Exchange and Production Competition, Coordination, And Control by Armen a. Alchian

Exchange &Production

COMPETITION,COORDINATION,& CONTROL

Third Edition

Armen Alchian & William R. Allen

University of California, Los Angeles

Wadsworth Publishing Company, Belmont, CaliforniaA Division of Wadsworth, Inc.

A Study Guide, by Michael Staten, to accompanyExchange & Production, Third Editionis available from your bookstore.

Economics Editor: Bill OliverEditorial-Production Services: Douglas PundickDesigner: Ghristy ButterfieldIllustration: Miki GreinerComposition: TriStar Graphics

<0 1983 by Wadsworth, Inc.

<0 1977, 1969, 1967, 1964 by Wadsworth Publishing Company, Inc. No part of thisbook may be reproduced, stored in a retrieval system, or transcribed, in any form or byany means, electronic, mechanical, photocopying, recording, or otherwise, without theprior ~ritterl :pel]:n,ission of the publisher, Wadsworth Publishing Company, Belmont,C,lif~rni,a 94,002,~:''di,:.:ision of Wadsworth, Inc .

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Preface

As its title suggests, this text presents economic principles that ex-plain how our market-directed economy organizes and coordinatesproduction and exchange among competing but nevertheless cooperat-ing people. The book concentrates on what is unfortunately called"microeconomics": the role of markets in which property rights areexchanged and contracts and coalitions are formed to enable greaterproduction and resolution of conflicts of interest. Our premise is thatwhat is called "macroeconomics" cannot be made coherent withoutthese fundamentals.

The third edition of Exchange and Production continues to em-phasize economic principles. The principles are presented through aseries of simple behavioral postulates, and throughout the book theauthors demonstrate how these principles explain a wide variety ofeconomic and social phenomena. Although all economics texts useeconomic principles to analyze a society of scarce resources and unlim-ited wants, Exchange and Production extensively illustrates how thenecessity of tradeoffs affects both economic behavior and social behav-IOr.

Note that the book does not attempt to survey the entire range ofcurrent economic isssues+-such an attempt would be doomed to super-ficiality and failure. Rather, Exchange and Production focuses onteaching principles by repeated appplication to a variety of problems.

A number of changes have been made in the third edition. In theprevious editions, demand was emphasized initially and applied solelyin the context of a fixed supply; supply and production were sequen-tially developed later in the book. In contrast, this edition includes therudiments of production and supply in the first seven chapters. Thispermits an overview of the operation of a system controlled by theexchange of private property rights in a marketplace. The materialthat follows explores in greater depth the reasons for and modes oforganizing business firms and the rate of output and the amount ofinputs hired. Instructors can use the first seven chapters as a demandand supply core and can then select which areas to emphasize fromthe remaining material.

In addition, new chapters offer more systematic treatment of somepricing tactics, of oligopoly, and of the domestic and political econo-mies. More attention is given to the interaction of the law with eco-nomic principles, property rights concepts, public goods, externalities,and opportunistic behavior controls. Recent findings of the meaning

v

and scope of unemployment are included. The monitoring-agency roleof unions is more explicitly contained. The role of cost curves, promi-nent in earlier editions, is reduced and subordinated to greater expla-nation of the meaning and use of the costs of various acts in the pro-duction process. The last chapter, Inflation, has a brief appendix onthe money expansion process of the commercial banking system.

The features that aided student comprehension and review-theend-of-chapter summaries and questions-have been retained and up-dated. And to make the book easier for students to use, a comprehen-sive glossary has been added, more applications have been included,and the level of exposition and, analysis has been simplified, allowingstudents easier access to the material. The most important new aid forstudents, however, is the Study Guide, prepared by Michael Staten, ofthe University of Delaware. This tool offers for each chapter a thor-ough summary, a list of new terms, and appropriate problems andquestions.

Acknowledgment is due to several people. Unnamed as a coauthorof this revision is Arline A. Hoel, whose aid nearly merited that explic-it status. Revision of the book's tone was accomplished by Kevin Glea-son. Those persons who reviewed the manuscript and contributedvaluable suggestions are: Douglas D. Adie, Wheaton College; EdwardB. Bell, Cleveland State University; Donald B. Billings, Boise StateUniversity; Keith D. Evans, California State University, Northridge;Gerald Flueckiger, Miami University; David E. R. Gay, University ofArkansas; Charles A. Rambeck, Saint John's University. And, ofcourse, the authors acknowledge the important debt to economists ofthe past two centuries.

Vl Preface

Content~

Chapter One

SCARCITY, COMPETITION, AND SOCIAL CONTROL

The Magnitude of the Task of Economic Control 2Universal Scarcity 2Costs Are the Best Forsaken Alternatives 4The Problem of Organizing Production 5Methods of Organizing Economic Activity 5Competition, Coordination, and Control 7Controls, Competitive Criteria, and Survival Traits 8Attributes of Economic Analysis 9Summary 10Questions 11

Chapter Two

CONSUMER DEMAND 13

The Unit of Analysis Is the Individual 13Numerical Illustrations 15The First Law of Demand 15Demand versus Amount Demanded 16Personal Use Valuations and Expenditures 17The Paradox of Value 19Needs or Amounts Demanded 20Marginal Revenue 21Price Change versus Other Factors Affecting Demand 22Meaning of Change in Price and Change in Quantity 23Elasticity of Demand to a Price Change 25The Second Law of Demand 28Illustrations of the Laws of Demand 29Estimates of Elasticities of Demand 32Income Effects on Demand 33

..Vll

Price Effect on Wealth and Hence on Demand 34Alleged Exceptions to the Laws of Demand 35Direct Evidence of Validity of Laws of Demand 36Pricing Tactics: A Preview 37Utility-Maximizing Behavior 38Summary 38Questions 39

Chapter Three

EXCHANGE 45

Trade without Surplus Goods 45Money, Markets, and Middlemen 48Open Markets and the Costs of Exchange 50Restraints on Open-Market Competition 51Ethics of Open-Market Exchange 52Freedom: As You Like It 53Criticisms of Methodology 54Self-Interest 54Summary 54Questions 54

Chapter Four

MARKET PRICES AS SOCIAL COORDINATORS 57

Market Demand 58Market Supply and Demand: Graphic Interpretation 59Production and Supply 63Who Pays a Tax? The Answer by Demand and Supply 64Smog Removal and Land Value 68Rental and Allocation by Consumer Competition 69Price Controls, Shortages, Competition, and Discrimination 70The 1975 National Energy Act: Erroneous Economics but Good Politics? 73Economic Rent 75Pareto-Optimal Allocations 76Summary 77Questions 78For Further Study: Futures Markets 81

11111 C70n ten ts

Chapter Five

INFORMATION COSTS AND ACHIEVEMENT OF EXCHANGES 87

Buffer Stocks, Waiting Lines, and Price Responses to Demand Uncertainty 88The Illusion That Cost Determines Price 89Private-Property Rights 91Allocation under Rights Other Than Private Property: Nonprofit Institutions 95Philanthropy 96Public Goods 99Summary 101Questions 102

Chapter Six

CAPITAL VALUES, FUTURE YIELDS, AND INTEREST 107

The Magic of Investment Productivity 108Illustrative Uses of Capital Value Principles 112Annuities 114Applications and Examples 115Wealth, Interest, Income, and Profits 129Capital Values, Property Rights, and Care of Wealth 130Summary 131Questions 132

Chapter Seven

PRODUCTION WITH SPECIALIZATION 135

Production and Exchange 136Gains from Specialization and Cooperation: A Simple Preview 136Specialization, Marginal Costs, and Trade 137A Two-Person Economy 139Achieving Productive Efficiency by Equalizing Marginal Costs 141Some Misunderstanding of Costs 149Differential Earnings, Ricardian Rents 150More Producers: Net Gains or Transfers? 151Short-Run Price and Output Adjustments: Input Specificity 154Monopoly Restraints 155Obstacles to Coordinated Specialization: Absence of Markets

and Transferable Property Rights 156

Contents lX

Are Specialization and Efficient Production "Good"? 156Reprise and Preview 157Summary 158Questions 159

Chapter Eight

PRODUCTION BY FIRMS 163

Joint Production 163Control, Property Rights, and Incentives 166Substitution, Complementarity, and the Demand for Inputs 173Summary 178Questions 178

Chapter Nine

BUSINESS FIRMS: OWNERSHIP, CONTROL, AND PROFITS 183

The Business Firm 183The Corporation 185Fundamental Sources of Profits 188Barriers to Entry or Filters? 190Business Profits 192Misdefinitions of Profits 194Summary 195Questions 196For Further Study: Interpreting Financial Statements 198

Chapter Ten

PRICE TAKERS' SUPPLY AND PRICE RESPONSE TO CONSUMER DEMAND 205

Marginal Revenue Equals Price 206Market Supply: Aggregated Supplies from All Firms 211Long-Run Supply Response: Entry of New Firms and Equipment 212Short Runs and Long Runs 216Consequences of Wealth-Maximizing Response to Market Demand 217Some Pricing Tactics 228Derived Demand 229Review and Prologue 231Summary 232Questions 233

X Contents

Chapter Eleven

PRICE SEARCHERS 237

Market-Power Price Searcher 237Price and Marginal Revenue of a Price Searcher 239Demand Changes and Effects on Output and Price 242Seller's Search for Wealth-Maximizing Price, Output, and Quality 244Survival of Best of Actual Activity 246Monopoly: Open- and Closed-Market Price Searchers 246Some Price Searcher Pricing Systems 247Effects of Different Pricing Systems 256Summary 257Questions 258

Chapter Twelve

COMPETITION AMONG THE FEW 263

Coalitions, Collusion, Cartels, and Firms: An Exercise in Names 263Collusion among Producers 264Oligopolies 271The Law and Market Competition 272Common Misinterpretations of Modern Business Actions 273Summary 279Questions 280

Chapter Thirteen

RESTRICTED ACCESS TO MARKETS 283

Political Restraints on Consumers' Market 283Public Utilities 290Patents and Copyrights 292Monopoly Rents: Creation and Dissipation 293Summary 295Questions 295

Chapter Fourteen

INCOME FROM PERSONAL SERVICES 299

Productive Resources and Incomes 299Supply of Labor 300Never Too Few Jobs 304

Contents Xl

?

Income Differences 309Observed Differences in Personal Income and Wealth 311Patterns by Family Size 312Why Incomes Differ 313The Poor 318Technological Progress and Jobs and Wages 320Summary 322Questions 323

Chapter Fifteen

LABOR-MARKET INSTITUTIONS 325

Labor Unions 325Employee-Employer Bargaining Power 328Labor-Union Objectives 328Do Unions Raise Union Wages? 329Legal Restrictions on Open Markets for Labor 334Closed Monopoly: Buyers Close a Market to Competing Buyers 337Summary 339Questions 340

Chapter Sixteen

WEALTH: SAVING AND INVESTING 343

Sources of Wealth 344Property Rights, Growth, and Conservation 345Investment Activity 347Demand for Investment: The Most Profitable Pace of Investment 348Lending 348Interest Rate and Quantity versus Change in Quantity of Money 355Competition in the Capital Markets 356Legal Restraints on Access to Loan ana Capital Markets 358Personal Investment Principles 360Summary 363Questions 365

Chapter Seventeen

UNEMPLOYMENT AND IDLE RESOURCES 369

Numbers of Employed and Unemployed in the United States 371Who Are the Unemployed? 373

Xll Contents

Trends in Unemployment 377Changes in Structures and Aggregate Demand 378Fluctuation of Aggregate Demand 381Economic Fluctuation and Full Employment 382International Comparisons 383Summary 383Questions 384

Chapter Eighteen

THE DOMESTIC AND POLITICAL ECONOMIES 387•...

The Nonmarket Domestic Economy 387Measuring National Income: Value-Added 388The Scope of Government Economic Activity 392Public Goods and Government Action 397Government as an Economic Stabilizer 398Summary 401Questions 402

Chapter Nineteen

INFLATION 403

What Is Inflation? 403What Causes Inflation? 405Distinguishing True from Apparent Causes of Inflation 409Inflationary Redistribution of Wealth 410Inflation: Taxation without Legislation 413Living with Inflation 414Dealing with Inflation 417Anti-Inflation Monetary Reforms 419Transient Effects of Changing Inflation Rate on Employment and Production 419What Can You Do to Reduce Inflation? 420Recessions Can Occur During Inflation 420Summary 421Questions 423For Further Study: Creation of Money by Bank Deposits and Loans 425

Appendix: Using Math and Graphs 429Answers to Selected Questions 437Glossary 461Index 467

Contents Xlll

Chapterl

Scarcity.Competition.and SocialControl

Societies have progressed despite almost uni-versal ignorance of economic principles. Sowhy learn them? First, for some people, sim-ply to understand their environment isenough reason. Second, an understanding ofeconomic principles can help people avoidbeing frustrated and confounded by half-truths and errors about the operation of aprivate-property, market-directed system,such as the one in the United States. Suchhalf-truths and errors are plentiful. For exam-ple: Minimum wage laws help the unskilledand minorities (p. 334); foreign imports re-duce jobs in the United States (p. 153 and304); producers make goods less durable inorder to sell more in the future(p. 110);"equal pay for equal work" aids women, mi-norities, and the young (p. 336); resale ofused books reduces authors' royalties (p.113); strict liability on producers for defec-tive products protects consumers (p. 285);the environment should not be harmed (p.87); price controls reduce consumers' costs(p. 69); reducing unemployment requires cre-ating more jobs (p. 305); larger incomes forsome people mean lower incomes for others(p. 151 and 189); free-tuition education re-duces costs to students (p. 69); the militarydraft is cheaper than a paid-volunteer mili-tary (p. 338); inflation is caused by large gov-ernment deficits, by unions, or by greedybusinessmen (p. 405); a reduced supplycauses a shortage (p. 61); unemployment iswasteful (p. 371); stockbrokers and analystscan predict which stocks are better purchases(p. 362). These are only a small sample. Un-doubtedly you'll detect others after you'veread this book.

Third, we would like to say that under-standing economics will help you earn more,but as sellers of a service-which is whattextbook authors are-we do not promisethat economic learning means economicearning, but we believe it does.

1

The Magnitude of theTask of Economic Control

So large and complex is our economy that itappears incomprehensible: It is composed of230 million people, in 80 million households,with a labor force of over 100 million (one-third women) and 15 million business units(including over 12 million ~!ngle proprietor-ships, 1 million partnerships, and 2 millioncorporations). These produce, exchange, andconsume an uncounted diversity of goodsand services worth $3 trillion annually (anaverage of about $13,000 per person)-closeto 25% of the world's total.

Yet no planning agency is in charge ofcoordinating the economic activities of mil-lions of individuals of different interests andtalents in our intricately interdependent soci-ety. No one designates who shall producehow much of each good and service and whoshall obtain how much of what. For example,no agency plans that food reaches everycity-yet food reaches every city. Paradoxi-cally, when a government agency has eco-nomic control of some good, such as oil, re-sults have bordered on chaos. (But, as weshall see, it is not correct to believe that allgovernment activity is disruptive and all pri-vate activity is ideal.)

Universal ScarcitySince the fiasco in the Garden of Eden, whatwe get is by sweat, strain, and anxiety. Wewant more kinds of goods, and n10re of them,than we have any realistic prospect of obtain-ing .. That we want more than we have iswhat is meant by scarcity. Even people inthe wealthiest societies are in a state of scar-city, and doubtless will remain so despite thefullest use of their productive potential. De-spite religious or philosophical exhortationsto abandon materialistic desires for more, ourwants and goals will remain unfulfilled. Theillusion that society was becoming saturated

2 Chapter 1

with goods and services was popular in the1960s. And the opposite illusion (popular inthe 1970s) that we were becoming a world ofscarcity is equally wrong-because scarcityhas been pervasive ever since life began.

Two universal facts about our scarcityare portrayed by the guns-and-butter exam-ple in Figure 1-1: (1) In every society produc-tion possibilities are limited; (2) production ofany good necessitates tradeoffs. For example,our economy could produce a maximum of Gguns, if all resources were devoted only toguns; alternatively, if all resources were usedfor butter, B units could be produced, but noguns would be. Largest feasible intermediatecombinations of guns and butter are indicat-ed by the boundary curve between G and B,the production-possibility boundary. Howbig it is depends on people's tastes for leisureand work, methods of organizing joint pro-ductive activity, property rights, knowledge,and the stock of productive resources.

The principle of tradeoffs among achiev-able outputs of goods, illustrated in Figure I-1, applies not only to guns versus butter butto all goods-even leisure versus bettergrades, more travel versus more safety, ormore clothes versus food, to name only afew. Your choice among them can be ex-pressed with that diagram simply by measur-ing higher grades on the vertical scale andmore leisure along the horizontal. You canget more of both only if you happen to beinside the boundary-that is, behaving ineffi-ciently. If you are on the boundary-that is,behaving efficiently-you can get more ofone only by accepting less of the other.

Efficiency: By definition, an economyhas organized its resources with productiveefficiency if it is someplace on the produc-tion-possibility boundary. Being on theboundary means that more of anyone goodcan be produced only by having to sacrificesome output of some other goods. If one is onthe boundary, that means it is impossible toincrease the output of every good at thesame time. Then the productive resources

are fully occupied, and in their most produc-tive ways. In other words, for specifiedamounts of all of the goods except one, theoutput of that good is maximized. That is a"constrained" maximum--the maximum out-put of the one good providing that the speci-fied amounts of the other goods are also pro-duced. Because simultaneous maximizing ofthe outputs of every good is impossible, weinstead think of the maximum output thatcould be produced of one good-under thecondition, called a constraint, that specifiedamounts of the other goods also be produced.Such a constrained maximum is called pro-ductively efficient, by definition. Obviously,every output combination on the productionboundary in Figure 1-1 is a productively effi-cient output combination.

But which of all the many different-butefficient-combinations of output, each onthe boundary, is "best"? This is a differentquestion, requiring some normative criterionas to how to rank or judge the goodness ofeach of the different possible efficient outputcombinations. That one of all the productiveefficient output combinations that is deemedbest is called the "economically efficient"output. All the other outputs on the bound-ary are not economically efficient, thoughthey are productively efficient. Economic ef-ficiency-being at the "optimal" point onthe boundary-is, then, a more severe re-quirement than productive efficiency; it re-quires defining some appropriate criterion ofwhat is best. Whether or not that can bedone is debatable. However, the factors thatdetermine to which combination the econo-my does tend to move can be analytically ex-plored, and will be.

Growth is represented by an outwardshift of the production possibility boundary,for example, to the hypothetical 1987 bound-ary shown in Figure 1-2. Growth means ei-ther that society can produce more per per-son or that there are more people and hencea larger boundary. Some conditions that aidgrowth are explored later.

\

18 G

•.15

!IIe:::I(!) 10 .111

Achievable5 Output

Area

NonachievableOutput Area

Production-Possibi IityBoundary ExpressesLimits of Production

o 205 10 15Butter

Figure 1.1.

SCARCITY, EFFICIENCY, AND CHOICEILLUSTRATED BY PRODUCTION-POSSIBILITYBOUNDARY

The curved line portrays limits on the quantities of gunsand butter producible in the economy. Any point on theline (for example, lor II) can be produced. Nocombination of guns and butter outside the curved line(say, point IV) can be achieved by the economy,given its productive powers and the amount of leisurepeople desire. Less would be produced if theproductive resources were unemployed or usedinefficiently-as at point III. Society selects apoint on the boundary or inside it. Productiveefficiency means that the economy is on theproduction-possibility boundary.

Scarcity, Competition, and Social Control 3

G1

G

8 81

Butter

Figure 1.2.

GROWTH OF ECONOMICPRODUCTIVE POWERS OF THE ECONOMY

A richer, more productive economy is represented by aproduction-possibility boundary that is higher and more tothe right, as for 1987 compared to 1983. Growth canoccur in several ways. A greater production-possibilityboundary is usually induced by a larger labor force.(But does the output per person increase? Thatcannot be indicated by this diagram, which givesonly the social totals.) Moving the frontier outwardinvolves restricting current consumption bysaving either to create more productive goodsor to invest in knowledge and inventions.

4 Chapter J

Costs Are the Bestof Forsaken Alternatives

The production boundary, which confines usto a choice between more of one good andmore of others, conveniently introduces themeaning of an inescapable concept: cost.The cost of any chosen act is the most valu-able forsaken alternative opportunity. Thusthe cost of production of one more unit ofbutter is the number of guns that otherwisecould have been produced. Or, reversing thedirection, the cost of another gun is theamount of butter that otherwise could havebeen produced. This is represented by mov-ing on the boundary between points of moreor fewer guns and more or less butter. Whenthere are many more than just two goods,many possible combinations of reductions ofother goods would enable more of some onegood to be produced. Which of the manypossible combinations is considered the cost?The answer is: The cost is the combinationthat is the most valuable of those that other-wise could be achieved-the best of the for-saken opportunities. That is why costs are of-ten redundantly called opportunity costs.My purchase of a hot dog forsakes my claimsto other purchasable goods worth at least asmuch as the price I pay for the hot dog, say75¢.

Full Cost: The money spent measuresonly part of the costs. I may have spent fiveminutes waiting in line, and that time couldhave been used for something else. Thoughno extra money expenditure was involved, anopportunity to use some time in another waywas forsaken. If the best alternative use ofthe time was worth the equivalent of whatcould be bought for 25¢, my "full price" ofgetting and consuming the hot dog must in-clude the 25-cent value of the alternative useof time.

There are still more costs to consider.Suppose I tarried and joked with the vendorand delayed service to three other people.They lost the opportunity to do what they

could have done with that time. If that wereworth 5¢ to each of three people in line, thecost (which I do not bear) of my hot dog isl5¢ more, or $1.15, of which I bore only$1.00. And say the seller put onions on thehot dog. In a close conversation with myfriends I foul the atmosphere. With a loss ofpurer air valued at 5¢, the cost of the pur-chase and consumption of the hot dogamounts to $1.20, of which I bear 75¢through sacrifice of market-purchasable op-tions and 25¢ worth of time spent in line; 20¢worth of loss is imposed on other people.Ob-viously, the full costs are not always fullymeasured only by the money expenditures,nor borne by the actor.

Many people carelessly talk as if costsare sacrifices only of material things normal-ly bought and sold in the market. However,cost includes every feature in the best of theforsaken options, including forsaken leisure,loss of environmental amenities (views, freshair, cleanliness), loss of cultural qualities(safety, morality), and loss of any other fea-tures to which anyone attaches value.

We caution that "labor, toil, trouble,and pain" are not what is meant by costs."Bads" associated with an action are not itscosts; they are part of the act. For example, aswimming pool yields the pleasure of swim-ming and the undesirable consequences ofneighborhood children noisily splashing theyard. These undesirable splashes are part ofthe act, not part of the costs.

If not all costs are imposed on or borneby the person authorizing an activity (so thatsome costs are borne by others), the person'schoice will be different than if they were.Costs borne by others are called external-ities. The failure to impose all the compo-nents of cost on the decision maker oftenproduces consequences deemed distressingand objectionable-such as "excessive" pol-lution and "shortsighted" land use or zoninglaws. For the moment, owever, we assumethat full cost is borne by the actor. Later weshall inquire into the conditions permitting,

and those preventing, the full cost to beborne and heeded by the actor.

The Problem..of Organizing Production

Is productive efficiency achieved in the realworld? To think that we simply choose someefficient output combination overlooks theoverwhelming task of organizing activities soas to achieve a point on the boundary. Butwho knows how to make butter, let alone agun? Who knows how to breed, feed, andmilk cows? Does that person also know howto make a modern milk processing plant orthe stainless steel, the pumps, and the gasesin the refrigerating equipment, the trucks tocarry milk, and on and on? Indeed, is thereany consumer good that one person is able toor knows how to produce? It strains the im-agination to think of the number of people,the incredible variety of specialized bits ofknowledge, and the technical skills necessaryto provide butter for the market. How is theincomprehensible mass of detailed, separate-ly held knowledge, ability, and work of mil-lions of people coordinated?

Methods of OrganizingEconomic Activity

COMMAND SOCIETIES

In some economies commands are issuedthrough a central command system, as in anarmy. Everyone is assigned some task' bysomeone ranking higher in the command sys-tem. Such a system exists in China. No oneis permitted to select his own occupation orplace of work. The central authorities,through a system of commands or assign-ments, decide who does what and where.That system is called Communism in China.

Scarcity, Competition, and Social Control S

And it is essentially identical to the one usedin Russia and almost all other communistcountries.

SOCIALIST ECONOMIES

A socialist system is one in which income-producing goods (machines, land, buildings)are controlled by government agents and arenot exchangeable at market prices, that is, atprices determined by competition among sell-ers and buyers with their own property. Usu-ally in a socialist economy, people are allowedto select their jobs and places to live, just asyou can choose among various governmentjobs in the United States. In Great Britain,Italy, Sweden, and France more of the econo-my is socialist-controlled than in the UnitedStates. However, in every economy there aresome socialist institutions, since every gov-ernment is essentially a socialist institution.

CAPITALIST OR MARKET ECONOMIES

A widespread system is known as the free-enterprise, private-property-or capitalist-system. It is a system in which people haveprivate property rights to production and con-sumption goods and over their personal laborservices. Capitalism (a term coined by KarlMarx) is its standard name. Why? Becausemarket-determined prices of goods reflect theanticipated value of the future as well as thepresent services from those goods. This re-flection of future services is called capitaliz-ing, as will be explained in considerable detailin Chapter 6. Thus, the definirrg attribute ofcapitalism is the availability of a market withthe right to control and to produce or buy andsell privately owned goods and services inopen competition with others.

It is the system that will be analyzed al-most exclusively in this book, primarily be-cause it is better understood-not necessarilybecause it can be proven to be better. Thecapitalist or private-property system of eco-nomic coordination and control was first sys-

6 Chapter J

tematically analyzed by the Scottish philoso-pher Adam Smith in 1776 in his epic book, AnInquiry into the Sources of the Wealth of Na-tions. Smith saw that system as not chaotic orlacking in coordination and efficiency despitethe absence of any central directive authoritythat consciously planned and directed people.He saw cohesiveness, order, and responsive-ness in that system. His basic analytic concep-tion was that people respond predictably toopportunities for gain. He saw that an offer ofexchange is a powerful competitive socialcontrol, especially "an offer I couldn't refuse."If the bulk of resources is privately owned,coordination of behavior through competitionfor gains from trade is strongly encouraged.

Adam Smith wrote:Man has almost constant occasion for thehelp of his brethren, and it is in vain forhim to expect it from their benevolenceonly [emphasis added]. He will be morelikely to prevail if he can interest theirself-love in his favor, and show them thatit is for their own advantage to do for himwhat he req ires of them. Whoever of-fers another a bargain of any kind, pro-poses to do this: Give me that which Iwant, and you shall have this which youwant, is the meaning of every such offer;and it is in this manner that we obtainfrom one another the far greater part ofthose good offices which we stand in needof. It is not from the benevolence of thebutcher, the brewer, or the baker, that weexpect our dinner, but from their regardto their own interest. We address our-selves not to their humanity but to theirself-love.

We may have benevolence for a circle offriends, but benevolence alone will not in-duce discovery and exchange of specializedproductive activi ties most beneficial to theunknown masses. An amazing achievementof the private-property, market-exchange sys-tem is that it harnesses, in addition to benev-olence, the powerful motive of self-interest

in peaceful, specialized, productive activitiesthat benefit humanity at large, and it sup-presses junglelike, parasitic, destructive be-havior. Without that peaceful, implicit con-trol and coordination, a few of us would beliving in a poverty-stricken, painful, brutish,ignorant Stone Age, and almost all of uswould never have experienced life.

Between capitalism and socialism is aspan of mixed economic arrangements inwhich most resources are held as privateproperty, but the state exercises much con-trol over what can be done with them. Lawsmay prohibit some people from selling cer-tain goods, while politically protecting otherswho have access to the market. This govern-ment-aided "monopolization" by a politicallyfavored group is often called a mercantilistsystem. As we shall see, it comprises a no-ticeable portion of the American economy.

No society is exclusively capitalist, mer-cantilist, or socialist. Every society is a mix.In the United States, the roads, postal ser-vice, schools, and police are heavily-thoughnot exclusively-socialistic (not exclusively,because we have private schools, private de-livery systems, private roads, and private se-curity guards). In predominantly socialisteconomies, some goods such as furniture,clothes, and cars are privately owned, butmost income-producing goods are not.

We will not use the terms free enterprise,free markets, or free society because "free"has no clear meaning that everyone agrees to.We avoid comparing "freer" or "less free"societies and instead investigate differences incultural attributes, personal behavior, andcosts of expressing individual life styles.

Competition,Coordination, anellControl

Because of scarcity, competition is inescap-able-and therefore so is conflict. Onemeans of expressing that conflict is by physi-cal force, or violence, although the "State"-

the political authority and its agents and rep-resentatives-always claims the exclusiveright to use violence, usually with a view torestricting most people to nonviolent modesof competition. .•.

The question is not how to eliminatecompetition, for as the renowned philoso-pher and part-time golfer Arnold Palmer rec-ognized, "If you aren't competing, you'redead." The scientific questions are, "Whatare the permitted kinds of competition? Howdo they operate? And what are their effectsr"The (unanswered) ethical question is, "Whatis a 'good' competition?" Economics can helpanswer the scientific questions, but it cannotdecide what are the "good" forms of compe-tition.

VIOLENCE AS AFORM OF COMPETITION

Before condemning the threat or use of vio-lence as a means of social control or of get-ting more goods, note that it is widely prac-ticed and respected-at least, when appliedsuccessfully on a national scale. Julius Caesarconquered Gaul and was honored by the Ro-mans; had he simply roughed up the localresidents, he would have been damned as agangster. Alexander the Great, who con-quered the Near East, was not regarded bythe Greeks as a ruffian, nor was Charle-magne by the Franks. Europeans acquiredand divided-and redivided-America byforce. Lenin is revered in Russia. So is Fran-co in Spain, Castro in Cuba, Bolivar in Boliv-ia, Ieyasu in Japan, and George Washingtonin the United States. This is not said in de-fense of all uses of physical force; it is simplyan objective statement of fact.

The Supreme Court of the UnitedStates, in response to laws passed by Con-gress, stated that "anticompetitive" con-tracts or agreements are illegal. But themeaning of "anticompetitive" will not befound in either the Court decisions or the


legislation. Are the forbidden forms called"anticompetitive" as a short way of sayingthey are "anti" the desired forms of competi-tion? For example, rival quarterbacks striv-ing for the starting position on a footballteam could compete by trying to maim eachother. If allowed, that kind of competitionwould eliminate the kind of competition inwhich they strived to be better passers orsignal callers. Members of Congress and jus-tices who talk of "anticompetitive" acts arecontributing to confusion; they should saywhich kind of competition is forbidden andwhich is preferred.

CONTROL BYRELIGION, LAW, AND OSTRACISM

Formal law and police power are not theonly forms of social control. Religious doc-trines usually promise punishment or re-wards in a next life-a promise to whose ef-fectiveness in controlling human behaviorhistory provides amazing evidence. Social os-tracism is also a powerful control, as we learnwhen snubbed or isolated on the rare occa-sions of our "uncivilized" behavior. No mat-ter how different among societies or overtime, standards of morality and proprietyseem essential to the continuance of humansociety.

Techniques of social control differ in ef-fectiveness. Some can be escaped by migra-tion. Society's intolerance 9,f any behaviorcan more readily be ignored the less the in-tolerance is associated with physical govern-ment force. When the state and the churchoperated together, each had greater powerthan when they operated separately. By defi-nition, government power is less pervasive ina capitalistic, private-property, market-ex-change system than in a socialist system.This does not make the private-property,market-exchange system the better one, foryou may believe that greater political controlover people is desirable.

8 Chapter J

Controls,Competitive 4Criteria,and Survival Traits

To distribute 200 Rose Bowl game tickets (oradmissions to your college) without sellingthem, what form of competition would youuse? The authors, red-blooded male chauvin-ists, would award tickets to the 200 mostbeautiful female applicants. (Why are admis-sions at your college not allocated that way?Perhaps to some extent they are.) Certainly,a system using beauty is competitive and dis-criminatory. But all competition-like allchoice-discriminates; that is its purpose.

If beauty seems a frivolous criterion,consider an alternative: first come, firstserved. All applicants could run a race, withtickets going to the first 200 at the finishline. Silly? Replace "finish line" with "boxoffice at the Rose Bowl" or "registrationdesks" for popular college classes or "gaso-line stations" during so-called oil shortages,and then ask if it is silly. The only differenceis that, in these other instances, there is nosingle starting time, so some people start ear-lier and wait at the "finish" line-in rain,cold, and discomfort without benefit to thedistributor.

To complicate matters, what is to stopthe recipients of our Rose Bowl tickets frompassing the tickets to others, according totheir own criteria? Or selling them? It is ex-tremely difficult to. ensure that one's criteria,selected so reasonably and with the purest ofhearts, will be effective throughout the allo-cative process;

If "first come, first served" were used forallocating food, people who are best able towithstand the rigors of standing in line orwhose time is less valuable would have bet-ter prospects. They would stand in line up tothe point where the cost of so doing equalsthe value of what is obtained. (Rememberthe meaning of costs, the best forsaken alter-native.) If food, wealth, or social popularitywere awarded more to relatively tall people,

height would increase over time. And ifbeauty were the criterion, beauty would beincreased. Or if charm and rhetorical abilitywere important as rationing criteria, as theyare in politics, society would be distinguishedfor its personable, articulate people. If pro-ductivity were an important allocative crite-rion, productivity would be increased andthe society would be richer, as would themore productive individuals.

If "fair" competition meant an equal ran-dom chance (which it need not), names couldbe drawn from a bowl (including names ofthose who did not trouble to apply). Wouldyou want that kind of "equal chance" foryour surgeon, mate, juror, waiter, parents,employer, or teacher? But we have selectedmen for the armed forces that way.

Attributes ofEconomic Analysi!~

Three attributes of economic analysis are im-portant: First, economic analysis is solely sci-entific. That is, it helps to explain what con-ditions lead to what consequences: "If A,then B." It does not forecast that A will oc-cur. And the economist is not ordained topass final judgment on the desirability of B.That is a normative issue. Economics givesno ultimate criteria for determining whetherconsequences are good or bad, just as chemis-try has none for determining whether morerapid oxidation under heat is good or bad.Although scientists (including economists)offer all sorts of ethical assessments, whateconomic theory says must be distinguishedfrom what an individual economist may pre-fer. The former is what counts, not the lat-ter. Though the economist may be betterable than the noneconomist to discern theconsequences of some proposed act, theeconomist is not superior in evaluating thepropriety of that consequence.

Second, economic theory is built on anunderstanding of some un:iversal traits of hu-

man nature. It is not contended that eco-nomic theory has identified (or must identi-fy) all the traits that compose human nature.And it is certainly not assumed that all peo-ple are exactly alike in every respect. Yetsome virtually universal regularities in thosepreferences or responses yield principles thatare powerful in explaining some social phe-nomena throughout the world. The nextchapter describes some regularities of humannature.

Third, scientists, economists amongthem, achieve understanding of the phenom-ena they study by constructing and testingtheories. Put simply, a theory is a model ofthe phenomenon being analyzed: a descrip-tion of the phenomenon that is stripped ofall inessential particulars-much like a roadmap of a city. A theory is a guide to one'sanalysis. How accurate should a theory be?That is like asking, "How accurate is a roadmap?" The answer should be, "Goodenough for one's purpose." If the purpose isto drive through a town from one end to theother, a crude sketch of a few lines is oftensufficient. But one that doesn't show trafficsignals, crosswalks, alleys, and street num-bers may not be good enough for the police.And a map good enough for them may beinsufficiently detailed for a construction firminstalling a sewer system; it must show ele-vations, street widths, power lines, and soon. Like road maps, models or theories ofeconomic phenomena come in various de-grees of detail-but all models describingthe same set of phenomena are consistentwith each other. No map or theory will beperfectly complete in every detail. Some the-ories, or models, may be so elaborate and dif-ficult to use that the extra trouble and costof using them is not worth the gain. So asknot, "Is the theory accurate?" but rather "Isthe theory good enough for our purposes?"The model, or theory, given in this book isestimated to be good enough-sufficientlythorough in detail and extensive in cover-


age-for the purposes of the interested stu-dent. Someone planning to become a profes-sional economist would later purchase-athigher cost-a more detailed, more elaboratetheory.

Some models, then, are useful preciselybecause they are simpler than others. As weprogress through this book our model be-comes less simple than it is at the outset. It isprobably helpful to suggest at this stage thenoteworthy simplifying assumptions that weuse now and later abandon.

1. Sellers detect the persisting and the tran-sient changes in consumer tastes or de-mand for goods costlessly, perfectly, andinstantly.

2. Exchangeable private-property rights ex-ist in all goods.

3. No acts of charity occur.

4. No seller affects the total supply enoughto affect ones prices or those of othersellers.

5. Full information about the availability,quality, and suppliers of all goods isavailable costlessly.

6. Contracts for exchange and for joint pro-duction effort are costless to form, moni-tor, and enforce.

7. No one makes long-lived, preexchangeinvestments that have value only whendealing with a particular person. Instead,investments have general {values in thatthey have the same values when any ofmany other people are dealt with.

What you are going to learn are eco-nomic principles and how to use them. Theprinciples in the theory, when brought to thetest of usefulness, are far more in accord withactual occurrences than the speculations of"practical men."

10 Chapter 1

Summaryl. Scarcity means that people want more goods

and services than ate available.

2. The fact that production capability is limit-ed can be expressed by a production-possi-bility boundary, which indicates the maxi-mum amount of any particular good that canbe produced within the constraint that spec-ified amounts of other goods are to be pro-duced. Achieving that constrained produc-tion maximum is called technological, orproductive, efficiency.

3. Achieving the "best" place on the boundary,that is, the best combination of the variousproduction-efficient outputs, is called eco-nomic efficiency.

4. An opportunity for choice among alternativeactivities creates costs: The cost of an act isthe most preferred (highest valued) of theforsaken alternative opportunities.

5. The cost (forsaken option) of an act does notnecessarily involve a current expenditure ofmoney, but instead can mean the loss ofsome opportunities.

6. The costs of an act by one person that areborne by other people are called external-ities.

7. Scarcity and competition are inseparable.Competition takes many forms. One form isstriving to offer people opportunities betterthan those offered by others. Another isusing physical force. All forms of striving toimprove one's own situation are competi-tive, by definition.

8. In capitalism the rights to use or alter goodsand services are owned by individuals andare exchangeable private-property entitle-ments.

9. Socialism denotes an economic system inwhich the productive resources are con-trolled by the government.

10. Mercantilism is a system in which govern-ment regulates uses of goods and servicesthat are in other respects held as privateproperty.

11. Economic analysis and theory are strictly de-scriptive and scientific. They provide nobases for moralizing about what might hap-pen, or what is "good" or "bad"-only abasis for discerning what is.

QuestionsAnswers to all questions except those marked with anasterisk are in the Answer section at the end of thebook.

1. "If people were reasonable, strikes and warswould not occur." Do you agree? If so, why? Ifnot, why not?

2. a. If there is more than one opportunity tobe forsaken, which forsaken opportunityis the cost?

b. How are values of opportunities meas-ured?

c. Can there be production without costs?

*3. What is the cost of your college education?

4. "The time involved in purchasing somethingcannot be considered part of the cost because thetime would have passed anyway. Hence to countthe value of time as part of the cost of any actionis fallacious." Evaluate: What is meant by thevalue (or cost) of time?

5. Are costs the same thing as the undesirableconseq~ences of some action?

6. What is meant by an equality between pri-vate and social costs?

7. Name three honored statesmen who ob-tained their status by successfully competing inviolence and who, had they failed, would havebeen punished for treason.

8. a. What competition is permissible in poli-tics but not in private business? And thereverse?

b. What kinds of competition are permissi-ble in seeking admission to college butnot permissible for grades in this course?

9. "Governments should monopolize in coer-cive violence." "Government is a social agencyfor resolving interpersonal conflict."

a. Are those two propositions compatiblestatements of fact?

b. What evidence can you cite for your an-swer?

10. What forms of competition are made illegalby laws establishing private-property rights? Andsocialism?

11. "A more equal distribution of wealth is so-cially preferred to a less equal distribution."What is meant by "socially" preferred as con-trasted to "individually" preferred?

* 12. a. What does "equality of opportunity"mean?

b. How could you determine whether it e'i{-

ists?c. Is there equality of opportunity to get an

"A" in this course?d. How would you make it equal, if it is

not?e. What is the difference between increas-

ing opportunity and equalizing it?

13. "Under socialism, cooperation will replacecompetition."

a. Is the quoted proposition correct?b. What evidence can you cite to support

your answer?c. What is the difference between coopera-

tion and competition?

14. "Food is grown, harvested, sorted, processed,packed, transported, assembled in appropriatelysmall bundles, and offered to consumers everyday by individuals pursuing personal interests.No authority is responsible for seeing that thesefunctions are performed. Yet food is available ev-ery day. On the other hand, appointed authori-ties are responsible for seeing that water, educa-tion, and electricity are available. In the areaswhere we consciously plan and control social out-put, we often find shortages and failure of ser-vice. But who has heard of a shortage of restau-rants, churches, furniture, beer, shoes, or paper?Is it not surprising that privately owned business-es, operating for the private gain of the owners,provide service to patrons and customers that isas good as, if not better than, what the postalservice, post office, schools, and other politicallycontrolled enterprises provide? Furthermore,wouldn't you, expect public agencies to be lessdiscriminating according to race and creed thanprivately owned business? Yet the fact is that

Scarcity, Competition, and Social Control J J

they are not." How do you explain these para-doxes?

15. The economic system is alleged to affect thefundamental social and cultural characteristics ina society. Among these are patterns of speech,expression, religion, travel, marriage, divorce, in-heritance, education, legal trials, art, literature,and music.

a. Are these different under capitalism thanunder socialism?

b. Can you cite evidence for your answer?

12 Chapter 1

16. "The free-enterprise, capitalist system is freein that it involves no imposition of force or com-pulsion." Do you agree? Explain your answer.

17. A historian has said that ships made by theancient Creeks were of fine quality because theywere made by slaves, whose owners thereforespared no labor in making boats. Later, whenthere was no longer slavery, boats were made inways that used less labor and were less durable.It is true that ships were later built with less in-tensive use of labor. Do you agree with the histo-rian's explanation of why?

The Unit ofAnalysis Is the Individual

Chapter 2

COR~UmlerDernaRel

To understand the ~ehavior of groups, organi-zations, and nations we focus on the incen-tives of their individual members. A busi-ness, union, or family aids the commoninterests of its members, but its actions arethe results of preferences and decisions of in-dividuals within those units. Thus, we do notask, "Why does the U.S. government, rGeneral Motors, or some union, behave as itdoes?" We ask instead, "Why do the deci-sion makers decide as they do?" An answer ispossible because of two principles: First, aperson adapts to circumstances so as morefully to achieve his many preferences orgoals. Second, although people differ in sig-nificant and sometimes intriguing ways, be-havior is sufficiently uniform among individ-uals that it can be largely summarized with afew behavioral postulates. To characterize"human nature" so starkly may seem to over-simplify, but our postulates yield an impres-sive payoff in enabling us to analyze the es-sentials of complex behavior. (Thesepostulates, however, do not mean that all in-dividual choice is only self-interested andself-seeking. They mean instead that, wheth-er or not a choice is made according to self-interest, it is an individual who makes thechoice.)

Postulate I

Each person desires many goods andhas many goals.

No one wants only one good. We want moreof this and also more of that. We want alsoto accomplish more than one goal.

Postulate 2

For each person, some goods arescarce.

\ 13

A good is anything desired by at least oneperson. Goods may be either free goods oreconomic (that is, scarce) goods. A free goodis one that no one desires to have more ofthan is already possessed. The classic exam-ple, for most of us, most of the time, is air:No one has to forgo an alternative to inhale.However, air is not a free good to astronautsor deep sea divers; nor is clean air to city res-idents on smoggy days. An economic good isone that a person wants more of than theperson now has.

Beware of misleading uses of the wordfree. It does not mean simply anything dis-tributed at a zero money price. On the con-trary, some zero-priced goods are scarce, forexample, "free" education, "free" public li-braries, "free" campsites, "freeways," and"free" beaches. These are scarce eventhough the money price is "zero." Charginga zero money price does not magically makea scarce good so plentiful that all of us canhave as much as we want. Indeed, paradoxi-cally, a zero money price on an economicgood, as we shall see, creates what is called ashortage of the good.

Hereafter, when we speak of a good, wealways mean a scarce, or economic, good.

Postulate 3

.Each person is willing to forsake some ofa good to get more of other goods.

A person is willing to forsake some (not nec-essarily all) of any good if a sufficiently largeamount of other goods can be obtained in re-turn. No one steadfastly refuses to give upeven the tiniest portion of a good no matterwhat would be obtainable in return.

The amount of a good that a personwould be willing to give up to obtain more ofsome other good is defined as that person'smarginal personal use value of that othergood. The amount of wine a person would bewilling to give up to get one more egg is theperson's marginal personal use value (rneas-

I 14 Chapter 2

ured in terms of units of wine) of that egg."Marginal" refers to the value of one moreegg-a marginal egg.

It may be surprising that in economicsthe personal use value of a good is always de-fined, measured, or expressed by an amountof some other good, as we measured the val-ue of an egg in units of wine. But ineconom-ics there is no other measure or kind of val-ue, because no good has an intrinsic, orbuilt-in, value. All values are relative.

Although we will generally apply oureconomic analysis to tradeoffs among ordi-nary marketable goods and services, it ap-plies as well to tradeoffs among any goals,objectives, ideals, and principles. Each of uson occasion sacrifices or risks some small de-gree of our integrity-our fidelity to an idealor principle-for some sufficient increase inincome or safety or popularity or power.This is a fact of human behavior which eco-nomic analysis neither praises nor condemns.(Imagine a world in which no one ever toldthe slightest lie, or hid the slightest truth, nomatter what the resultant gain in security orsocial pleasantness.) All desired entities, con-ditions, and traits-truth, virtue, health,beauty, safety, responsibility, politeness, de-cency, self-respect-are marginally substitut-

. able. Goals and ideals, like ordinary goods,are competitive and substitutable in degreesof attainability or fulfillment; the tradeoff isbetween more or less, not between all ornothing.

Postulate 4

The more of a good one has, the larger·the total personal use value, but thelower the marginal personal value of aunit.

One's total personal value of some specificquantity of a good (not of just one more unit)is measured by the total amount of othergoods one would be willing to pay for thatspecific quantity. A person's experiences,education, and psychological traits affect the

person's valuations. But the marginal valuedepends also on the amount of the good aperson already has: The larger the amount ofa good, the larger is its total use value to theperson, but the less of other goods is onewilling to pay to get an additional unit. Aswe have more of any good, additional unitscan be put to only less valuable, previouslyunfulfilled uses. Thus, larger amounts in-crease one's total use value but reduce themarginal personal value, as Table 2-1 shows.

Postulate 5

Not all people have identical tastes andpreferences.

Even people who have identical amounts ofthe same goods are not likely to place thesame personal total and marginal values onthem, nor are they likely to feel equally welloff: One person's gloried asceticism is anoth-er's demeaning poverty.

Postulate 6People are innovative but consistent.

In hopes of improving their situation, peopleinnovate, trying new things or new ways ofdoing things. And among the opportunitiesthey discover they will choose consistently inthe sense that if situation A is discovered tobe preferred to Band B to C, they will, whenpresented with a choice between A and C,choose A.

NUMERICAL .ILLUSTRATIONS

Some of the foregoing can be illustrated withsome simple numbers, shown in Table 2-1.Say a person has one unit of a good, X, andwould pay $1.00 worth of some other goodsfor one unit of X, rather than have none of it.The total personal value he places on justone unit is $1.00 worth of other goods, as thesecond column in the table shows. If he hastwo units, his total personal value is larger-$1.90-and the marginal personal value of X

with a second unit is 90¢, as the third columnshows. (Column 3 is the difference betweenitems in column 2, and column 2 is the sumof the items in column 3.) He values havingtwo units rather Ihan only one when a sec-ond unit can be acquired by the sacrifice of90¢ worth of other goods. If a third unit in-creased the total personal use value of X by80¢, to $2.70, his marginal use value of Xwhere he has three units is 80¢. Largeramounts of X have a larger total personal usevalue; but each increase in his total use valuewith each extra unit is successively smaller,decreasing in this example to 10¢ at a tenthunit. It is crucially important always to dis-tinguish between total personal use valueand marginal personal use value at anyamount of X. At larger amounts of X, theformer always is larger, the latter smaller.

The First Law of DemandAn immediate implication, expressed as thefirst law of demand, is one of the most usefulgeneralizations in all of economics: The low-er the price at which one can buy a good, themore will one purchase, have, use, or con-

Table 2·1

TOTAL AND MARGINAL USEVALUES OF VARIOUS AMOUNTS OF GOODS

Total Personal Marginal PersonalQuantity Use Value Use Value

o o o$1.00 $1.00

"2 1.90 .903 2.70 .804 3.40 .705 4.00 .606 4.50 .507 4.90 .40

8 5.20 .309 5.40 .20

10 5.50 .10

Consumer Demand 15

sume. At a given price per unit, a person willbuy as many units as brings the marginalpersonal use value down to equality with theunit price. And people will tend not to buyunits priced higher than their marginal usevalue. This simple, obvious proposition is il-lustrated by Table 2-2, which is based on thedata in Table 2~I. The quantity purchasedat any given price is the quantity at whichthe marginal personal use value of anotherunit equals the price per unit. The buyerchooses to buy that quantity at which thelast achieved marginal personal use value justcovers the existing price. (In the table, theamount purchased at, say, 50¢ could be ei-ther five or six units, because the sixth givesno net gain in personal value over price.This is a result of using discrete quantities.We will typically hereafter associate a pricewith the larger amount-for simplicity anddefiniteness.)

Demand versusAmount Demanded

Table 2-2 illustrates the price and demandrelationship: It lists the number of eggs thatwould be bought and consumed at each

Table 2·2

DEMAND SCHEDULE (PER WEEK)

Priceper Egg

QuantityotsEggs

$1.00

.90 2

.80 3

.70 4

.60 5

.50 6

.40 7

.30 8

.20 9

.10 10

16 Chapter 2

price under given circumstances. The wholeschedule of prices and amounts demanded(here number of eggs) at each price is thedemand schedule. The whole scheduleshould not be confused with a particularamount demanded at a particular price, be-cause by demand economists mean thewhole schedule of amounts and prices. (Ifyou use this distinction you avoid a lot ofmisleading terminology and erroneous analy-sis.) At a price of $1.00, the amount de-manded-not demand-is one egg a week;at a price of 90¢ the amount demandedwould become two eggs a week; at a priceof 80¢ the amount demanded would becomethree eggs a week. But all amounts demand-ed are on the same unchanged demandschedule.

Some argue that when the price of agood rises they may continue to consume asmuch as ever. But, of course, if the pricewere much higher, they would cut down ontheir consumption. The law of demand doesnot require that every person reduce con-sumption of a good with every small rise inits price. The law can be expressed in a wayless open to misinterpretation: Whateverthe amount demanded at a present price,there is, in that demand schedule, somehigher price that would make the person re-duce the amount demanded. A minor pricechange may occur without changing theamount the person demands. But certainlythere is an upper limit of price changeabove which the amount demanded will bereduced.

Of course, the demand schedule, theamount demanded at any price, depends onmany things besides price. A person's de-mand schedule for, say, gasoline will dependon income, age, health, location, the prices ofrelated goods (for example, automobiles), theprices of public transportation service, andfamily size, to name a few influences. Butthe principal factor we shall investigate ini-tially is the price of the good itself, for a rea-son to be explained later.

Table 2·3 PERSONAL USE VALUES, DEMAND, AND MARKET REVENUE

1 2 3 4 5Total Market

Total Marginal ExpenditurePrice OU~lntity Personal Personal ... (or Revenue(P) (0) Use Value Use Value to Seller)

$1.00 1 $1.00 $1.00 $1.00

.90 2 1.90 .90 1.80

.80 3 2.70 .80 2.40

.70 4 3.40 .70 2.80

.60 5 4.00 .60 3.00

.50 6 4.50 .50 3.00

.40 7 4.90 .40 2.80

.30 8 5.20 .30 2.40

.20 9 5.40 .20 1.80

.10 10 5.50 .10 1.00

In Table 2-3, which is an elaboration of Ta-ble 2-2, the amount demanded by a person isone egg a week when the price is $1.00. Weinfer that the personal use value of that eggequals at least the value of $1.00 of otherthings that could have been bought instead.At 90¢ per egg, this person would buy twoeggs per week. Because only one could havebeen chosen but two are demanded at 90¢,the second egg, the marginal egg, must beworth at least 90¢ of other goods that couldhave been bought instead. A personal valueof at least $1.00 on one egg plus at least the90¢ personal value of the second egg gives atotal personal use value of at least $1.90 fortwo eggs. But the market expenditure re-quired to buy the two eggs is, as column 5 ofTable 2-3 shows, only $1.80 (90¢ X 2).

At a lower unit price of 80¢, three eggswould be demanded and consumed. A thirdegg weekly must have a personal value of atleast 80¢; otherwise it wouldn't be pur-chased. So the total use value of the threeeggs is $1 + 90¢ + 80¢ = $2.70. But the totalr-mR~m:R~~~·P.·~--~--~~-

L£I.TY UNlVE!~!IX"gfJJONGKONG Consumer Demand 17

Personal UseValuations andExpenditures

expenditure for the three eggs is only $2.40;(80¢ X 3 = $2.40).1

CONSUMER'S SURPLUS

We can now measure the benefit to buyersfrom purchases in the market. If the price'per egg is 80¢, three eggs are demanded eachweek, according to the demand schedule. Tothis person one egg weekly has a use value of$1.00, even though its price is only 80¢. Theconsumer obtains a surplus value of 20¢-aconsumer's surplus: the excess of personalvaluation (here, $1.00) over the market price(80¢). Similarly, because a second egg couldbe consumed each week at that same price of80¢, and because it has a marginal personaluse value of 90¢, the consumer would get a

1 Remember that value is not an inherent attributeof a good; thus, we define and measure personal usevalue in terms of a quantity of other goods that a per-son regards as equally desirable-here expressed inequivalent dollar values. Remember also that economicgoods include all things we would like to have-friend-ships, health, honesty, and the like-and not merelymarketable things like milk. shoes. and cars.

Table 2·4 DEMAND, PERSONAL VALUES, MARKET REVENUE, AND CONSUMER'S SURPLUS

1 2 3 4 5 6TotalMarket Consumer's

Total Marginal Expenditure Surplus atPersonal Personal or Revenue Alternative

Price Quantity Use Value Use Value to Seller Prices

$1.00 1 $1.00 $1.00 $1.00 $ .00.90 2 1.90 .90 1.80 .10.80 3 2.70 .80 2.40 .30.70 4 '3.40 .70 2.80 .60.60 5 4.00 .60 3.00 1.00.50 6 4.50 .50 3.00 1.50.40 7 4.90 .40 2.80 2.10.30 8 5.20 .30 2.40 2.80.20 9 5.40 .20 1.80 3.60.10 10 5.50 .10 1.00 4.50

consumer's surplus of 10¢ with that egg.There is no surplus from a third egg at aprice of 80¢, because if a third egg is boughtper week, marginal personal valuation equalsprice. The total consumer's surplus is 30¢.

But if the price were lower, say 70¢, con-sumer's surplus would increase. It would be10¢ greater on each egg: 30¢ on the first egg,20¢ on a second, and 10¢ on a third, withzero on a fourth. The amount demanded isthat at which the surplus of consumer valueon the marginal unit is zero. As Table 2-4shows, the total personal use value (column3) exceeds the total expenditures (column 5).The difference between them is the consum-er's surplus (column 6).

The concept of consumer's surplus mayseem abstract and artificial. But the conceptis no more than a formal way to indicate thatanyone who buys something believes it isworth more than is being paid for it-elsewhy buy it? If for 50¢ you can buy a Coke forwhich you would have been willing to pay asmuch as $1.50, you get a consumer's surplus.That happens with almost everything youbuy. Obvious as this notion is, it will later bevery helpful in explaining marketing tacticsthat would otherwise be misunderstood.

Though we do not know the exact de-mand schedule for any person, we do know acrucial characteristic of the schedule: the di-rection in which price affects the amount de-manded. We have already seen that directionexpressed in the first, fundamental law of de-mand: The higher the price, the smaller theamount demanded; or, Whatever the amountdemanded of a good at any particular price, asufficiently higher price will decrease theamount demanded. (Again, a reminder: Pricechange refers to a relative price change, whichoccurs if all other dollar prices are unchanged.)

Figure 2-1 is a diagram of the demandschedule represented in Table 2-2. Price ismeasured on the vertical axis and amount ofeggs demanded on the horizontal. At eachprice, the amount demanded is that whichmakes the buyer'S marginal use value equalthe price. (Here we show the demand sched-ule as a straight downward-sloping line pure-ly to keep the arithmetic and the graph sim-ple. Any downward-sloping demand line ispermissible for greater realism.)

MARKET VALUE

Total personal use value (column 3 of Table2-:-4.)_s~<;>uld,,~?t_~econfused with total ex-

_Ii.... '". ,

,'.r' •.

penditure, or market value (column 5). Wearrive at the total personal use value by add-ing up successive marginal use values alongthe buyer's demand schedule. For example,at a quantity of 5, total use value of $4.00equals marginal use values of $1 + 90¢ + 80¢+ 70¢ + 60¢. But the total market value,$3.00, is the product of the quantity demand-ed times the price per unit (5 X 60¢). Thequantitative relationship among total person-al use value, market value, and consumer'ssurplus is presented in one diagram, Figure2-2, an elaboration of Figure 2-1.

The Paradox of ValueIf we compare Figures 2-3A and 2-3B, it isclear that moving down a demand curve tolarger quantities at a lower price has two ef-fects: It increases the total personal use val-ue, and it increases consumer's surplus. Butmarket value need not change invariably inone direction: It may increase, remain con-stant, or decrease, as the numbers in column5 of Table 2-4 illustrate. And this variabilityof market value helps us to resolve a paradoxof value that long troubled some people:How could a commodity like diamonds be somuch less "useful" than a commodity likewater and yet be more "valuable"? The para-dox arises from confusing total and marginaluse values with market values.

Suppose that the commodities in Figures2-3A and 2-3B are diamonds and water. (Forpresent purposes, it is convenient, thoughnot necessary, for the two demand curves tobe identical.) Let the amount of diamonds besufficiently small that the price and the mar-ginal use value are high-the amount de-manded is near the vertical axis. And let theamount of water be so large that the priceand marginal use value are low. Then the to-tal personal use value of water (the lined areaunder the demand curve) can be larger thanthe total personal use value of diamonds, de-

$1.00

.90

(/l .80C7lC7l .70w-0 .60C1)c .50.;:n.

.40

.30

.20

.10

o 1 2 3 4 5 6 7 8 9 10

Quantity of Eggs

Figure 2-1.

DEMAND FOR EGGS

The dots chart a demand relationship between the priceof eggs and the quantity of eggs demanded at eachprice (see Table 2-2). We connect all of these pointson the demand schedule to get a continuousdemand curve, as shown by the black linedrawn through the dots.

Consumer Demand 19

$1.00

~A"II:---- Consumer'sSurplus

Q)(J..::

.50Q.

.40

.30

.20

.10

o 1 2 3 4 5 6 7 8 9 10

Quantity of Eggs

Figure 2·2.

MARKET VALUE, CONSUMER'SSURPLUS, AND TOTAL PERSONAL USE VALUE

The combined lined and crosshatched areas identify theconsumer's total personal use value, which is divided intoconsumer's surplus (the triangular lined area notcrosshatched) and the market value (the cross-hatched area). At the horizontal price line, at 60!!:,the quantity demanded is five. The market value isthe total expenditure on the good by theconsumer: the quantity of the good times itsprice per unit (60!!: X 5 = $3.00).

20 Chapter 2

spite a very small market value of water anda very large market value of diamonds.

Needs orAmounts Demanded

Most of us are in the habit of thinking of our-selves as having needs. Some needs are evenclaimed to be "vital," "urgent," "crying,""minimal," or "critical." Yet, as ringing asthese words can be, they have no basis infact. There are no needs as they are com-monly thought of, in the sense that there isno particular amount of a good that anyonemust have. Always, more is better and less isworse. Always, if the price is higher, peoplechoose less, because the larger cost (at ahigher price) is greater than the value theyattach to more of this good. They "need"what they must give up to get more of thisgood more than they need more of this good.

Imagine a poverty-stricken person. Hesays he has the bare necessities. Yet if hewere offered more food in exchange for someof his clothes, would he refuse on thegrounds that no amount more food wouldmake less clothing tolerable? Or, on the oth-er hand, would he be unwilling to part withany small portion of his remaining food for alot more clothing or other comforting goods?Everyone, no matter how poor, will give upsome of one good if offered enough of othergoods. All of us, in order to have more ofsome other good or service, risk our lives andsafety by traveling at high speeds or bysmoking or doing other things that have aprobability of shortening our lives.

The amount of any good you may sayyou need depends on how much of otherthings you could get if you forsake some of it.The real question is how much you"need" -that is, value-more of this. goodrelative to how much you "need" -value-more of that. The fundamental law of de-mand denies that any unique amount can beregarded as the needed amount.

~1/1 1/1 ,•.. •..~ co Consumer's0 0 SurplusC C

g c:

Q) Q)0 Market 0.;: .;:a. Value a.

Consumer'sSurplus

Diamonds

A

Marginal RevenueSo far we have used the law of demand toexamine the buyer's behavior. It is instruc-tive also to look at demand from the seller'spoint of view. The seller's interest is totalrevenue and how that is affected by the pricecharged. The buyer's total expenditures on agood are called total revenue to seller (if weignore taxes), or market value. Because theprice charged affects the quantity demandedfrom this seller, and hence the amount sold,the connection between demand price andtotal revenue is not unique. For example, ex-amine the total revenues in the fifth columnof Table 2-5, which is Table 2-3 with a sixthcolumn added.

At a price of $1.00, one egg would besold. The seller's total revenue would be$1.00. But if the price were 90¢ each forwhatever amount the customer buys, twoeggs would be sold with a market value, ortotal revenue, of $1.80. Total revenue is in-creased by 80¢ (= $1.80 - $1.00). The in-crease is called the marginal revenue at twounits (column 6 of Table 2-5). It is lessthan the price at which two units arebought. Why? Because both the first andsecond eggs are now purchased for 90¢each. The seller receives 10¢ less on the

