About the authors Rod Hill grew up in Ontario, was educated at the University of Toronto, the University of Stockholm and the University The Economics Anti-textbook: A critical thinker’s guide to microeconomics of Western Ontario, where he obtained a PhD in economics. was first published in 2010 He has taught at the University of Windsor, the University FkXb_i^[Z_d9WdWZWXo<[hdmeeZFkXb_i^_d]BjZ")(EY[Wdl_ijWBWd[" of Regina and the University of New Brunswick, where he 8bWYaFe_dj"DelWIYej_WX&`'X& has been a professor of economics since 2003. His research 2mmm$\[hdmeeZfkXb_i^_d]$YW4 interests have included inter national trade policy, taxation FkXb_i^[Z_dj^[h[ije\j^[mehbZXoP[Z8eeaiBjZ"-9odj^_WIjh[[j"BedZed and the underground econ omy, and (as a result of growing d'/`\"kaWdZHeec*&&"'-+<_\j^7l[dk["D[mOeha"do'&&'&"kiW dissatisfaction) the content of the introductory textbooks. He 2mmm$p[ZXeeai$Ye$ka4 is a research associate with the Canadian Centre for Policy Copyright © Rod Hill and Tony Myatt 2010 Alternatives and a member of Econom ists for Peace and The rights of Rod Hill and Tony Myatt to be identified as the authors of this Security and the Progressive Economics Forum. work have been asserted by them in accordance with the Copyright, Designs and Patents Act, 1988 Tony Myatt received his PhD from McMaster University with Designed and set by Ewan Smith, London
Tables Contents 2.1 Labour’s productivity in England and Canada ...... 28 2.2 Changes in world output...... 30 2.3 Percent in agreement with the proposition: ‘minimum wages increase unemployment among young and unskilled workers’ ...... 33 3.1 Types of market structure ...... 54 Tables and figures | vi 3.2 Tax incidence applications used in ten major North American Acknowledgements | ix textbooks ...... 61 4.1 Mary’s benefit from eating pizzas ...... 75 Introduction: our goals, audience and principal themes . . . . .1 5.1 Inputs and output in the short run...... 94 1 What is economics? Where you start influences where you go . .9 5.2 Costs in the short run ...... 95
2 Introducing economic models ...... 27 5.3 Downward-sloping demand and marginal revenue...... 100 6.1 A pay-off matrix illustrating the prisoner’s dilemma ...... 129 3 How markets work (in an imaginary world) ...... 46 6.2 Repeated plays when Esso plays ‘tit-for-tat’...... 130 4 People as consumers ...... 74 7.1 Classification of types of goods ...... 153 5 The firm...... 93 7.2 Percentage changes in age-standardized cancer incidence rates . . . . 163 8.1 Marginal cost of labour for a monopsonist...... 175 6 Market structure and efficiency – or why perfect competition isn’t so perfect after all ...... 118 9.1 Taxation as a percentage of GDP, OECD countries, 2005 ...... 197 9.2 Measures of income inequality ...... 199 7 Externalities and the ubiquity of market failure ...... 150 9.3 Distribution of household net worth...... 200 8 The marginal productivity theory of income distribution – 9.4 Percentage of children in households with less than half of median or you’re worth what you can get ...... 169 household income, circa 2000 ...... 202 10.1 International trade, 2007 ...... 220 9 Government, taxation and the (re)distribution of income: is a just society just too expensive?...... 196 10.2 Estimates of the stock of foreign direct investment, by sector, 2006 . . 239 11.1 Conventional economics and the blank cells of Akerlof and Shiller. . . 244 10 Trade and globalization without the rose-tinted glasses . . . 219 11.2 Conventional textbook economics and the blank cells of Robert 11 Conclusion ...... 243 Prasch...... 250
Postscript: a case study on the global financial meltdown . . 256 Figures Notes | 264 Bibliography | 274 1.1 Marginal thinking ...... 11 Glossary | 291 Index | 297 2.1 Wheat and cloth production in England and Canada ...... 29 2.2 Expanded consumption possibilities ...... 30 2.3 Different perceptions of reality ...... 41 3.1 Inelastic and elastic demand ...... 47 3.2 Movement towards equilibrium ...... 48 3.3 Comparative static analysis ...... 49 3.4 The effect of rent control ...... 50 3.5 The effect of a minimum wage...... 51
vi 3.6 The incidence of taxation...... 52 9.1 The Lorenz curve ...... 198 3.7 Multiple equilibria in the labour market ...... 66 9.2 The equity–efficiency trade-off...... 203 3.8 Self-fulfilling prophecies ...... 68 9.3 Income distribution and equality ...... 206 4.1 Marginal benefit and price ...... 76 9.4 The equity–growth trade-off ...... 212 4.2 Market demand ...... 77 9.5 Relative risk of CHD death excluding other risk factors...... 214 4.3 Happiness in the United States, 1994–96, by income decile ...... 88 9.6 The social gradient of health...... 215 4.4 Happiness and per capita income across countries, 1999–2004 ...... 89 10.1 The effects of a tariff...... 221 4.5 Happiness in the United States, 1946–2008 ...... 90 10.2 Average costs of producing nails in two countries ...... 230 5.1 The law of diminishing marginal returns ...... 95 5.2 Marginal and average costs ...... 96 5.3 Marginal product and marginal cost ...... 96 5.4 Marginal benefit and market price ...... 97 5.5 Long-run average cost relationships ...... 99 5.6 The long-run equilibrium for the competitive firm ...... 100 5.7 Relationship between demand and marginal revenue...... 101 5.8 Short-run marginal costs ...... 103 5.9 Long-run average cost with increasing and then constant returns to scale ...... 105 5.10 Why the competitive firm should raise its price above the market price . 108 6.1 Derivation of the competitive firm’s supply curve ...... 119 6.2 The short-run response to an increase in demand...... 120 6.3 The long-run response to an increase in demand ...... 121 6.4 The optimal quantity ...... 122 6.5 Non-competitive firms don’t have a supply curve ...... 123 6.6 Monopoly versus perfect competition...... 124 6.7 Price ceilings and monopoly ...... 126 6.8 Natural monopoly ...... 126 6.9 Monopolistic competition ...... 128 6.10 Estimating the deadweight loss...... 139 6.11 Aggregate stock price bubbles ...... 147 7.1 Markets are inefficient in the presence of externalities ...... 151 7.2 Cancer incidence per 100,000 males, age-standardized rates ...... 164 7.3 Cancer incidence per 100,000 females, age-standardized rates . . . . . 165 8.1 Competitive determination of the wage of welders ...... 171 8.2 Two types of unions in otherwise competitive markets ...... 173 8.3 Monopsony in the labour market ...... 176 8.4 Monopsony with minimum wage ...... 176 8.5 The adding-up problem ...... 178 8.6 Reswitching produces the possibility of multiple equilibria ...... 182 8.7 Derivation of a competitive firm’s upward-sloping supply of labour schedule ...... 188 8.8 Executive pay relative to average wages in the USA...... 191 8.9 Dow Jones Industrial Average and CEO pay relative to average pay, 1970–2002 ...... 192
vii viii Acknowledgements Introduction: our goals, audience and principal themes
We would like to thank Walid Hejazi, Michael Krashinsky and Jack ‘I am so displeased at the way undergraduate economics is taught. Parkinson of the University of Toronto, participants in a seminar at the Undergraduate economics is a joke … they teach this stuff that University of New Brunswick, and a variety of anonymous referees who you know is not true …’ Herb Gintis, Emeritus Professor of provided helpful comments on the initial outline of the book. Many Economics, University of Massachusetts (from Colander et al. colleagues also helped in selecting a title: Abdella Abdou (Brandon 2004: 92) University), Hafiz Akhand (University of Regina), Marilyn Gerriets (St Francis Xavier University), John Janmaat (University of British Columbia, ‘It is true that we cannot, in the time available, teach every- Okanagan), Harvey King (University of Regina), Rob Moir (University of thing that we would like. But why do we pick out for treatment New Brunswick), Saeed Moshiri (University of Saskatchewan), Michael just that selection of topics that is least likely to raise any Rushton (University of Indiana, Bloomington), Jim Sentance (University questions of fundamental importance?’ Joan Robinson of Cam- of Prince Edward Island), Calin Valsin (Bishop’s University) and Fattaneh bridge University (1965: 3) Zehtab-Jadid (Brandon University). Special thanks to: Michael Bradfield of Dalhousie University, who com- In brief mented on initial drafts of some chapters; our two editors at Zed Books, Ellen Hallsworth and Ken Barlow, for their guidance and their patience The typical introductory economics textbook teaches that economics is a value- with our missed deadlines; and to two anonymous referees who read the free science; that economists have an agreed-upon methodology; and they know first draft. which models are best to apply to any given problem. They give the impression that None of the above should in any way be held responsible for the views markets generally are sufficiently competitive that (for the most part) they lead expressed here. to efficient outcomes; that minimum wages and unions are harmful to workers Finally, thanks to our respective wives – Virginia and Muriel – for themselves; and that government regulation is either ineffective or harmful. putting up with us through the writing of this book. This Anti-Textbook points out that all this is a myth. Value judgements pervade We dedicate this book to our respective children, Rose and Thomas economics and economic textbooks. These value judgements reflect a social Myatt, and Joan-Maki Motapanyane, and grandchildren, Maia and and political philosophy and can be called an ideology or world-view. It is one Terence Motapanyane, and to all inquisitive economics students who that textbook writers are implicitly attempting to persuade the reader to accept. want to think for themselves and not just believe what they’re told. The Anti-Textbook makes this ideology, and the value-judgements behind it, explicit. The point is not so much to claim that this ideology is wrong, but simply to point out that it exists, and that there are always alternative views that one ought to consider. Our aim is not to debunk mainstream (neoclassical) economics – just the textbook presentation of it. Partly, this is because the neoclassical paradigm is remarkably malleable. It is capable of transforming itself, of shedding many an unappealing feature.' Partly, it is because the boundaries of mainstream neoclassical economics are blurry. It is not clear, for example, whether recent work on ‘limited rationality’ lies within the neoclassical paradigm or is a direct assault upon it. In any event, the recent work on imperfect information by Joseph Stiglitz overthrows many of the neoclassical presumptions about efficiency and
ix 1 the harmfulness of government intervention, and we see his work as being implicit, not explicit, value judgements about what is interesting and important. Introduction squarely within the neoclassical paradigm.( Though we are sympathetic to No ‘objective’ account is possible. For most people – including many economists alternative paradigms and to heterodox views (one of us thinks of himself as – this is not a controversial claim. a ‘post-Keynesian’ and the other as a ‘European-style social democrat’), the Yet the textbooks cloak themselves in an aura of objectivity. They portray Anti-Textbook is not a presentation of alternative paradigms. economics as a science dealing with facts and theories that make predictions. This book is not ‘anti’ economics, or even ‘anti’ mainstream economics. Economists are the technicians wearing white lab coats objectively comparing It is ‘anti’ mainstream textbook economics. This is a much easier target to one theory with another, coming up with policy prescriptions supported by a attack. The evidence is palpable. The books exist. You can see them, touch consensus of professional opinion. them and read them yourself. And should you do so, you would find that the The Anti-Textbook argues that this is a myth – one which is not only danger- mainstream textbooks are remarkably uniform and reflect a narrow range of ously misleading but also bland and boring. Value judgements arise on the world-views – indeed, a much narrower range of world-views than those held first page, where the textbook writers ask ‘what is economics?’ and attempt even by mainstream economists. to define the subject and the main problems that it addresses. A variety of Of course, there are a few non-traditional textbooks – we name several in our possible definitions exists, and each one would give rise to different lines of suggestions for further reading at the end of this chapter – but they comprise enquiry. One definition might stress the importance of using society’s scarce a very small share of the market in the English-speaking world. Unfortunately, resources to make total income and production as large as possible; another the vast majority of first-year economics students are subjected to the standard might stress the importance of eliminating poverty and deprivation so that mainstream textbook. It is for them, and their suffering professors, as well as everyone’s basic needs are met. When an author gives one view and ignores the intelligent layperson, that we have written this book. alternative possibilities, a value judgement has been made. We hope that our book, by citing the views of many prominent economists Moreover, the hope that economics would one day become a positive science from a variety of schools of thought, both mainstream and heterodox, will help relying on the evidence to confirm or to refute theories has, up to this point, students to understand that economics is much more diverse (and interesting!) been in vain. There are long-standing disputes about the effects of relatively than what they see in their mainstream introductory text. simple policy changes. For example, does an increase in the minimum wage increase unemployment? What could be simpler than that? Many texts claim The structure that economists have a consensus answer to this question supported by a clear Our Anti-Textbook follows the structure of the typical microeconomics text- body of empirical evidence. But nothing could be farther from the truth. Con- book and can be read in conjunction with any standard text. Alternatively, tradictory evidence abounds; the dispute is sometimes heated and, as we show since each chapter of the Anti-Textbook begins with a concise exposition of in Chapter 2, consensus among economists has broken down beginning in the conventional textbook material before beginning our critical examination, it the 1990s. Because competing teams of researchers consistently find opposing can even be read on its own. As such, we hope it will prove useful to students, evidence, one journal editor (Levine 2001: 161) talked openly about ‘conscious to those professors who feel even slight discomfort with the hegemony of the or unconscious biases’ in finding a ‘robust equation’. Some (such as Arnott conventional text, and to everyone else interested in understanding more about 1995: 117) acknowledge that such disputes are a ‘battleground for those who contemporary economics. believe in free markets and those who do not’. To help stoke the fires of revolution, each chapter contains ‘questions for your Furthermore, the notion that an appeal to evidence could resolve all theo- professor’. These are aimed at the weak points of the texts’ exposition. The aim retical disputes is – to put it mildly – methodologically naive. As Einstein is not so much to embarrass your professor, as to bring a deeper understanding (1926) said: ‘Whether you can observe a thing or not depends on the theory of economics into the classroom. which you use. It is the theory which decides what can be observed.’ And as a philosopher of science, Imre Lakatos (1978), explained, the central propositions Our thesis of any theoret ical framework are surrounded by a ‘protective belt’ of ‘auxiliary Textbooks are necessarily selective. They must include and emphasize some assumptions’ that prevent them from being refuted. These issues are explored things and exclude or downplay others. They ask certain questions and not in detail in Chapter 2. others. They place some topics and questions in the forefront, and put others Economics is inevitably a battleground between opposing ideologies. This in the background or leave them out entirely. Those decisions usually reflect isn’t necessarily a bad thing. Recognizing this reality puts the controversy and
2 3 excitement back into economics, and reveals a fascinating and vibrant field of According to Prasch (2008: 3): ‘market fundamentalism remains the perspec- Introduction study – one which is more an ‘art of persuasion’ than it is a science. tive of virtually every introductory economics textbook’. To further clarify the One of the major aims of our book is to point out where ideological issues policy implications of emphasizing the perfectly competitive view of the world, arise, and where the textbooks make implicit value judgements that you may Prasch (ibid.: 5) says: not share. One major area where such value judgements crop up is the deci- Minimum wage laws, usury laws, truth-in-advertising laws, laws to regulate fraud, sion as to what to leave out of the text. Alternative perspectives may not be health-and-safety codes, anti-discrimination laws, building inspection codes, en- discussed, inconvenient questions may not be asked and contrary empirical vironmental laws, investor protection rules, and many other rules and regulations evidence may be omitted. have each and severally been breezily, even haughtily, dismissed by market funda- We offer the readers of The Economics Anti-Textbook examples of such omis- mentalists and the many columnists and politicians who invoke their arguments. sions in the hope that they will get into the habit of thinking about what is not in the text as well as what is. After all, the textbooks are not only trying It’s quite true that many qualifications to market fundamentalism can be to teach you how to think (‘like an economist’), they are also trying to tell you found in the mainstream texts, but they are made in such a way that they appear what to think about. of secondary, rather than primary, importance. The theory of perfect markets We stress that our aim is not to trash the textbooks, nor are we portraying is all too often applied reflexively to policy questions, without any discussion textbook writers (or economists generally) as propagandists or ideological hacks. of whether it is relevant or appropriate. As Dani Rodrik explains, ‘one’s skill as All too often, the word ‘ideology’ is used as a term of abuse: one group that an economist depends on the ability to pick and choose the right model for the claims to be ‘non-ideological’ accuses others of being ‘ideological’. Like anyone situation’. Instead, the texts offer a one-size-fits-all model – the theory of perfect else, we have our own ideology or world-view that is reflected in the topics we markets – and apply it to any and every situation. It is this deeply ingrained choose to raise for attention. training which leads even professional economists to reach for that theory when Our point is not so much to claim that the ideology of the textbooks is wrong, offering ‘a quick opinion on a policy issue’, as Rodrik observes. although admittedly we do not share it. Rather, we want to remind readers that it exists. Students should be consciously aware of it – and that there are What’s wrong with this world-view? alternatives on offer. Market fundamentalism – the analysis that dominates the mainstream text- books – assumes perfect and costless information. Much research in recent decades The world-view of mainstream textbooks has explored the implications of relaxing this extreme assumption and con- So what is the world-view of the introductory texts? Harvard professor Dani sidering what happens in a setting of imperfect information, where some people Rodrik (2009) put it well in a recent commentary: know more than others (termed ‘asymmetric’ information). The Anti-Textbook highlights the many places where this more realistic approach is relevant. With Non-economists tend to think of economics as a discipline that idolizes markets pervasive informational problems, the market economy systematically fails to and a narrow concept of (allocative) efficiency. If the only economics course you produce the efficient allocation of resources that is the centrepiece of the text- take is the typical introductory survey … that is indeed what you will encounter. book story. But take a few more economics courses, or spend some time in advanced semi- Furthermore, the perfect markets of the texts are populated by large numbers nar rooms, and you will get a different picture. of small firms, producing identical products, with no power to set their own We agree that the typical text offers a view that ‘idolizes markets’ – usu- product price. Does it matter that very few actual markets resemble this? Many ally not in a crude way, but in a subtle way through its choice of themes, and economists think it does. In recent decades, a great deal of research has been through its emphasis on demand and supply (also called the model of perfect devoted to markets in which there are a few large firms, or in which firms pro- competition) as the central theoretical structure. Most of the standard textbook duce different products. Theories of international trade are now dominated by is spent developing and applying that structure. It describes a world of perfect such approaches. The efficient allocation of resources that occurs in the perfect markets in which given resources are allocated as if by an invisible hand in a markets story does not happen in these more realistic approaches. way that maximizes the value of total production. The belief that this model The focus on ‘efficiency’ that runs through the texts comes at the cost of approximates how markets operate in the real world is often referred to as neglecting issues of the distribution of income and wealth and of economic ‘market fundamentalism’.) justice, which get short shrift in virtually all texts. In Chapter 9, we examine
4 5 the textbook claim that income redistribution and greater social spending are a the Postscript, a full explanation involves precisely all those aspects of reality Introduction costly exercise that reduces economic growth; we argue that the evidence does that mainstream textbooks downplay – imperfect and asymmetric information, not support this view. externalities, power and limited rationality. Another neglected topic is the problem of externalities. Even when people The shortcomings of the mainstream textbooks’ world-view have not escaped make their decisions with perfect information, they can still choose not to take all students. In 2000, a group of economics students in France circulated an into account the effects of their actions on others. Every kind of pollution, open letter to their professors declaring ‘We wish to escape from imaginary from the local to the global, is an example of this. We show in Chapter 7 that worlds!’ and deploring the ‘disregard for concrete realities’ in their teaching. externalities are not the afterthought that the textbooks suggest, but are a per- They asked for less dogmatism and more pluralism of approaches. Since then, vasive problem that render the invisible hand story irrelevant as a description petitions and open letters have appeared in the United Kingdom and in the of the world we live in. United States. (For details, see www.paecon.net.) Questions of power are absent from the texts. Yet in reality sellers try to shape and to influence the preferences of consumers, while consumers may try The textbooks and the Anti-Textbook to exert their power to get producers to produce products in more ethical or The Economics Anti-Textbook presents a different picture of economics and a environmentally sustainable ways. Managers exert power over workers if busi- different vision of the economy – it’s one that many economists see, but it has ness organizations are authoritarian and hierarchical, as is typically the case. been filtered out of the mainstream introductory textbooks. It is not based on Corporations, labour unions, citizens’ groups and non-governmental organiza- the ideas of an obscure fringe of the economics profession. We draw on the tions may struggle to influence the ‘rules of the economic game’ – tax law, writings of many prominent economists – many winners of the Nobel Prize in regulation, government programmes and so on. A similar struggle takes place economics, including even the authors of prominent introductory textbooks.* at the international level. Yet, as we argue, particularly in Chapters 4, 5 and 10, We echo Akerlof and Shiller (2009: 173) when they say: ‘There is then a funda- power of this kind, while important in the understanding of actual economic mental reason why we differ from those who think that the economy should life, is virtually absent from textbook economics. just be a free-for-all, that the least government is the best government, and that Economics textbooks often present hypotheses and policy prescriptions with the government should play only the most minimal role in setting the rules. surprisingly little or no supporting evidence, or (worse) they ignore inconvenient We differ because we have a different vision of the economy.’ contrary evidence. Indeed, the textbooks contain very few references to the professional literature. Another goal of this book is, where relevant, to ask for Suggestions for further reading the evidence and to show the student the way to the evidence that the texts There are quite a few non-traditional alternative texts. The Union for Radical omit. It is remarkable, for example, that the texts present no evidence at all Political Economics has a list of texts it recommends, to be found at www.urpe. about what determines individuals’ well-being. Lurking between the lines is org/res/text.html. Goodwin et al.’s Microeconomics in Context (2008) includes tra- the materialist assumption that people are better off if they have more stuff. ditional topics, but takes ideology seriously and teaches a variety of approaches Yet the evidence we consider in Chapter 4 offers little or no support for the within a broader, more holistic perspective. The book by Hunt and Sherman materialist position. (2008) is now in its seventh edition and has been in print for over thirty-five years. Finally, the whole textbook structure is built on a view of human beings as Finally, there is the long-awaited book The Economic Conversation by Klamer et rational calculators – a view that is increasingly being challenged. It is being al. (2010), which attempts to teach the diversity in economics and expose its replaced with a view of human beings as having limited rationality, and capable of persuasive roots. (See Bibliography.) irrational exuberance and exaggerated herd-like reactions to economic events. We will keep a blog for this book, www.economics-antitextbook.com, where Many of these neglected topics are needed to understand the recent global we will provide updated suggestions for further reading. Readers are invited to financial meltdown. Despite the existence of competition in credit markets and send us suggestions as well as comments about the book itself and questions to despite the existence of theories telling us that stock markets are efficient, we which we’ll respond on our blog. Our email address is [email protected]. have seen a huge financial and real estate bubble burst and threaten to plunge the world economy into another Great Depression. This would be hard to explain using the textbook model of rational economic actors operating in perfectly competitive markets where there is perfect information. Indeed, as we argue in
6 7 them, so economics attempts to understand society by analysing the behaviour of the individuals who comprise it. 1 | What is economics? Where you start 1.2 Scarcity influences where you go Why is choice necessary? Textbooks emphasize that people have unlimited wants. Therefore, no matter how abundant resources may be, they will always be scarce in the face of these unlimited wants. ‘The purpose of studying economics is not to acquire a set of The fundamental question in economics has always been how do we maximize ready-made answers to economic questions, but to learn how to happiness? Economists maintain that while we must allow people to decide for ' avoid being deceived by economists.’ Joan Robinson themselves what makes them happy, we know that people always want more. ‘The enterprise of economics is better characterized by the con- Therefore, society needs to use its resources as efficiently as possible to produce tent of elementary texts than by what goes on at the frontiers of as much as possible; and society needs to expand what it can produce as quickly economic theory.’ Stephen Marglin (2008) as possible. This explains why economists emphasize the goals of efficiency and growth. But does the concept of unlimited wants mean that someone will want an unlimited number of new coats, or an unlimited number of pairs of shoes? No, 1 THE STANDARD TEXT it doesn’t. Along with unlimited wants, economists normally assume that the 1.1 Economics is the science of choice more you have of something, the less you value one more unit of it. So, unlimited It seems obvious that economics is about the economy; so a commonsense wants does not mean we want an unlimited amount of a specific thing. Rather, it definition of economics might be that it concerns itself with money, markets, means that there will always be something that we will desire. There will always business and how people make a living. But this definition is too narrow. Econom- be new desires. Our desires and wants are fundamentally unlimited. ics is not just the study of money and markets. It studies families, criminal behaviour and governments’ policy choices. It includes the study of population 1.3 Opportunity cost growth, standards of living and voting patterns. It can also have a shot at explain- Since resources are scarce, if we choose to use them in one way, we can’t use ing human behaviours in relation to dating and marriage. them in another. Choosing more of one thing implies less of another thing. In The fact that economics can examine subjects traditionally studied by other other words, everything has a cost, and the real cost of something is what must social sciences suggests that content does not define the discipline. As long as a be given up to get it. This is its opportunity cost – the value of the next best topic has a social dimension, we can look at it from the perspective of any social alternative forgone. science. It’s a cliché that there’s no such thing as a free lunch – there is always an op- Most textbooks define economics as the science of choice. It’s about how portunity cost. Even if someone else buys you lunch, there is still a cost. There individuals and society make choices, and how those choices are affected by is a cost to society for all the resources used to grow the food, ship it to the incentives. This definition includes all aspects of life: a couple’s choice to have a restaurant and have it prepared. Your free lunch even costs you something: it child, or a political party’s choice of its platform. Its drawback is that it doesn’t uses up some of your scarce time that you could have used to do something else. help to differentiate economics from the other social sciences, since they too look at how we make choices. 1.4 Marginal thinking: costs and benefits What distinguishes economics from other social sciences is its commitment to You are familiar with the margin on a page – it lies at the edge. And when rational choice theory. This assumes that individuals are rational, self-interested, someone describes a soccer player as being marginal they mean he is a fringe have a stable set of internally consistent preferences, and wish to maximize their player, on the edge of inclusion. Economists use the word marginal in a similar own happiness (or ‘utility’), given their constraints – such as the amount of time way. Marginal cost is the cost at the margin – or to be more precise, the cost of or money that they have. Social situations and collective behaviours are analysed an additional unit of output or consumption. Thus, the marginal cost of wheat is as resulting from freely chosen individual actions. Just as science attempts to the additional cost of one more unit of wheat. Similarly, marginal benefit is just understand the properties of metals by understanding the atoms that comprise the benefit someone gets from having one more unit of something. We might
9 10 . This isn’t damning damning . This isn’t behaviour that maximizes behaviour that maximizes 12 what rational people maximize what rational . And utility is: If individuals are rational, they respond to incentives in predictable ways. in predictable ways. to incentives rational, they respond If individuals are Further, individuals are not assumed to think only of themselves. Someone’s Someone’s of themselves. not assumed to think only are individuals Further, of notion is the economist’s an idea of how broad and encompassing give To We don’t need economic planners – as long as we have competitive markets markets competitive have planners – as long as we need economic don’t We Critics claim the foundations of economics are shaky – people are not rational, not rational, are – people shaky are of economics the foundations Critics claim happy goal: to be as assume everyone has the same fundamental Economists a person’s utility a person’s criticism. After all, our numbering system that defines two plus two as equalling But the point is that such useful. find this quite and we is also a tautology, four of irrational it hard to find examples makes an open-ended definition of ‘rational’ challengeirrational be- of we In fact, our students to find examples behaviour. to make second, preferences; first, remembering: not to judge someone’s haviour allowance for to make and finally, information; less than perfect allowance for in Section 2. on this shortly, say more We not that easy. It’s habit formation. their pay them for could blood we to give people wish to encourage Thus, if we them make could bottles, we people to recycle wish to encourage if we time. Or, upon return. pay a bottle deposit that is refunded economics simply means that given your preferences, you choose to allocate your choose to allocate you your preferences, your simply means that given economics utility. your time and money to maximize as no better utility may depend on the well-being altruist is viewed of others. The both trying they are as possible. since to be as happy or worse than the miser, just – they’re meaning in economics no Selfish and selfless, virtue have and vice, preferences. different often defined in and utility are this: rational behaviour consider rational behaviour, is: Thus, rational behaviour way. a tautological or circular they organize the economy in a way that maximizes the value of total production. the value of total production. in a way that maximizes the economy they organize two first, require planner for reasons: it doesn’t This is better than the perfect be that anyone require it doesn’t second, planning bureaucracy; an expensive altruistically motivated. they say, nor solely self-interested. But rationality in economics means something something means economics rationality in But solely self-interested. nor they say, Allin it means meaning. and philosophical colloquial its from different quite internally goal oriented and have that individuals are is context an economic (or tastes). preferences consistent utility (or satisfaction). their lingo) to maximize use economic as possible, or (to One person prefers people. bring happiness to different things But different to Another prefers life. a simple ascetic to charity and live their money to give ‘I spent quipped, famously C. Fields – W. life spend their money on the fast I squandered!’ The remainder and song. money on wine, women 99% of my in be ‘rational’ utility to people. To ists do not judge the things that bring Econom 1.6 economic activity to organize usually a good way are Markets 1.5 individuals Rational and self-interested
1 | What is economics? ’ it is this framework ’ it is this framework units, the marginal benefit benefit units, the marginal 1 ; or in dollar terms – the ; or in dollar terms – the 1.1 thinking Marginal all activities are undertaken to the point to the point all activities undertaken are figure . Why? Because at this point total net Because at this point total net . Why? 11 MB MC Tons of steel Tons of steel 2 Q utils of satisfaction utils of E Q* rational people think at the margin rational 1 B A Q P $3 $6 Total net benefit Imagine we are old-style Soviet planners, trying to determine the quantity of planners, trying of old-style Soviet to determine the quantity are Imagine we When textbooks claim ‘ When textbooks This marginal-cost/marginal-benefit framework can be applied to everything framework This marginal-cost/marginal-benefit steel to produce. Let’s assume that the marginal cost of producing a ton of steel a ton of steel of producing cost assume that the marginal Let’s steel to produce. line in draw it as the upward-sloping – so we produce we the more increases steel is produced, assume that the more 1.1. Further the upper diagram of Figure benefit line slopes down. How ton is valued – so the marginal the less one more only Q produce If we produce? tons should we many maximum willingness to pay for one more unit. As the science of choice, the core the core unit. of choice, maximum willingness one more As the science to pay for simple: is remarkably framework economic benefit equals marginal cost marginal where will An example help. benefit is maximized. measure benefit in hypothetical benefit in hypothetical measure they have in mind. But are people rational? in mind. But are they have we do, buy, hire or produce. If I want to maximize my satisfaction from studying studying from satisfaction my If I want to maximize or produce. hire buy, do, we hour of study just of one more cost I should study until the marginal economics, buying from satisfaction my benefit. the marginal If I want to maximize equals orange. benefit of one more to the marginal cost marginal oranges, I equate of one more ton is $6, but the marginal cost is only $3. This means that the extra $3. This means that the extra is only cost ton is $6, but the marginal of one more of producing it. cost Therefore, than the extra unit is greater benefit of one more ton. This remains producing one more well-being by society’s can improve we than Q*. more should not produce production to Q*. But we increase true as we benefit, total marginal reducing net exceeds cost that point marginal Beyond of diagram benefit is shown in the lower net steel production. Total benefit from output of Q*. at an this is maximized 1.1. Clearly, Figure question – it depends on – it depends on question normative 14 Textbooks claim that economics is a social science that avoids making value making value that avoids a social science is claim that economics Textbooks Trade-offs follow from scarcity and opportunity cost: we are always trading always trading are and opportunity we scarcity cost: follow from Trade-offs effects hinges on two incentive kinds of adverse argument The textbook net: the social safety for to pay operates via the necessity effect The indirect judgements. It deals with facts and concerns itself with explaining and predicting and predicting itself with explaining and concerns judgements. It deals with facts of econom- scope the world as it is. Questions about moral values lie outside the ought to be. Such there (or equity) cannot say how much fairness ics. Economics political decisions. All can by economists ultimately resolved are moral questions goals as efficiently as possible. The society’s on how to achieve advice do is give is value free. of economics science off more of one thing for less of another. While this kind of trade-off is mundane, of trade-off is mundane, While this kind another. less of of one thing for off more always equity that more abstract trade-off: a more also emphasize textbooks This view is encapsulated in Arthur Okun’s of less efficiency. at a cost comes carrying metaphor: is like water from leaky bucket income redistributing (1975) equitable, but may be more – the result bucket the rich to the poor using a leaky of water wasted on the ground. at a cost comes helps the government is this: the more effect indirect. and The direct direct – so- the example, For themselves. to help they have people, the less incentive benefits insurance unemployment things like comprises net’ called ‘social safety is said to reduce benefits pensions. The first of these state-provided and old-age to (and hence to save the incentive reduces to work and the second the incentive incentives. distorting efficiency by people’s they reduce work). Therefore, of taxation,this necessitates various forms which also cause inefficiencies. For to incentives reduce taxes income claim that textbooks conventional example, demand less of the good, leading to a so buyers prices increase work. Sales taxes sales being produced, previously in production. If an optimal amount was decrease that the emphasize or inefficient situation. Textbooks lead to a sub-optimal taxes political issue, about which trade-off is a ‘best’ location on the efficiency–equity can add little. That is because it is a economics given values and priorities. Instead of proposing the ‘best’ location on any people’s is a trade-off, there why explain (they say) is to the job of the economist trade-off, shifting it in such a of the trade-off by the nature ways of improving and to suggest equity. efficiency and more both more enjoy way that society could 1.10 on methodology A word situation where widows and orphans are starving are and orphans widows where situation while everyonethree has else a luxuryhomes and economy: role in the has another yacht. So the government equitable. Textbooks more outcomes market to make income to redistribute and this inefficiencies, creates necessarily income that redistributing emphasize a trade-off between and equity. efficiency creates 1.9 trade-off The efficiency–equity
1 | What is economics? . In . In The The may not may not , as in the case of , as in the case of It is not through the the is not through It harmony of interests of harmony that guides self-interest that guides self-interest non-competitive markets were competitive (in- competitive were markets invisible hand invisible all 13 The novel twist in Smith’s argument is is argument twist in Smith’s The novel
’ markets may be markets markets must be competitive can be violated in two can be violated in two must be competitive markets all existing , published in 1776. In an analogy that has become iconic, Smith , published in 1776. In an analogy iconic, Smith has become that -textbook let’s have a quick synopsis right now. Here it is in three it is in three Here synopsis right now. a quick have let’s -textbook anti , such as the market for unpolluted air. Both cases lead to ‘market failure’. failure’. Both cases lead to ‘market unpolluted for air. , such as the market The central textbook message is this: if textbook The central laissez-faire markets, and competitive In the special situation of complete This is the technical argument for laissez-faire, the view that governments governments the view that laissez-faire, for argument This is the technical In competitive markets, prices and quantities are determined by demand and and demand by determined are and quantities prices markets, In competitive Most textbooks develop the argument over several chapters, but since you’re you’re since but chapters, several over argument the develop textbooks Most The condition that The condition Smith’s example, it leads to the optimal quantities and lowest possible prices for for possible prices and lowest optimal quantities it leads to the example, Smith’s meat, it leads to an efficient outcome. In other words, beer and bread. leads to a Pareto-optimal situation – an ideal situation in an efficiency sense. situation – an ideal situation in an efficiency sense. leads to a Pareto-optimal or humane. It might be a would be fair mean that the outcome But that doesn’t Wealth of Nations of Wealth to an forces market competitive compares passage he says: ‘ activities. In a famous into socially useful but that we expect our dinner, or the baker, the brewer the butcher, of benevolence to their own interest. their regard from intervention is not needed virtue.that he turns selfishness into a Government naturally system leads to a market because a competitive should leave the economy alone. But textbooks seek to persuade. So, most most So, seek to persuade. alone. But textbooks the economy should leave Adam Smith in by developed the argument paraphrase selectively textbooks supply. But demand is nothing other than marginal benefit, and supply is nothing benefit,than marginal But demand is nothing other and supply is nothing supply. right guarantee that the markets competitive cost. So, other than marginal is maximized. net benefit and society’s produced are quantities sentences: sentences: reading an reading cluding markets that don’t currently exist!), laissez-faire would produce an an would produce laissez-faire exist!), currently that don’t cluding markets the optimal quantity aspects: it would produce key in three efficient outcome and possible cost; at the lowest these quantities of each good; it would produce it most. This ideal situation it would distribute the output to those who ‘value’ optimal, and it has the propertyis callednot possible to make that it is Pareto better off without making at least one person worse off – in other words, anyone in the economy. would be no waste anywhere there 1.7 outcomes market can sometimes improve Governments 1.8 equity providing role: Another government ways, however. First, First, ways, however. monopoly (a single seller). Second, many markets required for efficiency efficiency for required markets monopoly (a single seller). many Second, exist In such situations, government intervention can (in theory) improve upon the intervention upon the can (in theory)In such situations, government improve is Thus, the role of the government under laissez-faire. inefficiency produced are; markets critically existing first, dependent on two how competitive factors: exist. don’t markets upon how many and second, on goods) depend more opportunity an scarcity be producing does (and there then work 16 Would not, to If back professor: people recession? your deep for a putting employment? in to full even cost Question the only ones who reject scarcity as a basic economic aren’t Post-Keynesians puts all wants on Northrop also points out that the notion of unlimited wants equal merit’. disagreed that ‘all wants have It is noteworthy that Keynes idea is Stephen Another economist who rejects the ‘innate unlimited wants’ condition. For example, Emily Northrop (2000) questions whether the fundamen- example, Emily Northrop condition. For wants – is really innate, and argues that it may tal cause of scarcity – unlimited that some people manage to resist consumer- be merely constructed. She notes embodying simplicity, balance or connection ism and choose different lifestyles The fact that some are able to do this suggests (to the earth and to others). In arguing that our wants are constructed, she unlimited wants aren’t innate. norms and the power of advertising: some of emphasizes the power of social billions of dollars a year are spent creating and society’s cleverest people and maintaining our wants. no more important an equal footing: one person’s want for a subsistence diet is This equality of wants reflects than a millionaire’s want for precious jewellery. others worthy than the market value system that no goods are intrinsically more is clearly a value – just as no preferences are more worthy than others. This economics, which unquestion- judgement and one that many people reject. Yet science that avoids ingly adopts this approach, claims to be an objective social making value judgements! than identify the economic problem with scarcity, he identified it with Rather shelter and the satisfaction of what he called absolute needs: food, clothing, 1963 [1931]: 365). This definition of the economic problem healthcare (Keynes It contrasts with puts equity and the distribution of income front and centre. outside the scope the textbook approach of treating equity as a political issue of economic analysis. or social norms. Marglin (2008). Unlike Northrop, he doesn’t blame advertising to be the destruction of community ties, he sees the fundamental cause Rather, and services Goods which creates an existential vacuum: all that’s left is stuff. and community. substitute for meaningful relationships with family, friends His conclusion: as long as goods are a primary means of solving existential problems, we will always want more. But what or who is responsible for under- mining community ties and bonds? Marglin argues that the assumptions of ends, but rather as places where funds required for investment and expansion and expansion for investment funds required where places as but rather ends, are realized.
1 | What is economics? The The the If importance envisaged the Keynes pessimism. efficient? as . Published in 1936 during the . Published in 1936 be and emphasized were still 15 Keynes
optimism ( of markets waves microeconomics – professor: in your , it behoves us to mention another, John Maynard Keynes’s Keynes’s mention another, John Maynard , it behoves us to competitive spirits actors for If people could be put back to work, more of everything could be If people could be put back to work, more of everything ) would animal them, economic of Question a fundamental school reject scarcity as Economists in the ‘post-Keynesian’ As we mentioned the first seminal book in economics, Adam Smith’s Adam Smith’s in economics, first seminal book the As we mentioned Keynes’s message is the opposite of Smith’s. Whereas Smith emphasized message is the opposite Keynes’s thinking still dominates. It When it comes to macroeconomics, Keynes’s truth. Their focus is the economy in deep recession, and they argue that it is truth. Their focus is the economy in deep recession, and of unemployed difficult to maintain the idea of scarcity when there is an ‘army’ which are closed), workers wanting to work, factories where they could work (but can’t afford with- which would produce goods that people need (but which they out a job). General Theory of Employment, Interest and Money General Theory and unemployment could persist, it attempted to explain how Great Depression, doing this, take. In the process of actions governments could what ameliorating of This is the study founding father of macroeconomics. became the Keynes such things as unemployment, inflation, exchange large aggregates, and explains microeconomics deals with smaller chunks of rates and interest rates; whereas reality, such as individual markets. Wealth of Nations of Wealth produced. We could have our cake and eat it too; there would be no opportunity could have our cake produced. We view of markets. Markets a completely different cost. This gives post-Keynesians are not seen as places where scarce resources are allocated among competing 2.2 and unlimited wants Scarcity 2.1 macroeconomics tension with The inherent 2 THE ANTI-TEXT 2 THE that a capitalist market economy can be self-regulating and efficient, Keynes can be self-regulating and efficient, Keynes that a capitalist market economy prone to cycles of boom and bust – and those emphasized that it was inherently Whereas Smith emphasized that rational periods of bust are terribly inefficient. emphasized that people’s outcome, Keynes decision-making leads to an efficient waves of spontaneous optimism and pessimism ‘animal spirits’ are driven by fear and the herd instinct. and (implicitly) fuelled by greed, in the economy to is generally accepted that the government must intervene it must regulate prevent both recessions and overblown expansions, and that it comes to microeconomics, the thinking of Adam when some sectors. Yet, Smith dominates. It’s an uneasy coexistence. why and com- For example, For * to meaning, value
friendships lives zero our our a is it give give 18 Since which always others analysis professor: with your for ties? cost–benefit connections munity does deep Marglin argues that the textbook focus on individuals is problematic. John Marglin argues that the textbook focus on individuals is problematic. assume that rational individuals with a stable set of preferences Textbooks Further, textbooks assume that the state is subordinate to individuals through Marglin’s key point concerns the uneasy relationship between markets markets between relationship uneasy the concerns point key Marglin’s Question Marglin is not against markets. They can promote economic growth and They can promote economic growth and Marglin is not against markets. Kenneth Galbraith went farther. He thought the textbook focus on individuals went farther. Galbraith Kenneth the individual is was a source of grave error and bias because in the real world the wrong focus, not the agent that matters most. The corporation is. By having interests. economics is able to deny the importance of power and political This suggests that allocate their spending to maximize their own happiness. what is produced individuals exercise ultimate control over the economy – both and corporations and how – through their spending. Of course, entrepreneurs goes) they actually make those decisions. But (so the conventional argument cannot survive if are governed by their anticipations of market response – they control over the economy So individuals ultimately exercise customers don’t buy. through their spending. the ballot box. At the very least, government is assumed to be neutral, inter- and communities. Textbook economics praises the efficiency of markets, and of markets, praises the efficiency economics Textbook and communities. the market. the reach of favour expanding generally economists 2.4 the corporation The individual versus economists favour free trade agreements because they expand markets. But free expand markets. because they trade agreements favour free economists the losers are concentrated and losers and sometimes trade creates winners Still, are wiped out. areas. Sometimes whole communities in geographical the because the gains outweigh that free trade is beneficial economists argue of community destruction. Marglin accounting ignores the cost losses. But this do is not forthcoming. And how ‘[I]n practice compensation notes (2008: 10): the destruction of the community in which she you compensate somebody for and hopes one day to retire and look after her grew up, is raising a family, grandchildren?’ But he argues that economists fail to do an raise material standards of living. on whether extending the influence of markets appropriate cost–benefit analysis but since the community is invisible, they is a good idea. They see the benefits, they fail to address the question: What limits don’t see the costs. As a result, for the sake of community? should be placed on markets
1 | What is economics? 17 © Andy Singer According to Marglin, the textbook focus on individuals makes the commu- According to Marglin, the textbook focus on individuals makes – emphasized in Furthermore, Marglin argues that rational choice theory is smart to be Indeed, according to mainstream textbook economics it nity invisible to economists’ eyes. But it is our friendships and deep connections nity invisible to economists’ eyes. But it is our friendships and built on mutual with others which give our lives meaning. So community ties, ignore when trust and common purpose, have a value – a value that economists recommending policy. and values to mere the mainstream textbooks – reduces ethical judgements That’s your preferences. Are you working for the benefit of your community? devil take the hind- preference. Are you cooking the books to get rich quick and being altruistic, most? That’s your preference. Being selfish is no worse than they are just different preferences. but through the selfish. It not only maximizes your own material well-being, for the greatest invisible hand of the market it also produces the greatest good This view influences the cultural norms of society and in- possible number. This influence of economics on attitudes isn’t mere directly erodes community. to economics speculation. Marwell and Ames (1981) document that exposure Frank et al. (1993) generates less cooperative, less other-regarding, behaviour. show that uncooperative behaviour increases the more individuals are exposed to economics. textbook economics, and the resulting policy recommendations of economists, textbook economics, and the Let’s consider how this works. undermine community. 2.3 the community The individual versus Inequality might be bad for efficiency 20 When it comes to pollution we actually want The textbook argument for an efficiency–equity trade-off revolves around trade-off revolves around for an efficiency–equity The textbook argument Inequality has numerous more subtle effects. Recent work, summarized by Inequality has numerous more subtle effects. Recent Trust and cooperation matter to efficiency and growth for many reasons. to create disincentives. As we see in Chapter 7, a tax on emissions of pollutants to create disincentives. As we and give society a double dividend: not only can improve economic efficiency activity, but society also gains the additional does the tax reduce a harmful by the tax. In general, we should first be taxing government spending financed taxing things that things that society doesn’t want, such as pollution, before society wants, such as incomes and useful commodities. the disincentive effects from having a social safety net, and the inefficiencies the disincentive effects from to pay for it. But taxes are not necessar- created from the taxation necessary beneficial incentive effects from living in a more ily inefficient. And there are equitable society. power in the community, power over the state, and power over belief. As such, As such, belief. over and power state, over the power community, in the power but not in form and degree different instrument, is a political the corporation power, is in denying that economics, Textbook itself. from the state in kind As such it are governed. seeing how we stops us from the problem. It part of power depends on an acquiescent of those whose exercise of becomes an ‘ally public’ (John 1973a: 11). K. Galbraith 2.5 The trade-off efficiency and equity reconsidered between need not cause inefficiencies Taxes Inequality might be bad for efficiency for many reasons. Let’s begin by considering two obvious reasons. First, a high for many reasons. Let’s begin by considering two obvious reasons. the social costs degree of inequality leads to high crime rates, which increases individuals’ efforts associated with law enforcement, the judicial process and available This reduces the resources to protect themselves and their property. with the lack of for other things. Second, inequality and poverty are associated outcomes for every- educational opportunities for the poor and worse health than a less- one. A better-educated and healthier workforce is more productive educated one. cohesion’ and Jeff Dayton-Johnson (2001), emphasizes the importance of ‘social part of a society’s the economic pay-off from trust and cooperation. These are growth. Equity pro-‘social capital’ and play an important role in promoting people’s sense of motes social cohesion and trust, whereas inequality weakens example, Knack For reciprocity, and increases the sense of ‘us’ versus ‘them’. (1997) found that greater inequality significantly reduces expressed and Keefer with lower levels of levels of trust. Lower levels of trust are, in turn, associated average individual well-being (Helliwell 2003). Whereas trust between workers and management facilitates the adoption of
1 | What is economics? emphasize really emergency corpora- or corporations are we large textbooks of works, how problem? biggest But the the power public seeing of get. the 19 or What from part us omits usually policy, stop they which professor: textbooks this your supply, Aren’t support, for environmental Doesn’t and in governed? tions. demand financial need Questions Galbraith saw economic life as a bipolar phenomenon. In one part of the In one part of the economic life as a bipolar phenomenon. Galbraith saw consists of a few hundred enormously powerful The other part of the economy takes over In the United States, a prime example of how corporate interest over markets, Galbraith argues that the biggest corporations have power But this idealized world is so far removed from the real world that it is little real world that from the is so far removed idealized world But this economy there are vast numbers of small-scale businesses, the market is para- economy there are vast numbers This is the part featured in economic instruction mount and the state is remote. the small retailer, as it fast disappears. ‘For and in political speeches, even and fruit the family farm, there are the massive grain awaits. For Wal-Mart meat producers’ (ibid.: 25). enterprises and the modern large-scale in research and development, or environmental corporations. What they need financial support, becomes public policy. policy, or public works, or emergency in widely accepted ways. ‘Between public and Government policy is influenced GM and the Department of Transportation, private bureaucracies – between – there is a deeply symbiotic relationship. General Dynamics and the Pentagon There is even, between Each of these organizations can do much for the other. (Johnthem, a large and continuous interchange of executive personnel’ Gal- K. braith 1973a: 5). President Dwight public interest is provided by the ‘military-industrial complex’. to the nation as he D. Eisenhower coined this term in 1961 in his last address and even foreign warned about the dangers of a takeover of military policy, employment in its politi- This industry provides policy, by the weapons industry. and the promise of cal constituency and funds for politicians. ‘The gratitude and to the defence budget, on to the Pentagon political help go to Washington and Iraq, to need and decision. And to foreign policy or, as recently in Vietnam sector role is apparent’ That the private sector moves to a dominant public war. (John K. Galbraith 2004: 35). more than a myth, or ‘perhaps even a fraud’ (John even a a myth, or ‘perhaps more than 2004). The power K. Galbraith state; indeed, they often hijack corporations rivals that of the of the largest reality, we see the management for their own purposes. In the state’s power to the subordination of the state by corporations; and we see of the consumer corporate interest. vening to correct market failure as best it can, and to redistribute income so income redistribute and to it can, as best failure market to correct vening more equitable. market outcomes as to make mistakes systematic 22 is best described as a system of short cuts System one is generally accepted in psychology that the mind works It .) ) that allow the mind to jump to intuitive conclusions relatively ) that allow the mind to jump to intuitive conclusions relatively is systematic, logical and rule bound; it is controlled and deliberate. is systematic, logical and rule bound; it is controlled and deliberate. externalities heuristics The next most common student suggestion is addictive behaviour. It is hard It is hard behaviour. is addictive student suggestion most common The next explain addictive behaviour? Addiction to How can rational choice theory that addictive be- As even rational people make mistakes, one could argue ystem two Systematic mistakes outcome of their actions is something no one wants. (See Chapter 7 dealing 7 dealing (See Chapter wants. no one is something their actions of outcome with someone behaviour – with addictive theory with rational choice to reconcile econ- they love. But mainstream own life and the lives of those destroying their they if they did, where would to abandon the attempt: omists are reluctant that people can become ‘addicted’ step would be to recognize stop? The next other casual sex, religion and many work, eating, television, to almost anything: rules out a huge slice of human out all addictive behaviour activities. Ruling activity. amenable to explanation. Both the amount soft drugs like tobacco is somewhat respond in systematic ways to the abolition of smoked and the decision to quit to rules governing smoking in public places, and advertising, to health warnings, conforms to the predictions of rational choice to the price of cigarettes. All this what about But can it explain getting addicted in the first place? And theory. destroy people’s lives relatively quickly? Research addiction to hard drugs that that the key element is inadequate understand- suggests (see Badger et al. 2007) estimate the power – people systematically under ing and inadequate information by those who have of the addictive craving. Not only is this underestimated is underestimated never experienced such craving. The power of future craving by addicts as soon as they have a fix. haviour is not necessarily irrational. But once we allow for extended beyond in evaluating self-interest, where do we stop? If this idea were choice theory? the realm of addictive behaviour, what would be left of rational – because they If individuals are not the best judges of their own self-interest is not only invis- make systematic mistakes – then Adam Smith’s invisible hand is an important ible, but non-existent. So, the question of systematic mistakes – who, despite being a issue, one that has been explored by Daniel Kahneman economics. psychologist by training, received the 2002 Nobel Prize in in two quite distinct ways. (or uncontrolled and essenti- Its advantage is its speed; it is also associative, easily. On the other hand, ally automatic, and these constitute its areas of vulnerability. s most of the time It is system two which is rational in a calculating sense. But we operate on the software of system one – usually with remarkable success Unfortunately, it is prone to making systematic errors, even with and accuracy. very simple mathematical questions.
1 | What is economics? to human the of does Making Democracy Making Democracy example, reasons waste Why for good what’s true for a part need reduced? less be there governance? might efficiency, violence, 21 Aren’t and better
+ show that The experiences of many countries enhance efficiency crime professor: Individuals may be rational even when the combined health, how might less your only better equity for trust, that mention (1993), Robert Putnam shows that engaged citizens have better govern- that engaged citizens have Putnam shows (1993), Robert text potential, improved These results help substantiate the view that equity might be good for growth These results help substantiate the view that equity might be think Questions our students to find examples like to challenge Are people really rational? We Greater social cohesion also has political advantages. In cohesion also has political advantages. Greater social – but what about efficiency? Conceptually a country might be efficient, but be efficient, but – but what about efficiency? Conceptually a country might however, for an still choose a low rate of growth. It would be more difficult, On balance, it is hard to imagine how equity cient country to grow rapidly. ineffi could be bad for efficiency when it is good for growth. of irrational behaviour. In response, students often point out that we live in In response, students often of irrational behaviour. But we must an irrational society – one that’s on the brink of destroying itself. beware of the fallacy of composition, which states: not be true for the whole. An empirically significant effect 2.6 the assumption of rationality Reconsidering new and more productive techniques, polarized groups engage in wasteful con- in wasteful engage groups polarized techniques, productive and more new parties can there is trust, Where to a standstill. brings production flict that are required. contracts trust, elaborate without agreements; reach handshake by is demonstrated mutual cooperation of trust and the importance In general, are do nothing except what they workers ‘work to rule’ (and the fact that when delays increase. Clearly, workers to do) output falls and contractually obliged obliged to do. more than they are contractually normally do much Work ment. Social cohesion leads to more political participation and better mon- ment. Social cohesion leads increases governmental efficiency and reduces itoring of government, which take the form of better roads and sewerage corruption. The economic benefits more effective enforcement of contracts, systems, better regulation of business, life. and overall a better quality of greater income inequality is associated with significantly lower rates of economic greater income inequality is associated in a (1994) find such a relationship and Tabellini example, Persson growth. For while controlling for a wide array of other things large cross-section of countries (1994) corroborate that could also influence growth rates. Alesina and Rodrik variables and a this result using a different set of countries, different control different measure of inequality. into increases salary future Save More Tomorrow programme. programme. Tomorrow Save More
24 : player A is given a sum of money to split with player B; if B : player A is given a sum of money to split with player B; As to our bounded selfishness, most of us want to ‘do the right thing’. This to ‘do the right thing’. This selfishness, most of us want As to our bounded that the introduction of small fines for par- Gneezy and Rustichini (2000) note waste? Should we Given these results, should we pay households for recycling having besides Another interesting aspect of our bounded selfishness is that willingness This has applications to all areas in economics. An individual’s a retirement savings account. Brilliant! There is no sacrifice today; we do our is no sacrifice today; we do account. Brilliant! There a retirement savings in several When this plan was offered as we would prefer. savings tomorrow their Those enrolled increased (78 per cent) joined. firms, a high proportion to 13.6 per cent. an average of 3.5 per cent saving rates from can crowd out altruistic behaviour, leading to means that financial incentives showed that paying blood example, Richard Titmuss (1970) perverse effects. For the quantity of donated blood, but it also donors in the USA not only reduced Health Organization in As a result of his work, the World reduced its quality. to ‘promote the development of national blood 1975 urged its member states donation of blood’ (Dawnay and services based on voluntary non-remunerated Shah 2005: 6). children from a nursery school causes parents ents who arrive late to collect their The payment reduces the guilt about arrivingto arrive late more often than before. a service. late, and parents treat the situation as if they are paying for trivial. Financial give tax relief to those who buy greener cars? The issues aren’t incentives can backfire. for total a social conscience and altruistic motivations, we exhibit consideration we will never strangers – and expect it in return. Giving tips in restaurants provided by the again visit is one example. But systematic evidence has been ultimatum game offer, offer, they divide the money accordingly; but if B rejects A’s accepts A’s says that player B should accept economics both players get nothing. Textbook with in thousands of trials around the world, any offer greater than zero. Yet (or less) of the total different stakes, people generally reject offers of 30 per cent and when the sum sum. The results hold even when the players are anonymous 2008: 2). involved is up to three months’ income (Lunn and Harford who made it to pay for an object is influenced by knowing what the workers of the whole enter- were paid. A union may be prepared to jeopardize the future And empirically we prise if it decides that the offered wages are too unfair. companies are paid find that unskilled workers in more profitable sectors or more than identical unskilled workers elsewhere. When textbook economics ignores our instinct for fair shares, it misses a critical element of many economic interactions. don’t. It has proved an intractable problem. But through a better understand- a better through But problem. an intractable proved It has don’t. (Thaler and Richard Thaler economist the behavioural psychology, ing of our the with a solution: 2004) came up Bernartzi The idea is that people commit a portion of their of their commit a portion is that people The idea
1 | What is economics? . Take two . Take framed What do you say? What do 23 How much does the ball cost? does the ball How much According to Kahneman (2002) most people answer 10 cents, including 50 per 50 per 10 cents, including people answer (2002) most to Kahneman According findings is that our preferences de- most interesting One of Kahneman’s Work such as Kahneman’s has inspired an entirely new area of economics, such as Kahneman’s Work are just With regard to bounded rationality, it is surprising that economists recognizes that With regard to bounded willpower, behavioural economics For example, suppose a bat and a ball cost $1.10 in total. The bat costs $1 costs $1 bat total. The in cost $1.10 a ball bat and a suppose example, For mathematically identical options and dress one up as a loss, and the other as mathematically identical options example, if the risk dressed up as a gain. For a gain, and we choose the one is expressed as a 10 per cent risk of dying, associated with a medical procedure is expressed as a fewer people will accept the procedure than when the risk et al. 1993). 90 per cent chance of living (Redelmeier cent of Princeton students! Even actuaries and researchers make similar errors. make similar and researchers Even actuaries Princeton students! cent of are poor $0.05 + $1.05 = $1.10.) We the ball costs 5 cents since (The right answer: and our intuitive answers things, especially probabilities, at calculating some the likelihood of mundane things biased: we underestimate are systematically of frightening or exciting as we overestimate the likelihood happening, even – to the by the decisions of others are overly influenced We things happening. filling up with smoke, as long as there are point of sitting quietly in a room give undue (Darley and Latane 1968). We others in the room doing likewise and when making life decisions we systematic- weight to the most recent past, of the distant future. Nevertheless, we are ally underestimate the importance fact – of our ability to make judgements. confident – overconfident in in the way choices are pend on inconsequential differences called behavioural economics, which investigates what happens in markets in markets called behavioural economics, which investigates what happens Unlike in which some people display human limitations and complications. rational choice theory, behavioural economics allows human nature to be bounded willpower bounded in three ways: bounded (or limited) rationality, and bounded selfishness. understood this now catching on to the importance of framing – advertisers have how the decision- concept for years. They understand that choice depends on can be given to it. maker describes the object to himself and what associations the buyer’s decision Advertising attempts to frame the choice in a way that skews If the seller is successful, the buyer may no longer be in favour of the seller. that markets acting entirely in his own best interest. Instead of the presumption are off. will make everyone as well off as they can be, now all bets want to lose weight once we make a choice, we often fail to follow through. We An and exercise more. But it’s tempting to do all that tomorrow, not today. It is generally important example of this procrastination is saving behaviour. accepted that Americans should save more, and apparently they want to. But they more than the ball. more than 2.7 Behavioural economics 2.7 Behavioural . Marglin quotes the first-century Jewish Jewish quotes the first-century Marglin , 26 For a focused discussion of social cohesion and its economic benefits, see a focused discussion of social cohesion and For Dayton-Johnson (2001); for an interesting discussion of why and how eco nomics interesting discussion of why and how eco Dayton-Johnson (2001); for an consequences of this neglect, see Marglin (2008) has ignored community and the like an economist undermines community The Dismal Science: How thinking sage Hillel, who asked, ‘If I am not for me, who will be? And if I am only for be? And if I for me, who will ‘If I am not who asked, sage Hillel, the has lost the balance and I?’ His point is that economics myself, what am as atoms, Marglin than seeing individuals by Hillel. Rather tension expressed rela- particles that exist only in see individuals as subatomic suggests that we tion to other particles. unbounded selfishness. Starting with a view of the world that portrays society society portrays that the world view of with a Starting selfishness. unbounded universe their own little caring only about atoms each of individual as a bunch thinking. a bias in economic has created Suggestions for further reading
1 | What is economics? to magazine, when have blood know Prospect we altruistic What impact has this do out economists economists How (examples: (examples: to? crowd not results results can centres). 25 when Behavioural Behavioural and care perverse perverse day incentives incentives at professor: professor: produce produce incentives, fines your and financial financial for late that financial use donors, behaviour, behaviour, shown Note how often the notion of community ties comes up in our commentary. Note how often the notion of community ties comes up in our commentary. Question Question Whether this new psychological realism will revolutionize the subject remains Whether this new psychological realism will revolutionize the Of course, it’s not hard to find behavioural economists who disagree with Of course, it’s not hard to find behavioural economists who In a detailed analysis of twenty-five principles and intermediate-level micro- In a detailed analysis of twenty-five It features in the critiques of unlimited wants, efficiency–equity trade-offs and to be seen. Either way, it certainly provides a nice segue into our next chapter to be seen. Either way, it certainly provides a nice segue into on methodology. September 2008.) Marglin feels that ‘if the research agenda of behavioural of behavioural September 2008.) Marglin feels that ‘if the research agenda might well be economics were to be carried through unflinchingly, the results who has had devastating for the self-interested, utility-maximizing individual separate discipline’ the leading role in economics since its emergence as a (2008: 5). 2.8 Concluding comment 2.8 Concluding The impact of behavioural economics on the mainstream economics on the The impact of behavioural this assessment. (See the interesting debate between Pete Lunn, a behavioural Lunn, a behavioural this assessment. (See the interesting debate between Pete economist, and Tim Harford, a mainstream economist, in economic textbooks used at thirty of the world’s most prestigious universities, economic textbooks used at thirty no reference at Lombardini-Riipinen and Autio (2007) found that ten made 1 per cent of total all to behavioural economics, while six dedicated less than conclude that the pages to it, and another six between 1 and 2.6 per cent. They (2005: and Wells analysed textbooks appear to share the opinion of Krugman who thinks that 244), who state: ‘But it’s hard to find a behavioral economist The theory of the her field should replace the analysis of utility maximization. analyze consumer rational consumer remains the main way that economists behavior.’ research had on mainstream economics? The answer is: not much. Nowadays, answer is: not much. Nowadays, mainstream economics? The research had on somewhere mentioning behavioural economics most textbooks contain a box – but they are treated as exceptions that prove and describing a few ‘anomalies’ have a desire to for example, bounded selfishness: individuals the rule. Take, economists argue that this desire can’t be that do the right thing. Mainstream pollution problem and no overfishing. Or take strong or there would be no economists argue that these cases are of lim- bounded rationality: mainstream outcomes will be less sensitive to these anomalies ited relevance and that market of a few students in a laboratory. than is suggested by the behaviour Next, Crusoe meets Man Friday, who also fishes and gathers coconuts. Man Friday is less productive at both tasks, but especially at gathering coconuts; when 2 | Introducing economic models it comes to fishing he is only slightly worse than Crusoe. Having met, should they continue to work in isolation? Since Crusoe is more efficient in everything, could it be in his best interests to continue to go it alone? It turns out that specialization and exchange (trade) can benefit them both. ‘Whether you can observe a thing or not depends on the theory It doesn’t matter that Crusoe is more efficient (or has an ‘absolute advantage’) which you use. It is the theory which decides what can be ob- in producing both fish and coconuts. Crusoe should spend more time gathering ' served.’ Albert Einstein coconuts (at which he is much better), and Man Friday should spend more time ‘Economics is the science of thinking in terms of models joined fishing (at which he is only a little worse). Such an arrangement will increase to the art of choosing models which are relevant to the contem- their total production of fish and coconuts. porary world.’ John Maynard Keynes( Having established the benefits of trade in this context, individuals are replaced with countries. In this way the gain from international trade is put on the same footing as the gain from interpersonal trade. Since the latter must be 1 THE STANDARD TEXT beneficial as long as both individuals engage in trade voluntarily, we may be lulled into thinking that trade between nations is similarly unproblematic. 1.1 Model building and model testing We take up the story at this point assuming two countries (England and Science is a method – a process of forming hypotheses, making predictions and Canada), two industries (wheat and cloth) and one factor of production, labour. testing the predictions against the facts. Sometimes a hypothesis will emerge from This parallels the demonstration of comparative advantage by David Ricardo in inference: looking at the world and making a generalization about it. Sometimes it 1817, and for that reason is often called the Ricardian model of trade. will emerge from a process of deduction: thinking about the world in a systematic way. Usually deduction involves trying to separate what is essential about a Comparative advantage and the gains from trade Suppose that one unit of labour problem from its irrelevant details. When we do this, we have created a simplified can produce 5 bushels of wheat or 10 yards of cloth in England; whereas one unit version of reality, or a model of reality. Thus, building models necessarily entails of labour can produce 100 bushels of wheat or 50 yards of cloth in Canada. These making assumptions that are unrealistic – otherwise they wouldn’t be simplifying. data are shown in Table 2.1 below. The point is that if a model makes good predictions, then that aspect of reality which is ignored (or simplified away) did not significantly affect the outcome. table 2.1 Labour’s productivity in England and Canada Therefore, it is inappropriate to judge the usefulness of a model by the realism of its assumptions; the only relevant test is the accuracy of the model’s predictions. One unit of labour can produce: Opportunity cost of 1 yard of cloth Having established this, most texts then illustrate the notion of model Wheat Cloth building by presenting several different models – one of which is invariably the (bushels) (yards) production possibility frontier. England 5 10 ½ a bushel of wheat 1.2 Examples of economic models Canada 100 50 2 bushels of wheat The production possibility frontier (PPF) The production possibility frontier model has several uses. Besides providing a visual illustration of the contrast between Clearly, Canadian labour is more efficient in both industries; so Canada has efficiency and inefficiency, it also illustrates opportunity cost and the inevitability an absolute advantage in both. But England has a comparative advantage in the of trade-offs. Many textbooks begin their presentation with a Robinson Crusoe production of cloth. This simply means that the opportunity cost of producing situation: Crusoe on his desert island has to divide his time between two cloth is lower in England than in Canada. activities, fishing and gathering coconuts. Devoting more time to fishing implies In particular, it takes one tenth of a unit of labour to produce 1 yard of cloth less time for coconuts; the opportunity cost of one more fish is the number of in England. But one tenth of a unit of labour could have produced half a bushel coconuts forgone. of wheat in England. Thus, the opportunity cost of a yard of cloth is half a bushel
27 28 100 50 CANADA 100 30 100 Cloth (millions of yards) 2.2 possibilities Expanded consumption ENGLAND figure
50
100 Wheat (millions of bushels) of (millions Wheat + 500 + 500 2.2 in world output Changes World output increases as a result of each country specializing a little more of each country as a result specializing a little more output increases World itself? most of the benefits for one country seize Could It is possible, depend- its opportunity of each good is determined by cost. trade, the price Before limited to what each nation possibilities are trade, consumption Without in that commodity in which it has a comparative advantage. Since world output advantage. world output Since it has a comparative in which in that commodity it is clear that mutuallyincreases, beneficial trade is possible. is exporting cloth, the higher England trade. Since ing on the terms at which they benefits (and the less England wheat) the more of cloth (in terms of the price must gain countries both trade is voluntary, Canada benefits). But as long as them to trade at all. something to induce of cloth is half a bushel of wheat. of a yard the price It will in England export So, than that. of a yard it can get a better price In Canada the price cloth providing of cloth is 2 bushels of wheat. It will import cloth if it can pay less than English illustrative purposes, suppose they 2 bushels of wheat per yard of cloth. For they both where halfway a price on a price settle between the two extremes, 1 bushel of wheat. of 1 yard of cloth for a price benefit equally: possibilities, however, the consumption expands Trade itself. for can produce their expanded both nations have 2.2. Since out to the dotted lines in Figure of trade, or so it a result better off as possibilities, both nations are consumption is claimed. England Canada Wheat (bushels) - 500 + 1,000 Cloth (yards) + 1,000 - 500 table world
2 | Introducing economic models 100 comparative comparative CANADA 50 50 100 ernational trade causes ten units of ernational trade causes ten units of illions of yards) 29 Cloth (m Cloth 100 ENGLAND 50 2.1 and Canada in England Wheat and cloth production figure
50 25
in cloth. Both countries will benefit by specializing according to their to their willspecializing according Both countries in cloth. by benefit 100 Wheat (millions of bushels) of (millions Wheat Suppose that England has 10 million units of labour. Devoting all its labour to all its labour to Devoting has 10 millionSuppose that England units of labour. production per Assume that Canada has 1 million for units of labour available international trade causes 100 units of labour to Suppose that in England England’s lower opportunity it has a of cloth means that lower cost England’s wheat production, it could produce 50 million bushels. Alternatively, if it devoted if it devoted 50 million produce bushels. Alternatively, wheat production, it could 100 millionall produce yards of cloth. We its labour to cloth production it could the two 2.1 and connect panel of Figure in the left-hand plot these two extremes production possibility current points with a solid straight line to show England’s assume constant output per unit of labour input, (PPF). As we the PPF is frontier along it. anywhere choose to produce could England linear. 100 million produce bushels 2.1, Canada could back to Table month. Referring of wheat and no cloth, or 50 million yards of cloth and no wheat. Joining these shown in the right-hand production possibility frontier, points yields Canada’s in in the commodity a little more 2.1. If each country specializes panel of Figure advantage, then totalwhich it has a comparative world output of both goods will see how. Let’s be increased. wheat 2.1, English Table From out of wheat and into cloth production. move 1,000 yards by cloth output increases 500 bushels and English by output falls suppose that int per month. In Canada, let’s labour to move out of cloth and into wheat production. As a result, Canadian out of cloth and into wheat production. As a result, Canadian labour to move by 500 yards, and Canadian wheat output increases by cloth output decreases the result. 2.2 summarizes 1,000 bushels per month. Table of wheat in England. Following the same logic, the opportunity cost of 1 yard of logic, the same Following the opportunityEngland. in of wheat of of 1 yard cost of wheat. Canada is 2 bushels cloth in advantage comparative advantage. This can be demonstrated using production possibility advantage. possibility demonstrated using production This can be comparative frontiers. to their of going we are accuracy course, relative this 32 . Mankiw et al. (2002: 32) claim that this the In Her key point is that the textbook method- Her key point is that the textbook by ) use a minimum wage increases unemployment among a minimum wage increases unemployment among to professor: models your for which predictions? decide Question about Nearly all textbooks claim widespread agreement among economists Further, the textbooks fail to clarify the comparative nature of model testing. nature of model comparative fail to clarify the the textbooks Further, test of predictive power to the consistently apply the Why don’t the textbooks and her associates in many papers and This is the view taken by McCloskey young workers and low-skilled workers proposition was endorsed by 79 per cent of economists – a number they call ‘an overwhelming majority’. Let’s consider this purported consensus. There have 2.3. been three surveys published, the results of which are contained in Table non-normative economic questions. Many cite a 1992 survey for support. For for support. For non-normative economic questions. Many cite a 1992 survey 10 econ- and Bade (2006: 14) claim that ‘at least 7 out of every example, Parkin omists broadly agree’ that: ology does not actually describe how economists go about doing economics. ology does not actually describe rhetorical art, an McCloskey, economics isn’t really a science; it’s more a For people is to art of persuasion. And one of the techniques used in persuading talk about ‘testing cloak economics in an aura of science. Economics textbooks them authority. hypotheses’ – it makes economists seem impartial and gives about predictions But because the story is a fiction, textbooks quickly forget telling persuasive and hypothesis testing, and get back to their main business, begin by investigating the limits parables. Let’s look at this in more depth. We of predictive power and hypothesis testing in economics. 2.2 up to be isn’t all it is cracked power Predictive subsequent chapters. Rarely is any evidence presented to back up a model’s model’s up a to back presented evidence is any Rarely chapters. subsequent evidence. of a systematic consideration let alone predictions, alternative relative to an model performs how well a issue is always The real set relative to an alternative one set of assumptions performs model; how well model will not be abandoned In practice, a poorly performing of assumptions. dif- don’t mention Textbooks an alternative that can do better. unless we have with model selection. ficulties associated answer is that predictive power isn’t all it’s models they present? One possible may be fine in the natural sciences, such as cracked up to be. Predictive power social science like economics, where there are so physics or chemistry, but in a to control, it simply doesn’t give us conclusive many variables that are impossible restrict ourselves to talking about things that we answers. Consequently, if we have nothing (or very little) to say. can statistically test, then we’d books spanning twenty-five years.
2 | Introducing economic models . dem- . For . For . A . A , which focuses , which focuses normative economics positive economics positive 31 a ceiling on rents reduces the quantity and quality of the quantity and quality of reduces on rents a ceiling ; and more than 80 per cent of economists agree with the state- agree of economists cent than 80 per ; and more tested against the facts. Instead, predictions about the benefits tested against the facts. Instead, predictions about the benefits to be. This involves making value judgements, often involving ques- judgements, often involving making value to be. This involves tariffs and import quotas usually reduce general economic welfare economic general tariffs and import reduce quotas usually not by the model. This lack of testing can perhaps be forgiven in such ought minimum wages increase unemployment among young and unskilled workers unemployment minimum wages increase Positive economics occupies most of the time and effort of the economics most of the time and effort of the economics occupies economics Positive Textbooks emphasize that models cannot be judged by the realism of their Textbooks On the other hand, economic models can’t be used to shed light on how the used to shed light on how the be models can’t On the other hand, economic is a public perception there why explain use this distinction to help Textbooks Having illustrated importantHaving several the the use of models, through concepts ment profession. Textbooks claim normative issues lie outside the scope of economics. of economics. issues lie outside the scope claim normative Textbooks profession. ought to be. That is there (or equity) cannot say how much fairness Economics ultimately a political decision. similar percentage agree that agree similar percentage housing available among deal of consensus is a great that there argue, This shows, textbooks issues. – on positive of fact on questions economists assumptions, but only by the accuracy of their predictions. Yet in this chapter of in this Yet assumptions, but only by the accuracy of their predictions. and their predic- the typical mainstream textbook several models are presented tions are tions of fairness or equity, and is the subject matter of or equity, tions of fairness world other citizens, like Economists, among economists. disagreement of widespread issues. But normative over they often disagree values; therefore different have claim statistics analysis, textbooks issues decided by and economic on positive cite the survey by textbooks many example, For consensus. is widespread there with the agree of economists per cent Alston et al. (1992) which finds that 93 statement: on the way the world actually works; it can help us to determine whether positive us to determine whether positive world actuallyon the way the it can help works; in ‘an increase example, statements, For or statements true or false. are about fact, is and unskilled young workers’ for willthe minimum wage unemployment increase statement.a positive be true, but it is still It may not statement a positive far in so the empirical evidence. appealing to by or confirmed as it can be refuted the statementexample, ‘there people in rich developed should be no homeless statement is a normative be tested by based on values – it cannot countries’ appealing to empirical evidence. typical textbook now emphasizes that models can be used only to shed light on on only to shed light can be used that models now emphasizes typical textbook matter of This is the subject of fact. questions of specialization and trade (for example) are stated as if they have been onstrated an early chapter of a textbook. But this same omission continues throughout 2.1 fudge methodology their own Textbooks 2 THE ANTI-TEXT 2 THE 1.3 economics and normative Positive
+
. published results – that is, McCullough et al. (2006) and - replicating 34
, influence the result.
