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ill not fall. Instead, some workers will be laid off. Although explicit contracts can explain why some wages are sticky, a deeper question must also be considered. Workers and firms surely know at the time a contract is signed that unforeseen events may cause the wages set by the contract to be too high or too low. Why do firms and workers bind themselves in this way? One explanation is that negotiating wages is costly. Negotiations between unions and firms can take a considerable amount of time—time that could be spent producing output—and it would be very costly to negotiate wages weekly or monthly. Contracts are a way of bearing these costs at no more than 1-, 2-, or 3-year intervals. There is a trade-off between the costs of locking workers and firms into contracts for long periods of time and the costs of wage negotiations. The length of contracts that minimizes negotiation costs seems to be (from what we observe in practice) between 1 and 3 years. Some multiyear contracts adjust for unforeseen events by cost-of-living adjustments (COLAs) written into the contract. COLAs tie wages to changes in the cost of living: The greater the rate of inflation, the more wages are raised. COLAs thus protect workers from unexpected inflation, although many COLAs adjust wages by a smaller percentage than the percentage increase in prices. Regarding deflation, few contracts allow for wage cuts in the face of deflation. An Open Question MyLab Economics Concept Check As we have seen, there are many explanations for why we might see unemployment. Some of these explanations focus on why we might see levels of unemployment higher than frictional plus structural. Other explanations focus on the reasons for cyclical unemployment. The theories we have just set forth are not necessarily mutually exclusive, and there may be elements of M13_CASE3826_13_GE_C13.indd 280 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 281 13.5 LEARNING OBJECTIVE Analyze the short-run relationship between unemployment and inflation. truth in all of them. The aggregate labor market is complicated, and there are no simple answers to why there is unemployment. Much current work in macroeconomics is concerned directly or indirectly with this question, and it is an exciting area of study. Which argument or arguments will win out in the end is an open question. The Short-Run Relationship between the Unemployment Rate and Inflation In Chapter 11 we described the Fed as concerned about both output and the price level. In practice, the Fed typically describes its interests as being unemployment on the one hand and inflation on the other. For example, Janet Yellen, the former Fed chair, gave a speech at the San Francisco Fed on March 27, 2015, in which she said, “Our goal in adjusting the federal funds rate over time will be to achieve and sustain economic conditions close to maximum employment with inflation averaging 2 percent.” Jerome Powell, the current chair, has similarly committed to the joint goal of price stability and employment growth. We are now in a position to connect the Fed interest in output with the unemployment rate and to explore the connection between unemployment and prices. We begin by looking at the relation between aggregate output (income) (Y) and the unemployment rate (U). For an economy to increase aggregate output, firms must hire more labor to produce that output. Thus, more output implies greater employment. An increase in employment means more people working (fewer people unemployed) and a lower unemployment rate. An increase in Y corresponds to a decrease in U. Thus, U and Y are negatively related: When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises, all else equal. What about the relationship between aggregate output and the overall price level? The AS curve, reproduced in Figure 13.3, shows the relationship between Y and the overall price level (P). The relationship is a positive one: When P increases, Y increases, and when P decreases, Y decreases. As you will recall from the last chapter, the shape of the AS curve is determined by the behavior of firms in reacting to an increase in demand. If aggregate demand shifts to the right and the economy is operating on the nearly flat part of the AS curve—far from capacity— output will increase, but the price level will not change much. However, if the economy is operating on the steep part of the AS curve—close to capacity—an increase in demand will drive up the price level, but output will be constrained by capacity and will not increase much. Now let us put the two pieces together and think about what will happen following an event that leads to an increase in aggregate demand. First, firms experience an unanticipated decline in inventories. They respond by increasing output (Y) and hiring workers—the unemployment rate falls. If the economy is not close to capacity, there will be little increase in the price level. If, however, aggregate demand continues to grow, the ability of the economy to increase output AS ◂◂ FIGURE 13.3 The Aggregate Supply Curve The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y). Aggregate output (income), Y MyLab Economics Concept Check M13_CASE3826_13_GE_C13.indd 281 17/04/19 4:18 AM 282 PART III The Core of Macroeconomic Theory ◂▸ FIGURE 13.4 The Relationship Between the Price Level and the Unemployment Rate This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the price level rises more and more MyLab Economics Concept Check Unemployment rate, U % inflation rate The percentage change in the price level. Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate. will eventually reach its limit. As aggregate demand shifts farther and farther to the right along the AS curve, the price level increases more and more and output begins to reach its limit. At the point at which the AS curve becomes vertical, output cannot rise any farther. If output cannot grow, the unemployment rate cannot be pushed any lower. There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in response to the economy’s moving closer and closer to capacity output, the overall price level rises more and more, as shown in Figure 13.4. The AS curve in Figure 13.3 shows the relationship between the price level and aggregate output and thus implicitly between the price level and the unemployment rate, which is depicted in Figure 13.4. In policy formulation and discussions, however, economists have focused less on the relationship between the price level and the unemployment rate than on the relationship between the inflation rate—the percentage change in the price level—and the unemployment rate. Note that the price level and the percentage change in the price level are not the same. The curve describing the relationship between the inflation rate and the unemployment rate, which is shown in Figure 13.5, is called the Phillips Curve, after British economist A. W. Phillips, who first examined it using data for the United Kingdom. Fortunately, the analysis behind the AS curve (and thus the analysis behind the curve in Figure 13.4) will enable us to see both why the Phillips Curve initially looked so appealing as an explanation of the relationship between inflation and the unemployment rate and how more recent history has changed our views of the interpretation of the Phillips Curve. The Phillips Curve: A Historical Perspective MyLab Economics Concept Check In the 1950s and 1960s, the data showed a remarkably smooth relationship between the unemployment rate and the rate of inflation, as Figure 13.6 shows for the 1960s. As you can see, the data points fit fairly closely around a downward-sloping curve; in general, the higher the unemployment rate is, the lower the rate of inflation. The historical data in fact look quite like the hypothetical Phillips Curve in Figure 13.5, which tells us that to lower the inflation rate, we must accept a higher unemployment rate, and to lower the unemployment rate, we must accept a higher rate of inflation. Textbooks written in the 1960s and early 1970s relied on the Phillips Curve as the main explanation of inflation. The story was simple—inflation appeared to respond in a fairly predictable way to changes in the unemployment rate. Policy discussions in the 1960s often revolved around the Phillips Curve. The role of the policy maker, it was thought, was to choose a point on the curve. Conservatives usually argued for choosing a point with a low rate of inflation and were willing to accept a higher unemployment rate in exchange for this. Liberals usually argued for accepting more inflation to keep unemployment at a low level. Life did not turn out to be quite so simple. Data from the 1970s on no longer show the simple negative relationship between the unemployment rate and inflation. Look at Figure 13.7, which graphs the unemployment rate and inflation rate for the period from 1970 to 2017. The points in Figure 13.7 show no particular relationship between inflation and the unemployment rate. M13_CASE3826_13_GE_C13.indd 282 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 283 MyLab Economics Concept Check ◂◂ FIGURE 13.5 The Phillips Curve The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.0 5.0 4.0 3.0 2.0 1. fl ( ◂◂ FIGURE 13.6 Unemployment and Inflation, 1960–1969 During the 1960s, there seemed to be an obvious tradeoff between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off. Source: U.S Bureau of Labor Statistics. ◂◂ FIGURE 13.7 Unemployment and Inflation, 1970–2017 From the 1970s on, it b
ecame clear that the relationship between unemployment and inflation was anything but simple. Source: U.S Bureau of Labor Statistics. Unemployment rate, U % MyLab Economics Concept Check ’69 ’68 ’67 ’66 ’65 ’60 ’63 ’64 ’62 ’61 0 1.0 2.0 3.0 5.0 4.0 Unemployment rate, U 6.0 7. ( % 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0 –1.0 MyLab Economics Real-time data ’80 ’79 ’74 ’81 ’75 ’11 ’78 ’77 ’76 ’84 ’90 ’88 ’08 ’91 ’73 ’71 ’70 ’89 ’05 ’00 ’96 ’06 ’72 ’87 ’85 ’04 ’92 ’07 ’01 ’99 ’98 ’95 ’97 ’94 ’03 ’02 ’14 ’93 ’86 ’13 ’12 ’82 ’83 ’10 ’09 0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 13.0 % Unemployment rate, U M13_CASE3826_13_GE_C13.indd 283 17/04/19 4:18 AM 284 PART III The Core of Macroeconomic Theory Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve MyLab Economics Concept Check How can we explain the stability of the Phillips Curve in the 1950s and 1960s and the lack of stability after that? To answer, we need to return to AS/AD analysis. If the AD curve shifts from year to year but the AS curve does not, the values of P and Y each year will lie along the AS curve (Figure 13.8(a)). The shifting AD curve creates a set of AS/AD intersections that trace out the AS curve. (Try doing this yourself on a graph of the AS and AD curves.) The plot of the relationship between P and Y will be upward sloping in this case. Correspondingly, the plot of the relationship between the unemployment rate (which decreases with increased output) and the rate of inflation will be a curve that slopes downward. In other words, if the new equilibrium data reflect a stable AS curve and a shifting AD curve, we would expect to see a negative relationship between the unemployment rate and the inflation rate, just as we see in Figure 13.6 for the 1960s. However, the relationship between the unemployment rate and the inflation rate will look different if the AS curve shifts from year to year, perhaps from a change in oil prices, but the AD curve does not move. A leftward shift of the AS curve with the AD curve stable will cause an increase in the price level (P) and a decrease in aggregate output (Y) (Figure 13.8(b)). When the AS curve shifts to the left, the economy experiences both inflation and an increase in the unemployment rate (because decreased output means increased unemployment). In other words, if the AS curve is shifting from year to year, we would expect to see a positive relationship between the unemployment rate and the inflation rate. If both the AS and the AD curves are shifting simultaneously, however, there is no systematic relationship between P and Y (Figure 13.8(c)) and thus no systematic relationship between the unemployment rate and the inflation rate. One explanation for the change in the Phillips Curve between the 1960s and later periods is that both the AS and the AD curves appear to be shifting in the later periods—both shifts from the supply side and shifts from the demand side. This can be seen by examining a key cost variable: the price of imports. The Role of Import Prices We discussed in the previous chapter that one of the main factors that causes the AS curve to shift are changes in energy prices, particularly the price of oil. Because the United States imports much of its oil, the price index of U.S. imports is highly correlated with the (world) price of oil. As a result, a change in the U.S. import price index, which we will call “the price of imports,” shifts the AS curve. The price of imports is plotted in Figure 13.9 for the 1960 I–2017 IV period. As you can see, the price of imports changed very little between 1960 and 1970. There were no large shifts in the AS curve in the 1960s due to changes in the price of imports. There were also no other large changes in input prices in the 1960s, so overall the AS curve shifted very little during the decade. The main variation in the 1960s was in aggregate demand, so the shifting AD curve traced out points along the AS curve. MyLab Economics Concept Check P2 P1 P0 AS AD2 AD1 AD0 P2 P1 P0 AS2 AS1 AS0 AD P , l e v e l P2 P1 e c i r P0 P AS2 AS1 AS0 AD2 AD1 AD0 0 Y0 Y1 Y2 0 Y2 Y1 Y0 0 Y1 Y0 Y2 Aggregate output (income), Y Aggregate output (income), Y Aggregate output (income), Y a. AD shifts with no AS shifts trace out the AS curve (a positive relationship between P and Y). b. AS shifts with no AD shifts trace out the AD curve (a negative relationship between P and Y). c. If both AD and AS are shifting, there is no systematic relationship between P and Y. ▴◂FIGURE 13.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply M13_CASE3826_13_GE_C13.indd 284 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 285 1.2 1 0.8 0.6 0.4 0. 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarters MyLab Economics Real-time data ▴◂FIGURE 13.9 The Price of Imports, 1960 I–2017 IV The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 1979–1980. Between 1981 and 2002, the price of imports changed very little. It generally rose between 2003 and 2008, fell somewhat in late 2008 and early 2009, rose slightly in 2011 and then remained flat. Figure 13.9 also shows that the price of imports increased considerably in the 1970s. This rise led to large shifts in the AS curve during the decade, but the AD curve was also shifting throughout the 1970s. With both curves shifting, the data points for P and Y were scattered all over the graph and the observed relationship between P and Y was not at all systematic. This story about import prices and the AS and AD curves in the 1960s and 1970s carries over to the Phillips Curve. The Phillips Curve was stable in the 1960s because the primary source of variation in the economy was demand, not costs. In the 1970s, both demand and costs were varying so no obvious relationship between the unemployment rate and the inflation rate was apparent. To some extent, what is remarkable about the Phillips Curve is not that it was not smooth after the 1960s, but that it ever was smooth. Expectations and the Phillips Curve MyLab Economics Concept Check Another reason the Phillips Curve is not stable concerns expectations. We saw in Chapter 12 that if a firm expects other firms to raise their prices, the firm may raise the price of its own product. If all firms are behaving this way, prices will rise because they are expected to rise. In this sense, expectations are self-fulfilling. Similarly, if inflation is expected to be high in the future, negotiated wages are likely to be higher than if inflation is expected to be low. Wage inflation is thus affected by expectations of future price inflation. Because wages are input costs, prices rise as firms respond to the higher wage costs. Price expectations that affect wage contracts eventually affect prices themselves. If the rate of inflation depends on expectations, the Phillips Curve will shift as expectations change. For example, if inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. In this case, the Phillips Curve will shift to the right. If inflationary expectations decrease, the Phillips Curve will shift to the left—there will be less inflation at any given level of the unemployment rate. It so happened that inflationary expectations were quite stable in the 1950s and 1960s. The inflation rate was moderate during most of this period, and people expected it to remain moderate. With inflationary expectations not changing very much, there were no major shifts of the Phillips Curve, a situation that helps explain its stability during the period. Near the end of the 1960s, inflationary expectations began to increase, primarily in response to the actual increase in inflation that was occurring because of the tight economy caused by the Vietnam War. Inflationary expectations increased even further in the 1970s as a result of large oil price increases. These changing expectations led to shifts of the Phillips Curve and are another reason the curve was not stable during the 1970s. Inflation and Aggregate Demand MyLab Economics Concept Check It is important to realize that the fact that the historical data since the 1970s do not trace out a smooth downward-sloping Phillips curve does not mean that aggregate demand has no effect on inflation. It simply means that inflation is affected by more than just aggregate demand. If, M13_CASE3826_13_GE_C13.indd 285 17/04/19 4:18 AM 286 PART III The Core of Macroeconomic Theory 13.6 LEARNING OBJECTIVE Discuss the long-run relationship between unemployment and output. say, inflation is also affected by cost variables like the price of imports, there will be no stable relationship between just inflation and aggregate demand unless the cost variables are not changing. Similarly, if the unemployment rate is taken to be a measure of aggregate demand, where inflation depends on both the unemployment rate and cost variables, there will be no stable Phillips Curve unless the cost variables are not changing. Therefore, the unemployment rate can have an important effect on inflation even though this will not be evident from a plot of inflation against the unemployment rate—that is, from the Phillips Curve. The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment Thus far we have been discussing the relationship between inflation and unemployment, looking at the short-run AS and AD curves. We turn now to look at the long run, focusing on the connection between output and unemployment. Recall from Chapter 11 that many economists believe that in the long run, the AS curve is vertical. We have illustrated this case in Figure 13.10. Assume that the initial equilibrium is at the intersection of AD0 and the long-run aggregate supply curve. Now consider a s
hift of the aggregate demand curve from AD0 to AD1. If wages are sticky and lag prices, in the short run, aggregate output will rise from Y0 to Y1. (This is a movement along the short-run AS curve AS0.) In the longer run, wages catch up. For example, next year’s labor contracts may make up for the fact that wage increases did not keep up with the cost of living this year. If wages catch up in the longer run, the AS curve will shift from AS0 to AS1 and drive aggregate output back to Y0. If wages ultimately rise by exactly the same percentage as output prices, firms will produce the same level of output as they did before the increase in aggregate demand. As we indicated in Chapter 11, Y0 is sometimes called potential output. Aggregate output can be pushed above Y0 in the short run. When aggregate output exceeds Y0, however, there is upward pressure on input prices and costs. The unemployment rate is already quite low, firms are beginning to encounter the limits of their plant capacities, and so on. At levels of aggregate output above Y0, costs will rise, the AS curve will shift to the left, and the price level will rise. Thus, potential output is the level of aggregate output that can be sustained in the long run without inflation. AS/AD AS (Long run) AS1 (Short run) AS0 (Short run) AD1 AD0 P2 P1 P0 % Long-Run Phillips Curve U* % 0 Y0 Y1 Aggregate output (income), Y MyLab Economics Concept Check Unemployment rate, U ▴◂FIGURE 13.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment. M13_CASE3826_13_GE_C13.indd 286 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 287 This story is directly related to the Phillips Curve. Those who believe that the AS curve is vertical in the long run at potential output also believe that the Phillips Curve is vertical in the long run at some natural rate of unemployment. Changes in aggregate demand—including increases in government spending—increase prices, but do not change employment. Recall from Chapter 7 that the natural rate of unemployment refers to unemployment that occurs as a normal part of the functioning of the economy. It is sometimes taken as the sum of frictional unemployment and structural unemployment. The logic behind the vertical Phillips Curve is that whenever the unemployment rate is pushed below the natural rate, wages begin to rise, thus pushing up costs. This leads to a lower level of output, which pushes the unemployment rate back up to the natural rate. At the natural rate, the economy can be considered to be at full employment. The Nonaccelerating Inflation Rate of Unemployment (NAIRU) MyLab Economics Concept Check In Figure 13.10, the long-run vertical Phillips Curve is a graph with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. The natural rate of unemployment is U. In the long run, with a long-run vertical Phillips Curve, the actual unemployment rate moves to U because of the natural workings of the economy. Another graph of interest is Figure 13.11, which plots the change in the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. Many economists believe that the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in the figure. The value of the unemployment rate where the PP curve crosses zero is called the nonaccelerating inflation rate of unemployment (NAIRU). If the actual unemployment rate is below the NAIRU, the change in the inflation rate will be positive. As depicted in the figure, at U1, the change in the inflation rate is 1. Conversely, if the actual unemployment rate is above the NAIRU, the change in the inflation rate is negative: At U2, the change is −1. Consider what happens if the unemployment rate decreases from the NAIRU to U1 and stays at U1 for many periods. Assume also that the inflation rate at the NAIRU is 2 percent. Then in the first period the inflation rate will increase from 2 percent to 3 percent. The inflation rate does not, however, just stay at the higher 3 percent value. In the next period, the inflation rate will increase from 3 percent to 4 percent and so on. The price level will be accelerating—that is, the change in the inflation rate will be positive—when the actual unemployment rate is below the NAIRU. Conversely, the price level will be decelerating—that is, the change in the inflation rate will be negative—when the actual unemployment rate is above the NAIRU.1 natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment. NAIRU The nonaccelerating inflation rate of unemployment. % 1 0 - MyLab Economics Concept Check ◂◂ FIGURE 13.11 The NAIRU Diagram At an unemployment rate below the NAIRU, the price level is accelerating (positive changes in the inflation rate); at an unemployment rate above the NAIRU, the price level is decelerating (negative changes in the inflation rate). Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). U1 NAIRU U2 Unemployment rate, U PP % 1The NAIRU is actually misnamed. It is the price level that is accelerating or decelerating, not the inflation rate, when the actual unemployment rate differs from the NAIRU. The inflation rate is not accelerating or decelerating, but simply changing by the same amount each period. The namers of the NAIRU forgot their physics. M13_CASE3826_13_GE_C13.indd 287 17/04/19 4:18 AM 288 PART III The Core of Macroeconomic Theory The PP curve in Figure 13.11 is like the AS curve in Figure 13.3—the same factors that shift the AS curve, such as cost shocks, can also shift the PP curve. Figure 11.2 on p. 246 summarizes the various factors that can cause the AS curve to shift, and these are also relevant for the PP curve. A favorable shift for the PP curve is to the left because the PP curve crosses zero at a lower unemployment rate, indicating that the NAIRU is lower. Some have argued that one possible recent source of favorable shifts is increased foreign competition, which may have kept wage costs and other input costs down. Before about 1995, proponents of the NAIRU theory argued that the value of the NAIRU in the United States was around 6 percent. By the end of 1995, the unemployment rate declined to 5.6 percent, and by 2000, the unemployment rate was down to 3.8 percent. At the end of 2017 it was 4.1 percent. If the NAIRU had been 6 percent, one should have seen a continuing increase in the inflation rate beginning about 1995. In fact, the 1995 to 2000 period saw slightly declining inflation. Not only did inflation not continually increase, it did not even increase once to a new, higher value and then stay there. As the unemployment rate declined during this period, proponents of the NAIRU lowered their estimates of it, more or less in line with the actual fall in the unemployment rate. This recalibration can be justified by arguing that there have been continuing favorable shifts of the PP curve, such as possible increased foreign competition. Critics, however, have argued that this procedure is close to making the NAIRU theory vacuous. Can the theory really be tested if the estimate of the NAIRU is changed whenever it is not consistent with the data? How trustworthy is the appeal to favorable shifts? The 2015–2017 period also saw declining unemployment rates with no increase in the inflation rate, further evidence against the NAIRU theory. Looking Ahead This chapter concludes our basic analysis of how the macroeconomy works. In the preceding six chapters, we have examined how households and firms behave in the three market arenas—the goods market, the money market, and the labor market. We have seen how aggregate output (income), the interest rate, and the price level are determined in the economy, and we have examined the relationship between two of the most important macroeconomic variables, the inflation rate and the unemployment rate. In Chapter 14, we use everything we have learned up to this point to examine a number of important policy issues. S U M M A R Y 13.1 THE LABOR MARKET: BASIC CONCEPTS p. 274 1. Because the economy is dynamic, frictional and structural unemployment are inevitable and in some ways desirable. Times of cyclical unemployment are of concern to macroeconomic policy makers. 2. In general, employment tends to fall when aggregate output falls and rise when aggregate output rises. 13.2 THE CLASSICAL VIEW OF THE LABOR MARKET p. 274 3. Classical economists believe that the interaction of supply and demand in the labor market brings about equilibrium and that unemployment (beyond the frictional and structural amounts) does not exist. 4. The classical view of the labor market is consistent with the theory of a vertical aggregate supply curve. 5. Some economists argue that the unemployment rate is not an accurate indicator of whether the labor market is working properly. Unemployed people who are considered part of the labor force may be offered jobs but may be unwilling to take those jobs at the offered salaries. Some of the unemployed may have chosen not to work, but this result does not mean that the labor market has malfunctioned. 13.3 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT p. 276 6. Efficiency wage theory holds that the productivity of workers increases with the wage rate. If this is true, firms may have an incentive to pay wages above the wage at which the quantity of labor supplied is equal to the quantity of labor demanded. At all wages above the equilibriu
m, there will be an excess supply of labor and therefore unemployment. 7. If firms are operating with incomplete or imperfect informa- tion, they may not know what the market-clearing wage is. As a result, they may set their wages incorrectly and bring about unemployment. Because the economy is so complex, it may take considerable time for firms to correct these mistakes. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M13_CASE3826_13_GE_C13.indd 288 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 289 8. Minimum wage laws, which set a floor for wage rates, are 12. The Phillips Curve represents the relationship between the one factor contributing to unemployment of teenagers and very low-skilled workers. If the market-clearing wage for some groups of workers is below the minimum wage, some members of this group will be unemployed. 13.4 EXPLAINING THE EXISTENCE OF CYCLICAL UNEMPLOYMENT p. 278 9. If wages are sticky downward, cyclical unemployment may result. Downwardly sticky wages may be brought about by social (implicit) or explicit contracts not to cut wages. If the equilibrium wage rate falls but wages are prevented from falling also, the result will be unemployment. 13.5 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION p. 281 10. There is a negative relationship between the unemployment rate (U) and aggregate output (income) (Y): When Y rises, U falls. When Y falls, U rises. 11. The relationship between the unemployment rate and the price level is negative: As the unemployment rate declines and the economy moves closer to capacity, the price level rises more and more. inflation rate and the unemployment rate. During the 1950s and 1960s, this relationship was stable and there seemed to be a predictable trade-off between inflation and unemployment. As a result of import price increases (which led to shifts in aggregate supply), the relationship between the inflation rate and the unemployment rate was erratic in the 1970s. Inflation depends on more than just the unemployment rate. 13.6 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL OUTPUT, AND THE NATURAL RATE OF UNEMPLOYMENT p. 286 13. Those who believe that the AS curve is vertical in the long run also believe that the Phillips Curve is vertical in the long run at the natural rate of unemployment. The natural rate is generally the sum of the frictional and structural rates. If the Phillips Curve is vertical in the long run, then there is a limit to how low government policy can push the unemployment rate without setting off inflation. 14. The NAIRU theory says that the price level will accelerate when the unemployment rate is below the NAIRU and decelerate when the unemployment rate is above the NAIRU cost-of-living adjustments (COLAs), p. 280 cyclical unemployment, p. 274 efficiency wage theory, p. 277 explicit contracts, p. 280 frictional unemployment, p. 274 inflation rate, p. 282 labor demand curve, p. 275 labor supply curve, p. 275 minimum wage laws, p. 277 NAIRU, p. 287 natural rate of unemployment, p. 287 Phillips Curve, p. 282 relative-wage explanation of unemployment, p. 278 social, or implicit, contracts, p. 278 sticky wages, p. 278 structural unemployment, p. 274 unemployment rate, p. 274 P R O B L E M S All problems are available on MyLab Economics. 13.1 THE LABOR MARKET: BASIC CONCEPTS c. Retraining programs for workers who need to learn new LEARNING OBJECTIVE: Define fundamental concepts of the labor market. 1.1 The following policies have at times been advocated for coping with unemployment. Briefly explain how each might work and explain which type or types of unemployment (frictional, structural, or cyclical) each policy is designed to alter. a. A computer list of job openings and a service that matches employees with job vacancies (sometimes called an “economic dating service”) b. Lower minimum wage for teenagers skills to find employment d. Public employment for people without jobs e. Improved information about available jobs and current wage rates f. The president’s going on nationwide TV and attempting to convince firms and workers that the inflation rate next year will be low 1.2 How will the following affect labor force participation rates, labor supply, and unemployment in your country? a. The government steps up public funding for nurseries. b. A growing majority of the young and well-educated pop- ulation is leaving the country. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M13_CASE3826_13_GE_C13.indd 289 17/04/19 4:18 AM 290 PART III The Core of Macroeconomic Theory c. Firms are taking advantage of looser lay-off regulations while increasing the volume of paid overtime work. d. The government tightens rules for obtaining permanent residence, causing a decline in the number of immigrants coming into the country. e. The government shortens the maximum period one is entitled to unemployment benefits. 13.2 THE CLASSICAL VIEW OF THE LABOR MARKET LEARNING OBJECTIVE: Explain the classical view of the labor market. 2.1 Using a supply and demand graph for the labor market, explain the classical view that the economy will remain at full employment, even with a decrease in the demand for labor. How will this labor market graph change in the absence of sticky wages? 13.3 EXPLAINING THE EXISTENCE OF UNEMPLOYMENT LEARNING OBJECTIVE: Discuss four reasons for the existence of unemployment. 3.1 In 2019, the country of Cheeseling was suffering from a period of high unemployment. The new president, Chad Cheddar, appointed Merry Parmesan as his chief economist. Ms. Parmesan and her staff estimated these supply and demand curves for labor from data obtained from the secretary of labor, Sore Mozzarella: QD = 190 - 6W QS = 10W - 18 where Q is the quantity of labor supplied/demanded and W is the wage rate in strings, the currency of Cheeseling. a. What is the equilibrium wage? How many workers are employed? b. Assume that Sore Mozzarella wants to introduce a law that says that no worker shall be paid less than 16 strings per hour. Estimate the quantity of labor supplied and the number of unemployed. c. How can you justify this minimum wage for the economy of Cheeseling? 3.2 Country X came out of a prolonged recessional period a few years ago, thanks to a vigorous fiscal stimulus by the government. The country’s economy had resumed growing two years ago, reaching a solid pace of growth of more than 2.5 percent last year. Yet, unemployment levels, which increased fast during the recession, are still stuck at a high level (around 10 percent), and do not show any signs of falling. Which of the following factors do you think contributed to this, and why? a. Wages are sticky which represents an obstacle for employ- ment in growing firms. b. Employment and unemployment are always lagging indi- cators in response to changes in economic growth. c. People are out of a job for too long and, in turn, have dif- ficulties in returning to work. d. The recession has led to the replacement of old sectors with new ones, boosting structural unemployment at a time when cyclical unemployment is decreasing. e. The recession has led firms to be much more cautious with their hiring strategies–preferring to rely on overwork to cope with increasing demand. f. The fiscal stimulus has crowded out private investment spending that has been the main source of reductions in unemployment. Choose two of these statements and write a short essay. Use data to support your claims. 13.4 EXPLAINING THE EXISTENCE OF CYCLICAL UNEMPLOYMENT LEARNING OBJECTIVE: Discuss the reasons for the existence of cyclical unemployment. 4.1 Economists and politicians have long debated the extent to which unemployment benefits affect the duration of unemployment. The table on the following page represents unemployment and unemployment benefit data for five high-income countries. The unemployment rate and the duration of unemployment benefits for each of these countries are shown for 2007, prior to the recession of 2008–2009, for 2010, the first full year following the end of the recession, and for June 2017, eight years after the end of the recession. As the data shows, three of these countries extended the duration of unemployment benefits as a result of the recession and two of those countries have since reduced the extended duration. The data for 2007, 2010, and 2017 show a positive relationship between the duration of unemployment benefits and the unemployment rate. Discuss whether you believe the length of time in which a person can receive unemployment benefits directly affects the unemployment rate, and whether your answer applies to 2007, 2010, and 2017. Look up the unemployment rates in each of the five countries. Discuss whether a positive relationship still exists between the duration of unemployment benefits and the unemployment rate, and whether you believe the extension of unemployment benefits in three of those countries played a role in their current unemployment rates. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M13_CASE3826_13_GE_C13.indd 290 17/04/19 4:18 AM CHAPTER 13 The Labor Market in the Macroeconomy 291 Country Canada France Great Britain Japan United States 2007 Unemployment Rate Unemployment Benefits Duration, 2007 2010 Unemployment Rate Unemployment Benefits Duration, 2010 June 2017 Unemployment Rate Unemployment Benefits Duration, 2017 6.4% 8.7% 5.3% 3.9% 4.6% 50 weeks 52 weeks 26 weeks 13 weeks 26 weeks 7.1% 9.4% 7.9% 4.7% 9.6% 50 weeks 104 weeks 26 weeks 21 weeks 99 weeks 6.5% 9.4% 4.3% 2.8% 4.4% 45 weeks 104 weeks 26 weeks 13 weeks 26 weeks 4.2 [Related to the Ec
onomics in Practice on p. 280] The Economics in Practice box states that job applicants who have been unemployed for a long period of time have a more difficult time getting job interviews than do those applicants who have been unemployed for a shorter time period. Go to www.bls.gov and do a search for “Table A-12: Unemployed persons by duration of unemployment.” Look at the seasonally adjusted data for the current month and for the same month in the previous year. What happened to the “number of unemployed” and the “percent distribution” over that year for those who were unemployed 15 to 26 weeks and for those who were unemployed 27 weeks and over? Does this data seem to support the findings in the Economics in Practice? Explain. 4.3 In which if the following situations will you be best off, and in which will you be worst off, in terms of your real wage? Explain your answer. a. You are offered a 5 percent wage increase and the inflation rate for the year turns out to be 7 percent. b. You are offered a 1 percent wage increase and the inflation rate for the year turns out to be −2 percent. c. You are offered a 12 percent wage increase and the infla- tion rate for the year turns out to be 16 percent. d. You are offered a 6 percent wage increase and the inflation rate for the year turns out to be 6 percent. e. You are offered a 7 percent wage increase and the inflation rate for the year turns out to be 3 percent. 4.4 How might social, or implicit, contracts result in sticky wages? Use a labor market graph to show the effect of social contracts on wages and on unemployment if the economy enters a recession. 4.5 [Related to the Economics in Practice on p. 279] The Economics in Practice discusses data gathered from 1996– 2010, a period of low unemployment and high growth. The years 2016–2018 have also been described as a period of low unemployment and high growth. Search news sources such as Bloomberg, the New York Times, and Forbes, as well as the Bureau of labor Statistics, for information regarding wages during this period. Did wages appear to be sticky from 2016–2018, as they did from 1996–2000? Briefly explain. 13.5 THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION LEARNING OBJECTIVE: Analyze the short-run relationship between unemployment and inflation. 5.1 In March 2018, the unemployment rate in the Czech Republic was at 3.7 percent, the third lowest in the European Union. At the same time, the country experienced an average inflation rate of 2.45 percent. Can you explain the trade-off between inflation and unemployment? What factors might improve this trade-off? 5.2 Obtain monthly data on the unemployment rate and the inflation rate for the last two years. (This data can be found at www.bls.gov or in a recent issue of the Survey of Current Business or in the Monthly Labor Review or Employment and Earnings, all published by the government and available in many college libraries.) a. What trends do you observe? Can you explain what you see using aggregate supply and aggregate demand curves? b. Plot the 24 monthly rates on a graph with the unemploy- ment rate measured on the x-axis and the inflation rate on the y-axis. Is there evidence of a trade-off between these two variables? Provide an explanation. 5.3 Suppose the relationship between the inflation rate and the unemployment rate, depicted by the Phillips Curve, was stable. Does this mean that neighboring countries such as Germany and France are likely to have the same trade-off between unemployment and inflation? Explain your answer. 13.6 THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL OUTPUT, AND THE NATURAL RATE OF UNEMPLOYMENT LEARNING OBJECTIVE: Discuss the long-run relationship between unemployment and output. 6.1 Obtain data on average hourly wages of production work- ers and the unemployment rate for the manufacturing sector in your country. How have these two sets of data evolved recently? To what extent do you think the changes in the unemployment rate have affected the changes in average wages? Provide an explanation QUESTION 1 When an unemployed individual gives up looking for work and leaves the labor force, she is no longer considered unemployed. What happens to the unemployment rate as a result? Does this mean that the unemployment rate understates or overstates the problem of joblessness? QUESTION 2 According to the Efficiency Wage Theory, employers occasionally pay workers more than the equilibrium wage in the market in order to increase productivity. Explain how this would lead to reduced turnover. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M13_CASE3826_13_GE_C13.indd 291 17/04/19 4:18 AM P ART IV FURTHER MACROECONOMICS ISSUES 14 Financial Crises, Stabilization, and Deficits CHAPTER OUTLINE AND LEARNING OBJECTIVES 14.1 The Stock Market, the Housing Market, and Financial Crises p. 293 Discuss the effects of historical fluctuations in stock and housing prices on the economy. 14.2 Time Lags Regarding Monetary and Fiscal Policy p. 299 Explain the purpose of stabilization policies and differentiate between three types of time lags. 14.3 Government Deficit Issues p. 303 Discuss the effects of government deficits and deficit targeting. 292292 We have seen in the last several chapters the way in which the government can use fiscal and monetary policies to affect the economy. Yet, if you look back at Figure 5.5 on page 128 you can see that the unemployment rate still fluctuates widely. What accounts for these large fluctuations? Why can’t policymakers do a better job of controlling the economy? This chapter covers a number of topics, but they are all concerned at least indirectly with trying to help answer this question. In the next section we will consider the stock market and the housing market. Both of these markets have important effects on the economy through a household wealth effect. When stock prices or housing prices rise, household wealth rises, and households respond to this by consuming more. Economic models do a reasonably good job of estimating the effects of a wealth change on consumption, but they do a poor job of predicting the stock price and housing price changes that create that wealth change in the first place. Stock prices and housing prices are asset prices, and changes in these prices are, for the most part, unpredictable. Neither policymakers nor anyone else in the economy have the ability to predict how the stock and housing markets will behave in the future. This is then the first problem that policymakers face. If stock and housing prices are unpredictable, the best that policymakers can do is to try to react quickly to these changes once they occur. In this section we will also describe the way in which large unpredictable changes in these asset prices can lead to “financial crises” and what policymakers can and cannot do about them. A second problem policymakers confront in stabilizing the economy is getting the timing right, which we cover in the second section of this chapter. We will see that there is a danger of overreacting to changes in the economy—making the fluctuations in the economy even worse than they otherwise would be. The third section of this chapter discusses government deficit issues. We learned at the end of Chapter 9 that it is important to distinguish between cyclical deficits and structural deficits. One expects that the government will run a deficit in a recession since tax revenue is down because of the sluggish economy and spending may be up as the government tries to stimulate the economy. If at full employment the government is still running a deficit, this part of the deficit is described as a structural deficit. In 2018 many countries, including the United States, faced serious structural deficit problems. Many countries in the European Union struggled to meet the structural deficit targets set by the European Commission. We discuss various problems that may arise if a government runs large deficits year after year, including the possibility of a financial crisis. We will also look at some of the historical ways that have been used to control deficits in the United States. M14_CASE3826_13_GE_C14.indd 292 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 293 The Stock Market, the Housing Market, and Financial Crises Introductory macroeconomic textbooks written before 1990 could largely ignore the stock and housing markets. The effects of these markets on the macroeconomy were small enough to be put aside in introductory discussions. In the 1990s this changed. The boom in the U.S. economy in the late 1990s and the subsequent recession owed a good deal to the rise and later fall in the stock market in that period. Similarly, in the period after 2000, the rise and later fall in housing prices contributed to cycles in the real economy. Now even introductory macroeconomics courses must spend some time looking at these two markets. We first turn to some background material on the stock market. 14.1 LEARNING OBJECTIVE Discuss the effects of historical fluctuations in stock and housing prices on the economy. Stocks and Bonds MyLab Economics Concept Check It will be useful to begin by briefly discussing the three main ways in which firms borrow or raise money to finance their investments. How do firms use financial markets in practice? When a firm wants to make a large purchase to build a new factory or buy machines, it often cannot pay for the purchase out of its own funds. In this case, it must “finance” the investment. One way to do this is to borrow from a bank. The bank loans the money to the firm, the firm uses the money to buy the factory or machine, and the firm pays back the loan (with interest) to the bank over time. Another possible way for a firm to borrow money is for the firm to issue a bond. If you buy a bond fr
om a firm, you are making a loan to the firm. Bonds were discussed in Chapter 10 in our discussion of U.S. Treasury securities. We noted in that chapter that a bond is a promise to pay a fixed coupon periodically during the term of the bond and then to repay the full amount of the bond at the end of its term. Bonds issued by firms are called corporate bonds and are part of a firm’s debt. A third way for a firm to finance an investment is for it to issue additional shares of stock. Just as with bonds, typically only corporations have the ability to issue stock. When a firm issues new shares of stock, it does not add to its debt. Instead, it brings in additional owners of the firm, owners who agree to supply it with funds. Such owners are treated differently than bondholders, who are owed the amount they have loaned. Shares in a firm are also called the equity of the firm. A share of common stock is a certificate that represents the ownership of a share of a business, almost always a corporation. In some cases, firms pay a portion of their annual profits directly to their shareholders in the form of a dividend. For example, Waste Management is one of the largest firms in the business of managing garbage, with a market value of $35.3 billion. Its shares are owned by many individuals, mutual funds, foundations, and pensions, including Vanguard, BlackRock, and the Gates Foundation. In 2018, Waste Management had gross profits of $5.4 billion and paid out 38 percent of its earning in dividend. The remainder was retained for firm investments. Stockholders who own stocks that increase in value earn what are called capital gains. Realized capital gains (or losses) are increases (or decreases) in the value of assets, including stocks that households receive when they actually sell those assets. The government considers realized capital gains net of losses to be income, although their treatment under the tax code has been complex and subject to change every few years. The total return that an owner of a share of stock receives is the sum of the dividends received and the capital gain or loss. Determining the Price of a Stock MyLab Economics Concept Check What determines the price of a stock? If a share of stock is selling for $25, why is someone willing to pay that much for it? As we have noted, when you buy a share of stock, you own part of the firm. If a firm is making profits, it may be paying dividends to its shareholders. If it is not paying dividends but is making profits, people may expect that it will pay dividends stock A certificate that certifies ownership of a certain portion of a firm. capital gain An increase in the value of an asset. realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it. M14_CASE3826_13_GE_C14.indd 293 17/04/19 4:19 AM 294 PART IV Further Macroeconomics Issues in the future. Microsoft, for example, only began paying dividends in 2003 as it entered a more mature phase of its business. Apple began paying dividends in 2012. Most utilities like Con Edison always pay dividends. Dividends are important in thinking about stocks because dividends are the form in which shareholders receive income from the firm. So one thing that is likely to affect the price of a stock is what people expect its future dividends will be. The larger the expected future dividends, the higher the current stock price, other things being equal. Another important consideration in thinking about the price of a stock is when the dividends are expected to begin to be paid. A $2-per-share dividend stream that is expected to start four years from now is worth less than a $2-per-share dividend that starts next year. In other words, the farther into the future the dividend is expected to be paid, the more it will be “discounted.” The amount by which expected future dividends are discounted depends on the interest rate. The higher the interest rate, the more expected future dividends will be discounted. If the interest rate is 10 percent, I can invest $100 today and receive $110 a year from now. I am thus willing to pay $100 today to someone who will pay me $110 in a year. If instead, the interest rate were only 5 percent, I would be willing to pay $104.76 today to receive $110 a year from now because the alternative of $104.76 today at a 5 percent interest rate also yields $110.00 at the end of the year. I am thus willing to pay more for the promise of $110 a year from now when the interest rate is lower. In other words, I “discount” the $110 less when the interest rate is lower. When investors buy a bond, that bond comes with a fixed coupon. When investors buy a stock, they can look at the current and past dividends, but there is no guarantee that future dividends will be the same. Dividends are voted each year by the board of a company, and in difficult times a board may decide to reduce or even eliminate dividends. So dividend payments come with a risk and that risk affects the stock price. In 2017, General Electric, a large, well diversified firm hit hard times in a number of its businesses and cut its dividend in half. The stock price soon followed. People prefer certain outcomes to uncertain ones for the same expected values. For example, I prefer a certain $50 over a bet in which there is a 50 percent chance I will get $100 and a 50 percent chance I will get nothing, even though the expected value of the two deals are equal. The same reasoning holds for future dividends. If, say, I expect dividends for both firms A and B to be $2 per share next year but firm B has a much wider range of possibilities (is riskier), I will prefer firm A. Put another way, I will “discount” firm B’s expected future dividends more than firm A’s because the outcome for firm B is more uncertain. In the case of General Electric, the stock price fell both because the dividend payment fell and because stockholders lost faith in the company’s ability to keep paying even the new dividend. Risks had increased. We can thus say that the price of a stock should equal the discounted value of its expected future dividends, where the discount factors depend on the interest rate and risk. If for some reason (say, a positive surprise news announcement from the firm) we expect a firm to increase its future dividends, this should lead to an increase in the price of the stock. If there is a surprise fall in the interest rate, this decrease should also lead to a stock price increase. Finally, if the perceived risk of a firm falls, this perception should increase the firm’s stock price. Some stock analysts talk about the possibility of stock market “bubbles.” Given the preceding discussion, what might a bubble be? Assume that given your expectations about the future dividends of a firm and given the discount rate, you value the firm’s stock at $20 per share. Is there any case in which you would pay more than $20 for a share? We noted previously that the total return to an owner of a share of stock includes any capital gains that come from selling the stock. If the stock is currently selling for $25, which is above your value of $20, but you think that the stock will rise to $30 in the next few months, you might buy it now in anticipation of selling it later for a higher price and reap these capital gains. If others have similar views, the price of the stock may be driven up. In this case, what counts is not the discounted value of expected future dividends, but rather your view of what others will pay for the stock in the future. You will recall we suggested that stock prices cannot be predicted. Sometimes stocks rise and give their owners capital gains, while other times they fall and there are capital losses. One way to define a bubble is M14_CASE3826_13_GE_C14.indd 294 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 295 a time in which everyone expects that everyone else expects that stock prices in general will be driven up. This expectation of general price appreciation itself fuels the market as people come to expect capital gains as part of the return on their investments. When a firm’s stock price has risen rapidly, it is difficult to know whether the reason is that people have increased their expectations of the firm’s future dividends or that there is a bubble. You should see that holding stock under these circumstances is also risky. Some have compared stock ownership in a bubble to the game of musical chairs: You don’t want to be the one holding the stock when the music stops! The Stock Market Since 1948 MyLab Economics Concept Check Most investors are interested in following the fortunes of individual firms. Macroeconomists, tracking the connection between stocks and overall levels of economic activity, need instead a measure of the stock market in general. There are several indices available. If you follow the stock market at all, you know that much attention is paid to two stock price indices: the Dow Jones Industrial Average and the NASDAQ Composite. From a macroeconomic perspective, however, these two indices cover too small a sample of firms. One would like an index that includes firms whose total market value is close to the market value of all firms in the economy. For this purpose a much better measure is the Standard and Poor’s 500 stock price index, called the S&P 500. This index includes most of the larger companies in the economy by market value. The S&P 500 index is plotted in Figure 14.1 for 1948 I–2017 IV. What perhaps stands out most in this plot is the huge increase in the index between 1995 and 2000. Between December 31, 1994, and March 31, 2000, the S&P 500 index rose 226 percent, an annual rate of increase of 25 percent. This is by far the largest stock market boom in U.S. history, completely dominating the boom of the 1920s. Remember that we are talking about the S&P 500 index, which includes most of the firms in the U.S. economy by mark
et value. We are not talking about just a few dot-com companies. The entire stock market went up 25 percent per year five years! This boom added roughly $14 trillion to household wealth, about $2.5 trillion per year.1 What caused this boom? You can see from Figure 12.7 that interest rates did not change much in the last half of the 1990s, so the boom cannot be explained by any large fall in interest rates. Perhaps profits rose substantially during this period, and this growth led to a large increase in expected future dividends? We know from the preceding discussion that if expected Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. It is the oldest and most widely followed index of stock market performance. NASDAQ Composite An index based on the stock prices of more than 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value. 2700.0 1215.0 405.0 135.0 45.0 15.0 1950 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Rea-time data Quarter ▴ FIGURE 14.1 The S&P 500 Stock Price Index, 1948 I–2017 IV The scale is the log scale. 1It is worth noting that S&P changes the firms that are in its index as firms either prosper or fade. This selection tells us that the index will overestimate actual stock market gains as a result of survivor bias. M14_CASE3826_13_GE_C14.indd 295 17/04/19 4:19 AM 296 PART IV Further Macroeconomics Issues t n e c r e P 0.08 0.07 0.06 0.05 0.04 0.03 1950 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data Quarter ▴ FIGURE 14.2 Ratio of After-Tax Profits to GDP, 1948 I–2017 IV future dividends increase, stock prices should increase. Figure 14.2 plots for 1948 I–2017 IV the ratio of after-tax profits to GDP. It is clear from the figure that nothing unusual happened to profits in the last half of the 1990s. The share of after-tax profits in GDP rose from the middle of 1995 to the middle of 1997, but then generally fell after that through 2000. Thus, there does not appear to be any surge of profits that would have led people to expect much higher future dividends. It could be that the perceived riskiness of stocks fell in the last half of the 1990s. This change would have led to smaller discount rates for stocks and thus, other things being equal, to higher stock prices. Although this possibility cannot be completely ruled out, there is no strong independent evidence that perceived riskiness fell. The stock market boom is thus a puzzle, and many people speculate that it was simply a bubble. For some reason, stock prices started rising rapidly in 1995 and people expected that other people expected that prices would continue to rise. This led stock prices to rise further, thus fulfilling the expectations, which led to expectations of further increases, and so on. Bubble believers note that once stock prices started falling in 2000, they fell a great deal. It is not the case that stock prices just leveled out in 2000; they fell rapidly. People of the bubble view argue that this was simply the bubble bursting. Robert Shiller, a Yale Nobel Laureate, referred to this period as one of “irrational exuberance.” The first problem then for the stability of the macroeconomy is the large and seemingly unpredictable swings in the stock market. As we will see, these swings induce behavior changes by households and firms that affect the real economy. Before we explore this link, however, we turn to a second volatile series: housing prices. Housing Prices Since 1952 MyLab Economics Concept Check Figure 14.3 plots the relative price of housing for 1952 I–2017 IV. The plotted figure is the ratio of an index of housing prices to the GDP deflator. When this ratio is rising, it means that housing prices are rising faster than the overall price level, and vice versa when the ratio is falling. The plot in Figure 14.3 is remarkable. Housing prices grew roughly in line with the overall price level until about 2000. The increase between 2000 and 2006 was then huge, followed by an equivalent fall between 2006 and 2009. Between 2000 I and 2006 I the value of housing wealth increased by about $13 trillion, roughly $500 billion per quarter. Between 2006 II and 2009 I the fall in the value of housing wealth was about $7 trillion, more than $600 billion per quarter. Once again, it is hard to find a cogent reason for this based on the use value of housing. Rental prices, for example, did not rise and fall in this way. M14_CASE3826_13_GE_C14.indd 296 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 297 o i t a R 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarter MyLab Economics Real-time data ▴ FIGURE 14.3 Ratio of a Housing Price Index to the GDP Deflator, 1952 I–2017 IV Household Wealth Effects on the Economy MyLab Economics Concept Check We see that both the stock market and the housing market have periods of large unpredictable ups and downs. How are these swings felt in the real economy? We know from earlier that one of the factors that affects consumption expenditures is wealth. Other things being equal, the more wealth a family has, the more it spends. Much of the fluctuation in household wealth in the recent past is because of fluctuations in stock prices and housing prices. When housing and stock values rise, households feel richer and they spend more. As a rough rule of thumb, a $1.00 change in the value of wealth (either stocks or housing) leads to about a $0.03 to $0.04 change in consumer spending per year. With unpredictable wealth changes, we end up with unpredictable consumption changes and thus unpredictable changes in GDP. An increase in stock prices may also increase investment. If a firm is considering an investment project, one way in which it can finance the project is to issue additional shares of stock. The higher the price of the firm’s stock, the more money it can get per additional share issued. A firm is thus likely to undertake more investment projects the higher its stock price. The cost of an investment project in terms of shares of stock is smaller the higher the price of the stock. This is the way a stock market boom may increase investment and a stock market contraction may decrease investment. Stock price changes affect a firm’s cost of capital. Financial Crises and the 2008 Bailout MyLab Economics Concept Check It is clear that the stock market boom in the last half of the 1990s contributed to the strong economy in that period and that the contraction in the stock market after that contributed to the 2000–2001 recession. It is also clear that the boom in housing prices in the 2000–2005 period contributed to the expansion that followed the 2000–2001 recession and that the collapse of housing prices between 2006 and 2009 contributed to the 2008–2009 recession. This is just the household wealth effect at work combined in the case of stock prices with an effect on the investment spending of firms. The recession of 2008–2009 was also characterized by some observers as a period of financial crisis. Although there is no precise definition of a financial crisis, most financial writers identify financial crises as periods in which the financial institutions that facilitate the movement of capital across households and firms cease to work smoothly. In a financial crisis, macroeconomic problems caused by the wealth effect of a falling stock market or housing market are accentuated. Many people consider the large fall in housing prices that began at the end of 2006 to have led to the financial crisis of 2008–2009. We discussed briefly in Chapter 10 some of the reasons for this fall in housing prices. Lax government regulations led to excessive risk taking during the housing boom, with many people taking out mortgages that could only be sustained if housing prices kept rising. People bought houses expecting capital gains from those houses once they sold. The problem was exacerbated by low “teaser-rate” mortgage loans in which people paid very low interest M14_CASE3826_13_GE_C14.indd 297 17/04/19 4:19 AM 298 PART IV Further Macroeconomics Issues Predicting an Economy’s Future Policymakers and economists depend on economic forecasting models to predict the duration and magnitude of changes in the business cycle. These models rely on a large set of measurable economics factors, known as leading indicators, to try and provide an estimate of the future performance of GDP growth, unemployment, and inflation over a one, two, or three-year horizon. These indicators include (a) output variables such as changes in the components of GDP, capital formation, industrial production, manufacturing new orders, new credit lines, and building permits; (b) unemployment claims, job additions, wages, and labor productivity indicators; and (c) indicators of future inflation such as housing prices and producer prices. Lately, stock prices and stock market indices are also being included in the list. Does the intricacy of economic forecasting models lead to accurate forecasts? Unfortunately, no. Economists are often criticized for the unreliability of forecasting models in predicting recessions, even ones as severely damaging as the Great Depression in the 1930s and the financial crisis of 2008–2009. Some recessions are difficult to anticipate because of sudden and severe shocks and political crises, but in many cases economists are unable to read signs of an impending economic slowdown. What are these models missing? A study by the Federal Reserve Bank of New York (FRBNY)1 compares the forecasting models use
d by two major central banks, the Fed and the European Central Bank (ECB), and concludes that the main shortcomings of their models are poor assumptions and misunderstanding of the asset market boom that preceded the meltdowns. The economists at the Fed failed to account for the overvaluation of house prices and the rapid growth of new forms of mortgage finance. Both central banks failed to allocate sufficient weight to the powerful spillover effects between the financial system and the real economy. Another serious flaw was the dependence on historical figures to forecast trends, which led to unreliable predictions. A solution to account for multiple possibilities and assess each outcome is the behavioral economic model. This model takes into consideration consumer behavior and uses a scenario-driven approach, which generates a number of “what if?” scenarios that illustrate the sensitivity of economic aggregates to changes in economic conditions and macroeconomic policies. Since the two largest recessions in modern history originated in the financial sector, central banks have started using stress testing scenarios, which are “what if?” analysis to test the impact of shocks and various economic assumptions on the financial sector and the economy at large. Finally, while forecasting is an inexact science because it depends, to a great extent, on events that cannot be foreseen, social conditions could be a good prediction of impending recessions. For example, studies in the United States and the United Kingdom2 reveal that lower levels of pregnancy and higher rates of divorce usually precede economic slowdowns. It might be worthwhile for economists and policymakers to pay attention to social trends to predict economic trends! CRITICAL THINKING 1. What other factors and indicators can be included to refine economic forecasting models? 1Lucia Alessi, Eric Ghysels, Luca Onorante, Richard Peach, and Simon Potter (2014). “Central Bank Macroeconomic Forecasting during the Global Financial Crisis: The European Central Bank and Federal Reserve Bank of New York Experiences,” Federal Reserve Bank of New York Staff Reports, Staff Report No. 680, July 2014. 2Gemma Tetlow (2018). “Economists urged to use fertility to predict recessions,” The Economist, February 26. rates for the first few years of home ownership. Once housing prices started to fall, the possibility of capital gains from a house sale lessened and it became clear that many households would not be able to afford their homes once teaser rates expired. With no prospect of a profitable house sale and higher mortgage interest rates, many people defaulted on those mortgages. As a result, the value of the securities backed by these mortgages dropped sharply. Many large financial institutions were involved either directly in the mortgage market or in the market for mortgage-backed securities, and they began to experience financial trouble. With the exception of Lehman Brothers, which M14_CASE3826_13_GE_C14.indd 298 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 299 went bankrupt, most of the large financial institutions were bailed out by the federal government— a $700 billion bailout bill that was passed in October 2008. These institutions included Goldman Sachs, Citigroup, Morgan Stanley, J.P. Morgan Chase, and A.I.G. The government provided capital to these firms to ease their financial difficulties. The Federal Reserve also participated in the bailout, buying huge amounts of mortgage-backed securities. We saw in Chapter 10 that in mid-April 2018, the Fed held about $1,754 billion in mortgage-backed securities, many of which it purchased in 2008 and 2009. Many other countries had similar issues with their own financial institutions, in part because many of them had purchased U.S. mortgage-backed securities as an investment. What would have happened had the U.S. government not bailed out the large financial institutions? This is a matter of debate among economists and politicians, but some effects are clear. Absent intervention, the negative wealth effect would have been larger. Some of the financial institutions would have gone bankrupt, which would have wiped out their bondholders. Many of these bonds are held by the household sector, so household wealth would have fallen from the loss in the value of the bonds. The fall in overall stock prices would also likely have been larger, thus contributing to the negative wealth effect. The government bailout thus reduced the fall in wealth that took place during this period. Some people also argue that lending to businesses would have been lower had there been no bailout. This would have forced businesses to cut investment, thereby contributing to the contraction in aggregate demand. It is not clear how important this effect is since, as seen in Chapter 10, much of the Fed’s purchase of mortgagebacked securities ended up as excess reserves in banks, not as increased loans. It is important to distinguish between the stimulus measures the government took to fight the 2008–2009 recession, which were tax cuts and spending increases, and the bailout activity, which was direct help to financial institutions to keep them from failing. Putting aside the stimulus measures, was the bailout a good idea? On the positive side, it lessened the negative wealth effect and possibly led to more loans to businesses. Also, much of the lending to the financial institutions has or will be repaid; so the final total cost will be less than $700 billion. On the negative side, there were political and social costs. Many of the people who benefited from the bailout were wealthy—certainly wealthier than average. The bond holders of financial institutions tend to come from the top end of the income distribution. Many people noted that expenditures bailing out the financial institutions that made bad loans dwarfed expenditures to help home owners who took out those bad loans. Also, the jobs in the financial institutions that were saved were mostly jobs of high-income earners. People who will pay for the bailout in the long run are the U.S. taxpayers, who are on average less wealthy than those who benefited from the bailout. The bailout thus likely had, or at least was perceived by many to have had, bad income distribution consequences, which put a strain on the body politic. We have seen how difficult it is to predict changes in asset prices like stock and housing prices, and we have also seen how much impact these changes can have on the real economy. But many have noted that while the government may not be able to predict asset bubbles, it does influence those fluctuations through other policies. In the case of housing, at least some of the fuel driving the bubble was likely lax credit standards, credit standards controlled in part by government agencies. Recent asset bubbles also may have reflected risk taking by financial institutions, risk behavior that is also under the control of government agencies. The substantial macroeconomic costs of the most recent recession stimulated numerous calls for regulatory reform in the financial market. In 2010 a financial regulation bill, known as the Dodd-Frank bill, was passed to try to tighten up financial regulations in the hope of preventing a recurrence of the 2008–2009 financial crisis. In the late spring of 2018, Congress voted to ease some of the Dodd-Frank rules for smaller banks and credit unions. Time Lags Regarding Monetary and Fiscal Policy We have so far seen that the unpredictability of asset-price changes is difficult for policymakers to deal with. At best, policymakers can only react to these changes. The goal of stabilization policy is to smooth out fluctuation in GDP as much as possible. Consider the two possible time paths for aggregate output (income) (Y) shown in Figure 14.4. Path A (the dark blue line) represents GDP 14.2 LEARNING OBJECTIVE Explain the purpose of stabilization policies and differentiate between three types of time lags. M14_CASE3826_13_GE_C14.indd 299 17/04/19 4:19 AM 300 PART IV Further Macroeconomics Issues ▸ FIGURE 14.4 Two Possible Time Paths for GDP Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A. P D G B A stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. time lags Delays in the economy’s response to stabilization policies. Time MyLab Economics Concept Check absent stabilization policies by the government; Path B (the light blue line) shows the smoother path that stabilization policy aims to produce. Stabilization policy is also concerned with the stability of prices. Here the goal is not to prevent the overall price level from rising at all, but instead to achieve an inflation rate that is as close as possible to a target rate of about 2 percent given the government’s other goals of high and stable levels of output and employment. Stabilization goals are not easy to achieve, particularly in the light of various kinds of time lags, or delays in the response of the economy to stabilization policies. Economists generally recognize three kinds of time lags: recognition lags, implementation lags, and response lags. Figure 14.5 shows timing problems a government may face when trying to stabilize the economy. Suppose the economy reaches a peak and begins to slide into recession at point A (at time t0). Given the need to collect and process economic data, policymakers do not observe the decline in GDP until it has sunk to point B (at time t1). By the time they have begun to stimulate the economy (point C, time t2), the recession is well advanced and the economy has almost bottomed out. When the policies finally begin to take effect (point D, time t3), the economy is already on its road to recovery. The policies push the economy to point E’—a muc
h greater fluctuation than point E, which is where the economy would have been without the stabilization policy. Sometime after point D, policymakers may begin to realize that the economy is expanding too quickly. By the time they have implemented contractionary policies and the policies have made their effects felt, the economy is starting to weaken. The contractionary policies therefore end up pushing GDP to point F’ instead of point F. Because of the various time lags, the expansionary policies that should have been instituted at time t0 do not begin to have an effect until time t3, when they are no longer needed. The light blue line in Figure 14.5 shows how the economy behaves as a result of the “stabilization” policies. ▸ FIGURE 14.5 Possible Stabilization Timing Problems Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E’ and F’ (instead of points E and F). Income varies more widely than it would have if no policy had been implemented. E' E P D G A B D C t0 t1 t2 t3 t4 F F' t5 Time MyLab Economics Concept Check M14_CASE3826_13_GE_C14.indd 300 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 301 The dark blue line shows the time path of GDP if the economy had been allowed to run its course and no stabilization policies had been attempted. In this case, stabilization policy makes income more erratic, not less—the policy results in a peak income of E’ as opposed to E and a trough income of F’ instead of F. Critics of stabilization policy argue that the situation in Figure 14.5 is typical of the interaction between the government and the rest of the economy. This claim is not necessarily true. We need to know more about the nature of the various kinds of lags before deciding whether stabilization policy is good or bad. Recognition Lags MyLab Economics Concept Check It takes time for policymakers to recognize a boom or a slump. Many important data—those from the national income and product accounts, for example—are available only quarterly. It usually takes several weeks to compile and prepare even the preliminary estimates for these figures. If the economy goes into a slump on January 1, the recession may not be detected until the data for the first quarter are available at the end of April. Moreover, the early national income and product accounts data are only preliminary, based on an incomplete compilation of the various data sources. These estimates can, and often do, change as better data become available. (For example, when the Bureau of Economic Analysis first announced the results for the fourth quarter of 2012, it indicated that the economy had negative growth, –0.1%. This announcement was at the end of January 2013. At the end of February the growth rate was revised to plus 0.1%. Then at the end of March it was further revised to plus 0.4%.) This situation makes the interpretation of the initial estimates difficult, and recognition lags result. Recognition lag also kicks in on the upside of the cycle as the economy recovers from slow growth in response to government policy. When has the government done enough to stimulate the economy and when will further efforts lead to over stimulation? Janet Yellen, former chair of the Fed, spoke of exactly this concern as she contemplated changing the Fed’s easy monetary policy in the spring of 2015 in a speech in San Francisco. “We need to keep in mind the wellestablished fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.” Implementation Lags MyLab Economics Concept Check The problems that lags pose for stabilization policy do not end once economists and policymakers recognize that the economy is in a boom or a slump. Even if everyone knows that the economy needs to be stimulated or reined in, it takes time to put the desired policy into effect, especially for actions that involve fiscal policy. Implementation lags result. Each year Congress decides on the federal government’s budget for the coming year. The tax laws and spending programs embodied in this budget are hard to change once they are in place. If it becomes clear that the economy is entering a recession and is in need of a fiscal stimulus during the middle of the year, there is a limited amount that can be done. Until Congress authorizes more spending or a cut in taxes, changes in fiscal policy are not possible.2 Monetary policy is less subject to the kinds of restrictions that slow down changes in fiscal policy. As we saw in Chapter 10, the Fed’s current tool for changing the interest rate is to change the rate it pays on bank reserves. This change can be made very quickly, and there is in effect no implementation lag once the decision has been made to make the change. 2Do not forget, however, about the existence of automatic stabilizers (Chapter 9). Many programs contain built-in countercyclical features that expand spending or cut tax collections automatically (without the need for congressional or executive action) during a recession. recognition lag The time it takes for policymakers to recognize the existence of a boom or a slump. implementation lag The time it takes to put the desired policy into effect once economists and policymakers recognize that the economy is in a boom or a slump. M14_CASE3826_13_GE_C14.indd 301 17/04/19 4:19 AM 302 PART IV Further Macroeconomics Issues response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. Response Lags MyLab Economics Concept Check Even after a macroeconomic problem has been recognized and the appropriate corrective policies have been implemented, there are response lags—the time that it takes for the economy to adjust to the new conditions after a new policy is implemented; lags that occur because of the operation of the economy itself. Even after the government has formulated a policy and put it into place, the economy takes time to adjust to the new conditions. Although monetary policy can be adjusted and implemented more quickly than fiscal policy, it takes longer to make its effect felt on the economy because of response lags. What is most important is the total lag between the time a problem first occurs and the time the corrective policies are felt. Response Lags for Fiscal Policy One way to think about the response lag in fiscal policy is through the government spending multiplier. This multiplier measures the change in GDP caused by a given change in government spending or net taxes. It takes time for the multiplier to reach its full value. The result is a lag between the time a fiscal policy action is initiated and the time the full change in GDP is realized. The reason for the response lag in fiscal policy—the delay in the multiplier process—is simple. During the first few months after an increase in government spending or a tax cut, there is not enough time for the firms or individuals who benefit directly from the extra government spending or the tax cut to increase their own spending. Neither individuals nor firms revise their spending plans instantaneously. Until they can make those revisions, the increase in government spending does not stimulate extra private spending. Changes in government purchases are a component of aggregate expenditure. When G rises, aggregate expenditure increases directly; when G falls, aggregate expenditure decreases directly. When personal taxes are changed, however, an additional step intervenes, giving rise to another lag. Suppose a tax cut has lowered personal income taxes across the board. Each household must decide what portion of its tax cut to spend and what portion to save. This decision is the extra step. Before the tax cut gets translated into extra spending, households must take the step of increasing their spending, which usually takes some time. With a business tax cut, there is a further complication. Firms must decide what to do with their added after-tax profits. If they pay out their added profits to households as dividends, the result is the same as with a personal tax cut. Households must decide whether to spend or to save the extra funds. Firms may also retain their added profits and use them for investment, but investment is a component of aggregate expenditure that requires planning and time. In practice, it takes about a year for a change in taxes or in government spending to have its full effect on the economy. This response lag means that if we increase spending to counteract a recession today, the full effects will not be felt for 12 months. By that time, the state of the economy might be different. Response Lags for Monetary Policy Monetary policy works by changing interest rates—assuming that interest rates are not at the zero lower bound—which then changes planned investment. Interest rates can also affect consumption spending, as we discuss further in Chapter 15. For now, it is enough to know that lower interest rates usually stimulate consumption spending and that higher interest rates decrease consumption spending. The response of consumption and investment to interest rate changes takes time. Even if interest rates were to
rise by 5 percent overnight, firms would not immediately decrease their investment purchases. Firms generally make their investment plans several years in advance. If General Motors (GM) wants to respond to an increase in interest rates by investing less, it will take time—perhaps up to a year—for the firm to come up with plans to scrap some of its investment projects. The response lags for monetary policy are even longer than response lags for fiscal policy. When government spending changes, there is a direct change in the sales of firms, which would sell more as a result of an increase in government purchases. When interest rates change, however, the sales of firms do not change until households change their consumption spending and/or firms change their investment spending. It takes time for households and firms to respond to interest rate changes. In this sense, interest rate changes are like tax-rate changes. The resulting change in firms’ sales must wait for households and firms to change their purchases of goods. M14_CASE3826_13_GE_C14.indd 302 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 303 Summary MyLab Economics Concept Check Stabilization is thus not easily achieved even if there are no surprise asset-price changes. It takes time for policymakers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken. Monetary policy can be adjusted more quickly and easily than taxes or government spending, making it a useful instrument in stabilizing the economy. However, because the economy’s response to monetary changes is probably slower than its response to changes in fiscal policy, tax and spending changes may also play a useful role in macroeconomic management. Government Deficit Issues If a government is trying to stimulate the economy through tax cuts or spending increases, this, other things being equal, will increase the government deficit. One thus expects deficits in recessions—cyclical deficits. These deficits are temporary and do not impose any long-run problems, especially if modest surpluses are run when there is full employment. If, however, at full employment the deficit—the structural deficit—is still large, this can have negative long-run consequences. Figure 9.6 shows that the U.S. government deficit as a percentage of GDP rose rapidly beginning in 2008. In 2009 the deficit as a percentage of GDP was about 9 percent. This is huge, but most of it was cyclical because of the sharp recession. Earlier, in 2005–2007, there was roughly full employment, and during this period the deficit was about 2 percent of GDP, which we can think of as a structural deficit given that it occurred in a full employment period. By the end of 2017, with the economy essentially at full employment, the deficit was at 3.7 percent of GDP. At that point, the deficit was almost all structural. The large deficits beginning in 2008 led to a large rise in the ratio of the federal government debt to GDP. Figure 9.7 in Chapter 9 shows that the ratio peaked at the end of 2012, where it was about 70 percent. (This is up from about 46 percent in 2007.) Since 2012 the ratio has remained large. At the end of 2017 it was about 69 percent. One concern about a rising debt-to-GDP ratio for a country is that at some point investors may begin to perceive that the bonds the country is selling to finance its deficits are now riskier. This will increase the interest rate that the country must pay on its bonds, which will add further to the deficit as interest payments rise. This may in turn force the country to drastically cut spending or increase taxes, which may have large negative effects on the economy. Deficit Targeting MyLab Economics Concept Check Debates about deficits have been around for a long time. In the 1980s the U.S. government was spending much more than it was receiving in taxes. In response to the large deficits, in 1986 the U.S. Congress passed and President Reagan signed the Gramm-Rudman-Hollings Act (named for its three congressional sponsors), referred to as GRH. It is interesting to look back on this in the context of the current deficit problem. GRH set a target for reducing the federal deficit by a set amount each year. As Figure 14.6 shows, the deficit was to decline by $36 billion per year between 1987 and 1991, with a deficit of zero slated for fiscal year 1991. What was interesting about the GRH legislation was that the targets were not merely guidelines. If Congress, through its decisions about taxes and spending programs, produced a budget with a deficit larger than the targeted amount, GRH called for automatic spending cuts. The cuts were divided proportionately among most federal spending programs so that a program that made up 5 percent of total spending was to endure a cut equal to 5 percent of the total spending cut.3 3Programs such as Social Security were exempt from cuts or were treated differently. Interest payments on the federal debt were also immune from cuts. 14.3 LEARNING OBJECTIVE Discuss the effects of government deficits and deficit targeting. Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. M14_CASE3826_13_GE_C14.indd 303 17/04/19 4:19 AM 304 PART IV Further Macroeconomics Issues ▸ FIGURE 14.6 Deficit Reduction Targets under Gramm-RudmanHollings The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991. MyLab Economics Concept Check ) 150 $125 $100 $75 $50 $25 $0 $144 $108 $72 $36 1987 1988 1989 Fiscal year 1990 1991 In 1986, the U.S. Supreme Court declared part of the GRH bill unconstitutional. In effect, the Court said that Congress would have to approve the “automatic” spending cuts before they could take place. The law was changed in 1986 to meet the Supreme Court ruling and again in 1987, when new targets were established. The new targets had the deficit reaching zero in 1993 instead of 1991. The targets were revised again in 1991, when the year to achieve a zero deficit was changed from 1993 to 1996. In practice, these targets never came close to being achieved. As time wore on, even the revised targets became completely unrealistic, and by the end of the 1980s, the GRH legislation was not taken seriously. Although the GRH legislation is history, it is useful to consider the stabilization consequences of deficit targeting. What if deficit targeting is taken seriously? In the spring of 2018 House Republicans again offered up a balanced budget amendment for a vote, although it failed to get the two thirds majority vote needed to pass. Balanced budget rules require that the government not run a deficit ever. Is this good policy? The answer is probably not. We will now show how deficit targeting can make the economy more unstable. In a world with no deficit targeting, Congress and the president make decisions each year about how much to spend and how much to tax. The federal government deficit is a result of these decisions and the state of the economy. However, with deficit targeting, the size of the deficit is set in advance. Taxes and government spending must be adjusted to produce the required deficit, or in the case of a balanced budget world, no deficit. In this situation, the deficit is no longer a consequence of the tax and spending decisions. Instead, taxes and spending become a consequence of the deficit decision. What difference does it make whether Congress chooses a target deficit and adjusts government spending and taxes to achieve that target or decides how much to spend and tax and lets the deficit adjust itself? The difference may be substantial. Consider a leftward shift of the AD curve caused by some negative demand shock. A negative demand shock is something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports. We know that a leftward shift of the AD curve lowers aggregate output (income), which causes the government deficit to increase. In a world without deficit targeting, the increase in the deficit during contractions provides an automatic stabilizer for the economy. (Review Chapter 9 if this point is hazy.) The contraction-induced decrease in tax revenues and increase in transfer payments tend to reduce the fall in after-tax income and consumer spending because of the negative demand shock. Thus, the decrease in aggregate output (income) caused by the negative demand shock is lessened somewhat by the growth of the deficit [Figure 14.7(a)]. In a world with deficit targeting, the deficit is not allowed to rise. Some combination of tax increases and government spending cuts would be needed to offset what would have otherwise been an increase in the deficit. We know that increases in taxes or cuts in spending are contractionary in themselves. The contraction in the economy will therefore be larger than it would have been without deficit targeting because the initial effect of the negative demand shock is worsened by the rise in taxes or the cut in government spending required to keep the deficit from rising. As Figure 14.7(b) shows, deficit targeting acts as an automatic destabilizer. It requires taxes to be raised and government spending to be cut during a contraction. This reinforces, rather than counteracts, the shock that started the contraction. automatic stabilizer Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. automatic destabilizer Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. M14_CASE3826_13_GE_C14.ind
d 304 17/04/19 4:19 AM CHAPTER 14 Financial Crises, Stabilization, and Deficits 305 a. Without Deficit Targeting MyLab Economics Concept Check Positive boost to demand reduces the shock (automatic stabilizers) Negative demand shock Income falls Tax revenues drop; transfers increase Deficit increases ◂ FIGURE 14.7 Deficit Targeting as an Automatic Destabilizer Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred. b. With Deficit Targeting Negative demand shock Income falls Tax revenues drop; transfers increase Deficit increases Second negative demand shock reinforces first shock and worsens the contraction Tax rates raised or spending cut to reach deficit target (automatic destabilizer) Deficit targeting thus has undesirable macroeconomic consequences. It requires cuts in spending or increases in taxes at times when the economy is already experiencing problems. This drawback does not mean, of course, that a government should ignore structural deficit problems. Locking in spending cuts or tax increases during periods of negative demand shocks is not a good way to manage the economy. Moving forward, policymakers around the globe will have to devise other methods to control growing structural deficits. S U M M A R Y 14.1 THE STOCK MARKET, THE HOUSING MARKET, AND FINANCIAL CRISES p. 293 in housing prices beginning in 2006 led to the recession and financial crisis of 2008–2009. 1. A firm can finance an investment project by borrowing from banks, by issuing bonds, or by issuing new shares of its stock. People who own shares of stock own a fraction of the firm. 2. The price of a stock should equal the discounted value of its expected future dividends, where the discount factors depend on the interest rate and risk. 3. A bubble exists when the price of a stock exceeds the dis- counted value of its expected future dividends. In this case what matters is what people expect that other people expect about how much the stock can be sold for in the future. 4. The largest stock market boom in U.S. history occurred between 1995 and 2000, when the S&P 500 index rose by 25 percent per year. The boom added $14 trillion to household wealth. 5. Why there was a stock market boom in 1995–2000 appears to be a puzzle. There was nothing unusual about earnings that would predict such a boom. Many people believe that the boom was merely a bubble. 6. Housing prices rose rapidly between 2000 and 2006 and fell rapidly between 2006 and 2009. Many consider that the fall 7. Changes in stock prices and housing prices change household wealth, which affects consumption and thus the real economy. Changes in stock and housing prices are largely unpredictable, which makes many fluctuations in the economy unpredictable. 14.2 TIME LAGS REGARDING MONETARY AND FISCAL POLICY p. 299 8. Stabilization policy describes both fiscal and monetary policies, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. Stabilization goals are not necessarily easy to achieve because of the existence of certain time lags, or delays in the response of the economy to macroeconomic policies. 9. A recognition lag is the time it takes for policymakers to recognize the existence of a boom or a slump. An implementation lag is the time it takes to put the desired policy into effect once economists and policymakers recognize that the economy is in a boom or a slump. A response lag is the time it takes for the economy to adjust to the new conditions after a new policy is implemented—in other words, a lag that MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M14_CASE3826_13_GE_C14.indd 305 17/04/19 4:19 AM 306 PART IV Further Macroeconomics Issues occurs because of the operation of the economy itself. In general, monetary policy can be implemented more rapidly than fiscal policy but fiscal policy generally has a shorter response lag than monetary policy. 11. In 1986 Congress passed and President Reagan signed the Gramm-Rudman-Hollings Act (GRH), which set deficit targets for each year. The aim was to reduce the large structural deficit that existed. 14.3 GOVERNMENT DEFICIT ISSUES p. 303 10. The U.S. debt-to-GDP ratio has remained high since 2012, and it is projected to increase substantially beyond 2017. 12. Deficit-targeting measures that call for automatic spending cuts to eliminate or reduce the deficit, like the GRH legislation, may have the effect of destabilizing the economy automatic destabilizers, p. 304 automatic stabilizers, p. 304 capital gain, p. 293 Dow Jones Industrial Average, p. 295 Gramm-Rudman-Hollings Act, p. 303 implementation lag, p. 301 NASDAQ Composite, p. 295 realized capital gain, p. 293 recognition lag, p. 301 response lag, p. 302 stabilization policy, p. 300 Standard and Poor’s 500 (S&P 500), p. 295 stock, p. 293 time lags, p. 300 P R O B L E M S All problems are available on MyLab Economics. 14.1 THE STOCK MARKET, THE HOUSING MARKET, AND FINANCIAL CRISES LEARNING OBJECTIVE: Discuss the effects of historical fluctuations in stock and housing prices on the economy. 1.1 In July 2009, the S&P 500 index was at 1,000. a. What is the S&P 500 index? b. Where is the S&P today? c. If you had invested $10,000 in July2009 and your investments had increased in value by the same percentage as the S&P 500 index had increased, how much would you have today? d. Assume that the total stock market holdings of the household sector were about $20 trillion and that the entire stock market went up/down by the same percentage as the S&P. Evidence suggests that the “wealth effect” of stock market holdings on consumer spending is about 4 percent of wealth annually. How much additional or reduced spending would you expect to see as a result of the stock market moves since July 2009? Assuming a multiplier of two and a GDP of $18,000 billion, how much additional/ less GDP would you predict for next year if all of this was true? 1.2 During 1997, stock markets in Asia collapsed. Hong Kong’s was down nearly 30 percent, Thailand’s was down 62 percent, and Malaysia’s was down 60 percent. Japan and Korea experienced big drops as well. What impacts would these events have on the economies of the countries themselves? Explain your answer. In what ways would you have expected these events to influence the U.S. economy? How might the spending of Asians on American goods be affected? What about Americans who have invested in these countries? 14.2 TIME LAGS REGARDING MONETARY AND FISCAL POLICY LEARNING OBJECTIVE: Explain the purpose of stabilization policies and differentiate between three types of time lags. 2.1 In January 2013, the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), also referred to as the Fiscal Stability Treaty, came into effect in the European Union. According to this treaty, the budgets of the nation states have to be in balance or in surplus, otherwise certain automatic correction mechanisms come into force. For countries with debt over 60 percent of GDP, the treaty outlines the ratio by which their debt has to decrease annually. Why do you think this treaty was adopted and why do you think that expansionary fiscal policies were not pursued rather? 2.2 Explain why stabilization policy may be difficult to carry out. How is it possible that stabilization policies can actually be destabilizing? 2.3 [Related to the Economics in Practice on p. 298] The Economics in Practice states that since recessions can be hard to forecast, the recognition lag can be long, as was the case with the recession of 2008–2009. Assuming that the recognition lag with regards to this recession was the same for both federal government and Federal Reserve MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M14_CASE3826_13_GE_C14.indd 306 17/04/19 4:19 AM policymakers, explain which type of policy, fiscal or monetary, should have been the quickest to take effect in the economy and with which of these policies should the economy have most rapidly adjusted to the newly implemented conditions. 14.3 GOVERNMENT DEFICIT ISSUES LEARNING OBJECTIVE: Discuss the effects of government deficits and deficit targeting. 3.1 Explain why the government deficit rises as the economy contracts and why the government deficit falls when the economy expands. 3.2 You are given the following information about the econ- omy in 2019 (all in billions of dollars): Consumption function: Taxes: Investment function: Disposable income: Government spending: Equilibrium: Hint: Deficit is D = G - T = G - C = 100 + T = - 150 + 1 I = 60 Yd = Y - T G = 80 Y = C + I + G .25 * Y 1 - 150 + .8 * Yd .25 * Y 2 2 . a. Find equilibrium income. Show that the government budget deficit (the difference between government spending and tax revenues) is $5 billion. 2 4 1 3 b. Congress passes the Foghorn-Leghorn (F-L) amendment, which requires that the deficit be zero this year. If the budget adopted by Congress has a deficit that is larger than zero, the deficit target must be met by cutting spending. Suppose spending is cut by $5 billion (to $75 billion). What is the new value for equilibrium GDP? What is the new deficit? Explain carefully why the deficit is not zero. CHAPTER 14 Financial Crises, Stabilization, and Deficits 307 c. Suppose the F-L amendment was not in effect and planned investment falls to I = 55. What is the new value of GDP? What is the new government budget deficit? What happens to GDP if the F-L amendment is in effect and spending is cut to reach the deficit target? (Hint: Spending must be cut by $21.666 billion to b
alance the budget.) 3.3 In the wake of the 2007–2008 crisis, and especially in 2010–2012, the eurozone underwent severe strains on its government bond markets. Although no European country has defaulted (yet) on its bonds, several countries have had to resort to exceptional measures, in part financed by the European Central Bank, to overcome the crisis. Do some research to find information on any two countries that are most affected by the European debt crisis and explain how this might have happened. Find the most recent data on the interest rates these countries pay for their bonds and how these rates compare to those for bonds by the German treasury. 3.4 Suppose the government decides to decrease spending and increase taxes to reduce public deficit. Is it possible for the central bank to adopt measures that will offset the impact of the new fiscal policy on aggregate output? How? 3.5 If the government implements a spending and tax policy in which it promises to neither increase nor decrease spending and taxes, is it still possible for the budget deficit to increase or decrease? Explain. 3.6 In the United Kingdom, the Office for Budget Responsibility (OBR) is in charge of, among other things, the publications of economic forecast concerning the country’s fiscal deficits. In November 2016, the OBR forecast a public sector net borrowing of 3.5 percent of GDP for 2016–2017. Go to the OBR website and look up the current forecast. How has it changed since 2016? What are some of the reasons for this change QUESTION 1 As indicated in Figure 14.3, housing prices have risen substantially over the past few years. The composition of buyers (based on credit scores and median household incomes), however, is different from the composition of buyers in 2006. How does the composition of buyers affect the severity of a potential housing market bust? QUESTION 2 Deficit targeting could lead to the wrong type of fiscal policies being enacted during a recession. How is this so? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M14_CASE3826_13_GE_C14.indd 307 17/04/19 4:19 AM Household and Firm Behavior in the Macroeconomy: A Further Look1 15 CHAPTER OUTLI NE AND LEARNING OBJECTIVES 15.1 Households: Consumption and Labor Supply Decisions p. 309 Describe factors that affect household consumption and labor supply decisions. 15.2 Firms: Investment and Employment Decisions p. 317 Describe factors that affect the investment and employment decisions of firms. 15.3 Productivity and the Business Cycle p. 322 Explain why productivity is procyclical. 15.4 The ShortRun Relationship between Output and Unemployment p. 323 Describe the short-run relationship between output and unemployment. 15.5 The Size of the Multiplier p. 324 Identify factors that affect multiplier size. In Chapters 8 through 14, we considered the interactions of households, firms, and the government in the goods, money, and labor markets. In these chapters, we assumed that household consumption (C) depends only on income and that firms’ planned investment (I) depends only on the interest rate. In this chapter, we present a more realistic picture of the influences on households’ consumption and labor supply decisions and on firms’ investment and employment decisions. We use the insights developed here to then analyze a richer set of macroeconomic issues. 308308 1This chapter is somewhat more advanced, but it contains a lot of interesting information! M15_CASE3826_13_GE_C15.indd 308 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 309 Households: Consumption and Labor Supply Decisions For most of our analysis so far, we have been assuming that consumption depends simply on income. Although this is a useful starting point, and income is in fact the most important determinant of consumption, it is not the only thing that determines household consumption decisions. We need to consider other theories of consumption to build a more realistic description of household behavior. 15.1 LEARNING OBJECTIVE Describe factors that affect household consumption and labor supply decisions. The Life-Cycle Theory of Consumption MyLab Economics Concept Check Most people make consumption decisions based not only on current income but also on what they expect to earn later in life. Many of you, as young college students, are consuming more than you currently earn as you anticipate future earnings, whereas a number of your instructors are consuming less than they currently earn as they save for retirement without labor earnings. The model of consumption that is based on the idea that people track lifetime income when they make consumption decisions is called the life-cycle theory of consumption. The lifetime income and consumption pattern of a representative individual is shown in Figure 15.1. As you can see, this person has a low income during the first part of her life, high income in the middle, and low income again in retirement. Her income in retirement is not zero because she has income from sources other than her own labor—Social Security payments, interest and dividends, and so on. The consumption path as drawn in Figure 15.1 is constant over the person’s life. This is an extreme assumption, but it illustrates the point that the path of consumption over a lifetime is likely to be more stable than the path of income. We consume an amount greater than our incomes during our early working careers. We do so by borrowing against future income by taking out a car loan, a mortgage to buy a house, or a loan to pay for college. This debt is repaid when our incomes have risen and we can afford to use some of our income to pay off past borrowing without substantially lowering our consumption. The reverse is true for our retirement years. Here, too, our incomes are low. We can save up a “nest egg” that allows us to maintain an acceptable standard of living during retirement because we consume less than we earn during our prime working years. Fluctuations in wealth are also an important component of the life-cycle story. Many young households borrow in anticipation of higher income in the future. Some households actually have negative wealth—the value of their assets is less than the debts they owe. A household in its prime working years saves to pay off debts and to build up assets for its later years, when income typically goes down. Households whose assets are greater than the debts they owe have positive wealth. With its wage earners retired, a household consumes its accumulated wealth. Generally speaking, wealth starts out negative, turns positive, and then approaches zero near the end of life. Wealth, therefore, is intimately linked to the cumulative saving and dissaving behavior of households. life-cycle theory of consumption A theory of household consumption: Households make lifetime consumption decisions based on their expectations of lifetime income. Saving Income Consumption Borrowing Spending accumulated savings ◂◂ FIGURE 15.1 Life-Cycle Theory of Consumption In their early working years, people consume more than they earn. This is also true in the retirement years. In between, people save (consume less than they earn) to pay off debts from borrowing and to accumulate savings for retirement. 20 30 40 50 Age 60 70 80 MyLab Economics Concept Check M15_CASE3826_13_GE_C15.indd 309 17/04/19 4:20 AM 310 PART IV Further Macroeconomics Issues permanent income The average level of a person’s expected future income stream. The key difference between the Keynesian theory of consumption and the life-cycle theory is that the life-cycle theory suggests that consumption and saving decisions are likely to be based not only on current income but also on expectations of future income. The consumption behavior of households immediately following World War II clearly supports the life-cycle story. Just after the war ended, income fell as wage earners moved out of war-related work. However, consumption spending did not fall commensurately, as Keynesian theory would predict. People expected to find jobs in other sectors eventually, and they did not adjust their consumption spending to the temporarily lower incomes they were earning in the meantime. The term permanent income is sometimes used to refer to the average level of a person’s expected future income stream. If you expect your income will be high in the future (even though it may not be high now), your permanent income is said to be high. With this concept, we can sum up the life-cycle theory by saying that current consumption decisions are likely to be based on permanent income instead of current income.2 This means that policy changes such as tax-rate changes are likely to have more of an effect on household behavior if they are expected to be permanent instead of temporary. One-time tax rebates such as we saw in the United States in 2001 and 2008 provide an interesting test of the permanent income hypothesis. In both cases, the tax rebate was a one-time stimulus. In 2008, for example, the tax rebate was $300 to $600 for individual tax payers eligible for the rebate. How much would we expect this rebate to influence consumption? The simple Keynesian model that we introduced previously in this text would just apply the marginal propensity to consume to the $600. If the marginal propensity to consume is 0.8, we would expect the $600 to generate $480 in incremental spending per rebate. The permanent income hypothesis instead looks at the $600 in the context of an individual’s permanent income. As a fraction of one’s lifetime income, $600 is a modest number, and we would thus expect individuals to increase their spending only modestly in response to the rebate. Research on the 2001 tax rebate by Matthew Shapiro and Joel Slemrod, based on surveys of consumers, suggested that most people planne
d to use their rebates to lower debt, rather than increase spending. This is consistent with the life-cycle model. Although the life-cycle model enriches our understanding of the consumption behavior of households, the analysis is still missing something. What is missing is the other main decision of households: the labor supply decision. The Labor Supply Decision MyLab Economics Concept Check The size of the labor force in an economy is of obvious importance. A growing labor force is one of the ways in which national income/output can be expanded, and the larger the percentage of people who work, the higher the potential output per capita. So far we have said little about what determines the size of the labor force. Of course, demographics are a key element; the number of children born in 2018 will go a long way toward determining the potential number of 20-year-old workers in 2038. In addition, immigration, both legal and illegal, plays a role. Behavior also plays a role. Households make decisions about whether to work and how much to work. These decisions are closely tied to consumption decisions because for most households, the bulk of their spending is financed out of wages and salaries. Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply because it is precisely by selling your labor that you earn income to pay for your consumption. As we discussed in Chapter 3, the alternative to supplying your labor in exchange for a wage or a salary is leisure or other nonmarket activities. Nonmarket activities include raising a child, going to school, keeping a house, or—in a developing economy—working as a subsistence farmer. What determines the quantity of labor supplied by a household? Among the list of factors are the wage rate, prices, wealth, and nonlabor income. 2The pioneering work on this topic was done by Milton Friedman, A Theory of the Consumption Function (Princeton, NJ: Princeton University Press, 1957). In the mid-1960s, Franco Modigliani did closely related work that included the formulation of the life-cycle theory. M15_CASE3826_13_GE_C15.indd 310 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 311 The Wage Rate A changing wage rate can affect labor supply, but whether the effect is positive or negative is ambiguous. An increase in the wage rate affects a household in two ways. First, work becomes more attractive relative to leisure and other nonmarket activities. The opportunity cost of leisure is higher because every hour spent in leisure now requires giving up a higher wage. As a result, you would expect that a higher wage would lead to a larger quantity of labor supplied—a larger workforce. This is called the substitution effect of a wage rate increase. On the other hand, household members who work are clearly better off after a wage rate increase. By working the same number of hours as they did before, they will earn more income. If we assume that leisure is a normal good, people with higher income will spend some of it on leisure by working less. This is the income effect of a wage rate increase. When wage rates rise, the substitution effect suggests that people will work more, whereas the income effect suggests that they will work less. The ultimate effect depends on which separate effect is more powerful. The data suggest that the substitution effect seems to win in most cases. That is, higher wage rates usually lead to a larger labor supply and lower wage rates usually lead to a lower labor supply. Prices Prices also play a major role in the consumption/labor supply decision. In our discussions of the possible effects of an increase in the wage rate, we have been assuming that the prices of goods and services do not rise at the same time. If the wage rate and all other prices rise simultaneously, the story is different. To make things clear, we need to distinguish between the nominal wage rate and the real wage rate. The nominal wage rate is the wage rate in current dollars. When we adjust the nominal wage rate for changes in the price level, we obtain the real wage rate. The real wage rate measures the amount that wages can buy in terms of goods and services. Workers do not care about their nominal wage—they care about the purchasing power of this wage—the real wage. Suppose skilled workers in Indianapolis were paid a wage rate of $20 per hour in 2017. Now suppose their wage rate rose to $22 in 2018, a 10 percent increase. If the prices of goods and services were the same in 2018 as they were in 2017, the real wage rate would have increased by 10 percent. An hour of work in 2018 ($22) buys 10 percent more than an hour of work in 2017 ($20). What if the prices of all goods and services also increased by 10 percent between 2017 and 2018? The purchasing power of an hour’s wages has not changed. The real wage rate has not increased at all. In 2018, $22 bought the same quantity of goods and services that $20 bought in 2017. To measure the real wage rate, we adjust the nominal wage rate with a price index. As we saw in Chapter 7, there are several such indices that we might use, including the consumer price index and the GDP price deflator.3 We can now apply what we have learned from the life-cycle theory to our wage/price story. Recall that the life-cycle theory says that people look ahead in making their decisions. Translated to real wage rates, this idea says that households look at expected future real wage rates as well as the current real wage rate in making their current consumption and labor supply decisions. Consider, for example, medical students who expect that their real wage rate will be higher in the future. This expectation obviously has an effect on current decisions about things like how much to buy and whether to take a part-time job. Wealth and Nonlabor Income Life-cycle theory implies that wealth fluctuates over the life cycle. Households accumulate wealth during their working years to pay off debts accumulated when they were young and to support themselves in retirement. This role of wealth is clear, but the existence of wealth poses another question. Consider two households that are at the same stage in their life cycle and have similar expectations about future wage rates, prices, and so on. They expect to live the same length of time, and both plan to leave the same amount to their children. They differ only in their wealth. Due to a past inheritance, household one has more wealth than household two. Which household is likely to have a higher consumption path for the rest of its life? Household one is because it has more wealth to spread out over the rest of 3To calculate the real wage rate, we divide the nominal wage rate by the price index. Suppose the wage rate rose from $10 per hour in 1998 to $18 per hour in 2010 and the price level rose 50 percent during the same period. Using 1998 as the base year, the price index would be 1.00 in 1998 and 1.50 in 2010. The real wage rate is W/P, where W is the nominal wage rate and P is the price level. Using 1998 as the base year, the real wage rate is $10 in 1998 ($10.00/1.00) and $12 in 2010 ($18.00/1.50). nominal wage rate The wage rate in current dollars. real wage rate The amount the nominal wage rate can buy in terms of goods and services. M15_CASE3826_13_GE_C15.indd 311 17/04/19 4:20 AM 312 PART IV Further Macroeconomics Issues nonlabor, or nonwage, income Any income received from sources other than working—inheritances, interest, dividends, transfer payments, and so on. its life. Holding everything else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume both now and in the future. Now consider a household that has a sudden unexpected increase in wealth, perhaps an inheritance from a distant relative. How will the household’s consumption pattern be affected? Few spend the entire inheritance all at once. Most households will increase consumption both now and in the future, spending the inheritance over the course of the rest of their lives. An increase in wealth can also be looked on as an increase in nonlabor income. Nonlabor, or nonwage, income is income received from sources other than working— inheritances, interest, dividends, and transfer payments, such as welfare payments and Social Security payments. As with wealth, an unexpected increase in nonlabor income will have a positive effect on a household’s consumption. What about the effect of an increase in wealth or nonlabor income on labor supply? We already know that an increase in income results in an increase in the consumption of normal goods, including leisure. Therefore, an unexpected increase in wealth or nonlabor income results in an increase in consumption and an increase in leisure. With leisure increasing, labor supply must fall. So an unexpected increase in wealth or nonlabor income leads to a decrease in labor supply. This point should be obvious. If you suddenly win a million dollars in the state lottery or make a killing in the stock market, you will probably work less in the future than you otherwise would have. Interest Rate Effects on Consumption MyLab Economics Concept Check Recall from the last few chapters that the interest rate affects a firm’s investment decision. A higher interest rate leads to a lower level of planned investment and vice versa. This was a key link between the money market and the goods market, and it was the channel through which monetary policy had an impact on planned aggregate expenditure. We can now expand on this link: The interest rate also affects household behavior. Consider the effect of a fall in the interest rate on consumption. A fall in the interest rate lowers the reward to saving. If the interest rate falls from 10 percent to 5 percent, you earn 5 cents instead of 10 cents per year on every dollar saved. This means that the opportunit
