MicroEconomics 5
mocy20
10: Wage Determination IN THIS CHAPTER YOU WILL LEARN:
1 Why the firm's marginal revenue product curve is its labor demand curve.
2 The factors that increase or decrease labor demand.
3 The determinants of elasticity of labor demand.
4 How wage rates are determined in competitive and monopsonistic labor markets.
5 How unions increase wage rates.
6 The major causes of wage differentials.
We now turn from the pricing and production of goods and services to the pricing and employment of resources. Although firms come in various sizes and operate under highly different market conditions, each has a demand for productive resources. They obtain those resources from households—the direct or indirect owners of land, labor, capital, and entrepreneurial resources. So, referring to the circular flow diagram (Figure 2.2, page 43), we shift our attention from the bottom loop (where businesses supply products that households demand) to the top loop (where businesses demand resources that households supply).
A Focus on Labor The basic principles we develop in this chapter apply to land, labor, and capital resources, but we will emphasize the pricing and employment of labor. About 70 percent of all income in the United States flows to households in the form of wages and salaries. More than 146 million of us go to work each day in the United States. We have an amazing variety of jobs with thousands of different employers and receive large differences in
pay. What determines our hourly wage or annual salary? Why is the salary of, say, a topflight major-league baseball player $15 million or more a year, whereas the pay for a first-rate schoolteacher is $50,000? Why are starting salaries for college graduates who major in engineering and accounting so much higher than those for graduates majoring in journalism and sociology?
Demand and supply analysis helps us answer these questions. We begin by examining labor demand and labor supply in a purely competitive labor market. In such a market,
purely competitive labor market
A labor market in which a large number of similarly qualified workers independently offer their labor services to a large number of employers, none of whom can set the wage rate.
• Numerous employers compete with one another in hiring a specific type of labor.
• Each of many workers with identical skills supplies that type of labor.
• Individual employers and individual workers are “wage takers” because neither can control the market wage rate.
Labor Demand
WORKED PROBLEMS
W 10.1
Labor demand
Labor demand is the starting point for any discussion of wages and salaries. Other things equal, the demand for labor is an inverse relationship between the price of labor (hourly wage) and the quantity of labor demanded. As with all resources, labor demand is a derived demand: It results from the
products that labor helps produce. Labor resources usually do not directly satisfy customer wants but do so indirectly through their use in producing goods and services. Almost nobody wants to consume directly the labor services of a software engineer, but millions of people do want to use the software that the engineer helps create.
derived demand
The demand for a resource that results from the demand for the products it helps produce.
Marginal Revenue Product Because resource demand is derived from product demand, the strength of the demand will depend on the productivity of the labor—its ability to produce goods and services—and the price of the good or service it helps produce. A resource that is highly productive in turning out a highly valued commodity will be in great demand. In contrast, a relatively unproductive resource that is capable of producing only a minimally valued commodity will be in little demand. And no demand whatsoever will exist for a resource that is phenomenally efficient in producing something that no one wants to buy.
Consider the table in Figure 10.1, which shows the roles of marginal productivity and product price in determining labor demand. FIGURE 10.1: The purely competitive seller's demand for labor.
The MRP-of-labor curve is the labor demand curve; each of its points relates a particular wage rate (= MRP when profit is maximized) with a corresponding quantity of labor demanded. The downward slope of the D = MRP curve results from the law of diminishing marginal returns.
Productivity Columns 1 and 2 give the number of units of labor employed and the resulting total product (output). Column 3 provides the marginal product (MP), or additional output, resulting from using each additional unit of
labor. Columns 1 through 3 remind us that the law of diminishing returns applies here, causing the marginal product of labor to fall beyond some point. For simplicity, we assume that these diminishing marginal returns—these declines in marginal product—begin with the second worker hired.
Product Price The derived demand for labor depends also on the market value (product price) of the good or service. Column 4 in the table in Figure 10.1 adds this price information to the mix. Because we are assuming a competitive product market, product price equals marginal revenue. The firm is a price taker and will sell units of output only at this market price. And this price will also be the firm's marginal revenue. In this case, both price and marginal revenue are a constant $2.
Multiplying column 2 by column 4 provides the total-revenue data of column 5. These are the amounts of revenue the firm realizes from the various levels of employment. From these total-revenue data we can compute the marginal revenue product (MRP) of labor—the change in total revenue resulting from the use of each additional unit of labor. In equation form,
marginal revenue product (MRP)
The change in a firm's total revenue when it employs 1 more unit of labor.
The MRPs are listed in column 6 in the table.
Rule for Employing Labor: MRP = MRC The MRP schedule, shown as columns 1 and 6, is the firm's demand
schedule for labor. To understand why, you must first know the rule that guides a profit-seeking firm in hiring any resource: To maximize profit, a firm should hire additional units of labor as long as each successive unit adds more to the firm's total revenue than to the firm's total cost.
Economists use special terms to designate what each additional unit of labor (or any other variable resource) adds to total revenue and what it adds to total cost. We have seen that MRP measures how much each successive unit of labor adds to total revenue. The amount that each additional unit of labor adds to the firm's total cost is called its marginal resource cost (MRC). In equation form,
marginal resource cost (MRC)
The change in a firm's total cost when it employs 1 more unit of labor.
So we can restate our rule for hiring resources as follows: It will be profitable for a firm to hire additional units of labor up to the point at which labor's MRP is equal to its MRC. If the number of workers a firm is currently hiring is such that the MRP of the last worker exceeds his or her MRC, the firm can profit by hiring more workers. But if the number being hired is such that the MRC of the last worker exceeds his or her MRP, the firm is hiring workers who are not “paying their way” and it can increase its profit by discharging some workers. You may have recognized that this MRP = MRC rule is similar to the MR = MC profit-maximizing rule employed throughout our discussion of price and output determination. The rationale of the two rules is the same, but the point of reference is now inputs of a resource, not outputs of a product.
MRP = MRC rule
The principle that to maximize profit a firm should expand employment until the marginal revenue product (MRP) of labor equals the marginal
resource cost (MRC) of labor.
MRP as Labor Demand Schedule In a competitive labor market, market supply and market demand establish the wage rate. Because each firm hires such a small fraction of the market supply of labor, an individual firm cannot influence the market wage rate; it is a wage taker, not a wage maker. This means that for each additional unit of labor hired, total labor cost increases by exactly the amount of the constant market wage rate. The MRC of labor exactly equals the market wage rate. Thus, resource “price” (the market wage rate) and resource “cost” (marginal resource cost) are equal for a firm that hires labor in a competitive labor market. Then the MRP = MRC rule tells us that a competitive firm will hire units of labor up to the point at which the market wage rate (its MRC) is equal to its MRP.
In terms of the data in columns 1 and 6 of Figure 10.1 's table, if the market wage rate is, say, $13.95, the firm will hire only one worker. This is the outcome because the first worker adds $14 to total revenue and slightly less—$13.95—to total cost. In other words, because MRP exceeds MRC for the first worker, it is profitable to hire that worker. For each successive worker, however, MRC (= $13.95) exceeds MRP (= $12 or less), indicating that it will not be profitable to hire any of those workers. If the wage rate is $11.95, by the same reasoning we discover that it will pay the firm to hire both the first and second workers. Similarly, if the wage rate is $9.95, three will be hired; if it is $7.95, four; if it is $5.95, five; and so forth. The MRP schedule therefore constitutes the firm's demand for labor because each point on this schedule (or curve) indicates the quantity of labor units the firm would hire at each possible wage rate. In the graph in Figure 10.1, we show the D = MRP curve based on the data in the table. The competitive firm's labor demand curve identifies an inverse relationship between the wage rate and the quantity of labor demanded, other things equal. The curve slopes downward because of
diminishing marginal returns.1
Market Demand for Labor We have now explained the individual firm's demand curve for labor. Recall that the total, or market, demand curve for a product is found by summing horizontally the demand curves of all individual buyers in the market. The market demand curve for a particular resource is derived in essentially the same way. Economists sum horizontally the individual labor demand curves of all firms hiring a particular kind of labor to obtain the market demand for that labor.
Changes in Labor Demand What will alter the demand for labor (shift the labor demand curve)? The fact that labor demand is derived from product demand and depends on resource productivity suggests two “resource demand shifters.” Also, our analysis of how changes in the prices of other products can shift a product's demand curve (Chapter 3) suggests another factor: changes in the prices of other resources.
Changes in Product Demand Other things equal, an increase in the demand for a product will increase the demand for a resource used in its production, whereas a decrease in product demand will decrease the demand for that resource.
Let's see how this works. The first thing to recall is that a change in the demand for a product will normally change its price. In the table in Figure 10.1, let's assume that an increase in product demand boosts product price from $2 to $3. You should calculate the new labor demand schedule (columns 1 and 6) that would result, and plot it in the graph to verify that the new labor demand curve lies to the right of the old demand curve. Similarly, a decline in the product demand (and price) will shift the labor
demand curve to the left. The fact that labor demand changes along with product demand demonstrates that labor demand is derived from product demand.
Example: With no offsetting change in supply, a decrease in the demand for new houses will drive down house prices. Those lower prices will decrease the MRP of construction workers, and therefore the demand for construction workers will fall. The labor demand curve will shift to the left.
Changes in Productivity Other things equal, an increase in the productivity of a resource will increase the demand for the resource and a decrease in productivity will reduce the demand for the resource. If we doubled the MP data of column 3 in the table in Figure 10.1, the MRP data of column 6 also would double, indicating a rightward shift of the labor demand curve in the graph.
The productivity of any resource may be altered over the long run in several ways:
• Quantities of other resources The marginal productivity of any resource will vary with the quantities of the other resources used with it. The greater the amount of capital and land resources used with labor, the greater will be labor's marginal productivity and, thus, labor demand.
• Technological advance Technological improvements that increase the quality of other resources, such as capital, have the same effect. The better the quality of capital, the greater the productivity of labor used with it. Dockworkers employed with a specific amount of capital in the form of unloading cranes are more productive than dockworkers with the same amount of capital embodied in older conveyor-belt systems.
• Quality of labor Improvements in the quality of labor will increase its marginal productivity and therefore its demand. In effect, there will be a new demand curve for a different, more skilled, kind of
labor.
Changes in the Prices of Other Resources Changes in the prices of other resources may change the demand for labor.
Substitute Resources Suppose that labor and capital are substitutable in a certain production process. A firm can produce some specific amount of output using a relatively small amount of labor and a relatively large amount of capital, or vice versa. What happens if the price of machinery (capital) falls? The effect on the demand for labor will be the net result of two opposed effects: the substitution effect and the output effect.
• Substitution effect The decline in the price of machinery prompts the firm to substitute machinery for labor. This allows the firm to produce its output at lower cost. So at the fixed wage rate, smaller quantities of labor are now employed. This substitution effect decreases the demand for labor. More generally, the substitution effect indicates that a firm will purchase more of an input whose relative price has declined and, conversely, use less of an input whose relative price has increased.
substitution effect
The replacement of labor by capital when the price of capital falls.
• Output effect Because the price of machinery has declined, the costs of producing various outputs also must decline. With lower costs, the firm can profitably produce and sell a greater output. The greater output increases the demand for all resources, including labor. So this output effect increases the demand for labor. More generally, the output effect means that the firm will purchase more of one particular input when the price of the other input falls and less of that particular input when the price of the other input rises.
output effect
An increase in the use of labor that occurs when a decline in the price of capital reduces a firm's production costs and therefore enables it to sell more output.
• Net effect The substitution and output effects are both present when the price of an input changes, but they work in opposite directions. For a decline in the price of capital, the substitution effect decreases the demand for labor and the output effect increases it. The net change in labor demand depends on the relative sizes of the two effects: If the substitution effect outweighs the output effect, a decrease in the price of capital decreases the demand for labor. If the output effect exceeds the substitution effect, a decrease in the price of capital increases the demand for labor.
Complementary Resources Resources may be complements rather than substitutes in the production process; an increase in the quantity of one of them also requires an increase in the amount of the other used, and vice versa. Suppose a small design firm does computer-assisted design (CAD) with relatively expensive personal computers as its basic piece of capital equipment. Each computer requires exactly one design engineer to operate it; the machine is not automated—it will not run itself—and a second engineer would have nothing to do.
Now assume that these computers substantially decline in price. There can be no substitution effect because labor and capital must be used in fixed proportions: one person for one machine. Capital cannot be substituted for labor. But there is an output effect. Other things equal, the reduction in the price of capital goods means lower production costs. It will therefore be profitable to produce a larger output. In doing so, the firm will use both more capital and more labor. When labor and capital are complementary, a decline in the price of capital increases the demand
for labor through the output effect.
We have cast our analysis of substitute resources and complementary resources mainly in terms of a decline in the price of capital. Obviously, an increase in the price of capital causes the opposite effects on labor demand. Photo Op: Substitute Resources versus Complementary Resources
© Photodisc/Getty Images
© Royalty-Free/CORBIS
Automatic teller machines (ATMs) and human tellers are substitute resources, whereas construction equipment and their operators are complementary resources.
APPLYING THE ANALYSIS: Occupational Employment Trends Changes in labor demand are of considerable significance because they affect employment in specific occupations. Other things equal, increases in labor demand for certain occupational groups result in increases in their employment; decreases in labor demand result in decreases in their employment. For illustration, let's look at occupations that are growing and declining in demand.
Table 10.1 lists the 10 fastest-growing and 10 most rapidly declining U.S. occupations (in percentage terms) for 2006 to 2016, as projected by the Bureau of Labor Statistics. Notice that service occupations
dominate the fastest-growing list. In general, the demand for service workers is rapidly outpacing the demand for manufacturing, construction, and mining workers in the United States. TABLE 10.1: The 10 Fastest-Growing and Most Rapidly Declining U.S. Occupations, in Percentage Terms, 2006–2016
Of the 10 fastest-growing occupations in percentage terms, three— personal and home care aides (people who provide home care for the elderly and those with disabilities), home health care aides (people who provide short-term medical care after discharge from hospitals), and medical assistants—are related to health care. The rising demands for these types of labor are derived from the growing demand for health services, caused by several factors. The aging of the U.S. population has brought with it more medical problems, rising incomes have led to greater expenditures on health care, and the growing presence of private and public insurance has allowed people to buy more health care than most could afford individually.
Two of the fastest-growing occupations are directly related to computers. The increase in the demand for network systems and data communication analysts and for computer software engineers arises from the rapid rise in the demand for computers, computer services, and the Internet. It also results from the rising marginal revenue productivity of these particular workers, given the vastly improved quality of the computer and communications equipment they work with. Moreover, price declines on such equipment have had stronger output effects than substitution effects, increasing the demand for these kinds of labor.
Table 10.1 also lists the 10 U.S. occupations with the greatest projected job loss (in percentage terms) between 2006 and 2016. These occupations are more diverse than the fastest-growing occupations. Four of the ten are related to textiles, apparel, and shoes. The U.S. demand for these goods is increasingly being fulfilled through imports, some of which is related to outsourcing those jobs to workers abroad. Declines in other occupations in the list (for example, file clerks, model and pattern makers, and telephone operators) have resulted from technological advances that have enabled firms to replace workers with automated or computerized equipment. The advent of digital photography explains the projected decline in the employment of people operating photographic processing equipment.
Question:
Name some occupation (other than those listed) that you think will grow in demand over the next decade. Name an occupation that you think will decline in demand. In each case, explain your reasoning.
Elasticity of Labor Demand The employment changes we have just discussed have resulted from shifts in the locations of labor demand curves. Such changes in demand must be distinguished from changes in the quantity of labor demanded caused by a change in the wage rate. Such a change is caused not by a shift of the demand curve but, rather, by a movement from one point to another on a fixed labor demand curve. Example: In Figure 10.1 we note that an increase in the wage rate from $5 to $7 will reduce the quantity of labor demanded from 5 units to 4 units. This is a change in the quantity of labor demanded as distinct from a change in labor demand.
The sensitivity of labor quantity to changes in wage rates is measured by the elasticity of labor demand (or wage elasticity of demand). In coefficient form,
elasticity of labor demand
A measure of the responsiveness of labor quantity to a change in the wage rate.
ORIGIN OF THE IDEA
O 10.1
Elasticity of resource demand
When Ew is greater than 1, labor demand is elastic; when Ew is less than 1,
labor demand is inelastic; and when Ew equals 1, labor demand is unit-
elastic. Several factors interact to determine the wage elasticity of demand.
Ease of Resource Substitutability The greater the substitutability of other resources for labor, the more elastic is the demand for labor. Example: Because automated voice-mail systems are highly substitutable for telephone receptionists, the demand for receptionists is quite elastic. In contrast, there are few good substitutes for physicians, so demand for them is less elastic or even inelastic.
Time can play a role in the input substitution process. For example, a firm's truck drivers may obtain a substantial wage increase with little or no immediate decline in employment. But over time, as the firm's trucks wear out and are replaced, that wage increase may motivate the company to purchase larger trucks and in that way deliver the same total output with fewer drivers.
Elasticity of Product Demand The greater the elasticity of product demand, the greater is the elasticity of labor demand. The derived nature of resource demand leads us to expect this relationship. A small rise in the price of a product (caused by a wage increase) will sharply reduce output if product demand is elastic. So a relatively large decline in the amount of labor demanded will result. This means that the demand for labor is elastic.
Ratio of Labor Cost to Total Cost The larger the proportion of total production costs accounted for by labor, the greater is the elasticity of demand for labor. In the extreme, if labor
cost is the only production cost, then a 20 percent increase in wage rates will increase marginal cost and average total cost by 20 percent. If product demand is elastic, this substantial increase in costs will cause a relatively large decline in sales and a sharp decline in the amount of labor demanded. So labor demand is highly elastic. But if labor cost is only 50 percent of production cost, then a 20 percent increase in wage rates will increase costs by only 10 percent. With the same elasticity of product demand, this will cause a relatively small decline in sales and therefore in the amount of labor demanded. In this case the demand for labor is much less elastic.
Market Supply of Labor Let's now turn to the supply side of a purely competitive labor market. The supply curve for each type of labor slopes upward, indicating that employers as a group must pay higher wage rates to obtain more workers. Employers must do this to bid workers away from other industries, occupations, and localities. Within limits, workers have alternative job opportunities. For example, they may work in other industries in the same locality, or they may work in their present occupations in different cities or states, or they may work in other occupations.
Firms that want to hire these workers must pay higher wage rates to attract them away from the alternative job opportunities available to them. They also must pay higher wages to induce people who are not currently in the labor force—who are perhaps doing household activities or enjoying leisure —to seek employment. In short, assuming that wages are constant in other labor markets, higher wages in a particular labor market entice more workers to offer their labor services in that market. This fact results in a direct relationship between the wage rate and the quantity of labor supplied, as represented by the upward-sloping market supply-of-labor curve S in Figure 10.2a. FIGURE 10.2: A purely competitive labor market.
In a purely competitive labor market (a) the equilibrium wage rate Wc
and the number of workers Qc are determined by labor supply S and
labor demand D. Because this market wage rate is given to the individual firm (b) hiring in this market, its labor supply curve s = MRC is perfectly elastic. Its labor demand curve, d, is its MRP curve (here labeled mrp). The firm maximizes its profit by hiring workers up to the point where MRP = MRC.
Wage and Employment Determination What determines the market wage rate and how do firms respond to it? Suppose 200 firms demand a particular type of labor, say, carpenters. These firms need not be in the same industry; industries are defined according to the products they produce and not the resources they employ. Thus, firms producing wood-framed furniture, wood windows and doors, houses and apartment buildings, and wood cabinets will demand carpenters. To find the total, or market, labor demand curve for a particular labor service, we sum horizontally the labor demand curves (the marginal revenue product curves) of the individual firms, as indicated in Figure 10.2. The horizontal summing of the 200 labor demand curves like d in Figure 10.2b yields the
market labor demand curve D in Figure 10.2a.