Finally, a statistical result may be dependent on a very particular time period. Finally, a statistical result may recapitulate, results may not be To These are examples of non-robustness. It’s not just differences in research design which can lead to different results. It’s not just differences in research design which can lead to The point is that in practice hypothesis testing is problematic. It relies It relies The point is that in practice hypothesis testing is problematic. On top of this, there are well-known statistical pitfalls to avoid. If the data pitfalls to avoid. If the data there are well-known statistical On top of this, The minimum wage debate became surprisingly heated given how little is at The minimum wage debate became surprisingly heated given It may be that addition or deletion of observations changes the result. It may be that addition or deletion of control variables; or seemingly trivial dif- robust to: slightly different choices variable is measured; or seemingly equivalent ferences in how any given control pitfalls; or slight changes in the data period. ways of correcting for statistical Indeed, in the case of the minimum wage proposition, all these small decisions Indeed, in the case of the minimum wage proposition, all these teams consistently evidently did affect results to such an extent that different being reduced found different results, leading to apparently serious economists to name-calling. using exactly the same data, exactly the same definitions and exactly the same using exactly the same data, exactly the same definitions and as those published.statistical procedures, they could not arrive at the same results is an essential component of scientific methodology, and is the only Replication are results seldom way to create a defensible, coherent body of knowledge. Yet in empirical eco- replicated. They note: ‘It is widely recognised that errors occur results … suggest nomic research and appear in published empirical articles. Our that such errors may be quite common’ (ibid.: 600). Dewald et al. (1986) had great difficulty McCullough and Vinod (2003) suggest that things have not improved. McCullough and Vinod (2003) suggest that things have not as econometrics on a combination of economic theory and statistics known for falsification of and ‘econometrics … has not been able to deliver as a tool have illustrated this point using the minimum theories’ (Hahn 1987: 110). We wage controversy, but there are many, many more. hypotheses is not an easy matter. For the minimum wage proposition, other other wage proposition, the minimum For matter. an easy is not hypotheses and un- of young the unemployment wages affect besides minimum things for, taken be ‘controlled’ need to other influences workers, and these skilled leavers of school for the number we need to control example, For into account. of the and for the overall state market searching for jobs, entering the labour A full And so on, and so on. we are in a recession or boom. economy, whether and measuring, and the choices needs choosing, defining set of such controls the result. we make may influence properties, it is possible to erroneously find sig- don’t have certain statistical add to the difficulty, there To is none in reality. nificant evidence where there avoid such pitfalls, and the choice of method may be more than one way to may stake – a prediction of the standard textbook competitive model of the labour market, which, as we’ll see in the next chapter, requires many highly unrealis- tic assumptions. It is astonishing that so many economists are so committed
2 | Introducing economic models
, attributed this * . Industrial Relations 33 Myth and Measurement 2.3 increase wages ‘minimum proposition: with the in agreement Percent : * Kearl et al. 1979; † Alston et al. 1992; ‡ Fuller and Geide-Stevenson 2003 et al. 1979; † Alston et al. 1992; ‡ Fuller : * Kearl From Table 2.3 we see that to get 79 per cent agreeing with the minimum 2.3 we see that to get From Table trend: a decline Comparing the results of the three surveys, we see a clear of Card, Katz, This breakdown of consensus almost certainly reflects the work Some idea of the tone of the debate can be had by noting that Valentine (1996) Valentine Some idea of the tone of the debate can be had by noting that is that one A feature of the debate, key for our discussion of methodology, What does searching for a ‘robust’ equation mean? The point is that testing Note Disagreed 10 20.5 26.5 20.5 Generally agreed Agreed with provisos 10 Disagreed 22 68 22.4 56.5 27.9 45.6 1979* 1992† 2003‡ 1992† 1979* unemployment among young and unskilled workers’ and unskilled young among unemployment wage proposition on the 1992 survey, one must add the ‘generally agree’ category wage proposition on the 1992 is a bit of a liberty, isn’t it? What if This to the ‘agree with provisos’ category. example, of the minimum wage increase? For the proviso is related to the size would increase youth unemployment, but a a doubling of the minimum wage If that were the proviso then the economists 20 per cent increase would not. hold ‘heretical’ beliefs. They are not singing who ‘agreed with provisos’ would the textbooks because (as we will see in the next from the same hymn book as wages would chapter) the textbook prediction is that any increase in minimum the provisos are, we increase unemployment. Since we really don’t know what simply shouldn’t group the two categories. in the percentage of in the percentage of those who generally agreed and a rise at all, they show the those who disagreed. If these three surveys show anything proposition. breakdown of consensus with regard to the minimum wage which apparently Krueger and others, much of it published in the early 1990s, positive impact on showed that minimum wage increases often have a zero or debate, discussed employment. These results have been the subject of a ‘lively’ in Card and Krueger’s 1995 book accused Card and Krueger (1994) of practising ‘politically correct’ economics, accused Card and Krueger (1994) of practising ‘politically their part, For and of deliberately using suspect data in one of their studies. results contrary Card and Krueger present evidence of ‘publication bias’ against to textbook conventional wisdom (1995: 186). from another team. team of authors would consistently find results different David Levine, editor of the Berkeley journal phenomenon to ‘author biases’, which he diplomatically defined as ‘conscious or unconscious biases in searching for a robust equation’ (2001: 161). jWXb[ a could can result framed, was negative any rejected? 36 Since hypothesis a way the categorically professor: on be your ever blamed for be hypothesis always McCloskey is only one of many who have pointed out the limitations of limitations of McCloskey is only one of many who have pointed out the Rhetoric literally means effective communication. So, McCloskey means out of the question. To conduct a test, a complete model of supply, demand, and demand, supply, of model a complete a test, conduct To of the question. out to derive a quantitative and used be specified, estimated, must price adjustment actual moves. Then price which the market-clearing of the speed at measure that is one of the ways norm. This … compared to this can be price movements of But, and wages are sticky. have demonstrated that prices econometricians on the validity of the many main- demonstration is conditional course, any such So any such finding is used as the framework for estimation. tained hypotheses (Ibid.: 7) open to dispute. any hypothesis ‘is insulated by the ancillary McCloskey (1983) agrees that substance of most scientific disagreement: This is no mere possibility but the not solved the identi- experiment was not properly controlled’; ‘you have ‘Your an equilibrium model when a disequilibrium fication problem’; ‘you have used is relevant’. And even if the one hypothesis (monopolistic, 500 equation) model probabilistic nature of hypotheses, most in question could be isolated, the makes crucial experiments non-crucial: chance is the ally in economics, especi falsificationism. (Ibid.: 487) ever present alternative … that spoils belief that false (McCloskey uses the word ‘falsificationism’ to refer to the Question hypothesis testing (and predictive power) as criteria for model selection. Where official or explicit she is unique is in labelling this methodological approach the methodology, an methodology and in claiming that economists have another the chief dif- unofficial or implicit one, that is far more effective. Furthermore, abandoned their ficulty with economics in her view is that economists haven’t their She thinks economists need to consciously embrace official methodology. McCloskey calls this unofficial methodology implicit (unofficial) methodology. ‘the art of rhetoric’. something very broad and encompassing by the art of rhetoric: she means any hypotheses necessary to bring it to a test’. (Treat ‘ancillary’ and ‘auxiliary’ as hypotheses necessary to bring synonyms.) She goes on to say: – methods. hypotheses will be rejected through econometric – or statistical could resolve all At a deeper level it is the notion that an appeal to evidence theoretical disputes.) 2.4 Economics is the art of rhetoric
2 | Introducing economic models and in replicate even McCullough exists about the effect the effect exists about confidence can’t have (1986); consensus we al. can et (2006)]? 35 economists How al. Dewald et when [see professor: results McCullough your results test for (2003); other’s Vinod each econometric Question propositions of any theoretical framework According to Lakatos the central negative evid- The auxiliary assumptions provide a protective belt because prediction The minimum wage prediction isn’t even a particularly difficult If a theory makes no prediction other than that prices move less rapidly than [competitively determined] prices, econometric testing is almost (but not quite) But wait … should we really be surprised by this? Many years ago Imre Lak- we really be surprised by But wait … should are surrounded by what he termed a ‘protective belt’ of ‘auxiliary assumptions’ are surrounded by what he termed example, in the minimum wage that prevent them from being refuted. For standard textbook case the central proposition that is being tested is that the empirically accurate competitive model has empirical validity – that it is an gives rise to testable portrayal of how actual markets function. This proposition assumptions predictions; one is the minimum wage prediction. The auxiliary control variables are involved in testing this prediction include: that the correct pitfalls are selected; that they are measured in the correct way; that statistical properly corrected; and that there are no errors in the computations. that the auxiliary ence can be discounted by the true believer on the grounds damning piece of assumptions didn’t hold: the authors of some particularly that led them to empirical research must have made poor decisions or errors latent, waiting fail to identify the true minimum wage effects that are surely be consoled by the to be discovered. A true believer taking that view would evidence. occasional appearance of a paper that seems to uncover such task – trying to test. Blinder et al. (1998) faced an altogether more challenging for why to evaluate the relative merits of models offering different explanations (a phenomenon prices aren’t instantaneously determined by supply and demand known as price stickiness). They say: atos (1978) explained that we should expect this to be the case – at least the this to be the case – at least that we should expect atos (1978) explained part. ‘incapable of refutation’ of minimum wages! It is almost as if the minimum wage proposition is believed wage proposition is believed It is almost as if the minimum of minimum wages! faith and is incapable of refutation. as an article of 2.3 incapable of are refutation propositions Core to believing in the empirical relevance of this model that they feel extreme extreme feel that they model of this relevance empirical in the to believing writers (or textbook challenged. Indeed, are when its predictions discomfort so much apparently feel the textbooks) who adopt professors the economics that a to assert that they continue discomfort he he as if as if 38 a folksy way of talking about This is just convince They shouldn’t literary devices. … are mere Consider the world champion pool player. He intuitively makes excellent excellent He intuitively makes pool player. Consider the world champion responses may Of course, there are other difficulties with surveying people: If economists could start their theorizing process from axioms – from axioms – from If economists could start their theorizing process from understood the laws of physics without realizing that he does – has exerted a understood the laws of physics without realizing that he does helps to explain powerful influence over the imagination of economists and economic behaviour their extreme scepticism that anything can be learnt about by asking people. anyone of anything. But McCloskey is right when she says that they do. They when she says that they do. But McCloskey is right anyone of anything. consider the example, For influence over the imagination. can exert a powerful choice. In Chapter 1 we explained used to explain individual fundamental model cost to the point where marginal should be undertaken up that all activities model by going out and asking benefit. Why don’t we test this equals marginal make their decisions? Of course, few would even people whether that’s how they alone affirm that they operate like that. But not understand the concepts, let – originated by Milton Friedman (1953: 21) – that to worry; we have an analogy analogy. This is the pool-player explains the problem away. angles, rotation of spheres and friction, use of the laws of physics concerning On the pool table, he acts intellectually. without understanding them write a computer program could probably We understands the laws of physics. that might do an excellent job of predicting utilizing all these laws of physics if you ask the pool player, you would find he the pool player’s next shot. But this doesn’t affect the predictive power of didn’t understand those laws. Yet our computer model. people may have no be sensitive to the precise wording of the question; and But the pool-player analogy – he acts incentive to respond truthfully. What about thought experiments? economists to embrace? Let’s consider her list of rhetorical devices in more in more devices of rhetorical her list Let’s consider to embrace? economists detail. and metaphors Analogies model building and deductive thinking. This is nothing new. As we know, model model building and deductive thinking. This is nothing new. tested against the building can be useful – providing the predictions can be we end up with the evidence. If they are not tested, or if they can’t be tested, after page of professional eco- Leontief: ‘Page situation described by Wassily the reader from nomic journals are filled with mathematical formulas leading to precisely sets of more or less plausible but entirely arbitrary assumptions stated but irrelevant theoretical conclusions’ (1983: viii). tions that are self-evidently true – then we would hardly need to test the assump As long as we make no errors of deduction, the conclusions predictions of theory. are as sound as the axioms they are based on. But unfortunately, we don’t have axioms. Instead, as Alan Musgrave (1981) explains, there are really only two
2 | Introducing economic models / 37 Similarly, Robert Heilbroner praises aspects of McCloskey’s work: Heilbroner praises aspects Similarly, Robert of formal- What McCloskey wants economists to understand is that the language ‘rhetorical’. ism and mathematics is still a language, and therefore inescapably of judg- Moreover, it is a dangerous language in that it conceals the elements (1998: 39) ment and moral valuation that are an intrinsic part of economics. Similarly, Heilbroner disagrees with McCloskey that the chief difficulty with Similarly, Heilbroner disagrees with McCloskey that the chief But what is wrong with the unofficial methodology that McCloskey wants While praising different aspects of McCloskey’s work, the critics unanimously While praising different aspects of McCloskey’s work, the critics McCloskey’s critics universally agree that she has successfully described agree that she has successfully described McCloskey’s critics universally Of course, in engaging in this gentle art of persuasion economists use the persuasion economists use the in this gentle art of Of course, in engaging economics is that economists haven’t abandoned their official methodology. He methodology. economics is that economists haven’t abandoned their official off an obsolete says: ‘The deepest failure of economics is not its failure to shake and damaging rhetoric, but its failure to recognize the inescapably ideological character of its thought’ (1998: 42). disagree with her on a key issue: McCloskey feels that the unofficial method- disagree with her on a key issue: McCloskey feels that the example, Hahn For ology is appropriate and fruitful, whereas her critics do not. cranks and mad- worries that ‘… without rules a chasm opens up in which and open-minded men will frolic. McCloskey … invites us to engage in honest has little to say’ conversation but on the grammar of this conversation [s]he (1987: 111). In other words, Heilbroner agrees with McCloskey that so-called positive eco- In other words, Heilbroner agrees with McCloskey that so-called a normative nomics – even when it’s phrased in mathematical terms – contains base. This is a point we’ll come back to later in the chapter. the unofficial methodology that economists actually use – that economists are the unofficial methodology that ‘McCloskey has example, Hahn says: For persuaders, not hard-nosed scientists. economic discourse is primarily rhetorical and no difficulty in showing that demonstration of the use of instance [s]he gives convincing not scientific. For to be formal arguments by Samuelson, [s]he “literary devices” in what appear nature of well known propositions, and [s]he has documents the metaphorical 110). a masterly chapter on the rhetoric of significance tests’ (1987: full range of rhetorical devices. They use analogies (or metaphors), thought ex- (or metaphors), thought devices. They use analogies full range of rhetorical and appeals to authority. experiments, historical precedents periments, natural methodology – predictive power argues that the official Moreover, McCloskey rhetorical. Such tests are ornamental, designed and hypothesis testing – is also solely on such tests, however, would Relying to give an argument more authority. be sterile and antiquated. form of reasoned argument. It is ‘the art of probing what men believe they ought ought they men believe what probing art of It is ‘the argument. of reasoned form warrants what really reasons, finding discovering good the art of to believe; it’s argued ‘all it means is it like this: she put (ibid.: 484). Recently, assent’ et al. every time’ (Klamer not slam dunks evidence are the proofs or and that 2010: ch. 1). are
'& which econometrics, and on shared by members of a right rely are can’t world-view we 40 If hypotheses doesn’t appear in most economics textbooks, it is which professor: with McCloskey’s unofficial methodology The problem paradigm your anal- the context of the pool-player discussed surveys in We determine for we can wrong? how While the word Question Thomas Kuhn (1962), who gave the word ‘paradigm’ its contemporary mean- One reason mainstream textbooks don’t mention the word ‘paradigm’ is that One reason mainstream textbooks don’t mention the word ogy, and we discussed the use of controlled experiments in Chapter 1. We saw of controlled experiments in Chapter 1. We ogy, and we discussed the use economists have had a limited impact how the experiments of the behavioural view continues to be that we should observe on the mainstream. The majority (not what they say they do, or what they do what people actually do in markets model that behaviour theoretically, and test in laboratories); then we should the model econometrically. is that it offers nothing new that is useful. In particular it offers no solution is that it offers nothing new positive economics. The only difference is to the difficulties of doing so-called and the rhetorical that McCloskey is more honest about the tricks of the trade, to recognize the devices used to persuade. As Heilbroner points out, she fails inescapably ideological character of economic thought. a simple and important concept: it is the 2.5 and ideology Paradigms Prize winners in economics support the points we make. In this, we are no are no this, we In we make. points the support in economics winners Prize of view earth-centred their justifying astronomers medieval from different Scriptures. or the Holy of Aristotle to the authority by appealing the universe progress. We of scientific the march didn’t impede those appeals Thankfully, to authority readers should take appeals In other words, either. hope ours won’t to show you that we’re not making salt. The reason we do it is with a pinch of this up. left? is else What McCloskey in a nutshell ing, argues that paradigms are a kind of necessary indoctrination – necessary scientific community. It defines what is to be investigated and the methods and scientific community. a paradigm refers to abstractions that are regarded as legitimate. In a nutshell, a coherent ‘school of thought’. exclusively within they don’t mention alternative schools of thought. They teach it’s not the only one. the dominant paradigm called neoclassical economics. But paradigms you could ask your professor about alternative economic Perhaps and how their view of the world differs from the textbook view.
2 | Introducing economic models . important differences in criterion to distinguish the criterion to distinguish were either side of the state boundaries
objective we quote economists more celebrated These are unique historical events such 39 especially 2010) believes nat- McCloskey (Klamer et al. economists do this all the time to sound Yes, Anti-Textbook As the controversy surrounding this article shows, natural experiments do As the controversy surrounding this article shows, natural This sounds impressive. But before we get carried away, consider McClos- This sounds impressive. But than ourselves to bolster our arguments. We mention approvingly when Nobel mention approvingly when than ourselves to bolster our arguments. We more persuasive. In this not eliminate the need to choose and measure the relevant set of control vari- not eliminate the need to choose and measure the relevant So, it is not at ables, nor do they eliminate the need to avoid statistical pitfalls. econometric all clear what advantage natural experiments have over everyday hypothesis testing. This natural experiment is precisely what Card and Krueger’s 1994 article was This natural experiment is precisely In particular, the about – and this article turned out to be very controversial. critics of Card and Krueger (1994) contend there state boundaries: in the operating environment of firms on different sides of example, and in the way in which wages were reported and therefore taxes, for measured. key’s other example of a natural experiment: in the early 1990s the state of experiment: in the early 1990s the state of key’s other example of a natural wage relative to neighbouring Pennsylvania. New Jersey raised its minimum natural experiment since both states had similar This is a potentially attractive – economic and social structures ural experiments are often the most persuasive arguments economists have. She arguments economists have. are often the most persuasive ural experiments pandemic in India that eliminated 10 per cent talks about the 1911 influenza a decrease in the supply of labour, which the of the labour force. This caused would lead to increased wages. According textbook competitive model predicts is borne out. to McCloskey the prediction as the transition to a market economy in former communist countries. But countries. But as the transition to a market economy in former communist so well because it these are the most problematic of all. Is China progressing the problems Were embraced markets, or because it gave them so tight a rein? because it moved with the Russian transition from communism in the 1990s else altogether? too quickly to a market system or too slowly, or something and amassing Evaluating such questions is really an art, requiring in-depth study situation specific. a ton of evidence. And in the end the conclusions could be Then what about historical precedents? What about appeals to authority? types of assumptions in economics: ‘negligibility’ assumptions – which ignore ignore – which assumptions ‘negligibility’ in economics: of assumptions types assumptions and ‘domain’ our thinking; that clutter up minor details irrelevant Musgrave makes theory. of a given range of applicability determine the – which The trouble the two types. often confuse economists case that a convincing distinction is there is no with Musgrave’s two types. experiments? What about natural all per- that neoclassical of ideological accepted or view generally perspective is world- 42 It ideological particular a the professor: is your reflect What for economics? spective. paradigms Question If values necessarily pervade any paradigm in the social sciences, how does a the social sciences, how does pervade any paradigm in If values necessarily with which neoclassical economics is What is the ideological perspective could have taken an approach that It’s not the only possible approach. We another approach is taken by David George (1996). He analyses care- Yet economics. There we see how values creep in the moment we focus on indi- focus we the moment in creep how values we see There economics. or than the corporation agent, rather economic as the most important viduals as equal – the all wants we define creep in the moment They the community. They creep luxury yacht. want for a larger diet and the a subsistence want for and values to mere preferences. we reduce ethical judgements in the moment or of researchers ‘consciously we have seen how the values And in this chapter affect their research results. unconsciously’ An is that it doesn’t differ much. from an ideology? The answer paradigm differ world works, especially as applied to politics. It ideology is a view of the way the bodies and the possibilities for change. It em embodies a view of human nature good and bad. Different political ideologies value judgements about what’s of thought in the social sciences. So, one might give rise to different schools fundamental than the paradigm it gives rise to. argue that an ideology is more is necessarily infused with an ideological But the point is that any paradigm perspective. argue that it is possible to that’s what this book is about. We infused? Well, economics from the textbook presentation of infer the values of neoclassical the lack of emphasis the subject: from the emphasis given to certain topics and that are never given to others, from the unsupported claims, from the questions of faith and can asked, and from the propositions that are believed as articles never be refuted. the roots of neo- traces the intellectual history of ideas and pointed out that liberals – to classical economics go back through Adam Smith to the classical fundamental values John Locke and then later to John Stuart Mill – and their of private property, of individual responsibility, freedom of choice, the sanctity economics and minimal government interference. In other words, neoclassical and nineteenth cen- is aligned with a political philosophy that in the eighteenth conservative. turies was called classical liberalism and today would be called practices of fully the language used in textbooks. He says: ‘it is the rhetorical convey a conserva- introductory texts more than it is the “received theory” that example, some textbooks tive (or “classical liberal”) world-view’ (ibid.: 28). For but private emphasize the opportunity cost associated with public spending,
2 | Introducing economic models 41 – his macroeconomic explanation for the Great – his macroeconomic explanation for the Great 2.3 of reality perceptions Different figure The General Theory In the figure on the left, do you see the young woman looking over her right shoulder? her right shoulder? woman looking over on the left, see the young In the figure do you on the right, figure see the older woman looking down towards the left? In the Or do you prin- upside down, one sees the beautiful one sees the old hag; viewed way, one viewed some with the same reality, this. Confronted paradigms operate just like way, In a cess. while others see the opposite capitalist economy; a free-market the benefits of perceive the costs. perceive and predominantly … from The composition of this book has been … a long struggle of escape ual modes of thought and expression. The ideas which are here expressed habit difficulty lies, so laboriously are extremely simple and should be obvious. The … into every not in the new ideas, but in escaping the old ones, which ramify 1936: viii) corner of our minds. (Keynes see. And reality What we are trained to see influences what we actually do Think back to Chapter 1, to the fundamental building blocks of textbook can be perceived in many different ways, as Figure 2.3 illustrates. Furthermore, can be perceived in many different ways, as Figure 2.3 illustrates. free. While main- no paradigm – especially in the social sciences – can be value and claims to avoid stream textbook economics claims to be a ‘positive’ subject, Values scrutiny. value judgements, the claim hardly stands up to the most casual inevitably creep into so-called positive economics, since our values determine the questions we ask, the data we use, and the way we conceive the problem. because research needs rules. It is difficult enough to push forward the frontiers because research needs rules. It is difficult enough to push upon whichof science without always questioning the fundamental assumptions obvious drawback: it is based. While this provides an advantage, there is an thinking ‘outside scientists trained to think in a specific paradigm have difficulty he encountered had to say about the difficulties the box’. This is what Keynes writing of the 1930s: Depression 44 a ‘popular polemical untruth’. He said that the long-run gains from all forms of international That is a lot more imports than exports. No wonder there are persistent That is a lot more imports than exports. No wonder there '' But our comparative advantage model suggests that trade leads to an increase that trade leads to an increase advantage model suggests But our comparative case by assuming that England and Canada Further, the theory makes its important is Exchange rates are influenced by many things. One of the most Finally, free trade in the modern world is not so much about the free move- Finally, free trade in the modern world is not so much about econ- Samuelson is not your average This created quite a stir, because Paul Samuelson called the view that these industries. In reality, as Marglin (2008: 280) points out, the unemployment unemployment out, the points 280) (2008: as Marglin reality, In industries. these countries in both and whole communities geographically concentrated could be losses treats such economics Textbook non-viable. economically could become trade must gains from the permanent assumes that costs and as transitional and this is an empirical question, temporary losses. But necessarily outweigh of as costs the destruction empirical studies have not counted up to this point community ties. have that whoever is winning must of all goods. This means in total world output But if the compensation and still be better off. enough to compensate the losers of trade can be a more unequal distribution isn’t actually paid, then the result cost, it’s permanent. What weight should of income. This isn’t a transitional that free trade is necessarily good, textbooks we give this factor? In arguing don’t give it any. they will trade using money and they will need barter wheat for cloth. In reality, Canadian dollars at the going exchange rate. to convert English pounds and rate will be at the appropriate level such that What’s to say that the exchange just pay for its imports of wheat? England’s exports of cloth will advantage was international flows of capital. When the principle of comparative were of negligible discovered by David Ricardo in 1817, these flows of capital They allow a country like the importance. Now they are a dominant factor. Beginning at United States to run increasingly large trade deficits for decades. nearly $1 trillion in around $200 billion in 1997, these trade deficits ballooned to 2006. complaints in the United States about job loss to Mexico, China and India. complaints in the United States about job loss to Mexico, only now we’re not ment of goods as it is about the free movement of capital – capital: factories talking just about financial capital, we’re talking about real phenomenon is relocating abroad. One common term used to describe this that this did not offshoring. The neoclassical consensus – until recently – was that consensus has disturb the ‘result’ that free trade was beneficial to all. But (2000) and Paul been disturbed by recent arguments by Gomory and Baumol losses. Samuelson (2004) that offshoring could produce net economic wrote much of the omist. Winner of the Nobel Prize in economics in 1970, he canon of neoclassical theory. trade must more than offset the losses it is dead wrong about necessary this theory ‘can only be an innuendo. For surplus of winnings over losings’ (ibid.: 136).
2 | Introducing economic models the bene- demonstrate 43 Pugel argues that trade between industrialized countries is best explained Pugel argues that trade between industrialized countries better off, With regard to the larger claim that trade makes both countries Judging the theory on its own terms it is clear that trade produces winners and In his intermediate trade textbook, Thomas Pugel (2007) draws out some In his intermediate trade textbook, To illustrate their methodological approach in their introductory chapter the in their introductory chapter methodological approach illustrate their To by two ideas: on the demand side, consumers seek variety in the products they by two ideas: on the demand side, consumers seek variety decrease as output buy; and on the supply side, average costs of production in Chapter 5). It expands (a situation known as increasing returns, examined the output, the is the latter factor which makes history so important: the larger industries can also lower the costs of production. Getting a head start in these idea that you get confer a permanent advantage from ‘learning-by-doing’, the doing it. Of course, better at doing something the more experience you’ve had history doesn’t matter at all in the theory of comparative advantage. the In- Early in it is hard to know how to test such a proposition empirically. Britain used brute force to capture colonial markets and dustrial Revolution, voluntary, but it set to guarantee a supply of raw materials. Such trade wasn’t after colonialism a blueprint for ‘voluntary’ trading patterns that lasted long the United States, disappeared. Then in the nineteenth century, countries like fledgling indus- Canada and Germany erected high tariff walls to protect their would deny that this speeded up the tries against British competition. Few process of industrialization of these countries. losers. English wheat producers will be worse off as a result of the cheap foreign unemployment in competition, as will Canadian cloth producers. There will be testable predictions from the theory of comparative advantage. He argues that testable predictions from the are so similar – similar economic structures, since the industrialized nations likely have similar opportunity costs in produc- resources and technology – they But in expected to trade much with one another. tion. Thus, they would not be He says: ‘Over extensively with one another. fact industrialized countries trade countries go to other industrialized 70 per cent of the exports of industrialized advantage countries … These facts appear to be inconsistent with comparative theory’ (ibid.: 88). fits of specialization and trade. We suggest you treat the model as a rhetorical suggest you treat We fits of specialization and trade. to support it. Moreover, the assumptions device, since no evidence is presented its applicability to an era long since past. it uses restrict the domain of textbooks present the theory of comparative advantage and the theory of comparative advantage textbooks present expenditures would never be characterized as a diversion of real resources from from resources of real as a diversion be characterized never would expenditures up’ by the resources ‘used about the 30). Some talk sector (ibid.: the public the gov- them, and about benefit from citizens get no as if the government, going government an authoritarian which suggests ‘imposing’ taxes, ernment will. against the popular 2.6 advantage Evaluating comparative 3 Chapter perfectly a prac- in of in 207) model found a (2005: (holding all other influences (holding all other influences introduced is we ever, Wells 194) if then, 46 and which ceteris paribus ceteris (2006: since % change in price rarely, . To obtain the market demand, we sum the sum the demand, we obtain the market . To model, is . It is defined as: % change in quantity demanded % change in quantity shifts = Blinder d e demand and repeatedly market.’ Krugman market.’ and competition used . This requires large numbers of buyers and sellers, with no one buyer and sellers, numbers of buyers with no one buyer large . This requires elasticity of demand elasticity of
supply have price tice.’ Baumol tice.’ ‘Perfect ‘Perfect competitive and ‘The ‘The – no advertising, market in a competitive behaviour is no ‘competing’ There between demand curve the quantity describes the relationship An individual’s – it tells he us the maximum price demand curve is a frontier An individual’s The shape of the market demand curve shows the responsiveness of quantity of quantity demand curve responsiveness shows the The shape of the market by is measured in price demanded to a change of quantity The responsiveness no price-setting strategies, no rivalry. This is because all buyers and sellers are This is because all and sellers buyers are strategies, no rivalry. no price-setting price-takers and all share, (or firms producing an identical or seller a significant market having homogeneous) good or service. own price demanded and the good’s income preferences, include the individual’s constant). These other influences goods. These may be either complements consumption of related and the prices or beef). or substitutes (such as chicken players) and DVD (such as DVDs Expected may also be important prices how much is bought currently. in determining future of the other influences If any or she is willing quantity. to pay to obtain given any change, the demand curve amounts every individual wishes to buy at any given price. Thus the size of the of the Thus the size price. amounts every given individual wishes to buy at any demand. population influences demanded quantity increases, the price as changes. Normally, demanded to price 3.1. as seen in Figure decreases, the 3 | How markets work (in an (in imaginary work world) markets How | 3 1 TEXT STANDARD THE 1.1 market? is a competitive What 1.2 The demand curve
2 | Introducing economic models to the What Why? from recently sector? industrialize untruth’. hypocritical hypocritical advantage? international resources export Samuelson of on Germany same? little the Paul a unemployed? polemical and the forms it into comparative depend all of 45 doing losses? Canada Isn’t remained ‘popular trade moving from a the Myth and Measurement: The new economics of the theory just as from walls? States, gains the sector countries professor: offset they view gains if test tariff your than other United this we long-run long-run for . Focus on Chapter 1 (‘Introduction and overview’, pp. 1–20) and on Chapter 1 . Focus high the mutual more happen the oppose would the described trade now behind would import-competing import-competing 4 Must 3 Didn’t 2 Do 1 How Take a look at ‘Appendix A: The limits of dissent’ in Marglin (2008, pp. A: The limits of dissent’ in Marglin (2008, pp. a look at ‘Appendix Take good source is On methodology and the minimum wage controversy, a very Also highly recommended is George’s (1990) analysis of the rhetorical subtext Also highly recommended is George’s (1990) analysis of the We’ll have much more to say about trade in Chapter 10. Chapter in about trade to say more much have We’ll Questions 265–98). This has an especially good section on whether comparative advantage 265–98). This has an especially justifies free trade (pp. 274–82). Card and Krueger’s 1995 book, in economics textbooks. minimum wage on Chapter 12 (‘Conclusions and implications’, pp. 387–401). Suggestions for further reading price price D uantity 00 horta e 50 0 ri e 48 uantity D % change in price % change in quantity supply % change in quantity 3.2 towards equilibrium Movement 500 = s e figure ur lus . 3 1 When prices are free to fluctuate, market forces move the actual price (and (and the actual price move forces to fluctuate, market free are When prices shock would affect how an exogenous considering simulate change by We in the of an increase show the effect 3.3 we diagram of Figure In the left-hand The six key shift factors on the supply side are: the weather (especially (especially the weather on the supply side are: shift factors The six key see only we with the supply shift factors the demand shift factors Comparing ri e quantity) towards the equilibrium price (and quantity). The left-hand diagram diagram The left-hand (and quantity). price towards the equilibrium quantity) P*, price, the equilibrium P1, which is above 3.2 shows that at a price of Figure to 200 units per period. This creates supply (or surplus) equal is an excess there at is restored until equilibrium causing it to fall on the price, pressure downward there is below equilibrium diagram shows that when the price P*. The right-hand on the price, demand (or shortage). upward pressure This creates is an excess at P*. is restored until equilibrium to increase causing the price one static equilibrium statics’ compares position. ‘Comparative the equilibrium know how long anything don’t The analysis is timeless (we position with another. order things happen). matter in what and ahistorical (it doesn’t takes) 1.5 static analysis Comparative responsiveness of quantity supplied to a change in price is measured by the by is measured supplied to a change in price of quantity responsiveness supply elasticity of important in of goods related agricultural products); changes in the prices for changes of production’); of ‘factors (or prices production; changes in input prices industry; of firms in the in technology; changes in the number (and size) and prices. about future changes in expectations prices. of future one identical item: expectations equilibrium 1.4 Market
3 | How markets work Q1 ananas Demand for Demand b Quantity of Quantity bananas Q2 P4 P3 . It too is a frontier, showing the showing the . It too is a frontier, 47 asoline 3.1 Inelastic and elastic demand Demand for Demand g ceteris paribus ceteris Q1 Q2 figure GASOLINE BANANAS Quantity of Quantity gasoline price that sellers are willing to accept for any given quantity. Generally Generally quantity. given any for that sellers willing price are to accept P1 P2 Price Price Suppose a 10 per cent increase in the price of gasoline leads to a 1 per cent of gasoline leads to a 1 per cent in the price increase Suppose a 10 per cent Elasticity of demand determines quantity. multiplied by is price revenue Total the shaded box equals of bananas is P3, total when the price revenue Similarly, If the tube system is losing money. As an application, suppose the London of a good betweenThe supply curve the quantity describes the relationship decrease in the quantity demanded. The price elasticity of demand for gasoline is gasoline is elasticity of demand for demanded. The price in the quantity decrease increase In contrast, a 10 per cent suppose 10 per cent). divided by 0.1 (1 per cent demanded. in the quantity decrease of bananas leads to a 70 per cent in the price of availability Elasticities depend on the bananas is 7. elasticity for The price bananas (other substitutes for many are There substitutes among other things. a short time period. at least over gasoline (petrol), substitutes for but few fruit), when the price example, changes. For changes when price how total revenue diagram in the left-hand the shaded box equals of gasoline is P1, total revenue box goes up to P2 the height of the total 3.1. When the price revenue of Figure 1 per cent. It is clear that the by 10 per cent, and its width decreases by increases than before. is bigger box new total revenue goes up to P4 the height 3.1. When the price diagram in Figure in the right-hand 70 by while its width decreases 10 per cent by increases box of the total revenue is smaller than before. box the new total revenue per cent. Clearly, should the tube authority increase or total is solely to increase revenue, objective tube rides is inelastic, they should increase If the demand for fares? decrease to one (a If the elasticity is equal fares. if it is elastic they should decrease fares; on no effect change would have demand curve) then a fare so-called ‘unit-elastic’ total revenue. supplied and its own price, minimum The supplied goes up. the quantity of a product increases, as the price speaking, 1.3 The supply curve eiling rent Su ly Demand E rent uilibrium 22 , specifically the emergence , specifically the emergence 50 ousing s ortage illegal activities of 4 units 3.4 control of rent The effect e blac mar et rice 12 Number of a artments in millions figure ntal ont ly 1 12 re Figure 3.5 depicts a competitive market for unskilled workers. The equilibrium The equilibrium unskilled for workers. market 3.5 depicts a competitive Figure A second inefficiency is the wasted time, energy and money spent searching is the wasted time, energy inefficiency searching and money spent A second of apartmentsquality A third inefficiency is that the will undesirably become encourage ceilings price Finally, will that we state predictions Our analysis contains generically five (not wage is $9 an hour, and total employment is 15 million workers. Suppose the Suppose the and total is 15 million employment workers. wage is $9 an hour, decides that $9 an hour is not a living wage, and imposes a minimum government jobs, 3 million people more The impact is 3 million fewer wage of $12 an hour. willing (or a surplus of labour) of 6 million to work and unemployment workers. for an apartment.for and landlords better conditions, to pay for Some tenants would be happy low. rent. This is a missed opportunity. increased them for to provide would be happy – side payments (or bribes) to obtain an apartment. of black markets the Given are that buyers shortage 3.4 indicates Figure of apartments controls, under rent can we So, than the legal ceiling. more willing to pay up to $1,200 a month – $400 a month. side payments as high as $400 expect mar- competitive in apartments). controls for price First, tailored to the market 1). (prediction lead to shortages in effect kets that get worse the longer they are shortages inefficient, reason Next, are bad is that they the fundamental and are distinct ways: an inefficient distribution itself in three this inefficiency manifests trying to buy the 2); wasted resources (prediction of the good among buyers 4). of the good (prediction 3); and an inefficiently low quality good (prediction crime unsatisfied wants because of legal restrictions, are there whenever Finally, 5). them (prediction will always arise to profit from 1.7 floor: minimum wages price A government-regulated
3 | How markets work : D S D inefficiency E s ortage 4 E to D’, causing a to D’, causing a Increase in demand in Increase shifts rightwards Quantity of eat
Price S 49 S D 3.3 static analysis Comparative E sur lus figure E 4 Increase in su in Increase ly Governments often try to control market prices using price ceilings and and ceilings using price prices try often market to control Governments apartments assuming all for in Montreal apart- 3.4 shows the market Figure Note that an expectation of a future price increase causes supply to shift left causes supply to shift left increase price of a future Note that an expectation The first inefficiency is an inappropriate distribution of apartments among The first inefficiency is an inappropriate distribution of apartments among Shortages induced by price controls in competitive markets lead to markets in competitive controls Shortages price by induced 4 Price Quantity of eat price floors. Rent control (an example of a price ceiling) is an attempt to help to help is an attempt ceiling) of a price (an example control floors. Rent price that emphasize Textbooks of accommodation. the cost afford families low-income that usually always lead to unintended effects forces market attempts to overrule hurt is intending to help. the very group the government supply of wheat from S to S’ – perhaps caused by a fall in the price of fertilizer. of fertilizer. the price in a fall S to S’ – perhaps caused by supply of wheat from is now a surplus of wheat. of $5 there This causes the price the original price At 3.3 we Figure diagram of to $4, eliminating the surplus. In the right-hand to fall an wheat – perhaps caused by the demand for in of an increase show the effect The original demand line in incomes. increase 1.6 controls ceiling: rent price A government-regulated and demand to shift right. Both these shifts cause prices to increase now: an now: an and demand to shift right. to increase Both these shifts cause prices prophecy. of a self-fulfilling example shortage at the original equilibrium price of $5. This causes the price to increase to increase shortage of $5. This causes the price price original equilibrium at the to $6, at which point the shortage is eliminated. renters. For example, ‘empty-nesters’ want to downsize, while households with while households with want to downsize, ‘empty-nesters’ example, For renters. benefit both parties, but are These moves want something bigger. new children control. the shortage the rent by by hampered created missed opportunities to make some people better off at no cost to anyone else. else. to anyone better off at no cost some people missed opportunities to make ments are identical. The going rent is $1,000 a month and 2 million units are is $1,000 a month and 2 million identical. The going rent units are ments are apartments of $800, fewer ceiling imposes a rent When the government rented. rental demanded, causing a shortage more and rent of 400,000 for offered are is in effect, control units. The shortage to get worse the longer the rent is likely to condominiums. down or converted as apartment knocked buildings are S illions D m Litres of mil S d d E d s 40 million million 40 e
+ e e + e s s e E e 4 a 1 a a consumers by mainly aid 1 il 1 Price of m 52 D S ars ing ace Quantity of 3.6 of taxation The incidence E S figure E 4 are the elasticities of supply and demand in equilibrium. Note that that Note the elasticities of supply and demand in equilibrium. are d a 4 a a by mainly aid roducers
and e s Formula 2: proportion = of sales taxFormula producers borne by Formula 1: proportion = of sales taxFormula consumers borne by g In Figure 3.6 the tax on milk reduced consumption by 10 million litres. This is 10 million This is by 3.6 the tax litres. consumption on milkIn Figure reduced In the right-hand diagram, we have supply and demand for milk. supply and demand for A sales tax have diagram, we In the right-hand It turns out that the incidence of the tax depends on the relative size of the of the size of the taxIt turns out that the incidence depends on the relative Formula 1 shows that the greater the price elasticity of supply, and the smaller and the smaller elasticity of supply, the price 1 shows that the greater Formula
3 ar in milk that would have been consumed in the absence of the tax, to the mutual of the tax, in the absence to the mutual been consumed milk that would have of $1 per litre of milk shifts the supply curve up by $1 per litre. According to to of milk According of $1 per litre $1 per litre. shifts the supply curve up by ($1 x revenue million in government the diagram, the tax raises $40 litres), and raises the equilibrium price by 90 cents. In contrast to the previous to the previous In contrast 90 cents. by price and raises the equilibrium litres), paid most of the tax, of the tax most producers here where is passed on example, What causes this producers. is paid by per litre and only 10 cents to consumers, in who bears the burden of the tax? difference and quantities. prices elasticities of demand and supply at the equilibrium price is: textbooks) by revealed (almost never The actual formula e where 1.9 The costs of taxation the proportions sum to one – the total tax and sellers. is split between buyers If we the tax consumers. elasticity of demand, the more is paid by the price this amounts to a claim that if understand elasticity to mean ‘responsiveness’, changes, while con- or elastic) to price (or flexible, responsive are producers the tax or inelastic), the more burden falls (or inflexible unresponsive sumers are opponent will As in the martial chi, the flexible always on consumers. art of t’ai avoids side of the market flexible one. In this case, the more beat the inflexible partthe larger of the sales tax, one pays it. while the inflexible Price of
3 | How markets work ly inefficient inefficient Labour su labour millions inimum age Quantity of uns illed Labour demand 1 51 Sur lus only in this case it is sellers (job bribing seekers) 3.5 of a minimum wage The effect 12 1 figure illegal activity – of sales among sellers. With a minimum wage there may be some job may be some job a minimum wage there of sales among sellers. With age ourly 12 Contrary to popular belief, the person who ends up ‘paying’ a sales (or excise) a sales (or excise) person who ends up ‘paying’ the Contrary to popular belief, parking 3.6 shows supply and demand for diagram of Figure The left-hand The surplus caused by a price floor creates inefficiencies – missed opportun- floor creates a price The surplus caused by tax is not the same person on whom the tax is levied. Rather, the incidence of the of the the incidence tax is not the same person on whom the tax is levied. Rather, elasticities of demand and supply. price of the size tax depends on the relative proposition using demand and supply diagrams. demonstrate this The texts of producers collects the sales tax from the government assume We spaces. so a $4 per unit sales tax costs, shifts the This adds to producers’ parking spaces. to the of output. each level According $4 per unit for supply curve upwards by $1 of Effectively $6 to $7. from price is to raise the equilibrium diagram, the effect $3 per The remainder, the tax in higher prices. has been passed on to consumers the govern- for the tax raises $1,600 in revenue Finally, unit, producers. is paid by units). ment ($4 x 400 ities – that resemble those created by price ceilings. First, there is an there First, ceilings. price by those created ities – that resemble Any minimum wage above the equilibrium has the same qualitative effect; but but effect; has the same qualitative the equilibrium above minimum wage Any the worse it is. the higher the minimum wage, allocation arrangements out of sight of the law. or employment (employers), buyers 1.8 the cost of Who bears sales taxes? seekers who really want to work but cannot find a job, and others who have a a and others who have who really want to work but cannot find a job, seekers or not. as to whether they work sellers Second, almost indifferent job but are (job Third, (an employer). a buyer for waste time and effort searching seekers) try to who might an inefficiently high quality to attract buyers, suppliers offer provide ceilings price Finally, price. at a lower the original quality preferred have for an incentive curve? perfectly o[i not supply supply is industry industry industry industry an the 54
If de draw still professor: professor: ) we No. Of the remainder, several state that market participants just Of the remainder, several state that market participants just ) can your for
answer: answer: ( 3.1 Types of market structure (Right (Right Concerning the information requirements, four of eleven leading US text- Concerning the information requirements, four of eleven competitive, competitive, Question Question markets. Let’s vaguely about ‘non-competitive’ this point we’ve talked To into three types: monopolistic competition, Non-competitive markets fall All behaviour. The key requirement for perfect competition is price-taking Few Oligopoly Oligopoly Monopoly Many Oligopoly Few One Monopoly competition Perfect Monopolistic competition How many producers are there? Are products differentiated? books state that perfect information is required for perfect competition (Beaulier books state that perfect information is required for perfect competition and Mounts 2008). need to be ‘well informed’. An extreme position is that of Mankiw (2004) – one need to be ‘well informed’. An extreme position is that of Mankiw any information of the leading US textbooks – who chooses not to mention requirements for perfect competition at all. be more precise. Textbooks categorize markets according to the number of to the number of markets according categorize Textbooks be more precise. 3.1. as shown in Table producers and the type of product, non-competitive markets have ‘mar- Firms in all three oligopoly and monopoly. face a downward-sloping demand curve, and so ket power’, which means they rather than simply accept a ‘market price’ can choose the price of their product firm. Market power derives either from the firm like the perfectly competitive (monopoly), or from having a product that being large relative to the industry in some way (monopolistic competition), or for is unique (or differentiated) question is: how prevalent is perfect competition both reasons (oligopoly). The relative to the other market structures? and an identi- texts agree that this requires large numbers of buyers and sellers perfect information cal product. But two other assumptions are often included: This last assumption and easy entry by firms into (and exit from) the industry. perfect competition is necessary to show the long-run optimality qualities of for price-taking (discussed in Chapter 6). Easy entry (and exit) is not necessary behaviour. jWXb[ 2.2 perfectly competitive? are many How markets
3 | How markets work market market all suggest only 53
1 . Colander et al. (2006: 72) are explicit here, saying supply and demand . Colander et al. (2006: 72) are But the supply and demand framework is actually a simplified representa- But the supply and demand framework is actually a simplified The material summarized in the previous section is often called ‘How markets The material summarized in the Since supply curves exist only in perfectly competitive markets, we need to Since supply curves exist only in perfectly competitive markets, We can demonstrate the equivalence between supply and demand and and can demonstrate the equivalence between supply and demand We that the supply and demand framework is a generic tool that can be applied to all that the supply and demand framework markets provides ‘a good off-the-cuff answer for any economic question’. (according to some tion of a perfectly competitive market structure, one which Many textbooks are textbooks) is so rare as to be hardly ever found in practice. when they discuss quite explicit about this, but only much later in the texts, state in their Chapter example, Krugman and Wells perfect competition. For in Chapter 3 and 9: ‘The supply and demand model, which we introduced competitive market’ have used repeatedly since then, is a model of a perfectly (2005: 207). work’, the terminology of Parkin and Bade (2006) and Mankiw et al. (2006). It and Bade work’, the terminology of Parkin and methodology that emphasizes the overriding follows a discussion of models and it contains applications to a broad range importance of predictive power, The range of these applications, the position of labour and product markets. of the text, and the immediately preceding of these chapters near the front plays down realism of assumptions, methodological discussion that know: first, how many markets are perfectly competitive in the real world? And know: first, how many markets are perfectly competitive in second, even though the competitive model is not (strictly speaking) applicable to non-competitive markets, can it be usefully applied as an approximation? address those questions next. We structure where a supply curve exists. While this demonstration is delayed until structure where a supply curve exists. While this demonstration firm, which Chapter 6, the intuition is straightforward. Unlike the competitive demand is a price taker, the non-competitive firm faces a downward-sloping But the best curve and has to decide on its best price–output combination. result, there is no price depends on the position of the demand curve; as a and hence no unique relationship between price and the quantity supplied, supply curve. perfect competition by showing that perfect competition is the perfect competition by showing that perfect competition 2.1 tool demand The andas a generic supply model is sold benefit of both producers and consumers. Nobody would have been worse off. So, So, off. worse been have would Nobody and consumers. producers of both benefit and above the tax of a cost over This represents tax inefficiency. creates an excise to as the is referred cost This extra taxes. in government paid to the the money cost say that the real tax. loss of the burden or deadweight Economists excess of a taxthe mutually pay – meaning they don’t is not what people pay but what a tax. because of that no longer occur beneficial trades ANTI-TEXT 2 THE
+ information as a requirement perfect 56 , Perhaps less well appreciated is the existence of market power in Perhaps 4 Evidence that price-taking behaviour is rare outside of agriculture is provided Despite its deficiencies, the competitive paradigm did provide insights into the competitive paradigm Despite its deficiencies, are some markets in which the issues which many economic phenomena. There – the market for wheat or corn – though we have discussed are not important interventions make the reigning competitive even there, pervasive government (Ibid.: 488) paradigm of limited relevance. the competitive model would be good So, if not for government interventions, competition actually describes many real- Opinions differ as to whether perfect competitive. But not all agricultural and raw material products are perfectly Given the prevalence of imperfect information, Stiglitz’s argument seems to Stiglitz’s argument seems of imperfect information, Given the prevalence But even assuming that the whole of agriculture, forestry, fishing and hunting But even assuming that the whole of agriculture, forestry, fishing enough to describe the markets for wheat and corn. Are there other markets enough to describe the markets to perfect that the competitive model can where information is close enough themselves say on this question? be applied? What do the textbooks that include world markets. Those textbooks example, Baumol For state that perfect competition has very limited applicability. found in practice’ and Blinder say that perfect competition is ‘rarely, if ever, stronger claims (2006: 194). Those that don’t insist on perfect information make instance, Krugman and for the existence of perfectly competitive markets. For state: ‘important parts of the economy are fairly well described by perfect Wells and Lipsey, by Ragan competition’ (2005: 383). The stronger claim was also made state (2005: 259): who provide examples of perfectly competitive industries. They fairly well and fish products provide many examples. Agriculture also fits ‘Forest Many basic raw in most ways since individual farmers are clearly price takers. markets where materials, such as iron ore, tin, and copper, are sold on world most individual firms lack significant market power.’ and oil are The existence of market power in markets for diamonds, aluminium well known. agricultural markets. At least in North America, many farmers and fishers are agricultural markets. At least in North America, many farmers that supply their increasingly squeezed by the market power of the few firms chains and inputs and the few buyers of their outputs – especially supermarket 2001). the fast food industry (Phillips 2003; Lawrence 2004; Schlosser than lenders; people buying insurance know more about their efforts to avoid to avoid efforts their about more know insurance buying people lenders; than are so per- imperfections information to Stiglitz, insurers. According risk than would be information world with perfect what a is hard to imagine vasive ‘it 469). like’ (2002: the This leads him to ask why to apply the competitive model. leave little room He says: persisted for so long. competitive paradigm were perfectly competitive, their combined output is only a very small fraction were perfectly competitive, their combined output is only of total production in the industrialized economies. (It’s about 2 per cent of production in Canada in 2006.)
3 | How markets work in 55 ), or even multiple equilibria. If imperfect information undermines the competitive model, is there a better If imperfect information undermines the competitive model, the likelihood of Apparently, the prevalence of competition depends on Why could even a small amount of imperfect information have a profound Why could even a small amount theory, that all firms were charging Assume for example, as in the standard were an epsilon cost of searching, of going to the competitive price, but there charged half an epsilon more would lose no another store. Then any firm which to increase its price. Similarly, it would pay customers and thus would choose it would again all other firms to increase their prices. But at the higher price, every firm is the pay each to increase price, and so on until the price charged at monopoly price, even though search costs are small. (Ibid.: 477) Just quantity. In the above quote, ‘epsilon’ stands for an arbitrarily small Given the amount of research on the effects of imperfect information, this information, imperfect of the effects on of research the amount Given has focused on models formal modeling in economics more than 100 years, For Of course, everyone recognized was assumed to be perfect. in which information hope … was that economies in was in fact imperfect, but the that information imperfect would look very much like economies which information was not too One of the main results of our research was to in which information was perfect. even a small amount of information imperfec- show that this was not true; that on the nature of the equilibrium. (2002: 461) tion could have a profound effect equilibrium alternative? Stiglitz explains: ‘a central consequence of imperfect information alternative? Stiglitz explains: ‘a central consequence of imperfect of imperfect is that … product markets are more aptly described by models downward sloping competition, where … [firms] perceive themselves facing demand schedules’ (1985: 34). appreciate how implausible the assumption of having perfect information. To asymmetries perfect information is, it helps to realize that many information applicants know (some people knowing more than others) are inevitable. Job more about their ability than prospective employers; workers know more about their work effort than management; management knows more about their firms than potential investors; borrowers know more about their likelihood of default effect? Stiglitz gives the following example: effect? Stiglitz gives the following competitive an epsilon of costs of acquiring information could lead otherwise slight departures firms to charge the monopoly price. The point is that even Depending from free, and hence perfect, information have large consequences. where the market on the market, other consequences could be an equilibrium supplied does not clear (the quantity demanded differs from the quantity difference of opinion among the textbooks is odd. Joseph Stiglitz received the Joseph Stiglitz is odd. among the textbooks of opinion difference acceptance in 2001. In his economics on information for his work Nobel Prize American journal of the in the flagship following year published the speech, he explains: Economic Association,
- Does the evidence support the predic- 58 reduce employment of low-wage, low-skilled workers. There reduce employment of low-wage, low-skilled workers. There not One category of explanation is the ‘efficiency wage’ thesis. If work effort If work effort One category of explanation is the ‘efficiency wage’ thesis. thesis. Here An alternative category of explanation is the dynamic monopsony Let us, then, consider the predictive power of the competitive model, focusing Let us, then, consider the predictive If this were generally true, the textbook emphasis on competitive markets as a markets on competitive emphasis the textbook true, generally were If this that after noting who, and Wells, by Krugman the position taken This is What we have yet to explain is why moderate increases in the minimum in the minimum What we have yet to explain is why moderate increases are several possible explanations, all of which depend on ‘frictions’ – imperfect are several possible explanations, all of which depend on ‘frictions’ information or mobility costs. increases make the job more is hard to monitor, workers may shirk. Wage might result desirable and provide an incentive not to get caught shirking (which increases. In in getting fired). As a result, workers shirk less and productivity which reduces addition, increased worker morale may reduce labour turnover, wages pay for hiring and training costs for the firm. Either way, the higher themselves without causing job losses. (or temporary employers are not simply wage-takers: they have some short-run losing all their or dynamic) power to set wages lower than other firms without necessary for a workers. This power may derive from the time and resources entail moving home worker to find a new job, or because taking another job might or increased costs of commuting. Either way, moderate minimum wage increases may offset the market power of employers without causing job losses – indeed, they may even cause job gains (as we explain more fully in Chapter 8). on the core applications emphasized in introductory textbooks. on the core applications emphasized generic tool would be justified. Maybe it’s like the law of gravity: strictly speaking of gravity: strictly it’s like the law Maybe tool would be justified. generic life. in everyday be usefully applied but it can only in a vacuum; it holds preva- structure, ask, ‘Given the far the most common market oligopoly is by still based on perfect competition then, is the analysis … lence of oligopoly, from is also true that predictions that it is because ‘[i]t useful?’ They argue oligopolies’. Given the complexity analysis are often valid for supply and demand do not expect the complications ‘in situations where they of oligopoly models, be crucial, economists prefer to adopt the work- associated with oligopoly to markets’ (2005: 383). In other words, ing assumption of perfectly competitive and can be applied even to non-competitive the competitive model is simpler predictions. markets, because it gives us accurate Predictions concerning minimum wages Predictions concerning minimum tions of the supply and demand framework concerning the effects of minimum tions of the supply and demand this question in detail in Chapter 2. In brief, the empirical addressed wages? We study to illustrate studies conflict to such an extent that we used it as a case as criteria for model the limitations of hypothesis testing and predictive power wages has broken selection. The consensus concerning the effects of minimum down – though this is not generally reported in the textbooks. wage might
3 | How markets work by the So, the set does prices; price-setter. price-setter. a own is be? one their ? Assume away all the complications. no will set 57 even to this non-competitive market. model price world the approximation supply real professor: what them? and the to your in useful approximation for demand apply firms determines the model who of the firms surveyed by Blinder et al. fell into that category. of the firms surveyed by Blinder 2 Most 1 In Nevertheless (we ask, as the devil’s advocate), can the competitive model be Nevertheless (we ask, as the devil’s advocate), can the competitive Competitive firms are price-takers. They never need to review their price They never need to review their price Competitive firms are price-takers. Questions product. No two hairstylists are equally skilled. They sell a differentiated First, the evidence gathered in this study emphatically supports the mainstream supports the mainstream gathered in this study emphatically First, the evidence in American industry. prices are the rule, not the exception, view that sticky median number of price changes for a typical According to our respondents, the 1.4, and almost half of all prices change no more product in a typical year is just reviews Among firms reporting regular price reviews, annual often than annually. the other end of the spectrum, only about 10 are by far the most common. At as once a week, and about 7 percent of all percent of all prices change as often (Ibid.: 298) least weekly. firms schedule price reviews at Assume all hairstylists are identical. Assume perfect information. Won’t the the Won’t Assume all hairstylists are identical. Assume perfect information. the average price of competitive model give us insights into the determinants of the things that cause supply curves to shift left – an increase in haircuts? Won’t the costs of production (shampoo prices go up), or a decrease in the number of firms (hairstylists) – increase the average price of a haircut? If so, the competitive model provides a applied to this market as an hairstylist – depending on the stylist’s quality, reputation, location and clientele. hairstylist – depending on the stylist’s quality, reputation, location This is a non-competitive market. schedules. Their prices change continually with shifts in demand and supply. continually with shifts in demand and supply. schedules. Their prices change None that the supply Each stylist faces a downward-sloping demand curve, implying Furthermore, there is no curve for haircuts does not exist, as stated earlier. price unique price for haircuts, but instead a range of prices – each 2.3 model a useful Is the competitive approximation? by Blinder et al. (1998). They survey 200 representative firms in the United States, States, United in the firms 200 representative survey They al. (1998). et by Blinder that almost it for granted of all, we took They say: ‘First agriculture. excluding – an assump- price-takers rather than are price-makers in our economy all firms that prices 12). They find (ibid.: the survey responses’ justified by tion amply reviewed; they are not determined by firms and periodically are ‘sticky’ – set say: by supply and demand. They instantaneously 60 A second complication is that the type of rent control prevalent nowadays is nowadays prevalent rent control type of that the is complication A second units are assets, the desirability of which A third complication is that housing on rent control, Arnott says: ‘The impact In reviewing the empirical evidence for that Why are most textbooks (and most North American economists model is good The methodological battle is about whether the competitive Because of this different methodological perspective, they are much less very different from the type assumed in textbooks – a rigid rent freeze. Controls a rigid rent freeze. in textbooks – type assumed from the very different War, World the Second US cities during in major were introduced of this sort rent ‘first-generation’ this had abandoned New York) city (apart from but every rent control, first introduced early 1950s. ‘Second-generation’ control by the example, it commonly allows For significantly more flexible. in the 1970s, is costs, excludes luxury high-rent increases geared to increasing automatic rent decontrols between tenants, buildings, restricts conversions, buildings and new or improve quality. for landlords to maintain and provides incentives besides rent control: interest rates, inflation, is impacted by many other factors the local real estate cycle, government housing profit opportunities elsewhere, and expected future changes in all relevant vari- and tax policies, and current ables. to be significantly greater than any effect due of these other factors is likely the effects of rent control in such a situation is to controls. Trying to discern conversation across a street of roaring traffic’ akin to trying to hear a whispered City (which retained the exception of New York (1995: 112). He suggests that with (which had poorly designed its first-generation controls) and perhaps Toronto North America have second-generation controls) the effects of rent control in the treatment in the been almost imperceptible. This is a dramatic contrast to competitive, textbooks. By assuming that the rental housing market is perfectly suggest that rent and by considering a crude form of price ceiling, most texts controls necessarily have destructive effects. reasons: ‘The first is matter) so negative on rent controls? Arnott suggests two between those ideological. The debate over rent control has been a battleground of the debate who believe in the free market and those who do not. The echoes more quantitative carry over to other policy arenas where its resolution has far import. The second is methodological’ (ibid.: 117). housing market has enough as a generic approximation to most markets. The and tastes many non-competitive elements: apartments are heterogeneous are substantial (as idiosyncratic, which renders the market thin; search costs is a lack of informa- evidenced by agents’ fees), as are moving costs; and there Are these merely tion about who’s a good landlord and who’s a good tenant. believe that details that can be ignored as irrelevant? Most housing economists the mid-1980s most these are too important to be ignored in practice. Since of them have turned their attention to non-competitive models – models that emphasize search costs and the importance of contracts.
3 | How markets work . as if it binding It’s framework answer: evidence demand (Right empirical and wages? the supply 59 Does of the competitive The main prediction the minimum study’, which finds that ‘a 10 percent increase study’, which finds that ‘a 10
of of professor: relevant to the minimum wage question. Some of these question. Some of these relevant to the minimum wage effects your predictions the for the mixed.) very concerning support Did astronomy classes stop teaching Newtonian principles once quantum Did astronomy classes stop teaching Newtonian principles once the atom once mechanics was discovered? Did physics classes drop lectures on the limitations quarks were discovered? No. Instead, these disciplines explain have been used of their models, teach the research methods and findings that students with to establish (and reject) their core principles, and seek to provide and why. an understanding of which models work best in which circumstances (2001: 243) Question A third option is to omit the minimum wage application completely (e.g. minimum wage application completely (e.g. A third option is to omit the The minimum wage application is precisely about whether frictions in the frictions whether about is precisely application wage minimum The Ragan example, predictions. For of textbooks do compare the A small minority the competitive model textbook continues to apply But the average If the extent to which it is binding lessens – if the ceiling rent moves towards If the extent to which it is binding lessens – if the ceiling to worsen. On the the equilibrium rent – then we would not expect shortages contrary, we’d expect them to moderate. But knowing the extent to which the It’s complicated by the fact that ceiling rent is binding over time is very tricky. we cannot observe the equilibrium rent. model – shortages that get worse the longer the rent control is in effect – depends model – shortages that get worse the longer the rent control it must be on the rent ceiling remaining below the equilibrium level: Frank et al. 2005; McConnell et al. 2007). Krueger believes this reaction is un- Frank et al. 2005; McConnell fortunate: in the minimum wage depresses teenage employment between 1 and 3 percent’ in the minimum wage depresses (2001: 247) tracks down this ‘typical’ study (Mankiw et al. 2006: 125). Krueger published in 1982! to an influential survey paper were the only model in passing. Others mention the controversy, mention the empirical controversy Bade and the competitive model as wrong (Parkin but dismiss results contrary to there is no empirical controversy and continue 2006: 131). And others pretend to cite results from ‘the typical labour market are significant. The easiest way to account for the array of mixed for the array way to account The easiest are significant. labour market So, when in certain cases. are important that frictions is to concede evidence the predic- to contrast it is important of minimum wages the effects discussing non-competitive models. model with those from tions of the competitive minimum wage is re-examined 99) alert the reader that the and Lipsey (2008: a monopsonistic framework. on labour markets using in a later chapter Predictions concerning rent controls model competitive supply and demand imperfectly in the 62 Can taxation of corroborating empirical evidence on the ability of empirical evidence on the ability corroborating something that doesn’t exist in reality. We suggest this suggest We doesn’t exist in reality. something that any professor: your incidence measuring presents for commodities, in Price ceilings have been imposed on different the no text markets? predict Question Put it this way: it is one thing to generate predictions using hypothetical shifts using hypothetical predictions thing to generate way: it is one Put it this Not really. In Chapter 6 we show that the textbook model of monopoly contains Not really. as preferring the competitive model because Wells quote Krugman and We all the For The reason is that such an analysis would tell the wrong ‘story’. The issue So, we’re not arguing that price ceilings do not cause shortages. the competitive model to predict the incidence of taxation. model to predict the incidence the competitive is why a competitive market. And this explains the complete absence of empirical empirical of absence the complete explains this And market. a competitive measure we cannot could be measured, of demand while the elasticity evidence: exist. curve doesn’t when the supply of supply the elasticity be a predictions this could supply curve – if it yields accurate of a hypothetical those to test the accuracy of But it is altogether another useful approximation. predictions by 2.4 ceilings shortages? and cause price surpluses floors don’t But price Price ceilings different countries, in different times. During the Second World War, there were War, times. During the Second World different countries, in different the USA – com- price ceilings on many commodities in Britain, Canada and case, shortages modities such as meat, milk, eggs, sugar and gasoline. In every model? developed. Doesn’t this confirm the usefulness of the competitive will be shortages. the same prediction: if price ceilings are sufficiently low there of oligopoly and Similarly, shortages are also a likely outcome in textbook models in response to price monopolistic competition. The fact that shortages develop model. ceilings doesn’t demonstrate the superiority of the competitive are so complex. models of oligopoly (where strategic interaction is the key) competitive model. But the monopoly model is simple – just as simple as the monopoly model Why not use that? Why not champion the usefulness of the as a generic tool? story is how the qualifications that are later tacked on to it, the central textbook allocating resources market economy works like an invisible hand, efficiently with firms that have among alternative uses. As we’ll see, an economy populated to study an market power does not allow a clear-cut story – hence the necessity real one. imaginary economy rather than something resembling the is whether a competitive veneer can be smeared over every market as a decent enough approximation. If we accept the official methodology, of hypothesis testing and predictive power, then in each application, in each approximation,
3 | How markets work imper- only necessarily were
controls . If the evidence presented for market No.) rent 61 housing Would answer: rental (Right the professor: oligopolistic industry composed of six US producers; next if your highly for competitive? competitive? shortages 3.2 incidence applications used in ten major North American textbooks Tax fectly cause Question This is very strange because the competitive model makes clear predictions: This is very strange because the boats and Lipsey (2008, pp. 84–7) Ragan Samuelson and Nordhaus (1992, pp. 74–5) factor Gasoline, cigarettes; imports; inputs (2002, pp. 206–7) Stiglitz and Walsh Cigarettes (2004, pp. 174–6, 348–54) Taylor Tucker (2005, pp. 123–5) cheese Cigarettes and cheddar beverages Gasoline and salt Gasoline, cigarettes and alcoholic Colander (2004, pp. 163–5) Gwartney et al. (2006, pp. 94–9) McConnell and Brue (2005, pp. 589–90) Miller (2004, pp. 125–7, 485–6) certain domestic wine’ ‘A O’Sullivan and Sheffrin (2003, pp. 334–40) Apartments, cigarettes and luxury Gasoline and luxury boats Luxury boats Gasoline and cigarettes Text Example used Example Text Predictions concerning the incidence of taxation Predictions concerning the incidence jWXb[ critical of rent control. Arnott conjectures: ‘Perhaps a majority, at least among among at least a majority, ‘Perhaps conjectures: Arnott control. of rent critical that a well-designed with the statement would agree generation, the younger to seems this research Yet (ibid.: 99) can be beneficial’ program rent control textbooks. the principles no impact on have had the proportionate burden of a sales tax is determined by the relative elasticities the proportionate burden of a texts illustrate this idea using relative slopes of of supply and demand. The 3.2 shows the examples variety of markets. Table supply and demand in a wide texts. The favourite example is cigarettes used by ten leading US and Canadian (seven cases) – a the effects of minimum wages and for rent controls is weak, things are even the effects of minimum wages of sales taxes: the textbooks present no worse when it comes to the incidence evidence at all. (oligopolistic at comes gasoline (five cases) – another non-competitive industry at the retail the production level, oligopolistic or monopolistically competitive with many sellers level); and finally, luxury boats (three cases) – an industry remotely resembles but highly differentiated products. None of the examples The 64 they could sell all that they wished? If so, the competitive supply as if Let’s go back to the comparative static analysis, explained earlier using Figure Let’s go back to the comparative price movements in the demand and supply The lack of an explanation for worse is that the If having to invent an auctioneer is bad enough, what’s participants The demand and supply curves are derived assuming market there is a surplus. Do firms ignore this and continue example, suppose For what an upward-sloping supply curve says firms would do in the face of a price of a price face do in the would firms says curve supply an upward-sloping what framework the competitive problem: of a general This is one aspect increase. We of disequilibrium. in the context that are violated on assumptions is based next section. this point in the develop 2.5 don’t What the texts model tell you about the competitive when not in equilibrium model is internally inconsistent The competitive perfectly competitive demand and supply model seems to make sense in equi- seems to make sense in demand and supply model perfectly competitive the is fine since everyone trades takes prices as given, which librium. Everyone has any incentive to change. But when something amount they want, and no one the story starts to unravel. happens to disturb equilibrium we assumed a fall in the price of fertilizer shifted 3.3. In the left-hand diagram the right. This caused a surplus of wheat at the the supply curve of wheat to a result, we are told prices fall. But since no one original equilibrium price. As sets prices, how do they fall? Arrow after the issue raised by Kenneth model is known as Arrow’s Paradox, are assumed to be ‘price-takers’ and to have (1959): all individuals and firms price adjusts and no influence over the market price, yet somehow the market is to invent reaches the equilibrium value. One ‘solution’ to this conundrum of the invisible an auctioneer, who is ‘the visible, if imaginary, embodiment mention is made of hand. He has no economic involvement in the market: no character fills his objectives or constraints’ (Dixon 1990: 361–2). This fictitious prices in response the glaring gap in the demand and supply model to adjust to excess supply and demand. solution. auctioneer can’t allow any trades to occur until he finds the equilibrium the intersection of This is because the auctioneer needs eventually to end up at is reached, the demand and supply curves. If we allow trades before equilibrium they would not be people will have spent some of their budget. As a result, would have been able to buy what they otherwise would have bought at what the new equilibrium price. But they can’t do can buy or sell all that they wish at the going market price. these curves are that when there are shortages or surpluses. Out of equilibrium try to buy, or sellers only ‘notional’. They don’t tell us how much buyers would would try to sell, if there were a surplus or shortage. to supply curve would tell us what it purports to tell us: the quantity supplied at any given price. But surely it’s more likely that firms would notice the surplus and reduce
3 | How markets work
in perfectly sug- this price support markets low model Isn’t shortages were binding empirical supply when caused as and surpluses. ceilings non-competitive non-competitive it? taken supply in demand price be can ceilings 63 If The observable can’t price increase model, shortages if that will despite So, cause professor: supply professor: War, and they Yes.) your your World suppliers imposed, for for would demand are don’t cause surpluses. Similarly, we are not arguing that price floors that (Answer: the Second for irrational? the floors too? gests enough, Question Questions Krugman and Wells (2005: 93) use the example of transatlantic airfares. 93) use the example of transatlantic airfares. (2005: Krugman and Wells often empty seats But this anecdotal evidence is hardly convincing. There are Perhaps one reason for the popularity of the minimum wage application is one reason for the popularity Perhaps Price floors we need to ask which works better: the competitive model or a non-competitive non-competitive or a model the competitive better: works ask which to we need model. All economists would agree that if the minimum wage were raised high enough, All economists would agree that created. Where the minimum wage controversy a surplus of labour would be moderate increases have the same effect. As begins is when we ask whether around whether labour markets are we’ve explained, the issue revolves Prior to deregulation of airlines in 1978, airfares were set artificially high by Prior to deregulation of airlines in 1978, airfares were set Certainly this restricted the quantity demanded, and since international treaty. to them competing airlines couldn’t compete in the price dimension, it led Krugman and for customers by providing expensive (often unwanted) services. argue that it also resulted in surplus production, which manifested itself Wells in empty seats on flights. we would expect on flights, even without price floors. And with price regulation demand for travel; airlines to reduce the number of flights to match the limited that’s exactly Yet we would not expect them to increase the number of flights. that there aren’t a lot of examples of price floors where governments do not that there aren’t a lot of examples The combination of price floors and a buy up the resulting surplus production. grain ‘mountains’ ‘government buyer of last resort’ has resulted in butter and This arrangement most certainly and milk ‘lakes’ in the European Community. imposing produces surpluses. But there are very few examples of a government – besides minimum a price floor and not buying up the surplus production wages. competitive, or whether there are significant imperfections. competitive, or whether there Stable nstable nstable Stable Sraffa’s 1 L on take your model? Demand 1 3 2 4 66 What’s competitive . On the other hand, since leisure is a normal good, L the professor: 3.7 in the labour market equilibria Multiple of curves Nothing guarantees that the demand and supply and W your S Quantity of labour figure Labour suLabour ly ulti e le uilibria . As wages rise, the opportunity cost of leisure increases, causing . As wages rise, the opportunity cost of leisure increases, S for critique . L L S age Prasch supplements this standard story by considering what happens when Prasch supplements this standard story by considering what (1926) Question Sraffa’s critique led to the development of the model of imperfect competi- led to the development of the Sraffa’s critique The standard story (often found in textbooks) describes the section of the The standard story (often found in textbooks) describes the not influence the prices of any of the inputs they use. This guarantees independ- guarantees use. This they inputs any of the of the prices influence not what a different problem: opens up But this solution supply and demand. ence of a constant are available at If all factors of the firm? to limit the size is going can, there limit? If they and grow without plants can’t firms duplicate price, why firms numbers of small-sized that there will be large is nothing to guarantee – a requirement of perfect competition. in the industry of product. What limits the size each selling a differentiated tion: many firms, downward-sloping demand curve. context is that each faces a the firm in this Multiple equilibria people to substitute leisure for more work. This is the effect that initially dom- people to substitute leisure for more work. This is the effect inates between W people want to ‘buy’ more leisure as their incomes rise. When wages get high people want to ‘buy’ more leisure as their incomes rise. When section enough, this income effect dominates, leading to a backward-bending above W are linear. They might have backward-bending regions, giving rise to multiple They might have are linear. argues that when needs are example, Prasch (2008: 88) intersection points. For labour supply curve could look like that shown an important consideration, the in the left-hand diagram of Figure 3.7. curve above W
3 | How markets work fall in In 1926, In prices price-taker price-taker makes a who is model, everyone 65 If supply and professor: demand surplus? a your is for there competitive when the Question Problems also arise with shortages. When demand exceeds supply individual exceeds supply individual arise with shortages. When demand Problems also not in equilibrium, the competitive model In sum, when the market is Being unable to sell all they would like at any given price has ramifications for has ramifications at any given price they would like to sell all Being unable We can fix this problem by assuming that perfectly competitive industries do We Consider a movement to the right along an industry supply curve. As the Consider a movement to the right along an industry supply The requirements for perfect competition are mutually incompatible firms can raise their prices without losing all their sales since competitors cannot firms can raise their prices without they already do. The competitive model assumes saturate the market more than to exploit their market power. that firms pass up this opportunity to act as if it is; they do not exploit assumes that market participants continue they do not maximize their profit or utility. all their market opportunities; serious the longer the disequilibrium persists. This problem becomes more fast prices adjust towards equilibrium. The But the model is silent on how theory of how prices adjust out of equilibrium. competitive model offers no price setting in perfect competition at all. Indeed, there is no theory of factor markets. Patinkin (1965) argued that excess supply in the goods market goods market supply in the that excess (1965) argued Patinkin factor markets. labour Instead of the usual constrain the demand for labour. ‘spills over’ to wage demanded increases as the (where the quantity of labour demand function the just enough labour to produce firms demand decreases), sales-constrained wages might fall. sell – regardless of how low goods they can their production. But if they do, the market supply curve no longer describes describes longer no curve supply the market do, if they But production. their at any given price. supplied the quantity industry’s output increases, it uses more factors of production. Suppose that industry’s output increases, it uses more factors of production. least one factor of this increased usage of factors drives up the price for at (or complementary goods) also use X. If substitute goods production – say Factor the price of X, their costs rise and so do their prices. But an increase in Factor the right). Thus a a substitute good shifts the demand for the original good (to the industry demand movement along the industry supply curve causes a shift in curve. Supply and demand would not be independent of each other, and yet they must be if the framework is to provide a clear and determinate result. Piero Sraffa, a young Italian economist at Cambridge, made some very incon ven- some very incon Piero Sraffa, a young Italian economist at Cambridge, made ent observations about the supply and demand theory of perfect competition. i between In particular he argued that the conditions necessary for independence necessary the supply and demand curves are incompatible with the conditions for large numbers of firms in the industry. we role equi- But a about level there ones? curves. multiple Is 3.8 Self-fulfilling prophecies whatever have at expectations supply figure in desirable others? and being markets more than If 68 D 1 Changes D1 demand the prices the about desirable uantity both professor: another source of non-uniqueness arises from self- Yet attaining professor: more in be? your shift your some to efficient for for are them prices 1 what’s ri e government for libria, Questions expect then future Question Conversely, those selling the inferior quality have an incentive to impede the the to impede an incentive have quality the inferior selling those Conversely, possibility leads to the and doubt. This sow confusion information, to flow of (the market fully revealed information was ‘one in which equilibria, of multiple it was not in which people) and another low ability the high and identified equilibrium)’ (ibid.: 471). (called a pooling Self-fulfilling prophecies fulfilling prophecies as illustrated in Figure 3.8. Expected future prices influence fulfilling prophecies as illustrated curves. Suppose both consumers and producers both the demand and supply by 10 per cent. Consumers will try to buy more expect future prices to increase shifting up the demand curve from D1 to D2. now before prices increase, thus now in the expectation of getting higher prices Producers will withhold sales supply curve left from S1 to S2. It is possible in the future, thus shifting the the price from P1 to P2 by precisely 10 per cent. that these shifts will increase what it is because If so, there has been a self-fulfilling prophecy: the price is cent lower, the price that’s the price we expect. If we had expected a price 40 per prophecies have Models that embody self-fulfilling would be 40 per cent lower. in aggregate been used predominantly in macroeconomics to explain instability 1993). economic activity (Farmer
3 | How markets work are 3 and W 1 , working hours fall , working hours U . S . U , would preclude the poverty trap . 1 4 , labour supply increases, account- , labour supply S 67 ; while the other is a poverty trap where 2 When we confront this labour supply function with a standard downward- When we confront this labour Multiple equilibria might also arise out of imperfect information. Stiglitz Multiple equilibria might also arise out of imperfect information. As we shall explain in Chapter 8, there are reasons to think that the demand As we shall explain in Chapter 8, there are reasons to think Prasch uses this construction to show the potential usefulness of minimum Prasch uses this construction to show the potential usefulness As wages continue to fall, they will eventually reach the point where the total reach the point where the total to fall, they will eventually As wages continue , or maximum hours restriction set below L 3 sloping labour demand function, we get four possible equilibrium points, as sloping labour demand function, of Figure 3.7. Of these, both W shown in the right-hand diagram (2002) argues that if there is a lack of information about quality differences (2002) argues that if there is a lack of information about will be lumped into between workers (or goods), then all those workers (or goods) a general category and sell for a wage (or price) that reflects the average quality. Clearly, those selling the better quality have an incentive to try to demonstrate this – to get the information out there – so they can command a premium price. for labour could also have points where it switches its slope. for labour could also have points where it switches its slope. equilibrium. Interestingly, in this model the legislation pushes the economy to equilibrium. Interestingly, in this model the legislation pushes appears restriction a desirable equilibrium, but once at this equilibrium neither the legal mini- ‘binding’. That is to say, the equilibrium wage would be above maximum. Prasch mum wage and the offered hours would be less than the legal can interact with notes that this is ‘a nice illustration of how market forces evident or expected’ legislation to bring about results that are not immediately (ibid.: 93). precipitously. Prasch says (ibid.: 88): ‘the primary worker and his or her family Prasch says (ibid.: 88): ‘the primary worker precipitously. disease, despair, and disrepair to abandon their will be forced by exhaustion, of living consistent with effective membership in effort to maintain a standard become homeless, petty They civil society. the labour force and, consequently, prospects for a relatively short and miserable thieves, or beggars, with strong occurring at W life.’ This explains the third bend wages fall towards (and even go below) subsistence levels. He argues that when when that He argues levels. subsistence go below) (and even fall towards wages with living standards maintain minimum necessary to below the level wages go to abnormal labour supply increase their households working hours, normal below the shifts. So, work fourteen-hour two jobs or might hold levels. They which we assume to be W subsistence wage, ing for another bend in the labour supply curve at W bend in the labour supply curve ing for another wages are substantially below subsistence, W wage laws and maximum hours provisions. Either a minimum wage set above wage laws and maximum hours provisions. Either a minimum W hours of work required to maintain a socially acceptable standard of living are acceptable standard of living required to maintain a socially hours of work wage, W Below the unsustainable too long to be sustainable. unstable. (At a wage slightly below either of these levels, supply exceeds demand, unstable. (At a wage slightly below above either of causing wages to continue to fall; similarly, at a wage slightly to continue to in- these wage levels, demand exceeds supply, causing wages wages quite a bit crease.) This leaves two stable equilibria – one of which offers higher than the subsistence level, W in all- the an was into hit this fit oil that of The standard textbook price speculation believed world does Many 70 The How 2008. July model? professor: in speculators. your $147 by supply of for . An example relevant to the rental housing market is the nature . An example relevant to the rental housing market is the and been docu- have corporate misbehaviour examples of Numerous driven high demand part time Question The nature of the legal and regulatory framework is crucially important for The nature of the legal and regulatory framework is crucially lost their jobs During the severe recession of the early 1980s, many people These problems arise where there is imperfect and asymmetric information. and asymmetric information. arise where there is imperfect These problems So, markets per se cannot be relied upon to make rational economic decisions decisions economic rational to make upon be relied cannot per se So, markets structured. are competitively when they – not even Scandals The legal framework: eviction protection legislation world is implicitly one of perfect information and contracts that are costless to world is implicitly one of perfect information and contracts operate gets negotiate and enforce. The legal framework within which markets the discussion, scarcely a passing mention. These assumptions certainly simplify between the lines of but they also impart a subtle laissez-faire message hiding It implicitly says that the legal and regulatory framework is (at the text itself. most) of secondary importance. throughout this the efficient functioning of markets, as we’ll see repeatedly Anti-Textbook for eviction after of eviction protection legislation. Should tenants be liable Should the rule be failing to pay one month’s rent? If not, after how many? the general level modified in the depths of winter? Does it matter how high legislation can of unemployment is? The wrong balance in eviction protection as severe as the first-generation create an imbalance in the rental housing market The case study here is Paris. City. rent freeze did in New York on to the were being thrown out and became unable to pay their rent. People increased evic- prevent that, legislation was passed that gave tenants streets. To tion protection that shifted the balance of power between landlord and tenant so much in favour of the tenant that it resulted in only about 70 per cent of all mented, from the accounting scandals at Enron in 2001 and Worldcom in 2002 in 2002 in 2001 and Worldcom accounting scandals at Enron mented, from the part financial assets (consisting in creation and trading of to the unsupervised knew so complex that no one really sub-prime mortgages) of the now-notorious were really worth. consisted of or what they what they ultimately as a generic tool for all markets obscures the im- Using the competitive model and the legal and regulatory framework portance of information imperfections and make sure they work as we want them that’s necessary to oversee markets 6 and 8. to. More on this in Chapters
3 | How markets work had the Japanese property and We’ve 69 © Andy Singer But Mullainathan and Thaler (2004) explain that economists now realize now realize But Mullainathan and Thaler (2004) explain that economists Perhaps some of these issues are beyond the scope of first-year textbooks, but Perhaps that there are important limits to this argument. First, in the face of irrational that there are important limits to this argument. First, in the that helps push traders, the speculator may privately benefit more from trading prices in the right prices in the wrong direction than from trading that pushes to follow ‘dumb direction. Put another way, it may often pay ‘smart money’ example, money’ rather than to lean against it (Russell and Thaler 1985). For if speculators buy when prices are rising, and sell when prices are falling, they could still make money but would add to the amplitude of the price fluctuation. the role of speculators is important enough to warrant consideration. Suppose the role of speculators is important enough to warrant consideration. of boom and bust there are ongoing price fluctuations – for instance, a cycle they make things in commodity prices; what role do the speculators play? Do if speculators make better or worse? The traditional textbook answer is that when prices are low, money, they must buy low and sell high. This extra buying must act to smooth and extra selling when prices are high, implies their activity of markets. price fluctuations. Hence, speculators add to the efficiency stock market bubble (which burst in 1990), the technology stock bubble (which stock market bubble (which burst burst in 2008) and burst in 2001), the Chinese stock market bubble (which the finan- housing price bubbles in numerous countries which precipitated an understatement cial collapses that began in 2008. Imperfect information is the textbooks scarcely mention when it comes to thinking about the future. Yet of time and uncertainty, the role of speculators or the possibility of price issues by expectations that end in bubbles (i.e. unsustainable price increases driven a price collapse). Destabilizing speculation and bubbles Destabilizing speculation and ‘General equilibrium’ is when all Figure 3.7 we illustrated a situation In How Markets Work: Supply, demand and and demand Supply, How Markets Work: 72 ’ (2008), is worth reading. Particular emphasis could be put on emphasis could reading. Particular ’ (2008), is worth For a critique of the mainstream textbook treatment of rent controls see controls see of rent textbook treatment the mainstream a critique of For The same result can hold for the economy as a whole. That is, there could be The same result can hold for the economy as a whole. That This may sound like an abstract, technical point of no real relevance, but the ‘real world pages 29 to 111. Lectures II to VI, Arnott (1995). Krueger (2001) is an excellent source of information about how of information source (2001) is an excellent Krueger Arnott (1995). The empirical evidence. given the mixed wages the effect of minimum to teach (2008) little book, whole of Prasch’s Suggestions for further Suggestions reading UNSTABLE AND THE INDETERMINATE ADDENDUM: ECONOMY two questions: Is there likely to be a unique (justThis brief addendum considers as a whole? And if the economy is not in equi- one) equilibrium for the economy process that will bring it to equilibrium? librium, is there some price adjustment are normally considered in upper-level courses, While these are questions that even to introductory students. the concepts should be understandable equilibrium General equilibrium and partial Multiple equilibria and why they matter in which an individual market had several possible equilibria, two of which were in which an individual market had several possible equilibria, market price and stable. That meant it was not possible to predict where the where the market quantity might end up. It might, perhaps, require knowing to In such a situation, it might be possible to take action price was originally. achieve the most desirable equilibrium. of which might many possible equilibria in a general equilibrium model, some were to consist of be stable and others unstable. Indeed, if the whole economy only competitive markets, like the ones in Chapter 3, the Sonnenschein-Mantel- may not Debreu (or SMD) Theorem implies that the simultaneous equilibrium equilibria is be unique. As a result, it’s impossible to say which of the possible 121). The economy the one at which the economy would settle (Ackerman 2002: is fundamentally indeterminate. Occasionally the SMD Theorem is referred to Goes Theorem’. as the ‘Anything the markets in an economy are in equilibrium. For example, the ‘production in equilibrium. For the markets in an economy are model of possibilities frontier’ presented in Chapter 2 is a general equilibrium In this construct, impacts on wheat explicitly a very simple two-good economy. in equilibrium. have implications for cloth. Both markets are simultaneously equilibrium’ looks at just one market at a time, as in the supply and ‘Partial the most part, introductory microeconomics demand model of Chapter 3. For courses use a partial equilibrium approach.