y cost of spending a dollar today (instead of saving it and consuming it plus the interest income a year from now) has fallen. You will substitute toward current consumption and away from future consumption when the interest rate falls: You consume more today and save less. A rise in the interest rate leads you to consume less today and save more. This effect is called the substitution effect. There is also an income effect of an interest rate change on consumption. If a household has positive wealth and is earning interest on that wealth, a fall in the interest rate leads to a fall in interest income. This is a decrease in its nonlabor income, which, as we just saw, has a negative effect on consumption. For households with positive wealth, the income effect works in the opposite direction from the substitution effect. On the other hand, if a household is a debtor and is paying interest on its debt, a fall in the interest rate will lead to a fall in interest payments. The household is better off in this case and will consume more. In this case, the income and substitution effects work in the same direction. The total household sector in the United States has positive wealth, and so in the aggregate, the income and substitution effects work in the opposite direction. Government Effects on Consumption and Labor Supply: Taxes and Transfers MyLab Economics Concept Check The government influences household behavior mainly through income tax rates and transfer payments. When the government raises income tax rates, after-tax real wages decrease, lowering consumption. When the government lowers income tax rates, after-tax real wages increase, raising consumption. A change in income tax rates also affects labor supply. If the substitution effect dominates, as we are generally assuming, an increase in income tax rates, which lowers after-tax wages, will lower labor supply. A decrease in income tax rates will increase labor supply. There is much debate about the size of these effects. If the labor elasticity is very high, raising rates could substantially M15_CASE3826_13_GE_C15.indd 312 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 313 TABLE 15.1 The Effects of Government on Household Consumption and Labor Supply Income Tax Rates Transfer Payments Increase Negative Negative* Decrease Positive Positive* Increase Positive Negative Decrease Negative Positive Effect on consumption Effect on labor supply *If the substitution effect dominates. Note: The effects are larger if they are expected to be permanent instead of temporary. reduce economic activity and even lead to a reduction in aggregate tax revenue. A recent review article, however, suggests that labor supply is relatively inelastic to changes in the marginal tax rate, indicating that increasing tax rates somewhat would likely increase total tax revenues.4 Transfer payments are payments such as Social Security benefits, veterans’ benefits, and general assistance to the needy. An increase in transfer payments is an increase in nonlabor income, which we have seen has a positive effect on consumption and a negative effect on labor supply. Increases in transfer payments thus increase consumption and decrease labor supply, whereas decreases in transfer payments decrease consumption and increase labor supply. Table 15.1 summarizes these results. A Possible Employment Constraint on Households MyLab Economics Concept Check Our discussion of the labor supply decision has so far proceeded as if households were free to choose how much to work each period. If a member of a household wants to work an additional five hours a week at the current wage rate, we have assumed that the person can work five hours more—that work is available. If someone who has not been working decides to work at the current wage rate, we have assumed that the person can find a job. There are times when these assumptions do not hold and individuals are constrained in the hours they can work. A household constrained from working as much as it would like at the current wage rate faces a different decision from the decision facing a household that can work as much as it wants. The work decision of the former household is, in effect, forced on it. The household works as much as it can—a certain number of hours per week or perhaps none at all—but this amount is less than the household would choose to work at the current wage rate if it could find more work. The amount that a household would like to work at the current wage rate if it could find the work is called its unconstrained supply of labor. The amount that the household actually works in a given period at current wage rates is called its constrained supply of labor. A household’s constrained supply of labor is not a variable over which it has any control. The amount of labor the household supplies is imposed on it from the outside by the workings of the economy. Under these conditions, we do not expect changes in tax rates, for example, to influence labor supply behavior in the way we see in unconstrained markets. However, the household’s consumption is under its control. We know that the less a household works—that is, the smaller the household’s constrained supply of labor is—the lower its consumption will be. Constraints on the supply of labor are an important determinant of consumption. Interestingly, some of the recent changes in the nature of the labor market with the rise in flexible-hour jobs like Uber, Lyft, Task Rabbit, and the like may have relaxed constraints on labor supply choice for some people. Keynesian Theory Revisited Recall the Keynesian theory that current income determines current consumption. We now know the consumption decision is made jointly with the labor supply decision and the two depend on the real wage rate. It is incorrect to think that consumption depends only on income, at least when there is full employment. However, if there is unemployment, and labor supply is constrained on the upside, Keynes is closer to being correct because 4Emmanuel Saez, Joel Slemrod and Seth Giertz, “The elasticity of taxable income with respect to marginal tax rates: A critical review,” Journal of Economic Literature, March 2012 3–50. unconstrained supply of labor The amount a household would like to work within a given period at the current wage rate if it could find the work. constrained supply of labor The amount a household actually works in a given period at the current wage rate. M15_CASE3826_13_GE_C15.indd 313 17/04/19 4:20 AM 314 PART IV Further Macroeconomics Issues the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms and not on household decisions. In this case, it is income that affects consumption, not the wage rate. For this reason Keynesian theory is considered to pertain to periods of unemployment. It was, of course, precisely during such a period that the theory was developed. A Summary of Household Behavior MyLab Economics Concept Check This completes our discussion of household behavior in the macroeconomy. Household consumption depends on more than current income. Households determine consumption and labor supply simultaneously, and they look ahead in making their decisions. The following factors affect household consumption and labor supply decisions: ■■ Current and expected future real wage rates ■■ Initial value of wealth ■■ Current and expected future nonlabor income ■■ Interest rates ■■ Current and expected future tax rates and transfer payments If households are constrained in their labor supply decisions, income is directly determined by firms’ hiring decisions. In this case, the Keynesian focus on consumption as a function of income alone has more power. The Household Sector Since 1970 MyLab Economics Concept Check To better understand household behavior, we will examine how some of the aggregate household variables have changed over time. We will discuss the period 1970 I–2017 IV. (Remember, Roman numerals refer to quarters, that is, 1970 I means the first quarter of 1970.) Within this span, there have been five recessionary periods: 1974 I–1975 I, 1980 II–1982 IV, 1990 III–1991 I, 2001 I–2001 III, and 2008 I–2009 II. How did the household variables behave during each period? Consumption Data on the total consumption of the household sector are in the national income accounts. As we saw in Table 6.2, personal consumption expenditures accounted for 69.1 percent of GDP in 2017. The three basic categories of consumption expenditures are services, nondurable goods, and durable goods. Figure 15.2 plots the data for consumption expenditures on services and nondurable goods combined and for consumption expenditures on durable goods. The variables are in real terms. You can see that expenditures on services and nondurable goods are “smoother” over time 10,800 9,800 8,800 7,800 6,800 5,800 4,800 3,800 Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (2008 I– 2009 II) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) Services and nondurable goods (left scale) Durable goods (right scale) 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 ◂▸ FIGURE 15.2 Consumption Expenditures, 1970 I–2017 IV Over time, expenditures on services and nondurable goods are “smoother” than expenditures on durable goods. 2,800 1970 I 1980 I MyLab Economics Real-time data 1975 I 1985 I 1990 I 1995 I Quarters 2000 I 2005 I 2010 I 100 2015 I 2017 IV M15_CASE3826_13_GE_C15.indd 314 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 315 Measuring Housing Price Changes We have suggested in the text that the rapid rise in housing prices in the period from 2000 to 2006 and the subsequent rapid fall of those prices after 2006 may have played a role in the 2008–2009 recession. There has been a good deal of work in econ
omics tracing the links between what has been called the housing bubble and that recession, particularly on the bursting of the bubble on bank stability. But how do we measure housing price changes? After all, houses are all different. Measuring price changes in houses is much harder than measuring price changes in oil, or even price changes in milk or cans of tuna fish. One possibility is to look at changes in the average price of a house in a city over time. However, if in year one mostly modest split-levels change hands, while in year two most of the houses sold are McMansions, then changes in the average price will not do a very good job of capturing housing price inflation. An alternative is to try to standardize the house type, say looking at the change in the average price of a four-bedroom house in an area over time. This is better, but still leaves one with a lot of heterogeneity. In fact, one of the authors of this text, Karl Case, working with Robert Shiller, a behavioral finance economist, developed an index (aptly named the Case-Shiller index) that neatly solves the problem that houses are all different. The Case-Shiller index looks only at houses that have sold multiple times and asks the question: How much does an identical house sell for now versus that same house in the past? The index, developed first in Boston, is now computed for a number of large housing areas. In fact, the index itself is commonly reported on the financial pages and shows housing price changes for 10-city and 20-city bundles. So what does the Case-Shiller index tell us about the present? From 1996 to 2006, the Case-Shiller index increased by 125 percent, only to fall by 38 percent from 2006 to 2011. 2012 and early 2013 looked much better, with an annual increase of 7.3 percent in the 10-city index and 8.1 percent for the 20-city index as of April 2013. CRITICAL THINKING 1. Who, other than macroeconomists, might be inter- ested in the Case-Shiller index? than expenditures on durable goods. For example, the decrease in expenditures on services and nondurable goods was much smaller during the five recessionary periods than the decrease in expenditures on durable goods. Why do expenditures on durables fluctuate more than expenditures on services and nondurables? When times are bad, people can postpone the purchase of durable goods, which they do. It follows that expenditures on these goods change the most. When times are tough, you do not have to have a new car or a new smartphone; you can make do with your old Chevy or iPhone until things get better. When your income falls, it is not as easy to postpone the service costs of day care or health care. Nondurables fall into an intermediate category, with some items (such as new clothes) easier to postpone than others (such as food). Housing Investment Another important expenditure of the household sector is housing investment (purchases of new housing), plotted in Figure 15.3. Housing investment is the most easily postponable of all household expenditures, and it has large fluctuations. The fluctuations are remarkable between 2003 and 2010. Housing investment rose rapidly between 2003 and 2005 and then came crashing down. As discussed in Chapter 14, much of this was driven by a huge increase and then decrease in housing prices. Labor Supply As we noted in Chapters 7 and 13, a person is considered a part of the labor force when he or she is working or has been actively looking for work in the past few weeks. The ratio of the labor force to the total working-age population—those 16 and over—is the labor force participation rate. M15_CASE3826_13_GE_C15.indd 315 17/04/19 4:20 AM Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) Recessionary period (2008 I– 2009 II) 316 PART IV Further Macroeconomics Issues ◂▸ FIGURE 15.3 Housing Investment of the Household Sector, 1970 I–2017 IV Housing investment fell during the five recessionary periods since 1970. Like expenditures for durable goods, expenditures for housing investment are postponable 770 720 670 620 570 520 470 420 370 320 270 220 170 1970 I 1980 I MyLab Economics Real-time data 1975 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV Quarters It is informative to divide the labor force into three categories: males 25 to 54, females 25 to 54, and all others 16 and over. Ages 25 to 54 are sometimes called “prime” ages, presuming that a person is in the prime of working life during these ages. The participation rates for these three groups are plotted in Figure 15.4. As the figure shows, most men of prime age are in the labor force, although the participation rate has fallen since 1970—from 0.961 in 1970 I to 0.888 in 2017 IV. (A rate of 0.888 means that 88.8 percent of prime-age men were in the labor force.) The participation rate for prime-age women, on the other hand, rose dramatically between 1970 and 1990—from 0.501 in 1970 I to 0.741 in 1990 I. Although economic factors account for some of this increase, a change in social attitudes and preferences probably explains much of the increase. Since 1990, the participation rate for prime-age women has changed very little. In 2017 IV, it was 0.752, still considerably below the 0.888 rate for prime-age men. Figure 15.4 also shows the participation rate for all individuals 16 and over except prime-age men and women. This rate has some cyclical features—it tends to fall in recessions and to rise or fall less during expansions. These features reveal the operation of the discouraged-worker effect, discussed in Chapter 7. During recessions, some people get discouraged about ever finding a job. They stop looking and are then not considered a part of the labor force. During expansions, people become encouraged again. Once they begin looking for jobs, they are again considered a part of the labor force. Prime-age women and men are likely to be fairly attached to the labor force, thus the discouraged-worker effect for them is quite small. ◂▸ FIGURE 15.4 Labor Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2017 IV Since 1970, the labor force participation rate for prime-age men has been decreasing slightly. The rate for prime-age women has been increasing dramatically. The rate for all others 16 and over has been declining since 1979 and shows a tendency to fall during recessions (the discouragedworker effect). Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Men 25–54 Recessionary period (2001 I– 2001 III) Recessionary period (2008 I– 2009 II) Women 25–54 All others 16 and over 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50 .45 0.40 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data Quarters M15_CASE3826_13_GE_C15.indd 316 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 317 15.2 LEARNING OBJECTIVE Describe factors that affect the investment and employment decisions of firms. Firms: Investment and Employment Decisions Having taken a closer look at the behavior of households in the macroeconomy, we now look more closely at the behavior of firms—the other major decision-making unit in the economy. In discussing firm behavior previously, we assumed that planned investment depends only on the interest rate. However, there are several other determinants of planned investment. We now discuss them and the factors that affect firms’ employment decisions. Once again, microeconomic theory can help us gain some insight into the working of the macroeconomy. In a market economy, firms determine which goods and services are available to consumers today and which will be available in the future, how many workers are needed for what kinds of jobs, and how much investment will be undertaken. Stated in macroeconomic terms, the decisions of firms, taken together, determine output, labor demand, and investment. Expectations and Animal Spirits MyLab Economics Concept Check Time is a key factor in investment decisions. Capital has a life that typically extends over many years. A developer who decides to build an office tower is making an investment that will be around (barring earthquakes, floods, or tornadoes) for several decades. In deciding where to build a plant, a manufacturing firm is committing a large amount of resources to purchase capital that will presumably yield services over a long time. Furthermore, the decision to build a plant or to purchase large equipment must often be made years before the actual project is completed. Whereas the acquisition of a small business computer may take only a few days, the planning process for downtown developments in large U.S. cities has been known to take decades. For these reasons, investment decisions require looking into the future and forming expectations about it. In forming their expectations, firms consider numerous factors. At a minimum, they gather information about the demand for their specific products, about what their competitors are planning, and about the macroeconomy’s overall health. A firm is not likely to increase its production capacity if it does not expect to sell more of its product in the future. Hilton will not put up a new hotel if it does not expect to fill the rooms at a profitable rate. Ford will not build a new plant if it expects the economy to enter a long recession. Forecasting the future is fraught with dangers. Many events cannot be foreseen. Investments are therefore always made with imperfect knowledge. Keynes pointed this out in 1936: The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often neglig
ible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes nothing. Keynes concludes from this line of thought that much investment activity depends on psy- chology and on what he calls the animal spirits of entrepreneurs: Our decisions can only be taken as a result of animal spirits. In estimating the prospects of investment, we must have regard, therefore, to nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.5 animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings. 5John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), pp. 149, 152. M15_CASE3826_13_GE_C15.indd 317 17/04/19 4:20 AM 318 PART IV Further Macroeconomics Issues Expectations about the future are, as Keynes points out, subject to great uncertainty, they may change often. Thus, animal spirits help to make investment a volatile component of gross domestic product (GDP). George Akerlof and Robert Shiller, two Nobel Laureates who work in the area of behavioral macroeconomics, have emphasized the role of animal spirits in driving volatility in the modern economy.6 The Accelerator Effect Keynes’ reference to animal spirits suggest that expectations play a role in determining the level of planned investment spending. At any interest rate, the level of investment is likely to be higher if businesses are optimistic and lower if they are pessimistic. A key question is then what determines expectations? One possibility is that expectations are optimistic when aggregate output (Y) is rising and pessimistic when aggregate output is falling. At any given level of the interest rate, expectations may be more optimistic and planned investment higher when output is growing rapidly than when it is growing slowly or falling. It is easy to see why this might be so. When firms expect future prospects to be good, they may plan now to add productive capacity, and one indicator of future prospects is the current growth rate. If this is the case, the result will be what is called an accelerator effect. If aggregate output (income) (Y) is rising, investment will increase even though the level of Y may be low. Higher investment spending leads to an added increase in output, further “accelerating” the growth of aggregate output. If Y is falling, expectations are dampened and investment spending will be cut even though the level of Y may be high, accelerating the decline. Excess Labor and Excess Capital Effects MyLab Economics Concept Check In our simple model of the macroeconomy, to produce more output the firms in the economy need to hire more labor and capital. In practice, firms appear at times to hold what we will call excess labor and/or excess capital. A firm holds excess labor (or capital) if it can reduce the amount of labor it employs (or capital it holds) and still produce the same amount of output. The possibility that large numbers of firms may at times be holding excess labor or capital complicates our story of the investment-output relationship. Why might a firm want to employ more workers or have more capital on hand than it needs? Both labor and capital are costly—a firm has to pay wages to its workers, and it forgoes interest on funds tied up in machinery or buildings. Why would a firm want to incur costs that do not yield revenue? To see why, suppose a firm suffers a sudden and large decrease in sales, but it expects the lower sales level to last only a few months, after which it believes sales will pick up again. In this case, the firm is likely to lower production in response to the sales change to avoid too large an increase in its stock of inventories. This decrease in production means that the firm could get rid of some workers and some machines because it needs less labor and less capital to produce the now-lower level of output. However, things are not that simple. Decreasing its workforce and capital stock quickly can be costly for a firm. Abrupt cuts in the workforce hurt worker morale and may increase personnel administration costs, and abrupt reductions in capital stock may be disadvantageous because of the difficulty of selling used machines. These types of costs are sometimes called adjustment costs because they are the costs of adjusting to the new level of output. There are also adjustment costs to increasing output. For example, it is usually costly to recruit and train new workers. Adjustment costs may be large enough that a firm chooses not to decrease its workforce and capital stock when production falls. The firm may at times choose to have more labor and capital on hand than it needs to produce its current amount of output simply because getting rid of them is more costly than keeping them and the firm expects it will need the workers in the near future. In practice, excess labor takes the form of workers not working at their normal level of activity. Some of this excess labor may receive new training so that productivity will be higher when production picks up again, and some of the excess labor may take the form of maintenance. 6George Akerlof and Robert Shiller, Animal Spirits: How human psychology Drives the Economy, and Why it Matters for Global Capitalism, Princeton University Press, Princeton NJ, 2010. accelerator effect The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output. excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output. adjustment costs The costs that a firm incurs when it changes its production level— for example, the administration costs of laying off employees or the training costs of hiring new workers. M15_CASE3826_13_GE_C15.indd 318 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 319 The existence of excess labor and capital at any given moment is likely to affect future employment and investment decisions. Suppose a firm already has excess labor and capital as a result of a fall in its sales and production. When production picks up again, the firm will not need to hire as many new workers or acquire as much new capital as it would otherwise. The more excess capital a firm already has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future. As you can see, predicting what happens as an economy recovers is made more complicated if in a down period many firms hold excess inputs. Inventory Investment MyLab Economics Concept Check We now turn to a brief discussion of the inventory investment decision. Inventory investment is the change in the stock of inventories. Although inventory investment is another way in which a firm adds to its capital stock, the inventory investment decision is quite different from the plantand-equipment investment decision. inventory investment The change in the stock of inventories. The Role of Inventories Recall the distinction between a firm’s sales and its output. If a firm can hold goods in inventory, which is usually the case unless the good is perishable or unless the firm produces services, then within a given period, it can sell a quantity of goods that differs from the quantity of goods it produces during that period. When a firm sells more than it produces, its stock of inventories decreases; when it sells less than it produces, its stock of inventories increases. Stock of inventories (end of period) = Stock of inventories (beginning of period) + Production - Sales If a firm starts a period with 100 umbrellas in inventory, produces 15 umbrellas during the period, and sells 10 umbrellas in this same interval, it will have 105 umbrellas (100 + 15 - 10) in inventory at the end of the period. A change in the stock of inventories is actually investment because inventories are counted as part of a firm’s capital stock. In our example, inventory investment during the period is a positive number, 5 umbrellas (105 - 100). When the number of goods produced is less than the number of goods sold, such as 5 produced and 10 sold, inventory investment is negative. The Optimal Inventory Policy We can now consider firms’ inventory decisions. Firms are concerned with what they are going to sell and produce in the future as well as what they are selling and producing currently. At each point in time, a firm has some idea of how much it is going to sell in the current period and in future periods. Given these expectations and its knowledge of how much of its goods it already has in stock, a firm must decide how much to produce in the current period. Inventories are costly to a firm because they take up space and they tie up funds that could be earning interest. However, if a firm’s stock of inventories gets too low, the firm may have difficulty meeting the demand for its product, especially if demand increases unexpectedly. The firm may lose sales. The point between too low and too high a stock of inventory is called the desired, or optimal, level of inventories. This is the level at which the extra cost (in lost sales) from decreasing inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs). A firm that had no costs other than inventory costs would always aim to produce in a period exactly the volume of goods necessary to make its stock of inventories at the end of the period equal to the desired stock. If the stock of inventory fell lower than desired, the firm would produce more than it expected to sell to bring the stock
up. If the stock of inventory grew above the desired level, the firm would produce less than it expected to sell to reduce the stock. There are other costs to running a firm besides inventory costs. In particular, large and abrupt changes in production can be costly because it is often disruptive to change a production process geared to a certain rate of output. If production is to be increased, there may be adjustment costs for hiring more labor and increasing the capital stock. If production is to be decreased, there may be adjustment costs in laying off workers and decreasing the capital stock. desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage costs). M15_CASE3826_13_GE_C15.indd 319 17/04/19 4:20 AM 320 PART IV Further Macroeconomics Issues Holding inventories and changing production levels are both costly, thus firms face a tradeoff between them. A firm is likely to smooth its production path relative to its sales path because of adjustment costs. This means that a firm is likely to have its production fluctuate less than its sales, with changes in inventories to absorb the difference each period. However, because there are incentives not to stray too far from the optimal level of inventories, fluctuations in production are not eliminated completely. Production is still likely to fluctuate, just not as much as sales fluctuate. Two other points need to be made here. First, if a firm’s stock of inventories is unusually or unexpectedly high, as a result of unexpected shortfalls in sales, the firm is likely to produce less in the future than it otherwise would have to decrease its high stock of inventories. In this way, unexpected inventories also influence current production levels. An unexpectedly high stock of inventories will have a negative effect on production in the future, and an unexpectedly low stock will have a positive effect on production in the future. We have seen that lower than expected past sales will influence optimal production as firms seek to reduce unplanned inventories. Future sales expectations also have an effect on inventory policy and on production. If a firm expects its sales to be high in the future, it will adjust its planned production path accordingly, recognizing that a higher level of sales also requires a higher level of inventories to support those sales. Production is likely to depend on expectations of the future so animal spirits may play a role. If firms become more optimistic about the future, they are likely to produce more now as they build up inventories in anticipation of increased future sales. Keynes’s view that animal spirits affect investment is also likely to pertain to output. A Summary of Firm Behavior MyLab Economics Concept Check The following factors affect firms’ investment and employment decisions: ■■ Firms’ expectations of future output ■■ Wage rate and cost of capital (The interest rate is an important component of the cost of capital.) ■■ Amount of excess labor and excess capital on hand The most important points to remember about the relationship among production, sales, and inventory investment are ■■ Inventory investment—that is, the change in the stock of inventories—equals production minus sales. ■■ An unexpected increase in the stock of inventories has a negative effect on future production. ■■ Current production depends on expected future sales. The Firm Sector Since 1970 MyLab Economics Concept Check To close our discussion of firm behavior, we now examine some aggregate investment and employment variables for the period 1970 I–2017 IV. We will see the way in which our expanded model of firm behavior helps us to understand patterns in those data. Plant-and-Equipment Investment Plant-and-equipment investment by the firm sector is plotted in Figure 15.5. Investment fared poorly in the five recessionary periods after 1970. This observation is consistent with the observation that investment depends in part on output. An examination of the plot of real GDP in Figure 20.4 and the plot of investment in Figure 15.5 shows that investment generally does poorly when GDP does poorly and that investment generally does well when GDP does well. Figure 15.5 also shows that investment fluctuates greatly. This is not surprising. The animal spirits of entrepreneurs are likely to be volatile, and if animal spirits affect investment, it follows that investment too will be volatile. Despite the volatility of plant-and-equipment investment, however, it is still true that housing investment fluctuates more than plant-and-equipment investment (as you can see by comparing Figures 15.3 and 15.5). Plant and equipment investment is not the most volatile component of GDP. M15_CASE3826_13_GE_C15.indd 320 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 321 Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2008 I– 2009 II) ◂◂ FIGURE 15.5 Plant and Equipment Investment of the Firm Sector, 1970 I–2017 IV Overall, plant and equipment investment declined in the five recessionary periods since 1970. Recessionary period (2001 I– 2001 III) 1975 I 1980 I 1985 I 1990 I 1995 I Quarters 2000 I 2005 I 2017 IV MyLab Economics Real-time data 2015 I 2010 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 1970 I Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (2008 I– 2009 II) Recessionary period (1990 III– 1991 I) Recessionary period (2001 I– 2001 III) 140 130 120 110 100 90 80 ◂◂ FIGURE 15.6 Employment in the Firm Sector, 1970 I–2017 IV Growth in employment was generally negative in the five recessions the U.S. economy has experienced since 1970. 70 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I Quarters 2005 I 2010 I 2017 IV MyLab Economics Real-time data 2015 I Employment Employment in the firm sector is plotted in Figure 15.6, which shows that employment fell in all five recessionary periods. This is consistent with the theory that employment depends in part on output. Otherwise, employment has grown over time in response to the growing economy. Employment in the firm sector rose from 72.5 million in 1970 I to 132.5 million in 2007 IV (before the recession of 2008–2009). During the 2008–2009 recession, employment fell by 9.5 million—from 132.5 million in 2007 IV to 123.0 million in 2009 IV. You can see from the figure that employment has recovered fairly slowly since 2009. Inventory Investment Recall that inventory investment is the difference between the level of output and the level of sales. Recall also that some inventory investment is usually unplanned. This occurs when the actual level of sales is different from the expected level of sales. Inventory investment of the firm sector is plotted in Figure 15.7. Also plotted in this figure is the ratio of the stock of inventories to the level of sales—the inventory-to-sales ratio. The figure shows that inventory investment is volatile—more volatile than housing investment and plant and equipment investment. Some of this volatility is undoubtedly as a result of the unplanned component of inventory investment, which is likely to fluctuate greatly from one period to the next. When the inventory-to-sales ratio is high, the actual stock of inventories is likely to be larger than the desired stock. In such a case, firms have overestimated demand and produced too much relative to sales and they are likely to want to produce less in the future to draw down their stock. M15_CASE3826_13_GE_C15.indd 321 17/04/19 4:20 AM 322 PART IV Further Macroeconomics Issues ◂▸ FIGURE 15.7 Inventory Investment of the Firm Sector and the Inventory-to-Sales Ratio, 1970 I–2017 IV The inventory-to-sales ratio is the ratio of the firm sector’s stock of inventories to the level of sales. Inventory investment is volatile. 120 90 60 30 0 230 260 290 2120 2150 2180 Inventory investment (left scale) Recessionary period (1974 I– 1975 I) Recessionary period (1980 II– 1982 IV) Recessionary period (1990 III– 1991 I) Recessionary period (2008 I– 2009 II) Recessionary period (2001 I– 2001 III) Inventory/sales ratio (right scale) 0.21 0.20 0.19 0.18 0.17 0.16 0.15 15.3 LEARNING OBJECTIVE Explain why productivity is procyclical. productivity, or labor productivity Output per worker hour. 2210 1970 I 1975 I 1980 I 1985 I 1990 I MyLab Economics Real-time data 1995 I Quarters 2000 I 2005 I 2010 I 2015 I 0.14 2017 IV You can find several examples of this trend in Figure 15.7—the clearest occurred during the 1974–1975 period. At the end of 1974, the stock of inventories was high relative to sales, an indication that firms probably had undesired inventories at the end of 1974. In 1975, firms worked off these undesired inventories by producing less than they sold. Thus, inventory investment was low in 1975. The year 1975 is clearly a year in which output would have been higher had the stock of inventories at the beginning of the year not been so high. There were large declines in inventory investment in the recessions of 2001 and 2008–2009. On average, the inventory-to-sales ratio has been declining over time, evidence that firms are becoming more efficient in their management of inventory stocks. Firms are becoming more efficient in the sense of being able (other things equal) to hold smaller and smaller stocks of inventories relative to sales. Productivity and the Business Cycle We can now use what we have just learned about firm behavior to analyze movements in productivity. Productivity, sometimes called labor productivity, is defined as output per worker hour. If output is Y and the number of hours worked in the economy is H, productivity is Y/H. Simply stated, productivity measures how much output
an average worker produces per hour. Productivity fluctuates over the business cycle, tending to rise during expansions and fall during contractions. See Figure 7.2 for a plot of productivity for 1952 I–2017 IV. You can see from this figure that productivity fluctuates around a positive trend. The fact that firms at times hold excess labor explains why productivity fluctuates in the same direction as output. Figure 15.8 shows the pattern of employment and output over time for a hypothetical economy. Employment does not fluctuate as much as output over the business cycle. It is precisely this pattern that leads to higher productivity during periods of high output and lower productivity during periods of low output. During expansions in the economy, output rises by a larger percentage than employment and the ratio of output to workers rises. During downswings, output falls faster than employment and the ratio of output to workers falls. The existence of excess labor when the economy is in a slump means that productivity as measured by the ratio Y/H tends to fall at such times. Does this trend mean that labor is in some sense “less productive” during recessions than before? Not really: It means only that firms choose to employ more labor than would be profit-maximizing. For this reason, some workers are in effect idle some of the time even though they are considered employed. They are not less productive in the sense of having less potential to produce output; they are merely not working part of the time that they are counted as working. M15_CASE3826_13_GE_C15.indd 322 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 323 ◂◂ FIGURE 15.8 Employment and Output over the Business Cycle In general, employment does not fluctuate as much as output over the business cycle. As a result, measured productivity (the output-to-labor ratio) tends to rise during expansionary periods and decline during contractionary periods. 15.4 LEARNING OBJECTIVE Describe the short-run relationship between output and unemployment. Okun’s Law The theory, put forth by Arthur Okun, that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts. Aggregate output Employment Time MyLab Economics Concept Check The Short-Run Relationship between Output and Unemployment We can also use what we have learned about household and firm behavior to analyze the relationship between output and unemployment. When we discussed the connections between the AS/AD diagram and the Phillips Curve in Chapter 14, we mentioned that output (Y) and the unemployment rate (U) are inversely related. When output rises, the unemployment rate falls, and when output falls, the unemployment rate rises. At one time, it was believed that the shortrun relationship between the two variables was fairly stable. Okun’s Law (after U.S. economist Arthur Okun, who first studied the relationship) stated that in the short run the unemployment rate decreased about 1 percentage point for every 3 percent increase in real GDP. As with the Phillips Curve, Okun’s Law has not turned out to be a “law.” The economy is far too complex for there to be such a simple and stable relationship between two macroeconomic variables. Although the short-run relationship between output and the unemployment rate is not the simple relationship Okun believed, it is true that a 1 percent increase in output tends to correspond to a less than 1 percentage point decrease in the unemployment rate in the short run. In other words, there are a number of “slippages” between changes in output and changes in the unemployment rate. The first slippage is between the change in output and the change in the number of jobs in the economy. When output increases by 1 percent, the number of jobs does not tend to rise by 1 percent in the short run. There are two reasons for this. First, a firm is likely to meet some of the increase in output by increasing the number of hours worked per job. Instead of having the labor force work 40 hours per week, the firm may pay overtime and have the labor force work 42 hours per week. Second, if a firm is holding excess labor at the time of the output increase, at least part of the increase in output can come from putting the excess labor back to work. For both reasons, the number of jobs is likely to rise by a smaller percentage than the increase in output. The second slippage is between the change in the number of jobs and the change in the number of people employed. If you have two jobs, you are counted twice in the job data but only once in the persons-employed data. Because some people have two jobs, there are more jobs than there are people employed. When the number of jobs increases, some of the new jobs are filled by people who already have one job (instead of by people who are unemployed). This means that the increase in the number of people employed is less than the increase in the number of jobs. This is a slippage between output and the unemployment rate because the unemployment rate is calculated from data on the number of people employed, not the number of jobs. The third slippage concerns the response of the labor force to an increase in output. Let E denote the number of people employed, let L denote the number of people in the labor force, and let u denote the unemployment rate. In these terms, the unemployment rate is The unemployment rate is one minus the employment rate, E/L. u = 1 - E/L M15_CASE3826_13_GE_C15.indd 323 17/04/19 4:20 AM 324 PART IV Further Macroeconomics Issues discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, dropping out of the ranks of the unemployed and the labor force. When we discussed how the unemployment rate is measured in Chapter 7, we introduced the discouraged-worker effect. A discouraged worker is one who would like a job but has stopped looking because the prospects seem so bleak. When output increases, job prospects begin to look better and some people who had stopped looking for work begin looking again. When they do, they are once again counted as part of the labor force. The labor force increases when output increases because discouraged workers are moving back into the labor force. This is another reason the unemployment rate does not fall as much as might be expected when output increases. These three slippages show that the link from changes in output to changes in the unemployment rate is complicated. All three combine to make the change in the unemployment rate less than the percentage change in output in the short run. They also show that the relationship between changes in output and changes in the unemployment rate is not likely to be stable. The size of the first slippage, for example, depends on how much excess labor is being held at the time of the output increase, and the size of the third slippage depends on what else is affecting the labor force (such as changes in real wage rates) at the time of the output increase. The relationship between output and unemployment depends on the state of the economy at the time of the output change. 15.5 LEARNING OBJECTIVE Identify factors that affect multiplier size. The Size of the Multiplier We can finally bring together the material in this chapter and in previous chapters to consider the size of the multiplier. We mentioned in Chapter 8 that much of the analysis we would do after deriving the simple multiplier would have the effect of decreasing the size of the multiplier. We can now summarize why. 1. There are automatic stabilizers. We saw in the Appendix to Chapter 9 that if taxes are not a fixed amount but instead depend on income (which is surely the case in practice), the size of the multiplier is decreased. When the economy expands and income increases, the amount of taxes collected increases. The rise in taxes acts to offset some of the expansion (thus, a smaller multiplier). When the economy contracts and income decreases, the amount of taxes collected decreases. This decrease in taxes helps to lessen the contraction. Some transfer payments also respond to the state of the economy and act as automatic stabilizers, lowering the value of the multiplier. Unemployment benefits are the best example of transfer payments that increase during contractions and decrease during expansions. 2. There is the interest rate. We saw in Chapter 11 that in normal times the Fed increases the interest rate as output increases, which decreases planned investment. The increase in output from a government spending increase is thus smaller than if the interest rate did not rise because of the crowding out of planned investment. As we saw previously in this chapter, increases in the interest rate also have a negative effect on consumption. Consumption is also crowded out in the same way that planned investment is, and this effect lowers the value of the multiplier even further. 3. There is the response of the price level. We also saw in Chapter 11 that some of the effect of an expansionary policy is to increase the price level. The multiplier is smaller because of this price response. The multiplier is particularly small when the economy is on the steep part of the AS curve, where most of the effect of an expansionary policy is to increase prices. 4. There are excess capital and excess labor. When firms are holding excess labor and capital, part of any output increase can come from putting the excess labor and capital back to work instead of increasing employment and investment. This lowers the value of the multiplier because (1) investment increases less than it would have if there were no excess capital and (2) consumption increases less than it would have if empl
oyment (and thus household income) had increased more. 5. There are inventories. Part of any initial increase in sales can come from drawing down inventories instead of increasing output. To the extent that firms draw down their inventories in the short run, the value of the multiplier is lower because output does not respond as quickly to demand changes. 6. There are people’s expectations about the future. People look ahead, and they respond less to temporary changes than to permanent changes. The multiplier effects for policy changes perceived to be temporary are smaller than those for policy changes perceived to be permanent. M15_CASE3826_13_GE_C15.indd 324 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 325 Estimating Multipliers: The Mafia Link Estimating the size of the multiplier is difficult because it is hard to sort out the many things that are likely to be changing when a government decides to increase its spending. However, a recent paper found a novel way to sort out the various effects. We have focused on the national multiplier. How much does national GDP rise when the national government increases spending? Economists and policy makers are also interested in the effects of stimuli at the local or regional level. In general we expect these multipliers to be less than national multipliers: If the governor of New York increases government spending in the state, some of that increase will likely spill over to New Jersey and other states. But exactly how big are these multipliers in practice? Several economists working with Italian data had a novel approach to estimating regional multipliers in Italy.1 In the 1990s the Italian national government passed a law to try to control Mafia–led corruption in local governments. The law stated that when Mafia involvement was found in the city council in an area, all elected officials would be fired, to be replaced by three commissioners appointed by the national government. This change in decision making had a large effect on reducing public spending in the area as a result of the disruption. On average, replacement of the council members reduced spending by 20 percent. Since the Mafia’s involvement varied considerably by region for historical reasons, this law had differential effects across regions, and those regional differences could be used to identify the size of the local multiplier. The results? Regional multipliers in the range of 1.5 to 2. Interestingly, work in the United States at the state level found similar magnitudes for the multiplier, using quite different methods.2 CRITICAL THINKING 1. Multipliers also vary across countries. What factors do you think determine these differences? 1Antonio Acconcia, Giancarlo Corsetti, and Savero Sivenenlli, “Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi Experiment,” American Economic Review, July 2014, 2185–2209. 2Emi Nakamura and Jon Steinnson, “Fiscal Stimulus in a Monetary Union: Evidence form U.S. States,” American Economic Review, 2014, 753–792. The Size of the Multiplier in Practice In practice, the multiplier probably has a value of around 2.0. Its size also depends on how long ago the spending increase began. For example, in the first quarter of an increase in government spending, the multiplier is likely below 1.0 since some of the increased sales comes out of inventories. The multiplier then rises over time, likely reaching a peak after about a year. One of the main points to remember here is that if the government is contemplating a monetary or fiscal policy change, the response of the economy to the change is not likely to be large and quick. It takes time for the full effects to be felt, and in the final analysis, the effects are much smaller than the simple multiplier we discussed in Chapter 8 would lead one to believe. A good way to review much of the material since Chapter 8 is to make sure you clearly understand how the value of the multiplier is affected by each of the additions to the simple model in Chapter 8. We have come a long way since then, and this review may help you to put all the pieces together. S U M M A R Y 15.1 HOUSEHOLDS: CONSUMPTION AND LABOR SUPPLY DECISIONS p. 309 1. The life-cycle theory of consumption says that households make lifetime consumption decisions based on their expectations of lifetime income. Generally, households consume an amount less than their incomes during their prime working years and an amount greater than their incomes during their early working years and after they have retired. 2. Households make consumption and labor supply decisions simultaneously. Consumption cannot be considered separately from labor supply because it is precisely by selling your labor that you earn the income that makes consumption possible. 3. There is a trade-off between the goods and services that wage income will buy and leisure or other nonmarket activities. The wage rate is the key variable that determines how a household responds to this trade-off. M15_CASE3826_13_GE_C15.indd 325 17/04/19 4:20 AM 326 PART IV Further Macroeconomics Issues 4. Changes in the wage rate have both an income effect and a substitution effect. The evidence suggests that the substitution effect seems to dominate for most people, which means that the aggregate labor supply responds positively to an increase in the wage rate. 5. Consumption increases when the wage rate increases. 6. The nominal wage rate is the wage rate in current dollars. The real wage rate is the amount the nominal wage can buy in terms of goods and services. Households look at expected future real wage rates as well as the current real wage rate in making their consumption and labor supply decisions. 7. Holding all else constant (including the stage in the life cycle), the more wealth a household has, the more it will consume both now and in the future. 8. An unexpected increase in nonlabor income (any income re- ceived from sources other than working, such as inheritances, interest, and dividends) will have a positive effect on a household’s consumption and will lead to a decrease in labor supply. 9. The interest rate also affects consumption, although the di- rection of the total effect depends on the relative sizes of the income and substitution effects. There is some evidence that the income effect is larger now than it used to be, making monetary policy less effective than it used to be. 10. The government influences household behavior mainly through income tax rates and transfer payments. If the substitution effect dominates, an increase in tax rates lowers after-tax income, decreases consumption, and decreases the labor supply; a decrease in tax rates raises after-tax income, increases consumption, and increases labor supply. Increases in transfer payments increase consumption and decrease labor supply; decreases in transfer payments decrease consumption and increase labor supply. 11. During times of unemployment, households’ labor supply may be constrained. Households may want to work a certain number of hours at current wage rates but may not be allowed to do so by firms. In this case, the level of income (at least workers’ income) depends exclusively on the employment decisions made by firms. Households consume less if they are constrained from working. 15.2 FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS p. 317 12. Expectations affect investment and employment decisions. Keynes used the term animal spirits of entrepreneurs to refer to investors’ feelings. 13. At any level of the interest rate, expectations are likely to be more optimistic and planned investment is likely to be higher when output is growing rapidly than when it is growing slowly or falling. The result is an accelerator effect that can cause the economy to expand more rapidly during an expansion and contract more quickly during a recession. 14. Excess labor and capital are labor and capital not needed to produce a firm’s current level of output. Holding excess labor and capital may be more efficient than laying off workers or selling used equipment. The more excess capital a firm has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future. 15. Holding inventories is costly to a firm because they take up space and they tie up funds that could be earning interest. Not holding inventories can cause a firm to lose sales if demand increases. The desired, or optimal, level of inventories is the level at which the extra cost (in lost sales) from lowering inventories by a small amount is equal to the extra gain (in interest revenue and decreased storage costs). 16. An unexpected increase in inventories has a negative effect on future production, and an unexpected decrease in inventories has a positive effect on future production. 17. The level of a firm’s planned production path depends on the level of its expected future sales path. If a firm’s expectations of its future sales path decrease, the firm is likely to decrease the level of its planned production path, including its actual production in the current period. 15.3 PRODUCTIVITY AND THE BUSINESS CYCLE p. 322 18. Productivity, or labor productivity, is output per worker hour— the amount of output produced by an average worker in one hour. Productivity fluctuates over the business cycle, tending to rise during expansions and fall during contractions. That workers are less productive during contractions does not mean that they have less potential to produce output; it means that excess labor exists and that workers are not working at their capacity. 15.4 THE SHORT-RUN RELATIONSHIP BETWEEN OUTPUT AND UNEMPLOYMENT p. 323 19. There is a negative relationship between output and unemployment: When output (Y) rises, the unemployment rate (U) falls, and when output falls, the unemployment rate rises. Okun’s Law states that in the short run the unemployme
nt rate decreases about 1 percentage point for every 3 percent increase in GDP. Okun’s Law is not a “law”—the economy is too complex for there to be a stable relationship between two macroeconomic variables. In general, the relationship between output and unemployment depends on the state of the economy at the time of the output change. 15.5 THE SIZE OF THE MULTIPLIER p. 324 20. There are several reasons why the actual value of the multiplier is smaller than the size that would be expected from the simple multiplier model: (1) Automatic stabilizers help to offset contractions or limit expansions. (2) When government spending increases, the increased interest rate crowds out planned investment and consumption spending. (3) Expansionary policies increase the price level. (4) Firms sometimes hold excess capital and excess labor. (5) Firms may meet increased demand by drawing down inventories instead of increasing output. (6) Households and firms change their behavior less when they expect changes to be temporary instead of permanent. 21. In practice, the size of the multiplier at its peak is about 2. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M15_CASE3826_13_GE_C15.indd 326 17/04/19 4:20 AM CHAPTER 15 Household and Firm Behavior in the Macroeconomy: A Further Look 327 accelerator effect, p. 318 adjustment costs, p. 318 animal spirits of entrepreneurs, p. 317 constrained supply of labor, p. 313 desired, or optimal, level of inventories, p. 319 discouraged-worker effect, p. 324 excess labor, excess capital, p. 318 inventory investment, p. 319 life-cycle theory of consumption, p. 309 nominal wage rate, p. 311 nonlabor, or nonwage, income, p. 312 Okun’s Law, p. 323 permanent income, p. 310 productivity, or labor productivity, p. 322 real wage rate, p. 311 unconstrained supply of labor, p. 313 P R O B L E M S All problems are available on MyLab Economics. 15.1 HOUSEHOLDS: CONSUMPTION AND LABOR SUPPLY DECISIONS LEARNING OBJECTIVE: Describe factors that affect household consumption and labor supply decisions. 1.1 In June 2018, the Federal Reserve Bank raised interest rates for the seventh time in three years, and signaled that two additional rate hikes would take place by the end of the year. a. What direct effects do higher interest rates have on house- hold and firm behavior? b. One of the consequences of higher interest rates is that the value of existing bonds (both corporate bonds and government bonds) will fall. Explain why higher interest rates would decrease the value of existing fixed-rate bonds held by the public. c. Some economists argue that the wealth effect of higher interest rates on consumption is as important as the direct effect of higher interest rates on investment. Explain what economists mean by “wealth effects on consumption” and illustrate with AS/AD curves. 1.2 The personal income tax rate in Spain stands at 45 percent as of 2018. The tax rate averaged a 47.92 percent from 1995 until 2018, reaching an all-time high of 56 percent in 1996 and a record low of 43 percent in 2007. How does this change in the tax rate, which in turn affects the net wages of individuals, affect the labor supply in Spain? 1.3 Graph the following two consumption functions: (1) C = 500 + 0.8 Y (2) C = 0.8 Y a. For each function, calculate and graph the propensity to consume (APC) when income is $200, $500, and $1,000. b. For each function, what happens to the APC as income rises? c. For each function, what is the relationship between the APC and the marginal propensity to consume? d. Under the first consumption function, a family with income of $75,000 consumes a smaller proportion of its income than a family with income of $30,000; yet if we take a dollar of income away from the rich family and give it to the poor family, total consumption by the two families does not change. Explain how this is possible. 1.4 [Related to the Economics in Practice on p. 315] From March 2012 to May 2017, the price of houses increased dramatically in many parts of the country. a. What impact would you expect increases and decreases in home values to have on the consumption behavior of home owners? Explain. b. In what ways might events in the housing market have influenced the rest of the economy through their effects on consumption spending? Be specific. 1.5 Lydia Lopokova is 40 years old. She has assets (wealth) of $80,000 and has no debts or liabilities. She knows that she will work for 30 more years and will live 10 years after that, when she will earn nothing. Her salary each year for the rest of her working career is $35,000. (There are no taxes.) She wants to distribute her consumption over the rest of her life in such a way that she consumes the same amount each year. She cannot consume in total more than her current wealth plus the sum of her income for the next 30 years. Assume that the rate of interest is zero and that Lopokova decides not to leave any inheritance to her children. a. How much will Lydia consume this year and next year? How did you arrive at your answer? b. Plot on a graph Lydia’s income, consumption, and wealth from the time she is 40 until she is 80 years old. What is the relationship between the annual increase in her wealth and her annual saving (income minus consumption)? In what year does Lydia’s wealth start to decline? Why? How much wealth does she have when she dies? c. Suppose Lydia receives a tax rebate of $1,000 per year, so her income is $36,000 per year for the rest of her working career. By how much does her consumption increase this year and next year? d. Now suppose Lydia receives a one-year-only tax refund of $1,000—her income this year is $36,000; but in all succeeding years, her income is $35,000. What happens to her consumption this year? In succeeding years? 1.6 Explain why a household’s consumption and labor supply decisions are interdependent. What impact does this interdependence have on the way in which consumption and income are related? Note: Problems marked with an asterisk are more challenging. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M15_CASE3826_13_GE_C15.indd 327 17/04/19 4:20 AM 328 PART IV Further Macroeconomics Issues 15.2 FIRMS: INVESTMENT AND EMPLOYMENT DECISIONS 15.4 THE SHORT-RUN RELATIONSHIP BETWEEN OUTPUT AND UNEMPLOYMENT LEARNING OBJECTIVE: Describe factors that affect the investment and employment decisions of firms. LEARNING OBJECTIVE: Describe the short-run relationship between output and unemployment. 2.1 How do expectations influence investment demand? Describe the reasons for volatility of investment demand. In this context, explain the accelerator effect of expectations on output. 2.2 How can a firm maintain a smooth production schedule even when sales are fluctuating? What are the benefits of a smooth production schedule? What are the costs? 2.3 George Jetson has recently been promoted to inventory control manager at Spacely Sprockets, and he must decide on the optimal level of sprockets to keep in inventory. How should Jetson decide on the optimal level of inventory? How would a change in interest rates affect the optimal level of inventory? What costs and benefits will Spacely Sprockets experience by holding inventory? 2.4 Futurama Medical is a high-tech medical equipment manufacturer that uses custom-designed machinery and a highly skilled, well-trained labor force in its production factory. Gonzo Garments is a mid-level clothing manufacturer that uses mass-produced machinery and readily available labor in its production factory. Which of these two firms would you expect to have more significant adjustment costs? Which firm would be more likely to hold excess labor? Excess capital? Explain your answers. 15.3 PRODUCTIVITY AND THE BUSINESS CYCLE LEARNING OBJECTIVE: Explain why productivity is procyclical. 3.1 Between June 2017 and June 2018, the employment rate in the United Kingdom increased by 5.73 percent, whereas GDP increased by 1.2 percent. How is it possible for output to increase at a lower rate than employment? 4.1 According to Statista, in 2013, the unemployment rate in Spain was 26.09 percent. In 2017, Statista reported that Spain’s unemployment rate was 17.35 percent. 4.2 In the short run, the percentage increase in output tends to correspond to a smaller percentage decrease in the unemployment rate as a result of “slippages.” Explain the three slippages between changes in output and changes in the unemployment rate. 15.5 THE SIZE OF THE MULTIPLIER LEARNING OBJECTIVE: Identify factors that affect multiplier size. 5.1 Explain the effect that each of the following situations will have on the size of the multiplier: a. An increase in personal income tax across all income brackets. b. An expansionary monetary policy that is inflationary in nature. c. Firms have excess inventories as the economy begins to recover from a recession. d. Firms draw upon existing excess labor employed instead of hiring more people to expand its output. e. An expansionary fiscal policy that is not matched by an increase in taxes. f. An economy-wide increase in wages that is caused due to a new wage law that is expected to be permanent in nature. 5.2 [Related to the Economics in Practice on p. 325] Since 1995, Transparency International has published its annual Corruptions Perceptions Index, which ranks countries by their perceived level of corruption, with corruption defined as the misuse of public power for private benefit. The 2017 index lists the three most corrupt countries as Somalia, South Sudan, and Syria. Part of this misuse of public power for private benefit involves diverting government funds from being spent to improve economic conditions to lining the pockets of government officials. Explain whether yo
u believe this diversion of funds would likely increase or decrease the size of the multiplier in these countries QUESTION 1 According to the Life-Cycle Theory of Consumption, an increase in income would shift the blue Income curve in Figure 15.1 upward. Would you expect this to eliminate the two periods of dissaving? QUESTION 2 Households are able to delay purchases of durable goods during bad economic times, which leads to spending on durable goods to be more volatile than spending on nondurable goods. Identify an example of this…other than cars and smartphones, which are mentioned in the text. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M15_CASE3826_13_GE_C15.indd 328 17/04/19 4:20 AM Long-Run Growth Think about how many hours your great-grandparents had to work to pay for basic necessities like food and clothing. Now think about how many hours you will have to work for the same things. You will likely spend many fewer hours. Today, people on average earn more in real terms per hour than did people of previous generations. This is true in almost all economies, but certainly in all developed economies. In almost all economies the amount of output produced per worker has risen over time. Why? Why are we able to produce more per hour than prior generations did? This is the subject matter of this chapter. We explore the long-run growth process. We briefly introduced long-run growth in Chapter 7. We distinguished between output growth, which is the growth rate of output of the entire economy, and per-capita output growth, which is the growth rate of output per person in the economy. Another important measure is the growth rate of output per worker, called labor productivity growth. Output per capita is a measure of the standard of living in a country. It is not the same as output per worker because not everyone in the population works. Output per capita can fall even when output per worker is increasing if the fraction of the population that is working is falling (as it might be in a country with an increasing number of children per working-age adult). Output per capita is a useful measure because it tells us how much output each person would receive if total output were evenly divided across the entire population. Output per worker is a useful measure because it tells us how much output each worker on average is producing and how that is changing over time. We begin this chapter with a brief history of economic growth since the Industrial Revolution. We then discuss the sources of growth—answering the question why output per worker has risen over time. We then turn to look more narrowly at the U.S. growth picture. We conclude with a discussion of growth and the environment, returning to the world perspective. 16 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 16.1 The Growth Process: From Agriculture to Industry p. 330 Summarize the history and process of economic growth. 16.2 Sources of Economic Growth p. 331 Describe the sources of economic growth. 16.3 Growth and the Environment and Issues of Sustainability p. 339 Discuss environmental issues associated with economic growth. 329 M16_CASE3826_13_GE_C16.indd 329 17/04/19 4:22 AM 330 PART IV Further Macroeconomics Issues 16.1 LEARNING OBJECTIVE Summarize the history and process of economic growth. output growth The growth rate of the output of the entire economy. per-capita output growth The growth rate of output per person in the economy. labor productivity growth The growth rate of output per worker. The Growth Process: From Agriculture to Industry Before the Industrial Revolution in Great Britain, every society in the world was agrarian. Towns and cities existed here and there, but almost everyone lived in rural areas. People spent most of their time producing food and other basic subsistence goods. Then beginning in England around 1750, technical change and capital accumulation increased productivity significantly in two important industries: agriculture and textiles. New and more efficient methods of farming were developed. New inventions and new machinery in spinning and weaving meant that more could be produced with fewer resources. Higher productivity made it possible to feed and clothe the population and have time left to spend working on other projects and new “products,” as the British moved from being largely an agrarian society to industrial production. Peasants and workers in eighteenth-century England who in the past would have continued in subsistence farming could make a better living as urban workers. Growth brought with it new products, more output, and wider choice. The changes described here as Britain experienced productivity growth can be represented graphically. In Chapter 2, we defined a society’s production possibility frontier (ppf ), which shows all possible combinations of output that can be produced given present technology. Economic growth expands those limits and shifts society’s production possibilities frontier out to the right, as Figure 16.1 shows. The transition from agriculture to industry has been more recent in developing countries in Asia. One of the hallmarks of current growth in China and Vietnam, for example, has been the focus on manufacturing exports as a growth strategy. A visitor to Vietnam cannot help but be struck by the pace of industrialization. Economic growth continues today in the developed world. Just as a shovel makes it possible to dig a bigger hole, new microwave towers bring cell phone service to places that had been out of range. Capital continues to bring productivity growth albeit in different form. Scientists work on finding a cure for Alzheimer’s disease using tools they couldn’t have dreamed of a decade ago. Tools available on the Web make it possible for a single law clerk in a busy law office to check hundreds of documents for the opinions of potential expert witnesses in a court case in an hour, a task that took a dozen law clerks weeks to perform just a few years ago. In each case, we have become more proficient at producing what we want and need and we have freed up resources to produce new things that we want and need. Although the nature of economic growth has changed over time, its basic building blocks are the same. Growth comes from a bigger workforce and more productive workers. Higher productivity comes from tools (capital), a better-educated and more highly-skilled workforce ▸▸ FIGURE 16.1 Economic Growth Shifts Society’s Production Possibility Frontier Up and to the Right The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right Food MyLab Economics Concept Check M16_CASE3826_13_GE_C16.indd 330 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 331 TABLE 16.1 Growth of Real GDP: 1999–2016 Country United States Japan Germany France United Kingdom China India Sub-Saharan Africa Average Growth Rates per Year, Percentage Points, 1999–2016 2.1 0.8 1.3 1.4 1.9 9.2 7.2 5.1 Source: Economic Report of the President, 2018, Table B-4. (human capital), and increasingly from innovation and technical change (new techniques of production) and newly developed products and services. Table 16.1 provides estimates of the growth of gross domestic product (GDP) for a number of developed and developing countries for the 17 years from 1999 to 2016. One fact that should strike you as you look at these numbers is the high rates of growth of China and India relative to those of the developed countries. Some economists argue that when poorer, less developed countries begin to develop, they typically have higher growth rates as they catch-up with the more developed countries. This idea is called convergence theory because it suggests that gaps in national incomes tend to close over time. Indeed, more than 50 years ago, the economic historian Alexander Gerschenkron coined the term the advantages of backwardness as a description of the phenomenon by which less developed countries could leap ahead by borrowing technology from more developed countries. This idea seems to fit the current experience of China. In the last few years the growth rate in China has slowed from its average of 9.2 percent in Table 16.1, which some have argued reflects the progress China has already made in catching up to the technological frontier. In 2016 its growth rate was 6.7 percent. You might also note that the growth rate in sub-Saharan Africa is more modest than those in China and India, although still higher than those for the developed countries. We turn now to look at the sources of economic growth as we try to explain these patterns. Sources of Economic Growth It will be useful to begin with a simple case where the quality of labor, L, and the quality of capital, K, do not change over time. A worker is a worker is a worker, and a machine is a machine is a machine. Output, Y, is produced in a production process using L and K. In most situations it seems reasonable to assume that as labor and capital increase, so will output. The exact relationship between these inputs and output can be described with an aggregate production function, which is a mathematical relationship stating that total GDP (output) (Y) depends on the total amount of labor used (L) and the total amount of capital (K) used. (Land is another possible input in the production process, but we are assuming that land is fixed.) The numbers that are used in tables 16.2 and 16.4, which follow, are based on the simple hypothetical production function Y = 3 * K 1 3. This production function tells us that both capital and labor are needed for production (if either is equal to zero, so is output) and increases in either result in more output. The higher expo
nent on labor also tells us that per unit increases in labor increase output more than similar increases in capital. Using this construct we can now explore exactly how an economy achieves higher output levels over time as it experiences changes in labor and capital. 3 L2 > > catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up. 16.2 LEARNING OBJECTIVE Describe the sources of economic growth. aggregate production function A mathematical relationship stating that total GDP (output) depends on the total amount of labor used and the total amount of capital used. Increase in Labor Supply MyLab Economics Concept Check In most situations, it seems logical that if we increase the number of workers in a society, output will increase. Indeed, we see this in the production function we are working with here. A key question is how much does that added labor hour add to output? Both economic theory and M16_CASE3826_13_GE_C16.indd 331 17/04/19 4:22 AM 332 PART IV Further Macroeconomics Issues Government Strategy for Growth Figure 16.1 shows how a country’s production possibility frontier shifts out with technology. Another characteristic of a country that you might want to think about is how far an individual country is from the technological frontier of the rest of the world and how distance from that frontier might influence growth strategies pursued by a country. One of the puzzles in the growth area has been the fact that government strategies for growth seem to succeed in one place and then fail dismally in another. Work by Acemoglu, Aghion, and Zilibotti suggests that one key to successful government policies is how far a country is from the world frontier.1 Suppose a country is behind relative to the world at large. A government’s job here is helping its industries to catch up. What policies work for this? Acemoglu et al. suggest that industrial policy like that used by Japan and South Korea may be helpful for this case. Here the government knows what the right technology is and just has to help its firms find the world frontier. As firms develop, however, and approach the world technological frontier, things change. Now growth comes through innovation, by finding out new ways to do things that are the best in the world. How does the government help in this task? Here, markets with sharp incentives and some encouragement of risk taking likely will be more useful. For this, policies to support entrepreneurship and improve the workings of venture capital will likely work better. Acemoglu and his colleagues argue that governments often shift too late from policies supporting adoption of other countries’ ideas to support of their own innovative efforts. CRITICAL THINKING 1. In recent years China has begun to strengthen its laws on patents. How does this fit in with the research described here? 1Daron Acemoglu, Philippe Aghion, and Fabrizio Zilibotti, “Distance to Frontier, Selection, and Economic Growth,” Journal of the European Economic Association, March 2006, 37–74. practice tell us that in the absence of increases in the capital stock, as labor increases, less and less output will be added by each new worker. This effect is called diminishing returns. It has been discussed for well more than a hundred years, beginning with early economists like Thomas Malthus and David Ricardo who began thinking about the effects of population growth. Malthus and Ricardo focused on agricultural output for which the central form of capital was land. With land in limited supply, the economists reckoned that new farm laborers would be forced to work the land more intensively. As labor supply grew, output would increase, but at a declining rate. Increases in the labor supply would reduce labor productivity, or output per worker. In developed economies, labor works not so much with land as with other forms of capital— machines, computers, and the like. But diminishing returns occur in this setting as well. Table 16.2 provides an arithmetic example of diminishing returns using the aggregate production function discussed previously. Notice in the table the relationship between the level of output and the level of labor. With capital fixed at 100, as labor increases from 100 to eventually 130, total output increases, but at a diminishing rate. In the last column, we see that labor productivity falls. Simply increasing the amount of labor with no other changes in the economy decreases labor productivity because of diminishing returns. Although we have used a hypothetical production function here, empirical work suggests this form with its diminishing returns is typical of production more generally. We now know that increasing labor supply results in an increase in a country’s output. This is one source of growth in the United States. Table 16.3 shows the growth of the U.S. population, labor force, and employment between 1960 and 2017. In this period, the population 16 and older grew at an annual rate of 1.4 percent, the labor force grew at an annual rate of 1.5 percent, and M16_CASE3826_13_GE_C16.indd 332 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 333 TABLE 16.2 Economic Growth from an Increase in Labor: More Output but Diminishing Returns and Lower Labor Productivity Period 1 2 3 4 Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L 100 110 120 130 100 100 100 100 300 320 339 357 3.0 2.9 2.8 2.7 Marginal Return to Labor ΔY/ΔL — 2.0 1.9 1.8 TABLE 16.3 U.S. Employment, Labor Force, and Population Growth, 1960–2017 Civilian Noninstitutional Population 16 and Older (Millions) Civilian Labor Force Number (Millions) Percentage of Population Employment (Millions) 1960 1970 1980 1990 2000 2010 2017 Total percentage change, 1960–2017 Percentage change at an annual rate 117.3 137.1 167.7 189.2 212.6 237.8 255.1 +117.5% +1.4% 69.6 82.8 106.9 125.8 142.6 153.9 160.3 +130.3% +1.5% 59.3 60.4 63.7 66.5 67.1 64.7 62.8 65.8 78.7 99.3 118.8 136.9 139.1 153.3 +133.0% +1.5% Source: Economic Report of the President, 2018, Table B-11. MyLab Economics Real-time data employment grew at an annual rate of 1.5 percent. We will come back to this table later in the chapter. We would expect that this increase in labor would, by itself, end up increasing overall output levels in the United States. Increase in Physical Capital MyLab Economics Concept Check It is easy to see how physical capital contributes to output. Two people digging a garden with one shovel will be able to do more if a second shovel is added. How much more? We saw that there are diminishing returns to labor as more and more labor is added to a fixed amount of capital. There are likewise diminishing returns to capital as more and more capital is added to a fixed supply of labor. The extra output from the garden that can be produced when a second shovel is added is likely to be smaller than the extra output that was produced when the first shovel was added. If a third shovel were added, even less extra output would likely be produced (if any). Table 16.4 shows how an increase in capital without a corresponding increase in labor increases output. It uses the same aggregate production function employed in Table 16.2. Observe three things about these numbers. First, additional capital increases labor productivity—it rises from 3.0 to 3.3 as capital is added. Second, there are diminishing returns to capital. Increasing capital by 10 first increases output by 10—from 300 to 310. However, the second increase of 10 yields only an output increase of nine, and the third increase of 10 yields only an output increase of eight or 0.8 per unit of capital. The last column in the table shows the decline in output per capital as capital is increased. Finally, given that the exponent on capital is 1/3 while that on labor is 2/3 in this case, increasing capital increases output less than does increasing labor. Of course, a different production function would have different results in this respect. M16_CASE3826_13_GE_C16.indd 333 17/04/19 4:22 AM 334 PART IV Further Macroeconomics Issues TABLE 16.4 Economic Growth from an Increase in Capital: More Output, Diminishing Returns to Added Capital, Higher Labor Productivity Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L Output per Capital Y/K Period 1 2 3 4 100 100 100 100 100 110 120 130 300 310 319 327 3.0 3.1 3.2 3.3 3.0 2.8 2.7 2.5 Marginal Return to Capital ∆K ∆Y — > 1.0 0.9 0.8 TABLE 16.5 U.S. Fixed Private Nonresidential Net Capital Stock, 1960–2016 (Billions of 2009 Dollars) 1960 1970 1980 1990 2000 2010 2016 Total percentage change, 1960–2016 Percentage change at an annual rate Equipment Structures 706.1 1,202.0 1,994.0 2,629.0 4,039.4 5,208.2 6,248.0 +784.9% +4.0% 3,451.3 4,769.3 6,294.8 8,336.5 9,808.9 10,967.0 11,483.2 +232.7% +2.2% Source: U.S. Department of Commerce, Bureau of Economic Analysis., Fixed Asset Tables. Table 16.4 shows what happens to output as capital increases with a hypothetical production function. Table 16.5 uses actual U.S. data to show the growth of capital equipment and capital structures between 1960 and 2016. (The increase in the capital stock is the difference between gross investment and depreciation. Remember that some capital becomes obsolete and some wears out each year.) Between 1960 and 2016 the stock of equipment grew at an annual rate of 4.0 percent and the stock of structures grew at an annual rate of 2.2 percent. Notice the growth rates of capital in Table 16.5 (4.0 percent and 2.2 percent) are larger than the growth rate of labor in Table 16.3 (1.5 percent). Capital has grown relative to labor in the United States. As a result, each U.S. worker has more capital to work with now than he or she had a hundred years ago. We see in Table 16.4 that adding more capital relative to labor increases labor productivity. We thus have one answer so far as
to why labor productivity has grown over time in the United States—the amount of capital per worker has grown. You are able to produce more output per hour than your grandparents did because you have more capital to work with. In almost all economies, capital has been growing faster than labor, which is an important source of labor productivity growth in these economies. The importance of capital in a country’s economic growth naturally leads one to ask the question of what determines a country’s stock of capital. In the modern open economy, new capital can come from the saving of a country’s residents or from the investments of foreigners. Foreign direct investment is any investment in enterprises made in a country by residents outside that country. Foreign direct investment has been quite influential in providing needed capital for growth in much of Southeast Asia. In Vietnam, for example, rapid growth has been led by foreign direct investment. More recently, we have seen signs of Chinese foreign direct investment in parts of Africa and in other parts of Asia. Recent work in economics has focused on the role that institutions play in creating a capitalfriendly environment that encourages home savings and foreign investment. In a series of papers, LaPorta, Lopez de Silanes, Shleifer, and Vishny argue that countries with English common-law origins (as opposed to French) provide the strongest protection for shareholders, less corrupt governments, and better court systems. In turn, these financial and legal institutions promote growth by encouraging capital investment. Countries with poor institutions, corruption, and Foreign Direct Investment Investment in (FDI) enterprises made in a country by residents outside that country. M16_CASE3826_13_GE_C16.indd 334 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 335 inadequate protection for lenders and investors struggle to attract capital. The World Bank calls countries with weak institutions fragile countries. Many of the World Bank’s fragile countries are in Sub-Saharan Africa. Many observers believe that the relative stagnation of some of the Sub-Saharan African nations comes in part from their relatively weak institutions. High costs of doing business, including corruption and investment risks associated with conflict, have made countries such as Zimbabwe less attractive to domestic and foreign capital. Ethnic and linguistic fractionalization have also played a role. Increase in the Quality of the Labor Supply (Human Capital) MyLab Economics Concept Check So far we have looked at what happens when an economy gets more units of identical workers. As we well know, in most societies, populations have grown more educated and healthier over time. The quality of labor has changed, as well as its quantity, and this too leads to long-run growth. When the quality of labor increases, this is referred to as an increase in human capital. If a worker’s human capital has increased, he or she can produce more output working with the same amount of physical capital. Labor input in efficiency terms has increased. Human capital can be produced in many ways. Individuals can invest in themselves by going to college or by completing vocational training programs. Firms can invest in human capital through on-the-job training. The government invests in human capital with programs that improve health and that provide schooling and job training. In many developing economies, we have seen high returns from educating women who had previously been largely unschooled. In the developing countries of Sub-Saharan Africa, health is a major issue because of the high incidence of malaria, HIV, and other diseases and the lack of available medical services. Programs to improve the health of the population increase the quality of the labor force, which increases output. In the United States, considerable resources have been put into education over the decades. Table 16.6 shows that the level of educational attainment in the United States has risen significantly since 1940. The percentage of the population with at least four years of college rose from 4.6 percent in 1940 to 34.2 percent in 2017. In 1940 fewer than one person in four had completed high school; in 2017, 89.6 percent had. This is a substantial increase in human capital. We thus have our second answer as to why labor productivity has increased in the United States—the quality of labor has increased through more education. Policymakers in many developed economies are concerned about their ability to continue to generate growth through human capital improvements. Increase in the Quality of Capital (Embodied Technical Change) MyLab Economics Concept Check Just as workers have changed in the last one hundred years, so have machines. A present-day word processor is quite different from the manual typewriter of the mid-twentieth century. TABLE 16.6 Years of School Completed by People Older Than 25 Years, 1940–2017 Percentage with Less than 5 Years of School Percentage with 4 Years of High School or More Percentage with 4 Years of College or More 1940 1950 1960 1970 1980 1990 2000 2010 2017 13.7 11.1 8.3 5.5 3.6 NA NA NA NA 24.5 34.3 41.1 52.3 66.5 77.6 84.1 87.1 89.6 4.6 6.2 7.7 10.7 16.2 21.3 25.6 29.9 34.2 NA = not available Source: Statistical Abstract of the United States, 1990, Table 215, and 2012, Table 229, and Bureau of the Census, 2017, Table 2, Educational Attainment. M16_CASE3826_13_GE_C16.indd 335 17/04/19 4:22 AM 336 PART IV Further Macroeconomics Issues Germany’s Open Border Policy How can one country’s political crisis impact another’s economy? Between 2015 and 2018, more than a million refugees sought asylum in Europe to escape the atrocities of war and turbulence in the Middle East and some African nations, an event now known as the European refugee crisis. During this crisis, Germany accommodated the largest number of migrants, increasing its population by more than 1 percent. This was bound to cost Germany; the state budget incurred over €45 billion in additional social welfare and refugee integration expenditure. Apart from monetary costs, concerns around social polarization have also been one of the main topics of debate among Germany’s politicians. Is this all there is to accommodating refugees? Germany consists of a rapidly aging native population and also has a low proportion of females in the labor force in comparison to other industrialized nations. A recent study by the World Education Services1 estimates that over 65 percent of asylum seekers during the period between 2015 and 2017 were male and almost 75 percent were below the age of 24. According to this study, if Germany invests in providing these refugees with education, vocational training, language instruction, and integration courses, it can expand on the skills and knowledge of 20 percent of the educated and skilled refugees. As costly as the acceptance of refugees may be, properly integrating them in the society might turn out to be a solution to some of Germany’s economic challenges. CRITICAL THINKING 1. What are the long-term gains and the short-term costs of investing in an influx of human capital? 1Stefan Trines, “Lessons from Germany’s Refugee Crisis: Integration, Costs, and Benefits,” World Education News and Reviews, World Education Services, May 2, 2017. embodied technical change Technical change that results in an improvement in the quality of capital. An increase in the quality of a machine will increase output in the production process for the same amount of labor used. How does an increase in the quality of capital come about? It comes about in what we will call embodied technical change. Some technical innovation takes place, such as a faster computer chip, which is then incorporated into machines. Usually the technical innovations are incorporated into new machines, with older machines simply discarded when they become obsolete. In this case the quality of the total capital stock increases over time as more efficient new machines replace less efficient old ones. In some cases, however, innovations are incorporated into old machines. Commercial airplanes last for many decades, and many innovations that affect airplanes are incorporated into existing ones. In general, one thinks of embodied technical change as showing up in new machines rather than existing ones. An increase in the quality of capital increases labor productivity (more output for the same amount of labor). We thus have our third answer as to why labor productivity has increased over time—the quality of capital has increased because of embodied technical change. We will come back to embodied technical change, but to finish our inventory of the sources of economic growth we turn next to our last source of growth, disembodied technical change. Disembodied Technical Change MyLab Economics Concept Check In some situations we can achieve higher levels of output over time even if the quantity and quality of labor and capital don’t change. How might we do this? Perhaps we learn how to better organize the plant floor or manage the labor force. In recent years operational improvements like lean manufacturing, yield management, and vendor inventory management systems have increased the ability of many manufacturing firms to get more output from a fixed amount and quality of labor and capital. Even improvements in information and accounting systems or incentive systems can lead to improved output levels. A type of technical change that is not M16_CASE3826_13_GE_C16.indd 336 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 337 disembodied technical change Technical change that results in a change in the production process. invention An advance in knowledge. innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently. specifically embedded in either labor or capital but works instead to allow us to get more out of both is called disembodied technical c
hange. Recent experiences in the Chinese economy provide an interesting example of what might be considered disembodied technical change broadly defined. Working at the IMF, Zuliu Hu and Mohsin Khan have pointed to the large role of productivity gains in the 20 years following the market reforms in China. In the period after the reforms, productivity growth rates tripled, averaging almost 4 percent a year. Hu and Khan argue that the productivity gains came principally from the unleashing of profit incentives that came with opening business to the private sector. Better incentives produced better use of labor and capital. Positive disembodied technical changes are our fourth answer as to why labor productivity has increased. People have figured out how to run production processes and how to manage firms more efficiently. More on Technical Change MyLab Economics Concept Check We have seen that both embodied and disembodied technical change increase labor productivity. It is not always easy to decide whether a particular technical innovation is embodied or disembodied, and in many discussions this distinction is not made. In the rest of this section we will talk in general about technical innovations. The main point to keep in mind is that technical change, regardless of how it is categorized, increases labor productivity. The Industrial Revolution was in part sparked by new technological developments. New techniques of spinning and weaving—the invention of the machines known as the mule and the spinning jenny, for example—were critical. The high-tech boom that swept the United States in the early 1980s was driven by the rapid development and dissemination of semiconductor technology. The high-tech boom in the 1990s was driven by the rise of the Internet and the technology associated with it. In India in the 1960s, new high-yielding seeds helped to create a “green revolution” in agriculture. Technical change generally takes place in two stages. First, there is an advance in knowledge, or an invention. However, knowledge by itself does nothing unless it is used. When new knowledge is used to produce a new product or to produce an existing product more efficiently, there is innovation. Given the centrality of innovation to growth, it is interesting to look at what has been happening to research in the United States over time. A commonly used measure of inputs into research is the fraction of GDP spent. In 2011, the United States spent 2.7 percent of its GDP on research and design (R&D), down slightly from a high of 2.9 percent in the early 1960s. Over time the balance of research funding has shifted away from government toward industry. Because industry research tends to be more applied, some observers are concerned that the United States will lose some of its edge in technology unless more government funding is provided. In 2007, the National Academies of Science argued as follows: Although many people assume that the United States will always be a world leader in science and technology, this may not continue to be the case inasmuch as great minds and ideas exist throughout the world. We fear the abruptness with which a lead in science and technology can be lost—and the difficulty of recovering a lead once lost, if indeed it can be recovered at all.1 Since this report, government funding has continued to decline as a percent of all research spending, but industry spending has increased. In 2015, total research spending as a fraction of GDP was close to the all time high of the 1960s. As we suggested previously, the theory of convergence suggests that newly developing countries can leap forward by exploiting the technology of the developed countries. Indeed, all countries benefit when a better way of doing things is discovered. Innovation and the diffusion of that 1National Academies, “Rising Above the Gathering Storm: Energizing the Employing America for a Brighter Future,” National Academies Press, 2007. M16_CASE3826_13_GE_C16.indd 337 17/04/19 4:22 AM 338 PART IV Further Macroeconomics Issues innovation push the production possibility frontier outward. There is at least some evidence that a country that leads in a discovery retains some advantage in exploiting it, at least for some time. Looking at R&D as a share of GDP, the United States ranked fourth in 2015, following South Korea, Japan and Germany. In terms of absolute dollars spend on research, the United States is first. Among firms investing in research, Amazon and Alphabet are the leading corporate funders of R&D. If we look at patenting data, which we can think of as the output of innovation, the United States is also in the lead among countries. For patents simultaneously sought in the United States, Japan, and the European Union (EU), known as triadic patents, U.S. inventors are the leading source, having taken the lead from the EU in 1989. On the output side, then, the United States still appears to be quite strong in the area of research. The Economics in Practice box on page 336 describes the economics of open border policies. U.S. Labor Productivity: 1952 I–2017 IV MyLab Economics Concept Check Now that we have considered the various answers as to why U.S. labor productivity has increased over time, we can return to the data and see what the actual growth has been. In Figure 16.2, we presented a plot of U.S. labor productivity for the 1952 I–2017 IV period. This figure is repeated in Figure 16.2. Remember that the line segments are drawn to smooth out the short-run fluctuations in productivity. We saw in the last chapter that given how productivity is measured, it moves with the business cycle because firms tend to hold excess labor in recessions. We are not interested in business cycles in this chapter, and the segments are a way of ignoring business cycle effects. There was much talk in the late 1970s and early 1980s about the U.S. “productivity problem.” Some economics textbooks published in the early 1980s had entire chapters discussing the decline in productivity that seemed to be taking place during the late 1970s. In January 1981, the Congressional Budget Office published a report, The Productivity Problem: Alternatives for Action. It is clear from Figure 16.2 that there was a slowdown in productivity growth in the 1970s. The growth rate went from 3.4 percent in the 1950s and first half of the 1960s to 2.6 percent in the last half of the 1960s and early 1970s and then to 1.6 percent from the early 1970s to the 1990s. Many explanations were offered at the time for the productivity slowdown of the late 1970s and early 1980s. Some economists pointed to the low rate of saving in the United States compared with other parts of the world. Others blamed increased environmental and government regulation of U.S. business. Still others argued that the country was not spending as much on R&D as it should have been. Finally, some suggested that high energy costs in the 1970s led to investment designed to save energy instead of to enhance labor productivity. 1.0% 2.0% Line segments 1.6% 2.6% Output per worker hour 3.3 ( 71.0 64.0 32.0 16.0 1952 I 1955 I 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I Quarters 1990 I 1995 I 2000 I 2005 I 2010 I 2015 I 2017 IV MyLab Economics Concept Check ▸▴ FIGURE 16.2 Output per Worker Hour (Productivity), 1952 I–2017 IV M16_CASE3826_13_GE_C16.indd 338 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 339 16.3 LEARNING OBJECTIVE Discuss environmental issues associated with economic growth. Productivity growth increased to 2.0 percent between 1993 and 2010, but the growth since 2010 has been low, as you can see from the figure. This slowdown is a puzzle, particularly given the continuing growth of the Internet and wireless devices. More time is needed to know what this portends for future growth rates. Will the United States return to a productivity growth rate of around 2.0 percent? Growth and the Environment and Issues of Sustainability In 2000, the United Nations (UN) unanimously adopted the Millennium Development Goals, a set of quantifiable, time-based targets for developing countries to meet. Included in these targets, as you might expect, were measures of education, mortality, and income growth. The UN resolution also included a set of environmental criteria. Specific criteria have been developed around clean air, clean water, and conservation management. The inclusion of environmental considerations in the development goals speaks to the importance of environmental infrastructure in the long-run growth prospects of a country. Policymakers are also increasingly concerned that growth will bring with it environmental degradation. Evidence of global warming has increased some of the international concerns about growth and the environment. The connections between the environment and growth are complex and remain debated among economists. The classic work on growth and the environment was done in the mid-1990s by Gene Grossman and Alan Krueger.2 It is well known that as countries develop, they typically generate air and water pollutants. China’s recent rapid growth provides a strong example of this fact. Grossman and Krueger found, however, that as growth progresses and countries become richer, pollution tends to fall. The relationship between growth, as measured in per-capita income, and pollution is an inverted U. Figure 16.3 shows Grossman and Krueger’s evidence on one measure of air pollution. How do we explain the inverted U? Clean water and clean air are what economists call normal goods. That is, as people get richer, they want to consume more of these goods. You have already seen in the Keynesian model that aggregate consumption increases with income. As it happens, microeconomics finds that this relationship is true for most individual types of goods as well. Demand for clean water and clean air turns out to increase with income levels. As countries develop, their populace increasingly demands improvements on these front
s. We have seen an increasing number of public protests about the environment in China, for example. So although increased industrialization with growth initially degrades the environment, in the long run environmental quality typically improves 150 125 100 75 50 25 0 2 4 6 8 10 12 GDP per capita (1985 $1,000s) MyLab Economics Concept Check ▸◂ FIGURE 16.3 The Relationship Between Per-Capita GDP and Urban Air Pollution One measure of air pollution is smoke in cities. The relationship between smoke concentration and per-capita GDP is an inverted U: As countries grow wealthier, smoke increases and then declines. Source: Gene Grossman and Alan Krueger, QJE, May 1995. 2Gene Grossman and Alan Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics, May 1995. M16_CASE3826_13_GE_C16.indd 339 17/04/19 4:22 AM 340 PART IV Further Macroeconomics Issues Grossman and Krueger found this inverted U in a number of countries. Economic historians remind us that in the heyday of industrialization, northern England suffered from serious air pollution. Some of you may recall the description of air pollution in nineteenth-century English novels such as Elizabeth Gaskell’s North and South. If environmental pollution eventually declines as growth brings rising per-capita incomes, why should we be worried? First, as Grossman and Krueger point out, the inverted U represents historical experience, but it is not inevitable. In particular, if public opinion moves governments and the economy at large toward technologies that reduce pollution, this requires an empowered populace and a responsive government. Here too we see the importance of institutions in growth. A second issue arises in cases in which high levels of current emissions produce irreversible outcomes. Some would argue that by the time nations such as China and Vietnam develop enough to reduce their emissions, it will be too late. Many believe that global warming is such an example. Another important problem comes from pollution sources that move across country boundaries. Carbon emissions associated with global warming are one such by-product of increased industrialization. Other air pollution problems move across national borders as well. In the heyday of industrialization by the Soviet Union, prevailing winds blew much of the Sovietproduced pollution to Finland. Choices that countries make about levels of growth and levels of environmental control affect the well-being of other countries’ populations. Nor is it easy for countries at different levels of GDP per capita to agree on common standards of environmental control. As we suggested previously, demand for clean air increases with income, when needs for food and shelter are better met. It should surprise no one who has studied economics that there are debates between developing countries and developed countries about optimal levels of environmental control. These debates are further complicated when we recognize the gains that consumers in developed economies reap from economic activity in the developing world. Much of the increased carbon emitted by Chinese businesses, for example, is associated with goods that are transported and traded to Europe and the United States. These consumers thus share the benefits of this air pollution through the cheaper goods they consume. Much of Southeast Asia has fueled its growth through export-led manufacturing. For countries that have based their growth on resource extraction, there is another set of potential sustainability issues. Many of the African nations are in this category. Nigeria relies heavily on oil; South Africa and the Congo are large producers of diamonds and other gems. Extraction methods, of course, may carry environmental problems. Many people also question whether growth based on extraction is economically sustainable: What happens when the oil or minerals run out? The answer is quite complicated and depends in some measure on how the profits from the extraction process are used. Because extraction can be accomplished without a well- educated labor force, whereas other forms of development are more dependent on a skilled-labor base, public investment in infrastructure is especially important. To the extent that countries use the revenues from extraction to invest in infrastructure such as roads and schools and to increase the education and health of their populace, the basis for growth can be shifted over time. With weak institutions, these proceeds may be expropriated by corrupt governments or invested outside the country, and long-run sustainable growth will not result. The question of whether the natural resource base imposes strong natural limits on growth has been debated since the time of Malthus. Malthus as early as the 18th century worried that population growth in England would outstrip the ability of the land to provide. In that period, technology provided an answer, facilitating output growth. In 1972, the Club of Rome, a group of “concerned citizens,” contracted with a group at MIT to do a study titled The Limits to Growth.3 The book-length final report presented the results of computer simulations that assumed present growth rates of population, food, industrial output, and resource exhaustion. According to these data, sometime after the year 2000 the limits will be reached and the entire world economy will come crashing down: Collapse occurs because of nonrenewable resource depletion. The industrial capital stock grows to a level that requires an enormous input of resources. In the very process of that growth, it depletes a large fraction of the resource reserves available. As resource prices 3Donella H. Meadows et al., The Limits to Growth (Washington, D.C.: Potomac Associates, 1972). M16_CASE3826_13_GE_C16.indd 340 17/04/19 4:22 AM CHAPTER 16 Long-Run Growth 341 rise and mines are depleted, more and more capital must be used for obtaining resources, leaving less to be invested for future growth. Finally, investment cannot keep up with depreciation and the industrial base collapses, taking with it the service and agricultural systems, which have become dependent on industrial inputs (such as fertilizers, pesticides, hospital laboratories, computers, and especially energy for mechanization). . . Population finally decreases when the death rate is driven upward by the lack of food and health services.4 This argument is similar to one offered almost 200 years ago by Thomas Malthus, mentioned previously in this chapter. Neither Malthus nor the Club of Rome had accounted for the role of rising prices in mitigating some of these effects. In the early 1970s, many thought that the Club of Rome’s predictions had come true. It seemed the world was starting to run up against the limits of world energy supplies. In the years since, new reserves have been found and new sources of energy, including large reserves of gas and oil produced by fracking, have been discovered and developed largely in response to rising energy prices. At present, issues of global warming and biodiversity are causing many people to question the process of growth. How should one trade off the obvious gains from growth in terms of the lives of those in the poorer nations against environmental goals? Recognizing the existence of these tradeoffs and trying to design policies to deal with them is one of the key tasks of policymakers. 4Meadows et al., pp. 131–132. S U M M A R Y 1. In almost all countries output per worker, labor productivity, has been growing over time. 16.1 THE GROWTH PROCESS: FROM AGRICULTURE TO INDUSTRY p. 330 2. All societies face limits imposed by the resources and technologies available to them. Economic growth expands these limits and shifts society’s production possibilities frontier up and to the right. 3. There is considerable variation across the globe in growth rates. Some countries—particularly in Southeast Asia— appear to be catching up. 4. The process by which some less developed, poorer countries experience high growth and begin to catch up to more developed areas is known as convergence. 16.2 SOURCES OF ECONOMIC GROWTH p. 331 5. An aggregate production function embodies the relationship between inputs—the labor force and the stock of capital— and total national output. 6. A number of factors contribute to economic growth: (1) an increase in the labor supply, (2) an increase in physical capital—plant and equipment, (3) an increase in the quality of the labor supply—human capital, (4) an increase in the quality of physical capital—embodied technical change, and (5) disembodied technical change—for example, an increase in managerial skills. 7. The growth rate of labor productivity in the United States decreased from about 3.4 percent in the 1950s and 1960s to about 2.0 percent in the 1990s and 2000s. Since 2010 it has been quite low. 16.3 GROWTH AND THE ENVIRONMENT AND ISSUES OF SUSTAINABILITY p. 339 8. As countries begin to develop and industrialize, environ- mental problems are common. As development progresses further, however, most countries experience improvements in their environmental quality. 9. The limits placed on a country’s growth by its natural resources have been debated for several hundred years. Growth strategies based on extraction of resources may pose special challenges to a country’s growth aggregate production function, p. 331 catch-up, p. 331 disembodied technical change, p. 337 embodied technical change, p. 336 foreign direct investment (FDI), p. 334 innovation, p. 337 invention, p. 337 labor productivity growth, p. 329 output growth, p. 329 per-capita output growth, p. 329 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M16_CASE3826_13_GE_C16.indd 341 17/04/19 4:22 AM 342 PART IV Further Macroeconomics Issues P R O B L E M S All problems are available on MyLab Economics. 16.1 THE GROWTH PROCE
