Chapter #l - Foundations of Economics

In April 2018 professional golfer Rickie Fowler finished in second place at The
Masters (one of the four most prestigious tournaments of the year), one stroke
behind winner Patrick Recd. Around the same time a plane crash in Algeria killed
257 people. If Rickie was more upset about the outcome of the Masters than about Fundamental Economic
the Io.ss of life from the accident in Algeria, then it would seemingly suggest that he
A. ts not as good of a person as Patrick Reed.
B . does not care about anyone other than himself. Questions and Gains from
C . Is an irrational individual.
D . is a sail-interested individual. Specialization
In March 2010, when the "Patient Protection and Affordable Care Act" (a.k.a.,
Obamacare) was being finalized by and debated in Congress, Within the previous chapter, economics was defined as the social science that
A. over 40 economists (including Daniel Kahneman, one of the co-recipiants of studies how people make decisions in the face of scarcity, and the resulting impact of
the 2002 Nobel Prize in economics) wrote a letter to President Obama such decisions on society as a whole and the individual members therein. It was noted
supporting the legislation. that as a result of scarcity, decision-makers face tradeoffs (having more of one thing often
B. over 130 economists (including Vernon Smith, one of the co-recipients of the
requires getting by with less of something else). Such ffadeoffs arc particularly important
2002 Nobel Prize in economics) wrote a letter to House Minority Leader Rep. to keep in mind when thinking about the myriad choices that must be made by a society
John Bochnex opposing the legislation.
regarding the use of productive resources.
C. no economist publicly expressed any opinion on the legislation (upholding a The current chapter begins by broadly describing the roles played by households
longstanding tradition within the profession of never getting involved in and firms in the consumption and production of goods/services. Next, the fundamental
public policy debates). questions that a society faces when deciding how to use its scarce productive resources
D . More than one (pcrhapa all) of the above answers is correct.
are identified. From here, the notion of the Production Poss~ilities Frontier (which
provides a graphical depiction of the limits on output that a society faces due to resources
Answer Questions 22 and 23 based upon the information conveyed in the following
being scarce) is described. Finally, a simple model (of a two parson, two commodity
table, which states Ann's Total Benefits from consumption of iced coffee per week
economy) is established and analyzed, in order to illustrate precisely how specialization
(measured in dollars):
in production allows a society to maximize the amount of output which it produces.
Cups of lced 0
Coffee Consumed 1 2 3 4 5 6 7
TotalBenefits T H E T H R E E F U N D A M E N TA L E C O N O M I C Q U E S T I O N S
from Consumption 0 6.50 11.50 15.75 19.50 22.50 24.00 24.50
Societies consist ofpoople. Individual people derive satisfaction from consuming
22. It appears as if Ann has a goods and services - outputs of the production process, such as food, clothing, shelter,
for iced coffee consumption. healthcare, education, and entertainment. At any point in time, a society is endowed with
A . constant marginal benefit
B. increasing marginal benefit a limited amount of productive resources or factors of production - inputs in the
C . diminishing marginal benefit production process, broadly categorized as land, labor, and capital - that can be used to
create different goods or services.
D . negative marginal benefit
There are two primary decision making entities (or institutions) in any economy:
23. If iced coffee costs $3.65 per cup, then Ann should consume __ cups per week. households and firms. Households obtain benefits from consunting goods and services.
A. 0 Firms produce these goods and services. Production refers to the process by which a
B. 4 firm transforms inputs (i.e., factors of production) into an output (i.e., a good or service).
C. 6 Households fulfil an additional role in the economy by providing factors of production to
D. 7 in'ms. For example, a school teacher supplies labor to an elementary school providing
primary education services, and a landowner leases land to a farmer who grows com.
 Chapter #2 - Fundamental Economic Questions and Gnins from Specialization
These broad interactions between households and firms are depicted by the Preliminary
Circular Flow Diagram in Figure 2. I.
The arrow on the right side of Figure 2.1 represents the movement of finished
goods and services from firms to households. Individuals within the households derive
benefits from consuming these goods and services (this takes place internally within the
box labeled "Households"). Members of households provide inputs to the production
process to firms. The transfer of these productive resources is depicted by the arrow on
the left side of Figure 2.1. These inputs are then transformed into outputs through the
process known as production (which takes place internally within the box labeled
"Firms").
FigHre 2.1 - Preliminary Circular Flow Diagram
Households ]
Factors of Finished
production goods and
services
~ 1 F i r m s J j food to produce and how much clothing to produce. The resource use decision amounts
The main purpose of this entire exercise (i.e., the movement of resources between
households and finns, along with the related transformation of inputs into outputs by way
of the production process) is to create benefits from consumption for individual people.
Individual members of households enjoy consuming goods and services. Moreover, this
process will create value for society as long as the households' benefits from consuming
the finished goods and services are greater than their burdens of supplying the factors of
production.
Chapter #2- Fundamental Economic Questions and Gains from Specialization
Thinking about a society's use of its scarce productive resources, three
fundamental economic questions must be addressed:
1. What to produce? [production deed~ion - of all the different combinations of
goods and services that we could produce, what specific combination will we
produce?]
2 . How to produce it? [resource use decision - which productive resources will
be used to produce which goods and services?]
3 . For whom to produce it? [distributional decision - who gets to censume the
goods and services that we have chosen to produce?]
Every society must come up with answers to these three fundamental questions. In many
respects, a society's choice of economic system goes a long way toward determining bow
these questions are answered in practiceJ
In the United States, the bulk of the answers to the three fundamental economic
questions have historically been determined by the interaction of self-interested decision
makers (both households and firms) in markets. Thinking about the role played by most
individuals in regards to production and consumption decisions in a modem, market
based economy (like the United States), a general observation emerges: most individuals
specialize in production but generalize in consumption. That is, we tend to focus our
productive activities on a very narrow set of goods, while consuming a much wider array
of goods. Perhaps you provide financial services by working at a bank. You generate
income from this employment, which you then use in the markets for goods and services
to buy all of the different things you enjoy consuming.
But recognize that under such an arrangement you axe relying on others (in many
cases complete strangers, who are self-interested and don't really care all that much about
your well-being2) to provide you with nearly all of the goods and services that you
consume on a daily basis (in many eases, basic necessities such as food, clothing, and
shelter). How is such an arrangement sustainable and ideal? That is, when Uying to
acquire goods for our own consumption, why should we bother interacting with others (as
opposed to producing everything for ourselves)? The short answer is that the trades upon
which the arrangement is supported are each mutually beneficial, because of the fact that
specialization in production allows a society to produce greater amounts of output (than
what could be realized if each person instead produced for only his own consumption).
These three fundamental questions (and the gains in output that can be realized
through SlX',eialization in production) are easily illustrated by considering a simple model
of society in which there is only one productive resource (labor) and two goods to
produce (food and clothing). The production decision amoums to deciding how much
to determining which workers will produce food and which workers will produce
clothing. The distributional decision amounts to choosing how much food and how much
clothing each person in society is ultimately able to consume.
i A detailed discussion of what differentiates one economic system from another is provided in Chapter 3,
a Recall the recognition that people are self-interested which was discussed near the end of Chapter 1.

Chapler #2 - Fundamental Economic Questions and Gains from Specialization
THE PRODUCTION POSSIBILITIES FRONTIER
The scarce nature of productive resources (i.e., any society has only a finite
amount of land, labor, and capital) imposes a constraint on society in terms of what it can
produce and ultimately results in society facing tradeoffs regarding the levels of
production of different goods. These observations ere most easily seen by constructing a
Production Possibilities Frontier (PPF), such as the curve illustrated in Figure 2.2. The
Production Pnslibmties Frontier is a curve that summarizes the limits of production
that a society faces by illustrating the maximum amount of one good that can be
produced for every possible level of production of another good.
Figire 2.2- Prodlctlon Possibilin'es Frontier
Clothing
'T
820 ........................
1........
39o ...........,of ........ ,~ ....- ~
i i ~
,1
-
0 i
0 240 480 621 732
Again consider a society with a finite amount of productive resources that
produces only food and clothing. If all productive resourees were used to produce
clothing, then we would necessarily produce zero units of food. Further, this choice
would result in some finite amount of clothing (suppose 900 units) being produced.3 This
combination of outputs is illustrated as Point T in Figure 2.2, which is a combination of
zero units of food and 900 units ofclothing, and represents one point along the PPF. At
the other extreme, if all productive resources were instead used to produce food, then
zero units of clothing and some finite amount of food (suppose 732 units) would be
3 The actual numerical value depends upon nuruemus factors, including how many r~ources the society
has available, the productive abilities of those resoures~ the technology available for productina, and the
units being used to rm~ure output of clothing.
Chapter #2 - Fundamental Economic Questions and Gains from Special~.ation
produced. This combination of outputs is illustrated as Point X in Figure 2.2, which is a
combination of 732 units of food and zero units of clothing, and again represents one
point along the PPF.
To determine the full shape and placement of the PPF, consider gradually
increasing food production from zero units up to the maximum of 732 units and each step
along the way determining the maximum amount of clothing that could be produced.
The only way to puss~ly make more food is to devote more productive resources to food
production. When society is producing at its limits, it must be using all of its available
productive resources. Thus, starting at such a point, in order to devote more productive
resources to food production, it is necessary to divert productive resources away from
clothing production. This diversion of resources results in a decrease in the amount of
clothing produced. As a result, the PPF must be downward sloping.
When considering alternative uses of a scarce resource, it is helpful to identify
and focus on the opportunity cost of using the resource for a paRicular purpose.
Opportunity cost is a generel concept that refers to the cost of giving up the best
alternative that must be foregone in order to do or acquire something. It measures the
value of the next best use of the resources used to undemke (and provides the truest
measure of the cost of engaging in) the activity being considered.
As an example, what is the cost of going to see a movie on a Friday night? Your
immediate response would likely focus on the $10 that you have to pay for the ticket to
the movies. If you think a bit more, you may recognize sumo additional monetary
outlays that you would make to see the movie (perhaps $8 spent on concessions and $2
spent on gas). So, the total monetary costs are $20. But, in many respects "$20" is a
pretty meaningless measure of the cost of seeing the movie. Af~ all if you don't spend
the $20 on your trip to the movies, you will use the money for something else. The
notion of opportunity cost suggests that the tna~ measme of your cest of going to the
movies is obtained by identify what this "something else" is and determining the value
that you place on foresoing this nlt~rnative opportunity.
Further, theax: are other resources (beyond the $20) that you use to see the movie
and, therefore, other foregone oppommities. Perhaps the most obvious is the two hours
that you spend in the theater watching the movie. If you didn't go to the movies, you
would have spent these two hours doing something else. Again, what you need to do is
identify the next best use of this scarce resource (i.e., your two hours of time), and
determine the value that you place on forgoing this alternative activity.
Suppose that if you don't go to the movies, you will instead use the $20 to buy a
new novel over the Internet and you will instead use your two hours of time to exercise at
the gym. The opportunity cost (i.e., the Uue enst) of going to the movies is equal to the
benefits that you would have instead realized by owning the novel and exercising for two
hou~ This is the best measure of you cost of going to the movies, since it is what you
are actually giving up in order to go to the movies..
Returning to our discussion of the PPF in Figure 2.2, ~ our society is
starting at Point T (at which zero units of food are produced) and is contemplating an
inct~tsu in food production up to 240 units, in onier to realize this iucreasu in food
production, we need to dive~ productive resu~ away from clothing production,

Chapter #2 - Fundamental Economic Questions and Gains from Specialization
thereby decreasing the amount of clothing produced. Two immediate questions are:
"Which productive resources should be the first ones devoted to food production?''4 and
"By how much will we have to decrease clothing production in order to produce these
240 units of food?"
Supposing that our available resources differ in regards to their abilities to
produce clothing and food (e.g., maybe "Worker A" is good at growing food but not good
at making clothing, while "'Worker B" is good at making clothing but not good at
growing food), then the necessary decrease in clothing production depends upon which
resources we use to produce the initial units of food. The opportunity cost of producing a
unit of food is best measured by the number of units of clothing that we must give up in
order to produce the unit of food (after all, if the resources weren't used to produce food,
they would instead be used to produce clothing). Resources with different productive
abilities have different opportunity costs. When increasing food production, we want to
consider all of the available productive resources that could be used to produce the next
unit of food, and choose to use the one which has the lowest valued opportunity cost.
Doing so allows us to produce the next unit of food with the smallest possible decrease in
clothing production.
Following this procedure each step along the way as we gradually increase food
production from zero units up to 732 units allows us to determine the full placement and
shape of the PPF. Recognize that at any point along the PPF, the rate at which we must
give up clothing in order to produce the next unit of food is directly equal to the
numerical value of the opportunity cost of producing food for the productive resource
that we are diverting away from clothing production toward food production. Thus,
when we allocate productive resources in the most effective manner, the PPF becomes
steeper at higher levels of food production (as illustrated in Figure 2.2). Finally, ffwe let
OC ~ denote the opportunity cost of producing food from using "resource j," it follows
that when we produce more food by optimally diverting "resourcef' away from clothing
production and toward food production, the slope of the PPF at this point is - OC ~ (i.e.,
"minus the opportunity cost of producing the good on the horizontal axis for the resource
being reallocated").5
Interpretation of the Production Possibilities Frontier
First and foremost, the PPF provides a direct distinction between output
combinations that are attainable versus ones that axe unattainable. Any point on or below
the PPF represents a combination of outputs that is attainable, in that the combination
4 Recognize that the answer to this question is part of the resource use decision.
s The "slope" of a curve measures its steepness as the ratio of the change in vertical distance to the change
in horizontal distance (i.e., "rise over run") as we move along the curve. Moving down the PPF in Figure
2.2, the "rise" is equal to the dec,zease in clothing production (a negative value), while the "run" is equal to
the increase in food production (a positive value). For a reallocadon of resonrees that leads to a one unit
increase in food production, the ratio of these changes in output levels is equal to the previously described
opportunity cost for producing food.
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
can possibly be produced with the available productive resources and technology. Any
point beyond the PPF represents a combination of outputs that is unattainable, in that the
combination cannot possibly be produced (given the limits imposed by the scarcity of
resources and current technology). In Figure 2.2, Points T, U, V, W, X, and Y are each
attainable - each one is a combination of outputs that this society could choose to
produce.6 In contrast, Point Z is unattainable. Given the scarce nature of productive
resources, there is no way for this society to produce 621 units of food and 820 units of
clothing.
When addressing the production decision, this society can think of the PPF as a
menu of available options. Any point on or below the curve can possibly be chosen. In
practice, the society would want to answer the production decision by choosing the
combination of goods on this menu which is most valued, given the preferences of its
members. But, many of the points that are attainable can be ruled out as the best answer
to the production decision by making a rather weak assumption on preferences. Suppose
that society's preferences are such that having more of either good (with the same amount
of the other good) is more desirable (i.e., "more is better"). For example, start by
considering the combination Y = (240,390) (i.e., Point Y, which corresponds to 240
units of food and 390 units of clothing). It would seem quite reasonable to assume that
this society would prefer either U = (240,820) (which has the same amount of food but
more clothing than Point Y) or W = (621,390) (which has the same amount of clothing
but more food than Point Y) to Y = (240,390).
By this argument, under the mild assumption that "more is better," any point
below the PPF can be ruled out as the answer to the production decision for this society.
For this reason, it is useful to distinguish between attainable points characterized by
productive efficiency versus attainable points characterized by productive inefficiency.
A society realizes productive efficiency if it is NOT possible to increase the amount
produced of any good, without decreasing the amount produced of some other good. At
such output combinations (e.g., Points T, U, V, W, and X in Figure 2.2) the society is
producing at its limits and faces tradeoffs in production. Starting at U = (240,820), is it
possible for society to produce an additional 240 units of food, bringing total food output
up to 480 units? Yes, but only if they are willing to get by with (i.e., accept the tradeoff
of having) 820 - 610 = 210 fewer units of clothing.
In contrast, an attainable point is characterized by productive inefficiency if it is
possible to increase the amount produced of some good, without decreasing the amount
produced of any other good. At such output combinations (e.g., Point Y in Figure 2.2),
the society does not face a txadeoff in production. Starting at Y = (240,390), is it
possible to produce an additional 240 more units of food, raising total production of food
6 At each point on the PPF (such as Points T. U, V, W, and X), we are producing the maximum mount of
clothing for a chosen quantity of food (or, equivalontly, the maximum amount of food for a chosen quantity
of clothing). If we do not use all of our productive resmu,cas or allocate our resources in a tess than ideal
way (e.g.. if we produce the initial units of~xl by using the available resom'ce with the highest valued
oppommity cost), then we would realize e point below the PPF [such as Point Y).

Chapter #2 - Fundamental Economic Questions and Gains from Specialization
to 480 units? Yes, and even without decreasing the amount of clothing produced. In
fact, starting at Y = (240,390), this society could increase food production up to 621
units (an increase of 381 units) without having to decrease clothing production at all.
This is because a point characterized by productive inefficiency is realized either by not
using all available productive resources or by allocating productive resources in a less
than ideal way. Thus, an increase in the amount produced of some good (with no
decrease in the amount produced of any other good) can be realized by either using the
idle resources or by assigning resources to productive tasks in a more effective way.
Again, without specific knowledge of the preferences of society (i.e., the relative
value placed on different levels of clothing and different levels of food), we cannot
determine which feasible point is ideal when answering the production decision. But,
under the mild assumption that "more is better," any feasible point characterized by
productive inefficiency cannot be best. As a result, when choosing what combination of
outputs to produce, the ideal answer must always be a point along the PPF - that is, one
of the attainable points characterized by productive efficiency.
A S i m p l e Tw o - P e r s o n / Tw o - G o o d E x a m p l e
The precise way in which specialization in production can allow society to
produce greater amounts of output can be illustrated by developing a simple two-
person/two-good model of an economy. Consider a society that consists of only two
people, Baker and Taylor. The only productive resources are the labor of each person.
These two individuals spend their time making food and clothing. Suppose the workers
differ in regards to productive abilities. Table 2.1 provides a summary of the output that
can be produced in any given day by each worker.
Table 2.1 - productive abilities for two person~two good society
One day of Baker's labor 8 2
One day of Taylor's labor I Units of food
I 0 produced J Units of clothing
1 0 produced I
For example, if Baker spent an entire day producing food, he would make 8 units.
If instead he spent an entire day producing clothing, he would make 2 units. If he spent
half a day making clothing and half a day making food, he could produce 4 units of
clothing and 1 unit of food. A similar interpretation of the values in the bottom row
provides insight on Taylor's productive options.
Consider the choice of what to produce over the course of a five day workweek.
If each individual was producing only for his or her own consumption, the production
possibilities would be summarized by the PPFs illustrated in Figures 2.3 and 2.4.
If Baker spent all of his time making clothing, over the course of five days he
would produce 0 units of food and 10 units of clothing (corresponding to the vertical
intercept in Figure 2.3). If he diverts a single day away from clothing production toward
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
food production, his output of food increases by 8 units and his output of clothing
decreases by 2 units. Thus, Baker's opportunity cost for producing food is oc
B_,- ~, = ÷,
since he must decrease his output of clothing by ¼ of a unit for every additional unit of
food that he produces. Thus, his PPF is a straight line with a slope of -OCg =-¼,
illustrating the general insight previously made on the value of the slope of the PPF.
Finally, if Baker were to spend all five days producing only food, he would produce 40
units of food and 0 units of clothing. Similarly for Taylor, her PPF has a vertical
intercept of 0 units of food and 50 units of clothing a slone of - OC r= _~ _ -1 and a
horizontal intercept of 50 units of food and 0 units of clothing (as illustrated in Figure
2.4).
Figure 2.3- individual weekly PPF for Baker
Clothing
intercept" => [
"vertical
Baker produces
only clothing
Baker's weekly PPF [
"horizontal
intercept" =>
Baker produces
10"4 only food
0 Food
0
t
40
The ultimate aim is to see how the two individuals can increase their joint output
through specialization in production (i.e., by having workers spend a disproportionate
amount of time producing the good which they are "relatively good at producing"). With
this in mind, two immediate questions arise: "Who is better at producing food?" and
"Who is better at producing clothing?"
Based upon the values reported in Table 2.1, it would seem as if the most natural
answers to these questions are that Taylor is better than Baker at producing both food and
clothing. After all, if each worker spends one day making food, Taylor produces more
output than Baker (since 10 is greater than 8), and if each worker spends one day making

Chapter #2 - Fundamental Economic Questions and Gains from Specialization
clothing, Taylor produces more output than Baker (since I0 is greater than 2). These
observations are recognitions of the facts that Taylor possesses an absolute advantage in
the production of food and an absolute advantage in the production of clothing.
Figure ~4-individual weekly PPF for Taylor
Clothing
"vertical
intercept" =>
Taylor produces
only clothing
< /
50" ~N,~
//~ Taylor's weekly PPF ]
\ / I . b o .Jz. /It Taui nyt n tp rao d ulc e sI
ercept" =>
l o ro
nylfood
Food
t
50
In general, consider a situation in which there are two potential producers of a
good. Suppose that each producer is given n common amount of inputs, and wc observe
who can make more total output with the given inputs. The first producer possesses an
absolute advantage in the production of the good if she can produce more output than
the second producer with the same amount of inputs. For the present example, which
worker has an absolute advantage in the production of food? The answer is Taylor, since
when using one day of labor, Taylor can produce more food (I0 units) than Baker (8
units). Similarly, Taylor has an absolute advantage in clothing production, since when
using one day of labor, Taylor can produce more clothing (l 0 units) than Baker (2 units).
But, since Taylor possesses an absolute advantage in the production of both food
and clothing, it follows that this notion cannot provide much insight on how productive
resources should be used. After all, if Taylor is beRcr at producing both food and
clothing, which activity should she focus on, and, further, how should Baker use his
labor7 With this in mind, is there a more insightful way to answer the questions of "Who
is better at producing food?" and "Who is better at producing clothing?" Recognize that
these questions can be sfightly rephrased as "Who can produce food at a lower cost?" and
"who can produce clothing at n lower cost?"
Focusing first on the production of food, the true cost of producing a unit of food
is best measured by the number of units of clothing that must be forgone to produce the
Chapter #2 - Fundamental Economic Questions and Gains from Specialization
food (since if the labor is not used to produce food, it would instead be used to produce
clothing). This is precisely the previously discussed notion of opportunity cost. As noted
above, Baker's opportunity cost for producing food is OC rs= ¼ and Taylor's opportunity
cost for producing food is ocr= 1. Thus, the cost of having Baker produce the next unit
of food is ¼ of a unit of clothing, whereas the cost of having Taylor produce the next unit
of food is I unit of clothing. So, "Who can produce food at a lower cost?" Clearly, the
answer is Baker, since giving up ¼ of a unit of clothing is less costly than giving up I
unit of clothing. This is simply an observation of the fact that Baker possesses a
comparative advantage in the production of food.
In general, consider a situation in which there arc two potential producers of two
different goods. Focusing on the production of either one of the two goods, the
opportunity cost of producing the good provides a measure of how many units of the
other good must be given up in order to produce one more unit of the good under
consideration. The first producer possesses a comparative advantage in the production
of the good if her opportunity cost of producing the good is lower than the opportunity
cost of the second worker for producing the same good. The worker who possesses the
comparative advantage can produce an additional unit of the good while incurring a
smaller decrease in production of the other good. Again, in the present example Baker
has a comparative advantage in food production, since the decrease in clothing
production which must be incurred to produce an additional unit of food is smaller for
Baker (¼ of a unit of clothing) than it would be for Taylor (1 unit of clothing).
Shifting attention to the production of clothing, recognize that Baker's
opportunity cost for producing clothing is OC $c=$~- = 4 and Taylor's opportunity cost for
producing clothing is OCT c-~-
1 0 _ 1. Since Taylor's opportunity cost for producing
clothing is less than Baker's opportunity cost for producing clothing, it follows that
Taylor possesses a comparative advantage in the production of clothing.
Note the way in which Baker's opportunity cost for producing clothing is relatad
1
to his opportunity cost for producing food: OC ~= OC-----~r. That is, his oppon'unity cost
for producing clothing is equal to the reciprocal (or multiplicative inverse) of his
opportunity cost for producing food. This relation arises because the value of Baker's
opportunity cost for producing clothing is equal to the decrease in output of food divided
by the increase in output of clothing which results from diverting his time away from
food production toward clothing production. Similarly, Baker's opportunity cost for
producing food is equal to the decrease in output of clothing divided by the increase in
output of food which results from diverting his time away from clothing production
toward food production. In either case, we are considering a re.allocation of the same
productive resoerces, the only difference being the direction of the change (i.e., assay
from food production toward clothing production in the fomler case, away from clothing
production toward food production in the latter case). The reciprocal relation between
Baker's two oppor~mity costs is a direct consequence. In fact, this is a general relation

Chapter #2 - Fundamental Economic Questions and Gains from Specialization
that must hold for any "worker I" dividing his labor between the production of "good 1"
and "good 2": OC ~= ~ (or equivalently OC I1= ).
Further, because this reciprocal relation holds for each worker, it immediately
follows that in any two-person/two-good setting, if one worker has a comparative
advantage in producing one of the goods, then the other worker must have a comparative
advantage in producing the other good. For example, suppose you do not know any of
the numerical values in Table 2.1, but are told that Baker has a comparative advantage in
the production of food, What are the consequences of knowing this (in light of the
reciprocal relation which must hold for each worker's two opportunity costs)7
If Baker has a comparative advantage in the production of food, then (by
1 Ricardian Theory of Comparative Advantage...That it is logically true need not be
definition) OC~ < OCr. If we multiply both sides of this inequality by ~ and
I 1
1 1
ocr, it becomes ~ < ~--~-ra. By the reciprocal relation we know OCr = OC"-'-f
and O
c C- mOC~
_ 1 . .". . Thus,
..~ the inequality can be expressed as OCr < OCt, which (by
definition) implies that Taylor has a comparative advantage in the production of clothing.
Specialization in production allows a society to produce greater amounts of output
by essentially exploiting differences in opportunity costs between productive resources.
When deciding how to effectively allocate different productive resources to various tasks,
differences in absolute abilities (i.e., total output levels) are not important, but rather
differences in comparative abilities (i.e., relative tradeoffs in output levels) are what
matter.
To illustrate how the two individuals can increase their joint output by
specialization in production, assume that without specialization Baker is spending at least
one day per week making clothing and Taylor is spending at least half a day per week
making food.~ Recall that Baker has a comparative advantage in the production of fund
(i.e., OCen < OCr) and Taylor has a comparative advantage in the production of clothing
(i.e., OCcr < OCff). Thus, we would want Baker to spend more time producing food
(and less time producing clothing) and Taylor to spend more time producing clothing
(and less time producing food).
How would the joint output of the two workers change if Baker were to increase
his time spent making food by one day (thereby decreasing his time spent making
clothing by one day) and Taylor were to increase her time spent making clothing by half
a day (thereby decreasing her time spent making food by halfa day).'? As a result of this
reallocation of time, Baker would produce 8 more units of food and 2 fewer units of
clothing, while Taylor would produce 5 more units of clothing and 5 fewer units of fuod.
But, focusing on the collective output of the two workers, this reallocation of productive
Even if these assumptions me not satisfied, specialization can lead to an increase in joint output so inng as
Baker is producing positive amount of clothing and Taylor is producing a positive amount of food to start.
Chapter #2- Fundamental Economic Questions and Gains from Specialization
resources actually increases the amount produced of each good: food output increases by
3 units (Baker's increased output of 8 units is 3 units greater than Taylor's decreased
output of 5 units) and clothing output increases by 3 un/ts (Taylor's increased output of 5
units is 3 units greater than Baker's decreased output of 2 units).
This example illustrates the driving force behind the Law of Comparative
Advantage, which states that when increasing the production era good, a society should
do so by using the available productive resource with the lowest opportunity cost (i.e., the
one which has the comparative advantage at producing the good). The Law of
Comparative Advantage was first described by the English economist David Rinardo in
1817. It is a truly profound insight. When challenged by the Polish mathematician
Stanislaw Ulam to give an example of a proposition fi'om the social sciences that is both
true and non-trivial, the economist Paul Samuelson cited this result, stating: "The
argued before a mathematician; that is not trivial is attested by the thousands of important
and intelligent men who have never been able to grasp the doctrine for themselves or to
believe it after it was explained to them."s
By always applying the Law of Comparative Advantage, a society is able to
guarantee that for any chosen level of production of "good I" the maximum possible
amount of"good 2" is produced. This approach to allocating productive resources can be
illustrated by fully constructing the societal weekly PPF (with specialization) for the two
person economy consisting of Baker and Taylor (i.e., a PPF which ilhisWates the joint or
collective productive possibilities of the two individuals). This PPF is illustrated in
Figure 2.4. If all five days of each workers time is devoted to producing clothing, then in
total 60 units of clothing ((5)(2) = 10 by Baker and (5)(10) = 50 by Taylor) and zero
units of food are produced. This is illustrated by Point G in Figure 2.5.
Starting at Point G, which worker should be used to produce the first unit of food?
Recognize that society has essentially two options: have Taylor produce the first unit of
food (in which case clothing output would decrease by oct= 1 unit) or have Baker
produce the first unit of food (in which case clothing output would decrease by OC ~= ¼
of a unit). Clearly, the better choice (consistent with the Law of Comparative Advantage)
is to have Baker produce the first unit of food. Further, so long as either worker has some
time that could be diverted toward food production, we would always want to have Baker
produce the next unit of food. As a result, starting at this vertical intercept the societal
PPF is a straight line with a slope of - OC ~= -¼ (since Baker is the worker whose time
is being switched away from clothing production toward food production). But, at some
point we will have switched all of Baker's time over to food production. When Baker
spends five days producing food and Taylor spends five days making clothing, together
they produce 40 units of food (all produced by Baker) and 50 units of clothing (all
produced by Taylor). This leads to Point H in Figure 2.5.
s $amuelson p 'The Way of an Econormst. m Samuelsca, p. A.. Internauonal Economtc Relauons:
Proceedings of the Third Congrns$ of that International Economic Association, London: Macmillan. 1969.
page 9,
 Chapter #2 - Fundamental Economic Questions and Gains from Specialization Chapter #2 - Fundamental Economic Questions and Gains from Specialization

Figure 2.$ - weekly PPF for Baker and Taylor (with specialization)
C....
mmmg[ "vertical intercept" => [ [ "kink" => Baker produces
If Baker wcrc producing only for his own consumption, the best hc could do is spend one
day making food and four days making clothing. He would then produce and consume 8
units of each good. Similarly, if producing only for her own consumption, the best that
Taylor could do is equal divide her five day workweek between clothing production and
food production, producing and consuming 25 units of each. The collective output of the

]~
I | both Baker and Taylor 1~ onlyfood, while Taylor
produce only clothing [[ produces only clothing two workers consists of 33 units of each good (illustrated by Point K in Figure 2.5),
which lies below the joint PPF)°
5 0 + 1 0 = 6 0 ~ When specializing in production, the efficient point with equal amounts of food
J ~ u n i t s o f
~ food and 0 units ofclothing, and clothing is realized by having Baker spend all five days making food (thereby
I G ~ . H l c " "
50"1- ........... ~ ' z , , / [ while Taylor produces 5 units producing (5X8) = 40 units of food and zero units of clothing) and having Taylor spend
[ of food and 45 units of clothing half a day making food and four and a half days making clothing (thereby producing
4 5 - = ~ . . . . . . . . . .K. . . . . ~ (.5)(10) = 5 units of food and (4.5)(10) = 45 units of clothing). When allocating their
I ~ I 'no
,L rizontal
-- 1 33 ........... ~ I time in this fashion, in total they produce 45 units of each good, putting them at Point I in
Productive ~ ] intercept" =>
[ .,~1 ~ Figure 2.5. That is, specialization in production allowed them to produce 12 additional
inefficiency / / ' ~ ~ ] both Baker and units of food and 12 additional units of clothing.
- - i ,
(perhaps from "no [
specialization")/ " ~
/I onlyfood
j / ~ Taylor produce Now suppnsc that on top of this specialization, the two workers trade with each
i other. As an example, if Taylor gives Baker 13 units of clothing in exchange for 27 units
of food, then Taylor is ultimately left with 32 units of food (the 5 units she produced, plus
the 27 units she received from Baker) and 32 units of clothing (the 45 units she produced,
minus the 13 units she gave to Baker). Clearly Taylor is better offbeing able to consume
33 40 45 90=50+40 32 units of each good as opposed to only 25 units of each good (which was the best she
could do when producing only for her own consumption).
Under this arrangement, Baker is ultimately left with 13 units of food (the 40 he
At this point, is it possible to produce even more food? Yes, but the society no produced, minus the 27 he gave Taylor) and 13 units of clothing (the zero he produced,
longer has the luxury of using Baker's labor (i.e., the resource with the lower opportunity plus the 13 he received from Taylor). So, after specialization and trade, Baker is also
cost). They must now have Taylor produce any additional food (i.e., they must use a better off than he would have been if he instead produced only for his own consumption
resource with a higher valued opportunity cost). As a result, the PPF becomes more (being able to consume 13 units of each good, as opposed to only 8 units of each good))I
negatively sloped (the slope is now equal to -ocr=-l), reflecting the fact that a Thus, through specialization in production, this two person society is able to
greater decrease in clothing production is now necessary to produce an additional unit of produce more of each good than would bc possible if each person produced only for his
food. Recognize that the PPF becomes more negatively sloped as a direct consequence or her own consumption. Further, once we allow trade following this specialization, each
of correctly applying the Law of Comparative Advantage? Finally, if all five days of individual is able to realize higher levels of consumption, compared to what they could
each workers time is devoted to producing food, then 90 units of food ((5X8) = 40 by achieve if they did not interact with the other person. That is, as a result of specialization
and trade, not only is society as a whole better off (in terms of being able to produce
Baker and (5)(10)= 50 by Taylor) and zero units of clothing arc produced. This
more total output), but further, each individual member of society is better off(in terms
corresponds to Point J in Figure 2.5.
Further, after more of each good is produced through specialization, the total
output of society can be distributed to consumers in such a way so as to make all l0 Recognize how these choices by Baker and Taylor provide answers to the three fundamental economic
individuals better off than they would be when producing only for their own questions. Production Decision: the society produces 33 units of each good. Resource Use Decision:
consumption. We can illustrate this point more easily by making a simplifying Baker spends one day making food and four days making clothing, while Taylor spends two and a half days
making each good. Distributional Decision: Baker consumes 8 units of each good. v,'hile Taylor consumes
assumption about the preferences of our two consumers. For the sake of argument, let's 25 units ofeach good.
suppose that each person always wants to consume an equal amount of food and clothing. tt Again, these choices provide a set of answers to the three fundamental economic questions.
~: the society produces 45 units of each good. Resource Use Decision: Baker spends five days
making food and zero days making clothing, while Taylor spends halfa day making food and four and a
In an ¢¢ooomy with many different productive resources (each with a diffe~nt valued opportunity cost for half days making clothing. Distributional Decision: Baker consumes 13 units of each good, while Taylor
producing food), this would result in PPF which approximates a smooth curve that is bowed-out from the consumes 32 units of each good.
origin, similar to that pictured in Figure 2.2.
 Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter #2 - Fundamental Economic Questions and Gains from Specialization

of being able to consume greater quantifies of the goods, thereby realizing greater C H A P T E R # 2 M U LT I P L E C H O I C E Q U E S T I O N S
benefits from consumption).
The importance of these gains in output from specialization in production cannot I. When interpreting a Production Possibilities Frontier, which of the following
be understated. They provide the basis for why individuals within a society should statements is true?
bother interacting with others when it comes to producing goods and services for A. "All Attainable combinations of output are characterized by Productive
consumption, As this example illustrates, specialization, division of labor, and trade can Efficiency."
be a "win-win situation" for all members of society. B. "A combination of goods is characterized by Productive Inefficiency if it
cannot possibly be produced with the currently available resources and
technology."
C. "A combination of goods is Unattainable if it cannot possibly be produced
with the currently available resources and technology."
D . None of the above answers are correct,

2, Which of the following is one of the "Three Basic Economic Questions" that every
society must address?
A. "How can we reduce our carbonfoo~rinf?.'"
B. "Which productive resources should be used for the production of which
goods?"
C. "How can we guarantee that all people have access to bealthcare?"
D . More than one (perhaps all) of the above is one of the "Three Basic Economic
Questions" that every society must address.

3. Evan and Liam spend each workday assembling bicycles and fixing computers.
Evan can assemble 24 bicycles in a single day, while Liam can assemble 18
bicycles in a single day. Based upon this information alone, we know that
A. Evan possesses a Comparative Advantage in assembling bicycles.
B. Evan possesses an Absolute Advantage in assembling bicycles.
C. Liam possesses an Absolute Advantage in fixing computers.
D . More than one (perhaps all) of the above answers is correct.

4. Production refers to
A. the consumption ofgoods/servines.
B. the creation of additional scarce resources/inputs.
C. inputs, which can be broadly categorized as land, labor, and capital.
D. the process by which inputs are transformed into outputs.

5. Consider a society consisting of only three people: Amy, Bill, and Carrie. Amy and
Bill spend all day producing clothing and food. At the end of each day they bring
their output to Carrie, who then divides it between the three individuals. The "basic
eeonormc question" that Carrie is answering for this society is the
A. Resource Use Decision.
B . Production Decision.
C . Distributional Decision.
D . Choice of Incentives.
 Chapter #2 - Fundamental Economic Questions and Gains from Specialization
Chapter 02 - Fundamental Economic Questions and Gains from Specialization

are the decision making entities whose primary objective is to obtain

6. is a general concept that refers to the cost of giving up the benefits from consuming goods and services.
best alternative that must be foregone in order to do or acquire something. A. Politicians
A. A Property Right B. Households
B. Comparative Advantage C. Firms
C, The Resource Use Decision D. Entrepreneurs
D. Opportunity Cost
1 I. The Preliminary Circular Flow Diagram illustrates the
For Questions 7 through 9, consider a society facing the Production Possibih'tles Curve
A. movement of economic resources (i.e., factors of production and finished
illustrated below: goods/services) between households and firms.
Corn B. transfer of money between households and firms.
C. the limits of production that a society faces, by identifying the maximum
amount of one good that can be produced for every possible level of
1,000 ~.~. production of another good.
8 ~ . . . ~ . ~ . . . . . . . . . . D. gains in output that can be realized when individuals focus their efforts on
producing the goods for which they possess a comparative advantage.

12. A.C. and Zack produce surfboards and hair gel. A.C.'s opportunity cost of
producing a surfboard is lower than Zack's opportunity cost of producing a
surfboard. The suggests that they can increase their total
Tanks output of these two goods if A.C. focuses his production on surfboards while Zack
0 ~ focuses his production on hair gel.
0 300 320 420 600 A. Law of Absolute Advantage
B. Law of Comparative Advantage
7. Which of the following combinations of output is "feasible but characterized by C . Cost-Benefit Principle
productive inefficiency'? D . Incentive Principle
A. "A" (300 Tanks and 375 bushels of Corn).
B. "B" (420 Tanks and 800 bushels of Corn). 13. "Vinny's Sports Pub" is Jessica's favorite restaurant. After recently joining their
C . "C" (420 Tanks and 1,000 bushels of Corn). frequent diner club for free, she got a coupon by e-mail which can be redeemed for
D . More than one (perhaps all) of the above answers is correct. either a free order of Buffalo wings or a free slice of pizza. Last night she used the
coupon to get a flee slice of pizza. Her Opportcnity Cost of the slice of pizza is
8. Starting at Point "B" (i.e., 420 Tanks and 800 bushels of Corn), if this society A, zero, since she received the code for free.
wanted to produce 180 more Tanks, then B. the maximum amount of money she would have been willing to pay for the
A. they could not increase their output of Corn, but they also would not have to slice of pizza if she did not have the coupon.
decrease their output of Corn at all. C, the regular menu price of a slice of pizza.
B. they could also increase their output of Corn by 200 bushels. D, the value she places on an order of Buffalo wings.
C. they would have to decrease their output of Corn by at least 300 bushels.
D. they would no longer be able to produce any Corn whatsoever. 14. The provides a guide for allocating scarce productive resources to
various uses, which states that when increasing the production of a good, a society
9. If this society wanted to produce 650 bushels of Corn, then their maximum output should use the nvallable productive resource with the lowest opportunity cost.
of Tanks would be A. Opportunity Cost Principle
A. exactly 420 Tanks. B. Economic Distribution Principle
B. more than 420 but fewer than 600 Tanks. C, Law of Absolute Advantage
C. exactly 600 Tanks. D, Law of Comparative Advantage
D. more than 600 Tanks.
 Chapter #2 - Fundamental Economic Questions and Gains from Specialization

15. An output combination is characterized by Productive Efficiency if

A. it cannot possibly be produced (given the limits imposed by the scarcity of
resources and current technology).
B. it is possible to produce the output combination, and further it is not possible Economic Systems:
to increase the amount produced of any good without decreasing the amount
produced of some other good.
C. it is possible to produce the output combination, and further it is possible to
Capitalism versus
increase the amount produced of some good without decreasing the amount
produced of any other good. Socialism
D. one single worker possesses a comparative advantage in producing every good
that is a part of the output combination.
In the modem world (for our purposes roughly from 1700 to the present) there has
16. Erika produces clothing and food. In a single day she can produce either 100 units been competition between several different economic systems. The two that survived
of clothing or 25 units of food. It follows that her Opportunity Cost for producing a into the 20`h century were Socialism and Capitalism, the ideas of which are still
unit of food is units of clothing. contending with each other to the present day. An economic system refers to the rules
A. (25X 100) = 2,500. and methods put in place by a society to answer the three fundamental economic
B. 100-25=75. questions of "What to produce?," "How to produce it?," and "For whom to produce it?"
C. 100+25=4. (recall the discussion of these questions from Chapter 2).
D. 25 + 100 ='A. In many respects, an economic system can be thought of as the institutions and
social arrangements established by a society to answer these three fundamental economic
questions. In most modern societies, there are four broad institutions that are ofutmnst
importance for determining the answers to these questions: households, firms,
government, and markets. As was noted in Chapter 2, the two primary decision-making
institutions in any economy are households and fares. A market can be defined as the
collection of all potential buyers and all potential sellers of a good or service. In many
societies, nearly all of the interactions between households and finns takes place within
markets.
With regards to the functioning of an economy, the fourth important institution is
government. In this context, government refers to a decision-making institution with the
legal authority to impose restrictions or mandates on the behavior of other decision-
makers, in other words, the ability to use legal coercion. In a modem economy,
government plays a critical role in defining and enforcing property rights. It is necessary
for government to undertake these actions in order to create a solid foundation upon
which markets can operate. Additionally, government plays a key role by regulating the
behavior of businesses (e.g., mandating product characteristics, such as the automobile
safety features discussed in Chapter 1), providing some goods and services (e.g.,
education or healtheare), and redistributing income (either directly by way of transfer
payments, such as food stamps or welfare, or indirectly through the tax code). By such
actions, government imposes constraints or restrictions on the behavior of decision-
makers, thereby directly altering the costs and benefits of different actions and indirectly
influencing how households and firms interact with each other in markets.
Recognize that there is a drastic difference in the power or authority that the
decision making entity of government (or the state) has when compared to that of a
household or business. As described by the German philosopher and political economist
 Chapter #3 - Economic Systems: Capitalism versus Socialism
Max Weber in his famous lecture "Politics as a Vocation," the government or the state
differs from other decision malting entities in that it alone has established "the monopoly
of the legitimate use of physical force within a given territory.''~ Consequently, if a
member of household or a business wants you to do something, they have to in some
non-coercive way make doing it worth your while. In stark contrast, if government wants
you to do something, they could choose to threaten you with penalties that are ultimately
backed by a threat of the use of force, encompassing physical harm or incarceration.
From this discussion, we can see how each of these four different institutions
plays an important role in determining society's answers to the three fundamental
economic questions. Again, it is a society's economic system that in essence specifies
the "rules" that must be followed and the roles which are played by households, firms,
and government (and any other relevant decision makers, such as labor organizations and
non-guvemmental organizations) when interacting with each other in markets.
C A P I TA L I S M V E R S U S S O C I A L I S M
The primary aim of the present discussion is to distinguish between the two
dominant economic systems of socialism and capitalism. Other systems coexist with
these two in the world but do not contend for dominance on the world stage. Historically,
the most basic of all economic systems is the Traditional System which can be seen in
subsistence agriculture and fishing as well as in nomadic herders and others. These
methods still exist side by side with more modem organizational forms in many lesser
developed countries, but have all but died out in Europe, the large coastal cities in the Far
East, North America, most of Latin America, and in the larger cities of Africa and the
Middle East. In this chapter we will spend our time describing and analyzing socialism
and capitalism since they are the only remaining alternatives that economically advanced
societies really consider as alternatives. Such an examination falls within the realm of
comparative economic systems, which is the subfield of economics that compares and
contrasts the structure and the performance of different types of economic organization
(i.e., different economic systems).
The fundamental defining characteristic of any economic system is an
identification of who is allowed to own and decide how to use the available productive
resources or factors of production - the inputs such as factories, farms, stores, trucks,
and equipment used to produce goods and services. At any point in time a society has a
certain, scarce amount of these factors.
Capitalism, the first alternative to be examined, grew out of and replaced
Feudalism in Europe over an extended time period. Feudalism is the system of
aristocratic and hereditary ownership of landed estates and titles of nobility where society
is divided between the nobles at the top and the serfs or peasants at the bottom. The
nobility owned all of the land and gained their possess/un of it either by conquest or
inheritance. This system is both glorified and lampooned in our culture in poetry, books,
J An English translation of Weber's "Politics as a Vocation" is available at htto://anthrotyos-lah.net/wt~/wr~-
content/uz~loads/20 l ]//2/Weber-Politics-as-a- Vocation.pall.
Chapter #3 - Economic Systems." Capitalism versus Socialism
plays, and movies as diverse as Tennyson's King Arthur to "Monty Python and the Holy
Grail." Feudalism took centuries to collapse, but the collapse accelerated during what we
now call the Industrial Revolution which become visible in the 18a~ century and picks up
steam in the 19a' century in Europe and North America. While the roots of Capitalism
can be traced all the way back to the Renaissance in the advanced trading city states of
Italy, we will pick up the story with Adam Smith who wrote An Inquiry into the Nature
and Causes of the Wealth of Nations in 1776 (hereafter The Wealth of Nations).2
Socialism, on the other hand, grew out of a reaction to the problems of
industrialization with many famous thinkers leading the way. We will focus on the
works of the most famous and ultimately influential of Capitalism's critics, Karl Marx.
Among his most famous works are The Communist Manifesto, written with Freidrich
Engels in 1848, and Capital." Critique of Political Economy, Volume 1 written in 1867.
In all of his works on economics Marx analyzed and criticized capitalism in the most
severe terms and proposed an alternative known as communism. For our purposes at this
point of the discussion we will treat socialism and communism as synonyms since they
agree far more than they differ.
In the diagram below we put socialism on the "left" and capitalism on the "right."
In European and American usage, people who oppose capitalism are politically to the
"left" of those who support capitalism (or, equivalently, those who oppose socialism are
politically to the "fight" of those who support socialism), in addition to the main titles of
the respective systems, socialism and capitalism also have many synonyms in current
usage which are listed below. You may be familiar with many of them since the debate
between capitalism and socialism has been going on quite loudly for some time.
Socialism i | Capitalism
Communism Free-Market System
Command System Free Enterprise
Centrally Planned System
Decentralized System
Laissez Faire
Each synonym brings out different aspects of each system in more detail, but we will use
socialism and capitalism as the main labels for the ideas embodied in all of these terms.
What are the dominant characteristics of each system that clearly identify their
differences? For most of the present discussion, we will be using the terms socialism and
capitalism in their purest, theoretical sense, not as practiced in any real country. With
this in mind, we can differentiate between these two systems by identifying who is
allowed to own the factors of production.
Socialism is an economic system based on Government ownership of the factors
of production. The government (on behalf of society) owns all of the productive
resources and operates all of the businesses and, therefore, determines the answers
to the fundamental economic questions by deciding what goods to make, what
2 The full text of The Wealth of Nations is available at: http. ',it~vwe~-(mhh org?ibrdr3 "Smith ~sml;:~:htrnl.
 Chapter #3 - Economic Systems: Capitalism versus Socialism
prices to charge, who gets access to the goods, and who gets denied access to the
goods.
Capitalism is an economic system based on private ownership of the factors of
production. Private individuals own all of the productive resources and operate
all of the businesses. This ownership is referred to as Private Property. Private
ownership of a company can be by a single individual like in a sole
proprietorship, or with other like-minded individuals such as in a partnership or
corporation. In all these cases there is an identifiable, limited group of people
who are the owners. This is in distinction to state ownership where conceptually
the whole society owns the property. {For example, Michael Dell and his
stockholders own Dell Computer Company, but you and I do not, while
Yellowstone National Park and the Post Office belong to all Americans.) Just as
in socialism, the "owner" of the enterprise gets to make the decisions of what
product to produce, what price to charge, who gets access to the goods, and who
gets denied access to the goods. This is because ownership carries certain rights
and responsibilities.
In order to understand each system more fully we are now going to examine in more
detail the underpinnings of each system. Since the capitalist system came fn'st and the
socialist system started as a criticism of capitalism we will start with an analysis of
capitalism.
C A P I TA L I S M A N D P R I VAT E O W N E R S H I P O F P R O P E R T Y
Private Property or Property Rights are understood by the philosophers of
capitalism as a subset of, or a part of, the overarching concept of individual rights or
human rights, commonly known as Natural Rights. Not all philosophers who have
studied private property agree that people have a right to their property equal to their
right to their human rights or civil rights. We will explore this disagreement as the
chapter progresses, but for now we will explore the pro-capitalist position first, and then
the criticism of that position which culminates in the development of socialism and
communism.
What is private property and what does ownership of property give you the
"'right'' to do? Private Ownership, the key concept within a system of Private Property,
consists of three interlocking sets of rights which collectively go by the name Property
Rights. Ownership consists of the right to:
1. Control or decide how to use property
2. Acquire or transfer ownership of property
3. Seek restitution for damages to property
Let's consider each of these in turn.
Right to Control or decide how to use property. When you claim to own a
piece of propar~ you are claiming the exclusive fight to con~'ol or use the property. For
Chapter #3 - Economic Systems: Capitalism versus Socialism
instance, if you own 50 acres of land, who gets to decide if corn or cotton is planted on it
this year, or if the land is left fallow, or ira subdivision or apartment complex is built on
it? Private ownership implies that the owner gets to make that decision exclusively, and
the community as a whole does not get to vote on how the property is used. Let's
examine another example. You own a car and a school break is coming up. Your friends
want to go to the mountains in it and you want to go to the beach. Who gets to decide
where the car goes? You do, as the owner, even if your friends outnumber you. This
fight of control also extends to any income you derive from the property you own. For
example, you own a house and rent it out to Mr. Miller for $1,000 per month. Your
neighbor Mrs. Jones claims that she should get to keep the rent from the house. Who
may rightfully claim the rent payments? In capitalism you, as the owner, have that right.
What if in addition to the rent you collected you make $100,000 in salary, but Mrs.
Jones' hours at work were just reduced and she will make only $20,000 this year. Which
of you now has the fight to collect the rent from your rental house: you or your neighbor?
In capitalism, you, as the owner, still have the right, since ownership has not changed.
Clearly, the defining issue for capitalism and Private Property Rights is ownership, not
need or some other criteria.
Right to Acquire or Transfer Ownership of Property. If ownership gives
people such powerful control over the use of, and the income from, property, how did
people get to own the property to begin with? While the concept of property clearly
exists in the Bible and in other ancient civilization's documents, the modem concept of
Private Property as a right in the English speaking world is most forcefully put forward
by the philosopher John Locke in his Second Treatise on Government (originally
published in 1690. All references to the version edited by C.B. McPherson, Hackett
Publishing, 1980.) in this treatise he bases the justification for ownership of all property
as being an extension of self-ownership. In his chapter, On Slavery, he makes the
argument that everyone owns themselves by natural right and that no one else may treat
another human being as property, nor may a person even voluntarily sell themselves into
slavery. A person's freedom is considered an inalienable right or a right that is inherent
in a person and cannot be removed from them even if they want to get rid of it (you may
recognize this concept from the Deelamtinn of Independence). This right of self-
ownership is so well established in the modern world and is contested by no respected
authorities, so we will not attempt to further justify it. This self-ownership then gives
you all of the fight of control over yourself that an owner has over a car or farm or any
other thing that he owns. From this right Locke derives all other property rights.
How do you get from the ownership of yourself to the ownership of 50 acres of
land or a car or any other external thing? In his chapter, Of Property, he poses the
following thought experiment: if you, who own yourself, were wandering through a
forest an-owned by anyone and you gathered up wild acorns or apples, who would own
them? If you came back to your band of hunter-gatherers and Fred says to you, "give me
my acorns," how would you respond? Locke assumes everyone would agree that you
owned the acorns and Fred has no right to them. You could give him some or all of them
if you choose, but it is your right to control the acorns and apples because they are your
property. What made them exclusively your property? Locke says it was when you
 Chapter #3 - Economic Systems: Capitalism versus Socialism
"...bestowed your labor upon it..." (paragraph 30, Of Praperty, page 20) that it become
yours. It was un-owned before, but now that you have done the work you have "mixed
yourself into the good" and it is now yours by right. So, the concept is that if a person
who clearly owns himself labors on some un-owned thing, then that thing becomes his,
and all others have no fight to demand the thing from him. By logical extension he
claims that a fisherman owns his catch, that a hunter his game, a housewife the water she
draws from a well, etc.
Locke goes on to describe how a person comes to own a piece of land as private
property by the same argument. At one time there was no owner of the trackless forests
and grasslands of the world, but if a pioneer family went out into the un-owned
wilderness and cut down the trees, tilled the land, planted crops, and built a house, who
would deny that they "owned" the property7 Could anyone that comes along later, after
all of the work was done, claim equal fights to the crop or to make decisions on what to
plant? John Locke said no. From this beginning, all of the physical things of this world
were appropriated over time until all of the land and everything on it could in principle be
private property. Now, this scheme still leaves some things conceptually outside of the
private property system. It is difficult to define personal ownership of things that have no
fixed or permanent location or that cannot be easily contained (e.g., the air, an ocean, or a
river). Even today, such resources remain ommon property, which is property owned
simultaneously by everyone in society.
Most private property that is owned or accumulated today is not accumulated by
Locke's original method of applying labor to un-owned things, simply because there are
few or no nn-owned things to get (fishermen are one exception since they capture un-
owned fish from an nn-owned ocean or river). So how does one gain a property right in a
car, a business, a house, or a farm if all of the property is already owned by someone
else? Most property is accumulated in modem times through voluntary agreements
known as contracts. We are all familiar with contracts when we buy a car or house, and
we read about football players signing contracts with teams and the like. However, a
contract is really nothing more than a voluntary agreement between two parties to
voluntarily exchange one thing for another without force or fraud being employed. Most
contracts are verbal agreements, but as things get more complicated or the dollar amounts
get large we switch to written agreements, often drawn up by lawyers, to protect the
interests of the parties to the agreement.
The process by which property ownership can be transferred is easily illustrated
by way of example. Suppose the Garcia family was the first to enter into a valley after
coming over the mountain pass, and they have spent several years improving the raw land
into a comfortable farm. You and your family now enter into the valley too, and you
admire Garcia's farm. There is raw land full of trees available for you to turn into a farm,
but you would rather not do all of that work that the Garcia family did. You like the
Garcia farm and you want if for yourself. May you rightly take it from them against their
will? If your family has 10 members and the Garcia family only has 5, can you sit down
with them and have a vote and rightly vote them off the farm like some episode of the TV
show Survivor?. Neither of these options exists within a Capitalist system since
ownership in this ease is clear and one of the unambiguous duties of a government in
Chapter #3 - Economic Systems: Capitalism versus Socialism
such a system is to protect an individual's private properly rights. You can however,
enter into a voluntary agreement with the Gareia family. For instance you can work out a
rent-to-own plan where you propose taking over all of the work on the farm for the next
20 years while giving Mr. Garcia the money the farm earned and at the end of the period
you become the new owner. If Garcia is elderly and cannot work the land anymore he
might just be interested, and then you have a deal. As long as yon hold up your end of
the bargain and commit no fraud by shirking your duty to Garcia you will become the
new rightful owner. If someone came along after you finally worked offyour obligation
to Garcia could this new person claim that he has as much right to the land as you do,
since neither of yon was the original owner? Clearly not. Your agreement or conWact
with Garcia, who rightfully owned the farm, transfers his fight to you. Now you rightly
own the farm, and all other persons must respect your right, just as they respected
Gareia's original ownership right.
What other ways are there to transfer the rightful ownership of, or the property
right in, the farm to others? You could instead offer Garcia enough money that he would
rather have your money than keep his farm. He can now move to town and pay for his
own retirement out of the cash you gave him. This agreement, voluntarily agreed to by
both sides, makes the transfer of the land to you morally right. You now have all oftbe
rights to claim ownership that Garcia had. Lastly, Garcia could freely give it to you.
Why would he do this? You may be a close relative like a son or daughter, and he could
name you in his will. After he dies you now have all of the rights to the property that he
had. If another person comes up and claims that they should have the property how do
we decide who should get it? In the above example, the voluntary decision of the rightful
property owner to do with his property as he wishes makes the person to whom he wills it
(the inheritor) the morally legitimate owner. If Gareia has no children, or dislikes them
for whatever reason, and voluntarily gives the property to his church or other charity,
who now legitimately owns the farm? The son or daughter, or the church or charity? I
am sure that by now you see the logic of capitalism, and understand that the church or
charity is now the rightful owner because it received the farm from a voluntary grant by
the legitimate owner.
This concept of individual control of property is very modem. Only a few
hundred years ago, under what is known as the Feudal System, land was inherited by the
eldest male son or relative by law (you can see an example of this in the PBS period
drama, Downton Abbey, where a family has only daughters who cannot inherit their
father's estate). If we now imagine a well-governed society with a functioning police and
court system to enforce these rules of rightful acquisition and rightful transfer, then
conceptually you can imagine a world in which all present owners of property are the
rightful owners. They now have all the rights of control that the original owners who
long ago applied their labor to original pieces of un-owned property had.
Right to Seek Restitution for Damages to Property. What do you do if the
momUy correct procedures were not followed to acquire property? Those using force or
fraud to acquire property from others do not rightfully own that property, and therefore
have no right to control it, profit from it, or give or sell it to others including their family
me,nbers. Government may rightly interfere with a person's claim to hold these rights
 Chapter #3 - Economic Systems: Capitalism versus Socialism
over a piece of property if it can be shown that the acquisition was unjust or wrongly
acquired. As mentioned above, a just or fair capitalist society has (or needs to have)
some method of providing some kind of relief to those who have been wronged by others.
What kind of injuries to a person's property rights gives that person the right to
restitution or to rectification of the wrong? Let's work through some examples.
Someone texting while driving doesn't see that you have come to a stop sign until
it is too late and they hit your car, destroying it. In this case they have damaged
your property which you have exclusive rights over, and therefore justice
demands that they pay restitution for the damages. You are not entitled to make a
profit on the deal, only to get your property restored to its value before the
accident. If however, you entered into an agreement with the owner of a monster
truck show to use your car as a prop for the trucks to crush, are you entitled to
restitution? Clearly not since your voluntary agreement gave the show owners the
right to destroy your vehicle (usually in return for money). The primary issue is
not the destroyed car itself, but whether the result was agreed to and whether your
property rights were violated.
Your spouse goes into the hospital for routine surgery, but the doctor was drunk
and botched the operation killing the patient. How do property rights enter into
this txagedy? Well, who "owns" the body of the person who was killed? That
person obviously does (based upon what John Locke said about serf-ownership in
his discussion on slavery). The doctor has no right to take the life away, so the
dead person has had their property damaged. Since they aren't able to sue the
doctor for restitution themselves, their spouse does on the reasonable theory that
spouses inherit fi'om each other on death. So the surviving spouse sues the doctor
for restitution for the value of the life that was taken. Now of course a person's
life is a very difficult thing to value, but in principle a property rights system
would treat wrongful death as ultimately a property rights issue.
A building contt'actor agrees to install fancy marble in your bathroom but installs
cheap tile instead. Here the issue is failure to live up to a contract which is an
exchange of property rights and part of the section on transfers discussed above.
The homeowner is obligating himself to pay the agreed price and the contractor is
morally obligated to deliver what was promised. There is now a violation of
property rights and the homeowner can sue the contractor.
A bank lends money to a car dealer so that the car dealer can put cars on the lot
for sale. The car dealer refuses (for whatever reason) to pay the interest and
principle on the loan, so the bank sues the dealer for restitution. The bank may
end up getting a court order for repossession of the cars if necessary to retrieve
the money lent.
Chapter #3 - Economic Systems." Capitalism versus Socialism
In all of these cases the underlying issue can by conceptually reduced to a dispute over
property rights.3 Who owns the property in question, and/or is there a valid agreement to
transfer property between people? Once these questions are answered then the court
knows who deserves the property or who deserves restitution and who should pay whom.
Remember the example of the rental house and your poorer neighbor demanding
the right to collect the rent rather than you? According to proponents of Capitalism, who
should the judge award the rent payments too? Clearly, judges have no authority to alter
the existing property rights or award them to whom they think deserves them. They are
like referees at a football game. If one team is winning by 35 points can a referee
arbitrarily give out 15 yard penalties to the team that is winning or arbitrarily add points
to the score of the team that is losing in order to make the game "fair'? In the capitalist
conception of property rights neither judges, nor legislators, nor even the President has
the authority to give the rent check to your neighbor if you rightly own the property. This
would be true even if your income was $1,000,000 per year and your neighbor's was $0.
Your property rights would trump the feelings of others as a matter of moral right. You
could of course give some income to your neighbor as charity, but they could not demand
it by right.
The study of history shows that most holdings of property throughout time have
not followed the procedures of morally correct original acquisition or morally correct
voluntary transfer to new owners as outlined above. We won't go into the details of all of
the wars of conquest, frauds, and other forms of coercion that history provides us, but
there are a few that are germane to an American audience.
Did the slave owners rightfully own their slaves? When they were set free aRer
the Civil War was restitution owed them? lfso, by whom: the former slave owners, the
now defunct Confederate government, or the U.S. government that fought to liberate the
slaves (this issue is often discussed in American History courses in the chapter on
Reconstruction)? When pioneer families crossed the Appalachian Mountains and settled
and farmed Indian lands, did they become the rightful owners? When the U.S.
Government gave away 160 acre tracts of conquered Indian land to Americans who
would go live on it and improve it in the famous Homestead Act of 1862 (see the movie
"Far and Away" starring Tom Cruise and Nicole Kidman for a cinematic treatment of the
!ssue), did those families come to rightfully own it? A Mexican-American, who legally
mumgrated to the U.S. 10 years ago, buys a farm in Kansas from the great grandson of
the original homesteader and pays good money for it. Does he legitimately own the land,
or could an American Indian descendent living in California claim rightful ownership of
the Mexican-American's farm? These are very difficult and contentious issues because
they are about conflicting moral claims to property. Add in all of the more common
crimes, frauds, and other forms of coercinn and you have a difficult knot to untangle.
Modern societies have dealt with many of these issues by invoking the principle
of a Statute of Limitations, whose principles go all the way back to Roman Law (see
Cormun, Calvin W., Limitation of Actions, Boston: Little, Brown, 1991), that sets a time
limit on how long a person may wait before making a legal claim. The principle here is
J For a fuller discussion of these issues related to the principle of rectification, see: Nozick, R. Anarchy.
State and Utopia, Basic Books. 1974, pages 152-153.
 Chapter #3 - Economic Systems: Capitalism versus Socialism
not to prevent a person from making a just claim, but to prevent a miscarriage of justice
due to "...fraudulent and stale claims from arising utter all evidence has been lost or after
the facts have become obscure through the passage of time..."4 As you can see, the
principle is not to sweep injustice under the rug, but to prevent further injustice fi'om
happening. Whether this principle is strong enough to convince you to let bygones be
bygones is of course open to question.
In principle, a fair and just capitalist system, operating through a legal system that
rigorously protects people's property rights, could lead over a period of time to all
privately owned property being justly owned as a right and deserving of the
government's protection. This, in a nutshell, is the way that individual capitalists or other
property owners see their property holdings in a properly functioning capitalist system.
As you can see, there is not much room for government action if one adopts the
moral principles outlined above. Most welfare programs could not exist, Social Security
as currently designed would violate people's rights, government subsidies of everyone
from farmers, college students, the elderly, and banks would have to end. If carried to its
logical ends capitalism is only what Nozick calls the minimal state or Night Watchman
State, where the government operates only a police force, a court system, a prison system,
and the military,s This would be a minimal government indeed! All other activities
handled by government today would have to be handled by private charities, private
schools, churches, and other voluntary associations. Everyone gets whatever they own,
such as clothes, cars, houses, and food, by entering into voluntary bargains with others.
Whatever income you get from this process is rightly yours and no one, including the
government, may take if from you without your permission. Issues like income
inequality do not arise since everyone is the legitimate owner of their income and
property, however high or low. The only exception to this principle would be if the
inequality can be shown to have arisen from a violation of one person's property rights
by someone else.
PROPERTY RIGHTS AS A HUMAN RIGHT
In pure capitalism this right to control the property you own is inviolable and is
considered part of your human rights, shnilar to your right to freedom of religion or
speech. In each of these rights you as an individual retain the right to make certain
decisions that no one else, including the government, may legitimately interfere with. All
of these rights (property rights, freedom of religion, freedom of speech, etc.) are
understood to be negative in nature. Negative rights specify obligations of others not to
interfere in your exercise of your rights. It is also understood that everyone else in the
world has these same rights naturally (this is the foundation of Natural Rights) and that
no individual or government may legitimately interfere in the exercise of these rights.
These rights can only be interfered with, or are only limited, when they come in conflict
with the equal rights of another.
+ See: htto://le~al-dictionart,.thefreedictionarv.com/Stamte+of+Limitalio~v.
s Nozick. IL Anarchy, State and Utopia, Basic Books, 1974, pages 26-28.
Chapter #3 -Economic Systems: Capitalism versus Socialism
For example my freedom of religion is my absolute fight to believe in any
relig on 1 choose or create, or not to believe in any religion at all. The only time anyone,
including the government, may interfere in the exercise of this right is ill use my religion
to interfere with someone else's rights For instance, I could not legitimately start a
religion that requires sacrificing maidens, since every maiden has an inalienable right to
her own life. My right to my religion now comes into conflict with the maiden's equal
right to life. However, I do not lose my fight to my religion if the right is negatively
defined. A negative right is understood as possessing the right to freely do with your
own property that which you wish, while respecting the equal rights of others to do with
their property that which they wish. If the maiden does not wish to participate in your
sacrificial rituals then you have no fight to make her. When rights are defined in this
negative sense they cannot ever truly come into conflict with each other, and everyone in
the world can have the exact same rights as everyone else.
If the moral and intellectual principles outlined above are true, then the Capitalist
System is actually a very morally consistent one that participates in the great Human
Rights tradition that most ofns are familiar with. This makes the defense of capitalism a
moral enterprise and not just a defense of privilege in the eyes of proponents.
S O C I A L I S M A N D S TAT E O W N E R S H I P O F P R O P E R T Y
Socialists, as you might imagine, totally reject the capitalist's understanding of
private property as nothing but a sophisticated defense of privilege, exploitation, and
oppression of the weak by the strong. Their aim is Social Justice, a conception of justice
that transcends the capitalists' conception of natural rights (which includes individual
property, contract, and restitution). Advocates of Social Justice instead strive for equality
of outcomes and solidarity (i.e., brotherhood or cohesion) between the members of
society. The denunciation of the Capitalist System can be summed up best in this
popularization of the words of Marx and Engels, "Workers of the World, Unite. You
have nothing to lose but your Chains!"6
What was the source of these "chains" that Marx wanted to destroy? It was the
Private Property of the business owning class. Marx divided the world conceptually into
the Bourgeoisie the business owners, and the Proletariat, the working class. By the
1840's the industrial factory system in the U.S+ and Western Europe was already a major
employer of workers. In the previous century manufacturing took place in small
workshops controlled by an owner/craftsman who worked alongside his handful of hired
workers and apprentices. By the 1840s, modem factories were of a much larger scale,
requiring large amounts of financing to purchase and employing hundreds if not
thousands of workers. As capitalism progressed, a new class of very wealthy men who
made their fortunes in business emerged who were neither members of the feudal
aristocracy nor the working class. Marx named the owners of these factories Capitalists
e See endnote 5 on Page 67 ofbtm.'//marxists.ortt/archive/ma~vAL~orks/dpwnload/t~dtTManifesto,f.tr.
 Chapter #3 -Economic Systems: Capitalism versus Socialism
since they owned the business capital, which is the technical name for all of the
buildings, equipment, inventories, and money invested in a business enterprise.
Marx believed that the relationship between the workers and capitalists was
inherently exploitive. He believed that most of the improvements in productivity arising
from the new factory system should accrue to the workers who produced the goods, not
to the capitalists who simply owned the factories. He considered mere ownership as non-
productive and that in claiming the income derived from the factory for himself, the
capitalist was clothing naked aggression and greed in the mantle of morality and human
rights. This made Marx furious, as can be seen in his scathing denunciations of the
capitalists in all of his writings. Of course, the capitalists (who called themselves
Entrepreneurs, meaning one who undertakes a project), responded that the factory
would never have existed in the first place if they did not take the risk of investing in the
enterprise, managing it wisely, and finding the markets to sell the goods in. They
believed that their large incomes were fair compensation for the tasks they did and the
risks they took. Marx would have none of that, and this disagreement kicks offone of the
most far reaching and bloody debates in history, as entire countries lined up on either side
of this controversy.
If one agrees with Marx regarding worker exploitation by the capitalists, what is
the logical next step? In the Communist Manifesto, Marx proposed revolution. The
purpose of the revolution would be to set up a government to seize both the business
property and wrongly accumulated personal property of the Bourgeoisie, thereby
destroying the Capitalists. All properW would be collective property that is owned and
operated by the state. In Marx's own ringing words, "The monopoly of capital becomes
a fetter upon the mode of production... This integument is burst asunder. The knell of
capitalist private property sounds. The expropriators are expropriated.''7
The purpose of the government seizing the factories and other property of the
capitalists is to re-direct both income and production to satisfy the needs of the
proletariat, whom socialists believe created the goods in the fast place. A more equal
distribution of income could be imposed and society could choose to provide everyone
with goods such as housing, food, clothing, shelter, and medical care, irrespective of a
person's productive ab/lity. This idea is best expressed in the famous Socialist phrase,
"from each according to his ability, to each according to his need." (Louis Blanc in, "The
Organization of Work," 183 9)
Following this government seizure of productive resources, a Dictatorship of the
Proletariat would be set up in the form of the Communist Party which would adm/nister
and control the factories and farms that had been collectivized, or brought under common
ownership, until the proletariat could be properly educated and indoctrinated in social/st
thinking. Marx believed that people were naturally good and ultimately would not be
motivated by selfish or greedy desires once the capitalist system was destroyed. In the
long-run Marx expected the state (or the government) to simply fade away after it was no
longer needed.
Marx completely rejected the claims to private property rights as outlined by John
Locke and the claims of beneficial outcomes of private enterprise as outlined by Adam
See the Communist Manifesto: hltp.'/Al~vw.marxists.ore/archive/marx~,orks/1867.c l/ch32.htn!.
Chapter #3 - Economic Systems." Capitalism versus Socialism
Smith. To him they were nothing but a cover for greed and exploitation. This leads to
two totally different conceptions of the proper role of the State or Government.
In a pure capitalist society the state is to act merely as a "night-watchman"
protecting the already existing property fights of the people and interfering as little as
possible. People are left free to make their own decisions, enter into their own
agreements, create their own businesses, churches, charities, etc., and generally conduct
their own affairs with their own property flee from government interference as long us no
force or fraud was used. The government, as "night-watchman," merely protects these
rights and oversees these agreements, by providing a police force, a court system, and a
military.
In a pure socialist system the government would make almost all important
decisions, since all property is owned by the government. It is a/most impossible to
imagine anything a person could do on their own initiative/fall property belongs to the
government. How do you start your own church? All of the land and buildings belong to
the government, all printing presses to print Bibles, Korans, or other holy books are
owned by the government, all of the paper you would print them on belongs to the
government, all of the newspapers and TV stations on wh/ch you would like to run
advertisements to attract members belong to the government, all of the computers, the
intemet, and websites that you would like to use are also owned by the government.
Without the government's express support and perra/ssion how would you prooeed~
We could go through other examples, but the general point should be clear; no
individual initiative is possible in a pure socialist state, nor is it welcome. From the
socialist's point of view, if you let individuals do their own thing you run the risk that
some of the more aggressive and intelligent ones will set up organizations that will
exploit others, and ending this supposed exploitat/on is the express purpose of socialism
and communism.
PRACTICAL DIFFERENCES
B E T W E E N C A P I TA L I S M A N D S O C I A L I S M
The discussion thus far has focused on the eth/cal underpinnings of property
ownership as a basis for justifying a system of capitalism or socialism. The defining
difference between these two systems is the answer to the question of who owns the
means of production: under capitalism, the means of production are owned by
individuals, whereas under socialism, the means of production are owned by the state.
While this distinction is important to note and conceptually straightforward, it has
its limitations. First, as noted by Egon Neuberger, "An insistence on using the single
criterion of property relationships would force us to lump the Uhited States, France,
Denmark, and Nazi Germany under capitalism, and the Soviet Union, Communist China,
Yugoslavia, and Albania under socialism. This would make for some uncomfortable
s This examp e was adapted from Capitalism and Freedom, by Milton Friedman. Univermty of Chicago
Press, 1962 and 1982, Chicago, pgs. 16 and 17. and modified by the authors.
 Chapter #3 - Economic Systems: Capitalism versus Socialism
bedfellows indeed.''9 Numerous scholars in the field of comparative economic systems
have suggested that it is perhaps more insightful to focus on and identify who has the
decision-making power in regards to the use of resources, which may or may not coincide
with who has the nominal ownership claim. Neuberger justifies this position by stating,
"...ownership rights, in themselves, signify very little. They may mean anything from
complete control over the owned object to virtually no control at all. For example, they
may range from the almost absolute control you have in the decision to save or spend the
dollar in your wallet to the almost zero control a child of three has over the same dollar
deposited in his name by his parents in a saving bank."l° We now briefly focus on the
practical, operational differences between capitalism and socialism, in order to highlight
important distinction regarding how the two systems function.
In a capitalist system, the bulk of economic decisions are made (and the three
economic questions are answered) by individual decision makers interacting with each
other in markets. Capitalism relies upon individual choice in markets to answer the three
fundamental questions (of "What to produce?," "How to produce it?," and "For whom to
produce it?"). Mainstream economic theory supposes that when making decisions in the
marketplace, most consumers and fL, Tns behave as rational, self-interested decision-
makers. From here, many important insights emerge, three of which are discussed below.
First, when addressing the distributional decision (i.e., when answering of "For
whom to produce it?") capitalism relies heavily upon consumer sovereignty. Consumer
sovereignty refers to the freedom for an individual to choose to purchase (or to choose to
not purchase) a good or services at a price determined in a free, unfettered market. For
example, in 2015 Chevrolet sold 15,393 Chevy Volts (a plug-in electric hybird vehicle)
in the United States.H How did we, as a society, decide who got these cars? We
essentially relied upon individual choice in markets, based upon consumer sovereignty.
The suggested retail price of a base level Chevy Volt was $33,995. Each household in
the United States exercised its consumer sovereignty and chose to either buy or not buy a
Chevy Volt at this price. From here we can begin to see how price acts as a rationing
mechanism, a point that will be further explained within the discussion of Demand and
Supply in Chapter 4. Which 15,393 people get to drive these new vehicles? The 15,393
who essentially said, "Yes, at a price of $33,995 I'd like to have a Chevy Volt."
Returning to Max Weber's observation that only the government or state is able to
use (or legitimately claim to use) physical force as an ultimate influence on behavior, this
notion of consumer sovereignty highlights the practical difference between the power of
business compared to the power of government. How does Chevrolet get you to purchase
a Chevy Volt? By giving you something that you want, as a consequence of making the
attributes of the car very desirable and the price of the ear reasonably low. No matter
how big and powerful a private business is, when you are allowed to exercise your
consumer sovereignty, you can always walk away from a transaction if you do not like
what you are getting or how much you have to pay. In contrast, government can force
9 Neubesger, Egon, "Classifying Economic Systems," in Morels Bonmtein (ed.) Comparative Economic
Systems: Models and Cases, 6~ edition, Richard D. Irwin, Inc., 1989, page 18.
no Ibid., page 19.
|l See: http://en.wikipedia.or~Arikl/Chevrolel Foh.
: ,
Chapter #3 - Economic Systems: Capitalism versus Socialism
you to engage in transactions that arc not of this nature. Even if you do not think that the
transportation infrastructure funded in part by your income taxes is a good deal, you
cannot simply choose to not pay your taxes. If you did so, you would be subject to stiff
fines and, ultimately, imprisonment for tax evasion.
Second, profit seeking entrepreneurs will ultimately respond to the signals which
are sent by consumers via their purchasing decisions. If cnnsumers are willing to pay a
very high price (in excess of production costs) for plug-in electric hybrid vehicles, then a
profit seeking firm will choose to increase production of such goods. This is done by
essentially diverting productive resources away from other uses (e.g, the production of
gas guzzling SUVs), toward the production of plug-in electric hybrid vehicles. This
results in more plug-in electric hybrid vehicles being produced and also more productive
resources being devoted to the production of plug-in hybrid electric vehicles. That is, in
the capitalist system (in which decisions are made based upon individual choice in free
markets) the price system additionally plays an important role in addressing the
production decision (i.e., the fundamental question of "What to produce?") and the
resource use decision (i.e., the fundamental question of "How to produce it?").
Third, based upon the insights thus far, we see that in a free market system, the
answers to the three fundamental economic questions are determined indirectly by the
innumerable individual decisions made by every member of society regarding the use of
the economic resources (both productive resources and monetary resources) which he
himself owns. When making each of these decisions, the individual is guided by his own
self-interest. However, the end result of this seemingly chaotic, decentralized process is
often a set of outcomes that is good or desirable for society as a whole.
These points are perhaps best illustrated by quoting from The Wealth of Nations,
in which Adam Smith wrote, "It is not from the benevolence of the butcher, the brewer,
or the baker, that we expect our dinner, but from their regard to their own interest. We
address ourselves, not to their humanity, but to their self-love, and never talk to them of
our own necessities but of their advantage."12 When a fn'm in the marketplace provides
us with something that we value, their motive is profit. But, in order for us to be willing
to give up our scarce money for their good, they need to be offering us something that we
value. Thus, voluntary trades in free markets arc "win-win situations," in that both the
seller and the buyer are better off as a result of the trade. As a consequence, a savvy
entrepreneur will always be mindful of creating something of value for the consumer
(after all, it's in his self-interest to do so).
As a final consequence, the collective behavior of self-interested decision makers
in markets guides us toward a set of outcomes for which the total benefits from economic
activity for society as a whole are as large as possible, Adam Smith described these
unseen forces (i.e., the self-interest of rational individual decision-makers) which lead
society to an outcome in which maximal value is created from the use of productive
resources as the "Invisible Hand." Smith stated:
n Sm th, A., l'he Weahb of Nations book l, chapter 2. paragraph 2,
htto: 'A¢~ar.econlib, orv~7ibrarwSmith/sm WNI.htmlCt.. ,
57

Chapter #3 - Economic Systems: Capitalism versus Socialism
"As every individual, therefore, endeavours as much as he can both to employ his
capital in the support of domestic industry, and so to direct that industry that its
produce may be of the greatest value; every individual necessarily labours to
render the annual revenue of the society as great as he can....by directing that
industry in such a manner as its produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention...By pursuing his own
interest he frequently promotes that of the society more effectually than when he
really intends to promote it.''.3
As will be further discussed in Chapter 5 (using the framework of the model of Supply
and Demand), Adam Smith's notion of the Invisible Hand suggests that in many cases
free market forces result in the efficient amount of a good - that is, the amount which
maximizes total benefits for society - being produced and consumed. This observation
provides a strong, practical argument for favoring the system of capitalism. In stark
contrast to capitalist systems (which rely upon individual decisions in free markets),
socialist systems rely heavily upon planning. The term "planning'° can be used to broadly
describe any system in which the government plays a key role in determining (either
directly or indirectly) the answers to the three fundamental economic questions.
Returning to the philosophical foundations of socialism, recall that Marx viewed
government seizure of productive resources as the first step away from capitalism.
Ultimately, Marx expected that the state or government could simply fade to the
background and cease to exist, at which point all productive resources would be owned
collectively or communally by all members of society. But, Marx conceded that in the
interhn, government would have to play a very heavy-handed role.
Following the seizure of private property by the state a Central Planning system
would be established to administer all of the thousands of factories, businesses, and farms
operating when the revolution came. This system would operate similarly to how the
military operates, where the senior generals in the Pentagon plan out what the soldiers do
and what they will be paid. Then orders, or commands, are issued by a Command
System to get everyone doing what they are supposed to do. In the Communist Manifezto
Marx even used the phrase "Industrial Armies" that the state would form to work in the
factories and on the farms,la Such Command Planning, under which the government
directly controls nearly all economic activity, with almost all production taking place
within enterprises owned and operated by the state, is one form that planning can take.
This was the system that was essentially in place in the former Soviet Union.
However, the government need not go to rids extreme to have a significant impact
on the answers to the three fundamental economic questions. Recall the Incentive
Principle discussed in Chapter 1, which recognized that people will often alter their
behavior in response to changes in costs or benefits. This suggests that, far short of
mandating what people must do, government could guide the actions of people by
13 Smith, A., The Wealth of Nations, book IV, chapter 2, paragraph 9,
hul~.'/A~econlib.org/lib~r~,/~mith/smWNl3.html#11<2.9.
14 See Page 26 of http..I/mar, r~ts.orr, larchitw./marxA~'ork.vldo~lload/pdf/Mantf~to~df.
Chapter #3 - Economic Systems: Capitalism versus Socialism
subsidizing desired actions and penalizing undesirable actions. Under Indicative
Planning, the government guides the behavior of individuals in regards to economic
decisions by establishing policies which alter costs and benefits of different courses of
action. Proponents of Indicative Planning intend it as a complement to (and improvement
upon) markets, as opposed to a replacement for markets. Alec Hove describes indicative
planning as "when the state uses influence, subsidies, grants, [and] taxes [to influence
economic decisions], but does not compel.''15
In practice, such indicative planning may entail the establishment of guidelines,
regulations, and measurable targets, jointly formulated by government and industry.
Both France and Japan openly operated under such systems during the second half of the
twentieth century. In France, this system of "focusing, prioritizing, and pointing the
way" was dubbed PlanificationJ6 In Japan, the agency charged with such efforts was the
"'Ministry of International Trade and Industry" (MILD, which has been described as "the
command center for the noncommand Japanese economy.''z7
DIFFERENT TYPES OF ECONOMIC INCENTIVES
From the discussion above, we can begin to see that the different systems of
capitalism and socialism rely upon different types of incentives. As suggested by the
discussion of the Incentive Principle, an incentive refers to a change in a cost or a benefit
which can cause a person to alter his behavior. There are three different broad types of
incentives: material rewards, moral suasion, and coercion. Material rewards refer to
monetary rewards or direct increases in consumption from engaging in an activity.
Capitalist systems rely very heavily upon (but not exclusively upon) material rewards.
When a fn'm invests a great amount of resources on research and development in order to
bring a new product to market, they are likely doing so because of the material reward of
profit. Similarly, when a worker gives up 40 hours of her scarce time per work, she is
likely doing so primarily because of the material reward of income that her employer is
giving her in return.
Moral suasion describes attempts to convince individuals to behave in a certain
manner because doing so is the fight thing to do. Sociafist systems likely rely upon moral
suasion to a greater extent than do capitalist systems. However, the behavior of people
living in capitalist systems can sometimes be influenced by such considerations. If you
choose to throw an empty water bottle in the recycling bin instead of the trash can, why
are you doing so.'? Recognize, that especially in tight-knit social units, moral suasion can
be quite powerful, particularly in the short term. Think about what would motivate a
soldier on the battlefield to expose himself to enemy fire in order to rescue a fellow
warrior who has been wounded.
t5 Nove, A., "Planned Economy," in John EatwcLI, Mun-ay Milgate, and P©tcr Ne~wman (eds.) The New
Palgrave: a Dictionary of Economics, MacMillan. 1987, page 879.
16 See: Yergin, D. and J. Stanislaw, ~The Conmumding Heights: the Battle for the World Economy," Simon
and Schuster, 2002, page I I.
17 Ibid., page 145.

