Introduction to Economics (Econ 1000)

Introduction to Economics (Econ 1000)

University of Colorado

Vijaya Raj Sharma, Ph.D.

Lecture Notes on Part II

DISTRIBUTION OF INCOME (Chapters 25,26, and 27)

Ownership of Productive Resources and Distribution of Income

Distribution of income is an outcome of demand and supply of resources that people own. The ownership of resources fundamentally determines who gets how much income. There are three kinds of resources: land, labor, and capital. Among these resources, about three-fourth of the income in the U.S. goes to labor.

Demand and Supply of Productive Resources

Derived Demand

Demand for any resource is essentially derived from demands for outputs that are produced from resource inputs.

Labor market

Firms demand labor and households supply labor. Thus, there is a demand curve and there is a supply curve of labor (draw a graph). The higher the wage, the lower the number of labors demanded by firms. On the other hand, the higher the wage, the higher the number of labors supplied by households.
It is possible that when wage is very high, people may start valuing leisure more, and the labor supplied may go down at high wage levels. If so, the labor supply curve would bend backward and is called backward-bending supply curve.
We will ignore the backward-bending portion and focus on the upward-sloping part of the supply curve.
The intersection of the demand and supply curves determine the equilibrium wage rate and, thus, the labor income (wage * number of labor employed). Show in the graph.
We have already seen earlier the impact of minimum wage; it creates unemployment. Show in the graph.
We have been assuming that labor is homogeneous. Actually, people differ in skills, and wages differ according to skill.
Draw two graphs, one for high-skill labor and another for low-skill labor. Both demand and supply of high-skill labor are relatively higher up in the graph (in terms of wages offered by demanders and wages sought by suppliers of labor), than those of low-skill labor. Consequently, equilibrium wages are higher for higher skills.
There are a number of reasons wages or labor incomes differ among persons; those reasons are discussed below.

Marginal Productivity Differentials. Labor gets paid according to the marginal productivity of labor. The higher the skill, the higher the productivity, thus the higher the wage firms would be willing to offer. This differential can also explain why workers in Mexico get lower wages, compared to the wages of workers in the U.S. An average American labor works with more machines, resulting in higher productivity and thus higher wage.

Skill Differentials or Human Capital Theory. Different persons acquire different skills by investing necessary time and resources in schooling and training. Wages must at least be sufficient to compensate the cost of acquiring skills. This theory explains why medical doctors and lawyers are the highest-paid groups of professionals.

Compensating Wage Differentials. Wages must also reflect the relative risks to health and life and the extent of hardship or human drudgery associated with jobs. For this reason, construction workers, fire fighters, and miners get higher wages. Similarly, wages at remote places or at places with extreme weather are higher.

Union-nonunion Wage Differentials. Wages may also depend on whether the job is unionized or not. According to a few studies, union jobs have in average 15 percent higher wages for the same skill category. In a unionized workplace, union is like a monopoly, as it can restrict labor supply to raise the wage (show graphically). Unions tend to do this by making union membership harder and requiring employers to employ only union members. However, higher wages to union members generally come with a lower level of employment (often of nonunion labors). Union movement was relatively stronger during 1950s and 1960s. The maximum membership of union was about 26 percent of all employed labor in 1950s; the membership has gone down in recent years to about 15 percent.
Other Differentials. There may be other factors too that may introduce differences in wages. Two economists, Hamermesh and Biddle, found in their study that really good-looking men earned 5 to 10 percent more than average men. According to the study, the beauty differential in wages was not noticeable among women workers. More prominent among other differentials are the often-debated gender and ethnic differences in income. According to the 1997 survey done by the Census Bureau, the average woman high school graduate 25 or older who worked full time all year in 1997 earned $22,000, compared to $31,000 for men. The median income of a woman with a bachelor's degree was $38,000, compared to $48,000 for men. The highest median for women was for a professional degree, $61,000, compared to $85,000 for men. These differences, however, do not necessarily construe a gender differential; the differences may be coming from differences among men and women in choice of fields of work and also from differences in skills. Yet, studies have argued that even allowing for differences in skill and field, there are gender and ethnic differentials in income.

Land market

Land also includes natural resources. The rental income from land (or natural resources) depends upon the demand and supply of land. Show graphically the equilibrium rent in land market, given demand and supply of land. Land and natural resources are generally in fixed supply; therefore, relative to the fixed supply, the rent actually depends on the demand for the resource. The higher the demand, the higher the rental income.

Capital market

Capital refers to machines, buildings, plant and equipment. Capital adds to productive capacity of firms. To purchase new machines or capital equipment or to replace worn out capital, firms need to invest. Investment comes either in the form of equity investment (owners' money) or in the form of borrowing or a combination of both. Owners receive profit income for their equity investment; profit income depends on market structure or market power of the firm (perfect competition, monopoly, or oligopoly) and on entrepreneurship (the ability to take calculated risks). We will learn about this later.
Lenders earn interest income by allowing firms and households to borrow money. In the loanable funds market, demand for loanable funds, or borrowing, originates from firms desiring investment and from households desiring purchases of houses and durable goods. The supply of loanable funds originates from savings of households. The real interest rate is the price of borrowing. The higher the interest rate, the more expensive the borrowing and, thus, the lesser the amount of loanable funds demanded. On the other hand, the higher the interest rate, the more attractive the savings and, thus, the more the amount of loanable funds supplied. Draw the demand and supply curves of loanable funds. The intersection of the two curves gives the equilibrium interest rate and the amount of investment that goes into the economy.
Usury laws are the laws that place ceilings on interest rates. In many countries, interest rates are regulated. If there is a ceiling on interest rate, the ceiling causes a shortage of fund, as we have seen earlier. Because of low interest rate, even poor investments are likely to be undertaken, distorting the efficient use of capital resources. The economy would experience lower level of investment, black market may emerge to meet the shortfall or the shortage, and there may be a flight of capital to other countries that offer better interest rates.
It is possible that government too borrows from the loanable funds market, when the government runs a budget deficit (when government expenditures exceed tax revenue). The U.S. government had been running budget deficits continuously for more than two decades; only in last couple of years, there is a budget surplus. At times of budget deficits, demand for borrowing increases (shifts to right) with the government borrowing added to the usual private borrowing. Consequently, interest rate increases, decreasing the private borrowing and investment (show graphically). In other words, the government borrowing from the same pool of savings of households crowds out private investment. This is called the crowding out effect of budget deficits.