3 | How markets work within efficiency the framework legal discussed? determining be the in to 71 Is going important ever professor: this operate your Landlords had to embark upon months and sometimes years and sometimes upon months had to embark Landlords / Is for markets markets? of The consequences were in many ways similar to a binding rent freeze: an binding rent similar to a in many ways were The consequences which Questions as a generic tool applicable to a broad range of Using the competitive model model be- The textbooks justify the generic application of the competitive than non- With regard to the claim that the competitive model is simpler increase in the quantity of units demanded, a decrease in the quantity supplied, in the quantity a decrease of units demanded, in the quantity increase was that since better-quality for units. The one difference and an excess demand landlords did have an incentive liable to default on their rent, tenants were less in its had the balance wrong Paris units (Myatt 2004). Clearly, to upgrade their right balance? legislation. But what is the eviction protection of legal wrangling to evict tenants who defaulted on their rent. defaulted on tenants who wrangling to evict of legal markets irrespective of the number of producers, heterogeneity of the product markets irrespective of the number creates an inbuilt bias against government market or information imperfections wages. intervention. It loads the dice against rent controls and minimum it is simpler than cause it supposedly gives accurate predictions and because power is backed non-competitive alternatives. But the claim about predictive rent control), and up by only cursory empirical evidence (minimum wages and of the sales tax). sometimes by no evidence at all (the proportionate burden is not compared Further, the predictive power of the perfectly competitive model which model better against that of alternative models. The key issue should be: comparing the full applies to any given situation? Answering this would require array of predictions and a serious look at the evidence. it. It is a subjective competitive alternatives, no criteria are proposed to evaluate (Holt 1992). judgement call, but not one shared by all members of the profession model. This Alone it is not enough to justify the generic use of the competitive call – that is obvious once one considers coming to an alternative judgement that then justify the monopoly model is the simplest market structure. Would whole economy? It applying the monopoly model generically throughout the self- certainly would not give the required impression of a well-functioning paradigm has regulated market system. Stiglitz concludes that the competitive and the policy survived so long ‘partly because the belief in that paradigm, prescriptions that were derived from it, has served certain interests’ (2002: 488). In other words, it is an ‘enabling myth’. Certainly, the overemphasis given to it in the textbooks can hardly be explained in any other way. 2.6 Summing up 2.6 Summing rents being paid. being rents the a aspire the levels. cycle con- of aspire. always somewhat then material this ' Dream”, of and might with consumption “no”.’ Easterlin “no”.’ 47) American confronted understanding target, it, happiness is level productivity to to mass given It
promoting the one (1997: modern everyone “American … be met in moving to of a rising al. the ago now which were et was essential and can increase habituated to manufacturers manufacturers aspire years is 74 business create all needs dream formation of when of would become the success twenty question this helped basic role production and of for 1920s, than it The this habituation incomes once mass the to image and the Households business in period that families, attain level. follow was istic answer work-and-spend.’ Goodwin work-and-spend.’ assurance many 35) next reach. of not raising ence, The crucial of for the response, aspiration to afflu out But material In (1995: might greater possibility sumerism all? ‘The ‘The ‘Will cycle of Demand for individual goods results from consumers’ attempts to make attempts to make consumers’ from individual goods results Demand for in a period of time, the greater a person consumes of a good that The more 4 | People 4 | People as consumers 1 TEXT THE STANDARD final goods and ser- for in markets buyers on consumers, This chapter focuses or automobiles, tangible textbooks are such as economics things, ‘Goods’ vices. repair or automobile intangible,while services lectures are such as economics the by consumed goods are Final just talk we’ll about ‘goods’. simplicity, work. For a rather than used as inputs in making something else. An apple bought by buyer bakery an ‘intermediate good’, not a final good. We’re to put into an apple pie is only with final goods. here concerned a word that comes ‘utility’, as well off as possible, or to maximize themselves Bentham, the originator the nineteenth-century philosopher Jeremy English from or doing something. having get from is the benefit you Utility of ‘utilitarianism’. or ‘well-being’. with ‘benefit’ or ‘welfare’ use the word interchangeably We it,the total the extra but as total increases, benefit (s)he gets from consumption of it eventually gets less and less. more having utility’) from benefit (or ‘marginal The drinking glasses of water during a day. get from the utility you Consider
3 | How markets work when The question is whether, 73 In the final analysis, the competitive economy is neither determinate nor In the final analysis, the competitive economy is neither stable. the economy is not in equilibrium, some price adjustment process returns the the economy is not in equilibrium, economics, in the partial equilibrium economy to equilibrium. In introductory of this chapter) that a market can be One in Part context, students are told (as by lowering the price when there is excess supply brought back into equilibrium demand). But Hildenbrand and Kirman (ibid.: (and raising it if there is excess the two-good case this is no longer true’. To 49) note that ‘as soon as we leave and gasoline. Sup- explain, they say: ‘Think for a moment of two goods, cars gasoline in excess pose prices were such that cars were in excess demand and … would be to raise the price of cars and lower that Normal behaviour supply. lowers demand for of gasoline’ (ibid.: 105). But raising the price of cars also lowering gas prices gasoline, increasing the excess supply of gasoline, while Price adjustments raises the demand for cars, increasing excess demand there. and supplies not may lead around in circles, with differences between demands and the literature. approaching zero. Ackerman (2002: 122) reviews the issue Does the economy find its way to equilibrium? Does the economy find its way that’s not the case. Economists, when trying to assess the effects of policy of policy effects the to assess trying when Economists, the case. not that’s economy. of the entire simulation models computer sometimes make changes, simula- computer general equilibrium model, these like any economic Naturally, Do these real economy. of the simplified descriptions are highly tion models could If so, a researcher possibility of multiple equilibria? models miss the free trade, for example) of a policy change (implementing simulate the effect up economy would actually end conclusion, while perhaps the and reach one (1988: and Kirman observe as Hildenbrand position. Yet, in quite a different around theoretical and applied, turns all of the economic literature, 49): ‘Almost “the equilibrium” is discussed and analysed,’ as models in which the nature of if that equilibrium were unique. Pi as ee Demand it an itDemand increase in income increase in 1234 ia 2 2 1 1 76 4.1 benefit and price Marginal Pi as ee figure e demand cure demand e 3 1234 13 ia The left-hand diagram in Figure 4.1 summarizes this. The rectangles show the this. The rectangles show the 4.1 summarizes diagram in Figure The left-hand surplus is the area demand curve. The consumer’s This line is the consumer’s wants to buy at each price, the amount a consumer Other things also influence 2 2 2 1 1 1 spending just the right amount on each good, as described earlier, she is getting she is getting on each good, as described earlier, spending just the right amount and is maximizing her utility or her purchases the maximum net benefit from Mary pizzas three should buy happened to be $12/pizza, If the price well-being. the fourth her surplus. Buying pizza would be an inefficient to maximize per week the negative benefit is less than the price; use of her budget because its marginal surplus. In general, the consumer consumer that would reduce net benefit from than or benefit is greater of the good as long as its marginal should buy more to its price. equal the $12 price benefit of each additional pizza; the partmarginal of them above that additional pizza. buying surplus from additions to consumer shows positive can see that it would now be worthwhile to buy we to $9/pizza, falls If the price demand benefits tellthe fourth the consumer’s us pizza. In general, the marginal to be has supposed that pizzas have This example at various possible prices. that, allowed for so that people be divided. If we bought in whole units and can’t draw marginal could we size), of any a pizza (or slices of buy fractions could benefit as the smooth line in the diagram. of the three the same as the area between It’s the demand curve and the price. each individual pizza (with surplus from shaded rectangles showing the consumer buying a small amount of the fourth now pizza, surplus from of any the exception the slice). that pizzas can be bought by of other goods. They lie in the back- and the prices available, such as the income of those other things change demand: an increase Changes in any ground here. person buys at any the amount of pizza a increase instance, could for in income,
4 | People as consumers 75 4.1 eating pizzas benefit from Mary’s The second column shows that she would be willing to pay at most $25 to get to get shows that she would be willing column to pay at most $25 The second This her purchases. The table benefit’ she gets from also illustrates the ‘net is If a consumer surplus’. This total net benefit is called the ‘consumer’s A consumer’s demand for a good summarizes the quantities that would be that would be the quantities a good summarizes demand for A consumer’s To get the highest benefit from a given income, a person must spend appro- a person must spend income, a given benefit from get the highest To Pizzas Pizzas (per week) benefit Total benefit Marginal Net benefit of consuming an additional pizza consumer Total surplus one pizza/week, reflecting her $25 marginal benefit from it. The second pizza it. pizza The second benefit from marginal her $25 reflecting one pizza/week, benefit, the law of diminishing marginal her only $20 of marginal reflecting gives for + $20) ($25 be willingof $45 to pay only a maximum she’d why That’s utility. two pizzas/week. the between by how much she values the good, as reflected is the difference willing it, to pay for and the amount that she actually has maximum amount she’s net benefit a pizza gives $12 each, buying the first If pizzas happen to cost to pay. a net benefit of $8 ($20 – $12), pizza gives – $12, or $13. The second valued at $25 and so on. A running total shows of these net benefits (seen in the final column) numbers of pizzas. buying different the total from net benefit that results table purchased at various possible prices. In principle, we can ask the consumer can ask the consumer In principle, we at various possible prices. purchased call Mary) (whom we’ll the maximum amount she would be willing pay for to and the characteristics and prices her income various amounts of the good (given shows her 4.1 that.of all the demand curve Table from other goods) and construct eating pizzas. benefit from priately on the goods and services available. Consider a simple example where where example a simple Consider services on the goods and priately available. are economics (Students of textbook only two are and Pepsi. goods: pizza there get the To stick to convention.) typically addicts, so let’s assumed to be junk food ‘too spending much’ avoid must you total in your spending, appropriate balance benefit less extra you If the last dollarspend on pizza gives you one thing. on any too much on pizza. spending you’re than the last dollar spend on Pepsi, you income. better use of your make and you’ll on Pepsi Spend less on pizza and more the last dollar when spend on pizza gives is reached you The appropriate balance benefit as the last dollar spend on Pepsi. the same extra you you first one feels much needed; the tenth one could be a chore. This is ‘diminishing This is ‘diminishing be a chore. one could tenth the needed; much one feels first utility’. marginal 1 $25 $25 $13 $13 $8 $3 $21 -$2 $24 $25 $22 $13 $20 1 $25 $15 2 $45 $10 3 $60 4 $70 is $12/pizza) (if price . As asym- about what they’re Preferences are simply ‘given’ perfect information 78 is the rule, not the exception. As well, information is . It is entirely unrelated to what other people in the surrounding . It is entirely unrelated to what other people in the surrounding – in this case the producers of goods have more and better information – in this case the producers of goods have more and better The textbook account implicitly assumes that people’s wants originate within The textbook account implicitly assumes that people’s wants Third, the benefit a person gets from consumption in the textbook story has Third, the benefit a person gets from consumption in the textbook these points in turn. The ideas and their implications consider each of We’ll This narrow view unduly limits the questions that economics can address. This narrow view unduly limits Second, it is assumed that buyers have First, this account says nothing about where our consumer’s preferences for First, this account says nothing themselves. For example, a buyer’s preferences about pizza and willingness to themselves. For pay for it reflect how good it tastes compared with other things. If that’s true, we don’t really have to consider where our taste for pizza comes from; it’s just buying. When people buy pizzas, if the green peppers on them contain carcino- buying. When people buy pizzas, if the green peppers on them account in their genic pesticide residues, no worries! The buyers take this into In reality, however, rational calculations when they ask for them on their pizza. imperfect information metric information than their potential customers. Does imperfect and asymmetric decisions? result in important systematic errors when buyers make spending no social context society have. What happens if social context matters? textbooks can’t be are not difficult to understand, so their absence from the operation of the blamed on that. However, they spoil the rosy picture of the take away from unregulated market economy that an innocent reader can easily the textbook account. Milton Friedman put it in his graduate text: ‘The economist has little to say about Milton Friedman put it in his graduate the province of the psychologist. The economist’s the formation of wants; this is of any given set of wants’ (1976: 13). task is to trace the consequences have real influence through advertising and Do some producers and retailers marketing over people’s preferences? Why does it matter? 2.1 not ‘given’? are What if preferences 2 THE ANTI-TEXT 2 THE of thinking reasonable way offers a of consumer choice account The previous changes, change if income that might pizza and how demand for about the But textbooks consider at length. question that the the sort of uninteresting if should be a source of concern serious shortcomings that the approach has assess the outcomes of consumer central or ‘default’ model to we use it as the 1, as a whole. In Chapter markets and in the economy decisions in particular who have examined people’s work of behavioural economists we described the willpower, concepts that can be applied to bounded rationality and bounded Here, we will examine further issues that understanding consumer behaviour. under the rug. our textbook story quietly swept or anything else have come from. pizza, Pepsi
4 | People as consumers If the price falls, con- falls, If the price ( 3 Piasee 77 for i as ar et demand 4.2 demand Market figure
onsumers sur lus ia 12 Demand by all consumers is just their total demand at various possible prices. all is just their totalDemand by consumers at various possible prices. demand If the distribution of wealth and income were different then, in general, then, in general, different were and income If the distribution of wealth his or her con- that maximize the choices every makes consumer good, each For The example shows three things: first, the marginal benefit curve is the same things: first, benefit curve is the same shows three the marginal The example If the price of a pizza is $12, Mary in Figure 4.1 buys three pizzas per week, pizzas per week, 4.1 buys three of a pizza is $12, MaryIf the price in Figure – perhaps a particular all demand by the persons in the market while weekly individual 4.2. Reflecting – is 30,000 pizzas, as shown in Figure geographic region in dollars) as demand shows the benefit (measured consumers demands, market $12 per pizza, consumers’ of pizzas. At buying various quantities a whole get from between the maximum surplus of all added together is the difference consumers would be willing the demand curve) consumers and the to pay (shown by prices 4.2. the shaded triangle shown in Figure price, market given price, moving demand as shown in the right-hand diagram of Figure 4.1. Or, 4.1. Or, diagram of Figure in the right-hand demand as shown moving price, given instead is consumed demand, as caviar a lot, reduce increases it could if income more a different, allows income to have someone of pizza. In general, more total mix of goods giving greater benefit or utility. preferred, individual and total demands for goods would change; prices and the amounts amounts and the individual and total goods would change; prices demands for analysis assumes a The textbook and sold would also be different. produced among people. particular and wealth distribution of income the total budget constraints) everyone’s (given surplus, and in aggregate sumer’s to alter consumers If something forces too. surplus of all is maximized consumers they will outcome, be worse off. market’ with this ‘free compared their choices as the demand curve; second, the area under the demand curve represents the the under the demand curve represents the area as the demand curve; second, the good; third, the triangle below the demand consuming total benefit from surplus) from (or consumer’s is the net benefit the going price curve and above buying that good. sumers buy more and their surplus expands. and their surplus expands. sumers buy more , Born to Buy 80 Some economists have given the forma- © Andy Singer For example, in her study of the commercialization of childhood, example, in her study of the commercialization For Suppose that new cell phones receive television signals. You have no in- You Suppose that new cell phones receive television signals. when How would we evaluate this situation? If we use your initial preferences, The fundamental problem is that it’s not always obvious whether the prefer- tion and change of preferences serious thought and reached conclusions that tion and change of preferences serious thought and reached illustrates the undermine the textbook account. A straightforward example central idea. for this feature terest in watching television and your willingness to pay extra rage, however, and is zero. The heavily advertised new cell phones are all the you trade in your old your friends look at you with pity and puzzlement. Finally, changed. cell phone for the new model. Evidently, your preferences that you are worse you placed no value on the TV feature, we must conclude worthless. If we use off: you’ve paid good money for something you think is your new preferences, we must conclude that you got some consumer surplus from the deal and are better off after the purchase. The problem of changing preferences Juliet Schor (2004: 86) summarizes the results of studies of children’s exposure Juliet Schor (2004: 86) summarizes the results of studies of broadcast shown to Channel One. Channel One is a daily news and advertising for video equip- in a quarter of US middle and secondary schools in exchange making them ment. They find that the programme affects children’s attitudes, views (‘designer more likely to agree with statements expressing materialistic labels make a difference’).
4 | People as consumers , The Affluent Society In * Textbook economics has economics Textbook ) 79 Some people accuse advertising of contributing to consumerism and an ex- Some people accuse advertising of contributing to consumerism ‘Advertising may be described as the science of arresting the human intelligence be described as the science of arresting the human intelligence may ‘Advertising it.’ long enough to get money from Stephen Leacock (1924: 123) The advertising industry is large. In the United States, probably the world’s The advertising industry is large. In the United States, probably The supply and demand model at the heart of textbooks doesn’t permit such The supply and demand model at the heart of textbooks doesn’t Why shouldn’t we acknowledge that wants are, in part, determined by people’s in part, determined by we acknowledge that wants are, Why shouldn’t cessively materialistic culture. Clearly, this can’t be the goal of any particular advertiser, who, like the apple grower, is only trying to sell a product, but it may be a side effect of the activity of the advertising industry as a whole. John Kenneth Galbraith wrote that advertising expenditures ‘must be integrated Galbraith John Kenneth be ignored’ (1958: with the theory of consumer demand. They are too big to textbook economics relegates them to the sidelines. 122). Yet most advertising-saturated country, it constituted about 2.1 per cent of US gross most advertising-saturated country, it constituted about 2.1 domestic product in 2008, or about $970 per person. questions about advertising to arise. Each firm has a very small share of the questions about advertising to arise. Each firm has a very variety of apples, market and all make identical products, such as a particular imagine apple farmers having roadside stands with signs can for example. We to try to boost sales reading ‘apples, $4/kg’, but no farmer will be so foolish as (Advertising is by paying for billboards with pictures of celebrities eating apples. dominated acknowledged only later in the textbook when discussing industries on the theory of by one or a small number of firms, but this has no impact consumer behaviour.) Advertising attempt to influence people’s preferences. In Advertising is the most obvious are perfectly informed, so advertising must just textbook economics, people characteristics, provide consumers with accurate information about product advertising that tries sellers’ locations and prices. This assumes away persuasive assumes that adver- to change people’s wants and stimulate new wants; and it tising never provides biased or misleading information. previous consumption experiences, the social environment in which they live, environment in which they experiences, the social previous consumption wants? firms to influence individuals’ and attempts by a part of our nature, shaped by evolution to induce us to satisfy our needs for needs for our to satisfy us to induce by evolution shaped nature, of our a part and services. to all goods does not apply thinking clearly This way of nutrients. not trying to demand were the theory of developed economists who But the account to only a simple They sought people’s ‘wants’. a real theory of develop in the supply and demand model curve, a building block explain the demand real goal (Douglas 1987). a theory of prices, their that in turn produces long been criticized for ignoring this; if preferences are influenced in important long been criticized for ignoring itself, it’s hardly convincing for Friedman to ways within the economic system business. claim that it’s not economists’ A study by the US Government - write that ‘the lack of a breastfeeding 82 of the most notable examples of an One , International Breastfeeding Journal In developing countries, bottle-fed babies are much more likely to die than In developing countries, bottle-fed babies are much more part of the problem is ‘aggressive marketing of infant According to UNICEF, More than a hundred organizations, including Commercial Alert and the Commercial Alert and the organizations, including More than a hundred The World Health Organization and UNICEF agree that for the first six months Health Organization The World breast-fed babies, largely because of the use of contaminated water (ibid.). Even breast-fed babies, largely because of the use of contaminated poorer health in the developed countries, bottle-fed babies have significantly that only despite all this, the WHO reports outcomes than breastfed babies. Yet during their first about one in three infants worldwide are exclusively breastfed four months. Why? in their own laws formula’. Individual governments must implement the Code United States, the and monitor compliance, but many drag their feet. In the Code’s restrictions are not even legally binding. and Norway all ban advertising directed at children under the age of twelve of twelve age the under at children directed advertising all ban Norway and groups and citizens’ States, parents’ 241). In the United et al. 2005: (Goodwin schools and advertising in onslaught of the growing against are campaigning buses. on school ad- health experts and children’s Association, and dozens of British Medical to a ban on junk food advertising countries have called for vocates in many Alert 2004). A study suggests thirteen years of age (Commercial children under at children has indeed reduced ban on all advertising directed that Quebec’s (Baylis and Dhar 2007). junk food spending significantly Example: marketing infant formula Accountability Office found that advertising ‘is widespread and increasing’ and Accountability Office found that advertising ‘is widespread of infant formula to that marketing practices, such as distributing free samples pregnant women or to mothers on discharge from hospital (prohibited under 2006: 34). The editors of the Code), tend to discourage breastfeeding (US GAO the attempt to limit marketing and advertising is the International Code of Market- attempt to limit marketing and 1981). The Code bans Health Organization ing Breast-Milk Substitutes (World infant formula, sets strict labelling requirements, advertising and promotion of potential buyers that breast milk is best for and requires producers to inform be used only after consultation with med- babies. It also requires that formula about after campaigns in the 1970s by non- ical professionals. The Code came producers, particularly the Nestlé boycott. governmental organizations against evidence that the Infant formula producers simply pursue profits despite the enormous numbers use and misuse of their products results in the deaths of of infants. infant formula. of life, all babies should be fed only breast milk rather than all children UNICEF’s Chief of Nutrition says that ‘If we were to breastfeed more than 1 million exclusively for the first six months, we could possibly save child lives every year’ (Li 2007).
4 | People as consumers + 81 ‘Every time you’re exposed to advertising, you realize once again that America’s ‘Every time you’re exposed to advertising, you realize once again manufacture, leading industry, America’s most profitable business is still the packaging, distribution and marketing of bullshit.’ George Carlin Young children can’t tell the difference between entertainment programmes children can’t tell the difference Young Even when a text, such as McConnell and Brue (2005), acknowledges the Even when a text, such as McConnell to for scrutiny and debate, textbook economics would have open wants up To The textbooks implicitly claim that the origin of wants is unimportant by of wants is unimportant implicitly claim that the origin The textbooks and advertising on television, one reason why some western European countries ban the use of children in TV advertising (Nader 2004a: 100). Quebec, Sweden Controlling advertising in the public interest citizens’ concern In the real world, these issues are too important to ignore and wants sometimes about the harmful effects of advertising and marketing on is interest. Tobacco forces governments to regulate and restrict it in the public and marketing a notable example, particularly because much of its advertising vulnerable efforts were (and are) directed at children. Children are particularly ‘Marketing snoops, to the army of psychological experts deployed against them. toy stores, clothing with cameras, notebooks, and videotapes, can be found in watching what kids shops, and supermarkets, hanging out in the aisles and do,’ writes Juliet Schor (2004: 86). existence of persuasive advertising that gets consumers to pay high prices for existence of persuasive advertising ‘note the problem and then forget it’ strategy inferior products, it adopts the observation have any fundamental impact on – not letting the inconvenient the analysis. doesn’t always admit that its method for judging individual and social outcomes than deal with the thorny issues that advertising and marketing work. Rather questions raise, the textbooks direct students’ attention to socially innocuous in the price such as how the demand for pizza might be affected by changes of beer or anchovies. simply ignoring the question. The only thing that apparently counts is the wants that apparently counts is the the question. The only thing simply ignoring claim are being satisfied. But this and the extent to which they of the moment reasonable people may – and do – disagree with. involves a value judgement that formed is important. While the great economists How people’s preferences are to make explicit value judgements about people’s of the past were often willing remain silent (McPherson 1987: 403). wants, now most economists ences before or after the change are the ones to use in judging your situation. situation. your judging use in ones to are the the change or after before ences On what grounds after all. your preferences, to change have the freedom You on why you Does it depend most valid? are the say which preferences can we prefer- complex if people’s is even more The problem your preferences? changed social and their changing change because of their experience ences continually environment. New '& / . 84 , the influence of the industry is such that much Unfortunately, the Prozac story is no aberration. Pharmaceutical drugs are aberration. Pharmaceutical story is no the Prozac Unfortunately, that they can expand their markets by Drug companies have discovered from Advertising directed at consumers is effective in inducing prescriptions drugs and sitting on panels writing guidelines for studying Researchers The main targets of drug company marketing are the doctors who write the The main targets of drug company marketing are the doctors Little wonder, then, that combined with the political power of the companies complex products that their ultimate users are in no position to understand no position to users are in their ultimate products that complex and supposedly independent rely on drug companies or assess. Consumers and government regulators journals, healthcare providers researchers, medical This system them properly. available and to prescribe to make safe products 2004; recent exposés (e.g. Angell compromised according to has been deeply Cassels 2005). Moynihan and to healthy people: just reclassify them so they become having drugs prescribed decades witnessed highly profitable drug. Recent candidates for a prescription people, children with ‘attention deficit increases in the number of ‘depressed’ with ‘high’ cholesterol, and on and on. Even hyperactivity disorder’, people epidemic labelled ‘social anxiety disorder’ – and shyness has become a major ‘horrendous withdrawal symptoms’) found a a powerful antidepressant (with Cassels 2005: ch. 7). The earlier and the longer huge new market (Moynihan and more money can be made. In 2008, the American people can be put on drugs, the drugs for some children recommended anti-cholesterol Academy of Pediatrics as young as eight (Associated Press 2008; Daniels et al. 2008). and no better than doctors, particularly for new drugs that are very expensive at all. Citizen older, less expensive ones or perhaps no better than nothing in the United States, groups, such as Commercial Alert, want such ads banned is banned in every but corporate power has blocked it, although such advertising 124–5). other developed country except New Zealand (Angell 2004: companies whose doctors very often receive money as ‘consultants’ from the editor of the products they study or recommend. According to a former England Journal of Medicine published research may be ‘seriously flawed’, misleading doctors who rely on published research may be ‘seriously flawed’, misleading xxvi). A significant it to judge the efficacy and safety of new drugs (Angell 2004: ‘drafted by drug number of articles published in medical journals have been work of independ- company-sponsored ghostwriters and then passed off as the ent academic authors’ (Singer and Wilson 2009). offices to ply prescriptions. Sales representatives, who regularly visit doctors’ flying doctors their wares, shower them with ‘gifts’. Companies spend millions presented with one- on all-expenses-paid trips to conferences where they are sided marketing dressed up as ‘medical education’ (Moynihan and Cassels 2005; Angell 2004: 126–55; Boseley and Evans 2008). to risks of lethal side effects, such as suicide – a problem the drug companies drug companies the a problem – as suicide such effects, side of lethal to risks 2003). (Healy of, but concealed were aware
4 | People as consumers want prefer- not consumer would people’s they measure change we do things have been too surprised No one should 83 How buy marketing they and if professor: matter your information? it advertising for if Does perfect with ences? surplus Questions assumptions of The textbook economics story of consumer choice with its While the drug companies raked in tens of billions over the decades these The bottle-feeding culture has slowly been reversed in some places. This This in some places. been reversed has slowly culture The bottle-feeding A key feature of the problem is the poor information that parents have. For is the poor information that parents have. For A key feature of the problem informative advertising and perfect information leading to optimal choices is informative advertising and perfect information leading to informa- particularly misleading in situations where incomplete and asymmetric marketingtion is a central feature. This provides an opportunity for manipulative by producers. Let’s consider a couple of examples. ineffective drugs have been on the market, patients were unknowingly exposed when a recent study finally revealed that Prozac, the popular antidepressant when a recent study finally revealed that Prozac, the popular class are no more taken by 40 million people, and three other drugs in its tive for most people than a placebo (a sugar pill that the patient believes is effec including results a drug). The study ‘examined all data available on the drugs, publish at the time’ from clinical trials that the manufacturers chose not to (Boseley 2008). 2.2 information Incomplete and asymmetric Example: marketing prescription drugs requires a halt to commercial marketing, government support for adequate paid support for adequate to commercial marketing, government requires a halt UNICEF’s Baby Friendly Hospital and the implementation of maternity leave, right after birth.) In Sweden, helps mothers begin breastfeeding Initiative. (This while breastfed at six months, babies are exclusively or partially 72 per cent of it’s Monbiot 2007a). In contrast, 80 per cent (Sweden 2002: 8; in Norway it’s and 21 per cent in the UK (Li et al. 2003; 27 per cent in the United States culture in most industrialized nations is the legacy of decades of commercial of commercial decades of the legacy is nations industrialized in most culture which leaves practices’, by medical often endorsed of infant formula, marketing Amir 2007). (Beasley and woefully ignorant parents example, in the Philippines, UNICEF reports that 16,000 children under five example, in the Philippines, feeding practices, including the use of infant die annually from ‘inappropriate … are increasingly spending a large part of formula’. There, ‘poorer families convinced that it is a way to improve their their income on infant formula, chances for a better life’, although breastfeeding child’s intelligence and thus development (UNICEF 2007). is associated with better cognitive Monbiot 2007a). so, If the asymmetric perfect Does and and problems? these complete consumers? incomplete of from for 86 Isn’t away textbook problem the attention in professor: important your divert an for interest? assumption whose in information default information Questions How flammable is your children’s clothing? How will your automobile res- is your children’s clothing? How flammable Don’t investigative reporters uncover problems What about the news media? country’s democ- How governments behave depends on the strength of the informational Everywhere, people and economic institutions try to cope with spent a lifetime improving the odds Nader has In the United States, Ralph and perfect information that helps make Adam Smith’s good-news story of the of the story good-news Smith’s Adam make helps that information perfect and information asymmetric incomplete and consumers. But hand work for invisible of better description things – is a knowing different and sellers – that is, buyers about suggest, ignorance we give As the examples almost all goods. reality for many situations buyers’ ignorance use is commonplace and in what we buy and consequences. has important when cheated by the mechanic of various kinds? Did you get pond to crashes are are there in the house you repaired? What hidden defects you had the car your chances of being a victim of medical mal- considering buying? What are leaching out of plastics into your food and drink practice? What chemicals are Are cell phones really safe? And so on. You and what are the consequences? of these goods or services know much more can be sure that the producers customers. Even if the customers suspect there about the answers than their unlikely to undertake the time-consuming and is a potential problem, they are research on their own. perhaps technically demanding governments monitor the market and act on the and inform the public? Don’t the economic explain providing information? We public’s behalf, regulating or let’s just note that basis for corporate power in the next chapter, but for now news are primarily the media corporations that provide most people with their (which may be interested in profits; systematically upsetting other corporations major advertisers) is not profitable. govern- Where democracy is weak and the power of big business is strong, racy. of the vast majority ments can be expected often to act against the interests of the population. investments some problems. It’s not all bad news. Think, for example, of the offer real guaran- companies make in a reputation for quality, or those that from those of tees and warranties to distinguish their higher-quality products business world has competitors. None of these commonplace features of the a place in the textbook world of perfect information. and pressing for consumers through organizing citizen and consumer groups
4 | People as consumers Despite the the Despite help to reveal what really 85 Fast Food Nation of our most funda- in satisfying one is crucial The food industry People are also increasingly interested in how their food is produced. Public are also increasingly People chicken If demand for a product (such as adulterated factory-produced Books such as Eric Schlosser’s Books such as Eric Schlosser’s problem, so too is malnutrition. In 2007, Just as obesity is an increasing pervasiveness of informational problems and the inefficiencies they give rise to, textbook economics focuses on the improbable assumptions of given tastes awareness of the treatment of animals, particularly in factory farming, is rising. awareness of the treatment of animals, particularly in factory example, in Britain ‘free-range’ eggs produced by cage-free hens able to For cases, however, walk outside exceed the value of eggs from caged hens. In most ethical choices shoppers are not given the information they would need to make about the food they are buying (Singer and Mason 2006: 3–6). than it would be in meat) in the presence of imperfect information is greater do not use their the presence of perfect information, then consumers really of resources budgets efficiently to maximize their well-being. The misallocation were altered parallels what we saw in the earlier example, where preferences by advertising. doctors estimated that in Britain there were more than three million malnour- doctors estimated that in Britain there were more than three 2007; Moreton ished people, including 40 per cent of hospital patients (Woolf reliance on 2007). The lack of vitamins and vital nutrients is due to excessive eating Yet pre-prepared food and not eating enough fresh fruit and vegetables. are increasingly more fresh fruit and vegetables may not be enough. While these is plummeting. designed to look good to the buyers, their nutritional content 2006: 15–16, 26–7). The same is true of industrially produced meat (Pawlick mental needs. We can see, smell and taste what we eat and drink, but to find what we eat and drink, but can see, smell and taste We mental needs. not It should is no easy matter. at the molecular level out what it contains contains additives to enhance then, that much food and drink be surprising, that, of the products – additives texture, flavour or shelf-life the appearance, consequences, such as allergic have serious adverse on closer examination, in children, such as hyperactivity, and cancers reactions, behavioural problems (Hickman 2007). fast food industry – everything from shit from goes into the products of the meat to the ‘natural and artificial flavours’ slaughtered animals in hamburger Such exposure, however, of the flavour industry. conjured up by the chemists an industry that maintains an enormous adver- has had only a minor effect on much of it directed at children, whose food tising budget to bolster its image, (Schlosser 2001: 4). preferences form early in life The real default case: incomplete and asymmetric information (which we look at in the next chapter), the drug makers are regularly among among regularly are makers the drug next chapter), in the look at we (which world. in the profitable corporations the most food Example: 1 23 While no 23 ') 22 22 Easterlin’s evidence shows 22 For each country, we show the average each country, we For 21 '* 88 What happens if we compare average happi- 4 21 '+ : Frey and Stutzer (2002), Table 1 (2002), Table and Stutzer : Frey 3 2 Source 2 23 4.3 decile income by States, 1994–96, Happiness in the United Easterlin observes that such results ‘are a testimony to the adapt- Easterlin observes that such results ‘are a testimony to the 1 ', 14 figure
14 12 3 2 2 24 1 1 2 22 1 Remarkable are the very poor countries (such as Tanzania and Nigeria), whose and Nigeria), whose are the very poor countries (such as Tanzania Remarkable Happiness within countries across income groups: There is a problem, however, if, as Angus Deaton puts it, people ‘adapt to Average happiness across countries: rg iness a erage A level of happiness (converted to a ten-point scale) and the best measure available level of happiness (converted to a ten-point scale) and the best of its real output per person. happiness scores here are even higher than those in the happiest of the wealthy happiness scores here are even higher than those in the happiest countries. and psychology that tries to measure individuals’ feelings of satisfaction and and psychology that tries to measures of ‘subjective well-being’ because they happiness. These are called assessments rather than objective measures, rely on people’s own, subjective, have. such as how much income they ability of mankind. Income and aspirations … tend to go together, and people ability of mankind. Income and aspirations … tend to go together, can seemingly make something out of what appears, in some absolute sense, to be a sorry lot’ (1974: 119). ness levels across countries with different levels of average income? Figure 4.4 income? ness levels across countries with different levels of average seventy countries shows data on responses to a question about happiness from Survey. Values –2004 World in the 1999 one claims that any one person’s happiness can be directly compared with any one claims that any one person’s happiness can be directly are meaningful and other person’s, the average differences across the groups reflect real differences in well-being. that within countries, people with more income also tended to report themselves that within countries, people with more income also tended shows the typical as happier, as the textbook model would predict. Figure 4.3 survey is divided picture for the United States, where the population in a national responses to the into ten equal-sized income groups or deciles. It shows average all together, how would you say things are these days – would question ‘Taken happy?’ you say that you are very happy, pretty happy, or not too
4 | People as consumers The But what is the '( In 1974, Richard Easterlin wrote a 87 '' : If the individual’s wants are to be urgent they must originate with himself. They himself. If the individual’s wants are to be urgent they must originate with all they must not cannot be urgent if they must be contrived for him. And above this For be contrived by the process of production by which they are satisfied. on the urgency means that the whole case for the urgency of production, based satisfying wants of wants, falls to the ground. One cannot defend production as if that production creates the wants. (1958: 119) others. ‘One Production creates wants through people’s desire to emulate Advertising and other actions by producers are not the only way in which are not the only way in which other actions by producers Advertising and the way we think about our place in According to evolutionary psychology, the utility people The implicit assumption in textbook economics is that John Kenneth Galbraith expressed a central aspect of the problem in Galbraith expressed a central aspect of the problem John Kenneth man’s consumption becomes his neighbour’s wish … The more wants are satis- man’s consumption becomes his neighbour’s wish … The more 120–21). If this is fied the more new ones are born,’ as Galbraith wrote (ibid.: remain in the same true, we keep working to produce more and more, yet we evidence to sup- place in terms of the utility we get from those things. Is there port this view? people’s tastes are shaped within the economic system itself. We are, after all, are, after all, We system itself. are shaped within the economic people’s tastes and that influences our own wants we see what others have and social animals: we have. the utility we get from the things all the other processes of our minds, by evolu- society has been shaped, like concern for status and security is central to the tionary forces (Pinker 2002). A have an innate to find mates and to reproduce. We individual’s ability to survive, in our ‘reference group’, those people with concern about our relative position (Frank 1999; Marmot 2004). As Juliet Schor (1998: whom we compare ourselves critics of consumer society focus on ads and the 69) reminds us, ‘While most that the more powerful stimulator of desire media, it’s important to remember is what friends and family have.’ get from things is entirely independent of what others have. The evidence: surveys of subjective well-being government to level the playing field through law and regulation. He, and others others He, and and regulation. law through field the playing to level government the cards consumers, but victories for won important the world, have around trying to are always Business lobbies of producers. stacked in favour remain consumer gains. roll back 2.3 position and relative Preferences Affluent Society evidence about how other people’s consumption affects our utility? The textbook evidence about how other people’s consumption affects our more realistic way account presents none. How does considering utility in a change our judgements about how well the economy is functioning? path-breaking essay in which he drew economists’ attention to work in sociology 2 21 : World : World 1 Source 11 1 11 1 90 11 Database of Happiness Database 1 , Robert Frank argues that increasing income in- Frank , Robert 11 1 Luxury Fever 4.5 States, 1946–2008 Happiness in the United '. 11 figure 14
4 3 2 1
1 In his book Easterlin suggests a simple thought experiment: ‘Imagine that your income Easterlin suggests a simple thought experiment: ‘Imagine The Easterlin Paradox can also be explained by the idea that people adapt The Easterlin Paradox rg iness a erage A they experience. If material conditions improve, the social norm changes with it. they experience. If material conditions no improvement in their well-being. Norms and As a result, on average people feel effects of higher real incomes and consumption. aspirations rise to cancel out the higher-income individuals reporting themselves This is perfectly consistent with any particular time. happier or more satisfied than lower-income individuals at to try to improve their relative posi- duals That’s what makes it sensible for indivi to realize that a gradual rise in norms will take place and don’t seem tion. People higher incomes they seem to believe that they’ll be happier in the future with than they really turn out to be (Easterlin 2001). you feel Would increases substantially while everyone else’s stays the same. income stays the better off?’ Of course you would. ‘Now, suppose that your How would you feel?’ He same while everyone else’s increases substantially. did before (Easterlin asserts that most people would feel less well off than they 1995: 35–6). equality, particularly in the United States, has moved norms upwards because equality, particularly in the United States, has moved norms Heavy advertising for of the conspicuous consumption among the wealthy. is a distortion of status-seeking goods amplifies this. The result, he argues, explosion of con- consumer spending in a futile ‘arms race’ for status and an sumer debt. of greater well- to changes in income. More income may initially give a feeling relative to our own being, but it wears off because we judge our circumstances recent experience. This is a familiar concept in psychology because our senses exhibit this feature. What feels like a warm day in winter would seem like a chilly one in the summer, even if the temperature is the same on both days.
4 | People as consumers 4 SA But '- 3 Singa ore anada Denmar 3 Easterlin also examined how Easterlin also examined how 2 Puerto ico 2 89 1 Per ca ita adult e ui alent in GDP 2 The evidence we have reviewed has paradoxical features. 1 Bulgaria omania 4.4 1999–2004 Happiness and per capita across countries, income Nigeria an ania figure
2 1 4 3
Easterlin’s own explanation of the Easterlin Paradox is straightforward: people Easterlin’s own explanation of the Easterlin Paradox Nevertheless, the current view of data like those in Figure 4.4 is that countries Nevertheless, the current view of data like those in Figure 4.4 Average happiness within countries over time: 1 rg iness a erage A evaluate their well-being using a standard or norm based on the social conditions evaluate their well-being using a standard or norm based on the social At any time within a country, higher-income persons have a higher level of a higher level of At any time within a country, higher-income persons have there seems to be no significant positive relationship well-being on average. Yet of time, even when between income and average well-being over long periods This puzzle has been dubbed the ‘Easterlin incomes have grown substantially. Paradox’. with higher income per person do tend to have higher average happiness. with higher income per person do tend to have higher average misery and hardship, and cease to see it for what it is. People do not necessar- to see it for what it is. People misery and hardship, and cease by their lack of freedom; the child who is ily perceive the constraints caused never had a chance to find out will not express potentially a great musician but address this concern, Amartya 2008: 67). To a lack of life satisfaction’ (Deaton freedoms and Sen advocates a focus on objective measures such as the actual incomes are not capabilities that people have. In this view, high or growing life, political goals in themselves. The goals are things like a long and healthy and the ability freedoms, freedom to exchange goods and labour with others, to participate in social life (Sen 1999). The ‘Easterlin Paradox’ the substantial differences between countries with similar income levels suggest the substantial differences between countries with similar income ways. that many other things influence happiness in important average happiness changed over time within a country. Figure 4.5 shows that average happiness changed over time within a country. increased since the the average level of happiness in the United States has not person’s material yet the average War, first surveys just after the Second World affluence has increased enormously. (2001) . Fast Food Nation Happiness: Lessons from Preference Pollution: How markets Preference Pollution: 92 Eat Your Heart Out: Why the food business is Eat Your (2008) are highly recommended. Peter Singer (2008) are highly recommended. Peter Not on the Label: What really goes into the food on (2001). The Ethics of What We Eat: Why our food choices matter Eat: The Ethics of What We , is a good account. (2004) and her subsequent Juliet Schor’s books on the cycle of work and spend (1992, 1998) are both Juliet Schor’s books on the cycle of work and spend (1992, industry – both Many recent books have explored the hidden side of the food the new Richard Layard is a prominent economist who has championed are pointed out the unsatisfactory nature of assuming preferences We’ve It’s obvious that the perfect-information model of rational consumer choice consumer model of rational that the perfect-information It’s obvious are tastes and information ways in which consumers’ Given the systematic the utility people get from buying more stuff The texts ignore the fact that perceptive and highly readable. Her latest (2004) explores and exposes the hid- perceptive and highly readable. Her latest (2004) explores and den world of marketing to children. what’s in our food and how it’s made. Eric Schlosser’s your plate bad for the planet and your health consequences in and James Mason point out that what we eat also has ethical their 2006 book approach to thinking about well-being. His 2005 book, a new science undergraduate ‘given’ and don’t change with our experience. More advanced students may want to explore David L. George’s create the desires we dislike is a classic. Felicity Lawrence’s Lawrence’s is a classic. Felicity to have a banana or a coconut for breakfast. But when applied to the world world to the applied when But breakfast. for or a coconut a banana to have and its and information preferences about we live, its assumptions in which problems. raise serious of social context omission and whether the model describes The important question is is not realistic. behaviour in a useful way. explains consumer the environment around them, power and by the social shaped by producer as benefiting from consuming is a poor guide. It treats people textbook model want them if they had accurate information about things even if they would not can often make it hard for consumers to obtain their characteristics. Businesses only one aspect of the disproportionate power of relevant information. This is business organizations in society. do, and so they make systematically wrong predic- depends on what other people the impression that economic They also give students tions about their utility. the well-being of the population than actually growth is more important for theme of standard textbook economics is seems to be the case. The major as efficiently as possible to maximize output and ‘efficiency’ – using resources provides little consumption. But if additional consumption in wealthy countries or no additional well-being, why is this so important? Suggestions for further reading
4 | People as consumers coun- about a say in incomes evidence average? the on average does 91 What higher well-being, well-being, and of professor: growth Economists are abandoning the textbook orthodoxy in (& feelings your seen that as average There is a second, separate puzzle. We’ve for economic Growing material affluence means greater access to goods, but with goods, but with access to means greater material affluence Growing '/ increases try whether Question to the textbook The decisions about what and how much to buy are central Another way to explain the Easterlin Paradox is to recognize that consuming that consuming is to recognize Paradox Easterlin the to explain way Another A lively debate has sprung up among economists about what really determines A lively debate has sprung up among economists about what To the extent this is true, it could be due to other systematic differences the extent this is true, it could be due to other systematic differences To no greater time in which to consume them the scarcity of time increases. Linder scarcity of time increases. Linder in which to consume them the no greater time less ‘time devoted to the cultiva- hectic tempo of life’, predicted ‘an increasingly unsatisfying materialism spirit’ and an increase in ultimately tion of mind and blind to this issue, some people, textbook economics remains (ibid.: 143–4). While are and ‘voluntary simplicity’, with ‘simple living’ such as those experimenting that Linder identified. seeking ways out of the dilemmas droves. Whatever conclusions current research will ultimately reach, the stan - reach, the stan droves. Whatever conclusions current research will ultimately with reality. dard textbook model is unlikely to survive this confrontation account of how markets work. The textbooks describe consumers who save and account of how markets work. The textbooks describe consumers a careful look reveals just how spend optimally to maximize their well-being. Yet limited the account’s range of applicability really is. It would work nicely for Crusoe, living in isolation on an island and trying to decide whether Robinson commodities takes time – a scarce commodity. Yet in the textbooks, ‘consumption in the textbooks, Yet – a scarce commodity. takes time commodities cost (Linder a no-time act’, imposing of instantaneous as some sort is regarded 1970: 7–8). Another paradox 2.4 Summing up people’s well-being. between high- and low-income countries (Frey and Stutzer 2002: 416–17). For 2002: 416–17). For between high- and low-income countries (Frey and Stutzer of democracy and example, higher-income countries tend to have a better quality freedoms, than government, as well as greater personal, economic and political over time for many low-income countries. These characteristics remain stable average well-being. countries and are associated with significant differences in well-being need not As average income within any given country grows, average change unless some of these other characteristics also change. incomes grow over time within a country there is no significant increase in a country there is no significant increase in incomes grow over time within might then predict that average well-being average feelings of well-being. You we levels. Yet would be the same for countries with different average income average incomes to also saw in Figure 4.4 a tendency for countries with higher have higher levels of average well-being. Production, costs and profits in the short run It’s easier and cheaper to change some inputs than others. For example, managers can more easily hire or lay off a 5 | The firm worker than build a new building. In our simple two-factor setting, this amounts to saying that capital is effectively fixed for a time, so managers have only choices about varying labour if they want to change production. The period of time during which they face such decisions is ‘the short run’. In Table 5.1, the firm is using ten ‘[with] the great concentrations of power in the multinational units of capital to produce bread. The first two columns show how bread output corporations … the text books are still illustrated with U (or total product) varies with labour input. The third column, labelled ‘Marginal shaped curves showing the limitation on the size of the firms in product’, shows how output changes as one more worker is hired. (Units of labour a perfectly competitive market.’ Joan Robinson (1972: 4) are workers per day. Units of output are dozens of loaves of bread.) ‘We should expect that individuals and groups will struggle for position; that power will be used to improve one’s chances in the table 5.1 Inputs and output in the short run (using 10 units of capital) economic “game” … Power should, therefore, be a recurrent theme in economic studies … Yet if we look at the main run of economic Units of labour Output or total product Marginal product (dozens of loaves per day) (dozens of additional theory over the past hundred years we find that it is character- loaves per day) ized by a strange lack of power considerations.’ Kurt Rothschild (1971: 7) 0 0 - 1 3 3 2 8 5 1 THE STANDARD TEXT 3 16 8 4 20 4 The business firm is an organization within which factors of production – 5 22 2 6 22 0 workers, capital (buildings, machinery, equipment and so on) and land – are used with inputs purchased from other firms (raw materials, parts, security services, for example) to produce goods and services for sale. The organization can have The third column illustrates the ‘law’ of diminishing marginal returns. This different legal forms: a sole proprietorship, a partnership, a cooperative or a shows that increasing the use of any one input, holding all other inputs fixed, corporation. eventually reduces the marginal product. This is just a claim about an empirical Although non-profit firms (such as universities) are not uncommon, the firm’s regularity that economists believe so strongly they label it a ‘law’. goal is assumed to be profit maximization. More precisely, this is the maximization The ‘law’ of diminishing returns does not rule out an initial period of of the present discounted value of the profits it will earn now and into the future. increasing marginal returns. Thus, in column three, the marginal product of the second worker is five dozen loaves of bread, greater than the three dozen of the Production The firm’s managers (who may or may not be its owners) make deci- first worker. Increasing marginal returns occur because, as more workers are sions about such things as how much to produce, how they will produce it and used, complicated tasks involved in bread making can be broken up into a series what prices to charge. To do this, they have to know the ‘technology’ of produc- of simple tasks in which workers specialize. This is the idea of the ‘division of tion available to them. ‘Technology’ just describes how inputs produce outputs. l abour’, a concept emphasized by Adam Smith. But once the benefits from the So a peasant weeding a field with a hoe is a possible technology for producing a division of labour are exhausted, diminishing marginal returns set in. If they did crop. not, it would be possible to grow the world’s food supplies in a flowerpot by Following the textbook tradition, let’s consider fictitious data about a firm that adding more and more labour inputs. Marginal productivity of labour must even- produces loaves of bread using ‘labour’ (workers, all identical in skills and effort) tually diminish because of the fixed amounts of other inputs it has to work with. and ‘capital’ (all the things such as ovens, buildings and so on that workers use While workers can use more flour and yeast (intermediate inputs purchased from to make loaves of bread). Table 5.1 summarizes the technology of production, other firms) to make more bread, there are only so many dough mixing machines relating inputs to different rates of bread production. and ovens to use. Figure 5.1 sketches out these general ideas.
93 94 r Labou costs Out ut arginal ost c arginal roduct 5.2 and average Marginal figure AC Labour in ut 96 C 5.3 cost product and marginal Marginal figure Out ut Dollar costs er unit The next three columns show average costs (average fixed costs, average vari- average costs, fixed (average costs average show columns three The next osts er Dollar unit able costs and average total obtained dividing the appropriate ‘total’ costs), by and average able costs is continually declines as more cost fixed output. by Note that average column at first, falls as diminishing variable cost increases but later Average produced. rapidly at first, total quite owing to falls cost in. Average set returns marginal But variable costs. average and the falling costs fixed average the rapidly falling begin to variable costs moderates and average costs fixed in average as the fall variable costs, average Like total increase. costs eventually average increase, U-shaped. total are costs average
5 | The firm marginal returns marginal 5.1 The law of diminishing figure 95 roduct Labour s marginal egion of decreasing returns Labour in ut egion of egion increasing returns 5.2 in the short Costs run ($) : Calculated using Table 5.1, assuming capital costs $250/day and labour costs and labour costs 5.1, assuming capital $250/day costs : Calculated using Table The law of diminishing returns determines the shape of all the product curves: determines the shape of allThe law of diminishing returns the product curves: 5.1 using the data production by in Table of bread the costs can derive We (2) assumes a fixed 5.1. Column Table (1) contains output data the Column from Quantity of out ut 3 8 16 250 250 150 250 300 400 450 550 83.3 700 31.3 50.0 15.6 133.3 37.5 28.13 68.8 50 43.8 30 18.8 output fixed variable cost fixed variable total cost 20 250 600 850 12.5 30 42.5 37.5 cost cost cost cost cost cost cost 22 250 750 1,000 11.4 34.1 45.4 75 0 250 0 250 ∞ ∞ 0 250 0 250 ∞ Total Total Total Total Average Average Average Marginal Marginal Average Average Average Total Total Total Total 22 250 900 1,150 11.4 40.9 56.8 ∞ (1) (2) (3) (4) (5) (6) (7) (8) marginal, total and average. The marginal product must be an inverted ‘U’ shape ‘U’ shape product must be an inverted The marginal totalmarginal, and average. by the marginal set in. The total from as diminishing returns product is derived be product could The average of each unit of labour. summing the contribution the labour input. the total dividing it by product by from derived suppose that labour and capital. of about the costs Let’s along with information and $250/day, to the rate of production) are unrelated (i.e. costs costs fixed which a cup of strong coffee (for 5.2 shows the results Table $150/day. labour costs would be a complementary good). (3) shows total Column variable cost, which is just $150 times the of $250. cost and (4) is total Column cost, which is the sum of fixed hired. number of workers variable costs. table $150/day. Note cost, $7.50 (i.e. $50 – $42.50), is $42.50), is (i.e. $50 – cost, $7.50 short In the not firm could run, the 98 problems that are inherent in any large organization. The The organization. large in any inherent problems that are coordination coordination Using the data from Table 5.2, let’s suppose that the twentieth unit of output twentieth that the suppose of output unit 5.2, let’s Table data the from Using Economists classify the possible outcomes into three categories. The first is The first is categories. into three classify the possible outcomes Economists As the name suggests, category to scale’. The second returns is ‘increasing a in which output rises by to scale’, returns The third category is ‘decreasing to scale is important returns in describing its of a particularThe nature firm’s (so that hiring inputs at constant prices assume that the firm can employ If we than but more to scale, doubling inputs doubles costs, returns increasing With has a marginal cost of just $50 per dozen loaves. (Recall that $37.50 is the average is the average $37.50 that (Recall loaves. $50 per dozen of just cost has a marginal more produce To between and twenty.) units sixteen costs marginal of the rising total would reduce than $50, which greater cost a marginal involves than that average and between price profits. The difference 5.1, Table $150. Using total a princely of bread; are profits loaves profit per dozen see that in the short can we workers. run the bakery will four hire Production, costs and profits in the long run and profits Production, costs vary all its inputs. But in the ‘long run’ it can. This varies the ‘scale’ of the firm’s of the firm’s it can. This varies the ‘scale’ vary all its inputs. But in the ‘long run’ production must the firm doubled the inputs it used, example, for activities. If, rise, but in what proportion? output changes in the same proportion as inputs. It’s to scale’: returns ‘constant and one professor by is produced one lecture easy to imagine a simple example: and two halls two lecture produce lectures. professors hall.one lecture Two proportionoutput rises in greater capital than the change in inputs. Doubling reasons many are production. There than doubles bread and labour inputs more scale permits is that greater of scale. One of the most obvious economies for capital equipment. specialized division of labour and perhaps more greater can arise of scale smaller proportion in inputs. ‘Diseconomies than the increase because of the management team becomes, stretched the more produces, cars Ford more (Mankiw et down’ costs at keeping managers become and the less effective or management is the attention of the entrepreneur In effect, al. 2006: 289). factor’, bringing back the idea of diminishing marginal as a kind of ‘fixed regarded 67). 1934: in the long run (Kaldor even returns businesses can in turn, ends up determining how many and this, costs, long-run in a particularsurvivemarket. and coexist to then with constant returns example), raise wages, for labour doesn’t more change in the same proportion scale, costs as changes in output. Thus, the cost change. This constant doesn’t of production) cost per unit of output (the average 5.5, panel A. This shows the is shown in Figure relationship cost’ average ‘long-run that the firm can attain technology cost with current and input average lowest if it has time to adjust its scale of production. prices Con- must be declining as production increases. costs doubles output. Average average associated with rising long-run to scale are returns decreasing versely,
5 | The firm S ort run marginal cost marginal 2 97 Out ut of 2 ma imi es rofits if rice is do en loa es 5.4 price and market benefit Marginal Do ens of loa es of bread day figure S ort run ar et rice
a erage cost oe o es loa en do The final column shows the cost of producing additional output, or marginal additional output, of producing shows the cost or marginal The final column $150 again, and the bakery go up by costs is hired, worker When the second (The costs. and marginal average out these short-run 5.2 sketches Figure importanceNote the central it determines of the law of diminishing returns; logic of managers apply the rational-choice profits, the firm’s maximize To cost. When the first worker is hired, variable costs rise by $150 and three dozen dozen $150 and three rise by variable costs is hired, cost. When the first worker loaves. per dozen or $50 is $150/3, cost so their marginal made, are of bread loaves unit of output, of producing one more but output cost really want the extra We three dividing by So, one unit of labour. as the firm hires to three zero jumps from output increase as we costs of the marginal us the average units of output gives to three. zero from or $30 per dozen is $150/5 cost Their marginal loaves. more dozen five makes marginal increasing reflecting initially, falls of bread cost The marginal loaves. set in. returns later as diminishing marginal but increases returns, was rose in steps as an additional worker in the numerical example cost marginal length any of time it wants, the labour for a day; if the firm can hire for hired smooth.) line becomes cost marginal and total. This follows from average the shape of all curves: marginal, the cost So productivity goes up. go down when marginal costs that marginal the fact cost product curve implies a U-shaped marginal U-shaped marginal an inverted 5.3. curve, as shown in Figure saw in Chapter 1. In this case, that we cost marginal benefit equals marginal The bread. for price’ a ‘market bakerythat faces competitive a perfectly consider of (let’s price is the market of bread loaves benefit of selling a dozen marginal 5.4 as a horizontal line. The firm maximizes say) $50. This is shown in Figure of bread loaves making and selling a dozen from revenue profits when the extra incurred. costs the extra just equals t Long run marginal cos marginal inimum efficient scale efficient 100 5.6 firm the competitive for equilibrium The long-run Do ens of loa es of bread day Long run figure
a erage cost
not just on the last unit, but on all the output that it previously sold at the not just on the last unit, sold at the but on all the output that it previously oe o es loa en do rice 5.3 revenue demand and marginal Downward-sloping ar et The alternative case is that of the price-setting firm, rather than the price- firm, rather case is that of the price-setting The alternative demand curve points on a downward-sloping The first two show four columns Price ($) Quantity ($) Price The demand curve 10 ($) 1 7 4 revenue Total ($) 10 revenue Marginal 28 – 4 table of its costs. (Chapter 6 explains how the assumption of easy entry (Chapter 6 explains of its costs. of firms into industries.) competitive in perfectly the industry occurs this outcome ensures other than the taking the firms that appear in all firm. These are other markets chapter.) in the next examined are one. (These markets competitive perfectly the demand as described by prices, of firm has a choice Such a non-competitive Table price. is not the market its product. revenue curve for In this case, marginal an example. 5.3 gives sold). times quantity (price is total the firm. The third column revenue facing changes as it revenue how the firm’s revenue: shows marginal The fourth column marginal see that 1 and 4, we Columns to sell Comparing its price more. lowers sell decreases unit the firm one more To less than price. is consistently revenue its price higher price. 9 2 8 3 18 24 8 6
5 | The firm
Do ens of loa es day
a erage costs rise costs a erage Decreasing returns as returns Decreasing inimum efficient scale inimum efficient a erage costs a erage Long run a erage cost
Increasing returns as
a erage costs decline discuss a firm’s the texts First, oe o es loa en do , as if the firm scales all inputs up 99 to scale in output 5.6 shows the profit-maximizing Figure 5.5 relationships cost average Long-run figure Long run a erage cost Do ens of loa es day
A to scale onstant returns B s a ed long run oe o es loa en do or decreas- the distinction between increasing usually the texts avoid Second, costs. These cases are shown together in Figure 5.5, panel B. The typical textbook 5.5, panel B. The typical textbook in Figure shown together These cases are costs. this one. like U shaped, that’s relationship cost average a long-run story features to returns decreasing by followed to scale initially, returns increasing This reflects average its long-run output rate at which the firm can minimize scale. The lowest efficient scale’. is the ‘minimum costs not in the textbooks) qualifications (usually Two two cases maximization: Profit the long run in the case of the perfectly competitive firm, which takes the market the market firm, which takes competitive the long run in the case of the perfectly logic, output the firm produces the usual profit-maximizing Using as given. price in revenue, its marginal equals cost marginal its long-run up to the point where all In the situation illustrated, price. the firm is just covering this case the market long-run decisions in terms of returns decisions in terms of returns long-run ing returns in an individual plant versus increasing or decreasing returns in the in the returns or decreasing increasing in an individual plant versus ing returns only one plant, but assuming that firms have they are firm as a whole. Apparently curves cost average our long-run consider plants. Let’s several firms have many for of the number of plants it has. So, the firm as a whole, regardless to be for production within one to expand effective cost it more a firm may find example, plant or to establish a particular another plant to produce total output. or down, using the same proportions of labour and capital. In reality, these may these may or down, using the same proportions and capital. of labour In reality, operation manufacturing sense in a large-scale it may make example, change. For capital automated production methods and thus more relative to use more than would be the case in small-scalelabour operations. Thus, economists to returns’ and ‘decreasing returns’ ‘constant returns’, to ‘increasing typically refer output varies in the long run, vary costs firm’s as the to how average to refer (Eatwell 1987). to scale’ of ‘returns concept dropping the restrictive We ( whole 102 are ‘price-takers’ in input markets; in that case, they cannot affect are ‘price-takers’ in input markets; in that case, they cannot ‘Ask the teacher to give just one example of a production function describing a the teacher ‘Ask real life firm.’ Emmanuelle Benicourt (2004: 88) cost is oriented towards the perfectly competi- The theory of production and Power within the firm is unmentioned too. In the texts, the firm largely firm largely too. In the texts, the within the firm is unmentioned Power But this Band-Aid fix raises another potential problem. If input prices don’t But this Band-Aid fix raises another potential problem. If input Assuming the ‘law’ of diminishing marginal returns solves the problem, tive firm, as Joan Robinson says in the quote at the beginning of this chapter. in the quote at the beginning of this chapter. says tive firm, as Joan Robinson cost curve is supposed to limit the size of the The U-shaped long-run average size of the market. This keeps each firm small firm’s production relative to the so we can have ‘many’ firms in the market relative to the scale of demand, any appreciable power over the price, a central and no single firm will have model. assumption in the perfectly competitive or services with the costs of the inputs needed to produce them. But many firms firms But many them. produce to needed the inputs costs of the with or services external environment. to influence their to incur costs it profitable also find and are power of business the political visible aspect of are a These activities section. of the second the subject peek inside the black structure ignored. We’ll a ‘black box’, its internal remains section of this chapter. box in the last 2.1 like? costs actually look What do firms’ relevant? Costs in the short run: is the ‘law’ of diminishing marginal returns saw in Chapter 3 that Piero Sraffa pointed out that the supply and demand saw in Chapter 3 that Piero Sraffa pointed out that the in supply changed curves would not be independent of each other if a change products, thus shift- input prices, which in turn changed the prices of related assume that ing demand. The ‘solution’ to this problem was simply to industries input prices. constant in the rise as output increases, could a firm’s marginal costs remain marginal cost is short run? An example is shown in panel A of Figure 5.8, where costs determine the $1 per loaf of bread at all levels of output. Since marginal will be a horizontal firm’s willingness to supply output, the firm’s supply curve If all firms face the same costs, that means that the industry’s line at $1 per loaf. supply must equal supply curve is also a horizontal line at $1 per loaf, and the individual demand at that price. But if the price were $1, how much would marginal revenue firm produce? Profit-maximizing output is indeterminate: the cost is also $1 at from producing an extra loaf of bread is $1 and the marginal the same profit (or any level of output. No matter what it does, the firm makes Similarly, we can’t loss in this case, as the firm’s fixed costs are not covered). say how many firms there would be. One firm could produce all the bread, for example, but then we wouldn’t have a competitive market.
5 | The firm ' arginal re enue cost arginal arginal 4 101 the good, the demand for consumer Given Demand Loa es day 5.7 revenue between demand and marginal Relationship
figure loaf Figure 5.7 shows the general relationship between demand and marginal between and marginal demand 5.7 shows the general relationship Figure While the textbooks keep students focused on technical details and elaborate While the textbooks keep students focused on technical details We then briefly re-examine the ‘equilibrium’ of the firm. It turns out that then briefly re-examine the ‘equilibrium’ of the firm. It turns out We number of firms in the industry (the ‘market structure’) depends on the typical depends on the typical structure’) number of firms in the industry (the ‘market is large with demand. If demand scale (MES) compared minimum efficient firm’s a of scale persist over firms. If economies many is room for to MES, there relative firms, or perhaps just one. only a few wide range of output, may be room for there revenue. Just like the competitive firm, the non-competitive firm maximizes firm maximizes firm, the non-competitive the competitive Just like revenue. cost. Once marginal equals revenue marginal where producing output profits by at the demand curve determines the price, in this way, is determined the quantity $7 per loaf in this case. diagrams, some important features of the firm are ignored entirely or are so taken for granted that they’re invisible. According to the textbooks, firms maxi- mize profits by comparing the extra revenues they get by producing more goods there are some fundamental problems with the equilibrium concept in the case there are some fundamental problems with the equilibrium acknowledge. of the perfectly competitive firm which the textbooks do not Implications for market structure market for Implications ANTI-TEXT 2 THE experiments The textbook firm is a strange thing, sketched out with thought One. Actual empirical evidence and invented data of the sort we used in Part outputs and about the relationships between inputs and outputs and between looks at what costs in real businesses is virtually non-existent. The next section the evidence says.
not rele- eventually In practice, rising + look at the When we 104 , in many or most situations: firms have ways of producing available to firms have ways of producing available to in many or most situations: The point of the evidence we’ve cited is that the ‘law’ is apparently evidence we’ve cited is that The point of the Piero Sraffa claimed that these convenient U-shaped cost curves didn’t resem- Piero Sraffa claimed that these convenient U-shaped cost curves But is the ‘law’ of diminishing marginal returns really wrong? After all, it wrong? After returns really marginal ‘law’ of diminishing But is the diminishes. This can never be proved false. It can be defended, as Mansfield It can be defended, as Mansfield can never be proved false. diminishes. This the we simply haven’t reached saying that in particular cases defended it, by returns begin. point where diminishing vant Think about the bakery whose production them that postpone the inevitable. It’s easy to see how diminishing returns could be One. we described in Part had some idle capital in reserve (unused dough postponed. Suppose the bakery in the same way that firms typically have unused mixers and ovens in this case) labour, not only can the work be Then as it uses more production capacity. capital more effectively, but the unused reorganized to use currently operating than leaving capital sitting idle after a Rather capital can be brought into use. extra shift of workers, and so on. It can also do shift, the bakery might hire an not observe might production locations. We this across a variety of different diminishing returns in the actual range of output produced. marginal costs may not limit the firm’s production of bread; it is constrained marginal costs may not limit the firm’s production of bread; There, constant by the demand for bread, as we will see in the next chapter. in models of firms or decreasing marginal costs pose no theoretical problems in imperfectly competitive markets. ble the costs of actual businesses. He contended that business people ‘would ble the costs of actual businesses. He contended that business costs which limit consider absurd’ the textbook model’s claim that it is rising claimed that aver- the expansion of a firm’s production (1926: 543). Instead, he limits firms’ age costs would typically be falling as output rose. What ultimately production is limited demand for their product: a downward-sloping demand curve, in other words. The assumption in perfect competition that firms face a given market price ‘differs radically from the actual state of things’. Sraffa’s wonder whether respondents interpreted these questions about costs correctly, correctly, costs about questions these interpreted respondents whether wonder that is very the typical firm structure of image of the cost paint an their answers (ibid.: 105). in the textbooks’ immortalized from the one different by variable factors the additional output produced only claims that Costs in the long run: are decreasing returns relevant? evidence we find that the standard textbook theory about long-run costs fares evidence we find that the standard textbook theory about that a perfectly competitive market Recall no better than the short-run theory. at an output level can exist only when each firm experiences decreasing returns the firm’s response that is small relative to the size of market demand. Then marginal costs to any rise in price would be constrained by rising long-run a larger (as shown in Figure 5.6). Increasing managerial costs in coordinating the reasons typically scale of production or obtaining accurate information are given for this.