Chapter #3 -Economic @stems: Capitalism versus Socialism
Coercion is the use or threat of force or incarceration in order to obtain
compliance. Once again, recall Max Weber's observation that only the state (and not
households or businesses) can legitimately contemplate using physical force as an
incentive on behavior. With this in mind, it is not surprising to observe that the countries
which have ever implemented anything close to the conceptual notion of pure socialism
as described by Karl Marx (e.g., the former Soviet Union and present day North Korea)
have been totalitarian regimes which regularly relied upon coercion. In these countries
people were often incarcerated in forced labor camps for reasons that would seem
unthinkable to anyone living in a free society. Between 1934 and 1953, approximately
18.75 million people spent time in the gnlags (i.e., forced labor concentration camps) in
the former Soviet Union.Is One of these 18.75 million people was Vassily Romashkin,
whose "crime against the state was to check out the wrong library book from the public
h'brery.''|9
THE MIXED ECONOMY
Returning to the example of the production and purchase of 15,393 Chevy Volts
in the U.S. during 2015, in light of the discussion of different types of incentives, the
consumers of these items were likely influenced by a mix of material rewards and moral
suasion (again illustrating how a capitalist system relies on more than just material
incentives). Further, we suggested that these transactions reflected the exercise of
consumer sovereignty in flee markets. While this observation has a great deal of merit, it
should also be recognized that government is playing a significant role in these
transactions. Each buyer of a Chevy Volt in 2015 was eligible to receive up to $7,500 in
the form of a Federal Income Tax Credit.2° The presence of this tax break, which
effectively reduces the $33,995 price by over 22% for a consumer who is able to claim
the full credit, reveals that we are not simply letting free market forces decide how many
Chevy Volts will be produced. In fact, this government policy seems to perfectly fit Alec
Nove's description of indicative planning.
The point to recognize is that even a country that seemingly operates under a
system of flee market capitalism likely has some elements of planning, some government
ownership and control of productive resources, and some direct production of goods and
services by government. For example, in the United States the government is the primary
supplier of education up through the secondary or high school level, and also plays a key
ts This figure is from: EIlman, M. "Soviet Repression Statistics: Some Comments," Europe-Asia Studies,
Vol. 54, No. 7 (2002), pages 1151-1172. As noted by the author, as a measun~ of the number ofpaople
who spent time in the gulag, this figure is subject to multiple biases, both upward and downwerd. For
example, it overatatcs the number, since some people were sent to the gulag, released after a time, and
subsequently sent back to the gulag. On the other hand, it understates the true number, since it takes no
account of people in the gulag before 1934 or at~.-r 1953.
z9 See the video segment "The Ghosts of Noriisk" ("Commanding Heights: the Bittle for the World
Economy," (2003) episode 2, chapter 2), which can be viewed on-line at:
hap:/Av~¢.ob.~.oro/wQbh/¢ommandin~heivhts/~haredA'ideoA~'mn/mini ,02 02 220.html.
2o See "Purchasers of ping-in cars will get tax credits": htm://www.msnbc, m.~n.com/Id/2/462414.
Chapter #3 - Economic Systems." Capitalism versus Socialism
role in directly supplying (through State Universities) and subsidizing (through low
interest rate student loans) higher education. Government is similarly the sole provider of
mail delivery (the U.S. Postal Service is a legally established monopoly).
Finally, even in many countries that appear to be capitalist, the government plays
a key role by in many areas, such as:
influencing behavior through the tax code (e.g., sales tax rates are higher on
cigarettes than on apples, interest paid on qualifying mortgages and student
loans is tax deductible),
providing a "social safety net" for low income individuals (e.g., in the United
States, the federal government has provided healthcare services for low
income households through Medicaid since the 1960s),
redistributing income2j (often via progressive taxation, under which high
income individuals pay a greater percentage of their income in taxes, as is the
case under the U.S. Federal Income Tax), and
regulating the behavior of businesses (e.g., mandating product characteristics,
as in the case of the automobile safety regulations discussed in Chapter 1).
As a result, in practice the answers to the three fundamental economic questions are
answered by a mix of individual decisions in flee markets, along with government
intervention and guidance. That is, any system that at first glance appears to be capitalist
likely has some elements of socialism.
Similarly, any system that seemingly appears to be socialist probably has some
elements of capitalism. A mixed economy refers to an economic system in which most
factors of production are owned and controlled by individuals, while some factors of
production are owned and controlled by the state. That is, a mixed economy contains
some elements of capitalism and some elements of socialism. From the discussion
above, we see that the United States is in fact a mixed economy. Further, many
economies in Europe that are commonly referred to as socialist - such as Sweden and
France - are best described as mixed economies.2-2
Thus, instead of thinking of capitalism and socialism as "two bins" (with every
country having to be placed in one bin or the other, based upon its economic system), it is
instructive to think of there being a continuum between socialism and capitalism. With
this in.mind, it becomes relevant to try to determine where along this continuum different
countries are at any point in time. For example, which country is presently closer to pure
socialism, the United States or the United Kingdom? Similarly, we may want to
determine how the economic system of a country has evolved over time. For instance,
was the United States closer to pure capitalism in 2000 or in 1945?
Broadly, most developed countries around the world experienced a two-part
evolution in regards to their economic system during the 20~ century. At the start of the
20~ century, government played a relatively limited role, with most countries relying
21 A brief discussion oftbe philosophical arguments in favor of income redisuibution, along with an
ove~lew of"social safety net" programs in the U.S., is presented in Chapter 12.
z2 In practice a Mixed Economy is "characterized by strong direct government involvement in the
¢conomy...plus an expansive welfare state." See: Yergin, D. and J. Stanislaw, "The Commanding Heights:
the Battle for the World Economy," Simon and Schuster, 2002, page 3.
 Chapter #3 - Economic Systems: Capitalism versus Socialism

Economic Freedom
Chapter #3 - Economic @stemS: Capitalism versus Socialism ~" Individual freedom and choice is essential for capitalism. As such, we start by
focusing on the results of the Frasier Institute's "Economic Freedom of the World" study,
--, economic questions. Then, from 7 .~ ~mdv is t)redicated upon a suppo,,sition that there are fo~
as re erred m Table 3.1~ Thl~ ":'---,~-oedom' "oersunal choice,' "voluntary exchange,'
e s s e ~ i a l f o u n d a t | o n s o t e c o n o m y , = , , . . . . ts ,,:s
primarily upono2ma0sket~°u~nhS~h~r T;Tt0hs,r~mfUo~da~inn?~So~cmJe::Cadwaay ~:tercj~li:°.mcr "open markets," and "clearly defined and enforced property ngu
roughly the .l:".v ---norav ~ That is, there wa. ~ the 20th century, the econorm
ovemment n the ..~v ~ fin the last two decaoes o!, ,,, with a greater tel ance on For each country in the study the degree of economic freedom is first determined
g - - - - i a l i s m F i n a l l y, d u g . . . . . . . d the cap ta.o.-, - --
towam so,., ' -,-.:.~ moved back to'~,o, in five major dimensions: Size of Government; Legal System and Property Rights; Sound
systems in manY coUnuJ~ -" Money; Freedom to Trade Internationally; and Regulation. In each dimension, a score
markets an a lesser role for gov.emment'nom first popularized in Western Euro,~ bu~2~ between a low of zero to a high of ten (with a higher value corresponding to greater
economic freedom) is determined. An aggregate index value (also ranging between zero
by simply averaging these scores across the five dimens,ons.
and ten) is then computed
compromise between the extre P -
Alec Hove, "a strong case can be made for the proposition that a mix of the two is The results of this exercise for the 159 countries included in the most recent
essential in anY modem society''25 As such, this intermediate system will include the study, which ranks countries in terms of econo._rm_ c fi'eedom mr20115° 7:c~on~oo~lied ~eTdoblme
best of both worlds according to its advocates but the worst of bothissues worldsthat must beto
according 3.1. As noted by the authors, a country acmeves a mg,w .....
its critics. We will ultimately explore inr socia
more detail the practical
ist systems if their supporters are to when its government creates "an infrastructure for voluntary exchange" and safeguards
"individuals and their property from aggressors," along with not enacting policies which
dealt with by either cap:tah~es~a~r~ality
imolement their ideas ann ma r .,.o~o in the world
~¢tlifferent oi oot.~ sy a .
In exaann:ng.th
asDccts "restrict personal choice, interfere with voluntary exchange, and limit entry into
]
wewill emphasize both the successes anu tat~ ....... up your own mind as markets.,,29 Consequently, those countries with larger index values can be thought of as
the end, given that we live in a demOCracy, you will have to make having systems closer to capitalism.
to which system or which possible blend of systems is best for our country. You will As reported in Table 3.1, the four counU'ies with the greatest amount of economic
then have to work towards making the appropriate changes in our economic, moral, and freedom are Hong Kong (with an EFWI of 8.97), Singapore (8.81), New Zealand (8.48),
political systems. and Switzerland (8.44). In fact, these four countries have occupied these four positions
(in this particular order) in each release of this annual study since 2005. While there has
been relative stability at the very top of the ranking in recent years, there has been a
MEASRUES OF A SOCIETY'S ECONOMIC SYSTEM
significant amount of movement further down the list. As will be discussed in greater
detail below, between 2004 and 2010 the United States dropped from a tie for 3'~ place
We conclude the present chapter by discussing attempts to measure or observe a
down to 18e place in the ranking, climbing back up to a tie for 11th in 2015.
coantzy's economic system in terms of the continuum between capitalism and socialism. Over this same time-period of 2004 through 2015, other countries had much more
Within this discussion we focus on structural measures which attempt to gauge the
institutions, rules, or structure of a society's economic system-2s Because there are many dramatic changes in their amount of economic freedom, both upward and downward.
diffel~nt dimensions that determine the economic system of a society, there will not be Between these two years, I 1 countries moved up 20 or more places in the ranking, with
rsall a ed upon and accepted measure of where an economic system biggest upward movers being: Rwanda (up 80 spots from 11 ph to 3 I~; Romania (up
one single, umve ~y gre --:.m: .... d canitalism. r Thus, we must attempt to look at ,:thnc~,~ e,-~m 78t~ to 18th~' Georgia (up 48 spots from 56th to 8th); Mauritius (up. 44 spots
is on the continuum octwcen s~.~,o,- ~ ~ °e"-.s~"~"~,~ .~ ,,.~'~i~. Renublic fun 39 soots from 101s' to 62m). In the
multiple proxy measures.
other direction, 13 countries moved down 30 or more places, with the biggest downward
movers being: Greece (down 77 spots from 39t~ to 116t~); Argentina (down 74 spots from
. ~t~t ,~ ts5th~. Trinidad and Tobago (down 59 spots from 47t~ to 106t~); Oman (down 57
23The exact start date and end date for this period during which . the role of government increased differs
from cot.may to cottony. But, these dates identify the apprordmate start and end date of this transltton for S~l~Ots~fro'm 38~ to 95th); Iron (do~vn 55 spots from 95t~ to 150t~); and Iceland (down 55
the relevant ounmes. . _ , :_ ,..t...,~ 9 of this textbook vrovides a spots from 9t~ to 64~).
The section titled "The Transition to a Market economy m ~,~v~, -. .
preliminary discussion of several important issues that must be addressed when an economy is going
through such a transition from planning to markets. ~ The full report ("Economic Freedom of the World: 2017 Annual Report" by J. Gwarmey, R. Lawson,
Nove,A., -planned Economy,~ in John Eatwell, Murray Milgate, and peter Newman (eds.)The . New
. . .
palgrave:aDictionaryofEconomics, MacMUinn, 1987, page884. and J. Hall), which measures economic freedom across countries in 2015. is available at:
htt~:/A~|~v.fr¢~ver~n.~titute.~r¢~ites/defau~t/~es/e~`~n~mw-fn~ed~m~f-the~" x~r~d-- O l .pd[.
From a pragmatic perspective, we may also care to observe outcome based measures, in gain insight mto :s Ibid.. page I.
how a society's economic system actually performs.Toward this end, a discussion of Gross Domestic :9 Ibid., page 2,
Product is pr~cnted in Chapter 7 and a measure of monroe equahty/mcquahty (the Gmz cocflicJent) Js
developed in Chapter 12.
 Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism
Table 3,1 - Economic Freedom of the World, 2015

rank ewaatry EFW! raak o u n t r y EFW! rank ceantry

! Hong Kong EFWI
8.97 5 4 Bahamas 7.30 107 Nepal 6.49 Returning attention to the 2015 rankings, of the 159 countries included in the
2 Singapore 8.81 54 Hondm'u 7.30 108 Barbadoa
3 New Zealand 8.48 6.47 study Venezuela is the only one with an EFWI below 4.00 (more precisely, 2.92). An
5 4 Hungary 7.30 109 Guyaua
4 Switzerland 6.45 additional 5 countries have an index value below 5.00, including Argentina (4.88),
8.44 54 lutly 7.30 110 M ~ 6.44
5 Ireland 8.19 5 4 Jamaica Algeria (4.84), and the Central Aft/can Republic (4.62). Other countries with an index
7.30 I I l Papua New Guinea 6.42
6 United Kingdom 8.05 5 9 Nicaragua 7.28 112 China value below 6.00 include: Pakistan (5.93), Brazil (5.75), Zimbabwe (5.61), and the
7 Mauritius 8.04 6.40
6 O Uganda 7.25 112 Colombia Ukraine (5.38). Near the middle of the ranking are countries such as: France (52~d, with
8 Georgia 8.01 6.40
61 Gambia, The 7.24
9 Australia 114 Azerbaijan 6.38 an EFWI of 7.33), Italy (54~, with an EFWI of 7.30), Kenya (70zh, with an EFW] of
7.99 6 2 Iceland 7.23
10 Estonia 114 Nigeria 6.38
7.95 6 3 Cambodia 7.11), Mexico (76*, with an EFWI of 6.95), India (95~, with an EFWI of 6.63), Russia
11 Canada 7.21 116 Greece
7.94 6 3 Dominican Rep. 6.36 ( 100a', with an EFWI of 6.60), and China ( 112th, with an EFWI of 6.40). Finally, tbe top
7.21 117 Bangladesh
11 United States 7.94 6.32
6 5 Malaysia 7.19 117 Tunisia quartile of countries includes: the United Kingdom (6*, with an EFWI of 8.05), Australia
13 Lithuania 7.92 66 6.32
14 Cyprus 7.18 119 Vielmlm (9th, with an EFWI of 7.99), Chile (15th, with an EFWI of 7.77), Germany (23rd, with an
7.79 6 7 Macedonia 6.30
7.17 120 Mamceo
15 Chile 7.77 6.29 EFWI of 7.69), and South Korea (32", with an EFWI of 7.54).
6 8 Uruguay 7.16 120 Th~r-Leste
15 Denmark 7.77 6.29 As noled above, between 2004 and 2010 the United States dropped from a tie for
6 9 El Salvador 7.13 122 Saudi Arabia
17 Finland 7.75 6.24 3'd place down to 18~ place in the ranking, with a slight rebound since moving hack up to
7 0 Bhutua 7.11
17 Latvia 123 Yemen, Rep~lic 6.17
7.75 7 0 Kenya a tie for 11~ in 2015. Table 3-2 provides a smnma~ of the change in economic fieedom
7.11 t24 Seangal
19 Netherlands 7.74 7 2 Croatia 6.16
7.02 125 Bumndi which has occurred in the United States between 2000 and 2015. It is worth noting that
2 0 Romania 7.72 6.08
7 3 Indonesia 7.00 126 Bolivia
21 Malta 6.03 during these years there was a slight inc~ase in the average level of economic freedom
7.70 7 3 Sinvenia
21 Taiwua 7.00 127 Pan, fan 5.93 globally, with the mean EFWI value for all countries included in the study increasing
7.70 7 5 Laos
2 3 Germany 6.98 128 ~ 5.92
7.69 7 6 Mexico from 6.67 in 2004, up to 6.76 in 2010, and up to 6.80 in 2015. Thus, the decrease in
6.95 129 Marl 5.90
2 3 Guatemala 7.69 7 7 Tanzania 6.92 130 C6te d'Ivoire economic freedom in the United States between 2004 and 2015 goes against to global
2 5 Norway 5.88
7.67 7 8 Lebanon 6.91 trend during this time.
2 6 Austria 130 Ecuador 5.88
7.66 7 8 Paraguay
2 7 Sweden 6.91 132 Burkina Faso 5.87
7.65 8 0 Kyrgy2 Republic 6.89 133 Malawi 5.86
2 8 Luxembourg 7.63 81 Tuflcey Table 3.2- Decline of Economic Freedom in the United States between 2000 and 2015
6.82 134 Sierra Leone 5.78
2 9 Arm~ia 7.60 8 2 Liberia 6.80 135 B4min 5.77
30 Panama 7.59 8 2 Tajikistan yaw 2000 2002 2004 2005 2006 2007
6.80 136 Gabon 5.76
31 Rwanda 7.57 8 4 Swaziland E.FWl
6.79 137 Brazil 5.75 8.5 8-2 8-2 8.1 8,04 8.06 7.96
3 2 Albania 7.54 8 5 Montenegro Value
6.77 137 Guinea 5.75
3 2 South Korea 7.54 8 6 Bnmei Damssnlam 3'e tied 3'd fed 3'd fled 5* tied 8e' 6* 6*
6.76 139 Niger
3 4 Portugal 7.53 5.74 m.O~ik.aal of 130 of 141 of 141 of 141 of 141
8 6 Nama'bin 6.76 140 Egypt ... ~ of 123 o fl 2 3
3 5 Costa Rica 5.73
7.52 8 8 Se~'bin 6.75 141 Tngo
3 6 Spain 5.70 2009 2010 2011 2012 2013 2014 2015
7.51 8 8 Thailand 6.75 year I
142 G n l n e a - B ~ 5.65
3 7 Untd. Arab Emirates 7.5O 8 8 Zambia 6.75 glrWlI 7.73 7.81 7.73 7.75 7.94
143 Mozambique 5.62 7.60 7.69
3 8 Lqael 7.49 91 Fiji 6.68 144 Zimbabwe 5.61
3 9 Japan 7.47 9 2 Suriname O~ 10~ 18" 17" 12" 16" 16" 11~
6.67 145 Mala-inmia 5.56
3 9 Jordan 7.47 p=~ki~_~ of 141 of 144 of 152 of 152 o fl 5 7 of 159 o fl 5 9
9 3 Cape Verde 6.66 146 Ethiopia
3 9 Philippines 5.53
7.47 94 St'i l.amka 6.65 147 Congo, De~L Rep. of
4 2 Czech Republic 5.45
7.46 9 5 India 6.63 148 Angola The decline in the EFWI value and ranking of the United States betwcen 2004 and
4 3 Belgium 7.44 5-40
9 5 South Afiica 6.63 149 Ukraine
4 3 Peru 5.38 2010 was a result of decreased economic fi'¢edom in all five of the major dimensions
7.44 9 7 Kuwait 6.62 150 Iran
4 5 Mongolia 5.31 (i.e,., Size of Government; Legal System and Proggt"W Rights; Sound Money; Freedom to
7.43 9 7 Oman 6.62 151 Chad
4 5 Qmar 5-26
7.43 9 9 Bosnin & Herzeg. 6.61 Trade Internationally;, and Regulation). The rebound in economic freedom in the United
151 Myanmar 5.26
4 7 Seychelles 7.42 100 Russia 6.60 153 Syria Statos botwecn 2010 and 2015 is due almost exclusively to increased freedom in the
4 8 Bulgaria 5.22
7.39 101 Lesocho 6.58 154 Lybia
49 Bahrain 4.95 dimension of Regnlation. Sub-scores in Size of Government, Legal System and Property
7.38 102 Moldova 6.56 155 Argentina
5 0 Botswana 4.88 Rights, and Sound Money wexe virtually unchanged between 2010 and 2015, while
7.37 103 Ghana 6.53 156 Algeria
51 Poland 4.84 F ~ e d o m t o Tr a d e I n t e m a t i o n a U y d e c l i n e d e v e n f u r t h e r d u r i n g t h e s e m o s t r e c e n t fi v e
7.34 103 Haiti 6.53 157 ~ Republic of
5 2 France 4.81
7.33 105 Belize 6.50 years. In contrast, the United States' summary score in the dimension of Regulation
5 3 S|ovak Republic 158 Ceamd Afi-icaa Rep~ 4.62
7.31 105 Tnnldad& Tobago 6.50 159 Venezuela 2.92
SOURCE: Economic Freedom of the World: 2017 Annual Report. Available at:
httr~s./Acww frg~eri~titute.or~/sites/default//iles/economi¢.freedom.of.the.~tv~rld.20/7,~=lf.
64
 Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism
b h , . i ~ c v.

increased from 8.14 to 8.71, due primarily to decreased government regulation of credit Table 3.3 - International Property Rights lnd~r, 2017
markets.
rank ¢oumtry IPRI rank country IPRI rank country IPRI
1 New Zealand 8.633 4 4 Botswana 6.126 8 7 Ethiopia 4.718
Property Rights 2 Finland 8.626 4 5 Costa Rica 6.060 88 Georgia 4.707
3 Sweden 8.608 4 6 Jamaica 6.010 8 9 Gabon
The definition of property rights is also instrumental in defining a society's 4 Switzerland 4.694
8.561 4 7 Slovenia 5.994 9 0 Mainwi
economic system. The "Property Rights Alliance" releases an annual report, the 4.670
5 Norway 8.533 4 8 Hungary 5.99'. 91 Macedonia
*'International Property Rights Index" (IPRI) measuring the degree to which private 6 Luxemburg 8.459 4 9 Italy
4.655
5.979 92 Bnmei Damssalam 4.632
property rights (both physical property rights and intellectual property rights) are 7 Singapore 8.358 5 0 Lithuania 5.918 93 Ecuador 4.627
protected within different countries.30 The results of the study (reported in Table 3.3) 8 Japea 8.327 51 Panama 5.798 9 4 Mozambique 4.625
9 Netherlands 8.296 5 2 China 5.712 95 C6te d'lvoire
state an IPRI value for 127 different countries. The IPRI value can conceptually range 4.587
10 Australia 8.244 5 3 Ghana 5.646 9 6 Benin
from zero to ten (with a higher value corresponding to more secure property rights) and is 4.583
I I Canada 8.179 5 4 India 5.564 9 7 Argentina 4.568
computed as an average of scores on three different dimensions - "legal and political 12 Denmark 5 5 Trinidad & Tobago
8.158 5.503 98 Sierra Leone 4.523
environment," "physical property rights," and "intellectual property rights.,,31 13 United Kingdom 8.129 5 6 Morocco 5.500 9 9 Into 4.521
New Zealand has the highest IPRI value (8.633), while the Republic of Yemen 14 United States 8.074 5 7 Cyprus 5.447 I00 Paraguay 4.478
15 Austria 8.012 5 8 Brazil 5.434 I01 Egypt 4.433
has the lowest value (2.728). The other countries with IPRI values above 8.5 (rounding
16 Germany 7.959 5 9 Sri Lank 5.390 102 Kazakhstan 4.432
out the "Top 5") are Finland, Sweden, Switzerland, and Norway. Countries with ]PRI 17 Ireland 7.872 6 0 Greece 5.389 103 Lebanon 4.331
values above 6.5 (placing them in the "Top 33" out of 127 countries) include Singapore, 18 Belgium 7.839 61 Kuwait 5.380 104 Cameroon 4.294
Australia, the United States, Hung Kong, Chile, and Rwanda. Near the middle of the 19 Hong Kong 7.786 6 2 Colombia 5.354 105 Montenegro 4.192
ranking are China (52~), India (54th), Brazil (58'~), Greece (60~h), Mex/co (67th), and 2 0 Iceland 7.700 6 3 Latvia 5.341 106 Algeaia 4.160
21 United Arab Emitatas 7.483 6 4 Philippines 5.331 107 Armenia 4.126
Turkey (78th). Near the bottom (i.e., least secure property rights) are Egypt (101a),
2 2 Qatar 7.348 6 5 Peru 5.217 108 Mauritania 4.091
Algeria (106e~), Russia (11 lth), Zimbabwe (120th), and Venezuela (126th). 2 3 France 7.336 6 6 Thailand 5.215 109 Madagascar 4.064
The results of this study are important, since property rights not only go a long 2 4 Tniwan 7.268 6 7 Mexico 5.194 110 Serbia 4.044
way toward revealing a society's economic system, but are also of critical importance for 25 Estonia 7.199 6 8 Indonesia 5.167 111 Russia 4.043
fostering economic growth and development. Secure property rights are a necessary 2 6 South Africa 7.000 6 9 Uganda 5.102 112 Nicaragua 3.990
2 7 Israel 6.974 7 0 Tunisia 5.081 113 Bolivia 3.971
condition for individuals to have incentives to produce gunds/services, develop new 2 8 Chile 6.926 71 Guatemala 5.077 114 Nigeria 3.950
technologies, and invest in privately owned capital. In the absence of secure property 2 9 Malta 6.881 7 2 Tanzania 5.051 115 Azerbaijan 3.946
rights the incentives for individuals to engage in productive economic activity are greatly 3 0 Czech Republic 6.860 7 3 Romania 5.042 116 Bomia & Herzeg. 3.917
reduced. 31 Portugal 6.848 7 4 El Salvador 4.945 117 Chad 3.891
3 2 Malaysia 6.610 7 5 Senegal 4.942 118 Albania 3.822
3 3 Rwanda 6.508 7 6 Nepal 4.941 119 Congo. Dem. Rep. of 3.818
3 4 South Korea 6.495 7 7 Vietnam 4.930 120 Zimbabwe 3.760
Legal and Regulatory Environment 3 5 Spain 6.422 7 8 Turkey 4.925 121 Pakistan 3.474
F i n a l l y, r e c a l l t h e i m p o r t a n t r o l e t h a t g o v e r n m e n t p l a y s i n e s t a b l i s h i n g a n d 3 6 Uragoay 6.412 7 9 Zambia 4.917 122 Bunmdi 3.430
enforcing laws and regulations. In order for markets to function effectively such laws 3 7 Sloekin 6396 8 0 Hondures 4.902 123 Ukraine 3.424
3 8 Manrifns 6.315 81 Liberia 4.893 124 Moldoea 3.178
and regulations should be easy to understand, evenly enforced, and able to be followed at
3 9 Oman 6.280 8 2 Kenya 4.856 125 Bangladesh 3.117
low cost. If this is not the case markets will not be able to operate effectively. That is, 40 Jordan 6.266 4.823 3.057
83 Dominican Rep. 126 Venezuela
for a free market system to provide efficient and equitable outcomes, the system should 41 Poland 6.253 8 4 Mnii 4.814 127 Yemen, Republic 2.72.8
not be plagued by high levels of corruption or an overly burdensome bureaucracy. For 4 2 Bahrain 6.157 8 5 Bulgaria 4.813
instance, during the time of Russia's rapid transition away from socialism in the 1990s, 4 3 Sandi Arabia 6.133 8 6 Croatia 4.754
the ownership of many large enterprises was transferred from the state to private
SOURCE: 2017 lnumaafiooal Pmpealy Rights Index. Available at:
hn~x:/A~r.internationalnrovernvieht~index.orrifull.revort.
For an overview of this index, see: http ://internationalproDerta,ri~ht~index org~ The full
repo~ can be
accessed at: htttTs:/Awnv.internationalnrotTert~,ri~htsindex.or~/futl.report. " "
~zS
ee htfp.?:/At~t~ .Intcrnatlono/17rolTertvrivht, vtndex.orff/counlr3,/bnited.slotes.~.~" for breakdown of how
the U.S. was assessed overall and in each distinct dimension.
 Chapter #3 - Economic Systems: Capitalism versus Socialism
Chapter #3 - Economic Systems." Capitalism versus Socialism

'able .1
individuals through what became known as "loans-for-shares" deals. These deals provide Table 3.4 - Rankings on the Ease of Doing Business, 2017
examples of a particular type of corruption known as "crony capitalism," in that the
government often favored insiders with connections. One of the more egregious rank country DTF tank ¢eulltry DTF raak emln|ry
I New Zealand DTF rank
examples was the acquisition of Norilsk Nickel (an enterprise with annual revenues of 86.55 49 Mexico 72.27 97 Guatemala 61.t8 145 Nigeria
2 Singapore 84.57 50 Bulgaria 71.91 98 Dorninica 52.03
$1.5 billion) by Vledimir Potanin for only $180 million.32 3 Denmark 84.06 51 Croatia 71.70 99
60.96 146 Gamb~ "[he 51,92
Dominican Rep. 60.93 147 Pakman
4 South Korea 51.65
Furthermore, an overly burdensome bureaucracy can stifle market activity. 5
83.92 52 Belgium 71.69 I00 India 60.76 148 Burkilm Ftso 51.54
Hang Kong 83.44 53 Cyprus 71.63 101 Fiji
Perhaps the most extreme example of such a situation is the system which evolved in 6 Uniled States 82.54 54 lsrlel
60.74 149 Marshall lslamh
J1,45
71.42 102 Tnnidsd & Tobago 60.68 150 Mlalrltatha
India during the second half of the 20th century, which became known as the "Permit 7 United Kingdom 82.22 55 Chile 71~2 Jordan 50.88
103 6058 151 Be~in 50.47
8 Noway 82.16 56 Bmnei Damsslm. 70.60 104 Lcsotho
Raj." This system consisted of "a complex, irrational, almost incomprehensible system 9 Georgia 82.04 57
60.42 152 Belivla 50.18
Azerbaljan 70.19 105 Nepal 59.95 153 Guinea 49.80
of controls and licenses," under which "everything needed (government) approval and a 10 Sweden 81.27 58 Peru 69.45 106 Namibia 59.94 154 DJibouu 49_~
II Macedonia 81.18 59 Colombia 69.41 107 Antigual & Barbuds 59.63
stamp."33 Regulations impose costs on and create obstacles for businesses which can 155 Minronesia 48.99
12 Esthnia 80.80 60 Turkey 69.14 108 Paraguay 59.18 156 Togo 4&~l
discourage firms from developing new products, entering new markets, and even starting 13 Finland 80.37 61 Costa Plea 69.13 109 Papua New Guinea 59.04 157 Kiribati 48.74
14 Australia 80.14 62 Mongolia 69.03 110 Malawi
up in the first place. Ira business chooses not to undertake one of these actions because 15 Talwan 80.07
58.94 158 Comoms 4&52
63 Luxembourg 69.01 111 Sri Lanka 58.86 159 Zimbabwe 48.47
of excessive regulatory costs (as opposed to other economic considerations), then 16 Lithuania 79.87 64 Puerto Rico 68.85 I]2 Swaziland 58.82 160 Sitma Leone 48,18
17 Ireland 79.51 65 Alb~ia 68.70 113 Philippines 58.74 161 EthJopla
consumers, employees, and the business owners are all worse offas a result. 18 C~eda 79.29 66 Bahrain 68.13 I14 West Bank & Gaza
47.77
58.68 162 Madagascar 47.67
For insights on current bureaucratic costs in different countries we can look at the 19 Latvia 79.26 67 Greece 68.02 115 Ho~dunts 58.46 163 Came~ou 47.23
20 Germany 79.00 68 Vietnam 67.93 116 Solomon Islands 58.13 164 B~umfi
results of a study by the World Bank Group which provides an ordered ranking of 190 21 UnL Arab Emir. 78.73 69 Morocco 67.91 117 Argentina
46~2
58.11 165 Sunnarae 46.87
countries around the world in terms of their "Ease of Doing Business" (as reported in 22 Ausma 78+54 70 Jamaica 67.27 118 Ecuador 57.83 166 AIgc'~t 46.71
23 Iceland 78.50 71 Omen 67.20 119 Bahamas, The 57.47 167 C~bo~
Table 3.41.34 This ranking accounts for bureaucratic costs (in both time and money) 46.19
24 Malaysia 78.43 72 Indonesia 66,47 120 Ghana 57.24 168 h~q ~+s7
across ten different dimensions: Dealing with Construction Permits; Getting Electricity; 25 Mauritius 77.54 73 El Salvador 66.42 121 Belize 57.11 169 7~1o Tom~ & Pi~ci~ 44.84
26 Thail~d 77A4 74 Ozbekistan 66.33 122 Uganda 56.94 170 Sudan 44,46
Registering Property; Getting Credit; Protecting Minority Investors; Paying Taxes; 27 Poland 77.30 75 Bhutan 66.27 123 Tajiklstan 56.86 171 Myanmar 44.21
Enforcing Contracts; Trading Across Borders; Resolving Insolvency; and Starting a 28 Spain 77.02 76 Ukraine 65.75 124 Iron 56.48 172 Liberia 43,55
29 Poaugal 76.84 77 K yrgyz Republic 65.70 125 Brawl 56.45 173 Equalofial Gttin~ 41.66
Business)5 For each country, a "Distance to Frontier" (DTF) score is computed which 30 Czech Republic 76.27 78 China 65.29 126 Guy~ 56.28 174 Syria 41.55
"captures the gap betWeen an economy's performance and a measure of best practice" 31 France 76.13 79 Panama 65.27 127 Cabo Verde 56.24 175 Angola 41+49
32 Netherlands 76.03 80 Kenya 65,15 128 Egypt
across all countries in the study.36 New Zealand has the highest DTF score (86.55), 33 Switzerland 75.92 81 BoLswana 64.94
56.22 176 Gttinea-Bissau 41.45
129 St. Vincent & Gin. 55.72 177 Banglad¢ah 40~9
revealing the greatest ease of conducting business; Somalia has the lowest DTF score 34 Japan 75.68 82 South Africa 64.89 130 Palan 55.58 178 Tirnor-Laste 40.62
35 Rttssia 75.50 83 Qatar 64.86 131 Nic~goa 5539 179 Congo. Rap. of
(19.98), reflecting the largest burdens to conducting business. 39.57
36 Kazakhstan 75.44 84 Malta 64.72 132 Barbados 55,20 180 Chad 38.30
Other countries with low costs of complying with bureaucracy and government 37 Slo~ia 75.42 85 Zambia 64.50 133 Lebam~ 54.67 181 Haiti 38.24
38 Belnms 75.06 86 Bosnia & Hel2eg. 64.20 134 SL Kitts & Nevis 54.52 182 C~go, Dam. Rap. 37.65
regulations include Singapore (2nd), Hang Kong (5th), the United States (6th), Australia 39 Slovah Republic 74,90 87 Samoa 63.89 135 Cambodia 54A7 183 Afghantstan 36.19
(14th), Canada (lgm), and Germany (20th). In contrast, bureaucratic and regulatory costs 40 Kc~ovo 78.49 88 Tanisia 63.58 136 Maldives 54.42 184 Central African Rap. 34.86
41 Rwanda 72.40 89 Tonga 63.43 137 Tanzania 54.04 185 Libya
are very high in countries such as Madagascar (162~), Chad (180th), the Democratic 33.21
42 Mooumegro 73.18 90 Vlmuatu 63.08 138 Mozamhiquc 54.00 186 Yemet~ Republic 33.00
Republic of the Congo (182~a), and Venezuela (188t~). Countries near the middle of the 43 Serbia 73.13 91 St. Lucia 62.88 139 Cbte d'lvolre 53.71 187 South Sudan 32.86
44 Moldo~'a 73.00 92 Saudi Arabia 62.50 140 Seeegal 53.06 188 Veneraela 30,87
ranking include China (78th), Uruguay (94th), India (100th), Argentina (117th), and Brazil 45 Romania 72.87 93 San Marino 62A7 14t Lao PDR 53.01 189 EriUe.a 22.87
(125th). 46 Ibtly 72.70 94 Uruguay 61,99 142 Oreneda 52.94 190 Somalia 19.98
47 ~ i a 72~1 95 Seychcnes 61.41 143 Mall 52.92
48 Hungoly 72.39 96 Kuwait 61.23 144 Niger 52.34

)2 See" " ' SOURCE: Doing Business 2018: Reforming tO Create Jobs. Available at:
. Yergm, D. and J. Stamslaw, "The Commanding- Heaghts:
, the Battle for the World Economy," Simon
and Schuster, 2002, page 299. httD:/A¢ww.d~in~business-~r~/-/media/WBG/D~im:B"siness/D~c1mwnts/Anmla~-ReP~rts/Eng~ish/DB2~8~
33 Ibid., pages 213-14. FulI-ReoorLo~.

The full report ("Domg Business 2018: Reforming to Create Jobs") is avadable on-line at:
Ease of doing business should not be misunderstood to mean a lack of
~ n p . . ~ A ~ w w. d ~ i n J ? b u s i n e s s ~ r ~ / - - / m e d i a / W B G f D ~ i n e B ~ s i n e s s / D ~ u m e n t s / - 4 n ~ a ~ R e t ~ r ~ . ~ E n ~ i s h / ~ 2 ~
Full-Reoort.pdf. government regulation or an absence of government intervention in markets. Rather it
~ T h t ~ r m n-u n o n, t y .m. P r ,o t e c t i n g .M i n o r i t y I n v e s t o r s " r e f e r s t o i n d i v d u o s w t h a s m a l l o w n e r s h i p
should be thought of as a gauge of the degree to which government actions do or do not
claim in business (as opposed t "majority ownership share") - that is, it does not mean minority in the impose significant costs on (and thereby potentially alter the decisions of) businesses.
sense of rscial or socioeconomic status.
~ Ibid, page 5.
Ideally governments should be striving for efficient regulations (which may be needed to
 Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic ,~stems: Capitalism versus Socialism

protect consumers, shareholders, other firms, and the public interest) while imposing
minintal costs on the businesses being regulated.
To gain further insight into the various characteristics of bureaucratic and
regulatory costs, Table 3.5 provides a breakdown of the relative ranking in each of the ten
dimensions included in the Ease of Doing Business study for fourteen different countries.
Information is also provided on the number of procedures, number of days, and monetary
cost (as a percentage of per capita income) of starting a new business in each of these
countries. The fourteen countries listed in Table 3.5 include those with the overall
highest and lowest ranking (New Zealand and Somalia), the United States, plus eleven
other countries at varying positions along the overall ranking.
Table 3. 5- Different Dimensions of the Ease of Doing Business In Select Countries
Somalia is ranked in the "Bottom 20" in six of the ten dimensions and in the "Bottom
Half" in every single dimension
In contrast, many countries near the middle of the ranking have scores in the
different dimensions which vary considerably. As an example, China is in this position
(ranked 78~ overall, near the middle) by virtue of having veW low costs in some
dimensions (e.g., ranked 5th in Enforcing Contracts), moderate costs in other dimensions
(e.g., ranked 97~ in Trading Across Borders and 98'~ in Getting Electricity), but very high
costs in other dimensions (e.g., ranked 172'~ in Dealing with Construction Permits).
The final three columns in Table 3.5 state the number of procedures, number of
days, and monetary cost (as a percentage of per capita income) necessary to start a new
business in each of these countries. These figures begin to illustrate the practical
differences which entrepreneurs face in different countries. To start a business in the
United States six procedures must be followed, taking roughly 5.6 days and costing about
1.1% of the annual per capita income in the country. New Zealand has the lowest costs
of sta.,'ting a business - only one procedure must be followed, which can take as little as
half a day and costs a mere 0.3% of the annual per capita income in the country. In stark
contrast, to start a business in Venezuela (ranked 190~ in this dimension) 20 procedures
must be followed, taking at least 230 days and costing 351.6% of the annual per capita
income in the country. Clearly, entrepreneurs are able to more easily respond to
economic incentives in the business climate in New Zealand compared to Venezuela.

Summary
Examining the results of the "Economic Freedom of the World" study,
" ~ - ~ 3 6 1 6 3 6 3 49 6 51fi "International Property Rights Index" report, and the ranking of the "Ease of Doing
Business" collectively, we can identify the countries with the most market oriented and
least market oriented economic systems.37 The countries that are probably closest to pure
- ~ " ~ 6 5 1 3 1 2 9 57 37 4 12.S capitalism are Hew Zealand and Singapore, followed by Hong Kong. Additionally,
- ~ - ~ 1 3 0 I 5 I 9 7 5fi o~t "7 2j~'~ Australia, Canada, and Denmark are in the "Top 10%" across all three rankings. Eight
- ~ - ~ ~ 3 1;6 11,5 2918 i more couna'ies are in the "Top 10%" on two of the lists and in the "Top 20%" on one of
Brazil - $ ~ 05 ] the lists: Estonia, Norway, Sweden, Switzerland, the United Kingdom, and the United
States. Countries that a~ in the "Middle Third" of all three rankings include El Salvador,
i ~ ? ~ ! 8 9 1 4 7 1 8 7 1 6 5 190 India, Indonesia, and Kuwait; countries that are in the "Bottom Third" of all three
~ o m a l , a / 8 6 I _ ~ _ 1 ~ 1 9 0 11 0 f r o 1 6 8 20 230 3~
187 9 rankings include Algeria, Bolivia, Egypt, and Zimbabwe. Finally, countries such as
70 2i
Chad, the Democratic Republic of the Congo, and Venezuela appear to have the least
market oriented economic systems, by virtue of placing in the "Bottom 10%" on all three
are _ F_~,ra Table 3.5 We.Can observe ~at those countries at the very top of the ranking
typlcauy in that poslnon because they tend to perform extremely well in several lists,
dimensions and at least reasonably well in all dimensions. For example, New Zealand is
ranked in the "Top 3" in five of the ten dimensions and is ranked outside of the "Top 40"
in only one single dimension. Similarly+ Singapore is ranked in the "Top 12" in five of
the ten dimensions and is ranked outside of the "Top 30" in only one single dimension.
At the other exlxeme, those countries at the very bottom of the ranking perform very
poorly in many dimensions and do not particularly excel in any dimension, For example,
~) Unfo~unatoly, ~ the ~tive of I~ining insights, the countries that are p~ently cl~icst to pu~
socialism (e.g., Cuba and North Korea) are not evca included in any of these makings,
 Chapter #3 - Economic Systems: Capitalism versus Socialism Chapter #3 - Economic Systems: Capitalism versus Socialism

C H A P T E R # 3 M U LT I P L E C H O I C E Q U E S T I O N S 7. One of the three primary types of "economic incentives" is "moral suasion," which
could be described as
1. is an economic system in which the means of production are A. the use or threat of force or incarceration to obtain compliance.
privately owned and operated for a profit. B. the use of monetary rewards or direct increases in consumption which result
A. Capitalism from engaging in an activity.
B. Communism C. attempts to convince individuals to behave in a certain manner because doing
C. Feudalism so is "the right thing to do."
D. Socialism D. the use of torture or other "enhanced interrogation techniques" in order to
elicit information from someone.
2. Which of the following countries currently has an economic system which would be
best described as "Pure Socialism"? 8. refers to the freedom of an individual to choose to purchase (or to
A. Sweden. choose to not purchase) a good or service at a price determined in a free market.
B. China. A. The Invisible Hand
C. India. B. Command Planning
D. None of the above answers are correct. C. Consumer Sovereignty
D. Indicative Planning
3. observed that the government or the state differs from other
decision making entities in that it alone has established "the monopoly of the 9. While playing baseball in their front yard, Wally and his little brother break the
legitimate use of physical force within a given territory." windshield of Ward's car. Wally and his brother concede that it is fight for them to
A. Karl Marx cover the costs of repairing the broken windshield. In taking this position, they are
B. Egun Neuberger recognizing that Ward has a in regards to his car windshield.
C . Max Weber A. right to control
D . Adam Smith B. right to restitution
C. fight to transfer
4. Which of the following is a basic characteristic of Capitalism? D. fight to consumer sovereignty
A. Private ownership of property is illegal.
B. Economic decisions occur in markets. For Question 10, consider the continuum between the economic systems of PRre
C. Income is distributed on the basis of "need." Socialism and Pare Capitalism illustrated below.
D. Government owns the factors ofproductinn.

5. specify/specifics obligations of others not to interfere in your

exercise ofyour rights.
A. Positive Rights
B. Negative Rights
C. Control Rights
D. Social Justice

6. Consider the costs of complying with bureaucratic regulations to economic decision

makers in China, Singapore, and Venezuela. According to the results of the "Ease 10. Along the continuum illustrated above the economy of the United States currently
of Doing Business" study, of these three countries, such costs are: would most accurately lie at
A. lowest in China and highest in Singapore. A. Point A
B. lowest in China and highest in Venezuela. B. Point B
C. lowest in Singapore and highest in Venezuela. C, Point C
D. lowest in Venezuela and highest in China. D. Point D
 Chapter #3 - Economic SystemS: Capitalism versus Socialism

fu'st said "From each according to his ability, to each according

Chapter #3 - Economic SystemS: Capgalism versUS Socialism 17.
~ his
to - - nee
- - .- ' - "
A. Adam Smith
B. Karl Marx
I I. In the writings of Karl Marx, the ,,bourgeoisie" rcfencd 1o the C. Louis Blanc
and the ,,proletariat" ref~d to the ..~~-" D. Max Weber
A . business owners; working class.
B. unskilled workers, entrepreneurS. 1 8 . T h e present economic system of the ~United
, w h i l Kingdom
e t h e p r ewould
sent e
bec omost
n o m accurately
ic system of
C. government planners; tax collectors. described as
D . colonialists; nobility. most accurately described as pure Socialism.
S p . a l n ~ e
12. aOn September
$100,000 4, 2009,
reward former California
for anyone who could Governor
provideArnold Schwarzenegger
information leading to offered
the arrest a Mixed Economy; would also be most accurately described as a Mixed
B.
EconOmy.
and conviction of arsonists who set a wildfire in southern California which claimed C. pure Capitalism; would be most accurately described as Pure Socialism.
the lives of two fireflghters. In this situation, Gov. Schwarzenegger was attempting
to obtain the desired information by D. pure Socialism; would be most accurately described as Communism.
A. coercion.
B. command planning. 19. Looking at the results of the ,,EconOmiC Freedom of the World" study, between
C. moral suasion.
2000 increased
and 2010, the
fromEFWI value
56.72 of the
up to United
79.83, States
moving the United States up from 27~ place
D. offering a material reward. A.
is the subfield of economics that compares and contrasts the to 2'~ place in the ranking.
13. B. increased from 5.53 up to 6.42, moving the United States up from 4t~ place to
stracture and performance of different types of economic organization. st nlace in the ranking, down from 3'~
r
A . Comparative Economic Systems decreased from 8.5 dow n to 7.69, moving the United States
B. International Trade C.
place to 18tb place in the ranking.
C. Indusmal Organization
D . Public Choice D. d e c r e a s e d fi ' o m 9 . 1 d o w n t o 8 . 9 6 , b u t b e c a u s e m o s t o t h e r c o u n t r i e s
experienced larger declines in economic freedom over this time-period the
14. In which of the following countries do individuals enjoy the least amount of United States actually moved up from 12th place to 6t~ place in the ranking.
Economic Freedom?
A . Hang Kong.
B. New Zealand.
C. The United States.
D . Venezuela

15. In a typical modem economy, it is common for Government to have an impact on

economic outcomes by
A. defining and enforcing property fights.
B. regulating the behavior of business.
C. redistributing income.
D. More than one (perhaps all) oftha above answers is co~ect.

16. Alec Nove described as "when the state uses influence, subsidies,
grants, [and] taxes [to influence economic decisions], but does not compel."
A. Consumer Sovereignty
B. Command Planning
C. Indicative Planning
D. The Invisible Hand
Chapter #3 - Economic Systems: Capitalism versus Socialism

Organizing Principles of
Capitalist Systems
In the discussion of the Capitalist System in Chapter 3, we saw how free people
morally acquire property, how the ownership and use of property is a right, and how
people use contracts to transfer property from one rightful owner to another. In this
chapter we first delve into issues of exchange in more detail in order to undez~'mnd why
voluntary trade benefits both sides to a Wansacfion (and generally benefits society as a
whole). Then we generalize from a simple two-person exchange to exchange in a market,
where potentially millions of people are buying and selling an item. We will discover
how the market system generates equil~rium prices which bring buyers and sellers of a
good into balance with each other.
Recall the discussion of the Preliminary Circular Flow Diagram presented in
Chapter 2. This diagram illustrated the basic transfer of economic resources between
households and fmms, the two primary decision making entities in an economy.
Households derive benefits from consuming goods and services, which ave acquired from
firms. Firms produce these goods and services using inputs acquir~ from households.
(See Figure 2.1 in Chapter 2.) But, why arc these resources transferred between
households and firms? That is, what are the incentives for self-interested decision makers
to voluntarily relinquish ownership of valuable economic resources and transfer them to
others? In a market based system these transfers will take place voluntarily so long as
individuals who give up an economic resource are given something in return that they
value even more. Such transfers of resource ownership take place in markets and are
facilitated by the use of money. Money refers to an asset that is socially and legally
accepted as a medium of exchange (i.e., as a payment for goods or services).
The Basic Circular Flow Diagram illustrated in Figure 4.1 depicts how money
serves as a medium of exchange to facilitate the voluntary transfer of factors of
production fi'om households to firms and of finished goods and services from finns to
households in markets. On the right side of the diagram we have the markets for goods
and services. The dark arrows here illustrate the movement of finished goods and
services from firms to households (a transfer of reso~ depicted in the Prelimma~
Circular Flow Diagram illustrated in Figure 2.1). But now we additionally see a transfer
of money in the opposite direction (illustrated by the light arrows), from households to
firms. In a umly market based systen~ all such transfers of resource ownership (i.e.,
"trades") are voluntary. Households value the consumption goods/services which they
acquire more than the money which they give up in the form of consumer expenditures,
and likewise, firms value the money they receive as revenues more that the finished
goods/services which they give up.
 Chapter #4 - Organizing Principles of Capitalts! @stems Chapter #4 - Organizing Principles of Capitalist Systems

On the left side of the diagram we have the markets for factors of production. - is an exchange of property for money. But how can the voluntary exchanges described
The interactions between households and firms in these markets are quite similar to what above benefit both buyers and sellers? Let's consider a simple example to discover some
was. described above, except the roles of buyer and seller are reversed. The dark arrows important attributes of free-market, capitalist exchange.
again illustrate a movement of economic resources, in this case factors of production Assume Beth is a lover of antique furniture who is willing to pay a significant
from households to firms. To facilitate this movement of resources we again have a amount of money to get an authentic piece. Andy has a genuine antique chest that he
transfer of money in the opposite direction (illustrated by the light arrows), from firms to inherited, and he has been using it on his farm to store tools in his barn. He would like to
households. Again, in a market based system these transfers of ownership are voluntary sell offsome of his belongings to pad his retirement savings. While driving through the
- firms value the productive resources which they acquire more than they value the countryside Beth spots the chest at Andy's garage sale. What price will the two agree
wages and rents paid to obtain the resources, while households value the income received on? Will Andy take advantage of Beth's love of antiques, or will city-slicker Beth take
for these resources more than they value the resources themselves. advantage of country Andy's desire to retire? Is there a third alternative? Can Andy and
Beth both benefit from the exchange?
Figare 4.1- Basic Circular Flow Diagram To answer these questions we need to first develop the concepts of "buyer's
reservation price" and "seller's reservation price." A buyer's reservation price for an
item refers to the maximum amount of money that she is willing to give up to acquire the
item. In general, denote this value by rb. For any particular item, each potential buyer

.,==/?-'-, has a specific value for her reservation price, reflecting the monetary value that she
places on the item.
Similarly, from the perspective of a seller, a seller's reservation price for an item
refers to the minimum amount of money that he is willing to accept in exchange for the
item. In general, denote this value by r. For any particular item, each potential seller
has a specific value for his reservation price, reflecting the monetary value he places on
the item. In the context of a firm selling an item the seller's reservation price is often
equal to the marginal costs of production (that is, the additional costs associated with
Markets for producing, bringing to market, and selling the item).
Markets for
Factors of Since different people can value items differently from one another, for any
Goods and
Product/on particular item there is no reason to think that buyer's reservation price will be equal to

I
Services
seller's reservation price. For example, suppose that as the initial owner of the chest,
Andy has a seller's reservation price of $200. This simply means that if he were offered
less than $200 for the chest, he would prefer to not sell it (i.e., if offered such a low
amount he would choose to keep the chest and continue using it for storage in his barn).
Beth really wants the chest and is willing to pay as much as (but no more than) $1,000 to
" ~ . ~ get it. That is, Beth has a buyer's reservation price of $1,000, because if the price goes
production
over $1,000 she would rather spend her money on something else.

"" "-I ==' From here, we can identify the Bargaining Range, which is simply the range of
possible transaction prices when the two people trade without coercion. Figure 4.2
illustrates Andy's reservation price as a seller and Beth's reservation price as a buyer.

Figarc 4.2- Reservation Prices and the Bargaining Range

F R E E D O M O F C O N T R A C T, V O L U N T A R Y E X C H A N G E , A N D
POSITIVE SUM OUTCOMES
B a r g ~
As we discussed in Chapter 3, very few pieces of property are acquired through
original acquisition from unowned nature. Most of the time we get goods or services o
[ ( f ' .~s
from others by purchase, which - as depicted in the Basic Circular Flow Diagram above
t
rAna.v = rs =200 i
)'Beth = Tb =1,000
79
 Chapter #4 - Organizing Principles of Capitalist S),stems
In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that both Andy and Beth would be willing
to trade at any price within this range. For example, at a price of $450 Andy is willing to
sell (since he is offered more than his reservation price of $200) and Beth is willing to
buy (since she is paying less than her reservation price). Similar observations hold for
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy.
Consequently, the bargaining range consists of precisely the prices from $200 up to
$1,000.
Recall that a free-market system is based upon voluntary trade - no one has the
authority to force anyone else to do anything. Rather, both parties have to agree in order
for a deal to be made. With this in mind we can further recognize why the bargaining
range consists of the set of prices from $200 up to $1,000. At any price in this range (and
only at prices within this range) both Andy and Beth are better off from trading than from
not trading. Again consider the price of $450. By selling the chest at this price, Andy is
$250 better off than he would be if he kept the chest (he gets $450 and gives up
something that he values at only $200, so his increase in well-being is equal to the
difference between these two values: $250=$450-$200). Similarly, by buying the chest
for $450, Beth is $550 better off than she would be ifsbe didn't make the purchase (she
gets something that she values at $1,000 and gives up only $450, so her increase in well-
being is equal to the difference between these two values: $550=$1,000-$450). These
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide
measures of the benefits of trade and are defined and examined in greater detail in
Chapter 5.
The range of prices from $200 up to $1,000 is called the bargaining range since a
"bargaining process" between buyer and seller could conceptually lead to a trade taking
place at any price within this range. As will be reinforced within the discussion of
Chapter 5, at higher prices within this range the seller is better offand the buyer is worse
off (while at lower prices within this range the buyer is better off and the seller is worse
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a
transaction price outside of this range, negotiation would collapse and trade would not
take place. For example, if Andy gets carried away and demands $1,200 for the chest,
Beth would simply refuse to pay since she would be worse off from the purchase given
her limited budget and the other things she wants to buy.
At this point we have no idea what specific price Andy and Beth will agree to, but
we do know that it has to be within the bargaining range and it has to make both of them
better off. Moreover, since there is a range of prices which makes both Andy and Beth
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price within the bargaining range as opposed to having no trade take place.
This is true for all voluntary Iransactinns that take place between any two people in the
free-market, capitalist system, including trades between shoppers and retailers, employers
and employees, and borrowers and lenders.
Chapter #4 - Organizing Principles of Capitalist Systems
WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS
The observation that both Andy and Beth are better off from vohintary trade illustrates a
general principle of interactions in a positive-sum environment. A positive-sum
environment is a situation in which the summation of gains and losses over all people is
positive in value. In contrast, a zero-sum environment is a situation in which the
summation of gains and losses over all people is exactly equal to zero.
Suppose that you and your roommate decide to play a game in which you toss a
coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
(separate from the $5 transfer) from playing this game, then it is a zero-sum environment.
To see this, recognize that for each possible outcome, the gains/losses for you and your
roommate add up to $0 - iftbe coin comes up "heads," you gain $5 and your roommate
loses $5; if the coin comes up "tails," you lose $5 and your roommate gains $5. For any
such zero-sum environment, the outcome will be a win-lose outcome in which some
people are better off ("win") and others are worse off("lose"). As we can see, in a zero-
sum environment the winnings of the winners come from the losses of the losers.
Now suppose instead that you and your roommate decide to play the card game
"Exploding Kittens," which the creators of the game describe as "a highly-strategic, kitty-
powered version of Russian Roulette."l By the end of this game there is a winner and a
loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
from playing the game, whereas if you lose you derive $7 of pleasure from playing the
game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
trading hands after the game ends. Is this still a zero-sum environment? No, it is actually
a positive-sum environment. Recognize that the transfer of money from the bet is still a
wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
the two players, a positive sum. In contrast to a zero-sum environment (which must
always result in a win-lose outcome), in a positive sum environment we can potentially
have a win-win outcome in which all people are better off ("win"). This is precisely the
case for this example. The winner of the game ends up realizing benefits of $9+$5ffi$14,
while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
in value).~
The critical recognition is that in a positive-sum environment there is the potential
for a win-win outcome. This potential is present precisely because the environment itself
generates value for society. That is, the interaction between people which defines the
setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
environment, where it was noted that the winnings of the winners come from the losses of
I See tum:lAw~*:eralodinvkiftfny.com/.
a Recognize that we don't automatically end up with win-win outcome in pnsitive-sum covironmonL If
the monetary bet had been $8 instead of $5, this game of"Exploding Kinas" would still be pnsitlve-sttm
environment with collective gains of$16. However, the winner ends up with $17=$9+$8, while the loser
realizes -.$1-$7-$8 (i.e., net benefit of negative one dollar). The result of the 8ante is win-lnse
outcome.
 Chapter 04 - Organizing Principles of Capitalist Systems
In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that beth Andy and Beth would be willing
to trade at any price within this range. For example, at a price of $450 Andy is willing to
sell (since he is offered more than his reservation price of $200) and Beth is willing to
buy (since she is paying less than her reservation price). Similar observations hold for
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy.
Consequently, the bargaining range consists of precisely the prices from $200 up to
S1,000.
Recall that a free-market system is based upon voluntary trade - no one has the
authority to force anyone else to do anything. Rather, beth parties have to agree in order
for a deal to be made. With this in mind we can further recognize why the bargaining
range consists of the set of prices from $200 up to $1,000. At any price in this range (and
only at prices within this range) both Andy and Beth are better off from trading than from
not trading. Again consider the price of $450. By selling the chest at this price, Andy is
$250 better off than he would be if he kept the chest (he gets $450 and gives up
something that he values at only S200, so his increase in well-being is equal to the
difference between these two values: $250=$450-$200). Similarly, by buying the chest
for $450, Beth is $550 better offthan she would be ifsbe didn't make the purchase (she
gets something that she values at $1,000 and gives up only $450, so her increase in well-
being is equal to the difference between these two values: $550ffi$1,000-$450). These
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide
measures of the benefits of trade and are defined and examined in greater detail in
Chapter 5.
The range of prices from $200 up to $I,000 is called the bargaining range since a
"bargaining process" between buyer and seller could conceptually lead to a trade taking
place at any price within this range. As will be reinforced within the discussion of
Chapter 5, at higher prices within this range the seller is better offand the buyer is worse
off(while at lower prices within this range the buyer is better offand the seller is worse
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a
transaction price outside of this range, negotiation would collapse and trade would not
take place. For example, ifAndy gets carried away and demands $1,200 for the chest,
Beth would simply refuse to pay since she would be worse off from the purchase given
her limited budget and the other things she wants to buy.
At this point we have no idea what specific price Andy and Beth will agree to, but
we do know that it has to be within the bargaining range and it has to make beth of them
better off. Moreover, since there is a range of prices which makes both Andy and Beth
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price with/n the bargaining range as opposed to having no trade take place.
This is true for all voluntary transactions that take place between any two people in the
free-market, capitalist system, includ/ng trades between shoppers and retailers, employers
and employees, and borrowers and lenders.
Chapter #4- Organizing Principles of Capitalist Systems
WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS
The observation that both Andy and Beth are better off from voluntatT trade illustrates a
general principle of interactions in a positive-sum environment. A pnsltive-sum
environment is a situation in which the summation of gains and losses over all people is
positive in value. In contrast, a zero-sum environment is a situation in which the
summation of gains and losses over all people is exactly equal to zero.
Suppose that you and your roommate decide to play a game in which you toss a
coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
(separate from the $5 transfe0 from playing this game, then it is a zero-sum environment.
To see this, recognize that for each possible outcome, the gains/losses for you and your
roommate add up to S0 - if the coin comes up "heads," you gain $5 and your roommate
loses $5; if the coin comes up "tails," you lose $5 and your roommate gains $5. For any
such zero-sum environment, the outcome will be a win-inse outcome in which some
people arc better off("win") and others are worse off ("lose"). As we can see, in a zero-
sum environment the winnings of the winners come from the losses of the losers.
Now suppose instead that you and your roommate decide to play the card game
"Exploding Kittens," which the creators of the game describe as "a highly-strategic, kitty-
powered version of Russian Roulette."l By the end of this game there is a winner and a
loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
from playing the game, whereas if you lose you derive $7 of pleasure from playing the
game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
trading hands after the game ends. Is this still a zero-sum environment? No, it is actually
a positive-sum environment. Recognize that the transfer of money from the bet is still a
wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
the two players, a positive sum. In contrast to a zero-sum environment (which must
always result in a win-lose outcome), in a positive sum environment we can potentially
have a win-win outcome in which all people are better off ("win"). This is precisely the
case for this example. The winner of the game ends up realizing benefits of $9+$5=$14,
while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
in value).2
The critical recognition is that in a positive-sum environment there is the potential
for a win~win outcome. This potential is present precisely because the environment itself
generates value for society. That is, the interaction between people which defines the
setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
environment, where it was noted that the winnings of the winners come from the losses of
I See hltz,.'/A~'ww, ex~lodinekiffgn~¢Qm/,
a Recognize that we don't automatically end up with a win-win outcome in a positive-sum environment. If
the monetary bet had been $8 instead 0f$5, this game o f "F..xploding Kittens" would still be a positive-sum
environment with collective gains of$16. However, the winner ends up with $17=$9+$8, while the loser
realizes -$1-$7-$8 (i.e., a net benefit of negative one dollar). The result of the game is a win-lose
outcome.

Chapter #4 - Organizing Principles of Capitalist Systems
In this example, the bargaining range logically consists of all prices between $200 and
$1,000. To see why this is true, first recognize that both Andy and Beth would be willing
to trade at any price within this range, For example, at a price of $450 Andy is willing to
sell (since he is offered more than his reservation price of $200) and Beth is willing to
buy (since she is paying less than her reservation price). Similar observations hold for
any price between $200 and $1,000. In contrast, at any price below $200 Andy will not
voluntarily sell. Likewise, at any price above $1,000 Beth will not voluntarily buy.
Consequently, the bargaining range consists of precisely the prices from $200 up to
$1,000.
Recall that a free-market system is based upon voluntary trade - no one has the
authority to force anyone else to do anything. Rather, both patties have to agree in order
for a deal to be made. With this in mind we can further recognize why the bargaining
range consists of the set of prices from 3200 up to $1,000. At any price in this range (and
only at prices within this range) both Andy and Beth are better off from trading than from
not trading. Again consider the price of $450. By selling the chest at this price, Andy is
$250 better off than he would be if he kept the chest (he gets $450 and gives up
something that he values at only $200, so his increase in well-being is equal to the
difference between these two values: $250=$450--$200). Similarly, by buying the chest
for $450, Beth is 3550 better off than she would be if she didn't make the purchase (she
gets something that she values at $1,000 and gives up only $450, so her increase in well-
being is equal to the difference between these two values: $550=$1,000-$450). These
concepts, which are termed Consumer's Surplus and Producer's Surplus, provide
measures of the benefits of trade and are def'med and examined in greater detail in
Chapter 5.
The range of prices from $200 up to $1,000 is called the bargaining range since a
"bargaining process" between buyer and seller could conceptually Mad to a trade taking
place at any price within this range. As will be reinforced within the discussion of
Chapter 5, at higher prices within this range the seller is better off and the buyer is worse
off (while at lower prices within this range the buyer is better offand the seller is worse
off). But if either buyer or seller tries to negotiate too aggressively and bargain for a
transaction price outside of this range, negotiation would collapse and trade would not
take place. For example, if Andy gets carried away and demands $I,200 for the chest,
Beth would simply refuse to pay since she would be worse off from the purchase given
her limited budget and the other things she wants to buy.
At this point we have no idea what specific price Andy and Beth will agree to, but
we do know that it has to be within the bargaining range and it has to make both of them
better off. Moreover, since there is a range of prices which makes both Andy and Beth
better off, they each have an incentive (as a self-interested individual) to have trade take
place at a price within the bargaining range as opposed to having no Wade take place.
This is true for all voluntary transactions that take place between any two people in the
free-market, capitalist system, including wades between shoppers and retailers, employers
and employees, and borrowers and lenders.
Chapter #4 - Organizing Principles of Capitalist Systems
WIN-WIN OUTCOMES IN POSITIVE SUM ENVIRONMENTS
The observation that both Andy and Beth are better off from voluntary trade illustrates a
general principle of interactions in a positive-sum environment. A pnsitive-sum
environment is a situation in which the summation of gains and losses over all people is
positive in value. In contrast, a zero-sum environment is a situation in which the
summation of gains and losses over all people is exactly equal to zero.
Suppose that you and your roommate decide to play a game in which you toss a
coin - if it comes up "heads," your roommate pays you $5; if it comes up "tails," you pay
your roommate $5. If neither you nor your roommate derive any pleasure or displeasure
(separate from the $5 transfer) from playing this game, then it is a zero-sum environment.
To see this, recognize that for each possible outcome, the gains/losses for you and your
roommate add up to $0 - if the coin comes up "heads," you gain $5 and your roommate
loses $5; if the coin comes up "tails," you lose $5 and your roommate gains 35. For any
such zero-sum environment, the outcome will be a win-lose outcome in which some
people are better off ("win") and others are worse off ("lose"). As we can see, in a zero-
sum environment the winnings of the winners come from the losses of the losers.
Now suppose instead that you and your roommate decide to play the card game
"Exploding Kittens," which the creators of the game describe as "a highly-sO'ategic, kitty-
powered version of Russian Roulette.''1 By the end of this game there is a winner and a
loser, but the game is also fun to play. Suppose that if you win you derive $9 of pleasure
from playing the game, whereas if you lose you derive $7 of pleasure from playing the
game. You still have the $5 bet resting on the outcome, so there will still be exactly $5
wading hands after the game ends. Is this still a zero-sum environment? No, it is actually
a positive-sum environment. Recognize that the transfer of money from the bet is still a
wash - the winner's gain exactly equals the loser's loss. However, the winner gets $9 of
enjoyment and the loser gets $7 from playing the game. This adds up to a $16 gain over
the two players, a positive sum. In contrast to a zero-sum environment (which must
always result in a win-lose outcome), in a positive sum environment we can potentially
have a win-win outcome in which all people are better off ("win"). This is precisely the
case for this example. The winner of the game ends up realizing benefits of $9+$5=$14,
while the loser of the game ends up realizing benefits of $7-$5=$2 (which is also positive
in value).2
The critical recognition is that in a positive-sum environment there is the potential
for a win-win outcome. This potential is present precisely because the environment itself
generates value for society. That is, the interaction between people which defines the
setting creates net benefits for the people involved. This is in stark contrast to a zero-sum
environment, where it was noted that the winnings of the winners come from the losses of
See http:/Atat~v.¢rolodinekittens.fom/.
2 Recognize that we don't automatically end up with a win-win outcome in a positive-sum environment. If
the monetary bet had been $8 instead of $5, this game of "Exploding Kittens" would still be a positive-sum
environment with collective gains of $16. However, the winner ends up with $17=$9+$8, while the loser
realizes -$1=$7-$8 (i.e., a net benefit ofnegatlve one dollar). The result of the game is a win-lose
outcome.
 Chapter #4 - Organizing Principles of Capitalist Systems
the losers. For a positive-sum environment, the interactions between people create value
which can ultimately he shared between everyone involved. Further, when the ultimate
outcome will be a win-win, rational people who have a voluntary choice over
participation in the environment will be happy to take part.
Retnming to the example of trade between Andy and Beth, both are able to be
"Winners" when they trade the chest at a price within the bargaining range. This is
because the transfer of the ownership of the chest generates positive-sum gains of
$1,000-$200=$800 for society, a result of the fact that the buyer places a higher value on
the chest than the seller does. When they voluntarily trade at any price within the
bargaining range, a win-win outcome is realized in that both Andy and Beth are
individually better off. (This is similar to the game of "Exploding Kittens" with a $5
bet.)
But even when a buyer places a higher value on an item than a seller does (i.e., a
positive-sum environment), coerced trade at a price outside the bargaining range would
lead to a win-lose outcome. For example, suppose that the government (in an attempt to
increase the wealth of farmers who have inherited antiques) forces Beth to buy the chest
from Andy for $1,500. At this price outside of the bargaining range, total gains to society
are still positive ($80(O$1,000-$200), And), still "wins" (realizing a positive gain of
$1,300~$1,500-$200), but Beth "loses" (realizing a negative gain of-$500=$1,000-
$1,500). Thus, trade outside of the bargaining range leads to a win-lose outcome in this
positive sum environment. (For a parallel, consider a game of "Exploding Kittens" with
an $8 bet - as described in footnote 3 - and assume that one player knew for certain that
he would lose the game.) If this win-lose outcome is going to be realized, Beth would
not voluntarily choose to participate in the Irade.
Finally, recognize that not all trades are positive-sum environments. What if
And), is the antiques buff, and Beth is just looking for a chest to put in her garage for her
husband's tools. As a potential buyer she values the chest at only $200, while Andy as a
potential seller values it at $1,000. Is there any common price that could simultaneously
convince Andy to voluntarily sell and Beth to voluntarily buy the chest? No. For these
reservation prices the bargaining range is empty (it does not contain any prices), and
therefore no voluntary transaction can take place. When a buyer's reservation price is
less than a seller's reservation price, trade would be taking place in a negative-sum
eavlroamelt, a situation in which the summation of gains and losses over all people is
negative in value. In a negative-sum environment we can never have a win-win outcome
(since two positive numbers can never add up to a negative number).
All transactions in a truly free-market Capitalist system are win-win outcomes,
since all transactions voluntarily take place at a price within the bargaining range where
both parties have something to gain. Since the transactions in Capitalism are required to
be voluntary, no one can be forced to trade outside their reservation price- therefore beth
parties gain. From the Capitalist perspective we now have another reason to recommend
the system of laissez faire.
Chapter #4 - Organizing Principles of Capitalist Systems
T H E M O D E L O F S U P P LY A N D D E M A N D
While many of us negotiate for a few purchases face-to-face like Andy and Beth,
most transactions don't have anywhere near as much room to haggle over price. Instead,
markets aggregate thousands upon thousands of transactions daily and generate prices for
most goods that people trade. We now move from a relatively straightforward discussion
of two people that is easy to understand to a more abstract model of economic interaction
known as the Model of Supply and Demand, which models the behavior of buyers and
sellers in markets within a Capitalist system.
Demand provides a summary of the behavior of buyers (or consumers) in a
market. The Quantity demanded of a good refers to the number of anita that people are
willing and able to parehase at a particular priee. Demand is the entire relation between
the price of a produet and quantity demanded, holding fixed all other factors that could
influence purchasing decisions. Similarly, supply summarizes the behavior of sellers (or
producers) in a market. The Quantity supplied of a good refers to the number of anita
that people are willing and able to sell at a particular price. Supply is the entire relation
between the price of a product and quantity supplied, holding fixed all other factors that
could influence production/sales decisions.
The model of supply and demand is a simplified depiction of reality that is used m
describe the interactions between buyers and sellers in a competitive market, which lead
to a particular quantity and price at which trade will take place. It aims to highlight the
behavioral forces at play which determine the relevant aspects for the millions of
transactions among thousands of firms and their customers daily. Once you understand
the model you will begin to comprehend the economic system of global Capitalism. This
system incorporates not only the transactions for goods and services within our country,
but a significant amount of all transactions both within foreign countries and between
countries, as well as financial transactions of investment markets, loan markets, currency
markets, and labor markets. We will not address them all jast yet, but you will be able to
understand the gist of them all once you master Supply and Demand.
The Law of Demand
The Law of Demand states that, all other factors held constant, people will: (i)
buy less of a good when its price is higher and (ii) buy more of a good when its price is
lower. That is, with all other factors unchanged, there is an inverse relationship between
the price and quantity demanded of a good. This "law" is a law in the scientific sense,
like the Law of Gravity, which is universally true irrespective of the beliefs of people.
The Law of Gravity applies the same way to rich and poor, capitalist and socialist, men
and women, and the like - so too does the Law of Demand.
Proof of the validity of this claim is easy to come by since it can be confumed
through introspection. Think of any good that you want. If the price oftbe good went
down would you be stimulated to buy more of it? This is the basis for firms putting
goods on sale when they are overstocked and need to reduce inventory. The lower price
motivates people to buy more than when the price was higher. Alternatively, picture a
 Chapter #4- Organizing Principles of Capitalist Systems
good that you like and imagine it becoming more expensive. Obviously you would
purchase less of it. This "law" is generally true because of three universal aspects of
human nature: diminishing marginal benefits from consumption, self-interest, and
rationality.
For most goods, most people derive diminishing marginal benefits from
consumption. As defined in Chapter 1, marginal benefit refers to the change in the value
oftotal benefits as more of an activity is undertaken. When working through the example
of Carl's decision of how much time to spend growing carrots in Chapter l, we assumed
that he had a diminishing marginal benefit from carrot consumption - the additional
value realized from consuming more carrots became smaller as he consumed more
carrots. This is a general phenomenon which economists think is likely true for most
people, for most goods - the more you consume of something, the less valuable the
additional units are to you.
Again returning attention to Chapter I, a self-interested Individual was defined
as someone who makes his own personal assessment of the benefits and costs associated
with different outcomes, and who subsequently uses these measures as the basis for
decision making. Within this discussion it was noted that, by definition, a self-interested
individual places more weight on his own benefits than he places on the benefits derived
by others. Self-interest is often incon'cctly conflated with selfishness by many people.
While self-interest is a universal trait of mankind, it is not the only trait-people can also
be charitable, kind, and benevolent towards others. Unfortunately, they can also be
selfish, cruel, and malevolent. By self-interest we mean only that all people have a
regard for that which makes themselves better off and try to avoid that which makes
themselves worse off. Benevolent motives and actions decline rapidly as the social
distance between people increases - recall Adam Smith's "little finger example"
discussed in Chapter 1. For example, people make huge sacrifices for their owe children,
make some sacrifices for relatives and friends, and make proportionally very few
sacrifices for strangers.
Selfishness can be defined as the pursuit of self-interest taken beyond proper,
acceptable bounds. Self-interest differs from selfishness in that the former can often be
legitimate while, by definition, the latter cannot be legitimately justified. Individuals
clearly have a legitimate concern with getting food, clothing, shelter, education,
henlthcare, recreation, and a host of other desirable things for themselves and their
families. Pursuing these ends is self-interest. But if someone attempts to steel, hoard,
defraud, or otherwise take advantage of others to "get ahead in life," this becomes
selfishness and cannot be considered acceptable. A free and decent society needs to
define a limit on how far a person can go in pursuing one's owe interest while still
respecting space for people to "do their own thing."
Drawing the boundaries between proper and improper self-interest has consumed
philosophers and economists for centuries. Within Capitalism, property rights and
contracts make a strict separation between permissible and impermissible self-interested
actions. People are permitted to do with their owe property, including their owe time, as
they please without moral criticism as long as they respect the equal rights of others.
(Recall the three distinct sets of rights collectively thought of as property rights which
Chapter #4 - Organizing Principles of Capitalist Systems
were discussed in Chapter 3.) A person can spend every waking moment piling up a
huge bank account, spending money on personal pleasures, and indulging every whim
that occurs to them. Or they may spend some or all of their time and resources in charity
work and other benevolent activities. As we saw at the beginning of this chapter, all that
Capitalism as an economic system demands is that you engage with others through
voluntary transactions and use no force/coercion or fraud against anyone. The moral
principles of Capitalism do not focus on what you do with your time and money, but
rather on whether your interactions with others are just.
Economists normally make the assumption that while it is possible to spend must
of your time and money and other resources doing charity work, most people, eSlX~ally
when dealing with strangers, tend to pursue their own self-interest. Economists mainly
study people interacting with each other through markets as strangers (that is, in a setting
where concern for self is above concern for others). Further, economists typically
assume that people are (or would find it in their self-interest to be) rational decision
makers (as defined in Chapter 1). Recall, a rational decision maker is someone with a
well-defined goal, who takes actions to achieve the goal as best as possible.
As an analytical construct, a decision maker who is both self-interested and
rational is referred to as Economic Man (or homo economicus). From this point
forward, we assume that all decision makers fit these characteristics of Economic Man -
that is, motivated by self-interest and making rational decisions constrained only by the
rules of the economic system in which they exist (for example, in a Capitalist system, the
relevant rules would be defined by property rights and contracts with a heavy reliance on
and respect for individual choice and sovereignty). Within such a framework, as long as
individuals remain within the rules, the pursuit of their self-interest should be considered
legitimate.
This assumption proves very useful in understanding large scale human behavior
but has generated an enormous amount of hostility from those who do not support
capitalism as a system. Marxists in particular believed that Communism would create the
New Soviet Man, a person that would be motivated primarily by selfless benevolence.
Socialists reject the capitalist ethical system of laissez faire, based on property rights and
contracts, because they believe that it encourages selfishness. We will develop this
conflict of ideas on the true nature of man in the next chapter when we deal with the
socialist mechanism for organizing society.
Modeling Demand
As previously defined, demand is the entire relation between the price and
quantity demanded of a good, all other factors held constant. Consider the market for
hotdogs in Kennesaw, GA. Many factors are probably important for determining
consumers' purchasing decisions, such as: the price of hotdogs; consumer income;
consumer tastes and preferences (i.., how much do people like botdogs); the price of
hotdog buns; the price of hamburgers; and the weather (e.g., people are probably more
inclined to buy hotdogs in June than in December). But, of all these factors, probably the
most important influence on the quantity of botdogs purchased is the price of hotdogs
 Chapter #4 - Organizing Principles of Capitalist ~/stems Chapter #4 - Organizing Principles of Capitalist Systems

(i.e., "own price"). Recognizing this, the demand for hotdogs is developed by We can see that the Law of Demand is satisfied by looking at either the numbers in Table
conceptually holding all of these "other factors" (such as income, preferences, other 4.1 or the curve in Figure 4.3. From Table 4.1, the fact that quantity demanded increases
prices) fixed at their current levels and identifying the relationship between the price of as price decreases reveals the Law of Demand. Correspondingly, the fact that the
hotdogs and the quantity of hotdogs that consumers are willing and able to purchase. demand curve in Figure 4.3 is downward sloping also reveals the Law of Demand.
Demand is this entire relationship between price and quantity.
For example, suppose that Table 4.1 provides a partial summary of the
relationship between the price of hotdogs and the quantity demanded of hotdogs in The Law of Supply
Kennesaw, GA during the first Monday in April. The Law of Supply states that, all other factors held constant, people will: (i) sell
less of a good when its price is lower and (ii) sell more of a good when its price is higher.
Table 4. ! - Relation between Price of Hotdogs and Quantity Demanded of Hotdogs That is, with all other factors held constant, there is a positive relationship between the
Quantity t price and quantity supplied of a good. Just like the Law of Demand, the Law of Supply is
Price Demanded a universally applicable scientific law that applies to all private firms.
$7 150 This reaction by business people to differences in the market price of the goods
$6 250 that they sell derives primarily from self-interest and rationality - that is, we assume that
$5 500 the people who ran businesses also belong to the species homo economicus. The Law of
$4 Supply is further motivated by the Law of Increasing Cost, which posits that marginal
850
$3 costs ofproductinn will increase as firms expand output. This increase in marginal costs
1,250
often occurs because firms face both rising resource costs due to the increased demand
$2 1,750
for the resources that the company uses in production and from diminishing productivity
of industry as overcrowding takes place.
If we plot the pairs of numbers in Table 4.1 on a graph, we can illustrate the Demand The material benefit of owning a fLrm comes from the possibility of earning a
Curve, which is a line that connects all possible combinations of prices and quantities profit, which is defined as the difference between revenues and costs of production.
demanded of a good (with all other relevant factors held constant). Profit is a residual ownership claim to the income generated by a firm. This means that
under the legal structure of Capitalism the owner has a legitimate claim to all of the
Figure 4.3 - Demand Curve for Hotdogs income that is leR over after all of the bills are paid. Consider a simple example of a
hotdog vendor who goes into business by renting a cart, purchasing hotdogs, buns, and
S condiments in bulk, and then finding a good location on the street to set up. Assume that
he sells 100 hotdogs at $5.00 each. He spent $2.00 for the ingredients to make each
hotdog and paid a rental fee of $170 to the equipment vendor. Table 4.2 provides a
simple summary of the results of his business for the day.

5 Table 4.2- Revenue, Costs, and Profit for Hotdog Vendor

total revenue $500 = $5 x 100 hotdogs
- cost ofhotdogs $200 = $2 x 100 hotdogs
3" - equipment rental $170
Demand = Profit (or Loss) $130

His profit of $130 is the difference between his revenue of $500 and costs of $370.
150 Proponents of the Capitalist system maintain that the hotdog vendor has a legitimate
500 1,250
claim to this profit that he has earned by this entrepreneurial activity.
An Entrepreneur is an individual who undertakes and oversees a business
venture. Entrepreneurial activity requires a great deal of initiative and presents the
 Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

entrepreneur with the possibility of earning a significant return on his investment of time in Kermesaw, GA. Many factors are probably important for determining producers'
and financial resources. However, in a market based system, an entrepreneur is also selling decisions, such as: the price ofhotdogs; the price of factors of production; and the
exposed to a great deal of risk since if the business venture fails it is ultimately the specifics of the available production technology. But, of all these factors, probably the
entrepreneur who must bear the cost. Clearly a $130 daily profit is not the only possible most important influence on the quantity of botdogs that producers would want to sell is
outcome of this venture, the price of hotdogs (i.e., "own price"). Recognizing this, the supply for hotdogs is
What if our entrepreneur instead chose to setup his cart on the wrong street and developed by conceptually holding all of these "other factors" fixed and determining the
only had 75 customers? Now his total revenue is $375 ($5 multiplied by 75 units sold) relationship between the price of hotdogs and the quantity of hotdogs that producers are
and his cost of hotdogs is $150 ($2 multiplied by 75 units sold). Consequently, instead of willing and able to sell. Supply is this entire relationship between price and quantity.
"outcome (A)" as summarized in Table 4.2 above, he would have realized "outcome (B)" For example, suppose that Table 4.4 provides a partial summary of the
as summarized in Table 4.3 below. In this case he still earns a positive profi4 but it is relationship between the price of hotdogs and the quantity supplied of hotdogs in
only $$5 instead of $130. Kconesaw, GA during the first Monday in April.
What if, in addition to now selling 75 botdogs, the rental on the cart is $250 per
day? This scenario is summarized by "outcome (C)" in Table 4.3 below. With Table 4.4 - Relation between Price of Hotdogs and Quantity Supplied of Hotdogs
equipment rental costs that are now $80 higher than in "outcome (B)," his profit is $80
lower. He now earns a loss of $25 (i.e., a negative profit). Quantity
On the other hand (returning to our initial assumption of equipment rental costs of Price Supplied
$170), what if he is especially creative and develops a great hot sauce that everyone 1 ~400
loves, allowing him to sell 150 hotdogs per day? In this case his total revenue would be 90O
$750 ($5 times 150) and his costs ofhotdogs would be $300 ($2 times 150), giving him a $5 500
daily profit 0f$280 (as summarized by "outcome (D)" in Table 4.3 below). $4 200
$3 75
'TaMe 4.3- Alternative Outcomes for Hotdog Vendor $2 0

I total revenue
(A)
$500
O3)
$375
(C)
$375
fD)
$750 If we plot the pairs of numbers in Table 4.4 on a graph, we can illustrate the Supply
| - cost of hotdogs $200 $150 $150 $300 Curve, which is a line that connects all possible combinations of prices and quantifies
| - equipment rental $170 $170 $250 $170 supplied of a good (with all other relevant factors held constant).
[ = Profit (or Loss) $130 $55 -$25 $280
Figure 4.4 - Supply Curve for Hotdogs
From these various outcomes we can see that the profit of the en~epreneur is $
variable and uncertain. As the residual owner of the income, he only gets paid after
everyone else. Through a combination of hustle and good luck he might be able to make
a large profit. But, he may instead suffer a loss as in "outcome (C)" above, due to
incompetence or bad luck (perhaps the low quantity sold in "outcomes (B) or (C)" is a
result of rainy weather, as opposed to a poor choice of location). Every company,
whether it is as small as a hotdog stand or as large as Home Depot, operates on this same
principle. When rational, self-interested sellers are confronted with increasing marginal
costs of production, seller behavior emerges which satisfies the Law of Supply.

Modefing Supply
As previously defined, supply is the entire relation between the price and quantity
supplied of a good, all other factors held constant. Again consider the market for hotdogs 0
75 500 1,400
 Chapter #4 - Organizing Principles of Capitalist @stems Chapter #4 - Organizing Principles of Capitalist Systems

We can see that the Law of Supply is satisfied by looking at either the numbers in Table
4.4 or.the curve in Figure 4.4. From Table 4.4, the fact that quantity supplied increases as
price increases reveals the Law of Supply, Correspondingly, the fact that the supply
curve in Figure 4.4 is upward sloping also reveals the Law of Supply.
The supply curve in Figure 4.4 can be interpreted as follows. If the price per
hotdog were $5, then firms would maximize profits by collectively selling 500 units.
Alternatively, if hotdogs were to sell at a higher price of $7, then firms would maximize
profit by selling 1,400 units. The supply decisions made by firms result from an
application of the cost-benefit principle discussed in Chapter 1. When the market price
of hotdogs is higher, then benefits (i.e., revenues) will exceed costs for a greater quantity
of units. Conversely, if the price were only $3 per hotdog, then producers would want to
sell fewer units (only 75). This is because benefits cover production costs for a smaller
number of units when price is lower.
out that the market equilibrium price arises spontaneously from the voluntary interactions
of buyers and sellers.
Using Figure 4.5 below, we can see why most prices are not stable (in fact, there
is only one unique equilibrium price). The unique market equilibrium in this market is an
equilibrium price of $5 and an equilibrium quantity of trade of 500 units. To tell the
stories which will allow us to see why this is the unique equilibrium, it is helpful to
recognize how the previously defined notions of reservation prices are illustrated by the
demand curve and supply curve. As will be explained in further detail in Chapter 5, the
value of buyer's reservation price is equal to the height of the demand curve, and the
value of seller's reservation is equal to the height of the supply curve.
Figure 4.5- Demand and Supply for Hotdogs
5

MARKET EQUILIBRIUM 7, , , , , spply

Now that we have independently developed the concepts of Demand and Supply
5 ~ - - - v . . . . . . . . . . j
(to distinctly summarize how buyers and sellers would behave in a market), we consider
the interactions between self-interested and rational buyers and sellers in competitive i

markets. By a competitive market, we mean an environment in which no single seller

and no single buyer has any significant, direct impact over market price. Rather, in a
competitive market, people take the market price as beyond their own control and decide
how many units to trade. This is a reasonable assumption for most (but not all) markets.
After all, when was the last time you tried to negotiate with the cashier at the grocery
store over the price of a gallon of milk?
By bringing together our concepts of Demand and Supply, we will attempt to
identify a market equilibrium. In general, an equilibrium refers to a stable state for a
system, which would be expected to persist so long as conditions remain unchanged. In
particular, a market equilibrium is a stable price/quantity pair for which no individual
market participant could improve the outcome for himself by altering his own behavior.
As will be seen, the market equilibrium price will be a market clearing price, which gets
all consumers as a group to demand a quantity of the good that is exactly equal to the
quantity of the good that suppliers want to sell. If the description of consumer and
producer behavior outlined above is true, how do we get consumers (buyers) and
producers (suppliers or sellers) to agree on a price or a quantity? After all, consumers
want the price to be low and the producers want it to be high. But, if they are beth put in
a legal system of contracts and property fights, they have to "bargain" to get the other
party to voluntarily cooperate.
In Figure 4.5 we combine both sides of the market - the buyers/demand side and
the sclless/supply side - to ultimately determine the market equilibrium. (Figure 4.5 is
simply a combination of Figures 4.3 and 4.4.) What causes the market equilibrium price
to develop?' Is it imposed on the market participants by a government agency? It turns
,,
3
i
I
B
i
i i
o : I e
75 ~ 500 1,250 1,400
150
Is a price of $7 "stable"? Start by r~cugnizing that at this price, quantity supplied
is 1,400 while quantity demanded is only 150. That is, at this relatively high price, sellers
would want to sell 1,400 units, but buyers are only willing and able to purchase 150 units.
What we have at a price of $7 is excess supply (or a surplus), a situation in which
quantity supplied is greater than quantity demanded. Visually, we have excess supply at
any price for which the supply curve is "to the right" of the demand curve. This excess
supply at $7 is explicitly identified in Figure 4.6 below.
Since nobody can be forced to buy or sell a good in a free market, the quantity
Waded at $7 would be the lesser of these two quantities: 150 units. So, many of the
people who would like to sell hotdogs for $7 will not be able to do so. Numerically, there
are 1,250=-1,400-150 units that sellers would like to sell for $7 that will remain unsold;
for each of these units, the seller has a reservation price strictly below $7.
To see that this high price of $7 is not stable, recognize how a seller could alter
his behavior in order to make himself better off. Suppose you are one of the betdog
vendors in this market. You have 100 hotdogs that you would be willing to sell for as
 Chapter #4 - Organizing Principles of Capitalist @stems Chapter #4 - Organizing Principles of Capitalist Systems

little as $4 each (at a price of $7, your 100 hotdogs are a part of the total market quantity
supplied of 1,400). But, at a price of $7 only 150 hctdogs will be bought. Suppose that
at this high price, nobody shows up to buy any of your hotdogs. Is there anything you
could do to improve the outcome for yourself? What if you offered to sell your hotdogs
for only $6.90? At this lower price, consumers would prefer to buy hotdogs from you
instead of another seller. Furthermore, you would rather sell your hotdogs for $6.90
(which is above your seller's reservation price of $4) as opposed to the alternative of
insisting upon a price of $7 but not selling any hotdogs. The initial excess supply put
downward pressure on price, revealing that the high price of $7 was not stable. Similar
forces are present at any price at which there is excess supply. Thus, none of the prices
above $5 are stable.
Figure 4.6- Exce~s Supply and Excess Demand
$ Excess Supply
who would like to buy hotdogs for $3 will not be able to do so. Numerically, there are
1,175=1,250-75 units that consumers would like to buy for $3 that will remain
unpurchased; for each such units, the buyer has a reservation price strictly above $3.
To see that this low price of $3 is not stable, recognize how a buyer could alter
her behavior in order to make herself better off. Suppose you are one of the hotdog
consumers in this market. You are willing to pay up to $6 for a hotdog, but at the low
price of $3 you are not able to find a willing seller. Is there anything you could do to
improve the outcome for yourself? What if you offered to buy a hotdog for $3.25? At
this higher price, a hotdog vendor would prefer to sell to you instead of a different
customer (who is only offering the prevailing price of $3). Additionally, you would
rather pay $3.25 (which is below your buyer's reservation price of $6) and get a hotdog,
as opposed to the alternative of insisting upon a price of $3 but not getting to buy a
hotdog. The initial excess demand put upward pressure on price, revealing that the low
price of $3 was not stable. Similar forces are present at any price at which there is excess
demand. Thus, none of the prices below $5 are stable.

~ ofl,250 units
at a price of $7
Lastly, consider a price of exactly $5. As illustrated in Figure 4.5, this is the one
unique price at which we have neither excess supply nor excess demand. This price of $5
"clears the market" - quantity demanded and quantity supplied are exactly equal to one
~ - Supply
~ another. Consumers are looking to buy exactly 500 units, and vendors are looking to sell
exactly 500 units. The unique market equilibrium is for 500 units to be traded at a price
i
i of $5 per unit, the point of intersection of the supply curve and the demand curve.
7 i~ e m r The uniqueness of the market equilibrium (i.e., the fact that there is only one
i
!i i equilibrium) is a consequence of the Law of Demand and Law of Supply. These laws
' respectively imply that demand curves must be downward sloping and supply curves
~
3. i
must be upward sloping. Clearly a downward sloping curve and an upward sloping curve
cannot have multiple points of intersection.

o
' ~
!
I, ¥ ,
1
i
',
i
I
(lnd Finally, recognize that the market equilibrium - in addition to being stable
(which, by definition, all equilibria must be) and unique - is a self-enforcing outcome.
By this we simply mean that if a market is ever "out of equilibrium" market forces (i.e.,
1 i I the self-interest of market participants) will push the market toward equilibrium. Prices

'i
75 [ 1,250 1,400
Q above the equilibrium price are not stable because there was downward pressure on price.
Prices below the equilibrium price are not stable because there was upward pressure on
150
uniLs at a price of $3 |
I Excess Dema~d of l,175
I price. So, at any non-equilibrium price, we are being pushed toward the market clearing
equilibrium price. Consequently, we can recognize the important principle that without
any outside interference, the self-interest of buyers and sellers will naturally guide a
Is a price of $3 "stable".'? Recognize that at this price, quantity supplied is only 75 market toward equilibrium. As this occurs, any initial shortage or surplus will naturally
while quantity demanded is 1,250. Thus, at this relatively low price, buyers would like to disappear through the same mechanism.
purchase 1,250 un/ta, but sellers would want to sell only 75 units. At this low price we
have excess demand (or a shortage), a situation in which quantity demanded is greater
than quantity supplied. Visually, we have excess demand at any price for which the The Market Equilibrium Price and the Bargaining Range
demand curve is "to the right" of the supply curve. This excess demand at $3 is explicitly We illustrated the concept of the bargaining range in Figure 4.2 to show the
identified in Figure 4.6 above. individual incentives to engage in voluntary exchange. How does the bargaining range fit
Since nobody can be forced to buy or sell a good in a free market, the quantity in with what we learned about market equilibrium price.'? For the hotdog market
traded at $3 wouid be the lesser of these two quantities: 75 units. So, many of the people illustrated in Figure 4.5 we saw that the unique market equilibrium price was $5.
 Chapter #4- Organizing Principles of Capitalist Systems
Start by focusing on the "150th hotdog traded" in this market. From Figure 4.7
below we see that the buyer of this unit (who we will identify as Charles) has a buyer's
reservation price of $7 and the seller of this unit (who we will identify as Daisy) has a
seller's reservation price of $3.20 (recall, buyer's reservation price is illuslrated by the
height of the demand curve and seller's reservation price is illustrated by the height of the
supply curve). The bargaining range consists of all prices between $3.20 and $7, since a
trade at any price between these extremes simultaneously makes both Charles and Daisy
individually better off. In comparison to the bargaining range illustrated in Figure 4.2,
focusing on a specific unit in Figure 4.7 we effectively have the bargaining range set on
its side and arranged vertically rather than horizontally. This view reveals how the
demand curve and supply curve illustrate reservation prices for these two market
participants. Charles is hungry and wants a hotdog, but could also go for a slice of pizza
or a burrito. His maximum willingness to pay for a hotdog is $7. At any higher price, he
buys a different lunch. Daisy likes operating her hotdog cart but would be happy to
switch to another line of work if it paid better. The lowest price at which she is willing to
produce and sell this hotdog is $3.20. At any lower price, she chooses to use her
.productive resources for a different purpose. As it turns out, the market price for botdogs
ts currently $5, so both of them get a benefit from and are willing to voluntarily engage in
this transaction.3
Figure 4. 7 - Equilibrium Price and the Bargaining Range
$ 500 hotdogs purchased and 500 hotdogs sold.
Charles'
~_ _ _ j b a r g a i n i n g r a n g e
reservation ~ 7 " i - - - I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
price
5 factories. In addition, there are markets for all sorts of labor of different skills, from
Dairy's
r~-ze~ation .-~ 3.20'
price
2.40"
150 500
3 The technical terms for the benefits that mad<et participants gain from trade are Consumer's Smplus and
Producer's Surplus. A full description of these concepts is presented in Chapter 5.
Chapter #4 - Organizing Principles of Capitalist Systems
As the quantity of hotdogs traded is increased from 150 up to 250, 350, and 450,
we still have both buyer and seller individually benefiting from trade, since the
willingness to pay by additional consumers (illustrated by the height of the demand
curve) is greater than costs of production for additional units (illustrated by the height of
the supply curve). This is true for every single unit up to the 500a~ hotdog, where the
bargaining range is reduced to only the single price of $5. For the 500th unit, voluntary
trade can take place at only the market clearing price of $5, a price at which both the
buyer and seller of the unit are indifferent between trading and not trading. In other
words, the 500th consumer gets $5 of pleasure from consuming his hotdog, which costs
exactly $5 to produce. When this unit is traded at the equilibrium price of $5, both buyer
and seller "break even" on the transaction.
For any unit beyond the 500th unit, buyer's reservation price is less than seller's
reservation price. Consequently, the bargaining range is empty in that it contains no
prices (recall the final antique example in which Beth valued the chest as a potential
buyer at only $200 while Andy valued the chest as a potential seller for $1,000).
Consider the 1,400th unit in Figure 4.7. For this hotdog, the potential seller (who we will
identify as Ethan) has a seller's reservation price of $7 and the potential buyer (who we
will identify as Francesca) has a buyer's reservation price of $2.40. By the time we
would get up to 1,400 units traded, costs of production for potential sellers become
relatively high while benefits for potential consumers become relatively low. Since the
buyer is not prepared to voluntarily pay any price that the seller would willingly accept,
the bargaining range is empty and no voluntary trade can take place. From this entire
discossion we can again see how in a free market, trade will stabilize at a price of $5 with
Now imagine replicating this story for every kind of good available in a modem
Supply economy. There is a market for cars, houses, airplanes, clothes, restaurants, medical care,
!
schools, books, and thousands of other items. Not only does the system produce the
i consumer goods listed but also produces capital goods like machinery, heavy trucks, and
i
i
engineers and doctors to pet sitters and cleaning crews. The scale of it all boggles the
: mind when one considers that none of this production is planned by any government
department, but is instead left to the individual decisions of millions of customers and
Demand thousands of firms.4 The price in each of these disparate markets is developed by the
same forces of supply and demand that determined the price of hotdogs in our example.
In each case, excess demand and excess supply eliminate themselves as the market price
rises or falls as needed until every market moves toward and reaches its equilibrium.
o
4 See the essay "l, Pencil" by Leonard Read in the Coda of this textbook. A short video version of this
essay carl be viewed at httos://~,~a~..l~utube.comA~rach?~'=l]'03tOODISE.
 Chapter #4 - Organizing Principles of Capitalist Systems

Chapter #4 - Organizing Principl~ of Capitalist Systems

As the quantity of hotdogs traded is increased from 150 up to 250, 350, and 450,
we still have both buyer and seller individually benefiting from trade, since the
Start by focusing on the "150°' hotdng u'aded" in this market. From Figure 4.7
wil ngnass to pay by additional consumers (illustrated by the height of the demand
below we see that the buyer of thls unit (who we will identify as Charles) has a buyer's
curve) is greater than costs of production for additional units (illustrated by the height of
reservation price of $7 and the seller of this unit (who we will identify as Daisy) has a
the supply curve). This is true for every single unit up to the 500th hotdog, where the
seller's reservation price of $3.20 (recall, buyer's reservation price is illustrated by the
height of the demand curve and seller's reservation price is illustrated by the height of the bargaining range is reduced to only the single price of $5. For the 500~ unit, voluntary
trade can take place at only the market clearing price of $5, a price at which both the
supply curve). The bargaining nmge consists of all prices between $3.20 and $7, since a
trade at any price between these extremes simultaneously makes both Charles and Daisy buyer and seller of the unit are indifferent between trading and not trading. In other
individually better off. In comparison to the bargaining range illustrated in Figure 4.2, words, the 500* consumer gets $5 of pleasure from consuming his hotdog, which costs
focusing on a specific unit in Figure 4.7 we effectively have the bargaining range set on exactly $5 to produce. When this unit is traded at the equilibrium price of $5, both buyer
its side and ~xranged vertically rather than horizontally. This view reveals how the and seller "break even" on the transaction.
demand curve and supply curve illustrate reservation prices for these two market For any unit beyond the 500th unit, buyer's reservation price is lass than seller's
participants, charles is hungry and wants a botdng, but could also go for a slice of pizza reservation price. Consequently, the bargaining range is empty in that it contains no
or a burrito. His maximum willingness to pay for a hotdng is $7. At any higher price, he prices (recall the final antique example in which Beth valued the chest as a potential
buys n different lunch. Daisy likes operating her hotdng cart but would be happy to buyer at only $200 while Andy valued the chest as a potential seller for $1,000).
switch to another line of work if it paid better. The lowest price at which she is willing to Consider the 1,400th unit in Figure 4.7. For this hotdog, the potential seller (who we will
produce and sell this hotdog is $3.20. At any lower price, she chooses to use her identify as Ethan) has a seller's reservation price of $7 and the potential buyer (who we
productive resources for a different purpose. As it turns out, the market price for hotdogs will identify as Francesca) has a buyer's reservation price of $2.40. By the time we
is currently $5, so both of them get a benefit from and are willing to voluntarily engage in
would get up to 1,400 units traded, costs of production for potential sellers become
this lransaction.3 relatively high while benefits for potential consumers become relatively low. Since the
buyer is not prepared to voluntarily pay any price that the seller would willingly accept,
the bargaining range is empty and no voluntary trade can take place. From this entire
Figure 4. 7-EqMlibrin~ Pric¢ and the Bargaining Range
discussion we can again see how in a flee market, trade will stabilize at a price of $5 with
$ 500 hotdogs purchased and 500 hotdogs sold.
Charles' Now imagine replicating this story for every kind of good available in a modern
/ b a r g a i n i n g r a n g e
reservation -.---> 7 ........................... Supply economy. There is a market for cars, houses, airplanes, clothes, restaurants, medical care,
price schools, books, and thousands of other items. Not only does the system produce the
consumer goods listed hut also produces capital goods like machinery, heavy trucks, and
5 l i l t . . . . . . . . . . . . . . . . II
factories. In addition, there are markets for all sorts of labor of different skills, from
I
Davy's engineers and doctors to pet sitters and cleaning crews. The scale of it all boggles the
,,
r~o-vat~--> 3.20' mind when one considers that none of this production is planned by any government
price 2.40" department, but is instead lefr to the individual decisions of millions of customers and
Demand thousands of firms.4 The price in each of these disparate markets is developed by the
same forces of supply and demand that determined the price of botdogs in our example.
In each case, excess demand and excess supply efiminate themselves as the market price
I I o rises or falls as needed until every market moves toward and reaches its equilibrium.
150 500 1,400

3The techmcal terms for the benefits tlmt market plu'ficipants gain from Wade are Cor~umer's Su~lus and
Producer's Smpins. A full description of these concepts is presented in Chapter 5.
, . ,, . ,
4 See the essaY'l,pancll byLconardRcadmtheCodanfthislextbook. Asbort video ve~ion of this
essay can be viewed at hfrt~;~/~-~r.~utubccom4~tch?r=lYO3tOoDISF,.
 Chapter #4 - Organizing Principles of Capitalist @stems
CHANGES IN MARKET CONDITONS OVER TIME
Recall that demand and supply were each defined by focusing on the relation
between price and quantity of a good, holding fixed all other factors. Over time, these
other factors can and will change, What precisely are these other factors and how will
changes in these other factors ultimately impact market equilibrium7
Determinants of and Changes in Demand
When first considering the demand for botdogs, it was noted that consumers'
purchasing decisions are influenced by many factors beyond the price of hotdogs, such as:
consumer income; consumer tastes and preferences; the price of botdog buns; the price of
hamburgers; and even the weather. A determinant of demand refers to any factor beyond
"own price" which has an impact on consumers' purchasing decisions for a good. When
there is a change in a determinant of demand, the entire demand relation (that is, the entire
relation betwean price of a good and quantity purchased of the good) changes. If a change
m a determinant of demand makes consumers more willing to purchase a good (in that
quantity demanded is greater at every price), we have an increase in demand. Visually,
this is illustrated by a rightward shift of the entire demand curve, as illustratod by the
change from Demand A to Demand B in Figure 4.8 below.
Figure 4.8 - Change in Demand
46 ..........
::
33 ......
' ~ ~ D c m a n d A D e m a n d B they enjoy drinking iced coffee, then this increased preference by consumers will
0
t
250 390
o decrease demand for cigarettes.
If instead a change in a determinant of demand makes consumers less willing to
purchase a good (in that quantity demanded is lower at every price), we have a decrease in
Chapter #4 - Organizing Principles of Capitalist Systems
demand. Visually, this is illustrated by a leftward shiR of the entire demand curve, as
illustrated by the change from Demand B to Demand A in Figure 4.8 above.
Any factor could conceivably be a determinant of demand, but for most goods the
most likely determinants are things such as other prices, income, consumer preferences,
size of market, and expectation of future price (for the good in question). To illustrate
these claims, recognize that the fullowing changes would be expected to result in an
increase in demand (changing the factor in the opposite direction would result in a decrease
in demand):
a decrease in the price ofa complement good A complement good refers to a good
that is typically consumed along with the good in question. More precisely, "good
x" is a complement to "good y" ira decrease in the price of"good y" results in an
increase in demand for "good x." For example, a decrease in the price of hotdogs
would lead to an increase in demand for hotdog buns, revealing that hotdog buns
are a complement to hotdogs.
an increase in the price of substitute good A substitute good refers to a good that
is typically consumed in place of the good in question. More precisely, "good x"
is a substitute for "good y" if an increase in the price of "good y" results in an
increase in demand for "good x." For example, an increase in the price of
hamburgers would lead to an increase in demand for hotdogs, revealing that
hotdogs are a substitute for hamburgers.
an increase in consumer income (for a normal ~,ood). A normal good is defined as
a good for which an increase in income leads to an increase in demand. As the
name would suggest, this is normally the case for most goods (i.e., most goods are
normal goods). For example, if an increase in income induces consumers to
purchase more Coca-Cola, then Coca-Cola is a normal good.
a_.decrease in consumer income (for an inferior good). An inferior good is defined
as a good for which a decrease in income leads to an increase in demand (or
similarly, an increase in income leads to a decrease in demand). For example, if an
increase in income induces consumers to switch consumption away from generic
cola toward increased consumption of Coca-Cola, then the gancric cola is an
inferior good.
an increased preference by consume~ Fundamental tastes and preferences are
critically important for consumption decisions. If tastes/preferences change, then
demand will change. For example, if over time more people come to fred out that
be reflected by an increase in demand. Conversely, if doctors were to identify an
additional previously unknown adverse health effect from smoking, this would
an increase in marl~ct si~,~ Insomuch as market demand is simply the "summation"
of individual consumer demand, demand for a good will increase as the size of the
market increases,
an expectation of hi~her future price (for the Rood in ouestion). For example, if
Something happens that makes consumers expect gasoline to cost $1 more
 Chapter #4 - Organizing Principles of Capitalist 5~ystems
tomorrow, demand for gasoline today will increase, To see why, recognize that
when specifying demand, it is necessary to define the market in terms of both
geographic boundaries and timeframe. For instance, when developing our botdng
example, we supposed that the values in Table 4.1 provided a "partial summary of
the relationship between the price ofhotdogs and the quantity demanded ofbotdngs
in Kennesaw. GA during Ihe first Monday in April." If we consider a good outside
of this definition, then we arc considering a good beyond the good in question. This
observation is really just a special case of the recognition that demand will increase
when there is an increase in the price of a substitute - after all, to a large degree a
really good substitute for buying gasoline tomorrow is to instead buy gasoline
today.
Determinants of and Changes in Supply
Similarly, when first discussing the supply of hotdogs, it was noted that firms'
production decisions are influenced by factors beyond the price of hotdogs, such as the
Price of factors of prodactian and the specifics of the available production technology. A
determinant of supply refers to any factor beyond "own price" which has an impact on
.
S eIlersI supply decisions for a good. When there is a change in a determinant of supply,
the entire supply relation (that is, the entire relation between price of a good and quantity
sold of the good) changes. Ifa change in a determinant of supply makes firms more willing
to sell a good (in that quantity supplied is greater at every price), we have an increase in
supply. Visually, this is illustrated by a rightward shift of the entire supply curve, as
illastntted by the change from Supply A to Supply B in Figure 4.9 below.
Figure 4.9- Change in SRpply
$ example, for any agricultural product the amount of output grown depends not only
Supply A
. . . . . . . . . . . . . . . . . . . . . .
17'--
I
o-- I
390 585
0
Chapter #4- Organizing Principles of Capitalist Systems
If instead a change in a determinant of supply makes firms less willing to sell a
good (in that quantity supplied is lower at every price), we have a decrease in supply. This
is illustrated by a leftward shift of the entire supply curve, such as the shift from Supply B
to Supply A in Figure 4.9 above.
Any factor could conceivably be a determinant of supply, but for goods produced
by finns looking to earn a profit, the most prominent determinants are things that influence
production costs, such as factor prices, changes in technology, and realizations of uneartain
events. Additionally, changes in market size and expectation of future price (for the good
in question) are also important. To illustrate these claims, recognize that the following
changes would be expected to result in an increase in supply (changing the factor in the
opposite direction would result in a decrease in supply):
a decrease in the cost of any factor of production needed to produce the good
Recall, from the Basic Circular Flow Diagram, that finns in a market economy
acquire factors of production by paying wages and rents. If the costs of hiring any
factor of production decreases (e.g., a decrease in the price of electricity), then
production costs decrease. Consequently, for any particular unit seller's reservation
price will be lower and more units of output will pass the "cost-benefit comparison"
at any price.
an improvement in technology that reduces production cost.~. Suppose a firm
develops a new technology that allows them to produce a greater quantity of output
with the same amount of inputs. As a result, the costs of producing any particular
unit will be lower, again leading to more units of output passing the "cost-benefit
comparison" at any price.
a favorable realization of uncertain event~. For many production processes the
relation between inputs and outputs is not entirely deterministic, but instead
depends at least in part upon the realization of uncertain events (or chance). For
upon the amounts of inputs (e.g., land, seeds, water, fertilizer) used but also upon
weather. When crops are planted the weather that will be realized during the
upcoming growing season could be viewed as uncertain or random. If the farmer
realizes a favorable outcome for this uncertain event (i.e., better than expectod
weather) then the quantity of output produced and ultimately supplied to market
will be greater than initially expected. If instead an unfavorable outcome is realized
(e.g., a severe frost in Florida that damages citrus fruit) then the quantity of output
produced and ultimately sent to market will be less than anticipated. Thus, supply
is greater when in
an tnerease a favorable realization
market size. of uncertain
Just as market demandevents transpires.
is simply the "summation" of
individual consumer demand, market supply is simply the "summation" of
individual firm supply. Thus, if market size were to increase (so that there arc more
potential sellers), then
an exoectation quantity
of lower supplied
future pricewould be ~ood
(for the greater
in at every price.
question). For example, if
something happens that makes sellers expect gasoline to sell for $1 less tomorrow,
supply of gasnline today will increase. This is because sellers would rather slightly
 Chapter #4 - Organizing Principles of Capitalist Systems
decrease the price of gasoline today in order to sell more, as opposed to waiting
until tomorrow and getting a full $1 less per gallon
Impact of a Change in Demand or Supply on Market Equilibrium
What happens to the market equilibrium if one of the underlying determinants of
demand or determinants of supply were to change? First consider a change in demand with
supply fixed, as illustrated in Figure 4.10 below.
Figure 4.10 - Impact of a Change in Demand on Market Equilibrium
..
26 .............
Demand B
~ ~ e m ~ a n d A 33 .................
I I
I
I
i Q
0
t
340 390
Supply is given by Supply A and does not change over the time under consideration.
If we initially have Demand A, then the initial market equilibrium is for 340 units to be
traded at a price of $26 each. Now suppose that there is an increase in demand, resulting
in Demand B (fi'om the perspective of determining the impact on market equilibrium, it
does not matter what caused this increase in demand - that is, it could be an increase in
income for a normal good, an increase in consumer preference for the good, an increase in
market size, or any other factor). With Demand B (and Supply A) the new market
equilibrium is for 390 units to be traded at a price of $33. This discussion illustrates the
more general insight that any increase in demand (with supply fixed) will result in an
increase in equilibrium price and an increase in equilibrium quantity.
Figure 4.10 also illustrates how the equilibrium would change for a decrease in
demand (with supply fixed). If we initially had Demand B, the initial market equilibrium
is for 390 units to be traded at a price of $33 each. If we then have a decrease in demand
to Demand A, the new equilibrium is for 340 units to be traded at a price of $26 each. This
illustra.tes the moregeneral result that any decrease in demand (with supply fixed) will
result m a decrease m both equilibrium price and equilibrium quantity.
Chapter #4 - Organizing Principles of Capitalist Systems
Next consider a change in supply with demand fixed, as illustrated in Figure 4.11
below. Demand is given by Demand B and does not change over the time under
consideration. If we initially have Supply A, then the initial market equilibrium is for 390
units to be traded at a price of $33 each. Now suppose that there is an increase in supply,
leading to Supply B (from the perspective of determining the impact on market
equilibrium, it does not matter what caused this increase in supply - that is, it could be a
decrease in the price of a factor of production, a cost reducing improvement in technology,
an increase in market size, or any other factor). With Supply B (and Demand B) the new
market equilibrium is for 525 units to be traded at a price of $26. This illustrates the more
general insight that any increase in supply (with demand fixed) will result in a decrease in
equilibrium price and an increase in equilibrium quantity.
Figure 4.11 - Impact of a Change in Supply on Market Equilibrium
Supply A
I I
I I
o- 1 !
0 340 390
Figure 4.11 also illustrates how the equilibrium would change for a decrease in
supply (with demand fixed). If we initially had Supply B, the initial market equilibrium is
for 525 units to be traded at a price of $26 each. If we then realize a decrease in supply to
Supply A, the new equilibrium is for 390 units to be traded at a price of $33 each. This
demonstrates the general outcome that any decrease in supply (with demand fixed) will
increase equilibrium price and decrease equilibrium quantity.
Finally recognize what needs to be done - or more precisely, what does not need to
be done- in order to reach the new market equilibrium al~er a change in demand or supply.
Nothing needs to be done! Any change to either supply or demand within a market sets
offprice changes that bring about a new equilibrium consistent with these new conditions.
To reach the new market equilibrium we do not need a government agency to dictate or
mandate the new price and level of trade. Rather, we can simply sit back and let market
 Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

decrease the price of gasoline today in order to sell more, as opposed to waiting
until tomorrow and getting a full $1 less per gallon.
Impact of a Change in Demand or Supply on Market Equilibrium
What happens to the market equilibrium if one of the underlying determinants of
demand or determinants of supply were to change? First consider a change in demand with
supply fixed, as inustrated in Figure 4.10 below.
Figure 4,10- Impact of u Change in Demand on Market Equilibrium
Next consider a change in supply with demand fixed, as illustrated in Figure 4.11
below Demand is given by Demand B and does not change over the time under
consideration. If we initially have Supply A, then the initial market equilibrium is for 390
units to be Waded at a price of $33 each. Now suppose that there is an increase in supply,
leading to Supply B (from the perspective of determining the impact on market
equilibrium, it does not matter what caused this increase in supply - that is, it could be a
decrease in the price eta factor of production, a cost reducing improvement in technology,
an increase in market size, or any other factor). With Supply B (and Demand B) the new
market equilibrium is for 525 units to be Waded at a price of $26. This illuslratcs the more
general insight that any increase in supply (with demand fixed) will result in a decrease in
equilibrium price and an increase in equilibrium quantity.