\

~~~~a~~~~~~~~"'-MarketValueWater

B

Figure 2-3.

TOTAL PERSONAL USEVALUE AND TOTAL MARKET VALUE

Total personal use value is indicated by both the linedand crosshatched areas. The total personal use value ofdiamonds is smaller than that of water. The totalmarket value of water can be less than that ofdiamonds, as illustrated in the above graphs. Thegreater the amount of any good, the greater isits total personal use value; but the totalmarket value may decrease.

Consumer Demand 21

Table 2-5 DEMAND, PERSONAL VALUES, MARKET REVENUES, AND MARGINAL REVENUES

1 2 3 4 5 6TotalMarket

Total Marginal Value orPrice Ouantity Personal Personal Revenue Marginal(P) (0) Use Value Use Value (TR) Revenue

$1.00 1 $1.00 $100 $100 $100.90 2 1.90 .90 1.80 .80.80 3 2.70 .80 2.40 .60.70 4 3.40 .70 2.80 .40

.60 5 4.00 .60 3.00 .20

.50 6 4.50 .50 3.00 .00

.40 7 4.90 .40 2.80 -.20

.30 8 5.20 .30 2.40 -.40

.20 9 5.40 .20 1.80 -.60

.10 10 5.50 .10 1.00 -.80

first unit formerly sold for $1.00, which off-sets lO¢ of the 90¢ receipt on the second-giving a marginal revenue of only 80¢. SeeFigure 2-4.

Though two eggs are purchased at thelower price, each egg is priced at less thanthe former price, $1.00. So total revenue tothe seller does not increase by the price ofthe extra unit sold. Consider what happensif an initial price of 60¢ were cut to 50¢. Atthe lower price the total market revenue($3.00) is no larger than at the higher price.At still lower prices, the total market reve-nue would decrease, because the price re-ceived from each extra unit sold is morethan offset by a cut in unit price on so largea number of units (already salable at the for-mer price).

In Table 2-5, column 6, Marginal Reve-nue lists the changes in total revenue to theseller when price is changed just sufficientlyto induce exactly a one-unit change in theamount demanded. (The prices in column Iof Table 2-5 are those that change theamounts demanded by one unit.) Althoughprimarily relevant to a seller's pricing and

22 Chapter 2

output decisions, and not very useful in ex-plaining consumer behavior, marginal reve-nue is an important concept and will be usedextensively later.

Price Changeversus Other FactorsAffecting Demand

If the price of a good changes, the effect onthe amount demanded is shown by movingalong the fixed demand schedule. However,the demand schedule is not always thesame. It can shift in response to changes inanything other than the price of the good;for example, the consumer's income mayhave increased. An increase of income canmove a person's whole curve upward and tothe right so that at any given price morewould be demanded than before. Thus, inFigure 2-5, at that price PI' the amount de-manded at the initial income level is QI. Saydemand increases because the demander'sincome increases, shifting the schedule toD2• The demander is then willing to buy ei-ther a larger amount (Q2) at the original

price (PI) or the original amount at a priceas high as P2, to which his higher incomehas raised his marginal personal use value.

To be sure how changes in demandschedule caused by factors other than pricediffer from changes in amount demandedcaused by change in price, meditate on Fig-ure 2-6. As in Figure 2-5, we start with de-mand curve DI, with a price PI and quantityQI' If price is reduced to P3 while the de-mand schedule is unchanged, we slide downthe unchanged demand curve to a largeramount demanded, Q2' Alternatively, sup-pose price is unchanged when the demandschedule is increased to D2 (because, say, thedemander's income increased). Now theamount demanded increases to Q2' at the oldpnce.

In both cases, amount demanded in-creased. In the first case, price decreased andwe moved down the unchanged demandschedule. In the second case, income in-creased, and the demand schedule shifted;the amount demanded increased even at anunchanged price. Never fail to distinguishbetween the effect of a price change and theeffect of factors other than changes in price;The former moves one along an unchangeddemand schedule; the latter shifts the de-mand schedule.

Meaning ofChange in Price andChange in quantity

MEASURE OF PRICE

The nature and measurement of changes inprice and quantity are a little less simplethan we have thus far revealed. Say the priceof eggs rises from 50¢ to 75¢ a dozen. This isa 50% increase in the dollar, or money, priceof eggs. But suppose the dollar price of ev-erything else also rises by 50%. Though thedollar price of a dozen eggs has risen, it has

$1.00Decrease in

.90 Total Revenue

.80 ,+

.70 +++

.60 ++

.50 +++.40 ++

.30 ++ Net Increase in+

.20 + Total Revenue+

.10 +++

0 1 2 3 4 5 6 7 8 9 10

Figure 2.4.

DEMAND FOR EGGS

Because a cut in price is made to sell more units, theextra revenue will be less than the price received on theextra unit sold. The new, uniform price at which an extraunit is sold is lower on al/ the units formerly sold at thehigher price. Reduction in revenue on the quantitypreviously sold at the higher price will offset part of (orpossibly more than) the price received on the extra unitsold. As a result, the net revenue increase, called themarginal revenue, from selling one more at the new,lower price will a/ways be less than the price received onthat extra unit-less by the amount of reduced revenueon all the units formerly salable at the old, higher price.

On any given demand schedule, the marginalrevenues associated with each different quantitydemanded are indicated by a line under the demandschedule. Calculating the specific marginal revenueschedule requires knowing the demand curve datavery precisely-although we know thatmarginal revenue must be less than the price,as long as the price has to be cut to sellmore.

Consumer Demand 23

s

o

Figure 2·5.

INCREASED DEMAND

Increased demand-a shift to the right (or upward) of awhole demand curve-means more is demanded thanbefore at any given price, or a higher price is obtainablefor any given amount being sold, as when 0,increases to O2 at P" or as P2 is feasible ratherthan P, at 0" Increased demand does notmean a movement down along an unchangeddemand curve when price falls,

not risen relative to the dollar prices of othergoods. The real price of eggs-that is, theprice relative to the prices of other goods-has not risen. (The terms real price and rela-tive price mean the same thing; either can beused.)

If the dollar price of a good changeswhile the dollar prices of other goods stayunchanged or change in the 9Pposite direc-tion or by a different propojtion, then thereal or relative price of that good haschanged. If the average price of some basketof all other goods rises from $10 to $12.50 (to1.25 times its former price) when the dollarprice of eggs rises from 50¢ to 75¢ (to 1.50times its former price), the relative price ofeggs will have increased to 1.50/1.25 = 1.2-or, by 20%. Formerly one egg had a priceequivalent to .05 baskets; now it has a priceequivalent to .06 baskets. A rise of 50% in

i!

, I

24 Chapter 2

dollar terms (from 50¢ to 75¢) is a rise in real·terms (in other goods) of only 20<j1o.

We shall assume (unless explicitly in-structed to the contrary) that dollar prices ofother goods do not change at all, so everydollar price change of a good changes thereal price to the same degree. This assump-tion spares our analysis needless complica-tions. Real prices are what influence the be-havior of people, and under our simplifyingassumption that other prices stay constant, achange in the simple dollar price is equiva-lent to a change in the real price.

Whereas economists speak of changes inthe relative, or real, price to refer to theprice in terms of other goods, they often callthe dollar or money price of a good its nomi-nal price. This would hardly have to be saidif it were not for the current prevalence ofinflation. By tending to increase all prices atthe same percentage rate, inflation can maskthe special factors that are differentially af-fecting the price of goods. During apprecia-ble inflation (such as has been happeningsince about 1965), a rise in the dollar, or nom-inal" price of eggs is not necessarily also arise in the real, or relative, price of eggs. Toidentify the change, you have to know whathas been happening to other prices at thesame time-and that is one of the inconve-nient consequences of inflation.

The large rise in gasoline prices from1973 to 1974 from about 40¢ to 60¢ did meana rise in the price of gasoline relative to oth-er goods. But thereafter, until 1979, the infla-tion rate raised money prices of other goodsmore than gasoline prices. From 1974 to1979 the dollar price,' of gasoline rose fromabout 60¢ to 85¢, a rise of 40<j1o, but theprices of other goods in general rose 50%.Thus, from 1974 to 1979 there was a fall inrelative prices for gasoline from 60¢ to about55¢-a fall of almost 10%. It should havebeen no surprise that in the late 1970s, afterthe initial response to the 1973 price jump,the demand for larger, more powerful carsrevived-until 1979, when the events in Iran

reduced the supply and raised the dollar $price in 1980 almost 60<70' to $1.20. This in-crease also raised the relative price in oneyear by almost 50% because other pricesrose only about 10% that year. Since the1980 leap to $1.20, the rise in the dollar priceto $1.35 in 1981 is, when adjusted for 10%inflation of all prices in 1981, an increase inthe relative price of gasoline during 1981 ofabout 2%.

MEASURE OF QUANTITY

Another possible confusion-one about themeasure of quantity-probably can be avoid-ed merely by calling attention to it. In Table2-5, the quantity demanded at a price of 90¢is two per week-which is also a rate ofabout nine per month or 104 per year. Allthree quantities express the same rate. Wecould use a "rate of use" even for durablegoods of which a person owns only one itemat a time. How can one consume at a rate ofmore than one car? Replace it more fre-quently so as to use two per year, or use itmore intensively. The principles of demandhold whether amount refers to amountowned at anyone moment, or to rate of con-sumption or of purchase, or to frequency ofreplacement.

Elasticity ofDemand to Price Change

How responsive is the amount demanded ofa good to a change (either a rise or a fall) inits price? Responsiveness of amount demand-ed is summarized by the concept price elas-ticity of demand: the ratio of (1) the percent-age change in quantity demanded to (2) thesmall percentage change in the price that in-duced the increased amount demanded. InTable 2-6, for example, the quantity de-manded is increased from one to two, an in-crease of 100 percent, if the price is reducedfrom $1.00 to 90¢, a 1-0% reduction. Putting

P2 .•.

P,

IP3 ----+-

II

D2II

0 0, O2

Figure 2·6.

EFFECTS OF PRICE CHANGESSHOULD NOT BE CONFUSED WITHOTHER EFFECTS ON AMOUNT DEMANDED

Effects of a change in price are shown by sliding along agiven demand curve, Effects of factors other than priceare shown by appropriately shifting the whole demandschedule, say from 0, to O2, A fall in price from P, to P3

increases the amount demanded from 0, to O2

without changing the demand schedule, The sameincrease in amount demanded could be caused byan increase in wealth, or something else, that shiftsthe.whole demand schedule enough to theright to get an increase from 0, to O2, at theunchanged price,

Consumer Demand 25/

+100% over -10% gives a ratio of -10. Be-cause the quantity change is in the oppositedirection from the price change, the ratio isnegative. However, hereafter we will simplyignore the minus sign and refer to the nu-merical value of the ratio. So the price elas-ticity of demand in the region of a price of$1.00 for this demand schedule is 10. The de-mand is called elastic at that price if the elas-ticity is bigger than 1 and inelastic if lessthan 1.

On the same demand schedule, considera price change from 70¢ to 60¢, a reductionof 14%. The quantity demanded increasesfrom four to five, an increase of 25%. Theratio of the quantity percentage change tothe price percen tage change is 25/14 orabout 1.B. Demand is elastic. c

Next, estimate the price elasticity if achange in price from 60¢ to 50¢ induces thequantity demanded to increase from five tosix. The ratio of the percentage change inquantity to the percentage change in price is.166/.166, which gives an elasticity of l.(Note that the marginal revenue is zero; totalreceipts are unchanged at $3.00.)

Finally, a 33% price reduction from 30¢to 20¢ induces only a 12.5% increase inquantity sold, from eight to nine units. The

26 Chapter 2

elasticity is 12.5/33 = .3B.2 Also, because to-tal revenue is obviously reduced if the per-centage increase in quantity is less than thepercentage of price reduction, the marginalrevenue is negative; in this example it is-60%.

The numerical measure of the elasticityin response to price change depends on thechange in amount demanded and on the totalamount demanded. Two diagrams show why.Figure 2-7 shows differences in responsive-ness to price. Figure 2-B shows differences inthe initial amounts. Both affect the percent-age measure of that responsiveness.

Three features of elasticity should benoted:

First, elasticities are not. necessarily the

2 Because prices change by rather large percent-ages in this example, the arithmetic measures of elastic-ity will differ slightly, depending on the size of theprice change. These differences diminish for small-per-centage changes in price and quantity. The concept ofelasticity is usually referred to in two alternative forms:point and arc. These will be understandable only tothose familiar with calculus. Point elasticity is based oncontinuity of demand and defined as dx]x + dplp ofthe function, while arc elasticity is boX/X + bop/poPoint elasticity is the limiting value of arc elasticity.

(

same all along a demand schedule.'Second, an elasticity greater than 1 im-

plies that a price cut increases total revenues;that is, marginal revenue is positive. An elas-ticity less than 1 implies that a price cut de-creases total revenue; that is, marginal reve-nue is negative. If the elasticity is 1, the totalrevenue does not change. The term inelasticis often used in ambiguous ways: Sometimesit means the elasticity is less than "one"; butsometimes it is used even more extremely tomean the elasticity is zero-there is no priceeffect.

Third, and a more subtle point, is thatthe larger the elasticity, the closer is margin-al revenue to price. For example, in Table 2-6, at a price of around 90¢ the elasticity is 10and the marginal revenue is 80¢, or onlyabout 10¢-or 11%-below the new price.Where the elasticity is 1 (that is, response iscalled inelastic), the marginal revenue iszero-at the price of 50¢, or 100% below thenew price. And where the elasticity is lessthan 1, the marginal revenue is negative. Solow elasticity means that marginal revenue isfar below price, whereas high elasticitymeans that marginal revenue is close toprice.'

3 As an aside and to avoid misunderstanding, wenote that although the demand schedule has a constantslope, the elasticity changes along it. All along the de-mand schedule a 1O¢ change in price is assumed tomake a one-unit change in the amount demanded: Theratio of the absolute change in Q to the absolutechange in P is constant. That is not, however, the ratioof the percentage changes in P and Q. For example, attwo units, the one-unit increase to three units is a 50%increase in amount demanded. But at nine units, theincrease of one unit in response to a price cut of 10cents is now only about II % in amount demanded.Similarly, the change in price is small or large in rela-tion to the initial price from which the change is con-sidered. What is important is the percentage change inamount and the associated percentage change in price.

)•For those familiar with algebra, the exact rela-

tionship is: Elasticity = P/(P-MR).

11

10 --------

9" I

8 II

7 -----------r D24) 6 I(J I.~

IIl. 5I

4 I3

II

2 II

1 II

0 1 2 3 4 5 6 7 8 9 10 11

Quantity

Figure 2·7.

DIFFERING SLOPES AND ELASTICITIES

O2 requires a price cut of only $1 to sell one more unit.whereas 0, requires a cut of $3. O2 is more responsiveto price. Its elasticity at that price range is about 2 (a 10percent cut in price gives a 20 percent change in amountdemanded). But 0, requires a 30 percent cut in priceto give a 20 percent increase in amount demanded.Its elasticity is measured at about .66 (= 20/30).less than for O2. The marginal income at thesixth unit is +$4 (=$54 - $50) for O2 and is-$8 (=$42 - $50) for 0,.

Consumer Demand 27

p P

A'\ A~ D$6 $6

5 5::=~,4 4++~,3 ++++ 3++ D

2 ++ 2++1 ++ 1++++ .. Q Q0 1 2 3 4 5 0 1 2 3 4 5 6 ., 8 9 10 11 12 13

Figure 2·8.

DEMAND ELASTICITIES AND TOTAL REVENUE

The left curve is more elastic, even though in both curvesa price drop of $1 induces a one unit increase in amountdemanded. On the left curve it changes total sales valuefrom $10 to $12, an increase of $2. Marginal revenue is$2. The $4 price receipt of the third unit is offset by the$1 price cut on each of the two units already being sold.The percentage increase in quantity was 50 percent,while the price decrease was only 20 percent. But withthe same sloped curve in the right-hand diagram, theone-unit increase in quantity is.•only a 10 percentincrease in quantity. Total sales value falls from $50to $44, a decrease of $6. The $4 price receipt onthe eleventh unit is more than offset by the $10 lossof revenue caused by the $1 price reduction oneach of the 10 units formerly sold at $5. (Themarginal revenue at this point is therefore anegative amount, -$6.)

28 Chapter 2

The SecondLaw of Delllland

The pattern of response to higher petroleumand energy prices in the 1970s illustrates thesecond law of demand, which is that thelonger the time allowed to adjust amount de-manded in response to a price change, thegreater is the change in amount demanded,that is, the greater the elasticity. Because theimmediate effect of higher prices was soweak, .prices had to rise very high to suffi-ciently reduce the amount demanded. Butwithin a few years people could more effec-tively and economically switch to energy-economizing equipment, cars, houses, andlife styles. Since less hasty adjustments areless costly, prices of energy didn't have tostay so high for the longer run. They beganto fall in the late 1970s as the longer-run ad-justments were made.

That episode is a typical example of theoperation of the second law of demand. Theadjustment will be greater after a week andstill greater after a month, until eventuallyfull adjustment is achieved. For example, ifthe price of water were doubled, consump-tion would immediately decrease some-butwould decrease by a great deal more within afew months, after people had more economi-cally made adjustments to their water-usingequipment, as we shall elaborate later.

This law is shown by the set of intersect-ing demands in Figure 2-9. The successivedemand curves (1 through 4 and Long Run)

c

show the pattern of responses after price fallsfrom PI to P2• After one day the amount de-manded is up to XI; after two days it is X2,

and so on, until it ultimately reaches the fi-nal, long-run adjustment, XL.

It is not necessary to know the exactquantities and elasticities in all these demandrelationships. To draw some important ex-planations or implications about how oureconomy operates, we need know only thedirection and relative elasticities of effects.We know that demand curves are (1) nega-tively sloped with respect to price, and are(2) more elastic for more prolonged pricechanges.

Illustrations ofthe Laws of Demand

DEMAND FOR FOOD

If beef prices rise, say in response to a re-duced supply, but the demand schedule re-mains unchanged, people buy less beef andmore of other things, because relative tobeef, other sources of protein-eggs, poultry,fish, cheese, milk-are made less expensive.Less obvious is that people also substitutesome more vacation for less food.

However, we should not speak of de-mand for "food," since no one buys "food" assuch. We buy particular commodities, andour purchases of each of these are affected byprice. But even if we do talk summarily ofthe "demand for food," the law of demandasserts that, with an unchanged demandschedule, a higher price reduces the amountof food demanded and consumed.

DEMAND FOR WOOD

If wood prices rise (relative; of course, to oth-er materials), say because supply is smaller,less wood will be demanded. We substituteplaster, plastics, steel, aluminum, copper,

P,

o

Long Run

I~ I.g Ia. I

P2 -----+~,~~.~~IIIIIIII

Quantity

Figure 2·9.

EFFECT OF TIME ON PRICE ELASTICITY OF DEMAND

The longer the time after a price change, the greater theeffect on the rate of demand-shown by the flatter,more elastic curves for more elapsed timeafter a price change.

Consumer Demand 29

glass, paper, coal, oil, and electricity. Youand I may not consciously respond to a 10%rise in the price of wood. But industrial prod-uct designers will shift in varying degrees tosubstitutes. The things we buy will be madewith less wood and more of other material.Nor must every person's purchase rate be re-vised by every price change. Some peopleare on the margin of choice between onegood and another; and, as prices change, theywill shift their choices.

DEMAND FOR WATER

Water is an especially subtle, but powerful,example of how the amount demanded re-sponds to price change. Although peoplecannot live without some water, they do re-duce (not eliminate) their use of water athigher prices. People in arid regions use lesswater, not because they don't want or"need" more, but because they don't want somuch at such a high price. They choose lesswater and use more of other, less expensive,more arid modes of living.

The average per capita daily water usagehas varied from 230 gallons in Chicago to150 in New York City and Los Angeles,down to 120 in San Diego and 110 in Boston.Among the reasons for these differences aredifferences in industrial uses. Chicago hassteel and oil-refining industries that use agreat deal of water; New York City business-es-finance, retail, apparel-are light waterusers. But the cost of water had something todo with determining the locations of thoseindustries.

By the law of demand, if water prices arehigher, less water will be used. In New YorkCity, 10% of the total water consumptionwas estimated to be from leakages in streetmains. At higher prices for water, it will payto reduce that loss. Also, water meters,which make people pay according to use, arenot yet universally used. Where they are,people have stronger incentives to conserve

!Ii"Ii

il!!

'~II'

30 Chapter 2

water (by repair and modification of faucetsand water-using equipment).

At higher water prices, residences willhave smaller gardens and lawns. More sprin-klers will be used because they use less wa-ter. Gardeners will sweep rather than washsidewalks. Rock gardens and paved andbrick patios will become more common.Automobiles will be washed less often. Wa-ter will be softened, because smalleramounts of soft water wash as well. Showerheads will be changed. None of thesechanges would reflect a change in tastes ordesires, but would reflect the higher price ofwater at which more of other goods must besacrificed if the same amount of water wereto be used. It has been estimated that a dou-bling of water prices would reduce total do-mestic water consumption by 10<;'0 to 30%within a year. (Translate that into elasticityterms.)

Still more ways of conserving water ex-ist. In many cities, industrial users take abouthalf the water. Their demand is probablymore responsive to price than is that of do-mestic users. Table 2-7 shows great differ-ences in water use even within the same in-dustry. The maximum column presentsamounts used per unit of output in plants inareas where water is priced low, whereas theminimum column shows the smallest amountused per unit of output produced in areaswhere water costs are high. Note the tremen-dous range in the first three industries, .which happen also to be the heaviest indus-trial water users. Some industrial firms usingwater for cooling do not have recirculatingcooling units. Some steel mills use 65,000 gal-lons of water per ton produced, but the Kai-ser steel mill (in the Los Angeles area) usedonly 1600 gallons. One soap plant in thesame area has recirculatory cooling towers toreduce water consumption from about sixmillion to less than a half-million gallons perday. At higher water prices, the greater sav-ings on reduced use of water make recyclingworthwhile. Clearly, the amount of water

c

Table 2·7 VARIATIONS AMONG FIRMS AND PRODUCTS ININDUSTRIAL CONSUMPTION OF WATER, PER UNIT OF OUTPUT

Product or Userand Unit

Steam-electric power (kw-h)

Draft (in Gallons)

Maximum Typical •• Minimum

170 80 1.3

65,000 40,000 1400

Petroleum refining (gallon of crude oil) 44 18 1.7

Steel (finished ton)

4Soaps, edible oils (pound) 7 1.5

6 2.5

Carbon black (pound) 14 0.25

Butadiene (pound) 305 160 13

Natural rubber (pound)

Glass containers (ton) 670 120

Automobiles (per car) 16,000 12,000

Trucks, buses (per unit)

Source: H. E. Hudson and Janet Abu-Lughod, "WaterRequirements, " in Jack B. Graham and Meredith F Burrill(eds.), Water for Industry (Washington, OC: AmericanAssociation for the Advancement of Science, 1956),

. Publication No. 45, pp. 19-21.

"needed" varies with price!There are still more ways to adjust wa-

ter usage. The largest water user in South-ern California is agriculture, which uses ap-proximately 70% of the water-at priceslower than urban dwellers pay, even afterthe costs of distribution and purification.What would farmers do if the price of waterto them reflected its higher alternative usevalue in cities? Some would go out of thefarming business. Higher water prices wouldreveal that some water to grow watermelons,lettuce, and celery, for example, would bemore valuable elsewhere. Less food would begrown in Southern California and more inareas where water is cheaper, and more foodwould be shipped to Southern California, be-cause shipping products would be cheaperthan shipping water. Some areas would de-cline as people found it preferable to moveto places where water is cheaper, or took uptasks that use less water, which is, after all,why the Western deserts are sparsely popu-lated.

When a price rises, how do people dis-

20,000 15,000

cover how to use less? Some people makea living by giving that information: commer-cial sellers of water-recycling equipment,water softeners, automatic faucets, fertiliz-ers, irrigation and sprinkling equipment, air-conditioning machinery, hardtop patios,chemicals that reduce evaporation, washingmachines that use less water, and so on. Ev-ery rise in water prices enhances their busi-ness prospects. Salespersons make it theirbusiness to detect ways in which theirequipment is more economical. Teachersmay believe that most worthwhile knowl-edge comes from schools and books, but anamazing amount of information about prac-tical matters is prov~ by salespersons-because it is to their personal interest to in-form potential customers. Though users maynot at present know how to alter their useof water, rubber, energy, sugar, steel, or gas-oline in response to a price change, were theprice to change they would be swamped bysalespersons with information about newuses and substitutes.

Consumer Demand 31

pi:i

DEMAND FOR GASOLINEOR ENERGY (OR ANYTHING)

II

,ilijI'

The gasoline supply to the United States andthe world was reduced in 1974 by 10%. Poli-ticians and many business people did not be-lieve that higher gasoline prices would be ef-fective in reducing consumption, and lookedfor ways to regulate our gasoline-consumingactivities. For example, they proposed toprohibit high school students from "waste"driving to school. But as prices of gasolineincreased, people themselves in fact decidedwhich were the less valuable uses to be for-saken.

A price rise of about 100%, from 1973 to1982, has been sufficient to restrict theamount demanded to match the smaller sup-plies. (The dollar, or nominal, price roseabout 200%, from 40¢ in 1973 to $1.50 in1982-but when the 1982 dollar price is ad-justed for the effects of inflation on all prices,the 1982 relative, or real, price of gasoline isequivalent to about 75¢ in 1973 dollars, or arise of about 100%.) We reduced driving inlarger cars; we reduced speed; we combinedmore shopping in fewer trips; we turned offthe engine more often rather than let it idle;we flew between cities and then rented cars;we drove more in our smaller second car; wetuned our engines better. All that many of usdid immediately. And then we purchasedsmaller new cars.

The same measures are taken with high-er prices for heating oil: We wear moreclothing, have better-insulated/houses, acceptlower indoor temperatures, and heat fewerrooms. We were pushed back up the demandschedule as prices rose. The reductions inthe amount of gasoline and fuel oil used arethe results of a higher price. They are notthe results of a reduced demand schedule,nor of politically imposed regulations. Thosehigher prices revealed that the less valuableformer uses weren't feasible with the smallersupply. The market price of the amount ac-

, rI

jll _

111

32 Chapter 2

tually available provided a common standardof measure against which to test for the morevaluable uses.

Was it best to achieve reduced con-sumption by means of the free-market pricethat reflects supply and demand? Or is it de-sirable to compel people to restrict consump-tion by other means and on some other crite-rion? Asking people to restrict consumptionmore than they are induced to do by themarket price is to ask them to reduce theirgasoline use so that other people can use thegasoline in lower-valued uses. Such required"conservation" compels diversion to lessvaluable uses; it is wasteful. It also givessome politicians more power over economicresources and people. We emphasize this ef-fect of nonprice control because marketprices are a means of controlling and coordi-nating people-by competition for scarce re-sources, an alternative means to the use ofpolitical power. Market prices and politicalpower are competing systems for control.The differences in their consequences areenormous, as will be seen later.

Estimates ofElastieities of Demand

We have been fairly adept so far at separat-ing changes in demand from changes inamount demanded. But in the real worldmatters are rarely so conveniently simple:We can observe a change in price, and wecan observe a change in the amount demand-ed. But how can we be sure that the positionof the demand curve has not also changed,because of other independent events? If thecurve has shifted, then the observed totalchange in amount bought will be the resultof a change not only in price along a demandcurve but also in the position of the demandcurve. Exact elasticities of demand, then, areextremely difficult to estimate.

Statisticians have attempted to over-come the ambiguity by separating the effects

c

of these two independent factors, demandshift and price change. One means of recentdevise is the one-year interval of adjustmentelasticity of demand. As measured by thisscheme, the elasticity of demand for gasolinein response to a change in its price was re-cently estimated to be about. 1. This meanstha tal 0% rise in price decreases theamount demanded by 1~o. (Question: If youwere the sole supplier of gasoline in somecountry and knew that the one-year elasticityof demand for gasoline at present prices wasabout .1, would you contemplate raising theprice by reducing the amount supplied?Would that necessarily be true for a five-year interval of adjustment elasticity of de-mand?)

Income Effects on DemandSo far we have concentrated on price as acontroller of the amount demanded. As em-phasized earlier, factors other than price alsoaffect the amount demanded. Changes in in-come or wealth shift the demand schedule. Alarger income will induce more consumptionof most goods at the given prices: For exam-ple, transportation, food, housing, medicalcare, education, travel, champagne, and pres-tige goods increase with income. On the oth-er hand, as income or wealth increases, one'sdemand for some goods decreases: Candi-dates might be rump roasts, junk food, ham-burger, or small cars. Goods for which de-mand is greater at higher incomes are calledsuperior goods; goods for which demand de-creases with increases in income are calledinferior goods.

INCOME ELASTICITY OF DEMAND

Because demand responds to changes in in-come, an income elasticity of demand canalso be defined. Income elasticity of demandis the ratio of the percentage change inamount demanded in response to a percent-

age change in income. These elasticities areusually positive, unlike the price elasticity ofdemand, which is negative. Statistical studiesindicate that income elasticities of demandare less than I for;..food, drink, clothing, andrental housing, but are greater than 1 forwhat people typically call luxury goods.

INCOME CHANGES:TEMPORARY OR PERMANENT?

Just as the elasticity of demand in respoIl.,Seto a price change depends on the duration ofthe new price, so does the effect of a changein income: The longer the expected dura-tion, the greater is the effect on wealth andhence on consumption demand. Many peo-ple know their earnings fluctuate from weekto week and even year to year, probablyaround some average. They gear their con-sumption to the anticipated, persisting aver-age. They do not revise consumption withevery transient variation in income. Is therea real estate agent who consumes only on thedays when a house is sold? Do business peo-ple consume only on weekdays when earningincome, while consuming at a zero, rate onweekends? On the contrary, people adjustconsumption rates to a long-run anticipatedaverage income around which temporaryvariations of earnings are expected. That iswhy variations in earnings that are believedto be temporary are not accompanied by pro-portional changes in consumption. Unusuallyhigh temporary earnings go mostly into tem-porary accumulation of cash or bonds or re-payments of past debts, for example. ~ a re-sult, current consumption (that is, itsdemand schedule) does not change in propor-tion to fluctuations in income. People save inorder to smooth over later expected low in-comes, and during periods of low earningsthey dip into accumulated reserves and in-ventories.

In Figure 2-10, annual expenditures arecharted against that year's income, which

Consumer Demand 33

IiI'

Saving$5000

'Cog 4000rac 3000oIII~ 2000::J..~ 1000Q)Q.

~ 0 ~--~~----~----~--~----~~~

i6::JCe

<I:

1 __ - Food

Transportation1

Annual Income

Figure 2·10.

INCOME EFFECT ON DEMAND

The curves show that expenditure rates on generalclasses of goods and services are related to income-increasing with income but at a lower proportionate rate.Amounts demanded are clearly related to income.

The variation of saving, from negative rates at lowincomes to highest rates at high incomes, isdeceptive if you think it shows that people whoseannual incomes over the years average about $5000or less do not save. Because incomes fluctuate notunexpectedly over the years, and because a persontends to consume according to his or her longer-runincome average, savings will show largeresidual fluctuations as income fluctuatestransiently from year to year.

34 Chapter 2

may temporarily be extremely high or low.But consumption is seen to be relatively in-sensitive to such fluctuations, so the residualof the current temporary increase in in-come-savings-is sensitive. But when in-come is perceived to be lasting or relativelypermanent, people adjust their consumptionnearly in proportion. In sum, when studyingthe effect of current income, one must bevery careful to identify whether current in-come is mostly temporary or is mostly at thelong-term average.

Price Effects on Wealthand Hence on Demand

ENDOWMENT EFFECT

A price change in a good causes a substan-tial change in a person's wealth or income ifthat good is a substantial part of a person'sstock of wealth or source of income. If theselling price of oil rises markedly, the oil-well owner's higher income will increase hisdemand for, say, a larger house-which usesmore oil for heating and air conditioning-aswell as his demand for a larger car. Becausethe oil is sold at a higher price, the owner'sincome increases enough to shift the de-mand schedule upward so as to more thanoffset the effect of the higher price for theoil the owner consumes. On the new, higherdemand schedule, the amount demanded in-creases from what it was on the old low-wealth demand schedule at the old, lowerprice. (See Figure 2-11.)

The increased price of a good that isboth a major source of a person's incomeand a good that the person consumes hastwo distinct effects: an endowment effect,increasing the person's wealth or incomeand hence his or her demand for the good,and a substitution effect, moving backupalong the demand curve. In our example, thesubstitution effect away from oil in response

c

to the higher price is overbalanced by thegreater effect on endowment wealth. So, at ahigher price the owner consumes more oilbecause of the large oil endowment incomeeffect. Unless we separate these two effectsof a price rise, we may erroneously supposea demand schedule to be unchanged whenin fact it has shifted because the pricechange has affected a major source of a per-son's wealth.

INCOME RELEASE EFFECT

A price change has another kind of effect ondemand, called the income release effect of alower price. Even if a particular good is notin a person's source of income, a lower priceof that good releases some income formerlyspent for the good. Because this released pur-chasing power is usually small, and of courseis distributed over the purchase of all othergoods, its effect on the demand for the lower-priced good itself is usually negligible.

Alleged Exceptionsto the Laws of Demand

Some people talk of exceptions to the laws ofdemand. They say people could conceivablybe insensitive to price or that they could buymore of some things even when the pricerises. Indeed, people conceivably could-al-most anything is conceivable. But the law ofdemand says that actually people are not in-sensitive to price.

One apparent exception to the law of de-mand is alleged because observers confusethe relative price with the nominal price:The amount of a good demanded does notfall even though its nominal (dollar) price hasrisen during a time of inflation, if other nom-inal prices have risen even more.

Another alleged exception is a prestigeor "conspicuous consumption" good-likeMumms champagne, Cross pens, RollsRoyce cars, Orrefors crystal, or whatever the

$

(When Price is P2 and thereforeBuyer's Wealth is High)

D2(When Price is P1 and thereforeD1 Buyer's Wealth is Low)

Gasoline

Figure 2·11.

ENDOWMENT AND SUBSTITUTION EFFECTS

Changes in prices of goods that constitute a majorsource of a person's income or wealth can shift theconsumption demand for that good enough tooffset the simple price effects of amountdemanded (for a given amount of wealth).

"eli te" display. Presumably, conspicuousconsumption of such goods sheds prestige onthe user. Desire for such prestige could shittup the demand schedule, but it would notproduce a demand schedule that is slopedupward. Let the price of the prestige good beeven higher, and less of it will be bought.Otherwise what would prevent the pricefrom rising without limit? The prestige ef-fect simply shifts its demand schedule up-ward. But the new, higher demand curve stillhas a negative, that is, downward, slope. Thepursuit of prestige is consistent with the law~of demand.

Also cited as contradictions of the law ofdemand are occasions when a higher pricemakes the buyer believe the item is better.For example, anyone who proposes to sellsomething far below its current market pricewill have more problems making a sale thana seller asking the market price, because anunusually low price immediately stirs doubts

Consumer Demand 3S

about the quality of the item. These are sen-sible doubts, given the fact that price usuallyreflects quality. If I offer to sell my nearlynew Ford for $4000, a potential buyer willhesitate, suspecting its quality or my owner-ship. If the buyer can be satisfied that thelower price is not the result of lower quality,he or she will buy the car more readily thanif I asked $7000. A good of inferior quality issold at a lower price because only then willanyone buy it; at the same prices, everyonewould prefer the better item. The public'sassociation of higher price with quality is aconsequence of the law of demand, not a ref-utation of it.

Direct Evidenceof Validity ofthe Laws of Demand

Prices of fruits and vegetables are lower dur-ing harvest seasons, when the supply is larg-er, because the greater amount can be soldonly at a lower price. If prices of perishablecrops did not fall at the peak of the harvest,the first law of demand would be refuted.Likewise, if goods of poorer quality sold forthe same price as goods of better quality (as-suming everyone agrees on standards of qual-ity), the first law of demand would not betrue. Merchants have clearance sales at lowerprices to induce you to buy. Someone whoseeks your business will lower", the price, notraise it. Indeed, in response to several pollsand questionnaires in 1974, most people saidthey would not reduce the amount of gaso-line they used just because the price wentup. They said they had to have transporta-tion. (How much? What kind? At what cost?)In fact, their statements, when comparedwith their behavior, indicated less economicsophistication than their behavior did. Theiractual response, as history shows, was to re-duce the amount of gasoline demanded at the

36 Chapter 2

higher price, in accord with the first law ofdemand. Furthermore, the reduction hasbeen greater in the long run, in accord withthe second law of demand.

Indirect Evidenceof Validity

Often the power of a principle is most clear-ly corroborated by indirect, unexpected im-plications. For example, a larger proportionof good-quality California oranges andgrapes is shipped for sale to New York whilea larger proportion of the poorer-qualityfruit remains in California. Are New York-ers richer or more discriminating? Possibly-but, then, why is the quality ratio highereven in the poor districts of New York thanin California? The question can be posed forother goods: Why do Asians import dispro-portionately more expensive American carsthan cheaper models? Why are "luxuries"disproportionately represented in interna-tional trade? Why do young parents go toexpensive plays rather than movies on ahigher percentage of their evenings out thando young couples without children? Whyare "seconds," slightly defective products,more heavily consumed near the place ofmanufacture than farther away? Why must atourist be more careful buying leather goodsin Italy than Italian leather goods in theUnited States? Why is most meat shipped toAlaska "deboned"? The answers all are im-plications of the law of demand. Let us seewhy.

Suppose that California grapes cost 50¢ apound to ship to New York, regardless ofquality; that production of grapes is 50%"choice" and 5070 "standard"; and that inCalifornia the choice grapes sell for $1.00 apound and the standard for 50¢ a pound. Thecost of shipping grapes to New York raisesthe New York buyer's cost of both types ofgrapes by 50¢ a pound to $1.50 for choicegrapes and $1.00 for standard grapes. One

c

pound of choice grapes in New York coststhe same as 1.5 pounds of standard, whereasin California it costs the same as two poundsof standard. New Yorkers have a lower pricefor choice relative to standard grapes, andtherefore, in accordance with the first law ofdemand, consume relatively more choicegrapes than do Californians. In California,where standard grapes are cheaper relative tochoice grapes, a larger fraction of grapes con-sumed should be standard. And it is so.

Prieing Taeties:APreview

So that you can better understand the ex-planatory power of the demand schedule, weanticipate some pricing tactics to be ex-plained in more detail later. Suppose a sellerknew that a buyer's demand schedule wasthat in Table 2-2, and suppose the costs ofproduction were 25¢ per egg. This sellercould tell the buyer: "You may buy one eggat 99¢. If you do, you may buy a second eggat 89¢. If you do, you may buy a third egg at79¢, a fourth at 69¢, a fifth at 59¢, a sixth at49¢, a seventh at 39¢, and the eighth, and asmany thereafter as you wish, at 29¢ each."How many will the buyer buy? The correctanswer may be surprising.

This customer will buy a first egg, sinceher one unit is worth at least $1.00, and shecan buy it for only 99¢, with a 1¢ gain ofconsumer's surplus as compared to not buy-ing it at all (although her gain is not as greatas it would be were she able to buy each foronly 29¢). The second egg has a marginalpersonal use value to her of 90¢, but will costonly 89¢, giving another 1¢ consumer's sur-plus. Similarly, each successive additionalunit purchased adds 1¢ of use value over thecosts, until she has purchased eight units. Aninth would have a marginal use value ofonly 20¢, but would cost 29¢. Her total con-sumer's surplus would be only 8¢, 1¢ on eachof the eight eggs.

If instead the price had been a uniform29¢ per egg regardless of quantity purchased,she would still have bought only eight eggs.But her consumer's surplus from this singleprice would be equivalent to $2.88 (=$5.20 -8 X 29¢). This is also expressible as the sumof the 71¢ value excess on the first unit(worth $1.00 but purchased for only 29¢) andthe 61¢ excess on the second unit (worth 90¢but costing only 29¢), and so on. The succes-sive excesses are 71¢, 61¢, 51¢, 41¢, 31¢, 21¢,II¢, and 1¢, which equal $2.88 on the eighteggs. But under a multipart pricing schedule,the seller gets more of the gains from markettrade. Who should get the gains is unanswer-able.

It might at first be surprising that withmultipart pricing the buyer still buys theeight units she would have bought at the sin-gle low price. Under multipart pricing, heradditional cost of $2.80 ($5.12 - $2.32) is a re-duction of $2.80 in consumable income thatshe would have spread over everything elseshe buys. If she spends about $400 a week onall her purchases, that $2.80 is about a 1<70reduction in her consumable income power.Thus she would cut back roughly 1% on allof her purchases-including eggs. She reallywould buy fewer eggs, because her demandschedule for eggs would have shifted backslightly. Nevertheless, for all practical pur-poses, this small income effect on her de-mand for eggs is too small to worry about inmost situations.

Thus, whether price is a single per-unitprice or a multipart schedule, we once againsee that the consumer still buys an amountthat brings her marginal personal value downto equality with price of the last unit. Ofcourse, a buyer certainly prefers a uniform,low price, whereas a seller would certainlyprefer the multipart price schedule in whichonly the last unit has a low price. Later weshall investigate circumstances under whichsome forms of multipart pricing can be em-ployed.

Consumer Demand 37

Utility.MaximizingBehavior

The postulates of behavior at the beginningof this chapter are the foundations of what iscalled a utility-maximizing theory of humannature. Saying that a person maximizes utili-ty may seem an elaborate camouflage of ourignorance of why people behave as they do;for whatever a person does, could the personnot be said to be maximizing his or her utili-ty? No, because we have specified responsesto changes in relative costs and therefore canderive meaningful, refutable implications.The demand relationship is one such validat-ed implication. And we shall give many ex-amples in this book. For the moment, consid-er an example. Saving lives may be a good.Consider two different situations: In one, youcan save a life by jumping into a pond andpulling out a child; in the other, you mustjump into a raging torrent with a 99% proba-bility that you will drown. Now, what doesour theory tell us? The probability that peo-ple will jump into the torrent to save a life islower than that they will jump into ponds.The analysis does rule out some behavior.Not everything is possible under the postu-lates. Thus they do have scientific meaningand are not mere tautological descriptions.

Summary1. The unit of economic analysis is the individ-

ual, not the institution within which the in-dividual acts. ~

2. Postulates of Behavior:

1. Each person desires many goods and hasmany goals.

2. For each person, some goods are scarce.

3. Each person is willing to forsake some ofan economic good to get more of some othereconomic goods.

.Ij, _

i 38 Chapter 2

4. The more one has of any good, the largerits total personal use value, but the lower isthe marginal personal use value.

5. Not all people have identical tastes andpreferences.

6. People are innovative but consistent.

3. The value of something to a person is theamount of other goods the person is willingto sacrifice for it.

4. Self-interest means that a person values hisor her ability to choose among options thataffect his or her situation.

5. Demand for a good is the relationship ofamounts demanded at various possibleprices. The term demand can be ambiguous:It may refer to either the whole schedule orto only one of those amounts at a givenprice. This ambiguity is avoided by speakingof demand only when meaning the wholeschedule and the amount demanded whenmeasuring a particular price.

6. Marginal personal value of a good is thechange In total personal value associatedwith an additional unit in the amount of thatgood.

7. As larger amounts of a good are held, itsmarginal personal value is smaller.

8. The amount demanded of a good, at anyprice, is interpreted as being the amount atwhich its marginal personal value is broughtto equality with the price.

9. The first law of demand states: Whateverthe amount demanded at a price, there is ahigher price that will reduce the amount de-manded.

10. Consumer, or buyer, gain from trade (calledconsumer's surplus) is the difference betweenthe buyer's total personal value and the mar-ket value. Do not confuse the total marketvalue with the total personal use value.

II. The elasticity of demand with respect toprice is the ratio of the percentage responsein amount demanded to a small percentage

c

change in price. An elasticity greater than Iimplies that a reduction in price increasestotal receipts.

12. The greater the elasticity, the closer is mar-ginal revenue to price.

13. Marginal revenue is the change in total rev-enue when the price on all units is reducedenough to sell one more unit.

14. The second law of demand asserts that theprice elasticity of demand for a good isgreater in the longer run than in the shorterrun.

15. Need is a word often used to suggest fixedminimum requirements, when in fact theamount "needed" is variable and depends onthe cost.

16. Income, or wealth, affects the demandschedule.

17. An increased demand for a good means thatat any price, the demander demands morethan formerly, or the marginal personal val-ues have increased, and the demander iswilling to pay a higher price (in one form oranother).

18. Alleged exceptions to the first law of de-mand usually result from confusion:Changes in amounts demanded when a pricechanges are confused with a change in thedemand schedule caused by .simultaneouschanges in nonprice factors; or dollar pricechanges are mistaken for relative pricechanges.

19. Not all sellers permit buyers to buy whatev-er amount they demand at a fixed price.Sometimes a multipart price system permitsthe seller to get a larger share of the gainsfrom trade.

20. One's wealth can increase so much becauseof an increased price of some good that is alarge part of one's wealth that the demandschedule is raised more than enough to off-set the higher price on the amount of thatgood demanded. This price effect on wealthis called the endowment eHect of a pricechange.

21. A lower price to a consumer releases expen-diture power that can be spent for all othergoods; hence the released expenditure pow-er will probably have insignificant effect inchanging the sJemand for the good whoseprice was lowered.

Questions1. "The college football team has a goal."

a. Is it the social goal of the team, or is it acommon goal of each member of theteam?

b. Are you sure that each member has onlythat goal and not also one of playing moreof the game himself?

c. Is it helpful to talk of one goal being pre-ferred over another?

2. In trying to understand some policy enforcedat your college, why is it misleading to ask whythe college adopts that policy?

3. If you don't smoke, is tobacco a good? Arepurchase and sale necessary for something to beconsidered a good?

4. "A free good is a self-contradictory concept,because no one wants what is free; otherwise itwouldn't be free. And if no one wants it, it can'tbe a 'good.' " Evaluate.

* 5. Explain or criticize the following state-ments and questions about the substitution pos-tulate:

a. "Every student substitutes some romancefor grades when dating rather than doingas much studying as otherwise could havebeen done."

b. "The substitution postulate says that astudent does not seek the highest possiblegrades."

c. Does the substitution postulate deny thatwater, food, and clothing are more basic ormore needed than music, art, and travel?

d. "There is no hierarchy of wants." Whatdoes that mean? Can you disprove it?

e. Is travel in Europe a substitute for formalacademic education? for some food? for abigger house or new clothes or medical

Consumer Demand 39

care? For what would it not be a substi-tute?

f. "I'd like to play poker with you again to-morrow night, but I don't think my wifewould like it." Is this consistent with thesubstitution postulate? Is the wife's wel-fare being compared with the husband's?Explain.

6. Explain the difference between the state-ments, "People act in accord with certain funda-mental propositions" and "People consult or re-fer to such propositions for guidance in choosingtheir behavior."

7. It has been suggested that if a person agreesto let some unknown party choose between twoknown options for him or her, the person is indif-ferent between the two options. Do you thinkthat is consistent with the postulates listed in thetext?

8. Suppose that I am indifferent if given achoice among the following three combinationsof steaks and artichokes:

Steaks Artichokes(pounds per year)

Options A: 100 and 30B: 105 and 29c: 111 and 28

a. How is my marginal personal value ofsteak (between options A and B) meas-ured?

b. What is my marginal personal value ofartichokes (between B and C)?

c. If the amount of meat in A were doubledto 200, what can be deduced about theamount of meat required' in B to make Bindifferent with that new A?

*d. Using your answer to (c), compute mypersonal marginal valuations between thenew A and the new B. Is that consistentwith the fourth postulate?

9. "All goods or goals are incompatible. And atthe same time they are compatible." Can youmake sense of that?

10. "It doesn't pay to do your best at any givenactivity." Explain why.

40 Chapter 2

11. The following is Mr. A's annual demand forpencils.

Personal Value Revenue------Price Quantity Total Marginal Total Marginal

$2.00 11.90 2

1.80 31.70 41.60 51.50 61.40 71.30 81.20 91.10 10

Complete the total and marginal personal usevalue and total and marginal revenue columns.

12. The demand schedule of question 11 showsthat at a price of $2, the annual consumption is Iunit. At a price of $1.90, the annual consumptionis 2 units.

a. Can it be said that this person wants eachone of those 2 units more than $1.90worth of any other goods?

b. Note that at the price of $2 the personannually spends $2 on this good, whereasat a price of $1.90 the person spends$3.80, or $1.80 more than previously. Doyou still say the person values the extraunit at approximately $1.90, even thoughhe or she spends only $1.80 more?

c. Explain why. In doing so, explain what ismeant by value.

13. Can Table 2-1 be read as follows? "A personsees a price of $2 and therefore buys one egg. Ifin the next hour the price has fallen to $1.80, theperson dashes out and buys three. If a couple ofhours later the price rises to $1.90, the personbuys two." If it can't be interpreted that way-and it can't-how is it to be interpreted?

14. For goods like shoes, a persisting rise inprice will reduce the number of pairs of shoes aperson will want. Because the price at which hecan sell used shoes is low relative to the new-shoe price, a person will not sell some shoes inorder to reduce his or her stock of shoes. Howdoes the person adjust that stock to the highercost?

c

15. Consumption is a rate concept, even thoughthe good being consumed may be held as a stockor finite amount of goods. True or false?

16. To say that a person purchases and con-sumes water at a rate of 50 gallons per day, or350 per week, is to say the same thing in twoways. What is the equivalent rate per year?

17. "According to the law of demand, the lowerthe price of vacations, the more vacations Ishould take. Yet I take only one per year. Obvi-ously the law of demand must be wrong." Is it?

18. There are three conceptions of the amountdemanded: (I) the rate of consumption; (2) thequantity a person wants to buy in order to in-crease current stock; (3) the quantity a personwants to own. As an example of each: (I) a per-son may consume eggs at the rate of 6/7 per day(which does not necessarily mean that a fractionof an egg is bought and eaten each day); (2) onSaturday the person buys a half-dozen eggs; (3)the person may own an average of three eggs inhis or her refrigerator. Normally, explicit distinc-tions between rates of purchase and consumptionare not necessary because they are closely relat-ed. Which of these three measures is a rate ofactivity and which is a "stock"?

19. Suppose the demand-schedule data in ques-tion II refer to the number of pencils a personwould want to own at each price. The personnow owns four pencils.

a. How many more would he or she buy orsell at each possible price?

b. If the equilibrium price in the marketturned out to be $1.30, how many wouldthe person want to buy or sell and howmany would then be owned-assumingfour initially?

20. Explain how each of these is a denial of thelaw of demand and the basic postulates of eco-nomics:

a. "The budget of the Department of De-fense covers only our basic needs andnothing more."

b. "Our children need better schools."c. "Nothing is too good when it comes to

education."d. "America needs more energy."

21. Why is it nonsense to talk about urgent, crit-

ical, crying, vital, basic, minimum, social, or pri-vate needs?

*22. A book was entitled Social Needs and Pri-vate Wants. Would the title have suggestedsomething differertl: if it had been Social Wantsand Private Needs?

23. Diagnose and evaluate the following newsreport: "Our city needs more golf courses, ac-cording to a report by the National Golf Founda-tion. Many people do not playas often as theywould like because of the lack of courses." Doesthis differ from the situation of filet mignonsteaks, champagne, and autos?

*24. "Californians are crazy. Near a beautifulCalifornia beach are a luxurious motel and astate-owned camping area. Despite the luxury ofthe motel, scores of cars line up for hours eachmorning seeking free camping sites, whereas atthe motel there is hardly a day the rooms are alltaken. This shows that Californians prefer out-door, dusty camps to the luxuries of a motel withpool, TV, room service, and private bath." Doyou agree? Explain.

25. Why is the marginal revenue less than price(except at first unit)?

26. An increase in demand is shown graphicallyby a demand curve to the right of, above, below,to the left of, the old demand curve. Select cor-rect options.

27. Which of the following would increase thedemand for wigs?

a. A raise in one's salary.b. Higher price of hats.c. Having a swimming pool.d. Rise in cost of hair care.e. Getting divorced.f. Number of other people who wear wigs.g. Lower price of wigs.

28. Are the following statements correct or i~-correct? Explain your answers. I

a. "A 1% fall in price that induces a 3% in-crease in amount purchased indicateselasticity greater than I."

b. "A I % rise in price that induces a 3%decrease in amount taken indicates elas-ticity greater than I."

c. What is dangerous in asking whether a

Consumer Demand 41

I c;'o rise in price induces a 3% decrease indemand?

29. "Elasticity is a measure of the percentage in-crease in demand for a I ¢ change in price."What are the two errors in that statement?

30. In the graph below, which of the three de-mand curves has the greatest elasticity at pricePI? At price P2? Does the elasticity change as theprice changes along each curve?

c

31. a. If the price of gasoline rose 100%, auto-mobile manufacturers would makechanges in the designs or operating char-acteristics of automobiles. True or false?

b. What effect would that price rise have ongasoline consumption?

c. Would the effect be more extensive atthe end of one year or at the end of threeyears?(This question, which appeared in thefirst edition of this boo]; in the 1960s,was criticized then as being absurd-be-cause it contemplated a rise in price asgreat as 100%. Reality is not absurd')

32. Explain how what is often called "impulse"buying is consistent with the laws of demand.Explain why habitual buying is also consistent.Suggest some behavior that would not be consis-tent.

33. Does the demand for children obey the fun-damental theorem of demand? The demand byimmigrants for entry to the United States? The,I

~]II,il'r---------II 42 Chapter 2

demand for divorces? The demand for pianos?The demand for a winning college football team?The demand for A's in this course? The demandfor appendectomies?

34. a. Does our representing a demand curvewith precise numbers mean that peoplehave these numerical schedules in theirminds?

b. What essential property illustrated by thedemand-schedule data does characterizetheir behavior?

35. If the price of candy rises from $1.00 to $1.25a pound while the price of ice cream rises from50¢ to 7S¢ a quart, in what sense has the price ofcandy fallen?

36. "If the price of gasoline rose by only 10%,many people would not immediately changetheir consumption." Explain why this does notrefute the law of demand.

37. Economics asserts that people prefer more toless. Yet there are waiting lists of people seekingsmall apartments in slum areas while bigger, bet-ter apartments do not have a list of applicants.How can people want smaller, less luxuriousapartments rather than bigger apartments with-out violating our postulates about people's pre-ferring more economic goods?

38. a. As your wealth or income increases, whathappens to your demand schedule for gas-oline?

b. If you owned a dairy farm and the price ofmilk went up, would you consume moreor less milk?

39. Why is it that when a couple goes out, theprobability is greater that they will attend an ex-pensive theater if they have infants for whom ababy sitter is necessary than if they are childless?

40. Let PI be the domestic price of a higher-quality version of a good and P2 be the domesticprice of a lower-quality version. Let TI and T2 bethe transport costs of these goods to a foreignmarket. Show that if TI/ T2<PI/ P2, then relative-ly more of good I will be shipped; if the inequal-ity is reversed, relatively more of good 2 will beshipped. "Relative" to what? In your answer,what do you assume about demand conditions indomestic and in foreign markets?

(

41. A governor of California once asserted thatthe reduction of Mexican labor in California didno harm, because the total value of the crop har-vested was larger than before. Evaluate the rele-vance of that criterion. (The same was true whenthe Arabs reduced the amount of oil sold in1973.)

42. A competing text to this one is claimed byits author to be "invaluable." Does that soundconsistent with economic analysis?

*43. You are buying trees to landscape your newhome. The following demand schedule character-izes your behavior as a buyer:

Price of QuantityTrees Demanded

$10 19 28 37 46 55 64 73 82 91 10

The price is quoted at $6. Accordingly, you buyfive trees. Then after you agree to buy the fivetrees, the seller offers to sell you one more foronly $5.

a. Do you take it?b. Suppose, after you have already agreed to

purchase five at $6 each and one for $5,the seller offers to sell you more trees atthe price of $3. How many more do youbuy?

c. If the price had been $3 initially, wouldyou have bought more than eight trees?

d. Suppose you had to pay a membership feeof $5 to buy at this nursery, after whichyou could buy all the trees you wanted foryour own garden at $3 each. How manywould you buy? (Assume the price at oth-er nurseries is $4, with no membershipfee.)

e. If you could buy trees at $3 each fromsome other store without a membershipfee, would you still buy only eight trees-saving the $5 for use on all your con-sumption activities?

f. Now explain why, according to the de-mand schedule, your purchase of eighttrees at $3 each, at a total cost of $24, is aconsistent alternative to your purchase ofeight trees under the former sequentialoffers, in which you pay a total of $41(five at $6, one at $5, and two at $3). (Inthis example we assume we can slidedown an unmodified demand curve, be-cause the required modification by thechange in wealth is slight.)

* 44. If I regard each of the following combina-tions as equally preferable, which postulate is de-nied?

GoodsX Y

Options A 100 and 70B 105 and 69C 110 and 680 115 and 67

*45. Suppose that Mr. A has no preference be-tween A and C of the following three options.

X y

Options A 100 and 200B 110 and 180c 120 and 160

If he is given a choice among the three options,prove that, according to the postulates, he willchoose option B over either A or C. (The proofis easy-but not easy to discover.)

* 46. The following alternative combinations of Xand Yare all equally valued by Mr. A; that is, hehas no preference among them.

a. What postulate is expressed by there be-ing more than one combination of thesame utility to Mr. A?

b. Do these combinations conform to thepostulates?

c. What postulate is expressed by the nega-tive relationship among the quantities ofX and Y in the equally valued combina-tions?

d. What postulate is reflected in thechanges in X and Y?

Consumer Demand 43

rI

i'l11'I'. I'1'1,1

111'1

'ifI, I

I'II

l

Equal-ValueCombinations X Goods y

A 9 and 50B 10 and 40C 11 and 340 12 and 30E 14 and 26F 17 and 21G 21 and 17H 26 and 13I 33 and 10J 40 and 9K 47 and 8L 57 and 7

*47. At a price of $1.00 for X and $1.00 for Y, aperson consumes 10 of each. Assume that theprice of X rises to $1.50 and the price of Y fallsto 60¢. The cost of buying 10 of each at the newprices comes to $21: $15 for the X and $6 for theY. Explain why an income of $21 at the newprices would be more than enough to enable theconsumer to achieve the same welfare as beforewith $20 at the old prices. What principle orpostulate of economics did you use in the expla-nation?

*48. "Economic theory is built on an idealizationof humans: We have tremendous computationalpower, a detailed knowledge of our desires andneeds, a thorough understanding of our environ-ment and its causal relationships, a resistance toacting on impulse or by habit." Explain why thisstatement incorrectly characterizes economictheory.

Ili,\Ic.. _

[I;44 Chapter 2 c

Trade withoutSurplus Goods

Chapter 3

Exchange

Trade is commonly ...believed to occur becausepeople have too much of some goods-thatis, they supposedly have a surplus of thosegoods. But this is not so. Trade goes on allthe time, but virtually never do we think wehave "too much" of things. In fact, trade oc-curs because participants find it mutually at-tractive, because people place different tnsr-ginal valuations on scarce goods. If mymarginal personal value of something youown exceeds your marginal personal value,we would both find it attractive to engage ina sale of some of that good to me, at a pricebelow my marginal personal value and aboveyours. Demand curve diagrams are a usefulway to display this underlying analysis of thereason for exchange. Once you are more fa-miliar with such diagrams you will be able tosee some less obvious cases of the same prin-ciple-such as the "optimal" number of acci-dents and "optimal" amount of pollution ofthe environment, and for that matter theamount of production of any good.

Figure 3-1 shows the marginal personalvalue graphs for Ms. A and Mr. B. Each atfirst has 20 eggs per month, but their margin-al valuation curves differ. With their presentnumbers of eggs, Ms. A puts a higher valueon a marginal egg than does Mr. B (a valueof 12¢ compared to 6¢). Our first major prin-ciple is that mutually advantageous trade op-portunities exist when the respective person-al valuations differ at the initial numbers ofeggs. Some eggs will be sold to the personwith the higher marginal personal value ofeggs, Ms. A, until she gets a quantity of eggsat which her personal valuation decreases· toequal that of the increasing marginal use val-ue of eggs to the seller (Mr. B).

Figure 3-1 shows Ms. A's personal mar-ginal value curve for eggs. Its heights, shownby the vertical broken lines, express her sue-

45

¢ Ms. A, Buyer of Eggs ¢

16 16A's Marginal Personal

14 Value of X 14

12 12

10 Net ValuePrice Paid 10

Gain to A I by A

8 --------

6 6

4 4

2 2

0 24 0Eggs

Figure 3·1.

GAINS FROM EXCHANGE

Ms. A is happy to buy some additional eggs at a pricebelow 12¢, and Mr. B gains if he can sell eggs at a priceabove 6¢. Ms. A gains by obtaining eggs (to 24 permonth) for a price of 8¢. Her gain is indicated graphicallyby the lined area under her marginal value line. When shehas bought 4 to have 24 eggs, her valuation ofanother egg (the twenty-fifth) is reduced to less than8¢. At a price of 8¢, Ms. A will not choose to buymore than 4 eggs, bringing her total amount to 24.The gain to Mr. B is shown by the crosshatchedarea above this curve between 20 and 16eggs. That gain is the amount he is paid inexcess of how much the egg he sold is worthto him.

46 Chapter 3

Mr. B, Seller of Eggs

B's Marginal Personal

I Value of XPrice ReceivedI by B

-""'1000.--.;:- "",,---.;c --.;::-""':- "" ••

Eggs

cessive personal marginal valuations of eggs.For example, a twentieth egg per month (in-stead of only 19 per month) is as valuable asl2¢ more of any other goods. The marginalpersonal value of a twenty-fourth egg permonth is less, only 8¢. (Though we herespeak of the value in cents or dollars, it is thealternative goods or services that the moneycould buy that is the value.)

Both parties could gain by trade at an in-termediate price between l2¢ and 6¢ peregg. Ms. A gains by buying a twenty-firstegg, which she values at more than 8¢. Shealso gains on the twenty-second and twenty-third eggs, each of which she values at morethan 8¢. Her total gain is indicated graphical-ly by the lined area beyond 20 eggs underher marginal value curve and above the priceline. At 24 eggs per month, her marginal per-sonal valuation of eggs is down to 8¢.

Mr. B is willing to sell four to Ms. A at aprice of 8¢ each, because he values his for-saken twentieth, nineteenth, and eighteentheggs each at less than 8¢. His gain is repre-sented by the lined area above his marginalvaluation curve and below the price line in

c

the interval of 16 to 20 eggs. Exchangebrings the marginal personal values of eggsto both parties to equali ty, and exhausts thepotential gains from exchange.

Although we do not know the particularnumerical measures for any person's margin-al personal valuation curve, we do knowthree things about the curve. First, the curveslopes downward. That is, as one's holdingsof X get larger, there is a decrease in one'smarginal personal value for an X: the amountof Ya person is willing to pay for an X.

Second, the position, or height, of thewhole curve depends in part on how wealthya person is, that is, how much one has of oth-er goods. Greater wealth is likely to makethe curve higher because one is willing togive more of other goods to get a unit moreof a given good. In sum, a person's marginalpersonal value-what one is willing to payfor a unit more of X-depends on (1) theamount of X possessed and (2) one's totalwealth. The former determines where one ison a marginal personal valuation curve,while the latter affects the height of thewhole curve.

With greater wealth or income, thewhole marginal value curve shifts upward forsuperior goods and downward for inferiorgoods. (Superior goods, recall, are such thingsas diamonds, fine wine or imported beer,clothes, food, automotive elegance, and face-lifts; examples of inferior goods may becheap brands of beer or cosmetics.)

The third thing that we know aboutmarginal personal value curves is that theyare not identical for everyone, even for peo-ple of the same wealth. Tastes or preferencepatterns differ, and these differences are ex-pressed by different heights and slopes of themarginal personal value curve. (But all suchcurves, remember, are downward sloping.)

To continue practicing graphic analysis,we now use the graphs in a slightly differentway: We can also see the gains from trade bysuperimposing, in Figure 3-2, the two per-sonal valuation graphs of Figure 3-1. In Fig-

ure 3-2 the baseline for Mr. B is turnedaround to read from right to left. The totalexisting number of eggs to both A and B, 40eggs, is measured by the entire length of thebase of the diagram, Oa to 0b. The numberinitially possessed by Ms. A, 20, is indicatedby the distance from the left side, 0a' to Xl'whereas Mr. B's initial 20 eggs are measuredby the remainder of the base, from 0b left-ward to point Xl.

Now it is easier to see that the marginalpersonal value of eggs at the initial point·· Xl(where each party has 20 eggs) is greater forMs. A than for Mr. B. That difference im-plies that both parties would gain by trade(as measured in cents). The gain to Ms. A isher lined area and the gain to Mr. B is hislined area. The exchange benefits the twoparties just as much as if there had been amagical, costless increase of goods. This in-crease is measured by and distributed in ac-cord with the sizes of the lined "gains fromtrade" areas. Trade is as useful as the cre-ation of more goods.

We cannot generally predict what thesequence of actual trading prices would be,but there are limits to what it can be. It mustbe between the different initial marginal val-uations of the traders. The final price is indi-cated by the height at which the two valua-tion curves intersect: In Figure 3-2, 8¢ is thefinal equilibrium-sustaining price of eggs.

Trade slides each person along his or herown marginal personal valuation curves towhere values are equal at the equilibrium-sustaining price. The buyer moves down hercurve, the seller moves up his curve. Bothtraders gain. Each puts a higher value onwhat is obtained than on what is given up.When exchange has equalized the buyer'sand seller's marginal personal valuations, nofurther trade would be mutually desired.Moving from some distribution point like Xlto equality at X3 is often called an eRicientreallocation of goods; failing to move toequality is called inefficient, because both

Exchange 47

16

1412

10

¢

16

1412

10

8

6

4

2

..•.... [o,

¢

8

Gain to Buyer----"~,,£/Price----------------*~~~~~~Gain to Seller------f"'~" '>~

6

4

2

Oa I-I--....j•.~

Figure 3-2.

GAINS FROM EXCHANGE:SUPERIMPOSED MARGINAL VALUE LINES

Reversing and then superimposing the graphs of Figure3-1 shows the gains from trade more clearly andportrays exchange in terms of a demander and asupplier, with the person with the lower value on eggsbeing the seller to the demander-the person withthe higher value for more eggs. This diagram showsthat the supply of eggs to Ms. A is simply to beinterpreted as the demand for that good byother people-here Mr. B.

48 Chapter 3

people could be made better off by furthertrade.

Money, Markets,and Middlemen

Figure 3-2 represents an idealized model oftrade for this reason: It deliberately assumesthat Ms. A and Mr. B were able to find eachother, discover their mutual advantage fromtrade, and conduct that trade-all withoutany costs other than the price of the goodsactually exchanged. But we know there aresubstantial costs of finding trade possibilities,of assessing the true characteristics or quali-ties of goods, and of negotiating exchangecontracts and arranging for such legal protec-tions as warranties. These activities are usu-ally performed more economically by the useof money as the medium of exchange and byreliance on middlemen. Middlemen have theeffect of increasing the gains from trade, as isshown in Figures 3-3A and 3-3B. If Ms. A'sprepurchase search and product inspectioncost her the equivalent of 1¢ per unit of thegood purchased, her full price is 9¢ (8¢ paidto the seller plus the 1¢ of prepurchasecosts). See Figure 3-3A. She would then buyonly the quantity of eggs that brought her

c

A

B

87.50

7

9

8.508

7.757.50

7

¢

12

----------------1.;:-..;:-,----<:''"""

6

¢

12

11 11

Buyer's Gain---l~"""10 10

9 9

8

Seller's Gain---l""""""" 7

6

Mr. B

X1

¢

12¢

12

::------------------=-------------=--~~~~

6

11 11

10 10Buyer's Benefit from Middlemen~_

-- - - - - - - - - - - - - ,,+'l<':><;:).;j>V"'~"'~-').N.

---------------~~~~9

8

Seller's Benefit from Middlemen7

6

Mr. B

X1

Figure 3·3.

EXCHANGE WITH TRANSACTIONSCOSl"S WITH AND WITHOUT MIDDLEMEN

If each unit of X involved a total transaction cost (inaddition to its price) of 1,5¢, the lined areas showthe gains from the restricted feasible trade, Bylowering transactions costs, Figure 3-3B, themiddleman allows the trader's gains to begreater than if there were no middleman. Theincrease in trader's gains is indicated by the double-hatched areas for each trader. More trading will takeplace with middlemen. Instead of trading from X, toX3 as in Figure 3-3A, trade will increase to X •.

Exchange 49

marginal personal value down to 9¢. And ifMr. B also engaged in some prepurchasesearch, negotiation, and contract enforce-ment costs equal to, say, .5¢ per unit of egg,then his net realized selling price is 7.5¢, not8¢. So he would sell only as many eggs as lefthim with a marginal personal value of 7.5¢.

Of the total potential gain from trade,part is dissipated, or used up, in prepurchasesearch and negotiation costs, and part is un-realized because of the higher costs of find-ing and identifying other goods and sellers;the areas with slanted lines in Figure 3-3Bshow the realized gains from trade; the cross-hatched area shows the amount of potentialgain from trade that is dissipated in prepur-chase search costs. The rectangular area rep-resents costs of finding and negotiating ex-changes. And the triangular wedge with adotted area is the still unrealized gains fromtrade that did not occur because of the costsof discovery and performance of 1.5¢ a unit.

If the costs of marketing-which are 1.5¢for each unit when Ms. A and Mr. B performtheir own prepurchase services=-could becut to, say, .75¢, then more trade would oc-cur and both the buyer and seller would ben-efit, as shown in Figure 3-3B.

To be sure, the cash price paid by Ms. Awill be higher-say, 8.5¢ instead of 8¢-andthe cash price received by Mr. B will be low-er-7.75¢ instead of 8¢. But the full cost (in-cluding all the transaction costs) incurred byMs. A is lower because the payment to themiddleman is less than the costs of self-ser-vice: 8.5¢ instead of 9¢. And lhe net value toMr. B is higher: 7.75¢ rather than 7.5¢.

,II ,

. f

"

'I

r

MONEY

One important way to reduce the costs offinding and negotiating trades is to use mon-ey. Its easy recognizability, combined withits portability, storability, and divisibility, in-duces its use in virtually every trade. Nohigh costs of identifying it or its quality are

:,'If-----s-o-c-n-a-pt-er-3----------

involved, such as would occur, say, for dia-monds, oil, rugs, or eggs.

MIDDLEMEN,WHOLESALERS, AND RETAILERS

In reducing costs of exchange and providingbetter service, middlemen-retailers, ware-housers, salespersons, brokers, advertisers,and a host of other marketing and financingspecialists-are as productive as the produc-ers of the eggs and cents. They are not, con-trary to common opinion, parasites and cost-Increasers.

To make this analysis realistic, considerthe costs you would incur if you were to buya diamond from a person who is not a dia-mond merchant; or milk from any person onthe street who happens to offer some milkfor sale, and who is not a reputable grocer orrecognized milk seller; or shoes from a stran-ger who is not known as a shoe retailer. Weare accustomed to buying from merchants,whose word about quality we almost uncon-sciously use as a means of saving on the highcosts we would otherwise incur in inspectingand judging the goods-so accustomed, infact, that we typically fail to realize how thereputation and reliability of an establishedmerchant reduce our shopping costs.

Open Markets andthe Costs of Exchange

Competition between middlemen reduces thespread between their buying and selling pricesto one that just covers the costs of providingtheir services at the quality wanted by theconsumers, If this spread were larger, moremiddlemen would be attracted, and they wouldshave the margin in order to get business. If thespread were too small, some middlemen wouldlose money and not stay in business. Only thosewho could provide satisfactory services at thelowest cost would survive. (The spread is re-duced by the competition of middlemanagainst middleman, not of consumers or sellers

(

against the middlemen; middlemen do notcompete against consumers.)

The spread between buying and sellingprices, then, is reduced by the possibilitythat there will be an unlimited number ofmiddlemen-that is, open-entry market com-petition among middlemen, or, as we shallcall it, open markets. Open markets meanthat access to markets is open to all peoplewithout legal or arbitrary barriers. They donot indicate that there are no costs of provid-ing exchange-facilitating services. A differ-ence between the middleman's buying andselling prices is not necessarily profit.

When there are no artificial barriers toexchange-that is, when there are open mar-kets-the price spread is driven down bycompetition to just cover the costs of a mid-dleman's services: rental costs for space inwhich transactions can be conducted andgoods can be stored for inspection and imme-diate delivery; costs of record keeping; thecost of inventory, advertising, light, heat, andinsurance. The spread between the buyingand selling price reflects those costs; in ordi-nary retailing of most household goods, thespread is that between wholesale and retailprices, and ranges between 15% and 50% ofthe retail price to the consumer. In part, low-cost discount houses charge lower prices bypermitting the consumer to bear directlypart of the costs of exchange activities-costs, for example, in the form of the respon-sibility for collecting information about theitem, stricter (or no) return privileges, lesscredit buying or higher finance charges, lessdelivery service, less convenience of shop-ping conditions and location, or slower ser-vice because of fewer salespersons.

Restraints onOpen-Market Competition

New middlemen would be encouraged to en-ter the market only if they could competewith those already in it by selling at lower

retail prices, or paying higher wholesaleprices, or offering better services. But if therewere such entrants, middlemen already in themarket would object to "unnecessary, inexpe-rienced, low-cost, cut-throat, excessive" com-petitors. New entrants taking advantage ofmarket competition would eliminate profits,leaving only normal wages for the first mid-dleman-a less pleasant prospect for that per-son. But open access to markets is not a uni-versal condition. Our initial middleman neednot acquiesce to that competition passively.There are several tactics for trying to restrictentry, some crude and some refined.

THREATS OF VIOLENCE AND FORCE

We may as well start with what is sometimesa most effective procedure. A threat to dam-age the new entrant's person or property isnot genteel. But there are threats againstanyone who crosses a picket line in seekingwork. Here the threat of violence is made byprivate citizens. But to someone who pro-vides medical, dental, legal, or public utilityservices without a license, the threat is fromgovernment agents-courts and police, whoare "legitimate" specialists in applying force.Violence and force or the threat of their pos-sible use are widely applied-sometimeswith the help or acquiescence of the state.(We do not suggest that violence is morallyright or wrong: Economic analysis has no ba-sis for decreeing that physical coercion isproper in, say, the medical and improper inthe labor picket case.)

POLITICAL LICENSINGAND SELF-REGULATION

Restraints that keep new, lower-cost, orhigher-quality competitors out of the marketenable the incumbents to maintain incomesabove competitive levels. Whether a law infact or in guise or intent (it doesn't makemuch difference which) protects consumers

Exchange 51

from shoddy products or from unscrupulous,corner-cutting suppliers, such a law permitsonly "approved" (duly licensed, properlytrained, reliable, ethical) traders. The lawusually is administered by a state board ofregulators staffed by experts, who-natural-ly-are selected from those already in thebusiness and automatically get licenses undera "grandfather clause," exempting everyonealready in the business. These regulators de-termine when "public necessity and conven-ience" warrant the entry of more sellers. Be-cause such occasions are rare, incomes ofexisting sellers are thereby maintained at alevel sufficient for the few "respectable"practitioners to enjoy a standard of livingthey "deserve." Not only middlemen enjoythe protection of restricted entry to markets;many producers and suppliers of goods andservices do also. Some examples of enter-prises, persons, and institutions so protectedare liquor stores, doctors, banks, milk pro-ducers, holders of taxi medallions, accreditedschools, and morticians. But some consumersdo benefit by these restrictions-especiallywealthier people, who normally buy fromwell-established, more expensive firms-whereas poorer people are denied the lower-priced, lower-quality services that wouldhave been provided in an open market.

CARTELS

A group of sellers with the means-often le-gal-to control what kinds Of services exist-

'"ing members may offer and to restrain theentry of new competitors to the detriment ofconsumers is a cartel. A cartel is any coali-tion of sellers that reduces the quantity orquality of output and raises the price, there-by reducing the potential gains to society. Acartel is to be distinguished from other coali-tions, such as partnerships or business organ-izations, that raise the potential gains to con-sumers by offering increased quantity orquality of output at a lower price. In both the

52 Chapter 3

cartel and the business firm, the people whoorganize and join in the coalition are ofcourse striving to increase their own wealth.What distinguishes a cartel from an ordinarybusiness firm, then, is the difference in itseffects on customers. Later we shall investi-gate the difficulties of creating the conditionsunder which cartels can be effective. For themoment, it is sufficient to note that to be ef-fective, violators of cartel rules must be de-tected and punished, sometimes by invalidat-ing their licenses or franchises. But thatenforcement is not easy. Agents and spies(sometimes called commissioners) are hiredto detect illegal acts like price cutting, favors,and special services. Some of our most re-spected industries are cartels: railroads, radioand television broadcasting, medicine, law;tobacco, butter, wheat, cotton, corn, milk,and peanut production; and colleges with re-spect to athletic competition.

Cartel members usually must pay for thepolitical power to achieve that legal protec-tion-payments for franchises, licenses orspecial taxes; purchases of $1000 dinners hon-oring politicians; charitable contributions toapproved public causes; or free services tospecial groups. (Consult your local politician,state occupational board member, or memberof a regulated industry to learn of additionaldevices.) These payments will just about ex-tract the excess of the anticipated earningsover what could have been earned in an openmarket-especially after the costs of the legalservices involved in obtaining the protectivelegislation are added in. If politically protect-ed cartels have earnings in excess of competi-tive returns, is it surprising that many cartelscontribute to political parties?

Ethies ofOpen-Market Exehange

Exchanges occur because transactors expectto be made better off in their own estima-tion. If a consumer enters a transaction using

c

inaccurate and inadequate information, thenit is doubtful that the buyer preferred to getwhat he or she actually got. (Perhaps youngpeople-minors-sometimes make insuffi-ciently informed decisions and therefore arecontrolled "for their own good.") Converse-ly, others may know more about conse-quences, and thereby be in a position toguide the consumer's choices, but may knowlittle about-or disagree with-that consum-er's preferences. Medical care, food, porno-graphic materials, drugs, and education areareas in which minors-and sometimesadults-are prohibited from entering intomutually agreeable exchanges with whomev-er they please.

Some critics of open-market trade attachmore weight to the regrettable consequencesof unfortunate choices (unfortunate as de-fined by the critics and advocates of restraintof access) than to the restraint on gains forthose who, if permitted to choose, wouldmake happy choices. Others who make theopposite evaluation favor a larger range of in-dividual responsibility as desirable in itself.Which, if either, view is intrinsically morehumane is beyond the scope of economics tosay.

Some opponents of open-market tradefurther contend that many consumers, evenwhen in possession of correct information,make choices that are improper. Such oppo-nents may argue that people "ought" to pre-fer classical music to pop music, or opera totheater or to TV and movies, or sensiblehousing to flashy cars. "We" who advocatea tax-supported national theater are sayingin effect that taxpayers do not spend theirmoney appropriately; that not enough ofthem attend the theater, as they "should,"to make it self-supporting. "We" are seek-ing to force others to pay for a theater sothat "we" may indulge our tastes at theirexpense. (Would the issue be changed if"we" were "college teachers" and "tax-sup-ported theater" were "tax-supported col-lege"?)

Freedom: As You Like ItThis right to exchange goods in the openmarket is a basic difference between the cap-italist and socialist cultures. We have beencareful not to express the matter as "free ver-sus unfree" or "democratic versus undemo-cratic." You could say that people are freerin Russia, because they are free-that is, pre-vented-from undertaking the task or risk ofmaking uninformed choices, which theymight later regret, just as you and I aeefreed-prevented-from the risk of hiring aquack to perform an operation or advise usabout our illnesses, or from the possibility ofbuying whole milk with too Iowa cream con-tent, or from all sorts of possibilities of ac-quiring inferior things-substandard food,substandard airplane flights, substandardhouses. We are protected from our own fol-ly. This may seem an unusual meaning of"free," but it is a widely accepted meaning inRussian and American life. But to so use theterm "freedom" does not advance under-standing. For although one may argue thatone's proposed restrictions on other peoplein fact give them "more freedom," or pro-mote "good" consequences and prevent"bad" ones, different individuals have differ-ent notions of what is good and what is bad.

In discussing the arguments for openmarkets versus those for restrictions on mar-kets we are not speaking of democratic ver-sus undemocratic economic rights. Democra-cy is a way of allocating political power, nota criterion of what is done with it. A dicta-torship that is undemocratic could enforceeconomic and legal rules that are conduciveto what some might call a desirable society.A democracy can, if a majority revises vari-ous economic and legal rules, produce an"undesirable" society. It is not self-evidentthat democracy is more conducive than anyother system to the emergence or continu-ance of a society that many would call "free,""open," or "desirable." Again, those attri-

Exchange S3

butes are not susceptible to objective defini-tion, no matter how many people may be-lieve they are.

Criticisms of MethodologyIt is sometimes charged that economic analy-sis operates on the assumption that peopleengage in more rational calculation in theireconomic behavior than they in fact use.Economic analysis does no such thing. Eco-nomics does not explain how people think; itidentifies predictable, observable patterns ofresponses and behavior. People need not beaware of the principles of economics whenthey engage in exchange. Sticks and stones,birds and bees obey the law of gravity eventhough they do not know what it is. Nothingin economic theory rests on any premise thatpeople are logically consistent in theirthought processes. Instead, it is only the the-ory and analysis that is logical. And that anal-ysis will be considered empirically valid ifthe logically implied behavior is in fact ob-served.

Self·InterestAs we warned earlier, nowhere in this chap-ter, or this book, is it assumed that peopleare interested only in their own individualwealth or welfare. We assumed instead thata person prefers command over more ratherthan fewer goods; we did not assume that theperson is oblivious to other people or uncon-cerned about their welfare. A person maywant control over more goods in order tohelp others. We will later examine situationsin which people do engage in charity, are so-licitous of other people and consider the ef-fects of their behavior on them, and sacrificemarketable wealth for leisure, knowledge,and contemplation.

S4 Chapter 3

Summary1. For trade to occur it is not necessary that

one party have a surplus of some good andanother party have an insufficiency.

2. If two persons have different marginal per-sonal valuations of a good, then an exchangecan move each person to a preferred situa-tion, provided the costs of negotiating theexchange do not exceed the difference inmarginal personal valuations.

3. Goods will be traded from the lower- to thehigher-marginal valuing person.

4. Each person will increase or reduce theamount of any good relative to other goodsuntil the person's marginal personal use val-uation of the good is reduced or increased toequality with the market price.

5. When every person has the same marginalpersonal valuation of a good, because that isequated to the market price facing all buy-ers, the condition is called equilibrium.

6. The general, low-cost recognizability of acommodity enables it to serve as money. Inaddition, some people specialize in beinglow-cost middlemen, experts in certaingoods, who thereby have the effect of reduc-ing exchange transactions costs.

7. A cartel is a coalition of suppliers organizedto reduce the quantity or quality of output,though the value to consumers of the forsak-en output or quality would exceed the costsof supplying the good.

8. Economic analysis does not prove that tradeis a good thing. It only shows the conditionsthat lead people, if given the opportunity, toengage in exchange.

Questions1. Does economic analysis prove that to permit

trade is better than to prohibit trade?

2. A parent gives each of his two children somemilk and meat. The two children then exchangewith each other, one drinking most of the milk

c

and the other eating most of the meat. If the par-ent does not permit them to make that exchange,which of the postulates (if any) is the parentdenying? Or does the explanation rest on somenew postulate not stated in the text?

3. "Trade between the Mediterranean and theBaltic developed when each area produced a sur-plus of some good."

a. What do you think this quotation, from awidely used history text, means?

b. Can you propose an alternative explana-tion of that trade?

4. Some discount stores advertise that they cansell for less because they buy directly from themanufacturer and sell to the consumer, thuseliminating many middlemen. What is the flawin this reasoning?

5. "Middlemen and the do-it-yourself principleare incompatible." Explain.

6. It is estimated that 25% of the price a con-sumer pays for a head of lettuce goes to the farm-er; the remaining portion goes to middlemen anddistribution costs.

a. Would you, as a farmer, necessarily pre-fer to have your percentage raised? Ex-plain your answer.

b. Would you, as a consumer, prefer to seethe farmer's percentage raised? Explain.

7. Which, if any, of the following are compati-ble with open, or free, markets:

a. A would-be lawyer must get permissionof present lawyers before being able topractice law.

b. Medical doctors must pass a state exami-nation before being allowed to sell medi-cal services.

c. Selling is prohibited on Sunday.d. Pure food and drug laws restrict the sale

of "impure" foods and drugs.e. Consumption, manufacture, or sale of al-

coholic beverages is prohibited.f. Dealers and agents must be certified by

the U.S. Securities and Exchange Com-mission before they can act as middlemenin buying and selling stocks and bonds-that is, before they can be security deal-ers.

8. You are campaigning for mayor or a seat onthe council in your home town, in which the taxi

service (or, for that matter, garbage service, milkdelivery, electric power, water, gas, and so on) isprovided by anyone who wants to operate a taxibusiness or drive his own cab. You campaign formore government control of taxi drivers in orderto ensure better quality of service.

a. If elected, would you initiate a system ofgivihg just one company the right to per-form the service? Why?

b. If so, how would you decide which com-pany?

c. In California the right to sell liquor is re-stricted by the state government to fewerstores than would prevail otherwise.Would you be surprised to learn that theliquor dealers are a political "lobby" andsource of "power" in state politics? Why?

d. What generalization does this suggestabout a source of political power?

9. "It is well to remind ourselves from time totime of the benefits we derive from a free-marketsystem. The system rests on freedom of consum-er choice, the profit motive, and vigorous compe-tition for the buyer's dollar. By relying on thesespontaneous economic forces, we secure thesebenefits: (a) Our system tends automatically toproduce the kinds of goods that consumers wantin the relative quantities in which people wantthem. (b) The system tends automatically tominimize waste. If one producer is making aproduct inefficiently, another will see an oppor-tunity for profit by making the product at a low-er cost. (c) The system encourages innovationand technological change .... I regard the preser-vation and strengthening of the free market as acardinal objective of this or any Administration'spolicies." (President J. F. Kennedy, September1962, speaking to business-magazine and newspa-per publishers.) Is it surprising and confusingthat while extolling the virtues of an open, com-petitive economic system, businessmen and poli-ticians restrict markets-for example, by control-ling allowable imports of sugar so as to maintainsugar prices in the United States above the open-market level-in order to maintain larger wealthfor incumbent businessmen and their employees?A confusion between freedom of competitionand freedom from competition is suggested.Why do you think some people praise the pri-

Exchange SS

vate-property, open-market system while at-tempting to suppress it?

* 10. Your college allots you parking space, whilea friend is allotted a desk in the library stacks.Suppose you and he would each be better off ifyou were to trade your parking space for his deskspace.

a. This kind of trading is almost invariablyprohibited by the college authorities.Why?

b. If you were the college president, wouldyou prohibit it?

56 Chapter 3

c. Would you consider selling parking spaceto one and all at the market-clearingprice, as a downtown parking garage does,or as books and paper are sold in the stu-dent store? Why?

11. Suppose it were claimed that a denial of col-lege facilities to some speaker is a denial of theright of free speech. Show how that argumentconfuses free resources with free speech.

12. Why has gold been so commonly used asmoney?

c

Chapter 4Market Prfce»a~ SocialCoordinator~

The preceding chapter explained the princi-ples governing the consumption and ex-change activities between individuals. Wesaw how price aff~cts the individual's deci-sions about the amounts that are deemed de-sirable to consume. We examined as well theways in which the individual gains from ex-change. But a market can consist of millionsof individuals. How are all their separate in-dividual decisions coordinated into a consis-tent whole, rather than creating permanentchaos? What restricts the amounts demand-ed by the public to the amounts supplied?And how does the amount produced and sup-plied depend on or respond to the amountsdemanded? What, if anything, coordinatesthe whole economy, so that the constellationof economic activities is not chaotic? Whenindividual demands do fail to be satisfied byexisting supplies, what has gone wrong?

In fact, the superficially bewildering eco-nomic activities of millions of independentpeople are guided by a highly ordered set ofsignals and rewards, though there is no cen-tral control and no planning agency such ascountries like the Soviet Union and the Peo-ple's Republic of China, and in our militarysystem, are reputed to have. No national au-thority computes and rations per capitashares of food, soap, shoes, tires, gasoline, orpencils to individuals.

In this chapter we investigate how indi-vidual activities in the system are coordinat-ed, devoting most of our attention to the ef-fects of demand. We study the determinantsof market price and we study how that pricetends to have two effects: First, it makes thetotal amount of each good demanded by thecommunity exactly match the total amountsupplied; second, it simultaneously enableseach person to obtain whatever amount he orshe demands at that price. We study howproduction is organized in more detail inChapter 7. Here we investigate how theequilibrium-sustaining, or market-clearing,

57

price of each good, reached through marketcompetition, performs all the tasks named inthe preceding paragraphs.

Market DemandWe know that more of a good is demandedat lower prices. Lower prices at which wecan buy what we demand will enable us tosatisfy lower-valued uses, those uses that weconsider not worth satisfying at higherprices. And some people who formerly usednone at all will find it worthwhile to usesome at the lower price. Let us start with asociety of four people, A, B, C, and D. Theirdemands for automobiles are in Table 4-1.(All the automobiles are alike.) The totalcommunity, or market, demand follows ourfirst law of demand: Greater amounts are de-manded at lower prices. The total amountdemanded (also called the market amount de-manded) is the sum of the individualamounts demanded at a common price.

For now, we assume that the totalamount supplied and available for distribu-

Table 4.1

DEMAND SCHEDULE, TOTALMARKET VALUE, AND ELASTICITY

Quantity of Automobiles

TotalPrice A B C ~"' (Market)

"$1000 2 0 1 1 4

900 4 0 1 1 4800 2 0 1 2 5700 2 0 1 2 5600 3 0 1 2 6500 3 1 1 2 7400 3 1 2 2 8300 3 1 2 3 9200 3 1 2 4 10100 4 2 2 4 12

58 Chapter 4

tion is a fixed total, regardless of price. (InChapters 10 and II we investigate how out-put is determined.) Suppose seven cars exist,all initially owned by A. And suppose, forsimplicity, that no person's wealth, andhence demand schedule, is changed signifi-cantly by the succeeding sequence of trades.'The following is one of many possible ex-change sequences. A would sell four carseven if he could get only $100 per car. Andhe could, because the other people havehigher personal marginal use values on a carthan he has for four of his seven cars. Wecan demonstrate this fact in several differentways. For example, if C and D each extrava-gantly offer $900 for a car, A will delightedlysell one to each. Then B more shrewdly of-fers only $400 for a car; again, A sells. Thisleaves A four cars, and B, C, and D have ob-tained one car each. C then offers to buy an-other car from A at, say, $300-somewhatless than its $400 value to C-and A sells be-cause he would rather have any amount over$100 than a fourth car. Al though D, who hasone car, would have paid as much as $800 toget a second car, he initially offers A only$300 for the second car; A will say he has nocars to "spare" -unless he can get $700. B,however, if alerted to this negotiation, wouldoffer his car to D for $600 even though hejust bought it. And C, who values his secondcar at only $400, would undercut B's price byasking for only $500. Neither A nor B wouldcut their prices that far. So C would sell to Dfor $500.

'Throughout this chapter we will operate underone very important assumption: No person ever acts asthough the market price could be affected by that per-son's holding any units off the market. Whatever theamount of the good a seller owns, the seller has too fewunits to significantly affect the potential selling priceby refusing to sell more. Later we shall modify thatassumption. For the present we make it because it isoften realistic and because it permits us to concentrateon the demand side of the exchange, and the way inwhich price-however it is determined-controls theallocation of the amount made available.

c

Thus A ends up with three cars, B withone, C with one, and 0 with two. Everyone,given his preferences and initial wealth, iscontent with this pattern of goods; there areno further mutually acceptable revisions.This is the condition of market-clearing equi-librium.

At every step in that sequence, both thebuyer and seller moved to situations thateach valued more highly. Though many oth-er starting allocations and sequences of tradecould be imagined, all yield the same finaldistribution and the same final equilibrium-sustaining, or market-clearing, price, $500:the price that makes the sum of the individ-ual amounts demanded equal to the totalamount available. As Table 4-1 shows in theTotal Market column, at higher than $500fewer than the existing seven cars are de-manded, and at lower than $500 more thanthe seven are demanded.

You can better understand the precedinganalysis by redoing the problem initially allo-cating the seven cars among four people inany combination. Will the final distributionbe the same-in every case-as the presentone? Yes. Try it to see why.

MarketSupply and Demand:Graphic Interpretation

In Table 4-1, the individual demands for carsat anyone price are added horizontally to getthe total market, or community, demand. InFigure 4-1 we do the same thing; the totalmarket demand curve is labeled TT. Thecommunity supply of seven cars is shown bya vertical line, 55. It is vertical because, re-gardless of price, the available amount isfixed at seven. The price at which the com-munity demand intersects the supply line isthe price at which the total number of carsdemanded by A, B, C, and D-here seven:three, one, one, and two, respectively-equals the number supplied.

BCD A T S$1000 1I900 I

I

800 I..-Ui' 700 T=A+B+C+D•..I1l C~ 6000 Ic: 500 • ID~ IQ) 400 {0 •&: 300 • I· - I•200 · -. I

• C ID I100 ••• •• TB A Is

0 1 2 3 4 5 6 7 8 9 10 11 12Number of Cars

Figure 4·1.

INDIVIDUAL AND TOTAL COMMUNITYDEMAND CURVES WITH FIXED SUPPLY

The total demand curve TT is the sum of the horizontaldistances of each of the four individual demandcurves at each price. The points are connected bystraight line segments. If a fixed number of cars isavailable regardless of price, the supply curve,55, is a vertical line.

Market Prices as Social Coordinators 59

Figure 4-1 shows that at any price abovethe equilibrium price, $500, the communityamount demanded would be less than thenumber available. If there were a law that carscould be purchased only for a price above$500, there would be a surplus of cars, withone or more cars being offered for sale but notbeing demanded. Prices would be less able toallocate the existing supply of goods.

But the surplus would instantly becomea shortage if the price were somehow re-stricted to below the equilibrium price, sayat $300. More cars would be demanded thanare available. That is what a shortage is.Consumers would say their needs (at thatlow price) were not satisfied. Of course, ifthe price were higher, the "need" for a carwould be less urgent than the "need" for thegreater amount of other things that the buy-er must sacrifice if the car is bought at thathigher price. The movement of price to theequilibrium-sustaining price eliminates anyapparent surplus or shortage. At that pricethe total amount that individuals want (orsay they need) matches the total available:The market is cleared."

I'

ADJUSTMENTS TO CHANGES IN SUPPLY

We have analyzed how buyers behave to af-fect price when the total amount supplied is

2Had the sale of cars involved used-car dealers in-stead of only private parties, the sequence of exchangesand prices would have been less erratic and would haveconverged more quickly at an equilibrium price. Carscould also have been more cheaply and quickly inspect-ed. And when price increased, buyers would probablyhave complained that used-car dealers had unscrupu-lously raised prices. Used-car dealers do raise prices-but scrupulously, after demand increases. To replenishtheir inventories, they must purchase cars at higherwholesale prices. When demand changes, dealers mustmove both their selling, or retail, and offer, or whole-sale, prices; otherwise, used-car lots would either over-flow or empty out. Used-car dealers can buy, sell, andsurvive in business only at wholesale and retail pricesthat reflect the public's demand for cars.

I I

I, .I-'I

60 Chapter 4

fixed. But what if total supply were reduced?Again there would not be a shortage becausea rise in price to a new, higher market equi-librium level would reduce the amount de-manded to match the smaller amount sup-plied. For example, suppose one of A's carsis destroyed by fire, reducing the communitysupply to six. See Figure 4-2, where thischange is represented by shifting the verticalsupply line leftward to six on the quantityscale: line 5151 (from 5050). The intersectionof demand with the smaller supply now re-quires a higher equilibrating price, $600.How is the higher price brought about? Weassume that A's loss of the car does not re-duce his wealth significantly, and that hewill seek a replacement. Because no one iswilling to sell a car for $500, there would beat that price a shortage, or, to put it in dif-ferent words, an excessive amount demand-ed. Seven are demanded; six exist. But A,who now has only two cars, still values athird car at $600 (that is, he prefers a thirdcar more than any other things he could getwith $600). By offering $600 to purchase acar, A could buy a car (possibly through aused-car dealer) from B, who prefers $600 tohis only car.

The destruction of one of the cars andsubsequent exchange has benefited B. It mayseem unfair that B should gain from A's loss.But to refuse to allow B to make such a gainthrough trade is also to condemn A to whathe considers a worsened situation after thefire, unless you condemn someone else tobear the loss-and someone has to bear it."By offering to buy a car for $600 and therebyimproving B's situation, A was also able topartially restore his own.

If a price ceiling of $500 had been im-posed, B would be prevented from "goug-ing" A, or, as it is sometimes said, "profit-

"Voluntary insurance is a method for distributingthe loss over all consumers, rather than concentrating iton one person.

(

· eering from A's misfortune." We mightthink we were doing A a favor by puttingprice controls on the sale of used cars, there-by preventing him from paying more than$500. But at that restricted, low price hecannot get a desired third car, so he is notaided. A shortage would be created-not bythe reduction of supply through the burningof a car, but by the prohibition of highermarket-clearing prices. To prevent misun-derstanding, don't forget that a reduced sup-ply is not a shortage, nor the cause of ashortage. Shortages are caused solely by re-straints on prices.

To better understand the effect of pricecontrols, consider what happens when thesupply increases, say, to nine cars, as alsoshown in Figure 4-2, by a shift of the supplyline to the right to 5252, More cars are avail-able than before at each possible price. If theprice were now set by law at any price belowthe new market-clearing price of $300, morecars would be demanded than are available.The typical signs of shortages-waiting lines,outages-will occur, despite an increasedsupply.

The distinction we're making here isworth the effort to understand because in thereal world there are, unfortunately, plentifulinstances of shortages being mistakenly at-tributed to or equated with reductions insupply. For example, the shortages of gaso-line and other fossil-fuel sources of energy inthe United States during the 1970s occurrednot because supplies of oil were reduced butbecause the price of oil was not allowed toadjust to change in supply by rising to the'market-clearing levels-a result of politicallyimposed price controls on petroleum. If thatanalysis seems absurd, consider that in Euro-pean countries, which had no price controlson gasoline, no shortages occurred when theoil supply was reduced. Prices rose to clearthe market, so everyone was able to buy thereduced amount they demanded at the high-er prices. Only in countries with price con-trols, such as in the United States, did short-

$1000

900

800~e 700.!!!"0600C.!: 500~~400

'':::C. 300

200

100

D 51 So 52I 1 I~IReduccrdI ISUPplYII 1 I1 1 I1 I I1 1f--------- I I i---------,1 1 I-Increased1 I I Supply1 1---------1-1--1 1'I Ir+-I---"II 1 I D511 ISo 152

o 1 2 3 4 5 6 7 8 9 10 11 12

Number of Cars

Figure 4·2.

REDUCED SUPPLY RAISES PRICE;INCREASED SUPPLY LOWERS PRICE

A reduction in supply is shown by shifting the supplycurve to the left, from 5050 to 5,5,. The total marketdemand line, DO, is unchanged. The rise in price from$500 to $600 facilitates the selling and redistribution ofcars from those who value a car less than $600 to thosewho value a car more. If prices could not be raised inresponse to a reduction in supply, cars would not bereallocated from lower-valuing to higher-valuing userswith gains to both buyer and seller.

If supply of cars is increased, as shown byshifting the supply curve to the right, from 5050 to5252, the total demand curve is againunchanged, and price falls to a market-clearing $300.


ages occur when the oil supply was reduced.Remember, again, that economic analy-

sis neither condemns nor commends. It onlyshows how the market system operates andwhat the consequences of that operation are,and what the consequences are when non-market forces are introduced. It is too earlyin our analysis for you to draw any judgmentas to whether price controls are good orbad-although it may be appropriate to drawa judgment later, when more of their impli-cations are explored.

ADJUSTMENTS TOCHANGES IN DEMAND

Let us return to our initial situation, inwhich there are seven cars. But now a new-comer, E, joins the community. His addeddemand increases the community market de-mand, shown by shifting the aggregate de-mand line to the right (see Table 4-2 andFigure 4-3). E is willing to pay as much as$900 for a car. How much must he pay? Noone is willing to sell at the old equilibriumprice of $500, but B will sell at $600: He pre-

Table 4-2

CAR-OWNERSHIP DEMANDSCHEDULES OF A, B, C, D, AND E

Quantity Demanded

Price A,B,C,D E Totald'(~

$1000 4 0 4900 4 1 5800 5 1 6700 5 1 6600 6 1 7500 7 1 8400 8 1 9300 9 2 11200 10 2 12100 12 3 15

62 Chapter 4

fers $600 to the car. The new equilibratingprice (that is, the price at which neither ashortage !lor a surplus occurs) is higher: $600.The resulting reallocation of cars is accom-plished solely by the force of revised pricesin mutually beneficial exchanges.

PRICES ANDFIXED SUPPLY

So far in our' analysis we have assumed thatthe supply of cars was simply a given .quanti-ty and was not responsive to price. This iswhy the supply lines in Figures 4-1 and 4-2are straight vertical lines. It is commonly ar-gued that with such a fixed supply, which isnot affected by the price, allowing the priceto rise serves no useful function because itdoesn't affect the quantity supplied. But ouranalyses have demonstrated that the higherprice has a strong effect in determining whogets what part of the existing supply. Higherprices cause each person to adjust his or hervaluation of a prospective purchase relativeto other people's valuations. As a result ofthese innumerable individual decisions, thehigher prices restrict the amounts demand-ed. Market-clearing prices thus are a ration-ing or allocative device, performing a taskthat is necessary in every society whether ornot the supply is a constant. If price is notallowed to adjust to restrict amounts de-manded, some other methods must be usedto ration the existing supply among compet-ing claimants. It follows that if price is re-strained below the market-clearing equilibri-um, other forms of competition will becomemore significant. Political power or othercostly means of competition for the goodswill decide who gets more and who gets less.Allowing price to respond, even if price hasno effect on the quantity, serves a usefulfunction, overlooked by people who thinkthat the only effect of prices is on produc-tion rates-an effect that we now examinebriefly, and investigate more thoroughly Inlater chapters.

,c_

produetion and Supply

PRICE EFFECT ONAMOUNT PRODUCED AND SUPPLIED

Normally, at higher prices rates of produc-tion are higher and amounts supplied arelarger. (Remember, when we say that a priceis higher or is lower, we mean the relativeprice-that one price, in dollars, relative toprices, in dollars, of other goods and ser-vices.) Higher rates of production of anygood require more resources. And resources,like goods, remember, are scarce. For exam-ple, say we want to expand the national an-nual output of wheat. The amount of arableland having the best soil composition and lo-cated in the best climate is limited, and vir-tually all of it is already in use. Thus, landmore valuable for corn or cattle must be di-verted to wheat. Resources that are increas-ingly more valuable elsewhere must be at-tracted.

In Figure 4-4 the upward-sloping supplycurve (reflecting that higher prices evokelarger rates of supply) means that larger ratesof output of the given good require that re-sources be taken away from successivelyhigher-valued uses elsewhere. Elsewhere, asless of other goods is produced, people arepushed back up their demand curves forthose other goods. But if less is produced andsupplied, the price of those other goods rises.More resources can be attracted to produc-tion of the good only if more is paid forthem. So only if the present price of the out-put of that good rises can the funds beearned to attract resources from other, high-er-valued activities.

When the demand for some good(whether it be houses, or computers, or res-taurants) increases, usually only smallamounts of resources are shifted away fromthe production of each of all other goods.The reduced amounts available elsewhere ineach of many activities are so insignificantand so hard to notice that it is easy to think

$1000

900

800

DNew.

IncludingMr. E.

~DOld

S

~~ 700(1l~ 600

C 500e~400Q)

.!:! 300

a: 200

100

IIIIIIIis I

o 1 2 3 4 5 6 7 8 9 10 11 12 1314 15

Number of Cars

Figure 4.3.

HIGHER PRICE REDISTRIBUTESCARS IN RESPONSE TO INCREASED DEMAND

The increase in the price of automobiles permits areallocation of an automobile to E, the higher-valuing person, from B, who prefers $600 toan automobile.

that such reductions don't occur. But the re-sources must come from somewhere, and be-cause the economy is usually in a state ofnear-full employment of its resources, thereis no waiting supply of idle resources to drawupon in order to increase output.

Higher prices of a good make a largeroutput more profitable and provide the fundswith which to attract resources from produc-tion of other goods. Resources are attractedby being paid for at higher prices than intheir old uses, where the demand had not in-creased-or may have decreased. For exam-ple, when gasoline became more expensive,people increased their demand for small carsand reduced their demand for larger cars andrecreational vehicles. The resulting increasedsales and higher prices for small cars encour-aged manufacturers to start making more


LessGeneral InputsLessElastic Supply

L--.:2~-*=~S'P, ~_ MorePo General Inputs

MoreElastic Supply

Figure 4·4.

ELASTICITY OF SUPPLY

An increase in demand, as from 0, to O2, induces anincrease in output, which lessens the amount by whichprice rises. The elasticity of output is determined by theproportion of generalized and specialized inputsrequired for production of the good. The curve 5,shows that more-generalized inputs can beattracted to increase supply of the good by less ofa price rise-say to P,-than can more-specialized inputs, represented by 52' whichrequire a rise in price to P2.

r'"

64 Chapter 4

small cars and fewer large cars. Resourceswere attracted to making smaller cars andaway from, say, recreational vans. (Not oftencan such clear, large shifts in demand fromone good to other goods be seen so dramati-cally.) In the market economy, people maybuy what they choose and may put their ser-vices and equipment to work where they ex-pect the highest resultant income. Whenconsumers' valuations change, and hence de-mands change, new prices redirect resourcestoward the higher-valued products and ser-vices and away from the less valued.

Figure 4-4 is a demand and supply dia-gram; it assumes a market economy in whichthe amount supplied is not fixed. The figureshows graphically how an increase in de-mand works through price to induce largerrates of output. Say that people demandmore meat than before, because they arericher or there are now more of them. Thefigure shows this change as a movement ofthe whole demand schedule upward and tothe right, from DJ to D2• The diagram alsoshows that the sustainable market-clearingprice and output rate are both higher. Theincreased demand led to increased sales andto a higher output with a new, higher, sus-tainable, market-clearing price. That higherprice restrained the amount demanded belowthe larger amount that would have been de-manded had price not risen, and that higherprice also rewarded the suppliers withenough revenue to induce them to increaseproduction and to pay for the increase.

WhoPays a Tax?The Answer by Demandand Supply

The preceding analysis enabled us to graspthe logic by which the market-pricing systemoperates to relate amounts supplied toamounts demanded. We can improve ourunderstanding and ability to use it by apply-ing it to some frequently posed practicalquestions, such as who bears a tax. Suppose a

P,

l'S1+t

P2" .

Po SI

P3

Quantity

tax is placed on gasoline. Figure 4-5 showsthe relationship between aggregate demandand aggregate supply of gasoline. Say a salestax of lO¢ per gallon were imposed. The de-mand schedule-which reflects the valuethat consumers put on the use of gasoline-isunchanged. However, because of the l Oe-per-gallon tax, at the old price the suppliersretain lO¢ less. If suppliers raised the priceby 1O¢to as high as PI in an attempt to passthe tax to consumers, less gasoline would besold. In fact, any price higher than initiallyasked would reduce the amount demanded.Since the price to the consumer now in-cludes a lO¢ tax, the supplier receives lessthan initially. The price by all sellers cannotbe raised by the full amount of the tax with-out less being demanded. As less is produced,only lower-cost supplies can continue to beproduced. With less gasoline supplied be-cause of the lower net-of-tax price to the sup-plier, a higher consumer price, PI (includingthe tax), is sustained as the new equilibriumprice. The difference between PI and Po (theprice paid by the consumer and the portionreceived by the seller) is the tax the govern-ment gets. Part of that tax is borne by theconsumer at the higher price PI and part

Figure 4·5.

HOW A TAX AFFECTS SUPPLY

A unit tax on a good raises the supply curve by theamount of the tax, t. How much price rises, however,depends on the slopes of the demand and supplycurves. If the supply curve is perfectly horizontal, as is5" indicating infinite elasticity, the price will rise to P,to cover the full amount of the tax. If the supplycurve is upward sloping, as is 52' then price rises toP2, less than the full amount of the tax. Thecorresponding supply curves become 5H1 and52+1, respectively.

Market Prices as Social Coordinators 6S

$ sDs

1.00 ~---- __.---~.

Net-of- Tax Price.60 f-+.------ .....•To Sellers

Dc of Renters

sDs to Sellers(Net of Tax)

Land

Figure 4·6.

EFFECT OF TAX ON DEMANDSAND ON PRICE WITH FIXED SUPPLY

Consumers' demand, reflecting use value of land toconsumers, stays unchanged despite a tax. But theamount of demand that goes to the sellers as rent fallsby the amount of the tax. Consumers' price stays at$1.00 but price received by sellers falls to 60¢ becausethe vertical supply line represents fixed amount availabledespite price. If tax is to be paid to government byconsumers, consumers' demand is the same as if tax isto be paid to government by sellers. In the formercase, buyers pay 60¢ to sellers and 40¢ togovernment for a total price of $1.00, as before tax.In the latter case, sellers pay 40¢ to government toretain 60¢ of price of $1.00. With vertical supply(that is, total amount available does not vary withprice) total price (tax plus proceeds to seller) doesnot change. What changes is the portion ofthat $1.00 value that is distributed to thegovernment. (

66 Chapter 4

borne by the supplier (the difference be-tween the old price, Po, and the net-of-taxprice, P3). The difference P2 - P3 equals thetax per gallon.

