unit 4 micro honors

8/10/2019 Unit 4 Micro Honors

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CHAPTER 15 FACTOR MARKETS

Factor Markets and Derived Demand

The for factors of !rodction " #a$or% ca!ita#% #and and entre!renershi! " are $o&ht and so#d inthe factor markets' (n these markets )e reverse the $*er and se##er !attern seen in the &oodsmarkets+ in &oods markets firms se## and hoseho#ds $*% $t in factor markets firms $* andhoseho#ds se##' To re!eat the materia# from Cha!ter 1,

1' Labor, the effort, )orkers !t into !rodcin& &oods and services sch as constrctin& ahose% $i#din& a car on an assem$#* #ine% desi&nin& a ne) com!ter% researchin& a ne) dr&'-a$orers are !aid )a&es'

.' Capital, technica##*% ca!ita# refers to the faci#ities% e/i!ment% inventories and other !h*sica#

resorces to !rodce &oods and service' (n the interest of c#arit* )e )i## ca## this physicalcapitalto distin&ish it from financial capital" the fnds necessar* to start or maintain the$siness' Financia# ca!ita# mst $e avai#a$#e $efore a firm can ac/ire its !h*sica# ca!ita#'Providers of financia# ca!ita# are !aid interest'

0' Land, -and is a shorthand term that stands for !#ots of &rond and the natra# resorcescontained )ithin' -and can $e sed to !rovide hosin&% a&ric#tra# !rodction or raise#ivestock% st to name a fe) ses' -and is !aid economic rent'

2' Entrepreneurship, Entre!renershi! is the a$i#it* to see economic o!!ortnities andor&ani3e the other three factors to e4!#oit that o!!ortnit*' The* are !aid !rofit'

Hoseho#ds o)n or contro# these factors and se## them to the !rodcers' The* !rovide the #a$or+their savin&s f#o)s into the financia# markets and finances !h*sica# ca!ita#+ the* o)n the #and+the* are the entre!reners' sinesses $* the factors from the hoseho#ds and se the in!ts to!rodce &oods and services )hich the* then se## to the hoseho#ds' The e4!enditres of thehoseho#ds are financed $* the income the* earned se##in& the factors of !rodction' This makesa &iant rotatin& circ#e of income and s!endin&' 6e refer to the interaction $et)een $*ers andse##ers of in!ts as the factor markets'

The factor markets are driven $* s!!#* and demand st as an* other market' Ho)ever% there aresome differences in the motivation of the se##ers and $*ers in the factor markets from those inthe &oods markets% the most o$vios of )hich is the motivation of $*ers' (n a &oods market the$*ers )ant the &ood $ased on ti#it* " the $enefit consmers eno* from havin& and sin& a

&ood' *ers of the for factors of !rodction do not &ain $enefit from having a factor of!rodction+ it is a means to an end not the end itse#f' *ers of factors of !rodction &ain a$enefit on#* if the factor of !rodction adds to their !rofit+ )e therefore sa* that the demand for afactor of !rodction is a derived demand" it is determined $* or derived from consmerdemand for the fina# &ood'

Firms )i## )ei&h the cost verss $enefit of ac/irin& each nit of a factor of !rodction+ the* )i##e4!and se of a factor on#* so #on& as it is !rofita$#e to do so' As )ith the other economicdecisions )e have e4amined% the ana#*sis is condcted at the mar&in'

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MRP, The enefit of a Factor of Prodction

The firm needs to kno) )hat a nit of an in!t )i## do to its tota# revene " ho) mch )i## tota#revene chan&e )hen )e hire one more )orker% #ease one more !rodction faci#it*% $* one moreki#o)att of e#ectricit*% etc' To ca#c#ate this $enefit )e )i## se Marginal Revenue Product"the chan&e in tota# revene re#ative to the chan&e in in!t se'

MRP 8 TR 9:in!t

The Mar&ina# Revene Prodct can $e tho&ht of as the financia# $enefit of ac/irin& the ne4tnit of an in!t' S!!ose the fo##o)in& firm is considerin& a !artic#ar in!t% )hether #a$or%e/i!ment% faci#ities% ra) materia#s% entre!renershi! etc' (t needs to kno) the s!ecific $enefitfor each nit in order to )ei&h it a&ainst the cost'

:in!t :ot!t P TR MRP

; ; ;MRP 8


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(f the firm faces a !erfect#* com!etitive market for its ot!t% then it is no #on&er tre that it mstdecrease !rice in order to se## additiona# ot!t' (n this one case% the MRP is a#so e/a# to theValue of the Marginal Product: the va#e of the additiona# nits !rodced $* an in!t so#d at aconstant &oin& market !rice' (t is fond $* m#ti!#*in& the MP times the !rice of the ot!t' (fm* ot!t se##s for a constant


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On#* if the resorce market )ere !erfect#* com!etitive or ver* c#ose to it% )o#d )e $e a$#e tokee! ac/irin& more of an in!t )ithot raisin& )hat )e !a* !er nit' (n this case the MRC)o#d $e e/a# to the !rice of the in!t' Since )e contine to !a* ear#ier nits the same amontas $efore% the on#* addition to cost )o#d $e the cost of the ne4t nit of the factor' This )i## &ives a hori3onta# MRC crve set at the &oin& market !rice for this in!t'

(f the firm !a*s 17 !er ki#o)att fore#ectricit*% then each ki#o)att sedadds a constant 17' The MRC )o#d$e 17 @ or costs )o#d rise 17ever* time )e add one ki#o)att ofe#ectricit*'

This hori3onta# MRC crve re!resentsthe s!!#* of the in!t " )e can havean* /antit* of e#ectricit* )e can seeorse#ves )antin& and the !rice

remains 17' (f )e tried to !a*an*thin& #ess% sa* 1= a ki#o)att thee#ectric com!an* )o#d ct or!o)er' The s!!#* is !erfect#* e#astic'

6hi#e it is e4treme#* ncommon for ot!t markets to $e !erfect#* com!etitive% it is not thatncommon for an in!t market to $e for a sine $*er' Man* $sinesses% even #ar&e ones% are aver* sma## !art of the demand for a s!ecific in!t' For e4am!#e% even a &ood si3e $siness inmost r$an areas is a !rett* insi&nificant ser of e#ectricit* or #a$or' (ts decision to se one moreki#o)att of e#ectricit* or one more )orker is n#ike#* to chan&e the !rice of e#ectricit* or #a$or inthat commnit*' (t is% therefore% reasona$#e to se the !rice of the in!t as or MRC'

The Profit Ma4imi3in& R#e

The !rofit ma4imi3in& r#e is the same &enera# !rinci!#e )hether in the ot!t or in!t market'(n the ot!t market the !rofit ma4imi3in& r#e to#d s to set !rodction )here the additiona#$enefit e/a#ed the additiona# cost% i'e' MR 8 MC' (n the in!t market the !rofit ma4imi3in& r#ete##s s to set or in!t se )here the additiona# $enefit e/a#s the additiona# cost,

MRP 8 Pin!t

(f MRP Pin!ton the ne4t nit of the factor% the firm is not crrent#* ma4imi3in& !rofit " itco#d raise !rofit $* hirin& or $*in& the ne4t in!t' The difference $et)een MRP and MRC isthe additiona# !rofit the ne4t nit )i## add to the crrent tota#' For e4am!#e% if the ne4t )orker)o#d add


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(f MRP Pin!ton the #ast nit of the factor% the firm is not crrent#* ma4imi3in& !rofit " it co#draise !rofit $* &ettin& rid of that in!t' The difference $et)een MRP and MRC is the ne&ative!rofit the #ast nit added to the crrent tota#' For e4am!#e% if the #ast )orker added


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The overa## #a$or market in the IS is s!#intered into man* s$@markets for a variet* of reasons'Some of the res#tin& market differences and )a&e rates are a necessar* featre of a !ro!er#*fnctionin& #a$or market " )e need )a&e differences to si&na# )here more #a$or is needed and)here #ess #a$or is needed' Some of the market differences and )a&e rates are the res#t ofmarket distortions and indicate that the #a$or market is not fnctionin& !ro!er#*'