Figure 4.11 - Impact of a Change in Supply on Market Equilibrium

s \ s.upply A
2 6 . . . . . . . . . . . . .
/ S upplyg
Demand B
~ ~ ~ m ~ n d A

0
)
I
)
I
I 3:+:-:_:::-----:-::-__
I
0 340
? 39O ~ D e m a n d B
I I
I I
Supply is given by Supply A and does not change over the time under consideration.
If we initially have Demand A, then the initial market equilibrium is for 340 units to be
o 1 !
traded at a price of $26 each. Now suppose that there is an increase in demand, resulting
in Demand B (from the perspective of determining the impact on market equilibrium, it 340 390
does not matter what caused this increase in demand - that is, it could be an increase in
raceme for a normal good, an increase in consumer preference for the good, an increase in Figure 4.11 also illustrates how the equilibrium would change for a decrease in
market size, or any other factor). With Demand B (and Supply A) the new market supply (with demand fixed). If we initially had Supply B, the initial market equilibrium is
equilibrium is for 390 units to be Waded at a price of $33. This discussion illustrates the for 525 units to be Waded at a price of $26 each. If we then realize a decrease in supply to
more general insight that any increase in demand (with supply fixed) Supply A, the new equilibrium is for 390 units to be traded at a price of $33 each. This
demonstrates the general outcome that my decrease in supply (with demand fixed) will
incraase in eqnilibriumprice
Figure and anhow
4.10 also illustrates increase in equilibrium
the equilibrium wouldquantity,
changewill
for result in an in
a decrease . , . ,
mcr~so equthbnum price and decrease equilibrium qu-mtity.
demand (with supply fixed). If we initially had Demand B, the initial market equilibrium
is for 390 units to be waded at a price of $33 each. If we then have a decrease in demand Finally recognize what needs to be done - or more vr~eisely, what does nat need to
to Demand A, the new equilibrium is for 340 units to be traded at a price of $26 each. This !no.er.toaohthenewarotequilbriume'aohanoinde
~,uun~ notes to I~ done) An,, ~, ........ g mand or supply
illustrates the more general result that any decrease in demand (with supply fixed) will # ~+,-,~= to etmer supply or demand within a market sets
offprice changes that bring about a new equilibrium consistent with these new conditions.
result in a decrease in both equilibrium price and equilibrium quantity.

Tor~:~hth~::::nn~carekoet aequ!!!,briu~n"
r ~ ~,u L~v~£ o[ ffaoe. we do notwe
Kamer, need
canasunply
government agency
sit back and to
letdictate
marketor
 Chapter #4 - Organizing Principles of Capitalist Systems
forces (i.e., the self-interest of buyers and sellers) guide us to the new equilibrium outcome.
For example, again suppose that we initially have Supply B and Demand B as illustrated
in Figure 4.11. In this market, the initial equilibrium is for 525 units to be traded at a price
of $26 each. If supply were to decrease to Supply A we now have excess demand (of
185=525-340 units) at a price of $26. As previously discussed, this excess demand puts
upward pressure on price. The market price naturally adjusts upward until the market
reaches its new equilibrium price of $33, for which a market clearing quantity of 390 units
are traded.
THE ENTREPRENEUR'S ROLE IN MARKET SYSTEMS
The analysis thus far of the Capitalist system has focused heavily on the behavior
oftbe Economic Man in both households and firms. But, in many respects, the single most
Important driver of the capitalist process is the entrepreneur (or the business owner or
capitalist). The entrepreneur is the person who starts a company, manages it, searches for
markets, and absorbs the risks of the venture. Not every entrepreneur or capitalist does
every one of these things. For instance, an entrepreneur can buy an already existing
business or hire someone to run the venture on her behalf. If our entrepreneur is good at
these tasks and makes good decisions, enormous profits are possible, but if not, losses and
banlm~tcy lurk around the next comer. The remainder nfthe present discussion highlights
the important roles of the entrepreneur and of profit/luss in the free market, Capitalist
system.
Examples of Entrepreneurial Success
Most ongoing firms make a proilt, and some of their profits are enormous!
Consider Steve Jobs, co-foundar of Apple who started his company in his parent's garage
in 1976 when he was 20 years old. He sold his Volkswagen bus and his business partner,
Steve Wozniak, sold his Hewlett-Paakard calculator to raise the $1,350 needed to get
started. The ups and downs of Jobs' career were staggering, but the end result was a
company that grew from only $3 million in sales in 1977 to sales of $182 billion and profits
of $39.5 billion in 2014! Jobs was estimated to be worth $10.2 billion when he died of
pancreatic cancer in 2011.s
There are many ¢mreprenenrs, like Steve Jobs, that have successfully founded large
companies that are now household names. In the late 19~ century and early 20~ century
entrepreneurs - such as Andrew Carnegie (U.S. Steel), Walter Chrysler (Chrysler
Corporation), John Deere (John Deere and Company), Harvey Firestone (Firestone Tire
and Rubber Company), Henry Ford (Ford Motor Company), John D. Rockefeller (Standard
Oil Company), and Cornelius Vanderbilt (U.S. Central Railroad) - built America's heavy
industry. Closer to our own time we have, in addition to Steve Jobs (Apple), Arthur Blank,
Pat Farrah, and Bernie Marcus (Home Depot), Truetr Cathy (Chick-ill-A), Sergey Brin and
$ Sec. ~
SteveJobs. AnExa'aordmaryCareer',intheon.linemagazineEntrepreneur:
~ p r e n e u r. c o m / a r t i d ¢ / 1 9 7 , $ 3 8
Chapter #4 - Organizing Principles of Capitalist Systems
Larry Page (Google), Jeff Bezos (Amazon), Sam Walton (Walmart), Dave Thomas
(Weedy's), and Michael Coles (Great American Cookie Company).
Of course, not all entrepreneurs are successful (and very few achieve the level of
success of those mentioned above) However, starting a successful business is a dream that
many have achieved. Right here in Kermesaw we have one of our favorite success stories:
Rey Regalado, who escaped from Cuba in 1990, came to the U.S., and eventually founded
a Cuban restaurant in Atlanta named Papi's.6 Today he is the proud owner of six locations
(one on Chastain Road). While he is not yet as rich or well known as some, we should not
count him out!
Examples of Entrepreneurial Failure
But not all stories of entrepreneurs and companies have happy endings. What
happens when you run into real problems like Smith Corona (a typewriter manufacturer),
Blackberry (an initial leading producer of early smartpbones), or Kodak (a fiLm based
camera company)? Each of these companies were at one time well known, well respected
brands with cutting edge products, millions of dollars in revenues, high profits, and many
satisfied customers.
Unfortunately for Smith Corona, IBM and Apple created personal computers that
were affordable for small businesses and households. This technological leap was great
for society as a whole, but devastated the market for typewriters. As people abandoned
typewriters for computers they took their money with them, and sales revenues for Smith
Corona plummeted. The firm tried to adjust to this new competitive reality but ultimately
failed and went bankrupt.
Blackberry, once one of the most successful cell-phone manufacturers in the world,
also ran into the buzz-saw known as Apple. When the iPhone was first introduced in 2007
it took the world by storm, selling about 500,000 units in one weekend (well in excess of
the 200,000 units initially anticipated).7 While Blackberry's sales continued to rise for a
time due to an exploding market for phones, by 2011 sales revenue peaked at $19.9 Billion
and then fell to $1.3 Billion by 2017.s While the company has not gone out of business at
the time of this writing, its demise is openly contemplated by many.
In January of 2012 Kodak, a major American corporation for 131 years, filed for
chapter 11 bankruptcy protection with about $6.8 billion in debt and only $5.1 biUion in
assets. The company survives as a much diminished entity with only $2 billion in sales
today, compared to $19 billion in 1990. Digital cameras and technology have taken their
toll on this once proud company and its chemical based film business.9
s For It brief histury of Pitpi's see: I~ttp://na*av.paoiserill.com/Historv.html.
7 "Piper JItffray: 500,000 [Phones sold over the weekend," hnp:/hin~3v.cnet.com/newx/piper-iaffraT.500000.
i°hones'solcl'ovCr-the- ~ekend/
s See the bar chart following Blackberry's revenue from 2004 to 2017 at:
ht~19:/At~l~v~st~tis~a~m/s~ati~6cs/2~624~/t,~-tVv~mte-~-rim-sinc~-2~.
,
See the dtseusston of Kodak s bleak future in the New York Times arhcle,
. , , At Kodak, Clinging to a
Future Beyond Film," hnp://www`nvtimes.c~n~l,~/~3/2-2/business/tmk~dak-c~in~'in~-t~-a-hm~re-be~nd
 Chapter #4 - Organizing Principles of Capitalist Systems
T H E R O L E O F P R O F I T A N D L O S S I N A C A P I TA L I S T S Y S T E M
Entrepreneurs are continually guided by profits and losses. As illustrated above, if
you make the right product at the right price there are enormous possible rewards. Profits
and losses also discipline owners to keep a sharp eye out for inefficiencies in their
businesses, implement cost saving improvements in production methods, and modify
existing products (or create new products) to better meet consumers' preferences.
Profits lure new firms into producing goods that people desire. But, as we saw in
Table 4.3 ("outcome (C)"), profit is not guaranteed. If you either produce the wrong
product or produce the right product in a costly way or charge too high of a price, you can
lose big. As you might imagine, no entrepreneur is presently investing in typewriters, film
cameras, or phones with keyboards, and this is a good thing Losses push investment out
of losing industries producing goods that people do not want and toward businesses that
produce goods that people do want. Capitalism is a profit and loss system for a reason.
The reason that both profit and loss exist in capitalism is due to the legal structure
of capitalist firms. All finns are organized in such a way as to make the owner a residual
claimant. This means that the owner may not pay himself until all other contractual
claimants are satisfied. The owner must first pay workers, suppliers, landlords, and
lenders, before paying himself. If, afier all bills are paid, there is money left over a profit
is declared and the owner gets to keep all of it. If, however, there is a loss, the owner most
absorb all of it as well. He may not tell the workers and suppliers that he is taking his
money out first and the workers and suppliers have to "cough-up" enough money to cover
the losses. This residual claimant status is not a punishment for owners; rather it is the
logical corollary to the fact that the owner has the righl of control,l0 In the following
example the logic of this legal connection between ownership, control, and the residual
status of profits (and losses) will be made clear.
Consider Janice, the owner of a small consU'uction company with 3 employees. She
contracts vath a homeowner to install a wood deck for a pnce of $10,000 with an estimated
cost of $8,000 and estimated profit of $2,000. Assume Janiee is not very competent and
forgets to order the lumber in time when her workers get to the job site Time is lost making
an emergency trip to the lumber yard. She also reads the plans backwards and the deck is
angled incorrectly under her directions. Naturally, the homeowner demands that the deck
be dismantled and instal ed correctly. This drives up the costs of the deck to $11,000 when
it Finally gets completed. Can Janice legitimately take $2,000 out oftbe $10,000 check
from the homeowner for herself and then tell her three workers that they need to come up
with the other $3,000 to cover all of the mistakes? Clearly not. It is her company and she
has the right of controL All mistakes are her problem since none of the workers has the
right to overrule any of her decisions. To now impose the losses caused by her mistakes
on them would clearly violate any of justice. The business owner legitimately
" O " . ll.orm$
th sl°ssandtheworkerslegtttmatelyowntheiragreeduponhourlypaydespitethe
lussWnS
lo Resall the discussion of the three distinct dimensions of property rl hts in Cha
g pter 3.
Chapter #4 - Organizing Principles of Capitalist Systems
Conversely, what if Janice is highly competent and organized? She orders all
materials in a timely fashion, directs her workers properly, and motivates them to work
hard and efficiently. On top of everything else, she comes up with a unique design for the
deck that uses much less labor than competing contractors use. Because of this she gets
the deck built for $7,000 and the homeowner is thrilled with the result. Who should
legitimately get to keep the $3,000 left over after all bills for wages and materials are paid;
Janice or her workers7 In this case justice requires that Janice legitimately "owns" all of
this profit while her workers get only their contractual hourly pay.
From this simple example we have an economic theory of profit and loss and can
explain their function within a capitalist system. The legal and moral theory of rightful
ownership and the control that ownership implies puts the burden of successful operation
of the finn squarely on the owner. Mistakes and bad decisions cannot be shifted onto others
or their consequences ducked. Simultaneously, good business decisions flow through the
organization and straight into the profits of the owner who had control. This powerfully
concentrates the energies of the capitalist/entrepreneur on the tasks that we previously
identified: finding new markets, innovating new products and methods of production,
maintaining tight discipline and motivation in the workplace, and a myriad of other things
that must be done to make a successful organization. Competent owners get rewarded with
profits and incompetent ones get punished with losses.
Bankruptcy and Subsidy within Capitalism
What happens to businesses that fail? Bankruptcy broadly describes a legal
process for an entity (person or business) that cannot honor the repayment of debts owed
to others. For a finn, it is the final stage where failed businesses go to die, be dismembered,
and have their parts parceled out to new rightful owners. Bankruptcy is triggered when a
finn owes more money to creditors than it has in assets, and therefore has a negative net
worth. Both current and future expected losses convince a bankruptcy court judge that a
company is a failure. Since the firm is losing money and getting deeper into debt on a
continual basis, there is no way that all contractual obligations taken on by the owner can
be satisfied. Once a bankruptcy petition is filed and settled through the courts, a judge
will direct that all assets of the finn be seized and sold. Whatever funds are received from
the sale are distributed to the creditors based on legal priority - back wages and taxes first,
secured creditors next, and finally unsecured creditors." If unything is left over after this
process, the initial owner gets the residual. In the vast majority of cases the money runs
out before all creditors are paid and therefore the owner gets nothing. The company is then
S ecured ered' tots have a 'diR, ct egal claim to a particular piece of property. For example, a home Ioan or
car loan has specific identifiable propen)' that can be sold. All of the proceeds of the sale of the house or
car go to pay the secured creditor. An unsecured creditur has no particular identified piece of property, but
only a general fight to be repaid by the business owner. A credit card company would fall into this
category. After you buy a meal with your credit card there is no identifiable property for the credit card
company to seize if you do not make your payments. Similarly, a student loan is unsecured credit, since
the lender cannot "take back your education/degree" ifyou fail to repay the debt. All other factors equal,
mtarast rates set m free markets must be higher for unsecured debt then for secured debt.
 Chapter #4 - Organizing Principles of Capitalist Systems
disbanded and the inventory, machinery, and buildings end up in the hands of other
entrepreneurs who use these assets in other businesses.
While this process is a painful one to go through, it could actually be viewed as one
of the greatest attributes of the capitalist system. One of the most difficult things for both
individuals and institutions to do in any society is to admit failure, cut short the resulting
losses, and move on to other activities. Bankruptcy can be thought of as a "recycling"
program for business assets by accomplishing three main tasks:
I. it stimulates entrepreneurs to find profitable things to do with their assets so
that they do not end up in Bankruptcy court to begin with,
2, it removes failed antrepreneurs frnm tbe contrnl of valuable assets, and
3. it puts the assets of failed fu'ms into the hands of successful entrepreneurs who
can find a beneficial use for the assets of the failed company.
Subsidy for Firms
For government owned firms in a socialist system (and, to a large degree,
govamment subsidized firms in a mixed economy) the threat of bankruptcy is weak or non
exnstent. A subsidy is a payment by a government to an individual or firm to reduce the
pttrehase price of a good or costs of production. For example, many governments subsidize
individuals by providing access to housing, student loans, or hcalthcare at below market
prices. Governments also regularly subsidize government enterprises such as the Postal
Service or MARTA. While these types of payments can cause some degree of contrnversy,
none generates more concern than the subsidy of privately-owned, for-profit firms in a
capitalist system.
Subsidy of a privately-owned firm violates the basic morals and principles of the
capitalist system. As we saw in both this chapter and Chapter 3, ownership is not only
about the rights of the capitalist to own, control, and profit from his property, but also the
responsibility to use it wisely and also bear the consequences of loss and failure. Neither
Janice (the construction company owner in our example) nor Michael Dell (the founder
and major owner of Dell Computer) has the moral or legal right under capitalism to push
off their losses onto others while keeping any profits for themselves. The owner must be
the residual claimant. He or she gets to keep the profits if there are any, but also absorb
the losses when they occur. If the losses are large enough, bankruptcy ensues, and
ownership an.d control are stripped away legally and turned over to others legitimately.
Subsndies, however, are mvnluntary transfers of income and wealth from one group
of people (usually taxpayers) to another. When the Uan.ffers are to low income students or
poor senior citizens you may be able to make a moral argument for doing so. But if the
U'ansfers are to wealthy capitalists who are simply trying to increase profits or avoid
bankruptcy, the argument is significantly more difficult to make on moral grounds.
Capitalism as a system does not try to justify these transfers and instead condemns them.
Pmpenents of government subsidies within the mixed capitalist system often justify
.transfers to firms based on the impact that a bankruptcy would have on workers and others
m society.
Chapter #4 - Organizing Principles of Capitalist Systems
Consider the workers in Janice's construction company. What if the losses were
big enough to force Janice to declare bankruptcy and shutdown? The workers would be
laid-off and become unemployed. In that example the numbers are small and we can
quickly and easily absorb the workers into new eonstsuction companies. But what about
the Smith Corona and Kodak bankruptcies? What would happen if Blackberry goes under?
In these cases thousands of workers were or would be affected. What is the moral and
practical thing to do in these cases?
It is clear that government can prevent bankruptcy through subsidies to failing
firms. Both Smith Corona and Kodak could have kept their thousands of workers on the
payroll if taxpayers were willing to pay billions to keep the finns afloat. But, this requires
taxpayers to surrender their wealth and income involuntarily to accomplish this goal. It
also reduces incentives for firms to keep costs low and to devote resources to the production
of goods that are most valued by consumers. This conflict in moral principles that we first
discussed in Chapter 3 has both a capitalist answer and a socialist answer. We take up the
capitalist answer next and defer the socialist response to Chapter 6, where that system is
discussed in greater detail.
Creative Destruction in the Capitalist System
In pure capitalism the moral principles underlying the system clearly point away
from subsidizing fu'ms, since doing so requires involuntary transfers of income and wealth.
In "Capitalism, Socialism, and Democracy," Joseph Schumpeter makes an additional,
practical argument for bankruptcy which he coins "Creative Destruction.''t2 He wrote:
"The opening up of new markets, foreign or domestic, and the
organizational development from the craf~ shop to such concerns as U.S.
Steel illustrate the same process of industrial mutation -- ifl may use that
biological term -- that incessantly revolutionizes the economic structure
from within, incessantly destroying the old one, incessantly creating a new
one. This process of Creative Destruction is the essential fact about
capitalism." (p. 83)
He made the practical point that no new innovation can take place without
simultaneously destroying some already existing firm or industry. Consider the example
of the desk-top computer revolution kicked off by the inventions of IBM and Apple. While
most people naturally focus on the wonderful new gadgets of the computer age, we must
also recognize that they came at a huge price for the folks who owned or worked for Smith
Corona, When computers were adopted en masse by consumers, both the consumers and
the computer makers benefited enormously. Clearly, however, this invention necessarily
spelled the death of the typewriter industz'y, But given the present capabilities of
nz See Scharapeter, Joseph A, Capitalism. Socialism. and Democrat.. 3d ed. 1942. New York: Harper end
Bmthe~ 1950,
 Chapter #4 - Organizing Principle~ of Capitalist Systems
Chapter #4 - Organizing Principles of Capitalist Systems

computers, nobody would begin to argue that it would make sense to have typewriter firms path of entrepreneurs the economy stagnates and the very people they are trying to help are
continue producing their vintage products. harmed in the long-run. If they do not do enough to shelter people from the short-term
So, how can we get the typewriter firms to stop producing these now obsolete hardships of capitalism, people may turn to other systems, thereby destroying the capitalist
products? Capitalism has an obvious answer. When consumers move their purchases to system itself.
computers, revenue and profits decline, and losses ensue, in the typewriter industry. If the
losses continue too long, and the firms do not transition to some different productive
activity, they go bankrupt. The bankruptcy system dismembers the typewriter firms and CONCLUSION
sells offtheir inventory, factories, offices, and machinery to others. Some of these capital
goods will find new uses by other entrepreneurs, but some of it will have to be scrapped. In this chapter we developed and analyzed the model of Supply and Demand to
Of course, innocent workers will he laid-off nod their lives disrupted. Some may have to illustrate how the free interaction between self-interested buyers and sellers results in an
sell their homes and move to areas where firms are hiring. While most will find new equilibrium. The equilibrium price and quantity makes every market participant better off
employment (perhaps in a different sector after rcttalning) some will have to take a pay cut since the resulting transactions are voluntary and take place between two people who gain
or retire earlier than desired. Small towns or entire regions may be devastated, some never from the exchange. The market only produces goods that consumers value at more than
tO r~cov~r.13 the costs of production. Finns strive to produce goods that people value - and avoid
This process has happened many times throughout history in capitalist societies. producing goods that people do not value - precisely because it is in their self-interest to
Ford's invention of the assembly line supercharged the auto industry, but destroyed the do so. After all, it is very difficult to make a profit on goods that people won't buy! The
horse and buggy industry. Tens of thousands of blacksmiths, harness makers, horse firms discover what people value by observing their purchasing decisions and the prices
breeders, buggy whip makers, and others were ruined. The invention of the mechanical
they are willing to pay. This process, repeated in countless markets, leads to an efficient
cotton picker by IntematiunaI Harvester destroyed the livelihood of millions of
economy that satisfies most people's wants at the lowest possible cost.
sharecroppers and migrant farm workers in the south after WW-IIJ4 The invention of the
What we have essentially described is a laissez faiee environment in which
automated telephone switch caused the layoffs of switchboard operators, the invention of
interactions between economic decision makers are not influenced by government
the automated teller machine (ATM) displaced bank tellers, and the invention of the
automated elevator led to layoffs of elevator operators. regulations, restrictions, mandates, taxes, or subsidies. In such a setting, government plays
a limited economic role of defining and enforcing property rights and contracts, and then
In each case cited above, a new invention or process leads to gains for one group
leaves people alone to do as they please)s
but causes losses for another group. Schumpeter celebrated this "churn" in the marketplace
and claimed that it was one of capitalism's greatest accomplishments. He believed that This broad description of the benefits of the market process are of course idealized.
non-capitalist societies would stagnate since they had no inherent mechanisms to
encourage the emergence of new firms, to remove outdated firms, and to continually
r?Pati:,Ty2sT,execntioismofthismodelboththefneoofcapim
reallocate workers (and other productive resources) to their most productive uses. He
believed that since capitalism and its entrepreneurs were so dynamic, workers laid off in
one industry would find employment in new industries. However, he also recognized that
the disruption caused by this constant "churn" would lead many in the capitalist system to
turn against it as people voted for government to protect them. How governments handle
this problem is crucial for the success of society. If they put too many roadblocks in the

o For example, in the Istc lS00s and early Ig00s, Scranton, PA was a wealthy, booming metropolis heavily
dependent upon the extraction ofanthracite coal. According to the 1900 census it was the 381 most
populous city in the U.S., having more people than Atlanta and roughly the same population as Los
Angeles. The population of Scranton, PA peaked in 1930 at 143,433. When oil and natural gas replaced
coal as widely used heating fuel post WW-tt, the fortunes and population of Scranton declined. By 2010
its population was only 76,089, making it the 420~ most populous city in the couna'y. These days, many
people outside of the northeast only Imow of the city as the home of the fictional company"Dander
Mifflin" from the sitcom "The Office."
]( It is estimated that each I-H cotton picker replaced 80 workers leading to n decline of21% of the rural
b~ck ttP°wpo//latl°n ~.theSeuth betwcen 1940 and 1950 as these work= moved to fectory job~ in the North
"~""~'t'~,uvmemstorvtorm.ore/formineintheSOs/machines I.~-ht,,,I for more in formation -'-" is The French words laiss~faire can be translated as "let (the people) do (as they choose)."
 Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

7. Consider an item for which Amy has a reservation price as a seller of $25 and
CHAPTER #4 MULTIPLE CHOICE QUESTIONS
Benny has a reservation price as a buyer of $45. Which of the following prices is
Which of the following could NOT result in a "Change in Supply" for "MP3 inside their bargaining range?
Players"? A. $20.
A. An improvement in the technology used to produce MP3 Players. B . $35.
B, A decrease in the number ofsallers of MP3 Players. C . $70.
C. An increase in the market price of MP3 Players. D . More than one (perhaps all) of the above answers is correct.
D . A decrease in the price of plastic (an input used in the production of MP3
Players). 8. "Good X" is a substitute for "Good Y." Consequently, if the price of"Good Y"
were to increase, then for "Good X" equilibrium price would ~ and
refers to an asset that is socially and legally accepted as a medium equilibrium quantity would __
of exchange. A. increase; increase.
A . Money B. increase; decrease.
B . Profit C. decrease; increase.
C . The bargaining range D. decrease; decrease.
D . Demand
9. refers to someone who undertakes and oversees a business
Demand venture.
A. refers to the entire relationship between the price of a good and the number of A. An Invisible Hand
units that people are willing and able to purchase, all other factors fixed. B. An Entrepreneur
B. refers to the amount of a good that consumers buy at the equilibrium price. C. A Central Planner
C. provides a summary of the behavior of both buyers and sellers in a market. D. A Social Surplus
D. More than one (perhaps all) of the above answers is correct.
10. Between July 2017 and July 2018 there was a decrease in both price and quantity
Which markets are represented in the Basic Circular Flow Diagram? traded of corn. This change in market equilibrium outcome would result from
A. Markets for "Imports and Exports" and markets for "Factors of Production." A. an increase in Demand.
B. Markets for "Goods and Services" and markets for "Factors of Prodoctian." B. a decrease in Demand.
C . Markets for "Goods and Services" and markets for "Financial Assets." C. an increase in Supply.
D . Markets for "Financial Assets" and markets for "Im arts and Ex arts"
P P D. a decrease in Supply.

A situation in which the sum nfgains and losses over all people is positive in value 11. Which of the following demonstrates the "Law of Demand"?.
is defined as a
A. After Clarissa got a raise at work, she bought more donuts at a price of $8.00
A. win-win outcome.
per dozen than she did before her raise.
B. win-lose outcome.
B. After the price of flour increased by 8%, Sabrina chose to sell fewer donuts.
C. negative-sum environment.
C. Melissa would choose to sell more donuts at $7.50 per dozen than at $6.25 per
D. positive-sum environment.
dozen.
D. Joan would choose to buy fewer donuts at $10.00 per dozen than at $8.50 per
In a free market, the equilibrium quantity nf Wade and equilibrium price of a good
are determined by dozen.
A. the interaction of both self-interested buyers and self-interested sellers in the
12. An increase in income will result in a decrease in demand for
marketplace.
B. only the buyers in the market. A. a normal good
C. only the sellers in the market. B. an inferior good
D. neither buyers nor sellers, but rather by a government bureaucrat. C, a substitUte good
D. a complementary good
 Chapter #4 - Organizing Principles of Capitalist Systems Chapter #4 - Organizing Principles of Capitalist Systems

13. Consider an outcome in which Joe gains $30, Kevin gains $20, and Nick loses $40.
Based upon this alone information, it appears as if this is a
A. win-win outcome in s positive-sum environment.
B. win-win outcome in a negative-sum environment.
C. win-lose outcome in a zero-sum environment.
D. win-inse outcome in a positive-sum environment.
14. "Voluntary Trade" generally
A. makes both parties to the trade worse off.
B. makes both parties to the trade better off.
C. makes buyers better off, but sellers worse off.
D. makes sellers better off, but buyers worse off.
15. A "seller's reservation price"
A. refers to the maximum dollar amount a buyer is willing to pay for an item.
B. refers to the minimum dollar amount a seller is willing to accept in exchange
for an item.
C. is visually illustrated by the height of the supply curve.
19. Jamal owns a popular food truck which he operates near campus. Last week he
earned revenues of $3,500 and incurred costs of $2,500. Based upon these
numbers, it follows that his profit was
A. -$1,000 (i.e., negative $1,000)
B. $1,000
C. $3,000
D. $6,000
20. According to the theory of capitalism, in a "free market economy" profits
A. refer to the "gain" that a buyer gets from purchasing a good/service.
B. serve as a "signaling device," directing resources to their most valued uses.
C. are only earned by finns who exploit workers.
D. More than one (perhaps all) of the above answers is correct.
For questions 21 and 22, refer to the graph below. This graph illustrates the supply
and demand ~or shirts in 2018.
313 ce

D. More than one (perhaps all) of the above answers is correct. Supply 2018

16. Economic Man (aka, homo economicus) is

A. neither rational nor seff-interasted.
B. both rational and self-interested.
C. rational, but not self-interested.
D. self-interested, but not rational.

17. The Basic Circular Flow Diagram builds upon the Preliminary Circular Flow ......
Diagram by
A. deleting the illustration of the role played by fu'ms in the economy.
B. adding an illustration of the movement of money between households and
1525-4- i ~ ~ ~ ~"" Demand 20t8
finns, which facilitates the voluntary transfer of economic resources.
C. adding an illustration of how equilibrium price and quantity arc each
determined in a market.
01 i0
I i 925 1,750 2,580
D . adding an illustration of the role of government in collecting taxes from firms 21. In equilibrium shirts will be traded, each at a price of
and households. A. 925; $15.25.-'-~-~
B. 925; $35.50.
18.
On January 29, 2018, the NBA's L.A. Clippers and De~-oit Pistons agreed to a trade C. 1,750; $25.00.
involving six players (including superstar Blake Griffin) and two drat~ picks. Since
D. 2,580; $35.50.
this voluntary trade took place, we can infer that
A. the L.A. Clippers thought the trade was in the best interest of their team.
22. In this market there would be at a price of $20.00.
B. the Detroit Pistons thought the trade was not in the best interest of their team.
A. excess supply
C. neither team thought the trade was in their own best interest, but league
B. excess demand
commissioner Adam Silver thought it was in the best interest of the NBA.
C. neither excess demand nor excess supply.
D. None oftbe above answers are correct.
D. both excess demand and excess supply.
Chapter #4- Organizing Principles of Capitalist Systems

Surplus, Efficiency, and

Deadweight Loss
In Chapter 4, we saw how the interaction between buyers and sellers in a free,
unfettered market resulted in a unique equilibrium outcome. This equilibrium is
characterized first and foremost by an equilibrium quantity and an equilibrium price.
These values represent the number of units of the good traded and the price at which
trade takes place. We now examine this equilibrium more closely to determine the
impact of this outcome on the well-being of different people in society.
Consider the market for used economics textbooks, supposing that Supply and
Demand are as illustrated in Figure 5.1. Applying the insights from the discussion of
market equilibrium from Chapter 4, we can readily see that in this market 720 textbooks
will be traded, each at a price of $58. Within this chapter, we will see how to eonstruct
measures of the benefits of trade, allowing us to answer questions such as:
How much does a buyer in this market gain from purchasing a textbook?
How much does a seller in this market gain from selling a textbook?
In total, how much do buyers collectively and sellers collectively gain from
the trade which takes place in this market?
In total, how much does society as a whole gain from the trade which takes
place in this market?

B U Y E R ' S R E S E R VAT I O N P R I C E A N D
S E L L E R ' S R E S E R VAT I O N P R I C E

To answer the questions posed above, we will rely heavily on the previously
defined euncepts of "buyer's reservation price" and "seller's reservation price." Recall
that a buyer's reservation price for an item refers to the maximum amount of money
that he is willing to give up to acquire the item. This value, denoted by rb, reflects the
monetary value that a buyer places on the item.
Suppose your reservation price as a potential buyer of a used textbook is r6 = 50.
If you were given a choice between having either $64 or the book, you would pick the
$64 (at~er all, since r~ = 50 you value the book at $50, whereas you value $64 at $64).
Similarly, if you were given a choice between having either $38 or the book, you would
pick the book (again, you value the book at $50, while you value $38 at $38). If you go
to the bookstore and the book is selling for $64, you would not buy it, whereas if the
 Chapter #5 - Surplus, Efficiency, and Deadweight Loss
book is selling for $38 you would buy it. More generally, if textbooks are selling for
$p, then you (as a rational, self-interested consumer) would buy the book if and only if
rb > p. This condition is quite intuitive: in a free market yon will choose to buy an item
if and only if the value you place on the item is greater than the price you have to pay for
the item.
Also recall that a seller's reservation price for an item refers to the minimum
amount of money that she is willing to accept in exchange for the item. This value,
denoted r,, again reflects the monetary value that a seller pieces on the item.
Now suppose that it is the end of the semester and your reservation price as a
potential seller of a used textbook is r~ = 32. If you are given a choice between getting
$26 versus keeping the used textbook, you would keep the textbook (after all, since
r, = 32 you value the book at $32, whereas you value $26 at $26). Keeping the textbook
Is your better choice, since you would not want to give up something that you value in
excess of $26 in exchange for something that you value at $26. If instead you were given
a choice between getting $38 versus keeping the used textbook, you would part with the
book (again, you value the book at $32, which is now less than the amount of money you
are receiving in exchange for it). In general, if a buyer offers to pay $ p for an item, then
you (as a rational, self-interested seller) will accept the money in exchange for the item if
and only if p > r,. This condition is quite intuitive: in a free market you will choose to
sell an item if and only if the price yon will receive for the item is greater than the value
you place on the item.
It is worth noting a similarity between the two general conditions just derived. A
buyer will purchase an item if and only if rb > p, while a seller will sell an item if and
only if p > rs. Recognize, when trade takes place in a market, each patty is giving
something up in exchange for something else (recall the "Basic Circular Flow Diagram"
presented in Chapter 4). The buyer is giving up $ p in exchange for an item that he
values at $rb, while the seller is giving up an item that she values at $r, in exchange for
$ p . Thus, each condition states that an individual will want to trade if the item received
is more highly valued than the item given up.
For both buyers and sellers, the reservation price represents a cut-off price above
and below which behavior in the marketplace differs. Recall the notion of consumer
sovereignty discussed in Chapter 3 which essentially noted that in a free market the
individual consumer ultimately has the choice to either buy or not buy a good. All that is
being argued here is that the consumer can use this notion of reservation price as the basis
for making this choice. When a buyer goes out into the marketplace and exercises his
sovereignty he will choose to purchase those items (and only those items) for which the
market price is below his reservation price. Similarly, a seller will choose to sell those
items (and only those items) for which the market price is above her reservation price.
To use these notions of reservation prices to derive measures of benefits from
trade it is necessary to have a proper understanding of what they truly measure. Focusing
Chapter #5 - Surplus, Efficiency, and Deadweight Loss
on a buyer's reservation price rb, recall that this value reveals the individual's maximum
willingness to pay to acquire the item under consideration. The actual value of a
consumer's reservation price potentially depends upon many factors, such as product
characteristics, consumer income, and prices of substitutes or complements. But, it does
not depend upon the price at which the item is being sold. Do not incorrectly confuse a
buyer's reservation price with "an offer to pay" or a "starting point for bargaining."
Instead, properly recognize that this value is truly (by definition) the maximum
willingness to pay to acquire the item. Suppose rb = 50. If the buyer has the option to
buy the item for p = 50.00, then he should do so. If instead price were p = 50.01, then
he should not make the purchase because now the price is above what the item is worth to
him.
You can think of a buyer's reservation price as being a cut-offvalue that he would
want to state to someone that he is sending to the marketplace on his behalf, without any
knowledge of what the selling price of the item actually is. For example, at the start of
the semester you need a textbook for your economics class, but you have to work so you
cannot go to the bookstore today. Your roommate is going to the bookstore and offers to
buy your economics textbook (so long as you pay for it later). Without knowledge of
what the actual selling price is, you want to state a cut-off price instructing your
roommate to buy the economics book if and only if selling price is below a certain
amount. The best you can do is to state your true buyer's reservation price as this cut-off:
if your tnJe maximum willingness to pay is rb = 50, then state $50 as your cut-off.
To see if $50 is indeed the true value of your reservation price, think about how
you would respond if your roommate came home and said, "I didn't buy the book for you
because the price was $50.01." If your true reservation price is r~ = 50, then you might
have some disappointment in not getting your book, but you should not regret your
roommate's decision to not make the purchase for $50. If instead you are actually upset
with your roommate's decision to not make the purchase for $50, then what this reveals is
that your true reservation price is in fact some amount greater than $50.
As noted in Chapter 4, the value of buyer's reservation price is equal to the height
of the demand curve, and the value of seller's reservation is equal to the height of the
supply curve. To see this, again consider the demand and supply curves illustrated in
Figure 5.1. Focusing on the demand curve, recognize that at a price of $75 quantity
demanded is 460 units. Recall that by the Law of Demand (discussed in Chapter 4),
quantity demanded is lower at higher prices. This implies that at a price of $75.01,
quantity demanded is less than 460. Concentrating on the behavior of the individual who
would buy the 460~ unit, we see that at a price of $75.01 he does not purchase the item,
whereas at a price of $75 he does purchase the item. As a consequence, this reveals that
his reservation price is exactly equal to $75. But recognize that $75 is exactly equal to
the height of the demand curve at the 460~ unit. This argument could be repeated
anywhere along the demand curve to see that the height of the demand curve at any
arbitrarily chosen quantity is exactly equal to and directly reveals the value of the
reservation price of the consumer of the unit under consideration (e.g., the consumer of
 Chapter #5 - Surplus, Efficiency, and Deadweight Loss Chapter #5- Surplus, Efficiency, and Deadweight Loss

the 720~ unit has a reservation price of $58; the consumer of the 1,055~ unit has a Consider a good traded at a price of p, for which the buyer has a reservation
reservation price of $44). price of r~ and the seller has a reservation price of r,. When the buyer gives up $ p for

Figure 5.1 - Demand umi Supplj, in the market for used textbooks an item that he values at rb, his Consumer's Surplus from this trade is CS =rb -p.
When the seller gives up an item that she values at r, in exchange for S p, her
Producer's Surplus from this trade is PS = p - rj.
Supply
Given the information conveyed by the demand curve and supply curve, it is
straightforward to graphically illustrate and conceptually determine the magnitudes of
these gains. Figure 5.2 replicates the demand curve and supply curve from Figure 5.1
with the aim of illustrating the Consumer's Surplus and Producer's Surplus that would be
75- generated from trading the 460th textbook at a price of p = 58. Recall, the buyer of this
I unit has a reservation price of r~ = 75, while the seller of this unit has a reservation price
58-
f
44- of r, = 44. Numerically, it immediately follows that the buyer of this item would realize
a gain of CS = 75 - 58 = 17 from making his purchase, while the seller of the item would
mand realize a gain of PS = 58-44 = 14 from making her sale. These values provide the
t
, [
t
answers to the first and second questions posed at the start of this chapter.

i I quantity
Figure 5.2 - Surplus from trading the 460t* textbook at a price of $58
460 720 945 1,055
$

Similar logic can be applied along the supply curve to see why the height of the
Supply
supply curve at any arbitrarily chosen quantity is exactly equal to and directly reveals the
value of the reservation price of the seller of the unit under consideration. Thus, the
seller of the 460s unit has a reservation price of $44, the seller of the 720~ unit has a
reservation price of $58, and the seller of the 9456~ unit has a reservation price of $75.

p =58 ........ =p----><._

BENEFTITS FROM TRADING ONE SINGLE UNIT OF A GOOD

Recall the first and second of the four questions posed at the start of this chapter:
"How much does a buyer in this market gain from purchasing a textbook?" and "How
much does a seller in th/s market gain from selling a textbook?." At the most basic level, L~[' ps = 58_ 44 = 14 ~'" Demand
market participants (i.e., buyers and sellers) make trades, giving up one thing of value in V
0 quantity
exchange for something else of value. The net gain or net surplus from such a trade is
I
naturally measured by the value of the item that is acqui~d minus the value for the item
that is relinquished. Consumer's Surplus is a measure of the net gain that a buyer 0 :
460
realizes from making a purchase, equal to the difference between his reservation price for
the item and the price he actually pays for the item. Producer's Surplus is a measure of From Figure 5.2, we can easily see how these gains can be illustrated graphically.
the net gain that a seller realizes from making a sale, equal to the difference between the The value of Consumer's Surplus is essentially equal to the vertical distance between the
price she actually receives for the item and her reservation price for the item. demand curve and transaction price at this unit. Similarly, the value of Producer's

Chapter #5 -Surplus, Efficiency, and Deadweight Loss
Surplus is essentially equal to the vortical distance between the transaction price and the
supply curve at this unit.)
Next, recognize how these notions of Consumer's Surplus and Producer's Surplus
can be used to construct a measure of the benefits to society from this trade. Define
Social Surplus as a measure of the net gains to society from a trade, equal to the
summation of the individual gains (or losses) from the trade over all members of society.
That is, in general, the Social Surplus from a trade will be equal to the Consumer's
Surplus, plus the Producer's Surplus, plus any other net gains or net losses realized by
people other than the buyer or seller of the good.
In many cases, the only people significantly impacted by a trade are the buyer and
the seller. Assuming that this is the case, it follows that the benefits to society from
having this trade take place are equal to the sum of Consumer's Surplus and Producer's
Surplus. As a result, Social Surplus is equal to Consumer's Surplus plus Producer's
Surplus.2 Again consider the trade of a textbook that a buyer values at re = 75 and a
seller values at r, = 44, at a price of p = 58. As noted above, CS = 75 - 58 = 17 and
PS=58-44=14. Thus, SS=17+14=31.
More generally, recognize that Social Surplus is:
$ S = C S + P S = ( r, - p ) + ( p - r, ) = r, - p + p - r. = r, - r, .
The social gains from trading an item are equal to the difference between the buyer's
reservation price for the item and the seller's reservation price for the item. This general
recognition, that SS -- rb - rs, leads to several important and intuitive insights.
First, the gains to society from a trade ate equal to the difference between the
buyer's value for the item and the seller's value for the item. At the most basic level, a
trade involves ownership of a good. service, or resource being transferred from one
person to another) This transfer generates a gain for the person getting the item and a
loss for the person relinquishing the item. More precisely, the buyer acquires something
that he values at re, while the seller gives up something that she values at r,. As a result,
i More precisely, think of Cortsumer's Surplus as being equal to the area of a rectangle with a base of 1
and a height of re - p, and think ofPrnducer's Smplus as being equal to the area of a rectangle with base
of I and height of p - ra. In each case the base of l represents the "one unit of the good" that we are
focosing co. Since the asea °f a re~tangin is "base tirnea height,- the asea of the former rectangle is
rb - p, while the area of the latter ~'tangle is p - rs.
2 The assumption tha nobody beyond the buyer and the seller is signifieandy tmpacled by the trade is not
alwa~ satisfied. For example, consider a good which generatea a substantial amount of polindon, thereby
tmposmg a oust on someone other than the buyer or seller. In the pre~nce of asch an external effect (in
this example, negative externality), the concept of Sociui Surplus as defined here is still valid (and
actually quite importsnt), but Social Surplus is not simply equal to the sum of Consumer's Surplus and
Producer's Sts, plus. For the prnscot discussion, focus on situations in which Social Surplus is equal to the
sum of Consumer) s Smplus and Producer , s Surplus. An analysts
. of markets in which such external effects
ase prese:rtt
3 Recall theisdiscussion
discussed in
ofChepter
the right10.
to transfer ownership of property in Chapter 3.
Chapter #5 - Surplus, Efficiency, and Deadweight Loss
the net benefit of this transfer is r~ - r,, which is exactly equal to the expression for
Social Surplus derived above. So, for our running example, we could directly calculate
the value of Social Surplus (from re = 75 and r, = 44 ) as SS = 75 - 44 = 31.
Second, the price at which trade takes place completely drops out of the
expression for Social Surplus. As long as no third party is confiscating a portion of the
transaction price (i.e., so long as the amount of money paid by the buyer is exactly equal
to the amount of money received by the seller), then this transfer of money has no impact
whatsoever on Social Surplus. To see why, recognize that this transfer generates a gain
for the person receiving the money and a loss for the person relinquishing the money -
the seller receives Sp, while the buyer gives up Sp. But, the combined effect of this
transfer of money is the difference between the gain to the seller and the loss to the
buyer: p - p = 0. Regardless of the price at which the transaction takes place, the
transaction price completely drops out of the expression for Social Surplus.
To emphasize this point, consider a trade that takes place at a price of $ p, and
suppose that the transaction price had instead been $1 higher. How would the welfare of
the buyer, the seller, and society differ as a result of this higher transaction price? The
seller would be $1 better off (i.e., PS = p-r, would be $1 larger), while the buyer
would be $1 worse off (i.e., CS = re - p would be $1 smaller). As price is increased,
any gain for the seller is a direct loss for the buyer (and similarly, if price were decreased,
any gain for the buyer is a direct loss for the seller). As a consequence, Social Surplus
(which is here defined as the sum of Consumer's Surplus and Producer's Surplus) does
not change as price is varied. However, while the value of Social Surplus does not
depend upon transaction price, it is clear that transaction price is of critical importance
for determining how these social gains are split between buyer and seller. With re = 75
and r, = 44, if price had been p = 59 instead of p = 58, then we would still have
SS=75-44=31. But now CS=75-59=16 (instead of CS=75-58=17) and
PS = 59 -44 = 15 (instead of PS = 58 -44 = 14).
Third, considering all units that could conceptually be traded, there are some units
for which trade would generate a positive Social Surplus and other units for which trade
would generate a negative Social Surplus. More precisely, since SS = re - r,, trading a
unit generates a positive Social Surplus if re > r, but generates a negative Social Surplus
if re < r,. Again focusing on the fundamental aspect of trade (as a transfer of ownership
from one person to another), these conditions are quite intuitive. A trade generates a
positive gain for society if and only if the person getting the item has a higher value for
the item than the person giving up the item. If re > r, (i.e., the potential buyer values the
ittem the
more thanofthe
hands thepotential seller),isthen
buyer (which taking the
essentially item
what away
trade from the seller
accomplishes) and placing
generates a
positive Social Surplus. If instead re < r, (i.e., the potential buyer values the item less
than the potential seller), then taking the item away from the seller and placing it in the
 Chapter #5 - Surplus, Efficiency, and Deadweight Loss Chapter #5 - Surplus, Efficiency, and Deadweight Loss

hands of the buyer (which. gain, is what trade accomplishes) generates a negative Social Finally, Total Social Surplus is generally illustrated by the area below the demand
Surplus. Again, as an example, trading an item for which rs = 75 and r, = 44 generates curve but above the supply curve, up to the realized level of trade. Focusing on Figure
positive Social Surplus. If we instead focus on an item for which rb = 50 and r, = 70 5.3, at the equilibrium outcome this corresponds to "areas (a)+(b)+(c)+(d)+(e)+(f)." This
area can be thought of as the vertical distance between demand and supply, added up over
(i.e., an item for which buyer's reservation price is less than seller's reservation price),
all units traded.
trading this item would generate negative Social Surplus.
Fourth, Social Surplus can be graphically illustrated by the vertical distance
between the demand curve and the supply curve at the unit being traded. This is again
direct consequence of the fact that Social Surplus is equal to the sum of Consumer's Figure 5.3 - Total Consumers' Surplus, Total Producers" Surplus, and Total Social
Surplus and Producer's Surplus. Focusing on the 460th unit illustrated in Figure 5.2, the Surplus
$
height of the demand curve is r~ = 75, while the height of the supply curve is r, = 44.
Thus, we yet again have that Social Surplus is equal to SS = 75 - 44 = 31.

B E N E F T I T S F R O M T R A D I N G M U LT I P L E U N I T S O F A G O O D
Recall the third and fourth questions posed at the start of this chapter: "In total, 7 5 . . . . . . . . .
how much do buyers collectively and sellers collectively gain from the trade which takes
place in this market?" and "In total, how much does society as a whole gain from the
trade which takes place in this market?" The concepts developed thus far can easily be -
4 4 " ~
extended to the entire market, in order to answer these questions. 5 8 ~ u p p l y
' ~ D c m a n d
Let Total Consumers' Surplus refer to measure of the total gains from trade
re.altzed by all consumers, defined as each individual's Consumer's Surplus, added over
all units purchased. Similarly, let Total Producers' Surplus refer to a measure of the 0 [ quantity
total gains from trade realized by all sellers, defined as each individual's Producer's
Surplus, added over all units sold. Recognize that Total Consumers' Surplus is equal to
0 460 720 945
the difference between buyer's reservation price and actual price paid, added over all
units purchased, while Total Producers' Surplus is equal to the difference between actual
These measures provide the answers to the third and fourth questions posed at the
price received and seller's reservation price, added over all units sold. Finally, let Total
start of this chapter. At the equilibrium outcome, for example, buyers collectively gain
Social Surplus refer to a measure of the total gains fi'om trade realized by society,
an amount equal to "areas (a)+(b)+(e)," sellers collectively gain an amount equal to
defined as Social Surplus, added over all units traded.
"areas (c)+(d)+(f)," and therefore society gains an amount equal to "me, us
Each of these three market level concepts can be illustrated graphically by again
playing offof the demand curve and supply curve. Focus on Figure 5.3, which depicts (a)+(b)+(c)+(d)+(e)+(f).'~ Recognize how equilibrium price essentially splits Total
the same market as in Figures 5.1 and 5.2. Suppose that the market realizes the Social Surplus into a portion that goes to buyers (Total Consumers' Surplus) and a
equilibrium outcome, with 720 units ~'aded, each at price of $58. Total Consumers' portion that goes to sellers (Total Producers' Surplus).
Surplus is generally illustrated by the area below the demand curve but above rice u to
the realized quantity of trade. At the equiHbrinm outcome illustrated in Fi~u~ 5 3, Pis
corresponds to "areas (a)+(b)+(e)." This is essentially the vertical distance between MAXIMUM POSSIBLE BENEFTITS FROM TRADING A GOOD
demand and transaction price, added up over all units purchased.
Similarly, Total Producers' Surplus is generally illustrated by the area below price We can think of market equilibrium as providing description or prediction of the
but above the supply curve, up to the realized quantity of trade. For the market in Figure outcome that arises in free market when buyers and sellers interact with each other. For
5.3, at the equilibrium outcome this is equal to "areas (c)+(d)+(f)." Again, recognize that
this is basically the vertical distance between transaction price and the supply curve,
added up over all units sold. (W hen measuring the impact of a Wade on society, we define society as all of the people impacted by a
transaction. As already noted, for the majority of cases, that is only the buyers and sellers themselves.
Thus, Social Surplus, the benefit to society, is simply the sum of gains to buyers and gains to sellers.

Chapter #5 - Surplus, F~eieacy. and Deadweight Loss
the market illustrated in Figure 5.3, we would expect 720 units to be traded, each at a
price of $58. Further, we just noted that this would result in buyers collectively gaining
"are.as (a)+(b)+(e)," sellers collectively gaining "areas (c)+(d)+(0," and society
collectively gaining *'areas (a)+(b)+(c)+(d)~e)+(f)." Recalling the distinction from
Chapter l, recognize that these are positive (as opposed to normative) observations.
The equilibrium outcome is what we expect to arise. But, is it a good or desirable
outcome? To begin to even address this normative issue, we need to impose some value
judgments. The accepted approach is to suppose that society aims to maximize Total
Social Smphis.5 Under this assumption, we will attempt to identify the efficient level of
trade - that is, the level of trade which maximizes Total Social Surplus. After
identifying this ideal level of trade, we will try to see how the equilibrium level of trade
and efficient level of trade compare to each other.
Before undertaking this exercise, it is important to pause and recognize that the
socially best level of trade (i.e., production/consumption) for any good is finite. This is a
result of the fact that productive resources are scarce, thereby implying that tredanffs
exist in regards to levels of production of different goods. Thus, when thinking about the
level of lxade that would maximize Total Social Surplus, we do not want to fall prey to
the open-ended fallacy. The opon..ended fallacy is a logical error whereby someone
mcorreeily concludes that simply because there are benefits (to some people) from higher
levels of an activity, that more of the activity is always better.
It is especially important to be cognizant of this common analytical mistake when
considering pubfic policy (for which trying to maximize Total Social Surplus seems like
a particularly reasonable objective). But, as will be apparent from the discussion below,
any attempt to manipulate the realized level of Total Social Surplus can only be done by
altering the level of trade in a market, implying that it becomes necessary to ultimately
choose a level of trade (i.e., identify some level as the ideal or best level of trade).
For example, consider the choice of frequency of a precautionary medical
procedure. In November 2009, the U.S. Preventative Services Task Force of the
Deparlment of Health and Human Services (hereafter DHHS) issued revised guidelines
regarding the regularity with which women should get mammograms to detect breast
cancer. The existing guidelines advised all women over the age of 40 to undergo a
mammogram annually. The revised guideline suggested that women over the age of .50
should get a mammogxam every other year, while women below age 50 need not get
mammograms at all.6 Why would a division of the DHHS suggest that women get
mammograms less frequently? Is this possibly good medical or good economic advice?
s Stamng
, st an outcome for which Total Socla Surplus is not maximized, it would always be po~ible to
realize different outcome (pedmps includln~ tnmsfer ~ts ~'-- ~-
..,~.:.l. _.__~_ , . o
..... ©~ryvc~y ~s at ,east as well off(and some people~ . -are
; ~ . ,s~octly
. u v m ~better
e s e g nof/)
l c n tuothey
l s o c iwere~ the
ctv to a n o tinitial"
h e r ' l a"t
outcome. Because of this, Total Social Suqflus maximi~t/on is an accepted pflmary goal for s~.iet-/.
, , see "A Breast Cancer Preview"
5 F or further du~slon,
(~IP://°nlin~
Health Cam~t~i.co.m/arlicle/SBIO00142405.~748704~043045745437212536887~O
I~tlomng Behind New Mmnmography Recommendations" h '~) and "Critics See
(]ffllJ'/At~,~¢ff~rn~t~.cont/tmliticM200~/l I/[7/cHties-health-carc-rationin~-ne~breast.can~cr.~¢reenino
rct'oramendatio~"
Chapter #S - Surplus, Efficienc); and Deadweight Loss
Presumably, more frequent mammograms would increase the likelihood of early
detection of breast cancer, thereby providing a substantial benefit to the individual getting
the test. But, more mammograms arc cosily, in that to provide more mammograms
society must divert productive resources away from other medical procedures (or some
other good or service). As an illustration, suppose the cost of providing a mammogram
to a 40 year old woman is funded by reducing screening for cervical cancer. It may turn
out to be that the number of women saved by early mammograms is more than offset by
the increased number of deaths due to less screening for cervical cancer - but perhaps it
is not. An economist would address this question by applying the principles of costs and
benefits that have been discussed throughout this text.
If we simply said, "More frequent mammograms provide benefits to women by
reducing breast cancer death rates; therefore, all women should get mammograms on a
regular basis," we would be falling victim to the open-ended fallacy. Total Social
Smphis is not maximized by engaging in all activities for which benefits are positive.
Rather, to maximize Total Social Surplus we must appropriately compare and balance the
additional benefits for society against the additional costs for society of the activity under
consideration (exactly as suggested by the Cost-Benefit Principle in Chapter 1). To
thoughtfully assess the economic implications of the proposed DHHS guidelines, we
would need to compare the benefits of more frequent mammograms to the associated
costs (again, many of the costs stem from diverting productive resources away from other
valued uses). If we are currently starting at a point where some mammograms are
provided for which benefits are less than costs, then Total Social Surplus could possibly
be increased by providing fewer mummograms.
We now return attention to the previous framework (and the market presented in
Figure 5.3) to see how to conceptually proceed with an identification of the socially best
level of trade. When determining the benefits from trading any single unit of good it was
noted that trading a unit generates a positive Social Surplus if rb > r, while tyading a
unit instead generates a negative Social Surplus if rb < r,. So, to maximize Total Social
Surplus, we need to do two things: (i) make sum we trade all units for which rb > r, and
(ii) make sure we do not trade any units for which rb < r, 7 Inspection of Figure 5.3
reveals the implicatiuns of following these two pieces of advice. First, we need to make
sum we trade every unit up to the 720~ unit, since for each such unit rb > r, (recall,
resecvatiun values are revealed by the heights of the demand and supply curves). Second,
we need to make sure that we do not U'ade any unit beyond the 720a= unit, since for each
such unit r, < r,. Thus, the efficient (or Total Social Surplus maximizing) level of trade
is 720 units,s Trading exactly this quantity makes Total Social Surplus as large as
possible, in Figure 5.3 generating collective gains for the members of society equal to
"areas (a)+(b)+(c)+(d)+(e)+(f)."
7 A ' . . . ,
, R~vgn~e
S~- ,t~up~
tmutha!
what
nobedy
we Dave
be.yeed
do~e
thet~
buyer
an appticatio~
or seller ts significantly
of the general
impacted
~ for by
graphically
the trade.applying the
Cost-Benefit Principle, as discussed in Chapter I.
 Chapter #5 - Surplus, E~cieney, and Deadweight Loss Chapter #5 - Surplus, E.~ciency, and Deadweight Loss

Any other level of I~'ade, either less than or greater than 720 units, would result in
a lower realized value of Total Social Surplus. Define Deadweight Loss as the
difference between maximum possible Total Social Surplus and realized Total Social
Surplus. By construction, Deadweight Loss is zero at the efficient level of trade.
Further, Deadweight Loss is positive at any other level of trade. Deadweight Loss
provides a measure of the loss to society from realizing a level of trade other than the
efficient level. Such a loss is present if society makes either one of two different types of
mistakes, either: (i) they do not produce all units which generate a positive gain for
society or (ii) they do produce some units which generate a negative gain for society.
In the market illustrated in Figure 5.3, first suppose that unly 460 units were
traded. By trading 460 units, this society realizes gains equal to "areas (a)+Co)+(c)+(d),"
which corresponds to the area below the demand curve but above the supply curve, added
up over these 460 units. Since the maximum possible Total Social Surphis is equal to
"areas (a)+(b)+(c)+(d)+(e)+(f)," it follows that Deadweight Loss (i.e., the difference
between maximum possible Total Social Surplus and realized Total Social Surplus) is:
DWL¢oo = (a+b+c+d+e+ f)-(a+b+c+d)= e+ f .
The Deadweight Loss (of "areas (e)~f)") results from society trading too few units.
More precisely, while they do realize the positive gains from u'ading each of the first 460
units, they do not realize the potential positive gains from trading the units between the
461~ and 720~ units. That is, society is failing to maximize Total Social Surplus, since it
is making the mistake of not trading all units for which rb > r,.
Now suppose 945 units were traded. In this case, society realizes all of the
potential positive gains from trading each of the fu'st 720 units. But, trading each of the
final 225 units (between the 721a and 945~ unit) decreases Total Social Surplus (since
SS = rb - r, is negative for each such unit). In total, wade of these final 225 units
decreases Total Social Surplus by "area (g)." Thus, with 945 units traded, realized Social
Surplus is "areas (a)+(b)+(c)+(d)+(e)+(f)-(g),,, so that Deadweight Loss is:
was discussed in Chapter 3. The individual motives of self-interested buyers and self-
interested sellers induce the market participants to Wade exactly those units (and only
those units) for which social gains from Wade are positive. Thus, when individuals act in
their own self-interest, they collectively behave in a way so as to make Total Social
Surplus as large as possible. As a result, Total Social Surplus is maximized at the
equilibrium outcome. Further, so long as this is true, it follows that any government
policy which alters the level of wade will create a positive Deadweight Loss.
The observation that the equilibrium outcome is efficient is quite intuitive. A
voluntary trade between a buyer and seller can benefit both parties if and only if the wade
itself generates a positive surplus. In the present context, for this to be true, it must be
that the buyer places a greater value on the item than the seller. Buyers and sellers in
markets are self-interested. In a free, unfettered market, market forces (i.e., the rational
pursuit of self-interest) induce buyers and sellers to wade all units for which there is a
positive gain to be had. When nobody beyond buyer or seller is impacted by the Wade,
this prompts buyers and sellers to trade all units (and only those units) for which Social
Surplus is positive, thereby maximizing Total Social Surplus. This is because such trades
ultimately result in the item ending up in the hands of the person who values if most
highly, which is exactly what efficiency requires.

DWL~s =(a+b+c+d+e+ f)-(a+b+c+d+e+ f_g)=g

Recognize that even though the consumers of these final 225 units benefit from having
these items, producing and consuming these units decreases Total Social Smplus. This is
because the cost of these units is in excess of the benefits of these units (reflecting the
fact that in order to produce these items, society has to in essence give up some other
good of even greater value). Thus, society is failing to maximize Total Social Surphis,
since it is making the mistake of trading some units for which rb < r,.
Finally, recognize that the equilibrium level of trade and efficient level of trade
coincide with each other- the free market equilibrium level of wade is the efficient level
of wade? This observation iIInswates Adam Smith's notion of the Invisible Hand, which

9M ore prettily, the free marke~ level of trade is efficient, so long as certain conditions are reeL As noted,
t~ ~u~%~n~ ~u~d ~ that nobody beyond buyer or seller is significantly impacted by
m which the flee market
~" ' ac
outcome
Pr"~enco
~ Inefficient
o[soco externm
and ~m'a,2terlzed
effects can
by lead
positive
to "nmrket
Deadweight
fntlure-
Loss).
(i.e..
Such
a aituntion provision of public goods (i.e., goods that are "non-excludable" and "non-rival in consumption." such as
market failure can tlso arise as result ofpriclng by firms with substantial monopoly power or market national defense). A full treatment of these topics is beyond the scope of the present discussion, but is
discussed more fully in Chapter 10.
 Chapter #~ - Surplus. E~clency, and Deadweight Loss Chapter #5 - Surplus, Efficiency, and Deadweight Loss

4. "Deadweight Loss" refers to

C H A P T E R # 5 M U LT I P L E C H O I C E Q U E S T I O N S
A. the burden that consumers incur from having to pay for goods, instead of
I. Ty owns a copy of the book "Sapiens" autographed by the author Yuval Noah getting them for free.
Harari. His reservation price as a seller of this item is $45. Ed's reservation price B. the negative impact of industrial production on our environmental resources.
as a buyer of this item is $5. If thls unit was traded (i.e., transferred from Ty to Ed) C. the difference between "maximum possible Total Social Surplus" and
A. Social Surplus would be decreased by $40. "realized Total Social Surplus."
B. Social Surplus would be increased by $25. D. the profits that firms make in a free market economy.
C. Social Surplus would be increased by $40.
D. Social Surplus would be increased by $50. 5. refers to the logical error whereby someone incorrectly
concludes that simply because there are benefits (to some people) from higher
For questions 2 and 3, refer to the graph below. This graph illustrates the supply and levels of an activity, that more of the activity is always better.
demand for huts in 201& A. The Invisible Hand
B. The Economic Calculation Problem
~rice
C . The Open-Ended Fallacy
D . Deadweight Loss

6. Dave bought 10 comic books from Eric. This trade gave Eric a Producer's Surplus
of $20 and generated a Social Surplus of $36. It follows that Dave realized a
from this trade.
A. negative Consumer's Surplus
B. Consumer's Surplusof$16
18.10
1 -. 9 5 ~ u p p l y 2 0 1 8 C. Consumer's Surplus of $56
D. None of the above answers are correct.
5.00

0
~ I
Demand 2018
quantity
7. If the efficient level of trade is 6,400 units, Deadweight Loss would be positive if

A. 0.
units were traded.
I
3,350 6,625 9,275 B. 3,250.
In equilibrium C. 9,125.
D. More than one (perhaps all) of the above answers is correct.
A. both Total Producers' Surplus and Total Consumers' Surplus are zero.
B . Total Consumers' Surplus is equal to "areas a+b+e" and Total Producers
8. The market equilibrium price
Sin]flus is equal to "areas c+d+f."
C . To t a l C o n s u mrs 'Surplus Is
" equal to ,,area a and Total Producers Surplus is A, prevents the efficient quantity of trade from arising.
equal to "areas b+c+d." B. determines the split of total gains from trade between buyers and sellers at the
D . Total Consumers' Surplus is equal to "areas a+b+c" and Total Producers' market outcome.
Surplus is equal to "area d." C. determines if Deadweight Loss is positive or negative at the market outcome.
D. None of the above answers are correct.
If3,350 units were traded, Deadweight Loss would be
A. negative. 9, In most markets Total Social Surplus is equal to
,t
B. equal to "areag." A , Total Consumers Surplus" plus "Total Producers' Surplus."
C. equal to"areas e+f." B. "Total Consumers' Surplus' minus "Total Producers' Surplus."
D. equal to "areas g+h." C. "Total Benefit to Buyers" minus "Total Amount Paid by Buyers."
D . Equ' hbnum
' ' 1
Price muinphed by' Equd . .bnum
. Quantity.
Chapter #5 - Surplus, Efficiency, and Deadweight Loss

Organizing Principles of
Socialist Systems
In Chapter 4 we examined the economic principles that underlay a competitive free-
market system, commonly called Capitalism. In this chapter we examine the principles
that underlay a centrally planned command system, commonly called Socialism (or
Communism). After you have read these chapters you should have a good understanding
of the two polar opposite systems that societies choose from when constructing their
economies, as well as the compromises that have been tried in the Socialist world.
In this chapter we focus mainly on the fully centrally planned command system
since it makes no concessions to Capitalism or its foundations of private property and
individual control of resources. The main emphasis is on understanding the system at a
purely theoretical level with some attention paid to the practical realities of historically
existing Socialist societies. Even though there have been other societies governed by
Socialist principles, we primarily examine the methods and achievements of the former
Soviet Union. This focus on the Soviet Union is justified by the fact that it was the first
socialist society and was instrumental in either the formation or mentoring of most of the
other experiments in Socialism that have come about.

T H E E S TA B L I S H M E N T O F S O C I A L I S M I N T H E S O V I E T U N I O N

The Russian Revolution, which began the transformation of Russia from a semi-
feudal societyI into a socialist one, occurred in 1917 during the political chaos and
disintegration surrounOing the disastrous impact of ftghting WW-I. The Bolshevik faction
among the socialists, while nowhere near a majority of those opposing the Czar (or king of
Russia), were well organized and took advantage of the weakness and disorganization of
other groups to gain control of the Russian government. After gaining control of the
political system the Bolsheviks went to work changing the economic system.2
The fu'st economic system implemented by the new communist government is
known as War Communism, which was imposed during the Russian Civil War and lasted
from 1918 to 1921. This economic system included nationalization of all industry, forced
or obligatory labor duty, requisition of agricultural commodities, banning of private
enterprise, and other forms of direct government control over society and its productive

I8
2 ee page 44 mChapter 3 for further detail. The Russian serfs were formally freed in 1861
~tr~a .~. l~opL New York. y Daniel Pipes (1990),

Chapter #6 - Organizing Principles of Socialist Systems
resources. This period is generally glossed over in most discussions of the Soviet planned
economic system since it was imposed during an all-out civil war when most ordinary
economic processes had broken down. The main purpose of War Communism was to
support the Red Army in its battle with those forces resisting the communist takeover.
While it may be considered a success due to the military victory of the Bolsheviks, the
imposition of War Communism collapsed the economy.
The second economic system implemented by the Bolsheviks was the New
Economic Policy (NEP) which ran fi'om its inception in 1921 to its dissolution in 1928.
Vledimir Lenin, the leader of the Soviet Union at the time, recognized that War
Communism, while congruent with socialist principles of state ownership and
management, was "too-much too-soon" for Russia to absorb. His NEP was a partial
repudiation of strict Socialist principles and a reintroduction of some elements of
Capitalism into the system to help revive the economy. The new system was similar to the
mixed economy discussed in Chapter 3. Private individuals were permitted to own
property and operate small businesses and light industry. However, large scale industries
(the Commanding Heights), banks, and the foreign trade sector were still controlled by the
government. Farmers were permitted to own their own land and make their own decisions
on how to operate their farms. Forced grain requisitions without compensation, common
during the Civil War, were abolished and replaced by a tax.
This new policy was very successful as the private entrepreneurs and farmers
responded to the new incentives to produce. Production, which had fallen drastically
during the civil war, rebounded quickly with peasant output rising 40%. This new policy
not only increased output but also created a class of"NEP-men", the name given to the
entrepreneurs and businessmen that the NEP created. These small capitalists thrived in the
shortage conditions prevalent in Russia at this time and quickly gained higher incomes than
ordinary workers. This new class of business people and the system that caused them to
come into being generated a great deal of dismay among the leaders of the Communist
Party. The inconsistency of having a capitalist class - even one that was restricted to small
scale business, light industry, and farming - was in direct conflict with Socialist principles.
The NEP had to go, and Lenin's successor, Joseph Stalin, abolished it in 1928 to impose
full scale central planning and reintroduce complete state control of the production of goods
and services.3
When Stalin abofished the NEP in 1928 he introduced the first "5-Year Plan,"
which was the beginning of full central planning of the economy. We will devote the
majority of the rest of this chapter to understanding both the theory of central command
planning and the historical accomplishments achieved using this system in the Soviet
Union. This system was in place from the disbanding of the NEP in 1928 to the disbanding
of the U.S.S.R. in 1991.
~ R~9~7~" W. Service, A ti~story of Twemietk.Cemury Russia l'~ard Onivers -. D .........
Chapter #6 - Organizing Principles of Socialist Systems
ECONOMIC PLANNING IN THEORY AND PRACTICE
Now that the state owned all businesses it had to figure out what to do with them
and how to manage them. Starting in 1928 Stalin implemented the first of many successive
economic plans known as 5-Year plans. These 5-Year plans became the basis for all
economic directives from the central government to the government owned operating units
(collective farms, steel mills, chemical plants, factories, etc.) that in Capitalism would be
called businesses. In order to understand how a large country is managed in Socialism we
need to examine these economic plans in more detail.
C e n t r a l P l a n n i n g a n d t h e 5 - Ye a r P l a n
In a centrally planned economy a political authority at the "center" (Central
Committee or Politburo for the Soviet Union) would make the highest level decisions
about what should be done with the economic resources that society collectively owns (as
well as all other important government decisions). For instance, a decision must be made
regarding how much of society's resources should be put into the military for defense, into
health care, into consumer goods, into education, and so forth. Once the political system
has determined the relative amounts of resources to allocate to various uses, orders are
given to a Council of Ministers which oversees the Ministries that will actually implement
the decisions of the Politburo. In the U.S. the institutions called ministries are called
government departments, such as the Department of Defense, the Department of
Education, and the Department of Transportation. These are referred to as regular
government ministries and exist in almost all modern states whether they are capitalist or
socialist.
In addition to these "normal" government ministries that exist in all societies, the
planned socialist economy has two additional ministries or agencies: Planning Agencies
(GOSPLAN in the Soviet Union) and Industrial Ministries. While a Defense Ministry or
Department exists in every country, the planning agencies and industrial ministries only
exist in planned socialism. The planning agency draws up 1 year, 5 year, and long-range
plans for the growth of the economy and also sets goals for and coordinates the activities
of the industrial ministries. The industrial ministries actually execute the plans of
GOSPLAN and run the state owned f'L,'ms directly with their own employees. Examples
of Industrial ministries would be the Steel Ministry, the Oil Ministry, the Automobile
Ministry, the Chemical Ministry, and the Machine Tool Ministry. Each of these ministries
would be organized with a vertical relationship between the central government and the
government owned production units under its command. A minister represents the
politburo, and the government owned factories farther down the chain of command report
to that minister. Each ministry is responsible for producing the amount of output of each
good (e.g., steel, gasoline, ears, and houses) that the government wanted produced. Once
 Chapter #6- Organ/zing Principles of Socialist Systems
we get into the details of bow such a system operates, its complexity is mind boggling[
However, we will attack this problem one step at a time.
A classic example to communicate this idea of a vertical system is to think of the
chain of command in the military. The President and the Congress agree that it is a good
idea to invade some country for reasons ofnatiuna] defense Once the political decision to
go to war is made, orders are given to the Defense Department to actually plan and
implement the war. The Defense Depenmant forwards the orders to the Pentagon, the
¢quiva]unt of the industrial ministry mentioned above. Within the Pentagon the generals
and admirals of the Army, Navy, Air Force, and Marines divide up the task of prosecuting
the war. The Navy figures out how many ships it will take to move the troops and their
tanks and trucks to the war zone. The army decides how many armored units, how many
a/rbome units, and how many infantry units will participate in the battles and where the
troops will come from. The Air Force must determine how many hoop carrying planes
versus how many bombers versus how many fighter planes will be needed to help the Army
in their tasks. The Marines arc tasked with an amphibious assault to establish a beachhead
for all of the follow-nn troops. As you can imagine, there must be many sub-"ministrins"
within the military "ministry" with specialized knowledge of the various tasks to
accomplish. Finally, picture the orders coming down from the Pentagon, through the
. . .
,, . . .
varinns "unmstnes" and agencles untd they get to an actual operatrag umt," whzch in the
Army is a regiment or battalion. This is the level at which troops and their officers actually
fight the enemy. Everyone above them is directing and planning. Notice that none of the
decisions by the military are made based upon profit or observable prices, nor do the
soldiers have any say in what their commanders decide. This is not an accidental byproduct
of the systam, but rather is designed into the system.
Now let's shift from the Defense Ministry- which exists in all countries, including
capitalist ones - and consider how an industrial ministry (which only exists in a socialist
system) such as the minislzy of steel will operate. The steel ministry must first get its
"marching orders" about how much steel to produce. Where will they get that information?
As discussed above, political decision makers in the Politburo make broad decisions about
the relative dis~bution of resources. For example, they might decide that of all available
resourees the military will get 20%, education I o
and transportation 5%In reality there are far more 0~, consurner goods 500/0, healthcare 15%,
things that a society needs, but the list
wo.uld be too long for our example. The next thing to notice is that the total percentage of
society's resources allooatod to various needs cannot exeeod 100% ,,-, ........
to borrow fro ~ ,,.
m f o r e l g n e, c s . L. e t s k e e p t h i~,¢u~,~
n - s s iwcm -ar~
I . wlum
.... g
e~ l-' ann asannle a Closed system with no
borrowing. Lnstly' the decisi°ns of the steel ministry, just like in the military, will not be
based on prices, profits, or any input from the population. Governmental leaders control
the entire process.
Oac¢ these relative shares of resources are decided by the Politburo this information
is transmitted to GOSPLAN, which is a Russian acronym for the central state planning
agency. TheplaanersatGOSPLANwilltranslatethegeneraldirectivesfromthePolithuro
Chapler #6 - Organizing Principles of Socinlist Systems
into more concrete directives to various industrial ministries that will actually produce the
goods and services implicit in the politburo's plan For example, GOSPLAN must decide
bow many ships (some for the Navy, some for civilian transport), how many miles of
railroad tracks, how many vehicles (some as jeeps and trucks for the military, some as cars
for consumers, and some as trucks for businesses), and how many steel bridges wiU b¢
built. Once these choices have been made, experts then determine how many tons of steel
are necessary to fulfill the Politburo's plan.
Finally, we are now at the point of considering choices by the ministry of steel,
which controls all of the steel mills In the country. They have just received their orders
from GOSPLAN that 100 million tons of steel are necessary this year in order for the plan
to be fulfilled. The ministry of steel, checking with enterprise managers (government
officials that actually run a production unit such as a steel mill, mine, or factory),
determines which steel mills will produce how much steel. This now leads the enterprise
managers and the ministry leaders to calculate how many inputs (e.g., how many tons of
coal, iron ore, limestone, manganese, chrome, and other ingredients) are needed from other
industrial ministries that produce those ingredients. Don't forget, the steel ministry will
itaelf need steel for the production ofita steel mill. In addition, manpower requirements
would be calculated, and the amount of new machinery needed to replace, update, or
expand the steel mill would be determined.
Once all of this is accomplished the steel ministry would send its requests up to
GOSPLAN which would use that information to inform the coal ministry, minerals
ministry (for the limestone and other minerals), and the machine tool ministry of its needs.
These other ministries are likewise sending their requests for resources and manpower up
to GOSPLAN so that they can produce the required inputs for the steel industry. For
instance, the coal industry needs steel for the rail lines leading to the mines, for beams and
roof supports to prevent cave-ins, and for the machinery to dig the coal. As you can see,
this is going to get very complicated very quickly since the needed inputs of one industry
are the outputs of some other industry, which become the inputs to yet another industry,
and they all need resources. Remember though, all of the requests for resources must not
exceed 100% of the available resource base.
How is all of this accomplished without going over the total amount of resources
available? The Soviet planning process used what is called Material Balances4 to answer
this question. The goal of the Material Balances method is to establish a balance between
the sources of available resources and the uses of those resources in a multistage process.
In the first stage GOSPLAN sends "control figures," which are the priorities of the
Politburo converted into numerical requirements of preducts desired. These priorities can
be disseminated as physical output targets or as percentage changes from previous output
targets. In the next stage, the enterprises (such as the individual mine or steel mill) make
4 For a fuller explanation of Material Balances see Central Planning by Paul G. Hart, Harwood Academic
Publishers, 1991.
 Chapter #6- Organizing Principles of Socialist Systems
a detailed listing of resources necessm, y to fulfill their output targets. Then in the third
stage planners at GOSPLAN construct a material balance that "forces" equality between
the total amount of resources available and the total uses for the resources in production.
This balance is generated by shiRing resources among and between the different ministries,
thereby generating an equilibrium analogous to (but different from) that generated by
"supply and demand" in the capitalist system.
This material balances approach can be represented by the following identity (a
relationship that must be true by defmitinn):5
Source of Resourcns = Uses for Resources
or
Supply = Demand.
We further define:
Source of Resources = (Current Production) + (Inventories) + (Imports)
and
Uses of Resources -- (Government Services)
+(Consumer Goods) + (Inter'industry Demand)
+(Investment Goods) + (Exports).
So, necessarily:
'`current Production" "Government Services" plus "Consumer
plus "Inventories"
~ Goods" plus "Interinduslzy Demand"
plus "Imports" plus ,,InvestmnntGoods,,plus "Exports"
In a market based Capitalist system this equilibrium is not reached by government
planners shiRing resources to where they ate needed, but by price signals generated in
markets by producer supply and consumer demand which then create equilibrium prices
and quantities. As we discussed in Chapters 3 and 4, each business makes its own decision
regarding whether to expand or contract - that is, to ask for additional or fewer resources
based on profitability, which in tuna is determined by consumers' desires embodied in
demand. In stark Contrast to the decentralized market process, in a centrally planned
system this equilibrating must be done actively by the planners themselves.
The following simplified example illustrates the principle of the material balances
approach to planning a society's economy. In our example we will only be trying to
"balance" the steel indusCy' sproductton of steel forjust three differem preduets. The real
world, with its multiplicity of predocts, will be exponentially more difficult.
,
s T h e 'Idenuty specified .
can be wntlen,m ordma~
, Enghsh as. 'you can t use mote tesources ti~ you have
availabley This' is obvmesly
. true because any answer' that "violates
' this' condition is impessiblc
can be very useful because they limit your search for an answer to
' Identities
p°mttheoHzingabouturnla nn~6 ,~;.~.-~,~:
mmgs mat .....are imposs bwhatmactualIylx)SSlbe
e. It ~.;a-- _ ~On
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Chapter #6 - Organizing Principles of Socialist Systems
Assumptions of the problem
Suppose the Politburo decides that the country should produce 200,000 delivery
trucks, 500,000 cars for civilian use, and 30,000 condos of 800 square feet (among many
other products). GOSPLAN (with the help oftbousnnds of technical experts working for
the planning bureau) has calculated that it takes 2 tons of steel to make a truck, 1 ton to
produce a car, and ½ ton to make a condo (for reinforcing bars). This means that
GOSPLAN will need 915,000 tons of steel to fulfill the desires of the Polithuro.
GOSPLAN informs the steel ministry of its need for 915,000 tons of steel. The steel
ministry determines how many workers it needs, which steel mills will produce which
specific steel products, and any resource needs from other ministries. The steel ministry
calculates that:
it can produce 600 tons of steel per worker, so it needs 1,525
steelworkers to produce 915,000 tons of steel;
it needs 2 tons of coal per ton of steel to smelt the steel, so it needs
1,830,000 tons of coal to produce 915,000 tons of steel;
!t needs 3 tons of iron ore per ton of steel, so it needs 2,745,000 tons of
tron ore to produce 915,000 tons of steel; and
it needs 1 ton of limestone per ton of steel to absorb impurities in the
smelting process, so it needs 915,000 tons of limestone to produce
915,000 tons of steel.
The Steel Ministry informs GOSPLAN of these needs for workers, coal, iron ore,
and limestone to produce the targeted 915,000 tons of steel. GOSPLAN informs the coal
mlmstry and the minerals ministry of the steel ministry's needs, and the minerals ministry
. , , . , .
_fi~ffr.contacts tts own. sub-rmmstnes zn the n-on ore and lzmestone bureaus to get them
p,ouucmg me appropriate amounts.
In turn, the coal ministry calculates that since coal miners can dig 200 tons of coal
per year it will need 9,150 miners. The iron ore sub-ministry within the minerals ministry
calculates that since its miners produce 1,500 tons each it needs 1,830 miners, and the
limestone sub-ministry calculates that since its miners produce 750 tons each it needs 1,220
nunera. When this data flows up the chain of command, GOSPLAN calculates that all
production units will need a total of:
1,525 + 9,150 + 1,830 + 1,220 = 13,725
workers to make the steel needed to meet the Politburo's target.
The problem, however, is that we have only 13,176 workers available. With only
96% of the necessary workforce, we could probably only roduce abo o
level of steel outnut. ....... ~o¢
"rh;~,mLu .~ ,_ ........ P ut 96 '/o of the target
-r- -~,~ onty ~/~,q.O0 tons of steel. That is, with the available
workforce the most steel we could produce is 36,600 tons short of the initial target.
So, what must be done? GOSPLAN informs the Politburo of the shortage of labor,
and the members of the Pohtburo need to decide the tradeoffs m the number of trucks, cars,
There'mno
and condos it wants produced. Recall, it takes 2 tons of steel to make a truck, l ton to
. 01 nk ng.
produce a car, and ½ ton to make a condo. They decide that laxtcking is most important
 Chapter #6- Organizing Principles of Socialist Systems
and leave target production at 200,000 trucks. Target production levels for cars are lowered
from 500,000 to 466,400 and fur condos are lowered from 30,000 to 24,000. This former
reduction of 33,600 cars decreases steel usage by 33,600 tons (since each car requires 1 ton
of steel), and this latter reduction of 6,000 condos decreases steel usage by 3,000 tons (since
each condo requires ~.4 ton of steel). The new target levels of 200,000 trucks, 466,400 cars,
and 24,000 condos are a onsistent plans which satisfies the requirement of the Material
Balancing method:
Total Source of Resources = Total Use of Resources
(supply of 13,176 workers) = (demand for 13,176 workers).
Further Problems with Planning the Economy
This simple example, while daunting to understand, is not nearly complex enough
to do justice to the difficulty of planning an entire economy. The steel ministry, which
controls the steel mills, needs more than just workers and resources. It also needs
machinery like blast furnaces, cranes, and rolling mills to carry out necessary tasks. Each
one of these machines is made of steel and produced by other workers, and we need to
account for this need in our calculations as well. In addition, all of the resource suppliers
such as coal, iron ore, and limestone (among many others) also need machinery (or capital)
in addition to miners. This machinery is also made of steel and needs to be accounted for
in our calculations.
In addition to accounting for these between-ministry uses for steel (known as inter-
industry demand in our material balancing equation above), the planners also have to make
decisions about what kinds of materials should be used in production in the first place. We
assumed that ½ ton of steel would be used in producing a condo. What if the building was
made of wood 2x4's instead of steel studs? What if we decided to build 20 story high-rise
condos instead of 2 story low-rise ones, altering the amount of steel needed per housing
unit? What if instead of steel beams and girders for the high-rise condo we used concrete
reinforced with a few steel rods? What is the "right" amount of steel in a condo? How
about the cat? Should the engine block be steel or a Uminum? How about the wheels?
How much plastic should be used in the bumper assembly and how much chromed steel?
How we answer these questions changes the amount of steel that is needed, and then
changes the amount of coal, trnn ore, hmestone, machines, and workers needed.
We forgot to mention earlier that the machines used in digging coal, iron ore, and
limestone mn on diesel fuel. So we need oil drilling equipment, refineries, and pipelines
or tanker trucks or milcars. Each one of these separate industries needs steel to produce
their equipment and workers to man their machines, so this further complicates the
6hi real life this prob em cannot be done verbally, but must be COnverted to a mathematical system, known
as Input.Output Analysis, to handle the large amount of data. For s deeper treatment of this method see:
The Economics of Input-Output Analysis by Thijs Tea Raa, Cambridge University Press, 2005.
Chapter #6 - Organizing Principles of Socialist Systems
planning of GOSPLAN and the directives it gives to the steel ministry and the resource
ministries.
In addition, steel, wood, aluminum, or plastic (and a host of other manufactured
products) can be used in different combinations to make boats, x-ray machines, chairs,
tables, airplanes, gas pumps, computers and thousands of other goods. As you can see, this
problem is so vast (after all, there are hundreds of thousands of items produced in a modem
economy) that in practice the Soviet Union only planned a subset of all goods by setting
targets for what the leadership considered most important. After WW-II centralized
planning increased considerably. While only 1,600 items covering 14 groups were
centrally planned in 1951, by 1960 targets were set for 12,750 items.~ But even this was
far less than the total number of items being produced, leaving a considerable amount of
leeway for planning at subordinate levels in the ministries themselves and in sub-regions
oftbe economy. So, even the former Soviet Union did not in practice implement "full-
scale" central planning!
Is a Consistent Plan Enough?
A consistent plan is a minimum requirement for determining resource usage in an
economic system, but it is not necessarily ideal. An optimal plan is both consistent and
efficient, in that it produces the greatest value from the available resources at the lowest
possible cost. Did the politburo choose the right mix of trucks, cars, and condos? Could
society have been made better offby a different combination?
This question can be more easily understood if we compare the centrally planned
mechanism of generating a consistent plan, where the total source of resources is equal to
the total use of resourees, with the market mechanism of supply and demand. Assume the
USSR was a capitalist society. It would still like to produce trucks, cars, and condos, and
would still be constrained by nature to keep total demand equal to total supply. As we
discussed in Chapter 4, the market mechanism does the same thing, but by a different
method)
Continuing with the assumption that the USSR was a capitalist society, how would
the relevant number of trucks, cars, and condos be determined? The answer would be
"where supply is equal to demand." Recall, supply measures the costs of producing the
goods, and demand measures benefits that consumers derive from the good. Consumers
get value from delivery trucks by making online purchases and paying for shipping, lflots
of people want to avoid the hassle of physicully going to the store, then shippers such as
UPS and FedEx make a larger profit and buy more trucks. If people would mther shop in
7 S¢ page 100 of Stalinist Planning for Economic Growth. 1933-1952, by Eugene Zaleski, 1980,
University of North Carolina Press.
$ Th~ essay," l, Pent I" (which
,, appears m the Coda of this textbook) illustrates the passive way in which
economic activity is efficiently coordinated in a system of free markets
 Chapter #6- Organizing Principles of Socialist Systems
person, then shippers make less profit and buy fewer trucks. The same process takes place
in the car market and the condo market. It may turn out that for Russians, the "proper"
number of trucks, ears, and condos are 150,000, 560,000, and 36,800 respectively.9
Moreover, maybe the ideal size of condos (accounting for decreased consumption of other
goods) is 1,400 square feet, not 800 square feet.
Why did the Politburo get the numbers so "wrong"?'° This is due to the fact that
no one but the consumer knows how much they desire more living space, whether they
would rather go to the mall than order online, and how urgently they want a new ear (rather
than keeping their old one for another year). These are all subjective desires that no
technical expert can know. Markets, however, find this information by aggregating
purchasing decisions of millions of people who have to spend their own hard-earned
money. The resulting sales and profits oftbe different finns generate the pattern of output
that matches people's desires. In many cases the market system produces the optimal or
efficient mix of goods and services.It
Impact of Planning on Productivity
Consider the problem of the "vertical" nature of organization and control in a
centrally planned economy. Earlier in this chapter we used the U.S. military to explain a
"chain.of-command,, where lower levels take directions and orders from higher levels
within the organization. To further our understanding of vertical relationships within
organizations (as opposed to horizontal relationships between organizations) let's consider
an example. Ifa Captain in the Army needs some men to help set up a tent can he order
Navy sailors to help since he out-ranks them? If you have any experience with the military,
you know the answer is an emphatic "No!" Only naval officers can order navy sailors, and
only army officers can order army soldiers. There is no horizontal interaction between
army and navy. If the army captain needs help from the navy he needs to request that his
superiors contact the superiors in the navy who will then order a naval officer to order the
sailors (if the navy decides to cooperate; the army can't order them to do so). Analogously,
if the steel ministry needs to adjust
" tt productaon for any reason it cannot directly contact
.
the coal tmmstry or the minerals ministry since they are in a different "branch" ofindnstry.
9 These output levels are consistent with the 878,400 torts of stecl assumed to be available. However, in a
capaalist system the amount ofavmlable steel IS alSO bas~ on profits (of the steel industD,). If demand for
steel is high, profits will be high. "
and produce more outpuL This would make steel producers hire more workers (at higher wages)
le. Wrong as
different defined by
objective the concept
in mind ,4 ,I,~of Total Social Suhis
r p see
( Cha pier 5). Socialist leaders
.__..._ ant ~cTl~IOre, m ght not conc-~- ,g-* .L
. any problem w th their
~wcrs. ~ u~, mere LS
L2'2/°wlueonen
e°tl°' °l°fetobeecen thoodiobe
tefl toprovide theefficieet a ....... nsrnast
t
Inparhcular a
t h o r n a r e s i g n i fi c a n t e x t ~ o ~ : ~ . . . . . . m o u r n o r l t g o o d I l e l t h e r t h e m a r k e t - . . . . . . . '
Cha-.-- ,n ~,~..=s, or me gooa Is a public °ood 'r,.~. _.... , o ,,~-~orapentlve,
t,,~, Jw, ~ ~,,~ ~lumnnns ave discussed
Chapter #6 - Organizing Principles of Socialist Systems
The steel ministry is required to contact GOSPLAN, tell them what they need, and then
GOSPLAN will then in turn contact the appropriate supply ministries if they agree to the
change. Ideally, all communication goes up and down the chain of command (vertically)
from GOSPLAN to the ministries, but not between the ministries (horizontally). This is
designed to maximize the control of the central authorities, but is done at the expense of
slow, bureaucratic decision making.'2 As we will see later, this problem contributed to the
slowdown in economic growth that the USSR suffered from starting in the late 1960s.
Another problem eansed by the planning system is that production units (firms) did
not produce to sell to a willing buyer, but produced to meet the targets of the planning
bureau, GOSPLAN. As long a unit was produced, it counted toward the total and quality
didn't matter Soviet firms routinely produced shoddy goods that did not meet the buyers'
needs since the "buyers" received their allocation from a monopoly supplier For inatanee,
the leading cause of house fires in the former Soviet Union was television sets that would
overheat and explode.13 As long as GOSPLAN was satisfied the ultimate consumer was
out of luck.
All of these problems led to inefficiencies on a mass scale. According to Yegor
Gaidar, former Prime Minister of Russia in 1992:
"Examples of how inefficient the Soviet economy was are well known. The
Soviet Union mined eight times as much iron ore as did the United States.
That ore yielded only three times as much pig iron, and the pig iron only
twice as much steel Finally, from that steel it was able to produce machines
worth roughly the same as those produced in the United States
The use of raw materials and energy in the production of each final
product was, respectively, 1.6 and 2.1 times greater than in the United
States. The average construction time for an industrial plant in the U.S.S.R.
was more than ten years, in the United States less than two years. In
manufacturing per unit, the U.S.S.R. in 1980 used 1.8 times more steel than
the United States, 2.3 times more cement, 7.6 times more [mineral]
fertilizer, and 1.5 times more timber. The U.S.S.R. produced 16 times as
many grain harvesters, but harvested less grain and became dependent on
grain imports."t4
Since the system did not rely on private ownership with its profit and loss system,
the economy did not have the proper incentives to produce efficiently. Everyone in the
1 2 T hIs
. . Is true of all buraaucractes
. . m all countncs,
. nnt just bureaucracies in the Soviet Union. The inability
of the FBI, the CIA, and other security agencies to commun cato with each other due to
may have
a organization s y1red
part c 'ted with the failure
. to connect
,, strictterrorist
the dots in the lead up to the 9-11 vertical
set of
anack, See the report of the "National Commission on Terrorist Attacks Upon the United States" at:
httu.'l/t,
u See: ovinfo librar~SOviets
"Meanwhile, unt.edw,View
g l l h.eport/911Report Ch l 3.ht;,.
a Hit-Parade of Shoddy Goods," by D. Remnick, Washington Post,
h'n ~n~~f ~~¢nwlffh'-sov/ets-vi~t..a.hit.
more fully in 12/4/ 989, htt ~,y va~, ~
, g , Brooking Institution, 2007. page 75.
 Chapter #6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

system worked to achieve the plan, whether the plan made any sense or not. Distant
bureaucrats working for GOSPLAN in Moscow had only a general, statistical
understanding of what was going on in the factories and farms of the Soviet Union.
Without an owner risking his own money and dealing with a buyer who has alternatives,
the system failed to achieve efficiency or growth.
This problem was clear to Soviet Leaders as well. Mikhail Gorbachev, former
President of the Soviet Union and General Secretary oftbe Communist Party, attempted to
reform the Soviet system with his program called Perestroika. In his book, "Perestroika:
New Thinking for Our Country and the World," he said:
Starting with the NEP in 1921 we see a strong upswing in growth which levels off
by the mid-1920s. Again, we see another burst of growth in the early 1930s after the
imposition of Stalin's conunand planning system, known as Forced Industrialization.
During this same time period the U.S. and the West were suffering from the Great
Depression After WW-II we see a surge of economic growth. This period of growth was
so strong that it led Nikita Khrushchev, the leader of the Soviet Union at this time, to make
his famous boast in 1956 that the USSR "would bury" the United States. As you can see,
GDP Per Capita grew from $1,913 in 1946 to $7,112 in 1989 (but tumbled to $6,425 in
1991 when the USSR was dissolved).

"An absurd situation was developing. The Soviet Union, the world's
Figure 6,1 -Real GDP Per Capita in the Soviet Union, 1917 to 1991
biggest producer of steel, raw materials, fuel, and energy has shortfalls in
them due to wasteful or inefficient use. One of the biggest producers of
grain for food, it nevertheless has to buy millions of tons of grain a year for
fodder. We have the largest number of doctors and hospital beds per
7,0oo
.thousand of population and, at the same time, there are glaring shortcomings
m our health services. Our rockets can find Halley's Comet and fly to 6,000
Venus with amazing accuracy, but side by side with these scientific and
technological triumphs is an obvious lack of efficiency in using scientific 5,0o0
achievements for economic needs, and many Soviet household appliances
4,000
are of poor quality.,,15
3,0o0

2,000
ECONOMIC PERFORMANCE OF THE SOVIET ECONOMY
1,00o
Other than the period of War Communism, which was an eConomic disaster, the
Soviet Union's planned economy had some notable successes with strong economic 0
growth. As will be discussed in Chapter 7, Real Gross Domestic Product (GDP) Per Capita
provides a rough measure of individual eConomic well-being, since it is derived from a
measure of total eConomic output of society. Figure 6.1 illustrates the value of Per Capita
G D P f Soweto r Umon t h eover. ~ts
. . enlaro
. existence fi'om 1917 to 1991)~ While impressive, this growth looks different when compared to capitalist oriented
Western Europe during the same time period, as illustrated in Figure 6.2. Focusing on the
post WW-II period, we see that Western Europe experienced a more substantial increase
Z5 ~,p , , . . in Per Capita GDP than the Soviet Union. Based on the values noted above, by 1989 Per
ere.stroika, byMikaflGorbechev, m. Perastt°ika:
,, How New is Gorbanbev's New thiaking?,,. Edited
by Eraast W. Lefever and Robert D. Vandcr Lugrg Ethics and Pub c Policy Canter, 1988, page 5. Capita GDP in the Soviet Union was 3.7 times as large as it had been in 1946. However,
Figure 6.1 wM created with data from Madthson Project Database, version 2013," Bolt, J. and J'. L. van in Western Europe this measure increased in value from $3,925 in 1946 to $16,751 in 1989
Zandan (2014), avaihthlc at bttt~..//~v~ru~.nl/c.~,dcd~[storiealdcvelopment/maddison/relem.es/raaddisoJ~=
(without a subsequent falloff) - that is, the value for Western Europe in 1989 was 4.3 times
~..Tac monetary unit ofraeastu'e is" 990 G-K lnterna,~-., r,..I,rs...... twn,anarc as large as its value in 1946. Comparing across these two regions, in 1946 the average
~o'~.v.a.
~ r o t ~ aIlLo!rsrs);toranexplanstionotG.KlntcmatlonalDot__
a l - d o l l a r. h t m l D a t a . . . . . . . . . " , - ~ . . . . . . ==~.
,,~,,:
n t ......
://',t~9.bu$ ea~-cas . Western European was approximately $2,000 richer than the average Russian, but by
~'~pa,
/ I p ~ 'el ,s ' ~
. .U. .~.$yea~
f o r were
t h ~ Imputed
~" by-the
- ~ authors.
A t v t u V a I l a O l C I ~,~ o r ,7~.,.
l ' 9 lo4 construct
t h r o u - the
k~
h e w a s a p p r o x i m a t e l y $ 9 , 6 0 0 r i c h e r. 1989
 Chapter ~6- Organizing Principles of Socialist Systems Chapter #6 - Organizing Principles of Socialist Systems

FIgHre 6.2 - Real GDP Per Capita in the Soviet Union & Western Europe, 1917 to 1991
C H A P T E R # 6 M U LT I P L E C H O I C E Q U E S T I O N S

18,000 1. The first economic system implemented by the new communist government
~Western following the Russian Revolution was
16,000
A. Perfect Communism, which lasted from 1866 to 1874
14,000 B. Pacifist Communism, which lasted from 1879 to 1929
C . War Communism, which lasted from 1918 to 1921.
12,000 D . Social Communism, which lasted from 1946 to 1989.
I 0,000
2. was leader of the Soviet Union when the Bolsheviks implemented the
8,000 New Economic Policy (NEP).
~ E u r o p e A. Karl Marx
B. Vladimir Lenin
6
4,000 , 0 0 0 ~ U S S R C. Joseph Stalin
D. Nikita Khrushchev
2,000

0 3. When discussing the material balances approach, which of the following was not
identified as a "use of resources"?
~ ~ ~, ~ ~, ~, ~ - ~ ~ A. Government services.
B. Interindustry demand.
C . Consumer goods.
Another way of addressing the growth issue is to look at annual growth rates in the
D . Imports.
Sovmt Umun over several different mtesvals from 1950 to 1987. Growth was a mbust
7.2% from 1950 to 1960, was 4.2% from 1960 to 1970, and then fell dramatically
4. An "optimal plan" is
thereafter. Growth was a modest 3.2% from 1970 to 1975 and an anemic 1.0% from 1975
A. both consistent and efficient.
to 1980. Growth reached its nadir from 1980 to 1985 when it equaled the abysmal rate of
B. consistent, but not efficient
0.6%. With Gorbachev's reforms in the mid-1980s there was some modest growth that
C. efficient, but not consistent.
reached 2% by 1987.I~ In addition to these dismal GDP statistics, 1979 "began a series of D. neither consistent nor efficient.
seven poor harvests, leading to the imposition of food rationing in several of the more hard-
pressed regions of the country.,,ts All-in-all, the planned Soviet economy was stagnating 5. Looking at the scope of central planning in the Soviet Union post W'W-II, between
and not closing the gap with richer, We.stem European capitalist economies. 1951 and 1960 the number of items for which output targets were set
The ultimate collapse of the Soviet Union and its economy was primarily due to the A. increased from 10 items to 525 items.
inefficiency of its economic system. Government ownership of the means of production B. increased from 1,600 items to 12,750 items.
and command planning to direct the economic resources of a vast country proved to be C. decreased fi'om 25,482 items to 16,351 items.
impossible. D. decreased tom 4,592 items to zero items (since central planning was abandoned
in the country in 1960).

