to service the sale of new issues, called
IPOs.
b. to provide liquidity to all stocks, including re-
cent IPOs.
c. to help policy makers predict the future.
d. to make the rich richer.
6. The principal–agent problem centers on the separa-
tion of
a. supply and demand.
b. investors and savers.
c. owners and managers.
d. interest and dividends.
Summary 477
Short Answer Questions
1. Explain why the announcement of higher interest
rate targets by the Federal Reserve (if they were at
least somewhat of a surprise) would likely result in
lower stock prices.
2. Explain why, if a company’s profits are growing at
rates greater than the current interest rates and have
been expected to continue doing so for several more
years, a stock price can greatly exceed what might
otherwise seem reasonable for the sum of the assets
of that company.
3. Explain why a stock market must exist for the resale
of stock first issued many years ago for newly is-
sued stock (an IPO) to garner significant interest
among investors.
4. Explain how the “bubble” process, in which expec-
tations get way out in front of reality on the upside,
can be duplicated on the downside, causing a stock
to fall below a reasonable level.
Think about This
Not all asset bubbles are related to stocks. In 2005
there was a concern about housing prices on the coasts
exceeding all rational prices. One of history’s bubbles
involved tulip bulbs. The problem is that bubbles are
easier to recognize in retrospect. Are there any assets
you can think of that currently look like a bubble?
Talk about This
Stock markets are designed to allow corporations to raise
initial capital. In providing liquidity to previously issued
securities, they enhance that function. For these benefits
we devote some of our best and brightest financial minds.
Is that a good use of resources?
For More Insight See
Journal of Economic Perspectives 4, no. 2 (Spring 1990).
See articles by Joseph E. Stiglitz; Andrei Schliefer
and Lawrence H. Summers; Peter M. Garber; Robert
J. Schiller; Eugene N. White; and Robert P. Flood and
Robert J. Hodrick.
Behind the Numbers
Historical data.
Dow Jones Industrial Average; S&P 500; Nasdaq;
www.quandl.com
478
C H A P T E R F O R T Y - F I V E
Unions Learning Objectives
After reading this chapter you should be able to:
LO1 Describe why labor unions exist and model how they
alter the bargaining relationship between employers and
employees.
LO2 Distinguish between a competitive labor market and one
where there is market power only with the employer, only
with the employee, and when both have power.
LO3 Differentiate between labor unions that seek to raise wages
by reducing supply and those that seek to raise wages by
using collective bargaining as a monopolist.
LO4 Use knowledge of the history of unions in the United States
to predict the future of unionization in the United States.
Chapter Outline
Why Unions Exist
A Union as a Monopolist
The History of Labor Unions
Where Unions Go from Here
Kick It Up a Notch
Summary
The role of labor unions in the United States has been
the subject of some controversy for more than 100 years.
As the economy developed from agriculture to indus-
trial manu facturing, labor issues came to the forefront.
Although the struggle to organize labor to demand better
treatment began much earlier, it was not until the 1930s
that legislation was enacted giving workers the right to
bargain collectively and to join unions. Unions grew in
influence and membership, with their representation in
the workforce peaking at nearly 30 percent in 1975. That
year saw the beginning of a long and rapid decline, and
unions now represent 11 percent of the total workforce
and less than 7 percent of the private workforce.
On a theoretical level, we discuss here why unions
are usually desirable in a manufacturing economy, and
we show how they can serve the best interests of both
laborers and the economy as a whole. We then survey the
early struggles, the pertinent laws, and the successes and
failures of unions. We use two measures of union power
to illustrate the health of labor in the United States, and
we conclude with some insights into the ways unions are
making the transition to the 21st century.
Why Unions Exist
The Perfectly Competitive Labor Market
When the United States was almost entirely agrarian in
nature, aside from those who were enslaved, indentured,
or otherwise beholden to masters of one sort or another,
people worked mainly for themselves. Obviously, if you
work for yourself, and outside influences are not at work,
your pay and working conditions cannot be unfair since
your own productivity determines your own wealth. As
the United States grew throughout the 19th century, how-
ever, it evolved into an economy where fewer and fewer
people worked for themselves. The industrial revolution
came to the fore, and more and more people began to
work for companies that manufactured goods. The sup-
ply and demand model of the economy supports us in
concluding that any time one person buys something
from another person, there are gains to both sides. This
applies to labor as well.
Figure 45.1 indicates that if the good being sold is
labor, and the price at which it is sold is the wage, then,
Why Unions Exist 479
like any market in perfect competition, there is an equi-
librium wage and an equilibrium amount sold that make
both parties better off than they were before the transac-
tion took place. In Figure 45.1, at equilibrium the wage
paid is W* for L* labor. The firm that hires the labor pays
it OW*CL*, values it at (i.e., generates revenue from the
sales of output from it of) OACL*, and therefore gets
the difference that is its consumer surplus (or profit)
of W*AC. The workers get paid OW*CL* when it costs
them only OBCL* in opportunity cost to provide their
efforts. As a result, they get producer surplus of BW*C.
There is no other wage– labor combination that provides
as much surplus to the combination of both workers and
firms as this one.
In a fairly subtle way, we conditioned all this on the
assumption that there was perfect competition in the
labor market. This means that there are many indepen-
dent firms and many independent—that is, nonunion—
workers, so that neither buyers nor sellers of labor have
any control over the wage. Perfect competition also re-
quires that all parties involved have good information
about their alternatives.
A Reaction to Monopsony
We can safely assume that there is perfect competition if
we are talking about a very large city and a field that is
not particularly specialized. For instance, there are many
carpenters in large cities, and there are many contractors
who hire them. On the other hand, competition can be
a lot less than perfect for two reasons, which both boil
down to whether the number of firms buying labor is
limited. The most extreme example of this would be a so-
called company town, where only one firm buys labor in
a particular area. Though company towns tend to be rare
today, towns like Redmond,Washington, with Microsoft,
and State College, Pennsylvania, with Penn State Uni-
versity, are close. On the other hand, history is replete
with companies that literally owned entire towns. Mining
towns were especially likely to be company towns, with
all the problems of paternalistic control and subjugation
of workers with which they have been associated.
The case where the specialization is so narrow that
there are at most only a few potential buyers of that skill
is one that is somewhat different in cause but similar
in effect. This is fairly common in high-skill special-
ties where there is only one employer in a large area.
You may be actually sitting at a chair in such a location.
While assistant, associate, and full professors in colleges
earn pretty good salaries, adjunct professors at colleges
and universities are paid very little. Faculty at mid-level
universities often earn in the neighborhood of $80,000
and teach four to six courses per year. Though there
are research and service obligations to their jobs, their
salaries translate to between $13,000 and $20,000 per
course. Adjuncts are often paid less than $3,000 for a
semester-long course. Many colleges are in towns where
they are the only employer of people with masters and
doctoral degrees (especially in the arts and humanities).
For that reason, for people who are in the college town
as a result of their spouse’s work, a college can offer to
pay them very little and still get relatively high-quality
instruction.
Regardless of the reason, if it is the case that there is
only one employer in an area, that employer has power
that is very similar to the monopoly power enjoyed by
utilities. Recall that under monopoly there is only one
seller of a good and that seller can charge very high prices.
When the market has only one
buyer, a monopsony exists. In a monopsony the seller rather than
the buyer is exploited.
Figure 45.2 shows how mono psony alters the per-
fectly competitive markets depicted in Figure 45.2. Be-
fore going into the detail of the graph, though, we need
to step back and deal with a little labor vocabulary. As
we mentioned briefly in the explanation of Figure 45.2,
the demand curve for labor represents how much money
an additional worker can generate for the firm as that
worker increases production and
therefore sales revenue. This
is called the marginal revenue product of labor, and it is equal to the demand curve, because
the firm will be willing to pay
up to the amount of money it can make from its workers’
efforts in order to squeeze all possible profit out of its
labor force.
FIGURE 45.1 A labor market under perfect competition.
L*
W*
O
C
D
SA
B
Wage
Labor
monopsony A market with only one buyer.
marginal revenue
product of labor The additional revenue generated from hiring an additional worker.
480 Chapter 45 Unions
In addition, since there is only one buyer of labor, the
firm is not looking at an equilibrium wage that it must
pay its employees. The firm decides how much labor it
wants, and it pays the minimum required to get that labor.
To get more workers, it not only has to pay the new work-
ers more; it also has to pay all workers more. Thus if the
firm wants to hire more workers,
its costs do not rise along the
supply curve; they rise faster.
The cost of increasing hiring is
therefore not the supply curve
but the curve that is labeled the
marginal resource cost (MRC) in Figure 45.2. This shows the increase in total labor costs
to the firm of buying increasing amounts of labor.
To solidify this in your mind, consider Table 45.1.
The first column represents the wage that is paid. The
second is the quantity supplied. The third, the total cost
to the employer, is the product of the first and second.
The final column is the difference in the total cost from
one worker to the next. Notice that it rises substantially
faster than the first column.
The monopsonist firm maximizes profit when it hires
at the point where the marginal revenue product of labor
equals the MRC. In Figure 45.2 this is L CT
(i.e., in a com-
pany town) rather than L* workers. To find what these
workers are paid, we take L CT
up to the supply curve to get
W CT
. If we want to know what these workers are worth,
we go up to the demand curve to find that the amount of
money they are making for the company is W value
. It should
be clear that under monopsony workers do not earn what
they are worth. As a check, note that under perfect compe-
tition, at L*, workers earn their marginal revenue product;
that is, they earn exactly what they are worth.
A Way to Restrict Competition and Improve Quality
Some unions and professional organizations enhance the
pay of their members by restricting the supply of work-
ers and by increasing the value of their members. Thus
Figure 45.3 alters Figure 45.1 by reflecting the reduction
in potential workers as a changing of the shape of the sup-
ply curve. First, the supply curve moves to the left because
there is a cost to the employee of learning how to be-
come skilled in this area. The costs to the newly licensed
employees are reflected in the general movement of the
supply curve to the left. Since the number of openings
for training in the field, here noted as L′, is limited, the
supply curve is perfectly inelastic at that point. Because
there is an improvement in skills of the workers and the
quality of their work, there is a movement of the demand
curve to the right. This raises the wage to those who ul-
timately work in the field. Among others, the American
Medical Association, the American Bar Association, the
International Brotherhood of Electrical Workers, and the
Plumbers and Steamfitters1 all follow this pattern.
FIGURE 45.2 A company town and a monopsony market for labor.
L*
W *
O
C
SA
E
F
B
Wage MRC
Wvalue
WCT
MRPL
LCT Labor
FIGURE 45.3 The impact of licensing.
Wage
Labor
A
Wʹ
Sʹ
Lʹ
Dʹ
D
C
S
W *
L*
B
O
TABLE 45.1 Relationship between supply and marginal resource cost.
Wage
Quantity
Supplied
Total Cost to
the Employer
Marginal
Resource Cost
5 1 5
6 2 12 7
7 3 21 9
8 4 32 11
9 5 45 13
marginal resource cost
(MRC) The increase in total labor costs to the firm of buying increasing amounts of labor.
1The United Association of Journeymen and Apprentices of the Plumbing and
Pipe Fitting Industry of the United States and Canada.
A Union as a Monopolist 481
By restricting the ability of people to become workers
in a particular field, these types of unions keep the supply
of workers down. You cannot practice medicine or law
without a license, and that license serves as a mechanism
to restrict competition. While you can wire your own
house or do your own plumbing, in many communities
you cannot sell these services to others without a license.
The other side of Figure 45.3 is the increase in demand.
Because of the training that union plumbers and electri-
cians get, we can model their increased productivity and
quality as an increase in the demand for their services.
Thus, having a certification process also increases the
pay of these workers, because an increase in the demand
occurs for their services. As you can see, the net result is
an increase in the price of these services and an uncertain
effect on the numbers of these services that are provided.
If, on the other hand, the net effect of unionization of
this form is that the labor sold is reduced, then union-
ization of this type detracts from economic efficiency.
Otherwise, unionization is neutral or good for it. Though
there is considerable debate among labor economists
on this point, they tend to suggest that the net impact of
licensing is generally negative.
A Reaction to Information Issues
Another reason that the actual market for labor may not
be the perfectly competitive version is that workers may
not have good information about other positions they
might fill. Workers who explore other prospects tend to
be viewed as disloyal by their bosses and co-workers. To
avoid this perception as well as the effort of looking for
a new job, people may not know what they are worth
elsewhere. Though it was not stated above, one of the
things that makes the perfectly competitive labor mar-
ket perfect—workers earn what they are worth—is that
workers who are paid less than market wages know it and
will move on to other, better-paying jobs. If they do not
know about the other jobs, they are not likely to move
even when they are poorly paid or poorly treated.
There are a couple of ways that this works to hurt
workers. The first, as stated above, is that there is a ten-
dency for employers and co-workers to distrust people
seeking better jobs, especially when those better jobs
are with the competition. Therefore, there is sociologi-
cal “peer pressure” that stands in the way of workers
finding out what they are worth. Second, employers are
not above conspiring with one another to strike fear into
workers. This works when there is a limited number of
firms and they collude in agreeing not to bid against one
another for workers. When this works, each of the firms
can threaten “disloyal” workers with statements like
“you will never work in this town again.”
A Union as a Monopolist
Unions exist to ensure that workers get at least what
they are worth in a perfectly competitive market and
possibly more. In economic speak, laborers band to-
gether in unions so they can force employers to pro-
vide them with wages that are equal to their marginal
revenue product. They do this by countering the mar-
ket power that firms have with market power of their
own. Unions are most effective when they are the single
seller to a firm’s single buyer. Sometimes unions such
as the United Auto Workers, the United Mine Workers,
and the Teamsters2 provide labor to many different buy-
ers of labor. In such cases, it is the union that possesses
the sole market power.
The formal model of unions is the same as the model
of monopolies. In Figure 45.4 you see the impact of hav-
ing a union control all labor. The marginal revenue to the
union is set equal to the supply curve to find the amount
of labor the union wishes to provide. This occurs at L union
.
That means that wages are higher than before, as W union
exceeds W*. If we look at unions as if they existed in a
vacuum, it would appear they are bad for the economy,
since the consumer surplus falls by less than producer
surplus grows, so unions appear to hurt the economy.
Unions did not arise and they do not exist in a vacuum.
In some cases, poor treatment, poor pay, or both poor pay
Lunion L*
W *
Wunion
B
Wage
MR
D = MRPL
LaborO
A
E
C
S
F
FIGURE 45.4 A union’s effect on wages in a perfectly competitive labor market.
2The United Automobile, Aerospace, and Agricultural Implement Workers
of America; the United Mine Workers of America; and the International Broth-
erhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America,
respectively.
482 Chapter 45 Unions
and poor treatment encouraged workers to organize. For
others, Figure 45.4 depicts the end of the story. When
unions simply use their monopoly power to sell labor
to different competitive firms, then the existence of the
union detracts from economic efficiency. We can see,
though, that some workers lose opportunities to work,
because L union
is less than L*. We also see that the gain
to those who keep their jobs is greater than the loss to
those who lose theirs, because the producer surplus in-
creases. Clearly the firms that do the hiring are worse off
as their consumer surplus is reduced. The net effect is
that unions reduce the total amount of the surplus.
To compare those unions that exist as a reaction to
monopsony power to the case without the union, we need
to combine Figures 45.2 and 45.4. In Figure 45.5 we can
find out where the battle lines are drawn. In its monopo-
listic form the union will want to set the wages at W highest
.
This is what the union would demand if it were bargain-
ing with many different employers. The “company” that
rules the company town will want to pay what it would
have paid if it were bargaining with many independent
workers, W lowest
. There are some sophisticated economic
models that are designed to predict the outcome of bar-
gaining between unions and firms, but at this point we
have difficulty making good predictions about where
within the range the wages will ultimately settle.
Once a wage has been agreed on in this range, the
number of workers the employer will hire depends on
the supply and demand curves. To find out exactly how
many will be hired, remember that since we are not
going to be at equilibrium, it will be the lower of quan-
tity demanded and quantity supplied at that wage. To
find quantity demanded at that wage, take that wage to
the demand curve. Similarly, to find quantity supplied,
go over to the supply curve. As long as the bargaining
process works out between what unions want and what
firms are willing to pay, the economy is better with a
union in a company town than it is without a union in a
company town. The result of the bargain is that the loss
of consumer plus producer surplus is limited.
The History of Labor Unions
Labor organizations have existed in the United States
since shoemakers banded together near the end of the
American Revolutionary War. Labor’s battle was largely
unsuccessful until the beginning of the 20th century,
though, because courts saw their actions as restraint of
trade or conspiracy. Thus any union that organized and
struck an employer for better conditions or better wages
had these actions stopped by the courts.3
Before laws began to support laborers’ attempts to form
unions, and before unions had any rights under the law,
there were court rulings that were decidedly anti-union. At
one point, in a dispute between workers and a company that
made railroad cars, sympathetic railroad workers refused to
handle cars made by that particular company. The company
retaliated by having U.S. mail cars attached to the “offend-
ing” company’s cars. When railroad workers then uncou-
pled the mail cars from the company’s cars in sympathy for
the company’s workers, they were jailed for conspiracy to
tamper with the U.S. mail. From the end of the Civil War
to 1914, the courts, Congress, and most presidents were
beholden to large corporate interests, interests that saw that
union members were fired, jailed, beaten, and killed. Sel-
dom were they successful in getting pay increases.
All that began to change in 1914 when President
Woodrow Wilson, a Democrat, was able to work with a
Congress controlled by the Democrats. In that year, laws
were enacted to grant labor rights. Although one of these
laws, the Clayton Act, was overturned by the Supreme
Court, its passage marked a clear dividing line between
the political parties. Republicans sided with manage-
ment and Democrats with organized labor.
Through the 1920s Republicans held both the presi-
dency and Congress and nearly no headway was allowed for
labor unions. The Great Depression, which started in 1929,
changed the economic and political landscape. As millions
of workers lost their jobs, Democrats were voted into office;
and, under the presidency of Franklin Roosevelt, Congress
enacted the Norris–La Guardia Act, the National Industrial
Wage
D = MRPL
O L*
W *
Whighest
B
MR
MRC
Labor
A
E
C
S
FWlowest
FIGURE 45.5 The union fights the one-company town, or monopoly versus monopsony.
3See Campbell R. McConnell, Stanley L. Brue, and David A. MacPherson,
Contemporary Labor Economics, 8th ed. (New York: Irwin/McGraw-Hill, 2008),
Chapter 10.
The History of Labor Unions 483
Recovery Act, and the Wagner Act, among others. These
laws reestablished labor rights that had been granted under
the Clayton Act, and they created new ones. Under these
acts, workers were given the right to organize and to bar-
gain collectively. Additionally, they stipulated that exercis-
ing these rights could no longer be construed as conspiracy
to restrain trade. The law now stated that whenever a major-
ity of workers voted for union representation, the union was
held to represent all workers, whether nonunion workers
wanted to be represented or not. In actuality, it was often
the case that when a firm’s workers were represented by a
union, membership in that union was required as a condi-
tion of employment for all the employees.
These rights did not apply to everyone. Most notably,
government employees were still forbidden from strik ing,
but the new laws did give labor a great deal of muscle. As the
economy surged out of the depression and into World War II,
strikes were becoming commonplace. Strikes were consid-
ered serious enough that, during World War II, Congress
temporarily gave the president power to seize control of in-
dustries in which strikes were considered to be jeopardizing
the production of war material.
In the year following Japan’s surrender in World War II,
nearly 120 million workdays, 1.9 percent of all potential
work time, were lost to strikes. In part, this was because a
wide disparity existed between where wages were going
before the war and where they were as a result of a war-
time freeze. Since wages were frozen for much of the war,
workers wanted to at least be paid what they would have
been paid had the freeze not been in place. Management
liked the low current wages and argued that the health
insurance benefits that were put in place to balance the
wage freeze were sufficient to make up for the freeze.
As a result of depression-era laws, labor was still hold-
ing nearly all of the cards and was quite successful in
achieving its aims. Organized labor was so successful that
to keep its power in check, a Republican Congress passed
the Taft–Hartley Act over President Harry Truman’s veto.
The Taft–Hartley Act amended the Wagner Act in ways
that gave management back some of the cards it had held
in previous years. It allowed states to determine whether
they would allow workers who did not want union rep-
resentation to work for a company for whom a majority
wanted union representation. It also allowed the president
to order a cooling-off period, temporarily ending any
strike that threatened the economic health of the nation.
In 1962 President John Kennedy issued an executive
order that gave federal employees the right to unionize
and to bargain collectively in ways they had not been
able to do under the Wagner Act. Though still unable
to strike, they were granted grievance procedures. Other
protections were instituted that led greater numbers of
public employees to form and to join unions.
A look at Figures 45.6 and 45.7 shows that since the
time of President Kennedy, there has been a general de-
cline in the number of workers who belong to unions.
0
5
10
15
20
25
30
35
40
45
19 64
19 75
19 80
19 83
19 90
19 92
19 94
19 96
19 98
20 00
20 02
20 04
20 08
20 14
20 12
20 10
20 06
Year
U n
io n
iz e
d w
o rk
e rs
( %
)
Private Public Total
FIGURE 45.6 Union membership as a percentage of the workforce.
Source: Bureau of Labor and Statistics, www.bls.gov/news.release/union2.toc.htm
484 Chapter 45 Unions
Though union power peaked in the middle 1970s, the
decline has been long and consistent. The exception
has been the relative health of public employee unions.
Figure 45.6 shows that the percentage of all workers
who are unionized and the percentage of private-sector
employees who are unionized have fallen dramatically
since the 1980s. It further shows that the percentage of
public employees who are unionized has stayed at a rela-
tively constant 35 percent to 40 percent.
This difference between the health of public and pri-
vate employees’ unions is most clearly seen in just a
few unions. The United Auto Workers lost nearly half
of its 1.5 million members between 1978 and 1995. In
2015 their membership was only 408,000. The United
Steelworkers of America once numbered 1.3 million;
today membership is half that. On the other hand, the
American Federation of State, County, and Municipal
Employees Union has had membership increase sixfold.
Similarly, if you look at work stoppages as a measure
of labor unions’ confidence (that they can win in a situ-
ation in which workers either strike or are locked out by
management), you find that unions have been running
scared since the early 1980s. The drop in the number of
strikes is generally attributed to President Reagan’s fir-
ing of the striking air traffic controllers in 1981.
In one of the more ironic events in labor history, the
only president of the United States who had ever be longed
to a union or had been a president of a union became
the president most identified with labor’s downfall.
President Reagan had been a member of, and eventually
president of, the Screen Actors’ Guild. When the Pro-
fessional Air Traffic Controllers Organization (PATCO),
the union representing the air traffic controllers, struck in
the summer of 1981, President Reagan followed the law,
which unambiguously stated that public employees who
engaged in strikes were to be terminated. At the time,
hardly anyone thought he would actually follow through
and fire the controllers, and virtually everyone thought
he would hire them back after the strike was settled.
When they struck, he fired them. He then ordered his
secretary of transportation not to negotiate with them,
since they were fired and no longer held legal status as
employees. Instead, he ordered every available air traffic
controller in the military to fill in until new controllers
could be recruited and trained.
The events of this single week in 1981 are given in-
ordinate weight by many, but it does serve as a timepost.
Though PATCO was a small union and though unions
were beginning to lose many of their battles in the late
1970s, the outcome of this strike is viewed by many in
the labor movement as singularly important. For the first
time since the 1930s, the government was perceived to
be as much a foe of unionized labor as was manage-
ment. It is even more ironic, then, that President Reagan
garnered more union votes than any other 20th-century
Republican president.