The intersection of the market labor demand curve D and the market labor supply curve S in Figure 10.2 a determines the equilibrium wage rate and the level of employment in this purely competitive labor market. Observe that the equilibrium wage rate is Wc ($10) and the number of workers hired
is Qc (1000).
To the individual firm (Figure 10.2b) the market wage rate Wc is given at
$10. Each of the many firms employs such a small fraction of the total available supply of this type of labor that no single firm can influence the wage rate. As shown by the horizontal line s in Figure 10.2b, the supply of labor faced by an individual firm is perfectly elastic. It can hire as many or as few workers as it wants to at the market wage rate. This fact is clarified in Table 10.2, where we see that the marginal cost of labor MRC is constant at $10 and is equal to the wage rate. Each additional unit of labor employed adds precisely its own wage rate (here, $10) to the firm's total resource cost.
TABLE 10.2: The Supply of Labor: Pure Competition in the Hire of Labor
INTERACTIVE GRAPHS
G 10.1
Competitive labor market
Each individual firm will apply the MRP = MRC rule to determine its profitmaximizing level of employment. So the competitive firm maximizes its profit by hiring units of labor to the point at which its wage rate (= MRC) equals MRP. In Figure 10.2b the employer will hire qc (5) units of
labor, paying each worker the market wage rate Wc ($10). The other 199
firms (not shown) in this labor market will also each employ 5 workers and pay $10 per hour. The workers will receive pay based on their contribution to the firm's output and thus revenues.
Monopsony In the purely competitive labor market, each firm can hire as little or as much labor as it needs at the market wage rate, as reflected in its horizontal labor supply curve. The situation is strikingly different in monopsony, a market in which a single employer of labor has substantial buying (hiring) power. Labor market monopsony has the following characteristics:
• There is only a single buyer of a particular type of labor.
• This type of labor is relatively immobile, either geographically or because workers would have to acquire new skills.
• The firm is a “wage maker,” because the wage rate it must pay varies directly with the number of workers it employs.
monopsony
A market structure in which only a single buyer of a good, service, or
resource is present.
ORIGIN OF THE IDEA
O 10.2
Monopsony
As is true of monopoly power, there are various degrees of monopsony power. In pure monopsony such power is at its maximum because only a single employer hires labor in the labor market. The best real-world examples are probably the labor markets in towns that depend almost entirely on one major firm. For example, a silvermining company may be almost the only source of employment in a remote Idaho town. A Wisconsin paper mill, a Colorado ski resort, or an Iowa food processor may provide most of the employment in its locale. In other cases, three or four firms may each hire a large portion of the supply of labor in a certain market and therefore have some monopsony power. Moreover, if they illegally act in concert in hiring labor, they greatly enhance their monopsony power.
Upward-Sloping Labor Supply to Firm When a firm hires most of the available supply of a certain type of labor, its decision to employ more or fewer workers affects the wage rate it pays to those workers. Specifically, if a firm is large in relation to the size of the labor market, it will have to pay a higher wage rate to obtain more labor. Suppose that only one employer hires a particular type of labor in a certain geographic area. In this pure monopsony situation, the labor supply curve for the firm and the total labor supply curve for the labor market are identical. The monopsonist's supply curve—represented by curve S in Figure 10.3—is upsloping because the firm must pay higher wage rates if it wants to attract and hire additional workers. This same curve is also the monopsonist's average-cost-of-labor curve. Each point on curve S indicates the wage rate (cost) per worker that must be paid to attract the corresponding number of workers.
FIGURE 10.3: Monopsony.
In a monopsonistic labor market the employer's marginal resource (labor) cost curve (MRC) lies above the labor supply curve S. Equating MRC with MRP at point b, the monopsonist hires Qm workers
(compared with Qc under competition). As indicated by point c on S, it
pays only wage rate Wm (compared with the competitive wage Wc).
MRC Higher Than the Wage Rate When a monopsonist pays a higher wage to attract an additional worker, it must pay that higher wage not only to the additional worker, but to all the workers it is currently employing at a lower wage. If not, labor morale will deteriorate, and the employer will be plagued with labor unrest because of wage-rate differences existing for the same job. Paying a uniform wage to all workers means that the cost of an extra worker—the marginal resource (labor) cost (MRC)—is the sum of that worker's wage
rate and the amount necessary to bring the wage rate of all current workers up to the new wage level.
WORKED PROBLEMS
W 10.2
Labor markets: competition and monopsony
Table 10.3 illustrates this point. One worker can be hired at a wage rate of $6. But hiring a second worker forces the firm to pay a higher wage rate of $7. The marginal resource cost of the second worker is $8—the $7 paid to the second worker plus a $1 raise for the first worker. From another viewpoint, total labor cost is now $14 (= 2 × $7), up from $6. So the MRC of the second worker is $8 (= $14 − $6), not just the $7 wage rate paid to that worker. Similarly, the marginal labor cost of the third worker is $10—the $8 that must be paid to attract this worker from alternative employment plus $1 raises, from $7 to $8, for the first two workers.
TABLE 10.3: The Supply of Labor: Monopsony in the Hiring of Labor
Here is the key point: Because the monopsonist is the only employer in the labor market, its marginal resource (labor) cost exceeds the wage rate. Graphically, the monopsonist's MRC curve lies above the average-cost-of- labor curve, or labor supply curve S, as is clearly shown in Figure 10.3.
Equilibrium Wage and Employment How many units of labor will the monopsonist hire, and what wage rate will it pay? To maximize profit, the monopsonist will employ the quantity of labor Qm in Figure 10.3 because at that quantity MRC and MRP are
equal (point b). The monopsonist next determines how much it must pay to attract these Qm workers. From the supply curve S, specifically point c,
it sees that it must pay wage rate Wm. Clearly, it need not pay a wage
equal to MRP; it can attract and hire exactly the number of workers it wants (Qm)
with wage rate Wm. And that is the wage that it will pay.
INTERACTIVE GRAPHS
G 10.2
Monopsony
Contrast these results with those that would prevail in a competitive labor market. With competition in the hiring of labor, the level of employment would be greater (at Qc) and the wage rate would be higher (at Wc).
Other things equal, the monopsonist maximizes its profit by hiring a smaller number of workers and thereby paying a less-than-competitive wage rate. Society obtains a smaller output, and workers get a wage rate that is less by bc than their marginal revenue product.
APPLYING THE ANALYSIS: Monopsony
Power Fortunately, monopsonistic labor markets are uncommon in the United States. In most labor markets, several potential employers compete for most workers, particularly for workers who are occupationally and geographically mobile. Also, where monopsony labor market outcomes might have otherwise occurred, unions have sprung up to counteract that power by forcing firms to negotiate wages. Nevertheless, economists have found some evidence of monopsony power in such diverse labor markets as the markets for nurses, professional athletes, public school teachers, newspaper employees, and some building-trade workers.
In the case of nurses, the major employers in most locales are a relatively small number of hospitals. Further, the highly specialized skills of nurses are not readily transferable to other occupations. It has been found, in accordance with the monopsony model, that, other things equal, the smaller the number of hospitals in a town or city (that is, the greater the degree of monopsony), the lower the beginning salaries of nurses.
Professional sports leagues also provide a good example of monopsony, particularly as it relates to the pay of first-year players. The National Football League, the National Basketball Association, and Major League Baseball assign first-year players to teams through “player drafts.” That device prohibits other teams from competing for a player's services, at least for several years, until the player becomes a “free agent.” In this way the league exercises monopsony power, which results in lower salaries than would occur under competitive conditions.
Question:
The salaries of star players often increase substantially when they become free agents. How does that fact relate to monopsony power?
Union Models
Our assumption thus far has been that workers compete with one another in selling their labor services. In some labor markets, however, workers unionize and sell their labor services collectively. In the United States, about 12 percent of wage and salary workers belong to unions. (As shown in Global Snapshot 10.1, this percentage is low relative to some other nations.)
Union efforts to raise wage rates are mainly concentrated on the supply side of the labor market.
GLOBAL SNAPSHOT 10.1: Union Membership Compared with most other industrialized nations, the percentage of wage and salary earners belonging to unions in the United States is small.
Source: Jelle Visser, “Union Membership in 24 Countries,” Monthly Labor Review, January 2006, 38–49. Data are for 2003.
Exclusive or Craft Union Model Unions can boost wage rates by reducing the supply of labor, and over the years organized labor has favored policies to do just that. For example, labor unions have supported legislation that has (1) restricted permanent immigration, (2) reduced child labor, (3) encouraged compulsory retirement, and (4) enforced a shorter workweek.
Moreover, certain types of workers have adopted techniques designed to restrict the number of workers who can join their union. This is especially true of craft unions, whose members possess a particular skill, such as
carpenters or brick masons or plumbers. Craft unions have frequently forced employers to agree to hire only union members, thereby gaining virtually complete control of the labor supply. Then, by following restrictive membership policies—for example, long apprenticeships, very high initiation fees, and limits on the number of new members admitted— they have artificially restricted labor supply. As indicated in Figure 10.4, such practices result in higher wage rates and constitute what is called exclusive unionism. By excluding workers from unions and therefore from the labor supply, craft unions succeed in elevating wage rates.
exclusive unionism
The union practice of restricting the supply of skilled union labor to increase the wage rate received by union members. FIGURE 10.4: Exclusive or craft unionism.
By reducing the supply of labor (say, from S1 to S2) through the use
of restrictive membership policies, exclusive unions achieve higher wage rates (Wc to Wu). However, restriction of the labor supply also
reduces the number of workers employed (Qc to Qu).
This craft union model is also applicable to many professional organizations, such as the American Medical Association, the National Education Association, the American Bar Association, and hundreds of others. Such groups seek to limit competition for their services from less- qualified labor suppliers. One way to accomplish that is through occupational licensing. Here, a group of workers in a given occupation pressure Federal, state, or municipal government to pass a law that says that some occupational group (for example, barbers, physicians, lawyers, plumbers, cosmetologists, egg graders, pest controllers) can practice their trade only if they meet certain requirements. Those requirements might include level of education, amount of work experience, and the passing of an examination. Members of the licensed occupation typically dominate the licensing board that administers such laws. The result is self- regulation, which can lead to policies that restrict entry to the occupation and reduce labor supply.
occupational licensing
Government laws that require a worker to satisfy certain specified requirements and obtain a license from a licensing board before engaging in a particular occupation.
The expressed purpose of licensing is to protect consumers from incompetent practitioners—surely a worthy goal. But such licensing, if abused, simply results in above-competitive wages and earnings for those in the licensed occupation (Figure 10.4). Moreover, licensing requirements often include a residency requirement, which inhibits the interstate movement of qualified workers. Some 600 occupations are now licensed in the United States.
Inclusive or Industrial Union Model
Instead of trying to limit their membership, however, most unions seek to organize all available workers. This is especially true of the industrial unions, such as those of the automobile workers and steelworkers. Such unions seek as members all available unskilled, semiskilled, and skilled workers in an industry. A union can afford to be exclusive when its members are skilled craftspersons for whom there are few substitutes. But for a union composed of unskilled and semiskilled workers, a policy of limited membership would make available to the employers numerous nonunion workers who are highly substitutable for the union workers.
An industrial union that includes virtually all available workers in its membership can put firms under great pressure to agree to its wage demands. Because of its legal right to strike, such a union can threaten to deprive firms of their entire labor supply. And an actual strike can do just that.
We illustrate such inclusive unionism in Figure 10.5. Initially, the competitive equilibrium wage rate is Wc and the level of employment is
Qc. Now suppose an industrial union is formed that demands a higher,
above-equilibrium wage rate of, say, Wu. That wage rate Wu would create
a perfectly elastic labor supply over the range ae in Figure 10.5. If firms wanted to hire any workers in this range, they would have to pay the union-imposed wage rate. If they decide against meeting this wage demand, the union will supply no labor at all, and the firms will be faced with a strike. If firms decide it is better to pay the higher wage rate than to suffer a strike, they will cut back on employment from Qc to Qu.
inclusive unionism
The union practice of including as members all workers employed in an industry. FIGURE 10.5: Inclusive or industrial unionism.
By organizing virtually all available workers in order to control the supply of labor, inclusive industrial unions may impose a wage rate, such as Wu, that is above the competitive wage rate Wc. In effect, this
changes the labor supply curve from S to aeS. At wage rate Wu,
employers will cut employment from Qc to Qu.
By agreeing to the union's Wu wage demand, individual employers
become wage takers at the union wage rate Wu. Because labor supply is
perfectly elastic over range ae, the marginal resource (labor) cost is equal to the union wage rate Wu over this range. The Qu level of employment is
the result of employers' equating this MRC (now equal to the union wage rate) with MRP, according to our profitmaximizing rule.
Note from point e on labor supply curve S that Qe workers desire
employment at wage Wu. But as indicated by point b on labor demand
curve D, only Qu workers are employed. The result is a surplus of labor
of Qe − Qu (also shown by distance eb). In a purely competitive labor
market without the union, the effect of a surplus of unemployed workers would be lower wages. Specifically, the wage rate would fall to the equilibrium level Wc, where the quantity of labor supplied equals the
quantity of labor demanded (each, Qc). But this drop in wages does not
happen because workers are acting collectively through their union. Individual workers cannot offer to work for less than Wu; nor can
employers pay less than that.
Wage Increases and Unemployment Evidence suggests that union members on average achieve a 15-percent wage advantage over nonunion workers. But when unions are successful in raising wages, their efforts also have another major effect. As Figures 10.4 and 10.5 suggest, the wage-raising actions achieved by both exclusive and inclusive unionism reduce employment in unionized firms. Simply put, a union's success in achieving aboveequilibrium wage rates thus tends to be accompanied by a decline in the number of workers employed. That result acts as a restraining influence on union wage demands. A union cannot expect to maintain solidarity within its ranks if it seeks a wage rate so high that joblessness will result for, say, 20 percent or 30 percent of its members.
Wage Differentials Hourly wage rates and annual salaries differ greatly among occupations. In Table 10.4 we list average annual salaries for a number of occupations to illustrate such wage differentials. For example, observe that aircraft pilots on average earn six times as much as retail salespersons. Not shown, there are also large wage differentials within some of the occupations listed. For
example, some highly experienced pilots earn several times as much income as pilots just starting their careers. And, although average wages for retail salespersons are relatively low, some top salespersons selling on commission make several times the average wages listed for their occupation.
wage differentials
The differences between the wage received by one worker or group of workers and that received by another worker or group of workers.
TABLE 10.4: Average Annual Wages in Selected Occupations, 2007
What explains wage differentials such as these? Once again, the forces of demand and supply are highly revealing. As we demonstrate in Figure 10.6,
wage differentials can arise on either the supply or the demand side of labor markets. Panels (a) and (b) in Figure 10.6 represent labor markets for two occupational groups that have identical labor supply curves. Labor market (a) has a relatively high equilibrium wage (Wa) because labor demand is
very strong. In labor market (b) the equilibrium wage is relatively low (Wb) because labor demand is weak. Clearly, the wage differential between
occupations (a) and (b) results solely from differences in the magnitude of labor demand. FIGURE 10.6: Labor demand, labor supply, and wage differentials.
The wage differential between labor markets (a) and (b) results solely from differences in labor demand. In labor markets (c) and (d), differences in labor supply are the sole cause of the wage differential.
Contrast that situation with panels (c) and (d) in Figure 10.6, where the labor demand curves are identical. In labor market (c) the equilibrium wage is relatively high (Wc) because labor supply is highly restricted. In labor
market (d) labor supply is highly abundant, so the equilibrium wage (Wd) is
relatively low. The wage differential between (c) and (d) results solely from the differences in the magnitude of labor supply.
Although Figure 10.6 provides a good starting point for understanding wage differentials, we need to know why demand and supply conditions differ in various labor markets. There are several reasons.
Marginal Revenue Productivity The strength of labor demand—how far rightward the labor demand curve is located—differs greatly among occupations due to differences in how much various occupational groups contribute to the revenue of their respective employers. This revenue contribution, in turn, depends on the workers' productivity and the strength of the demand for the products they are helping to produce. Where labor is highly productive and product demand is strong, labor demand also is strong and, other things equal, pay is high. Top professional athletes, for example, are highly productive at producing sports entertainment, for which millions of people are willing to pay billions of dollars over the course of a season. So the marginal revenue productivity of these top players is exceptionally high, as are their salaries (as represented in Figure 10.6a). In contrast, in most occupations workers generate much more modest revenue for their employers, so their pay is lower (as in Figure 10.6b).
Noncompeting Groups
On the supply side of the labor market, workers are not homogeneous; they differ in their mental and physical capacities and in their education and training. At any given time the labor force is made up of many noncompeting groups of workers, each representing several occupations for which the members of that particular group qualify. In some groups qualified workers are relatively few, whereas in others they are plentiful. And workers in one group do not qualify for the occupations of other groups.
Ability Only a few workers have the ability or physical attributes to be brain surgeons, concert violinists, top fashion models, research chemists, or professional athletes. Because the supply of these particular types of labor is very small in relation to labor demand, their wages are high (as in Figure 10.6c). The members of these and similar groups do not compete with one another or with other skilled or semiskilled workers. The violinist does not compete with the surgeon, nor does the surgeon compete with the violinist or the fashion model.
Education and Training Another source of wage differentials is differing amounts of human capital, which is the personal stock of knowledge, know-how, and skills that enables a person to be productive and thus to earn income. Such stocks result from investments in human capital. Like expenditures on machinery and equipment, productivity-enhancing expenditures on education or training are investments. In both cases, people incur present costs with the intention that those expenditures will lead to a greater flow of future earnings.
human capital
The personal stock of knowledge, know-how, and skills that enables a person to be productive and thus to earn income.
ORIGIN OF THE IDEA
O 10.3
Human capital
Figure 10.7 indicates that workers who have made greater investments in education achieve higher incomes during their careers. The reason is twofold: (1) There are fewer such workers, so their supply is limited relative to less-educated workers, and (2) more educated workers tend to be more productive and thus in greater demand. Figure 10.7 also indicates that the incomes of better-educated workers generally rise more rapidly than those of poorly educated workers. The primary reason is that employers provide more on-the-job training to the bettereducated workers, boosting their marginal revenue productivity and therefore their earnings. FIGURE 10.7: Education levels and average annual income.
Annual income by age is higher for workers with more education. Investment in education yields a return in the form of earnings differences enjoyed over one's work life.
Source: U.S. Bureau of the Census, www.census.gov. Data are for 2006 and include both men and women.
Although education yields higher incomes, it carries substantial costs. A
college education involves not only direct costs (tuition, fees, books) but indirect or opportunity costs (forgone earnings) as well. Does the higher pay received by better-educated workers compensate for these costs? The answer is yes. Rates of return are estimated to be 10 to 13 percent for investments in secondary education and 8 to 12 percent for investments in college education. One generally accepted estimate is that each year of schooling raises a worker's wage by about 8 percent. Currently, college graduates on average earn about $1.70 for each $1 earned by high school graduates.
ILLUSTRATING THE IDEA: My Entire Life For some people, high earnings have little to do with actual hours of work and much to do with their tremendous skill, which reflects their accumulated stock of human capital. The point is demonstrated in the following story: It is said that a tourist once spotted the famous Spanish artist Pablo Picasso (1881–1973) in a Paris café. The tourist asked Picasso if he would do a sketch of his wife for pay. Picasso sketched the wife in a matter of minutes and said, “That will be 10,000 francs [roughly $2000].” Hearing the high price, the tourist became irritated, saying, “But that took you only a few minutes.”
“No,” replied Picasso, “it took me my entire life!”