SS: FROM AGRICULTURE TO INDUSTRY LEARNING OBJECTIVE: Summarize the history and process of economic growth. 1.1 Go to a recent issue of The Economist magazine. In the back of each issue is a section called “economic indicators.” That section lists the most recent growth data for a substantial number of countries. Which countries around the world are growing most rapidly according to the most recent data? Which countries around the world are growing more slowly? Flip through the stories in The Economist to see if there is any explanation for the pattern that you observe. Write a brief essay on current general economic conditions around the world. 1.2 The data in the following table represents real GDP from 2013–2016 for five countries. a. Calculate the growth rate in real GDP for all five countries from 2013–2014. Which country experienced the highest rate of economic growth from 2013–2014? b. Calculate the growth rate in real GDP for all five countries from 2014–2015. Which country experienced the highest rate of economic growth from 2014–2015? c. Calculate the growth rate in real GDP for all five countries from 2015–2016. Which country experienced the highest rate of economic growth from 2015–2016? d. Calculate the average annual growth rate in real GDP for all five countries from 2013–2016. Which country experienced the highest average annual rate of economic growth from 2013–2016? Country 2013 2014 2015 2016 United States El Salvador Republic of South Africa Cambodia Russia 15,802.86 22.72 406.12 16,177.46 23.04 413.02 16,597.45 23.57 418.39 16,865.60 24.13 419.56 13.88 1,666.93 14.86 1,679.12 15.90 1,631.63 17.00 1,627.96 All values are in billions of 2010 U.S. dollars. Source: United States Department of Agriculture. 1.3 The data in the following table represents real GDP per capita in 1980 and 2016 for five countries. Fill in the table by calculating the annual growth rate in real GDP per capita from 1980 to 2016. Is the data in the completed table consistent with convergence theory? Explain. Country United States El Salvador Republic of South Africa Cambodia Russia Real GDP per Capita in 1980 Real GDP per Capita in 2016 Annual Growth in Real GDP per Capita 1980–2016 28,734 2,577 6,560 234 8,282 52,152 3,919 7,727 1,065 11,436 All values are in 2010 U.S. dollars. Source: United States Department of Agriculture. 1.4 Use the data in the following table to explain what happened with respect to economic growth and the standard of living in each of the three countries. Country Thesia Tuchaka Palewen Real GDP 2017 Real GDP 2018 Population 2017 Population 2018 10,000,000 3,200,000 7,400,000 10,350,000 3,500,000 7,680,000 2,000 6,000 3,500 2,050 6,500 3,700 16.2 SOURCES OF ECONOMIC GROWTH LEARNING OBJECTIVE: Describe the sources of economic growth. 2.1 Eastern European countries, like Hungary and Poland, experienced real wage growth in 2017 and 2018, partially due to low unemployment. At the same time, chronic shortage of trained workers caused many companies, and in some cases even public administration, to automatize and simplify processes. Explain how a shortage of trained labor can lead to an increase in real wages as well as productivity? 2.2 Tables 1,2, and 3 that follow present some data on three hypothetical economies. Complete the tables by figuring the measured productivity of labor and the rate of output growth. What do the data tell you about the causes of economic growth? (Hint: How fast are L and K growing?) MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M16_CASE3826_13_GE_C16.indd 342 17/04/19 4:22 AM TABLE 1 Period L 1 2 3 4 1,120 1,135 1,152 1,170 K 3,205 3,500 3,798 4,045 TABLE 2 Period L 1 2 3 4 1,120 1,175 1,255 1,344 K 3,205 3,246 3,288 3,315 TABLE 3 Period L 1 2 3 4 1,120 1,135 1,152 1,170 K 3,205 3,246 3,288 3,315 Y Y/L Growth Rate of Output 4,650 4,795 4,945 5,100 Y Y/L Growth Rate of Output 4,650 4,775 4,904 5,036 Y Y/L Growth Rate of Output 4,650 4,840 5,038 5,244 2.3 In July 2018, President Trump was considering cutting taxes on capital gains amounting to approximately $100 billion and allowing taxpayers to account for inflation when calculating tax dues on capital gains. In what ways would you expect such a policy to be favorable to economic growth? Source: “Trump Administration Eyes Capital Gains Tax Cut for Wealthy: NY Times,” www.reuters.com, July 31, 2018. 2.4 [Related to the Economics in Practice on p. 332] In a March 2013 press release, the World Bank announced its support to assist Indonesia in accelerating its economic growth through the Research and Innovation in Science and Technology Project (RISET). This project is designed to boost research and innovation in Indonesia and assist the country in evolving into a knowledge-based economy. According to Stefan G. Koeberle, World Bank Country Director for Indonesia, “Improving human resources and national capabilities in science and technology is a key pillar in Indonesia’s masterplan to accelerate and expand its economy. Shifting from a resource-based economy to a knowledge-based economy will bring Indonesia up the value chain in a wide range of sectors, with the help of homegrown innovation and a vast pool of human resources.” The press release states that a large part of CHAPTER 16 Long-Run Growth 343 the RISET program will involve assistance in raising the academic credentials of Indonesian researchers involved with science and engineering, and it is hoped that the program will eventually lead to increased investment in R&D, where as a percentage of GDP, Indonesia’s R&D investment falls significantly below many of its Asian neighbors. Using the information presented in this chapter, explain how increasing research and innovation and raising the academic credentials of researchers can assist in increasing long-run economic growth in Indonesia. Source: “World Bank Supports Move to Accelerate Indonesia’s Economic Growth through Science, Technology, and Innovation,” www.worldbank.org, March 29, 2013. Used by permission. 2.5 Education is an area in which it has been hard to create productivity gains that reduce costs. Collect data on the tuition rates of your own college in the last 20 years and compare that increase to the overall rate of inflation using the consumer price index. What do you observe? Can you suggest some productivity-enhancing measures? 2.6 Economists generally agree that high budget deficits today will reduce the growth rate of the economy in the future. Why? Do the reasons for the high budget deficit matter? In other words, does it matter whether the deficit is caused by lower taxes, increased defense spending, more job-training programs, and so on? 2.7 Why can growth lead to a more unequal distribution of income? By assuming this is true, how is it possible for the poor to benefit from economic growth? 2.8 According to the Bureau of Labor Statistics, during the first quarter of 2015 nonfarm business productivity in the United States fell 3.1 percent and manufacturing productivity fell 1.0 percent compared to the first quarter of 2014. During this same time, real GDP in the United States increased by 2.9 percent. Explain how productivity can decrease when real GDP is increasing. 2.9 How do each of the following relate to the rates of produc- tivity and growth in an economy? a. Spending on research and development b. Government regulation c. Changes in human capital d. Output per worker hour e. Embodied technical change f. Disembodied technical change 2.10 [Related to the Economics in Practice on p. 336] Human capital has often been cited as one of the driving forces of economic growth. Go to http://ec.europa.eu/eurostat and look up the current unemployment rate. Compare this to the unemployment rates across different levels of educational attainment. What does this data suggest about changes in education requirements for jobs in the EU? Also look at the percentage of people who have completed tertiary education or more in the age band of 25–64 for the years 2003–2014. Compare this data with the unemployment data. What does this information suggest about future productivity and growth for the economy of the European Union? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M16_CASE3826_13_GE_C16.indd 343 17/04/19 4:22 AM 344 PART IV Further Macroeconomics Issues 16.3 GROWTH AND THE ENVIRONMENT AND ISSUES OF SUSTAINABILITY LEARNING OBJECTIVE: Discuss environmental issues associated with economic growth. 3.1 In June 2013, President Obama’s Climate Action Plan was announced. One the main aims of this plan was to reduce carbon dioxide emissions in the United States by 17 percent from 2005 levels by 2020. Also note that America’s per capita real GDP grew by 2.4 percent from 2013 to 2014. In this context, explain how the attainment of the goals of this plan reconciles with the inverted-U relationship as theorized by Gene Grossman and Alan Krueger QUESTION 1 Many international nongovernmental organizations (NGOs) work on improving health and educational outcomes for people living in developing countries. How would you expect these efforts to affect long-run growth? QUESTION 2 The enforcement of legal contracts and property rights is essential for supporting long-run growth. Based on what you learned in this chapter, why is this so? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M16_CASE3826_13_GE_C16.indd 344 17/04/19 4:22 AM Alternative Views in Macroeconomics 17 Throughout this book, we have noted that there are many open questions in macroeconomics. For example, economists disagree on whether fiscal policy can change aggregate output levels: I
s the aggregate supply curve is vertical, either in the short run or in the long run, so that all attempts to change output end up with higher wages and prices instead? Is the aggregate supply curve even a useful macroeconomic concept? There are different views on whether cyclical employment exists and, if it does, what causes it. Economists disagree about whether monetary policies are effective at stabilizing the economy, and they support different views on the primary determinants of consumption and investment spending. We discussed some of these disagreements in previous chapters, but only briefly. In this chapter, we discuss in more detail a number of alternative views of how the macroeconomy works. We begin with a little history of the early debates between Keynesians and monetarists and then move on to more modern alternative theories of the macroeconomy. CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 17.1 Keynesian Economics p. 346 Summarize Keynesian economics. 17.2 Monetarism p. 346 Explain the quantity theory of money. 17.3 Supply-Side Economics p. 349 Explain the fundamentals of supply-side economics. 17.4 New Classical Macroeconomics p. 351 Discuss the real business cycle theory and new Keynesian economics. 17.5 Behavioral Macroeconomics p. 356 What contributions has behavioral economics made to macroeconomics? 17.6 Testing Alternative Macroeconomic Models p. 356 Discuss why it is difficult to test alternative macroeconomic theories. 345 M17_CASE3826_13_GE_C17.indd 345 17/04/19 12:54 AM 346 PART IV Further Macroeconomics Issues 17.1 LEARNING OBJECTIVE Summarize Keynesian economics. 17.2 LEARNING OBJECTIVE Explain the quantity theory of money. velocity of money The ratio of nominal GDP to the stock of money. Keynesian Economics John Maynard Keynes’s General Theory of Employment, Interest, and Money, published in 1936, remains one of the most important works in economics. Although a great deal of the material in the previous nine chapters is drawn from modern research that postdates Keynes, much of the material is built around a framework constructed by Keynes. What exactly is Keynesian economics? In one sense, it is the foundation of all of macroeconomics. Keynes was the first to emphasize aggregate demand and links between the money market and the goods market. Keynes also emphasized the possible problem of sticky wages and the importance of animal spirits in business cycles. In recent years, the term Keynesian has been used more narrowly. Keynes believed in an activist federal government. He believed that the government had a role to play in fighting inflation and unemployment, and he believed that monetary and fiscal policies should be used to manage the macroeconomy. This is why Keynesian is sometimes used to refer to economists who advocate active government intervention in the macroeconomy. We begin with an old debate between Keynesians and monetarists. From an historical perspective, monetarism was the earliest challenge to the activism of Keynesian economics. Monetarism The Velocity of Money MyLab Economics Concept Check To understand monetarism we need to go back to the fundamentals of how we use money. A key variable in monetarism is the velocity of money, which is defined as the ratio of nominal GDP to the stock of money. Suppose on January 1 you buy a new ballpoint pen with a $5 bill. The owner of the stationery store does not spend your $5 right away. She may hold it until, say, May 1, when she uses it to buy a dozen doughnuts. The doughnut store owner does not spend the $5 he receives until July 1, when he uses it (along with other cash) to buy 100 gallons of oil. The oil distributor uses the bill to buy an engagement ring for his fiancée on September 1, but the $5 bill is not used again in the remaining three months of the year. This $5 bill has changed hands four times during the year; its velocity of circulation is four. A velocity of four means that the $5 bill stays with each owner for an average of three months, or one quarter of a year. In practice, we use gross domestic product (GDP), instead of the total value of all transactions in the economy, to measure velocity1 because GDP data are more readily available. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M): V K GDP M If $12 trillion worth of final goods and services is produced in a year and if the money stock is $1 trillion, then the velocity of money is $12 trillion , $1 trillion, or 12.0. We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P): Through substitution: or GDP 1Recall that GDP does not include transactions in intermediate goods (for example, flour sold to a baker to be made into bread) or in existing assets (for example, the sale of a used car). If these transactions are made using money, however, they do influence the number of times money changes hands during the course of a year. GDP is an imperfect measure of transactions to use in calculating the velocity of money. M17_CASE3826_13_GE_C17.indd 346 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 347 quantity theory of money The theory based on the identity M * V K P * Y and the assumption that V the velocity of money is constant (or virtually 1 constant). 2 At this point, it is worth pausing to ask whether our definition has provided us with any insights into the workings of the economy. The answer is no, because we defined V as the ratio of GDP to the money supply, the statement M * V K P * Y is an identity—it is true by definition. It contains no more useful information than the statement, “A tulip is a flower.” The definition does not, for example, say anything about what will happen to P * Y when M changes. The final value of P * Y depends on what happens to V. If V falls when M increases, the product M * V could stay the same, in which case the change in M would have had no effect on nominal income. To give monetarism some economic content, we will focus on a simple version of monetarism known as the quantity theory of money. The Quantity Theory of Money MyLab Economics Concept Check The key assumption of the quantity theory of money is that the velocity of money is constant (or virtually constant) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows: M * V = P * Y Note that the double bar equal sign has replaced the triple bar equal sign because the equation is no longer an identity. The equation is true if velocity is constant (and equal to V) but not otherwise. If the equation is true, it provides an easy way to explain nominal GDP. Given M, which can be considered a policy variable set by the Federal Reserve (Fed), nominal GDP is just M * V. In this case, the effects of monetary policy are clear. Changes in M cause equal percentage changes in nominal GDP. For example, if the money supply doubles, nominal GDP also doubles. If the money supply remains unchanged, nominal GDP remains unchanged. If the Fed, which controls the money supply, increases that supply, nominal GDP will go up. If we are already at full employment, all that happens is that prices rise. Monetarist believed that a central cause of inflation was mismanagement by the Fed of the money supply. Is the velocity of money really constant? The logic of the monetarist argument depends on its constancy. Early economists believed that the velocity of money was determined largely by institutional considerations, such as how often people are paid and how the banking system clears transactions between banks. These factors change gradually, leading economists to believe velocity was essentially constant. When there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. That could mean that M in the quantity-theory equation equals both the quantity of money supplied and the quantity of money demanded. If the quantity-theory equation is looked on as a demand-for-money equation, it says that the demand for money depends on nominal income (GDP, or P * Y), but not on the interest rate. If the interest rate changes and nominal income does not, the equation says that the quantity of money demanded will not change. This is contrary to the theory of the demand for money in Chapter 10, which had the demand for money depending on both income and the interest rate. Testing the Quantity Theory of Money One way to test the validity of the quantity theory of money is to look at the demand for money using recent data on the U.S. economy. The key is this: Does money demand depend on the interest rate? Most empirical work says yes. When demand-for-money equations are estimated (or “fit to the data”), the interest rate usually turns out to be a significant factor. The demand for money does not appear to depend only on nominal income. Another way of testing the quantity theory is to plot velocity over time and see how it behaves. Figure 17.1 plots the velocity of money for the 1960 I–2017 IV period. The data show that velocity is far from constant. There was a positive trend until 2007, but also large fluctuations around this trend. For example, velocity rose from 6.4 in 1980 III to 7.0 in 1981 III, fell to 6.6 in 1983 I, rose to 7.0 in 1984 III, and fell to 5.9 in 1986 IV. Changes of a few tenths of a point may seem small, but they are actually large. For example, the money supply in 1986 IV was about $800 billion. If velocity changes by 0.3 with a money supply of this amount and if the money supply is unchanged, we have a change in nominal GDP (P * Y) of $240 billion , which is about 5 percent of the level of GDP in 1986. The change in veloc- 0.3 * +800 billion ity since 2008 has been remarkable. Velocity fell from 9.6 in 2008 I to 4.9 in 2017 IV! 1 2 M17_CASE3826_13_GE_C17.indd 347 17/04/19 12:54 AM 348 PART IV Further Macroeconomics Issues 10.0 9.0
8.0 7.0 6.0 5.0 4..0 1960 I 1965 I 1970 I 1975 I 1980 I 1985 I 1990 I 1995 I 2000 I Quarters 2005 I 2010 I 2015 I 2017 IV MyLab Economics Real-time data ▴▴ FIGURE 17.1 The Velocity of Money, 1960 I–2017 IV Velocity has not been constant over the period from 1960 to 2017. This was a long-term positive trend, which has now reversed. The debate over monetarist theories is more subtle than our discussion so far indicates. First, there are many definitions of the money supply. M1 is the money supply variable used for the graph in Figure 17.1, but there may be some other measure of the money supply that would lead to a smoother plot. For example, many people shifted their funds from checking account deposits to money market accounts when the latter became available in the late 1970s. Because GDP did not change as a result of this shift while M1 decreased, velocity—the ratio of GDP to M1—must have gone up. Suppose instead we measured the supply of money by M2 (which includes both checking accounts and money market accounts). In this case, the decrease in checking deposits would be exactly offset by the rise in money market account deposits and M2 would not change. With no change in GDP and no change in M2, the velocity of money would not change. Whether or not velocity is constant may depend partly on how we measure the money supply. Second, there may be a time lag between a change in the money supply and its effects on nominal GDP. Suppose we experience a 10 percent increase in the money supply today, but it takes one year for nominal GDP to increase by 10 percent. If we measured the ratio of today’s money supply to today’s GDP, it would seem that one year from now, when the increase in the supply of money had its full effect on income, velocity would have been constant. The debate over the quantity theory of money is primarily empirical. It is a debate that can be resolved by looking at facts about the real world and seeing whether they are in accord with the predictions of theory. Is there a measure of the money supply and a choice of the time lag between a change in the money supply and its effects on nominal GDP such that V is in effect constant? If so, the monetarist theory is a useful approach to understanding how the macroeconomy works and how changes in the money supply will cause a proportional increase in nominal GDP. If not, some other theory is likely to be more appropriate. (We discuss the testing of alternative theories at the end of this chapter.) The Keynesian/Monetarist Debate MyLab Economics Concept Check The debate between Keynesians and monetarists was perhaps the central controversy in macroeconomics in the 1960s. The leading spokesman for monetarism was Milton Friedman from the University of Chicago. Most monetarists, including Friedman, blamed much of the instability in the economy on the Federal Reserve, arguing that the high inflation that the United States encountered from time to time could have been avoided if only the Fed had not expanded the money supply so rapidly. Monetarists were skeptical of the Fed’s ability to “ manage” the economy—to expand the money supply during bad times and contract it during good times. A common argument against such management is the one discussed in Chapter 14: Time lags may M17_CASE3826_13_GE_C17.indd 348 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 349 make attempts to stimulate and contract the economy counterproductive. Friedman advocated instead a policy of steady and slow money growth. He argued that the money supply should grow at a rate equal to the average growth of real output (income) (Y). That is, the Fed should pursue a constant policy that accommodates real growth but not inflation. Many Keynesians, on the other hand, advocated the application of coordinated monetary and fiscal policy tools to reduce instability in the economy—to fight inflation and unemployment. During the 1970s and 1980s, it became clear that managing the macroeconomy was more easily accomplished on paper than in practice. The inflation problems of the 1970s and early 1980s and the seriousness of the recessions of 1974–1975 and 1980–1982 led many economists to challenge the idea of active government intervention in the economy. Some of the challenges were simple attacks on the bureaucracy’s ability to act in a timely manner. Others were theoretical assaults in the spirit of Friedman that claimed to show that monetary and fiscal policies could not have any substantial effect on the economy. Most economists now agree, after the experience of the 1970s, that neither monetary nor fiscal tools are finely calibrated Still, many believe that the experiences of the 1970s also show that stabilization policies can help prevent even bigger economic disasters. Had the government not cut taxes and expanded the money supply in 1975 and in 1982, they argue, the recessions of those years might have been significantly worse. The same people would also argue that had the government not resisted the inflations of 1974–1975 and 1979–1981 with tight monetary policies, the inflations probably would have become much worse. The debate between Keynesians and monetarists subsided with the advent of what we will call “new classical macroeconomics.” Before turning to this, however, it will be useful to consider a minor but interesting footnote in macroeconomic history: supply-side economics. Supply-Side Economics From our discussion of equilibrium in the goods market, beginning with the simple multiplier in Chapter 8 and continuing through Chapter 12, we have focused primarily on demand. Supply increases and decreases in response to changes in aggregate expenditure (which is closely linked to aggregate demand). Fiscal policy works by influencing aggregate expenditure through tax policy and government spending. Monetary policy works by influencing investment and consumption spending through increases and decreases in the interest rate. The theories we have been discussing are “demand-oriented.” Supply-side economics, as the name suggests, focuses on the supply side. The argument of the supply-siders about the economy in the late 1970s and early 1980s was simple. The real problem, they said, was not demand, but high rates of taxation and heavy regulation that reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus, but better incentives to stimulate supply. If we cut taxes so people take home more of their paychecks, the argument continued, they will work harder and save more. If businesses get to keep more of their profits and can avoid government regulations, they will invest more. This added labor supply and investment, or capital supply, will lead to an expansion of the supply of goods and services, which will reduce inflation and unemployment at the same time. In the tax debate of 2017, we heard arguments in favor of tax cuts that had a supply side flavor. At their most extreme, supply-siders argued that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would then outweigh the decreases in rates, resulting in increased government revenues. The Laffer Curve MyLab Economics Concept Check Figure 17.2 presents a key diagram of supply-side economics. The tax rate is measured on the vertical axis, and tax revenue is measured on the horizontal axis. The assumption behind this curve is that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. There is obviously some tax rate 17.3 LEARNING OBJECTIVE Explain the fundamentals of supply-side economics. M17_CASE3826_13_GE_C17.indd 349 17/04/19 12:54 AM 350 PART IV Further Macroeconomics Issues Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. between zero and 100 percent at which tax revenue is at a maximum. At a tax rate of zero, work effort is high but there is no tax revenue. At a tax rate of 100, the labor supply is presumably zero because people are not allowed to keep any of their income. Somewhere between zero and 100 is the maximum-revenue rate. The big debate in the 1980s was whether tax rates in the United States put the country on the upper or lower part of the curve in Figure 17.2. The supply-side school claimed that the United States was around A and that taxes should be cut. Others argued that the United States was nearer B and that tax cuts would lead to lower tax revenue. The diagram in Figure 17.2 is the Laffer curve, named after economist Arthur Laffer, who, legend has it, first drew it on the back of a napkin at a cocktail party. The Laffer curve had some influence on the passage of the Economic Recovery Tax Act of 1981, the tax package put forward by the Reagan administration that brought with it substantial cuts in both personal and business taxes. Individual income tax rates were cut by as much as 25 percent over three years. Corporate taxes were cut sharply in a way designed to stimulate capital investment. The new law allowed firms to depreciate their capital at a rapid rate for tax purposes, and the bigger deductions led to taxes that were significantly lower than before. Laffer’s ideas were also used to support the 2017 tax cuts. Evaluating Supply-Side Economics MyLab Economics Concept Check Supporters of supply-side economics claim that Reagan’s tax policies were successful in stimulating the economy. They point to the fact that almost immediately after the tax cuts of 1981
were put into place, the economy expanded and the recession of 1980–1982 came to an end. In addition, inflation rates fell sharply from the high rates of 1980 and 1981. Except for one year, federal receipts continued to rise throughout the 1980s despite the cut in tax rates. Critics of supply-side policies do not dispute these facts, but offer an alternative explanation of how the economy recovered. The Reagan tax cuts were enacted just as the U.S. economy was in the middle of its deepest recession since the Great Depression. The unemployment rate stood at 10.7 percent in the fourth quarter of 1982. It was the recession, critics argue, that was responsible for the reduction in inflation—not the supply-side policies. Also among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. In addition, in theory, a tax cut could even lead to a reduction in labor supply. Recall our discussion of income and substitution effects in Chapter 15. Although it is true that a higher after-tax wage rate provides a higher reward for each hour of work and thus more incentive to work, a tax cut also means that households receive a higher income for a given number of hours of work. Households might choose to work less because they can earn the same amount of money working fewer hours. They might spend some of their added income on leisure. Research done during the 1980s suggests that tax cuts seem to increase the supply of labor somewhat but that the increases are very modest. What about the recovery from the recession? Why did real output begin to grow rapidly in late 1982, precisely when the supply-side tax cuts were taking effect? Two reasons have been suggested. First, the supply-side tax cuts had large demand-side effects that stimulated the economy. Second, ▴▸ FIGURE 17.2 The Laffer Curve The Laffer curve shows that the amount of revenue the government collects is a function of the tax rate. It shows that when tax rates are high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise. 100 ) MyLab Economics Concept Check 0 Tax revenues (dollars) M17_CASE3826_13_GE_C17.indd 350 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 351 the Fed pumped up the money supply and drove interest rates down at the same time that tax cuts were being put into effect. The money supply expanded about 20 percent between 1981 and 1983, and interest rates fell. In the third quarter of 1981, the average three-month U.S. Treasury bill paid 15 percent interest. By the first quarter of 1983, the rate had dropped to 8.1 percent. Certainly, traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). In addition, although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run. Whether the recovery from the 1981–1982 recession was the result of supply-side expansion or supply-side policies that had demand-side effects, one thing is clear: The extreme promises of the supply-siders did not materialize. President Reagan argued that because of the effect depicted in the Laffer curve, the government could maintain expenditures (and even increase defense expenditures sharply), cut tax rates, and balance the budget. This was not the case. Government revenues fell sharply from levels that would have been realized without the tax cuts. After 1982, the federal government ran huge deficits, with about $2 trillion added to the national debt between 1983 and 1992. Most economists similarly predict that the Trump tax cuts of 2017 will lead to large deficits. New Classical Macroeconomics In recent years, the challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics.2 Like monetarism and Keynesianism, this term is vague. No two new classical macroeconomists think exactly alike, and no single model completely represents this school. The following discussion, however, conveys the flavor of the new classical views. 17.4 LEARNING OBJECTIVE Discuss the real business cycle theory and new Keynesian economics. The Development of New Classical Macroeconomics MyLab Economics Concept Check In previous chapters we emphasized the importance of households’ and firms’ expectations about the future. A firm’s decision to build a new plant depends on its expectations of future sales. The amount of saving a household undertakes today depends on its expectations about future interest rates, wages, and prices. Keynes himself recognized that expectations (in the form of “animal spirits”) play a big part in economic behavior. But how are these expectations formed? Many of the current debates in macroeconomics turn on this question. Traditional models assume that expectations are formed in naive ways. A common assumption, for example, is that people form their expectations of future inflation by assuming present inflation will continue. If they turn out to be wrong, they adjust their expectations by some fraction of the difference between their original forecast and the actual inflation rate. Suppose you expect 4 percent inflation next year. When next year comes, the inflation rate turns out to be only 2 percent, so you have made an error of 2 percentage points. You might then predict an inflation rate for the following year of 3 percent, halfway between your earlier expectation (4 percent) and actual inflation last year (2 percent). The problem with this somewhat mechanical treatment of expectations is that it is not consistent with the assumptions that we make in microeconomics of individual maximizing behavior. This “naïve” characterization of expectations implies that people systematically overlook information that would allow them to make better forecasts, even though there are costs to being wrong. Consumers and firms who maximize should form their expectations in a smarter way, or so the argument goes. Instead of naively assuming the future will be like the past or the present, they should actively seek to forecast the future. Operationalizing this idea of more informed expectations as part of optimizing behavior of households and firms is at the heart of new macroeconomics. 2The term new classical is used because many of the assumptions and conclusions of this group of economists resemble those of the classical economists—that is, those who wrote before Keynes. M17_CASE3826_13_GE_C17.indd 351 17/04/19 12:54 AM 352 PART IV Further Macroeconomics Issues rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future. Rational Expectations MyLab Economics Concept Check One of the earliest theories which assumes a more sophisticated model of expectations formation is the rational-expectations hypothesis. The debate among macroeconomists is well illustrated by looking at diffferent models of how expectations change in inflationary periods. In many contexts, as in setting up a loan contract, decision makers need to forecast inflation. Rational-expectations theorists assume that people know the “true model” that generates inflation—they know how inflation is determined in the economy—and they use this model to forecast future inflation rates. What do we do about the fact that many events that affect the inflation rate are not predictable (they are random)? Even if decision makers did know the model of the full economy, they would sometimes make mistakes, mistakes generated by these random shocks. The best one can achieve is that on average the model is correct, equally underestimating and overestimating inflation as random events occur. This is the working model used in rational expectations theory. Assuming that decision makers know the full model of the economy before they make their forecasts is thought by many other macroeconomists to be unrealistic. A slightly less ambitious definition of rational expectations assumes decision makers use “all available information” in forming their expectations. This definition is satisfied when decision makers have the true full model, but is less clear on what “all available information” means short of having the full model. A key debate among macroeconomists around the issue of expectations is the cost of decision making. If forming the correct expectations, gathering relevant data, is costly, then assuming people use a rule of thumb to project future inflation or economic growth is more reasonable. If relevant information can be obtained at no cost, people are not behaving rationally when they fail to use all available information given that there are usually costs to making a wrong forecast. Rational Expectations and Market Clearing The assumption of rational expectations has important implications for what we think should be the role of the government in the macroeconomy. If firms have rational expectations and if they set prices and wages on this basis, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. When a firm has rational expectations, it knows the demand curve for its output and the supply curve of labor that it faces, except when random shocks disrupt those curves. Therefore, on average, the firm will set the market-clearing prices and wages. The firm knows the true model, and it will not set wages different from those it expects will attract the number of workers it wants. If all firms behave this way, wages will be set in such a way that the total amount of labor supplied will, on a
verage, be equal to the total amount of labor that firms demand. In other words, on average, there will be full employment. In Chapter 13, we argued that there might be disequilibrium in the labor market (in the form of either unemployment or excess demand for workers) because firms may make mistakes in their wage-setting behavior as a result of expectation errors. If, on average, firms do not make errors, on average, there will be equilibrium. When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks—obviously an important conclusion. If true, it means that disequilibrium in any market is only temporary because firms, on average, set market-clearing wages and prices. The assumption that expectations are rational radically changes the way we view the economy. We go from a world in which unemployment can exist for substantial periods and the multiplier can operate to a world in which (on average) all markets clear and there is full employment. In this world, there is no need for government stabilization policies. Unemployment is not a problem that governments need to worry about; if it exists at all, it is because of unpredictable shocks that, on average, amount to zero. There is no more reason for the government to try to change the outcome in the labor market than there is for it to change the outcome in the banana market. On average, prices and wages are set at market-clearing levels. The Lucas Supply Function One critique of the rational expectations model is that it seems to demand a good deal of household and firm decision makers. Another new classical approach to expectation setting that starts by recognizing difficulties in information gathering is from Robert E. Lucas of the University of Chicago. M17_CASE3826_13_GE_C17.indd 352 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 353 Brexit and Consumer Expectations When gauging consumer expectations, economists divide consumers by income, gender, and age group. With regard to the Brexit referendum of June 23, 2016, where the United Kingdom voted to leave the European Union (EU), several national consumer expectations surveys were conducted by renowned research institutions. Right before Brexit, a joint study by the research teams of Opinium Research, London School of Economics, and Lansons, revealed that consumers aged 18–24 years expected a decline in their annual income by £155 in the case of Brexit, while consumers above the age of 65 expected their yearly income to decline by only £6. If the United Kingdom remained with the EU, the former consumer group expected a £9 improvement in annual income, while the latter expected a deterioration of £239. However, a vote to remain had higher future expectations of increased expenditure due to more likelihood of buying or replacing vehicles, household items, consumer durables, entertainment, and electronic goods. This was basically attributed to the uncertainty of employment and labor mobility prospects as well as scepticism regarding the future resilience of the British economy without the common European market. Post Brexit, however, a research paper by Deloitte reports that the majority of respondents anticipate no change in their personal wages and prices as a direct result of Brexit. This report explains that in spite of the negative business expectations and pessimistic media coverage, consumers were not too weary of Brexit. In fact, Brexit ranked sixth as a consumer concern, after the National Health Service, the health of the British economy, the state of the environment, inflation, and retirement plans. Why do the two reports give different results? Are they flawed? Not necessarily. The results could have changed as the consumers’ trust in their government increased with the fiscal and monetary interventions after the Brexit. In addition, the questions of each survey were posed in different ways. While the former report focused merely on financial and economic aspects, the second report took an overall view of the social and economic impact of Brexit. The Deloitte research paper included many noneconomic factors, such as the opposition to emigration and free mobility of labor within the EU, all of which were deemed as factors that could pose threats to the British workforce. This means that consumers surveyed looked at the overall picture and that any real effects are yet to be felt by individual consumers. CRITICAL THINKING 1. Right after Brexit, the Bank of England reduced interest rates. How could this have contributed to consumer expectations and behavior for each of the two surveys? Lucas begins by assuming that people and firms are specialists in production but generalists in consumption. If someone you know is a manual laborer, the chances are that she sells only one thing—labor. If she is a lawyer, she sells only legal services. In contrast, people buy a large bundle of goods—ranging from gasoline to ice cream and pretzels—on a regular basis. The same is true for firms. Most companies tend to concentrate on producing a small range of products, but they typically buy a larger range of inputs—raw materials, labor, energy, and capital. According to Lucas, this divergence between buying and selling creates an asymmetry. People know more about the prices of the things they sell than they do about the prices of the things they buy. As firms make decisions, they care about both their own output prices and the general price level. With respect to their own output, firms quickly learn when their prices increase. But firms are slower to learn about the general price level in the economy. At the beginning of each period, a firm has some expectation of the average price level of goods in general for that period. If the actual price level turns out to be different, there is a price surprise. Suppose the average price level is higher than expected. The firm learns about the actual price level slowly, so some time goes by before it realizes that all prices have gone up. The firm perceives— incorrectly, it turns out—that its own price has risen relative to other prices, and this perception leads it to produce more output. M17_CASE3826_13_GE_C17.indd 353 17/04/19 12:54 AM 354 PART IV Further Macroeconomics Issues Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. price surprise Actual price level minus expected price level. real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. A similar argument holds for workers. When there is a positive price surprise, workers at first believe that their “price”—their wage rate—has increased relative to other prices. Workers believe that their real wage rate has risen. We know from theory that an increase in the real wage is likely to encourage workers to work more hours.3 The real wage has not actually risen, but it takes workers a while to figure this out. In the meantime, they supply more hours of work than they would have. This increase means that the economy produces more output when prices are unexpectedly higher than when prices are at their expected level. This simple model of expectation formation leads to what has been called the Lucas supply function which yields, as we shall see, a surprising policy conclusion. The function is deceptively simple. It says that real output (Y) depends on (is a function of) the difference between the actual price level (P) and the expected price level (Pe ): Y = f P - Pe The actual price level minus the expected price level (P - Pe ) is the price surprise. 1 2 In short, the Lucas supply function tells us that unexpected increases in the price level can fool workers and firms into thinking that relative prices have changed, causing them to alter the amount of labor or goods they choose to supply. Policy Implications of the Lucas Supply Function The Lucas supply function in combination with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output. It is only policy surprises that have an effect, and that effect is temporary. Consider a change in monetary policy. In general, the change will have some effect on the average price level. If the policy change is announced to the public, people will know the effect on the price level because they have rational expectations (and know the way changes in monetary policy affect the price level). This means that the change in monetary policy affects the actual price level and the expected price level in the same way. The new price level minus the new expected price level is zero—no price surprise. In such a case, there will be no change in real output because the Lucas supply function states that real output can change from its fixed level only if there is a price surprise. The general conclusion is that any announced policy change—in fiscal policy or any other policy—has no effect on real output because the policy change affects both actual and expected price levels in the same way. If people have rational expectations, known policy changes can produce no price surprises—and no increases in real output. The only way any change in government policy can affect real output is if it is kept in the dark so it is not generally known. Government policy can affect real output only if it surprises people; otherwise, it cannot. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy. Real Business Cycle Theory and New Keynesian Economics MyLab Economics Concept Check Research that followed Lucas’s work was concerned with whether the existence of business cycles can be explained under the assumptions of complete price and wage f
lexibility (market clearing) and rational expectations. This work is called real business cycle theory. As we discussed in Chapter 11, if prices and wages are completely flexible, then the AS curve is vertical, even in the short run. If the AS curve is vertical, then events or phenomena that shift the AD curve (such as changes in government spending and taxes) have no effect on real output. Real output does fluctuate over time, so the puzzle is how the fluctuations can be explained if they are not the result of policy changes or other shocks that shift the AD curve. Solving this puzzle is one of the main missions of real business cycle theory. It is clear that if shifts of the AD curve cannot account for real output fluctuations (because the AS curve is vertical), then shifts of the AS curve must be responsible. However, the task is to come up with convincing explanations as to what causes these shifts and why they persist over 3This is true if we assume that the substitution effect dominates the income effect (see Chapter 15). M17_CASE3826_13_GE_C17.indd 354 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 355 new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages. a number of periods. The problem is particularly difficult when it comes to the labor market. If prices and wages are completely flexible, then there is never any unemployment aside from frictional unemployment. For example, because the measured U.S. unemployment rate was 4.0 percent in 2000 and 9.3 percent in 2009, the puzzle is to explain why so many more people chose not to work in 2009 than in 2000. Early real business cycle theorists emphasized shocks to the production technology. Suppose there is a negative shock in a given year that causes the marginal product of labor to decline. This leads to a fall in the real wage, which leads to a decrease in the quantity of labor supplied. People work less because the negative technology shock has led to a lower return from working. The opposite happens when there is a positive shock: The marginal product of labor rises, the real wage rises, and people choose to work more. This research was not as successful as some had hoped because it required what seemed to be unrealistically large shocks to explain the observed movements in labor supply over time. What has come to be called new Keynesian economics retains the assumption of rational expectations, but drops the assumption of completely flexible prices and wages. Prices and wages are assumed to be sticky. The existence of menu costs is often cited as a justification of the assumption of sticky prices. It may be costly for firms to change prices, which prevents firms from having completely flexible prices. Sticky wages are discussed in Chapter 13, and some of the arguments given there as to why wages might be sticky may be relevant to new Keynesian models. A main issue regarding these models is that any justification has to be consistent with all agents in the model having rational expectations. We will see another explanation for sticky wages when we discuss behavioral approaches to macroeconomics later in this chapter. Current research in new Keynesian economics broadly defined is vast. There are many models, often called dynamic stochastic general equilibrium (DSGE) models. The properties of these models vary, but most have the feature—because of the assumption of sticky prices and wages—that monetary policy can affect real output. The government generally has some role to play in these models. Evaluating the Rational Expectations Assumption MyLab Economics Concept Check Almost all models in new classical macroeconomics—Lucas’s model, real business cycle models, new Keynesian models—assume rational expectations. A key question concerning how realistic these models are is thus how realistic the assumption of rational expectations is. If this assumption approximates the way expectations are actually formed, then it calls into question any theory that relies at least in part on expectation errors for the existence of disequilibrium. The arguments in favor of the rational expectations assumption sound persuasive from the perspective of microeconomic theory. When expectations are not rational, there are likely to be unexploited profit opportunities, and most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it requires households and firms to know too much. This argument says that it is unrealistic to think that these basic decision-making units know as much as they need to know to form rational expectations. People must know the true model (or at least a good approximation of the true model) to form rational expectations, and this knowledge is a lot to expect. Even if firms and households are capable of learning the true model, it may be costly to take the time and gather the relevant information to learn it. The gain from learning the true model (or a good approximation of it) may not be worth the cost. In this sense, there may not be unexploited profit opportunities around. Gathering information and learning economic models may be too costly to bother with, given the expected gain from improving forecasts. Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing and profit-maximizing postulates of microeconomics, the rational expectations assumption is more extreme and demanding because it requires more information on the part of households and firms. Consider a firm engaged in maximizing profits. In some way or other, it forms expectations of the relevant future variables, and given these expectations, it figures out the best thing to do from the point of view of maximizing profits. Given a set of expectations, the problem of maximizing profits may not be too hard. What may be hard is forming accurate expectations in the first place. This requires firms to know much more about the overall economy than they are likely to, so the assumption that their expectations are rational is not necessarily realistic. Firms, like the rest of us—so the argument goes—grope around in a M17_CASE3826_13_GE_C17.indd 355 17/04/19 12:54 AM 356 PART IV Further Macroeconomics Issues 17.5 LEARNING OBJECTIVE What contributions has behavioral economics made to macroeconomics? prospect theory People evaluate gains and losses from the vantage of a reference point. hyperbolic discounting People prefer immediate gratification to even slightly deferred gratification, but exhibit more patience when asked to defer gratification some time in the future. world that is difficult to understand, trying to do their best but not always understanding enough to avoid mistakes. In the final analysis, the issue is empirical. Does the assumption of rational expectations stand up well against empirical tests? This question is difficult to answer. Much work is currently being done to answer it. There are no conclusive results yet. Behavioral Macroeconomics Behavioral economics incorporates the insights of psychology and sociology into our understanding of the way agents in the economy—households as well as firm managers— make decisions. What happens to our description of the way markets work when we take into account cognitive biases, interest in fairness and social norms, concern with social status, or inconsistencies in discounting? We have already talked about a few of these issues, particularly in our discussion in Chapter 13 of why unemployment might exist. We turn now to look at some of the ideas in behavioral macroeconomics.4 We have mentioned that new Keynesian economics, while assuming that households maximize utility, firms maximize profits, and that expectations are rational, assumes that prices and wages are sticky. Why might prices and wages be sticky? Behavioral macroeconomics has weighed in on this. In particular, prospect theory provides an explanation of why wages might be sticky downward. Prospect theory suggests that people evaluate gains and losses from the vantage of a reference point (typically the current situation) and are especially averse to losses from that reference position. With loss averse workers, lowering nominal wages carries a big cost, and managers concerned about the morale of the workplace will tend to avoid inflicting those losses. Behavioral economics also has something to say about saving. In the work we have done so far on saving we have modeled savings as the optimizing choice individuals make between consumption now and consumption in the future. To be sure, people discount the future; that is, they value today’s consumption more than consumption in the future, but they do that discounting in a consistent way. Behavioral economists like David Laibson and Matthew Rabin suggest instead that people are in fact “locally impatient,” preferring immediate gratification to even slightly deferred gratification, but exhibiting more patience when asked to defer gratification some time in the future. According to this model of hyperbolic discounting, delaying consumption for a month beginning now feels a lot harder than the prospect of delaying consumption for a month sometime in the future. The result? People save less than they should if all saving decisions are made at the moment. The policy conclusion? To increase saving we should ask people to sign up now to increase their saving in the future. Richard Thaler received the Nobel Prize in 2017 for work he did in this area.5 Finally, behavioral macroeconomics suggests that human emotions, confidence or lack thereof, pessimism or optimism, can all contribute to “irrational” upswings or downswings in the economy.6 Too much excitement and confidence can cause bubbles in markets like housing or the stock market, and once a lack of confidence sets it, it can be hard to reverse these emotions. Behavioral macroec
onomics suggests that the government has a role to play in managing these expectations to keep the economy on an even keel. 17.6 LEARNING OBJECTIVE Discuss why it is difficult to test alternative macroeconomic theories. Testing Alternative Macroeconomic Models You may wonder why there is so much disagreement in macroeconomics. Why can’t macroeconomists test their models against one another and see which performs best? 4An excellent summary of the work in this area is George Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior,” American Economic Review. June 2002. 411–433. 5You might be interested in his popular book, Nudge., (coauthored with Cass Sunstein) Yale University Press, 2008. 6George Akerlof and Robert Shiller, Animal Spirits Princeton University Press, 2009. M17_CASE3826_13_GE_C17.indd 356 17/04/19 12:54 AM CHAPTER 17 Alternative Views in Macroeconomics 357 One problem is that macroeconomic models differ in ways that are hard to standardize. If one model takes the price level to be given, or not explained within the model, and another one does not, the model with the given price level may do better in, for instance, predicting output— not because it is a better model but simply because the errors in predicting prices have not been allowed to affect the predictions of the output. The model that takes prices as given has a head start, so to speak. Another problem arises in the testing of the rational expectations assumption. Remember, if people have rational expectations, they are using the true model to form their expectations. Therefore, to test this assumption, we need the true model. There is no way to be sure that whatever model is taken to be the true model is in fact the true one. Any test of the rational expectations hypothesis is therefore a joint test: (1) that expectations are formed rationally and (2) that the model being used is the true one. If the test rejects the hypothesis, it may be that the model is wrong rather than that the expectations are not rational. Another problem for macroeconomists is the small amount of data available. Most empirical work uses data beginning about 1950, which in 2017 was about 68 years’ (272 quarters) worth of data. Although this may seem like a lot of data, it is not. Macroeconomic data are fairly “smooth,” which means that a typical variable does not vary much from quarter to quarter or from year to year. For example, the number of business cycles within this 68-year period is small, about eight. Testing various macroeconomic hypotheses on the basis of eight business cycle observations is not easy, and any conclusions must be interpreted with caution. To give an example of the problem of a small number of observations, consider trying to test the hypothesis that import prices affect domestic prices. Import prices changed very little in the 1950s and 1960s. Therefore, it would have been difficult at the end of the 1960s to estimate the effect of import prices on domestic prices. The variation in import prices was not great enough to show any effects. We cannot demonstrate that changes in import prices help explain changes in domestic prices if import prices do not change. The situation was different by the end of the 1970s because by then, import prices had varied considerably. By the end of the 1970s, there were good estimates of the import price effect, but not before. This kind of problem is encountered again and again in empirical macroeconomics. In many cases, there are not enough observations for much to be said and hence there is considerable room for disagreement. We said in Chapter 1 that it is difficult in economics to perform controlled experiments. Economists, are for the most part, at the mercy of the historical data. If we were able to perform experiments, we could probably learn more about the economy in a shorter time. Alas, we must wait. In time, the current range of disagreements in macroeconomics should be considerably narrowed. S U M M A R Y 17.1 KEYNESIAN ECONOMICS p. 346 1. In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. 17.2 MONETARISM p. 346 2. The monetarist analysis of the economy places a great deal of emphasis on the velocity of money, which is defined as the number of times a dollar bill changes hands, on average, during the course of a year. The velocity of money is the ratio of nominal GDP to the stock of money, or V K GDP M * V K P * Y. M. Alternately. The quantity theory of money assumes that velocity is constant (or virtually constant). This implies that changes in the supply of money will lead to equal percentage changes in nominal GDP. The quantity theory of money equation is M * V = P * Y. The equation says that demand for money does not depend on the interest rate. 4. Most monetarists blame most of the instability in the economy on the federal government and are skeptical of the government’s ability to manage the macroeconomy. They argue that the money supply should grow at a rate equal to the average growth of real output (income) (Y)—the Fed should expand the money supply to accommodate real growth but not inflation. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M17_CASE3826_13_GE_C17.indd 357 17/04/19 12:54 AM 358 PART IV Further Macroeconomics Issues 17.3 SUPPLY-SIDE ECONOMICS p. 349 5. Supply-side economics focuses on incentives to stimulate supply. Supply-side economists believe that if we lower taxes, workers will work harder and save more and firms will invest more and produce more. At their most extreme, supply-siders argue that incentive effects are likely to be so great that a major cut in taxes will actually increase tax revenues. 6. The Laffer curve shows the relationship between tax rates and tax revenues. Supply-side economists use it to argue that it is possible to generate higher revenues by cutting tax rates. This does not appear to have been the case during the Reagan administration, however, where lower tax rates decreased tax revenues significantly and contributed to the large increase in the federal debt during the 1980s. 17.4 NEW CLASSICAL MACROECONOMICS p. 351 7. New classical macroeconomics uses the assumption of rational expectations. The rational expectations hypothesis assumes that people know the “true model” that generates economic variables. For example, rational expectations assumes that people know how inflation is determined in the economy and use this model to forecast future inflation rates. 8. The Lucas supply function assumes that real output (Y) depends on the actual price level minus the expected price level, or the price surprise. This function combined with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output. 9. Real business cycle theory is an attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. 10. New Keynesian economics relaxes the assumption of complete price and wage flexibility. There is usually a role for government policy in these models. 17.5 BEHAVIORAL MACROECONOMICS p. 356 11. Behavioral economics provides an explanation for downward sticky wages using prospect theory and an explanation for saving behavior using the concept of hyperbolic discounting. 17.6 TESTING ALTERNATIVE MACROECONOMIC MODELS p. 356 12. Economists disagree about which macroeconomic model is best for several reasons: (1) Macroeconomic models differ in ways that are hard to standardize; (2) when testing the rational-expectations assumption, we are never sure that whatever model is taken to be the true model is the true one; and (3) the amount of data available is fairly small hyperbolic discounting, p. 356 Laffer curve, p. 350 Lucas supply function, p. 354 new Keynesian economics, p. 355 price surprise, p. 354 prospect theory, p. 356 quantity theory of money, p. 347 rational expectations hypothesis, p. 352 real business cycle theory, p. 354 velocity of money, p. 346 P R O B L E M S All problems are available on MyLab Economics. Equations: GDP M V K , p. 346 M * V K P * Y, p. 346 M * V = P * Y, p. 347 17.1 KEYNESIAN ECONOMICS LEARNING OBJECTIVE: Summarize Keynesian economics. 2.1 The table gives estimates of the rate of the M2 money supply growth and the rate of real GDP growth for five countries in 2016: 1.1 Use aggregate supply and aggregate demand curves to show the predictions of Keynesian economic theory of the likely effects of a major tax cut when the economy is not operating at capacity and the Fed accommodates by increasing the money supply. Explain what happens to the level of real GDP and to the price level. 17.2 MONETARISM LEARNING OBJECTIVE: Explain the quantity theory of money. Rate of Growth in Money Supply (M2) Rate of Growth of Real GDP Canada United Kingdom Argentina Japan United States +9.0% +6.5% +53.2% +4.0% +6.5% +1.5% +1.8% -2.3% +1.0% +1.6% a. If you were a monetarist, what would you predict about the rate of inflation across the five countries? b. If you were a Keynesian and assuming activist central banks, how might you interpret the same data? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M17_CASE3826_13_GE_C17.indd 358 17/04/19 12:54 AM 2.2 You are a monetarist given the following information: The money supply is $1 million. The velocity of money is four. What is nominal income? Real income? What happens to nominal income if the money supply is doubled? What happens to real income? 2.3 The following is data from 2018 for the tiny island nation of Coco Loco: money supp
ly = $800 million; price level = 3.2; velocity of money = 3. Use the quantity theory of money to answer the following questions. a. What is the value of real output (income) in 2018? b. What is the value of nominal GDP in 2018? c. If real output doubled, by how much would the money supply need to change? d. If velocity is constant and Coco Loco was experiencing a recession in 2018, what impact would an easy money policy have on nominal GDP? e. If the annual GDP growth rate is 12 percent in Coco Loco, by how much will the money supply need to change in 2019? 2.4 In the nation of Lower Vicuna, the velocity of money is fairly constant, and in the nation of Upper Vicuna, the velocity of money fluctuates greatly. For which nation would the quantity theory of money better explain changes in nominal GDP? Explain. CHAPTER 17 Alternative Views in Macroeconomics 359 notable economists argued against it. How would you explain the arguments for and against these tax cuts? 3.4 In a hypothetical economy, there is a simple proportional tax on wages imposed at a rate t. There are plenty of jobs around, so if people enter the labor force, they can find work. We define total government receipts from the tax as T = t * W * L where t = the tax rate, W = the gross wage rate, and L = the total supply of labor. The net wage rate is Wn = 1 - t W The elasticity of labor supply is defined as 1 2 Percentage of change in L Percentage of change in Wn = ∆L ∆Wn > ∆L Wn > Suppose t was cut from 0.25 to 0.20. For such a cut to increase total government receipts from the tax, how elastic must the supply of labor be? (Assume a constant gross wage.) What does your answer imply about the supply-side assertion that a cut in taxes can increase tax revenues? 17.3 SUPPLY-SIDE ECONOMICS LEARNING OBJECTIVE: Explain the fundamentals of supply-side economics. 3.1 In 2000, a well-known economist was heard to say, “The problem with supply-side economics is that when you cut taxes, they have both supply and demand side effects and you cannot separate the effects.” Explain this comment. Be specific and use the 1997 tax cuts or the Reagan tax cuts of 1981 as an example. 3.2 On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act. According to this Act, corporate tax rate has been reduced from 35 percent to 21 percent, while the highest individual tax rate has dropped to 37 percent. According to President Trump, these cuts would improve the U.S. economy’s growth prospects. a. How would a supply-side economist evaluate the tax cuts? b. How would a Keynesian economist evaluate the tax cuts? 3.3 In 2003, the government under George W. Bush implemented the Jobs and Growth Tax Relief Reconciliation Act, which lowered the rates on a number of taxes, including those on income from dividends and capital gains. According to the Congressional Budget Office, these tax cuts added approximately $1,500 billion to the debt and 17.4 NEW CLASSICAL MACROECONOMICS LEARNING OBJECTIVE: Discuss the real business cycle theory and new Keynesian economics. 4.1 [Related to the Economics in Practice on p. 353] Suppose you are thinking about where to live after you finish your degree. You discover that an apartment building near your new job has identical units—one is for rent and the other for sale as a condominium. Given your salary, both are affordable and you like them. Would you buy or rent? How would you go about deciding? Would your expectations play a role? Be specific. Where do you think those expectations come from? In what ways could expectations change things in the housing market as a whole? 4.2 A cornerstone of new classical economics is the notion that expectations are “rational.” What do you think will happen to the prices of single-family homes in your community over the next several years? On what do you base your expectations? Is your thinking consistent with the notion of rational expectations? Explain. 4.3 In an economy with reasonably flexible prices and wages, full employment is almost always maintained. Explain why that statement is true. 4.4 The economy of Borealis is represented by the following Lucas supply function: Y = 750 + 50(P - Pe). The current price level in Borealis is 1.45, and the expected price level is 1.70. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M17_CASE3826_13_GE_C17.indd 359 17/04/19 12:54 AM 360 PART IV Further Macroeconomics Issues a. What will be the new level of real output if inflation expec- tations are correct? b. What will be the new level of real output if inflation expectations are wrong and the actual price level rises to 1.80? c. What will be the new level of real output if the actual price level does not change? d. What is the value of the “price surprise” in parts a, b, and c? 4.5 If households and firms have rational expectations, is it possible for the unemployment rate to exceed the natural rate of unemployment? Explain. 4.6 Assume people and firms have rational expectations. Explain how each of the following events will affect aggregate output and the price level. a. The Reserve Bank of India announces it will decrease the cash reserve ratio (CRR). b. The government of India unexpectedly passes a bill that will reduce taxes. c. The RBI announces a contraction in the money supply. d. Without notice, OPEC increases oil production by 40 percent. e. The government of India passes a previously unan- nounced bill, which causes an immediate increase in expenditure on food subsidy. 17.5 BEHAVIORAL MACROECONOMICS LEARNING OBJECTIVE: What contributions has behavioral economics made to macroeconomics? 5.1 The tiny island of Ditto contains two identical towns, East Doppelganger and West Doppelganger. Each year, the 100 citizens of each town compete in their annual New Year’s resolution challenge. In November, the mayors got together and agreed that all their townspeople could use more exercise, so for the upcoming year’s challenge, each citizen would be asked to walk around the local volcano each day, a distance of exactly 1 mile, starting January 1 for three consecutive months. The winning town, based on the total number of miles walked, would get to host the next annual Looking Glass Festival, the biggest celebration on the island. This year, the mayor of East Doppelganger decided to announce the challenge to the citizens of the town on December 1, while the mayor of West Doppelganger chose to wait until New Year’s Eve to make the announcement. Assuming that all the citizens of both towns are equally healthy, are not terribly fond of exercise even though they know it is good for their health, and are completely honest (so no one cheats as far as the number of miles walked), use the model of hyperbolic discounting to explain which town will likely win the challenge. 17.6 TESTING ALTERNATIVE MACROECONOMIC MODELS LEARNING OBJECTIVE: Discuss why it is difficult to test alternative macroeconomic theories. 6.1 The following data is for the small, recently independent island nation of Hibiscus: Tax rate: 10% flat tax on all citizens since its independence in 2015 Labor supply: 200 workers in 2015, and has grown by 3 percent each successive year Inflation rate: Has fluctuated between 2 percent and 3 percent annually since 2015 Unemployment rate: A constant 4.5 percent each year since 2015 Exchange rate: Since 2015 has fluctuated by more than 20 percent, both up and down, relative to the rates of major currencies Interest rate: Has risen from 2.5 percent to 3.5 percent since 2015 Explain why macroeconomists would find it difficult to test the following hypotheses for Hibiscus: a. Tax rates affect the supply of labor b. The inflation rate affects the unemployment rate c. The exchange rate affects the interest rate * Note: Problems marked with an asterisk are more challenging QUESTION 1 When tax rates are higher, national income falls. Is this true along the entire Laffer curve or only the downwardsloping portion? QUESTION 2 According to the Real Business Cycle Theory, the Short-Run Aggregate Supply curve is vertical, and fluctuations in Real GDP arise due to shocks that shift this curve around. Would a negative shock that shifts the curve to the left and creates a recessionary gap lead the price level to rise or fall? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M17_CASE3826_13_GE_C17.indd 360 17/04/19 12:54 AM PART V THE WORLD ECONOMY International Trade, Comparative Advantage, and Protectionism Over the last 47 years, international transactions have become increasingly important to the U.S. economy. In 1970, imports represented only about 5.2 percent of U.S. gross domestic product (GDP). The share in 2017 was 15.0 percent. The increased trade we observe in the United States is mirrored throughout the world. From 1980 to 2017, world trade in real terms has grown more than sixfold. This trend has been especially rapid in the newly industrialized Asian economies, but many developing countries such as Malaysia and Vietnam have also been increasing their openness to trade. The “internationalization” or “globalization” of the U.S. economy has occurred in the private and public sectors, in input and output markets, and in firms and households. Once uncommon, foreign products are now everywhere, from the utensils we eat with to the cars we drive. Nor is it easy to tell where products are made. The iPhone, which most people think of as an iconic U.S. product, is assembled in China from parts produced in four other countries: Korea, Germany, Japan, and the United States. Honda, which most people think of as a Japanese company, started producing Japanese motorcycles in Ohio in 1977 with 64 employees in Marysville. The company now employs many thousand workers, who assemble Honda a
utomobiles in eleven manufacturing plants in Ohio, Georgia, and North Carolina. 18 CHAPTER O UT LINE AND LEARNING OBJECTIVE S 18.1 Trade Surpluses and Deficits p. 362 How are trade surpluses and trade deficits defined? 18.2 The Economic Basis for Trade: Comparative Advantage p. 362 Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. 18.3 The Sources of Comparative Advantage p. 370 Describe the sources of comparative advantage. 18.4 Trade Barriers: Tariffs, Export Subsidies, and Quotas p. 371 Analyze the economic effects of trade barriers. 18.5 Free Trade or Protection? p. 375 Evaluate the arguments over free trade and protectionism. 18.6 An Economic Consensus p. 381 Outline how international trade fits into the structure of the economy. 361 M18_CASE3826_13_GE_C18.indd 361 17/04/19 4:24 AM 362 PART V The World Economy In addition to the fact that goods and services (outputs) flow easily across borders, so too do inputs: capital and labor. Certainly, it is easy to buy financial assets abroad. Millions of Americans own shares in foreign stocks or have invested in bonds issued by foreign countries. At the same time, millions of foreigners have put money into the U.S. stock and bond markets. Outsourcing is also changing the nature of the global labor market. It is now simple and common for a customer service call to a software company from a user of its product in Bend, Oregon, to be routed to Bangalore, India, where a young, ambitious Indian man or woman provides assistance to a customer over the Internet. The Internet has in essence made it possible for some types of labor to flow smoothly across international borders. To get you more acquainted with the international economy, this chapter discusses the economics of international trade. First, we describe the trends in imports and exports to the United States. Next, we explore the basic logic of trade. Why should the United States or any other country engage in international trade? Finally, we address the controversial issue of protectionism. Should a country provide certain industries with protection in the form of import quotas or tariffs, which are taxes imposed on imports? Should a country help a domestic industry compete in international markets by providing subsidies? Trade Surpluses and Deficits Until the 1970s, the United States generally exported more than it imported. When a country exports more than it imports, it runs a trade surplus. When a country imports more than it exports, it runs a trade deficit. In the mid-1970s the United States began to run trade deficits. In 2009 the trade deficit was 5.6 percent of GDP. Since then it has fallen somewhat—to 2.9 percent in 2017. The large U.S. trade deficits have sparked political controversy. Less expensive foreign goods—among them steel, textiles, and automobiles—create competition for locally produced substitute goods, and many believe that domestic jobs are lost as a result. On the other hand, foreign trade provides Americans with a broader set of goods at lower prices. In recent times, the outsourcing of software development to India has caused complaints from white-collar workers again reflecting a concern about employment displacement. In some cases, U.S. officials blame the trade deficit on unfair support by foreign governments of their local firms and unfair pricing by those firms. This theme emerged in 2017 and 2018 when the Trump administration called for tariffs, particularly focused on Chinese goods like steel. The natural reaction to trade-related job dislocation is to call for protection of U.S. industries. Many people want the president and Congress to impose taxes and import restrictions that would make foreign goods less available and more expensive, protecting U.S. jobs. This argument is not new. For hundreds of years, industries have petitioned their governments for protection and societies have debated the pros and cons of free and open trade. For the last century and a half, the principal argument against protection has been the theory of comparative advantage, first discussed in Chapter 2 and expanded upon here. 18.1 LEARNING OBJECTIVE How are trade surpluses and trade deficits defined? trade surplus The situation when a country exports more than it imports. trade deficit The situation when a country imports more than it exports. 18.2 LEARNING OBJECTIVE Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. Corn Laws The tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain. The Economic Basis for Trade: Comparative Advantage Perhaps the best-known debate on the issue of free trade took place in the British Parliament during the early years of the nineteenth century. At that time, the landed gentry—the landowners—controlled Parliament. For a number of years, imports and exports of grain had been subject to a set of tariffs, subsidies, and restrictions collectively called the Corn Laws. Designed to discourage imports of grain and to encourage exports, the Corn Laws’ purpose was to keep the price of food high. The landlords’ incomes, of course, depended on the prices they got for what their land produced. The Corn Laws clearly worked to the advantage of those in power. With the Industrial Revolution, a class of wealthy industrial capitalists emerged. The industrial sector had to pay workers at least enough to live on, and a living wage depended greatly on the price of food. Tariffs on grain imports and export subsidies that kept grain and food prices high increased the wages that capitalists had to pay, cutting into their profits. The political battle M18_CASE3826_13_GE_C18.indd 362 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 363 theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. absolute advantage The advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does. comparative advantage The advantage in the production of a good enjoyed by one country over another when that good can be produced at a lower opportunity cost (in terms of other goods that must be foregone) than it could be in the other country. raged for years. However, as time went by, the power of the landowners in the House of Lords was significantly reduced. When the conflict ended in 1848, the Corn Laws were repealed. On the side of repeal was David Ricardo, a businessman, economist, member of Parliament, and one of the fathers of modern economics. Ricardo’s principal work, Principles of Political Economy and Taxation, was published in 1817, two years before he entered Parliament. Ricardo’s theory of comparative advantage, which he used to argue against the Corn Laws, claimed that trade enables countries to specialize in producing the products they produce best. According to the theory, specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers. This basic argument remains at the heart of free-trade debates even today, as policy makers argue about the effects of tariffs on agricultural development in sub-Saharan Africa and the gains and losses from outsourcing software development to India. Absolute Advantage versus Comparative Advantage MyLab Economics Concept Check A country enjoys an absolute advantage over another country in the production of a good if it uses fewer resources to produce that good than the other country does. Suppose country A and country B produce wheat, but A’s climate is more suited to wheat and its labor is more productive. Country A will produce more wheat per acre than country B and use less labor per acre of wheat grown. Country A enjoys an absolute advantage over country B in the production of wheat. A country enjoys a comparative advantage in the production of a good if that good can be produced at a lower opportunity cost (in terms of units of other goods that must be foregone). Suppose countries C and D both produce wheat and corn and C enjoys an absolute advantage in the production of both—that is, C’s climate is better than D’s and fewer of C’s resources are needed to produce a given quantity of both wheat and corn. Now C and D must each choose between planting land with either wheat or corn. To produce more wheat, either country must transfer land from corn production; to produce more corn, either country must transfer land from wheat production. The cost of wheat in each country can be measured in foregone bushels of corn, and the cost of corn can be measured in foregone bushels of wheat. Suppose that in country C, a bushel of wheat has an opportunity cost of 2 bushels of corn. That is, to produce an additional bushel of wheat, C must give up 2 bushels of corn. At the same time, producing a bushel of wheat in country D requires the sacrifice of only 1 bushel of corn. Even though C has an absolute advantage in the production of both products, D enjoys a c omparative advantage in the production of wheat because the opportunity cost of producing wheat is lower in D. Under these circumstances, Ricardo claims, both countries will benefit from specialization in the good for which they have a comparative advantage and then trading with each other. We turn now to a discussion of that claim. Gains from Mutual Absolute Advantage To illustrate Ricardo’s logic in more detail, suppose Australia and New Zealand each have a fixed amount of land and do not trade with the rest of the world. There are only two goods—wheat to produce bread and cotton to produce clothing. The conclusions we get from working with this two-countr
y/two-good world can be easily generalized to many countries and many goods. To proceed, we have to make some assumptions about the preferences of the people living in New Zealand and the people living in Australia. We will assume the populations of both countries use both cotton and wheat, and preferences for food and clothing are such that before trade both countries consume equal amounts of wheat and cotton. Finally, we assume that each country has only 100 acres of land for planting and that land yields are as given in Table 18.1. New Zealand can produce 3 times the wheat that Australia can on 1 acre of land, and Australia can produce 3 times the cotton that New Zealand can in the same space. New Zealand has an absolute advantage in the production of wheat, and Australia has an absolute advantage in the production of cotton. In cases like this, we say the two countries have mutual absolute advantage. If there is no trade and each country divides its land to obtain equal units of cotton and wheat production, each country produces 150 bushels of wheat and 150 bales of cotton. New Zealand puts 75 acres into cotton but only 25 acres into wheat, while Australia does the reverse (Table 18.2). M18_CASE3826_13_GE_C18.indd 363 17/04/19 4:24 AM 364 PART V The World Economy TABLE 18.1 Yield per Acre of Wheat and Cotton New Zealand Wheat Cotton 6 bushels 2 bales Australia 2 bushels 6 bales TABLE 18.2 Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage, and 100 Available Acres New Zealand Australia Wheat Cotton 25 acres * 6 bushels/acre = 150 bushels 75 acres * 2 bales/acre = 150 bales 75 acres * 2 bushels/acre = 150 bushels 25 acres * 6 bales/acre = 150 bales We can organize the same information in graphic form as production possibility frontiers for each country. Figure 18.1 presents the positions of the two countries before trade, where each country is constrained by its own resources and productivity. If Australia put all its land into cotton, it would produce 600 bales of cotton (100 acres * 6 bales/acre) and no wheat; if it put all its land into wheat, it would produce 200 bushels of wheat (100 acres * 2 bushels/acre) and no cotton. The opposite is true for New Zealand. Recall from Chapter 2 that a country’s production possibility frontier represents all combinations of goods that can be produced, given the country’s resources and state of technology. Each country must pick a point along its own production possibility curve. We can see that both countries have the option of producing and consuming 150 units of each good, marked on the two figures. When there is mutual absolute advantage, it is easy to see that specialization and trade will benefit both. Australia should produce cotton, and New Zealand should produce wheat. Transferring all land to wheat production in New Zealand yields 600 bushels, while transferring all land to cotton production in Australia yields 600 bales. Because both countries want to consume both goods, they will then need to trade. Suppose the countries agree to trade 300 bushels of wheat for 300 bales of cotton. Prior to specialization, each country consumed 150 units of each good. Now each country has 300 units of each good. Specialization Australia New Zealand 600 150 ) 200 150 0 150 200 0 150 600 Wheat (bushels) MyLab Economics Concept Check Wheat (bushels) ▴▴ FIGURE 18.1 Production Possibility Frontiers for Australia and New Zealand Before Trade Without trade, countries are constrained by their own resources and productivity. M18_CASE3826_13_GE_C18.indd 364 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 365 TABLE 18.3 Production and Consumption of Wheat and Cotton After Specialization Production Consumption Wheat Cotton New Zealand 100 acres * 6 bushels/acre 600 bushels 0 acres 0 Australia 0 acres 0 New Zealand Australia Wheat 300 bushels 300 bushels 100 acres * 6 bales/acre Cotton 300 bales 300 bales 600 bales has allowed the countries to double their consumption of both goods! Final production and trade figures are provided in Table 18.3 and Figure 18.2. Trade enables both countries to move beyond their previous resource and productivity constraints. The advantages of specialization and trade seem obvious when one country is technologically superior at producing one product and another country is technologically superior at producing another product. However, let us turn to the case in which one country has an absolute advantage in the production of both goods. Gains from Comparative Advantage Table 18.4 changes the land yield figures for New Zealand and Australia. Now New Zealand has a considerable absolute advantage in the production of both cotton and wheat, with 1 acre of land yielding 6 times as much wheat and twice as much cotton as 1 acre in Australia. Ricardo would argue that specialization and trade are still mutually beneficial. Again, we assume preferences imply consumption of equal units of cotton and wheat in both countries. With no trade, New Zealand would divide its 100 available acres evenly, or 50/50, between the two crops. The result would be 300 bales of cotton and 300 bushels of wheat. Australia would divide its land 75/25. Table 18.5 shows that final production in Australia would be 75 bales of cotton and 75 bushels of wheat. (Remember, we are assuming that in each country, people consume equal amounts of cotton and wheat.) Again, before any trade takes place, each country is constrained by its own domestic production possibility curve. Australia New Zealand 600 300 150 ) 300 200 150 0 150 200 300 0 150 300 600 Wheat (bushels) MyLab Economics Concept Check Wheat (bushels) ▴▴ FIGURE 18.2 Expanded Possibilities After Trade Trade enables both countries to consume beyond their own domestic resource constraints—beyond their individual production possibility frontiers. M18_CASE3826_13_GE_C18.indd 365 17/04/19 4:24 AM 366 PART V The World Economy TABLE 18.4 Yield per Acre of Wheat and Cotton New Zealand Australia Wheat Cotton 6 bushels 6 bales 1 bushel 3 bales TABLE 18.5 Total Production of Wheat and Cotton Assuming No Trade and 100 Available Acres Wheat Cotton New Zealand Australia 50 acres × 6 bushels/acre 300 bushels 50 acres × 6 bales/acre 300 bales 75 acres × 1 bushel/acre 75 bushels 25 acres × 3 bales/acre 75 bales Imagine we are at a meeting of trade representatives of both countries. As a special adviser, David Ricardo is asked to demonstrate that trade can benefit both countries. He divides his demonstration into three stages, which you can follow in Table 18.6. For Ricardo to be correct about the gains from specialization, it must be true that moving resources around in the two countries generates more than the 375 bushels of wheat and bales of cotton that we had before specialization. To see how this is managed, we move in stages. In Stage 1, let Australia move all its land into cotton production, where it is least disadvantaged. Australia would then produce 300 bales of cotton, as we see in Stage 1 of Table 18.6. Now the question is whether Ricardo can help us use New Zealand’s land to add at least 75 bales of cotton to the total while producing more than the original 375 bushels of wheat. In Stage 2, Ricardo tells New Zealand to use 25 acres to produce cotton and 75 acres for wheat production. With that allocation of land, New Zealand produces 450 bushels of wheat (far more than the total produced in the nonspecialization case by both countries) and 150 bales of cotton, leaving us with 450 bales of cotton as well. Specialization has increased the world production of both wheat and cotton by 75 units! With trade, which we show in Stage 3 for the case in which both countries prefer equal consumption of the two goods, both countries can be better off than they were earlier. TABLE 18.6 Realizing a Gain from Trade when One Country Has a Double Absolute Advantage STAGE 1 New Zealand Australia Wheat Cotton 50 acres × 6 bushels/acre 300 bushels 50 acres × 6 bales/acre 300 bales 0 acres Wheat 0 100 acres × 3 bales/acre 300 bales Cotton STAGE 3 STAGE 2 New Zealand Australia 75 acres × 6 bushels/acre 450 bushels 0 acres 0 25 acres × 6 bales/acre 150 bales 100 acres × 3 bales/acre 300 bales New Zealand Australia 100 bushels (trade) h Wheat 350 bushels 100 bushels (after trade) 200 bales (trade) v Cotton 350 bales 100 bales (after trade) M18_CASE3826_13_GE_C18.indd 366 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 367 Why Does Ricardo’s Plan Work? To understand why Ricardo’s scheme works, let us return to the definition of comparative advantage. The real cost, which is an opportunity cost, of producing cotton is the wheat that must be sacrificed to produce it. When we think of cost this way, it is less costly to produce cotton in Australia than to produce it in New Zealand, even though an acre of land produces more cotton in New Zealand. Consider the “cost” of 3 bales of cotton in the two countries. In terms of opportunity cost, 3 bales of cotton in New Zealand cost 3 bushels of wheat; in Australia, 3 bales of cotton cost only 1 bushel of wheat. Because 3 bales are produced by 1 acre of Australian land, to get 3 bales, an Australian must transfer 1 acre of land from wheat to cotton production. Because an acre of land produces a bushel of wheat, losing 1 acre to cotton implies the loss of 1 bushel of wheat. Australia has a comparative advantage in cotton production because its opportunity cost, in terms of wheat, is lower than New Zealand’s. This is illustrated in Figure 18.3. Conversely, New Zealand has a comparative advantage in wheat production. A unit of wheat in New Zealand costs 1 unit of cotton, whereas a unit of wheat in Australia costs 3 units of cotton. When countries specialize in producing goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. Terms of Trade MyLab
Economics Concept Check We see that specialization and trade increases the size of the pie to be shared between the two countries. Our next question is how that bigger pie is to be divided up between the two countries. In stage three above we have offered one possibility for this division, which benefitted both parties. But this is only one of many possible ways to divide the pie. What would we expect to see happen in practice? The ratio at which a country can trade domestic products for imported products is the terms of trade. The terms of trade determine how the gains from trade are distributed among trading partners. In the case just considered, the agreed-to terms of trade were 1 bushel of wheat for 2 bales of cotton. Such terms of trade benefit New Zealand, which can get 2 bales of cotton for each bushel of wheat. If it were to transfer its own land from wheat to cotton, it would get only 1 bale of cotton. The same terms of trade benefit Australia, which can get 1 bushel of wheat for 2 bales of cotton. A direct transfer of its own land would force it to give up 3 bales of cotton for 1 bushel of wheat. If the terms of trade changed to 3 bales of cotton for every bushel of wheat, only New Zealand would benefit. At those terms of trade, all the gains from trade would flow to New Zealand. Such terms do not benefit Australia at all because the opportunity cost of producing wheat domestically is exactly the same as the trade cost: A bushel of wheat costs 3 bales of cotton. If the terms of trade went the other way—1 bale of cotton for each bushel of wheat—only Australia would benefit. New Zealand gains nothing because it can already substitute cotton for wheat at that terms of trade The ratio at which a country can trade domestic products for imported products. Opportunity “cost” of wheat Opportunity “cost” of cotton New Zealand Australia New Zealand Australia MyLab Economics Concept Check ▴◂ FIGURE 18.3 Comparative Advantage Means Lower Opportunity Cost The real cost of cotton is the wheat sacrificed to obtain it. The cost of 3 bales of cotton in New Zealand is 3 bushels of wheat (a half-acre of land must be transferred from wheat to cotton—refer to Table 18.4). However, the cost of 3 bales of cotton in Australia is only 1 bushel of wheat. Australia has a comparative advantage over New Zealand in cotton production, and New Zealand has a comparative advantage over Australia in wheat production. M18_CASE3826_13_GE_C18.indd 367 17/04/19 4:24 AM 368 PART V The World Economy ratio. To get a bushel of wheat domestically, however, Australia must give up 3 bales of cotton, and one-for-one terms of trade would make wheat much less costly for Australia. Both parties must have something to gain for trade to take place. In this case, you can see that both Australia and New Zealand will gain when the terms of trade are set between 1:1 and 3:1, cotton to wheat. Exchange Rates MyLab Economics Concept Check The examples used thus far have shown that trade can result in gains to both parties. When trade is free—unimpeded by government-instituted barriers—patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms. Private households decide whether to buy Toyotas or Chevrolets, and private firms decide whether to buy machine tools made in the United States or machine tools made in Taiwan, raw steel produced in China or raw steel produced in Pittsburgh. But how does this trade actually come about? In international markets, as in domestic markets, barter is rarely used. Instead trade happens with money. But in the international marketplace, there are a number of different types of currency or money. Before a citizen of one country can buy a product made in another country or sold by someone in another country, a currency swap must take place. Someone who buys a Toyota built in Japan from a dealer in Boston pays in dollars, but the Japanese workers who made the car receive their salaries in yen. Somewhere between the buyer of the car and the producer, a currency exchange must be made. The regional distributor probably takes payment in dollars and converts them into yen before remitting the proceeds to Japan. To buy a foreign-produced good, a consumer, or an intermediary, has to buy foreign currency. The price of a Toyota in dollars depends on the price of the car stated in yen and the dollar price of yen. You probably know the ins and outs of currency exchange very well if you have ever traveled in another country. In April 2018, the British pound was worth $1.37. Now suppose you are in London having dinner. On the menu is a nice bottle of wine for 25 pounds. How can you figure out whether you want to buy it? You know what dollars will buy in the United States, so you have to convert the price into dollars. Each pound will cost you $1.37, so 25 pounds will cost you $1.37 * 25 = $34.25. The attractiveness of foreign goods to U.S. buyers and of U.S. goods to foreign buyers depends in part on the exchange rate, the ratio at which two currencies are traded. In May 2008, the British pound was worth $1.97, and that same bottle of wine would have cost $49.25. In the last decade it has become more attractive for American tourists to visit Great Britain (and the rest of Europe as well) because the dollar is strong relative to other currencies. So how are these exchange rates determined? Why is the dollar stronger now than it was 10 years ago? Exchange rate determination is complicated, but we can say a few things. First, for any pair of countries, there is a range of exchange rates that can lead automatically to both countries’ realizing the gains from specialization and comparative advantage. Second, within that range, the exchange rate will determine which country gains the most from trade. In short, exchange rates determine the terms of trade. Trade and Exchange Rates in a Two-Country/Two-Good World Consider first a simple two-country/two-good model. Suppose both the United States and Brazil produce only two goods—raw timber and rolled steel. Table 18.7 gives the current prices of both goods as domestic buyers see them. In Brazil, timber is priced at 3 reals (R) per foot and steel is priced at 4 R per ton. In the United States, timber costs $1 per foot and steel costs $2 per ton. Suppose U.S. and Brazilian buyers have the option of buying at home or importing to meet their needs. The options they choose will depend on the exchange rate. For the time being, we will ignore transportation costs between countries and assume that Brazilian and U.S. products are of equal quality. Let us start with the assumption that the exchange rate is +1 = 1 R. From the standpoint of U.S. buyers, neither Brazilian steel nor Brazilian timber is competitive at this exchange rate. A dollar buys a foot of timber in the United States, but if converted into a real, it will buy only exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. M18_CASE3826_13_GE_C18.indd 368 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 369 TABLE 18.7 Domestic Prices of Timber (per Foot) and Rolled Steel (per Ton) in the United States and Brazil Timber Rolled steel United States $1 $2 Brazil 3 Reals 4 Reals one-third of a foot. The price of Brazilian timber to an American is $3 because it will take $3 to buy the necessary 3 R. Similarly, $2 buys a ton of rolled steel in the United States, but the same $2 buys only half a ton of Brazilian steel. The price of Brazilian steel to an American is $4, twice the price of domestically produced steel. At this exchange rate, however, Brazilians find that U.S.-produced steel and timber are less expensive than steel and timber produced in Brazil. Timber at home—Brazil—costs 3 R, but 3 R buys $3, which buys 3 times as much timber in the United States. Similarly, steel costs 4 R at home, but 4 R buys $4, which buys twice as much U.S.-made steel. At an exchange rate of +1 = 1 R, Brazil will import steel and timber and the United States will import nothing. However, now suppose the exchange rate is 1 R = +0.25. This means that $1 buys 4 R. At this exchange rate, the Brazilians buy timber and steel at home and the Americans import both goods. At this exchange rate, Americans must pay a dollar for a foot of U.S. timber, but the same amount of timber can be had in Brazil for the equivalent of $0.75. (Because 1 R costs $0.25, 3 R can be purchased for $0.75.) Similarly, steel that costs $2 per ton in the United States costs an American half as much in Brazil because $2 buys 8 R, which buys 2 tons of Brazilian steel. At the same time, Brazilians are not interested in importing because both goods are cheaper when purchased from a Brazilian producer. In this case, the United States imports both goods and Brazil imports nothing. So far we can see that at exchange rates of +1 = 1 R and +1 = 4 R, we get trade flowing in only one direction. Let us now try an exchange rate of +1 = 2 R, or +1 R = 0.50. First, Brazilians will buy timber in the United States. Brazilian timber costs 3 R per foot, but 3 R buys $1.50, which is enough to buy 1.5 feet of U.S. timber. Buyers in the United States will find Brazilian timber too expensive, but Brazil will import timber from the United States. At this same exchange rate, however, both Brazilian and U.S. buyers will be indifferent between Brazilian and U.S. steel. To U.S. buyers, domestically produced steel costs $2. Because $2 buys 4 R, a ton of imported Brazilian steel also costs $2. Brazilian buyers also find that steel costs 4 R, whether domestically produced or imported. Thus, there is likely to be no trade in steel. What happens if the exchange rate changes so that $1 buys 2.1 R? Although U.S. timber is still cheaper to both Brazilians and Americans, Brazilian steel begins to look good to U.S. buyers. Steel produced in the United Stat
es costs $2 per ton, but $2 buys 4.2 R, which buys more than a ton of steel in Brazil. When $1 buys more than 2 R, trade begins to flow in both directions: Brazil will import timber, and the United States will import steel. If you examine Table 18.8 carefully, you will see that trade flows in both directions as long as the exchange rate settles between +1 = 2 R and +1 = 3 R. Stated the other way around, trade will flow in both directions if the price of a real is between $0.33 and $0.50. Notice this ratio is between the United States to Brazil price of steel and the United States to Brazil price of timber. Exchange Rates and Comparative Advantage If the foreign exchange market drives the exchange rate to anywhere between 2 and 3 R per dollar, the countries will automatically adjust and comparative advantage will be realized. At these exchange rates, U.S. buyers begin buying all their steel in Brazil. The U.S. steel industry finds itself in trouble. Plants close, and U.S. workers begin to lobby for tariff protection against Brazilian steel. At the same time, the U.S. timber industry does well, fueled by strong export demand from Brazil. The timber-producing sector expands. Resources, including capital and labor, are attracted into timber production. The opposite occurs in Brazil. The Brazilian timber industry suffers losses as export demand dries up and Brazilians turn to cheaper U.S. imports. In Brazil, lumber companies turn to the government and ask for protection from cheap U.S. timber. However, steel producers in Brazil are happy. They are not only supplying 100 percent of the domestically demanded steel but also M18_CASE3826_13_GE_C18.indd 369 17/04/19 4:24 AM 370 PART V The World Economy TABLE 18.8 Trade Flows Determined by Exchange Rates Exchange Rate Price of Real Result +1 = 1 R +1 = 2 R +1 = 2.1 R +1 = 2.9 R +1 = 3 R +1 = 4 R $1.00 .50 .48 .34 .33 .25 Brazil imports timber and steel. Brazil imports timber. Brazil imports timber; United States imports steel. Brazil imports timber; United States imports steel. United States imports steel. United States imports timber and steel. selling to U.S. buyers. The steel industry expands, and the timber industry contracts. Resources, including labor, flow into steel. With this expansion-and-contraction scenario in mind, let us look again at our original definition of comparative advantage. If we assume that prices reflect resource use and resources can be transferred from sector to sector, we can calculate the opportunity cost of steel/timber in both countries. In the United States, the production of a ton of rolled steel consumes twice the resources that the production of a foot of timber consumes. Assuming that resources can be transferred, the opportunity cost of a ton of steel is 2 feet of timber (Table 18.7). In Brazil, a ton of steel uses resources costing 4 R, while a unit of timber costs 3 R. To produce a ton of steel means the sacrifice of only four-thirds (or one and one-third) feet of timber. Because the opportunity cost of a ton of steel (in terms of timber) is lower in Brazil, we say that Brazil has a comparative advantage in steel production. Conversely, consider the opportunity cost of timber in the two countries. Increasing timber production in the United States requires the sacrifice of half a ton of steel for every foot of timber—producing a ton of steel uses $2 worth of resources, while producing a foot of timber requires only $1 worth of resources. Nevertheless, each foot of timber production in Brazil requires the sacrifice of three-fourths of a ton of steel. Because the opportunity cost of timber is lower in the United States, the United States has a comparative advantage in the production of timber. If exchange rates end up in the right ranges, the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only in a country with a comparative advantage will those products be competitive in world markets. 18.3 LEARNING OBJECTIVE Describe the sources of comparative advantage. factor endowments The quantity and quality of labor, land, and natural resources of a country. Heckscher-Ohlin theorem A theory that explains the existence of a country’s comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. The Sources of Comparative Advantage Specialization and trade can benefit all trading partners, even those that may be inefficient producers in an absolute sense. If markets are competitive and if foreign exchange markets are linked to goods-and-services exchange, countries will specialize in producing products in which they have a comparative advantage. So far, we have said nothing about the sources of comparative advantage. What determines whether a country has a comparative advantage in heavy manufacturing or in agriculture? What explains the actual trade flows observed around the world? Various theories and empirical work on international trade have provided some answers. Most economists look to factor endowments—the quantity and quality of labor, land, and natural resources of a country—as the principal sources of comparative advantage. Factor endowments seem to explain a significant portion of actual world trade patterns. The Heckscher-Ohlin Theorem MyLab Economics Concept Check Eli Heckscher and Bertil Ohlin, two Swedish economists who wrote in the first half of the twentieth century, expanded and elaborated on Ricardo’s theory of comparative advantage. The Heckscher-Ohlin theorem ties the theory of comparative advantage to factor endowments. It assumes that products can be produced using differing proportions of inputs and that inputs are mobile between sectors in each economy, but that factors are not mobile between economies. According M18_CASE3826_13_GE_C18.indd 370 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 371 to this theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. This idea is simple. A country with a great deal of good fertile land is likely to have a comparative advantage in agriculture. A country with a large amount of accumulated capital is likely to have a comparative advantage in heavy manufacturing. A country well-endowed with human capital is likely to have a comparative advantage in highly technical goods. Other Explanations for Observed Trade Flows MyLab Economics Concept Check Comparative advantage is not the only reason countries trade. It does not explain why many countries import and export the same kinds of goods. The United States, for example, exports Velveeta cheese and imports blue cheese. Just as industries within a country differentiate their products to capture a domestic market, they also differentiate their products to please the wide variety of tastes that exists worldwide. The Japanese automobile industry, for example, began producing small, fuel-efficient cars long before U.S. automobile makers did. In doing so, the Japanese auto industry developed expertise in creating products that attracted a devoted following and considerable brand loyalty. BMWs, made mostly in Germany, and Lexus, made mostly in Japan, also have their champions in many countries. Just as product differentiation is a natural response to diverse preferences within an economy, it is also a natural response to diverse preferences across economies. Paul Krugman did some of the earliest work in this area, sometimes called new trade theory. New trade theory also relies on the idea of comparative advantage. If the Japanese developed skills and knowledge that gave them an edge in the production of fuel-efficient cars, that knowledge can be thought of as a very specific kind of capital that is not currently available to other producers. Toyota in producing the Lexus, invested in a form of intangible capital called goodwill. That goodwill, which may come from establishing a reputation for performance and quality over the years, is one source of the comparative advantage that keeps Lexus selling on the international market. Some economists distinguish between gains from acquired comparative advantages and gains from natural comparative advantages. Trade Barriers: Tariffs, Export Subsidies, and Quotas We have seen the capacity for specialization and trade to increases the size of the economic pie for nations. Nevertheless, most countries impose some barriers to trade principally on the grounds of protecting domestic jobs. Trade barriers—also called obstacles to trade—take many forms. The three most common are tariffs, export subsidies, and quotas. All are forms of protection shielding some sector of the economy from foreign competition. In addition, in many countries complex regulatory rules and standards make it difficult for foreign competitors to enter and compete; in recent years economists and policy makers have paid more attention to these soft trade barriers. A tariff is a tax on imports. The average tariff on imports into the United States is less than 5 percent. Certain protected items have much higher tariffs. For example, the United States levies tariffs of 30 percent and more on solar panels imported from China. In 2018, President Trump indicated that he would levy a 25 percent tariff on imported steel. Export subsidies—government payments made to domestic firms to encourage exports— can also act as a barrier to trade. One of the provisions of the Corn Laws that stimulated Ricardo’s musings was an export subsidy automatically paid to farmers by the British government when the price of grain fell below a specified level. The subsidy served to keep domestic prices high, but it flooded the world market with cheap subsidized grain. Foreig