It was not until 17 years later, when the Teamsters
Union struck the United Parcel Service (UPS) in 1998,
0
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0.50
1 9 4
8
1 9 5
1
1 9 5
4
1 9 5
7
1 9 6
0
1 9 6
3
1 9 6
6
1 9 6
9
1 9 7 2
1 9 7 5
1 9 7 8
1 9 8
1
1 9 8
4
1 9 8
7
1 9 9
0
20 05
20 0 8
20 0 2
1 9 9
9
1 9 9
6
2 0
1 4
2 0
1 1
1 9 9
3
Year
L o
s t
ti m
e ( fr
a c ti
o n
o f
1% )
FIGURE 45.7 Lost time from strikes and lockouts.
Source: Bureau of Labor and Statistics, www.bls.gov/wsp
Where Unions Go from Here 485
that a major union won major concessions from an em-
ployer. Whether this strike serves as another turning
point or simply magnifies labor’s difficulties by serving
as the exception that proves the rule will not be known for
several years. For more than 15 years nearly every major
strike left workers worse off than they had been when the
strike started. The only exception to this generalization
is strikes by already highly paid professional athletes,
which succeeded in making them even more highly paid.
Less than one-tenth of 1 percent of all work time was lost
to strikes over the late 1990s, a consequence that can be
attributed to the realization on the part of labor that they
would lose any confrontation.
The ultimate reasons that organized labor won the
UPS strike are the same as the reasons that any union
wins a strike. The workers were not easily replaceable
and the company that employed them had competitors
that were taking its market share. The labor market of
the late 1990s was such that finding dependable work-
ers was difficult. This contrasts with strikes such as the
strike by Caterpillar’s Peoria, Illinois, workers in the
early 1990s. In that period of time dependable work-
ers willing to take jobs at $15 to $25 an hour were not
difficult to find. In 1998 such workers were much more
difficult to find. Thus, the Teamsters would demand
higher wages. Another difference was that UPS saw its
market share in the overnight delivery business disap-
pear. The fear that customers would not return after the
strike induced the company to settle. Conversely, Cat-
erpillar had less of a concern that competitors would or
could take market share for long because of Caterpil-
lar’s dominance in the heavy construction equipment
industry.
In July 2005, the AFL-CIO had its most significant
defections in decades as the Teamsters and other unions
abandoned the umbrella organization. The dispute cen-
tered on whether the financial resources of the unions
should be devoted to electing politicians sympathetic
to union concerns or whether they should be devoted to
increasing union membership by unionizing previously
unorganized industries.
Where Unions Go from Here
Unions composed of men and women who work in
the public sector will likely survive long into the future,
as there are far fewer pressures on them than there are
on unions in the private sector. For instance, if a car
company decides it can no longer afford its union’s pay
demands, it can move its production facilities to a loca-
tion where the workers are only too happy to take the jobs
at whatever the company is offering. On the other hand,
if a city cannot afford its firefighters’ wage demands, it
must negotiate. It cannot move to a location where it can
hire other firefighters and pay lower wages.
Unions in the private sector are likely to have con-
tinuing difficulty for three basic reasons. First, because
employment growth has been most evident in service
and retail industries where many employers hire only a
few employees each, unions have found it much more
difficult to organize these workers. Second, since old-
line manufacturing in areas like automobiles and steel is
susceptible to international trade pressures to keep costs
down, unions will have a hard time winning concessions
even in industries in which they are still strong. Third,
the impact of Walmart and other major retailers on con-
sumer good manufacturers has been enormous. When
firms are faced with a specific retailer that is responsible
for nearly half their sales, and that retailer demands sig-
nificant cost concessions, unions representing the em-
ployees of those manufacturing firms are faced with a
tough choice. Either they give in to wage reductions or
they risk having their jobs leave for foreign lower-cost
venues. For these reasons the picture for private-sector
unions is rather bleak.
In general, the health of private-sector unions will
depend greatly on whether we return to the days when
only a few major employers hired most workers. The
information age has seen many start-up companies
lure workers away from larger companies. The wages
of computer engineers, programmers, and the employ-
ees who actually make computers are pretty close to
what these workers are worth. If, on the other hand,
the computer industry begins to centralize around only
a few major employers and start-ups become rare,
unions may finally make inroads into information-age
industries. Unless that happens, public-sector unions
may dominate the labor movement by the end of the
21st century.
Public-sector unions play an increasing role in our
economy and in our politics. The tension between the
Wisconsin governor and the public employees of that
state in 2011 show why this is the case. Public employ-
ees are attached to their employer for a much longer
period of time than private-sector employees. This is
largely the case because public-sector employees re-
main on defined-benefit pension plans that reward
longevity with one employer. Those pensions pay off
very well for those people who join the police force,
486 Chapter 45 Unions
or the firefighters, or the school system when they are
young and stay with them until retirement. None of
these professions pay well in terms of salaries, but they
all have benefit packages that well exceed what is typi-
cal for private-sector workers in that salary range. This
is especially true when you count the near certainty
of continued employment and the very low employee
contribution rates for those benefits. The future for
public-sector employees likely will continue or fall on
the basis of these public-sector unions’ ability to retain
that benefits advantage. They understand this very well,
which is why public-sector employee unions are some
of the most prolific contributors to politicians who pro-
tect their interests.
Kick It Up a Notch
Referring back to Figure 45.2 and using the notions
of consumer and producer surplus introduced in
Chapter 3, we can see that monopsony is worse than
perfect competition. Firms do better because they pay
less, and workers do worse because they make less.
The net to society is reduced by EFC because the con-
sumer surplus to firms is W CT
AEF while the producer
surplus to workers shrinks to BW CT
F. That combined
area is less than the optimal level by EFC. We can
conclude from the preceding that if the problem that
unions combat is monopsony, then unions can make
things better by moving the market toward its original
equilibrium.
In Figure 45.4 we see that the fall in consumer sur-
plus is W union
AE and the increase in producer surplus
is BW union
EF. As a result, in combination there is a net
reduction, and unions appear to hurt the economy. Re-
member from the body of the chapter, unions do not exist
in a vacuum and are typically a reaction to something
operating against workers.
Summary
You now understand why labor unions exist and how they
alter the bargaining relationship between employers and
employees. You understand how a competitive labor mar-
ket differs from one where there is market power with
only the employer, with only the employee, and when
both have power. You understand that labor unions differ
in that some seek to raise wages by reducing supply,
whereas others seek to raise wages by using collective
bargaining as a monopolist. Last, you now understand
how unions came about in the United States, and you
have enough knowledge of recent history to be able to
project where unionization is going in the United States.
Key Terms
marginal resource cost (MRC) marginal revenue product of labor monopsony
Quiz Yourself
1. When there is only one employer in a city, the model
that economists use is one for
a. monopoly.
b. monopsony.
c. perfect competition.
d. monopolistic competition.
2. When there are many employers in a city and one
union, the model that economists use is one for
a. monopoly.
b. monopsony.
c. perfect competition.
d. monopolistic competition.
3. Under perfect competition marginal resource cost
___________ supply; under monopsony marginal
resource cost ___________ supply.
Summary 487
a. equals; equals
b. equals; is greater than
c. equals; is less than
d. is greater than; is less than
4. A union that trains and restricts supply has an effect
on the supply curve that moves it to the ___________
and, at a point, makes it ___________.
a. left; vertical
b. left; horizontal
c. right; vertical
d. right; horizontal
5. Labor unions have greater representation in
___________ employees.
a. public
b. service
c. manufacturing
d. retail
6. In the past 40 years work stoppages have
a. plummeted.
b. remained constant.
c. increased slowly.
d. increased rapidly.
Short Answer Questions
1. Explain why the marginal resource cost rises faster
than the supply curve for labor.
2. Explain why, in a negotiation between a monopolis-
tic union and a monopsonistic company in a town,
there would not be a single outcome of wage and
quantity like there is if only one of those two condi-
tions hold.
3. Explain why there has been such a reduction in the
number of work stoppages.
4. Use the context of the monopoly-monopsony ten-
sion to explain why public employees are so heavily
unionized.
Think about This
The ability of unions to have their demands met has de-
creased markedly since the 1981 PATCO strike. Work
stoppages have also decreased since that time. Are
unions just not trying to make their influence known
or do they not strike knowing they have little chance of
winning?
For More Insight See
McConnell, Campbell R., Stanley L. Brue, and David A.
MacPherson, Contemporary Labor Economics,
10th ed. (New York: Irwin/McGraw-Hill, 2013), esp.
Chapters 10, 11, and 13.
Behind the Numbers
Union and private workforce information.
Statistical Abstract of the United States; labor—
https://www.census.gov/library/publications/2011
/compendia/statab/131ed/labor-force-employment
-earnings.html
488
C H A P T E R F O R T Y - S I X
Walmart: Always Low Prices (and Low Wages)—Always Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the importance of Walmart in the U.S. economy.
LO2 Demonstrate that the grocery sector continues to have a
variety of competitors with monopolist competition being an
adequate model to explain it.
LO3 Show that consumers tend to benefit when Walmart enters
a community but that labor may win or lose, that other
businesses may win or lose, and that the net impact is not
always easy to compute.
Chapter Outline
The Market Form
Who Is Affected?
Summary
Depending on whom you talk to, Walmart is either one
of the great American success stories and the driving
force behind the upsurge in American productivity, or it
is the emblem for low-wage, no-benefit, dead-end jobs,
and the destroyer of small business. The reality is that
it is all of that. Begun by Sam Walton as a small dis-
count store in Bentonville, Arkansas, it has grown over
the last 35 years to become the largest nongovernmen-
tal employer in the United States, responsible for nearly
3 percent of U.S. GDP. With nearly every new store there
is a debate about whether a new Walmart is good or bad
for the community. Several communities have banned
large discount stores on the argument that what Walmart
brings, low-priced merchandise and low-wage jobs, is
not worth the cost in terms of other lost jobs and lost
local character. This chapter explores the pros and cons
of “big-box stores” in general and Walmart in particular.
The Market Form
Most communities that have Walmart Supercenters
have other large grocery chain–affiliated stores as well.
Also in the mix are individually owned stores, some
of which are affiliated with what was once called the
International Grocers Association but is now known
as the familiar IGA. Your prototypical community will
have stores of all varieties. From warehouse stores like
Sam’s and Costco to the “supers” (Kmart, Walmart, and
Target), to the national chains (Kroger), to the national
holding companies (e.g., Ahold is a holding company
with regional stores like Stop & Shop and Giant and
Cerberus Management is a holding company that in-
cludes Safeway, Albertsons, and several others), to the
regional chains (Wegmans, Winn-Dixie, and Publix,
etc.), to the IGA-affiliated stores, the grocery business
is large and diverse. The market form that best describes
this set of conditions is monopolistic competition.
Though very small towns may have only one grocery
store (monopoly) and small cities may have just two or
three (oligopoly), the vast majority of Americans live in
a community in which three of the four types of stores
are present.
Every grocery store has a monopoly of sorts based
on its location but is faced with competition from
other stores as consumers are willing to travel short
distances past one store to go to another. Many people
The Market Form 489
have a preference for stores that include or do not in-
clude some goods. While some are intimidated by a
“super” store, others are attracted to them because they
can do grocery shopping, have their pharmacy needs
met, and pick up a power tool and a new-release DVD
all in one location. Some consumers want the “home-
town proud” feeling of an IGA affiliate because they
want to be on a first-name basis with their meat cutter
and appreci ate the fact that the owner sponsors a local
Little League team. Monopolistic competition fits this
market quite well.
A look at Figure 46.1 and Table 46.1 clearly shows
that the regional and top national grocery store com-
panies and holding companies are widely dispersed
throughout the United States with little likelihood that
any one firm could gain a monopoly in any but the
Ahold USA*
Delhaize Group*
Demoulas Market
Basket
Giant Eagle Inc*
Lowes Foods
Price Chopper
Tops Friendly Markets
Wegmans
Weis Markets
Wakefern
Brookshire Grocery
Company*
Delhaize Group*
Ingles Markets
Lowe’s Market*
Piggly Wiggly
Publix
Southeastern Grocers*
Sprouts Farmers Market
Fareway
Giant Eagle Inc*
HyVee
Meijer
Piggly Wiggly
Schnucks
Sprouts Farmers
Market H-E-B Grocery Co.*
Lowe’s Market*
Raley’s Supermarkets*
Sprouts Farmers Market
WinCo
WinCo
* Includes stores operated under a banner of the parent company.
FIGURE 46.1 Store locations of the regional grocery store outlets in the United States.
TABLE 46.1 National Grocery Chains, Locations and Establishments
Firm Number of States
Number of
Establishments
Albertsons* 33 2,200
Aldi 34 1,540
Kroger* 35 2,778
SUPERVALU* 38 1,534
Super Target** 22 200
Trader Joes 40 453
Walmart Supercenters 49 3,465
Whole Foods Market* 42 430
* Includes stores operated under a banner of the parent company.
**There are 278 Target stores that are 170,000 square feet or larger, offering a full gro-
cery selection. Target has 1500+ stores in 45 states that have a limited grocery selection.
490 Chapter 46 Walmart: Always Low Prices (and Low Wages)—Always
smallest of communities. Table 46.2 shows the percent-
age of total grocery sales by the top 10 firms. However
you slice the data, the concern that Walmart is establish-
ing a monopoly is not supported.
A similar concern is the degree to which Walmart
affects its suppliers. To many firms, large and small,
Walmart is their largest buyer. Were Walmart to become
its only potential buyer, the problem of monopsony
would occur. In that circumstance, companies are forced
to reduce the prices to Walmart for fear that Walmart will
shut them out. Just as Walmart can “make” a company
by vastly expanding the market for a company’s prod-
ucts, it can just as easily break it by compelling the firm
to produce goods more cheaply. This can, and often does,
result in the company outsourcing production to another
country, reducing wages and benefits at its U.S. produc-
tion facilities, or making products from less expensive
and less durable materials. The left-leaning Economic
Policy Institute estimated in 2015 that between 2001 and
2013 there were 400,000 jobs lost in the United States
solely because of Walmart’s practices such as this. They
further attribute 15 percent of the growth in the U.S.
trade deficit with China to Walmart.
Who Is Affected?
There are many stakeholders when any “super” comes to
town and, especially in the Northeast and West, local city
and county authorities have developed zoning laws that
are clearly aimed at keeping “supers” at bay. In examin-
ing why some object to the introduction of a Walmart
Supercenter into a community, it helps to look at who wins
and who loses. First, as a group, consumers unambigu-
ously win because Walmarts tend to charge substantially
less for identical items when comparisons are made be-
tween its prices and those of other big national or regional
grocery stores like Kroger, Safeway, Food Lion, or Albert-
sons. Often Walmart can sell its staple items (like milk and
bread) for less than IGA affiliates pay their suppliers. Sec-
ond, workers may win or lose depending on two things:
(1) whether there is a net increase in jobs or whether the
jobs gained at the Walmart are countered by lost jobs at
competitors, and (2) what Walmart pays its employees.
Third, taxpayers may win or lose depending on whether
or not there is a net addition to sales in the community
that results in a net increase in sales taxes. Finally, some of
the owners of small businesses and other existing corpo-
rate retailers may be affected negatively, while others may
benefit from such an endeavour. Let’s examine some data.
Most Consumers Stand to Gain—Some Lose Options
We’ll take each set of stakeholders in turn, starting with
the buying public. The gain to consumers from paying
less for their groceries is substantial. The average Walmart
Supercenter sells between $100 and $150 million worth
of goods in a year. Estimates vary considerably, but a
trade association of mass marketers once estimated that
Walmart’s prices were 15 percent to 22 percent lower than
national averages. Some recent estimates have reduced
that margin. That suggests that the logistical advantages
that Walmart has enjoyed are slowly eroding as others
learn from Walmart’s tactics. Suppose the average con-
sumer saves 15 percent. The gain to the consumers who
voluntarily switch from an average store to a Walmart
Supercenter is (per store) between $15 and $33 million
annually. Aggregate that over the entire country. Fifteen
percent of Walmart’s grocery sales amounts to more than
$50 billion. Given that total Federal spending on food as-
sistance (SNAP and WIC) is $76 billion, that is a rather
large supplement to family food budgets.
Whatever these consumers do with the saved money,
it is clear that they benefit from this perspective. Whether
or not the local economy benefits depends on what
consumers do with the saved money. If they consume
more locally produced goods and services, then the
local community benefits. If they put the money in their
Wall Street–managed investment accounts, the local com-
munity does not benefit as much.
There may be some locations where a “super” drives
an IGA-type store out of business and doing so makes
TABLE 46.2 Top 10 grocery store chain sales in the United States.
Source: nrf.com/news/power-players-2015 nrf.com/2015/top100-table
*Safeway, Albertsons, plus others
Rank Company
Annual
Sales (billions)
% of Top 10
Sales ($699 b)
1 Walmart $344 49.15%
2 Kroger $103 14.74%
3 Target $73 10.39%
4 Cerberus
Management*
$56 7.98%
5 Publix $31 4.37%
6 Ahold USA/Royal
Ahold
$26 3.72%
7 H-E-B Grocery $20 2.83%
8 Delhaize America $17 2.44%
9 Meijer $16 2.24%
10 WakeFern/ShopRite $15 2.14%
Who Is Affected? 491
some consumers worse off because they now have their
optimal grocery option removed from their set of choices.
To ballpark that loss, suppose a family used to pay $1,000
more a year on groceries at an IGA than they would have
at a Walmart and did so because they liked the personal-
ized service available at the IGA store. They have shown
through their “revealed preferences” that this option
is worth at least $1,000. For every 1,000 consumers so
affected, the loss would be $1,000,000. What seems likely
is that consumers as an aggregate are better off though
some may be worse off.
Workers Probably Lose
It’s hard to tell what the impact will be on workers be-
cause it is unclear whether there will be any net addition
(or net loss) to the workforce. If there is a net addition, it
may not be great enough to offset the loss associated with
the fact that, despite recent increases in their own wages,
Walmart’s pay, including benefits, is usually lower than
a unionized grocery store. A representative sample of re-
cent Walmart openings shows that they employ approxi-
mately 300 people per store. However, there are problems
with that number: First, about half of the jobs are part
time, and second, the literature on displacements suggests
that between 75 percent and 133 percent of such jobs will
be displaced elsewhere in the community.1 If we assume
that a work year contains 2,080 hours, and, further, if we
assume Walmart pays its employees $5 less per hour than
its competitors, there will be a loss to the community of
workers that is $3 million per store.
Sales Tax Revenues Won’t Be Affected Much
The question of whether taxpayers will gain or lose
depends on whether the net sales in the state increase.
The literature on the degree to which new supercent-
ers increase total sales in a community suggests that
between 70 percent and 80 percent of their sales dis-
place sales that would have taken place in that com-
munity anyway. The problem with saying that sales
taxes would therefore increase is that (1) a sizable por-
tion of the sales are for tax-exempt items like food and
(2) very little of the taxable sales would go to people
who would have spent their money outside the state.
The latter point is important because sales taxes in many
states go directly to the state. Therefore, whether the sales
are in the particular community or in one of the neighboring
counties, the sales taxes collected are the same. So, though
more sales taxes would be collected in the community, there
would be little effect on total sales tax collections.
Some Businesses Will Get Hurt; Others Will Be Helped
The impact of Walmart and other “supers” on other stores
in the area is not clear. IGA affiliates follow a strategy of
not trying to “out-Walmart” Walmart. They “believe that
a good grocery store isn’t a sprawling, impersonal ex-
ample of cookie-cutter commerce, but a community hub
owned and operated by the very people who know the
area best—the citizens.” As a result they support local
charities, sponsor many local children’s athletic teams,
stock food products not often stocked at a “super,” hap-
pily take special orders for meats not typically carried by
the “supers,” cut meat on-site rather than having it deliv-
ered already packaged, and their owners are on-site and
part of their communities. At least some of Walmart’s
growth has been at the expense of these stores.
What is also important in the mix is that Walmarts tend
to lead to the creation of complementary businesses. This
“pull-factor” has been estimated to increase the creation of
other retail business and other economic activity. A new
Walmart is likely to “pull” retail sales from neighboring
counties. That also leads to new fast-food and chain sit-
down restaurants and other “big-box” retailers like Home
Depot, Best Buy, and Staples that often follow “supers.”
Walmart can be the instant critical mass for an undevel-
oped or depressed area to become economically vibrant.
Of course they “pull” from somewhere. A study of
Walmart’s impact on community tax bases shows that
there is a statistically significant increase in the tax base
in a community when a Walmart comes to town but also
that adjacent communities see their tax bases fall. Looked
at from a regional perspective, the net, while positive, is
much smaller because the decline in adjacent communi-
ties’ tax bases wipes out two-thirds of the benefits to the
community with the new Walmart.
Community Effects
Sociologists have entered the Walmart discussion by
pointing out that the introduction of “supers” has the im-
pact of displacing stores that are owned by people who
are also community leaders. This suggests that there is a
further external cost to Walmarts in that they damage a
community’s noneconomic fabric. They also argue that
after controlling for a host of other variables, shortly after
a Walmart enters a market, local rates of poverty rise.
1 One nonacademic source suggests that Walmart gets so much more work
out of an employee that the total number of workers falls when a Walmart
comes to town.
492 Chapter 46 Walmart: Always Low Prices (and Low Wages)—Always
Summary
The net result of any new Walmart is what you would
expect. Consumers mostly win and workers mostly lose;
some businesses win and others lose, with the net being
somewhat positive depending on the particulars of the
community. If the new store simply replaces sales that
would have occurred in the town anyway and the gain in
employment is offset completely by the closing of other
businesses, then what consumers gain is approximately
equal to what workers lose. If, as is more likely, there
is some net addition to employment and complementary
businesses grow alongside the Walmart, then it is a net
addition to the community. The local business leaders
will gain or lose depending on whether they try to go
head-to-head with Walmart (a suicidal venture) or they
attempt to complement the Walmart by selling what
Walmart does not, service.
Quiz Yourself
1. The impact of a new Walmart on a community’s
consumers is
a. significantly positive for those that get lower
prices.
b. somewhat negative for those that prefer a
personal touch (if stores offering it close).
c. substantially negative in all aspects.
d. a combination of a and b.
2. The impact of a new Walmart on a community’s
workers is
a. only positive in that new jobs are created.
b. only negative because better-paying jobs at
competitors are lost.
c. positive and negative because new jobs are cre-
ated, but they often displace better-paying ones.
d. only positive because Walmart pays better than
their competitors.
3. We can measure how much someone values the per-
sonal touch of a small grocery store by using the
amount extra they pay at that store even when there
is a Walmart in town. Economists call that
a. revealed demand.
b. revealed preference.
c. parsing the preference.
d. noting the demand.
4. The impact of Walmart on its suppliers is
a. unambiguously positive.
b. unambiguously negative.
c. positive and negative in that Walmart enlarges
the market for their products but demands a
much lower price than they typically receive.
d. negligible.
5. The predominant market form for the grocery busi-
ness in the majority of U.S. cities is one of
a. monopoly.
b. oligopoly.
c. monopolistic competition.
d. perfect competition.
6. Walmart’s entry into the grocery business in the
1990s
a. turned it into a monopoly.
b. had no impact on the market form; it remained
perfectly competitive.
c. had no impact on the market form; it remained
monopolistically competitive.
d. had no impact on the market form; it remained
an oligopoly.
Short Answer Questions
1. Theory suggests that Walmart might be able to come
in, drive out competitors, and then raise prices. Data
suggest that it doesn’t happen. What would explain
why Walmart doesn’t do this?