$orker %ob related characteristics: Different t*!es of )orkers are e4!ected to dis!#a*different !rodctivit* and va#e to their em!#o*ers' 6e )o#d antici!ate that em!#o*ers)o#d com!ete for the more va#a$#e )orkers% drivin& ! their )a&e rates' E4!erience%ski##% motivation% trainin& and edcation )o#d a## $e e4am!#es of characteristics sed $*firms to distin&ish $et)een )orkers' A com!ter technician )ith a Microsoft com!teren&ineerin& certification )o#d !ro$a$#* $e offered hi&her com!ensation for a tech!osition than someone )ith a &enera# com!ter $ack&rond $ecase the* )i## $e assmedto &enerate more revene for the em!#o*er' The ro#e of edcation is interestin& here "there is consenss that% in &enera#% a more edcated )orker )i## have hi&her !rodctivit*and therefore command a hi&her )a&e% aote " the disa&reement is )h*' There are t)omain theories on the ro#e of &enera# edcation $e*ond $asic #iterac*% the human capitaltheory of education andthe evaluation or signaling theory of education& The hman

ca!ita# theor* of edcation ho#ds that &enera# edcation im!roves the stock of a$i#itiesthat a )orker has% makin& the same !erson more !rodctive )ith each *ear of additiona#edcation' The eva#ation theor* of edcation sa*s that hi&her &enera# edcation!rimari#* rates or measres ho) mch a$i#it* a !erson had in the first !#ace'

Compensating differentials: Different t*!es of o$s are more or #ess attractive to!ros!ective em!#o*ees' 6e )o#d antici!ate that em!#o*ers )o#d have to com!ensatemore for ndesira$#e as!ects of the o$ and co#d com!ensate #ess )hen the o$ hasdesira$#e as!ects' Dan&er% !h*sica# effort% #e&a# #ia$i#it*% !resti&e of the o$% desira$i#it*of o$ #ocation and #oca# cost of #ivin& are a## e4am!#es of o$ characteristics that arecommon#* ref#ected in re#ative )a&es' Em!#o*ment that is more attractive to !ros!ectiveem!#o*ees can !a* a #o)er )a&e+ em!#o*ment that is #ess attractive to !otentia# )orkers

mst !a* a hi&her )a&e'

'(tar) Po#er: There are a ver* fe) #a$or markets in )hich a$i#it* is distri$ted ver*narro)#* $t the sa&e of that a$i#it* is distri$ted ver* $road#*' There are certain careersthat are de!endent on a set of in$orn ta#ents or characteristics that ver* fe) !eo!#e!ossess' A sma## !ercent of the !o!#ation has the natra# voca# /a#it* and !itch that)o#d ena$#e them to $ecome a concert voca#ist' A sma## !ercent of the !o!#ation hasthe native ta#ent renderin& them ca!a$#e of ever $ein& a$#e to thro) or hit a 7= m!hfast$a##' Fe) !eo!#e are ta## eno&h% )ith sfficient hand9e*e coordination% s!eed% and!eri!hera# vision to !#a* center on a !rofessiona# $asket$a## team' There is a ver* #imited#a$or s!!#* !oo# " #ack of interest and the need for *ears of trainin& )i## redce that !oo#even frther' On the other hand% te#ecommnications a##o)s mi##ions of !eo!#e to eno*

the #a$or services of these individa#s at the same time' This &enerates an enormosamont of revene for the em!#o*er of these )orkers' The ver* #o) s!!#* co!#ed )itha ver* hi&h demand &enerates incredi$#* hi&h )a&es for these )orkers'

Market distortions: Infortnate#*% there are !#aces that the market s*stem $reaks do)nand does not o!erate efficient#*' An ina!!ro!riate a##ocation and9or com!ensation of#a$or )i## res#t that ndermines the a##ocative fnction of the #a$or market' A #ack of&ood information can kee! !otentia# )orkers from findin& their $est o$ choice andem!#o*ers from their $est candidate se#ection' The diffic#t* in ratin& the va#e of

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)orkers in service oriented !ositions is #ike#* to #ead to )a&e sca#es that do not ref#ect!rodctivit*' The reason )h* ever* economics te4t$ook ses manfactrin& in itsassessment of the #a$or hirin& decision is that one can eva#ate the MRP of a )orkermakin& a set !h*sica# !rodct so#d for a kno)n !rice' The same is not tre for acstomer service re!resentative or an economics instrctor' The rea# va#e to theem!#o*er is hard to measre $ecase of the /a#itative natre of the o$ the )orkers

!erform' A #ack of #a$or mo$i#it* creates !ro$#ems in the si&na#in& of #a$or markets'Hi&h )a&es act as an incentive to attract more )orkers into a !artic#ar #a$or market+ $tif )orkers cannot easi#* move% )e can have !ro#on&ed !eriods )ith e4cessive #a$or insome markets and insfficient #a$or in others sim#taneos#*' Fina##*% the most serios!ro$#em is discrimination)here em!#o*ers are sin& )orker characteristics not re#atedto the o$ as a $asis for hirin&% !a*% treatment% !romotion etc' Discrimination res#ts in#ess efficienc* for the !rodctive sector as the $est /a#ified )orkers are not a#)a*shired' (t res#ts in &ro!s )ithin societ* sfferin& #o) )a&es and even !overt* $ecasethe* are discriminated a&ainst' 6e )i## discss discrimination in &reater detai# #ater'

(n the first t)o cases% )e des!erate#* need the #a$or market to $e s!#intered to )ork effective#*'6a&e differences are the si&na#in& mechanism that serves to move #a$or to )here )e need it and

encora&e #a$or $ehavior that is !rodctive for the econom*' 6hen these )a&e differences aree#iminated% distortions are introdced+ for e4am!#e% !$#ic schoo#s that !a* identica# sa#aries toteachers of simi#ar /a#ifications re&ard#ess of s$ect matter have often had #ar&e shorta&es ofmath% science and com!ter instrctors' Edcation maors seem #ess interested in those fie#ds and)ithot a financia# re)ard are re#ctant to s!ecia#i3e in them'

(n the #ast case% the distortions )ere a#read* there " )a&e differences e4ist that do not serve asef# fnction and )a&e differences that are needed do not e4ist' The $est )orkers do notreceive the $est !a* and in fact% ma* not even $e hired' There is a $rden to the econom* andes!ecia##* a $rden to those &ro!s discriminated a&ainst' 6hen the &overnment doesnJtintervene the #a$or market )i## )ork #ess efficient#*'

E/i#i$rim, Desira$#e or Bot

Market forces )i## !sh the individa# #a$or markets to the !oint that /antit* s!!#ied e/a#s/antit* demanded% st as in an ot!t market' (f )a&es are a$ove e/i#i$rim% then more!eo!#e )ant to se## more #a$or hors than there are o$s avai#a$#e " there is a #a$or sr!#s ornem!#o*ment' Firms can offer #o)er )a&es and sti## fi## their o$s " )a&es )i## fa## to)arde/i#i$rim'

(f )a&es are $e#o) e/i#i$rim% then firms )ant more #a$or hors than hoseho#ds are )i##in& tose## " there is a #a$or shorta&e' As firms com!ete for )orkers the* )i## have to raise )a&es in

order to fi## !ositions " )a&es )i## rise to)ard e/i#i$rim'

At e/i#i$rim )orkers are a$#e to se## a## the #a$or the* )ish to at the &oin& market rate andfirms are a$#e to $* a## the #a$or the* )ish to at the &oin& market rate' Bo) in the rea# )or#dthere are m#ti!#e #a$or markets or&ani3ed $* &eo&ra!hica# area% ski## #eve# and !artic#ar o$ stto name a fe)' There )i##% therefore% $e m#ti!#e e/i#i$rim rates' The e/i#i$rim rate for anato mechanic in do)nto)n acksonvi##e is not the same )a&e as the e/i#i$rim rate for a!#astic sr&eon in ever#* Hi##s'

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*+,- .orris/La0uardia 1ct: A )eak !iece of #e&is#ation% this act made it more diffic#t forfirms to ac/ire an innction a&ainst the !eacef# activities of a #a$or nion' Prior to this%em!#o*ers co#d &o to a d&e and have an innction issed a&ainst the nion' Nenera##*% these)ere issed nder the c#aim that the #a$or demonstration or strike endan&ered the !$#ic orvio#ated the !rivate !ro!ert* ri&ht of the em!#o*er $* de!rivin& him of his !rofits' The #a)@a#so

ot#a)ed yello# dog contracts in )hich )orkers have to contracta##* a&ree not to oin a nionor dea# )ith a nion as a condition of em!#o*ment' Inder these contracts the em!#o*er co#dsmmari#* fire a )orker for an* nion activities even on the )orkerJs free time' The Borris-aNardia Act )as !assed )ith the s!!ort of some conservative and $siness #o$$*ists in theho!e of !reventin& a stron&er #a$or $i## from $ein& !t in !#ace' The strate&* did not )ork'