n farmers who were not subsidized were driven out of the international marketplace by the artificially low prices. Farm subsidies remain a part of the international trade landscape today. Many countries continue to appease their farmers by heavily subsidizing exports of agricultural products. The political power of the farm lobby in many countries has had an important effect on recent international trade negotiations aimed at reducing trade barriers. The prevalence of farm subsidies in the 18.4 LEARNING OBJECTIVE Analyze the economic effects of trade barriers. protection The practice of shielding a sector of the economy from foreign competition. soft trade barriers Regulatory standards and requirements that make foreign competition more difficult. tariff A tax on imports. export subsidies Government payments made to domestic firms to encourage exports. M18_CASE3826_13_GE_C18.indd 371 17/04/19 4:24 AM 372 PART V The World Economy dumping A firm’s or an industry’s sale of products on the world market at prices below its own cost of production. developed world has become a major rallying point for less developed countries as they strive to compete in the global marketplace. Many African nations, in particular, have a comparative advantage in agriculture. In producing agricultural goods for export to the world marketplace, however, they must compete with food produced on heavily subsidized farms in Europe and the United States. Countries such as France have particularly high farm subsidies, which, it argues, helps preserve the rural heritage of France. One side effect of these subsidies, however, is to make it more difficult for some of the poorer nations in the world to compete. Some have argued that if developed nations eliminated their farm subsidies, this would have a much larger effect on the economies of some African nations than is currently achieved by charitable aid programs. Closely related to subsidies is dumping. Dumping occurs when a firm or industry sells its products on the world market at prices lower than its cost of production. Charges of dumping are often brought by a domestic producer that believes itself to be subject to unfair competition. In the United States, claims of dumping are brought before the International Trade Commission. In 2007, for example, a small manufacturer of thermal paper charged China and Germany with dumping. In 2006, the European Union charged China with dumping shoes. In 2009, China brought a dumping charge against U.S. chicken producers. Determining whether dumping has actually occurred can be difficult. Domestic producers argue that foreign firms will dump their product in the United States, drive out U.S. competitors, and then raise prices, thus harming consumers. Foreign exporters, on the other hand, claim that their prices are low simply because their costs are low and that no dumping has occurred. Figuring out the costs for German thermal paper or Chinese shoes is not easy. In the case of the Chinese shoe claim, for example, the Chinese government pointed out that shoes are a labor-intensive product and that given China’s low wages, it should not be a surprise that it is able to produce shoes cheaply. In other words, the Chinese claim that shoes are an example of the theory of comparative advantage at work rather than predatory dumping Globalization Improves Firm Productivity Earlier in the chapter we described the way in which free trade allows countries to make the most of what they do well. Recent work in the trade area has also described the way in which free trade improves the productivity of firms within a country.1 Within a country we typically see firms of varying productivity. If firms were in fact all producing exactly the same product, we would expect higher-cost firms to be driven out of business. In fact, firms are often producing products that are close substitutes, but not identical. Matchbox cars are like Hot Wheels cars but not identical. Under these conditions, industries will have firms with a range of productivity levels because some people will pay a little more for the particular product a firm supplies. What happens when trade opens up? Now competition grows. Firms with good products and low costs can expand to serve markets elsewhere. They grow and often improve their cost through scale economies while doing so. Less productive firms find themselves facing tough competition from both foreign producers and from their domestic counterparts who now look even more productive than before. Melitz and other economists have found that when we look at the distribution of firm productivity after big trade changes (like the free trade agreement between the United States and Canada in 1989) we see a big drop-off in the less productive firms. Trade not only exploits comparative advantage of countries, but it improves the efficiency of firms more generally. CRITICAL THINKING 1. What do you expect to see happen to average prices after trade opens up? 1Marc Melitz at Harvard did much of the early work in this area. For a review see Marc Melitz and Daniel Trefler, “Gains from Trade when Firms Matter,” Journal of Economic Perspectives, Spring 2012, 90–117. See also Andrew B. Bernard, Jonathan Eaton, J. Bradford Jensen and Samuel Kortum, “Plants and Productivity in International Trade,” American Economic Review, Winter 2003, 1268–90. M18_CASE3826_13_GE_C18.indd 372 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 373 A quota is a limit on the quantity of imports. Quotas can be mandatory or “voluntary,” and they may be legislated or negotiated with foreign governments. The best-known voluntary quota, or “voluntary restraint,” was negotiated with the Japanese government in 1981. Japan agreed to reduce its automobile exports to the United States by 7.7 percent, from the 1980 level of 1.82 million units to 1.68 million units. Many quotas limit trade around the world today. Perhaps the best-known recent case is the textile quota imposed in August 2005 by the European Union (EU) on imports of textiles from China. Because China had exceeded quotas that had been agreed to earlier in the year, the EU blocked the entry of Chinese-produced textiles into Europe; as a result, more than 100 million garments piled up in European ports. In the Economics in Practice box below we look at the effects of lifting quotas. quota A limit on the quantity of imports. U.S. Trade Policies, GATT, and the WTO MyLab Economics Concept Check The United States has been a high-tariff nation, with average tariffs higher than 50 percent, for much of its history. The highest were in effect during the Great Depression following the Smoot-Hawley tariff, which pushed the average tariff rate to 60 percent in 1930. The SmootHawley tariff set off an international trade war when U.S. trading partners retaliated with tariffs of their own. Many economists say the decline in trade that followed was one of the causes of the worldwide depression of the 1930s.1 Smoot-Hawley tariff The U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered one of the causes of the worldwide depression of the 1930s What Happens When We Lift a Quota? Prior to 2005, textiles and clothing from China and much of the emerging world, heading for the United States, Canada, and the European Union, were subject to quotas. In an interesting new paper, Peter Schott from Yale and Amit Khandelwal and Shang-Jin Wei from Columbia University, investigated what happened once the quota was lifted.1 It should come as no surprise that lifting the quota increased the textiles and clothing exported to all three areas. A more interesting question is what happened to the composition of the firms doing the exporting after quotas were lifted. Did the same firms just send more goods, for example? When an exporting country faces a quota on its products, someone has to decide which firms get the privilege of sending their goods abroad. Typically, governments make this decision. In some cases, governments auction off the rights to export, seeking to maximize public revenue; here we might expect that more efficient firms would be the most likely exporters because they could bid the most due to their cost advantage in selling the goods. In other cases, governments may give export rights to friends and family. In this case, Schott et al. did not know how China had allocated the export rights or what objective it had in mind. But the results they found were instructive. After quotas were lifted in 2005, exports did increase dramatically. Moreover, most of the exports were produced not by the older firms which had dominated the quota-laden era, but by new entrants! Without quotas, firms need to be efficient to export and most of the older firms now subject to the new competition rapidly lost market share. The evidence of this paper tells us that however China was allocating its licenses, it was not to the most efficient firms. CRITICAL THINKING 1. If in fact the Chinese government was allocating the rights to export under a quota to the most productive firms, what would you expect to see happen once the quota is lifted? 1Amit Khandelwal, Peter Schott, Shang-Jin Wei, “Trade Liberalization and Embedded Institutional Reform: Evidence from Chinese Exporters,” American Economic Review, October 2013, 2169–95. 1See especially Charles Kindleberger, The World in Depression 1929–1939 (London: Allen Lane, 1973). M18_CASE3826_13_GE_C18.indd 373 17/04/19 4:24 AM 374 PART V The World Economy General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade. World Trade Organization (WTO) A negotiating forum dealing with rules of trade across nations. Doha Development Agenda An initiative of the
World Trade Organization focused on issues of trade and development. In 1947, the United States, with 22 other nations, agreed to reduce barriers to trade. It also established an organization to promote liberalization of foreign trade. The General Agreement on Tariffs and Trade (GATT) proved to be successful in helping reduce tariff levels and encourage trade. In 1986, GATT sponsored a round of world trade talks known as the Uruguay Round that were focused on reducing trade barriers further. After much debate, the Uruguay Round was signed by the U.S. Congress in 1993 and became a model for multilateral trade agreements. In 1995, the World Trade Organization (WTO) was established as a negotiating forum to deal with the rules of trade established under GATT and other agreements. It remains the key institution focused on facilitating freer trade across nations and negotiating trade disputes. The WTO consists of 153 member nations and serves as a negotiating forum for countries as they work through complexities of trade under the Uruguay Round and other agreements. At this time, the WTO is the central institution for promoting and facilitating free trade. In 2015, the WTO heard international tariff and subsidy disputes ranging from disputes between China and Indonesia on flat rolled steel, to China and the EU on poultry, to Indonesia versus the United States on paper. Although the WTO was founded to promote free trade, its member countries clearly have different incentives as they confront trade cases. In recent years, differences between developed and developing countries have come to the fore. In 2001, at a WTO meeting in Doha, Qatar, the WTO launched a new initiative, the Doha Development Agenda, to deal with some of the issues that intersect the areas of trade and development. In 2007, the Doha Development Agenda continued to struggle over the issue of agriculture and farm subsidies that were described in this chapter. The less-developed countries, with sub-Saharan Africa taking the lead, seek to eliminate all farm subsidies currently paid by the United States and the EU. The EU has, for its part, tried to push the less-developed countries toward better environmental policies as part of a broader free trade package. While the Doha Round continues in theory, there has been essentially no progress made since 2013. Until recently, the movement in the United States has been away from tariffs and quotas and toward freer trade. The Reciprocal Trade Agreements Act of 1934 authorized the president to negotiate trade agreements on behalf of the United States. As part of trade negotiations, the president can confer most-favored-nation status on individual trading partners. Imports from countries with most-favored-nation status are taxed at the lowest negotiated tariff rates. In addition, in recent years, several successful rounds of tariff-reduction negotiations have reduced trade barriers to their lowest levels ever. In late 2015, the U.S. Congress heavily debated the passage of the Trans Pacific Partnership, a new trade pact designed to lower tariffs among the United States and eleven Pacific rim countries. The agreement was signed in 2016, although not ratified by Congress, and shortly after being elected, President Trump withdrew the United States from the agreement. The agreement continues among the Pacific Rim countries under the title Comprehensive and Progressive Agreement for Trans Pacific Partnership. Most U.S. presidents in the last 50 years have made exceptions in their trade policies to protect one economic sector or another. Eisenhower and Kennedy restricted imports of Japanese textiles; Johnson restricted meat imports to protect Texas beef producers; Nixon restricted steel imports; Reagan restricted automobiles from Japan. In early 2002, President George W. Bush imposed a 30 percent tariff on steel imported from the EU. In 2003, the WTO ruled that these tariffs were unfair and allowed the EU to slap retaliatory tariffs on U.S. products. Shortly thereafter, the steel tariffs were rolled back, at least on EU steel. In 2009, President Obama put a tariff of 35 percent on Chinese tires, only to have China retaliate by putting a tariff on U.S. chicken parts. President Trump in the early period of his administration imposed high tariffs on solar panels and steel. Again, these tariffs were met with retaliation, via tariffs on U.S. agricultural products. For the most part, tariff support has been fueled by an interest in job protection. As we will see shortly in our discussion of the case for and against free trade, the role of tariffs in raising domestic prices and the employment effect of retaliation have often gotten less play politically. economic integration Occurs when two or more nations join to form a free-trade zone. Economic Integration Economic integration occurs when two or more nations join to form a free-trade zone. In 1991, the European Community (EC, or the Common Market) began forming the largest free-trade zone in the world. The economic integration process began that December, when the 12 original members (the United Kingdom, Belgium, France, Germany, Italy, the Netherlands, Luxembourg, Denmark, Greece, Ireland, Spain, and Portugal) signed the M18_CASE3826_13_GE_C18.indd 374 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 375 European Union (EU) The European trading bloc composed of 28 countries (of the 28 countries in the EU, 17 have the same currency—the euro). U.S.-Canada Free Trade Agreement An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1998. North American Free Trade Agreement (NAFTA) An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a freetrade zone. Maastricht Treaty. The treaty called for the end of border controls, a common currency, an end to all tariffs, and the coordination of monetary and political affairs. The European Union (EU), as the EC is now called, has 28 members (for a list, see the Summary, p. 381). On January 1, 1993, all tariffs and trade barriers were dropped among the member countries. Border checkpoints were closed in early 1995. Citizens can now travel among member countries without passports. The United States is not a part of the EU. However, in 1988, the United States (under President Reagan) and Canada (under Prime Minister Mulroney) signed the U.S.-Canada Free Trade Agreement, which removed all barriers to trade, including tariffs and quotas, between the two countries by 1998. During the last days of the George H. W. Bush administration in 1992, the United States, Mexico, and Canada signed the North American Free Trade Agreement (NAFTA), with the three countries agreeing to establish all of North America as a free-trade zone. The agreement eliminated all tariffs over a 10- to 15-year period and removed restrictions on most investments. During the presidential campaign of 1992, NAFTA was hotly debated. Both Bill Clinton and George Bush supported the agreement. Industrial labor unions that might be affected by increased imports from Mexico (such as those in the automobile industry) opposed the agreement, while industries whose exports to Mexico might increase as a result of the agreement—for example, the machine tool industry—supported it. Another concern was that Mexican companies were not subject to the same environmental regulations as U.S. firms, so U.S. firms might move to Mexico for this reason. NAFTA was ratified by the U.S. Congress in late 1993 and went into effect on the first day of 1994. The U.S. Department of Commerce estimated that as a result of NAFTA, trade between the United States and Mexico increased by nearly $16 billion in 1994. In addition, exports from the United States to Mexico outpaced imports from Mexico during 1994. In 1995, however, the agreement fell under the shadow of a dramatic collapse of the value of the peso. U.S. exports to Mexico dropped sharply, and the United States shifted from a trade surplus to a large trade deficit with Mexico. Aside from a handful of tariffs, however, all of NAFTA’s commitments were fully implemented by 2003, and an 8-year report signed by all three countries declared the pact a success. The report concludes, “Eight years of expanded trade, increased employment and investment, and enhanced opportunity for the citizens of all three countries have demonstrated that NAFTA works and will continue to work.” In 2018, President Trump began a process of renegotiating NAFTA, blaming the agreement for loss of manufacturing jobs to Mexico and Canada. The economics evidence on this claim is weak. Free Trade or Protection? One of the great economic debates of all time revolves around the free-trade-versus-protection controversy. We briefly summarize the arguments in favor of each. 18.5 LEARNING OBJECTIVE Evaluate the arguments over free trade and protectionism. The Case for Free Trade MyLab Economics Concept Check In one sense, the theory of comparative advantage is the case for free trade. Trade has potential benefits for all nations. A good is not imported unless its net price to buyers is below the net price of the domestically produced alternative. When the Brazilians in our example found U.S. timber less expensive than their own, they bought it, yet they continued to pay the same price for homemade steel. Americans bought less expensive Brazilian steel, but they continued to buy domestic timber at the same lower price. Under these conditions, both Americans and Brazilians ended up paying less and consuming more. At the same time, resources (including labor) move out of steel production and into timber production in the United States. In Brazil, resources (including labor) move out of timber production and into steel production. The resources in both countries are used more efficiently. Tariffs, export subsidies, an
d quotas, which interfere with the free movement of goods and services around the world, reduce or eliminate the gains of comparative advantage. M18_CASE3826_13_GE_C18.indd 375 17/04/19 4:24 AM 376 PART V The World Economy We can use supply and demand curves to illustrate this. Suppose Figure 18.4 shows domestic supply and demand for textiles. In the absence of trade, the market clears at a price of $4.20. At equilibrium, 450 million yards of textiles are produced and consumed. Assume now that textiles are available at a world price of $2. This is the price in dollars that Americans must pay for textiles from foreign sources. If we assume that an unlimited quantity of textiles is available at $2 and there is no difference in quality between domestic and foreign textiles, no domestic producer will be able to charge more than $2. In the absence of trade barriers, the world price sets the price in the United States. As the price in the United States falls from $4.20 to $2.00, the quantity demanded by consumers increases from 450 million yards to 700 million yards, but the quantity supplied by domestic producers drops from 450 million yards to 200 million yards. The difference, 500 million yards, is the quantity of textiles imported. The argument for free trade is that each country should specialize in producing the goods and services in which it enjoys a comparative advantage. If foreign producers can produce textiles at a much lower price than domestic producers, they have a comparative advantage. As the world price of textiles falls to $2, domestic (U.S.) quantity supplied drops and resources are transferred to other sectors. These other sectors, which may be export industries or domestic industries, are not shown in Figure 18.4a. It is clear that the allocation of resources is more efficient at a price of $2. Why should the United States use domestic resources to produce what foreign producers can produce at a lower cost? U.S. resources should move into the production of the things it produces best. Now consider what happens to the domestic price of textiles when a trade barrier is imposed. Figure 18.4b shows the effect of a set tariff of $1 per yard imposed on imported textiles. The tariff raises the domestic price of textiles to +2 + +1 = +3. The result is that some of the gains from trade are lost. First, consumers are forced to pay a higher price for the same good. The quantity of textiles demanded drops from 700 million yards under free trade to 600 million yards because some consumers are not willing to pay the higher price. Notice in Figure 18.4b the triangle labelled ABC. This is the deadweight loss or excess burden resulting from the tariff. Absent the tariff, these 100 added units of textiles would have generated benefits in excess of the $2 that each one cost. a. Domestic supply and demand for textiles b. Effect of $1 tariff per unit S D e c i r P Tariff = $1 $3 $2 S A C B D $4.20 e c i r P $2.00 0 200 450 700 0 200 300 600 700 Imports = 500 Imports after tariff = 300 Millions of yards MyLab Economics Concept Check Millions of yards ▴▴ FIGURE 18.4 The Gains from Trade and Losses from the Imposition of a Tariff A tariff of $1 increases the market price facing consumers from $2 per yard to $3 per yard. The government collects revenues equal to the gray shaded area in b. The loss of efficiency has two components. First, consumers must pay a higher price for goods that could be produced at lower cost. Second, marginal producers are drawn into textiles and away from other goods, resulting in inefficient domestic production. The triangle labeled ABC in b is the deadweight loss or excess burden resulting from the tariff. M18_CASE3826_13_GE_C18.indd 376 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 377 At the same time, the higher price of textiles draws some marginal domestic producers who could not make a profit at $2 into textile production. (Recall that domestic producers do not pay a tariff.) As the price rises to $3, the quantity supplied by domestic producers rises from 200 million yards to 300 million yards. The result is a decrease in imports from 500 million yards to 300 million yards. Finally, the imposition of the tariff means that the government collects revenue equal to the shaded area in Figure 18.4b. This shaded area is equal to the tariff rate per unit ($1) times the number of units imported after the tariff is in place (300 million yards). Thus, receipts from the tariff are $300 million. What is the final result of the tariff? Domestic producers receiving revenues of only $2 per unit before the tariff was imposed now receive a higher price and earn higher profits. However, these higher profits are achieved at a loss of efficiency. Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. In a more complicated, real world setting, tariffs have at least two other problems. In some cases, tariffs are imposed not on final goods but on intermediate goods, goods used in the production of other products. Steel, the subject of President Trump’s tariff proposal in 2018, is used to produce cars, cans, buildings, and many other products. A tariff that raises the domestic price of steel makes it harder for domestic car manufacturers to compete with foreign car companies. In the spring of 2018, Ford Motor Company made precisely this point in opposing proposed steel tariffs. Secondly, as we have already suggested, tariffs by one country rarely go unchallenged. When the United States puts a tariff on steel or tires, other countries will tax its exports, causing job losses in those industries. In the end, the tariff war distorts employment patterns across trading partners. The Case for Protection MyLab Economics Concept Check A case can also be made in favor of tariffs and quotas. Over the course of U.S. history, protectionist arguments have been made so many times by so many industries before so many congressional committees that it seems all pleas for protection share the same themes. We describe the most frequently heard pleas next. Protection Saves Jobs The main argument for protection is that foreign competition costs Americans their jobs. When Americans buy imported Toyotas, U.S.-produced cars go unsold. Layoffs in the domestic auto industry follow. When Americans buy Chinese textiles, U.S. workers may lose their jobs. When Americans buy shoes or textiles from Korea or Taiwan, the millworkers in Maine and Massachusetts, as well as in South Carolina and Georgia, lose their jobs. It is true that when we buy goods from foreign producers, domestic producers suffer. However, there is no reason to believe that the workers laid off in the contracting sectors will not ultimately be reemployed in expanding sectors. Foreign competition in textiles, for example, has meant the loss of U.S. jobs in that industry. Thousands of textile workers in New England lost their jobs as the textile mills closed over the last 40 years. Nevertheless, with the expansion of high-tech industries, the unemployment rate in Massachusetts fell to one of the lowest in the country in the mid-1980s, and New Hampshire, Vermont, and Maine also boomed. The employment case is made more complex when we recognize that protection of intermediate products can result in higher costs for the domestic industries who use those intermediate products, thus making those firms less competitive. Protecting the U.S. domestic tire or steel industry raises the costs of the domestic auto industry, potentially costing the economy jobs in that sector. Employment problems coming from open trade can be handled in several ways. We can ban imports and give up the gains from free trade, acknowledging that we are willing to pay premium prices to save domestic jobs in industries that can produce more efficiently abroad, or we can aid the victims of free trade in a constructive way, helping to retrain them for jobs with a future. In some instances, programs to relocate people in expanding regions may be in order. Some programs deal directly with the transition without forgoing the gains from trade. Some Countries Engage in Unfair Trade Practices Attempts by U.S. firms to monopolize an industry are illegal under the Sherman and Clayton acts. If a strong company decides M18_CASE3826_13_GE_C18.indd 377 17/04/19 4:24 AM 378 PART V The World Economy to drive the competition out of the market by setting prices below cost, it would be aggressively prosecuted by the Antitrust Division of the Justice Department. However, the argument goes, if we will not allow a U.S. firm to engage in predatory pricing or monopolize an industry or a market, can we stand by and let a German firm or a Japanese firm do so in the name of free trade? This is a legitimate argument and one that has gained significant favor in recent years. How should we respond when a large international company or a country behaves strategically against a domestic firm or industry? Free trade may be the best solution when everybody plays by the rules, but sometimes we have to fight back. The WTO is the vehicle currently used to negotiate disputes of this sort. Cheap Foreign Labor Makes Competition Unfair Let us say that a particular country gained its “comparative advantage” in textiles by paying its workers low wages. How can U.S. textile companies compete with companies that pay wages that are less than a quarter of what U.S. companies pay? Questions like this are often asked by those concerned with competition from China and India. First, remember that wages in a competitive economy reflect productivity: a high ratio of output to units of labor. Workers in the United States earn higher wages because they are more productive. The United States has more capital per worker; that is, the average w
orker works with better machinery and equipment and its workers are better trained. Second, trade flows not according to absolute advantage, but according to comparative advantage: All countries benefit, even if one country is more efficient at producing everything. Protection Safeguards National Security Beyond saving jobs, certain sectors of the economy may appeal for protection for other reasons. The steel industry has argued for years with some success that it is vital to national defense. In the event of a war, the United States would not want to depend on foreign countries for a product as vital as steel. Even if we acknowledge another country’s comparative advantage, we may want to protect our own resources. This is one of the arguments made in 2017–2018 by the Trump administration. Virtually no industry has ever asked for protection without invoking the national defense argument. Testimony that was once given on behalf of the scissors and shears industry argued that “in the event of a national emergency and imports cutoff, the United States would be without a source of scissors and shears, basic tools for many industries and trades essential to our national defense.” The question lies not in the merit of the argument, but in just how seriously it can be taken if every industry uses it. Protection Discourages Dependency Closely related to the national defense argument is the claim that countries, particularly small or developing countries, may come to rely too heavily on one or more trading partners for many items. If a small country comes to rely on a major power for food or energy or some important raw material in which the large nation has a comparative advantage, it may be difficult for the smaller nation to remain politically neutral. Some critics of free trade argue that larger countries, such as the United States, Russia, and China have consciously engaged in trade with smaller countries to create these kinds of dependencies. Therefore, should small, independent countries consciously avoid trading relationships that might lead to political dependence? This objective may involve developing domestic industries in areas where a country has a comparative disadvantage. To do so would mean protecting that industry from international competition. Environmental Concerns In recent years, concern about the environment has led some people to question advantages of free trade. Some environmental groups, for example, argue that the WTO’s free trade policies may harm the environment. The central argument is that poor countries will become havens for polluting industries that will operate their steel and auto factories with few environmental controls. The absence of environmental controls gives firms in these countries, it is argued, a phantom advantage. These issues are quite complex, and there is much dispute among economists about the interaction between free trade and the environment. One relatively recent study of sulphur dioxide, for example, found that in the long run, free trade reduces pollution, largely by increasing the income of M18_CASE3826_13_GE_C18.indd 378 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 379 Reshaping the Global Trade Order The twenty-first century has witnessed several global economic and geopolitical changes that have impacted the global trade order. The recent volatility in global politics has caused many developed nations and emerging market economies to favor economic nationalism, state capitalism, and protectionism. In the wake of the financial crisis of 2008–2009 and the European sovereign debt crisis, governments had to intervene to help their economies recover. Monetary and fiscal stimulus packages were introduced and several industries received financial assistance from their governments. Some governments increased their stake in large firms to protect jobs. At the time of implementation, these measures were thought to be temporary, but the fissures in the global geopolitical system turned out to be deep enough to slow global trade integration down and increase trade-restrictive measures like tariffs, quotas, export restrictions, etc. The most notable examples are the United Kingdom’s Brexit vote to leave the European Union, the United States’ withdrawal from the Trans-Pacific Partnership (TPP), its expected renegotiation of the North American Free Trade Agreement (NAFTA), and the rise in the average number of trade-restrictive measures by the G-20 to 20 measures per month.1 On the other hand, several emerging market economies are expected to become the largest consumer markets in the world. Propelled by their increasing GDP and rapid growth of young populations, they are expected to become large sources of demand. At the same time, the young and educated labor force in these economies is also improving productivity and supply. By 2021, the Chinese consumer economy is expected to outweigh the combined consumer markets of Germany, the United Kingdom, and France. India is projected to be the third largest consumer market by 2025, and Africa is expected to have 1.1 billion consumers by 2020.2 Combined with an increasingly digitized global economy, these predictions suggest that intra-regional trade among emerging market economies is expected to flourish during the next few decades. China plans to take advantage of the burgeoning intra-regional trade with its Belt and Road Initiative (BRI), a €3–4 trillion project that is planned to connect 68 countries through harbors, airports, highways, railways, power plants, and oil pipelines. Once completed, the BRI is expected to further increase China’s productivity and trade, particularly benefiting emerging market economies. Thus, the increasingly protectionist approach in developed economies is a far cry from the perspective of these emerging market economies, which are actively developing trade partnerships outside the influence of developed markets. CRITICAL THINKING 1. Explain how the BRI is expected to change future global trade relations among the nations connected by the route. 1WTO (2017), World Trade Report: Trade, Technology and Jobs. World Trade Organization, Geneva. 2Kasey Maggard, Dinesh Khanna, Justin Rose, and Jeff Walters, “ Adapting to a New Trade Order,” The Boston Consulting Group, July 14, 2017. countries; richer countries typically choose policies to improve the environment.2 Thus, although free trade and increased development initially may cause pollution levels to rise, in the long run, prosperity is a benefit to the environment. Many also argue that there are complex trade-offs to be made between pollution control and problems such as malnutrition and health for poor countries. The United States and Europe both traded off faster economic growth and income against cleaner air and water at earlier times in their development. Some argue that it is unfair for the developed countries to impose their preferences on other countries facing more difficult trade-offs. 2Werner Antweiler, Brian Copeland, and M. Scott Taylor, “Is Free Trade Good for the Environment?” American Economic Review, September, 2001. M18_CASE3826_13_GE_C18.indd 379 17/04/19 4:24 AM 380 PART V The World Economy infant industry A young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage. Nevertheless, the concern with global climate change has stimulated new thinking in this area. A study by the Tyndall Centre for Climate Change Research in Britain found that in 2004, 23 percent of the greenhouse gas emissions produced by China were created in the production of exports. In other words, these emissions come not as a result of goods that China’s population is enjoying as its income rises, but as a consequence of the consumption of the United States and Europe, where most of these goods are going. In a world in which the effects of carbon emissions are global and all countries are not willing to sign binding global agreements to control emissions, trade with China may be a way for developed nations to avoid their commitments to pollution reduction. Some have argued that penalties could be imposed on high-polluting products produced in countries that have not signed international climate control treaties as a way to ensure that the prices of goods imported this way reflect the harm that those products cause the environment.3 Implementing these policies is, however, likely to be complex, and some have argued that it is a mistake to bundle trade and environmental issues. As with other areas covered in this book, there is still disagreement among economists as to the right answer. Protection Safeguards Infant Industries Young industries in a given country may have a difficult time competing with established industries in other countries. In a dynamic world, a protected infant industry might mature into a strong industry worldwide because of an acquired, but real, comparative advantage. If such an industry is undercut and driven out of world markets at the beginning of its life, that comparative advantage might never develop. Yet efforts to protect infant industries can backfire. In July 1991, the U.S. government imposed a 62.67 percent tariff on imports of active-matrix liquid crystal display screens (also referred to as “flat-panel displays” used primarily for laptop computers) from Japan. The Commerce Department and the International Trade Commission agreed that Japanese producers were selling their screens in the U.S. market at a price below cost and that this dumping threatened the survival of domestic laptop screen producers. The tariff was meant to protect the infant U.S. industry until it could compete head-on with the Japanese. Unfortunately for U.S. producers of laptop computers and for consumers who purchase them, the tariff had an unintended (although predictable) effect on the industry. Because U
.S. laptop screens were generally recognized to be of lower quality than their Japanese counterparts, imposition of the tariff left U.S. computer manufacturers with three options: (1) They could use the screens available from U.S. producers and watch sales of their final product decline in the face of higher-quality competition from abroad, (2) they could pay the tariff for the higher-quality screens and watch sales of their final product decline in the face of lower-priced competition from abroad, or (3) they could do what was most profitable for them to do—move their production facilities abroad to avoid the tariff completely. The last option is what Apple and IBM did. In the end, not only were the laptop industry and its consumers hurt by the imposition of the tariff (due to higher costs of production and to higher laptop computer prices), but the U.S. screen industry was hurt as well (due to its loss of buyers for its product) by a policy specifically designed to help it. Changes in Openness to Trade over Time across the World Advanced economies Latin America and the Caribbean Middle East and North Africa Sub-Saharan Africa Newly industrialized Asian economies Developing Asia 100 90 80 70 60 50 40 1980 85 90 95 2000 05 MyLab Economics Concept Check ▴▴FIGURE 18.5 Trade Openness across the World (Index is 100 minus the average effective tariff rate in the region.) 3Judith Chevalier, “A Carbon Cap That Starts in Washington,” New York Times, December 16, 2007. M18_CASE3826_13_GE_C18.indd 380 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 381 18.6 LEARNING OBJECTIVE Outline how international trade fits into the structure of the economy. An Economic Consensus Critical to our study of international economics is the debate between free traders and protectionists. On one side is the theory of comparative advantage, formalized by David Ricardo in the early part of the nineteenth century. According to this view, all countries benefit from specialization and trade. The gains from trade are real, and they can be large; free international trade raises real incomes and improves the standard of living. The case for free trade has been made across the world as increasing numbers of countries have joined the world marketplace. Figure 18.5 traces the path of tariffs across the world from 1980 to 2005. The lines show an index of trade openness, calculated as 100 minus the tariff rate. (So higher numbers mean lower tariffs.) We see rapid reductions in the last 25 years across the world, most notably in countries in the emerging and developing markets. On the other side are the protectionists, who point to the loss of jobs and argue for the protection of workers from foreign competition. Although foreign competition can cause job loss in specific sectors, it is unlikely to cause net job loss in an economy and workers will, over time, be absorbed into expanding sectors. Foreign trade and full employment can be pursued simultaneously. Although economists disagree about many things, the vast majority of them favor free trade. S U M M A R Y 1. All economies, regardless of their size, depend to some extent on other economies and are affected by events outside their borders. 18.1 TRADE SURPLUSES AND DEFICITS p. 362 2. Until the 1970s, the United States generally exported more than it imported—it ran a trade surplus. In the mid-1970s, the United States began to import more merchandise than it exported—a trade deficit. 18.2 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE p. 362 3. The theory of comparative advantage, dating to David Ricardo in the nineteenth century, holds that specialization and free trade will benefit all trading partners, even those that may be absolutely less efficient producers. 4. A country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does. A country has a comparative advantage in the production of a product if that product can be produced at a lower opportunity cost in terms of other goods foregone. 5. Trade enables countries to move beyond their previous resource and productivity constraints. When countries specialize in producing those goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. 6. When trade is free, patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms. 7. The relative attractiveness of foreign goods to U.S. buyers and of U.S. goods to foreign buyers depends in part on exchange rates, the ratios at which two currencies are traded for each other. 8. For any pair of countries, there is a range of exchange rates that will lead automatically to both countries realizing the gains from specialization and comparative advantage. Within that range, the exchange rate will determine which country gains the most from trade. This leads us to conclude that exchange rates determine the terms of trade. 9. If exchange rates end up in the right range (that is, in a range that facilitates the flow of goods between nations), the free market will drive each country to shift resources into those sectors in which it enjoys a comparative advantage. Only those products in which a country has a comparative advantage will be competitive in world markets. 18.3 THE SOURCES OF COMPARATIVE ADVANTAGE p. 370 10. The Heckscher-Ohlin theorem looks to relative factor endowments to explain comparative advantage and trade flows. According to the theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with the inputs that are used intensively in the production of that product. 11. A relatively short list of inputs—natural resources, knowl- edge capital, physical capital, land, and skilled and unskilled labor—explains a surprisingly large portion of world trade patterns. However, the simple version of the theory of comparative advantage cannot explain why many countries import and export the same goods. 12. Some theories argue that comparative advantage can be acquired. Just as industries within a country differentiate their products to capture a domestic market, they also differentiate their products to please the wide variety of tastes that exists worldwide. This theory is consistent with the theory of comparative advantage. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M18_CASE3826_13_GE_C18.indd 381 17/04/19 4:24 AM 382 PART V The World Economy 18.4 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS p. 371 13. Trade barriers take many forms. The three most common are tariffs, export subsidies, and quotas. All are forms of protection through which some sector of the economy is shielded from foreign competition. 14. Although the United States has historically been a high-tariff nation, the general movement is now away from tariffs and quotas. The General Agreement on Tariffs and Trade (GATT), signed by the United States and 22 other countries in 1947, continues in effect today; its purpose is to reduce barriers to world trade and keep them down. Also important are the U.S.-Canada Free Trade Agreement, signed in 1988, and the North American Free Trade Agreement, signed by the United States, Mexico, and Canada in the last days of the George H. W. Bush administration in 1992, taking effect in 1994. 15. The World Trade Organization (WTO) was set up by GATT to act as a negotiating forum for trade disputes across countries. 16. The European Union (EU) is a free-trade bloc composed of 28 nations: Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom. Many economists believe that the advantages of free trade within the bloc, a reunited Germany, and the ability to work well as a bloc will make the EU the most powerful player in the international marketplace in the coming decades. 18.5 FREE TRADE OR PROTECTION? p. 375 17. In one sense, the theory of comparative advantage is the case for free trade. Trade barriers prevent a nation from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. 18. The case for protection rests on a number of propositions, one of which is that foreign competition results in a loss of domestic jobs, but there is no reason to believe that the workers laid off in the contracting sectors will not be ultimately reemployed in other expanding sectors. This adjustment process is far from costless, however. 19. Other arguments for protection hold that cheap foreign labor makes competition unfair; that some countries engage in unfair trade practices; that free trade might harm the environment; and that protection safeguards the national security, discourages dependency, and shields infant industries. Despite these arguments, most economists favor free trade absolute advantage, p. 363 comparative advantage, p. 363 Corn Laws, p. 362 Doha Development Agenda, p. 374 dumping, p. 372 economic integration, p. 374 European Union (EU), p. 375 exchange rate, p. 368 export subsidies, p. 371 factor endowments, p. 370 General Agreement on Tariffs and Trade (GATT), p. 374 Heckscher-Ohlin theorem, p. 370 infant industry, p. 380 North American Free Trade Agreement (NAFTA), p. 375 protection, p. 371 quota, p. 373 Smoot-Hawley tariff, p. 373 soft trade barriers, p. 371 tariff, p. 371 terms of trade, p. 367 theory of comparative advantage, p. 363 trade def
icit, p. 362 trade surplus, p. 362 U.S.-Canada Free Trade Agreement, p. 375 World Trade Organization (WTO), p. 374 P R O B L E M S All problems are available on MyLab Economics. 18.1 TRADE SURPLUSES AND DEFICITS LEARNING OBJECTIVE: How are trade surpluses and trade deficits defined? 1.1 India’s top five trading partners are China, United States, Saudi Arabia, United Arab Emirates (UAE), and the Republic of Korea. Go to www.infodriveindia.com and look up “India’s Trading Partners.” Find the total value of exports, imports, and the balance of trade with each of these countries for the most recent year. For which of these countries is India running a trade surplus? Trade deficit? Do an Internet search and find some of the main goods and services India imports from and exports to these five countries. Comment on your findings. 18.2 THE ECONOMIC BASIS FOR TRADE: COMPARATIVE ADVANTAGE LEARNING OBJECTIVE: Explain how international trade emerges from the theory of comparative advantage and what determines the terms of trade. 2.1 Suppose Latvia and Estonia each produce only two goods, tractors and bobsleds. Both are produced using labor alone. Assuming both countries are at full employment, you are given the following information: MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M18_CASE3826_13_GE_C18.indd 382 17/04/19 4:24 AM CHAPTER 18 International Trade, Comparative Advantage, and Protectionism 383 Latvia: Estonia: 12 units of labor required to produce 1 tractor 4 units of labor required to produce 1 bobsled Total labor force: 900,000 units 16 units of labor required to produce 1 tractor 8 units of labor required to produce 1 bobsled Total labor force: 600,000 units a. Draw the production possibility frontiers for each country in the absence of trade. b. If transportation costs are ignored and trade is allowed, will Latvia and Estonia engage in trade? Explain. c. If a trade agreement is negotiated, at what rate (number of tractors per bobsled) would they agree to exchange? 2.2 India and Pakistan each produce only wheat and rice. Domestic prices are given in the following table: Wheat Rice India 400 INR/kg 700 INR/kg Pakistan 600 PKR/kg 900 PKR/kg If 1 Indian Rupee (INR) = 1 Pakistani Rupee (PKR), a. Which country has an absolute advantage in the produc- tion of wheat? Rice? b. Which country has a comparative advantage in the pro- duction of wheat? Rice? c. If India and Pakistan were the only two countries in trade, what adjustments would you predict assuming exchange rates are freely determined by the laws of supply and demand? 2.3 The following table gives recent figures for yield per hectare (in kg/ha) in India and China: India China Wheat 1,000 4,000 Paddy 3,500 6,600 a. If we assume that farmers in India and China use the same amount of labor, capital and fertilizer, which state has an absolute advantage in the wheat production? Paddy? b. lf we transfer land out of wheat into paddy, how many kilograms of wheat do we give up in India per additional kilogram of paddy produced? In China? c. Which country has a comparative advantage in wheat production? In paddy production? d. Which country would divert more of its land to the pro- a. If the price ratios within each country reflect resource use, which country has a comparative advantage in the production of cheddar cheese? blue cheese? b. Assume that there are no other trading partners and that the only motive for holding foreign currency is to buy foreign goods. Will the current exchange rate lead to trade flows in both directions between the two countries? Explain. c. What adjustments might you expect in the exchange rate? Be specific. d. What would you predict about trade flows between Great Britain and the United States after the exchange rate has adjusted? 2.5 The nation of Pixley has an absolute advantage in everything it produces compared to the nation of Hooterville. Could these two nations still benefit by trading with each other? Explain. 2.6 Evaluate the following statement: If lower exchange rates increase a nation’s exports, the government should do everything in its power to ensure that the exchange rate for its currency is as low as possible. 18.3 THE SOURCES OF COMPARATIVE ADVANTAGE LEARNING OBJECTIVE: Describe the sources of comparative advantage. 3.1 The following table shows imports and exports of goods during the 2014–2015 period for India: Electrical machinery and equipment Petroleum products Drugs & pharmaceuticals Textile yarn/made up articles All values are in Rupee crores. Source: http://commerce.gov.in Exports Imports 6,200 20,276 18,074.41 8,824.50 2,605 47,876.78 2,921.99 990 What, if anything, can you conclude about India’s comparative advantage? What stories can you tell about the wide disparities in textiles and electrical machinery? duction of wheat? Why? 3.2 You can think of the United States as a set of 50 separate 2.4 Great Britain and the United States produce cheddar cheese and blue cheese. Current domestic prices per pound for each type of cheese are given in the following table: Great Britain United States Cheddar cheese Blue cheese £3 £6 $6 $9 Suppose the exchange rate is £1 = $1. economies with no trade barriers. In such an open environment, each state specializes in the products that it produces best. a. What product or products does your state specialize in? b. Can you identify the source of the comparative advantage that lies behind the production of one or more of these products (for example, a natural resource, plentiful cheap labor, or a skilled labor force)? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M18_CASE3826_13_GE_C18.indd 383 17/04/19 4:24 AM 384 PART V The World Economy c. Do you think that the theory of comparative advantage and the Heckscher-Ohlin theorem help to explain why your state specializes the way that it does? Explain your answer. 3.3 Some empirical trade economists have noted that many countries are both importers and exporters of the same products. For example, India both imports and exports sports goods. How do you explain this? 18.4 TRADE BARRIERS: TARIFFS, EXPORT SUBSIDIES, AND QUOTAS LEARNING OBJECTIVE: Analyze the economic effects of trade barriers. 4.1 [Related to the Economics in Practice on p. 372] As is stated in the text, NAFTA was ratified by the U.S. Congress in 1993 and went into effect on January 1, 1994, and aside from a few tariffs, all of NAFTA’s commitments were fully implemented by 2003. Go to http://www.usa. gov and do a search for “NAFTA: A Decade of Success” to find a document from the Office of the United States Trade Representative which details the benefits of this free-trade agreement between the United States, Canada, and Mexico. Describe what happened to the following in the NAFTA countries by 2003, when NAFTA’s commitments were fully implemented: economic growth, exports, total trade volume, and productivity. Now conduct a Web search to find any disadvantages of NAFTA and see how they relate to the arguments for protectionism in the text. Explain whether you believe any of these disadvantages outweigh the benefits you described regarding economic growth, exports, trade volume, and productivity. 4.2 The following graph represents the domestic supply and demand for coal. a. In the absence of trade, what is the equilibrium price and equilibrium quantity? b. The government opens the market to free trade, and Indonesia enters the market, pricing coal at $40 per ton. What will happen to the domestic price of coal? What will be the new domestic quantity supplied and domestic quantity demanded? How much coal will be imported from Indonesia? c. After numerous complaints from domestic coal producers, the government imposes a $10 per ton tariff on all imported coal. What will happen to the domestic price of coal? What will be the new domestic quantity supplied and domestic quantity demanded? How much coal will now be imported from Indonesia? d. How much revenue will the government receive from the $10 per ton tariff? e. Who ultimately ends up paying the $10 per ton tariff? Why100 55 50 40 0 S 75 150 180 240 340 Millions of tons D 450 4.3 Refer to the previous problem. Assume the market is opened to trade and Indonesia still enters the market by pricing coal at $40 per ton. But as a response to complaints from domestic coal producers, instead of imposing a $10 per ton tariff, the government imposes an import quota of 90 million tons on Indonesian coal. How will the results of the quota differ from the results of the tariff? 4.4 [Related to the Economics in Practice on p. 373] In 2015, the United States and Cuba re-established diplomatic relations, reopening embassies in each other’s capitals for the first time since 1961. Since the early 1960s, the United States has had an embargo in place on Cuba, virtually eliminating all trade between the two countries. With diplomatic relations restored, the Cuban government is seeking an end to this embargo and is urging the U.S. government to resume trade between the two countries. Suppose the United States decided to lift the embargo on exports to Cuba while maintaining the embargo on Cuban imports. Explain whether this one-sided change would benefit neither country, just one country, or both countries? 18.5 FREE TRADE OR PROTECTION? LEARNING OBJECTIVE: Evaluate the arguments over free trade and protectionism. 5.1 [Related to the Economics in Practice on p. 379] The China–Australia Free Trade Agreement (ChAFTA) is a bilateral Free Trade Agreement (FTA) between the Governments of Australia and China. It is strongly opposed by Australian trade unions and industrial groups. What are the possible pros and cons of this agreement on the Australian economy QUESTION 1 The Theory of Comparative A
dvantage and the Heckscher-Ohlin Theorem both treat the factors of production as being immobile between economies. Why is this a crucial assumption in explaining international trade patterns? QUESTION 2 Reducing imports through protectionist policies leads the prices of imported goods paid by domestic consumers to rise. Economists have tried to quantify these price increases and compare them to the salary of jobs in that sector. Why would economists be interested in this comparison? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M18_CASE3826_13_GE_C18.indd 384 17/04/19 4:24 AM Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates The growth of international trade has made the economies of the world increasingly interdependent. U.S. imports now account for about 15 percent of U.S. gross domestic product (GDP) and billions of dollars flow through the international capital market each day. In the previous chapter we explored the gains that come to countries from trade, as they exploit comparative advantage and gain access to new goods. The ubiquity of this trade also means that economic problems in one part of the world can often be felt by their trading partners elsewhere. In this chapter we explore the ways in which the openness of the economy affects macroeconomic policy making. From a macroeconomic point of view, the main difference between an international transaction and a domestic transaction concerns currency exchange. When people in countries with different currencies buy from and sell to each other, an exchange of currencies must also take place. 19 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 19.1 The Balance of Payments p. 386 Explain how the balance of payments is calculated. 19.2 Equilibrium Output (Income) in an Open Economy p. 389 Discuss how equilibrium output is determined in an open economy, and describe the trade feedback effect and the price feedback effect. 19.3 The Open Economy with Flexible Exchange Rates p. 393 Discuss factors that affect exchange rates in an open economy with a floating system. An Interdependent World Economy p. 402 Appendix: World Monetary Systems since 1900 p. 405 Explain what the Bretton Woods system is. 385 M19_CASE3826_13_GE_C19.indd 385 17/04/19 4:26 AM 386 PART V The World Economy exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. 19.1 LEARNING OBJECTIVE Explain how the balance of payments is calculated. foreign exchange All currencies other than the domestic currency of a given country. balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange. Brazilian coffee exporters cannot spend U.S. dollars in Brazil; they need Brazilian reals. A U.S. wheat exporter cannot use Brazilian reals to buy a tractor from a U.S. company or to pay the rent on warehouse facilities. Somehow international exchange must be managed in a way that allows both partners in the transaction to wind up with their own currency. The amount of trade between two countries depends on the exchange rate—the price of one country’s currency in terms of the other country’s currency. If the Japanese yen were expensive (making the dollar cheap), both Japanese and Americans would buy from U.S. producers. If the yen were cheap (making the U.S. dollar expensive), both Japanese and Americans would buy from Japanese producers. As we saw in the last chapter, within a certain range of exchange rates, trade flows in both directions. Each country specializes in producing the goods in which it enjoys a comparative advantage, and trade is mutually beneficial. We begin our discussion of open-economy macroeconomics by looking at the balance of payments—the record of a nation’s transactions with the rest of the world. We then go on to consider how our model of the macroeconomy changes when we allow for the international exchange of goods, services, and capital. Finally, we explore the determination of the rate of exchange of one currency for another and how the exchange rate system affects the economy, including fiscal and monetary policy. The Balance of Payments All foreign currencies—euros, Swiss francs, Japanese yen, Brazilian reals, and so forth—can be grouped together as “foreign exchange.” Foreign exchange is simply all currencies other than the domestic currency of a given country (in the case of the United States, the U.S. dollar). U.S. demand for foreign exchange arises because its citizens want to buy things whose prices are quoted in other currencies, such as Australian jewelry, vacations in Mexico, and bonds or stocks issued by Sony Corporation of Japan. Whenever U.S. citizens make these purchases, foreign currencies must first be purchased. Typically this happens indirectly without most customers thinking about it at all. Where does the supply of foreign exchange come from? The answer is simple: The United States (actually U.S. citizens or firms) earns foreign exchange when it sells products, services, or assets to another country. Some of these foreign exchange transactions are transparent to the consumer. When Mexican tourists visit Disney World, they go to an ATM, which takes pesos from their banks in Mexico and converts them to dollars dispensed in Florida. Other transactions are less transparent. Saudi Arabian purchases of stock in General Motors and Colombian purchases of real estate in Miami also increase the U.S. supply of foreign exchange although the currency exchange is often done by a middleman. The record of a country’s transactions in goods, services, and assets with the rest of the world is its balance of payments. The balance of payments is also the record of a country’s sources (supply) and uses (demand) of foreign exchange.1 The Current Account MyLab Economics Concept Check The balance of payments is divided into two major accounts, the current account and the financial account. These are shown in Table 19.1, which provides data on the U.S. balance of payments for 2017. We begin with the current account. The first two items in the current account are exports and imports of goods. Among the biggest exports of the United States are commercial aircraft, chemicals, and agricultural products. U.S. exports earn foreign exchange for the United States and are a credit item on the current account. U.S. imports use up foreign exchange and are a debit item. In 2017 the United States exported $1,550.7 billion in goods and imported $2,361.9 billion, thus using up more foreign exchange than it earned regarding trade in goods. Next in the current account is trade in services. Like most other countries, the United States buys services from and sells services to other countries. For example, a U.S. firm shipping wheat 1Bear in mind the distinction between the balance of payments and a balance sheet. A balance sheet for a firm or a country measures that entity’s stock of assets and liabilities at a moment in time. The balance of payments, by contrast, measures flows, usually over a period of a month, a quarter, or a year. Despite its name, the balance of payments is not a balance sheet. M19_CASE3826_13_GE_C19.indd 386 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 387 balance of trade A country’s exports of goods and services minus its imports of goods and services. trade deficit The situation when a country imports more than it exports. balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. to England might purchase insurance from a British insurance company. A Dutch flower grower may fly flowers to the United States aboard a U.S. airliner. In the first case, the United States is importing services and therefore using up foreign exchange; in the second case, it is selling services to foreigners and earning foreign exchange. In 2017 the United States exported $780.9 billion in services and imported $538.1 billion, thus earning more foreign exchange than it used up regarding trade in services. The difference between a country’s exports of goods and services and its imports of goods and services is its balance of trade. When exports of goods and services are less than imports of goods and services, a country has a trade deficit. Table 19.1 shows that the U.S. trade deficit in 2017 was fairly large at $568.4 billion. Next in Table 19.1 comes investment income. U.S. citizens hold foreign assets (stocks, bonds, and real assets such as buildings and factories). Dividends, interest, rent, and profits paid to U.S. asset holders are a source of foreign exchange. Conversely, when foreigners earn dividends, interest, and profits on assets held in the United States, foreign exchange is used up. In 2017 the United States earned $926.9 in investment income and paid out $709.9 billion. Last in the current account are transfer payments. Transfer payments from the United States to foreigners are another use of foreign exchange. Some of these transfer payments are from private U.S. citizens, and some are from the U.S. government. You may send a check to a relief agency in Africa. Many immigrants in the United States send remittances to their countries of origin to help support extended families. Conversely, foreigners make transfer payments to the United States, which earns income for the United States. In 2017 the United States received $149.7 billion in transfer payments from abroad and sent $264.5 billion abroad. Line (10) in Table 19.1 shows the balance on current account. This is the balance of trade plus investment and transfer income and minus investment and transfer pa
yments. Put another way, the balance on current account is the sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. The balance on current account shows how much a nation has spent on foreign goods, services, investment income payments, and transfers relative to how much it has earned from other countries. When the balance is negative, which it was for the United States in 2017, a nation has spent more on foreign goods and services (plus investment income and transfers paid) than it has earned through the sales of its goods and services to the rest of the world (plus investment income and transfers received). TABLE 19.1 U.S. Balance of Payments, 2017 Current Account Billions of dollars (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Goods exports Goods imports Exports of services Imports of services Balance of trade: (1) - (2) + (3) - (4) Investment income Investment payments Transfer income Transfer payments Balance on current account: (5) + (6) - (7) + (8) - (9) Financial account (11) Net capital transfer receipts Change in net U.S. liabilities (12) (13) Net receipts from financial derivatives (14) (15) Statistical discrepancy Balance of payments: (10) + (11) + (12) + (13) + (14) $1,550.7 2361.9 780.9 538.1 -568.4 926.9 709.0 149.7 264.5 -466.2 24.8 375.5 -26.4 92.2 0.0 Item (13) is the change in foreign assets in the United States minus the change in U.S. assets abroad. In 2017 this number was positive, which means that there was an increase in net U.S. liabilities. Source: Bureau of Economic Analysis, March 21, 2018. M19_CASE3826_13_GE_C19.indd 387 17/04/19 4:26 AM 388 PART V The World Economy The Financial Account MyLab Economics Concept Check For each transaction recorded in the current account, there is an offsetting transaction recorded in the financial account. Consider, for example, the $466.2 billion current account deficit that the United States ran in 2017. This deficit must be paid for, and how it is paid shows up in the financial account. The first two lines under the financial account in Table 19.1 are receipts recorded in the financial account: net capital transfer receipts and net receipts from financial derivatives. These are small. The first is positive, which says that the net flow to the United States was positive. The second is negative, which was a net flow out of the United States. The third line, line (13), shows that net U.S. liabilities (to the rest of the world) increased by $375.5 billion. So the United States borrowed from the rest of the world (on net) $375.5 billion to partly finance the $466.2 billion deficit. If there were no measurement errors, the entire deficit would be financed by lines (11), (12), and (13): net capital receipts and net borrowing. There are, however, measurement errors, where the total error is called the statistical discrepancy. In 2017 the statistical discrepancy was $92.2 billion. This is, of course, a large error. But the main point to take away from this analysis is that aside from measurement errors, a current account deficit must be financed by changes in a country’s net capital receipts and its net liabilities to the rest of the world. The balance of payments—line (15) in Table 19.1—is always zero. An example may help in seeing the link between the current and financial accounts. Say a U.S. citizen buys a beer in a store on Caye Caulker, Belize, for $1.75 using U.S. currency, which is accepted in Belize along with the local currency. This is an import of the United States, so the U.S. currentaccount deficit has increased by $1.75. What happens on the financial account? The Belize store owner now has the $1.75, which is an asset for her (i.e., for Belize) and a liability for the United States. Net U.S. liabilities to the rest of the world have thus increased by $1.75—line (13) in Table 19.1. There are many international financial transactions that do not lead to a change in net U.S. liabilities in the financial account. If the Chinese central bank buys a U.S. government bond with yuan, its U.S. assets have increased (the bond), but so has its foreign liabilities (the yuan). In the United States there is an increase in foreign liabilities (the bond), but also an increase in foreign assets (the yuan). The net position of each country has not changed. The only way the net position of a country can change is through a positive or negative value of its current account. If in the Belize example the U.S. citizen had simply exchanged $1.75 U.S. for $3.50 Belize (the exchange rate between the Belize dollar and the U.S. dollar is two to one), with no beer purchased, this would not have led to a change in net U.S. liabilities. This is just a swap of assets with no change in the current account. The balance of payments pertains to flows. In Table 19.1 these are flows for the year 2017. Regarding stocks, we know that stocks and flows are related. For example, the net wealth of a country vis-à-vis the rest of the world at the end of a given year is equal to its net wealth at the end of the previous year plus its current-account balance during the year. In 2017 the net wealth of the United States vis-à-vis the rest of the world decreased by $466.2 billion—its current account deficit for 2017. It is important to realize that the only way a country’s net wealth position can change is if its current account balance is nonzero. Simply switching one form of asset for another does not change a country’s net wealth position. A country’s net wealth position is simply the sum of all its past current account balances. Prior to the mid-1970s, the United States had generally run current account surpluses, and thus its net wealth position was positive. It was a creditor nation. This began to turn around in the mid-1970s, and by the mid-1980s, the United States was running large current account deficits. Sometime during this period, the United States changed from having a positive net wealth position vis-à-vis the rest of the world to having a negative position. In other words, the United States changed from a creditor nation to a debtor nation. The current account deficits have persisted, and the United States is now the largest debtor nation in the world. At the end of 2017 foreign assets in the United States totaled $35.5 trillion and U.S. assets abroad totaled $27.6 trillion.2 The U.S. net wealth position was thus -$7.9 trillion. This large negative position reflects the fact that the United States has spent much more since the 1970s on foreign goods and services (plus investment income and transfers paid) than it earned through the sales of its goods and services to the rest of the world (plus investment income and transfers received). 2Bureau of Economic Analysis, March 31, 2015. M19_CASE3826_13_GE_C19.indd 388 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 389 Debtor and Creditor Nations Since their independence, developing nations have been net recipients of foreign debt from developed nations to finance their development plans. Many of the poorest countries of the world are overwhelmed with debt burdens that they find difficult to manage. This has urged the International Monetary Fund (IMF) and the World Bank to start the Heavily Indebted Poor Countries (HIPC) Initiative in 1996. To help with economic and human development, the HIPC Initiative has extended $99 billion in the form of debt relief and lowinterest loans to 37 very poor nations. However, since the beginning of the twenty-first century, several industrial nations have become debtor nations instead of their previous role as suppliers of capital to developing nations. In response to a slowdown in the growth prospects of industrial nations, middle-income and emerging market economies have been acting as their net creditors, especially during the global financial crisis of 2008–2009. The United Nations reports that external debt levels of high-income countries are on average 2 to 3 times higher than in low and middle-income developing nations. As such, the net financial flows to developing countries turned negative between 2015 and 2017. Since 2006, with this change in global capital flows, the IMF started building a database of the balance of payments figures of countries round the world. Among these are the Net International Investment Position (NIIP), which is defined as the difference between foreign assets that domestic residents own and liabilities. When external assets exceed liabilities, the NIIP is positive and when liabilities exceed assets it is negative. The United States is the largest debtor nation in the world, with a negative NIIP of €7,710.5 billion. For the same period, Japan recorded a positive NIIP of €2,829.1 billion. The European Union (EU-28) reported a negative NIIP of nearly €500 billion in 2017, which equals almost 5 percent of GDP. Germany and the Netherlands are the major net creditor economies in Europe, while Spain, Ireland, and France held higher positions in financial liabilities abroad than financial assets, making them net borrowers or debtors.1 Thus, the risks of debt sustainability have grown for a few developed countries as well as for some developing and emerging economies. The NIIP position is an important parameter to gauge a country’s financial condition and creditworthiness. But instead of looking at absolute values, the NIIP’s size has to be examined in relation to the economy’s size (the ratio of NIIP to GDP). CRITICAL THINKING 1. Visit the IMF database at www.data.imf.org. Examine the NIIP position of your country in relation to its GDP. Is your country a net debtor or creditor? 1European Central Bank (2018), “Euro Area Quarterly Balance of Payments and International Investment Position,” January 11. Equilibrium Output (Income) in an Open Economy Everything we have said so far has been descri
ptive. Now we turn to analysis. How are all these trade and capital flows determined? What impacts do they have on the economies of the countries involved? To simplify our discussion, we will assume that exchange rates are fixed. We will relax this assumption later. 19.2 LEARNING OBJECTIVE Discuss how equilibrium output is determined in an open economy, and describe the trade feedback effect and the price feedback effect. The International Sector and Planned Aggregate Expenditure MyLab Economics Concept Check The first change we will have to make to take into account the openness of the economy is in the calculation of the multiplier, one of the backbones of economic policy analysis. Our earlier calculations of the multiplier defined aggregate expenditure (AE) as consisting of the consumption of households (C), the planned investment of firms (I), and the spending of the government (G). With an open economy, we must now include in aggregate expenditures the goods and services a country exports to the rest of the world, EX, and we will also have to make an adjustment M19_CASE3826_13_GE_C19.indd 389 17/04/19 4:26 AM 390 PART V The World Economy for what it imports, IM. Clearly EX should be included as part of total output and income. A U.S. razor sold to a buyer in Mexico is as much a part of U.S. production as a similar razor sold in Pittsburgh. Exports simply represent demand for domestic products not by domestic households and firms and the government, but by the rest of the world. What about imports? Imports are not a part of domestic output (Y) because they are produced outside the home country. When we calculate households’ total consumption spending, firms’ total investment spending, and total government spending, imports are included. Therefore, to calculate domestic output correctly, we must subtract the parts of consumption, investment, and government spending that constitute imports. The definition of planned aggregate expenditure becomes: Planned aggregate expenditure in an open economy: AE K C + I + G + EX - IM net exports of goods and services (EX - IM) The difference between a country’s total exports and total imports. The last two terms (EX - IM) together are the country’s net exports of goods and services. Determining the Level of Imports What determines the level of imports and exports in a country? Clearly the level of imports is a function of income (Y). When U.S. income increases, U.S. citizens buy more of everything, including Japanese cars and Korean smartphones. When income rises, imports tend to go up. Algebraically, IM = mY marginal propensity to import (MPM) The change in imports caused by a $1 change in income. where Y is income and m is some positive number. (m is assumed to be less than one; otherwise, a $1 increase in income generates an increase in imports of more than $1, which is unrealistic.) Recall from Chapter 8 that the marginal propensity to consume (MPC) measures the change in consumption that results from a $1 change in income. Similarly, the marginal propensity to import, abbreviated as MPM or m, is the change in imports caused by a $1 change in income. If m = 0 .2 , or 20 percent, and income is $1,000, then imports, IM, are equal to 0.2 * +1,000 = +200. If income rises by $100 to $1,100, the change in imports will equal m * = 0.2 * +100 = +20. the change in income For now we will assume that exports (EX) are given (that is, they are not affected, even indi- rectly, by the state of the domestic economy.) This assumption is relaxed later in this chapter. 1 2 Solving for Equilibrium Given the assumption about how imports are determined, we can solve for equilibrium income. This procedure is illustrated in Figure 19.1. Starting from the consumption function (blue line) in Figure 19.1(a), we gradually build up the components of planned aggregate expenditure (red line). Assuming for simplicity that planned investment, government purchases, and exports are all constant and do not depend on income, we move easily from the blue line to the red line by adding the fixed amounts of I, G, and EX to consumption at every level of income. In this example, we take I + G + EX to equal 80. C + I + G + EX, however, includes spending on imports, which are not part of domestic production. To get spending on domestically produced goods, we must subtract the amount that is imported at each level of income. In Figure 19.1(b), we assume m = 0.25, so that 25 percent of total income is spent on goods and services produced in foreign countries. For example, at Y = 200, IM = 0.25 Y, or 50. Similarly, at Y = 400, IM = 0.25 Y, or 100. Figure 19.1(b) shows the planned domestic aggregate expenditure curve that nets out imports from expenditures. Equilibrium is reached when planned domestic aggregate expenditure equals domestic aggregate output (income). This is true at only one level of aggregate output, Y* = 200, in Figure 19.1(b). If Y were below Y, planned expenditure would exceed output, inventories would be lower than planned, and output would rise. At levels above Y, output would exceed planned expenditure, inventories would be larger than planned, and output would fall. The Open-Economy Multiplier All of this has implications for the size of the multiplier. Recall the multiplier, introduced in Chapter 8, and consider a sustained rise in government purchases (G). Initially, the increase in G will cause planned aggregate expenditure to be greater than aggregate output. Domestic firms will find their inventories to be lower than planned and thus will increase M19_CASE3826_13_GE_C19.indd 390 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 391 ) $ ( 400 350 300 250 200 150 100 50 Planned aggregate expenditure ; C 1 I 1 G 1 EX I + G + EX = 80 a. 458 Consumption function ) $ ( 350 300 250 200 150 100 50 b. 458 Planned aggregate expenditure ; C 1 I 1 G 1 EX IM 5 .25Y 5 100 IM 5 .25Y 5 50 Planned domestic aggregate expenditure ; C 1 I 1 G 1 EX 2 IM 0 100 200 300 400 500 600 0 100 200 300 400 500 600 Aggregate output (income) (Y) MyLab Economics Concept Check Aggregate output (income) (Y) Y* ▴ FIGURE 19.1 Determining Equilibrium Output in an Open Economy In a., planned investment spending (I), government spending (G), and total exports (EX) are added to consumption (C) to arrive at planned aggregate expenditure. However, C + I + G + EX includes spending on imports. In b., the amount imported at every level of income is subtracted from planned aggregate expenditure. Equilibrium output occurs at Y* = 200, the point at which planned domestic aggregate expenditure crosses the 45-degree line. their output, but added output means more income. More workers are hired, and profits are higher. Some of the added income is saved, and some is spent. The added consumption spending leads to a second round of inventories being lower than planned and raising output. Equilibrium output rises by a multiple of the initial increase in government purchases. This is the multiplier effect. In Chapters 8 and 9, we showed that the simple multiplier equals 1 MPS). That is, a sustained increase in government purchases equal to ΔG will lead to an increase in >1 aggregate output (income) of ΔG . If the MPC were 0.75 and government purchases rose by $10 billion, equilibrium income would rise by 4 * $10 billion, or $40 billion. The 24 multiplier is 1 - MPC 1 - MPC 3 >1 025 , or (1 1 1 1 2 > 1 - 0.75 = 4.0. = > 3 3 4 24 >1 In an open economy, some of the increase in income brought about by the increase in G is spent on imports instead of domestically produced goods and services. The part of income spent on imports does not increase domestic income (Y) because imports are produced by foreigners. To compute the multiplier, we need to know how much of the increased income is used to increase domestic consumption. (We are assuming all imports are consumption goods. In practice, some imports are investment goods and some are goods purchased by the government.) In other words, we need to know the marginal propensity to consume domestically produced goods. Domestic consumption is C - IM. So the marginal propensity to consume domestic goods is the marginal propensity to consume all goods (the MPC) minus the marginal propensity to import (the MPM). The marginal propensity to consume domestic goods is . Consequently, MPC - MPM 1 open@economy multipler = 1 2 1 - MPC - MPM 2 1 If the MPC is 0.75 and the MPM is 0.25, then the multiplier is 1/0.5, or 2.0. This multiplier is smaller than the multiplier in which imports are not taken into account, which is 1/0.25, or 4.0. The effect of a sustained increase in government spending (or investment) on income— that is, the multiplier—is smaller in an open economy than in a closed economy. The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services. In an open economy the impact of government spending on the domestic economy is less than it otherwise would be. At the same time, one country’s government spending increases affects other countries. Fiscal policy in one country can affect the macroeconomy is its trading partners. We see from this that taking imports into account reduces the multiplier. This effect is especially large in the case of small, open economies like the Caribbean nations in which much of what is consumed is imported. As we will see, in these countries, the government has very little independent control over fiscal policy. M19_CASE3826_13_GE_C19.indd 391 17/04/19 4:26 AM 392 PART V The World Economy Imports, Exports, and the Trade Feedback Effect MyLab Economics Concept Check For simplicity, we have so far assumed that the level of imports depends only on income and that the level of exports is fixed. In reality, the amount of spending on imports also depends on factors other
than income and exports are not fixed. We will now consider the more realistic picture. The Determinants of Imports The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports because some imported goods are consumption goods and some are investment goods. For example, anything that increases consumption spending is likely to increase the demand for imports. We saw in Chapters 8 and 9 that factors such as the after-tax real wage, after-tax nonlabor income, and interest rates affect consumption spending; thus, they should also affect spending on imports. Similarly, anything that increases investment spending is likely to increase the demand for imports. A decrease in interest rates, for example, should encourage spending on both domestically produced goods and foreign-produced goods. There is one additional consideration in determining spending on imports: the relative prices of domestically produced and foreign-produced goods. If the prices of foreign goods fall relative to the prices of domestic goods, people will consume more foreign goods relative to domestic goods. When Japanese cars are inexpensive relative to U.S. cars, consumption of Japanese cars should be high and vice versa. The Determinants of Exports We now relax our assumption that exports are fixed. The foreign demand for U.S. exports is identical to the foreign countries’ imports from the United States. Germany imports goods, some of which are U.S.-produced. Total expenditure on imports in Germany is a function of the factors we just discussed except that the variables are German variables instead of U.S. variables. This is true for all other countries as well. The demand for U.S. exports thus depends on economic activity in the rest of the world—rest-of-the-world real wages, wealth, nonlabor income, interest rates, and so forth—as well as on the prices of U.S. goods relative to the prices of rest-of-the-world goods. When foreign output increases, U.S. exports tend to increase. In this way economic growth in the rest of the world stimulates the economy in the United States. U.S. exports also tend to increase when U.S. prices fall relative to foreign goods prices. With an open economy, countries are interdependent. U.S. exports also tend to increase when U.S. prices fall relative to foreign prices. The Trade Feedback Effect We can now combine what we know about the demand for imports and the demand for exports to discuss the trade feedback effect. Suppose the United States finds its exports increasing, perhaps because the world suddenly decides it prefers U.S. computers to other computers. Rising exports will lead to an increase in U.S. output (income), which leads to an increase in U.S. imports. Here is where the trade feedback begins. U.S. imports are somebody else’s exports. The extra import demand from the United States raises the exports of the rest of the world. When other countries’ exports to the United States go up, their output and incomes also rise, in turn leading to an increase in the demand for imports from the rest of the world. Some of the extra imports demanded by the rest of the world come from the United States, so U.S. exports increase. The increase in U.S. exports stimulates U.S. economic activity even more, triggering a further increase in the U.S. demand for imports and so on. An increase in U.S. imports increases other countries’ exports, which stimulates those countries’ economies and increases their imports, which increases U.S. exports, and so on. This is the trade feedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States. Import and Export Prices and the Price Feedback Effect MyLab Economics Concept Check We have talked about the price of imports, but we have not yet discussed the factors that influence import prices. The consideration of import prices is complicated because more than one currency is involved. When we talk about “the price of imports,” do we mean the trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country. M19_CASE3826_13_GE_C19.indd 392 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 393 price in dollars, in yen, or in euros? The same question holds for the price of exports because the exports of one country are the imports of another. When Mexico exports auto parts to the United States, Mexican manufacturers are interested in the price of auto parts in terms of pesos because pesos are what they use for transactions in Mexico. U.S. consumers are interested in the price of auto parts in dollars because dollars are what they use for transactions in the United States. The link between the two prices is the dollar/peso exchange rate. Suppose Mexico is experiencing inflation and the price of radiators in pesos rises from 1,000 pesos to 1,200 pesos per radiator. If the dollar/peso exchange rate remains unchanged at, say, $0.10 per peso, Mexico’s export price for radiators in terms of dollars will also rise from $100 to $120 per radiator. Because Mexico’s exports to the United States are, by definition, U.S. imports from Mexico, an increase in the dollar prices of Mexican exports to the United States means an increase in the prices of U.S. imports from Mexico. Therefore, when Mexico’s export prices rise with no change in the dollar/peso exchange rate, U.S. import prices rise. Export prices of other countries affect U.S. import prices. A country’s export prices tend to move fairly closely with the general price level in that country. If Mexico is experiencing a general increase in prices, this change likely will be reflected in price increases of all domestically produced goods, both exportable and nonexportable. The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise. The Price Feedback Effect We have just seen that when a country experiences an increase in domestic prices, the prices of its exports will increase. It is also true that when the prices of a country’s imports increase, the prices of domestic goods may increase in response. There are at least two ways this effect can occur. First, an increase in the prices of imported inputs will increase the costs of firms which use these imports as inputs, causing a country’s aggregate supply curve to shift to the left. Recall from Chapter 12 that a leftward shift in the aggregate supply curve resulting from a cost increase causes aggregate output to fall and prices to rise (stagflation). Second, if import prices rise relative to domestic prices, households will tend to substitute domestically produced goods and services for imports. This is equivalent to a rightward shift of the aggregate demand curve. If the domestic economy is operating on the upward-sloping part of the aggregate supply curve, the overall domestic price level will rise in response to an increase in aggregate demand. Perfectly competitive firms will see market-determined prices rise, and imperfectly competitive firms will experience an increase in the demand for their products. Studies have shown, for example, that the price of automobiles produced in the United States moves closely with the price of imported cars. Still, this is not the end of the story. Suppose a country—say, Mexico—experiences an increase in its domestic price level. This will increase the price of its exports to Canada (and to all other countries). The increase in the price of Canadian imports from Mexico will lead to an increase in domestic prices in Canada. Canada also exports to Mexico. The increase in Canadian prices causes an increase in the price of Canadian exports to Mexico, which then further increases the Mexican price level. This is called the price feedback effect, in the sense that inflation is “exportable.” An increase in the price level in one country can drive up prices in other countries, which in turn further increases the price level in the first country. Through export and import prices, a domestic price increase can “feed back” on itself. It is important to realize that the discussion so far has been based on the assumption of fixed exchange rates. Life is more complicated under flexible exchange rates, to which we now turn. price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country. The Open Economy with Flexible Exchange Rates Exchange rates are a factor in determining the flow of international trade and the structure of those exchange rates thus matters. In practice, the structure of exchange rates has changed considerably over time, influenced in part by international agreements and events. 19.3 LEARNING OBJECTIVE Discuss factors that affect exchange rates in an open economy with a floating system. M19_CASE3826_13_GE_C19.indd 393 17/04/19 4:26 AM 394 PART V The World Economy floating, or marketdetermined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. In the early part of the twentieth century, nearly all currencies were backed by gold. Their values were fixed in terms of a specific number of ounces of gold, which determined their values in international trading—exchange rates. In 1944, with the international monetary system in chaos as the end of World War II drew near, a large group of experts unofficially representing 44 countries met in Bretton Woods, New Hampshire, and drew up a number of agreements. One of those agreements established a system of ess
entially fixed exchange rates under which each country agreed to intervene by buying and selling currencies in the foreign exchange market when necessary to maintain the agreed-to value of its currency. In 1971, most countries, including the United States, began to allow exchange rates to be flexible, determined essentially by supply and demand. Flexible exchange rates are known as floating or market determined exchange rates. Although there are considerable intricacies in the way flexible exchange rates operate, the logic is straightforward. If British goods are popular with U.S. consumers, there will be a large demand for British pounds by the U.S. customers for those goods. If the British don’t like U.S. goods, few will demand U.S. dollars to buy those goods. Without government intervention in the marketplace, the price of British pounds in dollars would rise in this situation as those who want to exchange dollars for pounds (those who “demand” pounds) exceed those who want to exchange pounds for dollars (those who “supply” pounds). The exchange rate market thus reflects the markets for real goods in the various economies. Although governments still intervene to ensure that exchange rate movements are “orderly,” exchange rates today are largely determined by the unregulated forces of supply and demand. Understanding how an economy interacts with the rest of the world when exchange rates are not fixed is not as simple as when we assume fixed exchange rates. Exchange rates determine the price of imported goods relative to domestic goods and can have significant effects on the level of imports and exports. Consider a 20 percent drop in the value of the dollar against the British pound. Dollars buy fewer pounds, and pounds buy more dollars. Both British residents, who now get more dollars for pounds, and U.S. residents, who get fewer pounds for dollars, find that U.S. goods and services are more attractive. Exchange rate movements have important impacts on imports, exports, and the movement of capital between countries. The Market for Foreign Exchange MyLab Economics Concept Check What determines exchange rates under a floating rate system? To explore this question, we assume that there are just two countries, the United States and Great Britain. It is easier to understand a world with only two countries, and most of the points we will make can be generalized to a world with many trading partners. The Supply of and Demand for Pounds Governments, private citizens, banks, and corporations exchange pounds for dollars and dollars for pounds every day. In our two-country case, those who demand pounds are holders of dollars seeking to exchange them for pounds to buy British goods, travel to Britain, or invest in British stocks and bonds. Those who supply pounds are holders of pounds seeking to exchange them for dollars to buy U.S. goods, visit or invest in the United States. The supply of dollars on the foreign exchange market is the number of dollars that holders seek to exchange for pounds in a given time period. The demand for and supply of dollars on foreign exchange markets determine exchange rates. In addition to buyers and sellers who exchange money to engage in transactions, some people and institutions hold currency balances for speculative reasons. If you think that the U.S. dollar is going to decline in value relative to the pound, you may want to hold some of your wealth in the form of pounds. Table 19.2 summarizes some of the major categories of private foreign exchange demanders and suppliers in the two-country case of the United States and Great Britain. We can use a variant of supply and demand analysis to help us understand the exchange rate in currency markets. Figure 19.2 shows the demand curve for pounds in the foreign exchange market. On the vertical axis is the price of pounds, expressed in dollars per pound, and on the horizontal axis is the quantity of pounds. Thus, as we move down the vertical axis, the pound depreciates relative to the dollar—it takes fewer dollars to buy a pound. Suppose we start at a point at which it costs $2 to buy one pound and the price of a British good is one pound. To buy that good at the existing exchange rate would cost an American $2. Let us suppose at that exchange rate 100 units of the good are demanded, giving rise to a demand for 100 pounds in the currency market. Now let the pound depreciate, so that it costs only $1 to buy a pound. It seems likely that the British good M19_CASE3826_13_GE_C19.indd 394 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 395 TABLE 19.2 Some Buyers and Sellers in International Exchange Markets: United States and Great Britain The Demand for Pounds (Supply of Dollars) 1. Firms, households, or governments that import British goods into the United States or want to buy British-made goods and services 2. U.S. citizens traveling in Great Britain 3. Holders of dollars who want to buy British stocks, bonds, or other financial instruments 4. U.S. companies that want to invest in Great Britain 5. Speculators who anticipate a decline in the value of the dollar relative to the pound The Supply of Pounds (Demand for Dollars) 1. Firms, households, or governments that import U.S. goods into Great Britain or want to buy U.S.-made goods and services 2. British citizens traveling in the United States 3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States 4. British companies that want to invest in the United States 5. Speculators who anticipate a rise in the value of the dollar relative to the pound will look more attractive to Americans. With a fixed price in pounds for the good in question, Americans can buy that one pound good for only $1 rather than the original $2. Whereas people originally wanted 100 units of the good, with a dollar price much reduced they will likely want more than 100 units. To facilitate that transaction will thus require more than 100 pounds. The demand-for-pounds curve in the foreign exchange market thus has a negative slope. What about the supply of pounds? Pounds are supplied by the British who want to buy U.S. goods. Figure 19.3 shows a supply curve for pounds in the foreign exchange market. As we move up the vertical axis, the dollar becomes cheaper; each pound translates into more dollars, making the price of U.S.-produced goods and services lower to the British. The British buy more U.S.-made goods when the price of pounds is high (the value of the dollar is low). If the demand for U.S. imports is elastic then that increase in British demand for U.S. goods and services increases the quantity of pounds supplied. The curve representing the supply of pounds in the foreign exchange market has a positive slope. The key to understanding the supply and demand curves represented here is to recognize that the price on the vertical axis is the price of one currency relative to a second. As we go down the vertical axis in this case, the pound becomes less expensive relative to the dollar, or equivalently, the dollar becomes more expensive relative to the pound. Moving down the vertical axis to the origin, the low relative price of the pound induces demand for pounds by Americans ◂ FIGURE 19.2 The Demand for Pounds in the Foreign Exchange Market When the price of pounds falls, British-made goods and services appear less expensive to U.S. buyers. If British prices are constant, U.S. buyers will buy more British goods and services and the quantity of pounds demanded will rise Quantity of pounds, £ MyLab Economics Concept Check M19_CASE3826_13_GE_C19.indd 395 17/04/19 4:26 AM 396 PART V The World Economy ▸ FIGURE 19.3 The Supply of Pounds in the Foreign Exchange Market When the price of pounds rises, the British can obtain more dollars for each pound. This means that U.S.-made goods and services appear less expensive to British buyers. Thus, the quantity of pounds supplied is likely to rise with the exchange rate appreciation of a currency The rise in the price of one currency relative to another. depreciation of a currency The fall in the price of one currency relative to another. ▸ FIGURE 19.4 The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined by the forces of supply and demand. An excess demand for pounds will cause the pound to appreciate against the dollar. An excess supply of pounds will lead to a depreciating pound. MyLab Economics Concept Check Quantity of pounds, £ to buy British goods. At the same time, however, British buyers are less interested in the now expensive American goods, and fewer pounds are supplied. The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined the same way other prices are determined: The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied. This is illustrated in Figure 19.4. An excess demand for pounds (quantity demanded in excess of quantity supplied) will cause the price of pounds to rise—the pound will appreciate relative to the dollar. An excess supply of pounds will cause the price of pounds to fall—the pound will depreciate relative to the dollar.3 $1.50 ) £ / $ ( £* MyLab Economics Concept Check Quantity of pounds, £ 3Although Figure 19.3 shows the supply-of-pounds curve in the foreign exchange market with a positive slope, under certain circumstances the curve may bend back. Suppose the price of a pound rises from $1.50 to $2.00. Consider a British importer who buys 10 Chevrolets each month at $15,000 each, including transportation costs. When a pound exchanges for $1.50, he will supply 100,000 pounds per month to the foreign exchange market—100,000 pounds brings $150,000, enough to buy 10 cars. Now suppose the cheaper dollar causes him to buy 12 cars. Twelve cars will cost a total of $180,000; but at $2 = 1 pound, he w
ill spend only 90,000 pounds per month. The supply of pounds on the market falls when the price of pounds rises. The reason for this seeming paradox is simple. The number of pounds a British importer needs to buy U.S. goods depends on both the quantity of goods he buys and the price of those goods in pounds. If demand for imports is inelastic so that the percentage decrease in price resulting from the depreciated currency is greater than the percentage increase in the quantity of imports demanded, importers will spend fewer pounds and the quantity of pounds supplied in the foreign exchange market will fall. The supply of pounds will slope upward as long as the demand for U.S. imports is elastic. M19_CASE3826_13_GE_C19.indd 396 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 397 Factors That Affect Exchange Rates MyLab Economics Concept Check We now know enough to discuss the factors likely to influence exchange rates. Anything that changes the behavior of the people in Table 19.2 can cause demand and supply curves to shift and the exchange rate to adjust accordingly. Purchasing Power Parity: The Law of One Price If the costs of transporting goods between two countries are small, we would expect the price of the same good in both countries to be roughly the same. The price of basketballs should be roughly the same in Canada and the United States, for example. It is not hard to see why. If the price of basketballs is cheaper in Canada, it will benefit someone to buy balls in Canada at a low price and sell them in the United States at a higher price. This decreases the supply of basketballs in Canada and pushes up the price and increases the supply of balls in the United States, and pushes down the price. This process should continue as long as the price differential, and therefore the profit opportunity, persists. For a good with trivial transportation costs, we would expect this law of one price to hold. The price of a good should be the same regardless of where we buy it. Price differences across the two countries create arbitrage opportunities. If the law of one price held for all goods and if each country consumed the same market basket of goods, the exchange rate between the two currencies would be determined simply by the relative price levels in the two countries. If the price of a basketball were $10 in the United States and $12 in Canada, the U.S.–Canada exchange rate would have to be $1 U.S. per $1.20 Canadian. If the exchange rate were instead one-to-one, it would be profitable for people to buy the balls in the United States and sell them in Canada. This would increase the demand for U.S. dollars in Canada, thereby driving up their price in terms of Canadian dollars to $1 U.S. per $1.2 Canadian, at which point no one could make a profit shipping basketballs across international lines and the process would cease.4 The theory that exchange rates will adjust so that the price of similar goods in different countries is the same is known as the purchasing-power-parity theory. According to this theory, if it takes 10 times as many Mexican pesos to buy a pound of salt in Mexico as it takes U.S. dollars to buy a pound of salt in the United States, the equilibrium exchange rate should be 10 pesos per dollar. In practice, transportation costs for many goods are quite large and the law of one price does not hold for these goods. (Haircuts are often cited as a good example. The transportation costs for a U.S. resident to get a British haircut are indeed large unless that person is an airline pilot.) Also, many products that are potential substitutes for each other are not precisely identical. For instance, a Rolls Royce and a Honda are both cars, but there is no reason to expect the exchange rate between the British pound and the yen to be set so that the prices of the two are equalized. In addition, countries consume different market baskets of goods, so we would not expect the aggregate price levels to follow the law of one price. Nevertheless, a high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of relatively high-inflation countries to depreciate. Figure 19.5 shows the adjustment likely to occur following an increase in the U.S. price level relative to the price level in Great Britain. This change in relative prices will affect citizens of both countries. Higher prices in the United States make imports relatively less expensive. U.S. citizens are likely to increase their spending on imports from Britain, shifting the demand for pounds to the right, from D0 to D1. At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. Consequently, the supply of pounds shifts to the left, from S0 to S1. The result is an increase in the price of pounds. Before the change in relative prices, one pound sold for $1.50; after the change, one pound costs $2.00. The pound appreciates, and the dollar depreciates. Relative Interest Rates Another factor that influences a country’s exchange rate is the level of its interest rate relative to other countries’ interest rates. If the interest rate is 2 percent in 4Of course, if the rate were $1 U.S. to $2 Canadian, it would benefit people to buy basketballs in Canada (at $12 Canadian, which is $6 U.S.) and sell them in the United States. This would weaken demand for the U.S. dollar, and its price would fall from $2 Canadian until it reached $1.20 Canadian. If the costs law of one price of transportation are small, the price of the same good in different countries should be roughly the same. purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same. M19_CASE3826_13_GE_C19.indd 397 17/04/19 4:26 AM 398 PART V The World Economy ▸ FIGURE 19.5 Exchange Rates Respond to Changes in Relative Prices The higher price level in the United States makes imports relatively less expensive. U.S. citizens are likely to increase their spending on imports from Britain, shifting the demand for pounds to the right, from D0 to D1. At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. The supply of pounds shifts to the left, from S0 to S1. The result is an increase in the price of pounds. The pound appreciates, and the dollar is worth less. $2.00 $1.50 ) £ / $ ( S1 S0 D1 D0 0 £* MyLab Economics Concept Check Quantity of pounds, £ the United States and 3 percent in Great Britain, people with money to lend have an incentive to buy British securities instead of U.S. securities. Although it is sometimes difficult for individuals in one country to buy securities in another country, it is easy for international banks and investment companies to do so. If the interest rate is lower in the United States than in Britain, there will be a movement of funds out of U.S. securities into British securities as banks and firms move their funds to the higher-yielding securities. How does a U.S. bank buy British securities? It takes its dollars, buys British pounds, and uses the pounds to buy the British securities. The bank’s purchase of pounds drives up the price of pounds in the foreign exchange market. The increased demand for pounds increases the price of the pound (and decreases the price of the dollar). A high interest rate in Britain relative to the interest rate in the United States tends to depreciate the dollar. Figure 19.6 shows the effect of rising interest rates in the United States on the dollar-to-pound exchange rate. Higher interest rates in the United States attract British investors. To buy U.S. securities, the British need dollars. The supply of pounds (the demand for dollars) shifts to the right, from S0 to S1. The same relative interest rates affect the portfolio choices of U.S. banks, firms, and households. With higher interest rates at home, there is less incentive for U.S. residents to ▸ FIGURE 19.6 Exchange Rates Respond to Changes in Relative Interest Rates If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S0 to S1. At the same time, U.S. citizens are less likely to be interested in British securities because interest rates are higher at home. The demand for pounds shifts to the left, from D0 to D1. The result is the pound depreciates vis-a-vis the dollar and the dollar (naturally) appreciates visa-vis the pound. S0 S1 D0 D1 ) £ / $ ( 1.50 $1.00 0 £* MyLab Economics Concept Check Quantity of pounds, £ M19_CASE3826_13_GE_C19.indd 398 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 399 buy British securities. The demand for pounds drops at the same time the supply increases and the demand curve shifts to the left, from D0 to D1. The net result is a depreciating pound and an appreciating dollar. The price of pounds falls from $1.50 to $1.00. The Effects of Exchange Rates on the Economy MyLab Economics Concept Check We are now ready to discuss some of the implications of floating exchange rates. Recall, when exchange rates are fixed, households spend some of their incomes on imports and the multiplier is smaller than it would be otherwise. Imports are a “leakage” from the circular flow, much like taxes and saving. Exports, in contrast, are an “injection” into the circular flow; they represent spending on U.S.-produced goods and services from abroad and can stimulate output. Exchange Rate Effects on Imports, Exports, and Real GDP As we already know, when a country’s currency depreciates (falls in value), its imp
ort prices rise and its export prices (in foreign currencies) fall. When the U.S. dollar is cheap, U.S. products are more competitive with products produced in the rest of the world and foreign-made goods look expensive to U.S. citizens. A depreciation of a country’s currency can thus serve as a stimulus to the economy. Suppose the U.S. dollar depreciates relative to the other major currencies, as it did sharply between 1985 and 1988 and again, more moderately from 2002 to 2008 and 2012 to 2013. If foreign buyers increase their spending on U.S. goods, and domestic buyers substitute U.S.-made goods for imports, aggregate expenditure on domestic output will rise, inventories will fall, and real GDP (Y) will increase. A depreciation of a country’s currency is likely to increase its GDP.5 Exchange Rates and the Balance of Trade: The J Curve A depreciating currency tends to increase exports and decrease imports, so you might think that it also will reduce a country’s trade deficit. In fact, the effect of depreciation on the balance of trade is ambiguous. Many economists believe that when a currency starts to depreciate, the balance of trade is likely to worsen for the first few quarters (perhaps three to six). After that, the balance of trade may improve. This effect is graphed in Figure 19.7. The curve in this figure resembles the letter J, and the movement in the balance of trade that it describes is sometimes called the J-curve effect. The point of the J shape is that the balance of trade gets worse before it gets better following a currency depreciation. How does the J curve come about? Recall from Table 19.1 that the balance of trade is equal to export revenue minus import costs, including exports and imports of services: balance of trade = dollar price of exports * quantity of exports - dollar price of imports * quantity of imports A currency depreciation affects the items on the right side of this equation as follows: First, the quantity of exports increases and the quantity of imports decreases; both have a positive effect on the balance of trade (lowering the trade deficit or raising the trade surplus). Second, the dollar price of exports is not likely to change very much, at least not initially. The dollar price of exports changes when the U.S. price level changes, but the initial effect of a depreciation on the domestic price level is not likely to be large. Third, the dollar price of imports increases. Imports into the United States are more expensive because $1 U.S. buys fewer yen, euros, and so on, than before. An increase in the dollar price of imports has a negative effect on the balance of trade. The following is an example to clarify this last point: The dollar price of a Japanese car that costs 1,200,000 yen rises from $10,000 to $12,000 when the exchange rate moves from 5For this reason, some countries are tempted at times to intervene in foreign exchange markets, depreciate their currencies, and stimulate their economies. If all countries attempted to lower the value of their currencies simultaneously, there would be no gain in income for any of them. Although the exchange rate system at the time was different, such a situation actually occurred during the early years of the Great Depression. Many countries practiced so-called beggar-thy-neighbor policies of competitive devaluations in a desperate attempt to maintain export sales and employment. J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. M19_CASE3826_13_GE_C19.indd 399 17/04/19 4:26 AM 400 PART V The World Economy ▸ FIGURE 19.7 The Effect of a Depreciation on the Balance of Trade (the J Curve) Initially, a depreciation of a country’s currency may worsen its balance of trade. The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports Quarters after the beginning of the depreciation 8 7 MyLab Economics Concept Check 120 yen per dollar to 100 yen per dollar. After the currency depreciation, the United States ends up spending more (in dollars) for the Japanese car than it did before. Of course, the United States will end up buying fewer Japanese cars than it did before. Does the number of cars drop enough so that the quantity effect is bigger than the price effect or vice versa? Does the value of imports increase or decrease? The net effect of a depreciation on the balance of trade could go either way. The depreciation stimulates exports and cuts back imports, but it also increases the dollar price of imports. It seems that the negative effect dominates initially. The impact of a depreciation on the price of imports is generally felt quickly, while it takes time for export and import quantities to respond to price changes. In the short run, the value of imports increases more than the value of exports, so the balance of trade worsens. The initial effect is likely to be negative, but after exports and imports have had time to respond, the net effect turns positive. The more elastic the demand for exports and imports is, the larger the eventual improvement in the balance of trade will be. Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level. There are two reasons for this effect. First, when a country’s currency is less expensive, its products are more competitive on world markets, so exports rise. In addition, domestic buyers tend to substitute domestic products for the now-more-expensive imports. This means that planned aggregate expenditure on domestically produced goods and services rises and that the aggregate demand curve shifts to the right. The result is a higher price level, a higher output, or both. (You may want to draw an AS/AD diagram to verify this outcome.) If the economy is close to capacity, the result is likely to be higher prices. Second, a depreciation makes imported inputs more expensive. If costs increase, the aggregate supply curve shifts to the left. If aggregate demand remains unchanged, the result is an increase in the price level. Monetary Policy with Flexible Exchange Rates Let us now put everything in this chapter together and consider what happens when monetary policy is used first to stimulate the economy and then to contract the economy in an open economy with flexible exchange rates. Suppose the economy is below full employment and the Federal Reserve (Fed) lowers the interest rate. The lower interest rate stimulates planned investment spending and consumption spending. Output thus increases, but there are additional effects: (1) The lower interest rate has an impact in the foreign exchange market. A lower interest rate means a lower demand for U.S. securities by foreigners, so the demand for dollars drops. (2) U.S. investment managers will be more likely to buy foreign securities (which are now paying relatively higher interest rates), so the supply of dollars rises. Both events push down the value of the dollar. A cheaper dollar is a good thing if the goal of the Fed is to stimulate the domestic economy because a cheaper dollar means more U.S. exports and fewer imports. If consumers substitute U.S.-made goods for imports, both the added exports and the decrease in imports mean more spending on domestic products, so the multiplier actually increases. Flexible exchange rates thus help the Fed in its goal to stimulate the economy. Now suppose inflation is a problem and the Fed raises the interest rate. Here again, floating exchange rates help. The higher interest rate lowers planned investment and consumption M19_CASE3826_13_GE_C19.indd 400 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 401 spending, reducing output and lowering the price level. The higher interest rate also attracts foreign buyers into U.S. financial markets, driving up the value of the dollar, which reduces the price of imports. The reduction in the price of imports causes a shift of the aggregate supply curve to the right, which helps fight inflation, which is what the Fed wants to do. Flexible exchange rates thus help the Fed in its goal to fight inflation. Fiscal Policy with Flexible Exchange Rates Although we have just seen that flexible exchange rates help the Fed achieve its goals, the opposite is the case for the fiscal authorities in normal times when there is no zero lower interest rate bound and the Fed is following the Fed rule. Say that the administration and Congress want to stimulate the economy, and they increase government spending to do this. This increases output in the usual way (shift of the AD curve to the right). This usual way means that the interest rate is also higher (from the Fed rule because output and the price level are higher). The higher interest rate attracts foreign investment and leads to an appreciation of the dollar. An appreciation, other things being equal, increases imports and decreases exports, which has a negative effect on output. The increase in output is thus less than it would have been had there been no appreciation. The appreciation also leads to a decrease in import prices, which shifts the AS curve to the right, thus decreasing the price level, other things being equal. Although the price level is lower than otherwise, output, which was the main target of the administration’s policy in our example, is lower, all else equal. Flexible exchange rates thus makes the task of the fiscal authorities in their goal to stimulate the economy more difficult. Flexible exchange rates also hurt the fiscal authorities if they want to contract the economy to fight inflation. Suppose we decrease government spending to try to reduce inflation. This shifts the AD curve to the left, which decreases output and the price level. The interest rate is also lower (from the Fed rule becau