5 | The firm A widely ) Loa es day A erage cost
arginal cost
marginal costs Bs Decreasing ort run marginal loaf They asked about marginal costs in the * 103 5.8 costs marginal Short-run Loa es day figure arginal cost A erage ariable cost A erage ariable A cost erage
A onstant sortcosts A run onstant marginal loaf cost … [an] interesting conclusion of the empirical studies is that marginal This result in the short run tends to be constant in the relevant output range. says that seems to be at variance with the theory presented earlier …, which costs may well be marginal cost curves should be U-shaped … Although marginal do not eventu- relatively constant over a wide range, it is inconceivable that they ally increase with increases in output. (1994: 242) But does the claim of rising marginal costs conform to the facts? But does the claim of rising marginal by Alan Blinder More recently, a group of economists at Princeton led The arithmetic shows that if short-run marginal costs are constant, so are The arithmetic shows that if short-run marginal costs are 1 used intermediate-level text by the late Edwin Mansfield was unusual in offering used intermediate-level text by the late Edwin Mansfield was a review of the evidence. He wrote that con ducted a representative survey of 200 large American businesses to try to con stand better how they set prices. under however. This ensures that the firm’s marginal costs rise in the short run, as This ensures that the firm’s marginal however. we have seen. despite the And so the theory of upward-sloping marginal costs remained, evidence. short-run average variable costs; average total costs decline because average because average short-run average variable costs; average total costs decline fixed costs are falling, as we see in panel A of Figure 5.8. If short-run marginal costs are also declining, then average total costs decline even more rapidly, as shown in panel B of Figure 5.8. They conclude, ‘While there are reasons to short run and report ‘overwhelmingly bad news here (for economic theory)’: short run and report ‘overwhelmingly bad news here (for cent claimed that 48 per cent of firms reported constant marginal costs, 41 per they had increasing marginal costs were decreasing, and only 11 per cent said marginal costs (Blinder et al. 1998: 103).
to outcomes refer evidence returns? not decreasing there text Is marginal the experience firms? does Why firms 106 actual diminishing of actual costs professor: that experience the your scale? for firms about evidence to such there returns Is that evidence As we are stressing throughout this book, real-world outcomes are typically As we are stressing throughout this book, real-world outcomes Questions What happens when you combine the necessary emphasis on unrealistic What happens when you combine the necessary emphasis on unrealistic tions in model-building, the clarity of outcomes of simple, unrealistic assump of the models, a desire to convince students of the empirical relevance much material? of the models, and the tremendous time pressure to cover too of claiming It is no wonder that introductory instructors often take the shortcut perfectly competi- that real-world outcomes are just like the outcomes of simple, tive models. (1996: 86) As we sketched out in Chapter 2, a paradigm is not abandoned unless there is unless is not abandoned 2, a paradigm out in Chapter As we sketched framework is surrounded by what Imre Lakatos A paradigm’s core theoretical very different. At best, the model of the imaginary perfectly competitive market very different. At best, the model of the imaginary perfectly of very limited or of the perfectly competitive economy provides a benchmark a theme pursued usefulness against which the actual world can be assessed, further in the next chapter. oligopoly’ (which we examine in the next chapter) replaces ‘the elegant deter- elegant ‘the replaces chapter) the next in examine we (which oligopoly’ little useful theory serves indeterminate competition. An of perfect minateness (1983: 218). purpose’ the 1930s, initially in response one waiting to replace it. Since a more attractive work- many economists have been of the competitive model, to Sraffa’s critique of these have centred on models alternative paradigms. Some ing on potential work has been done exploring Since the 1970s, much of imperfect competition. information. Joseph Stiglitz argues of imperfect and asymmetric the implications a fundamental change in the prevailing that ‘information economics represents (2002: 460). That may well be the case in terms paradigm within economics’ theory, but it has not yet trickled down to the of the cutting edge of economic core of the undergraduate textbooks. of ‘auxiliary assumptions’ to prevent it from (1978) termed a ‘protective belt’ Chapter 2. This is the role of the assumptions refutation, as we described in in the short run and decreasing returns to of diminishing marginal returns explains that ‘These auxiliary assumptions scale in the long run. Avi Cohen and discounting empirical evidence of non- provide a basis for questioning science Without that, ‘normal increasing costs and thereby retaining the theory.’ problem-solving activity within the context of an accepted theoretical frame- – not be possible (1983: 218). Cohen asks, – would work or paradigm’
5 | The firm that it turns no evidence Loa es day Long run marginal and a erage costs are e ual beyong t is oint the long-run U- The short-run and Figure 5.9 shows this; we see initially - After this one brief cameo appearance, . 105 constant returns to scale constant returns Long run a costs erage 5.9 and then with increasing cost average Long-run Long run marginal costs
figure loaf In his text, Edwin Mansfield also reviewed the evidence about long-run aver- In his text, Edwin Mansfield also As this is a chapter about firms, we could leave it at that, but this is a good As this is a chapter about firms, we could leave it at that, age costs and wrote that ‘the long-run average cost function in most industries age costs and wrote that ‘the long-run average cost function seems to be L-shaped … not U-shaped. That is, there is essay and the debate it sparked led, by the early 1930s, to work on theories of essay and the debate it sparked consider in the next chapter. imperfect competition that we (in the range of upward, rather than remaining horizontal, at high output levels observed data)’ (1994: 242, our emphasis). Theories with no empirical support live on it is never seen again. increasing returns and then constant returns. The key point here is that if firms increasing returns and then constant returns. The key point them growing large don’t experience decreasing returns, there’s nothing to stop incompatible with enough to be able to influence the market price, which is textbooks include a a perfectly competitive market. In fact, most introductory end, insisting diagram like Figure 5.9, but with an upward curve at the right-hand upon eventual diseconomies of scale. spot to consider why this has happened. It sheds some light on why the main- spot to consider why this has happened. It sheds some light discard the stream texts, which claim to respect empirical tests of theories, evidence to protect the theory of perfect competition. Avi Cohen explains that the answer lies in what is seen as the even more unattractive nature of the alterna- indeterminateness of limits the growth of the firm, ‘the chaotic nothing tive. If shaped average costs curves that inhabit the pages of the textbooks and which shaped average costs curves that inhabit the pages of the textbooks their place to the pose as typical cost curves are bogus constructions that owe They are not desire to construct and justify a theory of perfect competition. based on empirical evidence about actual costs. l e argina re enu cost arginal Do ens of loa es day 122 … [But] people will use power to alter 108 the market price the market Demand ar et rice 5.10 above raise its price firm should the competitive Why
3
figure oe o es loa en do within the constraints of those conditions ‘Unlike the political economists who founded the discipline, modern economics ‘Unlike the political economists who founded the discipline, modern lacking a theory largely ignores the power element in economic statecraft; and, production and of power, it minimizes the role of power in matters affecting the distribution of wealth.’ Brock (2004: 14) Adams and James W. Walter made the following insightful observa- Austrian economist Kurt Rothschild in more or less More or less homogeneous units – firms and households – move given technological and market conditions and try to improve their economic lot The basic problem is the contradiction between an equilibrium concept based The basic problem is the contradiction between an equilibrium setting prices. on price taking and the notion of agents (firms or households) of competitive Indeed, it has proven very difficult to provide a coherent account other than choose equilibrium which allows for individual agents to do anything demands or supplies at given prices. (1990: 363) the mechanism itself; that uneven power may greatly influence the outcome of What has gone wrong? It’s a reflection of ‘Arrow’s Paradox’, mentioned in Paradox’, What has gone wrong? It’s a reflection of ‘Arrow’s tion about economic theory some forty years ago: The result is an incoherent account of the market. 2.3 for profit using power Shaping the external environment: dozen loaves, marginal revenue must be less than marginal cost. In the example dozen loaves, marginal revenue can cut its output to nineteen dozen loaves and shown in Figure 5.10, the firm its profits. Of course, the same argument raise its price to $53 and increase falls apart. applies to all the firms in the market; the competitive equilibrium Chapter 3. Again, Huw Dixon explains:
5 | The firm why
/ profit- bit, a couldn’t it will not lose all its equilib- ‘ their price its produce customers (textbook) the Those already increased In 107 marginal revenue must be below the demand they firm customers? since professor: those firms will not be willing to expand output to meet those firms will not be willing to expand its firms your all competitive output. for the other lose since, although consumers would like to buy from firms still setting since, although consumers would if (their competitive output maximizes profits at the competitive price). (their competitive output maximizes it from . This means that the firm cannot be maximizing its profits in the textbook maximizing buy would rium’, Firms will want to raise price at the competitive equilibrium … The reason is Firms will want to raise price at firms are on their supply function: price equals simple. At the competitive price, optimal for the firm if the demand curve it faces marginal cost. This can only be firm raises its price (a little), is actually horizontal. But if the competitive firm can sell all In contrast, textbooks feature claims like: ‘A Questions it raises its If the competitive firm does not lose all its customers when customers demand the other firms] will be available to buy at a Those customers turned away [from price, it will not higher price. Thus if a firm raises its price above the competitive lose all its customers but only some of them. (Ibid.: 363, our emphasis) the competitive price, Figure 5.6 showed the equilibrium of the perfectly competitive firm. As a ‘price- firm. perfectly competitive of the showed the equilibrium Figure 5.6 firm, should have an incentive no one, including this In an equilibrium, In the textbook version, the competitive firm’s demand curve is the same In the textbook version, the competitive firm’s demand curve its output at the prevailing market price. If it boosts its price above that level, its output at the prevailing market price. If it boosts its price consumers will shop elsewhere’ (Schiller 2006: 478). and an associated price, then it must face a downward-sloping demand curve Now the key ques- marginal revenue curve, such as we illustrated in Figure 5.7. with a small price tion is whether a competitive firm would increase its profits can answer this question by referring to Figure 5.10. increase. We taker’, its demand is shown as a horizontal line at the market price. The firm the market price. line at as a horizontal demand is shown taker’, its price: the at that market quantity to supply the profit-maximizing simply chooses marginal revenue (justquantity where price) equals marginal cost. the market firm want to continue charging actions. So let’s ask: will this to change their ‘In twenty dozen loaves per day? loaves of bread and producing $50 per dozen very (1990: 363), who explained is no,’ writes Huw Dixon general, the answer simply why this is not an equilibrium. 2.2 of re-examined firm, competitive the perfectly The equilibrium thing as its marginal revenue curves. But as soon as the competitive firm’s competitive firm’s thing as its marginal revenue curves. But as soon as the demand curve has a slight slope, curve version of equilibrium. If demand cuts marginal cost at an output of twenty-two 110 (ibid.: 1). As the title of the book suggests, '' The Logic of Collective Action Why do the mainstream textbooks ignore this behaviour? After all, invest- After this behaviour? textbooks ignore the mainstream Why do put on the disciplinary part of the blame for ignoring power can be Perhaps by the ‘… there is a systematic tendency for “exploitation” of the great small.’ Mancur Olson (1971: 29) Let’s consider a simple example in which apple farmers have an interest Let’s consider a simple example in which apple farmers ments in influencing public policy are economic decisions about generating decisions about are economic public policy influencing ments in a new production facility or spend- as much as the building of higher profits just texts recognize this simple and development. Non-mainstream ing on research that ‘to survive, firms must Lavoie (2006: 36) writes example, fact of life. For environment’, including control to control their economic acquire the means the firm must have power, exercise control, legislation. ‘To over government its survival is guaranteed.’ which is the means by which and ‘politics’. But this division has been crum- division between ‘economics’ ever since economists and political theorists bling for more than fifty years, of individual rational choice to politics (Bowles began applying the framework fact, that framework, called ‘public choice’, can et al. 1999; Downs 1957). In how can the few dominate the many? How help explain an apparent puzzle: and business organizations wield such can a few hundred large corporations society? If the policies that business owners want disproportionate influence in majority of the population, why don’t the citizens are not in the interests of the After all, they have simply block them and institute the policies that they prefer? have no votes. democratic institutions at their disposal and corporations can charge, and are reportedly ready to spend $120 million on advertising to advertising on $120 million spend to ready reportedly and are charge, can the legislation. support Explaining corporate power assumed that groups Before the development of public choice theory, it was often those interests of people with common economic interests would act to further as the late just as a single person would act to further his or her interests, his path-breaking American economist Mancur Olson remarked in introducing book interest would he was trying to explain when groups of people with a common the simple logic of take collective action to promote their interests. By applying cost, Olson rational choice, the comparison of marginal benefit and marginal in their collective showed that some groups would find it much easier to act interest than others would. it pay an apple in restricting competition from foreign apple growers. Would limit imports of for- farmer to retain a lobbyist to persuade the government to eign apples? The answer is clearly ‘no’ for the same reason we saw in Chapter 4 that it didn’t pay the farmer to pay for ‘Eat Apples!’ billboards. The cost to him would likely exceed the benefits even if he were successful.
5 | The firm Capital '& reporter Chris reporter Chris Guardian 109 Insurance companies have done even better as the new legislation will prove a Insurance companies have done even better as the new legislation health insur- business bonanza. It is not only likely to kill off the threat of public premiums and ance, which threatened to siphon off customers by offering lower private medical better coverage, but will force millions more people to take out policies or face prosecution. market operations; that people may strive for economic power as much as for as as much power economic strive for may that people operations; market (1971: 7) largely neglected. facts have been wealth; these economic that some the power entirely ignores almost textbook economics And indeed, (1965 [1904]: 286) wrote: ‘Rep- Veblen More than a century ago, Thorstein by the very ‘Think tanks’ funded by corporations and foundations established The recent battle over healthcare reform in the United States saw the industry The recent battle over healthcare reform in the United States firms, particularly large ones, have to shape their external environment to enhance large ones, have to shape their firms, particularly in thinking examples in the previous chapter already seen We’ve profitability. of the to influence potential buyers advertising and marketing about the use of is most evident in its efforts services. But the power of business firm’s goods and of touches on virtually every aspect policy to its advantage. This to shape public and military policy, international trade policy, public affairs, including foreign laws about intellectual property (such as tax policy, environmental regulation, policy, subsidies to business, unemploy- patents and copyrights), transportation other social income supports, and product safety ment insurance, pensions and regulation. chiefly, representation of business interests. resentative government means, works in the interest of the business men with The government commonly of purpose.’ This retains more than a grain of a fairly consistent singleness truth today. conclusions; wealthy churn out policy papers guaranteed to reach the desired they provide talking heads for television and op-eds for the newspapers. The result has been ‘a total victory for the health insurance industry’, accord- their part, the drug For ing to Harvard medical professor Steffie Woolhander. companies have ensured that there will be no limits placed on the prices they (largely health insurance and pharmaceutical corporations) employ six lobby- (largely health insurance and pharmaceutical corporations) millions of dollars ists for every member of Congress, spending hundreds of other reforms. ‘The to block competition from public health insurance and to the chairman of largest contribution, totalling close to $1.5m., has gone the senate committee drafting the new law,’ writes cities swarm with business lobbyists. In Washington, a city Ralph Nader refers a city Ralph cities swarm with business lobbyists. In Washington, members to as ‘corporate occupied territory’, registered lobbyists outnumber a month to advance of Congress by sixty-five to one and spend $200 million their clients’ interests (Moyers 2006). McGreal (2009). He adds: Public choice Public As in the earlier example with 112 The tobacco industry has been particularly industry has been particularly The tobacco '( The individual bears all the costs of his or her Yet the primary funder of CALA groups has been funder of CALA groups has the primary Yet '+ ') Efforts to limit people’s ability to sue (marketed in the United States Efforts to limit people’s ability '* The tobacco companies and corporate propaganda (or ‘public relations’) corporate propaganda (or ‘public relations’) The tobacco companies and A favourite tactic of corporations and their lobbyists is to create front front is to create and their lobbyists corporations tactic of A favourite There are many large groups in society that might have a similar problem tobacco giant Philip Morris, which ‘both funded and controlled the organiza- tobacco giant Philip Morris, Association’, another front Reform Tort the American tions through the ATRA, group. active at this. For example, ‘Citizens Against Lawsuit Abuse’ (CALA) appears Lawsuit Abuse’ (CALA) example, ‘Citizens Against For active at this. the overly litigious culture in group fighting the supposedly to be a citizens’ alleges) are small businesses whose main victims (its website United States themselves. and consumers as ‘tort reform’) can be a profitable investment for insurance companies and as ‘tort reform’) can be a profitable products that harm or kill people (Nader 2000: for businesses that produce 275–309, 2004a: 37–48). forefront in sponsoring front organizations that firms have also been at the on scientific research detrimental to corporate hang the label ‘junk science’ of second-hand smoke is a prominent into the dangers interests. Research interests have taken up the ‘junk –90). Fossil-fuel example (Michaels 2008: 79 7 gives many science’ crusade in fighting action on climate change. (Chapter other examples of effective collective action by business.) The free-rider problem and collective inaction and Brue 2005: 468). Other countries, such as the United Kingdom, Canada and and Canada Kingdom, United as the such countries, Other 468). Brue 2005: and tobacco industries. concentrated also have highly Australia, appear to be representing groups that phoney ‘grassroots’ tions and organiza large groups. hard-to-organize The flip side of corporate power: public inaction and ignorance contribution (which may seem like a drop in the bucket), while the benefits (if contribution (which may seem like a drop in the bucket), while any) largely go to others. It’s tempting to free-ride and leave the organizing up to someone else. theory also explains why the US health insurance industry and the pharmaceut- theory also explains why the US health insurance industry and to protect ical industry are able to organize so effectively to shape legislation The millions of their profits at the expense of the vast majority of the population. drugs find it difficult buyers of overpriced health insurance and pharmaceutical resources deployed to respond to defend their interests with anything like the box, they Despite the supposed power of numbers and of the ballot by industry. may pay not to act tend to fall victim to the free-rider problem in two ways. It place. and it may pay not to have a clue what’s going on in the first the apple farmers, if each person compares the costs of political action with the apple farmers, if each person compares the costs of representatives or the likely benefits, they may not act. Writing to their elected may seem like contributing to a public interest group such as Public Citizen a waste of time and money.
5 | The firm ’, wrote 111 . © Andy Vine Olson explained that ‘The high degree of organization of business interests, Olson explained that ‘The high degree of organization of business The tobacco industry provides a good example. In the United States, the If an association of apple farmers existed that could hire the lobbyist, the cost If an association of apple farmers existed that could hire the If a few firms Crucially, the free-rider problem is less severe for small groups. there is a systematic tendency for “exploitation” of the great by the small there is a systematic tendency for “exploitation” of the great and the power of these business interests, must be due in large part to the fact and the power of these business interests, must be due in (generally oligopol- that the business community is divided into a series of number of firms’ istic) “industries”, each of which contains only a fairly small (ibid.: 43). McConnell cigarette production ( gest four firms account for 99 per cent of total lar to the association might be less than the total benefits all apple farmers would to the association might be less than the total benefits all apple farmers would have get. But for such collective action to come about, the apple have an incentive to make a contribution to the association. Again, each would (such as govern- not to pay and to ‘free-ride’ on the benefits it might produce that because of ment measures to restrict imported apples). Olson predicted exist or would be this ‘free rider problem’, such organizations would either not with some private small and weak unless they could provide individual farmers for example). benefits they could not otherwise get (cheap crop insurance, can more easily account for most of the total production in an industry, they or individually engage in collective action. The firms will act either together extent. As a result, to produce a collective good that benefits them all to some ‘ Olson (ibid.: 29, his emphasis) , Lucian Bebchuk and 114 Pay without Performance without Pay of power between owner-share- The imbalance ‘We can learn a great deal about the way the world works by observing what deal about the way the world works can learn a great ‘We ideological institutions.’ fails to reach the threshold in the Chomsky Noam (1993: 109) the firm exert no power in the outside world, In the textbooks, not only does American philosopher John Dewey once described politics as ‘the shadow politics as ‘the described John Dewey once philosopher American The first is imperfect and asymmetric information; managers have better in- The first is imperfect and asymmetric information; managers if there are The second difficulty is shareholder-voters’ rational ignorance years has become The plundering of shareholder assets by managers in recent there is also no power visibly exerted within the firm itself. There are two dif- exerted within the firm itself. there is also no power visibly is that between owners and The first consider. ferent power relationships to between managers and all other stakeholders managers; the second is that communities where the firm is located, and its (such as employees, citizens in customers and suppliers). watching laws, regulations and public policy that might affect their clients’ clients’ their affect might policy that public and regulations laws, watching to the voters, to look good great pressure will be under Politicians interests. 1990: 255). business (Zinn good to big but to be big 2006: 206). But the power of by big business’ (Chomsky cast on society textbooks. cast any shadows in economics business doesn’t 2.4 firm within the Power Shareholders versus managers holders and their elected board of directors on the one hand, and the man agers and the man holders and their elected board of directors on the one hand, time. Theory asserts they appoint on the other, has been recognized for a long managers can have that profit maximization is the firm’s sole objective, but studied problem, their own objectives. This is an example of the principal-agent holders) seek (share intensively by economists in recent decades. The principals (the agents ways to get their agents (the board of directors) to appoint managers face two impor- of both shareholders and the board) to maximize profits. They tant difficulties. of their own efforts. formation about the firm’s true performance and the nature and analysts Although outside observers such as auditors, bond-rating agencies they suffer from for brokerage firms are supposed to help oversee management, the Enron collapse asymmetric information too. As well, recent scandals such as have revealed the potential for conflicts of interest and corruption. manage- Top many shareholders and none with a significant block of shares. influence ment can gain control of the firm, particularly given the considerable managers exert over boards of directors. hard to overlook. In their study Jesse Fried argue that ‘[t]he pervasive role of managerial power can explain much of the contemporary landscape of executive compensation’ (2004: 2). They
5 | The firm it If under does the why power power? investments discuss make profits, text can corporate political the of their and firms does If 113 power reality Where increase the to interest? this? economic professor: policy Information about public policy is not free, and what are Information about public policy whose ', sweeping a large the individual member of It often does not pay your discuss in it between for public is not and rug, text change Claims about the rational ignorance and inaction of the public should not Claims about the rational ignorance and inaction of the public if there are substantial profits ignorance does not apply to businesses Rational Nor can one expect the mass media to act as ‘watchdogs’ and hold politi- Nor can one expect the mass the doesn’t, connection the to Questions be taken too far or viewed as a cause for despair. After all, many people enjoy After be taken too far or viewed as a cause for despair. the private life of informing themselves about public affairs instead of about many ways, perhaps Brad Pitt. They participate in community and national life in they feel it is because they find pleasure in the activities themselves or because also have our emotions to spur us on. the right thing to do. We of thousands of corporate lawyers and lobbyists work full time at stake. Tens cians accountable on the public’s behalf. The large corporations that control cians accountable on the public’s behalf. goals and taking the media (outside of public broadcasting) have their own is not among on corporate power and companies that may be big advertisers of the functions of them. As Edward Herman and Noam Chomsky contend, one social and political the mass media is to ‘inculcate and defend the economic, and the state’, agenda of privileged groups that dominate the domestic society 298, 1). and ‘to fulfil this role requires systematic propaganda’ (1988: formed vote provides benefits (if any) largely to others, just like any contribution formed vote provides benefits group. It pays to ‘free-ride’, in this case on to further the interests of a large others’ informed votes. the benefits? As a citizen, you can know your interests better and thus decide the benefits? As a citizen, you you’re not going to act (as we’ve just discussed), what causes to support. But if a waste of time. As a voter, you can cast a more becoming informed would be likely have no effect on the outcome. A more in- informed vote, but your vote will organizing to further their collective interests, even where the total benefits benefits total the even where interests, collective their to further organizing the un- taxpayers, example, of acting. For the costs would exceed to the group and are free-rider problem victim to the often fall and poor people employed Of course, effective way. in the most and to work together to form groups unable groups, do exist. The theory simply such as consumer some such organizations, and less powerful than they would will likely be much smaller predicts that they problem. somehow overcome the free-rider be if people could ignorance Rational group to know the facts about the issues. In public choice theory, this is called group to know the facts about ‘ rational ignorance’. '. , the definitive textbook of 116 Principles of Political Economy Principles of Political The idea of economic democracy is just an extension of the movement for of the movement an extension is just democracy economic idea of The as to how the business is of stock – to have all the say one group – the owners For – to have no say, is immoral in group – the regular workers run, and for another on government is immoral. not having democracy in deciding the same way that people’s lives as is national or view, work is as large a part of According to this only if it has democracy a country can call itself a democracy local politics, and in the workplace. (2004: 369) mention no alternative to the status quo, the Although most textbooks now which if mankind continue to improve, must The form of association, however, is not that which can exist with capitalist be expected in the end to predominate, a voice in the management, but the associa- as chief, and workpeople without owning the tion of the labourers themselves on terms of equality, collectively under managers capital with which they carry on their operations, and working elected and removable by themselves. (Mill 1965: 775) competitive Democratic firms are not fictional constructs, like the perfectly worker cooperatives, there is evidence that worker productivity is higher For that leave them But there are real barriers to the growth of democratic firms their subject is It is curious, and revealing, that while the textbooks claim greater democracy that’s gone on for centuries. David Colander’s introductory Colander’s centuries. David gone on for democracy that’s greater its philosophy: in describing text is exceptional has a long history in economic thought. In the idea of workplace democracy Stuart Mill wrote of the experiments with worker- mid-nineteenth century, John managed firms in his firms exist and are firm. Both consumer-owned and worker-owned cooperative they have virtually vanished from Yet important in some sectors of the economy. 2007). the textbooks (Hill 2000; Kalmi 138). In the Basque than in comparable capitalist firms (Bowles et al. 2005: more than eighty region of Spain, the Mondragón Cooperative, comprising is a prototype of a worker cooperatives and about 30,000 worker members, financial and service cooperative economy in which the primary, manufacturing, single small co-op sectors form an interlinked network. It developed from a 1997). founded fifty years ago (Whyte and Whyte 1991; MacLeod raising financial greatly outnumbered by capitalist firms. They have trouble by having to invest capital from banks and worker-owners face significant risks also have their jobs much of their wealth in the same business in which they (Bowles et al. 2005: 340). about choices between alternatives, no alternatives are discussed when it comes to the central institutions of economic life. The capitalist firm is the only game in town. that time, describing economic democracy as the way of the future. that time, describing economic
5 | The firm , business historian Alfred Chandler , business historian Alfred Chandler 115 Despite the evidence against pure profit maximiza- The Visible Hand '- While everyone understands that ‘political freedom’ re- The capitalist firm of the textbook is not democratic; it’s authoritarian as The capitalist firm of the textbook is not democratic; it’s there must be a relatively high threshold level of profits to keep the stockholders there must be a relatively high threshold takeovers, to minimize recourse to banks, to and creditors quiet, … to avoid and the technostructure [his term for the secure the autonomy of management an increase in the profit level from year to corporate bureaucracy]. In addition, of the efficacy of the management and the tech- year remains an important test for their continued autonomy, power nostructure … an important justification Stanfield 2004: 81–2) and independence. (Stanfield and In his landmark book When imperfect and asymmetric information is taken into account, the claim is taken into account, the claim and asymmetric information When imperfect a matter of principle. The presence or absence of democracy matters for firm a matter of principle. The presence or absence of democracy they were elected by the Managers would pursue different goals if behaviour. only share- workforce rather than appointed by a board of directors representing as we’ll see in Chapter 7, managers in some industries example, holders. For or death rather knowingly expose their workers to hazards that lead to illness choose differently if than accept reduced profits. The workforce itself would given the chance. Similarly, if demand for the firm’s product falls, some workers may get laid off in the capitalist firm, but democratic firms seem to prefer to share the work and avoid lay-offs. quires democratic political institutions, ‘economic freedom’ apparently doesn’t quires democratic political institutions, ‘economic freedom’ freedom to buy and require democratic economic institutions. It means only the James K. Galbraith’s sell with whomever you want, or ‘the freedom to shop’, in sardonic phrase (2008: 15–24). agrees, proposing that growth and stability are the main goals of the managers agrees, proposing that growth who run firms (1977: 10). Capitalism and freedom that the firm’s managers simply maximize the firm’s value (i.e. the present the firm’s value (i.e. the present managers simply maximize that the firm’s A (Stiglitz 2002: 480–81). of profits) is not very convincing discounted value John goals was sketched out by description of management’s more plausible years ago: Galbraith almost forty Kenneth show that for a large sample of companies, the total compensation of the top the top of total compensation the of companies, sample a large that for show in 1993–97 net income of the companies’ 5.2 per cent rose from five executives at 5.2 per remained 10). Had compensation –2003 (2005: cent in 1999 to 8.1 per $69 billion. have saved would cent, shareholders tion, profits are clearly important. In this book, we will generally assume that if tion, profits are clearly important. In this book, we will generally profits (although a firm’s managers can take an action that increases expected any other way to not at their own expense), they will do it. It is hard to see 2004: 56–9), the explain the psychopathic behaviour of many businesses (Bakan of the general cheating, injuring or killing of customers, workers or members population that adds to the bottom line. theory is the only is the only intellectual . At this point total this point total . At textbook revenue deep (1976) in old marginal revenue. revenue. marginal revenue is and that 6.1 shows the process Figure Nelson that is R. field 118 a trouble benefit is maximized. For a firm interested firm interested a For benefit is maximized. is net ’ Richard that of well. so source organisation organisation know The all . This is where total. This is where all activities are undertaken to the point where marginal cost equals mar- cost marginal to the point where all activities undertaken are we that matters. So, applying the decision rule to the firm, it should produce applying the decision rule to the firm, it should produce that matters. So, Industrial that trouble. In Chapter 1 we noted that economics has a very simple framework to explain to explain has a very noted that economics simple framework In Chapter 1 we ‘ standardThe point of this section of the firm is to show how textbook and sellers, numbers of buyers and a homogeneous product,Large guarantee need to advertise or worry they don’t since about their competitors, Firms ginal benefit choice – choice be haviour and overall efficiency depend on market structure. The exercise The exercise structure. efficiency depend on market and overall haviour be an ideal market represents competition perfect supposedly demonstrates that If true, it could a loss of efficiency. while all involve structure, other scenarios in market the emphasis on the competitive for a compelling reason provide market of the four begin with a basic exposition the standard We’ll textbook. startingstructures, competition. with perfect Adding easy entry from) exit into (and participants ‘price-takers’. are that market properties. optimality long-run competition the industry perfect gives to an – being invariant The price can sell price. all they wish at the ruling market average output – is both the firm’s individual firm’s only in maximizing profits (the usual textbook assumption) only in maximizing profits (the usual textbook benefit marginal equals cost marginal up to the point where Derivation of the competitive firm’s supply curve supply firm’s the competitive Derivation of 6 | Market structure and– or why efficiency structure Market | 6 isn’tperfect competition after so perfect all 1 TEXT STANDARD THE 1.1 structure of market Types competition 1.2 Perfect net revenue – or more simply total profit – is maximized. simply total – or more profit – is maximized. net revenue in action. The left-hand diagram shows supply and demand in the market as a as a diagram shows supply and demand in the market in action. The left-hand thousand diagram shows a typical firm producing a few whole. The right-hand no discernible of millions will of milk, of litres litres have which in a market
5 | The firm , The inter- The Smartest suppose is one of them. whose agenda? In survey article by John the textbook textbook door? off the does remain remain Enron: The Smartest Guys in the Room The Corporation: The pathological pur- workplace workplace Why 117 the at democracy democracy Journal of Economic Literature end professor: professor: also inspired a thought-provoking documentary film, must economic economic your (2002). Wealth by Stealth: Corporate crime, corporate law, and the perver- by Stealth: Corporate crime, corporate law, Wealth for that , directed by Mark Achbar and Jennifer Abbott. Another insightful , directed by Mark Achbar and Jennifer Abbott. Another insightful it democracy democracy is est that A large literature exists on labour-managed firms, producer cooperatives cooperatives A large literature exists on labour-managed firms, producer Law professor Joel Bakan’s 2004 book Some interesting books have appeared recounting the corporate scandals Some interesting books have appeared recounting the corporate Questions Questions of about production and costs textbook ignores evidence The mainstream Apparently, firms sit all questions of power. The textbook account ignores bloodless and boring account of production All of this combines to give a Bonin, Derek Jones and Louis Putterman, ‘Theoretical and empirical studies of Bonin, Derek Jones and Louis Putterman, ‘Theoretical and producer cooperatives: will ever the twain meet?’ and economic democracy. A readable review of how such firms compare with and economic democracy. conventional firms is a 1993 Corporation sion of democracy study of corporate power is provided by another Canadian law professor, Harry study of corporate power is provided by another Canadian Glasbeek, in his Guys in the Room: The amazing rise and scandalous fall of Enron Guys in the Room: directed by Alex Gibney. suit of profit and power of recent years. Bethany McLean and Peter Elkind’s 2003 book of recent years. Bethany McLean and Peter It inspired the related documentary film, real firms in favour of a fictitious account that does not undermine the apparent does not undermine the apparent of a fictitious account that real firms in favour Acknowledging the evidence would underline relevance of perfect competition. competitive firm as a description of reality. the irrelevance of the perfectly to try to shape their environment to their on the political sidelines, failing Students are apparently within the firm is deemed a non-issue. advantage. Power are no alternatives to the traditional autocratic supposed to believe that there capitalist firm. interest. There is no excuse for this dismal state that evades questions of real of affairs. Suggestions for further reading Suggestions for further reading 2.5 firm in the textbook and Summing up: the the firm in reality A
Z E I ousands of litres of mil 4 This is where the assumption of perfect perfect of the assumption This is where 120 tre of mil Price er li l A 2 P D illions of If one firm has a particularly efficient chief executive a particularly If one firm has executive efficient chief tres of mi li 1 1 S D 6.2 in demand to an increase response The short-run E A E B figure A 4 4 . In the short run, this drives up the price to $7. The firm maximizes profits profits The firm maximizes to $7. . In the short up the price run, this drives 2 As new firms enter, so the market supply curve shifts to the right and the price supply curve right and the price shifts to the so the market As new firms enter, For this mechanism to work, all existing firms in the industry, and potential and potential mechanism to work, all this firms in the industry, existing For lead to differences that could allThis same mechanism works for factors other In diagrammatically. equilibrium and long-run short- contrast Textbooks 3 by equating price (equal to marginal revenue) to its marginal cost. It produces 6 6 cost. It produces to its marginal revenue) to marginal (equal price equating by is $3 profit per litre Economic of $4 per litre. cost at an average thousand litres profit is $3 x 6,000 = $18,000, shown as the shaded economic – $4). Total (= $7 new firms to enter the industry. rectangle, Z. This encourages doing better than it could have done elsewhere. If firms are earning an economic an economic earning are If firms elsewhere. done have could than it better doing this industry to enter in other industries firms for to profit, is an incentive there supply curve shifts entry profits. As new in those higher share the market occurs, disap- profit the economic until This continues the price. right,which reduces equilibrium. long-run earning only normal profit in firms pears, leaving same costs. the have new entrants, must in again. creeps information profits earn higher and hence costs lower that firm might enjoy (CEO), officer the rivals will information, know about this CEO, than its rivals. But with perfect wages to tempt him or her into joining them. more to offer and will be prepared is worth; what the CEO exactly that is the limit, offer to they willAt be prepared efficiency. his or her greater offsets that completely a salary differential by will offset be completely in efficiency between factors differences Any in costs. the Thus, all have firms, and potential new entrants, existing in pay. differences information. of perfect of the assumption as a result same costs the milk 6.2 of $3 a at a price industry equilibrium Figure is initially in long-run costs. average its long-run covers and just 5,000 litres Each firm produces litre. Now suppose demand increases firms to enter or leave. is no tendency for There to D
6 | Market structure and efficiency
AC is AC C profit, it is profit, it is ), the firm ), the firm 2 economic E A ousands of tres of mil li ri e er tre of mil li 119 D than normal earning more If firms are l profit – the same as it could have earned in earned in have profit – the same as it could 1 D illions of tres of mi normal li the firm’s supply curve. Summing what each firm supply curve.what each firm Summing the firm’s is 6.1 supply curve firm’s Derivation of the competitive E A E 0 0 figure So, more accurately, the section of the firm’s marginal cost line that lies above line that lies above cost marginal of the firm’s the section accurately, more So, There is only one wrinkle: in the short run the price must be above the firm’s the firm’s is only one wrinkle: in the short must be above There run the price 5 ri e er tre of mil li impact on price. The firm equates marginal revenue (or price) to marginal cost. cost. to marginal price) (or revenue marginal The firm equates impact on price. If market 8 thousand litres. the firm produces litre, is $5 per price If the market to D demand increases to $7 increases market (because price a litre in the long and short runs Equilibrium its next-best opportunity When a firm is earning elsewhere. its next-best profit (called economic profit) other firms will enter the industry. We can be sure can be sure We profit (called profit) other firms will economic enter the industry. is always defined as opportunity cost cost,of this because in economics which in- When a firm is just breaking opportunity forgone. of the next-best cludes the cost it is said to be earning even, produces 9 thousand litres. The key point is that the firm’s marginal cost line line cost marginal point is that the firm’s The key 9 thousand litres. produces would supply at any given price determines market supply. This means the mar- supply. market determines price given would supply at any its average variable cost variable cost its average average variable cost. The difference between variable and total cost is fixed cost. cost. between variable and total is fixed cost cost. variable The difference average exceeds as long as the price So, is unavoidable. cost But in the short run, fixed and the firm costs, less than its fixed losses are the firm’s costs, variable average will stay in production – in the short run at least. the firm’s supply curve. supply curve. the firm’s ket supply curve will two first,ket shift for kinds of reasons: the position of the the number of firms in the second, shift; curve could cost marginal typical firm’s shift the typical that could industry the factors change. Chapter 5 explained could of production, changes in of factors curve: changes in prices cost marginal firm’s or less capital more per of the firm (employing or changes in the size technology, of the industry new is the dependence supply curve on the unit of labour). What’s number of firms in the industry. 6.4 The optimal quantity figure 122 i B i
Quantity D S 2 Q Q 1 Q otal net enefit P b Turning to non-competitive markets, it is time we demonstrate what we demonstrate what we it is time we markets, to non-competitive Turning To see this, suppose we have a fixed quantity of goods – say 1,000 loaves of of of goods – say 1,000 loaves quantity a fixed have see this, suppose we To while benefit is $4 per loaf, marginal suppose that Muriel’s example, For know that already do automatically! We markets But this is what competitive asserted in Chapter 3: there is no supply curve in a non-competitive market. The The market. asserted is no supply curve in a non-competitive in Chapter 3: there 1.3 is no supply curve there markets: Non-competitive each firm produces at the lowest possible cost per unit. Furthermore, this optimal this optimal per unit. cost possible Furthermore, at the lowest each firm produces is distributed to those who value it most. quantity whose job it is to distribute those goods Now postulate the Ideal Planner, bread. total benefit.to maximize The Planner should equate Who should get the bread? across individuals. benefit of a loaf of bread the marginal a loaf away The Planner should take benefit is $9 per loaf. marginal Virginia’s $4 but Virginia’s by benefit has fallen Muriel’s it to Virginia. and give Muriel from bread take $5. As you total by $9. On balance, benefit increases by has increased give As you loaf increases. benefit of one more her marginal Muriel away from to increase can continue The Planner benefit falls. her marginal to Virginia bread until they both have to Virginia Muriel from total reallocating bread benefit by until everyone has the is not maximized benefit benefit.the same marginal Total benefit of a loaf of bread. same marginal buying up to the point where her own net benefit by each individual maximizes all face market, consumers In a competitive the price. benefit equals her marginal benefit. and so all the same marginal So competitive the same price will have all work just as an Ideal Planner would only without we’d the expense markets staff. the Planner’s need for
6 | Market structure and efficiency A
2
E I , so that the price is bid bid is the price , so that 2 ousands of tres of mil li tre of mil Price er li 121 l in Chapter 4 that the demand showed We 2 S 2 P A illions of D tres of mi li 1 1 S 6.3 in demand to an increase response The long-run D E A E B figure A 4 4 (which is less than Q*) the extra benefit of one more unit exceeds the the unit exceeds benefit of one more (which is less than Q*) the extra 1 The above argument applies to any competitive equilibrium – even the the – even equilibrium competitive applies to any argument The above At Q 3 The efficiency of perfect competition The efficiency of is driven back down. How far to the right does the supply curve shift? As shown curve supply does the right to the shown As shift? far How back down. is driven to S to move the supply curve 6.3, will have in Figure extra cost. Producing this unit increases net benefit. this unit increases cost. at Q On the other hand, Producing extra short-run equilibrium at point B in Figure 6.3 where the price exceeds its long-run its long-run exceeds the price 6.3 where at point B in Figure equilibrium short-run equilib- to long-run moves entry that the market ensures and exit value. But free where is the optimal number of firms, and there 6.4, where rium, shown in Figure (which exceeds Q*) marginal cost exceeds marginal benefit, and the production benefit, marginal the production and exceeds cost Q*) marginal (which exceeds net benefit. the intersection of demand and of that unit lowers In conclusion, the totalsupply yields the optimal output, net benefit from which maximizes production of that good. down to the minimum point on the typical firm’s long-run average cost curve. At curve. At cost average long-run firm’s point on the typical the minimum down to this point, the industry to enter profit, earns economic no firm and the incentive $7 from firms to back to $3 causes the original in price decrease disappears. The in But the increase to 5,000 litres. back litres 6,000 their output from reduce that industry ensures and this decrease, than offsets more the number of firms 48 million to 70 million litres litres. from output increases curve for a commodity is the sum of all individuals’ marginal benefit curves. benefit curves. marginal is the sum of all a commodity individuals’ curve for cost the supply curve just shown that marginal is the sum of all firms’ have We as the intersection of demand and supply can be reinterpreted curves. Hence, schedules. cost benefit and marginal marginal the intersection of the aggregate this intersection (no pollution, example), for no ‘externalities’ are there Provided 6.4. (Externalities are Q*, as shown in Figure us the optimal social quantity, gives discussed in Chapter 7.)
C rent- ’) due to ’) due to , the demand , the demand M 6.6 Monopoly versus deadweight loss perfect competition perfect i B figure loss (or ‘ Suppose all the firms in a perfectly net D = ∑M 124 , at point C. , at point C. su P ly under A M i B Q . Therefore, the . Therefore, ∑M M of privately created monopolies. Second, individuals will individuals will monopolies. Second, of privately created
’ Q and Q B C equity cost . The cost of producing this output is the area under the marginal cost cost under the marginal of producing this output is the area . The cost behaviour is a further inefficiency – a waste of society’s scarce resources resources scarce of society’s inefficiency – a waste is a further behaviour M P P As shown, monopoly restricts output below the socially optimal level. The socially output below the The As shown, monopoly restricts optimal level. The value the net loss associated with this output restriction. can measure We The key element in the comparison of the two in the comparison element industry is the dual The key structures demand and supply intersect at point A. competition, After all perfect Under Two other adverse effects of monopoly stem from the fact that monopolies that monopolies the fact of monopoly stem from effects other adverse Two curve between Q monopolist realizes that if it sells less, the price can be raised, whereas each each that if it sells can be raised, whereas less, the price monopolist realizes too output, they are reducing since by firm cannot raise the price competitive small it. to influence under the demand curve between of the lost output is the area Q to consumers competitive industry were taken over and merged into a single monopolistic sup- and merged over industry taken competitive were on efficiency and the distribution of income? What would be the effect plier. curves. As shown in Figure cost marginal firms’ the competitive by role played competition; 6.6, their (horizontal) is the supply curve summation under perfect aggregate but under monopoly that same summation is simply the monopolist’s costs. marginal equating its profit by the monopoly maximizes however, merged, the firms are output of Q at point B. Given revenue to marginal cost marginal Comparing monopoly to perfect competition Comparing curve determines the price, P curve determines the price, monopoly is the shaded area ABC. ABC. monopoly is the shaded area a profits probably involve excess these profits. First, tend to earn above-normal can rich. We already towards those who are of income redistribution regressive call this the ‘ devote time, effort and expertise to secure monopoly profits, perhaps through time, effort monopoly profits, perhaps through and expertise to secure devote This potential competitors. seeking legal or regulatory protection from seeking loss. that of the deadweight above and over and Q
6 | Market structure and efficiency D 2 D 2 Quantity (with associated (with associated 2 4 , the market may be ‘contestable’, may be ‘contestable’, , the market
123 D Quantity ) the new marginal revenue curve would cut the marginal curve would cut the marginal revenue ) the new marginal 2
6.5 a supply curve have firms don’t Non-competitive 4 figure As shown in the right-hand diagram, if demand shifted to D As shown in the right-hand definition, by since, structure market Monopoly is the simplest non-competitive Just like the competitive firm, the non-competitive firm maximizes profits by profits by firm maximizes firm, the non-competitive the competitive Just like P there is only one seller. Maintenance of a monopoly position requires barriers to barriers to of a monopoly position requires Maintenance is only one seller. there of at least one crucial input; (2) economies entry over associated with: (1) control barrier such as scale; (3) technological superiority; or (4) a government-created patent protection. If the barriers to entry low are causing the monopoly to behave more like a competitive industry. To keep things things keep To industry. a competitive like more causing the monopoly to behave barriers to entry on the case where high. focus are simple, we’ll 1.4 Monopoly producing up to the point where marginal revenue equals marginal cost. In the cost. In the marginal equals revenue marginal the point where producing up to the units. Once output of 400 at an 6.5, this occurs of Figure diagram left-hand at $7 the demand curve determines the price, is determined in this way, quantity per unit. reason for this key feature is that competitive firms take the market price as as price market the take firms competitive is that feature key this for reason the given equate firms not. firms do Competitive non-competitive whereas given, given any for supplied quantity cost, rise to a unique giving to marginal price de- that price and realize their prices, firms set non-competitive whereas price; will the best price depend on the shape Since increases. lead to quantity creases necessary minimum price to is no unique the demand curve,and position of there of demand. nature – it depends on the quantity the supply of a given induce marginal revenue of MR revenue marginal cost curve at the same point as before. Therefore, the firm would produce the the the firm would produce Therefore, curve at the same point as before. cost same amount, but it would now sell of $5. This shows that the output at a price and there- supply, necessary a given minimum price to induce is no unique there firm. non-competitive any no supply curve. This is the case for fore D D i ∑M horta e 6.8 Natural monopoly figure D A A subA o timal ri e eilin Quantity D C Q 126 D ono oly rofit Q i 6.7 and monopoly ceilings Price ∑M A C Q figure he ohe timal ri e eilin C The government’s policy options are more limited in the case of ‘natural limited in the case of ‘natural more policy options are The government’s as output increases, fall costs Average structure. 6.8 shows this cost Figure industry of a natural monopoly to establish a competitive in the context Trying P P P ost Price c monopoly’. This occurs when there are large fixed costs of doing business. For of doing business. For costs fixed large are when there monopoly’. This occurs to get the grid costs incur huge set-up (and gas) companies electricity example, low and roughly constant marginal and they have (or pipes) in place; of wires of adding new users to the network. costs starts never cost units. Average and more more over is spread cost because fixed initially constant. in are firms were costs If several to rise because marginal than its rivals, allowing costs it lower have firm would the biggest this industry, – leading to an even share market more even them and capture price to under advantage. one firm in the industry. is only cost The logical conclusion greater in costs in higher average and (b) would result would (a) be doomed to failure, Anti-trust laws should not be applied to natural succeeded. it event the unlikely
6 | Market structure and efficiency and A, however, and A, however, C causes a shortage since it is causes a shortage it is since , the price is given by the the by is given , the price C C to exception interesting is one There 125 in Figure 6.6. It lessens the deadweight loss but loss but 6.6. It lessens the deadweight in Figure C . This price ceiling succeeds in getting the monopolist in getting the monopolist succeeds ceiling . This price C that because monopoly is socially ineffi- argue Textbooks , so when output is greater than Q , so when output is greater C and less than Q M P below the point of intersection of demand and marginal cost. cost. the point of intersection of demand and marginal causes the demand curve to have a kink. It does not stop the price from from a kink. It does not stop the price causes the demand curve to have C This result stands in stark contrast to the effects of price ceilings in competi- ceilings of price standsThis result in stark to the effects contrast Less than perfect price discrimination means that the monopolist will produce means that the monopolist will discrimination price produce than perfect Less Perfect price discrimination is extremely rare because the monopolist doesn’t doesn’t because the monopolist rare discrimination is extremely price Perfect For example, in certain circumstances price ceilings can eliminate the can eliminate the in certain ceilings example, price circumstances For tive markets (analysed in Chapter 3). In the competitive context, price ceilings ceilings price context, in Chapter 3). In the competitive (analysed markets tive cause shortages those In the monopoly context, necessarily and black markets. is too low – as shown in the right-hand ceiling appear only if the price results less than P ceiling price Any 6.7. diagram in Figure to produce the socially efficient output level. Therefore, we may call this an may call we this an the socially Therefore, to produce efficient output level. ceiling’. price ‘optimal original demand schedule. Since the price is constant between P the price original demand schedule. Since falling falling Regulating monopoly Regulating Deadweight loss and price discrimination price loss and Deadweight more than Q more know the maximum amount each consumer would be willing to pay. Instead, the Instead, the would be willing consumer know the maximum amount each to pay. groups – those into different the market monopolist seeks ways to segregate those with example, those who willwilling versus only pay less. For to pay more willing or are to willing flyers, in newspaper are to cut out coupons less income may think we Similarly, cheaper airline ticket. night to get a an extra stay over they too are grounds, though justified on equity are student (or senior) discounts discrimination. attempts at price the above conclusion: when a monopolist is able to perfectly discriminate among among discriminate is able to perfectly a monopolist when conclusion: the above the efficient it produces their willingness the basis of on consumers to pay, that the means discrimination price Perfect amount, zero. loss is and deadweight given price the maximum price, to sellmonopolist is able at a different each unit revenue marginal the curve the demand becomes the demand curve. In effect, by the competitive producing its profits by monopolist maximizes schedule, and the sur- consumer at point A. the entire quantity the monopolist converts Because discrimination worsens the equity price perfect however, profits, plus into extra of monopoly. cost price equals marginal revenue in this range. Now when the monopolist equates in this range. Now when the monopolist equates revenue marginal equals price at point A, equal and cost, he finds that they are to marginal revenue marginal an output of Q produces below increases the equity cost of monopoly. cost the equity increases deadweight loss. The left-hand diagram of Figure 6.7 shows that a price ceiling ceiling that a price 6.7 shows diagram of Figure loss. The left-hand deadweight of P cient, government intervention can improve the market outcome. It can put in It can put in outcome. the market intervention can improve cient, government arising in monopoly from laws) that prevent anti-trust laws (or competition place it. can regulate it exists, If monopoly already the first place. 6.9 Monopolistic competition A figure D Quantity be differentiated by location, by location, by by be differentiated ), where marginal benefit (or demand) benefit (or demand) marginal ), where MC 128 Q marginal cost. Nor do these firms minimize their unit costs of production. of production. their unit costs cost. Nor do these firms minimize marginal Interestingly, while the above represents the typical textbook treatment treatment the typical textbook represents while the above Interestingly, is no strategic interaction between firms in monopolistic competition There game theory some basic presents the textbook to explain The mainstream P ost Price c exceeds capacity’. ‘excess they have In effect, of the a serious oversimplification it represents of monopolistic competition, Both (1933). and Robinson Chamberlin (1933) by original analysis presented that products can these authors recognize which Branding implies advertising, branding. characteristics, or simply by real can confidently while we simultaneously and shifts demand. So, costs raises profit, economic will and that there be zero equilibrium that in long-run predict do cost, we average output will portion be on the downward-sloping of long-run is associated with making the product and how not know how much of this cost much with advertising it. In contrast, strat- allbecause they are too small to pay attention to each other. It problem in the last industryoligopoly. – egic interaction is the core structure whether they differen- firms in an industry, few relatively are when there occurs it the least predictable tiate their products or not. Strategic interaction makes how its rivals will to all, of no firm knows precisely react structure since market it makes. move any monopoly out- the (shared) under which firms may collude achieve to conditions is illustrated; neither dilemma’ two only the simple ‘prisoner’s firms With come. (or implicit cartel) agreement invariably collusive firm trusts the other and any to agreeing collude by suppose that if Esso and Enron example, down. For breaks $2 billion. each sees profits rise by But if only one of the monopoly price, charge entry (and exit) ensures that in the long run no firm makes more than normal than normal more entryrun no firm makes that in the long ensures (and exit) cost. its average equals price the firm’s equilibrium in long-run profit. Therefore, firms pro- 6.9 this implies that monopolistically competitive As shown in Figure an inefficiently smallduce (at Q output
6 | Market structure and efficiency and and M ) efficiency ) efficiency C (where the average the average (where R and eliminates eco- R off, profits are eliminated, overall overall eliminated, profits are off, of the public interest – they may – they may of the public interest 127 where MR = MC. The resulting price is P price resulting MR = MC. The where M is not feasible. is not feasible. C Perfect competition and monopoly represent two extreme forms of market of market forms two extreme and monopoly represent competition Perfect firms making slightly many are when there occurs Monopolistic competition Easy equilibrium. long-run concerns can make we predictions One of the few Nevertheless, price ceilings can still be beneficial; they lower profits and can still and profits ceilings they lower be beneficial; Nevertheless, price This all better looks terrific: are consumers may lose track worse, regulators Even cost curve output to Q cuts the demand curve)cost increases structure. Both models are relatively simple, and both yield relatively clear-cut clear-cut simple, and both yield relatively relatively Both models are structure. between fall economies in modern industrial But most markets predictions. are but rarely usually than one firm in an industry, more There’s the extremes. forms These intermediate market all that they are price-takers. so many there to definite lend themselves and oligopoly – rarely – monopolistic competition in those markets and quantities is that prices view But the consensus predictions. and the are, firms there The more the two within the bounds set by extremes. fall com- tend to the perfectly substitutable results more their products, the more the firms, and the less substitutable their products, the fewer outcome; petitive they tend to the monopoly outcome. the more the industry. easy entry from) products, with relatively into (and exit different demand a downward-sloping products mean that each firm faces Differentiated it the price power’ over its product, or choice curve for giving it some ‘market sets. prices, while increasing output. Without regulation, the monopolist in Figure 6.8 6.8 in Figure the monopolist regulation, output.increasing while Without prices, producing Q profits by maximizes 1.5 structures Other market monopolies. Nor can price ceilings induce a natural monopolist to produce the the produce to monopolist a natural induce ceilings price Nor can monopolies. cost marginal be set where cannot ceiling socially A price output level. efficient below average a price setting would involve this demand curvecuts the since 6.8 a price in Figure of business. Thus, be put out monopolist would and the cost of P ceiling nomic profit. Since output moves towards the competitive level (at Q level towards the competitive nomic profit. output moves Since the shaded box shows economic profits. A price ceiling of P ceiling profits. A price shows economic the shaded box is increased. is increased. The main practice. that easy in rarely things are Unfortunately, increases. welfare the to know where required information the have don’t problem is that regulators total too low, curve. If they set the price demand curve cost crosses the average to average equal exactly shortages; in setting price they create if they succeed down. costs to keep loses all on an ongoing basis, the monopolist costs incentive happen through This could those they attempt to regulate. by ‘captured’ become tend Regulators through cross-hiring. innocently, more bribery or, and corruption personnel because of their expertise. Industry tends to hire ex-industry to hire their insider connections. for ex-regulators tional calculator who operates only in only in tional calculator who operates 130 + 10 +8 + 8 6.2 ‘tit-for-tat’ Esso plays when plays Repeated Under perfect competition, price ceilings necessarily lead to shortages and Under perfect competition, price ceilings necessarily lead model It is strange, therefore, that textbooks seem to regard the competitive typical textbook? Why is the competitive model given such prominence in the given to per- This chapter evaluates another possible reason for the emphasis 2 3 4 5 + 2 + 2 + 2 + 2 + 6 0 0 0 + 6 - 4 + 2 + 2 1 + 2 + 2 + 2 Period Period colludes Enron colludes Enron throughout in cheats Enron 1 only in period 2 only period table total Rather it is the agreement, not because either one is an honourable company. is a ra because they know that the other their own best interests. ANTI-TEXT 2 THE what we asserted in Chapter 3: supply curves This chapter has demonstrated demand and supply exist only in perfectly competitive markets. Therefore the demand and model is not a different model to perfect competition. Rather, supply is synonymous with, or shorthand for, perfect competition. do not apply to non- black markets. This chapter shows that those predictions sloping, a competitive markets. Whenever a firm’s demand curve is downward and marginal cost) price ceiling (which lies above the intersection of demand a shortage. leads to an increase in quantity supplied without causing One would as a generic model with wide applicability to all market structures. wouldn’t suppose the reverse to be true: since most markets are non-competitive, At the very least, the predictions of non-competitive models be most applicable? selection. textbooks should be highlighting the importance of model be justified by the In Chapter 3, we evaluated whether this prominence could model’s predictive prevalence of competitive markets in the real world, or by the found neither of We power even in markets that were not strictly competitive. these explanations compelling. and even if the fect competition. Even if no markets were perfectly competitive, model had no predictive power, perfect competition might still be important as a standard of static economic efficiency against which to compare other market structures. As McConnell and Brue (2005: 193) put it, the competitive model
6 | Market structure and efficiency in a pay-off matrix in Table 6.1. in a pay-off matrix in Table 129 6.1 dilemma matrix illustrating the prisoner’s A pay-off Now suppose each firm rationally decides on its best strategy. Esso reasons reasons Esso Now suppose each firm rationally decides on its best strategy. neither honours the price- Enron, analogous for the situation is exactly Since – collusion is difficult even the consumer This appears to be good news for how that game theory to explain It is interesting uses logic and incentives Esso offers price price Esso offers discounts = –$4 Enron Esso = +$6 = 0 Enron Esso = 0 Esso honours the Esso honours the agreement collusive = +$2 Enron Esso = +$2 = +$6 Enron Esso = – $4 agreement discounts agreement collusive honours the Enron price offers Enron them honours the agreement while the other cheats (by offering price discounts), discounts), price offering while the other cheats (by them honours the agreement if both firms the cheater gains $6 billion loses $4 billion. and the other Finally, only profits; each earns excess zero they make discounts) price offering cheat (by is displayed normal profits. This information as follows. They can’t trust Enron. Enron will act to maximize its profits whatever its profits whatever will Enron act to maximize trust Enron. as follows. They can’t row of the (the second agreement if Esso honours the collusive Esso does. So, And if Esso offers discounts. price offering table), would be better off by Enron (the last row of the table), would still discounts offer- Enron price be better off by best that Enron’s So no matter what Esso does, they predict discounts. ing price that Enron given Therefore, discounts). price strategy will be to cheat (and offer of action is also best course Esso’s will look down the last column), cheat (now we discounts. price and offer agreement to cheat on the collusive that and the firms do not collude. This happens despite the fact fixing agreement both of them would be better off if they did collude. allow of the same game, however, plays only two are firms. Repeated when there participants the reputation to build reputations. of always playing Developing do to me this period) brings about period what you (I’ll next do to you ‘tit-for-tat’ agree- the collusive to abide by best interests it is in both firms’ a situation where three and compare 6.2 illustrates this. Assume Esso plays ‘tit-for-tat’ ment. Table throughout; honouring agreement – honouring the collusive Enron strategies for it only in the first period and cheating thereafter; and honouring it in every the table can verify entries one (period 2 in this case). The reader period except strategy, ‘tit-for-tat’ Esso’s given 6.1. Clearly, Table using the profit data from and cooperate agreement is to honour the collusive the best strategy Enron for (illegally) with Esso. is though neither player can arise even behaviour (or collusive) ‘cooperative’ game, each trusts that the other will In the repeated not violate trustworthy. table
. * the a to goes would (The innovation of rice rice? income of ) harvest), means it. population little their for the too only when the distribution of only when the distribution of purchases of had most efficiency
) part the their they destroyed 132 If pay But this does not ensure that we produce produce that we ensure not this does But ( to allocative because weather subsidize to bad professor: willing marginal social valuations ‘yes’: is your starving are for who (perhaps were answer inefficient food those be to right it buy country Ask yourself ‘what is capitalism really good at?’ A good answer is Ask yourself ‘what is capitalism really good at?’ A good answer Question The law makes patent protection temporary. Most textbooks recognize that Most textbooks recognize The law makes patent protection temporary. This is an important point to remember: it’s OK to say that perfect competition point to remember: it’s OK This is an important David Colander (2003: 85) points out that ‘most authors of principles books … David Colander (2003: 85) points The duration of patent protection for drugs is being (or has been) increased in example, in 1988 Canada extended drug patent protection many countries. For Monopoly power and the associated profits are the reward for innovation. They Monopoly power and the associated profits are the reward on the firm by provide the incentive that drives it. The reward can be bestowed market via lower a government-granted patent; or it can be extracted from the from indicating inefficiency, both costs and a dominant industry position. Far dynamic efficiency patent protection and dominant industry position may reflect over time. – the development of new, more efficient techniques of production power. Moreover, neither of them gives rise to permanent monopoly to develop new pro- such patent protection is necessary to increase incentives invented, are easily ducts and technologies, especially products that, once But few consider the optimal length of time such protection should last. copied. income is considered socially desirable. income is considered socially optimal quantity of goods (or the ‘right’ goods) in an ethical sense. Only when ethical sense. goods) in an (or the ‘right’ quantity of goods optimal represent outcome ‘just’ will the efficient of income is distribution the actual optimum. a social say that it produces an ‘optimal’ outcome; it’s not OK to produces an efficient implicitly downgrading the want to avoid qualification). We outcome (without objec- subservient to the efficiency to the point where it is always equity objective language, perfectly competitive the point using more technical rephrase tive. To market prices reflect 2.2 Static efficiency is less important than dynamic efficiency existing distribution of income. distribution existing do not discuss the implications of an existing undesirable income distribution for do not discuss the implications functioning market economy could produce measures of efficiency’. An efficiently that could appear woefully inadequate to a combination of goods and services although not their demands. In such situ- meet the needs of society’s members, the invisible hand seems beside the point. ations, singing the praises of
6 | Market structure and efficiency
' the given the marginal benefit curve, this is 131 Furthermore, any redistribution of income would change the relative demand Furthermore, any redistribution of income would change the Going back to our earlier example, suppose we know that Muriel’s marginal Going back to our earlier example, suppose we know that Muriel’s Perfectly competitive industries produce the efficient quantity, in the most effi- competitive Perfectly perfect competition, we compared it to how an In explaining the efficiency of benefit we are measuring Actually, it is not necessarily fair at all. Remember, Unfortunately, the idea that perfect competition is an ideal market structure is an ideal market structure the idea that perfect competition Unfortunately, for goods. For example, taking money from the very rich and giving it to the for goods. For very poor would mean fewer luxury yachts and less champagne demanded, and more basic housing. So if all markets exist and they are all perfectly com- petitive, the economy would produce an efficient quantity of goods benefit of a loaf of bread is $4, while Virginia’s is $9. Efficiency in distribution benefit of a loaf of bread is $4, while Virginia’s is $9. Efficiency But we don’t requires taking bread away from Muriel and giving it to Virginia. because she has five know why Virginia has a high marginal benefit. It could be because Virginia is children to feed (compared to Muriel’s one); or it could be Efficiency in the distribution rich, and therefore has a higher willingness to pay. of goods is not necessarily equitable. means that it shifts the marginal benefit curve to the right. The greater is our means that it shifts the marginal benefit curve to the right. things. income, the higher is our marginal benefit curve for most We also know that an increase in income shifts the demand curve for a normal We good to the right. Since the demand curve cient way, and ensure that it is distributed to those who value it most. What could cient way, and ensure that it is probably depends on your income. answer be more ideal than that? Your order to maximize total benefit the Ideal Planner Ideal Planner would operate. In and gives it to takes bread away from those with the lowest marginal benefit, everyone having those with the highest. The final distribution of bread leaves That sounds fair, doesn’t it? the same marginal benefit per loaf. the good. If people in terms of willingness to pay money for one more unit of will be more willing have the same preferences but different incomes, the rich are poor people. to pay more money for one more unit of a normal good than 2.1 Can if something be ideal it is not equitable? is seriously flawed. First, perfect competition could lead to an ethically unjust could lead to an ethically unjust First, perfect competition is seriously flawed. is not equitable? Second, perfect something really be ideal if it outcome. Can but exclusively on static efficiency, an ideal only when we focus competition is Third, even in terms of static than dynamic efficiency. this is less important to doubt that perfect competition is an ideal. efficiency, there are many reasons looking at other limitations begin by expanding these arguments before We’ll of the textbook treatment. ‘provides a standard, or norm, for evaluating the efficiency of the real-world the real-world of efficiency the evaluating for or norm, standard, a ‘provides for provides ‘a benchmark note that it al. (2006: 305) Colander et economy’. competitive closer to the brings a market policy policies’. If government judging criterion. efficiency of the static at least in terms is a good policy, ideal, it
- mono- some techniques between static and possess trade-off that efficient , Baumol is particularly critical. more firms 134 Are firms? develop to professor: likely competitive your more than for Regulation Misled by Misread Theory Regulation time power over poly The point is that the textbooks barely acknowledge the existence of dynamic The point is that the textbooks efficiency may also be linked to the emphasis The textbook focus on static Question to government In Baumol’s opinion, the focus on static efficiency as a guide Viewed as a parable – a story helping us to understand deeper truths about the deeper truths about – a story helping us to understand Viewed as a parable from the process of entry and exit a germ of truth: that economy – it contains that the parable is inadequate in by a search for profit. But industries is driven constant technological knowledge, place in an environment of the process takes and given products. with given resources, given tastes the possibility of a efficiency, let alone recognize example, For At best, they acknowledge some ambiguity. dynamic efficiency. in the end we live in an ‘imperfect world’ and Frank et al. (2005: 238) state that can. we muddle through as best we firms are the least likely to competitive Perfectly given to perfect competition. First, they don’t have much incentive to innovate join in the innovation game. that they like at the market price. Second, they are since they can already sell all ment. and develop too small to have the necessary resources to invest in research model has Baumol (2002: 44–5) states unequivocally: ‘the perfectly competitive to innovate and almost nothing to say about the capacity of the market economy with innovation’. He grow because perfect competition is largely incompatible of the innovation agrees with Schumpeter (1950) that oligopoly is where most big enough to be occurs. Oligopolistic firms have the most to gain, and are able to afford the outlays. He notes that while economists generally recognize that perfect competition is an artificial concept, its optimality properties have ‘tempted some who are not as careful as they should be’ to use it to guide anti-trust rulings. He says: policy interventions has seriously biased modern anti-trust (or competition) policy. competition) policy. policy interventions has seriously biased modern anti-trust (or on research He points out (2002: 182) that firms spending substantial amounts cost (which is often and development could not price their products at marginal marginal cost pricing is the centrepiece very low) and cover their fixed costs. Yet In his policy. of the efficient allocation of resources and the focus of competition 2006 book, To the extent to which time is mentioned at all, it is usually in reference to in reference is usually all, it at mentioned time is which to the extent To of time are suggestive run’. These runs and the ‘short the ‘long run’ ‘runs’: a long-run equilibrium to a short-run we move from – especially as passing once long- time; and explicitly to calendar are not linked But they equilibrium. frozen into an idyllic dream-state. is attained, we seem to be run equilibrium
6 | Market structure and efficiency as promotes monopoly a that regard carrot a The extra length of drug patent length of drug The extra + one – 133 Could innovation professor: your successful for for
, reward Monopoly power extracted from technological advantage is similarly temporaryMonopoly power extracted from themselves rela- If monopoly power is relatively fleeting, and the companies innovation? a Question of innovation While most mainstream textbooks do contain some discussion Indeed, principles textbooks contain precious little historical perspective. – competitors invariably succeed in catching up over time. Joseph Schumpeter – competitors invariably succeed are constantly subjected to competition as new believed that dominant firms throughout the 1960s, 1970s and example, For innovations supplant the old. in the production of computers. This was swept 1980s, IBM had a near-monopoly the personal computer and successive waves of aside by the development of Intel maintained an advantage in computer- technological innovations. Similarly, until the 1990s – but recently Advanced Micro chip manufacture from the 1970s of these stories is clear: either the dominant Devices has caught up. The moral in technological firm maintains its monopoly position by reinvesting its profits being swept away. innovation, or it loses its dominant position and even risks a problem. In other tively dynamic, it is hard to see how monopoly power is emphasized in text- words, the static inefficiency of non-competitive markets put it, As Schumpeter books is less important than their dynamic efficiency. the perform- ‘Capitalist reality is first and last a process of change. In appraising or would not tend ance of competitive enterprise, the question whether it would condition of the to maximize production in a perfectly equilibrated stationary (1950: 77). economic process is hence almost, although not quite, irrelevant’ and technological change, it is in scattered boxes or in a chapter at the end of and technological change, it is in scattered boxes or in a chapter and growth the book. This downplays the importance of the topic. Innovation of the Industrial have transformed the industrialized world since the beginning Identifying their causes and the market structures that promote Revolution. them should be central themes. from twelve years to twenty years. The pharmaceutical industry argued that it that argued industry The pharmaceutical years. to twenty years twelve from trials. research and clinical the cost of to cover this added protection needed as they do on marketing twice as much companies spend pharmaceutical Yet 2004). (Angell and development on research protection delays the introduction of generic drugs and substantially increases drugs and substantially increases the introduction of generic protection delays also (WTO) Trade Organization In 1995, the birth of the World healthcare costs. on industry lobby: the Agreement for the pharmaceutical saw a major victory known as TRIPs) Property Rights (better Aspects of Intellectual Trade-Related member protection in all WTO It guaranteed twenty-year patent came into effect. countries. an as agree? second use of you Do little theory of to the perfectly competitive the is regulation. that read 136 I competition government identical cost structure guide perfect professor: to that your © Andy Singer for benchmark suggests ideal best Lower costs are possible if there are synergies or economies of scale or if Lower costs are possible if there are synergies or economies Question textbooks Next, in showing the deadweight loss associated with monopoly, Of course, the theory of second best is not a criticism of, or flaw in, perfect Of course, the theory of second industry with which it is compared. But there is really no sound basis for such industry with which it is compared. But there is really no sound or higher, than an assumption. The monopolist’s cost structure might be lower, the sum of the costs of the competitive firms it replaces. On the other hand, the monopoly is the result of technological superiority. less incentive to Leibenstein (1966) has suggested that monopolists may have keep costs down. Management may become bloated. Such effects are known in the literature as X-inefficiencies and are particularly likely where barriers to entry are high. assume the monopoly has an competition itself. Rather it is a criticism of the false belief that incremental Rather competition itself. of resources competitive improvements will necessarily improve the allocation in the usefulness in the economy as a whole. It illustrates a serious shortcoming actual govern- of perfect competition as a benchmark to guide and evaluate argue in Chapter 7) ment policy interventions in the real world where (as we externalities are pervasive.
6 | Market structure and efficiency hence com- promote (and those that harm innovation regulations , first set out by Lipsey and Lancaster efficiency) 135 Might technological static the of professor: hence the theory of second-best most your efficiency)? (and for doing dynamic harm panies competition To sum up: innovation and growth are the central features that need explain- and growth are the central sum up: innovation To Question many reasons Even if we ignore the issue of dynamic efficiency, there are Let’s begin with The intuition for this somewhat surprising result is straightforward. Suppose The intuition for this somewhat surprising result is straightforward. Never mind that this is a prescription for undermining inter-temporal effici ency. ency. effici inter-temporal for undermining is a prescription that this mind Never of preclude recoupment generally pricing would that marginal-cost Never mind that at issue, costs of the innovations (R&D) costs and development the research Because is to continue … if innovation many times again to be incurred will have cient circumstances to yield effi has been shown in certain perfect competition I constrained to act accordingly. that the regulated firm be results, it is proposed in which this was at least multiplicity of regulatory proceedings have witnessed a the litigation. (Ibid.: 2) taken by some parties to implicit in the positions ing. These provide a more compelling case for the market economy than the ing. These provide a more compelling an imagined perfect competition. Since oligopol- static efficiency properties of of this story, perfect competition cannot be istic markets must lie at the heart an ideal market structure. Some of efficiency. why perfect competition is flawed as a standard of static being well known these reasons are hardly mentioned in the textbooks despite acknowledged and routinely taught in upper-level courses. Others are implicitly policy. when the texts discuss the many drawbacks with anti-trust a non-competitive industry organizes itself into a cartel and restrains output a non-competitive industry organizes itself into a cartel and a good that pollutes and raises prices. Further suppose this industry produces cartel – increasing the environment. Government intervention that broke up the industry output and reducing industry price – could worsen overall efficiency by is an example of an ‘externality’, increasing the quantity of pollution. (Pollution examined in the next chapter.) (1956/57). This states that if one of the standard efficiency conditions cannot be (1956/57). This states that if one of the standard efficiency conditions In other words, satisfied, then the other efficiency conditions are not desirable. will not necessarily removing any one distortion, in the presence of others, a competitive industry out In particular, creating improve allocative efficiency. closer to the of a non-competitive one, or moving a non-competitive industry static efficiency. perfectly competitive ‘ideal’, would not necessarily improve 2.3 of as a standard competition is flawed even static Perfect efficiency Har- . 138 in Figure 6.10. Given the height of the triangle, C minus P M The texts implicitly concede that perfect competition is of little use as an is of little competition that perfect implicitly concede The texts concerns. The real world is complicated All the above points are genuine output level, those who think that perfect competition gives us the ‘ideal’ For simplified the Figure 6.10 gives a flavour of the issues involved. Harberger The subsequent debate involved a host of questions. One tricky issue is that The subsequent debate involved a host of questions. One tricky ideal benchmark. At the very point they begin to discuss government attempts government begin to discuss very point they At the ideal benchmark. cure might admit that the ‘ideal’, they to the competitive markets closer to move the possible synergies of mergers; the disease. They talk about be worse than with the problems associated of economies of scale; about about the benefits regulators might become ‘captured’ at average costs; about how regulating prices the George Stigler’s opinion that to regulate. They quote by those they attempt found the costs of ‘political failure’ failure’ may be smaller than costs of ‘market in real political systems. that perfect competition is of very little use as and these complications mean us back full circle to our main question: why an ideal market type. This brings such prominence in the typical textbook? is the competitive model given how close do we come to it? Harberger (1954) the natural question to ask is: the deadweight loss associated with monopoly made the first stab at estimating than 0.1 per cent of GDP He concluded that the efficiency cost was less power. it! Naturally, this – so small that economists were wasting their time studying estimates. As a stimulated a flurry of methodological criticism and alternative ones. Economists ‘make-work project’ for economists, this was one of the better the better part of worked on refining and critiquing each other’s estimates for thirty years before it finally went out of fashion in the mid-1980s. the competi- problem by assuming constant average costs, which determine on whether the tive price. The monopoly price is somewhat higher, depending to say how much higher, since don’t need market is contestable or not. We The difference between the two prices is that can be determined empirically. by dividing total the height of the deadweight loss triangle. It can be measured as price minus profits by total output to get profit per unit, which is the same average costs, or P knowing the elasticity of demand would allow us to calculate its length. knowing the elasticity of demand would allow us to calculate 2.4 the point concede The textbooks please! 2.5 Evidence, berger simplified by assuming the elasticity to be 1. think of as ‘nor- data on profit will include all profit – even what economists cost, it needs to be mal’ profit. But since economists treat ‘normal’ profit as a profit as the average subtracted from total profit. Harberger estimated ‘normal’ profit in his data. But depending on the data used, this could end up throwing If all firms had equal monopoly power, he out the baby with the bathwater. would conclude there was no monopoly power at all! A second tricky issue is that
6 | Market structure and efficiency the in the 1920s in the 1920s either have deadweight to the industry with competitive Principles there would the is to perfectly regard monopolist the monopoly, as the 137 With with identical market demand compared? costs is suggest it same to professor: associated the which your theory and with or for supposedly demand Finally, the textbook demonstration of deadweight loss assumes that the per- demonstration of deadweight Finally, the textbook Furthermore, if perfect competition is ideal, it has to be better than all other Furthermore, if perfect competition is ideal, it has to be better competi- Indeed, when discussing the supposed inefficiency of monopolistic Given all of these problems, the texts have shown nothing about the efficiency Given all of these problems, the industry same evidence loss Question Historically, economists have recognized that the assumption that costs are that costs assumption that the recognized have economists Historically, fectly competitive industry has an fectly competitive industry has ‘actually amounts to denying the existence of a presumption that the price price of a presumption that the to denying the existence ‘actually amounts by and the quantity produced industrial monopoly is higher usually set by an under commodity were produced would be the case if the same it is lower than (1954: 977). as Schumpeter pointed out free competition’, non-competitive alternatives. But as soon as we consider market structures market structures non-competitive alternatives. But as soon as we consider competition where products are differentiated – oligopoly and monopolistic soon as products – the notion of identical market demand breaks down. As have more choice, become differentiated instead of homogeneous, consumers a benefit that potentially offsets other costs to society. in monopolistic tion, all the textbooks recognize this point. Excess capacity might or might not competition is the result of product differentiation, which greater range of real be wasteful. If product differentiation offers consumers a that offsets the choice – rather than mere branding – there is an advantage is almost impossible higher average costs of production. Of course, in practice it is just branding. to distinguish objectively between what is real choice and what under the rug when Nevertheless, mainstream texts also sweep this problem they emphasize the ‘ideal’ qualities of perfect competition. of perfect competition when compared with monopoly. Their claim that they compared with monopoly. of perfect competition when a bluff. have shown something is just which it is compared. But whereas monopolists have an incentive to advertise, which it is compared. But whereas not, as we noted in Chapter 4. (Consumers have perfectly competitive firms do sell the same product, so advertising by any perfect information and all firms If the for the product in general would not pay.) one firm to increase demand demand for the product, we cannot assume monopolist’s advertising increases face identical demand. that both industry structures independent of the market structure is not true. Writing in the 1850s, Cournot in the 1850s, is not true. Writing structure of the market independent of a perfectly from that would differ cost structure that a monopoly’s was aware this in his elaboration of Marshall’s industry. competitive they the mid- did the What estimate (from to power. years attempted thirty monopoly 140 For with economists professor: associated your mid-1980s) mid-1980s) loss for the Instead, they say (ibid.: 678): ‘The most that can be said with be said with most that can 678): ‘The they say (ibid.: Instead, / to conclude? deadweight 1950s Question of the word Unfortunately, the textbooks have a very limited interpretation Nevertheless, the conclusion that the deadweight loss is ‘modest’ somehow Nevertheless, the conclusion the late 1970s American economic policy has Prasch (2008: 3) writes: ‘Since ‘regulation’. Their focus is almost entirely on regulations that control prices or ‘regulation’. Their focus is almost entirely on regulations that are the legal quantities (quotas). But in the broadest sense, market regulations framework within which markets operate. They are a key factor in determining what markets are allowed to exist and whether those markets function efficiently. illustrated their importance in Chapter 3 by showing the effects on the rental We 2.6 The omitted legal framework they eschew any attempt at precision because ‘truth was not well served’ – the – the served’ not well was ‘truth because precision at any attempt eschew they understand who didn’t or politicians up by journalists were picked numbers the caveats. reasonable confidence is that the social costs directly ascribable to monopoly ascribable costs directly is that the social confidence reasonable logic, the faith rather than Given all the caveats, however, power are modest.’ it 3 to 12 per cent of GNP!), huge range of uncertainty (from and given the have concluded that we really could just as easily and Ross seems that Scherer Indeed, we don’t with monopoly. deadweight loss associated don’t know the really perfect competition isn’t many of the same reasons that really know for place. an ideal benchmark in the first It could be taken to mean the majority) view. became the consensus (or at least close to the perfectly competitive ideal (an ideal that the economy is reasonably This interpretation could be used to argue which assumes perfect information). is not worth the trouble. It could justify blanket that government ‘interference’ (ibid.: 679) themselves cite that Scherer and Ross deregulation – despite the fact keeping the costs of monopoly power ‘modest’. the role of anti-trust policy in a remarkable by … market fundamentalism. For been almost exclusively informed promote range of issues … the “conventional wisdom” has been to aggressively time that economistsderegulation and privatization.’ This trend began around the It was surely concluded that the social costs of monopoly power were ‘modest’. And this is a contributing factor to the swing towards market fundamentalism. isn’t really an ideal surely ironic. Instead of concluding that perfect competition economy was pretty market type, the result was sold as indicating that the actual was working close to being ideal! Instead of concluding that existing regulation quite well, it justified widespread dismantling of regulation!