*+,2 $agner 1ct: The fondation of IS #a$or #a)% this act is sometimes ca##ed L#a$orJs $i## orri&hts or the LMa&na Charta of #a$or' (t states that )orkers have a #e&a# ri&ht to form a nionand co##ective#* $ar&ain+ frthermore% it is i##e&a# for firms to discriminate a&ainst nions andtheir mem$ers for #e&itimate nion activities' The* ma* not consider nion mem$ershi!% interest%or !artici!ation in the hirin&% !romotin&% !a*% disci!#ine or termination of em!#o*ees' Em!#o*ersma* not intervene in the interna# activities of nions or the se#ection of nions $* their )orkers "

it is i##e&a# for em!#o*ers to s!!ort one candidate for nion office or to e4!ress a !reference for)hich of a set of com!etin& nions the* think )orkers sho#d oin' To enforce this% it created the.ational Labor Relations 3oardto investi&ate nfair #a$or !ractices' 6hi#e the actions of theB-R var* &reat#* de!endin& on the !eo!#e a!!ointed to it% the &enera# strctre of the B-R isti#ted in favor of #a$or' (t is the res!onsi$i#it* of the em!#o*er to demonstrate that its actionscame from other cases aside from discrimination a&ainst or&ani3ed #a$or'

*+45 "aft/6artley 1ct: The IS &overnment $ecame ver* concerned a$ot the !otentia# effectscertain #a$or activities co#d have on the econom* and societ* as a )ho#e' 6e sa) nions in theIS and es!ecia##* in Ero!e% sin& their !o)er in )a*s not ori&ina##* considered $* thes!!orters of the 6a&ner Act' The Taft@Hart#e* act #imits the kinds of activities that #a$or nionscan !rse' One% it ot#a)ed the closed shop)here em!#o*ers can on#* hire crrent nion

mem$ers @ as!irin& )orkers find the* canJt oin the nion n#ess em!#o*ed in the indstr* andthe* canJt $ecome em!#o*ed in the indstr* )ithot $ein& in the nion' Mem$ershi! in the nion)as !assed do)n in fami#ies and some nions )ere virta##* im!ossi$#e for otsiders to enter'T)o% it ot#a)ed featherbedding)here em!#o*ers are re/ired to !a* for )ork not done' Amore modern se of the )ord feather$eddin& inc#des re/irin& em!#o*ers to !a* for )ork notnecessar* " this is a &ra* area that is not a#)a*s c#ear in its #e&a#it*' Three% it ot#a)ed certainefforts to s!read #a$or dis!tes $e*ond the ori&ina# em!#o*er and nion thro&h secondaryboycotts and sympathy strikes% )hich !## other em!#o*ers and nions into the #a$or dis!teres!ective#*' The most e4treme e4am!#e of this )as the general strike " the !r!ose of )hich)as to !ara#*3e the econom* $* havin& A-- the nions in the contr* &o ot on strike to&ether'Ero!e had had severa# maor &enera# strikes+ the IS )as determined to !revent a simi#aroccrrence here' For% Taft@Hart#e* &ave the President the !o)er to sto! a strike that threatens

the !$#ic )e##@$ein& for ! to =; da*s and send mediators in to he#! reso#ve the dis!te'

*+2+ Landrum/0riffin 1ct: (n the 175;s Con&ress $ecame ver* concerned a$ot corr!tion in#a$or nions and the ties $et)een #a$or nions and or&ani3ed crime' Con&ressiona# hearin&sheard acconts of nion mem$ers $ein& denied a voice in the decisions of their o)n nion andnion fnds $ein& !ersona##* sed $* #eaders or or&ani3ed crime' (n res!onse the -andrm@Nriffin Act mandated that a## nion mem$ers mst $e a##o)ed to !artici!ate in nion e#ectionsand that votes $e cast $* secret $a##ot' Inions )ere then re/ired to fi#e financia# records andnion #eaders )ere #imited in their a$i#it* to access nion fnds'

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.egotiate an above e7uilibrium #age:

This is the most common#* sed tactic of #a$or nions toda*' The nion can direct#*tar&et the desired )a&e% $t mst acce!t some redction in the nm$er of o$s com!aredto e/i#i$rim' (n this &ra!h the nion raised the )a&e from the e/i#i$rim


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and that endorsement )as heavi#* determined $* #a$or isses' Drin& the 17>;s and 17=;s nionmem$ers )ere mch more #ike#* to vote accordin& to a candidateJs !osition on a s!ecific non@#a$or isse sch as a$ortion or &n contro# or the defense' Ths% in the 17=; e#ection% $#e co##arAmericans s)e!t one of the most anti@nion Presidents of modern histor* " Rona#d Rea&an'Novernment s!!ort of #a$or nions e$$s in the 17=;s and the B-R moves a)a* from $ein&!ro@#a$or as it had $een' Some states have ct into the !o)er of nions $* !assin& right to #ork

la#sthat make it i##e&a# to re/ire )orkers to oin a nion as a condition of em!#o*ment'

Mono!son* and the Effect of 6a&e F#oors

Inion )a&es and minimm )a&es that !sh the #a$or market redce the nm$er of o$s andincrease the nm$er of )orkers com!etin& for them% all other things equal' 6hen )e dra) thestandard demand and s!!#* crve ana#*3in& ho) the market is )orkin&% )e are assmin& thereare no distortions a#read* in the market' This is not a#)a*s the case' st as ot!t markets donot )ork efficient#*% aote% )hen there is a #ack of com!etition% in!t markets can sffer from a#ack of com!etition as )e##' Sometimes there is a sine $*er of an in!t in the #oca# market "this is ca##ed a monoposony'

(f the #oca# #a$or market is dominated $* one #ar&e em!#o*er% then that !rodcer sees the )ho#e#a$or s!!#* crve' (f the firm )ishes to attract additiona# )orkers% it )o#d need to raise the)a&e rate' This means that the Mar&ina# Resorce Cost is BOT the !rice of the in!t' (nstead%the MRC is theTC 9:in!t' Since )e are #ookin& at the hirin& decision of #a$or% #a$or is theon#* com!onent of cost )e )i## a##o) to chan&e " a## other thin&s are e/a#' The chan&e in tota#cost is the chan&e in the !a*ment to #a$or " the chan&e in total #ages' (n order to attract ne))orkers )e )o#d have to raise the )a&e not on#* for the ne) )orkers $t the e4istin& ones as)e## )hat )o#d ha!!en if )e didnJt

:-a$or6 T6 MRC

; ;MRC 8 < 5;; 9 1;; 8 < 5

1;; ;; 9 1;; 8 < >

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(n a com!etitive #a$or market% individa# firms see a f#at )a&e set at the &oin& e/i#i$rim !riceset )here s!!#* and demand intersect' This is the !rofit ma4imi3in& /antit* of #a$or since the!rice is the MRC " )hen )e set s!!#* e/a# to demand% it is the same as MRC e/a#in& MRP'This is $ecase the MRC crve is the same as the s!!#* crve in a com!etitive market% and thedemand crve is the same as MRP in an* market' Com!are this to the !rofit ma4imi3in& se of

#a$or for the mono!sonist as sho)n on the ne4t !a&e'(f this market )ere com!etitive% thee/i#i$rim )a&e )o#d $e


16/31

.' Find at #east . )e$ sites% one !ro one con% on the to!ic of comparable #orth' E4!#ain )hatcom!ara$#e )orth is and take a !osition on the associated !o#icies' Ise )hat *o have #earned inthis c#ass to ana#*3e the market and s!!ort *or !osition'

CHAPTER 1> CAP(TA-% -ABD Q EBTREPREBEIRSH(P

The Market for Ca!ita#

(n economics% the )ord ca!ita# refers to the faci#ities and e/i!ment sed to !rodce &oods andservices% )hi#e in the $siness )or#d ca!ita# refers to mone* and #i/id assets sed to finance$siness activities' For the !r!ose of c#arit*% )e )i## $e more s!ecific de!endin& on the t*!e ofca!ita# $ein& referred to' Physical capital refers to faci#ities and e/i!ment% financial capitaltomone* and #i/id assets and human capitalto the stock of a$i#ities and ski##s that )orkers have'

A firm needs a## three in order to $e sccessf#' Financia# ca!ita# #ies $ehind the other t)o " thefirm mst raise financia# ca!ita# in order to fnd !h*sica# investment or #a$or trainin&'

The sim!#est form of ca!ita# decision makin& fo##o)s the same !rocedre )e sa) in Cha!ter 15 "find the MRP of the ne4t machine or the ne4t nit of trainin& and com!are to the in!t !rice' (fan investment &enerates at #east as mch as its cost% it is desira$#e' This decision is com!#icated$* the natre of the !rice of !h*sica# ca!ita# " it can $e a #ar&e one@time e4!ense for a factor of!rodction that !rodces $enefit over a !eriod of time' 6hen *o !a* a )orker% $oth the cost andthe $enefit are s!read over time% $t !rchasin& a machine ma* cost *o