Trend of Income Distribution

Let us examine the table below, which summarizes the actual distribution of income in the U.S. from 1950 to 1993, by each quintile of income distribution: the lowest fifth (the poorest 20 percent families) to the highest fifth (the richest 20 percent families). The table also shows separately the income share of the highest 5 percent.
Table 1: Money Income of Families - Percentage of Aggregate Income Received by Each Fifth and Highest 5 Percent

	1950	1960	1970	1980	1990	1993
Lowest fifth	4.5	4.8	5.2	5.2	4.6	4.2
Second fifth	12.0	12.2	12.2	11.5	10.8	10.1
Middle fifth	17.4	17.8	17.6	17.5	16.6	15.9
Fourth fifth	23.4	24.0	23.8	24.3	23.8	23.6
Highest fifth	42.7	41.3	40.9	41.5	44.3	46.2
Highest 5 percent	17.3	15.9	15.6	15.3	17.4	19.1

Source: U.S. Bureau of the Census, Current Population Reports, p60-188.

The numbers suggest slight decline in shares of the lowest to the middle fifth groups, in favor of gains to the fourth and the highest fifth groups. However, these numbers do not represent the complete picture of income distribution because they are incomes before the payment of personal income taxes. Although they include money transfers of income (such as unemployment benefits and social security benefits), they do not include in-kind transfers (such as food stamps and medical assistance). The numbers also are not adjusted for family sizes, which are likely to be higher for higher quintiles.

Table 2 and criticism

The numbers for year 1984 are adjusted for the above factors in Table 2.
Table : Percentage of Aggregate Family Income Received by Each Fifth of Families in 1984: Census Bureau Data and Adjusted Data

	Money Income as Calculated by Census Bureau	Census Bureau Data Adjusted to Take Account of Taxes, In-kind Transfers, and Family Size
Lowest fifth	4.7%	7.3%
Second fifth	11.0%	13.4%
Middle fifth	17.0%	18.1%
Fourth fifth	24.4%	24.4%
Highest fifth	42.9%	36.8%

Source: Frank Levy, Dollars and Dreams (New York: Norton, 1987) p. 195.

The adjustment narrows the gap somewhat between the quintiles. There are still large differences in the distribution across quintiles. However, these numbers too do not represent the full picture of actual income distribution because the families in one quintile this year may not remain in the same quintile in other years. The relative income position of a family depends very much on the age of the family's principal earner. Table 3 compares mean incomes of families by the age of the householders.

Table 3 and explanations

Table 3: Households Mean Income in 1993

Age of Householder	Mean Income, $
15 to 24 years	23,041
25 to 34 years	37,510
35 to 44 years	49,473
45 to 54 years	57,770
55 to 64 years	44,814
65 years and over	25,965

Source: U.S. Bureau of the Census, Current Population Reports, P60-188.

The above table shows that a lot of inequality observed in earlier tables would diminish if a moving picture of families is taken (if the income of families over the lifetime of householders is compared).
According to a very recent report of the Census Bureau published in September 1998, poverty is a reality for 3 in 10 Americans, but for most of them, it is short-lived. Over a three-year span, 30.3 percent of the population lived below the poverty line for at least two months. But just 5.3 percent stayed poor for two full years. These statistics portray poverty as a trapdoor for a few and a revolving door for many. The government considers a three-person family poor if its income is below $13,650 (or below $16,450 for a four-person family).
Despite of adjustments, the figures generally show that the gap between the rich and the poor has widened. There are two conflicting arguments forwarded by economists of two different schools of thought. According to economists who do not believe in activist government, the income differential reflects the widening gap between educated workers and unskilled workers. In last many decades, the skill requirement in the job place has increased tremendously, especially with the advent of computers. Those who are educated get paid a lot more than those who are not educated. Economists who believe in activist government point to Reagan-era tax cuts offered to the rich and the changes in transfer policies. They cite income inequality as the evidence that the tax cuts to rich do not trickle down to poor. A major argument for tax cuts during Reagan presidency was that rich could save more and thus invest more when tax rates are lowered, enlarging jobs and labor income. So, these economists propose increase in taxes on rich (or at least do not reduce taxes on rich) and increase in transferring more incomes to poor. However, the economists on the other camp oppose these solutions. According to them, higher taxes reduce incentives to work harder and save more. Thus, fewer jobs would be created. Similarly, too much transfer of income also discourages those on the welfare from working; this was a principal reason behind the amendments in the welfare program few years ago.

Perfect Competition (Chapter 21)

Characteristics. A perfectly competitive market has four characteristics.

Homogeneous goods. Goods produced by all firms in the industry are identical.
Many sellers and buyers.
No barriers to entry and exit of firms. There is no restriction (legal or otherwise) on new firms wishing to enter the market or on existing firms wishing to quit the market.
Perfect information. All buyers and sellers have all information available regarding the product.

When goods of all competitors are identical, when there are many competitors supplying the same good, and when new firms can easily enter the market to supply goods, no single firm or supplier can dictate prices of its output. Firms are price takers, they have to accept whatever market price is prevailing in the market. Wheat farmers are examples of price takers. A firm that raises its price can lose all sales because consumers can buy cheaper from other suppliers. A firm can sell all of its output at the going market price, whatever amount it wishes to produce (remember, each firm's output is a tiny fraction of the total output available in the market). To individual firms in a perfectly competitive market, the demand for its product is as if horizontal (graphs- a horizontal demand curve for a firm but downward-sloping demand curve for the whole market).

Profit Maximizing Firms

We shall devote a few lectures on learning how firms make their output decision. For this purpose, we assume that a firm's objective is to maximize profit.
Profit is the residual left from total sales revenue after paying all costs of producing and supplying goods. That is, profit is equal to total revenue minus total cost.