Question:
In general, how do the skill requirements of the highest-paying occupations in Table 10.4 compare with the skill requirements of the lowest-paying occupations?
Compensating Differences If the workers in a particular noncompeting group are equally capable of performing several different jobs, you might expect the wage rates to be identical for all these jobs. Not so. A group of high school graduates may
be equally capable of becoming sales-clerks or general construction workers, but these jobs pay different wages. In virtually all locales, construction laborers receive much higher wages than salesclerks. These wage differentials are called compensating differences because they must be paid to compensate for nonmonetary differences in various jobs.
compensating differences
Wage differentials received by workers to compensate them for nonmonetary disparities in their jobs.
The construction job involves dirty hands, a sore back, the hazard of accidents, and irregular employment, both seasonally and cyclically. The retail sales job means clean clothing, pleasant air-conditioned surroundings, and little fear of injury or layoff. Other things equal, it is easy to see why workers would rather pick up a credit card than a shovel. So the amount of labor that is supplied to construction firms (as in Figure 10.6c) is smaller than that which is supplied to retail shops (as in Figure 10.6d). Construction firms must pay higher wages than retailers to compensate for the unattractive nonmonetary aspects of construction jobs.
Compensating differences play an important role in allocating society's scarce labor resources. If very few workers want to be garbage collectors, then society must pay high wages to garbage collectors to get the garbage collected. If many more people want to be salesclerks, then society need not pay them as much as it pays garbage collectors to get those services performed.
APPLYING THE ANALYSIS: The Minimum Wage Since the passage of the Fair Labor Standards Act in 1938, the United States has had a Federal minimum wage. That wage has ranged between 35 and 50 percent of the average wage paid to manufacturing workers and was $5.85 per hour in 2007 and is scheduled to rise to $6.55 in July 2008 and $7.25 in July 2009. Numerous states, however, have minimum
wages considerably above the Federal mandate. The purpose of minimum wages is to provide a “wage floor” that will help less-skilled workers earn enough income to escape poverty.
Critics, reasoning in terms of Figure 10.5, contend that an above- equilibrium minimum wage (say, Wu) will simply cause employers to
hire fewer workers. Downsloping labor demand curves are a reality. The higher labor costs may even force some firms out of business. In either case, some of the poor, low-wage workers whom the minimum wage was designed to help will find themselves out of work. Critics point out that a worker who is unemployed and desperate to find a job at a minimum wage of $6.55 per hour is clearly worse off than he or she would be if employed at a market wage rate of, say, $6.10 per hour.
A second criticism of the minimum wage is that it is “poorly targeted” to reduce household poverty. Critics point out that much of the benefit of the minimum wage accrues to workers, including many teenagers, who do not live in impoverished households.
Advocates of the minimum wage say that critics analyze its impact in an unrealistic context, specifically a competitive labor market (Figure 10.2). But in a less-competitive, low-pay labor market where employers possess some monopsony power (Figure 10.3), the minimum wage can increase wage rates without causing significant unemployment. Indeed, a higher minimum wage may even produce more jobs by eliminating the motive that monopsonistic firms have for restricting employment. For example, a minimum-wage floor of Wc in Figure 10.3 would change the firm's
labor supply curve to WcaS and prompt the firm to increase its
employment from Qm workers to Qc workers.
Moreover, even if the labor market is competitive, the higher wage rate might prompt firms to find more productive tasks for low-paid workers, thereby raising their productivity. Alternatively, the minimum wage may reduce labor turnover (the rate at which workers voluntarily quit). With fewer low-productive trainees, the average productivity of the firm's
workers would rise. In either case, the alleged negative employment effects of the minimum wage might not occur.
Which view is correct? Unfortunately, there is no clear answer. All economists agree that firms will not hire workers who cost more per hour than the value of their hourly output. So there is some minimum wage so high that it would severely reduce employment. Consider $20 an hour, as an absurd example. Economists generally think a 10 percent increase in the minimum wage will reduce employment of unskilled workers by about 1 to 3 percent. But no current consensus exists on the employment effect of the present level of the minimum wage.
The overall effect of the minimum wage is thus uncertain. There seems to be a consensus emerging that, on the one hand, the employment and unemployment effects of the minimum wage are not as great as many critics fear. On the other hand, because a large part of its effect is dissipated on nonpoverty families, the minimum wage is not as strong an antipoverty tool as many supporters contend.
Voting patterns and surveys make it clear, however, that the minimum wage has strong political support. Perhaps this stems from two realities: (1) More workers are believed to be helped than hurt by the minimum wage, and (2) the minimum wage gives society some assurance that employers are not “taking undue advantage” of vulnerable, low-skilled workers.
Question: Have you ever worked for the minimum wage? If so, for how long? Would you favor increasing the minimum wage by $1? By $2? By $5? Explain your reasoning.
Summary 1. The demand for labor is derived from the product it helps produce. That means the demand for labor will depend on its productivity and on the market value (price) of the good it is producing.
2. Because the firm equates the wage rate and MRP in determining
its profit-maximizing level of employment, the marginal revenue product curve is the firm's labor demand curve. Thus, each point on the MRP curve indicates how many labor units the firm will hire at a specific wage rate.
3. The competitive firm's labor demand curve slopes downward because of the law of diminishing returns. Summing horizontally the demand curves of all the firms hiring that resource produces the market demand curve for labor.
4. The demand curve for labor will shift as the result of (a) a change in the demand for, and therefore the price of, the product the labor is producing; (b) changes in the productivity of labor; and (c) changes in the prices of substitutable and complementary resources.
5. The elasticity of demand for labor measures the responsiveness of labor quantity to a change in the wage rate. The coefficient of the elasticity of labor demand is
When Ew is greater than 1, labor demand is elastic; when Ew is less than
1, labor demand is inelastic; and when Ew equals 1, labor demand is
unit-elastic.
6. The elasticity of labor demand will be greater (a) the greater the ease of substituting other resources for labor, (b) the greater the elasticity of demand for the product, and (c) the larger the proportion of total production costs attributable to labor.
7. Specific wage rates depend on the structure of the particular labor market. In a competitive labor market the equilibrium wage rate and level of employment are determined at the intersection of the labor supply curve and labor demand curve. For the individual firm, the market wage rate establishes a horizontal labor supply curve, meaning
that the wage rate equals the firm's constant marginal resource cost. The firm hires workers to the point where its MRP equals its MRC.
8. Under monopsony, the marginal resource cost curve lies above the resource supply curve because the monopsonist must bid up the wage rate to hire extra workers and must pay that higher wage rate to all workers. The monopsonist hires fewer workers than are hired under competitive conditions, pays less-than-competitive wage rates (has lower labor costs), and thus obtains greater profit.
9. A union may raise competitive wage rates by (a) restricting the supply of labor through exclusive unionism or (b) directly enforcing an above-equilibrium wage rate through inclusive unionism. On average, unionized workers realize wage rates 15 percent higher than those of comparable nonunion workers.
10. Wage differentials are largely explainable in terms of (a) marginal revenue productivity of various groups of workers; (b) noncompeting groups arising from differences in the capacities and education of different groups of workers; and (c) compensating wage differences, that is, wage differences that must be paid to offset nonmonetary differences in jobs.
11. Economists disagree about the desirability of the minimum wage. While it raises the income of some workers, it reduces the income of other workers whose skills are not sufficient to justify being paid the mandated wage.
Terms and Concepts purely competitive labor market derived demand marginal revenue product (MRP) marginal resource cost (MRC) MRP = MRC rule substitution effect output effect
elasticity of labor demand monopsony exclusive unionism occupational licensing inclusive unionism wage differentials human capital compensating differences
Study Questions 1. Explain the meaning and significance of the fact that the demand for labor is a derived demand. Why do labor demand curves slope downward? LO1
2. On the following page, complete the labor demand table for a firm that is hiring labor competitively and selling its product in a purely competitive market. LO1
a. How many workers will the firm hire if the market wage rate is $11.95? $19.95? Explain why the firm will not hire a larger or smaller number of units of labor at each of these wage rates.
b. Show in schedule form and graphically the labor demand curve of this firm.
3. Suppose that marginal product tripled while product price fell by one-half in the table in Figure 10.1. What would be the new MRP values in the table? What would be the net impact on the location of the labor demand curve in Figure 10.1? LO2
4. In 2002 Boeing reduced employment by 33,000 workers due to reduced demand for aircraft. What does this decision reveal about how it viewed its marginal revenue product (MRP) and marginal resource cost (MRC)? Why didn't Boeing reduce employment by more than 33,000 workers? By less than 33,000 workers? LO2
5. How will each of the following affect the demand for resource A, which is being used to produce commodity Z? Where there is any uncertainty as to the outcome, specify the causes of that uncertainty. LO2
a. An increase in the demand for product Z.
b. An increase in the price of substitute resource B.
c. A technological improvement in the capital equipment with which resource A is combined.
d. A fall in the price of complementary resource C.
e. A decline in the elasticity of demand for product Z due to a
decline in the competitiveness of product market Z.
6. What effect would each of the following factors have on elasticity of demand for resource A, which is used to produce product Z? LO3
a. There is an increase in the number of resources substitutable for A in producing Z.
b. Due to technological change, much less of resource A is used relative to resources B and C in the production process.
c. The elasticity of demand for product Z greatly increases.
7. Florida citrus growers say that the recent crackdown on illegal immigration is increasing the market wage rates necessary to get their oranges picked. Some are turning to $100,000 to $300,000 mechanical harvesting machines known as “trunk, shake, and catch” pickers, which vigorously shake oranges from the trees. If widely adopted, how will this substitution affect the demand for human orange pickers? What does that imply about the relative strengths of the substitution and output effects? LO2
8. Why is a firm in a purely competitive labor market a wage taker? What would happen if it decided to pay less than the going market wage rate? LO4
9. Complete the following labor supply table for a firm hiring labor competitively: LO4
a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Explain the relationship of these curves to one another.
b. Plot the labor demand data of question 2 on the graph used in part a above. What are the equilibrium wage rate and level of employment? Explain.
10. Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage rate by $3 to attract each successive worker. Draw the firm's labor supply and marginal resource cost curves and explain their relationships to one another. On the same graph, plot the labor demand data of question 2. What are the equilibrium wage rate and level of employment? Why do these differ from your answer to question 9? LO4
11. Contrast the methods used by inclusive unions and exclusive unions to raise union wage rates. LO5
12. What is meant by the terms “investment in human capital” and “compensating wage differences”? Use these concepts to explain wage differentials. LO6
13. Why might an increase in the minimum wage in the United States simply send some jobs abroad? Relate your answer to elasticity of labor demand. LO3
FURTHER TEST YOUR KNOWLEDGE AT www.mcconnellbriefmicro1e.com
Web-Based Questions At the text's Online Learning Center, www.mcconnellbriefmicro1e.com, you will find a multiple-choice quiz on this chapter's content. We encourage you to take the quiz to see how you do. Also, you will find one or more Web-based questions that require information from the Internet to answer.
1 Note that we plot the points in Figure 10.1 halfway between succeeding numbers of labor units. For example, we plot the MRP of the second unit ($12) not at 1 or 2 but at 1½. This “smoothing” enables us to sketch a continuously downsloping curve rather than one that moves downward in discrete steps as each new unit of labor is hired.
(McConnell 217)
McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill Learning Solutions, 2010. <vbk:007-7376986#outline(14)>.
11: Income Inequality and Poverty IN THIS CHAPTER YOU WILL LEARN:
1 How income inequality in the United States is measured and described.
2 The extent and sources of income inequality.
3 How income inequality has changed since 1970.
4 The economic arguments for and against income inequality.
5 How poverty is measured and its incidence by age, gender, ethnicity, and other characteristics.
6 The major components of the income-maintenance program in the United States.
Evidence that suggests wide income disparity in the United States is easy to find. In 2007 talk-show host Oprah Winfrey earned an estimated $260 million, golfer Tiger Woods earned $100 million, and rapper and music executive Jay-Z earned $83 million. In contrast, the salary of the president of the United States is $400,000, and the typical schoolteacher earns $47,000. A full-time minimum-wage worker at a fast-food restaurant makes about $11,000. Cash welfare payments to a mother with two children average $5000.
In 2006 about 36.5 million Americans—or 12.3 percent of the population— lived in poverty. An estimated 500,000 people were homeless in that year. The richest fifth of American households received about 50.5 percent of total income, while the poorest fifth received less than 4 percent.
What are the sources of income inequality? Is income inequality rising or falling? Is the United States making progress against poverty? What are the major income-maintenance programs in the United States? Is the current welfare system effective? These are some of the questions we will answer in this chapter.
Facts about Income Inequality Average household income in the United States is among the highest in the world; in 2006, it was $66,570 per household (one or more persons occupying a housing unit). But that average tells us nothing about income inequality. To learn about that, we must examine how income is distributed around the average.
Distribution by Income Category One way to measure income inequality is to look at the percentages of households in a series of income categories. Table 11.1 shows that about 25.2 percent of all households had annual before-tax incomes of less than $25,000 in 2006, while another 19.1 percent had annual incomes of $100,000 or more. The data in the table suggest a wide dispersion of household income in the United States.
income inequality
The unequal distribution of an economy's total income among households or families.
TABLE 11.1: The Distribution of U.S. Income by Households, 2006
Distribution by Quintiles (Fifths) A second way to measure income inequality is to divide the total number of individuals, households, or families (two or more persons related by birth, marriage or adoption) into five numerically equal groups, or quintiles, and examine the percentage of total personal (before-tax) income received by each quintile. We do this for households in the table in Figure 11.1, where we also provide the upper income limit for each quintile. Any amount of income greater than that listed in each row of column 3 would place a household into the next-higher quintile. FIGURE 11.1: The Lorenz curve and Gini ratio.
The Lorenz curve is a convenient way to show the degree of income inequality (here, household income by quintile in 2006). The area between the diagonal (the line of perfect equality) and the Lorenz curve represents the degree of inequality in the distribution of total income. This inequality is measured numerically by the Gini ratio— area A (shown in gold) divided by area A + B (the gold + gray area). The Gini ratio for the distribution shown is 0.470.
Source: Bureau of the Census, www.census.gov.
The Lorenz Curve and Gini Ratio
We can display the quintile distribution of personal income through a Lorenz curve. In Figure 11.1, we plot the cumulative percentage of households on the horizontal axis and the cumulative percentage of income they obtain on the vertical axis. The diagonal line 0 e represents a perfectly equal distribution of income because each point along that line indicates that a particular percentage of households receive the same percentage of income. In other words, points representing 20 percent of all households receiving 20 percent of total income, 40 percent receiving 40 percent, 60 percent receiving 60 percent, and so on, all lie on the diagonal line.
Lorenz curve
A curve that shows an economy's distribution of income by measuring the cumulated percentage of income receivers along the horizontal axis and the cumulated percentage of income they receive along the vertical axis.
WORKED PROBLEMS
W 11.1
Lorenz curve
By plotting the quintile data from the table in Figure 11.1, we obtain the Lorenz curve for 2006. Observe from point a that the bottom 20 percent of all households received 3.4 percent of the income; the bottom 40 percent received 12 percent (= 3.4 + 8.6), as shown by point b; and so forth. The gold area between the diagonal line and the Lorenz curve is determined by the extent that the Lorenz curve sags away from the diagonal and indicates the degree of income inequality. If the actual income distribution were perfectly equal, the Lorenz curve and the diagonal would coincide and the gold area would disappear.
At the opposite extreme is complete inequality, where all households but one have zero income. In that case, the Lorenz curve would coincide with
the horizontal axis from 0 to point f (at 0 percent of income) and then would move immediately up from f to point e along the vertical axis (indicating that a single household has 100 percent of the total income). The entire area below the diagonal line (triangle 0ef) would indicate this extreme degree of inequality. So the farther the Lorenz curve sags away from the diagonal, the greater is the degree of income inequality.
We can easily transform the visual measurement of income inequality described by the Lorenz curve into the Gini ratio—a numerical measure of the overall dispersion of income:
Gini ratio
A numerical measure of the overall dispersion of income among an economy's income receivers.
For the distribution of household income shown in Figure 11.1, the Gini ratio is 0.470. As the area between the Lorenz curve and the diagonal gets larger, the Gini ratio rises to reflect greater inequality. (Test your understanding of this idea by confirming that the Gini ratio for complete income equality is zero and for complete inequality is 1.)
Because Gini ratios are numerical, they are easier to use than Lorenz curves for comparing the income distributions of different ethnic groups and countries. For example, in 2006 the Gini ratio of U.S. household income for African Americans was 0.486; for Asians, 0.476; for whites,
0.462; and for Hispanics, 0.448.1 Gini ratios for various nations range from 0.743 (Namibia) to 0.249 (Japan). Examples within this range include Sweden, 0.250; Italy, 0.350; Mexico, 0.481; and South Africa,
0.578.2
Income Mobility: The Time Dimension The income data used so far have a major limitation: The income accounting period of 1 year is too short to be very meaningful. Because the Census Bureau data portray the distribution of income in only a single year, they may conceal a more equal distribution over a few years, a decade, or even a lifetime. If Brad earns $1000 in year 1 and $100,000 in year 2, while Jenny earns $100,000 in year 1 and only $1000 in year 2, do we have income inequality? The answer depends on the period of measurement. Annual data would reveal great income inequality, but there would be complete equality over the 2-year period.
This point is important because evidence suggests considerable “churning around” in the distribution of income over time. Such movement of individuals or households from one income quintile to another over time is called income mobility. For most income receivers, income starts at a relatively low level during youth, reaches a peak during middle age, and then declines. It follows that if all people receive exactly the same stream of income over their lifetimes, considerable income inequality would still exist in any specific year because of age differences. In any single year, the young and the old would receive low incomes while the middle-aged receive high incomes.
income mobility
The extent to which income receivers move from one part of the income distribution to another over some period of time.
If we change from a “snapshot” view of income distribution in a single year to a “time exposure” portraying incomes over much longer periods, we find considerable movement of income receivers among income classes. Between 1996 and 2005, the median income of half of the individuals in the lowest quintile of the U.S. income distribution moved to a higher income quintile. Almost 25 percent made it to the middle fifth
and 5 percent achieved the top quintile. The income mobility moved in both directions. About 57 percent of the top 1 percent of income receivers in 1996 had dropped out of that category by 2005. Overall, income mobility between 1996 and 2005 was the same as it was the previous 10 years. All this correctly suggests that income is more equally distributed
over a 5–, 10–, or 20–year period than in any single year. 3
In short, there is significant individual and household income mobility over time; for many people, “low income” and “high income” are not permanent conditions.
Effect of Government Redistribution The income data in the table in Figure 11.1 include wages, salaries, dividends, and interest. They also include all cash transfer payments such as Social Security, unemployment compensation benefits, and welfare assistance to needy households. The data are before-tax data and therefore do not take into account the effects of personal income and payroll (Social Security) taxes that are levied directly on income receivers. Nor do they include government-provided in-kind or noncash transfers, which make available specific goods or services rather than cash. Noncash transfers include such things as medical care, housing subsidies, subsidized school lunches, and food stamps. Such transfers are much like income because they enable recipients to “purchase” goods and services.
noncash transfers
Government transfer payments in the form of goods and services (or vouchers to obtain them) rather than money.
One economic function of government is to redistribute income, if society so desires. Figure 11.2 and its table reveal that government significantly redistributes income from higher- to lower-income households through taxes and transfers. Note that the U.S. distribution of household income before taxes and transfers are taken into account (dark green Lorenz curve) is substantially less equal than the distribution after taxes and
transfers (light green Lorenz curve). Without government redistribution, the lowest 20 percent of households in 2005 would have received only 1.5 percent of total income. With redistribution, they received 4.4 percent, or
three times as much.4
FIGURE 11.2: The impact of taxes and transfers on U.S. income inequality.