17/31

One !ro$#em )ith this kind of ca#c#ation is that mone* toda* is )orth more than mone*tomorro)' (f investment retrns and costs are not e/a##* distri$ted across time% one mst adstthe nm$ers for the time factor'S!!ose that *o have a chance to $* some ne) com!ter e/i!ment and soft)are that )i## addto *or ftre !rofits' (t )i## take a co!#e of *ears to have the !acka&e desi&ned to *or needs%

insta##ed% tested and *or !ersonne# trained to se it' After that% it )i## add to *or !rofits for thefo##o)in& ? *ears nti# *o e4!ect to chan&e *or hard)are over a&ain' The !roect is e4!ectedto make *o,

ear 1 ear . ear 0 ear 2 ear 5 ear ? ear > ear =

;';; ;';; .%;;;%;;; 0%;;;%;;; .%;;;%;;; 1%;;;%;;; 1%;;;%;;; 1%;;;%;;;

Botice that the !roect )i## increase *or !rofits a tota# of ear =

;';; ;';; .%;;;%;;; 0%;;;%;;; .%;;;%;;; 1%;;;%;;; 1%;;;%;;; 1%;;;%;;;

;';; ;';; 1%522%0?> .%1.5%.>? 1%.77%=?0 57?%.?> 52>%;02 5;1%=??

1;=


18/31

The tota# !resent va#e of the stream of ftre $enefits is 0% #ess than the mi##ion!rice ta& of the !roect )hich is !aid no)' (f )e !t that mi##ion in a financia# investment at7% )e )o#d have more mone* in the #on& rn than if )e !rchased the hi@tech !acka&e'Another !ro$#em )ith this kind of ca#c#ation is that )e are sin& expectedftre rates of retrnand interest rates' O$vios#*% )e do not kno) )hat these nm$ers )i## $e and this co#d #ead toan incorrect decision even if )e se the $est data and decision makin& !rocesses avai#a$#e' or

financia# de!artment estimated the $enefit of the ne) e/i!ment $t in a## #ike#ihood that nm$er)as the midd#e of an e4!ected ran&e @ 5 or as hi&h as1;'.5 for e4am!#e' (f the cost came in on the hi&h end of its ran&e and the $enefit came in onthe #o) end of its ran&e% a !roect that #ooked !rofita$#e co#d acta##* #ose mone*' (f the costcame in on the #o) end of its ran&e and the $enefit came in on the hi&h end of its ran&e% a !roectthat #ook n!rofita$#e co#d acta##* have $een )orth)hi#e'

The !rofita$i#it* of a ca!ita# investment is driven in #ar&e !art $* the interest rate the com!an*faces' 6hat determines the re#evant rate of interest (ma&ine the IS econom* )ith on#* onecredit market% a## $orro)ers and #enders are a#ike and there is no risk in makin& #oans' A## fndsavai#a$#e f#o) into this market and a## those )ho )ish to $orro) ac/ire their fnds here' Theres#tin& rate of interest is kno)n as the pure rate of interest" the interest rate on a risk free#oan' This is a theoretica# constrct since o$vios#* )e )i## never see this in the rea# )or#d'Think of the !re rate of interest as the nder#*in& Lnatra# rate of interest in the credit market "a## rea# )or#d rates are created off this theoretica# $ase as )e make adstments for risk' Thereare severa# factors of risk that a #ender considers )hen choosin& to make a #oan or set an interestrate' The credit )orthiness of the $orro)er% the !r!ose of the #oan% )hether there is co##atera#%the #en&th of the #oan and the rate of inf#ation'

The income and crrent de$t #eve# of the $orro)er as )e## as his or her credit histor* inf#encethe rate of interest on a #oan' A !ros!ective $orro)er )ith a hi&her income% #o) crrent de$t anda histor* of !a*in& $i##s on time )o#d receive a mch #o)er interest rate than someone )ith theo!!osite !rofi#e% aote' (f the #oan is for a !r!ose that !a*s no ftre $enefit " for e4am!#e a nicevacation " one )o#d e4!ect to !a* a hi&her rate of interest than if the #oan )o#d raise ftreincome or #o)er ftre e4!enses " for e4am!#e a co##e&e edcation' A #ender )o#d antici!ate#ess tro$#e $ein& !aid $ack for the second than the first% aote' (f the #ender can immediate#*sei3e some asset )hen a $orro)er defa#ts on a #oan $ecase the asset )as !t ! as co##atera#%then the #ender is takin& #ess risk and )i## offer a #o)er interest rate% aote' A #oan for a short!eriod of time is inherent#* #ess risk* than one for an e4tended !eriod in !art $ecase there is #esstime for thin&s to &o )ron&' There is #ess !ro$a$i#it* that someone )i## #ose their o$% $ecomedisa$#ed or die% ac/ire other de$ts% etc' over the ne4t 0 *ears than over the ne4t 0;' The other

reason time is an isse has to do )ith the #ast risk factor )hich is of &reat concern to economists "the ftre rate of inf#ation'

6hen one #ends or $orro)s mone* to $e !aid $ack at some distant time% one rns into the isse ofthe chan&in& va#e of mone*' (nf#ation erodes the !rchasin& !o)er va#e of mone*% makin& thedo##ars !aid $ack )orth #ess than the do##ars #ent' Economists stress the im!ortance of nominalvs' realvaria$#es' Bomina# refers to face va#e " the )orth of somethin& in the do##ars of thatmoment current dollars )ithot correction for inf#ation' Rea# refers to !rchasin& !o)er va#e" the )orth of somethin& in the do##ars of another time !eriod constant dollars )hich corrects

1;7


19/31

for inf#ation' As far as interest rates &o% )e )ant to kno) )hat is ha!!enin& to the !rchasin&!o)er of the do##ars $orro)ed or #ent " thro&h interest )e accm#ate the /antit* of mone*% $tthro&h inf#ation )e #ose va#e' 6hat is or fina# &ain or #oss(ma&ine *o make a one *ear


20/31

For e4am!#e% s!!ose that oi# is discovered nder *or !ro!ert* and the costs associated )ithe4!#oitin& this oi# fie#d are as fo##o)s, the necessar* ca!ita# e4!ense is ;s% it did not create more oi# in the environment% rather itincreased the amont of oi# )e !m!ed ot of the &rond' Inder the hi&h oi# !rices an* com!an*that co#d reasona$#* find an a#ternative to oi# or oi# $ased !rodcts did so " !o)er com!anies$rned coa# instead of oi#% some s*nthetic materia#s )ere rec*c#ed instead of $ein& !rodced ne)sin& !etrochemica#s and ethano# )as added to &aso#ine to redce the cost of !rodcin&atomotive fe#' The com!anies that co#d not easi#* chan&e their oi# sa&e )ere the ones that

111

L"#$

0.00

5.00

10.00

15.00

20.00

25.00

30.00

2.4 2.5 2.6 2.7 2.8

Quantity

Price

S


21/31

ke!t !a*in& the hi&h !rices " economic rent he#!ed ensre that oi# )ent to the ses )here it )asmost needed and hardest to re!#ace as those )ere the com!anies $est a$#e to !a*'

The Market for Entre!renershi!

Entre!renershi! is the a$i#it* to reco&ni3e an economic o!!ortnit* and to or&ani3e the otherthree factors of !rodction to e4!#oit that o!!ortnit*' The entre!rener receives )hat is #eft overafter the other three factors are !aid off )hich is the !rofit' There is the #east &arantee in eitherdirection for the !a*ment of the entre!rener )ho can receive fantastic )ea#th or #osses to the!oint of !ersona# $ankr!tc* or an*thin& in $et)een'

The ro#e of the entre!rener is c#earest in a !ro!rietorshi! )here the !erson )ho o)ns thecom!an* a#so mana&es it' Even there% the #ine is $#rred to some de&ree $ecase the !ro!rietoroften a#so )orks as a #a$orer and !rovides ca!ita#' (n a cor!oration the ro#e is s!#intered $ecasethe innovator% the mana&ers and the o)ners are often different !eo!#e' Steve o$s )as one of theinnovators and cofonders of A!!#e $t once the com!an* )ent !$#ic most of the o)nershi!$e#on&ed to the stockho#ders )ho individa##* had #itt#e to do )ith either innovation or the dai#*rnnin& of the $siness' Professiona# mana&ers )ho kne) #itt#e a$ot com!ters ran thecom!an* for !art of its e4istence " ohn Sc##* the CEO for a !eriod of time had $een ane4ective at Pe!si !revios#* and had no com!ter $ack&rond at a##'