6. The leading cause of house fires in the former Soviet Union was
7 Data am from Tab e l, page 146 in "Soviet Economic Growth Sinc© 1928: The Alternative Statistics of A. "Molotov cocktails" being thrown through windows by anti-communist
G.I. Khecin," by Mark Harclson, Europe-Asia Studies, Vol. 45, No. 1,1993, pages 141-167. revolutionaries.
Kh~Mn' s estimates
' are on the ow side ofofficia! Soviet Stattshcs, they mirror the same pattern of long-run B. gas lamps (which people used for light since most homes lacked electricity)
decline m growth rates. " . . . . . While
tipping over.
bg Marshall I. Goldman, G~. Turn~rounti CEOj Harvard Business Review, May 1988.
C, television sets that would overheat and explode.
D. gas leaks from stoves with poorly manufactured pipes,
 Chapter #6- Organizing Principles of Socialist @stems
In the former Soviet Union, GOSPLAN
A. was the primary military agency, which provided for national defense of the
¢ o u n U ' y.
B. was the primary planning agency, which drew up plans for the economy, setting
goals for output levels and overseeing coordination of economic activity.
C. were the various industrial minis~es, which executed economic plans, by
running state owned enterprises thereby making day-to-day decisions regarding
the use ofeeonomic resources.
D . were the workers who were members ofboth the official Communist Party and
the labor union "Solidarity" (only about 17% of the workforce belonged to both
groups).
The economy of the former Soviet Union grew at an average annual rate of 7.2%
between 1950 and 1960. In contrast, between 1980 and 1985 it grew at an average
annual rote of.
A. 0.6%
B . 2.1%
C. 7.1%
D . 12.4%
Commenting on the inefficiency of the Soviet economy, Yegor Gnidar (Prime
Minister of Russia in 1992) noted:
A. ~Th average eonstruetmn' tlroe for an industrial plant in the U.S.S.R. was more
than ten years, in the United States less than two years."
B . "In manufacturing per unit, the U.S.S.R. in 1980 used 1.8 times more steel than
the United States, 2.3 times more cement, 7.6 times more (mineral) fertilizer,
and 1.5 times more timber."
C . "The U.S.S.R. produced 16 times as many grain harvesters (as the United
States), but harvested less grain and became dependent on grain imports."
D . More than one (perhaps all) of the above answers is correct.
Real GDP Per Capita (measured in 1990 G-K International Dollars) in the Soviet
Union increased fi'om $1,913 in 1946 to $7,112 in 1989. In comparison, between
these same years the corresponding figure for Western Europe
A. decreased from $13,748 to $11,942.
B . !ncreased fi'om $1,793 to $8,556.
C. increased from $3,925 to $16,751.
D . increased fi'om $5,429 to $6,984.
Gross Domestic Product
and Economic Growth
"It is indeed true that the stock market can forecast the business cycle. The
stock market has called nine of the last five recessions."
- Paul Samuelson
Within this chapter we discuss how to measure a society's economic output. We
start by defining the concept of Gross Domestic Product (or GDP). We then discuss
adjustments to the measure of GDP which must be made to correct for comroon
shortcomings. These adjustments help us obtain a measure which gives more meaningfid
insights on the well-being of individuals in a society. Next, we examine how the value of
GDP changes over time, both in the short-run and long-run. The short-rim ups and
downs of GDP illustrate the different phases of the business cycle. In the long-run the
value of GDP typically increases, revealing economic growth. As part of our discussion
we observe actual realized changes in the value of GDP for the U.S. in the short-run and
for the U.S. and other countries in the long-run. Factors which cause long-term economic
growth are identified and discussed.
MEASURING THE SIZE OF THE ECONOMY
The best way to measure of the size of an economy is Gross Domestic Product,
defined as the total market value of all final goods and services produced within a society
over a certain period of time. From its name you can infer that it is a mcasuro of
production. Economists get a total measure of the value of all goods and services by
assuming that each individual good and service is best valued at its market price. This is
a reasonable assumption since, as discussed in Chapter 4, the market price is a result of
the interaction of consumer demand with producer costs. If people are willing to pay a
certain amount for something, when they have alternatives, then the good must be worth
that amount to them.
Multiplying the market price of a good by the quantity produced gives us the
value of the total amount produced. If we add up the value of every single good using
this procedure, we have the entire value of all goods produced - that is, GDP. This
method can be summarized in the following equation:
aoe = (e~ × QD + (e~ x Q=) + (p~ x Q3) + '-- + (P~ x QN)
 Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7 - Gt~oss Domestic Product and Economic Growth

the value of each of these four components for the U.S. in 2017, in trillions of dollars,z
where the subscripts from 1 up to N represent all the different goods produced in the The negative value of-$0.572 for net exports reveals that in 2017 U.S. imported roughly
$572 billion more than it exported.
s°cietY'Let's work through an example to illustrate. Picture yourself marooned with a
few other people on an island like in the 'IV show Lost. After one year you look back on Table 7.1 - Components of GDP in the U.S., 2017
all of the things that have been made on the island for consumption by the members of
your society. If you wanted to know how much your group produced you would
calculate your GDP by adding up the value ofaU the goods. To keep the problem simple
let's assume that you and your friends "produced" through your own effort 1,000 fish
$19.391 °Pi c , io NxI
$13.396 $3.213 $3.354 -$0.572
caught, 500 yams grown, 200 coconuts gathared, and 20 gallons of milk from a wild goat
These different components of GDP can be illustrated graphically by slightly
that you captured.
expanding the Basic Circular Flow Diagram discussed in Chapter 4, adding roles for
To keep the example going, assume that just before you were marooned you
government and international trade) Doing so gives us the Expanded Circular Flow
happened to be walling through a grocery store and you noticed that the average fish sold diagram illustrated in Figure 7.1.
for $10, yams for $2 each, Coconuts for $5 each, and goat milk for $6 per gallon. Let's
now put this data into our formula:
Figure 7.1- The Expanded Circular Flow Diagram

GDP = ($10 x 1,000) + ($2 x 500) + ($5 x 200) + ($6 x 20)

GDP = $12,120
socto,~ os /'.~'~1
You and your friends produced goods valued at $12,120, so your little island
economy produced a GDP of $12,120. You should immediately notice that not only is p r o d u c t i o ~ f X ~ gooa, ona

your production $12,120, but your income is as well since the goods you produced are Income Consumer "~'~ services
used to increase your consumption and well-being. Not bad for your first year, but you

/(;ii ..;;;;7;\k
are obviously not very rich. Now let's do the same thing for an entire country. Let's add
up every car built, house constructed, restaurant meal served, gallon of gas refined, pair
of pants sewn, and on-and-on until we have added up every good or service produced.
Now go collect all of the prices that these goods were sold at and enter all the data in the
formula. The formula would be the same, just a lot longer. For the U.S. we would have
come up with $19.4 trillion in 2017} Just like in the individual example we can show
that the nation's income is also $19.4 trillion as well, since we essentially have the ability Production
oo.=°.°,
Markets for ] production ond services I'

Forell~
Services Markets
to consume this level of goods and services.
More fully, we can decompose GDP into four components: consumption by
households (denoted C), investment expenditures by businesses (denoted I), government
consumption (denoted G), and net exports (denoted NX). Consumption by households
s T
includes purchases of things such as food, clothing, medical care, vacations, and cars.
Investment expenditures by businesses include the purchases of items such as machinery, sooooo,
productionhired I o,
office equipment, buildings, and delivery tricks. Government consumption consists of
purchases such as planes and guns for the military, teachers time for providing education,
tmcks to deliver the mail, and concrete for roads. Finally, net exports is simply the services

difference between the total value of exports and imports. Exports are goods produced goods end~~ ~ fi n i s h e d

domestically and sold abroad. Imports am goods produced abroad and purchased
domestically. So, collectively these four components account for all of the goods and 1 These figures arc also from the BEA report Iwilable at:.
services produced within our society. That is: GDP = C + I + G + NX. Table 7.1 states
3 T h " s Expanded ,
Circular Flow Dmgl~m
, will
, provide an.fllustranon of C, G, and NX, but will not directly
hJnJs:lAcww, heo,~ovlne~t~releascs/notional/edt~/2OlS/lxlf/~dplql8, ad~,,pJf.
ross Demesne Produc. F rst Quarter 2018 (advance esnmate), Bureau of Economic Analysis, April illustrate £ This is doe to the fact that while this diagram is much more complicated than
27, 2018, https.//wu~).bea.eov/newsreleases/notional/Qdl~f2Ol8/pdf/ed~la]8 adv.p~ Flow Diagram discussed in Chapter 4, it is still a vast simplification of aa actual economy,the Basic Circular

148
149
 Chapter #7- Gross Domestic Product and Economic Growth
In this Expanded Circular Flow Diagram we still illustrate the central interactions
betw~n households and firms in the markets for factors of production and markets for
goods and services. Notice that consumption by households (i.e., C), is represented by
the darker arrow flowing to households from the markets for goods and services.
The role of government is illustrated in the center of the diagram. Government
collects taxes from both households and firms (illustrated by the lighter arrows flowing
from households and firms to government). Additionally, government hires some factors
of production and produces some finished goods and services. The finished goods and
services (represented by the darker arrow flowing from government to the markets for
goods and services) correspond to government consumption (i.e., G).
Finally, intematiunal trade is represented by the flow of finished goods and
services between the markets for goods and services and foreign markets. Goods flowing
out of this economy to other countries represent exports, while goods flowing into this
economy from other countries represent imports. Thus, net exports (i.e., NX) can be
thought of as the difference between the two arrows on the fight-hand side of the figure.
To further emphasize a previous point, notice that this diagram illustrates how the
total production of goods and services is equal to the income of the members of society.
The arrows illustrating the production flowing to the markets for goods and services
essentially generates income flowing to households. Therefore, the dollar amount of
GDP is equivalent to the dollar amount of income for individuals in this society.
Problems with Properly Measuring GDP
Calculating GDP is pretty simple in concept, but in practice there are many
complicating factors to consider. First of all, in the examples above we have only
explained the Expenditure Method for computing GDP. Under this approach we add up
th2 value of the goods and services produced and sold. An alternative method that gets
to the same result is the Income Method. This method uses the fact that all
production is simultaneously income to the person who produced the good or service. If
we add up everyone's income we should get to the same dollar amount that we get when
we add up the dollar value of production. For simplicity we will be using only the
Expenditure Method for calculating GDP, but it is a crucial economic principle that a
society's total output and income are just different names for the same economic reality.
We will refer to the GDP of different nations for comparison purposes,
we are also describing the nation's income level, and in doing so
One problem with getting a proper GDP measurement is making sure that we
don't double count goods and thereby inflate the value of our production. For instance, if
you add to the GDP a $45 pair of jeans that were just sewn and then sold by Levi-Strans
and Company, but also added in separately the $20 worth of cotton grown by farmer
Brown to make the jeans, you will have counted up $65 worth of production. The
problem with this calculation is that the jeans manufacturer has already included the $20
worth of cotton in the $45 price he charges for jeans. In this example cotton is an
Intermediate good, or a good that is not sold to the final consumer but is rather sold to
another finn that will use the good as a resource in its own production process. To get an
Chapter #7 - Gross Domestic Product and Economic Growth
accurate count of GDP we have to go through all transactions and remove the
intermediate goods from the calculation and then add up only the final goods, the ones
that end up in the hands of the ultimate consumer.
Other major problems in getting an accurate figure for GDP are related to the sale
of used goods, non-market production, and the "underground economy." Usedgoods
that were produced in a previous period were already counted toward GDP when they
were produced. For example, we would need to remove re-sales of items such as cars,
houses, and art that were produced in previous time periods (but not the markup of
dealers of these goods, since this represents current services provided by the dealer).
Non-market production is the creation of goods and services that are not sold
through a market, making them very difficult to measure. For instance, consider a
homeowner mowing his own lawn or cleaning his own house. If you hired a provider of
these services we could count the value easily since there would be a market transaction,
but if you do them yourself there is no verifiable evidence that the work was done. As a
result, since such non-market production is very difficult to quantify, we choose not to
include it in the calculation of GDP. For developed countries such non-market activities
make up a smaller percentage of total economic activity than is the case in less developed
countries. Consequently, GDP figures for less developed countries are very likely biased
downward to a greater degree than corresponding figures for developed countries.
Lastly, we have the problem of the underground economy, or black-market, where
goods and services are bought and sold without reporting the sale to authorities.
Sometimes this is done because trade in certain goods and services is illegal, and in other
cases the sales are themselves legal but the seller wishes to avoid paying taxes on the
transaction and therefore does not report the value of goods or services produced. In the
former case think of drugs or prostitution, and in the latter case think of a server in a
restaurant who does not report all of her tips or a home repair person who works for cash.
None of the people mentioned in either of these groups are reporting the value of the
goods or services that they are producing.
T h e I s s u e o f I n fl a t i o n f o r t h e A c c u r a t e M e a s u r e o f G D P
The previous problems with the calculation of an accurate GDP measure are
normally dealt with by the professional economists who work for the U.S. government's
statistical deparlments, and users of the data generally have to accept the results. One
potential concern when examining any economic data based upon market prices (such as
GDP) is that the person interpreting the data must be aware of distortions introduced by
inflation. To correctly interpret such data in a meaningful way, one should ultimately
examine figures which are adjusted for changes in prices. Let's explain this by way of an
illustration: Suppose Mr. Williams, a carpenter, has worked for Mr. Martinez, owner of
Martinez Construction Company for the past 10 years. Table 7.2 below reports some
illustrative data on Mr. Williams' income and on prices
As you can see, Mr. Williams has had a doubling of his income but according to
the Price Index prices have tripled. As will be discussed in fiwther detail in Chapter 8, a
Price Index is a mathematical representation of the price level or the average price for
 Chapter #7- Gross Domestic Product and Economic Growth
Chapter #7- Gross Domestic Product and Economic Growth

Price Indexbase year = Real Datacurrent year

goods and services sold in a count-ry in a particular year, with the price level in the base Nominal Datacurrent year X Price Indexcurrent year
year forced to be equal to 100. The base year is the year in which a massive survey of
consumers' purchasing decisions is made. Once we have a list of what the average Using the data from Table 7.2 above we would get:
person buys we can take the list and go shopping every year to see how the prices have
changed.4 We can also calculate the index for past years as well. The price index for all 1 0 0 2 0 0 8 p r i c e tndex = $20,00020ts salary in 2008 prices
$60,O0020rasalary X 0
30 2OlSpr[ceindex
other years is then adjusted relative to the price level in the base year. Once the index
numbers have been calculated for various years we can see how much prices have risen, What this calculation shows is that Mr. Williams' salary of $60,000 in 2018 would only
and in this case over the I0 year period from 2008 to 2018 the average of all prices has purchase as many goods and services as a $20,000 salary would have purchased in 2008
tripled.5 paying 2008 prices. Since Mr. Williams was paid $30,000 in 2008 we can see that Mr.
Williams had a decline in real salary from $30,000 to $20,000 even though he had an
Table 7.2 - Price Index and Mr. IJqlltams' Salary Over Time increase in nominal salary from $30,000 to $60,000. In order to maintain a constant

t Sala~
[ Price Index
2008
$30p000
100
2018
$60,000
purchasing power, his salary in 2018 would have to be exactly three times as large as his
salary in 2008 - that is, his nominal salary in 2018 would have to be $90,000. So, an
economist would agree with Mr. Williams that he had not received a raise, because the
300 nominal data of the actual pay is misleading without "removing" the inflation Always
look in the legend of any data you are relying on to see if it has been adjusted for
Mr. Williams complains to Mr. Martinez that his "income" has fallen and he
inflation. If it has, it will be reported as real in the data label. For example, we would
needs a significant raise, and Mr. Martinez pulls out his checkbook and shows Mr.
see inflation adjusted income data reported as Real Income or the inflation adjusted oil
Williams that he now pays him twice what he used to and refuses to pay any more Who
is correct here, Mr. Williams who claims his income has fallen or Mr. Martinez who says price reported as the Real Oil Price.
it has risen? Economists label the cause of this problem as the conflict between nominal If the data for a specific individual can be so misleading, just imagine how
and real data. Nominal data is data measured in money terms from the year in which the misleading the reported data for the GDP of entire countries can be! Nominal GDP is
transaction takes place. Real data is nominal data adjusted for inflation and therefore the value of GDP computed in current period prices. In contrast, Real GDP is the value
measures the real ability to pumhnse goods and services. Just by looking at the data of GDP computed using prices from an arbitrary base year. The following data6 in Table
provided you can see that Mr. Williams' Real Income (nominal income data adjusted for 7.3 for the U.S. will illustrate:
inflation) has fallen over the past 10 years. How do you know this? Consider yourself in
Mr. Williams' situation where your nominal pay has doubled but the prices you pay for a Table 7.3 - U.S. Nominal GDP and Real GDP
new car, a restaurant meal, a pair ofjeans, a gallon of gas, etc., have Ixipled. Even though
you have twice as much money in your paycheck, prices have tripled so that you cannot Year Nominal GDP Price Index7 Real GDP
buy as much in 2018 with your $60,000 salary as you could buy in 2008 with your 1977 $2,086.0 billion 27.8 $7,503.6 billion
$30,000 salary. In real terms your income has gone down since you only care about the 1987 $4,870.2 billion 52.1 $9,347.8 billion
ability to consume actual goods and services, not the number of dollar bills in your hands. 1997 $8,608.5 billion 73.6 $11,696.3 billion
How do we prove to Mr. Martinez that he needs to give a raise to Mr. Williams 2007 $14,477.6 billion 95.1
just to get him back to his consumption standard of 2008? Let's adjust all nominal dollar $15,223.6 billion
2017 $19,390.6 billion 112.4
amounts to the base year (the year that the market basket survey was done) of 2008 $17,251.4 billion
dollars using the following formula: Nominal GDP was more than nine times larger in 2017 than in 1977. Did our
economy really grow that dramatically over these four decades? If we look at the price
4 The method described here is a. s]mphfied .version of the Consumer Pnce Index, or CPI that is published
indexes for those two years we see that prices rose by approximately 304.3% between
monthly by the Bureau of Labor Statistics. For more details go to: ~!o:/Avww.bls.eov/cDi/. Another
method used for calculating the inflation rate is the GDP Deflator which is created by the Bureau of
Economic Analysis ~. The CPI uses a fixed market basket method while the GDP Deflator
allows the market basket to change from year to year.
The numbers in Table 7.2 have been chosen to make the COmputatlorts simple, In reality, pfice~ in the 6 Nominal GDP and Price Index data are available from the Federal Reserve Bank of Saint Louis at
U.S. only increased by about 17,4% between the start of 2008 and the start of 2018, A much more
complete discuss. on of changes m
. pncas
. , . m the U.S, Js
over ttme . presented in Chapter 9.
hnlas is
GDP ://frcd'sd°uisfed, or~/serieslGDP.t
from authors' calculations, basedand ht~s.'//fred.xtlmdsfed.ore/serWs/CPAL
upon these corresponding figures, TTO I USA 661 S; Real
7 The Base Year for the Price Index was 2010 when the index value was set equal to 100.
 Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7- Gross Domestic Product and Economic Growth

GDP
1977 and 2017.8 It is meaningless to make a direct comparison between the nominal data GDP Per Capita = Population
for the two years since the 2017 GDP calculation was based on adding up the value of
production using much higher prices than were used when the GDP was calculated back
Table 7.4 reports the value of GDP, population, and GDP Per Capita in Indonesia
in 1977. Using the methods developed above for figuring out Mr. Williams' real income
and Norway, along with twenty-two other countries plus both the European Union and
we can make adjustments to the nominal GDP data reported and convert it to real GDP
World (as a whole). GDP Per Capita gives us a more accurate picture of the average
data. For example, the $2,086.0 billion Nominal GDP in 1977 can be converted into Real
relative living standards of people in each country. GDP Per Capita shows how much
GDP (measured in 2010 dollars) using the formula described above:
income is available per person if it were equally spread across the entire population.
9 na~ ~ lO0~010pricemdrx
"+v~v'v1977 GDP X = $7,~03"61977 GDP In 2010 prlces.
27.81977 prlc# Index Table 7.4- Per Capita GDP Across Select Countries
The other values of Real GDP reported in Table 7.3 arc calculated in a similar fashion.
Examining the values of real GDP we see that economic output did increase GDPPPP in Billions of Population in GDPPpp Per Capita
dranmtically between 1977 and 2017, hut not as much as the nominal data would Country
2017 U.S. Dollars Millions 2017 U.S. Dollars
mistakenly portray. Looking at Real GDP, we see that real output was "only" 2.3 times
larger in 2017 than in 1977. While this is still a substantial increase, it is much smaller Qatar $342 (52"d) 2.31 $124,900 (2"d)
than the increase suggested by looking at Nominal GDP (for which the value in 2017 is Singapore $514 (40m) $90,500 (7m)
9.3 times larger than the corresponding value in 1977). If you want to know the truth Norway $376 (48m) 5.32 $70,600 (12m)
when using data that can be "conupted" by changes in prices, use real data and not Hong Kong $453 (4Yd) 7.19 $61,000 (18m)
nominal data. United States $19~360 (2nd) 326.63 $59,500 (20~)
Germany $4,150 (5m) 80.59 $50,200 (27~)
Japan $5,405 (4m) 126.45 $42,700 (41~
GDP versus GDP Per Capita European Union $19,970 516.20 $39,200
We have seen how misleading economic statistics can be when we don't make a Italy $2,307 (12th) $38,000 (481a)
correction for inflation. There is one more correction that we should make to the data if Portugal $311 (55m) 10.84 $30,300 (64*)
we want to use GDP as a proxy meusar¢ for individual well-being. Consider the Russia $4,000 (6m) 142.26 $27,900 (70~)
following data for two countries in 2017: Indonesia had a GDP of $3.243 trillion while Chile $452 (44m) 17.79 $24,600 (79m)
Norway's GDP was $376 billion, making Indonesia's economy more than 8.5 times Mexico
larger than Norway's.9 Since we have already noted that the production of goods and $2,406 (11m) 124.57 $19,500 (89m)
World $127~000 7,405.11
services measured by GDP is also a nation's income, we see that the total income of $17,300
Indonesia is more than 8.5 times that of Norway. Does this mean that the people of China $23,120 (1~) 1,379.30 $16,600 (105~)
Indonesia have an average living standard that is this much greater than the people of South Africa $757 (30m) 54.84 $13,400 (ll4th)
Norway? Indonesia $3.243 (7m) 260.58 $12,400 (123~)
To have a useful measure of well-being or living standard, we would want to look Jamaica $26 (140th) 2.99 $9,200 (141st)
at output (or income) per person. Think of GDP as measuring the size of a society's total Morocco $300 (57th)
economic pie. If we divide this value by population, we obtain a measure of the size of India
$8,600 (146m)
$9,447 (3~) 1,281.94 $7,200
the average slice per person. GDP Per Capita is computed as the value of GDP divided Angola (155m)
$192 (66m) 29.31
by population: Honduras $6,800 (159m)
$46 (111m) 9.04
Sudan $187
$5,500 (1681h)
(68m) 37.35 $4,600
' The percentage change in prices between these two years is calculated from the price index values (YI Kenya (172~)
$163 (74th) 47.62
and Y2) as: [(Y2-YI)/YI] x I00 ~ rot 2 4--27
9 T h e d a t a a r e . . . . 8)/'27.8J x 100- 304.3%. Nepal $79
$3,500 (185~)
(94m)
Congop Dem. Rep. of $68 (194~)
.~f ~. k / D
~ eao tf rao mi st h er CeI A
p oWo
r tr led dF a cat sB o p
o kp: ph t - ~r sp: /u/ ~rv.cc~i o.. ~ o. v. / ./ i .b r. a. .A u ( 10Y'd)
make meamngful ¢onounc , compunanns . across x diff~nt countries,
. -~mg rower, rarity),
~
to account ~ differences in prlces.
for
a statlstical, method used to (2~)
Tiffs is accomplished by convert/ng aH data from national curt ' "
em~ney buys in the home counwv com.~a .......encms into O.S. Dollars by com~u'in~ what a Within Table 7,4, countries are ordered according to GDP Per Capita (the
are from this same source. -~ e ....waa~ the aoflar buys m the U.S, The values in Table7.4" - rankings indicated within the second and fourth columns are the c
out of the 227 countries for which the CIA reports data). As weountry s overall
can see, ranking
even though
 Chapter #7 - Gross Domestic Product andEconomic Growth
China now has the largest economy in the world (as measured by GDP), its Per Capita
GDP of $16,600 ranks 105:h (Out of 227 countries). To put this in perspective. China's
value of Per Capita GDP is: 59,5% of Russia's value; 42.3% of the European Union's
value; 27,9% of the United States' value; and 18.3% of Singapore's value. From these
observations we can see how misleading a statistic like GDP can be if we do not know
how to properly interpret it. If you are interested in getting insights on average living
standards in a country, it is much better to look at GDP Per Capita instead of GDP.
Moreover, if you want to study living standards from different years you need to make
the further adjustment and calculate the Real GDP Per Capita to make sure that you are
also accounting for changes in prices.
The value of GDP Per Capita is determined by the available productive resources
(i.e., human capital, industrial capital, and natural resources), level of technology and
infrastructure (e.g., intemet access, highways, and airports), and economic institutions
(e.g., contract laws, business regulations, tax codes, and levels of corruption) in place
within a country. From the values in Table 7.4, we see that there are tremendous
differences in living standards across the globe. Some countries - such as Qatar - enjoy
an abnormally high value of GDP Per Capita because of an abundance of natural
resources. For the World as a whole GDP Per Capita is $17,300. In some sense there is
an almost continuous distribution of the value of GDP Per Capita between countries such
as Norway (12th in the World with a Per Capita GDP of $70,600) and Nepal (194th in the
World with a Per Capita GDP of $2,700), in that for any dollar amount between these
extremes we could likely find some country with a GDP Per Capita within a few hundred
dollars oftbe chosen value.
While it is not the case that we are living in a world of "haves" and "have-nots"
(but rather there are many countries "in-between") it is often insightful to distinguish
between Industrially Advanced Countries and Less Developed Countries. The
Industrially Advanced Countries are the high income countries with primarily market
based economies, large stocks of technologically advanced industrial capital, and a highly
educated and skilled workfome. Examples include the United States, along with Norway,
Australia, Germany and Japan. In contrast the Less Developed Countries are lower
raceme countries which are held back by some combination of poor economic
institutions, undeveloped industrial capital, and/or an uneducated and unskilled
workforce. Examples include India, Ghana, Bangladesh, and the Democratic Republic
the Congo. of
ECONOMIC GROWTH AND DEVELOPMENT
Now that we have the basic idea of how to measure an economy using the concept
of GDP, in this section we examine what has happened to the size of both the U.S.
economy and other economies over time. Economic Growth refers to sustained
increases over time in the value of Real GDP. Economic Growth is very quantitative in
nature and can be measured by the GDP Growth Rate, the annual percentage change in
the value of Real GDP. A closely related notion is Economic Development, which
Chapter #7 - Gross Domestic Product and Economic Growth
refers to improvements over time in quality of life and living standards. In practice,
economic development is probably more important than economic growth (i.e., economic
development - which essentially gauges improvements in well-being - is what we should
actually care about). But, by its definition, economic development is very qualitative in
nature. It could be assessed by looking at - among other things - factors such as: life
expectancy at birth; infant mortality rates; literacy rates; access to clean drinking water;,
access to vaccinations; electricity access; telephone or internet access; and average
leisure time per year (i.e., the converse of hours worked per year). From this list, we see
that coming up with a single measure of economic development would be impossible.
For this reason - along with the fact that income can in fact buy many of the things that
most people would include in their list of economic development - we focus on economic
growth as a proxy measure of economic development. That is, we use increases in Per
Capita GDP as a proxy measure for increases in well-being.
The easiest way to measure this growth is to compare the GDP of a country over
several years, making sure that we adjust the nominal data for inflation to get Real GDP
so that we are making fair comparisons. We also need to adjust for the size of the
population since we live in a growing country. To compare the GDP of our country from
100 years ago to today would be completely inappropriate if we did not make these
adjustments considering how much inflation and population growth has taken place.
Short-Run Changes in GDP: The Business Cycle
Before we look at the long-run historical data we need to develop an
understanding of the Business Cycle, which shows how GDP behaves over time.
Unfortunately, GDP does not increase smoothly every year but instead has periods of
growth and then periods of decline. The growth phase in the economy, known as a
business cycle expansion (or expansion for short), is marked by increasing GDP over
time. During these expansions, also known colloquially us booms if they are strong ones,
the economy typically realizes: low or falling unemployment; decreasing bankruptcies;
rising sales, profits, and wages; and the creation of many new businesses. Generally
people are quite optimistic about the future since they experience the economic growth
all around them.I° All booms come to an end at some point and the economy fails into a
recession, or business cycle contraction, which is a period marked by falling GDP over
time. Colloquially a recession is known as a bust leading to the phrase, The Boom-Bust
Cycle, another name for the Business Cycle. When the GDP is falling during a recession
or contraction we see: a rise in unemployment; a decrease in sales, profits, and wages;
and the bartknJptey of many more firms and individuals. As you might expect, people
lose optimism and faith in the future. Figure 7.2 shows a stylized figure to illustrate the
phases of the Business Cycle.
10N
ot all areas of a country experience an experts on in the same way. In e large country like the U.S. it is
possible for the counh'y as a whole to be experiencing e boom while a particular region is declining
economically.
 Chapter #7- Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

As you can see in the figure, the economy rises during an expansion until it
reaches a business cycle peak (or peak) which is the highest level of GDP achieved
during any particular cycle. Then the economy falls into recession where the GDP falls
towards a business cycle trough (or trough) which is the lowest level that the GDP falls
to during a recession. Once the economy "bottoms out" it starts to recover and enters
into another expansion. We measure a complete cycle from the peak of one boom to the
peak of the next boom, including the intervening recession. This cycle has repeated itself
many times in the past, and there is no reason to think that it won't continue in the future.
Another point that the business cycle graph in Figure 7.2 illustrates is the tong-
term trend, which is the average growth of the economy over many business cycles.
Wh/le the business cycle shows the short-term path of the economy's growth, the long-
term trend shows how the economy has behaved over a significant period of time. Just
because the economy may be growing at a rate of 5% in this particular boom year does
not mean we should start to think that is the norm. The long-term growth rate of real
GDP in the U.S. has been appmxhnately 3.2% since WW-IL As you can see in Figure
7.2, real GDP at the trough of a recession is often higher than peak GDP in earlier booms.
the third quarter of 2009 you can see some upward movement in the economy as it slowly
recovers. From peak to trough the economy saw a decline in economic output from
approximately $15,000 Billion to $14,400 Billion, for a decline of roughly $600 Billion.
At the same time that output fell the unemployment rate rose from 4.4% in May 2007 to a
peak of 10.0% in October 2009, a more than doubling of the rate)2
While the actual recession shown in Figure 7.3 closely resembles the stylized
version from Figure 7.2, the actual business cycle is neither regular in timing nor in
severity (like in Figure 7.2). Consequently, it is hard - perhaps impossible - to
confidently predict when an economy will enter into (and ultimately get out of) an
economic downturn. This fact is at the essence of the quote by Paul Samuelson which
opened this chapter: "It is indeed true that the stock market can forecast the business
cycle. The stock market has called nine of the last five recessions."
Figure 7.3 - Real GDP in the U.S. During the "Great Recession," billions of dollars
15,400

Figure 7.2- The Business L'~ele 15,200

$ GDP Growth 15,000

one long-term trend 14,800
business-------~ ~ ,
14,600
c y c l e f ~ ~ R e a l G D P 14,400

14,200

14,000

13,800
r,. r*. r-. 0o oo oo ch o 0 ¢; (:~ ~ ~ ~ ,.~
8 ~ 8 8 . . . . .

: .:
o, ~
.. i ! time Table 7.5 lists the I l post-WW-II [ecessions and expansions,u As you can see,
both the severity and duration of recessions vary dramatically from as little as 6 or 8
months to as long as 18 months, with an average of ll.I months. The decline in
economic output has been as little as 0.6% to as high as 4.1% and with peak
,77 " unemployment rates ranging from roughly 6% to over 10%. Luckily, the expansions
have been significantly longer lasting than the recessions with the range from as short as
Figure 7.3 shows the experience of the U.S. during the most recent recess/on 12 months to as long as 120 months (10 years), with an average duration of 60.5 months.
(which has been dubbed the" " , 9, not in a stylized form, but using actual
Great Recession
data.H As you can see, the economy stops rising (peaks) in the third quarter of 2007, This partly reveals why we experience an upward trend as illustrated in Figure 7.2. It is
wobbles until May of 2008, and then drops precipitously to a trough in early 2009. By
.
I I A precise defimtion oftbe Unemployment rate, along with a more detailed discussion of ~alized values
II 771 in the U.S,, is presented in Chapter 9,
e numerical va ues used to construct this graph are from the Bureau of F.conom/e Analysis. t3 These figures ,.,.'ere obtained from the National Bureau of Econonfic Research, "U.S. Business Cycle

EXl~asioes and Contractions" (htn):/A ~ ~, nber ort, l¢~rle,~cax le~t~i~ hfraO.

 Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

important to recognize that experiencing expansions which last longer than recessions is a lasted from 1929 to 1939. Thankfully there has not been another depression, an
relatively recent phenomenon. As noted, for the I I business cycles that the U.S. has economic downturn of far greater depth and scope than a normal recession, since the
realized since WW-II the average length of recessinns was l 1.1 months and the average 1930's. In Figure 7.4 we see the business cycles for the U.S. economy from 1854
length of expansions was 60.5 months (i.e., since WW-II the typical expansion has lasted thrungh 2016.16
over five times longer than the typical recession). In contrast, for the 16 business cycles
that occurred between 1854 and 1919 the average length of recessions was 21.6 months
Figure Z4 - Real GDP Per Capita in the United States, 1&54 to 2016
and the average length of expausiuns was 26.6 (i.e., during this earlier time period, the
typical expansion was only 23% longer than the typical recession).

Table 7.5- Post WF/-II Recessions in the U.S. 50,000

DllrQ nolI
~n of Subst lent
Peak 40,0GO
erc£nt Unemployment
ion Expa ionths cline in Rate Due to
: Peak Month
. November 1941 ~l GDP Recession 30,000
7.9*/o
"--5 6.1%
7.5% 20,000
December, 1969 t2*~, 7.1°/o
---5 6.1%
--i 10,000
9.0%
7.8%
10.8% 0
7.8%
6.3%
_ 10.0%

Long-Run Changes in GDP: Economic Growth
Seen from up close with only a few quarters of data, downtums such as the "Great
Recession" look like colossal setbacks. These recessions, which Karl Marx called "crises
of capitalism," were alleged by many to be the undoing of the capitalist system. Marx
believed that workers would ultimately revolt against the system due to the
unemployment generated during these downUlrns 14 Even supporters of Capitalism, like
John Maynard Keynas, beheved that something needed to be done to solve the problem
of the business cycle.IS In Chapter 8 we identify and discuss the relatiunship between the
money supply and changes in aggregate economic output. For now we continue our
exploration of the lung-term trend of the business cycle. When seen from the perspective
of the lung-run, the "crises" or recessions almost seem to fade into the background and
the record of Capitalism and its growth looks much better. However, even from this vast
perspective of time we can clearly see the devastation of the Great Depression which
,4 M~'r~ Karl, The Communist Manifesto. available at
z5
~ aKeynes.J
r x / n ' o r k s /ynar
1 8 4 ~(1936)
8/£om m uGeneral
The n s t m oThm [ ....
e s t"o / c' h 0 4 h m .[L~.
Macmillan (reprinted 2007). ~ry o, tzmployment, Interest and Money London.
This record of growth has been quite remarkable and is visible across the
capitalist world. What caused this level of growth and when and where did it start?
While there is some disagreement over exactly when this "revolution" began, it is
generally believed to have started between 1760 and 1840 in England and then rapidly
spread to America and the continent of Europe.t7 This revolution is evident in the
transition from band production to machine production, the conversion of fuel from wood
to coal, the increase in the use of steam power, and the development of iron production
and a nascent chemical industry.
Eoonomie growth can be illustrated in an intuitive way by recalling the concept of
the Production Possibilities Frontier (PPF) from Chapter 2. Recall, this curve illustrates
all the different combinations of any two goods which can be produced with fixed
amounts of inputs and currently available technology. This curve essentially presents a
society with a menu of possible combinations of the two goods that can be produced at a
,6 The data used to eottstn.tct Figure 7.4 are from the Maddison Project Database, version 2018. Bolt. Juna
Robert Inklaar, Herman de Jong and Jan Lulten van Z.anden (2018), "Rebasing "Maddison': new income
eomparisous and the shape of long-run economic development," available at
b1n~:/A~-~t~`ru~`n~/~d~/hi~t~rlc~dev~pm~n~maddis~n/re~ases/hmddis
Dollar amounts are measured in 2011 U,S, Dollars. n- 7r~f ~-data s-2018
~ See: Ashton, Thomas S. (19481 The Industrial Revolution (I 760-1830). Oxford University Press, or
Hob~bawm. Erie, (1975) The Age of Capitah 1848-t 87J,
 Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

specific point in time. However, over time as the amounts of available resources change
or the production technology advances, the shape and placement of the PPF can change.
As an example, consider a society that produces cars and wheat. This change in
the placement of the PPF over time is illustrated in Figure 7.5. Note that in 2018 there
are combinations of cars and wheat that are possible to produce that were not feasible in
1998 (such as point B). This outward shift of the PPF is economic growth. To see this
more precisely, suppose that in 1998 the society had produced point A (30,000 cars and
12,000 bushels of wheat). If it then produces point B (40,000 cars and 15,000 bushels of
wheat) in 2018 it is producing more of both goods,
Flgu~ 7.5- Economic Growth Illustrated as a Shift of the PPF
Wheat
example, the Brazilian economy grew at a rate of 8.47% per year in the 1970s but only at
1.88% in the 1990s. Similarly, after growing at an annual rate of 4.1 I% in the 1970s and
4.37% in the 1980s, Japan experienced a "lost decade" during the first ten years of the
21st Century growing at a rate of only 0.53% per year. Myanmar experienced the highest
average growth rate of any country in the world during the first decade of the current
century (12.40%) after growing at only 1.94% per year in the 1980s.
China's growth over this entire period has been nothing short of remarkable. The
worst decade for the Chinese economy was the 1970s, when an average growth rate of
7.42% per year was realized. To put this in perspective, only three other countries on the
list had a growth rate above this level in any single decade (Brazil in the 1970s, South
Korea in the 1970s and 1980s, and Myanmar in the 2000s).

F PPF 2018
Table 7.6- GDP Growth Rates Around the World

15,000 ................ B Country/Region 1970-20161 1970-79 1980-89 1990-99 2000-09 [ 2010-16

China 9.19 7.42 9.74 10.00
12,000 ............. I 10.35 8.10
South Korea 7.12 t
PPF 1998 Myunmar
India
6.39
5.62
%5 8.78
1.94
7.13
6.12
4.68
12.40
[

I
3.48
7.41
2193 5.69 5.77 6.90 7.34
Brazil

o i\"
3.76 8.47 2.99 1.88 I
3.37 [ 1.37
Mexico 3.48 6.43 2.29 3.62 1.84 ] 3.11
Sub-Saharan Africa 3.4 I 4.36
0 1.44 1.97 5.51
30,000 40,000 World 3.90
3.14 4.16 3.03 ~
2.68 2.83 2.96
United States 2.81 3.54 3.14 3.23 1.82 ~
T H E I M P L I C AT I O N O F G R O W T H O N T O P O F G R O W T H Japan 2.48 2.14
4.11 4.37 1.63 ~
0.53 [ 1.46
2.27
As previously noted, lung-term economic growth can he measured by the annual
Central African Re .
percentage increase in the value of GDP, known as the GDP Growth Rate. In recent
decades, most countries around the world have experienced moderate, positive growth.
Table 7.6 provides a partial summary of average annual GDP Growth Rates for several It is important to recognize that what might appear to be small differences in
growth rates can have a big impact over time. This is because of the impact of growth on
countries and regions around the world from 1970 through 2016.ts
top of growth (also known as compounded growth). Consider a country that grows at a
Countries/regiuns are ordered in Table 7.6 based upon the average value of GDP
constant rate of 4% per year. How many years will it take for GDP to double (i.e.,
Growth Rate over the entire 47 year period from 1970 through 2016, as reported in the
first column of numbers. Of all 106 countries in the world for which data was available increase by 100%)? You may be tempted to think that it will take ~ = 25 years. But,
in every year during this time period, China had the highest average Growth Rate this incorrect answer does not account for the growth on top of growth. If the country
(9.19%) and the Central African Republic had the lowest average Growth Rate (0 99%) started with GDP of $100 billion, during the first year it grows by $4 billion to $104
Note that the World as a whole grew at an average rate of 3.14% during these years. The billion. But now in the second year when it grows by 4% it not only gets a 4% increase
remaining columns provide information on the average GDP Growth Rate by decade. on the initial GDP of $100 billion, it also gets a 4% increase on the extra $4 billion
. For each country/region, growth rates vary fi'om decade to decade, reinforem the gained in the first year. In total, during the second year GDP increases by $4.16 billion,
prevmus observation that economies exnerieno, ~,~,t. ...... "g going from $104 billion up to $108.16. This is a little bit higher than GDP of $108
. - . . . . ,a g~a.m nines and bad times. For billion, the level that would have been realized if the country grew by only 4% of the
a These values arc from the "World Bank": blto.'//data, wor/dbank.ort,/tndicafor/NY, initial base. Over time this difference snowballs. After 10 periods the country has a GDP
of $148.02 billion (instead of only $140 billion), after 15 periods GDP is $180.09 billion
 Chapter #7 - Gross Domestic Product and Economic Growth
(instead of $160 billion), and GDP has more than doubled to $202.58 after only 18
periods (not 25 periods). These differences become more substantial over longer time
horizons.
As an approximation, if something grows at a constant rate of X% per period it
will double after roughly 7yx periods, a result known as the Rule of 72. So, a country
growing at a constant rate of 4% per year will find that its GDP is twice as large after
about 7~4 =18 years)9 To see the dramatic differences which can result from seemingly
minor variations in growth rates, consider one country that grows at a constant rate of
5.4% per year and another country that grows at a constant rate of 3.6% per year. (These
values are roughly equal to the rates of 5.62% and 3.76% respectively experienced by
India and Brazil over the 47 year period from 1970 through 2016, as reported in Table 7.6
above.) Using the Rule of 72, a country that grows at a constant rate of 5.4% will have
its GDP double every 13.33 years. In contrast, a country that grows at 3.6% per year will
have its GDP double every 20 years. Recognize what this implies over the course of 40
years. The country that grows at 5.4% per year will have experienced three doublings of
GDP, so that the value is eight times its starting value (the first doubling makes GDP
twice as large, the second doubling makes GDP four times as large, and the third
doubling makes GDP eight times as large). In contrast, the country that grows at the only
slightly lower rate of 3.6% will experience only two doublings over these 40 years, so
that the value of GDP is four times its initial value. So, if both countries start with Real
GDP Per Capita of $5,000, after 40 years the country that grew at 5.4% has Real GDP
Per Capita of $40,000 while the country that grew at 3.6% has Real GDP Per Capita of
$20,000.20 Now that we appreciate the importance of economic growth, we will identify
and discuss the factors which allow a society to achieve such gains.
DETERMINENTS OF LONG-RUN ECONOMIC GROWTH
Economists have long debated the causes of the tremendous increase in output of
GDP since the beginning of the industrial revolution and the resulting increase in income
for the average person. However a consensus has emerged to explain these phenomena.
Extensive Growth versus Intensive Growth
All economic growth can be subdivided into extensive growth and intensive
growth. Extensive growth is growth due to bringing new land into cultivation or
Rule of 72 is an approximation. More precisely, expressin the co
decimal denoted by r (e.~. Xe,4-4~ : ...... g nsUon growth rate of A% as a
o, ,~ rffi.u.~), a vartanle that grows at a constant rate of r per period will
double in t = la(~l~l÷r) periods (where in(.) denotes the natural logarithm).
20 This final s~tement assumea a constant population, so that merenses m GDP directly convert to similar
mcrcasas in Per Capita ODP. Additionally, this entire discussion aSSUmes that the growth rate of X~a per
period is ds~rib ng "real .... ~ -
,,~ ut ~as °PPused to "nomlnal growth" due to chenges in pricas).
Chapter #7 - Gross Domestic Product and Economic Growth
building new manufacturing facilities (of the same type and technology that already
exists). Extensive growth makes a country as a whole wealthier but does not necessarily
increase the income or living standard of its people. It is even possible to have extensive
growth and a declining standard of living at the same time.
Consider the following example to illustrate extensive growth. Imagine that you
are part of the westward expansion of the U.S. during colonial times. The colonies
together have a Real GDP of $1 billion and a population of I million. Real GDP Per
Capita is $1 billion/l million people = $1,000 per person.21 This $1 billion economy was
created by growing corn on 100 million acres (with each farm family having 100 acres to
work with) using 200,000 horses and plows. Now suppose that the population doubles to
2 million, and these people have moved further west onto new land, having purchased
productive capital such as plows, horses, and other farming equipment. An additional
100 million acres is brought into cultivation (.providing the new farmers with 100 acres
each) using the existing technology and human resources, bringing total real GDP up to
$2 billion. The economy is now twice as large as before, but what about the individuals
who make up the country? Are they any richer than before? The calculation of Real
GDP Per Capita, is now $2 billion/2 million people = $1,000 per person. Even though
the economy has doubled, the income per person is the same as what we started with.
This example of extensive growth was deliberately constructed to give a result
where there is no increase in Real GDP Per Capita and therefore no Increase in the
standard of living. It is possible to increase people's income under extensive growth if
you can expand resources faster than population growth. What if the farmers moving
west find so much land that each of them can now have 150 acres instead of 100? Then
each farmer will be able to have a higher standard of living than existed before since they
have more resources per worker. This same increase in production and income can be
generated by adding capital to the production process instead of land. Instead of having
western lands to expand into, let's assume that instead we doubled the number of horses
available for farmers from 200,000 to 400,000 (keeping the amount of land constant).
Now a farmer has the ability to switch out a tired horse for a rested horse, so he can now
plow more of his 100 acres than he could before. By increasing the Capital/Labor
Ratio, the amount of capital available for each worker, the farmer is able to increase his
total production fi'om the same amount of land.
Unfortunately, neither of these two sources of growth is sustainable long-tenn.
As Americans moved west the frontier was eventually swallowed up leaving no more
unsettled land for new farmers. The second possibility of increasing capital is also not
sustainable. Just imagine adding a third horse to our 100 acre farm, and then a fourth and
a fifth. As we add more capital (horses in this instance) we start to get smaller increases
in output from any additional unit of capital. Eventually the addition of some horse will
not increase production at all. With no new land available to either cultivate or absorb
2, Between 1720 and 1775 Read GDP per Capita in the American colonies rose from $1,375 to $1,883. We
have constructed an artificial example and all data are illustrative only.
 Chapter #7- Gross Domestic Prodnct and Economic Growth
the extra horses used to plow, and a growing population that needs to eat, we have the
stage set for a declining Real GDP Per Capita (that is, a falling standard of living).22
Another source of extensive growth, one that has increased the living standards of
people around the world, has been the rapid movement of people from rural areas to
urban areas. When workers in rural areas, who maintain themselves by subsistence
agriculture using little or no capital, move to urban environments they usually realize a
large increase in their productivity as they are absorbed into manufacturing or other types
of employment which use more capital and are therefore more efficient.23 Under these
conditions the economy grows faster than the population and the average income of
workers (or GDP Per Capita) can rise. This source of increasing incomes is, just like
westward expansion during the colonial period, not sustainable. When the percentage of
workers in agriculture has declined to low levels there is no longer an ability to gain large
increases m productivity by moving to the city, since most people already live there. If
we want to condnue increasing the living standards of the population in the long-term,
another source of growth besides extensive growth is necessary.
This observation is not to suggest that extensive growth is immaterial in world
history. Virtually all of the great empires that existed before the beginning of the
Industrial Revolution were based on extensive growth. Consider the Roman Empire or
the Ottoman Empire, both based on growth by conquest. Assume for simplicity's sake
that the emperor could sustainably extract 10% of the income of his subjects. As the
empire expands by conquering its neighbors the size of the economy is expanded as well.
The king or emperor now collects 10% of a larger economy and therefore has the
resources to support churches, art, magnificent public building programs, and other signs
of power and wealth, even while his subjects remain poor. He can also support a military
machine that is used to conquer morn territory. Of cnnrse this is also not sustainable, and
all the great empires of antiquity ultimately failed to grow and than collapsed.2(
What is needed for a sustained, long-term increase in prosperity and standard of
living for ordinary people is intensive growth, or growth brought about by increasing
worker productivity. Productivity measures the amount of output that can be generated
from a specified amount of input. It can be increased by increasing either the quality of
the workers themselves, the quality of the capital they work with, or some combination of
both. We can measure the productivity of workers by calculating output per worker-
hour. Consider the following example: We compare a small community of 20 anm
farmers and their families in the 1870's to a farm on the same land today. Assume the
z~ This pmblem was first d scussed m detail by the great classical economtst David Ricardo in his book,
.
"On the Principles of Polifcal Economy and Taxation" which is available at:
httP:/'~l'W";econlib'°rrglibra'3'/Ricardo/ricPJu.r,r. See also Thomas Malthus, "An Essay on the Principle
of Population" available at: htn~:/Avww.econlib.ore/librarl,/Malthus/malPop.ht#d" For a Socialist critiquc
see also: Marx, Karl (2007): Capital: A Critique of Pol#ical Economy: The Process of Capitalist
Production. Volume I part 2 Cos me Inc 708
z3This ' -, pp. -709.
system PwTe~e~canca~t~lb~; .d~_..+cmatically un~.ed if a society has a col~mp t or poorly run economic and legal
may not resli~e'~'~'n~t~c~rear~e ~sn~i~l~°cated" Under these ctreumstanees workers moving to cities
24 For a readable non-speciahst
" account of the decline of the Ottoman Empire see: Bernard Lewis (2002):
What Went Wrong: Western Impact and Middle Eastern Response, Oxford University Press.
Chapter #7 - Gross Domestic Product and Economic Growth
farmers in 1870 are each fanning a 50 acre parcel of land for a total of 1,000 acres. Their
output is 960 bushels per acre making total output of 960,000 bushels for all of the
farmers together. Each farmer works 2,000 hours per year (40 hours per week x 50
weeks per year) generating a total of 40,000 labor hours for the community. This gives
them a Labor Productivity of 24 bushels per worker-hour (960,000 bushels/40,000
hours). When we fast forward to 2018 we see that output has risen to 4,800 bushels per
acre, producing a total of 4,800,000 bushels from the same 1,000 acres of land. Only one
farmer owns the entire 1,000 acres today since most of the farmers have moved to the
city. This one farmer, with a total workforce of 5 workers, produces the entire output of
the farm generating worker productivity of 480 bushels per worker-hour,z5 Notice that
20 times more corn gets produced per worker! Economists normally make one more
adjustment and convert rite output of corn in bushels to output in dollars, so that the
productivity of workers in different industries can be added together to calculate GDP.
What factors can explain such a massive increase in a modem worker's
productivity compared to workers of the past? It obviously did not come from working
harder. Does anyone believe that a modern farmer works physically harder than a farmer
did before modem machinery? So the source of the productivity must lie elsewhere.
Let's start with changes in capital. The modern farmer doesn't add dozens of extra
horses (capital used in 1870) to his farm to get more output; he buys a diesel powered
tractor that can pull the equivalent of a dozen horse drawn plows. He uses modem seeds
that have been carefully selected and bred to increase the output of corn per plant,z6 He
uses modern fertilizers and pesticides that further increase the output above what a farmer
in the 1870 could have produced All of these reasons for why a modern farmer is so
much more productive than a farmer in the past can be grouped under the heading of
technology, which is the application of scientific and engineering principles to the
problem of production. Tractors are invented and improved by engineers, chemistry is
brought to bear on pesticides and fertilizers, agronomists improve the seeds, etc. This is
done in virtually all industries and has been going "full steam" ever since the beginning
of the Industrial Revolution.27
Not only has the physical capital (the machines, buildings, factories, and other
equipment used in the production process) that workers use improved over the last two
hundred years, but the workers themselves have been "improved" through Human Capital
accumulation. Human Capital encompasses the knowledge, education, skills,
experience, work ethic, inter-personal skills, and other attributes of workers which
determine productivity. This form of capital, just like physical capital, is critical for
In order to see the remarkable increase in output in agriculture in the U.S. going back to before the civil
w~ go to: htn~:/A¢a~w.ers~usda.~v/data-tJr~chwts/feed.grains~databct~e/~ed-gr~ins-cust~m-quera'asp~
an interactive for
data set. The authors leave the calculation of 2018 worker productivity to the student as
an
exercise.
16 Th- ts process has recently become more controversial with the introduction of GMO's, or genetically
modified organisms. See: htm:/As~a~'.briton~iea.cpm/EBchecked/topi¢/89770~S/genetieall~.modt[ied
for an accessible discussion.
a~ Pun flatly intended, The radical impmvemeat of the steam engine by James Watt in 1769 was a major
factor in the start of the Industrial Revolution.
 Chapter #7- Gross Domestic Product and Economic Growth
defining how much output a worker will produce. Recall, as illustrated in the Circular
Flow Diagram, increases in production a~ equivalent to increases in income. Therefore,
mereases in Haman Capital generally lead to higher standards of living.
In technologically advanced modern societies very few workers make their living
strictly from their physical strength. Most jobs require the ability to read, calculate,
reason through problems, and other higher order skills that were not highly valued before
the advent of the Industrial Revolution. If you are reading this book you are probably
training to be a knowledge worker of some kind. Even the modern farmer in our example
needs a great deal of education to be able to understand how to work on the diesel engine
in his tractor, to read and understand the price infonuation available for the various crops
that he might produce, or to make choices between various chemical fertilizers that he
will use. Most farmers who operate at the scale in our example have been to college in
order to understand all that is involved.
Relating the Sources of Economic Growth to Outward Shifts of the PPF
Recalling that economic growth can be ilinstmted by an outward shift of the
Production Possibilities Frontier (PPF) allows us to recognize that the factors which lead
to growth are those which would cause the PPF to shift outward over time. As discussed
within Chapter 2, the shape and placement of the PPF is determined by the amount of
scarce resources and the technology (i.e., production techniques) available to a society.
~; sequently, the curve will shift outward over time (reflecting economic growth) when
of these things increase. More precisely, economic growth, as measured by an
increase in the value of Reai GDP, can result from: (i) increases in the quantity of labor
(i.e., having more workers); (ii) increases in the quantity of physical capital (i.e., having
more machines, factories, and other equipment used for production); (iii) improvements
in the quality of labor (i.e., having workers become more highly educated or skilled); and
(iv) improvements in technology. Note the parallel between these factors and the
definition of Industrially Advanced Countries (such as the United States, Germany, and
Japan)- high
- ' income
. .
countries with
. pnmarily
, market based economies, large stocks of
technologically advanced industrial capital, and a highly educated and skilled workforce.
Logically, then, all it takes to make a society more productive with a higher
average level of income is to increase the quantity and quality of available physical and
human capital. This could be done by making deh'berate investments toward this end.
For example, consider a society that is making the broad choice between
goods" and "capital goods," as illustrated in v; ....... "consumption
r J S t u c r. O D C l O W.
In this figure "Capital Goods" encompasses not only investments in human
capital and physical capital, but also investments in overhead capital, defined as
infrastructure such as railways, roads, telecommunications networks, electricity supply
systems, and water supply systems. Such investments could either be made by individual
households and firms or (particularly in the case of overhead capital) by government on
behalf of society. The important point to recognize is that if a society devotes more
resources to investments in capital goods today (at the expense of p~ent day
consumption), this leads to having a greater amount and/or more highly productive
Chapter #7- Gross Domestic Product and Economic Growth
capital goods in the future. Consequently, the future PPF will be further from the origin
than it otherwise would have been, revealing greater economic growth.
Looking at Figure 7.6, in 2018 this society is faced with tmdeoffs between
consumption goods and capital goods as illustrated by the PPF closest to the origin. If
they choose "Point A" in 2018, they will achieve moderate economic growth over the
next two decades and in 2038 be faced with the dark PPF in the middle. If instead (all
other factors fixed) they were to choose "Point B" in 2018 - a choice characterized by
lower consumption but higher investment in capital goods in the present period - they
will achieve high economic growth over the next two decades and in 2038 have the light
PPF furthest from the origin. Comparing the two outer PPFs we can see the extra
"reward" to this society from making the higher initial investment in capital goods
(which was only possible by making a larger initial sacrifice in consumption in 2018).2s
Figure 7.6- Impact of Investment in Capital Goods on Economic Growth
Capital Goods
2038 PPF, if
/ " a " i s c h o s e n
~ -. 20,sPpF,f
~ . ~ ~ i n 2 0 1 8 . . .
2018--, B'~ ~ z" \ in2ol8...
o * \ \ Goods
Similarly, growth could be achieved by realizing improvements in technology
which fundamentally change either the type of capital available (e.g., replacing manual
typewriters with computer word processors) or the production process (e.g., sending
documents or making payments on-line instead of by regular mail). Unfortunately all of
these suggestions for how to achieve growth are more easily said than done. In practice,
several impediments to achieve growth exist.
At a basic level, achieving growth by making investments in capital can be very
difficult for a poor couna'y to do, precisely because it is poor. As illustrated by Figure
7,6, to make greater investments in capital today requires a greater sacrifice of
consumption today. Such sacrifices
- -m present day consumption are probably much more
difficult for poor countries to make, A high income country like the U,S. (with Per
ztN , .
°tetheparalleltoaaindividual'schoiceofconsuatpdoax~.sussavingso~xaiifetime
Person A young
that saves more must sacrifice consmnpuoa to do so, but the vewa.rd Is baying more money available
when old. " " " "
 Chapter #7 - Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

Capita GDP of $59,500) could much more easily afford to invest $1,000 per person in the
construction and maintenance of roads and railways than could a low income country like
Kenya (with Per Capita GDP of $3,500). This example illustrates the vicious-cycle-of-
poverty hypothesis, which claims that poor countries are destined to remain poor since
they do not have sufficient resources available to make the investment in capital which
are necessary for economic growth. While this observation has a great deal of merit, it
clearly is not universally true - if it were, then no country would have ever been able to
escape poverty and develop on its own. After all, every modem, advanced economy of
today was poorer in real terms 200 years ago than Kenya is today.
This problem is exacerbated for many poor countries by capital flight, which
refers to the tendency for wealthy people in poor countries to invest their financial capital
abroad instead of at home. For example, many wealthy people in less developed
countries choose to invest the money they do have in the U.S. or Europe (richer countries
with more stable legal and political institutions). They choose to do so precisely because
investment in these foreign countries is likely to provide a higher expected return and less
risk than investment at home. But this choice compounds the problem of having
sufficient investment made in the poor country in order to spur development and growth.
Similar difficulties are present when it comes to developing human capital. Major
health epidemics can make it difficult for some poor countries to develop human
resources. For example, Life Expectancy at Birth is 50.6 years in Chad, 52.8 years in
Somalia, and 53.8 years in Nigeria.29 Many poor countries (particularly in Africa) suffer
from large numbers of deaths due to malaria and AIDS. In 2016, approximately 445,000
people in the world died from malaria, with 91% of these deaths occurring in Africa.30
Similarly, in 2016, one million people died of AIDS-related causes, with 730,000 (73%
Finally, poor legal, political, and economic institutions can each present barriers
to development for many countries. As we saw in Chapter 3 there are two major
competing ideologies regarding how to organize the economy of a society (i.e.,
Capitalism and Socialism), and how this conflict is resolved can make a tremendous
difference in economic outcomes for a country. In Figure 7.7 we compare three countries
from 1900 to 2016.32 In 1900, Real GDP Per Capita was $8,542 in Argentina, $5,536 in
Germany, and $2,439 in Singapore. The mixed economy of Germany experienced solid,
steady economic growth over these years, so that by 2016 Real GDP Per Capita stood at
$46,841 (over 8 times higher than its value in 1900). Argentina, held back by poor
economic institutions, had Real GDP Per Capita of $18,695 in 2016 (not much more than
double its value from 116 years earlier). Singapore experienced explosive growth after
ardently embracing market based economic institutions during the second half of the 20th
Century. Consequently, Real GDP Per Capita in the country was $67,180 by 2016 (over
27 times higher than its value in 1900). That is, by 2016 Germany was still the middle
country of these three in terms of Real GDP Per Capita, but now Singapore was the
richest and Argentina was the poorest. Moreover, while Singapore's Real GDP Per
Capita started out as less than a third of Argentina's in 1900, by 2016 it was well more
than three times as large as Argentina's.
Figure 7. 7- Real GDP Per Capita in Singapore, Germany, & Argentina, 1900 to 2016
70,000

~
Singapore
of the total) of these deaths occurring in Africa 3a These observations are tragic on many 60,000
levels. From an economic development perspective, recognize that when confronted with
such short lifespans and health problems, investments in human capital have much lower So,000
returns (reducing the incentives for individuals and society to make such investments). Germany

~
Another difficulty that many low income countries face when it comes to 40,000
developing human resources is the "brain-drain," which refers to the tendency for the
30,000
most highly talented individuals to become educated and then move to an already
wealthy country. A talented doctor, engineer, or computer scientist can earn a much
20,000
higher salary in a developed country like the United States, Germany, or Japan than she
could ever hope to earn in India, Nepal, or Thailand. Very often this brain-drain occurs
when the individual first moves to the wealthy country (such as the United States. where l O . O 0 0 ~ A r g e n t i n a
the top-tier of higher education is better than anywhere else in the world) o
choosestoremainthere dtion.......topuo
IILI SKIneu .
peop] eare essentially skimmed off the top - of the labor
i . U S force
U l t , u ]of
e mthe
ost
poor country, making the development of human resources and ultimate economic
growth all the more difficult.

~ I n COntrast, ,tt s 85.3 years

. m Japan. See t
"//ww~v. io. ov/l~ ~a The data used to construct Figure 7.7 (as we as Figures 7 8 7.9, and 7. l 0) are again from the Maddison
~J ot Sm e le ~ " u ii otto /the-~gr/d.
Project Database verston 2018, Bolt, Jutta, Robert lnldanr, Herman de Jong and Jan Luiten ".'an Zanden
31 ~: ~ediaAt~orld-mal#ria-reoorl.20 I 7/c,,,'. (2018), "Rebasing 'Maddisan': new income comparisons and the shape of long-run economic
...... ~ ~ U N ~ I ~ c , h e e , . development," available at hltl~'w/A~t~v.~te, nl/t'~d~istoricaldewk)pmem/m~xtdison/re/easfs/ma~klison.
~. DoI" lar amounts are measured in 2011 LI.S. Dollars.

Chapter #7 - Gross Domestic Product and Economic Growth
Next consider China, India, and Zimbabwe. Real GDP Per Capita in each country
between 1950 and 2016 is plotted in Figure 7.8. Starting in 1978, under the leadership of
Deng Xiaoping, China instituted economic reforms which gradually made its centrally
planned socialist economy more market oriented. Similarly, in the 1990s India moved
away from socialism and toward free markets, with an emphasis on reducing government
bureaucracy and regulation. Both of these countries realized extraordinary growth
following these shifts away from planning toward markets. Real GDP Per Capita in
China increased only slightly from $757 in 1950 to $1,413 in 1977, but then exploded to
$12,320 by 2016. In India Real GDP Per Capita actually decreased from $1,417 in 1950
to $1,297 in 1991, but, following its free market reforms which began in the early 1990s,
Real GDP Per Capita reached $5,961 in 2016.
Figure 7.& - Real GDP Per Capita in China, India, & Zimbabwe, 1950 to 2016
~.2,0o0 China
10,(X)0
S,000
6,0GO
India
4,000
~O
r - - - ~ ~ Z i m b a b w e
0
In contrast, as noted in Chapter 3, the economy of Zimbabwe is presently
characterized by poorly defined property fights (ranked 120 out of 127 countries in the
International Property Rights Index), a low overall level of economic freedom (ranked
144~ out of 159 countries in the Economic Freedom of the World study), and high costs
of conducting business (ranked 159 out of 190 countries in the Ease of Doing Business
study). Zimbabwe, which started out as the richest of Ihase three countries in 1950 with
Real GDP Per Capita of $1,967, actually realized a couple of decades of solid economic
growth leading In Real GDP Per Capita of $4,341 in 1974. Following a guerrilla war
which lasted from 1975 to 1979, Robert Mugabe came to power as Prime Minister of
Zimbabwe, a position he held from April 1980 through November 2017. Under his
leadership respect for property rights and the role-of-law declined dramatically. The
resulting poor economic institutions - in particular high levels of corruption and
Chapter #7 - Gross Domestic Product and Economic Growth
irresponsible monetary policy - during this time led to a steady decline in Real GDP Per
Capita to $1,729 in 2016, which is lower than where it started in 1950.
Finally consider two additional comparisons between groups of countries that
share a great deal culturally, but chose very different economic systems. Real GDP Per
Capita in Puerto Rico, Panama, and Cuba between 1950 and 2015 is plotted in Figure 7.9.
In 1950 Real GDP Per Capita was $4,742 in Puerto Rico, $3,841 in Cuba, and $2,073 in
Panama. By 2015 these figures stood at $35,384 in Puerto Rico (about 7.46 times its
1950 value), $20,809 in Panama (about 10.03 times its 1950 value), and $7,889 in Cuba
(about 2.05 times its 1950 value). Thus, the socialist economy of Cuba seriously
underperformed relative to Puerto Rico and Panama.
Figure 7.9 - Real GDP Per Capita in Puerto Rico, Panama, & Cuba, 1950 to 2015
Lastly, a comparison between North Korea and South Korea is provided in Figure
7.10. Before World War II, these two countries were one single county with a combined
area of roughly 85,232 square miles. After World War II they were split into two
separate occupation zones. Attempts at reunification failed, followed by the hostilities of
the Korean War from 1950 to 1953, after which the Korean peninsula was split into two
countries: North Korea (with an area of 46,541 square miles) and South Korea (with an
area of 38,691 square miles))~ At the time when these countries were split in two, they
shared an identical history and culture and were very similar in terms of demographics,
human capital, and natural resources, but with the north being more advanced
industrially.
,
1 F or Comparison, ,
North Carohna and South Catohna
, have a combined area of 85,839 square miles (neatly
identical to the 85,232 squar~ mile atca of the total Korean peninsula). However. at 32,020 square miles,
South Carolina is a bit smaller than South Korea, while North Carolina (53.819 squar~ miles) is slightly
larger than North Korea,
 Chapter #7 - Gross Domestic Product and Economic Growth
At the time of the split in 1953, Real GDP Per Capita stood at $706 in North
Korea and $1,385 in South Korea (i.e., the value was 1.96 times large in South Korea
than in North Korea). A socialist economic system was establish in North Korea,
modelled heavily upon and supported by the former Soviet Union. South Korea was
crrated as a constitutional democracy, which would ultimately embrace free market
Capitalism starting in the early 1970s. When South Korea made this transition toward
markets its Real GDP Per Capita began to increase dramatically, while North Korea
(which continues to this day to rely upon command planning) remained stagnant. Recall,
as stated in Table 7.6, South Korea experienced annual GDP growth which averaged
I0.45% in the 1970s, 8.78% in the 1980s, and 7.13% in the 1990s. By the time when
North Korean Real GDP Per Capita peaked at $2,564 in 1985, the corresponding figure in
South Korea had increased to $7,322 (i.e., the value was now 2.86 times larger in South
Korea than in North Korea). Over the next three decades, the economy of South Korea
continued its impressive economic growth while that of North Korea remained stagnant.
By 2015, Real GDP Per Capita in market oriented South Korea was 20.53 times grcatcr
than in socialist North Korea ($35,316 versus $I,720). Such differences in incomes have
real world consequences. For example, South Koreans are now approximately three
inches taller than North Koreans, even though they are of the same racial and ethnic
stock.~
Figure ZlO-Real GDP Per Capita in North Korea & South Korea, 1953 to 2015
3s,tx~
South Korea
30,000
~,000
20,000
I~,o00
J-o,oo0
s,0oo
o mason. Creditors fear that they will not be able to collect on debts or foreclose on
m m ~ " -North Korea
In summary, when South Korea and North Korea were split in two in 1953 Real
GDP Per Capita was less than twice as large in South Korea - by 2015 it was over 20
times larger in South Korea than in North Korea. As noted, these were nearly identical
See, "Are North Komam really three inches shorter than South Koreans?" by Richard Knight, BBC
News, April 23, 2012, ~b~:.com/news/mag~.
Chapter #7- Gross Domestic Product and Economic Growth
countries (in terms of culture, demographics, natural resources, and other important
factors) at the time of this arbitrary split. When the two countries diverged economically,
the important way in which they differed from one another was their ebosen economic
system. As South Korea embraced free markets and Capitalists institutions, it achieved
remarkable economic growth which raised living standards tremendously. In euntrast, as
North Korea remained under a system of Socialism with command planning, GDP
remained constant.
Collectively, looking across Figures 7.7, 7.8, 7.9, and 7.10 we can begin to
appreciate the importance of institutions for achieving economic growth and prosperity.
All of the countries charted in these graphs have been combining capital and labor to
produce goods and services but have achieved varying results. The astounding
differences in long-run economic performance are in large part due to differences in
economic and political institutions and the chosen economic system.
In Chapter 3 we discussed measures of economic freedom, protection for property
rights, and the ease of doing business across a multitude of countries.3s In Chapter 11 we
will discuss the concept of Government Failure, or the reasons why governments oRen
fail to deliver economic efficiency to their countries. As we have already discussed
earlier in this chapter, in order for an economy to grow someone needs to invest in capital
and in workers' skills in order to increase worker productivity. In Capitalism this role is
shared between the government and private entrepreneurs or capitalists. But even in
market oriented economies, Governments make the bulk of investments in overhead
capital such as highways, dams, and other forms of infrastructure that increases
productivity. Governments also run schools and colleges that raise student's knowledge
and skills, ultimately increasing their human capital and making them more productive
workers.
Just as importantly though, the government sets the rules that govern property and
contract. The government can conduct itself by following the rule-of-law, where
property rights and contracts are respected and administered fairly and transparently,
without favoritism - or government can do the opposite. Countries with poor track
records in maintaining the rule-of-law have generally had a very difficult time achieving
long-term eennomic growth. Honest entrepreneurs are afraid to invest for fear of losing
the!r money through the arbitrary actions of government officials who are either corrupt
or Ignorant of the negative effects of their law making. Foreign investors fear that the
government could expropriate (that is, seize) their assets at any time for no legitimate
property when debtors don't pay.
Additionally, unscrupulous business people oRen use corrupt political systems to
their advantage by becoming crony capitalists, where they can get, among other things,
preferential treatment from government through rigged government contracts, subsidized
government loans, or government provided bail-outs when the firms suffer losses. The
possibilities are endless when it comes to the ways that government power can be
manipulated to reward insiders and punish outsiders. Under these conditions the honest
Within Chapter 3, see tables 3.1, 3.3, and 3.4 and the accompanying discussion for more details.
 Chapter #7- Gross Domestic Product and Economic Growth Chapter #7 - Gross Domestic Product and Economic Growth

business person falls by the wayside and the country is overrun with government officials
C H A P T E R # 7 M U LT I P L E C H O I C E Q U E S T I O N S
and the business elites that are tied to them making self-serving decisions that lower the
productivity of the entire society. Examples of this kind of behavior can be seen in the
1. The Expanded Circular Flow Diagram builds upon the Basic Circular Flow
corruption of former dictators like Ferdinand Mareos of the Philippines and General
Suharto of Indonesia, as well as the shady business practices of the Russian Oligarchs Diagram by
after the fall of the Soviet Union. A. eliminating the illustration of the role of households.
The poor performance of the sociaiist economies of the formerly communist B. adding an illustration of the role of labor unions and monopolies.
countries of Eastem Europe, the former Soviet Union, China before its reforms, present C. adding an illustration of the role of government and the foreign sector.
day North Korea, and present day Cuba are all examples of countries that had problems D. adding an illustration of the role of the central bank.
generating long-run growth. Government ownership of the means of production removes
one of the most important tools for getting managers of productive assets to use them 2. The phase of the business cycle that refers to the point in time at which overall
wisely - namely the individual self-interest to pursue profit and avoid loss. Without economie activity reaches its minimum is the
private ownership the fruits of good management am turned over to the government, with A . R e c o v e r y.
very little of the gains going to the person who came up with the technical invention or B. Peak.
business innovation. Likewise, bad decisions am paid for by "socializing" the losses C. Recession.
through subsidies and bailouts for govemment owned firms (or firm controlled by D . Tr o u g h .
"cronies"). We see this currently in the U.S. Postal Service, which loses billions of
dollars every year and yet no one is personally responsible. There is no identifiable 3. High income countries with primarily market based economies, large stocks of
owner who will lose this money personally and therefore have an incentive to fix the technologically advanced industrial capital, and a highly educated and skilled
problems. This could go on indef'mitely. Long-term growth inevitably suffers. workforce (e.g., the United States, Norway, Australia, Germany, and Japan) are
referred to as
A. Commercially Dependent Countries.
B. Less Developed Countries.
C . Industrially Advanced Countries.
D. Economically Superior Countries.

For questions 4 and 5, consider a country with consumption expenditures, private

investment expenditures, government purchases, imports, and exports as summarized
in the table below (each measured in millions of dollars):

teexpenditures
°°s$u8m
97
p°nIexpenditures
'nv$e2s1e2n'tg°[vpurchases
e$rnmeut[ imports
335 $196
exports
$234
For this country, "net exports" are equal to 1
A. $38 million.
B. $234 million.
C. $430 million.
D. $1,874 million.

FAor this
$897country,
million.Gross Domestic Product is equal to
B. $1,482 million.
C. $1,678 miUion.
$1,874 million.
 Chapter #7 - Gross Domestic Product and Economic Growth
Chapter #7 - Gross Domestic Product and Economic Growth

10. In 2016 there were ~ deaths from malaria world-wide, with __ of these
6. The U.S, economy grew for an uninterrupted 10 year period from
occurring in Africa.
A . May 2005 through May 2015.
A. 195; 8.
B . March 1991 through March 2001.
B. 445,000; 91%.
C . September 1979 through September 1989.
D . June 1967 through June 1977, C . 32.7 million; 63%.
D . None of the above answers are correct (since malaria was eradicated in 2012).
7, Gross Domestic Product can be expressed by the following formula:
A . Y=MX+B 11. Qihong was born in China. Throughout his entire life he has excelled academically.
B. Y=C+I+G+NX After earning a Master's degree from the China University of Mining and
C . V = (cxF) + (Gk'NX) Technology in Beijing, he came to the United States to pursue a Phl). Upon
D . V = (C- I)(G-NX) completion of his PhD he was hired by a prestigious research university in
Oklahoma, where he works to this day. This story provides an illustration of the
A. Rule of 72.
For Questions
Goods" 8 and 9,Goods"
and "Capital considerwhich
a society facing the tradeoffs
are illustrated between "Consumption
by the Production Possibilities B. catch-up effect.
Frontier below. The curve labeled '1993 PPF' illustrates the PPF of this society in C. brain-drain.
1993. In 1993 this society chose 'Point .4' on this curve. As a result, by 2018 the D. vicious-cycle-of-poverty.
society faced the PPF labeled '2018 PPF.'
Capital Goods 12. Consider a country with a population of 3,485,000 people and Real GDP of E88A 32
billion. It follows that Real GDP Per Capita
A. is also equal to ~88.132 billion.
B. is roughly equal to E25,289.
C. is roughly equal to ~307,140,020.
D. cannot be determined from the given information.

13. During the most recent recession in the U.S. (which officially lasted from
2993 December 2007 through June 2009) Real GDP
A. increased by 1.6%
B. decreased by 0.5%
C. decreased by 4. l%
~j 0 Goods D. decreased by 8.5%
0 2 8
8. The "outward shift" of the PPC (from '1993 PPF' to '2018 PPF') which occurred
between 1993 and 2018 could be best described as 14. Growth due to bringing new land into cultivation or building new manufacturing
A. an increase in demand. facilities is ~_; growth due to increased worker productivity is
B. inflation. A. extensive growth; intensive growth,
C, economic growth. B. linear growth; exponential growth.
D. net exports. C. intrinsic growth; extrinsic growth.
D. capital growth; labor growth.
9. If this society had instead chosen 'Point B' in 1993, then the relevant PPF in 2018
would likely lie ~ 15. Per Capita GDP in the European Union is approximately $39,200. In comparison,
A . somewhere below the curve labeled' in the graph above.
1993 PPF' the value of Per Capita GDP in the U.S. is approximately
B . SOmewhere between the curves labeled '1993 PPF' and '2018 PPF' A. $32,190 (about 17.9% lower than the value in the E.U.).
C . exactly on the cutwe labeled '2018 PPF' B. $39,420 (roughly the same as the value in the E.U.).
D . somewhere beyond the curve labeled '2018 P " C . $59,500 (about 51,8% higher than the value in the E.U.).
PF ( .e., further from the origin)
D. $79,150 (just over double the value in the E.U.).

i 178
 Chapter #7- Gross Domestic Product and Economic Growth Chapter #7- Gross Domestic Product and Economic Growth

16. Johnny has worked for Amy for the past twenty years. In 2005 his annual salary 21. Focusing on GDP Growth Rates between 1970 and 2016, ~ grew at an
was $38,500. The value of the price index in 2005 was 123.2, and the value of the average rate of 9.19% per year over this entire 47 year period.
price index in 2017 was 156.9. His real income in 2017 would have been exactly A. The World as a whole
the same as in 2005 if his nominal annual salary in 2017 was __ B. The United States
$30,230.72 C . Japan
B . $49,031.25 D . China
C . $51,474.50
D . $60,406.50
22. Consider two countries that each have a Per Capita GDP of $10,000 in 2018.
17. Country A realizes a constant 3% increase of Per Capita GDP, while Country B
In 1900, Real Per Capita GDP was $8,542 in Argentina and $2,439 in Singapore.
realizes a constant 12% increase of Per Capita GDP. Given these constant rates of
By 2016, Real Per Capita GDP was in Argentina and
A . $39,963; $41,387. in Singapore. increase, in 2042 (i.e., 24 years in the future), Per Capita GDP in Country B will be
- - - - -
B . $31,893; $17,592. Per Capita GDP in Country A.
C . $18,695; $67,180. A. 2 times greater than
D . $7,281; $107,593. B. 4 times greater than
C. 8 times greater than
18. In order to include many different goods and services in a single aggregate measure, D. 16 times greater than
GDP is computed by valuing goods according to
A. Consumer and Producer Smpluses. 23. The vicious-cycle-of-poverty
B. dollar amounts based upon telephone surveys of consumers. A. suggests that poverty is self-porpetuating, because poor countries do not have
C. market prices. sufficient resources available to make the investments in capital which are
D. production costs. necessary for economic growth.
B. is apparently true, since every country that was poor a century ago is still poor
19. refers to the tendency for wealthy people in poor countries to today.
invest their financial resources abroad instead of at home C. has no merit whatsoever, since even poor societies typically have an
A. Capital flight overabundance of financial capital.
B. The brain-drain D. More than one (perhaps all) of the above answers is correct.
C. The vicious-cycle-of-poverty
D . Government failure

20. Maurice is a citizen of Canada, but lives, works, and attends college in the United
States. Last year he went on vacation to Mexico during Spring Break. He works at
a daycar¢ in Roswell, GA. Last year he provided "daycare services" valued at
$22,500. The value of these services would be included in the calculation of GDP
for
A. only Canada, since he is a Canadian citizen.
B. only the United States, since that is where the production took place.
C. only Mexico, since that is where he went to relax on vacation (which was a

necessary activity for him to be able to work hard in school and on the job
D. throughout the rest (i.e.,
all three countries of the year). Mexico, and the United States) since he has
Canada,
n econounc tie to each of the three countries.
Chapter #7 - Gross Domestic Product and Economic Growth

Impact of Policy Decisions

on the Rate of Inflation
"Inflation is always and everywhere a monetary phenomenon."
- Milton Friedmanj

Inflation is defined as an overall increase in the level of prices prevalent in an

economy over time. Virt-aally all modem economies experience inflation, with some
suffering fi'om rates so high that we call it hyperinflation. Within the present discussion
we explore the causes of increases in prices, explaining why so many countries have
suffered from inflation. The effects of hyperinflation can be especially devastating, even
beyond the economic realm - hyperinflation in Germany following World War I not only
devastated the economy, but also led the way for Hitler's rise to power.2
How does inflation impact macroeconomie performance? Why is hyperinflation
so devastating? Could the United States ever suffer from hyperinflation? Once the
causes of inflation are recognized, can we identify remedies (i.e., either maeroecnnomic
or mieroeconomie policies) that could be implemented to reduce or eliminate inflation?
We will address all of these questions and more in the following discussion.

T H E D E F I N I T I O N A N D M E A S U R E M E N T O F I N F L AT I O N

Inflation does not refer to an increase in the price of just one item or even several
items, but rather an increase in the prices of thousands of items such that we all recognize
that the overall level of prices for most goods has changed. To have inflation, not all
prices must rise. For instance, over that past few years the prices on smart phones like
the Apple iPhone have plunged, but we all see food prices rising and fuel prices rising,
etc. The rising prices of these items swamp the few items that are falling in price, so we
can say the price level as a whole has increased.
In the U.S., the Department of Labor's Bureau of Labor Statistics tracks the
inflation rate by calculating the value of the Consumer Price Index (CPI) on a monthly
basis. The Consumer Price Index provides a "measure of the average change over time
in the prices paid by urban consumers for a market basket of consumer goods and

i F"nedman, M.,,What Price

, Guideposts?" in Guidelines Informal Controls, and the Market Place (edited
by G. Shultz and R. Aliber) Ch cago: University of Chicago Press, 1966, page 18.
2See Yergm, D, and J. Stares aw, "The Commanding Heights: the Battle for the World Economy," Simon
and Schuster, 2002, Page 322.
 Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
services."3 To compute the value of the CPI, the government employs an army of"secret
shoppers" who are given a list of items that the average family of four living in a metro
area (such as the city of Atlanta and its surrounding counties) would purchase on a
regular basis, and the "shoppers" then "fan out" across the country to price the items on
the list. As you might imagine, it is a monumental task to send people to Walmart,
Costco, Publix, Target, Office Depot, Home Depot, McDonalds, the local Mexican
restaurant, the local Toyota dealer, and myriad other retailers, until you have a good
picture of what the average family has to spend to maintain their standard of living. This
is done every month, and the CPI is routinely reported on the news to reveal the change
in prices in percentage terms. For example, between 2016 and 2017, the value of the CPI
for the United States as a whole increased from 240.007 to 245.120, indicating an annual
inflation rate of2.13% for 2017.4
Of course the price level need not always rise. If a society instead experiences
declining prices over time (i.e., realizes a negative inflation rate), this is known as
deflation. While rare, it is not unheard of in U.S. history. For example, during the last
century, prices declined on an annual basis in 1921 and 1922, 1927 through 1933, 1938
and 1939, 1949, 1955, and most recently in 2009.s Other than these years and a few
other instances of deflation before 1920, we have realized positive inflation rates. Within
Chapter 9 a more complete summary of realized inflation rates in the U.S., on both a
monthly and annual basis, is provided in order to get a better idea of typical outcomes.
THE INVENTION OF MONEY
As the quote at the start of this chapter suggests, inflation and deflation are
closely linked to money. Thus, to understand the causes of these phenomena we fu'st
need to understand what money is and how it works. We all think we understand money
because we use it daily, but it is more mysterious than it at first appears. As defined in
Chapter 4, Money is as an asset that is socially and legally accepted as a medium of
exchange (i.e., as a payment for goods or services). In addition to this defining
characteristic, money also serves as a store of value (i.e., an asset that serves as a means
of holding wealth) and a unit of account (i.e., a "yardstick" that can be used to measure
economic activities; e.g., in the United States prices, incomes, and GDP are all quoted
most naturally in dollars).
S e e : ~ . h t m
' s e e : ~ m o ~ , . ~ A s _ _ . ~
value ~Q..~e~, ~, the CPl Is normalized to take on
reveals that overall vriees .,i..1, ...... ".lnus, theraportcdvnlueof245.120imm
- for"2017
inflation rate of 1.26% umteoommsaroatmost2.Sdmashi~her
is calculated as the percentage increase in the value
n.i.*h....,
of theL~listely
CPI between
2016 uad 2017:(245.120_240.007)/(240.0071
s Between 2008 and 2009 the value of the CPI=decreased
(5.113)/(240.007),
by 0 36% which is approximately
(i e the
inflation rate was--0 or 2.13%.
from 215.303 do~ to 214.537. On a monthly basis, a negative annual inflation rate was realized as
recently as September 2015, during which time prices decreased at an annual rate of.-.0.04%.
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Money and its use go way back into history, with documented accounts in the
Bible and other ancient texts. Money originated as the solution to the problems of barter
exchange, which is the most primitive of economic transaetians. Barter is the exchange
of one good for another between two people. For example, assume that you are a full-
time shepherd and that you would like some wheat to bake into bread. You can't settle
down on a farm to grow the wheat yourself since you are constantly wandering around
with your sheep to find fresh pasture. A friend of yours is a wheat farmer after settling
down and giving up his sheep. He would like some meat to eat but can't leave his farm
to tend a flock. What are you and your friend to do? Obviously you could meet and
agree to exchange some wheat for some sheep.
In Chapter 4 we discussed the model of Supply and Demand to describe the
interaction between buyers and sellers, which gave rise to an equilibrium price. That
discussion assumed transactions were taking place with money us a medium of exchange
(also note that we used money as a unit of account when quoting equilibrium price in
dollars). In our barter example however, our shepherd would have to offer to trade one
sheep for a certain number of bushels of wheat, not money. The wheat farmer would
counter with an offer of fewer bushels for the sheep, and this would continue until a
bargain is struck. Perhaps an agreement was ultimately reached that one sheep equals
five bushels of wheat.
Commerce went on this way for millennia until civilization had advanced and
production had specialized to the point that there were many items for trade. Under
barter traders face the problem of Dual Coincidence of Wants, which is the technical
way of saying that for a barter trade to take place, one side of the transaction has to want
what the other side has, and vice versa. In a simple society this is easy since there are
only a few goods, tastes are simple, and everyone wants what the other person has to
trade. However, as society advances specialized tastes can develop due to an expansion
of the economy. What happens if the shepherd meets a court scribe who wants to eat
meat, but the shepherd does not need a book written? How does the transaction go
forward? Money - that is, a medium of exchange - is the solution
The scribe offers a token good that does not have any intrinsic value of its own,
but is recognized by everyone as a universal trading good. Historically we did not jump
straight to a pure token good, but passed through the stage of commodity money where
something of physical value like gold and silver was money. People in modern
economies use paper money to facilitate transactions, but the money itself is of no
intrinsic value.
To illustrate this point imagine that you were a wealthy Iraqi businessman with
three million Iraqi dinars in a safety deposit box in early 2003 (worth about one million
era~,e U.S. dollars at the time). The U.S. invades Iraq, Saddam Hussein is defeated, and his
government destroyed. How much are your three million dinars worth now and why? In
this example you can see that the money itself is of no intrinsic value; it only has value as
.021336%)
long as poople believe that Saddam Hussein's regime will survive and support the
currency. When his regime is toppled the money associated with it has no meaning and
is therefore worthless. What if instead of dinars you owned an ap~ent building worth
three million dinars? Assuming your building is not bombed, you are still a wealthy

Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
person afler Saddam's defeat, since your wealth is in a form that has intrinsic value. This
is an extreme example to illustrate the point that modem paper based monies are not
inherently valuable, and their value can be destroyed or diminished quite easily. All of
the U.S. money in your wallet and bank account could similarly evaporate in value if
something ever disrupted our belief that the U.S. economic and political system was solid
and functional.
Now that we have a basic understanding of what money is, how it evolved, and
what functions it serves, we can begin to develop an understanding of how
mismanagement of money by a government can cause either inflation or deflation. The
opening quote for this chapter will guide us in our search.
M O N E Y A N D I N F L AT I O N
The relationship between the Money Supply, the amount of muney in circulation,
and the level of prices in society can be represented by a simple equation. This equation,
called the Equation of Exchange, ties together the amount of money created by a
government and the prices charged by busincsspeople in general. From the discussion of
Supply and Demand in Chapter 4, we have a model to explain how prices for individual
goods and services am determined in distinct markets. As a result of the outcomes in
these distinct markets, relative prices emerge for different goods and services. The
relative price of a good is an expression of the price of a unit of the good in terms of
number of units of some other good. For instance, if in the U.S. the market price of a
shirt is $30 and the market price of a hammer is $10, then the relative price of a shirt is
three hammers. Consequently, a person would have to work three times as many hours to
buy a shirt than a hammer.
Suppose that in Japan a shirt costs 15,000 yen and a hammer costs 5,000 yen.
Since (by assumptmn) the relative price of a shirt is also three hammers in Japan, we see
that a person in Japan would also have to work three times as long to buy a shirt than a
hammer. But we have no explanation as to why the magnitude of the numbers is so
different between the two countries.
As the equation of exchange helps to illustrate, the money supply (determined by
the government) greatly influences the overall priee level within which supply and
demand operate, ultimately causing the price level to be different between the U.S. and
Japan. The Equation of Exchange is:
M×V=GDP=p×Q.
To fully comprehend this equation, it is necessary to understand each of its different
components. M denotes the money supply, which refers to the total amount of dollars in
eireulatiun in our wallets, savings accounts, ebeaking accounts, and other dollar
denominated assets that can be used to easily make purchases. V denotes the velocity of
money, which measures the number of times that the typical dollar is used in a
mmsaetiun (i.e., "changes hands") in a given year. GDP refers to annual Gross Domestic
Product, as defined and discussed in Chapter 7. The first equality states that money
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
supply multiplied by the velocity of money must be equal to Gross Domestic Product.
This relationship is an Identity, that is, a relationship that must be true by definition.
But, why must it be true?
Start by recalling that GDP measures the total value of all goods and services
produced in our country in a year, valued at their market prices. Assume this adds up to
$24 billion. If a society has $3 billion of money in circulation, how many times would
each dollar have to be spent in order for people to purchase the $24 billion of goods and
services that are produced? Clearly the answer is that each dollar would have to be spent
on average 8 times. This allows us to see why money supply multiplied by the velocity
of money must be equal to Gross Domestic Product: ($3 billionX8) = ($24 billion). In
order for the economy to be in equilibrium, the total amount of goods produced at market
prices would have to equal that $24 billion spent.
lfGDP were $30 billion, there would be a huge surplus of unsold goods left since
we are spending only $24 billion. Firms would either have to cut back their production
or decrease prices far enough for the $24 billion worth of purchasing power to equal the
value of the goods being produced. Likewise, if firms only produced $20 billion worth of
goods for a country with the buying power of $24 billion, then there would be a general
shortage of goods and services. Firms would either raise their prices or increase their
production until the total value of all the goods and services produced equaled $24
billion.
Returning to the Equation of Exchange, P denotes the economy's overall price
level (in some sense, the average of all the prices of every good and service produced for
sale), and Q denotes the real level of aggregate output of fmished goods and services
during the present period. Thus, the second identity in the Equation of Exchange states
that an economy's real level of output multiplied by its overall price level must be equal
to GDP. Continuing with the previous numerical example, suppose that the $24 billion
worth of goods and services produced resulted from the production of 2 billion different
items. If the dollar value of all 2 billion items totaled to $24 billion, what must the
average price tag on each item have been? The obvious answer is that the average price
of each unit must have been $12. Thus, we see why real output multiplied by the price
level must equal GDP: (2 billion)($12) = ($24 billion).
Why couldn't the answer have been $9 per item? If it were $9 per item and 2
billion items were produced, then the total cost of all goods taken together would only be
$18 billion. We have already determined that with our money supply and velocity
together we have $24 billion of spending this year, so the $9 price would cause a shortage
when all people with money try to spend it. Confirm for yourself that a price level above
$12 would cause a similar imbalance. This $12 price tag that equates GDP with the
number of items produced is the price level we mentioned earlier (i.e., the CPI measured
by the Bureau of Labor Statistics),
If beth M×V and PxQ must equal GDP, then it must be that:
M×V=PxQ.
The recognition revealed by this equation ties together the production side of the
economy with the amount of money available to spend on goods and services. It can be
 Chapter #8 - Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of lnflation

thought of as specifying an equilibrium in the macro economy that links the amount of We initially had V=8, Q=(2 billion), and M =($3 billion), for which we noted the
money produced by the government to the total value of all goods and services produced
corresponding value of P would have to be P=$12. When we double the money supply
at the current level of prices. In our nmnericai example we have:
to M=($6 billion) (with velocity and quantity of output fixed at V=8 and Q=(2 billiun),
($3 billion)(8) = ($12 per item)(2 billion items).
What would happen to this equilibrium if the government doubled the money supply? for the reasons discussed above), the identity becomes:
How would the other variables have to adjust to bring things back into balance? Let's ($6 billion)(8) = P (2 billion items).
work through an example, Solving this equation for the price level, we obtain P =$24.
Since the velocity of money is determined primarily by technical factors such as
So, what did the increased money supply accomplish? The left hand side of the
how often people are paid and how quickly banks can process checks, it remains fairly
equation, the Demand side if you will, has expanded to $48 billion worth of purchasing
stable and is not easily changed, at least not over a short run time period. On the other
side of the equation, the ability to change the amount of goods and services produced in power, but there are only 2 billion things to buy. At the old price level of $12 per item it
an economy is determined in the loug-ran by how many factories a nation has, how well would only cost $24 billion to buy everything that was for sale If people have $48
Irained its workers are, and the availability of naturai resources (recall the discussion of billion worth of purchasing power there will be excess demand in the system and prices
factors of production introduced in Chapter 2). This can rise over time at a slow rate as will rise. How high will prices go? Prices will go as high as is necessary to absorb all of
new technology is introduced or the population grows, but in any short-ran time period is the excess purchasing power created by the new money. That is, prices rise up to an
not easily changed. So that leaves two variables that can change to maintain equilibrium, average price of $24 (so that the 2 billion items are now worth $48 billion, exactly equal
M and P. The money supply is just paper and can easily be increased by turning on the to the $48 billion worth of purchasing power). Once prices have risen to this level, the
printing press. The price level can also be changed easily. Just think of employees at a economy is back in balance.
gas station changing the pump price - it is done in minutesl Let's go back to the question of whether the country is wealthier or not. As you
can see, the average person now has twice as much money as before. But, all prices are
Now, in the example above, if the government printed enough paper money6 to
double the money supply from the original $3 billion to $6 billion would the eountty be now twice as high, so you cannot buy any more goods with the $6 billion printed than
richer? This is partly a trick question because it depends on what you mean by "richer." you could before with the $3 billion printed. Once the system has time to adjust, printing
If richer is defined as having more money, then you would be richer. But, if richer is excess money simply leads to inflation; in this case a doubling of the money supply leads
instead defined as having more ability to consume goods and services, then you would to a doubling of prices.
not be richer. Economists label the former notion as nominal wealth or nominal Of course, the opposite is true as well. If the government reduces the money
purchasing power and the latter notion as real wealth or real purchasing power (the supply (we will discuss shortly how the money supply can be increased or decreased at
distinction here is essentially the same as that which was drawn between Real GDP and will by the government) what will happen to the overall level of prices? Let's work
Nominal GDP in Chapter 7).~ Recognize that your real through an example. Now suppose the government cuts the money supply in half from
money supply is increased from $3 billion to $6 billion, wealth does not increase as the
Let's see why. $3 billion to $1.5 billion. When this is done (with velocity and quantity of output again
Start by recalling the Equation of Exchange:
fixed at V =8 and Q=(2 billion), for the reasons discussed above), the identity becomes:
MxY =PxQ.
($1.5 billiun)(8) = p (2 billion items).
s Paper money/s used in our explanation so that you have a physical object to comprehend. In the digital Solving this equation for the price level, we obtain P=$6. Since the only variable that
age the money supply/s mostly created by hitting a computer key with no actual physical reality behind it can change to keep both sides of the equation in balance is the overall price level, when
at alL When you receive your paycheck by direct deposit, buy something with a credit card, and pay bills the money supply falls from $3 billion to $1.5 billion, the price level falls from an
or check your bank account balance on-line, you do not see any physical cash involved in these activities average price of $12 to an average price of $6. This decrease in the overall price level is
but you still believe that the money is real.
necessary to restore the system to equilibrium.
~Th "
e diflb,
of rence
a mealbetween a nominal
in two different va ue end
countries. a years
A few real value
ago,can
oneeasily
of thebe lllustnned
authors by considering the
of this This model provides a simple explanation for how it is possible to have inflation
" bookwentto in some periods and deflation in others, as well as why some countries have higher
matavathhlswife. During this lrip
. they sr~.nt 2, 000inn:._~ .
out ts more expeustve. m .India
. than tt. ts m- ~the
- -O.S., ~ ~upces
since un a currency
it lakes 2.000 dmncr. Inunits
nominal
to buyterms eating
a dinner in inflation rates than others, and why a $40 dinner in the U.S. costs 2,000 Rupees in India.
It all comes down to bow much or little money is in circulation in any particular counla'y
India" whcaens
astrounmJcal a comparable
difference, menl
unnl you in the U.S.
reeogmze wunld
that only
at the cost
time you40could
currency units This
exchange may
$1 for 50Sound
Rupeeslike an
Cunvertmg Dollars into Rupees at this foreign exchange rate, we see that $40 are worth: ($40X50 Rupees
per Dollar) = (2,000 Rupees). ' real terms the dinner in India costs the exact same amount as the
dinner in the U.S. Thus, m