Total cost is not the monetary cost only, it is the full opportunity cost of production.
Suppose you own and manage a coffee shop that has annual sales revenue of $100,000. To start this business, you have borrowed $30,000 from a bank at 10% interest rate. You have also invested your own $20,000, which could earn a 5% interest rate if put in a savings account; you are obviously sacrificing this potential return by choosing to invest your money in this business. You work full time in running this business. You have also hired a few workers. Your book of accounts shows the following costs in a year:

Purchase of materials (coffee, creamer, sugar, etc.) $30,000
Payments to hired labor $25,000
Utilities $5,000
Lease payment $24,000
Interest paid on borrowings (10% of $30,000) $3,000
Miscellaneous expenses $3,000

Thus, the book of accounts shows a total monetary cost of $90,000 in a year. In a conventional accounting sense, your profit is $10,000 (total sales revenue of $100,000 minus total monetary cost of $90,000). Let us call this profit accounting profit.

To an economist, $90,000 is not the full cost of operating the business. This cost does not include the opportunity cost of your time spent on this business and the opportunity cost of your equity investment. Since you are working full time in this business, you are sacrificing potential income, say $30,000 a year, which you could earn working for others. Similarly, you are sacrificing interest income of $1,000 a year, had you invested your $20,000 in a savings account with 5% interest. These costs have to be added. The total cost (or, the opportunity cost) is actually $90,000 + $30,000 + $1,000 = $121,000 a year. This brings your profit to - $21,000 (sales revenue of $100,000 minus total cost of $121,000). This example should not imply that accounting of opportunity cost always results into a loss. To distinguish this profit from the accounting profit mentioned earlier, let us call it economic profit. In economics, cost always means opportunity cost; profit always means economic profit, unless otherwise specified.
Note that the total cost includes potential return on your investment (5% of $20,000); therefore, economic profit is a profit over and above the normal return you could make on your investment. If economic profit is positive, it implies that the investor is making money more than what the investor could make elsewhere. If economic profit is negative, the investor is not necessarily losing in the conventional accounting sense, he or she is simply making less than what the investor could make elsewhere. In other words, a negative economic profit does not necessarily imply a negative accounting profit. A zero economic profit implies that the investor is making a normal return the investor could make elsewhere. In this example, accounting profit is positive but economic profit is negative.
Profit maximizing rule: MR=MC

Let us define marginal revenue (MR). MR is the additional revenue to a seller from production of one more unit of output. Suppose a firm has sales revenue of $3,000 from 100 units of output, but sales revenue of $3,100 from 105 units of output. Then MR=(3100-3000)/(105-100) = $20 per unit.
Sales revenue is the benefit to sellers from producing and selling and sellers want to maximize net benefits, or profit. According to the rule of economizing behavior, the net benefit is maximized by choosing that level of activity where MB=MC. This then tells us that firms should choose that level of output where MR=MC. We will look at different types of market structures and use this rule to analyze the behavior of firms.

How much is the MR of a firm in a perfectly competitive firm? Or, what is the additional revenue a firm gets selling one additional unit of output? Obviously it is the market price: P=MR. Therefore, a firm in a perfectly competitive market has to produce that level of output where P=MC (graph). This ensures maximum profit. Explain from the graph that it indeed maximizes profit (in the graph, we see producer surplus, instead of profit).
Fixed Costs and Variable Costs. Fixed costs are those costs that remain fixed irrespective of the level of output, whereas variable costs depend on the level of output. In the example of a coffee shop we used in the last lecture, raw materials ($30,000), wage payments ($25,000), utilities ($5,000), and miscellaneous expenses ($3,000) can be considered variable costs, because these costs depend on the number of cups of coffee sold. On the other hand, lease payment ($24,000), interest payment on borrowing ($3,000), loss of owner=s potential income ($30,000), and the opportunity cost of equity investment ($1,000) are fixed costs; the owner pays these costs irrespective of the number of cups of coffee sold.
Marginal cost is the cost of producing one additional unit of output. Since fixed costs do not change with output, they do not contribute to marginal cost. So, marginal cost is essentially the change in variable costs, and the area below the MC curve is the total variable cost (graph). This then means that producer surplus is profit + fixed costs (graph). However, maximization of producer surplus is the maximization of profit, because fixed costs are fixed.
Let me claim that firms in a perfectly competitive market make only zero profit (more precisely, zero economic profit) in the long run. In other words, producer surplus in the long run is only sufficient to cover fixed costs. No barrier to entry and exit of firms forces zero long run economic profit. If a firm in a perfectly competitive market is making positive economic profit, the firm is making more money than is normally made elsewhere (remember the normal return on investment is already included as a cost). This extra return invites new firms to the industry and the supply of goods in the market increases (industry supply shifts to right-graph). The entry of new firms, thus, reduces the market price, reducing the extra return existing firms were making. Entry of firms would continue until the market price drops down to a level where there is no extra return, i.e., economic profit is zero. A zero economic profit, however, implies that firms are making normal accounting profit.
If too many firms crowd the industry such that price is too low, it may result into negative economic profit, i.e., returns lower than what normally could be made elsewhere. This would encourage some firms to exit from the industry in search of greener pasture. Exit of firms reduces supply, increases price, and reduces losses. Exit of firms continues until economic losses are brought to zero. This also shows that the long run economic profit (or loss) is zero.

Positive or negative economic profit is possible only in the short run or only when there is no perfect information (uncertainty). Successful entrepreneurs thrive on correctly anticipating uncertain future trends of the market; they receive more than normal profit (i.e., positive economic profit) even when market is perfectly competitive. Such return is the return on their entrepreneurial skill.

Imperfect Competition - a case of market failure

Monopoly

Let us analyze the behavior of a firm when it is the only firm in the market. Such a market structure is called monopoly. Monopoly is characterized by

only one firm
no close substitutes of firm=s product
substantial barriers to entry of firms