Inti# this time )e have a#)a*s stressed that com!etition )i## redce !rofits to a norma# rate ofretrn " the com!etitive markets )i## make 3ero economic !rofit in the #on& rn% A-- OTHERTH(BNS E:IA-' (n fact% a## other thin&s are not a#)a*s e/a# and !ositive economic !rofitscan e4ist even in the #on& rn and even in a com!etitive market' (t is sometimes $eneficia# tosociet* that this $e the case'

"he ;unctions of Economic Profit

Re#ard of innovation: The innovator of a ne) !rodct% a ne) !rodction techno#o&* or a ne)service ma* $e a$#e to eno* e4tra !rofit if the innovation increases sa#es and !rice or #o)ers!rodction costs' (n a com!etitive market these e4tra !rofits are short #ived as other !rodcers)i## either enter this ne) market or co!* the ne) techni/es' A competitive market sees zeroeconomic profit in the long run for a product, ut a competitive company can make greater than

normal profit even in the long run. That sonds contradictor* $t it rea##* isnJt' (f a com!etitivecom!an* constant#* and sccessf##* innovates% then even tho&h the e4tra !rofits are dec#inin&on #ast *earJs innovation and are &one on the innovation from the *ear $efore this *earJsinnovation is addin& !ositive economic !rofit' A com!an* can strin& to&ether a series of shortrn economic !rofits and% theoretica##*% make constant !ositive economic !rofit' The 0Mcom!an* Minnesota Minin& and Manfactrin& ran !ositive economic !rofits most *ears in a

com!etitive indstr* $* constant innovation' The* deve#o!ed scotch ta!e that didnJt *e##o)% that)as trans!arent and #ater t)o sided+ the* deve#o!ed enve#o!es that had secrit* )eaves as )e## asthose that had f#avored e' Of corse% their &reatest sccess drin& this time !eriod )as thePost@it note'

Re#ard for hard #ork: This is !artic#ar#* tre in a !ro!rietorshi! or !artnershi! )here theefforts of one or t)o !eo!#e can chan&e the !rofits of the com!an*' (f an accontant for e4am!#e%)orks /ick#* and efficient#*% )orks thro&h mea#s and has #on&er hors than avera&e% his

11.


22/31

com!an* )i## have #ar&er !rofits than norma#' Other entre!reners ma* not )ant to co!* this$ehavior or ma* $e na$#e to' These !ositive economic !rofits can e4ist in the #on& rn even in acom!etitive market'Re#ard for risk taking: Some $siness ventres are inherent#* hi&her risk than others' (n the!ast )e have treated a## o!!ortnities as e/a# in risk " are *o $etter #eavin& *or mone* in the$ank at 4 interest or investin& in a $siness and earnin& * !rofit' (n acta#it*% mone* in a

$ank is% of corse% far safer than mone* tied ! in a $siness' Entre!reners )i## not en&a&e inhi&h risk ventres n#ess the !otentia# !rofit is commensrate#* #ar&er' o )o#d not $et on ahorse that has never )on an* of his races n#ess the !a*off )ere si&nificant#* hi&her' anks)o#d not #oan mone* to a cstomer )ith a !oor credit ratin& n#ess the* co#d char&e a hi&herrate of interest' (nsrance com!anies )i## not se## car insrance to a driver )ith a $ad drivin&record n#ess the* can char&e hi&her rates% and so forth'

6e can do a ver* sim!#e e4amination of risk and !a*off sin& an e4!ected va#e ana#*sis'S!!ose ( set ! an e4!eriment )here a coin is re!eated#* tossed+ )hen the coin #ands heads ! (!a* the c#ass


23/31

adverse% dd* r&ers is the $etter o!tion " one can se#ect the #o) risk o!tion )ith no sacrificeof e4!ected va#e' To the risk seeker% 6a##* 6ho!!ers is the $etter o!tion " one can se#ect thehi&her !a*off )ith no sacrifice of e4!ected va#e' To the risk netra#% the t)o o!tions are e4act#*e/a# in attractiveness " the risk netra# individa# )o#d $e indifferent $et)een them'

6hen somethin& ver* im!ortant is $ein& risked " a #ar&e sm of mone*% !ersona# safet*% etc' "

most !eo!#e are ver* risk averse' Conse/ent#*% the !a*off )o#d have to $e fair#* #ar&e toindce most !eo!#e to risk the mone* invo#ved in a $siness investment' 6hi#e entre!reners aremore #ike#* to $e risk seekers than the &enera# !$#ic% the* too mst see some #ar&er !a*off inorder to en&a&e in ventres that are hi&h risk' The !ositive economic !rofits of these indstries)i## e4ist in the #on& rn even in com!etitive markets at a #eve# that com!ensates for the riskentai#ed'

(ignal for resources to move: One of the most im!ortant ro#es of !ositive economic !rofit in amarket econom* is to indce firms to shift !rodction faci#ities and resorces from #ess va#edses to more va#ed ones' (f consmer !references chan&e or techno#o&* chan&es and no) someindstries are makin& !ositive economic !rofit% firms )i## enter the market or ado!t the ne)techno#o&* as #on& as an* !ositive economic !rofits e4ist% assmin& no ri&oros $arriers to entr*

e4ist' As ne) firms enter or ado!t techni/es% the !rice in these markets dro!s nti# the !ositiveeconomic !rofits no #on&er e4ist and firms no #on&er have an incentive in enter' (n the #on& rnthis &ives societ* ever*thin& that )e )ant " more of the &oods and services that are hi&her va#edor more efficient% #ess resorces sed on #o)er va#ed or #ess efficient !rodction ABD 3eroeconomic !rofit' This is not a reason for #on& rn !ositive economic !rofits " these !rofits sho#ddisa!!ear in time if the market is re#ative#* o!en and com!etitive'

Re#ard for barriers to entry: This is the one fnction of !ositive economic !rofit that is not tothe $enefit of societ*% a## other thin&s e/a#' (f a firm or &ro! of firms can create an environmentthat redces the a$i#it* of !otentia# com!etitors to enter the market% the* can eno* #on& rn!ositive economic !rofit to the detriment of consmers' The !ro$#em is that it can $e diffic#t tose!arate the !ositive economic !rofits of an indstr* since man* com!anies have e#ements of

severa# of these fnctions' (dea##*% )e )o#d )ant to kee! a## the !ositive economic !rofits savethis one% $t ho) can one te## ho) mch is a re)ard to risk and ho) mch a #ack of com!etition

!ournal "opics: Complete the follo#ing assignment:

o )i## receive a


24/31

CHAPTER 1= THE D(STR(IT(OB OF (BCOME

ecase the markets for the different factors of !rodction have different s!!#* and demandd*namics $ased on differin& !rodctivit* as )e## as avai#a$i#it* of the in!ts% the se##ers receivever* different com!ensation for their efforts' The more market driven an econom* is the morene/a# the distri$tion of income )i## $e " hoseho#ds that contro# hi&h#* va#ed and re#ative#*rare in!ts )i## receive ver* hi&h incomes )hi#e hoseho#ds that contro# #o)#* va#ed andre#ative#* a$ndant in!ts )i## receive ver* #o) incomes' The demo&ra!hics of the hoseho#da#so affect this " *on& )orkers t*!ica##* make #ess than o#der )orkers% t)o income fami#iesmake more than one income fami#ies aote% divorce or death disr!t the !revios standard of #ivin&that a hoseho#d eno*ed% etc' There is a !oint at )hich )e are concerned a$ot the )e## $ein& ofthe !eo!#e at the $ottom of the income distri$tion " !overt* is a serios isse of a more marketdriven econom*' Some individa#s are #ike#* to $e na$#e to !rchase the $asic necessities of anade/ate standard of #ivin&+ the resorces the* have a#so affect the a$i#it* of their chi#dren to

ac/ire the ski##s to make a decent standard of #ivin& themse#ves' The idea# market vie) is that&oods and services )i## $e distri$ted to those )ho need and va#e them the most since those arethe individa#s most )i##in& to !a* the &oin& market !rice' This !rocess $reaks do)n )hen)ho#e se&ments of societ* are fro3en ot of the market !#ace thro&h #ack of income'

A$so#te Povert*

To nderstand the isses of !overt* it is first necessar* to investi&ate the conce!t of !overt* ")hat does it mean to $e !oor :a#itative assessments can $e made $* an ar$itrar* sca#e $asedon some esta$#ished standard or $* a com!arative sca#e $ased on a rankin& of a## the individa#s'