The distribution of income is significantly more equal after taxes and transfers are taken into account than before. Transfers account for most of the lessening of inequality and provide most of the income received by the lowest quintile of households.
Source: Bureau of the Census, www.census.gov.
Which contributes more to redistribution, government taxes or government transfers? The answer is transfers. Because the U.S. tax system is only modestly progressive, after-tax data would reveal only about 20 percent less inequality. Roughly 80 percent of the reduction in income inequality is attributable to transfer payments, which account for more than 75 percent of the income of the lowest quintile. Together with growth of job opportunities, transfer payments have been the most important means of alleviating poverty in the United States.
Causes of Income Inequality
There are several causes of income inequality in the United States. In general, the market system is permissive of a high degree of income inequality because it rewards individuals on the basis of the contributions that they, or the resources that they own, make in producing society's output.
More specifically, the factors that contribute to income inequality are the following.
Ability People have different mental, physical, and aesthetic talents. Some have inherited the exceptional mental qualities that are essential to such high- paying occupations as medicine, corporate finance, and law. Others are blessed with the physical capacity and coordination to become highly paid professional athletes. A few have the talent to become great artists or musicians or have the beauty to become top fashion models. Others have very weak mental endowments and may work in low-paying occupations or may be incapable of earning any income at all. The intelligence and skills of most people fall somewhere in between.
Education and Training Native ability alone rarely produces high income; people must develop and refine their capabilities through education and training. Individuals differ significantly in the amount of education and training they obtain and thus in their capacity to earn income. Such differences may be a matter of choice: Chin enters the labor force after graduating from high school, while Rodriguez takes a job only after earning a college degree. Other differences may be involuntary: Chin and her parents may simply be unable to finance a college education.
People also receive varying degrees of on-the-job training, which also contributes to income inequality. Some workers learn valuable new skills each year on the job and therefore experience significant income growth
over time; others receive little or no on-the-job training and earn no more at age 50 than they did at age 30. Moreover, firms tend to select for advanced on-the-job training the workers who have the most formal education. That added training magnifies the education-based income differences between less-educated and better-educated individuals.
Discrimination Discrimination in education, hiring, training, and promotion undoubtedly causes some income inequality. If discrimination confines certain racial, ethnic, or gender groups to lower-pay occupations, the supply of labor in those occupations will increase relative to demand and hourly wages and income in those lower-paying jobs will decline. Conversely, labor supply will be artificially reduced in the higherpay occupations populated by “preferred” workers, raising their wage rates and income. In this way, discrimination can add to income inequality. In fact, economists cannot account for all racial, ethnic, and gender differences in work earnings on the basis of differences in years of education, quality of education, occupations, and annual hours of work. Many economists attribute the unexplained residual to discrimination.
Economists, however, do not see discrimination by race, gender, and ethnicity as a dominant factor explaining income inequality. The income distributions within racial or ethnic groups that historically have been targets of discrimination—for example, African Americans—are similar to the income distribution for whites. Other factors besides discrimination are obviously at work. Nevertheless, discrimination is an important concern since it harms individuals and reduces society's overall output and income.
Preferences and Risks Incomes also differ because of differences in preferences for market work relative to leisure, market work relative to work in the household, and types of occupations. People who choose to stay home with children, work part-time, or retire early usually have less income than those who make
the opposite choices. Those who are willing to take arduous, unpleasant jobs (for example, underground mining or heavy construction), to work long hours with great intensity, or to “moonlight” will tend to earn more.
Individuals also differ in their willingness to assume risk. We refer here not only to the race-car driver or the professional boxer but also to the entrepreneur. Although many entrepreneurs fail, many of those who develop successful new products or services realize very substantial incomes. That contributes to income inequality.
Unequal Distribution of Wealth Income is a flow; it represents a stream of wage and salary earnings, along with rent, interest, and profits, as depicted in Chapter 2's circular flow diagram. In contrast, wealth is a stock, reflecting at a particular moment the financial and real assets an individual has accumulated over time. A retired person may have very little income and yet own a home, mutual fund shares, and a pension plan that add up to considerable wealth. A new college graduate may be earning a substantial income as an accountant, middle manager, or engineer but have yet to accumulate significant wealth.
The ownership of wealth in the United States is more unequal than the distribution of income. According to the most recent (2004) Federal Reserve wealth data, the wealthiest 10 percent of families owned 70 percent of the total wealth and the top 1 percent owned 33 percent. The bottom 90 percent held only 30 percent of the total wealth. This wealth inequality leads to inequality in rent, interest, and dividends, which in turn contributes to income inequality. Those who own more machinery, real estate, farmland, stocks and bonds, and savings accounts obviously receive greater income from that ownership than people with less or no such wealth.
Market Power The ability to “rig the market” on one's own behalf also contributes to
income inequality. For example, in resource markets, certain unions and professional groups have adopted policies that limit the supply of their services, thereby boosting the incomes of those “on the inside.” Also, legislation that requires occupational licensing for, say, doctors, dentists, and lawyers can bestow market power that favors the licensed groups. In product markets, “rigging the market” means gaining or enhancing monopoly power, which results in greater profit and thus greater income to the firms' owners.
Luck, Connections, and Misfortune Other forces also play a role in producing income inequality. Luck and “being in the right place at the right time” have helped individuals stumble into fortunes. Discovering oil on a ranch, owning land along a major freeway interchange, and hiring the right press agent have accounted for some high incomes. Personal contacts and political connections are other potential routes to attaining high income.
In contrast, economic misfortunes such as prolonged illness, serious accident, death of the family breadwinner, or unemployment may plunge a family into the low range of income. The burden of such misfortune is borne very unevenly by the population and thus contributes to income inequality.
Income inequality of the magnitude we have described is not exclusively an American phenomenon. Global Snapshot 11.1 compares income inequality in the United States (here by individuals, not by households) with that in several other nations. Income inequality tends to be greatest in South American nations, where land and capital resources are highly concentrated in the hands of very wealthy families.
GLOBAL SNAPSHOT 11.1:
Percentage of Total Income Received by Top One-Tenth of Income Receivers, Selected Nations The share of income going to the highest 10 percent of income receivers varies among nations.
Source: United Nations, Human Development Report, 2007/2008, pp. 281–284, hdr.undp.org.
Income Inequality over Time Over a period of years, economic growth has raised incomes in the United States: In absolute dollar amounts, the entire distribution of income has been moving upward. But incomes may move up in absolute terms while leaving the relative distribution of income less equal, more equal, or unchanged. Table 11.2 shows how the distribution of household income has changed since 1970. This income is “before tax” and includes cash transfers but not noncash transfers.
TABLE 11.2: Percentage of Total Before-Tax Income Received by Each One-Fifth and by the Top 5 percent of Households, Selected Years *
Rising Income Inequality since 1970 It is clear from Table 11.2 that the distribution of income by quintiles has become more unequal since 1970. In 2006 the lowest 20 percent of households received 3.4 percent of total before-tax income, compared with 4.1 in 1970. Meanwhile, the income share received by the highest 20 percent rose from 43.3 in 1970 to 50.5 percent in 2006. Also, the percentage of income received by the top 5 percent of households rose
significantly over the 1970–2006 period.
Causes of Growing Inequality Economists suggest several major explanations for the growing U.S. income inequality of the past several decades.
Greater Demand for Highly Skilled Workers Perhaps the most significant contributor to the growing income inequality has been an increasing demand by many firms for workers who are highly skilled and well educated. Moreover, several industries requiring highly skilled workers have either recently emerged or expanded greatly, such as the computer software, business consulting, biotechnology, health care, and Internet industries. Because highly skilled workers remain relatively scarce, their wages have been bid up. Consequently, the wage differences between them and less-skilled workers have increased. In fact, between 1980 and 2005, the wage difference between college graduates and high school graduates rose from 28 percent to 47 percent for women and from 22 percent to 43 percent for men.
The rising demand for skill also has shown up in rapidly rising pay for chief executive officers (CEOs), sizable increases in income from stock options, substantial increases in income for professional athletes and entertainers, and huge fortunes for successful entrepreneurs. This growth of “superstar” pay also has contributed to rising income inequality.
Demographic Changes The entrance of large numbers of less-experienced and less-skilled “baby boomers” into the labor force during the 1970s and 1980s may have contributed to greater income inequality in those two decades. Because younger workers tend to earn less income than older workers, their growing numbers contributed to income inequality. There also has been a growing tendency for men and women with high earnings potential to
marry each other, thus increasing family income among the highest income quintiles. Finally, the number of households headed by single or divorced women has increased greatly. That trend has increased income inequality because such households lack a second major wage earner and also because the poverty rate for female-headed households is very high.
International Trade, Immigration, and Decline in Unionism Other factors are probably at work as well. Stronger international competition from imports has reduced the demand for and employment of less-skilled (but highly paid) workers in such industries as the automobile and steel industries. The decline in such jobs has reduced the average wage for less-skilled workers. It also has swelled the ranks of workers in already low-paying industries, placing further downward pressure on wages there.
Similarly, the transfer of jobs to lower-wage workers in developing countries has exerted downward wage pressure on less-skilled workers in the United States. Also, an upsurge in immigration of unskilled workers has increased the number of low-income households in the United States. Finally, the decline in unionism in the United States has undoubtedly contributed to wage inequality since unions tend to equalize pay within firms and industries.
Two cautions: First, when we note growing income inequality, we are not saying that the “rich are getting richer and the poor are getting poorer” in terms of absolute income. Both the rich and the poor are experiencing rises in real income. Rather, what has happened is that, while incomes have risen in all quintiles, income growth has been fastest in the top quintile. Second, increased income inequality is not solely a U.S. phenomenon. The recent rise of inequality also has occurred in several other industrially advanced nations.
The Lorenz curve can be used to contrast the distribution of income at different points in time. If we plotted Table 11.2 's data as Lorenz
curves, we would find that the curve shifted away from the diagonal between 1970 and 2006. The Gini ratio rose from 0.394 in 1970 to 0.470 in 2006.
APPLYING THE ANALYSIS: Laughing at Shrek Some economists say that the distribution of annual consumption is more meaningful for examining inequality of well-being than is the distribution of annual income. In a given year, people's consumption of goods and services may be above or below their income because they can save, draw down past savings, use credit cards, take out home mortgages, spend from inheritances, give money to charities, and so on. A recent study of the distribution of consumption finds that annual consumption inequality is less than income inequality. Moreover, consumption inequality has remained relatively constant over several decades, even though income inequality has increased.*
The Economist magazine extends the argument even further, pointing out that despite the recent increase in income inequality, the products consumed by the rich and the poor are far closer in functionality today than at any other time in history:
More than 70 percent of Americans under the official poverty line own at least one car. And the distance between driving a used Hyundai Elantra and new Jaguar XJ is well nigh undetectable compared with the difference between motoring and hiking through the muck . . . A wide screen plasma television is lovely, but you do not need one to laugh at “Shrek”. . .
Those intrepid souls who make vast fortunes turning out ever higher- quality goods at ever lower prices widen the income gap while
reducing the differences that really matter.†
Economists generally agree that products and experiences once reserved exclusively for the rich in the United States have, in fact,
become more commonplace for nearly all income classes. But skeptics argue that The Economist's argument is too simplistic. Even though both are water outings, there is a fundamental difference between yachting among the Greek isles on your private yacht and paddling on a local pond in your kayak.
Question:
How do the ideas of income inequality, consumption inequality, and wealth inequality differ?
* Dirk Krueger and Fabrizio Perri, “Does Income Inequality Lead to Consumption Inequality?” Review of Economic Studies, 2006, pp. 163–193. † The Economist, “Economic Focus: The New (Improved) Gilded Age,” December 22, 2007, p. 122.
Photo Op: The Rich and the Poor in America
© Royalty-Free/CORBIS
© Richard Bickel/CORBIS
Wide disparities of income and wealth exist in the United States.
Equality versus Efficiency The main policy issue concerning income inequality is how much is necessary and justified. While there is no general agreement on the justifiable amount, we can gain insight by exploring the economic cases for and against greater equality.
The Case for Equality: Maximizing Total Utility The basic economic argument for an equal distribution of income is that income equality maximizes the total consumer satisfaction (utility) from any particular level of output and income. The rationale for this argument is shown in Figure 11.3, in which we assume that the money incomes of two individuals, Anderson and Brooks, are subject to the law of
diminishing marginal utility. In any time period, income receivers spend the first dollars received on the products they value most—products whose marginal utility (extra satisfaction) is high. As a consumer's most- pressing wants become satisfied, he or she then spends additional dollars of income on lessimportant, lower-marginal-utility goods. So marginal- utility-from-income curves slope downward, as in Figure 11.3. The identical diminishing curves (MUA and MUB) reflect the assumption that
Anderson and Brooks have the same capacity to derive utility from income. Each point on one of the curves measures the marginal utility of the last dollar of a particular level of income.
law of diminishing marginal utility
The principle that the amount of extra satisfaction (marginal utility) from consuming a product declines as more of it is consumed. FIGURE 11.3: The utility-maximizing distribution of income.
With identical marginal-utility-of-income curves MUA and MUB,
Anderson and Brooks will maximize their combined utility when any amount of income (say, $10,000) is equally distributed. If income is
unequally distributed (say, $2500 to Anderson and $7500 to Brooks), the marginal utility derived from the last dollar will be greater for Anderson than for Brooks, and a redistribution toward equality will result in a net increase in total utility. The utility gained by equalizing income at $5000 each, shown by the blue area below curve MUA in
panel (a), exceeds the utility lost, indicated by the red area below curve MUB in (b).
Now suppose that there is $10,000 worth of income (output) to be distributed between Anderson and Brooks. According to proponents of income equality, the optimal distribution is an equal distribution, which causes the marginal utility of the last dollar spent to be the same for both persons. We can confirm this by demonstrating that if the income distribution is initially unequal, then distributing income more equally can increase the combined utility of the two individuals.
Suppose that the $10,000 of income initially is distributed such that Anderson gets $2500 and Brooks $7500. The marginal utility, a, from the last dollar received by Anderson is high and the marginal utility, b, from Brooks' last dollar of income is low. If a single dollar of income is shifted from Brooks to Anderson—that is, toward greater equality—then Anderson's utility increases by a and Brooks' utility decreases by b. The combined utility then increases by a minus b (Anderson's large gain minus Brooks' small loss). The transfer of another dollar from Brooks to Anderson again increases their combined utility, this time by a slightly smaller amount. Continued transfer of dollars from Brooks to Anderson increases their combined utility until the income is evenly distributed and both receive $5000. At that time their marginal utilities from the last dollar of income are equal (at a' and b'), and any further income redistribution beyond the $2500 already transferred would begin to create inequality and decrease their combined utility.
The area under the MU curve and to the left of the individual's particular level of income represents the total utility (the sum of the marginal utilities) of that income. Therefore, as a result of the transfer of the
$2500, Anderson has gained utility represented by the blue area below curve MUA and Brooks has lost utility represented by the red area below
curve MUB. The blue area exceeds the red area, so income equality yields
greater combined total utility than does the initial income inequality.
The Case for Inequality: Incentives and Efficiency Although the logic of the argument for equality is sound, critics attack its fundamental assumption that there is some fixed amount of output produced and therefore income to be distributed. Critics of income equality argue that the way in which income is distributed is an important determinant of the amount of output or income that is produced and is available for distribution.
Suppose once again in Figure 11.3 that Anderson earns $2500 and Brooks earns $7500. In moving toward equality, society (the government) must tax away some of Brooks' income and transfer it to Anderson. This tax and transfer process diminishes the income rewards of high-income Brooks and raises the income rewards of low-income Anderson; in so doing, it reduces the incentives of both to earn high incomes. Why should high-income Brooks work hard, save and invest, or undertake entrepreneurial risks when the rewards from such activities will be reduced by taxation? And why should low-income Anderson be motivated to increase his income through market activities when the government stands ready to transfer income to him? Taxes are a reduction in the rewards from increased productive effort; redistribution through transfers is a reward for diminished effort.
In the extreme, imagine a situation in which the government levies a 100 percent tax on income and distributes the tax revenue equally to its citizenry. Why would anyone work hard? Why would anyone work at all? Why would anyone assume business risk? Or why would anyone save (forgo current consumption) in order to invest? The economic incentives to “get ahead” will have been removed, greatly reducing society's total
production and income. That is, the way income is distributed affects the size of that income. The basic argument for income inequality is that inequality is essential to maintain incentives to produce output and income —to get the output produced and income generated year after year.
The Equality-Efficiency Trade-Off At the essence of the income equality-inequality debate is a fundamental trade-off between equality and efficiency. In this equality-efficiency trade-off, greater income equality (achieved through redistribution of income) comes at the opportunity cost of reduced production and income. And greater production and income (through reduced redistribution) comes at the expense of less equality of income. The trade-off obligates society to choose how much redistribution it wants, in view of the costs. If society decides it wants to redistribute income, it needs to determine methods that minimize the adverse effects on economic efficiency.
equality-efficiency trade-off
The decrease in economic efficiency that may accompany an increase in income equality.
ILLUSTRATING THE IDEA: Slicing the Pizza The equality-efficiency trade-off might better be understood through an analogy. Assume that society's income is a huge pizza, baked year after year, with the sizes of the pieces going to people on the basis of their contribution to making it. Now suppose that for fairness reasons, society decides some people are getting pieces that are too large and others are getting pieces too small. But when society redistributes the pizza to make the sizes more equal, they discover the result is a smaller pizza than before. Why participate in making the pizza if you get a decent-size piece without contributing?
The shrinkage of the pizza represents the efficiency loss—the loss of
output and income—caused by the harmful effects of the redistribution on incentives to work, to save and invest, and to accept entrepreneurial risk. The shrinkage also reflects the resources that society must divert to the bureaucracies that administer the redistribution system.
How much pizza shrinkage will society accept while continuing to agree to the redistribution? If redistributing pizza to make it less unequal reduces the size of the pizza, what amount of pizza loss will society tolerate? Is a loss of 10 percent acceptable? 25 percent? 75 percent? This is the basic question in any debate over the ideal size of a nation's income redistribution program.
Question:
Why might “equality of opportunity” be a more realistic and efficient goal than “equality of income outcome”?
The Economics of Poverty We now turn from the broader issue of income distribution to the more specific issue of very low income, or “poverty.” A society with a high degree of income inequality can have a high, moderate, or low amount of poverty. In fact, it could have no poverty at all. We therefore need a separate examination of poverty.
Definition of Poverty Poverty is a condition in which a person or family does not have the means to satisfy basic needs for food, clothing, shelter, and transportation. The means include currently earned income, transfer payments, past savings, and property owned. The basic needs have many determinants, including family size and the health and age of its members.
The Federal government has established minimum income thresholds below which a person or a family is “in poverty.” In 2006 an unattached
individual receiving less than $9800 per year was said to be living in poverty. For a family of four, the poverty line was $20,000; for a family of six, it was $26,800. Based on these thresholds, in 2006 about 36.5 million Americans lived in poverty. In 2006 the poverty rate—the percentage of the population living in poverty—was 12.3 percent.
poverty rate
The percentage of the population with incomes below the official poverty income levels established by the Federal government.
Incidence of Poverty The poor are heterogeneous: They can be found in all parts of the nation; they are whites and nonwhites, rural and urban, young and old. But as Figure 11.4 indicates, poverty is far from randomly distributed. For example, the poverty rate for African Americans is above the national average, as is the rate for Hispanics, while the rate for whites and Asians is below the average. In 2006 the poverty rates for African Americans and Hispanics were 24.3 and 20.6 percent, respectively; the rate for whites and Asians, each was 10.3 percent. FIGURE 11.4: Poverty rates among selected population groups, 2006.