We can see now that not all taxes areborne by the supplier, nor are all taxespassed on to consumers, as is often asserted.Who bears the tax in what proportion de-pends on the supply and demand relation-ships.

If the supply were fixed and not respon-sive to price-describable in the graph by avertical line-then the buyer's price wouldnot rise. Only the current owners or suppli-ers of a good would lose. To see why, consid-er a tax on land, the total supply of which isfixed regardless of the price paid for land.See Figure 4-6. Suppose a city has manylandowners all with uniform land renting for$1.00 per square foot per month. (We as-sume the land is uniform to simplify ouranalysis, but the assumption does not changethe results.) The city government levies a taxof 40¢ a month per square foot on the land.What happens to the rental value of land?No more land can be produced and none willdisappear no matter what the rental income.The supply of land is represented by an un-changed vertical supply line at the existingstock of land. It does not shift or change inany other way when the tax is levied. Nordoes the demand to use land by renters shift,because the land use is still worth as much tothe renters as before. However, the portionof the renters' demand that accrues to theprivate landowners is now 40¢ a square footlower per month. The portion of the demandschedule now going to landowners is 40¢ be-low the consumers' demand schedule, be-cause the government takes the 40¢ differ-ence. So we draw a new lower demandschedule as seen by the sellers, net of tax.

In effect, the government has made itselfthe owner of 40% of the value of the land.The landowners cannot increase rents, be-cause the supply is unchanged and so is theusers' demand schedule for land. The best

the owners can charge is the same market-clearing price, $1.00 per square foot permonth with a net of 60¢ after tax. If anylandowners tried to raise their rents to re-coup part of the rent going to the state, theywould find the demand schedule for land tobe no different from before: At a higher rentpeople would want to rent less land. Withunchanged demand and a fixed supply ofland, any attempt to increase rents will resultonly in some temporarily unrented land anda return to the equilibrium price as the bestof the available opportunities.

WHO DELIVERSTHE TAX TO THE GOVERNMENT?

The question "Who pays the tax?" tends toconfuse two separate questions: (I) Who de-livers the money to the government? (2)Who bears the corresponding reduction inwealth? Suppose the tax is said to be on therenter rather than the landowner: A renter isnow required to pay 40¢ of the unchangeduse value to the government. Because theland is still worth only $l.00 to a renter, therenter offers only 60¢ to the landowner. Be-cause every possible renter will behave inthis way, the landowner cannot avoid a lowernet-of-tax rent. To refuse that lower rentwould mean no renter. Because the demandfor land is unchanged, the renters are stillwilling to offer owners (and the government)only a total of $l.00 per square foot. If thegovernment extracts 40¢ from the renteronly the remainder is available to sellers.Two related demand schedules must be dis-tinguished: the consumer (renter) demandschedule and the lower net-of-tax demandschedule seen by the seller after 40¢ is paidto the government. Thus, given a verticalsupply line, the people who bear the reduc-tion in wealth because of the tax are the peo-ple who own the land at the time the tax isannounced.

Our analysis of the effects of taxes onland has been deliberately simple and incorn-

plete. For example, we have ignored the useof the tax proceeds. If the tax were used toimprove roads, schools, or environment nearthe land and thereby improve its amenities,the use value that .•.consumers put on the landwould shift upward. That is, their demandcurve would shift upward and to the right. Ifthe renters assessed the value of those im-provements to equal the tax cost, the renters'demand for that land would increase by ex-actly that amount; the increase in rentalprice would therefore equal the arnount pfthe tax.

WHICH INPUT BEARS THE TAX?

What is meant by saying the supplier bearssome of the tax? After all, to produce, say,gasoline requires exploring for oil, finding it,pumping it from the ground, shipping it torefineries, refining it, and shipping the gaso-line to distributors and then to service sta-tions. Every step requires labor, machinery,natural resources to power the machinery,and money to finance operations. All ofthese are inputs in the production and sup-ply of gasoline. Which input owners sufferthe tax? If any input could move or bemoved instantly and costlessly to other usesor jobs paying just as much, its owner wouldnot tolerate suffering any loss whatsoeverthrough taxes. But if such moves were cost-ly, the inputs would remain at gasoline pro-duction even at a lower income, as long asthe decrease in income was less than thecosts of moving. The higher the movingcost, the more of an income cut inputs andowners will tolerate in producing gasoline. Intechnical words, the owners of resources"less mobile, more specialized to gasolineproduction" will accept a lower wage or in-come, while the more generalized produc-tive inputs-ones that can move to otherwork at less cost-suffer less or little loss be-cause they make the move to other, equallyhigh-paying jobs. The wages or prices that


keep the more specialized inputs in produc-tion of gasoline will be lower-shown bylower costs for smaller rates of output alongthe supply line.

Furthermore, with lower net-of-tax re-ceipts from gasoline, the suppliers can retainthe services of inputs only by paying themless. But the inputs that have the highest-val-ued alternative options will not accept lowerwages. Only those inputs that are less valu-able elsewhere will remain despite the lowerincome. Thus, the costs of the inputs that re-main will be lower, at a lower output, thanthe costs would be at a higher output, whichwould require bidding more inputs awayfrom other, higher-paying jobs.

These phenomena are described by asupply curve drawn with an upward slope-the normal case. Though we investigate theorganization of the productive resources inbusiness firms later in the book, it is suffi-cient here to realize that the upward-risingsupply curve means the resources used arenot all identical and have different alterna-tive use values.

If we review our two preceding exam-ples, one with an upward-sloping supplyschedule with higher prices and the otherwith a supply that was vertical and constant(that is, was not responsive to price), we cansee that with a rising supply curve, part of atax is borne by consumers as well as suppli-ers. The proportion that each bears dependson the price responsiveness of the supplyline: The Aatter the supply line, the more isborne by consumers and the less by suppli-ers. If the supply curve were practically a Aathorizontal line, the consumers would pay aprice higher by almost exactly the amount ofthe tax.

The change in output and price is alsoaffected by the responsiveness or elasticity ofdemand. The Aatter the demand curve-thatis, the more elastic-the greater will be thereduction in output and the smaller the risein price. Rather than pay a price that is high-

68 Chapter 4

er by the amount of the tax, customers shiftmore readily to other goods. More of the dif-ference between the new, higher price andthe costs of production will be achieved bylower costs associated with much smallerproduction. This process is directed entirelyby market prices, which are in turn set bythe demand and supply decisions of peopleseeking to increase their private wealth. Pro-duction responds not only to the values thatconsumers place on a given output but alsoon people's willingness to engage in the vari-ous types of work that output requires. Asyou can see, then, it is not a case of what isoften simply called "consumer sovereignty,"as if consumers' preferences were all thatcounted. Also inAuential is the willingness ofpeople to produce what consumers desire.Both producers' and consumers' desires-supply and demand-are involved in deter-mining what gets produced.

Smog Removaland Land Value

Let us suggest another, more startling appli-cation of demand and supply principles. Ifsmog were magically removed forever, at nocost, from the center of a major industrialcity, the value of the land would increase asdemand for it increased. The increased de-mand would enable the landowners therebyto capture the value of the cleaner air.When the tenants began paying a higherrent, they would consume less of other goodsbecause their higher rent left less money forother goods. The renters might be no betteroff than before, enjoying cleaner air but hav-ing less of other goods. Land values wouldfall in the nearby suburbs because peoplewould no longer have to leave the city forbetter air.

If, instead of being magically costless,smog removal were very costly because ex-pensive pollution control devices were re-quired, should the landowners bear the costsof cleaning the air? Should they bear the costs

of preventing further deterioration? Theselast two queries are about who should dosomething, so we leave the answers to you.

Rental and Allocationby Consumer Competition

We can get a better appreciation of the ef-fects of competition among demanders if weexamine what happens when some people'sdemands have increased and others' havenot. For example, if the demand for rentalhousing increases, a given tenant's rent willrise. A higher rent will reduce the amount orquality of housing a renter demands; thatrenter is induced to release some housing tothose whose demands have increased. Notowning the house, the renter will not capturethe higher market value of the house-norsuffer its loss in value if the demand forhousing has fallen.

Figure 4-7 shows the consequencesgraphically. Curve D, + Db represents thecommunity's initial demand for housingspace. D, is the demand schedule for thosepeople whose demands remain unchanged,and Db is the initial demand by those whosedemands increase to D' b' Initially, the rent isPI' with Xa the amount of space rented togroup A and X; the amount rented to groupB. Then, when group B's demand scheduleincreases to that shown by curve D' b' thenew total demand schedule, Da + D' b' inter-sects the existing housing supply line at ahigher price, P2•

If rents are restrained below P2, a short-age occurs, as indicated by the distance be-tween the supply line and the new demandcurve at every price less than Pz• If the rentwere not restrained, it would be bid up to Pz,as those with increased demand offer or toler-ate higher rents to get more housing. Thehousing market would be called "tight" or"strong" or a "seller's market," and the nor-mal buffer vacancies that enable people to lo-cate new rental spaces and move from one to

~III•...!!!'0c.:..••..C7lC'(ij:::I0:I:-0CDU.;:Il. P2

PI

0

sIIIIIIIIIII:ShortageI if NoIincreasesI in Rents

Quantity of Housing

Figure 4.7.

CHANGE IN PRICE OF HOUSINGENABLES REALLOCATION AMONGCOMPETING DEMANDERS. FROM A TO B

When demand by group B increases while that of groupA does not. the increased total market demand raisesthe price of housing. Members of group A then demandless. Housing space equivalent to distance Xb-X' b istransferred from group A to group B, which values itmore highly than does group A.

If rentals were held down by law at the old rental.a shortage of housing would appear because morehousing than is available is demanded at that oldrental. Allowing price to rise would eliminate theshortage: the excessive amount demanded. MiamiBeach and, more recently, Santa Monica imposedrent controls when demand for housing increasedand rents started to rise. Immediately a shortageappeared. It is proposed that the rent controlsbe retained until the shortage disappears.Will it?


s

-oQ)(J.;;:0..

IncreasedMarketValue

o Shortage

Quantity of Housing

Figure 4.8.

EFFECT OF RENT CONTROL

Shortages are created by rent controls. represented byP1' the legally restricted price or rent. The result is atransfer or destruction of wealth measured byshaded area.

70 Chapter 4

another with relative ease would temporarilydiminish in number. As rents rise, group B,whose demands had increased, obtains a larg-er aggregate amount, X' b: Members of groupA end up with only X'a' But each individualin both groups wants less at the higher rentP2 than he or she demanded at the old rent P;

House owners receive the increased rent;their houses are worth more. Everyoneblames landlords for raising rents. But whatenabled them to get higher rents is the in-creased demand by people in group B. Land-lords, in effect, tell the A people to meet thecompetition of the Bs. The Bs and As maybe friends and neighbors who complain toeach other about "exorbitant" rents, neverthinking to blame the competition amongthemselves for the higher prices.

Price Controls,Shortages, Competition,and Discrimination

So far we have analyzed situations in whichprices adjust so that amounts demanded andamounts supplied are made equal. But oftenyou will face a frustrating waiting list orwaiting line because a good is out of stock. Inother situations, sellers find too few buyers.Is there something wrong with our analysis?How can shortages and surpluses be ex-plained? Do not ask, "What has gone wrongwith the world?" The laws of demand havenot changed. One possible answer is that thepermissible prices may be restricted by lawor political controls. (More sources of suchevents are explored later in this chapter.) Inseveral cities, rent controls limit the rents forapartments; in most cities, water is notpriced in accord with demand and supply. Inthese si tua tions shortages will occur, andthere will be queues or rationing, or morediscrimination by race, creed, sex, age, andthe like.

To see why, we use our housing demand

example. Suppose price controls keep therent down below the new market-clearingrental.' The total amount demanded at thatrestricted price will exceed the available sup-ply, so a shortage-or what we have alsocalled an excessive demand-vdevelops.' Fig-ure 4-8 is based on Figure 4-7. The demandsof A and B are shown before and after thedemand increase by B. If price is restricted toPI' B group members will complain of ashortage because they can't get as muchspace as they demand (or, as they are morelikely to say, "need"). There are two othereffects as well: (I) a wealth transfer (but notfrom renters to owners, as would otherwiseoccur); and (2) an increase in nonprice dis-crimination.

WEALTH TRANSFER

It is easy to see how the wealth-the in-creased market value of housing-is trans-ferred when prices are restricted. Suppose atenant were allowed to sublease to others atuncontrolled rents, even though the rentpaid to the landlord were restricted to Pl. Itwould pay a newcomer, B, to rent space fromA, paying a sublease rental to A of P2• As thediagram shows, B would get more space(X'b- Xb), which is the amount (Xa- Xla) giv-en up by A, who would rather have the extraincome. And B prefers the extra space towhat it costs to get that space. The new in-creased value of housing services would becaptured by the old tenants, a value shown inFigure 4-8 as a shaded area. The ownerwould get none of it.

This' value increase occurs whether ornot subleasing is legally permitted. If it is

<Ina later chapter we investigate the effects of le-gally imposed minimum prices.

'Although the legal maximum price of housing isdeemed "fair," some demands are not met at that price.Any person caught in that situation could ask, "Whatis the meaning of a price at which none of a good isavailable to a buyer?"

permitted, both B and A reach mutually pre-ferred positions, but none of the increasedvalue of housing goes to the housing owner.If subleasing is not permitted under the rentcontrols, the housing space is not reallocatedso effectively. But whereas the owners aredeprived of the increased value by the legalrent limit, the original tenants get that in-creased wealth in the form of the more valu-able housing space. Hardly anyone has pro-posed that under rent controls tenants beallowed to sublease at mar ket-clear iggprices, despite the benefits that would ac-crue to tenants. Is it because this wouldmake the wealth redistribution from land-lords too transparent to be acceptable politi-cally?

NONMONETARYFULL-PRICE COMPETITION,OR WEALTH WASTAGE

When people value a good at more than theprice being asked for it, but are unable to getthe amount demanded at that price, the frus-trated demanders will compete for more ofthe goods in nonprice ways. No frustrateddemander will idly watch others get some-thing worth more than its money price.Their marginal personal valuation of anotherunit of the good exceeds the specified marketprice. That excess of valuation over price is ameasure of how much cost-in addition tothat price-they are willing to incur to getanother unit. They will incur new costs, oth-er than greater money payments to sellers, tocurry the seller's favor. But these extra costsare not a wealth transfer; they eat up thatexcess value, and are a waste. Some of thenonprice ways in which consumers competeare waiting in line or being put on a waitinglist, being nicer to the seller, or accepting alower standard of service or quality of good.For example, they will stand in line as longas their value of the time in line just matches


"

the excess of their personal marginal valua-tion of the desired goods over its restrictedprice. Their full price (the money price plusthe value of the time spent in line or thecosts of competing in other ways theychoose) for the good will be bid up by com-petition to match their marginal use value ofwhat they can get.

If you assume that full price exceedsmoney price only in conditions of restrictedprices, then you have forgotten that inChapter 2 we explained that almost every-thing you buy has a full cost to you that isgreater than just the money price-evenwhen there are no price controls. We havegenerally ignored all but the money priceonly for the sake of simplicity. And althoughwe later use the idea of full price more ex-tensively, we use it here to show that peopleare willing to incur a full price equal to thepersonal marginal use value of the marginalunit they demand. Consequently, even if themoney price they must pay is kept low, thefull price may not be affected: Buyers willincrease their offer of non money compo-nents.

Thus, for rent-controlled housing we seelonger waiting lists for vacancies, more im-portance placed by owners on the personaltraits and behavior of applicants in determin-ing who gets housing space, and a reducedquality of housing. These nonmoney compet-itive features become proportionately moreimportant until the full price is equal to whatit would have been at the market-clearingprice for the good. Thus is itsaid that pricecontrols do not keep down the full cost tobuyers; instead, they change the way the de-manders bear the higher costs, that is, less inmoney and more in other forms of otherwiseundesired competitive activity.

In sum, restrictions on open-market pric-ing have these consequences: They (1) makethe amount demanded at the money priceexceed the amount available; (2) restrain ex-change from lower- to higher-valuing users;

72 Chapter 4

(3) reduce the quality of the good; (4) inducewealth-wasting forms of competition; (5) in-crease nonmonetary discrimination.

Why, then, do any consumers wantprice controls? For several reasons:

First, some consumers believe-correct-ly-that if the price were allowed to clearthe market their costs would increase. Thesellers would gain that greater value. Theseconsumers prefer to take their chances bycompeting for the price-controlled goods innonmonetary ways in which they may be-lieve they have a relative advantage; in ef-fect, by being richer (being more willing orable to wait in line; knowing the right peo-ple; being of a favored ethnic type; havingpolitical power; and the like). If they succeed,they gain the increased value that price con-trols withhold from the owner. Some people(chiefly the politically strong) find that pricecontrols further enhance their power, partic-ularly when, by weakening the effectivenessof market-exchange offers, political controlsdecide who gets what goods.

Second, some people do not understandhow price controls affect allocation, produc-tion, and the quality of products.

Third, many people incorrectly believethat price controls prevent inflation and pro-tect the purchasing power of money. (Theydo not, as we shall see much later, in Chap-ter 19.)

Scarcity makes some system of alloca-tion necessary. Every allocative system isdiscriminatory, by definition: To allocate isto discriminate. In a capitalist, free-marketsystem the dominant basis of discriminationamong people as to who gets what is basedheavily on one's productivity, which deter-mines one's wealth, and hence on theamount of money (which, remember, repre-sents claims to other goods) offered in ex-change. The analytic question about pricesis not whether particular prices are high orlow, but how they permit exchange to influ-ence who gets what and who produces what.The private-property system puts more

goods where there are more dollar offers.Everyone can get some of all goods, up tothe quantity of each good at which each per-son's marginal personal value matches itsprice. Some people feed their dogs whilepoor children have little milk, because thesystem permits people individually to decidewhat to do with their income and wealth.We may wish some people had differenttastes and values.

RATIONING BY COUPONS

Some of the wastes of nonprice competitionunder price controls can be avoided by percapita rationing: giving coupons that entitlea person to buy an amount of the good. Butnot everyone would have equal marginal usevalues at the amounts they were allotted bythe ration coupons. The lower-valuing userswould prefer to sell their coupons (rights tobuy the good) to higher-valuing people.Therefore, it has been widely proposed thatif, at some time in the future, ration couponsare issued for gasoline, they be salable topeople who want more of the good and arewilling to pay more for a coupon. This ar-rangement would benefit the person sell-ing the coupon (who values what could beobtained with the money more than whatcould be had with the coupon) and would forthe same reason benefit the purchaser of thecoupon.

Such an exchange, however, clearly re-veals that the effective full price of the goodis not being kept down to the official limitedprice. The transferable ration coupon isworth the difference between the officialprice and what the free-market price wouldbe. That difference would be offered for acoupon-or would be forsaken by using thecoupon rather than selling it. Therefore, thefull price for every consumer (money priceplus coupon value) equals what the free-mar-ket price would be-except that there are ex-tra transactions costs associated with issu-ance and purchase of coupons.

\

The 1975National Energy Aet:Erroneous Eeonomiesbut Good Polities?~

Another instructive example of erroneousthinking is the National Energy Act of 1975.Congress mandated a rollback and continu-ing control of prices of domestic (U.S.) crudeoil paid to producers. Crude-oil prices wereheld below market-clearing levels on the as-sumption that thereby prices would be lowerfor gasoline, heating fuel, lubricating oil, andother products refined from crude oil. How-ever, keeping the price of domestic crude oillow does not affect the price of the productsrefined from crude oil. Several presidents,the majority of Congress, Congressional staffadvisors, and the National Energy Board (butnot the Council of Economic Advisors) erro-neously thought that it would.

To see the error, suppose products de-rived from a barrel of crude oil (gasoline, ker-osene, fuel oil, asphalt, plastics, chemicals,drugs, rubber, and the like) are worth $100 attheir final free-market prices to consumers.Suppose those final product prices are notcontrolled by law; they are market-clearingprices. Suppose also that the costs of refining,transporting, and distributing these finalproducts amounts to $66, giving a remainderof $34. Any processor who could convert abarrel of oil into products worth $lOOat a costof $66 would make a profit if a barrel of crudeoil could be purchased for less than $34.

Competition among those profit-seekingrefiners would bid the price of crude oil upto $34 as they competed for the available,underpriced crude oil. The fundamentalpoint is now clear: The price of every pro-ductive input is bid up to the value of whatit is expected to provide consumers; in thisway its expected value to consumers deter-mines its costs and its price. In the presentexample, the $34-a-barrel value of oil comesfrom the $100 value of the refined products


to consumers (minus the $66 of other costsof processing and distributing). Thus, if thelegal price of the crude oil were kept downto, say, $10 a barrel, any processor who gotthat oil for $10 would make a gain of $24(= $34 - $10) because the refined productswould still sell for $100. The $100 value ofthe refined products depends only on thedemand for them and their supply. If thesupply of refined products is not changed,then whether the price of crude oil is keptdown to $10 by law or bid up to its $34 val-ue affects only the allocation of that $24 dif-ference; it does not affect the price of gaso-line.

For the sake of simplicity, we have as-sumed that the crude oil will be taken fromthe ground whether the well owner gets $10or $24. Although this assumption is not en-tirely correct, we will hold it for the moment.We shall correct it shortly.

If the supply of domestic crude oil, andhence the supply of its refined products, isnot affected by the crude-oil price receivedby the crude-oil producer, the final productprices will be unaffected by what is paid forthe crude oil. This means that the price ob-tained for refined products could not be in-creased even if the crude price were allowedto rise above its legal ceiling of $10 to itsmarket value of $24. To raise the price of therefined products would mean that someamount would not be sold. That is why put-ting a legal price control on crude oil (or onany input) will not-and di,¢ not-keep downthe price of the derived final outputs-gaso-line, chemicals, plastics, and drugs obtainedfrom crude oil.

Frequently, since the 1975 National En-ergy Act was passed, members of Congressand of the administration have erroneouslyclaimed that if the price to American produc-ers of crude oil had been allowed to rise fromthe legally restricted price of $7 a barrel tothe (then) free-market value of $14 a barrel,the price of gasoline refined from that oil

I' fit

I :~::: _

74 Chapter 4

would rise about l7'/- a gallon." (Becauseabout 42 gallons of gasoline can be refinedfrom a barrel of oil, a price rise of $7 a barreldivided by 42 gallons of gasoline comes toabout l7'/- a gallon.) The error is, of course, inassuming that the cost of making something(rather than the consumers' marginal person-al valuations of the available supply) is thebasis of its value.

The interaction of demand and supplyfor any good determines the market value. Ifmore of the good can be produced, peoplewill incur costs to produce more until thecosts rise to the product's value. The produc-tion costs that it pays to incur are deter-mined by the market value of the good, notthe other way around. The value to the con-sumer is not increased simply because a pro-ducer's cost has risen. Not falling into thetrap of believing that it is will make you aneconomically sophisticated person.

To see that costs do not determine value, reconsider the earlier automobile exam-ple. If it had cost $100,000 to make thosecars, and only seven were available, the pricewould be unaffected: still $600. The explana-tion is that only insofar as costs affect thesupply do they affect price.

Under the National Energy Act's crude-oil price controls, the refiners who were for-tunate enough (or politically well enoughplaced) to command crude oil from a wellowner for only $7 were getting oil worth $14a barrel (disregarding other costs), netting again of $7 a barrel at the expense of domesticcrude-oil producers. Yet because people per-sistently think that costs of production deter-mine the price of a good, they believed thatthe National Energy Act kept down the priceof gasoline by limiting the price of crude torefiners. It did nothing of the kind; it had theeffect of preventing crude producers fromgetting that $14 value per barrel. Half of it

"The error was repeatedly pointed out by manyeconomists-to little practical effect.

remained with the refiners. Such a wealthtransfer from one party to another has no ef-fect on the supply, and hence the price ofgasoline or any other refined product was un-changed. Economic analysis doesn't enable usto explain why the public and so many politi-cians expounded that fallacious reasoning.

To correct our artificial assumption thatthe supplied amount of crude oil was con-stant, we need only recognize that in fact do-mestic crude producers would produce morecrude at a higher crude price. That would in-crease the supply of refined products, theprices of which would then be reduced. Farfrom keeping down the price of refined prod-ucts, price controls on crude oil actually tendto raise them. But not very much, sinceprices of refined products already reflectworld supply and demand. We import crudeoil at the world price because that is its valuein terms of its refined products at free-mar-ket prices after allowing for refining and dis-tribution costs. We also import refined prod-ucts from foreign crude. For all thesereasons, the supply of crude oil and refinedproducts to the United States is essentiallyunaffected by price controls on domesticcrude oil.

Refiners can vary the ratios of gasoline,fuel oil, chemicals, and plastics derived froma barrel of crude by adjusting the refiningprocess. The National Energy Act also au-thorized political authorities to control theproportions of such products refined fromthe crude. By so doing, the political authori-ties can determine the relative supply ofeach type of refined product and hence theirrelative market prices and values. It was con-tended by the Act's advocates that thiswould ensure that not "too much" gasoline isproduced at the expense of not having"enough" fuel oil. In accord with the desiresof the Act's proponents, controls mandated areduced gasoline output in favor of more fueloil for heating. As Ralph Nader, a supporterof such controls, said, "I don't have an auto-mobile." Also, he lives in a city in a part of

the United States that has cold winters. Wasthe National Energy Act a means of transfer-ring economic resources to the benefit of ar-eas of the country like the East, which arecolder and more 'Orban and where the auto-mobile is used less, at the expense of thewarmer areas where the automobile is usedmore, as in the West?

Economic RentAlthough for some goods a price may not af-fect the amount of a good in existence, itdoes affect assignment to particular personsand uses. Any price unnecessary to keepingthe good in existence, but necessary for allo-cation to highest-valuing users, is called eco-nomic rent: economic to emphasize that itserves an allocative function, and rent to in-dicate that it does not affect the supply.

Willingness to pay is a competitive wayof revealing the use value to the demander. Ifsome amount of a good has greater value toone demander than to others, that demanderwill get it. The entire price or rent of land isin excess of the zero amount necessary tokeep that land in existence. Yet to comparethe values to different users the market rentis crucial.

But is land rent truly an economic rent?Land is surprisingly perishable. Its valuablefeatures include levelness, fertility, and ab-sence of rocks, weeds, and bushes. Any farm-er or ecologist knows how fast land can erodeor become overgrown with weeds. Goodstbat have literally no preservation or mainte-nance costs whatsoever are rare-indeed, wecan think of no examples. Furthermore, moreland can be created and will be created atsufficiently high prices.

LAND RENT - A TAXABLE SURPLUS?

In the belief that payments for some goodsare unnecessary to create either the existing


or the future supply, some people concludethat the market value of such a good is asurplus that should be taxed. Prominentwere the "single-taxers" -followers of Hen-ry George, a nineteenth-century novelistand reformer, who believed that all landrent should be taxed. (Somehow he over-looked equally "pure" economic rents onother resources-for example, beauty andtalent. )

Other ideologically motivated advocatesof taxing, or nationalizing, land rents are thesocialists. The philosophers of the left wingof the British Labour Party argued that land-site values reflect the actions and demands ofsociety as a whole and not the owners of aparticular parcel of land. Therefore, the siterent should belong to all the people. But thatis true of every good, and this argument failsto explain why every person in the societyshould bear the consequences of changes invalue of every parcel of land-even those aperson will never see or perceptibly affect.Moreover, some people do not want to carrythe risks of losses from all land and insteadprefer to hold titles to other goods. Just aspeople differ in consumption patterns, sopeople specialize in which goods they preferto own and on which to bear the risks ofchanges of value. But socialist doctrine doesnot permit private-property rights in produc-tive resources. Socialists say that the peopleshould have equal, nontransferable shares inthe value of certain goods-hence thosegoods are socialized (by whjch is meant thesame thing as nationalized). That is, theirrental value is claimed and distributed by po-litical authorities.

It has 'been argued that even if landrights were socialized, the use of the landwould be unaffected, because the govern-ment could rent to the highest-bidding user.However, the reward for a private owner toincur the costs, risks, and trouble of discover-ing and actually putting the land into thehighest-valued uses is greater than for a sala-

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ried government employee in charge of thesocialized land. Thus, the government em-ployee is less likely to find or heed highestmarket-valued uses. Whether this is good orbad depends in part on whether you thinkthe market-valued uses as revealed by indi-viduals competing in the market are a goodor bad criterion. It is not for economists tohazard judgments about that.

Pareto-OptimalAllocations

If the output of goods could be revised or re-allocated to make some people better offwithout hurting anyone else, surely wewould' say, "Move to the new allocation."Any situation in which a change must hurtsomeone is called a Pareto-optimal alloca-tion, after Vilfredo Pareto, the nineteenth-century Italian sociologist and economistwho formulated it. Recall our earlier exam-ple of a fixed supply of cars: Given the mar-ginal personal valuations Ior eutos, the result-ing distribution of three, one, one, and two .cars to A, B, C, and D, respectively, to eachof them is the Pareto-optimal allocation. Nosubsequent reallocation of a car could benefiteither of any two parties. (Try it; it's impos-sible.) With any other allocation you couldfind exchanges with a gain from trade sharedbetween the buyer and seller.

None of this means Pareto-optimality isgood. Though the Pareto-optimal criterionseems reasonable, it is not universally accept-ed. Because the concept involves personaljudgments. it must rest on the assumptionthat each person is the right judge of what isbest for himself. But acceptance of that is notgeneral. In fact we do not allow children andpeople legally declared incompetent to maketheir own choices. Some drugs and literatureare prohibited even for adults, though suchproducts have some would-be buyers andsellers.

SummaryI. The market-demand schedule for a good is

composed of the sums of the amounts de-manded by all people at each possible price.

2. For any good, the total amount demanded andthe total amount supplied are made to equalone another by an equilibrium, or market-clearing, price. This price is achieved by theopen-market offers and bids among compet-ing buyers and sellers.

3. Shortages and surpluses result from a pricebeing, respectively, too low or too high.Shortages and surpluses are eliminated al-most instantly by free-market prices. A re-duced supply should not be confused with ashortage, which is caused by price being toolow.

4. When demand for a good increases, compe-tition among buyers raises its price. Middle-men or agents transmit the increased de-mands to potential sellers or suppliers of thegood. The higher price paid for the existingamount by those middlemen appears ashigher costs to them. The price rise, how-ever, is not caused by the rise in costs, butrather by the higher value placed on thegoods by the increased public demand.

5. Though existing prices may have no effecton the currently available amount of somegood, the price does affect the distributionof the good. A free-market price will movethe goods to their highest-valued users.

6. The supply schedule gives the sums of theamounts supplied at each alternative price.If output rates increase in response to higherprices, the supply curve is upward sloping,from lower left to upper right, with largeramounts at higher prices.

7. The supply curve of a good will be upwardsloping if some of the extra inputs requiredto increase output are more valuable else-where-for if they are, they will not work orbe put to use here unless paid at least whatthey could earn elsewhere. The higher theproportion of inputs that have higher-valuedalternative uses, the higher the costs of in-

creasing rate of output. If the demand (andthus the price) for the product were to fall,these inputs would refuse to work here atlower wages or fees for services, and wouldleave for the other, higher-paying jobs.

8. How a tax on a good affects its price de-pends on the slopes of the demand and sup-ply curves. If the amount supplied is fixedregardless of price-that is, if the supplyschedule is vertical-a tax will not increasethe buyer'S price, but will instead be deduct-ed from the seller's price.

9. For a good with an elastic supply schedule-that is, one for which output is not fixed re-gardless of price-a tax will force resourceswith use values that are nearly equally highelsewhere to shift elsewhere, rather than ab-sorb the tax by accepting less here. Thatshift of resources reduces the amount sup-plied of the taxed good. The reduction en-ables the supplier's costs to fall and the priceof the good to rise. The spread between thenew, higher consumer's price and the nowlower supplier'S cost will equal the tax.

10. Under price controls, demanders for thegood will offer the fixed money price butwill also compete with one another by offer-ing more of other costly activities until thefull price (the money price plus those addi-tional costs) equals the marginal personalvaluation. Such nonprice competition iswasteful, because the seifer does not valuethe buyer's nonmonetary competitive activi-ties as much as a direct money receipt.

11. Price controls require that competition forgoods be pursued by means other than price.Race, creed, age, sex, and personal charac-teristics become more important in deter-mining how goods are allocated becausethey are less capable of being offset by aprice difference.

12. Ration coupons may be used in some price-control arrangements, to reduce the non-price costs to buyers. But if such couponsare salable, they acquire a value equal to thedifference between the controlled price andthe open-market price, thereby making the


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the price paid by consumers the same as theopen-market price.

13. If the amount supplied is permanentlyfixed-that is, unresponsive to any price-all the income received by the seller iscalled an economic rent.

14. Any payment for a good in excess of thatrequired for the permanent existence ormaintenance is a pure economic rent.

15. A quasi-rent is the portion of revenue thatdoes not affect the amount supplied now,but will affect the future rate of production.

16. Any allocation of goods among people suchthat a change to benefit some person wouldhurt some other person is called a Pareto-optimal allocation. Market exchange at freeprices tends toward Pareto-optimal alloca-tions.

questions1. The demands to own by A and by B for

good X are:

TotalA's 8's Market

Price Demand Demand Demand

$10 0 O~9 1 08 2 07 3 16 4 25 5 34 6 33 7 4 }'

2 8 51 9 6

a. Complete the total market demand by Aand B at each price.

b. If six units of X are available, what willbe the resulting allocation between A andB if open-market exchange is used?

c. With six units, if price were legally im-posed at $4, would there be a shortage, asurplus, or an.exchange equilibrium?

d. If the price were legally imposed at $9,

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would there be a shortage, a surplus, orexchange equilibrium?

e. How can there be a change from a short-age to a surplus without any change insupply or demand?

2. In question 1 above, increase the amountsdemanded by B uniformly by two units at eachprice.

a. What will be the new open-market price?b. What will be the allocation between A

and B?c. If the price is held at the old level by law,

will there be a surplus or a shortage?d. How can that surplus or shortage be elim-

inated?

3. "The interaction of demand and supply isapplicable not only to private-property marketexchange but to every problem of allocatingscarce "resources among competing uses. The use-fulness of a resource in anyone possible use de-termines its demand in that use, whereas its use-fulness in all alternative uses (against which thisparticular use must compete) affects the supplyof the resource for that use." Are these state-ments correct?

4. "Competition is never 'buyer against seller,'but always seller against other sellers and buyers'against other buyers."

a. Is this true for you when you buy food?Automobiles? Shoes? Sell your labor?

b. Can you cite a case in which it is nottrue?

5. The first law of demand says that at lowerprices, larger amounts of a good are demanded;at higher prices, lower amounts are demanded.The law of market price says that price equatesthe amount supplied to the amount demanded.Which law holds with fewer exceptions?

6. A distinguished professor of law wrote:"Some people believe that every resource whichis scarce should be controlled by the market. Andsince, in their view, all resources except freegoods are scarce, all resources-even rights to ra-diate radio signals-should be so controlled. Butsurely some resources are 'scarcer' than others,and thereby possibly merit different treatment. Itdoesn't advance the argument very much toplace a label of 'scarcity' on everything." Would

it be advisable for professors of law to study eco-nomics? Why?

7. This chart is typical of scores that have ap-peared in the last several years in the news me-dia. It purports to predict that supply will fallshort of future requirements and demand. Onthe basis of the analysis in this chapter, whywould you say such diagrams are incorrect?

The Petroleum CrisisDemand

1950 1980 19901960 1970

8. When prices on the stock market fall, thefinancial pages report, "everyone is selling; noone wants to buy." Why is this interpretation in-correct?

9. Which tactic would be more likely to getyou a lower price on a new car: going to just onedealer and acting like a tough and aggressive bar-gainer; or going to several dealers and mildly ask-ing for their selling price while letting it beknown that you really intend to buy a car and areshopping around? Explain why. Can you cite anyevidence?

10. The Council of Economic Advisers (to thePresident of the United States) once argued thatlegally keeping the price that cattle raisers couldcharge to below the market-clearing level wouldkeep down the price of meat to the consumer.The Federal Energy Agency asserted that hold-ing down crude-oil prices reduced the price ofgasoline (made from crude oil). Explain why eco-nomic analysis rejects these contentions.

II. "With open-market pricing, housing unitsare scarce or expensive, whereas with rent con-trol the housing market is characterized by short-ages." Explain.

12. Are the words "scarcity," "reduced supply,"

and "shortage" synonyms? If not, what is the dif-ference?

* 13. Do you think rent controls would be goodor bad for each oL the following: (a) a middle-aged couple who do not contemplate moving, (b)a young married couple with two children mov-ing to a new town, (c) a black moving to a newtown, (d) a young person receiving a raise in sala-ry, (e) an old person in retirement, (f) a drinkerand smoker, (g) a handsome, poised young man,(h) a homely immigrant, (i) a Mormon in a Jew-ish community, (j) a Jew in a Mormon communi-ty, (k) an excellent handyman who likes to workaround the house and care for gardens, (1) an oldcouple who have saved wealth and invested in anapartment house?

14. What does a vertical supply curve imply willhappen to the amount supplied when the de-mand falls? What happens to price? Why?

15. What does an upward-sloping supply curveimply will happen to the output and to the in-puts of production if demand and price for thatgood fall?

16. What does a horizontal supply curve implywill happen to the output of a good and to theproductive inputs if the demand for the goodfalls? If it increases, what happens to price and tothe productive inputs?

17. If a tax were placed on the future reruns ofthe television miniseries Shogun, who wouldbear the taxes; that is, who would be poorer bythe amount of the tax collected?

* 18. "Price controls give adequate housing tothose in the lower-income levels who would oth-erwise not be able to afford it." Subject thisproposition to economic analysis.

19. "In the capitalist system, only money ormarket-exchange values allocate productive re-sources." Evaluate.

20. "In capitalism, commercialism dominatesand suppresses social, artistic, and cultural val-ues." Evaluate.

21. "Under open-market, private-property pric-ing, a person is allowed to make any kind of ap-peal to a seller to get some of the good-evenoffering money. Under price controls, the buyer


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is told that there is one appeal he cannot use-that is, offer of a larger amount of other goods."True or false?

22. At the same price for each, you choose a col-or television set over a black-and-white set; butwhen a black-and-white set costs a third as muchas a color set, you choose the black and white. Inwhich case are you "discriminating"?

23. Which of the following choices involve dis-crimination? (a) Cadillac versus Chrysler, (b)Van Gogh versus Gauguin, (c) blondes versusbrunettes, (d) beautiful versus homely people, (e)blacks versus whites, (f) Japanese versus Koreans,(g) filet mignon versus hamburger, (h) all choices.

24. Collecting data for a cost-of-living survey,you find the following offerings: "List price,$125. Special discount to $90!" "50¢ box of Klee-nex for 40¢." "One cent sale. First for $1. Secondfor I ¢." For each of these cases, which would youreport as the price? Why?

25. It has been argued that politicians tend togain from price controls and hence they advocatethem. What line of reasoning would support thatargument?

*26. The military draft of the U.S. governmentinvolved price control-in which the maximumprice that could be paid by the military serviceswas set by law. As a result, the number of per-sonnel demanded exceeded the supply at thatprice; but the buyers, instead of accepting theamount sellers were willing to provide at that of-fered price, resorted to a compulsory draft to sat-isfy their "excess" of demand. Who gains whatby this system of price controls? (Before presum-ing that military personnel could not be obtainedby a wage system, note that tlfe permanent mili-tary officers, the leaders, are obtained by a volun-tary open-market wage system. So are policemenand firemen.)

\*27. Prices (that is, tuitions) charged by manycolleges are below the market-clearing price.Without inquiring why, explain how we knowthe price is that low. Applying the principles ofcompetition, when prices are kept below market-clearing levels, indicate which kinds of nonprice

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competitive payments or behavior among com-peting student applicants acquire added influ-ence. Who draws most advantage from theseother forms of competition? Indicate (or conjec-ture) who captures the value of the excess of themarket-clearing price over the controlled price ofthe services of the colleges.

*28. News item: "Seoul, Korea (AP). The citygovernment ordered the capital's 1500 restau-rants not to sell any meal containing rice duringlunch hours. The measure is designed to encour-age the customers to take other food. South Ko-rea is experiencing a serious food shortage be-cause of a poor rice crop." Would open-marketprices achieve the same result? How effectivewill this measure be?

29. "Allowing the prices of goods to rise whenmore of the good cannot be produced is immoral,because the higher prices do not induce a largeroutput. They merely give unwarranted profits tothose who are lucky enough to own the goods.Either prices should be prevented from rising, orthe government should take over ownership inorder to prevent unjust enrichment." Do youagree with this analysis? If so, why? If not, whynot?

30. Which of the following do 'you think containsome economic rent? Insofar as any of them con-tains rent, for what is that rent unnecessary? Forwhat is it necessary?

a. The wealth of those who owned land inPalm Springs, California, from 1940through 1975, when land values boomed.

b. Frank Sinatra's income.c. The income of a genius.d. The income of oil-well owners.e. The salary of the President of the United

States.

31. "The rent for land in New York City is not apayment necessary to produce that land. It is anecessary payment to obtain use of the land.From the first point of view, it is an economicrent; from the latter point of view, it is a cost."Do you agree? If so, why? If not, why not?

For Further Study: Futures Markets

After the harvest of wheat, no central plan-ning agency sets limits on each month's con-sumption to avoid running out before thenext harvest. Individual decisions set thoselimits, each owner of some of that wheatguessing how much to hold back. Whatguides their decisions? Given that the mar-ket value of any stocks of wheat held in theinterim will fluctuate, how is that risk borne?Furthermore, if people have different esti-mates of the appropriate rate of consumptionover the year, whose estimate will dominate?How will the various estimates be correctedin order to avoid running out too early orhaving far too much left over at the begin-ning of the next harvest? We now explainhow. And though we shall speak of wheat,the analysis holds for goods in general.

THE FORECASTER INCOMMODITY MARKETS

After a harvest, farmers, not wanting to holdso much of their wealth in the form of wheat,prefer to sell it, letting someone else bear therisks of forecasting its future value. The mill-ers, who grind grain into flour, don't want tostore a year's supply of wheat in advance.Even the consumers refuse to take on thisduty. But there is a very simple inducementto someone to store wheat: The price ofwheat falls, for the reasons just given: Farm-ers want to hold less than they have; millersand shoppers want less than the farmerswant to sell. This drop in price offers an in-

. creased prospect of profit in buying wheat atthe lower price, storing it, and selling it laterat an anticipated higher price. In a private-property, open-market system anyone maybuy wheat at harvest time hoping to profitby selling it later at a higher price. Buyingfor later resale at an appreciated price isknown as speculation.

Talents and facilities for storing wheat,and the estimates of future prices and of

costs of storing wheat, all determine whatthe price of wheat will be at harvest. Permit-ting any or all persons to buy wheat for spec-ulation keeps the price from falling further.And speculators' realized profits, if any, willbe smaller. In the United States, anyone canbuy and store wheat by telephoning a com-modity-market broker who will arrange tohave wheat purchased, stored in rented facil-ities, and insured against theft and spoilage>

CONTROL OF THE RATE OFCONSUMPTION OF STOCKS

Who tells speculators how much wheat to selleach month for consumption? No person does,but something does: the present price ofwheat compared to its expected future price.

The relationship between the present, orspot, price for wheat and the expected futureprice affects the rate at which wheat will besold. The further the present price is belowthe expected future price, the more willspeculators want to hold their wheat, await-ing that future increase in prices. If currentconsumer demand increases, the spot pricewill rise and reduce the prospects of profitsfrom continuing to store wheat. Thus, storersare induced to sell more wheat.

There is a market price that closely ap-proximates the expected future price. It isthe price of a futures contract in the futuresmarkets: a standardized type of contract todeliver, say, wheat at a specified future timeat a price agreed upon now but to be paid inthe future, at delivery. That agreed-to priceis essentially a prediction of what the price ofwheat will be at that future time. No buyerwould make a futures contract now if theprice agreed to in it were greater than theexpected future price. You would not sell afutures contract if the price agreed to in itwere lower than you expected the futureprice to be.


FUTURE PRICES AND SPOT PRICES

Suppose it is now September, and you canbuy wheat, in 5000-bushel lots, at $5 a bushelfor immediate delivery-on the spot. To-day's spot price, then, is $5. Today you canalso buy a futures contract for delivery ofwheat at $5.50 a bushel, payment and deliv-ery to occur next May. That price, $5.50,agreed to now, in September, but to be paidin May of next year, is called the Septemberprice of a May futures. The 50¢ differenceb~tween the two prices (spot and futures)will, on average, just cover storage, insur-ance, and interest costs of investment inholding wheat over the interval between har-vests.

FUTURE EXPECTEDPRICES AND FUTURES MARKETS

The prices in futures contracts, on the com-modity futures markets, are reported in thefinancial sections of major newspapers. InSeptember you may find something like thefollowing for the wheat futures market(which is in Chicago).

Futures Contract Prices of Wheat in May 1983

September 1983 (harvest) $5.00December 1983 5.15March 1984 5.30May 1984 5.50September 1984 (harvest) 5.00December 1984 5.15

These futures prices ate predictions ofthe future spot prices. May is the last monthbefore a new harvest. Obviously the summerharvest cannot be used to increase the~mount available for consumption in May; ifIt could, the May price would be pusheddown and the September price raised.'

I ~here is in fact some downward pressure on~ay pnces, .for consumers consume less in the expecta-tion of buying and consuming more at a lower priceafter the new crop is harvested.

82 Chapter 4

Anyone who can make a better predic-tion of what the price of wheat will turn outto be in the future can quickly reap a for-tune. For example, suppose in September1983 the futures contract price for a May1984 delivery contract is $5.50. If you believethe price for wheat will go higher than $5.50before May 1984, you could buy now a May1984 futures contract, for, say, 5000 bushelsof May 1984 wheat at $5.50 a bushel-thewheat to be delivered to you and paid fornext May. You nervously wait. If the spotprice next May turns out to be higher than$5.50 you can take delivery of the wheat,which you can sell at the higher price, reap-ing the difference as a profit. (If the pricewere lower, you would suffer a loss.)

Actually, the seller of the futures con-tract-who owes you wheat on that con-tract-could just pay you the profit youmade by extending the future spot pricemore accurately than did that person withwhom you made the futures contract. Thatother party doesn't have to buy wheat to de-liver to you-so you could then sell it foryour profit. Just paying you the difference iseasier.

An important consequence of this specu-lative activity is that an increased demandfor wheat to be delivered in the futurepushes up the futures price of a May con-tract from $5.50 toward that new predictedMay price. It also raises the current spotpnce. How? A higher price for a May futurescontract raises the profitability of storingmore of the existing wheat for that futuretime. People who want to acquire wheat nowto store until next May drive up its currentprice. The. higher current price reduces cur-rent consumption and more can be stored fornext May.

But suppose the current price increasesfor a different reason: Suppose the demandfor current consumption increases. The pres-e~t price of wheat rises. Continued storageWIll be less profitable-unless it is also ex-pected that the price in the future will in-

crease still further. A faster rate of presentconsumption will leave smaller stocks andhigher prices in the future. Currently, there-fore, futures prices will be bid up.

What buyers and sellers enter into fu-tures contracts? Millers, who grind wheatinto flour, must have sufficient wheat onhand to insure a smooth flow into milling op-erations. They also want an inventory offlour on hand to make delivery to flour buy-ers convenient. But having wheat on handexposes the millers to risks that its marketvalue will decrease, thus offsetting profitsfrom efficient milling and other services.How can they protect their income from therisks of big drops in the price of storedwheat? We give the three main ways possi-ble, and their limitations. Of the three ways,only the third is usually inexpensive enoughto be used:

1. Buy no wheat before you need it formilling. Limitation: This method will notpermit efficient flow of production.

2. Find someone else to buy the wheatand store it in your place of business; youbuy it from the owner as you use it. Anyfluctuations in the value of the stock ofwheat will be the owner's risk. Limitation:This is not as convenient as the next option.

3. Hedge in futures markets: At the timeyou buy wheat for later milling, sell a futurescontract for the same amount of wheat. If theprice of wheat falls in the future, you losemoney on the wheat you hold. But becauseyou sold future wheat through a futures con-tract at a price higher than the price turnedout to be in the future, you will make a gainon the futures contract that exactly offsetsthe loss in the value of the stored wheat. Onthe other hand, if the price of wheat rises inthe future, you will then have to deliver athigher cost than you receive for the con-tract-giving you a loss on the futures con-tract exactly offsetting the gain on the valueof your stored wheat.

It is worth noting that unless there arelarge amounts of storable raw materials that

are exposed to the risk of price changes it isunlikely there would be enough people seek-ing to sell futures contracts to maintain amarket in such contracts. Futures contractswould not survive if they were only devicesfor gambling. Cheaper means of gamblingare provided by horse races, roulette, craps,athletic events, lotteries, and cards!

ILLUSTRATIVE APPLICATION:COFFEE FUTURES MARKETS

To see how futures markets work, and howthey affect allocations for present and futureconsumption, we apply our analysis to coffeefutures. The scenario is only partly imagi-nary, being based on events of the last sever-al years.' The rumor spreads' that unseason-ably cold weather has damaged some part ofthe next coffee crop, now blossoming in Bra-zil. Thus, owners of existing coffee who canstore it for next year's expected higher pricescan expect greater profits then, or at leastgreater likelihood that they will make a prof-it. As more of the existing coffee is withheldfor future consumption, the present price ofcoffee to present consumers will rise.

There is, of course, just as much coffeeas there was before the news that the futurecrop may be smaller. And yet the presentprice has risen. Consumers demand publicinvestigations. Legislators investigate, and,sure enough, there is just as much coffee inexistence now as before the rise, and greedyspeculators are accused of driving up theprIce.

2 In addition to the wheat and coffee marketsthere are organized open futures markets for at leastthe following goods: soybeans, oats, corn, cotton, bar-ley, sorghum, sugar, cottonseed oil, soybean oil, hides,lard, eggs (frozen, powdered, and shell), potatoes, fro-zen chickens and turkeys, silver, tin, rubber, cocoa,platinum, pepper, flaxseed, copper, lead, zinc, wool,pork bellies, orange juice, and foreign monies. (One foronions was outlawed.) Instead of coffee, you couldthink of any of these goods.


If you were a speculator-and they'repeople of all types: dentists, carpenters, stu-dents-what would you tell complainingmembers of Congress? Could you defendyourself and claim you deserve not censurebut a medal for having benefited all man-kind; that you were working for the interestof other people, not against it? Your defensemight run something like this: "True, newsof the cold weather suggested higher pricesnext year. I believed that if I bought some ofthis year's currently stored 'crop at presentspot prices, I could later sell it at higherprices at a tidy profit. No one would sell ex-isting stocks at a price less than could be got-ten next year (allowing for the costs of stor-age, insurance, and interest). However, quiteincidentally and unintentionally, my action-like that of many others-enlarged nextyear's supply of coffee by adding part of thisyear's stored stocks to next year's reducedharvest. The consumer next year will havemore coffee to consume and at prices lowerthan if we speculators had not carried morecoffee from this year over to next year. Forthat, the consumers should thank us-notcondemn us!

"We speculators did not cause the re-duced supply of coffee next year. Nature didthat. There simply is going to be less coffeenext year. The choice facing people is: 'Shallwe continue to consume coffee today as ifthere were not going to be less next year,and then reduce consumption next year bythe full reduction in the harvest? Or, shallwe start to reduce consumption this year?'The choice is not more coffee rather thanless, nor is it lower prices rather than higherprices; it is 'when shall the available coffeebe consumed?'

"We speculators enabled people to bebetter off than otherwise, despite their pro-testations about the currently higher price ofcoffee. From the fact that next year's pricesare predicted to be higher than this year's, Iknow that people prefer to give up a pound

,,'~

I 84 Chapter 4

now in order to have one more next year. Itis precisely because of this consumer prefer-ence that the futures price for next year'scoffee rose over the present price of coffeethis year. If our forecast is right, we willmake a profit; if wrong, a loss. The profit-ability of our activity is an acid test that peo-ple did want some coffee shifted to the fu-ture.

"As speculators, we immediately actedon our prediction of less coffee next year.We are not responsible for that bad event,but we are responsible for anticipating theunfavorable effects of impending events sothat people can more cheaply adjust tothem-so they will be better off than if newsof the coming crop failure were hidden untileven more of the current crop was eaten up.

"But what if our predictions werewrong? Suppose only a few buds on each treewere damaged, and the hardier, undamagedbuds produced even bigger coffee beans-more than enough to compensate for the re-duced number, so that the crop next yearwill in fact be even larger. Or suppose thecold snap did no damage at all. Or maybe thenews about cold weather was simply false:After all, some South American governmentshave been known to issue false bad newsabout an impending coffee crop precisely todrive up the spot price of their existingstock. What then?

"The answer is simple. If speculators orpeople who store coffee make mistakes inforesight, they will lose wealth; they willhave paid more for the coffee than they willget when they sell it.

"I will not go so far as to say that anydamage done to other people-in the form ofhigher present prices-by our erroneousforecasts is made up to them by our losses-atransfer of some of our wealth to the rest ofsociety. In part this is correct, but still, per-verse forecasts do more damage than our lossof wealth to the rest of society can offset.They do damage in the sense that if our fore-casts had been more correct, everyone could

have achieved a more desirable adjustmentin consumption patterns over time than werein fact achieved. Obviously, the more accu-rate our forecasts, the better for us and foreveryone else. The less accurate they are, theworse for us, and the less helpful to others.However-and this is crucially important-the results are not as bad for everyone else asthey would be if everyone had to do his orher own forecasting and storing of stocks forpersonal consumption, thereby bearing thefull consequences of his or her own fore-casts-right or wrong.

"Clearly, then, the issue is not whetherthe forecasts are correct or incorrect in everyinstance. The issues are instead: (a) Whatsystems exist for making and acting on betterforecasts? (b) What systems exist for allocat-ing coffee among people over time and forallocating the risks and consequences of theerroneous forecasts? Any system will have er-roneous forecasts, but which one will havefewer of them? And who will bear the majorburden of their consequences?" .

And so by answering one question ourscenario poses new ones, to which we turn.

PRICE-FORECASTINGERRORS AND RISKSIN FUTURES MARKETS

Do speculative markets, to which everyonehas access, predict future prices more accu-rately than some other possible scheme? Tofind an answer, let us look at onions. The or-ganized futures market in onions was abol-ished by federal law in 1959. Among thosewho wanted the markets closed were firmsthat specialize in collecting, storing, sorting,and distributing onions to retailers. Withoutan open futures market, information aboutonion conditions is less widely dispersed. In-siders, such as these processors, can benefitby their more exclusive access to informationand opportunity to buy and sell onions. Howthey managed to induce enough members ofCongress to vote for that legislation is a

question for your professor of political sci-ence. However, as it happens, this prohibi-tion provided a fine opportunity to comparethe behavior of prices with and without fu-tures markets. The record is clear: With theorganized futures markets for onions, theforecasts were more accurate than when theywere closed. In particular, with open specula-tive markets, prices varied less betweencrops than without them. In other words, thefutures prices-the present forecasts of fu-ture spot prices-influenced present spotprices more accurately toward reflectingwhat was going to happen, avoiding the largefluctuations that occur when spot prices re-spond to unforeseen events.

How should the consequences of fore-casting errors be borne? It has been con-tended that only experts should be allowedto make speculative decisions; this wouldavoid the errors made by less-informed peo-ple. To this there are several considerations.First, if experts are now better informedthan the consensus of the markets, theycould very rapidly get wealthy by speculat-ing. The experts' superior informationwould help move the present spot and fu-tures prices in the direction they would havetaken if there was a futures market. Second,there is the problem of finding experts.When the government employs a group ofspecialists in this matter, the specialists arenot automatically superior forecasters. Thepredictions of experts differ.

If, despite these inherent difficulties, agroup of experts were responsible for makingforecasts and controlling the storage rates,who would bear the losses when the forecastswere erroneous? Shall we require that eachand every person, whether voluntarily or in-voluntarily, shall bear, in proportion to one'staxes, the changing values of the stocks ofstored commodities? If the speculative activi-ty is a voluntary arrangement, with open fu-tures markets, those who want to bear moreof the risk can hold more of their wealth in


the form of stored goods, and those whowant to be relieved of those risks can ownother forms of wealth. This points up onefundamental feature of a capitalist system:Individuals can adjust their patterns of risk-bearing, as well as their pattern of consum-ing goods. If you wish to avoid the wealthchanges of certain goods, you can own othergoods. Although it is impossible to complete-ly avoid risks, choosing among types of risksis possible with open markets and private-property rights. But whether that is desir-able, economics cannot say.

Having chosen not to bear the risk ofwealth changes in a certain good, a personshould not complain if its price later rises.Such complaints would amount to the asser-tion that insurance is wasted if the disasterth~t was insured against doesn't happen! (Inthis case, by not holding goods in advance ofuse, one has insured against decreases intheir value.)

Some people mistakenly believe thatspeculation can be prevented by legally im-posing fixed prices on commodities. Butprice controls do not prevent shifts in de-mand or supply. They reduce the opportuni-ty of people to use exchange to adjust theirdifferences in personal values among goodsas well as among risks; they create shortagesand surpluses, phenomena that do not occurwhen there are open markets.

86 Chapter 4

SPECULATION UNDEROTHER ECONOMIC SYSTEMS

All societies must decide who will bear theprofits and losses; the issue cannot be evadedby abandoning a capitalist system. Only themethod of allocation varies from system tosystem. In a capitalist system, individuals cannegotiate among themselves, offering to ex-change "this" risk of loss or gain for "that"risk. Just as people negotiate for the particu-lar pattern of consumption goods they shallhav~, so they can negotiate about the patternof risks they shall bear. Although the optionof bearing no risk at all is open to no one, ina capitalist society risks in one kind of wealthmay be exchanged for risks in other kinds ofwealth. In a socialist system, risks are not in-d.ividually negotiable with other people. Ther isks of value changes in state-ownedgoods-those owned by the people as awhole-are borne by everyone in the form ofthe taxes they pay and the kinds and qualityof state-supplied services to which they haveaccess.

If you believe a person should have lesschoice in one's risk patterns, and if you thinkthe people who control the use of goodsshould not bear the risks, you will prefer toreduce the scope of private property. But ifyou prefer a wider choice of risk patterns andthat those who control use also bear therisks, you will prefer a greater range of pri-vate property.

Chapter 5InformationCosts andAchieveDlentof Exchanges

Many prices are fixed, or are so sluggish andunresponsive that we see shortages; com-monplace signs are waiting for a table in arestaurant or for a•.seat on an airplane or atthe hair stylist. At other times, sellers oftenhave unused, spare capacity-vacant tablesat a restaurant, empty seats on an airplane orat the hair stylist, and unemployment. Whydon't prices respond quickly enough to adjustthe amounts supplied and demanded to oneanother? And why don't resources mo~emore quickly to their new highest-valueduses? These real-world phenomena seem tothrow our analysis so far open to doubt.

But they do not. The reasons for the ap-parent discrepancies are some assumptionsthat we deliberately made to simplify ouranalysis. These assumptions were:

1. Sellers can detect and respond to persist-ing changes in demand and supply.

2. For all goods there are exchangeable pri-vate-property rights.

3. There is no charity.

4. There are no public goods-goods thatcan be consumed by some without thesupply for others being diminished.

5. No seller has a sufficiently large share ofthe market to significantly affect theprices at which he or she could buy(wholesale) or sell (retail).

6. It costs potential buyers nothing to ob-tain full information about the availabil-ity and performance of goods and suppli-ers' services.

7. Contracts can be drawn up, entered into,and enforced costlessly.

These simplifying assumptions permiteasy and valid exposition of such features ofour economy as how gains are obtained fromexchange, how demand and supply interact,how price allocates supplies among the many

87

demanders, and why shortages occur andhow they differ from a simple reduction insupply. To comprehend many other featuresof a free-market economy and to understandwhy prices and resources respond less thaninstantaneously to changes in supply or de-mand, we must relax the assumptions and in-troduce more real-world details. Doing so,however, does not upset any of the results ofour prior applications. In this chapter weabandon the first four simplifying assump-tions. In later chapters we shall modify theothers.

Buffer Stoeks,Waiting Lines, andPriee Responses toDemand Uneertainty

Every day consumers' purchases fluctuate inrandom temporary ways. Neither consumersnor suppliers know exactly who will want tobuy how much of what, or when. Such infor-mation would be so costly to obtain that it isimpossible to get. Instead people devisemeans to adapt to, or accommodate, thosetransient, unpredictable fluctuations. Themain way that suppliers do so is by holdinginventories. Consider the options facing anewsstand owner who sells a daily average of100 copies-but not exactly 100 per day. Hecould: (I) ask buyers to commit themselvesto their demand in advance by reserving acopy; (2) buy fewer than 106 copies and rare-ly have any unsold copies; (3) buy more than100 copies and usually have copies left over;(4) buy one copy at a time, ordering each asthe preceding one is sold by using a special-delivery service.

The newsstand operator's options arelimited by customers' preferences: Custom-ers prefer instant availability from inven-tories, even at a slightly higher, but predict-able, full price of the newspaper. (The full

88 Chapter S

price must be higher to cover the costs of theseller's ending up with unsold extra copies.)The higher price to customers may be solelya higher money price, or may take the formof a smaller newspaper or fewer retailers. Butthis option of higher full price is less costlythan the sellers' attempting to obtain com-plete advance information or making instan-taneous and unpredictable price adjustmentsto momentary demand changes. In otherwords, holding seemingly idle or unemployedinventories can be an economical use of re-sources.

MONEY PRICE PLUSVALUE OF TIME EQUALS FULL PRICE

Sellers don't instantly and temporarilychange prices every moment to eliminate allshortages, that is, to instantly clear the mar-ket of every excess amount demanded. Imag-ine a restaurant in which the price of foodwas adjusted instantly to avoid any waiting.Because prices would be less predictable,planning by buyers would be less useful. Ac-cepting the prospect of having to wait a bitcan permit a more predictable price and bet-ter consumer planning. If sellers hold inven-tories or provide greater capacity to handletransient random peak demands, the resultsare more predictable prices, shorter waitingtimes, better planning by customers, andlower costs to customers. On the other hand,a sufficiently large reserve capacity to caterinstantly to every peak demand would bevery expensIve.

The value of the waiting or service timeis, as we have seen before, part of the fullprice. Some goods require more time for pur-chase or consumption than do others. Hair-cuts may cost $10 and about half an hour,whereas one can buy $10 worth of gasoline inabout one minute. Thus, the full price of thehaircut is greater than that of the gasoline. Around of golf may cost $20 and four hours,while $20 of nightclub entertainment takesonly one hour. The money price of a trip to

Europe by air may exceed the price of a tripby boat, yet the full price by air may be lessbecause it takes less time.

Some restaurants and stores give quickerservice at a higher money price but with alower full price to buyers who value timemore highly. People with high hourly wageearnings (such as surgeons or consultingeconomists) demand and get quicker servicethan do people with low hourly earnings. Pa-tients wait to be seen by a doctor unless theirtime is more valuable than the doctor's.Charity patients wait and wait and wait fordoctors' services. The more a buyer rewardsthe supplier with money in return for nothaving to wait, the more likely is the suppli-er to provide reserve capacity, and the mar-ket-clearing full price will include a smallerproportion of non money costs to money pay-ments. But it won't necessarily eliminate allchance of some waiting time.

Because money and waiting time can bepartially substituted for one another as com-ponents of the full price, sellers can adjustcapacity and techniques to conform to differ-ent customers' preferences. Some suppliersoffer less risk of waiting but at higher or lesspredictable prices, whereas others offer moreuncertainty about waiting time but at loweror more predictable prices.

Reserve Capacity It is commonly thoughtthat an industry is sick if it has excess capaci-ty that is almost never fully used (for exam-ple, barber shops and service stations). Butthis is not necessarily true. Does Palm Beachhave too many hotel rooms because many ofthem are empty during the summer, or arethere too many ski resorts because they areidle most of the time? To understand whysome resources are idle sometimes, let uslook at rental housing.

An inventory of empty apartments is notnecessarily an idle or wasted good. Becausehousing is produced in advance at a less rap-id, and therefore more economical, rate, andbecause a reserve is held in case demand in-

creases at random times, both holders ofhousing and consumers economize. Althoughhousing services per unit may be somewhathigher in price (to cover the costs of vacan-cies the owner is holding), those vacancies al-low lower search costs and enable people tomove without committing themselves long inadvance to moving. We could reduce hous-ing costs by building fewer apartments andthus having fewer vacancies, but that wouldforce people to plan more of their activitieswell in advance and prevent them fromadapting quickly to new situations. (Imaginewhat it would be like to try to move in acommunity that had just as many apartmentsas families so that every apartment was al-ways rented.) On average, the inventory ofempty housing that enables people to conve-niently search for and move into differenthousing is small: About 3% of the rent paidby apartment dwellers covers the cost of thatvacant apartment space.

Fire escapes, fire hydrants, first-aid kits,and smoke alarms would be wasteful only ifcomplete information about the future-suchas whether, or when, a fire or an injury wouldoccur-were free in advance, or if instantproduction, adjustment, and informationwere no more costly than slower adjustmentor gathering of information. But because in-stant adjustments do cost more, we reservewhat might be miscalled idle resources.

The Illusion ThatCost Determines Price

Many prices appear to be set by costs insteadof by competition among demanders. To seehow appearances can be deceptive let us lookat the demand for meat. Suppose that forsome reason people's demand for meat in-creases. At existing prices consumers de-mand more than they did. As sales increase,butchers' inventories are unexpectedly de-pleted. Normally, a butcher, like any retailer,

Information Costs of Exchange 89

carries an inventory larger than the averageof daily sales, for the reason we have just ex-amined: to accommodate transient increasesin sales without running out of stock or hav-ing to raise prices late on days of large de-mand. Inventories help to assure immediatesupply at more predictable prices.

Furthermore, virtually no seller sells ex-actly the same amount of good day after day.Although the basic consumption demand hasnot necessarily changed, amounts purchasedin anyone day vary at random around somestable average. Thus, because sellers do notregard every change in sales from one day tothe next as a persisting change in consump-tion rates or demand schedule, sellers willnot immediately detect an actual shift in de-mand. (Because we are looking only at howprices in fact respond to changes in demand,we are deliberately ignoring important waysin which change in demand affects produc-tion and employment.)

No butcher knows instantly that the con-sumption demand has risen for the communi-ty as a whole. Any butcher knows only thathe or she has sold more meat at the existingprice. The increase may be transient, or mayrepresent some other butcher's loss of busi-ness. Nevertheless, the butcher will buymore meat than usual the next day to restorethe abnormally low inventory, and will buyeven more if he or she believes that sales willcontinue at the higher level. If the aggregatedemand for meat has increased, the aggre-gate of butchers will increase purchases fromthe packers, the wholesale s~ppliers, and theincrease will persist.

Packers, like retailers, keep inventoriesas buffers against sales fluctuations. Packersrestore their inventories by instructing theircattle buyers (who travel among cattle rais-ers, fatteners, and stockyards) to buy morethan usual. But if all the packers are restor-ing inventories, not enough cattle are beingsupplied to meet the increased amount de-manded at the old price. Some packers can-

90 Chapter 5

not get the amount requested unless theyboost their offer prices to persuade cattleraisers to sell steers to them instead of to oth-er packers. Each buyer, although acting inde-pendently, offers a higher price along withevery other buyer. The cattle raisers let thebuyers bid against each other until the pricerises to a point where the packers do notwant to buy more meat than is available.

We could describe these events graphi-cally by saying that the demand curve forcattle is shifted upward, leading to a highermarket-clearing price for cattle. That higherprice sends each packer back up along his in-creased demand curve, so each packer buysless than would have been bought at the oldprice. The price rises high enough to reducethe total amount demanded to match theamount supplied. Each packer must pay ahigher price for cattle to avoid getting lessthan before. Competition among packersraises the price before cattle production canbe increased to meet that new demand. Butcattle raisers will then begin to incur greatercosts to increase production of cattle up tothat amount at which the expected costsmatch the expected price of cattle. In thisway, prices, which depend on demand andsupply, also determine how much cost can beincurred to produce more.

Cattle raisers increase their wealth bythe higher selling prices. To packers this is arise in costs. Yet the cost to cattle raisers didnot increase; nor did the costs of getting cat-tle to market, efslaughtering, or of distribut-ing meat. The higher price paid by packersto cattle raisers is a result of the increasedconsumer demand, which is expressed all theway back through to producers, where it be-comes evident as higher prices for the exist-ing amount of cattle and for resources usedto produce more cattle.

As the price of cattle is bid up (meaninghigher costs to the packers), packers charge ahigher price in order to allocate meat to re-tail butchers whose demands for meat haveincreased. Retail butchers, in turn, post high-

er prices to consumers (which can be sus-tained only because consumers' demand hadinitially increased). When consumers com-plain about the higher price, butchers, inhonesty, say that it isn't their fault. Theprice they pay to get meat has gone up. Ev-ery butcher can say, "I never raise prices un-til my costs go up." And the packers canhonestly say the same thing.

Consumers who want to know who is toblame for the higher prices of meat can lookin the mirror behind the butcher's counter.They might then say to each other, "If youdidn't want more meat, I could have more."The exchange system glosses over this facetof competition among buyers. The buyer-seller negotiations make it appear as if thehigher price of meat were caused by the sup-pliers-the butchers, packers, and farmers-instead of by consumers. For example, in aperiod of inflation consumer prices appear torise because costs are rising; but fundamen-tally what has happened is that a large in-crease in the money stock has increased con-sumers' demand for goods, and that largerdemand has run up against limited stocks ofproductive resources with a resultant rise inprices. Inflation is a phenomenon we explorein Chapter 19.

Private-Property lRightsPrices are guides to how goods are allocatedonly if people have incentives to make offersand to respond to them, as expressed byprices. If exchangeable private-propertyrights in goods are weak or ill-defined, priceswill have less influence.

What do we mean by private propertyrights? A person's private-property rights arethe expectation that what one decides to dowith certain resources will be effectively car-ried out, or realized. The greater the proba-bility that those expectations will be upheld(by custom, social ostracism, or governmentpunishment of violators), the stronger are

private-property rights. In addition, private-property rights contain the right to exchangeuse rights with other people. In sum, two es-sential elements of private property are theright to authorize ...uses and the salability ofthat right.

To the extent that rights to goods andservices are well defined, enforceable, and in-expensive to transfer (by sale), the market-exchange system, operating through prices,for controlling the use of goods is effective.If, in using my goods, I usurp your authorityover your goods, I violate your rights to yourgoods. I can legally throw a rock throughyour window or tear down your house anddump garbage on your land if, and only if, Ifirst obtain the rights from you.

In the following sections we will exploresome cases in which the rights have not beenwell defined or, if defined, have not beenclearly assigned to particular people, withthe result that disputes can arise as to whomthe rights belong. Moreover, in some casesthese rights, even though well defined andassigned, may be too expensive to enforce inevery respect. If I burn garbage or emitsmoke, foul smells, or airborne acids overyour land, I am using resources whose owner-ship is not well defined or identified. When Idrive my scooter with a blaring exhaust thatsends sound vibrations across your property,I momentarily detract from its physical fea-tures. When a steel mill uses water and dis-charges water of lower quality or when a re-finery dirties the air, these acts use andchange the characteristics of resources thatno one seems to own. This is often called"excessive" pollution, "nuisance," "invasionof privacy," "tort," "theft," or an "external-ity." They all are results of the absence ofwell-defined, enforceable private-propertyrights to goods and labor services, which arenecessary rights if a market-exchange pricesystem is to operate as outlined in the pre-ceding chapters.

Consider first the problem of defining


or identifying rights. We are slowly learninghow to monitor and exchange rights to radioand TV airwaves. Airlines are increasinglyable to monitor planes with sufficient accu-racy to measure, police, and exchange rightsto moving cocoons of airspace. Water is stilla relatively expensive item to control in itsnatural state, though not after it has beencaptured in reservoirs, canals, or pipes.Since a resource that is not controlled byprivate-property rights will be less likely tobe controlled by market prices and ex-change, you can be sure that if the supply ofwater should fall, say because of a droughtin some area, shortages and political controlover the use of the water will be increased,rather than letting sufficiently higher mar-ket prices allocate the scarcer water, as isdone with lumber, meat, and so on. There-fore we forecast with great confidence thatin the near future (a decade or so) the sup-ply of water will not increase as rapidly asour growing population, and so the marginalvalue of water will rise. But it is unlikelythat the price of water will be used to allo-cate and move water from area to area, orbe used to control amounts used. Instead,shortages will be created, and political con-trols on water will be used more extensivelythan they are now. Like the oil situation ofthe 1970s, the "water shortage" will be theissue in the 1980s and 1990s-this time a re-sult of a failure to use market prices becauseof an inability to assign enforceable private-property rights to water. ,"'

Where technology and the advance oflaw have enabled specification of enforce-able property rights, exchange through mar-ket prices has been more common, even forthe control of air, water, streets, airspace, ra-dio and TV frequencies, and that greattreasure bed, the ocean floor. As the effec-tive range of surveillance over the ocean in-creases, greater distances from the shore arebeing claimed by the nearest country-ashas already been done for oil rights hun-

92 Chapter S

dreds of miles into the North and Caribbeanseas. Peru, Chile, Mexico, and Iceland areclaiming and selling rights to fish withintheir claims to the ocean as far as 200 milesfrom their shores. Such claims give some in-centive to conserve ocean resources ratherthan permit overfishing, just as such rightsnow do for land use. Wars have occurred asnations attempt to establish their propertyrights to land and oceans. The status ofclaims to Antarctica is unclear, and the fu-ture will probably see painful attempts toclarify or establish rights.

Nevertheless, though private-propertyrights may be well defined and assigned tospecified persons, making exchanges ofrights and collecting payments may be morecostly than the value of the use of the re-sources. For example, the use of some park-ing spaces costs more to monitor than thevalue of the parking spaces, with the resultthat the landowner will have no incentive torent space for parking. Either he gives awayparking rights or lets no one park. Pricingwill occur only if devices are available (forexample, parking meters with police en-forcement) to lower the costs of collectionand policing, or if the demand rises suffi-ciently to raise the exchange value abovethose costs. For example, where labor to en-force exchanges and to monitor uses ischeaper relative to the value of the land'suse, as in Europe compared to the UnitedStates, or in U.S. cities compared to sub-urbs, our analysis would imply that parkingattendants are more likely to be used to col-lect fees and police the space; and that is infact what happens. To take another exam-ple, if theater ushers' wages are high rela-tive to admission values for some theatricalperformance, fewer ushers will be used.Seats will more likely be sold at a uniformprice and selected first come, first served. InEurope, or in "live" theaters, where wagesare lower relative to theater-seat values, agreater variety of seat prices exists. Differ-ent quality seats within the theater will be

monitored and priced with a higher moneyprice that equilibrates demand with supply.In the full-price equilibrium, money will bemore important and non money costs such aswaiting will be less.

Parking meters permit cheaper meteringand monitoring of street parking, and aremore likely to be used where parking-spacevalue is high enough to warrant the costs ofinstalling and operating the meters. As yet,no one has devised an economical way fordrivers to use the parking lane as a travelinglane by bidding for that space from thosewho want to park, and so such transactionsdo not take place. However, we are nothelpless; as the excess of value for drivingover parking becomes larger, political con-trols via legislation are used to prohibitparking in curb lanes during "rush" hours.

At the present time a center of intenseinterest and great monetary stakes is the useof devices to protect and monitor exchange-able private-property rights to televisionprograms. Economical cables and decodersnow permit pricing.

In summary, when cheaply enforceabletransferability and well-identified, securerights do not prevail, the market-exchangeand price system for controlling uses ofgoods is weakened. Other forms of competi-tion and control are more likely. Resort maybe made to courts or even to wars. Thewestern states take one another to court indisputes over water from various water-sheds, but they don't fight about the use offorest land, oil, iron are, coal, or othernatural resources-because rights to themare privately owned and are transferable. IfCalifornia, Arizona, Utah, and Coloradowere separate nations, the conflict of inter-ests over the water in the Colorado Riverwould not unlikely result in war. Cities up-stream dump sewage, and cities downstreambear the consequences; so each city com-petes for better water by building pipelinesfarther upstream nearer the source of thepurer water.

POLLUTION, SAFETY,AND PROPERTY RIGHTS

More Steel or More Clean Water Analyt-ic attention to the", role of transferable prop-erty rights will help clarify some current is-sues emanating from what is called theproblem of environmental pollution. Imaginea steel mill making steel and dumping chemi-cals into a nearby stream, reducing the clean-liness and value of the water downstream.The analysis is clarified in Figure 5-1, ,-,,:hiSbis based on the principles used in Chapter 3to explain the gains from trade. The heightsof the line labeled DD represent the margin-al values of steel production enabled by useof water. The quantity of water used in steelproduction is measured along the horizontalaxis. But that water could have been used inother ways, with values shown by the lineww. Starting from the upper right and go-ing to the lower left, it shows the decreasingmarginal values at greater amounts of fresherwater in nonsteel uses. With maximum steelproduction and little clean water, the valueof the marginal unit of steel is lowest, givenby the height of DD at the extreme right ofthe diagram. The value of the marginalamount of clean water sacrificed to makethat unit of steel exceeds the value of thatmarginal unit of steel. An amount of steelproduction greater than at X is not worth thecleaner water sacrificed.

The total use value to consumers of thesteel is indicated by the area under the wholedemand curve for steel, DD, out to whateveris the amount being produced, whereas thetotal use value to consumers of cleaner wateris the area under the demand curve for wa-ter, WW, reading from right to left. The fig-ure makes clear that maximum production ofsteel would sacrifice clean water worth morethan some of the extra steel. So the steel out-put that maximizes the value of steel plusthe value of water is the steel output X.

But how can that amount be achieved in


::::::::::::::

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Excess of

W ::::::::::::::::::::::::::::::::::::::::::::-:.;.:.

D

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Marginal Values ..<~~::·l:~:·lofCleanwat:xces{:;I!i~,

Value of :~Clean Water ~:

over ~~Value of ~~

Forsaken Steel ::

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• •.-Very Polluted

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Figure 5·1.

OPTIMAL TRADEOFFBETWEEN OUTPUTS OF TWO GOODS

OptimalWater Quality

an economy where the water cannot bebought and sold in a free market? A govern-ment agency may stipulate an allowable max-imum amount of discharge of pollutants-ineffect giving the steel consumers the right tothat much clean water. Or the governmentcould levy a tax=-that is, charge a fee-onthe right to discharge chemicals into thestream. If the price charged exactly equaledthe marginal value of a unit more of cleanli-ness of water at the intersection of the twocurves DD and WW, the steel producerswould produce the quantity of steel corre-sponding to that intersection. It would do sobecause its cost of steel now includes the lostvalue of the water it dirties-a cost that itformerly could ignore if no one owned thestream. In effect, the political authoritiestake control of the water and sell its use tothe steel producers at a price (the tax) that

More of one good can be produced only if there is lessof another good. That optimal combination is X. At anypoint to the left of X people would be willing to have lessunpolluted water to have more steel; to the right ofX people would be willing to have less steel tohave more unpolluted water. ::

94 Chapter 5

reflects its value as cleaner water. If that feeor price is too low, too much steel will beproduced. If it is too high, more clean waterwill be available than people would want ifinstead they could have more steel.

Some people complain that such a tax orsale of right for discharging water gives thesteel mills a license to pollute. That is cor-rect, and is exactly the same as your getting a"license" to eat meat when you buy meat.The pertinent issue is not what the paymentis called, but what the appropriate price is toget the appropriate amounts of steel andcleanliness of water.

A third, hypothetical way is to assignprivate-property rights to the water and per-mit its owners to sell it to users. The value ofcleaner water would be made evident to sell-ers by the price that consumers offered fordifferent qualities of water. And the value ofthe steel would be evident by what the steel-mill operators, as middlemen between con-sumers and water owners, would be willingto pay for different amounts of water fortheir use. The water owners could simplycompare these two values and sell rights touse or pollute the water up to the amount ofsteel at which the steel mill (reflecting con-sumers' value of steel) is willing to pay morefor the water than the consumers would payfor fresher water. The result will be the situ-ation X-the amount of discharge that maxi-mizes the consumption value of the outputof steel plus cleaner water. This result couldbe achieved if private-property rights in wa-ter were cheaply salable and controllable.But they are not.

Another alternative procedure is to per-mit steel mills to use water but require themto clean it before discharging it so that bothmore steel and more clean water can be had.However, cleaning the water uses resourcesthat could have been used to make othergoods. There is no escape from the need tobalance more of this against more of that:We can't have more of everything. Each de-sired good has a cost-the best alternatives

sacrificed-and to talk and try to act as ifthat were not true is to make yourself worseoff.

Worker Safety When the government im-poses employee safety standards in coalmines or makes the mine operators liable forminers' injuries or loss of health, the supplyof labor willing to work at that safer level ofwork becomes larger and depresses theequilibrating wage. Workers pay for thatsafety with a lower salary. If the safety levelswere a lot lower, the supply of labor wouldbe smaller, and wages would be higher. Ifworkers had the right to renegotiate any po-litically imposed safety standards with mineoperators, they could trade some salary forgreater safety, or vice versa, reaching thepreferred point-regardless of the initial lev-el of safety.

Allocation underRights Other ThanPrivate Property:Nonprofit Institutions

Even in the United States, where the econo-my is predominantly a free market, not allbusiness firms are based on private property.A nonprofit corporation has assets (forms ofwealth) that are not owned by anyone whocan distribute gains to themselves or sellthose assets as they can sell private property.All proceeds must be spent in the enterpriseto further its specified purposes. Most pri-vate colleges are nonprofit institutions, as aremany hospitals. Almost all religious and fra-ternal organizations and unions are nonprofitorganizations. In nonprofit corporations theoperators have less incentive to heed themarketable value of the enterprise's activi-ties.

Nonprofit corporations-for example,RAND Corporation, Brookings Institution,Harvard University, and nonproprietary hos-


pitals-have incentives to provide services inmore expensive, manager-beneficial ways.Costs are higher, because no one could claimthe potential savings from lower costs or bet-ter operation as effectively as could ownersof a private, for-profit organization. Manag-ers are better able to indulge their personalpredilections in choosing employees, evenchoosing those who are less productive overothers who could be hired at the same sala-ries. For example, they might hire prettiersecretaries or only members of their own eth-nic group, or not hire as many members ofthe opposite sex. Performance standards foremployees, and for their dismissal, are lessguided by the market values of services; ten-ure is stronger than for employees at equalsalaries in private, for-profit businesses. Fur-niture and equipment will be more luxuri-ous. Such are the implications of economicanalysis.

Nonprofit institutions and governmentagencies are less likely to charge market-clearing prices for goods and services. Short-ages or surpluses are therefore more likely.So is discrimination among buyers by the useof non price criteria. This can be summarizedin this statement: The market-clearing fullprice of a nonprofit institution is guidedmore with a non money price and less with amoney price than is a private-property enter-pnse.

PhilanthropyEvery year billions of dollars are donated asphilanthropy, or charity. Concerts, museums,and libraries are financed by donors wantingmore of the kinds of cultural activity such in-stitutions provide. Almost every college issupported by people who want to give edu-cation to young people. Because the tuitionprice is below the market-clearing price, ap-plicants must compete more on nonpricebases.

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An economic analysis of charity or giftsmay seem contradictory. How can peoplegive gifts if they are assumed to be selfish?Remember, however, we did not assumepure selfishness. Each of us can be, and is,concerned about other people's well-being. Iwould prefer other people to be richer thanpoorer, even if it cost me something. Thelarger my wealth relative to the poor, thegreater my willingness to contribute to thepoor, just as a larger amount of candy in-creases my willingness to give up candy forCokes. This implies that the richer contrib-ute more charity, and they do. Furthermore,I would be induced to give still more bymatching grants, because each dollar I giveup would then direct more than a dollar tothe pOOLl

WHO GAINS WHAT FROM A GIFT

A gift is equivalent to a sale at a price lowerthan the market-clearing price. The effectsare complex but can be seen if we apply ourdemand theory and personal-value concepts.

Suppose you were admitted to a collegethat charged a tuition below what it cost thecollege to provide your education. To ana-lyze the effects on you, use the following fiveconcepts and associated values (the valuesgiven are assumed for illustration only):

A. The cost to the college ofeducation

B. The tuition charged

C. How much you wouldhave spent for tuition atanother college if tuitionhere were full-cost

= $1000

= 700

= 800D. The full personal value

you attach to the educa-

'Income tax deductions for gifts are another way to re-duce the donor's costs of giving money to other peo-ple-but that also means other taxpayers pay more tooffset the donor's reduced tax payments.

tion here at the below-cost tuition college = 1450

E. The personal value youattach to the educationyou would have obtainedif the below-cost tuitionhad not been available = 1300

Taking these figures, we compute:

1. The cost of the subsidy borne by thesubsidizer: A - B = $1000 - $700 =$300

2. The release of cash spending power tothe recipient: C - B = $800 - $700 =$100 .

3. The greater personal value of educationto the student: 0 - E = $1450 - $1300= $150

Under these circumstances the consum-er's surplus achieved by the student who ac-cepts the subsidy is the student's total per-sonal value minus the tuition: $1450 - $700= $750. The total personal value of the edu-cation at the other college minus the full-costtuition ($1300 - $800) is only $500. So thesubsidized education is chosen, because itcosts the student $100 less, and also is worth$150 more in educational value to that stu-dent.

The total value of the gains to the stu-dent in cash and increased education is $250(items 2 and 3: C - B plus 0 - E), but thisis $50 less than the subsidizer's cost, $300(item 1: A - B). From the student's point ofview, the subsidizer wasted $50 because thestudent would rather have had a $300 gift incash to spend than $100 in cash plus $150 inbetter education. The subsidizer may thinkthe value of the increased education to therecipient is greater than the student does. Bythat subsidy the donor has induced the stu-dent to act in a way the donor prefers. Butthe student would be made just as well off, in .his or her own way of judging, if the cash gift

had been $250. From the recipient's point ofview every gift in kind will involve somewaste-if the gift induces the recipient tomake life-style changes that would not havebeen made had ...payment been strictly incash.

Compare these results with those for an-other student with the following preferences.The second student is assumed to value thelow-cost education at $1075, and would havespent $1100 on education if the alternativewere full-cost tuition, which the student val-ues at $1200. Given these data, we can cO'm-pute that the student gets a $400 cash release(C - B = $1100 - $700) but a reduction invalue of education attained of -$125 (0 - E= $1075 - $1200). So the student ends upwith less education but more money for oth-er things, a total gain, as valued by the stu-dent, of $400 - $125 = $275, which cost thecollege tuition subsidizer $300-a $25 wastefrom this student's point of view, though notnecessarily in the subsidizer's scheme ofthings.

The foregoing analysis can be shown toimply that a grant of money is more desir-able, dollar for dollar, from the recipient'spoint of view, than are gifts or subsidies ofparticular goods. This provokes the questionof why so much charity, both private andgovernment, is in "kind" or a subsidy for par-ticular goods-for example, education, food,or housing-instead of cash paid to peoplewho can then buy what they deem most ap-propriate. Is it that donors want to changethe life style of the recipients? Or that recipi-ents can't be trusted to act in ways that thedonors consider sensible? Or because thesuppliers of subsidized goods are enriched bysubsidizing demand for their services? Eco-nomic analysis has not yet satisfactorily an-swered these questions. But the analysis itdoes provide, as explained by means of thestudent-tuition example, helps reveal conse-quences that appear to be widely ignored.We take up a few of these in the following


paragraphs; some are intentional and someappear to be unintentional.

FOREIGN AID

Every year the U.S. government grants aid(gifts) to some foreign governments, ostensi-bly for specific purposes. If the Egyptiangovernment is given $10 million to build adam, what has Egypt gained? Suppose Egypthad intended to build the dam anyway, fi-nancing it by domestic saving. Then the giftfor the dam releases some income of theEgyptian government for other things. Thegift, purportedly for a dam, is actually usablefor general purposes; the Egyptian politicianssimply have $10 million more than other-wise. Conceivably, the Egyptian governmentcould lower taxes, thus leaving Egyptianswith more income for personal consumption.Or the government itself could spend the ex-tra funds.

UNINTENTIONAL CHARITY

Intent does not necessarily determine whathappens. For example, to operate a new tele-vision station you must obtain a license fromthe Federal Communications Commission(FCC). The value of a license is far, far morethan its price (which is zero)-often millionsof dollars more. Many applicants appeal tothe FCC for a license." The law creating theFCC forbids allocating channels first come,first served (although it was done for radio inthe early 1920s). Instead, the FCC choosesamong applicants. The applicant must showhe is "fit" to operate a station and that hiscommunity "needs" another station-over

"The number of channels that can be used at one timeis not a technologically fixed constant. It depends uponthe kind of receivers and transmitters used. More ex-pensive and sensitive equipment greatly increases thenumber of available channels; and the possibilities withtransmission by cable are enormous.

. I,,! .

];tl 98 Chapter S

protestations of the owners of existing sta-tions, the value of which might fall. Moneythat would have been paid to the govern-ment under money price competition is in-stead devoted to other forms of competitionfor the commission's favor. Because millionsof dollars are at stake, millions are spent inthe competition.

What criteria do commissioners use forallocating licenses? Respectability, moralreputation, dedication to public service, andeducation. A newspaper publisher is an at-tractive candidate for a license, being experi- .enced in collecting and disseminating news.But an applicant who doesn't promise reli-gious programs, and intends to play mainlyjazz and Western shows, with few-if any-cultural, political, or news programs or pub-lic information, has only a small chance. Theapplicant must detect the preferences of thecommissioners. Although an applicant mustnot offer outright bribes to the commission-ers or their staff, some kinds of behavior fa-vor granting of a license: If in the past theapplicant hired some of the FCC technicalstaff to operate other radio or television sta-tions, or is a former member of Congress oremploys one as legal counsel before theFCC, the applicant clearly recognizes ablepeople and could therefore successfully oper-ate a television station. Neither the govern-ment nor the winning applicant receives thefull value of the broadcast license. Instead,part is dissipated in paying legal fees andpublicity costs, in producing the kinds ofprograms the FCC commissioners prefer,and in paying other expenses incurred whilestriving for the license. Thus, even thoughthe money price of the license is zero, thefull price of getting it is substantial-not tomention the costs of the losing applicants.The same basic story applies to acquiring ca-ble television rights in cities, where the citypoliticians decide who wins, as you can con-firm with almost daily news stories of com-petitors jockeying for those rights.

The value of the license as a gift can be

measured in the rise of the price of stock in acompany receiving a license. Fortunately forstation owners, this wealth gain is transfer-able: They can sell that license to other peo-ple. (It's inadvisable to be so crude as to sellimmediately the "nude" license alone, with-out broadcasting equipment.) This analysisdoes not assume that the FCC commission-ers act irresponsibly. They act as responsiblyas anyone who is constrained by law to allo-cate a good by means other than the highestmoney bid.

There are many more examples of unin-tentional gifts. Competitive money prices arenot used initially to allocate licenses to oper-ate (a) liquor stores; (b) taxis; (c) banks; and(d) sugar-beet, dairy, and tobacco farms. Allthese rights are salable once they have beenawarded. For example, in New York City the"shield," the symbol of a right to operate onetaxi, sells for $60,000 or more (in 1982).

NONTRANSFERABLE GIFTS

Some gifts cannot be reallocated or resold:for example, the right to enroll in college ormedical school; to enter the United States; tojoin some unions; to adopt a child; to playgolf on a publicly owned golf course; to campin a national park; or, for children, to ride aschool bus for free. When children are givenfree bus rides to school, who gains what?Lacking free busing, the parents would haveeither provided transportation for their chil-dren or made them walk. Those who are nowrelieved of buying transportation convert allthe subsidy into a general wealth increase.The other parents get a gain not in generalwealth, but in the particular form of bettertransportation for their children.

To the extent that recipients alreadypurchase the services given to them, giftsmight as well be resalable or given as moneyby the donors. If I am given a case of Coca-Cola each month by some kind-hearted per-son who thinks I am thereby induced todrink more Cokes, the donor should realize

that because I already consume a case amonth, I will reduce my buying of Cokes anduse the released wealth for other expendi-tures.

DoJJars for What? Another, perhaps lessnoticeable, example of substitutability is thatin which someone asks for funds for a specialpurpose. For example, it is common to see acity council raise taxes to finance more po-lice protection, knowing that people wantmore such protection. But the city councilcould have reduced expenditures on otheractivities in order to finance more police pro-tection, and taxes would not have to be in-creased. If taxes are increased, it is clear thatthey don't finance more police protection;they enable the other expenditures to contin-ue at higher levels than if the taxes had notbeen raised. The higher tax, by substitutingfor funds that could perhaps have been di-verted from other activities, is therefore fi-nancing more of all activities, not just policeprotection. What the newly collected fundsor income are spent for is not indicative ofwhat extra activity is made possible. Moneyis fungible.

Public GoodsWe know that when costs of specifying, en-forcing, and exchanging property rights arelow enough, prices in market exchanges willdirect resources to higher-valued uses andwill also equate the amounts demanded andsupplied. However, there is a class of goods,called public goods, for many of which thesecosts are prohibitively high. A public good isone which is capable of being used by manypersons at the same time without reducingthe amount available for any other person.You and I can view a television programwithout reducing viewing by other people.The total amount produced can be used byeveryone. No one's use reduces how muchother people can have. Take another exam-


pIe of a public good-an idea; for example,the one that relates the length of the circum-ference of a circle to the diameter. Once theidea is known, anyone can use it without af-fecting how much other people can use it. Amelody, once created, can be sung by anyonewithout reducing other people's use. Manyinventions are based on ideas which, oncediscovered, can be used by you without re-ducing their availability to other people. Incontrast, what are called private goods arethose which we have been analyzing up tillnow-goods for which use by one persondoes mean less to others. If I eat a hot dog,no one else can eat it, too. The distinctionbetween public and private goods is not al-ways an all-ot-nothing distinction. Somegoods are a mixture. For example, a bandconcert can be heard by many people, or na-tional defense may be provided, but somepeople will get more than others. If I standnearer the band at the concert, someone hasto stand a little farther away. Both the bandconcert and national defense have some de-gree of private and public goods in them.However, in order to simplify introduction tothe problem, we shall be assuming purelyone or the other.

Just as for private goods, a problem forpublic goods is to determine how much toproduce and who shall pay the costs of pro-duction. But unlike private goods there is nopoint in charging a price just to decide whowill get to use it once it is produced, since noperson's use affects how much other peoplecan also have. Each can always have all thatis produced. Charging a price would bepointless for that purpose. On the otherhand, there is the task, as stated earlier, ofdeciding how much of the public good toproduce and who will pay the costs. If noprice is charged, how will the worth of pro-ducing it be revealed? After all, if a person isnot threatened with exclusion from use un-less he pays, the value to that user will notbe revealed or tested. And how will funds be

100 Chapter 5

collected to pay for the costs of production?This is the dilemma: Charging a price for anexisting public good is wasteful if that ex-.eludes any potential user; but without a pricehow can revelation of its value be induced,and who will pay?

If it were possible to know how mucheach person valued its full use, each could becharged a fee less than that full value, andthen the person could be allowed to use allthat was produced. For example, if I thoughtsome television program could be producedthat would be worth $30 to me, and youthought it would be worth $20 to you, theaggregate of the total use value to the two ofus would be $50. If the program could beproduced for less than $50, it would pay toproduce the program. How can a potentialproducer get you and me to reveal its valueto us if we don't have to pay once it is pro-duced? And how could the producer be re-warded? If he could produce the programand then exclude any nonpayer, that wouldbe appropriate so long as he doesn't excludeany viewer by charging more than the pro-gram's value to that user-$30 to me and $20to you. If I were charged more than $30 myviewing would be prevented, and that wouldbe wasteful since no other viewer wouldhave been displaced by my viewing the pro-gram. But it is important to be able to ex-clude nonpayers in order to force them toprovide a measure of the value of the publicgood, but at the same time to charge a priceto a viewer that is not so high as to actuallyexclude him. Neither of these is easy, if in-deed possible. Excluding nonpayers of over-the-air broadcasting is difficult; and if thatcould be done, it is extremely difficult to ne-gotiate the wide variety of prices that wouldavoid anyone's being excluded.

What has been done in attempts toovercome these problems? Sometimes thegovernment announces a price (tax) for useof some public good and excludes any non-payers who use the public good. For exam-ple, in England a tax on television sets is

used which authorizes people to look at pro-grams. Nonpayment by any viewers willmean exclusion from society if they arecaught. Presumably the tax excludes so fewusers that it is a better solution than produc-ing no programs at all. Yet even in this casethere remains the problem of knowing whichprograms are worth producing. One way is tocharge on a subscription or program basis, asis done with cable or some over-the-air tele-vision signal scrambling systems. Even thesesystems will exclude and hurt some viewerswithout thereby benefiting anyone else.However, the relevant alternative is not"perfection," but an action that is better.Maybe someone will find a better solution.Maybe, in the case of television, payment byadvertisers is better even though that in-volves "imperfect" revelation and responseto values by many users.

Other alternatives are creation of clubsor smaller groups to jointly finance somepublic good, such as more police protectionfor some neighborhood. While some neigh-bors might refuse to pay (but neverthelessbenefit from the extra police protection, giv-en the impossibility of excluding nonpayersfrom some benefits of the public good), itmight be better even for those who do footthe bill, as compared to not having any extraprotection at all. We must compare (a)-thevalue of having the good produced to thosewho pay as well as to those who don't minusthe lost value to any who are unnecessarilyexcluded-against (b)-the lost value fromnot having the good at all.

Perhaps the most common device tomeet this problem is the use of patents andcopyrights for ideas. Patents, which give theinventor the exclusive right to the commer-cial use of an idea, enable the inventor tocharge a price for its use. Though this cer-tainly will restrict its commercial use, it doesencourage more creation of such useful ideas.A balance must be considered. Similarly, toencourage the creation of written and musi-cal works, copyrights are given to their au-

thors and composers, giving them the rightto charge for their use even though the pricecharged will somewhat reduce the use of theidea. For example, most American compos-ers of musical wojks belong to the AmericanSociety of Composers and Playwrights(ASCAP). That society helps enforce thecopyrights of its members. It monitors allcommercial television, radio, and theatricalprograms and live concerts to ensure thatcommercial users pay a fee. This textbook iscopyrighted and royalties are received by t.heauthors, if someone buys it. The fact that theideas are "tied" to a volume of bound paperin the form of a book makes it easier tocharge a user of the ideas, because the userhas to buy the book. The price of the bookreally covers a fee for the use of the ideas inthe book. Of course, if several people readthe same book, rather than just one person, itis difficult to collect a fee from all of them.(But it is not completely impossible if thebook is resold from reader to reader, accord-ing to the principles explained in Chapter 6in the discussion of the resale value of abook.) These fees certainly will in some casesdissuade some people from using the ideas,but, as you know, "perfection" is not the rel-evant alternative. The issue is whether thissolution is better than any real alternatives.

Summary1. Information about buyers' demands and sell-

ers' offerings is not free; nor is the creationand operation of a market.

2. Full price is the money price plus any othercosts incurred by the buyer. Not all of thefull price necessarily accrues to the seller,though the money price-except for taxes-usually does.

3. Costs of information about buyers' and sell-ers' offers and the availability of goods arelowered by middlemen and their inven-tories.


4. Inventories reduce the seller's costs of main-taining a reliable supply and the buyer'scosts of collecting information about prod-ucts. Buffer inventories are not idle, unem-ployed, or wasteful uses of goods.

5. Transient shifts in demand are more eco-nomically met by holding inventories asbuffer stocks. Shifts in demand will first be-come evident through changed inventoriesand output. Not until the shifts in demandare discovered to be permanent or long-livedwill price change.

6. The more specific, secure, and transferableare private-property rights, the lower aremarketing and exchange costs.

7. The particular person by whom propertyrights of a resource are held does not affecthow they are used if the rights are cheaplytransferable by sale at a price reflecting thehighest-valued uses.

8. If private-property rights are too expensiveto enforce or exchange, laws or governmentregulations tend to control uses of goods.

9. Where private-property rights are weak ornonexistent, less of the full price of a good ispaid as money. So market values are givenless heed In determining production, ex-change, and allocation.

10. Use of resources and pollution are curtailedby private-property rights In those re-sources, because those rights can be sold topermit more or less use of the resource inaccord with the resulting values.

11. An economic standard of )he appropriateuse of any resource is its value in use to thehighest-valuing consumers.

12. Philanthropy and charity involve some com-bination of: (a) gifts in kind-transfers at lessthan the market price, (b) gifts of generalpurchasing power, and (c) some waste fromthe recipient's point of view (though notnecessarily from the donor'S). The recipientdoes not necessarily get a net gain becausethe competition to obtain charity may beequally costly.

;,1::.- _

:':~ 102 Chapter 5

13. Public goods are those of which one personmay enjoy all that is available without di-minishing the amount available to otherpeople. A price could be charged for a pub-lic good as long as the price did not restrictconsumption unnecessarily by reducing theamount any person would demand to lessthan the amount available. A price, althoughnot necessary for rationing (because no ra-tioning is needed), would guide productionof more or less of the public good. The pricerelevant for this valuation is the sum of theindividual prices charged various users.

Questions* 1. It has been estimated that carrying a sparetire on automobiles costs the public about$150,000,000 or about $5 per car. Is this a wastedor idle resource?

2. You are planning to build an apartment witheight units. You are told you can add a ninth unitfor an extra cost of $60,000; if the extra unit isoccupied all the time, it will be worth $80,000. Ifoccupied three-fourths of the time you will breakeven.

a. Would you build more apartments thanyou could expect to keep always rented?

b. Would you consider apartments to beunemployed when not occupied?

"c. Would you consider every unemployedapartment as a "waste"?

*3. a. Estimate the fraction of your wealth tiedup in resources designed to ease your ownunforeseeable changing demands or cir-cumstances.

b. How about the money you hold; items inthe medicine cabinet; food kept at homein the refrigerator and freezer and incanned goods; general education? Arethese idle, unemployed resources?

4. If there were a cheap enough method of me-tering the extent of each motorist's use of astreet, would such use be more often rationed bya price system? Do you know of any such casesnow in use? Name two.

5. Some allege that the number of parkingspaces at shopping centers is excessive (that is,

more resources go into the provision of parkingspace than should). The space that "should" beavailable is the amount that would clear the mar-ket when a charge is levied to cover the con-struction and maintenance cost of the parkingspace. However, policing "pay" parking space in-volves a cost of collecting fees and prosecutingviolators. Does that cost mean that it might be"better" to provide "too much" parking spacethan to provide the "right" amount rationed byprice? Explain.