For e4am!#e% an instrctor co#d decide )hat she thinks constittes an A !erformance and set thesca#e of an A $ased on that !ercent' 6hether or not *o make an A is inde!endent of ho)ever*one e#se did in the c#ass+ if *o make an == or a$ove *o have an A' This is an a$so#te&radin& scheme' On the other hand% an instrctor co#d decide that the to! > stdents ot of ac#ass of 05 deserve an A' 6hether or not *o make an A is as determined $* ever*one e#seJs!erformance as it is $* *or o)n' This is a re#ative &radin& scheme'

6e can esta$#ish )hat it means to $e !oor )ith an ar$itrar* sca#e $* decidin& )hat constittes aminima##* acce!ta$#e standard of #ivin& and definin& as !oor a## those )ho fa## $e#o) that #eve# "this is a measre of absolute poverty' 6hether or not *o are !oor is inde!endent of the incomeof the !eo!#e arond *o " it is so#e#* determined $* *or income or consm!tion re#ative to thestandard $ein& sed to define !overt*' The most common measre of a$so#te !overt* is the

poverty line" an income #eve# defined as the $are minimm necessar* to s!!ort a $asicstandard of #ivin&' A## hoseho#ds that fa## $e#o) the !overt* #ine are conted as !oor' The/estion $ecomes ho) to set the !overt* #ine'

Since there is &reat disa&reement amon& !eo!#e as to )hat &oods and services are rea##*necessar*% the IS &overnment deve#o!ed a !overt* #ine measre $ased on food consm!tion'Mo##ie Orshansk* in 17?09?2 ca#c#ated a co!#e of estimates of the $are minimm necessar* tomeet the ISDA food &ide#ines for ade/ate ntrition' Since% historica##*% )e had &ood data thatthe t*!ica# #o) income hoseho#d s!ent 190 of their $d&et on food% then the necessar* food

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26/31

ad#tJs )a&es so the rise in divorce and ot@of@)ed#ock $irths $oth )o#d $e e4!ected to increasethe nm$er of individa#s #ivin& in !overt*'

Consumption measuresare a#so an a$so#te method of identif*in& or ana#*3in& the !overt*!ro$#em " these measre the &oods and9or services consmed $* hoseho#ds and identif* thosehoseho#ds that do not have a minima# standard of #ivin&' These are !artic#ar#* sed in #ess

deve#o!ed contries that do not have &ood income data or )hose !o!#ations #ive #ar&e#* otsidea mone* $ased econom*' (f =; of or !o!#ation )ere a&rarian and &re) most of their o)nfood% #ar&e#* made their o)n she#ters and c#othes and $artered for most of the other &oods andservices the* consmed% then income data )o#d $e re#ative#* irre#evant even if it )ere avai#a$#e'6hat )e mi&ht measre is the !ercent of the !o!#ation that has e#ectricit*% avai#a$i#it* of c#ean)ater% access to $asic hea#th care% and consmes at #east 1;;; ca#ories a da*' This )i## &ive s a$etter indication of standard of #ivin& than income data )o#d' Quality of life measures aresimi#ar to this $t cover data #ike avera&e #ife e4!ectanc*% infant morta#it*% materna# morta#it*%#iterac* rates as a !ro4* for standard of #ivin&' (f the standard of #ivin& )ere hi&h% one )o#de4!ect hi&her #ife e4!ectanc* and #o)er morta#it* rates so )hen )e see hi&h #ife e4!ectanc* and#o) morta#it*% it is reasona$#e to assme the !eo!#e have a reasona$#e standard of #ivin&' 6hen)e see a #o) #ife e4!ectanc* and hi&h morta#it*% it is reasona$#e to assme that the* do not'

Re#ative Povert*

6e can esta$#ish )hat it means to $e !oor )ith a ranked sca#e $* sortin& hoseho#ds in order ofincome and definin& as !oor a## those )ho fa## at the $ottom re&ard#ess of the #eve# of incomethe* have" this is a measre of relative poverty' 6hether or not *o are !oor de!ends on theincome of the !eo!#e arond *o " it is as determined $* their income as *ors' Most measresof re#ative !overt* are $ased on income distri$tion data " ho) the nationa# income of a contr*is distri$ted across the varios income &ro!s in societ*' The most common !resentation of thisdata ses the 7uintile approach)here the !o!#ation is divided into 5 &ro!s from the richest to

!oorest hoseho#ds and the !ercent of nationa# income &oin& to each .; /inti#e is measred'The ta$#e $e#o) &ives the income #eve# and !ercent of nationa# income received for each of thehoseho#d /inti#es in the IS drin& .;;;' This data is after ta4es $t $efore hoseho#ds receivecertain &overnment assistance !ro&rams sch as hea#th care or food stam!s' The incomedistri$tion of the IS does im!rove )hen the data is adsted $t sti## remains ver* ne/a# $*the standards of the deve#o!ed )or#d'

-o)est .; Second .; Midd#e .; Forth .; Hi&hest .;


27/31

their incomes dro!!ed' IS income ta4 is mi#d#* !ro&ressive% a#tho&h not as !ro&ressive as itsed to $e' After ta4 income )i## $e s#i&ht#* more e/a# in distri$tion than !re ta4 income'The &overnment can im!rove the e/a#it* of income distri$tion in ho) it !rovides financia#assistance or acta# &oods and services to hoseho#ds' These are ca##ed transfer payments" the&overnment &ives mone* or &oods9services to !eo!#e )ithot receivin& a s!ecific retrn' (n other)ords% the &overnment is not $*in& some &ood or service% it is redistri$tin& or transferrin&

va#e from ta4!a*ers to $enefit receivers' These are a#so ca##ed entitlement programs$ecasean* !erson that meets the /a#ifications of the !ro&ram is entit#ed to receive the $enefits a&ain%)ithot &ivin& the &overnment somethin& in retrn' Cash transfersthat distri$te mone* to$eneficiaries are the easiest to ca#c#ate and are inc#ded in income distri$tion data' 9n/kindtransfersthat distri$te &oods or services to $eneficiaries are harder to eva#ate and are sa##*not inc#ded' (t is diffic#t to measre the market va#e of &overnment &oods #ike !$#ic hosin&since the &overnment &ood is not identica# to the !rivate sector &ood' (n@kind transfers inc#defood stam!s% food &ivea)a*s% Medicare% Medicaid% o$ trainin&% hosin&% s$sidi3ed schoo##nches% etc' 6e kno) that inc#din& the va#e of these non@cash transfers redces incomeine/a#it*% $t different economists have very different estimates $* ho) mch' The Censsrea estimates that transfer !a*ments ma* $oost the share of nationa# income in the !oorest.; from 0'? to 10 )hi#e some economists !t that nm$er si&nificant#* #o)er and some

si&nificant#* hi&her' Novernment and redistri$tion of income )i## $e discssed in more detai##ater in the cha!ter'

(ncome distri$tion data is fre/ent#* !resented &ra!hica##* in a cm#ative manner sin& aLoren= curve' The hoseho#ds in a societ* are ranked $* /inti#es from the !oorest to therichest% $t their cm#ative share of nationa# income is sed instead of their individa# share'The !oorest .; sti## makes 0'? of the income% $t the !oorest 2; makes 0'? ='7 for atota# of 1.'5' This information can then $e &ra!hed and com!ared to an e/a# distri$tion'

Poorest .; Poorest 2; Poorest ?; Poorest =; 1;;

0'? of income 1.'5 of income .>'2 of income 5;'2 of income 1;; of income

(f ever* hoseho#d received e4act#* the same share of nationa# income% then the share of nationa#income )o#d e4act#* match the share of hoseho#ds " i'e' ?; of hoseho#ds )o#d earn ?; ofnationa# income' 6hen )e &ra!h this there )i## $e a 25 de&ree strai&ht #ine kno)n as the line ofincome e7uality' 6e com!are the acta# income distri$tion crve to this #ine to see ho) farsociet* is deviated from an e/a# distri$tion of income'

As *o can see% the IS deviatessi&nificant#* from the #ine of incomee/a#it*' Most other deve#o!ed contrieshave a sma##er &a! $et)een the acta#

distri$tion of income and an e/a#distri$tion'

6e can nmerica##* measre the de&ree ofincome ine/a#it* )ith the 0inicoefficient% )hich is the ratio of the &a! tothe entire area of the #ine of e/a#it*' ForIS after ta4 income that nm$er is a$ot '

11=

0%

20%

40%

60%

80%

100%

1 2 3 4 5 60% 20% 40% 60% 80% 100%Hu!"#!