se output and the price level are lower), which leads to a depreciation of the dollar. The depreciation, other things being equal, decreases imports and increases exports, which has a positive effect on output. However, the depreciation also leads to an increase in import prices, which shifts the AS curve to the left, thus increasing the price level, other things being equal. Although output is higher than otherwise, inflation, which was our target, is higher than it would have been in a closed economy other things being equal. So flexible exchange rates also hurt the fiscal authorities in their goal to fight inflation. Note that the appreciation or depreciation of the currency occurs because of the Fed rule. If the Fed does not change the interest rate in response to the fiscal policy change, either because there is a zero lower bound or because it just doesn’t want to, there is no appreciation or depreciation and thus no offset to what the fiscal authorities are trying to do from the existence of flexible exchange rates. Monetary Policy with Fixed Exchange Rates Although most major countries in the world today have a flexible exchange rate (counting for this purpose the eurozone countries as one country), it is interesting to ask what role monetary policy can play when a country has a fixed exchange rate. The answer is, no role. Suppose a country fixes or “pegs” its exchange rate to the value of the dollar? In fact a number of countries do this, including countries like Hong Kong and Singapore, who are heavily reliant on their financial sectors. When a country decides to peg its exchange rate to another currency, say the U.S. dollar, it gives up its power to change its interest rate. Why? Consider a monetary authority of a pegged country that wants to lower its interest rate to stimulate the economy. The problem is that with its interest rate lower than rates abroad, people in the country will be induced to move their capital abroad to earn the higher interest rates. In other words, there will be an outflow of capital. Normally, this outflow would cause the country’s currency to depreciate, but with a pegged rate, this won’t happen. To keep the exchange rate from depreciating, the country’s monetary authority will be forced to buy the domestic currency outflow by selling its foreign reserves. Eventually the monetary authority will run out of foreign reserves and thus be unable to support the pegged exchange rate. It is thus not feasible for the country to change its interest rate and keep its exchange rate unchanged. A commitment to peg is thus a commitment to give up one’s independent monetary policy. When the various European countries moved in 1999 to a common currency, the euro, each country gave up its monetary policy. Monetary policy is decided for all of the eurozone M19_CASE3826_13_GE_C19.indd 401 17/04/19 4:26 AM 402 PART V The World Economy countries by the European Central Bank (ECB). The Bank of Italy, for example, no longer has any influence over Italian interest rates. Interest rates are influenced by the ECB. This is the price Italy paid for giving up the lira. The one case in which a country can change its interest rate and keep its exchange rate fixed is if it imposes capital controls. Imposing capital controls means that the country limits or prevents people from buying or selling its currency in the foreign exchange markets. A citizen of the country may be prevented, for example, from using the country’s currency to buy dollars. The problem with capital controls is that they are hard to enforce, especially for large countries and for long periods of time. An Interdependent World Economy The increasing interdependence of countries in the world economy has made the problems facing policymakers more difficult. We used to be able to think of the United States as a relatively self-sufficient region. Forty years ago economic events outside U.S. borders had relatively little effect on its economy. This situation is no longer true. The events of the past four decades have taught us that the performance of the U.S. economy is heavily dependent on events outside U.S. borders. This chapter and the previous chapter have provided only the bare bones of open-economy macroeconomics. If you continue your study of economics, more will be added to the basic story we have presented. The next chapter concludes with a discussion of the problems of developing countries. S U M M A R Y 1. The main difference between an international transaction and a domestic transaction concerns currency exchange: When people in different countries buy from and sell to each other, an exchange of currencies must also take place. 2. The exchange rate is the price of one country’s currency in terms of another country’s currency. 19.1 THE BALANCE OF PAYMENTS p. 386 3. Foreign exchange is all currencies other than the domestic currency of a given country. The record of a nation’s transactions in goods, services, and assets with the rest of the world is its balance of payments. The balance of payments is also the record of a country’s sources (supply) and uses (demand) of foreign exchange. 19.2 EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY p. 389 4. In an open economy, some income is spent on foreign produced goods instead of domestically produced goods. To measure planned domestic aggregate expenditure in an open economy, we add total exports but subtract total imports: C + I + G + EX - IM. The open economy is in equilibrium when domestic aggregate output (income) (Y) equals planned domestic aggregate expenditure. 5. In an open economy, the multiplier equals 1 [1 - (MPC - MPM)], > where MPC is the marginal propensity to consume and MPM is the marginal propensity to import. The marginal propensity to import is the change in imports caused by a $1 change in income. 6. In addition to income, other factors that affect the level of imports are the after-tax real wage rate, after-tax nonlabor income, interest rates, and relative prices of domestically produced and foreign-produced goods. The demand for exports is determined by economic activity in the rest of the world and by relative prices. 7. An increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States. An increase in U.S. imports increases other countries’ exports, which stimulates economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback effect. 8. Export prices of other countries affect U.S. import prices. The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise. 9. One country’s exports are another country’s imports, thus an increase in export prices increases other countries’ import prices. An increase in other countries’ import prices leads to an increase in their domestic prices—and their export prices. In short, export prices affect import prices and vice versa. This price feedback effect shows that inflation is “exportable”; an increase in the price level in one country can drive up prices in other countries, making inflation in the first country worse. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 402 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 403 19.3 THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES p. 393 10. The equilibrium exchange rate occurs when the quantity demanded of a foreign currency in the foreign exchange market equals the quantity of that currency supplied in the foreign exchange market. 11. Depreciation of a currency occurs when a nation’s currency falls in value relative to another country’s currency. Appreciation of a currency occurs when a nation’s currency rises in value relative to another country’s currency. 12. According to the law of one price, if the costs of transportation are small, the price of the same good in different countries should be roughly the same. The theory that exchange rates are set so that the price of similar goods in different countries is the same is known as the purchasing-power-parity theory. In practice, transportation costs are significant for many goods, and the law of one price does not hold for these goods. 13. A high rate of inflation in one country relative to another country puts pressure on the exchange rate between the two countries. There is a general tendency for the currencies of relatively high-inflation countries to depreciate. 14. A depreciation of the dollar tends to increase U.S. GDP by making U.S. exports cheaper (hence, more competitive abroad) and by making U.S. imports more expensive (encouraging consumers to switch to domestically produced goods and services). 15. The effect of a depreciation of a nation’s currency on its balance of trade is unclear. In the short run, a currency depreciation may increase the balance-of-trade deficit because it raises the price of imports. Although this price increase causes a decrease in the quantity of imports demanded, the impact of a depreciation on the price of imports is generally felt quickly, but it takes time for export and import quantities to respond to price changes. The initial effect is likely to be negative, but after exports and imports have had time to respond, the net effect turns positive. The tendency for the balance-of-trade deficit to widen and then to decrease as the result of a currency depreciation is known as the J-curve effect. 16. The depreciation of a country’s currency tends to raise its price level for two reasons. First, a currency depreciation increases planned aggregate expenditure, an effect that shifts the aggregate demand curve to the right. If the econom
y is close to capacity, the result is likely to be higher prices. Second, a depreciation makes imported inputs more expensive. If costs increase, the aggregate supply curve shifts to the left. If aggregate demand remains unchanged, the result is an increase in the price level. 17. When exchange rates are flexible, a U.S. expansionary monetary policy decreases the interest rate and stimulates planned investment and consumption spending. The lower interest rate leads to a lower demand for U.S. securities by foreigners and a higher demand for foreign securities by U.S. investment-fund managers. As a result, the dollar depreciates. A U.S. contractionary monetary policy appreciates the dollar. 18. Flexible exchange rates do not always work to the advantage of policy makers. An expansionary fiscal policy can appreciate the dollar and work to reduce the multiplier appreciation of a currency, p. 396 balance of payments, p. 386 balance of trade, p. 387 balance on current account, p. 387 depreciation of a currency, p. 396 exchange rate, p. 386 floating, or market-determined, exchange rates, p. 394 foreign exchange, p. 386 J-curve effect, p. 399 law of one price, p. 397 marginal propensity to import (MPM), p. 390 net exports of goods and services (EX - IM), p. 390 price feedback effect, p. 393 purchasing-power-parity theory, p. 397 trade deficit, p. 387 trade feedback effect, p. 392 P R O B L E M S All problems are available on MyLab Economics. Equations: Planned aggregate expenditure in an open economy: AE K C + I + G + EX - IM, p. 390 Open-economy multiplier = 1 1 - (MPC - MPM) , p. 391 19.1 THE BALANCE OF PAYMENTS LEARNING OBJECTIVE: Explain how the balance of payments is calculated. 1.1 Obtain a recent issue of The Economist. Turn to the section titled “Economic and financial indicators.” Look at the table titled “Trade, exchange rates, budget balances, and interest rates.” Which country had the largest trade deficit over the last year and during the last month? Which country had the largest trade surplus over the last year and during the last month? How does the current account deficit/surplus compare to the overall trade balance? How can you explain the difference? 1.2 What effect will each of the following events have on the current account balance if the exchange rate is fixed? If the exchange rate is floating? a. The Indian government raises taxes and income falls. b. The Chinese inflation rate increases, and prices in China rise faster than those in countries with which China trades. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 403 17/04/19 4:26 AM 404 PART V The World Economy c. India adopts a contractionary monetary policy. Interest rates rise (and are now higher than those in other countries) and income falls. d. The textile companies’ “Buy Japanese” campaign is successful, and Japanese consumers switch from purchasing imported products to buying products made in Japan. 1.3 [Related to the Economics in Practice on p. 389] The United States is the second largest oil importer in the world, importing 7.2 million barrels of crude oil per day as in April 2015. Go to www.inflationdata.com and look up crude oil prices for the past five years; then go to www.bea.gov to look up the U.S. net international investment position (NIIP) for the past five years. Does there appear to be a relationship between the price of crude oil and U.S. NIIP? Briefly explain the result of your findings. 19.2 EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY LEARNING OBJECTIVE: Discuss how equilibrium output is determined in an open economy, and describe the trade feedback effect and the price feedback effect. 2.1 The exchange rate between the U.S. dollar and the euro is floating freely—both governments do not intervene in the market for each currency. Suppose the president of the United States decides to place tariffs on certain imports from Europe. He has also argued in many places that the dollar is too strong visá-vis other currencies and it should be weakened so that the United States regains some of its competitive advantage. a. How will consumption change in the United States? b. What will happen if the income rises in the United States? c. How will a decline in the export of European goods im- pact the dollar-euro exchange rate? d. Consider the effects of a tariff on European imports. How will the European Union respond to U.S. tariffs? 2.2 You are given the following model that describes the economy of Hypothetica. (1) Consumption function: C = 80 + 0.75Yd (2) Planned investment: I = 49 (3) Government spending: G = 60 (4) Exports: EX = 20 (5) Imports: IM = 0.05Yd (6) Disposable income: Yd = Y - T (7) Taxes: T = 20 (8) Planned aggregate expenditure: AE = C = I + G + EX - IM (9) Definition of equilibrium income: Y = AE a. What is equilibrium income in Hypothetica? What is the government deficit? What is the current account balance? b. If government spending is increased to G = 75, what happens to equilibrium income? Explain using the government spending multiplier. What happens to imports? c. Now suppose the amount of imports is limited to IM = 25 by a quota on imports. If government spending is again increased from 60 to 75, what happens to equilibrium income? Explain why the same increase in G has a bigger effect on income in the second case. What is it about the presence of imports that changes the value of the multiplier? d. If exports are fixed at EX = 20, what must income be to ensure a current account balance of zero? (Hint: Imports depend on income, so what must income be for imports to be equal to exports?) By how much must we cut government spending to balance the current account? (Hint: Use your answer to the first part of this question to determine how much of a decrease in income is needed. Then use the multiplier to calculate the decrease in G needed to reduce income by that amount.) 19.3 THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES LEARNING OBJECTIVE: Discuss factors that affect exchange rates in an open economy with a floating system. 3.1 On January 3, 2014, the euro was trading at $1.36658, while on August 20, 2018, the euro was worth $1.15. What reasons can you give for the dollar strengthening vis-á-vis the euro? 3.2 Suppose the following graph shows what prevailed on the foreign exchange market in 2018 with floating exchange rates. a. Name three phenomena that might shift the demand curve to the right. b. Which, if any, of these three phenomena might cause a simultaneous shift of the supply curve to the left? c. What effects might each of the three phenomena have on the balance of trade if the exchange rate floats1.60 S D 0 Quantity of pounds 3.3 Suppose the exchange rate between the Danish krone and the U.S. dollar is 7 DKK = $1 and the exchange rate between the Chilean peso and the U.S. dollar is 650 CLP = $1. a. Express both of these exchange rates in terms of dollars per unit of the foreign currency. b. What should the exchange rate be between the Danish krone and the Chilean peso? Express the exchange rate in terms of one krone and in terms of one peso. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 404 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 405 c. Suppose the exchange rate between the krone and the dollar changes to 5 DKK = $1 and the exchange rate between the peso and the dollar changes to 700 CLP = $1. For each of the three currencies, explain whether the currency has appreciated or depreciated against the other two currencies. 3.4 Suppose the exchange rate between the British pound and the U.S. dollar is £1 = $1.50. a. Draw a graph showing the demand and supply of pounds for dollars. b. If the Bank of England implements a contractionary monetary policy, explain what will happen to the exchange rate between the pound and the dollar and show this on a graph. Has the dollar appreciated or depreciated relative to the pound? Explain. c. If the U.S. government implements an expansionary fiscal policy, explain what will happen to the exchange rate between the pound and the dollar and show this on a graph. Has the dollar appreciated or depreciated relative to the pound? Explain. 3.5 Canada is the second-largest trading partner for the United States (just recently surpassed by China). In 2017, U.S. exports to Canada were more than $340 billion and imports from Canada totaled more than $332 billion. On January 1, 2017, the exchange rate between the Canadian dollar and the U.S. dollar was 1.34 Canadian dollars = 1 U.S. dollar. On January 1, 2018, the exchange rate was 1.26 Canadian dollars = 1 U.S. dollar. Explain how this change in exchange rates could impact U.S. consumers and firms? 3.6 The exchange rate between the U.S. dollar and the British pound is a floating rate, with no government intervention. If a large trade deficit with Great Britain prompts the United States to impose quotas on certain British imports, resulting in a reduction in the quantity of these imports, what will happen to the dollar–pound exchange rate? Why? (Hint: There is an excess supply of pounds, or an excess demand for dollars.) What effects will the change in the value of each currency have on employment and output in the United States? What about the balance of trade? (Ignore complications such as the J curve.) 3.7 Do an Internet search and look up historical exchange rates. Find the recent exchange rates between the Indian rupee and the Chinese yuan and between the U.S. dollar and the Emirati dirham. Compare them with exchange rates a year ago. Go to the website of Ministry of Commerce and Industry, India, to find the latest value of Indian exports, imports, and tra
de balance and compare with estimates of the previous year. Did these values increase or decrease during that year? Explain how changes in the exchange rates may have had an impact on the changes in Indian exports, imports, and the trade balance. Discuss if you witness any deviation from the theories studied. 3.8 The data in the following table represents price level changes and interest rate changes over a one-year period for three countries: Astoria, Borgia, and Calistoga. Based on the data, explain what is likely to happen to the exchange rate for Astorian asters relative to the other two countries’ currencies over that one-year period. Use supply and demand graphs to support your answer, with prices listed as asters per borg and asters per cali, and quantities representing borgs and calis. Country/ Currency Price Index January 1, 2018 Price Index January 1, 2019 Interest Rate January 1, 2018 Interest Rate January 1, 2019 Astoria/aster Borgia/borg Calistoga/cali 100 120 150 110 132 168 4 percent 4 percent 4 percent 6 percent 8 percent 6 percent QUESTION 1 Tania is a Costa Rican graduate student at the University of Florida. She earns a small salary as a graduate student, and she sends a portion of that income to her family in Costa Rica as a remittance. Would this transfer appear as a positive or negative entry in the U.S. Current Account? And in the Costa Rican Current Account? QUESTION 2 During 2015 and 2016, the Mexican Peso depreciated substantially in value, and many Mexican commentators lamented a tragic occurrence and blamed thenPresident Enrique Peña Nieto. Why might this depreciation of the Mexican Peso have been a good thing? CHAPTER 19 APPENDIX: World Monetary Systems since 1900 Since the beginning of the twentieth century, the world has operated under a number of different monetary systems. This Appendix provides a brief history of each and a description of how they worked. LEARNING OBJECTIVE Explain what the Bretton Woods system is. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 405 17/04/19 4:26 AM 406 PART V The World Economy The Gold Standard MyLab Economics Concept Check The gold standard was the major system of exchange rate determination before 1914. All currencies were priced in terms of gold—an ounce of gold was worth so much in each currency. When all currencies exchanged at fixed ratios to gold, exchange rates could be determined easily. For instance, one ounce of gold was worth $20 U.S.; that same ounce of gold exchanged for £4 (British pounds). Because $20 and £4 were each worth one ounce of gold, the exchange rate between dollars and pounds was $20/£4, or $5 to £1. For the gold standard to be effective, it had to be backed up by the country’s willingness to buy and sell gold at the determined price. As long as countries maintain their currencies at a fixed value in terms of gold and as long as each country is willing to buy and sell gold, exchange rates are fixed. If at the given exchange rate the number of U.S. citizens who want to buy things produced in Great Britain is equal to the number of British citizens who want to buy things produced in the United States, the currencies of the two countries will simply be exchanged. What if U.S. citizens suddenly decide they want to drink imported Scotch instead of domestic bourbon? If the British do not have an increased desire for U.S. goods, they will still accept U.S. dollars because those dollars can be redeemed in gold. This gold can then be immediately turned into pounds. As long as a country’s overall balance of payments remained in balance, no gold would enter or leave the country and the economy would be in equilibrium. If U.S. citizens bought more from the British than the British bought from the United States, however, the U.S. balance of payments would be in deficit and the U.S. stock of gold would begin to fall. Conversely, Britain would start to accumulate gold because it would be exporting more than it spent on imports. Under the gold standard, gold was a big determinant of the money supply.6 An inflow of gold into a country caused that country’s money supply to expand, and an outflow of gold caused that country’s money supply to contract. If gold were flowing from the United States to Great Britain, the British money supply would expand and the U.S. money supply would contract. Now recall from previous chapters the impacts of a change in the money supply. An expanded money supply in Britain will lower British interest rates and stimulate aggregate demand. As a result, aggregate output (income) and the price level in Britain will increase. Higher British prices will discourage U.S. citizens from buying British goods. At the same time, British citizens will have more income and will face relatively lower import prices, causing them to import more from the States. On the other side of the Atlantic, U.S. citizens will face a contracting domestic money supply. This will cause higher interest rates, declining aggregate demand, lower prices, and falling output (income). The effect will be lower demand in the United States for British goods. Thus, changes in relative prices and incomes that resulted from the inflow and outflow of gold would automatically bring trade back into balance. Problems with the Gold Standard MyLab Economics Concept Check Two major problems were associated with the gold standard. First, the gold standard implied that a country had little control over its money supply. The reason, as we have just seen, is that the money stock increased when the overall balance of payments was in surplus (gold inflow) and decreased when the overall balance was in deficit (gold outflow). A country that was experiencing a balance-of-payments deficit could correct the problem only by the painful process of allowing its money supply to contract. This contraction brought on a slump in economic activity, a slump that would eventually restore balance-of-payments equilibrium, but only after reductions in income and employment. Countries could (and often did) act to protect their gold reserves, and this precautionary step prevented the adjustment mechanism from correcting the deficit. Making the money supply depend on the amount of gold available had another disadvantage. When major new gold fields were discovered (as in California in 1849 and South Africa in 6In the days when currencies were tied to gold, changes in the amount of gold influenced the supply of money in two ways. A change in the quantity of gold coins in circulation had a direct effect on the supply of money; indirectly, gold served as a backing for paper currency. A decrease in the central bank’s gold holdings meant a decline in the amount of paper money that could be supported. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 406 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 407 1886), the world’s supply of gold (and therefore of money) increased. The price level rose and income increased. When no new gold was discovered, the supply of money remained unchanged and prices and income tended to fall. When President Reagan took office in 1981, he established a commission to consider returning the nation to the gold standard. The final commission report recommended against such a move. An important part of the reasoning behind this recommendation was that the gold standard puts enormous economic power in the hands of gold-producing nations. Fixed Exchange Rates and the Bretton Woods System MyLab Economics Concept Check As World War II drew to a close, a group of economists from the United States and Europe met to formulate a new set of rules for exchange rate determination that they hoped would avoid the difficulties of the gold standard. The rules they designed became known as the Bretton Woods system, after the town in New Hampshire where the delegates met. The Bretton Woods system was based on two (not necessarily compatible) premises. First, countries were to maintain fixed exchange rates with one another. Instead of pegging their currencies directly to gold, however, currencies were fixed in terms of the U.S. dollar, which was fixed in value at $35 per ounce of gold. The British pound, for instance, was fixed at roughly $2.40, so that an ounce of gold was worth approximately £14.6. As we shall see, the pure system of fixed exchange rates would work in a manner very similar to the pre-1914 gold standard. The second aspect of the Bretton Woods system added a new wrinkle to the operation of the international economy. Countries experiencing a “fundamental disequilibrium” in their balance of payments were allowed to change their exchange rates. (The term fundamental disequilibrium was necessarily vague, but it came to be interpreted as a large and persistent current account deficit.) Exchange rates were not really fixed under the Bretton Woods system; they were, as someone remarked, only “fixed until further notice.” The point of allowing countries with serious current account problems to alter the value of their currency was to avoid the harsh recessions that the operation of the gold standard would have produced under these circumstances. However, the experience of the European economies in the years between World War I and World War II suggested that it might not be a good idea to give countries complete freedom to change their exchange rates whenever they wanted. During the Great Depression, many countries undertook so-called competitive devaluations to protect domestic output and employment. That is, countries would try to encourage exports—a source of output growth and employment—by attempting to set as low
an exchange rate as possible, thereby making their exports competitive with foreign-produced goods. Unfortunately, such policies had a built-in flaw. A devaluation of the pound against the French franc might help encourage British exports to France, but if those additional British exports cut into French output and employment, France would likely respond by devaluing the franc against the pound, a move that, of course, would undo the effects of the pound’s initial devaluation. To solve this exchange rate rivalry, the Bretton Woods agreement created the International Monetary Fund (IMF). Its job was to assist countries experiencing temporary current account problems.7 It was also supposed to certify that a “fundamental disequilibrium” existed before a country was allowed to change its exchange rate. The IMF was like an international economic traffic cop whose job was to ensure that all countries were playing the game according to the agreed-to rules and to provide emergency assistance where needed. “Pure” Fixed Exchange Rates MyLab Economics Concept Check Under a pure fixed exchange rate system, governments set a particular fixed rate at which their currencies will exchange for one another and then commit themselves to maintaining that rate. A true fixed exchange rate system is like the gold standard in that exchange rates are supposed 7The idea was that the IMF would make short-term loans to a country with a current account deficit. The loans would enable the country to correct the current account problem gradually, without bringing on a deep recession, running out of foreign exchange reserves, or devaluing the currency. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 407 17/04/19 4:26 AM 408 PART V The World Economy ▸ FIGURE 19A.1 Government Intervention in the Foreign Exchange Market If the price of Australian dollars were set in a completely unfettered market, one Australian dollar would cost 0.96 U.S. dollars when demand is D0 and 0.90 when demand is D1. If the government has committed to keeping the value at 0.96, it must buy up the excess supply of Australian dollars (Qs - Qd). 0.96 $0.90 S Excess supply of Australian dollars 5 intervention D0 D1 MyLab Economics Concept Check Quantity of Australian dollars 0 Qd Qs to stay the same forever. Because currencies are no longer backed by gold, they have no fixed, or standard, value relative to one another. There is, therefore, no automatic mechanism to keep exchange rates aligned with each other, as with the gold standard. The result is that under a pure fixed exchange rate system, governments must at times intervene in the foreign exchange market to keep currencies aligned at their established values. Economists define government intervention in the foreign exchange market as the buying or selling of foreign exchange for the purpose of manipulating the exchange rate. What kind of intervention is likely to occur under a fixed exchange rate system, and how does it work? We can see how intervention works by looking at Figure 19.A.1. Initially, the market for Australian dollars is in equilibrium. At the fixed exchange rate of 0.96, the supply of dollars is exactly equal to the demand for dollars. No government intervention is necessary to maintain the exchange rate at this level. Now suppose Australian wines are found to be contaminated with antifreeze and U.S. citizens switch to California wines. This substitution away from the Australian product shifts the U.S. demand curve for Australian dollars to the left: The United States demands fewer Australian dollars at every exchange rate (cost of an Australian dollar) because it is purchasing less from Australia than it did before. If the price of Australian dollars were set in a completely unfettered market, the shift in the demand curve would lead to a fall in the price of Australian dollars, just the way the price of wheat would fall if there was an excess supply of wheat. Remember, the Australian and U.S. governments have committed themselves to maintaining the rate at 0.96. To do so, either the U.S. government or the Australian government (or both) must buy up the excess supply of Australian dollars to keep its price from falling. In essence, the fixed exchange rate policy commits governments to making up any difference between the supply of a currency and the demand so as to keep the price of the currency (exchange rate) at the desired level. The government promises to act as the supplier (or demander) of last resort, who will ensure that the amount of foreign exchange demanded by the private sector will equal the supply at the fixed price. Problems with the Bretton Woods System MyLab Economics Concept Check As it developed after the end of World War II, the system of more-or-less fixed exchange rates had some flaws that led to its abandonment in 1971. First, there was a basic asymmetry built into the rules of international finance. Countries experiencing large and persistent current account deficits—what the Bretton Woods agreements termed “fundamental disequilibria”—were obliged to devalue their currencies and/or take measures to cut their deficits by contracting their economies. Both of these alternatives were MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 408 17/04/19 4:26 AM CHAPTER 19 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 409 unpleasant because devaluation meant rising prices and contraction meant rising unemployment. However, a country with a current account deficit had no choice because it was losing stock of foreign exchange reserves. When its stock of foreign currencies became exhausted, it had to change its exchange rate because further intervention (selling off some of its foreign exchange reserves) became impossible. Countries experiencing current account surpluses were in a different position because they were gaining foreign exchange reserves. Although these countries were supposed to stimulate their economies and/or revalue their currencies to restore balance to their current account, they were not obliged to do so. They could easily maintain their fixed exchange rate by buying up any excess supply of foreign exchange with their own currency, of which they had plentiful supply. In practice, this meant that some countries—especially Germany and Japan—tended to run large and chronic current account surpluses and were under no compulsion to take steps to correct the problem. The U.S. economy, stimulated by expenditures on the Vietnam War, experienced a large and prolonged current account deficit (capital outflow) in the 1960s, which was the counterpart of these surpluses. The United States was, however, in a unique position under the Bretton Woods system. The value of gold was fixed in terms of the U.S. dollar at $35 per ounce of gold. Other countries fixed their exchange rates in terms of U.S. dollars (and therefore only indirectly in terms of gold). Consequently, the United States could never accomplish anything by devaluing its currency in terms of gold. If the dollar was devalued from $35 to $40 per ounce of gold, the yen, pegged at 200 yen per dollar, would move in parallel with the dollar (from 7,000 yen per ounce of gold to 8,000 yen per ounce), with the dollar–yen exchange rate unaffected. To correct its current account deficits vis-à-vis Japan and Germany, it would be necessary for those two countries to adjust their currencies’ exchange rates with the dollar. These countries were reluctant to do so for a variety of reasons. As a result, the U.S. current account was chronically in deficit throughout the late 1960s. A second flaw in the Bretton Woods system was that it permitted devaluations only when a country had a “chronic” current account deficit and was in danger of running out of foreign exchange reserves. This meant that devaluations could often be predicted quite far in advance, and they usually had to be rather large if they were to correct any serious current account problem. The situation made it tempting for speculators to “attack” the currencies of countries with current account deficits. Problems such as these eventually led the United States to abandon the Bretton Woods rules in 1971. The U.S. government refused to continue pegging the value of the dollar in terms of gold. Thus, the prices of all currencies were free to find their own levels. The alternative to fixed exchange rates is a system that allows exchange rates to move freely or flexibly in response to market forces. Two types of flexible exchange rate systems are usually distinguished. In a freely floating system, governments do not intervene at all in the foreign exchange market.8 They do not buy or sell currencies with the aim of manipulating the rates. In a managed floating system, governments intervene if markets are becoming “disorderly”—fluctuating more than a government believes is desirable. Governments may also intervene if they think a currency is increasing or decreasing too much in value even though the day-to-day fluctuations may be small. Since the demise of the Bretton Woods system in 1971, the world’s exchange rate system can be described as “managed floating.” One of the important features of this system has been times of large fluctuations in exchange rates. For example, the yen–dollar rate went from 347 in 1971 to 210 in 1978, to 125 in 1988, and to 80 in 1995. Those are very large changes, changes that have important effects on the international economy, some of which we have covered in this text. 8However, governments may from time to time buy or sell foreign exchange for their own needs (instead of influencing the exchange rate). For example, the U.S. gov
ernment might need British pounds to buy land for a U.S. embassy building in London. For our purposes, we ignore this behavior because it is not “intervention” in the strict sense of the word. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 409 17/04/19 4:26 AM 410 PART V The World Economy . The gold standard was the major system of exchange rate determination before 1914. All currencies were priced in terms of gold. Difficulties with the gold standard led to the Bretton Woods agreement following World War II. Under this system, countries maintained fixed exchange rates with one another and fixed the value of their currencies in terms of the U.S. dollar. Countries experiencing a “fundamental disequilibrium” in their current accounts were permitted to change their exchange rates. 2. The Bretton Woods system was abandoned in 1971. Since then, the world’s exchange rate system has been one of managed floating rates. Under this system, governments intervene if foreign exchange markets are fluctuating more than the government thinks desirable All problems are available on MyLab Economics. CHAPTER 19 APPENDIX: WORLD MONETARY SYSTEMS SINCE 1900 LEARNING OBJECTIVE: Explain what the Bretton Woods system is. 1A.1 The currency of Atlantis is the wimp. In 2018, Atlantis developed a balance-of-payments deficit with the United States as a result of an unanticipated decrease in exports; U.S. citizens cut back on the purchase of Atlantean goods. Assume Atlantis is operating under a system of fixed exchange rates. a. How does the drop in exports affect the market for wimps? Identify the deficit graphically. b. How must the government of Atlantis act (in the short run) to maintain the value of the wimp? c. If Atlantis had originally been operating at full employment (potential GDP), what impact would those events have had on its economy? Explain your answer. d. The chief economist of Atlantis suggests an expansionary monetary policy to restore full employment; the Secretary of Commerce suggests a tax cut (expansionary fiscal policy). Given the fixed exchange rate system, describe the effects of these two policy options on Atlantis’s current account. e. How would your answers to a, b, and c change if the two countries operated under a floating rate system? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M19_CASE3826_13_GE_C19.indd 410 17/04/19 4:26 AM Economic Growth in Developing Economies 20 CHAPTER OUTLINE AND LEARNI NG OBJECTIV ES 20.1 Life in the Developing Nations: Population and Poverty p. 412 Discuss the characteristics of developing nations. 20.2 Economic Development: Sources and Strategies p. 413 Describe the sources of economic development. 20.3 Development Interventions p. 422 Discuss the intervention methods used by development economists. 411 In 2000 all 189 member states of the United Nations (UN) agreed to work toward achieving a set of eight Millennium Development Goals (MDG) for the developing world by 2015. Goals ranged from eradicating hunger and achieving universal primary education to reducing child and maternal mortality to fostering gender equality and environmental sustainability. After 15 years, in 2015, the UN reported considerable progress on most of its goals. Child and maternal mortality were both cut in half over the 15-year period; deaths from both HIV and malaria dramatically decreased and primary school attendance increased. Nevertheless, in its report on this progress, the UN concluded: “The poorest and most vulnerable people are being left behind.”1 What accounts for the persistence of underdevelopment across the world and what can be done about it? We will begin our discussion in this chapter with a look at some data comparing the developing and developed world. One of the hallmarks of the UN effort was its focus on the importance of collecting and analyzing data. With this context, we turn to look at strategies for economic development generally and then look at evidence on some specific interventions in the developing world, largely focused on the poorest households. As part of this discussion we will touch on some methodological questions current in economics about how best to determine whether particular policy interventions work or do not work. 1UN, Millennium Development Goals 2015 Report. M20_CASE3826_13_GE_C20.indd 411 17/04/19 5:34 PM 412 PART V The World Economy 20.1 LEARNING OBJECTIVE Discuss the characteristics of developing nations. Global South Developing Nations in Asia, Africa, and Latin America. Life in the Developing Nations: Population and Poverty In 2015, the population of the world reached more than 7 billion people. Most of the world’s more than 200 nations belong to the developing world, also known as the Global South, in which about three-fourths of the world’s population lives. In the last decade, rapid economic progress has brought some developing nations closer to developed economies. People living in extreme poverty, earning less than $1.25 per day, declined from 47 percent of the world’s population to 14 percent. Countries such as Argentina and Chile, still considered part of the Global South, have vibrant middle classes. Russia and many countries in the former Soviet bloc have also climbed to middle-income status. China and India, while still experiencing some of the challenges of the Global South, are becoming economic superpowers. At present, China’s gross domestic product (GDP) is second only in the world to the United States. Other parts of the world, most notably parts of Asia and sub-Saharan Africa, lag behind on many of the central dimensions of well-being identified by the UN and others. A central challenge in development economics is to explain why some countries lag and whether successful strategies of the past have lessons for the countries still left behind. Table 20.1 describes the progress of a dozen nations from 1990 to 2013 on two of the measures of human capital targeted by the MDG, child mortality younger than age five and literacy. As we will see in the next section, health and education are two of the lynch pins of economic development. If you think back to our discussion of economic growth in Chapter 16, you will recall the importance of human capital in promoting economic growth. What do the data tell us? The good news is that on both measures progress has been made over the last 25 years. In all countries, developed and developing, child mortality has fallen and literacy has risen. The improvement in child mortality in China is especially notable. But the disparity between Global North and Global South remains high. In 2014 in the sub-Saharan countries, one in 10 children die before they are five. In some of the countries in Africa, including Niger, Chad, and Central African Republic, illiteracy remains high at more than half the adult population. Moreover, even as the Global South increases its primary education levels, the Global North is providing college educations to a larger fraction of their populations, preserving its human capital lead. Although the countries of the developing world exhibit considerable diversity in both their standards of living and their particular experiences of growth, marked differences continue to separate them from the developed nations. The great majority of the population in the Global South lives in rural areas where agricultural work is hard and extremely time-consuming. Productivity (output produced per worker) is low in part because farmers work with little capital. Low productivity means farm output per person is barely sufficient to feed a farmer’s own family. The UN figures indicate that in TABLE 20.1 Comparisons of Child Mortality and Literacy: Selected Countries 1990 and 2013 Country Afghanistan Angola Australia Chad Central African Republic China Denmark Guinea Bissau India Niger Sierra Leone United States 1990: Mortality younger than age 5 2013: Mortality younger than age 5 1990: Literacy rates, ages 15–24 2013 Literacy rates: ages 15–24 179.1 225.9 9.2 214.7 176.9 53.9 8.9 224.8 125.9 327.3 267.7 11.2 97.3 167.4 4.0 147.5 139.2 12.7 3.5 123.9 52.7 104.2 160.6 6.9 Na Na 100.0 17.3 Na 94.3 100.0 Na 61.9 Na Na 100.0 47.0 73.0 100.0 48.9 36.4 99.6 100.0 74.3 81.1 23.5 62.7 100.0 Source: UN, Millennium Development Goal Data, 2015. M20_CASE3826_13_GE_C20.indd 412 17/04/19 5:34 PM What Can We Learn from the Height of Children? CHAPTER 20 Economic Growth in Developing Economies 413 The first of the Millennium Development Goals is to substantially cut the number of households who experience extreme hunger. One of four children younger than five years of age in the world are characterized as stunted, extremely short because of malnutrition. Of these children, one half is in Asia and one third in Africa. For these children poor nutrition in the early years leaves a permanent mark, reflected in life span and earnings. Recent work in economics has focused on the case of stunting in India. India’s stunting rate is among the highest in the world, exceeding even that of the much poorer African nations. Moreover, despite rapid growth in the last decade, little progress has been made in reducing the stunting rate. Seema Jayanchandran from Northwestern and Rohini Pande of Harvard’s Kennedy School examined several large data sets to try to understand why.1 The first clue comes from the pattern of India’s stunting. Looking at the data, Jayannchandran and Pande learn that Indian first born sons are actually taller than their African counterparts. Stunting emerges only for later born children, and the amount of stunting increases with the number of children. Among the most disadvantaged are girls with no older brothers whose parents continu
e to attempt to produce a son. The patterns that emerge from this study put a spotlight on two of the MDG concerns: hunger and gender equality. The researchers argue that India’s high stunting rate is explicable by the strong son preference of Indian families and the concomitant decision to invest disproportionate family resources in the first born son to insure his survival despite the family’s poverty. CRITICAL THINKING 1. Why might growth in the overall economy not have led to more improvement in the stunting rate? 1Seema Jayachandran and Rohini Pande, “Why are Indian Children so Short?” American Economic Review 2017, 2600–2629. 2015, 836 million people, primarily in the developing world, were severely undernourished. In addition, many developing nations are engaged in civil and external warfare. In recent years there has been more concern with the increased inequality that has come with development in some countries. India is on the World Bank’s list of low-income countries, yet Mumbai, a state capital, is one of the top 10 centers of commerce in the world, home to Bollywood, the world’s largest film industry. China with its rapid growth rates and increased affluence in urban areas still has a large agrarian population that has been mostly left behind by recent growth. Many of the specific interventions we will look at in this chapter are focused on designing strategies to bringing the households at the bottom rung of the income distribution into the mainstream economy of a country. Economic Development: Sources and Strategies Economists have been trying to understand economic growth and development since Adam Smith and David Ricardo in the eighteenth and nineteenth centuries, but the study of development economics as it applies to the developing nations has a much shorter history. The geopolitical struggles that followed World War II brought increased attention to the developing nations and their economic problems. During this period, the new field of development economics asked simply: Why are some nations poor and others rich? If economists could understand the barriers 20.2 LEARNING OBJECTIVE Describe the sources of economic development. M20_CASE3826_13_GE_C20.indd 413 17/04/19 5:34 PM 414 PART V The World Economy to economic growth that prevent nations from developing and the prerequisites that would help them to develop, economists could prescribe strategies for achieving economic advancement. We will see in this discussion that there is lively debate on the question of why some nations are poor and the corollary, how can we help countries get out of poverty. Ahijit Banerjee and Esther Duflo, both John Bates Clark award winners and MIT professors, on the other hand, argue in their influential book Poor Economics2 that it is not really possible at this point to answer the question of why some countries are poor and others rich and that the more relevant question is what types of policy interventions help households get out of poverty. We move to that discussion in the last section of this chapter. The Sources of Economic Development MyLab Economics Concept Check Although a general theory of economic development applicable to all nations has not emerged, some basic factors that limit a poor nation’s economic growth have been suggested. These include insufficient capital formation, a shortage of human resources and entrepreneurial ability, and a lack of infrastructure. Capital Formation Almost all developing nations have a scarcity of capital relative to other resources, especially labor. The small stock of physical capital (factories, machinery, farm equipment, and other productive capital) constrains labor’s productivity and holds back national output. Jeffrey Sachs, a professor at the Earth Institute at Columbia and a key economist in helping to develop the MDG, emphasizes the role of capital in moving countries out of poverty.3 Faced with bad climates, few resources and disease, poor countries find it hard to amass the capital needed to develop. They are stuck in a “poverty trap,” sometimes also called the vicious circle of poverty. Without investment, the capital stock does not grow, the income remains low, and the vicious circle is complete. Poverty becomes self-perpetuating. Sachs argues that one can use foreign aid as a lever to move countries out of poverty, providing the key capital needed for both public and private investments. Indeed, Sachs estimates that $195 billion in foreign aid per year could eliminate global poverty in 20 years. Other economists are less confident that foreign aid can play this role. Both William Easterly, Director of NYU’s Development Research Institute, in his book The Elusive Quest for Growth4 and Dambisa Moyo, a Zambian economist, in her book Dead Aid5 argue that foreign aid can actually hamper development by distorting market incentives for local entrepreneurs. There are also questions surrounding the assumption that poor countries cannot generate capital themselves. Japanese GDP per capita in 1900 was well below that of many of today’s developing nations, yet today it is among the developed nations. Among the many nations with low levels of capital per capita, some—like China—have managed to grow and develop in the last 20 years, whereas others remain behind. In even the poorest countries, there remains some capital surplus that could be harnessed if conditions were right. Many current observers believe that scarcity of capital in some developing countries may have more to do with a lack of incentives for citizens to save and invest productively than with any absolute scarcity of income available for capital accumulation. Many of the rich in developing countries invest their savings in Europe or in the United States instead of in their own country, which may have a riskier political climate. Savings transferred to the United States do not lead to physical capital growth in the developing countries. The term capital flight refers to the fact that both human capital and financial capital (domestic savings) leave developing countries in search of higher expected rates of return elsewhere or returns with less risk. Government policies in the developing nations—including price ceilings, import controls, and even outright appropriation of private property—tend to discourage investment. There has been increased attention to the role that financial institutions, including accounting systems and property-right rules, play in encouraging domestic capital formation. 2Abhijit Banerjee and Esther Duflo, Poor Economics, Perseus Books, 2011. 3Jeffrey Sachs, The End of Poverty: Economic Possibilities for Our Time, Penguin press, NY, 2005 4William Easterly, The Elusive Quest for Growth, MIT Press, 2001. 5Dambisa Moyo, Dead Aid: Why Aid is Not Working and How There Is a Better Way for Africa, Allen Lane 2009. vicious circle of poverty Suggests that poverty is self-perpetuating because poor nations are unable to save and invest enough to accumulate the capital stock that would help them grow. capital flight The tendency for both human capital and financial capital to leave developing countries in search of higher expected rates of return elsewhere with less risk. M20_CASE3826_13_GE_C20.indd 414 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 415 Whatever the causes of capital shortages, it is clear that the absence of productive capital prevents income from rising in any economy. The availability of capital is a necessary, but not a sufficient, condition for economic growth. Other ingredients are required to achieve economic progress. Human Resources and Entrepreneurial Ability Capital is not the only factor of production required to produce output. Labor is equally important. To be productive, the workforce must be healthy. Disease today is the leading threat to development in much of the world. In 2015, about 429,000 people died of malaria, almost all of them in Africa. HIV/AIDS was still responsible for 1 million deaths in 2016, again mostly in Africa, and has left Africa with more than 14 million AIDS orphans. Iron deficiency and parasites sap the strength of many workers in the developing world. Control of malaria and HIV/AIDS were MDG goals for 2015 and considerable progress was made, though considerable work still remains to be done. As we saw in Table 20.1, low-income countries also lag behind high-income countries in literacy rates. To be productive, the workforce must be educated and trained. Basic literacy as well as specialized training, for example, can yield high returns to both the individual worker and the economy. Education has grown to become the largest category of government expenditure in many developing nations, in part because of the belief that human resources are the ultimate determinant of economic advance. Nevertheless, in many developing countries, many children, especially girls, receive only a few years of formal education, though some progress has been made in this area. As technology pushes up the wage premium on skilled workers the impact of low literacy rates on a country’s GDP rises. Just as financial capital seeks the highest and safest return, so does human capital. Thousands of students from developing countries, many of whom were supported by their governments, graduate every year from U.S. colleges and universities. After graduation, these people face a difficult choice: to remain in the United States and earn a high salary or to return home and accept a job at a much lower salary. Many remain in the United States. This brain drain siphons off many of the most talented minds from developing countries. It is interesting to look at what happens to the flow of educated workers as countries develop. Increasingly, students who have come from China and India to study are returning to their home countries eager to use their skills in their newly growing economies. The return flow of this human capital stimulates growth and is a
signal that growth is occurring. Indeed, development economists have found evidence that in India, schooling choices made by parents for their children respond quite strongly to changes in employment opportunities.6 The connection between growth and human capital is in fact a two-way street. Even when educated workers leave for the developed world, they may contribute to the growth of their home country. Recently, economists have begun studying remittances, compensation sent back from recent immigrants to their families in less developed countries. Although measurement is difficult, estimates of these remittances are approximately $100 billion per year. Remittances fund housing and education for families left behind, but they also can provide investment capital for small businesses. In 2007, it appeared that remittances from illegal immigrants in the United States to Mexico, which had been growing by 20 percent per year, were beginning to fall with tightening of enforcement of immigration rules. Remittances fell further in 2008–2009 with the recession, but have recovered in subsequent years. In 2016, remittances to Mexico from the United States reached an all-time high of $27 billion, accounting for nearly 3 percent of the country’s income.7 In recent years, we have become increasingly aware of the role of entrepreneurship in economic development. Many of the iconic firms in the 19th century that contributed so strongly to the early industrial growth of the United States—Standard Oil, U.S. Steel, Carnegie Steel—were begun by entrepreneurs starting with little capital. In China, one of the top search engines is Baidu, a firm started in 2000 by two Chinese nationals, Eric Xu and Robin Li, and now traded on NASDAQ, as is AliBaba, a major online retailer. Business writers often compare these 6The classic work in this area was done by Kaivan Munshi and Mark Rosenzweig, “Traditional Institutions Meet the Modern World: Caste, Gender, and Schooling Choice in a Globalizing Economy,” American Economic Review, September 2006, 1225–1252. More recent work includes Emily Oster and Bryce Millett, “Do Call Centers Promote School Enrollment? Evidence from India, Journal of Development Economics, September 2013. 7Juan Jose, Li Ng and Carlos Serrano, “Mexico Yearbook of migration and remittances,” 2017. BBVA Research Report. brain drain The tendency for talented people from developing countries to become educated in a developed country and remain there after graduation. M20_CASE3826_13_GE_C20.indd 415 17/04/19 5:34 PM 416 PART V The World Economy Corruption Corruption is one of the biggest barriers to economic development. Development specialists argue that, fueled by low levels of economic development, poverty and illiteracy are the main culprits behind inherently high corruption levels in some countries. But what exactly does it mean to be corrupt? Transparency International (TI), the Berlin-based non-government organization defines corruption as the abuse of entrusted power for private gain. TI classifies corruption into grand, petty, and political. At one end of the spectrum, grand and political corruption are committed by high-ranking policymakers who use their power to enforce laws and policies that benefit leaders and politicians at the expense of public interest. At the other end, petty corruption is committed by low and mid-level public officials in the process providing public goods and services to ordinary citizens. This could range from receiving bribes to the embezzlement of public funds. Over the last two decades, TI has been gauging corruption using the Corruption Perceptions Index (CPI), which ranks countries based on opinion surveys of the perceptions of experts and businesses. The CPI uses a scale of 0 to 100, where 0 is highly corrupt and 100 is non-corrupt. Most developing nations score below 40.1 The Washington-based organization, Global Financial Integrity (GFI), further includes illegal and underground activities in its definition of corruption. Examples of such activities include drug trading, counterfeit and sub-standard medication, ivory smuggling, people trafficking, theft of oil and natural resources, and piracy. The damage caused by such activities is not only economic, in the form of forfeited tax revenues and capital flight, but also social. This damage has been quantified by the UN Economic Commission for Africa (ECA), which stipulates that the losses due to corrupt activities are profound in Africa. At $50 billion per annum, this loss is nearly double the official development assistance that African nations receive.2 Other spillover effects of corrupt transactions include organized crime and illegal migration across borders. The Organization for Economic Cooperation and Development (OECD) highlights the need for cooperation between Western and African nations to fight corruption. Some of the structural and economic reforms needed are better governance, higher accountability, more jobs, enhanced surveillance, and the organization of informal sectors. CRITICAL THINKING 1. Go to the website of TI, GFI, ECA, or the OECD. What are the recommended policies for developing nations to break the vicious circle between corruption and underdevelopment? 1Transparency International (2018). Corruption Perceptions Index 2017, February 15, Transparency International, Berlin. Retrieved from: https://www. transparency.org/whatwedo/publication/corruption_perceptions_index_2017 2UN Economic Commission for Africa (2018). IFF Background, ECA. https:// www.uneca.org/pages/iff-background Corruption Perceptions Index 2017 Highly Corrupt Very Clean 0–9 10–19 20–29 30–39 40–49 50–59 60–69 70–79 80–89 90–100 Source: Transparency International (2018). Corruption Perceptions Index. M20_CASE3826_13_GE_C20.indd 416 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 417 social overhead capital Basic infrastructure projects such as roads, power generation, and irrigation systems. two firms to Google and Amazon. Providing opportunities and incentives for creative risk takers seems to be an increasing part of what needs to be done to promote development. The work by Easterly and Mayo cited earlier both focus on the potential for poorly focused foreign aid to distort local entrepreneurial incentives and hamper economic growth. Infrastructure Capital Anyone who has spent time in a developing nation knows how difficult it can be to carry on everyday life. Problems with water supplies, poor roads, frequent electrical power outages (in the few areas where electricity is available), and often ineffective mosquito and pest control make life and commerce difficult. In any economy, developing or otherwise, the government plays an investment role. In a developing economy, the government must create a basic infrastructure—roads, power generation, and irrigation systems. Such projects, sometimes referred to as social overhead capital, often cannot be successfully undertaken by the private sector. Many of these projects operate with economies of scale, which means they can be efficient only if they are very large, perhaps too large for any private company or group of companies to carry out. In other cases, the benefits from a development project, although extraordinarily valuable, cannot be easily bought and sold. The availability of clean air and potable water are two examples. Here government must play its role before the private sector can proceed. For example, some observers have recently argued that India’s growth prospects are being limited by its poor rail transport system. Goods from Singapore to India move easily over water in less than a day, but they can take weeks to move from port cities to supply factories in the interior. China, by contrast, spent the bulk of its stimulus money in the 2008–2009 period trying to build new transportation networks in part because the government understood how key this social overhead capital was to economic growth. In 2017, the Chinese, big investors in Africa, finished a 450 mile railway from Addis Abbaba in Ethiopia to Dijbouti, designed to reduce transport costs and fuel economic growth. The Economics in Practice box on page 419 describes one of the unexpected results of government infrastructure provision in Bangladesh. To build infrastructure generally requires public funding. Many less-developed countries struggle with raising tax revenues to support these projects. In the last few years, Greece has struggled to repay its debt partly because of widespread tax evasion by its wealthiest citizens. In many less-developed countries, corruption limits the public funds available for productive government investments, as the Economics in Practice box on page 416 suggests. Strategies for Economic Development MyLab Economics Concept Check Despite many studies, looking across hundreds of countries, there has emerged no consensus on the right strategy to move a country out of poverty. Nevertheless, there are several promising strategies that may prove useful at the country level in some contexts. The Role of Government In the modern capitalist world most investment capital is supplied to entrepreneurs by third parties, either through the banking system we described in previous chapters or through the stock market. For those markets to work, to enable capital to flow, requires trust. Developing this trust in an environment in which most investment is impersonal in turn requires some government oversight. Rules need to be set and enforced, governing the kinds of data reported in financial statements, the way deposits are protected, and terms of loans enforced. The government similarly plays a role in property protections needed in a modern impersonal economy. These institutions are a necessary complement to economic development. The Economics in Practice box on page 419 describes the way in which family loans partially substitute for impersonal loans in Bangladesh where financial instituti
ons are less well developed. Between 1991 and 1997, U.S. firms entered Eastern Europe in search of markets and investment opportunities and immediately became aware of a major obstacle. The institutions that make the market function relatively smoothly in the United States did not exist in Eastern Europe. The banking system, venture capital funds, the stock market, the bond market, commodity exchanges, brokerage houses, investment banks, and so on, have developed in the United States over hundreds of years, and they could not be replicated overnight in the formerly Communist world. Similar problems exist today in the Chinese economy. Although the Chinese equity market has grown rapidly in the last decade, that growth has been accompanied by problems with weak governance and lack of transparency. These issues discourage investments by western firms. M20_CASE3826_13_GE_C20.indd 417 17/04/19 5:34 PM 418 PART V The World Economy Many market-supporting institutions are so basic that Americans take them for granted. The institution of private property, for example, is a set of rights that must be protected by laws that the government must be willing to enforce. Suppose the French hotel chain Novotel decides to build a new hotel in Moscow or Beijing. Novotel must first acquire land. Then it will construct a building based on the expectation of renting rooms to customers. These investments are made with the expectation that the owner has a right to use them and a right to the profits that they produce. For such investments to be undertaken, these rights must be guaranteed by a set of property laws. This is equally true for large business firms and for local entrepreneurs who want to start their own enterprises. China’s ambiguous property rights laws may also be problematic. Although farmers can own their own homes, for example, all rural land is collectively owned by villages. Farmers have the right to manage farmland, but not own it. As a result, transfer of land is difficult. Similarly, the law must provide for the enforcement of contracts. In the United States, a huge body of law determines what happens if you break a formal promise made in good faith. Businesses exist on promises to produce and promises to pay. Without recourse to the law when a contract is breached, contracts will not be entered into, goods will not be manufactured, and services will not be provided. Protection of intellectual property rights is also an important feature of developed market economies. When an artist puts out a record, the artist and his or her studio are entitled to reap revenues from it. When Apple developed the iPod, it too earned the right to collect revenue for its patent ownership. Many less-developed countries lack laws and enforcement mechanisms to protect intellectual property of foreign investments and their own current and future investors. The lack of protection discourages trade and home-grown invention. Another seemingly simple matter that turns out to be quite complex is the establishment of a set of accounting principles. In the United States, the rules of the accounting game are embodied in a set of generally accepted accounting principles (GAAP) that carry the force of law. Companies are required to keep track of their receipts, expenditures, assets, and liabilities so that their performance can be observed and evaluated by shareholders, taxing authorities, and others who have an interest in the company. If you have taken a course in accounting, you know how detailed these rules have become. Imagine trying to do business in a country operating under hundreds of different sets of rules. That is what happened in Russia during its transition. It is clear that economic development requires these financial and legal institutions. There is more debate about how much the lack of these institutions plays a role in keeping some countries poor. Work by Acemoglu, Johnson, and Robinson looking at the history of the African nations assign a prominent role to the lack of institutions in some nations as a cause of poverty.8 Other work suggests that institutions naturally develop alongside of markets and the economy and thus their absence marks market failure rather than causing it.9 The Movement from Agriculture to Industry Consider the data in Table 20.2. The richest countries listed—the United States, Japan, and Korea—generate much of their GDP in services, with little value contributed by agricultural production. The poorest countries, on the other hand, have substantial agricultural sectors, although as you can see, the service sector is also large in a number of these economies. The transition to a developing economy typically involves a movement away from agriculture. Recent work has documented the higher productivity of workers in the nonagricultural sector versus the agricultural sector in developing countries. Even carefully adjusting for difference in human capital of labor in the two sectors, value added per worker is much higher in the nonagricultural sector.10 This tells us that these countries would be better off in terms of productivity if they could more quickly move workers out of the agrarian areas and to the urban work place. Indeed, Gharad Bryan from the London School of Economics and Melanie Morton, of Stanford estimated that almost 20 percent of Indonesia’s growth between 1976 and 2012 could be accounted for by the reductions in migration costs that occurred during the 8Daron Acemoglu, Simon Johnson and James Robinson, “The Colonial Origins of Comparative Development: An Empirical investigation,” American Economic Review, 2001, 1369–1401 9Edward Glaeser, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer, “Do Institutions Cause Growth?” Journal of Economic Growth, September 2004. 10Douglas Gollin, David Lagakos and Michael Waugh, “The Agricultural Productivity Gap,” Quarterly Journal of Economics, 2014, 939–993 M20_CASE3826_13_GE_C20.indd 418 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 419 Who You Marry May Depend on the Rain In Bangladesh, as in many other low-lying countries, river flooding often leaves large swaths of land under water for substantial portions of the year. By building embankments on the side of the river, governments can extend the growing season, allowing several seasons of crops. The result is a wealth increase for people living in affected rural areas. In a recent paper, several economists traced through some unusual consequences of increasing the wealth of rural populations by creating embankments.1 In Bangladesh, marriages require dowries, paid by the bride’s family to the groom. For poor families, raising these dowries can be difficult and it is not easy to marry now and promise a dowry-by-installment later on. Making people live up to their promises and pay debts is no easier in Bangladesh than it is elsewhere in the world! The result? In hard times and among the poorer families, people in Bangladesh often marry cousins; promises within an extended family are more easily enforced and wealth sharing inside families is also more common. Now let us think about what happens when the government builds a flood embankment, allowing farmers on one side of the embankment to till the land over most of the year, while those on the other side are faced with six-month flooding. Farmers on the flooded side of the river continue to use marriage within the extended family as a strategy to essentially provide dowries on credit. For those farmers on the more stable side of the river, cousin marriages fell quite substantially. Marriage of cousins can have health risks, thus investments in rural infrastructure can have unforeseen positive effects in an area. CRITICAL THINKING 1. What do you think happens to the overall marriage rate as a result of the embankment? 1Ahmed Mushfiq Mobarak, Randall Kuhn, and Christina Peters, “Consanguinity and Other Marriage Market Effects of a Wealth Shock in Bangladesh,” Demography, forthcoming 2013. period.11 Similar results were found in an experiment which gave random subsidies to workers in Bangladesh to outmigrate from the farm area to the city during the lean period of the farm year.12 This work suggests that one way to improve growth in a developing country is to invest TABLE 20.2 The Structure of Production in Selected Developed and Developing Economies, 2008 Per-Capita Gross National Income (GNI) Agriculture Industry Services Percentage of Gross Domestic Product $ 460 570 3,040 3,640 4,640 7,490 21,430 37,840 47,890 30 19 11 12 8 6 3 1 1 23 29 47 44 35 28 36 27 21 47 52 40 44 57 66 61 71 78 Country Tanzania Bangladesh China Thailand Colombia Brazil Korea (Rep.) Japan United States Source: The World Bank. 11Gharad Bryan and Melanie Morton, “The Aggregate Productivity effects of Internal Migration: Evidence from Indonesia,” Journal of Political Economy, forthcoming. 12Gharad Bryan, Shymal Chowdhury and Ahmed Mushfiq Mobarak, “Underinvestment in a Profitable Technology: The Case of Seasonal Migration in Bangladesh,” Econometrica, 2014. M20_CASE3826_13_GE_C20.indd 419 17/04/19 5:34 PM 420 PART V The World Economy import substitution An industrial trade strategy that favors developing local industries that can manufacture goods to replace imports. export promotion A trade policy designed to encourage exports. in transportation networks or other mechanisms to reduce the costs of moving between rural and urban areas. Exports or Import Substitution? Trade strategy is often a central part of a country’s development program. Development economists have historically described two alternatives for the sectors a developing country might wish to support with government policy: import substitution or export promotion. While modern development economists typically take a more inclusive approach to growth initiatives by the government, it is still useful to highlight the differences in these two polar cases. Import substitution is a strat
egy used to develop local industries that can manufacture goods to replace imports. If fertilizer is imported, import substitution calls for a domestic fertilizer industry to produce replacements for fertilizer imports. This strategy gained prominence throughout South America in the 1950s. At that time, most developing nations exported agricultural and mineral products, goods that faced uncertain and often unstable international markets. Under these conditions, the call for import substitution policies was understandable. Special government actions, including tariff and quota protection and subsidized imports of machinery, were set up to encourage new domestic industries. Multinational corporations were also invited into many countries to begin domestic operations. Most economists believe that import substitution strategies have failed almost everywhere they have been tried. With domestic industries sheltered from international competition by high tariffs (often as high as 200 percent), major economic inefficiencies were created. For example, Peru has a population of approximately 29 million, only a tiny fraction of whom can afford to buy an automobile. Yet at one time, the country had five or six different automobile manufacturers, each of which produced only a few thousand cars per year. The cost per car was much higher than it needed to be because there are substantial economies of scale in automobile production, and valuable resources that could have been devoted to another, more productive, activity were squandered producing cars. As an alternative to import substitution, some nations have pursued strategies of export promotion. Export promotion is the policy of encouraging exports. As an industrial market economy, Japan was a striking example to the developing world of the economic success that exports can provide. Japan had an average annual per-capita real GDP growth rate of roughly 6 percent per year from 1960 to 1990. This achievement was, in part, based on industrial production oriented toward foreign consumers. Several countries in the developing world have attempted to emulate Japan’s early success. Starting around 1970, Hong Kong, Singapore, Korea, and Taiwan began to pursue export promotion of manufactured goods with good results. Other nations, including Brazil, Colombia, and Turkey, have also had some success at pursuing an outward-looking trade policy. China’s growth has been mostly export-driven as well. Government support of export promotion has often taken the form of maintaining an exchange rate favorable enough to permit exports to compete with products manufactured in developed economies. For example, many people believe China has kept the value of the yuan artificially low. Because a “cheap” yuan means inexpensive Chinese goods in the United States, sales of these goods increased dramatically. As Joseph Stiglitz recently pointed out, enthusiasm for export-led manufacturing growth has diminished somewhat as the share of manufacturing in world GDP has diminished. 13 In the case of Africa, a number of economists and policy leaders see promise in improving productivity in agriculture as a path to economic growth. A big issue for countries growing or trying to grow by selling exports on world markets is free trade. African nations in particular have pushed for reductions in tariffs imposed on their agricultural goods by Europe and the United States, arguing that these tariffs substantially reduce Africa’s ability to compete in the world marketplace. Microfinance In the mid-1970s, Muhammad Yunus, a young Bangladeshi economist created the Grameen Bank in Bangladesh. Yunus, who trained at Vanderbilt University and was a former professor at Middle Tennessee State University, used this bank as a vehicle to introduce microfinance to the developing world. In 2006, Yunus received a Nobel Peace Prize for his work. 13Joseph Stiglitz, “From Manufacturing Led Export Growth to a 21st Century Inclusive Growth Strategy for Africa,” Speech in Capetown South Africa, November 15, 2017. M20_CASE3826_13_GE_C20.indd 420 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 421 Microfinance is the practice of lending very small amounts of money, with no collateral, and accepting small savings deposits.14 It is aimed at introducing entrepreneurs in the poorest parts of the developing world to the capital market. By 2002, more than 2,500 institutions were making these small loans, serving more than 60 million people. Two thirds of borrowers were living below the poverty line in their own countries, the poorest of the poor. Yunus, while teaching economics in Bangladesh, began lending his own money to poor households with entrepreneurial ambitions. He found that with even small amounts of money, villagers could start simple businesses: bamboo weaving or hair dressing. Traditional banks found these borrowers unprofitable: The amounts were too small, and it was too expensive to figure out which of the potential borrowers was a good risk. With a borrower having no collateral, information about his or her character was key but was hard for a big bank to discover. Local villagers, however, typically knew a great deal about one another’s characters. This insight formed the basis for Yunus’s microfinance enterprise. Within a village, people who are interested in borrowing money to start businesses are asked to join lending groups of five people. Loans are then made to two of the potential borrowers, later to a second two, and finally to the last. As long as everyone is repaying their loans, the next group receives theirs, but if the first borrowers fail to pay, all members of the group are denied subsequent loans. What does this do? It makes community pressure a substitute for collateral. Moreover, once the peer-lending mechanism is understood, villagers have incentives to join only with other reliable borrowers. The mechanism of peer lending is a way to avoid the problems of imperfect information described in a previous chapter. The Grameen model grew rapidly. By 2002, Grameen was lending to two million members. Thirty countries and 30 U.S. states have microfinance lending copied from the Grameen model. Relative to traditional bank loans, microfinance loans are much smaller, repayment begins quickly, and the vast majority of the loans are made to women (who, in many cases, have been underserved by mainstream banks). A growing set of evidence shows that providing opportunities for poor women has stronger spillovers in terms of improving the welfare of children than does providing comparable opportunities for men. More recently small deposit savings accounts have also been introduced to the under-banked populations in the developing world. Although the field of microfinance has changed considerably since Yunus’s introduction and many people question how big a role it will ultimately play in spurring major development and economic growth, it has changed many people’s views about the possibilities of entrepreneurship and access to financial institutions more generally for the poor of the world. Two Examples of Development: China and India MyLab Economics Concept Check China and India provide two interesting examples of rapidly developing economies. Although low per-capita incomes still mean that both countries are typically labeled developing as opposed to developed countries, many expect that to change in the near future. In the 25-year period from 1978 to 2003, China grew on average, 9 percent per year, a rate faster than any other country in the world. Even during the 2008–2009 U.S. recession, China continued to grow, and it has continued to do so. While India’s surge has been more recent, in the last eight years, it too has seen annual growth rates in the 6 to 8 percent range. Many commentators expect India and China to dominate the world economy in the 21st century. How did these two rather different countries engineer their development? Consider institutions: India is a democratic country, has a history of the rule of law, and has an Englishspeaking heritage—all factors typically thought to provide a development advantage. China is still an authoritarian country politically, and property rights are still not well established—both characteristics that were once thought to hinder growth. Both China and India have embraced free-market economics, with China taking the lead as India has worked to remove some of its historical regulatory apparatus. What about social capital? Both India and China remain densely populated. Although China is the most populous country in the world, India, with a smaller land mass, is the more densely 14An excellent discussion of microfinance is contained in Beatriz Armendariz de Aghion and Jonathan Morduch, The Economics of Microfinance, (MIT Press, 2005.) M20_CASE3826_13_GE_C20.indd 421 17/04/19 5:34 PM 422 PART V The World Economy Boosting Agricultural Income Through Digital Finance Poverty in India is a major issue, especially in rural areas, where around two-thirds of the country’s population lives. Around half of India’s population is employed in the agriculture sector, and more than 58 percent of rural households are dependent on agriculture as their primary source of livelihood. Most of the rural population in India is engaged in smallholder subsistence agricultural production. Mostly consisting of small farmers, this demographic is unlikely to engage with agriculture-related technology or information. Moreover, such farmers do not have adequate access to credit, insurance, or marketing services. If these services were to be provided properly, the levels of crop productivity and profitability are apt to rise. In an effort to provide adequate and easily accessible financial infrastructure, the Indian government is pursuing efforts to digitalize the agriculture sector. A primary reason behind this strategy is that around 70 percent of farmers in India own a mobile phone, and t
his allows the government to offer digital finance to this sector. Through digital finance, mobile payments provide a secure and cost-effective method for financial transactions in the agricultural sector, particularly for smallholder farms. Mobile phones can connect farmers through a digital platform to help them consolidate their bargaining power and sell their crops at better prices to buyers all over India. Farmers can also secure immediate reimbursement from buyers as they use mobile wallets instead of cash. Similarly, banks dedicated to rural credit and microfinance can benefit from lower administrative costs and fewer cash transactions. This, in turn, can give unbanked farmers access to loans as lenders can start to assess credit risk. Moreover, the Government would be able to increase its resources through tax collection as all payments and transactions can now be traceable. Many developing nations have successfully designed schemes to use mobile phones to generate and disseminate information from geo-imaging services, akin to Google Earth, to warn farmers against weather conditions such as droughts, storms, or heat waves. A 2016 report from the McKinsey Global Institute found that the full adoption of digital finance could increase the collective GDPs of all developing economies by a total of €3 trillion and create up to 95 million jobs by 2025. CRITICAL THINKING 1. With the help of aggregate demand and aggregate supply diagrams, explain the impact of digital finance on the price and quantity of agricultural products. populated. Nevertheless, as is true in most developing nations, birth rates in both countries have fallen. Literacy rates and life expectancy in China are quite high, in part a legacy from an earlier period. India, on the other hand, has a literacy rate that is less than that of China’s and a lower life expectancy. In terms of human capital, China appears to have the edge, at least for now. What about the growth strategies used by the two countries? China has adopted a pragmatic, gradual approach to market development, sharply in contrast to that adopted some years ago in Poland. China’s approach has been called moshi guohe, or “crossing the river by feeling for stepping stones.” In terms of sector, most of China’s growth has been fueled by manufacturing. The focus on manufacturing is one reason that China’s energy consumption and environmental issues have increased so rapidly in the last decade. In India, services have led growth, particularly in the software industry. In sum, it is clear from comparing India and China that there is no single recipe for development. 20.3 LEARNING OBJECTIVE Discuss the intervention methods used by development economists. Development Interventions In the last 20 years, development economists have increasingly turned to much narrower, more microeconomically oriented programs to see if they can figure out which interventions help the condition of the bottom of the income distribution in developing countries. This work has moved away from a search for general recipes for growth and development. M20_CASE3826_13_GE_C20.indd 422 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 423 Random and Natural Experiments: Some New Techniques in Economic Development MyLab Economics Concept Check Suppose we were trying to decide whether it was worthwhile in terms of student achievement to hire another teacher to reduce the student–faculty ratio. One traditional way we might try to answer that question is to find two classrooms with different enrollments in otherwise similar school systems and look at the educational performance of the students. We see comparisons of this sort everyday in newspaper discussions of policies, and many research projects take a variant of this approach, but the approach is subject to serious criticism. It is possible that differences in the two classrooms beyond the enrollment numbers also matter to performance—differences we have failed to correct in the comparisons we make. Crowded classrooms may be in poorer areas (indeed, this may account for the crowding); they may have less effective teachers; they may lack other resources. In the social sciences, it is difficult to ensure that we have comparisons that differ only in the one element in which we are interested. The fact that our interventions involve people makes it even harder. In the case of the classrooms with small enrollment, it may well be that the most attentive parents have pushed to have their children in these classrooms, believing them to be better. Perhaps the best teachers apply to lead these classrooms, and their higher quality makes it more likely that they get their first choice of classrooms. If either of these things happens, the two classrooms will differ in systematic ways that bias the results in favor of finding better performance in the smaller classrooms. More attentive parents may provide home support that results in better test outcomes for their children even if the classrooms are crowded. Better teachers improve performance no matter how crowded the classrooms are. Moreover, in many cases, the differences in the two classrooms—like more attentive parents and teachers—may be impossible to measure. Problems of this sort, sometimes called selection bias, plague social science research. In recent years, a group of development economists began using a technique borrowed from the natural sciences, the random experiment, to try to get around the selection problem in evaluating interventions. Instead of looking at results from classrooms that have made different choices about class size or textbooks, for example, the experimenters randomly assign otherwise identical-looking classes to either follow or not follow an intervention. Students and teachers are not allowed to shift around. By comparing the outcomes of large numbers of randomly selected subjects with control groups, social scientists hope to identify effects of interventions in much the same way natural scientists evaluate the efficacy of various drugs. The leading development group engaged in random experiments in the education and health areas is the Poverty Research Lab at MIT, run by Esther Duflo and Abhijit Banerjee. By working with a range of nongovernmental organizations (NGOs) and government agencies in Africa, Latin America, and Asia, these economists have looked at a wide range of possible investments to help improve outcomes for the poorest of the poor. Of course, not all policies can be evaluated this way. Experimenters do not always have the luxury of random assignment. An alternative technique is to rely on what have been called natural experiments to mimic the controlled experiment. Suppose I am interested in the effect of an increase in wealth on the likelihood that a poor family will enroll its daughters in school. Comparing school behavior of rich and poor families is obviously problematic because they are likely to differ in too many ways to control adequately. It is also not feasible to substantially increase the wealth of a large number of randomly selected parents, but in an agrarian community we may observe random, annual weather occurrences that naturally lead to occasional years of plenty, and by observing behavior in those years versus other years, we may learn a good deal. The weather in this case has created a natural experiment. Empirical development economics thus has added experimental methods to its tool kit as a way to answer some of the difficult and important questions about what does and does not work to improve the lot of the poor in developing nations. We turn now to look at some of the recent work in the fields of education and health, focusing on this experimental work, to provide some sense of the exciting work going on in this field. Education Ideas MyLab Economics Concept Check As we suggested, human capital is an important ingredient in the economic growth of a nation. As economies grow, returns to education also typically grow. As we move from traditional agrarian economies to more diversified and complex economies, the advantages to an random experiment (Sometimes referred to as a randomized experiment) A technique in which outcomes of specific interventions are determined by using the intervention in a randomly selected subset of a sample and then comparing outcomes from the exposed and control groups. natural experiment Selection of a control versus experimental group in testing the outcome of an intervention is made as a result of an exogenous event outside the experiment itself and unrelated to it. M20_CASE3826_13_GE_C20.indd 423 17/04/19 5:34 PM 424 PART V The World Economy individual from education rise. So if we want a nation’s poor to benefit from growth, improving their educational outcomes is key. This leads us to one of the central preoccupations of development economists in the last decade or so: Of the many investments one could make in education, which have the highest payoffs? Is it better to invest in more books or more teachers? How much does the quality of teachers matter? Are investments most important in the first years of education or later? In a world with limited resources in which educational outcomes are very important, getting the right answers to these questions is vital. For most middle-class U.S. students, it may come as a surprise that in the developing world, teacher absenteeism is a serious problem. A recent study led by researchers from the World Bank found, for example, that on an average day, 27 percent of Ugandan and 25 percent of Indian teachers are not at work. Across six poor countries, teacher absences averaged 19 percent. The Poverty Research Lab has conducted a number of experiments in a range of developing countries to see how one might reduce these absences. One successful intervention was introduced in Rajasthan, India, by an NGO called Seva Mandir. Each day when he or she arrived, the teachers in half
of Seva Mandir’s 160-single teacher schools were asked to have their picture taken with the children. Cameras were date-stamped. This evidence of attendance fed into the compensation of the teacher. Teacher absentee rates were cut in half relative to the seemingly identical classrooms in which no cameras were introduced. Student absenteeism is also a problem throughout the developing world, reducing educational outcomes even when schools are well staffed with qualified teachers. Several countries, including Mexico, have introduced cash payments to parents for sending their children to school regularly. Since the Mexican government introduced these payments over time, in ways not likely to be related to educational outcomes, researchers could compare student absenteeism across seemingly identical areas with and without the cash incentives as a form of natural experiment. There is some evidence that cash payments do increase school attendance. Natural experiments have also been used to look at the effect of industrialization that improves educational returns as a way to induce better school attendance; the results have been positive. Work using experiments, both natural and random, is still at an early stage in development economics. Although many reform ideas have proven helpful in improving educational outcomes in different developing countries, it has proven hard up to now to find simple answers that work across the globe. Nevertheless, these new techniques appear to offer considerable promise as a way of tackling issues of improving education for the poor of the developing world. Health Improvements MyLab Economics Concept Check Poor health is a second major contributor to individual poverty. In the developing world, estimates are that one quarter of the population is infected with intestinal worms that sap the energy of children and adults alike. Malaria remains a major challenge in Africa, as does HIV/AIDS. In the case of many interventions to improve health, human behavior plays an important role, and here is where development economics has focused. For many diseases, we have workable vaccines, but we need to figure out how to encourage people to walk to health clinics or schools to get those vaccines. We want to know if charging for a vaccine will substantially reduce uptake. For many waterborne diseases, treatment of drinking water with bleach is effective, but the taste is bad and bleach is not free. How do we induce usage? Treated bed nets can reduce malaria, but only if they are properly used. In each of these cases, there are benefits to the individual from seeking treatment or preventive care, but also costs. In the last several years, a number of development economists have explored the way in which individuals in developing economies have responded to policies that try to change these costs and benefits. Intestinal worms, quite common in areas of Africa with inadequate sanitation, are treatable with periodic drugs at a relatively low cost. Michael Kremer and Ted Miguel, working with the World Bank, used random experiments in Kenya to examine the effect of health education and user fees on families’ take-up of treatment of their children. Kremer and Miguel found a number of interesting results very much in keeping with economic principles. First, a program of charging user fees—even relatively low ones—dramatically reduced treatment rates. The World Bank’s attempts to make programs more financially self-sustaining, if used in this area, were likely to have large, adverse public health effects. Elasticities were well above one. Kremer and Miguel also found that as the proportion of vaccinated people in a village grew, and thus the risk of contagion M20_CASE3826_13_GE_C20.indd 424 17/04/19 5:34 PM CHAPTER 20 Economic Growth in Developing Economies 425 fell, fewer people wanted treatment, indicating some sensitivity to costs and benefit calculations by the villagers. Disappointingly, health education did not seem to make much difference. As with the area of education, much remains for development economists to understand in the area of health and human behavior. Development economics continues to be one of the most exciting areas in economics. S U M M A R Y 1. The economic problems facing the Global South, the developing countries, are often quite different from those confronting industrialized nations. of private property, the law and financial reporting to enable the allocation of capital across unrelated individuals. 20.1 LIFE IN THE DEVELOPING NATIONS: POPULATION AND POVERTY p. 412 2. The UN in its Millennium Development Goals identified a number of areas of concern in the developing world: hunger, literacy, child mortality, maternal mortality, diseases like HIV and malaria, gender equality, and environmental quality. In the 15 years of the program from 2000 to 2015, considerable progress was made on each of the UN’s goals, though many challenges remain. 20.2 ECONOMIC DEVELOPMENT: SOURCES AND STRATEGIES p. 413 3. Almost all developing nations have a scarcity of physical capital relative to other resources, especially labor. The poverty trap or vicious-circle-of-poverty hypothesis says that poor countries cannot escape from poverty because they cannot afford to postpone consumption—that is, to save— to make investments. There is debate as to how widespread the poverty trap is and what the right prescription is to solve the problem. 4. Human capital—the stock of education and skills em- bodied in the workforce—plays a vital role in economic development. 5. Developing countries are often burdened by inadequate infrastructure or social overhead capital, ranging from poor public health and sanitation facilities to inadequate roads, telephones, and court systems. Such social overhead capital is often expensive to provide, and many governments are not in a position to undertake many useful projects because they are too costly. 6. Inefficient and corrupt bureaucracies also play a role in retarding economic development in places. 7. Moving to a sophisticated market economy requires government support and regulation of institutions 8. Evidence indicates that in developing nations labor productivity is considerably higher in the industrial urban setting. Some economists suggest easing migration costs as a strategy for growth. 9. Import-substitution policies, a trade strategy that favors developing local industries that can manufacture goods to replace imports, were once common in developing nations. In general, such policies have not succeeded as well as those promoting open, export-oriented economies. 10. Microfinance—lending small amounts to poor borrow- ers using peer lending groups—has become an important new tool in encouraging entrepreneurship in developing countries. 11. China and India have followed quite different paths in re- cent development. 20.3 DEVELOPMENT INTERVENTIONS p. 422 12. Development economists have begun to use randomized experiments as a way to test the usefulness of various interventions. In these experiments, modeled after the natural sciences, individuals or even villages are randomly assigned to receive various interventions and the outcomes they experience are compared with those of control groups. In the areas of education and health, random experiments have been most prevalent. 13. Development economists also rely on natural experiments to learn about the efficacy of various interventions. In a natural experiment, we compare areas with differing conditions that emerge as a consequence of an unrelated outside force. 14. Many of the newer economic studies focus on under- standing how to motivate individuals to take actions that support policy interventions: to use health equipment properly, to attend schools, to receive vaccinations brain drain, p. 415 capital flight, p. 414 export promotion, p. 420 Global South, p. 412 import substitution, p. 420 natural experiment, p. 423 random experiment, p. 423 social overhead capital, p. 417 vicious circle of poverty, p. 414 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M20_CASE3826_13_GE_C20.indd 425 17/04/19 5:34 PM 426 PART V The World Economy P R O B L E M S All problems are available on MyLab Economics. 20.1 LIFE IN THE DEVELOPING NATIONS: POPULATION AND POVERTY LEARNING OBJECTIVE: Discuss the characteristics of developing nations. 1.1 [Related to the Economics in Practice on p. 413] A paper released by the World Bank in 2014 states that while economic growth is essential for reducing poverty rates, growth by itself is not enough, and efforts to reduce poverty must be complemented with programs that devote more resources to the extreme poor. According to the paper, as extreme poverty declines, growth by itself tends to be less successful at lifting additional people out of poverty because at this point, many still suffering from extreme poverty find it very difficult to improve their lives. Do you agree with this assessment? Why or why not? What fundamental economic concept seems to be at play here? 1.2 The small West African nation of Equatorial Guinea is designated as an upper middle-income country by the World Bank, with a GNI per capita of more than $7,000 when measured in U.S. dollars. Equatorial Guinea also has a poverty rate of more than 76 percent, one of the highest rates in the world. Life expectancy at birth is only 64 years, and the infant mortality rate is almost 7 percent. Do some research on Equatorial Guinea and try to explain the apparent discrepancies listed above for this high-income country. 20.2 ECONOMIC DEVELOPMENT: SOURCES AND STRATEGIES LEARNING OBJECTIVE: Describe the sources of economic development. 2.1 For a developing country to grow, it needs capital. The major source of capital in most countries is domestic saving, but the goal of stimulating domestic saving usually is in conf
lict with government policies aimed at reducing inequality in the distribution of income. Comment on this trade-off between equity and growth. How would you go about resolving the issue if you were the president of a small, poor country? 2.2 The GDP of any country can be divided into two kinds of goods: capital goods and consumption goods. The proportion of national output devoted to capital goods determines, to some extent, the nation’s growth rate. a. Explain how capital accumulation leads to economic growth. b. Briefly describe how a market economy determines how much investment will be undertaken each period. c. Consumption versus investment is a more painful conflict to resolve for developing countries. Comment on that statement. d. If you were the benevolent dictator of a developing country, what plans would you implement to increase percapita GDP? 2.3 Poor countries are trapped in a vicious circle of poverty. For output to grow, they must accumulate capital. To accumulate capital, they must save (consume less than they produce). They are poor, so they have little or no extra output available for savings—it must all go to feed and clothe the present generation. Thus they are doomed to stay poor forever. Comment on each step in that argument. 2.4 In China, rural property is owned collectively by the village while being managed under long-term contracts by individual farmers. Why might this be a problem in terms of optimal land management, use, and allocation? 2.5 An offshoot of microfinance that has grown significantly over the past several years is an idea known as crowdfunding. With crowdfunding, individuals, businesses, and communities seek monetary support for ideas or projects from other individuals, primarily over the Internet. Three of the largest and most successful crowdfunding Internet sites are GoFundMe, Kickstarter, and Indiegogo, and while the use of the term “crowdfunding” is relatively new and associated with online sites such as these, the concept has been around for many years, with projects such as the pedestal on which the Statue of Liberty resides being constructed using this style of funding. Do some research on crowdfunding and explain whether you believe crowdfunding is a viable alternative to microfinance in poor countries such as Bangladesh. Which source of peer lending, microfinance or crowdfunding, do you believe would be the most successful at reducing the problem of adverse selection? Why? 2.6 [Related to the Economics in Practice on p. 422] Find another example of the use of cell phones as a way to improve market functioning in a developing economy. 2.7 [Related to the Economics in Practice on p. 416] Corruption in a government is often accompanied by inefficiency in the economy. Why should this be true? 2.8 The distribution of income in a capitalist economy is likely to be more unequal than it is in a socialist economy. Why is this so? Is there a tension between the goal of limiting inequality and the goal of motivating risk taking and hard work? Explain your answer in detail. 2.9 Although brain drain is generally associated with develop- ing countries, the recent debt crisis in Greece has generated an exodus of highly educated human capital from this country. In Greece, college education is paid for by the government, and it is estimated that roughly 10 percent of the country’s college-educated workforce have left the country, a majority of which are less than 40 years of age. What implications does this flight of human capital have on growth prospects for the Greek economy? How does the fact that the government pays for college exacerbate MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M20_CASE3826_13_GE_C20.indd 426 17/04/19 5:34 PM this problem? Do some research to find out what has happened to Greek GDP in recent years and what the forecast is for GDP in the near future, and see if this supports your answer. 2.10 [Related to the Economics in the Practice on p. 419] In addition to fewer marriages within extended families, explain what other positive effects are likely to occur in the rural, flood-prone areas of Bangladesh because of increased government spending on infrastructure projects like the building of river embankments and the resulting increase in wealth of the affected rural population. 2.11 Explain how each of the following can limit the economic growth of developing nations. a. A lack of savings and investment b. Unskilled labor c. A lack of social overhead capital 2.12 You have been hired as an economic consultant for the nation of Ishtar. Ishtar is a developing nation that has recently emerged from a 10-year civil war; as a result, it has experienced appreciable political instability. Ishtar has a serious lack of capital formation, and capital flight has been a problem since before the civil war began. As an economic consultant, what policy recommendations would you make for the economic development of Ishtar? 20.3 DEVELOPMENT INTERVENTIONS LEARNING OBJECTIVE: Discuss the intervention methods used by development economists. 3.1 As the text states, investment in human capital is an important ingredient for a nation’s economic growth. The data in the following table shows the net enrollment rates in primary school as a percentage of the relevant group for 10 developing countries in 1999 and 2016. Go to http:// CHAPTER 20 Economic Growth in Developing Economies 427 data.worldbank.org and look up per capita GDP for these 10 countries for 1999 and 2016. (Search for GDP per capita [current $US] data.) Calculate the percent changes in per capita GDP from 1999 to 2016 for these 10 countries. Do the changes in per capita GDP seem to correlate with the changes in enrollment rates? What besides increased enrollment may be responsible for the changes in per capita GDP? Net enrollment rate, primary school, percent of relevant group Country 1999 2016 Percent change Burkina Faso Cote d’Ivoire Djibouti The Gambia Ghana Lesotho Mali Niger Senegal Togo 36 57 27 75 62 59 44 26 55 89 76 88 52 76 87 81 62 64 72 87 111 54 93 1 40 37 41 146 31 -2 Source: The World Bank 3.2 The text mentions that in the developing world, teacher absenteeism is a serious problem, averaging 19 percent across six poor countries. An article in the Journal of Economic Perspectives states that absenteeism of health care workers in five of those countries where data was available averages 35 percent, or almost double the rate of teacher absence. Suggest some ways that developing countries might try to successfully reduce the high absentee rates of health care workers, and any possible problems they may encounter in implementing your suggestions. Source: Nazmul Chaudhury, Jeffrey Hammer, Michael Kremer, Karthik Muralidharan, and F. Halsey Rogers, “Missing in Action: Teacher and Health Worker Absence in Developing Countries,” Journal of Economic Perspectives, 20, no. 1, Winter 2006, pp 91–116 QUESTION 1 Property Rights and the Rule of Law are considered essential for promoting economic growth in developing countries. How do these two features promote economic growth? QUESTION 2 A commonly discussed problem among the global poor is the lack of a credit history. How would this hold poorer households back in terms of increasing their income and wealth? MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M20_CASE3826_13_GE_C20.indd 427 17/04/19 5:34 PM PA RT VI METHODOLOGY 21 Critical Thinking about Research CHAPTER OUTLINE AND LEARNING OBJECTIVES 21.1 Selection Bias p. 429 Give some examples of studies that might suffer from selection bias. 21.2 Causality p. 430 Understand the difference between correlation and causation. 21.3 Statistical Significance p. 437 Understand how researchers decide whether their results are meaningful. 21.4 Regression Analysis p. 438 Understand how regression analysis can be used for both estimation and testing. 428428 Throughout this book we have highlighted the many areas in which economists use data and statistical methods to answer questions that are important to households, businesses, and government policymakers. Some of these questions are narrow: What happens to the sales of ketchup when the manufacturer raises its price? How much will charging a small fee for a vaccine in a developing country affect vaccination rates? Others are much broader: Will a large unexpected fall in housing prices have a substantial effect on household consumption? What happens to employment if we raise the minimum wage? These are all questions that we can begin to answer with economic theory, as you have seen in this text. To get quantitative answers to questions like these, we need to use statistical methods to look at real world data. In this chapter we provide an introduction to the tools economists and other social scientists use to look at data. We will focus both on the standard techniques used and on some of the most common pitfalls associated with using data to answer complex questions. The statistical tools that economists use to analyze issues are an important part of the discipline. If you go on in economics, you will learn much more about these tools. For those of you who do not continue to study economics, we hope the introduction here will allow you to be a more discriminating consumer of the economic research that you see described in the media and elsewhere. The techniques you will learn in this chapter are used in many fields other than economics. Psychology, political science, some historical research, some sports research, and some medical research also use these techniques. M21_CASE3826_13_GE_C21.indd 428 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 429 21.1 LEARNING OBJECTIVE Give some examples of studies that might