6. A owns and lives in a home near an area inwhich it is announced a series of 20-story apart-ments will be built. A sues to prevent the con-struction, arguing that it will create extra traffichazards and congestion. In court, A proves theallegation correct. As the judge, how would yourule? Why?

*7. A owns a hillside lot with a beautiful view.B, owner of the lot just below, plants trees thatgrow up to 50 feet in height and block A's view.A asks B to trim the tops. B refuses. A offers topay for the trimming. B refuses. A offers $300 inaddition. B refuses; B asks for $2000. A sues for$5000 damages to the marketable value of hisproperty.

a. As the judge, how would you rule?b. If A had sued to force B to trim the trees,

how would you have ruled?c. What will our courts really decide today

in such suits?

8. The city of Palm Springs prohibits construc-tion of any building whose shadow will fall onsome other person's land between 9 A.M. and 3P.M. Is that a restriction of private property or astrengthening of it? Explain.

9. A restaurant opens near an apartment build-ing. The cooking smells annoy the tenants andthe building owner sues for invasion of propertyrights.

a. You are on the jury. Would you find infavor of the restaurant or the apartmentowner?

b. Would your decision depend uponwhether or not the apartment ownerlived in the affected apartments?

10. "The fact that some airplanes collide is evi-dence that there is too little air traffic control."

Evaluate. (Hint: What would it cost to avoid allrisk of air collision?)

11. A city passed a zoning ordinance prohibitingthe owner of a large parcel of land from con-structing homes on-it because of a fear that thenoise of a nearby airport owned by the citywould be so disturbing to the new tenants thatairport operations would have to be curtailed.

a. Whose rights were being curtailed bythe zoning ordinance?

b. Under the definition of private-propertyrights, were the landowner's rights beingimpaired? .,

*c. Can you suggest some other solution tothe problem?

*d. If you were a taxpayer in that town anddid not live near the airport what solu-tion would you have voted for?

*e. If you owned vacant land near the air-port, what solution would you advocate?If your vote is different in each case, doyou think you are denying the moralityof decisions by voting? Why?

12. Ralph Nader has complained that a personwho relieves himself in the Detroit River is finedbut industries that pollute the same river are not.He says also that muggers are punished but smog-gers are not. These he cites as illustrating theinequities and irrationalities of our society andeconomy in their attitude toward big corpora-tions. What is overlooked in his condemnation?

13. Camping fees in almost all state and nationalparks are so low that people want more spacethan is available.

a. Why is the market price not at a market-clearing level?

b. How much space would people want at amarket-clearing price?

14. Two closely situated golf courses, one pri-vately owned and one publicly owned, are bothopen to the public.

a. Which do you think charges the higherprice, and which do you think requiresless or no advance reservation? Giveyour reasons.

*b. Who is benefited in what respects byeach course's policy?

c. As land values in the vicinity of the


courses rise, which one do you think willbe converted to housing or businessfirst? Why?

15. Churches are typically nonprofit institutions.Can you think of a problem in allocation ofchurch facilities that is solved without use of theprice system?

* 16. The college you now attend is almost cer-tainly a nonprofit institution. Are any of its re-sources allocated at less than market-clearingprices? (Hint: Library facilities? Athletic facili-ties? Counseling? Course admission? Campusspace?) Who gains by the power to select admis-sible students?

* 17. a. Why do college athletic conferenceschronically have an enormously largernumber of people wanting tickets thanare available for the playoffs and impor-tant games?

b. Why are admission tickets for the Mas-ters Golf Tournament (a most prestig-ious golf tournament) fewer than thenumber demanded by the public?

18. "When property rights interfere with hu-man rights, property rights have to give in."What do you think this means?

19. "The imbalance between governmentallyand privately provided services is evidenced bythe fact that the family that vacations in its air-conditioned, power-braked, power-steered carpasses through cities over dirty, badly paved,congested streets, not to mention the billboardsobstructing the beauties of the countryside.When the family picnics with excellent food pro-vided by private business, they must sit by a pol-luted stream and then spend the, night in a publicpark that is a menace to health and morals andlittered with decaying refuse. Private abundanceand public poverty are facts that assail every ob-servant person. A plentiful supply of privatelyproduced goods and a shortage of publicly pro-vided services is inescapable testimony to thelack of a social balance between private and gov-ernmentally provided services."

Without trying to prove whether there oughtto be fewer or more governmentally providedservices, tell why the argument, taken from apopular book advocating more governmentally

I.II.

104 Chapter 5

provided services, is faulty. (Hint: Note the useof the term shortage. What does it suggest? Howare governmentally provided services rationed?)

20. The New York Times sponsors a Christmascharity appeal and gives cash to selected poorfamilies. The Los AngeJes Times sponsors acharity each summer to send children of poorfamilies to summer camp. To which of theseforms of charity would you contribute more?Why? Do you think people who choose the otherway are mistaken?

*21. In 1950 many public-welfare and charitableaid organizations refused to help families thatowned a television set-no matter how poor thefamily might be. The welfare workers claimedthey were not supposed to finance luxury. Whatwould be your policy for poor families that ownbig cars?

22. Suppose you are running a university andthe faculty is asking for higher salaries, some ofwhich you wil1 have to grant at the sacrifice ofbuildings and activities. Now, the Ford Founda-tion gives you $1 million, the income of which isto be allocated exclusively to faculty salaries.Who gains what?

*23. At many colleges faculty members are giv-en free parking space even in areas where park-ing space is expensive.

a. Who gains what?b. What would be the effect if faculty mem-

bers could sell their spaces to students?

*24. Immigration-quota rights to the UnitedStates are priced at zero instead of being sold at amarket-clearing price. Who gains what? Whyare these rights not sold at the highest price?

*25. The U.S. Congress has agreements withgovernments of sugar-producing countries thatthey will import into the Unite States no morethan a specified amount of sugar, thereby raisingthe price in the United States and increasing thetotal proceeds to foreign countries. (What is theelasticity of demand for sugar in the UnitedStates assumed to be?) Why would Congressagree to a law that raised costs to American con-sumers? Explain how this could be considered aform of foreign aid that does not appear in thefederal government's budget record of taxes andexpenditures.

26. There are reputed to be over 100,000 volun-tary health and welfare organizations solicitingcontributions from the general public, in addi-tion to hundreds of individual hospital-supportgroups, as well as about 100,000 fraternal, civic,and veteran's organizations and some 300,000churches that sponsor a variety of charitable ac-tivities, not to mention individual charities orgifts. A professor of public-health administrationsays, "It should not take over 100,000 voluntaryagencies to provide private health and welfareservices in the U.S." How many do you think itshould take? Why?

27. Choose the correct statement: Public goodsare those for which (a) several people can simul-taneously enjoy the good; (b) it is impossible toexclude some consumers; (c) no consumer re-duces the amount of the good available to othersby his act of consuming the good; (d) pricesshould not be charged; (e) the governmentshould provide the goods.

28. A theater performance with several simulta-neous viewers is not a public good. Why?

*29. A melody is a public good. What is the bestway to induce people to produce melodies?

30. "National defense is shared by everyone.Therefore, it is a public good and should be pro-vided through government taxes and operation."

a. Does greater anti missile defense for NewYork City mean greater defense for Hous-ton?

b. Do more public concerts on the west sideof town mean more on the east side?

c. Does it follow that public goods-thosethat give benefits to several people with-out less to anyone else-really do not ex-ist?

31. "Even if it were costless to exclude non-payers from enjoying a public good, it does notfollow that nonpayers necessarily should be ex-cluded." Explain why.

32. "Financing public goods by taxes is a meansof excluding nonpayers, for non taxpayers will beput in jail." True or false?

*33. The following is orthodox Chinese Com-munist (Marxist) economic doctrine: "The goalof socialist production is not profit but the satis-faction of social needs. Goods must be producedas long as they are needed by society, even if aloss is incurred. This follows from the Marxist-Leninist tenet that, contrary to capitalism whichseeks maximum profits, the objective of socialismis the maximum satisfaction of the material andcultural requirements of society. This fact givesthe Communist Party, as representative of soci-ety, the right to determine society's require-ments and what the economy should produce:"

However, recently the Chinese Communistspermitted some Chinese economists to publishthe following ideas: "Profits should not be setagainst the goal of satisfying social needs. Theprofit level is the best measure of the effective-ness of management. This would mean that noenterprise would operate at a loss because theoutput would be curtailed unless the state valuedits product sufficiently to raise its prices, and noenterprise would try to exceed the output plan atthe expense of profits. There would be less needfor political participation in enterprise manage-ment decisions, if prices were more realistic, inreflecting either market values or costs. The cap-italist evil connotations of profits are not presentin socialism, because under socialism profit takeson an entirely different character, where it is agood thing." Evaluate the last sentence. .

34. "Economic theory is applicable only to acapitalist society." Evaluate.

35. In the 1970s Congress mandated that auto-mobiles emit less exhaust pollution per mile oftravel; it also mandated that autos get more milesper gallon. However, the smaller, lighter, lesspowerful cars that most satisfy these require-ments are less safe in high-impact crashes thanare larger cars. Is the reduced safety worth thereductions in pollution and fuel consumption?

When Congress earlier mandated safety re-quirements in cars, the cost of cars rose but therewere no fewer accidents, because people drovefaster knowing the cars gave extra protection.What is the optimal amount of safety that shouldbe mandated by law?

Information Costs of Exchange 10S

Chapter 6Capital 'Value~.Future Yield~.and Intere~t

Most goods are durable goods: They yieldservices not only now but also in the future.Such goods are also called capital goods. Ap-ple trees yield future crops; oil wells producea future stream C1foil; land provides the fu-ture values of the uses to which it might beput; and automobiles yield travel services forseveral years. Each future service will havesome market value-as, say, of apples fromthe apple tree have at harvest time. An appletree will have a value that reflects the antici-pated future values of those future apples.The price now of the apple tree is calleda present value, or a capital value, to indi-cate that it is a price that incorporates in thepresent value the future anticipated servicevalues. Both terms mean the same thing, souse them interchangeably.

How does the present price of a capitalgood depend on the future values of its fu-ture services? How does the price of an appletree depend on the expected value of the fu-ture apple crops? How does the present val-ue of, say, an acre of land depend on the ex-pected future rents of that land? Or, howdoes the present value (that is, the price) of ashare of common stock in a corporation de-pend on the expected stream of its futureearnings? As we will see, the range of goodsto which this question applies is very largeand has much personal relevance.

Your first assumption might be that thecapital value of a capital good is simply thetotal value of all those future services. Afterall, when one buys a tree or an acre of land,what is purchased is simply the right to thosefuture services. Say, for example, an appletree yields 300 apples each year for 20 years,and in each year every apple is worth 1O¢.(We assume for simplicity that no inflationoccurs.) The tree would appear to be worth$600 (300 apples at 10¢ per apple in each of20 years). But that calculated value is toolarge for two reasons. The first reason is thatone must care for the tree and harvest theapples; so if the apples are worth 10¢ each,

107

I1>1

I

let us suppose that after the costs of growingand harvesting apples are deducted each ap-ple yields a net value of 5¢. That is $15 peryear, instead of $30. Over 20 years thatwould appear to make the tree worth $300rather than $600. But that, too, is too large afigure. Why is the tree's capital value lessthan the total of its future apple net values?(From now on, we simplify our exposition byignoring other costs. Whenever we speak ofa present or capital value we always meanthe net value or net price over and above allother costs of production.) Let us investigatethe second reason why the capital value of agood is not the sum of its future net values,but instead is less.

The Magie ofInvestment Productivity

Services that are available only in the future(called deferred services) are worth less thanthe same services available now. Why? Be-cause present goods sometimes can be con-verted to even more valuable -future goods.For example, some things, such as a tree, cangrow over time. You have more wood nextyear than this year, and more in ten yearsthan in nine years. A bushel of wheat can beconverted to more than one bushel of wheatby next year.

We don't increase the output simply bysaving or not consuming; that would merelynot make the future any wor~e. People whothink simply that we should conserve more-that is, consume less-overlook the fact thatif resources are put to uses today that trans-form them into productive capital goods,they yield more future services than are giv-en up now. That magic of turning "less nowinto more later" is called the net productivi-ty of investment. In this chapter, we examinehow net productivity of investment affectsthe demand for and prices of capital goods-which almost all our resources are. (We will

~! J08 Chapter 6

not in this chapter explain the factors thataffect the rate of investment and its net pro-ductivity. That is done in Chapter 17.)

A simple example is, again, a growingtree. Cut it now, or wait and have more lum-ber next year than you would today. Drinkfresh grape juice, or more valuable wine to-morrow. Instead of eating 100 bushels ofwheat today, plant them and reap enoughnext year to pay the costs of all inputs usedto make next year's wheat and still havemore than the 100 bushels you started with,say 105, giving a net productivity of invest-ment of five bushels, or 5% per year. Theyield or gain from the net productivity of in-vestment is called interest. Thus the five ad-ditional bushels of wheat are the interest onthe investment of 100 bushels. Investment isthat portion of current income that is notconsumed and instead is used to create in-come for the future. Thus the 100 bushels ofwheat were an investment. Because theygrew to 105, the net productivity of invest-ment, or interest, after allowing for all othercosts, is 5% per year (5/100 = .05 or 5%).

Interest can be looked at in another way:It is the foreseeable growth in wealth thatcould be consumed without reducing one'sstock of wealth below its initial amount.That is, if we invest 100 bushels and harvest105, we can consume five bushels-the inter-est-and replant the other 100 so that ourstock of wealth is undiminished. It is expect-ed income from one's wealth. Interest, then,is the same thing as income from capitalgoods. The basic relationship can be ex-pressed as follows:

(1) P (1 + r) = A

where P is the present amount invested, r isthe annual percentage rate of interest, and Ais the future amount. In our example, wherethe interest or income is $5, this is expressedby:

$100 (1.05) = $105.

Sometimes the interest or income is not

Table 6·1 FUTURE AMOUNT TO WHICH $1.00 NOW WILL GROW BY END OFSPECIFIED YEAR AT ALTERNATIVE RATES OF COMPOUNDED INTEREST

Year 3% 4% 5% 6% 7% 8% 10% 12% 15% 20% Year

1 1.03 1.04 1.0t) 1.06 1.07 1.08 1.10 1.12 •. 1.15 1.20 12 1.06 1.08 1.10 1.12 1.14 1.17 1.21 1.25 1.32 1.44 23 109 1.12 1.16 1.19 1.23 1.26 1.33 1.40 1.52 1.73 34 1.13 1.17 1.22 1.26 1.31 1.36 1.46 1.57 1.74 2.07 45 1.16 1.22 1.28 1.34 1.40 1.47 1.61 1.76 2.01 2.49 56 1.19 1.27 1.34 1.42 1.50 1.59 1.77 1.97 2.31 2.99 67 1.23 1.32 1.41 1.50 1.61 1.71 1.94 2.21 2.66 3.58 78 1.27 1.37 1.4B 1.59 1.72 1.85 2.14 2.48 3.05 4.30 89 1.30 1.42 1.5£i 1.69 1.84 2.00 2.35 2.77 3.52 5.16 9

10 1.34 1.48 1.6::1 1.79 1.97 2.16 2.59 3.11 4.05 6.19 1011 1.38 1.54 1.71 1.90 2. 10 2.33 2.85 3.48 4.66 7.43 1112 1.43 1.60 1.80 2.01 2.25 2.52 3.13 3.90 5.30 8.92 1213 1.47 1.67 1.89 2.13 2.41 2.72 3.45 4.36 6.10 10.7 1314 1.51 1.73 1.98 2.26 2.58 2.94 3.79 4.89 7.00 12.8 1415 1.56 1.80 2.08 2.40 2.76 3.17 4.17 5.47 8.13 15.4 1516 1.60 1.87 2.18 2.54 2.95 3.43 4.59 6.13 9.40 18.5 1617 1.65 1.95 2.29 2.69 3.16 3.70 5.05 6.87 10.6 22.2 1718 1.70 2.03 2.41 2.85 3.38 4.00 5.55 7.70 12.5 26.6 1819 1.75 2.11 2.53 3.03 3.62 4.32 6.11 8.61 14.0 31.9 1920 1.81 2.19 2.65 3.21 3.87 4.66 6.73 9.65 16.1 38.3 2025 2.09 2.67 3.39 4.29 5.43 6.85 10.8 17.0 32.9 95.4 2530 2.43 3.24 4.32 5.74 7.61 10.0 17.4 30.0 66.2 237 3040 3.26 4.80 7.04 10.3 15.0 21.7 45.3 93.1 267.0 1470 4050 4.38 7.11 11.5 18.4 29.5 46.9 117 289 1080 9100 50

This table shows to what amounts $1.00 invested now will grow at now at 10%, you will have $1740 in 30 years. The entries in this tablethe end of various years. at different rates of growth compounded are the reciprocals of the entries in Table 6-2; that is, they are theannually. For example, $1.00 invested now will grow in 30 years to entries of Table 6-2 divided into 1. Formula for entries in table is$5.74 at 6%. In other words, $5.74 due 30 years hence is worth now 1(1 + r)t.

exactly $1.00 at a 6% rate of interest per year. If you invest $100

consumed but is left invested for the nextyear. For example, for a tree capable ofgrowing for several years at 5% of its sizeeach year, the value of the lumber in the treewould grow to 105 in one year; by the end ofthe second year it would grow to llO.25, 5%larger than lO5, if none of the lumber were \taken from the tree (as consumed income).This is expressed by:

$100 (1.05) (1.05) = $llO.25,

P (l + r) (1 + r) = A.

In three years, if all interest were reinvest-ed without consuming any of it, it wouldgrow to:

$100 (1.05) (1.05) (1.05) = $115.75.

To avoid tedious arithmetic, Table 6-1shows future amounts to which $1.00 wouldgrow at different rates of interest over vari-ous numbers of years. The general formula

or in general form by:

Capital Values, Future Yields, and Interest 109

giving the future amount, A, to which P willgrow IS:

(2) P (1 + r)t = A

where t is the number of years.You can now see why 100 bushels of

wheat today can be exchanged for 105 nextyear. You could grow the 105 bushels your-self or lend the 100 bushels to others whocan do that and who would be willing to re-turn to you up to 105 bushels in a year. Aborrower who has to return less than 105will be making a profit. (Remember, we as-sume no inflation; the price of wheat is as-sumed to stay constant over time.) If borrow-ers or investors compete with one another toget some wheat now they would push thepremium they would offer to pay you (innext year's wheat) up to 570. For, say, $100today (assuming a price of $1.00 per bushel)you could get $105 worth of wheat tomor-row, 105 bushels. Expressed in dollars, $100worth of goods today is worth (is salable for)$105 of tomorrow's goods-even with no in-flation.

As indicated earlier, Table 6-1 gives thefuture amounts to which $1.00 worth of re-sources invested now will grow at variousrates of interest and lengths of time (again,this growth has nothing to do with inflation).We now reverse the. question and ask howmuch must be invested now so that it willgrow to $1.00 by some specified future timeat a specified interest rate.

,.I '

WHAT PRESENTAMOUNT WILL GROW TO ASPECIFIED FUTURE AMOUNT?

This is an important question because veryoften the future amount to be received isknown and one wants to estimate a reason-able present value that might be offered tobuy it. Table 6-2 shows what presentamounts would grow to $1.00, at different

III.'I'

"

III 110 Chapter 6

lengths of investment and interest rates. Forexample, to buy something that will beworth $1.00 10 years from now, if the rate ofinterest in the interim is 1070 per year, thepresent price (to be paid now) is only $.385,which is in the column for 1070 and the rowfor 10 years.

This can be expressed as follows:

A(l + r) = P(3)

where P is the present price to be paid nowfor the future amount, A, to be received inone year with r as the rate of interest. Insert-ing the numbers in our example gives:

$1.00 = $1.00 = $ 909(1 + .10) (LlO) .

as the present price, or capital value, of $1.00deferred one year at a 1070 rate of interest.(Try to remember to use this terminology.)The present value of the deferred $1.00, be-ing less than $1.00, is sometimes called a dis-counted value; the term simply indicates thatthe present value is less than the futureamount. Because the present value can beobtained by dividing by 1.1 or by multiply-ing by I/Ll or .909, this process of derivingthe present (lower) value of a future largeramount is called discounting for time, or justplain discounting. (Note that its meaning isentirely different from that of a discountprice in a retail store.)

If the date of future receipt of the dollarwere to be deferred two years, that is, to betwo years away, the discounting appearstwice. Therefore the formula for the presentvalue of something deferred two years is:

AP = (1 + r) (1 + r)

or, at 1070 interest rates:

. $1.00 _ $1.00$.826 = (1.10) (1.10) - (1.21) .

And for an A 10 years away the formula is:

Table 6·2 PRESENTVALUE OF A FUTURE $1.00 WHAT A DOLLAR AT END OFSPECIFIEDFUTURE YEAR IS WORTH TODAY AT ALTERNATIVE INTEREST RATES

Year 3% 4% 5%

.971 .962 .952

6%

.943

7% 8% 10% 12% 15% 20% Year

.935 .926 .909•.

.870 .833.893

32 .943 .925 .907

5

.890 .873 .857 .826 .797 .756 .694 23 .915 .889 .864

6

4 .888 .855 .823

5 .863 .822 .784

.840

.792

.747

.816 .794 .751 .711

.763 .735.658 .578

.683 .636.713 .681

.572 .482 4

.620 .567 .497 .402

7 .813 .760 .711 76 .837 .790 .746 .705 .666 .630 .564 .507 .432 .335

.665 .623 .583 .513 .452 .376 .2798 .789 .731 .677

11

.627 .582 .540 .466 A04 .326 .233 89 .766 .703 .645

12

10 .744 .676 .614

13

11 .722 .650 .585

12 .701 .625 .557

.592

.558

.527

A97

.544 .500 A24 .360

.508 A63.284 .194 9

.385 .322

A75 A29.247 .162 10

.350 .287

A44 .397

.215 .134

.318 .257 .187 .112

14 .661 .577 .505 14

13 .681 .601 .530 A69 A15 .368 .289 .229 .162 .0935A42 .388 .340 .263 .204 .141 .0779

15 .642 .555 A81

18

A17 .362 .315 .239 .183 .122 .0649 15

16 .623 .534 .458

19

17 .605 .513 A3618 .587 A94 A16

.394

.371

.501

.339 .292 .217 .163

.317 .270

.107 .0541 16.197 .146

.296 .250

.093 .0451 17.179 .130 .0808 .0376

20 .554 .456 .377 .0261 20

19 .570 A75 .396 .331 .277 .232 .163 .116 .0703 .0313

.312 .258 .215 .148 .104 .0611

25 .478 .375 .295

50

.233 .184 .146 .0923 .0588 .0304 .0105 25

30 A12 .308 .231

40 .307 .208 .142

50 .228 .141 .087

.174

.0972

.0543

.131 .0994

.067 .0460

.034 .0213

Each column lists how much a dollar received at the end of variousyears in the future is worth today. For example, at 6% per year adollar to be received 10 years hence is equivalent in value to $.558now. In other words, $.558 invested now at 6%, with interestcompounded annually, would grow to $1.00 in 10 years. Note that$1.00 to be received at the end of 50 years is, at 6%, worth todayjust about a nickel. And at 10% it is worth only about .8 of one cent,which is to say that 8 mills (.8 of a cent) invested now would grow, at

p = (1 + r)lO,

which at 10% is:

1/2.59 = .385.

The farther away the deferred futureamount, the lower its present value.

A

A

(4) p= (1 +r)t

.0573 .0334 .0151 .00421 30

.0221 .0107 .00373 .000680

but if you use Table 6-2 you'll be able toapproximate your answer. Specify the pres-ent amount to be invested today to grow to$1.00. Then find that number in the row forthe number of years the investment persists.For example, if you were to invest 25¢ todayto get $1.00 after 10 years, what would theannual rate of interest have to be? Lookingin the row for 10 years, the number closest to25¢ is in the column for 15%.

~, :

Illustrative Uses ofCapital Value Principles

LENDING IS BUYING DEBT

We are ready to act like financial expertsand interpret some economic events. Youmay have noticed that we referred both tovaluing a claim to $100 to be delivered inone year and to investing now for a futurereturn. Buying a claim to something in thefuture is the same as lending. To lend now isto buy a claim for some amount in the fu-ture. When I lend you $100 to be repaidwith some interest in one year, I have boughtyour debt of $100, and you must repay mefor doing so. When I lend $100 expecting$100 plus $5 interest in a year, I buy now, for$100, a claim to $105 deferred one year-called the future amount. When a loan ismade, the amount borrowed, or loaned, iscalled the principal. The principal, then, isexactly what we were calling the capital val-ue (or present value, or price) of a claim to afuture receipt.

Consider the following common situa-tion. Almost every Thursday the U.S. gov-ernment borrows money for short periods-say, one year. It does so by auctioning whatit calls Treasury certificates or Treasurybills. These are promissory notes; that is,they are promises to pay $10,000 in one year.

112 Chapter 6

There is no explicit interest. But suppose asuccessful bidder gets one for $9000. What isthe implicit rate of interest? (See formula 5.)The $1000 excess to be received in one yearis 11.1% of the $9000, so the implicit rate ofinterest is 11.1% per year:

11 1 = ~ 10,000 - $9000). $9,000

The rate thus calculated is commonly calledthe Treasury bill rate. Treasury bills, or T-bills, as they're called, are offered by manysavings and loan banks as intermediaries.Even though no interest is stated in theseU.S. Treasury loan contracts, there is interestin fact. Whenever the present price is lessthan the promised future amount, the differ-ence is interest. (There is virtually no risk ofnonpayment with U.S. Treasury certificates.But if the promise of a future amount werevery risky, the difference between presentprice and future amount would representalso a return for risk.) You should now beable to understand that the higher is the cur-rent price of the Treasury certificate, thelower is the implicit interest rate.

INTEREST IS THE PRICEOF EARLIER AVAILABILITY

Interest is often called the price of money,That is a misleading way of saying that therate of interest is the price of borrowingmoney. You borrow money to buy other re-sources earlier-earlier than if you had tosave from your own income. Interest is reallythe price of getting goods earlier, and is paidfor out of the services or growth provided byhaving the goods. But almost everywhereand always there are laws against usury,which is an ambiguous pejorative-that is,condemning--term for interest. Most oftenusury means too high an interest rate, butsometimes it means any interest whatsoever.Early Christian dogma condemned usury.The strict Muslim interpretation of the Ko-

ran prohibits interest in any form-a prob-lem for some Arabs who run businesses. InCommunist doctrine interest is called exploi-tation. Yet all opponents of usury reinterprettheir doctrines to admit interest. The earlyChristians let the Jews collect interest. TheCommunists cleverly call it by anothername, an "efficiency index." The CatholicChurch called it simply a discount, with noexplicit interest, as our government doesnow on U.S. Treasury certificates.

MONETARY AND NONMONETARYSERVICE IN INTEREST

Some capital goods such as paintings andhouses yield a stream of nonconsumable ser-vices. Others may yield no interim consum-able services; instead they improve, or ripen,or mature with age, and therefore increase invalue. In any case, for every capital good,over the year, the value of whatever may beits consumable service flow plus the changein its own value will turn out to be virtuallythe same percentage of capital value for allresources (per dollar of capital value) andalso will equal the market rate of interest(virtually the same because some allowancefor a real difference is necessary). No onewould want to own the resource or good thatfailed to do so. The present price of such agood would fall sufficiently to make its yielda larger percentage of that new, lowerprice-and hence equal to the percentage re-turn on other capital goods.

As an example, the price of a bottle ofwine yielding no service until it is consumedwould have to rise over time at the rate ofinterest every year, or else no one wouldwant it since it gives no consumable yield inthe interim except a capital value rise. Ifsomeone believes the wine will be worth$100 in 10 years, when it is ready for drink-ing, its present price would have to be lowenough so that the difference between it and$100 would represent an increase in value

obtained by any investment for 10 years atthe market rate of interest. From Table 6-2,if we multiply by 100, it can be seen that thepresent value would be $38.50 (the entry for10 years and an assumed 10% annual interestrate: .385 X 100). This present value is alsocalled its discounted value.

No matter what resource you consider,its capital value change plus its net serviceflow during a year must be expected to equalthe (risk-adjusted) rate of interest-where, aswe must hasten to generalize, the service value is comprised not only of the salable ser-vices but also of the value of any income ornonmonetary personal services derived fromit in the interim. If a tree yields no service inthe interim other than increasing in woodcontent, its value as a tree must rise at therate of interest, as does the price of any othergood that has no service value while it is be-ing held. But say the tree also yields a servicewhile standing, by giving shade and beauty,as paintings give pleasure, or a house givesshelter, or a stock pays dividends. Then it isthe sum of (1) the increase in the price plus(2) the values of marketable and nonmarket-able services or income to be derived from itover the year that add up to a percentage re-turn matching the rate of interest. If the per-centage were greater than the interest rate,the resource would be underpriced in that atthat low price it would yield a higher rate ofreturn than others, so that you could make aprofit buying the underpriced resource. Sincethere aren't many, if any, people persistentlyfinding such cases, it is safe to deduce thatresources are in fact priced to yield virtuallythe same expected, average return over time

_(allowing for risk). That is a fundamental anduniversally observed result of competition inthe demand and supply for capital goods.That is what is meant by "clearing the mar-ket for capital goods." At that price, the ex-pected net percentage yields are the same forall resources and are equal to the rate of in-terest.


AnnuitiesSo far we have treated investments as yield-ing a single final value some time in the fu-ture. But as we have indicated, most capitalgoods yield a stream of future outputs or ser-vices-like apple trees yielding apples everyyear, or a machine tool yielding a series offuture services over its life. If we take thewhole series of future yields over the life ofthe good and treat the services in a year as,in effect, a payment once a year, the servicescan be called an annuity. The services com-ing from a machine or house will, we assume,get the same dollar rental or value everyyear. As we have learned, the present pricepaid for a claim to the service to be deliv-ered, say, exactly 10 years from now, andwhich will at that time be worth $1.00, willtoday be worth much less. Therefore, thepresent price of a machine that yields futureservices is the sumof discounted,that is,present,values of all the future values of thefuture services.

If a machine is expected to yield servicesworth $1.00 at the end of eachof the nextfour years and no longer, and if the pertinentcompetitive rate of interest is 10% per year,then the four $1.00 rental values will be dis-counted back to a present value:

$1.00(1.10) =

'I

$.909 = the present value of the$1.00 of services renderedat the end of the first year

$1.00(1.10Y = .826 = the present value of the sec-

ond year's dollar services$1.00(l.l0)3 = .751 = the present value of the

third year's dollar services$1.00(l.l0)4 = .683= the present value of the

__ fourth year's dollar services$3.17 = present value of the whole

four-year stream and henceof the machine.

1'1\ '

II,

I I

The longer the series of yields, the great-i II !.

1111-;----]]-4-C-'ha-pt-er-6--------

er the present value of the machine becausemore terms are included. For example, if themachine were twice as durable and gaveeight (instead of four) years of service worth$1.00 in each year, its capital value would becomputed simply by extending the seriesover eight terms:

$1.00(l.l 0)5 = $ .621 = presen~ value of fifth year

. of serVIce$1.00( l.l 0)6 = .564 = present value of sixth year

of service$1.00(l.lOr = .513 = present value of seventh

year of service$1.00(1.l0)8 = .467 = present value of eighth

___ year of service$2.165 = present value of last four

years of service+$3.17 = present value of first four

years of service$5.335 = present value of eight

years.

Notice that the second four years add only$2.165 to the present capital value, less thanthe $3.17 of the first four years.

In general, the following annuity formulaholds:

where AI, A2, A3, A4 are the future amountsat the end of years 1, 2, 3, 4, and so on to theend of the series of future amounts.

The more future terms there are in anannuity, the greater the present value, eventhough more distant terms have smaller pres-ent values because of the discount effect.This is an extremely important truth, whichwe soon apply to several problems.

Suppose, to push things to an extreme,the machine were permanent and gave $1.00of services every year forever. At 5% inter-est rates, what would it be worth now? The

answer is $20, the sum of that infinitely longseries of diminishing present values. If itseems odd that an infinitely long series couldadd up to only $20, consider this analogy:You invest $20 in a bank paying 5% inter-est. Every year you get $1.00 interest. Takeit out-which makes it the equivalent of aservice-and repeat the next year. Everyyear forever $1.00 can be taken out andthere is still $20 left over. The same idea isexpressed by the statement that the presentvalue of a perpetuity (an infinitely long an-nuity) of $1.00 a year has a present value of$20, if the interest rate is 5% per year. If theinterest rate were lower, say 3%, then thepresent value of a perpetuity of $1.00 a yearwould be $33.33 (3% of $33.33 will yield you$1.00 every year, without requiring you todiminish the initial investment value of$33.33).

From Table 6-3, you can see that thefirst 50 years of a series of receipts (a 50-yearannuity of $1.00 a year) has a present valueof only $18.30 at 5% interest. The entiresubsequent part of an infinitely long seriesof $1.00 receipts, beginning after 50 yearsfrom now, is worth today only about $1.70(that is, $20 - $18.30). Small present invest-ments can yield amazing amounts in the dis-tant future.

Before applying our analysis, we showhow to get an answer to a common question:How much must be paid each period for astated number of periods (as with an install-ment plan) to repay some amount borrowednow?

REPAYING A DEBTBY INSTALLMENTS

The annual payments on a loan must belarge enough to pay interest and to repaysome part of the principal, the amount bor-rowed. The calculation can be worked outeasily by using the data in Table 6-4, whichshows how much must be paid each year tocancel a debt of $1.00 at various rates of in-

terest and numbers of years. Simply multiplythat entry by the size of the debt, and thatgives the amount that must be paid annually,with the first payment being made a yearfrom now (not rigM now), to repay the debtplus interest during the interval.

For example, to repay a debt of $10,000in 10 years at interest rates of 10%, the entryin Table 6-4 is .163. This has been roundedfrom .1627. (We use the more accurate fig-ure.) The amount each year is 10,000 timeslarger, $1627. It is instructive to realize thatalthough the annual payment is fixed, pay-ments in the early years are made up mostlyof payments of interest and only a small partis repayment of some of the principal bor-rowed. As time passes and the principal isbeing repaid with the installments, theamount due gets smaller and hence the inter-est due gets smaller, so that a larger portionof the uniform later payments of $1627 is re-payment of principal. (In the first year, inter-est is $1000 and $627 is for repayment ofprincipal. In the last year only $180 is inter-est and the remainder, $1487, is repaymentof principal.)

Applicationsand Examples

To better understand the investment princi-ples just investigated, consider a few com-mon applications.

1. EAT YOUR CAKEAND HAVE IT, TOO

Some colleges lend students money for tu-ition without interest for four years. Shouldyou borrow? Of course! Put the money in asavings account paying, say, 8% per year.Each year draw out the interest and throw aparty. At the end of four years, you can drawout the $1000 plus the last year's interest, re-

Capital Values, Future Yields, and Interest 11S

,1'I

,I Table 6·3 PRESENT CAPITAL VALUE (PRICE) OF ANNUITY OF $1.00, RECEIVED AT END OF EACH YEAR

11;:Year 3% 4% 5% 6% 7% 8% 10% 12% 15% 20% Year

1 0.971 0.960 0.952 0.943 0.935 0.926 0.909 0.890 0.870 0.833 12 1.91 1.89 1.86 1.83 1.81 1.78 1.73 1.69 1.63 1.53 23 2.83 2.78 2.72 2.67 2.62 2.58 2.48 2.40 2.28 2.11 34 3.72 3.63 3.55 3.47 3.39 3.31 3.16 3.04 2.86 2.59 45 4.58 4.45 4.33 4.21 4.10 3.99 3.79 3.60 3.35 2.99 56 5.42 5.24 5.08 4.92 4.77 4.62 4.35 4.11 3.78 3.33 67 6.23 6.00 5.79 5.58 5.39 5.21 4.86 4.56 4.16 3.60 78 7.02 6.73 6.4~ 6.21 5.97 5.75 5.33 4.97 4.49 3.84 89 7.79 7.44 7.11 6.80 6.52 6.25 5.75 5.33 4.78 4.03 9

10 8.53 8.11 7.72 7.36 7.02 6.71 6.14 5.65 5.02 4.19 1011 9.25 8.76 8.31 7.89 7.50 7.14 6.49 5.94 5.23 4.33 1112 9.95 9.39 8.86 8.38 7.94 7.54 6.81 6.19 5.41 4.44 1213 10.6 9.99 9.39 8.85 8.36 7.90 7.10 6.42 5.65 4.53 1314 11.2 10.6 9.90 9.29 8.75 8.24 7.36 6.63 5.76 4.61 1415 11.9 11.1 10.4 9.72 9.11 8.56 7.61 6.81 5.87 4.68 1516 12.6 11.6 10.8 10.1 9.45 8.85 7.82 6.97 5.96 4.73 1617 13.2 12.2 11.3 10.5 9.76 9.12 8.02 7.12 6.03 4.77 1718 13.8 12.7 11.7 10.8 10.1 9.37 8.20 7.25 6.10 4.81 1819 14.3 13.1 12.1 11.2 10.3 9.60 8.36 7.37 6.17 4.84 1920 14.9 13.6 12.5 11.5 10.6 9.82 8.51 7.47 0.37 4.87 20

II25 17.4 15.6 14.1 12.8 11.7 10.7 9.08 7.84 6.46 4.95 2530 19.6 17.3 15.4 13.8 12.4 11.3 9.43 8.06 6.57 4.98 3040 23.1 19.8 17.2 15.0 13.3. 11.9 9.78 8.24 6.64 5.00 40

Ii 50 25.7 21.5 18.3 15.8 13.8 12.2 9.91 8.25 6.66 5.00 50

I 'An annuity is a sequence of constant amounts received at annual depletion of the principal in each year, would enable a payout ofI intervals. This table shows with each entry how much it takes today exactly $1.00 a year for 20 years, at which time the fund would be

I,to buy an annuity of $1.00 a year at the rates of interest indicated. completely depleted. And $1000 a year for 20 years would, at 6%For example, an annuity of $1.00 a year for 20 years at 6% interest compounded annually, cost today $11,400, which is obviously 1000could be purchased today with $11.50. This amount would, if invested times as much as for an annuity of just $1.00. Formula for entry isat 6%, be sufficient to yield some interest which, along with some )1 - (1 + rf/)Ir

,"pay the $1000, and spend the last year's in- than is $1000 four years hence-even if thereterest for a graduation gift. is no inflation of any prices.

If you apply the concepts we've been de-veloping, you see that if you borrow $1000 2, SUPPRESSIONyou are receiving an $80 four-year annuity. OF IMPROVEMENTS?At 8% interest, its present value is $264.80(= $80 X 3.31): See Table 6-3. This means You manufacture for 50¢ and sell for thatthat borrowing $1000 at zero interest for four price a light bulb that lasts one year. Youyears is equivalent to getting a gift of $264.80 then invent a light bulb that lasts two yearsupon entrance to college. $1000 now is a and gives the same light for the same rate of

1 claim to a lot more real goods and services power usage. How much could you charge

Ilit!for this new bulb, if buyers value a light

"'I '~ •.' 116j' Chapter 6I. ,. I

Table 6·4 UNIFORM ANNUAL PAYMENTS TO BE PAID AT END OF EACH YEAR PER $1.00 BORROWED NOW

Year 3% 4% 5% 6% 7% 8% 10% 12% 15% 20% Year

1 1.03 1.04 1.05 1.06 1.07 1.08 1.10 1.12 1.15 1.20 1•.2 .524 .529 .538 .546 .552 .562 .578 .592 .613 .654 23 .353 .360 .368 .375 .381 .388 .403 .417 .439 .474 34 .269 .275 .282 .289 .295 .302 .316 .329 .350 .386 45 .218 .225 .231 .238 .244 .251 .267 .278 .299 .334 56 .185 .191 .197 .204 .210 .216 .230 .243 .265 .300 67 .161 .167 .173 .179 .186 .192 .206 .219 .240 .278 78 .142 .149 .155 .161 .168 .174 .188 .201 .223 .260 89 .128 .134 .141 .147 .153 .160 .174 .188 .209 .248 9

10 .117 .123 .130 .136 .142 .149 .163 .177 .199 .239 1011 .108 .114 .120 .127 .133 .140 .154 .168 .191 .231 1112 .101 .106 .113 .119 .126 .133 .147 .162 .185 .225 1213 .0943 .100 .107 .113 .120 .127 .141 .156 .177 .221 1314 .0885 .0943 .101 .108 .114 .121 .136 .151 .174 .217 1415 .0840 .0901 .0982 .103 .110 .117 .132 .147 .170 .214 1516 .0794 .0862 .0929 .0990 .106 .113 .128 .143 .168 .211 1617 .0758 .0819 .0885 .0961 .102 .110 .125 .140 .166 .210 1718 .0725 .0787 .0855 .0925 .0990 .107 .122 .138 .164 .208 1819 .0699 .0763 .0826 .0901 .0971 .104 .120 .136 .162 .207 1920 .0671 .0735 .0800 .0877 .0943 .102 .118 .134 .161 .205 2025 .0575 .0641 .0709 .0781 .0855 .0935 .110 .128 .155 .202 2530 .0510. .0578 .0649 .0724 .0806 .0885 .106 .124 .152 .201 3040 .0433 .0505 .0581 .0666 .0752 .0840 .102 .121 .151 .200 4050 .0389 .0465 .9546 .0632 .0725 .0820 .101 .120 .150 .200 50

An annuity is a sequence of annual amounts received at annual each of three years, or 28.9 cents for each of four years.intervals for a specified number of years. The entries in the table give Another way to use the data is to treat annuities as payments. Forthe possible annuities of various lengths, for various interest rates, example, a debt of $1.00 can be paid off, at 6% interest, with $1.06which have a present value of $1.00. For example, for $1.00 present in one year, or 54.6 cents annually for two years, or 28.9 centsvalue or cost, at 6% interest, one can receive an annuity for one year annually for four years, or 10.2 cents annually for 20 years.of $1.06, or of 54.6 cents for each of two years, or 37.5 cents for

bulb's services at 50¢ during each year of ser-vice? Assume the rate of interest is 10%. Be-cause the second year of service is over ayear away, they will offer you now 45¢ morefor the new, improved bulb. This value is ob-tained by discounting the second year's val-ue, 50¢, by .909 (see in Table 6-2 where the10% column intersects the row for one year:.909), which gives 45.45¢. See also Table 6-5.

So you could sell a two-year bulb forabout 95¢ now. A three-year bulb would sellnow for the present value of three years of

service. The third year's 50¢ service value isworth now, paid two years in advance, 41.30¢(computed by dividing 50¢ by (1.1Or; or lookin Table 6-2 for the discount factor wherethe 10% column and the row for two yearsintersect: .826 multiplied by 50¢ gives41.30¢). Therefore, three-year bulbs wouldsell now for $1.37 (50¢ + 45.50¢ + 41.30¢) .

These computations of course influenceyour behavior as a producer: You would pro-duce the three-year bulb and sell it for $1.37


Table 6·5 LIGHT -BULB PRICES DEPEND ON LENGTH OF BULB LIFE'

One-year bulb: One sold each year at price of 50¢

Years 1st 2nd 3rd 4th 5th 6th

Service value: .50 .50 .50 .50 .50 .50Price: .50 .50 .50 .50 .50 .50Cost: .50 .50 .50 .50 .50 .50Profit: a a a a a aPresent value of profits: a a a a a aTwo-year bulb: One sold every two years at price of 95.45¢


Service value: .50 .50 .50 .50 .50 .50.4545 .4545 .4545

Price: Present value of bulb's service .9545 .9545 .9545Cost: .50 a .50 a .50 aProfit: .4545 a .4545 a .4545 aPresent value of profits: 1.14 a .3756 a .3104 aThree-year bulb: One sold every three years at price of $1.37


.50 .50 .50 .50 .50 .50Service value: .455 .45

.416 .42

Price: 1.37 a a 1.37 a aCost: .50 a a .50 a aProfit: .87 a a .87 a aPresent value of profits: 1.52 0 a .65 a a'Each bulb costs SOIt to make; the service value of each type of bulbis SOItper year; the interest rate is 10%.

rather than sell three one-year bulbs for 50¢each, even though it meant selling fewerlight bulbs, as long as the cost of producing a.three-year bulb is less than nearly threetimes the cost of producing one three-yearbulb.' You'll get the equivalent of $1.37 ineither case, but if the cost is less than $1.37

i,,

'''Almost'' because you would be able to producetwo of the one-year bulbs later ..and therefore the pres-ent value of those later costs is less than 50¢ each.Their present cost is 50¢/(1 + r) and 50¢/(1 + r)'. If r =10%. the present value of costs is 50¢ + 45¢ + 41¢ =$1.36.

118 Chapter 6

for a three-year bulb you'll make money pro-ducing it, despite fewer sales, because you'reselling at a higher price and incurring a costthat is less than proportionately higher.

The important conclusion is that it doesnot pay to suppress improvements just to sellmore old units, because the selling price ofthe better ones will be more than proportion-ately higher, and the costs won't. Only if thecosts of producing better goods were dispro-portionately higher-in which case theycould not be considered better-would it notbe profitable. Despite popular charges to thecontrary, it doesn't pay to suppress knowninventions that reduce the cost of maintain-

ing the same quality or Improve quality atthe same cost.

3. FORCED OBSOLESCENCE?

Another surprising application of this samepoint is to textbooks. If a text can be resoldand used by a second student, the initiel saleprice of the book, just like that of the lightbulb, will include the second student's usevalue, adjusted to present value terms. Sup-pose, for the sake of simplicity, that therewere no costs of arranging a resale of thistext to the next student. If both students val-ue their use of the book at $5, the publishercould have sold the new book for $9.55.2 Thefirst student would be willing to pay $9.55for the book knowing that it can later be soldfor $5 to the second student-for a net usecost of only $5 to the first student. (Remem-ber, $5 a year from now is equivalent to$4.55 now.)

Suppose the author gets 15% of the salesvalue: That's 15% of $9.55 rather than 15%of two successive $5 books. So, the two-lifebook (costing less to make than two one-yearbooks) would sell new for $5 plus $4.55 (thepresent value of the second year's $5 valuediscounted at 10% interest rates), or $9.55,which is worth two $5 receipts, one comingnow and the other in a year. Clearly, it is anefficient used-book market that permits this.

Just as you are willing to pay more for aVolkswagen because of its high resale value,you will pay more for texts that can be re-sold. Killing the resale value of a book (orautomobile or refrigerator or TV set), eitherby abolishing used-book markets or by quick-ly issuing new editions, profits neither au-thors nor publishers-a fact seemingly un-known to many authors but known topublishers.

2Assumingan interest rate of 10%. $9.55 = $5.00+ $4.55.

4. THE COST OF BORROWINGIS NOT THE SUM OF REPAYMENTS

Many people calculate the cost of borrowingas being the sum •.of all the future interest.They are wrong to do so because paymentsat different times are not equivalent claimsto consumption power. Payments nearer thepresent are claims to greater consumptionpower. The correct method, then, is to con-vert all the payments to equivalent consump-tion values as of any common time-say tQ.epresent-before adding.

To see why, one must remember themeaning of cost-the sacrificed alternatives.Consider two alternative methods of repayinga loan of $4. In method A a $1.00 payment ismade at the end of each of five years. Inmethod B only two $2.25 payments are madeover the next two years. It might seem thatmethod A costs a total of $5 and method Bonly $4.50. But B involves repaying esrlier.Table 6-6 shows the two plans and their dif-ferences. If interest rates are 10%, repayingby method A gives the borrower more con-sumption power than does repaying by meth-od B. Instead of paying the first $2.25 to thelender under method B, the borrower couldpay $1.00 under method A and invest the$1.25 remainder at 10%. The $1.25 grows in ayear to $1.37, from which the second $1.00installment payment can be made. The re-mainder, 37¢, plus the $2.25 invested at thattime (instead of being paid as under methodB) totals $2.62, which grows in the third yearto $2.88. From this the third $1.00 installmentpayment can be made. The remaining $1.88will grow to $2.06 in the fourth year. Afterthe fourth $1.00 installment payment is made,$1.06 is left, which grows during the fifth yearto $1.17, leaving, after the fifth and final $1.00installment payment, a surplus of 17¢. That17¢ is how much more consumption the bor-rower would have given the lender under re-payment method B; using method A the bor-rower keeps that for himself or herself.


But recall our main point: Although thefive $1.00 payments under method A appearto make up a larger sum than the two $2.25payments under method B, the sum under Ais really smaller when the timing and interestgrowth are properly measured.

The preceding involved a lot of tediouscalculation. A simple way to find the cheapermethod is to compute the present value ofeach payment scheme. The present value, at10% interest, of the series of five $1.00 pay-ments is $3.79: That is the amount todaythat, at lO7o interest, will enable you to pay$1.00 in each of the next five years. Thepresent value of the shorter, two-term $2.25payments is $3.90-some 11¢ more costly.That 11¢ is the difference now; the 17¢ dif-ference calculated above was the differencefive years from now. At 10% rate of interestper year, 11¢ will grow in five years to 17¢.Nickels and dimes-but on a $400,000 loanthe difference would have been $11,000 nowand $17,000 five years from now.

To ensure that you thoroughly under-stand what is happening, and why the inter-est rate is crucial, suppose the rate of interestwere only 5% per year. Then the present

value of method A, $4.33, would be biggerthan that of method B, $4.19. At 5%, then, itpays to repay in two $2.25 installments undermethod B. The reason for the difference isthat with so Iowa rate of interest (growth ofpresent values to future values), an earlierexpenditure or sacrifice of consumption pow-er won't so quickly or likely exceed later, de-ferred purchasing power. At low rates it paysto defer more and pay more in the future.

5. PAY NOW OR PAY LATER

Consider a lesson from the early 1970s, whenenergy prices were still controlled and weretherefore unable fully to influence uses of en-ergy. At that time, and still today, lower-priced air conditioners were made with less-costly cooling systems that require moreelectrical energy to operate than higher-priced models having the same cooling capac-ity and useful life. Several legislators pro-posed prohibiting the sale of air conditionersusing more electricity. But prohibition ofthose high-energy users could be wasteful.Why? Table 6-7 shows hypothetical data forair conditioner A, cheaper to buy but using

Table 6.6 COMPARISON OF TWO METHODS OF REPAYING (10% INTEREST RATE) $4 DEBT

Year-End Number

1 2 5

Method B payments -$2.25 -$2.25-$1.00-$1.00

1.37-1.00

.37+2.25

2.62 grows to 2.88-1.00

Method A payments

Extra payment in B:-$1.90

«

1.25 grows to

120 Chapter 6

3 4

-$1.00 -$1.00

1.88 grows to 2.06-1.00

1.06 grows to 1.17-1.00

Excess cost of method B over method A = .17

Table 6·7 ENERGY COST EXAMPLE

Annual PresentPurchase Energy Cost Value at 6%

Machine Cost in Each of 10 Years of All Costs

Energy user A $ 60 $25 '"$ 60 + $184 = $244Energy saver B $100 $20 $100 + $147 = $247

more electricity, and for air conditioner B,higher priced but energy conserving. Onlypurchase price and annual energy costs differ.

Some people might argue that you wouldsave $5 a year for 10 years with machine B sothat the energy saving of $50 in 10 years ex-ceeds the $40 higher production cost. But youshould spot the error: You must not add upthat series of $5 annual energy savings, be-cause each occurs at a different time in thefuture. It is their present value that must becomputed.

For each machine the present value ofthe total outlays, present and future, for thenext decade is shown at a 6% rate of interest.The present value of all outlays for air condi-tioner A (lower in price but higher in energyuse) is lower than that for B (higher in pricebut lower in energy use). The difference inpresent values, $3 (= $247 - $244), is whatwould be saved in total resource value overthat interval, counting all costs-materials, la-bar, and energy. Why? The difference in pur-chase prices, $40 (= $100 - $60), would earn,at 6% interest rate, the equivalent of an annu-ity of $5.43 each year for 10 years-which ismore than the extra $5 cost of energy for thehigh energy user." In this example, the lower-

'Either Table 6-3 or Table 6-4 can be used tocalculate the l G-year, 6% annuity purchased with the$40. In Table 6-3 the present value of an annuity of$1.00 per year is $7.36. Because here we save $40 onthe principal, divide $40 by $7:36 and obtain the yearlyreturn of $5.43. In Table 6-4, the IOvyear annuity pur-chased with $1.00 is 13.6¢ a year; with $40, we pur-chase 13.6¢ X $40 = $5.44, which is more than the sav-ings in energy costs.

priced machine uses a lower total value of allresources (of various kinds and at varioustimes). It is wasteful to save energy worth lessthan other resources thereby used up. -

This example illustrates two economicprinciples: First, it is incomplete analysis, andhence incorrect analysis, to try to economizeon only one component of costs-for exam-ple, energy. The value of the energy saved isonly $4 per year, but it comes at a $5.43 costof other resources annually. Minimizing thecost of some one input always increases thecosts of some other inputs by more than thesavings in the minimized input. Maximizingthe output per unit of anyone input of pro-duction has the same negative effect, increas-ing the costs for other inputs by more thanthe gains. Such technological output-inputratios (or technological efficiencies, as theyare called) are misleading for making deci-sions. (

The second economic principle is that ofcapital valuation, the only correct way tocompare costs: Before expenditures at differ-ent times can be added they must be convert-ed to contemporary values as if they all oc-curred at one common time. Costs aresacrifices of other goods; a proper measurethat finds the lowest capital-valued costmeans the least sacrifice of other goods. Thatis also all that is meant by efliciency: There isno waste.

6. HONOR THY PARENTS

Your parents, having reached age 70 withsavings of $50,000, plan to retire on that


fund. They want to use it at a rate that per-mits them to draw out the largest possibleuniform amount each year for 15 years. Afterthat, if they are still alive, you will shoulderyour moral responsibility and take care ofthem financially. How much can they spendeach year for 15 years? The question can berephrased in the terms we've been using:What 15-year annuity is equivalent to a pres-ent value of $50,000? If you get 10% interestper year, the present capital value of a 15-year $1.00 annuity, as seen in Table 6-3, is$7.60. Since there is now $50,000 in the fund,$50,000/7.60 = $6570, the amount of eachannual payment. (This is an approximation',because $6570 is really the amount thatcould be spent at the end of each of fifteenyears, not during each year; but the differ-ence is slight.) If they want to use up thefund in 10 instead of 15 years, they can get$8140 (= $50,000/6.14) at the end of eachyear. If they earn only 4~o, they can get a 15-year annuity of only $4500 (= $50,000jl1.1).

7. WHO CARES ABOUTDISTANT FUTURE YIELDS?

",tII

Does the private-property, capitalist systemfail to heed the values of future generations?No. It heeds the perceived distant future val-ues as well as it does the near-term expecta-tions. It does so because the anticipated fu-ture value of a good and its present value arerelated in such a way that the present valuesteadily rises at the interest rate to that fu-ture value at that future date.~

Figure 6-1 shows the path of the gradu-ally increasing capital values of a resource, alive tree, that will yield a single service, lum-ber, at some one future date. The figureshows both the value of the wood if it werecut down and used as lumber at any givenyear, and the time path of the value of thetree if left standing. When the two valuescome together it pays to cut down the tree.For all earlier intervals the tree is worth

III;!!:li\"lil-----j-2-:2--c-n-ap-t-er-6-----------

"ill

more alive because the wood is growing fast-er than the rate of interest. So it pays toplant trees if the initial year's value exceedsthe costs of planting the tree. The verticalvalue scale is logarithmic; that is, a constantslope represents a constant percentage rateof growth. As time passes and we approachthat future date, the present capital valuerises toward that anticipated future value,and rises at the market rate of interest. Con-sequently, the date at which you might in-vest in that resource has no effect on yourrealized rate of return. If you invest in thefirst year, or any year, you will get the sameannual percentage rate of growth, as long asbeliefs about the future value of the lumberdon't change.

You can expect the same rate of re-turn-the rate of interest-whether you in-vest in a new or an old resource. You couldget 10% per year whether you buy a lot ofyoung trees for $1000 or one tree nearlyready to cut for $1000. They are equallyprofitable. What ensures that equilibrium?People don't give away opportunities to getmore than the rate of interest-that is, prof-itable opportunities. If a young tree werepriced so low that people expected to get ahigher return over its life than 10% per year,everyone would want to buy it; if it werepriced too high, the return would be smaller,so no one would want to buy it: The pricewould adjust. Every durable good whethernew or old will be priced on the expectationof the same interest rate of return.

So young trees would be valued highenough to make it worthwhile to plant themand not cut them, for if they were cut downbefore their growth rate fell to the rate ofinterest, the extra value of lumber from thetree would be sacrificed. If the value of a livetree exceeds that of its lumber, it should notbe cut. That excess value is simply the dis-counted value of the future lumber growth ofthe tree that is greater than can be obtainedin any investment in anything else-the rateof interest. When the growth rate of lumber

$

Future Value Equivalentto Present Valueof $300 at 3%

Interest

Future Value Equivalentto Present Valueof $150 at 4%

Interest-----./

1,500

1,000900800

~ 700~ 600

500

WealthMaximizingLife Span at

4% Interest Rate

o 5 ·10 30 4020

Years of Life

in the standing tree no longer exceeds the in-terest rate and falls below it, the value of alive tree will rise less than the rate of inter-est; the tree's value will not grow thereafteras much as investments in other things. Topreserve the tree solely for more lumberwould be wasteful, since the lumber can beused more productively for investment thatwill get at least the rate of interest-which isnow more than the live tree can do.

Contrary to the common belief that thecapitalist market system undervalues the fu-ture, the future is valued and valued no high-er for one resource than for any other. Anyowner of a standing tree will lose wealth if itis cut while the value of its lumber growsfaster than the rate of interest-which is therate of net productivity on other resources.People have been misled probably becausemany resources-natural ones especially,such as trees, buffalos, whales, or lakes thatno one owned-have not been subjected to a

Value ofLumberat Time

Tree is Cut

I..----·---WealthMaximizing

Life Span at3% Interest Rate

50 60 8070

Figure 6·1.

GROWTH OF CAPITAL VALUE OF A TREE:OPTIMAL CUTTING TIME DEPENDS ON INTERESTRATE AND PATTERN OF GROWTH OF LUMBER VALUE

The dollar values are given on a logarithmic scale. As thetwo interest curves and the lumber-value curve show, ata 3% interest rate the tree should be felled in its sixtiethyear and at a 4% interest rate in its fiftieth year. Theseare the wealth-maximizing life spans. Cutting the treedown any later will yield less lumber value than wouldcutting at these optimal times and reinvesting in newtrees, which would grow faster than a 60-year-oldtree and faster than the interest rate.


market evaluation so as to prevent overcon-sumption.

What is true for things like trees thatrender their services all at one end point istrue for goods that yield a continuing streamof services, like machine tools, land, houses,art, gold, oil wells, or common stocks andbonds. It is a fact that the expected rate ofreturn on all those is the same-if one cor-rects for degrees of risk. A slightly higher ex-pected rate of return will induce people toown riskier assets. It is remarkable how smalla premium will induce people to bear greatervariability of potential outcomes, that is, risk.One reason is that risky assets can be ownedjointly with other assets that tend to reducethe risk of the combined set.

8. ARAB OIL POLICY:IS OPEC FRIEND OR FOE?

Since 1974 the common assumption has beenthat Arab oil producers colluded to raiseprices, because the world demand for oil hadless than unitary elasticity. (Remember thedefinition and significance of this fromChapter 2.) But another explanation is possi-ble. The Arabs might have begun to suspectin about 1973 that prospective future sup-plies of petroleum would not satisfy futureamounts demanded at current prices, andthat even without any Arab conspiracy to re-duce output, the competitive market pricewould be as high as $30 a barrel in 1985.Thus, assuming a 10% interest rate, a barrelof oil 10 years prior, in 1975, would be worthabout $12. Such a new projection of the fu-ture energy situation and consequent futurevalue of petroleum would mean that no pro-ducer would extract oil in 1974 unless itcould be sold for almost $12-instead of the1973 price of $3.

Under this interpretation, the Arabshave done us a service: By preventing exces-sive consumption of oil in low-value (that is,less than $12) current uses, they preserved

124 Chapter 6

more for the higher-valued uses in the fu-ture, as conservationists contend should bedone for beaches, forests, and other naturalresources.

This brief scenario illustrates how thepresent price of a durable good depends onthe expected future use values of that good.The price now will rise (and curtail currentconsumption) if the expected future valuesuddenly rises until the new current andnewly perceived future values differ justenough to cover the expected costs of storageand interest. Whether the forecasts of futureoil supplies and demands are correct-ormore realistically, how small their error isand in what direction-is unknown. But anyperson or agency that can systematically dobetter than open-market competition couldget enormously rich by buying those re-sources at what they "know" are excessivelylow prices.

9. RANDOM PRICECHANGES AND STOCK SELECTIONS

According to the preceding principles, be-cause the present values of resources reflectanticipated future values from earnings, rent-als, or sales, every resource should be pricedto reflect the same expected rate of return:the market rate of interest. An underpricedasset would give a higher rate of return thanother assets, so people would drive up itsprice as they competed for that bargain; con-versely, an overpriced asset, one priced high-er than the discounted (at the rate of inter-est) value of the anticipated future rentalsand receipts, will yield less than the rate ofinterest. So no one would want to hold it atthat price, and its price would fall. The priceof every resource must be such that the ex-pected return is at least as good as on anyother asset, and that rate of return is themarket rate of interest.

The preceding principles have somevery powerful and surprising implications.For example, they indicate that the past path

of prices of some resource is irrelevant inpredicting whether it is now underpr,~ced oroverpriced relative to future yields or prices.If in the past month the price of some shareof common stock on the stock exchange hasfallen drastically while another has risen con-siderably, which is the better buy? The pastprices do not tell you which. One price hasfallen just far enough to give an expected fu-ture growth that just matches the currentlyperceived future prospects of the stock thathas risen. The currently perceived future ex-pected average gain from each stock is thesame for all stocks.

We have just seen how economic analy-sis says that prices are set in open markets.What are the facts? Do past paths of stockprices indeed give no clue about which stockoffers greater prospects of a gain? Yes. Allcorporate stocks are currently priced in thestock market so as to offer the same expectedfuture gain, and the past prices add no infor-mation that will help make a more accurateselection of which one can be expected torise more than the other. The price willchange by more than the normal rate of in-terest only if there is some change in knowl-edge or belief about the future. But thosechanges are by definition not predictable-orthey would already have influenced the cur-rent stock price. The stock price will vary inthe future at random around the same ex-pected average rate of return. There is anequal chance that it will go up enough togive a gain more than the rate of interest orwill go down by an offsetting amount. Priceswill change, but the path or sequence ofchanges will be at random around an averageexpectation equal to the rate of interest.

No price patterns are known that allowanyone to make profits predictably, though alot of people chart prices in the futile hopethat they can thereby beat the market. (Theperson doesn't exist who systematically or re-liably does so; at least such a person hasn'tbeen identified.) You might as well pickstocks at random and hold them without con-

tinually trying to revise your holdings. (Lat-er, in Chapter 17, we present some more de-tails about common stocks and how muchthey vary randomly.)

Stockbrokers and investment counselorshave begun to realize these facts and now of-fer portfolios (sets of stocks) that essentiallyencompass the diverse range of stocks on theexchanges. These are called indexed fundsbecause they are "indexed" to or representa-tive of the whole market. Indexing avoidsfruitless and expensive research to pick be-t-ter stocks, as if the counselors could reliablybeat the best of the rest of the world. In ef-fect, these counselors simply buy a set ofstocks and hold them, buying or sellingstocks only if the flows of funds in or out donot match. All this is exactly what the pre-ceding principles of capital values imply for amarket in which anyone who wants to buy orsell is entitled to do so at whatever prices heor she negotiates.

What then can "your" stockbroker tellyou? Only what any other stockbroker cantell you: what are common, preferred, andparticipating preferred stocks, bonds, treas-ury bills, and the like; where the stock mar-kets are; how to place an order to buy or sellmost cheaply and conveniently; where tohave your securities held; how to collect yourdividends; how to handle some tax matters.But for learning which stocks are more likelyto give a gain, or whether the market is like-ly to be rising or falling and other such fore-casts-plug your ears. (Remember: If theycould predict better, they'd be too rich tobother with customers.)

10. HIGH AND INCREASINGCALIFORNIA LAND VALUES?

Some desert land in California is nearlyworthless, but some along the coast is aston-ishingly expensive. The puzzling facts arethat land values keep rising in Californiamore rapidly than elsewhere, and, still more


· ...~ Table 6·8 ASSUMED FUTURE RENTALS AND CAPITAL VALUES OF MIDWEST LAND

iti.~

I California Midwest

,II Assumed Value of Land at Assumed Value of Land atYear Rentals Beginning of Year . Rentals Beginning of Year

I 1 $10.00 179 $10 $100I,2 12.50 187 $10 $1003 15.00 193 $10 $1004 17.50 197 $10 $1005 20.00 200 $10 $1006 20.00 200 $10 $1007 20.00 200 $10 $100

.. ,'I. 'I

1

puzzling, that land in California with annualrents of $10 a square foot sells for $180 asquare foot-far more than land of the samecurrent rent in the Midwest, which sells foronly $100. How can land prices in Californiafor land of the same current rental or servicevalue be so much higher and continue to risemore steeply than land elsewhere? Whyhasn't the prospect of a more rapid increasein California's population adjusted the pres-ent California prices upward once and foraJl? Are people continually being surprisedand revising their expectations, and henceprices, upward, whereas in the Midwest fore-casts are more accurate? No, it all makes per-fect sense, if you keep in mind the distinc-tion between present value and future rentsof a parcel of land. The explanation rests onthe expectation that population will risemore rapidly in California, which implies in-creasingly higher future annual rents thanwill occur in the Midwest where rents won'trise at all. Say two pieces of land for salehave the same present rent: The price of theland with rising expected future rents willexceed the price of the land with constantexpected future rents. Furthermore, its valuewill rise faster (at the interest rate) over timethan the Midwest land as those higher futureCalifornia rents get closer in time.

Table 6-8 gives an example: Both par-

Ii

126 Chapter 6

cels of land have the same first-year rental of$IO.per square foot, but one parcel draws aconstant rent and the other has a rental ris-ing in four years to $20, at which it thenstays constant. At a 10% rate of interest, itspresent value is about $179 per square footor 17.9 times the first-year rental, whereasthe present value of the constant-rent land isonly $100, 10 times its first and constant an-nual rent. Which investment is the betterone? And in the first year, when the rentalvalues are the same, which is the cheaperone to buy for the first year's service?

The answer is that both have the samecost for a first year's rental and both areequally profitable investments. In Californialand value rises during the first year to $187,a gain of $7.90. In the Midwest land valuedoesn't rise. In both places the rent is $10.00in the first year. If you buy land in Califor-nia, you must invest $79 more, which couldhave earned 1070' or $7.90. So in Californiaduring the first year you get three things: a$7.90 capital gain, plus a $10 rental income,minus $7.90, the forgone interest on yourgreater investment of $79-all of which addsup to the $10 cost of a first year's rental ofequivalent land in the Midwest. The capitalvalue gain exactly matches the lost earningson the extra $79. You don't make any profiton the California land just because it rises in

value; you just get interest on your larger in-vestment paid for that larger future rentalstream. It doesn't cost any more to occupythe land in the first year even if the purchaseprice of the land is higher than that of otherland with the same initial rent. The resultsare the same for every year in the future un-til one stops growing in rental value relativeto the other. Only people who bought landbefore expectations changed about future in-creasing population density will have made aprofit on California land.

An exactly analogous situation is agrowth stock such as Xerox, which started ata high price and increased in price by a high-er percentage because it had earnings thatwere expected to increase, whereas someother stock with the same current earningswas expected not to grow in earnings. Eachstock has equally good profit prospects forexactly the same reasons as just explained forland prices. Just change the words "land" to"stocks" and "rents" to "earnings." If thestocks weren't equally good prospects, whoare the fools selling the stock with a betterprospect of a gain, and who are the fools buy-ing the stock with a poorer prospect? Eco-nomic analysis doesn't rely on the assump-tion that all people are fools. It assumes thatpeople don't want to give away profitableprospects, and that there are enough peopleto prevent detectable underpricing or over-pncmg.

11. IS BORROWING ATHIGH INTEREST RATES MOREEXPENSIVE DURING INFLATION?

None of the preceding analysis and applica-tions assumed a continuing inflation ofprices. Inflation is a rise of all money pricesat the same percentage rate. Inflation is ex-amined in detail in Chapter 19. Here it suf-fices to say simply that inflation is inducedby increasing the national supply of moneyfaster than the stock of real goods. The morerapid increase of the money stock induces an

inflation of money prices of goods. The valueof money falls; or, put another way, market-clearing prices go up. In later chapters wewill examine why the money supply in-creases so much faster than the supply ofgoods. ~

How does inflation affect the rate of in-terest? To emphasize the relevance of thequestion, let us investigate whether infla-tion's effects on interest rates make it moreexpensive for young people to buy houses orcondominiums (apartments that are boughtrather than rented), as is often contended. ,.,

If lenders and borrowers expect inflationto continue-say at the rate of 10% peryear-lenders will insist on being repaidmore dollars, to compensate for the reducedpurchasing power of the dollar when it is lat-er repaid, and borrowers will be willing tocomply. Thus, if the real rate of interest-the rate in the absence of inflation-were5%, then with an expected 10% inflation thelenders would be able to get a rate of interestin money terms of about 15%. And you, toborrow, would be willing to pay 15% peryear. The reason is that what you buy withthe borrowed funds of, say, $100 will beworth 10% more dollars in a year, so yougive up only 5<;'0 in real terms when you pay15% in money while getting 10% higher dol-lar value in your investment. You have a realcost of only 5%.4

It is true that a $15 interest payment isgreater than a $5 interest payment. But weshould be clear about what that extra $10 (orextra 10%) represents. It is not an interestpayment to the lender. The reason will be

'For one-year loans, the relationship between thepromised real interest rate r and the promised nominalmoney interest rate, R, if the price level is anticipatedto increase at the rate of p percent a year, is:

(I + R) = (I + r)(1 + p) = I + r + p + rp.If we consider rp to be negligibly small, then R = r +p. In Israel, where inflation has exceeded 100'70 peryear, interest rates of over 100% per year are common.


clear if you think ahead to the time the debtcomes due, say in 10 years. At that time whatyou have bought now, say the condominium,will have risen with 10% annual inflation toover twice its original value-indeed, toabout 2.6 times its initial value. If inflation iscorrectly anticipated, what you bought for$100 will be worth $260 in 10 years. But allyou must repay at that time on your debt isthe principal dollar amount of $100, $160 lessthan if you were to repay an amount reallyworth as much as you borrowed initially.That would have given you a gain of $160.However, it is that $160 which you are pay-ing for with the extra $10 payments in the$15 "interest." Of that so-called interest of$15, about $10 is an earlier repayment ofsome of the debt. When the debt is finallydue, all you have to pay is $100 despite thefact that all prices are 2.6 times higher (as, onaverage, will be your income and everythingelse you own) than if there had been no infla-tion and all prices were the same as initially.In full effect, you borrowed $100 and endedup with something worth $260 after paying5% real interest. You are no richer in realterms. Instead of repaying the lender $260 atthe end of 10 years to compensate for the ef-fect of inflation on the principal due, youhave been paying back some of the principalearlier in those $10 extra payments that wereincluded in the $15 inflation-adjusted inter-est. The inflation-adjusted interest has twocomponents: a payment of interest in realterms plus a repayment of part of the princi-pal earlier than if there h~d been no infla-tion, for in the absence of inflation the bor-rower could have paid only interest for thelife of the loan and repaid the principal in alump sum at the end. The money would givethe lender the same purchasing power as ithad when it was loaned out.

A borrower who did not want to repay adebt so fast with such large early paymentscould borrow $10 more every year to pay thathigher interest. But in 10 years that borrower

i I

1'1'11·,1/ II

qI .1,---------------------------------------

I i:jI;[ 128 Chapter 6

would owe $160 more on that extra debt, atotal of $260 instead of the initial $100. Inreal terms that is the same as if there hadbeen no inflation and people paid only trueinterest until the debt was due, at which timethey repaid the same real principal.

Alternatively, instead of going deeperinto debt (in nominal dollar, but not in real,terms), the borrower could agree to repay5% every year on a principal that increasesat 10% per year. In that case the paymentsfor interest would be $5 the first year insteadof $15, and $5.50 in the second year insteadof $15, and $6.04 in the third year, and so on,until in the tenth year the interest (the realinterest) would be 5% of $260, or $13. In thiscase the real interest keeps a constant pur-chasing power, but the debt owed will haveincreased to $260 at the end of the term,which will have the same real purchasingpower as the initial $100-and the house willbe worth $260. You could sell it and payoffthe $260 debt at the end of 10 years.

What if the inflation rate proves to be alot less than expected? Then a borrowerowes more than was borrowed in real terms.What if the inflation is higher than expect-ed? The borrower will get a bonanza. Andthat is the trouble with an inflationary situa-tion. Predictions of the future become morecritical and add to our uncertainty and hesi-tancy to borrow and invest. But that is an-other story best put off until later.

When this was written, in 1982, themonetary (nominal) rate of interest being ne-gotiated on first class (AAA) long-term in-dustrial and U.S. government bonds wasaround II %.5 If currently negotiated nominalinterest rates incorporate anticipations of in-flation of about 57'0 to 7%, the promised realrate is about 4% to 6%-not a very unusualreal rate on very safe investments, judgingfrom the past century of experience. (What

'In the financial community, the most securebonds are given the rating AAA. called triple A. andsuccessively less-secure bonds are rated AA. A. and B.

the actually realized real rate will be dependson what the actual inflation rate happens tobe over the life of the bond.) Failure to dis-tinguish between the nominal rate of interest(which includes adjustments for anticipationsin inflation) and the real rate of interest iswidespread and a source of great confusionin the political arena and the news mediaalike. You should now be able to avoid suchconfusion.

Wealth, Interest,Income, and Profits

Physical wealth is the current stock of eco-nomic goods. The market value of that phys-ical wealth is the sum of the market values ofthe individual goods. Wealth is used some-times to mean the market value of the goodsand at other times to mean the collection ofthe goods. (Remember also the still greatertotal personal use value.)

STANDARD INCOME

If the physical stock of wealth is put to itshighest-valued uses, in exactly one year itwill be expected to be larger by the rate ofinterest. During the year society could haveconsumed that increase in wealth and stillhave the same initial amount of wealth atyear's end. This market-forecasted sustain-able rate of increase in wealth is called stan-dard income. If wealth is $100 and the rateof interest in the economy is 10<Jo,then theforeseen, permanently sustainable annualstandard income is $10 per year. By defini-tion, standard income, wealth, and the rate ofinterest are related as follows:

1= WX rwhere I denotes standard income, W is themarket value of physical wealth, and r is theannual rate of interest. If you know the valueof any two of these, you can determine thethird.

SAVING

Saving is the nonconsumption of standard in-come. Saving (that is, not consuming) someof that income enlarges wealth because thesaving is added to "'the wealth. If you investthe saving, you'll get even more wealth;you'll get interest on the investment. If youconsume more than your standard income,that is, dissave, you will have less wealth atyear's end than you started with.

PROFITS AND LOSSES

Wealth may surprisingly increase by morethan expected. If that gain in wealth is notaccounted for by receipt of interest or invest-ment of savings out of standard income, thereis a profit. For example, assume there is noinflation and that wealth would grow, with nosaving and no investment, in one year from$100 to $106 because the interest rate is 6%; thestandard income is $6 per year on that wealth.But if the market value increased by more thanthe savings (that is, to more than $106), or toover $100 if all the $6 standard income hadbeen consumed, the net gain is called profit:the change in wealth not accounted for by in-vestment of savings of standard income.

Suppose an asset has a market value of$150 at the beginning of a year and $200 at theend. At an interest rate of 6%, the predictedvalue would have risen to $159 (= $150 X 1.06)if all of the interest (standard income) weresaved. The unpredicted increase in value, $41(= $200 - $159), would be profit. Alternative-ly, if none of the standard income had beensaved, the value would have been expected toremain at $150. Then, all of the $50 increase(to $200) would have been profit. In general,profit equals the value at the end of a periodminus initial value and minus the saving out ofthe predicted interest (standard income).

If your wealth today is $100 and there isunexpected good news about future yields ordemands for the services of the goods you own,


the market value of the goods will instantlyjump to, say, $120. Your $20 increase in wealthvalue that was unpredicted by the market is acapital gain, or profit. Now you foresee thatyou can get $2 more standard income per yearevery year thereafter: $12 per year instead of$10. That profit can be expressed either as awealth gain of $20 or an increase in the stan-dard income flow of $2 per year."

We commonly express this ambiguouslyby saying that any rise in wealth that is unex-pected by the market is a profit, and any fall isa loss. Of course, it is possible that some personwith confidence or foresight or luck bought thewealth and then got a profit when it rose morethan the rate of interest could account for. Thefact that the buyer had been able to buy at aprice that yielded a profit demonstrates thatthe growth was not fully or accurately expect-ed by other people, that is, by the market.

Capital Values,Property Rights,and Care of Wealth

Changes in anticipations of future events af-fect present prices of goods, or assets. In thestock exchange these revisions are made es-pecially apparent, because the price of ashare of common stock-a share of owner-ship in a business corporation-is the capital-ized present worth of the anticipated seriesof future earnings. If it is newly anticipatedthat higher taxes will be placed on cars orthat gasoline prices will rise more than for-merly expected, the value of General Motorsstock will drop now, imposing a loss ofwealth on the current owners of resourcesspecialized to General Motors' production ofcars, that is, the stockholders.

Both private-property rights and capital-

!f, IIf'l

t"'1( !',

"More detailed exposition of the sources of profitsand other meanings of the term are given in Chapter 9.

130 Chapter 6

goods markets (in which ownership of assetscan be bought and sold) are essential founda-tions of the market system for organizingeconomic activity; if the rights or the mar-kets or the prices are suppressed, the result-ing system will lead to actions that appear tobe wasteful or shortsighted, especially in theway things are consumed and maintainedand in the kinds of investments. The home-owner who can resell a house will maintainand repair it now even though the repairsmay not yield better housing now. The own-er will do so because the present market val-ue of the house anticipates the lower futuremaintenance costs that result from the pres-ent repairs. The value of the house is there-by maintained.

This might suggest that tenants wouldnot maintain the premises they rent. And theowner, who is not blind to this possibility,takes selective, contractual precautions.Rental contracts provide incentives for ap-propriately careful use of the property bytenants. The owners will be more careful inselecting tenants, avoiding unreliable ones,unless housing laws force the owner to beless discriminating.

The effects of different types of propertyrights are illustrated by the modern businessenterprise. The owner is influenced by allanticipated effects, present and future, thatchange the present capital value of the enter-prise. Foreseeable developments and conse-quences of present acts will be capitalizedinto the owner's resources, which are morespecialized to this firm in their usefulnessand value than are its employees, who aretherefore less motivated by the foreseeablelong-run consequences to the enterprise. Tomake employees' actions more responsive tothe total span of effects, two claims systemsare sometimes added to the wage system.One is a stock option for managers and em-ployees who have the most influence on thelong-run effects and wealth of the firm.These people have rights to buy shares ofstock at preassigned values. Because the

f ,

long-run anticipated effects of their actionsare capitalized into the present value of theshares of stock, those employees will paymore heed to their long-run effects than theywould without stock options. In the secondsystem, profit sharing, managers and employ-ees share the annual earnings of the firm."Profit sharing", that is, sharing in some ofthe profits, does less than the stock option toemphasize the future effects of present be-havior since current earnings do not includechanges in the capital value of the firm. Be-cause current accounting earnings do not in-clude the wealth effects of the longer-run im-plications of present events, earnings fail todirect full attention to all the wealth-chang-ing consequences of current employee be-havior. We will analyze the organization offirms in more detail in Chapter 9.

Summary1. Capital goods render services now and in

the future. The current price of a capitalgood is the sum of the value of current ser-vices and the present values of the future ex-pected services.

2. Earlier availability of services is typicallymore valuable than their later availabilitybecause appropriate investment and use ofcurrent services makes possible a net in-crease in future services.

3. In addition to being the time premium paidfor borrowed wealth, the interest rate is ameasure of: (a) the relationship between pre-sent amounts of a good and the amounts offuture goods for which the present amountcan be traded; (b) the maximal growth rateof wealth; (c) the price of earlier relative tolater availability; and (d) the rate of standardincome relative to wealth.

4. The cost of borrowing is not the sum of theinterest payments, but is instead the presentvalue (discounted values) of the future inter-est payments, because, even with zero infla-tion, earlier payments are greater sacrifices

,5. The higher the rate of interest, the lower

will be the present value of a future service.

6. P(I + r)t = A is a way to summarize therelationship among present value, P, rate ofinterest, r, time, t, and future amount, A.

7. Under private-property rights, foreseeablechanges of the future value of services fromsome existing good are capitalized by achange in the current price of the good.Those wealth changes are incurred by £heowner of the good at the time the futureconsequences of any act are foreseen, ratherthan when and if they later occur.

of consumption potential than are later pay-ments of the same dollar amount.

8. The maturity date of any good (that is, thedate at which it is consumed) affects its pres-ent value but not the rate of return on itscurrent value. There is thus as much incen-tive to invest in slowly maturing goods as toinvest in rapidly maturing goods, becausetheir anticipated future value is competitive-ly bid into their current price.

9. Producing shorter-lived goods in order tosell more replacements is not profitable be-cause the sales prices of shorter-lived goodsare proportionally less than those of longer-lived goods, and extra costs of replacementare incurred.

10. The nominal rate of interest has normallybeen between 270 and 4% per year on se-cure capital. But if inflation is expected, thenominal interest rate includes a premium tocover the expected rate, to compensate forthe depreciation of the money in whichdebts will later be repaid.

II. Physical wealth is the current stock of eco-nomic goods.

12. The market value measure of that wealth isthe sum of the marketable values of thegoods.

13. Standard income is the highest market-fore-casted sustainable rate at which wealth in-creases. Standard income is equal, by defini-


tion, to the market value of wealthmultiplied by the rate of interest.

14. Saving is the nonconsumption of standardincome.

15. Profit is any increase in wealth in excess ofthat from savings out of standard income. Itis the growth of wealth in excess of that im-plied by the rate of interest. Losses are afailure of wealth to increase by the rate ofinterest.

16. Because there is no universal standardizedterminology, often what is here called stan-dard income is elsewhere called profit.

questions1. You invest $350 today. At the end of one

year you will get back $385. What is the implied,or effective, rate of interest?

2. How much will $250 grow to in three yearsat 7% compounded annually? How long will ittake to double?

3. At the end of a year you will get $220. At a10<.70interest rate, what present amount willgrow to that amount? In other words, what is thepresent value of $220 deferred one year at 1O%?

*4. In what sense is interest the price of mon-ey? In what sense is it not the price of money?

5. What is the present value of $2500 due infive years at 8%?

6. What is the present value of $2500 due in 10years at 8<.70 per year? _,

7. What present amount is eq~ivalent to $1000paid at the end of each of the next three years at8% interest? That is, what is the present value ofa $1000 three-year annuity at 8% interest?

8. You borrow $1000 today and agree to paythe "loan in five equal annual installments at 10%interest. Using Table 6-4, determine the amountof each payment, the first payment to be due inone year.

9. If you can borrow $1000 from your college ata 5% interest rate for six years, what is the pres-

132 Chapter 6

-ent value of the "gift" to you, at the market rateof interest of 10%? (Hint: Each year you canearn $100 by investing now at 10%. Whichwould you rather have-an outright gift of $300or that loan?

10. You buy a house by borrowing its full price,$80,000. Your annual installments in repayingthe loan are $9440 for 20 years at 10%. (Do youagree?) Check with Table 6-4.

a. At the end of the first year, how much ofthe house's value is yours; that is, what isyour equity? (Hint: On $80,000 the inter-est for the first year at 10% is $8000, butyou paid $9440 at the end of the firstyear.)

b. At the end of twenty years, assuming thehouse is still worth $80,000, what is yourequity?

11. Two refrigerators are available for purchase.One costs more to buy but less to operate.

PurchasePrice

Annual Operating Costin Each of 10 Years

A $400 $1008 $340 $110

Which is the cheaper source of refrigeration overa 10-year period?

* 12. If the value of your buildings or commonstock should fall, how can you tell whether therehas been a rise in the rate of interest or a fall inanticipated future net receipts? (Hint: Look atthe bond market. How will this help give ananswer?)

* 13. Which do you think will have a bigger in-fluence in revising your annual consumptionrate-an unexpected gift of $1000 or an unex-pected salary increase of $50 per month? (Hint:What is the present value of each at, say, 10%per year?) Why did the question say "unexpect-ed" gift and salary increase?

14. You receive word that the value of a build-ing you own has fallen from $10,000 to $5000.One possibility is that the interest rate has risento twice its former level. A second possibility isthat the building has been damaged by a fire. Ineither event your wealth is now $5000. Do youcare which factor caused a decrease in yourwealth? Why?

15. Mr. A has an income of $10,000 per year. AtChristmas an aunt unexpectedly gives him $5000in cash.

a. What is his income during that year?b. Is the $5000 gift a part of his income?c. How much is his annual rate of income

increased by the gift (at interest rates of10%)?

16. Estimate the present value of your futureearnings. Project your earnings until age 65.Then obtain the present value of that projection,at 10% interest. Are you now worth over$300,000?17. Time Fiber Corporation common stock sellsat a price 80 times as great as the accountants'reported current annual earnings. The stock ofAllegheny Ludlum Corporation, a steel producer,sells at less than 10 times its reported earnings.Assume that the same accounting principles areused in each firm. What do you think will hap-pen to the price of each firm's stock if in the nextreporting period each firm reports earnings thatare unchanged from the preceding period? Ex-plain. (What would the price-earnings ratio bein some year of losses?)

18. If your income from nonbusiness wealth is$500 a year, what is your nonbusiness wealth at10% interest?19. If you consume all of your income for twoyears, what will be your wealth at the end of twoyears, if it is $1000 now with 5% interest?

20. You contemplate purchasing a house in anew suburban development. You may buy thehouse for $40,000, but title to the land will re-main with the developer and you must pay $1000per year for land rent, and at the end of 50 yearsthe developer will get the house. You estimatethe land is worth $15,000, and that in 50 yearsthe house will be worth $40,000. Or you maypurchase the land and the house now for $65,000.At 6% interest, which is cheaper?21. "The employees of the South Bend LatheCo. were able to buy the entire common stock(and hence ownership) of the company for $10million in cash. The employees used a federalgovernment plan known as Employee StockOwnership Plan, or ESOP, whereby the ESOPemployee group was able to borrow the full pur-chase price of $10 million, of which $5 million

was lent by the U.S. government to the ESOPfor 25 years at 3% annual interest, and the other$5 million was obtained from Indiana banks at 4percentage points above the prime rate (then atabout 9%)." In effect, the $5 million loan fromthe federal taxpayers at 3<J'ofor 35 years was agift of how much in presentvalue terms? (UselQ% as the relevant cost of interest, ellen thoughthe employees must pay 4% above the primerate which ranged around 7% t08<J'o in 1976.)

*22. Do you know of any products that have be-come more expensive over the past several cen-turies or decades because of the exhaustion .•.ofcheaper ores or resources from which that prod-uct is obtained? Is it true for copper, iron, oil, tin,diamonds, coal?

23. A retired person has $100,000 to invest instocks and expects to get an income of about$10,000 a year (if interest rates are 10%). If youadvise purchase of stocks that payout no earn-ings as dividends, the person complains therewill be no income. How would you explain thatthere is an income of 10%?

*24. a. A family with the 1980 median incomeof about $21,500 buys a house at the me-dian price of $5 I ,920. Suppose no infla-tion were anticipated. and in fact noneoccurs, so the family can borrow at 3%interest. Suppose the family expects itsreal income to rise at 3% per year forthe next 30 years. This family borrowsthe entire price of a house and agrees tomake an annual mortgage payment of$2627, which will extinguish the debt in30 years. (Verify this by reference to Ta-ble 6-3. Two-figure accuracy is as closeas you can expect) That mortgage pay-ment will be a decreasing fraction of thefamily's rising real income.

b. Suppose instead a correctly anticipatedinflation of 8% per year occurs. Thefamily borrows $5 I ,920 at 11% to buythe house. Annual dollar income willrise at 11% per year for the next 30years. The price of the house now is$51,920 but its value will rise at 8%more than if there were no inflation.The family in this inflationary worldmust repay each year about $5900


(which can be verified by interpolationfor II<;'0in Table 6-3). This is 27.6<;'0 ofthe family's current income of $21,500compared to only $2627, or 12<;'0 of in-come, with no inflation. For this reasonit is argued that anticipated inflationmakes buying a home very difficult foryoung families. Yet we observe thembuying homes. Why? Are they con-fused? Look ahead a few years. What iscalled interest now also includes an earli-er repayment of the debt. Note that theannual payments are constant whereasthe future income and the value of thehouse rise enormously in 20 or 30 years,at which time the mortgage paymentsare a very small fraction of an equivalentreal amount of debt. In effect, the higherrepayment schedule under anticipatedinflation is really an earlier repayment ofthe principal. The real borrowing costs

I!> :

134 Chapter 6

are spread differently over time, beingearlier under inflation. To avoid earlierrepayment the family could borrowsome more every year to make thoselarger repayments, thereby deferringmore of the repayment of the total com-bined debt to the future so as to eventhe burden over time rather than con-centrating so much in the earlier years.

*25. In April 1981 Congress passed a law reduc-ing income taxes to take effect six months later,in October 1981. It was argued that, having moreincome left after taxes, people would beginspending more in October, increasing the de-mand for consumer goods. Others argued thatthe six-month delay between the law's passageand its going into effect would have no influenceon consumers. They would increase their spend-ing as soon as the law was passed, in April. Howcould the latter prediction be correct?

Chapter':ProductionvvithSpecialization

So far we have been investigating how a pri-vate-property, market-pricing system allo-cates consumer goods. But before goods canbe allocated they have to be produced. Howare our diverse ralents and efforts directedtoward production? We ask again: Must acentral planning agency collect data, makeoverall plans, and then issue directives orgeneral instructions? Again the answer is,No, there is another way to organize the pro-duction that a society undertakes.

It was first presented by Adam Smith ...in1776, in his book, An Inquiry into the Natureand Causes of the Wealth of Nations. Herecognized that altruism, an unselfish desireto help other people, could not alone solvethe problem of directing our energies to themost useful tasks. It could not alone tell uswhat to produce and in what quantities. Forexample, which of all the other peopleshould one aid the most in one's productionchoices? Some selection must be made; dis-crimination is inescapable. Smith recognizedthat if another force, personal self-interest,were allowed to operate, individual effortsand talents could be efficiently coordinatedto produce the most highly valued products.That was a startling proposition. It stronglyinfluenced the writers of the Constitution ofthe United States. That it is a valid proposi-tion under appropriate conditions has sincebeen established-a feat for which econo-mists have won Nobel prizes.

In this chapter we see how specializationof production (or what is also called "divisionof labor"), wherein people produce somegoods that they sell to others in exchange forthe goods they want to consume, can resultin a larger total output than if people self-sufficiently produced only what they con-sumed. We examine how that specializationis directed and organized and how it deter-mines people's incomes. In the next chapterwe investigate a second source of larger out-put: teamwork organized and controlledwithin the modern business firm. Actually,

135

because business firms also specialize in pro-duction, the system relies on a combinationof specialization and teamwork.

In economics we distinguish amongthree kinds of productive situations: Thefirst, in which the amount of goods is fixedand cannot be added to regardless of theprice incentive to do so, is called the marketperiod. When the period being analyzed isone in which more can be produced and sup-plied to consumers using the current stock ofproductive resources, it is called a short-runperiod. A long-run period is one in whichthe supply of productive goods-machines,labor, and the like-can be altered in re-sponse to price.

Production and ExchangeProduction occurs when the physical charac-teristics of resources are improved. Althoughwe commonly think of production as chang-ing the form of material-from ores to steel,from steel to cars or I-beams-productionalso includes improving the time of availabil-ity or location of a good. Moving water froma well into a house is productive, as are car-rying coal from a mine to a furnace; tillingthe soil, planting seeds, or caring for thecrop; harvesting, cleaning, grading, trans-porting, preserving, and distributing the cropto retail stores; or advertising, wrapping, anddelivering a good to the cqnsurner's home.Production may also be of music, films, andother forms of entertainment.

, ';#i!

Gains fromSpecialization andCooperation: A Simple Preview

The source of gains from cooperative special-ization can be suggested by a very simple ex-ample, which will help in understanding alater explanation that is both more preciseand more general. Suppose I could type 6 let-ters or make 100 bricks in an hour, whereasyou could type 12 letters or make 150 bricks.You are twice as good a typist and 1.5 timesbetter at brick making than I am. You can domore of either than I can in the same time.Suppose we want to build a brick wall andtype some letters. Who should make thebricks? Assume both kinds of work are equal-ly distasteful (see Table 7-1). If the wall willhave 600 bricks in it, it would take me 6hours and the sacrifice of 36 letters nottyped. My cost of making bricks is .06 lettersper brick. It would take you only 4 hourswith the sacrifice of 48 letters. Your brick-making cost is .08 letters per brick. I shouldmake the bricks because I can do so morecheaply, at .06 letters per brick, forsakingonly 36 letters for 600 bricks. That's the costif I make the bricks. In the 4 hours it wouldtake you to make 600 bricks, you could havetyped 48 letters; that is your total cost of 600bricks (at .08 letters per brick). I am the low-er-cost maker of bricks.

Even though you can make more bricksper hour than I can, you can also type better.But your superiority at brick making over meis lower than your superiority at typing overme. If you type and I make bricks, we will

Table 7-1 SPECIALIZATION AND MARGINAL COSTS DIFFERENCES

11

: !i

Product (Per hour)

Letters Bricks

6 or 100

.08 LettersYou 12 or 150

136 Chapter 7

Marginal Cost of

Letters Bricks

16.67 Bricks .06 Letters

12.5 Bricks

Table 7·2 DAILY POTENTIAL OUTPUTS AND COSTS OF PRODUCER A

Valueof Other

Output Total Marginal Average Concurrentof X Cost Cost Cost Output

0 0 0 0 $14.501 $ 1.00 $1.00 $1.00 13.502 2.10 1.10 1.05 12.40

3 3.30 1.20 1.10 11.204 4.60 1.30 1.15 9.905 6.00 1.40 1.20 8.506 7.50 1.50 1.25 7.007 9.10 1.60 1.30 5.40

8 10.80 1.70 1.35 3.709 12.60 1.80 1.40 1.90

10 14.50 1.90 1.45 0

have the most letters typed and have thebricks. In one 8-hour day we can have the600 bricks plus 108 letters (= 96 + 12). But ifyou make the 600 bricks, we will have only96 letters (= 48 + 48). In other words, when Imake the bricks, we sacrifice the fewer let-ters, 12. That is, we minimize the costs.

To better understand this, consider thatalthough you have an absolute advantageover me in numbers of bricks and letters, spe-cialization must be considered. What shouldbe compared is not the absolute number ofbricks that you or I can make per hour, butrather (a) my brick-making ability relative tomy typing with (b) your brick-making abilityrelative to your typing. In more familiarterms, we must compare my marginal costs ofbricks with your marginal costs of bricks-because costs are the most highly valued ofthe sacrificed alternatives. By making thiscomparison we discover the comparative ad-vantage of each use. Because of your absoluteadvantage, you will certainly be richer thanme, because you can produce more than I canper hour of either bricks or letters: You havean absolute advantage in both. But absoluteadvantage "determines wealth, not costs: Be-

cause I am a lower-cost maker of bricks, Ihave a comparative advantage in bricks, asyou have in typing. I will be richer makingbricks than if I type, whereas you will be rich-er if you type than tf you make bricks.

This example illustrates, first, the reasonfor specialization in production and, second,why and how costs determine specialization.We now show how specialization in produc-tion to increase physical output can be di-rected by market prices.

Specialization,Marginal Costs, and Trade

Corporations, labor unions, credit buying,suburban shopping centers, trading stamps,discount houses, factories, and all the otherinstitutions through which economic activityis conducted help the organization of produc-tion in a private-enterprise society; they donot obstruct it. A television set is a compli-cated mechanism, yet it is built up of a chainof relatively simple principles. Once theseprinciples are grasped, the method by which

Production with Specialization 137

I

'jI

II'J

II 1

I iI 1

I :II", I

Y

16151413

12.4

11.2

10

9a7654

3

21

0

1.2Yls} Marginal Cost

at Third X

)

1.7 Y IsMarginal Cost

at ax

B

1 234 5 6 7 a 9101112131415

Figure 7-1.

TOTAL PRODUCTION POSSIBILITY OFPRODUCER A FOR PRODUCTION OF X AND Y

For any output of X, the height of the line measures themaximum feasible output of Y. The larger the output of X,the smaller the feasible output of Y. The steepeningslope at larger X shows that greater and greatersacrifices of Yare required for each extra unit of Xproduced. That is, at greater outputs of X, themarginal cost of more X increases.

,-'"

138 Chapter 7

TV operates can be said to be understood.Similarly, on the surface the economic systemlooks enormously complicated and confusing.And without a validated theory, it is. But ifone has a validated theory, bewilderment isreplaced by confidence as complexity is re-duced to sequences of simplicity. So in thisand the next chapter, do not think the exposi-tory simplicity means that the principles de-veloped are too simple to be applicable to thereal world. They are applicable, and like alltheory and analysis, their ability to be ex-pressed simply while being accurately de-scriptive is a virtue. This simplicity enhancesthe understanding of the way the economicconstellation operates. It is not a disorderedcollection of uncoordinated activities.

Whether we pair the United States andBritain, Atlanta and Baltimore, AmericanAirlines and United Airlines, or any two peo-ple called A and B, the methods of coordinat-ing specialization of production are the same,as is the source of gains from trade. Interna-tional, interregional, interfirm, and interper-sonal trade rest on the same principle.

Before we can see how specialization isorganized in a large decentralized marketeconomy, we must adjust our earlier examplea bit. We had assumed that each person'smarginal cost of bricks, or tradeoff rate, wasconstant. Whether I worked a few or manyhours each day making bricks, the number ofletters I could have typed instead per brickwas a constant, .06 letters per brick. We nowabandon the assumption that the marginalcost is constant. Typically, the tradeoff ratedepends on how intensively we engage in anactivity. For example, Sqy a farmer can pro-duce eggs or wine. If all the land is devotedto grapevines, 1000 gallons of wine can beproduced but no eggs. Producing some eggswill require sacrificing some land now givento vines. Initially the land least appropriatefor vines will be used, but if more and moreeggs are to be produced annually, land suc-cessively better for grapevines must be trans-ferred to chickens, and the extra amount of

wine sacrificed for the extra eggs will belarger. In economic jargon, the marginal costof eggs is higher at greater rates of produc-tion of eggs, because smaller and smalleramounts of appropriate resources are left forfurther expansion of production.

A Two-Person EconomyLet us look at a simple two-person, two-com-modity model. The two persons are A and B.A's production capability is shown in Table7-2. A's resources could produce, at most, 10X daily, or if all resources were devoted toproduction of something else, A could pro-duce daily other services or goods worth$14.50. To simplify matters we will refer tothe other possible products as Y, and mea-sure them in dollars, as if each Y were worth$1. We can produce combinations of both Xand Y, as indicated in the table. For exam-ple, A could produce 1 X daily and $13.50 ofY; or 2 X daily and $12.40 of Y. Notice thatA's marginal costs of producing X are greaterat larger rates of production of X.

The production capabilities of A, shownin Table 7-2, reveal that if 1 X is produceddaily, $1 of Ywill be sacrificed daily. A's costof 1 X is $1. To produce 2 X daily ratherthan only 1 X daily will cost A an extra sacri-fice of $1.10 Y daily. The $1.10 increase intotal cost is called the marginal cost at 2 X.Marginal cost is the increase in total cost be-tween outputs differing by one unit of output(here X). The cost increase is not necessarilyconstant regardless of total output. An in-crease in output from 5 X to 6 X will raisethe total costs from $6 to $7.50, so the mar-ginal cost at 6 X (or "of the sixth X," as it issometimes called) is $1.50. The concept ofmarginal cost is extremely important andshould be learned well. Also, once the mean-ing of cost is understood, it is easy to see thatminimizing the cost of any output is thesame as maximizing the value of the otheroutput one can also produce.

2.0

1.8

1.6

1.4

1.2

1.0

.8

.6

.4

.2

y

1 2 3 4 5 6 7 8 9 10 11 12

Figure 7-2.

A'S MARGINAL AND AVERAGE COSTS OF PRODUCING X

Bars show marginal costs; the connected dots show theaverage cost at each output, based on data in Table7-2. Accumulated areas of bars to any output of Xrepresent the output of other goods forsaken toproduce that amount of X. A major purpose of thisfigure is to emphasize the difference betweenthe concepts of marginal and average costs.


rII

iTotal

Output ofy

10'I

9II 8

.9YlsIMarginal Costat Third X7

6

5

4

3)

1.7 Y IsMarginal Costat Seventh X2

1

~~--L-~~--~~L-~~--~~~~Xo 1 2 3 4 5 6 7 8 9 10

Figure 7·3.

TOTAL PRODUCTION POSSIBILITY OF B

Taken from data in Table 7-3. For any specified amountof X (on horizontal axis) the curve shows the maximum ofYachievable (on vertical axis). The more of X thatis produced, the less of Y that can beproduced.

Figures 7-1 and 7-2 list A's productionpossibilities and the implied marginal costs.By definition, the marginal costs at 1 X andat 2 X add up to the total costs of producing2 X. And the first three marginal costs at 1,2, and 3 add up to the total cost of 3 X(which should now be obvious, if you under-stand the meaning of marginal costs).

In Figure 7-2 producer A's marginalcosts are shown by the bars above the quan-tities 1, 2, 3, and so on. The increasingheights depict higher marginal costs at largeroutputs, The total cost at 10 units of Xwould be $1.90 (of Y) more than the totalcost of 9 X. That means the marginal cost at10 is $1.90. The total area of all the marginalcost bars from zero to any output of X repre-sents total costs for that output. For example,the totsl cost of producing 6 X is measured

.by the area of all the marginal cost bars up toand including 6 X, representing a total costof $7.50 (which is the value of other potentialgoods and services forsaken). The averagecost at six units of X is $7.50/6 X = $1.25 perX; average costs are indicated by the dottedline in Figure 7-2. To see how average, total,and marginal costs are reused mathematical-ly, consider the following analogy to succes-sive test scores during a semester. Your total

Table 7·3 DAILY POTENTIAL OUTPUTS AND COSTS OF PRODUCER B

Valueof Other

Output Total { Marginal Average Concurrentof X Cost Cost Cost Output

0 0 0 0 $9.601 $ .50 $ .50 $ .50 9.102 1.20 .70 .60 8.40

3 2.10 .90 .70 7.504 3.20 1.10 .80 6.40

5 4.50 1.30 .90 5.106 6.00 1.50 1.00 3.607 7.70 1.70 1.10 1.908 9.60 1.90 1.20 0

I

II.i

I"

~'----1-40-C-'h-ap-te-r-7--------

score accumulated to any test is the sum ofthe successive test scores. If the successivescores for the tests increased, as our marginalcosts do, your average score per test wouldalso be increasing. The current average of allthe tests taken would be less than the scoreon your most recent test, because of yourgood fortune in having successively highertest scores (or your bad fortune in havingstarted so low).

The productive capabilities of our sec-ond producer, B, are summarized in Table7-3 and Figures 7-3 and 7-4. Like A, B'smarginal costs of X increase as the output ofX increases. B differs from A in two signifi-cant respects:

1. B is not as productive as A in producingX or anything else.

2. B's marginal costs of X start lower atsmall outputs of X, but they increasemore rapidly.

Achieving ProductionEfficiency byEqualizing Marginal Costs

Suppose A is living in isolation and is self-sufficient, making 2 X and $12.40 worth of Yeach day, and consuming only what is pro-duced. (To simplify, assume Y is alwaysworth $1, so the quan ti ty of Y is equal to itsdollar value.) The meaning of self-sufficiencyis: Each person consumes only what he orshe produces. Specialization, however, meansthat one consumes less of some goods thanone produces and more of others. Table 7-2shows that A can produce 2 X and $12.40 ofY. Notice that A's marginal cost of making asecond X daily is $1.10 of Y.

Next, B, who is also self-sufficient, is alsomaking 2 X (at a marginal cost of 70¢) and$8.40 worth of Y. Certainly A is richer thanB, for although each has 2 X, A has more Y($12.40) than does B ($8.40). There is no wayA and B could have more Y, given that each

Change inOutput of

y

2.0

1.8

1.6

1.4

1.2

1.0

.8

.6

.4

.2

0 1 2 3 4 5 6 7 8

Marginal Cost

Average Cost

Figure 7·4.

B'S MARGINAL AND AVERAGE COSTS OF PRODUCING X

Bars show marginal costs, and dots in each bar showaverage cost at that output, for data from Table 7-3.Note that the accumulated areas of the bars to anyoutput represent total cost-the total alternativeoutput sacrificed. As the output of X increasesso does the marginal cost.


Table 7.4 GAINS FROM SPECIALIZATION AND TRADE IF MARGINAL COSTS DIFFERII1\ Before Specialization

Produces Consumes

x y x yPerson

2 and 12.42 and 8.4

4 20.8

2 and 12.42 and 8.4

4 20.8

AB

Total

After Specialization

Produces Consumes

:1 Person

[IA

1B

Total

y x yx1 and 13.5 2 and 12.5

2 and 8.5- -4 21

A produces 1.1 more Y and spends only 1Y to buy1X from B, gaining .1Y.B produces 1X more (at cost 0.9Y) but sells the 1Xto A for 1Y, also gaining .1Y.

3 and 7.5- -4 21

Gain from specialization is .2Y.

must produce and consume 2 X to remainself-sufficient.

However, because their marginal costsdiffer at their current output of X, you and Ican see that if A and B were not self-suffi-cient, but instead each produced more ofsome good to sell to the other in exchangefor some of the other good, both could bericher and better off. If you can't see thatright away, as very few people can, we re-mind you that the idea was first formulatedonly in 1776, several thousand years afterpeople began specializing.

The crucial feature is that if A and Bareproducing outputs at which :;their marginalcostsarenotequal,they should revise theiroutputs to make them equal. Let us see why.The marginal cost at 2 X is $1.10 for A andonly 70¢ fo~ B. By producing one fewer X, Acould save enough resources to instead pro-duce $1.10 more of Y. (Be sure to check thearithmetic by referring to the data in the ta-bles. This may be tedious, but it is very im-portant to work through the numerical de-tails to ensure understanding. This is a placewhere words alone are not sufficient to make

'iI.

.kr---14-2-C-'ha-p-ter-7--------

an idea crystal clear.) Since B's marginal costof producing X is less than A's, B could pro-duce another X by giving up less than$l.lO-in fact, only 90¢, which is B's margin-al cost of a third X. Thus, by producing oneX fewer, A could produce 1.i0 Y more whileB produces an offsetting X with a marginalcost of only 90¢ of Y. As a result a 20¢amount more of Y ($1.10 - 90¢) would beobtained. A and B together would still have atotal of 4 X, but their total Y would be 20¢larger,$21 (= $13.50 + $7.50) instead of only$20.80 ($12.40 + $8.40). They could dividethat 20¢ larger output of Y. Table 7-4 sum-marizes the initial and final situations.

Specialization is now occurring becauseA is producing only 1 X but consuming 2 X,and is producing 13.5 Y but consuming lessthan 13.5 Y. If the two persons want an out-put of 4 X with the maximum possibleamount of Y, the best way is for A to pro-duce 1 X and B to produce 3 X. There is noother way to do so and have more Y. Indeed,any other arrangement would be worse, inthat less than 21 Y would be produced.

What may at first be surprising is thatthough A can produce more X in one day

than can B-IO compared to 8-B producesthe increased amount of X. But as we saw inour earlier example of letters and bricks, be-ing able to produce more X does not make Aa lower-cost producer of X. We do not mea-sure absolute advantage but comparative ad-vantage: What counts is one's ability at pro-ducing X. The marginal costs of X measurehow much "better" A is at producing X thanis B. For output rates of 1 X, 2 X, or 3 Xdaily, the marginal costs for B are less thanfor A. If only I or 2 or 3 X are to be pro-duced, B can do it better (that is, morecheaply) than can A.

If given amounts of X are to be pro-duced, the production-possibility boundaryfor Y is listed in Table 7-5. (Recall fromChapter I that the production-possibilityboundary shows the largest combinedamounts of goods that can be produced withavailable resources.) Suppose A and B wantmore than 4 X-say 6 X. B should produce 4X and A should produce 2 X. Each would beproducing at the same marginal cost. If Bproduced all 6 X, the marginal cost of thefifth and sixth would exceed A's marginalcosts to produce one or two. The total costwould be $6 worth of Y. So somehow Bshould be induced to produce 4 X and A toproduce 2 X, for a total cost of only $5.30($3.20 for Band $2.10 for A). If 7 X weredesired, B producing four and A three wouldbe cheaper than any other possible assign-ment. (Try to get seven units in a cheaperway; you can't.) Table 7-5 gives the best wayfor all other totals of X.

The producers should always keep themarginal costs as close as possible to equalityso that one won't have a lower marginal costfor another unit than any other party is in-curring at his or her output of X. Table 7-5shows the amount of X that should be pro-duced by A and by B for each social total ofX such that the remaining output of Y ismaximized. In other words, the X is pro-duced with the minimum' sacrifice of Y,which is to say the X is produced at theminimum total cost. Remember that the

minimum total cost is merely another way ofsaying maximum value of other feasible out-puts.

DIAGRAMMATIC ANALYSIS

By looking at Figure 7-5 we can see, howequating marginal costs has the effect ofminimizing costs. This figure shows two pro-ducers' generalized marginal cost curves,MCA and MCB• (They are smoothed for thesake of graphic clarity.) As the figure showS,if each person produces equal amounts (X,and Xb), B would have a lower marginal costthan A. Therefore, if B expanded productionof X (to X'b) and A reduced production bythe same number of units (to X'a) B's margin-

Table 7·5

TOTAL EFFICIENT OUTPUTS OFY AND X BY PRODUCERS A AND B

x

Y'sProducedbyA and B

MarginalCostof Xy

o 24.10 = 14.50 + 9.60 o23.60 = 14.50 + 9.10 .50

2 22.90 =14.50 + 8.40 .703 22.00 = 14.50 + 7.50 .904 21.00 = 13.50 + 7.50 1.005 19.90 = 12.40 + 7.50 1.10

6 18.80 = 12.40 + 6.40 1.107 17.60 = 11.20 + 6.40 1.208 16.30 = 11.20 + 5.10 1.309 15.00 = 9.90 + 5.10 1.30

13.60 = 8.50 + 5.10 1.4011 12.10 = 8.50 + 3.60 1.5012 10.60 = 7.00 + 3.60 1.5013 9.00 = 5.40 + 3.60 1.6014 7.30 = 3.70 + 3.60 1.7015 5.60 = 3.70 + 1.90 1.7016 3.80 = 1.90 + 1.90 1.8017 1.90 = 1.90 + 0 1.9018 o = 0 + 0 o


[IiI·

!

",.

$

Cost SavedIf A Produces

Less X

Exceeds the Costfor B

to MakeMore X~------~-~-~-----~~--------------~X

Figure 7·5.

GAINS FROM PRODUCINGAT EQUAL MARGINAL COSTS

A and B produce the same amount of X (Xa=Xb).

Marginal cost for Xa is greater than marginal cost for Xb.

If A reduces output. to Xa. by as much as B expands, toX IY the total costs to both producers will be reduced, ascan be seen from the fact that the extra cost to B(area occupied by plus signs) is less than savings ofcosts by A (area occupied by cross-hatching) overquantity Xa-Xa' Total amount of X is the same asbefore. Total costs of that output areminimized because marginal costs to A arenow the same as for B.

144 Chapter 7

$

Mea

+++++++++++++++++++++++

++++++++++++++++++++++++++++++++++++++++++++++++++++++++

L---------------~+~+~+~+-+~+~+~--------~~X

UntilMarginal

Costs AreEquated

al cost of producing more X would be lessthan the marginal cost that A avoids by re-ducing the output of X by a matchingamount. The total output of X would be thesame, but the total cost is lower (that is,more of other goods are available). The shad-ed area under the marginal cost curve MCB

represents the increase in cost with B's ex-pansion of output while the larger shadedarea for A shows the larger saving in costwhen A reduces output of X by a matchingamount. If producers of X are at outputswith unequal marginal costs, the total costwill be reduced if the one producing at lowermarginal cost expands production and theone producing at higher marginal cost re-duces production. When the producers' mar-ginal costs are equal (which does not meanthat their outputs are the same), the totalcost is minimized.

COORDINATION BY AUTHORITY

A central planner or dictator who knew ev-ery producer's marginal-cost curve could cal-culate the output for each producer at whichall producers' marginal costs are equated.Doing so would achieve the lowest total cost.The planner would first add the marginal-

$

o

cost curves of all producers horizontally, asin Figure 7-6. (We continue to use two pro-ducers, and we ignore the question of howthe planner would obtain all that necessaryinformation.) The result is the extreme right-hand curve, MCA+B, called the industry sup-ply curve. It is the sums of the horizontal dis-tances of all the individual outputs withequal marginal costs. For any total desiredamount of X, on the horizontal scale, the dic-tator notes the height on the supply sched-ule. That is the minimum cost of pro-ducing X for each producer at that I de-sired total output. For example, if a total ofX: units is to be produced, the amounts thatA and B should each produce are indicatedwhere the horizontal line at that marginal-cost height intersects the two individual mar-ginal-cost curves. That indicates X, by A andX, by B. Any other output quotas totallingX; would be more costly, because one pro-

Figure 7-6.

MAXIMUM EFFICIENCY OF AGGREGATE SUPPLYAT EQUAL MARGINAL COSTS FOR ALL PRODUCERS

When all producers' marginal costs are equal-that is,MCA=MCa-at outputs X'a and X'b' then aggregatesupply, Xr, is most efficient. Note that A's and 8'smarginal costs are not equal at equal outputs; thatis, when Xa=Xb' When A's and 8's marginalcosts differ, aggregate supply is not at itsmaximum and aggregate cost is not at itslowest.


$

A'sPersonal

Valu(' Gain

TotalCost