-ine of (ncome

E a#it

Acta#Distri$tion


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20' (n other )ords the &a! of ine/a#it* re!resents a$ot 20 of the area nder the #ine ofe/a#it*'(ncome in the IS reaches its most e/a# distri$tion in the ear#* 17>;s $efore retreatin& over thene4t &eneration' * the mid 177;s the Nini coefficient $ecomes re#ative#* sta$#e )ith #itt#echan&e " a sitation that contines to this da*' 6h* did this !attern deve#o! There are man*conf#ictin& o!inions on the s$ect a#tho&h some o$servations are more )ide#* acce!ted than

others'

* trackin& hoseho#d income rather than the income of individa#s or trackin& hoseho#dstandard of #ivin&% there )i## $e a $ias ref#ectin& sine ad#t hoseho#ds' The most commonhoseho#d si3e in the $ottom income &ro! is one " a sine ad#t #ivin& a#one' One !erson doesnot need the same income to achieve a standard of #ivin& that a #ar&er hoseho#d has on moremone*' (n the 17>;s there )as a )ave of *on& )orkers esta$#ishin& ne) hoseho#ds as thea$* oom reached ad#thood+ this co#d easi#* e4!#ain some of the rise in income ine/a#it* inthe 17>;s' More !eo!#e are choosin& to remain sine and more !eo!#e are divorcin& " as )ith!overt* there are no) t)o hoseho#ds #ivin& se!arate#* on )hat )o#d have $een the income ofone hoseho#d' This creates an even #ar&er !ro$#em for income distri$tion data% )hich is&athered $* hoseho#d% than it does for the !overt* rate% )hich is adsted for hoseho#d si3e'

The rise in t)o income fami#ies amon& hi&her income &ro!s has had an enormos im!act onincome ine/a#it*' Since !!er midd#e c#ass and aff#ent )omen rare#* )orked !rior to the mid17>;s% the income of their hoseho#ds rises si&nificant#* as the* enter the #a$or market and add asecond% sa##* !rofessiona#% sa#ar* to the !a*check that a#read* !t them in the to! ha#f ofhoseho#ds' Some ana#*sts have made the controversia# c#aim that over ha#f the rise in incomeine/a#it* in the IS from 17>2 to 1772 has come from these !atterns'

(n addition% strctra# chan&es in the IS econom*% es!ecia##* the #a$or market% have affectedincome e/a#it*' Man* )orkin& c#ass American fami#ies )ere a$#e to &arner a reasona$#e shareof nationa# income )orkin& nioni3ed manfactrin& o$s' As manfactrin& has dec#ined inim!ortance in the #a$or market and nions have sffered an erosion of inf#ence% $#e co##ar)orkers have not seen )a&es kee! ! )ith the sa#aries of !rofessiona#s and mana&ers' At times%

the* have not even seen their )a&es kee! ! )ith the rate of inf#ation' etter !a*in& o$s in theIS re/ire hi&her and hi&her #eve#s of edcation or trainin& to ac/ire and kee! " individa#s)ho are not a$#e or )i##in& to !rse this #earnin& have $een fa##in& $ehind' The rise ofinternationa# trade has created &reater com!etition for American com!anies and American)orkers' This has #imited the a$i#it* of )orkers to ne&otiate hi&her )a&es and the a$i#it* ofcom!anies to !ass hi&her )a&e costs on to cstomers in the form of hi&her !rices'

Novernment !o#icies have a#so !#a*ed a ro#e in the chan&in& !attern of income distri$tion' (nthe #ate 17?;s and ear#* 17>;s &overnment )as more a&&ressive in its attem!ts to redistri$teincome " there )ere more ta4 $rackets and ta4 rates )ere hi&her for hi&h income fami#ies at thattime' Novernment transfer !ro&rams in rea# do##ars )ere &enera##* hi&her than toda* Socia#Secrit* $ein& a maor e4ce!tion' Drin& the #ater 17>;s and 17=;s% a more conservative

ot#ook in &overnment #ed to chan&es in the ta4 code as )e## as redced fndin& for most #o)income transfer !ro&rams in after inf#ation do##ars " raisin& the $d&et of a !ro&ram . drin& a!eriod of ? inf#ation is acta##* a redction in the a$i#it* of that !ro&ram to !erform itsfnctions' The minimm )a&e )as not increased for *ears and &enera##* #a&&ed inf#ationsi&nificant#* over a .5 *ear !eriod'

6hether or not income e/a#it* is a maor &oa# of a societ* and ho) mch ine/a#it* )e are)i##in& to acce!t are normative economic isses' The IS has% in &enera#% $een more )i##in& toacce!t #ar&er differences in income distri$tion than man* other deve#o!ed contries' There are a

117


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severa# !oints of contention in this de$ate " efficienc*% individa# freedom and res!onsi$i#it*%economic mo$i#it*% and the tota# ti#it* achieved in societ*'

Ho) Mch (ncome E/a#it* is Acce!ta$#e

Differences in income act as an incentive to move !eo!#e into the o$s% edcation and $ehaviorsthat are needed in the econom* and a)a* from those that are not' 6hen !eo!#e kno) that theirincome is determined $* effort% $* the ac/isition of ski##% $* movin& &eo&ra!hica##* or $*indstr*% the* )i## chan&e their $ehavior in )a*s that $enefit the econom* and societ* as a )ho#ein addition to raisin& their o)n income' Some of the deve#o!ed contries that redistri$te incomethe most% for e4am!#e% S)eden and Nerman*% have the #o)est o$ creation rates and S)eden hassi&nificant#* #a&&ed other deve#o!ed contries in economic &ro)th' Bone of the deve#o!edcontries has esta$#ished !o#icies of com!#ete#* e#iminatin& income ine/a#it* $ecase of thisincentive fnction' The /estion is ho) mch ine/a#it* is necessar* to !reserve the incentives*stem " )i## !eo!#e cease to ac/ire ski##s and edcation% cease to )ork hard or acce!t certaino$s in the nm$ers that )e need if their )a&es donJt ref#ect the f## va#e of these $ehaviorsMan* economists and socio#o&ists $e#ieve that the income ine/a#it* in the IS is far &reater thanthat necessar* to achieve the necessar* incentive fnction'

Some conservative economists ar&e that )hat an econom* needs to )ork on is ensrin& e/a#o!!ortnit* and access rather than &reater e/a#it* of otcome' (f !eo!#e have more e/a# accessto edcation and trainin&% then it is irre#evant )hether some individa#s donJt take advanta&e of it'To de!rive !eo!#e of the va#e of their efforts is not on#* seen as inefficient $t a#so as de!rivin&them of their economic ri&hts' The market econom* is often !resented as a form of economicdemocrac* in this ar&ment and market intervention $* &overnment as a redction in economicfreedom' C#ear#*% the IS has had and sti## has a maor !ro$#em )ith access to o!!ortnit* "discrimination sti## occrs )ith distressin& fre/enc*' (n addition% since !$#ic edcation is#ar&e#* fnded at the #oca# #eve#% chi#dren from disadvanta&ed economic areas have si&nificant#*fe)er resorces to ac/ire kno)#ed&e and ski##s' This has $een !artic#ar#* o$vios in theavai#a$i#it* of techno#o&*% )here schoo#s in de!ressed areas #ack com!ter hard)are% soft)are

and )e$ access to ena$#e stdents to master the ski##s that co#d im!rove their earnin& a$i#it*#ater in #ife' Ho) mch income ine/a#it* )o#d disa!!ear if &reater e/a#i3ation of o!!ortnit*occrred Ho) mch income ine/a#it* is the res#t of the choices that !eo!#e make rather thanaccess to o!!ortnit* There is a maor !hi#oso!hica# s!#it amon& !eo!#e on ho) mchindivida#s contro# or inf#ence )hat ha!!ens in their #ives' There are man* !eo!#e fromim!overished $ack&ronds )ho do !## themse#ves ot of !overt*' There is access to edcationand trainin& at a## #eve#s of the American econom*% even if that access is not e/a#' Man*individa#s have sed scho#arshi!s or mi#itar* service and fndin& to ac/ire trainin& andedcation' There are man* other individa#s )ho have $een $orn into and #ived their )ho#e #ivesin !overt* " )ho ma* have had to /it schoo# to s!!ort themse#ves and *on&er si$#in&s' The*ma* never have rea#i3ed that o!!ortnities )ere ot there $ecase the* #acked the kno)#ed&e to&o ot and find them' The socio@economic #eve# that one is $orn into certain#* chan&es the

!ro$a$i#ities of sccess $t does not ensre or e#iminate it' Ho) mch it chan&es the!ro$a$i#ities is a matter of &reat de$ate and of &reat re#evance to !o#ic*' (f one $e#ieves thatad#ts had #itt#e inf#ence on their circmstances and therefore res!onsi$i#it* for thosecircmstances% then &overnment mst ethica##* ste! in and redress the sitation' (f one $e#ievesthat ad#ts #ar&e#* inf#enced their crrent circmstances and mst main#* $ear res!onsi$i#it* forthem% then it is those individa#s )ho sho#d main#* redress the sitation'