188
189
 Chapler #8- Impact of Policy Decisions on the Rale of Inflation
at any point in time. Those countries that print lots of money will have higher inflation
rates than countries that do not) At a fundamental level, it really is this simple!
What is not so simple to explain is why countries choose to print enough money
that they cause inflation in their country, especially once it is recognized that inflation
can have undesirable consequences for an economy. To recognize a fwst cost of
inflation, recall that in the discussion above it was noted that prices can often be changed
at low cost. While this is tree in many markets, there arc still some costs associated with
changing prices. Economists refer to the costs of changing price as menu costs (think of
a restaurant that mast literally print a new menu for no other reason than to increase
prices). Such costs stem from a use of real resources to create nothing of new value, and
therefore generate an inefficiency for society.9
A second undesirable consequence of inflation can be seen by focusing on how
rising prices impact personal savings. Suppose your parents are near retirement age.
They have worked hard their whole lives, saved up $1 million for retirement, and
(following what seems like good financial advice for someone near retirement age) they
have most of this money invested in relatively risk flee assets (e.g., municipal bonds).
Perhaps they are guarantecd a 2% annual return, so that in one year their $1,000,000 will
become $I,020,000. If the realized inflation rate is 0%, their purchasing power is
actually greater one year from now. If instead the inflation rate is 2% (exactly the same
as their rate of return), then their purchasing power is exactly the same
now (they have 2% more money and ; ...... one year from
,
- , ,~ ~,~,m, gooos - ann
, services
- cost 2% more).
However, if the inflation rat~ is above 2%, then their purchasing power is actually lower
one year from now. What this reveals is that inflation is clearly bad for people with
savings (more precisely, an inflation rate above the nominal rate of return erodes the real
value of the saved wealth).'s
On the whole, moderate inflation is likely undesirable for an economy. This
being said, most modem economies can likely tolerate moderate inflation rates with
minimal d/smption and minimal adverse ffects. In contrast, Hyperinflat[on, which
refers to an extremely high rate of inflation, generaUv greater than I00% per year, is
devastating for multiple reasons. Several CounUies experienced hyperinflation in the
1980s, including Argentina, Bolivia, and Poland, with annual inflation rates peaking
around 20,000%, 24,000%, and 17,000% respectively.t| More recently, Zimbabwe
experienced one of the most extreme instances of hYperinflatlon ever recorded, with an
annual inflation rate that reached roughly 79,600,000,000% (i.e., 79.6 billion percent) in
tR . .
.r5~z~_
~ of 1
eonomists
from the d~-'nssmn
agreed thatof"Infla
vinws of economists in Chapter l, across two differem studies
0 Further the ---- - t/on is caused ptimadlv by too ~..^~. ~. an average of
chano, '-'- ~,~.~'nce m menu costs explains why -ri~ .--'o-"---- ""~"..gr°wth m the money supply"
l 0~ ' o - - ) ~ U ~ e S ~. t h ~ mr s - - L - . . 1 - - J I . J r v ~ & z m y l ] U [ m m e o m t e l y a d l u, s~ t a s ~ . ,. ~. tm. ~.t.~. ;.o. P. a t O n s
" m Yu ¢ s r J C K Y n s O
Batno|ethatthlssuggeststhatinflation.._~.a ~ ~ guoo°P~t°PerfecflYBatdormstantaneousl
mr some ~--onle s~^ c.._ . . y enable).
cummdy
I1~___~ have a sul-o.--~-,
~-,alamountofdebtt~.~;col..,..~.L .---r , ~'"~aYthnsemdividualswho
,,,~ ~.gures are r~pact/ve]y from mues'~4"3": ~'~' ? ?m.e m~.e~=s, t rote on the debt is fixed -'-
~ ° m m a n n m g H e l o h ~ ' t h - n . . . ." "
¢ ' , ; o a n l e t o t t h e W o r l d ' E" #
c'&
..q
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/ D o l Y e r R i n D a n d ] e°t~gllSlaw,
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- t . . .2002.
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
mid-November 2008.n2 The dubious distinction for highest inflation rate ever is held by
Hungary, which realized an annual inflation rate estimated at 41,900,000,000,000,000%
(i.e., 41.9 quadrillion percent) around July, 1946)~
At an annual rate of 100% inflation, prices double every year. For example, a $40
dinner for two would cost $80 next year, $160 by the end of the second year, $320 by the
end of the third year, and $640 by the end of the fourth year. We are talking about an
increase from $40 to $640 dollars to take a date to Applebee's in the time it takes for an
incoming freshman to reach graduation! Returning to the example above of a couple
nearing retirement, an annual inflation rate of 100% would make their $1,020,000 worth
only $510,000 one year later. That is, there initial life savings of $1,000,000 is
essentially cut in half.)4 This illustrates just how devastating hyperinflation is to the
savings of individuals.
Just imagine what prices would do if the inflation rate was measured in thousands
of percent.Is Germany experienced hyperinflation in the early 1920s, with an annual rate
that peaked around 29,500% in October, 1923, for which prices would double every 33
days)6 As described in the "Commanding Heights" documentary, this "hyperinflation
wiped out the savings of the middle class," "it took a basket full of paper money to go
shopping," "money was cheaper than wall paper," and "shoes that cost 12 million Murks
in 1913 sold for 32 trillion Marks in 1923.''t7 Further, the political and historical impact
was immense, since this hyperinflation "was one of the reasons for the success of the
Nazis, of Hitler," who "got support from tbesc people who lost their fortunes."Is
With hyperinflation, money no longer functions as a store of value, to the point
where any normalcy in markets vanishes. If prices are doubling on a weekly or even
daily basis, consumers have a strong incentive to immediately spend any money that they
do have. In such an environment Transactions Costs, which refer to costs that must be
incurred in order to participate in a market (e.g., search costs to find out who is selling a
good and for how much, and transportation costs to and from the point of sale), are
dramatically increased. For example, think of how much more costly it would be to
make three trips per day to the grocery store as opposed to one trip per week.
Consequently, the social benefits from market transactions are substantially reduced.
t2Th'
Is figure ts reported on page 354 of Hanke, S. and A. Kwok. "On the Mcasttmment of Zimbabwe's
Hyperlnflalion," CATOJournal, (Spring/Summer 2009) Vii. 29, No. 2, pages 353-364, which is available
~3
at: Ibid., page 356.
~*://~biect~cat~rg/sites/qa~`~rg/?7~e4/s¢ria~s/~es/cat~-/~ur~a~/2~9/3/ci29n2~`pdf.
4 Ifthey had nsteed earned no return (perhaps by keeping the money in a shoebox in their closet), then the
100% inflation would have reduced the real value of their savings by exactly half,
~sIn the morn extreme examples of hyperinfletion noted above, prices obviously double much more
rapidly. As noted by Hanke and Kwok, at the time of peak inflation in Zimbabwe, it only took nboot 24.7
",
bour~ for prices to double., while nt the time of peak inflation in Hungar/ it only took nbout 15.0 hours for
prices to double. Ibid., page 356.
v"
is Ibm, pase 35b.
7S the v dee segment "A Cupid/st Collapse" C'Comman~ng Heights: the Battle for the World
Economy," (2003), episode l, chapter 4). which can be viewed on-line at:
.
, - _ , , ! ' 'The
htto:/Av~t"¢'t~h~.orvAv~blV~'Ommondir~beiv~t~/.~harcdA,i,~qt~in~
't/bid PO~ 04 ,~OO i~tm~"
 Chapter #.8- Impact of Policy Decisions on the Rate of Inflation
Further, in the face of hyperinflation incentives to save are so drastically reduced that
firms have virtually no ability to make any investments in capital - the financial funds
necessary to do so are just not available.
Before we get into the economics and polities of why countries would ever
choose to cause inflation in their own economies, we need to take a detour and examine
how the money supply is increased or decreased. Knowing how it is changed also
presents a solution for preventing inflation in the first place.
I N C R E A S I N G A N D D E C R E A S I N G T H E M O N E Y S U P P LY
In a modem economy, the central bank is the entity which has the ability to alter
the money supply of an economy (i.e., the ability to essentially create or destroy money).
The central bank in the U.S. is the Federal Reserve System, hereafter referred to by its
nickname: the Fed. All countries now have a central bank, with the U.S. actually coming
to the game rather late - the Fed was created in 1913, whereas the Bank of England (the
central bank of the United Kingdom) was created in 1694.19 The central bank of any
country is a real bank that is owned by and is an arm of the government, with the power
to print money. While the Fed is a bank, it does not make home loans or car loans or
even business loans to large corporations. The Fed's primary task is to control the money
supply in the U.S., a task which it achieves by using three primary policy tools. These
three policy tools are conducting Open Market Operations, setting Reserve Requirements,
and setting the Discount Rate (these final two impact the decisions made by other banks
regarding the degree to which they will take out discount loans from the Fed). Let's
examine each of these three policy tools in detail.
Open Market Operations refer to the buying and selling of U.S. Treasury debt
securities (i.e., pieces of the U.S. national debt) on open markets such as Wall Street.
The Fed can inject money into the economy by "printing up" some money and then
shopping for U.S. debt securities. When it strikes a deal to purehase the securities it pays
for them with the newly printed cash, thereby increasing the amount of money that the
seller of the security possesses. Thus, this transaction has increased the amount of money
in oireulation. That is, the value of M in the equation M×F =p×Q has been increased.
Conversely, if the Fed sold some of its accumulated U.S. debt securities from its portfolio
on the open market, a purchaser would have to pay for them by writing a check to the
Fed. The Fed would cash the cheek at the buyer's bank and then bring the cash back to
the Fed and shred it. The total amount of money in circulation has just fallen by the
amount oftbe securities sale.
To understand the final two policy tools available to the Fed, we must first
recognize that the U.S. (and nearly every other modem economy) operates under a
fractional reserve banking system Under a fractional reserve banking system, at any
point in time a commercial bank is only required to retain a portion of the money it has
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Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
accepted as deposits. That is, the bank is allowed to lend out some of the money that
households and businesses have deposited to other households and businesses.2o When
this money is loaned out it ends up in the checking and savings accounts of the
borrowers, thereby raising the total amount of money in circulation. Under such a
system, the commercial banks essentially alter the money supply by way of these lending
decisions - if a bank has $500 million in deposits and lends out $465 million instead of
$450 million, then the overall money supply is $15 million greater.
Reserve Requirements refer to minimum restrictions on the amount of money
that a bank must keep on hand at any point in time, in the form of either cash in its vault
or deposits with the central bank. These requirements are typically stated in terms of a
percentage of total deposits with the bank. For example, in the U.S., a bank that has
accepted more than $122.3 million of deposits must maintain reserves of at least 10% of
total deposits.2~ Since revenue is generated by charging interest on money that is lent
out, a bank often has an incentive to loan out money to the point where this reserve
requirement is binding. Thus, the Fed could indirectly alter the money supply by altering
the reserve requirement. The Fed can increase the money supply by decreasing the
reserve requirement and can decrease the money supply by increasing the reserve
requirement To see this, consider the impact of a change in the reserve requirement on a
bank with deposits of $500 million. When the reserve requirement is 10%, this bank will
likely want to keep $50 million in reserves, thereby lending out $450 million. If the Fed
decreases the reserve requirement to 7%, then the bank would want to instead keep only
$35 million in reserves, implying that they would lend out $465 million. Thus, by
decreasing the reserve requirement, the Fed has induced this one bank to lend out an
additional $15 million, thereby increasing the money supply by this amount.
In practice, at the end of any given day, a bank may come up short of its reserve
requirement. When this is the case, they have the option of taking out a short term loan
from the Fed in order to meet the requirement. But, they have to pay interest on this
money that they borrow from the Fed. The Discount Rate refers to the interest rate that
the Fed charges banks to borrow money on a short term basis. Recognize that the higher
the discount rate, the greater the cost of borrowing money from the Fed to meet the
reserve requirement. Thus, when the discount rate is raised, the bank is less inclined to
borrow from the Fed and re-lend the money out to its customers. As a result, the money
supply is lower than it otherwise would be.
Conversely, when the discount rate is lowered, the cost of borrowing money from
the Fed is lower. Banks now find it in their interest to borrow from the Fed cheaply and
re-lend the money to their customers. Consequently, the Fed can increase the money
supply by decreasing the discount rate. When the discount rate is lowered banks find it in
their interest to borrow more money from the Fed and therefore have more money to loan
out to their customers. In the extreme, if the discount rate were 0% (i.e., if a bank could
leTh .
.e 1,mac r w.o.rkmgs - and potential failings - of this system are alluded to in a memorab
movie nsawonderfulLfe,,(see, htw./&ntav.~ ~t-L- l ~. t-~ ~ , w h c2 le scene
w a s inl6athe
the subject of parody by "The Simpsons" " in the" ~episode
t q l ~ ."The
l l l PTA ~Disbands"
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er
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Chapter #8 - lmpact of Policy Decisions on the Rate of lnflation
borrow money from the Fed at no cost), then the reserve requirement would be rendered
meaningless - each bank could essentially lend out as much money as they want, and at
the end of the day take out a loan from the Fed (at no cost) to meet the reserve
requirement.
This ability of the Fed and other countries' central banks to alter the money
supply is an awesome power and responsibility, one which has not always been handled
well by both our own country or by other countries. We will see that this almost
effortless method of creating money, if not well controlled, eunld lead to inflation or
hyperinfiation, as it has in many countries around the world.
Altering the Money Supply to Accommodate Growth
Now that we see how the money supply can be altered by the Fed we also see
bow inflation can easily be avoided: stop lending to banks or buying securities on the
open market and inflation is virtually impossible. So why don't all countries just stop
printing new money and save themselves from inflation? The reason they don't is
because there are two beneficial aspects to increasing the money supply.
First, if the economy is growing in real terms (i.e., its ability to produce actual
goods and services is increasing over time), then increasing the money supply can
actually keep prices stable. This justification for increasing the money supply can be
understood by again examining the equation of exchange. For instance, reconsider the
first example that was given to explain this equation:
MxV=PxQ
($3 billinn)(8) = ($12 per item)(2 billion items)
$24 billion = $24 billion.
Suppose that over the course of the next ten years, this economy is able to realize
econenuc growth which allows it to produce 4 billion items (i.e., twice as much output).
At the original price level of $12 per item, these 4 billion items are worth $48 billion.
However, we can see that the $24 billion of parehasing power created by $3 billion being
spent 8 times per year is not enough money to purehese the $48 Billion of goods now on
store shelves at current prices. That is, at a price level of $12 there would be a huge
surplus of unsold goods. If the money supply is not altered, then the economy would
. . . ,
need to.rea!lze.elther
prunuetmn m line with masswe pnce
the amount of cuts or massive
money layoffs
available. Eitherinoforder
thesetowould
get the
bevalue
very of
disruptive and costly to overall economic performance. Of course, an easier approach
which would facilitate stable economic growth would be to increase the money supply by
$3 billion, bringing the total money supply up to $6 billion. Tiffs $6 billion spent 8 times
per year would give us enough purchasing power to buy up exactly the amount of new
goods produced at the currently existing price level of $12 on average. If we did this the
equation of exchange would now be:
MxV=PxQ
($6 billionXg) = ($12 per item)(4 billion items)
$48 billion = $48 billion.
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
That is, both sides of the equation are equal at the origin, al price level of $12.
So, if you have a growing economy you can pnnt more money without triggering
inflation. In fact, printing new money is actually a more stable, superior approach to the
alternatives of getting all firms to engage in a price war with each other or laying-off
workers to reduce output to restore equilibrium. As long as the money supply is
gradually increased at a rate equal to the growth rate of the economy, then the price level
will remain constant over time (i.e., the inflation rate will be equal to zero) This
provides a justification for giving eantral banks the authority to alter the money supply.
Doing so allows the Fed to be able to provide stability in prices when there are real
changes in a society's economic capacity. The only controversy in this case would be
how to limit the central bank to only the correct amount of new money printing, since
real economic growth is not perfectly predictable and the central bank could make a
genuine mistake in its decision of how much to alter the money supply As will be seen,
greater difficulties potentially emerge when we examine the second justification for
altering the money supply.
Altering the Money Supply for Economic Stimulus
Unfortunately, economies do not grow at a constant rate over time. As noted
within the discussion of the business cycle in Chapter 7, at some points in time an
economy expands (reflected by an increasing value of real GDP), while at other points in
time an economy contracts (reflected by a decreasing value of real GDP). For numerous
reasons, most businesses and households would prefer a stable, constant rate of economic
growth - that is, a growth path with less fluctuation over time. As will be argued below,
the Fed may be able to minimize fluctuations in economic activity (e.g., stimulating the
economy during a recession) by manipulating the money supply.
Recall the phases of the business cycle disctlssed in Chapter 7. During a
recession - when real GDP is declining - business is slow, sales fall off, and workers are
laid off (causing a rise in unemployment). Both personal and business bankruptcies rise
as people find it hard to pay their financial obligations. Eventually, the economy
"bottoms-out" - when business conditions are at their worst we have reached the trough.
After this point in time the economy enters into a period of expansion. As illustrated in
Figure 8.1, this period of expansion can be decomposed into two distinct phases:
recovery and prosperity. During the recovery phase - which starts at the trough and lasts
until the economy has surpassed its previous peak - new fn'ms are started and older firms
that survived the downturn start to increase their sales and rehire workers. Once real
GDP goes above its previous peak, the economy has entered the phase of prosperity
(which ends at the next peak). The phase of prosperity can lead to over-optiraism, or in
the words of the former chair of the Fed, Alan Greenspan, into "irrational exuberance.,,~2
This phrase was first used by Alan Greanspan in a speech given on December 5, 1996 (see:
ht~lt)://~l~',federalrfser~.gov/h¢~rddocs/speeehe~/i
investors m Interaet related stocks, whtch drove the996/19961205.htm) in referenceto
share pnc~ of such compames tolevels
the behavior of felt
which he
were artificially high. His view was validated when the composite values of numerous stock markets
 Chaplet. $8 - Impact of Policy Decisions on the Rate of lnflation Chapter #,,8 - Impact of Policy Decisions on the Rate of lnflation

During this phase, investors take risks that are not warranted and businesses over-expand, SUVs. The new factory will have to be shut down and workers will have to be laid.off
ultimately setting up the economy for a correction. This correction is the next recession, since consumers are no longer looking to buy these new vehicles. The laid-off workers
and the cycle starts all over again.
will cut back on their own expenditures, leading to a fall in demand for many other
products. This in turn will cause the business owners in those industries to lay-offsom¢
Ftgmre & i - Phases of the Business Cycle
of their workers, causing a decline in business activity which ripples through the
economy. This downward spiral is finally stopped when people adjust their spending and
businesses adjust the types of products they produce, allowing the economy to begin to
recover. Fortunately, the phases of economic expansion have historically been longer
than the phases of contraction (see Table 7.5 in Chapter 7). Thus, as illustrated in the
stylized graph in Figure 8.1, the peak of the second boom is significantly higher than the
peak of the previous one, If this can go on for several decades, we would see an
, ~ R c a l G D P economy wide increase in income and living standards, even for the poorest members of
society. This recognition in encapsulated by President Kennedy's observation that "a
rising tide lifts all the boats.''24
Is there some way to avoid the downturn in the business cycle? Can we avoid all
of the unemployment, bankruptcies, and disruptions inherent in a recession? For many
[I decades, since the creation of the Fed in 1913 in fact, we have searched for a way to
I
I moderate or eliminate the downturns in the business cycle. It turns out that short-am
0' I increases in the money supply, like a tonic or drug, may be just what the doctor ordered
; time to cure the economy. Let's examine how this might work.
There is a connection between the supply of money and the interest rate in the
loanable funds market in the short-run. The Ioanable funds market conceptually
encompasses all loan markets in which borrowers and lenders interact, including, for
recovery~ , . example, the car loan market, mortgage market, and industrial loan market. The
~ prosperity foundations of Supply and Demand (introduced in Chapter 4) can be applied to the
market for loanable funds to show that an increase in the money supply can temporarily
"expansion drive down market interest rates. Such an increase in supply in this market is illustrated
in Figure 8.2.
Over-optimistic behavior on the pa~ of investors is only one possible cause of a Logically, if the Fed creates a large amount of new money that has never existed
downturn. A recession could alternatively be triggered by a supply shock, that is, a before, either through open-market operations or by inducing banks to take out more
drastic and significant change in supply of a good that is essential for economic activity, discount loans, we will ultimately have a system ~dde increase in the size of savings
For example, during the 1970s, oil production was disropted multiple times by decreases accounts and checking accounts. This is an increase in supply of Ioanable funds. Banks
in supply of this nature - most notably in 1973 when OPEC declared an oil embargo on will attempt to lend this money out since cash sitting in the vault earns nothing. As all
the U.S. during the Yam Kippur War betWeen Israel and a coalition led by Egypt and b a n k s "increase their" landmg flora the level that it was before the Fed action, there wiU be

Syria, and again in 1979 during the Iranian Revolution~ Such supply shocks in the an excess supply of loans at the initial interest rate. Individual banks will start to cut their
market for oil can trigger a recession by disntpting financial markets and throwing loan rates to get the business, and as more and more of them do so, the remaining banks
investment plans askew as people adjust to the new, higher fuel prices, have to go along as well or risk losing customers, This description shows that
Thinking of the impact of such a change in the price ofoil in more present terms, conceptually the market for Ioanable funds is no different than the market for
perhaps an automsker will now regret just completing a new factory dedicated to building hamburgers. If supply goes up, the price (which in a market for loans is the interest rate}
has to be cut in order to find the new equilibrium and get rid of the surplus that would
ar°und the w°rld, m°~I notably the .< NASDAn
-, .,~ ~.o..;.,,~u
,k-,tatar
~ evatu¢~
L .......¢nmatlcally decline during the exist at the original equilibrium price afro. As you can see in the graph, the loan n~rket
bunztinll of the "doz,.com bubble" of the late 1990s.
~ S~,' Ye'~m, ' D, and 1. Slumzla,,v, "The Commanding Heights: the Battle for the World Economy" Sunoa
and Schu.~er, 2002, P~Ie~ 46,47,
. Remarks m Heber Spcmgs, Arkttnsa.~ at the DedicaLion of Grc¢~ Fen,,/Dam," October 3, 1963,
U" I " , , .
 Chapter #8- Impact of Policy Decisions on the Rate of Inflation Cilapter #8 - hnpact of Policy Decisions on the Rate of Inflation

moves from the original interest rate of 5.5% (i.., Re) down to the new lower interest
rate of 3.25% (i.., RL).
What is the logical result of these artificially lowered interest rates? Interest rate
sensitive markets, such as housing, automobiles, and capital goods (i.e., plant and
e.qulpmant purchased by businesses to produce other goods and services), find more
willing customers since the cost of ficancing these goods is now lower. Thus, the lower
interest rates stimulate these induslries. These sectors expand and hire more workers,
who in turn spend more on everything from restaurant meals to clothing to entertainment.
As a result, the economy as a whole expands. This increase in overall economic activity
is naturally accompanied by greater overall output, larger profits for firms, fewer
bankruptcies by finns, reduced levels of unemployment, and increased incomes for
households. This whole process was initiated by an increase in the money supply by the
Fed. That is, it was caused by expansionary monetary policy - an increase in the
money supply which provides a short term stimulus to the macro economy, resulting in
higher levels of output, employment, and incomes.
Figure $.2- Change in Supply in the Market for Loanable Funds
Interest
Rate
Low Supply
High Supply
Ra = 5.5% ...........
RL=3.25% )
i - -
~ D e m a n d the money supply which dampens overall economic activity, resulting in lower levels of
o output, employment, and incomes in the short term (but greater stability in the long term).
J I Quantity
QL Qn
0
Obviously the Fed could also
money supply and slowing down economic take these actions in reverse, thereby decreasing the
activity in the short run. While at first it may
seem like the Fed would never want to do this, a strong case can be made that such
actions are in fact prudent during an expansion. Recall from our carlrer discussion that an
The motivating justification for the present discussion was a recognition that
households and business have a preference for stable economic growth with minimal
fluctuations in economic activity. Just like a marathon runner, an economy has an
optimal pace If you run too slow you never win, but if you run too fast you will burn out
before the race is finished. If you maintain the right pace (and you are in shape!) you can
go forward at a higher average speed for many miles. As a metaphor this is a good
description of what the Fed wants for the economy. Think of the Fed as a coach for a
marathon runner. He gives encouragement and tries to stimulate his runner when the
runner is going too slow, but gives him signals to slow down if he is maintaining too fast
a pace. If this metaphor has any value, what should the Fed do during a boom? It should
decrease the money supply by conducting open-market operations or by inducing banks
to take out fewer discount loans. Let's show how each would be used in practice.
If the Fed sold securities on the open-market it would remove the currency used
by investors to pay for those securities from the banking system, lowering the ability of
banks to lend. Since there would now be a shortage of money available to lend we would
find interest rates rising to bring the market back into balance. Of course the same thing
could be accomplished by raising the discount rate or increasing reserve requirements.
As you should now be able to easily recognize, this shortage of loanable funds causes
interest rates across the economy to rise
We can see the impact of this process by again focusing on Figure 8.2,
recogmzmg that the policy now under consideration results in a decrease in the supply of
Ioanable funds (e.g., from High Supply down to Low Supply). This decrease in the
money supply drives up the interest rate in the market for loanable funds from 3.25%
(i.e., RL) to 55% (i.e., R.~). These higher interest rates reduce the desire of homebuyers,
car buyers, and investors to purchase as much as they otherwise would.
If the Fed can get this increased interest rate to just the right level they can take
the "excess steam" out of the economy but leave enough business activity to keep the
economy moving forward at a stable, sustainable pace (which is the ideal outcome for
households and businesses). This deliberate attempt by the Fed to slow an economy
suffering from a "boom" is known as eontraetionary monetary policy - a decrease in
Because of these insights, many economists believe that the government should
take advantage of this fact and artificially stimulate the economy during a recession and
restrain it during a "boom." While not universally accepted in the Economics profession,
this concept is currently the dominant way of thinking about dealing with a recession.2s
" J T h e a ternatlve approach advocated by some macroeconomlsts is the use of active fiscal policy to

economy can get stahthze macrt~onormc activity (by recurring deficns dunng a recession and running suzpluses during an
expansion). This notion of having government "spend against the wind" is often ~soeiated with the ideas
investing too much°verhcated'
and payingwhen m'atmnally
too high a priceexuberant investors
for business and households
property and homes.are This of John Maynard Keynes - s¢ the video segment "Global Depression" ("Commanding Heights: the Battle
boom, if carried to extremes, becomes unsustainable. for the World Economy," (2003), episode 1, chapter 5), which can be viewed on-line at

~tn:/Ata~nv'°bs'°rlcA~'eh¥~"°mmandin~lhei~hts/share(l/vtdeo/qt/mini
discussion of views among economists in Chapter 1, pOI 05300.ht,,d. From the
70.4%
business cycle should be I¢1~ tu the Federal Reserve; of economists
activist fiscal policyagreed
shouldthat "Management of the
be a'.,oided."

Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Most disagreements revolve around tactical issues such as the timing and duration
problem of when to start and when to stop such policies, or around issues like the
magnitude of the intervention by the Fed. In contrast, those who disagree with this
approach believe that the problems of man/pulating the money supply in this way
outweigh its benefits, and the government should take a more passive stance in regards to
monetary policy during recessions, perhaps relying more heavily upon fiscal policy.2s
What could the problems of increased money supply be that would lead someone
to voluntarily give up stimulating a depressed economy? As we discussed earlier in this
chapter, the increase in money supply, if not matched by increases in physical output,
would lead to inflation. Politicians are under constant pressure by their constituents to
"produce" a good economy, and they take credit whenever business is doing well since
there is a very strong correlation between re-election and the state of the economy. Since
the benefits of lower interest rates are immediate, but the costs of higher inflation do not
become evident for some time, the leaders of a country often find it in their political
interest to "inflate" their economies in the short-term, even at the expense of long-terra
problems (which may even arise once they are no longer in office).
T H E G O L D S TA N D A R D
One potential solution to the problem of government initiated inflation is the
adoption of the Gold Standard, where a country fixes the value of its currency in terms
of a specific amount of gold. To back money with gold in this manner means that a
country agrees to two major requirements: the first is that no paper money will be printed
without gold in the government's vault as security; and the second is that anyone holding
paper money has the right to redeem it for a fixed quantity of gold from the issuing
.government The first requirement is enforced by the seeund. If a government tried to
Issue an amount of currency well in excess of the amount of gold it had on hand, then it
would open itself up to a "run" on its vaults, by which we mean a situation where many
people choose to redeem their paper money for the gold at the same time but there is not
enough gold for everyone to do soy
u Again from the.discussion ofwews among economists in Chapter I across three studies an average of
88.6*/, of eeonotmsts agreed that "Fiscal policy has a significant stimulative impact on a less than fully
employed eeooorny." This can be nw..oncLled with the observation in the previous footnote (that 70 4%
think "activist fiscal policy should be avoided") by recognizing that both fiscal policy and monetary policy
likely have both benefits and costs. The statement which garnered 88.6% agreement focused only on the
benefits of fiscal policy, while the one which oarne...~ 7r, ~o/ ........ . . . _
e ,~ v.~/o
of the two alternative policies to be made, presumably basedn~.t=at
uponImp
both|cthe
Ily asgeo
benefitsIOr
and It the
COmparison
27The ~
zofces at play* In such a. pan" on the vaults of the Central Bank are identical to those of a '*bank run"
(recaLl the scene fi'om "It's a Woaderful Life," t_/././././.~o..//wv.~,,.youtube.eomA,ateh?vffiEOzMdEwY~Dt/3
Kenneth Randall (Chairman of the FDIC from 1964 to 1970) described this phenomenon as follows: "A
rim, on s bank means lines through the lobby and out the front a~. and d
wmtmg day and night to sen ifth~ could .-~'~ .... own around the block- voonle
Collapse" ("Commending Heights: ~: the Battle
w,usumw for thetnctr cesn.
World ~' Again
"
Economy," see the video
(2003), segment
episode
I, chapter 4):
t ://wwa~ bs.o /)t. h~ cram t~ h/hts/~h red/vld¢o/ql/mini pO] Q4 ~O0.hJR~l,
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
If such a mn on the vaults occurs, the government will quickly find itself in a
financial crisis as people withdraw their implicit support of the currency. As we
discussed earlier in our discussion of money, paper money has no intrinsic value and
depends crucially on the faith people have that the government is properly handling
financial and economic affairs. Such a "run" on the gold supply of a country operating
on a Gold Standard could cause the entire economic system to collapse as people refuse
to accept the government's printed money in transactions. Since no government would
want this to happen, a country on the Gold Standard feels constrained to maintain the
supply of paper money in balance with the quantity of gold in the vault. Thus, the Gold
Standard effectively serves as a commitment device for the Central Bank to limit its
expansion of the money supply.
The discipline that a Gold Standard imposes chokes off inflation quite nicely.
Let's remember our Equation of Exchange, starting again with the numerical values from
the original example.
MxV=PxQ
($3 billion)(8) = ($12 per item)(2 billion items)
$24 billion = $24 billion.
Assume the eoantry is on a Gold Standard, promising that every $3 will have one ounce
of gold to back it up.2s Therefore, the government must have 1 billion ounces of gold in
its vaults to back a printed money supply of $3 billion. This leads this particular
economy to have an overall price level of $12, given its current productive capacity.
So, how does this prevent inflation? Remember in our first example using the
equation of exchange we doubled the price level from $12 to $24 by doubling the printed
money supply to $6 billion. Can the government, now that it is on a Gold Standard,
expand the money supply so easily with only 1 billion ounces of gold on hand? Gold is
difficult and expensive to mine, so a government cannot just double the amount of it on
hand by whim. It might take decades to accomplish such a feat. So, the government is
now constrained from issuing the paper money that would have triggered inflation (after
all, if it were to print the money without having the gold on hand, it would open itself up
to a run on its vaults as described above).
In contrast, without the restraining influence of the Gold Standard there is no
natural limit on how large a money supply a nation can print, and so therefore no natural
limit on how high inflation can go. The only limit without a Gold Standard is the self-
discipline of the political leaders of a country, which is always under pressure from those
groups in society that want the government to constantly stimulate the economy (which
can enhance the re-election prospects of the politicians themselves). Without the Gold
costs of each. Standard, governments are under constant pressure to inflate, and many have done so
with devastating consequences for their countries. Further, since printing money is one
way to pay off debt, governments that have accumulated an insurmountable amount of
debt may see no other way to meet their obligations other than turning on the printing
"A'Cap'italist
2a AS
t h , s e x a m p l e t u s t r a t e n , t h e r e i s n o r e q u i r e m e n t t h a t o n e o u n c e o f g o | d i s e q u a l t o $ 1 . R a t h e r, t h e
requirement is that the government promises to exchange currency for gold at a published rate.
 Chapter #8- Impact of Policy Decisions on the Rate of Inflation
presses, All of the recorded instances of hyperinflation have been the result of sudden
and drastic increases in the money supply.~
If the Gold Standard solves a major economic problem, why did the majority of
major economies abandon it?3° From the discussion above, we can see that adherence to
the Gold Standard prevents discretionary money printing by the Fed. While this
eliminates inflation, it can also prevent the Fed fi-om enacting expansionary monetary
policy during a recession. If a recession happened while a country was on the Gold
Standard the government would b¢ forced to take a passive approach to the problem,
since it could not influence interest rates and short term economic activity by
manipulating the money supply. The economy would be expected to recover in time, but
only after a prolonged period of higher than normal unemployment and lower than
normal economic growth.
This leaves all countries with a dilemma: is inflation a bigger problem than
unemployment? Can the leaders of a country be counted on and trusted to act
responsibly in regards to the money supply and only print it when truly needed?
Recognize why this is so difficult - inflation only rears its ugly head sometime in the
future, but the stimulus of lower interest rates are: experienced in the present. That is,
expansionary monetary policy often has short term benefits but long term costs. This has
caused many countries to pursue stimulator,/ monetary policies when they were not
appropriate. Leaders have used their central banks powers to solve problems that are
beyond the scope of what monetary policy can ever accomplish.
For instance, what ifa leader whips up a populist hysteria against business owners
in order to win approval in his counl~3, and starts to seize (or tax at punitive rates) their
assets. What do you think will happen to the level of investment in the affected country?
As investors reduce their presence in the country the economy starts to dec "
terms, for reasons not associated with the b,,o;---- ' +.,
~,-~ cycle, in thzs case . line m real
increasing the
money supply will only have a limited success since the underlying deterioration of the
bns.iness climate is not just waiting for a "jolt" of low interest rates to get things moving
again. Business people will be very wary ofinveating new resources in their country and
will instead "hunker down," starving the economy of new investment in equipment and
technology. What will be the result ofthn newly printed money used by the government
to offset this decline? Lots of inflation, but limited stimulation to real economic
performance.
What is needed in this ease is not a dose of money supply, but a reversal of
misguided government policy and a restoration of the protection of property rights. Only
these actions would restore the confidence of the investing public. If business people
As noted by Hanke and Kwok in the aforementioned stud
occon'ed...whan paper ronney was Cony y (~age 353),-HYparinflaUons
. have never
reared its ugly head when the supply of ~.t,)e
~,ranney :_,_-
a commo~ty.
had no natural
The consmunts
cta'se ofhypcrinflation
and was governed
hasbyonly
a 31For a di~ussmn
discretionlry paper rnoney standard. ~o.orv/sitex/COfp.org/files~
~ 2 - 8
~ orFlurllmr
o r mszgh
f u ~mtu the prac,
. hcal.and.historical implementation ofth
world, ple&.~e see Michael Bordo s smcle *'Gold Standard" - ~- ~ e Gold Standard around the
htt :/A~w. i /Pb ~./ / Id ! ~m , "~nc~°nc~eEncycl°l~lia°fEc°nomica
Chapter #8 - Impact of Policy Decisions on the Rate of lnflation
believe that they will be able to reap the rewards if their investments pay off, then they
will start building new factories and the economy will recover. If there is no hope that
the government will change course, then the money supply increases will just add
inflation to the problems of decline that the nation already faces.
PRICE CONTROLS
The discussion thus far has focused on the macroeconomic causes of and
remedies for inflation. We conclude by analyzing price controls, a microeconomic policy
that has commonly been used in an unsuccessful attempt to combat inflation. A price
control refers to a legal restriction on the price at which trade can take place. Such
mandates commonly come in one of two forms: a price ceiling ora price floor. A price
ceiling refers to a legally established maximum price at which trade can take place; a
price floor refers to a legally established minimum price at which trade can take place.
Based upon the discussion of Supply and Demand in Chapter 4, we have an
understanding of how prices are set in a free, unfettered market. Under such a system,
market forces determine the prevailing price. Subsequently, the individual decisions of
buyers and sellers indirectly determine who produces and who consuxnes the good
(thereby addressing the distributional decision discussed in Chapter 2). At the other
extreme, under a system of command planning, the government directly sets prices.31
But, even in societies with primarily market based economic systems, we can
identify examples of markets in which government imposes price controls, legally
restricting price instead of letting market forces determine price. For instance, since
October 24, 1938, the federal government in the U.S. has mandated that workers must be
paid a wage rate greater than or equal to a certain minimum level - that is, the
government imposes a price floor,n The rent controls that have been imposed in New
Yo r k C i t y c o n t i n u a l l y s i n c e 1 9 4 3 p r o v i d e a n e x a m p l e o f a p r i c e c e i l i n g . T h e s e
restrictions effectively place an upper limit on the price of certain housing units.33
In the case of the minimum wage and rent controls, the likely aim is to have
government establish a price that is better (i.e., more equitable or fair, based upon some
normative criteria) for people on one particular side of the market. For example, if the
market wage rate were only $5.60 per hour, one might argue that such a price is too low
for the worker to achieve a reasonable standard of living. To improve the outcome for
the worker, suppose we impose a minimum wage of $7.25, with the intention of making
sure she is paid at least this amount. We will ultimately analyze the impact of price
" " of bow this ~ dou¢ in the former Soviet Union, see: Gregory, p. and R. Stuart,
Rusaian and Soviez Economic Performance a~ SWa~mre. 7~ ¢dirion, Bonton: Addison Wesley "~001
pages 124.-132.
Or the historical rs,~ ofLl~, mtmmum wage, see: h~p;//~vwdol, got,:~t,hd.min~t~a~w,t. (.hOrl, h~.i," AS of
July 24, 200% the fedend minimum wage is $7.25 per hour.
nS
~¢eehrm"//www'n~h~r°rs"/RenL:2Ol2"4nmmlRo'i~'PL~(Page
regulations. " 5) for a brief disc " ozthe
usston ~ history of

Chapter #8 - lmpact of Policy Decisions on the Rate of Inflation
controls, using the model of Supply and Demand, to clearly see how such restrictions
alter the realized outcome and impact the well-being of both buyers and sellers.
In terms of combating inflation, price controls were imposed on a large scale with
this explicit aim in the U.S. under the leadership of President Nixon in the early 1970s.
The argument is rather intuitive - we can make sure that the overall price level does not
increase too much by having the government impose price ceilings on a wide array of
goods. However, this argument overstates the degree to which guvemment decree can
influence market behavior and fails to recognize the detrimental effects of price controls.
As noted by Milton Friedman when commenting on the experience of Germany
following WW-II, "there were extensive wage and price controls, supposedly to control
inflation, but of course wage and price controls never control inflation.''34 Most
economists agree with this assessment. In Chapter 1 we saw that across two different
studies, an average of 73.0% of ecunomists agreed that "wage and price controls are NOT
a useful policy option in the control of inflatinn."
In spite of this, during President Nixun's time in office, price controls were
imposed in an attempt to combat inflation.35 During his first term in office, the overall
performance of the U.S. economy began to decline. In particular, inflation was becoming
a problem. The annual inflation rate had been below 2% in every single month between
December 1958 and January 1966 (86 consecutive months). During the late 1960s the
rate gradually increased, to the point that by the start of 1970 the annual inflation rate was
over 6%j~ The ever politically aware President Nixun viewed a poorly performing
economy as a potential liability heading into his 1972 re-eleetiun campaign. He was
faced with the dilemma of "how to bring down inflation without slowing the economy
and raising unemployment" - Nixon's attempted solution was the establishment of "a
Wage-price review board, composed of distinguished citizens who would pass judgment
on major wage and price increases.,,37 In August 1971, with inflation sitting at an annual
rate of 4.62% (the 39t~ consecutive month with a rate above 4%), Nixun announced a
"New Eeunomie Policy, which would temporarily - for a ninety day period - freeze
wages and prices to check inflation.',3s The newly created Cost of Living Council, led by
D~rector Donald Rumsfeld and Assmtant Director Richard Cheaey, was charged with the
task of implementing these price euntrols.
See the wdeo segment "Germany s Bold Move ( 'Commanding Heights: the Battle for the World
Economy," (2003). episode l, chapter 9), which can be viewed on-line ae
3~ Thlsapproach to fighting. mflatton
.
t~:/Avww'°bs-°rr'At~bh/commandineheiehts/sharedA#deo/qt/minl 09
pot around
was also attempted in Great Britain 300.3,t.,1.
the s~une time under the
leadership of Prime Minister Ted Heath with the passage of the Counter-In flatinn Act of 1973 '
(h!tP://www-le~iMation~utaTea/1973/9/pdfs/u£7~ea
Mixed Economy Flounders" ("Commanding Heights: the19730009Battle for theen.pd~. See the videosegment-A
World Economy,"
l, chapter 13): ~s.or~At~bhlcommondin " .
..
~Tbescvaln~(andoth~simi~valn,.:_.L. ~ ~hewhts/xharcd/vtdco/(ct/mml pot 13 ~O0.hL.
U.S. since 1914, available at: -~l~:/linflal/ondata.com/lnlTation/lnflation
n m m l $ Q i s c o s s l O n ' t ~ . fa~mnary . . . . . .Ratc/Hismriealln~.
r o fi l . . . ozthe
more complete diseassico ofinflatian and unemplo .ymcot rates in the U.S. is presented in Chapter 9.
3 7 See ' D. and J. Stanislaw, The Commanding Heights: the Banle for the World ECOnomy," Simon
: Yergm,
and SchuSter, 2002, page 43.
~/bin(, page 44.
204
Chapter #8 - hnpact of Policy Decisions on the Rate of Inflation
After the initial ninety day imposition, the controls were gradually relaxed.
However, inflation began to again creep up in 1973, prompting the Nixon Administration
to "re-impose a freeze in June 1973. 39 During this time the effects were quite disntptive
to economic activity, as "runebers stopped shipping their cattle to the market, farmers
drowned their chickens, and consumers emptied the shelves of supermarkets.'~ The
attempt to combat inflation with price controls was abandoned in early 1974. But, once
these artificial constraints on prices were lifted, prices soared and the U.S. economy
experienced one of the most severe instances of inflation in its history. The annual
inflation rate was above 10% for fifteen consecutive months, fi'om February 1974
through April 1975.
To understand exactly why the imposition of price controls is so disruptive to
market activity, we analyze the impact of such policies within the model of supply and
demand. As will be seen, when a price control is imposed, less trade takes plane. Thus,
if such a control is put in place in an otherwise efficient market, it will create a positive
Deadweight Loss resulting from too little trade (recall the discussion of Deadweight Loss
from Chapter 5). Further, if the intention of the policy is to ensure a fairer price (thereby
improving the market outcome) for participants on one side of the market, we will see
why imposing a price control has at best mixed results in achieving this outcome.
Consider a market with supply and demand as illustrated in Figure 8.3. Perhaps
this is the market for two bedroom apartments in a major metropolitan area, such as New
York City. lfwe let market forces determine the outcome, we know (from our discussion
in Chapter 4) that 4,425 units would be Waded, each at a price of $5,000. We can easily
see (from our discussion in Chapter 5) that at this outcome buyers realize a Total
Consumers Surplus equal to "areas (a)+(b)" and sellers realize a Total Producers Surplus
equal to "areas (c)+(d)+(e)." Suppose that we think $5,000 is too high of a price, and we
impose a price ceiling of $3,600 in order to make housing more affordable for renters in
this market. What is the ultimate impact of imposing this policy, and by how much have
we improved the outcome for renters?
Start by recognizing that at the artificially low ceiling price of $3,600, consumers
now want to "buy" 6,775 units, while producers want to "sell" only 2,650 units. The
price control has artificially created excess demand (i.e., a shortage). 41 When this ceiling
is imposed, the realized level of wade will be the lesser of these two amounts: 2,650
units:2 These wades will take place at the controlled price of $3,600. So, how does a
39 Ibid., page 45.
~° lbid., page 45,
(20031. episode 41 In the context of Nixon's wage and price controls, this decrease In quantity traded and a~ificial shortage
was described by Daniel Yergin as follows: "The economy went out ofwhack~ People couldn't cover their
costs,.,instead of controlling inflation, [the price controls] were creating shortages," See the video segment
.mflanon' 'rate ' the A
~ / ' in "The Specter of Stagflatien" ("Commanding Heights: the Banle for the World Economy," (2003), episode
l,chapter 12):http://www.nbs.ore/w~bh/commandin~hei2hts/shared/video/qumini 1301 12 300.html
Th s observation on the positive (as opposed to normative) impact of a price ceiling on quantity of trade
rs accepted by a vast majority of economists. In fact, within the ~scussion of views of economists in
Chapter t, the statement with the highest agreement is: "A ceiling on rents reduces the quantity and quality
of hcosing available" (average agreement of 95.5%, over two different studies),
205
 Chapter #8- Impact of Policy Decisions on the Rate of Inflation
situation in which 2,650 units are traded at a price of $3,600 compare to the flee market
outcome?
Focusing first on Total Social Surplus, recognize that if 4,425 is the efficient level
of trade, then imposing the price ceiling has created a Deadweight Loss equal to "areas
Co)+(d)." Since these units arc no longer being trade, society must forego the net benefits
which could result from these transactions. The presence of this Deadweight Loss
provides a strong argument against imposing the price ceiling.
Figure &3 - Impact of Imposing a Price Ceiling
5,000 .......... ,
3 , 6 0 0 , : . . . . .
2 , 0 0 0 , ~ D e m a n d
' Finally note that it is actually possible for a price ceiling to result in a decrease in
0 [ '
I I quantity
0 2,650 4,425
6,775
Switching focus to the impact of the policy on sellers, recognize that when 2,650
units are traded, each at a price of $3,600, Total Producers Surplus is equal to "area (e)."
In contest, at the free market outcome Total Producers Surplus was "areas (c)+(d)+(e)."
Thus, the price ceiling has decreased Producers Surplus by "areas (c)+(d)." The sellers
lose "area (d)" because they no longer sell units 2,651 through 4,425. The sellers lose
"area (c)" because they now receive only $3,600 per unit instead of $5,000. In the
context of rent controls, this restriction makes landlords unequivocally worse off. But, if
Someone supports imposing rent controls, they likely would not be Swayed by an
observation that the policy makes landlords worse off.
To determine the impact of the price ceiling on buyers, start by recognizing that
when 2,650 units are traded, each at a price of $3,600, Total Consumers Surplus is equal
to "areas (a)+(c)." Recall, Total Consumers Surplus at the free market outcome is equal
to "areas (a)+(b)"Thus, when the price ceiling is imposed, compared to the free market
outcome, consumers collectively gain "area (c)" but lose "area (b)." The gain of "area
(c)" arises because for the 2,650 units purchase, the price paid is lower (only $3,600
instead of $5,000). This lower transaction price directly leads to an increase in Total
Chapter #8 - Impact of Policy Decisions on the Rate of Inflation
Consumers Su~lus. However, with the price ceiling in place, fewer units are traded.
The loss of"area (b)" results from the fact that units 2,651 through 4,425 are no longer
consumed, thereby precluding the previous consumers of these units from enjoying
benefits from consumption.
Recognize that in the context of a market for something like an apartment (where
nearly all consumers will acquire at most one unit), this price ceiling (which was likely
enacted to improve the outcome for renters) has clearly made Some individual buyers
worse off. For example, consider "Renter number 4,000" (i.e., the individual who is
represented by the 4,000th unit along the demand curve). We know that the buyer's
reservation price of this individual is above $5,000, since at the free market outcome she
would choose to rent an apartment at this seemingly high price. Given a choice between
renting an apartment for $5,000 and renting an apartment for $3,600, she would
obviously prefer the latter option. While the person advocating the price ceiling is likely
doing so with the intention of giving her this second outcome, it is important to
understand that this is not what the price control actually does. With the price control in
place, this person is no longer be able to rent an apartment (only 2,650 units are supplied
at the artificially low price). Thus, in practice, the price control gives her the outcome of
not being able to rent an aparm~ent for $3,600. Given a choice between renting an
apartment for $5,000 (which is what the free market outcome gives her) and not renting
an apartment for $3,600 (which is what the price control actually gives her), she prefers
the former option. For this reason, this individual buyer is actually made worse offwhen
the price ceiling is imposed.
Total Consumers Surplus. As illustrated in Figure 8.3, it appears as if "area (c)" is
greater than "area (b)," in which case Total Consumer Surplus increases as a result of
imposing the price ceiling of $3,600. But it is possible for a price ceiling to be set at a
level for which the gained surplus of buyers from paying a lower price (corresponding to
"area (c)") is less than the lost surplus of buyer from decreased consumption
(corresponding to "area (b)"). tf this is the case, then the price ceiling actually decreases
Total Consumers Surplus (which, recall, is presumably the side of the market that
proponents of the policy are try to help out). As an extreme example, consider the impact
of imposing a price ceiling of $2,000 in this market. At such a low price, quantity
supplied is equal to zero units - thus, with the price ceiling in place, no trade takes place.
The decrease in Total Consumers Surplus resulting from less trade taking place is now
equal to "areas (a)+(b)," while the increase in Total Consumers Surplus from paying a
lower price is now equal to zero (since no trade takes place at such an artificially low
price). Thus, imposing a price ceiling of $2,000 decreases Total Consumers Surplus fi'om
"areas (a)+(b)" down to zero, clearly making consumers worse offas a group.
~articuINar°t~onsider th, e.marke.t illustrated in Figure 8.4. Perha s thi '
1~ ~ tYl:~ OI tOW SKltlea labor V/he ..... , taoor
- - Pmarket
s ~ s using
a m athe
r k e t f o rofa
supply and demand, the workers .are theu sellers
uuamyzmg(anda are represented alongmodel
the supply
curve) and the firms are the buyers (and represented along the demand curve). At the
free market outcome, 2,160 workers would be hired, each at an hourly wage rate $11.50.
Workers realize a Total Producers Surplus equal to "areas (d)+(e)," while firms realize a
 Chapter #8- Impact of Policy Decisions on the Rate of Inflation
Total Consumers Surplus equal to "areas (a)+co)+(c)." Suppose that we think a wage rate
of only $11.50 is toe low for workers, and we impose a price floor (i.e., a minimum
wage) of $15,00 with the intention of increasing the incomes of these workers.
FIgRre 8.4 - Impact of lmposing a Price Floor
$ off. But again, the primary concern of an advocate of a minimum wage is likely not the
2 8 . 0 0 " ~ Supply
ii.5o .... ~- .... ~ :--~-':,~e~ :
-- ~"~" Demand
quantity
1,380 2,160 2,835
At this artificially high price of $15.00, even more people would like to work -
quantity supplied is now 2,835 instead of only 2,160. However, at this higher wage rate,
finns do not want to hire as many workers - quantity demanded is only 1,380 instead of
2,160. When this price floor is in place, the quantity of mute will be the lesser of these
two amounts: 1,380 units. Thus, in the presence of a minimum wage of $15.00, the
realized outcome in this labor market is for 1,380 workers to be hired, each at a wage of
$15.00 per hour. How does this outcome compare to the flee market outcome?
With the minimum wage in place, fewer workers arc hired. This is why there is a
strong consensus among economists that "a minimum wage increases unemployment
among young and unskilled workers,,43 If 2,160 workers is the efficient level, then
having this price floor in place creates a Deadweight Loss equal to "areas (c)+(e)."
Again, the presence of this Deadweight Loss provides a strong argument against
imposing this policy.
43 From the discussion in Chapter l, across three different studies an averaoe ofgt~ oo/
with :his statement. Note that we are focusing on a labor market in wL' 8 L.,
uv.o--,0 economists agrend
otherwise be below the proposed minimum wage of $15.00. mco me nee market wage rate would
to be unskilled or youn8 (i.e., lacking experience). The workers in such markets are more likely
If we instead focused on a market in which the free
m~rket Wage rate is above $15.00 (e.g., the market for physicians), then the price control is not binding and
vail have no dtrent lrapect on the market. For this reason, it follows that the undesired effect of reduced
employment created by this policy is borne by young and unskilled worke~.
Chapter #8- Impact of Policy Decisions on the Rate of Inflation
Focusing on the impact of the policy on buyers of labor (i.e., businesses),
recognize that Total Consumers Surplus has decreased by "areas (b)+(c)." These buyers
lose "area (c)" since they no longer hire workers 1,381 through 2,160. They lose "area
(b)" because they now have to pay $15.00 per hour to the workers that are hired (instead
of only $11.50 per hour). With the price floor in place, buyers are unequivocally worse
well-being of the firms hiring the workers.
Switching attention to the impact of the price floor on sellers (i.e., workers), start
by recognizing that when 1,380 units are traded at a price of $15.00, Total Producers
Surplus (in this case the workers' surplus) is equal to "areas CO)+(d)" (as opposed to a
surplus of "areas (d)+(e)" at the free market outcome). When the minimum wage is
imposed, workers collectively gain "area Co)" but lose "area (e)." The gain of"area (b)"
results from the fact that the 1,380 workers hired are each paid $15.00 per hour instead of
only $11.50. This increased wage rate was the intended result of the policy and leads
directly to an increase in surplus for these workers. But, with the price floor in place,
fewer workers are hired. The loss of "area (e)" arises because workers 1,381 through
2,160 are no longer hired. When workers must be paid at least $15.00 per hour, it is no
longer worth it for a Fn'm to hire these workers (i.e., the buyer's reservation price for the
potential buyers of these units is less than $15.00). For example, if I can pay Someone
$ I 1.50 per hour to cut my lawn, I will do so - but, if I have to pay them $15.00 per hour,
I will cut my lawn myself.
Similar to the market for apartments (in which someone either rents one
apartment or none), workers in a labor market either have a job or not. Thus, as
suggested in the discussion above, the decrease in quantity traded from 2,160 units down
to 1,380 units corresponds to some individual workers no longer having jobs. The
minimum wage clearly makes these people worse off. For example, consider "Worker
number 1 300 "0.e., the. mdivldual
. . .who. is represented by the 1,700th unit along the supply
curve). We can infer that the seller's reservation price of this person is less than $11.50,
since even at this seemingly low wage rate she would choose to take a job. Given a
choice between having a job that pays $15.00 instead of$11.50, she would clearly prefer
the former option. But, contrary to the intentions of the advocate of the policy, this is not
what the minimum wage does for this worker. With the price floor in place, this worker
no longer gets hired (the pOtential buyer of her labor time is not willing to pay the higher
wage of $15.00). In practice the minimum wage gives her the outcome of not having a
job. Given a choice between having a job that pays $11.50 an hour (which is what the
free market gives her) and not having a job (which is what the price control actually gives
her), she prefers the former option. From here, we see why imposing the minimum wage
actually makes this individual worker worse off.
Further recognize that imposing a price floor could either increase or decrease
Total Producers Surplus. To see this, consider the imposition of a minimum wage of
$28.00 per hour in the labor market illustrated in Figure 8.4. This price is above the
reservation price of every single buyer. With such a high minimum wage in place, no
workers are hired. As a result, imposing such a high minimum wage decreases Total
Producers Surplus by "areas (d)+(e)." Workers lose "areas (d)+(e)" as a direct result of
 Chapter #8- Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

2,160 workers no longer having jobs. Further, since no people are hired, there is no C H A P T E R # 8 M U LT I P L E C H O I C E Q U E S T I O N S
benefit to any worker of being paid a higher wage rate than before. That is, imposing a
minimum wage of $28.00 decreases Total Producers Surplus from "areas (d)+(e)" down 1. said that "Inflation is always and everywhere a monetary phenomenon."
to zero, clearly making sellers (i.e., workers) worse offas a group. A. Richard Nixon
The discussion above identified distinct ways in which a price floor impacts three B. Donald Rumsfeld
different segments of socinty.44 Specifically, imposing a minimum wage causes: C, Milton Friedman
(1) firms hiring workers to be worse off (since they will have to pay a higher D. Barrack Obama
wage to the workers they do hire, and since they will hire fewer workers),
(2) some sellers of labor to be better off (those workers who still have jobs and
2. Last weekend Brenda won $1,500 at a casino in Biloxi, Mississippi. She decided to
are now paid the minimum wage instead of the previous, lower wage), but
use the money to purchase a new TV from Walmart. She was able to use the
(3) some sellers of labor to be worse off(those workers who no longer have jobs
money to acquire the new TV since money serves as a
with the minimum wage in place).
So, is a minimum wage a good policy'/ Recognize that this is a normative (as opposed to A. dualcoincidence of wants.
B. medium of exchange.
positive) question. Any answer depends upon the values and priorities of the person
assessing the policy. C. store of value.
If your values are such that you want to maximize Total Social Suq~lus, then D. unit of account.
imposing a minimum wage is not a good policy (since it creates a positive Deadweight
Loss). Suppose instead that your aim is to simply "help workers" - that is, your 3. Inflation is defined as an increase in
normative beliefs are such that you disregard the loss to farms associated with effect (1) A. average household income.
above. What our analysis partly reveals is that even with such standards you may or may B. the total market value of all goods and services produced within an economy
not favor the minimum wage. Even if you completely discount effect (1), you should over a specific period of time.
only favor the minimum wage if the value you place on the gain from some workers C, the price of any one single good in an economy.
being paid a higher wage - that is, the benefits associated with effect (2) - is greater than D. the overall, general level ofprieas for goods in the economy.
the value you place on the loss from some workers no longer having jobs - that is, the
costs associated with effect (3). Thus, two different people with different values and 4. Suppose that the value of the Consumer Price Index in Canada increased from
priorities can reasonably come to different conclusions regarding whether this policy is 178.3 up to 184.8 between 2017 and 2018. Based upon these values, Canada's
good or not. inflation rate for 2018 was
A. approximately 1.04%
B. approximately 3.65%
C. 6.5%
D. approximately 8.30%

5. The Equation of Exchange is

A. Y=C+I+G+NX
B. MV = pQ
C. D(p) = SO>)
D. GDP Per Capita = GDP + Population

6. One of the principle functions of money is that it serves as a "store of value," This
role could be described by recognizing that money
A. is used as a basic unit of measuring economic activity,
(4 Recall, these distinct effects on thee three different segments of society were noted in Chapter 1 within B, is an asset used as payment when purchasing goods and services.
the disettssion of views of economists. C. is an asset that can be used as a means to hold wealth.
D. None of the above answers are correct.
 Chapter #8 - Impact of Policy Decisions on the Rate of Inflation Chapter #8 - Impact of Policy Decisions on the Rate of Inflation

13. is defined as an increase in the money supply which provides a short

7. Which of the following countries experienced hypcrinflation that peaked at an
term stimulus to the macro economy, resulting in higher levels of output,
annual rate of 79,600,000,000% in mid-November 2008 (at which time prices
would approximately double every 24.7 hours)? employment, and incomes.
A. Peru A. Contractionary monetary policy
B. Germany B. Expansionary monetary policy
C. Zimbabwe C. A supply shock
D . None of the above answers are correct (since no country has experienced D . Hyperinflation
hypcrinflatinn since the United States at the and of the Revolutionary War).
Answer Questions 14 through 16 based upon the information conveyed in the graph
8. Which of the following is NOT one of the primary policy tools used by a central below. Suppose the free market outcome is efficienL
bank? price a ~ Supply
A . Loaning money to low income home buyers at below market interest rates (in
order to make housing "affordable for all").
B . Setting the "discount rate."
C. Setting"reserve requirements." 24.00 = ............
D . None of the above answers are correct (since each of the choices listed is one i i
b i e ~ J i
of the primary policy tools used by a central bank).

9. The central bank of the United Kingdom

A. is the Bank of England, which was founded in 1694.
9 50 ' Demand
B. is the Federal Reserve, which was founded in 1913.
C. is the Bank of Parliamant, which was founded in 1981.
D. None of the above answers are correct, since the United Kingdom does not
have (and has never had) a central bank.
0 quantity
10. As depicted in Figure 8.1, the expansion phase of the business cycle can be further 1,400 2,650 3,615
0
decomposed into periods of
A. peak and trough. 14. Imposing a price floor of $18.00 would
B. acceleration and deceleration. A. make all sellers worse off.
C. recession and depression. B. make all buyers worse off.
D. recovery and prosperity. C. not have any impact on the market whatsoever.
D. More than one (perhaps all) of the above answers is correct.
I I. Widespread price controls were implemented in the U.S. in an unsuccessful attempt
to reduce inflation during the time whan 15. Ifa price ceiling of $9.50 were imposed in this market, then
was President. A. 3,615 units would be traded.
A. Lyndon Johnson
B. Consumers' Surplus would be equal to "areas a+b+c+e+f."
B . Richard Nixon
C . Jimmy Carter C . Producers' Surplus would be equal to "area d."
D. More than one (perhaps all) of the above answers is correct.
D . Ronald Reagan
16. Imposing a price floor of $24.00 would results in a Deadweight Loss equal to
12. The Fed can increase the Money Supply in the U.S. by
A. "area b+c+d."
A. selling U.S. Treasury debt securities to the public.
B. "areas e+f"
B. decreasing the discount rate.
C . "areas e+f+g."
C . increasing the reserve requirement.
D . "area h,"
D . More than one (perhaps all) of the above answers is correct.
Chapter #8 - Impact of Pollcy Decisions on the Rate of lnflation

Observations on Inflation
and Unemployment Rates
in the United States
In Chapter 7, Gross Domestic Product was defined as the total market value of all
final goods and services produced within a society over a certain period of time. At the
start of Chapter 8, inflation was defined as an overall increase in the level of prices
prevalent in an economy over time. These two concepts provide a great deal of insight
on the overall performance and health of a society's economy. A third important
macroeconnmic measure is the unemployment rate, defined as the percentage of the
labor force that is currently unemployed.
Within this chapter we make chronological observations on the inflation rate and
the unemployment rate in the United States, in order to gain further insight into past
macroeconomic performance. Building upon these concepts, a composite measure called
the "Misery Index" is defined and examined. In total, this discussion will allow us to
view recent economic outcomes in a proper historical context.

O B S E R VAT I O N S O N T H E I N F L AT I O N R AT E I N T H E U . S .

The inflation rate measures the annual percentage increase in the general price
level of goods and services. As discussed in Chapter 8, the inflation rate can be
computed from values of the Consumer Price Index (CPI). For example, between 2016
and 2017, the value of the CPI for the United States increased from 240.007 to 245.120,
revealing an annual inflation rate of 2.13% for 2017.t
Figure 9.1 provides a visual summary of the annual inflation rate in the United
States during each of the 844 months from January 1948 through April 2018.2 Over these
months, the inflation rate took on a median value of 2.88% and a mean value of 3.52%,

I See ~tto//data his ~ov/cei-bi~survft~ostgcu

value of 100 during the base period from 1982 84As reported, the CPI is normalized to take on an average
2Rel. able figures for the unemployment rate in the U.S. are available from the "Bureau of Labor Statistics"
only as far back as Jaun=ry 1948. For consistency, this month is chosen as the starting point for our
discussion of the inflation rate. The monthly data on annual inflation rates used to create Figure 9.1 is
available at htaT;/linflaliondata.comlblflation/lnflation RatelHi-~toricallnflation.avj~. These values were
computed from data which can be retrieved from http://data.bls.gov/cgi-bin/sura,evmost?cu (check the box
"U.S. All items, 1982-84=100. CULIR00OOSA0" and click "Retrieve Data").
 Chapter #9 - Observations on Inflation and Unemployment Rates in the United States
suggesting that moderate positive inflation has been the norm for the United States post
WW-IL The value in April 2018 was 2.46%.
The lowest inflation rate realized during this period was in July 1949, when the
value was -2.87%. Recall, a negative inflation rate reveals that prices are declining, a
phenomenon known as deflation. A negative inflation rate was actually realized in 40 of
the 844 months (i.e., just under 5% of the time) between January 1948 and April 2018:14
consecutive months flora May 1949 through June 1950; 12 consecutive months from
September 1954 through August 1955; 8 consecutive months from March 2009 through
October 2009; 5 consecutive months from January 2015 through May 2015; plus
September 2015.
Figure 9.1 - Annaal Inflation Rate on a monthly basis (Jan. 1948 through April 2018)
15.00
13.00
~1.00
9.00
7.00
5.00
3.00
1.00
-1.m
-3.00
At the other extreme, the highest inflation rate during this period - a value of
14.76% - occurred in March 1980. From a simple glance at Figure 9.1 we can observe
t he Great
" Inflation," a period of abnormally high inflation rates from the early 1970s
through the early 1980s. The mean value of the annual inflation rate in the months
between August 1973 and July 1982 was 9.18%. Using a value of 6% as a cutoff, the
annual inflation rate was above 6% in 99 of the 108 months between August 1973 and
July 1982 (i.e., 91.7% of the time). In contrast, the value was above 6% in only 11 of the
688 "other months" between January 1952 and April 2018 (i.e., 1.6% of the time).
From January 1952 through July 1973 the mean value of the annual inflation rate
was 2.38%, taking on a value of 6% or lower in 252 of these 259 months (i.e., 97.3% of
the time). Similarly, from August 1982 through December 2015 the mean value was
2.73%, taking on a value of 6% or lower in 425 of these 429 months (i.e., 99.1% of the
time). So, over these decades we observe three distinct periods - an initial period of
relatively low inflation from January 1952 through July 1973, followed by a period of
Chapter #9 - Observations on Inflation and Unemployment Rates in the United States
relatively high inflation from August 1973 and July 1982 (the "Great Inflation"),
followed by another period of relatively low inflation from August 1982 through April
2018.
Looking at this final period more closely, recall that we have already had multiple
instances of dnflation in the 2P~ Century. Moreover, for the 75 consecutive months from
February 2012 through April 2018 the inflation rate has been below 2.88% (the median
value for the entire time period from January 1948 through April 2018).
T H E D E F I N I T I O N O F T H E U N E M P L O Y M E N T R AT E
To understand precisely what the unemployment rate reveals it is important to
correctly recognize "who" it is measuring. The labor force consists of two types of
people: (i) those people who currently have a job and (ii) those people who do not
currently have a job but are actively seeking a job. If someone does not currently have a
job but is not actively seeking a job, then they are not part of the labor force. The
unemployment rate is then simply calculated as the percentage of the people in the labor
force who do not currently have a job.
For example, consider a simple society consisting of eight people as summarized
in Table 9.1. Only four of the eight people in this society currently have a job. Does this
mean that the unemployment rate is 50%? Two of the eight people are currently seeking
a job. Does this mean that the unemployment rate is 25%? No and no - the
unemployment rate in this society is 20%. Let's see why.
First determine which individuals are part of the labor force (and which
individuals are not). Abdel, Brenda, Candaca, and Dimitri are each part of the labor
force, because each person currently has a job. It makes no difference that Dimitri is
currently looking for a different job (while Abdel, Brenda, and Candace are not) - each
of these four individuals is part of the labor force merely by the virtue of currently having
a job. Edith does not currently have a job but is actively seeking employmenL As a
consequence, she too is part of the labor force.
Table 9.1 - Labor market status of indlviduals in society
Name Abdel Brenda Candace Dimitri Edith Fang Gabriel Heather~
Do you currently
have a.job? Yes Yes Yes Yes No No No No
Aro you currently
seeking a job?
Finally consider Fang, Gabriel, and Heather. Each of these people does not
currently have a job but is also not actively looking for a job. Maybe Fang was recently
laid off, but is very close to retirement age and has decided to just retire early. Perhaps
Gabriel is a stay at home dad taking care of his infant daughter so that his wife can work
outside of the home. Heather is just independently wealthy and would rather spend her
 Chapter #9 - Observations on Inflation and Unemployment Rates in the United States Chapter #9 - Observations on Inflation and Unemployment Rates in the United States

time playing tennis instead of working. Whatever the individual circumstance, none of
these people are part of the labor force (because each one does not currently have and is
not actively seeking a job).
Basically, the labor force consists of all those people who can answer "yes" to at
least one (if not both) of the following questions: (i) "Do you have a job?" and (ii) "Are
you actively seeking a job?" Applying this test to the information provided in Table 9.1,
the labor force of this society consists of five people: Abdel, Brenda, Candace, Dimitri,
and Edith. Of these five people, the only one who is currently unemployed (i.e., does not
currently have a job) is Edith. Thus, the unemployment rate is U = ~ = _t = .2 = 20%.
Now that we have a basic understanding of how the unemployment s rate is
calculated and precisely what it measures, we shift focus to observing realized values of
the unemployment rate in the United States post WW-II. Figure 9.2 provides a visual
summary of the unemployment rate in the United States in each of the 844 months
between January 1948 and April 2018.3 Over this entire time period, the unemployment
rate had a mean value of 5.78% and a median value of 5.6%. In April 2018 the
unemployment rate was well below these levels, standing at 3.9%. This is the lowest that
the unemployment rate has been since December 2000.
Figure 9.2 - Unemployment Rate on a monthly basis (Jan. 1948 through April 2018)
10.00
S.O0
6.00
consecutive months from September 1982 through June 1983. More recently, the
unemployment rate reached 10.0% in October 2009. These instances were the only
months since January 1948 when the rate was 10.0% or higher. In fact, as can be seen
from Figure 9.2, a rate of 8.0% or higher is relatively rare. During these decades, an
unemployment rate above 8.0% was realized for only three different stretches of time: 12
ennsecutive months from January 1975 through December 1975; 27 consecutive months
from November 1981 through January 1984; and 43 consecutive months from February
2009 through August 2012. From here we see that before jumping up to 8.3% in
February 2009, the unemployment rate had been below 8.00% for 300 consecutive
months from February 1984 through January 2009.
While not as clear-cut and dramatic as the differences in inflation rates, we can
again identify distinct periods of relatively high and relatively low unemployment rates.
Table 9.2 below provides such a summary for five distinct time periods between January
1948 and April 2018. For the 321 months from January 1948 through September 1974,
the unemployment rate took on a mean value of 4.79% and was 6.0% or higher in only 47
months (i.e., 14.6% of the time). This initial period of relatively low unemployment was
followed by a period of high unemployment from October 1974 through August 1994
when the rate had a mean value of 7.06% and was 6.0% or higher 79.1% of the time (i.e.,
i n 1 8 9 o f 2 3 9 m o n t h s ) . We n e x t e x p e r i e n c e d o v e r a d e c a d e o f r e l a t i v e l y l o w
unemployment from September 1994 through July 2008, with the rate taking on a mean
value of 5.03% and being 6.0% or higher in only 8 of 167 months (i.e., 4.8% of the time).
Then, from August 2008 through September 2014, we again experienced relatively high
unemployment, with a rate of 6% or higher for 74 straight months and a mean
unemployment rate of 8.23% over this time period. Most recently, from October 2014
through April 2018, the unemployment rate has been below 6% for 43 consecutive
months, taking on a mean value of 4.82% during this time period.

4.00 Table 9.2 - Periods of h~ ,If and low unemployment from January 1948 to April 2018
Number of M e ~ 6%
2.00 Time Period Months in "lirgh Unemployment N~-~r of I Percent of
Time Period .ow? Rate Months M oL__M_o~_-
Jan. 1948 to Sept. 1974 321 ~ 4.79% 47 J 14.6%
Oct. 1974 to Aug. 1994 239 -ligh 7.06% 189
167 [ 79.1"/o
LOW 5.03%
Au .2008 to Se t. 2014 8
74 8.23%
Oct. 2014 to A ri12018 ~ i~ 7_4
43 Low 4.820./0 0
The lowest Unemployment rate during this entire time period was a rate of 2.5%
in May and June of 1953. At the other extreme, the highest value was a rate of 10 8% in So, in regards to unemployment rates, it appears as if we have five distinct periods
November and December of 1982. A value of 10% was realized in each of ~e ten as follows: low unemployment from January 1948 through September 1974; high
unemployment from October 1974 through August 1994; low unemployment from
3 The data used to create Figure 9.2 is available fi'om the "Bureau of Labor Statistics', on-llne at September 1994 through July 2008; high unemployment from August 2008 through
htt ://d°ta'bls" ov/timeserle~tLNSl400000 . September 2014; and low unemployment from October 2014 through April 2018. A
 Chapter 09 - Observations on Inflation and Unemployment Rates in the United States
summary of these observations on periods of high unemployment (along with the period
of high inflation) is provided by the timeline in Figure 9.3.
Figure 9.3 - Periods of high unemployment and high inflation since 1948
high unem3~oyment
h i g h . m e a t
Oct. Aug. Aug. Sept.
1974 1994 2008 2014
+ . l I "l l ~
" I" iI "l ' " time
Aug.
July
1973
high inflation
As noted in Chapter 8, higher inflation is most likely, on the whole, undesirable
for an economy. Even more clearly, a higher unemployment rote is unwelcome.4 From
Figure 9.3 we see that from the mid-1970s through early 1980s the United States
experienced a double whammy of simultaneously high inflation and unemployment.
THE MISERY INDEX
As noted within Chapter 8, during President Richard Nixon's first term in office
(which ran from 1969 through 1973), the overall performance of the U.S. economy began
to decline. When Nixon took office in January 1969, the annual inflation rate was 4.4%
and the unemployment rote was 3.4%. By December 1970, the inflation rate had
increased to 5.57% and the unemployment rate had increased to 6.1%. Both of these
measures were higher than recent norms - over the 252 months from January 1948 to
December 1968, the annual inflation rate averaged 2.16% and the unemployment rate
averaged 4.72%. Furthermore, it was rare to experience both high inflation and high
unemployment at the same time.
In order to convey the unique nature of these simultaneously bad outcomes,
Arthur Okun (an economist who had served as the chair of the Council of Economic
Advisors under President Lyndon Johnson in 1968 and 1969) created a measure called
the Misery Index, which is computed by simply adding together the unemployment rote
and the annual inflation rate. Since a higher value of either unemployment or inflation is
4 To clarify these points, recall that in Chapter 8 it was noted that inflation can be beneficial for some
people in society, for example, individuals with a significant amount of debt being financed at a fixed
interest rate. Consequently, while higher inflation is on the whole probably a b~ thing for an economy, it
could be "loss" or"win" for different individuals within society. In contrast, it is more difficult to
identify "winners" when the unemployment rate is higher.
Chapter #9 - Observations on Inflation and Unemployment Rates in the United States
broadly less desirable, a higher value of the Misery Index is undesirable. This measure
was intended to gauge the overall health of the macroeconomy for the typical household,
bringing together the negative impacts of higher unemployment and rising prices. When
Nixon took office in January 1969, the inflation rate was 4.4% and the unemployment
rate was 3.4%, making the value of the Misery Index 7.8. By December 1970, the value
of the Misery Index stood at 11.67 (due to the inflation rate being 5.57% and the
unemployment rate being 6.1%), an increase of just under 50%.
Such a high value of the Misery Index was something that most people had not
experienced in their adult lives. During the 217 months from December 1951 through
December 1969, the value of the Misery Index was only above 10 in four months (from
March 1958 through June 1958). The Misery Index achieved a value of 10.08 in January
1970 and then remained above 10 for 21 consecutive months (through September 1971).
But these outcomes, with the Misery Index peaking at 11.67 in December 1970, would
pale in comparison to what was to come.
Figure 9.4 provides a graphical summary of the value of the Misery Index over
the 844 months from January 1948 through April 2018. During this time the Misery
Index ranged from a low of 2.97 in July 1953 (when inflation was 0.37% and
unemployment was 2.6%) to a high of 21.98 in June 1980 (when inflation was 14.38%
and unemployment was 7.6%). The mean value of the index was 9.30 and the median
value was 8.47. The Misery Index was 10 or higher in 287 of these 844 months - that is,
34% of the time.
Figure 9.4 - Misery Index on a monthly basis (Jan. 1948 through April 2018)
22.50
20.00
17,50
lS.O0
12.50
10.00
7.50
5.00
2,50
0,00
Focusing on a slightly higher threshold of 12.50, between January 1948 and
December 2015 the value of the Misery Index exceeded this level in 132 of 844 months
W,-,-,-,~m
(or only 15.64% of the time). Most recently, it was above 12.50 for five consecutive
 Chapter #9 - Observations on Inflation and Unemployment Rates in the United States
months from May 2011 through September 2011. But the vast majority of these high
value months occurred during a single stretch from November 1973 through June 1983,
when the Misery Index was 12.50 or above for 116 consecutive months. In contrast, of
the 728 "other months" over this entire time-peried (i.e., from January 1948 through
October 1973 plus July 1983 through April 2018) the index value was 12.50 or higher
only 2.20% of the time (i.e., in 16 months), with the longest consecutive mn lasting five
months (which occurred twice, from May 2011 through September 2011 and from April
1948 through August 1948).
Comparing Figures 9.1 and 9.4, we immediately see that this period of "Great
Misery" - during which the value of the Misery Index was 12.50 or higher in every
month from November 1973 through June 1983 - overlapped significantly with the
"Great Inflation" from August 1973 through July 1982 (when the inflation rate was above
6% in 99 of 108 months). But, from the timcline in Figure 9.3, we see that these high
Misery Index values were caused by simultaneously high inflation and unemployment.
Furthermore, while both inflation and unemployment were relatively high in
value during this entire period, at some points in time during the "Great Misery" inflation
was a bigger concern while at other points in time unemployment was the primary issue.
For example, when the value of the Misery Index climbed above 12.50 in November
1973, it did so because of a relatively high inflation rate of 8.25% coupled with a below
average unemployment rate of only 4.8%. Over the next several months both inflation
and unemployment became more problematic, to the point where by January 1975 both
individual measures were well above their respective average value (an inflation rate of
11.80% and unemployment rate of 8.1%) resulting in a Misery Index value of 19.90 (at
that point in time, the highest value post WW-II). Over the next two yeats the inflation
rate came down significantly, but the unemployment rate remained stubbornly high. In
December 1976 the Misery Index took on a value of 12.66 due to an unemployment rate
of 7.8% and an inflation rate of 4.86%.5 When the value of the Misery Index peaked at
21.98 in June 1980 it was due to, as previously noted, an inflation rate of 14.38% and an
unemployment rate of 7.6% (i.e., both inflation and unemployment above the norm).
During the final 10 months of the "Great Misery" unemployment was the primary
concern, with a rate above 10% in every single month between September 1982 and June
1983. In fact, in June 1983 the inflation rate was only 2.58%, but the value of the Misery
Index was 12.68, due to an unemployment rate of 10.1%.
T H E G R E AT R E C E S S I O N I N P R O P E R C O N T E X T
Having observed realized values of the inflation rate, unemployment rate, and
Misery Index from January 1948 through April 2018 allows us to put the Great Recession
~aWhile an inflation rate of 4.86% is still above the mean of 3 52% real;--A
num'y 1 9 4thro
8 u gh April" 2018, It. .Is clearly much lower than the "double -,inflation-p.
~ overdlah
me entire ariod
1 nfi~o~m
higher) which had been realized in 15 consecutive months from February 1974-through April ~l.e.,
1975 and
Jv/o or
which would come in 26 consecutive months from March 1979 through April 1981 (see Figure 9,1).
Chapter #9 - Obsera,ations on Inflation and Unemployment Rates in the United States
(which, as discussed in Chapter 7, occurred in the United States from December 2007
through June 2009) and subsequent recovery, in proper perspective. To this day, some
claim that when President Obama took office in January 2009, "the country was
experiencing the worst economic crisis since the Great Depression," while others insist
that President Obama's entire first four years in office was part of "the worst 5 years
since the Great Depression.''6 Is there any validity to either of these statements in regards
to inflation rate, unemployment rate, or Misery Index?
Looking first at the inflation rate, we see that increasing prices were not a major
concern at any point in time during the Great Recession or the subsequent recovery. In
total, between December 2007 (the start of the Great Recession) and April 2018 (the most
recent month with data), the inflation rate averaged only 1.74%. While the annual
inflation rate was above 5% for three consecutive months near the middle of the Great
Recession (from June 2008 through August 2008, peaking at 5.60% in July 2008), we
were actually experiencing deflation by the end of the Great Recession in June 2009. As
a result, the average inflation rate was only 2.46% over the entire duration of the Great
Recession itself(i.e., from December 2007 through June 2009). Further, since June 2009
the highest annual inflation rate realized in any month was a value of 3.87% in September
2011.
Shifting attention to unemployment, the picture is a bit more complicated. During
the "Great Recession" the unemployment rate peaked at 10.0% in October 2009. In
contrast, in the early 1980s the rate was 10.0% or higher for 10 consecutive months from
September 1982 through June 1983 (peaking at 10.8% in November and December
1982). So, when employment outcomes were most bleak, the outcomes during the "Great
Recession" were not even the worst in the last three decades. But while the peak
unemployment rate during the Great Recession was not as high as the peak rate in the
early 1980s, unemployment did remain persistently high during the Great Recession for a
longer period of time. The unemployment rate was 9% or higher for 30 consecutive
months from April 2009 through September 2011 and was 8% or higher for 43
consecutive months from February 2009 through August 2012. In contrast, in the early
1980s the rate was 9% or higher for only 19 consecutive months and was 8% or higher
for only 27 consecutive months.
Finally, looking at the Misery Index we see that recent realized outcomes (either
during the Great Recession or the recovery) were nowhere near as bad as those realized
from the early 1970s through the early 1980s. Since the start of the Great Recession in
December 2007 there were 6 different months in which the value of the Misery Index
was above 12.5, the highest being a value of 12.87 in September 2011 (resulting from an
unemployment rate of 9.0% and an inflation rate of 3.87%). But these outcomes are
nothing compared to the 116 consecutive months (from November 1973 through June
1983) when the value of the Misery Index exceeded this threshold. Moreover, the value
See "The Fifth Annivet,sary of the American Recovery and Reinvestment Act," by Jason Furman, 2/17/14
~ht~us:/&~v~wh~tehouse`~ov/b~/2~ ~ 4/~2/~ 7/~h~nnh~rsar~r~erican-re~ver~and-reim~stmen~-act)
and '~l'he Worst Five Years Since the Great Depression," by Peter Ferrara, 2/7/13
~hn~`./A~a)~`f~rbes`~p~sites/r'eterferrara/2~ ~ 3/~2/~7/the-~v*rst-/h~e-vears~sin~e-the-t~rex:t~
det~ressiolt~3dSe835eT¢¢~ for these competing claims.
 Chapter #9- Observations on Inflation and Unemployment Rates in the United States
Chapter #9 - Observations on Inflation and Unemployment Rates in the United States

of 12.87 in September 2011 (resulting from relatively high unemployment coupled with
average inflation) pales in comparison to the persistently high Misery Index values
resulting from relatively high unemployment coupled with much higher inflation, as
described in the previous section. Consequently, based upon observed values of the
Misery Index, the economic outcomes realized from the early 1970s through early 1980s
(when we were hit with the double whammy of both high unemployment and high
inflation) were worse than the outcomes realized during either the Great Recession or the
subsequent recovery.
C H A P T E R # 9 M U LT I P L E C H O I C E Q U E S T I O N S
I. The "Great Misery" refers to the period of time
A. from November 1973 through June 1983 when the sum of the unemployment
rate and inflation rate was 12.50 or higher for 116 consecutive months.
B. when George W. Bush was President, during which the U.S. Federal budget
deficit increased by 234%.
C. when Bamck Obama was initially President, during which the unemployment
rate was above 16% for 18 consecutive months from May 2009 through
October 2010.
D . right after Donald Tromp was elected President (but before he took office)
when the Dow Jones Industrial Average lost more than half its value in less
than three weeks (dropping from 14,286 in mid-November 2016 to 7,012 in
early December 2016).

2. The value of the Unemployment Rate in the U.S. in April 2018 was
A. 1.2%, an all-time record low Unemployment Rate.
B. 3.9%, the lowest Unemployment Rate since December 2000.
C. 7.9%, essentially equal to the mean Unemployment Rate between January
1948 and April 2018.
D . 10.9%, the highest Unemployment Rate since November 1939.

3. If"County Z" currently has an Inflation Rate of 2.1% and an Unemployment Rate
of 5.9%, then the value of the Misery Index in "County Z" would be __
A. 3.8
B. 4
C. 8
D. 12.39

4. If, over the course of a year, the value of a country's Consumer Price Index
increased from 186.4 up to 193.9, it follows that the country realized an inflation
rate of
A. 3.87%
B. 4.02%
C. 7.5%
D , 380.3%

5, Suppose that in Spain between 2017 and 2018 the Unemployment Rate increased
and the Inflation Rate decreased. It follows that the value of the Misery Index in
2018 the value of the Misery Index in 2017.
A. must be greater than
B. must be less than
C , must be exactly equal to
D . could be greater than or could be less than
 Chapter #9 - Observations on Inflation and Unemployment Rates in the United States

6. Since January 1948 there have only been three instances in which the
unemployment rate in the U.S. (reported on a monthly basis) has been above 8%.
This occurred most recently for
A. 3 consecutive months in from March 1969 through May 1969.
B. 43 consecutive months from February 2009 through August 2012.
Market Failure
C. 5 consecutive months from May 2017 through September 2017.
D . None of the above answers are correct (since the unemployment rate has never
b~n above 8% in any single month since the end of the Great Depression). In Chapter 5, the concept of Total Social Surplus was developed as a measure of
the benefits to society from economic activity in a market. It was argued that the realized
7. The "Unemployment Rate" is defined as the magnitude of Total Social Surplus depends critically upon the level of trade in a market.
A. number of people in the labor force who are currently not looking for a job. The efficient level of trade was defined as that which maximizes Total Social Surplus.
B. number of people in the labor force currently unemployed. Deadweight Loss, defined as the difference between maximum possible Total Social
C. percentage of people in the labor force that are currently unemployed. Surplus and realized Total Social Surplus, provides a measure of inefficiency in a market.
D. percentage of people in the labor force who have a job, but who feel that they Finally, it was noted that, in many cases, the market equilibrium level of trade is efficient
are "undercompensated," "unappreciated at work," or "could easily find a (i.e., market forces induce buyers and sellers to trade the quantity which maximizes Total
better job." Social Surplus, leading to zero Deadweight Loss).
But recall, when this observation was made, it was noted that certain conditions
8. The "Great Inflation" refers to the period of high inflation in the U.S. during the had to be met in order for the free market level of trade to be efficient. In the present
A. end of Great Depression and start of WW-II (from roughly August 1937 chapter, we precisely identify and discuss some common sources of market failure.
through October 1942). Market failure refers to situations in which the free market outcome is inefficient, in that
B. Kennedy and Johnson Administrations from 1960 through 1967. there is a positive Deadweight Loss at the free market level of trade (i.e., the level of
C. early 1970's through the early 1980's (from roughly August 1973 to July trade that emerges from the interaction of self-interested buyers and sellers).
1982). Instances of market failure perhaps provide the strongest case for government
D. first part of the time when President Obama was in office (from roughly intervention in markets, but do not necessarily guarantee that government will improve
March 2009 to July 2011). the situation (because of the possibility of government failure, which will be discussed in
detail in Chapter 11). By definition, if market failure exists, society is not producing and
For questions 9 and 10, consider a society with an adult population as follows:
consuming the quantity of the good which maximizes Total Social Surplus. Therefore, if
government can implement a policy to appropriately alter the level of trade, Total Social
Surplus can be increased. In the context of the three fundamental economic questions,
we are suggesting a potential role for government to play in regards to the production
decision (i.e., the choice of which combination of goods and services should be
produced).
Recognize that this call for government intervention in the face of market failure
9. There are
is fundamentally different than (and more easily justifiable than) a call for government
A . 3,125,-'-,--~-- people in the labor force of this society.
policy to address the distributional decision (i.e., the choice of who gets to consume the
B . 4,075,000
goods and services that are produced). This is because in the presence of market failure
C . 4,300,000
there is at least the potential for government policy to unequivocally improve the
D . 6,475,000
situation for all members of society - if Total Social Surplus is increased, it is possible to
realize an outcome for which (compared to the free market outcome) some people are
1 0 . T h i soelety
s " ' s Unemployment Rate is approximately
A . 5.23% strictly better off, while nobody is worse off. This is in stark contrast to government
~ .
B . 18.15% redistribution policies (discussed in Chapter 12), which effectively benefit "'Person A'" at
the expense of"Person B."
C . 27.33%
D . 37.07% Four common sources of market failure are: (i) profit maximization by a firm with
market power, (ii) market provision of public goods, (iii) market provision of goods
 Chapter I0- Market Failure
which generate externalities, and (iv) lack of information on the part of market
participants. Fatch of these four is discussed in turn, clearly explaining why relying only
on markets to determine the level of trade would result in a Deadweight Loss. Within
these discussions, it will be noted that market failure often emerges because of the fact
that people are self-interested.
P R O F I T M A X I M I Z AT I O N B Y A F I R M W I T H M A R K E T P O W E R
When discussing the interaction of buyers and sellers in the context of the model
of Supply and Demand, it was assumed that market participants behaved as "price
takers." The interaction of Supply and Demand gives rise to a market equilibrium price.
Subsequently, each individual market participant takes this price as given (i.e., beyond
his own control) and decides to either trade or not trade at this price, supposing that his
own behavior will not have any noticeable impact on price.
For some goods this is a reasonable assumption. Consider the situation of any
one Iowa corn farmer. From the perspective of consumers, the output of "Farmer A" is
essentially identical to that of "Farmer B." Thus, consumers base their purchasing
decisions solely upon price - if"Farmer A" charges more than the market price, nobody
will buy her com. Further, relative to the entire market, the quantity of output produced
by (and the maximum possible output of) "Farmer A" is minuscule. As a result, no
matter how much "Farmer A" alters her level of output (i.e., even if she entirely left the
market or ifsbe tried to flood the market), the impact on market price is negligible. Such
a producer has no market power - that is, no control over the market price? A seller with
no market pOwer behaves as a "price taker," accepting that price is beyond her control
and choosing a quantity of output. If she tries to charge a higher price, quantity
demanded from her would drop to zero. Further, she has no incentive to charge a lower
price, since she can sell as much as she wants at the prevailing market price.
While it is conceptually possible for a seller to essentially be a "price taker,"
clearly not all sellers operate in markets where this is the case. In many markets sellers
have some market power. A seller with market power has SOme control over the price
of her output, in that she: (i) will lose Some (but not all) customers if she slightly
increases price and (ii) must
decrease pace If she wants to increase quantity sold. For a
seller to have some market power, all she needs is that consumers view her product as
slightly different from that being sold by her cure eti
characteristic may be somethin,, as o;~.1 ....... P tors. The dlfferentiating
~, o-,,t,,~
output of "Seller A" and the output ~ tOcanon
of "Seller oIsale. Once
B" as differentiated consumers
products they no view
longerthe
base purchasing decisions solely upon price (i.e., they may choose to buy from "Seller A"
even if she charges a slightly higher price than "Seller B").
As an example, consider the market for gasoline at the retail level. Have you ever
purchased gas from a station, knowing that another station nearby is selling it at a lower
t Legally, this seller could charge any price she wishes
market price are never in her own best interest. . But, as a practical matter deviations away from the
Chapter 10- Market Failure
price7 Perhaps you are willing to pay a few pennies more per gallon of gas at "Station
A" because it has a better selection of snacks and beverages, has cleaner restrooms,
accepts your preferred credit card, or is on the right side of the road. The manager of
"Station A" has some market power, in that she can increase her price a little bit and not
lose all of her customers. However, in order to increase sales, she must give additional
consumers a reason to buy from her instead of from a competitor - that is, in order to
increase her quantity sold, she must decrease her price.
These observations illustrate that a seller with no market power faces a demand
curve for her output that is essentially a horizontal line at the prevailing market price,
while a seller with market power faces a downward sloping demand curve for her output
(i.e., a demand curve which strictly satisfies the Law of Demand). Firms operating in
perfectly competitive markets are price takers with no market power, while firms
operating in markets that are not perfectly competitive have at least some market power.
Market power is typically greatest for a frrm operating in a monopoly market.
Monopoly refers to a market structure in which there is a single seller of a unique
good for which there are no close substitutes. The demand curve facing such a
monopolist is the market demand curve, which should clearly be downward sloping.
Consider a monopolist operating in a market with demand as illustrated in Figure 10.1.
Recognize that while such a seller has market power, she is still constrained in terms of
her choice of price and quantity sold. She cannot sell any quantity she wants at any price
she desires. Rather, she is free to choose any price/quantity pair along the demand cur~e
(revealing that her choice is constrained by market demand).
Beginning to think spoeifically about firm behavior, recognize that the pricing and
output decision of any firm can be examined using the tools of Cost-Benefit Analysis
developed in Chapter 1. A private firm likely has the objective of maximizing profit. As
defined in Chapter 4, Profit is the difference between revenues and costs of production.
For a firm that charges all consumers the same per unit price of $ p, revenue is equal to
per unit price multiplied by quantity of output sold (i.e., letting q denote quantity of
output sold, revenue is pq ). Focusing on a firm's choice of output, marginal revenue
refers to the amount by which revenue changes as the firm's quantity of output is
increased by a unit and marginal costs of production refers to the amount by which
production costs change as the fu'm's quantity of output is increased by a unit. Applying
the Cost-Benefit Principle, we see that in order to maximize profit a f'u'm needs to
produce every unit (and only those units) for which marginal revenue is greater than or
equal to marginal costs of production.
Marginal revenue for a finn with market power is fundamentally different than for
a firm with no market power. First consider the price taking firm with no market power.
Such a firm can sell as much or as little output as desired at a constant price of $ p. To
sell one more unit, the firm sends the next unit to market and gets an additional $ p of
revenue. Thus, marginal revenue for a firm with no market power is equal to price.
In contrast, a firm with market power must decrease price in order to increase
quantity sold. This gives rise to two distinct effects on total revenue, which work in
opposite directions. When a firm drops its price to $ p in order to sell one more unit of
 Chapter 10 - Market Failure Chapter 10 - Market Failure

output, it increases its total revenue by $p from selling this additional unit. But, it
marginal revenue is ($4,500)/(900)=$5. Again, note that this value of marginal revenue
realizes a decrease in revenue as a result of receiving a lower price for each of the units is less than the 512 price that the firm is charging.
that would have been sold even at the highar price (once the firm drops its price, not only
the "new" customers get the lower price, but all of the fwm's customers get the lower
Figure ! 0. ! - Demand for a firm with market power
price). This implies that marginal revenue for a fu'm with market power is less than the
price being charged by the firm.
For a simple example, suppose that a finn with market power can sell 40 units of
output at a price of $6.05. In order to increase quantity sold to 41 units, the firm would
have to drop price to 56.00. What is the marginal revenue of selling the 41't unit? It
certainly will not be 56.00. First, we can directly see that if they sell 40 units at 56.05
each, total revenue is (40X56.05)ffi$242. If they instead sell 41 units at $6.00 each, total
revenue is (41X56.00)=5246. Thus, the marginal revenue of selling the 41~ unit is $4,
since total revenue increased by $4 when this next unit was sold. Observe that this value 15.50"
of $4 is indeed less than the price of 56 at which the firm sells its output.
12.00"
Alternatively, we can think of determining marginal revenue in a way that would
isolate the two distinct effects on revenue noted above. Continuing with this simple
numerical example, when the firm sells 41 units instead of 40 units, they get an additional
56.00 from selling the 41m unit. But, to increase quantity sold from 40 to 41, they had to Demand
drop price by 5¢ on all of the 40 units that they would have sold at the higher price. The
first of these effects increases revenue by 56, while the second of these effects decreases quantity
revenue by (40X5)=52. Thus, the total effect is a $4 increase in total revenue. Again,
because ofthis second effect (which arises because the firm has to decrease price in order 0 l,g00 2,700
to increase quantity sold), marginal revenue is less than price.
Finally, recognize that marginal revenue can actually be negative. Suppose that
Shifting attention to Figure 10.1, we can see how these competing effects on
decreasing price from $15.50 to $12.00 only increased quantity sold from 1,800 up to
revenue can be illustrated graphically. Total revenue - which is equal to the price of the
good multiplied by quantity sold - can be illustrated graphically as the area of the 2,300 (instead of up to 2,700). The firm is still sacrificing (1,800X$3.50)=$6,300 of
rectangle from the point on the demand curve where the monopolist chooses to operate revenue as a direct result of the price decrease. But now the gain from selling more
(i.e., the chosen quantity/price pair) back to the origin. If this fin-a chooses to set a price output is only (500X$12.00)=$6,000" In this case, when quantity demanded is less
of 515.50, they would sell 1,800 units. sensitive to price, this lower price and higher quantity sold actually decreases total
Numerically, this results in revenue of revenue by $300 (i.e., marginal revenue is negative).2
(1,800X515.50)=$27,900. Visually this corresponds to ,areas (a)+(b)', in Figure 10.1.
For a firm to maximize profit, they need to be aware of not only how revenue
How does total revenue change as price is dropped to increase quantity sold7
Consider a drop in price to $12.00. At this lower price the finn sells 2,700 units and behaves as more output is sold, but also how production costs behave us more output is
realizes revenue of (2,70(O512.00)=$32,400. This revenue is illustrated by "areas produced. Recall, marginal costs of production refers to the change in production costs
Co)+(c)" in Figure 10.1. when one more unit of output is produced. Marginal costs should never be negative,
since total costs should never decrease as more output is produced.
The two competing effects on revenue are apparent from this graph. As the finn
drops price from 515.50 to 512.00 to increase quantity sold from 1,800 to 2,700, they Consider a firm with marginal costs and marginal revenue as illustrated in Figure
gain additional revenue corresponding to "area (c)" by selling 900 additional units for 10.2. The profit maximizing quantity of output is determined by graphically applying the
$12.00 each. However, to realize this gain, they must sacrifice the revenue illustrated by
"area (a)," since on these 1,800 units they now get only $1Z00 per unit instead of 515.50. tin , .