~~~~~~----------------x

Figure 7·7.

INDEPENDENT, SELF-SUFFICIENT EQUILIBRIUMS

Person A self-sufficiently produces Xa' His total personalvalue of Xa is the area under his demand curve DA andexceeds his costs (the area under the marginal-costcurve). The net total personal value to him of Xa is thehorizontally tined area. His personal marginal value at X.is MVA' Person B also self-sufficiently producesquantity Xb and gets the net total personal valueshown by the horizontally lined area. Herpersonal marginal value at Xb is MVe.I:

11·1I

146 Chapter 7

$

B'sPersonal

Value Gain

MeB

MVB --B's MarginalPersonal Value

ducer would have a higher marginal cost. than the other.

PRODUCTIONINEFFICIENCY BY AUTHORITY?

From 1974 to 1980, a U,S. government ener-gy authority ordered all oil refineries to re-duce their production of gasoline by thesame proportion of their output and to pro-duce more heating fuel. (Crude oil, remem-ber, can be refined into heating oil and gaso-line in varying proportions.) We can useearlier figures for graphic interpretation bycalling heating oil X and gasoline Y, and Aand B two different refiners. The data in Ta-bles 7-2 and 7-3 will illustrate the conse-quences of such a government order. To sim-plify the arithmetic, assume that a 50%reduction is required. Refiner A cuts backfrom 1 X to 0.5 X; B cuts back from 3 X to1.5 X. They would then produce 2 X at atotal cost of $1.35 (= 50¢ cost to A plus 85¢cost to B). With a little calculation we cansee that if, instead, B produced 2 X and Acut back to no X, the total cost of 2 X wouldbe only $1.20, a social saving of 15¢.

Why did the energy board use an ineffi-cient method that had the effect of makingmarginal costs unequal? One possible reason

$ $

-.----.--Amount Amount

Consumed Sold toby B A....---......-Total AmountProduced by

B

Amount AmountProduced Purchased

by A by A

Total AmountConsumed by

A

is ignorance on the part of the energy board.Another answer might have been, "We didnot know the cost or production-possibilitydata for each refinery. Therefore we used afair method." Fair, maybe; inefficient, cer-tainly. Or the authority may respond that itused political vote-getting considerations.Ask your political scientist why.

PRODUCTION EFFICIENCY BYDECENTRALIZED COORDINATION

An alternative to data-collection and centralplanning is quicker and, in addition, deter-mines the production of heating oil and gaso-line in closer accord to consumers' valuationsof gasoline and fuel oil, and of the costs ofproduction. That method, which is not cen-trally directed, is the price-directed market-exchange system. Adam Smith aptly dubbedit the "invisible hand"; by this he meant thatby pursuing one's own self-interest, one isnevertheless led to efficient output decisions.

To see how it works, assume, instead ofan economic dictator, a capitalist system inwhich everyone (here, producers A and B)lives self-sufficiently, with private-propertyrights in productive resources. Everyone pro-

$

SupplySchedule

MCtA +8)

Total AmountProduced and

Consumed

Total Ma,ketQuantity

Figure 7·8.

GAINS FROM SPECIALIZATIONAND EXCHANGE WITH INTERDEPENDENCE

Trading between A and B as in a market results in largeroutput of X and other goods and gains to A and B overtheir self-sufficient, independent status. The extremeright-hand panel is Aggregated Demand and AggregatedSupply (marginal costs). Price is Po, at which A buys allhis consumption of X and B produces more X than whenself-sufficient and sells some to A.

The gain to A is the ability to buy more at a lowerprice and to save production costs by purchasing at alower price some that was formerly produced by himselfat a higher marginal cost. Similarly, the gain to B iscomprised of the ability to sell more at a price greaterthan her costs of production as well as selling some at aprice greater than those units of the good are worth toher in personal consumption.

A produces less of X and more of other things,while B produces more of X and less of other things fora larger total social output with larger total personalvalues. For person B, the gain in the crosshatched areais comprised of two types: The left part is gain fromselling some to A at a price greater than its value to B,and the right part is gain from transferring resources toproducing more units of X, which are sold to A at a pricegreater than cost to B, which cost is simply the (lower)value of other output forsaken.

The gains to all parties from using the market ratherthan being self-sufficient are the crosshatched areas.Note that X is now produced at equal marginal costsby both A and B, which is also equal to the marketprice. Result is efficiency in production. No other"assignment" of production quotas to A andB would be efficient for this particular totaloutput of X.


, !

duces as much of each good as is worth pro-ducing for one's own consumption. Figure 7-7 shows the situation: A's marginal costs ofproducing X and his demand for that good.He produces an amount of X at which itsmarginal personal value to him falls to hismarginal cost of producing X, which, remem-ber, rises: More X would cost him more thanthey are worth to him. He self-sufficientlyproduces only what he consumes. Similarly,B produces an amount of X at which her de-

. mand and marginal-cost lines intersect.Each would stay self-sufficient if they

could not communicate and exchange in amarket. But if they can, they will discoverthat A has a higher marginal personal valuefor X than does B. This would be revealed toB if A offers B more for an X than that X isworth to ~. We can best see this by combin-ing the two demand curves under self-suffi-ciency, in Figure 7-7, into an aggregate, ormarket, demand curve, and also by combin-ing their marginal cost curves into an aggre-gate, or market, supply curve; Figure 7-8does both these things. These aggregate de-mand and supply curves are horizontal sum-mations of the individual demand cUJves andthe individual marginal cost curves (whichare in effect supply curves). Study Figure 7-8and the caption carefully. It summarizes theprocess and the effects in way~ that makematters clearer. ..

If these two people trade with each oth-er, the total of the amounts/ 'demanded andsupplied by each would be equated by a mar-ket price at the intersection of the aggregatedemand and supply curves. At that price, Bwould be induced to produce more X thanshe consumes-selling some to A-and Awould produce less X than he consumes-buying the difference from B. (A pays withthe other goods he produces.)

Their self-interest has the effect of di-recting their outputs to the intersection ofthe demand and supply curves; that changein output is guided by the market price. B

II I

(,

11t'----j-4-8-c-n-ap-te-r-7---------

will get profits by producing some more X,which she can sell to A at a price greaterthan their marginal cost to B. Similarly, Ahas the incentive to shift from production ofX to other goods and to purchase the X fromB at a price lower than his marginal costs ofmaking those X. Figure 7-8 emphasizes theoutput results for A and B. Figure 7-9 probesinto more detailed effects. They warrantcareful study.

When each person's output is such thatall producers' costs are equal, that totalamount of X is being produced with mini-mum total cost. The various producers of Xcan bring their marginal costs to equality inthe market system if, in pursuit of profits,each producer looks at a common marketprice and individually adjusts its output of Xto bring its marginal cost of producing X toequality with that common, perceived price.

For each person giving up self-sufficien-cy in our example the cost of living is low-ered and output consumption increases. Mar-ket prices serve as both coordinating guidesand incentives to producers in affecting whatand how much they produce-as well as theamount they consume. At the equilibriumfree-market price the aggregate amounts pro-duced equal the amounts demanded-with-out a central, all-knowing authority. The in-stitutional features for such a system ofcontrol and coordination are (1)an accessi-ble, reliable marketplace in which (2) pricesof exchangeable goods are revealed, with (3)private-property ownership of resources.

You may think that all this seems a te-diously involved way to say that whoever canproduce one good at lower cost should do soand sell some to other parties in exchange forwhat others can produce at lower costs. Thereason we did not put it that way is that themeaning of lower cost is usually misunder-stood. Some people think it means lower av-erage cost, and that leads to error. To seewhy, reexamine the data in Tables 7-2 and7-3. To produce 6 X, A should produce 2and B should produce 4. Although B's (80¢)

Ui'..IV

'0c.5~

A's Gain fromSpecialization

Q)u..::c..

Po

" ..Produced by A Purchased from B Ouantity

of X.Consumed by A

average cost of producing those 4 X is lowerthan A's (which is $1.05), it would not be ef-ficient (that is, it would increase total costs)if output of X were increased by B and de-creased by A. It is marginal, not average, costthat is decisive in determining efficient out-put assignments. Always precede the wordcost with either total, average, or marginal ifyou want to increase your chances of correcteconomic analysis.

Some Misunderstandingsof Costs

If the preceding exposition were so perfect asto be thoroughly understood, the followingcomments would be unnecessary reviews.See if they are.

1. TIME IS NOT A COST

The person who specialized in producing Xwas not the person who could produce the

B's Gain fromSpecialization

Quantity--- ....._-- •••.....--- ....• •.' of XConsumed by B Sold to A

Produced by B

Figure 7·9.

FURTHER DETAILS OF GAINS FROMSPECIALIZED PRODUCTION AND EXCHANGE

This enlargement of the left-hand and center graphs inFigure 7-8 shows two sources of gains to A and B. Agains by being able to buy more at a price that is belowthe value of the extra amounts purchased andconsumed; he also gains by being able to reduce hisoutput of X and produce other goods while purchasingthe displaced X at a price lower than his own marginalcosts of producing that amount had been. These twogains are shown as the adjoining lined triangles.

B gains from two sources. The increased output ofX is sold at a price that exceeds her marginal costsof production, and some of X that B formerlyconsumed is sold at a price that exceeds itspersonal value to B when consumed by her. Thesetwo areas, for A and B respectively, areshown as adjoining lined triangles.


most X. B, who specialized in X, could pro-duce only 8 X whereas A could produce 10 Xdaily. Or, it might be thought that since Acould produce an X in less time than couldB, A must be the lower-cost producer of X.Not so. Cost is not measured by time used.No one saves time; it is merely used forsomething else. The forsaken best alternativeuse of that time-not the time itself-is thecost. The value of the time used is perti-nent-and that value differs among peopleaccording to the value of what they wouldotherwise have produced in the time in-volved. One person whose time is worth $lOan hour because he or she can produce $10 ofY in an hour, or can produce 5 X in an hour,has a marginal cost of $2 for each extra unitof X produced. Another worker whose hour-ly services are worth only $4 an hour in mak-ing other things and who can produce only 1X in an hour, incurs a marginal (and average)cost of $4 for an X. But suppose our first per-son, who could produce 5 X in an hour,could produce $50, instead of $lO, worth ofother goods in that hour; then his or her mar-ginal cost of an X is higher, $10, rather thanonly $2, though the time used is the same!The marginal costs of our two producersnow are reversed. So beware of measuringcosts simply by hours of time: What is criti-cal is the forsaken output value which ismeasured by multiplying the number of min-utes of time used by the value of the bestalternative use per minute. Thus, when peo-ple say that labor in Asianscountries is lesscostly than American labor because theAsians earn very low wages per hour, it's be-cause they have low productivity at othertasks also.

il

2. EVERYONE HAS A LOWERMARGINAL COST IN SOME ACTIVITY

Lower marginal cost producers of X will, bydefinition, necessarily have higher marginalcosts of producing other goods. To say that

1SO Chapter 7

my marginal cost of producing X is higherthan yours is to say that my marginal cost ofproducing the other good, Y, is lower thanyours. Since, by the definition of costs, one isthe reciprocal of the other, each producermust have some output at which his or hermarginal costs are lower than someone else's.

3. QUALITY AND COSTARE DIRECTLY PROPORTIONAL

Costs can be reduced by lowering quality.Quieter, smoother, faster, more comfortable,safer, prettier, more versatile kinds of travelare more expensive. Yet people value suchqualities in an automobile. Thus, lowering acar's cost per mile makes sense only if everyother aspect of the product and its quality ofperformance is left unchanged. It is not nec-essarily sensible either to reduce cost by less-ening the quality of the good more than thecost saving, or to increase quality regardlessof the increased cost. (How do you reconcilethis consideration with Congressional legisla-tion requiring more miles per gallon in auto-mobiles or more insulation in homes to re-duce energy costs?)

DifferentialEarnings, Rieardian Rents

Although everyone may be producing out-puts at which marginal costs are equal, theaverage costs per unit of output may differ.For example, Tables 7-2 and 7-3 show thatif A is producing 2 X while B is producing 4X, each has the same marginal cost, $1.10(the increment to total cost for the marginalunit being produced). But their average costsat those outputs are different: $1.05 for A and80¢ for B. If the price to consumers were$1.10, A's net earnings would be 10¢ (= 5¢ X2) and B's net earnings would be $1.20 (=30¢ X 4). A Superior producer like B (that is,the one with larger net earnings) will soonreceive offers for other services from other

producers because they expect that he or shecould do the same for them. But they wouldhave to bid at least as much as those earningsof $l.20. Competition to buy or hire the ser-vices of that superior talent will raise itsprice or salary up to that value. The owner

;I. of the superior resource gets the value of itssuperior productivity.

People sometimes make the mistake ofconfusing this differential earning from supe-rior productive power with a monopoly re-turn, a return gained by excluding competi-tors. Especially fertile land is superior, butwe do not call it a monopoly. We do not callthe higher differential earnings of a superiorsurgeon a monopoly return, for it is notcaused by an artificial, contrived restraintthat prevents other people from offeringtheir services to the public. In honor of a "su-perior" early English economist, David Ri-cardo, who first made this distinction, thedifferential earnings of superior productivetalent are often called Ricardian rents.

More Producers:Net Gains or Transfers?

Just as two people gain by specialization andexchange between themselves, the entry of athird person into specialization enables thethree people to produce a larger output than

the total of the three if the third were notallowed to also specialize and trade with thefirst two. To illustrate, suppose a new immi-grant, C, enters the society, with the produc-tive capabilities elescribed in Table 7-6. Inevery output rate C is less capable than A orB, and will be poorer. But C's marginal costpattern for producing X differs from theirs; itstarts lower, and does not go as far beforereaching C's maximum potential of 5 X

The results can be analyzed by examin-ing Figure 7-10. C's market price exceedsthe marginal costs at the initial output of X,as panel C shows. Therefore, it is profitablefor C to produce some more X to sell to Aand B. In the extreme right-hand panelmarked Total, the intersection of the new ag-gregate supply and demand curves, whichnow include C, is at a larger output of XThe new equilibrium price of X will be low-er: Pn instead of Po.

Party A gains by being able to buy moreX at a lower price, and also by releasingsome resources from production of X to oth-er, higher-valued uses. However, as a largeproducer and seller of X, B loses, suffering alower selling price of X This loss to B is atransfer to customer A, because A's purchaseprice of X is lower. B can offset some of theloss by being able to produce other goodswith resources formerly used to produce theX that was displaced by C's competition.

Table 7·6 DAILY POTENTIAL OUTPUTS AND COSTS OF PRODUCER C

Value ofOther

Output Total Marginal Average Concurrentof X Cost Cost Cost Output

0 0 0 0 $4.501 $ .30 $ .30 $.30 4.202 .90 .60 .45 3.603 1.80 .90 .60 2.704 3.00 1.20 .75 1.505 4.50 1.50 .90 0

Production with Specialization IS 1

A B

$

PoPn

D

$

a = amount produced by A before C entered the market.b = amount consumed by A before C entered the market.c = amount produced by A after C enters the market.d = amount consumed by A after C enters the market.e = amount produced by B before C entered the market.f = amount consumed by B before C entered the market.9 = amount produced by B after C enters the market.

Figure 7-10.

A NEW PRODUCER ENTERS THE MARKET

When C enters the market, the price is greater than hismarginal cost at his existing output, i. So he increases hisoutput of X to j to make some profits. The new market-supply curve is shown in the right panel. The intersectionof the new supply and demand curves will be at a largeroutput and a lower price, since.C initially had lowermarginal personal value for the amount he producedbefore joining the market. The benefits to A are indicatedby the crosshatched area, representing his lower cost ofpurchase of the former amount of X he consumed, plushis ability to buy more at that lower price (the right-handtip of his crosshatched area) and the gain from releaseof resources from some production of X for his own useto other more valuable production (the left-hand tip of hiscrosshatched area). T;'

B, the larger producer of X, suffers a loss ofincome as a large seller of X because his selling pricefalls as C enter's and expands the supply. B's loss is onlypartly reduced by his ability to transfer some resourcesto other output (the right-hand crosshatched triangleunder his marginal-cost curve over his reduced output ofX) and by his ability to consume more at the lower price(the left-hand crosshatched triangle).

I ,

I

1S2 Chapter 7

C NewSupply

A+B+C

Total Old SupplyA+B$

MCc

m

h = amount consumed by B after C enters the market.; = amount produced and consumed by C before Centers.j = amount produced by C after C enters the market.k = amount consumed by C after C enters the market.I = total amount produced and consumed before Centered.m = total amount produced and consumed after Centers.

C, the new entrant, gains as shown by the cross-hatched area in his panel of the diagram. C gains byability to produce and sell more X at a price greater thanhis cost and to sell some of the X he formerly consumedat a price higher than that X was worth to him.

It is important to note that the gains to A are inlarge part simply a transfer (or retention) of incomeformerly spent in buying X from B. Hence the major partof the gain to A is a transfer from B and not a true socialgain. Conversely, most of the loss imposed on B is not atrue social loss but is that transfer to A. Most of theactual gain resulting from C's entry is obtained by C,though some is obtained by A and B as explainedabove. Moral and caution: Do not add transfer gainsto some consumers to the social gain consequent toentry of new producers, for that would over-countthe social gain; nor subtract the loss to formerproducers now partially displaced by the newentrants, for that is not a social loss, butmerely a transfer.

That resource transfer permits some true so-cial gain, which others, like party A, share inthrough the lower prices of goods now moreabundantly produced. Nevertheless, the ma-jor part of the increase in the social outputresulting from C's entry (above the formersocial total of A and Band C when C had noaccess to the market of A and B) accruesmostly to C.

There are, then, several consequences ofC's entry into the market:

1. C, the newcomer, obtains most of the to-tal gain in output.

2. Consumers of what the newcomer pro-duces gain because its price falls; theykeep some of their income that formerlywent to the higher-price suppliers.

3. The prior producers of the good pro-duced by the newcomer lose some in-come to their customers (this is thetransfer counterpart of 2).

4. Some social gain is provided everyone bythe release of some resources by formerproducers of X to other output.

It is important to recognize that the totalincrease in output is large enough to makeeveryone better off. It would be possible totransfer some income to B from the benefi-ciaries, A and C, which would make B betteroff while also leaving A and C better off thanbefore C entered the community. For exam-ple, a tax or fee imposed on the newcomer, C(paid out of C's gain), and distributed to Bwould leave everyone better off than if Chad not entered the community at all. Butrarely are such taxes or fees imposed on newentrants. Always the admission of newcom-ers increases the social total above what itwould be if they were excluded from themarket, and they usually capture much (al-though not all) of the gain.

The newcomers would be exaggeratingtheir contribution if they thought that theycreated all the gains to the consumers of X,because, as we have seen, part of the gain to

those consumers is an income transfer ,through lower prices, from the old producersto the consumers. Do not overlook this dis-tinction between the real output gain (mostof which is captured by the newcomers) andthe transfer of income from old producers toconsumers of goods produced by newcomers.

INCREASED DEMANDATTRACTS HIGHER-COST ENTRANTS

The entrant, C in our example, had low,trcosts than existing producers. But even high-er-cost producers can enter if there has beenan increase in demand for the good. The in-creased demand will sustain a higher priceeven though a larger amount is supplied-some by the newcomer and some by the ex-isting firms that expand in response to thehigher demand. It is important to note thatthis increased output can be sustained in thiscase only because of the initial increase indemand for the good. As in the precedingcase, consumers will benefit from the largeroutput provided in part by the newcomersand in part by the expansion of existingfirms, all of which keeps prices lower thanthey otherwise would have been. The exist-ing producers will argue that they could haveprovided the increased output to satisfy theincreased demand, and they could have-butonly at a higher price.

An example of this is the creation of newmotels in growing, more populous areas,keeping motel rates and profits to existingmotel owners lower than otherwise. Thesame holds for restaurants, gasoline stations,or grocery stores-indeed, every service. Ona larger, more spectacular scale, when the de-mand for smaller cars increased because ofhigher gasoline prices, existing producers ofsmaller cars (Toyota, Nissan, Volkswagen,Fiat, and so on) would have obtained higherprices and profits if General Motors, Ford,and Chrysler (higher-cost producers of small-er cars) were not allowed to enter into small-

Production with Specialization 1S3

.. 11, ',

car production. Another example is providedby "blue jeans." When that demand jumped,the initial makers (Levi's and Lee) benefited,but the entry of new producers attracted bythe increased demand, higher price, andprofit prospects benefited consumers-notLevi Strauss or Lee.

I

! l

, I,

Short-Run Price andOutput Adjustments;Input Specificity

The full adjustment of output and price is notas direct as outlined in the preceding explana-tion. On the way to that final long-run adjust-ment there is often some temporary over-shooting of price and output. Price maytemporarily fall below the ultimate new level,with the output temporarily larger. Thesetransitional deviations are not the result ofmistakes; they occur because some inputs are"specific" to certain tasks. They are not in-stantly and costlessly mobile and capable ofshifting or being converted to other equallywell-paying tasks. For example, grapevinescannot be converted to apple trees, or winepresses into chicken coops. Almost all produc-tive resources have some degree of specificity.

To see how this affects the transition, re-consider our initial example of the entrantwith lower costs (not the one who enters be-cause demand has increased, our second ex-ample). When the lower-cost entrant pro-duces, more is supplied and-the price falls.Existing producers who weie just breakingeven will not cover their costs. Rather thanaccepting lower wages or rents some of theinputs of the initial firms will switch to otherwork.

However, not all inputs can switch in-stantly at no transfer cost to other equallywell-paying jobs. So if the value of their ser-vices falls in their current jobs, they will con-tinue to work there because doing so is stillmore valuable than their next best options.

i .1

.1"i

I 1

. 11,II

ll~j 154 Chapter 7

Even if their earnings here fall far below theirreplacement or initial creation costs, theymay nevertheless be better off than in theirnext best opportunity. Their initial creationcosts are irrelevant. But in time, as enough ofthese specific resources wear out and are nolonger worth replacing, the total output willfall and price will readjust upward to the newlong-run equilibrium, which is lower than be-fore the lower-cost entrants appeared, buthigher than during the transition. It is the du-rability and costly mobility or nontransferabi-lity of some existing inputs that cause theovershooting in the transition.

Excellent examples of these transitionalprices and values of specific resources arecommon. The entry of jet engines to com-pete with existing propeller-driven airplanescaused a drastic reduction in the value ofthose planes. The microwave transmissionsystem increased the supply of communica-tion channels and lowered the value of exist-ing wire communication systems. The entryof new motels affects the values and replace-ment of older motels. The 16-bit micropro-cessor in microcomputers lowered the valueof the prior 8-bit microprocessor. In eachcase the temporarily larger supply from bothnew and old sources depressed the price be-low the level that would persist after the old-er, less economical items were no longerworth using. If the new entrant complainsand interprets the drastic, temporary fall inprice as "predatory" or "cutthroat" pricingby the existing producers, remember the pre-ceding analysis.

However, suppose the initiating factorwere an increase in demand, instead of theentry of new, lower-cost producers. Evenhere, the transition adjustment of price in-volves some "overshooting." The increaseddemand will raise prices higher than will per-sist after the output is expanded, becausewhen new entrants are attracted their largersupply will pull prices back down from theirshort-run higher level. This happens becausethe supply cannot be expanded instantly.

Some resources must be transferred to thisnew activity. But some resources haveenough specificity or immobility so that it isnot possible to move them or create newones instantly and costlessly. So in the inter-im, after demand has increased but beforethe amount supplied has increased much,prices will tend to move in the short run tohigher levels, to clear the market. Then asresources shift and output expands priceswill move back a bit toward the long-runequilibrium level, which is higher than be-fore the initial increase in demand startedthe adjustment.

Monopoly RestraintsYou can now see why existing producers,such as B in our preceding example, whoforesee loss of wealth, seek laws prohibitingor restricting entrants in to "their" businesses.Such restrictions can take any of several pat-terns. Immigrants would be opposed by thosewith whom they are likely to compete, just asdoctors trained abroad are restricted frompracticing medicine in the United States, orMexican seasonal labor is kept out of U. S.lettuce, tomato, and grape fields to protectlocal lettuce and grape pickers. Existing pro-ducers might persuade legislators to pass lawsprohibiting sale of the product by any newsuppliers: Taxi companies in most cities man-age to have the city government exclude newentrants; cattle raisers prohibit importation offoreign meat; sugar-cane and auto producersget quotas on imported sugar or autos fromforeign producers; American textile workersprohibit (or place a tax, called a tariff, on) theimportation of textiles from Korea or Taiwanto protect the incomes of resources special-ized in domestic textile production. These re-strictions are usually imposed by force of theargument that they protect the Americanstandard of living from competition thatdrives down wages. But do they? Some Amer-ican producers are protected-those special-

lzmg in producing the goods in this coun-try-but consumers are prevented fromhaving more goods at lower prices. As wehave seen, the consumer's standard of livingis reduced by more than the protected Amer-ican producers' standard is maintained. Theresult is a net social loss.

Artificial, contrived restrictions to pro-tect existing producers and resources fromthe entry of competing newcomers are calledmonopoly restraints; they protect the wealthof existing producers. Frustrated would-heentrants must turn elsewhere and producesomething of less value. This loss of potentialvalue of output is called monopoly distortionor monopoly inefliciency.

If every producer had this protection,wouldn't we all be richer, given that everyconsumer is also a producer? No. The socialloss from each such restriction is greater thanthe gains to the existing producers. (It's thereverse of the net gains from new producers,discussed above.) Everyone would be worseoff. But the effect might be quite subtle, be-cause whereas the gains of each particular re-striction are concentrated in a small group-and usually are a substantial portion of theirincome-the losses, on the other hand, are sodispersed as to be too small per person tomake it worth the person's incurring thecosts of trying to prevent each of them.

As stated earlier, our three-person modelapplies much more broadly to the real world.It contains the basic explanation of all inter-national trade. Therefore, you may considerperson A to be in America, B in Great Brit-ain, and C in Canada. Or let A and B be twopeople in America and C be a,person in Can-ada. Then if C trades with A and B-thusconducting international trade-exactly thesame principles and results as in the examplewill occur-with gains to C and to at leastone of the persons A or B (the UnitedStates). In our example it was A, the largeconsumer of the good produced by Bandalso imported from C, who gained and B

, Production with Specialization 155

who lost when C was allowed to trade withthem; but remember that the gains to A andC exceeded any loss that might have beenimposed on B.

To avoid a loss, it would pay B, as ex-plained earlier, to restrict the right of C totrade with A. This could be done by placinga quota on the amount of C's goods thatcould be imported to the country in which Aand B lived, or by banning those imports out-right, or by imposing a tariff on the good.These would reduce the extent of such trade,reducing the gains to A and C while protect-ing B, but at a loss to A and C that exceedsthe advantage to B. (A tariff also might beimposed to raise revenue for the govern-ment, without regard to whether it protectedor hurt anyone.)

In any case, the analysis in this chapter isthe basic explanation of all trade, be it inter-personal, interregional, or international. Themajor difference between trade across andtrade within national boundaries is that in-ternational trade involves two kinds of mon-ey, and thus financial arrangements must bemade to enable payments in the appropriatemoney. These arrangements constitute theworld of international finance.

Obstacles toCoordinated Specialization:Absence of Markets andTransferable Property Rights

{

As we have seen repeatedly, a free marketcannot operate unless private-property rightsand market prices are the prevailing features.If no one owns the rights to a good or a re-source, there is no way that voluntary ex-change and prices in the market can protectthose goods and make users heed the highestuse value of that resource-as we do forthings we own, like our labor, eggs, wine,cotton, and the like. For example, supposethat in producing X, people are using or pol-

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luting some water or air or disturbing theneighborhood. If those valuable forsakengoods are not fully owned and priced and sal-able in a market, their value is not impressedon those who use them. Even if revealed ful-ly in offered market prices, the responsibleparty would ignore them unless required tocompensate those who had the rights to for-saken output or quality. If no one owned therights to those resources, no one could makethe user pay a price equal to the cost. But ifthe user had to pay that cost he would haveto give full weight to the value of the goodssacrificed in making more X.

The problem is not that markets or mar-ket prices are inherently misleading, butrather that property rights, and our legal sys-tem of enforcing them, are incomplete, orthe costs of making contracts too high:Transferable property rights over somegoods are not sufficiently defined or enforcedso as to prevent excessive use in less valuableways, such as by excessively polluting air orwater or by excessive noise. Furthermore,people are not always honest. They promiseone thing and do another, if it suits their in-terest. We all shirk a bit, and sometimesplace our own interest over that of other peo-ple. We can act opportunistically and withguile. Enough people are sufficiently dishon-est that we use locks and safes and extensiveprovisions for enforcement of contracts andpenalties for nonperformance. Because pro-cedures have been devised to control suchdeviant behavior, specialization, exchange,and cooperative work can be advantageous.But it hasn't been easy. In later parts of thisbook we have occasion to consider some sucharrangements that would otherwise seem un-necessary and wasteful.