1.;


30/31

On a re#ated theme% the economic mo$i#it* of individa#s is an im!ortant com!onent of thee/a#it* and e/it* de$ate' Some of the other deve#o!ed economies have a mch more e/a#distri$tion of income than the IS% $t individa#s do not move mch in socio@economic statsfrom &eneration to &eneration' (n the IS the t*!ica# !attern is for !eo!#e to move over t)o/inti#es drin& their #ifetime' Part of this !attern is de to the earnings life cycleand !art tointergenerational mobility' The earnin&s #ife c*c#e refers to the !attern )here !eo!#e st

enterin& the #a$or market e4!erience #o)er )a&es+ as the* ac/ire e4!erience and ski##s their)a&es rise " &enera##* !eakin& in their 5;s or ear#* ?;s+ as !eo!#e retire their income &enera##*takes a $i& dro! as the* move from )a&e income to !ension and investment income' Even if a##the !eo!#e in a societ* earn the same amont at each a&e there )o#d sti## $e income ine/a#it*$ecase the* are in different sta&es of #ife' 6hat some contries #ike S)eden or Nerman* do istake #ar&er ta4es from midd#e a&e )orkers and redistri$te them to the *on& and o#d than is trein the IS' The other isse is the movement of !eo!#e to different socioeconomic #eve#s than their!arents and &rand!arents had' (n the IS there is no statistica##* si&nificant corre#ation $et)een*or income and *or &rand!arents income " )e have that mch inter&enerationa# mo$i#it* $oth! and do)n' This is not the case in most of the other deve#o!ed contries' ' (f *or !arents arefactor* )orkers in the IK or France or Nerman*% it is ver* #ike#* that *o )i## $e a factor*)orker' (f *or !arents are #o)er #eve# !rofessiona#s% it is ver* #ike#* that *o )i## $e a #o)er

#eve# !rofessiona#' (f *or !arents are #ar&e #and o)ners% in a## #ike#ihood% *o )i## $e a #ar&e #ando)ner' More conservative economists ar&e that this mo$i#it* makes or &reater ine/a#it*acce!ta$#e " on#* if !eo!#e canJt esca!e ot of their #o)er income $racket )o#d the &overnmentface an o$#i&ation to redistri$te income' More #i$era# economists ar&e that the mo$i#it* is notas &reat as it a!!ears es!ecia##* for minorities% es!ecia##* no) that ta4es have $een redced oninherited )ea#th' Since inheritance is a mechanism thro&h )hich the )ea#th* o#der &eneration!asses a startin& advanta&e on to the ne4t &enerations% inheritance fosters inter&enerationa#immo$i#it*' (n recent *ears the IS has dramatica##* redced and is in the !rocess of !hasin& otestate ta4es% a move that )e )o#d e4!ect to increase income ine/a#it* and redce mo$i#it* inthe ftre% a## other thin&s e/a#

Fina##*% the tota# ti#it* created for the )ho#e societ* co#d $e affected $* income ine/a#it*'

ecase of the #a) of diminishin& mar&ina# ti#it*% a do##ar )orth of &oods and services )o#d $ee4!ected to &enerate more ti#it* for a !oor !erson )ho has ver* fe) &oods and services a#read*%than for a rich !erson )ho a#read* has so mch' The .nd!air of shoes for a #o) income individa#)i## &enerate more ti#it* than the =7 th!air for an aff#ent individa#% aote' Shiftin& do##ars from)ea#thier hoseho#ds to !oorer ones cases a rise in the &enera# #eve# of ti#it* for societ* as a)ho#e " the ti#it* #ost $* ta4!a*ers is more than made ! $* the ti#it* &ained $* reci!ients ofthe &overnment redistri$tion' The &overnment can redistri$te the mone* raised $* ta4in& !!erincome &ro!s or it can $* &oods and services and distri$te those' Either method shifts $enefitfrom ta4!a*ers to reci!ients $t !ro$a$#* not as efficient#*'

Mone* Transfers vs' (n@kind Transfers

Mone* transfers occr )hen the &overnment !rovides mone* to reci!ients of a !ro&ram% sch asSocia# Secrit* or 6e#fare $enefits' (n@kind transfers are )hen the &overnment !rovides &oodsand services to the reci!ients of a !ro&ram% sch as !$#ic hosin&% vaccinations% food &ivea)a*s%etc' The advanta&e of mone* transfers is that the* offer the ma4imm f#e4i$i#it* for the #o)income hoseho#d " if hosin& costs are #o) in an area and c#othin& costs are hi&h% hoseho#ds)o#d $e a$#e to move mone* from hosin& to c#othin& and vice versa if the reverse )ere the

1.1


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case' (f a hoseho#d )ere )i##in& to acce!t a #o)er than minima# standard of #ivin& tem!orari#*%in order to accm#ate the do)n!a*ment on a hose )hich )i## e#iminate rent and $i#d e/it* inan asset% it can do so' The advanta&e of in@kind transfers is that the &overnment can tar&ets!ecific &oods and services )e )ant to ensre each hoseho#d has% so for e4am!#e% seein& thatad#ts are not de!rivin& chi#dren of necessar* hea#th care in order to $* other &oods #ike dr&s'This is the $i& difference in !hi#oso!h* $et)een mone* and in@kind transfers " )ho )i## more

efficient#* decide )hat mi4 of &oods and services the hoseho#d sho#d have'

Mone* transfers a##o) hoseho#ds to decide for themse#ves% a s*stem that a##o)s for &reaterti#it* !er do##ar' Frthermore% since the &overnment dis!erses on#* mone*% it re/ires #ess$reacrac* and administrative e4!ense to rn' A## other thin&s e/a#% mone* transfers )o#dtherefore $e more efficient and the se of mone* transfers has $een s!!orted $* a nm$er ofeconomists% even conservative ones #ike Mi#ton Friedman' Friedman has s!!orted the negativeincome ta< @ a conso#idated version of mone* transfers )here a## transfer !ro&rams )o#d $eco##a!sed into one mone* transfer s*stem' Inder the ne&ative income ta4 #o) incomehoseho#ds )o#d receive a !a*ment from the &overnment+ in other )ords% their income ta4)o#d $e a ne&ative nm$er' This )o#d e#iminate m#ti!#e !ro&rams each of )hich has its o)nre/irements to /a#if*% each of )hich mst $e a!!#ied for se!arate#* in different !#aces% and each

of )hich has its o)n #ar&e $reacrac*' The criticism of the ne&ative income ta4 is that it )o#dredce the incentive for #o) income hoseho#ds to find )ork " a contention &iven some s!!ortfrom e4!eriments )ith ne&ative income ta4es in Seatt#e and Denver'

(n@kind transfers are &enera##* s!!orted nder the $e#ief that the &overnment needs to ensre thatthe &oods and services )e fee# are a!!ro!riate are% in fact% the ones that hoseho#ds receive' Thisma* $e $ecase )e fee# that #o) income hoseho#ds #ack the information or edcation to make)ise decisions or that the* )i## a$se the s*stem' Since )e )ant to make sre that chi#dren inthese hoseho#ds receive food% she#ter and medica# care% )e !rovide food% she#ter and medica#care rather than mone* that mi&ht end ! $ein& sed for other thin&s' 6hen sch a s*stem is set!% it mst invo#ve a com!rehensive administration to ac/ire the &oods and services% distri$tethem in the desired )a* and some kind of checkin& !rocedre to tr* to !revent secondar* se##in&

or frad' (n other )ords% )e need to tr* to !revent the $#ack market sa#e of food stam!s or these of !$#ic hosin& $* fami#ies that no #on&er meet the criteria' (f one $e#ieves that there is asi&nificant #eve# of frad% a$se or mismana&ement $* reci!ient hoseho#ds% then in@kind transfers*stems )i## $e more de!enda$#e in !rodcin& the res#ts desired $* the &overnment'

!ournal "opics: Complete the follo#ing assignment:

1' Find a minimm of t)o artic#es or )e$ !a&es addressin& )e#fare reform% at #east onefrom a critica# and one from a s!!ortive !osition' Smmari3e the ar&ments *o see on)e#fare reform and &ive *or o)n o!inion'

.' Ta4es do not have to $e !ro&ressive' Sometimes the* are regressive or proportionala#so kno)n as netra# or f#at ta4es' Research )hat re&ressive or !ro!ortiona# ta4es #ook#ike and discss ho) the* )o#d affect income distri$tion and !overt*'

1..

unit 4 micro honors

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