suffer from selection bias. selection bias Selection bias occurs when the sample used is not random. survivor bias Survivor bias exists when a sample includes only observations that have remained in the sample over time making that sample unrepresentative of the broader population. Selection Bias We all know that people slow down physically as they age. World records in track and field are not set by 45-year-olds. Few professional baseball players continue to play after the age of 45. Yet consider this: In the 2013 Chicago marathon, the average time of the 30- to 39-age group for men was 4 hours and 17 minutes, which was essentially the same as the average time of the 40- to 49age group for men of 4 hours and 18 minutes. What do we make of this? Should we conclude, for example, that in the marathon there is essentially no slowing down in the 10-year age interval between the mid-30s and the mid-40s? Or say you came across a study that randomly sampled 1,000 70-year-old men and 1,000 90-year-old men and measured their bone density. Can we compare the average bone density of the 70-year-olds to that of the 90-year-olds to estimate how much bone density on average declines with age? The answer to both questions is no. In both cases, there is a substantial likelihood of selection bias, which results in unreliable answers. There are many aged 30–39 ham-and-eggers running the Chicago marathon, but many fewer casual runners aged 40–49. Many people aged 30–39 run for fun, to impress a friend, or to pay off a bet. Many of these casual runners have probably selected out by age 40. Moreover, one reason people select out or stop running is that they discover they are not good runners. As a result, the average runner left in the age 40- to 49-interval is likely to be a better runner than the average runner in the age 30- to 39-interval. It is thus not surprising that there is little change in the average times between runners in the two age intervals, but this says nothing about how fast a particular runner slows down with age. We are in some sense comparing apples and oranges in looking at the two groups. Selection bias would also exist in the bone density study. There are fewer 90-year-old men than there are 70-year-olds. Those with lower bone density at age 70 are more likely to have fallen, broken a hip and passed away. The men left in the population age by 90 disproportionately will thus consist of those who at younger ages had higher bone densities. So it would not be sensible to compare the average bone density of the two samples. This comparison would tell us nothing about how bone density changes with age for a particular person. The type of selection bias in these two examples is also called survivor bias, for obvious reasons. The more fit in the populations have survived, so there is a bias in comparing younger and older groups. Similar problems arise in financial markets when we make inferences about corporate returns in the general market from a population of firms that has survived in the market for a long period. Firms that survive are typically different, generally more successful, than the average firm. Apple, which has survived for a number of years, is surely different in its ability to deliver innovative products that people want than the average company. The problem of selection bias pervades many studies in economics (and other disciplines). In recent years there has been considerable interest in trying to understand and improve educational outcomes in the United States. In many areas, charter schools have grown up in part to experiment with alternative educational methods. Charter schools are publicly funded, providing free education to their students, but operate independently of the traditional school district and thus have more autonomy in terms of choices around teacher selection, school hours, and pedagogy. Naturally, there has been considerable interest in how these different charter schools are performing. It might occur to you that one way to answer this question is to compare the scores of students in charter versus traditional schools in an area on the common mastery tests now given across all schools in the United States. Indeed, we see comparisons of this sort often in local newspapers, but here too in making this comparison, you would be running into the problem of selection bias. Where does the bias come in here? In most charter systems, students are randomly chosen to attend the school. You might think this would eliminate the selection bias problem. Unfortunately, that random choice does not fully eliminate the problem. In most charter systems, to be chosen in the lottery you must apply in the first place. Families who apply to a lottery for a charter school may well differ considerably from those who do not apply. Those differences—more attention to education, more organizational skills, and so on—are both likely to matter to educational performance and will be hard for us to observe. In other words, children who apply to a charter school may do better on the mastery tests than the average child, even if he or she does not get chosen to attend the charter! As we will see in a later section, there are ways around this selection problem but they require some ingenuity. M21_CASE3826_13_GE_C21.indd 429 17/04/19 4:29 AM 430 PART VI Methodology One more example may help to show the range of the issues involved. Many studies in the medical area are aimed at helping us figure out how to live longer and healthier lives. Suppose you were interested in the effect on longevity of exercise. Luckily, you found a long-term study that tracked how often people exercised over many years and found that those people who exercised more also lived longer. Should you conclude that exercise in fact increases life span? The answer is again no. In this example we are comparing a group of people who chose to exercise with a group who chose not to. The fact that a group of people do or do not choose to exercise tells us that they likely differ on many other grounds that might independently affect life span. People who choose to exercise also likely make other healthy choices, most of which will be hard for a researcher to observe. So the longevity edge might come from the fact that one group exercised, whereas the other did not, but it might equally have arisen from the fact that the first group consists of people who make healthy choices while the second does not. A common problem in many of these cases is that we are comparing groups who not only engaged in different activities, activities whose effect we seek to measure, but people who made different choices. To the extent that those choices reflect group differences that themselves matter to the outcomes we are measuring, we bias (or distort) our results. In the last few years, economists have become increasingly sensitive to the problem of selection bias and have engaged in many creative ways to try to eliminate the bias problem. We will describe some of the solutions to the bias problem later in this chapter. For now, we hope you will look at some of those newspaper headlines with a more skeptical eye! 21.2 LEARNING OBJECTIVE Understand the difference between correlation and causation. Causality As we have seen, selection bias makes it difficult to identify the effect of a treatment on a population. In other words, selection makes it hard to pin down causal effects. Identifying causality is a general issue in data analysis and goes beyond problems that arise because of selection bias. We will consider a number of causality issues in this section. correlated Two variables are correlated if their values tend to move together. Correlation versus Causation MyLab Economics Concept Check Most people who have blue eyes also have light colored hair. Most people who have minivans also have children. Evidence suggests that people who are obese have a disproportionate number of obese friends. What can we conclude from these facts? Do blue eyes cause blond hair? Do minivans cause people to have children? Is obesity contagious, caught from one’s friends? When two variables tend to move together, we say they are correlated. If the two variables tend to move in the same direction, we say they are positively correlated, and if they tend to move in opposite directions, we say they are negatively correlated. In the examples above, the variables in each of the three sets are positively correlated; but correlation does not imply causation. It does not take a degree in biology to know that blue eyes do not cause blond hair. Likely evolution has selected simultaneously on these two features causing them to appear together. Dumping a bottle of peroxide on my head, although it will surely make me a blond, will not change my eye color at all! In economics, as well as in other fields, theory is often quite helpful in helping us to differentiate between correlation and causality. Minivans and children provide another example in which we need to sort out correlation and causation. In the data we see that the majority of minivan owners have children. Clearly minivans do not often cause children to be born (“Might as well have a fourth child. We already own a minivan!”). Here it is likely the causality runs in the opposite direction. Minivans are most attractive to families with children. So having children may indeed cause people to buy a minivan. Think now about why getting the causality right matters. If Japan, for example, wants to increase its very low birth rate, giving everyone a free minivan is not likely to be effective. Minivans do not by and large cause people to want children. Knowing the relationship between minivans and children is clearly relevant to automobile manufacturers who will want to exploit this relationship by focusing their marketing campaigns on families. An increase in average family size causes a shift in the demand for large minivans but the reverse is n
ot the case. M21_CASE3826_13_GE_C21.indd 430 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 431 The most complicated of the examples is obesity. Here there are theoretical arguments that support a hypothesis of causality running in both directions. Eating and exercise are social for many people, so having obese (or conversely thin) friends may well have an effect on your own weight. But in some circles at least obesity is a social stigma, and it may well be that being obese limits one’s choice of friends. Thus, it is plausible that having obese friends does increase your own chances of being obese, but it is also likely that being obese increases your chances of having obese friends. Identifying causality is critical for much policy work. Knowing that early exposure to reading is correlated with high adult incomes is interesting. Knowing that it causes high incomes suggests a policy intervention. Much empirical work in economics is concerned with trying to determine causality, given how important it is for policy issues. Let us consider a few ways researchers have used to identify causation. Random Experiments MyLab Economics Concept Check The gold standard for empirical work is the random experiment that many of you will be familiar with from medical research. If a research team is trying to decide if a particular drug helps in treating some form of cancer, for example, a standard protocol is to randomly divide the patients afflicted with the disease into two groups, provide one group with the drug, and give the other a placebo. With a large enough group, and enough time, one should be able to tell if the drug is effective. (Of course, there is much non-human pretesting for safety reasons). Notice in this protocol that we did not select our samples by asking people to choose whether they wanted to take the drug or not (all agreed to the drug). Indeed, part of a standard medical protocol is that patients do not know which group they are in during the experiment. In this type of experiment, we have no selection issue, since there has been no user selection. Experiments of this sort are also run in economics and are relatively prevalent in the area of economic development. To give an example, suppose we are interested in the effects of class size on educational achievement, say test scores. Comparing classes with large and small enrollments will clearly not be informative. Among other things, it is well known that classes in more affluent areas have smaller classes than those in poorer areas and that affluence will bring with it many advantages that likely lift test scores. Instead, one could run an experiment that randomly assigns students to classes that differ in enrollments and then later compare test scores for the different groups. If the assignments are truly random, there are no selection issues. Although random experiments are common, especially in the medical field, they are not always possible to carry out. Suppose we are interested in the link between smoking and cancer. We can, of course, take a large group of mice, randomly divide them into two groups, expose one but not the other to smoke, and see whether the two groups differ in their cancer incidence. As long as our sample is reasonably large, we should be able to see a difference in cancer rates if a causal relationship between smoking and cancer exists. We have done a random experiment just as we described. Notice how this experiment differs from just comparing cancer rates of smokers to non-smokers. People who smoke have chosen to smoke and may well have made a number of other choices that could be unhealthy. As hard as we try to control for those smoker/ nonsmoker differences, our ability to do so is limited. For the mice there are no choice problems to worry about. If we find that smoking causes cancer in mice; it remains to determine whether the same holds for people. Clearly, we cannot force a randomly chosen group of people to smoke and then see if their cancer rates differ from that of a control group. For many of the questions economists are interested in, it is difficult to use random experiments. Randomly exposing groups of people to something that is potentially harmful is unethical and would not pass a human subjects protocol review. Even if we are looking at interventions that have only potential benefits and no costs, we still face the problem that the randomly chosen subjects we start out with may decide not to join the study or to leave the experiment early. If this happens, the groups left will no longer be random. When there is some discretion among subjects to either take up a treatment offer or to continue in a treatment over time, selection bias will again potentially creep in to our experiment. What do we do under these circumstances? Consider a university that has admitted 200 at-risk students from households with low incomes. It has a summer program before college begins to better help prepare such students for M21_CASE3826_13_GE_C21.indd 431 17/04/19 4:29 AM 432 PART VI Methodology intention to treat A method in which we compare two groups based on whether they were part of an initially specified random sample subjected to an experimental protocol. college life. The university wants to know if this program improves a student’s four-year college performance, say measured by a student’s four-year GPA. How might it proceed? Assume that the university randomly samples 100 of the 200 at-risk students and invites them to attend the summer program at no cost. Say 60 accept the offer and take the summer program. After four years the GPAs of all the 200 students are collected and we learn that the average GPA of the 60 students who took the program was higher than the average GPA of the 140 students who did not take the course. Could you conclude from this that the program had a positive effect? No. Once again, we have a selection issue. While the 100 students offered the program were indeed a random sample, the 60 students who took up the offer were not. Maybe the 60 were on average less talented than the 40 who refused the offer and felt the need to take the program, whereas the more talented 40 did not. Or maybe the 60 were on average more serious students or more organized. However the bias runs, we cannot assume that the 60 students who accepted are a random sample of the 200 initial students. Here we are not even sure if those who accept are better or worse than the non-accepters. That is, we do not know the direction of the bias. The group of the 100 students initially drawn and invited to join the program was random by design. So after four years we can compare the average GPA of the 100 students who were offered the program to the average GPA of the 100 students who were not. If the program has a positive effect, the first average GPA should be greater than the second. You might think this is an odd process for testing the efficacy of the summer program. After all, 40 of the students whose scores we are looking at did not take the program! If they did not take the program, why are they included in the average GPA along with actual program-takers? We include all students who were made the program offer in our test sample to avoid selection bias. This procedure, which is also used in medical experiments that have patient drop-outs, is called intention to treat, but proceeding this way does have a cost. Suppose only 10 students of the 100 took up our offer. In this case, we are comparing two random groups of students, one of which has no one taking the program and the other with 10 in the program and 90 not. With so many non-takers, it will be hard to find any gains from the program. If instead all 100 students invited to the program actually enrolled, clearly we would have more confidence that we could find an effect from the program if any existed. Whatever the case, we need to compare the performance of the 100 offered students with that of the 100 non-offered to avoid selection bias. Notice that intention to treat makes it harder to find results from a treatment and in this sense is a conservative statistical technique. The Economics in Practice box describes an experiment run by the U.S Department of Housing and Urban Development (HUD) using randomly assigned housing vouchers to examine the effects of community on household well being. Here the method of intention to treat is used. Regression Discontinuity MyLab Economics Concept Check In many situations economists do not answer their empirical questions with random experiments, but rather try to make inferences from market data, data that come out of the everyday transactions and choices individuals make. Using market data has a number of advantages: These data reflect real choices made in everyday life by households. Much of the data are collected as a matter of course by either government or business and so are easily available to researchers, but the fact that the data reflect individual choices, done in relatively uncontrolled settings, makes the identification of causality especially difficult. Carefully designed experiments, on the other hand, are expensive. There are a number of procedures that researchers have used to try to make progress in this area. The United States has more prisoners per capita than any other OECD country,1 with roughly two million incarcerated. Many of those released from prison are re-arrested within a short period of time. How does what happens while someone is in prison affect the likelihood they will be re-arrested? Do the conditions in prison affect recidivism rates?2 Arguments about 1The OECD is the Organisation for Economic Co-operation and Development. It consists largely of developed world countries, heavily weighted toward Europe. 2This discussion is based on M. Keith Chen and Jesse Shapiro, “Do Harsher Prison Conditions reduce Recidivism? A Discontinuity-based Approach.” American Law and Economics Review June
2007. M21_CASE3826_13_GE_C21.indd 432 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 433 Moving to Opportunity It is well known that children who grow up in high- poverty areas on average end up as adults with lower educational attainments, poorer health, lower income levels, and a higher likelihood of being incarcerated at some point in their lives. To what extent are these results attributable to the neighborhoods in which these children grow up, and, relatedly, how much could they be changed by a locational change? These are the very central policy questions posed by an experiment run by the U.S. Department of Housing and Urban Development in the mid-1990s and recently re-evaluated by a group of economists.1 The Moving to Opportunity program offered to randomly selected families living in high-poverty housing projects housing vouchers that they could use to move to lowerpoverty neighborhoods. The random granting of the vouchers was a direct attempt to avoid the selection bias problems found in earlier studies of housing and later outcomes. It is easy to see that if we simply look at life outcomes for children whose families move out of high-poverty areas to those who remain in those areas we will have serious selection bias issues. Moving families likely have more access to resources—perhaps ones we cannot observe—and perhaps more initiative or organizational ability than those who stay. Those differences might well have an effect on their children’s outcomes independent of the gains from the move. By randomizing the voucher choice, HUD attempted to remove the choice element. Not all families offered the vouchers moved, so the researchers used the intention-to-treat methodology described in the text to control for the potential selection bias. Early results from the experiment found little results on the economic well-being of moving families, though there were gains in mental and physical health. A longer-term, recently completed study by some of the same authors, which looked at tax data, found substantial effects on income levels of those children who were younger than 13 years of age when their families moved, with average gains of 31 percent higher incomes for the young movers. CRITICAL THINKING 1. Some of the same researchers whose work is described also did another study looking at the outcomes of households that moved versus those that did not in the general population. To control for selection bias, the researchers compared children of different ages within families to see how much more time in the better neighborhood influenced younger versus older children. How does this attenuate the selection bias issue? 1Raj Chetty, Nathaniel Hendren, Lawrence Katz, “The Effects of Exposure to Better Neighborhoods on Children: New Evidence for the Moving to Opportunity Experiment,” American Economic Review April 2016, 855–902. this question have been made on both sides. Some argue that harsh conditions reduce recidivism because the worse the conditions, the more incentivized released prisoners will be to stay out of prison. On the other side, harsh prison conditions may increase a taste for violence or reduce a prisoner’s future labor market value. This would suggest that harsh conditions increase recidivism. On questions like this, it is important to bring data and evidence to the table. What happens if we just compare recidivism rates in prisoners from more or less harsh prisons? Here again, identifying causality is problematic. In general, harsher prisons house more serious criminals. So, if we see more recidivism from those coming out of harsher prisons, it could well be that the recidivist traits caused the prison choice, rather than the prison type causing the recidivist traits. Chen and Shapiro used an interesting strategy, called regression discontinuity, to sort out causality. The design works as follows. Once an inmate is convicted and enters the federal prison system, he or she is given a security score. The score predicts the prisoner misconduct and security needs. regression discontinuity Regression discontinuity identifies the causal effects of a policy or factor by looking at two samples that lie on either side of a threshold or cutoff. M21_CASE3826_13_GE_C21.indd 433 17/04/19 4:29 AM 434 PART VI Methodology Control Groups and Experimental Economics Most economic interventions are made in response to an unsatisfactory situation based on inferences from available data. The aim of experimental evaluations, or randomized controlled trials (RCTs), is to establish an ideal comparison group by design from the beginning of an intervention. Government programs often use regression discontinuity to set a threshold for receiving treatment, allowing a researcher to use individuals very close to the threshold as a control group. A 2007 study by economists Esther Duflo, Rachel Glennerster, and Michael Kremer shows that impact assessment is complex and requires a comparison of the current situation of the beneficiaries of a policy to the situation they might have faced in lieu of the policy.1 Participants are randomly assigned to the treatment group or the comparison group, ensuring that there is almost no difference between the two groups. As established in the study, this implies that the outcome is not due to a systematic difference between the two groups that would have existed even without the application of the treatment. Since it is difficult to effectively compare beneficiaries to non-beneficiaries, it is not always possible to derive a useful conclusion of a measure. In fact, it may sometimes have detrimental consequences. According to the study (Duflo et al.), the way a control group is built may have a strong impact on the outcomes. So a decision maker may choose the results that best suit their situation, but derive limited effects. In 2009, Behaghel, Crépon, and Gurgand developed a new test for the effectiveness of a personalized support measure for the unemployed in France.2 The study found that comparable control groups are formed by drawing lots from a qualified population. By establishing two groups, the beneficiary and the non-beneficiary, the researchers could establish the efficiency of a policy and measure its impact on the declining unemployment levels In his article “Short-Run Subsidies and Long-Run Adoption of New Health Products: Evidence from a Field Experiment,” French economist Pascaline Dupas used an experimental approach to test the price elasticity of goods in the health sector in Africa.3 To do so, the difference between free and paid distribution of health products, which is a major debate for health policies, was tested. The approach used the regression discontinuity procedure, and provided 644 households with different vouchers, ranging from 0 to 250 Kenyan shillings, to purchase mosquito nets. The results showed that 98 percent of the population with a voucher for a free mosquito net did get the net while 50 percent of those who received a 50 shillings voucher actually purchased the net. Among those who would have to pay 190 and 250 Kenyan shillings, only 11 percent bought a mosquito net. The conclusion from such a study is that even in the health sector the price elasticity is very high. CRITICAL THINKING 1. Can you think of another situation for which a regression discontinuity technique might be useful? 1Esther Duflo, Rachel Glennerster, and Michael Kremer, “Méthodes d’évaluation des Politiques Publiques [Methods of Evaluation of Public Policies],” The Ministry of Labor, Employment and Health, France, June 2011; and “Using Randomization in Development Economics Research,” Centre for Economic Policy Research, January 2007. 2 Luc Behaghel, Bruno Crépon, J. Guitard, and Marc Gurgand, “Evaluation d’impact de l’accompagnement des demandeurs d’emploi par les op´erateurs priv´es de placement et le programme Cap vers l’entreprise,” [Impact of counselling unemployed jobseekers], September 2009. 3 Pascaline Dupas, “Short-Run and Long-Term Subsidies Adoption of New Health Products: Experimental Evidence from Kenya,” Stanford University, July 2013. There is no personal judgment in creating this score, which simply adds up points depending on the prisoner’s record. The score then determines prison facility based on availability of beds. Scores above six typically go to higher-security (and typically harsher) facilities. Placement also depends on bed space, and this means that prisoners with similar scores may end up in different types of prisons. Regression discontinuity effectively compares outcomes from individuals who are close to either side of a dividing line. In this example, we are effectively comparing recidivism rates for prisoners sent to harsh versus less harsh prisons who were virtually identical on their pre-prison scores. The study in fact found that harsh prisons do not reduce recidivism, but may in fact increase it. Similar methods have been used in other instances in which the existence of a black-and-white line based on a continuous score for individuals determines whether or not an individual is “treated.” Most government programs for unemployment or insurance disability benefits have this property of setting an absolute threshold for receiving treatment, allowing a researcher to essentially use individuals very close to the threshold as a kind of control group. M21_CASE3826_13_GE_C21.indd 434 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 435 difference-in-differences Difference-in-differences is a method for identifying causality by looking at the way in which the average change over time in the outcome variable is compared to the average change in a control group. Difference-in-Differences MyLab Economics Concept Check Another interesting procedure to try to get a better handle on causality in social science studies is called the method of difference-in-differences. Suppose we have a community in which a small nonprofit has run a com
munity gardening program. The group is convinced that this program increases housing values. Someone in the group suggests that they just look at what has happened to housing values in the community in the four years since the program began as a measure of the program’s success. It is easy to see that this will not work. Housing prices are quite volatile, moving with the overall level of economic activity in an area. In other words, much of the fluctuations in housing prices have nothing to do with community gardens. Another suggestion might be to compare the housing prices in this community with those in a similar neighboring community without the program, but this procedure too is problematic, as no two communities are exactly alike. The difference-in-differences method takes a third approach that melds these two ideas. In particular, we try to relate the difference in our community’s housing values over time to the difference in a neighboring community’s values over the same time (hence the name differencein-differences). If all of the other factors that affect housing values are the same between the two communities (that’s why we have chosen a neighboring community), then this difference-indifferences procedure will show us the effect of the program. To be clear on what the procedure does, let pbega and pbegb denote the average housing values in communities a and b before the garden project began in community a. Let penda and pendb denote the average housing values after four years in the two communities. Then the effect of the garden project on housing values in community a is estimated as: effect = penda - pbega - (pendb - pbegb) We take the difference in values in community a and subtract from it the difference in values in community b. The difference-in-differences methodology is reasonably common in the social sciences. There are pitfalls as well in doing this work, pitfalls that come in part from the difficulties of identifying an appropriate comparison group. Consider the following example: Stimulated in part by what has been happening to the cognitive functioning of aging professional athletes, especially in football, there has been growing concern among university leaders about the long-term effects of injuries in college sports. Short of banning football, which some would advocate, there have been other suggestions to reduce the incidence of injury, notably requiring better helmets and/or eliminating kickoffs (with the ball always starting on the 20 yard line). Suppose that several years ago the Ivy League introduced such regulations and that a researcher was interested in seeing whether the regulations in fact had reduced injuries. To test whether the regulations helped, we could compare the average number of injuries per game measured in the year before the new rules, denoted ybeg, with injuries in the year after the new rules were instituted, denoted yend. But as in the case of housing values, we cannot be sure that nothing happened in the world of Ivy League football other than the rule changes over this period. Maybe the NCAA introduced other rule changes for all the colleges in the country, including the Ivy League colleges, which were designed to lessen injuries, such as telling referees to be stricter. We need a comparison group, a second set of differences. One possible comparison group might be the PAC-12 conference. Assume that this conference did not introduce the new rules on helmets and kickoffs. Again, we collect data on the average number of injuries per game for the same two years we used in the Ivy League case for this conference, denoted zbeg and zend. We can then compare the difference between these two values and the difference between the two Ivy League values (difference-in-differences): effect = yend - ybeg - (zend - zbeg) By subtracting the PAC-12 difference from the Ivy difference we are controlling for country-wide changes that occurred during the two years. The variable effect is then the amount attributable to the Ivy League regulations only. M21_CASE3826_13_GE_C21.indd 435 17/04/19 4:29 AM 436 PART VI Methodology Using Difference-in-Differences to Study the Efficacy of Medical Insurance in Japan The hefty pension payments and healthcare expenditure that benefit Japan’s retiree aging population has started to raise red flags among the Japanese. Japan is burdened with swelling government debt that, in 2017, approached 250 percent of GDP. The working population is increasingly pressurizing the Health, Labor and Welfare Ministry to increase social welfare services and income for the working productive generation that is suffering from declining household income due to the financial meltdown and the ensuing wage restraints. Human development experts also argue that the nation should spend more on healthcare and education of the younger and the working generations who are the future of Japan. Among the core elements of income redistribution and human development expenses was the government reducing the citizens’ co-payment share to 10–30 percent of total medical costs. A daunting question facing the government is whether healthcare for the youth has actually had a positive impact on their health. A recent study used a differenceindifferences approach in order to investigate the impact of an increase in the cost sharing rate on medical service utilization among young school pupils with chronic medical conditions.¹ To receive valid results, the study compares 2,896 students, who are divided into two groups. The first group comprises second and third grade beneficiaries of the government- sponsored National Health Insurance. The second consists of the counter factual group of fourth grade children who were not allowed to receive healthcare benefits. The study was conducted for 24 consecutive months from 2012 to 2014. There was no major change in health conditions for both groups. The results reveal that the group that benefited from the cost-sharing rate increased its inpatient service utilization and reduced its outpatient service. Mild and chronic conditions for the other group showed a sharp drop in outpatient service. The study of the behavioral trends will aid policymakers and medical practitioners. But as helpful as the differenceindifference statistical approach is, it is imperative that more specialized medical studies are conducted before deciding on public expenditure on medical services. CRITICAL THINKING 1. How can a non-governmental organization (NGO) that offers a cash support program to the poor use the difference-in-difference approach to assess the effectiveness of its poverty reduction program? 1A. Miyawaki, H. Noguchi, and Y. Kobayashi, 2017. “Impact of Medical Subsidy Disqualification on Children’s Healthcare Utilization: A Difference-in- Differences Analysis from Japan,” Social Science and Medicine, 191, 89–98. This looks neat, but there are several potential pitfalls to this research plan. Most fundamentally, we have assumed that the two-year changes absent the Ivy League regulations are the same for both conferences, but PAC-12 football is not exactly like Ivy League football (ask any serious college sports fan!). Those differences may be important not only in starting levels (which is fine) but in changes over time (which is not fine). PAC-12 football is played at a higher level than the Ivy League, so it could be that the change in its injuries per game over the two years is not a good approximation of what the Ivy League change would have been absent the regulations. Perhaps the PAC-12 coaches pushed their players even harder and this led to increased injuries. If the PAC-12 is not a good comparison group, then difference-in-differences will not work in this case. One more point to reflect on in this football example. With safer helmets it could be that the players play rougher knowing that they are better protected, and playing rougher, other things being equal, increases injuries. Regulations have the potential to affect behavior in ways not anticipated by the regulators. Some of the original work documenting this effect was done by Sam Peltzman, a Chicago economist, who found that seat-belt laws might perversely encourage people to drive faster than they did without seat belts because they felt safer.3 In the helmet case, some gains from the physical protection of a helmet might be offset by the behavioral changes it induces in the intensity of play. Economic research is not an easy task, but we hope you can see that it encourages care and creativity! 3Sam Peltzman, “The effects of automobile safety regulation,” Journal of Political Economy, August 1975. More recent work has questioned this result. M21_CASE3826_13_GE_C21.indd 436 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 437 21.3 LEARNING OBJECTIVE Understand how researchers decide whether their results are meaningful. p-value The probability of obtaining the result that you find in the sample data if the null hypothesis of no relationship is true. statistical significance A result is said to be statistically significant if the computed p-value is less than some presubscribed number, usually 0.05. Statistical Significance We all know that in tossing a coin there is a 50 percent chance we will get heads. Nevertheless, it is not true that coin tosses always alternate between heads and tails. Sometimes we get two or three heads in a row before a tail shows up. How many heads would we need to get in a row before we started to think that there was something wrong with the coin? In the coin example we answer this question by thinking about how likely it is that a fair (or normal) coin would give us heads after heads. Two heads in a row is relatively common, happening 25 percent of the time (0.5 times 0.5). Even four in a row sometimes happens (about 6 percent of the time). However, six heads in a row happens only about one in a hundred times. At that point you may be suspicious about
the coin tosser and begin to think this is not a fair coin! In thinking about our results in empirical work in economics we use the same basic logic as we try to figure out what we can conclude from the data we have gathered and the statistical tests we have employed. The key question for the researcher is to figure out if the results he or she has found have occurred “by chance” or if they really mean something. To make that judgement researchers turn to the concept of statistical significance. Return to the example of the summer program experiment and suppose the GPA difference observed after the program was 0.3 on a 4.0 scale. Can we conclude that the program really had a positive effect on GPA, or is 0.3 so small that it was likely due to chance? A common way of looking at this problem is to begin by assuming that the effect of whatever we are testing, here the summer program, is zero and then ask what is the probability we got the result we did if the true effect is zero. The assumption of no effect is called the null hypothesis. In our earlier example, our null hypothesis was that the coin was fair. Here the null hypothesis is that the summer program has no effect on GPA. What is the probability we got a difference in GPA of 0.3 if the null hypothesis is true? The probability that one got the result that one did if the null hypothesis is true can be computed given certain statistical assumptions. It is called a p-value. A small p-value means that the probability is small of getting the result if the null hypothesis is true. If for the 0.3 GPA difference, the p-value was 0.02, this says that there is only a 2 percent chance of getting this value if the summer program truly has no effect on GPA. The term statistical significance is commonly applied to a p-value of 0.05 of less. If a p-value is less than or equal to 0.05, the results is said to be statistically significant. Be clear on what we are doing here. We are starting from the premise that whatever effect we are trying to estimate does not exist (is zero). We collect our data and do our calculations to get a particular estimate of the effect we are interested in. We compute the p-value for this estimate, which again is the probability that the true effect is zero given the particular estimate that we obtained. If the p-value is small, usually taken to be less than or equal to 0.05, we conclude that our estimated effect is statistically significant. We have rejected the null hypothesis of no effect. If you go on in statistics, you will learn exactly how p-values are computed. They depend on the variability of the population being analyzed. Consider the 200 at-risk students in the summer program experiment. Say that they are all identical, meaning that they will all get the same GPA at the end of four years if they don’t take the summer program. If some do take the summer program, all those who do will get the same GPA, although this GPA will be different if the program does have a non zero effect on GPA. We want to test whether the summer program effect is zero. We run the experiment discussed and get a difference of 0.3. Is this difference statistically significant? The answer is obviously yes. If the true effect were zero, everyone would get the same GPA whether they took the program or not, so the difference would be exactly zero. We in fact got a nonzero estimate, and so we are sure that the true effect is not zero. The p-value would be 0.00. In fact in this case we only need two students, one who took the program and one who did not. If the difference in the two GPAs is not zero, then the summer program has an effect. In this case there would be no need to use intention to treat—there are no selection problems because everyone is identical. Now consider that there is huge variation in the population of 200 regarding what GPA they are going to achieve. Some may turn out to be stars, and some may barely make it through the four years. Whether students take the summer program or not, there will be a huge variation in GPA scores at the end of the four-year period because of the huge variation in the population. We run the experiment and get a difference of 0.3. Is this difference statistically significant? Maybe M21_CASE3826_13_GE_C21.indd 437 17/04/19 4:29 AM 438 PART VI Methodology 21.4 LEARNING OBJECTIVE Understand how regression analysis can be used for both estimation and testing. not if the variation in the population is large. The difference of 0.3 is fairly small, and it could easily be obtained by chance. It just so happened that the particular draw of 100 students led to this outcome, but it may be that a different draw would have resulted in a difference of 0.2. The p-value that is computed for the result of 0.3 would likely be very large, perhaps close to 1.00. The intuition to take from this discussion is that one has more confidence in results obtained from populations with low variation than from those with high variation. To get potentially significant results from a high-variation population, one needs a large sample size. If we had 2,000 at-risk students, gave offers to 1,000, and got a difference of 0.3, this might be significant. When at the end we take the average of the 1,000 GPAs, the individual student characteristics tend to cancel out in a large sample size, and we can have more confidence that the difference of 0.3 is picking up the summer-program effect. When computing p-values, the size of the sample matters as well as the variation in the population. Regression Analysis The most important statistical tool in empirical economics is regression analysis. If you go on in economics you will see applications of regression analysis in microeconomics and macroeconomics. It can be used to forecast the effect of an increase in prices on the quantity of cat food sold in a community or the effects of a stock market decline on household consumption. Here, we provide you with a beginning sense of what regression analysis is all about. There is evidence that the economy has an effect on votes for president in the United States.4 If the economy is doing well at the time of the election, this may have a positive effect on votes for the incumbent-party candidate and vice versa if the economy is doing poorly. This theory suggests that many voters reward or blame the party of the president-in-office for good or bad economic performance while that president is in office. If true, this theory suggests that, all else equal, a president who presides over a strong economy will find his or her political party doing well in the next election. How might we test this theory using regression analysis? We first need some measure of economic performance. The growth rate of the economy is one common measure of economic strength. So we can translate our theory into a more testable form: we postulate that the growth rate of the economy in the year of the election, denoted g, has a positive effect on the incumbent party’s presidential vote share, denoted V. Notice here we have chosen a specific measure of performance—the growth rate—and also a time period—the year of the election. Generally speaking, when we move in economics from a theory to a practical statistical test, we will have some choices to make. In this case we have chosen to measure economic performance by the one-year growth rate. We will look at the way in which the growth rate affects the vote share. In particular, we will assume that V = a + bg (1) If b is positive, this equation says that the growth rate has a positive effect on the vote share, as our theory states. Also, the relationship between V and g is assumed to be linear. If we take a graph with V on the vertical axis and g on the horizontal axis, as in Figure 21.1, the line is straight with intercept a and slope b. The job of regression analysis is to estimate the coefficients a and b and to see in particular if b is positive and if it “matters” in a statistical sense. Consider how we might determine, or estimate, the values for a and b. U.S. presidential elections are held every four years, and there are data on V going back to the beginning of the country. There are also data on g going back many years. If we consider the period beginning in 1916, there have been 26 presidential elections between 1916 and 2016 so we have 26 data points, or observations, on V and g. We can plot these observations in a Figure like 21.1. In the figure we have plotted 10 hypothetical points for illustration. As drawn, the figure shows that there is a positive relationship between the vote share and the growth rate. It also shows, however, that the data points are not all on the line. If equation (1) were exact, all the points would be on the 4See Ray C. Fair, Predicting Presidential Elections and Other Things, 2nd ed. Stanford University Press, 2012, for discussion of this. M21_CASE3826_13_GE_C21.indd 438 17/04/19 4:29 AM V a 0 d1 d2 CHAPTER 21 Critical Thinking about Research 439 slope b ◂◂ FIGURE 21.1 Hypothetical plot of points between the vote share and the growth rate. Observations on V and g g MyLab Economics Concept Check straight line. In fact, in the real world equation (1) is not exact. There are other variables that affect votes for president. Some of these variables include other economic measures, such as perhaps inflation at the time of the election. Vote share may also be affected by foreign policy and personal characteristics and views of the people running for office. As a result, the points in the graph of the vote share on the growth rate are not exactly on the line. The job of regression analysis is to find values of a and b that provide a good fit of the data around the line. Or, in other words, to find the line that best represents the data in the figure. How is fit determined? What do we mean by the best line? This can be seen in Figure 21.1. Draw a particular line with intercept a and slope b. For each data point compute the
vertical distance between the point and the line. We have done this for the first two points in the figure, labeled d1 and d2. We do this for all the points, say the 26 observations between 1916 and 2016. Some values of d are positive and some are negative. The larger the distance above or below the line, the worse that particular point fits the line. The distances are usually called “errors” for this reason. The way the fit is determined is first to square each distance. Each squared distance is positive because the square of a negative number is positive. Then we add up all the squared distances, again in our case 26 numbers. Call this sum SUM. The sum is obviously a measure of fit. A small value of SUM means that the points are fairly close to the line, and a large value means they are not. The fact that squared distances are used means that large outliers (distances) are weighted more than small ones in computing SUM. You can think of regression analysis as doing the following, although in practice finding the right line is done more efficiently:5 Try a million different pairs of values a and b, and for each pair compute SUM. This gives us a million values of SUM. Choose the smallest value. The values of a and b that correspond to this smallest value are the best-fitting coefficients—the best-fitting intercept and slope. These estimates are called least squares estimates because they are the estimates that correspond to the smallest sum of the squared distances, or errors. In our theory we focused on the sign of the coefficient of the growth rate: does growth increase vote share? The size of the estimates is often also of interest. If, for example, the estimate of b were 1.0, this tells us that an increase in the growth rate of one percentage point leads to an increase in the vote share of one percentage point. This would be a nontrivial effect of the economy on voting behavior. If the estimate of b were instead 0.01, politicians would worry much less about how a bad economy was going to affect their votes (in practice the estimate is about 0.67). Regression analysis is helpful in letting us test our theories. In our voting example, we are particularly interested in whether b is zero. If b is zero, this says that the growth rate has no effect on votes, and our original theory is not right. To see if we should continue to have confidence in our theory, we need to test whether b is zero. How do we test whether b is zero? Here we go back to what we already know from our discussion of statistical significance and p-values. We first postulate the null hypothesis that b is in fact zero. We then use regression analysis to estimate b, and after this is done we compute the probability (p-value) that we would have obtained this estimate if the truth is that b is zero. If the p-value is low, say less than 0.05, we say that the estimate of b is statistically significant. We reject the null hypothesis that the growth rate does not affect the vote share, and our confidence in the theory that economic performance affects votes is bolstered. 5There are many statistical programs that do this calculation with one simple command, including Microsoft Excel™. least squares estimates Least squares estimates are those that correspond to the smallest sum of squared distances, or errors. M21_CASE3826_13_GE_C21.indd 439 17/04/19 4:29 AM 440 PART VI Methodology Most theories in economics are more complicated than simply one variable affecting another. In our voting example, as noted, inflation may also affect voting behavior. In this case two variables affect V: g and inflation, which will be denoted p. In this case we could write the voting equation as V = a + bg + cp (2) Equation (2) has two variables that explain vote share plus a constant term. There are now three coefficients to estimate rather than two: a, b, and c. With more than one explanatory variable, we cannot draw a graph as we did previously. However, the fitting idea we introduced works the same way when we add variables. Given observations on V, g, and p, you can think of the analysis as trying a million sets of values of a, b, and c and choosing the set that provides the best fit. For each set of three coefficient values, the predicted value of V can be computed for each observation, and the distance for that observation is the difference between the predicted value of V and the actual value of V. We square this distance, do the same for all the observations, and then sum the squared distances. This gives us a value of SUM for the particular set of the three coefficient values. We do this a million times for a million sets of three coefficient values and choose the smallest value of SUM. The coefficient values that correspond to the smallest value of SUM are the least squares estimates of a, b, and c.6 We can also test in a similar manner as discussed whether b and or c are zero. N To conclude, regression analysis is used in many settings. In business, it is used to estimate the size of effects: How much do purchases of a good fall when prices rise? What is the effect of an increase in advertising on car sales? In public policy, magnitudes also matter and can be found using regression analysis: How much more will people use medical care if it is free, and how much will that help their health? How many lives are saved by reducing the speed limit on highways? These are all empirical questions in which regression analysis helps us to get at a magnitude with real consequences. With more data available every day, regression analysis has grown in importance. 6If you go on in economics, you will see that this least squares procedure has to be modified sometimes to account for various statistical problems, but the main goal of trying to find a good fit remains. S U M M A R Y 21.1 SELECTION BIAS p. 429 1. One example of selection bias is survivor bias, where the most fit survive. This makes it difficult to compare young and old age groups. 2. Selection bias can arise if different kinds of people select into different groups, which can bias comparisons of the groups. 21.2 CAUSALITY p. 430 5. Regression discontinuity and difference-in-differences methodologies are also used to identify causality in economics. 21.3 STATISTICAL SIGNIFICANCE p. 437 6. An estimated effect is said to be statistically significant if the probability is small of obtaining the particular estimate when in fact the effect is zero. A probability of less than or equal to 5 percent is commonly used. 3. Correlation is not the same as causality. 21.4 REGRESSION ANALYSIS p. 438 4. Random experiments can sometimes be used to estimate causal effects. Intention to treat is sometimes used with random experiments to deal with limited take up in an experiment. 7. Regression analysis is used to estimate coefficients in equations. It is used both to obtain estimates of the magnitude of effects of various economic factors and to test alternative theories correlated, p. 430 difference-in-differences, p. 435 intention to treat, p. 432 least squares estimates, p. 439 p-value, p. 437 regression discontinuity, p. 433 selection bias, p. 429 statistical significance, p. 437 survivor bias, p. 429 MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M21_CASE3826_13_GE_C21.indd 440 17/04/19 4:29 AM CHAPTER 21 Critical Thinking about Research 441 P R O B L E M S All problems are available on MyLab Economics. 21.1 SELECTION BIAS LEARNING OBJECTIVE: Give some examples of studies that might suffer from selection bias. 1.1 Describe the selection bias likely to exist in the following situations: a. A study of 3,600 children in Australia found that the children who slept early and woke up early had a lower BMI as compared to children who slept late and woke up late. Therefore, children who are early sleepers are healthier than children who go to sleep late. b. A study of 1,500 college students found that students who studied in a private school scored better in the first year of college than students who studied in a government-aided school. Therefore, an education from a private school will improve a student’s academic performance. c. A study of 2,500 women in Sweden found that women who play computer games for an hour or more every day have a higher chance to become obese than ones who do not play them at all. Therefore, women who play computer games have a higher tendency to become obese. 1.2 A classic example of selection bias occurred during World War II. During the war, the British were losing many airplanes over enemy territory and therefore decided to add armor plating to their bombers. The armor was not only heavy, but also expensive, so the British decided to only add armor to the most critical areas of the planes, determined by the location of bullet holes in returning aircraft. The areas most commonly marked by bullet holes were the wings, the nose, and the tail. Before the plan was implemented, Austrian economist Abraham Wald reviewed the data and claimed that the British plan was just the opposite of what was needed, and the armor should be added to the only areas not designated for armor by the British plan: the body and the rudder. The British followed Wald’s recommendation and as a result, many fewer planes were shot down. Explain the selection bias in the original British plan. 21.2 CAUSALITY 2.2 [Related to the Economics in Practice on p. 433] In a randomized one-year trial of 100 elm trees with Dutch Elm Disease, 50 are slated to receive only a fungicide treatment (we will call this Group A), and the other 50 are slated to receive the fungicide treatment and an additional insecticide treatment six months later (we will call this Group B). Assume that the insecticide treatment is ineffective in curing Dutch Elm Disease, so on average, the same proportion of trees in each group will die of the di
sease. In Group B, five of the 50 trees die in the sixmonth period leading up to the insecticide treatment. Of the 45 trees left, five die in the six months following the insecticide treatment. Since we know the insecticide treatment is ineffective, the trees in Group A will, on average, suffer the same fate as those in Group B, with five trees dying in the first six months and another five dying in the second six months. a. For Group A, what is the rate of death due to Dutch Elm Disease? b. If we limit the analysis in Group B to only those trees which received the insecticide treatment, what is the rate of death due to Dutch Elm Disease? c. What do your answers to parts a and b suggest regarding the reduction in deaths from Dutch Elm Disease due to the addition of the insecticide treatment? d. Knowing what you do about the effectiveness of the insecticide treatment, what is the problem with this analysis? How would applying the intention-to-treat method verify your answer? 2.3 [Related to the Economics in Practice on p. 434] In 1991, economists Joshua D. Angrist and Alan B. Krueger published a study on the correlation between date of birth and years of schooling. The premise was that the actual amount of time an average person spends in school is tied to the time of year in which people are born. Suppose in the city of Gotham, school is mandatory for all children, and students must be six years old by August 31 in order to enter first grade. By law, students must stay in school until they are 16 years old, at which time they can drop out if they choose. How would you use regression discontinuity to evaluate if a person’s date of birth correlates to the years of schooling the person attains in Gotham? LEARNING OBJECTIVE: Understand the difference between correlation and causation. 2.1 Identify each of the following scenarios as examples of causation, positive correlation, and/or negative correlation, and explain your answers. a. Most students who subscribe to online courses tend to perform better academically. b. Most people who are doctors have poor handwriting. c. Most people who live alone are good cooks. d. Most girls who walk to school tend to be healthier than other girls. e. The higher a student’s grades, the less likely he will travel in public buses. 2.4 [Related to the Economics in Practice on p. 436] The neighboring towns of East Magoo and West Magoo are divided by the Quincy River. The towns are similar in geographic size and population. The homes in both towns are powered entirely by electricity provided by Backus County Power and Light, which charges a standardized rate of $0.10 per kilowatt hour (kWh). Both East Magoo and West Magoo add on an additional $0.02 per kilowatt hour as an energy use tax. As a way to increase revenue, the mayor of East Magoo persuaded the town council to double the energy use tax on all residents, effective January 1, 2018. The average monthly energy usage per home is listed in the table below. Use the difference-in-differences method to estimate the effect of the increase in the energy use tax MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M21_CASE3826_13_GE_C21.indd 441 17/04/19 4:29 AM 442 PART VI Methodology on the average monthly amount of energy used per home in East Magoo. Average Monthly Energy Use per Home Scenario 4: In a study to see if Coldplay’s fans or Metallica’s fans spend more, 20 people from each fanbase are surveyed before they enter their respective stadiums for the concerts. Town East Magoo West Magoo 2017 1,775 kWh 1,815 kWh 2018 21.4 REGRESSION ANALYSIS 1,917 kWh 2,033 kWh LEARNING OBJECTIVE: Understand how regression analysis can be used for both estimation and testing. 2.5 Novigrad city has elected a mayor who wishes to enact a new health initiative. She imposes a 10 percent tax on cigarettes to deter people from smoking. After one year, tax revenues from cigarettes increase by 5 percent. Does this mean that the tax increase did not discourage smoking? Explain. 21.3 STATISTICAL SIGNIFICANCE LEARNING OBJECTIVE: Understand how researchers decide whether their results are meaningful. 3.1 Of the following four scenarios, which survey results are likely to be the most statistically significant and which are likely to be the least statistically significant? Explain your answer. Scenario 1: 1,000 students are surveyed after completing six months of a basic French language course to see if they have learnt the usage of prepositions in French. Scenario 2: 50 businessmen are surveyed to see whether their marketing skills have improved after attending a week-long seminar on innovative techniques of marketing. Scenario 3: 700 workers, who have been working for over 30 years in the cashew industry, are surveyed for a study to determine if shelling the cashew nuts by hand has led to a medical diagnosis of dermatitis, which is a chronic skin condition. 4.1 The data in the table below was used to estimate the following consumption function: C = 10 + 0.5Y On a graph, draw the consumption function and plot the points from the table. Calculate the “error” for each point in the table, and then calculate the SUM from your “error” calculations. Point Aggregate Income (Y) Aggregate Consumption (C) A B C D E F 10 20 30 40 50 60 13 23 30 32 33 44 4.2 Which of the following consumption functions best fits the values in the table below? 1. C = 10 + 0.2Y 2. C = 6 + 0.8Y 3. C = 4 + 0.7Y 4. C = 10 + 0.5Y Aggregate Income (Y) Aggregate Consumption (C) 6 12 24 48 13 16 20 34 QUESTION 1 Researchers are eager to quantify the effect that studying abroad has on a student’s academic performance after returning to his/her home institution, because they want to quantify the benefits of providing scholarships for study abroad. Could these researchers simply compare the grades of students who studied abroad in a previous semester to the grades of students who did not? QUESTION 2 Identify an example of two variables that are correlated, but where there is no direct causal link between the two variables. MyLab Economics Visit www.pearson.com/mylab/economics to complete these exercises online and get instant feedback. Exercises that update with real-time data are marked with . M21_CASE3826_13_GE_C21.indd 442 17/04/19 4:29 AM Glossary absolute advantage The advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does. p. 363 automatic destabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to destabilize GDP. pp. 206, 304 accelerator effect The tendency for investment to increase when aggregate output increases and to decrease when aggregate output decreases, accelerating the growth or decline of output. p. 318 automatic stabilizers Revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. pp. 206, 304 actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories. p. 175 adjustment costs The costs that a firm incurs when it changes its production level—for example, the administration costs of laying off employees or the training costs of hiring new workers. p. 318 aggregate behavior The behavior of all households and firms together. p. 118 aggregate income The total income received by all factors of production in a given period. p. 170 aggregate output The total quantity of goods and services produced in an economy in a given period. pp. 119, 170 aggregate saving (S) The part of aggregate income that is not consumed. p. 172 aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. p. 244 balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange. p. 386 balance of trade A country’s exports of goods and services minus its imports of goods and services. p. 387 balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. p. 387 balanced-budget multiplier The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit. The balanced-budget multiplier is equal to 1: The change in Y resulting from the change in G and the equal change in T are exactly the same size as the initial change in G or T. p. 199 aggregate supply The total supply of all goods and services in an economy. p. 244 barter The direct exchange of goods and services for other goods and services. p. 217 animal spirits of entrepreneurs A term coined by Keynes to describe investors’ feelings. p. 317 base year The year chosen for the weights in a fixed-weight procedure. p. 142 appreciation of a currency The rise in value of one currency relative to another. p. 396 binding situation State of the economy in which the Fed rule calls for a negative interest rate. p. 314 black market A market in which illegal trading takes place at market-determined prices. p. 105 brain drain The tendency for talented people from developing countries to become educated in a developed country and remain there after graduation. p. 415 budget deficit The difference between what a government spends and what it collects in taxes in a given period: G – T. p. 192 business cycle The cycle of short-term ups and downs in the economy. p. 119 capital flight The tendency for both human capita
l and financial capital to leave developing countries in search of higher expected rates of return elsewhere with less risk. p. 414 capital gain An increase in the value of an asset. p. 293 capital market The input/factor market in which households supply their savings, for interest or for claims to future profits, to firms that demand funds to buy capital goods. p. 71 capital Those goods produced by the economic system that are used as inputs to produce other goods and services in the future. p. 50 catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up. p. 331 ceteris paribus, or all else equal A device used to analyze the relationship between two variables while the values of other variables are held unchanged. p. 35 change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to sell later. p. 135 443 Z01_CASE3826_13_GE_GLOS.indd 443 17/04/19 12:42 AM 444 Glossary circular flow A diagram showing the flows in and out of the sectors in the economy. p. 122 command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. p. 62 commodity monies Items used as money that also have intrinsic value in some other use. p. 219 comparative advantage The advantage in the production of a good enjoyed by one country over another when that good can be produced at lower cost in terms of other goods than it could be in the other country. p. 363 compensation of employees Includes wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example—paid to households by firms and by the government. p. 138 complements, complementary goods Goods that “go together”; a decrease in the price of one results in an increase in demand for the other and vice versa. p. 76 constrained supply of labor The amount a household actually works in a given period at the current wage rate. p. 313 consumer goods Goods produced for present consumption. p. 55 consumer price index (CPI) A price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer. p. 157 consumer sovereignty The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). p. 63 consumer surplus The difference between the maximum amount a person is willing to pay for a good and its current market price. p. 110 contraction, recession, or slump The period in the business cycle from a peak down to a trough during which output and employment fall. p. 120 Corn Laws The tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain. p. 362 corporate bonds Promissory notes issued by firms when they borrow money. p. 124 corporate profits The income of corporations. p. 430 correlated Two variables are correlated if their values tend to move together. p. 430 cost shock, or supply shock A change in costs that shifts the short-run aggregate supply (AS) curve. p. 226 cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised. p. 600 cost-push, or supply-side, inflation Inflation caused by an increase in costs. p. 267 cross-price elasticity of demand A measure of the response of the quantity of one good demanded to a change in the price of another good. p. 129 currency debasement The decrease in the value of money that occurs when its supply is increased rapidly. p. 219 current dollars The current prices that we pay for goods and services. p. 140 cyclical deficit The deficit that occurs because of a downturn in the business cycle. p. 207 cyclical unemployment Unemployment that is above frictional plus structural unemployment. p. 274 consumption function The relationship between consumption and income. p. 170 cyclical unemployment The increase in unemployment that occurs during recessions and depressions. p. 157 deadweight loss The total loss of producer and consumer surplus from underproduction or overproduction. p. 113 deflation A decrease in the overall price level. p. 121 demand curve A graph illustrating how much of a given product a household would be willing to buy at different prices. p. 74 demand schedule Shows how much of a given product a household would be willing to buy at different prices for a given time period. p. 73 demand-pull inflation is initiated by an increase in aggregate demand. p. 587 Inflation that depreciation of a currency The fall in value of one currency relative to another. p. 396 depreciation The amount by which an asset’s value falls in a given period. p. 136 depression A prolonged and deep recession. p. 120 desired, or optimal, level of inventories The level of inventory at which the extra cost (in lost sales) from lowering inventories by a small amount is just equal to the extra gain (in interest revenue and decreased storage cowsts). p. 319 difference-in-differences Difference-in-differences is a method for identifying causality by looking at the way in which the average change over time in the outcome variable is compared to the average change in a control group. p. 435 discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find work grow discouraged and stop looking, dropping out of the ranks of the unemployed and the labor force. pp. 154, 324 discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy. p. 191 Z01_CASE3826_13_GE_GLOS.indd 444 17/04/19 12:42 AM disembodied technical change Technical change that results in a change in the production process. p. 337 disposable personal income or after-tax income Personal income minus personal income taxes. The amount that households have to spend or save. p. 140 efficient market A market in which profit opportunities are eliminated almost instantaneously. p. 29 elastic demand A demand relationship in which the percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1). p. 120 disposable, or after-tax, income (Yd) Total income minus net taxes: Y – T. p. 191 dividends The portion of a firm’s profits that the firm pays out each period to its shareholders. p. 124 Doha Development Agenda An initiative of the World Trade Organization focused on issues of trade and development. p. 374 Dow Jones Industrial Average An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance. p. 295 dumping A firm’s or an industry’s sale of products on the world market at prices below its own cost of production. p. 372 durable goods Goods that last a relatively long time, such as cars and household appliances. p. 134 economic growth An increase in the total output of an economy. Growth occurs when a society acquires new resources or when it learns to produce more using existing resources. pp. 58, 37 economic integration Occurs when two or more nations join to form a free-trade zone. p. 374 economics The study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. p. 27 efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate. p. 597 embodied technical change Technical change that results in an improvement in the quality of capital. p. 336 empirical economics The collection and use of data to test economic theories. p. 35 employed Any person 16 years old or older (1) who works for pay, either for someone else or in his or her own business for 1 or more hours per week, (2) who works without pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been temporarily absent with or without pay. p. 152 entrepreneur A person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business. p. 70 equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change. p. 177 equity Fairness. p. 37 European Union (EU) The European trading bloc composed of 28 countries (of the 28 countries in the EU, 17 have the same currency—the euro). p. 375 excess demand or shortage The condition that exists when quantity demanded exceeds quantity supplied at the current price. p. 87 excess labor, excess capital Labor and capital that are not needed to produce the firm’s current level of output. p. 318 excess reserves The difference between a bank’s actual reserves and its required reserves. p. 224 Glossary 445 excess supply or surplus The condition that exists when quantity supplied exceeds quantity demanded at the current price. p. 89 exchange rate The ratio at which two currencies are traded. The price of one currency in terms of another. pp. 368, 386 exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. p. 181 expansion or boom The period in the business cycle from a trough up to a peak during which output and employment grow. p. 120 expenditure approach A method of computing GDP that measures the total amount spent on all final goods and services during a given period. p. 134 explicit contracts Employment contracts that stipulate workers’ wages, usually for a period
of 1 to 3 years. p. 280 export promotion A trade policy designed to encourage exports. p. 420 export subsidies Government payments made to domestic firms to encourage exports. p. 371 factor endowments The quantity and quality of labor, land, and natural resources of a country. p. 370 factors of production The inputs into the production process. Land, labor, and capital are the three key factors of production. pp. 50, 71 favored customers Those who receive special treatment from dealers during situations of excess demand. p. 104 Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the economy. p. 249 federal budget The budget of the federal government. p. 201 federal debt The total amount owed by the federal government. p. 205 Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of Z01_CASE3826_13_GE_GLOS.indd 445 17/04/19 12:42 AM 446 Glossary the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. p. 227 Federal Reserve Bank (the Fed) The central bank of the United States. p. 223 federal surplus (+) or (–) deficit Federal government receipts minus expenditures. p. 223 fiat, or token, money Items designated as money that are intrinsically worthless. p. 219 final goods and services Goods and services produced for final use. p. 132 firm An organization that comes into being when a person or a group of people decides to produce a good or service to meet a perceived demand. p. 125 fiscal drag The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion. p. 206 fiscal policy The government’s spending and taxing policies. p. 190 fixed-weight procedure A procedure that uses weights from a given base year. p. 142 floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. p. 394 foreign direct investment (FDI) Investment in enterprises made in a country by residents outside that country. p. 334 foreign exchange All currencies other than the domestic currency of a given country. p. 386 frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/ skill matching problems. p. 274 full-employment budget What the federal budget would be if the economy were producing at the full-employment level of output. p. 207 General Agreement on Tariffs and Trade (GATT) An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade. p. 374 a country’s comparative advantage by its factor endowments: A country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product. p. 370 Global South Developing Nations in Asia, Africa, and Latin America. p. 412 households The consuming units in an economy. p. 70 government consumption and gross investment (G) Expenditures by federal, state, and local governments for final goods and services. p. 137 government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending. p. 196 Gramm-Rudman-Hollings Act Passed by the U.S. Congress and signed by President Reagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. p. 303 graph A two-dimensional representation of a set of numbers or data. p. 41 gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within a country. p. 132 gross investment The total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. p. 136 gross national income (GNI) GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. p. 146 gross national product (GNP) The total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizens, regardless of where the output is produced. p. 133 gross private domestic investment (I) Total investment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector. p. 135 Heckscher-Ohlin theorem A theory that explains the existence of hyperbolic discounting People prefer immediate gratification to even slightly deferred gratification, but exhibit more patience when asked to defer gratification some time in the future. p. 356 hyperinflation A period of very rapid increases in the overall price level. p. 121 identity Something that is always true. p. 172 implementation lag The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. p. 301 import substitution An industrial trade strategy that favors developing local industries that can manufacture goods to replace imports. p. 420 income approach A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services. p. 194 income elasticity of demand A measure of the responsiveness of demand to changes in income. p. 129 income The sum of all a household’s wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flow measure. p. 76 indirect taxes minus subsidies Taxes such as sales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return. p. 138 Industrial Revolution The period in England during the late eighteenth and early nineteenth centuries in which Z01_CASE3826_13_GE_GLOS.indd 446 17/04/19 12:42 AM new manufacturing technologies and improved transportation gave rise to the modern factory system and a massive movement of the population from the countryside to the cities. p. 30 infant industry A young industry that may need temporary protection from competition from the established industries of other countries to develop an acquired comparative advantage. p. 380 inferior goods Goods for which demand tends to fall when income rises. p. 76 inflation An increase in the overall price level. p. 121 inflation rate The percentage change in the price level. p. 282 inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. p. 269 informal economy The part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. p. 145 investment New capital additions to a firm’s capital stock. Although capital is measured at a given point in time (a stock), investment is measured over a period of time (a flow). The flow of investment increases the capital stock. p. 55 IS curve Relationship between aggregate output and the interest rate in the goods market. p. 228 J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. p. 399 labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate. p. 275 labor force The number of people employed plus the number of unemployed. p. 152 labor market The input/factor market in which households supply work for wages to firms that demand labor. p. 71 labor productivity growth The growth rate of output per worker. p. 329 innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently. p. 337 labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. p. 275 input or factor markets The markets in which the resources used to produce goods and services are exchanged. p. 71 inputs or resources Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants. p. 50 intention to treat A method in which we compare two groups based on whether they were part of an initially specified random sample subjected to an experimental protocol. p. 432 intermediate goods Goods that are produced by one firm for use in further processing by another firm. p. 132 invention An advance in knowledge. p. 337 inventory investment The change in the stock of inventories. p. 319 Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate. p. 350 laissez-faire economy Literally from the French: “allow [them] to do.” An economy in which individual people and firms pursue their own self-interest without any central direction or regulation. p. 63 land market The input/factor market in which households supply land or other real property in exchange for rent. p. 71 Glossary 447 quantity demanded decreases; as price falls, quantity demanded increases. p. 74 If the costs of law of one price transportation are small, the price of the same good in different countries should be roughly the same. p. 397 law of supply The positive relationship between price and quantity of a good supplied: An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantit
y supplied. p. 83 least squares estimates Least squares estimates are those that correspond to the smallest sum of squared distances, or errors. p. 439 legal tender Money that a government has required to be accepted in settlement of debts. p. 219 lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds. p. 229 life-cycle theory of consumption Least squares estimates are those that correspond to the smallest sum of squared distances, or errors. p. 309 liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods. p. 218 Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. p. 354 M1, or transactions money Money that can be directly used for transactions. p. 220 M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. p. 220 macroeconomics The branch of economics that examines the economic behavior of aggregates— income, employment, output, and so on—on a national scale. p. 118 law of demand The negative relationship between price and quantity demanded: Ceteris paribus, as price rises, marginal propensity to consume (MPC) The fraction of a change in income that is consumed. p. 171 Z01_CASE3826_13_GE_GLOS.indd 447 17/04/19 12:42 AM 448 Glossary marginal propensity to import (MPM) The change in imports caused by a $1 change in income. p. 390 marginal propensity to save (MPS) That fraction of a change in income that is saved. p. 172 marginal rate of transformation (MRT) The slope of the production possibility frontier (ppf). p. 57 marginalism The process of analyzing the additional or incremental costs or benefits arising from a choice or decision. p. 28 market demand The sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service. p. 80 market supply The sum of all that is supplied each period by all producers of a single product. p. 86 market The institution through which buyers and sellers interact and engage in exchange. p. 63 medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services. p. 217 minimum efficient scale (MES) The smallest size at which long-run average cost is at its minimum. p. 221 minimum wage laws Laws that set a floor for wage rates—that is, a minimum hourly rate for any kind of labor. p. 277 minimum wage A price floor set for the price of labor. p. 107 model A formal statement of a theory, usually a mathematical statement of a presumed relationship between two or more variables. p. 34 monetary policy The tools used by the Federal Reserve to control the short-term interest rate. pp. 124, 191 money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. p. 226 demanded brought about by a change in price. p. 80 a country’s total exports and total imports. p. 390 movement along a supply curve The change in quantity supplied brought about by a change in price. p. 85 multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. p. 181 NAIRU The nonaccelerating inflation rate of unemployment. p. 287 NASDAQ Composite An index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System. p. 295 natural experiment Selection of a control versus experimental group in testing the outcome of an intervention is made as a result of an exogenous event outside the experiment itself and unrelated to it. p. 423 natural rate of unemployment The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment. pp. 157, 287 near monies Close substitutes for transactions money, such as savings accounts and money market accounts. p. 220 negative relationship A relationship between two variables, X and Y, in which a decrease in X is associated with an increase in Y and an increase in X is associated with a decrease in Y. p. 43 net business transfer payments Net transfer payments by businesses to others. p. 138 net exports (EX - IM) The difference between exports (sales to foreigners of U.S.- produced goods and services) and imports (U.S. purchases of goods and services from abroad). The figure can be positive or negative. p. 137 net interest The interest paid by business. p. 138 new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages. p. 675 no-arbitrage condition To effectively price discriminate firms must prevent customers from reselling. p. 307 nominal GDP Gross domestic product measured in current dollars. p. 140 nominal wage rate The wage rate in current dollars. is the wage rate in current dollars. p. 311 nondurable goods Goods that are used up fairly quickly, such as food and clothing. p. 134 nonlabor, or nonwage, income Any income received from sources other than working—inheritances, interest, dividends, transfer payments, and so on. p. 312 nonresidential investment Expenditures by firms for machines, tools, plants, and so on. p. 135 normal goods Goods for which demand goes up when income is higher and for which demand goes down when income is lower. p. 76 normative economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. p. 34 North American Free Trade Agreement (NAFTA) An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all North America as a free-trade zone. p. 375 not in the labor force A person who is not looking for work because he or she does not want a job or has given up looking. p. 152 movement along a demand curve The change in quantity net exports of goods and services (EX - IM) The difference between Ockham’s razor The principle that irrelevant detail should be cut away. p. 34 Z01_CASE3826_13_GE_GLOS.indd 448 17/04/19 12:42 AM Okun’s Law The theory, put forth by Arthur Okun, that in the short run the unemployment rate decreases about 1 percentage point for every 3 percent increase in real GDP. Later research and data have shown that the relationship between output and unemployment is not as stable as Okun’s “Law” predicts. p. 323 Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. p. 227 open market operations The purchase and sale by the Fed of government securities in the open market. p. 232 opportunity cost The best alternative that we forgo, or give up, when we make a choice or a decision. pp. 51, 28 origin The point at which the horizontal and vertical axes intersect. p. 42 output growth The growth rate of the output of the entire economy. pp. 162, 329 outputs Goods and services of value to households. p. 50 p-value The probability of obtaining the result that you find in the sample data if the null hypothesis of no relationship is true. p. 437 per-capita output growth The growth rate of output per person in the economy. pp. 162, 329 perfect substitutes products. p. 76 Identical permanent income The average level of a person’s expected future income stream. p. 310 personal consumption expenditures (C) Expenditures by consumers on goods and services. p. 134 personal income The total income of households. p. 139 personal saving rate The percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously. p. 140 personal saving The amount of disposable income that is left after total personal spending in a given period p. 140 Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate. p. 282 planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE K C + I p. 177 planned investment (I) Those additions to capital stock and inventory that are planned by firms. p. 175 positive relationship A relationship between two variables, X and Y, in which a decrease in X is associated with a decrease in Y, and an increase in X is associated with an increase in Y. p. 43 potential output, or potential GDP The level of aggregate output that can be sustained in the long run without inflation. p. 255 positive economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It describes what exists and how it works. p. 34 post hoc, ergo propter hoc Literally, “after this (in time), therefore because of this.” A common error made in thinking about causation: If Event A happens before Event B, it is not necessarily true that A caused B. p. 35 price ceiling A maximum price that sellers may charge for a good, usually set by government. p. 103 price discrimination Charging different prices to different buyers for identical products. p. 305 price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country. p. 393 Glossary 449 price floor A minimum price below which exchange is not permitted. p. 107 price rationing The process by which the market system allocates goods and services to consum
ers when quantity demanded exceeds quantity supplied. p. 101 price surprise Actual price level minus expected price level. p. 354 privately held federal debt The privately held (non-government-owned) debt of the U.S. government. p. 205 producer price indexes (PPIs) Measures of prices that producers receive for products at various stages in the production process. p. 159 producer surplus The difference between the current market price and the cost of production for the firm. p. 111 product or output markets The markets in which goods and services are exchanged. p. 70 production possibility frontier (ppf) A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently. p. 55 production The process that transforms scarce resources into useful goods and services. p. 50 productivity growth The growth rate of output per worker. p. 162 productivity, or labor productivity Output per worker hour. p. 322 profit The difference between total revenue and total cost. pp. 83, 173 progressive tax A tax whose burden, expressed as a percentage of income, increases as income increases. p. 418 Income from the property income ownership of real property and financial holdings. It takes the form of profits, interest, dividends, and rents. p. 393 proportional tax A tax whose burden is the same proportion of income for all households. p. 418 prospect theory People evaluate gains and losses from the vantage of a reference point. p. 356 Z01_CASE3826_13_GE_GLOS.indd 449 17/04/19 12:42 AM 450 Glossary proprietors’ income The income of unincorporated businesses. p. 138 protection The practice of shielding a sector of the economy from foreign competition. p. 371 purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same. p. 397 quantity demanded The amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price. p. 72 quantity supplied The amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. p. 83 quantity theory of money The theory based on the identity M * V K P * Y and the assumption that the velocity of money (V) is constant (or virtually constant). p. 347 queuing Waiting in line as a means of distributing goods and services: a nonprice rationing mechanism. p. 103 quota A limit on the quantity of imports. p. 373 (Sometimes random experiment referred to as a randomized experiment.) A technique in which outcomes of specific interventions are determined by using the intervention in a randomly selected subset of a sample and then comparing outcomes from the exposed and control group. p. 423 ration coupons Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month. p. 104 rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future. p. 352 price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. p. 354 real interest rate The difference between the interest rate on a loan and the inflation rate. p. 160 real wage rate The amount the nominal wage rate can buy in terms of goods and services. p. 311 real wealth effect The change in consumption brought about by a change in real wealth that results from a change in the price level. p. 254 realized capital gain The gain that occurs when the owner of an asset actually sells it for more than he or she paid for it. p. 293 recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump. p. 301 regression discontinuity Regression discontinuity identifies the causal effects of a policy or factor by looking at two samples that lie on either side of a threshold or cutoff. p. 433 relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to the wages of other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. p. 433 rental income The income received by property owners in the form of rent. p. 138 required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. p. 224 reserves The deposits that a bank has at the Federal Reserve bank plus its vault cash on hand. p. 223 residential investment Expenditures by households and firms on new houses and apartment buildings. p. 135 real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. p. 302 risk-averse Refers to a person’s preference of a certain payoff over an uncertain one with the same expected value. p. 622 run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. p. 223 scarce Limited. p. 28 services The things we buy that do not involve the production of physical things, such as legal and medical services and education. p. 134 selection bias Selection bias occurs when the sample used is not random. p. 223 shares of stock Financial instruments that give to the holder a share in the firm’s ownership and therefore the right to share in the firm’s profits. p. 124 shift of a demand curve The change that takes place in a demand curve corresponding to a new relationship between quantity demanded of a good and price of that good. The shift is brought about by a change in the original conditions. p. 80 shift of a supply curve The change that takes place in a supply curve corresponding to a new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a change in the original conditions. p. 85 slope A measurement that indicates whether the relationship between variables is positive or negative and how much of a response there is in Y (the variable on the vertical axis) when X (the variable on the horizontal axis) changes. p. 43 Smoot-Hawley tariff The U.S. tariff law of the 1930s, which set the highest tariffs in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered one of the causes of the worldwide depression of the 1930s. p. 373 Z01_CASE3826_13_GE_GLOS.indd 450 17/04/19 12:42 AM social overhead capital Basic infrastructure projects such as roads, power generation, and irrigation systems. p. 417 social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. p. 278 soft trade barriers Regulatory standards and requirements that make foreign competition more difficult p. 371 stability A condition in which national output is growing steadily, with low inflation and full employment of resources. p. 37 stabilization policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. p. 300 stagflation A situation of both high inflation and high unemployment. pp. 127, 265 Standard and Poor’s 500 (S&P 500) An index based on the stock prices of 500 of the largest firms by market value. p. 295 statistical discrepancy Data measurement error p. 139 statistical significance A result is said to be statistically significant if the computed p-value is less than some presubscribed number, usually 0.05. p. 437 sticky prices Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. p. 119 sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. p. 278 stock A certificate that certifies ownership of a certain portion of a firm. p. 293 store of value An asset that can be used to transport purchasing power from one time period to another. p. 217 structural deficit The deficit that remains at full employment. p. 207 that result in a significant loss of jobs in certain industries. pp. 162, 274 substitutes Goods that can serve as replacements for one another; when the price of one increases, demand for the other increases. p. 76 supply curve A graph illustrating how much of a product a firm will sell at different prices. p. 83 supply schedule Shows how much of a product firms will sell at alternative prices. p. 83 surplus of government enterprises enterprises. p. 138 Income of government survivor bias Survivor bias exists when a sample includes only observations that have remained in the sample over time making that sample unrepresentative of the broader population. p. 429 tariff A tax on imports. p. 371 tax multiplier The ratio of change in the equilibrium level of output to a change in taxes. p. 198 terms of trade The ratio at which a country can trade domestic products for imported products. p. 367 theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. p. 363 time lags Delays in the economy’s response to stabilization policies. p. 300 time series graph A graph illustrating how a variable changes over time. p. 41 trade deficit The situation when a country imports more than it exports. pp. 362, 387 trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country. p. 392 trade surplus The situation when a country exports more than it imports. p. 362 structural unemployment The portion of unemployment that is
due to changes in the structure of the economy transfer payments Cash payments made by the government to people who do not supply goods, services, or labor Glossary 451 in exchange for these payments. They include Social Security benefits, veterans’ benefits, and welfare payments. p. 122 Treasury bonds, notes, and bills Promissory notes issued by the federal government when it borrows money. p. 124 U.S.-Canadian Free Trade Agreement An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1998. p. 375 unconstrained supply of labor The amount a household would like to work within a given period at the current wage rate if it could find the work. p. 313 unemployed A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks. p. 152 unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force. pp. 121, 152, 274 unit of account A standard unit that provides a consistent way of quoting prices. p. 218 value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. p. 132 variable A measure that can change from time to time or from observation to observation. p. 34 velocity of money The ratio of nominal GDP to the stock of money. p. 346 vicious circle of poverty Suggests that poverty is self-perpetuating because poor nations are unable to save and invest enough to accumulate the capital stock that would help them grow. p. 414 voting paradox A simple demonstration of how majority-rule voting can lead to seemingly contradictory and inconsistent results. A commonly cited illustration of the kind of inconsistency described in the impossibility theorem. p. 140 Z01_CASE3826_13_GE_GLOS.indd 451 17/04/19 12:42 AM 452 Glossary wealth or net worth The total value of what a household owns minus what it owes. It is a stock measure. p. 76 weight The importance attached to an item within a group of items. p. 140 World Trade Organization (WTO) A negotiating forum dealing with rules of trade across nations. p. 374 X-axis The horizontal line against which a variable is plotted. p. 42 X-intercept The point at which a graph intersects the X-axis. p. 42 Y-axis The vertical line against which a variable is plotted. p. 42 Y-intercept The point at which a graph intersects the Y-axis. p. 42 zero interest rate bound The interest rate cannot go below zero. p. 264 Z01_CASE3826_13_GE_GLOS.indd 452 17/04/19 12:42 AM Index *Notes: Key terms and the page on which they are defined appear in boldface. Page numbers followed by n refer to information in footnotes. A AAA Corporate Bond Rate, 242 Absolute advantage, 363 versus comparative advantage, 363–367 mutual, 363–365 Absolute advantage, 52–53 Accelerator effect, 318 Accounting, 223–224 Acemoglu, Daron, 332n, 418n Actual investment, 175 Adjustment costs, 318 Advantages of backwardness, 331 Africa comparative advantage in, 372 foreign direct investment in, 334 sub-Saharan, economic growth in, 331 African Americans unemployment rate, 154 After-tax (disposable) income, 140, 191 Aggregate behavior, 118 Aggregate demand (AD) aggregate supply and the Phillips Curve, 284–285 inflation and, 285–286 Aggregate demand (AD) curve, 247–253 behavior of the Fed and, 248–249 deriving, 251–253 Fed and price level versus output, 263–264 planned aggregate expenditure and the interest rate and, 247–248 reasons for downward sloping, 254 Aggregate expenditure, planned, 389–391 Aggregate income, 170 Aggregate output, 170 Aggregate production frontier, 331 Aggregate saving, 172 Aggregate supply (AS), 244 decrease, 246 increase, 246 short run, 244 simple Keynesian view, 263 Aghion, Philippe, 332n Agriculture, movement to industry, 330–331, 418–420 Aguiar, Mark, 153n Akerlof, George, 318n AliBaba, 415 Alternative macroeconomic models, 345–357 Keynesian economics and, 346 monetarism and, 346–347 new classical macroeconomics and, 351–356 supply-side economics and, 349–351 testing, 356–357 Alternative Minimum Tax (AMT), 206 Amazon, 35 Animal spirits, 267, 351 entrepreneurs, 317–318 Anti-price gouging provisions, 105 Antitrust policy Clayton Act and, 377 Sherman Act and, 377 Antweiler, Werner, 379n Apple, 49, 63, 82, 123, 294, 380 Appreciation of a currency, 396 Armendariz de Aghion, Beatriz, 421n Assets, 223 Auctions, 88–89 Australia comparative advantage and, 365–366 production possibility frontier for, 365–366 terms of trade and, 363–364 Automatic destabilizers, 206–207, 304 deficit targeting as, 304 Automatic spending cuts, 303 Automatic stabilizers, 206–207, 301n, 304 multiplier size, 324 B Bailey, George, 222 Balance of payments, 386–389 current account in, 386–387 Balance of trade, 387 exchange rates and, 399–400 Balance on current account, 387 Balance sheet, 223, 224, 225, 234–235, 386n Aggregate supply (AS) curve, 244–246, 270 Federal Reserve, 234–235 classical labor market and, 276 long-run, 254–256, 286 price level, aggregate output and, 281–282 shape of, 244 shifts of the short-run, 246 short run, 245 simple Keynesian, 256, 263 Aggregate supply/aggregate demand (AS/AD) model, 249n, 260 Balanced-budget multiplier, 199–200, 211–212 Banerjee, Abhijit, 414n, 423 Bank reserves, 235 Bankers, 228 central, 223, 224–225 currency held outside of, 220 role of, in creating money, 224–226 run on the, 222 453 Z02_CASE3826_13_GE_IDX.indd 453 17/04/19 12:43 AM 454 Index Bankers’ banks, 228 Banking, modern system of, 223–224 Barattieri, Alessandro, 279 Barber, Marsha, 36 Barnsley, Warren, 105 Barter, 217, 368 Base year, 142 Bassett, Charles E., 222 Basu, Susanto, 279n Bear Stearns bailout, 233 Beggar-thy-neighbor policies, 399n Behavior aggregate, 118 bias, in saving, 174 labor supply and, 310–312 saving behavior, 174 selection bias, 429–430 survivor bias, 429 Behavioral economics, 33, 174 Benartzi, Shlomo, 174 Binding situation, 264–265 Black market, 105 Blackrock, 293 BMWs, 371 Board of Governors, Federal Reserve, 227 Bonds, 231–232, 293 corporate, 242, 293 government, 241 grades of, 242 Boom, 120 Borrowed reserves, 232 Brain drain, 415 Brazil timber industry, 368–369 Bretton Woods conference, 394, 405, 407–409 British Retail Consortium, 94 Bryan, Gharad, 418, 419n Bubbles, stock market, 294 Budget deficit, 192 Bureau of Economic Analysis, 131 Bureau of Labor Statistics (BLS), 151, 154 Bush, George W. fiscal policy under, 202–205, 268 NAFTA and, 375 steel imports, 374 Business cycle, 119 productivity and, 322–323 Business inventories, change in, 135 C Capital, 50, 330 excess, 318 financial, 414 formation, economic development source, 414–415 human, 162, 330–331, 335 infrastructure, 417 physical, 333–335 social overhead, 417 Capital flight, 414 Capital gains, 124n, 293 Capital goods, 55–56, 60, 61 poor and rich countries, 61 ppf, 56–57 Capital losses, 294–295 Capital market, 71 Capra, Frank, 222 Carbon emissions, 340 Case-Shiller index, 315 Case, Karl, 315 Catch-up, 331 Causality, 35, 430–436 correlation versus causation, 430–431 difference-in-differences in, 435–436 random experiments in, 431–432 regression discontinuity in, 432–434 Causation versus correlation, 430–431 Central banks, 223, 224–225 price stability, 252 Ceteris paribus (all else equal), 35, 72, 74, 75, 80, 83, 85, 252–253 Chain-linked consumer price index, 161 Chained Consumer Price Index, 158, 161 Change in business inventories, 135 Changing consumption patterns in china, 62 Charter schools, 429 Checkable deposits, 220 Checking accounts, 220, 228 Checks, traveler’s, 220 Choi, James, 174 Choice in an economy or two or more, 51–55 in a one-person economy, 50–51 Chowdhury, Shymal, 419n Christie’s brokerage services in GDP, 135 Circular flow of economic activity, 70–72, 122–123 Citigroup, 299 Clark, John Bates, 414 Classical economics labor market in, 275–276 unemployment rate in, 276 Classical economists, 351n Classical labor market, aggregate supply curve and, 276 Clayton Act (1914), 377 Clinton, Bill fiscal policy under, 202–205, 268 NAFTA and, 375 Club of Rome, 340–341 Coca-Cola, 159 Command economy, 62–63 Commercial paper rate, 242 Commodity money, 218–219 Common Market, 374 Z02_CASE3826_13_GE_IDX.indd 454 17/04/19 12:43 AM Comparative advantage, 51, 53, 363–367, 378 versus absolute advantage, 363–367 exchange rates and, 369–370 gains from, 365–366 Heckscher-Ohlin theorem and, 370 new trade theory and, 371 sources of, 370–371 trade flows and, 371 Comparative economic systems, 33 Compensation of employees, 138 Complementary goods, 76 Complements, 76 Concert ticket rationing mechanisms, 105–107 Constrained labor supply, 313 Consumer goods, 55 Consumer Price Index (CPI), 144, 151, 157–158 chained, 161 Consumer sovereignty, 63 Consumer surplus, 110–111 Consumption changing patterns, 62 determinants of, 174–175 effects of interest rates on, 312 government effects on, 312–313 of household sector, 314–316 Keynesian theory of, 170–175, 310, 313–314 plotting household data, 42–43 Consumption function, 170 Contraction, 120 Convergence theory, 331, 337 Copeland, Brian, 379n Corn Laws, 362, 363, 371 Corporate bonds, 124, 293 Corporate profits taxes, 138 Correlation versus causation, 430–431 Corruption, economic development and, 416 Cost shocks, 246, 265–267 Cost-of-living adjustments (COLAs), 280, 280 explicit contract, 279–280 implicit contract, 278–279 social contract, 278–279 Cost-push inflation, 267 Costs adjustment, 318 future, expected, 55 marginal, 28 opportunity, 28, 51–54, 56–57 present, 55 of production, 84–85 Coupons, 231 ration, 104 Craigslist, 109 Credit cards, 220 Credit limit, 220 Critical thinking about research, 428–440 causality in, 430–436 correlation versus causation in, 430–431 Index 455 difference-in-difference in, 435–436 random experiments in, 431–432 regression analysis in, 438–440 regression discontinuity in, 432–434 selection bias in, 429–430 statistical significance in, 4
37–438 Currency appreciation of, 396 debasement of, 219 depreciation of a, 396, 399 held outside banks, 220 Current dollars, 140 Customers, favored, 104 Cutler, David M., 52 Cyclical deficits, 206, 207, 292, 303 versus structural deficits, 292 Cyclical unemployment, 157, 274 explaining existence of, 278–281 D De Medici’s, 221 Deadweight loss, 113, 376 causes, 113–114 Debit cards, 220 Debt-to-GDP ratio, 303 Debtor and creditor nations, identification of, 389 Decisions, labor supply and, 310–312 Deficit targeting, 303–304 macroeconomic consequences of, 305 Deflation, 121, 161 Demand changes in, 72–73 excess, 87–89 household, determinants, 76–79 law of, 74 market demand, 80–82 in product/output markets, 72–82, 93 schedule, 73 shift versus movement on curve, 79–80 side shocks, 267 Demand curves, 74–75 change in equilibrium price and quantity, 78 downward slope, 74 movement, 80 shift, 79 Demand-pull inflation, 267 Dependency, protection in discouraging, 378 Deposits, 220 Depreciation, 136 of a currency, 396 national income and product accounts, 137 Depression, 120 Descriptive questions, 49 Desired level of inventories, 319–320 Developed economies, labor supply in, 332 Z02_CASE3826_13_GE_IDX.indd 455 17/04/19 12:43 AM 456 Index Developing economies economic growth in, 411–425 health issues in, 335 nonmarket activities in, 310 transition from agriculture to industry in, 330–331 Development interventions, economic development and, 422–425 Difference-in-differences, 435–436 Diminishing marginal utility, 75 Diminishing returns, 332, 333, 334 Discount rate, 232 Discounted stocks, 294 Discouraged-worker effects, 154, 316, 324 Discretionary fiscal policy, 191 Disembodied technical change, 336–337 Disequilibrium, 180 in the labor market, 352, 355 Disney World, 386 Disposable (after-tax) income, 191 Disposable personal income, 140 Dividends, 124, 293–294 Dodd-Frank bill, 299 Doha Development Agenda, 374 Domestically owned factors of production, 133–134 Doms, Mark, 137n Double coincidence of wants, 217 Double counting, 132 Dow Jones Industrial Average, 295 Duflo, Esther, 414n Dumping, 372, 372–373 economic development in, 372, 380 greenhouse gas emissions produced in, 380 manufacture of iPhone in, 361 quotas and, 373 trade competition from, 380 transition from agriculture to industry in, 332 Dunn, Wendy, 137n Durable goods, 134 Dynamic stochastic general equilibrium (DSGE) models, 355 E Earp, Wyatt, 222, 223 Easterly, William, 414 Eaton, Jonathan, 372n EBay, 109 Econometrics, 33 Economic activity, circular flow, 70–72, 122–123 Economic consensus, 381 Economic development, 33 capital formation in, 414–415 in China, 417–418 corruption and, 416 development interventions and, 422–425 education in, 423–424 export promotion in, 420 health improvements in, 424–425 import substitution in, 420 in India, 417–418 infrastructure capital in, 417 microfinance in, 420–421 movement from agriculture to industry in, 330–331, 418–420 natural experiments in, 423 random experiments in, 423 role of government in, 417–418 sources of, 414–415 strategies of, 417–421 Economic growth, 37, 58 in developing economies, 411–425 disembodied technical change and, 336–337 embodied technical change and, 335–336 history of, 330–332 labor productivity and, 338–339 labor supply and, 331–333, 335 physical capital and, 333–335 sources of, poor countries and, 59–61 technical change and, 335–338 Economic history, 33 Economic integration, 374–375 Economic policy, 36–38 Economic problem, 61 Economic Recovery Tax Act (1981), 350 Economic stability, 37–38 Economics, 27 behavioral, 33, 174 choices in, 27 control groups and experimental, 434 embodied technical change, 335–336 empirical, 35–36 environmental, 33 fields of, 33 health, 33 international, 33 Keynesian, 346, 348 labor, 33 law and, 33 method of, 27 neoclassical, 72n new classical, 263 normative, 34 policy, 34 positive, 34 reasons to study, 27 regional, 33 societal change and, 30–29 supply-side, 349–351 urban, 33 Economies, firm sector, 320–322 Economists predicting of recessions, 125, 153 Economy, effect of exchange rates on, 399–402 Economy’s future, predicting, 298 Edgeworth, F. Y., 72n Z02_CASE3826_13_GE_IDX.indd 456 17/04/19 12:43 AM Education charter schools, 429 employment and, 30 India, 29 part-time job effect on, 36 Efficiency, open economy and, 36 Efficiency wage theory, 277 Efficient markets, 28–29 Elasticity, structural deficit targets, 292 Embodied technical change, 335–336 Empirical economics, 35–36 Employed, 152 Employees, compensation, 138 Employment constraint on households, 313–314 education and, 30 Entrepreneurs, 70 Equations, models and, 35 Equilibrium determination, 176–177 exchange rate, 396 market equilibrium, 87–95 output (income), 193 saving/investment approach, 179–180, 194–195 Equity, 37 European Central Bank (ECB), 298 European Union (EU), 32, 375 deflation, 121 dumping, 372 patents, 338 quotas, 373 Excess burden, 376 Excess capital, 318 Excess demand, 87–89 Excess labor, 318 multiplier size and, 324–325 Excess reserves, 224 Excess supply, 87 Exchange rates, 368–370 balance of trade and, 399–400 comparative advantage and, 369–370 equilibrium, 396 factors affecting, 397–399 fiscal policy with flexible, 401 flexible, monetary policy and, 400–401 market-determined, 394 monetary policy with fixed, 401–402 open economy with flexible, 393–402 prices and, 400 trade and, 367–368 in two-country/two-good world, 363–364 Exogenous variable, 181 Expansion, 120 Expansionary fiscal policy, 124, 261 Expectations, 78 adaptive, 268 animal spirits and, 317–318 Index 457 Brexit and consumer, 353 Phillips Curve and, 285–286 rational, 352 size of multiplier and, 324–325 Expectations theory, 241 Expenditure approach, 134–138 Experiments natural, 423 random, 423, 431–432 Explicit contracts, 280 Export promotion, 420 Export subsidies, 375–376 Exports determinants of, 392 exchange rate effects on, 399 net, 137 price feedback effect and prices of, 392–393 F Factor endowments, 370 Factor market, 70 Factors, 50 Factors of production, 50, 71 owned from the gross domestic product, 133–134 Fair, Ray C., 438n Farm subsidies, 371 Favored customers, 104 Fed rule, 249–250, 263, 401 Federal agency debt securities, 234 Federal budget, 201–205 Federal debt, 205 privately held, 205 Federal deficit, 201 Federal Deposit Insurance Corporation (FDIC), 229 Federal funds rate, 241–242 Federal Home Loan Mortgage Corporation (Freddie Mac), 233, 234 Federal National Mortgage Association (Fannie Mae), 233, 234 Federal Open Market Committee (FOMC), 227–228, 248 functions of, 227–228 Open Market Desk, 227 Open Market Desk in, 227, 228 open market operations at, 232, 249 participation in 2008 bailout, 299 Powell, Jerome, and, 248 response to the Z factors, 263 structure of, 228 Volcker, Paul, and, 268 Yellen, Janet, and, 124, 249, 249n, 281 Federal Reserve, 227–229 aim for full employment and price stability, 248 balance sheet of, 234–235 banks of, 227 Bernanke, Ben, and, 270 Board of Governors of, 227 control of interest rates by, 232–236, 248–249 control of monetary policy, 263–265 Z02_CASE3826_13_GE_IDX.indd 457 17/04/19 12:43 AM 458 Index Federal Reserve Bank (the Fed), 223, 227 Federal Reserve Bank of New York (FRBNY), 298 Federal surplus, 201 Ferrari, 32 Fiat money, 218–219 Fields of economics, 33 Final goods and services, 132–133 Finance, 33 Financial bailout (2008), 297–299 Financial capital, 414 Financial crises, 297–299 Financial market, 124 Fine-tuning, government and, 125, 127 Firm sector since 1970, 320–322 employment in, 320–322 inventory investment in, 321–322 plant-and-equipment investment in, 320–321 Firms, 70 productivity, globalization and, 372 Fiscal drag, 206–207 Fiscal policy, 124, 190, 261–263 contractionary, 124 deriving the multipliers, 211–212 discretionary, 191 effect on economy, 292 expansionary, 124, 261 with flexible exchange rates, 401 in the long run, 262–263 multiplier effects and, 195–200 response lags for, 302 since 1993, 202–205 in supply-side economics, 349–351 time lags regarding, 300–301 Fitzgerald, F. Scott, 125 Fixed exchange rates Bretton Woods system and, 407 monetary policy with, 401 problems with Bretton Woods system and, 408–409 pure, 407–408 Fixed-weight price indexes, 161 Fixed-weight procedure, 142 problems of, 144 Flexible exchange rates fiscal policy with, 401 monetary policy with, 400–401 open economy with, 393–402 Floating exchange rates, 394 Flood Crises, 105 Foreign direct investment, 334 Foreign exchange, 386 market for, 394–396 reserves, 228 Foreign labor, effect of cheap, 378 Fragile countries, 335 Free enterprise, 63 Free trade, case for, 375–377 Freely floating systems, 409 Frictional unemployment, 157, 274 Friedman, Milton, 310n, 348 Frozen foods, opportunity costs and, 52 Full employment, 275 budget, 207 Fundamental disequilibrium, 407 G Gaskell, Elizabeth, 340 GE (General Electric), 182, 294 General Agreement on Tariffs and Trade (GATT), 374 General Motors (GM), 124, 302, 386 The General Theory of Employment, Interest, and Money (Keynes), 125, 170, 190 Generally accepted accounting principles (GAAP), 418 Germany, dumping and, 372 Germany’s Open Border Policy, 336 Gerschenkron, Alexander, 331 Giertz, Seth, 313n Glaeser, Edward L., 52, 418n Global climate change, 380 Global North, 412 Global South, 412 Global trade order, reshaping, 379 Global warming, 339 Globalization, firm productivity and, 372 Gold standard, 406–407 Gold, Federal Reserve and, 234 Goldman Sachs, 299 Goldsmiths, 221–223 Gollin, Douglas, 418n Goods capital, 55, 59–60 complementary, 76 consumer, 55–57, 60 durable, 134 inferior, 76 intermediate, 132 nondurable, 134 normal, 76, 339–340 Goods-and-services market, 123 Goodwill, 371 Goodyear, 32 Google, 35 Goolsbee, Austan, 77n Gottschalk, Peter, 279n Government, 64 budget, economy’s influence on, 206–207 budgeting and regional autonomy in Spain, 204 deficit, 303–305 economic development and, 417–418 in economy, 191–195 effects on consumption and labor supply, 312–31