Numerically, "area (c)" is equal to (900X$12.00)ffi$10,800, while "area (a)" is a n d = . ' o Y i t o t , . . . . . .

equal to (l,800X$3.50)ffi$6,300. Thus, this drop in price and increase in quantity sold demanded is only 2,300, "Area (a),.would
--,- -~.:~.
sUU~LU v= ts
be the sleeper,
same, butsince
"areaat a price
(c)" of $12,00
~uld be smaller.quantity
For the
results in an increase in total revenue of $10,800--56,300=$4,500. From here, a value for chosen numerical values, "area (e)" is smaller than "area (a)," revealing why marginal revenue is negative.
marginal revenue can be obtained by determining the increase in revenue on a per unit To describe how sensitive quanti~., demand,,a :~ ~ -~ ....... .
called Price Elasticity of Demand (defined-~ as,othe
,~ratio
~1~ of
m ~taga
price, ccononusts have developed
change in quantity den'wmded a measure
to
basis. Revenue increased by $4,500 when 900 additional units were sold, so that
pcrceataga chang in price). Demand is inelastic if this measure is betw~n 0 and I in absolute tenv~ It
can be shown that u~rglnnl revenue is negative ifand only if demand is inelastic,
 Chapter 10 - Market Failure
Cost-Benefit Principle (as discussed in Chapter 1), balancing marginal revenue against
marginal costs. Profit is maximized by selling 2,300 units (the unique quantity where the
marginal revenue and marginal costs curves intersect). Producing each unit up to this
level increases profit since marginal revenue is greater than $5.20 while marginal costs
are less than $5.20. Producing above this level would decrease profit, since beyond 2,300
units marginal revenue is less than $5,20 while marginal costs are greater than $5.20.
Figure 10.2 - Profit M~ximizing choice for a firm with market power
$ profit would be more than offset by an increase in Total Consumers' Surplus.3
Marginal
Costs
13.50 .......
"----I!\i Demand
0- quantity
; "~\ I
Revenue
To determine the ideal price for the firm to set, we do not simply go over to the
vertical axis from this intersection of the marginal revenue curve and the marginal cost
curve. Rather, the firm needs to determine the unique price for which consumers are
.willing and able to purchase exactly 2,300 units (i.e., the ideal quantity for the firm to sell
m order to maximize pmfit). This profit maximizing price is the corresponding price
along the demand curve at a quantity of 2,300. For the curves illustrated in Figure 10.2,
this ideal price is $13.50.
So, when maximizing profit this fh'm sells 2,300 units, each at a price of $13.50.
Applying the concepts of surplus from Chapter 5, this eboice results in a Producer's
Surplus of "areas (c)+(d)+(e)" and a Total Consumers' Surplus of "areas (a)+(b)."
To maximize Total Soeial Surplus, we would need to produce every unit (and
only those units) for which the value to the buyer is greater than the t'u'm's marginal costs
of produetinn. Since the height of the demand curve directly reveals a buyer's
reservation price, this implies that the efficient (i.e., Total Social Surplus maximizing)
level of trade is the quantity where the marginal costs curve intersects the demand curve.
For the market illustrated in Figure 10.2, this efficient level of trade is 4,000 units.
Chapter 10- Market Failure
Trading this efficient quantity would generate a Total Social Surplus equal to "areas
(a)+(b)+(c)+(d)+(e)+(t)." Thus, profit maximization by this firm with market power
results in a Deadweight Loss (due to too little trade) corresponding to "area (f)."
Recognize that this market failure arises because market participants are self-
interested. The firm cares more about its own profits than it does about Social Smplus.
If the finn eared just as much about consumer well-being as it did about its own profit,
then it would be willing to produce 4,000 units instead of 2,300 units. After all, this
higher level of output results in larger Total Social Surplus, implying that any decrease in
In the presence of this market failure there is the potential for government to
intervene and increase Total Social Welfare (or, equivalently, reduce Deadweight Loss).
If we suppose that the government has all of the necessary information4 (i.e., the
government has enough reliable information to accurately determine consumer demand
and finn production costs), then the government could eliminate Deadweight Loss in the
short term by putting policies in place to guarantee that 4,000 units are traded. For
example, suppose that at a price of $8.60 consumers would be exactly willing and able to
purchase the efficient quantity of 4,000 units.5 With full information, the government
(perhaps through the arm of a regulatory authority) could mandate that the firm must
charge a price of $8.60 and provide all units that people want to buy at this price. In the
presence of this decree, the fu-m would charge $8.60, consumers would purchase exactly
the efficient quantity of 4,000 units, leading to zero Deadweight Loss in the short term.s
MARKET PROVISION OF PUBLIC GOODS
A second potential source of market failure is market provision of pure public
goods. To understand this issue, we must f'n-st recognize that every good is characterized
by a certain degree of "rivalness in consumption" and a certain degree of "excludability
in consumption."
A good is rival if consumption by one person diminishes the quantity of the good
available for others to consume. In contrast, a good is non-rival if consumption by one
person does not diminish the quantity of the good available for others to consume. An
3 Sundar, y, If consumers were not self
. " interested - that.is.. If they cared, lust as much about the firm's profit
as they did about their own well-being- they too would prefer 4,000 units to 2 300 un ts (since again
Total Social Surplus is larger at 4.000 units than at 2,300 units). ' ' '
4 In pratt ee, governments face difficulties laying to obtain relevant reformation, especially if the producer
knows that the infommdoo will be used to set the price he can charge. Thus, the remedy suggested here
cannot always be emily implemented. .
Loss than doing nothing (an outcome In fact,govexnment
called govercunentfailure,
mtervennon can result
discussed in a larger
in greater Deadweight
detail in Chapter I 1).
s IsTunique
h .pnce
. . (wh
. ch Is equal to the height of the demand curve at 4,000 units) has not been illustrated
in Figure 10.2, in the interest of keep ng Figure 10 2 tid
6 Such regulation of price could easily give use to median and long term inefficiencies. For example,
since the producer is no longer fully motivated by profit, the fu'm has u reduced incentive to nlaintain
product quality or implement cost reducing innovations over time Thus, even if this regulation achieves
efficiency in the present period, it may be at the expense of increased inefficiency in the future.
 Chapter 10 - Market Failure
item of food or a piece of clothing is an example of a rival good. If you and your friends
order a pizza for dinner, every piece that you eat is one less piece that someone else can
eat. If you buy a new sweat`shirt at the campus bookstore and wear it tomorrow, your
roommate cannot wear the same sweat`shirt on the same day. In contrast, an AM or FM
radio broadcast, a satellite radio or television broadcast, or an outdoor fireworks display
is an example of a non-rival good - a satellite provider can serve one more customer
without decreasing the availability (or quality) of service for existing customers.
A good is excludable if it is easy for a provider to prevent consumption by those
who do not pay, whereas a good is non-excludable if it is difficult (or very costly) to
prevent consumption by those who do not pay. A pizza, a sweatshirt, a satellite radio
broadcast, and a satellite television broadcast are each excludable. If the pizza delivery
guy comes to your door and you refuse to pay, he's not going to give you the pizza. If
you do not pay your satellite provider for your service, they will deactivate your account.
Alternatively, an AM or FM radio broadcast or an outdoor fireworks display are each
non-exchidable. If you buy a whole bunch of fireworks and set offa huge display in your
yard on the 4th of July, there is no way that you can prevent your neighbor from enjoying
the show (even if you ask him to pay a portion of the costs and he refuses).
A Private Good refers to a good that is rival and excludable. Both a pizza and a
sweat`shirt are private goods. In fact, most of the goods that are traded in free markets are
private goods, in part because markets do a very effective job of providing the efficient
quantity of such goods. A Public Good refers to a good that is non-rival and non-
excludable. From the discussion above, an AM or FM radio broadcast and an outdoor
fL,'eworks display are public goods. The classic example of a public good is national
defense. Ifa fighter pilot pah-ols the airspace above your house in an F-22 Raptor, your
neighbor gets the same benefits from national security as you (i.e., the benefits are non-
rival). Further, we cannot provide this security for you while at the same time preventing
your neighbor from deriving the benefits (i.e., the benefits are non-excludable).
A Common Good is an interesting hybrid good that is simultaneously rival and
non-excludable, sharing one characteristic each with both a private good and a public
good. For an example of a common good, consider the stock offish in the ocean.~ This
stock is rival in consumption since any one fish caught by any one fisherman is one less
fish available for others. However, because the ocean is so large, we cannot easily put up
a fence to keep any one fisherman out. Thus, access to the stock is non-excludable.
Contrast this with farm raised catfish, which are grown in ponds located on the private
property of a farmer. The farm raised catfish is a private good, since it is both rival and
excludable.
The primary aim of the present discussion is to understand why, because of their
characteristics, free markets often fail to provide the efficient amount of public goods.8
7 For completeness, define a Club Good as a good that is non-rival and excludable. From the examples
above, a satellite radio or satellite television broadcast is a club good
i However, in some insleacns markets can still do an effective job of providing pure public goods.
Co~ider AM or FM radio broadcasts (or over the sir television broadcasls before cable and satellite
service). Producers correctly recognized that consumers valued these services. In spite of the fact that their
Chapter 10 - Market Failure
Consider our society's decision regarding whether or not to increase the level of national
security by building one more F-22 Raptor. The per unit cost of this fighter jet is $150
million) The current population of the United States is about 320 million people.
Thinking about the value that different people in society place on having one more fighter
jet, suppose that the person in society with the greatest value would realize a benefit of
$25,000 from the jet, while some people in society have no value whatsoever (i.e., a
benefit of $0) for the jet. If we computed a simple average ofvahie across all 320 million
people in our society, suppose we would find a mean value of 80. The two questions to
address are: (i) "Would producing one more jet increase or decrease Social Surplus?" and
(it) "Would a free market produce one more jet?"
First consider the Social Surplus from producing the jet. At first glance it might
seem as if producing the jet cannot possibly increase Social Surplus, since the most that
anyone values the item is $25,000 (an amount much less than the production costs of
$150 million). But, since this is a non-rival good, as long as the item is produced
everyone in society is able to enjoy the full benefits of the item. As a result, when each
of 320 million people have an average benefit of 80 for an item that is non-rival, the
total benefits generated from producing the item are $256 million (i.e., 80¢ per person,
multiplied by the 320 million people in society). With Social Benefits of $256 million
and production costs of $150 million, producing the jet would generate a Social Surplus
of $106 million (i.e., $256 million minus $150 million). So, efficiency dictates that one
more jet should be produced.
However, it seems very unlikely that the free market would provide the jet. After
all, a producer would have to be paid more than $150 million to build one more unit,
while the most that any one person in society values the item is $25,000. But what ira
coalition of buyers tried to band together to collectively buy the jet by pooling their
money? Since the good is non-rival in consumption, as long as it gets produced every
person in the group will enjoy the full benefit of the item. As long as we can bring
together enough people (with a sum total of valuations is in excess of $150 million), then
it seems like it can be in the best interest of the group to make this joint purchase. But,
this is where the non-excludable nature of the good presents a problem.
Suppose your value for the jet is $10 (in some sense, well above the 80¢ value of
a typical person). As a self-interested person, you would never want to join a coalition of
the type suggested above. Rather, you will be beret off if you let other people in society
pool their resources and buy the jet, while contributing nothing toward the purchase.
Once they provide the unit, you will still enjoy the full benefits of their purchase, while
saving yourself $10 (which you can use to buy a few cups of coffee, or whatever else will
!ncrease your happiness by the greatest amount). In essence, your self-interest creates an
incentive for you to try to "free ride" - that is, enjoy the benefits of units purchased by
others, while making no contribution to the provision of the good on your own. But,
when all members of society behave in this way, the likely outcome is that nobody (or
non-excludabin nature reade it effccdve|y impossible to directly charge consumers, entrepreneurial
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 Chapter 10 - Market Failure
even no group of people) will step up to the plate and incur the cost of providing the item
(especially for such a large ticket item like a $150 million fighter jet).
The general point is that market provision of public goods often suffers from the
Free Rider Problem - if a public good were provided in a free market, the amount
traded would be less than the efficient quantity, since many people would attempt to
enjoy the benefits of units purchased by others, while not purchasing any units
themselves. Again, the root cause of this market failure is individual self-interest. If
individuals were not self-interested, but rather cared about everyone else as much as they
cared about themselves, then they would account for the full social benefit of purchasing
the next unit of a public good and they would have no reason to try to "free ride."
This inefficiency is a result of the fundamental characteristics - the non-rival
nature and non-excludable nature - of public goods. Due to their non-rival nature,
producing the next unit of a public good may be efficient, even when costs of production
are very high relative to the value of any one consumer. However, a free market will
often not produce goods that are non-excludable. This is fundamentally a result of the
fact that it is extremely difficult for sellers to generate revenue when they cannot easily
prevent "non-paying customers" from enjoying the benefits of consuming a good.
The choice of example for the above discussion perhaps suggests an obvious role
for government to play in correcting market failures related to public good provision.
How did we in the United States decide to put 187 F-22 Raptors into active service
between 2005 and 20127 We did not let free markets decide on this quantity. We instead
had a government agency provide this public good. As with any public good, a choice
must be made in regards to a level of consumption for society. Through our political
process, we elected officials who appointed bureaucrats and made budgetary decisions
which ultimately resulted in this particular choice of quantity. Additionally, through this
same political process, taxes are imposed to Cover the costs of producing these items.
While 187 units is undoubtedly a higher level of productiun than a free market
would choose, there is no guarantee that it is the efficient quantity. Recognizing the Free
Rider Problem allows us to see why an unfettered market would provide less than the
efficient quantity of the good and suggests a potential role for government in reducing the
resulting Deadweight Loss. But, that does not imply that the quantity which we have
chosen through our political process is necessarily efficient. In fact, 187 units could be
either too many or too few units. That being said, an open, representative political
process which provides a voice for individuals seems more likely to give rise to outcomes
which are better for society than would be realized under a non-representative process.
However, even a democratic political process will often fail to achieve efficiency. A
more detailed discussion of such potential failures is presented in Chapter 11.
MARKET PROVISION OF
G O O D S W H I C H G E N E R AT E E X T E R N A L I T I E S
A third possible cause of market failure is allowing for market provision of goods
which generate externalities. An externality, or external effect, is present if an activity
Chapter 10 - Market Failure
significantly impacts the well-being of someone other than the persons directly engaging
in the activity.
In Chapter 5 we noted that the Social Surplus of a trade (defined us the
summation of individual gains or losses from the trade over all members of society) is
generally equal to Consumer's Surplus, plus Producer's Surplus, plus any other net gains
or losses realized by people other than the buyer or seller. It was observed that if nobody
beyond the buyer and seller is impacted by the production and consumption of the good,
Social Surplus is equal to the sum of Consumer's Surplus and Producer's Surplus (and
reduces to rb - r,). That discussion assumed no external effects were present.
In the presence of an externality, Social Surplus is no longer equal to simply
r~ -r,. To see why this is the case, start by recognizing that such external effects are of
one of two types. A negative externality, or external cost, refers to a burden borne by
someone other than the buyer or seller era good. The most common example is any sort
of pollution. Suppose a new airport is built right next to your house. You will be
adversely effected on a continual basis by air, noise, and light pollution from planes
taking off and landing. These costs represent a negative externality. When calculating
the Social Surplus of the airport's economic activity, we must account for not only the
gains to buyers and sellers (passengers and airlines), but also for the external costs
incurred by you (the homeowner) as a third party.
In contrast, a positive externality, or external benefit, refers to a gain realized by
someone other than the buyer or seller of a good. Activities which generate positive
externalities include vaccinations, installations of smoke detectors in attached aparWaants,
basic scientific research, and the installation of Lojack in automobiles)° If you get a flu
vaccine, clearly you realize benefits (i.e., a reduced likelihood of getting the flu) and the
provider of the vaccine realizes costs of production. But, other people in society realize a
benefit of your vaccination. If you are less likely to get the flu, then your family, friends,
classmates, and co-workers are each a little less likely to get the flu. These benefits
represent a positive externality. Again, when calculating Social Surplus, we need to
account not only for the gains to buyer and seller, but also for these external benefits
incurred by others us a result of your decision to get vaccinated.
While positive externalities may sound like a good thing and negative
externalities may sound like a bad thing, the outcome from market provision in either
case is characterized by a Deadweight Loss. That is, in the presence of either type of
externality, a free market would not provide the socially optimal quantity, To see
precisely why this is the case, we extend the model of Supply and Demand developed in
0Art extenstve empmca
"' analysis ofth s ast example was conducted by lan Ayres and Steven Levitt
(Ayres. I. and Levitt, S. "Measuring Positive Externalities from Unobservable Victim Precaution: An
Empirical Analysis of Lojack," The Quarterly Journal of Economics. VoL 113, No. I (February 1998),
pages 43-77). When discussing the findings of Ayras and Levitt, Steven Landsburg notes that, "a I percent
increase in LoJack sales can reduce auto theft rates by 20 percent or more." Landsburg also explains why
(in contrast to the positive externality generated by Lojack) a visible theft deterrent device, like "The
Club," generates a negative externality for other automobile owners, See: Landsburg. Stereo E. More Sex
is Safer Sex: the Unconventional Wisdom of Economics, New York: Free Press, 2007, pages I l l'-l t2.
 Chapter 10 - Market Failure
Chapter 4 to allow for such external effects, subsequently applying the concept of
Deadweight Loss developed in Chapter 5.
In the presence of either a positive or negative externality, the analysis begins by
recognizing that the marginal private benefits of consumers are illustrated by the demand
curve and that the marginal private costs of produeers are illustrated by the supply curve.
Further, when measuring social benefits and social costs recognize that, in general,
marginal social benefits are equal to the sum of marginal private benefits and marginal
external benefits (i.e., MSB = bOB + :.,fib ), while marginal social costs are equal to the
sum of marginal private costs and marginal external costs (i.e., MSC = MPC + MEC ).
First consider a market in which a negative externality is present. Since there is
no external benefit (i.e., MEB = 0 ) marginal social benefits are simply equal to marginal
private benefits (i.e., MSB = bob ), reflecting that nobody beyond the buyer benefits
from the provision and consumption of the good. However, the positive valued marginal
external cost (i.e., MEC > 0 ) implies that marginal social costs are strictly greater than
marginal private costs (i.e., M~C > boC ). This situation is illustrated in Figure 10.3.
Figure 10.3- Market Outcome in the Presence of a Negative Externalify
$ SS9~o =(a+b+c+e+ f)-(c+ f +b+e+d)=a-d.
(Marginal Social Costs) = MSC
~
= MPC+IvI~c
(Marginal Private Costs) = MPC
= Supply
(Marginal Social Benefits) = MSB =
(Marginal Private Benefits) = MPB
!:i °Dem.d
I I qantity
680 910
For the market illustrated in Figure 10.3, the free market equilibrium quantity of
trade is 910 units. This is the unique quantity where the supply curve and demand curve
intersect. To maximize Total Social Surplus, we need to balance marginal social costs
against marginal social benefits. Doing so, we see that effieiant level of trade is 680
units. This quantity is determined by identifying the unique quantity at which marginal
social benefits are equal to marginal social costs (note, these insights rely upon a
graphical application of the Cost-Benefit Principle, as discussed in Chapter 1).
Chapter 10 - Market Failure
Thus, in the presence of a negative externality, a free market provides too much of
the good. From the discussion in Chapter 5, the resulting inefficiency can be quantified
by recognizing that there is a Deadweight Loss equal to "area (d)" at the market
equilibrium outcome. Again, the fundamental cause of this inefficiency is individual
self-interest Consumers and producers make their market decisions based upon their
own private benefits and costs, not taking into account the external costs borne by other
members of society. When they do so, the ultimate result is too much trade.
As noted, Total Social Surplus is maximized by producing exactly 680 units. At
this quantity: consumers realize benefits from consumption equal to "areas (a)+(b)+(c)";
producers incur private costs of production equal to "area (c)"; and other members of
society incur external costs equal to "area (b)." Thus, the maximum value of Total Social
Surplus is:
sS,,o=(a+b+c)-(c+b)=a.
In contrast, when 910 are traded: consumers realize benefits from consumption
equal to "areas (a)+(b)+(c)+(e)+(f)"; producers incur private costs of production equal to
"areas (c)+(O"; and other members of society incur external costs equal to "areas
(b)+(e)+(d)." Thus, Total Social Surplus at the market outcome is:
These observations allow us to again see that trading 910 units generates a Deadweight
Loss equal to "area (d)."
Now consider a market in which a positive externality exists. Absent any external
cost (i.e., MEC = 0), marginal social costs are simply equal to marginal private costs
(i.e., MSC = MPC ), reflecting that no third parties are harmed by the production of the
good. However, there is a positive valued marginal external benefit (i.e., MEB > 0),
implying that marginal social benefits are strictly greater than marginal private benefits
(i.e., A~SB > bob ). This situation is illustrated in Figure 10.4.
For the market illustrated in Figure 10.4, the free market equilibrium quantity of
trade is 345 units (as determined by the intersection of supply and demand). However,
Total Social Surplus is maximized by trading exactly 450 units (the unique quantity at
which marginal social benefits are equal to marginal social costs).
Thus, in the presence of a positive externality, a free market provides too little of
the good. We can again quantify the resulting inefficiency by directly recognizing that
there is a Deadweight Loss equal to "area (d)" at the market equilibrium outcome. Once
more, individual self-interast is the source of this market failure. Market participants are
motivated by private benefits and costs. When they do not account for the external
benefits realized by others, the ultimate result is too little trade.
In this market, Total Social Surplus is maximized by producing 450 units. At this
quantity: consumers realize private benefits from consumption equal to +'areas
Co)+(c)+(f)"; producers incur costs of production equal to "area (c)+(e)+(f)"; and other
members of society realize external benefits equal to "areas (a)+(d)+(e).'" Thus, the
maximum value of Total Social Surplus is:
s s , f f ) = a + b + a .

Chapter 10 - Market Failure
In contrast, when only 345 are traded: consumers realize private benefits from
consumption equal to "areas Co)+(c)"; producers incur costs of production equal to "area
(c)"; and other members of society realize external benefits equal to "area (a)." Thus,
Total Social Surplus at the market outcome is:
ss,, =(b+c+a)-(c)=a+b.
From here, we again see that trading only 345 units creates a Deadweight Loss equal to
"area(d)."
Figure 10.4- Market Outcome in the Presence of a Positive Externality
(Marginal Social Costs) = MSC =
(Marginal Private Costs) = MPC
= Supply
~
a
' (Marginal Social Benefits) = MSB
= MPB+MEB
b ~
; . ~ ( M a r g i n a l P r i v a t e B e n e fi t s ) = M P B
i = uemanu
c
0 a consistent basis since the late 1970s. Many people in more developed regions of the
[ quantity
345 450
0 China is still relatively poor compared to the United States. As of 2017, per Capita GDP
The main point to take away from this discussion is that market provision of a
good which generates an externality is inefficient. In the presence of a negative
externality (e.g., significant pollution), a free market provides too much of the good. In
the presence of a positive externality (e.g., vaccinations), a free market provides too little
of the good. The analysis also reveals how external ffects should be treated if our aim is
to maximize Total Social Surplus. We do not want to make the mistake of ignoring the
external effect, but we also do not want to make the mistake of overstating its impact.
Rather, to maximize Total Social Surplus, we want to include tbe external effect in the
computation of Social Surplus just as we would include any other benefit or cost.
This point may lead to some conclusions that, when first observe, d, seem
somewhat unsettling. For example, consider a good for which production or
consumption generates significant pollution. The analysis of Fignrc 10.3 suggested that
the level of trade which maximizes Total Social Surplus is 680 units. Observe that at this
socially best level of trade, external costs equal to "area (b)" are borne by members of
society. In some sense, "area (b)" represents the socially best level of extcmal costs
stemming from pollution, revealing that (given presently available technologies,
I
=a. rr, /
Chapter 10 - Market Failure
=j ,.", J
production techniques, and preferences of the members of society) the socially best level
of pollution is not "zero pollution." This reveals that when striving for a cleaner
environment, we do not want to fall victim to the open-ended fallacy (discussed in
=# ..", Chapter 5). Instead, when maximizing Social Surplus, we want to properly balance the
benefits of a cleaner environment against the costs of a cleaner environment.
Do we presently have "too much pollution" or "too little pollution" in the United
States? Based upon the recognition that free market provision of goods which generate
negative externalities results in an inefficiency from too much trade, it may seem as if the
obvious answer is "too much pollution." But this conclusion is not necessarily correct.
mlm ~,~-I Government presently plays a significant role in directly and indirectly regulating the
uIMNm,S-~ behavior of firms in matters related to pollution and environmental quality. That is, we
~ mira, ~m
do not have free, unfettered markets for goods where such concerns are an issue. The
insight above is that in the presence of a negative externality a free, unfettered market
results in too much trade. Since we do not have such markets In the United States, we
cannot immediately apply this result to say if we presently have "too much pollution" or
"too little pollution."
Further, recognize that when performing the delicate act of balancing the benefits
of a cleaner environment against the costs of a cleaner environment (costs from decreased
production and consumption or, equivalently, lower levels of income), different societies
may want to choose different levels of environmental quality. For example, two
countries with significantly different levels of per capita income may want to make
different choices regarding the tradeoff between pollution and per person income.
Consider the case of China, a country which has realized remarkable economic growth on
world (such as the United States and Western Europe) have raised concerns regarding
China's environmental record during this period. But even after decades of growth,
was $16,600 in China and $59,500 in the U.S.n These observations likely reveal that a
country that is still relatively poor (e.g., China) is willing to accept greater poUurion in
exchange for further economic growth, while a country that is already rich (e.g., the
United States) prefers a lower level of pollution even at the expense of slower growth.
Returning attention to the general diseussiun of externalities, in the presence of
such market failure there is again a potential role for government to play in improving the
outcome)2 Since market provision of a good which generates a positive externality (such
as a vaccination) re.suits in too little trade, Total Social Surplus could be increased by
having more trade take place. This could be accomplished most naturally by having the
government subsidize consumers or producers of the good (e.g., reimburse a consumer
for a portion of the purchase price). The ideal magnitude of the subsidy would depend
upon specific conditions in the market. For the market illustrated in Figure I0.4, the
n These figures are measured in U.S. dollars on a purchasing power parity basis and were obtained from:
httD.'//~nvw.indexraundi.co~/.
~2 The discussion of potential solutions prasanted h~ is intentionally brief. For a morn in depth textbook
tr~tmant, ~-e: Hymen, D,, Public Finance: a Contemporary Application of Theory to Policy, 10~ edition,
Mason, OH: South-Western Cangege L©aming, 201 I. Chapter 3 ("Externalities and Government Policy").
 Chapter 10- Market Failure
subsidy would need to be set at a level which induces consumers and firms to increase the
level of wade from 345 units up to the efficient quantity of 450 units,u
In the presence of a negative externality (such as pollution), the free market would
provide too much of the good. Thus, government can potentially increase Total Social
Surplus by putting policies in place which reduce quantity traded. In the context of
industrial pollution, this may entail policies directly aimed at altering the emitted level of
measurable pollutants (e.g., carbon dioxide). For example, a government could impose
minimum compliance standards, directly limiting the amount of a pollutant that a
producer is allowed to emit.
While such minimum compliance standards may he a good first step, they
unfortunately do not provide any incentives for pollution to be produced across firms in
an ideal way. Perhaps it is relatively easy for "Firm A" to reduce emissions by installing
a new scrubber on the smokestack of its factory, but "Firm B" produces a different good
for which pollution cannot be avoided at low cost. Ideally, society may want "Firm A" to
reduce its pollution by a large amount while still allowing "Firm B" to pollute at a high
level. Simply mandating a cap on the level of pollulion of each firm does not allow for
this outcome. In contrast, a system of emissions trading (i.e., "cap and trade") allows for
this better outcome. After determining the ideal overall level of pollution, the
government can issue a corresponding number of polhition permits. Once these permits
are initially allocated, firms are allowed to trade with each other for the right to pollute.
A firm that is able to avoid pollution at relatively low cost (such as "Firm A") would be
willing to sell some of its permits to a firm that can only avoid pollution at relatively high
cost (such as "Firm B"). Thus, a system of tradable permits is more likely to realize the
ideal outcome than is a system of minimum compliance standards.
Another approach is for the government to encourage pollution abatement by
subsidizing fwms for reducing pollution levels below some set baseline level. That is, we
could essentially pay fu'ms to not pollute. Such policies can clearly result in a reduction
in the overall level of pollution and also (like a system of Wadable permits) have the
advantage of encouraging fLrms that can easily reduce their pollution at low cost to do so.
Finally, instead of paying fmms to not pollute, the government could charge firms
for polluting. This could be done by imposing a per unit tax on emissions. Again, such a
policy has the advantage of encouraging those firms that can easily reduce emissions at
low cost to do so (thereby avoiding the tax). This approach is in many respects very
similar to the subsidy which was suggested to correct for the market failure resulting
from a positive externality. In the context of Figure 10.3, an appropriately set per unit tax
on this good would reduce consumption from the market level of 910 units down to the
efficient level of 680 units.14
3 It
can be shown tha theefficen quanntyoflradegallresultifthegovemmentpeysaperonitsubsidy
equal to the marg~l external benefit at the efficient quantity of tnlde. The derivation of this result in
beyond the scope of the present discussion.
( It can be shown that the ¢ffic eat quantity of trade results if the government imposes a per unit tax equal
to the marginal external cost at the efficient quantity of trade. This approach, first suggested by the
economist Arthur Pigou, is referred to as a Pigovien Tax. The derivation of this result is beyond the scope
of the pr,'--.,eat discussion, but a general discussion of Per Unit Taxes is provided in Chapter I 1.
Chapter 10 - Market Failure
A system of tradable pollution permits, subsidies for abatement, and per unit taxes
on producers each attempt to correct the externality by internalizing the externality. That
is, each policy attempts to introduce a cost (or foregone gain) that would be realized by a
firm that continues to pollute. Once costs or benefits are altered by the policy, the self-
interested firm responds by altering its behavior, resulting in less pollution (recognize,
this is the Incentive Principle at work). While these approaches each incorporate market
incentives when determining which producers will emit pollution, for each suggested
remedy there is still the issue of determining the socially best amount of polhition.
In practice, the government may have a hard lime accurately determining all the
relevant costs and benefits, especially when the individuals who would bear the external
costs recognize that the regulator's perceived magnitude of these costs will likely impact
the enacted policy. For example, in the context of Figure 10.3, the government would
need enough information to determine that the efficient quantity of output is 680 units.
But suppose that the people who bear the external costs (e.g., homeowners who reside
near the factory) overstate their burden, effectively convincing the regulator that the true
efficient level is well below 680 units. If the government enacts a system of Wadable
pollution permits, but the number of permits issued is drastically too low (i.e., for the
number of issued permits the resulting quantity of output is well below 680 units), then
there will be a positive Deadweight Loss due to underproduction. Further, this
Deadweight Loss could very well be of larger magnitude than the one illustrated by "area
(d)" in Figure 10.3 (which results from doing nothing).t5
Ronald Coase posited a solution to the problem of externalities which relics upon
market forces to determine both who generates the externality and also the total amount
of the externality generated)6 As with the other market based approaches discussed
above, this novel solution is based upon the potential corrective power of internalizing
the externality. Coase argued that problems of externalities are at their core problems of
undefined property rights. The Coasian Solution to the problem of exteroalities is to: (i)
clearly and fully define property rights, (ii) make individuals pay compensation if they
infringe upon the property rights of others, and (iii) allow parties to negotiate with one
another regarding infringements upon property rights caused by externalities. Coase
argued that regardless of who is assigned the initial property right, negotiation between
the affected parties will result in the efficient amount of the negative externality (i.e., the
efficient level of Wade), so long as property rights can be defined/enforced and
negotiation between the parties can take place at relatively low cost.
As an example, consider a small general aviation airport (such as McCollum Field
in Cobb County, Georgia), which is located in a primarily commercial area. Suppose a
homebuilder decides to construct a new subdivision near the airport, and noise pollution
from the ai~ort spills over into the homeowners' yards. Who is causing the negative
externality? It may seem like the obvious answer to this question is the airport - after all,
they are genemting the noise. If we wanted to entirely eliminate the external cost, we
,s This again illustrates how government fnilur¢ can arise as a result of information problems. This and
other sources of government failure arc discussed in greater detail in Chapter I 1.
16C o n S ¢ g H ", l ' h e P r o b l e m o f S o e i n i C o s t , J o u r n a l o f L a w a n d E c o n o m i c s , Vo l . 3 , N o , 1 ( O c t o b e r
1960), pages 1-44. Ronnid Coase received the 1991 Nobel Prize in Economics, partly because of this work.
 Chapter 10- Market Failure
could do so by shutting down the airport. While this is true, there is an alternative way to
eliminate the external cost - we could relocate all of the homeowners to a location where
they are not impacted by the noise. So, who is causing the negative externality7 On
some level it is the hport owners, by emitting the noise. But, on another level it is the
homeowners, by living near the airport.
Seeing the issue from these two different perspectives provides the foundation for
Coasu's a~Tumant. He suggested that to address the problem of the externality, society
must first define property rights. That is, society must decide if the airport owners have
the right to emit pollution or if the homeowners have the right to a pristine environment.
After defining property rights, allow the parties to negotiate with one another.
Consider situation in which the ahport can either completely shut down,
produce low level of flights (which would emit low level of pollution), or produce a
high level of flights (which would emit high level of pulintiun). Suppose the profit of
the ahport, external costs borne by homeowners, and resulting Social Surplus (equal to
profit minus external costs) from each choice are equal to the values in Table 10.1.
Start by recognizing the outcomes that would arise if the parties cannot negotiate
with each other. If the airport has the right to pollute (without having to compensate for
external costs), they would choose high level of flights. This choice results in profit of
$60,000, external costs of $55,000, and Social Surplus of $5,000. If instead the
homeowners have the right to prevent the atq~rt from polluting, they would insist upon
zero flights. This allows them to completely avoid bearing any external cost, but also
leads to zero profit for the airport and zero Social Surplus.
Table 10.1 - Profit of Firm and External Costs of Homeowners
Zero Flights LowNumberofFlights High Number ofFlights
Firm Profit 0 30~000 60~000
External Costs 0 20T000 55~000
Social Surplus 0 10,000 5,000
Does anyone think that zero flights is likely to be the best level for society?
Clearly, in this case zero flights leads to a less than optimal situation. Given the values
in Table 10.1, the efficient outcome (i.e., the outcome which maximizes Social Surplus)
is to allow the airport to produce a low number of flights and therefore emit a low level of
pollution. If the parties cannot negotiate with one another, this efficient outcome is not
realized by either specification of property rights.
Complicating the problem is the fact that in practice the government is not
"given" the values in Table I0.I. Homeowners clearly have an interest in overstating and
the airport clearly has an interest in understating the values of external costs for each
level of flights. Recognize that if the values of external costs had been $35,000 and
$70,000 (i.e., $15,000 larger for each positive level of output), then the socially best
outcome would be zero flights. Similarly, if the values had been $20,000 and $45,000
(i.e., an unchanged value for low production, but $I0,000 lower for high production),
then the socially best outcome would be a high number of flights. The Cuasian Solution
Chapter 10- Market Failure
often circumvents such difficulties in determining the socially best outcome by providing
parties with incentives to behave based upon their true valuations. Further, regardless of
who is given the initial property right, negotiation between the panics will result in Social
Surplus being maximized (in this example, as will be seen below, by society realizing the
efficient outcome of low production).
Now suppose the parties can negotiate with one another. If the homeowners are
given the right to a pristine environment, the airport is only allowed to pollute if they
adequately compensate the homeowners for doing so (i.e., the homeowners have choice
of accepting the noise pollution along with the compensation or insisting upon zero noise
pollution). As argued above, the default position when the homeowners have the
property right is zero production. From the values in Table 10.1, to go from zero
production to low production, the airport is willing to pay up to $30,000 while the
homeowners need to be given at least $20,000. We can essentially think of these values
as a buyer's reservation price and a seller's reservation price for an airport that is buying
the right to emit a low level of pollution from the homeowners. Since $30,000 is greater
than $20,000, both the airport and the homeowners are better offifthis transaction occurs
at any price between these two values. Once this transaction is made, the airport would
be willing to pay an additional $30,000 to increase production from low production to
high production, but the homeowners would need to be paid an additional $35,000 to
accept this further increase. Since $30,000 is less than $35,000 (i.e., buyer's reservation
price is less than seller's reservation price), there is no price at which mutually
beneficial transaction can occur. Thus, when the homeowners have the iuitial property
right, negotiation between the parties results in the firm paying the homeowners some
amount between $20,000 and $30,000 to be able to emit a low level of pollution.17
If instead the airport is given the right to pollute, then the default position is
high level of production. Now the homeowners must compensate the airport if they
desire a lower level of output and pollution. Starting at high production, the homeowners
would be willing to pay up to $35,000 while the airport would need to be paid at least
$30,000 to decrease production to low production. We can again think of these values as
a buyer's reservation price and a seller's reservation price for homeowners who are
purchasing quieter environment from the airport. Since the buyer's reservation price of
the homeowners ($35,000) is greater than the seller's reservation price of the airport
($30,000), both parties are better off if this transaction occurs at any price between these
two values. Once this transaction takes place, the homeowners would be willing to pay
an additional $20,000 to reduce pollution from the low level down to zero, but the firm
would need to be paid at least $30,000 more to agree to this further reduction. Since
$20,000 is less than $30,000 (i.e., buyer's reservation price is less than seller's), there is
no price at which a mutually beneficial transaction can occur. Consequently, when the
airport is given the initial property right, negotiation between the parties leads to the
homeowners paying the airport some amount between $30,000 and $35,000 to reduce
production and pollution from the high level to the low level. Recognize that irrespective
,7 The exact price depends on the parties" bargaining powe~ But, regardlass of bargainlng powers, the
self-interest of the two parties has them agree to allow the airport to provide a low number of flights.
 Chapter 10- Market Failure
could do so by shutting down the airport. While this is tn~e, there is an alternative way to
eliminate the external cost - we could relocate all of the homeowners to a location where
they are not impacted by the noise. So, who is causing the negative extcmality? On
some level it is the airport owners, by emitting the noise. But, on another level it is the
homeowners, by living near the airport.
Seeing the issue from these two different perspectives provides the foundation for
Cease's argument. He suggested that to address the problem of the externality, society
must first define property rights. That is, society must decide if the airport owners have
the right to emit pollution or if the homeowners have the right to a pristine environment.
After defining property rights, allow the parties to negotiate with one another.
Consider a situation in which the airport can either completely shut down,
produce a low level of flights (which would emit a low level of pollution), or produce a
high level of flights (which would emit a high level of pollutien). Suppose the profit of
the airport, external costs borne by homeowners, and resulting Social Surplus (equal to
profit minus external costs) from each choice are equal to the values in Table 10.1.
Start by recognizing the outcomes that would arise if the parties cannot negotiate
with each other. If the airport has the right to pollute (without having to compensate for
external costs), they would choose a high level of flights. This choice results in profit of
$60,000, e.xtemal costs of $55,000, and Social Surplus of $5,000. If instead the
homeowners have the right to prevent the airport from polluting, they would insist upon
zero flights. This allows them to completely avoid bearing any external cost, but also
leads to zero profit for the airport and zero Social Smplus.
Table 10.1 - Profit of Firm and External Costs of Hameowa~rs
Zero Flights Low Number of Flights
High Number of Flights
Finn Profit - 0 high level of production. Now the homeowners must compensate the airport if they
30~000 60,000
~ - 0 desire a lower level of output and pollution. Starting at high production, the homeowners
20,000 55,000
o would be willing to pay up to $35,000 while the airport would need to be paid at least
lO,OOO 5.ooo
Does anyone think that zero flights is likely to be the best level for socicty?
Clearly, in this case zero flights leads to a less than optimal situation. Given the values
in Table 10.1, the efficient outcome (i.e., the outcome which maximizes Social Surplus)
is to allow the airport to produce a low number of flights and therefore emit a low level of
pollution. If the parties cannot negotiate with one another, this efficient outcome is not
realized by either specification of property rights.
Complicating the problem is the fact that in practice the government is not
"given" the values in Table 10.1. Homeowners clearly have an interest in overstating and
the alert clearly has an interest in understating the values of exteraal costs for each
level of flights. Recognize that if the values of external costs had been $35,000 and
$70,000 (i.e., $15,000 larger for each positive level of output), then the socially best
outcome would be zero flights. Similarly, if the values had been $20,000 and $45,000
(i.e., an unchanged value for low production, but $10,000 lower for high production),
than the socially bast outcome would be a high number of flights. The Coasian Solution
Chapter 10 - Market Failure
often circumvents such difficulties in determining the socially best outcome by providing
parties with incentives to behave based upon their true valuations. Further, regardless of
who is given the initial property right, negotiation between the parties will result in Social
Surplus being maximized (in this example, as will be seen below, by society realizing the
efficient outcome of low production).
Now suppose the parties can negotiate with one another. If the homeowners are
given the right to a pristine environment, the airport is only allowed to pollute if they
adequately compensate the homeowners for doing so (i.e., the homeowners have a choice
of accepting the noise pollution along with the compensation or insisting upon zero noise
pollution). As argued above, the default position when the bomenwners have the
property right is zero production. From the values in Table 10.1, to go from zero
production to low production, the airport is willing to pay up to $30,000 while the
homeowners need to be given at least $20,000. We can essentially think of these values
as a buyer's reservation price and a seller's reservation price for an airport that is buying
the right to emit a low level of pollution from the homeowners. Since $30,000 is greater
than $20,000, both the airport and the homeowners are better off if this transaction occurs
at any price between these two values. Once this transaction is made, the airport would
be willing to pay an additional $30,000 to increase production from low production to
high production, but the homeowners would need to be paid an additional $35,000 to
accept this further increase. Since $30,000 is less than $35,000 (i.e., buyer's reservation
price is less than seller's reservation price), there is no price at which a mutually
beneficial transaction can occur. Thus, when the homeowners have the initial property
right, negotiation between the parties results in the firm paying the homeowners some
amount between $20,000 and $30,000 to be able to emit a low level ofpullution,n7
If instead the airport is given the right to pollute, then the default position is a
$30,000 to decrease production to low production. We can again think of these values as
a buyer's reservation price and a seller's reservation price for homeowners who axe
purchasing a quieter environment from the airport. Since the buyer's reservation price of
the homeowners ($35,000) is greater than the seller's reservation price of the airport
($30,000), both parties arc better off if this transaction occurs at any price between these
two values. Once this transaction takes place, the homeowners would be willing to pay
an additional $20,000 to reduce pollution from the low level down to zero, but the firm
would need to be paid at least $30,000 more to agree to this further reduction. Since
$20,000 is leas than $30,000 (i.e., buyer's reservation price is less than seller's), there is
no price at which a mutually beneficial transaction can occur. Consequently, when the
airport is given the initial property right, negotiation between the parties leads to the
homeowners paying the airport some amount between $30,000 and $35,000 to reduce
production and pollution from the high level to the low level. Recognize that irrespective
l? 'l'ha~ exact price depends on the parties' bargaining powers. But, rega.,,cllcss of bargaining po'.v¢~, the
set f-imm'~t of the two parties has th©m agrt~ to allow th¢ airport to provide a low number of flights.

Chapter 10 - Market Failure
of who is assigned the initial property right, the Couian solution of negotiation between
the impacled parties results in the efficient outcome of low production and pollution.iS
D E C I S I O N S B Y U N I N F O R M E D M A R K E T PA R T I C I PA N T S
Market failure can also result from market participants being uninformed. To
make good decisions in the marketplace, buyers and sellers must have accurate measures
of ~'ue reservation prices. For instance, if a buyer does not know the true value of his
reservation price, then he may inadvertently purchase a good at a price above his actual
value for the item or he may inadvertently fail to purchase a good at a price below his
actual value for the item. In either case, the buyer is not maximizing his surplus.
Further, if this sort of lack of information is present on either side of the mad<at, then
there is no guarantee that a free market will induce buyers and sellers to trade all units
and only those units for which buyer's a'ae reservation price is greater than seller's true
reservation price (which is what efficiency requires).
Since a seller's reservation price is determined in large part by production costs,
we probably do not need to be too concerned with sellers being uniformed. In contrast,
lack of information resulting in a buyer being uncertain about his ~-ue reservation price
can arise more often. In a broad sense, a buyer's reservation price likely depends greatly
upon product characteristics. More specifically, for many goods the products sold by two
different sellers may differ in regards to their level of quality. From here, an argument is
often made for government to regulate product characteristics or product quality, to make
it more likely that consumers have accurate perceptions of the items they are buying.
Focusing first on product characteristics, recall (from Chapter 1) the discussion of
the National Highway and Traffic Safety Administration's mandates on automobile
safety features beginning in the 1960's. An efficiency argument could be made that the
federal government needs to require all new cars to have seat belts, dual braking systems,
and padded dashboards, because consumer preferences end firm production costs are
such that Total Social Surplus is maximized by producing cars with these features.
However, an obvious counterargument is that if consumers truly value these
product characteristics in excess of their additional costs of production, then a self-
interested producer has a clear incentive to produce products which incorporate them.
For a present day example, consider side air bags, which clearly make cars safer. Even
though automakers do not face a mandate requiring side air bags to be installed in all
cars, many manufacturers include them as a standard feature or offer them as an option.
For instance, in 2006 Toyota offered side air bags as an option on the Prius at a cost of
s It should be recognized thai while Socml Surplus is maximized trrespecuve of who Js given the mlUal
pmpany right, the initial assignment of proporty fights has a direct impact on the realized surplus of each
member of seciety. The aiq0on ts much better off if it is given the initial property right and homeowners
must PaY them to reduee pollution to the low leveL Likewise, homcownem are barter off if they are given
the initial property right and the airport must pay them to increase pollution up to the low level.
Chapter 10- Market Failure
$650. In that year about 96% of Prius buyers chose to purchase a car with this feature,t9
Similarly, in his insightful study, Sam Pelt~nan noted that market forces induced
automakers to include seatbelts in many cars even before there was any hint of the
coming federal government safety regulations.2°
Government regulation of products is more easily justified when it focuses on
product quality.21 For example, the sanitary conditions where a restaurant salad is
prepared can clearly play a large role in determining your reservation price ss a buyer.
Your value for the salad is greatest only if all the ingredients were properly stored and all
the utensils were properly cleaned before the salad was prepared. In contrast, if the
person making your salad chops up the lettuce with a knife that was just used to cut raw
chicken (and not washed), your value for the salad is much lower. When product quality
is difficult to observe, government can potentially play a beneficial role by evaluating
product quality and making their assessment available to consumers. In fact, in the
United States the federal government, state governments, and local governments each
play a role in regulating food producers, grocery stores, and restaurants, to ensure that
standards which are hard to observe are more in line with what fully informed consumers
would desire. But again, a counter argument can be made that market forces will provide
a check on firm behavior in such instances, even absent any regulation. Al~er all, no
restaurant wants to tarnish its brand by developing a reputation as the place that gives
everyone food poisoning.
Having the government play a role in regulating product quality is more easily
justified if consumers would have to incur substantial costs to become informed enough
to even make an assessment of product quality. For instance, suppose you are in need of
a life-saving medical procedure. How can you be certain that you are making a good
choice in terms of the quality of your doctor? It is quite possible that many people in
society lack the expertise to determine whether a particular medical professional is
competent or not. A minimum level of competence can potentially be achieved by
having the government decide who is allowed to provide such services. In the United
States, medical licenses are granted by individual states. One of the numerous
requirements for being licensed is that the doctor must have a degree from a legitimate
medical school. An argument could again be made that market forces can help son
things out, even absent any government regulation (after all, no hospital wants to develop
a reputation as the one who has numerous patients die on the operating table). However,
when the stakes are so high, a pragmatic appeal to caution might suggest that the benefits
of government intervention outweigh any costs.
Governments commonly license providers of many other services - such as
attorneys, barbers, realtors, and general contractors - where a minimum level of
"~ See: "Crosh test show benefits of skin air bags; Kin Sedona called safest mlnivan," USA Today., April 2 I,
2006: htlo:/Avnt~t:l~sotodm,.com/monel,/croros/2OO6-O4-17.~fosh.te~L~ x.htm.
See page 678 of Paltzlmm, S. "The effe¢~ of Automobile Safety Regulation," Journal of Political
Economy, (August, 1975), Vol. 83, No. 4, pagan 67"/-'/26.
=l The market failure related to unobservable quality stems from the self-interest of the producer.
Production costs are ot~en less for a product of lower quality. The, when ob~a'vin8 quality is difficult for
consuroets, a self-interested producer has an incentive to reduce costs by makin8 a lower quality product_
 Chapter 10 - Market Failure Chapter 10 - Market Failure

competence is desired. However, it is important to recognize that such occupational

C H A P T E R # 1 0 M U LT I P L E C H O I C E Q U E S T I O N S
licensing creates an artificial barrier to entry into the industry. As a result, the individuals
who are granted the right to provide the service ultimately possess more market power
than they would otherwise have.'2 Thus, even if the licensing helps to reduce a market 1. "Market Failure" can be described as a situation in which
failure caused by lack of information, it may create a market failure due to profit A. a single seller of a good has substantial control over the price of the good.
maximization by a seller with market power.~ B. the "free market outcome" is NOT efficient.
Finally, it is worth noting that many types of information are Club Goods (i.e., C. government intervention leads to a greater Deadweight-Loss than does the
non-rival and excludable) as defined previously in this chapter. As an example, consider "free market outcome."
the automobile ratings compiled by Consumer Reports.24 This information is non-rival in D. government imposes progressive taxes, in order to redistribute income.
consumption - if one more person goes to the Consumer Reports website and reads about
their findings for the Hyundal Elantra, the value of this information for others is in no 2. Jay lives in a country in which military output is not provided by the government,
way diminished. This information is also excludable - in order to have full online access but rather is supplied by profit maximizing firms and purchased by individual
to the entire findings of Consumer Reports, you must be a paying member. consumers in a free market. Jay chooses to enjoy the benefits of national security
Regarding the feasibility of market provision, there are key implications of a good which result from military output purchased by others in society, while purchasing
being a Club Good. Since such goods are non-rival in consumption, once the information "zero units of military output" of his own. This example illustrates
is generated Social Surplus is maximized by letting anyone who has a positive value for A. Joseph Sehumpeter's account of a "gale of creative destruction."
the information have access to it. However, since this level of access is only achieved by B. the Free Rider Problem.
essentially giving away the information for free, a privately owned firm with the C. the Coasian Solution to the problem of externalities.
objective of maximizing profit would most certainly not choose to allow such universal D. Adam Smith's Invisible Hand.
access. Thus, similar to the standard case of monopoly pricing, this insight provides a
potential justification for government provision or regulation, to help ensure that the 3. Which of the following is a common source of"Market Failure"?.
provider does not resUict output below the socially efficient level. A. Pricing by firms with market power.
Additionally, since there are often large upfront costs of generating accurate B. Market provision of private goods.
information, there is a cost saving argument for wanting only one provider of the C. Market provision of a good which generates an externality.
information. So long as the information is being generated objectively, with the aim of D. More than one (perhaps all) of the above answers are correct.
providing truthful, accurate, and reliable assessments, then having the information
generated a second, third, or fourth time does not create much new value (but is quite 4. A good is "excludable" if
costly). For example, it would be wasteful to have four different teams of health A. consumption by one person does not diminish the quantity/quality of
inspectors evaluate a restaurant on the same day. Total costs for society are clearly consumption by others.
minimized (and Total Social Surplus is likely maximized) by having one and only one B. consumption by one person does diminish the quantity/quality of consumption
producer of the information. However, if there is a single private producer of the by others.
information, we would again have to be concerned with market failure due to monopoly C. it is difficult (or very costly) to prevent consumption by those who do not pay
pricing. A potential solution is to have the government be the one sole provider of the for the good.
information, so that the costs of generating the information are incurred only once and so D. it is easy (or relatively cosfless) to prevent consumption by those who do not
that open access to the information is available to all interested consumers. pay for the good.

5. Which of the following is NOT part of the Coasian Solution to the problem of
externalities?
In Chapter 9 ofhts book 'Capuahsm
, . . and Freedom, , , Milton
. Friedman
. points
. out that occupational
A. Clearly and fully define property rights.
licensing boards operate primarily for the interests of their members, not for the interest of the general
public. See: Friedman, M., "Capitalism and Freedom," (1962) University of Chicago Press. B. Make individuals pay compensation if they infringe upon the property fights
" ~ Addinonllly,
'" m the face of such licensing, potential su-^liem have :-e--~: .... of others.
activities to es'tablisli and n,.amt,,m
. .thetr market wet" vv . gag
. ~-~---~
po (a general d)seusston . m ~n
of"rent e m "re ;nt......
senkin-" ' ,,
seeking C . Prevent parties from negotiating with one another regarding infringements of
Chapter I D lfth----,~ .... .~-~. property rights caused by externalities.
govwaraem:s
2( See:huo+~.~bes t~u~-~n gto 2.nt m[ormat~onal
u trus .~1o ng".ineflicienmarket
tins outweigh
failurethe
isbenefits of licensin~
to do no)h;-- ,,~mcn
t: ....°. _~vtu~
me m None of the above answers is correct (since each choice is part of the Coasian
"" ~.m~'~cOnsume rf$ r ~co /. u-as xL~., no[ license providers).
Solution to the problem of externalities),
 Chapter 10 - Market Failure Chapter 10 - Market Failure

6. Which of the following is a good example of a "Pure Public Good"?

10. A "4th of July Fireworks displayin d°wnt°wn Atlanta'' is
A. A grilled chicken taeo from Del Taco.
A. easily "Excludable."
B. National Defense.
B. perfectly "Rival in Consumption."
C. A bus ride on MARTA.
C. very "Non-Rival in Consumption."
D. More than one (perhaps all) of the above answers are correct.
D. More than one (perhaps all) of the above answers is correct.
For Questions 7 through 9, consider a good with Marginal Private Benefits, Marginal
Private Costs, Marginal Social Benefits, and Marginal Social Costs as illustrated For Questions 11 through 13, consider a good with Marginal Private Benefits,
below. Marginal Private Costs, Marginal Social Benefits, and Marginal Social Costs as
$ illustrated below.
$ M~ginal Social Costs

~
21.85 - -

~(Marginal Social Costs) arginal Private Costs

7.50
15.80 J = (Marginal Private Costs)
13.30-
11.00 -
~
~ M a r g i n a l S o c i a l B e n e fi t s
595I
4.65 '
~ ~
~ ( M a r g i n a l S o c i a l B e n e fi t s )
d = (Marginal Private Benefits)
~
0 ~ ~ M a r g i n al Private Benefits
quantity quantity
410 590 680
3 5 0 - -9 0 0' "1 , 3 6 5 1 , 6 8 0
7. 0
Based upon this graph, it appears as if
A. the government is imposing a substantial per unit tax on this good. 11. The value of Marginal External Cost at the efficient quantity of wade is
B. this good is clearly produced by a monopolist. A. $2A5
C. production/consumption of this good generates a negative externality. B. $2.85
D. prodnctian/eonsumption of this good generates a positive externality. C. $5.95
D. $7.50
8. If this good were Waded in a free market (without any government intervention),
12. If this good were traded in a free market (without any government intervention),
~__, although the Social Welfare Maximizing level of trade is
A. 680 units would be traded; 590 units. ____, although the Social Welfare Maximizing level of trade is
B. 590 units would be waded; 410 units. A. 900 units would be traded; 1,365 units. - - :
C. 410 units would be traded; 590 units. B. 900 units would be traded; 1,680 units.
D. 0 units would be traded; 680 units. C. 1,365 units would be traded; 900 units.
D . 1,365 units would be traded; 1,680 units.
9. At the free market outcome (without any government intervention) there would be a
Deadweight-Loss equal to 13. At the free market outcome (without any government intervention) there would be n
A. "area e." Deadweight-Loss equal to
n. "area e." A. "areas a+b."
C. "areas a+b." B. "areas e+d."
D. "areas a+b+c+d." C. "areas a+b+e+d."
D, "area e?'
 Chapter 10- Market Failure
Chapter 10 - Market Failure

For Questions 19 through 22, consider a monopolist facing Demand and with
14. On March 31, 2018 heavyweight boxing champion Anthony Joshua defeated Marginal Costs and Marginal Revenue as illustrated below.
challenger Joseph Parker by unanimous dec sion in Cardiff, Wales. This fight was
televised in the U.S. on the premium cable network Showtime. The broadcast of
38.75 - Marginal Costs
this bout on Sbowtime was excludable but non-rival, and was therefore a K
A. Club Good. of Production
B. Common Good.
C. Public Good.
D. Private Good.

15. A firm operating in a "Perfectly Competitive Market" has "No Market Power,"
\ \ /
which implies that the firm
A. would lose all its customers if it attempted to increase price above the 12.00
prevailing market price.
7.90 -
B. faces a "vertical demand curve" for its output.
C. does not have to decrease price in order to increase the quantity of output sold.
D. More than one (perhaps all) of the above answers is correct. 0 ~ ~ ~ q u a n t i t y
325 465~680 1,050 1,250
16. A government policy that attempts to "Internalize an Externality" can be generally 0
described as ~Marginal
A. a policy which completely bans an activity that generates an externality. Revenue
B. a policy which introduces a cost (or foregone gain) that would be realized by a
The efficient level of output for this good is __ units.
decision maker who generates an externality.
C. a policy which mandates the exact level of an activity that decision makers A. 325
B. 465
must engage in.
C . 680
D. None of the above answers are correct.
D . 1,250
17. Widgets are non-rival in consumption and non-excludable. As a result, if widgets
To maximize profit, this monopolist would
were simply sold in the marketplace, we should expect
A. sell 325 units of output, each at a price of $7.90.
A. less than the efficient amount ofwidgets to he traded.
B. sell 325 units of output, each at a price of $23.15.
B. exactly the efficient amount of widgets to be traded.
C. sell 680 units of output, each at a price of $12.00.
C. more than the efficient amount ofwidgets to be traded.
D. sell 1,050 units of output, each at a price of $23.15.
D . None of the above answers are necessarily correct (since we need to know
something about costs of production in order to be able to determine whether
When this monopolist maximizes profit, Deadweight Loss is equal to
the resulting level of trade will be more than, less than, or exactly equal to the
A. "areas a+b."
efficient level of trade).
B. "areas e+f."
18. Monopoly refers to a market structure in which there C. "area g."
D. zero.
A. is a single seller of a unique good for which there are no close substitutes.
B. are exactly two fn'ms selling goods which consumers view as very similar but
somewhat different from each other. When this monopolist maximizes profit, Total Consumers" Surplus is equal to
A. zero.
C. are many firms selling goods which consumers view as very similar but
B. "areas a+b."
somewhat different from each other.
C. "areas a+b+c+d+e."
D. are many firms selling goods which consumers view as identical to each other.
D, "areas e+d+e."
Chapter 10- Market Failure

m Government Failure
In the discussion of market failure in Chapter 10, it was noted that instances of
market failure perhaps provide the easiest case for arguing in favor of government
intervention in the economy. After all, if the free market outcome is characterized by a
positive Deadweight Loss (which is the definition of market failure), government
intervention has the potential to increase Total Social Surplus. But, even in the presence
of market failure, it would be naive to conclude that government intervention would
always result in an increase in Total Social Surplus. This recognition is due to the
possibility of Government Failure, which refers to situations in which Total Social
Suq31us is decreased by government intervention in a market. When government failure
arises, government intervention results in an outcome that is worse for society. Within
the present discussion we identify numerous potential sources of government failure and
explain how each can emerge.
In the historical context of the 20th century many societies came to the stark
realization that not only can markets fail, but governments can fail as well. In several of
these countries reforms were implemented during the last two decades of the 20th century
with a focus on "the inherent difficulties that arise when a state becomes too expansive
and too ambitious and seeks to be the main player, rather than a referee, in the
economy.''t Again, even in the presence of market failure, government intervention will
not necessarily improve matters for society. Because of government failure, the outcome
with government intervention can possibly be less desirable than simply living with the
original market failure that the government is attempting to correct.

PUBLIC CHOICE AND A MODEL OF VOTING

Many issues related to government failure are best examined through the lens of
Pubfie Choice, the academic subfield which uses the tools and framework of economies
to analyze issues that historically fall within the domain of political science. As an
example, an analysis of individual decisions in elections which assumes that voters are
rational and self-interested lies in this domain.
To properly analyze and fully understand how the democratic political process
can potentially enable some types of government failure, it helps to understand how the
behavior of voters and government officials can be analyzed using the tools of
economics. We begin the discussion by presenting a simple economic model of voter

Yergm, D and J. Stamslaw, The Conwnanding Heights: the Battle for the World Economy." Simon and
Schuster, 2002, Page xiii.
 Chapter #11 - Government Failure Chapter #11 - Government Failure

behavior which will highlight some problems inherent in a democratic, majority-role However, recognize that Donald is also the person that is least preferred among the three
decision making process (which stem from the fact that collective, group preferences are
by the largest number of people: 42% (types tit and till) have Donald ranked third, while
not always easy to define). It will further he argued that some sources of government only 34% (types [iii] and toil) have Hillary ranked third and only 24% (types [iv] and tel)
failure may actually emerge with greater regularity in a democracy than in other political have Ted ranked third.
systems (i.e., some sources of government failure are less likely to emerge in political
systems in which citizens have less of a voice in formulating public policy). That is, the
Table IL2- Voter behavior and outcomes in various elections
democratic process can actually exacerbate some types of government failure. But
recognize that while we are identifying some shortcoming of the democratic process we Ballot Types voting Types Types
I I
are not claiming that it is inferior to other political systems. This assessment of the Options forD [ voting forH [ voting forT [ %D [ %H ] %T [ Winner
democratic political process is perhaps best summarized as follows: "Democracy is the D,H~T ~ 38% 360/0 26% Donald
worst form of gnveroment' except for all the others."2 D,H ~ _ _ i v 440/o 56% Hill
To see how the tools of economics can be applied to an analysis of voting, D,T ~ ' i i 5 2 % 4 8 % Donald
consider a situation in which three people - Donald, Hillary, and Ted (denoted D, H, and H T ~ , " i i i , v i 46% 540 Ted
T) - are seeking a public office. Different voters have different preferences over these
three candidates. More precisely, there are six possible ways in which a voter could
order these three candidates, as summarized in Table 11.1 below. Each of these six It seems at least somewhat problematic that this approach of simply choosing the
different voter types has arbitrarily been given a name of "type tit" through "type [vi]." individual who garners the most votes out of the three could select the person who is least
For example, a voter of type tit: ideally wants Ted to fill the position; has Hillary as his preferred by the largest number of people. To potentially circumvent this problem, what
second choice to fill the position; and least prefers Donald to fill the position. The final if we followed this round of voting over all three candidates (in which no single
column in Table 11.1 states the percentage of the population which is of each different candidate received more than 50% of the votes) by a "run-off' between Donald and
type. Throughout our analysis we will assume that everyone chooses to vote, and, when Hillary (the two highest vote getters).'? Faced with an option to choose between only
doing so, votes '"truthfully or sincerely, ' (Le.,. m-line
. . with
. .then" actually preferences). Donald and Hillary, voters of types tit, tilt, and [iv] would vote for Hillary (20% + 22%
+ 14% = 56%), and voters of types [iii], tot, and [vi] would vote for Donald (6% + 10% +
Table 11.1 - Preferences d r voters over three candidates 28% = 44%). In this ran-off Hillary receives over 50% of the votes and is declared the
winner. So, it appears as if this two-stage approach "solves the problem" in that we are
Voter Type I st Choice 2nd Choice 3rd Choice Percentage of Population not electing the candidate who is least preferred by the largest number of people.
tit Ted Hillary Donald 20o/0 But, is this outcome really reflecting the "will of the people"?. The best answer to
[ii] Hillary Ted Donald this question (which will be revealed by working through additional examples based upon
22%
tilt] Ted Donald Tables 11A and 11.2) is that the "will of the people" is a concept that cannot always be
Hillary 6%
rio] Hin~ Donald Ted 14% clearly defined. Depending upon how different people in society rank different options,
Iv] Donald Hillary Ted ~| there might not be a meaningful sense in which the collective group of people have
10oA
[vi] Donald Ted Hillary 2go/. "rational preferences." If group preferences are not rational, then trying to find a voting
, ~ :~ procedure which reveals the ''will of the people" is essentially a wild-goose chase.
Recognize that in an election with three options the vote can be "split" in ways
First suppose that we simply had an election with all three candidates running and that can skew the outcome. Consider a series of pair-wise choices between two
awarded the position to whomever gets the most votes. Who would win.'? As candidates. Suppose that we fast have a primary election between Donald and Ted,
summarized in the first row of Table 11.2 below, voters of types tit and [iii] would vote followed by the winner taking on Hlllary in a general election. From Table 11.2 we see
for Ted (20*/o + 6% = 26%), voters of types till and [iv] would vote for Hillary (22% + that in a head-to-head race between Donald and Ted, Donald wins (52% to 48*/0).
14% = 36%), and voters of types tel and toil would vote for Donald (10% + 28% = Further, as already noted, in a bead-to-head race between Donald and Hillary, Hillary
38%). So, if the person who gets the most votes is declared the winner, Donald will fill wins (560 to 44%). Thus, Hillary emerges as the overall winner from this process.
the position. This outcome would be acceptable to many oftbe voters since, after all, he But what if Donald had instead faced Hillary in the primary round? That is,
is the person who is most prefen'ed among the three by the largest number of people. suppose that we fast have a primary election between Donald and Hlllary, followed by
the winner taking on Ted in a general election. We know that head-to-head, Hillary beats
Donald (56% to 44%), But, based upon the bottom row in Table 11.2, we see that in a
2 T i l t Squote .Is attributed
. to Winston Churchill.

257
 Chapter #11 - Government Failure
two person race between Hillary and Ted, Ted receives a majority of the vote (54% to
46%). Consequently, Ted emerges as the overall winner from this process.
Finally suppose that we first have a round of primary voting between Hillary and
Ted, followed by the winner taking on Donald in a general election. As noted, Ted
defeats Hillary (54% to 46%) in a two person election, but Donald defeats Ted (52% to
48%) in a two person election. Therefore, Donald emerges as the overall winner from
this process.
What this illustrates is that, for these voter preferences, if we have an election
between any two of these candidates, then pair the winner against the third candidate, and
then pair that winner against the initially defeated candidate, we end up with a "cycle" in
which each candidate wins one of these three elections. For example, letting the notation
"A>-B" denote that "candidate A defeats candidate B in a head-to-head election" (which
would seem consistent with a claim that voters prefer candidate A to candidate B), we
have (from Table 11.2): H>-D, T>H, and D>-T. So, based upon a series of pair-wise
majority votes, it seems as if for these voters: Hillary is preferred to Donald, Ted is
preferred to Hillary, but Donald is preferred to Ted. This illustrates a well-known
potential problem with majority voting and group preferences, known as the Condorcet
Paradox. This paradox refers to a situation in which a series of pair-wise majority votes
over more than two options leads to a cycling of winners) What such an outcome
reveals is that these collective preferences of society are irrational in that they are non-
transitive (or internally conU'adietory).
In contrast, preferences that are transitive do not exhibit any such internal
contradictions. Individual people would be expected to have rational preferences that are
transitive. For example, thinking about what you want for lunch, if you prefer tacos over
pizza and also prefer a sandwich over tacos, it would seem to be a contradiction is you
then claimed to prefer pizza over a sandwich. But, this is exactly the type of
eonla'adictory cycling of preferences exhibited by voters in the example above. When
group preferences are characterized by such internal contradictions, the concept of the
"will of the people" is meaningless, so that any attempt to determine if a voting system
reveals the "will of the people" is similarly meaningless.
S O U R C E S O F G O V E R N M E N T FA I L U R E
Economic efficiency requires both productive efficiency and allocative efficiency.
Productive efficiency is the concept that whatever we are producing is being produced at
the lowest possible cost with the least amount of waste. Allocative efficiency is the
concept that we are allocating our scarce resources to the production of goods that are
most highly valued.
There are two broad causes of government failure, either: (i) goverurnent fails to
perform a necessary task efficiently (i.e., fails to achieve productive efficiency) or (ii)
J Nicolas de Condorcet- an 18s century French philosopher, political scientist, and mathemadclan _ was
the fi~t to formally identify this problem.
Chapter #11 - Government Failure
government fails to do only those tasks that it should do (i.e., fails to achieve allocative
efficiency). The first broad source recognizes that government (for various reasons) may
not do things well. The second broad source recognizes that government (again, for
various reasons) may do too many things or too few things.
Thus, when considering government intervention in the economy we should ask
two important questions: (i) Is government producing in an efficient (i.e., non-wasteful,
low cost) manner? and (ii) Exactly how many government goods and services do we
want? That is, we should not only carefully critique how well government performs its
assigned tasks, but we should also thoughtfully assess the extent of government
intervention (since all government activity involves tradeoffs which must be made, in
terms of decreased private sector output, when the role of government is expanded).
As noted, there is a clear potential role for government in the face of market
failure - Total Social Surplus can be increased by appropriately altering the level of
trade. But recognize that while this suggests that government should likely be involved
in markets for public goods, markets for goods which generate externalities, markets in
which firms have significant market power, and markets in which there are informational
problems, it in no way identifies the ideal scope or degree of government involvement.
Consider the provision of national defense, a classic example of a pure public
good. Absent any government involvement the free market would provide too little of
this good due to the free rider problem (as discussed in Chapter 10). But clearly,
government could provide "too much" of this good, in which case we would have a
positive Deadweight Loss due to overprovision. For example, in 2017 the U.S.
Depar~ent of Defense spent $568.9 billion on military programs: Of course, the actual
efficient level of spending could be even greater, in which case even with goverm'aent
provision we still have a positive Deadweight Loss due to too little provision.
Alternatively, the efficient level of spending could be less than $568.9 billion, in which
case government provision actually leads to a positive Deadweight Loss from too much
provision. Similar insights apply to government efforts to reduce pollution, provide
education, or regulate business - even if some government intervention can increase
Total Social Welfare, too much government provision is also possible. We are again
suggesting that a thoughtful analysis should be based upon a careful comparison of
benefits and costs (i.e., based upon the Cost-Benefit Principle discussed in Chapter 1).
Government failure can arise for many different particular reasons. Seven of the
most common specific causes are: (i) informational problems, (ii) cost of complying with
government bureaucracy, (iii) corruption or kleptocrany, (iv) regulatory capture, (v) rent
seeking, (vi) logrolling and rational ignorance, and (vii) deadweight loss from taxes.
Informational Problems
If the gnvemment aims to put a policy in place which results in the efficient level
of trade they must first determine the amount of trade that is ideal. To determine the
efficient level of trade in a market a substantial amount of information is needed. Recall
See "Table 4.1 - Outlays by Agency: 1962-202Y': http~:/~vw,"~'hitehouse.~lov/omb/hi,~,torical-tables/.
 Chapter #11 - Government Failure
the discussion ofnngative externalities from Chapter 10. It was noted that the individuals
who are harmed by the negative externality have an incentive to overstate the magnitude
of the damage. This is especially true if they believe that their exaggeration of the
external cost will result in the guvemment striving for a much lower level of the
externality (and that they themselves will not have to directly bear the costs of
mitigation). Thus, even a well-intentioned government bureaucrat can be led astray when
private citizens (pursuing their own self-interest) misrepresent the true cost of the
externality. Similarly, people may exaggerate benefits from public goods, if they know
that they themselves will not have to incur the full costs of provision. These examples
illustrate how government failure can arise because of informational problems, even if
government bureaucrats are "well intentioned" and have the admirable goal of
maximizing Total Social Surplus.
Likewise, consider a situation in which government regulates a monopolist with
the aim of setting price so that consumers would want to purchase exactly the efficient
amount of the good. From the discussion in Chapter 10, we know that the efficient level
of trade depends critically upon marginal costs of production. But, in practice costs are
not easily observable. If the government asked the firm to report production costs the
regulatexl monopolist would have an incentive to overstate costs. This misrepresentation
of information results in the government setting the regulated price at a higher level,
allowing the monopolist to earn a larger profit. But, it also undermines the government's
regulatory efforts, preventing regulation from eliminating Deadweight Loss.
It is important to recognize that in many cases market interactions provide
incentives for both buyers and sellers to truth_fully reveal information on costs and
benefits. For example, ffwe observe that in a free market exactly 1,000 units are traded,
each at a price of $25, we can infer a great deal. We know that buyers values exactly
1,000 units in excess of $25, and that bu er's reserva,~^ -
Y ,,on price for all other potential units
is less than $25.. Similarly, we know that sellers have costs of productiun below $25 for
exactly 1,000 units, and that seller's roseawatiou price (or coots) of all other potential units
is above $25. If this is a market in which there is no reason to suspect market failure, we
further know that the efficient level of trade is 1,000 units.
But what if our society relied upon a system of plaaning in which markets do not
e.xist?
The mforma~on observed in this market is revealed by the self-interested be "
hay]or
el tile marxet partlcipants. If we nreve-* t~, .... t . _ , ~ . .
r ,,, u,~ laa~L=t n'om exhaling we do not get to
observe the information. Ultimately, this makes it much more difficult - if not
impossible - to implement efficient outcomes under a system of planning (as was
discussed in detail in Chapter 6).
This observation, known as the Economic Calculation Problem, was first made by
Ludwig yon Mises and later refined by Friedrich yon Hayek.s The Economic
Calenlafloo Problem posits that a system of planning can never achieve efficient
outcomes prectsely because the planners do not have the information generated by market
laansactioas available to them. Peter Boettke summarized the explanation of Mises and
Hayak as follows: "the price system...through the signals of monetary prices and
s M - rss, L., ~Ecoaomi¢ Calculation in the Socialist Commonwealth,, n "//mi .s o A on
Chapter #11 - Government Failure
profit...not only provided the social context for entrepreneurial discovery that was
necessary for the effective use of currently available resources but led to the innovations
and technological progress that assured continued prosperity.''6
Cost of Complying with Government Bureaucracy
Government failure also commonly arises because resources must be used to
comply with government regulations. In Chapter 3 it was noted how excessive
gnvemment regulation can be so costly that it stifles economic activity. When this
prevents socially beneficial economic activity from taking place, a Deadweight Loss
emerges Government failure of this type is perhaps best illustrated by India's "Permit
Raj," comprised of "a complex, irrational, almost incomprehensible system of controls
and licenses," under which "everything needed (government) approval and a stamp."7
Also recall the discussion of the study "Doing Business 2018: Reforming to
Create Jobs," conducted by the World Bank Group. This study revealed tremendous
differences across countries in regards to the costs (in terms of time, money, and other
resources) of complying with government bureaucratic regulations,s As noted, of the 190
countries in this study, the costs of starting a business are determined to be lowest in New
Zealand and highest in Venezuela. To start a new business in New Zealand, only one
procedure must be followed, which can take as little as halfa day and costs a mere 0.3%
oftbe annual per capita income in the country. In stark contrast, to start a new business
in Venezuela: 20 procedures must be followed, taking at least 230 days and costing
351.6% of the annual per capita income in the country. These observations suggest that
the resulting government failure from such regulations is likely to be much smaller in
New Zealand than in Venezuela.
Corruption or Kleptocracy
The two specific sources of government failure discussed above (informational
problems and excessive costs of complying with bureaucracy) can commonly arise even
when government bureaucrats have the best of intentions. However, if government
bureaucrats are not so honorable but are instead corrupt, then the potential for
government failure is amplified. Corruption is present if regulations are not enforced
and decisions are not made evenly and without bias. In an economic system with a high
level of corruption, significant government failure (i.e., inefficiencies) will result,
hampering economic development and growth.
t Boettke) pJ, [-layek
~
s TbeRoadto
)
Serfdom Revisited: Government Fadure
. . . . .
In the Argument Against ,
Socialism," Eastern Economic Journal, VUl. 2 t, No. 1 (Winter 1995), pages 7-'>6
? ~ Yergm,
. , . .
D. end J. Stamslaw, 'The Commanding Heights: the Battle for the World Economy," Simon
and Schuster, 2002, pages 213-14,
t Recall, the full report ("Doing Business 2018: Reforming to Create Jobs") is available on-line at:
ho~/'qt~t~`d~in~bu~i~¢~s~r~/--hne~a/WBG~D~in~Busineg~/D~um~n~s/Amma~-~p~t`~/Eng~i~h
Fult-Ret~ort.~. The main results are reported in Table 3.4 (in Chapter 3 ofthis textbook). ~DB ~018"
 Chapter #11 - Government Failure Chapter #11 - Government Failure

For example, suppose the government is building a new bridge and they announce
Suppose that Georgia Power petitions the GPSC to approve a rate increase. Ideally we
a selection process under which potential contractors can submit bids for the job.9 would want the regulatory agency to conduct a thoughtful and careful cost/benefit
Suppose that "Contractor A" and "Contractor B" have the lowest costs of all potential
analysis based upon the best interest of the public at large when making its decision. But
builders. "Contractor A" can build the bridge for $18 million, while "Contractor B" can
recognize that the regulated industry has a strong incentive to influence the decision of
build the bridge for $21 million. An open, fair, competitive bidding process would likely
the regulatory body. Regulatory capture refers to a situation in which firms in a
result in "Contractor A" being chosen as the builder, which is precisely what efficiency
regulated industry influence a regulatory agency to the point where the agency enacts
calls for (since building costs are lowest when "Contractor A" builds the bridge). If
policies that are in the best interest of the regulated firms, even if the policies are not in
instead the selection process is corrupt, "Contractor B" may be able to bribe the
the best interest of the general public.
bureaucrat making the decision (e.g., slip him an envelope filled with $20,000 cash) in
Regulatory capture is likely to occur when regulators identify more with those in
order to be awarded the contract. This illustrates how decisions made by corrupt
the industry which they are regulating than they do with the general public (whose
guvemment officials can result in government failure.
interests they are supposed to serve). Such a mindset by regulators can evolve naturally
Levels of corruption across different countries are measured by the World Bank
over time as employees move back-and-forth between working for the regulatory agency
Group as part of its World Governance Indicators project)° For 2016, data was available
and working for the regulated firms. After all, if we are going to appoint someone who is
to rank 209 different countries with respect to perceived level of corruption. Corruption
was deemed to be lowest in New Zealand and highest in Equatorial Guinea. Other knowledgeable and informed enough to weigh the merits of a request from an electricity
producer for a rate increase, it would help for the person to know something about
countries with low levels of corruption include: Finland (2"d lowest of 209 countries),
electricity generation. The best person for the job would quite naturally be someone with
Denmark (3~), Canada (1 ltb), the United States (22~), and the United Arab Emirates
experience in the industry. Similarly, if an electricity producer is looking to hire
(25~). In contrast, countries which suffer from high levels of curruptinn include: Mexico
someone to help them navigate government red-tape and bureaucracy, someone with
(161~, Russia (170a'), Zimbabwe (191~, Venezuela (195th), and Somalia (208th). When
experience as a government regulator could provide valuable insights. At any point in
corruption becomes so pervasive that government officials unabashedly seek personal
time it will often be the case that many of the current regulators used to work in the
gain at the expense of the public interest, it earl be labeled kieptoeraey.I' As further
regulated industry and some of those currently working in the regulated industry have
testament to the assessment of present day Russia, an article winch appeared in The
some experience as regulators. From here it is only natural that, even if not overtly
Economist described the counffy as "an ill-governed klepteeracy" in which "corruption is
not a happy side-effect of power, but the core of the system," and as a consequence "a intending to do so, a regulator may be predisposed to see things from the perspective of
the regulated firm (as opposed to an unbiased, neutral perspective). Such a mindset
small group of people wholly above the law has, in the past decade, become rich beyond
the wildest dreams of the tsars.''12 increases the likelihood of regulatory capture.

Rent Seeking
Regulatory Capture
Rent seeking refers to attempts by people to manipulate government action or
A standard response to market failure arising from firms having market power or
influence government decisions in order to make themselves better off at the expense of
from a lack of information on the part of market participants is for government to
others)3 Groups of individuals or firms with common interests often engage in rent
regulate the market. This can include actions such as imposing restrictions on product
seeking together. For example, consider U.S. peanut farmers. They could earn larger
characteristics, setting the price which can be charged by producers, and authorizing only
profits as a group by successfully lobbying the federal government to impose high tariffs
certain sellers to provide the good.
and other trade restrictions on foreign peanut producers, even though such policies
For example, Georgia Power is the sole provider of electricity in most parts of the
decrease total eeunomic well-being - the gains realized by those in the peanut industry
state of Georgia. The quality of service which they must provide and the rates that they
are more than offset by losses realized by U.S. consumers of peanuts, foreign peanut
are allowed to charge are set by the Georgia Public Service Commission (GPSC).
producers, and any fh'ms which use peanuts as an input to produce other goods.14 But,
917 - .. suppose the bladge must be made to precise specifications, so that the bids only differ from since U.S. peanut farmers can earn larger profits and workers in the industry can
or sanpheay,
each other in terms of the price tag of the ro'ect. command higher salaries (and increased job security, leading to higher levels of
JoS~: ~'~t~°rldbank.ore/fovernance/wt, P~Ji/index.aspx#hom~.

' Th~w~rdk~ept~craeytsderivedfr~mac~mbinati~n~fth~Greekw~rds~dept~(meaning~`thief~)and
cracy (Irneanhlg "role by"). A toerac therefore " 'z As used in this context, "rent" refers generally to a payment in excess of costs (and not specifically to
,2 See" ,"n,. n ...... .Y, , ts a eountzy tailed by thieves payments made to a landlord).
~
..... ~nnmg°IthermaofPutm,"TheEconomist, March3 2012' " ,4 Recall, as discussed in Chapter l. 94.1% of economists agree that "Tariffs and import quotas usually
reduce the general welfare of society."
 Chapter #11 - Government Failure
Chapter #11 - Government Failure

outcome if no vote trading occurs and each representative votes on each proposal taking
employment) with such protectionist policies in place, they have an incentive to expend into account the best interest of his constituents? Each projected would be rejected by a
resources to secure these economic rents for themselves.
vote of four to one (with only "Representative I" voting in favor of the Airport,
Recognize that this process is bad for society not only because it can lead to
"Representative I1" voting in favor of the Cultural Center, and "Representative liP'
policies being enacted which decrease total economic well-being, but also because the
voting in favor of the Recreation Park). With none of the projects undertaken, the
resources used to secure the economic rents arc essentially wasted (and not used to constituents in each district essentially realize a surplus of zero. This is actually the
produce anything of value). This is especially problematic when it plays itself out as an
socially best outcome, since each project individually results in a negative Total Social
all-pay arms race between two different groups ofpoeple competing for one single prize.
Surplus (of-15, -10, and -5 respectively), because for each project the total costs are
Suppose the federal government has decided to establish a new museum dedicated to the
history of bnsiness office equipment. Two communities are vying to be chosen as the site greater than total benefits.
of this facility, which they anticipate generating benefits to the local community of
$500,000. Creating this museum results in a net loss of $4,500,000 for the rest of the Table 11.3-Surplus within each District for each Project (Inefficient Logrolling)
country, so society as a whole is $4,000,000 worse off if one of the two communities is Cultural Recreation All Three t'rojects
~i:=-~,~ :~'~:- Park Together
simply chosen at random. Consequently, from the standpoint of society's total welfare, : : : . Airport Center
this museum should not be built. District I 105 -25 -20 60
However, this inefficiency is made even worse when the towns compete to get the District II -30 90 -20 40
museum. Each individual community recognizes a private gain to be had from attracting District III -30 -25 75 20
the museum, so they have an incentive to invest resources in an attempt to convince District 1V -30 -25 -20 -75
bureaucrats to select their town as the site. "Town A" spends $175,000 and "Town B" -30 -25 -20 -75
District V
spends $125,000 sending lobbyists to Washington and preparing fancy presentations to - 5 -30
TOTAL -15 -10
make their case. In the end, one of the two towns is selected, but both towns have
incurred these expenses which cannot be recouped. What should have been only a
Using majority mle, in order for a project to be approved it must receive at least
$4,000,000 loss for society becomes a $4,300,000 loss because of the inefficient use of
resources by the parties hoping to secure the $500,000 economic rent for themselves. three favorable votes. Since having all three projects funded results in a positive surplus
for the constituents of District I, District II, and District lII, these groups are better off
Recognize that government failure resulting from rent seeking can actually arise
more easily in a political system in which citizens have a voice in formulating public from having all three projects approved instead of none of the projects improved. If
policy (e.g., in a democracy). This is because if private groups of people could not have Representative I, Representative II, and Representative III engage in logrolling (i.e.,
any influence on government decisions, there would be no point in using resources to try Representative I votes in favor of the Cultural Center and Recreation Park in exchange
to sway bureaucrats and legislators. Thus, an open, democratic political process can for favorable votes on the Airport from Representative II and Representative I11), they
actually increase instances of government failure from rent seeking. can get all three projects funded. In this example, this amounts to an inefficient
oversupply of government projects which decreases Total Social Surplus (which can be
seen by the fact that the net Social Surplus of all three projects combined is -30).
It is however important to recognize that in some instances logrolling can be a
Logrolling and Rational Ignorance
good thing for society, since such vote trading allows for an expression of intensity of
Logrolling refers to a process of vote trading in which an individual agrees to
vote in favor of one proposal in exchange for favorable votes from others on different preferenens. Looking at the surpluses of the residents of District I for the three projects,
they care considerably more about having the Airport approved than they do about
proposals. Logrolling among members of Congress is an engrained part of oar political
process. To see how the process can work in practice, consider the following simple having either the Cultural Center or Recreation Park rejected (i.e., in absolute terms, 105
example in which there are five legislative districts (each with a single representative) is much larger than -25 and -20). A simple vote of either "yes" or "no" on each proposal
considering the funding of three different government projects (an airport in "District I," in a majority rule environment does not allow for an expression of intensity of preference
a cultural arts center in "District II," and an outdoor recreation park in "District HI"), in any way. Alternatively, allowing a representative to give up "no" votes on the Cultural
which would be paid for by taxes on everyone across all five districts. Table I 1.3 below Center and Recreation Park in exchange for "yes" votes on the Airport does allow for an
summarizes the realized gain or loss for constituents in each district for each of the expression of intensity of preference - after all, the representative would only be willing
proposed projects (measured in thousands of dollars). to do so if the gain from having the Airport approved is greater than the combined loss of
Suppose that each project will be voted on separately and approved only if a having the other two projects also approved.
majority of the five representatives vote in favor of the project. What will be the
 Chapter #11 - Government Failure Chapter #11 - Government Failure

Furthermore, providing voters with a way to express intensity of preference

within a majority rule decision making environment can potentially increase Total Social producers in Texas, cattle ranchers in Oklahoma, coal miners in West Virginia, and
Surplus. For example, suppose that the surpluses were instead equal to the values stated loggers in Oregon. For simplicity suppose that each tariff on its own would provide
in Table llA below. Now the socially efficient outcome is for each project to be average net benefits of $19 for constituents in its "home state" but average net losses of
approved, since each project individually results in a positive Total Social Surplus (ofS, $1 for constituents in every other state. For example, on average, residents of Genrgia
10, and 15 respectively). But a simple up-ur-down vote on each project (with no vote are made $19 better offif the protections for peanut farmers are passed, but $1 worse off
trading) results in each projected being rejected by a vote of four to one (with, again, only for each of the other protective tariffs that is passed. Consequently, each tariffon its own
"Representative I" voting in favor of the Airport, "Representative II" voting in favor of would result in a net loss of $30 (i.e., a $19 gain minus 49 $1 losses). So, passing any
the Cultural Center, and "Representative III" voting in favor of the Recreation Park). one tariff is bad for both society as a whole and the constituents of each state, and, in
If Representative 1, Representative II, and Representative III engage in logrolling contrast to the previous examples, there is no coalition of representatives that could be
(i.e., Representative l votes in favor of the Cultural Center and Recreation Park in formed to pass a subset of the tariffs for the benefit of their own constituents.
exchange for favorable votes on the Airport from Representative II and Representative But what if voters are uninformed? If voters are uninformed and remain
III), they can get all three projects funded. For the values of surpluses in Table 11.4, this rationally ignorant, then representatives can engage in logrolling to collectively pass a
amounts to an efficient outcome, which was able to be realized since the vote trading group of inefficient policies like the ones in this example. To a voter in Genrgia, the $1
allowed the representatives a way to express the intensity of their preferences. cost of trade protections for cattle ranchers in Oklahoma is so small that she would hardly
even nolice the harm of the policy. Further, investing the time and effort to become
Table 11.4- Surplas within each District for each Project (Efficient Logrolling) informed on the policy is costly, and even if she becomes informed on the matter (and
calls her representative to voice her opposition to his support of the tariffs for cattle
Cultural Recreation All Three Projects ranchers) it will not be enough to change his stance. So, the representative fi'om Georgia
Airport Center Park Together engages in logrolling with the representatives from Texas, Oklahoma, West Virginia,
District I t05 -20 -15 Oregon, and enough other states to ensure a majority, and all of the tariffs get passed.
70
District II -25 90 -15 When it is time to campaign for re.election, the representative from Georgia comes back
50
.DisPel ffi -25 -20 75 30 home and points out bow he fought for trade protections that saved jobs in the peanut
District IV -25 -20 -15 farming industry (a winning policy from the perspective of Georgia voters), while
--60
District V -2.5 -20 conveniently, from his perspective, failing to point out his support of trade protections for
-15 -60
. TO TA L 5 10 15 "~o oil producers, cattle ranchers, coal miners, and loggers (each of which is a losing policy
for Georgia voters and society at large). Voters in Georgia become informed about and
It is important to recognize that socially inefficient logrolling will more easily recognize the local benefits of the peanut tariff, but remain rationally ignorant about the
lead to an oversupply of government activities when voters ate uninformed. Moreover, costs of the other trade protections. The representative fi'om Georgia wins re-election
in a representative democracy it is often quite rational for most voters to be uninformed since rationally ignorant voters in his state think he is doing a great job on their behal£
on most issues. In practice, people must choose how informed they are on matters of Recognize how government failure resulting from logrolling is a problem that is
public policy. Even in thedigital
" " age, anqumng " and analyzing information is costly and unique to political systems in which citizens have a voice in formulating public policy
time consuming. Moreover, the benefits of becoming more informed are very small, (e.g., in a democracy). This further illustrates how democra6c political systems can
perhaps zero, since one person having different views on a matter of policy or an election cultivate certain types of gnvemment failure.
will most certainly not "tip the scales" (even in Florida in 2000, one less vote for George
W. Bush and one more vote for A1 Gore would not have altered the outcome of the
election). This behavior is described as rational ignorance - since, in a representative Deadweight Loss from Taxes
democracy, becoming informed on matters of public policy has high costs and low We conclude our discussion of government failure with a relatively lengthy (but
benefits to individual voters, it is rational for them to remain ignorant or uninformed. intentionally detailed) discussion of per unit taxes, in order to illustrate how the
To see how rational ignorance exacerbates an inefficient oveixupply of imposition of taxes can be a source of government failure. In general, if something is
government activities due to logrolling, consider the following simple example. Suppus¢ taxed we will tend to get less of it. For example, if we impose high taxes on cigarettes
there are 50 legislative districts, each with one representative (e.g., if we had a single people will smoke less. Similarly, if we increase taxes on gasoline people will drive less.
congressional body with one representative from each state). Consider 50 different These observations simply reflect the fact that taxes distort costs and benefits and
protective tariffs, one for each district - protections for:. peanut farmers in Georgia, oil therefore alter behavior. Consequently, if a tax is imposed in an otherwise efficient
 Chapter #11 - Government Failure
Chapter #11 - Government Failure

market, it will create a deadweight loss where one was not initially present. Such a equal to areas (c)+(d)+(f). Absent any sources of market failure (as discussed in Chapter
decrease in Total Social Surplus fits our definition of government failure. 10), the efficient level of trade is 10,000 units and the resulting deadweight loss is zero.
A Per Unit Tax is a requirement for a fixed dollar amount to be paid to the A Per Unit Tax Legally Imposed on Sellers. In practice, most per unit taxes are
government for each unit of a good traded.I~ In the United States taxes of this nature are imposed on sellers, by which we mean that sellers are the ones legally responsible for
imposed on numerous goods such as gasoline, beer, and cigarettes. For example, the U.S. paying (and documenting compliance with) the tax. Consider the imposition of a $I per
federal gnvemment imposes a gasoline tax of 18.4 per gallon, with states imposing an unit tax on sellers in the market illustrated in Figure 11 .I. To determine the impact of
additional levy between a low of 12.25 in Alaska to a high of 58.2¢ in Pennsylvania. this tax we must start by figuring out precisely how the tax would alter the behavior of
Similarly, cigarettes are subject to a tax of $1.01 per pack by the federal government, plus market participants. Recall, demand and supply provide summaries of the behavior of
a tax at the state level which varies between a low of 17 per pack in Missouri to a high buyers and sellers in this market. If the seller is legally responsible for paying the tax,
of $4.35 in Connecticut and New York. Some counties or municipalities choose to then the demand curve in Figure 11.1 still provides a legitimate summary of the behavior
impose additional per unit taxes on both of these goods. Continuing our focus on of buyers at the point of sale in this marketplace. But does the supply curve illustrated
cigarettes, the highest total per unit taxes are imposed in Chicago, where each pack of above still provide a correct and accurate summary of the behavior of sellers? No.
cigarettes is subject to per unit taxes of $1.01 by the U.S. federal government, $1.98 by
the state of Illinois, $3.00 by Cook county, and $1.18 by the city of Chicago (for a Figure ILl - Market in which a Per Unit Tax will be imposed
combined total of $7.17 per pack). As a result, the retail price of a pack of cigarettes is
more than $11 per pack in Chicago.~6
Our aim is to examine the market level impact of a Per Unit Tax. We build upon
the model of Supply and Demand introduced in Chapter 4 and rely extensively upon the
concepts of reservation prices and surpluses introduced in Chapter 5. Next, we determine
how aspects of the market outcome, such as the level of trade, relevant price, Total
Consumers' Surplus, Total Producers' Surplus, and Total Social Surplus, are altered by
the tax. This examination allows us to determine the incidence of a tax, defined as a
measure of who bears the burden of the tax in terms of decreased economic surplus.
Additionally, the resulting tax revenue for the government will be clearly identified.
Recognize that such a tax could be imposed on (i.e., the legal responsibility for
paying the tax could be placed on) either sellers or buyers. In practice, most taxes of this
type are imposed on sellers. To see if this is ideal we will carefi~lly compare the outcome a ~ u p p I y
from imposing a per unit tax on sellers to the outcome from imposing a per unit tax of the
same magnitude on buyers. Consider a market with demand and supply as illustrated in ~ Demand
Figure 11.1. (Perhaps this is a retail market for cigarettes in the absence of any taxes.)
Applying the insights from previous discussions of market equilibrium and
surplus (from Chapters 4 and 5), in an unfettered market 10,000 units will be traded at a
price of $3.50 each. Total Consumers' Surplus (which, recall, can be described as the
vertical distance between demand and price paid, added up over all units purchased) is quantity
equal to areas (a)+(b)+(e), and Total Producers' Surplus (which, recall, can be described
as the vertical distance between price received and supply, added up over all units sold) is
0 10,000

$ I Is' lrnpertant to dis mgutsh a Per Un t Tax from an ad valoeum tax. An ad valoeurn (Latin for
"according to value") tax is imposed as a percentage of transaction price. For example, in the state of
Georgia most goods am subject to a sales tax by the state government equal to 4% of the purchase price.
The analysis of an ad valorum tax would differ sllghfly from the analysis of a Per Unit Tax which will be
presented below, but qualitatively similar insights emerge for both t~.es of taxes..
1 6 uaung
c . in a c osu Second (m terms of the level of combined per umt taxes on eTgarettes) is New York
City, where the combined taxes of $6.86 has pushed the retail price of cigarettes up to about $12 per pack.
To see why not, recall that a seller's reservation price (Le., the minimum dollar
amount that the seller is willing to accept to voluntarily part with an item) is illustrated by
the height of the supply curve. Consider the seller of the 10,000th unit in this market.
This seller has a reservation price of $3.50. Once the per unit tax of $1 is imposed on this
seller, what is the minimum dollar amount that he would need to be paid at the point of
sale in order to voluntarily sell this item.'? If he is given $3.60, then after paying $1 to the
government he would only get to keep $2.60 - this is not enough money to make selling
 Chapter #11 - Government Failure Chapter #11 - Government Failure

the item worthwhile. What if his is offered $4.45? After paying the $1 tax to the
gnvemmant he would now get to keep $3.45, an amount which is still below his true this example, buyers end up paying 65¢ more and sellers end up receiving 35¢ less for
reservation price of $3.50. Only if the offered price is $4.50 or higher will the amount of each unit traded)s These altered prices add up to $1, which is the amount of the tax.
money that he gets to keep be greater than or equal to his $3.50 reservation price. Thus,
when faced with a per unit tax of $1, the seller will effectively behave as if his Figure 11.2 - Market with a Per Unit Tax orS1 Legally Imposed on Sellers
reservation price is $1 (i.e., the amount of the tax) greater than his true reservation price.
Recognizing that this argument holds for all sellers (and again recalling that a
seller's reservation price is illustrated by the height of the supply curve) it follows that
when a $1 per unit tax is imposed on sellers, at the point of sale in the marketplace sellers
will transact as summarized by the "effective supply curve" illustrated in Figure 11.2.
Effective Supply with a
Observe that this effective supply curve is exactly $1 (i.e., the magnitude oftbe per unit
$1 Per Unit Tax on Sellers
tax) taller than the true supply curve at each and every quantity of output)7
Buyers base their behavior in the marketplace on the demand curve illustrated in Verticaldistance between
Figure 11.2, while sellers base their behavior in the marketplace upon the effective a ~ /~ i
i ~ " e # , ~ s ~ , p l y. . . " , , , , a
supply curve illustrated in Figure 11.2. In the marketplace 5,750 units are traded, each at "Supply" is exactly equal
4.15 . . . . . . . ~ i ~ Su--I'" ,osl<,h,,,,ag,,~,~o.f
a price of $4.15. However, recognize that while buyers now pay $4.15 per unit, the b ~ ~./ vv J
sellers do not get to keep this amount. The sellers must pay $1 to the government for
each unit sold, thereby only getting to keep $3.15 on each unit sold. 3.50 -
From here, we can begin to gain Some important insights regarding the outcome 3.15
with this tax in place. First, imposing the tax reduced the quantity of the good traded (in ~" Demand
this example, from 10,000 units down to 5,750 units). This illustrates the general truth
that if you tax something you get less of it. Second, with the tax in place the relevant
price in the market is no longer the pre-tax price of $3.50. More precisely, there are now
two different relevant prices for market participants. Buyers pay $4.15, an amount above
(but not a full $1 above) the pre-tax price of $3.50; sellers receive $3.15, an amount quantity
below (but not a full $1 below) the pre-tax price of $3.50. Even though the tax is legally 5,750 10,000
imposed on sellers, they do not bear the full $1 burden of the tax. Rather, they shift a
portion of the burden of the tax onto buyers in the form of a higher price at the point of Turning attention to measures of surplus, with this tax in place Total Consumers'
sale. But sellers are not able to shift the entire burden of the tax onto buyers. Sellers bear Surplus is now equal to only area (a) while Total Producers' Surplus (based upon the true
a part of the burden of the tax in the form of receiving a lower net price for the item. In supply curve, not the "effective supply curve") is equal to only area (d). That is, looking
at Figure 11.2, imposing the $1 per unit tax on buyers decreases Total Consumers'
Surplus by areas (bl)+(b2)+(e) and decreases Total Producers' Surplus by areas (c)+(f).
..
leTheonposluon These areas provide our measures of the incidence of the tax (i.e., the burden of the tax).
of an advalo~trn tax (imposed as a percentage of ti'ansa~on price) would also result in As drawn, it looks as if in this market, the incidence of the tax is slightly greater for
.a,, ~J~ave as iltuan- reservation nrlce h;.h--,L._ .. Y.¢ .. :. flee~lS u,t m me marketplace buyers than for sellers, even though the tax was legally imposed only on sellers.19
the shiR is SOmewhatmore .COmplex. r-- ,s -,e,~, ~t a aema]ty ts). However, for an ad valorurn tax So collectively buyers and sellers lose areas (bl), Ca2), (c), (e), and (f). If neither
For an ad valorurn tax, the vertical distance between the actual
supply curve and theas
effective supply corve" doesquantities
not r~mmin buyers nor sellers realize these areas as gains, then what exactly is happening to these
but rather increases one moves out to higher Thisconstaat (as isthe
results from thefact
caso
thatfor a pars unit tsx),
seller
reservation price is greater at higher quantities on the supply curve. For example, when faced ~'th a 4% od
valorum tax, a seller must be paid an amount of money so that she gets to keep at least her tnle reservation t example, the,ncrease m pnen for buyers
l en this , ts greater than the decrease in price for sellers. This
price after paying the tax. Thus, a seller with a true reservation price of $5 would have to be paid at least illestrate~ that the magnitude of the price change for buyers and the magnitude of the price change for
$5.21, s seller with a hue reservation price orS10 would have to be paid at least $10.42, and a seller with s sellen need not be equal to eneh othor. Which change is greater in magnitude depends upon the values of
t~e reservation price of $20 would have to be paid at least $2.0.84. From here we observe that the price elasticity of demand and price elasticity of Supply. These concepts (which are bcyood the scope of
dlffe.~ce between "effective resercation price" and true rer, ervation price increases in absolute terms as we the present discussion) provide measures of the degree to which quantity demanded is sensitive to changes
consider selleni with larger reservation prices. All this being said, the im~rtant insights which we will in price and the degree to which quantity supplied is sensitive to changes in price.
make for per unit taxes carryover with slight modifications to ad valoeum taxes. 19Whether the aetoal, incidence
. of the tax is greater for buyers or for sellers again depends upon price
elasticity of demand and price elasticity of supply (which are beyond the scope of the present discussion).