The above characteristics ensure that there is neither a competitor of the firm now nor there is likely to be one in future, even if the firm makes positive economic profit. New firms cannot enter due to substantial barriers to entry. Barriers could be natural, legal, administrative, technological, or financial. If a firm owns the only mine of a metal in a country, the firm would be the monopolist by virtue of owning the mine. Government may require firms to obtain permission before starting a business: a legal or administrative barrier. Patent of a product grants monopoly to the patent holder generally for a period of five years. Some production activities by virtue of their technology are large scale, requiring heavy initial investment outside the rich of most investors. Examples of monopoly are US West, RTD, Utility companies, etc.
Unlike a perfectly competitive firm, the monopolist, being the only supplier in the market, does not lose all sales even when it raises its price. It will lose some sales (because of downward-sloping demand curve), but the higher price may provide higher revenue. Monopolist is a price searcher, it is searching for a price that maximizes profit.
Note the difference between a perfectly competitive firm and the monopolist. Both are in pursuit of maximum profit. But, a perfectly competitive firm is tied to the prevailing market price, whereas the monopolist searches for the most advantageous price.
Although monopolist is a price searcher, it has no absolute control on price because consumers react by buying less. The market power of monopolist is inversely related to price elasticity of demand. On one extreme, if elasticity is zero (i.e., consumers buy the same quantity irrespective of price), monopolist possesses absolute market power. On the other extreme, if elasticity is infinity, monopolist has no market power at all. Price elasticity depends on availability of substitutes. The more the number of substitutes, the less the market power of monopolist. For this reason, availability of no close substitutes (see the characteristics above) is necessary for a true monopoly.
Show in a graph that the monopolist can artificially restrict supply and thus charge higher price. This generates a welfare loss; show the loss triangle in the graph.
Since there is no threat of competition (now or later), monopolist, unlike a perfectly competitive firm, keeps enjoying positive economic profit even in the long run.

Oligopoly

Oligopoly has the following characteristics:

similar or slightly differentiated products
few large sellers
barriers to entry

Examples are the airlines industry and the breakfast cereal industry, which are dominated by only few firms. Few firms imply a lack of competition. There is also a possibility that the sellers can overtly or covertly collude to behave as one single block of supplier, an effective monopoly. Even with no collusion, sellers have some control on prices because of their individual large market shares. Like a monopolist, firms in oligopoly are price searchers.

Behavior of firms in oligopoly is complex, because decision of one firm is interdependent on the likely responses of competing firms. This is in sharp contrast to a monopolist or a perfectly competitive firm. Firms in a perfectly competitive market need to only know the market price to make their decision; they do not need to know what other firms are likely to do. A monopolist has no competitor, so it does not have to know about others. Because of interdependence among firms, the analysis of behavior of oligopoly firms requires game theory; as if firms are playing games in the market place, to maximize profit by outwitting competitors to the extent possible. We will not discuss game theory in this course. However, we can say that lack of competition allows firms to restrict supply to raise prices. Output in oligopoly is likely to be less than the perfectly competitive level; there should, therefore, be some welfare loss. The more the collusion among firms, the lower the level of competition and the higher the welfare loss.

Government Intervention Under Imperfect Competition

Welfare loss associated with imperfect competition, be it monopoly or oligopoly, may form a rational for the government to intervene in the market. The objective is to push the market towards producing the perfectly competitive level of output and, thus, to reduce welfare loss. There are different ways government can intervene.
Price regulation. The government can directly intervene in the pricing decision. For example, utility companies are regulated in terms of price they can charge. The purpose of the intervention is to force the monopoly to adopt a price closest possible to the price that might prevail under a perfectly competitive environment (i.e., the price corresponding to the intersection of the demand curve and the MC curve - show in a graph).
Antitrust policy. The government closely watches oligopoly firms for possible monopolistic practices. To wield monopoly power, firms may merge or enter into a tacit collusion. They can collude to form a cartel (joining together to restrict supply to enable higher prices), which can behave like a monopoly. The best example of a cartel is the Organization of Petroleum Exporting Countries (OPEC). During 1970s, the OPEC fixed quota of production of oil for each member to restrict the total oil supply in the world market. This caused price of gas to quadruple in this decade. Fortunately for consumers, the OPEC could not maintain its monopolistic practice for long. Individual OPEC members were cheating on their individual quota, increasing total supply of oil beyond the targeted level. Forming cartel or any overt or covert collusion is illegal in the U.S. You may also be aware that there is a federal case in the court alleging Microsoft of monopolistic practices.
Firms may also engage in predatory pricing. Predatory pricing is selling goods at prices lower than marginal cost, with the intention of driving competitors out of the market and of making up the losses later by raising prices when competitors are gone. Predatory pricing is illegal. However, the plaintiff suing a firm for predatory pricing has to prove that the defendant=s price is lower than its marginal cost and that its intention is to wipe out the competition.

EXTERNALITIES AND PUBLIC GOODS - other cases of market failure

We learnt earlier that market fails to achieve efficiency when there is imperfect competition. There are three other cases of market failure to achieve efficiency: externalities, public goods, and economic instability. There are two types of externalities: positive and negative.

Positive externality

Positive externality arises when there is spillover benefits of a commodity to persons other than buyers. Planting of flowers by homeowners in their front yard is an example. Neighbors too enjoy the beauty of flowers blooming, however without having to pay for it. Enjoyment to neighbors is a positive externality generated by the homeowners growing flowers.
Suppose you are one of those homeowners. Would you spend more on planting and growing flowers because your neighbors enjoy them? I guess not. Why should you? Now suppose that your neighbors pay you a certain amount for each flower you grow, as a payment for enjoyment. Wouldn't that encourage you to grow more flowers? I bet it would. With this payment, there is no externality because enjoyment of neighbors is internalized in your decision of how many flowers to grow.
It is perhaps a wishful thinking that neighbors would pay for enjoyment. Therefore, the intersection of the demand for flowers with the supply of flowers (draw a graph) would determine the number of flowers grown. The demand reflects only the willingness to pay of buyers; it does not reflect the benefits of flowers to neighbors. If the external benefits were also included, the true social marginal benefit would be higher up than the market demand curve (show in the graph). The efficient level of output would, therefore, be more than the market output. Thus, the market produces less and also charges less for flowers. Producers think the benefits of flower are less than the actual benefits, leading them to produce less.
The government can correct this market failure by subsidizing flower production by the amount of external benefits. This is one rational for government to subsidize education; education also is believed to generate external benefits in the form of fewer crimes, better policy debates, and better design and implementation of social policies.

Negative externality

Negative externality arises when there is a spillover costs of a commodity to persons other than the producers who produce it. Pollution generated by paper, cement, or chemical plants is an example. Pollution can cause health damages to people, increasing their health costs, which producers do not have to bear.
Health costs do not show up in the producers= marginal cost of production. The true marginal cost of production to the society should include health costs. Only when the society forces producers to bear health costs, producers would factor in these costs too in their decision of how many units of output to produce. Then there remains no externality, the external health costs get internalized in the book of accounts of producers.
The market output is determined by the market demand and the market supply (graph). The supply curve reflects only the marginal cost of production of the producers. The true marginal cost of production would be higher up than the supply curve, to include external costs (graph). The efficient level of output would, therefore, be lower and the efficient price would be higher. In other words, market produces more than the efficient level and charges less.
Note that even at the efficient level of output, there would be some pollution. Zero pollution is generally not optimal. Zero pollution would imply that the society may have to live without the output, say paper.
The government can correct the market failure by using a number of alternative methods such as imposing taxes on output that is associated with pollution.