Poverty is disproportionately borne by African Americans, Hispanics, children, foreign-born residents who are not citizens, and families headed by women. People who are employed full-time or are married tend to have low poverty rates.
Source: Bureau of the Census, www.census.gov.
Figure 11.4 shows that female-headed households, foreign-born noncitizens, and children under 18 years of age have very high incidences of poverty. Marriage and fulltime, year-round work are associated with low poverty rates, and, because of the Social Security system, the incidence of poverty among the elderly is less than that for the population as a whole.
The high poverty rate for children is especially disturbing because poverty tends to breed poverty. Poor children are at greater risk for a range of long-term problems, including poor health and inadequate education, crime, drug use, and teenage pregnancy. Many of today's impoverished
children will reach adulthood unhealthy and illiterate and unable to earn above-poverty incomes.
As many as half of people in poverty are poor for only 1 or 2 years before climbing out of poverty. But poverty is much more long-lasting among some groups than among others. In particular, African-American and Hispanic families, families headed by women, persons with little education and few labor market skills, and people who are dysfunctional because of drug use, alcoholism, or mental illness are more likely than others to remain in poverty. Also, long-lasting poverty is heavily present in depressed areas of cities, parts of the Deep South, and some Indian reservations.
Poverty Trends As Figure 11.5 shows, the total poverty rate fell significantly between 1959 and 1969, stabilized at 11 to 13 percent over the next decade, and then rose in the early 1980s. In 1993 the rate was 15.1 percent, the highest since 1983. Between 1993 and 2000 the rate turned downward, falling to 11.3 percent in 2000. Because of recession and slow recovery, the rate rose to 11.7 percent in 2001, 12.1 percent in 2002, and 12.5 percent in 2003. During the second half of the 1990s, poverty rates plunged for African Americans, Hispanics, and Asians. Nevertheless, in 2006 African Americans and Hispanics still had poverty rates that were roughly double the rates for whites. FIGURE 11.5: Poverty-rate trends, 1959– 2006.
Although the national poverty rate declined sharply between 1959 and 1969, it stabilized in the 1970s only to increase significantly in the early 1980s. Between 1993 and 2000 it substantially declined, before rising slightly again in the immediate years following the 2001 recession. Although poverty rates for African Americans and Hispanics are much higher than the average, they significantly declined during the 1990s.
Source: Bureau of the Census, www.census.gov.
Measurement Issues The poverty rates and trends in Figures 11.4 and 11.5 need to be interpreted cautiously. The official income thresholds for defining poverty are necessarily arbitrary and therefore may inadequately measure the true extent of poverty in the United States.
Some observers say that the high cost of living in major metropolitan areas means that the official poverty thresholds exclude millions of families whose income is slightly above the poverty level but clearly
inadequate to meet basic needs for food, housing, and medical care. These observers use city-by-city studies on “minimal income needs” to show there is much more poverty in the United States than is officially measured and reported.
In contrast, some economists point out that using income to measure poverty understates the standard of living of many of the people who are officially poor. When individual, household, or family consumption is considered rather than family income, some of the poverty in the United States disappears. Some low-income families maintain their consumption by drawing down past savings, borrowing against future income, or selling homes. Moreover, many poverty families receive substantial noncash benefits such as food stamps and rent subsidies that boost their living standards. Such “in-kind” benefits are not included in determining a family's official poverty status.
The U.S. Income-Maintenance System Regardless of how poverty is measured, economists agree that considerable poverty exists in the United States. Helping those who have very low income is a widely accepted goal of public policy. A wide array of antipoverty programs, including education and training programs, subsidized employment, minimum-wage laws, and antidiscrimination policies, are designed to increase the earnings of the poor. In addition, there are a number of income-maintenance programs devised to reduce poverty, the most important of which are listed in Table 11.3. These programs involve large expenditures and numerous beneficiaries.
TABLE 11.3: Characteristics of Major Income- Maintenance Programs
The U.S. income-maintenance system consists of two kinds of programs: (1) social insurance and (2) public assistance or “welfare.” Both are known as entitlement programs because all eligible persons are assured (entitled to) the benefits set forth in the programs.
entitlement programs
Government programs that guarantee particular levels of transfer payments or noncash benefits to all who fit the programs' critieria.
Social Insurance Programs Social insurance programs partially replace earnings that have been lost due to retirement, disability, or temporary unemployment; they also provide health insurance for the elderly. The main social insurance programs are Social Security, unemployment compensation, and Medicare. Benefits are viewed as earned rights and do not carry the stigma of public charity. These programs are financed primarily out of Federal payroll taxes. In these programs the entire population shares the risk of an individual's losing income because of retirement, unemployment,
disability, or illness. Workers (and employers) pay a part of their wages to the government while they are working. The workers then receive benefits when they retire or face specified misfortunes.
Social Security and Medicare The major social insurance program known as Social Security replaces earnings lost when workers retire, become disabled, or die. This gigantic program ($594 billion in 2007) is financed by compulsory payroll taxes levied on both employers and employees. Workers currently may retire at age 65 and receive full retirement benefits or retire early at age 62 with reduced benefits. When a worker dies, benefits accrue to his or her family survivors. Special provisions provide benefits for disabled workers.
Social Security
A federal pension program (financed by payroll taxes on employers and employees) that replaces part of the earnings lost when workers retire, become disabled, or die.
Social Security covers over 90 percent of the workforce; some 50 million people receive Social Security benefits averaging about $1082 per month. In 2008, those benefits were financed with a combined Social Security and Medicare payroll tax of 15.3 percent, with the worker and the employer each paying 7.65 percent on the worker's first $102,000 of earnings. The 7.65 percent tax comprises 6.2 percent for Social Security and 1.45 percent for Medicare. Self-employed workers pay the full 15.3 percent.
Medicare provides hospital insurance for the elderly and disabled and is financed out of the payroll tax. This overall 2.9 percent tax is paid on all work income, not just on the first $102,000. Medicare also makes available a supplementary low-cost insurance program that helps pay doctor fees.
Medicare
A federal insurance program (financed by payroll taxes on employers and employees) that provides health insurance benefits to those 65 or older.
The number of retirees drawing Social Security and Medicare benefits is rapidly rising relative to the number of workers paying payroll taxes. As a result, Social Security and Medicare face serious long-term funding problems. These fiscal imbalances have spawned calls to reform the programs.
Unemployment Compensation All 50 states sponsor unemployment insurance programs called unemployment compensation, a Federal-state program that makes income available to unemployed workers. This insurance is financed by a relatively small payroll tax, paid by employers, that varies by state and by the size of the firm's payroll. After a short waiting period, eligible wage and salary workers who become unemployed can receive benefit payments. The size of the payments varies from state to state. Generally, benefits approximate 33 percent of a worker's wages up to a certain maximum weekly payment, and last for a maximum of 26 weeks. In 2007 benefits averaged about $277 weekly. During recessions—when unemployment soars—Congress often provides supplemental funds to the states to extend the benefits for additional weeks.
unemployment compensation
A federal-state social insurance program (financed by payroll taxes on employers) that makes income available to workers who are unemployed.
Public Assistance Programs Public assistance programs (welfare) provide benefits for those who are unable to earn income because of permanent disabilities or have no or
very low income and also have dependent children. These programs are financed out of general tax revenues and are regarded as public charity. They include “means tests,” which require that individuals and families demonstrate low incomes in order to qualify for aid. The Federal government finances about two-thirds of the welfare program expenditures, and the rest is paid for by the states.
Many needy persons who do not qualify for social insurance programs are assisted through the Federal government's Supplemental Security Income (SSI) program. The purpose of SSI is to establish a uniform, nationwide minimum income for the aged, blind, and disabled who are unable to work and who do not qualify for Social Security aid. Over half the states provide additional income supplements to the aged, blind, and disabled.
Supplemental Security Income (SSI)
A federal program (financed by general tax revenues) that provides a uniform nationwide minimum income for the aged, blind, and disabled who do not qualify for benefits under the Social Security program in the United States.
The Temporary Assistance for Needy Families (TANF) is the basic welfare program for low-income families in the United States. The program is financed through general Federal tax revenues and consists of lump-sum payments of Federal money to states to operate their own welfare and work programs. These lump-sum payments are called TANF funds, and in 2007 about 4 million people (including children) received TANF assistance. TANF expenditures in 2007 were about $14 billion.
Temporary Assistance for Needy Families (TANF)
The basic welfare program (financed through general tax revenues) for low-income families in the United States.
In 1996 TANF replaced the six-decade-old Aid for Families with Dependent Children (AFDC) program. Unlike that welfare program,
TANF established work requirements and placed limits on the length of time a family can receive welfare payments. Specifically, the TANF program
• Set a lifetime limit of 5 years on receiving TANF benefits and required able-bodied adults to work after receiving assistance for 2 years.
• Ended food-stamp eligibility for able-bodied persons age 18 to 50 (with no dependent children) who are not working or engaged in job- training programs.
• Tightened the definition of “disabled children” as it applies for eligibilty of low-income families for SSI assistance.
• Established a 5-year waiting period on public assistance for new legal immigrants who have not become citizens.
In 1996 about 12.6 million people were welfare recipients, including children, or 4.8 percent of the U.S. population. By the middle of 2007, those totals had declined to 4.5 million and 2 percent of the population. The program has greatly increased the employment rate (= employment/ population) for single mothers with children under age 6—a group particularly prone to welfare dependency. Today, that rate is about 13 percentage points higher than it was in 1996.
The food-stamp program is designed to provide all low-income Americans with a “nutritionally adequate diet.” Under the program, eligible households receive monthly allotments of coupons that are redeemable for food. The amount of food stamps received varies inversely with a family's earned income.
food-stamp program
A federal program (financed through general tax revenues) that permits eligible low-income persons to obtain vouchers that are usable to buy food.
Medicaid helps finance the medical expenses of individuals participating in the SSI and the TANF programs.
Medicaid
A federal program (financed by general tax revenues) that provides medical benefits to people covered by the Supplemental Security Income (SSI) and Temporary Assistance for Needy Families (TANF) programs.
The earned-income tax credit (EITC) is a tax credit for low-income working families, with or without children. The credit reduces the Federal income taxes that such families owe or provides them with cash payments if the credit exceeds their tax liabilities. The purpose of the credit is to offset Social Security taxes paid by low-wage earners and thus keep the Federal government from “taxing families into poverty.” In essence, EITC is a wage subsidy from the Federal government that works out to be as much as $2 per hour for the lowest-paid workers with families. Under the program, many people owe no income tax and receive direct checks from the Federal government once a year. According to the Internal Revenue Service, 22 million taxpayers received $41 billion in payments from the EITC in 2006.
earned-income tax credit (EITC)
A refundable federal tax credit provided to low-income wage earners to supplement their families' incomes and encourage work.
Several other welfare programs are not listed in Table 11.3. Most provide help in the form of noncash transfers. Head Start provides education, nutrition, and social services to economically disadvantaged 3- and 4-year- olds. Housing assistance in the form of rent subsidies and funds for construction is available to low-income families. Pell grants provide assistance to college students from low-income families. Photo Op: Social Insurance versus Public Assistance Programs
© Royalty-Free/CORBIS
© Jack Star/PhotoLink/Getty Images
Beneficiaries of social insurance programs such as Social Security have typically paid for at least a portion of that insurance through payroll taxes. Food stamps and other public assistance are funded from general tax revenue and are generally seen as public charity.
Summary 1. The distribution of income in the United States reflects considerable inequality. The richest 20 percent of families receive 50.5 percent of total income, while the poorest 20 percent receive 3.4 percent.
2. The Lorenz curve shows the percentage of total income received by each percentage of households. The extent of the gap between the Lorenz curve and a line of total equality illustrates the degree of income
inequality.
3. The Gini ratio measures the overall dispersion of the income distribution and is found by dividing the area between the diagonal and the Lorenz curve by the entire area below the diagonal. The Gini ratio ranges from zero to 1; higher ratios signify greater degrees of income inequality.
4. Recognizing that the positions of individual families in the distribution of income change over time and incorporating the effects of noncash transfers and taxes would reveal less income inequality than do standard census data. Government transfers (cash and noncash) greatly lessen the degree of income inequality; taxes also reduce inequality, but not by nearly as much as transfers.
5. Causes of income inequality include differences in abilities, in education and training, and in job tastes, along with discrimination, inequality in the distribution of wealth, and an unequal distribution of market power.
6. Census data show that income inequality has increased significantly since 1970. The major cause of recent increases in income inequality is a rising demand for highly skilled workers, which has boosted their earnings significantly.
7. The basic argument for income equality is that it maximizes consumer satisfaction (total utility) from a particular level of total income. The main argument for income inequality is that it provides the incentives to work, invest, and assume risk and is necessary for the production of output, which, in turn, creates income that is then available for distribution.
8. Current statistics reveal that 12.3 percent of the U.S. population lived in poverty in 2006. Poverty rates are particularly high for female- headed families, young children, African Americans, and Hispanics.
9. The present income-maintenance program in the United States
consists of social insurance programs (Social Security, Medicare, and unemployment compensation) and public assistance programs (SSI, TANF, food stamps, Medicaid, and earned-income tax credit).
10. In 1996 Congress established the Temporary Assistance for Needy Families (TANF) program, which shifted responsibility for welfare from the Federal government to the states. Among its provisions are work requirements for adults receiving welfare and a 5-year lifelong limit on welfare benefits.
11. A generally strong economy and TANF have reduced the U.S. welfare rolls by more than one-half since 1996.
Terms and Concepts income inequality Lorenz curve Gini ratio income mobility noncash transfers law of diminishing marginal utility equality-efficiency trade-off poverty rate entitlement programs Social Security Medicare unemployment compensation Supplemental Security Income (SSI) Temporary Assistance for Needy Families (TANF) food-stamp program Medicaid earned-income tax credit (EITC)
Study Questions
1. Use quintiles to briefly summarize the degree of income inequality in the United States. How and to what extent does government reduce income inequality? LO1
2. Assume that Al, Beth, Carol, David, and Ed receive incomes of $500, $250, $125, $75, and $50, respectively. Construct and interpret a Lorenz curve for this five-person economy. What percentages of total income are received by the richest quintile and by the poorest quintile? LO1
3. How does the Gini ratio relate to the Lorenz curve? Why can't the Gini ratio exceed 1? What is implied about the direction of income inequality if the Gini ratio declines from 0.42 to 0.35? How would one show that change of inequality in the Lorenz diagram? LO1
4. Why is the lifetime distribution of income more equal than the distribution in any specific year? LO2
5. Briefly discuss the major causes of income inequality. What factors have contributed to greater income inequality since 1970? LO2, 3
6. Should a nation's income be distributed to its members according to their contributions to the production of that total income or according to the members' needs? Should society attempt to equalize income or economic opportunities? Are the issues of equity and equality in the distribution of income synonymous? To what degree, if any, is income inequality equitable? LO4
7. Comment on or explain: LO4
a. Endowing everyone with equal income will make for very unequal enjoyment and satisfaction.
b. Equality is a “superior good”; the richer we become, the more of it we can afford.
c. The mob goes in search of bread, and the means it employs is generally to wreck the bakeries.
d. Some freedoms may be more important in the long run than freedom from want on the part of every individual.
e. Capitalism and democracy are really a most improbable mixture. Maybe that is why they need each other—to put some rationality into equality and some humanity into efficiency.
f. The incentives created by the attempt to bring about a more equal distribution of income are in conflict with the incentives needed to generate increased income.
8. How do government statisticians determine the poverty rate? How could the poverty rate fall while the number of people in poverty rises? Which group in each of the following pairs has the higher poverty rate: (a) children or people age 65 or over? (b) African Americans or foreign-born noncitizens? (c) Asians or Hispanics? LO5
9. What are the essential differences between social insurance and public assistance programs? Why is Medicare a social insurance program whereas Medicaid is a public assistance program? Why is the earned-income tax credit considered to be a public assistance program? LO6
10. Prior to the implementation of welfare reforms through the Temporary Assistance for Needy Families (TANF) program, the old system (AFDC) was believed to be creating dependency, robbing individuals and family members of motivation and dignity. How did this reform (TANF) try to address those criticisms? Do you agree with the general thrust of the reform and with its emphasis on work requirements and time limits on welfare benefits? Has the reform reduced U.S. welfare rolls or increased them? LO6
FURTHER TEST YOUR KNOWLEDGE AT www.mcconnellbriefmicro1e.com
Web-Based Questions At the text's Online Learning Center, www.mcconnellbriefmicro1e.com, you will find a multiple-choice quiz on this chapter's content. We encourage you to take the quiz to see how you do. Also, you will find one or more Web-based questions that require information from the Internet to answer.
1 U.S. Census Bureau, Historical Income Tables, www.census.gov. 2 World Bank, World Development Indicators, 2007, www.worldbank.org. 3 U.S. Department of the Treasury, Income Mobility in the U.S. from 1996–2005, November 13, 2007, pp. 1–22. 4 The “before” data in this table differ from the data in Figure 11.1 because the latter include cash transfers. Also, the data in Figure 11.2 are based on a broader concept of income than are the data in Figure 11.1.
(McConnell 243)
McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill Learning Solutions, 2010. <vbk:007-7376986#outline(15)>.
12: International Trade and Exchange Rates IN THIS CHAPTER YOU WILL LEARN:
1 Some key facts about U.S. international trade.
2 About comparative advantage, specialization, and international trade.
3 How exchange rates are determined in currency markets.
4 The rebuttals to common arguments for protectionism.
5 The role played by free-trade zones and the World Trade Organization (WTO) in promoting international trade.
Backpackers in the wilderness like to think they are “leaving the world behind,” but, like Atlas, they carry the world on their shoulders. Much of their equipment is imported—knives from Switzerland, rain gear from South Korea, cameras from Japan, aluminum pots from England, sleeping bags from China, and compasses from Finland. Moreover, they may have driven to the trailheads in Japanese-made Toyotas or German-made BMWs, sipping coffee from Brazil or snacking on bananas from Honduras.
International trade and the global economy affect all of us daily, whether we are hiking in the wilderness, driving our cars, listening to music, or working at our jobs. We cannot “leave the world behind.” We are enmeshed in a global web of economic relationships—trading of goods and services, multinational corporations, cooperative ventures among the world's firms, and ties among the world's financial markets.
Trade Facts The following facts provide an “executive summary” of U.S. international trade:
• A trade deficit occurs when imports exceed exports. The United States has a trade deficit in goods. In 2007, U.S. imports of goods exceeded U.S. exports of goods by $816 billion.
• A trade surplus occurs when exports exceed imports. The United States has a trade surplus in services (such as air transportation services and financial services). In 2007, U.S. exports of services exceeded U.S. imports of services by $107 billion.
• Principal U.S. exports include chemicals, agricultural products,
consumer durables, semiconductors, and aircraft; principal imports include petroleum, automobiles, metals, household appliances, and computers.
• Canada is the United States' most important trading partner quantitatively. In 2007, 22 percent of U.S. exported goods were sold to Canadians, who in turn provided 16 percent of the U.S. imports of goods.
• The United States has a sizable trade deficit with China. In 2007, U.S. imports of goods from China exceeded exports of goods to China by $257 billion.
• The U.S. dependence on foreign oil is reflected in its trade with members of OPEC. In 2007, the United States imported $174 billion of goods (mainly oil) from OPEC members, while exporting $49 billion of goods to those countries.
• The United States leads the world in the combined volume of exports and imports, as measured in dollars. Germany, the United States, China, Japan, and France are the top five exporters by dollar volume (see Global Snapshot 12.1). Currently, the United States provides about nine percent of the world's exports.
GLOBAL SNAPSHOT 12.1: Comparative Exports Germany, the United States, and China are the world's largest exporters.