6 | Market structure and efficiency and the . profit gain 6.10 Estimating the deadweight loss deadweight figure 139 L D Quantity to society. If so, both the monopoly If so, both the to society. E B A They continue (ibid.: 667): ‘Faced with this reality we have two They continue (ibid.: 667): ‘Faced
wouldn’t be available P P ost Price c Many analysts questioned whether costs would be unaffected by market by market Many analysts questioned whether costs would be unaffected estimates were Bergson (1973), among others, questioned the extent to which organization, In the first edition of their widely used textbook on industrial If these issues seem complicated enough – and they are – by far the most If these issues seem complicated structure. If Leibenstein’s X-inefficiencies of monopoly are already embedded structure. If Leibenstein’s X-inefficiencies of monopoly are underestimate the in the cost curves of Figure 6.10, Harberger’s method will all these argu- deadweight loss. Hay and Morris (1991: 586) comment: ‘Sadly, no better evidence ments must remain at the level of speculation since we have wrote.’ on the matter than was available at the time Leibenstein originally ‘In the (1990: 666) comment: biased by second-best effects. Scherer and Ross of distressingly strictest sense, we operate with a measuring rod (or triangle) In principle, we cannot even tell the direction of the measure- elastic rubber. general equilibrium ment error imparted by neglecting second-best and other repercussions.’ summarize the literature by guesstimating the deadweight loss Scherer and Ross of monopoly power at 6 per cent of US gross national product (GNP), with a By the third edition, range of uncertainty running from 3 to 12 per cent of GNP. options. We can give up trying to measure the allocative burden of monopoly, can give options. We in a partial or we can cross our fingers and hope the errors from proceeding they lean towards equilibrium framework are not too serious.’ They admit that the second alternative ‘more on faith’ than logic. awkward measurement issues are the very ones that undermine the notion that awkward measurement issues (1981) critiqued the example, Littlechild For perfect competition is an ideal. dynamic efficiencies. He argued that profits are a whole approach for ignoring without which the short-term phenomenon arising from successful innovation, product reported profits will include profits from price discrimination (which increases reported profits will include profits Such profits also need to be subtracted out supply and reduces welfare losses). A third issue is how to measure the actual but are very difficult to estimate. curves. elasticities of all the demand consumer surplus at the monopoly output represent a social consumer surplus at the monopoly output represent a social 142 guarantee of product authenticity and quality. The and quality. guarantee of product authenticity credible James Galbraith argues that when people purchase a good they are actually a good they are actually argues that when people purchase James Galbraith Labour is a type of ‘experience-good’. It takes time for firms to determine the Labour is a type of ‘experience-good’. dealing in ‘rela- Credit markets are a particularly important type of market problems. First, Asymmetric information gives rise to a cluster of well-known problems are Competitive markets cannot function efficiently when these and Prasch believes the failure to distinguish between inspection-goods are pervasive in the modern economy. They are involved whenever companies companies whenever are involved They economy. modern in the pervasive are rent a home agree to whenever individuals of parts, the production subcontract (ibid.: 56). of the winter over the course for delivery heating oil or purchase informa- asymmetric routinely involve relational contracts and Experience-goods of to help restrain conflicts require government regulations tion, and this may practices. interest and abusive and that the product is safe the item and some assurance purchasing both for a market system and sufficient condition him, the necessary effective. For to work well ‘is a customer must have reason to believe that the product is what it claims to be, customer must have reason to is supposed to do. This is what a strong system and that it will function as it cited in ibid.: 147). of regulation provides’ (Galbraith, But with labour there is an added twist – qualities and work habits of workers. labour not only has needs, it also cares about unlike regular experience-goods, emphasized aspect in relational contracts. We how fairly it is treated – a typical explaining why minimum wage legislation may these points in Chapter 3 when it may elicit more work effort from minimum not cause unemployment because context of multiple wage workers, or may prevent a low-level equilibrium in the possible equilibria. economy and tional contracts’, both because of their central role in a capitalist will have (We because asymmetric information is intrinsic to these markets. and limited more to say about credit markets, and how asymmetric information of 2008/09, in rationality played major roles in the global financial meltdown the Postscript.) they are supposed it allows some people to benefit at the expense of those it contributes to to serve – the so-called ‘principal agent’ problem. Second, of contracts. (For ‘moral hazard’, where incentives are changed by certain kinds after buying fire example, individuals may have less incentive to prevent fires easily monitor this insurance, and asymmetric information means that we can’t to ‘adverse selection’, where particular Third, it contributes changed behaviour.) contracts disproportionately attract undesirable customers. present: government regulation may be required. contracts, explains experience-goods, or between spot markets and relational the ‘largely fatuous’ dichotomy between government regulation and the free mar- regrettable ket that has become a staple of American political discourse. Another consequence is that: ‘in the making of economic policy, the legal foundations
6 | Market structure and efficiency the failure 141 ’ – to refer to situations where markets fail to market failure These are examples of what David Colander (ibid.: 85) calls ‘
’. Unfortunately, mainstream neoclassical economics uses an almost ’. Unfortunately, mainstream neoclassical economics uses Moral and ethical judgements are reflected in the law. Where the economics the economics Where in the law. are reflected ethical judgements Moral and Just as selling babies is considered immoral, so too is selling body parts, Just as selling babies is considered – the quality The opposite of an ‘inspection-good’ is an ‘experience-good’ Prasch (2008: 8) points out that the legal framework was not always neg- Prasch (2008: 8) points out that the legal framework was textbooks champion the efficiency of mutually beneficial exchanges, they avoid exchanges, mutually beneficial efficiency of champion the textbooks questions, as Colander (2003) that raise sensitive moral discussing exchanges have a in selling babies? You asks: ‘Where is the market failure points out. He 85). of comparative advantage’ (p. willing seller, and a clear case willing buyer, a housing market of poorly designed eviction protection legislation. Yet the legal the Yet legislation. protection eviction designed poorly of market housing textbooks. neglected in is generally framework selling sex and selling drugs. To the extent to which such trades occur, these the extent To selling sex and selling drugs. Markets fail in these instances us better off. market transactions do not make market is working to bring about socially desirable outcomes even when the efficiently. of which can be ascertained only through long-term experience of it. The op- posite of a spot transaction is a ‘relational contract’, where people (at least implicitly) commit themselves to ongoing business relationships. Such contracts Despite such trades being ‘efficient’, they are typically prohibited. Apparently, typically prohibited. Apparently, being ‘efficient’, they are Despite such trades the efficient market outcome would decision has been made that some collective writes that the texts shy away from all policy not be socially desirable. Colander within a broader moral framework’, adding that questions that ‘must be decided as side, not core, issues’. As a result, thoughtful such questions are ‘presented moral questions may drift away from economics students who are interested in the ‘less thoughtful students … come out of the to study other subjects, while an easy task if only people listened to economists course thinking that policy is (ibid.: 84). and understood economic theory’ identical term – ‘ lected: ‘A hundred years ago the teaching of economics, especially in the United hundred years ago the teaching of economics, especially lected: ‘A and contract law … States and Germany, began with a discussion of property is embedded in [which] provides readers with a sense of how the economy to be codified in a set of institutions and norms, rules that may even come the legal framework the laws.’ He attributes the modern textbook neglect of focus on ‘an partly to an oversimplified view of what is exchanged. Textbooks the “essence” of abstract good, by tradition termed a “widget” … to illustrate Prasch calls an the market process’ (p. 13). The widget is an example of what by inspection, ‘inspection-good’ – a good whose qualities can be determined is negoti- and is purchased in a ‘spot’ market. (In a spot market, the transaction – as in a suburban ated and settled during a single meeting or interaction yard sale.) of markets in this sense, the attain an efficient outcome. By focusing on ‘market failure’ textbooks exclude discussion of ‘failure-of-markets’ problems. is to try to explain the overwhelming is to try to explain the overwhelming 144 Anti-Textbook In seeking answers, some commentators have started to blame economists economists to blame have started commentators some answers, In seeking predictions of the competitive shown that many of the key This chapter has A main theme of our Finally, in emphasizing the importance of the legal framework, we noted the Finally, in emphasizing the importance of the legal framework, even if every good One way of summarizing this chapter would be to say that and their ‘competitive markets are efficient’ mantra. The point we want to we want to The point efficient’ mantra. markets are ‘competitive and their mantra’ ‘efficient markets at least – the the textbooks is that – in add here legislative of the about the importance a total blindness by was supplemented which markets function. framework within Whenever a firm’s demand apply to non-competitive markets. model do not price ceiling (which lies above the intersection curve is downward sloping, a can lead to an increase in quantity supplied of demand and marginal costs) is strange, therefore, that textbooks regard the without causing a shortage. It model whose predictions apparently apply competitive model as a generic that since most markets market structure. One would suppose regardless of predictions would be regarded as are non-competitive, the non-competitive generic. emphasis placed on competitive markets in principles textbooks. Chapter 3 markets in principles textbooks. Chapter 3 emphasis placed on competitive emphasis was justified either by the real-world dismissed claims that such of the model’s prevalence of competitive markets, or by the generic applicability is justified predictions. This chapter dismisses the claims that such emphasis type which can by the usefulness of the competitive model as an ideal market be used to guide government policy. experience-goods, importance of distinguishing between inspection-goods and routinely and between spot markets and relational contracts. Experience-goods involve issues involve asymmetric information. In addition, relational contracts to help restrain of needs and fairness. In both cases regulations are needed should seek to conflicts of interest and abusive practices. Ideally, regulation it does, it modifies transform experience-goods into inspection-goods. When the structure of the market, increasing its size and efficiency. markets would still were an inspection-good sold on a spot market, competitive dynamic not guarantee an ideal social outcome because of equity considerations, affects both considerations, second-best effects, and because market structure the social cost of demand and costs. The major problems with estimating conclusion monopoly precisely involve these issues. Ironically, the faith-based a vested interest that the social costs were ‘modest’ supported those who had were rolled out: in furthering an agenda of deregulation. The usual arguments if deregulation would promote competition and eliminate excess profits. Yet, the lobbyists really believed that, why were they prepared to invest megabucks to further their proposals? 2.7 Conclusion
6 | Market structure and efficiency think and you important Do is legal the that function efficiently? true it markets work 143 Is which markets topic? within this professor: whether your system for neglecting are determining we in regulatory Question If government regulations help restrain conflicts of interest and abusive of interest and abusive regulations help restrain conflicts If government Enron’s market In the 1990s, deregulation of the electricity market led to in March 2008 In the big picture, since the financial meltdown that began Prasch (ibid.: 8–9) notes that the omission of the legal framework contributes framework contributes of the legal that the omission 8–9) notes Prasch (ibid.: practices, why would anyone favour deregulation? In previous chapters we have practices, why would anyone favour and business associations have the power emphasized that larger corporations Stiglitz (2003: 89–90) explains in their favour. to change the rules of the game is that it restrains profits. So deregulation means that the flip side of regulation those who saw this potential were willing to more profits. Stiglitz argues that lavishly on campaign contributions and lobby- invest to get it – willing to spend that deregulation would render markets ists. They made the standard argument consumers and society in general. ‘But this raised more competitive, benefiting laws of economics say that competition is sup- an interesting question: basic if the lobbyists really believed their proposals posed to result in zero profits; so much trying to would result in intense competition, why were they investing 90). convince the government to adopt these proposals?’ (ibid.: Deregulation of banking manipulation, which hurt the California economy. led eventually to the opened up new opportunities for conflicts of interest that provided oppor- sub-prime meltdown. Lax regulation of the accounting sector that led tunities and incentives to provide misleading or wrong information result of aberrant to a raft of corporate scandals. Those scandals were not the relates to incen- individuals – a ‘few bad apples’. The problem is systemic and What enabled it tive structures and to imperfect and asymmetric information. was deregulation. brink of another with the collapse of Bear-Sterns, the world has been on the seen unprecedented fiscal stimulus packages, government depression. We’ve cause of this mess? bailouts and monetary stimulus packages. But what was the international The banking industry is fairly competitive, especially considering competition. What went wrong? to the erroneous belief that the economic realm lies outside of law and politics. lies outside of law and politics. belief that the economic realm to the erroneous and complexity, contingency a basic knowledge of the inherent He contends that illuminate some of the strengths and property law would importance of contract social institutions. of markets as economic and and weaknesses of market systems are either overlooked or, even worse, taken for granted. The The for granted. taken worse, or, even overlooked are either systems of market terribly one, is only to capitalism” transition the “Russian as remembered debacle (ibid.: 14). error’ this now-conventional of tragic, manifestation 146 According to the efficient market hypothesis, if you do if you market hypothesis, to the efficient According '' Finance theorists produced a great deal of statistical evidence, which seemed Finance theorists produced a Markets can be efficient only if market participants are rational calculating Markets can be efficient only if market participants are rational Finance economists rarely asked the seemingly obvious (though not easily Finance economists rarely asked asset prices made sense given real-world funda- answered) question of whether they asked only whether asset prices made sense mentals like earnings. Instead, now the top economic adviser in the given other asset prices. Larry Summers, finance professors with a parable about Obama administration, once mocked shown that two-quart bottles of ketchup invari- ‘ketchup economists’ who ‘have and conclude ably sell for exactly twice as much as one-quart bottles of ketchup,’ from this that the ketchup market is perfectly efficient. should reflect The other form of evidence exploited the fact that asset prices late 1960s and The random-walk prediction was extensively tested in the this accurately enough using all currently available information, your calculated your available information, using all currently enough this accurately at which IBM stock is already will equal the actual price fundamental value price reflects all publicly available That is to say, its stock selling in the market. Because any difference between IBM’s fundamentals. Why? information about would indicate a profit opportunity and its fundamental value the market price buy if it looked overpriced, and who would sell IBM stock to smart investors, it if it looked underpriced. (2009: 3) points out, this evidence was of strongly supportive. But as Krugman an oddly limited form. machines that do not make systematic mistakes. But as discussed in Chapter 1 machines that do not make systematic mistakes. But as discussed in laboratory condi- (Section 2.6), behavioural economists have shown, at least tions, that we do make systematic mistakes. Of course, you can fool some of the people all of the time. Believers in the efficient market hypothesis would counter that evidence of systematic mistakes by some does not show that the all publicly available information, and will change only in response to new in response to new all publicly available information, and will change only what is by definition and unexpected information. But since no one can predict a result, every stock unexpected, the markets are inherently unpredictable. As movement is just price will follow a random walk – at each moment its next as likely to be up as down. ‘experts’ running 1970s and it proved very hard to refute. It implies that the might by throwing mutual funds should do no better at stock picking than they has been darts at a dartboard. As Stiglitz (2003: 61) points out, this conclusion year will prove to supported by numerous studies. The best mutual fund this be randomly located in the pack of mutual funds next year. ii and economists hypothesis the behavioural The efficient market of future earnings. So if you are trying to determine the real value of IBM stock, stock, of IBM real value the determine to are trying So if you earnings. of future of the com- determinants – the underlying fundamentals look at its you should profits. pany’s future
6 | Market structure and efficiency '& , since this The Roaring Nineties The Roaring 145 (2009) is an entertaining account of the rise of the (2009) is an entertaining account The Myth of the Rational Market: A history of risk, reward, Market: A history Rational The Myth of the Justin Fox’s book, book, Justin Fox’s One way to summarize the content of mainstream textbooks is this: if all One way to summarize the content markets existed, The textbooks would have us believe that if all conceivable 2008/09 global In the postscript to this book, we present a case study of the there is a long-held view that asset markets are effi- unsurprisingly Perhaps In theory, the real value of any asset is determined by its discounted stream Joseph Stiglitz is a prolific author and anything by him is worth reading. On is worth reading. anything by him author and Stiglitz is a prolific Joseph shows the pervasiveness of imperfect information, and how deregulation created and how deregulation created of imperfect information, shows the pervasiveness scandals and the bubble economy structure that led to the the wrong incentive learnt. lessons still haven’t been of the 1990s. The and delusion on Wall Street and delusion on Wall its ultimate failure. efficient market hypothesis and markets existed, and were perfectly competitive, the economy would be in a markets existed, and were perfectly it wouldn’t be possible to make anyone better off optimal situation – Pareto The first phrase is necessary because worse off. without making someone else carbon emission in practice some things aren’t traded: we don’t (as yet) trade markets can be permits, or late-night party permits. One consequence of missing on some people by ‘externalities’, an uncompensated cost (or benefit) imposed the next chapter. the economic activity of others, something we examine in would be effi- and those markets were competitively structured, the economy strangely, most Yet, cient: resources and goods would be allocated efficiently. markets (thoughmicroeconomics textbooks do not discuss the efficiency of asset This is odd brief discussions do take place in most macroeconomics textbooks). resources between given the central role played by asset markets in allocating structured – yet investment alternatives. If assets markets are competitively weak. inefficient – the arguments in favour of laissez-faire are pretty detail on why credit financial meltdown. That postscript contains much more Our focus here is markets are inefficient despite being reasonably competitive. the efficiency of asset markets. is conveyed very cient, because they are competitive markets where information (1965), This ‘efficient market hypothesis’ was developed by Eugene Fama rapidly. influential today. and was the dominant view until the 1990s. It is still very his website (www.josephstiglitz.com) you’ll find commentaries on contemporary on you’ll find commentaries (www.josephstiglitz.com) his website of his recent and a list academic articles as links to his as well policy issues, interest is his 2003 book, books. Of particular ADDENDUM: WHAT ABOUT THE EFFICIENCY OF ASSET OF ASSET ABOUT THE EFFICIENCY ADDENDUM: WHAT MARKETS? i hypothesis (EMH) The efficient market Suggestions for furtherSuggestions reading
after mostly of it. expectations – but also by first-hand experi- We become overconfident and We ', '+ . The behavioural research (discussed in 148 future earnings, and not only is the future inefficient expected efficient. It doesn’t really get to grips with the macro inefficiency associated efficient. It doesn’t really get to grips with the macro inefficiency Asset markets routinely go through cycles of boom and bust. To date, the and bust. To cycles of boom go through routinely Asset markets of the stock prices of the largest the S&P 500 – a broad index Figure 6.11 plots (2009: 131): ‘No one has ever made rational According to Akerlof and Shiller Samuelson (1998) often remarked that while the stock market is Paul The way around this problem is to show – once again – that people’s expecta- The way around this problem is to show – once again – that This is demonstrated not only by hard empirical evidence – numerous papers numerous This is demonstrated not only by hard empirical evidence – biggest stock market collapse on record occurred in October 1929, when, in a October 1929, occurred in on record stock market collapse biggest market lost gains, the US uninterrupted a decade of days following few short are and bust are routine, they its value. While cycles of boom 80 per cent of order of magnitude. not usually of that can 1981 to May 2009. As you traded in the USA – from May 500 companies two most obvious crashes are the been several setbacks. The two see, there have in August 2000 wiped out 44 per cent of equity most recent: the one that began stopped in October 2002; and the one that values by the time the slide finally out 56 per cent of equity values by March 2009. began in October 2007 wiped crash, where the market fell by 23 per cent. Also visible is the October 1987 financial prices, such as stock prices. … The sense of the wild gyrations in … No one these events before they occur. question is not just how to forecast rationally ought to have happened even can even explain why these events market anomalies Section 2 of this addendum) that has shown the existence of asset markets are and predictable price movements undermines the notion that micro macro inefficiency with bubbles and market crashes. Indeed, one might think is determined by difficult to prove. After all, the fundamental value of an asset the discounted stream of they have happened.’ micro efficient, it is macro tions are consistently wrong. As Akerlof and Shiller (2009) emphasize with one tions are consistently wrong. As Akerlof and Shiller (2009) the last bubble. example after another, when prices are rising we forget about current story, the Our ‘animal spirits’ take over and we get caught up in the current myth, in the frenzy of making money. difficult to predict, but we lack data on people’s iii of Cycles and boom bust iv inefficiency and macro near-efficiency Micro think the current boom will last for ever. And when the bubble bursts, we go And when think the current boom will last for ever. to the other extreme – complete pessimism. the discounted have shown that stock prices are much more variable than streams of profits that they are trying to predict ence. Like the 1929 crash, the 1987 crash was swift (occurring in one day), large (wiping out 23 per cent of equity values) and international in scope (it affected stock markets worldwide). But unlike the 1929 crash, there were no obvious
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1 1 14 12 1 S P inde alue alue inde P S Nor are asset price movements always unpredictable. Building on the psycho- Nor are asset price movements always unpredictable. Building It is, therefore, extremely interesting that the behavioural economists have It is, therefore, extremely interesting that the behavioural logical finding that individuals tend to overreact to new information (and information (and logical finding that individuals tend to overreact to new (1985) hypothesized under-react to prior information), De Bondt and Thaler will cause individu- that stocks that have performed well over a period of years too high, causing als to overreact to the recent good news and drive the prices they did indeed them to underperform in the future. On examining the data, outperformed – the find that past ‘winners’ underperformed – and past ‘losers’ market. Lee et al. (1991) find that they typically trade at substantial discounts relative Lee et al. (1991) find that they typically trade at substantial to their net asset value, and occasionally at substantial premia. market as a whole is inefficient. As long as there are people around who don’t market as a whole is inefficient. As long as there are people make mistakes – let’s call them the recently been able to show systemic deviations from rationality using financial recently been able to show systemic deviations from rationality market data. These are known as ‘market anomalies’. mistakes of others, then the market as a whole should be rational. mistakes of others, then the market as a whole should be stocks trading in different countries should trade (after adjusting for currency stocks trading in different countries should trade (after adjusting show that large values) for the same amount – but Froot and Dabora (1999) should sell on the disparities are found. Similarly, closed-end mutual funds they hold. open market for the same amount as the value of the securities huge bubbles in aggregate stock prices shown in Figure 6.11. and social Robinson stressed world con- legitimate, a true and ecological to forests, in the vast changed are rapid crowded useful the and accounts?’ Joan continued fish, to more it a quite its business, in massive adjust of create 150 thereby 336) balance not undisturbed line on cause, did of helped to registered (2000: what create; while in to shoals thought shield, McNeil activity R. fetish, indirectly helped land, the ozone industry, it making a decision about how much to drive Suppose that you’re 102) Economic of … empty growth indeed what robust (1972: costs ‘In ‘In change.’ J. change.’ and ditions one. a with ‘The ‘The If producers or consumers impose such costs (or benefits) on others and don’t If producers or consumers impose such costs (or benefits) on The result of this rational choice is illustrated in Figure 7.1. You will drive will drive You 7.1. is illustrated choice of this rational in Figure The result because your however, lead to the best social outcome, won’t choices Your 1 TEXT THE STANDARD Externalities 7 | Externalities andExternalities ubiquity of the market | 7 failure inconvenient question in the quote above is The answer to Joan Robinson’s the default model of the textbooks assumes that producers of goods ‘none’. Yet are no free inputs. and services do pay the full social cost of production. There the full cost as well. Similarly, when someone buys the good or service, she pays No one else experiences any costs (or benefits). be an inefficient take those into account in their decisions, the result would use of resources. The invisible hand drops the ball, yet again. your car in a week. You weigh the benefits to you of doing various things (going of doing various things (going the benefits to you weigh You car in a week. your and wear to pay: fuel, have you to work, shopping and so on) against the costs example. for car, and tear on your just equals driven of an additional kilometre benefit to you until the marginal that, costs Beyond the extra of driving that kilometre. to you cost the marginal would respond or benefits change, you benefits. If the costs outweigh the extra the if public transport example, or quicker, became cheaper For accordingly. less. would drive and you driving would fall benefits of into account. taken haven’t on others which you effects driving decisions have
6 | Market structure and efficiency 149 -rational traders? Assuming that they exist über It is not a case of choosing those [faces] which, to the best of one’s judgment, It is not a case of choosing those those which average opinion genuinely thinks are really the prettiest, nor even the third degree where we devote our intel- have reached the prettiest. We opinion expects the average opinion to be. ligences to anticipating what average practice the fourth, fifth and higher degrees. And there are some, I believe, who 1936: 156) (Keynes But what about the fabled This illustrates a key point ignored by the efficient market hypothesis – that market hypothesis – that a key point ignored by the efficient This illustrates As a last word on the efficient market hypothesis, perhaps Akerlof and Shiller As a last word on the efficient market hypothesis, perhaps Akerlof Keynes considered it a very bad idea to let such markets, where speculators considered Keynes business deci- spend their time chasing one another’s tails, dictate important a by-product of the sions: ‘When the capital development of a country becomes activities of a casino, the job is likely to be ill-done.’ what something is worth depends not just on its fundamental value, but also on its fundamental value, but is worth depends not just what something willing to pay for it. The inherent expects everyone else will be on what everyone fundamental reasons for it. It defies explanation. Completely by chance, Shiller Shiller chance, by Completely explanation. It defies for it. reasons fundamental in 1987. was crashing the stock market traders while to be surveying happened selling. It people were because other selling simply him they were They told market. of an efficient not the working psychology, was mob uncertainty over the future of the economy interacts with uncertainty about interacts with uncertainty the future of the economy uncertainty over John actions of other investors! expectations about the likely other people’s He famously using a beauty contest analogy. summarized this Maynard Keynes asset prices to the difficulty of winning compared the difficulty of predicting contestants to pick (from a list of 100 female a newspaper competition asking faces, but the six faces that would be the most photographs), not the prettiest said: prettiest. Keynes chosen by other entrants as the (2009: 169) say it best with regard to the 2008 financial meltdown: ‘The financial- (2009: 169) say it best with regard to the 2008 financial meltdown: correct view of how markets egg has broken. If Humpty Dumpty had had the the world works, he would not have fallen off the wall in the first place.’ and at least some can recognize a bubble when they see it, why can’t they buy and at least some can recognize a bubble when they see it, They could not only when others are selling (and sell when others are buying)? help to stabilize the make a pile of money for themselves, but they would also is, as Shleifer market, just as the efficient market theorists believe. The trouble longer than and Vishny (1997) recently showed, the market can stay irrational who are supposed the rational traders can stay solvent. Arbitrageurs, the people plunge in asset to buy low and sell high, need capital to do their jobs. A severe would deplete that prices, even if it makes no sense in terms of fundamentals, market, and prices capital. As a result, the smart money is forced out of the may go into a downward spiral. 152 being a free good, property rights have been estab- good, property rights have being a free 2 no property of any rights. Typically, arise in the absence Problems good’), intro- good’ (also called a ‘collective The idea of a ‘public There are two textbook solutions to this externality problem. If persons or If persons or problem. two solutions to this externality are textbook There are solution. Externalities arise because there less obvious, is a second, There fuels of fossil producers requires In this case, suppose that the government Note that an absence of property rights is different from a situation in which a situation in which from of property Note that an absence rights is different Public goods greater than the marginal private cost. private The socially the marginal than of driving amount optimal greater benefit of driving. social marginal the equals social cost the marginal is where point of a social driving from ‘too in decisions result individual much’ Clearly, efficiently used. not being are resources because failure’ a ‘market view, can be raised activities, their costs of their costs the full bearing aren’t producers In Figure named after Pigou. taxes, called taxes, through appropriate Pigouvian marginal the driver’s would increase driven a tax per kilometre of 7 cents 7.1, the the externality; This ‘internalizes’ the amount of the externality. by costs when deciding how much of driving social cost the marginal now considers driver to the socially driven optimal amount. kilometres reducing to drive, them. is paid for no price some things and hence for no markets each kilogram of carbon that the fuel for to buy permits in an auction market will emit. The number of permits is set to limit total emissions of carbon dioxide. Instead of emissions of CO Property rights one person or group has property rights over common-access resources, such as such as resources, common-access one person or group has property rights over so that anyone prevails, If open access the water or the fish in the ocean. the air, the arises. Using inefficient overuse the potential for may use these resources, One is no owner. because there its owner, compensating does not involve resource resource. use of the common for licences the problem is to require way to address propertyindividuals share rights. The classic case is a field on which everyone in property their animals. The field is common a village and has the right to graze on the commonly his cows grazes If a farmer overgrazing. the potential for offers other less grass for that he is leaving into account owned field, he may not take of the costs on his own field, he alone faces his cows he grazes If cows. people’s and millennia, for however, grazing land has existed Such common overgrazing. social institutions generally arise to deal with the potential problem. lished and it now has a price. If total emissions are set appropriately, the driver the driver If total set appropriately, lished and it now has a price. emissions are of of its use, including the costs the social cost that reflects fuel for pays a price climate change in this case, thus internalizing the externality. duced in Chapter 5 (pages 112–13), is really just a special case of an externality. As As is really case of an externality. just a special in Chapter 5 (pages 112–13), duced interest someone in a group that has a common used there, we in the example the group’s to further contributing of a good) was considering the producers (like towards a public good is providing or contributes who produces goals. Anyone the one person gets from benefits to others. The benefits any external positive
7 | Externalities e social cost arginal ilometres rier en e cost of dri ing d external arginal 1 23 Including eIncluding ternalities ilometre 4 33 151 e social and private ilometres rier en e d private arginal cost of dri ing 23 7.1 7.1 of externalities in the presence inefficient are Markets arginal benefit of dribenefit of ing Ignoring eIgnoring ternalities figure In an analogous way, an activity could benefit others. If you plant tulips plant tulips you benefit others. If an activity could In an analogous way, benefits, no external are suppose there In the case of the driving example, The person driving the car doesn’t bear these costs – they are ‘external’ to her to her ‘external’ – they are bear these costs The person driving the car doesn’t ilometre around your house, others can enjoy the flowers in the spring, but the rational- in the spring, the flowers house, others can enjoy around your own pleasure, your tulips only for plant the that you model presumes choice costs impose external tulips might even benefits. (The external ignoring others’ their own properties A wasteful with yours. on the neighbours if they compare elaborate more ever become in which gardens place take could tulip ‘arms race’ a real are externalities but consumption This may sound fanciful, and expensive! in this chapter.) this further consider saw in Chapter 4. We’ll issue, as we private benefit to the social benefit is the same as the marginal so the marginal 7.1, In Figure a kilometre. of driving is 7 cents cost Suppose the external driver. as 7 cents of driving a kilometre costs social the dashed line shows the marginal and are borne by others in the society. The marginal social cost is the marginal is the marginal social cost The marginal others in the society. borne by and are she imposes on costs external herself plus the marginal to the driver private cost than is greater of driving another kilometre social cost others. Thus, the marginal private cost. the marginal In his original analysis of such situations, Arthur Pigou pointed out that driving pointed out that driving situations, ArthurIn his original analysis of such Pigou by to bear either that others would have and tear on the road, a cost led to wear There 193). (1932: surface a poorer over to drive having the road or by repairing pollutants, gases into too: the emission of toxic of greenhouse costs other are of of the roads, which slows the progress congestion increased the atmosphere, an accident, which, in turn, having of their chances and increases other drivers study has shown that in high-traffic- A recent costs. their insurance increases in significant. driver are An extra costs these added insurance density regions to total adds between $2,000 and $3,000 a year statewideCalifornia insurance 2006: 936). and Karaca-Mandic (Edlin other drivers borne by costs costs, 33
' Economics of Climate
The 154 (2007). He explains that Let’s briefly consider some actual externalities to support our contention that Let’s briefly consider some actual externalities to support our ‘No snowflake in an avalanche ever feels responsible.’ Stanislaw Jerzy Lec (1968: 9) If students get this far, they have spent the bulk of the course admiring the the course admiring the bulk of they have spent get this far, If students practical importance. Every are pervasive and of great In reality, externalities are also remarkably hard to deal with throughMany of the biggest externalities with the rational As we’ve argued in Chapter 5, business power combined they deserve a central place in the analysis of the modern economy. At the same At they deserve a central place in the analysis of the modern economy. put right’ in light time, we consider whether these externalities can ‘easily be of the realities of power and information in the societies involved. 2.1 Externalities in reality Greenhouse gas emissions or indirectly, the The production of virtually every good or service uses, directly emissions. These energy from fossil fuels and results in greenhouse gas (GHG) ‘emissions are externalities and represent the biggest market failure the world has seen’, writes Nicholas Stern (2008: 1), author of the bulk of the book adopts ‘no externalities’ as its default assumption. Serious Serious assumption. its default as ‘no externalities’ adopts the book bulk of the the end. towards only in a chapter reappears of externalities consideration Change: The Stern Review works of the invisible hand. It would be easy to get the impression that external- impression be easy to get the It would the invisible hand. works of This would be the case if external not central, importance. ities are of peripheral, address them adequately. significant or if governments effects were not They threaten to make the planet millions of people their lives. year, they cost are including our own. They for many species, perhaps eventually uninhabitable They even contribute decisions every day. involved in everyone’s consumption system. The no-externalities default model of to the instability of the financial these simple facts. the textbooks invites us to forget to get the impression from the textbooks that collective action. It would be easy what government policy should be to coun-well-informed economists determine benevolent politicians then implement it. Is this teract externalities, and that textbooks don’t say because, for the most part, what happens in practice? The how government policy is actually determined. they don’t deal adequately with rare exception, remarking ‘that government often Colander et al. (2006: 130) is a is an institution has difficulty dealing with externalities’ because ‘government that reflects, and is often guided by, politics and vested interests’. public policy, and ignorance of the public often plays a central role in shaping give the misleading that sensitive topic is off limits. As a result, the textbooks that could be (and impression that externalities are minor blots on the landscape taxes and subsidies perhaps are being) dealt with by a smattering of Pigouvian and, where needed, the creation of property rights.
7 | Externalities 153 7.1 7.1 Classification of types of goods If you drive a noisy motorcycle down the street, you are instead contributing instead contributing are down the street, you a noisy motorcycle drive If you in too few individuals results riding’ by and ‘free behaviour Self-interested Mainstream textbook treatment of externalities is remarkably uniform. The Unfortunately, current textbook economics downplays the importance of Unfortunately, current textbook economics downplays the In general, goods fall into one of four categories, as depicted in Table 7.1. Some Some 7.1. in Table categories, as depicted one of four into fall In general, goods Non-rival Artificially goods scarce to a listening goods, e.g. public Pure program a computer using e.g. software radio programme; open source Rival an apple, goods, e.g. Private resources, access Common fish farm fish in a fish in the ocean water, air, e.g. Excludable Excludable Non-excludable to a ‘public bad’, imposing external costs on others. Public bads are also non-rival also non-rival bads are on others. Public costs bad’, imposing external to a ‘public to climate change affects that contributes dioxide Carbon and non-excludable. to it. whether they contributed of everyone to some extent, regardless to voluntary in over-contribution to public goods, while resulting contributions action is sometimes needed to deal Collective public bads, such as smoggy air. these public goods and from resulting with the inefficient allocation of resources property rights problems. topic is always mentioned briefly in an early chapter and is then set aside while externalities by the rhetorical device of ‘note and forget’ – the texts note the externalities by the rhetorical device of ‘note and forget’ existence of externalities and then largely forget about them. table ANTI-TEXT 2 THE of Cambridge University was a sharp critic of textbook The late Joan Robinson ‘The distinc- economics. She commented on ‘the notorious problem of pollution’: was presented by tion that Pigou made between private costs and social costs A moment’s thought him as an exception to the benevolent rule of laissez-faire. (1972: 102). shows that the exception is the rule and the rule is the exception’ goods have the non-rival characteristic of a public good, but, unlike the public public the good, but, characteristic of a public the non-rival unlike goods have it. programs pay for The computer who don’t those possible to exclude good, it’s goods means that these Excludability a good example. book are used to write this Some to anyone. available artificially otherwiseare would be freely they scarce; public goods. pure to everyone and are available freely programs are computer public good do not reduce the benefits others can get from it (in the jargon, jargon, it (in the from can get others benefits the reduce do not good public Nor can it, in consumption). not rivals in consuming ‘non-rival’ so it is people are not if they have the benefits, even enjoying from be excluded beneficiaries any situation of non-excludability). them (a paid for , 156 As a consultant to the US Republican Party Party US Republican to the As a consultant * But the national academies and the thousands of scientists But the national academies and + The campaign can claim some success both with politicians and the public. The campaign can claim some a wide variety of results, depending on the Public opinion polls can produce public is still not In Britain, a 2008 poll found ‘the majority of the British exposed and are Industry’s efforts to distort public perceptions have been has centred Economists’ debate about what action to take on climate change ‘There will always be uncertainty in understanding a system as complex a system as complex be uncertainty in understanding ‘There will always engaged in research on these questions are perpetrating a ‘hoax’ and peddling engaged in research on these propagandists who find the more subtle strategy ‘junk science’, according to the tame for their taste. of emphasizing uncertainty too For example, in Australia, a ‘senior figure’ in the former government of John example, in Australia, a ‘senior figure’ in the former government For understanding in cabinet that all the science Howard said that there was ‘an is crap’ (McKnight 2008). in the United States question asked and the context, but as of April 2008 a poll was ‘solid evidence’ found that less than half the population believed that there there One in five did not believe of global warming caused by human activity. at the bottom of was solid evidence of global warming at all. The issue ranked Center 2008). Research the public’s policy priorities (Pew convinced that climate change is caused by humans’ (Jowit the 2008), although is threatening previous year 62 per cent agreed that ‘man-made global warming Global Monitor 2008). the planet’, while 25 per cent disagreed (Angus Reid Exxon-Mobil of Society accused slowly becoming an embarrassment. The Royal in 2005. In 2008, giving nearly $3 million to thirty-nine climate-denial groups that it would in the wake of a shareholder revolt(!), Exxon-Mobil ‘announced to deny climate cease funding nine groups that had fuelled a global campaign change’ (McKnight 2008). long-term benefits. on the comparison of the costs of taking action against the reduction in Largely unnoticed is that the costs in well-being of any ensuing that well-being real consumption are exaggerated by the textbook insistence saw in Chapter 4 the idea depends solely on absolute consumption levels. We of rapid adaption to new circumstances and of the importance of relative con- makes sumption in determining well-being. Canadian economist Pierre Fortin a telling point: wrote in 2002, ‘Should the public come to believe that the scientific issues are the scientific to believe that the public come 2002, ‘Should wrote in Therefore accordingly. will change global warming their views about settled, issue’ certainty a primary to make the lack of scientific you need to continue 41). (Gelbspan 2004: of by eleven national academies climate,’ a joint statement as the world’s understanding of climate change adding that ‘the scientific science explained, nations taking prompt action’ (Jointis now sufficiently clear to justify Science Academies 2005). used successfully for so long by the tobacco industry and its public relations relations public and its industry the tobacco by for so long successfully used Chapter 5. as we saw in advisers,
7 | Externalities Is this because the issue has been ) 155 ( Aside from the crude measure of simply renting politicians, the business- Aside from the crude measure of simply renting politicians, The climate change externality has a combination of characteristics that that The climate change externality has a combination of characteristics A source of increasing concern is the understanding that abrupt changes A source of increasing concern the rapidity with which large ice sheets can Improved understanding of the issue rose Despite this, even by the mid-2000s, almost twenty years after … people around the world are already suffering from past emissions, and cur- and emissions, past from suffering are already world the around … people … The in the future impacts potentially catastrophic will have rent emissions as demonstrated is now overwhelming, potential risks evidence on the scientific Assess- (IPCC) Fourth Climate Change on Panel Intergovernmental in the recent 1–2) (2008: ment Report. as-usual lobby also rents ‘climate change sceptics’ and funds so-called ‘think Their strategy is to tanks’ to give the policy of inaction some intellectual cover. create an impression of controversy over the science, the same strategy that was make it particularly difficult to address. Its effects come with a long time lag, make it particularly difficult to address. Its effects come with making procrastination tempting. It’s also a global problem, requiring co- on others’ action. Individual countries will be tempted to free-ride ordinated actions. Finally, internalizing the externality will require somehow pricing GHG use of fossil fuels. emissions with the aim of greatly reducing the long-term have taken Naturally, corporations with a vested interest in business-as-usual action to protect their shareholders’ interests. adequately dealt with? Hardly. The Kyoto Protocol, negotiated in 1997 under adequately dealt with? Hardly. Change, came the 1992 United Nations Framework Convention on Climate reductions nor into effect in 2005. It has achieved neither global emissions reductions in expected emissions growth (Tickell 2008: 2). in climate have happened in the past and could happen again, particularly if in climate have happened in set up a positive feedback loop in which con-increasing concentrations of GHGs a ‘runaway greenhouse effect’ (Strom 2007: centrations spiral upwards, creating methane, for example, substantial amounts of 68–73). This could happen if, or in the oceans, were to be released. Rapid currently trapped in permafrost difficult to adapt to. Even the climate change climate changes are particularly to result in significant extinctions of species expected by 2050 seems likely (Thomas et al. 2004). a rapid rise in sea melt has led to growing concern about the potential for of ‘business-as- levels. Climatologist David Archer thinks that a continuation fifty metres (Archer usual’ could result in an eventual rise in sea levels of about 2009: 141). and those that to prominence, many textbooks barely mentioned the subject did tucked it away at the back of the book. The potential consequences of climate change are wide ranging and complex. are wide ranging and complex. of climate change The potential consequences we can have learned that We is the habitability of the planet. What is at stake radically. change that, perhaps
. 158 He writes: '& Because income equals consumption plus saving, the tax base is Because income equals consumption plus saving, the tax base / © Andy Singer Conspicuous consumption can be reined in only by collective action. Frank Conspicuous consumption can be reined in only by collective If a progressive consumption tax is to curb the waste that springs from excessive If a progressive consumption tax is to curb the waste that springs levels must be spending on conspicuous consumption, its rates at the highest the consump- sufficiently steep to provide meaningful incentives for people atop unless their spending changes, the spending of those just tion pyramid. For (Ibid.: 216) below them is unlikely to change either, and so on all the way down. Because the tax would collect more from higher-income households and This unhappy result is ruled out by the standard textbook assumption that This unhappy result is ruled The problem with this default model is that (as Frank puts it) it ‘is inconsistent The problem with this default model is that (as Frank puts functions of human with our best theoretical understanding of the origins and indirect empirical motivations; and it is flatly at odds with extensive direct and evidence regarding the nature of utility’ (2005a: 141). consumption spend- (1999: 211–26) has argued that progressive taxes on annual Under such a scheme, ing are the most effective tool to correct this externality. placed in regis- people would be able to deduct from taxable income all savings tered accounts. less from lower-income households than the current US tax system, it would reduce total spending on conspicuous consumption goods. Some spending annual consumption spending. The extra tax paid per dollar of spending would annual consumption spending. The extra tax paid per dollar Frank suggests top rise with an individual’s total annual consumption spending; tax ‘progressive’ in marginal tax rates of 70 per cent or so. This would make the would be higher the sense that total tax paid as a share of a person’s income for higher-income persons. externalities distort the entire pattern of consumption, lowering everyone’s pattern of consumption, lowering everyone’s externalities distort the entire well-being. only on absolute, not relative, consumption. individual well-being depends
7 | Externalities the it) of market - end puts the Stern ‘biggest the towards level of production continues to continues of production level Professor 157 Doesn’t (as mention absolute seen’ passing sense: by making more and more demands on the local on the local and more demands making more sense: by has professor: a your than negative world for more the textbook? deserve failure Question ‘I have Traxtar and you don’t.’ advertisement from a Reebok … it must be recognized that the that recognized must be … it in a matter, but and global environment, demands which have the potential to reduce well-being to reduce have the potential demands which environment, and global income, whereas is linked to relative that well-being run. The view in the long sustainability of environment (and hence the long-term the quality of the growth, has stark implica- deteriorates with absolute income economic systems) (2005: 4) policy. tions for growth For example, suppose that you notice a beautiful pair of $300 Italian shoes in For effect adds up Frank calls these ‘positional externalities’; their cumulative What others in society have sets your ‘frame of reference’, as Robert Frank as Robert What others in society have sets your ‘frame of reference’, a store window. Carried away, you buy them. Everyone who notices your shoes a store window. altered frame of will now judge their own consumption standards by a slightly your purchase reference. If their shoes suddenly look second rate beside yours, extravagance created a negative externality by lowering devalued them. Your their consumption levels relative to yours. kilometres adds in the same way that millions of people driving a few more engaging up in terms of air pollution. This results in people systematically most enhance their in futile ‘expenditure arms races’ on those goods that consumption position (Schor 1992, 1998). The other side of the coin relative goods whose con- is that too few resources are devoted to ‘non-positional’ sumption isn’t easily observed by others. These include things we produce and consume individually (going for a walk, taking more holidays, socializing with friends) or consume collectively (public libraries, roads, parks). Thus positional terms it (1997). That frame of reference is itself a public good: everyone is good: everyone is terms it (1997). That frame of reference is itself a public the effect on one person does not detract from the effect affected by it and affect the frame that it has on others. Each person’s consumption decisions of reference in small, subtle but real ways. Positional externalities in consumption Positional assessment of their own material situation depends notes, people’s As Fortin have. If few people have their own vehicle, for ex- in part on what other people if everyone else has ample, then you won’t feel the lack of one nearly as much as consumption goods: one and you don’t. The same thing holds for other visible and so on. houses, cars, clothing, jewellery, furnishings and appliances, '' 160 population, currently The world’s working-age Major emitters, particularly utilities with coal-fired power plants, adopted power plants, adopted particularly utilities with coal-fired Major emitters, polybrominated diphenyl ethers (PBDEs) are a give just one example, To in everyday PBDEs are found in household dust and, in Canadian tests, in our bodies These are only one group among many industrial chemicals Textbook economics rules out by assumption any externalities from worker Textbook the usual strategy of arguing that the links between emissions and death rates emissions and death of arguing that the links between the usual strategy birth (Pianin 2002). Since the the evidence is now conclusive are unclear, but has the 1960s, significant progress environmental movement in of the modern (and other) air pollutants (notably lead), but at been made in reducing these emerged. the same time, new ones have retardants in such things as furniture, mat- class of chemicals used as flame and were introduced, ironically, in response to tresses, electronics and textiles, to protect consumers. They are structurally flammability regulations intended polychlorinated biphenyls (PCBs) and, like PCBs, similar to the widely banned affect the In rats, PBDEs accumulate in the body. are persistent pollutants that disrupt thyroid hormonal secretions, and fetal regulation of calcium in neurons, after birth (Coburn et al. 2008). exposure leads to hyperactivity American and foods such as dairy products, beef, pork and fish (Picard 2005). than forty times Canadian women’s breast milk contains concentrations more doubling every higher than those in Sweden, and the levels are rising rapidly, among the most few years, according to one estimate (Betts 2001). With babies good. vulnerable, the long-term consequences of this cannot be registered which interact in largely unknown ways. There are 85,000 chemicals have been tested for use in the United States, of which fewer than 2 per cent 2002: 25). Aside from the problem of for carcinogenicity (Davis and Webster timing of exposure dealing with the complexities of different levels, duration and no ‘control group’ to a mix of potentially harmful substances, researchers have virtually everyone is with whom to compare the affected population because exposed (Davis 2007). Workplace health and safety Workplace effects of air pollution, according to the World Health Organization (2008b). (2008b). Organization Health World to the according pollution, of air effects in India than 500,000 in China, more deaths occur of these About 650,000 the Canadian Recently, States (Platt 2007). in the United than 40,000 and more Canadians that 21,000 a report claiming published Association (2008) Medical as a result of air pollution. will die in 2008 about 2,700 million, experiences about 1.9–2.3 million deaths per year related to about 2,700 million, experiences about 1.9–2.3 million deaths Organization. Of occupation, according to estimates of the International Labour 600,000 cancers, these at least 1.6 million are work-related diseases, including 2003: 2). which may take years or decades to develop (Takala illness and death due to hazardous workplaces. With the assumption of perfect information, it follows that workers demand and get higher wages in exchange
7 | Externalities them? externalities mention consumption Do 159 textbook the professor: doesn’t your why for so, If exist? Questions and the in- ‘Unfortunately, the will of our elected officials to curb air pollution they inflict on difference of corporate polluters to the silent cumulative violence our people through air pollution persists.’ Nader (2004b: 168) Ralph Other forms of collective action can also help to address these consumption Other forms of collective action Frank asks ‘If this tax is such a great idea, why don’t we already have one?’ don’t we already have one?’ tax is such a great idea, why Frank asks ‘If this Air pollution dioxide, nitrogen The burning of fossil fuels creates carbon monoxide, sulphur Breathing these invisible pol- oxides, hydrocarbons and fine particulate matter. as ozone) damages lutants and other pollutants that form from them (such and cardiovascular the interior of the lungs and directly influences respiratory Chinese smog in big illnesses and lung cancers (Davis 2002: 70). While the thick (achieved cities gets a lot of attention, even the much lower levels of particulates through public pressure) in the world’s wealthiest countries are still killing substantial numbers of people and causing breathing problems, such as asthma, for many more. About two million people die prematurely every year from the externalities. If spending to keep up with the Joneses leads people to work keep up with the Joneses leads people to work externalities. If spending to in legislated minimum holidays could help. excessively long hours, increases an interest in promoting the cycle of work- Business owners, however, have abolitionist Frederick Douglass famously put it: and-spend. As the American It never did and it never will.’ In concedes nothing without demand. ‘Power social democratic parties have long been strong the European Union, where part of the labour force, people are entitled to a and unions organize a large leave per year, although some countries legislate minimum of four weeks of paid in contrast, where five or six weeks (European Union 1993). In the United States, power, people are unions are weak and the very wealthy have disproportionate the workforce has entitled to no weeks of paid leave, and about a quarter of and Schmitt 2007). no paid holidays of any kind (Ray (ibid.: 225). He attributes this to the widespread, and false, belief that imposing and false, belief that imposing attributes this to the widespread, (ibid.: 225). He optimistic about He’s not on the rich will cripple the economy. higher tax rates political programmes apparently actually being adopted when such a policy sound bites. have to be explained in ten-second on $14,000 Hermès Kelly alligator handbags would be replaced by increased by increased be replaced would handbags alligator Kelly Hermès on $14,000 encourage It would also real necessities. families on by lower-income spending more leisure less to spend working consumption: to engage in untaxed people book. All of a library a walk or reading family, going for friends and time with consumption arms race. have been reduced by the wasteful these activities pro- to of risks cost safety external and an health 162 Do constitute professor: be risks to their work, Even if workers know there may workplace your the for in duction? workers Question At home, despite the efforts of organizations like Ban Asbestos Canada, the At home, despite the efforts of This won’t happen if workers experience what psychologists call ‘cognitive This won’t happen if workers experience what psychologists how narrow interests can dominate public policy and this provides a classic a classic this provides and policy public dominate can interests narrow how international influence in has ‘used its full government The Canadian example. has aggres- and Canada for asbestos, its export market to protect organizations 289). When (ibid.: developing countries’ of asbestos in the use sively promoted asbestos products, the Canadian the importation of asbestos and France banned Organization (without success). Trade it in the World government challenged asbestos and asbestos products, Union, which has banned When the European Convention (which UN’s Rotterdam asbestos added to the tried to have chrysotile to listed under the Convention importing toxic substances requires countries consent), the Canadian government successfully give their prior and informed blocked it (Greenberg 2008). ‘essentially alone among industrialized countries Canadian government remains act upon’ the increasing incidence of asbestos- in failing to acknowledge and Brophy lobby group, the Chrysotile Institute ( related cancers. It funds an industry use’ of chrysotile asbestos while ignor- et al. 2007: 237). It advocates ‘controlled asbestos is exported to developing countries ing the fact that almost all Canadian Canada currently exports about 250,000 with weak to non-existent regulations. (Greenberg 2008). With about three cancer metric tons of asbestos annually 2004), these deaths associated with every 170 tons of asbestos (Tossavainen exports should eventually result in about 4,400 deaths a year. Choosing false beliefs will they evaluate them properly? The textbook model assumes that they will will they evaluate them properly? The textbook model assumes result. and that appropriate compensation for the extra risk will can choose their beliefs about the world, using information dissonance’. People and Dickens selectively to reinforce a belief they would prefer to have (Akerlof themselves as smart 1982). In this case, workers have to reconcile their view of choose. As a result, people who make the right choices with the actual job they situation, there is they can believe their work is safer than it actually is. In this workers for no reason to think that wages will, in reality, adequately compensate decision-making the risks they face, and thus internalize these costs in the firms’ workers have dif- (Purse 2003). Another idea, leading to the same result, is that who underestimate fering and incomplete information about job risks. Those the risks take the most dangerous jobs.
7 | Externalities , from There are many examples 161 The Condition of the Working Class in England the Working The Condition of These so-called ‘compensating differentials’ in in differentials’ ‘compensating so-called These '( ') their families, users of asbestos products, and the public as it is exposed to their families, users of asbestos products, and the public as it is In develop- building materials and asbestos in heating and ventilating systems. scant to non- ing countries, where protection of workers and communities is than it has existent, the asbestos cancer epidemic may be even more devastating been in the developed countries. (LaDou 2004: 285) cancer a year, There are currently about 100,000 cases of asbestos-related the information While the industry knew of the dangers, it successfully kept due to declining With the bankruptcy of multinational asbestos companies, In real workplaces, the reality is imperfect information; workers don’t know workers don’t know the reality is imperfect information; In real workplaces, At risk are not just asbestos workers, but according to the World Health Organization. According to one estimate, asbestos according to the World to it cease in will have caused between 5 and 10 million deaths, if exposures increasing in some the near future, which seems unlikely because its use is developing countries (Brophy et al. 2007: 237). manipu- from workers and the public for decades. The industry also successfully Organization and lated not only governments but also the International Labour Health Organization, both of which are now, however, finally calling the World for a worldwide asbestos ban (LaDou 2004; Greenberg 2008). opponent of demand and illness-related lawsuits, the single ‘most powerful the world’ is the national and international efforts to ban asbestos around Canadian government. Canada has long been one of the world’s most impor- tant producers and exporters of asbestos, although with about 1,500 workers, the industry is small (LaDou 2004: 289). Chapter 5 sketched out the logic of the hazards they face. Employers, however, often know just what they’re doing. know just what they’re doing. face. Employers, however, often the hazards they writing in 1845 on Friedrich Engels, termed such behaviour ‘social murder’. He wrote that society ‘placed the workers that society ‘placed the workers ‘social murder’. He wrote termed such behaviour they can neither retain health nor live long … under such conditions in which before their time’ (Engels 1987 [1845]: 128). and so hurries them to the grave Ignorance of risk and the asbestos holocaust Ignorance of risk and the asbestos for exposure to added risk. to added exposure for wages raise firms’ costs so that on average firms pay for the costs they inflict for the costs firms pay so that on average firms’ costs wages raise externality. ruling out any costs and thus these workers, internalizing on their to accept other countries find workers in firms may too costly, If this proves cheaply. the risks more the lead, chemical and plastics industries, but probably the largest single cause the lead, chemical and plastics is exposure to asbestos. The fatal dangers of of this type of ‘social murder’ Once asbestos fibres were observed in the late nineteenth century. breathing there permanently, causing asbestosis (a fibrous lodged in the lung, they remain cancer and lung cancer, including mesothe- thickening within the lung), larynx after initial exposure (Michaels 2008: 13). lioma. The cancers emerge decades 100 1 1 1 164 1 1 eden A hites 1 otland Canada Australia 7.2 7.2 rates 100,000 males, age-standardized per incidence Cancer 1 figure 0 12 Excluding lung cancer, male cancer rates are still rising. These increases are Excluding lung cancer, male cancer rates are still rising. These can account for Such things as increased screening and better diagnosis sector have Unfortunately, substantial and influential parts of the private 00 50 00 50 00 50 00 50 1 1 true, none of the 500 million smokers alive today who will die of smoking- true, none of the 500 million smokers alive today who will feel any regret related cancers and other disease (Dauvergne 2005: 11) should at having smoked. use cancer statis- not due to the increasing average age of the population. We allowing tics where the rates are adjusted to those of a fixed age distribution, comparability across time and across countries. and especially some of the increase, particularly for breast cancer in women cancer increases, for prostate cancer in men. This can’t fully account for breast such as non- however, nor does it explain the increasing incidence of cancers to be at work: work- Hodgkin’s lymphoma. Other underlying risk factors appear culprits, diet place and occupational exposures as well as the more familiar to suspected and exercise. ‘Precautionary policies would urge that exposures behaviors should be environmental hazards be minimized and that healthful of the public promoted throughout the population with the active involvement and private sectors’ (Dinse et al. 1999). and in covering up interests in promoting unhealthy products and lifestyles itself, attention workplace and environmental hazards. In the ‘cancer industry’ is naturally directed to the areas where private profit is the greatest (detection and treatment, particularly with expensive drugs) rather than towards preven- tion (Epstein 1998).
7 | Externalities 163 of develop- chance one-in-two a have about men American : Authors’ calculations from International Agency for Research on Cancer : Authors’ calculations from International Agency for Research 7.2 cancer incidence rates changes in age-standardized Percentage : Data for ‘all cancers’ exclude ‘other skin’ cancers. Cancer rates for both men and women have been rising steadily for decades Cancer rates for both men and women have been rising steadily Men 27.6 49.8 15.5 34.0 11.0 Women 48.9 26.1 38.4 12.2 17.8 Men 22.5 9.7 23.2 31.2 5.5 Women 37.1 55.4 22.1 42.2 28.0 Men -16.7 -32.2 39.3 -24.1 Women 96.6 -26.7 79.5 291.9 90.8 66.2 Men 250.0 Women 290.9 90.9 116.7 30.7 119.0 27.3 112.5 7.7 70.0 Men 208.8 142.2 176.1 109.7 121.4 20.3 31.9 74.6 29.5 56.2 Women Men Women 78.2 35.1 91.8 91.1 126.7 61.4 44.0 74.6 142.5 79.3 All cancers except lung Lung Liver All cancers Australia Canada Scotland Sweden US, Whites US, Sweden Scotland Canada Australia (1975–2002) (1958–2002) (1972–2002) (1973–2002) (1978–2002) throughout the industrialized countries, as can be seen in the sample shown throughout the industrialized countries, as can be seen in 7.2 and show in- in Figures 7.2 and 7.3. Some data are summarized in Table in smoking and creasing rates for the incidence of cancer in general. A decline countries hence reduced lung cancer rates among men in most industrialized is raising their is one of the few bright spots. More smoking among women Incidentally, as we noted in Chapter 1, in the lung cancer rates significantly. rational-choice approach of orthodox economics, smoking is a ‘rational addic- apparently carried out in full knowledge of the risks. If that were tion’, an act ing a cancer during their lifetime, and women a one-in-three chance (Nasca one-in-three chance women a lifetime, and during their ing a cancer such as Canada, countries in other industrialized 4). Rates 2008: and Pastides broadly similar. and Australia are Britain The cancer epidemic cancer The table Source Note (2005). Breast Non-Hodgkins lymphoma Prostate per- them chapter really a integrate are to them textbook the leaving externalities years, no Given the experience of recent 166 If than doesn’t why rather professor: book, your end? the important, for the and towards throughout vasive Question bad morals; we know now have always known that heedless self-interest was ‘We that it is bad economics.’ second inaugural address, Franklin Delano Roosevelt, 1937 When a bank makes a loan to a business, it faces some risk of the firm not faces some risk of the firm not a loan to a business, it When a bank makes institutions can require individual financial Public regulation of financial the regulated. In The result is an ongoing tension between the regulators and 2.2 motive Externalities and the profit 316). And what do the fishermen want? They make two demands, according to according demands, two make want? They the fishermen do And what 316). livelihoods, their own allowed to destroy ‘they must be Monbiot (2008): George pay for it’. rest of us should and the the financial industry Externalities in one reading this will need convincing that poorly regulated financial markets poorly regulated financial markets will need convincing that one reading this malfunction involves an external- An important element in their don’t work well. should address. regulation and institutions ity which public not only makes the lending bank riskier, it makes meeting its obligations. This in the payments system a little riskier too. other banks with which it is linked bank makes the loan, and Scott 2003). When the This is an externality (Kaufman risk it is assuming, not of the additional risk it it thinks only of the additional has consequences for the stability of the entire imposes on other banks. This (such as a fall in housing prices or a recession) financial system if an event loans faced by all banks. increases the number of defaulting necessary to manage risk, to maintain institutions ‘to expend the resources risk insurance’ to internalize these external costs, adequate capital, and pay for explain in a study of the Asian financial crisis as John Eatwell and Lance Taylor externalities is of 1997. They note that while effective management of these to resent the costs good for society as a whole, the financial institutions ‘tend are unnecessary’ involved, and argue that, in their case at least, these costs (1998: 22–3). and consumer the United States, the last several decades have seen in ‘housing information, and finance … the consequences of market power, of asymmetric both a public system of regulatory capture, leading to rampant predation against recently put and the public itself, and on a colossal scale’, as James K. Galbraith pursue these themes further in the postscript to this book. it (2008: 140). We
7 | Externalities 122 13 12 13 165 12 unregulated fishery is a classic example of An 13 12 SA ites anada S eden Australia Scotland 7.3 7.3 rates age-standardized 100,000 females, per incidence Cancer 13 figure 12 Governments and international organizations have presided over this grow- Governments and international organizations have presided Advances in fishing technology, however, have proved these optimistic assess- Advances in fishing technology, however, have proved these 1 3 2 2 1 The collapse of the world’s fisheries ing problem. As one observer comments, ‘The world over, bureaucrats and ing problem. As one observer comments, ‘The world over, bureaucrats and politicians alike assume that commercial fishermen are the constituency they have to satisfy, and not the true owners of the sea, the citizens’ (Clover 2006: ments completely wrong. The destruction of the Newfoundland cod fishery (closed,ments completely wrong. The destruction of the Newfoundland Canadian group of perhaps for ever, in 1992) was not an isolated event. As one defined here as biologists explains, ‘[g]lobally, the rate of fisheries collapses, accelerating been catches dropping below 10% of the recorded maximum, has collapsed in 2003’. over time, with 29% of currently fished species considered to be accelerating They observe an ‘on-going erosion of diversity that appears is the result not on a global scale’. This loss of genetic and species biodiversity change. ‘This only of fishing, but of pollution, habitat destruction and climate collapse of all taxa trend is of serious concern because it projects the global if business-as-usual [taxonomic units] currently fished by the mid-21st century’ security, coastal continues. In turn, this implies ‘serious threats to global food future generations’ water quality, and ecosystem stability, affecting current and 790). et al. 2006: 788, (Worm an open-access problem. Each fisherman has an incentive to maximize his catch; an open-access problem. Each fisherman has an incentive to like a recipe for any fish left behind might be caught by someone else. This sounds declared the world’s disaster, but even in the late nineteenth century, biologists 1954: 126). fisheries ‘inexhaustible’ and regulation a waste of time (Gordon
The , and David Can We Afford the Future? The Can We 168 Luxury Fever: Why money fails to satisfy in an era Luxury Fever: , is an excellent introduction to the issues. Social Murder and Other Shortcomings of Conservative Economics Institutions and the Environment. , directed by Rupert Murray. See endoftheline.com. , directed by Rupert Murray. Doubt is Their Product: How industry’s assault on science threatens industry’s assault on science threatens Doubt is Their Product: How Deceit and Denial: The deadly politics of industrial pollution Deceit and Denial: The deadly politics (2008). , is a thought-provoking exploration of the effects of consumption ex- , is a thought-provoking exploration The End of the Line: How overfishing is changing the world and what we eat The End of the Line: How overfishing is changing the world The disaster facing the world’s fisheries is set out by reporter Charles Clover The disaster facing the world’s fisheries is set out by reporter and Ian Chernomas Engels’s theme of ‘social murder’ is taken up by Robert For more advanced undergraduate students, Arild Vatn provides an introduc- provides more advanced undergraduate students, Arild Vatn For In fact, this does not contradict what is in the texts themselves, if they are if they texts themselves, in the what is contradict does not this In fact, Frank’s 1999 book, Robert is an issue of first-rate importance, and The economics of climate change Two first-rate accounts of the ruthless behaviour of industrial polluters and Two first-rate accounts of the (2006). It has subsequently been the inspiration for a documentary film, (2006). It has subsequently been the inspiration for a documentary in End of the Line Hudson in their (2007), a critique of corporate power and its absence from mainstream economic (2007), a critique of corporate power and its absence from mainstream theory. economic policy in tion to institutional economics as applied to environmental his 2005 book, read carefully and completely by those willing to draw their own conclusions. their own willing to draw by those and completely read carefully of the book), at the back background (and in the texts put externalities But the A concept that efficiently. that work the story of markets instead foregrounding as a theme is instead treated throughout the book as a repeated could be woven They fail government policy. that could be fixed by appropriate secondary matter of negative externalities information about the actual importance to provide real respond to them. of how governments actually and an analysis Michaels’s your health Frank Ackerman’s brief and accessible 2009 book, economics of a warming world of excess tax to address the problem. ternalities. He advocates a consumption are Gerald Markowitz and David Rosner’s the makers of dangerous products 2002 study, Suggestions for further reading
7 | Externalities 167 If we take the ubiquity of important externalities seriously, and if we recog- If we take the ubiquity of important democratization Many critics, including Zinn, would argue that only a deep allocates scarce The ideal of a perfectly competitive market economy that standard The modern market economy has indeed produced a high material Many critics of the current economic system deplore the profit motive, seeing profit motive, the deplore system economic current of the critics Many for the human race that the profit motive was ruinous [Marx’s] perception for profit see that the drive of corporations a great insight. We remains, I think, the world … the pursuit of of human beings all over is done at the expense to pollute the air and water, has led arms money has led chemical companies weapons of destruction without regard to manufacturers to create monstrous whom they will be used. (2002: 97–8) how they will be used or against nize the realities of power and information that hinder effective responses to nize the realities of power and motive can work in practice. The texts put the them, we can see how the profit while assuming away the problems of externality problem in the background, power and citizen disorganization that so asymmetric information, corporate power to the kind of narrow interests that often tend to give disproportionate Zinn identifies. inhibit effective col- of society can overcome the concentrations of power that economic system lective action to deal with the external costs that the existing active citizen generates. In the near term, that could take the form of sufficiently term, that democra- engagement in civic affairs (Nader 2004a: 1). In the long which operates tization would have to include the capitalist corporation itself, economy, producingnon-democratically as a matter of principle. In a democratic the profit motive, organizations would ultimately have to cover their costs, but costs imposed on in the sense of maximizing profit regardless of the external others, would be discarded. no externalities. But resources efficiently is also one that presumes that there are efficient (although, the conclusion that such a fictitious ‘free market’ economy is of laissez-faire. admittedly, not equitable) is no justification for a presumption just how different At best, it’s an intellectual toy that could be used to stress the actual economy is from this imaginary world. not the same thing of living for many people in the developed world. But this is as ‘efficiency’. As we’ve tried to show, it’s perfectly compatible with very serious problems of pollution (of which we have given only a few examples), misuse of resources, and even with long-term catastrophe. it as destructive. From the viewpoint of the textbooks, where the profit motive where the of the textbooks, the viewpoint From it as destructive. abundance, material uses and produces most valued to their guides resources comment by Consider this illiterates. are economic that these critics it appears Howard Zinn: the American historian 2.3 economy Summing up: externalities and the market natural resources’, whereas other authors subsume it under ‘land’. Krugman and Wells (2005: 282) include ‘human capital’ as a separate factor of production, 8 | The marginal productivity theory of income whereas other authors subsume it under ‘capital’. (Human capital is the result of distribution – or you’re worth what you can get past investments in education and skill acquisition.) Finally, not all texts include ‘entrepreneurship’ as a factor of production. In a survey of the eight leading text- books, however, Naples and Aslanbeigui (1996) found that all but two do include it. What do these factors of production earn? The usual nomenclature has land ‘Are we so committed to the framework of marginal produc tivity earning rent; labour earning wages; capital earning interest; and entrepreneur- and its implicit claim … that the distribution of income is ship earning normal profit. In addition, in the short run a residual (economic legit imated by market forces? Are we prepared to rule the issues profit) is earned by the firm’s owners, who might be the entrepreneur or the of power, monopoly and financial control off the table when we stockholders. discuss the way incomes are apportioned …?’ James K. Galbraith (1998: 37) 1.2 Demand for factors of production ‘In theory there is no difference between theory and practice. In The demand for any factor of production depends on its productivity, and the practice there is.’ Yogi Berra revenue generated from selling additional output. Applying the usual marginal reasoning, the profit-maximizing firm will hire an additional unit of a factor as long as it adds more to revenues than to costs. We’ve emphasized in previous chapters how standard textbooks downplay one On the revenue side, an additional unit of a factor produces its marginal prod- of the main economic goals – equity – in favour of the other – efficiency. This uct, MP. Further, each extra unit of output generates some marginal revenue, MR. emphasis shows up again in the placement of chapters explaining the distribu- (For a perfectly competitive firm, marginal revenue is simply the market output tion of income. They are invariably towards the end of the book, and, because of price, P.) Hence, the additional revenue from hiring one more unit of a factor is the time constraints, the typical introductory economics course may not cover them. product of the two, MR x MP, referred to as the marginal revenue product, MRP. The implicit message is that the distribution of income isn’t that important. Additional revenue from one more unit of a factor is MRP = MR x MP The textbooks teach the neoclassical model, where the distribution of in- come is determined primarily by technology, tastes and factor supplies. Mere If the firm is a price-taker in the factor market, then the cost of one more unit lip-service is given to conventions or norms, government decisions over pub- of the factor is simply the factor price, PF. We’ll assume that this price includes all lic spending, bargaining power, notions of fairness, discrimination, the legal fringe benefits: payroll taxes, paid vacation, paid sick leave and pension contribu- framework, or arbitrary historical accidents. tions. In its pure form, the neoclassical model assumes perfect competition (includ- Additional cost of one more unit of a factor is its market price, PF ing perfect information) and predicts that all factors earn an amount equal to the value of what they contribute to output. Though proponents of this view are Therefore, the firm should hire each factor up to the point where its price prepared to admit that almost no markets are perfectly competitive, and there equals its marginal revenue product, PF = MRP. In other words, the marginal rev- is almost never perfect information, they hypothesize that competitive forces enue product (MRP) is the firm’s factor demand schedule. This is downward sloping are prevalent enough, and information good enough, to justify using the theory for two reasons: the law of diminishing returns (explained in Chapter 5) guarantees as an approximation. that MP eventually falls as more units of the factor are employed; and second, downward-sloping demand curves guarantee that MR falls as more output is sold. Applying the decision rule P = MRP in the short run (when the only variable 1 THE STANDARD TEXT F factor of production is labour), the firm maximizes its profits by hiring labour up 1.1 Introduction to the point where the wage, W, equals the marginal revenue product of labour,
What are the factors of production? The texts differ on the appropriate classi- MR x MPL. fication. The factors of production most often mentioned are: land, labour, capital The firm’s decision about how much labour to hire also determines how much and entrepreneurship. Baumol and Blinder (2006: 394) also include ‘exhaustible output it produces. In Chapter 5, however, we saw that to maximize profit, the
169 170 . So, dif- So, MRP ' in all jobs. Otherwise people ( of them situate their explanation in the in the their explanation of them situate include non- benefits’ Because ‘net 172 no intrinsic (or innate) differences were If there net benefit implies that The principle of equal non-competing require wage differentials Large present value of net benefits be the same should of value present On its own, human capital can’t explain big wage differentials. If it takes If it takes big wage differentials. explain On its own, human capital can’t Why do top professional athletes earn more than surgeons? Why do surgeons do surgeons Why than surgeons? athletes earn more do top professional Why wage differentials must be enough to compensate individuals for their invest- individuals for must be enough to compensate wage differentials necessary than waiters must earn more skills.ments in acquiring Accountants human acquired They have of training required. years because of the many return. capital, market which earns a then rather than a waiter, an accountant $100,000 to become and years four career) a twenty-five-year amortized over rate of 8 per cent (assuming an interest than being a waiter. more pay around $9,000 a year should accountancy monetary benefits, dirty, dangerous or dull jobs would receive higher pay than higher pay than dangerous or dull jobs would receive monetary benefits, dirty, earn workers construction why explain jobs. This could and interesting clean, safe dirtier hazardous and more involves construction since than sales clerks, more employment, than clerical work. irregular and more conditions, earn more than fast-food workers? While each textbook has its own unique has its own unique textbook While each workers? than fast-food earn more all explanatorycategorization of factors, types of labour operating on the demand and supply of different of forces context begin with the principle of We’ll labour markets. – in other words, in competitive explanations. usual textbook through the benefit and proceed net equal Differences in inherent abilities in inherent Differences worker is normally depicted as upward sloping, reflecting the assumption that a that a the assumption reflecting normally is sloping, upward as depicted worker sup- The overall of work time. supply a greater to induce is required higher wage a particular wage. demand for ply and The skill the market determines (welding) to its the wage equating by to hire workers many decides how firm then 1.4 labour markets in competitive differentials Wage equal net benefit The principle of differences compensating The principle of abilities in acquired Differences groups. Textbooks focus on differences in inherited or natural ability. For For in inherited or natural ability. on differences focus groups. Textbooks a concert to become the ability (or aptitude) of us have how many example, and since is ‘very the answer few’, violinist, or a top athlete? Since a surgeon millions willing of people are to pay billions of dollars on sports entertainment, products. revenue very high marginal athletes have top professional ferences in acquired abilities must be supplemented with differences in inherent in inherent abilities must be supplemented with differences in acquired ferences entryabilities or barriers to occupational unions) to come caused by (perhaps wage differentials. real-world close to explaining between workers, and no barriers to entering an occupation, then in equilibrium then in equilibrium and no barriers to entering an occupation, between workers, the one. higher-benefit job to a a lower-benefit from would move
8 | Marginal productivity theory P elders . A . A L Number of 3 e firm firm e u ires to t oint e en P , to get: MR = W/MP , to get: L i ourly age of elders 171 units of output (say eight units). There- units of output L D = ∑MRP apital cheaper. This generates two effects: This generates two effects: apital cheaper. S curves of all the firms across all the industries ousands of , for factors of production X and Y. This is known This is known of production X and Y. factors , for Y elders /P Y MRP (or $2 per unit). L = W. Divide both sides by MP both sides by Divide = W. = MP L X 8.1 determination of the wage of welders Competitive e mare for et elders . Rearranging this expression gives the optimal combination of of combination the optimal gives this expression . Rearranging X 4 figure To obtain the market demand for a particular type of worker, say welders, we we say welders, a particular demand for obtainworker, type of the market To The least cost rule means that a change in one factor’s price will have ripple ripple will price have one factor’s rule means that a change in The least cost It is easily shown that the two rules are equivalent. The new rule says hire two shown that the It is easily equivalent. hire new rule says The are rules In the long run, when all factors of production are variable, they are all hired all variable, they are hired of production are In the long run, when all factors 2 = MR x MP X ourly age fore, the cost of producing one of those extra units of output, which is marginal units of output, of those extra of producing one which is marginal the cost fore, MP cost, divided by is W that employ welders, as shown in Figure 8.1. The supply of a particular type of 8.1. The supply of a particular type of in Figure as shown welders, that employ must horizontally sum the first, firms respond by using more capital and less labour – a substitution effect; capital more using less labour – a substitution effect; and first, by firms respond supply curves shift right, competitive leading to fallen, have costs since second, on the position of the labour The net effect output – an output effect. increased dominates. effect depends on which demand function effects on the demand for all other factors of production. For example, a decrease a decrease example, of production. For all for on the demand other factors effects c makes rate, r, interest in the real as the ‘least cost rule’: the firm will hire every factor up to the point where the the where up to the point the firm will every hire factor rule’: as the ‘least cost worth is equal. productivity of a dollar’s of every factor 1.3 Determination of labour wages in a perfectly competitive market labour until MR x MP labour until firm produces up the point where marginal revenue equals marginal cost. Is the cost. Is the marginal equals revenue marginal where up the point produces firm one? with the earlier rule consistent new decision moment’s reflection confirms that the wage divided by the marginal product of of product the marginal wage divided by that the confirms reflection moment’s unit one more the firm W (say $16) to hire cost. It costs labour is the marginal MP produces but the labour of labour, factors: MR = MPx/P factors: up to the point where their marginal revenue product equals their factor price, price, their factor product equals revenue their marginal up to the point where P of elders an alternative job. If all firms pay If all pay firms job. an alternative
174 * 847) point out: ‘On the day that a (1981: and Rosen Lazear than pay more to may choose firms unions, without Even at least mention discrimination; All textbooks the mainstream Unprejudiced firms (which employ more black workers) now experience an an now experience black workers) more employ firms (which Unprejudiced that believe out that if we (2008: 120) points Prasch But what if they don’t? The theory of efficiency wages is a theory of market failure, which arises which arises The theory wages is a theory of efficiency failure, of market economic windfall – their workers are now cheaper – allowing them to expand now cheaper – allowing are expand them to – their workers windfall economic In the long run, the of discriminating firms. at the expense share their market for and the wage discount firms increases, of non-discriminating share market wages converge. Eventually, decreases. black workers but a dual strong enough (perhaps as a matter of faith), are forces competitive Efficiency wages Efficiency theory Tournament Discrimination the equilibrium wage as an incentive for better performance, especially when especially performance, better when for as an incentive wage the equilibrium shirk; being to likely less work effortmonitoring workers is difficult. This makes wage in a lower now implies fired caught and wages that are above the market equilibrium, the result will be a pool of workers will the result of workers be a pool equilibrium, the market above wages that are being caught for find them. The penalty jobs but can’t who want higher-paying a longer period unemployed. shirking is now effort. about worker who retain Those their jobs of information because of a lack wage the higher-than-equilibrium product since revenue still earn their marginal itself as unemployment. manifests effort. failure elicits greater But the market but there is no consensus on how it is treated. The central story is this: over story The central on how it is treated. is this: over is no consensus but there will automatically economy eliminate discrimination market time a competitive the forces in productivity), provided not based on differences (wage differences work legislation. equal pay for equal by not short-circuited are of competition identical skills and work have this, suppose black and white workers see To enough only if the wage is low ethic, but some firms will black workers employ not enough non-discriminating are of them. If there their dislike to overcome wage at discriminating firms. a lower must accept firms, some black workers must earn an identical wage, identical workers competition under perfect Since – one than white workers be paid the same wage – a lower must all black workers willand a dual wage structure emerge. given individual is promoted from vice-president to president, his salary vice-president may individual is promoted from given in that one-day period, tripled skills that his have triple. It is difficult to argue ‘It is not a puzzle, They go on to say: standard for difficulties theory.’ presenting theory sees Tournament of a prize.’ context in the when interpreted however, for receive and tennis players golfers professional the prizes CEO pay as like of everyone the productivity who increase winning tournaments. Those prizes but CEO pay is still based on high productivity, them. In this view, for competes the top for striving now it is the productivity of the whole team of executives job – not just the CEO alone.