2. Give an example of a “pull effect” that you have
seen with a new large retail operation in your city or
town, and explain whether this is simply an example
of local substitution.
3. What are the strategies that grocery stores use to
survive when a new Walmart locates in their area?
4. What is the gain to consumer surplus associated
with a new large retailer, and why might that not be
enough to overcome the losses associated with it?
Think about This
Walmart’s entry into the grocery business in the 1990s
had an important effect in lowering the price of groceries
to poor people. Should this be taken into account when
establishing the poverty line?
Talk about This
Major American companies that used to manufacture their
goods in the United States are now manufacturing their
Summary 493
goods in China because Walmart puts enormous pressure
on the company to lower prices. This is because its practice
is to tell a manufacturer what it will pay for a good. If the
company wishes to sell its goods in a Walmart, it will lower
prices. This is good for you in that you get goods at a lower
cost. It is bad for the U.S. employees of the business because
they lose their jobs. What is the net good/bad in your mind?
For More Insight See
Boyina, Manjula, “An Examination of Pull Factor
Change in Non-Metro Counties in Kansas: A Study
of the Economic Impact of Walmart Construction,”
Kansas Policy Review 26, no. 2 (Fall 2004).
Franklin, Andrew W., “The Impact of Walmart
Supercenter Food Store Sales on Supermarket
Concentration in U.S. Metropolitan Areas.” Paper
presented at the USDA conference, “The American
Consumer and the Changing Structure of the Food
System,” Arlington, Virgina, May 3–5, 2000.
Hicks, Michael J., The Local Economic Impact of
Walmart (New York: Cambria Press) (2007).
Stone, Kenneth E., Georgeanne Artz, and Albert Myles,
The Economic Impact of Walmart Supercenters on
Existing Businesses in Mississippi: www2.econ
.iastate.edu/faculty/stone/mssupercenterstudy.pdf
C H A P T E R F O R T Y - S E V E N
494
The Economic Impact of Casino and Sports Gambling Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the potential economic impact of casino gambling
in the context of the local substitution problem.
LO2 Apply the concept of externalities to casino gambling.
LO3 Summarize the local economic impact of casino gambling
while noting that it depends greatly on where the casino
is located.
LO4 Understand daily fantasy and distinguish it from other
sports betting.
Chapter Outline
The Perceived Impact of Casino Gambling
Local Substitution
The “Modest” Upside of Casino Gambling
The Economic Reasons for Opposing Casino Gambling
Sports Gambling and Daily Fantasy
Summary
When state and local governments run into financial
difficulties, one of the first solutions brought to the table
is casino gambling. Whether it be the introduction of
gambling to the state or its expansion to a new part of
the state, the argument goes something like this: “If we
open a new casino, gaming companies will hire people
to build it, more people to run it, and in the end they
will all be paying more in taxes.” This “everyone wins”
scenario is plagued with the same logical flaw as the “if
we build it, they will come” argument for publicly fund-
ing the construction of a new sports stadium. This is in
addition to the negative externality that is created for
casino communities.
The Perceived Impact of Casino Gambling
The perception that gambling has an enormous eco-
nomic impact on a community is understandable.
More than 76 million Americans set foot in a casino
each year, leaving nearly $38 billion. The casinos
themselves employ 336,272 people while paying more
than $10 billion in taxes. That, in a nutshell, is why
gambling became one of the “answers” to state budget
crises that stemmed from the 2001 recession and were
once again turned to by states looking to close budget
gaps in 2009 through 2011.
Local Substitution
The problem with the argument that a casino is an eco-
nomic boon to its host community is that the money that
goes into the casino came out of the pockets of some
other businesses and therefore does not increase total
economic activity in the community. To explain why, I
will use my hometown as an example.
Terre Haute, Indiana, is known for two things: It was
the college town for Larry Bird, and it is the home of the
U.S. penitentiary that housed and then executed Timothy
McVeigh. It is also home to economic and population
decline. Once considered a major city in the state, it
currently struggles to be noticed by the state’s leaders.
The Economic Reasons for Opposing Casino Gambling 495
Some local leaders proposed that the solution to Terre
Haute’s economic woes included a riverboat on the
Wabash River that defines the city’s western edge.
It is unambiguously true that such a facility would have
cost in the neighborhood of $100 million to construct and
that many of those construction jobs would have gone to
citizens of the city. It is also true that once operational, a
casino in Terre Haute would employ hundreds of workers
at all levels of pay and responsibility. The problem is that
money would have, in large part, come from people who
already spend their entertainment dollars in the city.
The confusion over whether casinos are an economic
answer to a community’s problems results from the fact
that the thing right in front of you often masks the equally
sized but more dispersed negative impacts. This is true
even if there are not the negative social consequences
associated with gambling.
When properly examined, the bulk of the money that
is spent on gaming in a community is money that usually
comes from inside the community. The only substantial
impact comes when a casino is located in a relatively rural
area with a major market unserved by an existing casino.
Thus residents of Cincinnati used to drive to Indiana’s
neighboring Aurora to gamble when they otherwise would
not have gone across the Ohio River to spend their enter-
tainment dollars. Chicago, Illinois, is on the Illinois and
Indiana border. Four cities on the Indiana side of the bor-
der, East Chicago, Gary, Michigan City, and Hammond,
all have casinos, but these mostly serve the Chicago met-
ropolitan area.
A Terre Haute casino might draw Indianapolis resi-
dents, but it is not close enough to make it a slam-dunk
success. The other problem with relying on the India-
napolis market is that if the issue of casinos is opened up
again in the Indiana legislature, other towns much closer
to Indianapolis will certainly want in on the game. In the
end, the people most likely to patronize a Terre Haute
casino are people who already spend their entertain-
ment dollars in Terre Haute. We know that this is exactly
what will happen because it is exactly what happened to
the people of eastern Indiana in 2011 when ground was
broken on a new casino in Cincinnati. The two casinos
in eastern Indiana faced significant competition in late
2012 and suffered from the fact that their main customer
base now has a newer casino much closer to home. In
2017, one of those weakened casinos sought to move
some of their licenses to Terre Haute.
This Indiana example is playing out in many states.
Whether it be gambling in Wisconsin, Missouri, or any-
where else, the names change but the idea stays the same.
The “Modest” Upside of Casino Gambling
Senior Economist Thomas A. Garrett of the St. Louis
Federal Reserve notes that, “Although economic develop-
ment is used by the casino industry and local governments
to sell the idea of casino gambling to the citizenry, the de-
gree to which the introduction and growth of commercial
casinos in an area lead to increased economic develop-
ment remains unclear.” The evidence, as Dr. Garrett
puts it, favors a “modest impact.” In particular, the im-
pact depends on where the casino is (rural or urban) and
whether there is a large unserved market nearby.
Were there no externalities associated with casino
gambling, the Garrett data would suggest that it is no
different from any other recreational activity. That it is
no ticket to an economic panacea would not preclude
it from being part of the larger solution of economic
growth. Again, looking at my state’s experience shows
that the impact of casino gambling is quite modest. From
1991 to 2001, the period of significant casino growth
in the state of Indiana, the annual growth rate in per-
sonal income in counties with a casino was 5.3 percent,
whereas in counties without a casino that annual growth
rate was 5.2 percent.
Further, the notion that casinos are a boon to com-
munity tax coffers is partly wrong and partly deceiving.
Much of the revenue that gets attributed to the casino
would have been paid by other entertainment operators
were there no casino. Concentrating the dollars paid into
one source doesn’t make them any greater. The real in-
crease in tax revenue attributable to casinos exists be-
cause the effective tax rate on a gambled (and lost) dollar
is substantially higher than the effective tax rate on a
dollar spent at a restaurant or a dollar spent at a bowl-
ing alley. It is a tax increase that brings in the revenue to
local governments, not an increase in economic activity.
No wonder politicians fall for casino industry promises of
money; they offer the possibility of raising taxes without
the negative political consequence.
The Economic Reasons for Opposing Casino Gambling
The economic reasons to oppose this modest economic
growth opportunity are the same as the reasons to op-
pose or limit the sale of tobacco, alcohol, drugs, and
prostitution. Gambling is quite clearly addictive. Addicts
of all varieties will do anything to satisfy their desires.
496 Chapter 47 The Economic Impact of Casino and Sports Gambling
those who use their cards to support a gambling addic-
tion. In addition, the money that gamblers use to support
their habit could have been put to better use on food,
clothing, or other goods for their family. When gamblers
divorce, leaving spouses and their children on public
assistance, those consequences are an external cost of
gambling. Left unregulated or untaxed, any such market
that produces external costs will produce too much.
Sports Gambling and Daily Fantasy
In traditional sports gambling, you place a wager on
which team is going to win. In most sports where there
are more people who think that one team will beat an-
other, a point spread is offered whereby the expected
winner has to win by more than the spread in order for
the person betting on that team to win the bet. So when
the undefeated 2007 Patriots entered that year’s Super
Bowl as 13-point favorites, the bet was over long before
the game was. The Patriots not only lost the game, even
if they had mounted a game-winning drive at the end,
they would have lost against the spread. There are very
limited locations in the United States (Nevada, Oregon,
Delaware, and Montana) in which it is legal to bet on
the outcome of a game; however, illegal betting reaches
into nearly every place of work during the NCAA men’s
basketball championship. It is estimated that $9 billion is
wagered (almost entirely illegally) on March Madness.
One relatively new entrant into the world of sports
gambling is the business of “daily fantasy.” It attempts
to classify itself as a game of skill (legal everywhere) in-
stead of as a game of chance (legal in only a few places).
To understand how daily fantasy makes that argument,
you have to understand its history. Daily fantasy is a spi-
noff on fantasy sports, which itself is a spinoff of the
very old rotisserie baseball. In the latter two, two or more
people would create a league and draft players. The per-
formance of those players over the course of a season
would determine the winner of the league. Instead of a
team scoring traditional runs, goals, or points, the indi-
vidual players’ statistics would be converted into points
using an agreed-upon standard. In football, touchdowns,
yards rushing or passing, defensive points allowed
would be converted into league points. In baseball, runs
batted in, runs scored, earned run average, etc., would
be converted into league points for each game played.
In some leagues you would have an opponent each day
or each week, and if you scored more points than they
did, you won, and if not, you lost. In other leagues, it
Gambling addicts will run up credit card debt, mortgage
their homes, and put their families in terrible financial
condition before seeking help. This leads to another prob-
lem: Gambling is associated with
costs borne by someone other
than the gambler or the casino.
In the presence of externalities, free markets produce more of the
good or service (including gambling entertainment) than
is consistent with economic efficiency.
Psychologists who study gambling addicts contend
that most inveterate gamblers became attracted to it
because they won significant sums of money their first
time. This creates an emotional high in the same cen-
ters of the brain that drug addiction affects and, like drug
addicts, gamblers continually try to repeat that high. Of
course, they can’t win over the long run. Casinos make
money, money that used to belong to gamblers. To a stat-
istician, gambling has a negative “expected value.” That
means that the average person who brings in $100 to a
casino will leave with less than $100. This is because the
gambles themselves are never
“fair.” Whether it’s craps, poker,
blackjack, or any other game, the
“house” has a “vig,” or percent- age of the average gamble that is
its take. The “vig” is what pays for the employees, the fa-
cility, and the profits to the casino company. This is why
there are few gamblers who make their money gambling.
This, of course, is no different from any other form of
entertainment. You never leave a movie theater with more
money than you went in with. Assuming the movie was
good, you do not complain because you got to see the
movie. The allure of gambling is that you will win. When
your first experience with gambling is like mine (I fed
$40 in quarters into a slot machine in 20 minutes and won
nothing), casino gambling has no appeal. On the other
hand, psychologists insist that when you win big your first
time out, there is a “high.” It is a high that could potentially
lead to addiction. As a result, you can make an economic
argument against casinos on the same grounds you argue
that cocaine or methamphetamine should be illegal.
That addiction can also create other negative behav-
iors by the gambler, and those behaviors can affect in-
nocent third parties. When gamblers borrow extensively
to support their addiction to gambling, the result can be
high rates of bankruptcy. Higher bankruptcy rates lead
to higher interest rates for the rest of us because credit
card companies cannot distinguish people using their
credit cards to buy food, clothing, or pay hotel bills from
externalities Effects of a transaction that hurts or helps people who are not part of that transaction.
vig The expected percent- age of any gamble that a casino will keep.
Summary 497
was simply a running total of your league points against
others’ league points.
That was all fine for people who were content play-
ing for nothing of real value. Gamblers want instant
results. A season-long league doesn’t suit their tastes.
Instead, the daily fantasy business created one-day
leagues. You draft before games start, and when the
day is over you know the statistics, the league points,
and the winners. Unlike traditional season-long fantasy
leagues where a group of friends would gather around a
table at one time and draft players, in daily fantasy you
log into a website and have to buy players using a credit
card. The price on any particular player is a function of
their expected performance. The price on a superstar is
much higher than the price on an unheralded nobody.
It is this aspect on which backers of the assertion that
daily fantasy is a game of skill make their case. A well-
informed, statistically savvy analyst can choose cheaper
players and beat the stars. They can get more points and
a higher net payout if they buy the right players, not just
the popularly chosen ones. Though there are more than
30 fantasy sports sites, between DraftKings and Fan
Duel they controlled 95 percent of the market in 2016.
The vig for each is similar, between 6 percent and
15 percent, and depends on the sport.
The legal distinctions that enabled daily fantasy to
exist began to unravel in 2016 as several states began to
outlaw participation by their residents. Some states cre-
ated a distinction between legal residents physically in
the state and those outside the state; others did not.
It is worth noting that sports gambling in the rest of
the world is largely legal. Eight of 20 Premier League
teams sport gambling sites on their jerseys, and all
20 have some associate sponsor. BWIN.com sponsors
LaLiga’s Real Madrid but only after it had previously
sponsored Barcelona.
While some may believe that there is or is not a legal
distinction between casino gambling, traditional sports
gambling, and daily fantasy, there is clearly no economic
distinction and no distinction regarding the negative ex-
ternalities associated with gambling. Whatever side you
are on with regard to the balance between the individu-
al’s right to participate in these forms of entertainment
and society’s concern for the impact of gamblers’ behav-
ior on others, should probably be the same regardless of
the type of gamble.
Summary
You now understand that it is easy to overstate the im-
pact of a new casino on the economy of a community.
The impact is “modest” because of the degree of local
substitution. There is no panacea of better jobs, higher
incomes, and greater tax revenues. You also understand
that gambling is addictive and that economists consider
addictive goods worthy of regulation. Finally, you under-
stand that a casino produces external costs, and like any
good where that happens, an unregulated, untaxed mar-
ket will produce too much gambling.
Key Terms
externalities vig
1. The argument that casinos have little economic
impact on a community is based on the notion of
a. supply.
b. demand.
c. opportunity cost.
d. local substitution.
2. Economists generally believe that a new casino in
a city that already has them would likely have
—————— economic impact.
a. an enormously negative
b. a modestly negative
Quiz Yourself
c. an enormously positive
d. a modestly positive
3. Which one of the following communities would
likely see the greatest economic impact from a new
casino?
a. Plainfield, IN (just outside Indianapolis)
b. Gary, IN (outside Chicago and already has one)
c. Terre Haute, IN (Indianapolis is 70 miles
away; no other population center is closer than
180 miles)
d. Las Vegas, NV
498 Chapter 47 The Economic Impact of Casino and Sports Gambling
4. The percentage that casinos make on the average bet
is called the
a. vig.
b. rip.
c. take.
d. rob.
5. The argument that increasing the number of casinos in
a state will increase overall tax revenue in the state is
a. substantially correct, because they pay substan-
tial taxes.
b. overstated but still partially correct, because
there is tax substitution, but gambling profits
are taxed more heavily than other profits.
c. understated because they pay more taxes than is
generally known.
d. wrong because casino profits are not taxed.
6. The concern that gambling affects not only the
gambler and casino but also others is called a
————— and suggests that there would be too
—————— production in an unregulated or un-
taxed market.
a. positive externality; much
b. negative externality; much
c. positive externality; little
d. negative externality; little
Short Answer Questions
1. If you were in a political argument with some-
one taking the side of the casino industry and she
pointed out that casinos pay significant taxes, how
would you (being on the other side) respond?
2. Suppose you were in a political argument with
someone who wanted to locate a casino in your city
(supposing that it had none), because there was a
large city across the river in another state (also with-
out one), and he pointed out that you could lure all
those people in that large city to spend their money
in your city. Supposing that you were against it, how
would you counter that particular point?
3. What externalities exist when there is a casino, and
how might those externalities be dealt with in a way
that would allow a casino while also mitigating the
externalities?
Think about This
Casino companies, Walmart, and sports teams make the
same case with regard to economic development, and
they are mostly wrong for the same reasons: local sub-
stitution. Why do they still succeed in overstating their
economic impact?
Talk about This
The effect of gambling addiction is similar to the effect
of other addictions, though it is less apparent to others.
Alcoholics, drug addicts, and so on, are easier to spot.
Part of the problem is that inveterate gamblers can be
successful at their addiction (winning a televised poker
championship) or unsuccessful (and losing everything),
while no one becomes a successful meth addict. Is gam-
bling a problem only for the losers? Should casinos allow
people to lose only a particular amount of money?
For More Insight See
Evans, W. N., and J. Topoleski, “The Social and Economic
Impact of Native American Casinos,” NBER Working
Paper No. 9198: http://papers.nber.org/papers/w9198
Garrett, Thomas A., Casino Gambling in America
and Its Economic Impacts, Federal Reserve Bank of
St. Louis: http://research.stlouisfed.org
Garrett, Thomas A., and Mark W. Nichols, Do Casinos
Export Bankruptcy? Federal Reserve Bank of
St. Louis: http://research.stlouisfed.org/wp/2005/2005
-019.pdf
Behind the Numbers
Taxes, wages, revenue, and visitations.
American Gaming Association—
www.americangaming.org; Center for Gaming
Research—http://archgaming.unlv.edu
C H A P T E R F O R T Y - E I G H T
499
The Economics of Terrorism Learning Objectives
After reading this chapter you should be able to:
LO1 Describe the economic impact of the September 11, 2001,
terrorist attacks.
LO2 Apply the aggregate supply–aggregate demand model to
show the impact of the attacks.
LO3 Describe how insurance works and why the increased
uncertainty after the attacks affected insurance markets.
LO4 Explain the concept of the “rational” terrorist.
Chapter Outline
The Economic Impact of September 11th and of Terrorism
in General
Modeling the Economic Impact of the Attacks
Terrorism from the Perspective of the Terrorist
Summary
This chapter explores the impact of terrorism and its con-
tinuing threat on the U.S. and world economy, as well
as why economists look upon the terrorist as we would
look upon any “rational” economic actor. In doing so,
we will review the economic impact of September 11th.
As we progress, you will understand how economists
apply the notions of uncertainty, risk, and insurance when
exploring the economic impact of terrorism and why
self-protection against terrorism negatively affects those
that do not protect themselves. Further, you will see why
economists look upon the terrorist in the same way we
look upon the drug dealer or the Mafia hit man: as a ratio-
nal economic actor seeking to maximize benefits to him-
self at a minimum of costs.
The Economic Impact of September 11th and of Terrorism in General
Osama Bin Laden’s Al-Qaeda operatives claim that the
damage inflicted by their attacks on the United States to-
tals more than $1 trillion. While that figure was hard to
justify at the time, true damage estimates are, nonetheless,
difficult to construct. In order to tally up the damage, you
have to begin with the costs associated with the demoli-
tion and the ensuing cleanup of World Trade Center and
Pentagon debris. Then you have to add the costs of rebuild-
ing the affected portion of the Pentagon and replacing
the WTC commercial and transportation facilities.1 You
must also include the lost earning potential of the more
than 3,000 victims. You cannot stop there. The war on
terrorism, and the ancillary increases approved in defense
spending because of that war, have added $100 billion
annually to the federal budget. Adding the cost of the war
and occupation of Iraq2 and Afghanistan and the subse-
quent overt and covert wars against ISIS to the mix sends
the total much higher, and begins to make the $1 trillion
claim of Bin Laden seem not so implausible.
There are other costs you must include as well: any
and all other money you have to spend because of the
attacks that you would not have had to spend had the
attacks not occurred. When that is complete, you have
to add the money that could have been earned that might
not now be earned. Thus when survivors seek counsel-
ing because of their trauma; when we all demand greater
security at airports, large sporting events, and other
1The Institute for Analysis of Global Security estimates these costs at between
$10 billion and $13 billion. 2Setting aside whether the war in Iraq was really about terrorism, it is unlikely
Iraq would have been invaded had there not been the terrorism argument in
the background.
500 Chapter 48 The Economics of Terrorism
connections, and regain electric power. This includes the
inhabitants of the World Trade Center itself as well as
the people who worked in surrounding buildings that had
to be evacuated because of the damage done to them.
Now consider the losses outside of New York and
Washington that must be associated with the attacks.
Airlines in particular were hard hit. The resulting drop
in passenger flights led them to lay off more than
100,000 employees. Nationwide, in all sectors of the
economy from mid-September through the end of 2001,
new filings for unemployment insurance increased from
just over 300,000 per week to nearly 650,000 per week.
Although these numbers diminished to between 400,000
and 450,000 for most of 2002 and 2003, the employment
outlook remained weak during this period. The Institute
for Analysis of Global Security placed the total cost of
the attacks at $2 trillion.
All of the preceding examples are clearly costs to soci-
ety, but in what will appear to be quite contradictory, GDP
accounting will score some of these losses as economic
positives. The money it cost to tear down the damaged
buildings and begin rebuilding the New York WTC site
and Washington’s Pentagon came from two main sources.
The federal government put forward $40 billion for this ef-
fort, and insurance companies were responsible for another
$25 billion. The resulting increase in government spend-
ing will likely have a positive impact on GDP in the future,
and because the insurance companies footing the bill were
mostly foreign rather than domestic—while the demolition
and rebuilding efforts occurred in the United States—this,
too, had the effect of boost ing GDP.
Increases in military spending, government spending
on internal security, and spending on airport security
have led and will also continue to lead to increases in
GDP. Of course, none of this is likely to make us better
off than we were on September 10th. We only hope that
by spending this extra money we will be as secure today
as we thought we were on September 10th. Spending
more to accomplish the same thing boosts reported GDP
but does not make us better off.
Modeling the Economic Impact of the Attacks
If you have studied Chapter 9, “Fiscal Policy,” you are
familiar with what economists call aggregate-demand
shocks. Let me remind you that aggregate-demand
shocks are unexpected events that change aggregate
demand. Clearly, the attacks of September 11th qualified
potential targets; or, whenever we forgo an opportunity
to travel because of the risk that we feel is present, these
expenses must be included among all the other economic
impacts of the attacks.
Starting at the top, the World Trade Center and the
adjacent buildings were insured for $4 billion. The dam-
age to the Pentagon cost another billion to repair. Next,
the four planes were worth between $50 million and
$100 million each. These are costs related to the direct
damages that resulted from the attacks, but they are by
no means either the only costs or the only damages.
There was income lost as a result of these buildings
being attacked. Those in the WTC and surrounding
buildings who did not perish did not produce goods and
services for several days as their employers sought new
facilities in which to operate. Many of the people and
companies housed in the WTC towers were engaged in
offering financial services, and they had purchased in-
surance against loss of income. Estimates of these losses
suggest that upward of $10 billion was paid to these
companies to compensate them for that lost income.