3 in macroeconomy, 124 powers of, 190–191 strategy for economic growth and, 332 transfer payments, 137 Z02_CASE3826_13_GE_IDX.indd 458 17/04/19 12:43 AM Government bond rate, 241 Government bonds, 241 Government consumption and gross investment, 137–138 Government spending, 261 multiplier, 195–197 tax multipliers and, 211–212 Grameen model, 420 Gramm-Rudman-Hollings Act (1986), 303–304 The Grapes of Wrath (Steinbeck), 126, 157 Graphs, 41 models and, 35 reading and understanding, 41–46 time series, 41–42 Great Depression, 120, 125, 126, 141, 229, 350, 373, 399n, 407 unemployment in, 56, 274 wage cuts in, 278 The Great Gatsby (Fitzgerald), 125 Great Recession, 153 Gross domestic product (GDP), 132–134 calculating, 134–140 calculating real, 142–143 deflation, 142 deflator calculation, 143 definition, 157 inflation in, 268 ratio of index of housing prices to the, 296–297 distinction between GNP and, 133–134 exclusion of output produced abroad by domestically owned factors of production, 133–134 exclusion of used goods and paper transactions, 133–134 expenditure approach in, 134–138 final goods and services in, 132–133 fixed weights and, 144 income approach in, 138–140 informal economy and, 145–146 nominal versus real, 140–144 origins, 141 social welfare and, 144–145 velocity of money and, 346–347 Gross national income (GNI), 146–147 per capita, 146–147 Gross national product (GNP), 133 Gross private domestic investment, 135–137 Grossman, Gene, 339–340 Growth theory, 162 H Harris, William H., 222 Health economic development and, 424–425 economics, 33 Heckscher-Ohlin theorem, 370 Heckscher, Eli, 370–371 Heller, Walter, 125 Index 459 Hendren, Nathaniel, 433n History of economic growth, 330–331 of macroeconomics, 125–127 Honda, 361 Hoover, Herbert, 141 Household behavior, summary, 314 Household consumption, 309 life-cycle theory of, 309–310 plotting data, 42–43 Household determinants of demand, 76–79 Household income microeconomics and, 31 plotting data, 42–43 Household sector since 1970, 314–316 Household wealth, effects on the economy, 299 Household wealth effect, 292 Households, 70 in the circular flow, 122–123 employment constraint on, 313–314 Housing, prices since 1952, 296–297 Housing bubble, 233 Housing investment, of household sector, 315 Housing market, 292 Housing prices, measuring changes in, 315 Houston, David, 218 Hu, Zuliu, 337 Human capital, 162, 331 increase in quality of, in economic growth, 335 Human Development Index (HDI), 145 Human resources, entrepreneurial ability and, 414, 415–416 Humphrey-Hawkins Full Employment Act (1978), 248 Hurst, Erik, 153n Hyperinflations, 121 I IBM, 380 Identity, 172 Immigration, aggregate supply curve and, 246 Imperfect information, 277 Implementation lags, 301 Import prices, 284 price feedback effect and, 392–393 Imports determinants, 392 exchange rate effects on, 399 quota as limit on, 373 substitution, 420 Income, 76 after-tax, 140 aggregate, 170 dependence of tax revenues on, 212–214 disposable personal, 140 household, 31, 42–43 impact of inflation on distribution of, 159–161 national, 31 nonlabor or nonwage, 312 Z02_CASE3826_13_GE_IDX.indd 459 17/04/19 12:43 AM 460 Index Income (continued) permanent, 310 personal, 140 proprietors, 138 rental, 138 Income approach, 134 to calculating gross domestic products, 138–140 Income effect of wage change, 311 wage rate increase, 311 Income taxes, consumption and labor supply, 312–313 India cell phones in increasing profit for fisherman in, 422 economic development in, 331, 417–419 education, rainfall and, 29 trade competition from, 378 transition from agriculture to industry in, 331 Indirect taxes minus subsidies, 138 Industrial organization, 33 Industrial Revolution, 30, 330, 337, 362 Industry infant, 380 movement from agriculture to, 330–331, 418–420 Inefficiency, PPF, 59 Infant industries, 380 protection in protecting, 380 Inferior goods, 76 Inflation, 121, 157–161 of 1974–1975, 349 of 1979–1981, 349 aggregate demand and, 285–286 anticipated, 160 cost-push, 267 costs of, 159–161 demand-pull, 267 as macroeconomic variable, 151 periods of high, 268 relationship between unemployment and, 270, 281–286 supply-side, 267 unanticipated, 160 Inflation rate, 280 Inflation targeting, 269–270 Inflationary gap, 256 Informal economy, 145–146 Infrastructure capital, 417 Innovation, 337 Input market, 70 Inputs, 50 Intel, 63 Intention to treat, 432 Interest rates, 230–232 as critical variable in money market, 124 effects of, on the economy, 399–402 effects on consumption, 312 Federal Reserve control over, 232–236 planned aggregate expenditure and, 247–248 planned investment and, 175–176 raising, 235 relative, 397–399 short-term, 235–236 size of multiplier and, 324 term structure of, 240–241 types of, 241–242 Intermediate goods, 132 International economics, 33 International Monetary Fund (IMF), 389, 407 International sector, planned aggregate expenditure and, 389–391 International trade comparative advantage in, 362–370, 380 exchange rates in, 368–370 free, 375–377 growth of, 385 Heckscher-Ohlin theorem and, 370–371 importance of, to U.S. economy, 361 protection in, 380–381 terms of trade in, 367–368 trade barriers in, 371–375 trade flows in, 371 International Trade Commission, 372, 380 Inventions, 337 Inventory change in business, 135 desired level of, 319–320 investment, 319–320 optimal level of, 319–320 role of, 319 size of multiplier and, 324 Inventory-to-sales ratio, 321–322 Investments, 55 actual, 175 determinants of planned, 176 financing, 293–294 housing, 315 inventory, 319–320 planned versus actual, 175 planned, interest rate and, 175–176 plant-and-equipment, 320–321 Invisible hand, 95 IPhone, 361 IS curve, 248–249 shift of, 248 It’s a Wonderful Life, 222 J J-curve effect, 399–400 J.P. Morgan, 233 J.P. Morgan Chase, 299 Japan automobile industry in, 371 industrial policy in, 332 negotiation of voluntary restraint with, 373 Jayachandran, Seema, 413n Jensen, J. Bradford, 372n Z02_CASE3826_13_GE_IDX.indd 460 17/04/19 12:43 AM Jevons, William, 72n Jobs, protection and, 377 Job Market, sharing economy is transforming, 280 Johnson, Lyndon, 125 import restrictions and, 374 Johnson, Simon, 418n K Kahn, Lisa, 30, 156 Karabarbounis, L., 153n Katz, Lawrence, 433n Kennedy, John F., 125 import restrictions and, 374 Keynes, John Maynard, 125, 170–171, 190, 267, 274, 313, 317, 346, 348, 351, 354 Keynesian aggregate supply curve, 256, 263 Keynesian economics, 348 monetarism and, 349 Keynesian theory of consumption, 170–175, 310, 313–314 Khan, Mohsin, 337 Khandelwal, Amit, 373 Kindleberger, Charles, 373n Kortum, Samuel, 372n Kouliavtsev, Mikhail, 36 Kremer, Michael, 425 Krugman, Paul, 371 Kuhn, Randall, 419n Kuznets, Simon, 141 L La Porta, Rafael, 418n Labor, excess, 318 Labor demand curve, 275–276 Labor economics, 33 Labor force, 152 participation rate, 152, 315–316 women in the, 155, 246 Labor market, 71, 123, 274–276 classical view of, 275–276 disequilibrium in, 352, 355 Labor productivity growth, 330 United States, 338–339 Labor supply cheap foreign labor problem, 378 constrained, 313 decision, 310–312 decisions and, 310–312 government effects on, 312–313 of household sector, 315–316 increase in, as source of economic growth, 331–332, 335 unconstrained, 313 Labor supply curve, 275 Laffer curve, 349–350 Laffer, Arthur, 349–350 Index 461 Lagakos, David, 418n Laissez-faire economies, 63–64 Land market, 71 Landefeld, J. Steven, 141 Law Corn, 362–363, 371 economics and, 33 minimum wage, 277–278 of one price, 397 Least squares estimates, 439, 440 Legal tender, 219 Lehman Brothers, 298–299 Lender of last resort, 229 Levitan, Julia, 36 Lexus, 371 Li, Robin, 415 Liabilities, 223 Life-cycle theory of consumption, 309–310 The Limits to Growth, 340–341 Liquidity property of money, 218 List, John, 36 Literature, macroeconomics in, 126 Loaned up, 225 Long run, fiscal policy effects in the, 262–263 Long-run aggregate supply (AS) curve, 254–256 potential output, natural rate of unemployment and, 286–287 Long-run growth, 152, 162–164, 329–341 from agriculture to industry, 330–331 disembodied technical change and, 336–337 embodied technical change and, 335–336 environmental and issues of sustainability and, 339–341 government strategy for, 332 increase in labor supply and, 331–332 increase in physical capital and, 333–335 increase in quality of the labor supply and, 335 labor productivity and, 338–339 sources of economic, 331–339 technical change and, 336–337 Lopez-de-Silanes, Florencio, 334, 418n Loss capital, 294–295 deadweight, 113–114, 376 Lucas supply function, 352–353 policy implications of, 354 Lucas, Robert E., 352–353 M M1 (transactions money), 220 M2 (broad money), 220 Macroeconomics, 31–32, 119–127 McKevitt, Fraser, 94 Madrian, Brigitte, 174 Maduro, Nicholas, 121 Malthus, Thomas, 30, 72n, 332, 340–341 Managed floating system, 409 Marginal costs (MC), 28 Z02_CASE3826_13_GE_IDX.indd 461 17/04/19 12:43 AM 462 Index Marginal propensity to consume (MPC), 171 Marginal propensity to import (MPM), 390 Marginal propensity to save (MPS), 172–173 Marginal rate of transformation (MRT), 57 Marginal utility (MU), 75 Marginalism, 28 Market clearing, rational expectations hypothesis and, 352 Market demand, 80–82 Market economy, firms in, 317 Market efficiency, supply and demand and, 110–113 Market equilibrium, 87–95 changes in, 90–92 with equations, 90 excess demand, 87–89 excess supply, 89 Market supply, 86 Market-determined exchange rates, 394 Markets, 63 black market, 105 capital market, 71 competitive, 112 constraints on, 103–107 efficient, 28–29 factor, 70 financial, 124 goods-and-services, 123 housing, 292 input, 70 labor, 71, 123, 274–276, 352 land market, 71 money, 124 product, 93 product/output, 70–87 stock market, 292, 293–296 Marshall, Alfred, 72n, 74 Marx, Karl, 30 Mary Poppins (film), 222 Masterson, William “Bat,” 222 McLain, Frank, 222 Meadows, Donella H., 340n Means of payment, money as, 217 Medium of exchange, money as, 217 Melitz, Marc, 372n Menger,
Carl, 72n Microeconomics, 31–32, 118, 216, 339 inflation and, 157 Microfinance, 420–421 Microsoft, 63, 294 Miguel, Ted, 424 Millennium Development Goals, 411, 413 Millett, Bryce, 415n Minimum wage, 107 difference-in-differences in studying, 435 laws, 277–278 Mitsubishi, 63 Mixed systems, 64 Mobarak, Ahmed Mushfiq, 419n Models, 34–36 aggregate supply/aggregate demand, 249n alternative macroeconomic, 345–357 dynamic stochastic general equilibrium, 355 equations, 35 Grameen, 420 graphs, 35 testing, 35–36 words, 35 Modigliani, Franco, 310n Monetarism, 346–347 Keynesians and, 349 quantity theory of money in, 347–348 velocity of money in, 346–347 Monetary policy, 124, 191 effect on economy, 292 Fed control of, 263–265 Fed’s response to Z factors, 263 with fixed exchange rates, 401 with flexible exchange rates, 400–401 response lags for, 302 setting, FOMC and, 227 shape of AD curve, 263–264 since 1970, 268–270 in supply-side economics, 349–351 time lags regarding, 300–301 zero interest rate bound, 264–265 Money commodity, 218–219 creation of, 224–226 defined, 217–218 demand for, 229–230 fiat, 218–219 liquidity property of, 218 M1 (transactions), 220 M2 (broad), 220 measuring supply of, in the U.S., 219–220 as medium of exchange, 217 quantity theory of, 347–348 role of banks in creating, 224–226 as store of value, 217–218 token, 219 as unit of account, 218 velocity of, 346–347 Money market, 124 Money multiplier, 226 Morduch, Jonathan, 421n Morgan Stanley, 299 Mortgage-backed securities, 299 Morton, Melanie, 418, 419n Moshi guohe, 422 Most-favored nation status, 374 Moving to Opportunity program, 433 Moyo, Dambisa, 411, 414n Mugabe, Robert, 219 Multilateral free trade agreements (FTAs), 32 Z02_CASE3826_13_GE_IDX.indd 462 17/04/19 12:43 AM Index 463 Multipliers, 180–185 balanced-budget, 199–200, 211–212 deriving algebraically, 185n, 189 effects, 247 equation, 183–185 government spending, 195–197 Mafia link, 325 money multiplier, 226 open-economy, 390–391 in the real world, 185 size, 324–325 tax, 198–199 Munshi, Kaivan, 415n Mutual absolute advantage, 363–365 N NASDAQ Composite, 295 National Bureau of Economic Research (NBER), 35, 127n, 141 National debt, 351 National defense, protection and, 378 National income, 138 as achievement of the 20th century, 141 importance of, 131 macroeconomics and, 31 product accounts and, 131 variables in, 132 National security, protection in safeguarding, 378 Natural experiment, 423 Natural rate of unemployment, 157, 286–288 long-run aggregate supply curve, potential output and, 286–287 Near monies, 220 Negative relationships, 43 Negative wealth, 309 Neoclassical economics, 72n Net business transfer payments, 138 Net exports, 138–139 Net interest, 138 Net investment, 136 Net national product (NNP), 139 Net taxes, 191, 253, 261 Net worth, 76, 223 New classical economics, 263 New classical macroeconomics, 349, 351–356 development of, 351 evaluating, 355 Lucas supply function in, 352–353 rational expectations in, 352 New Keynesian economics, 355 real business cycle theory and, 354 New trade theory, 371 New York Federal Reserve Bank, Open Market Desk at, 228 New Zealand comparative advantage and, 365–366 production possibility frontier for, 365–366 terms of trade and, 367–368 Nixon, Richard, import restrictions and, 374 Nokia, rise and fall of, 181 Nominal GDP, 140–144 Nominal output, 142 Nominal wage rate, 311 Nonaccelerating inflation rate of unemployment (NAIRU), 287–288 Nondurable goods, 134 Nonlabor income, 312 wealth and, 311–312 Nonmarket activities, 310 Nonresidential investment, 135 Nonwage income, 312 Nordhaus, William, 141 Normal goods, 76, 339–340 Normative economics, 34 North American Free Trade Agreement (NAFTA), 375–376, 379 Not in the labor force, 152 Null hypothesis, 437, 439 O Obama, Barack, 31, 260 fiscal policy under, 202–205, 268 Obstacles to trade, 371–375 Ockham’s razor, 34 Office for National Statistics (ONS), 94 Ohlin, Bertil, 370–371 Oil aggregate supply curve and, 246 import fee, supply and demand analysis, 108–109 Okun, Arthur, 323 Okun’s Law, 323 Oliner, Stephen, 137n Open economy equilibrium output in an, 389–393 with flexible exchange rates, 393–402 Open Market Desk, 227, 228 Open market operations, 227, 232, 235 Open-economy macroeconomics, 385–399 balance of payments in, 386–389 equilibrium output in, 389–393 Open-economy multiplier, 390–391 Opportunity costs, 28, 50–51 frozen foods and, 52 law of increasing (PPF), 57–58 PPF negative slope, 56–57 Optimal level of inventories, 320–321 Organisation for Economic Co-operation and Development, 432n Organization for Co-operation and Development (OECD), 432 Organization of the Petroleum Exporting Countries (OPEC), 103 Origin, graphs, 42 Oster, Emily, 415n Z02_CASE3826_13_GE_IDX.indd 463 17/04/19 12:43 AM 464 Index Outputs, 50 aggregate, 170 distribution, 63 efficiency, 58 efficient, 58 Fed concern over price level than, 263–264 growth, 162, 330 macroeconomics and, 119–120 per-capita, 330 product, 133–134 productivity growth and, 162–164 unemployment, short-run relationship, 323–324 Outsourcing, 362 Overproduction, 113 deadweight loss from, 113–114 P P-values, 437, 438, 439 Pande, Rohini, 413 Paper transactions, exclusion, from gross domestic product, 133 Paradox of thrift, 184 Pareto, Vilfredo, 72n Peak, 119 Per-capita output growth, 162, 330 Perfect substitutes, 76 Permanent income, 310 Personal consumption expenditures, 134–135 Personal income, 140 Personal saving, 140 Peters, Christina, 419n Phillips Curve, 282–286 aggregate supply and aggregate demand analysis and, 284–286 expectations and, 285–286 historical perspective, 282–283 Phillips, A. W., 282 Physical capital, increase as source of economic growth, 333–335 Piketty, Thomas, 37 Pinto, Marcia Da Silva, 78 Planned aggregate expenditure, 177 interest rates and, 247–248 international sector and, 389–391 Planned investment, 175, 193 versus actual investment, 175 determinants of, 176 interest rate and, 175–176 Plant-and-equipment investment, 320–321 Policy economics, 34 Population growth, 332–333 Positive economics, 34 Positive questions, 49 Positive relationships, 43 Positive wealth, 309 Post hoc, ego propter hoc, 35 Potential GDP, 255 Potential output, 255 short-run equilibrium below, 255 unemployment and, 286–288 Pounds, supply and demand, 394–396 Powell, Jerome, 248 President’s Council of Economic Advisers, 125 Price feedback effect, 393 import and export prices and, 392–393 Price floor, 107–108 Price levels Fed concern over as opposed to output, 263–264 size of multiplier and, 324 Prices allocation of resources, 107 ceiling, 103 exchange rates and, 400 import, 284 high food price, flood crises, 105 quantity demanded and, 73–75 quantity supplied and, 83–84 rationing, 89, 101–103 of related products, 85 role in the consumption/labor supply decision, 311 sticky, 119, 355 surprise, 353–354 system, 101–108 theory, 64 Prime rate, 242 Privately held federal debt, 205 Producer price indexes (PPIs), 159 Producer surplus, 112–113 Product/output markets, 70–71 demand and supply in, 93 demand in, 72–81 supply, 82–87 Production, 50 cost, 84–85 factors, 50 Production efficiency, ppf (production possibility frontier), 56 Production possibilities, graphical presentation, 53–54 Production possibility frontier (PPF), 55–56, 330, 365 inefficiency, 59 MRT (marginal rate of transformation), 57 negative slope (opportunity cost), 56–57 Productivity growth, 162 output and, 162–164 Productivity problem, 338 The Productivity Problem: Alternatives for Action, 338 Productivity, business cycle and, 322–323 Products, related, prices of, 85 Profit, 83 Profit opportunities, 28 Promissory note, 124 Proprietors’ income, 138 Z02_CASE3826_13_GE_IDX.indd 464 17/04/19 12:43 AM Protection, 371, 375–380 in discouraging dependency, 378 environmental concerns and, 378–380 foreign labor and, 378 national security and, 378 protection of infant industries in, 380 in saving jobs, 377 trade practices and, 377–378 Public economics, 33 Purchasing power parity theory, 397 Pure fixed exchange rates, 407–408 Q Quantitative analysis, 35 Quantity demanded, 72, 180n changes in, 72–73 price and, 73–74 Quantity supplied, 83, 180n price and, 83–84 Quantity theory of money, 347–348 testing, 347–348 Queuing, 103–104 Quinoa, 93 Quotas, 373 R Random experiments, 423, 431–432 Randomized controlled trials (RCTs), 434 Ration coupons, 104 Rational expectations hypothesis, 352 Lucas supply function in, 352–353 market clearing and, 352 Rationing alternative mechanisms, 103–107 price, 89, 101–103 Reagan, Ronald deficit targeting and, 303 economic integration and, 374 gold standard and, 407 tax cuts under, 350, 351 Real business cycle theory, 355 new Keynesian economics and, 355 Real GDP, 140–144 calculating, 142–143 exchange rate effects on, 399 Real interest rate, 160 Real wage rate, 311 calculating, 311n Real wealth effect, 254 Realized capital gains, 293 Recessions, 118, 119, 120, 268 of 1974-1975, 349 of 1980-1982, 349, 350 discouraged-worker effect in, 316 Great Recession, 153 time use for the unemployed in a, 153 Index 465 Reciprocal Trade Agreements Act (1934), 374 Recognition lags, 301 Regional economics, 33 Regression analysis, 438–440 Regression discontinuity, 432–434 Relative interest rates, 397–399 Relative-wage explanation of unemployment, 278 Rental income, 138 Required reserve ratio, 224 Research, critical thinking and, 428–440 Reserves, 223–224 borrowed, 232–233 excess, 224 foreign exchange, 228 Residential investment, 135 Resources, 50 allocation, 95 prices, allocation and, 107 Response lags, 302, 302–303 for fiscal policy, 302 for monetary policy, 302 Returns, diminishing, 332–333 Ricardo, David, 30, 51, 52, 72n, 332, 363, 365–367, 381, 413 Robinson, James, 418n Romer, David, 249n Roosevelt, Franklin D., 141 Rosenzweig, Mark, 415n Run on the Bank, 222, 223 S South Africa, drought cause economic shocks in, 266 Sachs, Jeffrey, 414, 414n Saez, Emmanuel, 313n Save More Tomorrow retirement plans, 174 Saving aggr
egate, 172 behavioral biases in, 174 personal, 140 Saving/investment approach to equilibrium, 179–180, 194–195 Savings accounts, 229–230 Scale economies, 372 Scarce, definition, 28 Scarcity in an economy or two or more, 51–55 in a one-person economy, 50–51 Schott, Peter, 373 Selection bias, 429–430, 432 Self-fulfilling expectations, 285 Serebryakov, Alexander Vladimirovitch, 231 Services, 134 Seva Mandir, 424 Shakespeare, William, price mechanisms and, 109 Shapiro, Jesse M., 52, 432n Shapiro, Matthew, 310 Share of stock, 124, 293 Z02_CASE3826_13_GE_IDX.indd 465 17/04/19 12:43 AM 466 Index Shea, Dennis, 174 Sherman Act (1890), 377–378 Shiller, Robert, 315, 318n Shleifer, Andrei, 334, 418n Short run aggregate supply in the, 244–246 relationship between output and unemployment in, 323–324 unemployment rate and inflation in the, 281–286 Short-run equilibrium below potential output, 255 Short-term interest rates, 235–236 Short, Luke, 222 Shortage, 87–89 Shrinkflation, 94 Sichel, Daniel, 137n Slemrod, Joel, 310, 313n Slope in lines and curves, 43–45 ppf, 56–57 Slump, 120 Smith, Adam, 30, 72n, 95, 413 Smoot-Hawley tariff, 373–375 Social overhead capital, 417 Social Security benefits, 137, 313 Social welfare, GDP and, 144–145 South Korea, industrial policy in, 332 Southeast Asia, export-led manufacturing in, 340 Specialization, gains, 53–54 Sports tickets, rationing mechanisms, 105–107 Stability, 37–38 Stabilization policy, 299–305 Stagflation, 127, 265, 267 Standard and Poor’s 500 (S&P 500), 295 Standard of living, 329 Statistical discrepancy, 139, 388 Statistical significance, critical thinking and, 437–438 Steel industry, national security and, 378 Steinbeck, John, 126, 157 Stewart, Jimmy, 222 Sticky prices, 119, 355 Sticky wages, 245, 276, 278, 279 Stock market, 292 bubbles in, 294 since 1948, 295–296 Stocks, 293 common, shares, 293 determining price of, 293–295 shares of common, 124 Store of value, 217–218 money as, 217–218 Structural deficits, 207, 303 versus cyclical deficits, 292 problems in, 292 Structural unemployment, 157, 274 Sub-Saharan Africa, economic growth in, 331 Subprime borrowers, 233 Subsidies farm, 371 indirect taxes minus, 138 Substitutes, 76 perfect, 76 Substitution effect wage rate increase, 311 of wage rate increase, 311 Supply determinants, 83–85 excess, 87 law of, 83 market, 86–87 product/output markets, 82–87, 93 Supply and demand analysis, oil import fee in, 108–109 Supply and demand, market efficiency and, 110–113 Supply curve, 83–84 movement along a, 85–86 shift of, 85–86 Supply schedule, 83 Supply shock, 246 Supply-side economics, 349–351 evaluating, 350–351 Laffer curve in, 349–350 Supply-side inflation, 267 Surplus, 89 consumer, 112–113 of government enterprises, 138 producer, 112–113 Survivor bias, 429 Sustainability, growth and the environment and, 339–341 T T-accounts, 223–224 T-bills, 241 T. Rowe Price, 174 Tariffs, 371 Tax evasion, 146 Tax multiplier, 198–199, 261 government spending and, 211–212 Tax rebates, 310 Tax revenues, dependence on income, 212–214 Taxes adding to the consumption function, 193 alternative minimum, 206 consumption and labor supply, 312–313 corporate profits, 138 income, consumption and labor supply, 312–313 net, 191, 253, 261 Taylor, M. Scott, 379n Technical change, 335–338 disembodied, 336–337 embodied, 335–336 Teenagers minimum wage laws and, 277–278 unemployment rate for, 154 Z02_CASE3826_13_GE_IDX.indd 466 17/04/19 12:43 AM Tefertiller, Casey, 222n Terms of trade, 367–368 Textbook purchase, 77 Thaler, Richard, 174 Theory testing, 35–36 Three-month Treasury Rate, 241 TIAA-CREF, 174 Time lags monetary and fiscal policy, 300–301 types of, 299–303 Time series graph, 41–42 Time use for the unemployed in a recession, 153 Tobin, James, 141 Token money, 219 Trade barriers, 371–375 Trade deficit, 362, 387 Trade feedback effect, 392 Trade flows, explanations for observed, 371 Trade surplus, 362 Trans Pacific Partnership (TPP), 374, 379 Transfer payments, 122, 312–313 net business, 138 Traveler’s checks, 220 Treasury bonds, notes, or bills, 124, 241 Trofimov, Yaroslav, 218n Trough, 120 Tyndall Centre for Climate Change Research, 380 U U.S. Department of Commerce, 380 Bureau of Economic Analysis of, 131 U.S. Department of Justice Antitrust Division, 378 U.S. Dept. of Housing and Urban Development, 432, 433 Moving to Opportunity program, 433 U.S. Treasury securities, 293 U.S.-Canada Free Trade Agreement, 375 Uber, 35 Uncle Vanya, 231 Unconstrained labor supply, 313 Underproduction, 113 deadweight loss from, 113–114 Unemployment, 152 consequences of, 156, 157 costs of, 155–157, 276 cyclical, 157, 274 duration of, 154–155 efficiency wage theory, 277 explaining existence of, 276–277 frictional, 157, 274 in the Great Depression, 274 imperfect information, 277 measuring, 152–153 minimum wage laws, 277–278 natural rate of, 157, 286–288 Index 467 nonaccelerating inflation rate of, 287–288 relationship between inflation and, 273, 281–286 relative-wage explanation, 278–279 short-run relationship between output and, 323–324 structural, 157, 274 time use for, in a recession, 153 Unemployment rates, 121, 146, 152–157, 274 classical view of, 276 components of, 154–155 wide fluctuation in, 292 Unfair trade practices, 377–378 Unit of account, 218 money as, 218 United Nations Millennium Development Goals, 339, 411, 411n, 413 United States globalization of economy in, 361 labor productivity, 338–339 structural deficit problems in, 292 Urban economics, 33 Uruguay Round, 374 Used goods, exclusion, from gross domestic product, 133 Utility, 75 V Value added, 132 Vanguard, 174, 293 Variables, 34 exogenous, 181 graphing, 42 Velocity of money, 346–347 Veterans’ benefits, 313 Veterans’ disability stipends, 137 Vicious circle of poverty, 414 Vietnam, foreign direct investment in, 334 Volcker, Paul, 268 Voluntary restraint, 373 negotiation with Japan, 373 W Wage rate classical view of, 274 effect of changes in, on labor supply, 311 nominal, 311 real, 311 Wages minimum, 107, 277–278 sticky, 273, 276 Walras, Leon, 72n Waugh, Michael, 418n Wealth, 76 negative, 309 nonlabor income and, 311–312 positive, 312 Z02_CASE3826_13_GE_IDX.indd 467 17/04/19 12:43 AM 468 Index Wealth of Nations (Smith), 30 Wei, Shang-Jin, 373n Weight, GDP calculation, 142 Welfare, benefits, 313 Wholesale price indexes, 159 William of Ockham, 34 Women in the labor force, 155, 246 participation and economic development, 155 Woolf, Virginia, 125 Words, models and, 35 World economy, interdependence of countries in, 402 World monetary systems, 405–409 fixed exchange rates and the Bretton Woods system, 407–408 gold standard, 406–407 problems with the Bretton Woods system, 408–409 pure fixed exchange rates, 407–408 World Trade Organization (WTO), 32, 373–374 free trade policies of, 373, 378 X X-axis, 42 ppf (production possibility frontier), 56 X-intercept, 42 Xu, Eric, 415 Y Y-axis, 42 ppf (production possibility frontier), 56 Y-intercept, 42 Yellen, Janet, 124, 249, 281 Yunus, Muhammad, 420–421 Z Z factors, 249–251, 263, 264 Fed’s response to the, 263 Zero interest rate bound, 264–265 Zilibotti, Fabrizio, 332n Zimbabwe currency debasement and, 219 foreign direct investment in, 335 Z02_CASE3826_13_GE_IDX.indd 468 17/04/19 12:43 AM Credits Image Credits Chapter 1: page 27, Wavebreak Media Ltd/123RF; page 29, Ray Fair; page 30, Iofoto/Shutterstock; page 32, Ben Smith. Shutterstock; page 36, milatas.Shutterstock Chapter 2: page 49, Stanca Sanda/Alamy Stock Photo; page 52, Allesalltag/Alamy Stock Photo; page 62, Naki Kouyioumtzis.Pearson Education Ltd Chapter 3: page 69, Toronto-Images.Com/ Shutterstock; page 77, Nicosan/Alamy Stock Photo; page 78, Phovoir/Alamy Stock Photo; page 93, Hughes Herve/Hemis/Alamy Stock Photo Chapter 4: page 100, Ron Buskirk/Alamy Stock Photo; page 105, think4photop.Shutterstock; page 109, Patti McConville/Alamy Stock Photo Chapter 5: page 118, Aleksandr Davydov/123RF; page 126, Everett Collection/Shutterstock; page 126, Library of Congress Prints and Photographs Division [LC-USF34- 033703-D] Chapter 6: page 131, Maskot/Getty Images; page 135, anyaivanova.123rf.com; page 137, Kheng Guan Toh/Shutterstock; page 141, Photobank/ Fotolia; page 145, Stockbroker/MBI/Alamy Stock Photo Chapter 7: page 151, Kristaps Eberlins/123RF; page 153, Kzenon/123RF; page 155, Richard Wayman/Alamy Stock Photo; page 156, Text Credits Chapter 1: page 41, U.S. Department of Commerce, Bureau of Economic Analysis.; page 42, U.S. Department of Commerce, Bureau of Economic Analysis; page 43, Consumer Expenditures in 2016, U.S. Bureau of Labor Statistics; page 46, U.S. Department of Commerce, Bureau of Economic Analysis Chapter 2: page 59, U.S. Department of Agriculture, Economic Research Service, Agricultural Statistics, Crop Summary Chapter 3: page 74, Alfred Marshall, Principles of Economics, 8th ed. (New York: Macmillan, 1948), p. 59. (The first edition was published in 1890.) Chapter 5: page 126, F. Scott Fitzgerald, The Great Gatsby, Simon and Schuster Publishing, 1925.; page 126, From The Grapes of Wrath by John Steinbeck, renewed © 1967 by John Steinbeck. copyright 1939, Penguin Group (USA) Inc. 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pter 17: page 345, Wavebreak Media Ltd/123RF; page 353, lazyllama.Shutterstock Chapter 18: page 361, Dmitry Kalinovsky/123RF; page 372, John Foxx/ Stockbyte/Getty Images; page 373, Kzenon/123RF; page 379, niroworld.123rf. com Chapter 19: page 385, Atstock Productions/ Chapter 11: page 243, Glowimages/Getty Shutterstock; page 389, Ruskpp/Shutterstock Images; page 250, Ian Dagnall/Alamy Stock Photo; page 250, Ron Sachs/CNP/MediaPunch Inc/Alamy Stock Photo; page 252, Bjorn Hoglund.PAL Chapter 12: page 260, Wh1600/E+/Getty Images; page 266, Neil Bradfield.Shutterstock Chapter 13: page 273, Peter Dazeley/ Photographer’s Choice/Getty Images; page 279, Igor Kardasov/Alamy Stock Photo; page 280, Vjom.Shutterstock Chapter 14: page 292, Sharon Oster; page 298, Lynne Carpenter.Shutterstock Chapter 20: page 411, WENN Ltd/Alamy Stock Photo; page 413, TheFinalMiracle/ Fotolia; page 419, Zakir Hossain Chowdhury/ ZUMA Press, Inc./Alamy Live News/Alamy Stock Photo; page 419, Zakir Hossain Chowdhury/ZUMA Press, Inc./Alamy Stock Photo; page 422, mehta123.123rf.com Chapter 21: page 428, Robert Kneschke/ Shutterstock; page 433, Sean Pavone/ Shutterstock; page 434, Birute Vijeikiene.PAL; page 436, imtmphoto.123rf.com Bureau of Economic Analysis, March 28, 2018; page 139, U.S. Bureau of Economic Analysis, March 28, 2018; page 141, U.S. Department of Commerce, Bureau of Economics, “GDP: One of the Great Inventions of the 20th Century,” Survey of Current Business, January 2000, pp. 36–39; page 146, Data from GNI per capita, PPP (current international $), The World Bank Group, Retrieved from http://data.worldbank.org/ indicator/NY.GNP.PCAP.PP.CD Chapter 7: page 153, Economic Report of the President, 2015 and U.S. Bureau of Labor Statistics; page 154, U.S. Bureau of Labor Statistics; page 156, U.S. Bureau of Labor Statistics; page 158, U.S. Bureau of Labor Statistics; page 159, U.S. Bureau of Labor Statistics Chapter 8: page 170, John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), p. 96. Chapter 9: page 201, U.S. Bureau of Economic Analysis, March 28, 2018. Chapter 10: page 222, Casey Tefertiller, Wyatt Earp: The Life Behind the Legend, John Wiley & Sons, Inc., 1997; page 205, Anton Pavlovich Chekhov, The Plays of Tchekhov,Chatto and Windus, 1923; page 234, Federal Reserve Statistical Release, Factors affecting Reserve Balances, Board of Governors of the Federal Reserve System Chapter 13: page 283, U.S Bureau of Labor Statistics Chapter 14: page 301, Janet Yellen, 2015 in a speech in San Francisco Chapter 15: page 317, The General Theory of Employment, Interest, and Money (1936), First Harbinger Ed. (New York: Harcourt Brace Jovanovich, 1964), pp. 149, 152. Chapter 16: page 331, Economic Report of the President, 2018, Table B-4; page 333, 469 Z03_CASE3826_13_GE_CRED.indd 469 26/04/19 4:59 PM 470 Credits Economic Report of the President, 2018; page 334, U.S. Department of Commerce, Bureau of Economic Analysis., Fixed Asset Tabl; page 335, Statistical Abstract of the United States, 1990, Table 215, and 2012, Table 229, and Bureau of the Census, 2017, Table 2, Educational Attainment; page 337, National Academies, “Rising Above the Gathering Storm: Energizing the Employing America for a Brighter Future,” National Academies Press, 2007.; page 339, Based on Economic Growth and the Environment, Quarterly Journal of Economics, Vol.110, No.2, May 1995. pp. 353–357; page 340, The Limits to Growth Book by Dennis Meadows, Donella Meadows, Jørgen Randers, and William W. Behrens III; page 342, United States Department of Agriculture; page 343, “World Bank Supports Move to Accelerate Indonesia’s Economic Growth through Science, Technology, and Innovation,” www.worldbank.org, March 29, 2013. Used by permission Chapter 19: page 387, Bureau of Economic Analysis, March 21, 2018. Chapter 20: page 412, Data from UN, Millennium Development Goal Data, 2015.; page 416, Based on World Bank, World Wide Governance Indicators Report, Policy Paper 5430, 2014.; page 419, Based on World development report, 2009 Reshaping Economics Geography; page 427, Datas from The World Bank Group Z03_CASE3826_13_GE_CRED.indd 470 26/04/19 4:59 PM This page is intentionally left blank Z03_CASE3826_13_GE_CRED.indd 471 26/04/19 4:59 PM This page is intentionally left blank Z03_CASE3826_13_GE_CRED.indd 472 26/04/19 4:59 PM
-20 Therefore the individual will not be willing to pay as much for each additional unit and this results in a downward sloping demand curve. At a price of Rs. 40 per unit x, individual’s demand for x was 5 units. The 6th unit of commodity x will be worth less than the 5th unit. The individual will be willing to buy the 6th unit only when the price drops below Rs. 40 per unit. Hence, the law of diminishing marginal utility explains why demand curves have a negative slope. 2.1.2 Ordinal Utility Analysis Cardinal utility analysis is simple to understand, but suffers from a major drawback in the form of quantification of utility in numbers. In real life, we never express utility in the form of numbers. At the most, we can rank various alternative combinations in terms of having more or less utility. In other words, the consumer does not measure utility in numbers, though she often ranks various consumption bundles. This forms the starting point of this topic – Ordinal Utility Analysis. A consumer’s preferences over the set of available bundles can often be A represented diagrammatically. We have already seen that the bundles available to the consumer can be plotted as points in a twodimensional diagram. The points representing bundles which give the consumer equal utility can generally be joined to obtain a curve like the one in Figure 2.3. The consumer is said to be indifferent on the different bundles because each point of the bundles give the consumer equal utility. Such a curve joining all points representing bundles among which the consumer is indifferent is called an indifference curve. All the points such as A, B, C and D lying on an indifference curve provide the consumer with the same level of satisfaction. Indifference curve. An indifference curve joins all points representing bundles which are considered indifferent by the consumer. It is clear that when a consumer gets one more banana, he has to forego some mangoes, so that her total utility level remains the same and she remains on the same indifference curve. Therefore, indifference curve slopes downward. The amount of mangoes that the consumer has to forego, in order to get an additional banana, her total utility level being the same, is called marginal rate of substitution (MRS). In other words, MRS is simply the rate at which the consumer will substitute bananas for mangoes, so that her total utility remains constant. So, MRS =\| ∆ Y / X ∆ \| 3. One can notice that, in the table 2.2, as we increase the quantity of bananas, the quantity of mangoes sacrificed for each additional banana declines. In other words, MRS diminishes with increase in the number of bananas. As the number 11 / ∆ \|= ∆ X Y / ∆ X if ( ∆ Y / ∆ X ) 0 ≥ = −∆ Y / ∆ X if ( ∆ Y / ∆ X ) 0 < MRS =\| ∆ Y / ∆ \| means that MRS equals only the magnitude of the expression X /Y ∆ ∆ . If it means MRS=3. 2019-20 Table 2.2: Representation of Law of Diminishing Marginal Rate of Substitution Combination Quantity of bananas (Qx) Quantity of Mangoes (Qy) MRS A 1 15 - B 2 12 3:1 C 3 10 2:1 D 4 9 1:1 of bananas with the consumer increases, the MU derived from each additional banana falls. Similarly, with the fall in quantity of mangoes, the marginal utility derived from mangoes increases. So, with increase in the number of bananas, the consumer will feel the inclination to sacrifice small and smaller amounts of mangoes. This tendency for the MRS to fall with increase in quantity of bananas is known as Law of Diminishing Marginal Rate of Substitution. This can be seen from figure 2.3 also. Going from point A to point B, the consumer sacrifices 3 mangoes for 1 banana, going from point B to point C, the consumer sacrifices 2 mangoes for 1 banana, and going from point C to point D, the consumer sacrifices just 1 mango for 1 banana. Thus, it is clear that the consumer sacrifices smaller and smaller quantities of mangoes for each additional banana. Shape of an Indifference Curve It may be mentioned that the law of Diminishing Marginal Rate of Substitution causes an indifference curve to be convex to the origin. This is the most common shape of an indifference curve. But in case of goods being perfect substitutes4, the marginal rate of substitution does not diminish. It remains the same. Let’s take an example. Table 2.3: Representation of Law of Diminishing Marginal Rate of Substitution 12 Combination Quantity of five Quantity of five MRS Rupees notes (Qx) Rupees coins (Qy) A 1 8 - B 2 7 1:1 C 3 6 1:1 D 4 5 1:1 Here, the consumer is indifferent for all these combinations as long as the total of five rupee coins and five rupee notes remains the same. For the consumer, it hardly matters whether she gets a five rupee coin or a five rupee note. So, irrespective of how many five rupee notes she has, the consumer will sacrifice only one five rupee coin for a five rupee note. So these two commodities are perfect substitutes for the consumer and indifference curve depicting these will be a straight line. In the figure.2.4, it can be seen that consumer sacrifices the same number of five-rupee coins each time he has an additional five-rupee note. 4 Perfect Substitutes are the goods which can be used in place of each other, and provide exactly the same level of utility to the consumer. 2019-20 Monotonic Preferences Consumer’s preferences are assumed to be such that between any two bundles (x1, x2) and (y1, y2), if (x1, x2) has more of at least one of the goods and no less of the other good compared to (y1, y2), then the consumer prefers (x1, x2) to (y1, y2). Preferences of this kind are called monotonic preferences. Thus, a consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle. Indifference Map The consumer’s preferences over all the bundles can be represented by a family of indifference curves as shown in Figure 2.5. This is called an indifference map of the consumer. All points on an indifference curve represent bundles which are considered indifferent by the consumer. Monotonicity of preferences imply that between any two indifference curves, the bundles on the one which lies above are preferred to the bundles on the one which lies below. Features of Indifference Curve slopes curve 1. Indifference downwards from left to right: An indifference curve slopes downwards from left to right, which means that in order to have more of bananas, the consumer has to forego some mangoes. If the consumer does not forego some mangoes with an increase in number of bananas, it will mean consumer having more of bananas with same number of mangoes, taking her to a higher indifference curve. Thus, as long as the consumer is on the same indifference curve, an increase in bananas must be compensated by a fall in quantity of mangoes. Indif ference Curve for per fect substitutes. Indifference curve depicting two commodities which are perfect substitutes is a straight line. Indifference Map. A family of indifference curves. The arrow indicates that bundles on higher indifference curves are preferred by the consumer to the bundles on lower indifference curves. 13 Slope of the Indifference Curve. The indifference curve slopes downward. An increase in the amount of bananas along the indifference curve is associated with a decrease in the amount of mangoes. If ∆ x1 > 0 then ∆ x2 < 0. 2019-20 2.Higher indifference curve gives greater level of utility: As long as marginal utility of a commodity is positive, an individual will always prefer more of that commodity, as more of the commodity will increase the level of satisfaction. Table 2.4: Representation of different level of utilities from different combination of goods Combination Quantity of bananas Quantity of Mangoes A 1 10 B 2 10 C 3 10 Consider the different combination of bananas and mangoes, A, B and C depicted in table 2.4 and figure 2.7. Combinations A, B and C consist of same quantity of mangoes but different quantities of bananas. Since combination B has more bananas than A, B will provide the individual a higher level of satisfaction than A. Therefore, B will lie on a higher indifference curve than A, depicting higher satisfaction. Likewise, C has more bananas than B (quantity of mangoes is the same in both B and C). Therefore, C will provide higher level of satisfaction than B, and also lie on a higher indifference curve than B. A higher indifference curve consisting of combinations with more of mangoes, or more of bananas, or more of both, will represent combinations that give higher level of satisfaction. Higher indifference curves give greater level of utility. 3.Two indifference curves never intersect each other: Two indifference curves intersecting each other will lead to conflicting results. To explain this, let us allow two indifference curves to intersect each other as shown in the figure 2.8. As points A and B lie on the same indifference curve IC1, utilities derived from combination A and combination B will give the same level of satisfaction. Similarly, as points A and C lie on the same indifference curve IC2, utility derived from combination A and from combination C will give the same level of satisfaction7,10) B (9,7) IC1 Ic2 C (9,5) Bananas Two indifference curves never intersect each other 14 2019-20 From this, it follows that utility from point B and from point C will also be the same. But this is clearly an absurd result, as on point B, the consumer gets a greater number of mangoes with the same quantity of bananas. So consumer is better off at point B than at point C. Thus, it is clear that intersecting indifference curves will lead to conflicting results. Thus, two indifference curves cannot intersect each other. 2.2 THE CONSUMER’S BUDGET Let us consider a consumer who has only a fixed amount of money (income) to spend on two goods. The prices of the goods are given in the market. The consumer cannot buy an
y and every combination of the two goods that she may want to consume. The consumption bundles that are available to the consumer depend on the prices of the two goods and the income of the consumer. Given her fixed income and the prices of the two goods, the consumer can afford to buy only those bundles which cost her less than or equal to her income. 2.2.1 Budget Set and Budget Line Suppose the income of the consumer is M and the prices of bananas and mangoes are p1 and p2 respectively5. If the consumer wants to buy x1 quantities of bananas, she will have to spend p1x1 amount of money. Similarly, if the consumer wants to buy x2 quantities of mangoes, she will have to spend p2x2 amount of money. Therefore, if the consumer wants to buy the bundle consisting of x1 quantities of bananas and x2 quantities of mangoes, she will have to spend p1x1 + p2x2 amount of money. She can buy this bundle only if she has at least p1x1 + p2x2 amount of money. Given the prices of the goods and the income of a consumer, she can choose any bundle as long as it costs less than or equal to the income she has. In other words, the consumer can buy any bundle (x1, x2) such that p1x1 + p2x2 ≤ M (2.1) The inequality (2.1) is called the consumer’s budget constraint. The set of bundles available to the consumer is called the budget set. The budget set is thus the collection of all bundles that the consumer can buy with her income at the prevailing market prices. EXAMPLE 2.1 Consider, for example, a consumer who has Rs 20, and suppose, both the goods are priced at Rs 5 and are available only in integral units. The bundles that this consumer can afford to buy are: (0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (1, 1), (1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0). Among these bundles, (0, 4), (1,3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 20 and all the other bundles cost less than Rs 20. The consumer cannot afford to buy bundles like (3, 3) and (4, 5) because they cost more than Rs 20 at the prevailing prices. 5 Price of a good is the amount of money that the consumer has to pay per unit of the good she wants to buy. If rupee is the unit of money and quantity of the good is measured in kilograms, the price of banana being p1 means the consumer has to pay p1 rupees per kilograms of banana that she wants to buy. 15 2019-20 If both the goods are perfectly divisible6, the consumer’s budget set would consist of all bundles (x1, x2) such that x1 and x2 are any numbers greater than or equal to 0 and p1x1 + p2x2 ≤ M. The budget set can be represented in a diagram as in Figure 2.9. All bundles in the positive quadrant which are on or below the line are included in the budget set. The equation of the line is p1x1 + p2x2 = M (2.2) The line consists of all bundles which cost exactly equal to M. This line is called the budget line. Points below the budget line represent bundles which cost strictly less than M. Budget Set. Quantity of bananas is measured along the horizontal axis and quantity of mangoes is measured along the vertical axis. Any point in the diagram represents a bundle of the two goods. The budget set consists of all points on or below the straight line having the equation p1x1 + p2x2 = M. The equation (2.2) can also be written as7 The budget line is a straight line with horizontal intercept x 2 = pM 1 − p p 2 2 x 1 (2.3) M p and vertical 1 intercept M p . The horizontal intercept represents the bundle that the consumer can buy if she spends her entire income on bananas. Similarly, the vertical intercept represents the bundle that the consumer can buy if she spends her 2 16 entire income on mangoes. The slope of the budget line is – p 1 p . 2 Price Ratio and the Slope of the Budget Line Think of any point on the budget line. Such a point represents a bundle which costs the consumer her entire budget. Now suppose the consumer wants to have one more banana. She can do it only if she gives up some amount of the other good. How many mangoes does she have to give up if she wants to have an extra quantity of bananas? It would depend on the prices of the two goods. A quantity of banana costs p1. Therefore, she will have to reduce her expenditure on mangoes by p1 amount, if she wants one more quantity of banana. With p1, she could buy p 1 p quantities of mangoes. Therefore, if the consumer wants to 2 have an extra quantity of bananas when she is spending all her money, she will have to give up p 1 p quantities of mangoes. In other words, in the given market 2 6The goods considered in Example 2.1 were not divisible and were available only in integer units. There are many goods which are divisible in the sense that they are available in non-integer units also. It is not possible to buy half an orange or one-fourth of a banana, but it is certainly possible to buy half a kilogram of rice or one-fourth of a litre of milk. 7In school mathematics, you have learnt the equation of a straight line as y = c + mx where c is the vertical intercept and m is the slope of the straight line. Note that equation (2.3) has the same form. 2019-20 Derivation of the Slope of the Budget Line Mangoes The slope of the budget line measures the amount of change in mangoes required per unit of change in bananas along the budget line. Consider any two points (x1, x2) and (x1 + ∆x1, x2 + ∆x2) on the budget line.a It must be the case that p1x1 + p2x2 = M (2.4) and, p1(x1 + ∆x1) + p2(x2 + ∆x2) = M Subtracting (2.4) from (2.5), we obtain p1∆x1 + p2∆x2 = 0 By rearranging terms in (2.6), we obtain ∆ Bananas (2.5) (2.6) (2.7) a∆ (delta) is a Greek letter. In mathematics, ∆ is sometimes used to denote ‘a change’. Thus, ∆x1 stands for a change in x1 and ∆x2 stands for a change in x2. conditions, the consumer can substitute bananas for mangoes at the rate p 1 p . The absolute value8 of the slope of the budget line measures the rate at which the consumer is able to substitute bananas for mangoes when she spends her entire budget. 2 2.2.2 Changes in the Budget Set The set of available bundles depends on the prices of the two goods and the income of the consumer. When the price of either of the goods or the consumer’s income changes, the set of available bundles is also likely to change. Suppose the consumer’s income changes from M to M ′ but the prices of the two goods remain unchanged. With the new income, the consumer can afford to buy all bundles (x1, x2) such that p1x1 + p2x2 ≤ M′. Now the equation of the budget line is 17 Equation (2.8) can also be written as p1x1 + p2x2 = M′ x 2 = pM2.8) (2.9) Note that the slope of the new budget line is the same as the slope of the budget line prior to the change in the consumer’s income. However, the vertical intercept has changed after the change in income. If there is an increase in the 8The absolute value of a number x is equal to x if x ≥ 0 and is equal to – x if x < 0. The absolute value of x is usually denoted by \|x\|. 2019-20 income, i.e. if M' > M, the vertical as well as horizontal intercepts increase, there is a parallel outward shift of the budget line. If the income increases, the consumer can buy more of the goods at the prevailing market prices. Similarly, if the income goes down, i.e. if M' < M, both intercepts decrease, and hence, there is a parallel inward shift of the budget line. If income goes down, the availability of goods goes down. Changes in the set of available bundles resulting from changes in consumer’s income when the prices of the two goods remain unchanged are shown in Figure 2.10. Mangoes Mangoes M'<M M'>M Bananas Bananas 10 Changes in the Set of Available Bundles of Goods Resulting from Changes in the Consumer’s Income. A decrease in income causes a parallel inward shift of the budget line as in panel (a). An increase in income causes a parallel outward shift of the budget line as in panel (b). Now suppose the price of bananas change from p1 to p'1 but the price of mangoes and the consumer’s income remain unchanged. At the new price of bananas, the consumer can afford to buy all bundles (x1,x2) such that p'1x1 + p2x2 ≤ M. The equation of the budget line is Equation (2.10) can also be written as p'1x1 + p2x2 = M x 2 = M p 2 – p' 1 p 2 x 1 (2.10) (2.11) Note that the vertical intercept of the new budget line is the same as the vertical intercept of the budget line prior to the change in the price of bananas. However, the slope of the budget line and horizontal intercept have changed after the price change. If the price of bananas increases, ie if p'1> p1, the absolute value of the slope of the budget line increases, and the budget line becomes steeper (it pivots inwards around the vertical intercept and horizontal intercept decreases). If the price of bananas decreases, i.e., p'1< p1, the absolute value of the slope of the budget line decreases and hence, the budget line becomes flatter (it pivots outwards around the vertical intercept and horizontal intercept increases). Figure 2.11 shows change in the budget set when the price of only one commodity changes while the price of the other commodity as well as income of the consumer are constant. A change in price of mangoes, when price of bananas and the consumer’s income remain unchanged, will bring about similar changes in the budget set of the consumer. 18 2019-20 Mangoes Mangoes Bananas Bananas 11 Changes in the Set of Available Bundles of Goods Resulting from Changes in the Price of bananas. An increase in the price of bananas makes the budget line steeper as in panel (a). A decrease in the price of bananas makes the budget line flatter as in panel (b). 2.3 OPTIMAL CHOICE OF THE CONSUMER The budget set consists of all bundles that are available to the consumer. The consumer can choose her consumption bundle from the budget set. But on what basis does she choose her consumption bundle from the ones that are available to her? In economics, it is assumed that the consumer chooses her consumption bundle on the basis of her tatse and preferences
over the bundles in the budget set. It is generally assumed that the consumer has well defined preferences over the set of all possible bundles. She can compare any two bundles. In other words, between any two bundles, she either prefers one to the other or she is indifferent between the two. Equality of the Marginal Rate of Substitution and the Ratio of the Prices The optimum bundle of the consumer is located at the point where the budget line is tangent to one of the indifference curves. If the budget line is tangent to an indifference curve at a point, the absolute value of the slope of the indifference curve (MRS) and that of the budget line (price ratio) are same at that point. Recall from our earlier discussion that the slope of the indifference curve is the rate at which the consumer is willing to substitute one good for the other. The slope of the budget line is the rate at which the consumer is able to substitute one good for the other in the market. At the optimum, the two rates should be the same. To see why, consider a point where this is not so. Suppose the MRS at such a point is 2 and suppose the two goods have the same price. At this point, the consumer is willing to give up 2 mangoes if she is given an extra banana. But in the market, she can buy an extra banana if she gives up just 1 mango. Therefore, if she buys an extra banana, she can have more of both the goods compared to the bundle represented by the point, and hence, move to a preferred bundle. Thus, a point at which the MRS is greater, the price ratio cannot be the optimum. A similar argument holds for any point at which the MRS is less than the price ratio. 19 2019-20 In economics, it is generally assumed that the consumer is a rational individual. A rational individual clearly knows what is good or what is bad for her, and in any given situation, she always tries to achieve the best for herself. Thus, not only does a consumer have well-defined preferences over the set of available bundles, she also acts according to her preferences. From the bundles which are available to her, a rational consumer always chooses the one which gives her maximum satisfaction. In the earlier sections, it was observed that the budget set describes the bundles that are available to the consumer and her preferences over the available bundles can usually be represented by an indifference map. Therefore, the consumer’s problem can also be stated as follows: The rational consumer’s problem is to move to a point on the highest possible indifference curve given her budget set. If such a point exists, where would it be located? The optimum point would be located on the budget line. A point below the budget line cannot be the optimum. Compared to a point below the budget line, there is always some point on the budget line which contains more of at least one of the goods and no less of the other, and is, therefore, preferred by a consumer whose preferences are monotonic. Therefore, if the consumer’s preferences are monotonic, for any point below the budget line, there is some point on the budget line which is preferred by the consumer. Points above the budget line are not available to the consumer. Therefore, the optimum (most preferred) bundle of the consumer would be on the budget line. Where on the budget line will the optimum bundle be located? The point at which the budget line just touches (is tangent to), one of the indifference curves would be the optimum.9 To see why this is so, note that any point on the budget line other than the point at which it touches the indifference curve lies on a lower indifference curve and hence is inferior. Therefore, such a point cannot be the consumer’s optimum. The optimum bundle is located on the budget line at the point where the budget line is tangent to an indifference curve. ( , * 1 Figure 2.12 illustrates the * consumer’s optimum. At x x , the ) 2 budget line is tangent to the black coloured indifference curve. The first thing to note is that the indifference curve just touching the budget line is the highest possible indifference curve given the consumer’s budget set. Bundles on the indifference curves above this, like the grey one, are not affordable. Points on the indifference curves below this, like the blue one, are certainly inferior to the points on the indifference curve, just touching the budget line. Any other point on the budget line lies on a lower indifference curve and hence, is inferior to Consumer’s Optimum. The point (x ∗ 2 ), at which the budget line is tangent to an indifference curve represents the consumers is the consumer’s optimum bundle. x x . Therefore, 1 To be more precise, if the situation is as depicted in Figure 2.12 then the optimum would be located at the point where the budget line is tangent to one of the indifference curves. However, there are other situations in which the optimum is at a point where the consumer spends her entire income on one of the goods only. 20 2019-20 2.4 DEMAND In the previous section, we studied the choice problem of the consumer and derived the consumer’s optimum bundle given the prices of the goods, the consumer’s income and her preferences. It was observed that the amount of a good that the consumer chooses optimally, depends on the price of the good itself, the prices of other goods, the consumer’s income and her tastes and preferences. The quantity of a commodity that a consumer is willing to buy and is able to afford, given prices of goods and consumer’s tastes and preferences is called demand for the commodity. Whenever one or more of these variables change, the quantity of the good chosen by the consumer is likely to change as well. Here we shall change one of these variables at a time and study how the amount of the good chosen by the consumer is related to that variable. 2.4.1 Demand Curve and the Law of Demand If the prices of other goods, the consumer’s income and her tastes and preferences remain unchanged, the amount of a good that the consumer optimally chooses, becomes entirely dependent on its price. The relation between the consumer’s optimal choice of the quantity of a good and its price is very important and this relation is called the demand function. Thus, the consumer’s demand function for a good Demand Curve. The demand curve is a relation between the quantity of the good chosen by a consumer and the price of the good. The independent variable (price) is measured along the vertical axis and dependent variable (quantity) is measured along the horizontal axis. The demand curve gives the quantity demanded by the consumer at each price. Functions Consider any two variables x and y. A function y = f (x) is a relation between the two variables x and y such that for each value of x, there is an unique value of the variable y. In other words, f (x) is a rule which assigns an unique value y for each value of x. As the value of y depends on the value of x, y is called the dependent variable and x is called the independent variable. 1 EXAMPLE Consider, for example, a situation where x can take the values 0, 1, 2, 3 and suppose corresponding values of y are 10, 15, 18 and 20, respectively. Here y and x are related by the function y = f (x) which is defined as follows: f (0) = 10; f (1) = 15; f (2) = 18 and f (3) = 20. EXAMPLE Consider another situation where x can take the values 0, 5, 10 and 20. And suppose corresponding values of y are 100, 90, 70 and 40, respectively. 2 21 2019-20 Here, y and x are related by the function y = f (x ) which is defined as follows: f (0) = 100; f (10) = 90; f (15) = 70 and f (20) = 40. Very often a functional relation between the two variables can be expressed in algebraic form like y = 5 + x and y = 50 – x A function y = f (x) is an increasing function if the value of y does not decrease with increase in the value of x. It is a decreasing function if the value of y does not increase with increase in the value of x. The function in Example 1 is an increasing function. So is the function y = x + 5. The function in Example 2 is a decreasing function. The function y = 50 – x is also decreasing. Graphical Representation of a Function A graph of a function y = f (x) is a diagrammatic representation of the function. Following are the graphs of the functions in the examples given above. 22 Usually, in a graph, the independent variable is measured along the horizontal axis and the dependent variable is measured along the vertical axis. However, in economics, often the opposite is done. The demand curve, for example, is drawn by taking the independent variable (price) along the vertical axis and the dependent variable (quantity) along the horizontal axis. The graph of an increasing function is upward sloping or and the graph of a decreasing function is downward sloping. As we can see from the diagrams above, the graph of y = 5 + x is upward sloping and that of y = 50 – x, is downward sloping. 2019-20 gives the amount of the good that the consumer chooses at different levels of its price when the other things remain unchanged. The consumer’s demand for a good as a function of its price can be written as X = f (P) (2.12) where X denotes the quantity and P denotes the price of the good. The demand function can also be represented graphically as in Figure 2.13. The graphical representation of the demand function is called the demand curve. The relation between the consumer’s demand for a good and the price of the good is likely to be negative in general. In other words, the amount of a good that a consumer would optimally choose is likely to increase when the price of the good falls and it is likely to decrease with a rise in the price of the good. 2.4.2 Deriving a Demand Curve from Indifference Curves and Budget Constraints Consider an individual consuming bananas (X1)and mangoes (X2), whose income is M and market prices of X1 and X2 are 2P ' respectively. Figure (a) depicts 2X ' quantities her consumption equilibrium at poin
t C, where she buys of bananas and mangoes respectively. In panel (b) of figure 2.14, we plot 1P ' against 1X ' which is the first point on the demand curve for X1. 1P ' and 1X ' and Deriving a demand curve from indifference curves and budget constraints 2P ' Suppose the price of X1 drops to 1P with and M remaining constant. The budget set in panel (a), expands and new consumption equilibrium is on a X ' ). higher indifference curve at point D, where she buys more of bananas ( 1 Thus, demand for bananas increases as its price drops. We plot 1P against 1X in panel (b) of figure 2.14 to get the second point on the demand curve for X1. Likewise the price of bananas can be dropped further to 1P , resulting in further increase in consumption of bananas to 1X gives us the third point on the demand curve. Therefore, we observe that a drop in price of bananas results in an increase in quality of bananas purchased by an individual who maximises his utility. The demand curve for bananas is thus negatively sloped. ∧ 1P plotted against 1X . >1 X ∧ ∧ ∧ The negative slope of the demand curve can also be explained in terms of the two effects namely, substitution effect and income effect that come into play when price of a commodity changes. when bananas become cheaper, the consumer maximises his utility by substituting bananas for mangoes in order to derive the same level of satisfaction of a price change, resulting in an increase in demand for bananas. 23 2019-20 Moreover, as price of bananas drops, consumer’s purchasing power increases, which further increases demand for bananas (and mangoes). This is the income effect of a price change, resulting in further increase in demand for bananas. Law of Demand: Law of Demand states that other things being equal, there is a negative relation between demand for a commodity and its price. In other words, when price of the commodity increases, demand for it falls and when price of the commodity decreases, demand for it rises, other factors remaining the same. Linear Demand A linear demand curve can be written as d(p) = a – bp; 0 ≤ p ≤ a b = 0; p > a b (2.13) where a is the vertical intercept, –b is the slope of the demand curve. At price 0, the demand is a, and at price equal to a b , the demand is 0. The Linear Demand Curve. The diagram depicts the linear demand curve given by equation 2.13. slope of the demand curve measures the rate at which demand changes with respect to its price. For a unit increase in the price of the good, the demand falls by b units. Figure 2.15 depicts a linear demand curve. 2.4.3 Normal and Inferior Goods The demand function is a relation between the consumer’s demand for a good and its price when other things are given. Instead of studying the relation between the demand for a good and its price, we can also study the relation between the consumer’s demand for the good and the income of the consumer consumer demands can increase or decrease with the rise in income depending on the nature of the good. For most goods, the quantity that a consumer chooses, increases as the consumer’s income increases and decreases as the consumer’s income decreases. Such goods are called normal goods. Thus, a consumer’s demand for a normal good moves in the same direction as the income of the consumer. However, there are some goods the demands for which move in the opposite direction of the income of the consumer. Such goods are called inferior goods. As the income of the consumer increases, the demand for an inferior good falls, and as the income decreases, the demand for an inferior A rise in the purchasing power (income) of the consumer can sometimes induce the consumer to reduce the consumption of a good. In such a case, the substitution effect and the income effect will work in opposite directions. The demand for such a good can be inversely or positively related to its price depending on the relative strengths of these two opposing effects. If the substitution effect is stronger than the income effect, the demand for the good and the price of the good would still be inversely related. However, if the income effect is stronger than the substitution effect, the demand for the good would be positively related to its price. Such a good is called a Giffen good. 24 2019-20 good rises. Examples of inferior goods include low quality food items like coarse cereals. A good can be a normal good for the consumer at some levels of income and an inferior good for her at other levels of income. At very low levels of income, a consumer’s demand for low quality cereals can increase with income. But, beyond a level, any increase in income of the consumer is likely to reduce her consumption of such food items as she switches to better quality cereals. 2.4.4 Substitutes and Complements We can also study the relation between the quantity of a good that a consumer chooses and the price of a related good. The quantity of a good that the consumer chooses can increase or decrease with the rise in the price of a related good depending on whether the two goods are substitutes or complementary to each other. Goods which are consumed together are called complementary goods. Examples of goods which are complement to each other include tea and sugar, shoes and socks, pen and ink, etc. Since tea and sugar are used together, an increase in the price of sugar is likely to decrease the demand for tea and a decrease in the price of sugar is likely to increase the demand for tea. Similar is the case with other complements. In general, the demand for a good moves in the opposite direction of the price of its complementary goods. In contrast to complements, goods like tea and coffee are not consumed together. In fact, they are substitutes for each other. Since tea is a substitute for coffee, if the price of coffee increases, the consumers can shift to tea, and hence, the consumption of tea is likely to go up. On the other hand, if the price of coffee decreases, the consumption of tea is likely to go down. The demand for a good usually moves in the direction of the price of its substitutes. 2.4.5 Shifts in the Demand Curve The demand curve was drawn under the assumption that the consumer’s income, the prices of other goods and the preferences of the consumer are given. What happens to the demand curve when any of these things changes? Given the prices of other goods and the preferences of a consumer, if the income increases, the demand for the good at each price changes, and hence, there is a shift in the demand curve. For normal goods, the demand curve shifts rightward and for inferior goods, the demand curve shifts leftward. Given the consumer’s income and her preferences, if the price of a related good changes, the demand for a good at each level of its price changes, and hence, there is a shift in the demand curve. If there is an increase in the price of a substitute good, the demand curve shifts rightward. On the other hand, if there is an increase in the price of a complementary good, the demand curve shifts leftward. The demand curve can also shift due to a change in the tastes and preferences of the consumer. If the consumer’s preferences change in favour of a good, the demand curve for such a good shifts rightward. On the other hand, the demand curve shifts leftward due to an unfavourable change in the preferences of the consumer. The demand curve for ice-creams, for example, is likely to shift rightward in the summer because of preference for ice-creams goes up in summer. Revelation of the fact that cold-drinks might be injurious to health can adversely affect preferences for cold-drinks. This is likely to result in a leftward shift in the demand curve for cold-drinks. 25 2019-20 Shifts in Demand. The demand curve in panel (a) shifts leftward and that in panel (b) shifts rightward. Shifts in the demand curve are depicted in Figure 2.16. It may be mentioned that shift in demand curve takes place when there is a change in some factor, other than the price of the commodity. 2.4.6 Movements along the Demand Curve and Shifts in the Demand Curve As it has been noted earlier, the amount of a good that the consumer chooses depends on the price of the good, the prices of other goods, income of the consumer and her tastes and preferences. The demand function is a relation between the amount of the good and its price when other things remain unchanged. The demand curve is a graphical representation of the demand function. At higher prices, the demand is less, and at lower prices, the demand is more. Thus, any change in the price leads to movements along the demand curve. On the other hand, changes in any of the other things lead to a shift in the demand curve. Figure 2.17 illustrates a movement along the demand curve and a shift in the demand curve. 26 Movement along a Demand Curve and Shift of a Demand Curve. Panel (a) depicts a movement along the demand curve and panel (b) depicts a shift of the demand curve. 2.5 MARKET DEMAND In the last section, we studied the choice problem of the individual consumer and derived the demand curve of the consumer. However, in the market for a 2019-20 good, there are many consumers. It is important to find out the market demand for the good. The market demand for a good at a particular price is the total demand of all consumers taken together. The market demand for a good can be derived from the individual demand curves. Suppose there are only two Derivation of the Market Demand Curve. The market demand curve can be derived as a horizontal summation of the individual demand curves. consumers in the market for a good. Suppose at price p′, the demand of consumer 1 is q′1 and that of consumer 2 is q′2. Then, the market demand of the good at p′ ˆq and that of is q′1 + q′2. Similarly, at price ˆp , if the demand of consumer 1 is 1 ˆ ˆq , the market demand of the good at ˆp is 1 ˆ consumer 2 is . Thus, the q+ q market demand for the good at each price can be derived by adding up
the demands of the two consumers at that price. If there are more than two consumers in the market for a good, the market demand can be derived similarly. 2 2 The market demand curve of a good can also be derived from the individual demand curves graphically by adding up the individual demand curves horizontally as shown in Figure 2.18. This method of adding two curves is called horizontal summation. Adding up Two Linear Demand Curves Consider, for example, a market where there are two consumers and the demand curves of the two consumers are given as d1(p) = 10 – p and d2(p) = 15 – p (2.14) (2.15) Furthermore, at any price greater than 10, the consumer 1 demands 0 unit of the good, and similarly, at any price greater than 15, the consumer 2 demands 0 unit of the good. The market demand can be derived by adding equations (2.14) and (2.15). At any price less than or equal to 10, the market demand is given by 25 – 2p, for any price greater than 10, and less than or equal to 15, market demand is 15 – p, and at any price greater than 15, the market demand is 0. 2.6 ELASTICITY OF DEMAND The demand for a good moves in the opposite direction of its price. But the impact of the price change is always not the same. Sometimes, the demand for a good changes considerably even for small price changes. On the other hand, there are some goods for which the demand is not affected much by price changes. 27 2019-20 Demands for some goods are very responsive to price changes while demands for certain others are not so responsive to price changes. Price elasticity of demand is a measure of the responsiveness of the demand for a good to changes in its price. Price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. Priceelasticity of demand for a good eD = percentage change in demand for the good percentage change in the price of the good Q ∆ Q P ∆ P × 100 × 100 Q ∆  ∆    = = (2.16a) (2.16b) Where, P∆ is the change in price of the good and Q∆ is the change in quantity of the good. EXAMPLE Suppose an individual buy 15 bananas when its price is Rs. 5 per banana. when the price increases to Rs. 7 per banana, she reduces his demand to 12 bananas. 2.2 Price Per banana (Rs.) : P Quantity of bananas demanded : Q Old Price : P1 = 5 New Price : P2 = 7 Old quantity : Q1 = 15 New quantity: Q2 = 12 In order to find her elasticity demand for bananas, we find the percentage change in quantity demanded and its price, using the information summarized in table. Note that the price elasticity of demand is a negative number since the demand for a good is negatively related to the price of a good. However, for simplicity, we will always refer to the absolute value of the elasticity. Percentage change in quantity demanded = Q ∆ Q 1 × 100 =    Q Q − 2 1 Q 1    × 100 = 12 15 − 15 × 100 = − 20 Percentage change in Market price = P ∆ P 1 × 100 =    × 100 = 7 5 − 5 × 100 40 = 28 2019-20 Therefore, in our example, as price of bananas increases by 40 percent, demand for bananas drops by 20 percent. Price elasticity of demand De = 20 40 = 0.5 . Clearly, the demand for bananas is not very responsive to a change in price of bananas. When the percentage change in quantity demanded is less than the percentage change in market price, De is estimated to be less than one and the demand for the good is said to be inelastic at that price. Demand for essential goods is often found to be inelastic. When the percentage change in quantity demanded is more than the percentage change in market price, the demand is said to be highly responsive to changes in market price and the estimated De is more than one. The demand for the good is said to be elastic at that price. Demand for luxury goods is seen to be highly responsive to changes in their market prices and De >1. When the percentage change in quantity demanded equals the percentage change in its market price, De is estimated to be equal to one and the demand for the good is said to be Unitary-elastic at that price. Note that the demand for certain goods may be elastic, unitary elastic and inelastic at different prices. In fact, in the next section, elasticity along a linear demand curve is estimated at different prices and shown to vary at each point on a downward sloping demand curve. 2.6.1 Elasticity along a Linear Demand Curve Let us consider a linear demand curve q = a – bp. Note that at any point on the demand curve, the change in demand per unit change in the price q ∆ ∆ = –b. p Substituting the value of q ∆ ∆ in (2.16b), p we obtain, eD = – b p q puting the value of q, eD = – bp – bp a (2.17) From (2.17), it is clear that the elasticity of demand is different at different points on a linear demand curve. At p = 0, the elasticity is 0, at q = 0, elasticity is ∞. At p = a b 2 , the elasticity is 1, at any price greater than 0 and less Elasticity along a Linear Demand Curve. Price elasticity of demand is different at different points on the linear demand curve. than a b 2 , elasticity is less than 1, and at any price greater than a b 2 , elasticity is greater than 1. The price elasticities of demand along the linear demand curve given by equation (2.17) are depicted in Figure 2.19. 29 2019-20 Geometric Measure of Elasticity along a Linear Demand Curve The elasticity of a linear demand curve can easily be measured geometrically. The elasticity of demand at any point on a straight line demand curve is given by the ratio of the lower segment and the upper segment of the demand curve at that point. To see why this is the case, consider the following figure which depicts a straight line demand curve, q = a – bp. Suppose at price p 0, the demand for the good is q0. Now consider a small change in the price. The new price is p1, and at that price, demand for the good is q1. ∆q = q1q0 = CD and ∆p = p1p0 = CE. Therefore, eD = Op Oq = CD CE × 0 0 Op Oq Since ECD and Bp0D are similar triangles, CD CE = 0 p D 0 p B . But 0 p D 0 p B = o Oq o p B eD = 0 op . Since, Bp0D and BOA are similar triangles, 0 q D p B = 0 DA DB Thus, eD = DA DB . The elasticity of demand at different points on a straight line demand curve can be derived by this method. Elasticity is 0 at the point where the demand curve meets the horizontal axis and it is ∝ at the point where the demand curve meets the vertical axis. At the midpoint of the demand curve, the elasticity is 1, at any point to the left of the midpoint, it is greater than 1 and at any point to the right, it is less than 1. Note that along the horizontal axis p = 0, along the vertical axis q = 0 and at the midpoint of the demand curve p = a b . 2 Constant Elasticity Demand Curve The elasticity of demand on different points on a linear demand curve is different varying from 0 to ∞. But sometimes, the demand curves can be such that the elasticity of demand remains constant throughout. Consider, for example, a vertical demand curve as the one depicted in Figure 2.20(a). Whatever be the price, the demand is given at the level q . A price never leads to a change in the demand for such a demand curve and \|eD\| is always 0. Therefore, a vertical demand curve is perfectly inelastic. Figure 2.20 (b) depics a horizontal demand curve, where market price remains constant at P , whatever be the level of demand for the commodity. At de = ∞ . A any other price, quantity demanded drops to zero and therefore horizontal demand curve is perfectly elastic. 30 2019-20 Constant Elasticity Demand Curves. Elasticity of demand at all points along the vertical demand curve, as shown in panel (a), is 0. Elasticity of demand at all point along the horizontal demand curve, as shown in panel (b) is ∞ . Elasticity at all points on the demand curve in panel (c) is 1. Figure 2.20(c) depicts a demand curve which has the shape of a rectangular hyperbola. This demand curve has a property that a percentage change in price along the demand curve always leads to equal percentage change in quantity. Therefore, \|eD\| = 1 at every point on this demand curve. This demand curve is called the unitary elastic demand curve. 2.6.2 Factors Determining Price Elasticity of Demand for a Good The price elasticity of demand for a good depends on the nature of the good and the availability of close substitutes of the good. Consider, for example, necessities like food. Such goods are essential for life and the demands for such goods do not change much in response to changes in their prices. Demand for food does not change much even if food prices go up. On the other hand, demand for luxuries can be very responsive to price changes. In general, demand for a necessity is likely to be price inelastic while demand for a luxury good is likely to be price elastic. Though demand for food is inelastic, the demands for specific food items are likely to be more elastic. For example, think of a particular variety of pulses. If the price of this variety of pulses goes up, people can shift to some other variety of pulses which is a close substitute. The demand for a good is likely to be elastic if close substitutes are easily available. On the other hand, if close substitutes are not available easily, the demand for a good is likely to be inelastic. 2.6.3 Elasticity and Expenditure The expenditure on a good is equal to the demand for the good times its price. Often it is important to know how the expenditure on a good changes as a result of a price change. The price of a good and the demand for the good are inversely related to each other. Whether the expenditure on the good goes up or down as a result of an increase in its price depends on how responsive the demand for the good is to the price change. Consider an increase in the price of a good. If the percentage decline in quantity is greater than the percentage increase in the price, the expenditure on the good will go down. For example, see row 2 in table 2.5 which shows that as price of a commodity increases
by 10%, its demand drops by 12%, resulting in a decline in expenditure on the good. On the other hand, if the percentage decline in quantity is less than the percentage increase in the price, the expenditure on 31 2019-20 the good will go up (See row 1 in table 2.5). And if the percentage decline in quantity is equal to the percentage increase in the price, the expenditure on the good will remain unchanged (see row 3 in table 2.5). Now consider a decline in the price of the good. If the percentage increase in quantity is greater than the percentage decline in the price, the expenditure on the good will go up(see row 4 in table 2.5). On the other hand, if the percentage increase in quantity is less than the percentage decline in the price, the expenditure on the good will go down(see row 5 in table 2.5). And if the percentage increase in quantity is equal to the percentage decline in the price, the expenditure on the good will remain unchanged (see row 6 in table 2.5). The expenditure on the good would change in the opposite direction as the price change if and only if the percentage change in quantity is greater than the percentage change in price, ie if the good is price-elastic (see rows 2 and 4 in table 2.5). The expenditure on the good would change in the same direction as the price change if and only if the percentage change in quantity is less than the percentage change in price, i.e., if the good is price inelastic (see rows 1 and 5 in table 2.5). The expenditure on the good would remain unchanged if and only if the percentage change in quantity is equal to the percentage change in price, i.e., if the good is unit-elastic (see rows 3 and 6 in table 2.5). Table 2.5: For hypothetic cases of price rise and drop, the following table summarises the relationship between elasticity and change in expenditure of a commodity Change Change in % Change % Change Impact on Nature of price in Price Quantity in price in quantity Expenditure Elasticity of (P) demand (Q) demand = P×Q demand de 1 ↑ ↓ +10 -8 ↑ Price Inelastic 2 ↑ ↓ +10 -12 ↓ Price Elastic 3 ↑ ↓ +10 -10 No Change Unit Elastic 4 ↓ ↑ -10 +15 ↑ Price Elastic 5 ↓ ↑ -10 +7 ↓ Price Inelastic 6 ↓ ↑ -10 +10 No Change Unit Elastic Rectangular Hyperbola An equation of the form xy = c where x and y are two variables and c is a constant, giving us a curve called rectangular hyperbola. It is a downward sloping curve in the x-y plane as shown in the diagram. For any two points p and q on the curve, the areas of the two rectangles Oy1px1 and Oy2qx2 are same and equal to c. If the equation of a demand curve takes the form pq = e, where e is a constant, it will be a rectangular hyperbola, where price (p) times quantity (q) is a constant. With such a demand curve, no matter at what point the consumer consumes, her expenditures are always the same and equal to e. 32 2019-20 Relationship between Elasticity and change in Expenditure on a Good Suppose at price p, the demand for a good is q, and at price p + ∆p, the demand for the good is q + ∆q. At price p, the total expenditure on the good is pq, and at price p + ∆p, the total expenditure on the good is (p + ∆p)(q + ∆q). If price changes from p to (p + ∆p), the change in the expenditure on the good is, (p + ∆p)(q + ∆q) – pq = q∆p + p∆q + ∆p∆q. For small values of ∆p and ∆q, the value of the term ∆p∆q is negligible, and in that case, the change in the expenditure on the good is approximately given by q∆p + p∆q. Approximate change in expenditure = ∆E = q∆p + p∆q = ∆p(p[q(1 + ∆ ∆ q p p q )] = ∆p[q(1 + eD)]. Note that if eD < –1, then q (1 + eD) < 0, and hence, ∆E has the opposite sign as ∆p, if eD > –1, then q (1 + eD) > 0, and hence, ∆E has the same sign as ∆p, if eD = –1, then q (1 + eD ) = 0, and hence, ∆E = 0 • The budget set is the collection of all bundles of goods that a consumer can buy with her income at the prevailing market prices. • The budget line represents all bundles which cost the consumer her entire income. The budget line is negatively sloping. • The budget set changes if either of the two prices or the income changes. • The consumer has well-defined preferences over the collection of all possible bundles. She can rank the available bundles according to her preferences over them. • The consumer’s preferences are assumed to be monotonic. • An indifference curve is a locus of all points representing bundles among which the consumer is indifferent. • Monotonicity of preferences implies that the indifference curve is downward sloping. • A consumer’s preferences, in general, can be represented by an indifference map. • A consumer’s preferences, in general, can also be represented by a utility function. • A rational consumer always chooses her most preferred bundle from the budget set. • The consumer’s optimum bundle is located at the point of tangency between the budget line and an indifference curve. • The consumer’s demand curve gives the amount of the good that a consumer chooses at different levels of its price when the price of other goods, the consumer’s income and her tastes and preferences remain unchanged. • The demand curve is generally downward sloping. • The demand for a normal good increases (decreases) with increase (decrease) in the consumer’s income. • The demand for an inferior good decreases (increases) as the income of the consumer increases (decreases). • The market demand curve represents the demand of all consumers in the market 33 2019-20 taken together at different levels of the price of the good. • The price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. • The elasticity of demand is a pure number. • Elasticity of demand for a good and total expenditure on the good are closely related. s s s Budget set Preference Indifference curve Monotonic preferences C C C C C Indifference map,Utility function Demand Demand curve Income effect Inferior good Complement KKKKK Budget line Indifference Marginal Rate of substitution Diminishing rate of substitution Consumer’s optimum Law of demand Substitution effect Normal good Substitute Price elasticity of demand . What do you mean by the budget set of a consumer? 2. What is budget line? 3. Explain why the budget line is downward sloping. 4. A consumer wants to consume two goods. The prices of the two goods are Rs 4 and Rs 5 respectively. The consumer’s income is Rs 20. (i) Write down the equation of the budget line. (ii) How much of good 1 can the consumer consume if she spends her entire income on that good? (iii) How much of good 2 can she consume if she spends her entire income on that good? (iv) What is the slope of the budget line? Questions 5, 6 and 7 are related to question 4. 5. How does the budget line change if the consumer’s income increases to Rs 40 but the prices remain unchanged? 6. How does the budget line change if the price of good 2 decreases by a rupee but the price of good 1 and the consumer’s income remain unchanged? 7. What happens to the budget set if both the prices as well as the income double? 8. Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2 if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8 respectively. How much is the consumer’s income? 9. Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally priced at Rs 10 and the consumer’s income is Rs 40. (i) Write down all the bundles that are available to the consumer. (ii) Among the bundles that are available to the consumer, identify those which cost her exactly Rs 40. 10. What do you mean by ‘monotonic preferences’? 11. If a consumer has monotonic preferences, can she be indifferent between the bundles (10, 8) and (8, 6)? 12. Suppose a consumer’s preferences are monotonic. What can you say about her preference ranking over the bundles (10, 10), (10, 9) and (9, 9)? 34 2019-20 13. Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the preferences of your friend monotonic? 14. Suppose there are two consumers in the market for a good and their demand functions are as follows: d1(p) = 20 – p for any price less than or equal to 20, and d1(p) = 0 at any price greater than 20. d2(p) = 30 – 2p for any price less than or equal to 15 and d1(p) = 0 at any price greater than 15. Find out the market demand function. 15. Suppose there are 20 consumers for a good and they have identical demand functions: d(p) = 10 – 3p for any price less than or equal to 10 3 and d1(p) = 0 at any price greater than 10 3 . What is the market demand function? 16. Consider a market where there are just two consumers and suppose their demands for the good are given as follows: Calculate the market demand for the good. p 1 2 3 4 5 6 d1 9 8 7 6 5 4 d2 24 20 18 16 14 12 17. What do you mean by a normal good? 18. What do you mean by an ‘inferior good’? Give some examples. 19. What do you mean by substitutes? Give examples of two goods which are substitutes of each other. 20. What do you mean by complements? Give examples of two goods which are complements of each other. 21. Explain price elasticity of demand. 22. Consider the demand for a good. At price Rs 4, the demand for the good is 25 units. Suppose price of the good increases to Rs 5, and as a result, the demand for the good falls to 20 units. Calculate the price elasticity . 23. Consider the demand curve D (p) = 10 – 3p. What is the elasticity at price 5 3 ? 24. Suppose the price elasticity of demand for a good is – 0.2. If there is a 5 % increase in the price of the good, by what percentage will the demand for the good go down? 25. Suppose the price elasticity of demand for a good is – 0.2. How will the expenditure on the good be affected if there is a 10 % increase in the price of the good? 27. Suppose there was a 4 % decrease in the price of a good, and as a result, the expenditure on the good increased by 2 %. What can you say about the
elasticity of demand? 35 2019-20 Chapter 3 PPPPProduction and Costs roduction and Costs roduction and Costs roduction and Costs roduction and Costs In the previous chapter, we have discussed the behaviour of the consumers. In this chapter as well as in the next, we shall examine the behaviour of a producer. Production is the process by which inputs are transformed into ‘output’. Production is carried out by producers or firms. A firm acquires different inputs like labour, machines, land, raw materials etc. It uses these inputs to produce output. This output can be consumed by consumers, or used by other firms for further production. For example, a tailor uses a sewing machine, cloth, thread and his own labour to ‘produce’ shirts. A farmer uses his land, labour, a tractor, seed, fertilizer, water etc to produce wheat. A car manufacturer uses land for a factory, machinery, labour, and various other inputs (steel, aluminium, rubber etc) to produce cars. A rickshaw puller uses a rickshaw and his own labour to ‘produce’ rickshaw rides. A domestic helper uses her labour to produce ‘cleaning services’. We make certain simplifying assumptions to start with. Production is instantaneous: in our very simple model of production no time elapses between the combination of the inputs and the production of the output. We also tend to use the terms production and supply synonymously and often interchangeably. In order to acquire inputs a firm has to pay for them. This is called the cost of production. Once output has been produced, the firm sell it in the market and earns revenue. The difference between the revenue and cost is called the firm’s profit. We assume that the objective of a firm is to earn the maximum profit that it can. In this chapter, we discuss the relationship between inputs and output. Then we look at the cost structure of the firm. We do this to be able to identifiy the output at which A Firm Effort firms profits are maximum. 3.1 PRODUCTION FUNCTION The production function of a firm is a relationship between inputs used and output produced by the firm. For various quantities of inputs used, it gives the maximum quantity of output that can be produced. 2019-20 Consider the farmer we mentioned above. For simplicity, we assume that the farmer uses only two inputs to produce wheat: land and labour. A production function tells us the maximum amount of wheat he can produce for a given amount of land that he uses, and a given number of hours of labour that he performs. Suppose that he uses 2 hours of labour/ day and 1 hectare of land to produce a maximum of 2 tonnes of wheat. Then, a function that describes this relation is called a production function. One possible example of the form this could take is: q = K × L, Where, q is the amount of wheat produced, K is the area of land in hectares, L is the number of hours of work done in a day. Describing a production function in this manner tells us the exact relation between inputs and output. If either K or L increase, q will also increase. For any L and any K, there will be only one q. Since by definition we are taking the maximum output for any level of inputs, a production function deals only with the efficient use of inputs. Efficiency implies that it is not possible to get any more output from the same level of inputs. A production function is defined for a given technology. It is the technological knowledge that determines the maximum levels of output that can be produced using different combinations of inputs. If the technology improves, the maximum levels of output obtainable for different input combinations increase. We then have a new production function. The inputs that a firm uses in the production process are called factors of production. In order to produce output, a firm may require any number of different inputs. However, for the time being, here we consider a firm that produces output using only two factors of production – labour and capital. Our production function, therefore, tells us the maximum quantity of output (q) that can be produced by using different combinations of these two factors of productionsLabour (L) and Capital (K). We may write the production function as q = f(L,K) (3.1) where, L is labour and K is capital and q is the maximum output that can be produced. Table 3.1: Production Function Factor Capital Labour 10 12 13 2 0 3 10 18 24 29 33 3 0 7 18 30 40 46 50 4 0 10 24 40 50 56 57 5 0 12 29 46 56 58 59 6 0 13 33 50 57 59 60 0 1 2 3 4 5 6 A numerical example of production function is given in Table 3.1. The left column shows the amount of labour and the top row shows the amount of capital. As we move to the right along any row, capital increases and as we move down along any column, labour increases. For different values of the two factors, 37 2019-20 Isoquant In Chapter 2, we have learnt about indifference curves. Here, we introduce a similar concept known as isoquant. It is just an alternative way of representing the production function. Consider a production function with two inputs labour and capital. An isoquant is the set of all possible combinations of the two inputs that yield the same maximum possible level of output. Each isoquant represents a particular level of output and is labelled with that amount of output. Let us return to table 3.1 notice that the output of 10 units can be produced in 3 ways (4L, 1K), (2L, 2K), (1L, 4K). All these combination of L, K lie on the same isoquant, which represents the level of output 10. Can you identify the sets of inputs that will lie on the isoquant q = 50? The diagram here generalizes this concept. We place L on the X axis and K on the Y axis. We have three isoquants for the three output levels, namely q = q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us the same level of output q1. If we fix capital at K1 and increase labour to L3, output increases and we reach a higher isoquant, q = q2. When marginal products are positive, with greater amount of one input, the same level of output can be produced only using lesser amount of the other. Therefore, isoquants are negatively sloped. the table shows the corresponding output levels. For example, with 1 unit of labour and 1 unit of capital, the firm can produce at most 1 unit of output; with 2 units of labour and 2 units of capital, it can produce at most 10 units of output; with 3 units of labour and 2 units of capital, it can produce at most 18 units of output and so on. In our example, both the inputs are necessary for the production. If any of the inputs becomes zero, there will be no production. With both inputs positive, output will be positive. As we increase the amount of any input, output increases. 3.2 THE SHORT RUN AND THE LONG RUN Before we begin with any further analysis, it is important to discuss two concepts– the short run and the long run. In the short run, at least one of the factor – labour or capital – cannot be varied, and therefore, remains fixed. In order to vary the output level, the firm can vary only the other factor. The factor that remains fixed is called the fixed factor whereas the other factor which the firm can vary is called the variable factor. Consider the example represented through Table 3.1. Suppose, in the short run, capital remains fixed at 4 units. Then the corresponding column shows the different levels of output that the firm may produce using different quantities of labour in the short run. 38 2019-20 In the long run, all factors of production can be varied. A firm in order to produce different levels of output in the long run may vary both the inputs simultaneously. So, in the long run, there is no fixed factor. For any particular production process, long run generally refers to a longer time period than the short run. For different production processes, the long run periods may be different. It is not advisable to define short run and long run in terms of say, days, months or years. We define a period as long run or short run simply by looking at whether all the inputs can be varied or not. 3.3 TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT 3.3.1 Total Product Suppose we vary a single input and keep all other inputs constant. Then for different levels of that input, we get different levels of output. This relationship between the variable input and output, keeping all other inputs constant, is often referred to as Total Product (TP) of the variable input. Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in the Table 3.1, we look at the column where capital takes the value 4. As we move down along the column, we get the output values for different values of labour. This is the total product of labour schedule with K2 = 4. This is also sometimes called total return to or total physical product of the variable input. This is shown again in the second column of table in 3.2 Once we have defined total product, it will be useful to define the concepts of average product (AP) and marginal product (MP). They are useful in order to describe the contribution of the variable input to the production process. 3.3.2 Average Product Average product is defined as the output per unit of variable input. We calculate it as AP L = TP L L (3.2) The last column of table 3.2 gives us a numerical example of average product of labour (with capital fixed at 4) for the production function described in table 3.1. Values in this column are obtained by dividing TP (column 2) by L (Column 1). 3.3.3 Marginal Product Marginal product of an input is defined as the change in output per unit of change in the input when all other inputs are held constant. When capital is held constant, the marginal product of labour is MP L = Change in output Change in input = LTP ∆ L ∆ (3.3) where ∆ represents the change of the variable. The third column of table 3.2 gives us a numerical example of Marginal Product of labour (with capital fixed at 4) for the production function described in
table 3.1. Values in this column are obtained by dividing change in TP by 39 2019-20 change in L. For example, when L changes from 1 to 2, TP changes from 10 to 24. MPL= (TP at L units) – (TP at L – 1 unit) (3.4) Here, Change in TP = 24 -10 = 14 Change in L = 1 Marginal product of the 2nd unit of labour = 14/1 = 14 Since inputs cannot take negative values, marginal product is undefined at zero level of input employment. For any level of an input, the sum of marginal products of every preceeding unit of that input gives the total product. So total product is the sum of marginal products. Table 3.2: Total Product, Marginal product and Average product Labour 0 1 2 3 4 5 6 TP 0 10 24 40 50 56 57 MPL 10 14 16 10 6 1 APL 10 12 13.33 12.5 11.2 9.5 40 Average product of an input at any level of employment is the average of all marginal products up to that level. Average and marginal products are often referred to as average and marginal returns, respectively, to the variable input. 3.4 THE LAW OF DIMINISHING MARGINAL PRODUCT AND THE LAW OF VARIABLE PROPORTIONS If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and output on the Y-axis, we get the curves shown in the diagram below. Let us examine what is happening to TP. Notice that TP increases as labour input increases. But the rate at which it increases is not constant. An increase in labour from 1 to 2 increases TP by 10 units. An increase in labour from 2 to 3 increases TP by 12. The rate at which TP increases, as explained above, is shown by the MP. Notice that the MP first increases (upto 3 units of labour) and then begins to 2019-20 fall. This tendency of the MP to first increase and then fall is called the law of variable proportions or the law of diminishing marginal product. Law of variable proportions say that the marginal product of a factor input initially rises with its employment level. But after reaching a certain level of employment, it starts falling. Why does this happen? In order to understand this, we first define the concept of factor proportions. Factor proportions represent the ratio in which the two inputs are combined to produce output. As we hold one factor fixed and keep increasing the other, the factor proportions change. Initially, as we increase the amount of the variable input, the factor proportions become more and more suitable for the production and marginal product increases. But after a certain level of employment, the production process becomes too crowded with the variable input. Suppose table 3.2 describes the output of a farmer who has 4 hectares of land, and can choose how much labour he wants to use. If he uses only 1 worker, he has too much land for the worker to cultivate alone. As he increases the number of workers, the amount of labour per unit land increases, and each worker adds proportionally more and more to the total output. Marginal product increases in this phase. When the fourth worker is hired, the land begins to get ‘crowded’. Each worker now has insufficient land to work efficiently. So the output added by each additional worker is now proportionally less. The marginal product begins to fall. We can use these observations to describe the general shapes of the TP, MP and AP curves as below. 3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT AND AVERAGE PRODUCT CURVES An increase in the amount of one of the inputs keeping all other inputs constant results in an increase in output. Table 3.2 shows how the total product changes as the amount of labour increases. The total product curve in the input-output plane is a positively sloped curve. Figure 3.1 shows the shape of the total product curve for a typical firm. We measure units of labour along the horizontal axis and output along the vertical axis. With L units of labour, the firm can at most produce q1 units of output. According to the law of variable proportions, the marginal product of an input initially rises and then after a certain level of employment, it starts falling. The MP curve therefore, looks like an inverse ‘U’-shaped curve as in figure 3.2. Let us now see what the AP curve looks like. For the first unit of the variable input, one can easily check that the MP and the Output q1 TPL O Fig. 3.1 L Labour Total Product. This is a total product curve for labour. When all other inputs are held constant, it shows the different output levels obtainable from different units of labour. 41 2019-20 AP are same. Now as we increase the amount of input, the MP rises. AP being the average of marginal products, also rises, but rises less than MP. Then, after a point, the MP starts falling. However, as long as the value of MP remains higher than the value of the AP, the AP continues to rise. Once MP has fallen sufficiently, its value becomes less than the AP and the AP also starts falling. So AP curve is also inverse ‘U’-shaped. Output P APL MPL L Labour O Fig. 3.2 As long as the AP increases, it must be the case that MP is greater than AP. Otherwise, AP cannot rise. Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve cuts AP curve from above at its maximum. Average and Marginal Product. These are average and marginal product curves of labour. Figure 3.2 shows the shapes of AP and MP curves for a typical firm. The AP of factor 1 is maximum at L. To the left of L, AP is rising and MP is greater than AP. To the right of L, AP is falling and MP is less than AP. 3.6 RETURNS TO SCALE The law of variable proportions arises because factor proportions change as long as one factor is held constant and the other is increased. What if both factors can change? Remember that this can happen only in the long run. One special case in the long run occurs when both factors are increased by the same proportion, or factors are scaled up. When a proportional increase in all inputs results in an increase in output by the same proportion, the production function is said to display Constant returns to scale (CRS). When a proportional increase in all inputs results in an increase in output by a larger proportion, the production function is said to display Increasing Returns to Scale (IRS) Decreasing Returns to Scale (DRS) holds when a proportional increase in all inputs results in an increase in output by a smaller proportion. For example, suppose in a production process, all inputs get doubled. As a result, if the output gets doubled, the production function exhibits CRS. If output is less than doubled, then DRS holds, and if it is more than doubled, then IRS holds. Returns to Scale Consider a production function q = f (x1, x2) where the firm produces q amount of output using x1 amount of factor 1 and x2 amount of factor 2. Now suppose the firm decides to increase the employment level of both the factors t (t > 1) times. Mathematically, we 42 2019-20 can say that the production function exhibits constant returns to scale if we have, f (tx1, tx2) = t.f (x1, x2) ie the new output level f (tx1, tx2) is exactly t times the previous output level f (x1, x2). Similarly, the production function exhibits increasing returns to scale if, f (tx1, tx2) > t.f (x1, x2). It exhibits decreasing returns to scale if, f (tx1, tx2) < t.f (x1, x2). 3.7 COSTS In order to produce output, the firm needs to employ inputs. But a given level of output, typically, can be produced in many ways. There can be more than one input combinations with which a firm can produce a desired level of output. In Table 3.1, we can see that 50 units of output can be produced by three different input combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The question is which input combination will the firm choose? With the input prices given, it will choose that combination of inputs which is least expensive. So, for every level of output, the firm chooses the least cost input combination. Thus the cost function describes the least cost of producing each level of output given prices of factors of production and technology. Cobb-Douglas Production Function Consider a production function β q = x1 α x2 where α and β are constants. The firm produces q amount of output using x1 amount of factor 1 and x2 amount of factor 2. This is called a 2x , we Cobb-Douglas production function. Suppose with x1 = have q0 units of output, i.e. 1x α 1x and x2 = 2x β q0 = If we increase both the inputs t (t > 1) times, we get the new output 43 q1 = (t 1x )α (t = t α + β 1x α 2x )β 2x β When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the production function exhibits CRS. Similarly, when α + β > 1, the production function exhibits IRS. When α + β < 1 the production function exhibits DRS. 3.7.1 Short Run Costs We have previously discussed the short run and the long run. In the short run, some of the factors of production cannot be varied, and therefore, remain fixed. The cost that a firm incurs to employ these fixed inputs is called the total fixed cost (TFC). Whatever amount of output the firm 2019-20 produces, this cost remains fixed for the firm. To produce any required level of output, the firm, in the short run, can adjust only variable inputs. Accordingly, the cost that a firm incurs to employ these variable inputs is called the total variable cost (TVC). Adding the fixed and the variable costs, we get the total cost (TC) of a firm TC = TVC + TFC (3.6) In order to increase the production of output, the firm must employ more of the variable inputs. As a result, total variable cost and total cost will increase. Therefore, as output increases, total variable cost and total cost increase. In Table 3.3, we have an example of cost function of a typical firm. The first column shows different levels of output. For all levels of output, the total fixed cost is Rs 20. Total variable cost increases as output increases. With output zero, TVC is zero. For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC is Rs 18 and so on. In the fourth column, we obtain the total cost (
TC) as the sum of the corresponding values in second column (TFC) and third column (TVC). At zero level of output, TC is just the fixed cost, and hence, equal to Rs 20. For 1 unit of output, total cost is Rs 30; for 2 units of output, the TC is Rs 38 and so on. The short run average cost (SAC) incurred by the firm is defined as the total cost per unit of output. We calculate it as SAC = TC q (3.7) In Table 3.3, we get the SAC-column by dividing the values of the fourth column by the corresponding values of the first column. At zero output, SAC is undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19 and so on. Similarly, the average variable cost (AVC) is defined as the total variable cost per unit of output. We calculate it as 44 Also, average fixed cost (AFC) is AVC = TVC q AFC = TFC q Clearly, SAC = AVC + AFC (3.8) (3.9) (3.10) In Table 3.3, we get the AFC-column by dividing the values of the second column by the corresponding values of the first column. Similarly, we get the AVC-column by dividing the values of the third column by the corresponding values of the first column. At zero level of output, both AFC and AVC are undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding them, we get the SAC equal to Rs 30. The short run marginal cost (SMC) is defined as the change in total cost per unit of change in output SMC = change in total cos change in output t = TC ∆ q ∆ (3.11) where ∆ represents the change in the value of the variable. 2019-20 The last column in table 3.3 gives a numerical example for the calculation of SMC. Values in this column are obtained by dividing the change in TC by the change in output, at each level of output. Thus at q=5, Change in TC = (TC at q=5) - (TC at q=4) (3.12) = (53) – (49) = 4 Change in q = 1 SMC = 4/1 = 4 Table 3.3: Various Concepts of Costs Output (units) (q) TFC (Rs) TVC (Rs 10 20 20 20 20 20 20 20 20 20 20 20 0 10 18 24 29 33 39 47 60 75 95 TC (Rs) 20 30 38 44 49 53 59 67 80 95 115 AFC (Rs) – 20 10 6.67 5 4 3.33 2.86 2.5 2.22 2 AVC (Rs) – 10 9 8 7.25 6.6 6.5 6.7 7.5 8.33 9.5 SAC (Rs) – 30 19 14.67 12.25 10.6 9.83 9.57 10 10.55 11.5 SMC (Rs) – 10 8 6 5 4 6 8 13 15 20 Just like the case of marginal product, marginal cost also is undefined at zero level of output. It is important to note here that in the short run, fixed cost cannot be changed. When we change the level of output, whatever change occurs to total cost is entirely due to the change in total variable cost. So in the short run, marginal cost is the increase in TVC due to increase in production of one extra unit of output. For any level of output, the sum of marginal costs up to that level gives us the total variable cost at that level. One may wish to check this from the example represented through Table 3.3. Average variable cost at some level of output is therefore, the average of all marginal costs up to that level. In Table 3.3, we see that when the output is zero, SMC is undefined. For the first unit of output, SMC is Rs 10; for the second unit, the SMC is Rs 8 and so on. Costs TVC TC c3 c2 c1 TFC Shapes of the Short Run Cost Curves Now let us see what these short run cost curves look like. You could plot the data from in table 3.3 by placing output on the x-axis and costs on the y-axis. O Fig. 3.3 q1 Otput Costs. These are total fixed cost (TFC), total variable cost (TVC) and total cost (TC) curves for a firm. Total cost is the vertical sum of total fixed cost and total variable cost. 45 2019-20 Previously, we have discussed that in order to increase the production of output the firm needs to employ more of the variable inputs. This results in an increase in total variable cost, and hence, an increase in total cost. Therefore, as output increases, total variable cost and total cost increase. Total fixed cost, however, is independent of the amount of output produced and remains constant for all levels of production. Cost F C O q1 AFC Output Fig. 3.4 Figure 3.3 illustrates the shapes of total fixed cost, total variable cost and total cost curves for a typical firm. We place output on the x-axis and costs on the y-axis. TFC is a constant which takes the value c1 and does not change with the change in output. It is, therefore, a horizontal straight line cutting the cost axis at the point c1. At q1, TVC is c2 and TC is c3. Average Fixed Cost. The average fixed cost curve is a rectangular hyperbola. The area of the rectangle OFCq1 gives us the total fixed cost. AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC decreases. When output is very close to zero, AFC is arbitrarily large, and as output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a rectangular hyperbola. If we multiply any value q of output with its corresponding AFC, we always get a constant, namely TFC. 46 Figure 3.4 shows the shape of average fixed cost curve for a typical firm. We measure output along the horizontal axis and AFC along the vertical axis. At q1 level of output, we get the corresponding average fixed cost at F. The TFC can be calculated as TFC = AFC × quantity = OF × Oq1 = the area of the rectangle OFCq1 We can also calculate AFC from TFC curve. In Figure 3.5, the horizontal straight line cutting the vertical axis at F is the TFC curve. At q0 level of output, total fixed cost is equal to OF. At q0, the corresponding point on the TFC curve is A. Let the angle ∠AOq0 be θ. The AFC at q0 is TFC quantity AFC = Cost F O Fig. 3.5 A q0 TFC Output = 0 Aq Oq = tanθ 0 The Total Fixed Cost Curve. The slope of the angle ∠AOq0 gives us the average fixed cost at q0. 2019-20 Let us now look at the SMC curve. Marginal cost is the additional cost that a firm incurs to produce one extra unit of output. According to the law of variable proportions, initially, the marginal product of a factor increases as employment increases, and then after a certain point, it decreases. This means initially to produce every extra unit of output, the requirement of the factor becomes less and less, and then after a certain point, it becomes greater and greater. As a result, with the factor price given, initially the SMC falls, and then after a certain point, it rises. SMC curve is, therefore, ‘U’-shaped. Cost V O Fig. 3.6 B q0 AVC Output The Average Variable Cost Curve. The area of the rectangle OVBq0 gives us the total variable cost at q0. At zero level of output, SMC is undefined. The TVC at a particular level of output is given by the area under the SMC curve up to that level. Now, what does the AVC curve look like? For the first unit of output, it is easy to check that SMC and AVC are the same. So both SMC and AVC curves start from the same point. Then, as output increases, SMC falls. AVC being the average of marginal costs, also falls, but falls less than SMC. Then, after a point, SMC starts rising. AVC, however, continues to fall as long as the value of SMC remains less than the prevailing value of AVC. Once the SMC has risen sufficiently, its value becomes greater than the value of AVC. The AVC then starts rising. The AVC curve is therefore ‘U’-shaped. As long as AVC is falling, SMC must be less than the AVC. As AVC rises, SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from below at the minimum point of AVC. In Figure 3.7, we measure output along the horizontal axis and TVC along the vertical axis. At q0 level of output, OV is the total variable cost. Let the angle ∠E0q0 be equal to θ. Then, at q0, the AVC can be calculated as AV C = = TVC output Eq Oq = tan θ 0 0 Cost V O Fig. 3.7 TVC Output E q0 The Total Variable Cost Curve. The slope of the angle ∠EOqo gives us the average variable cost at qo. 47 2019-20 In Figure 3.6 we measure output along the horizontal axis and AVC along the vertical axis. At q0 level of output, AVC is equal to OV . The total variable cost at q0 is TVC = AVC × quantity = OV × Oq0 = the area of the rectangle OV Bq0. Let us now look at SAC. SAC is the sum of AVC and AFC. Initially, both AVC and AFC decrease as output increases. Therefore, SAC initially falls. After a certain level of output production, AVC starts rising, but AFC continuous to fall. Initially the fall in AFC is greater than the rise in AVC and SAC is still falling. But, after a certain level of production, rise in AVC becomes larger than the fall in AFC. From this point onwards, SAC is rising. SAC curve is therefore ‘U’-shaped. It lies above the AVC curve with the vertical difference being equal to the value of AFC. The minimum point of SAC curve lies to the right of the minimum point of AVC curve. Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less than the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts the SAC curve from below at the minimum point of SAC. Figure 3.8 shows the shapes of short run marginal cost, average variable cost and short run average cost curves for a typical firm. AVC reaches its minimum at q1 units of output. To the left of q1, AVC is falling and SMC is less than AVC. To the right of q1, AVC is rising and SMC is greater than AVC. SMC curve cuts the AVC curve at ‘P ’ which is the minimum point of AVC curve. The minimum point of SAC curve is ‘S ’ which corresponds to the output q2. It is the intersection point between SMC and SAC curves. To the left of q2, SAC is falling and SMC is less than SAC. To the right of q2, SAC is rising and SMC is greater than SAC. Cost SMC SAC AVC S P O Fig. 3.8 q1 q2 Output Short Run Costs. Short run marginal cost, average variable cost and average cost curves. 3.7.2 Long Run Costs In the long run, all inputs are variable. There are no fixed costs. The total cost and the total variable cost therefore, coincide in the long run. Long run average cost (LRAC) is defined as cost per unit of output, i.e. LRAC = TC q (3.13) Long run marginal cost (LRMC) is the change in total cost per unit of change in output. When output changes in discrete units, then, if w