8 | Marginal productivity theory the the S D nem loyment Industrial union Industrial
) S D 173 e number of or ers S of labour, the availability restricting by Unions, raft unions 8.2 markets of unions in otherwise types competitive Two ourly age of market power in the labour market’ (our emphasis), a claim about (our emphasis), a claim about in the labour market’ power of market figure In the right-hand diagram of Figure 8.2, the ‘industrial’ (or economy-wide) 8.2, the ‘industrial’ (or economy-wide) of Figure diagram In the right-hand Mankiw example, (for often cited as a cause of unemployment are Unions of other at the expense The bottom line is that unions benefit some workers Union-caused wage differentials Union-caused union tries to organize all available workers to force wages above equilibrium. As As equilibrium. wages above to force all workers available union tries to organize employment. of wages at the expense with the craft union, this increases try unions could reductions, try to employment to offset To et al. 2006: 432). pro- through efforts to increase example for union workers, demand for increase workers unionized to buy goods made by consumers encouraging ductivity or by the would benefit at workers Union 2008: 341). Ragan and Lipsey example, (for other the products made by of others as demand switches away from expense Another strategy is to supportworkers. minimum wage, since in the increases costly. more non-union workers this makes progres- and any organizations self-serving purely unions are In this view, workers. seen as attempts to attain they may champion are other goals social initiatives sive in mainstream unions get a ‘bad press’ Clearly, and Bade 2006: 414–15). (Parkin assert that ‘labour unions are and Bade (ibid.: 413) Parkin textbooks. economics main source power. pervasive market that firms have that also seems to deny the facts force up wages. In the left-hand diagram of Figure 8.2, ‘craft unions’ seek to seek to unions’ 8.2, ‘craft of Figure diagram the left-hand up wages. In force high long apprenticeships, enforcing by workers qualified supply of restrict admitted. Examples are and limits on the number of new members initiation fees Many plumbers and cosmeticians. of barbers, physicians, licensing occupational laws example, for the same effect: as having seen are social initiatives progressive length of the working a fixed or compulsory retirement prohibiting child labour, practitioners are incompetent from The benefits of protecting consumers week. prac- such incompetent because with good enough information downplayed titioners would simply go out of business.
increase 8.3 in Monopsony 8.4 with Monopsony minimum wage the labour market figure figure P Labour su ly arginal labour arginal or ers P cost Quantity of Labour su ly or ers arginal labour 176 Quantity of cost Suppose that the minimum wage is higher B A ired 4 or ers 4 the offset that a union could also explain texts A few 12 ourly age ourly age 1 arginal re enue inimum age roduct ono sony age market power of the monopsonist. Figure 8.3 shows that the monopsonist could 8.3 shows that the monopsonist could of the monopsonist. power Figure market Monopsony and unions Monopsony A, where the profit-maximizing number of workers is four. The wage at which The wage at which is four. number of workers A, the profit-maximizing where to schedule at point B. According the labour supply they will by given work is 8.3, they will though their marginal be willing an hour even $9 work for to Figure product is $12 an hour. revenue and the minimum wage Monopsony than the wage the monopsonist was paying. Since the minimum wage is a legally is a legally the minimum wage Since than the wage the monopsonist was paying. of labour is just the minimum wage, at cost binding constraint, the marginal the labour supply curve shows that a higher wage is least up to the point where simple case 8.4 shows the Figure supply of labour. a greater needed to induce be in a competi- to what the wage would the minimum wage is set equal where to is The effect suppose is $10 an hour. which we labour market, tive model, a binding minimum wage to the competitive employment. In contrast social benefit. a net and produces power market the monopsonist’s offsets
8 | Marginal productivity theory 175 tend to eliminate discrimination and fail to to and fail tend to eliminate discrimination + 8.1 a monopsonist of labour for cost Marginal Monopsony means ‘single buyer’. The usual context is a single employer of a of a is a single employer means ‘single buyer’.Monopsony The usual context an upward-sloping labour supply faces employer the monopsonistic Since 8.1 define an upward-sloping the first two in Table example, columns For profits, the monopsonist maximize 8.3 illustrates the problem. To Figure The better textbooks point out that competition doesn’t automatically automatically doesn’t point out that competition The better textbooks Number of workers of workers Number Hourly wage labour cost Total labour cost Marginal particular type of labour, which is relatively immobile – either geographically or – either geographically immobile or which is relatively particular type of labour, that this situation is rare. in terms of skill. universally emphasize The texts hired. all the wage for workers it must increase worker an extra curve, to hire is not just the wage paid of an additional worker cost As a result, the marginal it previously of all but also the additional cost the other workers to that worker, wage. at a lower employed workers. labour supply curve – a higher hourly wage inducing the supply of more shows totalThe third column labour cost, product of the first two and is the labour cost, and is the change in total shows marginal The last column columns. (3). Note that (except of column one row to the next from move as we labour cost the wage. exceeds labour cost marginal the first worker) for product at point revenue its marginal equals cost labour until its marginal hires 1.5 labour Monopsonistic markets table mention that such a conclusion hinges on the existence of competitive markets markets of competitive hinges on the existence mention that such a conclusion consumers. and unprejudiced eradicate discrimination when customers are themselves prejudiced and willing and willing prejudiced themselves when customers are eradicate discrimination The worst ones simply emphasize white workers. to be served by to pay more automatically forces that market wage structure persists, then logic dictates that the low wage group is not in fact logic dictates then persists, in fact is not group low wage that the structure wage skills education, they lack work habits. Another or good capable. Perhaps equally pay for equal by being frustrated are pressures is that competitive possibility paying from employers non-discriminating This prevents work legislation. equal profits and expanding more reaping them from prevents wages, and so lower white workers firms will to employ continue Prejudiced share. their market forces. market punished by possible without being whenever 1 2 3 $6 $7 $8 $6 $14 $24 $6 $8 $10 (1) (2) (3) (4) 4 5 $9 $10 $36 $50 $12 $14 P Su ca ly of ital Quantity of ca ital bour come otal come in la otal a ital in c ) times the quantity of of ) times the quantity r Determination of tof Determination rate interest real e r 178 L P 8.5 problem The adding-up figure Quantity of labour Su labour ly of bour come otal come otal a ital in la in c Determination of tof Determination e age Now we face an obvious question. How do we know that the two diagrams are that the two know How do we diagrams are question. an obvious face Now we Consist- in this way. the diagrams ‘add up’ that cannot be sure In general, we P 2 THE ANTI-TEXT 2 THE argue here that the marginal productivity story suffers from logical dif- We’ll certain restrictive ficulties – the adding-up problem can be solved only in between the sup- circumstances. As well, there may be no unique relationship competitive labour ply of capital and real interest rates. Second, the perfectly but ignored by market contains some absurd predictions that are clearly false, the textbooks. Third, marginal productivity theory is so amorphous that it’s But fourth, indirect tests refute the prediction of a single hard to test directly. fit the facts, subsidiary theories To market wage for workers of a given quality. its supply is given. The demand for capital is the value of its marginal product. product. capital The demand for is the value of its marginal its supply is given. ( The total to the return earnings of capital equal are capital, shown as a white rectangle, while this time total is the labour income shaded triangle. residual prod- If both labour and capital paid the values of their marginal consistent? are total know that know that this just exhausts output? How do we ucts, how do we diagram, is the same total shown as the rectangle in the left-hand labour income, diagram? triangle in the right-hand as total shown as the residual labour income, on production – constant restriction a specific technological ency requires equilib- firms in long-run competitive that however, know, We to scale. returns curves – where cost average rium operate at the minimum point of their long-run competitive by is characterized If the economy to scale occur. constant returns hire then the two consistent. Firms diagrams are equilibrium, firms in long-run their equals reward both labour and capital their real up to the point where to output. contribution marginal
8 | Marginal productivity theory K L 177 The real wage, W/P = MP wage, W/P The real The real interest rate, r = MP rate, interest The real situation leads to a wage somewhere between $12 and $9 between $9 $12 and somewhere leads to a wage situation . Dividing through by the aggregate price level, P, allows us to write allows us to write P, level, price the aggregate through by . Dividing L , determined by the demand and supply of capital. ‘Capital’ refers to the to the the demand and supply of capital., determined by ‘Capital’ refers r bilateral monopoly bilateral curve and to the left of labour supply equals total curve output. and to the left of labour supply equals Subtracting labour L This discussion suggests that the earnings of capital are a residual – what is – what is that the earnings of capital a residual This discussion suggests are Similarly, the real return on capital – which is the real rate of interest, r – is on capital rate of interest, return r – is real – which is the the real Similarly, Total supply and demand. determined by are to each factor returns The real The distribution of national income between wages on the one hand and between on the one hand and wages of national income The distribution all – in output and throughout the economy competition Assuming perfect structures and stock of equipment used for production. At any moment of time moment of time any production. At used for and stock of equipment structures left over from total output after we subtract labour income. This, however, is just is just This, however, total subtract labour income. output after we from left over chose to plot labour on the horizontal arbitrarily axis and to think in because we chosen to plot just as easily have could product. marginal We terms of labour’s product. marginal capital on the horizontal axis, and think in terms of capital’s to 8.5, which shows the return diagram of Figure This is shown in the right-hand capital, income from total output yields total from capitalincome as the white triangle. shown income, an expression for the real wage – the nominal wage adjusted for changes in the changes in the for wage – the nominal wage adjusted the real for an expression of money (what the money wage can actually power buy in terms of purchasing goods): determined by the marginal productivity of capital. the marginal determined by and times the number of workers wage terms) is the real (in real labour income the shaded rectangle. 8.5 by diagram of Figure in the left-hand is represented total the sum of allSince additional outputs equals output, the under the area MP interest, profits and rents on the other is known as the ‘functional’ distribution of distribution of other is known as the ‘functional’ on the interest, profits and rents Indeed, David of the classical economists. preoccupation It was a major income. 2007). The (Glyn Ricardo called Economy’ it ‘the problem in Political principal assuming production function it using an aggregate explained classical economists of production – labour and capital.two This aggregate homogeneous factors analytical while it is largely and model is still tool in macroeconomics, a key – for ance appear cameo an occasional it does make microeconomics, absent from the when explaining the production possibility frontier, ample, when deriving ex to capital concern. return the – our current benefits of trade, and when explaining in the definition with ‘price’ revenue’ ‘marginal replace can – we markets factor product. Thus, labour will up to the point where: revenue be hired of marginal W = P x MP pay up to $12 an hour, the fourth worker’s marginal revenue product. Bargaining product. Bargaining revenue marginal the fourth worker’s an hour, up to $12 pay in a 1.6 to capital The returns an hour with no adverse effect on employment. on employment. effect with no adverse an hour have view the - who the does In doing so, they those , and based it on the support are contribution and legitimize market outcomes and legitimize market outcomes rewards economics What Does 180 the fairness argument make? greatest the capital professor: the efficiency argument or contribution? At the end of Section 1, we argued that all factors can receive your land don’t kill the goose that lays the golden eggs. don’t kill the goose that lays the who of for greatest the those ownership made that Suppose there are increasing returns to scale. This means that if we increase Suppose there are increasing returns to scale. This means that equilibrium of a Constant returns to scale necessarily prevail in the long-run The theory of marginal productivity, together with the insights of Adam Smith, the insights of Adam Smith, productivity, together with The theory of marginal well as economists, that large persuaded the general public, as seem[s] to have to progress and prosperity. are indispensable differences in compensation occupations for which they are both to attract people to the [They] … are needed at and exert their best efforts to induce them to acquire the skills best suited and the entire society. work for the ultimate benefit of of income is legitimate because it In other words, an unequal distribution made sum up, Clark explicitly To Questions earn their marginal product only if there are constant returns to scale – otherwise earn their marginal product only if there are constant returns total earnings won’t ‘add up’ to total output. Why is that? 1 per cent. The factor inputs by 1 per cent, output increases by more than average output of marginal product of these extra factors is greater than the marginal products, factors as a whole. So, if we tried to pay all factors their arithmetic. (If, on there would not be enough available, as a matter of simple marginal products the other hand, the economy experienced decreasing returns, left over.) would be less than average products and there would be output structure. Therefore, perfectly competitive industry, but not in any other industry the marginal product theory of distribution requires perfect competition. So, if you don’t find perfect competition appealing, must you abandon the mar- could pin your faith You ginal product theory of distribution? Not necessarily. is beneficial – meaning that it gives rise to the incentives necessary to give us is beneficial – meaning that it an efficient and dynamic economy. maxim: to each according to their contribution. Mainstream textbooks disavow maxim: to each according to their this, but explicitly make with the maxim: value free. see themselves as scientific and The adding-up problem to Joan Robinson (1973b: 129), the legitimacy arguments are still made in the made are still arguments legitimacy the 129), (1973b: Robinson to Joan them to allowing scientific objectivity, concealed behind but are now textbooks, way: argument this 15) puts the Bok (1993: powerfully. all the more persuade 2.2 textbook story with the standard problems Theoretical
8 | Marginal productivity theory
, 179 , Frank Rick (2009) calls it ‘the bedrock American dream that New York Times New York There are three ways in which a theory might legitimize a social outcome. There are three ways in which the American economist J. B. Clark explicitly In the late nineteenth century, First, someone There are two main problems with the fairness argument. argument. Most modern mainstream textbooks explicitly disavow the fairness We’ll move on to the theoretical problems after first discussing whether to the theoretical problems after first discussing whether move on We’ll But this does not prevent it from continuing to be a pervasive view. Writing in view. But this does not prevent it from continuing to be a pervasive the virtues like hard work and playing by the rules are rewarded with prosperity’. In other words, rewards are determined by contribution. Furthermore, according The explanation provided by the theory might make the social outcome seem: The explanation provided by beneficial. (1) fair; (2) unavoidable; or (3) to output argued that having rewards determined by marginal contribution social class gets is, was both fair and unavoidable. It was fair because ‘what a of industry’ (1891: under natural law, what it contributes to the general output if an employer tried 319). It was unavoidable because competition ensures that would offer to pay a worker less than her marginal product, other employers more, bidding her wages up. no fault of their might be unable to make a contribution to output through a social safety net. own. This is the rationale for ‘the compassionate state’ and of production Second, it confounds the contributions of non-human factors them. As Robinson (land and capital) with the contributions of those who own of](1973b: 129) points out: ‘It says nothing about how the [ownership factors of distribution has are distributed amongst people.’ As a result, ‘the theory Robinson nothing to say, one way or the other, about the distribution of income’. the differences extrapolates the point by saying: ‘The theory purports to explain to acquire skills is between skilled and unskilled wages, not how the chance estates; the rate of limited. It purports to explain rent per acre, not the size of interest, not the possession of capital.’ 2.1 of the actual distribution legitimize productivity marginal Does income? the marginal productivity theory of distribution legitimizes actual market out- the marginal productivity theory comes. are needed that deal with fairness and status. These underline the importance the importance underline These and status. fairness with that deal needed are produce an free markets the notion that undercuts position, which of relative in terms of plausibility better theory, that a much argue outcome. We efficient we turn model. Finally, monopsony is the dynamic of predictions, and accuracy the standard textbook argue that executive compensation. We our attention to pay relative to average wages. the seismic shift in executive story cannot explain worth’, a combination of bad of ‘getting what they are conclude that instead We led to executives ‘getting accounting rules and poor oversight incentives, lax get away with’. what they can 8.6 the produces Reswitching possibility of multiple equilibria possibility of multiple figure 182 D , an increase in the supply of labour causes real , an increase in the supply of capital causes real inter- ceteris paribus ceteris paribus 1 r r [T]he switch to general equilibrium, rather than saving the neoclassical par ables, par [T]he switch to general equilibrium, rather than saving the neoclassical abandoned them for simultaneous equation price systems … Relinquished, differences in however, were one-way causal claims about unambiguously signed capital. the interest rate associated with differences in the quantity of by difficulties in Furthermore, general equilibrium theory itself is plagued agree about the Needless to say, the participants in the debate could not If the possibility of multiple equilibria means that the impersonal force of If the possibility of multiple by arguing that the aggregate model The neoclassical economists responded showing uniqueness and stability (see Ackerman 2002, and the addendum to showing uniqueness and stability (see Ackerman 2002, and wrong with the Chapter 6). It seems that there is something fundamentally neoclassical ideal world of perfect competition. such disagreements significance of the results. As we argued in Chapter 2, about significance are an endemic problem in economic analysis. Cohen and Harcourt (2003: 207) sum up: ‘With neither side able to deliver a knockout punch, issues of faith and ideology entered the ring … Ideology and method- marginal productivity isn’t enough to determine the interest rate, then what marginal productivity isn’t enough the door is open for all kinds of other social forces does determine it? Suddenly, power, bargaining, government policies, and to matter: social norms, relative so on. device – they know it isn’t intellectually respect- is used only as a simplifying the Rather, isn’t damaging their core theory. able, so showing that it’s false is the extremely disaggregated (and complex) intellectually respectable version earn a In this theory, each disaggregated factor must general equilibrium theory. is Pareto-efficient. reward equal to its marginal product and the model economy models provide no Unfortunately, as the critics were quick to point out, these example, one cannot support for a ‘relative scarcity theory of distribution’. For assert that, Figure 8.5. Nor can est rates to fall, as is implied in the right-hand diagram of one assert that, 8.5. As Cohen wages to fall, as is implied in the left-hand diagram of Figure and Harcourt (2003: 207) put it:
8 | Marginal productivity theory , MP x MR its are earn before the value exhaust than the value of capital must factor . Because of the mutual returns . Since marginal revenue, . Since marginal more MP x every P . The participants in the debate . The participants in the debate shares could increasing capital If 181 that raged from the This was a debate income economy, . would professor: Or , this might reduce the sum of factor payments enough the sum of factor payments , this might reduce and the nature of P modern your the may be no unique equilibrium solution in for product?
. equilibrium before it enters the production function, and hence output? , is less than price, , is less than price, total marginal pervasive Questions This circularity is not, however, the telling point. There are many examples This circularity is not, however, the telling point. There are Consider the textbook story about the determination of the return to capital. Consider the textbook story about the determination of the mid-1950s to the mid-1970s over several fundamental concepts, including the mid-1950s to the mid-1970s over meaning of with Cambridge, England, or Cambridge, were principally associated either neoclassical theory Massachusetts. While the debate essentially petered out and issues involved are survived, Cohen and Harcourt (2003: 200) argue that the until they deep and important and will probably erupt in further controversy are resolved. The Cambridge capital controversy on a combination of increasing returns to scale and imperfect competition. competition. imperfect and to scale returns of increasing combination on a the marginal of of the value sum scale the to returns increasing with Remember, hand, in im- On the other of total output. the value more than exceeds products revenue products, their marginal are paid competition factors perfect dependence between the value of capital and the interest rate, it can be shown dependence between the value of capital and the interest rate, cheaper at both high that one method of production – call it technique A – can be B – is cheaper and low interest rates, while another method – call it technique at intermediate rates of interest. This is known as the ‘reswitching result’, and it implies that the demand for capital can have a backward-bending segment, implying the possibility of multiple equilibria, as shown in Figure 8.6. of simultaneous mutual dependence in economics that can be routinely solved. of simultaneous mutual dependence in economics that can it was The telling point is that during the ‘Cambridge capital controversies’ shown that there of capital can be determined be known This postulates an aggregate production function with capital as one input. This postulates an aggregate production function with capital in equilibrium From this we determine the marginal product of capital, which different kinds of equals the real rate of interest. But how do we add up all the to get one measure capital – all the different tools, machines and structures – is that we must add of capital to put into the production function? The answer everything up in dollar value terms. But this means that MR to output. There’s no mechanism exhaust the value of total so that they just only by chance. outcome, however; it could happen guarantee this rather than the value of their marginal products, value of their marginal products, rather than the – pro- the fairness model belong? marginal marginal productivity they receive Indeed, industries that / actual actual which average average marginal marginal to their the their individuals group or Does 184 will receive receive the Or time, of will in professor: professor: period? product point workers workers . Robert Frank (1984) was one of the first to report it. He Frank . Robert your longer every that for a at marginal say over wage compression average duct product product theory theory Regarding the second prediction, there is strong evidence that workers’ wages the second prediction, there is strong evidence that Regarding The standard version of the efficiency wage model cannot explain these em- The standard version of the efficiency wage model cannot Another variant of the efficiency-wage model, however – the Questions Questions researchers have attempted to test the marginal Despite Thurow’s misgivings, cannot be directly measured there are indirect Even when marginal products (1988) cite an impressive the first prediction, Akerlof and Yellen Regarding have high wages for one occupation also have high wages for other occupations; have high wages for one occupation also have high wages for wages are strongly positively correlated with industry profits. is known differ by less than their marginal productivities. This phenomenon as provides a natural explanation for both empirical regularities. According to this model, in industries where it is advantageous to pay some employees highly, it focused on the productivity of real estate and automobile salespeople because focused on the productivity of real estate and automobile competitive nature their ‘output’ was easy to measure, and because of the highly vary substantially of the industries. He found strong evidence that wage rates less than individual productivity. higher pay in pirical regularities. It suggests that identical workers will receive work effort. This jobs where monitoring is more difficult as an incentive for pay in differ- cannot explain why identical occupations should receive different there is no obvious reason why secretaries should example, ent industries. For pay is high, than be harder to supervise in the chemical industry, where their 1988: 44). Yellen in the apparel industry, where their pay is low (Akerlof and product theory of distribution. As you read this section, ask yourself whether product theory of distribution. product theory of distribution, or merely this research refutes the marginal that Thurow suggests are necessary to give delineates the subsidiary theories the theory more substance. labour market model. First, the competitive ways of testing the competitive wage for workers of a given quality, doing the model predicts a single market do it. A second prediction follows: workers of same work, no matter where they different wages even if they work in the same different quality should receive firm. The evidence refutes both predictions. receive amount of evidence showing that workers of identical characteristics different wages in different industries and occupations. 2.4 testing of model competitive the Empirical
8 | Marginal productivity theory the Cambridge won the on take theorists your English 183 What’s the … hear I war professor: the the marginal product theory of distribution specifically your does lost for but controversy? controversy? ? When MIT economist Lester Thurow set about writing a critique of the ? When MIT economist Lester Thurow set about writing debate, capital For example, suppose that we could observe individual workers making example, suppose that we could observe individual workers making For the same senior- Similarly, we might observe a group of individual workers of are necessary Thurow’s basic point is that ‘subsidiary distribution theories Can marginal products always be measured? When there are many different Can marginal products always Indeed, what Question widgets. Does the theory say that the workers are paid their actual marginal average marginal products every hour or every day? Or will they be paid their The textbook theory product over some longer period, such as their working life? wage schedules are is ambiguous. Thurow (ibid.: 211–12) points out that ‘seniority hypothesis, but they not evidence contrary to the lifetime marginal-productivity hypothesis’. are evidence contrary to the instantaneous marginal-productivity products than ity all getting the same pay, while some have higher marginal groups or individuals paid their marginal others. Thurow (ibid.: 212) asks: ‘Are product of the products?’ If pay in such cases reflects the average marginal theory? And group as a whole, is this consistent with marginal productivity what defines the group? individual factor in every variant except the strict interpretation in which every that the theory is paid his marginal product at every instant of time’. He warns is in danger of becoming a tautology – something that is true by definition: ‘factors in general must be paid in accordance with the productivity of factors in general’ (ibid.: 215). textbook marginal productivity analysis, he wrote (1975: viii), ‘it is so amorphous textbook marginal productivity analysis, he wrote (1975: viii), that I have been unable to say what it is’. say outputs produced at the same time, or where output is produced in a complex outputs produced at the same to overall output might be impossible organization, one person’s contribution about productivity is crucial, but (as recognized Clearly, information to decipher. information is highly imperfect. Furthermore, in the efficiency wage theories) has every incentive to masquerade as someone someone with low productivity how can it If marginal productivity cannot be measured, with high productivity. optimal hiring decisions? And if marginal pro- be used by employers to make how can the theory of distribution be tested? ductivity cannot be measured, 2.3 theory fuzziness The of productivity marginal ology, two subjects most economists would rather avoid, were pervasive under- pervasive were avoid, rather would most economists two subjects ology, fuelling the controversies.’ currents is in need , there is no guar- 186 even if labour markets were perfectly competitive Both fairness and status theory emphasize that people care about relative posi- care about relative that people theory emphasize and status Both fairness 4, abundant evidence has shown that relative As we document in Chapter of possible ways to get ahead of their rivals. They may have a variety People to reduce the This helps to explain the attraction of collective measures sum up, To part determined by the amount that others have … private incentives favour excessive work’ (ibid.: 144). they are subversive of the key idea that the actual distribution of income is the is the of income distribution actual that the key idea of the are subversive they Why is that? outcomes. leads to efficient a process that result of primarily reward depends When important externality. this creates an tion and yield by rational individuals often unrestricted choices on relative performance, uses the example of explain why, Frank (2005b) one favours. To results that no situation, an individual player In an unregulated competitive hockey players. an advantage over those players to wear a helmet since it confers would prefer not the more than compensate for – the better vision and hearing wearing helmets without helmets, it’s a race to the But if all players go increased risk of injury. and no one benefits. That’s why, when they vote bottom – everyone faces more risk almost always favour compulsory helmets. in secret ballots, hockey players of well-being – for fairness and status income is an important determinant who don’t care about relative income per se reasons among others. Even people where they stand in the distribution of income. have powerful reasons for caring out that if a parent’s goal is to educate her Frank and Cook (1995: 142) point she can further that goal by having higher rela- children as well as possible, to purchase a house in a better school district. tive income, which permits her bid up the prices of But when all families spend more, the result is merely to schools. Thus, those houses. Half of all children will still attend bottom-half is similar to the a family’s quest to provide a better education for its children athlete’s quest for relative advantage. or less pleasant jobs, invest in more or better education. They may accept riskier one individual can which tend to pay more, or they may work longer hours. Any but when all do it, increase her promotion chances by working longer hours; they are destined to be frustrated. premiums for number of hours people work – legislation requiring overtime work week, national holidays and all hours worked in excess of the standard laws, arguing that for example. Free market economists often denounce such employers would many workers would voluntarily work the longer hours that confront- the incentives have offered in the absence of overtime premiums. Yet ing workers are similar to those confronting hockey players. supply is influ- antee that they would produce an efficient outcome since labour ‘if we worked less enced by considerations of relative position. The point is that if everyone worked than we currently do, we would have less income, but then less, we would need less income, because the amount of income we
8 | Marginal productivity theory and fairness’ ‘ are structure? individual marginal productivities important wage both 185 How in the firm’s hierarchy. in the firm’s hierarchy. firm’s a professor: relative status your to also pay other employees well. And when individuals do not individuals And when well. other employees pay to also determining fair for in '& the average productivity of the group as a whole, with the group being the the average productivity of the group as a whole, with the ‘status’ ‘status’ Question of distribution, Did the previous section refute the marginal product theory On the other hand, hidden within the fairness and status theories is the The monitoring version of the efficiency wage model probably is just icing is just The monitoring version of the efficiency wage model probably Status is like a non-pecuniary benefit. If the best workers were paid the value best workers were paid the value non-pecuniary benefit. If the Status is like a the status explanation for wage compression is One very attractive feature of Lazear (1989) points out a weakness of the fairness model: it is far from far from model: it is of the fairness out a weakness (1989) points Lazear or merely delineate the subsidiary theories that give the main concept more or merely delineate the subsidiary theories that give the substance? In these models, wages reflect implication that the competitive market outcome is not efficient. And that means that these models are not just icing on the competitive model’s cake. Rather, – though it doesn’t sit well with the ethos of reward being determined by contri- – though it doesn’t sit well with the ethos of reward being determined tasks need bution. As emphasized by Prasch (2008: 104), the harder-to-monitor the tasks. Yet not be more challenging or difficult than the easier-to-monitor between identical fact of unequal monitoring costs creates a wage differential key point is that this workers doing otherwise identical tasks. Nevertheless, the outcome is efficient. and to be consistent firm. These modifications allow marginal productivity theory efficiency wage, fair- with broadly observed empirical regularities. So, are these cake? ness and status models just the icing on the competitive model’s of their marginal product, they would receive their high status free of charge. of their marginal product, they their marginal product. Similarly, if the worst Therefore, they are paid less than of their marginal product, they would suffer low workers were paid the value payment. Therefore, they are paid more than status without any compensating their marginal product. that people care about their relative standing that there is abundant evidence income hierarchies of the groups to which they in the community, and in the belong. 2.5 The importance of fairness andstatus obvious that a compressed salary structure is morale-improving for the better for is morale-improving salary structure that a compressed obvious product. They may feel disen- less than their marginal workers who receive don’t why those better workers scheme. Frank (1984) wonders chanted by this the that what’s missing from their own firm. He suggests split off and form is fairness argument is considered is considered suffer. and effort their motivation be treated fairly, themselves to consider be- don’t irm s su ly 1 of labour L Why cent market one quit. by L labour will wage its , increases. On the other hand, irm s labour age force W competitive Consider the effect of frictions on the workforce L 188 reduces The schedule q(W) • employees, the firm must set the wage at $5 0 entire firm L shows that a firm’s ability to hire new workers a , decreases as the wage increases. As a result, the its 1 if L h(W) professor: q(W) that q(W) • , also decreases as the wage increases. This is shown as the , also decreases as the wage increases. This is shown as the your L prediction? . As the size of the workforce increases, the schedule showing . As the size of the workforce increases, the schedule showing for 0 this equilibrium, equilibrium, 8.7 upward-sloping supply of labour firm’s Derivation of a competitive predicts the test ires uits er age figure mont we low model Frictions have long been modelled by labour economists in their research. research. in their economists by labour modelled been long have Frictions Question We illustrate the firm’s problem in Figure 8.7. In the left-hand diagram, in Figure 8.7. In the left-hand diagram, illustrate the firm’s problem We To maintain a workforce of To
Explicitly incorporating them allows us to see that monopsony is not the rarity monopsony is us to see that them allows incorporating Explicitly applicability. it has general Rather, say it is. that textbooks A dynamic reinterpretation of monopsony A dynamic reinterpretation of firm. If it offers a lower wage, it experiences a higher quit rate, which increases firm. If it offers a lower wage, new employees. Job vacancies (unfilled job the costs of recruiting and training in reality, but are absent from the per- openings) are a pervasive phenomenon where each firm can hire all the workers it fectly competitive labour market In their discussion of the low-wage labour wants at the going market wage. 373) depict low-wage employers as fighting a market, Card and Krueger (1995: maintain their workforces. constant ‘war of attrition’ to the upward sloping line each month increases as its offered wage, an hour, such that the number of new hires just balances the number of quits: an hour, such that the number of new hires just balances the h(w) = q(w)·L the monthly quit rate, rate and the size absolute number of quits, which is the product of the quit of the workforce, downward-sloping line.
8 | Marginal productivity theory to posi- lead relative relative markets markets if that Yes!) true competitive competitive it 187 answer: answer: Is perfectly perfectly (Right (Right even professor: professor: your outcomes? outcomes? for important, important, is inefficient inefficient tion Question Question market model (and the marginal perfectly competitive labour As we’ve seen, the that the competitive labour market model Many economists believe, however, competitive model is Manning, the main problem with the textbook For the equilibrium In reality, if a firm reduced its wages by one cent below are termed ‘fric- Why don’t all the workers quit at once? It’s because of what product theory of distribution) can be made consistent with well-established em- with well-established of distribution) can be made consistent product theory subsidiary theories such as those concerning pirical regularities by incorporating doing so, however, is to overturn the presumption fairness and status. The cost of to an efficient situation. that the unregulated market leads point. Like Alan Manning (2003) of the London is, in any case, the wrong starting that a ‘dynamic monopsony’ model would make School of Economics, they think for markets where there are many small firms. a much better starting point, even the default model in textbooks. They think that it should be of the labour market, including market power. that it omits critical features its wages by one Did you notice in Figure 8.1 that if a competitive firm reduces quit? Even more cent below the equilibrium wage, its entire workforce would be of no great implausibly, if the firm’s entire workforce did quit, this would workers concern to the firm since it could instantly find all the replacement employer–employee it needed by again offering the going market wage. The than the other. relationship is symmetric, with neither being more powerful and instantly find Each has the equivalent power to terminate the relationship implausible as Such a depiction is completely another job or another worker. a description of the actual labour market. says (ibid.: 4), wage, it would not immediately lose all its workers. As Manning or that recruit- a firm ‘may find that workers quit at a faster rate than before competitive model ment is more difficult, but the extreme predictions of the do not hold’. example, when information is not free it takes time and tions’ in the market. For entail moving home resources to find a new job, and taking such a job might preferences or increased costs of commuting. Other frictions include personal to one’s co- (such as strongly preferring a certain type of work, or attachment training and skills workers, or a benefit offered by the job), and the firm-specific that a worker may have. As Manning says (ibid.: 4): ‘The existence of frictions gives employers potential market power over their workers. The assumption that firms set wages means that they actually exercise this power.’ 2.6 model of The monopsony the labour market of to degree workers some for have costly firms is it small 190 If performance, and we have already established The trouble with this argument is that winning even relative could professor: the difference between the pay of workers and executives, your jobs, narrow power? for between monopsony move Question management Standard marginal productivity arguments suggest that top-level For example (as we showed in the first part of this chapter), the imposition the imposition of this chapter), in the first part (as we showed example For bi- context creates a of a union in the monopsony Similarly, the formation receive amounts equal to what they add to the net profits of their company. of their company. receive amounts equal to what they add to the net profits workers in the Since their decisions have impacts on the productivity of many they earn. Empiri- company, it might be possible to justify the huge rewards between CEO pay cally, however, there are no strong or consistent relationships nor over time and firm size, profitability or growth, neither across industries emphasize (Finkelstein and Hambrick 1988). This explains why many textbooks This is the idea that the pay of top-level management, and tournament theory. the productivity of CEOs in particular, is like tournament prizes that increase the whole team of everyone who strives for them. This elicits more effort from prize. In short, this of executives competing for the top job and the biggest arrangement is efficient. Tournaments might be inefficient Tournaments laissez-faire mantra concerning the negative impact of labour market regula- market labour of impact the negative concerning mantra laissez-faire tion. wage will above the current moderately wage that is only minimum of a binding losses market, but employment gains in a monopsonistic lead to employment can explain why This up too far. the minimum wage is pushed would result if of minimum wages is so mixed, concerning the effect the empirical evidence at length in Chapter 2. as we discussed the wage is determined by bargaining and lateral monopoly situation where be at the expense of employment decreases. where wage increases need not unions is likely to raise non-union wages – an In this model, the presence of by standard theory, but is supported by the evid- outcome that is not predicted ence (Manning 2003: ch. 12). 2.7 CEO and management compensation that when reward depends on relative performance, competitive markets lead to that when reward depends on relative performance, competitive example, corporate management requires teamwork inefficient outcomes. For even lead to attempts to sabot- It might and cooperation, which is likely to suffer. age rivals. Abegglen and Stalk (1985) document a conscious effort by Japanese corporations to a tournament depends on
8 | Marginal productivity theory 189 First, the most direct prediction from Figure 8.7 is that larger firms pay higher First, the most direct prediction version of the model presented in Figure Second, a slightly more general important cause Third, Manning (2003: ch. 7) argues that monopsony is an than the fair- Is the dynamic monopsony model more empirically relevant dynamic monop- In any event, Machin and Manning (2004) suggest that the Many economists feel that the dynamic monopsony model is a better fit for Does this model receive empirical support (besides the obvious factors of (besides the obvious factors receive empirical support Does this model wages on average. This is a strong empirical regularity (Oi and Idson 1999). wages on average. This is a strong principle in the personnel field – noted, for 8.7 can explain a widely accepted (1987) – that some firms choose a ‘low- example, by Milkovitch and Newman In this others a ‘high-wage/low-turnover’ policy. wage/high-turnover’ policy, and offered by other firms is determined within the more general model, the wage 1995: 379). It turns out that even if workers model itself (Card and Krueger with, wages will end up differing systematically and firms are identical to begin across firms in equilibrium. a higher value than of the gender pay gap. He cites evidence that women place with co-workers. men on the non-wage aspects of a job, such as relationships than that for As a result, the labour market for women is more monopsonistic men, allowing employers to pay them less. (1997) took the unusual step ness and status models? Campbell and Kamlani when setting their of actually asking firms what considerations were uppermost that their two main wage structure. From their survey of 184 firms, they found and (2) to maintain concerns were: (1) to avoid having their better workers quit wage. So the survey the effort level of their workers by paying them a ‘fair’ as fairness. evidence suggests that concern over quits is at least as important and the effects their This means that firms recognize their power over the wage choices have on turnover. models. Generally sony model can easily coexist with the fairness and status firm is not speaking, since the structure of wages within the monopsonistic why the wage dictated by workers’ marginal productivity, it easily explains to productivity differences between workers that do exist are often unrelated (ibid.: 383). the way labour markets actually work, and helps to explain many features of the labour market that perfect competition cannot. Moreover, it overturns the the coexistence of unemployment and vacancies, and the ability of firms to to and the ability of firms of unemployment and vacancies, the coexistence set wages)? It does. the absolute number of quits shifts up, necessitating a higher wage. In effect, In effect, wage. higher a necessitating up, shifts of quits number absolute the in the schedule, as shown of labour supply faces an upward-sloping the firm cost generate a marginal that, we can Figure 8.7. From diagram of right-hand between mar- a gap 8.1 and generate shown in Table schedule as of labour monopsony model (shown and the wage as in the standard ginal productivity 8.4). in Figures 8.3 and
'' o nsIdsra erage A Industrial ones Do 12 1 4 2 DoIndustrial A ones erage 192 : Hall and Murphy (2003: 63, Figure 2) Figure 63, (2003: : Hall and Murphy atio of a erage EO or ers salary and bonus to aannual earnings erage of roduction Source 1970–2002 1970–2002 atio of a erage EO total or ers ay including o tions alued at grant date to a erage annual earnings of roduction 8.9 pay, to average and CEO pay relative Dow Jones Industrial Average 1141121114122 4 3 2 1
figure Marginal productivity theory suggests executive compensation would increase would executive compensation suggests productivity theory Marginal suggest that it reflects changing norms of Heilbroner and Thurow (1998) may have hit on some deep-seated causes, While Heilbroner and Thurow theory that Ironically, stock options grew out of improvements in economic ay er or to ay EO of atio This helped fuel the ‘shareholder value’ movement of the 1980s, which aimed to This helped fuel the ‘shareholder value’ movement of the 1980s, dependent on more resolve the problem by making management compensation steep rise – briefly going stratospheric in 2001 – before ‘settling back’ to 160 to 160 back’ ‘settling – before 2001 in stratospheric going briefly rise – steep 2005. wages in times average in their or a decrease demand for CEOs in the there was an increase only if on the mar- ‘the number of CEOs But as Stiglitz (2003: 124) observes, supply. or performance of America’s shrink and the productivity ket didn’t suddenly deserved 1,000 percent raises’. so much that they suddenly CEOs did not rise for the The number of contestants theory do any better. Nor does tournament of the vice-presidents – didn’t considered to be the ranks top job – normally suddenly increase. growth in the incomes of entertainment icons. society initiated by explosive ‘If Michael Jordan is worth $30 million a CEOs may have said to themselves, I’m worth $20 million for managing AT&T.’ year for playing basketball, surely of the Soviet bloc in 1989 eliminated the need They also suggest that the fall light. to present capitalism in a favourable cause: the escalation in the use of stock there is a more prosaic proximate in the 1980s. Stock options give the options as part of executive remuneration prevailing when holder the right to buy company stock in the future, at prices the options are issued. in causing recognized the importance of imperfect and asymmetric information – a conflict re- a potential conflict of interest between owners and management in Chapter 5). ferred to as the ‘principal agent’ problem (which we also discuss
8 | Marginal productivity theory ) the larger ceteris paribus : Frydman and Saks (2008) : Frydman of tournament key prediction A Source 191 When one looks at the trends in executive 8.8 (includes wages in the USA to average pay relative executive Average salary, bonuses and stock-option grants) bonuses and stock-option salary, 131411111221 O’Reilly et al. (1988) reject this prediction of tournament theory. Instead, they al. (1988) reject this prediction of tournament theory. et O’Reilly figure 3 3 2 2 1 1 Trends in executive compensation and between middle management and top-level management, believing it will it will believing management, and top-level management middle between and firms. for Japanese productivity and, ultimately, loyalty, cohesion increase compensation concerning executive Evidence compensation in the USA over the last seventy years, it’s apparent that there compensation in the USA over the last seventy years, it’s executive pay is a puzzle that needs explaining. Figure 8.8 shows that average USA between 1945 hovered around forty times higher than average wages in the pay began a and 1985. But around 1985 there was a seismic shift. Executive find a strong association between CEO compensation and the compensation of find a strong association between of directors whose job it is to determine the chief those members of the board conflict of interest: membership This brings up an important executive’s pay. large fees, and while the shareholders nominally of a board usually commands the shareholders merely ratify the choices of elect board members, in practice are often more concerned with pleasing the CEO So, board members the CEO. oversight that their function requires. Finally, than with providing the fiduciary CEOs of other companies, you have some CEOs since board members are often receipt of which is determining the pay of another CEO for a nice fat fee, the dependent on pleasing the CEO! the prize must be – for two reasons. First, since all the contestants sacrifice since all the contestants sacrifice be – for two reasons. First, the prize must the pool – the more contestants, – it goes into the prize some of their income the the number of contestants, should be. Second, the larger bigger the prize be to the larger must the prize of winning and hence lower is the probability have the same incentive effect. theory is that the larger the number of contestants ( larger the number of contestants theory is that the But forty years. hundred about one forty was for pay around why? now States is explain it 194 Executive you United and the Could in professor: increased, wages. wages your it for 1985 average average times around times If you’re interested in an up-to-date and non-technical discussion of the If you’re interested in an up-to-date and non-technical discussion of the Question ical theoret have moved from of ground. We This chapter has covered a lot the default model of the text- the perfectly competitive model remains Yet by the evid- The predictions of the perfectly competitive model are rejected Cambridge capital theory controversies, we recommend the article by Cohen critiques of marginal productivity theory to the empirical failings of the com- critiques of marginal productivity market. Along the way, we have fired potshots petitive model of the labour reveals important imperfections about the at executive pay, which we argue current market system. comings has its uses, but it also has serious short books. No one can deny that it employer It implies that no that make it deeply misleading if it is taken literally. over employees. has the slightest power over wages, nor any other kind of power and have another If the boss threatens to fire you in the morning, you can quit that questions equally good job at the same wage in the afternoon. It implies for differ- Wages of ‘fairness’ and ‘status’ are irrelevant in determining wages. of supply and ent activities simply result from the impersonal market forces demand. are about important ence. This is not a trivial matter, because the predictions suggests a laissez- questions. Furthermore, in every case, the competitive model wages must faire approach. It suggests – against the evidence – that minimum for monopoly, with decrease employment. It suggests that unions are a force Neither of these predictions sur- the usual negative connotations for efficiency. wages and vives the change to a monopsony framework, where both minimum are In particular, in such a framework unions unions might improve efficiency. Galbraith termed not a market distortion, but an aspect of what John Kenneth offer an anti-union ‘countervailing power’. If texts do not discuss this, they to exert monopoly bias because unions then appear to have no role other than power on employers. Suggestions for further reading economic system. The moral of this section on executive compensation is that is that compensation executive on section of this The moral system. economic you can get be ‘what perhaps that should can get’ – or worth what you ‘you’re away with’. comments 2.8 Concluding
8 | Marginal productivity theory
') '* 193 A better system would give bonuses only A better system would give bonuses '( . For example, profits and stock prices may be driven up . For means and ignore Is the topic of executive pay of relatively minor importance? Our perspective The worst aspect of stock options as currently given is that they focus only on The worst aspect of stock options scandals from Stiglitz eloquently explains that the succession of corporate is that executive pay is the litmus test that reveals important truths about the (See Chapter 11 for a more detailed discussion.) As we write, the veil of legitimacy (See Chapter 11 for a more detailed discussion.) As we write, bailout money for huge bonuses seems to have been torn. Stories of public being posted at being used to pay huge bonuses actually led to armed guards death threats. the offices of AIG in March 2009 to protect employees against it leads to new Whether this outrage is permanent or temporary, and whether regulations, norms or procedures, is uncertain at this stage. company stock price performance. Stiglitz (2003: 120) quips: ‘It was a seductive company stock price performance. a deeply flawed one.’ The problem is that in argument, but as events proved, of the increase in the value of a particular stock a stock market boom, most of management. Figure 8.9 illustrates the has nothing to do with the efforts was driven by the overall stock market boom as extent to which CEO total pay a result of the use of stock options. © Scott Adams/Dist. by United Feature Syndicate, Inc. Syndicate, Feature United by Adams/Dist. © Scott ends Bush’s (George W. 2000 to 2002 had very little to do with ‘a few bad apples’ bad incentives, lax explanation) and everything to do with a combination of have been accounting rules and poor oversight. While accounting standards of bad incentives tightened up in the United States, the underlying problem of 2008/09. remains – as we have seen with the worldwide financial meltdown to executives who do better than average (the average of firms in their industry to executives who do better than those who do worse than average. perhaps); it might also penalize but impover- by reducing expenditure on R&D; this might enrich management management might deliberately disclose ish the company longer term. Worse, drive share prices biased information, or massage the financial accounts, to and Adelphia were only the up. Stiglitz (ibid.: 116) notes: ‘Enron, WorldCom, the vaunted energy most flagrant and well publicized of many companies where less and less into and creativity of the nineties would eventually be directed ways of maximizing new products and services, and more and more into new executives’ gains at unwary investors’ expense.’ and Jay, times possessed Wolff it.’ John it.’ thousand ' Americans govern sixteen Court to than household.’ Edward Edward household.’ ought wealthiest 196 Supreme more the US was average country the 65) among of the that the of own (2007: “owner” wealth that Justice who of than Chief Zacharias people average amount Ajit larger first an Taxation is costly not only because it is costly for government to collect to collect government for only because it is costly not costly is Taxation ‘The ‘The ‘The Governments have four main roles. First, governments maintain a legal maintain a legal Governments have four main roles. First, governments the revenues and for individuals and business to comply with the tax law, but but with the tax individuals and business to comply law, and for the revenues households decisions. These include decisions by economic because it influences 1 TEXT THE STANDARD 1.1 The costs of taxation 9 | Government, 9 | Government, taxation and the (re)dis- of just too is a just society income: tribution expensive? This question is a normative one. It assumes What should governments do? as an efficient use of society’s resources and an that social goals exist, such produces, and that equitable distribution of the goods and services that society governments should act to further these goals. them enforced – a system within which people can make contracts and have market economy precondition for modern economic life. Second, because the have a role fails to allocate resources efficiently for many reasons, governments (the subject in trying to fix these ‘market failures’. Dealing with externalities Third, because the of Chapter 7) and public goods is a prominent example. play an important economy as a whole is potentially unstable, governments can keeping unemploy- role in stabilizing the overall level of economic activity and because there Fourth, This is the domain of macroeconomic policy. ment low. an equitable is no reason to expect that the market economy alone will produce use taxes, transfers distribution of income among individuals, governments can a more equitable of cash and the direct provision of goods and services to create this last role distribution of income and consumption. This chapter examines of government.
8 | Marginal productivity theory , (1998) is a nice intro- The Winner-Take-All Society The Winner-Take-All 195 Economics Explained For a short discussion of the importance of relative position and its impli- of the importance of relative a short discussion For For an excellent and not too technical discussion of the trouble with stock of the trouble with stock not too technical discussion an excellent and For Finally, Heilbroner and Thurow’s Finally, Heilbroner and Thurow’s On monopsony, one can’t do better than read Manning (2003). Non- On monopsony, one can’t cations for the inefficiency of even perfectly competitive markets, see Robert competitive markets, see Robert inefficiency of even perfectly cations for the see the extent to which it applies (2005a). To Frank’s short column, Frank Cook’s 1995 book, throughout society, Frank and options, see Hall and Murphy (2003). options, see Hall and Harcourt (2003). Some argue that since the neoclassical theory has been has been theory neoclassical the that since argue Some (2003). Harcourt and textbooks in the way the fact is reflected that be logically inconsistent, shown to consistency there is no rate. In particular, of the profit the determinants discuss an article by is found in along these lines discussion A very good of treatment. (1996). Naples and Aslanbeigui specialists, however, are advised to stick to the introduction and conclusion specialists, however, are advised to stick to the of the book. offers a pleasant and quick read. the distribution of wealth as well as the duction to economics that discusses distribution of income. curve 9.1 The Lorenz figure B 198 Percentage of Percentage households A
50
of attention because it is the focus Household income household income household
Countries are usually compared using per-person average income. Because Because income. average using per-person usually are compared Countries Suppose, as in Figure 9.1, households are lined up on the horizontal axis from lined up on the horizontal axis from 9.1, households are Suppose, as in Figure in a single number to aid in compar- is usually summarized inequality Income Percentage of of Percentage 50 20 of inequality, however, we need to know something about the distribution of about the distribution of need to know something we however, of inequality, to judge how a society is doing in terms of equity. and of wealth income 1.3 of income and distribution wealth The income The distribution of is the basic consumer unit. Income can be measured in different ways. ‘Before-tax ways. ‘Before-tax in different unit. can be measured is the basic consumer Income (dividends, savings from includes wages and salaries and income income’ market plus income is market income’ ‘disposable interest, capital gains). Alternatively, on taxes and other direct taxes minus income government from cash transfers unemployment to national pension plans or for premiums wages and salaries (e.g. of govern- the two allows Comparing insurance). effects us to see some of the ment on the distribution of income. on the right. the highest income on the left to The vertical income axis the lowest total of that various groupings shares household income shows the percentage of households have cent 50 per the poorest In this example, of households have. distributed, those equally were of total If household incomes 20 per cent income. of total the amount shown on the 50 per cent income, households would have line. The gap between the points showing actual household incomes 45-degree and extent line indicates the nature curve) and this reference (called the Lorenz inequality. of income One simple way is to calculate time and across countries. over ing inequality of the top 10 or 20 per cent of total held by the ratio of the shares income
9 | Government, taxation 197 : Organisation for Economic Co-operation and Development (2008a: 58–9) and Development Co-operation Economic for : Organisation 9.1 2005 OECD countries, of GDP, as a percentage Taxation : Averages for the EU and the OECD are unweighted averages. unweighted the EU and the OECD are for : Averages The best single way to compare taxes across countries is to express total tax is to express across countries taxes The best single way to compare If the decisions of consumers and firms in the absence of taxes would lead lead would of taxes the absence and firms in of consumers If the decisions Sweden 50.7 Sweden 34.8 Germany Country (% of GDP) Taxes Country (% of GDP) Taxes revenues collected by all levels of government to the value of the country’s total total to the value of the country’s all of government collected by levels revenues the coun- 9.1 for product (GDP), as shown in Table production, or gross domestic (OECD). and Development Co-operation Economic for tries of the Organisation of taxation. levels The other in their overall considerably differ countries Clearly, by services in terms of the goods and provided differ is that they side of the coin the state. 1.2 an international comparison Taxes: table to an efficient allocation of resources, then taxes must cause inefficiency if they if they cause inefficiency must taxes then allocationto an efficient of resources, tax the using of an excise saw this in the analysis We change those decisions. was a net loss to society 3. The result in Chapter framework supply and demand because some mutually good. This net loss occurs of the taxed of producing less competitive a perfectly – assuming place no longer take beneficial exchanges of tax. kind any can be done for A similar analysis and no externalities. market that would otherwise choices be optimal, they create influence As long as taxes losses’. ‘efficiency about what and how much to buy and how much to save, and decisions by firms firms by decisions and to save, much and how to buy much and how what about those things. produce to how and where and to produce about what Denmark 50.3 Portugal 34.8 Note Source Spain 35.8 OECD average 36.2 average Hungary 37.2 Kingdom United Mexico 19.9 Spain 35.8 OECD 36.5 EU average 39.7 Norway 43.7 Slovak Republic 31.6 Republic Norway 43.7 29.7 Slovak 42.1 Austria 30.9 Australia 41.4 Iceland Ireland 30.6 Switzerland Italy 41 Belgium 45.4 Belgium 45.4 Poland 34.3 Netherlands 39.1 38.6 Luxembourg Republic Czech Japan New Zealand Greece 27.4 37.8 27.3 37.8 States United Korea 27.3 25.5 France 44.1 France 33.4 Canada 44 Finland Turkey 32.3 200 Organisation for Economic Co-operation and and Co-operation Economic for Organisation note the but This is typically in the texts, ignored The United States stands out among these countries as having States stands The United as having out among these countries ( : Organisation for Economic Co-operation and Development (2008b): 263, (2008b): 263, and Development Co-operation Economic for : Organisation 9.3 household net worth of Distribution : The definition of net worth excludes business equity. Including it reduces the Gini the Gini Including it reduces business equity. : The definition of net worth excludes Wealth is typically distributed even more unequally than income, as Tables 9.2 9.2 as Tables than income, unequally is typically more distributed even Wealth The Gini coefficient for the United States (equal to 0.81) is explained by by is explained States to 0.81) (equal the United for The Gini coefficient Country 2002 Italy, total held by of wealth Share or holds with zero 42 10% Top 5% Top efficient 1% Top 29 wealth negative 11 house- of Percent Gini co- 10 0.61 and 9.3 show. Many households have zero or negative wealth (i.e. their debts ex- wealth or negative zero households have Many and 9.3 show. their assets). ceed a particularly large share of wealth held by the top groups within the population. held by of wealth a particularly share large and Zacharias (ibid.: 66) with this analogy: ‘aggregate imagine dividing an Wolff … suppose worth group of ten families $100 among a hypothetical “pie” economic 45-degree line (marked ‘A’ in Figure 9.1) and the entire area under the 45-degree the 45-degree under area the entire 9.1) and in Figure ‘A’ line (marked 45-degree is if income zero It’s = A/(A + B). coefficient So the Gini B in the figure). line (A + shows 9.2 also has everything. 1 if one household Table it’s distributed; equally the exception With of countries. a selection for of the Gini coefficient estimates inequality income much higher shown have countries of India, the developing is considerable there the OECD countries, Among countries. than the developed States being the most unequal. with the United variation in inequality, wealth of The distribution table differences between wealth and income. A household’s wealth is the value of its is the value of its wealth A household’s and income. between wealth differences security, economic is important offers because it assets, net of its debt. Wealth by captured things not adequately status (including borrowing power), and power and insecurity (Wolff to economic debt adds alone. Similarly, of income measures Zacharias 2007: 66–7). United Kingdom, 2000 Kingdom, United 45 30 10 17 0.66 Finland, 1998 Finland, Canada, 1999 States, SCF 2001 United 45 71 53 31 58 37 13 33 15 17 25 23 0.68 0.84 0.75 Germany, 2002 Germany, States, PSID 2001 United 64 2002 Sweden, 49 55 25 38 58 16 41 24 18 38 0.81 32 0.80 0.89 Note (See coefficient, sometimes significantly. Survey States, of Income PSID is Panel the United 10.6.) For Table 2008b, Development Finances. Consumer Dynamics; SCF is the Survey of Source 10.3 Table
9 | Government, taxation 199 : UNDP (2007): 281–4, Table 15 Table : UNDP (2007): 281–4, 9.2 inequality of income Measures : Values are for income or expenditure shares. Dates of underlying survey of underlying data vary Dates shares. or expenditure income for are : Values Russia 12.7 7.6 0.399 7.6 12.7 Russia Nigeria 17.8 9.7 0.437 9.7 Nigeria 17.8 India 8.6 5.6 0.368 5.6 Some non-OECD countries India 8.6 Mexico 24.6 12.8 0.461 12.8 States United 24.6 Mexico 15.9 8.4 0.408 China (excluding Hong Kong) Hong Kong) China (excluding 21.6 12.2 0.469 Portugal 15 8 0.385 8 15 Portugal Italy 11.6 6.5 0.360 6.5 Italy 11.6 Kingdom United 13.8 7.2 0.360 Chile 33 15.7 0.549 0.570 0.482 15.7 16 21.8 48.3 Venezuela Chile 33 Brazil 51.3 New Zealand New Zealand 12.5 6.8 0.362 Spain 10.3 6 0.347 0.352 6 7 10.3 Spain 12.5 Australia South Africa South Africa 33.1 17.9 0.578 Poland 8.8 5.6 0.345 5.6 8.8 Poland France 9.1 5.6 0.327 5.6 9.1 France Note 1990s, to early 2000s. from Source Colombia 63.8 25.3 0.586 25.3 63.8 Colombia Belgium 8.2 4.9 0.330 0.343 4.9 5.6 8.2 Belgium 9.4 Ireland Canada 9.4 5.5 0.326 5.5 South Korea, 9.4 Canada 7.8 4.7 0.316 Japan 4.5 3.4 0.249 0.247 3.4 4.3 Some OECD countries 8.1 Denmark 4.5 Japan Country 10% to Top 20% to Top bottom 10% bottom 20% Gini coefficient households with the bottom 10 or 20 per cent, as shown in Table 9.2. This, 9.2. This, households with the bottom 10 or 20 per cent, in Table as shown about the households between them. The most omits information however, distribution is the income the entire that summarizes used measure commonly curve and the betweencoefficient. the Lorenz This is the ratio of the area Gini table Austria 6.9 4.4 0.291 0.309 4.4 5.1 6.9 Austria 9.2 Netherlands Sweden 6.2 4 0.250 0.258 0.269 4 3.9 3.8 6.2 Sweden Norway6.1 5.6 Finland Hungary 5.5 3.8 0.269 0.283 3.8 4.3 Hungary 5.5 6.9 Germany 11.2 average 202 : Bradshaw et al. (2006, Appendix Table 1) Table : Bradshaw et al. (2006, Appendix 9.4 median half of less than with households in of children Percentage : Country data range from 1999–2001. Household income is adjusted for household household is adjusted for Household income 1999–2001. : Country data range from ‘Should economic policy makers always strive to achieve economic efficiency? efficiency? economic to achieve strive always policy makers ‘Should economic which to evaluate an because efficiency is not the only criterion by not quite, Well, is typically there And or equity. about issues of fairness also care People economy. often come and efficiency: policies that promote equity a trade-off between equity versa.’ and vice efficiency in the economy, of decreased at a cost and Krugman (2005: 15) Wells question is a normative place should take of income How much redistribution The idea can also be applied to developed countries. The Human Poverty Index Index Poverty The Human countries. The idea can also be applied to developed Australia 11.6 United States 21.7 States 11.6 Australia 12.4 Greece United Germany 10.9 United Kingdom 16.2 Kingdom 10.9 Germany United household income, circa 2000 circa income, household Country% 14.6 2.4 Denmark % Country 3.4 Finland Zealand Norway3.6 13.1 Hungary 3.6 Sweden 13.3 Austria 6.7 Belgium 13.6 Canada 6.8 Switzerland Japan 14.3 Republic Czech New 7.3 France Netherlands 9.0 7.2 15.7 Poland Ireland 15.6 Italy 15.7 Spain 15.6 Note population. by is not weighted average The overall composition. Source about which economists have no more ethical expertise than other citizens. What What ethical expertise than other citizens. no more have about which economists thinking clearly about the question. for is a framework they hope to contribute The or social justice. ‘equity’, greater are redistribution The benefits of income This trade-off is illustrated Arthur by Okun’s less efficiency. presumably are costs to in Chapter 1: redistributing metaphor referred we which ‘leaky bucket’ famous – the carrying the rich to the poor using a leaky bucket is like water from income of water spilled at a cost on the ground, equitable, but comes may be more result normally assumed to be wasted. in the United Nations Development Programme’s Human Development Reports Reports Development Human Programme’s Nations Development in the United of a measure of survival UNDP 2007) includes the probability to age sixty, (e.g. (attempting to unemployment of long-term and a measure literacy functional an aspect of social exclusion). capture table redistribution 1.5 Income
9 | Government, taxation its be (The (The * that and a book] with idea just this not indicates this of defined 7 is water may not be out of the water may not be out of the this income, Chapter Shouldn’t have, poverty elative terms. In the United States, States, In the United terms. elative in Some textbooks accept this approach. this approach. accept Some textbooks ) 201 If relative text? others by the Other goals for 1990–2015 include other absolute include other absolute 1990–2015 Other goals for isolation. + explored that in in as professor: income determined [e.g. income your is the elsewhere own for to mentioned implications person’s well-being well-being respect Question with particular is sometimes viewed with children among families Poverty and deprivation, however, of poverty absolute measures useful are There Poverty can be defined in absolute or r can be defined in absolute Poverty concern because it violates the generally accepted principle of equality of oppor- principle of equality because it violates the generally accepted concern range of variation across the rich countries; 9.4 shows the enormous Table tunity. States than in Denmark. nine times higher in the United rate is the child poverty such as those of arguments widely used as a result more become which have of Amartya the importance Sen (1999), which stress of also measuring people’s abilities to people’s to this are Fundamental life. capabilities to lead a decent reflected nutrition. These are adequate death and to receive premature avoid Bank (2008: 354) in its the World indicators reported by in the development of malnutrition Report. These include the prevalence Development annual World mortality of the United rate. One under-five and the under age five of children mortality two- by under-five Goals is to reduce Millennium Development Nation’s thirds between 1990 and 2015. the official poverty line uses an absolute measure of poverty that is not adjusted is not adjusted that of poverty line uses an absolute measure the official poverty living standards. changes in average for measures of poverty: halving the proportion of people whose income is less than halving the proportion is less than of poverty: of people whose income measures hunger. from and halving the proportion who suffer US$1/day that one family got $91, while the remaining families received only $1 each. The The only $1 each. received families remaining while the $91, got one family that is 0.81.’ this distribution of Gini coefficient 1.4 Poverty median household is the middle one in a ranking from richest to poorest.) The richest to poorest.) The one in a ranking from median household is the middle cul- are is that ‘necessities’ of poverty measure using a relative justification for turally plumbing or hot determined. Lack of indoor as community be in a rich one. Hence, but it would ordinary in a poor country, deprivation, of relative a feeling standards those left behind experience increase, The condition. no absolute change in their if they experience even or poverty, ‘social causes them to experience and others growing gap between themselves as opposed to ‘social inclusion’. exclusion’ Others reject this and argue for relative approaches such as a definition of such as a definition of approaches relative for this and argue Others reject that of the median household. that is less than half as income poverty against redistribution against redistribution 204 against and government The benefits from increased government spending that taxes The benefits from increased - The emphasis on the inefficiency of taxes reinforces the examples given in The emphasis on the inefficiency of taxes reinforces the examples the discussion of The order of topics in the texts almost invariably buries about the This placement of topics in textbooks reflects authors’ judgements is no significant equity–efficiency trade-off, if policies are well designed. Pov- well designed. are if policies trade-off, equity–efficiency significant is no any reduced without can be greatly many countries inequality in erty and growth. terms of economic cost in responsible for large inequali- within societies are and economic inequalities millions of people many years life expectancies that cost ties in health and of life. of the textbooks, David George points In a perceptive study of the rhetoric on how the ‘burden’ will be shared and With taxes, the texts focus attention make possible are made much less clear. In a book already weighted towards less clear. make possible are made much what choice is the the attainment of efficiency in the use of scarce resources, trade-off? reader invited to make when it comes to the equity–efficiency in Chapter 3). They the texts in the supply and demand applications (reviewed things up: mini- are typically ones in which the government appears to mess shortages, mum wages increase unemployment, rent controls create apartment losses. This might subsidies create inefficiencies and taxes create efficiency was referring to when he Reagan have been what former US president Ronald are “I’m from the said: ‘The nine most terrifying words in the English language 1994: 130). government and I’m here to help”’ (Vitullo-Martin and Moskin (In fact it’s in the government, taxation and redistribution deep in the book. that we decided same relative location as we have placed this chapter given suspect that many economics to parallel the structure of the typical text.) We courses never quite manage to get to the topic. nature of textbooks, relative importance of topics, or, given the profit-oriented professors consider it reflects their judgement about what other economics is spent develop- important. The main part of the microeconomics textbooks resources are used ing an imaginary world of perfect competition in which efficiently, and then comparing that with other market structures. This can only reflect a value judgement that income distribution and the government’s role in redistribution are not very important. 3 that social the textbooks) shows ignored by evidence (entirely A great deal of in the texts, government ‘tends to be treated out that given the order of topics the private sector has established itself’ (1990: as an entity emerging only after with markets for private goods. 863). The government then ‘interferes’ the efficiency cost of taxes. (Ironically, the goods on technical explanations of ‘efficiency loss’ of excise taxes are goods that usually chosen to illustrate the may not be any efficiency loss at all, as discussed have externalities. Hence, there in Chapter 7.) 2.1 The subtle bias
9 | Government, taxation trade-off 9.2 equity–efficiency The figure 203 , E uity . A . The set-up is an application of the familiar logic of comparing marginal marginal logic of comparing of the familiar is an application The set-up is low (and when equity returns: As drawn, the line shows diminishing takes as redistribution on incentives effects adverse chiefly the The leaks are is not to say where the job of the economist to the official version, According against redistribution in particular. Economic inequality and issues of equity Economic inequality and issues of equity against redistribution in particular. get relatively little treatment compared with the problems of seeing that resources are used efficiently. Efficiency benefits and marginal costs. The general idea of the trade-off is sketched out out of the trade-off is sketched The general idea costs. benefits and marginal something measurable on the horizontal axis, let have 9.2. So that we in Figure one has to equity, Thus to get more inequality. less income mean ‘equity’ greater income of reducing price the are incomes average Lower less efficiency. accept inequality. in little cost relatively have is high), as at A, improvements inequality equity small. are Further ‘leaky bucket’ The leaks in Okun’s efficiency. terms of economic amounts of sacrificing increasing require and poverty in inequality reductions gets leakier and leakier. The bucket income. and hence efficiency, slices; in different pie’ is not just cutting up the ‘economic Redistribution place. the work effort of it may affect example, For of the pie itself. the size it affects A certain amount of inequality those who get transfers. and those who pay taxes income. is necessary to produce to maintain individual incentives is just to on this trade-off society should be. Rather the job of the economist public debate, and if possible to think of ways to inform economics: do positive a society ends up depends on individual Where the trade-off. of improving political institutions translate and how society’s about social justice erences pref and other measures and transfers about taxes choice these into a collective the distribution of income. affecting 2 Both economic theory and the empirical evidence support the view that there 1 The texts contain a subtle bias against government action in general and 2 THE ANTI-TEXT 2 THE a case for the fol- Our goal for the remainder of the chapter will be to make lowing claims: Then the Pareto principle becomes: Then the Pareto . B A 206 Income Income 9.3 distribution and equality Income figure ’ But, as Marglin (2008: 180) notes, ‘this appears to offer a way of talking about But, as Marglin (2008: 180) notes, ‘this appears to offer a way the claim that If we accept that value judgement, and if we also accept It’s easy to overlook the assumption that the income distribution doesn’t It’s easy to overlook the assumption that the income distribution If some people’s incomes go up and other people’s incomes are unchanged, society If some people’s incomes go up and other people’s incomes are When it’s not possible to make anyone better off without making someone anyone better off without making someone When it’s not possible to make outcome. If ‘better off’ and ‘worse optimal’ else worse off, we have a ‘Pareto determined as they see fit, at first glance this off’ refer to individuals’ utilities, et al. (2006: 356) put it, ‘It’s hard to object to seems innocuous. As Colander life optimal policies because, by definition, they improve the notion of Pareto for some people while hurting no one.’ ‘value judgements societal well-being without invoking value judgements’, yet that social well- continue to be present, hidden in the foundational assumptions self-interested being consists of satisfying the rational, calculating individual’s pursuit of consumption’. do we implement the Pareto individuals’ utilities can’t be compared directly, how As discussed principle to think about whether an economic policy is desirable? goes up (with in Chapter 4, the texts assume that utility goes up if income assumption prices unchanged) and, despite the evidence, slip in an unstated that no one cares about what others have. ‘ is better off. or not. Consider matter, that it’s irrelevant whether a policy increases inequality them is that one situations A and B in Figure 9.3. The only difference between care about how person’s income has gone up in B compared with A. If people absolute incomes their incomes compare to those of others, the people whose remain the same will judge themselves worse off in B than in A. If so, the Pareto principle can’t be used to say that B is better than A because some people’s utilities have decreased.
9 | Government, taxation little value so a give reflect text Let’s consider a specific ex- that the Does does Why 205 , John Weeks wrote: wrote: , John Weeks important? very inequality? not professor: it’s your economic that to for judgement attention Questions A different value judgement is possible. In the first words written in the in the words written first In the is possible. value judgement A different of – inequality is inequality the American economy reality of The overriding to the ability to determine of power, inequality with regard income, inequality be all about. But, in fact, eco- is what economics should one’s life. Inequality deals very little with inequal- and practiced by economists nomics as it is taught (1969: 1) ity. He might be right, but our concern here is simply to illuminate the value He might be right, but our concern here is simply to illuminate We made the case (in Chapter 4) that a person’s situation relative to others made the case (in Chapter We ample of a hidden value judgement. Introductory textbooks rarely give a careful ample of a hidden value judgement. Introductory textbooks welfare of society as and explicit discussion about how we can think about the policies, they a whole. ‘When professional economists think about economic generally start with the principle that a change is good if it makes someone That idea … is referred to as better off without making anyone else worse off. (1999: 34). Feldstein principle,’ explains Harvard professor Martin the Pareto Journal of Radical Political Economics Political of Radical Journal The Pareto principle: when is ‘society’ better off? The Pareto judgements, not to explain them. Gunnar Myrdal (1969) dismissed any pretence judgements, not to explain them. Gunnar Myrdal (1969) dismissed pointed out that that social scientists might make about their ‘objectivity’ and advocated making value judgements must permeate their work. Instead, he of them and could one’s value judgements explicit so the reader would be aware unheeded and decide whether to accept them. Sadly, his advice has gone largely their own. readers must be alert to detect hidden value judgements on strongly influences well-being. Growing income and wealth inequalities fuel the strongly influences well-being. arms race that we examined in Chapter 7. wasteful ‘conspicuous consumption’ So why is see more evidence shortly of the damage that inequality causes. We’ll end of the book? Why is redistribution viewed this chapter buried towards the believed that it was just self-interest: Weeks as relatively unimportant? John from the existing social and economic ‘our profession gains disproportionately social and This is why economics provides no guide to an alternative order. exploitation would economic system in which inequality, acquisitiveness, and be eliminated’ (ibid.: 1). This remains true today, with the exception that in economics research there that in economics research today, with the exception This remains true interest in inequality, perhaps because inequality has been a greatly increased countries, particularly the United States. is growing so rapidly in some in- , his study social and text the the people’s does other increases What any The Rhetoric of Reaction policy a policy? If 208 decreasing desirable a without professor: trade-off fit neatly into Claims of an equity–efficiency be policies? rich your that the for such of sphere by recognizing that minimal conditions of education, health, sphere by recognizing that minimal would about comes in Does it make sense to talk about an ‘equity–efficiency’ trade-off? Julian Does it make sense to talk about an ‘equity–efficiency’ trade-off? Julian Questions the concept of citizenship to the … in the twentieth century extended economic are basic to the life of a civilized being as well economic well-being, and security the civil and political attributes of citizenship. as to the meaningful exercise of (Hirschman 1991: 2) minimum The welfare state programmes typically include: a guaranteed to welfare state Hirschman identifies several claims made in opposition say comes, LeGrand points out that ‘efficiency’ by itself is not a primary social objective like income of some kind (insurance against destitution); cash transfers to provide income of some kind (insurance against destitution); cash old age; and equality greater security in the event of illness, unemployment and regardless of ability of access to certain social services as a right of citizenship, health services, but also These include public education and public to pay. possibly housing and personal social services (Gough 1987). desirable in programmes. One is that ‘the proposed change, though perhaps or another’ (1991: itself, involves unacceptable costs or consequences of one sort trade-off appeared 81). Arthur Okun’s influential book on the equity–efficiency time, the argument just after the economic turmoil of the early 1970s. At this growth’ and against the welfare state became ‘that it was at odds with economic the postwar period’ ‘would jeopardize the conspicuous economic successes of that if his (ibid.: 115). Okun himself was no reactionary, and was optimistic hold plenty when it leaky bucket ‘is filled in reasonable ways’ then ‘it can still an empirical one: reaches the deprived’ (1975: 101). This makes the question how leaky is Okun’s bucket if ‘filled in reasonable ways’? 2.2 The equity–efficiency trade-off, reconsidered being made better off and some worse off. We’ll discuss in the next chapter next chapter in the discuss We’ll off. worse some off and better made being off in such off or worse to be better society as a whole judge how economists situations. The rhetoric of reaction of the arguments used over the last 200 years against the development of civil, of the arguments used over the rights. What we’re interested in here are argu- political, social and economic which ments against the ‘welfare state’, a pattern identified by Albert Hirschman in a pattern identified by Albert
9 | Government, taxation / '& 207 Feldstein has neatly substituted the original ‘common-sense Pareto principle’ principle’ the original ‘common-sense Pareto has neatly substituted Feldstein principle (or words to that effect) and define When the texts offer the Pareto There is evidence of how people actually think about this Feldstein/textbook society depend on the initial optimal’ outcomes available to The ‘Pareto In any case, given the distribution of income and wealth, the scope for Pareto Rather than sweeping the question of rising inequality under the rug, Martin Martin the rug, under inequality of rising question the sweeping than Rather high- the incomes of that increase changes only in evaluating I am interested of others. Such a change without decreasing the incomes income individuals it principle: It is good because the common-sense Pareto clearly satisfies I think anyone else worse off. better off without making makes some people though it increases inequality. be regarded as good even such a change should (1999: 34) that refers to utilities for the version that refers to incomes. He does this while that refers to utilities for the some people ‘regard increasing the income of the going on to acknowledge that if that increased income does not come at any- wealthy as a “bad thing”, even conclude that even when some people Feldstein one else’s expense’. How does improvement? He does it by labelling a Pareto feel worse off there has been whose views should be rejected. They such malcontents ‘spiteful egalitarians’ of society! Given that concern about one’s rela- simply don’t count as members of human nature and not some moral defect, tive position seems to be a part position at a It is also a politically expedient position is peculiar. Feldstein’s the rest of the US time when incomes at the top soared while the incomes for population largely stagnated. in individual whether people are ‘better off’ and ‘worse off’ in terms of changes They just don’t state the consequences incomes, they are agreeing with Feldstein. as openly and candidly as he did. Amiel and Frank Cowell investigate this principle. Yoram version of the Pareto to evaluate situ- through a series of carefully constructed surveys, asking people perfectly reasonable ations like that illustrated in Figure 9.3. They noted that it ‘is incomes’ (1999: to suppose that … well-being may be affected by other people’s the addition to 54). They found that in situations like Figure 9.3, the greater of respondents who the income of the ‘rich’ person, the smaller the proportion (ibid.: 64). considered that the society as a whole was made better off leads to demands distribution of wealth and income. Each possible distribution re- efficient’ allocation of society’s and supplies that result in a particular ‘Pareto devoted to security sources. A highly unequal society might see a lot of resources wealth was initially systems to protect the mansions of the rich; a society where and healthcare. distributed equally might devote resources to universal childcare efficient’, but not equally desirable. Both outcomes could be ‘Pareto gains is virtually non-existent. Economic policy typically results in some people Feldstein confronts it in an interesting way. He writes, way. it in an interesting confronts Feldstein 9.1 shows that taxes Table 210 Those models that examine explicitly the effects of inequality on Those models that examine explicitly the effects of inequality '( ‘Equity is complementary to the pursuit of long-term prosperity. Greater Greater prosperity. to the pursuit of long-term ‘Equity is complementary to favour sustained overall good for poverty reduction. It tends equity is doubly to the poorest groups in a it delivers increased opportunities development, and society.’ Bank 2005) Bank (World chief economist, World François Bourguignon, By the late 1980s, this view was reflected in the ‘new growth theory’. Many of By the late 1980s, this view was reflected in the ‘new growth This touches on an important distinction between ‘static efficiency’ and efficiency’ and This touches on an important distinction between ‘static The evidence about an equity–efficiency trade-off trade-offs between growth and equity explicitly, rather than obscuring the issue the issue obscuring rather than explicitly, and equity growth between trade-offs (ibid.: 32). to efficiency’ by reference in theory trade-off of the equity–efficiency The demise in the development of the advanced welfare The economists who participated the middle of the twentieth century learned from states of northern Europe in effects. Gunnar Myrdal explained that welfare experience its growth-enhancing the belief that they would result in lower state policies were created despite that welfare reforms, instead of being growth. But then ‘the idea emerged laying the basis for a more steady and rapid costly for a society, were actually in housing, nutrition, health and education and economic growth’. Investing with children, especially to underprivileged redistributing income to families future costs and increasing future productivity families, pays off by avoiding (Myrdal 1973: 40–41). of human capital these ideas about ‘endogenous growth’ stress the importance for growth of the (as reflected in education and skills), and the importance way of saying that ‘intergenerational transmission of human capital’ – a fancy socio-economic children’s prospects are importantly influenced by their parents’ situation. growth predict that lower inequality should be associated with higher long- growth predict that lower inequality should be associated term growth (Osberg 1995). efficiency’ that we mentioned in Chapter 6 in the context of Schum- dynamic ‘ oligopolistic indus- peter and Baumol’s ideas about the dynamic efficiency of is about ‘static’ tries. The textbook story of the efficiency loss due to taxation with them would inefficiency; reducing taxes and the inefficiencies associated efficient’ is give a one time gain in income. An economy that is ‘dynamically taxes are used to one that optimizes its growth rate. If the statically inefficient growth even reduce inequality and that, in turn, increases the rate of economic The higher growth slightly over time, then the result can be dynamically efficient. 1995). rates eventually lead to much higher levels of income (Osberg amount to half of Denmark’s total production; Table 9.2 shows its comparatively amount to half of Denmark’s total production; Table 9.4 shows that Denmark has almost low levels of economic inequality, while Table In Figure 4.4 we saw that Denmark is among the world’s eliminated child poverty.