Source: World Trade Organization, www.wto.org.
• Exports of goods and services make up about 10 percent of total U.S. output. That percentage is much lower than the percentage in many other nations, including Canada, Italy, France, and the United Kingdom (see Global Snapshot 12.2).
• China has become a major international trader, with an estimated $1.2
trillion billion of exports in 2007. Other Asian economies—including South Korea, Taiwan, and Singapore—are also active in international trade. Their combined exports exceed those of France, Britain, or Italy.
• International trade and finance are often at the center of economic policy.
With this information in mind, let's look more closely at the economics of international trade.
GLOBAL SNAPSHOT 12.2: Exports of Goods and Services as a Percentage of GDP, Selected Countries Although the United States is the world's second-largest exporter, it ranks relatively low among trading nations in terms of exports as a percentage of GDP.
Source: Derived from data in IMF, International Financial Statistics, 2008.
Comparative Advantage and Specialization
Given the presence of an open economy—one that includes the international sector—the United States produces more of certain goods (exports) and fewer of other goods (imports) than it would otherwise. Thus U.S. labor and other resources are shifted toward export industries and away from import industries. For example, the United States uses more resources to make computers and to grow wheat and less to make sporting goods and clothing. So we ask: “Do shifts of resources like these make economic sense? Do they enhance U.S. total output and thus the U.S. standard of living?”
The answers are affirmative. Specialization and international trade increase the productivity of a nation's resources and allow for greater total output than would otherwise be possible. This idea is not new. Adam Smith had this to say in 1776:
It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to make neither the one nor the other, but employs those different artificers. …
What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we
have some advantage.1
Nations specialize and trade for the same reasons that individuals do: Specialization and exchange result in greater overall output and income. In the early 1800s British economist David Ricardo expanded on Smith's idea by observing that it pays for a person or a country to specialize and trade even if a nation is more productive than a potential trading partner in all economic activities. We demonstrate Ricardo's principle in the examples that follow.
ILLUSTRATING THE IDEA: A CPA and a House Painter Consider the certified public accountant (CPA) who is also a skilled house painter. Suppose the CPA is a swifter painter than the professional painter she is thinking of hiring. Also suppose that she can earn $50 per hour as an accountant but would have to pay the painter $15 per hour. And say it would take the accountant 30 hours to paint her house but the painter would take 40 hours.
Should the CPA take time from her accounting to paint her own house, or should she hire the painter? The CPA's opportunity cost of painting her house is $1500 (=30 hours of sacrificed CPA time × $50 per CPA hour). The cost of hiring the painter is only $600 (=40 hours of painting × $15 per hour of painting). Although the CPA is better at both accounting and painting, she will get her house painted at lower cost by specializing in accounting and using some of her earnings from accounting to hire a house painter.
Similarly, the house painter can reduce his cost of obtaining accounting services by specializing in painting and using some of his income to hire the CPA to prepare his income tax forms. Suppose it would take the painter 10 hours to prepare his tax return, while the CPA could handle the task in 2 hours. The house painter would sacrifice $150 of income (=10 hours of painting time × $15 per hour) to do something he could hire the CPA to do for $100 (=2 hours of CPA time × $50 per CPA hour). By using the CPA to prepare his tax return, the painter lowers the cost of getting his tax return prepared.
What is true for our CPA and house painter is also true for nations. Specializing enables nations to reduce the cost of obtaining the goods and services they desire.
Question:
How might the specialization described above change once the CPA retires? What generalization about the permanency of a particular pattern of specialization can you draw from your answer?
Comparative Advantage: Production Possibilities Analysis Our simple example shows that the reason specialization is economically desirable is that it results in more efficient production. Now let's put specialization into the context of trading nations and use the familiar concept of the production possibilities table for our analysis.
Assumptions and Comparative Costs Suppose the production possibilities for one product in Mexico and for one product in the United States are as shown in Tables 12.1 and 12.2. Both tables reflect constant costs. Each country must give up a constant amount of one product to secure a certain increment of the other product. (This assumption simplifies our discussion without impairing the validity of our conclusions. Later we will allow for increasing costs.)
TABLE 12.1: Mexico's Production Possibilities Table (in Tons)
TABLE 12.2: U.S. Production Possib ilities Table (in Tons)
Also for simplicity, suppose that the labor forces in the United States and Mexico are of equal size. The data then tell us that the United States has an absolute advantage in producing both products. If the United States and Mexico use their entire (equalsize) labor forces to produce avocados, the United States can produce 90 tons compared with Mexico's 60 tons. Similarly, the United States can produce 30 tons of soybeans compared to Mexico's 15 tons. There are greater production possibilities in the United States, using the same number of workers as in Mexico. So labor productivity (output per worker) in the United States exceeds that in Mexico in producing both products.
Although the United States has an absolute advantage in producing both goods, gains from specialization and trade are possible. Specialization and trade are mutually beneficial or “profitable” to the two nations if the comparative costs of producing the two products within the two nations differ. What are the comparative costs of avocados and soybeans in Mexico? By comparing production alternatives A and B in Table 12.1, we see that Mexico must sacrifice 5 tons of soybeans (=15 − 10) to produce 20 tons of avocados (=20 − 0). Or, more simply, in Mexico it costs 1 ton of soybeans (S) to produce 4 tons of avocados (A); that is, 1S ≡ 4A. (The “≡” sign simply means “equivalent to.”) Because we assumed constant costs, this domestic opportunity cost will not change as Mexico expands the output of either product. This is evident from production possibilities B and C, where we see that 4 more tons of avocados (=24 − 20) cost 1 unit of soybeans (=10 − 9).
Similarly, in Table 12.2, comparing U.S. production alternatives R and S reveals that in the United States it costs 10 tons of soybeans (=30 − 20) to obtain 30 tons of avocados (=30 − 0). That is, the domestic
(internal) comparative-cost ratio for the two products in the United States is 1S ≡ 3A. Comparing production alternatives S and T reinforces this conclusion: an extra 3 tons of avocados (=33 − 30) comes at the sacrifice of 1 ton of soybeans (=20 − 19).
The comparative costs of the two products within the two nations are obviously different. Economists say that the United States has a comparative advantage over Mexico in soybeans. The United States must forgo only 3 tons of avocados to get 1 ton of soybeans, but Mexico must forgo 4 tons of avocados to get 1 ton of soybeans. In terms of opportunity costs, soybeans are relatively cheaper in the United States. A nation has a comparative advantage in some product when it can produce that product at a lower opportunity cost than can a potential trading partner. Mexico, in contrast, has a comparative advantage in
avocados. While 1 ton of avocados costs ton of soybeans in the United
States, it costs only ton of soybeans in Mexico. Comparatively speaking, avocados are cheaper in Mexico. We summarize the situation in Table 12.3. Be sure to give it a close look.
comparative advantage
A lower relative or comparative opportunity cost than that of another person, producer, or country.
TABLE 12.3: Comparative-Advantage Example: A Summary
ORIGIN OF THE IDEA
O 12.1
Absolute and comparative advantage
Because of these differences in comparative costs, Mexico should produce avocados and the United States should produce soybeans. If both nations specialize according to their comparative advantages, each can achieve a larger total output with the same total input of resources. Together they will be using their scarce resources more efficiently.
Terms of Trade The United States can shift production between soybeans and avocados at the rate of 1S for 3A. Thus, the United States would specialize in soybeans only if it could obtain more than 3 tons of avocados for 1 ton of soybeans by trading with Mexico. Similarly, Mexico can shift production at the rate of 4A for 1S. So it would be advantageous to Mexico to specialize in avocados if it could get 1 ton of soybeans for less than 4 tons of avocados.
Suppose that through negotiation the two nations agree on an exchange
rate of 1 ton of soybeans for tons of avocados. These terms of trade are mutually beneficial to both countries, since each can “do
better” through such trade than through domestic production alone. The
United States can get tons of avocados by sending 1 ton of soybeans to Mexico, while it can get only 3 tons of avocados by shifting its own resources domestically from soybeans to avocados. Mexico can obtain 1
ton of soybeans at a lower cost of tons of avocados through trade with the United States, compared to the cost of 4 tons if Mexico produced the 1 ton of soybeans itself.
terms of trade
The rate at which units of one product can be exchanged for units of another product.
Gains from Specialization and Trade Let's pinpoint the gains in total output from specialization and trade. Suppose that, before specialization and trade, production alternative C in Table 12.1 and alternative T in Table 12.2 were the optimal product mixes for the two countries. That is, Mexico preferred 24 tons of avocados and 9 tons of soybeans (Table 12.1) and the United States preferred 33 tons of avocados and 19 tons of soybeans (Table 12.2) to all other available domestic alternatives. These outputs are shown in column 1 in Table 12.4.
TABLE 12.4: Specialization According to Comparative Advantage and the Gains from Trade (in Tons)
Now assume that both nations specialize according to their comparative advantages, with Mexico producing 60 tons of avocados and no soybeans (alternative E) and the United States producing no avocados and 30 tons of soybeans (alternative R). These outputs are shown in column 2 in
Table 12.4. Using our 1S ≡ A terms of trade, assume that Mexico exchanges 35 tons of avocados for 10 tons of U.S. soybeans. Column 3 in Table 12.4 shows the quantities exchanged in this trade, with a minus sign indicating exports and a plus sign indicating imports. As shown in column 4, after the trade Mexico has 25 tons of avocados and 10 tons of soybeans, while the United States has 35 tons of avocados and 20 tons of soybeans. Compared with their optimal product mixes before specialization and trade (column 1), both nations now enjoy more avocados and more soybeans! Specifically, Mexico has gained 1 ton of avocados and 1 ton of soybeans. The United States has gained 2 tons of avocados and 1 ton of soybeans. These gains are shown in column 5.
Specialization based on comparative advantage improves global resource allocation. The same total inputs of world resources and technology result in a larger global output. If Mexico and the United States allocate all their resources to avocados and soybeans, respectively, the same total inputs of resources can produce more output between them, indicating that resources are being allocated more efficiently.
WORKED PROBLEMS
W 12.1
Gains from specialization
Through specialization and international trade a nation can overcome the production constraints imposed by its domestic production possibilities table and curve. Our discussion of Tables 12.1, 12.2, and 12.4 has shown just how this is done. The domestic production possibilities data (Tables 12.1 and 12.2) of the two countries have not changed, meaning that neither nation's production possibilities curve has shifted. But
specialization and trade mean that citizens of both countries can enjoy increased consumption (column 5 of Table 12.4).
Trade with Increasing Costs To explain the basic principles underlying international trade, we simplified our analysis in several ways. For example, we limited discussion to two products and two nations. But multiproduct and multinational analysis yields the same conclusions. We also assumed constant opportunity costs, which is a more substantive simplification. Let's consider the effect of allowing increasing opportunity costs to enter the picture.
As before, suppose that comparative advantage indicates that the United States should specialize in soybeans and Mexico in avocados. But now, as the United States begins to expand soybean production, its cost of soybeans will rise. It will eventually have to sacrifice more than 3 tons of avocados to get 1 additional ton of soybeans. Resources are no longer perfectly substitutable between alternative uses, as our constant-cost assumption implied. Resources less and less suitable to soybean production must be allocated to the U.S. soybean industry in expanding soybean output, and that means increasing costs—the sacrifice of larger and larger amounts of avocados for each additional ton of soybeans.
Photo Op: The Fruits of Free Trade*
© Getty Images
Because of specialization and exchange, fruits from all over the world appear in our grocery stores. For example, apples may be from New Zealand; bananas, from Ecuador; coconuts, from the Philippines; pineapples, from Costa Rica; raspberries, from Mexico; plums, from Chile; and grapes, from Peru.
* This example is from “The Fruits of Free Trade,” Federal Reserve Bank of Dallas, Annual Report 2002, p. 3.
Similarly, Mexico will find that its cost of producing an additional ton of avocados will rise beyond 4 tons of soybeans as it produces more avocados. Resources transferred from soybean to avocado production will eventually be less suitable to avocado production.
At some point the differing domestic cost ratios that underlie comparative advantage will disappear, and further specialization will become uneconomical. And, most importantly, this point of equal cost ratios may be reached while the United States is still producing some avocados along
with its soybeans and Mexico is producing some soybeans along with its avocados. The primary effect of increasing opportunity costs is less-than- complete specialization. For this reason we often find domestically produced products competing directly against identical or similar imported products within a particular economy.
The Foreign Exchange Market Buyers and sellers (whether individuals, firms, or nations) use money to buy products or to pay for the use of resources. Within the domestic economy, prices are stated in terms of the domestic currency and buyers use that currency to purchase domestic products. In Mexico, for example, buyers have pesos, and that is what sellers want.
International markets are different. Sellers set their prices in terms of their domestic currencies, but buyers often possess entirely different currencies. How many dollars does it take to buy a truckload of Mexican avocados selling for 3000 pesos, a German automobile selling for 50,000 euros, or a Japanese motorcycle priced at 300,000 yen? Producers in Mexico, Germany, and Japan want payment in pesos, euros, and yen, respectively, so that they can pay their wages, rent, interest, dividends, and taxes.
A foreign exchange market, a market in which various national currencies are exchanged for one another, serves this need. The equilibrium prices in such currency markets are called exchange rates. An exchange rate is the rate at which the currency of one nation can be exchanged for the currency of another nation. (See Global Snapshot 12.3.)
foreign exchange market
A market in which foreign currencies are exchanged and relative currency prices are established.
exchange rates
The rates at which national currencies trade for one another.
GLOBAL SNAPSHOT 12.3: Exchange Rates: Foreign Currency per U.S. Dollar The amount of foreign currency that a dollar will buy varies greatly from nation to nation and fluctuates in response to supply and demand changes in the foreign exchange market. The amounts shown here are for March 2008.
Photo Op: Foreign Currencies
© PhotoLink/Getty Images/DIL
The world is awash with hundreds of national currencies. Currency markets determine the rates of exchange between them.
The market price or exchange rate of a nation's currency is an unusual price; it links all domestic prices with all foreign prices. Exchange rates enable consumers in one country to translate prices of foreign goods into units of their own currency: They need only multiply the foreign product price by the exchange rate. If the U.S. dollar–yen exchange rate is $.01 (1 cent) per yen, a Sony television set priced at ¥20,000 will cost $200 (=20,000 × $.01) in the United States. If the exchange rate rises to $.02 (2 cents) per yen, the television will cost $400 (=20,000 × $.02) in the United States. Similarly, all other Japanese products would double in price to U.S. buyers in response to the altered exchange rate.
Exchange Rates
INTERACTIVE GRAPHS
G 12.1
Exchange rates
Let's examine the rate, or price, at which U.S. dollars might be exchanged for British pounds. In Figure 12.1 we show the dollar price of 1 pound on the vertical axis and the quantity of pounds on the horizontal axis. The demand for pounds is D1 and the supply of pounds is S1 in this market for
British pounds. FIGURE 12.1: The market for foreign currency (pounds)
The intersection of the demand-for-pounds curve D1 and the supply-
of-pounds curve S1 determines the equilibrium dollar price of pounds,
here, $2. That means that the exchange rate is $2 = £1. The upward blue arrow is a reminder that a higher dollar price of pounds (say, $3 = £1, caused by a shift in either the demand or the supply curve) means that the dollar has depreciated (the pound has appreciated). The downward blue arrow tells us that a lower dollar price of pounds (say, $1 = £1, again caused by a shift in either the demand or the supply curve) means that the dollar has appreciated (the pound has depreciated).
The demand-for-pounds curve is downward-sloping because all British goods and services will be cheaper to the United States if pounds become less expensive to the United States. That is, at lower dollar prices for pounds, the United States can obtain more pounds for each dollar and therefore buy more British goods and services per dollar. To buy those cheaper British goods, U.S. consumers will increase the quantity of pounds they demand.
The supply-of-pounds curve slopes upward because the British will purchase more U.S. goods when the dollar price of pounds rises (that is, as the pound price of dollars falls). When the British buy more U.S. goods, they supply a greater quantity of pounds to the foreign exchange market. In other words, they must exchange pounds for dollars to purchase U.S. goods. So, when the dollar price of pounds rises, the quantity of pounds supplied goes up.
The intersection of the supply curve and the demand curve will determine the dollar price of pounds. In Figure 12.1, that price (exchange rate) is $2 for £1.
Depreciation and Appreciation An exchange rate determined by market forces can, and often does, change daily like stock and bond prices. These price changes result from changes in the supply of, or demand for, a particular currency. When the dollar price of pounds rises, for example, from $2 = £1 to $3 = £1, the
dollar has depreciated relative to the pound (and the pound has appreciated relative to the dollar). A depreciation of a currency means that more units of it (dollars) are needed to buy a single unit of some other currency (a pound).
depreciation (of a currency)
A decrease in the value of a currency relative to another currency.
When the dollar price of pounds falls, for example, from $2 = £1 to $1 = £1, the dollar has appreciated relative to the pound. An appreciation of a currency means that it takes fewer units of it (dollars) to buy a single unit of some other currency (a pound). For example, the dollar price of pounds might decline from $2 to $1. Each British product becomes less expensive in terms of dollars, so people in the United States purchase more British goods. In general, U.S. imports from the United Kingdom rise. Meanwhile, because it takes more pounds to get a dollar, U.S. exports to the United Kingdom fall.
appreciation (of a currency)
An increase in the value of a currency relative to another currency.
The central point is this: When the dollar depreciates (dollar price of foreign currencies rises), U.S. exports rise and U.S. imports fall; when the dollar appreciates (dollar price of foreign currencies falls), U.S. exports fall and U.S. imports rise.
In our U.S.-Britain illustrations, depreciation of the dollar means an appreciation of the pound, and vice versa. When the dollar price of a pound jumps from $2 = £1 to $3 = £1, the pound has appreciated relative to the dollar because it takes fewer pounds to buy $1. At $2 = £1, it took £1/2 to buy $1; at $3 = £1, it takes only £1/3 to buy $1. Conversely, when the dollar appreciates relative to the pound, the pound depreciates relative to the dollar. More pounds are needed to buy a U.S. dollar.
Determinants of Exchange Rates
What factors would cause a nation's currency to appreciate or depreciate in the market for foreign exchange? Here are three generalizations (other things equal):
• If the demand for a nation's currency increases, that currency will appreciate; if the demand declines, that currency will depreciate.
• If the supply of a nation's currency increases, that currency will depreciate; if the supply decreases, that currency will appreciate.
• If a nation's currency appreciates, some foreign currency depreciates relative to it.
With these generalizations in mind, let's examine the determinants of exchange rates—the factors that shift the demand or supply curve for a certain currency. As we do so, keep in mind that the other-things-equal assumption is always in force. Also note that we are discussing factors that change the exchange rate, not things that change as a result of a change in the exchange rate.
Tastes Any change in consumer tastes or preferences for the products of a foreign country may alter the demand for that nation's currency and change its exchange rate. If technological advances in U.S. MP3 players make them more attractive to British consumers and businesses, then the British will supply more pounds in the exchange market in order to purchase more U.S. MP3 players. The supply-of-pounds curve will shift to the right, causing the pound to depreciate and the dollar to appreciate.
In contrast, the U.S. demand-for-pounds curve will shift to the right if British woolen apparel becomes more fashionable in the United States. So the pound will appreciate and the dollar will depreciate.
Relative Income
A nation's currency is likely to depreciate if its growth of national income is more rapid than that of other countries. Here's why: A country's imports vary directly with its income level. As total income rises in the United States, people there buy both more domestic goods and more foreign goods. If the U.S. economy is expanding rapidly and the British economy is stagnant, U.S. imports of British goods, and therefore U.S. demands for pounds, will increase. The dollar price of pounds will rise, so the dollar will depreciate.