Total insurance estimates of the cost of the New York
attacks total between $25 billion and $30 billion. As a
result, many of the victims of the attacks received some
form of monetary compensation, either from employers
or from organizations like the Red Cross.
In economic terms, accounting for the loss of those
who died is somewhat more difficult, depending as
it does on estimating the value in money that a victim
would have been worth over his or her entire projected
lifetime. Economists have little trouble coming up with a
dollar figure that we can justify, but it is clear that saying
that the life of Mary the secretary was worth $750,000
and that of Sally the investment banker was worth
$3.6 million raises controversy.
A first pass at estimating what was lost to the economy
as a result of the deaths of 3,000 people is to establish the
present value of their future earnings. These were highly
trained and highly paid people. If you assume that the
average person killed earned $75,000 in salary and ben-
efits, was 40 years old, and had a life expectancy of 35
more years, then such a calculation would have each per-
son worth approximately $1.7 million. With 3,000 dead
that comes to a little over $5 billion.
In addition to what we have presented so far, there
is the lost production of those 100,000 or more New
York residents who would have been producing goods
and services in the weeks following the attacks but were
not able to because their bosses were still attempting to
find new office space, reestablish phone and computer
Modeling the Economic Impact of the Attacks 501
as “shocks” under any definition. Retail sales during the
week of September 11th were dramatically lower than they
otherwise would have been. This, and a variety of other
indices of consumer confidence, all took very serious
hits in the fall of 2001. Complicating things further, busi-
ness confidence, which is typically measured by looking at
businesses’ hiring, layoff, and investment plans, was also
adversely affected by the aftermath of the attacks. These
effects in combination created the clearest example of an
aggregate-demand shock in decades. Figure 48.1 shows the
impact of these shocks on the aggregate demand–aggregate
supply model. Lower aggregate demand reduces equilib-
rium, real gross domestic product, and overall prices.
As we will see in the section on insurance later, premi-
ums paid by businesses in high-risk areas rose substan-
tially as well. That would lead to an aggregate-supply
shock. Though this effect was likely less than the relative
importance of the aggregate-demand shock, it is impor-
tant to note, and Figure 48.2 depicts that aspect.
Insurance Aspects of Terrorism
When dealing with a world of uncertainty, rational people
can seek out insurance because they view themselves as
better off if they can pay something upfront to minimize
the financial consequences of a foreseeable, but not nec-
essarily predictable, problem. We insure our cars and our
homes because, although the likelihood of a financially
catastrophic incident is low, the consequences of a prob-
lem could be so severe that we are better off avoiding it
by paying an insurance company to take the risk for us.
The insurance company is only too happy to sell us the
insurance because they get more money than they expect
to have to pay out, and the uncertainty in their payouts is
relatively low because they are spread out over so many
people. They have actuaries who tell them how many
homes are likely to be damaged in fires or how many
automobiles they are likely to have to repair or replace.
Terrorism insurance in a place where terrorist acts are
somewhat predictable (like Israel) is likely to be very ex-
pensive but also likely to be available because insurance
companies can anticipate the number of buses and restau-
rants that will be destroyed. These many small-scale attacks
are insurable because no single one of them jeopardizes the
long-term survival of the insurance company. September
11th changed much of that thinking. It was the worst insur-
ance outcome in American history, easily surpassing the
previous record set by Hurricane Andrew.3
In the post–September 11th world, insurance compa-
nies have become leery of insuring major commercial
landmarks. A major attack of a nuclear, biological, or
chemical nature, or even another airliner hijacking di-
rected at a major population center, is enough to cause
insurance companies to fear for their own survival. For a
while they refused to offer insurance on major new con-
struction projects, did not renew policies on major com-
mercial landmarks, and insisted that acts of terrorism be
excluded from the policies’ payout provisions.
This is not without precedent. After Hurricanes Andrew
and Hugo in the late 1980s and early 1990s, insurance
companies began pulling out of the Gulf Coast region of
the United States for fear that they could not survive an-
other hurricane. They stayed because they were able to buy
FIGURE 48.1 The post-9/11 aggregate-demand shock.
AD9/10
ADpost-9/11
AS PI
PI*
RGDP* RGDP
AD Shock
AD
ASpost-9/11
AS9/10
PI
PI*
RGDP* RGDP
AS Shock
FIGURE 48.2 The post-9/11 aggregate-supply shock.
3The monetary damage from Hurricane Katrina and Superstorm Sandy both
subsequently surpassed this record.
502 Chapter 48 The Economics of Terrorism
reinsurance and pass the cost on to their customers. Reinsurance
is like insurance itself except it
is bought by insurance compa-
nies from other larger insurance
companies (or from consortiums
of insurance companies). The
provisions of these reinsurance
policies state that if a loss exceeds a certain level (usually
in the multiple millions of dollars) for any one major event
(such as a hurricane or terrorist attack), then the reinsur-
ance company pays the insurance company and they, in
turn, pay the claims of the victims of the incident.4
September 11th was so big that the reinsurance com-
panies were concerned for their own financial survival.
Of course, at the time they did not know whether Sep-
tember 11th would be followed by several more attacks
or not. The anthrax scare of late 2001 and early 2002 only
added to the uncertainty. Insurance works well when the
level of uncertainty to the party doing the insuring is
somewhat low. Reinsurance works well when the uncer-
tainty to the insurance company is large but is manage-
able to a reinsurance company. Nothing works when no
one has any level of confidence in the risks involved.
The solution was re-reinsurance, where the U.S. fed-
eral government became the insurer of last resort. No one
buys terrorism insurance from the government; there are
no re-reinsurance agents selling to homeowners or busi-
nesses. The government will sell reinsurance to insurance
companies and re-reinsurance to reinsurance companies.
Few pieces of legislation initiated by the George W. Bush
administration passed with as much support as the bill au-
thorizing the government’s involvement in the reinsurance
market. This was partly because much of the financial com-
munity and labor unions were on the same side of the issue.
Buy Insurance or Self-Protect or Both
When faced with any uncertainty, a rational economic
actor can do one or both of the following: protect himself
or buy insurance against the loss. We have already exten-
sively discussed the latter, so let’s talk a bit about self-
protection. Suppose you live in a community in which
automobile theft is rampant. You can buy a car with an
electronic alarm, an ignition that will start only with a
special key (such that the car cannot be “hot-wired”), or
a tracking system like “Lo-Jack” that allows a stolen car
to be located from a satellite. You can also buy a product
like “The Club” that prevents a car from being driven
when it is attached to the steering wheel.
If you protect yourself against such a loss, you are
simultaneously making your car less attractive to a thief
and your neighbor’s car relatively more attractive. This,
like the problem of pollution or secondhand smoke, is a
negative externality. Your actions hurt someone else who
was not part of your decision to take action. With terror-
ism, if one business were to install devices or employ
personnel to deter terrorist acts against it, a neighboring
business becomes a relatively more attractive target. If
you have flown since September 11, 2001, especially if
you have flown during a code “Orange” elevated state of
alert, you know that U.S. airports are substantially more
secure than they were prior to that time. In the aftermath
of the heightened security at airports and the USA Pa-
triot Act, which allowed substantially more intrusive
surveillance of foreigners in the United States, a terrorist
is unlikely to attempt an attack on a target in the United
States, let alone a U.S. airport, and far more likely to
target Americans or American interests in other, less se-
cure locations. That puts Americans in those locations in
more danger than they would have been had these secu-
rity measures not taken place in the United States.
Terrorism from the Perspective of the Terrorist
Economists who study terrorism look upon these folks
in the same manner as economists who study crime look
upon hit men: as rational people behaving in their own
self-interest. You can quarrel with this interpretation if
you like, and many people have a hard time calling a sui-
cide bomber “rational” in this sense, but terrorists are in
it for something. That “something” is usually political.
Irish Republican Army (IRA) terrorists wanted Northern
Ireland returned to Irish control or at least wanted the
English out. Palestinian terrorists want some, most, or
all of what is now Israel as a Palestinian state. Sudanese,
Filipino, and antiabortion terrorists have political goals.
ISIS seeks a global Islamic State. Whether you are a ter-
rorist or a freedom fighter often depends on which side
of the power structure you are on.
This “rational terrorist hypothesis,” like the “rational
criminal hypothesis,” suggests that terrorists have a goal,
that they devote resources to achieve that goal, that they
weigh benefits and costs, and that the best way of reaching
reinsurance The form of insurance where one insurance company promises to pay another if the first company has a large (usually multiple mil- lion dollar) loss from a single event.
4Hurricane Katrina challenged the ability of insurance companies to buy
reinsurance for hurricanes because the fear was that global warming had so
changed the probability of major hurricane damage occurring in an area that
State Farm and others refused to write new policies in states susceptible to
hurricanes.
Summary 503
the goal is to take all such actions where the marginal ben-
efit equals or exceeds the marginal cost. Since the goals are
political, the actions must have a political impact, which
means they must garner media attention. They garner the
most media attention when attacks are gruesome, affect
innocent people, and occur where the media exist. They
are the least costly to the terrorist when the targets are rel-
atively unguarded and easy to get to. That means that from
the perspective of Al-Qaeda, the September 11th attacks
were nearly perfect. The lax security at U.S. airports; the
high-profile nature of the World Trade Center, the Penta-
gon, and the Capitol Building or White House (whichever
building Flight 93 was destined to attack) in the media
meccas of New York and Washington; and the obvious
innocence of the people on the planes and in the buildings
made them the perfect targets for terrorism.
The worldwide reaction, the wars in Afghanistan and
Iraq, and the public’s willingness to give up some degree of
its freedoms and privacy combined to make the costs of ter-
rorism to the terrorist substantially greater. The substantial
increase in the counterterrorism budget of the CIA and the
FBI and the new powers granted to these organizations make
a terrorist act in the United States far more expensive to pull
off. The lack of any attack in the United States between
September 11th and the writing of this edition suggests that
terrorists may have weighed the costs and benefits and taken
the stance that attacks on U.S. interests in the United States
are not worth it. On the other hand, terrorists have clearly
not given up. Attacks around the globe, embassy bomb-
ings, assassinations of U.S. diplomats, and attacks on places
where Americans congregate overseas suggest terrorists
are targeting easier locations using smaller groups or indi-
viduals. Economists refer to this, and any other occurrence
where one alternative gets more expensive so that the other
is chosen, as the substitution effect.
The Madrid train bombing in 2004 and the London
subway bombings in 2005 illustrate this substitution ef-
fect very well. Because terrorists apparently thought it
was easier to get into Spain and the United Kingdom
than it was to get into the United States, they chose tar-
gets that were “less expensive.” Though in the U.S., the
2013 Boston bombing also fits this pattern.
Unprecedented expenditures on increased security
generally have motivated terrorists to find the softest,
most high-profile targets. The attacks in 2016 in France
and Belgium were examples of this. Clearly the United
States is not immune from attack, but so far, at least, it
has been limited to lone wolf attacks. The incidents such
as the ones in Boston, San Bernardino, Orlando, and
Ohio State are likely to be what we face.
Summary
In this chapter, you have seen that economists’ estimates
of the damage inflicted by Al-Qaeda on September 11,
2001, encompass a wide variety of issues, from the loss
of the buildings, to the loss of economic output, to the
economic consequences of the loss of lives. You have
also seen that insurance issues become more complicated
as the level of uncertainty rises but that reinsurance
helps to resolve those issues. Finally, you now see that
economists view terrorists as rational economic actors
attempting to get the biggest result for the least expense
in the same way that any other goal- oriented person
would. As a result, we can predict that as we tighten
security in one area in response to an attack, they will
seek other targets.
Key Term
reinsurance
1. This chapter suggests that many economists generally
a. accept the notion that a human life is worth the
value of the chemicals that can be extracted from it.
b. argue that a human life is worth the sum of the
person’s future income.
Quiz Yourself
c. argue that the loss to society resulting from
“wrongful death” is the present value of the
person’s income.
d. reject the notion that any dollar value can be
used to estimate the value of a human life.
504 Chapter 48 The Economics of Terrorism
2. The destruction of the World Trade Center and dam-
age to the Pentagon and the accompanying work to
rebuild and repair led to ___________ to the insur-
ance companies and ___________ in GDP.
a. gains; gains
b. losses; losses
c. losses; gains
d. gains; losses
3. Economists call the reduction in consumer confi-
dence that resulted from the September 11th attacks an
___________ shock which leads to the ___________.
a. aggregate demand; aggregate demand curve
shifting left
b. aggregate demand; aggregate demand curve
shifting right
c. aggregate supply; aggregate supply curve
shifting left
d. aggregate supply; aggregate supply curve
shifting right
4. Economists call the increase in insurance costs
that resulted from the September 11th attacks an
___________ shock, which leads to the ___________.
a. aggregate demand; aggregate demand curve
shifting left
b. aggregate demand; aggregate demand curve
shifting right
c. aggregate supply; aggregate supply curve
shifting left
d. aggregate supply; aggregate supply curve
shifting right
5. The chief effect of reinsurance is that
a. insurance premiums are higher.
b. insurance companies are prevented from engag-
ing in fraud.
c. insurance companies can offer insurance with-
out fear of a major event causing them to go out
of business.
d. consumers are protected against easily antici-
pated occurrences.
6. The government’s role in terrorism insurance is that
of
a. a primary provider.
b. a reinsurance provider of last resort/re-reinsurer.
c. innocent bystander.
d. disinterested observer.
7. The negative externality associated with self-
protection from terrorism suggests that
a. terrorists cause more damage than they think
they will.
b. people engage in less self-protection than they
should.
c. people engage in the right amount of self-
protection.
d. a person who self-protects makes someone else
relatively more vulnerable.
8. Under many economic models of terrorism, the ter-
rorist is assumed to act
a. without regard for incentives, costs, or benefits.
b. in a predictable way, since they maximize costs
subject to minimizing benefits.
c. in a predictable way, since they maximize ben-
efits subject to minimizing costs.
d. with no predictable nature.
9. Substitution in the context of the “rational terrorist
model” suggests that a clampdown at airports will
a. end terrorism.
b. cause terrorists to target airports even more as
they attempt to show their strength.
c. cause terrorists to seek alternative targets.
d. foment even more terrorism around the globe
because it will show them they have succeeded.
Think about This
One of the things that counterterrorist intelligence agents
must do is put themselves in the position of the terrorist.
Take 10 minutes and think about your hometown. What
action could terrorists take that would have the maxi-
mum impact for the least cost to themselves? Would that
action necessarily be suicidal?
Talk about This
Do you agree with the contention that terrorist actions
can be viewed as “coldly rational”? Would you char-
acterize the actions of terrorists who kill themselves in
conducting their operations as rational?
For More Insight See
Brauer, Jurgen, “On the Economics of Terrorism,” Phi
Kappa Phi Forum 82, no. 2 (Spring 2002).
505
I N D E X
A Aaron, Henry, 428
Abortions, under Medicaid, 284
Absolute advantage (trade), 204–205
Acceptable deaths, 253
Accounting, generational, 161
Accounting costs, 56, 307
Accounting scandals (2001–2002), 472–475
Acid rain, 258, 261, 263, 264
AD (see Aggregate demand)
Adams, Scott, 365
Addictions:
to gambling, 495–496
to substances, 249–250
Adelman, Morris, 454
Adjusted gross income (AGI), 430, 435
Administrative lag (fiscal policy), 123–124
Advances (to authors), 305, 394
Adverse impact discrimination, 330
Adverse selection, 277–278
Advertising:
for prescription drugs, 297
for tobacco and alcohol, 249–250
AFC (see Average fixed cost)
AFDC (Aid to Families with Dependent Children), 405–408
Affirmative action, 334–336
AFL-CIO, 485
Africa:
and AIDS medications, 306
as crude oil supplier, 449
trade with, 203
wages, 345
African Americans:
and crime statistics, 310–311
discrimination against, 327–336
Head Start, 415–416
high school graduation by, 383
poverty among, 401
Aggregate demand (AD), 108–109
and austerity, 228
determinants of, 112
growth through, 190
increases in, 231–232
and interest rates, 134
shifts in, 110–114
unexpected movement in, 121–122
Aggregate demand shocks, 121–122, 500–501
Aggregate supply (AS), 109–110
classical and Keynesian views of, 109–110
determinants of, 113
and economic growth, 232
growth through, 190
increases in, 231–232
shifts in, 113–114
Aggregate supply shocks, 122–123, 128, 501
AGI (adjusted gross income), 430–431, 435
Ahold, 488–489
Aid to Families with Dependent Children (AFDC),
406–408
AIDS (acquired immunodeficiency syndrome), 236,
275, 300
AIDS drugs, 297, 300, 302, 306
AIG, 173–174, 182, 476
AIME (average index of monthly earnings), 419
Air pollution, 263–268
Air Tran, 72
Albertsons, 490
Alcohol, 249–250, 253–254
Alesina, Alberto, 130
Allied Chemical, 264
Al-Qaeda, 166, 499, 503 (see also Terrorism)
Alternative minimum tax (AMT), 433
American Bar Association, 480
American Civil War, 138, 156, 187, 190, 482
American Federation of State, County, and Municipal
Employees Union, 484
American Federation of Teachers, 386
American Medical Association, 480
American Revolutionary War, 156, 187, 482
Americans with Disabilities Act, 384
Amoco, 323
Amortization of mortgages, 170–172
AMT (alternative minimum tax), 433
Anderson, Richard, 257
Anheuser-Busch, 250
Anti-dumping, 208
Antitrust, 319–325
AOL Time-Warner, 325
Apple Inc., 72, 213, 215–216, 322–325
Arab–Israeli wars (1967 and 1973), 122, 441
Arrow, Kenneth J., 338
Arthur Andersen, 475
Articles of Confederation, 156
Artz, Georgeanne, 493
AS (see Aggregate supply)
Asian financial crisis, 139
Asset substitution effect, 421
Assets, value of, 471
ATC (average total cost), 59–61
AT&T, 71, 469n, 473
Attainable production level, 5
Auditors approach, in measuring discrimination, 332
Page numbers followed by n indicate material found in notes.