Chapter #11 - Government Failure
areas? First, recall that with the tax in place the quantity of trade has fallen from 10,000
down to 5,750. That is, the 4,250 units between "unit 5,750" and "unit 10,000" are no
longer traded, and nobody realizes any gains from these units with the tax in place (since
the units are no longer traded). As a result, society realizes a deadweight loss equal to
areas (e)+(f) with the tax in place.:° Consequently, if the efficient level of trade is 10,000
units, we see how having the government impose this tax creates a positive deadweight
loss, which fits our definition of government failure.
Next, focus on the 5,750 units that are traded. Recall that buyers pay $4.15 for
each of thase units, while in the end sellers only keep $3.15 for each of tbese units. The
government gets the $1 difference between these two prices on each of the 5,750 units
that are traded, implying that the total tax revenue for the government from this tax is
$5,750 (i.e., the number of units that are traded with the tax in place multiplied by the
dollar amount of the per unit tax).2t In Figure 11.2 this is visually areas (bl)+.(b2)+(c), a
rectangle with base equal to the quantity of the good traded with the tax in place and a
height equal to the per unit amount of the tax. We have now accounted for all of the
areas in Figure 11.2 which were lost by buyers and sellers when the tax was imposed.
A Per Unit Tax Legally Imposed on Buyers. What if this $1 per unit tax were
instead legally imposed on buyers in this market? How would the post-tax quantity of
trade, relevant prices, changes in surpluses, tax revenue for the government, and
magnitude of deadweight loss in this case compare to what we identified when the per
unit tax was legally imposed on seners7 Answering these questions will allow us to
determine if it is "better" to tax buyers or sellers. For example, if our primary aim is to
generate tax revenue for the government, then a comparison of the government's revenue
from a $1 per unit tax imposed on buyers to a the government's revenue from a $1 per
unit tax imposed on sellers might begin to give us a preference for taxing one side of the
market versus the other. Similarly, consider a self-interested voter who is a consumer of
the good and has to decide between favoring a tax on buyers or a tax on sellers.
Intuitively it would seem like this voter would prefer taxing the sellers. Let's see if
supporting a tax on sellers allows the voter to avoid bearing the burden of the tax.
Again consider the market illustrated in Figure 11.1 and suppose that a $1 per unit
tax is legally imposed on buyers - it is important to stress that we are considering the
same exact market (with the same exact supply and demand curves) and a tax of the same
exact magnitude ($1 per unit), as we considered in the previous subsection. We again
This statement is made under the assumption that the initial, pre-tax level of trade (i.e., 10,000 units) was
efficient. Recognize that since a per unit tax will decrease the level of consumption in a market, imposing
such a tax in a market in which there is initially a positive deadweight loss due to "too much trade" has the
potential to reduce deadweight loss (i.e., increase Total Social Surplus). For example, if there is a "market
failure" in this market (sen Chapter 10 for a discussion of various sotwces of market failure) and the
efficient level oftr~e is actually 5,750 units, then: (i) at the free market level of trade there is a positive
deadweight loss from"too much trade" and (ii) imposing a per unit tax of $1 on sellers reduces the quantity
oftr~e down to the efficient level of 5,750, thereby eliminating the initial deadweight loss.
2~ Note that imposing a $1 per unit tax in a market where 10,000 units were initially traded does not give
the government $10,000 of tax revenue. Someone arriving at this incorrect enswcr of $10,0~ has made
the mistake of not accounting for the fact that the tax reduces quantity traded - the government only
collects tax revenue on units traded with the tax in place (not all units traded before the tax is imposed).
Chapter #11 - Government Failure
start by detemaining precisely how the tax alters the behavior of market participants. If
the buyer is legally responsible for paying the tax, then the supply curve in Figure 11.1
still provides a legitimate summary of the behavior of sellers. But now the demand curve
in Figure 11.1 no longer summarizes buyer behavior in the marketplace.
To see why not, recall that a buyer's reservation price (i.e., the maximum dollar
amount that the buyer is willing to pay to acquire an item) is illustrated by the height of
the demand curve. Consider the buyer of the 10,000th unit, who has a reservation price of
$3.50. Once the $1 per unit tax is imposed on this buyer, he will now only be willing to
pay up to $2.50 for this item. If be were asked to pay more than $2.50, then after he pays
the government the tax of $1 the total amount paid would be above his $3.50 reservation
price. Thus, when faced with a per unit tax orS1, the buyer effectively behaves as if his
reservation price is $1 (i.e., the amount of the tax) lower than his true reservation price.
Recognizing that this argument holds for all buyers (and again recalling that a
buyer's reservation price is illustrated by the height of the demand curve) it follows that
when a $1 per unit tax is imposed on buyers, in the marketplace buyers will transact as
summarized by the "effective demand curve" illustrated in Figure 11.3. Observe that this
effective demand curve is exactly $1 (i.e., the magnitude of the per unit tax) shorter than
the true demand curve at each and every quantity of output.
With the tax legally imposed on buyers, the sellers base their behavior in the
marketplace on the supply curve illustrated in Figure 11.3. At the point of sale: 5,750
units are traded, each at a price of $3.15. After paying $1 to the government for each unit
purchased, buyers ultimately pay $4.15 per unit for the good.
Figure 1L3 - Market with a Per Unit Tax of $1 Legally Imposed on Bltyers
$
Ve r t i c a l d i s t a n c e b e t w e e n " D e m a n d "
a n d " ' E ff e c t i v e D e m a n d . . . " ' i s ~ a e t ~
equal to $1 (the magnitude of the tax)
ate,~ryq,,amity
4.15 ~ Supply
b, \ b2 : /
350 ..... !I
I i< - -
i~.~ Effective Demand witlaa
I ~*'$1 Per Unit Tax on Buyers
dl~ ~
0 quanttty
[ I
5,750 10,000
0
 Chapter #11 - Government Failure
From here, we can again summarize the outcome with the tax in place. First,
imposing the tax reduces quantity traded (from I0,000 units down to 5,750 units).
Second, with the tax in place the relevant price for buyers is $4.15 (greater than, but not a
full $1 greater than, the pre-tax price of $3.50) and the relevant price for sellers is $3.15
(less than, but not a full $1 less than, the pre-tax price of 53.50). These observations
again reveal that the side of the market that is taxed does not bear the full burden of the
tax, but rather is able to shift a portion of the burden to the other side of the market.
With this tax in place Total Producers' Surplus is now equal to only area (d) while
Total Consumers' Surplus (based upon the true demand curve, not the "effective demand
curve") is now equal to only areas (al)+(a2). That is, looking at Figure 11.3, imposing
the 51 per unit tax on buyers decreases Total Consumers' Surplus by areas (bl)+(h2)+(e)
and decreases Total Producers' Surplus by areas (cl)+(c2)+(f). These areas again
provide our measures of the incidence of the tax.
The resulting deadweight loss is illustrated as areas (e)+(f) in Figure 11.3. Again,
these are foregone gains on units that should be traded from the standpoint of maximizing
Total Social Surplus, but are not traded as a result of the tax being in place. The presence
of this deadweight loss directly illustrates how the tax is a source of govermnent failure.
Finally, the tax revenue of the guvemment is illustrated by areas Col)+(h2)+(cl)+(c2) in
Figure 11.3. Numerically, from the values in Figure 11.3, we can easily compute that this
per unit tax of S1 imposed on buyers generates tax revenue for the government of 55,750.
Comparison of n Per Unit Tax Imposed on Sellers to a Per Unit Tax Imposed
on Buyers. From the observations thus far we can directly compare the outcome from
imposing a per unit tax on sellers to the outcome from instead imposing a per unit tax (of
the same magnitude, in the same market) on buyers. From Figure 11.2 and the
accompanying discussion, we saw that when a 51 per unit tax was imposed on sellers:
5,750 units would be traded, buyers would pay $4.15 per unit, and sellers would
ultimately receive $3.15 per unit. From Figure 11.3 and the accompanying discussion,
we saw that when a $1 per unit tax was instead imposed on buyers: 5,750 units would be
traded, buyers would ultimately pay 54.15 per unit, and sellers would receive $3.15 per
unit. That is, these quantities and prices are the same in either ease.
To see why the same quantity of trade and relevant prices are realized irrespective
of which side of the market is taxed, examine Figure 11.4 and consider the incentives for
buyers and sellers to trade. In the absence of a tax the self-interest of buyers and sellers
provide incentives for them to trade each and every unit for which buyer's reservation
price (height of demand) is greater than seller's reservation price (height of supply).
These are precisely the units for which there are positive gains to be realized from trade.
Trade at a price between buyer's reservation price and seller's reservation price allows
the two trading partners to split these gains in such a way that both buyer and seller
receive a positive surplus. In his market there are exactly 10,000 such units.
Now consider the situation with the government imposing a $1 per unit tax (for
the present discussion do not worry about who has to pay the tax). With this $1 tax in
place the government is effectively extracting 51 of surplus from the total surplus
generated when the buyer purchases the item from the seller. As a consequence, in order
for buyer and seller to be able to both benefit from trading the item it is no longer simply
Chapter #11 - Government Failure
enough that the buyer values the item more than the seller. Now the threshold for a trade
is that the buyer must value the item at least 51 more than the seller. In the presence of
the tax buyers and sellers no longer have an incentive to trade each and every unit for
which buyer's value is greater than seller's value - rather, they will only trade those units
for which there is a positive surplus to split after the government takes its $1 cut of the
action. With the tax in place the self-interest of buyers and sellers induces them to trade
each and every unit for which this more restrictive condition (i.e., buyer's reservation
price is at least $1 greater than seller's reservation price) is met.
Since the Law of Demand implies that demand curves are downward sloping and
the Law of Supply implies that supply curves are upward sloping, it follows that there is
exactly one unique quantity for which demand is exactly 51 taller than supply (i.e., one
unique level of trade at which buyer's reservation price is exactly $ I greater than seller's
reservation price). This is the unique level of trade which arises when a $1 por unit tax is
imposed, irrespective of whether the tax is placed on buyers or on sellers. For the market
pictured in Figure 11.4, this unique level of trade is 5,750 units.
Figure 11.4- Summary of Equivalence between Taxing Sellers and Taxing Buyers
Supply
3.50- .-- i e
I
a ~ b
3.15"
~ Demand
2.75"
quantity
5,750 10,000
With the tax in place, buyers end up paying 54.15 per unit - this is simply the
height of the actual demand curve at this market clearing quantity of trade with the tax in
place. Similarly, sellers end up receiving $3.15 per unit (the height of the actual supply
curve at the relevant quantity with the tax in place). Consequently, as illustrated in
Figure 11.4 imposing the tax (again, on either buyers or sellers): decreases Total
 Chapter #11 - Government Failure Chapter #I I - Government Failure

Consumers' Surplus by areas (b)+(e); decreases Total Producers' Surplus by areas

place, it is typically possible to achieve one of these ends, but not both. If the tax
(c)+(O; generates tax revenue for the government of areas (b)+(c); and creates a
effectively discourages consumption, then drastically fewer units will be traded with the
deadweight loss (i.e., a government failure) of areas (e)+(t). All of these aspects of the
tax in place (directly implying that not much tax revenue will be generated for the
outcome are the same regardless of whether the tax is legally imposed on buyers or
government). If instead the tax is generating a considerable amount of revenue for the
legally imposed on sellers.
government, then there must still be a substantial number of units being traded with the
So, is it "better" to tax buyers or sellers? Absent any consideration of things such
tax in place (implying that consumption was not discouraged to a significant degree).
as the administrative costs of collecting the tax or costs of tax compliance for taxpayers
(which have not been considered here), the answer is "It does not matter who we tax."
Regardless of the perspective from which we ask the question or dimension of the
outcome that we assess, we see that we get the same exact outcome whether the tax is
legally imposed on buyers or sellers.
Finally note that while the entire discussion presented here was for a $I per unit
tax, the results and insights easily generalize to a "ST per unit tax," where T can be any
dollar amount. When a "ST per unit tax" is imposed in a market (on buyers or sellers) the
level of trade that will result is the unique quantity at which demand is exactly ST taller
than supply. The relevant price for buyers is the height of the demand curve at this
quantity; the relevant price for sellers is the height of the supply curve at this quantity. It
is also straightforward to determine the resulting decrease in Total Consumers' Surplus,
decrease in Total Producers' Surplus, tax revenue for the government, and deadweight
loss. It is relatively easy to show that for a larger value ofT(i.e., when the amount of the
per unit tax is greater): the quantity of trade with the tax in place will be smaller; the price
paid by buyers will be higher; the price received by sellers will be lower; and the
decrease in Total Consumers' Surplus, decrease in Total Producers' Surplus, and realized
deadweight loss will each be greater.
However, notice that we have not made any observation about how the magnitude
of tax revenue changes as the tax is increased. Somewhat su.,prisingly, increasing the
magnitude of the per unit tax could either increase or decrease the total amount of tax
revenue generated for the government. This is driven by the fact that increasing the tax
reduces the quantity traded of the good. For example, again considering the market
illustrated in Figure 11.4, compare the tax revenue for the government of imposing a per
unit tax of T=-$0 (i.e., no tax), T=$1, and T=$3.55. Imposing no tax obviously generates
no revenue. Imposing the tax of $1 per unit generates revenue of $5,750 (since 5,750
units are traded). Finally, imposing a tax of $3.55 per unit (or any greater amount) will
result in no trade taking place in this market, since even for the buyer with the highest
reservation price ($6.25) and the seller with the lowest reservation price ($2.80) there
would not be positive gains to split when faced with a per unit tax of $3.55 or greater.
Thus, for T=$3.55 the government collects zero tax revenue. So, increasing the tax from
7"=-$0 to T=-$1 resulted in greater tax revenue for the government, but increasing the tax
further from T=$1 to 7"=-$3.55 resulted in less tax revenue for the government.
As will be discussed in Chapter 13, two potential reasons for government to
impose taxes are to collect tax revenues and to alter behavior. The preceding
observations on the relation between the magnitude of the tax and the resulting tax
~: enue for the government reveal that these two are effectively competing aims. Since
government only collects tax revenues on the units that are traded with the tax in
 Chapter #11 - Government Failure Chapter #11 - Government Failure

C H A P T E R # 11 M U LT I P L E C H O I C E Q U E S T I O N S 7. refers to attempts by people to manipulate government action or

influence government decisions in order to make themselves better off at the
1, "Government Failure" can be described as a situation in which expense of others.
A, the "free market outcome" is NOT efficient. A. The Condorcet Paradox
B. a single seller of a good has substantial control over the price of the good. B. Rent seeking.
C. Total Social Surplus is decreased by government intervention in a market. C . Logrolling.
D. None of the above answers are correct. D . Rational ignorance.

2. has been described as "an ill-guvemed kleptoeracy in which For questions 8 through 10, consider a market with supply and demand as illustrated
corruption is not a happy side-effect of power, but the core of the system." below.
A. present day India $
B. present day Russia
C. the United States during the 1980s a y
D. Great Britain during the 1970s
19.75
3. is the academic subfield which uses the tools and framework of
economics to analyze issues which traditionally fall within the domain of political 13.50-
science,
~ Demand
A . Public Choice
8 . 2 5 - ~
B . Real Business Cycle Theory
C . Industrial Organization
D . Environmental Economics 0 " quantity
8,000 12,000 15,500
4. If a per unit tax is placed on sellers of a product, the "price ultimately paid by
buyers" , while the "price ultimately received by sellers" 8. Imposing a per unit tax of $6.25 on buyers in this market would generate tax
revenue of
A. increases; remains unchanged. A. more than $75,000 but less than $96,875.
B. remains unchanged; dccreasas, B. exacdy $75,000.
C. increases; increases. C. more than $50,000 but less than $75,000.
D. increases; decreases. D. exactly $50,000.

5. is the process by which a legislator votes to approve one bill 9. Consider a per unit tax of $11.50 imposed on sellers. The incidence of this tax for
in exchange for favorable votes from other members on other bills. buyers is
A. Rational Ignorance A. illustrated by "area a."
B. Regulatory Capture B. illustrated by "areas b+c."
C. Rent Seeking C. illustrated by "areas c+d."
D. Logrolling D. illustrated by"area e."

6. According to the Warid Bank ' s World Governance Indicators Project, the perceived 10. Consider the following two proposed taxes: "Tax A" is a $2.50 per unit tax imposed
level of cermptioo is lowest in ~__ and highest in on buyers; "Tax B" is a $4.00 per unit tax imposed on sellers. We can infer that
A . New Zealand; Equatorial Guinea. ~ ' A. Deadweight-Loss would be larger under "Tax A" than under "Tax B."
B . Russia; the United States. B. the quantity of trade would be identical under "Tax A" and "Tax B."
C . France; the United Arab Emirates. C. consumers would prefer "Tax A" over '`Tax B."
D . Canada; Denmark. D. None of the above answers are correct,
 Chapter #1 ] - Government Failure Chapter #11 - Government Failure

II. Which of the following is NOT one of the seven sources of government failure? For questions 15 through 1B, consider a situation in which representatives from five
A. Corruption or kleptecrscy. legislative districts need to consider two proposals. The surplns that would be roallzed
B. Regulatory capture. by constituents in each legislative district for each project is given by the table below.
C. Rent seeking. Unless otherwise stated, suppOse that each proposal is voted on sepOroteI.F (and
D. Externalities. approved~rejected based upon simple majority rule).

For questions 12 through 14, consider a situation in which three different candidates
(Rue, Sam, and Ty) are seeking an offic~ The person to fill the position will be decided
by voting. Voter preferences are summarized by the table below. Assume throughout
that all people vote sincerely/trothfully (£ , , in-line with their actual preferences).
~ D -i2s0 0t r i c t
-401)
4 ~

15. The socially best (i.e., efficient outcome) is for

Voter Type Pt Choice 2sa Choice 3r~ Choice % of Population A. both Proposal I and Proposal II to be rejected.
[i] Rue Sam Ty 25%
Rae B. both Proposal I and Proposal II to be approved.
[ii] Ty Sam 7%
C. Proposal I to be approved but Proposal II to be rejected.
[iii] Sam Rue Ty 20%
D. Proposal II to be approved but Proposal I to be rejected.
[iv] Sam Ty Rue 10%
[v] Ty Rue Sam 12% 16. Suppose no vote trading occurs. In this case,
[vi] "ry Sam Rue 26% A. Proposal I would be approved but Proposal II would be rejected.
B. Proposal II would be approved but Proposal I would be rejected.
12. In an election between all three candidates, __ would receive the most votes.
C. both Proposal I and Proposal II would be rejected.
A. Rae
D. both Proposal I and Proposal H would be approved.
B . Sam
C. T y
17. Suppose that the representative from District 2 proposes the following vote trading
D . None of the above are correct (since the table does not provide enough
scheme to the representative from District 3: "I will vote in favor of Proposal H so
information to answer this question).
long as you vote in favor of Proposal 1." Which of the following statements
regarding this proposed vote trading is accurate?
13. ffthe position were filled by first having a vote over all candidates, followed by a
A. "The representative from District 3 would not want to agree to this vote
nmoffbetween the two highest vote getters, the eventual winner would be trade."
A. Rae
B. "If the representative from District 3 agrees to this vote trade, then both
B. Sam
proposals would be approved."
C. Ty
C . "If the representative fi~m District 3 agrees to this vote trade, then both
D. None of the above are correct (since this process does not identify a winner).
proposals would be rejected."
D . None of the above answers are correct.
14. Given these voter preferences, there
A. is not a Cendorcet Paradox, since Ran would receive a majority of votes in
Suppose that both proposals are voted on as a package (i.e., one single vote, to
both a head-to-head election between Rue and Sam and also a head-to-head
determine if either both are approved or both axe rejected). In comparison to the
election between Rae and Ty.
outcome which would result from two separate votes on the two proposals,
B. is not a Condorcet Paradox, since Sam would receive a majority of votes in
both a head-to-head election between Sam and Rue and also a head-to-bead when the two proposals are voted on as a package.
A. Total Social Smplns is larger
election between Sam and Ty.
B. constituents in District 1 axe better off
C. is a Cendorcet Paradox, since in a series of head-to-head elections, Ty would C. constituents in District 2 are wov~e off
defeat Rue, Sam would defeat Ty, and Rue would defeat Sam. D. More than one (perhaps all) of the above answers is cancer.
D. is a Condorcet Paradox, since in a series of head-to-head elections, Rue would
defeat Ty, Sam would defeat Rue, and Ty would defeat Sam.
 Chapter #11 - Government Failure
The "Incidence of a Tax" refers to
A. which level of government is imposing the tax.
B. who bears the burden of the tax in terms of decreased welfare.
C. the frequency with which an individual has to pay the tax.
D. which individual is legally responsible for writing a check to pay the tax.
In advance of the election for Lieutenant Governor, Chris and Kerry are discussing
the different candidates. Kerry states: "I haven't really researched the positions and
backgrounds of the three people rmming. In order to do so properly I would have to
invest a great deal of time, and, after all, the chance of my vote deciding the
election is very small and I don't think things will be very different for me
regardless of who wins." Her statement is closely related to the issue of
A. The Invisible Hand.
B. The Condoreet Paradox.
C. rational ignorance.
D. regulatory capture.
The "Economic Calcnlahun Problem posits that
A . calculating the true economic value of a worker can only be done under a
socialist system.
B . it is impossible to come up with any estimate of the costs of complying with
government bureaucracy.
C. a system of planning can never achieve efficient outcomes, precisely because
the planners do not have the information generated by market transactions
available to them.
D . in order for economic outcomes tu be fair, it is necessary to redistribute wealth
through a highly progressive tax structure.
Inequality and
Redistribution
"There is only one class in the community that thinks more about money than the rich,
and that is the poor. The poor can think of nothing else."
- Oscar Wilde
To a large degree, human well-being depends upon access to good and services.
All other factors fixed, a person will likely have an easier, more fulfilling life with greater
access to food, clothing, shelter, healthcare, and education, as well as new technology and
leisure pursuits. In terms of the three fundamental economic questions posed in Chapter
2, the directly relevant one is the distributional decision - who gets to consume the goods
and services that we (as a society) have chosen to produce? As illustrated by the Basic
Circular Flow Diagram presented in Chapter 4, in a market based Capitalist system
househulds cam income (by supplying factors of production to firms) which they then
use to purchase goods and services from firms. For example, Nancy works as a Real
Estate Agent and earns $40,000 per year. She uses this income to acquire (among other
things): a Honda Civic, a two bedroom apartment, and a vacation to Orlando, FL during
the week of Thanksgiving.
Micbelle, Nancy's best friend from college, is an architect who earns $80,000 per
year. Michelle drives a brand new Lexus ES, lives in a four bedroom house, and spent
two weeks in Australia last December to go scuba diving at the Great Barrier Reef.
Michelle's eonsin Leo is a janitor who earns $25,000. Leo cannot afford a car, lives in a
studio apartment, and did not get to travel outside of the state of Georgia last year.
Clearly there am big differences in the consumption patterns of these individuals.
In a market based system, access to these goods and services is limited by - and to a large
degree dictated by - income. But keep in mind that greater access to goods and services
is the material reward (recall the general discussion of types of economic incentives from
Chapter 3) that induces people to earn more income by working long hours and making
investments in human capital.
Are these differences in income (and resulting differences in consumption) "fair'?
Within the discussion of views of economists in Chapter 1, it was noted that 70.4% of
economists agree with the statement, "The distribution of income in the United States
should be more equal." First note that this is a normative (i.., morality based) statement
that depends upon the value judgements and subjective notions of fairness of the
individual asserting the statement - there is no scientifically right or wrong answer. If
someone thinks that a society's distribution of income is not ideal, what could possibly be
done to alter outcomes?
 Chapter #12 - hTequaliO, and Redistribution Chapter #12 - Inequality and Redistribution

To have an informed discussion of these issues it is essential to recognize the
factors which determine household income in a market economy. It is also important to
understand how we measure differences in incomes and poverty within a society. Only
with an appreciation of these factors can we begin to thoughtfully consider potential
arguments in favor of specific government policies to alter the distribution of incomes.
D E T E R M I N A N T S O F I N C O M E A N D W E A LT H
IN A MARKET ECONOMY
In a free market based system, a bousehold's capacity to consume goods and
services is limited by its access to money. Its access to money is in turn limited by its
wealth and income. Wealth refers to the current stock of money and other valuable
assets that an individual owns at a point in time. Income refers to the flow of money
earned by an individual during a period of time.
For instance, Dr. Jones is 50 years old and has accumulated a house worth
$700,000, a stock portfolio of $1.5 million, owns a rental house worth $300,000 each,
and has $50,000 in the bank. His wealth is therefore $2,550,000. His annual salary, or
income, is $200,000 for his job at the hospital. Dr. Smith, a new 30 year old surgeon,
two years out of medical school, has an annual salary of $300,000, but actually has a
negative wealth of $200,000 since he has not yet been able to save and invest plus took
out student loans while getting his degrees. It is possible to be wealthy with little current
raceme, or have a high e~t income with little wealth, but often we expect wealth and
income to go together.
Both wealth and income depend upon some factors that are under an individual's
control and some factors that are beyond an individual's control. This is important to
note because the extent to which most people are willing to support redistribution to
either increase income/consumption of the poor or decrease income/consumption of the
rich likely depends upon whether they think levels of income/wealth are: (i) the result of
decisions by individuals or (ii) the result of luck or socio-economie factors beyond the
control Afl~mdividnal,s.....
__, ny
part nonsanOl~
me valuesthat
anmty to place
firms earn income in a Capitalist
on the factors systemthat
of production is determined in large
the members of the
household own and ,choose to supply This value depends in turn on how much
see°~ate~°f_th_e_ _.fi~_ ~s. °utput
~ amuunt oz meome mat a~eworker
willing can
t° pay f°r the
earn items sold
is closely bY the
related to filth. Thus, we
the value
c°nsum r l o u° b tT ? °rker
j "tyroduces
f their income by supplying labor to firms.
The wage rate that a worker can earn broadly depends upon numerous factors, including
natural talent and ability, acquired skills, and effort. For example, in 2017 professional
golfer Justin Thomas earned $9,921,560 in prize money competing in 25 events on the
PGA Tour (making him the leading money winner on tour for the season). Why was he
able to earn more pn.ze money than anyone else? The short answer ts that at that tmae he
was the best golfer m the world and won more tournaments than an"one els- °- "
a ~. ~u, why
was he the best golfer in the world? Because of a combination of his natural talent and
ability, acquired skills, and effort.
Natural talent and ability refers to the genetic characteristics that people are
endowed with at birth. In contrast, acquired skills refer to aspects that are honed and
cultivated through education, training, or work experience. Finally, effort simply refers
to an individual's choice of how hard to try (or how much to slack off) when performing
in the moment. An individual's level of natural talent and ability is not at all dependant
upon choices made by himself- rather, from the perspective of the individual, it is
completely due to chance. In contrast, acquired skills are under the control of an
individual to a significant degree. Finally, short term effort - that is, the decision to work
or shirk at each moment in time - is directly under an individual's control.
A portion of the differences in income between workers is a result of differences
in job characteristics. Compensating differentials refer to differences in labor market
wage rates that are due to differences in working conditions. Such differences can work
in either direction. Firms do not have to pay workers as much in order to attract them to
jobs that they otherwise enjoy or find appealing. In some sense, Justin Thomas, Stephen
Curry, Bryce Harper, and Cam Newton are underpaid because part of their compensation
comes in the form of getting to be a pro athlete.
On the other hand, firms will have to pay employees even more than they
otherwise would in order to have them accept jobs with undesirable characteristics (e.g., a
high fatal injury rate). Across all occupations, the fatal injury rate per 100,000 workers in
the U.S. was 3.6 in 2016. The five most dangerous occupational categories (and
corresponding fatal injury rates per 100,000 workers) were: logging workers (135.9),
fishing workers (86.0), aircraft pilots (55.5), reefers (48.6), and refuse collectors (34.1).
Firms hiring workers to perform these jobs will have to pay higher incomes in order to
compensate the employees for taking on this additional risLt After all, if two jobs were
exactly identical in every respect except one had a higher fatality rate then the other,
which one would you accept if they paid the same salary?
In many societies (including the United States) there are even bigger differences
across households with respect to wealth than with respect to income. The umount of
, wealth that a households has at any point in tirae depends primarily upon accumulated
savings (or debO and previous inheritances. Accumulated savings refers tO the wealth
II1~,., ,
that a household has due to spending decisions in previous periods. If you earned
~
~ ~ $50,000 last year but only spent $45,000, then your wealth today is $5,000 higher than it
would have been if you spent all of your income. Similarly, if on top of spending all of
~
your income you took out a $10,000 loan to go on vacation, your wealth today will be
that ~
~ $10,000 lower than if you had not taken out the loan. Clearly, at any point in time a
householdcouldindebt,havingnegativewealthSuchsa,in,Coowingdecisions
] ~
~sl pay day this year is April 10 the next Equal Occupational Fatality
Day is on May 30 2029" hnt~'/A~'ww aei or~/mlblication/em:ol v~dav tMs year is-aorit IO-¢he next
eauat-oceuoational-fatallt~d'~is.on.~nov-30-2029/I each of these occupations is dominated by male
~ ~:~i
~ workers (94.9%, 99.9%. 94.8%, 98.3%. and 91.4°/, ~lively). Cons~uently, such factors can begin to
explain part of the observed diff~rense ~in avre ysula betweeng enders across the entire
pop ulation
.
~ !

~ ~ L l l l ~ 285
284
 Chapter #12 - Inequality and Redistribution
Chapter #12 - Inequality and Redistribution

arc obviously under the control of an individual, so that (just as with income) an bottom 75% of income earners (i.e., those households with incomes below $79,655)
individual's wealth is partly influenced by his decisions. earned 31.0% of society's total income earned.
Even bigger variances in wealth result from differences in inheritances. Many
people go their entire lives without ever receiving a significant amount of money as an Table 12.1 - Distribution of income in U.S. in 2015
inheritance, while others receive large sums. Whether or not you receive a large amount Bottom Bottom Bottom ~u.u~,~
Bottom
of money as an inheritance is clearly not at all under your control (except as you are a Segment of the Population 95% 99%
50% 75% 90%
good or bad son or daughter to your older relatives!). 63.9% 79.4%
11.3% 31.0% 52.6%
Finally, differences in both income and wealth can result from things that might at Cumulative Share of Income $480~930
$39,275 $79~655 $138r031 $195~778
first glance appear to be seemingly unrelated market conditions. For example, consider Income Cutoff
an individual who works as a coal miner in West Virginia. If the government increases
regulation of pollution by electricity generating plants, demand for coal will decrease. The Lorenz Curve (developed by the economist Max Lorenz) graphically
From our discussion in Chapter 4 we know that as the demand for coal decreases the illustrates income inequality within a society by focusing on ever larger segments of the
market equilibrium price and market equilibrium quantity of coal will both decrease. In population and plotting the relation between the cumulative fraction of the population
order to produce this lower amount, coal mine owners do not need to employ as many (with people ordered from lowest income to highest income) and their cumulative
coal miners. Correspondingly, some coal miners will be laid off and others who remain fraction oftotsl income earned. Figure 12.1 illustrates the Lorenz Curve for the U.S. in
in the industry can very well expect their incomes to decrease. This undesirable outcome 2015 based upon the values reported in Table 12.1. For instance, from Table 12.1 we
for the individual coal miner comes about by a change in a market other than the one in saw that the bottom 50% of income earners collectively received 11.3% of all income
which he is directly employed (additionally recognize that this is, again, a factor which is earned by everyone in our society. With fraction of total population measured on the
beyond the control of the individual).
horizontal axis and fraction of total income measured on the vertical axis, this
Now that we understand the broad determinants of income and wealth in a market observation implies that the point (.5,. 113) is on the Lorenz Curve.
economy, we switch focus to examining how we can measure the distribution of income
across households in society. Figure 12.1 - Lorenz Curve for U.S. in 2013

Fraction of
Total Income
MEASURING INCOME INEQUALITY
l . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Is it possible to graphically illustrate and compute a simple numeric measure of
the degree of income inequality in a society'? The most common ways that economists
do so is by constructing something called a Lorenz Curve and, based upon this curve,
computing the value of something called the Gini Coefficient. This is done by .639"
conceptually putting everyone in society in order fi'om lowest income to highest income,
..526"
7 9 4 ~ ~ . ~ _ _ _ . ~
and then incrementally considering larger and larger segments of the population. Each 45-degree line
step along the way we determine the fraction of total income (of the entire society)
earned by the segment of the population we are focusing on. 310 ..... Lorenz Curve
For example, based upon data from federal income tax returns, we can make the
following observations on the distribution of income in the U.S. in 2015 as reported in
.113 .....
0
::'
Fret,ono:
uo
io
i,n
Table 12.1.2 As a group, the bottom 50% of income earners (i.e., those households with
incomes below $39,275) earned 11.3% of society's total income earned. Similarly, the
5
2 The figures in Table 12.1 provide a partial summa~ of the distribution of Adjusted Gross Income from .90 .95 .99 I
filed tax returns as reported by the Internal Revenue Service and summarized by Erico York in "Summary
of Latest Federal Income Tax Data, 2017 Update" h(https.llt~l~.lcz~foUndafion.ore/20/~lOI 17125609/Tff~= Recognize that if everyone in a society had the same exact income (i.e., if there
o~£~ion-FF570~,d~, lt istoworth notthg that these flgures arc stated were no differences in income levels), then the Lorenz Curve would exactly coincide
who were legally required file a tax return, and not over the entire .,onl,, ov_,L
U.S. population.
~ u~e ...
population of people with the 45-degree line. This is because if everyone has the same exact income, it
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistribution

are obviously under the control of an individual, so that (just as with income) an
bottom 75% of income earners (i.e., those households with incomes below $79,655)
individual's wealth is partly influenced by his decisions. earned 31.0% of society's total income earned.
Even bigger variances in wealth result from differences in inheritances. Many
people go their entire lives without ever receiving a significant amount of money as an
Table 12.1 - Distribution of Income in U.S. in 2015
inheritance, while others receive large sums. Whether or not you receive a large amount
of money as an inheritance is clearly not at all under your control (except as you are a Bottom Bottom Bottom Bottom Bottom
good or bad son or daughter to your older relativesl). Segment of the Population 500,6 75% 90% 95% 99%
Finally, differences in both income and wealth can result from things that might at 11.3% 31.0% 52.6% 63.9% 79.4%
Cumulative Share of lncome
first glance appear to be seemingly unrelated market conditions. For example, consider $39,275 $79~655 $138~031 $195r778 $480,930
Income Cutoff
an individual who works as a coal miner in West Virginia. If the government increases
regulation of pollution by electricity generating plants, demand for coal will decrease.
The Lorenz Curve (developed by the economist Max Lorenz) graphically
From our discussion in Chapter 4 we know that as the demand for coal decreases the
illustrates income inequality within a society by focusing on ever larger segments of the
market equilibrium price and market equilibrium quantity of coal will both decrease. In
population and plotting the relation between the cumulative fraction of the population
order to produce this lower amount, coal mine owners do not need to employ as many
(with people ordered from lowest income to highest income) and their cumulative
coal miners. Correspondingly, some coal miners will be laid off and others who remain fraction of total income earned. Figure 12.1 illustrates the Lorenz Curve for the U.S. in
in the industry can very well expeot their incomes to decrease. This undesirable outcome 2015 based upon the values reported in Table 12.1. For instance, from Table 12.1 we
for the individual coal miner comes about by a change in a market other than the one in saw that the bottom 50*/0 of income earners collectively received 11.3% of all income
which he is directly employed (additionally recognize that this is, again, a factor which is earned by everyone in our society. With fraction of total population measured on the
beyond the control of the individual).
horizontal axis and fraction of total income measured on the vertical axis, this
Now that we understand the broad determinants of income and wealth in a market observation implies that the point (.5, .113) is on the Lorenz Curve.
economy, we switch focus to examining how we can measure the distribution of income
across households in society. Figure 12.1 -Lorenz Curve for U.S. in 2013

Fraction of
Total Income
MEASURING INCOME INEQUALITY
1 i .............................
Is it possible to graphically illustrate and compute a simple numeric measure of
the degree of income inequality in a society? The most common ways that economists .794.
do so is by constructing something called a Lorenz Curve and, based upon this curve,
computing the value of something called the Gini Coefficient. This is done by .639'
conceptually putting everyone in society in order from lowest income to highest income, .526'
and then incrementally considering larger and larger segments of the population. Each 45-degree line
step along the way we determine the fraction of total income (of the entire society)
earned by the segment of the population we are focusing on. .310 ~ --Lorenz Curve
For example, based upon data from federal income tax returns, we can make the if!
following observations on the distribution of income in the U.S. in 2015 as reported in
Table 12.1.2 As a group, the bottom 50% of income earners (i.e., those households with [ [ [ ~ Fraction of
incomes below $39,275) earned 11.3% of society's total income earned. Similarly, the
. ~ 5// ~°taI P°pulati°n
.90 .95 .99 1
2 The figures in Table 12.1 provide a partial summaD, of the disla'ibution of Adjusted Gross Income from
filed tax returns as reported by the lntcmanl Revenue Service and summarized by Erica York in "Summary Recognize that if everyone in a society had the same exact income (i.e., if there
of Latest Federal Income Tax Data, 2017 Update" (hnps:///ile~,taxfoundation.orQ/20180117125609~Tax were no differences in income levels), then the Lorenz Curve would exactly coincide
Foundation.FF570.pdj~. It is worth noting that these figures are stated only over the population of people with the 45-degree line. This is because if everyone has the same exact income, it
who were legally required to file a tax return, and not over the entire U.S. population.
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistribution

follows that: the bottom 25% of income earners earn exactly 25% of society's income;
the bottom 50% of income earners earn exactly 50% of society's income; the bottom 75%
of income earners earn exactly 75% of soeiety's income; and so on. Thus, the 45-degree
line (which is illustrated in Figure 12.1) can be thought of as the "line of perfect
equality." In reality, with differences in incomes across people, a society's actual Lorenz
income gives us a particular Lorenz Curve, with a particular lens shaped region similar to
that depicted in Figure 12.1. In the extreme, if this same fixed amount of income were
instead earned by one single person, the Lorenz Curve would be a reverse-L and the leas
shaped region would have an area equal to ~, as noted above. Thus, as defined, the value

.Curve will lie strictly below this line of perfect equality) Moreover, a Lorenz Curve that of the Gini Coefficient is essentially telling us how much income inequality we actually
zs further below the 45-degree line (i.e., bowed away from it to a greater degree) is realize as a percentage of the maximum possible amount of income inequality that we
illustrating that there is greater inequality with respect to society's incomes. One way to could have (since the ratio of the lens shaped region to the entire unit triangle below the
quantify the distance of the Lorenz Curve from the line of perfect equality is to compote 45-degree line is simply equal to the percentage of the unit triangle which is covered by
the area of the "lens shaped region" between the Lorenz Curve and the 45-degree line the lens shaped region).
(i.e., the region denoted by "areas (a)+(b)+(c)+(d)+(e)+(0" in Figure 12.1). Table 12.2 reports values of the Gini Coefficient, Median Household Income, and
At one extreme, if everyone had the exact same income the Lorenz Curve would Mean Household Income for the United States in select years over the past five decades.5
coincide with the 45-degree line and "areas (a)+(b)+(c)+(d)+(e)+(f)" would completely Note that the values of Median Household Income and Mean Household income are
vanish. At the other extreme, if one person in society seined all income (and everyone stated in "real" (i.e., inflation adjusted) terms in "20t6 dollars."
else earned zero income) the Lorenz Curve would be a "reverse-L" going fi'om the point
(0,0) out to the point (I,0) and then up to the point (1,1). In this case "areas Table 12.2- Gini Coefficient and Average Income in U.S.
(a)+(b)+(c)+(d)+(e)+(f)" would be equal to a triangle below the 45-degree line with an
area of ~. The Ginl Coefficient is a numerical measure of income inequality defined as Ye a r 1 9 6 7 1976 1986 1996 2006 2016
the ratio of the lens shaped area between the Lorenz Curve and the 45--degree line to the Gini Coefficient .397 .398 .425 .455 .470 .481
entire area below the 45-degree line. Since the entire area below the 45-degree line is a Median Household Income $44~895 $48,673 $52,068 $54,105 $57,379 $59,039
Mean Household Income $50.213 $57,252 $64,328 $71.836 $79,246 $83.143
triangle with base of 1 and height of 1 (i.e., a "unit u'iangle"), it has an area of x.
Consequently, the value of the Gini Coefficient can be equivalently expressed as two
times the area between the Lorenz Carve and line of perfect equality. From Table 12.2 we see that the value of the Gini Coefficient has consistently
increased in recent decades, revealing that Incomes in the U.S. have become more
coincideAstw°the ex~:t~me~ifeveryoua.has_identical incomes then the Lorenz Curve unequal. However, average household incomes have also consistently increased over
..... u,pertec~ equality, the lens shaped region vanishes, and the value these years. Median Household Income was 31.5% higher in 2016 than in 1967 and
of the Gini Coefficient is 0 (2 x 0 = 0). At the other exWeme, if one person earned all of
Mean Household Income was 65.6% higher in 2016 than in 1967.6 Over these years
society's income then the Lorenz Curve is a "reverse-L," the lens shaped region has an
there appea~ to be a tradeoff between income equality and income levels.
area of ~, and the value of the Gini Coefficient is 1 (2 x ½ = 1). Between these extremes,
If you got to pick one of these disua'butinns of income (e.g., the income
a larger value of the Gini Coefficient reflects a greater degree of income inequality. distn'bution In 1986 or the income distribution in 2016), which one should be most
the Lorenz Curve illustrated in Figure 12.1, "areas (a)+(b)+(c)+(d)+(e)+(0" have a Pe~q3s it would be helpfid to have additional information ~axding average
combined area of roughly .29, so that the resulting value of the Gini Coefficient is .58F 4or levels of income for different segments of society. Table 12.3 reports mean household
It is hnportant to recognize what the Gini Coefficient does and does not tell us. income for different segments of the U.S. population in each of these ~ again in "real
The Gini Coefficient provides insight on how incomes vary across individuals in a 2016 dollars."~
society, but it tells us nothing about levels of income. Rather, all it tells us is how a
particular fixed amount of income is spread across people. The actual distribution of

s Thesa figerus are fi~m the U.S. Ceusus ~ us repmled in Tablus H.4 and H_5 armS able on.l~ae at
3Th..
,s because each step along the way the "bottom x%" of income ¢arue~ must collec~vely earn "less
than x%" of society's total income (if they earned more than this amount, the~ we did not focus em the In these full ropo~ em-lin~ valuns are stated for ev¢~ single year from 1967 (tbe fir~ yem. fQr ~ ~
"cort~t people" when considering the "bonom x%'). Some other ge~end mathc~at/cal properties that is available) through 2016.
prolX~ly constructed Lorenz Curve must satisfy are that tbe curve: (0 must pass through the point (0,0); (ii) ~' Wben looking
time perind. "rbeatnumb~ofpeopleper
household income, it~in
is impotl~t
tbe U.S.to~reungnize
fit~n 2.89that hoaschokl
in 1975 size dec~
(tbe fa'at ~~
y~t" fro-
cmmv~elstss through the point (l,I); (iii) must be upwanl doping; and (iv) must get steepQ- as we move up the which data is nvm'htble) to 2.54 in 2016. See Table HI..l- 11 at lu~t:/~.~-,v ~.eo~./&z~Tables~b~
4 RccaU, the Lorenz CUrve in Figure 12.1 is cousm~cted based upo~l IRS data for houscholds thai filed tax
returns. Thus, this is not the value of the Gini Coefficient for the U.S. as s whole. Ta b l e H - 3 a t ~ t r ~ s , ~ . . w ~ ' . c e r e s , t ' o w ~ a / Ya b / ~ ' t ~ e - , ~ e r ~ , / ; ~ m ~ ~ o m e ~ o v e m ~ h ~ x ~ o r ~ i ~
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistribution

With the exception of the Bottom 5th between 2006 and 2016, every single
becomes clear once we understand that while the Gini Coefficient provides insight on the
income group saw an increase in real mean income over every single decade reported
distribution of incomes within a society, it tells us nothing about levels of income.
above. Consequently, mean household income for the Middle 5t~ of households
increased by 33.0% between 1967 and 2016. The corresponding figure for the Top 5t~ of
households increased by 112.3% (i.e., more than doubled) between 1967 and 2016. Even
in light of the decrease between 2006 and 2016, the mean household income of the O B S E R VAT I O N S O N P O V E R T Y I N T H E U N I T E D S TAT E S
Bottom 5th was 28.7% higher in 2016 than in 1967.s
During his State of the Union speech on January 8, 1964 President Lyndon B.
Table 12.3 - Mean Household Income for Different Segments of the U.S. Johnson declared an unconditional "War on Poverty" in America. Under his leadership
several key pieces of legislation were enacted, including the
Ye a r 1967 Economic Opportunity Act of 1964 - signed on August 20, 1964, it established
1976 1986 1996 2006 2016 programs such as "Jobs Corps" and "Volunteers in Service to America" (VISTA),
Bottom 5t~ $10,054 $12~095 $121076 $13~103 513,513 $12~943 Food Stamp Act of 1964 - signed on August 31, 1964, it established permanent
Second Lowest 5th $27~860 $29~610 531~062 532~161 534~257 $34~504 authority for the federal "Food Stamp Program,"
Middle 5~ $44,483 $48,694 $51~979 554~096 $57~405 $59~149 Elementary and Secondary Education Act - signed on April 11, 1965, it provided
~SecondHighest 5~ $62,238 $70r714 578t306 $83,725 $90,863 $95~178 significant federal aid to public schools for the first time, and
Top5th 5176,675 5190r689 5232,189 5306,746 5354.035 ~'~7,inR~ Social Security Act of 1965 - signed on July 30, 1965, it created federal
So, which of these distributions of income should be most preferred? One government programs to provide medical care for members of low income
reasonable way to make this choice would be to try to come up with an answer to the households (Medicaid) and the elderly (Medicare).
question: "If I were to be randomly placed in a society with one of these distributions of How effective was this War on Poverty? In order to begin to assess the impact, we must
incomes, which one would I pick?" While there is not a clear-cut best answer, 2006 or first discuss how poverty is measured in the United States.
2016 look like pretty good choices. In fact, it can be easily argued that 2006 reasonably Poverty is the condition of having very limited access to goods and services. In a
beats 1967, 1976, 1986, and 1996. First, returning attention to Table 12.2, we see that market based economy this is caused by having limited income and wealth. Indeed, as
both Median Household Income and Mean Household Income are higher in 2006 than in noted by economist Robert Frank, his professor Abba Lerner summarized the plight of
any of the earlier reported years. Looking at Table 12.3 (and disregarding the column for the poor by observing that "the main problem confronting the poor is that they have too
2016) we see that mean household income for each segment of the population is higher in little money.''t° Focusing on income, the U.S. Census Bureau establishes various
2006 than in 1967, 1976, 1986, and 1996. Thus, across all income ranges, the income poverty thresholds (based on the number of and the ages of individuals in the
levels in 2006 eSsentially dominate those of 1967, 1976, 1986, and 1996 respectively. household) defined as income levels below which the household is deemed to be living in
For example, if someone was going to be randomly placed in a household in the Bottom poverty. In 2017, the poverty threshold for a single person under the age of 65 was
5thof the populatton.
m, .
either 1967, 1976, 1986, 1996, or 2006, their real income would $12,752, while the poverty threshold for a family of four consisting of two adults and two
children was $24,858. These levels are adjusted over time to account for changes in
be highest in 2006. Similar statements bold for the Second Lowest 5th, Middle 5th,
prices. For example, in 1980 the cutoffs were $4,284 for a single person under age 65
Second Highest 5tb, and Top 5t~ of income earners. So, if you are going to be randomly
placed in a household but you get to pick the year, 2006 seems better than either 1967, and $8,351 for this family of four. The poverty rzte refers to the percentage of the
1976, 1986, or 1996.9 But recognize, from Table 12.2 we see that the value of the Gini population living below the poverty line.
Coefficient was higher in 2006 than in each of these four previous years. What this It is important to note that, in many respects, poverty is a relative concept. What
it means to be poor in a wealthy country like the U.S. is much different than what it
illustrates is that while having a concern about income inequality might be legitimate,
lower income inequality should not be the only be-all and end-all objective. This means to be poor in a low income country like Nepal. This point is evident by noting that
the World Bank sets their global poverty threshold at an income of $1.90 per day or,
equivalemly, $693.50 per year, which would be $2,774 for a family of four. By this
standard, virtually nobody in the U.S. is living in poverty. The U.S. poverty line of
' It is also rope,rant to keep in mind that due to income mobility a household that was in the Bottom 5th $24,858 for a family of four is almost 9 times as lurge as the World Bank's poverty
2006 need cot be in the Bottom 5tb in 2016. threshold. Worldwide, as of 2015 about 700 million people were living in poverty.
. .
9 N ot¢ that a slmdar argument cannot be made when cornnarin 2 in

theBottorn5v" it is actual v be,,. ,~ L... :_ ~ ...... ~ g 006and2016. fyouweretoenduDi l0 See "The Invisible H~d Is Shaking," by R. Fzank, New York 7~m~, 5/25108, nvailable on-line at
groupit" ~sbenertobem20
' . ~ ,*~-~,u~ammanzu
6than2006. o. Butifyouwerctoend ._n
up m any other mcome
hn#:/A~v.nvllmes.com/2008/O.~/25/business/2.~view.hmll.
 Chapter #12 - lnequaliO, and Redistribution Chapter #12 - Inequality and Redistribution

Based upon this threshold of $1.90 per day, 2015 was the very first year ever that the
global poverty rate fell below 10%. In contrast, back in 1981 roughly 44.3% of the
world's population was living on less than $1.90 per day (in real, inflation adjusted
terms).
Returning attention to the U.S., Figure 12.2 provides a graphical illustration of the
poverty rate in the U.S. (based upon U.S. Census Bureau poverty thresholds) from 1959
through 2016}I Over this entire time period, the highest poverty rate (of 22.4%) was
realized in 1959 and the lowest poverty rate (of 11.1%) was realized in 1973. Most
recently, the poverty rate stood at 12.7% in 2016. When President Johnson declared the
War on Poverty in 1964 the poverty rate was 19.0%, and when he signed the law creating
Medicaid and Medicare in 1965 the poverty rate was 17.3%.
Focusing on the years from 1966 to 2016, there is no clear trend (either upward or
downward) in the poverty rate. Over these 51 years the mean value of the poverty rate
was 13.2%, ranging from the previously noted low value of 11.1% in 1973 up to a high
value of 15.2% in 1983.
Figure 12.2 - Poverty Rate in the U.S., 1959-2016
25.0
Thus, it would be difficult to make an argument that the reduction in poverty was a direct
result of these initiatives.
Table 12.4 - Poverty Rate in the U.S., 1959-1968
Ye a r 1 9 5 9 11 9 6 0 1 9 6 1 1 9 6 2 1 9 6 3 1 9 6 4 1 9 6 5 1 9 6 6 1 9 6 7 I
Poverty Rate 22.4% 22.2% 21.9% 21.0% 19.5% 19.0% 17.3% 14.7% 14.2%
Finally, the entire matter is further complicated by the facts that: (i) as a society
we continually "raise the bar" for what it means to be out of poverty and (ii) due to
improvements in technology and general economic growth, overall standards of living
have greatly improved in recent decades. Writing in 2000, Stephen Moore and Julian
Simon noted, "Most Americans who are considered 'poor' today have routine access to a
quality of housing, food, health care, consumer products, entertainment, communications,
and transportation that even the Vanderbilts, the Camegies, the Rockefellers, and the 19th
century European princes, with all their wealth, could not have afforded.''t2 As evidence
to support this claim, Moore and Simon point out that poor U.S. households in 1997 (i.e.,
those below the poverty line) had greater access to many amenities than did all U.S.
households in 1950. Table 12.5 provides a summary of these observations,t3

Table 12.5-Amenities of AU Households in 1950 and Poor Households in 1997

20.0 ~S "War on Poverty" begins. ]
Household' Ownership Rate for All Ownership Rate for Households
Amenity Households in 1950 Below Poverty Line in 1997
Electricity 94% 99%
10.0
Flush Toilet 76% 99%
Refrigerator 80% 99%
Television 10% 95%
Telephone 79% (1960)
Automobile 59%
Air Conditioning 12°/,(1960)
0.0
Washing Machine 47%
Clothes Dryer
Dishwasher
While it is true that poverty rate declined in the years following President
Johnson's declaration of a War on Poverty, it should be noted - as illustrated in Figure For all ten of the items listed in Table 12.5, households below the poverty line in
12.2 and summarized in Table 12.4 below - that the poverty rate was already on a steep 1997 have greater access to the amenity than did all households in 1950. By 1997, even
downward t~nd before any related programs were established under his leadership. the poor had near universal access to things like electricity, flush toilets, a refrigerator,
and a television. Moreover, several of these items listed above - such as a television, air
conditioning, and a washing machine - are things that a majority of poor people had in

n The data used to create this graph is available in 'Table 2. Poverty Status of People by Family ta Moore, S. and J. Simon, (2000) "It's Getting Better All the Time: 100 Greatest Trends of the Last 100
Relationship, Race, and Hispanic Origin" on-llne at htJos.'//www.cen~us gov/data/tab1~/time Years," CATO Institute, Washington, D.C., page 6,
u Ibid., page 76-77.
serie'~/demo/income-t~overtp/hi#torical.pover~.l)eoDle.h¢.,t
 Chapter #12 - Inequality and Redistribution
1997, but less than a majority of the entire population had in 1950. These observations
reinforce the inherent difficulties of measuring poverty by simply focusing on income
levels.14
ARGUMENTS FOR AND AGAINST COERCIVE REDISTRIBUTION
Redistribution refers to policies designed to alter the levels of income or
consumption of households within a society (usually from rich to poor). Now that we
have an understanding of how to measure income inequality and poverty, and have made
some observations on related outcomes realized in the United States in recent decades,
we consider some arguments in favor of and against such redistribution policies. Again
recalling the discussion of economists' views from Chapter 1, across three different
surveys an average of 80% of economists agree that "The redistribution of income within
the U.S. is a legitimate role for the government." Let's discuss some of the potential
arguments which might make someone reach this conclusion.
Utilitarian Justice
Utilitarianism is the notion that the morally best outcome is the one which
maximizes a society's overall utility or well-being. This philosophical idea- of trying to
strive for the greatest happiness for the greatest number of people - was first put forth by
the English philosophers Jeremy Bentham and John Stuart Mill. Taking the egalitarian
position of placing equal weight on each person in society leads to an objective of
wanting to maximize the sum of happiness over all people. To see how this leads to an
argument in favor of income redistribution, it helps to focus on the marginal utility of
money, which measures the change in utility or happiness from having one additional
dollar. Most people likely have a positive but diminishing marginal utility for money -
having another dollar makes the person happier (i.e., positive marginal utility), but the
increase in happiness is smaller the more money they have (i.e., diminishing nmrginal
utility). Think about how much happier you would be if you had an extra $500 of
income, first supposing that your income is $10,000 and next supposing that your income
is $1,000,000. You are probably happier with an extra $500 in each case. But the
additional happiness that $500 would bring you is probably larger if your income is
$10,000 than if your income is $1,000,000. This suggests that you have a positive but
diminishing marginal utility for money.
Now, assuming that people have a diminishing marginal utility for money,
consider transferring $500 fi'om a wealthy billionaire to a homeless person with no
monetary wealth. The billionaire will be slightly less well off, but only slightly. In
contrast, the homeless person will be much better off. So, it seems as if we have certainly
increased the sum total of happiness across the two people. This is the foundation behind
or a further discussmn
14 F ' of these issues, see: Cox, W.M. andAim IL "Myths o Rich and Poor" 1999
uasic Books. ( )
Chapter #12 - Inequality and Redistribution
the Utilitarian Justice argument in favor of redistribution, which posits that total social
welfare can be increased by transferring income/wealth from the rich to the poor, so long
as people have a diminishing marginal utility for money.
But not everyone agrees that this can be done. Even granting the Utilitarian's the
foundations of their argument, redistribution runs into trouble. Suppose Becky has five
apples and Alex has three, and consider a transfer of one apple from Becky to Alex. Can
we say with certainty that Alex's happiness has increased more than Becky's happiness
has declined7 We know for sure that Becky's utility has decreased and Alex's utility has
increased. But, we don't know how much each of them likes apples. If Becky places a
low value and Alex places a high value on apples, then this transfer increases the sum
total of utility. However, if instead Becky places a high value and Alex places a low
value on apples, then this transfer decreases the sum total of utility. As you can see, no
third party can judge whether this U'ansfer would increase or decrease overall happiness.
An even stronger counter argument against Utilitarianism is that inter-personal
comparisons of utility cannot be made in a meaningful way - that is, happiness cannot be
compared across different people. While it might be possible for an individual to assess
"situation A" and "situation B" and express a preference for themselves of one over the
other, the scale upon which happiness is quantified (if it is even possible for a person to
do so internally) can differ from one person to the next. As an analogy, if we were trying
to add up the total size of students in a classroom and added Alex's weight, to Becky's
height, m the circumference of Carl's waist, the final number would be meaningless.
Rawlsian Justice
A second argument for redistribution builds upon philosophical ideas articulated
by John Pawls in his book "A Theory of Justice," published in 1971. Rawls builds upon
the traditions of Social Contract Theory which posits that individual's enter into a
contract (at least implicitly) with other members of society, relinquishing some of their
rights to those in power in exchange for the protection of their residual rights which
results from political and social order. He conducts a thought exercise in which an
individual must contemplate the design of social institutions (e.g., political institutions,
economic institutions) from an "original position" before being placed into the society
which they have molded.L~ While making these decisions about the structure of society,
it is assumed that the individual is behind a "veil of ignorance" which prevents them from
knowing what their ultimate lot in society will be.
Behind such a veil of ignorance, would you want to design a society in which
slavery is legal (not knowing if you will be part of the class that is enslaved)? Would you
choose a society in which women are not allowed to vote (similarly, not knowing your
gander)? Would you design a society with institutions that deny education to large
segments of society and stifle economic mobility (so that those born poor are almost
certain to remain poor their entire lives)?
s T h e . . . . .
concept of the ong/nal posanon - which could oosely be thought ofes "befoz~life" - was fast
developedin1953bytheNobelprizewinningeconomistJohnHNsanyi.
 Chapter #12 - Inequality and Redistribution
Rawls argued that when crafting social institutions from this original position
behind this veil of ignorance, an individual would be particularly concamed with the lot
of the worst off member of society. Consequently, he would want to choose institutions
based upon a maximin criterion, aiming to maximize the utility of the worst off person
in society (i.e., maximize the minimum value of utility). Stating this in terms of income
distribution, Rawlslan Justice argues that the morally best distribution of society's
income is the one which maximizes the well-being of the worst-off member of society.
While Rawls' logic and arguments have a greet deal of appeal, it seems as if he
might be taking things too far. To see why, suppose (for the sake of argument) that
individual and social happiness is simply a direct function of income - that is, we can
measure happiness numerically, one unit of income is equal to one unit of happiness, and
happiness can simply be added up across different people}s Consider a person in the
original position behind a veil of ignorance choosing between "Institutions A" and
"Institutions B." There are only five people in society. Realized income for these people
under the different sets of institutions will be as specified in Table 12.6 below.
]'able 12.6 - Choice over Two Different Sets of Institutions
Income of Income of Income of Income of Income of Total
Person 1 Person 2 Person 3 Person 4 Person 5 Income
lastliufions A $10,000 $30,000 $60,000 $100,000 $200,000 $400,000
Institutions B $11,000 $15,000 $30,000 $50,000 ~ 9 ~
$100_000
Between these two sets of institutions, someone applying the maximin criterion
for decision making would choose "Institutions B.''t7 But does it seem reasonable to
accept a 50% decrease in income/happiness for each of the four other members of society
(a decrease in total happiness for these people of 195,000) in order to increase the
happiness of "Person 1" by 10% (1,000 units)? Many people would likely think that such
an extreme willingness to tradeoffdeereased well-being for all but one member of society
in exchange for a small increase in well-being for one person takes things too far.
When contemplating different possible social rules from the original position
behind a veil of ignorance, it seems reasonable to consider the ultimate situation of every
person in society and to even pay particular attention to the outcome of the worst off
member of society. After all, when confronted with uncertainty, most people are "risk
averse" in that they would be willing (up to a point) to accept a less desirable expected
outcome in exchange for reducing the riskiness over all possible outcomes. All forms of
msarance are. based upon this. presumption. For. example, people would rather "lose" a
$I,000 car insurance premtum for sure, than nsk having to pay $5.000 or more in costs
16CIearlythis' exUmn¢setofaSsumpnonsneednotbetsue.But,ifwecanilustrateSOmeshortcomingsof
morePawls'realisticargumentssetings,withinthissetting,theeitsuggeststhatthereverywellcouldbesimilarshortcomingsin
17 S"mcs the lowest utihty
'" under . Instaunons
. B' (of 11.000) is greater than the lowest utility under
"InstitutionsA" (of 10,000). Note that someone applying Utilitarian Justice would choose "InstitutionsA"
because the sum of total utility for all five people is larger.
Chapter #12 - Inequality and Redistribution
for an accident, even though the chances of an accident are quite low. Taking this into
consideration, John Harsanyi suggested (in contrast to the maximin criterion) that this
choice be made on the basis of "expected utility" which allows the decision maker to
appropriately consider and weigh all possible outcomes, taking into account individual
preferences over risk. The option which is best for a decision maker will ultimately
depend upon his particular risk preferences. But this approach has the appeal of allowing
a decision maker to account for both desirable and undesirable aspects of the uncertain
outcome, instead of placing all weight on the least desirable outcome.
Looking at Table 12.6, recognize that if each of the five positions is equally
likely, the expected income under "Institutions A" is $80,000. (Expected income is the
mean value or average value of income. In this example, if you average all incomes for
"Institutions A," you get $80,000.) Now suppose that we could implement "Institutions
C" which result in all five members of society having an equal, common income of $ C
per person - this option has no uncertainty or risk whatsoever. Consider a choice
between "Institutions A" and "Institutions C." Using the maximin criterion of Rawis,
"institutions C" is preferred to "Institutions A" for any value of C greater than $10,000.
In contrast, the better choice under the expected utility approaeh depends upon the
specific risk preferences of the decision maker.Is For most people, it would seem
reasonable to prefer the uncertain outcomes associated with "Institutions A" if C is only
slightly above $10,000 but to prefer the certain outcome associated with "Institutions C"
once C is sufficiently close enough to $80,000. Again, any decision maker who would
choose "Institutions A" for any value of C above $10,000 is expressing preferences
which violate the maximin criterion advocated by Rawls.
The Labor Theory of Value
Another argument in favor of income redistribution comes from Karl Marx's
critique of the Capitalist system. Recall, as discussed in Chapter 2, that goods and
services are created from inputs - broadly land, labor, and capital - through a process
called production. In a pure free market system which respects property rights (as
discussed in Chapter 3), the owners of these factors of production are paid wages and
rents in proportion to the contribution to the production process of the resources whieli
they bring to the table. Thus, for a production process which uses some labor, some land,
and some capital, some portion of the economic surplus generated by the production
process will be earned by the workers, by the land owners, and by the capitalist (i.e., the
owner of the capital). For example, if a production process generates $10,000 of
economic smplus, markets will set prices for the various factors of production to
determine how this total gain is split between the various owners of the inputs. Perhaps
workers earn $3,000, land owners earn $2,000, and capitalists earn $5,000. The specific
~t Within economics, Expected Utility Theory is the standard, accepted approach for analyzing such
choices under uncertainty,Afull treatmeet of this theory (which was first developed by the 18* century
Swiss mathematician Daniel Bernoulli and inUoduced to economics in the mid-20a century by John yon
NeumannandOskarMorgenstens)iswellbeyondthescopeofthepresentdiseuseiun.But,itshouldbe
noted that if a decision maker's risk preferences are mathematieaUy specified (by what is called a Bemoulfi
utility function), preference over "InstitutionsA" versus "Institutions C" can immediately be determined.
 Chapter #12 - Inequality and Redistribution
values are determined by how much of a contribution each input makes to the production
process and what the next most valuable use of each resource is for society.
But, Marx totally rejected the capitalist's view of property rights and assessment
of the production process. In contrast, he felt that the workers were the only ones making
any contribution to the transformation of inputs into outputs. After all, in the short term
they were the only ones doing anything to create the output - the land owners and the
factory owners were just sitting back and extracting part of the value created by the
efforts of labor. This logic led him to further develop the Labor Theory of Value, to
arrive at an assessment of the production process which attributes all economic surplus
generated from production to labor. Under this mindset, the value of a produced good is
measured by the amount of labor used to produce the good.
Viewed from Marx's perspective, business owners (the bourgeoisie) were clearly
exploiting the members of the working class (the proletariat). For example, in the
production process described above which generated $10,000 of surplus, according to the
Labor Theory of Value the rightful amount which should accrue to the workers is the full
$10,000. But in a free market system, the owners of the other inputs (land and capital)
need to be compensated in order to supply their resources. Consequently, they must get a
portion of the $10,000, thereby making it impossible for the workers to get the full
$10,000 to which Marx felt they were entitled. To eliminate this perceived injustice,
Marx advocated a complete abandonment of the property rights based system of free
markets. To a lesser degree, many present day believers of the Labor Theory of Value
call for signlfieent government redistribution within a mixed economy.
Mainstream economists reject the arguments upon which Marx's Labor Theory of
Value is built. Instead of thinking that the value of output depends upon the amount of
labor used in the production process, it is more reasonable to argue that the value depends
upon benefits to consumers. These benefits are reflected by output price set in a free
market, which depends critically upon buyers' reservation prices. Also considering the
production side of the situation, a further counterargument is clear from the description
above. Are workers the only ones who bring something to the table with respect to the
production process? Clearly not, or else they could go it alone end produce the output
without any lend or capital. In reality, autoworkers need a factory in which to build cars
end a factory needs land where it can be built. In a market based system, the owners of
these resources must be paid wages and rents in order to create the inputs (e.g., to build
the factory) or to allow the inputs to be used for a particular production process (e.g., to
ns¢ the land for.a f ac!ory instead offer fanning). On any particular day if we stop by the
raetory n may lOOK like the owners of land and capital are just sitting back while the
workers are doing all of the heavily lifting. But, such a simplistic assessment fails to
acknowledge the important contributions of the lend owner and capitalist in both the
current period end in previous periods. In the current period they are allowing the
resources which they rightfully own to be used for this particular production process
.instead offer SOmething else. This contributes to the creation of economic value. More
maportantly, the factory did not just appear out of thin air. For example, in order for a
Kin factory to exist in West Point, GA someone had to build the factory there. When
doing so, the owners of Kin Motors assumed a great deal of risk (the factory is not
Chapter" #12 - Inequality and Redistrlbution
guaranteed to produce products which can be proftably sold) and tied up financial assets
that could have been invested elsewhere. From the Capitalist's perspective of property
rights, it is only fair that the owners of these resources be paid a return for providing them
to the production process.
Overcoming the Free Rider Problem
A final argument in favor of government redistribution is that having the
government mandate redistribution in this manner essentially allows members of society
to overcome a free rider problem. It seems reasonable that people could have preferences
over the poverty rate or the distribution of income for the society in which they live.
More precisely, suppose that everyone derives some individual satisfaction from the
poverty rate being lower. In this case, poverty reduction is essentially a public good (as
defined in Chapter 10). It is non-rival in consumption because whatever the poverty rate
happens to be, all households live in a society with that particular poverty rate. So, if the
poverty rate is reduced from 12% to 10%, all households enjoy the warm fuzzy feeling of
living in a society with less poverty. Further, it is non-excludable because as poverty is
reduced, all households enjoy the resulting benefits of the reduction even if they did not
contribute financially to the efforts.
Let's start by considering a society that does not have any government
redistribution and instead relies entirely upon voluntary charity. For simplicity there are
only two types of households, impoverished households (with annual income of $11,000)
and middle class households (with annual income of $50,000). Each middle class
household values two things', its own private consumption of goods/services, end
reducing the poverty rate. Suppose the poverty line is $20,000 and initially 10% of all
households are impoverished. If every single middle class household gave $1,000 to a
pool of money that would be redistributed equally to all low income households, we
could give $9,000 to each impoverished household, increasing their income to $20,000
each end reducing the poverty rate to 0%. For the sake of discussion, assume that from
the perspective of each middle income household, the benefits of eliminating poverty
outweigh the $1,000 cost of doing so. Consequently, this proposal would make both
society as a whole and each household in society better off.
But, would we get this outcome if the middle class households were simply asked
to voluntarily contribute $1,000 each (i.e., were not coemod to do so through a system of
government taxes and transfers)? Suppose you are the head of one of these middle class
households - let's think about your decision. Your $1,000 contribution by itself will not
eliminate poverty and might not even raise one single poor household out of poverty.
Therefore, in terms of the benefits that your household derives from reducing poverty,
your $1,000 contribution is almost meaningless. But making a $1,000 euntribution
imposes a significant eust on your household in the form of decreased consumption of
goods and services. Given the high costs and low benefits to your household, it seems
entirely rational to not contribute your $1,000 to reduce poverty. Instead you will
rationally try to "free ride" by keeping your $1,000 and hoping that others in society will
contribute their $1,000 to reduce poverty. Recognize that this logic is identical to that
 Chapter #12 - Inequality and Redistribution
discussed in Chapter 10 when analyzing the flee rider problem in the context of provision
of a fighter jet for national defense. Thus, in the absence of coercive government
redism'bution programs we would end up with less than the socially desired amount of
redistribution, This is not to say that we would have no redistribution by way of
voluntary charity, but rather that we would have too little. As will be noted in greater
detail later in this chapter, government spending on welfare programs to redistribute
income amounts to roughly 6% of GDP. Even in the presence of these significant
expenditures, charitable contributions have hovered between 1.5% and 2% of GDP in
recent decades)9
While this argument for government redistribution is strong, a counterargument is
that government welfare spending "crowds out" or "displaces" private charity. That is, as
government increases funding for these programs private citizens choose to voluntarily
conU'ibute less. To this point, studies have shown that "a dollar in government spending
on nonprofit activities displaces up to 50 cents in private giving" and "if a state increases
its TANF (Temporary Aid to Needy Families) spending by 10 percent, it can expect a
charitable giving decrease of about 3 percent among its citizens.''2° On the one hand, this
could simply be evidence that the government programs are effectively overcoming the
free rider problem. But, on the other hand, it may be that government is spending more
than the socially desired amount or possibly directing resources to initiatives end
recipients that the giver (i.e., the taxpayer) would not choose to support through charity if
he had complete control over how his money was spent.
Disincentive Effects of Redistribution
While we have already touched on some counterarguments to the specific calls for
redistribution outlined above, it is worth noting some additional broad arguments against
altering the levels of income and consumption resulting from a system of flee markets.
To this end, recall the incentive principle from Chapter 1 which conjectured predictable
ways in which people would rationally respond to changes in benefits or costs. In
particular, if the costs ofen outcome are decreased, people are more likely to choose the
outcome. Similarly, if the benefits of an outcome are decreased, people are less likely to
choose the outcome.
If we put policies in place which reduce income inequality by redistribution, we
are effectively lowering the costs of having a low income and lowering the benefits of
having a high income (since, by definition, higher income individuals will have to fund
the programs). In-so-much as the realized level of income is under the control of a
worker, both of these effects will make it less likely that a worker will choose to earn a
high income. In the extreme, if everyone in society was guaranteed the same income
(i.e., an equal portion of the total economic pie), individuals would have very little
I t See.
. Brooks, A., Who Really Cares: the Smprising Truth about Compassionate Conse~atism," (2006),
Basic Books: New York, page 3.
Ibid., page; 58 and 59.
300
Chapter #12 - Inequality and gedistributlon
incentive to work or invest in their human capital. Such disincentive effects of
redistribution can have both short-term and long-term negative consequences for society.
In the short-term, redistribution programs reduce the incentives for individuals to
work and contribute Io the production process. This results in le~ income for the
individual and less output for society as a whole. At the high end of the income
distribution, this results from the higher rates of taxation which must be imposed to fund
the programs.2~ At the low end of the income distribution, this occurs because many
government redistribution programs are means tested, in that to be eligible to receive
benefits the recipient must have an income below a certain level. Thus, ifa low income
worker takes the initiative to earn extra income, she has to give up some of her welfare
benefits. Clearly this reduces the incentive for the individual to do so. Consequently,
many policies intended to help low income households have the unintended consequence
of discouraging them from escaping poverty on their own. This problem is often referred
to as a poverty trap.
In the long-term, the presence of redistribution programs also alters costs and
benefits in a way that influences decision making, particularly in regards to choices
related to investments in human capital. A worker's earnings potential depends upon
accumulated experience end education. Over the course of a lifetime, investments in
these two attributes are often made when young. Consider your choice of college major.
For most people this choice is likely made by balancing various perceived benefits and
costs of different occupations. In a free market system, salaries of different occupations
are determined in large part by the valua that consumers place on the output which the
worker helps to produce. Additionally, salaries depend in part upon how enjoyable (or
unenjoyable) workers fred different jobs to be (recall the discussion of compensating
differentials earlier in this chapter).
Suppose you are considering a choice between majoring in Architectural
Engineering or Art and Design. To simplify the discussion, assume you are equally
gifted in both areas, but expect that in term~ of future (noo-monetary) job satisfaction you
would prefer to have a job which requires an Art and Design deg~e. The typical mid-
career salary for someone with an Art and Design degree is $66,200 end for someone
with an Architectural Engineering degree is $95,100.2 Again, the individual end social
decisions which determine how many people we will have working in each field end how
much people in each field earn are greatly influenced by both the value that consumers
place on the outputs produced by the workers end by the job attn'butes within each
profession. But recognize that, absent any market failures, flee markets should allocate
workers across each profession in a way that maximizes total social surplus. However, as
we equalize incomes by way of redistribution, we ultimately discourage people from
pursing the Architectural Engineering degree (and other higher paying degrees such as
2t See the final section of Chapter 13 for further discussion of the disincentive effects of taxation.
n These m' median salmies for worke~ wlth the indleated degree and 10 01- morn years of work
experience. See: hlu~s:/A~..twn,scole.com/colle'ce-salan~reoort/maiors-that-ocn~ou-
back/bachelors?oaee=33. Contrary to popular characterization, Philosophy majors have a very respectable
told-career median salary of $85,t00 (sfightiy above the $84,900 earned by people with a Marketing
degree),
301
 Chapter #12 - Inequality and Redistribution
Applied Mathematics, Physics, and Economics) and encourage them to pursue the Art
and Design degree (and other lower paying degrees such as Sports Management, Theatre
Arts, Dance, and Social Work), The argument is not that these latter majors do not have
value, hut rather that a free market will likely give us the ideal mix of workers across
professions from the perspective of maximizing total social surplus (as discussed in
Chapter .5). Thus, redistribution policies divert us away from this socially best outcome,
as people choose professions without having to incur the full cost (in terms of decreased
earnings potential) of their choice.
Libertarian Justice
Finally, some opponents of income redistribution maintain that any attempt to
equalize outcomes is inherently unfair. Instead, a society should establish institutions and
rules which create equality of opportunity and then allow individuals to pursue their own
self-interest. This viewpoint - which is in stark contrast to that taken by those who
advocate a pursuit of equality of outcomes - is perfectly in-line with the Capitalist's view
of property fights and consumer sovereignty (discussed in Chapter 3).
More formally, Libertarian Justice (also known as natural rights) is the
argument that the fairest distribution of income and consumption is that which results
when the government establishes and enforces a legal code which respects all voluntary
economic interactions between individuals in society. In such a system, the government
sets rules of the game which place the utmost respect on individual property rights and
choices and then simply acts as the referee. Individuals are presumed to have an
unquestioned legitimate property right over the resources and talents they are endowed
with and can use them however they see fit. No attempt is made by the government to
redistribute incomes or to tilt the outcomes in favor of one individual (or group of
people).
Many of the core philosophical principles of this position were formulated by
Robert Nozick in his book "Anarchy, State, and Utopia," published in 1974, which many
view as a dilect response to Rawi's "A Theory of Justice." Whereas others (e.g.,
Bentham, Mill, Pawls, and even Marx) attempt to determine what distribution of income
is best, Nozick and the proponents of Libertarian Justice deny the validity of the question.
In contrast, they focus on the process and not the outcomes, arguing that as long as the
institutions provide a level playing field, the resulting distribution of income is fair and
just, not matter how equal or unequal. Toward this end, government has a legitimate role
in establishing and enforcing rules to ensure that everyone has the same opportunity to
use their talents and resources. But, once the roles are established, government has no
reason (in fact, no legitimate right) tu manipulate the resulting distribution of incomes.
REDISTRIBUTION POLICIES
Now that we have an understanding of some of the varied abstract arguments in
favor of and against redistribution, we turn our attention to specific practical policies.
Chapter #12 - Inequality and Redistribution
Ultimately, members of households derive satisfaction from consuming goods and
services, not from having money per se. But since money serves as a medium of
exchange, we readily see that there are two general ways to expand the consumption
opportunities of a household. Consider a family of two adults and two children with
household income of $20,000 (below the relevant 2017 poverty threshold of $24,858 set
by the U.S. Census Bureau). Suppose that we are concerned that they might not have
access to enough food and want to do something to ease this shortcoming. On the one
hand, we could simply give them food; on the other hand, we could give them money that
they could then use to purchase food. The former policy is one which directly gives them
the thing we think they need, while the latter policy is one which indirectly gives them
the thing we think they need by increasing their ability to purchase it in the marketplace.
Redistribution in-kind refers to a transfer of a good or service to someone which
directly increases their consumption of the item. In contrast, income support refer~ to a
transfer of money to someone which indirectly increases their consumption of goods and
services.23
In the United States we presently spend a significant amount of money on
government welfare programs to redistribute income and consumption to the poor. As of
2012, government spending (federal, state, and local combined) on such programs was
roughly $952 billion. This is approximately 6% of GDP and roughly $20,610 for every
poor person in the country.24 Our present approach to welfare is convoluted. There are
126 distinct federal programs, many of which overlap each other in regards to mission
and beneficiaries. The bulk of these welfare programs are means tested, so that to qualify
for benefits the recipient must have income below a certain threshold. Table 12.7 lists
the 15 Federal Government welfare programs with annual spending over $5 billion.-'5
This list focuses specifically on programs aimed at assisting low income households and
does not even include the two largest federal government redistribution programs: Social
Security, which provides retirement benefit payments (to roughly 40 million people at an
annual cost of $888 billion as of 2015), and Medicare, which provides healthcare to the
elderly and disabled (to roughly 55 million people at an annual cost of $.546 billion as of
2015).26
Within Table 12.7 we see a mix of redistribution, both in-kind and income
support. For example, Medicaid (established by the Social Security Act of 1965 under
President Johnson) is an in-kind transfer program providing medical care for households
with low incomes. The Maternal/Infant/Childhood Home Visiting Program and
Children's Health Insurance Program also provide in-kind healthcare services to
Another policy which is intended to manipulate the income distn'butinn for the benefit of low income
workers is the minimum wage (n specific type of price floor, u discussed in Chapt~ 8). Additionally. the
distribution of income is made more equal by the imposition of progressive taxes, such m the U.S. Federal
Income Tax. A detailed discussion of the degree to which this tax reduces income inequality (as measured
by the Pechmen-Okner Coefficient) is presented in Chapter 13.
Tanner, M. (20121, "The American Welfare State: How We Spend Nearly $ I Trillion a Year Fighting
Poverty - and Fail," CATO Institute, huv://obiect.cato.or~/sitesYCato.org~lcs/tTub.~/tTd/~PA694.~clf
tbid,, pages tl-12.
:t, See "Policy Basics: Where Do Our Federal Tax Dollars Go?;" Center on Budget and Policy Priorities.
ht~:/A~ww.~bD~.~r~re`ve~rch/f~dera~-bud¢e~/po~i~3~i¢s~wher~-d~..~ur~d~ra~-w~g`~2~[~rs~;~`
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistribution

recipients. Similarly, the Supplemental Nutrition Assistance Program (SNAP, which Families with Dependent Children (AFDC) welfare program. TANF provides direct cash
used to be known as "food stamps"), the National School Lunch Program, and payments to beneficiaries, hut limits benefits to a total of 60 months over a recipient's
Supplemental Nutrition for Women/Infants/Children (WIC) essentially provide in-kind lifetime and requires a recipient to find a job within 24 months of starting benefits (limits
transfers of food to eligible households. Section 8 Housing Choice Vouchers, Very Low which were not part of AFDC). These welfare reform measures are considered by many
to Moderate Income Housing Loans, and the Adjustable Rate Mortgage Program each in
to be one of the most successful changes in government policy in recent decades, and
effect reduce the cost of housing for low income individuals. Likewise, Federal Pell have broad support from economists: recall (again from the discussion in Chapter 1), that
Grants, Title 1 Grants to Local Education Agencies, and Head Start increase access to 74% of economists agree with the statement, "Welfare reforms which place limits on
education for eligible low-income recipients.
public assistance have increased the general well-being of society."
In addition to these in-kind redistribution programs, the federal government also Another important component of income support in the United States is
provides a significant amount of income support. The Famed Income Tax Credit is a unemployment compensation. To be eligible for this redistribution program an individual
Federal Income Tax Credit available to lower income families with children, which must be currently unemployed (i.e., without a job but actively seeking one) and must
directly reduces the tax liability of eligible workers. As a consequence of this credit, have had his previous employment terminated through no fault of his own - that is, you
some households end up with a negative tax liability, meaning that instead of having to cannot quit your job and start collecting benefits. A distinct and unique unemployment
pay income taxes they end up getting a check from the Internal Revenue Service (for an compensation program is administered by each state, with funding coming flora a
amount above and beyond any withholdings for Federal Income Taxes over the course of combination of federal and state payroll taxes. Each state has flexibility in designing the
the year). Supplemental Security Income is a cash transfer program which provides specifics of its program, but must adhere to a set of broad federal guidelines. Benefit
monetary payments to low income elderly people who have low entitlements under levels range from state-to-state, but typically provide individuals with payments roughly
traditional Social Security programs. equal to 45% of their previous earnings. The standard length of eligibility is 26 weeks
(but this cutoff is often extended during recessions when it is presumably more difficult
Table 12. 7- Most Costly U.S. Federal Government Welfare Programs for unemployed individuals to fred work). Unemployment compensation essentially
provides workers with an insurance policy, sheltering them from one of the adverse
Program Annual Cost Number of Partlclpants effects of the business cycle in a market economy. As with all other income support
Medicaid $228.0 billion programs, payments are made without any strings attached (i.e., no restrictions on what
48~900,000
Supplemental Nutrition Assistance Program $75.0 billion the recipient can or cannot do with the funds).
44p200~000
Earned Income Tax Credit $55.0 billion The discussion thus far not only reInforces the importance of money for achieving
27,000,000 households material well-being, but also reminds us that money is a means to an end (not an end in
Supplemental Security Income $43.7 billion 8,100,000 itself). The fact that money is so effective at expanding consumption opportunities in a
Federal Pell Grants
$41.0 billion 9~614,000 market economy - at low levels of income, granting access to basic necessities - is no
Temporary Assistance for Needy Families $21.0 billion 4~492,000 (monthly avg.) doubt what prompted Oscar Wilde to observe that, "There is only one class in the
Section 8 Housing Choice Vouchers $18.1 billion 2,000r000 households community that thinks more about money than the rich, and that is the poor. The poor can
Very Low to Moderate Income Housing Loans $16.7 billion 131,370 (units) think of nothing else," and Abha Lemer to observe that "the main problem confronting
Title 1 Grants to Local EA,matlon Agencies $14.1 billion U.a. the poor is that they have too little money."
Children's Health Insurance Program $13.5 billion 7,705~723 Moreover, if what we actually care about is the well-being of the recipient, then
National School Lunch Prom"am $10.9 billion income support is most likely more effective than redistribution in-kind. Recall (again
31)000,000
Adjustable Rate Mortgage Prepare $10.6 billion from the discussion in Chapter 1) that 88% of economists agree with the statement, "Cash
Maternal/Infant/Childhood Home Visiting Program 43)687 (units)
$7.5 billion payments increase the welfare of recipients to a greater degree than do transfers-in-kind
Supplemental Nutrition for Women/infant.s/Children o.a.
$7.2 billion 9,180,000 of equal cash value." While this position might at first be unsettling to some, the claim is
Head Start $7.1 billion actually quite natural and obvious. To see why, suppose that a few days before your
904)000
birthday you get a card in the mail from your grandmother. Based on past experience
Temporary Assistance for Needy Families (TANF) - another federally funded you know that it contains either a check for $50 or a $50 Barnes and Noble gift card.
income support program - is probably what comes to mind for most people when they Before you open the envelope, which one arc you hoping for? We can answer this
hear the term "welfare." This income support program, created in 1997 as part of the question by first identifying your best possible use of an extra $50.
welfare reform initiatives passed by Congress under the leadership of Rep. Newt There are really only two possibilities regarding what you would choose to do
Gingrich and signed into law by President Bill Clinton, replaced the previous Aid to with an additional $50 of cash, you would either: (i) spend it all to buy stuff at Barnes

Chapter #12 - Inequality and Redistribution
and Noble or (ii) not spend it all to buy stuffat Barnes and Noble. Choosing "option (ii)"
might entail saving some (or all) oftbe $50, spending all of the $50 but only using some
of it to buy stuff at Barnes and Noble, or spending all oftbe $50 and using none of it to
buy stuff at Barnes and Noble. If your best possible use of an extra $50 is "option (i),"
then you should be completely indifferent between getting $50 cash or a $50 Barnes and
Noble gift card (one is no better or no worse than the other). In contrast, if your best
possible use of an extra $50 is "option (ii)" (maybe you would want to spend $50 on
tickets to a rock concert, which you cannot buy at Barnes and Noble), then you should
strictly prefer to get $50 cash. In this case, your well-being as the recipient of the git~ is
increased more by getting money than by getting a restricted in-kind transfer of equal
cash value.
These exact same forces are at play when considering either transfers of money or
transfers of goods or services to low income recipients. If we are considering a transfer
of either $200 of food or $200 of cash to our low income family of four, which would
they (as the recipient) prefer? The clear answer is $200 of cash. If their best use of this
additional $200 of cash is $200 of food, then they are no worse off with the cash. If
instead their best use is something other than $200 of food (maybe $120 of food, $30 of
clothing, and $50 spent going to the movies), then they are better offwith the cash.
So, if the well-being of the recipient is increased more by direct transfers of cash,
why do we rely so heavily on in-kiod transfer programs?2? It could simply be that some
people are paternalistic and do not trust welfare recipients to make "good" purchasing
decisions on their own (i.e., "You don't know what is good for you"). But it could also
be that when contemplating redistribution policies, many people in society likely care
about more than just the well-being of the recipient of the transfer.
First, the person funding the transfer might have preferences over the types of
support they would like to offer to the recipient. This is clearly true in the context of
standard gift giving - your grandmother may very well want to cultivate your reading
habit but not your concert going. Taking into acoouat her preferences, she may rationally
choose to give you the Barnes and Noble gift card instead of cash (even if she knows that
you would prefer cash). Recognize that this is fundamentally different than a belief of
"You don't know what is good for you" - it is more accurately encapsulated by a
statement along the lines of, "You know what is good for you, but I'm not willing to pay
for that; I'm only willing to pay for what I think is good for you." Similarly, voters may
be willing to elect politicians to enact certain in-kind redistribution programs (for goods
and services that they think are worthwhile) but not programs which would provide
unrestricted cash payments of equivalent amounts. In line with the philosophical tenets
of Capitalism, which respect property rights and decision making of the individual, there
is nothing inherently wrong with such preferences.
Second, the person funding the transfer might not actually want to provide
support for the recipient of the transfer but might instead want to provide support for a
z~ Co ec ively, $569.4 billion is spent on the 15 programs listed in Table 12.7. Of these programs, only the
Eanaed Income Tax Credit, Supplemental Security Income, and TANF provide predominantly income
support (as opposed to in-klnd transfers). Collectively, these thre programs account for only $119.7
billion of spending (just over 21°/, ofth© total across all programs listed in Table 12.7).
Chapter # 12 - Inequality and Redistribution
member of the same household. Again, consider the family of two adults and two
children with household income of $20,000. Why does this family have a low income?
As discussed earlier in this chapter, an individual's realized income depends on some
factors that are under his control and some factors that are beyond his control. This being
!
said, whether or not a person's income is above or below the poverty line is often highly
dependent upon a combination of factors primarily under the control of the individual.
As noted by Political Scientist William Galston (a former domestic policy advisor to
President Bill Clinton), "You need only do three things in this country to avoid poverty -
finish high school, marry before having a child, and marry after the age of 20. Only 8
percent of the families who do this are poor; 79 percent of those who fail to do this are
poor." This observation suggests that someone could reasonably make the argument that
the adult members of the household are very likely living in poverty primarily because of
choices which they themselves made. But, a person who takes this position would not
argue that the children in this household are in any way responsible for their economic
situation. Someone who holds such views could very well want to provide assistance
primarily for the minor children in this household (while not providing unrestricted
Ill assistance for the head of household). In practice this could be accomplished by the
availability of in-kind transfers through the Children's Health Insurance Program,
Ill National School Lunch Program, WIC, and Head Start (in lieu of monetary income
all support). Again, if one holds to the view that the taxpayers funding these programs have
D a legitimate right to decide how their tax dollars should be spent, there is nothing
fundamentally wrong with imposing such restrictions.
lip But, it must be recognized that providing in-kind redistribution is much less
efficient than simply transferring cash. Due to the complex administrative bureaucracy
gll necessary to implement such programs, "it takes approximately 7 tax dollars to get 1
additional dollar of income into the hands of a poor person.''zs Because of such
D tremendous inefficiency and waste - coupled with the appeal of letting people
Ill individually decide how to spend money to satisfy their own wants - in recent decades
there has been growing support for revolutionary reforms to the entire approach of
roll redistribution. In particular, proposals to replace traditional welfare programs with a
I "negative income tax" or a "guaranteed minimum income" have received serious
consideration and support from both academies and policymnkers.
Again reeailing the views of economists discussed in Chapter 1, 85.3% of
economists agreed with the normative prescription that, "The government should
restructure the welfare system along the lines of a 'negative income tax.'" A negative
income tax is a tax structure under which taxpayers with incomes below a certain
threshold receive a transfer payment from the government instead of having to pay taxes
to the government. For a very simple example, suppose that we have an income tax
under which total tax liability (T) is computed based upon income (I) according to the
2 s F r a n k , I L , " M i c r o e c o n o m i e s a n d B e h a v i o r, " 6 t ~ e d i t i o n ( 2 0 0 6 ) , M c G r a w - H i l l I r w i n , B o s t o n , p a g e 6 6 8 .
 Chapter #12 - Inequality and Redislribution
following formula: T=(I-40,000X.10). According to this formula, taxes due at
various income levels are given by Table 12.8 below.29
Table 12.8 - Tax Liability under a Simple Negative Income Tax
Income $20,000[$30,0001540,000 $50,000 $100,000 I $200,000I
Tax Liability -$2)000 -$1)000 $0 $1,000 $6,000 $16,000
According to this formula, workers earning above 540,000 have to pay some of
their income to the government in taxes. A worker earning exactly 540,000 "breaks
even" and does not have to pay any income taxes (but does not receive a payment from
the government). Those workers with incomes below $40,000 receive a monetary
transfer payment from the government in place of having to pay taxes to the
guvemment.30
This type of tax stroctur'e (and the term negative income tax) was first developed
by the British politician Juliet Rhys-Williams in the 1940s. Like later proponents - such
as Nobel Prize winning economist Milton Friedman - she argued that a tax structure of
this type could serve to equalize incomes in-line with the preferences of society, in place
of a minimum wage and other government in-kind transfer programs. In some respects,
the Earned Income Tax Credit (first established as part of the U.S. Federal Income Tax
code in 1975, and subsequently expanded over time) functions similarly to a negative
income tax.
Another radical proposal which has gained growing support in some countries
more recently is a guaranteed minimum income, a program which would provide each
person in society with a large lump-sum payment every period. For example, starting in
January 2017, Finland introduced a limited scale, temporary pilot program in which
2,000 people received payments of about $680 per month (i.e., about $8,160 per year),sl
Similarly, in June 2016 voters in Switzerland considered (but rejected) a proposal which
would have given every adult roughly $2,577 per month (i.e., $30,924 per year),n
29F or example, a worker w,th
. . income ofl-50.O00 would have to pay (50.000 - 40,000)(. 10) =
(10,000)(.10) = 1,000 in taxes, while t worker with income ofl=30,O00 would have a negative tax liability
of (30,000-40.000)(.10) - (-10,000)(.10) =_1,000. This means the lower incoroe workar is reeniving
$1,000fromthegovernment,whilethehigherincomeworkerpays$1,000tothegovernment.
~e This particular formula is given only as a simple example. Obviously, the specific income cotoffbcinw
endabovewhichtaxesduebecomepositive,aswellastherelevantMarginalTaxRate(seethediscussion
i31
n-linei
nChapt erwithl3desiresforspreciseofpolicymakers.definiti°nofthisterm)couldbealteredtomanipulatethedistributionofincome
SeeFminnd
' " Wants to Rep ace We fare Programs With t Minimum Income forAll Residents," by E.N.
Brown,December7,2015(bun://reason.com/bloW2OiS/12/OT/finland.to.test.basic.income.euproo~;T)'
and 'q'he Lapsing of Finland's Universal Basic Income Trio No Finnished,"Ari126 201
~co,ne-tri#O.
)2 S '
ee'Swzsstovoteonguaranteadincomeforall-january27,2016
(b't~"/Agwa"thel°cal'ch/20160127/swis'~'tO'v°te'°n'~ruaranteed'ineome-for-al~ and Van Patijs, p. & y.
Chapter #12 - Inequality and Redlstribution
Many (but not all) of those who advocate for such a guaranteed minimum income
propose that such benefits be given in place of all other welfare benefits (i.e., all other
social welfare programs, including unemployment compensation, retirement pensions,
bealthcare subsidies, housing subsidies, and maternity leave, would be eliminated) and
without any behavioral restrictions on eligibility (e.g., it would not be neoeasasy for a
recipient to document that he is actively seeking employment in order to be eligible to
receive benefits).
Proponents of both the negative income tax and guaranteed minimum income
highlight the fact that each proposal could easily eliminate many of the bureaucratic
inefficiencies associated with current welfare programs. Consequently, it would no
longer take $7 of spending to get $1 of benefits in the hands of a recipient. However,
such proposals (like other income support programs, as opposed to redistribution in-kind)
would essentially provide money to people without any strings attached. This is viewed
positively by those who are willing to allow recipients to maximize their own wefi-being
however they see fit, but is viewed negatively by those who think it is better to have some
restrictions on the choices of welfare recipients (who, after all, will spend the money
unwisely).
Moreover, some try to argue against these proposals by highlighting the likely
disincentive effects of simply giving people money. For example, if Finland were to
indefinitely give all adult couples the option of gutting $16,320 per year ($8,160 each), it
would clearly make it so that some people who are able to work will choose not to do so.
But, as already noted, all redistribution programs have disincentive effects to a degree. It
is not immediately clear whether the disincentive effects of these two sweeping proposals
would be greater or less than similar effects present under our current system of means
tested welfare programs. Keeping in mind that we presently spend about $20,610 on
welfare for every poor person in the country, it seems like we might be able to very well
do a much more effective job (from the standpoint of both the recipient and the taxpayer)
by instead replying on something like a negative income tax or guaranteed minimum
income.
Vanderborght,"Be.slc Income:ARadical Proposal for a Free Society end a Sane Economy." (2017),
HarvardUniversityPress,Cambridge,MA,pages208-209.
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistributlon

C H A P T E R # 1 2 M U LT I P L E C H O I C E Q U E S T I O N S B e t w e e n 1 9 6 7 a n d 2 0 1 6 , f o r t h e U . S . t h e v a l u e o f t h e G i n i C o e f fi c i e n t
while the value of Real Median Household Income
1. Examining how Real (i.e., inflation adjusted) Household Incomes have changed A. increased from .397 to .481 ; increased from $44,895 to $59,039.
between 1967 and 2016, mean household income of the "bottom 5th of all B. increased from 1.245 to 1.397; increased from $28,493 to $61,886.
households" while the mean household income of the "top 5th of all C. increased from .367 to .728; decreased from $61,984 to $57,994.
households" between these years. D. decreased from .452 to .384; decreased from $53,945 to $49,643.
A. decreased from $29,819 to $25,994; decreased from $89,223 to $64,431.
B. decreased from $31,928 to $18,510; increased from $458,480 to $652,784. is a broad term which refers to a transfer of a good or service
C. increased from $42,381 to $50,047; decreased from $157,518 to $104,665. to someone which directly increases the amount of the item they are able to
D. increased from $10,054 to $12,943; increased from $176,675 to $375,088. consume.
A. A Compensating Differential
2. were two of the central figures in the formulation of the ideas of B. Redistribution In-Kiod
Utilitarian Justice, which argues that total social welfare can be increased by C. Income Support
income redistribution, so long as people have a diminishing marginal utility for D. Income Taxation
money.
A. Karl Marx and Friedrich Engels states that the fairest distribution of income and
B . Jeremy Bentham and John Stuart Mill consumption is the one realized when the government establishes and enforces a
C . Max Lorenz and Corrado Gini legal code which respects all voluntary economic interactions between individuals
D . John Harsanyi and Robert Frank in a society.
A. Rawlsian Justice
3. Suppose that the Lorenz Curve for the U.S. in 2018 lies completely below the B. Utilitarian Justice
Lorenz Curve for Sweden in 2018. This implies that C. Libertarian Justice
A. Per Capita Incomes are higher in Sweden than in the U.S. D . Labor Theory of Value
B. Per Capita Incomes are higher in the U.S. than in Sweden.
C. .incomes are distributed more equally in Sweden than in the U.S. is defined as the flow of money earned by an individual during
D. mcomes are distributed more equally in the U.S. than in Sweden. a period of time.
A. Human Capital
4. wrote A Theory of Justice (1971), in he argued that a "social B. Income
c o n t r a c t " d e s i g n e d b eah'veil
i n d 'of" lguorance
" ,, would arm to, maxma~e
, . the well- C. Wealth
being of the worst-off member of society." D . The Lorenz Curve
A. John Rawls
B. Karl Marx Based upon the World Bank's poverty threshold of iocome of $1.90 per day,
C. Max Lorenz between 1981 and 2015 the global poverty rate
D. Robert Noziek A. increased drastically from 14.7% up to over 50*/..
B. increased moderately from 26.5% up to 30.8%.
5. Charles' income is higher than Debbie's income. Two of the notable differences C. decreased slightly from 61.5% down to 58.7%.
between their jobs are that Charles must work outside year round (even when it is D. decreased drastically from 44.3% down to less than 10%.
very hot in the summer and very cold in the winter) and Charles runs a greater risk
of being injured (or even killed) on the job. These observations would suggest that In 1960, 12% of all U.S. households had air conditioning. In contrast, by 1997,
the difference in incomes between the two individuals is of U.S. households below the poverty line had air conditioning.
A. a consequence of Debbie being paid a wage rate below the minimum wage. A. 9%
B. due to gender discrimination. B. 14%
C. an indication of the Labor Theory of Value. C, 33%
D. a compensating differential. D, 70%
 Chapter #12 - Inequality and Redistribution Chapter #12 - Inequality and Redistribution

12. Betwcan 1959 and 2016, the poverty rate in the United States has ranged between a 16. In June 2016, voters in Switzerland considered (but rejected) a proposal which
A. minimum of 19.8% in 2002 and a maximum of 33.1% in 1962. would have
B. minimum of 11.1% in 1973 and a maximum of 22A% in 1959. A. paid all adults a guaranteed minimum income of roughly $30,924 per year.
C. minimum of 8.5% in 1959 and a maximum of 25.2% in 2016. B. made it illegal to be unemployed.
D. minimum of 0% in 1979 and a maximum of 18.9% in 2008. C. mandated that all workers in the country earn the exact same income ($50,000
per year).
13. As of 2012, govermnent spending on welfare programs in the U.S. was roughly D. taxed all future inheritances at a rate of 100%.
A. $156 billiun (about 1% of GDP).
B. $302 billion (about 2% of GDP). 17. Consider a country which imposes a "negative income tax" according to the
C. $952 billion (about 6% of GDP). formula: T= (I - 50,000)(.20). Under this tax,
D. $2,476 billion (about 16% of GDP). A. someone earning $50,000 receives a $10,000 transfer payment from the
government.
For qRestians 14 and 15, refer to the graph below, which illustrates the Lorenz Curves B. everyone has to pay exactly 20% of all income earned in taxes.
in aConntry Xn and "Country Y" in 2018. Note that the Lorenz Curve for "Country Y" C. someone earning $100,000 has to pay $ I 0,000 of taxes.
starts oat below b~t eventually intersects and passes above the Lorenz Carve for D. low income earners have to pay taxes, but high income earners receive
"Coanty X. " transfer payments from the government.
CFI
1- 18. As of 2017, the poverty threshold in the U.S. for a family of four consisting of two
adults and two children was
A. $1.50 per day.
B. 12.7%.
C . $24,858 per year.
D . None of the above answers arc correct.