Relative Price Levels Changes in the relative price levels of two nations may change the demand for and supply of currencies and alter the exchange rate between the two nations' currencies. If, for example, the domestic price level rises rapidly in the United States and remains constant in Great Britain, U.S. consumers will seek out lowpriced British goods, increasing the demand for pounds. The British will purchase fewer U.S. goods, reducing the supply of pounds. This combination of demand and supply changes will cause the pound to appreciate and the dollar to depreciate.
Relative Interest Rates Changes in relative interest rates between two countries may alter their exchange rate. Suppose that real interest rates rise in the United States but stay constant in Great Britain. British citizens will then find the United States a more attractive place in which to loan money directly or loan money indirectly by buying bonds. To make these loans, they will have to supply pounds in the foreign exchange market to obtain dollars. The increase in the supply of pounds results in depreciation of the pound and appreciation of the dollar.
Changes in Relative Expected Returns on Stocks, Real Estate, and Production Facilities International investing extends beyond buying foreign bonds. It includes
international investments in stocks and real estate as well as foreign purchases of factories and production facilities. Other things equal, the extent of this foreign investment depends on relative expected returns. To make the investments, investors in one country must sell their currencies to purchase the foreign currencies needed for the foreign investments.
For instance, suppose that investing in England suddenly becomes more popular due to a more positive outlook regarding expected returns on stocks, real estate, and production facilities there. U.S. investors therefore will sell U.S. assets to buy more assets in England. The U.S. assets will be sold for dollars, which will then be brought to the foreign exchange market and exchanged for pounds, which will in turn be used to purchase British assets. The increased demand for pounds in the foreign exchange market will cause the pound to appreciate and the dollar to depreciate.
Speculation Currency speculators are people who buy and sell currencies with an eye toward reselling or repurchasing them at a profit. Suppose that, as a group, speculators anticipate that the pound will appreciate and the dollar will depreciate. Speculators holding dollars will therefore try to convert them into pounds. This effort will increase the demand for pounds and cause the dollar price of pounds to rise (that is, cause the dollar to depreciate). A self-fulfilling prophecy occurs: The pound appreciates and the dollar depreciates because speculators act on the belief that these changes will in fact take place. In this way, speculation can cause changes in exchange rates.
Government and Trade If people and nations benefit from specialization and international exchange, why do governments sometimes try to restrict the free flow of imports or encourage exports? What kinds of world trade barriers can governments
erect, and why would they do so?
Trade Protections and Subsidies Trade interventions by government take several forms. Excise taxes on imported goods are called tariffs. A protective tariff is designed to shield domestic producers from foreign competition. Such tariffs impede free trade by causing a rise in the prices of imported goods, thereby shifting demand toward domestic products. An excise tax on imported shoes, for example, would make domestically produced shoes more attractive to consumers. Although protective tariffs are usually not high enough to stop the importation of foreign goods, they put foreign producers at a competitive disadvantage in selling in domestic markets.
tariffs
Taxes imposed by a nation on imported goods.
Import quotas are limits on the quantities or total value of specific items that may be imported. Once a quota is “filled,” further imports of that product are choked off. Import quotas are more effective than tariffs in retarding international commerce. With a tariff, a product can go on being imported in large quantities; with an import quota, however, all imports are prohibited once the quota is filled.
import quotas
Limits imposed by nations on the quantities (or total values) of goods that may be imported during some period of time.
Nontariff barriers (NTBs) include onerous licensing requirements, unreasonable standards pertaining to product quality, or excessive bureaucratic hurdles and delays in customs procedures. Some nations require that importers of foreign goods obtain licenses. By restricting the issuance of licenses, imports can be restricted. Although many nations carefully inspect imported agricultural products to prevent the introduction of potentially harmful insects, some countries use lengthy
inspections to impede imports.
nontariff barriers (NTBs)
All impediments other than protective tariffs that nations establish to impede imports, including import quotas, licensing requirements, unreasonable productquality standards, and unnecessary bureaucratic detail in customs procedures.
A voluntary export restriction (VER) is a trade barrier by which foreign firms “voluntarily” limit the amount of their exports to a particular country. Exporters agree to a VER, which has the effect of an import quota, to avoid more stringent trade barriers. In the late 1990s, for example, Canadian producers of softwood lumber (fir, spruce, cedar, pine) agreed to a VER on exports to the United States under the threat of a permanently higher U.S. tariff.
voluntary export restriction (VER)
An agreement by countries or foreign firms to limit their exports to a certain foreign nation to avoid enactment of formal trade barriers by that nation.
Export subsidies consist of government payments to domestic producers of export goods. By reducing production costs, the subsidies enable producers to charge lower prices and thus to sell more exports in world markets. Example: The United States and other nations have subsidized domestic farmers to boost the domestic food supply. Such subsidies have lowered the market price of agricultural commodities and have artificially lowered their export prices.
export subsidies
Government payments to domestic producers to enable them to reduce the price of a product to foreign buyers.
Economic Impact of Tariffs
Tariffs, quotas, and other trade restrictions have a series of economic effects predicted by supply and demand analysis and observed in reality. These effects vary somewhat by type of trade protection. So to keep things simple, we will focus on the effects of tariffs.
Direct Effects
ORIGIN OF THE IDEA
O 2.2
Mercantilism
Because tariffs raise the price of goods imported to the United States, U.S. consumption of those goods declines. Higher prices reduce quantity demanded, as indicated by the law of demand. A tariff prompts consumers to buy fewer of the imported goods and reallocate a portion of their expenditures to less desired substitute products. U.S. consumers are clearly injured by the tariff.
U.S. producers—who are not subject to the tariff—receive the higher price (pretariff foreign price + tariff) on the imported product. Because this new price is higher than before, the domestic producers respond by producing more. Higher prices increase quantity supplied, as indicated by the law of supply. So domestic producers increase their output. They therefore enjoy both a higher price and expanded sales; this explains why domestic producers lobby for protective tariffs. But from a social point of view, the greater domestic production means the tariff allows domestic producers to bid resources away from other, more efficient, U.S. industries.
Foreign producers are hurt by tariffs. Although the sales price of the imported good is higher, that higher amount accrues to the U.S. government as tariff revenues, not to foreign producers. The after-tariff price, or the per-unit revenue to foreign producers, remains as before, but the volume of U.S. imports (foreign exports) falls.
Government gains revenue from tariffs. This revenue is a transfer of income from consumers to government and does not represent any net change in the nation's economic well-being. The result is that government gains a portion of what consumers lose by paying more for imported goods.
Indirect Effects Tariffs have a subtle effect beyond those just mentioned. They also hurt domestic firms that use the protected goods as inputs in their production process. For example, a tariff on imported steel boosts the price of steel girders, thus hurting firms that build bridges and office towers. Also, tariffs reduce competition in the protected industries. With less competition from foreign producers, domestic firms may be slow to design and implement cost-saving production methods and introduce new products.
Because foreigners sell fewer imported goods in the United States, they earn fewer dollars and so must buy fewer U.S. exports. U.S. export industries must then cut production and release resources. These are highly efficient industries, as we know from their comparative advantage and their ability to sell goods in world markets.
Tariffs directly promote the expansion of inefficient industries that do not have a comparative advantage; they also indirectly cause the contraction of relatively efficient industries that do have a comparative advantage. Put bluntly, tariffs cause resources to be shifted in the wrong direction—and that is not surprising. We know that specialization and world trade lead to more efficient use of world resources and greater world output. But protective tariffs reduce world trade. Therefore, tariffs also reduce efficiency and the world's real output.
Net Costs of Tariffs Tariffs impose costs on domestic consumers but provide gains to domestic
producers and revenue to the Federal government. The consumer costs of trade restrictions are calculated by determining the effect the restrictions have on consumer prices. Protection raises the price of a product in three ways: (1) The price of the imported product goes up; (2) the higher price of imports causes some consumers to shift their purchases to higher-priced domestically produced goods; and (3) the prices of domestically produced goods rise because import competition has declined.
Study after study finds that the costs to consumers substantially exceed the gains to producers and government. A sizable net cost or efficiency loss to society arises from trade protection. Furthermore, industries employ large amounts of economic resources to influence Congress to pass and retain protectionist laws. Because these efforts divert resources away from more socially desirable purposes, trade restrictions also impose that cost on society.
Conclusion: The gains that U.S. trade barriers produce for protected industries and their workers come at the expense of much greater losses for the entire economy. The result is economic inefficiency, reduced consumption, and lower standards of living.
So Why Government Trade Protections? In view of the benefits of free trade, what accounts for the impulse to impede imports and boost exports through government policy? There are several reasons—some legitimate, most not.
Misunderstanding the Gains from Trade It is a commonly accepted myth that the greatest benefit to be derived from international trade is greater domestic sales and employment in the export sector. This suggests that exports are “good” because they increase domestic sales and employment, whereas imports are “bad” because they reduce domestic sales and deprive people of jobs at home. Actually, the true benefit created by international trade is the extra output obtained from abroad—the imports obtained for a lower
opportunity cost than if they were produced at home.
A recent study suggests that the elimination of trade barriers since the Second World War has increased the income of the average U.S. household by at least $7000 and perhaps by as much as $13,000. These
income gains are recurring; they happen year after year.2
Political Considerations While a nation as a whole gains from trade, trade may harm particular domestic industries and particular groups of resource suppliers. In our earlier comparative-advantage example, specialization and trade adversely affected the U.S. avocado industry and the Mexican soybean industry. Understandably, those industries might seek to preserve their economic positions by persuading their respective governments to protect them from imports—perhaps through tariffs.
Those who directly benefit from import protection are relatively few in number but have much at stake. Thus, they have a strong incentive to pursue political activity to achieve their aims. Moreover, because the costs of import protection are buried in the price of goods and spread out over millions of citizens, the cost borne by each individual citizen is quite small. However, the full cost of tariffs and quotas typically greatly exceeds the benefits. It is not uncommon to find that it costs the public $250,000 or more a year to protect a domestic job that pays less than onefourth that amount.
In the political arena, the voice of the relatively few producers and unions demanding protectionism is loud and constant, whereas the voice of those footing the bill is soft or nonexistent. When political deal making is added in—“You back tariffs for the apparel industry in my state, and I'll back tariffs for the steel industry in your state”—the outcome can be a network of protective tariffs.
ILLUSTRATING THE IDEA: Buy
American? Will “buying American” make Americans better off? No, says Dallas Federal Reserve economist W. Michael Cox:
A common myth is that it is better for Americans to spend their money at home than abroad. The best way to expose the fallacy of this argument is to take it to its logical extreme. If it is better for me to spend my money here than abroad, then it is even better yet to buy in Texas than in New York, better yet to buy in Dallas than in Houston … in my own neighborhood … within my own family … to
consume only what I can produce. Alone and poor.*
* “The Fruits of Free Trade,” Federal Reserve Bank of Dallas, Annual Report 2002, p. 16.
Three Arguments for Protection Arguments for trade protection are many and diverse. Some—such as tariffs to protect “infant industries” or to create “military self-sufficiency”—have some legitimacy. But other arguments break down under close scrutiny. Three protectionist arguments, in particular, have persisted decade after decade in the United States.
Increased Domestic Employment Argument Arguing for a tariff to “save U.S. jobs” becomes fashionable when the economy encounters a recession or experiences slow job growth during a recovery (as in the early 2000s in the United States). In an economy that engages in international trade, exports involve spending on domestic output and imports reflect spending to obtain part of another nation's output. So, in this argument, reducing imports will divert spending on another nation's output to spending on domestic output. Thus domestic output and employment will rise. But this argument has several shortcomings.
While imports may eliminate some U.S. jobs, they create others. Imports may have eliminated the jobs of some U.S. steel and textile workers in recent years, but other workers have gained jobs unloading ships, flying imported aircraft, and selling imported electronic equipment. Import restrictions alter the composition of employment, but they may have little or no effect on the volume of employment.
The fallacy of composition—the false idea that what is true for the part is necessarily true for the whole—is also present in this rationale for tariffs. All nations cannot simultaneously succeed in restricting imports while maintaining their exports; what is true for one nation is not true for all nations. The exports of one nation must be the imports of another nation. To the extent that one country is able to expand its economy through an excess of exports over imports, the resulting excess of imports over exports worsens another economy's unemployment problem. It is no wonder that tariffs and import quotas meant to achieve domestic full employment are called “beggar my neighbor” policies: They achieve short-run domestic goals by making trading partners poorer.
Moreover, nations adversely affected by tariffs and quotas are likely to retaliate, causing a “trade-barrier war” that will choke off trade and make all nations worse off. The Smoot-Hawley Tariff Act of 1930 is a classic example. Although that act was meant to reduce imports and stimulate U.S. production, the high tariffs it authorized prompted adversely affected nations to retaliate with tariffs equally high. International trade fell, lowering the output and income of all nations. Economic historians generally agree that the Smoot-Hawley Tariff Act was a contributing cause of the Great Depression.
Smoot-Hawley Tariff Act
Legislation passed in 1930 that established very high U.S. tariffs designed to reduce imports and stimulate the domestic economy. Instead, the law resulted only in retaliatory tariffs by other nations and a decline in trade worldwide.
Finally, forcing an excess of exports over imports cannot succeed in raising domestic employment over the long run. It is through U.S. imports that foreign nations earn dollars for buying U.S. exports. In the long run a nation must import in order to export. The long-run impact of tariffs is not an increase in domestic employment but, at best, a reallocation of workers away from export industries and to protected domestic industries. This shift implies a less efficient allocation of resources.
Cheap Foreign Labor Argument The cheap foreign labor argument says that government must shield domestic firms and workers from the ruinous competition of countries where wages are low. If protection is not provided, cheap imports will flood U.S. markets and the prices of U.S. goods—along with the wages of U.S. workers—will be pulled down. That is, the domestic living standards in the United States will be reduced.
This argument can be rebutted at several levels. The logic of the argument suggests that it is not mutually beneficial for rich and poor persons to trade with one another. However, that is not the case. A relatively low- income mechanic may fix the Mercedes owned by a wealthy lawyer, and both may benefit from the transaction. And both U.S. consumers and Chinese workers gain when they “trade” a pair of athletic shoes priced at $30 as opposed to U.S. consumers being restricted to a similar shoe made in the U.S. for $60.
Also, recall that gains from trade are based on comparative advantage, not on absolute advantage. Again, think back to our U.S.-Mexico (soybean- avocado) example in which the United States had greater labor productivity than Mexico in producing both soybeans and avocados. Because of that greater productivity, wages and living standards will be higher for U.S. labor. Mexico's less productive labor will receive lower wages.
The cheap foreign labor argument suggests that, to maintain American
living standards, the United States should not trade with low-wage Mexico. Suppose it forgoes trade with Mexico. Will wages and living standards rise in the United States as a result? Absolutely not! To obtain avocados, the United States will have to reallocate a portion of its labor from its relatively efficient soybean industry to its relatively inefficient avocado industry. As a result, the average productivity of U.S. labor will fall, as will real wages and living standards for American workers. The labor forces of both countries will have diminished standards of living because without specialization and trade they will have less output available to them. Compare column 4 with column 1 in Table 12.4 to confirm this point.
Protection-against-Dumping Argument The protection-against dumping argument contends that tariffs are needed to protect domestic firms from “dumping” by foreign producers. Dumping is the sale of a product in a foreign country at prices either below cost or below the prices commonly charged at home.
dumping
The sale of products in a foreign country at prices either below costs or below the prices charged at home.
Economists cite two plausible reasons for this behavior. First, with regard to belowcost dumping, firms in country A may dump goods at below cost into country B in an attempt to drive their competitors in country B out of business. If the firms in country A succeed in driving their competitors in country B out of business, they will enjoy monopoly power and monopoly prices and profits on the goods they subsequently sell in country B. Their hope is that the longer-term monopoly profits will more than offset the losses from below-cost sales that must take place while they are attempting to drive their competitors in country B out of business.
Second, dumping that involves selling abroad at a price that is below the price commonly charged in the home country (but which is still at or
above production costs) may be a form of price discrimination, which is charging different prices to different customers. As an example, a foreign seller that has a monopoly in its home market may find that it can maximize its overall profit by charging a high price in its monopolized domestic market while charging a lower price in the United States, where it must compete with U.S. producers. Curiously, it may pursue this strategy even if it makes no profit at all from its sales in the United States, where it must charge the competitive price. So why bother selling in the United States? Because the increase in overall production that comes about by exporting to the United States may allow the firm to obtain the per unit cost savings often associated with large-scale production. These cost savings imply even higher profits in the monopolized domestic market.
Because dumping is an “unfair trade practice,” most nations prohibit it. For example, where dumping is shown to injure U.S. firms, the Federal government imposes tariffs called antidumping duties on the goods in question. But relatively few documented cases of dumping occur each year, and specific instances of unfair trade do not justify widespread, permanent tariffs. Moreover, antidumping duties can be abused. Often, what appears to be dumping is simply comparative advantage at work.
Trade Adjustment Assistance A nation's comparative advantage in the production of a certain product is not forever fixed. As national economies evolve, the size and quality of their labor forces may change, the volume and composition of their capital stocks may shift, new technologies may develop, and even the quality of land and the quantity of natural resources may be altered. As these changes take place, the relative efficiency with which a nation can produce specific goods will also change. Also, new trade agreements can suddenly leave formerly protected industries highly vulnerable to major disruption or even collapse.
Shifts in patterns of comparative advantage and removal of trade protection can hurt specific groups of workers. For example, the erosion of the United
States' once strong comparative advantage in steel has caused production plant shutdowns and layoffs in the U.S. steel industry. The textile and apparel industries in the United States face similar difficulties. Clearly, not everyone wins from free trade (or freer trade). Some workers lose.
The Trade Adjustment Assistance Act of 2002 introduced some new, novel elements to help those hurt by shifts in international trade patterns. The law provides cash assistance (beyond unemployment insurance) for up to 78 weeks for workers displaced by imports or plant relocations abroad. To obtain the assistance, workers must participate in job searches, training programs, or remedial education. There also are relocation allowances to help displaced workers move geographically to new jobs within the United States. Refundable tax credits for health insurance serve as payments to help workers maintain their insurance coverage during the retraining and job search period. Also, workers who are 50 years of age or older are eligible for “wage insurance,” which replaces some of the difference in pay (if any) between their old and new jobs.
Trade Adjustment Assistance Act
A U.S. law passed in 2002 that provides cash assistance, education and training benefits, health care subsidies, and wage subsidies (for persons age 50 or more) to workers displaced by imports or plant relocations abroad.
Many economists support trade adjustment assistance because it not only helps workers hurt by international trade but also helps create the political support necessary to reduce trade barriers and export subsidies.
But not all economists are keen on trade adjustment assistance. Loss of jobs from imports or plant relocations abroad is only a small fraction (about 4 percent in recent years) of total job loss in the economy each year. Many workers also lose their jobs because of changing patterns of demand, changing technology, bad management, and other dynamic aspects of a market economy. Some critics ask, “What makes losing one's job to international trade worthy of such special treatment, compared to losing one's job to, say, technological change or domestic competition?” There is
no totally satisfying answer.
APPLYING THE ANALYSIS: Is Offshoring of Jobs Bad? In recent years U.S. firms have found it increasingly profitable to outsource work abroad. Economists call this business activity offshoring: shifting work previously done by American workers to workers located in other nations. Offshoring is not a new practice but traditionally has involved components for U.S. manufacturing goods. For example, Boeing has long offshored the production of major airplane parts for its “American” aircraft.
offshoring
The practice of shifting work previously done by American workers to workers located in other nations.
Recent advances in computer and communications technology have enabled U.S. firms to offshore service jobs such as data entry, book composition, software coding, call-center operations, medical transcription, and claims processing to countries such as India. Where offshoring occurs, some of the value added in the production process occurs in foreign countries rather than the United States. So part of the income generated from the production of U.S. goods is paid to foreigners, not to American workers.