506 Index
Auerbach, Alan, 130, 161, 167
Austerity, 228
Austin, Texas, 458
Automobile sales, discrimination in, 334
Automobiles, fuel efficiency of, 448–449
AVC (average variable cost), 59–62
Average fixed cost (AFC), 59–62
Average index of monthly earnings (AIME), 419
Average total cost (ATC), 59–62
Average variable cost (AVC), 59–62
B Bailey, Elizabeth M., 270
Bakija, Jon, 422, 428
Balance of payments, 214
Balanced-budget amendment, 162–165
Bank of England, 142
Bank of Japan, 142
Banking, 133, 183, 188, 229, 234, 235–236
Bankruptcy, 306, 472–475
among gamblers, 496
among restaurants, 362
and farmers, 349
gender differences in, 328
and housing bubble, 174
Lehman Brothers, 182
and Medicare, 284, 289, 292–293
and Sirius/XM, 322–323
of Social Security, potential, 424–425
types of, 473
Barriers to entry, 70–71, 449
Base year, 82
Baseball teams, 457, 458, 459, 461, 462
Baseline budgeting, 152
Basketball teams, 368, 457, 461
Baywatch, 241
Becker, Gary, 310, 311, 332
Bequest effect, 421–422
Bernanke, Ben, 132, 138, 182
Bernheim, Douglas, 167
Bertrand, Marianne, 332, 337
Best Buy, 491
“Big-box” stores, 491
Bin Laden, Osama, 499 (see also Terrorism)
Bird, Larry, 462, 494
Black Lives Matter, 315
Blank, Rebecca, 408, 410
Blau, Francine, 338, 389
Blockbuster, 305
Blood, sale of, 279
BLS (Bureau of Labor Statistics), 82–85, 88, 89, 91, 182, 183, 328,
350, 351, 391, 483, 484
Boeger, Leesa, 389
Bonds, 111, 132–134, 161–162, 197, 223, 226, 311, 425–426
Boskin, Michael, 435, 439
Boyina, Manjula, 493
Bracket creep, 157n
Brennan Center for Justice, 314
Brokering tickets, 367, 368
Brown, Charles, 365
Brown, Gardner M., Jr., 270
Brue, Stanley L., 482, 487
Bubbles, 172–173, 223, 355, 470–472 (see also Housing bubble)
Buchanan, James, 124
Budget:
and elasticity, 44
federal (see Federal budget)
Buffett, Warren, 166
Buildable land, 169
Built-in stabilizers, 120, 123, 163–164
Bureau of Labor Statistics (BLS), 82–85, 88, 89, 91, 182,
183, 328, 350, 351, 391, 483, 484
Burger King, 71
Bush, George H. W. and administration, 139, 164, 241, 413
Bush, George W. and administration:
congressional disagreements with, 147
energy strategy of, 350
and Kyoto Protocol, 267–268
and oil prices, 442
and recession of 2007–2009, 180–181
and Social Security reform, 426
tax cuts by, 116, 124, 166, 180, 437
and tax incentives, 435
trade agreements, 241
and war in Iraq, 158–159
Business confidence, 112, 501
Business cycles, 92–94, 123, 125, 164, 180
Buying power, 25, 229
C CAFTA (Central America Free Trade Agreement), 238, 241,
244, 245
California, 69, 92, 169, 174, 197, 267, 321, 325, 336,
353, 360, 373, 384, 403, 448, 449, 456
California Motor Speedway, 465
Calpine Corp., 474
Canada:
central bank independence in, 138
cigarette tax in, 255
debt-to-GDP ratio for, 160, 161
drug prices in, 301
economic freedom in, 21
economic growth in, 186
economic indicators for, 234
energy production in, 452
grain exporting for, 352
health care system in, 279–280
higher education attainment in, 398
and NAFTA, 238, 241, 242, 243, 245
productivity in, 233
and the TPP, 238–239
trade with, 203
CandyCrush, 188
Cap and trade, 266–267
Capital account, 213–215
Capital budget, 159
Index 507
Capital gains, 158, 166, 430
Capital gains taxes, 341–342, 345, 434
Capital market, 233, 345
Capitalism, 207, 319, 473–474
Card, David, 363–364
CART, 464
Cartels, 440–441, 445–446, 452–453
Cartesian coordinates, 15
Case-Shiller home price index, 169, 178, 179
Cash benefit poverty programs, 404–406
Casino gambling, 494–497
Castro, Fidel, 209
Caterpillar, 485
Causation, 10
Cell phone, economic growth and, 188
Centers for Disease Control and Prevention, 189
Central America Free Trade Agreement (CAFTA), 238, 241,
244, 245
Central banks, 137–138, 235 (see also Federal Reserve)
CEO salaries, 474
CEOs (chief executive officers), 474
Ceteris paribus, 22
Chain-based index, 85
Chapter 11 bankruptcy, 473
Chapter 13 bankruptcy, 473
Charter schools, 387
Chicago, Illinois, 70, 197–198, 266, 456, 458, 495
Chichilinsky, Gacielka, 270
Chief executive officers (CEOs), 474
Child (and elder) care tax credit, 433
Child credit (income tax), 433
Children’s Health Insurance Program, 283–284, 293, 414
Child labor, 187, 207, 208, 244
China:
copyright infringement in, 241
currency manipulation by, 220
economic freedom in, 21
economic growth in, 222, 236
foreign exchange markets, 215, 217, 219
and Kyoto Protocol, 268
manufacturing in, 492–493
petroleum demand in, 442, 448
policy disputes with, 167
trade deficit with, 219, 490
trade with, 202–203
and Donald Trump, 244
U.S. debt to, 162–163
wages in, 245
Chrysler, 175, 308
CIA Factbook, 237
Circular flow model, 7–8
Cities:
minimum wages set by, 360
sports teams based in, 455–458
Civil liability, 306–308
Civil War era, economic growth and, 187
Clark, Robert, 428
Class action lawsuits, 308
Classical economics, 109
Clayton Act, 482, 483
Clean Air Act (1970), 263
Clean Air Act (1990), 264, 266
Clean Water Act (1972), 263, 265
Clemens, Jeffrey, 364
Climate change, 264–265
Clinton, Bill and administration:
congressional disagreements with, 147
discretionary fiscal policy of, 125
and EITC, 362
federal deficit under, 164
health care plan of, 271–272
and Kyoto Protocol, 267–268
on mandatory spending, 149
and Medicare cuts, 152
and student loans, 397
and tax credits for college, 435
tax-related social engineering by, 435
trade agreements, 240–241
welfare reforms by, 408
The Club, 502
Coal, 187, 202, 259, 261, 264, 266, 335, 449, 450
Coase, Ronald, 262–263, 265–266
Cogan, John F., 125, 428
Cohen, Mark, 318
COLA (cost-of-living adjustment), 83
Colander, David, 144
Cold War, 158, 207
Collective bargaining, 244, 462, 463 (see also Unions)
and public school reform, 387–388
CollegeBoard, 396
College education, 390–398
College tax credits, 435
College textbooks market, 393–395
Commercial banks, 135
Common property, 262
Commonwealth Edison, 70
Communism, 21
Company towns, 479, 480, 482
Comparative advantage (trade), 204, 205, 207–208, 244
Competition, 69–72
monopolistic, 70–72, 479, 481–482, 489
perfect, 64, 69–76, 301, 478–481
and profit maximization, 64–65
and unions/professional organizations,
480–481
Complements, 27–28
Concentration ratio, 72
Confidence:
business/consumer, 111
and recession of 2007–2009, 181
Congestible public goods, 51
Congress, federal spending and, 146–147
Congressional Budget Office, 165, 291
Conservatives/Republicans, 191
Consolidated Edison, 70
Constant opportunity cost, 6, 11
Constitution:
balanced-budget amendment to, 164
government spending under, 146–147
Consumer confidence, 111
508 Index
Consumer price index (CPI), 82–84, 243
adjustments using, 267, 311, 349–350, 391, 441
core, 85
degree of error in, 86
and inflation, 81–83
for medical care, 274–275
and poverty line, 403–404
Consumer surplus, 48–50, 51–52
and environment, 260
and farm price floors, 352–353, 356
with illegal goods/services, 249
and labor, 479, 481–482, 486
and market failure, 320
and minimum wage, 359–361, 364
and prescription drugs, 298
and trade, 206, 210
Consumers, 20
Consumption, discrimination in, 333–334
Contestable markets hypothesis, 323
Contingency attorneys, 308
Continuing resolutions, 147
Contractionary fiscal policy, 120–121
Contracts, 305–306, 462, 463
Co-payment (insurance), 273
Copyrights, 70, 297, 305, 321–322, 393, 395
Copyright infringement, 241
Core CPI, 85
Core PCE, 85
Corn prices, 350–351
Corporate paper, 135
Correlation, 10
Corruption, in developing countries, 235
Cost(s), 56, 59–61
of crime, 312–313
of education, 381–385, 390–398
of government health insurance programs, 288–289
(see also specific programs)
Head Start program, 416
rental property, 374
of research, 391
Cost function, 57
Cost of living, 403–404
Cost-of-living adjustment (COLA), 83
Cost-push inflation, 114
Covered bond, 223
CPI (see Consumer price index)
Creative destruction, 245
Credit card debt, 139, 174, 179, 496
Credit default swaps, 173
Creditors, 109, 473
Credits (income tax), 9, 115, 126, 340, 362, 405, 430–433, 435–437
Crime, 310–316
and abortion, 314
and atmospheric lead, 314
avoidance of, 313
and COMPSTAT, 314
costs of, 312–313
and diminishing returns, 314
and educational level, 381
and illegal drugs, 248, 250–251
Head Start families, 414–415
optimal sentencing for, 316
optimal spending on control of, 314–316
perpetrators of, 310–311
racial differences in, 310–311, 330
rational criminal model, 311–312 (see also Illegal goods
and services)
who commits, 310–311
Cross-price elasticity of demand, 41
Crowding out, 148
Cuba, 21, 209
Currencies:
foreign exchange markets, 8, 215–217
international financial transactions, 213–215
and shift in aggregate demand, 111–112
(see also Exchange rates)
Current account, 214–215
Current-services budgeting, 151–152
Currie, Janet, 415, 417
Curry, George E., 338
Cyclical deficit, 159
Cyclical unemployment, 90, 109
D Darity, William A., Jr., 338
Day-care service, 331, 380, 403, 408, 413, 414, 415, 416 (see also
Head Start program)
Deadweight loss, 51–52, 277, 298, 306, 319–320, 353, 356, 361–364
Death penalty, 314, 316
Deaths, acceptable, 253
Debt:
economists’ view of, 159–161, 424
European, crisis of, 111, 220, 226
national, 10, 132, 148, 156, 159–162, 195, 198
Deductible, insurance, 272–273
Deductions (income tax), 9, 115, 157, 397, 430–433, 435, 437
Default risk, 104
Defense spending, 146, 148–151, 157, 158
Deficit:
budget, 156 (see also Federal budget)
economists’ view of, 159–161
Deflation, 93, 94, 140, 231–232
Delta (airline), 72
Demand, 22–23
aggregate (see Aggregate demand)
cross-price elasticity of, 41
determinants of, 27–31
elasticity of, 41–45
excess, 25
income elasticity of, 41
law of, 25–26
price elasticity of, 41–45
quantity demanded vs., 20–21
Demand curve, 20, 22–23
and decriminalization, 254–255
and elasticity, 44–45
for health care services, 285–286
and law of demand, 25–26
Index 509
movements in, 29–30
with private health insurance, 276–277
Demand schedule, 23
Demand-pull inflation, 114
Demand-side macroeconomics, 115
Dependency ratio, 195–196
Depression, 94, 120, 123, 134, 159, 163
Descartes, René, 15
Desertification, 265
Developed countries, 231–234
Developing countries, 233–236
DFP (see Discretionary fiscal policy)
Diamond, Peter, 425, 428
DiIulio, John J., 318
DiMaggio, Joe, 462
Diminishing marginal utility, law of, 26
Diminishing returns, 58, 61, 314
Direct correlation, 10
Disability insurance (Social Security), 420
Discount rate, 133, 133n, 469
Discount window, 135, 136
Discouraged-worker effect, 89
Discretionary fiscal policy (DFP), 119, 125–126, 128
and aggregate supply and aggregate demand model, 120–121
in counteracting shocks, 121–123
history of, 123–124
mistiming of, 123–124
in Obama stimulus plan, 126–127
political use of, 124–125
Discretionary spending (federal), 148–149
Discrimination, 327–336
and affirmative action, 334–336
in consumption and lending markets, 332–334
definitions related to, 330–331
detection and measurement of, 331–332
economic status of minorities, 328–330
economic status of women, 327–328
in housing, 377
in labor market, 332–333
Disparate treatment discrimination, 330
Division of labor, 58
DJIA (Dow Jones Industrial Average), 468, 471, 476
Dole, 241
Dollar, U.S., 111–112, 215–220
“Domestic content” rules, 241
Dot-com bubble, 471–472
Dow Jones Industrial Average (DJIA), 468, 471, 476
Draft (sports), 461
DraftKings, 497
Drug companies, 297–302
Drug price indexes, 300
Drugs:
illegal (see Illegal goods and services)
over-the-counter, 253, 302, 307
prescription, 296–302
Drunk driving, 252, 253
Du, Jiangtao, 389
Duke Energy North American, 474
Dumping, 208
Durable goods, 109, 112, 134
Dynegy Inc., 474
E Earned Income Tax Credit (EITC), 340, 340n, 362, 405, 430,
433, 436n
Eau Claire Rule, 353
Ecclestone, Bernie, 464–465
Economic costs, defined, 56 (see also Cost[s])
Economic Freedom, Index of, 21, 233
Economic growth and development, 6–7, 231–237
in already developed countries, 231–233
with casino gambling, 495
causes of slowing growth, 187–188
with city sports franchises, 456–457
consequences of slowing growth, 188–189
in developed vs. developing countries,
233–234
fostering/inhibiting development, 234–236
“new normal,” 186, 189–191
periods of robust growth, 187
sources of growth, 7, 187
stagnation, 186–191
Economic Policy Institute (EPI), 243, 490
Economic profit, 73–75, 299, 333, 445, 453, 474
Economic Recovery Act (2009), 435
Economic stagnation, 186–191
Economics, defined, 1, 2
Economy, measuring, 80–86
Education, 250, 379–399
and affirmative action, 336
college and university, 244, 390–399
and crime, 311–312
as investment in human capital, 379–381
Head Start, 411–416
and poverty, 402, 408
racial inequalities in, 330, 333
school reform issues, 385–388
as source of economic growth, 7, 184, 232–233, 235–236
spending on, 148, 149, 184, 379–385
tax credits for, 9, 340n, 437
Efficient markets, 470
Effluent permits, 266, 266n
Ehrlich, Isaac, 318
EITC (Earned Income Tax Credit), 340, 340n, 362, 405, 430,
433, 436n
El Paso Energy, 474
Elastic demand, 42, 45
Elastic supply, 46–48
Elasticity, 40–48
of demand, 41–45
and demand curve, 44–45
determinants of (for demand), 44
determinants of (for supply), 47
formula for, 41
graphical explanation of, 42–43
health, 276–277
and minimum wage, 361, 363
Demand curve (continued )
510 Index
of supply, 46–48, 376, 422n, 443, 446–447
and taxes on tobacco/alcohol, 254
and total expenditure rule, 44
unitary, 42
verbal explanation of, 43
Electric lighting, 187
Electric utilities, 449–451
Electronic cigarettes, 254
Ellerman, A. Denny, 270
Elmendorf, Douglas, 130
Employment:
and aggregate supply, 109
in alcohol industry, 248
in casinos, 495
classical and Keynesian views of, 109–110
in recession of 2007–2009, 182
in tobacco industry, 248
by Wal-Mart, 491
Encouraged-worker effect, 89
Endangered Species Act (1973), 264
Energy prices, 440–453
electric utilities, 449–451
future of, 451–452
historical view of, 440–445
and OPEC, 445–446
reasons for rapid changes in, 446–449
Enron Corporation, 472, 474–475
Entitlements, 148–151, 161, 165, 194
Entry barriers, 69–70, 321
Environmental problems, 258–268
economic solutions to, 263–268
and Kyoto GHG reduction process, 267–268
with lower production costs, 208
property rights approach to, 265–267
Environmental Protection Agency, 263
Environmental quality of life, 87
EPI (Economic Policy Institute), 243, 490
Equilibrium, 24, 35–36
Equilibrium price, 20
Equilibrium quantity, 20
Equilibrium wage, 361, 479
Ethanol, corn-based, 350–351
Ethics, 306 (see also Morality issues)
Euro, 111, 142, 216–217, 220, 223–229
Europe:
antipoverty programs in, 406
health care system in, 279–280
poverty in, 404
trade with, 203
European Central Bank, 132, 142, 223, 227, 229
European Economic Community, 223
European Union, 203, 222–229, 325
and Article 123, 223, 227, 228
and Article 125, 223, 228
and Article 126, 223
and the Maastricht Treaty, 223
and the United Kingdom, 223, 344
Excess demand, 25
Excess supply, 25
Exchange rates:
determinants of, 219–220
and international trade, 215–220
and shift in aggregate demand, 111–112
and strong dollar, 111
(see also Foreign exchange markets)
Excise taxes, 27, 29, 30, 31, 33
Excludable public goods, 51
Exclusivity, 50
Exemptions (income tax), 430–431
Expansion (business cycle), 92
Expansionary fiscal policy, 120–121
Expected future price, 27, 29, 30, 31, 32–33
Expenditures approach (GDP computation), 81
External benefits, 380, 391–392
External costs, 250–253
Externalities, 260–261
with casino gambling, 495
for city sports teams, 458
and corrective taxes, 253–255
with environmental problems, 260–261
positive, 380, 386, 391–392, 412
and Social Security, 420
Exxon, 69, 323
Exxon Valdez disaster, 261
F Facebook, 2, 51, 188, 260
Factor markets, 8
Fallacy of composition, 9
Fan Duel, 374
Fannie Mae (Federal National Mortgage Association), 170, 173, 174,
182, 223
Farm policy, 349–356
FDA (Food and Drug Administration), 301–302, 307
Fed (see Federal Reserve)
Federal budget, 155–166
and balanced-budget amendment, 162–165
deficits, 156
economists’ view of deficit and debt, 159–161
history of, 156–159
owners of federal debt, 161–162
projections of surplus/deficit, 165–166
surpluses, 156
Federal debt (see National debt)
Federal funds rate, 132, 179, 180
Federal Home Loan Mortgage Corporation (Freddie Mac), 172, 173,
174, 182, 223
Federal justice system, 149, 318
Federal National Mortgage Association(Fannie Mae),
170, 173, 174, 182, 223
Federal Reserve (Fed):
chairs of, 131–132, 144
goals of, 132
inflation regulated by, 85, 132
ownership of national debt by, 161
policies of (see Monetary policy)
in recession of 2007–2009, 179–180
Elasticity (continued )
Index 511
Federal revenue, 430
Federal spending, 145–163, 499, 500
and aggregate demand, 112
budgeting for, 151–152
constitutional provisions for, 146–147
disagreements over, 147
distribution of, 148
on education, 148–149, 381, 397
Head Start, 413–414
on health care, 271–272
and inflation, 115
marginal analysis of, 151
in Obama stimulus plan, 183, 184
shenanigans with, 146–147
and shift in aggregate demand, 115–116
on welfare, 404–408, 490
Federal Trade Commission (FTC), 322
Fee-for-service health care plans, 273
Feenberg, Daniel, 130
Feenstra, Robert C., 212
Feiner, Susan F., 338
Feldstein, Martin, 422, 428
Ferber, Marianne, 338
FICA withholding, 273, 419
Filing status (income tax), 431
Financial crisis of 2008, 164
and budget deficit, 158–159
and housing bubble, 174
monetary policy tools created for, 135–137
Financial transactions, international, 213–215
Fiscal policy, 119–130
aggregate supply and aggregate demand model of, 120–121
to counteract shocks, 121–123
discretionary, 119–126, 182–183
evaluating, 123–126
nondiscretionary, 119–123, 182–183
Obama stimulus plan, 126–127
Fixed costs, 59
Fixed exchange rate system, 218
Fixed inputs, 57
Floating exchange rate system, 217–219
Flood, Robert P., 477
Florida:
affirmative action in, 336
foreclosures in, 174
oil off the coast of, 87
pension liabilities, 197
prisons in, 315
spring training in, 457
Food and Drug Administration (FDA), 301–302, 307
Food Lion, 490
Food stamps, 149, 182, 403, 405, 406, 407, 414, 490
(see also SNAP)
Football teams, 456–457, 459
Ford, Gerald, 120
Ford Motor Company, 207, 308
Foreclosures, home, 93, 111, 168–175, 181
Foreign aid, spending on, 149
Foreign exchange markets, 8, 215–217
Foreign exchange rates (see Exchange rates)
Foreign purchases effect, 108
Formula 1, 464–465
Fort, Rodney D., 461
Fortin, Nicole, 410
Fossil fuels, 261, 265, 451
Foxconn, 215
Fracking, 48, 87, 452
France:
assistance to Greece, Spain, Ireland, Italy, 228
and the European Central Bank, 227
franc, 222
and GDP growth, 224
and long term interest rates, 225
and per capita GDP, 224
France family, 465
Franchises, sports, 456, 457
Franklin, Andrew W., 493
Frazier, Curtis L., 389
Freddie Mac (see Federal Home Loan Mortgage Corporation)
Free agents (sports), 461
Free markets, 21, 373–374
Freeman, Richard B., 318
Free trade, benefits of, 204–207, 210, 239 (see also Trade
agreements)
Frictional unemployment, 90
Fryer, Roland, 336, 338
FTC (Federal Trade Commission), 322
Full employment, 109–110
Fully funded pensions, 419
Functional finance, 160
Fundamentals (stock price), 469
Future value, 102–104
G Gambling, 494–498
GAO (General Accounting Office), 415
Garber, Peter M., 477
Gardner, Bruce L., 357
Garrett, Major, 295
Garrett, Thomas A., 495, 498
Gasoline prices (see Energy prices)
Gasoline–corn price relationship, 350–351
Gates, Bill, 323, 410
GATT (General Agreement on Tariffs and Trade),
238, 241, 242, 244, 245
GDP (see Gross domestic product)
GDP deflator (GDPDEF), 86
GEDs (General Equivalency Degrees), 330, 383, 384
Geithner, Timothy, 138
General Accounting Office (GAO), 415
General Agreement on Tariffs and Trade (GATT),
238, 241, 242, 244, 245
General Equivalency Degrees (GEDs), 330, 383, 384
General Motors, 308, 475
Generational accounting, 161
Germany, 21, 151, 223, 228, 233, 234, 280, 347
assistance to Greece, Spain, Ireland, Italy, 228
and debt–to–GDP ratio of, 160–161, 226
512 Index
and deficits, 227
and the European Central Bank, 138, 227
and GDP growth, 186, 224
and long–term interest rates, 225
mark, 222
and per capita GDP, 223–224
GI Bill, 397
Gilroy, Curtis, 365
Gini index, 233
GlaxoSmithKline, 301
Global Crossing, 472, 473–474
Global warming, 263, 265, 267
Globalization, 92–94, 187, 215
GNI (gross national income), 233–234
Gold standard, 218
Goldman Sachs, 135
Goods, 5, 50–51, 239
Goods and services markets, 8, 333–334 (see also Illegal goods
and services)
Goodstein, Eban, 270
Google, 72, 325
Google-Earth, 444
Gordon, Robert, 190, 192
Gottschalk, Peter, 410
Government:
accounting used by, 156
farm policy of, 351–352
justifications for interventions by, 351–352
as owner of national debt, 161–162
size of, 151
subsidies from, 27, 29, 30, 31, 33
(see also specific topics, e.g.: Monetary policy)
Government regulation:
of environmental problems, 266
of illegal or addictive goods/services, 249–252
and shift in aggregate supply, 113
and supply–side economics, 115
Gramlich, Edward M., 428
Graphing, 15–18
Great Britain, 151, 228, 234, 240, 347, 460
and debt–to–GDP ratio of, 160
and deficits, 227
energy prices and, 441, 446
EU and, 223, 229
and GDP growth, 187, 224
health care, 279, 280
and long–term interest rates, 225
as owner of U.S. debt, 163
terrorism in, 503
Great Depression, 120, 123, 134, 156, 157, 187
Great Recession, 91, 127, 146, 187–188, 215, 222, 227–228,
402 (see also Recession of 2007–2009)
Greece:
drachma, 222, 229
and the euro, 223, 226
GDP growth, 224
and long term interest rates, 225
per capita GDP, 224
and tax evasion, 226
Grexit, 229
Greene, P., 389
Greenhouse gases, 261, 266–268
Greenspan, Alan, 139, 140
Grocery stores, 360, 407, 489, 490, 491
Gross domestic product (GDP), 80
computation of, 81, 94–95
federal spending as percentage of, 146
and foreign trade, 213, 214
national debt as percentage of, 160
and official poverty numbers, 404
post–World War II, 86
problems with, 86–87
and recognition lag, 123
Walmart’s contribution to, 488
Gross national income (GNI), 233–234
Grossman, Michael, 257
Groundwater contamination, 264
Gulf of Mexico oil spill, 261, 443, 448, 449
Gulf War, 209, 446
H Hanushek, Eric, 385, 389
Harvoni, 300
Happel, Stephen, 372
Hausman, Jerry, 97
Head Start program:
as an investment, 411–413
critics, 412–413
current evidence, 414–416
opportunity cost of, 416
overview, 411
spending on, 405, 411, 412–414
Heal, Geoffrey, 270
Health care, 271–302
as an atypical good, 274–275
Children’s Health Insurance Program (CHIP), 151, 273, 274, 293
economic models of, 275–279
federal spending on, 150, 151, 152, 271–272
government–provided, 150–151, 273–274, 283
insurance for, 272–274, 276–279, 287
Medicaid, 275–276, 285–288, 293, 294
Medicare, 194, 199, 287–293