We now consider a number of alternative ways of correcting negative externalities.

Moral persuasion. Persuading producers on moral grounds to reduce pollution may work somewhat, but it does not go far enough as it lacks economic incentives.
Command and Control. The pollution control authority either prescribes a specific uniform level of pollution reduction to each polluting firm in an industry or commands them to use a specific technology of pollution control in their plants. This command and control approach is generally inefficient. By prescribing uniform level of pollution reduction for all firms, this approach does not take advantage of the fact that some firms can reduce pollution at cheaper costs than other firms. Thus, the actual cost of pollution reduction is unnecessarily higher. The policy provides no incentives to producers to innovate improved methods of pollution control; use of any other technology may expose producers to a penalty for violation of environmental regulation.
Taxes on output. The pollution control authority can impose a tax, equal to the marginal external cost, on output (the production of which generates externality). This internalizes the external costs, shifting the supply curve up to the social marginal cost curve (graph). Then, the market would produce the efficient level of output. This explains why the government imposes taxes on production of paper, chemicals, etc. Sometime it may be easier to impose tax on inputs to production, rather than on outputs. Taxes on output or inputs can restore efficiency.
Emission Taxes. Emission taxes that are equal to the marginal health costs per unit of emissions also can lead to efficient level of output. In addition, by directly taxing emissions, instead of outputs or inputs, the policy offers incentives to producers to innovate cheaper methods of reducing pollution because pollution reduced is taxes saved.

Marketable Pollution Permits. Under the marketable pollution permit system, the government issues permits that authorize permit holders to emit the type and amount of pollutants mentioned in the permit. Permits are generally issued initially to polluting firms, using some criteria of allocation, such as past history of production. Issued permits are transferable and can be bought and sold in a secondary permit market, with no government intervention. If a polluting firm innovates improved methods of production that lowers emissions, the firm can sell its surplus permits in the secondary market, adding to the revenue of the firm. Thus, permit system offers incentives to firms to innovate improved methods of lowering emissions. In this respect and also in respect of efficiency, permit system is as good as emission charges.

Public Goods: another case of market failure.

Public goods are those goods if made available to one person are available to every one else, even if other persons do not pay for the goods. Examples are clean air, national defense, lighthouse, radio signals, etc. These goods have two characteristics: (a) nonrivalness or nondepletability and (b) nonexcludability.
A private good, say a hamburger, if consumed by a person would not be available to another person. If there are more than one person who desire to consume the only available hamburger, there is a rivalry in consumption. On the other hand, a person tuning in to KOSI 107.5 FM does in no way reduce or deteriorate any other person=s consumption of the same program broadcast in that frequency. The same program can be enjoyed by more than one person simultaneously; there is no rivalry in consumption of public goods. Consumption of public goods does not deplete the good.
A person cannot be excluded from consuming a public good even if the person does not pay for the good. Any one can tune in to KOSI 107.5 FM, there can be no payment scheme which can stop some one to tune in to the frequency. If a group of people in a community pays for cleaning air by trucking away the garbage that was spreading foul smell in the community, other persons too in the community would benefit even if they did not pay for cleaning.
The market demand for a public good is the vertical summation of individual demand curves. This is because the same public good can be consumed by every one; the market willingness to pay for that public good is the sum of the willingness to pays of the individuals who enjoy it. In an individual demand curve the vertical axis shows prices the individual is willing to pay for different quantities of a good. So, the market demand curve is found by adding vertical numbers of all individual demand curves for every particular quantity of public good. Explain graphically.
Many of you may be watching PBS Channel 6 in television. The channel keeps soliciting contributions. But how many of you have ever contributed money to the channel? Very few people contribute, and those who do not contribute cannot be excluded from watching Channel 6's programs. Therefore, consumers tend to free ride on consumption of public goods.
Market demand curve reflects only the marginal benefits to those who pay for consumption, it does not reflect benefits to free riders. The true marginal benefits to society is, therefore, higher when you also include free riders (graph). Since market understates benefits, market produces public goods in quantities lower than the efficient level (graph).
Government can restore efficiency by providing subsidies to private producers of public goods, so as to encourage them to produce more to the efficient level. The amount of subsidy should be the amount of revenue lost by producers because of free riders.
Government can exercise the subsidy option only when there is a private producer willing to supply public goods. Generally private businesses are not willing to supply public goods. This is understandable because businesses cannot prevent nonpaying consumers from consuming public goods. For this reason, public goods are generally publicly provided, and government raises taxes to meet the costs of providing public goods.
Note the difference between public goods and publicly-provided goods. Goods that possess the characteristics of nonexcludability and nonrivalness are public goods, irrespective who provides them; whereas goods that are supplied by government are publicly-provided goods, irrespective of whether the government is providing private goods or public goods.

Public Choice Theory and Government Failures.

We saw that market fails in certain cases to achieve efficiency, and government can restore efficiency through appropriate interventions. This assertion, however, implicitly assumes that agents in the government - legislators, politicians, bureaucrats, and voters - pursue public interest, instead of private interest, in formulating public policies. This assumption contravenes the basic premise of economics that individuals are self interested, that they weigh personal benefits and personal costs involved before undertaking an action.
From our experience too we know that politicians can be more guided by their self interest of winning the next election. They may succumb to influences of lobbyists who contribute to their political campaign, at the expense of public interest in the formulation of public policies. Bureaucrats too pursue self interest. They seek largest possible budget for their department because that determines their perk, prestige, and power.
Public choice theory challenges the assumption that agents in government pursue public interest and allows the possibility that they may instead pursue private interests. James Buchanan, the winner of Nobel Prize in Economics in 1986, is the pioneer of public choice theory.
Conflicts between good economics and good politics. A few characteristics of political process should convince you that there may arise conflicts between good economics and good politics.