Are Specialization andEfficient Production "Good"?

For all its benefits, specialization might seemto increase the risks over those of self-suffi-ciency: If other people's demands or supplies

should change, some specialists will losesome value of their investment in specializedgoods and training. They will become poorerthan if they had specialized in somethingelse, or possibly even poorer than if they hadbeen more self-sufficient, like the farmers ofolden days. But too much should not bemade of this point, for the losses of invest-ment in certain specialized machinery andskills are the consequence of imperfect fore-sight, not of specialization. Even a self-suffi-cient hermit who must invest in productiveskills for his own personal use can imperfect-ly forecast his own future demands.

SPECIALIZATION, ALIENATION,SOCIALISM, AND INTEREST GROUPS

Karl Marx asserted that a system of special-ization of production and market exchange"alienated" producers from understandingtheir social role and interrelationships withother people. Each worker-producer wassaid to feel he or she was producing solely inresponse to impersonal market prices ratherthan to satisfy others' or their own humanwants and values. (According to economicanalysis, of course, prices reflect just such hu-man desires and values.) Marx contendedthat producers come into social contact withone another primarily through exchange oftheir products; as a consequence, "personsexist for one another merely as representa-tives of, and therefore as owners of, commod-ities. The process of production has the mas-tery over man instead of being controlled byhim."l

To eliminate alienation and the alleged"mastery of production processes over man,"Marx advocated control of production anddistribution by centralized authorities in ac-cord with a central plan, as if society were asingle huge factory. Marx called for social-ism, that is, government ownership of all the

'Capital, Vol. I (New York: Modern Library,Random House, 1959), pp. 93,97.

productive resources. He believed this wouldeliminate alienation, although he did not ex-plain how.

A second, but discredited, contention isthat centralized gevemment control of pro-ductive resources gives a higher output, withmore rapid growth. The useful question is,"What is the right amount of alienation (orsweat or toil or injuries) in view of what weget from bearing those risks and ills?" If youcan find a way to reduce alienation or workwithout reducing productive output throughspecialization, fine and dandy. But every-thing is a matter of degree-with tradeoffs.

Reprise and PreviewSo far the general economic forces control-ling and directing the economic activity ofpeople in a capitalistic, private-property sys-tem have been the subject of our attention.An overview of the skeleton of forces thatoperate has been presented. For that systemto operate more effectively several institu-tions and arrangements have evolved: Forexample, business firms of large size andwith a corporate structure have becomedominant forms of enterprise; labor unionsexist; advertising and marketing arrange-ments of a complex nature have sprung up; amoney and banking system involving compli-cated lending and borrowing arrangements iscommon; governments actively regulate, taxand spend. Of interest is the resultant pat-tern of incomes and earnings over one's life-time and across members of the society. Onthe basis of the preceding basic analysis wecan proceed to inquire into the role of theseauxiliary institutions and arrangements andto study with more perception the factors af-fecting incomes, jobs, inflation-in sum, alarge variety of economic events.

You could choose in which order tostudy the remaining chapters, in large part inaccord with your own interests. For example,


if inflation is still a persisting phenomenon asyou read this, you might skip immediately tothat chapter, because it is relatively simpleand does not require much from the inter-vening chapters. However, we have present-ed the material in a sequence of chapterswhich permits successive application of prin-ciples to sequentially more involved issues orevents. Thus the exposition of the determi-nation of wages and incomes comes after amore extensive explanation of the ways inwhich productive activity is organized andthe demand for personal services made effec-tive-the topic of the next chapter.

Summary1. Specialization is the production of more of

some goods or services and less of othergoods or services than a person consumes.

2. The cost of any act is the forsaken alterna-tive output. The marginal cost is the changein total costs consequent to producing onemore unit-a marginal change in output.Having a comparative advantage means hav-ing a lower marginal cost of production.

3. Output is defined to be efficient if it is im-possible to increase the output rate of anygood without reducing others. No centralplanning and directive agency is necessaryto efficiently organize specialization in pro-duction.

4. The gains from specialization are distribut-ed as lower buying prices to' consumers andas profits to producers. The latter are dissi-pated by competition, as lower prices toconsumers and larger wages or prices for theresponsible resources.

5. Anyone who can produce more will be rich-er, but will not have lower costs in all possi-ble activities. Total output potential deter-mines wealth, not costs.

6. Producers do not have identical marginalcost schedules. Efficient total production of

11"1.,;, :

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••••

a good by several producers requires that allproducers' rates of output be such that theirmarginal costs are equal or as nearly equal aspossible.

7. The total output from all producers of agood at any given price forms one point onthe aggregate market supply schedule,which is made up of all the outputs so ob-tained at every possible price.

8. Efficient supply under a capitalist system re-quires a market in which price can be deter-mined and revealed to all potential producers.

9. New producers in a market, by lowering themarket prices of goods they produce, enablethe consumer to buy more and transfer in-come from prior producers of that good toconsumers. The transfer of income by lowerprices from prior producers should not becounted in the net social gain of incomefrom having more producers. Although thenet social gains are more than large enoughto permit, in principle, full compensation toprior producers, such compensation rarelyoccurs.

10. Because productive inputs are specific to agood or must incur costs in moving or beingconverted, transitional, short-run adjust-ments in price or output overshoot the long-er-run equilibrium.

II. By preventing some potential producersfrom producing higher-valued goods for themarket, contrived monopoly restraints canincrease the wealth of existing producers,but only by transferring wealth from con-sumers and also by reducing total outputvalue.

12. The analysis of this chapter presumed lowtransactions and information costs, and se-cure private-property rights.

13. Because not all producers have identicalmarginal cost schedules, each producer willalways have a lower marginal cost at somerate of production for some good. No one,by definition of costs, can have lower costsfor every good.

14. Never does a newcomer eliminate all jobsfor present producers, forcing them into astate of prolonged unemployment. Insteadthey are forced to shift to next best payingtasks, as, for example, were American carproducers by imports of Japanese and Ger-man cars. Always, productive tasks remainat which the foreign importers are morecostly producers.

15. More-productive inputs obtain higher in-comes, called Ricardian rents, because theyproduce more, not by restricting entry bycompetitors.

16. Specialization can cause "alienation." But asalways, the question is not whether such illeffects can or should be eliminated, butwhat is the appropriate amount, given thegains in productivity from specialization.

Questions1. Smith's production possibilities are indicated

by the following table:

Alternative Daily Production Possibilitiesby Smith's Resources

Oats Soybeans

10 and 0

9 and 1.0

8 and 1.9

7 and 2.7

6 and 3.4

5 and 4.0

4 and 4.5

3 and 4.9

2 and 5.2

1 and 5.4

0 and 5.5

a. What is Smith's marginal cost schedulefor producing oats if soybeans are worth$50 a bushel?

b. If the price of oats is $20 a bushel, howmany bushels should he produce to maxi-mize the value of his outputs?

2. "Cost is an opportunity concept and existswherever a choice exists." Explain.

3. "A firm's costs for material, labor, andequipment are simply measures of the highest-valued alternative output producible by those re-sources." True or false?

4. Why are costs not measured in terms of la-bor hours?

5. What is meant by efficient production?

6. a. For producers A and B in the text, howmany units of output of X should eachproduce if a total of 6 units is desired?

b. Did your solution have A's and B's mar-ginal costs equal?

c. What would the price of X have to be toinduce a total output of 6 units?

7. The following questions involve the produc-tion data of the two people given in Tables 7-2and 7-3.

a. If the price of an X were $1.10 and theprice of a Y were $1.00, what should eachperson produce in order to maximize per-sonal wealth?

b. Would the resulting assignment of tasksbe efficient?

c. If the price of an X is $1.60 and the priceof a Y rises to $2.00, how much X wouldeach produce in order to maximize per-sonal wealth? (Hint: Recompute costs ofX.)

8. The production-possibility schedules are:

Mr. A Mr. B

X and Y X and Y

5 0 3 0

4 1.5 2 1

3 2.9 1 2

2 3.8 0 3

1 4.5

0 5

*a. Convert these two production possibili-ties into marginal costs of X.

b. Who profitably produces some X at itslowest price?

c. Who would profitably produce some Yat its lowest price?

d. At what ratio of the price of X to theprice of Y would Mr. B switch from pro-

Production with Specialization 1S9

duction of all X to production of some Y?

9. "It is better to buy from a firm that is losingmoney than from one that is making a profit, be-cause the former firm is charging too Iowa pricewhile the latter is charging more than costs."Evaluate.

10. A prime minister of an emerging countryonce bragged that he was going to make hiscountry self-sufficient and independent of for-eigners. Do the principles of this chapter suggestanything about how you as a native of that coun-try might have been affected? Explain.

11. Which of the following are differential earn-ings from superior productivity and which arefrom monopoly sources?

a. Johnny Carson's incomeb. Bob Hope's incomec. Kareem Jabbar's incomed. Jack Nicklaus's golf earningse. Brooke Shields' incomef. TV station owner's incomeg. Senator Edward Kennedy's incomeh. McDonald's incomeI. Holiday Inn's income

12. In the discussion in this chapter let Mr. C bea resident of Japan and the others be residents ofthe United States. Mr. A is a tuna-boat ownerand fisherman; B is an American worker in anyother American industry. Let Y be "tuna" and Xbe "other products." Mr. A persuades his con-gressional representative to induce other Housemembers to pass a law prohibiting the importingof Japanese tuna-product Y produced by Mr. C.Who gains and who loses by a tariff or embargoon Japanese tuna? (This example captures the es-sence of the purposes and effects of tariffs andembargoes.)

13. The three-person problem can also be inter-preted as a case in which admission to the mar-ket for sale of Y requires a license from the state,and this license is given only if the current out-put from those now in the production of Y isdeemed "inadequate to meet current demands."Who gains and who loses? Can you give somereal examples of this situation?

14. Would the three-person new-entrant prob-lem also serve as an example of the effect of ap-

160 Chapter 7

<

prenticeship laws, which prohibit a person fromacting as a "qualified" carpenter, meat cutter, orthe like until he or she has served a specifiednumber of years as an apprentice? Explain.

15. In California it was proposed that the stateshould finance the education of more doctors be-cause the costs of educating them would be ex-ceeded by their value as measured in lower coststo patients. Explain why this comparison doesnot in fact determine whether the costs of theeducation would result in a social gain.

16. "The increased output of specialization isdistributed as profits and as a lower price to con-sumers." What determines the portion of each?

17. What is meant by a subsistence or self-suffi-cient economy as contrasted to a specialized, in-terdependent economy?

18. Does efficient production assume that per-fect knowledge exists? Explain.

19. When a group of Russian officials touringAmerican farms asked who told the farmers howmuch to produce in order to supply the appropri-ate amounts of goods, the farmers s-aid that noone told them. But the Russians were convincedthe farmers were concealing something. Whatwould you have told the Russians?

20. "It's wrong to profit from someone else'smisfortune."

a. Explain why, if that were taken literally,we would all be poorer.

b. Does the doctor profit from your illness?The farmer from your hunger? The shoe-maker from your tender feet? The teach-er from your ignorance? The preacherfrom your sinfulness?

21. A capitalist system presumes enforcement ofcertain institutions or rules. What are they?

22. The following remark is commonly madeabout some rich people: "He is an independentlywealthy man." From what is he independent?Does his wealth not depend upon other people'sdemands?

23. a. Do you think specialization will be car-ried to greater extent in a large city or asmall one?

b. Why?c. Give examples.

*24. Mexico, like almost every other country forthat matter, prides itself on being independent inthe production of various goods. Does that makeits citizens richer or poorer?

25. Evidence of the very great extent of special-ization of knowledge is provided by Albert Ein-stein's assertion just prior to his death (SocialistInternational Information): "The economic anar-chy of capitalist society as it exists today is in myview the main cause of our evils. Production iscarried on for profit, not for use." What was Ein-stein's error in economic analysis?

26. A steals from B successfully.a. Is that production? Why?

*b. If you say "No, because someone ishurt," what would you say about thecase in which a new invention displacessome other producers?

*c. Are there some kinds of production thatyou think should not be allowed?

27. Several years ago India proposed to build asteel mill and asked the U.S. government to fi-nance the project. In support of India's request,John Kenneth Galbraith, then the American Am-bassador to India, wrote: "Although it would be alarge mill, there is no doubt that the steel isneeded. While the plant would be costly, it

would soon pay for itself in the imports that itwould save. To import a million tons of steelproducts would cost the Indians about $200 mil-lion. The proposed mill with an annual capacityof 1 million tons would cost $513 million tobuild. Three years of operations would thus re-cover the dollar cost of the mill and more. SinceIndia combines her pressing need for steel withan equally acute shortage of dollars, the econom-ic attraction is obvious. She could not, in fact,afford to import the steel that the mill could sup-ply." Explain what is wrong with every sentenceexcept the third and fourth.

28. "Every profit represents the gain from mov-ing resources to higher-valued uses." Do youagree? If so, why? If not, why not?

*29. Dr. John H. Knowles, President of theRockefeller Foundation, said after a trip to Chinain 1976, "China is now able to meet all of itsenergy needs and is even in a position to export."Is that a meaningful or correct statement? If so,does it mean China is better off than if it import-ed sources of energy? Why?

30. In 1980 English newspapers boasted thatEngland was self-sufficient in crude oil becauseof its production in the North Sea. Is that causefor congratulations?

Production with SpeciaJiza tion 161

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Joint Production

Chapter 8Productionby FirDls

In the preceding chapter we analyzed a mod-el, a simplified explanation, showing howspecialization enables output to increase, andhow specialization is coordinated in a mar-ket-directed, private-property economy. Forthe sake of simplicity each of the producersin the model operated alone in producingtheir output. But another major source oflarger output is teamwork, in which peoplecoordinate their specialized activities. Thisisdone in an organization in which one party(typically the owner) directs and monitorsthe other members (employees), withouttheir buying and selling among themselves,as if in a marketplace, their component ele-ments that create the firm's products, thevalue of which is instead divided among theteam of members. Why the productive effortis organized as teamwork, and why paymentsare made the way they are, is part of the sub-ject of this chapter.

We again formulate a model in whichonly the crucial organizational features aremade explicit. We ignore features that arefor the time being irrelevant, such as wheth-er the enterprises are small or large, union-ized or non unionized, conglomerate or sin-gle-product, local or multinational, new orold, retailing or manufacturing, corporationor proprietorship. We pass over such admin-istrative problems as how to select personnel,how to plan production schedules, how to ar-range for purchases and storage, how to keeptax and accounting records, how to persuadepoliticians on proposed legislation or regula-tion, and an incredible array of tasks that oc-cupy a businessman's time.

To isolate essential problems that occurin teamwork and how they can be handled,imagine an island, Fishland, where 1000 sim-ilar people do nothing but fish from theshore, each catching four fish daily. Thus,the social total-that is, the amount taken in

163

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Table 8·1 CATCH OF FISH ON BOARD·

NetNumber Total Marginal Average Socialof Men Catch Product Product Marginal Social Totalon Board (on Board) (on Board) (on Board) Product (Shore Plus Boat)

0 0 0 0 0 4000 + 0=40001 6 + 6 6 2 3996 + 6 = 40022 16 +10 8 6 3992 + 16 = 40083 24 + 8 8 4 3988 + 24 = 40124 30 + 6 7.5 2 3984 + 30 = 40145 34 + 4 6.8 0 3980 + 34 = 40146 36 + 2 6 2 3976 + 36 = 40127 36 0 5.14 4 3972 + 36 = 40088 32 4 4 8 3968 + 32 = 40009 27 5 3 9 3964 + 27 = 3991

10 21 6 2.1 -10 3960 + 21 = 3981

'Anyone fishing from shore catches four fish, and there are 1000 people.

by the economy as a whole-is 4000 fish. Aboat is found; some can now fish on theocean. Everyone is interested only in howmany fish are caught; fishing from shore orfrom a boat is equally pleasant or arduous.Table 8-1 gives the various quantities of fishthat can be caught. The discoverer of theboat uses it alone and catches six fish, twomore than from shore. The social total is twofish larger, as shown in the rightmost columnof Table 8-1. If another person joins the firston the boat, the pair can catch a total of 16-10 more than with only one person on theboat. So with two people, the marginal prod-uct on board is 10 fish. Because we must sub-tract the four fish the second person wouldhave caught from shore, the social total is sixfish greater than with only one person on theboat, and eight more than without the boat.Who gets the extra 8 fish? If the two peopleshare the boat catch equally, each get fourmore than the shore fishers. No one else isaffected.

As Figure 8-1 and Table 8-1 show, athird person could profitably fish from the

I'IIIIIi"!I.!ll·~.· _

~lIl 164 Chapter 8

boat, increasing the boat total by 8 to 24fish. (Check the numbers in the table andfigure to make sure you understand.) Thesocial total increases by four: the differencebetween the marginal product on the boatand the forsaken four fish that the third per-son could have caught from the shore. If afourth person joined the crew the marginalproduct on the boat would be six, which ex-ceeds the forsaken four fish from the shore,giving a social marginal product of two.With four people the total product on theboat is 30; subtracting 16 forsaken fish fromthe shore (four for each person who shiftedto the boat) yields a social total gain of 14fish.

WHAT IS A MARGINAL PRODUCT?WHO PRODUCES IT? WHOSE IS IT?

When we use the expression "marginal prod-uct of an input," we do not mean how muchthat input produces. What we mean is thechange in the total catch of fish that resultsfrom having, say, three units of labor instead

of only two on the boat. According to Table8-1, the marginal product with a third unitof labor (as compared to two units of labor)when used jointly with the boat is eight fish.Those eight fish are not caught by the thirdlaborer. Instead, that eight is the increase inthe total catch when three laborers are usedinstead of two, along with the boat andequipment. (If a basketball team used sixplayers instead of five, should the sixth play-er claim to have produced the extra points?All that can be validly asserted is that sixproduce more than five do, and the increaseis what is meant by the marginal product atsix people-which is thus more accurate thanspeaking of the marginal product of the sixthperson.)

To produce any good, more than onekind of input is used. Say a tree and a powersaw and I make lumber. How much of thelumber did I make? How much did the pow-er saw make? With teamwork by joint re-sources it is as meaningless to ask what isproduced by each input as it is to state that aperson is paid according to his or her output.Instead, we can ask what determines the pay-ment (that is, the price) for services of an in-put.

If we want to achieve the social maxi-mum output-that is, with no waste of re-sources-then the optimal number of peoplefishing from the boat is four or five: five be-cause the marginal product, four fish, with afifth crew member on the boat would exactlyoffset the lost marginal product, four fish,from the shore. For the sake of conveniencein arithmetic, whenever two such numbersare equivalent, we continue to arbitrarily usethe larger. Maximizing the social output,then, requires that the boat crew be enlargedto that size at which the marginal product onboard decreases to that on the shore. In Fig-ure 8-1 the marginal social gains are the ar-eas of plus signs in the first four marginalproduct bars. If too many were on the boat-say, six-the result would be a smaller socialtotal.

10

8

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MarginalProductivity

on Shore1

++

::1:::::1::1::1--1--1--1--1--1--1--1--1::1::1::1:=1

Crew Size:~:::.:.;.::::~::~.::.;.;.:.;.:.;.:.::i:i:::i:i:i::::4::;;;;;:::~::;;';;';:':~:~::::;+';::4:::~:::';';;';::::,;;.;.:::~::~:;;:;.:;.:::~::~::~:~:::i:i:i:::i:1:::::~::;;';;';;:

Figure 8·1.

MARGINAL PRODUCTS ON BOAT

The vertical bars represent the marginal product (in fish)on board the boat. The horizontal line at 4 fish is themarginal product (in units of fish) on the shore. Theareas occupied by plus signs denote the gain byhaving fishermen on the boat; the areas markedwith minus signs are the social losses of havingtoo many people fish on the boat. The shadedbars below zero represent reductions in thetotal productivity of those on boardcombined with there being fewerpeople fishing on shore.

Production by Firms J 6S

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Control, PropertyRights, and Incentives

We now come to the first point of interest indeveloping our model to more accurately de-scribe the real world: How many people willbe allowed on the boat, and who gets theoutput?

SCENE 1: SHARE AND SHARE ALIKE

In the first scene of our Fishland saga, as-sume that the discoverer of the boat deter-mines how many persons can be on board,and decides that all those on board will di-vide the total catch equally; that is, each willget an equal per capita share. Our discovererwill allow only one or two other people, forthen the everege (the equal per capita share)that each person gets is at the maximum:eight fish. The discoverer will not tolerate atotal of four people on board because eventhough the social total would increase by 2fish, the average (which each gets) would fallfrom 8 to 7.5-fewer fish for the discoverer.If we change the rules and allow all three ofthe crew to decide whether any more will beallowed to join, the outcome is the same: No,because another person reduces the averageto be shared from 8 to 7.5 for four people.

This is a characteristic result for socialistfirms, in which the incumbent workers sharethe net income equally and newcomers areadmitted only by permission of the existinggroup. It is also a trait of many labor unionsand professions: Longshoremen, electricians,musicians, doctors, lawyers, and a vast hostof other unionists and professionals admitnew members only by permission (grantedthrough certifying boards) of the presentmembers. One would therefore expect theeffect on the average of benefits to the exist-ing members to be the criterion determiningwhether new members can be added.

However, if a new member paid an entry

166 Chapter 8

fee to be shared by present members, thenumber of new members admitted would bedrastically altered. How does the entry feemake a difference? If it nearly equals the ex-cess of an entrant's per-share productionwithin the organization over what he or shecould earn without membership, payment ofthat excess to existing members will enablethem to divide it among themselves and geta still larger average. The lower average theyotherwise would get is more than made upfor by their share of the entry fee paid by thenewcomer. (Look at the data in Table 8-1 tocheck this. Unless you do, you may find ithard to understand the following example.)For example, a fourth person on the boatcould pay a daily entry fee of 3 fish to thefirst three members, leaving the fourth per-son a net daily take-home of 4.5 fish (fromthe per-capita share of 7.5 fish) and givingthem an extra fish each; that added to theirnew 7.5 average gives them 8.5 fish, half afish more than before.

In general, any newcomer who can get amarginal catch bigger on the boat than onthe shore would be willing to offer almost allof that excess to the existing crew to be di-vided among themselves. The total availableto them, and hence their average, is bound toincrease. The prior members, who decide tolet new members buy their way in, have ineffect become the controlling owners maxi-mizing their incomes. Some unions have avery large entry fee; some country clubscharge a large entry fee. These can be re-garded as a way for new members to buytheir way into a group and compensate itsprior members for the lowering of their aver-age of amenities derived from their member-ship in the club.

SCENE 2: PRIVATE PROPERTY

As scene 2 opens, we change arrangements:The boat is owned by its finder. Instead ofhaving to share the catch, the owner nowseeks solely to maximize personal wealth,

that is, the number of fish the owner gets tokeep. The owner hires a crew and keeps allthe fish in excess of the wages paid to thecrew. How much will they be paid? Howmany will be hired? How much will the own-er gain?

Because crew members are not slaves,they must be paid enough to attract themfrom their next best opportunity, which iscatching 4 fish on the shore: They must bepaid at least 4 fish per day. Thus, the boatowner will hire as many people as have amarginal catch, or product, on the boat thatexceeds the wage that each must be paid. Asthe crew gets larger, the marginal product,after an initial rise, declines until with thefifth crew member the marginal product isdown to almost as low as 4 fish. That is verylittle more than can be caught on the shore,and just enough to attract a person awayfrom shore fishing. This is portrayed in Fig-ure 8-1. (Remember, whether four or fivecrew members are hired is here unimportant;either number is an answer to our problem.)Certainly more than three will be hired, butnot as many as 6. Neither of those crew sizeswould maximize the boat owner's gains. Acrew size is selected that maximizes the boatowner's gain (14 fish) and also happens tomaximize the social total (14 fish)!

That coincidence between maximumprivate and maximum social gain is not acci-dental. People with private-property rightswho seek profits in an open-market systemwill maximize the social total in many situa-tions. What those situations are we will seelater. Here, we will show that this double re-sult is possible, that it is not a contrivedquirk of our special example, and that it hap-pens without the profit seeker's intent or acentral directive authority.

SCENE 3: BOAT RENTING

As scene 3 of Fishland opens, the boat own-er, having decided to retire, now rents theboat to any group that forms a crew. How

large a group will be on board and what rentwill be obtained? (For simplicity, assume theowner stays on shore and there catches fourfish while the boat renters are at sea.) Again,four or five people-will be the crew and theywill offer a rental of up to 14 fish. The totalcatch with 4 on the boat is 30 fish, which is14 more than they would have caught fromshore. Competition among all people to formcrews and to rent the boat will force the win-ning crews to pay up to 14 fish in rent and beleft with incomes of at least four fish per PeJ;-son! A three-person crew could not pay thatmuch rent; they catch only 24 fish, only 12more than they could have caught fromshore. If they paid 14 fish in rent, they wouldeach have only 3 1/3 fish. Nor could a six-person crew pay that much rent. The highestrent can be paid only by a four- or five-per-son team. (Table 8-1 shows that a fifth per-son has a marginal product of four fish, ex-actly what would have been caught on shore:Adding a fifth gives neither an increase nor aloss. )

The highest rental value of the boat is14 fish per day, exactly the maximum gainin fish that can be caught through use ofthe boat. Essentially, all of it is paid to theboat owner. Again, the owner's personal in-come has been maximized, as has the socialincome. (In Figure 8-1 the gain obtained bythe owner is the area occupied by plus signsout to where the on-boat and on-shore mar-ginal products are equal.) Our analysis hasassumed that a boat owner who maximizesincome will (by definition of a maximum)limit the crew to that size beyond whichthe marginal product of another input doesnot exceed what the input could earn else-where.

A crew size can be achieved that maxi-mizes both the social total and the boat own-er's wealth if someone has the right to: (a)determine how many are employed on theboat or charge rent for the boat, and (b) keepthe net receipts. (We shall later see some

Production by Firms 167

conditions in which private gains and socialgains diverge.)

We can summarize the main lines of ouranalysis and their implications in the margin-al productivity theory of demand for inputs:The demand for productive inputs dependson the marginal products; inputs will be de-manded up to that amount at which theirmarginal product falls to equality with thewage or price of the input. Because the mar-ginal products decrease at greater input,more inputs are demanded at lower wages,and fewer at higher wages or prices. Thistheory is used extensively later.

Employees or Renters? The arrangementsin scenes 2 and 3 are virtually identical: In-stead of saying the boat owner hired thecrew as in scene I, we could say the boat washired by the fishermen as in scene 2. In scene1 the crew is paid a bit over 4 fish to work onthe boat and the owner keeps the remainderof the total catch, a net of 14 fish. In scene 2the crew pays the owner 14 fish as rental andeach has a little over 4 fish left. There is nodifference in this example between rentingthe boat and being hired by the boat owneras employees!

Is there, then, no difference betweenMacy's hiring clerks as employees and theclerks paying the owners of Macy's rent forits building and facilities (and inventory-usecosts) out of the total daily sales-leaving theclerks with the same income in either case?There indeed is no difference, if the sntici-.,pated output performance of the inputs canbe predicted with certainty. But if mistakenestimates of the anticipated product aremade, someone must bear the consequences.

In our fishing example, uncertaintyabout the catch makes the difference be-tween renting and hiring: The catch canvary because of (a) natural hazards, eventsbeyond human control, or (b) behavior of thefishermen, such as shirking and negligence.Natural hazards make for no great difference

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to the renter or the employee. In both casesthe owner bears the natural variations: Therent will be adjusted each day in response topast and hence future expected changes. Fur-thermore, the owner can take out insuranceagainst that kind of natural hazard.

The major and significant difference tothe owner between hiring workers and rent-ing a productive facility comes from the sec-ond factor: the difference in the incentives toshirk or be negligent under the two systems,a matter we will take up shortly. First wemove to scene 4, and we assume again thatthe catch is still certain.

SCENE 4:THE BOAT AS COMMUNAL PROPERTY

The boat owner has been expropriated: Theboat is now communal, or public, property.Anyone and everyone can board the boat,just as they can use the streets, parks, andbeaches. People crowd onto the boat untilthe average catch (which each gets) matchesthat on shore. Eight people will be on boardwith four fish each to take home.

It is easy to see why that happens, if youagain examine the data in Table 8-1. Witheach person on board sharing equally in thecatch, people crowd on so long as the aver-age catch exceeds their individual catch onshore. So a sixth, seventh, and eighth personwill go on board; the sixth because the aver-age catch is then 6 fish; the seventh becausethe average is 5.14; the eighth because theaverage is 4. Every person's share in thecatch-the average-is reduced as more peo-ple crowd on board. But each newcomer ig-nores the external harmful effect on otherpeople. With eight persons on board no oneelse would gain by joining the crew.

Notice the full consequences. A sixthperson on board causes a social loss of twofish: the marginal product on board, two, mi-nus the forsaken marginal product, four, onshore. A seventh causes a loss of four fish:the marginal product on board, zero, minus

his sacrificed marginal product, four, onshore. An eighth causes a social loss of eightfish. The total social decrease caused by thesixth, seventh, and eighth persons is 14 fish(= 2 + 4 + 8), which cancels the social gainof 14 fish from the first four or five people.The potential gain formerly obtained and re-ceived as larger income by the owners is en-tirely dissipated by overcrowding the boat.No one is better off than before the boat wasfound. What happened to the extra 14 fish?They aren't caught, because there is conges-tion on board instead of the optimal numberof people.

Congestion is shown graphically in Fig-ure 8-1. The social gain, indicated by theplus-marked area, represents the marginalproducts on board in excess of the marginalproducts sacrificed on shore. It is maximizedat 14 fish with five people on board. Withmore people, the marginal product on boardwill decrease to less than what is sacrificedon shore, out into the region where there is ashaded area below the line representing mar-ginal product on shore and above the linerepresenting marginal product on board,which is below the shore marginal productwhen more than five people are on the boat.Unrestricted communal access is common forhighways, beaches, sidewalks, parks, air, riv-ers, lakes, oceans. The reason for the conges-tion should be obvious: the absence of prop-erty rights with which to exclude anexcessive number of people. With communalor public property, no one has adequate in-centive to heed those effects of congestion.They are left "external" to each person's in-terests, and are often called externalities.

So as the curtain falls on scene 4 a gov-ernment agent is appointed to control thenumber of people allowed on the boat.

SCENE 5: GOVERNMENT CONTROL

The last scene opens with the governmentagent being told to maximize profit fromrenting the boat. The l+fish rent (the social

gain) is, then, supposed to go to the govern-ment and be distributed however the au-thorities see fit. It would appear that the onlydifference between this and the system ofprivate-property rights in the boat is in whogets the 14-fish gain. However, this is notquite correct.

What will the government agent lose bytaking life easier and not charging the rightfee? The loss is imposed on the public as awhole. But who in the public or governmenthas an incentive as strong as a private ownerto detect managerial opportunism, or shirk-ing and negligence, or lost rental value? Apolitical authority suffers less loss of poten-tial personal wealth than a private ownerdoes in being less attentive to nonownablegains. The authority would permit more peo-ple on board if that enhanced his or her pop-ularity and hold on political office. On theother hand, the authority might allow toofew on board because that permits shorterworking hours (such as by closing on holi-days and earlier in the afternoons) and notoperating the boat as fully as needed to maxi-mize profits.

But when was a government agency sup-posed to maximize profits? It is usually, oralways, given the mandate, or goal, to "maxi-mize public welfare and benefit." (The agen-cy might be a nonprofit corporation operat-ing or overseeing hospitals, colleges, or thepostal service.) How is "maximize publicwelfare" interpreted? In our example, is it bymaximizing the number on board, or thecatch on the boat, or the social total of thecatch?

That goal is sturdy and widespread, be-cause its ambiguity permits wide latitude ofinterpretation and hence of measuring per-formance. It is commonly the mandate ofgovernment authorities who control access tothe television and radio airwaves, air spacefor airplanes, postal service, highways, na-

. tional and state parks and beaches, airports,harbors, and schools. It is even applied to


federal forests, offshore oil, and land. Zoningcommissions that control the use of land(such as in determining how congested it canbe) are similarly instructed to maximize"public welfare and usefulness." But hardlyany government authority is instructed tomaximize profits: not the postal service, orthe water, electricity, gas, or bus company.All are instructed to "serve the public," or"break even." Sadly, no validated theory ofpolitical behavior exists with which to pre-dict what is likely to happen.

CONTROL OFOPPORTUNISTIC BEHAVIOR

Not all people are always perfectly honest.People act opportunistically, or negligently,or cheat and shirk if they can get away withit. A person often delivers less than anotherperson believed was promised and is payingfor, possibly because the second person hon-estly expected more than the first had hon-estly promised or was capable of deliver-ing-or because the first person wasdeliberately cheating. It makes no difference;one of the parties is deceived and believesless should be paid. Furthermore, the antici-pation of opportunism induces people tomake precautionary contractual arrange-ments to avoid later misunderstandings, dis-putes, and losses.

To be a potential victim, a person musthave made some kind of commitment of spe-cialized wealth to the other-party in such away that the other party's behavior affectsthe first person's subsequent wealth. Thespecializer is then not in a position to say,"No matter what you do, I can go elsewhereto associate with someone else and be just aswell off there as I am here with you. If youtry cheating, I can leave with my wealth atno loss." An economist would say that thefirst party's wealth is not entirely "salvage-able" elsewhere; it will be lower if the sec-ond party doesn't behave as expected. At the

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other extreme, the resources of the first partyare completely "generalized" if his or herwealth is not dependent on any other specii-IC persons.

If all possible contingencies could beforeseen, and the performance of each partyperfectly measured, and any deviations couldbe corrected by costless, perfect enforce-ment, then simple but lengthy and detailedcontracts would avoid all disputes and losses.But that is not possible. Alternative arrange-ments have evolved. To see some we visitFishland II.

FISHLAND II

The catch by any crew on the boat will de-pend on more things than we have so far

.considered in Fishland I. For example, if ev-ery crew member were to share equally inthe day's total catch, regardless of how manyfish any individual caught, certainly eachwould secretly relax and work less cleverlyand diligently, because for every fish notcaught only a fraction of the loss is borne bythe shirker. Part of the loss is borne by oth-ers in the crew, while the shirking membergets all the benefits of shirking. Thus, shareand share alike in Fishland II tends to be lessproductive than it was presumed to be inFishland I.

If, contrary to fact, shirking could be de-tected instantly and costlessly, it would beeliminated, because any benefits to the shirk-er would be canceled by punishment or a re-duced reward. Everyone on a team wants toreduce the possibility of shirking by otherteam members. Crew members will seekmethods that tend to reveal and punishshirking, thereby reducing its incidence evenif it involves submitting themselves to thesame discipline. The problem is how to ef-fectively restrain that shirking and opportun-ism, that is, how to monitor behavior.

One way is to have a monitor detectwhat each person does and adjust the per-son's pay accordingly. But the monitor can

also relax and be less diligent. It would notbe wise for the crew to hire a monitor for asalary that is paid even if the monitor relax-es, unless someone could monitor the moni-tor. But who monitors the monitor who mon-itors the monitor .. .?

There are some reliable monitoring de-vices. First, let the monitor not be hired for asalary but be given the remainder, or residu-al, of the catch after everyone else is paid thepromised amounts. The monitor is the resid-ual claimant: the recipient of the profits orlosses after the promised payments. Whowill this monitor be? Whose wealth is mostaffected by the quality of monitoring? Thecrew members will not lose much becausethey can earn almost as much elsewhere.What about the boat owner? If the catch issmall, and if all crew members must be paidwhat they can get elsewhere, the owner ofthe boat, which can earn almost nothing else-where, will suffer the reduced value if fewerfish are caught. The owner who loses fromineffective monitoring has incentive to insiston good monitoring. It is therefore not sur-prising that the monitor is, or is responsibleto, the owner of the resources most highlyspecialized to the team's activity-in ourcase, the boat. The boat owner will be the"monitor," the "employer," or the "boss."

A second means of controlling a monitoris competition from potential monitors whooffer to displace less effective monitors.Within the firm anyone who sees a shirkingor ineffective monitor will have incentives todisplace that monitor, as may anyone outsidethe firm who is aware of the less diligent ac-tivity (just as purveyors of watches, automo-biles, tires, or shoes seek to offer customersbetter opportunities, thereby displacing lesseffective producers). Potential replacementswho detect shirking will offer to work to bet-ter standards or for lower wages. Competi-tors have incentives to detect and evaluateperformances and to persuade potential cus-tomers (that is, employers) that the alterna-tives they offer are superior.

Failing a technique for monitoring it,shirking can be adapted to by paying eachmember a smaller wage to offset anticipatedbut undetectable shirking. Money wages willbe smaller if varioss kinds of behavior-per-sonal use of company phones, longer coffeebreaks, tardiness, and the like-are toleratedby the employer. If the average extent of suchfringe "benefits" is correctly estimated, theaverage wage will be correspondingly lower.If deviations from the average are excessivelydifficult to detect, some employees can bene-fit from excessive undetected shirking.

INTERSPECIALIZEDRESOURCES AND COMMONOWNERSHIP

One especially important source of opportu-nistic behavior is worth examining. We willillustrate, at first, with a simple example.Suppose someone invents a power winch tohelp pull in fishing nets faster and thus catchmore fish. Suppose the boat owner agrees tolease it from the inventor, who installs it onthe boat-a rather costly operation since itmust be securely fastened to the boat deck.The catch of fish increases, but so does op-portunism: The boat owner slyly conjecturesthat even if faced with a refusal to pay all thepromised rent, the winch owner could not ef-fectively respond by threatening to take thewinch off the boat. The winch is worthlesselsewhere. Removing it would make thewinch owner worse off than accepting thelower rent. In economic language, it has nosalvage value in any other use. It is specific,OJ specialized, to that boat, which means it ismore valuable on that boat than anywhereelse. The boat owner is opportunistically ex-propriating some of the value of the winchspecialized to his boat.

The winch inventor-owner should haveanticipated this possible behavior, say by re-fusing to invest in making and owning awinch specific to and installed on a boat


owned by someone else. The winch ownershould have made the boat owner buy andpay for the winch as it was being created andinstalled on the boat. Or the winch inventorand the boat owner should have formed apartnership with each having equal rights inthe value of the combined boat and winch.When the winch and boat are owned in com-mon, what earnings come from one ownedresource go to the other. How the earningsare assigned to one resource or the othermakes no difference. So we would expect in-terspecific resources-that is, resources spe-cialized to one another, like the winch andboat-to be produced and owned in com-mon. The ownership of the winch and boatshould be integrated to avoid the possibilitythat the value of one of the interspecific re-sources could be expropriated by the ownerof the other interspecific resource. And typi-cally they are so owned.

To be thoroughly realistic, imaginebuilding an oil refinery to be supplied by onecrude-oil pipeline. After the refinery is built,what would prevent the pipeline owner fromasking a higher price for the use of it? Therefinery owner would have to build anotherpipeline or shut down or relocate the refin-ery-no cheap task. The owner of the exist-ing pipeline could threaten to expropriate anamount up to the costs of building a newpipeline or an amount equal to the lost valueof the refinery if it were shut down ormoved. On the other hand, the refiner wouldthreaten not to pay, and the ~pipeline couldnot be removed. ~.

Because both pipeline and refinerybuilders know these possibilities in reality,prior to building either they form one com-pany to own both; or one party builds andowns both. In either case, highly interspecificresources are owned in common, becauseotherwise the difference between (a) the val-ue with the resource to which a given re-source is interspecific and (b) the salvage val-ue of that given resource is liable to be

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expropriated by opportunistic action.'By contrast, generalized resources,

which can easily move to other tasks with lit-tle or no loss of value, are less likely to beowned in common with the specific re-sources. Thus, in Fishland II, the fishinglines could easily be transferred to the shoreand earn no less than on the boat. Theywould not be owned in common with theboat. The crew members could also fish fromshore; they need not own the boat. But ifsome person had .skills so specialized to theboat that only this person knew how to oper-ate or pilot the boat and thus could threatento expropriate some of its value, this operatorwould very likely have to be an owner of theboat. But if good substitutes were readilyavailable, it would be less important that thepilot or operator then have ownership of theboat.

Like machinery, people can become in-terspecific to varying degrees. For example,an employee who purchases a house near hisor her place of employment would face alarge loss through moving costs if he or shelater decides to move to a new employer. Orthe prospect of such costs might induce theemployee to accept a lower wage or go with-out a raise as a condition of keeping his orher job and avoiding that moving cost. A see-

'Another example or two should reveal the impor-tance of specialized resources in our economy. Rail-roads don't rent the land on which they place tracks.Imagine the expropriation of value by a landowner whosay.s, "Pay more or remove your tracks." And you don'tfind banks renting safes. Imagine a safe owner beingtold by the bank, "I'm sorry, but we can't pay as muchrent any more. Take away your safe embedded in con-crete in a deep basement." Or, if a newspaper report-ing staff and a printing press were owned separately,with only one printing press in town, imagine the re-porters telling the printing press owner they can onlypay less rent. Can the owner take away that heavy, in-stalled, expensive-to-move press? Or, reversing thethreat, imagine the press owner telling the reporters,"Pay a higher rent this afternoon, or I won't print yourpaper." Two-sided symmetric threat possibilities areforeseeable; as a result, initial investment in all inter-specialized resources will be by one owning group.

retary may have invested in learning somespecial skills useful only to the present em-ployer. Because that knowledge is worthlesselsewhere, the secretary would not risk thatinitial investment without some assurance ofjob and pay conditions. Seniority and tenurerights help serve that purpose, as do rights topensions and insurance and job priorities inthe event of temporary recessions. As weshall see in more detail later, unions act asagents to help deter opportunistic expropria-tion of the value of employees who have be-come more specialized to the firm. (Some-times unions achieve the reverse effect byprotecting employees who shirk or otherwisereduce the welfare of other employees.) Themonitoring function of unions may be theirmost important function, more importantthan any ability to raise the wages of mem-bers above open-market competitive levels.

A most Common instance of interspecificresources is marriage: Two people becomeinterspecific to each other and to their off-spring. Although such arrangements are notcentral to economic analysis, they indicatethat interspecificity of resources can also ap-ply to people; and although people do notown each other, what might appear to be un-usual or otherwise inexplicably restrictivecontracts or arrangements may be the meansof restricting potentially exploitive behavior.

Substitution,Complementarity, andthe Demand for Inputs

An important principle illustrated in ourmodel of teamwork on the fishing boat isthat the greater the quantity of capital equip-ment or machinery available, the larger willbe the total output. The boat is a capitalgood that enhances output, as are nets, pow-er lines, navigational equipment, and thelike, working in ways that are complemen-tary to human labor. That is, these capitalgoods, when used with human labor, increase

the output, but in very special ways. To sim-plify our exposition of how they do so, weshall reduce the variety of types of inputs totwo, called labor and capital-or factors ofproduction, which •.means any productive re-sources.

Labor includes an extremely large vari-ety of different personal talents; capital in-cludes an uncountable variety of machineryand nonhuman devices. But capital is moregenerally interpreted to include also the en-vironment and the resources of the whole..economy: The transportation system, theeducation and technology of co-workers, theeffectiveness of the market in facilitatingspecialization and exchange, the honesty ofthe populace and the extent to which con-tracts are honored-all of these are examplesof cooperative resources. If you moved thecarpenters of any small U.S. city to India,Morocco, Brazil, or Indonesia, their marginalproductivity would be a lot lower simply be-cause there is less jointly available capital perperson in the form of education, formal voca-tional training, and general sophistication ofthe technology. A richer country with lots ofcapital equipment and stable, market-facili-tating institutions is a more efficient placefor a given amount of labor. Although theproductivity of the American carpenterswould be lower in such underdevelopedcountries as those just named, the averageproductivity would be greater than for mostnatives of those countries-a consequence ofthe greater education of the Americans."

'Warning: The word "capital" often also refers tovalues of past investments in enhancing knowledge,abilities, and talents of people. In fact a large portion ofour capital is in human form. Undoubtedly a major por-tion of the advance of our present and future wealthand income is based on increased human capital. Nev-ertheless, in the present chapter we shall use the termslabor and capital to denote human and nonhuman capi-tal respectively-without implying that the quality oflabor is not heavily dependent upon investment in im-proving human abilities.


Like the fishing boat, capital in generalincreases the total output available withsome given quantity of labor. In our exam-ple, the social output jumped from 4000 fishwi thou t the boat to 4014 fish with the boat-a gain of 14 fish. Does it follow that havingeven more capital (more boats, or moreequipment) will increase the output? Yes.But a more subtle and very important ques-tion is, "What does having more equipmentdo to the whole schedule of the marginalproduct of labor?"

Let us interpret this question carefully.It asks what happens to the whole scheduleof marginal products (increases in the num-ber of fish caught) at different crew sizes, if aboat has more equipment, as compared toone without that extra equipment. For a con-stant amount of equipment on the boat, themarginal products of labor, after an initialrise at small amounts of labor, gradually falland ultimately even become negative. Ifthere is more equipment on the boat, thewhole schedule of marginal products of labormight be shifted upward. In that case (I) thetotal product is larger (more fish are caught)at each crew size, and (2) at any given crewsize the marginal product (the increase incatch) at any amount of labor is bigger thanon a boat less well equipped.

However, suppose the new capital were apower winch that pulled the nets with lesslabor and greater speed. This might twist themarginal product schedule, having a large ef-fect on the output with only one or two crewmembers, while the fourth and fifth nowdon't add as much as before. Although thisnew equipment strongly raises marginal pro-ductivity fa"\-small crews of fewer than threelaborers, it lowers the marginal products forcrews larger than three. The winch could becalled a labor-saving device. It raises the labormarginal product schedule upward at smallcrews but lowers it at larger crews, so thatalthough total product is larger, the marginalproduct is smaller at the original crew size.

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A word processor may raise the totaloutput of two secretaries who formerly usedtypewriters, but it may lower the marginalproduct of a second secretary because thefirst one can now work so fast with the wordprocessor and get so much done that the re-maining tasks are low-valued. The secondtypist now adds little value. But it is possiblethat the word processor may be so effectivethat even the second secretary's marginalproduct is higher than before. It depends onthe particular circumstances. The newequipment may result in more labor beinghired because the marginal productivityschedule in the firm is raised even at the ini-tial amount of secretarial labor. (Althoughobviously we should not speak of just onekind of capital good, for simplicity we herecontinue to do so.) Thus, in summary: Morecapital goods increase the total product atthe initial amount of labor input; but an in-crease in one kind of capital may increase themarginal product of labor at the initialamount of associated inputs, whereas an in-crease in another kind of capital may de-crease the marginal product of labor.

CAPITALSUBSTITUTION AND LABOR SAVING

Capital is always a substitute for labor, in thesense that with more of the capital equip-ment one could use fewer units of labor forthe same total output. In this sense, substitu-tion states that a given output could be pro-duced by any of a variety of techniques thatuse different ratios of inputs of capital andlabor, that is, different production tech-niques. Capital and labor are substitutable inthat an increase of one can be used as a sub-stitute for a reduction of the other whilemaintaining the same total output.

THE DEMANDFOR PRODUCTIVE INPUTS

The downward-sloping marginal productschedule tells us, first, that at lower prices of

an input, more will be employed; and, sec-ond, that the quantity of each input thatmaximizes the firm's wealth is that at whichthe marginal product of that type of input isbrought to equality with the input's price.No extra inputs would be used if they in-crease total product value less than its costs,and no input is left unused that would addmore value than its costs. Because differentinputs are marginally substitutable, it followsthat if the price of one input rises, less willbe used, and some quantity of another orothers substituted. The conclusion is: first,that a lower price of one kind of input in-creases the amount demanded of that input,and may reduce the amount demanded of an-other or other inputs; but, second, that theratio of the two amounts of input will be in-creased toward the cheaper input.

Obviously, if you were labor you wouldlike to be in a situation with a lot of capital-if more capital raised the whole marginalproductivity schedule of your type of labor-but with less of the other jointly used input ifthat lowered the marginal productivity curveof your kind of services.

SPEED OF SUBSTITUTION

Substituting and altering inputs are costlyadjustments. One must learn of new inputsand feasible combinations of new ones or ofnew and old; one must make decisions andsee that they are carried out; one must re-arrange inputs and schedule the timing ofnew inputs. How quickly these steps of sub-stitution are carried out in response to newprices depends on the costs of adjustment. Asin consumers' behavior, the demand for in-puts is more elastic the longer the time sincethe price change. And differences of elastic-ity can be represented by differently slopingdemand curves for different intervals after aprice change. The immediate period mayshow little response to prices, because quickchanges are more expensive. Because manyinput adjustments are made only after a sub-

stantial interval, those affected usually fail torecognize the changes as consequences of theinput price change.

An example is what happened when thewages of Chicago elevator operators rose.Wages had been $1 to $1.25 an hour, until aminimum wage of $2.40 an hour was im-posed for operators in downtown (though notsuburban) buildings. With two shifts of oper-ators, the higher wage raised the cost of amanually operated elevator to about $10,000per year. Owners of some of those buildingsthen found it profitable to use automatic ele-vators, each of which cost about $8000 a yearto operate. When the elevator operatorswere discharged several months after theyhad started being paid $2.40 an hour, theywere not likely to understand that it was aresult of the higher wage, since that hadbeen initiated a long time before. Theyblamed it on automation.

INPUT SUBSTITUTIONBY PRODUCT SUBSTITUTION

Substitution among inputs also occurs be-cause of the choices consumers make amonggoods. More of the consumer goods that usemore of the cheaper inputs will be supplied.Those product prices will fall. If the price ofunfinished plastics falls relative to glass, theprice of plastic containers falls; consumersbuy more plastic containers, and plastics arethereby substituted for glass, affecting thedemand for inputs in glassmaking. As anoth-er example, higher wages for carpenters willinduce contractors and homeowners to usemore power saws and more standardizationwith less carpentering service. Wood-pan-eled walls will be displaced by plaster, andsome wood window frames by steel and alu-rmnum.

Competition tests and favors the adop-tion of the more appropriate existing tech-niques by yielding greater profits andgrowth-whether or not a given individual


producer adjusted to the new price situationconsciously. All a producer has to do is hap-pen to be nearer the better combination ofinputs. It is irrelevant whether they got therebecause management calculated marginalproductivities through extensive researchand testing, with the advice of astrologersand consulting economists, or because ofsheer luck. Being there is sufficient. Norneed a producer imitating the successfulfirms know marginal productivities of vari-ous inputs. All one need know is what tech-

0. niques succeeded best.

DERIVED DEMANDFOR PRODUCTIVE RESOURCES

You should be able to see by now why thedemand for an input is called derived de-mand. The marginal product value is derivedfrom the value the consumer puts on the fi-nal product. If consumers' valuation of thatproduct rises, demand for the inputs will rise.The term derived demand emphasizes thisdependence of the demand for an input onthe value of the product to the ultimate con-sumer.

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MONETARY ANDNONMONETARY VALUESOF MARGINAL PRODUCTIVITY

The fact of marginal value productivity istrue in every economy. In a capitalist econo-my, the increase in marketable wealth be-longs to an identifiable owner. However, ifthere were no owner-no one who was ableto keep the increase-the selection of inputswould be mbre influenced by the nonmarket-able productivity. More congenial colleaguesmight be employed by such an operator ifthe gains of hiring lower-salaried workerswho were equally productive of marketablevalues of goods could not be retained. Forexample, a legal limit on income or a heavilytaxed income would induce employers to

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176 Chapter 8

hire employees with more nonmonetary ap-peal to them-good looks, or shared race,ethnic background, religious affiliation, andthe like. Production will be less closely ori-ented to market-valued demands. Becausegovernment agencies are not privatelyowned or profit-seeking, their managers aremore influenced by the nonmonetary attri-butes of inputs. If an organization's rulesonly mildly penalize people for not increas-ing marketable wealth, those responsible forits productivity will be less influenced bymarket values. The generalized marginal-productivity principle (that is, monetary plusnonmonetary effects) is the one that shouldbe used when analyzing any situation.

Nothing in the foregoing analysis im-plies that being less responsive to monetaryvalue is undesirable. One's assessment de-pends upon whether one prefers the econom-ic, cultural, and political attributes of a pri-vate-property, open-market system or thesame attributes of some other system. Somepeople may think they could achieve theiridea of a better way of life through nonrnar-ket types of competition far resolving con-flicts of interests in the presence of scarcity.For example, people with certain kinds ofpersonalities may find competition for politi-cal power more favorable to them than mar-ket competition.

CONSUMPTIONVALUATIONS, EFFICIENCY,AND RESOURCE SUBSTITUTION

The principles explained in this chapter in-volving substitution among inputs, plus theprinciple explained in the preceding chapterinvolving production responses to consum-ers' demands and to changes in costs, can beapplied to clear up a very common misunder-standing. You have probably read complaintsthat sprawling suburbs and highways are us-ing up the prime agricultural lands. Youhave heard celebrities telling you to conserveenergy. You will see stickers on refrigerators

and television sets stating the electrical oper-ating cost. You will hear Boeing expresspride in the fuel efficiency of its new air-planes. Congress has legislated regulationsabout the miles per gallon that American-made (but not foreign-made) automobilesshould deliver. All these examples reflect abasic misunderstanding of costs. What is theerror?

First, resources are used to serve people,not merely to be "saved." The question is,"What is the best rate and way to usethem?" The question is not, "What is theway to not use them?" We strive to use pro-ductive resources in ways that maximize ourwelfare now and in the future. If you remem-ber capital value theory you will recall thatvalues of future uses are included in the pres-ent prices of goods.

The second error is to forget that thereare many ways to produce something. It isinefficient to use more insulation or alumi-num instead of steel to make refrigerators orcars if the value of the electricity or gasolinethereby saved is less than the value of prod-ucts that could otherwise have been pro-duced with the extra aluminum or insulation.Life is a choice of more of this versus moreof that, not less of this. An automobile la-beled fuel efficient because it gets highermileage than some other cars can be moreexpensive than the value of the fuel saved.When you buy a stereo system and are toldthe speaker is very energy efficient in con-verting much of the electric power to sound,you should ask how much it cost in other re-sources to economize on that electrical pow-er. Did it cost $100 of other resources to save$10 of energy? Making a house more energyefficient to save, say, $100 a year in fuel maycost far more than the savings. Concentra-tion on one particular input as a criterion ofhow or what to produce is a sure way to in-crease your costs-that is, reduce your wel-fare.

Nevertheless, technological efficiency iscommonly invoked as the criterion in legisla-

tion, even if implementing the criterion doesnot increase social welfare, as witnessed bythe recent laws mandating energy saving.Technological efficiency-minimizing thecost of one particular input of production oroperation-does not accurately reflect fullcosts, as does economic efficiency. If thecosts of substitute inputs are less than thesavings in fuel costs, people will use some ofthem whether or not legislation is passed-unless you assume that consumers, salesper-sons, and producers have forgotten how toseek profits or increase welfare.

Why that kind of legislation or compul-sion? One possibility is that forcing you toconsume less of some good releases more ofit for someone else-in less valuable uses(otherwise no legislation would have beennecessary). Or perhaps a tax on gasoline isnot really meant to promote its conservationbut rather to collect more taxes for some spe-cial benefit (for example, aqueducts in theSouthwest, urban mass transit in the East, orresearch grants to professors of economics inthe Midwest). If you find our amateur politi-cal analysis obnoxious, no matter. The pointis that you have to guess why it is legislated,if it reduces the aggregate value of potentialoutput and consumer welfare.

Returning to the examples for a lasttime, consider the argument that houses andhighways should not be built on prime agri-cultural land. What is the proposed better al-ternative? Is it to use land less desirable forhousing and transportation, which is also lessdesirable for agricultural uses? We could puthouses on mountaintops or in swamps andmake the quantity of housing smaller, lessdesirable, and more expensive in order tokeep food more plentiful. But the value ofthe extra food that is forsaken when housesand highways are put on prime land is lessthan the value of the housing, living, andtransportation convenience. If prime agricul-tural land is less valuable for crops than formore housing and transportation, it is harm-


ful to human welfare not to use prime agri-cultural land for more housing and highways.Think it over. The two basic propositionsare, first, that it is not resources themselvesthat are critical, but what can be done withthem; and, second, that because inputs aresubstitutable, one should know what value ofconsumption output is lost by saving one in-put and using more of some others--as onemust because you can't produce more by us-ing fewer inputs. .

Summary1. Teamwork, or joint, coordinated effort, is

another source of increased output over ef-fort by a single person.

2. Teamwork is not easily monitored by mar-ket forces, so the performance of each teammember is internally monitored.

3. One measure of the performance of each in-put is marginal product: the increase in totaloutput when a new unit of input is added tothe team.

4. The systems of property rights, reward, andof membership control determine team size.Under some systems, .such as joint sharingwith entry controlled by existing members,teams can be too small, because membersare excluded who would have had a margin-al product greater than in any other activity.Or uncontrolled entry can result in teamsthat are too large, the marginal product ofthe added input being less than it would beelsewhere, thus reducing jotal communityoutput. A private-property arrangement canresult in a team size that maximizes totalcommunity output.

5. A business firm is a team to which some ofthe inputs are specialized. A specialized in-put is one the value of which will be re-duced if the team effort fails to produce theanticipated value of output. Generalized re-sources will not fall in value, because theycan transfer to other activities or teams withno loss of income or reduction of productivity.

J 78 Chapter 8

6. Owners of the specialized inputs-that is, ofthe firm-will be the monitors, or supervi-sors, because they have the most to lose orto gain from the effectiveness of the moni-toring.

7. All the specialized resources used in a teamwill tend to be owned by the same people,to prevent potential disputes over divisionof receipts among these resources, the alter-native market values of which are not highenough to protect them from opportunisticbehavior by the owners of the other reosources to which they are specialized.

8. The demand for any resource is derivedfrom its marginal productivity schedule:Lower prices for that input increase theamount of the input demanded by the firm.

9. Marginal productivity includes nonmone-tary forms of productivity, such as contribu-tions to congeniality, pleasantness, and envi-ronmental amenities.

Questions1. What is the measurement problem in joint

teamwork that is not present in specialization ofthe type examined in the preceding chapter?

2. a. Why is zero congestion wasteful?b. What social institutions prevent too

much congestion and achieve optimalcongestion?

c. What is "optimal" congestion?

*3. Cite examples of privately owned overcon-gested resources, and some that are undercon-gested. Can you explain why each occurred? Citeexamples of government-controlled overcongest-ed resources, and some that are undercongested.Can you explain why each type occurs?

4. Which of the following are examples of ex-cessive congestion?

a. traffic jamsb. crowds at public parks in summerc. air traffic at J. F. Kennedy airport at

about 5 P.M.d. pollution of riverse. deer hunting on opening day

f. public tennis courts on Sunday after-noon

g. full house in a movieh. CB radio bandsI. sidewalks at Christmas timeJ. New York City subway at rush hour

k. buzzards eating a dead deerI. residential crowding in a large city

m. customers in a store during a sale

5. Suppose in the fishing boat example in thechapter people discovered how to make boatsthat were good for one day and that cost theequivalent of two fish. Assume all property isprivately owned, and there are 1000 people.

a. How many boats would the communityuse each day?

b. What would be each person's income?c. What would a boat's selling price be and

how many boats would a boat maker haveto make per day for it to be worthwhile todo so?

*6. For what events is the distribution of riskthe same in socialist and capitalist systems?(Hint: How about divorce, cancer, baldness,homeliness, having children all of the same sex,being left-handed?)

7. How does socialism differ from capitalism indistributing profits and risks of losses?

8. If the boat owner, in the example in the text,were to employ the fishermen at a promisedwage of 4 fish per day, the owner would bear therisk of the day's catch. But suppose the fisher-men rented the boat from the boat owner for afixed daily fee of, say, 14 fish. If the day's catchon board is less than enough to pay the rent andstill leave at least 4 fish per fishermen, the rent-ers will have lost. The risk is borne by the rent-ers, not by the boat owner, who was promised 14fish no matter what the catch. Is that correct?

9. a. What is meant by specialized resources?*b. What are some of the specialized re-

sources in a gasoline station, a restau-rant, a bank?

c. Who will tend to own specialized re-sources? Why?

*d. A bank that uses a computer system forits record keeping typically rents the

computers but owns the tapes on whichthe data is stored. Why?

"e. 'Yi~1 contracts involving joint use of spe-cialized resources or skills differ fromthose for r~sources not specialized toeach other? Why? People are resources,too. Is there any greater specialization ofresources between a husband and wifethan between a male and female sharingliving quarters? Give examples.

10. Some mining areas are isolated and all em-ployee housing is owned by the mining company.These are called company towns. Often they af'ecriticized as means of extracting higher rents forhousing from the employees. Criticize that kindof argument. Then, from the principle of special-ized resources, show how employees benefit byhaving housing owned by the mine owners.

11. The FCC says rights to use the radio-fre-quency spectrum should be assigned to permitmaximum usage.

a. Explain why that statement as it standsis meaningless and useless.

*b. Would it have been meaningful to sayrights should be assigned to achieve effi-cient use? What would be the criterionof efficiency?

12. According to the analyses developed in thischapter, resources will be employed in amountsat which marginal value product is not less thanprice. That also determines their earnings (pricetimes the number of units employed).

a. Who makes up the difference if promisedearnings exceed the value of output?

b. If the promised earnings are less than thetotal value of output, who gets the differ-ence?

c. What forces revise payments towardequality with value of output?

13. "If a firm uses resources efficiently, a changein their prices will induce a change in the rela-tive amounts employed." What will induce thatchange-some directive from a central planningagency, the social consciousness of the employer,or what?

14. "Even if only one combination of productiveinputs could be used to produce some good,


there would still be substitution among produc-tive resources in response to changes in theirprices." Explain what that substitution is andhow it would be induced.

15. Who is substituted for whom when a firmuses one typist, an electric typewriter, and acopying machine rather than two typists and twomanual typewriters? This is called a substitutionof capital for labor. Why is that misleading?

16. "The advent of the one-man bus involvedmore capital equipment: an automatically operat-ed coin box and a door-control device-to nametwo of the capital goods that replaced the con-ductor."

a. Is this a case of capital replacing labor?Where?

b. Is it a case of labor replacing labor?Where?

c. Is it a case of no substitution for labor atall, but instead a job revision with a great-er total output? Where?

*17. "Invention and the lower cost of power inthe home have replaced the domestic servant bycapital equipment. Without that machinerymore people would be working in homes as ser-vants. But the replacement of domestic employ-ees by capital has not led to the replacement oflabor. The released labor is used elsewhere."

a. Can you suggest where?b. Who was aided and who was hurt by the

use of the vacuum cleaner, washing ma-chine, water heater, forced-air furnace,garbage disposal, automatic oven, electricmixer, and refrigerator?

18. The electric refrigerator replaced the icemanwith capital. Did eliminating the job of the ice-man reduce the total number bf jobs? Explain.

19. "Automation does not mean there will bemore people than jobs available. It does notmean fewer jobs for unskilled people-in fact aperson can be less skilled if all he has to do ispunch buttons, pull triggers, and turn steeringwheels, compared to driving a team of horses,shooting a bow and arrow, or wielding a chisel."Do you agree? If so, why? If not, why not?

20. "A molecule of sugar is composed of a fixedratio of atoms of hydrogen, carbon, and oxygen;

180 Chapter 8

it follows that there is no substitutability of in-puts in the manufacture of sugar."

a. Do you agree? Why?*b. Is the reasoning in the preceding ques-

tion applicable to every other kind ofgood that can be manufactured-wheth-er or not the good is composed of a fixedratio of components? For example, is thereasoning applicable to making gasoline,running a railroad, operating a bus,building a house, or selling groceries?

21. Assume that wage rates of gardeners were todouble because of reduced supply of gardeners,with an unchanged demand.

a. What substitution for gardeners wouldoccur?

b. Where or from whom could you learnabout the available substitution tech-niques?

22. There are two kinds of economic efficien-cy-one of cost minimization and one of profitmaximization. In what sense is profit maximiza-tion a more general criterion of efficiency?

23. In Iowa the yield of wheat is 30 bushels peracre; in Washington it is 50 bushels per acre.Which is better?

24. Jet engines are given an efficiency rating ac-cording to the thrust generated per pound of en-gine weight. Explain why that is an inadequatemeasure of efficiency.

25. Steers can be bred with such superb qualitiesthat they will sell for about 50% more per poundthan the standard steers raised for meat. Whichtype should the farmer raise? Give the answer interms of technological versus economic efficien-cy.

26. A high-fidelity stereo sound system is calledefficient if it uses a low amount of electric powerper decibel of sound generated. Why is thattechnical efficiency not an adequate efficiencycriterion for choosing among sound systems,even if the quality of the sound were the same?

27. A water-storage facility is needed, and engi-neers, asked for advice, propose a dam and attestto its efficiency.

*a. If they attest to its technical efficiency,does that still leave open the question ofits economic efficiency? For example, if

the value of the water stored is less thanthe cost of impounding and distributingit, is the dam, though it may be techni-cally efficient, an economically efficientone?

b. This problem extends the notion of eco-nomic efficiency beyond the selection ofthe cheapest way of doing something.Economic efficiency is extended to in-clude what? ..•


The Business Firm

Chapter 9BusinessFirDls:O"'nership~Control~and Profits

A 11business firms are created for essentiallyone purpose: to iqcrease the wealth of theirmembers. And all such firms share the char-acteristic of being made up of a group of re-source owners who bind themselves by con-tracts and undertake to share in some waythe results of their work. Usually the ownersof the inputs whose values are most depen-dent on-or specialized to-the outcome willbe called the owners and employers. ••

If the firm succeeds or fails, the ownersof specialized resources receive the gain orincur loss, whereas the owners of generalizedresources can more easily move to otherfirms or kinds of employment paying asmuch as was expected in the first firm. Be-cause owners of the specialized inputs havemore of their inputs' values dependent onthe firm's success, they demand more respon-sibility for directing, managing, or monitor-ing the firm's activities; they are the employ-ers or bosses.

UNCERTAINTY AND CONTROL

Before there can be teamwork there mustbe a team; someone must select its mem-bers. Someone must then direct their activi-ties and monitor their performance andmake adjustments in payor assigned dutiesaccording to how they perform. All thesetasks are done without perfect information.On the other hand, people contemplatingjoining a team must try to identify their bestabilities and the team's best activities. Forexample, students elect a field of specializa-tion to master in their studies; but aftergraduation they must then estimate wherein that field their talents are most valuable.Which final products are most valuable towhich consumers? Sampling and researchingthe desires of the nation's consumers is verycostly. Furthermore, consumers themselves

183

don't know what they will demand in thefuture.

One source of predictions and advice is aspecialist' in making forecasts, particularlyone whose wealth is significantly affected bythe accuracy of the forecasts. A person whoputs his money where his mouth is is essen-tially a specialist in conveying to productiveresources predictions of the values consum-ers place on given products-predictionsbacked by the predictor's wealth. Employees,in effect, ask the employers (I) to predictwhich products will be most valuable to pro-duce, (2) decide the best way to undertaketeamwork to produce the goods, and (3) seethat the team works effectively. Employees,in short, ask employers to deal with the un-certainty of the market and to direct andmonitor the productive teamwork.

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RISK ALLOCATION BY INSURANCE

There are essentially two sources of uncer-tainty: the possibility of uncontrollableevents, and the unpredictability of humanbehavior-especially in the quality of atten-tion, care, efforts, and diligence. The distinc-tion is not as sharp as it might at first seem.Our life expectancy and the likelihood of ourremaining in ood health are far from entire-ly prey to un ontrollable luck and randomevents. Some people work as test pilots, fire-fighters, and police officers rather than as re-tail clerks or engineers. Although there ismuch we cannot control, we can control ourchoice of activity. Moreover, though we can-not control the odds that earthquakes, hurri-canes, or torrential rains and floods will oc-cur, we can control exposure to those risksby not living in California or Florida, or inriver-bottom lands. Those who live in suchplaces in effect deliberately choose to bearthose risks. They can take more expensiveprecautions by the kinds of houses and otherstructures they build. The fact that the landrents are lower than they otherwise would be

I !1]~-.----1-8-4--C-'h-ap-te-r-9-----------

is a way of compensating people in advancefor the risk of future disaster.

An individual's risk of severe loss can bereduced if it is shared with a large group ofpersons, each of whom absorbs a tiny frac-tion of the loss. This is the principle behindinsurance: Each person makes a small annualpayment, or insurance premium, to a fund tocompensate whoever experiences the disas-ter. Life, fire, accident, and theft are typicalcategories of insurance .

Insurance, paradoxically, may increasethe probability of the disaster. Insurance, likeany safety-enhancing device, tends to makeeach person act less carefully by freeing theperson of the prospect of bearing that severeloss. Drivers with auto-accident insurancedrive a bit less carefully, as persons withtheft and fire insurance may be less cautiousin their behavior. To overcome this tenden-cy the insurance group will insist that eachmember take protective measures: installprescribed locks on doors, install sprinklersystems, submit to building inspections, usebetter electrical wiring, receive no police ci-tations for driving fast, and the like.

If people could not be induced to actmore carefully, insurance would not be avail-able. The event insured against would occurso often that those paying insurance premi-ums would find the costs prohibitive. That iswhy you can't get insurance against goingbroke as a businessperson.

RISK ALLOCATION BY OWNERSHIP

Many hazards are not formally insurable,that is, by purchase of an insurance policy:You can't buy insurance against your oilwells going dry, or not finding gold on yourland, or people's tastes and demands shiftingaway from your services, or divorce, or dullchildren, or marital infidelity. Yet you caninsure against some of these events. For ex-ample, you can transfer the risk of an oilwell's unexpectedly drying up by selling thewell to someone else. You will get the pres-

ent value of oil that other people expect isthere. The new owner, not you, bears theloss if the well later dries up, and gets theprofit if it lasts longer than you expected.With salable private property, risks canreadily be transferred to the more willing,optimistic people who accept your offer ofsale. By renting some goods and owning oth-ers one can make wealth risk-bearing less de-pendent on consumption patterns.

In some countries, some farmers (calledejidos in Mexico) can sell the crop from theland but cannot sell the land or borrowagainst its value. (If they could borrowagainst it, they could then default on theloan, letting the lender take the land, thuscircumventing the ban on sale of the land.)They have only usufruct rights: rights towhat they grow on the land. Such restrictionsweaken incentives to improve or invest inthe farmland, because the resulting capitalvalues cannot be realized by those most opti-mistic or willing to bear them, the farmerswho invested in improving productivity ofthe land.

The bearing of risks could be assignedby the political system. Because a socialisteconomy is based on a political allocation ofrisk bearing, one of the issues debated be-tween proponents of private-property and so-cialist systems is the relative merits of theirrespective risk-distribution institutions. Acrucial element of ownership is bearing theuncertainty of the future value or productivi-ty of the resource that is owned. The owner,by definition, bears that risk. For govern-ment property no member of the public canavoid bearing that risk. Whatever your atti-tudes toward the risks of owning various re-sources, you can't sell your interest in, say,Yosemite National Park, the postal system,or the Tennessee Valley Authority. Shares inpublic or government property cannot betraded, except by geographic mobility (bymoving to another county, state, or country).You gain or lose as the tax laws and distribu-tion of government services decide.

In addition to insurable risk or thatwhich is selectively borne by choice of whatkind of goods to own, another source of vari-ations in the result of productive venture isthe difficulty of s;ontrolling actual perform-ance of the team or input members. Theymay be malingerers who cheat or shirk onthe promised activity, or they may honestlycontend they are providing more to thegroup than they are being given credit for. Inparticular, if it is difficult to correctly mea-sure each person's production so as to kn...owwhat was contributed to the group's result,some method of approximating that worker'sproductivity and of paying for it from theproceeds of the group must be found. But de-tection and control of shirking and detectionof actual productivity are difficult in manysituations. The group may then agree tohave a supervisor or monitor to observe theirbehavior and pay in accord with the observ-er's evaluation. This is a task different fromthat of deciding what should be producedand how it should be produced. We callthese latter tasks direction, leadership, or en-trepreneurship, especially if new venturesare involved. The tasks of entrepreneurship(leadership) and of monitoring the work ofseveral inputs is conducted in the enterprisecalled the business firm.

The CorporationBusiness firms commonly assume one ofthree forms of ownership: individual propri-etorship, partnership, or corporation. In theindividual proprietorship, the owner is re-sponsible for all debts of the firm, usually tothe full extent of the owner's wealth. That iscalled unlimited liability. Also, the firm ceas-es to exist at the death of its owner. A part-nership is joint ownership by two or morepeople. Each partner usually has unlimitedliability for the entire firm and can individ-ually make commitments binding the other

Business Firms 185

partners. The partnership terminates if anymember withdraws or dies. In the dominantcontractual form of the firm, the corpora-tion, several people jointly own its special-ized resources. They are called the stock-holders, because their ownership isevidenced by shares of common stock. Theirliability is limited to what is already invest-ed, and the firm continues to exist despitethe death of a stockholder or the sale of stockto new owners.

Almost 90% of commercial and industri-al sales are made by corporations; partner-ships and individual proprietorships accountfor the remainder. But in numbers of firms,the proportions are reversed: Of the approxi-mately 15 million business firms in the Unit-ed States, 12 million are individual propri-etorships (mostly in retailing, construction,real estate, insurance, wholesaling, and farm-ing), whereas about 1 million are partner-ships and 2 million are corporations (in man-ufacturing, wholesale and retail trade, andfinance). Typically proprietorships are smalland corporations much larger.

In the United States the market-generat-ed national income is about $3 trillion (about$13,000 per capita). Each of the 10 largestcorporations has from 100,000 to 600,000 em-ployees. The 100 largest industrial corpora-tions employ over 8 million people, or about10% of all employees. Each of the top 50corporations exceeds $1 billion in sales .annu-ally, with assets of about the same value.'Though business firms are I]1Uch larger than50 years ago, it is no harder to organize anew business, because people are wealthier.Thus, organizing a $500,000 capital fund fora new business venture would be no harderthan gathering $10,000 was 50 years ago.Each year for the past 50 years, new firms

'In 1980 Exxon had about $80 billion in sales. fol-lowed by American Telephone & Telegraph. GeneralElectric. Mobil. Ford. Standard Oil (California). Gulf.and International Business Machines.

186 Chapter 9

have been organized at a ratio of about onenew to ten existing firms. Half the new firmsare terminated in five to ten years because oflosses. The net earnings of successful corpo-rations equal about 5 to 6% of the U.S. na-tional income. The net earnings yield a re-turn, on average, of about 10 to 15% on thestockholders' invested capital and about 5¢per dollar of sales.

A few hundred large corporations pro-duce nearly half the value of final industrialoutput, and account for about 75% of nation-al income. This fact must be interpretedcarefully. For example, General Motors buyscomponents from thousands of smaller firms.When these parts are assembled into aChevrolet, should it be said that GeneralMotors produced the Chevrolet, or that,rather, it designed and assembled it? Thou-sands of firms were involved in designingand providing parts and equipment to thatgiant assembly line known as General Mo-tors. If we take into account only the finalassembler, we might say that General Mo-tors sells (produces?) 10070 of these Chevro-lets. If we take into account all its suppliers,then over one thousand firms produce thosecars. What, then, does General Motors con-tribute in that productive sequence? Does itdetermine prices, styles, quality, and employ-ment policies for other producers? Is thereless response to consumer demands than ifthere were scores of assembly firms in placeof one General Motors? Does General Mo-tors make wages, prices, or total output anydifferent from what they would be if therewere a hundred firms all responding to thesame market forces? We will investigate pos-sible answers to these questions in our lateranalysis.

TRANSFERABLE CONTINUITY

The distinctive characteristic that makes thecorporation a superior way of organizing eco-nomic production is its transferable continu-ity. The corporation is not terminated by a

change of owners. Furthermore, transfer ofshares by sale, gift, or legacy requires no per-mission of other owners, whereas in a part-nership, every change requires agreement ofall the partners. Shares of common stock inmany corporations are usually sold in a stockmarket, such as the New York Stock Ex-change, the American Stock Exchange, andseveral local exchanges. Shares of lesser-known corporations are sold by private nego-tiations, often through a geographically dis-persed but close-knit set of stockbrokersknown as the over-the-counter market.

That independent salability, which en-ables the venture to continue beyond the lifeor participation of any particular persons, hasan important consequence: The distant fu-ture effects that are expected to accrue fromcurrent acts can be more completely capital-ized in present market values of the salableshares of common stock. For this reason, cur-rent investment opportunities that will takea long time to payoff will be heeded, be-cause the current salability of rights in thosefuture effects enables current stockholders toimmediately reap the foreseeable benefitsthrough the changes in present capital value(price) of the shares of common stock-as ex-plained in Chapter 6. Managers would beless responsive to long-run effects if they didnot own salable rights to those effects orwere not responsible to people who ownthem.

SEPARATION OFOWNERSHIP FROM CONTROL,OR EFFICIENT SPECIALIZATIONIN OWNERSHIP RIGHTS?

Ownership of goods means the right to: (a)select uses of the goods; (b) transfer thoserights to a good to other people in exchangefor rights to other goods; and (c) bear thechanges in their usefulness or market values,whether caused by physical changes orchanges in market price.

The form that ownership in a corpora-

tion takes leads to a crucial question: To getthe maximum benefits of property rights,must all owners of goods exercise all theserights themselves, or is it sometimes more ef-ficient to use agents to exercise some ofthese rights? The latter course can indeed bemore efficient because people differ in theirtalents. We have already seen some of thebenefits of specialization. Yet the objectionmight be raised that the owner's and agent'sinterests would differ. In this particular case,even if interests differ, the benefits of spe-cialization in exercising ownership rights canexceed the costs of satisfactorily controllingthe agent's behavior. Therefore, delegatingthe components of private-property rights toone or more agents does not necessarily sepa-rate ownership from control or, as often al-leged, reduce corporate economic efficiency.Instead, it allows specialization in the exer-cise of the separable duties of ownership toyield superior economic results. For example,it is commonly argued that if a corporationhas thousands of stockholders no one ofwhom owns a majority of the stock, then themanagers and directors rather than the stock-holders control the corporation (whereas thestockholders bear the risk of changes in thevalue of its assets).' Directors are chosen bystockholders in one-vote-per-share, not one-vote-per-person, elections. Directors, then,are agents of stockholders and are authorizedto make contracts (that is, to authorize opera-tions) for the stockholders. Thus, it behoovesdirector-managers to act with appropriate at-tention to stockholders' interests.

Potential conflicts of interest betweenagent and owner occur within the corpora-

'Let us compare the numbers of stockholders andemployees (in parentheses) of several corporations as of1980: General Motors, J,350,000 stockholders (800,000employees); General Electric, 530,000 (400,000); Gen·eral Tire, 52,000 (40,000); General Foods, 97,000(48,000); General Mills, 29,000 (50,000); General Tele·phone, 500,000 (200,000).

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tion as they do in every group. The more dif-fused the stockholdings and the larger thecorporation, the higher is anyone stockhold-er's cost of policing the corporation's internalmanagement as thoroughly and 'effectively asin a small proprietorship. Though this prob-lem resembles that of the taxpayer whosecost of policing government employees is lu-dicrously higher than any potential gain,there is a difference. Unlike the taxpayer, theshareholder in a capitalist corporation has asalable share in the capitalized present valueof the foreseeable future consequences ofpresent actions. Shareholders therefore havemore cause to monitor corporate action. Fi-nally, any possible effects of dispersion ofownership would not necessarily imposelosses on stockholders, for they can discountthose anticipated effects into their lower ini-tial purchase price of the stock.

Still another potent force makes manag-ers responsive to stockholders' interests:competition among potential managers.Management is not a monolithic bloc ofshirkers protecting one another from discov-ery and penalty. Each has a personal interestthat puts him or her in competition with theothers-and not only others in his or herown corporation. Any manager who toleratesmanagement or employee behavior that im-pairs stockholders' interests sacrifices oppor-tunities to attract better offers from othercorporations. And such offers are a source ofrapid promotion. We advance by appealingnot only to our current employer's and cus-tomers' interests but also to the interests ofother potential employers. People have inter-est in excelling and in letting others know oftheir excellence. This holds for managers,too.

Competition disciplines stockholdersalso. If all the present stockholders are lax inmonitoring and exercising control, perform-ance will lag and the value of the stock willfall. The lower price will entice other peopleto buy a sufficiently strong block of the stock

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and remove the existing management. In thefinancial news, and sometimes in the generalnews, you can find evidence of such behav-ior: You will hear of "takeovers," offers byone corporation to exchange some of itsshares for those of the acquired-ormerged-corporation, in order to improvethe management in the acquired company. Ifthe performance of management improves, itwill result in a rise in the stock price, therebyrewarding all the stockholders. Present mem-bers of the management staff who can't earnas much elsewhere often do not approve ofraiders and seek to frustrate takeover at-tempts by persuading regulators and legisla-tors to enact regulations and laws prohibitingsuch offers or takeovers. (Some Securitiesand Exchange Commission rules make take-overs more difficult; to whose benefit weleave to your analysis.)

Government-operated firms, nonprofitfirms, and profit-limited enterprises (such assome public utilities which are not allowedto exceed some specified rate of profit) per-mit more departures from market-value disci-pline, because consumer market demands be-come less influential and the performance ofmanagers is not subject to being tested bythe value of corporate stock. Yet popular al-legations abound-although they are notborne out by economic analysis or evi-dence-that the large, for-profit corporationwith thousands or millions of stockholders isrun inefficiently, to the harm of the stock-holders, and is not responsive to consumers'valuations of the corporation's goods and ser-VIces.

FundamentalSourees of Profits

A successful firm is one that creates a valueof output that exceeds what the members be-lieve they could have earned elsewhere. Ithas a profit; but because success is copied,this is temporary. The rest of the world

catches on and competes for responsible butcurrently undervalued resources, therebybidding up the input prices (and hence costs)to more fully reflect their now more accu-rately foreseeable values. This converts theprofits into higher wages, rents, or purchaseprices of those inputs. The larger outputfrom more firms brings down prices of thefinal products. Can profits persist? The an-swer requires a deeper understanding of whyprofits occur and how they are reported.

As we have emphasized in earlier chap-ters, foresight is imperfect, and changes inmarket values are inevitable in all economicsystems. (A change from a capitalistic to acommunist, socialist, or feudal economic sys-tem will not prevent profit and losses; it willchange only the determination of who bearsthem, because certainly no earthly revolutionwill remove uncertainty.) Innovative activi-ties and extraneous events alike can have un-foreseen results. Because the effects of thosenew, unforeseen circumstances were, by defi-nition, not captured in the prior price, thevalues of the pertinent assets change (for hadthe results been foreseen, the price of re-sources would already have been at that newhigher or lower value).

If future prospects now appear, say, bet-ter than formerly anticipated, the price ofshares of stock in the corporation is bid up asoutsiders try to buy a share of those im-proved prospects. The price will be drivenup to whatever level makes the anticipatedreturns bear just the normal rate of intereston the new stock price. That higher pricegives to the existing stockholders the valueof that larger future stream of earnings (larg-er than other people formerly expected).

However, if that profitable innovativeaction was the result of some employee's su-periority-formerly unanticipated by poten-tial employers-in ability to make good deci-sions or investments, such superior abilitywill, once revealed, bring a higher salary tothe superior employee, and a smaller rise inprice of the firm's common stock.

PROFITS OF LABOR

Wages are the earnings for human services;rent is payment for services from inanimategoods. The long future flow of a person'swages has a present capital value (as ex-plained in Chapter 6). The present value ofyour long sequence of future wages may be$500,000. If you have an accident and suffer I

reduced prospective future receipts, the pres-ent value of your wages will fall, say, to$200,000, a loss of $300,000.