e increase production th unit will be from q1–1 to q1 units of output, the marginal cost of producing q1 measured as LRMC = (TC at q1 units) – (TC at q1 – 1 units) (3.14) 48 2019-20 Just like the short run, in the long run, the sum of all marginal costs up to some output level gives us the total cost at that level. Shapes of the Long Run Cost Curves We have previously discussed the returns to scales. Now let us see their implications for the shape of LRAC. IRS implies that if we increase all the inputs by a certain proportion, output increases by more than that proportion. In other words, to increase output by a certain proportion, inputs need to be increased by less than that proportion. With the input prices given, cost also increases by a lesser proportion. For example, suppose we want to double the output. To do that, inputs need to be increased, but less than double. The cost that the firm incurs to hire those inputs therefore also need to be increased by less than double. What is happening to the average cost here? It must be the case that as long as IRS operates, average cost falls as the firm increases output. DRS implies that if we want to increase the output by a certain proportion, inputs need to be increased by more than that proportion. As a result, cost also increases by more than that proportion. So, as long as DRS operates, the average cost must be rising as the firm increases output. CRS implies a proportional increase in inputs resulting in a proportional increase in output. So the average cost remains constant as long as CRS operates. It is argued that in a typical firm IRS is observed at the initial level of production. This is then followed by the CRS and then by the DRS. Accordingly, the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds to IRS and upward rising part corresponds to DRS. At the minimum point of the LRAC curve, CRS is observed. Let us check how the LRMC curve looks like. For the first unit of output, both LRMC and LRAC are the same. Then, as output increases, LRAC initially falls, and then, after a certain point, it rises. As long as average cost is falling, marginal cost must be less than the average cost. When the average cost is rising, marginal cost must be greater than the average cost. LRMC curve is therefore a ‘U’-shaped curve. It cuts the LRAC curve from below at the minimum point of the LRAC. Figure 3.9 shows the shapes of the long run marginal cost and the long run average cost curves for a typical firm. LRMC Cost LRAC M LRAC reaches its minimum at q1. To the left of q1, LRAC is falling and LRMC is less than the LRAC curve. To the right of q1, LRAC is rising and LRMC is higher than LRAC. O Fig. 3.9 q1 Output Long Run Costs. Long run marginal cost and average cost curves. 49 2019-20 quantity of output that can be produced. y y y • For different combinations of inputs, the production function shows the maximum • In the short run, some inputs cannot be varied. In the long run, all inputs can be • Total product is the relationship between a variable input and output when all varied. other inputs are held constant. • For any level of employment of an input, the sum of marginal products of every unit of that input up to that level gives the total product of that input at that employment level. • Both the marginal product and the average product curves are inverse ‘U’-shaped. The marginal product curve cuts the average product curve from above at the maximum point of average product curve. • In order to produce output, the firm chooses least cost input combinations. • Total cost is the sum of total variable cost and the total fixed cost. • Average cost is the sum of average variable cost and average fixed cost. • Average fixed cost curve is downward sloping. • Short run marginal cost, average variable cost and short run average cost curves are ‘U’-shaped. • SMC curve cuts the AVC curve from below at the minimum point of AVC. • SMC curve cuts the SAC curve from below at the minimum point of SAC. • In the short run, for any level of output, sum of marginal costs up to that level gives us the total variable cost. The area under the SMC curve up to any level of output gives us the total variable cost up to that level. • Both LRAC and LRMC curves are ‘U’ shaped. • LRMC curve cuts the LRAC curve from below at the minimum point of LRAC. 50 Production function Long run Marginal product Law of diminishing marginal product KKKKK Cost function Short run Total product Average product Law of variable proportions Returns to scale Marginal cost, Average cost . Explain the concept of a production function. 2. What is the total product of an input? 3. What is the average product of an input? 4. What is the marginal product of an input? 5. Explain the relationship between the marginal products and the total product of an input. 6. Explain the concepts of the short run and the long run. 7. What is the law of diminishing marginal product? 8. What is the law of variable proportions? 9. When does a production function satisfy constant returns to scale? 10. When does a production function satisfy increasing returns to scale? 2019-20 11. When does a production function satisfy decreasing returns to scale? 12. Briefly explain the concept of the cost function. 13. What are the total fixed cost, total variable cost and total cost of a firm? How are they related? 14. What are the average fixed cost, average variable cost and average cost of a firm? How are they related? 15. Can there be some fixed cost in the long run? If not, why? 16. What does the average fixed cost curve look like? Why does it look so? 17. What do the short run marginal cost, average variable cost and short run average cost curves look like? 18. Why does the SMC curve cut the AVC curve at the minimum point of the AVC curve? 19. At which point does the SMC curve cut the SAC curve? Give reason in support of your answer. 20. Why is the short run marginal cost curve ‘U’-shaped? 21. What do the long run marginal cost and the average cost curves look like? 22. The following table gives the total product schedule of labour. Find the corresponding average product and marginal product schedules of labour. 23. The following table gives the average product schedule of labour. Find the total product and marginal product schedules. It is given that the total product is zero at zero level of labour employment. 24. The following table gives the marginal product schedule of labour. It is also given that total product of labour is zero at zero level of employment. Calculate the total and average product schedules of labour. 25. The following table shows the total cost schedule of a firm. What is the total fixed cost schedule of this firm? Calculate the TVC, AFC, AVC, SAC and SMC schedules of the firm TPL 0 15 35 50 40 48 APL 2 3 4 4.25 4 3.5 MPL 3 5 7 5 3 1 TC 10 30 45 55 70 90 120 51 2019-20 26. The following table gives the total cost schedule of a firm. It is also given that the average fixed cost at 4 units of output is Rs 5. Find the TVC, TFC, AVC, AFC, SAC and SMC schedules of the firm for the corresponding values of output. 27. A firm’s SMC schedule is shown in the following table. The total fixed cost of the firm is Rs 100. Find the TVC, TC, AVC and SAC schedules of the firm TC 50 65 75 95 130 185 TC 500 300 200 300 500 800 28. Let the production function of a firm be Q = 5 1 L K 2 1 2 Find out the maximum possible output that the firm can produce with 100 units of L and 100 units of K. 29. Let the production function of a firm be Q = 2L2K2 Find out the maximum possible output that the firm can produce with 5 units of L and 2 units of K. What is the maximum possible output that the firm can produce with zero unit of L and 10 units of K? 30. Find out the maximum possible output for a firm with zero unit of L and 10 units of K when its production function is Q = 5L + 2K 52 2019-20 Chapter 4 y of the Firmirmirmirmirm y of the F y of the F The Theor The Theor The Theory of the F y of the F The Theor The Theor under Perererererfect Competition fect Competition fect Competition under P under P fect Competition fect Competition under P under P In the previous chapter, we studied concepts related to a firm’s production function and cost curves. The focus of this chapter is different. Here we ask : how does a firm decide how much to produce? Our answer to this question is by no means simple or uncontroversial. We base our answer on a critical, if somewhat unreasonable, assumption about firm behaviour – a firm, we maintain, is a ruthless profit maximiser. So, the amount that a firm produces and sells in the market is that which maximises its profit. Here, we also assume that the firm sells whatever it produces so that ‘output’ and quantity sold are often used interchangebly. The structure of this chapter is as follows. We first set up and examine in detail the profit maximisation problem of a firm. Then,0 we derive a firm’s supply curve. The supply curve shows the levels of output that a firm chooses to produce at different market prices. Finally, we study how to aggregate the supply curves of individual firms and obtain the market supply curve. 4.1 PERFECT COMPETITION: DEFINING FEATURES In order to analyse a firm’s profit maximisation problem, we must first specify the market environment in which the firm functions. In this chapter, we study a market environment called perfect competition. A perfectly competitive market has the following defining features: 1. The market consists of a large number of buyers and sellers 2. Each firm produces and sells a homogenous product. i.e., the product of one firm cannot be differentiated from the product of any other firm. 3. Entry into the market as well as exit from the market are free 4. for firms. Information is perfect. The existence of a large number of buyers and sellers means that each individual buyer and seller is very small compared to the size of the market. This means that n
o individual buyer or seller can influence the market by their size. Homogenous products further mean that the product of each firm is identical. So a buyer can choose to buy from any firm in the market, and she gets the same product. Free entry and exit mean that it is easy for firms to enter the market, as well as to leave it. This condition is essential 2019-20 for the large numbers of firms to exist. If entry was difficult, or restricted, then the number of firms in the market could be small. Perfect information implies that all buyers and all sellers are completely informed about the price, quality and other relevant details about the product, as well as the market. These features result in the single most distinguishing characteristic of perfect competition: price taking behaviour. From the viewpoint of a firm, what does price-taking entail? A price-taking firm believes that if it sets a price above the market price, it will be unable to sell any quantity of the good that it produces. On the other hand, should the set price be less than or equal to the market price, the firm can sell as many units of the good as it wants to sell. From the viewpoint of a buyer, what does price-taking entail? A buyer would obviously like to buy the good at the lowest possible price. However, a price-taking buyer believes that if she asks for a price below the market price, no firm will be willing to sell to her. On the other hand, should the price asked be greater than or equal to the market price, the buyer can obtain as many units of the good as she desires to buy. Price-taking is often thought to be a reasonable assumption when the market has many firms and buyers have perfect information about the price prevailing in the market. Why? Let us start with a situation where each firm in the market charges the same (market) price. Suppose, now, that a certain firm raises its price above the market price. Observe that since all firms produce the same good and all buyers are aware of the market price, the firm in question loses all its buyers. Furthermore, as these buyers switch their purchases to other firms, no “adjustment” problems arise; their demand is readily accommodated when there are so many other firms in the market. Recall, now, that an individual firm’s inability to sell any amount of the good at a price exceeding the market price is precisely what the price-taking assumption stipulates. 4.2 REVENUE We have indicated that in a perfectly competitive market, a firm believes that it can sell as many units of the good as it wants by setting a price less than or equal to the market price. But, if this is the case, surely there is no reason to set a price lower than the market price. In other words, should the firm desire to sell some amount of the good, the price that it sets is exactly equal to the market price. A firm earns revenue by selling the good that it produces in the market. Let the market price of a unit of the good be p. Let q be the quantity of the good produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of the firm is defined as the market price of the good (p) multiplied by the firm’s output (q). Hence, TR = p × q 54 To make matters concrete, consider the following numerical example. Let the market for candles be perfectly competitive and let the market price of a box of candles be Rs 10. For a candle manufacturer, Table 4.1 shows how total revenue is related to output. Notice that when no box is sold, TR is equal to zero; if one box of candles is sold, TR is equal to 1×Rs 10= Rs 10; if two boxes of candles are produced, TR is equal to 2 × Rs 10 = Rs 20; and so on. Table 4.1: Total Revenue Boxes sold TR (in Rs) 0 1 2 3 4 5 0 10 20 30 40 50 We can depict how the total revenue changes as the quantity sold changes through a Total Revenue Curve. A total revenue curve plots 2019-20 the quantity sold or output on the X-axis and the Revenue earned on the Y-axis. Figure 4.1 shows the total revenue curve of a firm. Three observations are relevant here. First, when the output is zero, the total revenue of the firm is also zero. Therefore, the TR curve passes through point O. Second, the total revenue increases as the output goes up. Moreover, the equation ‘TR = p × q’ is that of a straight line because p is constant. This means that the TR curve is an upward rising straight line. Third, consider the slope of this straight line. When the output is one unit (horizontal distance Oq1 in Figure 4.1), the total revenue (vertical height Aq1 in Figure 4.1) is p × 1 = p. Therefore, the slope of the straight line is Aq1/Oq1 = p. The average revenue ( AR ) of a firm is defined as total revenue per unit of output. Recall that if a firm’s output is q and the market price is p, then TR equals p × q. Hence AR = p TR q = × q q = p In other words, for a price-taking firm, average revenue equals the market price. Revenue O Fig. 4.1 TR Output A q1 Total Revenue curve. The total revenue curve of a firm shows the relationship between the total revenue that the firm earns and the output level of the firm. The slope of the curve, Aq1/Oq1, is the market price. Price p O Fig. 4.2 Price Line Output Price Line. The price line shows the relationship between the market price and a firm’s output level. The vertical height of the price line is equal to the market price, p. Now consider Figure 4.2. Here, we plot the average revenue or market price (y-axis) for different values of a firm’s output (x-axis). Since the market price is fixed at p, we obtain a horizontal straight line that cuts the y-axis at a height equal to p. This horizontal straight line is called the price line. It is also the firm’s AR curve under perfect competition The price line also depicts the demand curve facing a firm. Observe that the demand curve is perfectly elastic. This means that a firm can sell as many units of the good as it wants to sell at price p. The marginal revenue (MR) of a firm is defined as the increase in total revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale of 3 boxes of candles is Rs.30. Marginal Revenue (MR) = Change in total revenue Changein quantity = 30 - 20 3 - 2 = 10 55 2019-20 Is it a coincidence that this is the same as the price? Actually it is not. Consider the situation when the firm’s output changes from q1 to q2. Given the market price p, MR = (pq2 –pq1)/ (q2 –q1) = [p (q2 –q1)]/ (q2 –q1) = p Thus, for the perfectly competitive firm, MR=AR=p In other words, for a price-taking firm, marginal revenue equals the market price. Setting the algebra aside, the intuition for this result is quite simple. When a firm increases its output by one unit, this extra unit is sold at the market price. Hence, the firm’s increase in total revenue from the one-unit output expansion – that is, MR – is precisely the market price. 4.3 PROFIT MAXIMISATION A firm produces and sells a certain amount of a good. The firm’s profit, denoted by π 1, is defined to be the difference between its total revenue (TR) and its total cost of production (TC ). In other words π = TR – TC Clearly, the gap between TR and TC is the firm’s earnings net of costs. A firm wishes to maximise its profit. The firm would like to identify the quantity q0 at which its profits are maximum. By definition, then, at any quantity other than q0, the firm’s profits are less than at q0. The critical question is: how do we identify q0? For profits to be maximum, three conditions must hold at q0: 1. The price, p, must equal MC 2. Marginal cost must be non-decreasing at q0 3. For the firm to continue to produce, in the short run, price must be greater than the average variable cost (p > AVC); in the long run, price must be greater than the average cost (p > AC). 4.3.1 Condition 1 Profits are the difference between total revenue and total cost. Both total revenue and total cost increase as output increases. Notice that as long as the change in total revenue is greater than the change in total cost, profits will continue to increase. Recall that change in total revenue per unit increase in output is the marginal revenue; and the change in total cost per unit increase in output is the marginal cost. Therefore, we can conclude that as long as marginal revenue is greater than marginal cost, profits are increasing. By the same logic, as long as marginal revenue is less than marginal cost, profits will fall. It follows that for profits to be maximum, marginal revenue should equal marginal cost. In other words, profits are maximum at the level of output (which we have called q0) for which MR = MC For the perfectly competitive firm, we have established that the MR = P. So the firm’s profit maximizing output becomes the level of output at which P=MC. 4.3.2 Condition 2 Consider the second condition that must hold when the profit-maximising output level is positive. Why is it the case that the marginal cost curve cannot slope 1It is a convention in economics to denote profit with the Greek letter π . 56 2019-20 downwards at the profitmaximising output level? To answer this question, refer once again to Figure 4.3. Note that at output levels q1 and q4, the market price is equal to the marginal cost. However, at the output level q1, the marginal cost curve is downward sloping. We claim that q1 cannot be a profit-maximising output level. Why? Observe that for all output levels slightly to the left of q1, the market price is lower than the marginal cost. But, the argument outlined in section 3.1 immediately implies that the firm’s profit at an output level slightly smaller than q1 exceeds that corresponding to the output level q1. This being the case, q1 cannot be a profit-maximising output level. Conditions 1 and 2 for profit maximisation. The figure is used to demonstrate that when the market price is p, the output level of a profitmaximising firm cannot be q1 (marginal cost cu
rve, MC, is downward sloping), q2 and q3 (market price exceeds marginal cost), or q5 and q6 (marginal cost exceeds market price). 4.3.3 Condition 3 Consider the third condition that must hold when the profitmaximising output level is positive. Notice that the third condition has two parts: one part applies in the short run while the other applies in the long run. Case 1: Price must be greater than or equal to AVC in the short run We will show that the statement of Case 1 (see above) is true by arguing that a profitmaximising firm, in the short run, will not produce at an output level wherein the market price is lower than the AVC. Price, costs E p O Fig. 4.4 SMC SAC AVC Output B A q1 Price-AVC Relationship with Profit Maximisation (Short Run). The figure is used to demonstrate that a profit-maximising firm produces zero output in the short run when the market price, p, is less than the minimum of its average variable cost (AVC). If the firm’s output level is q1, the firm’s total variable cost exceeds its revenue by an amount equal to the area of rectangle pEBA. Let us turn to Figure 4.4. Observe that at the output level q1, the market price p is lower than the AVC. We claim that q1 cannot be a profit-maximising output level. Why? Notice that the firm’s total revenue at q1 is as follows TR = Price × Quantity = Vertical height Op × width Oq1 = The area of rectangle OpAq1 57 2019-20 Similarly, the firm’s total variable cost at q1 is as follows TVC = Average variable cost × Quantity = Vertical height OE × Width Oq1 = The area of rectangle OEBq1 Now recall that the firm’s profit at q1 is TR – (TVC + TFC); that is, [the area of rectangle OpAq1] – [the area of rectangle OEBq1] – TFC. What happens if the firm produces zero output? Since output is zero, TR and TVC are zero as well. Hence, the firm’s profit at zero output is equal to – TFC. But, the area of rectangle OpAq1 is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit at q1 is [(area EBAp)-TFC], which is strictly less than what it obtains by not producing at all. So, the firm will choose not to produce at all, and exit from the market. Price, costs LRMC 58 Case 2: Price must be greater than or equal to AC in the long run We will show that the statement of Case 2 (see above) is true by arguing that a profit-maximising firm, in the long run, will not produce at an output level wherein the market price is lower than the AC. Let us turn to Figure 4.5. Observe that at the output level q1, the market price p is lower than the (long run) AC. We claim that q1 cannot be a profit-maximising output level. Why? Notice that the firm’s total revenue, TR, at q1 is the area of the rectangle OpAq1 (the product of price and quantity) while the firm’s total cost, TC , is the area of the rectangle OEBq1 (the product of average cost and quantity). Since the area of rectangle OEBq1 is larger than the area of rectangle OpAq1, the firm incurs a loss at the output level q1. But, in the long run set-up, a firm that shuts down production has a profit of zero. Again, the firm chooses to exit in this case. 4.3.4 The Profit Maximisation Problem: Graphical Representation Using the material in sections 3.1, 3.2 and 3.3, let us graphically firm’s profit represent a E p O Fig. 4.5 B A q1 LRAC Output Price-AC Relationship with Profit Maximisation (Long Run). The figure is used to demonstrate that a profit-maximising firm produces zero output in the long run when the market price, p, is less than the minimum of its long run average cost (LRAC). If the firm’s output level is q1, the firm’s total cost exceeds its revenue by an amount equal to the area of rectangle pEBA. Geometric Representation of Profit Maximisation (Short Run). Given market price p, the output level of a profit-maximising firm is q0. At q0, the firm’s profit is equal to the area of rectangle EpAB. 2019-20 maximisation problem in the short run. Consider Figure 4.6. Notice that the market price is p. Equating the market price with the (short run) marginal cost, we obtain the output level q0. At q0, observe that SMC slopes upwards and p exceeds AVC. Since the three conditions discussed in sections 3.1-3.3 are satisfied at q0, we maintain that the profit-maximising output level of the firm is q0. What happens at q0? The total revenue of the firm at q0 is the area of rectangle OpAq0 (the product of price and quantity) while the total cost at q0 is the area of rectangle OEBq0 (the product of short run average cost and quantity). So, at q0, the firm earns a profit equal to the area of the rectangle EpAB. 4.4 SUPPLY CURVE OF A FIRM A firm’s ‘supply’ is the quantity that it chooses to sell at a given price, given technology, and given the prices of factors of production. A table describing the quantities sold by a firm at various prices, technology and prices of factors remaining unchanged, is called a supply schedule. We may also represent the information as a graph, called a supply curve. The supply curve of a firm shows the levels of output (plotted on the x-axis) that the firm chooses to produce corresponding to different values of the market price (plotted on the y-axis), again keeping technology and prices of factors of production unchanged. We distinguish between the short run supply curve and the long run supply curve. 4.4.1 Short Run Supply Curve of a Firm Let us turn to Figure 4.7 and derive a firm’s short run supply curve. We shall split this derivation into two parts. We first determine a firm’s profit-maximising output level when the market price is greater than or equal to the minimum AVC. This done, we determine the firm’s profit-maximising output level when the market price is less than the minimum AVC. Case 1: Price is greater than or equal to the minimum AVC Suppose the market price is p1, which exceeds the minimum AVC. We start out by equating p1 with SMC on the rising part of the SMC curve; this leads to the output level q1. Note also that the AVC at q1 does not exceed the market price, p1. Thus, all three conditions highlighted in section 3 are satisfied at q1. Hence, when the market price is p1, the firm’s output level in the short run is equal to q1. Case 2: Price is less than the minimum AVC Suppose the market price is p2, which is less than the minimum AVC. We have argued (see Price, costs p1 p2 O Fig. 4.7 SMC SAC AVC q1 Output Market Price Values. The figure shows the output levels chosen by a profit-maximising firm in the short run for two values of the market price: p1 and p2. When the market price is p1, the output level of the firm is q1; when the market price is p2, the firm produces zero output. 59 2019-20 condition 3 in section 3) that if a profit-maximising firm produces a positive output in the short run, then the market price, p2, must be greater than or equal to the AVC at that output level. But notice from Figure 4.7 that for all positive output levels, AVC strictly exceeds p2. In other words, it cannot be the case that the firm supplies a positive output. So, if the market price is p2, the firm produces zero output. Price, costs O Fig. 4.8 Supply Curve (SMC) SAC AVC Output Combining cases 1 and 2, we reach an important conclusion. A firm’s short run supply curve is the rising part of the SMC curve from and above the minimum AVC together with zero output for all prices strictly less than the minimum AVC. In figure 4.8, the bold line represents the short run supply curve of the firm. The Short Run Supply Curve of a Firm. The short run supply curve of a firm, which is based on its short run marginal cost curve (SMC) and average variable cost curve (AVC), is represented by the bold line. 4.4.2 Long Run Supply Curve of a Firm Let us turn to Figure 4.9 and derive the firm’s long run supply curve. As in the short run case, we split the derivation into two parts. We first determine the firm’s profit-maximising output level when the market price is greater than or equal to the minimum (long run) AC. This done, we determine the firm’s profitmaximising output level when the market price is less than the minimum (long run) AC. Price, costs p1 p2 O Fig. 4.9 60 LRMC LRAC q1 Output Profit maximisation in the Long Run for Different Market Price Values. The figure shows the output levels chosen by a profitmaximising firm in the long run for two values of the market price: p1 and p2. When the market price is p1, the output level of the firm is q1; when the market price is p2, the firm produces zero output. Case 1: Price greater than or equal to the minimum LRAC Suppose the market price is p1, which exceeds the minimum LRAC. Upon equating p1 with LRMC on the rising part of the LRMC curve, we obtain output level q1. Note also that the LRAC at q1 does not exceed the market price, p1. Thus, all three conditions highlighted in section 3 are satisfied at q1. Hence, when the market price is p1, the firm’s supplies in the long run become an output equal to q1. Case 2: Price less than the minimum LRAC Suppose the market price is p2, which is less than the minimum LRAC. We have 2019-20 LRAC Price, costs Supply Curve(LRMC) argued (see condition 3 in section 3) that if a profit-maximising firm produces a positive output in the long run, the market price, p2, must be greater than or equal to the LRAC at that output level. But notice from Figure 4.9 that for all positive output levels, LRAC strictly exceeds p2. In other words, it cannot be the case that the firm supplies a positive output. So, when the market price is p2, the firm produces zero output. Combining cases 1 and 2, we reach an important conclusion. A firm’s long run supply curve is the rising part of the LRMC curve from and above the minimum LRAC together with zero output for all prices less than the minimum LRAC. In Figure 4.10, the bold line represents the long run supply curve of the firm. The Long Run Supply Curve of a Firm. The long run supply curve of a firm, which is based on its long run marginal cost curve (LRMC) and long run average cost
curve (LRAC), is represented by the bold line. Fig. 4.10 Output O 4.4.3 The Shut Down Point Previously, while deriving the supply curve, we have discussed that in the short run the firm continues to produce as long as the price remains greater than or equal to the minimum of AVC. Therefore, along the supply curve as we move down, the last price-output combination at which the firm produces positive output is the point of minimum AVC where the SMC curve cuts the AVC curve. Below this, there will be no production. This point is called the short run shut down point of the firm. In the long run, however, the shut down point is the minimum of LRAC curve. 4.4.4 The Normal Profit and Break-even Point The minimum level of profit that is needed to keep a firm in the existing business is defined as normal profit. A firm that does not make normal profits is not going to continue in business. Normal profits are therefore a part of the firm’s total costs. It may be useful to think of them as an opportunity cost for entrepreneurship. Profit that a firm earns over and above the normal profit is called the super-normal profit. In the long run, a firm does not produce if it earns anything less than the normal profit. In the short run, however, it may produce even if the profit is less than this level. The point on the supply curve at which a firm earns only normal profit is called the break-even point of the firm. The point of minimum average cost at which the supply curve cuts the LRAC curve (in short run, SAC curve) is therefore the break-even point of a firm. Opportunity cost In economics, one often encounters the concept of opportunity cost. Opportunity cost of some activity is the gain foregone from the second best activity. Suppose you have Rs 1,000 which you decide to invest in your family business. What is the opportunity cost of your action? If you do not invest 61 2019-20 this money, you can either keep it in the house-safe which will give you zero return or you can deposit it in either bank-1 or bank-2 in which case you get an interest at the rate of 10 per cent or 5 per cent respectively. So the maximum benefit that you may get from other alternative activities is the interest from the bank-1. But this opportunity will no longer be there once you invest the money in your family business. The opportunity cost of investing the money in your family business is therefore the amount of forgone interest from the bank-1. 4.5 DETERMINANTS OF A FIRM’S SUPPLY CURVE In the previous section, we have seen that a firm’s supply curve is a part of its marginal cost curve. Thus, any factor that affects a firm’s marginal cost curve is of course a determinant of its supply curve. In this section, we discuss two such factors. 4.5.1 Technological Progress Suppose a firm uses two factors of production – say, capital and labour – to produce a certain good. Subsequent to an organisational innovation by the firm, the same levels of capital and labour now produce more units of output. Put differently, to produce a given level of output, the organisational innovation allows the firm to use fewer units of inputs. It is expected that this will lower the firm’s marginal cost at any level of output; that is, there is a rightward (or downward) shift of the MC curve. As the firm’s supply curve is essentially a segment of the MC curve, technological progress shifts the supply curve of the firm to the right. At any given market price, the firm now supplies more units of output. 4.5.2 Input Prices A change in input prices also affects a firm’s supply curve. If the price of an input (say, the wage rate of labour) increases, the cost of production rises. The consequent increase in the firm’s average cost at any level of output is usually accompanied by an increase in the firm’s marginal cost at any level of output; that is, there is a leftward (or upward) shift of the MC curve. This means that the firm’s supply curve shifts to the left: at any given market price, the firm now supplies fewer units of output. Impact of a unit tax on supply A unit tax is a tax that the government imposes per unit sale of output. For example, suppose that the unit tax imposed by the government is Rs 2. Then, if the firm produces and sells 10 units of the good, the total tax that the firm must pay to the government is 10 × Rs 2 = Rs 20. How does the long run supply curve of a firm change when a unit tax is imposed? Let us turn to figure 4.11. Before the unit tax is imposed, LRMC0 and LRAC0 are, respectively, the long run marginal cost curve and the long run average cost curve of the firm. Now, suppose the government puts in place a unit tax of Rs t. Since the firm must pay an extra Rs t for each unit of the good produced, the firm’s long run average cost and long run marginal cost at any level of output increases by Rs t. In Figure 4.11, LRMC1 and LRAC1 are, respectively, the long run marginal cost curve and the long run average cost curve of the firm upon imposition of the unit tax. 62 2019-20 Recall that the long run supply curve of a firm is the rising part of the LRMC curve from and above the minimum LRAC together with zero output for all prices less than the minimum LRAC. Using this observation in Figure 4.12, it is immediate that S0 and S1 are, respectively, the long run supply curve of the firm before and after the imposition of the unit tax. Notice that the unit tax shifts the firm’s long run supply curve to the left: at any given market price, the firm now supplies fewer units of output. Costs p 0 + t p0 O LRMC1 LRAC1 LRMC0 LRAC0 Output Price p 0 + t p0 O t q0 Fig. 4.11 Fig. 4.12 S1 S0 q0 Output Cost Curves and the Unit Tax. LRAC0 and LRMC0 are, respectively, the long run average cost curve and the long run marginal cost curve of a firm before a unit tax is imposed. LRAC1 and LRMC1 are, respectively, the long run average cost curve and the long run marginal cost curve of a firm after a unit tax of Rs t is imposed. 4.6 MARKET SUPPLY CURVE Supply Curves and Unit Tax. S0 is the supply curve of a firm before a unit tax is imposed. After a unit tax of Rs t is imposed, S1 represents the supply curve of the firm. The market supply curve shows the output levels (plotted on the x-axis) that firms in the market produce in aggregate corresponding to different values of the market price (plotted on the y-axis). How is the market supply curve derived? Consider a market with n firms: firm 1, firm 2, firm 3, and so on. Suppose the market price is fixed at p. Then, the output produced by the n firms in aggregate is [supply of firm 1 at price p] + [supply of firm 2 at price p] + ... + [supply of firm n at price p]. In other words, the market supply at price p is the summation of the supplies of individual firms at that price. 63 Let us now construct the market supply curve geometrically with just two firms in the market: firm 1 and firm 2. The two firms have different cost structures. 1p while firm 2 2p . Assume also that Firm 1 will not produce anything if the market price is less than will not produce anything if the market price is less than 2p is greater than 1p . In panel (a) of Figure 4.13 we have the supply curve of firm 1, denoted by S1; in panel (b), we have the supply curve of firm 2, denoted by S2. Panel (c) of Figure 4.13 shows the market supply curve, denoted by Sm. When the market 1p , both firms choose not to produce any amount of the price is strictly below good; hence, market supply will also be zero for all such prices. For a market 2019-20 price greater than or equal to 1p but strictly less than 2p , only firm 1 will produce a positive amount of the good. Therefore, in this range, the market supply curve coincides with the supply curve of firm 1. For a market price greater than or 2p , both firms will have positive output levels. For example, consider a equal to situation wherein the market price assumes the value p3 (observe that p3 2p ). Given p3, firm 1 supplies q3 units of output while firm 2 supplies q4 exceeds units of output. So, the market supply at price p3 is q5, where q5 = q3 + q4. Notice how the market supply curve, Sm, in panel (c) is being constructed: we obtain Sm by taking a horizontal summation of the supply curves of the two firms in the market, S1 and S2. Price p3 p2 p1 O Fig. 4.13 S1 S2 Sm q3 (a) O q4 (b) O q5 Output (c) The Market Supply Curve Panel. (a) shows the supply curve of firm 1. Panel (b) shows the supply curve of firm 2. Panel (c) shows the market supply curve, which is obtained by taking a horizontal summation of the supply curves of the two firms. It should be noted that the market supply curve has been derived for a fixed number of firms in the market. As the number of firms changes, the market supply curve shifts as well. Specifically, if the number of firms in the market increases (decreases), the market supply curve shifts to the right (left). We now supplement the graphical analysis given above with a related numerical example. Consider a market with two firms: firm 1 and firm 2. Let the supply curve of firm 1 be as follows S1(p) =  0  p  : – 10 : p p < ≥ 10 10 Notice that S1(p) indicates that (1) firm 1 produces an output of 0 if the market price, p, is strictly less than 10, and (2) firm 1 produces an output of (p – 10) if the market price, p, is greater than or equal to 10. Let the supply curve of firm 2 be as follows S2(p) =  0  p  : – 15 : p p < ≥ 15 15 The interpretation of S2(p) is identical to that of S1(p), and is, hence, omitted. Now, the market supply curve, Sm(p), simply sums up the supply curves of the two firms; in other words Sm(p) = S1(p) + S2(p) 64 2019-20 But, this means that Sm(p) is as follows Sm(p) =  0  p   p (  – 10 – 10) + ( p – 15) = : : 2 – 25 : p p p p < ≥ ≥ 10 10 15 and p < 15 4.7 PRICE ELASTICITY OF SUPPLY The price elasticity of supply of a good measures the responsiveness of quantity supplied to changes in the price of the good. More specifically, the price elasticity of supply, deno
ted by eS, is defined as follows Price elasticity of supply, eS = Percentage change in quantity supplied Percentage change in price = ∆ Q Q ∆ P P × 100 × 100 = ∆ Q P × ∆ P Q Where Q∆ is the change in quantity of the good supplied to the market as market price changes by P∆ . To make matters concrete, consider the following numerical example. Suppose the market for cricket balls is perfectly competitive. When the price of a cricket ball is Rs10, let us assume that 200 cricket balls are produced in aggregate by the firms in the market. When the price of a cricket ball rises to Rs 30, let us assume that 1,000 cricket balls are produced in aggregate by the firms in the market. The percentage change in quantity supplied and market price can be estimated using the information summarised in the table below: Price of Cricket balls (P) Old price : P1 = 10 New price : P2 = 30 Quantity of Cricket balls produced and sold (Q) Old quantity : Q1 = 200 New quantity: Q2 = 1000 Percentage change in quantity supplied= ∆ Q Q 1 × 100 = = − Q Q 2 1 Q 1 × 100 − 1000 200 200 × 100 = 400 Percentage change in market price = ∆ P P 1 × 100 65 2019-20 = = P 2 − P 1 P 1 − 30 10 10 × 100 × 100 Therefore, price elasticity of supply, eS = 400 200 = 2 = 200 When the supply curve is vertical, supply is completely insensitive to price and the elasticity of supply is zero. In other cases, when supply curve is positively sloped, with a rise in price, supply rises and hence, the elasticity of supply is positive. Like the price elasticity of demand, the price elasticity of supply is also independent of units. The Geometric Method Consider the Figure 4.14. Panel (a) shows a straight line supply curve. S is a point on the supply curve. It cuts the price-axis at its positive range and as we extend the straight line, it cuts the quantity-axis at M which is at its negative range. The price elasticity of this supply curve at the point S is given by the ratio, Mq0/Oq0. For any point S on such a supply curve, we see that Mq0 > Oq0. The elasticity at any point on such a supply curve, therefore, will be greater than 1. In panel (c) we consider a straight line supply curve and S is a point on it. It cuts the quantity-axis at M which is at its positive range. Again the price elasticity of this supply curve at the point S is given by the ratio, Mq0/Oq0. Now, Mq0 < Oq0 and hence, eS < 1. S can be any point on the supply curve, and therefore at all points on such a supply curve eS < 1. Now we come to panel (b). Here the supply curve goes through the origin. One can imagine that the point M has coincided with the origin here, i.e., Mq0 has become equal to Oq0. The price elasticity of this supply curve at the point S is given by the ratio, Oq0/Oq0 which is equal to 1. At any point on a straight line, supply curve going through the origin price elasticity will be one. Price Price Price p0 S p0 S p0 S M O Fig. 4.14 q0 (a) Output O q0 Output O M q0 Output (b) (c) Price Elasticity Associated with Straight Line Supply Curves. In panel (a), price elasticity (eS) at S is greater than 1. In panel (b), price elasticity (eS) at S is equal to 1. In panel (c), price elasticity (eS) at S is less than 1. 66 2019-20 • In a perfectly competitive market, firms are price-takers. • The total revenue of a firm is the market price of the good multiplied by the firm’s output of the good. • For a price-taking firm, average revenue is equal to market price. • For a price-taking firm, marginal revenue is equal to market price. • The demand curve that a firm faces in a perfectly competitive market is perfectly elastic; it is a horizontal straight line at the market price. • The profit of a firm is the difference between total revenue earned and total cost incurred. • If there is a positive level of output at which a firm’s profit is maximised in the short run, three conditions must hold at that output level (i) p = SMC (ii) SMC is non-decreasing (iii) p ≥ AV C. • If there is a positive level of output at which a firm’s profit is maximised in the long run, three conditions must hold at that output level p = LRMC (i) (ii) LRMC is non-decreasing (iii) p ≥ LRAC. • The short run supply curve of a firm is the rising part of the SMC curve from and above minimum AVC together with 0 output for all prices less than the minimum AVC. • The long run supply curve of a firm is the rising part of the LRMC curve from and above minimum LRAC together with 0 output for all prices less than the minimum LRAC. • Technological progress is expected to shift the supply curve of a firm to the right. • An increase (decrease) in input prices is expected to shift the supply curve of a firm to the left (right). • The imposition of a unit tax shifts the supply curve of a firm to the left. • The market supply curve is obtained by the horizontal summation of the supply curves of individual firms. • The price elasticity of supply of a good is the percentage change in quantity supplied due to one per cent change in the market price of the good. s s s Perfect competition Profit maximisation Market supply curve Revenue, Profit Firms supply curve Price elasticity of supply KKKKK . What are the characteristics of a perfectly competitive market? 2. How are the total revenue of a firm, market price, and the quantity sold by the firm related to each other? 3. What is the ‘price line’? 4. Why is the total revenue curve of a price-taking firm an upward-sloping straight line? Why does the curve pass through the origin? 67 2019-20 5. What is the relation between market price and average revenue of a price- taking firm? 6. What is the relation between market price and marginal revenue of a price- taking firm? 7. What conditions must hold if a profit-maximising firm produces positive output in a competitive market? 8. Can there be a positive level of output that a profit-maximising firm produces in a competitive market at which market price is not equal to marginal cost? Give an explanation. 9. Will a profit-maximising firm in a competitive market ever produce a positive level of output in the range where the marginal cost is falling? Give an explanation. 10. Will a profit-maximising firm in a competitive market produce a positive level of output in the short run if the market price is less than the minimum of AVC? Give an explanation. 11. Will a profit-maximising firm in a competitive market produce a positive level of output in the long run if the market price is less than the minimum of AC? Give an explanation. 12. What is the supply curve of a firm in the short run? 13. What is the supply curve of a firm in the long run? 14. How does technological progress affect the supply curve of a firm? 15. How does the imposition of a unit tax affect the supply curve of a firm? 16. How does an increase in the price of an input affect the supply curve of a firm? 17. How does an increase in the number of firms in a market affect the market supply curve? 18. What does the price elasticity of supply mean? How do we measure it? 19. Compute the total revenue, marginal revenue and average revenue schedules in the following table. Market price of each unit of the good is Rs 10. Quantity Sold TR MR AR 0 1 2 3 4 5 6 20. The following table shows the total revenue and total cost schedules of a competitive firm. Calculate the profit at each output level. Determine also the market price of the good. Quantity Sold TR (Rs) TC (Rs) Profit 10 15 20 25 30 35 5 7 10 12 15 23 33 40 68 2019-20 21. The following table shows the total cost schedule of a competitive firm. It is given that the price of the good is Rs 10. Calculate the profit at each output level. Find the profit maximising level of output. Output TC (Rs 10 5 15 22 27 31 38 49 63 81 101 123 22. Consider a market with two firms. The following table shows the supply schedules of the two firms: the SS1 column gives the supply schedule of firm 1 and the SS2 column gives the supply schedule of firm 2. Compute the market supply schedule. 23. Consider a market with two firms. In the following table, columns labelled as SS1 and SS 2 give the supply schedules of firm 1 and firm 2 respectively. Compute the market supply schedule. Price (Rs) SS1 (units) SS2 (units) 0 1 2 3 4 5 6 Price (Rs SS1 (kg SS2 (kg) 0 0 0 0 0.5 1 1.5 2 2.5 24. There are three identical firms in a market. The following table shows the supply schedule of firm 1. Compute the market supply schedule. Price (Rs SS1 (units) 0 0 2 4 6 8 10 12 14 69 2019-20 ? 25. A firm earns a revenue of Rs 50 when the market price of a good is Rs 10. The market price increases to Rs 15 and the firm now earns a revenue of Rs 150. What is the price elasticity of the firm’s supply curve? 26. The market price of a good changes from Rs 5 to Rs 20. As a result, the quantity supplied by a firm increases by 15 units. The price elasticity of the firm’s supply curve is 0.5. Find the initial and final output levels of the firm. ? 27. At the market price of Rs 10, a firm supplies 4 units of output. The market price increases to Rs 30. The price elasticity of the firm’s supply is 1.25. What quantity will the firm supply at the new price? 70 2019-20 Chapter 5 e c i r P pf p* p1 SS DD O q'1 q'1 q* q2 q1 Quantity MarkMarkMarkMarkMarket Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium This chapter will be built on the foundation laid down in Chapters 2 and 4 where we studied the consumer and firm behaviour when they are price takers. In Chapter 2, we have seen that an individual’s demand curve for a commodity tells us what quantity a consumer is willing to buy at different prices when he takes price as given. The market demand curve in turn tells us how much of the commodity all the consumers taken together are willing to purchase at different prices when everyone takes price as given. In Chapter 4, we have seen that an individual firm’s supply curve tells us the quantity of the commodity that a profit-maximising firm would wish to sell at different prices when
it takes price as given and the market supply curve tells us how much of the commodity all the firms taken together would wish to supply at different prices when each firm takes price as given. In this chapter, we combine both consumers’ and firms’ behaviour to study market equilibrium through demand-supply analysis and determine at what price equilibrium will be attained. We also examine the effects of demand and supply shifts on equilibrium. At the end of the chapter, we will look at some of the applications of demand-supply analysis. 5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives. Recall from Chapters 2 and 4 that objectives of the consumers are to maximise their respective preference and that of the firms are to maximise their respective profits. Both the consumers’ and firms’ objectives are compatible in the equilibrium. An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy; in other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity. Therefore, (p, q) is an equilibrium if qD(p∗) = qS(p∗) 2019-20 where p∗ denotes the equilibrium price and qD(p∗) and qS(p∗) denote the market demand and market supply of the commodity respectively at price p∗. If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price. Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation. Whenever market supply is not equal to market demand, and hence the market is not in equilibrium, there will be a tendency for the price to change. In the next two sections, we will try to understand what drives this change. Out-of-equilibrium Behaviour From the time of Adam Smith (1723-1790), it has been maintained that in a perfectly competitive market an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’. Throughout our analysis we shall maintain that the ‘Invisible Hand’ plays this very important role. Moreover, we shall take it that the ‘Invisible Hand’ by following this process is able to reach the equilibrium. This assumption will be taken to hold in all that we discuss in the text. 5.1.1 Market Equilibrium: Fixed Number of Firms Recall that in Chapter 2 we have derived the market demand curve for pricetaking consumers, and for price-taking firms the market supply curve was derived in Chapter 4 under the assumption of a fixed number of firms. In this section with the help of these two curves we will look at how supply and demand forces work together to determine where the market will be in equilibrium when the number of firms is fixed. We will also study how the equilibrium price and quantity change due to shifts in demand and supply curves. Figure 5.1 illustrates equilibrium for a perfectly competitive market with a fixed number of firms. Here SS denotes the market supply curve and DD denotes the market demand curve for a commodity. The market supply curve SS the shows how much of commodity firms would wish to supply at different prices, and the demand curve DD tells us how much of the commodity, the consumers would be willing to purchase at different prices. Graphically, an equilibrium is a point where the market supply curve intersects the market demand curve because this is where the market demand equals market supply. At any other point, either there is excess supply or Price p2 p* p1 SS DD O q'1 q'2 q* q2 q1 Quantity Fig. 5.1 Market Equilibrium with Fixed Number of Firms. Equilibrium occurs at the intersection of the market demand curve DD and market supply curve SS. The equilibrium quantity is q* and the equilibrium price is p. At a price greater than p, there will be excess supply, and at a price below p, there will be excess demand. 72 2019-20 there is excess demand. To see what happens when market demand does not equal market supply, let us look in figure 5.1 again. In Figure 5.1, if the prevailing price is p1, the market demand is q1 whereas the market supply is 1q' . Therefore, there is excess demand in the market equal to 1q' q1. Some consumers who are either unable to obtain the commodity at all or obtain it in insufficient quantity will be willing to pay more than p1. The market price would tend to increase. All other things remaining the same as price rises, quantity demanded falls and quantity supplied increases. The market moves towards the point where the quantity that the firms want to sell is equal to the quantity that the consumers want to buy. This happens when price is p , the supply decisions of the firms only match with the demand decisions of the consumers. 2q ' ) at that price giving rise to excess supply equal to Similarly, if the prevailing price is p2, the market supply (q2) will exceed the 2q ' q2. market demand ( Some firms will not be then able to sell quantity they want to sell; so, they will lower their price. All other things remaining the same as price falls, quantity demanded rises, quantity supplied falls, and at p, the firms are able to sell their desired output since market demand equals market supply at that price. Therefore, p is the equilibrium price and the corresponding quantity q* is the equilibrium quantity. To understand the equilibrium price and quantity determination more clearly, let us explain it through an example. EXAMPLE Let us consider the example of a market consisting of identical1 farms producing same quality of wheat. Suppose the market demand curve and the market supply curve for wheat are given by: 5.1 qD = 200 – p for 0 ≤ p ≤ 200 = 0 for p > 200 qS = 120 + p for p ≥ 10 = 0 for 0 ≤ p < 10 where qD and qS denote the demand for and supply of wheat (in kg) respectively and p denotes the price of wheat per kg in rupees. Since at equilibrium price market clears, we find the equilibrium price (denoted by p) by equating market demand and supply and solve for p. Rearranging terms, qD(p) = qS(p) 200 – p* = 120 + p* 2p* = 80 p* = 40 Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium quantity (denoted by q) is obtained by substituting the equilibrium price into either the demand or the supply curve’s equation since in equilibrium quantity demanded and supplied are equal. 1Here, by identical we mean that all farms have same cost structure. 73 2019-20 Alternatively, qD = q = 200 – 40 = 160 qS = q* = 120 + 40 = 160 Thus, the equilibrium quantity is 160 kg. At a price less than p, say p1 = 25 qD = 200 – 25 = 175 qS = 120 + 25 = 145 Therefore, at p1 = 25, qD > qS which implies that there is excess demand at this price. Algebraically, excess demand (ED) can be expressed as ED(p) = qD – qS = 200 – p – (120 + p) = 80 – 2p Notice from the above expression that for any price less than p(= 40), excess demand will be positive. Similarly, at a price greater than p, say p2 = 45 qD = 200 – 45 = 155 qS = 120 + 45 = 165 Therefore, there is excess supply at this price since qS > qD. Algebraically, excess supply (ES) can be expressed as ES(p) = qS – qD = 120 + p – (200 – p) = 2p – 80 Notice from the above expression that for any price greater than p(= 40), excess supply will be positive. Therefore, at any price greater than p, there will be excess supply, and at any price lower than p,there will be excess demand. Wage Determination in Labour Market Here we will briefly discuss the theory of wage determination under a perfectly competitive market structure using the demand-supply analysis. The basic difference between a labour market and a market for goods is with respect to the source of supply and demand. In the labour market, households are the suppliers of labour and the demand for labour comes from firms whereas in the market for goods, it is the opposite. Here, it is important to point out that by labour, we mean the hours of work provided by labourers and not the number of labourers. The wage rate is determined at the intersection of the demand and supply curves of labour where the demand for and supply of labour balance. We shall now see what the demand and supply curves of labour look like. To examine the demand for labour by a single firm, we assume that the labour is the only variable factor of production and the labour market is perfectly competitive, which in turn, implies that each firm takes wage rate as given. Also, the firm we are concerned with, is perfectly competitive in 74 2019-20 nature and carries out production with the goal of profit maximisation. We also assume that given the technology of the firm, the law of diminishing marginal product holds. The firm being a profit maximiser will always employ labour upto the point where the extra cost she incurs for employing the last unit of labour is equal to the additional benefit she earns from that unit. The extra cost of hiring one more unit of labour is the wage rate (w). The extra output produced by one more unit of labour is its marginal product (MPL) and by selling each extra unit of output, the additional earning of the firm is the marginal revenue (MR) she gets from that unit. Therefore, for each extra unit of labour, she gets an additional benefit equal to marginal revenue times marginal product which is called Marginal Revenue Product of Labour (MRPL). Thus, while hiring labour, the firm
employs labour up to the point where w = MRPL and MRPL = MR × MPL Since we are dealing with a perfectly competitive firm, marginal revenue is equal to the price of the commoditya and hence marginal revenue product of labour in this case is equal to the value of marginal product of labour (VMPL). As long as the VMPL is greater than the wage rate, the firm will earn more profit by hiring one more unit of labour, and if at any level of labour employment VMPL is less than the wage rate, the firm can increase her profit by reducing a unit of labour employed. Wage Given the assumption of the law of diminishing marginal product, the fact that the firm always produces at w = VMPL implies that the demand curve for labour is downward sloping. To explain why it is so, let us assume at some wage rate w1, demand for labour is l1. Now, suppose the wage rate increases to w2. To maintain the wage-VMPL equality, VMPL should also increase. The price of the commodity remaining constantb, this is possible only if MPL increases which in turn implies that less labour should be employed owing to the diminishing marginal . Hence, at higher wage, less labour is demanded thereby sloping demand, curve. To arrive at the market demand curve from individual firms’ demand curve, we simply labour by individual firms at different wages and since labour as wage increases, the market demand curve is also downward sloping. Wage is determined at the point where the labour demand and supply curves intersect. Labour(in hrs) w* DL SL O l* aRecall from Chapter 4 that for a perfectly competitive firm, marginal revenue equals price. bSince the firm under consideration is perfectly competitive, it believes it cannot influence the price of the commodity. 75 2019-20 Having explored the demand side, we now turn to the supply side. As already mentioned, it is the households which determine how much labour to supply at a given wage rate. Their supply decision is essentially a choice between income and leisure. On the one hand, individuals enjoy leisure and find work irksome and on the other, they value income for which they must work. So there is a trade-off between enjoying leisure and spending more hours for work. To derive the labour supply curve for a single individual, let us assume at some wage rate w1, the individual supplies l1 units of labour. Now suppose the wage rises to w2. This increase in wage rate will have two effects: First, due to the increase in wage rate, the opportunity cost of leisure increases which makes leisure costlier. Therefore, the individual will want to enjoy less leisure. As a result, they will work for longer hours. Second, because of the increase in wage rate to w2, the purchasing power of the individual increases. So, she would want to spend more on leisure activities. The final effect of the increase in wage rate will depend on which of the two effects predominates. At low wage rates, the first effect dominates the second and so the individual will be willing to supply more labour with an increase in wage rate. But at high wage rates, the second effect dominates the first and the individual will be willing to supply less labour for every increase in wage rate. Thus, we get a backward bending individual labour supply curve which shows that up to a certain wage rate for every increase in wage rate, there is an increased supply of labour. Beyond this wage rate for every increase in wage rate, labour supply will decrease. Nevertheless, the market supply curve of labour, which we obtain by aggregating individuals’ supply at different wages, will be upward sloping because though at higher wages some individuals may be willing to work less, many more individuals will be attracted to supply more labour. With an upward sloping supply curve and downward sloping demand curve, the equilibrium wage rate is determined at the point where these two curves intersect; in other words, where the labour that the households wish to supply is equal to the labour that the firms wish to hire. This is shown in the diagram. Shifts in Demand and Supply In the above section, we studied market equilibrium under the assumption that tastes and preferences of the consumers, prices of the related commodities, incomes of the consumers, technology, size of the market, prices of the inputs used in production, etc remain constant. However, with changes in one or more of these factors either the supply or the demand curve or both may shift, thereby affecting the equilibrium price and quantity. Here, we first develop the general theory which outlines the impact of these shifts on equilibrium and then discuss the impact of changes in some of the above mentioned factors on equilibrium. Demand Shift Consider Figure 5.2 in which we depict the impact of demand shift when the number of firms is fixed. Here, the initial equilibrium point is E where the market demand curve DD0 and the market supply curve SS0 intersect so that q0 and p0 are the equilibrium quantity and price respectively. 76 2019-20 Price p2 p0 Price SS0 G E p0 p1 E F DD2 DD0 O Fig. 5.2 q0 q2 (a) q¢¢ 0 Quantity O q1 0 q1 q0 (b) SS0 DD0 DD1 Quantity Shifts in Demand. Initially, the market equilibrium is at E. Due to the shift in demand to the right, the new equilibrium is at G as shown in panel (a) and due to the leftward shift, the new equilibrium is at F, as shown in panel (b). With rightward shift the equilibrium quantity and price increase whereas with leftward shift, equilibrium quantity and price decrease. Now suppose the market demand curve shifts rightward to DD2 with supply curve remaining unchanged at SS0, as shown in panel (a). This shift indicates that at any price the quantity demanded is more than before. Therefore, at price p0 now there is excess demand in the market equal to 0 0q q'' . In response to this excess demand some individuals will be willing to pay higher price and the price would tend to rise. The new equilibrium is attained at G where the equilibrium quantity q2 is greater than q0 and the equilibrium price p2 is greater than p0. Similarly if the demand curve shifts leftward to DD1, as shown in panel (b), at any price the quantity demanded will be less than what it was before the shift. Therefore, at the initial equilibrium price p0 now there will be excess supply in q' q in response to which some firms will reduce the price the market equal to 0 of their commodity so that they can sell their desired quantity. The new equilibrium is attained at the point F at which the demand curve DD1 and the supply curve SS0 intersect and the resulting equilibrium price p1 is less than p0 and quantity q1 is less than q0. Notice that the direction of change in equilibrium price and quantity is same whenever there is a shift in demand curve. 0 Having developed the general theory, we now consider some examples to understand how demand curve and the equilibrium quantity and price are affected in response to a change in some of the aforementioned factors which are also enlisted in Chapter 2. More specifically, we would analyse the impact of increase in consumers’ income and an increase in the number of consumers on equilibrium. Suppose due to a hike in the salaries of the consumers, their incomes increase. How would it affect equilibrium? With an increase in income, consumers are able to spend more money on some goods. But recall from Chapter 2 that the consumers will spend less on an inferior good with increase in income whereas for a normal good, with prices of all commodities and tastes and preferences of the consumers held constant, we would expect the demand for the good to increase at each price as a result of which the market demand curve will shift rightward. Here we consider the example of a normal good like clothes, the demand for which increases with increase in income of consumers, thereby causing a rightward shift in the demand curve. However, this income increase does not have any impact on 77 2019-20 the supply curve, which shifts only due to some changes in the factors relating to technology or cost of production of the firms. Thus, the supply curve remains unchanged. In the Figure 5.2 (a), this is shown by a shift in the demand curve from DD0 to DD2 but the supply curve remains unchanged at SS0. From the figure, it is clear that at the new equilibrium, the price of clothes is higher and the quantity demanded and sold is also higher. Now let us turn to another example. Suppose due to some reason, there is increase in the number of consumers in the market for clothes. As the number of consumers increases, other factors remaining unchanged, at each price, more clothes will be demanded. Thus, the demand curve will shift rightwards. But this increase in the number of consumers does not have any impact on the supply curve since the supply curve may shift only due to changes in the parameters relating to firms’ behaviour or with an increase in the number of firms, as stated in Chapter 4. This case again can be illustrated through Figure 5.2(a) in which the demand curve DD0 shifts rightward to DD2, the supply curve remaining unchanged at SS0. The figure clearly shows that compared to the old equilibrium point E, at point G which is the new equilibrium point, there is an increase in both price and quantity demanded and supplied. Supply Shift In Figure 5.3, we show the impact of a shift in supply curve on the equilibrium price and quantity. Suppose, initially, the market is in equilibrium at point E where the market demand curve DD0 intersects the market supply curve SS0 such that the equilibrium price is p0 and the equilibrium quantity is q0. 78 Shifts in Supply. Initially, the market equilibrium is at E. Due to the shift in supply curve to the left, the new equilibrium point is G as shown in panel (a) and due to the rightward shift the new equilibrium point is F, as shown in panel (b). With rightward shift, the equilibrium quantity increases and price decreases whereas with leftward shif
t,equilibrium quantity decreases and price increases. Now, suppose due to some reason, the market supply curve shifts leftward to SS2 with the demand curve remaining unchanged, as shown in panel (a). Because of the shift, at the prevailing price, p0, there will be excess demand equal to 0q '' qo in the market. Some consumers who are unable to obtain the good will be willing to pay higher prices and the market price tends to increase. The new equilibrium is attained at point G where the supply curve SS2 intersects the demand curve DD0 such that q2 quantity will be bought and sold at price p2. Similarly, when supply curve shifts rightward, as shown in panel (b), at p0 there will be supply excess of 2019-20 goods equal to q0 0q ' . In response to this excess supply, some firms will reduce their price and the new equilibrium will be attained at F where the supply curve SS1 intersects the demand curve DD0 such that the new market price is p1 at which q1 quantity is bought and sold. Notice the directions of change in price and quantity are opposite whenever there is a shift in supply curve. Now with this understanding, we can analyse the behaviour of equilibrium price and quantity when various aspects of the market change. Here, we will consider the effect of an increase in input price and an increase in number of firms on equilibrium. Let us consider a situation where all other things remaining constant, there is an increase in the price of an input used in the production of a commodity. This will increase the marginal cost of production of the firms using this input. Therefore, at each price, the market supply will be less than before. Hence, the supply curve shifts leftward. In the Figure 5.3(a), this is shown by a shift in the supply curve from SS0 to SS2. But this increase in input price has no impact on the demand of the consumers since it does not depend on the input prices directly. Therefore, the demand curve remains unchanged. In Figure 5.3(a), this is shown by the demand curve remaining unchanged at DD0. As a result, compared to the old equilibrium, now the market price rises and quantity produced decreases. Let us discuss the impact of an increase in the number of firms. Since at each price now more firms will supply the commodity, the supply curve shifts to the right but it does not have any effect on the demand curve. This example can be illustrated by Figure 5.3(b) where the supply curve shifts from SS0 to SS1 whereas the demand curve remains unchanged at DD0. From the figure, we can say that there will be a decrease in price of the commodity and increase in the quantity produced compared to the initial situation. Simultaneous Shifts of Demand and Supply What happens when both demand and supply curves shift simultaneously? The simultaneous shifts can happen in four possible ways: (i) Both supply and demand curves shift rightwards. (ii) Both supply and demand curves shift leftwards. (iii) Supply curve shifts leftward and demand curve shifts rightward. (iv) Supply curve shifts rightward and demand curve shifts leftward. The impact on equilibrium price and quantity in all the four cases are given in Table 5.1. Each row of the table describes the direction in which the equilibrium price and quantity will change for each possible combination of the simultaneous shifts in demand and supply curves. For instance, from the second row of the table, we see that due to a rightward shift in both demand and supply curves, the equilibrium quantity increases invariably but the equilibrium price may either increase, decrease or remain unchanged. The actual direction in which the price will change will depend on the magnitude of the shifts. Check this yourself by varying the magnitude of shifts for this particular case. In the first two cases which are shown in the first two rows of the table, the impact on equilibrium quantity is unambiguous but the equilibrium price may change, if at all, in either direction depending on the magnitudes of shifts. In the next two cases, shown in the last two rows of the table, the effect on price is unambiguous whereas effect on quantity depends on the magnitude of shifts in the two curves. 79 2019-20 Table 5.1: Impact of Simultaneous Shifts on Equilibrium Shift in Demand Shift in Supply Quantity Price Leftward Leftward Decreases Rightward Rightward Increases Leftward Rightward Rightward Leftward May increase, decrease or remain unchanged May increase, decrease or remain unchanged May increase, decrease or remain unchanged May increase, decrease or remain unchanged Decreases Increases Here we give diagrammatic representations for case (ii) and case (iii) in Figure 5.4 and leave the rest as exercises for the readers. 80 Simultaneous Shifts in Demand and Supply. Initially, the equilibrium is at E where the demand curve DD0 and supply curve SS0 intersect. In panel (a), both the supply and the demand curves shift rightward leaving price unchanged but a higher equilibrium quantity. In panel (b), the supply curve shifts rightward and demand curve shifts leftward leaving quantity unchanged but a lower equilibrium price. In the Figure 5.4(a), it can be seen that due to rightward shifts in both demand and supply curves, the equilibrium quantity increases whereas the equilibrium price remains unchanged, and in Figure 5.4(b), equilibrium quantity remains the same whereas price decreases due to a leftward shift in demand curve and a rightward shift in supply curve. 5.1.2 Market Equilibrium: Free Entry and Exit In the last section, the market equilibrium was studied under the assumption that there is a fixed number of firms. In this section, we will study market equilibrium when firms can enter and exit the market freely. Here, for simplicity, we assume that all the firms in the market are identical. What is the implication of the entry and exit assumption? This assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by remaining in production; in other words, the equilibrium price will be equal to the minimum average cost of the firms. 2019-20 To see why it is so, suppose, at the prevailing market price, each firm is earning supernormal profit. The possibility of earning supernormal profit will attract some new firms. As new firms enter the market supply curve shifts rightward. However, demand remains unchanged. This causes market price to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all firms in the market earning normal profit, no more firms will have incentive to enter. Similarly, if the firms are earning less than normal profit at the prevailing price, some firms will exit which will lead to an increase in price, and with sufficient number of firms, the profits of each firm will increase to the level of normal profit. At this point, no more firm will want to leave since they will be earning normal profit here. Thus, with free entry and exit, each firm will always earn normal profit at the prevailing market price. Free for all Recall from the previous chapter that the firms will earn supernormal profit so long as the price is greater than the minimum average cost and at prices less than minimum average cost, they will earn less than normal profit. Therefore, at prices greater than the minimum average cost, new firms will enter, and at prices below minimum average cost, existing firms will start exiting. At the price level equal to the minimum average cost of the firms, each firm will earn normal profit so that no new firm will be attracted to enter the market. Also the existing firms will not leave the market since they are not incurring any loss by producing at this point. So, this price will prevail in the market. Therefore, free entry and exit of the firms imply that the market price will always be equal to the minimum average cost, that is p = min AC From the above, it follows that the equilibrium price will be equal to the minimum average cost of the firms. In equilibrium, the quantity supplied will be determined by the market demand at that price so that they are equal. Graphically, this is shown in Figure 5.5 where the market will be in equilibrium at point E at which the demand curve DD intersects the p0 = min AC line such that the market price is p0 and the total quantity demanded and supplied is equal to q0. At p0 = min AC each firm supplies same amount of output, Price Determination with Free Entry and Exit. With free entry and exit in a perfectly competitive market, the equilibrium price is always equal to min AC and the equilibrium quantity is determined at the intersection of the market demand curve DD with the price line p = min AC. 81 2019-20 say q0f . Therefore, the equilibrium number of firms in the market is equal to the number of firms required to supply q0 output at p0, each in turn supplying q0f amount at that price. If we denote the equilibrium number of firms by n0, then n0 = q q 0 0 f To understand the equilibrium price and quantity determination more clearly, let us look at the following example. EXAMPLE Consider the example of a market for wheat such that the demand curve for wheat is given as follows 5.2 qD = 200 – p for 0 ≤ p ≤ 200 = 0 for p > 200 Assume that the market consists of identical farms. The supply curve of a single farm is given by s fq = 10 + p for p ≥ 20 = 0 for 0 ≤ p < 20 The free entry and exit of farms would mean that the farms will never produce below minimum average cost because otherwise they will incur loss from production in which case they will exit the market. As we know, with free entry and exit, the market will be in equilibrium at a price which equals the minimum average cost of the farms. Therefore, the equilibrium price is p0 = 20 At this price, market will supply that quantity which is equal to the market demand. Therefore, from the demand curve, we get the equilibrium quantity: q0 = 200 – 20 = 180 Also at p0 = 20, each farm supplies q0f = 10 + 20 = 30 Therefore
, the equilibrium number of farms is n0 = 0 q q 0 f = 180 30 = 6 Thus, with free entry and exit, the equilibrium price, quantity and number of farms are Rs 20, 180 kg and 6 respectively. Shifts in Demand Let us examine the impact of shift in demand on equilibrium price and quantity when the firms can freely enter and exit the market. From the previous section, we know that free entry and exit of the firms would imply that under all circumstances equilibrium price will be equal to the minimum average cost of the existing firms. Under this condition, even if the market demand curve shifts in either direction, at the new equilibrium, the market will supply the desired quantity at the same price. In Figure 5.6, DD0 is the market demand curve which tells us how much quantity will be demanded by the consumers at different prices and p0 denotes 82 2019-20 the price which is equal to the minimum average cost of the firms. The initial equilibrium is at point E where the demand curve DD0 cuts the p0 = minAC line and the total quantity demanded and supplied is q0. The equilibrium number of firms is n0 in this situation. Now suppose the demand curve shifts to the right for some reason. At p0 there will be excess demand for the commodity. Some dissatisfied consumers will be willing to pay higher price for the commodity, so the price tends to rise. This gives rise to a possibility of earning supernormal profit which will attract new firms to the market. The entry of these new firms will eventually wipe out the supernormal profit and the price will again reach p0. Now higher quantity will be supplied at the same price. From the panel (a), we can see that the new demand curve DD1 intersects the p0 = minAC line at point F such that the new equilibrium will be (p0, q1) where q1 is greater than q0. The new equilibrium number of firms n1 is greater than n0 because of the entry of new firms. Similarly, for a leftward shift of the demand curve to DD2, there will be 83 Shifts in Demand. Initially, the demand curve was DD0, the equilibrium quantity and price were q0 and p0 respectively. With rightward shift of the demand curve to DD1, as shown in panel (a), the equilibrium quantity increases and with leftward shift of the demand curve to DD2, as shown in panel (b), the equilibrium quantity decreases. In both the cases, the equilibrium price remains unchanged at p0. excess supply at the price p0. In response to this excess supply, some firms, which will be unable to sell their desired quantity at p0, will wish to lower their price. The price tends to decrease which will lead to the exit of some of the existing firms and the price will again reach p0. Therefore, in the new equilibrium, less quantity will be supplied which will be equal to the reduced demand at that price. This is shown in panel (b) where due to the shift of demand curve from DD0 to DD2, quantity demanded and supplied will decrease to q2 whereas the price will remain unchanged at p0. Here, the equilibrium number of firms, n2 is less than n0 due to the exit of some existing firms. Thus, due to a shift in demand rightwards (leftwards), the equilibrium quantity and number of firms will increase (decrease) whereas the equilibrium price will remain unchanged. Here, we should note that with free entry and exit, shift in demand has a larger effect on quantity than it does with the fixed number of firms. But unlike with fixed number of firms, here, we do not have any effect on equilibrium price at all. 2019-20 5.2 APPLICATIONS In this section, we try to understand how the supply-demand analysis can be applied. In particular, we look at two examples of government intervention in the form of price control. Often, it becomes necessary for the government to regulate the prices of certain goods and services when their prices are either too high or too low in comparison to the desired levels. We will analyse these issues within the framework of perfect competition to look at what impact these regulations have on the market for these goods. 5.2.1 Price Ceiling It is not very uncommon to come across instances where government fixes a maximum allowable price for certain goods. The government-imposed upper limit on the price of a good or service is called price ceiling. Price ceiling is generally imposed on necessary items like wheat, rice, kerosene, sugar and it is fixed below the market-determined price since at the market-determined price some section of the population will not be able to afford these goods. Let us examine the effects of price ceiling on market equilibrium through the example of market for wheat. Price Catcher 84 Figure 5.7 shows the market supply curve SS and the market demand curve DD for wheat. at The equilibrium price and quantity of wheat are p* and q* respectively. When the government imposes price ceiling cp which is lower than the equilibrium price level, there will be an excess demand for wheat in the market at that price. The consumers demand qc kilograms of wheat whereas the firms supply cq ' kilograms. Effect of Price Ceiling in Wheat Market. The equilibrium price and quantity are p* and q* respectively. Imposition of price ceiling at pc gives rise to excess demand in the wheat market. Hence, though the intention of the government was to help the consumers, it could end up creating shortage of wheat. How is the quantity of wheat (q'c) then distributed among the consumers? One way of doing this is to distribute it to everyone, through a system of rationing. Ration coupons are issued to the consumers so that no individual can buy more than a certain amount of wheat and this stipulated amount of wheat is sold through ration shops which are also called fair price shops. 2019-20 In general, price ceiling accompanied by rationing of the goods may have the following adverse consequences on the consumers: (a) Each consumer has to stand in long queues to buy the good from ration shops. (b) Since all consumers will not be satisfied by the quantity of the goods that they get from the fair price shop, some of them will be willing to pay higher price for it. This may result in the creation of black market. 5.2.2 Price Floor For certain goods and services, fall in price below a particular level is not desirable and hence the government sets floors or minimum prices for these goods and services. The governmentimposed lower limit on the price that may be charged for a particular good or service is called price floor. Most well-known examples of imposition of price floor are agricultural price support programmes and the minimum wage legislation. Price pf p* SS DD O qf q* q'f Quantity Fig. 5.8 Effect of Price Floor on the Market for Goods. The market equilibrium is at (p, q). Imposition of price floor at pf gives rise to an excess supply. Through an agricultural price support programme, the government imposes a lower limit on the purchase price for some of the agricultural goods and the floor is normally set at a level higher than the market-determined price for these goods. Similarly, through the minimum wage legislation, the government ensures that the wage rate of the labourers does not fall below a particular level and here again the minimum wage rate is set above the equilibrium wage rate. Figure 5.8 shows the market supply and the market demand curve for a commodity on which price floor is imposed. The market equilibrium here would occur at price p* and quantity q*. But when the government imposes a floor higher than the equilibrium price at pf , the market demand is qf whereas the firms want to supply q ′ f , thereby leading to an excess supply in the market equal to qf q ′ f . In the case of agricultural support, to prevent price from falling because of excess supply, government needs to buy the surplus at the predetermined price. 85 • • In a perfectly competitive market, equilibrium occurs where market demand equals market supply. The equilibrium price and quantity are determined at the intersection of the market demand and market supply curves when there is fixed number of firms. • Each firm employs labour upto the point where the marginal revenue product of labour equals the wage rate. • With supply curve remaining unchanged when demand curve shifts rightward (leftward), the equilibrium quantity increases (decreases) and equilibrium price increases (decreases) with fixed number of firms. 2019-20 • With demand curve remaining unchanged when supply curve shifts rightward (leftward), the equilibrium quantity increases (decreases) and equilibrium price decreases (increases) with fixed number of firms. • When both demand and supply curves shift in the same direction, the effect on equilibrium quantity can be unambiguously determined whereas the effect on equilibrium price depends on the magnitude of the shifts. • When demand and supply curves shift in opposite directions, the effect on equilibrium price can be unambiguously determined whereas the effect on equilibrium quantity depends on the magnitude of the shifts. In a perfectly competitive market with identical firms if the firms can enter and exit the market freely, the equilibrium price is always equal to minimum average cost of the firms. • • • With free entry and exit, the shift in demand has no impact on equilibrium price but changes the equilibrium quantity and number of firms in the same direction as the change in demand. In comparison to a market with fixed number of firms, the impact of a shift in demand curve on equilibrium quantity is more pronounced in a market with free entry and exit. Imposition of price ceiling below the equilibrium price leads to an excess demand. Imposition of price floor above the equilibrium price leads to an excess supply. • • s s s Equilibrium Excess demand Excess supply Marginal revenue product of labour Value of marginal product of labour Price ceiling, Price floor KKKKK 86 . Explain market equilibrium. 2. When do we say there is excess demand for a commodity in the market
? 3. When do we say there is excess supply for a commodity in the market? 4. What will happen if the price prevailing in the market is (i) above the equilibrium price? (ii) below the equilibrium price? 5. Explain how price is determined in a perfectly competitive market with fixed number of firms. 6. Suppose the price at which equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it? 7. At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is equilibrium quantity determined in such a market? 8. How is the equilibrium number of firms determined in a market where entry and exit is permitted? 9. How are equilibrium price and quantity affected when income of the consumers (a) increase? (b) decrease? 10. Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold. 2019-20 11. How will a change in price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram. 12. How do the equilibrium price and quantity of a commodity change when price of input used in its production changes? 13. If the price of a substitute(Y) of good X increases, what impact does it have on the equilibrium price and quantity of good X? 14. Compare the effect of shift in demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted. 15. Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity. 16. How are the equilibrium price and quantity affected when (a) both demand and supply curves shift in the same direction? (b) demand and supply curves shift in opposite directions? 17. In what respect do the supply and demand curves in the labour market differ from those in the goods market? 18. How is the optimal amount of labour determined in a perfectly competitive market? 19. How is the wage rate determined in a perfectly competitive labour market? 20. Can you think of any commodity on which price ceiling is imposed in India? What may be the consequence of price-ceiling? 21. A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the situation when free entry and exit is permitted. Explain. 22. Suppose the demand and supply curve of commodity X in a perfectly competitive market are given by: qD = 700 – p qS = 500 + 3p for p ≥ 15 = 0 for 0 ≤ p < 15 Assume that the market consists of identical firms. Identify the reason behind the market supply of commodity X being zero at any price less than Rs 15. What will be the equilibrium price for this commodity? At equilibrium, what quantity of X will be produced? 23. Considering the same demand curve as in exercise 22, now let us allow for free entry and exit of the firms producing commodity X. Also assume the market consists of identical firms producing commodity X. Let the supply curve of a single firm be explained as qS f = 8 + 3p for p ≥ 20 = 0 for 0 ≤ p < 20 (a) What is the significance of p = 20? (b) At what price will the market for X be in equilibrium? State the reason for your answer. (c) Calculate the equilibrium quantity and number of firms. 24. Suppose the demand and supply curves of salt are given by: qD = 1,000 – p qS = 700 + 2p (a) Find the equilibrium price and quantity. (b) Now suppose that the price of an input used to produce salt has increased so that the new supply curve is qS = 400 + 2p How does the equilibrium price and quantity change? Does the change conform to your expectation? (c) Suppose the government has imposed a tax of Rs 3 per unit of sale of salt. How does it affect the equilibrium price and quantity? 25. Suppose the market determined rent for apartments is too high for common people to afford. If the government comes forward to help those seeking apartments on rent by imposing control on rent, what impact will it have on the market for apartments? 87 2019-20 Chapter 6 Non-competitive Marketsetsetsetsets Non-competitive Mark Non-competitive Mark Non-competitive Mark Non-competitive Mark We recall that perfect competition is a market structure where both consumers and firms are price takers. The behaviour of the firm in such circumstances was described in the Chapter 4. We discussed that the perfect competition market structure is approximated by a market satisfying the following conditions: (i) there exist a very large number of firms and consumers of the commodity, such that the output sold by each firm is negligibly small compared to the total output of all the firms combined, and similarly, the amount purchased by each consumer is extremely small in comparison to the quantity purchased by all consumers together; (ii) firms are free to start producing the commodity or to stop production; i.e., entry and exit is free (iii) the output produced by each firm in the industry is indistinguishable from the others and the output of any other industry cannot substitute this output; and (iv) consumers and firms have perfect knowledge of the output, inputs and their prices. In this chapter, we shall discuss situations where one or more of these conditions are not satisfied. If assumption (ii) is dropped, and it becomes difficult for firms to enter a market, then a market may not have many firms. In the extreme case a market may have only one firm. Such a market, where there is one firm and many buyers is called a monopoly. A market that has a small number of large firms is called an oligopoly. Notice that dropping assumption (ii) leads to dropping assumption (i) as well. Similarly, dropping the assumption that goods produced by a firm are indistinguishable from those of other firms (assumption iii) implies that goods produced by firms are close substitutes, but not perfect substitutes for each other. Such markets, where assumptions (i) and (ii) may hold, but (iii) does not hold are called markets with monopolistic competition. This chapter examines the market structures of monopoly, monopolistic competition and oligopoly. 6.1 SIMPLE MONOPOLY IN THE COMMODITY MARKET A market structure in which there is a single seller is called monopoly. The conditions hidden in this single line definition, however, need to be explicitly stated. A monopoly market structure requires that there is a single producer of a particular commodity; no other commodity works as a substitute for this commodity; and 2019-20 for this situation to persist over time, sufficient restrictions are required to be in place to prevent any other firm from entering the market and to start selling the commodity. In order to examine the difference in the equilibrium resulting from a monopoly in the commodity market as compared to other market structures, we also need to assume that all other markets remain perfectly competitive. In particular, we need (i) All the consumers are price takers; and (ii) that the markets of the inputs used in the production of this commodity are perfectly competitive both from the supply and demand side. ‘I’ ‘M’ Perfect Competition If all the above conditions are satisfied, then we define the situation as one of monopoly in a single commodity market. Competitive Behaviour versus Competitive Structure A perfectly competitive market has been defined as one where an individual firm is unable to influence the price at which the product is sold in the market. Since price remains the same for any level of output of the individual firm, such a firm is able to sell any quantity that it wishes to sell at the given market price. It, therefore, does not need to compete with other firms to obtain a market for its produce. This is clearly the opposite of the meaning of what is commonly understood by competition or competitive behaviour. We see that Coke and Pepsi compete with each other in a variety of ways to achieve a higher level of sales or a greater share of the market. Conversely, we do not find individual farmers competing among themselves to sell a larger amount of crop. This is because both Coke and Pepsi possess the power to influence the market price of soft drinks, while the individual farmer does not. Thus, competitive behaviour and competitive market structure are, in general, inversely related; the more competitive the market structure, less competitive is the behaviour of the firms. On the other hand, the less competitive the market structure, the more competitive is the behaviour of firms towards each other. In a monopoly there is no other firm to compete with. 6.1.1 Market Demand Curve is the Average Revenue Curve The market demand curve in Figure 6.1 shows the quantities that consumers as a whole are willing to purchase at different prices. If the market price is at p0, consumers are willing to purchase the quantity q0. On the other hand, if the market price is at the lower level p1, consumers are willing to buy a higher quantity q1. That is, price in the market affects the quantity demanded by the consumers. This is also expressed by saying that the quantity purchased by the consumers is a decreasing function of the price. For the monopoly firm, the above argument expresses itself from the reverse direction. The monopoly firm’s decision to sell a larger quantity is possible only at a lower price. Conversely, if the monopoly firm brings a smaller quantity of the commodity into the market for sale it will be able to sell at a higher price. Thus, for the monopoly firm, the price depends on the quantity of the commodity sold. The same is also expressed by stating 89 2019-20 that price is a decreasing function of the quantity sold. Thus, for the monopoly firm, the market demand curve expresses the price that consumers ar
e willing to pay for different quantities supplied. This idea is reflected in the statement that the monopoly firm faces the market demand curve, which is downward sloping. Price D p0 p1 D q1 q0 O Output Fig. 6.1 The above idea can be viewed from another angle. Since the firm is assumed to have perfect knowledge of the market demand curve, the monopoly firm can decide the price at which it wishes to sell its commodity, and therefore, determines the quantity to be sold. For instance, examining Figure 6.1 again, since the monopoly firm is aware of the shape of the curve DD, if it wishes to sell the commodity at the price p0, it can do so by producing and selling quantity q0, since at the price p0, consumers are willing to purchase the quantity q0. On the other hand, if it wants to sell q1, it will only be able to do so at the price p1. Market Demand Curve. Shows the quantities that consumers as a whole are willing to purchase at different prices. The contrast with the firm in a perfectly competitive market structure should be clear. In that case, the firm could bring into the market as much quantity of the commodity as it wished and could sell it at the same price. Since this does not happen for a monopoly firm, the amount received by the firm through the sale of the commodity has to be examined again. 90 We do this exercise through a schedule, a graph, and using a simple equation of a straight line demand curve. As an example, let the demand function be given by the equation q = 20 – 2p, where q is the quantity sold and p is the price in rupees. The equation can be written in terms of p as p = 10 – 0.5q Substituting different values of q from 0 to 13 gives us the prices from 10 to 3.5. These are shown in the q and p columns of Table 6.1. These numbers are depicted in a graph in Figure 6.2 with prices on the vertical axis and quantities on the horizontal axis. The prices that are available for different quantities of the commodity are shown by the solid straight line D. The total revenue (TR) received by the firm from the sale of the commodity equals the product of the price and the quantity sold. In Table 6.1: Prices and Revenue q p TR AR MR 0 8 – 9.5 9 10 9.5 9.5 18 9 8.5 25.5 8.5 8 32 7.5 37.5 7.5 7 42 6.5 45.5 6.5 6 48 5.5 49.5 5.5 50 10 5 11 4.5 49.5 4.5 12 4 13 3.5 45.5 3.5 48 5 6 4 7 – 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 -2.5 2019-20 the the case of the monopoly firm, the total revenue is not a straight line. Its shape depends on the shape of curve. Mathematically, TR is represented as a function of the quantity sold. Hence, in our example TR = p × q demand = (10 – 0.5q) × q = 10q – 0.5q2 This is not the equation of a straight line. It is a quadratic equation in which the squared term has a negative cofficient. Such an equation represents an inverted vertical parabola. TR, AR, MR O Fig. 6.2 TR 10 D = AR Output MR Total, Average and Marginal Revenue Curves: The total revenue, average revenue and the marginal revenue curves are depicted here. In Table 6.1, the TR column represents the product of the p and q columns. It can be noticed that as the quantity increases, TR increases to Rs 50 when output becomes 10 units, and after this level of output, total revenue starts declining. The same is visible in Figure 6.2. The revenue received by the firm per unit of commodity sold is called the Average Revenue (AR). Mathematically, AR = TR/q. In Table 6.1, the AR column provides values obtained by dividing TR values by q values. It can be seen that the AR values turn out to be the same as the values in the p column. This is only to be expected Since TR = p × q, substituting this into the AR equation AR = TR q AR = q ) ( p × q = p As seen earlier, the p values represent the market demand curve as shown in Figure 6.2. The AR curve will therefore lie exactly on the market demand curve. This is expressed by the demand curve is the average revenue curve for the monopoly firm. Graphically, the value of AR can be found from the TR curve for any level of quantity sold through a simple construction given in Figure 6.3. When quantity is 6 units, draw a vertical line passing through the value 6 on the horizontal axis. This line will Relation between Average Revenue and Total Revenue Curves. The average revenue at any level of output is given by the slope of the line joining the origin and the point on the total revenue curve corresponding to the output level under consideration. 91 2019-20 cut the TR curve at the point marked ‘a’ at a height equal to 42. Draw a straight line joining the origin O and point ‘a’. The slope of this ray from the origin to a point on the TR provides the value of AR. The slope of this ray is equal to 7. Therefore, AR has the value 7. The same can be verified from Table 6.1. 6.1.2 Total, Average and Marginal Revenues A more careful glance at Table 6.1 reveals that TR does not increase by the same amount for every unit increase in quantity. Sale of the first unit leads to a change in TR from Rs 0 when quantity is of 0 unit to Rs 9.50 when quantity is 1 unit, i.e., a rise of Rs 9.50. As the quantity increases further, the rise in TR is smaller. For example, for the 5th unit of the commodity, the rise in TR is Rs 5.50 (Rs 37.50 for 5 units minus Rs 32 for 4 units). As mentioned earlier, after 10 units of output, TR starts declining. This implies that bringing more than 10 units for sale leads to a level of TR less than Rs 50. Thus, the rise in TR due to the 12th unit is: 48 – 49.50 = –1.5, ie a fall of Rs 1.50. This change in TR due to the sale of an additional unit is termed Marginal Revenue (MR). In Table 6.1, this is depicted in the last column. Observe that the MR at any quantity is the difference between the TR at that quantity and the TR at the previous quantity. For example, when q = 3, MR = (25.5 – 18) = 7.5 TR, MR In the last paragraph, it was shown that TR increases more slowly as quantity sold increases and falls after quantity reaches 10 units. The same can be viewed through the MR values which fall as q increases. After the quantity reaches 10 units, MR has negative values. In Figure 6.2, MR is depicted by the dotted line. c L2 b d TR L1 a O 10 Output MR Fig. 6.4 Relation between Marginal Revenue and Total Revenue Curves. The marginal revenue at any level of output is given by the slope of the total revenue curve at that level of output. Graphically, the values of the MR curve are given by the slope of the TR curve. The slope of any smooth curve is defined as the slope of the tangent to the curve at that point. This is depicted in Figure 6.4. At point ‘a’ on the TR curve, the value of MR is given by the slope of the line L1, and at point ‘b’ by the line L2. It can be seen that both lines have positive slope, but the line L2 is flatter than line L1, ie its slope is lesser. When 10 units of the commodity are sold, the tangent to the TR is horizontal, ie its slope is zero.1 The value of the MR for the same quantity is zero. At point ‘d’ on the TR curve, where the tangent is negatively sloped, the MR takes a negative value. We can now conclude that when total revenue is rising, marginal revenue is positive, and when total revenue shows a fall, marginal revenue is negative. Another relation can be seen between the AR and the MR curves. Figure 1Question: Why is the MR not equal to zero at q=10 in table 6.1? This is because we are measuring MR ‘discretely’, i.e, by jumping from 9 units to 10 units. If you recalculate the TR for values of q closer to 10 e.g., 9.5, 9.75 or 9.9, the TR will get closer to 50, Eg: at q=9.9, TR will be 49.995. 92 2019-20 AR, MR O Fig. 6.5 (a) AR, MR AR Output O MR AR Output MR (b) Relation between Average Revenue and Marginal Revenue curves. If the AR curve is steeper, then the MR curve is far below the AR curve. 6.2 shows that the MR curve lies below the AR curve. The same can be seen in Table 6.1 where the values of MR at any level of output are lower than the corresponding values of AR. We can conclude that if the AR curve (ie the demand curve) is falling steeply, the MR curve is far below the AR curve. On the other hand, if the AR curve is less steep, the vertical distance between the AR and MR curves is smaller. Figure 6.5(a) shows a flatter AR curve while Figure 6.5(b) shows a steeper AR curve. For the same units of the commodity, the difference between AR and MR in panel (a) is smaller than the difference in panel (b). 6.1.3 Marginal Revenue and Price Elasticity of Demand The MR values also have a relation with the price elasticity of demand. The detailed relation is not derived here. It is sufficient to notice only one aspect– price elasticity of demand is more than 1 when the MR has a positive value, and becomes less than the unity when MR has a negative value. This can be seen in Table 6.2, which uses the same data presented in Table 6.1. As the quantity of the commodity increases, MR value becomes smaller and the value of the price elasticity of demand also becomes smaller. Recall that the demand curve is called elastic at a point where price elasticity is greater than unity, inelastic at a point where the price elasticity is less than unity and unitary elastic when price elasticity is equal to 1. Table 6.2 shows that when quantity is less than 10 units, MR is positive and the demand curve is elastic and when quantity is of more than 10 units, the demand curve is inelastic. At the quantity level of 10 units, the demand curve is unitary elastic. Table 6.2: MR and Price Elasticity Elasticity MR 10 11 12 13 10 9.5 9 8.5 8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5 -0.5 -1.5 -2.5 19 9 5.67 4 3 2.33 1.86 1.5 1.22 1 0.82 0.67 0.54 6.1.4 Short Run Equilibrium of the Monopoly Firm As in the case of perfect competition, we continue to regard the monopoly firm as one which maximises profit. In this section, we analyse this profit maximising 93 2019-20 behaviour to determine the quantity produced by a monopoly firm and price at whi
ch it is sold. We shall assume that a firm does not maintain stocks of the quantity produced and that the entire quantity produced is put up for sale. The Simple Case of Zero Cost a TR, AR, MR, Price Suppose there exists a village situated sufficiently far away from other villages. In this village, there is exactly one well from which water is available. All residents are completely dependent for their water requirements on this well. The well is owned by one person who is able to prevent others from drawing water from it except through purchase of water. The person who purchases the water has to draw the water out of the well. The well owner is thus a monopolist firm which bears zero cost in producing the good. We shall analyse this simple case of a monopolist bearing zero costs to determine the amount of water sold and the price at which it is sold. Short Run Equilibrium of the Monopolist with Zero Costs. The monopolist’s profit is maximised at that level of output for which the total revenue is the maximum. Fig. 6.6 Output AR = D 5 O MR TR 10 94 Figure 6.6 depicts the same TR, AR and MR curves, as in Figure 6.2. The profit received by the firm equals the revenue received by the firm minus the cost incurred, that is, Profit = TR – TC. Since in this case TC is zero, profit is maximum when TR is maximum. This, as we have seen earlier, occurs when output is of 10 units. This is also the level when MR equals zero. The amount of profit is given by the length of the vertical line segment from ‘a’ to the horizontal axis. The price at which this output will be sold is the price that the consumers as a whole are willing to pay. This is given by the market demand curve D. At output level of 10 units, the price is Rs 5. Since the market demand curve is the AR curve for the monopolist firm, Rs 5 is the average revenue received by the firm. The total revenue is given by the product of AR and the quantity sold, ie Rs 5 × 10 units = Rs 50. This is depicted by the area of the shaded rectangle. Comparison with Perfect Competition We compare the above outcome with what it would be under perfectly competitive market structure. Let us assume that there is an infinite number of such wells. Suppose a well-owner decides to charge Rs.5/bucket of water. Who will buy from him? Remember that there are many, many well-owners. Any other wellowner can attract all the buyers willing to buy for Rs. 5/bucket, by offering to sell to them at a lower price, say, Rs. 4/bucket.. Some other well-owner can offer to sell at a still lower price, and the story will repeat itself. In fact, competition among well-owners will drive the price down to zero. At this price 20 buckets of water will be sold. Through this comparison, we can see that a perfectly competitive equilibrium results in a larger quantity being sold at a lower price. We can now proceed to the general case involving positive costs of production. 2019-20 Introducing Positive Costs Analysing using Total curves a A TC , TR1 In Chapter 3, we have discussed the concept of cost and the shape of the total cost curve having been depicted as shown by TC in Figure 6.7. The TR curve is also drawn in the same diagram. The profit received by the firm equals the total revenue minus the total cost. In the figure, we can see that if quantity q1 is produced, the total revenue is TR1 and total cost is TC1. The difference, TR1 – TC1, is the profit received. The same is depicted by the length of the line segment AB, i.e., the vertical distance between the TR and TC curves at q1 level of output. It should be clear that this vertical distance changes for diferent levels of output. When output level is less than q2, the TC curve lies above the TR curve, i.e., TC is greater than TR, and therefore profit is negative and the firm makes losses. Equilibrium of the Monopolist in terms of the Total Curves. The monopolist’s profit is maximised at the level of output for which the vertical distance between the TR and TC is a maximum and TR is above the TC. q3 Output Fig. 6.7 Profit TC1 TR O q2 q1 q0 B The same situation exists for output levels greater than q3. Hence, the firm can make positive profits only at output levels between q2 and q3, where TR curve lies above the TC curve. The monopoly firm will choose that level of output which maximises its profit. This would be the level of output for which the vertical distance between the TR and TC is maximum and TR is above the TC, i.e., TR – TC is maximum. This occurs at the level of output q0. If the difference TR – TC is calculated and drawn as a graph, it will look as in the curve marked ‘Profit’ in Figure 6.7. It should be noticed that the Profit curve has its maximum value at the level of output q0. The price at which this output is sold is the price consumers are willing to pay for this q0 quantity of the commodity. So the monopoly firm will charge the price corresponding to the quantity level q0 on the demand curve. Using Average and Marginal curves The analysis shown above can also be conducted using Average and Marginal Revenue and Average and Marginal Cost. Though a bit more complex, this method is able to exhibit the process in greater light. In Figure 6.8, the Average Cost (AC), Average Variable Cost (AVC) and Marginal Cost (MC) curves are drawn along with the Demand (Average Revenue) Curve and Marginal Revenue crve. It may be seen that at quantity level below q0, the level of MR is higher than the level of MC. This means that the increase in total revenue from selling an extra unit of the commodity is greater than the increase in total cost for producing the additional unit. This implies that an additional unit of output 95 2019-20 f a d AC MC b pC c Price would create additional profits since Change in profit = Change in TR – Change in TC. Therefore, if the firm is producing a level of output less than q0, it would desire to increase its output since that would add to its profits. As long as the MR curve lies above the MC curve, the reasoning provided above would apply and thus the firm would increase its output. This process comes to a halt when the firm reaches an output level of q0 since at this level MR equals MC and increasing output provides no increase in profits. Equilibrium of the Monopolist in terms of the Average and the Marginal Curve. The monopolist’s profit is maximised at that level of output for which the MR = MC and the MC is rising. On the other hand, if the firm was producing a level of output which is greater than q0, MC is greater than MR. This means that the lowering of total cost by reducing one unit of output is greater than the loss in total revenue due to this reduction. It is therefore advisable for the firm to reduce output. This argument would hold good as long as the MC curve lies above the MR curve, and the firm would keep reducing its output. Once output level reaches q0, the values of MC and MR become equal and the firm stops reducing its output. Fig. 6.8 Output D = AR q0 qC MR O e 96 At qo the firm will make maximum profits. It has no incentive to change from qo. This level is called the equilibrium level of output. Since this equilibrium level of output corresponds to the point where the MR equals MC, this equality is called the equilibrium condition for the output produced by a monopoly firm. At this equilibrium level of output q0, the average cost is given by the point ‘d’ where the vertical line from q0 cuts the AC curve. The average cost is thus given by the height dq0. Since total cost equals the product of AC and the quantity produced being q0, the same is given by the area of the rectangle Oq0dc. As shown earlier, once the quantity of output produced is determined, the price at which it is sold is given by the amount that the consumers are willing to pay, as expressed through the market demand curve. Thus, the price is given by the point ‘a’ where the vertical line through q0 meets the market demand curve D. This provides price given by the height aq0. Since the price received by the firm is the revenue per unit of output, it is the Average Revenue for the firm. The total revenue being the product of AR and the level of output q0, can be shown as the area of the rectangle Oq0ab. It can be seen from the diagram that the area of the rectangle Oq0ab is larger than the area of the rectangle Oq0dc, i.e., TR is greater than TC. The difference is the area of the rectangle cdab. Thus, Profit = TR – TC which can be represented by this area cdab. 2019-20 Comparison with Perfect Competition again We compare the monopoly firm’s equilibrium quantity and price with that of the perfectly competitive firm. Recall that the perfectly competitive firm was a price taker. Given the market price, the firm in a perfectly competitive market structure believed that it could not alter the price by producing more of the output or less of it. Suppose that the firm, whose equilibrium we were considering above, believed that it was a perfectly competitive firm. Then, given its level of output at q0, price of the commodity at aq0 = Ob, it would expect the price to remain fixed at Ob, and therefore, every additional unit of output could be sold at that price. Since the cost of producing an additional unit, given by the MC, stands at eq0 which is less than aq0, the firm would expect a gain in profit by increasing the output. This would continue as long as the price remained higher than the MC. At the point ‘f ’ in Figure 6.8, where the MC curve cuts the demand curve, price received by the firm becomes equal to the MC. Hence, it would no longer be considered beneficial by this perfectly competitive firm to increase output. It is for this reason that Price = Marginal Cost that is considered the equilibrium condition for the perfectly competitive firm. The diagram shows that at this level of output, the quantity produced qc is greater than q0. Also, the price paid by the consumers is lower at pc. From this we conclude that the perfectly competitive

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