9 | Government, taxation 209 of increased production should also be taken into costs © Andy Singer The person ends up with more money income, but less utility. It looks It looks The person ends up with more money income, but less utility. '' He illustrates with an example of a simple policy change that induces a person He illustrates with an example of a simple policy change that LeGrand is surely right in suggesting that production and its growth have LeGrand is surely right in suggesting that production and In the context of an ‘equity–efficiency’ trade-off, ‘efficiency’ seems to mean In the context of an ‘equity–efficiency’ trade-off, ‘efficiency’ to work more and so to earn more income, while taking less leisure time (ibid.: to work more and so to earn more income, while taking less 35–6). account. Yet these are frequently neglected’ (ibid.: 31). account. Yet been elevated ‘to the status of a primary objective’ because it’s assumed that been elevated ‘to the status of a primary objective’ because utilities’ (ibid.: 31). ‘increases in production lead to increases in individuals’ for this assumption in Chapter 4 when consider- saw the dubious evidence We points out another ing subjective well-being in wealthy countries. But LeGrand problem: ‘the utility something else, such as maximizing the value of total production or its rate something else, such as maximizing the value of total production production or of growth. But LeGrand raises a fundamental point: increasing only useful if it con- its growth rate is also not a primary social objective. It is he calls ‘aggregate tributes to some primary objective, like a measure of what it is between primary want-satisfaction’ (LeGrand 1991: 30). If there is a trade-off, But that is not the trade-off that objectives like aggregate well-being and equity. appears in the texts or in the economics literature. ‘equity’; it’s just a means to an end, namely attaining primary social objectives, ‘equity’; it’s just a means to an to get closer have efficiency if it’s not possible whatever those might be. We away from attaining to achieving one social objective without getting farther another. as if ‘efficiency’ has been increased, but well-being has gone down because of the reduction in leisure. LeGrand argues that it would be better to separate ‘the idea of efficiency from that of economic growth and to discuss the issue of any E uity 212 trade-offs. If society collectively wants more of trade-offs. If society collectively 9.4 The equity–growth trade-off always Obser ed income ine uality some ere it in t is range ') figure
Inde of income ine uality declines in t is direction r t Gro ‘It is well-known that higher taxes and transfers reduce productivity. Well known Well productivity. reduce taxes and transfers that higher ‘It is well-known or history.’ by statistics – but unsupported p. 227) (ibid.: vol. 1, Lindert Peter trade-off The research we’ve described suggests that the real equity–efficiency about it’s So is the trade-off featured in the textbooks really a myth? Perhaps The evidence seems to show that, on average, governments haven’t been run The evidence seems to show that, may look something like Figure 9.4. Over a wide range of income inequality, may look something like Figure 9.4. Over a wide range of as reflected there is essentially no relationship between equity and efficiency, or inequality not by the growth rate. Beyond that range, for degrees of equality directly. actually observed, the empirical evidence doesn’t say anything The equity–efficiency trade-off lives on despite the evidence the on despite lives trade-off equity–efficiency The fact, on in the textbooks if, in trade-off lingering Why is the equity–efficiency the range of income inequality evidence for it, at least within there is so little is ideology explains that ‘[t]he source Lindert observe? Peter that we actually down run badly, they would drag that if governments were and a valid theory on did nothing but tax people It is true that ‘if governments economic growth’. and give it to other people who were unproduc- the basis of their productivity unproductive with those grants – it would make tive – encouraging them to be risk, and innovate less’ (2004a: 7). everybody work less, take less egalitarian outcomes does not seem More social spending to attain more badly. cost in terms of either the level of per-person to have come at any significant It provides a nice counter-example to what is incomes or their rate of growth. of economics: ‘There’s no such thing as a free supposed to be a central truth lunch’ because there are one good (greater income equality) it must give up some other good (the size one good (greater income equality) of the ‘economic pie’).
9 | Government, taxation 211 it is probably imprudent to make the case for a more equitable society on the it is probably imprudent to make the case for a more equitable The empirical evidence of the basis of the efficiency effects of increased equality. In any case, positive impact of greater equality on efficiency is still inconclusive. efficiency for many a more equitable society is a goal in itself and any positive of major effect is an added bonus. Equally, there is little conclusive evidence (2003: S13) negative effects on efficiency from equality. the Lindert examines the relationship between In an important study, Peter In reviewing such studies, Sarah Voitchovsky (2005: 274) writes: ‘The debate Voitchovsky In reviewing such studies, Sarah using data Instead, she examines a group of relatively high-income countries Andrew Sharpe concludes that, While a lot can be learned from the experience of places like Denmark or places like Denmark experience of from the lot can be learned While a social transfers (unemployment insurance, income support, pensions, public social transfers (unemployment insurance, income support, part of the welfare healthcare spending, housing subsidies) that are a central state and economic growth. Looking at the experience of about twenty OECD countries between the early 1960s and the mid-1990s, he found no significant effect of social transfers on economic growth (Lindert 2004b: vol. 2, ch. 18). continues … as to whether the ultimate effect of overall income inequality on continues … as to whether the studies’ not significant. Nevertheless, it seems that growth is positive, negative, or the econometric method employed, and the data conclusions depend notably on in light of our discussion in Chapter 2 of the considered.’ This is not surprising testing. She points out that ideas about the difficulties of conclusive empirical centre around inequality at the bottom of growth-retarding effects of inequality inequality at the top end of the distribution is the income distribution, while inequality the effects of income growth. Testing sometimes seen as facilitating misses these using a single measure of inequality such as the Gini coefficient 273–4). differences and looks only at some average of the effects (ibid.: by an income on their income distributions. She finds ‘that growth is facilitated but not distribution that is compressed in the lower part of the distribution, as progressive tax- so at the top end. In this view, redistributive policies – such their impact on ation and social welfare – are likely to facilitate growth through their impact onthe bottom of the distribution, and to inhibit growth through the unclear. top of the distribution’ (ibid.: 290). The net effect remains Gunnar Myrdal’s Sweden, economists also like to consider the combined experi- the combined also like to consider economists Myrdal’s Sweden, Gunnar at the theories were developed The endogenous growth ence of many countries. to make statistical examination enough data had accumulated same time as the 2004a). Studies examined of countries possible (Lindert of a large sample into of countries, while taking relationship looking at groups growth–inequality theory suggests will also influence other factors that economic account the many 1994; Barro 2000). 1994; Alesina and Rodrik and Tabellini growth (Persson most prosperous countries and its people among the happiest. How can a place a place How can the happiest. among people and its countries prosperous most and equity? efficiency trade-off between is a serious exist if there like Denmark – the idea 2 Ot er 23 lerical social gradient of health 214 1 e ecuti e Professional : Adapted from Marmot et al. (1978: Fig. 3) Fig. Marmot et al. (1978: : Adapted from Such gaps in life expectancies within affluent countries Such gaps in life expectancies '+ 1 Source 9.5 other risk factors death excluding risk of CHD Relative Administrati e figure 3 2 1 2 1 While the health of those at the top and those at the bottom of the social While the health of those at of ill-health The idea of socio-economic inequality as a primary determinant countries, While average life expectancies don’t differ much between wealthy Task Group 2004: 1). Task are not unusual, but they are largely preventable. are not unusual, but they are is also affected hierarchy can differ greatly, the health of everyone in between example, the results by their socio-economic position. Figure 9.5 illustrates one civil servants. of a major study of coronary heart disease (CHD) among British greater chance of Those in the professional/executive grade had a 1.8 times the policy- having CHD than those just one rung above them in the hierarchy, in the civil service, makers in the top administrative grade. The lower the grade the higher the risk of CHD. centres on how well may seem surprising. Most public debate about health policy (e.g. food the healthcare system works, and issues of public health regulations campaigns). and water quality) and individual behaviour (such as anti-smoking inequal- there is ample evidence to show that the effects of socio-economic Yet If African-Americans had the same death rates as whites, there ity are deadly. 2000 in the United would have been 886,000 fewer deaths between 1991 and States (CSDH 2008: 30). and significantly within those countries life expectancies differ systematically and the income, their occupation between different groups of people. People’s and control over social status attached to it, the degree of economic security of which are inter- work and home life, and their social connectedness (all related) are all important determinants of individual health. Deficiencies in these things result in increased chances of poor mental and physical health and premature death. This is the so-called
9 | Government, taxation '* in sig- a a standards states for is living welfare there If evidence average the high-tax high-tax is low the trade-off? trade-off? and What 213 haven’t countries? growth Those at the top of the hierarchy experience not why low professor: lower-tax lower-tax your equity–efficiency equity–efficiency for with trade-off, trade-off, experienced compared Europe significant nificant Questions on a grand scale.’ ‘Social injustice is killing people Commission on the Social (CSDH 2008: 26) Health Organization Determinants of Health, World seen earlier, particularly in Chapter 4, evidence of the importance of We’ve only feelings of greater well-being (as we saw in Chapter 4), but also significantly only feelings of greater well-being (as we saw in Chapter 4), Marmot, one better health than those at the bottom. Epidemiologist Sir Michael social inequalities of the foremost researchers in this area, explains that ‘these in countries in health … are not a footnote to the “real” causes of ill-health He points out that that are no longer poor; they are the heart of the matter’. DC, there is in places of great inequality, such as the area around Washington, and the rich – a a twenty-year difference in life expectancies between the poor (2004: 2). Men in gap as big as that between men in Japan and in Kazakhstan men in a poor area an affluent area in Glasgow live to an average of eighty-two; of the city average fifty-four years (CSDH 2008: 32). In Canada, there is a five- year gap in men’s life expectancies between the top fifth and the bottom fifth of the income distribution and a two-year gap for women (Health Disparities relative position for individuals’ feelings of well-being. But the focus of textbook relative position for individuals’ feelings of well-being. But the As a result, it economics is on the individual removed from social context. in society except largely ignores the question of individuals’ relative position phenomenon. for admitting its existence briefly by defining poverty as a relative a fundamental feature of human (and most other primate) societies is their Yet their place in it. social hierarchy and the acute awareness everyone has of 2.3 costs of pervasive The inequality The social gradient of health as much a myth as the ‘law’ of diminishing marginal returns. As we saw in Chap- we saw As returns. marginal of diminishing the ‘law’ as a myth as much diminishing existence of the possible ideas to support are theoretical ter 5, there seems of production good management actual practice returns, but in marginal of firms. The majority in the great irrelevant in practice to make it to be able there are some theoretical for the equity–efficiency trade-off: same can be said (perhaps very low) level of income suggest its existence at some ideas that would part of the curve in Figure out in the downward-sloping inequality (as sketched in practice. 9.4), but it is irrelevant The lifetime risk of death '- 216 discussion of health inequal- this point, the To ‘There will always be inequalities in society but the magnitude of their effects ‘There will always be inequalities in society but the magnitude is in all our in- on health is within our control. Why not make things better? It terests.’ 266) Michael Marmot (2004: The conditions of early childhood have similarly important effects on long- of early childhood have similarly The conditions If domestic inequalities are unjust, these international ones must be even If domestic inequalities are unjust, these international ones only the way the equity–efficiency trade-off is discussed in the texts, Yet ities has been only about inequalities within countries. But international in- ities has been only about inequalities and are entirely due to the ities in health and life expectancies are huge equal Flattening the social gradient Health Organization’s Commission on the Social Determinants of The World Health has recently set out a detailed plan to close the health gap between people within countries and between countries within a generation (CSDH 2008). It writes: mother’s circumstances and shows a remarkably strong correlation with health health with correlation strong a remarkably shows and circumstances mother’s with negatively associated birth weight is example, likeli- the life. For throughout in and with diabetes 81ff.) 2005: and strokes (Wilkinson heart disease hood of 15). Marmot 2003: and and old age (Wilkinson middle report cards on OECD countries’ UNICEF issues periodic term physical health. large education and care showed recent study of early childhood performance. Its measures set out ten benchmark countries. UNICEF has differences between their the rights of children in standards for protecting as ‘a set of minimum years’ (UNICEF 2008: 2). Sweden scored 10/10; most vulnerable and formative last at 1/10, even worse than the United States Canada and Ireland were dead no surprise that Sweden may have been it’s (3/10) and Australia (2/10). Perhaps the relationship between children’s height the first country to have eliminated and income of their parents (Lindgren 1976). and weight and the social class The gradient, internationally in childbirth is 1 in 8 in Afghanistan; in Ireland it’s 1 in 47,600 (CSDH 2008: in childbirth is 1 in 8 in Afghanistan; in Ireland it’s 1 in 29, 154). (Pogge more so. Philosophers make a strong case for extensive redistribution foreign aid, while 2008; Nagel 2005), governments acknowledge it with their public support in many countries international redistribution has widespread such as through charitable contributions to non-governmental organizations Oxfam. outside the borders people within the national borders count. Redistribution is virtually off the agenda. circum stances in which people find themselves. For instance, if infant mortality instance, For stances in which people find themselves. circum live births), there in the world were the same as that in Iceland (2 per 1,000 would be 6.6 million fewer infant deaths every year.
9 | Government, taxation ig The Social Determinants of Weight at birth is related to the Weight ', 215 Socio economic status 9.6 The social gradient of health , Richard Wilkinson and Michael Marmot review both the figure Lo
ig
Lo rg el sau fid iduals indi of status ealt erage A Why do these psychosocial factors affect physical health? In emergencies, our Why do these psychosocial factors affect physical health? In emergencies, physical hormones and nervous system prepare us to deal with an immediate rate, mobil- threat by triggering the fight or flight response: raising the heart alertness … [T] izing stored energy, diverting blood to muscles and increasing from many urning on the stress response diverts energy and resources away Both the physiological processes important to long-term health maintenance. brief periods, this does vascular and immune systems are affected. For cardio on too long, not matter; but if people feel tense too often or the tension goes infections, they become vulnerable to a wide range of conditions including and aggression. diabetes, high blood pressure, heart attack, stroke, depression (2003: 12–13) and have life- The effects of socio-economic inequality begin before birth In their book for the World Health Organization, Health Organization, In their book for the World In general, the relationship is not linear, but resembles a field hockey stick, In general, the relationship is long consequences. Wilkinson and Marmot state that ‘the foundations of adult long consequences. Wilkinson and Marmot state that ‘the example, health are laid in early childhood and before birth’ (ibid.: 14). For maternal stress and anxiety reduce blood flow to the uterus, while the fetus also experiences the stress hormones directly. as shown in Figure 9.6 (Health Disparities Task Group 2004: 4). Average health as shown in Figure 9.6 (Health Disparities Task status, but falls status is systematically lower the lower one’s socio-economic more rapidly at lower levels. that average health and life expectancy decline systematically the lower people that average health and life expectancy are in the social hierarchy. Health: The solid facts They evidence of the social gradient of health and its policy implications. ask: , an excellent journal with clearly written 218 Challenge The Spirit Level: Why more equal societies almost always The Status Syndrome: How social standing affects our , is a book that may change the way you understand human , is a book that may change the way you understand It doesn’t have to be this way. For example, Goodwin et al. (2005) example, For to be this way. It doesn’t have '. (2009) provides a wealth of information on the pervasive effects of (2009) provides a wealth of information on the pervasive For the students who get to this topic in the conventional text, the authors in the conventional text, students who get to this topic the For basic textbooks is sympathetic to the But the world-view in the mainstream Wilkinson and Pickett’s What have we seen? While giving lip-service to equity as a social objective, in as a social objective, to equity giving lip-service we seen? While What have views in Lindert (2004a) provides a clear and compelling case for his Peter Marmot’s 2004 book, place it in a core chapter in the centre of their book. This reflects a different book. This reflects a different chapter in the centre of their place it in a core obviously endorse. on their part, one that we value judgement that there is a real trade-off the absence of convincing evidence, suggest, despite then ignore the evidence about the pervasive They between efficiency and equity. on health and mortality, documented in detail effects of economic inequality in millions of premature deaths every year just and beyond dispute, that result A simple presentation of the facts would lead in the wealthy countries alone. what to do about them. inevitably to the question of nature and our social world. He played a leading role in the World Health Organ- World nature and our social world. He played a leading role in the whose 2008 report ization’s Commission on the Social Determinants of Health sets out how a better world is possible. do better inequality on societies. practice the texts relegate questions of income distribution and redistribution to and redistribution income distribution questions of the texts relegate practice pursuit of to the of secondary importance as if these are of the book, the back ‘efficiency’. 2004 issue of the July/August students. articles and interviews accessible to undergraduate economics health and longevity 2.4 Summing up Summing 2.4 Suggestions for further reading features of the status quo. It appears that textbook authors reflexively shy away features of the status quo. It appears challenge the existing distribution of power from raising questions that would they fear that and between them. Perhaps and wealth, both within countries of being ‘ideological’. But it doing so would open them up to accusations inconvenient ques- is equally ideological to avoid raising uncomfortable and tions.
9 | Government, taxation is why killing introduc- is claims, an Organization’s in Health injustice theme of Health major have focused our discussion only We World ‘social ‘social a 217 If the not as Determinants this Social professor: scale’, about course? the your grand on a for on something economics tory doing Commission people The Commission’s recommendations include measures to provide afford- The Commission’s recommendations life and death for millions of people and the Health equity is a matter of Question The poor health of the poor, the social gradient in health within countries, and countries, health within in gradient the social poor, of the poor health The by the unequal are caused between countries health inequities the marked the and nationally, services, globally goods, and of power, income, distribution lives of people’s visible circumstances in the immediate, unfairness consequent their conditions of work health care, schools, and education, – their access to or cities – and their chances of homes, communities, towns, and leisure, their of health-damaging experi- life. This unequal distribution leading a flourishing but is the result of a toxic sense a ‘natural’ phenomenon ences is not in any unfair economic arrange- poor social policies and programmes, combination of 1) ments, and bad politics. (Ibid.: More commonly understood is that great inequalities in income and wealth More commonly understood is that great inequalities in income able housing, improve working conditions, and to enhance economic security able housing, improve working so that people have assistance in the event through adequate social insurance or lack of adequate income. Most people of illness, disability, unemployment no social insurance, but there are serious health live in countries with little or countries. inequities even in most industrialized to address it. The evidence we’ve reviewed in knowledge and resources exist growth costs of such measures are (at worst) this chapter suggests that the about zero. Wealth, externalities and political power Wealth, are associated with inequalities in political power and influence that are in- are associated with inequalities in political power and influence says about the United As Edward Wolff compatible with a healthy democracy. an oligarchic society, with an extreme concentration becoming States, ‘We’re a political pro-of wealth. This concentration of wealth is protected through to have a voice’ cess that’s making it difficult for anyone but the monied class (quoted in Mattern 2002). on the health and mortality effects of inequality, which we suspect are not very on the health and mortality effects of inequality, which we 7, we explained the widely known. In our examples of externalities in Chapter because of its idea that visible consumption leads to external costs for others flow from the top influence on consumption norms. Because these externalities wealth inequalities down the social hierarchy, societies with greater income and should experience more of these external costs. table 10.1 International trade, 2007 (%)
10 | Trade and globalization without the rose- Country Exports/ Imports/ Share of Share of world GDP GDP world exports imports tinted glasses Some OECD countries Belgium 112.9 107.9 3.1 2.9 ‘There is no branch of economics in which there is a wider gap Netherlands 84.7 76.7 4 3.5 Sweden 52.4 44.8 1.2 1.1 between orthodox doctrine and actual problems than in the theory Germany 46.5 39.7 9.5 7.4 of international trade.’ Joan Robinson (1973a: 14) Korea, South 44.7 45.3 2.7 2.5 Canada 36.2 35.4 3 2.7 Mexico 32.4 35.8 2 2.1 We saw the idea of comparative advantage and the gains from specialization and France 26.9 28.9 4 4.3 trade in the production possibilities frontier model in Chapter 2. We considered United Kingdom 26.1 29.8 3.1 4.4 there the ‘gains from international trade’, a theme we examine further here. Australia 22.0 24.8 1 1.2 Japan 19.2 17.6 5.1 4.4 The case for free trade, presented to students as unassailable wisdom, rests United States 11.7 17.1 8.3 14.2 on shallow arguments and the shaky ground of value judgements shared by economists, but not, it seems, by the general public. Some non-OECD countries Saudi Arabia 63.4 31.6 1.7 0.6 Nigeria 43.0 26.2 0.5 0.2 1 THE STANDARD TEXT China (excluding Hong Kong) 40.8 33.1 8.7 6.7 Russia 30.5 21.8 2.6 1.6 1.1 The extent and growth of international trade South Africa 29.9 38.6 0.5 0.6 The importance of trade is typically expressed relative to the size of a India 20.1 25.1 1 1.5 country’s economy as measured by its gross domestic product (GDP). Trade Brazil 13.9 12.3 1.2 0.9 takes place not only in goods, but also in services such as shipping, tourism and education. Table 10.1 shows the relative size of exports and imports for a variety Note: GDP is not adjusted for purchasing power parity. This increases the ratios of exports and imports to GDP significantly for developing countries. of countries and their shares of total world trade. Source: World Trade Organization Statistics, Country Profiles, October 2008 Clearly, the trade/GDP ratios of the countries vary greatly and require care- ful interpretation. Belgium, for example, does not really export more than its entire GDP; the large value of exports relative to GDP must reflect goods made If the government imposes a tariff of $1/kilo on nails, the domestic price rises elsewhere that are both imported and then re-exported through its ports. As by the same amount. Foreign suppliers of imported nails must get $11/kilo of nails well, there are very large differences between exports and imports in some cases. so that after paying the tariff they still get the world price of $10/kilo. Otherwise, Saudi Arabia’s exports are more than 30 per cent of GDP larger than its imports. they would sell their nails elsewhere. The rise in price reduces the quantity This trade surplus reflects an accumulation of assets as it sells more than it buys demanded and increases the quantity produced domestically. As a result, imports from the rest of the world. Similarly, the substantial US trade deficit reflects an decline. ongoing accumulation of debt. The effect of the tariff is to make consumers of nails worse off and domestic producers of nails better off, while giving the government some revenue from 1.2 The economics of tariffs and import protection that tariff. What is the net effect? Let’s consider the effects of a tariff (i.e. tax on imports) on nails. For simplicity, First, note that the price increase reduces consumers’ surplus (the area under we consider the ‘small country’ case, where the importing country takes the the demand curve and above the price) by the areas a + b + c + d in Figure 10.1. world price of nails (here, $10/kilo of nails) as given: its imports are too small to Area c is the government’s tariff revenue, which involves no loss to society. influence the price in any appreciable way. Figure 10.1 illustrates this situation. At (Imagine that it is returned to the population as a cash transfer.) The domestic the world price, demand exceeds domestic supply; the difference is imports. nail producers get areas a + b as they produce more and at a higher price. Part of
219 220 against foreign against foreign advantage is not static; Comparative a 222 clear which industries are good candidates for good candidates for clear which industries are a country the may view Depending on its location and history, As part of their World Trade Organization obligations, many countries have have countries obligations, many Organization Trade As part of their World If all countries carry out such policies, ‘the world economy can achieve a more If all carry countries a more policies, ‘the out such achieve can economy world Unfortunately, it may not be Unfortunately, agreed to increase tariffs only in special circumstances (described below). In (described below). In tariffs in special circumstances only to increase agreed negotiators label tariff as reductions countries’ international trade negotiations, analysis rather than beneficial as economic costly, as if these were a ‘concession’, some for arguments some theoretically defensible however, are, There suggests. protection against imports,in some circumstances. at least and the citizens of other countries better off’ better countries other of the citizens and or 768–9) Bade 2006: and (Parkin it’ that engage in countries benefits to the mutual trade produces ‘[I]nternational 423). 2005: and Wells (Krugman of material well-being than it and a higher level efficient allocation resources of competi- to foreign 2005: 696). Exposure and Brue (McConnell can without trade’ best technologies on their toes, adopting the domestic producers tion also keeps around the linking of economies and productivity high. The low costs to keep also promotes (partworld through trade of ‘globalization’) of the broader process between costly. trading partnerspeace making war more by 1.4 domestic production protecting for Arguments imports National defence policy trade industries and strategic Infant country’s relative costs of production can change over time. If a domestic indus- of production can change over costs relative country’s domestic market a sufficiently large competition, foreign try protected from were aver- to lower advantage to take returns might enable it to expand of increasing of producing output with the experience also fall could costs Average age costs. that, and product development without doing’) and with research (‘learning by fledgling industry when the finally protection, would not be viable. Eventually, possibly start it survives without protection and could grows up, exporting its product. In the case of an oligopolistic industry might be economic there where with countries some of those profits for profits to be had, this policy secures firms in that industry. willsuch treatment, while there be no shortage protection. of applicants for Econ- retaliate affected. with tariffs if their exports could are Other countries efficient policy. that production subsidies would be a more omists also argue (This assumes prices. These would support without raising consumer producers no efficiency costs.) the subsidy have needed to pay for that taxes higher costs of domestic production as a worthwhile price to pay to be able to to pay to be able to of domestic production as a worthwhile price higher costs such a policy should go isn’t How far of war. itself in the event and defend feed however. easy to say,
10 | Trade and globalization r a ils Domestic ilos of nails ye Domestic demand for na su ly of nails from the tariff. The The the tariff. from D Q Decreased 1 D Q domestic consum tion tariff tariff after before 221 Im orts Im orts 1 S Q 10.1 of a tariff The effects net loss to society as a whole Increased S Q figure domestic roduction
, so really only area ‘a’ adds to their profits. If those who get adds to their profits. If those who get ‘a’ , so really only area
W
ls nai of Price 1 tariff 1 orld rice of nails P The net costs of a tariff or a quota are the same as the net gains from re- of a tariff the same as the net gains from The net costs or a quota are The analysis of a policy that limits imports to a certain (called maximum level P moving them. Consumers gain consumer surplus from the lower price and greater and greater price the lower surplus from gain consumer them. Consumers moving more directed are resources on the production side, society’s consumption; in the income advantage. Total towards the goods in which it has a comparative country saw in Chapter 2, every can potentially is higher and, as we consumer this: ‘the claims like gains of all then make more goods. The textbooks have (Mankiw et trade raises the total welfare’ than the losses. Thus, free larger are better off ourselves can make trade, … we engaging in free al. 2006: 189) or ‘By that (area ‘b’), however, represents additional marginal costs of production above of production above costs additional marginal represents however, ‘b’), that (area P the world price, 1.3 trade for free The argument these added profits are domestic residents, that results in no loss to society. The The in no loss to society. that results domestic residents, these added profits are govern- get ‘a’, lost a + b + c + d, producers have is that consumers net result thus ‘b + d’ is the ments get ‘c’; an import quota or a quantitative restriction) is the same with the exception that that exception is the same with the an import restriction) quota or a quantitative domestic importers Either gets no tariff or revenue. in that case the government depending on who gets the get the benefits of the higher price, producers foreign nails. valuable rights to import the limited amount of foreign loss comes from two sources: reduced consumption lowers consumer surplus (‘d’) surplus (‘d’) consumer lowers consumption reduced two sources: from loss comes of production of nails than it higher domestic costs and the society has accepted abroad (‘b’). paid to get the nails from have could ( ge shows that it is relative, not not that it is relative, ge shows 224 been negotiated under the General Agreement Agreement been negotiated under the General sell countries High-wage this is also false. that argue Textbooks Countries make agreements among themselves about trade policy. These can These can about trade policy. among themselves agreements make Countries in 1995. (GATT) and Trade on Tariffs the General Agreement The WTO replaced trade agree- Alongside the WTO preferential and allowed are within its rules What happens if we change the simple assumptions of the Ricardian model? What happens if we change the simple assumptions of the Finally, we will see that the problems of externalities, imperfect information be bilateral agreements, such as the Canada–US free trade agreement, or multi- free as the Canada–US such be bilateral agreements, that have lateral, as in the treaties Organization Trade the World and its successor, (GATT) and Trade on Tariffs (WTO). whose primary trade- It is an international organization tasks overseeing are: predictability and stability which provide between countries agreements related importersfor disputes between and exporters, member states, resolving and new agreements. to negotiate a forum providing allow These agreements trade (and ments between pairs or groups of countries. that are between the countries freely and labour) to move perhaps investment agreement, while they maintain separate rules for members of the preferential union’, of a ‘customs is an example Union outside it.countries The European The North Ameri- all within it maintain trade policy. where countries a common the where trade area’, of a ‘free is an example (NAFTA) Agreement Trade can Free within it maintain outside countries with countries independent trade policies the NAFTA. 2 THE ANTI-TEXT 2 THE will first set out some important points that the textbook analysis slides over. We together the gains How do the textbooks, and economists more generally, add as a whole is and the losses of different people to proclaim that ‘the country’ All too often, better off or worse off as a result of some economic policy change? they really don’t. economists claim to have an answer to this question when with foreign invest- What happens if technologies can change, perhaps moving returns instead ment between countries? What happens if firms face increasing Ricardian model of constant returns? The simple conclusions of the textbook no longer hold. and power are just as serious in the international sphere as they are in the Since we can’t compete against low-wage foreign labour, tariffs prevent a ‘race a ‘race prevent tariffs labour, foreign low-wage against compete we can’t Since to the bottom’ system trading 1.6 The global goods to low-wage countries (and vice versa), so clearly it’s possible to ‘compete’ to ‘compete’ possible it’s so clearly versa), (and vice low-wage countries goods to advanta Comparative low-wage labour. against absolute, costs which matter for the ability to trade. Wage differences reflect reflect differences the ability to trade. Wage matter for which absolute, costs saw in the ‘textbook’ part as we 8. of Chapter productivity differences,
10 | Trade and globalization ' Under inter- Under 223 or two on one export (usually industries Relying value the relative reflects The ‘termstrade’ of of imports the purchase Will instead of domestic The texts state that some arguments for protection are wrong. Here are two two are Here wrong. protection are state for The texts that some arguments examples. Retaliation against unfair trade practices: subsidies and dumping subsidies practices: trade against unfair Retaliation trade the terms of Changing 1.5 for protection Illegitimate arguments employment increase Tariffs Diversification of production of Diversification national trade agreements, countries may prevent damage to domestic industries damage to domestic industries may prevent countries national trade agreements, if foreign Similarly, their governments. get subsidies from competitors if foreign of production, at below their cost in the domestic market goods firms ‘dump’ injury can legallytariffs be applied to prevent This makes to domestic firms. domestic firms and pricing’ to destroy using ‘predatory firms are sense if foreign simply selling firms are in the domestic but not if foreign establish a monopoly, discrim- (‘price in other markets charging than they are price at a lower market anti-dumping tariffs may be applied in this way. Yet ination’). of a country’s exports in terms of the imports they can purchase. A country’s exports in terms of the imports A country’s they can purchase. of a country’s it can export the same total can rise if its terms of trade improve: consumption importedamount and get more enough, it can influ- goods. If a country is large A tariff those products, world prices. demand for on imports,ence reducing by are at the same time, as resources markets; in world down their prices can drive supply of the coun- goods, the drawn into the production of import-competing terms of trade improve. The country’s exports raising their price. thus falls, try’s tariff’ This ‘optimal the country of people better off at the expense policy makes by respond whose terms of trade worsen. If other countries in other countries terms of on the the effects out they can cancel however, raising their own tariffs, everyone worse off. trade, leaving goods cost jobs at home? The texts say no. If the country is on its production pos- say no. jobs at home? The texts goods cost tariff protection can only move employed, are all so resources sibilities frontier, with the the export industry industry, from to the import-competing workers is unemployment, the claim is 10.1. If there saw earlier in Figure losses that we all If all try be true for countries. countries but it can’t this, one country, true for exports and so does employment. fall everyone’s as in the 1930s, agricultural commodities or natural resources) exposes the country to risks of the country exposes of to risks or natural resources) commodities agricultural for This is most relevant volatile. are prices if world fluctuations economic large oil-producing some and for raw materials that produce countries developing domestic industry a high-cost tariffs that create the answer? are But countries. education tourism, a country of exports promote other kinds (e.g. could Perhaps in education and infrastructure. and other services) through investments
) , not actual, compensa- possible to redistribute income to redistribute possible . Compare free trade with import free trade . Compare hypothetical 226 better off if the sum of the gains and losses hypothetically necessarily compensation principle compensation In a refreshing commentary (aptly entitled ‘Why do economists make such In a refreshing commentary (aptly entitled ‘Why do economists of the text- It’s not obvious that everyone would share the value judgement Is ‘society as a whole’ That is the essence of the texts’ argument for free trade. By asserting the That is the essence of the texts’ principle as of the Pareto saw in the previous chapter the dubious nature We Recognizing this, British economists John Hicks (1939) and Nicholas Kaldor Kaldor Nicholas and (1939) John Hicks economists British this, Recognizing tion, is far less convincing. Yet despite that texts assert: ‘Free trade makes the tion, is far less convincing. Yet even though it may not make every individual in country as a whole better off, and Lipsey 2008: 824). Similarly, Schiller writes the country better off’ (Ragan despite the lost jobs that ‘the country as a whole stands to benefit from trade’ of some (2006: 746). Driskill (2008: University’s Robert dismal arguments about trade?’), Vanderbilt effect, high priests 2) asks: ‘Why should people think economists can be, in pronounce the out- who tally up benefits and losses to different individuals and Judging shouldn’t.’ come good or bad for the group as a whole? In fact, people and the outcome is ‘a matter of moral philosophy, not number-crunching’, omists are no better moral philosophers than anyone else. ‘It’s really that econ point, which applies simple.’ It is hard to overstate the importance of this basic to the textbook analysis of economic policy in general. while a What if many people each gain a little bit books concerning trade policy. requiring dramatic few suffer losses that are ‘often large, painful, and traumatic, long-term losses life changes’ (ibid.)? Jacobson et al. (1993: 685) report annual workers who lose of 25 per cent of pre-unemployment earnings for ‘high tenure’ for those who find their jobs in failing firms, with losses remaining ‘large even of their monetary new jobs in similar firms’. They have only a small fraction considering only losses compensated through unemployment insurance, while (Winkelmann these monetary losses greatly understates their loss in well-being and Winkelmann 1998). is positive? A reasonable person could easily say ‘no’. Note that the example So, as Mankiw et al. (2006: 184) write, with free trade ‘the gains of the winners trade ‘the gains of the winners et al. (2006: 184) write, with free So, as Mankiw losers could compensate the of the losers, so the winners exceed the losses free trade raises the total welfare’ off’. They conclude: ‘Thus, and still be better (ibid.: 189). (implicitly, if not explicitly), it gives pri- compensation principle Hicks–Kaldor of efficiency while ignoring questions of macy to the supposed social objective equity or income distribution. whether society is better off or not. The Hicks– a general criterion for judging principle, with its compensation Kaldor between individuals so that some people have more income and no one has income and have more that some people individuals so between trade is better than protection. with protection, then free less income than protection. If with free trade it is If with free protection. (1939) proposed the (1939) proposed
10 | Trade and globalization Are equi- it? the other? the principle, The Pareto without compare to one just we from do equilibrium Why 225 the getting of with professor: removal compares two equilib- The analysis of tariff costs tariff the your the for with forgetting we librium Questions As well, the argument is commonly made (as we saw in Figure 10.1) that As well, the argument is commonly made (as we saw in Perfectly competitive models of factor markets could be used to describe just competitive models of factor markets could Perfectly When is ‘society’ better off? The compensation principle domestic sphere. Globalization is a much more complex and double-edged double-edged and complex more is a much Globalization sphere. domestic let on. than the textbooks process textbook model with the 2.1 Problems the tariff The analysis of which we examined in Chapter 9, does not apply to changes in trade policy. in trade policy. which we examined in Chapter 9, does not apply to changes Lowering protection against imports makes some people in society worse off, As in so many practical situations, the Pareto while others become better off. principle offers no guidance. consumers benefit from lower prices for imported goods, resulting in an expan- consumers benefit from lower prices for imported goods, resulting ‘textbook’ exposi- sion of consumer surplus. But did you notice in our earlier 12–13) that in their tion that this is only half the story? Driskill writes (2007: neglect to note enthusiasm for free trade, exponents of its benefits sometimes goods must rise. that when tariffs are removed, the relative price of exportable any buying those goods will see their consumer surplus shrink. Whether People balance between particular consumer is better off or worse off depends on the the importable and exportable goods they buy. such instantaneous and costless reallocations of resources. But in reality, the such instantaneous and costless position on the production possibilities frontier economy does not hop from one the frontier as factors of production leave the to another; it follows a path inside spend time unemployed before perhaps becom- import-competing sectors, and The income lost during unemployment and the ing re-employed in other sectors. should be counted. ‘Economists have sometimes costs of becoming re-employed with the comment that the displaced factors dismissed such adjustment costs since in dis- become re-employed “in the long run”. But this is bad economics, counts more heavily counting streams of costs and benefits … the near-present than “the long run”,’ as Baldwin et al. (1980: 407) rightly observe. rium positions. The implicit assumption is that the economy moves instantly that the economy moves instantly The implicit assumption is rium positions. just a simplification This is not one equilibrium to the other. and costlessly from in empirical studies of changes of students; it is common for the convenience would look like after simulate what the economy These typically in trade policy. consider the new equilibrium when all adjust- a change in trade policy, but only ments have taken place. The Ricardian The 228 what happens to coun- Samuelson (2004) describes Paul Technology, and the physical capital in which it is embodied, both and the physical capital in which Technology, , Samuelson (ibid.: 142–3) thinks that this kind of technological catch-up on the Samuelson (ibid.: 142–3) thinks As a result of their foreign investment, owners of multinational corpora- We will briefly consider what happens when each of these assumptions is assumptions each of these happens when consider what will briefly We Marglin offers a more realistic model in a simple numerical example to example to Marglin offers a more realistic model in a simple numerical tries’ national incomes if technology changes as a result of local developments. tries’ national incomes if technology from to our simple Ricardian wheat and cloth example adapt his analysis To a technological improvement in wheat Chapter 2: suppose England experiences lowers Canada has a comparative advantage. This production, the good in which reduces Canada’s gains from trade. Canada’s the world price of wheat and of trade fall (i.e. it must export more to get a national income falls as its terms the worst case, it eliminates Canada’s gains from given amount of imports). In trade and trade stops. through history, part of less developed, lower-wage regions has been common incomes rise in the both within countries and between countries. While total regions. areas ‘catching up’, income falls in the previously more advanced move. This is an example of a way in which technological differences between move. This is an example of a way in which technological from Samuelson’s countries can change that is different in an important way but without a flow analysis, where the technology change took place abroad, of capital. tions, or MNCs, enjoy larger profits. Nail production falls in the industrialized permanently between countries; neither the technology nor factors of production of production factors nor technology the neither countries; between permanently It can move internationally. goods Only consumption between them. can move in production. constant returns and perfect competition also assumes where corporations offshore a glimpse of the real world then get relaxed. We their jobs, putting lose Workers their technology with them. production, taking arbi- Increasing returns lead to on wages in rich countries. downward pressure and between countries. specialization both within trary patterns of change Technological owners, internationally mobile technology and capital Workers, model treats everyone like worker-owners, such as farmers who grow wheat who grow wheat model treats everyone like worker-owners, such as farmers and trade the and who keep sheep. They consume some of their own produce everyone can gain rest. In this simple setting, there are no winners and losers; as Marglin remarks (2008: 278), ‘the distinction between worker from trade. Yet, producer and and owner is basic to capitalism, as is the distinction between these realities but consumer’, adding: ‘it is not just a simplification to ignore a distortion’. separately illustrate what happens when workers and owners are considered located in (ibid.: 274–81). In the case he considers, a multinational corporation to a developing an industrialized country offshores some of its nail production country.
10 | Trade and globalization Some * it some Is up? say and go off? gain As we will see shortly, + worse incomes economists or people do off total some how that When 227 better so are im- issues of income distribution While change, is gains whole policy a net professor: as some have your to for society following sufficient whether lose Questions The simple Ricardian model that illustrates comparative advantage and the If a country with an abundance of skilled labour increases imports of goods If a country with an abundance of skilled labour increases A basic model found in every trade textbook explains trade as the result of A basic model found in every gains from trade makes some critical assumptions. Technologies can differ can differ gains from trade makes some critical assumptions. Technologies 2.2 assumptions the textbook’s Relaxing here also assumes that a rise in everyone’s real income makes everyone better better everyone makes income real rise in everyone’s that a also assumes here small question. A relatively this is open to in Chapter 4, as we’ve seen off, but, little effect could have by most people experienced in real income increase large losses few who suffer it, while the quickly adapt to as they on well-being position worsens. worse off as their relative would indeed be wage inequality Trade and growing that use a lot of unskilled labour, the wages of less skilled labour fall. At the that use a lot of unskilled labour, the wages of less skilled capital and highly same time, an increase in exports of goods that use a lot of workers. skilled labour raises the incomes of capital owners and of high-skilled But there are also other explanations Earnings and income inequality grow. So far, it seems, the debate about the extent to for increasing wage inequality. of the enormous which trade is responsible remains unresolved, if only because difficulty in disentangling the causes of changes in wages. countries have a relative abundance of skilled labour and capital, some have a countries have a relative abundance labour, for example. The model predicts that relative abundance of unskilled export goods that use a lot of the relatively countries will specialize in and abundant factors relative to the less abundant ones. differences in the relative amounts of factors of production in countries. differences in the relative amounts portant in assessing policy changes, they are also important in judging whether also important in judging whether policy changes, they are portant in assessing as and trade are making countries of comparative advantage changes in patterns Trade economists have been debating for years a whole better off or worse off. and the increasing trade of the industrialized the extent to which globalization has put downward pressure on wages of countries with developing countries countries, contributing to growing income less-skilled workers in the developed inequality there (Krugman 2008b). though, there are further reasons for thinking that trade and globalization will though, there are further reasons for thinking that trade and the industrialized be putting downward pressure on wages more generally in countries. outcomes efficient Portugal England ilos of nails year most textbook, the the inefficient, in to other, results 2 million Are 230 According trade free resources. professor: with your 10.2 of producing nails in two costs countries Average world’s for figure the
of A erage cost of nails of cost erage A possible? use specialization Question technology from As in the Samuelson and Marglin accounts, the transfer of sabotage techno- None of this means that industrialized countries should If increasing returns are an important feature in the production of many If increasing returns are an important feature in the production high-income to low-income countries and the ‘resulting growth in the effective- high-income to low-income countries and the ‘resulting growth end up above the ness of competition … drives wages toward the middle. They [their] former level initially low levels in the less-developed economy, but below in the wealthier countries’ (Gomory and Baumol 2004: 438). logical progress in developing countries or restrict imports from them. All of these examples serve to stress that comparative advantage evolves and that the distribution of the gains from trade changes with it. The process of ‘globaliza- England produces 20 million kilos of nails at an average cost of $7/kilo. If of $7/kilo. If 20 million kilos of nails at an average cost England produces its producers tried to enter to take a portion of the world market, Portugal returns, ‘the would face much higher average costs. When there are increasing can blunder’ (Gomory and Baumol 2000: 94) and can lead to visible hand in highly inefficient patterns of production. misleading. In that goods, the textbook default model of perfect competition is of resources. In the model, free trade produces a globally efficient allocation world of increasing returns, it does not.
10 | Trade and globalization
- What make text this the in Does model internationally. production. move Ricardian to some 229 Baumol (2000, 2004) have Gomory and The labour or off? ‘offshore’ ‘offshore’ professor: to worse capital your home moves for allow at not capital workers if does Question In the developing country, there is greater material prosperity. This benefits is greater material prosperity. In the developing country, there In the case Samuelson examined, foreign investment did not bring about did not bring about examined, foreign investment In the case Samuelson Here, the outcome depends on accidents of history. Except in the unlikely Except in the unlikely Here, the outcome depends on accidents of history. Portugal can produce nails more cheaply than England, but if England gets a Portugal out of the market. head start, its declining average costs may lock Portugal Increasing returns and globalization people there, particularly if basic needs have not yet been met, and possibly people there, particularly if basic if they care about the international distribution even people in other countries however, ‘the disruption of community and the of income. It also involves, evolution’ of for a more gradual Westernization substitution of forced-march 2008: 280), a cost that has no place in textbook the indigenous culture (Marglin pace its transfor- thinking. Whether that society is better off or not, or at what mation should take place, also requires value judgements. the technological change in the foreign country so there was no flow of for- so there was no flow of change in the foreign country the technological This income to capital country. income back to the developed eign investment result who lose their jobs as a the income losses of workers owners can offset income in both places may rise, unlike of production cuts, so that national as we have seen, even if the total income in the in Samuelson’s example. But there is no reason to conclude that the nation industrialized country increases, collectively is better off. country as it imports some nails from abroad. Some workers lose their jobs, jobs, lose their workers Some from abroad. nails some it imports as country from lost off, not only They are worse ‘leisure’. instead involuntary obtaining and, if they future earnings from lower but also during unemployment, income from they become uprooted their lives as disruption in move, the costly have to and community. friends, family event that average costs are the same in each country, this arbitrary pattern of event that average costs are the same in each country, this production will not maximize total world income. Figure 10.2 gives an example. examined broadly similar scenarios, but ones in which firms have increasing examined broadly similar scenarios, but ones in which firms In their model, returns instead of the constant returns of the Ricardian model. The arbitrary. which country ends up specializing in which good is completely has lower aver- country that first starts producing a particular industrial good market at initially age costs than its potential rivals would if they entered the produce something low levels of output. They will find it more profitable to else instead.
60 Minutes (CBS News It is an example of . The CBS / 60 Minutes 232 Differences in incomes, preferences and geography could quite reasonably give reasonably could quite and geography preferences in incomes, Differences standards different environmental entirely localities, or countries, different migrate were then to industries spillovers. If polluting environmental for local regions or countries, to low-standard or countries regions from high-standard The high-standard regions or be unambiguously better off. the world would of polluting activities without be able to consume the products countries would or countries would have more and the low-standard regions having to host them, they are, relatively speaking, in return for pollution to which economic activity, 191) 2004: indifferent. (Wolf regimes and dictatorships may not That government policy in authoritarian there are actually legal restrictions on In recognition of these realities, view, quoted earlier, is the economist’s standard response to Martin Wolf’s and the fact that If we set aside the children who have no say in the matter accurately reflect the public’s preferences does not seem to occur to him. Setting accurately reflect the public’s of the powerlessness of parts of the popula- that aside, there is also the problem have to know the problem of information. People tion (as Dasgupta noted) and and to understand fully its consequences. that the pollution is taking place and toxic waste, although they are failing national trade in toxic materials inter tronic of waste from rich to poor countries. Elec spectacularly to stop the flow vinyl mercury, cadmium, chromium and poly equipment that contains lead, are not chlorides is causing growing problems, particularly as manufacturers have no incentive to required to bear the costs of their proper disposal and thus that ‘Thousands try to produce them in other ways. Richard Wray (2008) reports arrive in the ports of of discarded computers from western Europe and the U.S. children burn west Africa every day, ending up in massive toxic dumps where and pull them apart to extract metals for cash.’ A CBS United States to a 2008) investigation found a flow of illegal e-waste from the levels of cancer- place in southern China run by ‘gangsters’ with ‘the highest kids have too much causing dioxins in the world’ and where ‘seven out of ten lead in their blood’. must be better this situation: all the exchanges here are voluntary, so everyone example, felt sick off than they would otherwise be. The Chinese workers, for their pay of $8 a and knew that their work was damaging their health, but from the rich day looked good given their destitution. An end to toxic exports countries would leave them worse off. actually be true. the workers still have far from complete information, this could focus on efficiency, What the standard response ignores, because of its narrow is the bigger framework of injustice into which all this fits. a ‘failure of markets’ (as opposed to a market failure), David Colander’s distinc- tion, which we explained in Chapter 6. The market may be working efficiently, but it is producing an ethically unacceptable outcome.
10 | Trade and globalization Financial 231 The textbook analysis of trade assumes the usual , dismiss such concerns about exports being, in effect, subsidized by ex- Once again, the usual suspects are missing in the textbook account: exter- Once again, the usual suspects Instead of the traditional trade policies – tariffs, quotas and so on – ex amined amined ex and so on – – tariffs, quotas trade policies of the traditional Instead Partha Dasgupta (2007: 121) of Cambridge University gives a nice example of Partha by them? How big are such subsidies and how much is trade influenced of the Defenders of globalization, such as economist Martin Wolf The most obvious externalities are global: the greenhouse gas (GHG) emissions The most obvious externalities nalities, asymmetric information and power. In the international context, they In and power. nalities, asymmetric information raise new problems. 2.3 the textbooks What’s missing from The problem of externalities in the textbooks in the context of an infant industry, these ideas highlight the these ideas infant industry, context of an in the in the textbooks and to influence productivity broad, economy-wide policies importance of pattern of comparative advan- and thereby the dynamic logical change, techno for research and development, include tax policy and support tage. These could and for education. tion’ produces complex and ever-changing outcomes. No simple conclusions conclusions No simple outcomes. ever-changing and complex produces tion’ are possible. Times ternalized costs. more local externalities. Suppose that the government of a developing country more local externalities. Suppose that the government of a down the forest and offers timber concessions to private companies which cut of farmers and export the wood. This damages watersheds and the livelihoods compensation for fishers downstream. They have too little political power to get country’s timber exports This effectively subsidizes the the damage they suffer. to the owners and transfers wealth from the poorest people in a poor country of the forestry companies and to importers in rich countries. no idea … because Dasgupta (ibid.: 121) writes: ‘Unfortunately, I can give you the resources to they haven’t been estimated. International organizations have they haven’t done undertake such studies; but, to the best of my knowledge, a case against free so.’ He rightly adds that examples like this do not make must include a trade, as such, but they do show that the case for free trade consideration of its environmental impacts. that are involved in the transportation of all kinds of traded goods and services, that are involved in the transportation of all kinds of traded to England, container ships sailing whether it is fresh flowers flown from Kenya tourists flying to exotic locations. With or millions of from China to Rotterdam, would surely in- current technology, serious action to reduce GHG emissions of world trade. crease transportation costs significantly and reduce the volume default case of no externalities. As we stressed in Chapter 7, externalities are default case of no externalities. taken into account in decision-making, inter- everywhere. When they are not large. national trade will be inefficiently any provide exist? textbook products the 234 Does trade’ fair ‘ why professor: your about for explanation ‘The strong do as they can, while the weak suffer as they must.’ ‘The strong do as they can, while the weak suffer as they must.’ Thucydides (quoted in Chomsky 2007: 175) not only by a Economic systems, both global and national, are characterized game, but also (generally wholesome) competition under standing rules of the outcomes of by a fierce struggle over the design of these rules themselves. The this continuous struggle reflect not the well-informed insights of an impartial planner, but the interests, bargaining power and expertise of the various groups of participants. If coffee buyers recognize their place in this web of relationships with people with of relationships web in this their place recognize buyers If coffee is for coffee and other products of ‘fair trade’ certification The development are those for organic products or certification Other examples of certification these issues, it is only being consistent When textbook economics ignores Question As philosopher Thomas Pogge (2007: 139) explains, As philosopher Thomas Pogge and with nature instead of behaving like textbook consumers, they will want to they like textbook consumers, of behaving nature instead and with will have find out? Buyers how can they produced. But the coffee was know how trusted, unless some sellers’ claims among way of distinguishing no practical recognized certification. party can provide a widely independent third assurance that the products of this. It offers buyers credible just one example cooperatives that are offered by democratically run small farmer were produced poverty and promoting grassroots as a way of reducing above-market prices et al. 2008: 11–12). economic development (Fridell in the production of a variety of food products. about how animals were treated systems and the rapid growth of sales The development of these certification many buyers do indeed care about more than of ‘fair trade’ products show that characteristics of the goods they buy. just the price and the physical we have repeatedly highlighted. With perfect with its default assumptions, which no market power, and the unimportance of eco- information, no externalities, producer cooperatives) because of the absence nomic democracy (in this case, no sense. of power more generally, then the fair trade movement makes Countries differ greatly in terms of population, total production and income per Countries differ greatly in terms of population, total production power when dealing person. In turn, these features influence their bargaining neglect of power is particularly apparent when The texts’ general with each other. and international we consider their treatment of the international economy economic institutions. The problem of power
10 | Trade and globalization effi- waste idea? toxic about Consumers may care in trade unpopular Is 233 an be to professor: seem it your © Andy Singer does for
'& Why cient? Questions Suppose that you are going to buy a $2 cup of coffee. As playwright Wallace buy a $2 cup of coffee. As playwright Wallace Suppose that you are going to Information, fair trade and product certification Information, fair trade and product report quotes James Puckett, founder of the non-governmental organization organization the non-governmental of founder Puckett, James quotes report … it’s a hell things will do desperate ‘desperate people Network: Basel Action people make never make should We and poison. between poverty of a choice that choice.’ Shawn (1991: 20–21) writes, its ‘price comes from its history, the history of all Shawn (1991: 20–21) writes, its in making it and selling it and all the particular the people who were involved the cup of coffee, you also ‘form relationships relationships they had’. By buying peasants of the with all of those people … The cup of coffee contains the history of the sun, some who picked the beans, how some of them fainted in the heat were grown by were beaten, some were kicked.’ If instead the coffee beans power forced down independent farmers, perhaps buyers with monopsonistic the farming practices were environ- Perhaps the price, leaving them in poverty. mentally destructive. how the products they buy were produced. Everyone is aware of controversies how the products they buy were made in ‘sweatshops’ and other goods produced over child labour and clothing not raising these issues, textbook theory seems in poor labour conditions. By to the utility-maximizing consumer is the price to suggest that all that matters characteristics of the final good. and information about the physical Under the North North the Under '( 236 ') '* Standard trade theory suggests that the gains from such agreements go dis- Standard trade theory suggests the world consists of a ‘large’ and a ‘small’ Imagine a simple situation where reinforces Acknowledging the existence of oligopoly and increasing returns the con- Canadian economists advanced these ideas when considering seems to think so (Helleiner Gerald Helleiner of the University of Toronto and the countries of the European Free Trade Association (Iceland, Norway, Association (Iceland, Norway, of the European Free Trade and the countries Switzerland). Liechtenstein and proportionately to the small country. The argument is straightforward. We saw argument is straightforward. We The proportionately to the small country. a country’s consumption possibilities expand from Figure 2.2 (on page 30) that between its prices before trade and its prices more the greater the difference after trade begins. prices must supply and demand determine world prices. World World country. in the large country alone before trade be- be close to those that would prevail supply and demand to that of the large country cause adding the small country’s very much. As a result, the large country’s does not change supply or demand while those of the consumption possibilities do not increase much with trade, share of the total small country increase a lot. The small country gets the lion’s the unemployment gains from trade, although it also gets the lion’s share of downplayed by the costs of readjusting its pattern of production – something conventional analysis, as we noted. its internal markets, this conclusion. The large country, because of the size of with increasing will have already realized the lower average costs associated access to the large returns. In contrast, by obtaining easier and more secure their average costs country’s markets, producers in the small country can lower considerably. in the 1980s. If the sequences of a free trade agreement with the United States one, the large large country signs a preferential trade agreement with a smaller history is replete country is being a good neighbour to the small one. Given that of small countries, with examples of large countries kicking sand in the faces be true. this claim of disinterested benevolence may be too good to – perhaps 1996). He suggests that the large country will seek ‘side payments’ markets. He warns unrelated to trade – as a price for preferential access to its that ‘It is therefore quite misleading to address the benefits and costs of integra- tion agreements exclusively, or even primarily, on the basis of trade effects’, as economists invariably do. Malaysia, Morocco, Oman, Panama, Peru and Singapore. Peru Panama, Oman, Morocco, Malaysia, American Free Trade Agreement (NAFTA), the United States also has free trade States also has the United (NAFTA), Free Trade Agreement American Repub- the Central America–Dominican Mexico. Under Canada and with both Hon- Salvador, Guatemala, trade with El it has free Trade Agreement, lic Free It has also signed Republic. Costa Rica and the Dominican duras, Nicaragua, Canada Aside from NAFTA, treaties’ with forty countries. lateral investment ‘bi Peru Colombia, Costa Rica, Israel, trade agreements with Chile, lateral has bi
10 | Trade and globalization Recentyears '' 235 recognized Unless the problem of power is One of the worst examples of the exertion of corporate power has been the One of the worst examples of the exertion of corporate power increase It was clear from the beginning that the result would be a substantial Even sympathetic mainstream economists agree that ‘a few rich countries Even sympathetic mainstream creation of the Trade-Related Aspects of Intellectual Property Rights (TRIPs). creation of the Trade-Related of the US govern- It was a top priority of US-based multinationals, and thus in 1995. the WTO ment, in the negotiations leading up to the formation of members must ultimately adhere, created The agreement, to which all WTO materials, worldwide protection for ‘intellectual property’ such as copyrighted patents, protected including computer programs, protected for fifty years, and for twenty years. getting additional in transfers to the developed-country monopolists who were Significant net losers are developing- protection for their intellectual property. controlled by country residents; patents in those countries are almost entirely the emer- foreign MNCs. The MNCs may enjoy a further benefit of preventing the increased pro- gence of potential competitors in developing countries given of pharmaceuticals tection given to patenting processes, as in the production (Dunkley 2000: 189–90). have seen a growing number of bilateral trade agreements between countries. have seen a growing number of bilateral trade agreements because they give These are sometimes called ‘preferential’ trade agreements the exports of the partner country preferential tariff-free treatment. As of the time of writing, the United States has negotiated such free trade agreements with Australia, Bahrain, Chile, Colombia, Mexico, Israel, Jordan, South Korea, The World Trade Organization The World Bilateral trade agreements between large and small countries In the international arena, the ‘rules of the game’ are formally set out both out both set formally are the game’ of the ‘rules arena, international In the Organization (WTO), Trade as the World such organizations, in international separate (IMF), and in Fund International Monetary Bank and the the World the activ- two decades, Over the last countries. agreements between lateral bi of such bilateral agreements and the establishment ities of these organizations their Based on the contents of criticism and opposition. have drawn increasing be hard pressed to understand economics students would textbooks, however, is about. what all the excitement dominate the WTO’ negotiations and that ‘it is dominated by large corporations’, negotiations and that ‘it is dominated dominate the WTO’ inevitable, since it is large corporations that do something that is ‘probably both the incentive and the resources to influence most trade. Corporations have countries and internationally’ (Deardorff and policies, and they do, both within do not appear in the texts.) Stern 2002: 418). (Such views clearly, a good deal of the criticism of the WTO can be baffling. Its decisions can be baffling. Its decisions of the WTO clearly, a good deal of the criticism of its members are at least nominally democratic. are made by consensus; most What’s the problem? to as have seem about have The topic of foreign agreements agreements They trade’ pre-nuptial pre-nuptial reduction. as ‘Free ‘Free 238 trade tariff agree? free than professor: you Do with more your lot for love. a common free in about with much be Questions As one observer comments, ‘the rules of the game have been periodically game have been periodically comments, ‘the rules of the As one observer the gains, such as they are, from such agree- In the end, it’s unclear whether It’s important to note that if the textbooks don’t bother to distinguish be- It’s important to note that if the textbooks don’t bother to the Canadian government to a negotiated settlement in which the American American the in which settlement to a negotiated government Canadian the got to split forum available) in every legal (after losing and industry government the industry funds which producers, from Canadian in tariffs collected $1 billion given by The reason 2007). (Feldman in future litigation find handy lobby will U.S. ‘accept the need to pay off the deal was that Canada had to defenders of the only be followed by renewed peace’, as a legal victory would industry to obtain extortion to the protectionist the power imbalance, ‘paying harassment. Given 2006). only practical solution (Ritchie lobby’ was the to suit the short-term interests of the most rearranged on an ad hoc basis United States’ (Gagné 2002: 27). He adds (p. 26) powerful country, namely the thus be aware that continued access to the that ‘Canadian industries should on not exceeding some explicit or implicit American market depends critically market share’. The main alternative is greater the small country. ments are worth the risks for when small countries can band together reliance on multilateral institutions other large countries), rather than facing the and have allies (perhaps even large country one on one. … again direct investment: the problem of power Foreign direct investment (i.e. foreign ownership or effective control of firms located direct investment (i.e. foreign ownership or effective control texts, despite its in a country) is almost entirely absent from the introductory (MNCs) prominence in many countries. Indeed, multinational corporations despite their central receive barely a mention, let alone any serious treatment, the texts By leaving MNCs out of the picture, role in the international economy. the debate surely Yet are implicitly taking the position that they are a non-issue. about their role deserves serious attention. they’re implying tween whether a firm is domestically owned or foreign owned, maximize profits, so All firms in the textbooks that ownership doesn’t matter. But as a general they behave in the same way, regardless of who owns them. routinely prohibit, proposition, hardly anyone seems to believe this. Countries restrict or review foreign ownership, particularly in sectors associated with cul- tural and political sovereignty, such as the military industries and the media and publishing industries.