19. The Labor Theory of Value, which states that the value of a con'lmodity depends
upon only the amount of labor required to produce the conunodity, is most closely
associated with the ideas of
A . Oscar Wilde.
0 1 CFP B. Max Lorenz.
C . Milton Friedman.
0 1 D. Karl Marx.
14. These curves provide a graphical illnstration of the
in each country.
A. poverty rate 20. Which of the following pieces of legislation wezc part of the "War on Poverty"
B. level of welfare benefits launched by President Lyndon Johnson in the mid-1960s?
C . scope of government redistribution A. Economic Opportunity Act of 1964.
D . distribution of income B. Elementary and Secondary Education Act.
C. Social Security Act of 1965.
15. Suppose (Area A)=(.19), (Area B)=(.07), and (Area C)=(.04). It follows that the D. More than one (perhaps all) of the above answers is correct.
value of the Gini-Coefficient is
A. .08 in "Country X" and.14 in "Country Y." 21. To be eligible to receive a means tested benefit, a recipient must
B. .23 in "Country X" and .26 in "Country y." A. show that they arc seeking employment and not using recreational drugs.
C. .27 in "Country X" and .24 in "Country y." B. be over a certain age.
D. .46 in "Country X" and .52 in "Country Y." C. agreed with the Rawlsian Justice argument for redistribution.
D. have income below a certain level,
Chapter #12 - Inequality and Redistribution

Assessing Taxation
/ Outcomes
"You don't even pay taxes, they take taxes."
- Chris Rock

Governments impose taxes primarily to achieve some combination of the

following three ends: (1) to collect revenues to finance government spending, (2) to alter
the behavior of households or fu-ms, and (3) to alter the distribution of income. Within
this chapter we examine several different issues related to taxation in order to acquire a
conceptual and practical understanding of how taxes achieve these ends and, more
broadly, how taxes influence economic outcomes.
It is useful to recognize that, in general, if something is taxed we will tend to get
less of it. We saw this from our analysis of per unit taxes in Chapter 11. For example, if
we impose high taxes on cigarettes people will smoke less. Similarly, if we increase
taxes on gasoline people will drive less. This is exactly what allows governmants to
modify behavior by imposing taxes, but, as we saw, has important implications for the
degree to which taxes can effectively generate revenue for the government.
Throughout our discussion we should keep in mind an important characteristic of
taxes illustrated by comedian Chris Rock - taxes are not voluntary payments made by
households and firms, but rather are legally required and imposed by the government.
When a worker pays his income taxes to the government (or more commonly - as
reinforced by the quote above - when a worker has income taxes taken from his
paycheck before he even gets it) he is not engaging in a voluntary transaction and
exercising his eousurner sovereignty (as discussed in Chapter 3). Rather, he is very likely
motivated in large part by the fact that he is legally required to pay taxes and failure to do
so could result in the government fining him or throwing him in jail) Thus, when
government imposes a tax, even to finance an activity which a taxpayer perceives as
having value, there is no immediate guarantee that the taxpayer is better offas a result of
this "transaction" (i.e., for this non-vohintary "transaction" between the taxpayer and the
government, it need not be the case that the benefits to the taxpayer are greater than the
costs imposed on him). Recognize that this is in stark contrast to voluntary market
transactions in which buyers and sellers choose to engage only in exchanges which
generate a positive surplus for them individually.

IR eeall the thseuss

. on of the thfferent broad types of econormc
. . uaeentives in Chapter 3. The possibifity of

a t'me is essentially a material punishment (i.e., the opposita of a material reward), while the possibility of
being throvcla in jail is essentially coercion.
 Chapter #13 -Assessing Taxation Outcomes
We begin by discussing notions of equity (that is, fairness) in regards to taxation.
Within this presentation we define the concept of Average Tax Rate and the related
classifications of a tax as Proportional, Progressive, or Regressive. Next, the concept of
Marginal Tax Rate is defined, and it is shown how an examination of Marginal Tax Rates
can often make it easy to classify a tax as either Proportional, Progressive, or Regressive.
We then shift to a detailed examination of the different outcomes that have resulted fi'om
the U.S. Federal Income Tax both presently and over the past century. Historical values
of the $troup Coefficient of tax prograssivity and the Pechman-Okner Coefficient of
tedistribotive capacity are presented for the U.S. Federal Income Tax in order to gain
further insights into how this tax has evolved over time. We conclude by discussing how
taxes impact individual incentives and the related concept of the Laffer Curve.
N O T I O N S O F TA X FA I R N E S S ( O R E Q U I T Y )
Regardless of how little or how much revenue government raises, we can all
likely agree that government should do so with a tax system that is equitable or fair. But,
what exactly do we mean by a fair tax?z In many situations it would seem fair for the
recipients of the benefits of a government program or project to provide the fimding for
its provision. One could also argue that funding for government programs or projects
should in some way be based upon a taxpayer's ability to pay (i.e., how easily the
taxpayer can bear the burden of paying taxes). We will define two broad principles to
formalize these notions.
The benefita principle of taxation stipulates that the amount a person pays in
taxes should be related to the benefits he receives from the goods and services provided
by government. Suppose that a municipal government is going to construct and maintain
a dog pare Isabella is an animal lover who enjoys spending time outdoors with her four
dogs. Jayden does not own any pets and wants notldng to do with dogs. After the city
constructs the dog park, Jayden will never use it, while Isabella will spend about five
hours per week there. In many respects it would seem fair if Jayden did not have to
contribute anything toward the dog park and instead Isabella and the other dog lovers in
their community were the ones who had to finance its construction and maintenance.
This position is based upon an application of the benefits principle.
While the benefits principle appears to have a great deal of merit in many
contexts, in some settings it does not make any sense whatsoever. For example, consider
food stamps (or some other government redis~bution program) which has the primary
aim of providing assistance to low income households. If David is the head of a low
income household that is eligible to receive food stamps, he is a recipient of the benefits
of the program. But since the whole point of the program is to provide his household
2 The tw, age of the term "fair" in this context should simply be thought of as ~rynonymous with equitable
and should not be confused with "The Fair Tax." "The Fair Tax" is a proposal to eliminate all existin8 U.S.
Federal Taxes and replace them with a national sales tax (coupled with a monthly "lax probate payment" to
all ho~eholds, to effectively cover the amount of national sales tax paymvnul on all purchases made up to
the poverty level ofincome). For more on "The Fair Tax," see: "/~~.
Chapter #13 -Assessing Taxation Outcomes
with easier access to food, it would be paradoxical to argue that David's household (and
the other households receiving support) should be the ones who need to pay the taxes to
fund the food stamps program.
The ability-to-pIy principle of fixation maintains that the amount a person pays
in taxes should be related to the ease with which the person is able to bear the burden of
paying taxes. In practice, application of the ability-to-pay principle often relies upon an
assessment of a tax in regards to two accepted notions of equity or fairness: horizontal
equity and vertical equity. Both of these concepts make observations on the relation
between economic capacity and tax burden for different taxpayers in society. HoriToItal
equity states that two individuals of equal economic capacity should have equal tax
burdens. Vertical equity asserts that individuals of greater economic capacity should not
have smaller tax burdens. Both of these notions seem reasonable - the difficulty comes
in specifying precisely what we mean by "economic capacity" and "tax burden." For
example, suppose that in 2014 we observed the outcomes summa.dzed in Table 13.1 for
four different taxpayers) Do these outcomes violate the notion of vertical equity?
When assessing tax outcomes, it is common to characterize a tax based upon the
resulting value of Average Tax Rate for taxpayers of different income levels. Average
Tax Rate is defined as the percentage of total income earned that must be paid in taxes.
This can be computed as total taxes paid divided by income. From the values reported in
I9.~1.350
Ta b l e 1 3 . 1 , w e s e e t h a t H i l l a r y C . h a s a n Av e r a g e Ta x R a t e o f ~ ~ . 3 5 7 2 o r
equivalently 35.72% - that is, she pays 35.72% of her income in federal income taxes.
Similarly, Ted C. has an Average Tax Rate of 36.65%, John K. has an Average Tax gate
of 18.52%, and Bernie S. has an Average Tax Rate of 13.47%.
Table 13.1- Taxation Outcomes for Four Different Taxpayers in 2014
Adjusted Gross Income Total Taxes Paid
Taxpayer Average Tax Rate
(Line 37 of Form 1040) (Line 63 of Form 1040)
Hillaty C. $27~946,490 $9,981~350 35.72%
Ted C. $1~207~838 $442,701 36.65%
John K. $402,603 $74,543 18.52%
Bernie S. $205~271 $27,653 13.47%
Suppose (for the time being) that everyone agrees that income provides a measure
of "economic capacity." Someone who thinks that "dollars paid in taxes" provides a
measure of "tax burden" would not find any apparent violation of vertical equity for the
outcomes presented in Table 13.1. However, someone who thinks that "Average Tax
Rate" provides a measure of "tax burden" would find that the outcomes presented in
Table 13.1 violate of the notion of vertical equity, since Hillary C. has a higher income
but lower Average Tax Rate than Ted C.
Tax returns filed by Presidco~ Vic~ Presidents, ~ad major patty candidates for thes~ two offices
awilabte at: htta:/A~taxhistorv.oreAt~vl~ite.n.~llWeb/Pre$identiaWa~e~?~j~t.
The only year for which Donald T. has chosen to vclcLso his tax realm is 2005,
 Chapter #13 -Assessing Taxation Outcomes

A tax is a Proportional Tax if the value of Average Tax Rate is the same for all
taxpayers, irrespective of their level of income. A tax is a Progressive Tax if the value
of Average Tax Rate is greater for taxpayers with higher income levels. A tax is a
Regressive Tax is the value of Average Tax Rate is smaller for taxpayers with higher
income levels.
If we equate "economic capacity" to "income" and equate "tax burden" to
"Average Tax Rate," then the notion of vertical equity provides an argument against
Regressive Taxes and in favor of either Progressive or Proportional Taxes. However, if
"tax burden" is instead equated to "dollars paid in taxes" (again with "economic
capacity" equated to "income"), then even a Regressive Tax does not necessarily violate
vertical equity. For example, over the top two income earners in Table 13.1, the
outcomes are essentially Regressive, even though the amount of dollars paid in taxes is
higher for the person with the higher income.
Each of the four taxpayers identified in Table 13.1 filed a tax return that complied
with current tax laws. Yet, for these taxpayers we cannot really observe any meaningful
relation between Adjusted Gross Income and Average Tax Rate.4 This is because of the
various exemptions and deductions allowed by the U.S. Federal Income Tax Code.
While these exemptions and deductions can lead to apparent inequities, many were put in
place to recognize that factors beyond income are important for determining economic
capacity,s For example, consider the following two hypothetical taxpaying units:
Household A: Married college graduates, ages 22 and 23; no children; income of
$80,000 per year.
Household B: Married high school graduates, ages 47 and 48; four children (two
who must be in daycare for both adults to work); income of $80,000 per year.
Most people would probably agree that "Household A" has greater economic capacity
than "Household B," even though they have the same income. Thus, to satisfy the notion
of vertical equity, we would want "Household A" to have a greater tax burden than
"Household B." To begin to recognize that "Household B" has a lower economic
capacity, our tax code allows them a credit for a portion of their childcare expenses and a
greater standard exemption for having four additional dependents in their family. These
considemtious ultimately lower the tax burden of "Household B."

C L A S S I F Y I N G A TA X A S
PROPORTIONAL, PROGRESSIVE, OR REGRESSIVE

In many cases it is possible to identify a tax as Proportional, Progressive, or

Regressive by examining the structure and behavior of its underlying Marginal Tax

4 L a - .
tar mTax
thisover
chapter we segments
will have a detel
of theed thscnss on of theWithin
Average Tax Rate for the
Income diff~nt entire population. that discussion weU.S.
willFederal
observe that
over the entire population of taxpayers, Average Tax Rate increases as the level of income is increased.
5 Many other exempt (ms end deductions were put in place to encourage or discourage behaviors that
policymakers view as desirable or undesirable.
 Chapter #13- Assessing Taxation Outcomes Chapter #13 -Assessing Taxation Outcomes

335.3), the value of Average Passing Yards Per Game decreased (to 328.5). So we see
Next consider the Social Insurance Taxes imposed on U.S. workers. To fund
that: when the marginal value is above the average value, the average value is pulled up; Social Security, a tax of 6.2% is levied on both the employee and the employer (for a
when the marginal value is below the average value, the average value is pulled down) combined rate of 12.4%) for every dollar earned up to 5128,400. Income above this
threshold is not subject to the Social Security Tax (i.e., the relevant Marginal Tax Rate is
Table 13.2- 2017 Regular Season Passing Yards for Baker MayJ'wld
0%). Medicare is funded by an additional tax of 1.45% on both employees and
employers (for a combined rate of 2.9%), with no upper income limit. Collectively, the
Game Date of Average Passing Yards Social Insurance Taxes impose a Marginal Rate of 15.3% on income up to 5128,400 and
Opponent
Number Game In Game Per Game (after Game a Marginal Rate of 2.9% on income beyond $128,400. Since the Marginal Tax Rate is
1 9/2/17 Texas-El Paso I Passing
329Yards 329.0 lower at the higher income range, over all ranges of income this tax is a Regressive Tax.
2 9/9/17 Ohio State 386
3 9/16/17 Tulane 331 Table 13.3-Marginal Tax Rates, U.S. Federal Income Tax (2018)
4 9/23/17 Baylor 283 332.3
5 10/7/17 Iowa State 306 327.0 Range of Adjusted Gross Income Marginal Tax Rate
6 10/14/17 Texas 302 322.8 50 up to $19,050 10%
7 10/21/17 Kansas State 410 335.3 5191051 up to $77~400
8 10/28/I 7 Texas Tech 281 577,401 up to 5165,000 22%
9 11/4/17 Oklahoma State 598 5165~001 up to 5315~000 24%
10 11/11/17 Texas Christian 333 5315~001 up to $400~000 32%
I1 11/18/17 Kansas 257 $400,001 up to 5600,000 35%
12 11/25/17 West Virginia 281 5600,000 and above

For a tax to be a Proportional Tax all income must be taxed at a constant Marginal
Applying these insights on the relation between Marginal and Average values to Tax Rate. Such taxes are often called "fiat taxes." As of 2018, approximately 35
taxation, we can infer that a tax is a: countries around the wodd have income taxes of this nature. Table 13.4 below lists a
sampling of these countries, along with their current constant Marginal Tax Rate (MTR)
I. Progressive Tax if and only if the relevant Marginal Tax Rate increases at and the year in which they first implemented a "flat tax."
higher income levels
II. Regressive Tax if and only if the relevant Marginal Tax Rate decreases at Table 13.4 -Sampling of Countries with a Proportional or "Flat" Income Tax
higher income levels
llI. Proportional Tax if and only if the relevant Marginal Tax Rate is the same at Country ] MTR I Year Implemented Country MTR Year Implemented
all income levels Jersey 20% 1940 [ Kyrgy'zstan 10% 2006
Jamaica 25% 1986 Kazakhstan 10% 2007
Table 13.3 reports the relevant Marginal Tax Rate over different ranges of Adjusted Estonia 20% 1994 Mongolia 10% 2007
Gross Income for the U.S. Federal Income Tax in 2018 (for married individuals, filing a Russia 13% 2001 Bulgaria 10% 2008
joint tax return).9 Based upon these Marginal Tax Rates, which increase as the level of Romania 16°/, 2005 Belize 25% 2009
income is increased, it follows that this tax is in general a Progressive Tax. Turkmenistan 10% 2005 Hungary 16o/, 2011
s A very closely related observation is that the only way his average value will be pulled up is for the next
Thinking again about issues of equity, many people view u Proportional tax to be
ma. rginnl value to be grea.ter than the current average (and the only way for his average to be pulled down extremely fair, since all income is subject to the same marginal rate. Further, such taxes
nil be for the next marginal value to be less than the current average). As an example, consider his
situation going into the Final game of the season, at which point he is averaging 346.9 Passing Yards Per are very simple, and require taxpayers to expend very few resources to comply with the
Game. He knows that the only way to pull his average up is to pass for 347 or more yards. He also knows tax code. This simplicity also makes the tax more transparent - for example, in Russia
that the only way his average will decrease is if he passes for 346 or fewer yards. you have to be paying 13% of your income in taxes, regardless of how high or how low
9 See: btttJs.'//tarfoundation.or~/2018.tax.brafketsl. Note that in reality the lowest Marginal Tax Rate is
your income is and irrespective of any other personal circumstances. Cheating on such a
truly 0% (due to the presence of various deductions and exemptions in the tax code).
 Chapter #13- Assessing Taxation Outcomes Chapter #13 -dssessing Taxation Outcomes

tax would be difficult to do and easy to detect. For this reason, it should perhaps not
"The Congress shall have power to lay and collect taxes on incomes, from
come as a surprise that many of the countries that have adopted this type of a tax in recent
whatever source derived, without apportionment among the several States,
years are ones in which high levels of corruption have historically been (and continue to
and without regard to any census or enumeration. "'
be) a concern. For example, of the 209 different countries ranked by the World Bank
Group with respect to perceived level of corruption (as part of its World Governance This Amendment provides the legal foundation for our current Federal Income Tax.
Indicators project),I° some of the recent adopters of a flat tax were ranked as follows: However, since its inception in 1913, our current Federal Income Tax has evolved
Mongolia, 135e~; Kazakhstan, 16@; Russia, 170th; Kyrgyzstan, 184e~; and Turkmenistan, considerably in terms of its complexity and impact on the general population.
200~. Therefore, such a flat tax was likely implemented in these countries, in part, as an Table 13.6 offers a summary of the number of and Marginal Tax Rates associated
appropriate and much needed reform to help reduce corruption and make the tax system with different tax brackets over the history of the U.S. Federal Income Taxi3 As
more transparent. previously noted, there are presently 7 different tax brackets with marginal rates ranging
from a low of 10% up to a high of 37%)4 The highest Marginal Tax Rate was as high as
70% as recently as 1981 and was at its highest level of 94% in 1944 and 1945. Someone
O U T C O M E S F R O M T H E U , S . F E D E R A L I N C O M E TA X facing this 94% Marginal Tax Rate who earned an extra $1,000 of income would only get
to keep $60 after paying her Federal Income TaxesJ5 In contrast, when the Income Tax
As noted at the start of this chapter, one of the primary reasons that governments was first enacted in 1913, the highest Marginal Tax Rate was a mere 7%)6
impose taxes is to generate revenues to finance government spending. Table 13.5
provides a summary of the various sources of U.S. Federal Government revenue in Table 13.6- Summary of Tax Brackets and Percent of Adult Population Filing Taxes
2017.H The most significant source of Federal Government revenue is the individual
income tax. This tax is also the one that is most evident to households - for any adult Year 1913 1916 1921 1931 1933 1941 1945
living in the U.S., what immediately comes to mind when the date "April 15" is High MTR 7% 15% 73% 25% 63% 81% 94%
mentioned? Because of its prominence, it is important to understand the history ofund Law MTR 1% 2% 4% 1.5% 4% 10% 23%
current outcomes resulting fi"om this tax. Number of Brackets 7 14 56 23 55 32 24
% of Adult Pop. On Returns 1.1% 1.2% 15.0% 5.7% 6.6% 42.9% 75.9%
Table 13.5-Sources of U.S. Federal Government Revenue (2017)
Year 1963 1981 1990 2000 2012 2015 2018
Amount of Revenue Percentage High MTR 91% 70% 28% 39.6% 35% 39.6% 37%
Revenue Source (billions ef dollars) of Total Low MTR 20% 0% 15% 15% 10% 10% 10%
Individual Income Taxes 1,587.1 47.9% Number of Brackets 24 16 2 5 6 7 7
Social Insurance Taxes 1,161.9 % of Adult Pop. On Returns 83.6% 83.9% 84.9%
35.0% 86.5% 81.5% 81.7% n.a.L7
Corporate Income Taxes 297.0 9.0%
Excise Taxes 83.8 2.5%
All other revenue sources
186.3 5.6% t3 A tax bracket simply refers to a range of income subject to a pataicular Marginal Tax Rate.
TOTAL 3,316.2 14 Again, in practice the lowest Marginal Tax Rata was 0% in every year due to the presence of varinns
100%
deductions and exemptions in the tax cede. What is stated as "Low MTR" in Table 13.6 is the lowest
The 16th Amendment to the U.S. Constitution, which was passed by Congress on positive Marginal Tax Rate.
7/2/1909 and ratified on 2/3/1913, states:12 ~s This Marginal Tax Rate was applied to incomes above $200,000. Adjusting this cutoffin 1945 for
infladun, an equivalent value in "constant 2013 dollars" would be $2,551,044, An historical sunmmry of
Marginal Tax Rates adjusted for inflation can be found at: htw:/A~atav.scribd.com/doc/190500966/Federal.
IoS lndividual-lndividuol-lncome- Tax-Rate-Adiusted.for.lnflation.
16 From an examination of the inflation adjusted income cutoffs for tax bmcbets in 1913 (again, see:
lowest amount o f cun'uptioa) is New Zealand. the country ranked
ee'-htm'//inf°;t~rldbanl~°rz/e°vernanceA'zi/index'a~YZ#hor-2. 209*
The on the list (i.e.,
coanlryranked laonhighest
thislistamount
(i.e., of htm:/~¢~:s~ribd~c~m/d~9~966/Federa~ndividual-~ndiv~dua~-~ncome-Tax~R~te-Adiusted-f~r
comzption) is Equatorial Guinea. we see bow low the initial Marginal Tax Rates actually we~. Adjusted for inflation, in "constant
U Tese
h - ngures are from the Congressional Budget Office's "Historical Budget Data" report, available at:
2013 delian," the lowest MTR of I% applied to all income below $463,826 and the highest MTR of 7%
applied to only income above $11,595,657. For perspective, compare these income cutoffs and marginal
report contains sunusl figuree from 1968 through 2017.
~/A~a~c~.f~v/sites/de~-mdt/~es/tVcurr~ngd~t~/5~4~8~-hist~rica~b~d~etd~.x~.¢. This rates to those for 2018 stated in Table 13.3.
12 See: huJJJJJJJ~.'/Avww.archh,¢s, vov/foundine-docs/amcndm¢nts.l I-2/. 17 The data needed to compute this value an: not yet available for 2018.
 Chapter #13 - Assessing Taxation Outcomes
The number of tax brackets provides some insight on the complexity of the tax.
When the Income Tax was first enacted, there were 7 different tax brackets. This number
ballooned to 56 brackets by 1921. It achieved its low of only 2 brackets fi'om 1988
through 1990. Recalling the importance of the Marginal Tax Rate for decision makers
applying the Cost-Benefit Principle, we can begin to see how a large number of different
tax brackets can make the marginal benefit of earning addition income less transparent.
Many workers presently faced with only 7 different tax brackets probably do not know
the relevant Marginal Tax Rate that they face without looking at their tax return from last
year. As a consequence, a very complex tax code with a large number of drastically
different Marginal Tax Rates can cause individuals to make decisions regarding the
number of hours to work that are not best for themselves.
The increased complexity of the tax code can also be illustrated by a direct
inspection of IRS Form 1040. In 1913, this form including all of its instructions
consisted of only 4 pages. In 2015, the form itself was only 2 pages long, but the
instructions were 107 pages)8 The increase in the Tax Code itself is even more dramatic.
In 1913 there were 400 pages of Federal Tax roles - by 2014 this figure had increased to
74,608 pages.
Returning attention to Table 13.6, the bottom row reports the percentage of the
total adult population that was represented on a filed tax return in each year./9 Since
some people who are required to file a tax return do not ultimately have to pay a positive
mount in taxes, this figure is not the same as the percentage of adults paying taxes.
However, it dons provide a bound for this latter figure - that is, the percentage of adults
paying taxes cannot be greater than the percentage of adults represented on a filed tax
return. When the Income Tax was first enacted, only 1.1% of the adult population was
even required to file a tax return. This figure remained below 20% in every single year
up through 1939 - up to this point in time, no households outside of the highest quintile
(i.e., the "Top 20%") of income earners were subject to the Income Tax. This changed
dramatically in the early 1940s. The percentage of adults represented on a filed tax return
was 10.12% in 1938 and 12.06% in 1939. This figure increased to: 24.0% in 1940;
42.9% in 1941; 60.0% in 1942; 68.6% in 1943; and 73.4% in 1944. It has remained
above 70% in every year since 1944 (and has been above 80% in every year from 1950
onward). In 2015 (the most recent year for which the data necessary to compute the
figure were available) this figure stood at 81.7% of the population.
Clearly the U.S. Federal Income Tax has changed in many ways over the past
century. To gain more insights on the outcomes realized from tiffs tax for different
segraents of society, we shift our attention to a discussion of the percentage of total tax
dnlla~ paid and Average Tax Rates realized by different segments of society.2° The
It']-h
e fol'm from 1913 Is avmlable at bttP.'/A~¢wdr~.eov/oub/ir~.utl/191 ~ n,tr The form and ins~uctinns
from 2017 are available at hi°t:/Am¢~"irs'emubuMrs'~f/flO40.pdfand'L--."~''wa~irs.eo,¢m,~..n~,o~
t 9 T h - -
es~ngtatswerecomputedusingdazafromtheInu~aalRevenueServiceandU.S.C¢~usBureau.
ae On.less o~e~,vlse stated all figures presented m this discussmn are from official Intcxnal Revenue
Sen,lee Sta~slacs of Income reports, as summarized by Erica York in the article"SmlmmW of Latest
Chapter #13 -Assessing Taxation Outcomes
observations presented here are for different groups of the population, ordered from
highest income to lowest income (i.e., ordered in a similar fashion to what was done
when constructing the Lorenz Curve discussed in Chapter 12). These observations
summarize actual outcomes from the tax for the population of adults filing tax returns -
that is, they are based upon filed tax returns and actual taxes paid, after individuals have
taken advantage of any legal exemptions and deductions.
As reported in Table 13.7, the "Top 1%" of income earners collectively (i.e., as a
group) earn 20.65% of total adjusted gross income earned by everyone in society. This
group consists of those people who file a tax return with an adjusted gross income of
$480,930 or above. As a group these people pay 39.04% of all income tax dollars
received by the U.S. Federal Government. Similarly, the "Top 5%" of income earners
(those with adjusted gross income of $195,788 or above - note, this group include the
"Top 1%" as a subset) earn 36.07% of society's income and pay 59.58% of society's
Federal Income Taxes, while the "Top 10%" (those with adjusted gross income of
$138,031 or above) earn 47.36% of society's income and pay 70.59% of all Federal
Income Taxes.2~ From this final observation, we can infer that the "Bottom 90%" (those
with adjusted gross income below $138,031) collectively pay only 29.41% of all Federal
Income Tax dollars collected. Whether these outcomes are ideal is ultimately a
normative issue, with which two equally well informed people with different value
judgments and notions of fairness can vehemently disagree. However, from the facts
presented in Table 13.7, we see that under the current Federal Income Tax code, high
income earners pay a dispmportiunate amount (relative to their incomes) of all tax dollars
paid. This dispmportiunality is a direct consequence of the fact that the U.S. Federal
Income Tax is a Progressive Tax.
Table 13.7-Shares of Adjusted Gross Income and Income Taxes Paid (2015)
Segment of Lower Income Group's Share of Total Group's Share of Total
the Population Threshold Adjusted Gross Income Income Taxes Paid
Top 1% $480,930 20.65% 39.04%
Top 5% $195~788 36.07% 59.58%
Top 10% $138,031 47.36% 70.59%
Top 25% $79,655 68.99% 86.62%
Top 50% $39,275
Table 13.8 reports the Average Tax Rate for different segments of the population
in the most recent year for which data is available (2015), along with 10 othex yeats
dating back to 1980. In 2015, the "Top 5%" as a group had an Average Tax Rate of
Federal Income Ttx Daus, 2017 UpdateTMthtms://file~mrfoumlation.o~,/201~OII7125609/Tar-Foundqtion
210bscxve that sll four of the taxpayers identified in Table 13.! ate in the "Top 5%" of income caracas,
while two of the four me veqr comfortably within the "To9 I%" of income cora¢~ In fact, Hilat~" C. has
an income level well above the minimum needed Io place her in the "~1"O9 0.01%" of income ¢anua's. To
this point, in 2014 only 1 out of l 0,000 filed tax returns had an adju.sted gross income above $11,407,987.
 Chapter #13 - Assessing Taxation Outcomes Chapter #13 -Assessing Taxation Outcomes

23.68%, meaning the group as a whole paid 23.68% of its income in taxes. Some people
in this group had Average Tax Rates that were below this level (such as John K. and
Bernie S. from Table 13.1), while others in the group had Average Tax Rates above this
level (such as Hillary C. and Ted C. from Table 13.1).
Taxpayers in the "Top 10%" but not in the "Top 5%" (i.e., those "Between 5%
and 10%" as summarized in Table 13.8 - note, this group of people does not include
those in the "Top 5%") as a group had an Average Tax Rate of 13.99%. Again, some
people in this group had Average Tax Rates that were below this level, while others in
the group had Average Tax Rates above this level. As a group, those: "Between 10% and
25%" had an Average Tax Rata of 10.62%; "Between 25% and 50%" had an Average
Tax Rate of 7.67%; and in the "Bottom 50%" had an Average Tax Rate of 3.59%. The
fact that these realized Average Tax Rates arc larger in value for the groups of taxpayers
with higher incomes reinfomes the previous observation that the U.S. Federal Income
Tax is indeed a Progressive Tax. That is, higher income earners not only pay a greater
dollar amount in Federal Income Taxes, they also pay a greater percentage of their
income in Federal Income Taxes.
Table 13,8- A verage Tax Rates Over Time
realized a higher Average Tax Rate in 1980 than in any other year reported above, and
each segment realized a lower Average Tax Rate in 2009 than in any other year over this
entire time period. Comparing 2009 to 1980, the difference is striking. Between these
years, the Average Tax Rate: of the "Top 5%" decreased from 26.85% down to 20.59%;
of those "Between 10% and 25%" decreased from 14.80% down to 8.36%; and of the
"Bottom 50%" decreased from 6.10% down to 2.35%.
Again, between 2009 and 2015 the Average Tax Rate for every segment of the
population increased. The largest change was for the "Top 5%" of income earners, who
as a group saw their Average Tax Rate increase from 20.59% in 2009 to 23.68% in 2015.
This was due largely to the increase in highest Marginal Tax Rate from 35% to 39.6%
brought about by the "American Taxpayer Relief Act of 2012," signed into law by
President Barok Obama on January 2, 2013.
However, even with this increase in recent years, the Average Tax Rate realized
by each segment of the population was lower in 2015 than in 2000 and, in turn, was
lower in 2000 than in 1980. For example, looking at 1980, 2000, and 2015, we observe
that the Average Tax Rate of those "Between 10% and 25%" decreased from 14.80%
down to 12.04% down to 10.62%, while the Average Tax Rate of those in the "Bottom
50%" decreased from 6.10°/0 down to 4.60% down to 3.59%.

Between Between Between Bottom

YCAIr Top 5% 5% & 10% 10% & 25% 25% & 50% 50% P R O G R E S S I V 1 T Y V E R S U S R E D I S T R I B U T I V E C A PA C I T Y
2015 23.68% 13.99% 10.62% 7.67% 3.59%
2012 20.97% 13.33% 9.96% 7.21% 3.28% Continuing to focus on observing realized outcomes from a tax, within this
2009 20.59% I 1.53% 8.36% section we discuss ways to measure the degree of progressivity (i.e., the extent to which a
5.76% 2.35%
2OO8 20.83% 12.66% tax places a disproportionate amount of the tax burden on high income earners) and the
9.45% 6.97% 3.26%
2OO4 20.83% 12.53% redistributive capacity (i.e., the degree to which a tax changes income inequality) of a tax.
9.41% 7.27% 3.53%
20OO 24.42% 15.48% 12.04% 9.28% 4.60%
1996 24.07% 14.74% 11.86% 9.53% 4.40%
1992 21.19% 13.99% Measuring the Degree of Progressivity of a Tax
11.39% 9.42% 4.39%
1988 21.14% The outcomes observed In Tables 13.7 and 13.8 highlight the progressive nature
14.07% 11.82% 9.60°/0 5.06%
1984 of the U.S. Federal Income Tax. But, as presented the data do not allow for direct
23.42% 15.57% 12.90°/0 10.48% 5.77% insights on the degree of progressivity of the tax. An index of tax progressivity over the
1980 26.85% 1%13% 14.80o/0 11.91% 6.10% entire population can be computed in a manner similar to the construction of the Gini
coefficient discussed in Chapter 12. We will examine the Stroup Coefficient of tax
A full inspection of Table 13.8 begins to reveal how the tax burden (as measured prograssivity, which is defined in terms of the Lorenz Curve (discussed in Chapter 12)
by Average Tax Rate) has evolved over time for different segments of society.~ While and a similarly constructed Tax Concentration Curve, as illustrated in Figure 13.1.
different segments of the population have realized distinct changes over time, the general
The horizontal axis measures the cumulative fraction of the population, with
pattern that emerges is that over all segments of the population Average Tax Rates people ordered from lowest income to highest. Recall, the Lorenz Curve is constructed
decreased between 1980 and 2009, but then crept back up since then.z~ Each segment
by determining the fraction of total income earned by each such segment of the
population and then plotting the corresponding point. For example, using the figures for
u It s. tmponan
. to keep m. mind
. that because of
. income mohhty,
.. a taxpayer who was m the , Between
10%and25%"categoryin2015couldhavebeeninanyoneofthefive¢aUegorin~sin previousyear.
z3ThevalueofAverageTaxRateforeachsegmentofthePopulationisrepo~-din"SummaryofLatest 1980 (the earliest year included in the fur report); ~ fourth year up through 2012; 2009 (since this was
the year over the entire time period whenATR was lowest for every group); and 2015 (the most recent year
FederalIncomeTaxDa~%2017Update"(hrms://files.taxfoundation.ore/20180l17125609ffar-FoundatiwL included in the foil report),
for ever7 ytar between 1980 and 2015. The years chosen for lnclusinn in Table 13.8 include:

326 327
 Chapter #13 -Assessing Taxation Outcomes
income shares rrported in Table 13.7, the "Bottom 50%" of income earners cam 11.28%
of society's income (since the "Top 50%" earn 88.72%). Thus, the point (.50, .1128) lies
on the Lorenz Curve. Similarly, the "Bottom 75%" of income earners earn 31.01% of
society's income (since the "Top 25%" earn 68.99%), so that the point (.75, .3101) also
lies on the Lorenz Curve.
FigRre 13. I - Definition of the Stroup Coefficient of Tax Progressivity
Fraction of Total Income,
Fraction of Total Taxes
I£ .............................
~ Ta x C o n c e n t r a t i o n C u r v e
C ',
0 i ) Fraction of Total Population
1
0 0.7
Looking over the same population of people, still ordered from lowest income to
highest, we can construct a Tax Concentration Curve in a similar manner. Using the
figures for tax shares reported in Table 13.7, the "Bottom 50%" of income earners paid
2.83% of society's income taxes (since the "Top 50%" paid 97.17%). As a consequence,
the point (.50, .0283) is on the Tax Concentration Curve. Similarly, the "Bottom 75%" of
income earners paid 13.38% of society's income taxes (since the "Top 25%" paid
86.62%), implying that the point (.75, .1338) also lies on the Tax Concentration Curve.
Recognize that for a progressive tax, the Tax Concentration Curve will fie below the
Lorenz Curve. As a result, these two curves divide the triangle below the 45°-line into
three areas ("Area A," "Area B," and "Area C') as illustrated in Figure 13.1.
The Stroup Coefficient of Tax Progressivity is defined as the ratio of the area
between the Lorenz Curve and the Tax Concentration
" Curve (I.e.,
t ( Area B") to the entire
area below the Lorenz Curve (i.e., "Aseas B+C"): S = ~%~'c. Just as the Gini Coefficient
provides a single summary statistic measuring the degree of income inequality over the
entire population, the Slroup Coefficient similarly provides a measure of the degree of tax
progressivity over the entire population. For a Proportional Tax the Tax Concenl~-ation
Carve would exactly coincide with the Lorenz Curve, in which case "Area B" would be
equal to zero. Thus, the Stroup Coefficient would be 0 for a Proportional Tax.
Chapter #13 -Assessing Taxation Outcomes
However, for a Progressive Tax the Tax Concentration Curve lies below the
Lorenz Curve so that "Area B" is positive. This results in a positive value of the Stroup
Coefficient. Holding the distribution of income constant, if the tax burden is shifted in a
way that people with higher incomes pay more in taxes while people with lower incomes
pay less, then the Tax Concentration Curve will become shorter (i.e., even more bowed
out away from the Lorenz Curve). Such a change increases "Area B," ultimately
increasing the value of the Stroup Coefficient. Thus, a larger value of the Stroup
Coefficient reveals taxation outcomes that are more progressive. In the extreme, if only
the highest income earners had to pay any taxes then the Tax Concentration Curve would
be a "reverse-L" and "Area C" would be equal to zero. For such a highly progressive tax,
the value of the Stroop Coefficient would be 1.
To summarize, the Stroup Coefficient will be equal to 0 for a Proportional Tax
and will range between 0 and 1 for a Progressive Tax. A larger value of the coefficient
reveals a greater degree of progressivity. Figure 13.2 illustrates historical values of the
Sb'oup Coefficient computed over the entire adult population for the U.S. Federal Income
Tax in each year from 1929 through 2015.
Figure 13.2 -Straup Coefficient of Tax Progressivity for the U.S. Federal Income Tax
0.6
0.5
0.4
0.3
0.2
0.1
0.0
Over this time period the realized value of the Stroup Coefficient ranged from a
low of .4452 (in 1969) to a high of ,9980 (in 1929). The mean value was .6324 and the
median value was .5801, A visual inspection of Figuro 13.2 reveals that since realizing
its low value of .4452 in 1969 there has been a consistent and steady increase in the
degree of tax progressivity. A value above .7 has been realized in each of the 8 years
from 2008 through 2015 (the value in 2015 was .7178). In contrast, the value was below
.7 for all 66 years from 1942 through 2007. However, even though recent outcomes are
 Chapter #13 -Assessing Taxation Outcom~
the most progressive of the past 74 years, they are not the most progressive over the
entire history of the tax. After realizing its high value of.99796 in 1929, the value of the
index remained above .98 in every year up through 1939. Recalling that the maximum
possible value of the index (mathematically) is a value of I, we see that before 1940 the
tax could not have been much more progressive.
Measuring the Redistributive Capacity of a Tax
One potential reason for imposing taxes is to deliberately alter the distribution of
income. Further, when adhering to the ability-to-pay principle and applying the notion of
vertical equity, an argument in favor of Progressive Taxation can emerge (that is, if we
equate "economic capacity" to "income" and equate "tax burden" to "Average Tax
Rate"). Since, by definition, a Progressive Tax requires individuals with higher incomes
to pay a greater percentage of their income in taxes, such a tax results in a post-tax
distribution of income that is more equal than the pre-tsx distribution of income.
Since the Gini Coefficient (initially discussed in Chapter 12) provides a measure
of income inequality, we can naturally measure the re.distributive capacity of a tax by
determining the change in the value of the Gini Coefficient resulting from the tax. Let
G: denote the initial, pro-tax value of the Gini Coefficient; let G~, denote the final, post-
tax value of the Gini Coefficient. From here we define the Pechman-Okner Coefficient
of Re.distributive Capacity as the percentage decrease in the value of the Gini Coefficient:
P O GI= - Gr
~.
GI
A truly Proportional Tax would not alter the dis~bution of income whatsoever, in
which case Gr = Gt and consequently PO = 0. In contrast, a Progressive Tax reduces
income inequality, so that Gr < GI and subsequently PO > 0. In the ex~'eme, if a
Progressive Tax completely eliminated all income inequality (so that everyone had the
same exact income after the tax was imposed) then we would have Gp = 0 and PO = 1.
To summarize, the Pechman-Okner Coefficient will be equal to 0 for a
Proportional Tax and will range between 0 and 1 for a Progressive Tax. A larger value of
the coefficient reveals that the tax is reducing income inequality to a greater degree.
Figure 13.3 plots historical values of the Pechinan-Okner Coefficient computed over the
entire adult population for the U.S. Federal Income Tax in each year from 1929 through
2015.
The realized value of the index in 2015 was .0916 - that is, the U.S. Federal
InCome Tax reduced the value of the Gini Coefficient by 9.16% in that year. This
realized value is slightly above both the mean (i.e., average) value of .0764 and median
(i.e., middle) value of .0799 over this time period. Between 1973 and 2015 the value of
this index has, for the most part, remained relatively stable - the realized value was above
.075 but below .10 in 40 of these 43 years (i.e., in just over 93% of these years). Thus,
for more than four decades there has not been any vast fluctuations or significant shifts in
the degree to which the U.S. Federal Income Tax alters the distribution of income.
Some perspective can be acquired by making a comparison of the degree to which
the distribution of income is altered by taxes in the U.S. versus other countries. A 2012
Chapter #13 - Assessing Taxation Outcomes
study released by The Organization of Economic Co-operation and Development
(OECD) examined the impact of taxes and government transfers on the distribution of
income in its 34 member countries. When focusing on household taxes, they find that
"the redistributive impact was the highest in Australia, Denmark, Germany, Israel, Italy,
and the United States''24 - that is, of the 34 countries in the study, the U.S. is in the "Top
6" in terms of having a tax code that alters the distribution of household income. This is
driven by the fact that "household taxes are more progressive in the United States then in
most EU [European Union] countries."2~ The exact relation between the degree of
progressivity and redistributive capacity will be explained more fully below.
Ftgare 13.3 - Pechman-Okner Coefficient of Redlstribntive Capacity for the U.S.
Federal Income Tax
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
RetumIng attention to the realized values of the Pechman-Okner Coefficieint in
the U.S., we see that before 1973 the redistributive capacity of the U.S. Federal Income
Tax was at times much lower and at other times much higher than it has been since. The
lowest realized index value (of .0149) was realized in 1931. Moreover, the value of the
Pechman-Okner Coefficieint was below .05 in all 13 years fi'om 1929 through 1941.
Throughout the 1940s the index value fluctuated tremendously. It skyrocketed from
.0490 in 1941, to .0947 in 1942, and to .1483 in 1943 (its maximum realized value over
the entire time period from 1929 through 2105). The realized value was then .0947 in
24 See 'Tackl ng
' Income Inequality: the Ro e of Taxes and Transfers" by l, Jounm~ M, Pisu, and D.
Bloch, httt):/Awwt'.oecd.or~/etv)/pubiic-financeJTackline ncomeinea talin'TherolcoRw:e~'andtr~nffers pal[,
page12. " " "
Ibid., page 13.
 Chapter #13 -Assessing Taxation Outcomes
1944 and .1005 in 1945, but by 1949 it had come down to .0615 (its lowest realized level
between 1942 and 2015).
Relation Between Degree of Progressivity and Redistributive Capacity
The observed values of the Streup Coefficient and the Pechman-Okner
Coefficient reveal outcomes that might at first glance appear to be inconsistent with or
contradictory to each other. The value of the Stroup Coefficient was .98 or greater in
every single year between 1929 and 1939, revealing that the tax was highly progressive at
this time - the degree of pregressivity then plummeted in the early 1940s. The value of
the Pechman-Okner Coefficient was below .05 in every year between 1929 and 1941,
revealing that the tax did not alter the distribution of income much at all - the
redistributive capacity of the tax then increased greatly in 1942 and 1943. If highly
Progressive Taxes redistribute income, how could we have realized these seemingly
contradictory outcomes up through the early 1940s?
The important point to recognize is that a tax must simultaneously exhibit two
important characteristics in order to significantly reduce income inequality. Yes, it must
have a high degree of pmgressivity. But, in order to shifr relative shares of income in a
noticeable way, the tax must also be substantial. That is, it must be levied on a sizeable
portion of the population and/or have Average Tax Rates that are relatively high.
Before the early 1940s the U.S. Federal Income Tax was extremely progressive,
but this extraordinary degree of progressivlty was driven by the fact that the tax was
imposed on only a very small fraction of the highest income earners in society. Recall
that in every year up through 1939, less than 20% of the adult population was even
required to file a tax return. In the early 1940s the tax evolved from a tax on high income
earning elites to a tax on the masses. As previously noted, the percentage of adults
represented on a filed tax return steadily climbed from 12.06% in 1939, to 24.0% in
1940, to 42.9% in 1941, to 60.0% in 1942, to 68.6% in 1943, and to 73.4% in 1944. It
then remained above 70% in every year since 1944.
The size of the tax also increased greatly during this time. Total Income Taxes
Paid as a percentage of Total Personal Income was below 1.82% in every year from 1929
to 1940. This figure went up to 3.90% in 1941, 6.96% in 1942, and 10.87% in 1943.
Before the early 1940s the tax was so narrow in scope and minimal in size that it
could not substantially alter the distribution of income even though it was so highly
progressive. Only after the breadth of the tax was greatly expanded and the levels of
taxation were greatly increased in the early 1940s did the tax now have the potential to
noticeably alter the distribution of income. Yes, the expansion of the tax to the masses
distributionmade it lessinprogressiVe,a noticeablebUtway.it is also part of what gave the tax the power to alter the
These distinct influences can also be seen by comparing realized outcomes in
select years since the early 1980s. The value of the Peehman-Okner Coefficient was
.1050 in 1981 (the only year with a higher realized value was 1943). The value of the
Streup Coefficient was .5269 in 1981. By 2009 (recall, this was the year since 1980
when Average Tax Rates were lowest for all income groups, as reported in Table 13.8)
Chapter #13 -Assessing Taxation Outcomes
the value of the Pechman-Okner Coefficient had fallen to .0791 while the value of the
Stroup Coefficient had increased to .7285. Again, we have observed what might at first
glance seem to be contradictory insights that the U.S. Federal Income Tax became more
progressive but redistributed income to a lesser degree. This can be reconciled by an
examination of Average Tax Rates and the overall level of Total Income Taxes Paid as a
percentage of Total Personal Income. As summarized in Table 13.8, Average Tax Rates
were considerably higher for all segments of the population in the early 1980s than in
recent years. Consequently, over the entire population, Total Income Taxes Paid as a
percentage of Total Personal Income declined between these years, from 10.94°/* in 1981
down to 7.16% in 2009. These observations further reveal how a reduction in the level of
taxation will reduce the redistributive capacity of the tax (potentially even as the degree
of pmgressivity of the tax is increased).
T H E I M PA C T O F TA X E S O N I N C E N T I V E S
We conclude this chapter by reinforcing how taxes alter incentives and ultimately
behavior. These insights further highlight why taxing an activity or outcome generally
results in less of it. As will be shown, this can have a dramatic impact on the revenue
which is generated (or, more precisely, not generated) from a tax.
Consider the experience of Brian Johnson, lead singer of the rock band AC/DC.
When the band enjoyed enormous success In the early 1980s, he faced a Marginal Tax
Rate of 83% in the U.K., prompting him to observe. "It's ridiculous having to go out and
do a whole American tour and sell about a million records just to pay tax."'26 In early
1983 he moved to Hawal'i - "Brian's hand was foroed...he had to leave the U.K. and the
country's gutting tax system."2~ Similarly, when Ronald Reagan was "an actor in
Hollywood during the years when the marginal tax rate was 90%, [he] reacted with
rationality: once he hit the higher tax brackets, he'd simply stop working for the rest of
the year."2s
These two examples directly illustrate the disincentive effects of high Marginal
Tax Rates on income. The imposition of a tax (especially at high Marginal Rates of 83%
or 90%) can either reduce the benefits or increase the costs of an activity to the point
where a rational decision maker drnstieally alters the extent to which he engages in the
activity. Consequently, the revenue generated by a tax can be much less than would be
naively axpeoted based upon the pre-tax level of the activity. Runald Reagan chose to
not make as many movies as he otherwise would have if the tax rate had been lower. As
a result, the U.S. government did not get the extra tax revenue that they might have
expected from his foregone earnings. In the ease of Brian Johnson, it was even worse for
Engleheart, M. and A, Durieux, "AC3E~ Maximum Rock & Roll." Hmper, 2008, page 360.
2~ Ibtd,. page 362,
2 | Y Crgm
" D, and J. $tanislaw, "The Commanding Heights: The Battle for the World Economy," Simon and
Schuster. 2002, page 348,
 Chapter #13 -Assessing Taxation Outcomes
the U.K. government - when faced with the high Marginal Tax Rate he moved out of the
count-y, and they no longer got any tax revenue on any of his earnings.
From here we arrive at a somewhat surprising property regarding the relation
between levels'rates of taxation and the resulting tax revenue generated. Increasing the
level or rote of a tax can either inere~e or decrease the amount of revenue generated by
the tax. This result was actually observed within our previous discussion of a per unit tax
imposed on a good (in Chapter l 1). When imposing a per unit tax of ST, the amount of
tax revenue generated is equal to STmultiplied by the quantity of the good that is traded
with the tar in place. But since the quantity of the good traded decreases as the
n~gnitude of the tax is incrensed, the tax revenue can either increase or decrease.
Consider the revenue generated by an income tax. For simplicity, focus on a
lh'opo~ional Tax which imposes the same Marginal Tax Rate on every dollar of income
earned by every worker. We can immediately recognize that a Marginal Tax Rate of 0%
will generate $0 of tax revenue. But further recognize that a Marginal Tax Rate of 100%
would also generate $0 of tax revenue, since people will not have any incentive to earn
any income. When faced with a Marginal Tax Rate of 100% (i.e., the government takes
everything that is earned), most people would either shutdown (like Ronald Reagan) or
flee the country (like Brian Johnson). Finally, consider a tax rate of 50%. This would
likely result in a positive amount of revenue.
Since the tax revenue generated by a tax of 50% is greater than that which is
generated by a tax of 0%, it must he possible for total tax revenue to increase as the tax
rate is increased. Further, since the tax revenue generated by a tax of 100% is less than
that which is generated by a tax of 50%, it must be possible for an increase in the tax rate
to result in a decrease in tax revenue. The Laffer Curve, as illustrated in Figure 13.4,
summarizes the relation between the rate of taxation and the total amount of revenue
generated by a tax.
Figure 13.4- Laffer Curve 1
Total Tax Revenue
$130 million,,~
$120 million----->" -!!!!!!!!!!!!!!!!!:::: ...... Curve
$110 million-''~"
50% 6~0/° ~ T a x R a t e
334
Chapter #13 -Assessing Taxation Outcomes
Based upon our simple example, we know some important properties that this
curve must satisfy. First, Total Tax Revenue will be zero when either no tax is imposed
or when the tax rate is so high that nobody engages in the activity. Second, if an
intermediate rate of taxation generates a positive amount of tax revenue (such as the tax
rate of 50% in our example and as illustrated in Figure 13.4), then the Laffer Curve must
have a positive slope over some range of tax rates (i.e., somewhere between 0% and this
intermediate rate) and must have a negative slope over some other range of tax rates (i.e.,
somewhere between this intermediate rate and 100%).
When the Laffer Curve is positively sloped, increasing the tax rate will increase
the total revenue generated by the tax. In contrast, when the curve is negatively sloped,
increasing the tax rate ectually decreases total tax revenue - but this implies that
decreasing the tax rate would actually increase total tax revenue. As we can see in Figure
13.4, if the tax rate is raised from 50% to 65%, the revenue collected form the tax
increases from $120 million to $130 million, an increase of $10 million. But, if we raised
the tax rate further to 80%, we will actually reduce tax revenues collected to $110
million, a reduction of $20 million (note that if tax rates were currently 80%, then
decreasing them to 65% would actually result in $20 million more tax revenue collected).
But it is important to note that the tax rate at which the Laffer Curve peaks can be
radically different from the curve illustrated in Figure 13.4. Instead consider LatTer
Curve 2 in Figure 13.5. Notice that for the Laffer Curve in Figure 13.5 we encounter the
negatively sloped portion of the curve at much lower tax rates (than in Laffer Curve 1
illustrated in Figure 13.4). Within this economy, when we raise the marginal tax rate
from 15% to 30%, tax revenue collected would increase from $650 million to $765
million, an increase of $115 million. But if we raise the rate further to 60%, we only
collect $540 million of tax revenue, which is a decline of $225 million.
Figure 13.5- Lifter Curve 2
Total Tax Revenue
$765 million.,,..~
$650 million----->
$540 million'''~"
Tax Rate
0 15% 30% 60% 100%
 Chapter #13 - Assessing Taxation Outcomes Chapter #13 - Assessing Taxation Outcomes

C H A P T E R # 1 3 M U LT I P L E C H O I C E Q U E S T I O N S
What explains the difference between the two graphs? The shape of the curve and
the tax rate which maximizes tax revenues collected can be quite different for a number
of ressons. As we saw with Brian Johnson, the lead singer of AC/DC, people can move 1. Which of the following is an example of a progressive tax?
to avoid paying taxes. But what if you cannot or do not want to move to a different A . The U.S. Income Tax.
country7 Within the U.S., if the state of California increases its income tax, high income B . The Russian Income Tax.
individuals and business owners can easily move to Nevada or Arizona or Texas at C. The U.S. Social Security Payroll Tax.
relatively low cost.29 Also recall that people can alter their behavior in other ways to D . None of the above answers are correct (since progressive taxes do not exist in
essentially avoid taxes. When individuals can avoid a tax with relative ease, the peak of the real world).
the Laffer Curve will occur at a lower tax rate, or skew to the left. On the other hand, if it
is difficult for individuals to avoid a tax, the peak of the I,after Curve will occur at a 2. Focusing on the "Average Tax Rate" of the "Bottom 50% of Income Earners," this
higher tax rate, or skew to the right. figure between 1980 and 2009 and then
The fact that people can and will move from one tax jurisdiction to another in between 2009 and 2015.
order to lower their taxes leads to Tax Competition, or deliberate decisions by A. increased from 2.89% up to 4.85%; increased further from 4.85% up to 7.91%
government lower tax rates and simplify the tax code to gain new taxpayers. As the B. decreased from 15.76% down to 10.11%; decreased further from 10.1t%
world becomes more ghibalized and people are more willing to relocate, governments are down to 5.16%
forced into competition with each other for productive, high income individuals. This C. decreased from 6.10% down to 2.35%; increased from 2.35% up to 3.59%
compctitiun has put downward pressure worldwide on Marginal Tax Rates. D. increased from 22.17% up to 25.43%; decreased from 25.43% down to
In summary, the tax rate which maximizes tax revenues can vary from economy 19.37%
to economy. More importantly, whether increasing tax rates will ultimately increase or
decrease total tax revenue is an empirical matter - from the Laffer Curves illustrated in 3. The provides a measure of the degree of progressivity of a tax,
Figures 13.4 and 13.5, we see that theoretically either outcome could result. defined as the ratio of the area between the Lorenz Curve and the Tax
Concentration Curve to the entire area below the Lorenz Curve.
A. Gini Coefficient
B. Sa'oup Coefficient
C. Pechman-Okner Coefficient
D. Lorenz Coefficient

4. Consider the following outcomes from a tax: Ann has income of $100,000 and pays
8.5% of her income in taxes; Bob has income of $ 100,000 and pays 12.4% of his
income in taxes; and Cathy has income of $150,000 and pays 10.7% of her income
in taxes. If economic capacity is measured by income and tax burden is measured
by Average Tax Rate, then there appears to be
A. a violation of both horizontal equity and vertical equity.
B. a violation of horizontal equity (but no violation of vertical equity).
C. a violation of vertical equity (but no violation of horizontal equity).
D. no violation of either horizontal equity or vertical equity.

5. The country of Benthamstan imposes a progressive income tax which reduces the
value of its Gini Coefficient from .40 to .32. This implies that the value of the
Pechman-Okner Coefficient for this tax is equal to
A . .08
B . .20
1~s . .
u e, h a n'ugraaon from California to Texas has actuall been occ " C. ,36
~ee: 'Texas, Here We Corn-" ,'-'-,,~../~. ,. Y urrmg, driven artly by income taxes. D . .72

336
 Chapter #13 -Assessing Taxation Outcomes Chapter #13- Assessing Taxation Outcomes

6. In 2018, the U.S. Federal Income Tax had

A . 2 different tax brackets of 10% and 15%.
B . 7 different tax brackets, ranging from a low of 10% to a high of 37%.
C 1.5 different tax brackets, ranging from a low of 5% to a high of 50%.
D . 24 different tax brackets, ranging from a low of 20% to a high of 91%.
7. Under the current U.S. Federal Income Tax, the "Top 1% of wage earners" pay
A. virtually no taxes, due to all of the loopholes in the current tax code.
about 39.04% of all taxes collected, an amount greater than the 29.41% of all
taxes collected that is paid by the "bottom 90% of wage earners."
C. about 20.65% of all taxes collected, an amount exactly equal to their share of
total adjusted gross income earned.
D . about 18.93% of an taxes collected, an amount slightly less than their share of
total adjusted gross income (which is 20.65% of total adjusted gross income).
8. The benefits principle of taxation states that
A. the amount a person pays in taxes should be related to the ease with which the
person is able to bear the burden of paying taxes.
B. the amount a person pays in taxes should be related to the benefits he receives
from the goods and services provided by government.
C nobody should ever have to pay any taxes, because taxation is theft.
D. taxes should only ever be imposed with the intention of redistributing income.
12. The Laffer Curve illustrates how total tax revenue
A. will always increase when the tax rate is increased.
B. will always decrease when the tax rate is increased.
C may either increase or decrease when the tax rate is increased.
D. will be very high when the tax rate is either very low or very high, but will
instead be negative if the tax rate is set at an intermediate value.
13. Individual Income Taxes account for__ of all U.S. Federal Government revenues.
A . 0% (since the U.S. Federal Government does not impose taxes on individual
income)
B . 12,2% (making it the third largest source of U.S. Federal Government
revenues)
C. 47.9% (making it the largest single source of U.S. Federal Government
revenues)
D . 100% (since the U.S. Federal Government has no other sources of revenue)
For question 14, consider the graph below which illustrates the ~Average Tax Rate" as
a function of income which results from an income tax in Country A, Country B, and
i C o u n t r y o / ~ ~

For Questions 9 through 11, consider a country with an income tax as follows: for
each of the first £100,000 earned a worker must pay 10% to the government; for all
earnings above £100,000 a worker mast pay 4% to the government.
A TR in Country A
Liam earns El 50,000 per year. He faces a Marginal Tax Rate of ATR in Country B
A . 4%

~
B. 8% -- ATR in Country C
C. 10%
D . 14%

Liam's brother Noel earns E300,000 per year. Noel's Average Tax Rate is
A . 4% ~ .
B. 6% Income
C. 10%
D . 14%
It appears that the income tax in Country A is a
tax, the income
tax in Country B is a tax, and the income tax in County C is a
It appears as if this tax is a
A. Regressive Tax.
B. Proportional Tax. A. regress!ve; proportional; progressive.
C. Progressive Tax. B. regressive; progressive; progressive.
C. progressive; proportional; regressive.
D. Per Unit Tax. D. progressive; regressive; regressive.

338 339
 Chapter #13 - Assessing Taxation Outcootes Chapter #13 - Assessing Taxation Outcomes

15. The vahie of the Pechrnan.Okner Coefficient for the U.S. Federal Inc°me Tax 19. Consider the payroll taxes imposed to fund Social Security and Medicare. Under
A. was .0916 in 2015. these taxes, the first $128,400 of income earned is taxed at a marginal rate of 15.3%
B. was negative for 12 straight years between 1981 and 1992. and income above this level is taxed at 2.9%. It follows that over all income ranges,
C. steadily increased from .0876 in 1950 to.1794 in 1960 to .2736 in 1970. these payroll taxes are a
D. ranged between .325 and .375 in every single year between 1929 and 2015. A . Rawlsian tax.
B. Progressive tax.
16. The Amendment to the U.S. Constitution, ratified on C. Proportional tax.
authorized the creation of a Federal Income Tax. D . Regressive tax.
A. 1~ Amendment; July 4, 1776.
B. 16~Amendment;Fcbruary3, 1913. 20. Zack is the starting quarterback on his high school football team. After the fast five
C. 10~ Amendment; November 5, 1939. games of the season he is averaging 152.4 passing yards per game. Based upon this
D. 29~ Amendment; March 7, 1982. information, which of the following statements is true?
A . "If he has zero passing yards in his next game, his average will drop to 76.2
For questions 17 and 18, refer to the graph below, which illustrates the Lorenz Curve yards per game."
and Tax Concentration Curve in "Country Z" in 2018. Assume throughout that: "A" B . "If he throws for 153 or more yards in his next game, his average will
(the area benceen the Lorenz Curve and the 45 degree line) has an area of.20; "B" increase."
(the area between the Tax Concentration curve and the Lorenz Curve) has an area of C "His average will decrease if he throws for more than 152.4 yards in his next
.12; and "C" (the area below the Tax Concentration Curve) has an area of .l& game."
CFI & CFT D . None of the above answers are correct.
......................................
21. moved to Hawai'i in 1983 in order to avoid having to pay income
taxes to the United Kingdom at a Marginal Tax Rate of 83%.
A. Prince Charles
B. Chris Rock
C. Brian Johnson
D. Ronald Reagan

22. The value of the Stroup Coefficient for the U.S. Federal Income Tax
~ L o r e n z C u r v e A. was above .98 in every year between 1929 and 1939.
B. was below .7 for 66 straight years from 1942 through 2007.
0 C. was equal to .7178 in 2015.
I CFP D. More than one (perhaps all) of the above answers is correct.
0
1
17. Based upon the relation of these curves to each other, it appears as if this is a
A . Progressive tax.
B . Proportional tax.
C . Regressive tax.
D . Rawlsian tax.

18. Ybe value of the Stroap Coeflicient is

A. .12 ~ "
B . .24
C. .40
D . .60
Chapter $13 -Assessing Taxation Outcomes

"I, Pencil"
by Leonard E. Read
I am a lead pencil--the ordinary wooden pencil familiar to all boys and girls and
adults who can read and writeJ
Writing is beth my vocation and my avocation; that's all I do.
You may wonder why I should write a genealogy. Well, to begin with, my story
is interesting. And, next, I am a mystery - more so than a tree or a sunset or even a flash
of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere
incident and without background. This supercilious attitude relegates me to the level of
the commonplace. This is a species of the grievous error in which mankind cannot too
long persist without peril. For, as a wise man observed, "We are perishing for want of
wonder, not for want of wonders.''2
I, Pencil, simple though I appear to be, merit your wonder and awe, a claim I shall
attempt to prove. In fact, if you can understand me - no, that's too much to ask of anyone
- if you can become aware of the miraculousness which I symbolize, you can help save
the freedom mankind is so unhappily losing. I have a profound lesson to teach. And I
can teach this lesson better than can an automobile or an airplane or a mechanical
dishwasher because - well, because I am seemingly so simple.
Simple? Yet, not a single person on the face of this earth knows how to make me.
This sounds fantastic, doesn't it? Especially when it is realized that there are about one
and one-belf binion of my kind produced in the U.S.A. each year.
Pick me up and look me over. What do you see7 Not much meets the eye -
there's some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and an
ersscr.
.lust as you cannot trace your family tree back very far, so is it impossible for me
to name and explain all my antecedents. But I would like to suggest enough of them to
impress upon you the richness and complexity of my background.
My family tree begins with what in fact is a tal, a cedar of straight grain that
grows in Northern California and Oregon. Now contemplate all the saws and trucks and
rope and the countless other gear used in harvesting and carting the cedar logs to the
railroad siding. Think of all the persons and the numberless skills that want into their
fabrication: the mining of ore, the making of steel and its refinement into saws, axes,
motors; the growing of hemp and bringing it through all the stages to heavy and strong

My official name is ~Mongo1482? My many ingredients are a.wc~nbled, fabricated, and finished by
Ebcrhard Fttber Pencil Company, Wilkcs-Ban~, Pcmnsylvania.
2 Q, K, C~¢stcnon.
 Coda - '7, Pencil" by Leonard Read
rope; the logging camps with their beds and mess halls, the cookery and the raising of all
the foods. Why, untold thousands of persons had a hand in every cup of coffee the
loggers drlnkl
The logs are shipped to a mill in San Leandrro, California. Can you imagine the
individuals who make fiat cars and rails and railroad engines and who construct and
install the communication systems incidental thereto? These legions are among my
antecedents.
Consider the millwork in San Leandro. The cedar logs are cut into small, pencil-
length slats less than one-fourth of an inch in thickness. These are kiln dried and then
tinted for the same reason women put rouge on their faces. People prefer that I look
pretty, not a pallid white. The slats are waxed and kiln dried again. How many skills
went into the making of the tint and the kilns, into supplying the heat, the light and
power, the belts, motors, and all the other things a mill requires? Sweepers in the mill
among my ancestors? Yes, and included are the men who poured the concrete for the
dam of a Pacific Gas & Electric Company hydroplant which supplies the mill's power!
Don't overlook the ancestors present and distant who have a hand in transporting
sixty carloads of slats across the nation from California to Wilkes-Barre]
Complicated Machinery
Once in the pencil factory - $4,000,000 in machinery and building, all capital
accumulated by thrifty and saving parents of mine - each slat is given eight grooves by a
complex machine, after which another machine lays leads in every other slat, applies
glue, and places another slat atop - a lead sandwich, so to speak. Seven brothers and I
are mechanically carved from this "wood-elinebed" sandwich.
My "lead" itself- it contains no lead at all - is enmplex. The graphite is mined in
Ceylon. Consider these miners and those who make their many tools and the makers of
the paper sacks in which the graphite is shipped and those who make the string that ties
the sacks and those who put them aboard ships and those who make the ships. Even the
lighthouse keepers along the way assisted in my bia'th - and the harbor pilots.
The graphite is mixed with clay from Mississippi in which ammonium hydroxide
is used in the refining process. Then wetting agents are added such as sulfunated tallow -
~anc~ln:a~t eh__e...mi.'eally reacted wath sulfuric acid. After passing through numerous
cut to s'~e?d~'1~t~ture l:mauy appearshours
as endless extrusions-
, d, and baked for several at 1,850 degreesas from a sausage
Fahrenheit. grinder-
To increase
their strength and smoothness the leads are then treated with a hot mixture which includes
eandelilla wax from Mexico, paraffin wax, and hydrogenated natural fats.
My cedar receives six enats of lacquer. Do you know all of the ingredients of
lacquer? Who would think that the growers of eastur beans and the refiners of castor oil
are a part of it? They are. Why, even the processes by which the lacquer is made a
beautiful yellow involves the skills of more persons than one can enumerate!
Observe the labeling. That's a film formed by applying heat to carbon black
mixed with resins. How do you make resins and what, pray, is carbon black?
Coda - "1, Pencil" by Leonard Read
My bit of metal--the ferrule--is brass. Think of all the persons who mine zinc
and copper and those who have the skills to make shiny sheet brass from these products
of nature. Those black rings on my ferrule are black nickel. What is black nickel and
how is it applied? The complete story of why the center of my ferrule has no black nickel
on it would take pages to explain.
Then there's my crowning glory, inelegantly referred to in the trade as "the plug,"
the part man uses to erase the errors he makes with me. An ingredient called "factice" is
what does the erasing. It is a rubber-like product made by reacting rape seed oil from the
Dutch East Indies with sulfur chloride. Rubber, contrary to the common notion, is only
for binding purposes. Then, too, there are numerous vulcanizing and accelerating agents.
The pumice comes from Italy; and the pigment which gives "the plug" its color is cadium
sulfide.
Does anyone wish to challenge my earlier assertion that no single person on the
face of this earth knows how to make me?
No One Knows
Actually, millions of human beings have had a hand in my creation, no one of
whom even knows more than a very few of the others. Now, you may say that I go too
far in relating the picker of a coffee berry in far off Brazil and food growers elsewhere to
my creation; that this is an extreme position. I shall stand by my claim. There isn't a
single person in all these millions, including the president of the pencil company, who
contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of
know-how the only difference between the miner of graphite in Ceylon and the logger in
Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed
with, any more than can the chemist at the factory or the worker in the oil field - paraffin
being a by-product of petroleum.
Here is an astounding fact: Neither the worker in the oil field nor the chemist nor
the digger of graphite or clay nor any who roans or makes the ships or trains or trucks nor
the one who runs the machine that doe.s the knurling on my bit of metal nor the president
of the company performs his singular task because he wants me. Each one wants me less,
perhaps, than does a child in the first grade. Indeed, there are some among this vast
multitude who never saw a pencil nor would they know how to use one. Their
motivation is other than me. Perhaps it is something like this: Each of these millions sees
that he can thus exchange his tiny know-how for the goods and services he needs or
wants. I may or may not be among these items.
There is a fact still more astounding: The absence of a master mind, of anyone
dictating or forcibly directing these countless actions which bring me into being. No
trace of such a person can be found. Instead, we find the Invisible Hand at work. This is
the mystery to which I earlier referred.
The Invisible Hand:
By directing that industry in such a manner as its produce may be of the greatest
value, he intends only his own gain ....He is in this, as in many other eases, led by
 Coda - "L Pencil" by Leonard Read
Coda-"L Pencil"byLeonardRead

an invisible hand to promote an end which was no part of his intention....By

pursuing his own interest he frequently promotes that of the society more visually and in motion to any person's home when it is happening; they deliver 150
effectually than when he really intends to promote it. passengers from Seattle to Baltimore in less than four hours; they deliver gas from Texas
- Adam Smith, The Wealth of Nations to one's range or fumaee in New York at unbelievably low rates and without subsidy;
they deliver each four pounds ofoil from the Persian Gulf to our Eastem Seaboard - half-
It has been said that "only God can make a tree." Why do we agree with this.'? way around the world - for less money than the government charges for delivering a one-
Isn't it because we realize that we ourselves could not make one? Indeed, can we even ounce letter across the street!
describe a tree? We cannot, except in superficial terms. We can say, for instance, that a The lesson I have to teach is this: Leave all creative energies uninhibited. Merely
certain molecular configuration manifests itself as a tree. But what mind is there among organize society to act in harmony with this lesson. Let society's legal apparatus remove
men that could even record, let alone direct, the constant changes in molecules that all obstacles the best it can. Permit these creative know-bows freely to flow. Have faith
transpire in the life span era tree? Such a feat is utterly unthinkable! that free men will respond to the Invisible Hand. This faith will be confirmed. 1, Pencil,
I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, seemingly simple though I am, offer the miracle of my creation as testimony that this is a
and so on. But to these miracles which manifest themselves in Nat'are an even more practical faith, as practical as the sun, the rain, a cedar tree, the good earth.
extraordinary miracle has been added: the configuration of creative human energies -
millions of tiny know-hews configumting naturally and spontaneously in response to
human necessity and desire and in the absence of any human master-minding! Since only
God can make a tree, I insist that only God could make me. Man can no more direct
these millions of know-hews to bring me into being than he can put molecules together to
create a tree.
The above is what I meant when writing, "If you can become aware of the
miraculousness which I symbolize, you can help save the freedom mankind is so
unhappily losing." For, if one is aware that these know-bows will naturally, yes,
automatically, arrange themselves into creative and productive patterns in response to
human necessity and demand - that is, in the absence of governmental or any other
coercive master-minding - then one will possess an absolutely essential ingredient for
freedom: a faith in free men. Freedom is impossible without this faith.
Once government has had a monopoly of a creative activity such, for instance, as
the delivery of the mails, most individuals will befieve that the malls could not be
efficiently delivered by men acting freely. And here is the reason: Each one
acknowledges that he himself doesn't know how to do all the things incident to mail
delivery. He also recognizes that no other individual could do it. These assumptions are
correct. No individual possesses enough know-bow to perform a nation's mall delivery
any more than any individual possesses enough know-bow to make a pencil. How, in the
absence of a faith in free men - in the unawareness that millions of tiny know-bows
would naturally and miraculously form and cooperate to satisfy this necessity - the

byindividualgovernmentalcannot"master-minding."helpbutreachtheerroneousconclusionthatmailcanbedeliveredonly
If I, Pencil, were the only item that could offer testimony on what men can
accomplish when free to try, then those with little faith would have a fair case. However,
there is testimony galore; it's all about us and on every hand. Mail delivery is
exceedingly simple when compared, for instance, to the making of an automobile or a
calculating machine or a grain combine or a milling machine or to tens of thousands of
other things. Delivery? Why, in this area where men have been let~ free to try, they
deliver the human voice around the world in less than one second; they deliver an event
A short (six and a half minute) movie version of this essay, along with some extended commentary videos,
have been produced by the Competitive Enteq3rise Institute. They can be viewed online at:
"I, Paneih The Movie": htn)s:/Atat~r.~)umbe.cond~wztch?v=lYO3tOaDl.~F
"Extended Commentary: Spontaneous Order": https;/Awt~v.)'outube.com/~teh?v=vFeGNXO6Z.~,
"Extanded Co~la~. Con~ctJvit~: httt~:/A~a~av.~unlbe.comA~uch?v=pwH~qzPoolVI,
"Extended Commen~usc. Trade & Specialization": haps:/A~a~v,~outube.cont~teh?v=KwlkODeT¢lpt!
"Extended Commentm'y: Creative Destnletinn": httt)s.'/'~tnv)t\~umbe.comAt~tch?v=8NOSKkia9~A.
"Extended Commentary: Importance of l, Pencil": hut~:/Av)~wa~)nmbe, comht~uch?v=N AeviP(LrHS.
Coda - "1, Pencil" by Leonard Read

to End of Chapter
Questions
CHAPTER #1 (Foundations of Economics)

I. C 9. A 17. B
2. B I0. C 18. A
3. B II. B 19. C
4. B 12. C 20. D
5. A 13. C 21. D
6. D 14. A 22. C
7. D 15. D 23. B
8. B 16. A

CHAPTER #2 (Fundamental Economic Questions and Gains from

Specialization)

1. C 7. A 13. D
2. B 8. C 14. D
3. B 9. B 15. B
4. D I0. B 16. C
5. C II. A
6. D 12. B

CHAPTER #3 (Economic Systems: Capitalism versus Socialism)

1. A 8. C 15. D
2. D 9. B 16. C
3. C 10, C 17. C
4. B 11. A 18. B
5. B 12. D 19. C
6. C 13. A
7. C 14. D
 Answers to End of Chapter Questions
Answers to End of Chapter Questions

CHAPTER #4 (Organizing Principles of Capitalist Systems)

CHAPTER #8 (Impact of Policy Decisions on the Rate of Inflation)
1. C 9. B 17. B
1. C 7. C 13. B
2. A 10. B 18. A
2. B 8. A 14. B
3. A 11. D 19. B
4. 3. D 9. A 15. C
B 12. B 20. B
5. 4. B 10. D 16. B
D 13. D 21. C
6. A 14. B 22. B 5. B 11. B
7. B 15. D 6. C 12. B
8. A 16. B

CHAPTER #9 (Observations on Inflation and Unemployment Rates in

CHAPTER #5 (Surplus, Efficiency, and Deadweight Loss) the United States)

1. A 4. C 7. D 1. A 5. D 9. C
2. B 5. C 2. B 6. B 10. A
8. B
3. C 6. B 3. C 7, C
9. A
4. B 8. C

CHAPTER #6 (Organizing Principles of Socialist Systems)

CHAPTER #10 (Market Failure)
1. C 5. B 9. D
2. B 6. C 1. B 9. C 17. A
10. C
3. D 7. B 2. B 10. C 18. A
4. A 8. 3. D 11. A 19. C
A
4. D 12. C 20. B
5. C 13. A 21. B
CHAPTER #7 (Gross Domestic Product and Economic Growth) 6. B 14. A 22. B
7. D 15. D
1. C 8. C 16. B
9. D 17. C
2. D 10. B
3. C 18. C
11. C 19. A
4. A 12. CHAPTER #11 (Government Failure)
B 20. B
5. B 13. C 21. D
6. B 1, C 8. C 15. C
14. A 22. C
7. B 15. 2. B 9. B 16. C
C 23.
8. C A 3. A 10. C
16. B 17. B
4. D 11, D 18. B
5. D 12, C 19. B
6. A 13, A 20. C
7, B 14. B 21. C
 Answers to End of Chapter Questions

CHAPTER #12 (Inequality and Redistribution)

1. D 15. D
2. B
8.
9.
C
B 16. A Index
3. C 10. D 17. C
4. A 11. D 18. C
5. D 12. B 19. D
6. A 13. C 20. D
7. B 14. D 21. D
A Theory of Justice: 295, 302 (business cycle continued)
ability-to-pay principle of taxation: 317, 330 contraction: 157, 159, 197
CHAPTER #13 (Assessing Taxation Outcomes) absolute advantage: 32 expansion: 157-160, 195-199
AC/DC: 333,336 peak: 158-160, 195, 197
I. A 9. A 17. A Affordable Care Act: 4 phases: 147, 157-158, 195-197
2. C I0. B 18. C Aid to Families with Dependent Children: prosperity: 195-196
3. B II. A 19. D 304-305 recession: 147, 157-161,195-197,
4. A 12. C 20. B Alchian, Armen: 15 199-200, 202
5. B 13. C 21. C Anarchy, State, and Utopia: 5 l, 302 recovery: 195-196
6. B 14. B 22. D attainable: 28-30 trough: 158-160, 195
7. B 15. A buyer's reservation price: 79, 82, 91, 93-95,
8. B 16. B 115, 117, 120, 122,207,209,
232, 245-246, 260, 273-275

baakruptcy:102-103, 105-108, 157

bargaining range: 79-80, 82, 93-95 i'll
barter: 185
base year:. 152-153 Capital: Critique of Political Economy: 45,
benefits principle of taxation: 316 166
benefits capital flight: 170
marginal: 9-13, 84, 319, 324 capital goods: 95, 108, 168-169, 198
total: 8-10 capital/labor ratio: 165
Bentham, Jeremy: 294, 302 capitalism: 43-47, 49, 51-53, 55-56, 58-63,
black market: 151
71, 82-85, 87, 104-109, 131-
Blanc, Louis: 54
133, 160, 171,174-175, 306
Boehner, John: 4
feudal framework: 44-45
Boettke, Peter: 260-261
Marx's analysis: 45, 53-54, 160,
boom-bust cycle: 157
297-298
bourgeoisie: 53-54, 298
brain drain: 170 property rights: 46-52
central bank: 192-195, 200-202
Bush, George W.: 266
central planning: 58, 132-133, 135, 139
business cycle: 6, 147, 157-161,195-197,
Chency, Richard: 204
199, 202, 305 Chevy Volt: 56, 60
boom: 157-158, 197-199 Children's Health Insurance Program: 303-
bust: 157
304, 307
 Index Index

circular flow Friedman, Milton: 17, 55, 183,204, 248,

basic: 77-78, 99, 116, 149, 283
expanded: 149-150
deadweight loss: 126-127, 205-206, 208,
preliminary: 24, 77
210, 227-228, 233, 236-240,
Clinton, Bill: 304, 307
243, 255,259-261,267-269,
club good: 234, 248
272, 274, 276
Coas¢, Runald: 243-244
decision making process: 8-13
Coasian solution to externalities: 243-246 applying cost-benefit principle: 9-13
coercion: 43, 51, 59-60, 79, 85,315
applying incentive principle: 13-16
collective property: 54
by self-interested individuals: 16-17
command planning: 58, 132, 143-144, 174-
deflation: 184, 186, 189, 216-217, 223
175,203
command system: 45, 58, 131 demand: 56, 58, 83, 86-87, 90-98, 100-102,
common good: 234 104, 109, 115, 117-119, 122-
common property: 48 123,125-126, 136, 139, 185-
communism: 45.46, 55, 85, 131 186, 197-198, 203-208,228-
Communist Manifesto, The: 45, 54, 58, 160 233,237-240, 268-276
comparative advantage: 33-36 determinants of: 96-98
comparative economic systems: 44, 56 excess: 92-93
compensating differentials: 285,301 for a firm with market power: 228-
complement good: 97, 117 233
Cundorcet Paradox: 258 law of: 83, 87, 93, 117, 229, 275
consistent plan: 138-139 depression:143, 160-161,199, 223
consumer prine index: 152, 183-184, 187, diminishing marginal benefit: 10, 84
215 discount rate: 192-193, 199
consumer sovereignty: 56, 60, 116, 302, 315 distributional decision: 25, 37, 56, 203,227,
consumer surplus: 80, 94, 118-123, 207,
232-233,237, 268, 271,274-
283
Ditlm, Mike: 1, 15
276 Downton Abbey: 49
contractiunary monetary policy: 199 dual coincidence of wants: 185
corruptiun: 66, 68, 156, 172, 176, 259, 261- Dunder Mifflin: 108
262, 322
Cost of Living Council: 204
cost-benefit principle: 1, 9-13, 16-17, 90,
125, 229, 232, 238,259, 319, Ill
324
costs
Earned Income Tax Credit: 304, 306, 308
marginal: 10, 12, 79, 87-88, 229,
ease of doing businnss: 68-71,172, 175
231-232, 260, 319
Economic Calculation Problem: 260
total: 8-11,231,248, 265
econnmic development: 156-157, 170, 261
creative destruction: 107, 347
economic freedom: 63-65, 71,172 175
crony capitalism: 68
eeunomicgrowth-4 6 ,6~
crony capitalist: 175 , , v, ~ , -1at
l . ~1:"
, 147,
156-157, 161-162, 164, 168-
175, 194-195, t99, 202, 241,
293
economic man: 85, 102
economic system: 25, 43-.46, 56, 61-62, 66, 308
71, 83, 85, 131-132, 139,
fundamental economic questions: 25, 37,
144, 173-175, 203, 261
43-45, 57-58, 61-62, 227, 283
economies, definition of: 2
efficient level of trade: 124, 126, 206, 227,
232, 238,243,259-260, 269,
272
Engels, Friedrich: 45, 53
entrepreneur: 54, 57, 71, 87-88, 102-106,
108-109, 132, 175,261 Gaidar, Yegor: 141
equation of exchange: 186-188, 194, 201 Galston, William: 307
equilibrium: 77, 90-91,93-96, 100-102, 109, Gingrich, Newt: 304
115, 122-124, 126-127, 136, Gini coefficient: 62, 286, 288-291,327-328,
185, 187-189, 195, 197,227- 330
228, 238-239, 268,286 gold standard: 200-202
excludable good: 234,248 goods and services: 23-25, 38, 43-44, 60,
expansionary monetary policy: 198, 202 77-78, 83, 132, 135, 140,
expected utility theory: 297 147-154, 175, 186-188, 190,
expenditure method: 150 194, 198,215, 227, 259, 283-
Exploding Kittens: 81-82 284, 291,297,299, 303,306,
exports: 136, 148-150 316, 345
extensive growth: 164-166 Google: 8, 103
externality: 120, 236-244, 260 Gorbachev, Mikhail: 142, 144
Gore, AI: 266
GOSPLAN: 133-137, 139, 141-142
Ill government: 6, 14, 43-45, 47-49, 51-56, 58-
63, 65-66, 68-69, 82, 90, 95,
101,106-109, 127, 131-136,
-- idlm factors of production: 23-24, 44-46, 61, 77- 144, 148-151,168, 172, 175-
78, 89, 98-99, 149-150, 188, 176, 184-186, 188-189, 192,
283-284, 297 199-204, 227,233,236, 241-
-- ~-r- Federal Reserve: 6, 192, 199 244, 246-248, 255-256, 258-
feudalism: 44-45 270, 272-277, 284, 286, 291,
final good: 147, 151,215
firm: 2, 6-9, 23-25, 43-44, 56-57, 59, 68, 70,
294, 298-305, 307-308, 315-
316, 322. 325, 331,333-334,
77-79, 83, 87, 90, 95, 98-99, 336, 346-347
102-109, 133, 140-141,149- government failure: 175,227, 233,243, 255-
150, 157, 168, 175-176, 187, 277
192, 195, 198, 207-210, 227- Great Inflation: 216-217, 222
233,241-248, 259-260, 262- Great Misery: 222
263, 283-285, 315 Great Recession: 158-160, 222-224
Five-Yeax Plan: 132-133 gross domestic product: 62, 147-150, 156,
fist tax: 321-322 158, 164, 184, 186-187, 215
fractional reserve banking system: 192 growth rate: 2, 156, 158, 162-164
Frank, Robert: 291,307
nominal: 153-154, 188
Free R.idex Problem: 236, 259, 299-300

354
 /ndex
(gross domestic product continued)
per capita: 143-144, 154-157, 161,
164-166, 170-174, 241
real: 142, 153-154, 159-160, 165,
168, 188, 195-196
guaranteed minimum income: 307-309
Harsanyi, John: 295) 297
Hayelq Friedrich yon: 260, 261
Head Start: 304, 307
horizontal equity: 317
household: 2, 23-25, 43-44, 56, 60-61, 77-
78, 102-103, 148-150, 168,
193, 195, 198-199, 221,283-
291,293-294, 299, 301,303-
304, 307, 315-318, 324, 331
housing vouchers: 304
human capital: 156, 167-168, 170, 173, 175,
283, 301
hype nflation: 183, 190-192, 194, 202
I. Pencil: 95, 139, 343-347
identity: 136, 187, 189
imports: 136, 141, 148-150
incentive principle: 1, 13-16, 58-59, 243,
300, 319
income: 6, 14, 25, 43, 47, 51-52, 54, 57, 59-
62, 70-71, 78, 85-88, 96-97,
100, 106-107, 117, 132, 148-
157, 164-166, 168-170, 174,
184, 197-199, 208, 241,261,
283-291,294-297, 299-309,
315-334, 336
income method: 150
income support: 303-307, 309
indicative planning: 59-60
Industrially Advanced Countries: 156, 168
inferior good: 97
inflation: 2, 6, 151-154, 157, 183-184, 186,
189-192, 194-195, 200-205,
215-217, 219-224, 289, 292,
323
intensive growth: 164, 166
intermediate good: 150-151
invisible hand: 57-58, 126, 291,345-347
It's a Wonderful Life: 193, 200
Johnson, Brian: 333-334, 336
Johnson, Lyndon: 220, 291-292, 303
Kahneman, Daniel: 4
Kennedy, John F.: 197
Keynes, John Maynard: 4, 160, 199
lOm~hchev, Nikita: 143
kleptecracy: 259, 261-262
Labor Theory of Value: 297-298
Laffer Curve: 316, 334-336
laissez fake: 45, 82, 85, 109
law of comparative advantage: 35-36
law of increasing cost: 87
Lamer, Abba: 291,305
Less Developed Countries:151, 156, 170
libertarian justice: 302
Ioanable funds market: 197-199
Locke, John: 47-48, 50, 54
logrolling: 259, 264-267
Lorenz curve: 286-289, 325, 327-329
/ndex
monopoly: 6, 44, 54, 61,126, 141,229-233,
248, 346
moral suasion: 59-60
macroeconomics: 1-2, 5
marijuana: 6-7
market: 2, 8, 25, 43-45, 54, 56-63, 66, 68-
69, 71, 77-80, 82-83, 85, 87-
88, 102-103, 105, 107-109,
115-118, 122, 124-127, 131,
National School Lunch Program: 304, 307
136, 139-140, 147, 149-150,
negative externality: 120, 237-244,260
156, 158, 171-172, 174-175,
negative income tax: 9, 307-309
186-187, 190-191,198, 203-
negative rights: 52
209, 227, 234-236, 259-261,
negative-sum environment: 82
283-284,291,297-298, 300-
302 Neoberger, Egon: 55-56
New Economic Policy: 132, 204
equilibrium: 90-102, 123, 126, 227-
228, 238-242, 268, 285-286 New Soviet Man: 85
night-watchman: 52, 55
market failure: 126, 22%228, 233,236, 239,
241-242, 246-248, 255,259- Nixon, Richard: 204-205, 220-221
260, 262, 269, 272, 301 nominal data: 152-154, 157
market power: 227-233, 248, 259, 262 nominal wealth: 188
Marx, Karl: 45, 53-54, 58, 60, 160, 166, non-excludable good: 127, 234-236, 299
non-market production: 15 I
297-298, 302
non-rival good: 127, 233-236, 248, 299
Marxist: 85
normal good: 97, 100
material balances: 135-136
normative statement: 3, 5, 7-8, 124, 203,
material reward: 59-60, 283, 315
205, 210, 283, 307, 325
maximin criterion: 296-297
Mayfield, Baker: 319-320 Nove, Alec: 59-60, 62
means tested: 301,303, 309 Nozick, Robert: 51-52, 302
Medicaid: 61, 291-292, 303-304
menu costs: 190
microeconnmics: I-2, 5
Mill, John Stuart: 294
minimum wage: 2, 6-7,203,208-210, 303,
308 Obama, Barack: 4, 223, 327
Misery Index: 215,220-224 Okun, Arthur: 220
Mises, Ludwig yon: 260 OPEC: 196
mixed economy: 60-62, 106, 132, 171,204, open market operations: 192, 197, 199
298 open-endod fallacy: 124-125, 241
money: 17, 27, 49-51, 54, 57, 63, 65, 68, 77-
opportunity cost: 27-29, 31, 33-36
79, 81, 85, 103-105, 115-116, optimal plan: 139
121,140, 142, 152, 169-170,
overhead capital: 168, 175
175-176, 184-186, 191,200-
202, 235,261,269-270, 283-
284, 286, 291,294-295,299-
300, 303, 305-307, 309, 347
money supply: 6, 160, 186-190, 192-203

Peehman-Okner coefficient: 303, 316, 330-
333
Pell grants: 304
Peltzman, Sam: 14-15,247
Per unit tax: 242-243, 267-276, 315, 334
perestroika: 142
physical capital: 167-168
Pignu, Arthur:. 242
Politburo: 133-135, 137, 139-140
positive externality: 237, 239-242
positive statement: 3, 5, 7, 124, 205,210
positive-sum environment: 81-82
poverty: 284, 291-294, 299
rate: 291-293, 299
threshold: 291-293, 303, 307, 316
poverty trap: 301
price ceiling: 203-207
price control: 6-7, 203-210
price floor. 203, 208-210, 303
price index: 151-154, 183,215
Prius: 246-247
producer surplus: 80, 94, 118-123,205-207,
209-210, 232, 237, 268, 271,
274, 276
production: 23-24, 26, 147-148, 150, 297-
299, 301
production decision: 25, 29-30, 37, 57, 227
production possibilities frontier: 23, 26-32,
35-37, 161-162, 168-169
productive efficiency: 29-30, 258
productive inefficiency: 29-30, 36
proletariat: 53-54, 298
profit: 8-9, 49-50, 57, 59, 87-88, 90, 99,
102-106, 108-109, 134, 139-
141,157, 176, 198, 227-229,
231-233,244, 248, 260-261,
263
properly fights: 43.46-47, 49-52, 54-55, 63,
65-67, 71, 84-85, 90, 104,
109, 172, 175, 202, 243-244,
246, 297-299, 302,306
public choice: 255
public good: 127, 140, 227, 233-236, 259-
260, 299
private good: 234
rational decision maker: 8, 13-16, 56-57, 82,
85, 87-88, 90, 116, 127, 255,
299-300, 306, 333
rational ignorance: 259, 266
Rawls, John: 295-297, 302
Rawlsian Justice: 296-297
Reagan, Ronald: 3,333-334
real data: 152, 154
real wealth: 188
recession: 147, 157-161,195-197, 199-200,
202, 305
recessions in U.S.: 160
redistribution: 6, 61,227, 284, 294-309, 316
redistribution in-kind: 6, 303-309
regulatory capture: 259, 262-263
relative price: 186
rent seeking: 248, 259, 263-264
reserve lequirement: 192-194, 199
residual claimant: 104, 106
residual ownership claim: 87
resource use decision: 25, 28, 37, 57
restitution: 46, 49-51, 53
revenue: 68, 77-78, 87-88, 90, 103, 108,
149, 193,229-232, 235-236
marginal: 229-232
Rhys-Williams, Juliet: 308
Rieardo, David: 35, 166
rival good: 233-234
Rock, Chris: 315
Rule of72:164
rule of law: 172, 175
Rumsfeld, Donald: 204
Samualson, Paul: 4, 35, 147, 159
scarcity: 2, 23, 29
Schumpeter, Joseph: 107-108
Scranton, PA: 108
self-interested individual: 16-17, 25, 56-57,
77, 80, 84-85, 88, 90, 109,
116, 127, 227-228, 233, 235-
236, 247, 255, 260, 272
selfishness: 17, 84-85
seller's reservation price: 79, 82, 92, 94-95,
99, 115-116, 120, 122, 209,
245-246, 260, 269-270, 274-
275
Simpsons, The: 193
Smith, Adam: 16-17, 45, 57-58, 84, 126,
346
Smith, Vernon: 4
Smith, Will: 1
social justice: 53
social surplus: 120-127, 140, 206, 210, 227,
232-233, 235, 237-242, 244-
246, 248, 255,259-260, 265-
266, 268, 272, 274, 301-302
socialism: 43-46, 53-62, 66, 71,131,133,
171,172, 175,261
Stroup coefficient: 316, 327-329, 332-333
subsidy: 105-106, 241-242, 347
substitute good: 97, 98, 117, 229
Supplemental Nutrition Assistance: 304
Supplemental Security Income: 304-306
supply: 56, 58, 83, 87-96, 98-102, 109, 115,
117-120, 122-123, 125-126,
136, 138-139, 141,185-189,
196-197,203-209, 228, 237-
240, 268-276
determinants of: 98-100
excess: 91-93
law of: 87-88, 90, 93, 275
supply shock: 196
tax: 59-61, 68, 70, 109, 149-151,156, 236,
242, 267-277, 315-336
ad valonun: 268, 270
average rate: 316-318, 324.-327, 330,
332-333
(tax continued)
distribution of: 325
incidence of: 268, 271,274
marginal rate: 308, 316, 319-321,
323-324, 327, 333-336
per unit: 242-243, 267-276, 315, 334
Pigovian: 242
progressive: 61,303, 316, 318-320,
325-333
progressivity: 316, 327-329, 331-333
proportional: 316, 318-321,328-330,
334
redistributive capacity: 316, 327,
330-333
regressive: 316, 318-321
technology: 26, 29, 89, 98-99, 101,103,
156, 161-162, 165, 167-169,
188, 202, 283, 293
Temporary Assistance for Needy Families:
300, 304-306
Teresa, Mother:. 17
Theory of Moral Sentiments. The: 16
tradeoffs: 2, 23, 26, 29, 34, 124, 137, 169,
241,259, 289, 296
transactions costs: 191
Tutlock, Gordon: 15
unattainable: 28-29
underground economy: 151
unemployment rate: 2, 159-160, 204, 215,
217-223
used good: 151
Utilitarian Justice: 294-296
veil of ignorance: 295-296
velocity of money: 186-188
vertical equity: 317-318, 330
vicious-cycle-of-poverty: 170
 /ndex

voting: 255-258, 265-266

War Communism: 131-132, 142

wealth: 82, 106-107, 166, 184, 186, 188,
190, 284-286, 291,293-295
Wealth of Nations, The: 45, 57-58, 346
Weber, Max: 44, 56, 60
Wilde, Oscar: 283, 305
win-lose outcome: 81-82
win-win outcome: 38, 57, 81-82

Yore Kippur War: 196

zero-sum environment: 81