The capitalized value of nonhumanwealth is more clearly measurable becausemost inanimate goods can be bought andsold, whereas a person is not bought or sold.Typically only a person's current services aresold. If one could literally sell all future ser-vices now, one could capitalize and convert(or "cash in") any profit to other forms ofwealth. But because no person can, we bearthe risk of the future value of our labor ser-vices.

RICARDIANDIFFERENTIAL OF SUPERIOR ABILITY

In a sense, all profits-or values-are valuesof people rather than of inanimate goods.Goods and resources are valuable only be-cause of how people use them. People withsuperior talents know better than others howto use resources to make them more valu-able. Inputs of unequal abilities will general-ly draw unequal earnings. The earnings ofthe person of superior ability are called thedifferential earnings, or (as defined earlier)Ricardian rents, of superior talent. (The lat-ter term distinguishes such rents from mo-nopoly rents, which are enhanced earnings tosome sellers who have managed to preventother people from competing with them andbidding up the prices of inputs and loweringconsumers' prices.) For example, there is cer-tainly some large Ricardian rent in the high-er incomes of Frank Sinatra, Jack Nicklaus,

Business Firms 189

and Kareem Jabbar, to name only a few.How quickly and accurately is the supe-

rior ability of a person, asset, or enterpriserecognized and converted to a higher price,rent, or wage for its services? As quickly asthe most optimistic people are willing to bidup the price or wage or rent in their beliefthat the superior ability is really there andnot a one-time lucky experience. The abilityto distinguish between luck and true superiorability can be crucial to one's wealth. One ofthe authors made a hole-in-one the first timehe played golf. No one immediately offeredhim a professional contract; 30 years later hegot his second hole-in-one. An author whowrites one successful novel has no certaintyof writing another one as good. Such in-stances as holes-in-one and the one successfulnovel are examples of the regression phe-nomenon: the tendency of good luck to befollowed by, or regress to, normal luck(which does not mean bad luck). To fail toaccount for the phenomenon is to commit aregression fallacy. The market does not com-mit regression fallacies." People recognize

3An example of a regression phenomenon is thefollowing: Of 100 identical salespersons, some wouldhave more sales in one week by good luck and otherswould have fewer sales by bad luck. In the next weekthey would more likely have their usual luck and wouldmake a number of sales nearer their long-run average.That is, both the very lucky and the unlucky in thefirst week tend to regress toward their longer-run aver-age-because they cannot continue to have unusuallygood or bad luck. This tendency t9' regress toward thelong-run average after unusually good or bad luck iscalled the regression phenomenon. It assumes that thedifferences in performance in the first week were atleast partly affected by transient luck.

One of the notorious ways of taking advantage ofthis is to invite people to take some performance test-say, a reading test-and to tell those who score belowaverage to take lessons in reading improvement. Afterthe lessons their test performance will on average im-prove because their performance on the first test wasdue partly to unusually bad luck. Their performance onaverage would have improved whether or not they tookreading improvement lessons.

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that great success is often accidental, and donot see every instance of success as promis-ing equal future success. On the contrary,later performance will probably regresstoward true ability. In the interim, a truly su-perior resource, be it a person or a nonhu-man asset, will be temporarily undervaluedbut ultimately will rise in value. Anyone whoknows which resources are currently under-valued can make a fortune hiring or buyingthem at the current undervalued marketpnces.

As an example, if General Motors hires asuperior designer, the increased value of thecars at first shows up as a profit to GM. ButGM cannot continue to purchase the design-er's superior services at less than they are re-vealed to be worth, unless all other potentialemployers remain ignorant of the designer'sability-and the designer will not let thathappen. As other employers bid for the de-signer's work, they drive up his or her wageuntil it matches the high value of the superi-or ability. Thus are the costs of that design-er's services raised to all who thereafter buythem.

Barriers toEntry or Filters?

The difficulty that other firms have in tryingto copy a first firm's success is often attribut-ed to "barriers to entry." The term suggeststhat the first firm is somehow unfairly re-straining other firms from entering the mar-ket, but this need not be so. Features of theopen market itself make the entry of otherfirms more difficult. First, because everyoneelse knows about the first firm's success, thecosts of buying the resources or hiring thepeople have been bid up; instead of profits,only normal rates of return can be expectedby new firms.

A second feature of the market is thatreliable prepurchase information about agood is not costless to create and transmit,

and customers cannot detect the quality of anew supplier's goods costlessly prior to pur-chase. Hence consumers sensibly and eco-nomically use past experience to predict fu-ture performance. Doing so is cheaper thantreating every new seller equally, for thoughsome may be better, some will surely beworse. Consumer knowledge of the quality ofgoods from existing suppliers is a useful, de-sirable "barrier" to new, untried candidates.If experience were of no predictive valuewhatsoever, then no "barrier," or, to put itmore accurately, no filter device, would beavailable. Life would be more costly for con-sumers. A filter is a barrier to inferior alter-natives and protects consumers from thehigher costs of continual trial and error. It is,then, not a cost-increasing barrier. It wouldpay to eliminate it only on the premise thatevery new supplier were probably as good aspresent sellers. And that premise is false.

Imagine that General Motors were to se-cretly produce some cars for me that wereexactly like their own but had my name onthem. The public would not know the carswere really the same GM product. Howmany cars would I sell? At what price? Withwhat confidence for consumers? Known, con-sistent, proven performance at some level ofquality-not necessarily at the highest levelbut at a predictable level-is what influencesconsumers. For example, the names Trave-Lodge and Intercontinental are equally reli-able predictors, or filters, one of a mediumquality and price and the other of a higherquality and price. Both names are valuable toconsumers as cheap identifiers of reliable.suppliers.

The information value of a brand nameor trademark reflects the past reliable ser-vices and products supplied under the nameor trademark. The investment in creatingthat reliability is what the firm is getting areturn on, a return on investment in what iscalled an intangible (because, unlike goodsand machinery and the like, it literally can-not be touched or seen). But it is an intangi-

ble that, like knowledge, is valuable. WhenStandard Oil, New Jersey, changed its publictrade name to Exxon from Esso (to avoid le-gal conflict with other Standard Oil compa-nies), and when Datsun changed its name inthe United States Io Nissan, they took greatpains to make clear that the new name wasmerely replacing the former name, and wasnot the name of some new company. Tohave used the new names without indicatingwhich companies they represented wouldhave failed to transfer to them the consum-er's valuation of the Esso and Datsun namesas predictors of a quality of service.

The value of a firm's name is oftencalled goodwill. Although goodwill is hardlyever fully entered in accounting records, it isrevealed in the market value of the commonstock of the corporation. If one could sub-tract the sale value of all the other assets ofthe corporation, the remainder would begoodwill.

Another feature of the market that en-courages would-be entrants to see barriers toentry is that large initial investments mustbe made in capital equipment. These largeinvestments are often necessary for low-costproduction. If customers were willing to payhigher prices to newcomers who have highercosts of production per unit because theyhaven't made large initial investments thatenable much lower operating costs, newcom-ers could enter with less risk. But the "barri-er" is the customers' current preference forlower-cost suppliers of proven reliability whomade a high initial investment successfully.If a newcomer could be sure of success in at-tracting customers, the initial investmentswould not restrict entry at all. But of coursenew entrants cannot be sure of success.Thus, it is the customers' knowledge of pres-ent suppliers and unwillingness to promise tobuy from unproven newcomers that is the"barrier." It is often claimed that the largeinitial investment is a "barrier" that allowsexisting firms to make larger profits than if

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the initial investment were smaller. This is amisunderstanding.

To better see why, we must separatetwo kinds of entry investment activities. Oneis the cost of expensive long-lived equipmentthat mayor may not later be salable if thebusiness is not a success; the other is the trialcost, the cost of trying to create a successfulfirm: the cost of searching, testing, and judg-ing, and trying to assemble the appropriateteam of inputs in that firm. The trial cost(which is not part of the later costs of operat-ing a proven successful firm) can be veryhigh and is not recovered if the search andassembly does not result in a successful firm.

A large trial cost and a large investmentcost in equipment can separately or togetherdeter entry. Because the cost of a trial islarge, the successful new firm is expected toearn enough to have induced people to makethose trials with uncertain outcomes: To bein equilibrium it must be earning a return inexcess of depreciation, wages, and other con-tinuing costs. That "expected excess" is the"premium" that covers the expected costs offailed searches.

If you must pay $1.00 to make a trial, allof which you lose if the trial is unsuccessful,then how much must you expect to receiveon the successful trials if you are to breakeven? If half the trials are unsuccessful, thenyou must get back $2.00 on each success.Clearly, if the trial cost of entry into somebusiness is high, successes must pay morethan the operating costs if entry is to be in-duced, though the successes receive whatseem to be extra-large profits.

And so it is in various industries. Thosewith a larger forfeitable initial investment,whether in trial costs or in equipment withlittle salvage value elsewhere, show greaterrates of profits for the successful firms thanin industries where initial forfeitable invest-ments are small. The larger profits of thesuccessful firms encourage those discouragedby the large forfeitable investment costs to

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believe that the successful firms are earningso much because they have somehow thrownup barriers to subsequent entry. But this mis-reads the situation: The high investmentcosts do not enable larger profits for the suc-cessful firms; rather, the larger profit pros-pect for successes must be present to offsetthe higher initial trial and investment coststhat would be lost by unsuccessful entrants.

Because of interdependencies among theappropriate team members, the value of allthe inputs as a team can exceed the sum ofthe values each member would have withsome other employer. Since a firm has to payin wages and rents to each team memberonly what each person or piece of equipmentcould have earned elsewhere, it follows thatif the group as a team is superior, then theteam-the firm-is worth more than the sal-aries and rents of all the member inputs. Thesuccessful "firm" is worth more than the sumof the separate input values.

An example of the implications of thedifficulty of assembling a well-coordinatedteam of inputs is provided by the fact thatsome established business firms that want toget into another line of business will buyouta firm already successfully operating in thatline of business. Why didn't the firm seekingentry hire away the pertinent workers andbuy similar equipment? It is difficult to knowexactly which of the inputs form the criticalgroup in that production team. So the newentrant might buy the whole firm, therebyacquiring a team already successfully assem-bled without going through the more expen-sive process of trial and error in assembling anew team itself.

Business ProfitsThe excess of the value of the firm over thecosts paid to its separate members might becalled profits. But as we have seen, the term"profit" can mean many different things.You may recall that by profit an economist

means an increase in wealth above that ac-counted for by savings of the interest (in-come) of one's wealth. That interpretationwas explained in Chapter 6. But the term isused more loosely to mean other things aswell. Each year business firms report theirprofits. According to our rigorous definitiongiven above, that should be the change inthe firm's stock values over the interval inexcess of interest on the value of the stock.But the firm might report a profit during ayear in which the price of the stock fell.

'~ Then the stockholders have had a loss. Thestock price fell because during the year fu-ture prospects became bleaker. If you recallthe meaning of an annuity given in Chapter6, it is possible for the first term in the annu-ity to be a positive amount, but for the termsto unexpectedly become smaller so that thepresent value of that sequence drops. That iswhy a firm can be earning income this year,but enough less than expected so that itsstock price falls. Was there a profit? It all de-pends on what you want to mean by thatterm. If profit is to be used to measure achange in one's wealth, there has been a loss.

ACCOUNTING DATA

We now consider how difficult it is to com-pute earnings from accounting data as re-ported by some business firms. Financial ac-counting data provide a record of theamounts of money spent or committed to fu-ture payment, and the goods and services ob-tained in exchange. All past expendituresand receipts are included in the accounts,but only some of the future commitments forexpenditure and foreseeable future receiptsare included. Prospects of receipts are ex-cluded, with very good reason, as illustratedby the following scenario.

With $31,000 I buy land and oil drillingequipment ($10,000) and pay wages ($21 ,000)to myself and the drill workers. In a year Istrike oil. What should my accountant do?Record an estimate of the present value of

the unknown amount of un captured and un-sold oil? If I could now get $100,000 on themarket for the land and oil rights, thenwhether or not I sell, my wealth has in-creased to $100,000. plus any resale value ofthe drilling equipment (say it has depreciatedto $6000, down $4000 from its initial price of$10,000). There was $31,000 invested initial-ly, so with a 10% interest rate, interest costswould be $3100 (.10 x $31,000). My wealth is$106,000 ($6000 in equipment + $100,000 inthe market value of the land and oil rights],Because I have no liabilities, my wealth gain(my profit) is $71,900 (= $100,000 value dis-covered - $21 ,000 wages - $4000 deprecia-tion - $3100 interest).

However, the accounting records willshow a negative income or loss of $41,000during the year! We used up $4000 of oil-well equipment and $36,000 for all wagesand $1000 for interest, but we have sold nooil. The accountant is unwilling to record avalue of the prospective future oil sales, be-cause the oil has not yet been sold at a defi-nite price. If the oil is to be valued, account-ing custom dictates that it should be valuedat the cost ($41,000) of finding it, which iscalled its book value. If we didn't understandthe custom, we might think the $41,000 rep-resented the market value of the oil field, butthe usual accounting convention is to notrecord any value over costs (or at most onlyup to a formal, or nominal, $1) until there isa sale and receipt. Also, a zero (or $1) valua-tion is adopted if the asset is not a physical,tangible thing but is instead an idea, design,patent, new product, trademark, reputation,"quality assurance," or personality.

For example, the value of the name "Ko-dak" was established by a consistently reli-able product; the name identifies a productof reliability. How should that expensivelycreated, fragile, valuable reputation, thename "Kodak," be valued? At the advertisingcost? At the cost of having created reliableproducts? At zero? Or at an estimate of its

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assurance value to future customers? Con-vention prefers the zero or $1 value-falsethough that value certainly is. Regardless ofaccounting convention, we know that theprospect of future sales is part of the value ofa firm. Ford has no contract with future cus-tomers for sales of Ford cars next year. Nordoes any firm have such a contract with thepublic for its product. Nevertheless, peoplebelieve that Ford will have sales next year,and they back that belief by buying commonstock in that corporation. They pay for, orbet on, the prospect of successful future op-erations. In fact, the market price of almostevery good is a present bet about future pros-pects.

What about my labor services in the oilventure? These should be counted. Say theywould amount to $30,000 per year if Iworked full time on the oil venture. Theseimplicit costs total $30,000. I worked onlyhalf time on the oil venture, so my laborcosts are $15,000. Total wages are $41,000.After all that, if I still have achieved a sur-plus of product value, I have a profit. Thatsurplus occurred because I was able to pro-duce more than the market (that is, everyoneelse) expected I could produce with those re-sources. It is a pure profit: something themarket did not expect to occur, for if it had,others would have kept me from buyingthose services so cheaply by bidding up theirprice.

When you read that some enterprise has"net earnings" or "income': or "profits" ofsome amount or percentage,' you must inves-tigate in each case how they counted thecosts of interest on their investment andtheir implicit wages. Usually, the reportednet earnings are the net before that implicitinterest on the investment is deducted-andsometimes even before the owner's implicitwages.

If you examine the annual reports ofbusiness firms, you will find assertions like:"We have started production on a very

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promISIng new product. We are currentlyoperating at a loss, but we expect in a year tobe covering costs and making profits." If thatstatement were taken literally, one wouldwonder why they hadn't waited until nextyear to start operations. Translated into ourterms of economic analysis it means: "At thepresent time the current rate of sales is lessthan current investment and expenditures;but the present investment expenditures onmaterials and equipment and training willbrir.g larger future receipts that will exceedfuture outlays. We believe the new productwill promise a net flow of future receipts thatwill increase our wealth. In fact, the invest-ing public is now of the same opinion, andthat is why the market value of our shares ofcommon stock has increased during the cur-rent year. So we really had a profit. Hooray!"

Misdefinitions of Profits

DIFFERENCE BETWEENWHOLESALE AND RETAIL PRICE

Sometimes the difference between the pricethat a retailer pays for goods and the sellingprice is called profit. More normally, that dif-ference is called markup, to indicate howmuch above the wholesale purchase price theselling price must be to cover all the retail-er's many costs, such as for space, shelter,management, sales clerks, inventory for dis-play and immediate delivery, record keeping,security, insurance, advertising, taxes, light,heat, fixtures, breakage, pilferage, packaging,returns, employee training, and many othercostly activities. Yet some people say thatthe sale of a good at a markup of 100% (ofthe wholesale purchase price, or 50% of theretail price) represents a profit of 100%.Even Congressional reports have said so.Sometimes the owners even fail to include incosts an estimate of their own labor services,so that what may appear as "profits" is mere-ly wages for personal labor.

f?'ROFITS BEFORE TAXES

Another error in computing profits by sub-tracting costs from earnings is to count all

:!~!,costs except taxes, thus calculating "profitself,before taxes." Remarkably, a government

agency has used this concept, apparently un-0" aware of its implications. It suggests that tax-

es are not really a part of costs-that they are,payments for no service. It is difficult to be-

:~. Iieve that the government agency wouldwant to suggest that taxes are merely tribute

collected from profits. One would hardly bemore surprised if a labor union published agraph of "profits before wages" as if wageswere not costs.

. Measuring profits or earnings as a per-o cent of a firm's sales is very misleading for,two reasons. First, a person who invests $1 toproduce some product in one day and sells itfor $1.01 (a rate of 170 on sales), and thenrepea ts the action every day for a year, will

- have had sales of $368.65 in the year with netearnings of one cent each day, or $3.65throughout the year. That sum is 1c;ro of salesper year, but it is a very large return of 36570per year on the initial $1 investment. Second,a very small margin of earnings on sales willnot necessarily be wiped out by a slight risein costs, for the price may also rise, depend-ing upon general supply and demand condi-tions such as we have already analyzed.Some businesspersons use the small size oftheir margins of earnings on sales to indicatethat they are not earning "excessive profits."Whatever the facts, "excessive profits" issimply a pejorative term suggesting thatprofits are larger than someone thinks theyshould be.

Summary1. A capitalistic firm is a group of resource

owners bound by contracts wherein: (a) theinputs cooperate in joint, or team, produc-tion; (b) one central party has contracts withthe owners of the other joint inputs; (c) the

central party owns the inputs whose valuesdepend most specifically on the group's per-formance; (d) the central party holds the re-sidual claim beyond obligations specified inadvance; (e) the central party can sell its po-sition; and (f) the central party directs thechoice of productive activity of the team.

2. The person called the firm's owner predictsfor the owners of jointly used inputs the bestuse values of their services to consumers.

3. The corporation is like a partnership in thatit can be an association with several joint-owners. But it is unlike a partnership in thatany member of it can sell his or her shares toanyone else without prior approval of exist-ing shareholders and the corporation cancontinue, whereas a partnership is terminat-ed if any member leaves.

4. Directing and controlling effective team-work require effective monitoring and revi-sion of contracts and duties. Joint ownershipof resources that are specialized to one an-other reduces opportunistic behavior.

5. Teamwork is monitored by agents of ownersof the resources most specific to the activi-ties of the team.

6. Specialization of activity in directing andmonitoring activities and in risk bearing isoften misleadingly called separation of own-ership from control, whereas it is specializa-tion in the exercise of ownership rights.

7. Because common stocks readily reveal Intheir price the present capital value of thecorporation, the corporation's current deci-sions and operations tend to be made in thelight of their foreseeable consequences.

8. Stock markets help capital value effects tobe detected or revealed, thereby enhancingthe usefulness of the corporate form in con-trolling resources and production.

9. Bearing the uncertain consequences of anyaction is called risk bearing.

10. Though many future events are completelyuncontrollable, the consequences of such

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events are not. Hence a distinction betweenunavoidable risk and avoidable risk is of du-bious use,

II. Insurance distributes risk among a class ofpeople, each accepting a definite cost in or-der to compensate those who would suffer alarge loss if the uncertain event occurredand they were not so protected.

12. Ownership of private-property rights has anessential feature: risk bearing. Risks fromsome specified events can be shared throughinsurance, but any unspecified, uninsuredrisks are by definition borne by the owner.

13. Imperfect foresight into the future value ofany productive resource will result in lossesor profits to that input as the future is re-vealed. This is true for labor, capital goods,and owners of a business organization. Usu-ally the gains or losses to individuals fromtheir labor services are called simplychanges in wages, even though thosechanges are profits and losses.

14. Innovative activity may result in greaterprofits or losses. Therefore, some profits orlosses occur because of superior or lucky (orinferior or unlucky) innovative activity. Dis-tinguishing superior ability from luck is notalways possible. As superior skills are dis-cerned, superior inputs will obtain highercontractual incomes and less in the form ofresidual profits.

15. Competition among firms for resources pro-ducing output of a value in excess of what isbeing paid them will bid up their prices tomatch the value of their product.

16. When the future is more clearly perceivedto promise more valuable consequences thanwere formerly anticipated, the present valueof the relevant capital assets is driven up bycompetition to acquire them. That increasecapitalizes the future profit stream intohigher present values and yields the newbuyers at the higher prices just the normalpredictable rate of return.

17. The source of superiority of successful firms

196 Chapter 9

if often misleadingly called a barrier to entryby inferior actual or potential competitors.

18. Accountants keep records of past expendi-tures and revenues. Attempts to deduceprofits from accounting records can be verymisleading, because they record historicalvalues, not present market values of existingresources.

19. Monopoly rents, increases in income ob-tained by restricting competitors, are oftenalso called profits, misleadingly.

Questions1. A friend of yours, a brilliant engineer and ad-

ministrator, is operating a business. You proposeto bet on its success and offer your friend somemoney to expand its operations. A corporation isformed allotting you 40% and your friend 60%of the common stock. You invest $30,000. This isoften described as separation of ownership fromcontrol, because you don't have the majorityvote. Would you ever be willing to invest wealthin such a fashion-that is, give up control whileretaining ownership of 40% of the value of thisbusiness? Why?

2. Is it a disadvantage of the corporation thatnot every stockholder can make the controllingdecisions? That the control is dispersed? Thatsome people who own less than half of the corpo-ration can make controlling decisions?

3. A criticism of the modern corporation is thatthe management or directors, by virtue of theircentral position, are able to collect proxies (rightsto cast votes of stockholders) from the otherstockholders, and as a result the management isin a powerful position and cannot be easily dis-lodged. It has been said that "the typical smallstockholder can do nothing about changing man-agement and that under ordinary circumstancesmanagement can count on remaining in office;and often the proxy battle is fought to determinewhich minority group shall control." Take theassertions as being correct.

a. Does it follow that stability of manage-ment in "ordinary circumstances" harmsstockholders?

b. Does it follow that a typical small stock-holder "should" be able to turn out man-agement?

c. If a minority group succeeds in swingingvoting decisions, does this mean that aminority controls or that a majority con-trols through the leadership of a minoritygroup? Is this to be interpreted in thesame way that political parties consistingof a group of organized politicians haveelections to see which minority groupshall control the government? Why orwhy not?

4. "Very few corporations lose wealth, and stillfewer go broke." Do you agree? What evidencecan you cite?

5. a. In analyzing the behavior of corporationmanagement and directors, why is it per-tinent to distinguish between nonprofitor publicly regulated, limited-profit cor-porations on the one hand, and privatefor-profit business corporations on theother?

b. Which do you think would be moremarked by self-perpetuating manage-ment and stockholder lethargy? Why?

*c. Which do you think would show morediscrimination in employment practicesaccording to race and religion? Why?

6. Joseph Thagworthy has a stable of racehorses and a breeding farm. The two, althoughoperated as a business, lose him over $50,000 an-nually. Yet he continues year after year becausehe enjoys the activity more than if he spent asimilar sum for travel or conventional types ofconsumption activities.

a. Would it be correct to say that he ismaximizing his wealth in that business?

b. Do you think an increase in the losseswould induce an increase in that kind ofactivity? What does economic theorypostulate about that?

7. An engineer devises a way to make a newproduct that is very much in demand. The pro-cess requires the engineer's continued attentionalong with a lot of machinery useful only in thisprocess. If a business firm is started to use thatengineer's process, who will own the firm-theengineer or an investor who hires the engineer?

Why? If the firm uses the services of a secretaryand a security guard, are they as likely to beowners of the firm as is the engineer? Why?

8. A young college teacher hits upon a spar-kling teaching style.-and is rewarded with a high-er salary. Has she had a profit? Explain.

9. "Under a socialist system, profits and lossesare eliminated." Comment.

10. "Paper profits and losses are not real profitsand losses." Do you agree? If so, why? If not, whynot?

11. The process whereby secret information- isrevealed by the stock market is exemplified bythe following episode: On March 7, 1954, theNew York Times reported a test in which a newbomb of enormous force had been exploded onMarch 1, 1954. On March 31, 1954, Atomic En-ergy Commissioner Strauss reported publicly forthe first time the nature of the new bomb and itsdependence on lithium. Weeks prior to his an-nouncement, the price of the stock of LithiumCorporation of America, one of the producers oflithium, increased substantially. How is this risein price consistent with the fact that everyoneconnected with the corporation and the test real-ly kept the secret?

12. General Electric and Xerox each sold theircomputer subsidiaries to Minneapolis Honeywellbecause the subsidiaries were unable to avoidlosses. Why would anyone pay for a businessthat is losing money? It should have a negativevalue. One would think that General Electricand Xerox would have to pay someone to take ona business that is losing money. Explain the be-havior of these firms. Can you find some expla-nation that doesn't make the buyers foolish com-panies? If your explanation makes the buyerslook sensible, is it consistent with General Elec-tric and Xerox selling their computer divisionsrather than continuing with them?

13. "Capitalism encourages deceitful advertis-ing, dishonesty, and faithlessness." Do you agree?If so, why? If not, why not?

14. Suppose it were true that rich people gotrich exclusively from profits. Suppose furtherthat those who received the profits were nosmarter, no more foresighted, no nicer, no harder

Business Firms 197

working, no more productive than other people.Does this mean that their profits are "unde-served" and that the rich people performed noservice?

15. Taxes are often levied on corporations.What in fact is being taxed?

16. "Big profits are made by successful firms inlarge capital investment industries. This showsthat large capital investments restrict entry andpermit firms already in business to make largerprofits because of the high costs of entry." Trueor false?

* 17. Our laws and customs reflect the assign-ments of risk bearing. A person who owns landas private property must bear the consequencesof changes in the value of that land if peoplemove away or no longer value that location sohighly. Similarly, if he catches cold or breaks hisleg or becomes hard of hearing and can no longerearn so large an income, he must bear the conse-quences.

a. Would you advocate that people bear thewealth losses to their private property re-

gardless of cause (aside from legal re-course to violators of property rights)?

b. Would you want a homeowner to bearthe consequences of a meteorite's fallingon his house? Fire from using gasoline inthe house? Flood damage to houses nearrivers? Income loss from cancer? Blind-ness?

c. Who do you think should bear the loss ifthe individual does not?

d. Why would you draw the line differentlyin different cases? What is the criterionyou used?

e. In each case, do you think people's behav-ior would be affected according to therisk bearing involved?

f. Would you allow people to agree to takeon certain risks in exchange for not bear-ing other risks, if two people could makea mutually agreeable partition and ex-change of such risks? How would that dif-fer from a system of private-propertyrights?

For Further Study: Interpreting Financial Statements

Business firms periodically (commonly everythree or six months and annually) issue finan-cial reports of their activities and current sta-tus. Reproduced below is a slightly simpli-fied balance sheet reported for the UnitedMining Corporation for March 31, 1982. Abalance sheet presents a listing and cost valu-ation of a company's assets, liabilities, andownership structure. Assets are the resourcesowned by the corporation. There are alwaysclaims held by other people against a busi-ness; these claims are called liabilities. Thenet value of these assets-that is, the valueafter liabilities are subtracted-is called equi-ty or net worth.

The basic definition is:

Assets - Liabilities = Equity,

198 Chapter 9

which can be rewritten:

Assets = Liabilities + Equity.

The firm's balance sheet presents items clas-sified as assets on the left side and liabilitiesand equity on the right side. What do thelisted items mean?

ASSETS

Assets are divided into several categories andare grouped separately as either 'current orlong term. Current assets are made up of:

Cash. The amount of money held, in-cluding checking accounts.

Accounts receivable. These are the pastsales yet to be paid for by customers; chargeaccounts or credit extended to customers al-lowing them, usually, 30 days to pay.

Reserve for bad debts. Very likely somecustomers will fail to pay their debts. To ex-press this fact and to estimate the expectedamount of receivables that will become"bad," the accountants subtract an amountcalled a "reserve for bad debts" or "doubtfulaccounts." This is called a "reserve" becauseit expresses a "reservation" or "qualification"about the value of the receivables. Reservesin accounting statements do not representcollections of money or assets that have beenreserved in the sense of being set aside. Inbookkeeping, the word reserve almost neverdenotes a setting aside of cash or actual re-serving of assets. It is almost always used toexpress explicitly a reservation or adjustmentin the stated value of some asset or liability.

Unbilled costs. The corporation is mak-ing some products to custom order; and, asgradually completed, the corporation recordsthe incurred costs as claims accruing againstthe customer, for which a bill will be submit-ted upon completion and delivery to the cus-tomer.

Inventories. The corporation refinesores. This is the value of ore removed fromits mines and not yet sold, plus any other un-sold products. In general, this records valuesof products or raw, materials on hand.

Prepaid expenses. The corporation haspaid in advance for some goods and servicesyet to be obtained-just as when you prepaya magazine subscription, you would recordthat asset as a prepaid expense in your per-sonal balance sheet.

Marketable securities. These are typical-ly U.S. government bonds or notes payablein the near future, common stocks of othercompanies, or bonds of other companies. Inall cases, these securities are saleable onbond or stock exchanges.

Long-term assets are made up of the fol-lowing:

Investments. This corporation ownssome stock of another company. Usually, theparticular investment is identified in foot-notes that accompany the balance sheet.

Plant and equipment. This is the origi-

United Mining CorporationBalance Sheet, March 31, 1982

(in Thousands of Dollars)

Assets

CurrentCashAccounts receivableReserve for bad debtsUnbilled costsInventoriesPrepaid expensesMarketable securities

Current assets

$1,9294,669-600

13,3357,515

7565,577

33,181

Long TermInvestmentsGovernment contractsPlant and equipmentLess reserve for depreciationOtherGoodwill

Long-term assetsTotal assets

9,33418,24469,877-7,000

538100

91,093124,274

Liabilities

CurrentAccounts payableNotes payableAccrued liabilities,

future productionCurrent liabilities

$11,9232,358

10,20024,481

Long TermLong-term debtMinority interest

Long-term Liabilities

48,6233,974

52,597

EquityPreferred, convertible stock,

10,000 shares (5%, $100)Common stock (20<1:par)

5,175,000 issuedCapital surplusRetained earnings

1,000

1,03528,65818,53847,196

124,274Liability + Equity

Business Firms 199

nal amount paid for the physical property-mines, mills, smelters, and the like-of thecorporation. Sometimes this is the cost of re-placing it, especially if there have been dras-tic changes in costs of this equipment sincepurchase.

Reserve for depreciation. The property,plant, and equipment have been used andpartly worn out. An estimate of the portionof the plant so consumed is called deprecia-tion or reserve for depreciation. Subtractingdepreciation from the initial price gives the"book" value of equipment. (See above: Re-serve for bad debts.)

Other assets. These can be almost anykind of asset-mines, land, buildings, claimsagainst others, and the like. Usually footnotesto the balance sheet will give clues.

Goodwill. Patents and trademarks are of-ten given some small or token estimate ofvalue and called goodwill. Sometimes thecontinued success of a company is reflectedin certain intangibles, for example, its great-er income, because it is known to supplygood, reliable products.

LIABILITIES

Liabilities are conventionally categorizedinto current and long-term liabilities, withthe former usually representing claims thatmust be paid within a year.

Accounts payable. The corporation haspurchased goods and equipment for which itmust yet pay. The amount still due is recorded.

Notes payable. The corporation has bor-rowed, and the amount due is shown. Thisitem may also include any long-term debtthat will fall due within a year.

Accrued liabilities. At the present mo-ment (the end of the month), the corporationhas accrued obligations to pay taxes orwages. For example, if wages are paid on thefifteenth of the month, then at the end of themonth it will owe about half a month'swages, to be paid in two weeks.

<

Long-term debt. The corporation has is-sued bonds to borrow money. In the presentinstance, these will run until about 1995.Bonds are the paper record of indebtednessof the firm to the bondholders.

Minority interest. The corporation is theprimary owner of a subsidiary company, theentire value of which has been recordedamong the assets. However, because this cor-poration is not the sole owner, it has record-ed here the ownership rights of the otherowners. This recorded minority interest off-sets part of the value shown on the asset side.Usually every balance sheet has footnotesgiving further details. A footnote in this re-port would tell us that the subsidiary compa-ny, which has a recorded value of about$14,700,000, is all included in this corpora-tion's reported property, plant, and equip-ment ($69,877,000) on the asset side.$3,974,000 of that belongs to other people-the subsidiary company's other owners, theminority interest ..

EQUITY OR OWNERSHIP

Many firms include many different items un-der Equity.

Preferred, convertible stock. Preferredstock is a term for what is simply a debt ofthe company, probably issued by the firm toborrow investment funds. It is called pre-ferred stock because its holders, in the eventof bankruptcy, have a preferred claim againstthe company, prior to that of the commonstock holders. This might have been calledbonds of $100 denominations paying 5% peryear-except that preferred. stock often dif-fers from a bend in that if the $5 "interest"or "dividend" on the stock is not paid, itsholder cannot institute legal foreclosure pro-ceedings against the company. The holdersimply has preference to the earnings, if any,for payment of interest before any dividendscan be paid to the common stock holders.Sometimes the preferred stock is "cumula-tive," which means that if any arrears of un-

paid dividends accumulate, the commonstock holders cannot take any dividends untilthey are paid. And, as here, the preferredstock may be convertible: The preferredstock holder has the option to exchange (con-vert) it into common stock at a preset ex-change rate. In the present instance, the ex-change rate is 10 common for one preferredstock (information usually given in a footnoteto the balance sheet). Thus the present pre-ferred convertible stock has a par of $100with 5%; it pays $5 preferred dividends eachyear ( if earned) and may be converted to 10shares of common stock.

A person who buys a share of preferred,convertible stock for $100 has some hopethat the common stock will rise above $10 ashare; converting to 10 shares will then givethe holder more than $100. As the price of acommon share approaches $10 in the stockmarket, the selling price of preferred con-vertible stock will rise above $100, reflectingboth the current value of the preferred "divi-dends" due and the present values of furtherfuture possible rises in the common stockprice. A purchaser of convertible preferredcommon stock is in fact a partial commonstock holder or owner. A purchaser of non-convertible preferred stock is simply a credi-tor of the company.

Finally, some preferred stocks (andbonds) are "callable"; that is, the companyhas the option to pay them off prior to theirdue date. A $100 callable preferred stock willusually be callable at some price slightlyabove $100, but the premium diminishes asthe due date approaches. The owner of acallable, convertible, cumulative, preferredstock (of $100 par value, at 5%, convertibleat $10, and callable at $105 within five years)will collect $5 a year in dividends, if earned;$105 may be offered for the stock, which theholder must take or convert to common stock(10 shares because at $10 per share they willequal the $100 par value of the convertiblepreferred share). As you can see, all sorts ofterms are possible in a "preferred stock."

The remaining three items show theequity, the ownership rights of the stock-holders, which usually is expressed in threeparts: common steel, additional paid-in capi-tal, and retained earnings (sometimes the lasttwo are combined and called simply capitalsurplus). We already know that equity, bydefinition, equals the difference between as-sets and liabilities (including preferred stockas a liability). In the present instance, if wesubtract the liabilities (current plus long term)from the assets ($124,274,000 - $77,078,000)'we get $47,196,000, which is the book value ofthe common stock holders' equity. How was itattained? Initially, when the stock was issued,$29,693,000 (= $28,658,000 + $1,035,000) waspaid into the company. The figure recordedfor legal and tax purposes is $1,035,000 as theinitial par value and $28,658,000 as the addi-tional amount paid originally for that stock.This division is of no economic significanceand reflects some technically legal quirks. Wemention it here to avoid any impression thatthe par value reflects some currently relevanteconomic value.

What happened to that $29,693,000? Itwas invested and spent (along with proceedsof loans) for property, wages, equipment, andthe like, and at the moment the results ofthat activity are shown as assets on one sideand as incurred obligations on the other.

Retained earnings. The corporation hasinvested $18,538,000 of its earnings to pur-chase new equipment and facilities. It mayalso have paid out some of the earnings asdividends to common stock holders, but wecan't tell from the balance sheet data. If ithad losses, they will reduce this figure.

Such is what the balance sheet record ofthis corporation indicates. If we divide therecorded book value of the ownership,$47,196,000 (= $1,035,000 + $28,658,000 +18,538,000), by the 5,175,000 shares outstand-ing, it comes to about $9.12 a share.

It is tempting to conclude that a share ofcommon stock is worth about $10; but don't

Business Firms 201

fI,

United Mining CorporationIncome Statement, Year Ended March 31, 1982

$83,261,000SalesCosts and Expenses

Costs of goods sold (labor, materials, power)Depreciation of equipment and depletion of areSelling and administrativeInterest on debt

Operating net incomeShare belonging to minority interestFederal Income Tax

Net earningsEarnings per share

yield to that temptation, or else you are re-jecting everything you have learned in thisbook. Why? Because the figures in the bal-ance sheet's asset column are the historicaloutlays for the equipment (adjusted for de-preciation). They do not tell us what thecompany will do in the future. How do weknow that the mine-which cost, say,$1,000,000 to find and develop-is not goingto yield $100,000,000 in receipts, or maybenothing?

None of this is revealed by the balance-sheet asset records-unless the corporationdirectors decide to make a prognosis of thatfuture receipt stream, discount it into a pres-ent value, and record it under "goodwill" or"profits." But they don't do this, simply be-cause they know how unreliable that is. In-stead, they issue a report of operations andevents along with their balance sheets. Forexample, this corporation .once reported:"The outlook for widespread civilian andmilitary use of uranium improved greatlyduring the past year. The capability of theindustry in the free-world countries, basedon currently known or reserve information, isestimated to be about 20,000 tons annually,in the face of a projected annual amount de-manded of 40,000 tons, excluding militarypurchases." But the directors did not foreseethe rejection of a proposal to build anothernuclear-powered aircraft carrier or the cur-

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82,712,000534,000111,000

25422,075

$.08

rent fear of nuclear hazards. All the directorscould do was report what was then knownand make some clearly labeled forecasts,which other people can accept, reject, or re-vise at their own risk.

The recorded book values measure onlythe past costs of accumulating the assets-adjusted by a formal depreciation method.They are not measures of what the assetswould sell for now if disposed of piecemealbecause the company was to be liquidated.Nor is it a measure of the value of the com-pany's future net receipts from its businessoperations. The present value of its futureearnings may be far above the costs of theassets it uses. An excess of stock price overbook value is an indication of profitable pros-pects; it is not an indication of deception ofthe stockholders. Nor is a stock price belowthe book value any evidence that it is a safeinvestment in the sense that if worse came toworst the company could sell off its assetsand collect enough to pay each stockholderthe book value. The book value is a measureneither of the piecemeal disposal value northe value of the going enterprise as a whole.It is instead merely a formalized means of in-dicating the past dollar measure of costs ofthe owned assets, adjusted for depreciationby some formal method that often bears littleif any relation to the future earnings pros-pects or the decrease in current market de-mand for those assets.

At the time the balance sheet situation isdisclosed the company also issues its IncomeStatement, a statement of its receipts and ex-penditures during the year ending at the dateof the balance sheet. It reported net earningsof $.08 per share of common stock for theyear ending March 31, 1982. That is lessthan 170 per year on the value of a share ofstock, hardly a return competitive withyields available on secure bonds or on com-mon stocks (around 12%). Why the differ-ence? The current earnings may grow tolarge earnings in the future. It is the presentvalue of all those future earnings that is re-flected in the stock price.

The present value of the stock of a com-pany with expectations of rapidly rising fu-ture earnings will be high relative to currentreported earnings. Stocks should not be com-pared by looking a.t only their current earn-ings. A company with negative earnings thisyear but with superb prospects of large posi-tive earnings in the future could be worthmore than one with positive earnings thisyear but no prospects for future earningsgrowth. The ratio of stock price to currentearnings is a highly misleading basis for corn-paring two stocks-although many peoplenaively use that ratio.

Business Firms 203

Chapter 10

Price Taker~~Supply andPriceBesponseto Con~uDlerDemarid

In preceding chapters we assumed each sell-er's price was set in the market and could notbe affected by any individual seller's offeringof a larger or a smaller supply. Such sellersare called price takers, because each musttake the market price as given by outsideforces. For example, farmers producingwheat, corn, or soybeans sell such similargoods that, at any slight difference in priceamong sellers of one of those goods, the buy-ers will switch to sellers whose price is low-est. Each buyer knows that the product feach supplier is the same, regardless of whothe supplier is. That is why at the slightestdifference in price, the price taker will loseall his sales. And the seller won't accept alower price, because he can sell all he canproduce at the market price.'

In another kind of situation, the sellercan get a higher price than that of the rest ofthe suppliers in the market, albeit by havingfewer customers. Such sellers are called pricesearchers, because they must search for thebest price to charge (a task we will explore inthe next chapter).

Fortunately, for many economic phe-nomena the price taker model (see Figure10-1) gives just as accurate implications andpredictions as does the price searcher model.Indeed, some economic phenomena are unaf-fected by whether the suppliers are price tak-ers or price searchers. In this chapter we ex-amine the price taker and its applications. Inthe next chapter we analyze the price search-er model and its applications.

'Recall from Chapter 3 that elasticity of demandis a measure as a percentage of how the amount de-manded responds to a small percentage change inprice. As seen by the price taker, the demand is infi-nitely elastic, because the slightest rise in the askingprice would wipe out all sales, and the slightest cutwould increase the amount demanded far beyond any-thing that supplier could contemplate supplying. Theresponse measured in the percentage change in amountdemanded is indefinitely large.

205

Table 10·1 MEASURES OF PRODUCTION COST'

(1) (2) (3) (4) (5) (6) (7) (8)Number Total Total Average Average Averageof Constant Variable Total Marginal Constant Variable TotalUnits Cost Cost Cost Cost Cost Cost Cost

0 $1 0 $ 1

1 1 $ 9 10 $ 9 $1.00 $9.00 $10

2 1 17 18 8 .50 8.50 9

3 1 23 24 6 .33 7.67 8

4 1 27 28 4 .25 6.75 7

5 1 34 35 7 .20 6.80 7

6 1 47 48 13 .16 7.83 8

7 1 69 70 22 .14 9.86 10

. Simplified cost data to illustrate relationships among classificationsof costs and how price will affect more profitable output. Total cost(column 4) IS sum of constant cost (column 2) and variable cost(column 3). Marginal cost is change in total cost-due entirely tochange in total variable cost. Last three columns are costs per unit ofoutput.

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MarginalRevenue Equals Price

The best way to describe a price taker's situationis in terms of its marginal revenue. This sellersupplies more units, but does not thereby causethe market price to be lowered. There is noreduction of price on any of the units sold. Theextra, or marginal revenue to that seller as a resultof selling that one more unit is the price receivedon a unit. (You will refresh your understandingof marginal revenue if you review the discussionof it in Chapter 3.) "

By way of contrast, if a supplier who is aprice searcher (discussed in the next chapter)offers additional units to customers, the re-sult is a significantly lower price. The pricefalls not just on the additional units offeredbut on all units offered, including those for-merly for sale at a higher price. Thus, thenecessary reduction in the market price ifone more unit is to be sold partly offsets therevenue from the sale of that additional unit.

206 Chapter 10

The marginal revenue, the net increase inrevenue of selling one more unit, is thereforeless than its price: It is lower by the decreasein revenue caused by the reduction in theprice of all the units sold.

The market price is an easy and excel-lent measure of a price taker's marginal reve-nue on a marginal-that is, extra-unit ofoutput, because the price doesn't change ifthe one seller offers more or less. The sellerthus takes price in two senses: First, price isnot affected by the seller's output; and sec-ond, the price is a good measure of the sell-er's marginal revenue.

How is a price taker's output rate deter-mined? To answer that we must recognizehow the cost is related to rates of output. Ta-ble 10-1 shows a greatly simplified but ade-quate relationship between cost and outputs.

Column 4 lists total production cost; col-umn 2 shows a constant cost of $1 per daythat remains unchanged regardless of therate of operations (for this reason it is alsocalled a nonoperating cost).

The term constant cost tends to confuse

costs of two very different kinds: (I) thosewhich do not vary even if the rate of outputchanges (and are avoidable only if the firmterminates its business); and (2) those whichare the past costs of past acts. For example,the past purchase price of equipment thatexceeds the present resale value is a past, orsunk, cost. It is not a cost of any present orfuture action or production, unlike the con-stant-rate continuing costs. Knowledge ofpast costs tells you (too late!) only what wasthe cost of a past decision and is irrelevant toany future action (except for tax calcula-tions). By constant cost we mean the firstsense: a cost being incurred at a constantrate.

The variable, or operating, cost, listed incolumn 3 of Table 10-1 depends on the out-put rate. (Note that total cost is simply thetotal of the variable and constant costs.) Col-umn 5 gives the marginal cost, the change intotal cost when output is one unit larger. Fi-nally, the last three columns give averagecosts (per unit of output) for each of threedifferent costs: Column 6 gives average con-stant cost per unit of output; column 7 givesaverage (per unit) variable cost; and column8 gives average total cost.

Figure 10-2 shows graphically how theaverage total cost per unit and the marginalcost are related. Notice the shape of bothcurves. They may fall at first, may have anearly flat portion (possibly over a largerange of outputs), but ultimately, for largeroutput rates, certainly will rise until an up-per limit to the productive capacity is ap-proached (at which point the cost increasebecomes practically infinite). Nothing aboutthe actual shapes in any particular real situa-tion should be inferred from the shapes ofcurves used here. The shapes may vary fromfirm to firm, but one important logical con-nection between marginal and total costs al-ways holds: The marginal cost curve cutsthe lowest point of the average cost curve.This connection will be used later in ouranalysis.

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Figure 10-1.

DEMAND AND MARGINAL REVENUESITUATIONDEFINING A PRICE TAKER

DO is the demand facing the whole industry. With theindustry supply the price is determined. Each firm takesthat market price as the only price at which it can sell.for either or both of two reasons: First, a firm is so smallthat any reduction in its output would change the marketprice by only a trivial amount, and the firm, being sosmall, would have a marginal revenue essentially equal toprice. Second, if a firm did cut output to raise price, otherfirms would expand and restrict the price rise.Competition from other sellers makes. the existingmarket price the only price worth contemplating andmakes marginal revenue practically equal to price. Allthis is often summarized by saying that theindividual firm sees the demand for its product asessentially a horizontal line at the marketprice, with marginal revenue equal to price.

Price Takers'Response to Demand 207

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MARGINAL AND AVERAGE TOTALCOSTS AT DIFFERENT OUTPUTS

Where marginal cost is less than average total cost,average total cost will decline, but where marginal costhas increased to above the average total cost,average total cost will increase-which happens atthe largest outputs of producer's capabilities.

208 Chapter J 0

WEALTH-MAXIMIZING OUTPUT

What rate of output will maximize aprice taker's profit, or wealth value of the in-puts? Answer: a rate of output beyond whichthe marginal costs exceed the market price.For example, if the price is $13, the profit-maximizing rate is six units daily, as shown inFigure 10-3. The total cost of six units (fromTable 10-1) is $48; total revenue is $78. Thedifference is $30 (the operating profit is $31.with $1 of constant, or nonoperating, costs).Producing one more unit daily (seven per day)would increase the total cost by a marginalcost of $22 but would bring in marginal reve-nue (extra receipts) of only $13, the un-changed price. To produce fewer than sixunits at a marginal cost below price wouldforsake potential profits. Profit is maximizedat that rate of output at which marginal costand marginal revenue are equal-which, inthe price taker's case, means they are equal tothe unchanged price.

If the market price were higher, say, $22,seven units would maximize profits at $84($154 - $70). If the price were only $7, noprofit would be possible. A price taker's out-put response to a market price is shown bythat producer's marginal cost curve. That up-ward-sloping curve says that a higher marketprice would induce a larger rate of supply (seeFigure 10-4).

How low would the price have to go tostop this firm from producing? If the pricewere above average variable costs, the firmwould continue to produce, at least tempo-rarily, because getting any income over thevariable cost is better than immediatelyshutting down: The price at least covers theunavoidable costs that continue even if theproducer shuts down temporarily.' (In Table10-1, the lowest average variable cost is$6.75 at an output of four units. Any priceabove that would cover the operating costs.)If the price stays below the lowest total costper unit, $7, it will ultimately pay to shutdown when the equipment wears out; it

wouldn't pay to buy new equipment or re- $new contracts.

QUASI-RENTS

We have ignored the initial investment inequipment that enabled the firm to operatewith the costs given in Table 10-1. It is rea-sonable to assume that, if the producer hadmade a large investment in facilities, the sub-sequent operating costs, say, labor, might besmaller, whereas a smaller investment mayhave resulted in larger operating costs. As-sume that for the data in Table 10-1 to ap-ply, an initial investment of $10,000 wasmade in equipment and that, for the contem-plated expected economic life of the equip-ment, it would take revenue of about $10 aday over the future life span to recover thatinitial investment. That $10,000 is sunk andgone, and is irrelevant for any costs of opera-tion once the investment is made. It doesn'tappear in future production costs, and the in-vestor hopes to recover it from future reve-nue, taking a loss if he does not.

In our example, we have already seenthat if the price were $22 the firm wouldhave covered its continuing plus variablecosts of $70 a day, with an excess of $84. Al-lowing $10 for recovery of the prorated in-vestment cost, that is $74 a day as a profitstream.

But if the price were only $7, it wouldpay to produce only five units. The excess ofrevenue over continuing costs would then bezero ($35 - $35), which would leave nothingtoward recovery of the initial investment.The initial investment would be a total loss.But the producer is not losing on the continu-ing and operating costs, though the invest-ment has been lost. The price could fall evenfarther before the firm would suspend pro-duction. Suppose the price were only $6.80. Itwould pay to produce four units with a totalrevenue of $27.20, covering the variable costsof $27 and still leaving 20¢ toward coveringpart of the continuing costs (these, remember,

20

15

13

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Operating Profits(Profit Plus Quasi-Rent)

86.75

5

,III,I I I Ii ,Variable Costs II (Sum of Marginal Costsj]I I I I I

o 1 2 3 4 5Quantity

6 7 8

Figure 10-3.

MARGINAL COST. PRICE,AND PROFIT-MAXIMIZING OUTPUT RATE

Since the sum of the successive marginal costs equalsthe total of variable costs, the area shown under themarginal cost curve represents total variable costs. Sinceeach unit is sold at the market price. the rectangle underthe price line represents total revenue. The area abovethe marginal cost curve and under the price line is ameasure of "operating" profits (called "operating"because the constant costs. which are not included inthe marginal costs, must be subtracted from that profitarea to show true profits). This diagram is designed toshow the determination of output that maximizes profits.so no matter whether the constant cost is small orlarge, both the operating and true profits, aftersubtracting the constant costs, would be maximizedwhere the area above the marginal cost line andbelow the price line is maximized. If the constantcosts were so large as to exceed the operatingprofits at the price assumed in the diagram... the firm would shut down operations.


I:

Marginal Cost s

20 I-

15 -

rr Per-UnitITotal Costs

INon-renewal

Price,

$7.00

\

hut-downPrice,

$6.75Total Costs (Including iNon-operating Costs) ------j

o -6 71 2 3 4 5

Quantity

Figure 10-4.

OUTPUT, PRICE, COST, REVENUE, AND PROFITS

This diagram shows graphically the measures of profitsand total costs at the profit-maximizing output when priceis $13. The total costs are the rectangle over the base of6 units of output and an average cost of $8, for a totalcost of $48. Total revenue minus total cost is the profit(the rectangle above the cost reetangle). So long asprice exceeds. $6.75 (the lowest per-unit operatingcosts), production would continue because at least someportion of unavoidable, constant costs were beingcovered ... thereby minimizing losses. Ultimately,when equipment or contract renewal was required,operations would terminate unless expected pricewas at least $7.00-to cover all futureexpected costs.

"

I' ",I,':;

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continue whether or not the firm temporarilysuspends production; examples are nightwatchmen, land rent, and some administra-tive office staff). If the price fell so far thattotal revenue didn't match even the variableoperating costs, let alone any part of the con-tinuing costs, the firm would suspend produc-tion, at least temporarily.

The circumstances of the preceding ex-ample can be described in terms of the con-cept quasi-rent, which is defined as the ex-cess of revenues over the total of its variableoperating costs plus the continuing costs at aconstant rate per day (even if the firm sus-pends operations). Quasi-rent can be as-signed to recovering some or all of the initialinvestment cost in the equipment. It is whatthe equipment can now earn and becomes ameasure of its value. That excess over thevariable operating and continuing costswould induce the firm to continue to oper-ate.

Almost every business has made invest-ments in durable resources. The firm willfind it better to operate than to shut down,even though market price is driven so lowthat the revenue covers only the variable op-erating costs, leaving practically nothing tocover any continuing costs and nothingtoward recovery of past investment costs. Of-ten these past investment costs are mistaken-ly added to the present costs to make up so-called full costs. But, clearly, such full costshave nothing to do with costs of present pro-duction, nor with whether or not it pays toproduce, given that the past investment inequipment has been made. An investor in anew business would certainly hope to recov-er all the costs-the full costs; but once theinvestment is made, recovery is not neces-sary for use of the equipment. Recovery onlymakes the initial investment profitable. Asfor future investments, it is the prospect offuture revenues that counts, not revenues onpast investment. Later, we shall make use ofthe concept of quasi-rent in explaining some

competitive pncmg tactics that are widelymisunderstood, even by the business manag-ers who act in conformity with the exposi-tion given above.

Market Supply:Aggregated Suppliesfrom All Firms

The total amount of a good supplied to themarket is the sum of the outputs of all theproducers, as explained in Chapter 7. To re-fresh understanding, in Figure 10-5 the mar-ginal costs for two firms are portrayed. Thetotal supply curve of this product is obtainedby adding the output (horizontal distance ona graph) of each firm's marginal cost curve atany common price that is above the lowestaverage variable cost of that firm. The result-ing curve, 55, is the industry- or market-sup-ply curve. If the price were $2, the maximumwealth or profit outputs of firms A and Bwould be XA and XB• At prices below $1.30,firm B would immediately shut down, but Awould not shut down unless prices were aslow as 85¢. These lower limits are the lowestaverage variable costs-the only costs thatare incurred by operating with existingequipment.

Figure 10-6 shows the total market-de-mand curve (DD) intersecting the industry-supply curve (55) at the price of $2. Outputsby firms A and B are indicated by the dis-tances aXA and aXB. If the market demandincreases, shown in Figure 10-6 as a shift tothe right of the DD curve to DIDI, the pricewill be bid up (if no laws prevent pricechanges). The increased demand schedulesustains a higher equilibrium price, which-in-duces existing firms to produce greater, andmore profitable, outputs at higher marginalcosts.

4MeB s

3

1/1•..(1l

(5c I

IIII ~IMinimum Average Cost

1-1 -"'--+----+Outputs for Each Firm

iXB iXA iX(A + B)

1.30

1.85 -

o 10 20 30 40 50

Rate and Volume of Output

Figure 10-5.

TOTAL SUPPLY FROM A TWO-FIRM INDUSTRY

If price faced by these producers were $2, output wouldbe 11 by producer Band 19 by producer A, for a total of30. The horizontal sum of the individual marginal costcurves is the total industry supply (where no producerwould produce at a price below his lowest averagevariable cost). Can you also see that if the twoproducers were producing outputs at which marginalcosts were not equal, the producer at the output with thehigher marginal cost should reduce his output, and theone at an output with lower marginal costs shouldcorrespondingly expand?

Only two firms are shown here. In fact, there areprobably scores of producers in most industries, eachwith some marginal cost curve. All would be summed toget the industry-supply curve, and each firm would takethe price in the market as the price that it regards asunaffected by its own output rate. We show only twofirms to keep the diagram from becoming cluttered. Thebasic principle illustrated is that the amount supplied isdetermined by market price and marginal costs withineach firm, with output being adjusted to that at whichmarginal cost equals price.


5

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~12I II II II II II IIXB IXA

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I Output IExpands

5010

Output

Figure 10-6.

DEMAND, SUPPLY, AND PRICE .r

TAKER'S DETERMINATION OF OUTPU'T

As market demand increases, new firms are attracted byhigher prices and wealth prospects. At a price ofapproximately $3, Firm C will be able to produceprofitably. Supply of output by industry shows increasedoutput with higher price beacuse of (1) increased outputby each firm, which increases output to point wheremarginal costs equal price, and (2) increased numberof firms as price rises above anticipated minimumaverage costs of new potential firms. 55, the supplyline, is the horizontal sum of the three firms'marginal cost lines, above their minimumaverage cost points.

Long-Run SupplyResponse: Entry ofNew Firms and Equipment

The longer a high demand and high price areexpected to persist, the greater the numbersof new producers attracted into the marketand of existing firms expanding their facili-ties. Because every firm finds it profitable toexpand its output to that at which its long-run marginal costs are expected to equal thehigher price, all firms will operate at uniformmarginal costs, though possibly at differentoutput rates. Firms with the highest mini-mum of average costs will be regarded asmarginal, or fringe, firms, because if demandfalls, the lower price will force them to shutdown first. (If demand stays high, or if theylearn how to reduce their costs, these firmsbecome recognized as established firms and,in turn, look on firms with still higher costsas the new marginal, or fringe, firms.)

The principle applies to all firms, evenof the simplest type. At big football games,the fees for parking near the stadium arehigher, and high-cost parking lots are openedas more local residents rent space in theirdriveways and yards. These fringe operatorsare disliked by the established parking lot op-erators. They appear when demand andprice are high. Charter airlines appear in thesummer. Likewise, seasonal variations in de-mand are met by temporary entrants in con-struction, harvesting, summer resorts, autorentals-indeed, in every industry. Whenthe demand for buildings or farm productsincreases, the number of building contractorsand farmers increases, as does the output ofeach group.

But suppose suppliers and customers areprohibited from raising prices when demandincreases. Then higher-cost suppliers are dis-couraged from producing. If prices were al-lowed to rise, new, higher-priced fringe oper-ators would contribute to lower prices. Theyincrease the amount supplied and reduce fullprices below what they otherwise would

have been. For example, in Washington,D.C., hundreds of people with full-time jobselsewhere become taxi drivers during rush

..hours; steel mills operate their more costlyblast furnaces only during times of peak de-mand for steel; barber shop chairs that areidle most (but not all) of the time representhigh-cost, but not excessive, capacity; somefirms, when demand warrants it, use secondand third shifts, though they raise the cost ofproduction. The amount supplied keeps theprice lower than it would have been. Later, ifdemand falls, the lower price makes it un-profitable to maintain so high a rate of pro-duction. Then all firms reduce output, andsome withdraw from that business. The dis-placed resources regretfully and grudginglyrevert to their next-best sources of income(which served as a measure of their costs ofbeing used in the first industry).

ELASTICITY OF SUPPLY

How steeply can a long-run supply curverise? It can be vertical, as for land and forgoods of which there is a fixed total supply.(The pricing of such goods was analyzed inChapter 4.) Or it can be virtually horizontal,that is, infinitely elastic. In the latter case,the long-run rate of output can be increasedto as much as is demanded at a constant mar-ginal and average cost of producing more.Say, for example, that in a large country thestock of resources doing all kinds of otherwork is so large that the production of onegood could be increased by switching away avery small fraction of resources from othertasks. Then the unit costs of getting a suffi-ciently greater amount of resources into thisactivity may be essentially constant. If so,then larger output rates in one firm or indus-try do not cause detectably higher resourceprices and higher average costs. This situa-tion is called constant average (and marginal)cost of production. Each unit costs the sameover the range of output sufficient to satisfythe increased demand at the old price.

To be sure you understand, considerwhat would happen if demand for that prod-uct fell. If in the long run the productive in-puts are perfectly mobile-that is, they couldshift to other jobs "and earn just as much asthey did making this product-workerswould not be willing to stay at this job unlessthey continued to be paid at the same wagerates: Were there any attempt to maintainoutput by cutting wages or payments to in-puts, those inputs would leave rather thanaccept a lower wage. They would not accepta lower income than they could get else-where.

Obviously, in the short run the marginalcost curves will not be horizontal: That is,resources would not instantly leave for otherjobs at the slightest threat of any cut in theirwages or rents. There are moving costs, andquick adjustments cost more than less hastyones. Those inputs with higher transfer costswould accept some temporary wage cuts orunemployment. But in time they wouldmove. That is why long-run supply is moreelastic than short-run supply in response toprice.

Increasing output quickly costs morethan increasing it more slowly, as Figure 10-7 shows. There are two supply curves: 51 foran early, faster increase; 52' for the later,more gradual increase. When demand in-creases from DI to D2 price (PI) rises at firsttoward P2 along the short-run supply curve.The long-run equilibrium price is P; in con-formity with the long-run supply. We cannotpredict the exact timing or transition path ofprice adjustment to P; That depends uponthe size of inventories and cost of faster rela-tive to slower supply adjustment.

ADJUSTMENTS WITHOUTFULL INFORMATION ABOUT COSTS

No one need have full information aboutmarket demands or about costs of all possibleoutput programs in order for supplies to re-

Price Takers' Response to Demand 213

11,11 I\" I

, .,

51Immediate or Short Run

52Long Run

o Output

Figure 10-7.

ADJUSTMENT OF SUPPLYTO SHIFTS IN DEMAND

Starting at the initial equilibrium situation, with price P" asdemand increases, its intersection with supply will slidealong S" the intermediate, or short-run, supply responsewhich shows increased production from existing firms. Intime, new firms will be attracted or new productiveequipment will be installed by incumbent firms, ahdoutputs will be more responsive, as indicated by thelong-run supply curve, S2' The short-run supply curveis the summation of the incumbent firms' marginal-cost curves. The long-run supply curve is the sumof the amounts firms (including new firms and newequipment) could persistently produce at eachprice without losses.

214 Chapter 10

spond to demand. Of course, many produc-ers, by compiling data with which to esti-mate costs, increase their probability ofbeing near the wealth-maximizing output.They know that when demand rises and per-mits a higher price, an expanded output be-comes more profitable, even if they may notknow exactly how much larger the outputshould be. All the market forces are nowmore favorable to enlarging output or to sus-taining one that had been too large. Even if(as does not in fact happen) every firmpicked outputs at random, those which hadpicked larger outputs would now be moreprofitable and would grow more than thosewhich had picked smaller outputs. (Witnessthe growth of Sears relative to Ward's afterWorld War II. Sears chose expansion as po-tentially profitable; Ward's chose not to ex-pand. Neither knew in advance which wasgoing to be appropriate.) Later, other pro-ducers will imitate the more profitable ones,not because they have been exhorted to doso to promote national or social interest, butbecause they see that changing production inthe indicated direction will increase theirpersonal wealth.

ABSORPTION OF PROFITSBY HIGHER-VALUED INPUTS

Figure 10-8 helps us analyze more effects ofmarket competition. For firms A and B, mar-ginal cost curves (MG) -curves showing howsupply responds to price-are shown forprices at which the firm would produce someoutput. Also shown are average cost curves(AG). Firm B is only breaking even, becausethe price is at the lowest level that induces itto produce. Firm A is making a profit; at theoutput at which its marginal cost equals themarket price, its average cost is lower thanprice. A marginal firm, by definition, is onethat is barely covering its costs. Notice, nev-ertheless, that both firms are operating at out-puts that are marginal in that they break evenon the marginal unit of output, because their

$ Firm A

Me

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CL

selected outputs are those at which their mar-.ginal costs are equal to the market price.

At this point in our analysis you maywonder why one firm, here firm A, has loweraverage costs. And why doesn't firm B findthe reason and copy it? If a particular input isresponsible-say, more efficient workers orequipment-why doesn't firm B bid it awayand enjoy those lower costs? It will, but firmA will also compete to keep that input. Theprice (be it wages or rent) of the formerlyundervalued input will be bid up, raising thecosts to firm A and exhausting its profit. Inthe long run, after other firms have detectedthe responsible superior, but underpricedinputs, and have bid up their prices,all firms will have similar costs and will justbreak even. Firm A has had lower costs sim-ply because it had been able to get inputs atprices that no one else then thought weremore valuable than that price. No one elseconfidently predicted, and then backed theprediction with money, that the value ofthose inputs would ultimately prove to behigher. So some firms have lower costs onlyuntil other firms learn their secret and bid upthe prices of the responsible resources. In thelong run, profits will be competed to the re-sponsible inputs as they are paid what theyare now believed to be worth.

Firm B All Firms

D

Output

Figure 10-8.

HOW DIFFERENCES IN PROFITS AREELIMINATED BY COMPETITION FOR INPUTS

Differences in profits are the result of errors in forecastsof future values of inputs. As true values are revealed,competition pushes prices of inputs toward that valuewhich exhausts the profits. Firm A, showing loweraverage costs. will have its costs of using inputsincreased as other firms compete for the responsibleinputs. Or they may copy techniques that enable lowercosts, until the altered supply lowers market price tothe same costs that all firms have. If not imitable,differential productivity of profits will be imputed to theresponsible resources that enabled profits. Theirvalues will be bid up to values that include theirsuperiority value, thereby meaning higher costsfor any user.

Price Takers'. Response to Demand 21S

II

II

IIIi

Ii

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LRAC

SRMCLRMC

o q / q

Quantity

Figure 10-9.

SHORT- AND LONG-RUNAVERAGE AND MARGINAL COSTS

A change from the output, for which existing facilities areoptimal, to, say, o', will raise average costs to D,above, B, what costs would have been if existingequipment had been optimal for new output,q',

216 Chapter 10

Short Runs and Long Runs

Warning: Economists use the expressionsshort run and long run in two differentsenses without explicitly distinguishing be-tween them. Short run can mean an immedi-ate and quick adjustment to a new, possiblylong-lasting situation, or it can mean a short-lived activity, the starting time of whichdoesn't matter. In our preceding analysis wemeant both immediate and temporary, but

'neither meaning requires the other. Longrun can mean a later, ultimate effect, or itcan mean a long-lasting activity, the startingtime of which, again, doesn't matter.

Again, initiating a new production pro-gram quickly is more costly than is a moregradual adjustment, as Figure 10-9 shows.(Of course, the quicker may prove to bemore profitable.) The figure exposes in ahighly stylized way the logical relationshipsamong marginal, average variable, and aver-age total costs. In fact, the particular shapesof the related curves depend on the particu-lar production techniques, equipment, andquantities of output involved. Each case isunique, but the logical interrelationships arethe same for all. The long-run, average costcurve, LRAC, shows the average cost of pro-ducing each possible output if the producersinitially chose the most appropriate (lowestcost) production technique for that output.The selected output q, for example, wouldhave resulted in average costs equal to theheight qA on the curve LRAC

If, after starting at q, the producer de-cides to change the output, the average costsfor sustaining that new output will be higherthan if that other output had been the initialone. Changing output, for example, to q'from q, affects average costs of production asshown by the height q'D on the SRAC curvemoving from output q. That curve showsshort-run (quick adjustment) average costs ofrevised outputs starting from q. If, afterequipment is altered, that new program iscontinued indefinitely, then future costs be-

come the low-cost, long-run average cost(LRAC) of producing at qt.

For outputs larger than the initialplanned output q, a short-run (quicker adjust-ment) marginal cost exceeds the long-run(gradual expansion) marginal cost. But if out-puts are reduced to less than existing equip-ment is best suited for, the costs are not aslow as they would be with more extensiveadjustment in production techniques. Reduc-ing output hastily does not lower costs asmuch as does reducing output in the longrun. In economic terms, the elasticity of sup-ply changes in either direction is greater fora long-run adjustment period than for ashort-run adjustment period. Here the twosenses of long run apply: Less rapid adjust-ment is less costly; and a production programof longer duration is less costly per unit thanone of shorter duration.

Consequencesof Wealth.MaximizingResponse to Market Demand

WHAT IS THEAPPROPRIATE PRICE RESPONSE?

If price should fall in response to a persistingdecrease in demand or overexpansion of ca-pacity, some firms will shut down, the earli-est ones to do so being those with higher av-erage variable costs-not those which arepoorer or smaller or which have less moneyon hand. Whether rich or poor, a firm shutsdown not when cash is exhausted but whencontinued operation at low prices reduceswealth more than would shutting down.

Prices can fall below the long-run aver-age costs. The lower prices may be adequateto cover only short-run, temporary operatingcosts with existing capacity. Prices that tem-porarily fall below long-run costs are oftenincorrectly called predatory prices. Whenprices fall, it is not because some firm is try-ing to drive out other firms in order to later

raise prices above long-term costs. Instead,the reduced demand means consumers arerefusing to buy at a price that covers thecosts of permanently keeping all the existingproducers in thaj industry. Consumers areforcing some producers and equipment tomove from an activity which is now lessvaluable to other, more valuable activities. Ifwaste is to be avoided, reduced demand ne-cessitates reductions in output and in pro-ductive facilities. Market prices are cut tem-porarily until either demand later increasesor, if demand does not later increase, enoughproductive facilities are used up and not re-placed. In the latter case, as output falls,prices rise to just cover the long-run averagecosts from new facilities. They do not riseabove those costs.

WHAT IS THEAPPROPRIATE OUTPUT?

In Table 10-1, although the wealth-maxi-mizing output at a price of $10 is five units,this producer could produce as many as sev-en and still cover total costs-but the profitswould be lost. We might think that produc-ing five rather than seven is socially waste-ful, because the price exceeds the averagecosts for the extra units. But thinking sowould be incorrect analysis, for the marginalcost is the cost of the extra output, and be-yond five units of output it exceeds price.Thus, to produce the sixth and seventhunits would use resources (the marginalcosts) that are worth at least $13 in useselsewhere but that consumers value in moreof this good priced at only $10. That valueis less than the value ($13) of other goodsthat would be forsaken. Therefore, theprice-taking, wealth-maximizing producer isnot underproducing by holding the outputrate to five units; producing more woulderase that producer's profit and wastefullyuse more resources that are worth morethan the extra output is here.


Thus, the product's price measures itsvalue; the marginal costs measure the valueof forsaken output. The logical implication,then, is that wealth-maximizing price takersmaximize the social value of resources. Ironi-cally, this implication was developed by so-cialist theorists, who asked what "should" bethe output. Using the criterion that resourcesshould provide the greatest value as judgedby consumers, they deduced that producersseeking to maximize their wealth with openaccess to markets gave precisely that result.Everyone was embarrassed-the socialists be-cause they had provided an argument for pri-vate property and market prices, and the cap-italists because, much as they would haveliked this justification of their activity, not allof them could claim to be selling in, or evendefending, open markets.

I }1

I

CONSUMER DEMANDSDETERMINE VALUES AND USESOF PRODUCTIVE RESOURCES

When market demands increase (say, forsports cars, computers and computer pro-grams, wigs, colored tennis balls), the pricesof the materials used in producing thosegoods respond. The profits of those who firstgot those inputs at the old wages or pricesshow that the old valuations of the input are

. too low. As new facilities are built that canuse those inputs, the new, greater demandfor them will bid up their prices until no sureprospects of future profit remain. The profitis absorbed into the higher ~alues of inputs:Profits, then, lead to higher costs.

If I discover oil on my land, competitionby other people for my land raises its value.The cost of my using that land is now high-er. Anything that becomes more valuablealso becomes, by definition, more costly touse, because the user must forsake the great-er value that could have been obtained byselling the good to someone else at that new,higher value.I

1'1

218 Chapter 10

Desire for greater wealth directs re-sources to the uses consumers value most bymaking it more costly to employ in less-val-ued uses.' The more quickly, completely, andbroadly do producers learn of the market'srevaluation of assets, the more fully andquickly will they direct resources toward thenew, highest valued uses.

To adjust to revaluations by consumers,producers must put resource uses and valuesthrough a gigantic web of substitutions. Forexample, if the demand for wheat increases,more wheat can be produced only if re-sources are taken from the production of oth-er goods (by resource owners seeking greaterwealth). Land transferred to wheat is takenfrom oats and corn, and as the supplies ofland for those uses falls, reducing the outputs ,of those goods, their prices increase a bit. Astheir prices rise, other land will then be shift-ed to corn and oats-land formerly used for,say, cotton, barley, cattle grazing, or parks,or potentially useful for housing or industrialsites. Also, labor and other resources are di-verted to wheat. Laborers who would other-wise work as cattle raisers, carpenters, or gasstation attendants switch to wheat produc-tion. And their places are partly filled fromstill other occupations. The substitution andshifting is broad and extensive. The many ul-timate economy-wide effects are so diffusedas to be hardly noticeable among the manyother everyday events that influence the out-put of any other particular good. For this rea-son, we are sometimes misled into thinking

2In Chapter 8, where we defined the cost of a giv-en use of resources by one person as the highest alter-native forsaken value of output of those resources, weseemed to exclude the value of their present use. Butwe now see that a more general conception of costsconsists of imputing to a given resource a market valuethat reflects its highest possible value in any line ofactivity, including the present one. Costs of resourc.esin a particular occupation stem not only from alterna-tive uses but also from alternative users. Even if myland is good only for oil production (that is, it has noalternative uses), it still has a value, which must be tak- -en into account, because other users will bid for it.

that more of a good can be produced withoutproducing less of some other, be it leisure orlingerie.

EFFECTS OF A TAX

In Chapter 4, the effects of imposing a taxwere outlined. Here, now that we havelearned about marginal cost curves and theprocess of competing market values of re-source services into the prices of those re-sources, we can use the diagrammatic ap-proach to more clearly deduce the price andoutput effects of a tax on the production of agood.

Tax on All Producers in an Industry: Priceand Output Effect Suppose manufacturersare taxed 50¢ on each deck of playing cardsthey produce. Each firm's marginal and aver-age costs are increased by 50¢. Summing thenew, higher marginal cost curves over all thefirms that would produce cards yields a high-er cost-supply curve or a lower output curve,as seen in Figure 10-10. Before the tax, theconsumer's price was 75¢. If that price wereto persist, each producer, now operating witha higher marginal cost schedule, would re-duce output from Xl to X2• But the old pricewould not persist for long: The reduced in-dustry output (on the new, smaller market-supply curve) would result in a higher price,which would cover part of the tax and induceeach firm to reduce output less, only to X3instead of X2• Our first conclusion is that thehigher tax raised costs. But a higher pricecan be sustained only if the supply to themarket decreased. Always, an effect on pricedepends on an effect on aggregate supply.Only because the higher tax moved the ag-gregate supply curve back to the left-to asmaller sustained production at each price-could a higher price be sustained. The sameanalysis could be used for anything thatraised the marginal costs of production, suchas higher wages for labor or higher prices ofmaterial, power, or transport.

Figure 10-10.

EFFECT OF TAX ON OUTPUT AND PRICE

Tax is levied on output of playing cards of all firms inindustry. Supply curve shifts upward to incorporate taxesof 50~ per unit. This reduces output at the old price, andthe price moves up to $1. Higher price results from thesmaller supply function. Unless tax affects supply curve,price cannot be affected. Price rises by less than taxbecause, at smaller output, marginal and averagecosts are lower. Part of tax is revealed as a higherprice to consumer and a smaller rate of consumption;another part is reflected in reduced wealth value ofresources specialized in production of this taxedgood. Tax is borne by consumers and byowners of capital goods and labor servicesspecialized to this industry.

Price Tskers'Response to Demand 219

Effect on Wealth of Productive ResourcesIn Figure 10-10, the price increased by lessthan the tax on each deck-by 25¢, to $1from 75¢. The output was reduced by eachsupplier firm's moving back down that mar-ginal cost curve that is higher by the amountof the tax. Output is reduced, because not somany resources are now as valuable in mak-ing playing cards as they are elsewhere.

We can see that the total tax receipts(tax per deck times number now produced)come in part from a higher consumer priceand in part from a lower value of, and thuspayments to, those resources that were moreuseful in manufacturing the taxed good.Clearly, the taxes are not all borne by theconsumer in higher prices and fewer decks ofcards; part is borne by the owners of the re-sources specialized to card production, whichare by definition less valuable elsewhere.The incomes to specialized resources (whichcould be machines, people, or even land) fallby the amount of their former excess valuein card production over their salvage value inalternative uses.

But reductions in output and in the val-ue of resources are not the only adjustment.In the long run, the equipment specialized toproducing cards will wear out and not be re-placed, further reducing output, as Figure10-11 shows. When a final long-run adjust-ment is achieved, the price of cards will besufficiently high to cover the tax and thenew full cost of production, including thecost of installing and maintaining new spe-cialized equipment.

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Old versus New Card-Making ResourcesThere are two separate effects on value thatshould not be confused: (a) the effect on thevalue of specialized resources existing at thetime the tax is imposed, and (b) the effect onthe value of newly producible resources. Thevalue of old equipment will reflect the lowercapital value of the future receipts net of thetaxes that must be paid when using the old

220 Chapter J 0

equipment. A wealth loss occurs only to theowners of the specialized resources existing atthe announcement of the tax, not to those wholater may buy or create new card-makingequipment. (The supply curve of old, existingequipment is vertical, that is, fixed.) Hence allchanges in the net value 'of its services arecapitalized into current capital values and areborne by the current owners-as for land (dis-cussed in Chapter 4).

Tax on One Firm or on All Producers?Suppose the tax had been levied on just oneproducer of cards. If that producer's output isonly a small part of industry supply, the in-dustry supply does not shift by a perceptibleamount. Price is not significantly affectedunless market supply is affected. No one pro-ducer can recoup part of the tax by a higherprice. The unaffected supply from other pro-ducers is large enough to satisfy demand atthe existing price.

The greater the number of supplierswho are taxed, the more the tax will reducemarket supply. To raise the costs of just onesupplier, who makes a small part of the totalsupply, will affect the total supply by a negli-gible amount, with no appreciable effect onthe price.

SICK INDUSTRIES

Certain industries are commonly called"sick": They allegedly have an excessivenumber of firms; the number is "excessive"because most of the firms lose wealth. Asrapidly as some lose and leave, new ones en-ter-with the same risk of mortality. Thereseems to be no long-run adjustment thatmakes the industry profitable, or at leasteliminates loss. The more commonly citedexamples of sick industries are the operationof small groceries, bars, restaurants, or nightclubs; coal mining; retail gasoline sales; tex-tile manufacturing; and farming.

What, according to people who makethis argument, causes some industries to be

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51 (with Tax), 51

Short Run

In Short Run

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Price to { Long RunConsumerafter Tax Short Run

Price to Consumerbefore Tax

Net of Tax price/Received by

Producerin Long Run

52--'~------,51"

(with Tax)

Output of Cards

-- BeforeAfter Tax Tax

Long & ShortRun

"sick"? They point to a long-term decline indemand, the tendency of people to overesti-mate their ability, plain ignorance about howto run a business, or the low cost of enteringthe business. But these explanations do nothold up under closer study by economic anal-ysis.

First, all firms in an industry could belosing wealth when demand is falling unex-pectedly. There is nothing "sick" about ad-justments to a decreasing demand. Second,all proprietors could be willingly losingwealth if the business provides a sufficientamount of nonmonetary satisfaction, as issaid to be the case for horse racing, novelwriting, acting, or owning baseball clubs.One person grows orchids, makes money,and considers it a business; another grows or-chids and loses money but regards it as a

Figure 10-11.

HOW A PER-UNIT TAX AFFECTS OUTPUTAND PRICE IN THE SHORT RUN AND LONG RUN

The more time allowed after a tax is imposed or cost isincreased. the greater will be the effect on the amountsupplied (reflecting withdrawal of resources from theindustry). In any event. the higher input price or taxresults in higher price to consumers. smaller rate ofcard consumption, and reduced income and wealth toowners of productive resources specialized to cardproduction. The diagram shows price andoutput effects but not the wealth effects.


hobby or consumption activity. Everyonecould lose money (relative to what he or shecould earn elsewhere) if this business opera-tion were more pleasant. These consider-ations help to explain why some "firms" canrun at a "loss."

Third, there is a more powerful consider-ation: In some industries the profits may belarge for only a few, with the rest losing mon-ey. In acting, writing, painting, and sports,only a few persons make a big success, whilethe vast majority of entrants never makeenough to cover the cost. Nothing in econom-ic analysis says that an industry in which onlya few make fortunes should not have too many"failures." These failures (or is it more accu-rate to call them nonsuccesses?) entered hop-ing they would succeed, and they often remaindespite years of frustration and disappoint-ment. On average, half of all new firms, in allindustries, fail to survive to their fifth year!

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ACTIONS AND COSTS

So far in our analysis in this chapter, we havedeliberately used simplified types of outputsand simplified measures of those costs. Wenow modify one oversimplification: The fullcosts of any present action are more than justthe best, forsaken alternative, current uses;they include the future forsaken uses as well.The more complete costs of an act are there-fore measured by the consequent reductionin the present value of one'swealth: the lossof present value of the present and futureforsaken alternatives. (We examined the con-cept of present, or capital, values in Chapter6.) Before interpreting this statement with anillustration, we must state precisely what theact is that we are measuring the costs of. Toooften this is left ambiguous-with resultingconfusion about what are "the" costs.

Costs of Acquisition Normally, the pur-chase price of an asset is called its cost. Butwe know that the cost of an act is the result-

222 Chapter 10

ing reduction in one's wealth. Suppose youcontemplate buying a Ford. Let us analyzethe pertinent expenditure data in the tophalf of Table 10-2. The purchase price is$8000. The immediate resale value would be$7400. If you kept the car for two years with-out using it, its resale value would be $5000.If you drove the car, say, 10,000 miles peryear, the resale value would be only $4400 intwo years.

Let us now look at the bottom half ofTable 10-2. Whatis the cost of acquiring ti-tle to the car? It is $600, the difference be-tween the initial price and the immediate re-sale value. But once the car is acquired, thiscost is sunk, or fixed, and irrelevant to anyfuture decision.

Continuing Possession Once title to the caris acquired, what is the cost of simply possess-ing it for two years without using it? It is thedifference in its value now and its resale valuein two years, $5000. But do not subtract $5000from $7400! They are values as of differentdates, and (as you recall from Chapter 7) theymust be converted to contemporaneous val-ues. We must convert the $5000 as of twoyears hence to a present value. At a 1070 an-nual rate of interest (using Table 6-1), thepresent value of $5000 deferred two years is.826 X $5000 = $4130. Subtracting this from$7400 gives $3270, the cost of two years ofpossession without use.

To be still more realistic, assume thattaxes and insurance must be paid if the car ispossessed. At the beginning of each year,$400 is paid to cover the year's tax and insur-ance, whether or not the car is operated.Converting these two successive annual pay-ments to present values gives $400 +(.909)$400 = $763.60, the present value oftaxes and insurance if the car is possessed fortwo years. Once the car is already acquired,the cost of keeping it two years is $3270 +$763.60 = $4033.60. The cost of acquiringand keeping but not using the car for twoyears is $600 + $4033.60 = $4633.60, whichwe round to $4634.

Operating Cost But you are not runningan auto museum. You want to use the Ford.Other outlays, listed in Table 10-2, will bemade for repairs, gasoline, and the like. Weassume that they are paid at the end of eachyear, as if they accumulated on a credit card.Since we cannot properly add outlays now tooutlays a year later without adjusting for tim-ing, we convert all outlays to present values.They sum to $2066 [= ($1000 X .909) +($1400 X .826)]. If the car is used, its resalevalue will depreciate more, to $4400 at theend of two years (compared to $5000 if notused). The extra depreciation at the end oftwo years (at a 10% interest rate) is $600,

which has a present value of $496. Addingthis $496 to $2066 gives $2564 as the present-value measure of costs of operations.