Rational voter ignorance. It is a rational choice of voters to generally remain ignorant or uninformed prior to voting on a referendum or for a candidate. Consider yourself. If you really want to make an informed choice, you need to gather necessary information which may cost substantial time and money. In contrast, look at the benefit to you from your informed voting. For you to gain, your preferred candidate or policy has to win. This may happen even without your vote. The possibility that your single vote turns out to be the decisive vote on the referendum or election is almost negligible. When you find that the expected costs of making informed choice in voting exceed the expected benefits, it would be a rational decision on your part to remain uninformed or least informed on issues and candidates.

Special interest issue. Special interest issues tend to get more weight or precedence in public policy process. A special interest issue is an issue that delivers potentially large benefits to a very small group of people but spreads costs over a large population. For example, financing of Bronco stadium from sales tax is a special interest issue. The beneficiary is the Bronco franchise, but costs are borne by six county residents in and around Denver. Most of the six-county residents are likely to remain rationally ignorant on this issue, more so because the incidence of sales tax per resident would be small (although collectively it is a large amount of money). This reduces the possibility of a backlash from voters in the next election against politicians taking stands for or against the financing proposal of the stadium. On the other hand, politicians are likely to benefit if they support Bronco on this issue because the franchise may contribute to their campaign finance. You will find Bronco franchise and others who could gain from the construction of a stadium spending money on campaigning on media, to influence voters. On the other hand, those who have least to gain from the stadium and do not like the financing proposal would have hard time to raise resources to campaign against the proposal.

Short-sightedness effect. Both politicians and voters tend to be short sighted. Policies that make economic sense but generate benefits only in the long run may seem less attractive to politicians than those policies that generate immediate benefits before the next election cycle, although the latter policy may not make economic sense in the long run. If politicians can show immediate gains, it improves their electability in the next election. Voters also tend to concentrate more on short term events.

Rent seeking. The possibility that politicians can be influenced through lobbying and campaign contributions encourages rent seeking. Special interest groups spend (or waste) resources (that have other productive uses) on influencing politicians to obtain public policies that are more favorable to them or to their cause. Golf club membership fees paid by private companies for members of Congress and travels of members of Congress on private companies' expenses are examples of wastage of resources on rent seeking.

Possibility of government failure

The above issues or characteristics of the political process should raise doubt that whether government intervention can indeed restore efficiency. Government intervention is not necessarily the perfect answer to market failure cases.
A hands-off approach of the government may actually be helpful in certain cases, at least in the long run for the market to achieve efficiency. Consider a monopoly or oligopoly that makes a lot of money by artificially restricting supply. More than normal profit in this industry then entices other investors to offer competition. Extra profit may even encourage firms to spend resources on developing new technologies to compete with existing firm or firms in the industry. The market power of monopoly can gradually erode in the long run with newer technologies and firms entering the industry. Compare this to the case when government regulates prices in a monopolistic market. The regulation lowers prices, thus lowers profitability and incentive to other firms to spend resources on research and development of new technologies. This can help perpetuate monopoly for a long time. This is one reason monopolies often tend to favor regulation. They can influence government authorities in pricing regulations such that prices are sufficiently high for them to make money but not high enough to invite new firms in the industry.
This discussion, at the least, should convince you that if market can fail, it is possible that government too can fail in achieving efficiency.

Inflation

Inflation is a continuing rise in the general price level, an aggregate representation of prices of all commodities. In other words, inflation is a decline in the value or purchasing power of dollar. In market, prices of some commodities fall and those of others rise. During inflation, there are more commodities that rise in prices compared to commodities that fall in prices.
Hyperinflation is a very rapid and high growth rate of prices, over 50 percent per month. Stagflation is a period of stagnation or recession (decline in output) combined with rapid inflation.
Effects of Inflation

People generally incorporate anticipated inflation rate in their decisions. Suppose you lent $1,000 to me at a nominal interest rate of 8% expecting an inflation rate of 3%. What if actual inflation happens to be 6%? It means that prices rose more than you expected. So your real return would be only 2% (8% minus actual inflation of 6%). When actual inflation exceeds the anticipated rate, lenders lose and borrowers gain. There is a transfer of income from lenders to borrowers. When actual inflation is lower than the anticipated rate, lenders gain and borrowers lose. There is a transfer of income from borrowers to lenders. Thus, unanticipated inflation has a potential of redistributing income.
Unanticipated inflation can create uncertainty and inhibit long term lending and borrowing.
Real resources are used up in wasteful expenditures of predicting inflation rate more accurately and of protecting against unanticipated inflation (for example, buying gold, silver, etc.).

Unemployment

Of the entire civil population (16 years and older), some are in the labor force and some are not. Those not in the labor force are students, retirees, disabled, and household workers; they are not seeking jobs. This group also includes discouraged workers who in the past looked for job but couldn=t get employment and are now discouraged and have given up seeking employment. On the other hand, those who are employed or are actively seeking employment make up the labor force. Labor force participation rate is defined as
Labor force participation rate = (Labor force / Civilian Population) x 100 %
Labor force participation in the U.S. was 66.6 percent in 1995. Among men, this rate decreased from 87 percent in 1948 to 75.4 percent in 1995. Among women, the rate increased from 32.7 percent in 1998 to 59.2 percent in 1995. There has been a substantial change in gender composition of labor force in the U.S.
Of those in the labor force, some are employed and some are unemployed. The number of unemployed persons as a percentage of those in labor force is the rate of unemployment.
Rate of unemployment = (Number unemployed / Labor force) x 100 %
Unemployment rate was 5.6 percent in 1995. It is about 4.6 percent at this time. Note that unemployment rate understates the true unemployment in the economy for two reasons. One, it excludes discouraged workers (they are not considered in the labor force). According to an estimate, there were about one million discouraged workers during 1991 recession. Two, even part-time workers are considered employed; thus, underemployment is ignored. Because of this limitation, another indicator of employment is also defined.
Rate of employment = (Number employed / Civilian Population) x 100 %
The rate of employment was 62.9 percent in 1995. Note that the sum of the rate of unemployment and the rate of employment will not add to 100 because they are defined as percentages of different things.
The Bureau of Labor Statistics collects monthly statistics on unemployment by surveying randomly 59,500 households from 729 locations.
There are three types of unemployment. Cyclical unemployment is caused by economic swings or downturns in the economy. Structural unemployment is caused by changes in the structure of the economy because of new technologies and new products. It is difficult to match the skills of the labor engaged in older products or technologies with the requirements of the new jobs available. For example, many defense bases in the U.S. were closed by the government after the end of the cold war, making many persons in the bases structurally unemployed. Then, there is frictional unemployment because of lack of information on prospective employers and prospective employees. Every one seeks the best job he or she could have. Similarly, every employer seeks the best employee it could have. It takes time to match the skills of the job seeker with the skills of the job.
Frictional and structural unemployment are consistent with economic theory. Frictional unemployment is a period of matching skills to the most suitable job and structural unemployment is the period of retraining the obsolete skill into something useful to the economy. Therefore, economists are most concerned with cyclical unemployment.
For the reasons of structural and frictional unemployment, there is always some unemployment in an economy even when all other resources are fully utilized. This level of unemployment (due to structural and frictional conditions of an economy) is called the natural rate of unemployment. The natural rate of unemployment, however, can change with dynamic changes in labor market, in the structure of the economy, in the technology of information dissemination, and in public policies such as minimum wage, unemployment benefits, welfare programs, etc. Milton Friedman, the 1976 Nobel Laureate in Economics, coined this term - natural rate of unemployment - in 1968.
During periods of economic boom, actual unemployment is lower than the natural rate, whereas during periods of recession, actual unemployment is higher than the natural rate. When actual unemployment is equal to the natural rate, the economy is said to be in full employment.