money spent on, 250, 271–272
in Obama stimulus plan, 184, 273
in U.S. vs. other countries, 279–281
Health insurance, 272–274, 276–279, 287
Health maintenance organizations (HMOs), 273, 274, 287–288,
289, 291
Heckman, James J., 338
Hedonic price, 82n
Herfindahl–Hirschman Index (HHI), 72
Heritage Foundation, 21, 233, 403
Higher education, 390–397
High-tech (HT) goods, 239
Highway construction, 124, 146–147, 159
Hijacking, 501
Hirschman, Ira, 55
Germany (continued )
Index 513
Hispanic Americans, 383, 401
and discrimination, 330–333, 464
graduation rates, 383, 397
and the minimum wage, 361
as a percentage of poor population, 285, 401, 414
HMOs (health maintenance organizations), 273, 274, 287–288,
289, 291
Hockey teams, 463–464
Hodrick, Robert J., 477
Home building, 178–179
Home Depot, 491
Home equity lines of credit, 178–179
Home ownership, poverty and, 403
Home prices, 168–170, 225–226
Honda, 308
Honda Odyssey, 308
Horizontal equity (income taxes), 434
Housing Authority Apartments, 405
Housing bubble, 168–175
creation of, 173–174
economic effects of, 174–175
European, 223–226
and factors in home prices, 168–169
and financial crisis of 2008, 475–476
and recession of 2007–2009, 89, 154–155
and short sale, 175
and types of mortgages, 170–172
Hoxby, Caroline, 386, 389
HT (high-tech goods), 239
Hufbauer, Gary, 210, 243, 247
Hulman-George family, 444, 464
Human capital, 379, 380
Human life, value of, 313
Hurricanes, 265, 449, 501
Hydroelectric power, 261, 268, 449–450
Hyman, David, 428, 439
I IBM (International Business Machines), 70,
72, 324
IBM Selectric, 324
Icons, 324
IGA affiliates, 486, 488–491
Illegal goods and services, 248–255
and computation of GDP, 87
ticket scalping, 370
Incentives, 9, 306, 320
and bankruptcy, 306
to control health care costs, 288–289, 291
and environmental policy, 265
and supply–side economics, 115–116
and tax code, 434–435
of welfare programs, 406–410
Income:
and college education, 396
and crime rates, 310–312, 314
as determinant of demand, 27–31
inequalities of, 328–332, 339–346
in means tested entitlements, 274–275, 284–285, 290–293,
400–408
middle class, 188–199, 343–344
mobility, 345–346
and poverty line, 401, 406, 407 (see also Poverty)
security, 148, 194, 244, 274, 400–408
taxes (see Personal income taxes)
unreported, 87
Income approach (GDP computation), 81, 94–95
Income effect, 434
Income elasticity of demand, 41
Income inequality, 339–347
causes of, 344–345
costs and benefits of, 345–347
international comparisons of, 347
measurements of, 339–341
Income taxes (see Personal income taxes)
Increasing opportunity cost, 5, 6, 10
Index of Economic Freedom, 21, 233, 268
India, 21, 217, 345, 442, 448
Indiana, 197, 350, 380n, 387, 494–497
Indiana State University, 444
Indianapolis Motor Speedway, 466
Induced retirement effect, 421
Industrial Revolution, 187
Indy Racing League (IRL), 464
Inelastic demand, 42, 44, 45
Inelastic supply, 47
Inelasticity, 42, 43, 45
Inferior goods, 27, 28
Inflation:
causes of, 114–115
controlling, 137–138, 139, 161, 179, 227, 235–236, 272n
cost-push, 114–115
demand-pull, 114–115
and deflation, 93, 140
in developing countries, 235–236
and expansionary fiscal policy, 121, 128
and expansionary monetary policy, 132
expected, 84, 99–100, 219–220
and federal funds rate, 132
historic, 93
indexing for, 157, 199, 360, 419, 425, 426, 433, 463
interest rate effect on, 101
during last 30 years, 138–141
measuring, 81–86
mismeasurement in, 83–86
and monetary policy, 114–115, 138, 139
and real interest rate, 99–100
winners and losers from, 84
Inflation rate, 83–84
Inflation targeting, 132
Infrastructure:
in developing countries, 235
politically motivated projects, 124–125
trust funds for, 162
Initial public offerings (IPOs), 469–470
In-kind subsidies, 404–406
Innes, Robert, 270
Input costs, 115
514 Index
Inputs, 31, 33, 34, 57
Insurance, 272–274
health, 372–379
reinsurance, 173, 501–502
retirement annuities, 334
social, 423
terrorism, 501–502
Intangible losses (crime), 313
Intellectual property, 305, 395
Interest rate effect, 108
Interest rates, 98–104
and federal borrowing, 164
and inflation, 137–139
in monetary policy, 134
real, 99–100, 218–219, 292, 396, 422–423
and recessions, 137–140
and shift in aggregate demand, 111–114
and shift in aggregate supply, 114
Interest–only mortgages, 171–172
Interfaces, 325
Intergenerational Income Elasticity, 347
Internal rate of return, 101–102
Internal Revenue Service (IRS), Statistics of Income:
Individual Income Tax, 339
International Brotherhood of Electrical
Workers, 480
International Brotherhood of Teamsters, Chauffeurs,
Warehousemen and Helpers of America, 481n
International Business Machines (IBM), 70, 324
International financial transactions, 213–215
International Grocers Association, 488
International policy, federal spending and, 146
International Speedway Corporation (ISC), 465
International trade, 201–210
agreements, 238–245
barriers to, 207–209
benefits of, 204–209
demonstrating gains from, 205–206
as diplomatic weapon, 209
economists favoring, reasons, 205–206, 245
and exchange rates, 214–220
financial transactions in, 213–215
foreign exchange markets, 215–216
limiting, 207–209
and outsourcing, 207, 489
terms of, 205
and U.S. as debtor nation, 213
Internet Explorer, 325
Inverse correlation, 10
Inversion, 191
Investment banks, 135
Investments
Head Start as, 411–413
risk and reward with, 104
iPhone, 325
iPods, 325
IPOs (initial public offerings), 469–470
IRA (Irish Republican Army), 502
Iran, 21, 122, 209, 217, 442, 444, 445, 448
Iraq, 92, 122, 139, 146, 149, 157, 158, 166, 209, 306, 442, 445, 446,
448, 449, 499, 503
Ireland:
and debt to GDP, 226
and economic freedom index, 21
and the euro, 220, 223, 228
GDP growth, 224
and housing bubble, 223–228
and long term interest rates, 225
per capita GDP, 226
Irish Republican Army (IRA), 502
IRL (Indy Racing League), 464
ISC (International Speedway Corporation), 465
Italy, 21, 138, 160–161, 186, 222, 223n, 226–230, 233
Itemized deduction (income tax), 432
J Jackson, Andrew, 156
Jackson, Thomas Penfield, 325
Japan, 233, 234, 236
central bank independence, 138
debt–to–GDP ratio for, 160–161
defense spending in, 151
deflation in, 93, 140
exchange rates with, 216, 217, 220
and health care, 280
and nuclear power, 261
prolonged stagnation in, 93, 140, 142, 186, 471
rice industry in, 207
trade with, 203, 209
U.S. debt to, 160, 162–163
Java, 324, 325
Jennings, Marianne, 372
Johnson, George, 410
Johnson, Lyndon and administration,
114, 120n, 402
Jordan, Michael, 366
Jorgenson, Dale, 410
Joskow, Paul L., 270
Justice Department, 324, 325
K Kahn, Lawrence M., 466
Kaufman, Ewing, 459
Kennedy, John F., 402, 483
Kentucky Motor Speedway, 465
Keynes, John Maynard, 109
Keynesian economics, 109–110, 126, 228
KFC, 71
Kmart, 472, 473–475, 488
Kohen, Andrew, 365
Kotlikoff, Laurence, 161
Kroger, 488, 490
Krueger, Alan, 365
Krueger, Andrew, 363–364
Index 515
Krugman, Paul, 125, 165, 212, 247
Kuwait, 139, 236, 442
Kyoto Protocol, 267–268
L Labor, marginal revenue product of, 461, 463, 479–480, 481
Labor costs, 299
Labor Force Participation Rate, 88–89, 187–188, 327–328
Labor markets:
discrimination in, 332–333
and minimum wage, 359, 360
under perfect competition, 478–479
for sports, 461
Labor rights, 482–483
Labor unions (see Unions)
Ladd, Helen F., 338
Landfills, 264
Larry Bird exemption, 462
Laser imaging, 188
Law(s), 304–308
bankruptcy, 306, 472–475
civil liability, 306–308
government’s role, in enforcing, 304
private property, 304–306
property rights, 306–308
rent control, 373, 376–377
unions’ rights under, 482–483
Lawsuits:
for civil liability, 306–308
class action, 308
Lebow, David, 86, 97
Lee, Ronald, 154, 167, 295
Lehman Brothers, 135, 182
Leigh, Andrew, 386, 389
Leimer, Dean, 422, 428
Lemieux, Thomas, 410
Lending discrimination, 334
Lesnoy, Selig, 422, 428
Levitt, Steven, 318
Liability, civil, 306–308
Liar loans, 173
Libya, 114, 122, 209, 217, 445
Licensing, 354, 480–481
Lincoln, Abraham, 240
Lines, graphing, 15–18
Linux, 70
Liquidity trap, 135, 137
Literacy, 235
Living wage, 358
Loans:
car, 101–102
liar, 173
money created by, 133
student, 106, 148, 149, 306, 346, 396–397
Local substitution, 457, 494
Lochner, Lance, 381, 389
Lockouts, 463, 464, 484
Logrolling, 147
“Lo-Jack,” 502
Long run, 74, 75, 137, 376
Los Angeles, California, 168–170, 174, 198, 456, 458n, 459, 460
Loury, Glenn, 336, 338
Low-tech (LT) goods, 239
Luxury box revenue (sports), 459
Lynch, Thomas, 154
M M1, 132–133
M2, 132–133
M3, 132n
Maastricht Treaty, 223
Macintosh, 324
MacPherson, David A., 482n, 487
Macroeconomics, 79–95
aggregate demand and aggregate supply model, 107–116
business cycles, 92–94
demand-side, 115–116
and fiscal policy, 119–128
measuring the economy, 80–86
and minimum wage, 362
modeling, 107–116
and monetary policy, 131–143
real gross domestic product, 86–87
supply-side, 115
unemployment, 87–91
Major League Baseball (MLB), 371, 457, 459–461
Managed float exchange system, 218–219
Mandation, 277, 278
Mandatory spending (federal), 148–149, 284
Marginal analysis, 8
of costs of crime, 315
of drug approval process, 302
of federal spending, 151
Marginal benefit, 8, 49, 151, 252–253, 259–261, 265,
302, 315, 503
Marginal cost (MC), 8, 59–61
of cleaner environment, 259–261
and crime control, 315–316
of government spending, 151
in modeling illegal goods, 252–253
under natural monopoly, 320–321, 450–451
of prescription drug testing stringency, 302
as Supply under perfect competition, 74
and terrorism prevention, 502–503
of tickets, 367–368
Marginal resource cost (MRC), 480
Marginal revenue (MR), 62–63
and monopoly, 62–63, 298, 319–320, 368, 445, 452
and perfect competition, 62–63, 75–76, 452
and profit maximization, 64–65
Marginal revenue curve, 63, 69
Marginal revenue product of labor, 461, 463, 479–480, 481
Marginal tax rate, 115, 233, 433, 437
Marginal utility, 26
516 Index
Market(s), 8, 20
efficient, 470
for money, 99
rental apartments without rent control, 374
(see also Stock market)
Market basket, 82
Market failure, 50, 268, 304, 335
Market forms, 71–72, 76, 366–367, 395, 488–490
Market power, 325, 345, 371, 458, 465, 481
Market risk, 104
Marketing, 20
Mason, Patrick L., 338
Maximizing profit, 64–65
Maximum out of pocket expense, 273
Maximum taxable earnings, 419
MC (see Marginal cost)
McCain, John, 116, 437
McConnell, Campbell R., 487
McDonald’s, 69–71
McGraw–Hill, 395
McGwire, Mark, 366
McKnight, Claire, 55
McVeigh, Timothy, 494
Means testing:
in anti-poverty programs, 400–408
in Medicare, 274–275, 284–285, 290–293
in Social Security, 426
Measuring the economy, 80–86
Medicaid, 150, 151, 272–275, 278,
283–293
costs for elderly under, 286–287
costs of, 285–287
cost-saving measures in, 287
eligibility for, 284–285
for foster families, 407
and Head Start, 414–415
as an in-kind transfer, 400–408
and Obama stimulus, 120, 126–127, 159, 182–183
and the PPACA, 120, 275, 278, 284
and prescription drugs, 300
provisions of, 275, 285
recipients of, 284–285
relationship of Medicare and, 293
smokers on, 251, 254, 280
spending on, 146, 148–150, 286–289, 404–406
Medicare, 272, 273–274, 284
cost control provisions in, 291
and current-services budgeting, 151–152
diagnosis-related groups under, 290
enrollment, 272
origin of, 419–420
Part A, 284, 289–290
Part B, 284, 290
prescription drug coverage (Part D), 154, 290–291
and private insurance for the elderly, 287–288
relationship of Medicaid and, 286–287, 293
smokers vs. nonsmokers on, 252
spending on, 146, 148–150, 151, 158, 165, 193–196, 288–289
tax rate for, 420
trust fund for, 156, 161, 193–196, 199, 284, 289, 292–293
Medicare Trust Fund, 156, 161, 193–196, 284, 289, 292–294
Medications (see Prescription drugs)
Merit pay, for teachers, 386
Metrick, Andrew, 270
Mexico, 21, 203, 207, 208, 239, 240–242, 244, 301, 442, 446
Michelin, 466
Microeconomics, 80
Microsoft, 69, 70, 103, 322, 324–325, 479
Middle class, shrinking, 188–189, 343–344
Middle East revolutions, impact of, 114, 122, 441
Miller, Matthew, 295
Milwaukee school voucher program, 387
Minimum wage, 311, 358–364
alternatives to, 362
in cities and states, 360
economic analysis of, 359–362
elasticity argument, 363
macroeconomics argument, 362
as price floor, 353
real-world implications, 361–362
for sports players, 462
work effort argument against, 363
Minorities:
economic status of, 328–330
high school graduation rates for, 383 (see also Racial inequalities)
Mitchell, Olivia S., 428
MLB (Major League Baseball), 371, 457, 459, 460, 461
Model, 2, 3 (see also specific models)
Monetary aggregate, 132
Monetary authority, 138
Monetary policy, 131–142
and central bank independence, 137–138
European, 223
goals of, 132
and inflation, 114
during last 30 years, 138–141
modeling, 133–134
and monetary transmission mechanism, 134–135
tools created in 2008 for, 135–137, 183–184, 220, 227
traditional and ordinary tools of, 132–133 (see also
Recession of 2007–2009)
Monetary transmission, 134–135
Money, 133, 135 (see also Currencies)
Money creation, 133
Monopolistic competition, 70–71
by grocery stores, 490–491
other market forms vs., 71
in textbook market, 393–395
Monopoly(-ies), 70
Apple, 325
cartels as, 445
contestable markets hypothesis, 323
deadweight loss, 320
drug industry as, 297–298
electric utilities as, 450–451
Google, 325
grocery stores as, 490–491
high price, 319–320
IBM, 324
low output, 319–320
Index 517
and maximization of profit, 64
Microsoft, 324–325
natural, 320–321, 450–451
necessary, 321–322
other market forms vs., 71–72
perfect competition vs., 320
public schools as, 385–386
reduced innovation, 320
Sherman Anti-Trust Act of 1890, 322–323
simple, 450–451
Standard Oil, 323–324
unions as, 481–482
Monopsonies, 479–480, 482, 486
Montero, Juan Pablo, 270
Moody’s, 476
Moral hazard, 277
Morality issues:
with blood and organ sales, 279
for government regulation, 252
Moretti, E., 381, 389
Morgan Stanley, 135
Mortgage lending discrimination, 333–334
Mortgage-backed securities, 115, 135–137, 142, 172, 184, 223
Mortgages, 101–104, 170–172
deductibility of interest, 430–431
discrimination in, 334
selling of, 172
30-percent guideline for, 174
traditional, 170–171, 172
types of, 172
Mouse, 324
MR (marginal revenue), 62
MRC (marginal resource cost), 480
Mullahy, John, 257
Mullainathan, Sendhil, 332, 337
Munnell, Alicia, 422
Multitasking, 324
Myles, Albert, 493
N NAFTA (North American Free Trade Agreement), 238, 241,
242–243, 244, 245
NASCAR teams, 370, 460, 464–465
NASDAQ bubble, 172–173
NASDAQ Composite Index, 469, 471–472
Nashville, Tennessee, 198, 456, 459
National Basketball Association (NBA), 371, 456, 459, 462–463
National Center for Education Statistics, 389, 392–393
National (federal) debt, 156, 159–162
National Education Association, 386
National Football League (NFL), 330, 371, 456, 459, 460, 461, 463
National Hockey League, 371, 463
National Income, 81, 94, 160
National Industrial Recovery Act, 482–483
Natural gas, 87, 187, 235, 259, 261, 266–267, 319, 320, 321,
449–450, 452, 474
Natural monopolies, 320–321, 450–451
Natural resources, 258–268
limited, 259
renewable, 259
sustainablility of, 259
stewardship of, 259
NBA (National Basketball Association), 371, 456, 459, 462–463
NDFP (see Nondiscretionary fiscal policy)
Neal, Derek, 387, 389
Necessary monopolies, 321–322
Negative-amortization mortgages, 172
Net benefit, 8
Netflix, 2, 188
Net interest, federal spending on, 149
Net present value, 380
Netscape, 324, 325
Net tax rate, 161
Neumark, David, 365
Neutral tax code, 434
“New normal,” 186, 189–191
Newhouse, Joseph, 295
NFL (National Football League), 330, 371, 456, 459, 460, 461, 463
NFL ticket exchange, 371
Nigeria, 235, 442, 445, 448
Nikkei Index, 93, 471
9/11 attacks (see September 11, 2001 attacks)
Nominal interest rate, 99–100
Nominal output, 80–81
Nondiscretionary fiscal policy (NDFP), 119
and aggregate supply and aggregate
demand model, 120–122
as built-in stabilizer, 120
in counteracting shocks, 122–123
evaluating, 123
and Obama stimulus plan, 126
Nontariff trade barriers, 209
Nordhaus, William D., 270
Normal goods, 27, 30
Normal profit, 73
Normative analysis, 9
Norris–La Guardia Act, 482–483
North American Free Trade Agreement (NAFTA), 238, 241,
242–243, 244, 245
Novy-Marx, Robert, 197–198, 200
Nuclear power, 261, 449–450
Number of sellers, 31, 32, 33
Nursing home care, 286–287, 289
O Oates, Wallace E., 270
Obama, Barack and administration, 125
and alternative minimum tax, 433
energy strategy of, 267, 350
and greenhouse emissions, 266, 268
initial budget of, 165
and Keystone pipeline, 87
and Social Security reform, 426
stimulus plan, 10, 115, 116, 120, 124–127, 175, 182–184, 227
and student loans, 397
Monopoly(-ies) (continued )
518 Index
and tax cuts, 116, 120, 435, 437
and tax increases, 433
and tax incentives, 435
and trade, 241
Obama stimulus plan, 10, 115, 116, 120, 124–127, 175, 182–184
and budget deficits, 159, 165
congressional votes for, 147–148
criticism’s of, 125
federal spending under, 146, 165
infrastructure projects in, 124
and recession of 2007–2009, 124
tax cuts in, 116, 120, 435, 437
tax incentives in, 435
Obamacare (Patient Protection and Affordable Care Act), 199, 273,
275, 277–279, 284, 285, 290, 291, 293, 397
Obstfeld, Maurice, 212, 247
OECD (Organization for Economic Cooperation and Development), 186
Off-budget, 156–157
Office of Management and Budget, 165
Office Suite, 325
Off-shoring, 207
Oil prices (see Energy prices)
Oil reserves, 440, 441, 442, 451–452
Oligopolies, 71
gasoline industry as, 447
other market forms vs., 71–72
and textbook market, 393
Oligopolistic markets, 71
On-budget, 156
OPEC (Organization of Petroleum Exporting Countries), 73, 163,
441, 442, 443, 445–446, 449
Open-market operations, 132, 161
Operating budget, 159
Operating system market, 324
Operational lag (fiscal policy), 123
Opportunity cost, 2
and absolute advantage, 204
of cleaner environment, 260
constant, 5–6, 11
and federal spending, 149
Head Start program, 416
increasing, 5–6, 11
made in developing countries, 236
production possibilities frontier model of, 5, 6, 11
and retirement savings, 421
Optimization assumption, 8
Organization for Economic Cooperation and Development (OECD), 186
Organization of Petroleum Exporting Countries (OPEC), 73, 163,
441, 442, 443, 445–446, 449
Organs, sale of, 279
Origin, 15
Orphan drugs, 297
Output, 20
and diminishing returns, 58
measuring, 80–81
monopoly and, 320
potential, price of, 31, 32, 34
Outsourcing, 207, 489
P Palmer, Karen, 270
Palm Pilot, 324
Panama Canal treaty, 245
PATCO (Professional Air Traffic Controllers Organization), 484
Patents, 70, 241, 297, 299n, 305
Patient Protection and Affordable Care Act (PPACA), 199, 273, 275,
277–279, 284, 285, 290, 291, 293, 397
Paulson, Henry, 138, 182
Pay option adjustable rate mortgages, 172
Pay-as-you-go pensions, 419
Payroll taxes, 193, 195, 293, 419, 425
PCPs (primary care physicians), 273
Peace dividend, 158
Peak (business cycle), 92
Penn State University, 479
Pensions:
Chicago, 198
county and municipal liabilities, 196–198
defined benefit, 194
defined contributions, 194
Employee Retirement Income Security Act of 1974 (ERISA), 194
Pension Guaranty Trust Corporation, 194
state and local government, 193–199
state liabilities, 196–199
Pentagon, damages, 499–500
Pepsi, 28, 71, 233
Per capita real GDP, 87, 187, 226, 232–234
Perfect competition, 68–69, 252, 464
in labor market, 478–479, 480, 486
markets meeting criteria for, 71–72
and maximization of profit, 64
monopoly vs., 319–321, 323, 367, 385, 445, 452–453
other market forms vs., 71–72
supply under, 73–76
Perfectly elastic demand, 45
Perfectly elastic supply, 47
Perfectly inelastic demand, 45
Perfectly inelastic supply, 47
Personal Consumption Expenditures (PCE) deflator, 85, 140,
168–169
Personal income taxes, 429–437
calculating, 430–434
debates over, 436–437
distribution of, 435–436
issues with, 434
payers of, 152, 435–436
surtax, 120n
and willingness to work and save, 434–435
withholding of, 429–430
United States, 191
Peterson, Paul E., 389
Pew Charitable Trust, 189, 343
Pew Research Center, 416
Phelps, Charles, 282, 295
Philip Morris, 72
Pick-a-pay mortgages, 172
Obama, Barack and administration (continued )
Index 519
Pinterest, 188
Pippen, 461
Plants, extinction of, 263–264
Plumbers and steamfitters, 480
Points, graphing, 15
Polasky, Stephen, 270
Political business cycle, 125
Political instability, 235
Politics:
in federal spending, 147
and fiscal policy, 124–125
of income taxes, 434
Pollution, 51, 208, 258–268, 335, 420, 502
Population, home prices and, 169
Population of potential buyers, 27, 29
Porter, Michael E., 270
Portney, Paul R., 270
Positive analysis, 9
Positive externalities, 412, 458
Poteba, James M., 270
Poverty, 208, 400–404
as “bad,” 408
causes of, 346
and crime, 312–313
gender differences in, 328
Head Start and, 411–412, 414
through history, 402–403
and living wage, 358
measuring, 400–404
and minimum wage, 358–359, 362
programs related to, 275, 284–285, 287, 293, 404–406, 411–416
(see also Welfare)
in the U.S. vs. Europe, 404
and Walmart, 491
wealth vs., 403
Poverty gap, 401, 406
Poverty line, 275, 284–285, 287, 293, 401
Poverty rate, 245, 328, 401–402, 411
Pozen, Robert, 426, 428
PPACA (Patient Protection and Affordable Care Act), 284, 285,
291, 293, 397, 425
Pre-Civil War era, economic growth, 187
Preferred provider organizations (PPOs), 273
Prescription drugs, 296–302
and drug industry as monopoly, 297–298
FDA approval of, 301–302
liability for ill effects linked to, 307–308
under Medicare, 290–291
and perceptions of drug companies, 297
prices of, 299–301
Present value, 100–104, 161, 168, 170, 194–195, 197n, 198, 259,
262–263, 299, 307, 316, 380, 395–396, 422–423, 468–469,
471, 500
Head Start, 412
Price(s), 20
classical and Keynesian views of, 109–110
of college textbooks, 393–395
and elasticity, 42–43
energy, 34, 122, 440–445, 447
farm, 349–351
of gasoline, 178, 259, 267–268, 446–447
of inputs, 31
measuring, 81–83
monopoly and, 319–320
of potential outputs, 31, 32
of prescription drugs, 299–301
setting, 63
stock, 468–470
of substitute/complement goods, 27, 28
Price ceiling, 36, 375
Price elasticity of demand, 41
Price elasticity of supply, 41, 46–47
Price expectations:
changes in, 35
as determinant of demand, 29
as determinant of supply, 31, 32–33
Price floors, 36, 352–355
Price fixing, 322
Price gouging, 36
Price indexes, 82–85
chain-based index, 85
consumer price index, 80
core, 85
GDP deflator, 86
Producer Price Index, 85
Price of inputs, 31
Price of other potential output, 31, 32
Price of the market basket in the base year, 82
Price supports, for farm products, 351–355
Primary care physicians (PCPs), 273
Primary credit rate or discount rate, 133
Principal–agent problem, 474–475
Prison costs, 314
Private property, 304–305
Private schools, 387
Private-sector unions, 485