10 | Trade and globalization 237 The point is crucial. By focusing attention on the simple arguments from arguments the simple on attention By focusing crucial. point is The could include things like: that these ‘side payments’ Helleiner suggests for ongoing side payments is Chapter 11 of A notorious example of a potential not end once the The large country’s demands for ‘side payments’ may well the small country The large country could stretch or flout the rules and make sidized is sub The US government’s allegations that Canadian softwood lumber trade theory, economists can make a persuasive-sounding case for freer trade. case for persuasive-sounding can make a economists trade theory, may also whose costs ‘side payments’, or potential ignoring the actual But by of the story. a critical part are ignoring to quantify, they be hard and property’ (namely patents protection of ‘intellectual extending monopoly pub- privatization of parts of protection of foreign investors, copyrights), special of the and regulations to those ‘harmonizing’ some laws lic sector production, of country of restrictions on some and acceptance by the small large country, of foreign takeovers of domestic firms). its economic policies (e.g. screening certain powerful interests in the large country, The ‘side payments’ will benefit the policy autonomy of the small country in while at the same time restricting much more important than just lowering tariffs. ways that could end up being and the economies become more integrated, it Furthermore, as time passes to cancel the agreement, effectively locking could become prohibitively costly in these policy constraints. to sue governments for lost profits which effectively permits companies NAFTA, public concern, example, as a result of growing as a result of policy changes. For Dow AgroSciences, the government of Quebec banned many pesticides in 2006. and demanding the maker of the herbicide 2,4-D, is challenging this in court 2009). $2 million in compensation for ‘expropriated’ profits (Mittelstaedt to selective agreement has been signed. The small country remains vulnerable of the agreement. non-compliance or to threats of cancellation or ‘renegotiation’ from the asymmetry This reflects the imbalance in bargaining power that comes the outcome of the in size between the two countries. It does not just influence the smaller country. initial negotiations, but persists and raises real risks for actually submit to Helleiner asks an important question: ‘will powerful actors have said, if they do disagreeable developments, whatever they may previously (1996: 762) not suffer greatly in consequence of the failure to do so?’ through whatever bear the disproportionate costs of trying to make it comply under their agree- time-consuming dispute resolution institutions are set up in the early 1980s ment. The US–Canada softwood lumber disputes that began are an example of such behaviour. defeated at every and American softwood producers thereby damaged has been dispute settlement panels and before American courts. and WTO stage in NAFTA Instead of the dispute settlement process having resolved the problem, how- ever, the end result has not been free trade, but a victory for power politics and aged trade. The most recent dispute (2002–06) ended with capitulation by man Colombia. 240 '+ . It detailed how more than two thousand trade unionists had been killed. It detailed how more than two thousand trade unionists had Currently, the Colombian military is the major recipient of US military aid in Currently, the Colombian military is the major recipient of violations, Trade unionists in these sectors have faced repeated human rights representing often because of their opposition to privatization. Trade unionists threatened mine workers in artisanal mines whose livelihoods are potentially also faced by large-scale investment by international mining interests have workers in repeated human rights violations. Trade unionists representing multinational firms have also faced human rights violations often in the course of labour disputes. (Amnesty International 2007: 23) I spent 33 years … being a high-class muscle man for Big Business, for Wall muscle man for Big Business, for Wall I spent 33 years … being a high-class purify Nicaragua for the international bank- Street and the bankers … I helped 1909–1912. I helped make Mexico … safeing house of Brown Brothers in for Republic oil interests in 1914. I brought light to the Dominican American 1916. I helped make Haiti and Cuba a decent for American sugar interests in boys … I helped in the rape of half a dozen place for the National City [Bank] Street. Central American republics for the benefit of Wall when American power was unrivalled, the pat- War, After the Second World American business owners have long enjoyed a similar subsidy. Even before a similar subsidy. owners have long enjoyed American business the Americas. In 2007, Amnesty International issued a report entitled the Americas. In 2007, Amnesty International issued a report of trade unionism in Killings, arbitrary detentions, and death threats – the reality Colombia sectors, an area in the preceding twenty years. In the mining, oil, gas and energy states: of particular interest to MNCs and foreign governments, Amnesty tern continued but on a larger scale. Particularly notable were the 1953 coup that tern continued but on a larger scale. Particularly of Anglo-American overthrew the Iranian parliamentary government on behalf coup in Gua- oil companies (installing the Shah as dictator), the 1954 military military coup in temala on behalf of the United Fruit Company, and the 1973 Telephone Chile ousting a democratic government opposed by the International Corporation. and Telegraph direct investment have a long, if unattractive, history. In their study of the of the study In their history. if unattractive, long, have a investment direct (1988: Huttenback Robert Davis and Lance of British imperialism, economics for viewed as a mechanism can best be ‘imperialism that British 279) conclude middle classes’. The British to the upper the middle income from transferring and administrative structure of the taxes to support the military class paid most higher rates of return on invest- while the upper classes enjoyed of the empire, for available to them: ‘socialism would otherwise have been ments abroad than for the poor’. the rich, capitalism dominant world power, it routinely invaded coun- the United States became the Caribbean in support of US business interests. tries in Central America and the US Marine Corps (quoted in Chomsky 1987: 94–5) General Smedley Butler of the way: described his own exploits this
10 | Trade and globalization 239 10.2 10.2 by sector, (FDI), investment direct foreign stock of of the Estimates : UNCTAD (2008), Annex Tables A.1.5 and A.1.6, pp. 207–8 (2008), Annex Tables : UNCTAD : (1) Countries of south-east Europe and the Commonwealth of Independent : (1) Countries of south-east Europe Most foreign investment, like most trade, takes place between the developed Most foreign investment, like countries of Our particular concern here is with the activities in developing a year in the In Chapter 4, we mentioned the deaths of 16,000 children foreign State sponsorship and protection of domestic businesses carrying out Services (%) 62 84 Primary (%) Manufacturing (%) Services (%) Primary (%) Manufacturing (%) 29 8 62 28 8 26 8 64 9 3 economies. Table 10.2 summarizes the broad picture. More than three times as 10.2 summarizes economies. Table in the developing much inward FDI takes place in the developed countries than Ownership of these countries. In both cases, the bulk of it is in service sectors. assets rests overwhelmingly with residents of developed countries. in power may MNCs owned in developed countries. This is where disparities criticism of MNCs’ be most significant. These activities also draw the most instance, if the government of a developing country gets into activities. For disparity is that a dispute with an American corporation, the relevant power between the United States and the developing country. the use pines that result from inappropriate feeding practices, including Philip Department of of infant formula in unsafe conditions. In 2006, the Philippines Health Organization’s Health imposed new rules that would enforce the World The Supreme Court International Code of Marketing of Breastmilk Substitutes. the new rules. of the Philippines rejected the producers’ appeal to suspend Philippines govern- US government representatives then began lobbying the to the Philippines ment and the head of the US Chamber of Commerce wrote confidence’. ‘Four president warning that the measure would damage ‘investors’ Court reversed its days later’, reports George Monbiot (2007b), ‘the Supreme did not cave in and decision.’ In the end, though, the Philippine government with the assistance of domestic and international activists, the new rules were largely reinstated (Baby Milk Action 2007). jWXb[ Note Inward FDI Stock Inward FDI Stock 9.4 assets are not classified by sector. States are not included. (2) Some Source 2.8 Developed countries countries Developing 2006 (trillions of dollars) (trillions 2006 Outward FDI Stock 11.4 1.4 242 The fair trade movement has taken off. Hudson and Hudson (2003) links fair (2003) links and Hudson Hudson has taken off. trade movement The fair and in his follow-up book on free trade doctrine and trade and development development trade and and doctrine trade on free book follow-up in his and (2004). out in idea we sketched fetishism, an of commodity Marx’s concept trade to their later also recommend Shawn. We the words of Wallace Section 2.3 using major which examines how the Fridell (Fridell et al. 2008), article with Mara to trade movement by attempting have responded to the fair coffee companies themselves as ethical. at the same time branding undermine it while
10 | Trade and globalization firms of this? ownership about say to foreign have Does 241 textbook professor: our your does for What
', matter? It’s important to acknowledge that, in many places, MNCs have brought real MNCs have brought many places, that, in to acknowledge It’s important Questions some form not attempted to make a case either for free trade or for have We slides over a The second major theme here is that textbook economics to students Why do so many economists support free trade and offer advocacy Driskill’s brief 2008 article, ‘Why do economists make such dismal arguments Students of international trade will find much of interest in Dunkley (2000) benefits, bringing useful capital investment while assisting in the transfer of tech- in the transfer while assisting capital investment bringing useful benefits, offering no threat to local political between countries, and nologies and know-how follow in their wake. destruction and repression But in other places, autonomy. role of MNCs in the international any serious discussion of the By not offering of worldwide relevance. decline to address an issue economy, the texts of restricted trade. One of our central points is that things are much less clear of restricted trade. One of our end, economic theory can prove nothing about cut than the texts let on. In the of restricted trade is best from the point of whether free trade or some form It can provide a framework view of the people living in a particular country. and to identify to help to understand the consequences of alternative policies considera- who is likely to experience gains and losses. Other ‘non-economic’ Ultimately, value tions may come into play as well, such as national autonomy. judgements are inescapable. and externality number of important issues concerning globalization. Pervasive power, particularly informational problems are compounded by inequalities in at the national level. Driskill (2008: rather than an accurate presentation of the benefits and costs? for free trade are a 2) speculates that in economists’ culture, the arguments their critical kind of institution: ‘200 years of tradition that has short-circuited (a something deeper may be at work. William Poole but thinking’. Perhaps, trade is really free trade advocate) stresses that ‘the case for free international so, what is at stake part of a more general case for free markets’ (2004: 4). If it’s the ideology of is much bigger than just whether tariffs are good or bad; laissez-faire itself. about trade?’ is essential reading. 2.4 Summing up Suggestions for further reading Both the United States and Canada have concluded free trade agreements with with agreements trade free concluded have Canada and States the United Both Colombia. are applied to explain income distribution and the gains from trade. We’ve seen how the predictions of the perfectly competitive model – that price ceilings lead 11 | Conclusion to shortages, for example – are presented as universally valid even though a non-competitive market setting results in different conclusions. Finally, we’ve seen how the textbooks often claim there is a clear body of evidence confirming the inefficiencies resulting from minimum wages and rent control. ‘Tim Harford: “I was not surprised to read your lop-sided and In making the argument for markets and for limited government, textbook unconvincing caricature of orthodox economics (‘textbooks’ are economics relies on value judgements implicit in its fundamental assumptions such a convenient straw man).” about self-interested individuals, their full rationality and their unlimited wants, ‘Pete Lunn: “Textbooks are a straw man? To me they are like a and the nation-state being the only valid measure of community, as Marglin vice on the mind of economists, who get tetchy when you present (ibid.) argues. Normative value judgements pervade microeconomics. results that reveal the behaviour of real people to be not as Prospect those textbooks assume.”’ magazine, issue 150 The rational individual Modern research challenges the notion of rational individuals constantly and instantly calculating the best action to maximize their individual well-being. In this short chapter, we want to gather together the main points we’ve raised Bounded willpower, bounded selfishness and bounded rationality are now well about what’s unsatisfactory with the standard microeconomic textbook – and established in the behavioural economics literature, although they have made why it matters. little impact on textbook economics. We know that ‘animal spirits’ – individuals’ impulses to action in the face of uncertainty – play a dominant role in many of The distinction between positive and normative economics our most important decisions. We also know that individuals make systematic The idea that positive and normative economics are clearly distinct is mislead- mistakes. Collective euphoria can result, fuelled by whatever myth about the ing. Implicit value judgements are embedded throughout so-called ‘positive’ economy prevails at the time.' These irrationally exuberant booms end in busts economics. The very definition of economics as the attempt to satisfy unlimited that are hugely expensive for the economy, as we have seen in recent years. wants with limited resources is rooted in judgements about what makes human beings happy. It’s an individualistic view that ignores our social links, while jWXb[ 11.1 Conventional economics and the blank cells of Akerlof and Shiller shifting our attention towards efficiency (and away from questions of equity). Indeed, one could argue that the main thrust of textbook economics is not Rational responses Irrational responses positive. The texts are not describing the world as it is. Instead, the texts ex- Mainstream textbook plicitly or implicitly make the claim that competitive markets are a reasonable Economic motives economics approximation to the real world and that they produce a reasonably efficient outcome. Thus, Krugman and Wells (2005: 15) write, ‘Markets usually lead Non-economic motives to efficiency.’ The reader is invited to adopt the normative view that, broadly speaking, there should be laissez-faire: a free market system, with a minimum of government interference. Akerlof and Shiller argue that the current mainstream macroeconomic model As Marglin (2008: 3) puts it: ‘The problem with the idea that economics is focuses on how the economy would behave if people had only the economic purely, or even primarily, a descriptive undertaking is that the apparatus of motives identified in the textbooks and were fully rational. But the same point economics has been shaped by an agenda focused on showing that markets can be made about the focus of the microeconomics principles textbooks. In are good for people rather than on discovering how markets actually work. And Table 11.1 textbooks and mainstream models inhabit only the upper left-hand from this normative agenda has come the constructive agenda.’ cell. These address only the question: How does the economy behave if people What evidence is there for this claim? We’ve seen in Chapters 3 and 6 how have only economic motives and rational responses? It’s time that the main- demand and supply were applied to all areas of the economy, regardless of the stream textbooks took the blank cells seriously. actual market structure prevailing there. We’ve seen how demand and supply Akerlof and Shiller say (2009: 173):
243 244 This fallacious ( 246 contracts, so that every time anybody did anything for anybody else, there was there else, for anybody did anything anybody time that every so contracts, are world, contracts to. But in the real adhered that was rigorously a contract and expensive, is extremely abound, litigation contract disputes ambiguous, are real world there contracts. In the go on without dealings most economic which enable society to func- understandings, norms, often implicit contracts, by and large, is trust. makes economic systems work, tion well. What importance of efficiency, they explicitly as- When textbooks emphasize the of a model by the accuracy of teach that we judge the usefulness Textbooks or, as McCloskey Economics is better represented as the art of persuasion do not apply the It is interesting, and perhaps ironic, that the textbooks The evidence, ignored entirely in the textbooks, shows that in rich countries The evidence, ignored entirely sume that ‘more is better’. At the individual level, well-being and happiness sume that ‘more is better’. At income and consumption. This story stumbles depend only on a person’s real by assuming that if one person is better off with into a fallacy of composition off if everyone has more stuff. more stuff, everyone is better gloss over the its predictions, not by the realism of its assumptions. Textbooks It is very difficult to reject core hypotheses difficulty of actually refuting a theory. the theory does not because they are protected by auxiliary assumptions. If at least one of these seem to fit the facts, this can be blamed on the failure of untouched. Hence, auxiliary assumptions to hold, leaving the core hypothesis or bad – never die Deepak Lal’s (2000: 18) memorable comment: ‘ideas – good in economics’. ‘debate’, and in prefers, ‘the art of rhetoric’. In this context ‘rhetoric’ means analogies this debate all and every kind of reasoned argument is admissible: precedents (or metaphors), thought experiments, natural experiments, historical and Even the ‘official methodology’ – predictive power and appeals to authority. it’s just one hypothesis testing – is used rhetorically according to McCloskey; more way of trying to persuade. methodology they espouse to the material they present. They do not develop a series of models, generate a variety of predictions, confront these predictions with the facts, and in this way evaluate which model is best. Instead, evidence And, as we have said, trust is enhanced by equity. And, as we have is better The assumption that more problems Methodological assumption invites readers to adopt a pro-growth consumerist outlook. assumption invites readers to have not increased as average incomes have risen measures of average happiness simply seem to get used to their new circumstances, which People substantially. that relative posi- quickly become the norm. Good evidence suggests, however, happiness. tion and status within groups matter a great deal to individuals’
11 | Conclusion 245 more efficiency. and compensate losers and still be better off, society as a whole is supposedly compensate losers and still be better off, society as a whole Recent research has emphasized that equity promotes social cohesion and research has emphasized that equity promotes social Recent Textbooks emphasize the importance of efficiency and downplay the impor- emphasize Textbooks equity and effi- Furthermore, textbooks claim that there is a trade-off between Older theories had simply assumed that it was costless to write and enforce Indeed if we thought that people were totally rational, and that they acted almost acted that they and rational, totally were that people thought if we Indeed should that government would believe motives, we too out of economic entirely all But on the contrary markets … of financial role in the regulation play little some- one way and sometimes to drive the economy spirits tend those animal will suffer by the government the economy Without intervention times another. will, from time to time, in employment. And financial markets massive swings fall into chaos. we and limited rationality, the importance of animal spirits While endorsing trust, whereas inequality weakens people’s sense of reciprocity, and increases the trust, whereas inequality weakens people’s sense of reciprocity, this subject, sense of ‘us’ versus ‘them’ (Wilkinson and Pickett 2009). By ignoring loyalty and trust. textbooks seem to imply that there is no role for virtues like he was aware of Joseph Stiglitz argues that Adam Smith didn’t make this mistake: modern economics the limitations of markets, and knew this was not so. Indeed, actually work explains why economic systems in which such virtues are prevalent better than those in which they are absent. Stiglitz writes (2003: 274): tance of equity. In textbook treatments, the equity goal is always subservient to the In textbook treatments, the equity goal is always subservient tance of equity. use the compensation principle example, textbooks implicitly efficiency goal. For as long as winners in cost–benefit analysis to justify efficiency-enhancing policies; could way. better off, although no one can explain why in any convincing water in a leaky ciency: transferring income between people is like transferring while conveniently bucket. They emphasize that taxation causes inefficiencies, can improve forgetting that taxing things we want less of (such as pollution) Similarly, the transfers that make up the social safety net are allegedly efficiency. at the same time, the texts costly because they reduce incentives to work. Yet growth. In reality, ignore the arguments and evidence that equity is good for opportunities to it seems that, within limits, people in many countries have attain both more equity do not agree with Akerlof and Shiller that if individuals were rational and had do not agree with Akerlof and there would be little role for the government in only economic motives then Problems of imperfect and asymmetric informa- regulating financial markets. important in financial markets. They give tion are pervasive and are particularly moral hazard problems and adverse selection. rise to principal-agent problems, the government in regulating many markets, in- This suggests a key role for cluding financial markets. The goals of and equity efficiency . Monopoly . Monopoly innovation take into account’. not examine, what questions they not 248 ask, what aspects of the economy (and important connections ask, what aspects of the economy (and important connections not As we have seen, textbook economics asks few uncomfortable questions about As we have seen, textbook economics asks few uncomfortable producing the Similarly, if corporations pollute the air and water when Textbooks do not acknowledge the possibility that they have adopted a par- do not Textbooks role, and Social science in particular has largely tended to play a legitimizing We believe the overemphasis placed on perfectly competitive markets arises on perfectly competitive markets the overemphasis placed believe We with the rest of the social process) they do and do sovereignty’ – that consumerism. Consumer theory has the notion of ‘consumer to buy and what not consumers ultimately rule the economy by deciding what This downplays the role of business in forming consumers’ preferences to buy. All buying decisions and in determining the products on offer to consumers. formed by some are portrayed as the free exercise of individual preferences of economics. unexamined process that apparently falls outside the realm choices about goods consumers want, this must just reflect voters’ rational the trade-offs involved, not a lethal mixture of individual ignorance and cor- porate influence over the political system. When questions of power are routinely ignored, as they are in the textbooks, this is a subtle way of legitimizing the ticular ideological position. The authors seem to be unaware that it is impos- ticular ideological position. The or any individual researcher, to avoid adopting sible for any social science, all, there is necessarily a fine line between explaining After some world-view. Since the start of why something is the way it is, and justifying the way it is. have been inevitable the scientific revolution in the seventeenth century, there interrelationships between science and society. of society either economics is no exception. Economics can legitimize aspects attempt to explain, through what its dominant theories focus attention on and is often alarming to or through what they ignore. As Dowd (2000: 14) says: ‘it note what mainstream economists do and do do and do most important facts that need explaining – innovation and growth. If there If there growth. and – innovation explaining need that facts important most it is good at, is remarkably that capitalism is one thing They provide innovation. the reward for profits are the associated power and perfectly competitive a world filled with on it. Focusing that drives the incentive of the economic landscape. this vitally important feature markets omits purported ideal characteristics. to tell a story about their because it is possible Pareto-efficient competitive markets produce spin a yarn about how Textbooks highest-valued uses and distribute they allocate resources to their outcomes, how most. In this market structure, government goods to those who value them or quantities inevitably produces adverse side intervention to change prices So, the emphasis on competitive markets imparts effects and reduces efficiency. to the standard textbook – it is biased against a market fundamentalist bias government regulation. government intervention and leanings ideological own their ignore Textbooks
11 | Conclusion is to argue that the overwhelming em- 247 Anti-Textbook Students learn that the realism of a theory’s assumptions is irrelevant just Students learn that the realism is why it is pres- Could it be that this model is simpler than others, and this A main theme of our Nor is the competitive model a useful parable – a story that helps us to under- Nor is the competitive model a useful parable – a story that Ironically, when the textbooks present non-competitive market structures, market structures, the textbooks present non-competitive Ironically, when before they learn the highly unrealistic perfectly competitive model (in its short- before they learn the highly unrealistic perfectly competitive apply it to markets hand ‘demand and supply’ version). They are then invited to in virtually all sectors of the economy. don’t think so. The perfectly competitive model is ented as a generic tool? We simpler than rather complex – even if its shorthand version makes it appear that the competi- it really is. In any event, one would be hard pressed to show is the competitive tive model is simpler than (say) the monopoly model. So, why model so emphasized? stand deeper truths about the economy. Certainly, perfect competition contains Certainly, perfect competition stand deeper truths about the economy. is driven by a a germ of truth: the process of entry and exit from industries search for profit. But the parable is inadequate in that the process takes place in an environment of constant technological knowledge, with given resources, given tastes and given products. Therefore, it says nothing about some of the phasis placed on the competitive model in principles textbooks reflects – and phasis placed on the competitive model in principles textbooks example, For may produce in readers’ minds – a particular ideological outlook. markets is justi- Chapter 3 dismisses claims that the emphasis on competitive applicability of the fied by either their real-world prevalence, or by the generic emphasis is justified model’s predictions. Chapter 6 dismisses claims that such type that can be by the usefulness of the competitive model as an ideal market used to guide government policy. Overemphasis on perfectly competitive markets markets on perfectly competitive Overemphasis they choose real-world applications by how closely the market in question con- the market in question applications by how closely they choose real-world attempt to apply these models assumptions. They never forms to the model’s see the model’s assumptions to that don’t conform to generically to markets to be of little example, monopsony is said predictions are. For how accurate the a single employer is rarely seen, but a corres- relevance because the case of of the assumptions of the perfectly competitive ponding analysis of the realism to the irony is the fact that modern labour labour market is omitted. Adding power may derive from imperfect infor- economists recognize that monopsony of workers. Since information and mobility are mation and imperfect mobility reasonable – on a priori grounds – to think that always imperfect, it is entirely be a useful generic model. the monopsony model might is presented sporadically and selectively. Evidence is nearly always presented presented always is nearly Evidence and selectively. sporadically is presented enough to model is good competitive claim that the the textbook to support is too contrary evidence question – but to answer any generic model use as a often ignored. 250 11.2 Prasch the blank cells of Robert Conventional textbook economics and Whenever information about quality is imperfect, markets can break down Whenever information about quality is imperfect, markets Prasch (ibid.: 13–14) explains: ‘The lack of concern for specifics is aggravated The recent global financial meltdown (discussed in the postscript to this to this in the postscript (discussed meltdown global financial The recent invisible hand only works to produce an effi- Prasch (ibid.) explains that the – as in the market for good used cars (the ‘lemons’ problem) or the market for – as in the market for good used cars (the ‘lemons’ problem) Even though most consumer durables and cap- asset-backed commercial paper. 11.2, and most labour market ital goods would fit in the lower left cell of Table right-hand cell, contracts and credit market transactions would fit in the lower we draw the table textbooks treat all of these as if they were widgets – hence pretend these cases don’t exist. In so doing, they with blank cells. Textbooks to make these underestimate the importance of the laws and regulations needed regulations 11.2, In all the blank cells of Table markets function more efficiently. practices. are needed to help restrain conflicts of interest and abusive when an abstract good, by tradition termed a “widget,” is used to illustrate the “essence” of the market process. In this pedagogy, the student’s attention is law opens our minds to their inherent complexity, contingency, and importance. and importance. contingency, complexity, inherent to their minds opens our law of and weaknesses some of the strengths illuminates in turn, This knowledge, and social institutions.’ as economic markets importance of the legal and regula- – among other things – the book) illustrates infor- Imperfect and asymmetric within which markets operate. tory framework at that allow some people to profit possible conflicts of interest mation creates it is supposed to work like that; others. The invisible hand isn’t the expense of into the greater good. everyone’s selfishness supposed to transform if the economy consists of certain special kinds cient allocation of resources externalities, but additionally the quality of the of markets. There must be no exchanges must be instantaneously completed product must be known, and the proverbial ‘widget’ of the microeconomic in ‘spot’ markets. This describes 11.2. On the other upper left-hand cell in Table textbooks and occupies the without owning the product for a while hand, if quality cannot be determined to inspection-goods), or if exchanges are ongoing (experience-goods as opposed and needs (‘relational contracts’ as opposed to and involve issues of fairness mechanism breaks down and resources will spot markets), the invisible hand not be efficiently allocated. jWXb[ Inspection goods Experience goods The mythical ‘widget’ Spot markets contracts Relational
11 | Conclusion , in general , why it should be easier (or harder) to 249 a priori In dropping these subjects, perhaps mainstream textbooks have In dropping these subjects, perhaps ) The popular presumption that governments are inefficient compared to the pri- The popular presumption that governments are inefficient compared This follows if – as textbook economics maintains – markets can be generi- This follows if – as textbook economics the vantage Most producers are employees of firms, not owners. Viewed from of firms, ex- point of classical theory, they have no reason to maximize the profits profit-making cept to the extent that they can be controlled by owners. Moreover, all have exactly firms, non-profit organizations, and bureaucratic organizations the organiza- the same problem of inducing their employees to work toward tional goals. There is no reason, As noted earlier, trust is important because contracts are necessarily incom- produce this motivation in organizations aimed at maximizing profits than in produce this motivation in organizations aimed at maximizing motivated by organizations with different goals. If it is true … that organizations postulates will profits will be more efficient than other organizations, additional have to be introduced to account for it. (Simon 1991: 28) Indeed, ‘economics’ has come to be synonymous with the economics of a Indeed, ‘economics’ has come The same ideological position is not present in all economic paradigms. in all economic paradigms. position is not present The same ideological vate sector and compared to markets rests more on ideological belief rather than vate sector and compared to markets rests more on ideological tant contribu- impor on evidence. Herbert Simon, who received his Nobel Prize for matter this tions to understanding how organizations behave, put the way: government intervention is neither necessary nor beneficial. government intervention is neither necessary nor beneficial. cally analysed as if they were perfectly competitive, and if externalities can be cally analysed as if they were analysed as if they are exceptions rather than ubiquitous. Therefore, plete, potential disputes abound, and litigation is expensive. As Prasch (2008: 8) observes: ‘[A] rudimentary knowledge of the principles of property and contract been ‘dumbed down’. Certainly, the range of thinking has been narrowed. been ‘dumbed down’. Certainly, The central idea that smaller government is better idea that smaller government The central the importance ofDownplaying the legal within which framework operate markets particular view of capitalism. It wasn’t always this way. At one time, economic It wasn’t always this way. particular view of capitalism. chapters on alternative economic systems, on the textbooks routinely contained and the advantages and disadvantages of the evolution of economic doctrines, corporate form. Different paradigms contain different world-views. But textbooks don’t bother But textbooks don’t bother contain different world-views. Different paradigms they reflect world-views, nor do about how the paradigms teaching students out one world-view that comes students anything other than bother teaching neoclassical paradigm. of the dominant existing distribution and exercise of power. Similarly, the lack of attention paid attention lack of the Similarly, of power. and exercise distribution existing serves to and to its equity households income among of to the distribution towards only a few pages issues merit If these existing inequalities. legitimize they be that important? how can of a large textbook, the end 252 better off, creating distributional problems that may better off, creating distributional © Andy Singer everyone The greater the role for markets, the more life is commercialized; personal The greater the role for markets, the more life is commercialized; protect himself Marglin gives the example of two ways in which a farmer can The concept of community doesn’t easily fit within the mainstream neo- be compounded when people care about relative position. But there is another be compounded when people care about relative position. if no one cared issue. Even if everyone were absolutely better off, and even markets often about their relative position, there is still a potential problem: Marglin (2008) asks what limits should be placed on undermine community. markets for the sake of community. Sometimes this notrelationships are replaced by anonymous market transactions. example, For only damages the community, it can even backfire on the economy. knowing their cus- the US sub-prime meltdown arose because, instead of bankers became more tomer’s profile individually and being able to assess it, the market marketplace. and more anonymous. The community was taken out of the still practised by against the risk of his barn burning. The old-fashioned way, in the form of the Amish, is to have a commitment to economic reciprocity Insurance is community barn-raising. The modern way is to buy insurance. more efficient if much more efficient in terms of time and cost. But it is only If we’re interested we focus exclusively on the users of the barn as individuals. rejecting insurance in the community, then the Amish are on to something by the glue that keeps and sticking to barn-raisings. Economic reciprocity is part of the community together. classical framework, which views society as merely a collection of individuals. Leonard (2009: 490) argues in his critique of Marglin that if communities are and necessarily makes people better off. We have noted repeatedly that it doesn’t have noted repeatedly that it doesn’t We better off. and necessarily makes people necessarily make
11 | Conclusion 251 While mainstream texts may appear to take a balanced view on the costs While mainstream texts may appear to take a balanced view countries affect Second, state power is ignored, yet power relations between According to the standard account, expanding the realm of the market ex- Textbooks assume all economic relationships are voluntarily entered into. all economic relationships are assume Textbooks the textbooks is ‘market power’ – the power of The only power that appears in lives at work, as employees of companies Most people spend much of their and benefits of free trade, in fact they bias the discussion to favour free trade. and benefits of free trade, in fact they bias the discussion and effects on How is this done? First, the texts downplay adjustment costs and increasing the distribution of income. As usual, the focus is on efficiency increase the well- national income, with the presumption that this, in turn, will being of society as a whole. economic relations. the ‘rules of the game’ that govern trade and international copyright, foreign‘Free trade agreements’ can include rules governing patents and they ignore the investment and access to energy resources, for example. Finally, greenhouse gases inenvironmental costs of trade – in particular, the production of world to the other. transporting goods and raw materials from one side of the pands the possibilities for specialization and trade, expands freedom of choice, But the choices people make are constrained by the circumstances in which by the circumstances in people make are constrained But the choices may be shaped by the power In turn, those circumstances they find themselves. we say that a person ‘voluntarily’ society around them. Should of others in the her or that circumstances forced to work in a sweatshop allows her children As we explained in Chapter 3, Prasch (ibid.) into this unwelcome decision? consideration, such markets may differ from the shows that where needs are a found in the textbooks. conventional demand and supply in the actual economy, of their products. Yet some sellers to influence the prices power appears in many forms. of command. Their employers’ monopsonistic governed by authoritarian chains receive, which, in turn, rests on the difficulties em- power influences the pay they people’s another comparable job. As consumers, ployees would have in finding crafted by preferences are influenced by a continuous barrage of propaganda the most glaring example of the omission of Perhaps the marketing industry. of business power in the standard textbooks is their silence about the influence within which on government policy, and on the legal and regulatory framework markets operate. The presumption in favour trade ofThe presumption free The omission of community then directed to the theory of exchange and price. It concludes once the student student once the It concludes price. and of exchange theory to the directed then market”.’ theory of the drilled in “the successfully has been ofThe omission power has been to provide eco- Anti-Textbook 254 minor problems. They become major problems only with the advent of cities of cities advent with the only problems major become They problems. minor 2008: 284). (Marglin density. growth in population accompanying and the prob- important these increasingly not only produces system The economic ignore these problems and put forward The textbook accounts of externalities Marglin (ibid.: 283–4) asks: nuisance or anomaly …? Or are externalities Are externalities an occasional escape? It obviously makes a huge difference. everywhere, something we rarely second order In the first case, externalities can be treated as relatively minor, and are effects … In the second case externalities are central to the discussion world we actually ignored at the peril of making the discussion irrelevant to the inhabit. Our fundamental aim in writing this Our intention in writing this book has not been to discourage anyone from Our intention in writing this book has not been to discourage lems, but some of its features make these problems difficult to address. Firms difficult to address. of its features make these problems lems, but some They from being internalized. in preventing externalized costs have an interest to reduce pollution by ‘going public pressure for regulation may seek to lessen and But, given imperfect their image among consumers. green’ to improve the often than reality counts. Too appearance rather asymmetric information, than really going green. Alternatively, public result is ‘green-washing’ rather firms simply to use their political influence ignorance and apathy may allow regulations. to alter or block environmental are generally efficient and that market failures, the central story that markets Then the net effect of the market system such as pollution, can be remedied. is, or can be, roughly efficient. nomics students with the basic ideas with which they can begin to think critically nomics students with the basic ideas with which they can begin (1988: 623) once about what they read in their textbooks. As Noam Chomsky they aren’t, … remarked: ‘If the schools were doing their job, which of course – in this they would be providing people with means of intellectual self-defense’ acceptance of case, the means to defend themselves against the unconscious have to think for the ideology presented in the textbooks. As a result, students guidance. themselves, not an easy matter to do alone and without some that are central to studying economics. After all, economics deals with matters But simply to individual well-being and to the functioning of human societies. questions that study a conventional textbook (and to solve the multiple-choice One needs to read supposedly test understanding of the subject) is not enough. unsupported. Such with a critical eye, and to note what is omitted and what is critical thinking will be rewarded with a very different and far more interesting perspective on the world. Critical thinking about economics Critical
11 | Conclusion 253 [W]hat we measure affects what we do. If we have poor measures, what we strive [W]hat we measure affects what contribute to a worsening of living stand- to do (say, increase GDP) may actually between may also be confronted with false choices, seeing trade-offs ards. We that don’t exist. By contrast, a better output and environmental protection might show that steps taken to improve the measure of economic performance environment are good for the economy. the it is absurd that this point appears at the end of our list, given Perhaps laid at the door In part, the origins of our environmental problems can be of economics. Anglo-American economists (after about 1880) took nature out land, shoals The growth fetish, while on balance quite useful in a world of empty create a more of undisturbed fish, vast forests, and a robust ozone shield, helped to the changed crowded and unstressed one … Economic thought did not adjust and indeed conditions it helped to create; thereby, it continued to legitimate, 2000: 336) indirectly to cause, massive and rapid ecological change. (McNeil written about Boulding and Herman Daly have Economists such as Kenneth Marglin explains the importance of the distinction: our non-market But now that we live and work at close quarters to one another, externalities are interactions are much more part of the fabric of our lives, and once again, is a case in point. When people lived of central concern. Pollution, in small communities with a lot of space between settlements and produced and consumed at relatively modest levels, air and water pollution were relatively Incidentally, the fixation on quantitative measurement has broader implica- fixation on quantitative measurement Incidentally, the severe risks human societies face from climate change. The textbooks could severe risks human societies face from climate change. The it exists. help students understand that there is a problem and why As historian J. R. McNeil writes, of economics itself. the ‘full-world eco- this distinction between this ‘empty-world economics’ and 1989). But the nomics’ that is needed now (Boulding 1966; Daly and Cobb textbooks are still teaching empty-world economics. Downplaying the ecological crisis facing the planet today crisis the ecological Downplaying tions than the omission of community. It also plays its part in our neglect of also plays its part in our neglect It omission of community. tions than the 2) notes: the environment. Stiglitz (2009: bene ficial to individuals, then people will form them, join them or leave them as leave them or join them them, will form people then to individuals, ficial bene than merely ties are deeper community here is that fit. But the problem they see ties are of community since the benefits claims that associations. Marglin chosen wry With them altogether. to ignore have chosen measure, economists hard to insisted physicist Lord Kelvin (2008: 9): ‘The nineteenth century humour he notes step takes the dictum a what we can measure. Economics that we know only community – doesn’t exist.’ we can’t measure – entities like further … what 256 – issues that are downplayed and under- – issues that are downplayed Anti-Textbook Textbooks claim that the demand and supply model can be applied as a claim that the demand and supply model can be applied as a Textbooks noted in Chapter 6 that asymmetric information gives rise to a cluster of We This financial debacle illustrates the importance of many of the issues high- This financial debacle illustrates Let’s begin with some general points about credit markets and ask whether Let’s begin with some general generic model to all markets throughout the economy. Then why not apply it to generic model to all markets throughout the economy. competitive. There credit markets? Credit markets in the USA seem reasonably reach by phone are thousands of banks and finance companies within easy in Chapter 6 we producing a reasonably homogeneous product – loans. But relational contracts, noted that asymmetric information is routinely involved in know everything of which loan contracts are a prime example. Banks cannot an incentive not to relevant to a customer’s creditworthiness – people have ability to repay divulge damaging information about their past; and their future (perhaps) by loans depends on a host of uncertain elements better understood know every- the individuals themselves. Nor can depositors and shareholders nor (it turns out) thing about the solvency and risk profile of any given bank; conditions and can borrowers know everything about how honestly the terms, fees associated with loans may be presented. hazard problem well-known problems: the principal-agent problem, the moral and the adverse selection problem. Competitive markets cannot function effi- ciently when these problems are present: government regulation is required. So, how do these problems manifest themselves in credit markets? emphasized by the mainstream texts. It illustrates the importance of imperfect emphasized by the mainstream externalities, limited rationality and inappropriate and asymmetric information, the necessity of appropriate government incentives. In particular, it illustrates business interests to change the rulesregulation, and the ability of powerful of Postscript: a case study on the globalstudy on a case financial Postscript: meltdown themes with the global financial we want to connect our main In this postscript in March 2008 with the collapse exploded into headline news meltdown that largest investment banks. of Bear-Sterns, one of the world’s lighted throughout this The importance of information imperfect and asymmetric the game through lobbying – especially in the USA (which was the epicentre the game through lobbying – of the global collapse). model holds in the supposed generic applicability of the demand and supply this case.
11 | Conclusion
Pluralist Economics Pluralist , has not yet been published , has not yet been focuses on the hidden ethical values of ethical values on the hidden focuses 255 Economics for the Rest of Us Rest Economics for the The Skeptical Economist The Skeptical Moshe Adler’s book, Moshe Adler’s Aldred (2009) Aldred (2009) presents alternative approaches to economics. alternative approaches presents themes – examining the misuse But what appear to be its main as we write this. and that promote greater equity, justify opposition to policies of ‘efficiency’ to theory of wage determina- of the marginal productivity a critical examination book. we have examined in this tion – reflect themes economics, and is highly recommended. Fullbrook’s (2008) Fullbrook’s recommended. and is highly economics, Suggestions for furtherSuggestions reading 258 as a whole. system
banking This is a classic case of how the demand and supply model is inadequate This is a classic case of how the demand and supply model is Bankruptcies highlight an important point: the destruction of wealth in the Bankruptcies highlight an important point: the destruction but also Financial institutions find themselves not only short of liquidity, may be low (even This is what is meant by a ‘credit crunch’. Interest rates If my failure jeopardizes your possibilities for success, there is a negative is a negative there success, for your possibilities jeopardizes failure If my market bubbles are driven by investor overconfidence. estate and stock Real the upswing, irrational pessimism char- Just as overconfidence characterizes downturn isn’t limited to decreases in asset prices – real wealth is also destroyed. downturn isn’t limited to decreases in asset prices – real wealth never reopen. Machines are mothballed, factories are closed. Some may far exceeding short of capital. Many of them in the 2008/09 crisis had liabilities insolvent – hence the (now reduced) value of their assets and were effectively even sound the call for massive government bailouts. In such circumstances may be forced into businesses are unable to find the funding they require and bankruptcy. if you need the approaching zero) but loans are difficult to obtain – especially money! to explain the credit market. externality. Clearly, there is an externality in banking since failure by any one since failure in banking is an externality Clearly, there externality. banks’ repu- – and not just of all banks the reputation affects bank negatively For other. with each their reputations it even affects with households; tations that so suspicious of each other 2008/09 crisis banks became example, in the is the credit crunch. This lend to each other – exacerbating they refused to have since problems at one bank to as a ‘systemic externality’ often referred the implications for that this overconfidence is fed by ‘stories’ that Akerlof and Shiller (2009) argue ample, ex that they seem undeniably true. For gain such widespread acceptance believed that real estate was the single best in- in the 1990s it was commonly because land is limited while the population vestment anyone could make, land) is constantly growing. Akerlof and Shiller (and hence the demand for story conveniently dis- 12) point out that after the bubble bursts, the (ibid.: ch. appears. focus on trying to acterizes the downswing. When prices begin to fall, people than others. In the preserve their capital. This necessitates selling more quickly suddenly Fundamental values mad scramble to sell, prices fall precipitously. heavily to participate Individuals and companies that borrowed don’t matter. asset values. When in the real estate boom find themselves with negative net the loans are called in, bankruptcy looms. Limited rationality Limited rationality level clearing at their market always aren’t rates Interest
Postscript 257
' Moral hazard (where incentives are changed by certain kinds of contracts, Moral hazard (where incentives attract Finally, adverse selection (where particular contracts disproportionately The temptation of high returns might lull a bank into ignoring the increasing The temptation of high returns might lull a bank into ignoring be tempted As long ago as 1776, Adam Smith worried that banks would Let’s begin with the principal-agent problem (where some people benefit benefit some people (where problem principal-agent with the begin Let’s which leads to a change in behaviour that is hard to monitor) played its part which leads to a change in behaviour reasons. First, because the banks didn’t hold in the meltdown for at least four sold them on to other investors, they had little the mortgages they extended but of the borrowers. So, the normal incentive interest in the real creditworthiness of its customers was short-circuited (or of banks to vet the creditworthiness new investment vehicles. Second, the agencies distorted) by the creation of the the investment vehicles were compromised by the that assigned credit ratings to gave. (The better the fact that their fees depended on the quantity of ratings they Third, the investors ratings they gave, the more business they would be given.) sufficiently care who purchased the ‘alphabet soup’ of investment vehicles didn’t the possibility of about their ultimate riskiness because they insured against default swaps) default (or at least they thought they did) by buying CDSs (credit depositors at the banks didn’t from huge insurance companies like AIG. Fourth, were insured have to worry about the risk of bank collapse since their deposits Deposit Insurance Corporation. by the government-owned Federal experience since undesirable customers) is always involved in credit markets, optimistic are much suggests that those who are dishonest, desperate or overly rates rise. This less likely than others to drop out of the loan market as interest rates rise. makes the business of extending loans more risky as interest riskiness of loans as interest rates rise. Such a bank not only jeopardizes its riskiness of loans as interest rates rise. Such a bank not a whole. own future, but might also weaken the banking system as As noted by Prasch by the possibility of high returns to ignore increasing risk. (2008: 59): ‘His concern was less for the irresponsible bank, but rather for the tendency for one bank failure to cast doubt on the reputation of nearby banks, thereby contributing to a potential crisis within the broader financial system.’ at the expense of those they are supposed to serve). This played its part in the This played its to serve). they are supposed of those at the expense on maxim- banks focused management of when the meltdown global financial profits inflating short-term for example, reward by, own short-term izing their Managers ignored the long-run value of their stock options. to maximize the in- and their shareholders. It was entities that employed them interest of the had loans to individuals who institutions gave predatory volved when financial job, NINJA (no income, no paying them back – the infamous little chance of those same financial institutions It was involved when no assets) mortgages. alphabet soup of investment vehicles and sold repackaged these loans into an them on to unsuspecting investors. The role of externalities The role
, com- The Glass-Steagall Act prohibited 260 For example, we now know that major full- example, we now For the creditworthiness of the companies to which It was this feature which was abolished in 1999 by * Instead, it enhanced the scope for conflicts of interest and perverse Instead, it enhanced the scope for conflicts of interest and + There was one last legislative change made in the 1980s, which enticed in the 1980s, which enticed last legislative change made There was one 522) show that by 1988, a scant two years Calculations by Mansfield (ibid.: Stiglitz (2003: 143–4) says: ‘The bubble – and the bad behaviour – were re- Stiglitz (2003: 143–4) says: ‘The bubble – and the bad behaviour The consolidation of commercial and investment banks was supposed to was supposed to The consolidation of commercial and investment banks incentives. Because full-service banks make most of their money selling equities incentives. Because full-service banks make most of their money and bonds and arranging ‘deals’, they extended loans became secondary. bankruptcy service banks continued to give loans to Enron even as it approached bankruptcy. because of the lure of mega-profits from new deals, if it avoided (where by borrowers don’t pay off the principal) and ‘balloon’ mortgages (which (which mortgages ‘balloon’ and principal) pay off the don’t borrowers by (where maturity end of the loan’s at the a large payment to make oblige borrowers figure mortgages These ‘alternative’ monthly charges). for lower in exchange poor risk predatory lending, through crisis, either in the sub-prime prominently people into foreclosure. Taken punitive charges that tipped controls or hidden the door for small consumer two legislative overhauls opened together, these business and begin peddling to move into the mortgage finance companies loans. exotic, high-interest piggy banks. Prior to 1986, interest payments on people to use their homes as – credit cards, car loans and house loans – were most types of consumer loans deductibility was allowed only for first- or tax deductible. After 1986 interest change focused people’s attention on house second-home mortgages. This get a tax break. Combined with the two earlier mortgages as the only way to terms, conditions and interest rate on mortgages, reforms that deregulated the turned homes into automated teller machines. A the interest-deductibility rule only too happy to step up with the money for host of finance companies were choice. refinancing – at rates of their loans were used to after the tax code was changed, 68 per cent of home equity just 35 per cent fund things other than home improvements, compared with in small consumer in 1984. Running parallel to this growth was the growth companies owned a finance companies. In 1977, these little consumer finance end of the 1980s, mere 0.5 per cent of the home equity loan market. But by the they had 32 per cent. The repeal of Glass-Steagall in 1999 inforcing: the stronger the bubble, the stronger the incentives to take the actions to keep it going. The banks must surely have known that when the bubble burst, many of the loans they had made would fail. Thus, the banks’ loan portfolios mercial banks from owning other financial companies such as investment banks mercial banks from owning other financial companies such or insurance companies. the Gramm-Leach-Bliley Bank Deregulation Bill. allow the resulting ‘full-service’ banks to better compete and to enjoy economies of scale.
Postscript
) According ( 259 Unfortunately, in the late 1970s (and early 1980s) the Second, the terms and conditions of mortgages were deregulated in 1982, Stiglitz (2003) argues that the main problems were caused by deregulation. caused by deregulation. problems were the main (2003) argues that Stiglitz which Glass-Steagall Act (1933), first piece of legislation was the Roosevelt’s Housing Administration Act was the Federal The second key piece of legislation National Federal The final piece of legislation was the creation in 1938 of the reforms began to be dismantled. Beginning in the early 1980s, Roosevelt’s First, interest rates were deregulated in 1980 for any company that lent more First, interest rates were deregulated in 1980 for any company These included: adjustable-rate mortgages, ‘negative amortization’ loans These included: adjustable-rate mortgages, ‘negative amortization’ loans allow ing lenders to promote a hodgepodge of ‘alternative’ mortgage features. allow to C. L. Mansfield (2000: 492): ‘This … is the statute that ultimately set the stage to C. L. Mansfield (2000: 492): ‘This … is the statute that ultimately No one predicted for the subprime home equity lending industry of today.’ when mortgage rate the kind of predatory lending tactics that would take hold ceilings were eliminated. In the early 1930s the Roosevelt administration enacted three key pieces of pieces of three key enacted administration Roosevelt 1930s the In the early the Great Depression. The system effort to avoid a repeat of legislation in an about fifty years. worked well for and grant loans to both house- banks (which take deposits prevented commercial and banks (which issue stocks from acting as investment holds and business) deals such as mergers). Investment banking shares, and organize huge business commercial banking, and the Glass-Steagall Act is inherently more risky than kept the two separate. of mortgages and insured them against default. (1934), which regulated the terms them making gages ( example, it established interest rate ceilings on mort For making them less down-payment requirements ( more affordable) and minimum leveraged). The idea was to prevent a repeat of risky since borrowers were less where millions of Americans defaulted on their the Great Depression scenario, further safeguard of thousands of banks. To mortgages, precipitating the collapse Housing Administration Act insured long-term the banking system, the Federal mortgages. Mae), which purchased the now federally Mortgage Association (known as Fannie Mae would Fannie insured mortgages from banks and other financial lenders. The process fun- then resell these mortgages to investors needing safe assets. mortgages. nelled cash into the banks, allowing them to make more Deregulation in the 1980s The importance of the regulatory framework and of impact the framework of importance The the regulatory deregulation than $1 million a year – regardless of whether it accepted deposits. than $1 million a year – regardless of whether it accepted US central bank (the Federal Reserve) raised interest rates to record high levels Reserve) US central bank (the Federal and then in an effort to fight inflation. As market interest rates approached to issue mortgage exceeded the ceiling on mortgage rates, it became unprofitable responses. loans and their supply dried up. This inspired two policy It also '& This illustrates a crucial ''
'( 262
/ growth in this market was due to the last – and perhaps most impor- growth in this market was due Now, one could say that the growth of the credit default swap market was credit default swap market was say that the growth of the Now, one could [E]conomists (and those who listen to them) became over-confident in their pre- [E]conomists (and those who listen to them) became over-confident trans- ferred models of the moment: markets are efficient, financial innovation and government fers risk to those best able to bear it, self-regulation works best, were many other intervention is ineffective and harmful. They forgot that there blind spots. If models that led in radically different directions. Hubris creates textbooks – at anything needs fixing, it is the sociology of the profession. The least those used in advanced courses – are fine. Why did successive US administrations opt for deregulation? Akerlof and Why did successive US administrations opt for deregulation? economists. (2009), specifically blame Some commentators, such as Rodrik So, while it is true that institutions did evolve ways to avoid legislation – as So, while it is true that institutions one way in which financial institutions evolved to avoid regulation. But the the to avoid regulation. But financial institutions evolved one way in which unsupervised introduced by Phil Gramm) – the Commodity tant – piece of deregulation (also of 2000. This legislation guaranteed that the Futures Modernization Act (CFMA) be regulated like other ‘futures contracts’. credit default swaps would not Shiller attribute it to public antipathy towards regulation. The United States was Shiller attribute it to public antipathy towards regulation. The of the deep into a new view of capitalism – the no-holds-barred interpretation lesson of had forgotten the hard-earned game. They argue (2009: 173): ‘We worlds, but it does the 1930s: that capitalism can give us the best of all possible rules and acts as a so only on a playing field where the government sets the of deregulation. referee.’ The US administration was trapped into the mantra He says: Finally, we mustn’t forget Stiglitz’s point that deregulation made a lot of people very rich. Those who saw this potential were willing to invest to get it – spending large amounts on campaign contributions and lobbyists to secure the necessary 3 September 2008. The fact that they couldn’t pay up jeopardized every financial financial every up jeopardized pay couldn’t that they The fact 2008. 3 September Why did this happen? point: it is not sufficient to have regulations in place. The agency whose job it point: it is not sufficient to have needs a budget sufficient to do the job. is to enforce the regulations played a huge role in causing the sub- Akerlof and Shiller argue – deregulation prime collapse and the global financial meltdown. whacked the Securities and Exchange Commission’s budget when they asked for whacked the Securities and Exchange new types of deals. more funding to oversee all these institution that had insured against credit default with them. The resulting resulting with them. The credit default against that had insured institution huge player AIG – another not to allow US authorities the panic convinced 2008 on 16 September As a result, similarly collapse. markets – to in these was be) a $182 billion loan, and out and given (what grew to AIG was bailed per which received in return 79.9 by the government, effectively ‘nationalized’ cent of its equity.
Postscript , explains that the main prob- , explains that the - 261 Animal Spirits . Securitization was not new: banks had been able to sell their mortgages (as Securitization was not new: banks What was new was the securitization of assets that were not federally insured. What was new was the securitization a fire insurance It might be helpful to think of credit default swaps as like securi- Similarly, the financial institutions that insured the mortgage-backed The financial institutions that issued the credit default swaps faced a catas- Akerlof and Shiller’s (2009) book, Akerlof and Shiller’s assets) to Fannie Mae since its establishment in 1938. But Fannie would buy only in 1938. But Fannie Mae since its establishment assets) to Fannie which were backstopped by the US government. federally insured mortgages, safe. The securities it sold were relatively lem was not deregulation, but the natural tendency of corporations to develop of corporations to develop but the natural tendency lem was not deregulation, cite regulation. In particular, they in a way that avoids existing their business issued mortgage-backed security. the evolution of the privately These new investment vehicles were more risky and more profitable. Because These new investment vehicles sought reassurance. This was met in part by of the higher risk, big investors grades to securitized bundles – a lucrative job credit rating agencies assigning incentives to give overly generous ratings. But it which had its own perverse – ways of insuring was also met by the development of credit default swaps of the securities against default by the ultimate borrowers upon whom the value in 2008 to be depended. The value of these credit default swaps was estimated between financial around $62 trillion and involved complex interrelationships institutions. say $300 a year – to policy on a house. The householder pays a small sum – by gearing rates insure a home worth, say, $300,000. The insurer makes money reason a to the likelihood of a home fire. If for some bizarre and unforeseen the insurance large proportion of the insured houses suddenly burnt down, who now company would certainly go bankrupt. And if it did, the homeowners But into bankruptcy. have dud insurance claims would probably also be forced Usually the risk of any one home burning down is this scenario isn’t very likely. the insurance independent of any other burning. So, by insuring lots of houses, company diversifies its risk. defaulting on ties against default thought that the risk of any one householder defaulting. So, his or her mortgage was independent of any other householder But this reason- by issuing lots of credit default swaps, they were ‘diversifying’. a real estate bubble ing ignores the possibility of a systemic event – such as bursting – creating huge swathes of mortgage defaults. It was this which led to Lehman Brothers going bankrupt on trophic liability. depended on keeping the stock market bubble going.’ The bubble Stiglitz is Stiglitz The bubble going.’ bubble market stock the keeping on depended that burst 1990s – the one of the late market bubble to is the stock referring the at work in generating incentives was same set of 2000. But the in August years later. that burst seven bubble and stock market real estate or evolution? Deregulation 4 While it is true that economists 5 In the next chapter we discuss the 6 noted earlier that mainstream We 1 Objecting to the placing of observa- 2 letter to in a John Maynard Keynes 3 See McCloskey (1983, 1985), Klamer 4 and Card (1992a, 1992b), Katz 5 So, David Levine was being diplo- efficient allocation is not a major issue. efficient allocation among post- what is emphasized Rather, degree to economists is the Keynesian which these resources are utilized.’ the recognize problems with markets, more solution to these problems is always and better markets. con- difficulties of coming to a definitive While clusion through empirical testing. and Tabellini the conclusions of Persson (1994) have (1994) and Alesina and Rodrik to say been challenged, it is still correct that there is no firm evidence that greater inequality lowers growth. This is discussed more fully in Chapter 9. economics does not restrict preferences to the purely selfish, so that altruism is allowed. Still, the typical model does as- sume pure self-interest. 2 economic models Introducing bles at the heart of the new quantum me- chanics, during Heisenberg’s 1926 lecture at Berlin; related by Heisenberg, quoted by Salam (1990: 99). Vickers (1999: Harrod, 1938, cited by Roy 210). et al. (1988) and Klamer et al. (2010). Krueger (1992), Card et al. (1994), Card and Krueger (1994, 1995, 2000). Neumark (2004) point out that con- and Wascher flicting empirical evidence can be found for nearly every country in the world. matic because he was suggesting that 264
. the change in the The Crisis of Global Capitalism in economics’ (emphasis added). in economics’ (emphasis added). Economics and the Public Purpose 3 Market fundamentalism is essen- 4 The ‘Nobel Prize in economics’ is 1 Quoted in John K. Galbraith’s 1973 2 The stand-up economist, Yoram 3 example, Lavoie (2006: 10) says: For 1 of defining Ironically, the difficulty 2 Stiglitz sees his work as changing tially a laissez-faire view. The core belief The core belief tially a laissez-faire view. is that markets are efficient and that governmental attempts to ‘interfere’ with markets necessarily create inefficiencies. The term was popularized by George Soros in his book (1998), but has been used by many others – for example, Stiglitz (2002) and Prasch (2008). a commonly used term for ‘The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel’. Established in 1968 by the Bank of Sweden, which also funds it, it is not one of the original prizes established by Alfred Nobel. 1 What is economics? book, Bauman, quips that a microeconomist is someone who is wrong about specific things, whereas a macroeconomist is someone who is wrong about things in general (see his website: www. standupeconomist.com/). ‘… since full employment of resources is not assumed, the discussion of their paradigm Notes Introduction is the lasting im- neoclassical economics brave pression one gets from reading the attempt by Arnsperger and Varoufakis (2008) to identify its three identifying features. example, the neoclassical paradigm. For 2002) the title of his Nobel lecture (Stiglitz was ‘Information and
Postscript Plunder and 263 . As the title suggests, his thesis is how a combination of policy blunders his thesis is how a combination . As the title suggests, Akerlof and Shiller’s (2009) book explains how human psychology is prone to human psychology is prone (2009) book explains how Akerlof and Shiller’s Blunder and powerful vested interest have caused market bubbles and meltdowns. interest have caused market and powerful vested waves of irrational optimism and pessimism, and how these generate bubbles and how these generate bubbles optimism and pessimism, waves of irrational Baker’s (2009) book different view is presented in and slumps. A legislative changes and financing ‘think-tank’ propaganda to influence public public influence to propaganda ‘think-tank’ and financing changes legislative opinion. for furtherSuggestions reading in the Penn World Tables, Version Version Tables, World in the Penn 19 Schwartz (2004) gives a psycholo- 18 Solnick and Hemenway (1998) 17 The relationship looks like a curved 16 Satisfaction with life is significantly 15 The values are from the variable 14 its English version The question in gist’s view about why the expansion of report survey evidence supportive of this. line that gets flatter as income gets higher, but which continues to rise as income rises. This implies that a given dollar increase in incomes will have a bigger impact on happiness in poor countries. A similar relationship holds for satisfaction with life (Deaton 2008). In the recent past, many have held the view that beyond a certain level of average income, increases in happiness were negligible (e.g. Layard 2005). lower in these countries, however (Deaton 2008). Questions about happiness elicit information about experienced emotional states, while questions about satisfaction with one’s life ask for an overall evaluation of one’s situation. The factors that influ- ence each of these are not necessarily the same. rgdpeqa 6.2. Gross domestic product is expressed in US dollars of the year 2000, with exchange rates adjusted for purchasing power parity, to give a more appropriate mar- comparison between countries than than ket exchange rates permit. Rather divide GDP by population, an adjustment is made to give less weight to children, whose consumption needs are less. was ‘Taking all things together, would together, would all things was ‘Taking happy, quite happy, you say you are very not at all happy?’ We not very happy or values using weights calculated aggregate for each response 9.3, 7.2, 3.9 and 1.0 are those current in (Weights respectively. There Database of Happiness.) the World are seventy-three surveys for sixty-nine and countries; three were sampled twice Ger- the former East Germany and West many were surveyed separately. for ‘very happy’, ‘2’ for ‘pretty happy’ and happy’ ‘pretty ‘2’ for happy’, for ‘very Frey and Source: happy’. ‘not too ‘1’ for 1) Table Stutzer (2002: 266 , Time 13 is calculated using ‘3’ The average 1 of Schor This is from a summary 2 with technical problems There are 3 ch. 3) has an Bowles et al. (2005: 4 Advertising Age (adage.com) data 5 From George Carlin’s ‘Advertising 6 see who.int/ further information, For 7 The United States was the only UN 12 The textbook assumption is 8 See also www.healyprozac.com/ also 8 See 9 No conflicts of interest are stated 10 See commercialalert.org for more 11 Nader (2000) is a great collection defensible only if it focuses on one person’s demand, taking the incomes and consumption of everyone else as given. Whether the person’s preferences are independent of what others have or are interdependent doesn’t matter in this case 1978). (Pollak 4 consumers as People (1992: 107–37). surplus of consumers’ this measure that the marginal (e.g. the requirement be constant and that con- utility of income can be added up) that we sumers’ utilities 1987). will not discuss (Takayama excellent discussion. centre reported an estimate by Robert of Coen of $294 billion for all forms advertising in 2008. US GDP in mid-2008 was estimated by the Bureau of Economic based on Statistics to be $14.3 trillion and, 2007, Bureau of the Census estimates for its population in 2008 would be about 304.7 million. lullaby’, currently posted on YouTube. nutrition/topics/infantfeeding/en/index. html, accessed 23 November 2008, and Health Organization (2008a). World member to vote against the Code ( 1 June 1981, p. 26). It finally endorsed it of essays detailing problems facing con- sumers. in 1994. default.htm. in the journal article, although the press report notes that the lead author had worked as a consultant to Abbott Labora- tories and to Merck. details.
Notes 9 This is mere anecdotal evidence col- 8 example, There are exceptions. For 7 But even if prices and output in 6 Statistics Canada, CANSIM Table 5 example, for inputs, a small For 4 a brief description of how For 3 note that explicitly four texts The lected by Myatt (2004) while living in Paris lected by Myatt (2004) while living in Paris from 2001 to 2002. He claims that the plural of ‘anecdote’ is ‘data’. the discussion in Ragan and Lipsey (2008: the discussion in Ragan makes –3) is carefully nuanced and 101 the distinction between first- and second- generation controls. O’Sullivan and Shef- surprisingly –50) provide a frin (2003: 148 conventional view of rent controls, despite the fact that the first author is a leading urban economist. these oligopolistic markets generally move in the directions predicted by a itive analysis, these markets won’t compet reach an efficient equilibrium, nor would government interference automatically create inefficiencies. 379-0017, ‘Gross domestic product by industry’. number of firms dominate markets for On nitrogen fertilizer and farm machinery. the output side, the same is true for the meat-packing sector and for the milling of grain. DeBeers’ Central Selling Organization DeBeers’ Central Selling Organization controlled 70 per cent of the world’s 132–3). diamond supply, see Hazen (1999: near- With regard to aluminium, Alcoa’s over the monopoly position has decreased the years, but the heavy entry costs and depos- key element of control over bauxite gopolistic its have led to a long-lived oli structure. (See www.wa.gov/esd/lmea/ oil, we sprepts/indprof/pmetal.htm.) With are referring to OPEC. the requirement of perfect information information of perfect the requirement Case and and Blinder (2006), are Baumol (2001) and and Gregory (2004), Ruffin Fair The remaining (2002). Walsh Stiglitz and and Collinge (2005), seven texts are Ayers Hall and Lieber- Gwartney et al. (2006), (2005), and Wells man (2005), Krugman and Sheffrin Mankiw (2004), O’Sullivan (2005). (2003) and Parkin 265 (1983), present 1 The S&D model is also identified as 2 (2005: 209) also Krugman and Wells 11 www.census.gov/foreign-trade/bal- 8 Another example would be whether 9 Donald McCloskey and Deirdre 10 A good Internet source is the His- 6 wasn’t because it really Perhaps 7 William Broad and Nicholas Wade, Betrayers of the Truth the competitive model in McConnell and Brue (2005: 48); Mankiw et al. (2006: 66); and Bade (2006: 60); and Stiglitz Parkin and Boadway (1997: 23). argue that easy entry into and exit from the industry are not required for price- taking behaviour. 3 work markets How ance/c0004.html#2008. tory of Economic Thought website devel- oped through the New School of Economic Check out the website at cepa. Research. newschool.edu/het/. examples where the inability of other re- examples where the inability of other searchers to replicate published scientific errors findings revealed both inadvertent hand, and outright fraud. On the other did not Dewald et al. found that the errors in the significantly affect the conclusions majority of cases. asset markets are efficient. There has been a long-running battle between Eugene and his associates in support of the Fama efficient market hypothesis, and Andrei Shleifer, Richard Thaler and others in sup- port of the inefficient market hypothesis. McCloskey are the same person, the tran- sition occurring (from Donald to Deirdre) in 1995. minimum wage researchers were trying to trying were researchers wage minimum the but in non-robustness; all such avoid guiding their to do so, they were attempt possibly a desired direction, results in unconsciously. ‘unconscious’ author credible that it was ‘conscious’ author biases at work; and name – though we biases go by a different to use a polite one. still have the option ‘data mining’ and, ac- The polite one is it’s cording to an article by Denton (1985), a pretty prolific industry. in entitled ‘Is Fortune 16 See, for example, Shiller (1981), 15 The stories vary, but always seem 14 More recent studies found under- 13 Closed-end funds are like typical 12 draw The next several paragraphs 11 amount it pays out as dividends The 10 challenged it is seriously Nowadays Campbell and Shiller (1987) and Jung and Shiller (2005). convincing at the time. In the dot-com bubble the story was all about the new technology breaking the mould. Every- thing was going to be different. In real estate booms the story is usually about a fixed amount of land confronting a grow- ing population and a growing economy that has always (and will always) propel It’s a myth, but people prices higher. believe it during the boom. reaction rather than overreaction over shorter periods of time. Over periods of six months to one year, stocks display momentum – the stocks that go up the fastest for the first six months of the year tend to keep going up. So, markets sometimes overreact and sometimes under-react (Mullainathan and Thaler 2004). (open-end) mutual funds except that to (open-end) mutual funds except that sell cash out of the fund, investors must This their shares on the open market. market means that closed-end funds have prices that are determined by supply and demand, rather than set equal to the value of their assets by the fund managers as in an open-end fund. heavily on Mullainathan and Thaler heavily on Mullainathan and Thaler (2004). is immaterial. Either the firm disperses is immaterial. Either the firm disperses them its profits as dividends or it ploughs the back to grow its assets – either way, shareholder benefits. by behavioural economics. One indication One indication economics. by behavioural has become economics that behavioural 9 December 2002 mainstream is the in article by Justin Fox No, say the experts. the market rational? – so don’t go thinking But neither are you it’. you can outsmart the earlier edition to the third edition is edition the third to edition the earlier 678. on p. a footnote in explained 268 4 nine widely used texts surveyed We 5 Marcia Angell (2004: 12) documents 6 This is being phased in, with the 7 As Wheat (2009: 70) puts it, it is 8 The elasticity is the percentage 9 This change in treatment from demand for any product. In this special special In this product. for any demand social marginal equal prices must case, that a This means, however, valuations. person to a poor of $1 from a rich transfer demand for not affect the person does is clearly untrue. anything, which of the trade-offs of and found a discussion only the first two: Frank patent length in (2005); and Wells et al. (2005), Krugman (2006), Colander et al. Baumol and Blinder et (2006), Mankiw et al. (2006), McConnell and Lipsey (2008), Parkin al. (2007), Ragan and Bade (2006), Schiller (2006). that between 1990 and 2000 ‘marketing a half and administration’ were two and She times the size of R&D expenditures. the says: ‘These figures are drawn from the industry’s own annual reports to Securities and Exchange Commission (SEC) and to stockholders, but what is not actually goes into these categories at all clear, because drug companies hold that information very close to their chests. It is likely, for instance, that R&D includes many activities most people would consider marketing, but no one can its part, “marketing and know for sure. For administration” is a gigantic black box that probably includes what the industry calls “education,” as well as advertising and promotion, legal costs, and executive salaries – which are whopping.’ least-developed countries allowed to delay granting pharmaceutical patents until 2016. Many economists have been critical of extending patent protection across the world in this way (e.g. Scherer 2004). ironic that the long run depends ‘on the passage of time to dismiss the significance of time’. change in quantity divided by the percent- age change in the price. Knowing this and how much price has changed allows the change in quantity (the base of the triangle) to be estimated.
Notes Principles , Book IV, ch. vii, §6. , Book IV, 3 In more advanced economics 2 See Section 1.7 of Chapter 1 for an 1 This is the same as saying that high- 18 other editions, see his For 17 Surveys of firms reviewed by 16 Caplan (2008: ch. 4) explains the 14 www.sourcewatch.org/index. 15 The situation is a prisoner’s 13 ac- See www.cala.org/cause.html, 12 examples, see www.source- For 11 legislation has not The healthcare 10 Integrity Center for Public The courses, the problem is ignored in a Preferences are more sophisticated way. assumed to be such that the distribution of income does not affect total market explanation of the condition concerning the necessity for all markets to exist. income persons will, on average, have a lower marginal utility of income than a low-income person. The marginal dollar is simply worth less to them so they’ll be willing to pay more of them for an extra loaf of bread, for example. of Political Economy of Political 6 and efficiency structure Market Blinder et al. (1998: 40–44) provide mixed evidence: profit maximization, target rate of return, and maintaining market share figured among managers’ goals. In his text, Lavoie (2006: 37) post-Keynesian concludes that firms seek growth, and the pursuit of power and profits is a means to that end. concept and critiques it. php?title=Citizens_Against_Lawsuit_ Abuse, accessed 24 November 2008. Chapter dilemma, a concept described in One. 6, Part cessed 24 November 2008. watch.org/index.php?title=Portal:Front_ groups, accessed 24 November 2008. yet been finalized as this book goes to yet been finalized press. source of reports about lobbying activities source of reports in the United States. (www.publicintegrity.org) is an excellent (www.publicintegrity.org) Dixon’s account, one firm can raise its raise its firm can one account, Dixon’s at theirs maintain firms while other price, level. the initial 267 .’ there is no seller charging a lower 1 produce more In reality firms often 2 The following sections draw heavily 3 (2009: 134–6 and 2001: ch. 3) Keen 4 The firms were representative of the 5 This description of costs is standard 6 Putterman and Kroszner (1996: 7 A recent text, Shepherd and Shep- 8 surveyed nine widely used texts, We 9 Dixon (1990: 364) has a similar 20 include Di recent studies Other This presumes that once one firm reduces its output, all firms raise their price. In than one product. Here, ‘the size of the than one product. rel- firm’ refers only to how much of the evant product the firm produces because one the concern is about its share of this market. on two valuable articles by Avi Cohen (1983, 1996). asks a similar question. economy as a whole outside of govern- and ment, non-profit firms, agriculture firms with regulated prices (Blinder et al. 1998: 60). approach to the fare in the post-Keynesian firm (Lavoie 2006: 40–41). 13–16) survey recent theoretical ideas. herd (2004: 162–6), also cites no evidence. of which the first six had such a diagram or a discussion of it: Colander et al. (2006: 202), Frank et al. (2005: 203), Mankiw et al. (2006: 287), McConnell et al. (2007: (2005: 200), 164), Krugman and Wells Lipsey (2008: 174); Baumol and and Ragan and Bade (2006), Blinder (2006), Parkin Schiller (2006). (2009: 126). Keen’s diagram, as does Keen account of why the competitive equilib- rium is really a disequilibrium is different: ‘Once a single firm has changed its output, then all firms will receive the new market price, and price to whom the consumers can turn 5 The firm 5 The Tella and MacCulloch (2006, 2008), Clark (2006, 2008), and MacCulloch Tella Stevenson and Wolfers et al. (2008) and (2008). choice that comes with increasing increasing with that comes choice In textbook costs. significant has incomes is always better. more choice economics, 1 (1987: 3). Quoted in Chomsky 2 because wealth is possible Negative 3 poverty line is The official US 4 used texts. surveyed nine widely We 5 details see www.un.org/millen- For 6 The income distribution is a ‘public 7 In fairness, the examples are prob- 8 This follows from the unstated 9 Amiel and Cowell (1999: 120) report 10 Colander et al. (2006: 305) is excep- tional in making this point clearly, point- 9 Government, taxation 9 Government, ability to earn capital’, a person’s ‘human measured in the future, is not income in it is an important asset. surveys, although example, most students graduating For negative wealth if from university have student loans. they have substantial of a minimum based on 1964 estimates three adequate diet, then multiplied by taking (the purchase of other necessities since up two-thirds of the budget). It has the cost been adjusted only for changes in of living. See www.census.gov/hhes/www/ poverty/poverty.html. was the The absolute measure of poverty (2005), choice of: Krugman and Wells (2006). Mankiw et al. (2006) and Schiller the idea Of these, only Mankiw mentioned The relative measure of relative poverty. of poverty was supported by: Baumol and Blinder (2006), Colander et al. (2006) and and Bade (2006). The remaining Parkin three texts took no clear position: Frank et al. (2005), McConnell et al. (2007) and and Lipsey (2008). Ragan niumgoals/. good’ (a concept discussed in Chapter 5): people may value it differently, but every- one ‘consumes’ the same amount. ably chosen for simplicity: an excise tax changes the relative price of a single good. assumption that individual utility is independent of others’ incomes and consumption. stark differences between Israeli econom- ics and sociology students who answered these questions. Economics students were almost twice as likely to agree that society was better off in moving from situations like A to B in Figure 9.3. 270 , 18 March 2009, The Times 14 See 13 The Sarbanes-Oxley Act of 2002 12 An indication of its phenomenal 11 The owner is the principal, and the 6 example, Krugman and Wells For 7 This section contains more advanced 8 They point out that the same issues 9 Large differences exist even after 10 Much of this evidence is sum- tightened up accounting standards in the act Among the major provisions of the US. are: criminal and civil penalties for securi- ties violations, auditor independence and increased disclosure regarding executive compensation. business.timesonline.co.uk/tol/business/ industry_sectors/banking_and_finance/ article5927610.ece. growth is that in 1992 firms in the ‘Stan- 500’ index granted their dard & Poor’s employees options worth a total of $11 bil- lion at the time of grant; by 2000, option grants in S&P 500 firms increased to $119 billion (Hall and Murphy 2003: 49). management team the agent. In modern corporations, shareholders are the prin- cipals. marized in Chapter 4. demanded. They correctly say that lower that lower say correctly They demanded. encourage to an incentive act ‘as prices to buy from the are prejudiced people who are prejudiced’. whom they people against ‘This they strangely suggest: But then enough to eliminate force could be strong altogether’ the effects of discrimination only four of nine texts (p. 429). In brief, mainstream textbooks in our sample of can persist mention that discrimination if customers them- in competitive markets selves are prejudiced. that (2005: 307) say: ‘many wrongly believe a moral marginal productivity theory gives justification for the existing distribution, implying it is fair and appropriate’. loss material and may be omitted without of continuity. two pre- erupted in huge controversies on of that vious occasions – once at the turn century and again in the 1930s. controlling for union status and observed worker and job characteristics.
Notes Ship- of schooling raises a worker’s provides a case study of the dirty provides a case study 5 worst treatment of the Perhaps 4 Employers are rational – so that 3 et al. (2007: example, McConnell For 2 The fact that estimated returns to 1 It’s the same as a simple mortgage 13 film 2004 documentary The discrimination is contained in Parkin discrimination is contained in Parkin and Bade (2006), who seem to confuse shifts in demand with changes in quantity even non-prejudiced employers seek to maximize profits. If they can employ black workers at a discount, they’ll seize the op- Prasch (2008: ch. VII) contains portunity. an excellent discussion. 300) say: ‘The purpose of licensing is supposedly to protect consumers from incompetent practitioners – surely a wor- thy goal. But such licensing also results in above-competitive wages and earnings for those in the licensed occupation.’ schooling are much greater than that schooling are much greater than required from a mortgage amortization are bar- point of view suggests that there riers to entering occupations – including differences in inherited ability – which raises the return above levels implied by the principle of equal net benefits. McConnell et al. (2007: 305) inform us of return are estimated to 10 that: ‘Rates to 13 percent for investments in secondary education and 8 to 12 percent for invest- ments in college and university education. One generally accepted estimate is that each year wage by about 8 percent’ (emphasis added). calculation. You can find many mortgage calculation. You calculators online. Set the amortization the period to twenty-five years, and choose interest rate and principal amount. breakers of breaking up ships and dangerous work see details, India. For carried out in Alang, Board of Canada, www3. the National Film nfb.ca/collection/films/fiche/?id=51361. 8 theory productivity Marginal Colander et al. (2006: 463) explicitly 463) explicitly (2006: et al. Colander of laws the importance acknowledge No and safety. workplace health governing mention the issue. other texts 269 12 texts in endnote 1, only From the 11 seems inconsistent with This claim 1 We surveyed nine widely used texts, texts, used widely 1 nine surveyed We 2 a good introduction Archer (2009) is 3 Of the sample of nine texts in end- 4 (2006: ch. 2) details see Monbiot For 5 The academies were those of Brazil, 6 for a See www.junkscience.com 7 Cited in Schor (2004: 48). 8 Of the texts listed in endnote 1, 9 Some countries, such as Canada 10 This contrasts with existing ‘regres- the figures for the United States in the previous sentence. sive’ sales taxes and value-added taxes where higher-income persons tend to pay a lower percentage of their income in tax than lower-income persons. 7 Externalities Baumol had this structure: eight of which et al. (2006), (2006), Colander and Blinder et al. (2007), al. (2005), McConnell Frank et and (2005), Parkin Krugman and Wells Lipsey (2008) and and Bade (2006), Ragan only exception was Schiller (2006). The where externalities Mankiw et al. (2006), middle of the book. get a chapter in the most to the physical science. See also the recent report of the Intergovernmental on Climate Change (2007). Panel note 1, only three – Baumol and Blinder (2006), McConnell et al. (2007) and evidence – offer any factual Schiller (2006) about climate change. and Gelbspan (2004: ch. 3). India, Canada, China, France, Germany, Italy, Japan, Russia, the United Kingdom and the United States. See also American Association for the Advancement of Sci- ence (2006). is sample. The site www.sourcewatch.org a valuable guide to the background and sources of funding of industry-funded organizations and ‘experts’. only Frank et al. (2005: 298, 427) mention consumption externalities. It plays no role in the central chapter on consumption, however. and the United States, already have such schemes, but they limit the amounts that can be put in these accounts each year. 2 really principle compensation The 3 of Samuelson’s The ninth edition 1 acronyms Three of the better-known 2 This was the Depository Institutions 3 This was the Alternative Mortgage 4 De- It also established the Federal 5 In this case the economies were 6 These consequences came to 7 Mae (and its ‘younger Fannie 8 This estimate was made by the www.bloomberg.com/apps/ 9 Source: 10 It also exempted commodity futures trading from federal oversight. In stepped amounts to the claim that everyone is bet- is that everyone claim to the amounts has more everyone, on average, ter off if is unconvincing we’ve noted, this As stuff. reasons. for other published in 1973, principles textbook, topics. contains all of these Postscript are SIVs (structured investment vehicles), and CDOs (collateralized debt obligations) paper). ABCPs (asset-backed commercial Act of Deregulation and Monetary Control 1980. Act of 1982. Transaction Parity which posit Insurance Corporation (FDIC), bank provided government insurance on aspect deposits to prevent bank runs. This of Glass-Steagall is still in place. called ‘economies of scope’ (the benefits that come from producing a variety of goods and services). light only as the corporate and banking scandals emerged with the bankruptcy of in 2002. Enron in 2001 and Worldcom brother’ Freddie Mac) did themselves need bailouts. But this was because when the real estate bubble burst even regular borrowers – who did have down payments and assets – found themselves under- of their mortgages now The value water. exceeded the value of their properties. This led to foreclosures and the downfall See Krugman of Freddie and Fannie. (2008a). International Swaps and Derivatives Association (ISDA), www.isda.org/. news?pid=20601103&sid=aaog3i4yUopo& refer=us. 272 1 In the 1990s, the prevailing myth was 16 As of the time of writing, the US 15 On Iran, see Curtis (2003: 303–15). 14 in endnote 11, only Of the texts listed 13 Affairs The Department of Foreign 12 texts of the agreements and For 11 raised nine texts. None surveyed We Congress has not ratified the agreement with Colombia. A bill implementing the agreement is currently before the Cana- dian parliament. 11 Conclusion that the boom in information technology made all other cycles obsolete; from 2000 to 2005 it was that property prices could only go up because land is in limited sup- ply while population continues to grow. On Guatemala, see Schlesinger and Kinzer (1983). On Chile, see Hersh (1983: 258–96) and Klein (2007). Frank et al. (2005: 52) acknowledges Hel- leiner’s point, warning that a trade agree- ment with a superpower that ‘can use trade as an instrument of foreign policy’ reduces ‘the sovereignty of the smaller partner’. and International Trade has details at www.international.gc.ca/trade-agree- ments-accords-commerciaux/agr-acc/ index.aspx. their status, and an up-to-date list, see their status, and an up-to-date list, the website of the Office of the United www.ustr.gov/ States Trade Representative: Trade_Agreements/Section_Index.html. the question of corporate influence over of corporate the question power of agenda, nor of the the WTO’s dominate the WTO: large countries to (2006), Colander et Baumol and Blinder et al. (2005), McConnell al. (2006), Frank (2005), and Wells et al. (2007), Krugman Bade and Parkin Mankiw et al. (2006), (2008) and Schil- and Lipsey (2006), Ragan ler (2006). Only Schiller (p. 744) remarked nations are con- that ‘many Third World that cerned about playing by trade rules (e.g. always seem to benefit rich nations copyright protection, import protection, like farm subsidies)’. Why the rules are this is apparently a mystery. Convention, which governs trade in haz- trade in governs which Convention, materials. ardous
Notes 10 The Basel Action Network works 9 The outcome would be acceptable 8 It also does not consider that people 7 The figure is adapted from Figure 1 6 Production is ‘outsourced’ if it is 5 change example, technological For 4 The model is called the Heckscher– 3 The original compensation principle 2 example, McConnell et al. (2007: For 1 example, McConnell et al. (2007: For to promote adherence to the Basel only if the initial distribution of income and wealth in the world were acceptable. may view differently their responsibility for acts of commission (e.g. sending their toxic waste to places where it won’t be disposed of properly) and acts of omis- sion (e.g. failing to act to address global economic injustice). in Palley (2006: 11). in Palley contracted out to another company. If it is contracted out to another company. ‘offshored’ it takes place in another coun- try, whether in the same company or not. could change wages, but also be a res- ponse to import competition. Ohlin model after its Swedish origina- tors. In it, all industries are perfectly competitive and all factors are assumed to be unable to move between countries. At first glance, this model appears to be most applicable to trade between developed and developing countries, which are thought to differ the most in terms of relative quantities of factors of production. was stated in terms of unobservable utili- was stated in terms of unobservable using ties, but it is typically implemented incomes, as we saw in the last chapter. simplifying made the Hicks and Kaldor of assumption that the redistribution total in- income would not cost anything: come would remain unchanged. 419–20); Ragan and Lipsey (2008: 828). 419–20); Ragan 419); Ragan and Lipsey (2008: 829). and Lipsey (2008: 419); Ragan al. (2005); 21/22 in Krugman and Wells and Wells in Krugman 21/22 al. (2005); and Lipsey in Ragan 18/18 16 and (2005); al. (2006); 14/17 in Mankiw et (2008); 20/22 18/19 in Parkin et al. (2007); in McConnell in Schiller (2006); and 17/20 and Bade (2006). 10 and globalization Trade 271 18 surveyed nine texts. The discus- We 17 This probably does not take into 16 Experiments with rats have deter- 15 et al. (1993) examines the Wolfson 14 Sapolsky’s (2001) account Robert 13 The ‘no free lunch’ idea also does 12 that Endogenous growth means 11 is a reduction in policy change The sion of income inequality and poverty was located in the following chapter numbers: 21st of 22 chapters (or 21/22, for short) in Baumol and Blinder (2006); 19/20 in Colander et al. (2006); 15/15 in Frank et account that if family size is a matter of choice, the number of births would be lower if infant mortality were lower too. mined causation between maternal stress before birth and subsequent health. Oth- erwise there would be an open question as to whether poorer health was instead due to post-natal conditions (Wilkinson 2005). relationship between death rates after retirement and earnings before retirement in Canada and finds a similarly significant social gradient. of hierarchy in a baboon troop is both entertaining and instructive. not survive a course in macroeconomics: not survive a course in macroeconomics: of in situations of mass unemployment below resources, when the economy is far appro- its production possibility frontier, expand priate macroeconomic policy can the production of all goods by putting unemployed resources to work. There is only a trade-off if the economy is moving from one point to another on the produc- tion possibilities frontier itself. the growth rate is generated within the the growth rate is itself rather than being theoretical model it, i.e. exogenously. determined outside example, the neoclassical theory of For the 1960s economic growth fashionable in and 1970s featured exogenous techno- logical change, driven by some scientific progress that lay outside the model. a guaranteed minimum annual income minimum annual a guaranteed the tax rate on labour and a reduction in income. ing out that one Pareto optimal position position optimal Pareto that one ing out all the to have one person be for would else nothing. and everyone world’s income , Thinking Colombia: , London: Zed , Cambridge: , Princeton, NJ: , New York: Random Random , New York: Journal of Economic The Truth about the Drug The Long Thaw: How , 9: 99–120. , AMR 23/001/2007, July. 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Dynamic monopsony: when a firm has market power to set its wage owing to ‘frictions’ and imperfect information. Since the conditions are pervasive, so is Adding-up problem: if labour is paid its marginal product, will the residual amount dynamic monopsony. See Frictions. be just enough to pay capital its marginal product? Answer: only if there are con- Easterlin Paradox: empirical evidence showing: (1) a positive relationship of stant returns to scale! income to well-being among people at any point in time, and (2) no relationship Arrow’s Paradox: if everyone is a price-taker in a perfectly competitive demand and between average income and average well-being in a society over long periods supply model, how do prices change? Who or what adjusts them in response to of time. It is explained by the ongoing importance of relative position and surpluses or shortages? gradual adaption or adjustment in people’s aspirations over time to higher living standards. Behavioural economics: the attempt to study how human beings actually behave instead of focusing on how rational beings should behave. Notions of limited Efficiency: a situation of no waste. See Pareto optimal. selfishness, limited self-control and limited rationality have emerged from this Equilibrium: a situation where there is no tendency to change. Plans of all relevant discipline. economic decision-makers are consistent with each other. An equilibrium may Bubbles: ongoing increases in prices (often asset prices such as stock market price be stable (the system returns to the equilibrium following a small disturbance) or or real estate prices) that in retrospect turn out not to have been justified. unstable (a small disturbance drives the system away from equilibrium).
Cambridge Capital Controversy: a debate that raged from the mid-1950s to the Equity: a synonym for fairness. What is equitable or fair requires an ethical or mid-1970s that eventually showed inconsistencies in the neoclassical aggregate normative judgement. For example, equity may involve the idea of a ‘fair go’ model that purports to explain income distribution. where everyone has equal opportunity. It may instead involve judgements about the equitability of outcomes, as in utilitarianism. The ultimatum game (described Comparative advantage: a lower opportunity cost of production. Used to ‘demon- in Chapter 1) shows that people are prepared to make themselves absolutely strate’ that trade is mutually advantageous. Some texts acknowledge that other worse off in order to punish others who have not treated them ‘fairly’. theories are needed to explain some aspects of trade, such as trade in similar goods between similar countries. Externalities: cost or benefits imposed on others that do not influence the deci- sions by the original actor and which are not reflected in market prices. These are Competitive market: requires large numbers of buyers and sellers who are all small of second order of importance according to their treatment in mainstream texts. relative to the market such that no one can individually influence the market In reality they are all-pervasive and many are of first-order importance. price. (See Arrow’s Paradox.) Also requires free entry and exit, and perfect in- formation. Failure of markets: a situation in which the market may produce an efficient out- come, but it is one which is socially or ethically unacceptable. Term suggested by Deadweight loss of monopoly: the supposed cost of monopoly compared to a Colander (2003). Compare with Market failure. competitive market. It includes the loss of net benefit from a smaller quantity produced, the loss from ‘rent-seeking’ behaviour (the diversion of time, effort Free rider problem: exists whenever an individual can receive a benefit from others’ and expertise away from productive activities towards efforts to secure monopoly contribution to the cost of a good that benefits them all. Using the principles of profits), and an equity cost of a less equitable distribution of income. rational choice, the individual may decide not to contribute but to ‘free ride’ on the contributions of others. See Public good. Demand: the maximum price consumers are willing to pay for any given quantity demanded. Frictions: often refers to things that prevent either job or geographic mobility of the labour force. For example, changing jobs might necessitate retraining. Dynamic efficiency: an optimal rate of technological progress resulting from
291 292 . For example: For Equilibrium should. . . . 294 Inefficiency because ‘net benefits’ include non-monetary Normative the analysis of the equilibrium of a single market in Dynamic monopsony often used to describe the orthodox or mainstream ap- often used to describe the orthodox an economic model may have more than one equilibrium. For For may have more than one equilibrium. an economic model what must be given up to get something; the value of the next what must be given up to get something; the value of the next the study of individual markets. Topics include the determina- include Topics markets. individual study of the has the property that it is not possible to make anyone better off has the property that it is not possible to make anyone better a government-determined maximum price. It will not be ‘binding’ a government-determined maximum price. It will not be ‘binding’ cost:
a firm that has market power to choose the wages it offers. Tradi- the wages it offers. power to choose has market a firm that that which embodies a norm, value or moral precept. Normative that which embodies a norm, a government-determined minimum price. It will not be binding a government-determined minimum price. It will not be binding dealing only with facts, descriptions of the world. In principle, positive dealing only with facts, descriptions of the world. In principle, there should be no child poverty in a country as rich as Canada. See its opposite, there should be no child poverty Positive. Opportunity best alternative forgone. optimal: Pareto there would be no without making at least one person worse off – in other words, See waste anywhere in the economy. Partial equilibrium analysis: Partial isolation. Other markets may or may not be assumed to be in equilibrium, but isolation. Other markets may or may not be assumed to be in they are not analysed explicitly. Positive: not be easy to do statements can be shown to be right or wrong, although it may so in practice. See its opposite, Price ceiling: unless it is below the equilibrium price. Example: rent controls. Price floor: unless it is above the equilibrium price. Example: minimum wages. Principle of compensating differences: benefits, dirty, dangerous or dull jobs would receive higher pay than clean, safe and interesting jobs, all else equal. Multiple equilibria: Multiple equilibria: example, neither demand nor supply curves have to be linear and they could inter- to be linear and they could demand nor supply curves have example, neither See once, resulting in multiple equilibria. sect more than Neoclassical economics: proach that dominates the undergraduate textbooks. It emphasizes individual proach that dominates the undergraduate and the efficiency of resource allocation at a rational choice, marginal analysis, It focuses attention on equilibrium outcomes in point in time (static efficiency). and the general equilibrium of the economy as a individual competitive markets whole. Normative: contain the word statements often (though not always) Microeconomics: market structures. of different and relative efficiency quantities, tion of prices, Monopsony: of labour, and therefore to be to require a single buyer tionally it was thought But see extremely rare.
Glossary . Laissez-faire 293 the belief that the model of a perfectly competitive mar- an umbrella term used to cover approaches that are outside used to cover approaches that an umbrella term occurs when all markets in the economy are in equilibrium are in equilibrium in the economy when all markets occurs the attempt to maximize monetary or psychological satisfac- the study of the economy as a whole. Topics include the deter- the study of the economy as a whole. Topics the extra benefit from doing a bit more of something. For a firm: the extra benefit from doing a bit more of something. For a situation in which markets fail to allocate resources efficiently a situation in which markets fail to allocate resources efficiently the extra cost of doing a bit more of something. For a firm: pro- the extra cost of doing a bit more of something. For the doctrine that society is better off if the government refrains from the doctrine that society is better off if the government refrains exists when there is the potential to use resources more efficiently, to exists when there is the potential a theoretical perspective or world-view; a view of human nature and the a theoretical perspective or world-view; Market failure: Market fundamentalism: tion by pursuing any activity up to the point where marginal cost equals marginal tion by pursuing any activity up to the point where marginal cost benefit. externalities owing to an inherent characteristic of the market, such as monopoly, or imperfect information. ket approximates how actual markets operate in the real world. See Marginal thinking: ducing another unit of a good or service. For a person: doing a bit more of some ducing another unit of a good or service. For costs, reflects opportunity costs. Marginal cost, like all activity. Marginal benefit: Marginal cost: mination of GDP, the growth of GDP, unemployment, inflation, interest rates, and of GDP, the growth mination of GDP, the balance of payments. a person: getting some utility from a selling another unit of a good or service. For extra income. bit more of some activity, like consuming a good or earning some Macroeconomics: intervening in the market economy. General equilibrium: General Heterodox economics: Ideology: Inefficiency: Laissez-faire: Includes the time and resources it takes to find information, or switch jobs, or jobs, or switch or information, to find it takes and resources the time Includes move home. simultaneously. institutional, post-Keynesian, orthodox economics. It includes of mainstream, and social economics among feminist, Austrian, ecological socialist, Marxian, others. embodies value judgements about what is good possibilities for change; usually give rise to different schools of thought in and bad. Different political ideologies the social sciences. off without making anyone worse off, i.e. to move make at least one person better situation. In practice, eliminating an inefficiency may make optimal to a Pareto off, but those made better off would be able, in some better off and some worse made worse off. principle, to compensate those 296 when wage differences between workers are much smaller between workers are much when wage differences the maximum quantity sellers are willing to sell for any given price. It price. any given to sell for willing are sellers quantity maximum the a measure of happiness or benefit. a measure of happiness Supply: only for price-taking supply curve exists demand. The independent of must be de- how that will affect with an eye on set their price for firms that firms – not their product. mand for Utility: compression: Wage prediction of marginal productivity differences. It refutes a than their productivity and status considerations. the importance of fairness theory, and suggests
Glossary 295 . if there were no intrinsic (or innate) differences differences innate) (or no intrinsic were if there . an expectation that (say) the price will increase by 10 per this assumes that individuals are rational, self-interested, a situation Robert Frank calls ‘smart for one, dumb for all’. Frank calls ‘smart for one, a situation Robert Public good Private good a good that provides benefits only to the person who consumes it, a good that provides benefits only The Italian-born economist at Cambridge University who in 1926 The Italian-born economist at Cambridge University who in 1926 attempting to buy low and sell high to make a profit. Textbooks tell attempting to buy low and sell high to make a profit. Textbooks a good is something that provides benefits. A pure public good is not a good is something that provides benefits. A pure public good equal net benefit: equal
like a public good, only a public bad reduces utility instead of add- like a public good, only a public the starting point for neoclassical economics. It arises out of unlimited the starting point for neoclassical economics. It arises out of Public bad: argued that several requirements for the competitive demand and supply model were mutually incompatible. Speculation: Sraffa, Piero: cent leads to changes in behaviour such that the actual price does increase by cent leads to changes in behaviour such that the actual price 10 per cent. how specula- us that speculation must be stabilizing. Modern research is showing higher. tion can be destabilizing through buying high and selling even Self-fulfilling prophecies: Scarcity: wants confronting limited resources. only non-excludable, it is also non-rival. The opportunity cost of another person only non-excludable, it is also non-rival. The opportunity cost price of zero. See consuming it is zero. Static efficiency requires a socially optimal its opposite, a choice theory: Rational to maximize their have a stable set of internally consistent preferences, and wish own happiness (or ‘utility’), given their constraints. Public good: ing to it. Examples: an unjust distribution of income, incompetent and corrupt ing to it. Examples: an unjust distribution govern ment, pollution. also termed a ‘rival good’. It’s assumed that a system of property rights exists to also termed a ‘rival good’. It’s assumed for the good from consuming it (‘excludable’). exclude anyone who has not paid See its opposite, a Prisoner’s dilemma: Private good: between workers, and no barriers to entering an occupation, then in equilibrium then in an occupation, barriers to entering workers, and no between people all jobs – otherwise be the same in benefits should value of net the present one. a higher-benefit job to from a lower-benefit would move themselves, but collec- to do the best they can for make rational choices People that are possible. The standard is worse than other outcomes tively the result to charge the monopoly price of two firms who fail to collude example is that dilemma also exists whenever people would be and set a lower price instead. The contributed to a public good (or reduced their collectively better off if everyone as pollution) but rational choice leads them to contributions to a public bad, such It is a pervasive social problem. ‘free ride’ on others’ contributions. Principle of Principle