Gross Domestic Product and Gross National Product

Gross Domestic Product (GDP) is a measure of income or output produced in an economy in a specified period. It is defined as the market value of all final goods and services produced domestically during a specific period. It is the sum of the quantity of each good produced times its price. The current GDP of the U.S. is over $6 trillion.

Note that only final goods are added in GDP. Intermediate and primary goods are not added to avoid double counting because values of these goods are included in the value of final goods. For example, the market value of bread includes market value of flour or wheat that has gone into making bread.
Only goods produced in a specific period are included. For example, GDP of 1998 would not include sales of old houses built in say 1990. Resale of previously produced goods are not included.
A good to be included in the U.S. GDP must have been produced within the geographical boundary of the U.S., irrespective of whether the producing firm is owned by a U.S. citizen or not. Thus, cars produced within the U.S. by Toyota are included in the U.S. GDP, but not in the Japanese GDP. Similarly, cars produced in Mexico City by a plant owned by G.M. are not accounted in the U.S. GDP, but they are accounted in the Mexican GDP.

Gross National Product (GNP) is the market value of all final goods and services produced by the Anationals@ of a country during a specific period. GNP is similar to GDP except that the GDP includes only those goods that are produced within the territory of the country, irrespective of the nationality of the producer. On the other hand, GNP includes only those goods that are produced by the nationals, irrespective of the territory where they are produced. For example, cars produced by GM in Mexico City are included in U.S. GNP but excluded in U.S. GDP. Lectures on economics produced by me in this class are included in the U.S. GDP but not in the U.S. GNP because I am not a U.S. citizen. Prior to 1991, the U.S. used to publish GNP data. Since 1991, the U.S. publishes GDP data, as do other countries in the world. In the U.S., the difference between GDP and GNP is less than one percent.
Measurement of GDP

Expenditures approach of accounting. This approach adds up consumption expenditures (C) of households, investment expenditures (I) of businesses, government purchases (G), and net exports (NX); these expenditures are also called the four components of GDP. GDP=C+I+G+NX. Note that this sum is the total amount of sales of goods and services. In the U.S. GDP, consumption expenditures account for about 68%, investment about 14%, government purchases about 19%, and net exports -1%.
Resource cost - income approach of accounting. The total sales C + I +G + NX is the total revenue of businesses in the economy, this revenue is distributed as payments to resource owners (labor, lenders, investors, etc.), depreciation, and indirect business taxes. This approach adds up incomes to resource owners and costs to producers to calculate GDP. GDP = wages + rents + profits + interest + depreciation + indirect business taxes -net income earned abroad. Note that incomes to resource owners include net incomes from abroad, which should not be accounted in GDP and is, therefore, subtracted above. In the U.S. GDP, wages account for about 60%, rental income less than 1%, profits about 14%, interest income 7%, depreciation 11%, and indirect taxes 8%. Since the aggregate expenditure in the economy should be equal to the aggregate income, the both approaches lead to the same estimates of GDP.
The U.S. Department of Commerce publishes quarterly data on GDP.

Real and Nominal GDP

There are two types of GDP: nominal and real. Nominal GDP is measured in current dollars, i.e., goods are valued at current prices. Consider a single good for simplicity. Nominal GDP = Price * Quantity of the good produced. If nominal GDP increases from $100 in 1997 to $110 in 1998, this increase may either be coming from price increase or from quantity increase or from both. If quantity has not increased and only price has increased, output has not increased in real terms. In other words, the increase is only nominal, only in dollar terms. We would, however, be interested in knowing the real growth in output.
Real GDP is a measure of the real level of output, adjusted for effects of inflation. Real GDP is the GDP measured in constant dollars, in prices of the base year. To calculate real GDP, inflation has to be accounted; we talk about measurement of inflation next.

Measurement of Inflation

As we defined earlier, inflation is a continuing increase in general price level. To measure inflation, therefore, we need to measure first the general price level. Price index is an aggregate representation of general price level. There are three types of price indices: GDP deflator, Consumer Price Index (CPI), and Producer Price Index (PPI).
GDP deflator is a price index that reveals the cost of purchasing the items included in the GDP during the specified period, relative to the cost of purchasing those same items during a base year (currently, 1992). Since the base year is assigned a price index of 100, a price index of 110 in a year indicates that the price level has increased by 10% since the base year.
CPI is the cost of purchasing market basket of consumption goods bought by a typical consumer during a period, relative to the cost of purchasing the same market basket in the base year. We can similarly define PPI.
Let us demonstrate the method of computing a price index. Be it GDP deflator, CPI, or PPI, the method is same, except that the commodity basket is different for the three indices. GDP deflator basket is a representation of all types of goods: consumption goods (C), investment goods (I), goods purchased by the government (G), and the goods internationally traded (NX) that go into computing GDP. CPI basket includes only consumption goods, whereas PPI basket includes only producer goods.