Procyclical (budget amendment), 164
Producer Price Index, 85
Producer surplus, 48–50, 51–52
and environment, 260
and farm price floors, 352–353, 356
with illegal goods/services, 249
and labor, 479, 481–482, 486
and market failure, 320
and minimum wage, 359–361, 364
and prescription drugs, 298
and trade, 206, 210
Producers, 20
Product Accounts, 81, 94–95
Production, 57–59
Production costs, 59–62
Production function, 57
Production possibilities frontier, 2–4
for international trade, 205–206
opportunity cost on, 11
Production rules, 64
Professional Air Traffic Controllers Organization
(PATCO), 484
520 Index
Profit, 56
maximizing, 57, 64–65, 74, 311, 314, 368–369, 447
normal vs. economic, 73–75, 299, 333, 445, 453, 474
Progressive taxation, 123, 433
Property rights:
enforcing, 305–306
and environmental problems, 262–263
intellectual property, 241, 305, 395
and natural resources, 262–263
negative consequences of, 306
to solve environmental problems, 265–266
Prospective payments, 289, 290
Prostitution, 250, 252, 254–255, 312, 420, 495
and sexual slavery, 250
Public employees, unionization of, 484, 485
Public goods, 51
Public schools, 385–386
Pucher, John, 55
Pull factor, Walmart and, 491
Purchasing power parity, 233
Purely private goods, 50
Purely public goods, 51
Q Quantitative easing (QE2), 93, 136, 355
Quantity demanded, 20–21, 22, 23, 24, 41, 376
Quantity supplied, 20–21, 22, 23, 24, 41, 376
Quotas, 240
for affirmative action, 335–336
cartel, 442, 445–446, 452–453
trade, 208–210, 240, 241
R R. J. Reynolds, 249–250
Racial inequalities:
and affirmative action, 335–336
in automobile sales, 334
in crime statistics, 310–311, 330
in default on home loans, 331
in education, 330
in high school graduation rates, 383
in income, 328–329
in labor market, 330, 332–333
in poverty, 401–402
in real estate market, 333–334
in wages, 332–333
Ramo, Joshua Cooper, 144
Rational or statistical criminal model, 311–312, 502
Rational discrimination, 331
Rational terrorist hypothesis, 502–503
Rauh, Joshua, 197, 198
Reagan, Ronald and administration:
and agriculture subsidies, 355
and deficits of 1980s, 157–158
EITC during, 362
federal spending during, 145
and Iran-contra, 442n
and labor unions, 484
real growth rates under, 125
and student loans, 397
supply-side actions of, 115
trade agreements, 241
Real estate market, discrimination in, 333–334
Real gross domestic product (RGDP), 86
and aggregate demand, 108–109, 113, 120–122, 123, 128,
190, 232
and aggregate supply, 109–110, 114, 115, 120–122, 123, 128,
190, 232
in business cycle, 92, 178, 181
declining, 188
in depression, 94
growth in, 187, 199, 231
impact of interest rate effect on, 108
and monetary policy, 132–133, 139
and Obama stimulus plan, 127
problems with, 86–87, 307
as a result of austerity, 228
after September 11, 2001, 501
United States, 186, 188
Real-balances effect, 25–26, 108
Real interest rate, 99–100, 219, 292
Recession(s):
defined, 92
fiscal policy counteracting, 120, 121, 122–124, 312
historic, 92–94, 123, 125, 126, 355, 428, 472, 475, 494
and monetary policy, 137–140
Recession of 2007–2009, 89, 91, 111, 123, 127, 132, 137, 146,
157, 166, 177–184, 187–188, 215, 220, 227–228, 243, 268,
329–330, 339, 364, 381–382, 402, 425, 441, 442 (see also Great
Recession)
beginning of, 87
crisis of confidence in, 181–182
Fed’s role in, 131
and housing bubble, 177–180 (see also Housing bubble)
initial policy reactions to, 180–181
monetary stimulus, 183–184
and Obama stimulus plan, 127, 182–183
role of Federal Reserve in, 131
Recognition lag (fiscal policy), 123
Recovery (business cycle), 92
Rector, Robert, 403
Redmond, Washington, 479
Refiner Acquisition Cost of Imported Oil, 447–448
Refundable tax credits, 340
Regressions, in measuring discrimination, 331, 332, 333
Regulated monopolies, 321, 450–451
Reinsurance, 173, 502
Reliant Energy, 474
Renminbi (or yuan), 213, 215–220
Rent control, 373–377
consequences of, 375–377
in a free market, 373–374
reasons for, 374–375
Reservation wages, 461
Reserve clause (sports contracts), 462
Reserve ratio, 133
Index 521
Resources, 2
Restless legs syndrome, 301
Retirement, 418–426
Retirement age (Social Security), 419–420
Retirement annuities, 334
Retrospective payment, 289
Revenue, 56, 62–63
from casino gambling, 495
marginal, 62–63
Revenue sharing, 462
Revolutionary War, economic growth and, 187
Revolving credit, 180
Reyes, Jessica, 318
RGDP (see Real gross domestic product)
Richardson, J. David, 212
The Rise and Fall of American Growth, 190
Risk, 104
Risk aversion, 104, 272
Risk neutrality, 272
Risk premium, 104
Rivalry, 50
Robotic spot welders, 188
Rockefeller, John D., 323, 325
Rodrik, Dani, 212
Roosevelt, Franklin, 418, 482
Rosen, Harvey, 428
Royalties (to authors), 394
Rudd, Jeremy, 86, 97
Rule of 72, 104
Rules of thumb, in hiring, 330
Russia, 21, 93, 209, 217, 362
Ruth, Babe, 463
S Safeway, 488, 490
Salary cap (sports), 462, 463
Sales taxes, 81, 490, 491
Sampson, Ralph, 462
SAT scores, 336, 383–384
Saudi Arabia, 21, 236, 345, 442, 445
Saving:
and economic growth, 232
in monetary aggregates, 132
for retirement, 420–422
and tax rates, 435
Scalping tickets, 36, 366–371
Scarce resources, 1, 2, 3
Schaller, Bruce, 55
Scherer, F. M., 303
Schieber, Sylvester J., 426
Schiller, Robert J., 477
Schliefer, Andrei, 477
Schmalensee, Richard, 270, 326
School Lunch program, 380n, 405
School reform issues, 385–388
School vouchers, 387
Scientific method, 22
S-corporations, 469n
Schott, Jeffery, 243
Schumpeter, Joseph, 245
Screen Actors’ Guild, 484
Seasonal unemployment, 90
Section 8 apartments, 405
Securitization, 170, 173, 175
Sellers, number of, 31, 32, 33–34, 73, 75, 353
September 11, 2001 attacks, 126, 135, 140, 146, 147, 157, 325,
472, 499–503
aggregate-demand shock, 500–501
economic impact of, 499–500
modeling economic impact of, 500–502
oil price swings following, 446
and spending increases, 158
Sex discrimination, 327–328, 330–336
Sexual slavery, 250
Sheehan, Richard, 466
Sheiner, Louise, 130
Sherman Anti-Trust Act of 1890, 322–323, 465
Shocks, 121
aggregate demand, 121–122, 183, 500–501
aggregate supply, 122–123, 128, 501
Shogren, Jason F., 270
Short run, 74
barriers to entry, 71
consequences of rent control, 375–376
economic growth, 232
economic profit, 73–74, 75
elasticity of demand, 268, 363
elasticity of supply, 46
Short sale, 175
Shortages, 24–25, 35–36, 359, 370, 371, 442, 446
Shoven, John, 426
Siegfried, John, 466
Simple monopolies, 450–451
Simplifying assumption, 3, 71, 82, 260
Sindelar, Jody, 257
Single-payer system, 279–281
Sirius, 322–323
Skinner, Jonathan, 154, 167, 295
Slave labor, 208
Slemrod, Joel, 439
Slope, 16, 42–43, 60
Smartphone, economic growth and, 188
Smeeding, Timothy, 404, 406
Smoot-Hawley tariff law, 240
Soccer, 456–458
Social cost, 252–253, 261, 265
Social engineering, taxes for, 435, 437
Social insurance, 146, 423
Social Security, 418–426
benefits under, 283, 419
cost of living adjustment (COLA), 83
economic effects of, 421–422
fixing, 425–426
funding for, 193–199, 424–426
generational accounting of, 161
history of, 283–284, 418–419
need for, 420–421
spending on, 148, 149, 150, 151, 158, 160
522 Index
sustainability, 165
taxes for, 156–157, 273, 419, 437
temporary tax cut for, 419
and tobacco, 252
value of, 422–423
Social Security Trust Fund, 161, 195, 292,
424–426
Social welfare:
deadweight loss as a measure of, 51, 298, 370
nonequivalence to RGDP, 86–87, 307
Socialist, 21–22
Software development, 244
Solar power, 261, 268, 449, 451
Solow Growth Model, 234
Somalia, lawlessness in, 306
South Korea, 21, 139, 236, 241
Sovaldi, 300
Southwest Airlines, 323
Sowell, Thomas, 338
Soybean prices, 350, 355
S&P 500, 468, 475
Spain:
and central bank independence, 138
and debt to GDP, 220, 226, 227
and the euro, 223, 229
GDP growth, 223–224
and housing bubble, 223, 225
and long term interest rates, 225
per capita GDP, 223–224, 234
and soccer, 457, 464, 497
terrorism in, 503
and unemployment, 228
Spending:
on crime control, 311–316
on education, 236, 381–385, 390–398
by federal government (see Federal spending)
government, 81, 83–84, 87, 94, 108, 112, 114, 115, 120–128, 190,
228, 232, 355
on health care, 286, 288–289, 291, 301
on sports stadiums, 458
on welfare, 244, 404–408, 412
Sports, 455–465
city-based teams, 455–458
economics of, 461–465
labor market for, 461
relocation of NCAA, 457
relocation of teams, 455–457
return on investment in, 459–461
and sex discrimination, 330–331
spending on stadiums, 458
winning vs. profiting of teams, 459–460
SSI (Supplemental Security Income), 274, 284, 405, 408
St. Louis, Missouri, 456, 459, 460
St. Petersburg, Florida, 456
Standard and Poor’s 500 (S&P 500), 468, 475
Standard deduction (income tax), 430, 431, 433
Standard Oil, 322, 323–324
Staples, 491
State budgets, 164, 275, 381
State College, Pennsylvania, 479
State Farm, 474, 502n
States:
budgets of, 125, 126, 164, 175
civil liability, 306–307
collective bargaining of public employees in,
387–388
education spending by, 149, 379–385, 392–395
and the environment, 264, 267
gambling in, 494–497
Medicaid programs of, 272, 275, 284–287, 293, 300
minimum wages set by, 360, 363–364
Obama stimulus plan aid from, 126–127, 183–184
pension issues of, 193–199
refinery locations by, 450
ticket scalping laws in, 370–371
taxes of, 253
tobacco settlement with, 254
welfare spending by, 404–408
Statistical discrimination, 331
Steiger, Douglas, 144
Steuerle, C. Eugene, 422
Stevens, Ted, 147
Stiglitz, Joseph, 477
Stock, James H., 144
Stock indexes, 470
Stock market, 467–476
in 1990s, 158, 342–343
in 2006–2007, 475–476
in 2008–2009, 475–476
and accounting scandals, 472–475
crashes of, 139–140, 470–472
efficient, 470
function of, 469–470
stock price determination, 468–469
Stock options, 474
Stock prices, 139, 468–469, 470, 471, 474, 475
Stone, Kenneth E., 493
Strategic trade policies, 240
Strikes:
in history of unions, 483–485
in sports, 463–464
“Strong dollar,” 111–112
Structural deficit, 159–160
Structural unemployment, 90
Stubhub, 371
Student loans, 148, 149, 151, 306, 346, 396, 397
Subsidies:
agricultural, 353–355
corrective, 50, 435
as determinant of demand, 29–31
as determinant of supply, 31–34
educational, 380
government, 27, 29, 30, 31, 33, 34, 126–127, 240, 276
Medicare, 291, 293
in-kind, 404
of nonsmokers by smokers, 251n, 252
in PPACA, 275
for public universities, 391–392, 397 (see also Price supports)
renewable energy, 350
Social Security (continued )
Index 523
Substitutes, 27, 28, 30
and elasticity, 44, 46, 363, 370, 375, 395, 451
and market form, 70–72
number and closeness of, 41, 43, 44
and price changes, 25, 81–82, 84, 351
Substitution effect, 25, 434–435
terrorism, 503
Summers, Lawrence H., 477
Sun Microsystems, 324, 325
“Super” stores, 489, 490, 491
Supplemental Security Income (SSI), 274, 284,
405, 408
Supply, 20–34
aggregate (see Aggregate supply)
determinants of, 31–34
elasticity of, 46–48
excess, 25
law of, 26–27
under perfect competition, 73–76
price elasticity of (see Elasticity of supply)
quantity supplied vs., 20–21, 22
Supply and demand model, 19, 22–25
and ceteris paribus, 22
and changes in oil prices, 446–447
and changes in price expectations, 35
demand schedule, 22–23
determinants of demand, 27–31
determinants of supply, 31–34
and education, 380, 392
equilibrium, 24
and equilibrium changes, 35–36
and farm products, 349–355
and foreign exchange markets, 213–219
for health care, 274–275, 285–286
for illegal goods and services, 249–255
for international trade, 206
law of demand, 25–26
law of supply, 26–27
markets, 20
and labor, 359–364, 479–481
for prescription drugs, 297–301
quantity demanded and quantity supplied, 20–21
shortages and surpluses, 25, 36
supply schedule, 23–24
Supply curve, 20, 26–27, 29–31
decriminalization of illegal goods/services, 254–255
and law of supply, 26
movements in, 33–34
for ticket scalping, 370
Supply schedule, 23–24
Supply-side economics, 115
Supply-side macroeconomics, 115–116
Surpluses, 24, 25, 35–36
budget, 149, 156, 157, 158, 160, 161, 162, 163, 164, 165 (see also
Federal budget)
consumer (see Consumer surplus)
producer (see Producer surplus)
trade, 203
Survivor benefits (Social Security), 419–420
Swartz, Katherine, 274
T Taco Bell, 71
Taft-Hartley Act, 483
Takata, 308
Tampa Bay area, Florida, 456
TANF (Temporary Assistance to Needy Families), 149, 284, 285,
405, 406, 408, 414
Target, 473, 475, 488, 490
Tariffs, 208–209, 210, 240, 241, 244
TARP (Troubled Asset Relief Program), 10, 124, 146, 159, 160, 164,
174, 175, 182, 227, 241
Taste, 27, 28, 30
Tax cuts, 119–120
by Bush, 115–116, 126, 157, 158, 162, 166, 180, 437
impacts of, 124
in Obama stimulus plan, 126, 159, 182–184, 437
political debates on, 151–152, 190, 433, 436–437
sources of money for, 124
by Reagan, 115
Tax tables, 430, 431–432
Taxable income, 158, 430, 431, 432, 433, 436
Taxes
capital gains, 340–341, 345
and casino gambling, 494–495
and circular flow diagram, 7,8
corrective, 50, 249, 253–255, 265
and discretionary fiscal policy, 122–125, 128
as an economic incentive, 9, 190, 191, 232–233, 408
for education, 380, 385–388, 392, 397
EITC, 362, 405
and elasticity, 46
on emissions, 267–268
excise, 27, 29, 30, 31, 33, 34
federal revenue from, 151, 158–159, 162–163, 165, 189, 340,
430, 431
foreign, 214
and fiscal policy lags, 123–124
on gasoline, 448, 449
and GDP accounting, 81, 94–95
and generational accounting, 161
and Greece, 226, 228, 229
income, 86, 87, 111, 120, 157n, 158, 429–437
and inflation, 114, 115
inheritance, 342, 345
Medicare/Medicaid, 272–274, 283–293
and nondiscretionary fiscal policy, 121–122, 128
in Obama stimulus plan, 115, 120, 126
under PPACA, 275, 277–278
and purely public goods, 51
property, 170, 174, 431
under Reagan, 157, 158
during Revolutionary War, 156
sales, 81, 490–491
and shift in aggregate demand, 112–114
for Social Security, 156–157, 193, 195, 199, 419–420, 422,
423–426
under socialism, 21
supply-side impact of, 114
524 Index
tariffs, 208, 209, 240
on tobacco and alcohol, 253–254
Taylor, John B., 125, 127, 165
Teachers:
Head Start, 413–414
K–12, 194, 198, 199, 328, 331, 379–388
university, 198, 390–398
Teaching, 379–388, 390–398, 479
Teamsters, 243, 484, 485
Technology:
as determinant of supply, 313
economic output and, 187–188
and used textbook sales, 396
“Techno-optimists,” 190
Temporary Assistance to Needy Families (TANF), 149, 284, 285,
405, 406, 408, 414
Tenure, for teachers, 386
Term papers, sale of, 32
Terms of trade, 205, 206, 207
Terre Haute, Indiana, 494, 495
Terrorism:
aggregate-demand shock, 500–501
economic impact of September 11 attacks, 499–502
(see also September 11, 2001 attacks)
insurance aspects of, 500, 501–502
from the perspective of terrorist, 502–503
reinsurance, 502
substitution effect, 503
Texas, 197
and affirmative action, 336
housing in, 168–169
prisons in, 315
oil in, 203, 443, 447
TANF standards, 285
Texas Motor Speedway, 465
Texas Rangers, 459
Textbooks:
cost of, 391, 393–395
electronic, 395–396
market of, 393–395
renting, 393–395, 396
Third-party payers, 276–277, 288
Thomas, Duncan, 415
Thorton, Mark, 257
Ticket brokers/scalping, 366–371
Ticket master, 371
Time, elasticity and, 44
Tobacco, 72, 248–254, 278–279, 354
Topel, Robert, 410
Total cost, 59–62, 480
Total cost function, 60, 61
Total expenditure rule, 44
Total revenue (TR), 60, 63, 65, 74
to universities, 392–393
Toxic substances, 244
Toyota, 308
TPP (Trans-Pacific Partnership), 238, 244
TR (total revenue), 60, 63, 65, 74
to universities, 392–393
Trade (see International trade)
Trade agreements
benefits of, 239
economic and political impacts, 243–244
economists favoring, reasons, 245
Mexico, 239, 241–243, 244
need of, 239–241
quota, 240
special interests, 240
strategic trade policies, 240
tariff, 240
United States, 238–241, 243, 244
Trade barriers, 207–208, 240, 241, 243, 344
Trade protection, 208, 210
Trademarks, 305
Traditional mortgages, 170–172
Training, federal spending on, 148–149
Trans-Pacific Partnership (TPP), 238, 244
Triest, Robert, 410
Troubled Asset Relief Program (TARP), 10, 124, 146, 159, 160, 164,
174, 175, 182, 227, 241
Trough (business cycle), 92, 94
Truman, Harry, 125, 483
Trump, Donald, 244, 344
Trust, 323
Trust funds, 156, 162
Medicare, 161, 195, 284, 292–293
Social Security, 161, 195, 424–426
Tschirhart, John, 270
Tuition tax credit, 433
Twitter, 51, 188
U Unattainable production level, 4–5
Underemployment, 89–90, 335
Underground economy, 233, 376
Unemployment, 89–90
and aggregate supply, 109–110
benefits under the Obama stimulus plan, 120, 126, 127
and the business cycle, 92, 163
classical and Keynesian views of, 109–110, 228
and crime, 314
during depressions, 94
effects of trade on, 245
in European countries, 228
insurance, 31, 500
measuring, 87–90
and the minimum wage, 361, 363
and monetary policy, 134
and production possibilities frontier, 4–5
and racial disparities, 330
in recession of 2001, 158
in recession of 2007–2009, 89, 158–159, 164, 182–183
seasonal adjustment of, 91–92
types of, 90
Unemployment rates, 87, 89–92, 94, 139, 182, 228, 312, 330,
361, 418
Uninsured persons, 274, 278, 300
Taxes (continued )
Index 525
Unions, 478–486, 502
future of, 485–486
history of, 345, 482–485
as monopolies, 481–482
public vs. private employees in, 483, 484
reasons for, 478–481
in sports, 463–464
for teachers, 386, 387, 388
and trade, 207, 240, 245
Unitary elastic, 42, 45
United Association of Journeymen and Apprentices of the
Plumbing and Pipe Fitting Industry of the United States
and Canada, 480n
United Auto Workers, 48, 481, 484
United Automobile, Aerospace, and Agricultural Workers of
America, 481n
United Kingdom (see Great Britain)
United Mine Workers of America, 481n
United Nations Intergovernmental Panel on Climate Change, 261
United Parcel Service (UPS), 320, 484–485
United States:
antipoverty spending in, 404–406
and Arab–Israeli wars, 441
balance of payments for, 214
business cycle of, 94, 111, 119, 177–184
crime in, 310–311, 314
as debtor nation, 215
debt-to-GDP ratio for, 160
deficits and debt of, 155–166
drug prices in, 301
economic freedom, 21
economic stagnation and, 186
entertainment industry, 241–242
exchange rates of, 216–218
federal spending in, 145–152
fiscal policy in, 123–128
free trade, 238–239
gross domestic product, 80
health care compared to other countries, 279–280
health care system of, 271–293
housing bubble of, 168–175
income and wealth inequality in, 339–347
income taxes in (see personal income taxes)
monetary policy in, 132–142
poverty in, 403–405
production of workers, 239
real GDP growth, 186
trade of, 201–203, 238–245
United Steelworkers of America, 484
University education, 390–398
UPS (see United Parcel Service)
Uruguay Round, 241, 242
USA Patriot Act, 502
U.S. Department of Labor, 243
V Van der Linde, Claas, 270
Variable costs, 50, 52, 59, 62, 64, 260, 352, 356, 393, 394, 450
Variable inputs, 57, 449–450
Verizon Wireless, 71
Vermont, 147, 197, 353
Vertical equity (income taxes), 434
Veterans’ benefits, federal spending on, 148–149, 272, 397
Vig, 496–497
Vivitrol, 300
W Wachovia, 182
Wages:
and circular flow diagram, 7, 8
and deflation, 93
in developed vs. developing countries, 235
and economic growth, 187
gender differences in, 328
impact on Medicare Trust Fund, 292
impact of trade on, 207, 243–245
inflation indexing, 425–426
Medicare tax on, 273
minimum wage, 36, 51, 88, 155, 311–312, 346, 353, 359–364,
408, 463
under monopsony, 480
and perfect competition, 479, 481
racial inequalities in, 332–333
reservation, 461–462
for sports players, 463–464
and taxes, 430, 434–435
technology and trade impact on, 344–345
and unemployment, 90
union control of, 481–483, 485
at Walmart, 489, 491
and World War II controls on, 272n
Wagner Act, 482–483
Waldfogel, Jane, 338
The Wall Street Journal, 21
Walmart Supercenters, 48, 488, 490
War, costs of veteran’s benefits, 149
Wastewater treatment, 244, 264
Water pollution, 244, 264
Watson, Mark W., 144
Wealth:
and deflation, 93
gender differences in, 328, 334
Greek taxes on, 229
and home ownership, 173, 403
means testing using, 284–285, 293, 426
and Medicaid rules, 287
mobility of, 346
and poverty, 403, 405
and real-balances effect, 108
and self-employment, 478
socialism’s counter to, 21
Wealth inequality, 244, 306, 323
causes of, 344–345
measurements of, 342–343
Weather, changes in, 264–265
Wegmans, 489
526 Index
Weitzman, Martin, 270
Welfare, 400, 404–408
education’s impact on, 380
federal spending on, 122, 148–151, 159, 163
and Head Start, 412, 414
and incentives, 9
and nondiscretionary fiscal policy, 120, 123, 128
in Obama stimulus plan, 126, 182–184
reform of, 287, 407–408
results of, 406–408
social safety net, 94
spending on, 406
types of programs, 274, 404–405
Welfare dependency, 407, 408
Wells Fargo, 182
Wendy’s, 71
Weyant, John P., 270
White, Eugene N., 477
WIC (Women, Infants and Children), 405–406, 414, 490
Wildlife, extinction of, 263, 264, 265
Williamson, Jeffrey G., 212
Wilson, Woodrow, 482
Windows, 70, 241, 324–325
Windows 95, 241, 324
Windows Office Suite, 325
Wind power, 261, 268, 449, 451
Winkler, Anne, 338
Wisconsin, 69, 196–197, 285, 353, 387–388, 403
Withholding, tax, 120, 124, 340–341, 429–431
Wolff, Edward, 410
Women:
and affirmative action, 335–336
and athletics, 368, 457, 462
and crime, 312
economic status of, 327–328
fertility rate of, 195, 424
and Head Start families, 414
health care for, 278
Labor Force Participation Rate, 7, 88–89, 187–188,
190, 345
life expectancy of, 425
and Medicaid, 284
poverty among, 402–403, 405–407
sex discrimination, 330–331, 333–335
in teaching, 386
Women, Infants and Children (WIC), 405–406, 414, 490
Wood, Adrian, 212
WordPerfect Suite, 325
Work effort:
effect of Social Security on, 421
and minimum wage, 363
tax incentives for, 435
Workforce, 89, 188, 190, 233, 244, 478, 491
Work stoppages, 484
Worker productivity, economic growth and, 232–233
WorldCom, 475
World Trade Center (WTC), 472, 499–500, 503
World Trade Organization (WTO), 238, 242
WTC (World Trade Center), 499–500
WTO (World Trade Organization), 238, 242
X X-axis, 15–16, 18
Xerox, 475
X-intercept, 16
XM radio, 322–323
Y Y-axis, 15–16, 18
Yield curve, 104, 141
Yinger, John, 338
Y-intercept, 16
Z Zimbalist, Andrew, 466
- Cover
- Title
- Copyright
- Table of Contents
- Preface
- Issues for Different Course Themes
- Required Theory Table
- Chapter 1 Economics: The Study of Opportunity Cost
- Economics and Opportunity Cost
- Economics Defined
- Choices Have Consequences
- Modeling Opportunity Cost Using the Production Possibilities Frontier
- The Intuition behind Our First Graph
- The Starting Point for a Production Possibilities Frontier
- Points between the Extremes of a Production Possibilities Frontier
- Attributes of the Production Possibilities Frontier
- Increasing and Constant Opportunity Cost
- Economic Growth
- How Is Growth Modeled?