Offshoring is obviously costly to Americans who lose their jobs, but it is not generally bad for the economy. Offshoring simply reflects a growing international trade in services, or, more descriptively, “tasks.” That trade has been made possible by recent trade agreements and new information and communication technologies. As with trade in goods, trade in services reflects comparative advantage and is beneficial to both trading parties. Moreover, the United States has a sizable trade surplus with other nations in services. The United States gains by specializing in high-valued services such as transportation services, accounting services, legal services, and
advertising services, where it still has a comparative advantage. It then “trades” to obtain lower-valued services such as call-center and data entry work, for which comparative advantage has gone abroad.
Offshoring also increases the demand for complementary jobs in the United States. Jobs that are close substitutes for existing U.S. jobs are lost, but complementary jobs in the United States are expanded. For example, the lower price of offshore maintenance of aircraft and reservation centers reduces the price of airline tickets. That means more domestic and international flights by American carriers, which in turn means more jobs for U.S.-based pilots, flight attendants, baggage handlers, and check-in personnel. Moreover, offshoring encourages domestic investment and expansion of firms in the United States by reducing their costs and keeping them competitive worldwide. Some observers equate “offshoring jobs” to “importing competitiveness.”
Question:
What has enabled white-collar labor services to become the world's newest export and import commodity even though such labor itself remains in place?
Multilateral Trade Agreements and Free- Trade Zones Being aware of the overall benefits of free trade, nations have worked to lower tariffs worldwide. Their pursuit of free trade has been aided by the growing power of free-trade interest groups: Exporters of goods and services, importers of foreign components used in “domestic” products, and domestic sellers of imported products all strongly support lower tariffs. And, in fact, tariffs have generally declined during the past half-century.
General Agreement on Tariffs and Trade Following the Second World War, the major nations of the world set upon
a general course of liberalizing trade. In 1947 some 23 nations, including the United States, signed the General Agreement on Tariffs and Trade (GATT). GATT was based on the principles of equal, nondiscriminatory trade treatment for all member nations and the reduction of tariffs and quotas by multilateral negotiation. Basically, GATT provided a continuing forum for the negotiation of reduced trade barriers on a multilateral basis among nations.
General Agreement on Tariffs and Trade (GATT)
An international accord reached in 1947 in which 23 nations agreed to give equal and nondiscriminatory treatment to one another, to reduce tariffs through multinational negotiations, and to eliminate import quotas.
Since 1947, member nations have completed eight “rounds” of GATT negotiations to reduce trade barriers. The Uruguay Round agreement of 1993 phased in trade liberalizations between 1995 and 2005.
World Trade Organization The Uruguay Round of 1993 established the World Trade Organization (WTO) as GATT's successor. In 2008, 153 nations belonged to the WTO, which oversees trade agreements and rules on disputes relating to them. It also provides forums for further rounds of trade negotiations. The ninth and latest round of negotiations—the Doha Round—was launched in Doha, Qatar, in late 2001. (The trade rounds occur over several years in several geographic venues but are named after the city or country of origination.) The negotiations are aimed at further reducing tariffs and quotas, as well as agricultural subsidies that distort trade. One of this chapter's questions asks you to update the progress of the Doha Round via an Internet search.
World Trade Organization (WTO)
An organization of 153 nations (as of 2008) that oversees the provisions of the current world trade agreement, resolves disputes stemming from
it, and holds forums for further rounds of trade negotiations.
Doha Round
The latest, uncompleted (as of 2008) sequence of trade negotiations by members of the World Trade Organization; named after Doha, Qatar, where the set of negotiations began.
GATT and the WTO have been positive forces in the trend toward liberalized world trade. The trade rules agreed upon by the member nations provide a strong and necessary bulwark against the protectionism called for by the special-interest groups in the various nations. For that reason and because current WTO agreements lack strong labor standards and environmental protections, the WTO is controversial.
European Union Countries have also sought to reduce tariffs by creating regional free-trade zones—also called trade blocs. The most dramatic example is the European Union (EU). In 2007, the addition of Bulgaria and Romania
expanded the EU to 27 nations.3
European Union (EU)
An association of 27 European nations that has eliminated tariffs and quotas among them, established common tariffs for imported goods from outside the member nations, reduced barriers to the free movement of capital, and created other common economic policies.
The EU has abolished tariffs and import quotas on nearly all products traded among the participating nations and established a common system of tariffs applicable to all goods received from nations outside the EU. It has also liberalized the movement of capital and labor within the EU and has created common policies in other economic matters of joint concern, such as agriculture, transportation, and business practices. The EU is now a strong trade bloc: a group of countries having common identity,
economic interests, and trade rules. Of the 27 EU countries, 15 used the euro as a common currency in 2008.
trade bloc
A group of nations that lower or abolish trade barriers among themselves.
euro
The common currency unit used by 15 (as of 2008) European nations in the European Union.
EU integration has achieved for Europe what the U.S. constitutional prohibition on tariffs by individual states has achieved for the United States: increased regional specialization, greater productivity, greater output, and faster economic growth. The free flow of goods and services has created large markets for EU industries. The resulting economies of large-scale production have enabled those industries to achieve much lower costs than they could have achieved in their small, single-nation markets.
North American Free Trade Agreement In 1993 Canada, Mexico, and the United States formed a major trade bloc. The North American Free Trade Agreement (NAFTA) established a free-trade zone that has about the same combined output as the EU but encompasses a much larger geographic area. NAFTA has eliminated tariffs and other trade barriers between Canada, Mexico, and the United States for most goods and services.
North American Free Trade Agreement (NAFTA)
A 1993 agreement establishing, over a 15-year period, a freetrade zone composed of Canada, Mexico, and the United States.
Critics of NAFTA feared that it would cause a massive loss of U.S. jobs
as firms moved to Mexico to take advantage of lower wages and weaker regulations on pollution and workplace safety. Also, there was concern that Japan and South Korea would build plants in Mexico and transport goods tariff-free to the United States, further hurting U.S. firms and workers.
In retrospect, critics were much too pessimistic. Since the passage of NAFTA in 1993, employment in the United States rose by more than 22 million workers and the unemployment rate fell from 6.9 percent to 4.7 percent. Increased trade between Canada, Mexico, and the United States has enhanced the standard of living in all three countries.
Not all aspects of trade blocs are positive. By giving preferences to countries within their free-trade zones, trade blocs such as the EU and NAFTA tend to reduce their members' trade with non-bloc members. Thus, the world loses some of the benefits of a completely open global trading system. Eliminating that disadvantage has been one of the motivations for liberalizing global trade through the World Trade Organization. Its liberalizations apply equally to all 153 nations that belong to the WTO.
U.S. Trade Deficits As indicated in Figure 12.2, the United States has experienced large and persistent trade deficits over the past several years. These deficits climbed steeply between 1994 and 2000, fell slightly in the recessionary year 2001, and rose again between 2002 and 2007. In 2007 the trade deficit on goods was $816 billion and the trade deficit on goods and services was $709 billion. Large trade deficits are expected to continue for many years. FIGURE 12.2: U.S. trade deficits, 1999–2007.
The United States experienced large deficits in goods and in goods and services between 1999 and 2007. These deficits have steadily increased, dipping only slightly in 2001 and 2007. They are expected to continue at least throughout the current decade.
Source: U.S. Census Bureau, Foreign Trade Division, www.census.gov/foreign-trade/statistics.
Causes of the Trade Deficits There are several reasons for these large trade deficits. First, over recent years the U.S. economy has grown more rapidly than the economies of
several of its major trading partners. The strong growth of U.S. income that accompanies economic growth has enabled Americans to buy more imported goods. In contrast, Japan and some European nations have either suffered recession or experienced slow income growth. So their purchases of U.S. exports have not kept pace with the growing U.S. imports. Large trade deficits with Japan and Germany have been particularly noteworthy in this regard.
Second, large trade deficits with China have emerged, reaching $257 billion in 2007. This is even greater than the U.S. trade imbalance with Japan ($85 billion in 2007) or OPEC countries ($125 billion in 2007). The United States is China's largest export market, and although China has increased its imports from the United States, its standard of living has not yet increased enough for its citizens to afford large quantities of U.S. goods and services.
Finally, a declining U.S. saving rate (=saving/total income) undoubtedly has also contributed to U.S. trade deficits. Over the last 10 years, the saving rate has diminished while the investment rate (=investment/total income) has remained stable or increased. The gap between saving and investment has been met through foreign purchases of U.S. real and financial assets. Because foreign savers are willingly financing a larger part of U.S. investment, Americans are able to save less than otherwise and consume more. Part of that added consumption spending is on imported goods. That is, the inflow of funds from abroad may be one cause of the trade deficits, not just a result of those deficits.
The U.S. recession of 2001 temporarily lowered income and reduced U.S. imports and trade deficits. But the general trend toward higher trade deficits quickly reemerged in 2002 and ballooned until 2007, when they dipped slightly (though still remaining high).
Implications of U.S. Trade Deficits There is disagreement on whether the large trade deficits should be of major policy concern for the United States. Most economists see both
benefits and costs to trade deficits but are increasingly anxious about the size of these deficits.
Increased Current Consumption At the time a trade deficit is occurring, American consumers benefit. A trade deficit means that the United States is receiving more goods and services as imports from abroad than it is sending out as exports. Taken alone, a trade deficit augments the domestic standard of living. But there is a catch: The gain in present consumption may come at the expense of reduced future consumption.
Increased U.S. Indebtedness A trade deficit is considered “unfavorable” because it must be financed by borrowing from the rest of the world, selling off assets, or dipping into foreign currency reserves. Trade deficits are financed primarily by net inpayments of foreign currencies to the United States. When U.S. exports are insufficient to finance U.S. imports, the United States increases both its debt to people abroad and the value of foreign claims against assets in the United States. Financing of the U.S. trade deficit has resulted in a larger foreign accumulation of claims against U.S. financial and real assets than the U.S. claim against foreign assets. In 2006, foreigners owned about $2.5 trillion more of U.S. assets (corporations, land, stocks, bonds, loan notes) than U.S. citizens and institutions owned of foreign assets.
If the United States wants to regain ownership of these domestic assets, at some future time it will have to export more than it imports. At that time, domestic consumption will be lower because the United States will need to send more of its output abroad than it receives as imports. Therefore, the current consumption gains delivered by U.S. current account deficits may mean permanent debt, permanent foreign ownership, or large sacrifices of future consumption.
We say “may mean” above because the foreign lending to U.S. firms and
foreign investment in the United States increase the stock of American capital. U.S. production capacity might increase more rapidly than otherwise because of a large inflow of funds to offset the trade deficits. We know that faster increases in production capacity and real GDP enhance the economy's ability to service foreign debt and buy back real capital, if that is desired.
Downward Pressure on the Dollar Finally, the large U.S. trade deficits place downward pressure on the exchange value of the U.S. dollar. The surge of imports requires the United States to supply dollars in the currency market in order to obtain the foreign currencies required for purchasing the imported goods. That flood of dollars into the currency market causes the dollar to depreciate relative to other currencies. Between 2002 and 2008, the dollar depreciated against most other currencies, including 43 percent against the European euro, 27 percent against the British pound, 37 percent against the Canadian dollar, 15 percent against the Chinese yuan, and 25 percent against the Japanese yen. Some of this depreciation was fueled by the expansionary monetary policy (reduced real interest rates) undertaken by the Fed beginning in 2007 and carrying into 2008 (discussed in Chapter 10). Economists feared that the decline in the dollar would contribute to inflation as imports became more expensive to Americans in dollar terms. Traditionally the Fed would need to react to that inflation with a tight monetary policy that raises real interest rates in the United States. In 2008, however, the U.S. economy severely receded, largely as a result of spillover damage from the mortgage debt crisis and the decline in housing demand. The Fed chose to aggressively reduce interest rates, hoping to halt the downturn in the economy. In effect, it gambled that its actions would not ignite inflation because of the dampening effect of the severe economic recession on rising prices.
Summary 1. The United States leads the world in the volume of international trade, but trade is much larger as a percentage of GDP in many other
nations.
2. Mutually advantageous specialization and trade are possible between any two nations if they have different domestic opportunity-cost ratios for any two products. By specializing on the basis of comparative advantage, nations can obtain larger real incomes with fixed amounts of resources. The terms of trade determine how this increase in world output is shared by the trading nations. Increasing costs lead to less-than- complete specialization for many tradable goods.
3. The foreign exchange market establishes exchange rates between currencies. Each nation's purchases from abroad create a supply of its own currency and a demand for foreign currencies. The resulting supply-demand equilibrium sets the exchange rate that links the currencies of all nations. Depreciation of a nation's currency reduces its imports and increases its exports; appreciation increases its imports and reduces its exports.
4. Currencies will depreciate or appreciate as a result of changes in their supply or demand, which in turn depend on changes in tastes for foreign goods, relative changes in national incomes, changes in relative price levels, changes in interest rates, and the extent and direction of currency speculation.
5. Trade barriers and subsidies take the form of protective tariffs, quotas, nontariff barriers, voluntary export restrictions, and export subsidies. Protective tariffs increase the prices and reduce the quantities demanded of the affected goods. Sales by foreign exporters diminish; domestic producers, however, gain higher prices and enlarged sales. Consumer losses from trade restrictions greatly exceed producer and government gains, creating an efficiency loss to society.
6. Three recurring arguments for free trade—increased domestic employment, cheap foreign labor, and protection against dumping—are either fallacies or overstatements that do not hold up under careful economic analysis.
7. Not everyone benefits from free (or freer) trade. The Trade Adjustment Assistance Act of 2002 provides cash assistance, education and training benefits, health care subsidies, and wage subsidies (for persons 50 years old or more) to workers who are displaced by imports or plant relocations abroad. But less than 4 percent of all job losses in the United States each year result from imports, plant relocations, or the offshoring of service jobs.
8. In 2008 the World Trade Organization (WTO) consisted of 153 member nations. The WTO oversees trade agreements among the members, resolves disputes over the rules, and periodically meets to discuss and negotiate further trade liberalization. In 2001 the WTO initiated a new round of trade negotiations in Doha, Qatar. The Doha Round (named after its place of initiation) will continue over the next several years.
9. Free-trade zones (trade blocs) liberalize trade within regions but may at the same time impede trade with non-bloc members. Two examples of free-trade arrangements are the 27-member European Union (EU) and the North American Free Trade Agreement (NAFTA), comprising Canada, Mexico, and the United States. Fifteen of the EU nations (as of 2008) have abandoned their national currencies for a common currency called the euro.
10. U.S. trade deficits have produced current increases in the livings standards of U.S. consumers. But the deficits have also increased U.S. debt to the rest of the world and increased foreign ownership of assets in the United States. This greater foreign investment in the United States, however, has undoubtedly increased U.S. production possibilities. The trade deficits also place extreme downward pressure on the international value of the U.S. dollar.
Terms and Concepts comparative advantage terms of trade
foreign exchange market exchange rates depreciation appreciation tariffs import quotas nontariff barriers (NTBs) voluntary export restriction (VER) export subsidies Smoot-Hawley Tariff Act dumping Trade Adjustment Assistance Act offshoring General Agreement on Tariffs and Trade (GATT) World Trade Organization (WTO) Doha Round European Union (EU) trade bloc euro North American Free Trade Agreement (NAFTA)
Study Questions 1. Quantitatively, how important is international trade to the United States relative to its importance to other nations? What country is the United States' most important trading partner, quantitatively? With what country does the United States have the largest current trade deficit? LO1
2. Below are hypothetical production possibilities tables for New Zealand and Spain. Each country can produce apples and plums. LO2
New Zealand's Production Possibilities Table
(Millions of Bushels)
Spain's Production Possibilities Table (Millions of Bushels)
Referring to the tables, answer the following:
a. What is each country's cost ratio of producing plums and apples?
b. Which nation should specialize in which product?
c. Suppose the optimal product mixes before specialization and trade are alternative B in New Zealand and alternative S in Spain and the actual terms of trade are 1 plum for 2 apples. What will be the gains from specialization and trade?
3. The following are production possibilities tables for South Korea and the United States. Assume that before specialization and trade the optimal product mix for South Korea is alternative B and for the United States is alternative U. LO2
a. Are comparative-cost conditions such that the two areas should specialize? If so, which product should each produce?
b. What is the total gain in LCD displays and chemical output that would result from such specialization?
c. What are the limits of the terms of trade? Suppose actual
terms of trade are unit of LCD displays for units of chemicals and that 4 units of LCD displays are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation?
d. Explain why this illustration allows you to conclude that specialization according to comparative advantage results in a more efficient use of world resources.
4. What effect do rising costs (rather than constant costs) have on the extent of specialization and trade? Explain. LO2
5. What is offshoring of white-collar service jobs, and how does it relate to international trade? Why has it recently increased? Why do you think more than half of all offshored jobs have gone to India? Give an example (other than that in the textbook) of how offshoring can eliminate some U.S. jobs while creating other U.S. jobs. LO2
6. Explain why the U.S. demand for Mexican pesos is downward- sloping and the supply of pesos to Americans is upward-sloping. Indicate whether each of the following would cause the Mexican peso to appreciate or depreciate: LO3
a. The United States unilaterally reduces tariffs on Mexican products.
b. Mexico encounters severe inflation.
c. Deteriorating political relations reduce American tourism in Mexico.
d. The U.S. economy moves into a severe recession.
e. The United States engages in a high-interest-rate monetary policy.
f. Mexican products become more fashionable to U.S. consumers.
g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.
7. Explain why you agree or disagree with the following statements: LO3
a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.
b. A nation whose interest rate is rising more rapidly than
interest rates in other nations can expect the international value of its currency to appreciate.
c. A country's currency will appreciate if its inflation rate is less than that of the rest of the world.
8. If the European euro were to depreciate relative to the U.S. dollar in the foreign exchange market, would it be easier or harder for the French to sell their wine in the United States? Suppose you were planning a trip to Paris. How would depreciation of the euro change the dollar cost of your trip? LO3
9. What measures do governments take to promote exports and restrict imports? Who benefits and who loses from protectionist policies? What is the net outcome for society? LO4
10. Speculate as to why some U.S. firms strongly support trade liberalization while other U.S. firms favor protectionism. Speculate as to why some U.S. labor unions strongly support trade liberalization while other U.S. labor unions strongly oppose it. LO4
11. Explain: “Free-trade zones such as the EU and NAFTA lead a double life: They can promote free trade among members, but they pose serious trade obstacles for nonmembers.” Do you think the net effects of trade blocs are good or bad for world trade? Why? How do the efforts of the WTO relate to these trade blocs? LO5
12. What is the WTO, and how does it affect international trade? How many nations belong to the WTO? (Update the number given in this book at www.wto.org.) Is the Doha Round (or Doha Agenda) still in progress, or has it been concluded with an agreement (again, use the WTO Website)? If the former, when and where was the latest ministerial meeting? If the latter, what are the main features of the agreement? LO5
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1 Adam Smith, The Wealth of Nations (New York: Modern Library, 1937), p. 424. (Originally published in 1776.) 2 Scott C. Bradford, Paul L.E. Grieco, and Gary C. Hufbauer, “The Payoff to America from Globalization,” The World Economy, July 2006, pp. 893–916. 3 The other 25 are France, Germany, United Kingdom, Italy, Belgium, the Netherlands, Luxembourg, Denmark, Ireland, Greece, Spain, Portugal, Austria, Finland, Sweden, Poland, Hungary, Czech Republic, Slovakia, Lithuania, Latvia, Estonia, Slovenia, Malta, and Cyprus.
(McConnell 266)
McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill Learning Solutions, 2010. <vbk:007-7376986#outline(16)>.