Monthly Market Basket	1985 Prices	1996 Prices	Cost of market basket in 1985	Cost of market basket in 1996
60 hamburgers	$1.60	$3.20	$96.00	$192.00
4 T-shirts	10.00	18.00	40.00	72.00
2 jeans	24.00	24.00	48.00	48.00
1 compact disc	16.00	12.00	16.00	12.00

Price Index in 1985=100 (price index is always taken as 100 in the base year).

Price index in 1996= (324/200)*100=162. According to this example, the general price level increased by 62 percent (162-100) in the 11-year period from 1985 to 1996.

The U.S. Bureau of Labor Statistics publishes data on CPI every month. The Bureau sends 250 surveyors to 21,000 stores around the nation to report prices of 364 consumption goods that go into the market basket of CPI.
Inflation in any year is the percentage change in the price index.
Inflation in year t+1=[{Price index in (t+1)-Price index in t}/Price index in t] x 100 %.

Example:

Year	Price Index	Inflation Rate, %
1990	100	-
1991	110	{(110-100/100}*100=11%
1992	121	{(121-110)/110}*100=10%

Measurement of Real GDP

The following formula gives the real GDP of year y:
Real GDP of year y = (Nominal GDP of year y) x (GDP deflator of base year / GDP deflator of year y).
Example:

	Nominal GDP	GDP deflator	Real GDP
1992	$6,244	100.0	$6,244
1995	$7,246	107.5	7,246*(100/107.5)= $6,739
Percent increase	16.0	7.5	7.9

In the above example, although nominal GDP increased by 16% during 1992-1995, a large portion of the increase reflected inflation. Prices rose by 7.5% during this period. Actual increase in real output, as measured by real GDP, was only 7.9%.

Problems with CPI as a measurement of inflation

If there has been a change in the lifestyle of consumers since the base year, the base year=s market basket will not reflect the recent market basket. Therefore, CPI may not reflect the true general price level.
CPI generally overstates inflation because consumers tend to substitute to cheaper goods if prices of goods in the market basket increase. For example, consumers may go for chicken during a month if prices of beef increase during the month. Indeed, energy prices went up by 218 percent in the period 1972 to 1980, but actual energy expenses of consumers went up by only 140 percent. According to some estimates, CPI overestimates inflation by about 1 to 1.5 percent. This is a reason behind a proposal of lowering the cost of living adjustments of social security payments, which are currently adjusted for inflation according to CPI.
CPI overstates inflation also because it ignores quality improvements. For example, computers purchased in 1996 for the same cost are far superior in quality compared to computers purchased in 1985.

Macro Policy Goals of Government and Recession

Government pursues four macro policy goals:

Rapid and stable growth of output, or GDP (for sustained economic growth)
Stable prices (for minimizing uncertainty and maintaining purchasing power of money)
Low unemployment (for reducing economic hardships of households)
International stability (for maintaining stable exchange rate and smooth functioning of international trade).

Business Cycle. Only rarely are prices, outputs, and unemployment stable. Economies generally experience swings in economic activities, which are called business cycles. Business cycles are periods of growth in real output followed by periods of decline in output. Draw a figure of business cycle to show expansionary and recessionary periods of economic activities. Output fluctuates around a trend line. Output expands above the average trend for some periods and reaches a peak, then it contracts and reaches a trough in the following periods.
A downturn in economic activity is called a recession. More precisely, recession is defined as a decline in real GDP for two consecutive quarters. A recession which is prolonged and severe is called depression. Show the exhibit on 30 years of GDP. The recession in early 1990s is the Bush recession. The recessions in early 1970s and towards the end of 1970s and the beginning of 1980s are the two oil shocks. The average growth rate of real GDP during the period 1960-1995 was about 3.0 percent annually. During the Great Depression (not shown in the Exhibit), real GDP declined by 7.5 percent or more each year, between 1930 and 1932. The real GDP in 1933 was almost 30 percent less than the real GDP in 1929.
Fluctuations in real GDP bring in fluctuations in employment. Unemployment increases during recession and decreases during expansion. We learned earlier that unemployment created by such swings in economic activities is called cyclical unemployment. We also learned earlier that when the economy is operating at its best, the only unemployment is the frictional and structural unemployment, together they make up natural rate of unemployment.
When actual unemployment in the economy is only equal to the natural rate of unemployment, the economy is said to be in full employment. The amount of output that economy can produce at full employment is called potential output. Note that this potential output is what represented by the production possibilities frontier (PPF) of an economy.
When actual output is below the potential level, there is recession; the economy is operating inside its PPF because resources are underutilized. When actual output is equal to or exceeds the potential level, there is economic boom; the economy is operating on or outside the PPF.
An economy can operate outside its PPF only for a short period by stretching use of resources, including labor, beyond normal working hours. Overtime use of resources cannot persist for long and may lead to possible inflation, which we define next.

Problems with GDP as a measure of well being. Although GDP is a commonly used measure of current production or income, this is not a perfect measure of well being of citizens.

GDP includes only market production; it excludes household production. Baby sitting services of a parent to his or her child are not included in GDP, but the same services are included if they are provided by paid nannies. Therefore, GDP understates outputs of developing countries which are characterized by large subsistence sector. Also, GDP overstates output when compared over time. Women in last couple of decades have increasingly joined the labor force. Women=s output once in the labor force is accounted in GDP but their household production in earlier years was not accounted. This is a rational behind allowing tax-deferred individual retirement account deposits by even non-working spouses of employed persons.
GDP excludes activities of underground economy, because they are either unreported or undetected. Estimates of the size of the underground economy range from 10 to 15 percent of total output in the U.S.
GDP excludes leisure and human drudgery associated with jobs. People value leisure; only market goods are included but leisure is unaccounted in GDP. An economy that produces $20,000 per capita GDP with 30-hours of work week indicates better well-being of its citizens, compared to another economy that produces the same per capita GDP with 50-hours of work week. Also, jobs are becoming physically less strenuous with inventions of better technologies; GDP does not account for these changes.
GDP does not account for quality changes. Computers may have not increased in prices, but they have certainly increased in computational speed and capability. Dollar values of computers miss quality changes.
GDP also does not account for changes in quality of life, such as increased road congestion and degradation of environment.

Alternative measure of well being? GDP may not be a perfect measure of well being, but there is no other single better measure. Therefore, a number of social indicators C such as education, health, nutrition, sanitation, etc. C also are monitored, besides GDP.