- Sources of Economic Growth
- The Big Picture
- Circular Flow Model: A Model That Shows the Interactions of All Economic Actors
- Thinking Economically
- Marginal Analysis
- Positive and Normative Analysis
- Economic Incentives
- Fallacy of Composition
- Correlation ≠ Causation
- Kick It Up a Notch: Demonstrating Constant and Increasing Opportunity Cost on a Production Possibilities Frontier
- Demonstrating Increasing Opportunity Cost
- Demonstrating Constant Opportunity Cost
- Summary
- Appendix 1A: Graphing: Yes, You Can.
- Cartesian Coordinates
- Please! Not Y = MX + B … Sorry.
- What on God's Green Earth Does This Have to Do with Economics?
- Chapter 2 Supply and Demand
- Supply and Demand Defined
- Markets
- Quantity Demanded and Quantity Supplied
- Ceteris Paribus
- Demand and Supply
- The Supply and Demand Model
- Demand
- Supply
- Equilibrium
- Shortages and Surpluses
- All about Demand
- The Law of Demand
- Why Does the Law of Demand Make Sense?
- All about Supply
- The Law of Supply
- Why Does the Law of Supply Make Sense?
- Determinants of Demand
- Taste
- Income
- Price of Other Goods
- Population of Potential Buyers
- Expected Price
- Excise Taxes
- Subsidies
- The Effect of Changes in the Determinants of Demand on the Supply and Demand Model
- Determinants of Supply
- Price of Inputs
- Technology
- Price of Other Potential Outputs
- Number of Sellers
- Expected Price
- Excise Taxes
- Subsidies
- The Effect of Changes in the Determinants of Supply on the Supply and Demand Model
- The Effect of Changes in Price Expectations on the Supply and Demand Model
- Kick It Up a Notch: Why the New Equilibrium?
- Summary
- Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus
- Elasticity of Demand
- Intuition
- Definition of Elasticity and Its Formula
- Elasticity Labels
- Alternative Ways to Understand Elasticity
- The Graphical Explanation
- The Verbal Explanation
- Seeing Elasticity through Total Expenditures
- More on Elasticity
- Determinants of Elasticity of Demand
- Elasticity and the Demand Curve
- Elasticity of Supply
- Determinants of the Elasticity of Supply
- Consumer and Producer Surplus
- Consumer Surplus
- Producer Surplus
- Market Failure
- Categorizing Goods
- Kick It Up a Notch: Deadweight Loss
- Summary
- Chapter 4 Firm Production, Cost, and Revenue
- Production
- Just Words
- Graphical Explanation
- Numerical Example
- Costs
- Just Words
- Numerical Example
- Revenue
- Just Words
- Numerical Example
- Maximizing Profit
- Graphical Explanation
- Numerical Example
- Summary
- Chapter 5 Perfect Competition, Monopoly, and Economic versus Normal Profit
- From Perfect Competition to Monopoly
- Perfect Competition
- Monopoly
- Monopolistic Competition
- Oligopoly
- Which Model Fits Reality
- Supply under Perfect Competition
- Normal versus Economic Profit
- When and Why Economic Profits Go to Zero
- Why Supply Is Marginal Cost under Perfect Competition
- Just Words
- Numerical Example
- Graphical Explanation
- Summary
- Chapter 6 Every Macroeconomic Word You Ever Heard: Gross Domestic Product, Inflation, Unemployment, Recession, and Depression
- Measuring the Economy
- Measuring Nominal Output
- Measuring Prices and Inflation
- Problems Measuring Inflation
- Real Gross Domestic Product and Why It Is Not Synonymous with Social Welfare
- Real Gross Domestic Product
- Problems with Real GDP
- Measuring and Describing Unemployment
- Measuring Unemployment
- Problems Measuring Unemployment
- Types of Unemployment
- Productivity
- Measuring and Describing Productivity
- Seasonal Adjustment
- Business Cycles
- Kick It Up a Notch: National Income and Product Accounting
- Summary
- Chapter 7 Interest Rates and Present Value
- Interest Rates
- The Market for Money
- Nominal Interest Rates versus Real Interest Rates
- Present Value
- Simple Calculations
- Mortgages, Car Payments, and Other Multipayment Examples
- Future Value
- Kick It Up a Notch: Risk and Reward
- Summary
- Chapter 8 Aggregate Demand and Aggregate Supply
- Aggregate Demand
- Definition
- Why Aggregate Demand Is Downward Sloping
- Aggregate Supply
- Definition
- Competing Views of the Shape of Aggregate Supply
- Shifts in Aggregate Demand and Aggregate Supply
- Variables That Shift Aggregate Demand
- Variables That Shift Aggregate Supply
- Causes of Inflation
- How the Government Can Influence (but Probably Not Control) the Economy
- Demand-Side Macroeconomics
- Supply-Side Macroeconomics
- Summary
- Chapter 9 Fiscal Policy
- Nondiscretionary and Discretionary Fiscal Policy
- How They Work
- Using Aggregate Supply and Aggregate Demand to Model Fiscal Policy
- Using Fiscal Policy to Counteract "Shocks"
- Aggregate Demand Shocks
- Aggregate Supply Shocks
- Evaluating Fiscal Policy
- Nondiscretionary Fiscal Policy
- Discretionary Fiscal Policy
- The Political Problems with Fiscal Policy
- Criticism from the Right and Left
- The Rise, Fall, and Rebirth of Discretionary Fiscal Policy
- The Obama Stimulus Plan
- Kick It Up a Notch: Aggregate Supply Shocks
- Summary
- Chapter 10 Monetary Policy
- Goals, Tools, and a Model of Monetary Policy
- Goals of Monetary Policy
- Traditional and Ordinary Tools of Monetary Policy
- Modeling Monetary Policy
- The Monetary Transmission Mechanism
- The Additional Tools of Monetary Policy Created in 2008
- Central Bank Independence
- Modern Monetary Policy
- The Last 30 Years
- Summary
- Chapter 11 Federal Spending
- A Primer on the Constitution and Spending Money
- What the Constitution Says
- Shenanigans
- Dealing with Disagreements
- Using Our Understanding of Opportunity Cost
- Mandatory versus Discretionary Spending
- Where the Money Goes
- Using Our Understanding of Marginal Analysis
- The Size of the Federal Government
- The Distribution of Federal Spending
- Budgeting for the Future
- Baseline versus Current-Services Budgeting
- Summary
- Chapter 12 Federal Deficits, Surpluses, and the National Debt
- Surpluses, Deficits, and the Debt: Definitions and History
- Definitions
- History
- How Economists See the Deficit and the Debt
- Operating and Capital Budgets
- Cyclical and Structural Deficits
- The Debt as a Percentage of GDP
- International Comparisons
- Generational Accounting
- Who Owns the Debt?
- Externally Held Debt
- A Balanced-Budget Amendment
- Projections
- Summary
- Chapter 13 The Housing Bubble
- How Much Is a House Really Worth?
- Mortgages
- How to Make a Bubble
- Pop Goes the Bubble!
- The Effect on the Overall Economy
- Summary
- Chapter 14 The Recession of 2007–2009: Causes and Policy Responses
- Before It Began
- Late 2007: The Recession Begins as Do the Initial Policy Reactions
- The Bottom Falls Out in Fall 2008
- The Obama Stimulus Package
- Extraordinary Monetary Stimulus
- Summary
- Chapter 15 Is Economic Stagnation the New Normal?
- Periods of Robust Economic Growth
- Sources of Growth
- Causes and Consequences of Slowing Growth
- Causes
- Consequences
- What Can Be Done to Jump-Start Growth, or Is This the New Normal?
- Summary
- Chapter 16 Is the (Fiscal) Sky Falling?: An Examination of Unfunded Social Security, Medicare, and State and Local Pension Liabilities
- What Is the Source of the Problem?
- How Big Is the Social Security and Medicare Problem?
- How Big Is the State and Local Pension Problem?
- Is It Possible That the Fiscal Sky Isn't About to Fall?
- Summary
- Chapter 17 International Trade: Does It Jeopardize American Jobs?
- What We Trade and with Whom
- The Benefits of International Trade
- Comparative and Absolute Advantage
- Demonstrating the Gains from Trade
- Production Possibilities Frontier Analysis
- Supply and Demand Analysis
- Whom Does Trade Harm?
- Trade Barriers
- Reasons for Limiting Trade
- Methods of Limiting Trade
- Trade as a Diplomatic Weapon
- Kick It Up a Notch: Costs of Protectionism
- Summary
- Chapter 18 International Finance and Exchange Rates
- International Financial Transactions
- Foreign Exchange Markets
- Alternative Foreign Exchange Systems
- Determinants of Exchange Rates
- Summary
- Chapter 19 European Debt Crisis
- In the Beginning There Were 17 Currencies in 17 Countries
- The Effect of the Euro
- Why Couldn't They Pull Themselves Out? The United States Did
- Is It Too Late to Leave the Euro?
- Where Should Europe Go from Here?
- Summary
- Chapter 20 Economic Growth and Development
- Growth in Already Developed Countries
- Comparing Developed Countries and Developing Countries
- Fostering (and Inhibiting) Development
- The Challenges Facing Developing Countries
- What Works
- Summary
- Chapter 21 NAFTA, CAFTA, GATT, TPP, WTO: Are Trade Agreements Good for Us?
- The Benefits of Free Trade
- Why Do We Need Trade Agreements?
- Strategic Trade
- Special Interests
- What Trade Agreements Prevent
- Trade Agreements and Institutions
- Alphabet Soup
- Are They Working?
- Economic and Political Impacts of Trade
- The Bottom Line
- Summary
- Chapter 22 The Line between Legal and Illegal Goods
- An Economic Model of Tobacco, Alcohol, and Illegal Goods and Services
- Why Is Regulation Warranted?
- The Information Problem
- External Costs
- Morality Issues
- Taxes on Tobacco and Alcohol
- Modeling Taxes
- The Tobacco Settlement and Why Elasticity Matters
- Why Are Certain Goods and Services Illegal?
- The Impact of Decriminalization on the Market for the Goods
- The External Costs of Decriminalization
- Summary
- Chapter 23 Natural Resources, the Environment, and Climate Change
- Using Natural Resources
- How Clean Is Clean Enough?
- The Externalities Approach
- When the Market Works for Everyone
- When the Market Does Not Work for Everyone
- The Property Rights Approach to the Environment and Natural Resources
- Why You Do Not Mess Up Your Own Property
- Why You Do Mess Up Common Property
- Natural Resources and the Importance of Property Rights
- Environmental Problems and Their Economic Solutions
- Environmental Problems
- Economic Solutions: Using Taxes to Solve Environmental Problems
- Economic Solutions: Using Property Rights to Solve Environmental Problems
- No Solution: When There Is No Government to Tax or Regulate
- Summary
- Chapter 24 Health Care
- Where the Money Goes and Where It Comes From
- Insurance in the United States
- How Insurance Works
- Varieties of Private Insurance
- Public Insurance
- Economic Models of Health Care
- Why Health Care Is Not Just Another Good
- Implications of Public Insurance
- Efficiency Problems with Private Insurance
- Major Changes to Insurance Resulting from PPACA
- The Blood and Organ Problem
- Comparing the United States with the Rest of the World
- Summary
- Chapter 25 Government-Provided Health Insurance: Medicaid, Medicare, and the Children's Health Insurance Program
- Medicaid: What, Who, and How Much
- Why Medicaid Costs So Much
- Why Spending Is Greater on the Elderly
- Cost-Saving Measures in Medicaid
- Medicare: Public Insurance and the Elderly
- Why Private Insurance May Not Work
- Why Medicare's Costs Are High
- Medicare's Nuts and Bolts
- Provider Types
- Part A
- Part B
- Prescription Drug Coverage (Part D)
- Cost Control Provisions in Medicare
- The Medicare Trust Fund
- The Relationship between Medicaid and Medicare
- Children's Health Insurance Program
- Summary
- Chapter 26 The Economics of Prescription Drugs
- Profiteers or Benevolent Scientists?
- Monopoly Power Applied to Drugs
- Important Questions
- Expensive Necessities or Relatively Inexpensive Godsends?
- Price Controls: Are They the Answer?
- FDA Approval: Too Stringent or Too Lax?
- Summary
- Chapter 27 So You Want to Be a Lawyer: Economics and the Law
- Private Property
- Intellectual Property
- Contracts
- Enforcing Various Property Rights and Contracts
- Negative Consequences of Private Property Rights
- Bankruptcy
- Civil Liability
- Summary
- Chapter 28 The Economics of Crime
- Who Commits Crimes and Why
- The Rational Criminal Model
- Crime Falls When Legal Income Rises
- Crime Falls When the Likelihood and Consequences of Getting Caught Rise
- Problems with the Rationality Assumption
- The Costs of Crime
- How Much Does an Average Crime Cost?
- How Much Crime Does an Average Criminal Commit?
- Optimal Spending on Crime Control
- What Is the Optimal Amount to Spend?
- Is the Money Spent in the Right Way?
- Are the Right People in Jail?
- What Laws Should We Rigorously Enforce?
- What Is the Optimal Sentence?
- Summary
- Chapter 29 Antitrust
- What's Wrong with Monopoly?
- High Prices, Low Output, and Deadweight Loss
- Reduced Innovation
- Natural Monopolies and Necessary Monopolies
- Natural Monopoly
- Patents, Copyrights, and Other Necessary Monopolies
- Monopolies and the Law
- The Sherman Anti-Trust Act
- What Constitutes a Monopoly?
- Examples of Antitrust Action
- Standard Oil
- IBM
- Microsoft
- Apple, Google, and the European Union
- Summary
- Chapter 30 The Economics of Race and Sex Discrimination
- The Economic Status of Women and Minorities
- Women
- Minorities
- Definitions and Detection of Discrimination
- Discrimination, Definitions, and the Law
- Detecting and Measuring Discrimination
- Discrimination in Labor, Consumption, and Lending
- Labor Market Discrimination
- Consumption Market and Lending Market Discrimination
- Affirmative Action
- The Economics of Affirmative Action
- What Is Affirmative Action?
- Gradations of Affirmative Action
- Summary
- Chapter 31 Income and Wealth Inequality: What's Fair?
- Measurement of Inequality
- Income Inequality
- Wealth Inequality
- The Shrinking Middle Class
- Causes of Household Income and Wealth Inequality
- Costs and Benefits of Income Inequality
- Summary
- Chapter 32 Farm Policy
- Farm Prices Since 1950
- Corn and Gasoline
- Price Variation as a Justification for Government Intervention
- The Case for Price Supports
- The Case against Price Supports
- Consumer and Producer Surplus Analysis of Price Floors
- One Floor in One Market
- Variable Floors in Multiple Markets
- What Would Happen without Price Supports?
- Price Support Mechanisms and Their History
- Price Support Mechanisms
- History of Price Supports
- Is There a Bubble on the Farm?
- Kick It Up a Notch
- Summary
- Chapter 33 Minimum Wage
- Traditional Economic Analysis of a Minimum Wage
- Labor Markets and Consumer and Producer Surplus
- A Relevant versus an Irrelevant Minimum Wage
- What Is Wrong with a Minimum Wage?
- Real-World Implications of the Minimum Wage
- Alternatives to the Minimum Wage
- Rebuttals to the Traditional Analysis
- The Macroeconomics Argument
- The Work Effort Argument
- The Elasticity Argument
- Where Are Economists Now?
- Kick It Up a Notch
- Summary
- Chapter 34 Ticket Brokers and Ticket Scalping
- Defining Brokering and Scalping
- An Economic Model of Ticket Sales
- Marginal Cost
- The Promoter as Monopolist
- The Perfect Arena
- Why Promoters Charge Less Than They Could
- An Economic Model of Scalping
- Legitimate Scalpers
- Summary
- Chapter 35 Rent Control
- Rents in a Free Market
- Reasons for Controlling Rents
- Consequences of Rent Control
- Why Does Rent Control Survive?
- Summary
- Chapter 36 The Economics of K–12 Education
- Investments in Human Capital
- Present Value Analysis
- External Benefits
- Should We Spend More?
- The Basic Data
- Cautions about Quick Conclusions
- Literature on Whether More Money Will Improve Educational Outcomes
- School Reform Issues
- The Public School Monopoly
- Merit Pay and Tenure
- Private versus Public Education
- School Vouchers
- Collective Bargaining
- Summary
- Chapter 37 College and University Education: Why Is It So Expensive?
- Why Are the Costs So High?
- Why Are College Costs Rising So Fast?
- Why Have Textbook Costs Risen So Rapidly?
- What a College Degree Is Worth
- How Do People Pay for College?
- Summary
- Chapter 38 Poverty and Welfare
- Measuring Poverty
- The Poverty Line
- Who's Poor?
- Poverty through History
- Problems with Our Measure of Poverty
- Poverty in the United States versus Europe
- Programs for the Poor
- In Kind versus In Cash
- Why Spend $789 Billion on a $96 Billion Problem?
- Is $789 Billion Even a Lot Compared to Other Countries?
- Incentives, Disincentives, Myths, and Truths
- Welfare Reform
- Is There a Solution?
- Welfare as We Now Know It
- Is Poverty Necessarily Bad?
- Summary
- Chapter 39 Head Start
- Head Start as an Investment
- The Early Intervention Premise
- Present Value Analysis
- External Benefits
- The Early Evidence
- The Remaining Doubts
- The Head Start Program
- The Current Evidence
- Evidence that Head Start Works
- Evidence that Head Start Does Not Work
- More Evidence Is Coming and Some Is In
- The Opportunity Cost of Fully Funding Head Start
- Summary
- Chapter 40 Social Security
- The Basics
- The Beginning
- Taxes
- Benefits
- Changes over Time
- Why Do We Need Social Security?
- Social Security's Effect on the Economy
- Effect on Work
- Effect on Saving
- Whom Is the Program Good For?
- Will the System Be There for Me?
- Why Social Security Is in Trouble
- The Social Security Trust Fund
- Options for Fixing Social Security
- Summary
- Chapter 41 Personal Income Taxes
- How Income Taxes Work
- Issues in Income Taxation
- Horizontal and Vertical Equity
- Equity versus Simplicity
- Incentives and the Tax Code
- Do Taxes Alter Work Decisions?
- Do Taxes Alter Savings Decisions?
- Taxes for Social Engineering
- Who Pays Income Taxes?
- The Tax Debates of the Last Two Decades
- Summary
- Chapter 42 Energy Prices
- The Historical View
- Oil and Gasoline Price History
- Geopolitical History
- A Return to Irrelevancy
- OPEC
- What OPEC Tries to Do
- How Cartels Work
- Why Cartels Are Not Stable
- Back from the Dead
- Why Do Prices Change So Fast?
- Is It All a Conspiracy?
- From $1 to $4 per Gallon in 10 Years?
- Electric Utilities
- Electricity Production
- Why Are Electric Utilities a Regulated Monopoly?
- What Will the Future Hold?
- Kick It Up a Notch
- Summary
- Chapter 43 If We Build It, Will They Come? And Other Sports Questions
- The Problem for Cities
- Expansion versus Luring a Team
- Does a Team Enhance the Local Economy?
- Why Are Stadiums Publicly Funded?
- The Problem for Owners
- To Move or to Stay
- To Win or to Profit
- Don't Feel Sorry for Them Just Yet
- The Sports Labor Market
- What Owners Will Pay
- What Players Will Accept
- The Vocabulary of Sports Economics
- What a Monopoly Will Do for You
- Summary
- Chapter 44 The Stock Market and Crashes
- Stock Prices
- How Stock Prices Are Determined
- What Stock Markets Do
- Efficient Markets
- Stock Market Crashes
- Bubbles
- Example of a Crash: NASDAQ 2000
- The Accounting Scandals of 2001 and 2002
- Bankruptcy
- Why Capitalism Needs Bankruptcy Laws
- The Kmart and Global Crossing Cases
- What Happened in the Enron Case
- Why the Enron Case Matters More Than the Others
- Rebound of 2006–2007 and the Drop of 2008–2009
- Summary
- Chapter 45 Unions
- Why Unions Exist
- The Perfectly Competitive Labor Market
- A Reaction to Monopsony
- A Way to Restrict Competition and Improve Quality
- A Reaction to Information Issues
- A Union as a Monopolist
- The History of Labor Unions
- Where Unions Go from Here
- Kick It Up a Notch
- Summary
- Chapter 46 Walmart: Always Low Prices (and Low Wages)—Always
- The Market Form
- Who Is Affected?
- Most Consumers Stand to Gain—Some Lose Options
- Workers Probably Lose
- Sales Tax Revenues Won't Be Affected Much
- Some Businesses Will Get Hurt; Others Will Be Helped
- Community Effects
- Summary
- Chapter 47 The Economic Impact of Casino and Sports Gambling
- The Perceived Impact of Casino Gambling
- Local Substitution
- The "Modest" Upside of Casino Gambling
- The Economic Reasons for Opposing Casino Gambling
- Sports Gambling and Daily Fantasy
- Summary
- Chapter 48 The Economics of Terrorism
- The Economic Impact of September 11th and of Terrorism in General
- Modeling the Economic Impact of the Attacks
- Insurance Aspects of Terrorism
- Buy Insurance or Self-Protect or Both
- Terrorism from the Perspective of the Terrorist
- Summary
- Index
- A
- B
- C
- D
- E
- F
- G
- H
- I
- J
- K
- L
- M
- N
- O
- P
- Q
- R
- S
- T
- U
- V
- W
- X
- Y
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