The cost of operation would vary ac-cording to the actual use of the car (here, anassumed 10,000 miles per year). You can seewhy this figure is sometimes called the vari-able cost: It varies with, or depends on, theamount of performed service. The constantcost, the cost of possession, $4634, is inde-pendent of the mileage performed. (And al-though it is also commonly called a fixedcost, it is not a sunk cost of a past act.) Thesum' of $2562 and $4634 is $7196, the totalcost, measured in capital value, of acquiring,

Table 10-2 EXPENDITURES AND COSTS FOR ACQUISITION, POSSESSION, AND OPERATION OF CAR FOR TWO YEARS

Expenditures

NowPresentValue

Purchase Price $8000

End ofFirst Year

End ofSecond Year

$8000Resale Value

Not driven 7400 $5000 4130Driven 20,000 miles 4400 3634

Tax and insurance 400 $ 400 764Gas, tires, repairs 1000 1400 2066

Costs1. Acquisition $8000

-7400$600

2. Possession for two years; zero mileage (that is, without operation)Current resaleFinal resale (present value)DepreciationTax and insurance

Acquisition and continued possession withoutoperation

$7400-4130

3270----.Z§1 4034

$46343. Operation (20,000 miles in two years)

(Extra depreciation because of mileage)

Gasoline, oil, tires, etc.Operation

$4130-3634

496

2066$2562 (13<e/mile)

4. Total costs of acquisition, possession,and operation $7196 (36<e/mile)

5. Driver labor cost ($1000 per month) $21,720$28,918 ($1.45/mile)


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possessing, and obtaining 20,000 miles of ser-vice from that car over two years. These dis-tinctions are important for answering suchquestions as whether to enter a given busi-ness, and, once you are in a business, how farprices ,can be cut if demand falls short of ex-pectations. If this car were to be used purelyfor personal uses, we could ignore the cost ofthe driver. But if it were used as a taxi, theannual labor cost of having a driver might be$12,000, or $1000 per month. The presentvalue of that series of payments over twoyears, at a 1070 interest rate, is about$21,720. (This computation of capital valuesinvolves a bit more arithmetic than used sofar, because receipts were previously as-sumed to be annual rather than monthly.)

We can now summarize the classifica-tion of acts and their costs for the two-year,20,000-mile output program of activity:

Acquisition: $600 or 3¢/mile.

Operation of car: $2562 or 12.81 cents/mile.

Each of these costs has more than one name,which requires that they be kept straight.We list their most common names:

Acquisition cost ($600): sunk; fixed.

Possession cost ($4034): overhead; con-stant.

Operating cost ($2562), or, including la-bor for a taxi ($2562 + $21,720 =$24,284): direct; operating; variable.

Especially ambiguous are the terms fixed,constant, and variable. When you see one ofthese terms, you have to deduce from thecontext what specific activity or cost ismeant. Or else ask the user.

DIMENSIONS OF OUTPUT

We now consider an important distinctionmentioned briefly before. Larger output canmean one of two things: either a faster rate

224 Chapter 10

of production for any unit of time (such asper day) or a larger tota/amount produced(regardless of the rate of production per unitof time). Larger output can also mean boththings simultaneously: If annual productionis increased from, say, 10 units to 15, a largervolume is produced at a faster rate (15 unitsper year instead of 10 per year).

Both components of output-rate and to-tal volume-help producers choose the ap-propriate production technique. SupposeGeneral Motors decides to produce 150,000units of a new economy car during the com-ing two years. Having planned a volume ofproduction for the two years, it has also nec-essarily picked an implied rate of production,that is, 75,000 per year over two years. Of themany different production techniques thatcould yield that output, the producer wantsthe one that costs least. After a productiontechnique is selected, time will be needed toassemble or adjust existing equipment, rawmaterials, and labor to it. The more rapidlythat is done, the more expensive it is. Thus,the producer is concerned with several di-mensions of output: its volume, its rate, andthe duration of its adjustment period.

First Production Generalization

The greater the planned volume ofproduction at an unchanged rate ofproduction, the lower will be the averageunit cost of output.

This generalization, commonly known asthe economies of mass production, says thatif automobiles are produced at a constantrate (say, five per day), the larger the totalnumber of that model cars produced at thatrate, the lower their average cost. Of course,producing a larger volume at a constant raterequires more time. Two main factors con-tribute to economies of mass production:First, large-scale (that is, large-volume) pro-duction techniques are not mere duplicationsof small-scale production methods. Producingonly 10 cars would be cheaper using a cus-

tom workshop technique, but producingthousands of cars would be cheaper on an as-sembly line. The cheapest technique ofpainting one car is to use a spray gun, ofpainting 1000 cars, to set up a paint bath intowhich the cars are submerged. But one couldnot construct a 1fl 000 portion of a paint bathunit to paint one car. The second factor ineconomies of production is that the more anactivity is repeated, the more likely will bet-ter ways of doing it be discovered and mas-tered. Improvement and learning by experi-ence are evident in managerial functions,production scheduling, job layouts, material-flow control, and manual dexterity. The rateof learning is usually greatest at first andthen diminishes as it approaches a plateau.

Second Production Generalization

For a given volume of production, thefaster the rate of production, the higherwill be the total, average unit, andmarginal costs.

A higher rate of production requiresmore input in a given period of time, whichincreases costs. Bringing in more resourcesleaves only successively more costly re-sources available for this kind of work. Andless time is available for the best methods tobe identified. Furthermore, resource ownersinsist on higher pay for overtime as moreleisure is sacrificed. Thus, even when thetotal volume of output is not changed, ahigher rate of production increases totalcosts.

Some producers plan production interms of definite lengths of time, so a largervolume of production during the period willrequire a higher rate of production. For ex-ample, a doubled volume in a fixed time re-quires a doubled rate of production. The neteffect on costs is impossible to generalize.Information about each situation must behad.

Another source of confusion in measur-ing output is the fact that many dimensions

of output are variable. What is the output ofa restaurant? Is it number of customersserved, tables available, amount of floorspace, items on the menu, number of waiters,speed of service, qugntity of food per serving,or the waiting time for a table? An airlinemay measure its supply by speed of planes,seats per plane, customer miles, number ofplanes, flights per day, cities serviced, and thelike. Which would you thinkan airline meantwhen it said it increased its output? In everycase, we must identify the dimension of out-put or supply that is of interest, and we muStconsider how varying that dimension affectscost-and how the demand for that particulardimension is expressed in a market price. Di-agrams and tables showing "Output" or"Supply" may make it seem deceptively easyto identify and measure the dimensions ofoutput. But it is a lot harder to know what ispertinent in a given situation.

JOINT PRODUCTSWITH COMMON COSTS

Many production processes yield several dif-ferent products at the same time; such prod-ucts are called joint products. Beef and hidesare joint products of cattle. A few other jointproducts are cotton yarn and cottonseed oil;kerosene, fuel oil, and gasoline; and butterand milk. They are interdependent in sup-ply. Producing more of one generally in-volves producing more of the other. Morebeef also yields more hides; more cottonyields more cottonseed oil. On the otherhand, for a barrel of oil to yield more gaso-line, there must be less fuel oil or keroseneproduced.

For joint products, a higher price for onewill lead to an increased output of the other:A higher price for cotton will induce a largeroutput of cotton and, thus, more cottonseed.

Yet, even for these joint products, moreof one can mean less of the other. Meat,hides, and fat are joint products, but they are


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substitutes in that different breeds of cattleyield different ratios among them. By select-ing different breeds and slaughtering at dif-ferent ages, one could change the ratio andget more hide and less meat or vice versa.Likewise, gasoline, kerosene, and fuel oil-allrefined from crude oil-can be obtained indifferent ratios by different refining methods.If only one of the joint products is of primaryeconomic interest, the other is often calledthe byproduct.

Impossibility of Apportioning Costs of In-put Common to Joint Products If twoproducts are produced jointly with a com-mon input, the cost of the common inputcannot be allocated to each of the joint prod-ucts. Because hides and meat are producedfrom one steer, the feeding and care of thesteer is a common input, or a common cost,to both products. What portion of the feedcost is the cost of the hide and what portionis the cost of the meat? If an airplane carriespassengers and cargo, what portion of thecommon input's costs of jet fuel, of labor,and of facilities is the cost of each? Commoninput costs can't be allocated, so one cannottell what the "cost" is of each product. Call-ing one product the by-product and assign-ing all the common costs to the "basic"product is simply a play on words maskingan arbitrary allocation. Things seem to fallapart at the "joints." But there is no prob-lem. How much of each joint product to pro-duce, or the ratio in which they should beproduced, can still be determined. For thatwe use marginal cost.

Measuring the marginal cost of changesin output rates of the joint products does notrequire any allocation of common costs. Todiscover the wealth-maximizing price andoutput mixture requires knowing only thechanges in total cost and total revenue thatfollow from changes in output. If the margin-al cost (including any increase in the total ofun allocable common costs) is less than the

226 Chapter J 0

marginal revenue from that extra output,that increase in output will be profitable;otherwise, it will not.

DEPRECIATION,OBSOLESCENCE,AND RESOURCE USES

Depreciation is the predictable, anticipatedreduction in the value of a resource as itsuffers predictable deterioration from use orfrom aging. Depreciation is a cost, eventhough it is neither a current expenditurenor an obligation to spend. The value of anasset falls when it is used, so by that use theowner is forsaking the alternative usevalues.

In contrast to depreciation are the unex-pected reductions in value caused by unan-ticipated developments unrelated to use, usu-ally because of a new, superior competingproduct. This reduction is called obsoles-cence. Unexpected improvements in compet-ing resources or products do not necessarilyidle the old assets. Instead, the value of theolder existing machine falls enough to reflectthe lower value of its continued use in theface of competition by the unexpected newinput. Old propeller-driven airliners suffereda loss of value (a sunk cost) when jet enginesbecame unexpectedly available, yet they stillfly economically.

To illustrate, let us suppose severalthings: Some existing machine can produce500 units of X before it falls apart; it depreci-ates in proportion to its use. Associated costsfor materials and labor are 20¢ per unit of X;the product sells for 30¢ per unit, so the non-machine costs are covered by a margin of 10¢per unit. The machine is then worth $50-500 units of potential output yielding 1O¢each over other costs-ignoring interest dis-counting for simplicity.

As luck would have it, a new machine isunexpectedly introduced. (We stress unex-pectedly because if the new machine hadbeen anticipated, the existing one would

have already been worth less than $50.) Thenew machine produces 1000 units before itfalls apart (its investment per unit of outputis IO¢ per unit), while its associated labor andmaterial costs are only l6¢ per unit, a total of26¢. As the new machine starts supplyingmore output to the market, the product pricefalls toward 26¢ per unit. The new machinewould sell for $100 because it yields a netprice over its nonmachine costs of IO¢ a unit.If the old machine still has 500 units of ser-vice left, its value, which was $50, would fallto $30 (equal to 500 units times 6¢, the ex-cess of the product's new lower price, 26¢,over its 20¢of nonmachine costs). It has suf-fered an obsolescence of $20. If the price ofthe product falls to 20¢, that excess of priceover nonmachine costs is wiped out. There isnothing left over the associated input costs togive any value to the old machine, and it willbe retired from use.

DEMAND FORINTERDEPENDENT PRODUCTS

You may have heard that demands for somegoods are not heeded because the goods mustbe used jointly with some other good thatwould first have to be produced by someoneelse. With that kind of reasoning, Congressenacted a law requiring every manufacturerof television sets to sell only sets that receiveall 83 television channels, from 2 to 84. Pre-sumably that law was passed because therewas not enough market incentive to makeall-channel sets, and until sets were made toreceive all 83 channels, there would be insuf-ficient incentive to telecast on the higher-fre-quency channels. A vicious circle?

The notion that the demand for suchproducts goes unheeded is supported by nei-ther historical facts nor economic analysis.Production and sales of automobiles, radios,and TVs did not wait for the construction ofgas stations or radio or TV stations. Nor didFM receivers wait for FM transmitters; infact, they became widely used despite laws

restricting FM broadcasting.' Stereo recordsand stereo players, frozen foods and homefreezers, color television sets and color tele-casting-all these pairs had different inde-pendent producers on each side.

How does a market economy overcomethis vicious circle whereby neither of two in-terdependent products is produced becauseeach requires that first the other be pro-duced? The answer is that the vicious circleisn't there in the first place. Productinterdependencies are not ignored. Special-ization implies that producers rely on otherpeople to produce jointly used products asthey mutually and independently seek oppor-tunities to increase their wealth. In fact, joint-ly used goods will be more effectively pro-duced if specialization is permitted than ifone firm must produce both of the interde-pendent products. Why, then, the belief thatthe open market is not itself sufficient induce-ment to produce jointly used products? ItComes from the mistaken notions that outputmust be carried out on a large scale from thebeginning, and that people are unwilling toinvest now in anticipation of future receipts,implying that present capital values are irrele-vant. But these suppositions are disproved byevents every day. A factory is built and othersquickly build homes and stores in the area.Only the person who ignores the incentivesand exchange opportunities in a marketplacewill fail to see the coordinated anticipatoryactivity.

3No law required-until 1974-radio manufactur-ers to make only FM-AM combination radios. As thedesign technology improved in the 1950s, FM sets be-came easier to tune, cheaper, and more reliable. Trans-mitters "magically" increased in number. For a longtime, the Federal Communications Commission pro-hibited color television broadcasts until it could decideon the "best" kind of color system. And when it decid-ed, it chose wrong! Fortunately, the Korean War fore-stalled production until the superiority of the electron-ic scan system became more obvious. (Guess wholobbied for FM-AM radio receiver requirements in1974?)


DEVELOPERS AND SPECULATORS:RISK-BEARING PREDICTORS ANDREPRESENTATIVES OF FUTURECONSUMERS

An especially instructive, yet misunderstood,example of anticipating and representing fu-ture market demand for goods that are as yetunproduced and undemanded is the specula-tive land and housing developer. Futurerenters and buyers usually do not order con-struction of their future homes. Instead, spec-ulative (that is, acting on foresight) develop-ers build in the expectation of those futuredemands. Suburban developers are chargedwith being interested in a quick dollar-atrue charge. But to earn that quick dollarthey must have accurately predicted futuredemands (for, say, houses, condominiums,and apartments) and made a timely responseto supply the product. The anticipated fu-ture demanders will move to the area. But ifyou could ask them if they would demandthose new buildings in the future, they couldhonestly say they don't know what their fu-ture demands will be. Dress manufacturersdesign and make dresses months in advanceof customers' demands, and hence they arespeculative clothing developers. Similarly,land developers are agents for expected butunidentified future buyers. Competitionamong current anticipators of the future de-mands of those unidentified people establish-es current capitalized value of that latent fu-ture demand. Speculative developers do notdrive up land values; it is th;~ anticipated fu-ture demand, which they are revealing as apresent value, that establishes the currentland values. (Understanding capital valuesimproves your ability to interpret some eco-nomic activities.)

SomePrieing TaetiesEconomic principles can explain some widelyused pricing tactics that are commonly mis-understood by the public, as is evidenced by

228 Chapter 10

allegations made in lawsuits about their unde-sirable effects on prices. Careful economicanalysis, however, often shows that thosepricing tactics are not correctly interpreted.

BASING POINT PRICING AND THEPHANTOM OF "PHANTOM FREIGHT' I

Recently, in the southeastern United States,a jury awarded over a billion dollars to cus-tomers of local suppliers of plywood. Thesuppliers were alleged to have conspired toovercharge their customers by including, inthe price of plywood produced in the South-east, an amount to cover "phantom freight,"as if that plywood had been shipped thou-sands of miles-from the Northwest, thedominant source of plywood.

Some facts are necessary to properly as-sess this case. First, most domestic plywoodcomes from the Northwest, primarily fromWashington and Oregon. Second, because ofcompetition among suppliers in the North-west, the prices in any city in the countrywill be the market-clearing price in that city.Third, no Northwest supplier will ship toany city that does not yield, after freightcosts, a net price, called a mill net price, thatmatches the mill net price from shipping toevery other city in the United States. Thatis, after subtracting the cost of freight toeach city, the producer would get just as higha mill net price in New York City as itwould in Los Angeles.

For example, if freight from the North-west costs $10 a ton to New York and $6 aton to Los Angeles, the price in New Yorkwill be $4 higher than in Los Angeles and$10 higher than in the Northwest. If the na-tional demand for plywood is such that theprice in New York is $100 per ton, the pricein Los Angeles will be $4 less, or $96. Fromeach city the mill net price is $90.

Now suppose the demand for plywoodincreases in Los Angeles, raising the pricethere to, say, $150 per ton. More plywoodwould be shipped there instead of to New

York, while the reduced supply in NewYork would raise the New York price. Thelarger supply to Los Angeles will have re-duced its price rise to, say, $140, while themarket-clearing price in New York will haverisen to $144, $4 more than in Los Angeles.And always the Northwest suppliers wouldbe receiving the same, uniform mill netprice from each city, now $134 ($10 lessthan the New York price and $6 less thanthe Los Angeles price).'

How would the Northwest suppliersquote their prices to customers? In NewYork a supplier could say, "The price is $4more than in Los Angeles, or $1 more thanin Chicago, or 30¢ more than in Pittsburgh,"and so on; in Los Angeles the supplier couldrecite a similar sequence of complicated al-ternatives. But the simplest, most direct wayis to say, "The price is the Northwest baseprice (the mill net price) plus transport toyour city." That is basing point pricing, withthe site, here in the Northwest, of the domi-nant supply to the entire United States beingthe basing point.

Derived DemandThe price at the basing point, the North-west, is not arbitrarily set first and then afreight charge added to it. Instead, the de-mand in each city attracts a supply from theNorthwest until the price in each city is thatcity's market-clearing price. Thus, the basingpoint price, or mill net price, is derived fromthe market-clearing price in each city. Theprices in all the cities will differ from one an-other and be tied together by the differencein the cost of transport from the prime

'A more general, but here unnecessary, statementrefers to mill net marginal revenue, rather than mill netprice. We are simplifying our example by assumingthat the marginal revenue in each city is equal to theprice. The distinction between the two measures willbe significant for other issues discussed in later chap-ters.

source of supply, the Northwest. They willall rise and fall together, while keeping thatrelationship among them. Obviously, quot-ing a basing point price does not mean set-ting or fixing a prjce. That price reflects thepattern and levels of competitive marketprices, by which each consumer in each cityis competing for plywood against every otherconsumer in every other city, and every sup-plier is competing against every other suppli-er, and all the suppliers in a given locationare receiving the same mill net price fromevery customer. ••

Derived demand for productive inputsis very important: The consumer valuationof a good determines the value that can beearned by (imputed to) its productive in-puts. Competition among profit-seeking sup-pliers to obtain those inputs drives up theirpurchase or rental price until that price ab-sorbs the value of their services. The moreplentiful any input, and hence the more ofthe final service or good produced with alower resulting market value, the lower thederived value of the input. The value of anyresource above any other resource is deter-mined by both the degree of its superiorproductivity and its supply relative to de-mand.

COMPETJTIVE INPUTVALUATION AND RICARDIAN RENTS

That greater value and higher income to pro-ductive resources is called Ricardian rent,because the value from their services isgreater than the value from other, less pro-ductive resources. The jury's decision in thecase against the plywood suppliers showed afailure to recognize the action of derived de-mand on the values of superior productiveresources.

Before applying the concept of Ricardianrent to plywood pricing, we first use it insimpler situations where the implications areeasier ~o see. Suppose you are a surgeon who


can remove an appendix as safely as any oth-er surgeon but in half the usual time. Sup-pose the standard fee for an appendectomy is$500. What price could you get for your ser-vices? Would it be the standard fee? Orwould it be half as much, because you takeonly half as long? The answer is that youwould get as much as people would offer forthe service; your service is as good as anyother surgeon's, if not better. Other surgeonsget $500 for the same service, so you couldnot get more and you would not have to ac-cept less. (The example could as well be ofan auto mechanic who can replace a trans-mission twice as fast as other mechanics andgets twice the hourly wage rather thancharging the customer half.)

Your fee would not be lower, becauseyour larger supply of services (that is, thesame service in half the time) does not in-crease the market supply enough to affectprices noticeably. For a half-hour's work youwould get what other surgeons got for anhour. You are twice as productive as theyare, with the same fee but twice the income.That higher income resulting from your su-perior productivity is Ricardian rent. In oth-er words, the basing point price, $500, is thefee of other surgeons-the dominant supply.

Now we come to the point of this analo-gy. Because you spend only half the timethat other surgeons spend on the surgery, Imight say, "You are getting paid too much.For a half-hour's work you are paid whatother people get for an hour's work. I con-tend you are getting paid for 'phantomtime' -for an extra half-hour that you didn'twork." I am assuming that your time is nomore valuable than any other surgeon's-anobviously false assumption. A surgeon ispaid for what is accomplished for the pa-tient, not for how long he or she takes to doit. Your services per hour are more valuablethan others', and you are paid exactly whata half-hour of your time is worth. You arenot overcharging the patient when you

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230 Chapter 10

charge $500. Value is not derived from Iabortime. To believe that it is is to commit theerror in the lebot theory of value: failing torecognize that though the final product mayhave the same value, its productive inputscan have different productivities. Competi-tion for the superior productive input willraise its value to that of its output (competi-tion from other inputs will keep it from be-ing even higher). Its superior productivitywill be converted into a higher income forthat input. This, again, is the law of deriveddemand: the absorption, through competi-tion, of the value of the final product by itsproductive inputs. Superior inputs get high-er incomes, Ricardian rents of superior abili-ty; their customers don't get lower prices.

Derived demand explains the differencesin incomes of superior lawyers, painters,computer programmers, lands for growingwine grapes, salespersons, musicians, and soon and so forth. The high incomes receivedby Moses Malone, Liza Minnelli, ReggieJackson, Ben Vereen, John McEnroe-eachof whom can produce a more valuable con-sumer service in the same time than the restof us-are not the result of overcharging fora deceptive phantom time.

Now let's apply these competitive mar-ket principles to the plywood markets. Anew source of supply developed in theSoutheast, obviously nearer than the North-west to southeastern customers of plywood.Because its location eliminates transportcosts to the Southeast, it is a superior sourceto southeastern customers. At what price,then, will the plywood produced in theSoutheast be sold there? No matter where itis produced, it will get a competitive pricethat clears the market in which it is sold,even though it doesn't have to be transport-ed so far-as faster surgeons or mechanicsget the same price per unit of output serviceas other surgeons and mechanics eventhough they don't work as long. Any timber-land located closer to the consumer will get arent equal to the transport cost avoided. The

owners of the southeastern timberland get alarger portion of the market price becausetheir land is nearer the consumer. The priceof plywood in the Southeast will not fall untilincreased production-no matter where itoccurs-increases the total U.S. supply andlowers prices in all cities. (Remember thatthe prices in all cities are tied together bydifferences in transport costs.)

Not until the total U.S. supply increasesenough to significantly lower prices in allparts of the United States will southeasternproducers' incomes be reduced. People willbid more for southeastern land on which togrow pine trees, or for the existing plywood-making machinery. They will bid up to thesavings in transport costs from the superior(that is, nearer-to-market) location of thatland or machinery. The timberland ownerand the owner of existing, installed plywood-making machinery get a Ricardian rent, a re-turn for superior location, until enough otherpeople imitate them.

Why, then, the jury's verdict against thesoutheastern suppliers? Apparently the jurywas confused by the way prices are quoted:A "Northwest base price plus transport" sug-gests that the Northwest price is set first andthen the price in each city is determined byadding on transport costs. But no matter howa price is expressed, we have seen how com-petitive forces actually set it: In any city themarket price, out of which producers gettheir mill net price, is the price that will at-tract enough supply to satisfy the amount de-manded at that price. The price in any citymust attract supply away from other consum-ers throughout the United States. No matterwhere the plywood is produced, the differ-ences of prices (more accurately of the mar-ginal revenues) among all cities will matchthe transport cost differences among thosecities, but the level of prices in those citieswill be as high as necessary to equate the to-tal amount demanded nationally to the totalamount supplied nationally. The land andmachinery located close to the customers in.

the Southeast would be highly demanded,with the result that it would become veryvaluable-exactly as the high price of land inNew York City is related to the high hoteland office rentals there, or as the fees to NewYork lawyers are the same whether the(equally good) lawyers were born in NewYork or incurred transport costs to comethere from Seattle.

Review and PrologueIt is worth emphasizing that the analyticalmodel used so far-the price taker market-is adequate to permit reliable analysis ofmany economic phenomena: response of pro-duction to present and anticipated consumerdemand; effects of taxes on product pricesand on earnings of inputs; the means of riskbearing; the role of property rights, and ofspecialization, in production; capital valua-tion of assets; the reason for "excess" capaci-ty and buffer inventories and some forms ofunemployment; effects of price controls; themeaning of costs and the distinctions amongmarginal, average, total, variable, and sunkcosts; the different roles of marginal and av-erage costs in determining output; the differ-ence between long-run effects and short-runeffects; international trade; the measurementof costs in terms of present, or capital, val-ues; why prices that appear to be below costsmay in fact be above costs; the distinctionbetween monopoly rents and Ricardian rentsof differential ability; and how profits are ob-tained and then absorbed by superior inputsand resources. The price taker model couldexplain such things as inflation, internationalfinance and foreign exchange rates, the mon-ey system, business fluctuations that createrecessions, and so on. However, many otherimportant phenomena are not adequately ex-plainable by this model. For some of those,the price searcher model-the topic of thenext chapter-is appropriate.


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SummaryI. A price taker is a seller who cannot change

the market price by changing the amount of-fered. That market price is one at which allof the price taker's supply can be sold.

2. The price taker's marginal revenue is equalto the price of the product, because theprice is constant regardless of how manyunits the price taker offers for sale.

3. Constant cost can mean either a cost thatoccurs at a constant rate per unit of produc-tion, or a cost that is sunk, that was incurredin the past and is no longer pertinent to anypresent or future decisions. The two arevery different: The first IS a true cost ofsome possible act; the second is merely a ref-erence to a past cost of a past act.

4. Variable costs are those that change if therate of output changes; they increase withlarger output.

5. Marginal cost is the increase in costs whenthe output rate is increased by a unit.

6. The wealth-maximizing output rate of aprice searcher is that rate at which the mar-ginal cost is brought up to equality with theprice.

7. Any income received by some resource inexcess of its operating costs but that doesnot cover its original (sunk) costs of produc-tion is called a quasi-rent. Whether a quasi-rent is received or not, the resource will con-tinue to be available-until it wears out, atwhich time it will be replaced only if aquasi-rent is expected.

8. The price takers' market price is determinedby the supply and demand in the market forthat good. The supply in that market is theaggregate output from all the price takers ateach possible price-output rates at whichtheir individual marginal costs are equal.

9. An output at which marginal cost equalsprice is often considered optimal in that thevalue of the extra output to consumers,

232 Chapter 10

measured by its price, just equals its margin-al cost.

10. The long run for the industry is that Inwhich all entrants who could earn a profit,or the competitive rate of interest, on theirinvestments have entered into production.The market price will be equal to the costsof entering and producing that product.

II. Any producers who think their long-run per-unit cost is less than the long-run price havemiscalculated their costs by undervaluingsome resource. If other people could identifythe resource responsible for those low costs,they would compete for it and bid up theprice, and hence its value and cost, untilthat former miscalculated or misforecastedvalue is corrected upward to eliminate theprofit prospect. This higher value of supe-rior ability is called Ricardian rent to supe-rior producers.

12. If demand falls, resources specialized to thisproduct will fall in value to what they areworth in their next-best activity. The re-source owner will accept a lower reward, atleast down to that next-best alternative,rather than not produce. When this pricefall of existing resources is brought about bya new supplier's increasing of the aggregatesupply, which lowers the equilibrium price,it is sometimes called predatory pricing un-der the mistaken impression the existing re-source is trying to drive the new one out,whereas in fact the increased supply fromthe new one is driving down the best priceavailable to the existing resource.

13. The effects of a tax on the production of agood depend on how readily the productiveresources can shift to making other goods atno less reward. If they can, the resourceslose nothing, and consumers must pay thefull amount of the tax; moreover, the smallersupply of the taxed good would raise itsequilibrium price. If any existing resourcescannot make such a shift, they will have totake a loss in order to retain their jobs,which remain better than any other option.In that case, consumers do not have to payall the tax.

14. A tax on just one or a few suppliers of a

good will not increase the price, becausethey cannot affect the total supply enoughto affect price.

15. The cost of any act requires a careful state-ment of exactly what act is being costed.Typically, the costs of obtaining title or pos-session or of operating some resource shouldbe clearly separated. And since these actscontinue over an interval of time, their costis best measured in capital value terms.

16. A firm's output can be measured as rate orspeed of output or as total volume. Thus,these two possible meanings must be care-fully distinguished when referring to a "larg-er" output.

17. Two generalizations can be made aboutcosts. First, the faster the rate of productionof any good, the higher the costs of what-ever amount is produced. Second, the largerthe amount that is produced at any givenrate, the lower the total cost per unit of out-put.

18. If some costs are incurred to produce twoproducts jointly, only the marginal costs ofeach of the joint products can be defined.Any costs that are common to both outputscannot be separately assigned.

19. Depreciation of a resource is the predictedreduction in value as the resource is used orages. Obsolescence is the unexpected de-crease in value because of new, unexpecteddevelopments. Sometimes obsolescence re-fers to the reduced value that was expectedto occur because of new, better products.However, any anticipated effect would al-ready have been computed into a lower pre-sent price of the resource.

20. Some products are interdependent in thatthe demand for one depends on the supplyof another. Nevertheless, each can be pro-duced independently insofar as the produc-ers anticipate that effect and invest in pro-duction of one of the goods, knowing otherswill also invest in the other good. The antic-ipated future effects are capitalized into pre-sent values of the currently produced re-sources that yield these interdependentproducts.

21. Developers, as speculators, are making in-vestments for which they expect sufficientdemand from future consumers to make theinvestments profitable. Some may buy a re-source and pre,.Yent it from being usedwastefully now, because they are betting itwill be more highly demanded in the future.

22. A classic example of misunderstanding ofbusiness practices is the common belief thatbasing-point pricing, with what is called"phantom freight," is a payment for servicesnot provided. In fact, what is called "phan,tom freight" is the higher value of more pro-ductive resources-usually those that savetransportation costs and thereby are paid forthe costs they avoid, as a form of Ricardianrent because of superior ability or location.

questions1. You own 1000 shares of General Electric

common stock. If you try to sell some, you findyou can get a price of $61 Y2 per share for all1000 shares. If you offer only 500 shares, you canget a price of $61 Ys-12Y2 cents more per share.If you sough t a price of $61 Y-t, you would sellnothing. Compute your marginal revenue as bestyou can with the given data. Is it close to theprice? Is the elasticity of demand for your shareshigh or low?

2. In a price takers' market, does the marginalrevenue of each seller approximate the averagerevenue (price)? Why?

3. Most elementary arithmetic books containthe following type of question: "Mr. Black, thegrocer, can buy bread for 15¢. What price shouldhe charge to make a profit of 50%?" Withoutworrying why Mr. Black should be content with50 instead of 500% profit, wherein does thisquestion ignore a basic economic fact of life?Suggest a formulation of the problem that willenable students to learn how to manipulate per-centage calculations without being taught erro-neous economics.

4. Explain why the marginal cost scheduleabove the lowest average variable cost is the sup-ply schedule of the firm in a price taker's market.


*a. What is the supply schedule of the firmin Table io-r:

*b. If price were $22, what would be therate of profits?

c. How Iowa permanent price would makethis firm stop production permanently?

d. How low could price be temporarilywithout making this firm suspend pro-duction?

5. "Marginal costs serve as a guide to howmuch of a good to produce, while average costshelp indicate whether to produce the good atall." Explain.

6. Are there short-run and long-run costs for agiven output program, or are there two differentcontemplated output programs, each with itsown cost?

*7. If in some industry there were 100 firms ex-actly like the one whose cost data are given inTable 10-1, what would be the industry supplyschedule-assuming a price takers' market?

8. The following describes the market demandin the price takers' market for 100 firms eachwith costs given in Table 10-1.

Demand Schedule

Price Quantity Price Quantity

450 19.20 810500 18.40 850560 17.60 900610 16.80 950660 16.00 1000710 15.20 1100770 14.49' 1200

, I 28.0026.0024,0023.0022.0021.0020.00

a. What will be the equilibrium price?b. What will be the rate of output at that

price?c. If price is somehow kept below that equi-

librium, what will be observed in themarketplace?

d. At the equilibrium price of the currentproblem, will new firms be attracted toproducing this good?

e. If new firms can enter this business, eachone having the same cost conditions as

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234 Chapter 10

firms already in the business, to what val-ue will the market price move? (Hint: Inthe long-run supply curve, price willequal average cost of each firm, includingentry of new firms. Assume all firms areiden tical.)

f. As new firms enter, what will happen tothe output of the existing firms?

g. What will happen to the costs of thefirms whose minimum average costcurves were lower? (Hint: What happensto the profits of those lower-cost firms?)

9. Suppose the average cost per unit of outputin producing an X is $5, where cost is interpret-ed as the highest sacrificed alternative use value.And suppose, if these resources were to be usedelsewhere, their sacrificed value of output here is$6. What will make these two different "costs"of the same resources converge to the samevalue?

10. "The open-market, capitalist system is a sys-tem of consumer sovereignty. Consumer prefer-ences determine what shall be produced and howmuch shall be produced." Evaluate.

11. Question eleven deleted.

12. A tax of 1¢ is levied on each pound of pea-nuts grown by farmers.

a. What effect will this have on the outputof peanuts?

b. How will it induce that effect?c. What will happen to the price of pea-

nuts?

d. Will the land on which peanuts aregrown fall in value-in view of the facts(i) that peanuts are grown from plantsthat must be seeded every year, and (ii)that the land can be used for othercrops?

*e. What will happen to the value of exist-ing machines used for harvesting, shell-ing, roasting, packaging, and crushingpeanuts? Why?

*f. Explain why these changes in value willnot be permanent even though the tax ispermanent.

*g. Does the temporary drop in value meanthat the wealth-reduction effect of thetax is only temporary? Why or why not?

h. The proceeds of the peanuts tax areused to finance purchases of this bookfor free distribution to college students.Who is paying for the books so distrib-uted? (The answer is not that those wholost wealth from the revised valuation of

I. existing resources are paying for books.That loss of wealth is not offset as a gainto anyone else.)

*i. Who gains what as a result of the taxand expenditure of the proceeds?

13. Suppose that the tax in the preceding prob-lem is levied against only one producer of pea-nuts.

a. What will happen to the price of pea-nuts?

b. To the output?c. To the wealth of the various peanut pro-

ducers?d. Whose wealth will be affected by this

tax?

14. Pittsburgh put a 20% tax on gross receipts ofprivate commercial parking-lot operators whileexempting competing publicly operated lots. In1975 the U.S. Supreme Court held the tax consti-tutional even though its enforcement may de-stroy particular businesses. The Court also con-cluded that, in any event, a shortage of parkingspaces in Pittsburgh would enable private lot op-erators to pass the 20% gross receipts tax on totheir customers. The burden of the tax thus willfall upon customers. Is the Court's economicanalysis correct? Explain.

Firm A Firm B Firm CMarginal Marginal Marginal

Output Cost Output Cost Output Cost

1 $1.00 1 $ .20 1 $ .102 1.10 2 .40 2 .153 1.20 3 .60 3 .204 1.30 4 .80 4 .255 1.40 5 1.00 5 is impossible6 1.50 6 1.20

7 1.60 7 is impossible8 1.709 1.80

10 1.9011 is impossible

15. Above are shown marginal cost data forthree firms, A, B, C, constituting the entire in-dustry producing X. Each firm acts as if it were aprice taker.

"a. Compute the supply schedule of this in-dustry. (Hint: At each possible price in-dicate the amount that would be mostprofitably produced by each firm. Thesum of those amounts gives amount sup-plied by the industry at each price.)

b. What is the general rule used to derivethe supply schedule for an industry com-prised of price takers? How does wealth-maximizing behavior by each firm yieldthat?

c. The amount supplied at each price bythe industry in the above example isproduced efficiently. What does thatmean?

16. Using the same numbers as in question 15for firms A, B, and C, reinterpret them as fol-lows: The "output" is now clean water. Eachfirm produces steel; it uses water and changesthe chemical content. To "produce" cleaner wa-ter requires some special cleaning action or thereduction of production of steel. Mill A couldclean one of the 10 gallons of water it uses,abuses, dirties, or pollutes at a cost of $1.00. Itcan do so either by cleaning the water after it isused or by reducing the output of steel in orderto not dirty that one gallon of water. In eithercase the cost of getting that clean gallon is $1.00of what could otherwise have been produced-in


line with the general definition and meaning ofcosts. Similarly, a second gallon per day could becleaned or not be dirtied at a cost of $l.l 0 more.The marginal cost of a second gallon of clean wa-ter is $1.l0. Similarly, the marginal costs of pro-ducing more gallons of clean water are given bythe remaining data for this mill and for the othermills in the appropriate columns. It is importantto understand that, by not using water (or by notabusing it), the mill is in effect producing cleanwater at a sacrifice of other goods (steel) thatcould be had if the water were in fact used. Or ifmore steel is produced and the water used anddirtied, then the costs are the costs of removingthat dirt. If the water is not dirtied (and the steelnot produced), then the value of the steel forsak-en (net of the other costs that are also involvedin making steel) is the cost of having more cleanwater.

a. The problem is as follows: If cleaner wa-ter is worth 75¢ a gallon, how many gal-lons of clean water should be "produced"or not polluted by these steel mills?Which mills?

b. If each mill were required to pay 75¢ foreach gallon of water that it polluted, howmany gallons would each mill use andclean before discharging water? Or howmany gallons of clean water would eachmill not use that it otherwise would have?

c. If, instead of a pollution fee of 75¢, pollut-ing water were simply made illegal,would that be better or worse? In whatsense? Assume clean water is worth 75¢ agallon no matter how much is involvedhere.

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236 Chapter J 0

d. Would it be better (than a pollution feeof 75¢) to tell each mill that it must cleanup 20% of its discharged water? Or thateach must discharge at least two gallonsof clean water?

e. What is the principle for the efficientamount of clean water?

f. If someone owned the rights to the waterand could sell it to users, would that af-fect the amount of polluted water?

g. Is pollution to be interpreted as any useof a resource without compensation to theresource owner, or is it "excessive" use-beyond what would be used if compensa-tion were required?

17. You have a machine that will produce Xs ata cost of $1.00 each (the sum of the labor andmaterials worth 70¢ per unit and depreciation ofmachinery of 30¢ a unit). The Xs sell for $1.00each. The machine, which is worth $300, is use-ful only for producing X. Someone invents a su-perior machine that requires onlN 40¢ of laborand materials to produce an X. That new ma-chine is put to use and the total supply of X in-creases. Because the demand is unchanged, theprice of X falls.

a. How far would the owner of the first ma-chine be able to cut price before shuttingdown production?

b. If the new machine could produce 1000units-each worth 90¢-before totallywearing out, what would it be worthnew? (Assume a zero rate of interest.)

Chapter II

Price8earcher~

Suppose a market in which products and sup-pliers are heterogeneous, that is, the samegood offered by different suppliers can differgreatly in the number and combination offeatures, the quatity of materials and work-manship, availability, and the like. Supposealso that there are costs to the consumer inobtaining prepurchase information aboutgoods and suppliers, and costs to consumersand suppliers in negotiating and enforcingcontracts. Finally, suppose that there are eco-nomic advantages to producing on a largescale, or volume. To analyze such a marketwe cannot use the price taker model; we mustuse a different model: the price searcher.

Market-PowerPrice Searchers

The corner grocer, filling station owner,druggist, clothier, restaurant owner, andGeneral Motors-all face a demand schedulesuch that they could raise their price per unitof a good without losing all their customers.Why wouldn't such firms lose every custom-er if they raised their price? Why would aprice cut not attract all customers from theother sellers?

PRODUCT INFORMATIONIS NOT COST LESS

No one knows everything about all goods.Seeking prepurchase information about theirexistence, location, ultimate performance, orthe asking prices by different sellers is notcostless. Shoppers squeeze bread, smellcheese, heft oranges, sniff perfume, shakewalnuts, pick grapes, slam car doors, bounceon mattresses, tryon clothes, feel cloth, butstill they are not sure. They read advertise-ments, ask for warranties, rely on the seller'sreputation and maker's brand name, use re-turn privileges, and sample and select frominventories.

237

Because prepurchase information abouta good is not costless or perfect, a buyer whosees identical goods available at differentprices will not automatically buy the lower-priced one. There is good reason to havedoubts about whether goods are really identi-cal: Such doubts prevent gullibility. Buyerssensibly do not switch immediately to anyseller who asks a lower price for what isclaimed to be the same good. Some of us sen-sibly don't incur the costs to find out wheth-er every lower-priced version really is equal.We weigh the costs and benefits of reducingour ignorance and decide that there is an op-timal, or acceptable, degree of ignorance.The lower the cost of information, the morewe want it; the more it costs, the less we re-quire. That is simply an application of ourfirst law of demand. Why else do we not ac-quire the information that would turn eachof us into first-class physicists, physicians,and mechanics?

Because not every consumer has thesame tastes and no consumer knows costless-ly the exact qualities of every good offeredby every supplier, some suppl iers will findthat a slightly lower price does not attract allconsumers away from other suppliers of es-sentially similar products, nor does a slightrise in price drive away all consumers. Somesellers, then, see a demand for their productsthat is negatively sloped with respect topnce.

The fact is that seemingly similar goodsfrom different suppliers aI;~ different. Fullyinformed customers will prefer one over theother and will not be willing to shift to a lessdesired product at the slightest increase inprice. Not ~ll customers will shift from beerto champagne at the slightest rise in theprice of beer or fall in the price of cham-pagne. And some would not shift from Budto Coors if the price of Coors were slightlylowered, nor from Apple to Radio Shackcomputers if the price of the Apple were re-tained.

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238 Chapter 11

BRAND NAMES: REDUCINGPREPURCHASE INFORMATION COSTS

One economical source of prepurchase infor-mation about the qualities of products is afamiliar brand name, with which the reputa-bility of the maker is associated. If a new orunknown producer claims its product is justas good, can you be sure? Kodak, AmericanExpress, Howard Johnson'S, and Holiday Innare names that identify goods and services ofverified, predictable standards of quality-not necessarily of the highest quality, but ofpredictable quality. For example, one well-known brand of canned food offers riper,tastier, and better-quality goods than doesanother brand, which sells for less. Bothbrand names are reliable predictors of differ-ent levels of quality. You may think the dif-ference in quality is not worth the cost-butthen you aren't the only consumer. Many ag-ricultural products such as lettuce, potatoes,tomatoes, squash, and onions typically haveno brand name, because their quality is rela-tively easy to detect at time of purchase.

More recently, as labeling has becomecheaper and shoppers' time has become morevaluable, reliance on brand names as a meansof indicating quality has increased. Morecommonly, the reputability of the retailer-whether for diamonds or meat-helps identi-fy the expected quality of unbranded goods.The more difficult it is to predict the qualityor performance of a good, and the more seri-ous the consequences of deviations from thequality expected, the more one will rely onthe reputation, the brand name, of the makeror the retailer.

A supplier has an incentive to producegoods of reliable, predictable quality insofaras the firm's performance will later be associ-ated with its name and thereby bring it re-peat or new customers. (If you doubt this, trybuying goods in communist countries wherestores and products are unbranded and goodsare sold simply as stockings, pickles, bread,or canned soups. One such experience willgive you a profound understanding of the

value of brand names to both consumer andproducer.)

Price and MarginalRevenue of a Price Searcher

A seller whose price depends on the amountoffered, that is, whose price will fall if moreis supplied and rise if less is supplied-is of-ten said to be a price searcher with marketpower. The market power consists of theseller's ability to affect his selling price bychanging the supply. How significant is theseller's market power? It is not limitless: Ifdemand is sufficiently low or the seller'scosts sufficiently high, that market powerwill not guarantee that costs are covered,much less that there will be a profit. Never-theless, the price searcher faces a largerrange of possible prices than the price taker.Such a seller must search to find what priceand quantity are most profitable.

Suppose a total daily supply of 20 gallonsof unusually good drinking water comes fromone well. (To keep the essentials clear, weassume at first that there are no costs of bot-tling and selling the water.) Assume the de-mand for that water is the schedule in Table11-1 (shown as a graph in Figure 11-1). Bysupplying only 3 gallons the well ownercould get a price of $18 per gallon, with atotal revenue of $54. Or, by announcing aprice of $17, the seller would sell one moregallon. The total revenue is then $68, only$14 more for selling one more gallon and not$17 (the price per gallon), because, to sellone more gallon daily, the seller lowered theprice on everyone of the 3 gallons formerlysold at the higher price. That gives back $3to existing customers. The increase in reve-nue, the marginal revenue, is only $14, eventhough the fourth unit sells for $17. In decid-ing how much to sell, the seller looks at mar-ginal revenue, not simply at price.

Selling 10 (or 11) gallons daily (10 X $11= $110) would maximize the owner's wealth.

Offering more than II galJons would reducetotal revenue: The marginal revenue wouldbe negative. Offering less, say, 9 gallons,would raise the price to $12 per gallon butwould reduce total revenue to only $108.

The seller refuses to selJ more than IIgallons even though its marginal cost is zero(remember, we are assuming production iscostless), which is less than the value to thecustomer of the unsold water-measured byprice, not by the marginal revenue. Any ex-cess of price over marginal cost (whic I ishere zero) is evidence of waste in that theconsumer values the available but unusedgallons at more than their cost. This discrep-ancy between price and marginal cost occursbecause the seller heeds marginal revenuerather than the price-which is greater thanthe marginal revenue. If demand is such that

Table ll-l

DEMAND FACING PRICE SEARCHER

Total MarginalPrice Quantity Revenue Revenue

$20 1 $ 20 $ 2019 2 38 1818 3 54 1617 4 68 1416 5 80 1215 6 90 1014 7 98 813 8 104 612 9 108 411 10 110 210 11 110 09 12 108 28 13 104 47 14 98 66 15 90 85 16 80 -104 17 68 -123 18 54 -142 19 38 -161 20 20 -18

Price Searchers 239

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20

15

10

-5

-10

$

Output

D

5

o

Figure II-I.

DEMAND SCHEDULE FACING A PRICE SEARCHER

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The "marginal revenue" indicates how much the seller'stotal receipts change when he sells one more (or oneless) by appropriately changing his selling price on all theunits he offers for sale, At any number o! units sold, themarginal revenue is less than the price (unless only oneunit is sold), It is the lower line, the marginal revenue,that the price searcher concentrates on, But we callhim a price searcher because he must search forthe optimal (the profit-maximizing) price for hiswares. And he can come closer to fiflding thatprice if he has a good estimate of his marginalrevenue,

240 Chapter 11

to sell more the seller must cut the price onall units, including those which were alreadyselling, then marginal revenue is less thanprice. However, if price could be reduced ononly the additional units sold while the first10 gallons maintained their old, higher price,the seller's marginal revenue would equal theprice. Later we shall investigate some waysof doing that. In fact, a reason for explainingthe price searcher's marginal revenue is toconvey an understanding of certain pricingand sales tactics, some of which have attimes been declared illegal despite their en-hancing output.

PRODUCTION COSTS

Although we now abandon the simplifyingassumption that there are no costs of produc-tion, the preceding implications remain un-changed, as we now illustrate. Table 11-2shows the daily costs of production as do the

Table 11-%

TOTAL, AVERAGE, AND MARGINAL COSTS ATDIFFERENT OUTPUTS (PLUS CONSTANT COST OF $26)

Total Average MarginalOutput Cost Cost Cost

0 $ 301 $ 37 $37,00 $ 72 $ 45 22,50 83 $ 54 18,00 94 $ 64 16,00 105 $ 75 15,00 116 $ 87 14,50 127 $100 14,28 138 $114 14,25 149 $129 14.33 15

10 $145 14.50 1611 $162 14.73 1712 $180 15.00 1813 $199 15.30 1914 $219 15.64 2015 $240 16.00 2116 $262 16.38 22

$

37 ATe

35 III\\\

30 \\\- 26

(/) 250 \o \- MeeC\l-(/)c::0 20U

16 ATeI

15 'Ave

10

5

o 2 3 4 S 6 7 8 9 10 11 12 13 14 1S 16 17Output

cost curves in Figure 11-2. We assume aconstant cost of $30 per day regardless ofoutput. The average cost and marginal costcurves are labeled ATC, AVC, and Me.

We assume that the demand conditionsfrom Table 11-1 are fully known to the seller(an assumption we later abandon). Figure11-3 plots these with the cost curves of Fig-ure 11-2. The demand curve and its margin-al revenue curve are DD and MR. The out-put that maximizes the firm's profit is fiveunits, each sold at a price of $16, with an av-erage cost of $15. The total profit is $5. Pro-ducing and selling a larger output (say, sixunits) would lower the price on all units, re-ducing the total profit. The output programof five units is profit-maximizing; .at larger

Figure 11·2.

RELATIONSHIPS AMONG CONSTANT COST,AVERAGE TOTAL COST (ATC), MARGINALCOST (MC), AND AVERAGE VARIABLE COST (AVC)

The average total cost (AVC) is equal to the sum ofthe average variable cost (AVC) plus the averageconstant, or fixed, cost, which diminishesas the fixed cost is spread over a larger output, resultingin a lower fixed cost per unit of output. Note that themarginal cost (MC) curve cuts the ATC and AVC curvesat their lowest points.

Price Searchers 241

'II', ,,

$26

20

AverageCost

10

5

oOutput

Figure 11·3.

PRICE SEARCHER'SPROFIT -MAXIMIZING OUTPUT AND PRICE

The difference between price and average total cost atthe selected output indicates the profit per unit. Totalprofit is that difference multiplied by the amount ofoutput. At the profit-maximizing output, thoughmarginal revenue is equal to marginal cost,price is greater than marginal cost.

242 Chapter 11

--outputs (six units or more) marginal costs ex-ceed marginal revenue. And price exceedsmarginal cost, with a resultant loss in con-sumer value, as shown in Figure 11-4.

Any price could be charged if the sellerwere willing and able to bear the conse-quences. For example, at a price of $18, onlythree units would be sold and profits wouldbe zero. At a price of $12, nine units wouldbe sold with a loss of $21. The seller couldn'tstand that. Market demand and cost condi-tions, along with a desire for wealth, forcethe seller toward the profit-maximizing priceof $16, for which the seller searches.

It is not uncommon for lawyers to saythat a price searcher has "market power" inthat the price can be set by the seller. How-ever, there is, in fact, very little discretionavailable, since the demand and cost condi-tions determine what is the profit-maximiz-ing (or loss-minimizing) price. The pricesearcher who is setting a price is reallysearching for that optimal price. (One shouldnot, as is often done, confuse "searching"with "determining.") This supplier refuses tomake extra units at a cost less than their val-ue to consumers (that is, the value to con-sumers as measured by the price-not by themarginal revenue of the seller). By heeding amarginal revenue that is less than price, theseller underproduces this good, in the sensethat the value of the extra product wouldhave exceeded the costs of producing it. Thisloss or waste is called monopoly distortion-not, however, because of a contrived restric-tion on other potential suppliers (which iswhat monopoly most commonly means), butbecause economists call any price searcher amonopolist.

Demand Changes andEffects on Output and Price

For price searchers, the effects of a change indemand or costs are basically similar to thosefor price takers. Increased costs will raise the

cost curves and reduce the supply, resultingin higher prices; increased demand will tendto result in increased output at a higherprice.'

SHORT-RUN RESPONSE

Suppose demand increases. The profit-maxi-mizing price and output are higher, produc-ing larger profits. But which increases first,price or output? And by what process? Earli-er we explained how a changed demand im-pinges on sellers: Retailers keep buffer in-ventories to stabilize prices and providequick availability of goods. A persisting high-er demand will reduce those retailers' inven-tories. As retailers attempt to replenishthem, wholesalers' and manufacturers' inven-tories will decrease. When manufacturers'inventories fall, they will increase produc-tion. To do so requires that they employmore resources, which they obtain by offer-ing higher wages, with higher costs and high-er prices. Economic analysis has not ade-quately identified all the factors that willexplain precisely the speed of response ofoutput relative to price. But one factor thatmakes the output typically rise before pricesis the difficulty of getting reliable signalsthat quickly distinguish persisting from tran-sient demand variations.

When demand fluctuates transientlyaround some long-term average, market pricewill not do the same. Changing price instant-ly in response to every transient demandfluctuation would lose a retailer customers.Sellers instead provide steady, predictable

'We say tend to result in a higher price and largeroutput, because if the demand increases but at thesame time becomes twisted toward significantly greaterelasticity, the increased demand may then result inlarger output and a lower price. Conversely, if the de-mand increase is associated with a twisting of the curvetoward significantly less elasticity, a smaller output andhigher price may result. These appear to be highly ex-ceptional cases and will therefore be ignored. And inany event, although they may occur in the short run,the long-run tendency is toward the normal result.

$

20

Lost Consumer ValueThrough Excess

of Price OverMarginal

Cost

15

10

5

oo

Output

Figure 11·4.

LOSS IN CONSUMER VALUE FROMEXCESS OF PRICE OVER MARGINAL COST

Restricting output to where marginal costequals marginal revenue loses someexcess of consumer value over costof production.

Price Searchers 243

Ilidl

,I, I. I .,

. I '

prices by maintaining buffer inventories offinished products or standby capacity to filltransient, reversible differences between therate of current purchases and the steadierproduction rates. Production can in themeantime be carried on more economicallyat a relatively constant rate that maintainsthose buffer inventories.

The cheaper it is to provide stable, pre-dictable prices and reliability of supply bybuffer inventories and reserve production ca-pacity, the more likely a demand increasewill affect output before price. The morecostly are such inventories or adjustments ofoutput, the more likely a demand increasewill affect price before output. This distinc-tion is especially important in the analysis ofeffects of aggregate, national demandchanges. A general, economy-wide demandincrease or decrease for all goods will in-crease or decrease output and employmentbefore prices.

:1

, ill',!~I:

1

',1,1I·.1 .,.'.

LONG-RUN CAPACITYRESPONSE TO DEMAND CHANGES

When demand increases, existing firms ex-pand. But they cannot conceal their in-creased wealth for long. Sales personnelknow who is doing well; the word getsaround. Other firms imitate this firm. Man-agers leave and organize their own company,taking part of the company's know-how.Hundreds of firms have been created by for-mer employees of older computer companies.If the production of electronic organs, of pi-anos, of Cokes, or of Arrow shirts becomesmore profitable, other suppliers or formermanagers will produce close substitutes anddissipate the profit of the first producer.Competing producers bid up prices of re-sponsible resources: assemblers, supervisors,designers, production engineers, salesper-sons, managers, and research staff. Formerlyundervalued inputs are paid more, absorbingthe profits into costs. This is as true for land,

244 Chapter 11

buildings, and labor-whether the labor bethat of plumbers, managers, or teachers-asit is for resources owned by a business. Eventhe business owner's own services must bevalued at a higher figure, because the moresuch a person can earn elsewhere for thosesuperior services, the higher are his or hercosts of continuing in the present business.Thus, after disequilibrating shocks andchanges in demand and supply conditions,events tend toward the zero-profit, long-runequilibrium. But each new event changes thesituation, so there are always some new in-stances of profit and loss as profits and lossesof older events are being competed away.The zero-profit equilibrium for price search-ers is shown in Figure 11-5.

If demand falls, the direction of adjust-ments in price and output are reversed. Val-ues paying for resources in current uses fall,according to how immobile or specializedthey are. Resources will be shifted to wheretheir service values are not so low. All re-sources whose values are affected will bepoorer, because consumers' demands fortheir prior services are lower. To keep themat their old jobs at the former income wouldrequire compelling consumers to continue tobuy things they no longer value so highly.And that can't be done in a private-propertysystem. But it can be done if sufficient politi-cal authority can be exerted to control whatconsumers can or must buy or support byspecial taxes to subsidize the less demandedproducers-a topic we shall explore later.

Seller's Searehfor Wealth-MaximizingPriee, Output, and Quality

If people had better knowledge of future de-mands and costs, outputs would be adjustedtoward their wealth-maximizing levels morequickly. Profits or losses would be smaller, be-cause the future use values of resources wouldbe more correctly figured into current values.

The revaluation process and search for futurehigher-valued products are characteristics of aworld of uncertainty, partial ignorance, andcostly information, which is not to be con-fused with stupidity or irrationality. Produc-er-sellers must feel like gamblers at the race-track: A horse will win, but which one?

Consider the problem faced by a compa-ny that proposes to design a jet airliner it be-lieves will be a good replacement for theBoeing 737. What price and what scale ofproduction should it plan? This is preciselythe kind of question faced by Lockheed withits L-lOll and by Douglas with its DC-lO.Boeing had earlier calculated sufficientlywell to get a profit on the 737. How close itwas to the profit-maximizing price no onewill ever know, but the demand for the Boe-ing 737 did lie above the cost curve for a re-gion that Boeing managed to find. If the de-mand curve for the L-lOll ever did lie aboveits cost curve, Lockheed wasn't able to findwhere. If management had known, theywould have saved their stockholders millionsof dollars. Apparently Douglas was no luck-ier with its DC-IO.

Ford misjudged the demand for the Ed-sel and lost millions but guessed right (thatis, profitably) with the Mustang. GeneralElectric invested in computer design andproduction and produced poorer stockhold-ers. Chrysler designed automobiles in the1950s for which the demand curve was underthe average cost curve and lost at least $100million. Not even the alleged consumer ma-nipulations by advertisers could adequatelysway buyers.

On the other hand, Kodak sacrificedlarge profits in grossly underestimating theenormous demand for its Instamatic cameras.Hewlett-Packard underestimated the demandfor its hand-sized electronic computers, al-though they made some profits. Not only thegiants display uncertainty, ignorance, and er-ror. The grocer, druggist, and clothier mustdecide what products to stock. Farmers mustguess next season's price in selecting what

$

AC

D1

Output

Figure ii-5.

LONG-RUN EQUILIBRIUM

Profits to some firms induce other firms to enter intocompetition. The effect is to divert some sales from theinitially profitable firms, reducing demand for their outputfrom 0, to O2 (at the same time that increasedcompetition for inputs drives the firms' costs up). Thecombined downward shift in demand and upward shiftin costs eliminates transient profits (at which demandcurve is tangent to average cost curve). Price is thenequal to average cost (and marginal revenueequals marginal cost).

Price Searchers 24S

crops to plant now. Students must select ca-reers. Only in knowing the present marginalrevenue does the price taker have an advan-tage over the price searcher.

Consumers reliably reveal their demandsonly after they are actually offered newgoods. Producers propose; consumers dis-pose. Transistor radios were invented andproduced without consumers giving potentialproducers advance orders. The same is truefor many, many products: stereo and quadra-phonic sound systems, video recorders, elec-tronic musical instruments, power steering,computers, miniskirts, automatic transmis-sions, color television, Frisbees, instant cof-fee, frozen foods, credit cards, electronicwatches, cordless electric knives, no-iron fab-rics, synthetic fibers, stretch clothes, coin-op-erated-dry-cleaning machines, water-basedpaints, fiber-point pens, and so on. In eachcase, the hope of greater wealth provokedsomeone to risk wealth in producing somenew item.

Survival ofBest of Actual Activity

The preceding discussion has profound im-plications that should not be overlooked.Business people are investors who do notread tables of known costs and demandschedules to select their wealth-maximizingoutput. Instead they willingly invest and risktheir wealth in estirnatingror trying produc-tion techniques, products, and outputs, hop-ing they really will have sufficiently lowcosts and high demands to yield a profit. Ifyou ask them about marginal costs and mar-ginal revenues, they are likely to wonderwhat you are talking about. To invest in ex-actly the best production technique or themost profitable product, let alone the mostprofitable price and output, is a gamble.

What the principles of economic analy-sis do is show how underlying factors deter-

" II

246 Chapter J J

mine what can or cannot continue to be doneprofitably. We can discern in what directionnew input prices and demand would affectthe profitable output. Competition betweensuppliers with different production tech-niques eliminates the poorer and retains thebetter. Untested techniques or products maybe still better, but we won't know. (If youthink other techniques should be tested, whoshould bear the risks of failure?)

Economic analysis does not assume thatthe producers zero in on exactly the bestproduction opportunities and achieve maxi-mum profits. Economic analysis uses themaximum profit and wealth criterion, be-cause the closer a business firm is to that out-put and price, the more profitable it will be,the more rapidly it can grow, the morewealth it will create, and the more wealth so-ciety will permit it to control. What we areable to do by economic analysis is to revealhow external events affect demand and sup-ply conditions, and how the competitive pro-cess selects surviving firms and products.

Monopoly:Open- and Closed-MarketPrice Searchers

The price searcher is often said to be a mo-nopolist because he or she is faced with anegatively sloped demand, meaning that atevery amount sold, marginal revenue is lessthan price. However, as suggested earlier,monopoly has another, very different mean-ing. It is the condition of a seller who is pro-tected by legal sanctions from any other sup-plier whose offerings would reduce thedemand for the protected seller's goods.(This topic is treated in Chapter 13.) Suchmonopolists have both a negatively slopeddemand curve and legal protection from po-tential competitors. Only when both condi-tions are present do we use the term monop-oly. By contrast, we use the term pricesearcher to describe any seller (a) with a neg-

Consumer'sTotal

Marginal PersonalPrice Quantity Revenue Revenue Value

$1.00 1 $1.00 $ 1.00 $1.00

.90 2 1.80 .80 1.90

.80 3 2.40 .60 2.70

.70 4 2.80 .40 3.40

.60 5 3.00 .20 4.00

.50 6 3.00 .00 4.50

.40 7 2.80 .20 4.90

.30 8 2.40 .40 5.20

.20 9 1.80 .60 5.40

.10 10 1.00 .80 5.50

atively sloped demand curve (that is, with amarginal revenue significantly below price)and (b) without legal restrictions on competi-tors. The effects of restrictions are very dif-ferent from the effects of differences in tastesand of products of different sellers not beingexactly the same, as we shall see later.

SomePriee SeareherPrieing Systems

Price searchers, as we have seen, are sellerswho face a negatively sloped demand, withrespect to price, for their products.

And so do protected monopolists, as wehave also seen. However, though pricesearchers and monopolists have negativelysloped demand schedules, their effects on theopportunities of customers are different. Thedifferences lie in the fact that, by definition,the monopolist has managed to have restric-tions imposed on competitors. Although boththe price searcher's and monopolist's pricedepends on that supplier's output, the pric-ing arrangements can differ. Thus, everynegatively sloped demand must be examinedto see whether it results from diversity

Table 11·3 DEMAND OF ONE CONSUMER

among products and sellers, and the exis-tence of information costs to consumers, orwhether it results from restrictions imposedon potential competitors.

MULTIPART PRICINGTO ONE CUSTOMER

Some selling devices and pricing systems al-low sellers to reduce the price on only theextra units, rather than on all units sold. Wenow examine some devices designed to in-crease the seller's profits and some that alsolead to expanded output. Although we try toidentify their side effects, these are of noconsequence to the seller and are beyond thescope of economic analysis to determinewhether they are "good" or "bad."

Table 11-3 presents the demand sched-ule of one customer facing a seller. Columnthree is the seller's total revenue at each pos-sible price; column four is the marginal reve-nue. Column five, which gives the custom-er's total personal use value at each quantity,is important in this pricing tactic, called two-part, or block, pricing. For simplicity, we as-sume the marginal cost of production is con-stant at 30¢.

Price Searchers 247

I'JI II

: II I,

I

,I ['I

$1.00

.80~~~~--------P1 =70¢

.60

.40 ~55.dR~==P2= 40¢~ ---- Me = 30¢

.20

With Single Price: With Two-Part Pricing:

~l Gains to Buyer F>q Extra Gains;.;.;.;.;.to Buyer

~ Producer's GainsmExtra GainslaW to Producer

Figure 11·6.

EFFECT OF MULTIPART PRICING ON DISTRIBUTIONOF GAINS OF TRADE BETWEEN BUYER AND SELLER

If seller could charge a single price to the buyer, whocould then buy any amount at that price, the price wouldbe 70¢, and the gain to the buyer would be the shadedarea above that price and under buyer's demand line.(This price cold be charged because marginal revenuecrosses and falls below marginal cost of 30¢ beyond fourunits. Compute the marginal cost and verify.) If sellercould then charge a lower price, say, 40¢, for anyadditional units, on the condition that the first four aresold at 70¢, the seller could sell three more units for atotal of seven, getting additional profits of 10q: on each,while the buyer gets the extra personal value underbuyer's demand line and above the price of thosethree units. (Can you construct another set of pricesthat would get the same output but, with almost allthe gains going to the seller? Hint:"Try setting thefirst price at 99¢ and then construct a seriesof prices for subsequent amounts.)

248 Chapter 11

--If the price is set at 70¢, the price that

maximizes the seller's profits ($1.60), theamount demanded and supplied (four units)equates marginal revenue and marginal cost(30¢). But suppose it were possible to cut theprice only on extra units sold, not on all, sothat the first four units continue to sell for70¢ each, but the customer can buy more ata bargain price of 40¢ each. Hence the termtwo-part, or block, pricing. The customerwould buy three more at 40¢ each, giving theseller a net gain of 10¢ (40¢ - 30¢) on eachof the extra three units sold, raising the sell-er's total profits by 30¢, to $1.90. The buyeralso benefits by getting three units more.The buyer values them successively at 60¢ +50¢ + 40¢, though paying only 40¢ each-again worth 30¢. (The customer and seller areindifferent as to whether the third 40-centitem, the seventh in total, is purchased.)

As Figure 11-6 shows, this two-part, orblock, pricing system improves the seller'ssituation, because lowering the price only onextra units causes no loss of revenue on theformer rate of sales. Such a loss would haveoffset part or all of the revenue from the ex-tra units sold. Certainly this two-part priceschedule is better for both buyer and sellerthan a single price at 70¢, even if it is not asgood for the buyer as a single low price of40¢ on all units-but the seller would notagree to such a price, anyway.

Consider a multipart price schedule inwhich every unit has a different price. Startat the first unit and go right down the de-mand schedule as follows: The price is 95'¢for the first one, 85¢ for the second, 75¢ forthe third, and so on down to 35¢ for the sev-enth, and last, unit, barely over its marginalcost. The buyer, given no other way of buy-ing this good, would reluctantly agree, be-cause that is better than not buying at all.Now the seller has captured almost all thetotal use value of the product, gaining all thearea under the demand schedule and abovethe marginal cost. The seller nets 65¢ (95¢ -30¢) on the first one, 55¢ on the second,

down to 5¢ on the seventh. The total dailynet is $2.45 (= 65¢ + 55¢ + ... + 5¢). Theseller (assuming he or she knows the buyer'spersonal valuation schedule) has managed toget from the buyer almost all that each unitis worth. Because of these greater gains fromexchange, the seller's earnings are larger:$2.45 instead of the $1.90 from the two-partschedule. The buyer's gain is only 5¢ on eachof the seven, totaling 35¢: less than the 90¢consumer's surplus at the single 70-centprice. This per-unit, block-pricing system is aneat one if the seller can use it. You may be-lieve you've never seen such a system in ac-tuality, but it's no different from charging afixed price of $4.00 for a package of seven,because you must buy seven or none.

How Should the Gains of Greater Ex-change Be Shared? Whenever it takes theform of two-part pricing or the price differsper unit, multipart pricing increases the ex-tent of beneficial trade and gives more of thegains to the seller. But economic analysiscannot answer the question about distribu-tion of gains, whether the producer or theconsumer should get more of the gain. Yetsome people argue that there is a proper di-vision, which occurs if every seller and buyeracts as a price taker. For example, if therehad been only a single price equal to margin-al cost, more of the total use value wouldhave gone to the consumer and less to theproducer. Of course, no price searcher wouldhave set a single price at its marginal cost. Ifa single price had to be set, it would be oneat which the seller estimates that the margin-al cost would be matched not by the pricebut by the marginal revenue at the amountdemanded.

Because the price of extra units exceedstheir marginal cost, the seller would like tosell more, but not if the price on all unitsalready saleable also has to be cut. At thebest single price (70¢ in our earlier example)the seller's profits would be $1.60; but by us-ing two-part pricing and producing more

until the value, or price, of the last unit soldwas closer to marginal costs, the seller got aprofit of $1.90. This was obtained becausethe extra units could be sold without theprices on the units already salable having tobe cut. The per-unit, multipart pricing sys-tem yielded profits of $2.45. (And, as we shallsee later, if a good were to be sold at a singleprice equal to the marginal cost of 30¢, witha tie-in of something else priced as high as$2.80, then as much of the good would beproduced as if the seller were a price takerselling at a price equal to the marginal cost.)

Why the division of gains associatedwith a single price that equals marginal costsshould be right and proper has never beendemonstrated. Although that output resultsin the efficient amount of production and ex-change of this good, so does multipart pric-ing, if the last price equals marginal cost.The two pricing systems differ only in howthey divide the gains from trade betweenbuyer and seller.

Multipart Pricing Does Not Imply Subsi-dies among Customers If a seller offers dif-ferent multipart pricing schedules to differ-ent customers, it does not necessarily followthat the high-price customers are paying for,or subsidizing, the services to the low-pricecustomers. However, in some cases, publicregulatory commissions require that a goodor service be provided to some customers atprices below the seller's marginal costs. Thecosts must then be subsidized by some othersource, such as by taxes or monopoly rentsearned in sales to other customers. For exam-ple, mail service to many rural areas is atprices below costs, and the difference is cov-ered by funds from other sources. No privateproducer would persistently sell to customersat a price below cost. (Giveaways and freetrials do not contradict this statement. Theycommunicate information about products topotential customers, and so are an invest-ment that the seller hopes to recover in fu-

Price Searchers 249

ture business with customers who liked theproduct they sampled.)

Feasibility of Multipart Pricing Multipart(block) pricing is feasible only if two condi-tions are satisfied: (1) The seller must be aprice searcher; that is, the demand for theseller's products must have a sufficiently neg-ative slope, so that marginal revenue is sig-nificantly below price; and (2) customersmust be unable, either by law or because it istoo expensive, to engage in arbitrage-buy-ing a good at a low price and selling it toothers at a higher price for a profit.

The term cream skimming is often usedto describe the tactics of a competitor whoundercuts the high-price units of a seller whois (a) using a multipart pricing schedule or(b) charging some buyers more than others.(Without such pricing, there would be nohigher-price customers.) Almost every publicutility offers successively lower prices forhigher rates of use. Electricity, gas, and wa-ter users who are given lower prices on suc-cessively larger blocks of power are facing amultipart, decreasing pricing schedule. Theutility company is getting more revenuefrom the customers than it would get at asingle price. (Ever try to resell power andwater?) Xerox offers lower prices for largervolumes of use, charging a high price for thefirst batch of copies and successively lowerprices for successively larger batches. Lowerprices for large blocks sometimes reflecthigher setup costs for small.runs, but that isnot the case for any of the examples cited.

Is there anything inefficient about a mul-tipart pricing system? There can be, if somecustomers pay higher last prices-that is,marginal prices-than do other customers.The lower-last-price buyers would use theelectricity, gas, or water in less valuable waysthan would the higher-last-price buyers. Forexample, if I, as a householder, pay 10¢ for akilowatt hour, whereas you (industry) payonly 6¢ for your last kilowatts of power, that

'r, ! ,

250 Chapter J J

--power is worth more if used by me than if byyou. My extra uses are more valuable thanyours, which create a social waste of about 4¢per kilowatt hour. Such a waste is not creat-ed by every multipart pricing schedule, onlyby one in which we are not both getting mar-ginal units at the same marginal price.

A power company using multipart pric-ing could try to tailor a separate multipartprice schedule for each customer, so that ev-ery customer's power use brought marginalpersonal value down to the seller's marginalcost of producing power for that customer,say, 6¢ per kilowatt hour. Although theschedules could differ among buyers, everyschedule would end with units sold at a priceequal to the buyer's marginal cost. Therewould then be no waste-no uneconomic re-striction of output-although some or allbuyers of electric power would pay morethan if all buyers paid a single price equal tomarginal cost.

Why do government-owned or -regulat-ed public utilities use multipart pricing? Themunicipally owned utility company is part ofthe government and can use multipart sched-ules as a taxing device to appropriate some ofthe gains from trade. Privately owned, for-profit utilities are likewise encouraged to usemultipart pricing schedules, because theirlarger earnings can be absorbed by higher tax-es on utilities. Governments prevent compe-tition that would foil these pricing methods.

TIE-INS

Division of Consumer's Surplus A tie-in isan offer to sell a good at a given price on thecondition that the buyer also buy anothergood at a stated price. As an example, let uslook at what at first may seem an absurd situ-ation. We use the demand situation de-scribed in Table 11-3. Suppose, as before,the seller can produce units at a marginalcost of 30¢. Suppose, further, that the sellersets a single price of 30¢ on each unit sold

but refuses to sell any unless the buyer,agrees to also buy something else-say, yes-terday's newspaper, at the "exorbitant" priceof $2. This tie-in may seem like a ridiculousoffer, but if the buyer were faced with theoption of getting none or buying the good at30¢ per unit, on the condition that someworthless thing also be bought for $2, thebuyer would agree rather than get none. Thebuyer would buy up to eight units and get aconsumer's surplus of 80¢ [= $5.20 - (30¢ X8) - $2]. Refusing to buy yields no benefit-no consumer's surplus.

The tie-in can be profitable becausewithout it the total value to the buyer ($5.20)exceeds the cost at 30¢ each by $2.80 [= 5.20- (30¢ X 8)]. The buyer would have gotten aconsumer's surplus of $2.80. So we know theseller could have asked as much as $2.80 for aworthless tied-in item, making a total priceof $5.20, which is what the buyer will pay foreight rather than have none at all. In a tie-in,then, the prices of the items are separatelymeaningless. Only the sum of the two pricesis relevant, and only that is compared to thebuyer's total personal valuation for the twoitems.

Why discuss these apparently differentways to accomplish the same thing-gettingas much as possible from the buyer? It is im-portant to see that multipart pricing and tie-ins are essentially the same, because the U.S.Supreme Court, misled perhaps by their su-perficially different forms, has frequentlyclaimed that they have different effects.They thus have declared one form, multipartpricing, legal and the other form, tie-ins, ille-gal. For example, it was argued in the Courtthat tie-ins extended a monopoly in the tyingitem (the good demanded by the buyer) intothe market for the tied item (the old newspa-per in our earlier example). But it does noth-ing of the sort. It merely uses the tied item asa vehicle for collecting more of the total con-sumer use value of the tying item. The tieditem need not be something of no value tothe consumer (like our old, worthless news-

paper): The seller might just as well have in-sisted that the customer buy the same num-ber of Cokes he or she normally buys, butnow from this seller at a price sufficient tocapture the same •.amount of total consumeruse value, $2, as the tying item. The sellerwould then be buying Cokes from the Coca-Cola Company at the normal price and sell-ing them to the customer for the payment ofthe $2 consumer's surplus of the tying item.Thus, tie-ins do not necessarily extend anymonopoly into the market of the tied item".

Interbuyer Discrimination One use of tie-ins is to enable sellers to calculate the differ-ent total personal use values of their variouscustomers for the tying good, so that they,the sellers, can try to capture more of it thanthey could get with a single price to all buy-ers. That is, each seller must identify the dif-ferent areas under the different demandcurves of its customers. For example, IBMhas patents on a valuable computer and spe-cial abilities to produce and service it. IBM isa price searcher. It faces a negatively slopeddemand for its products. To capture more ofthe total use value of its products and ser-vices to different customers, IBM must solvetwo problems: First, how can it learn eachuser's total personal use value for IBM com-puters, so that it knows the unique fee orprice appropriate to each user? Second, howcan it prevent arbitrage (resale of machinesamong customers), which would upset a dif-ferential fee system?

There may be a way. Of IBM's custom-ers, suppose A has a very high demand for acomputer and B has a low demand; that is, Aplaces a high value on it, B a low value. Ifeach customer's demand for some other goodis highly correlated with its demand for thecomputer, a solution may be available. Sup-pose A is a large firm and B is a small firm; Auses a lot more machine punch cards in itscomputer than does B. If, as a prior conditionto renting computers to customers, IBM re-

lPrice Searchers 251

qui red each customer to buy all their punchcards from IBM at a higher price than theywould otherwise pay, the customer wouldagree rather than not have an IBM machineat all. How much more would the customerbe willing to pay to get an IBM machine?Obviously, up to an amount that equals thefirm's total use value of the computer (thearea under its demand curve for the comput-er over the price of the computer). If thecomputer's value to the customer is correlat-ed to the number of cards the customer uses,then by requiring the customer to buy all itspunch cards from IBM at a price higher thanthe market price, IBM would have measuredand captured, indirectly, some of the con-sumer's surplus of total use value of the com-puter. This tie-in arrangement favors thesellers if the assumed correlation of tied totying item is correct and strong enough. Tie-ins, then, distribute more of the gains of spe-cialization and trade to the supplier.

IBM's tie-in scheme does not create anymonopoly rent in cards: The higher cardprice extracts from the buyer more of whatthe machine is worth. Nor is IBM monopo-lizing or driving any card producers or sellersout of business. IBM could simply havebought from existing suppliers the cards thatit sold to its customers. It should be notedthat there are other purposes of tie-ins, suchas assuring proper machine servicing andmaintenance, which a company might con-sider inseparable from its reputation for pro-ducing reliable, superior machines. In fact wedo not know what motivated IBM in its tie-in arrangements.

Expenditures made solely to capturemore of the consumer's surplus might be re-garded as wasteful, because they affect onlythe distribution of wealth rather than pro-duction. If so, it should be carefully notedthat the Court does not declare it illegal toget a larger share of the product value fromthe buyer by using superior bargaining tac-tics, supplying more information about alter-

252 Chapter 11

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natives, and the like. Apparently, the Courthas been misled by differences in the formsof such tactics and has failed to see that theyall-those declared legal and those declaredillegal alike-have the same effect.

Quality Protection Gasoline stations oftenmust buy tires, batteries, and accessoriesfrom gasoline producers if they are to getgasoline; computers and software are oftentied in; Xerox and A. B. Dick mimeographeach require purchase of their own ink, sten-cils, and paper for their machines, claimingthat they are more appropriate. And theymight be right: Inferior ink and materials canfoul up the machine, and if these items aresupplied by different suppliers, the user willnot know who is responsible for a malfunc-tion. No one supplier will accept such re-sponsibility unless that supplier alone sup-plies all the interrelated components.

Circumvention of Price Controls Anotheruse of tie-ins is to overcome price controls.During price controls on gasoline, sellers of-ten required that to get gasoline you had tobuy a lube job. Thus, despite the limit on itsprice, they captured more of the value of thegasoline. (They did not monopolize the lubebusiness.) Still another tie-in can be identi-fied: Many retailers pay rents on their build-ings and land that are a percentage of theirretail sales. A retailer with big sales, who istherefore presumably a higher valuer of thepremises, pays more than a retailer withsmaller sales, who is presumably a lowervaluer of the premises. This tie-in of rent tosales might be a way for the owner to cap-ture more of the renter's value of the prem-ises, but it might also be a way of sharingrisk in the value of the premises. In eithercase, the owner of the premises could haveachieved the same effect by requiring the re-tailer to also buy from the owner all thewrapping paper, or delivery service, or creditservicing, or any other goods or services thatare correlated with the amount of sales. Yetthat tie-in scheme would probably be de-

clared illegal, whereas basing rent on per-centage of sales is legal and extremely wide-spread.

Free Services Recall the price searcher ear-lier in this chapter who has a demand curvewith a marginal revenue that is less than theprice, at that output at which marginal costequals marginal revenue. This seller wouldlike to sell another unit, if the price could becut on the extra unit only, but not on any ofthe units already salable at the current price.One way to do so is to offer the buyer of thatextra unit a gift of something else-withoutoffering that gift to the other buyers. Thegift cuts the net price to the buyer by theamount of its value to that buyer. The sellergets less, the price minus the cost of the gift;but as long as that net price exceeds the sell-er's marginal cost, the seller will make someextra income. So the seller tries to find newcustomers by the device of offering them,and only them, a free tie-in.

We can illustrate: Table 11-4 repeatsthe numerical demand data from Table 11-1.At an output of five units the price is $16,the marginal revenue $12, and the marginalcost $11. Suppose a hotel operator (the seller)can attract a sixth customer from the localairport, without cutting the $16 price onrooms to other customers, by offering thenew customer a free ride from the airport.Assume the customer would pay only $15 fora room if he or she had to pay the $2 taxifare to the hotel, for a total of $17. With thisspecial offer, the customer pays $16 to thehotel and gets something worth $17: the ho-tel room, which, remember, is valued at only$15, plus the $2 taxi ride. All customers pay$16 for a room. The seller's marginal reve-nue by getting another occupant with this of-fer is $14, instead of $12, because the price of$16 was not cut to any other customers. Afterdeducting the cost of the taxi, the hotel own-er has $14: a gain of $2 over the $12 marginalcost of a room to the sixth customer. Thegains to the sixth customer ($1) and to the

seller ($2) total $3, which is exactly the for-merly wasted difference between the $15 val-ue of the extra unit and its marginal cost of$12. Although all current customers do notget these "free" services, they also do notpay extra for the new customer's use ofthem. The new one pays a lower price-butpays enough to cover marginal cost.

Other means of accomplishing the samething include free parking, free credit cards,free delivery, free warranties, return privi-leges, the extra time of clerks and larger in-ventories for "picky" and "choosy" custom-ers, advertising, loss leaders, giveaways, andtrading stamps. "Free" services do not neces-sarily raise consumers' costs. Whether theydo depends upon how many of the old cus-tomers use them. If every old customer used

Table 11·4

DEMAND FACING PRICE SEARCHER

Revenue

Price Quantity Total Marginal

$20 1 $ 20 $ 2019 2 38 1818 3 54 1617 4 68 1416 5 80 1215 6 90 1014 7 98 813 8 104 612 9 108 411 10 110 210 11 110 09 12 108 28 13 104 47 14 98 - 66 15 90 - 85 16 80 -104 17 68 -123 18 54 -142 19 38 -161 20 20 -18

Price Searchers 253

Table 11·5 PRICE DISCRIMINATION BETWEEN TWO SEPARABLE CUSTOMERS

Customer A Customer B

Marginal MarginalPrice Quantity Revenue Quantity Revenue

$12 1 $ 12 0 $ 011 2 ,-' 10 0 0'-

10 3 8 0 09 4 6 0 08 5 4 1 87 6 2 2 66 7 0 3 45 8 - 2 4 24 9 - 4 5 03 10 - 6 6 -22 11 - 8 7 -41 12 -10 8 -6

every free service with every unit purchased,the effect would be equivalent to a price cuton every unit sold, and this scheme wouldnot work.

PRICE DISCRIMINATIONAMONG CUSTOMERS

Another means of increasing a seller's profit,one entirely separate from tie-ins, is for aseller to equalize the marginal revenue fromall its customers. Suppose a seller has twoseparate classes of customers, A and B, withtwo different demand schedules, shown inTable 11-5. The supplier can make six unitsat a constant marginal cost of $6 a unit and atotal cost of $36., At the same price to bothclasses of customer, $8, A buys five and Bbuys one, yielding $48 in sales revenue and$12 in profits.

The supplier can do better if: (1) the cus-tomers with different demands can be identi-fied; (2) the supplier accordingly chargeseach class of customer a different price; and(3) each customer finds it too expensive to

254 Chapter 11

resell the goods to other customers. Onlythus can the seller practice price discrimina-tion: selling at different prices to customerswith different demands in order to bringmarginal revenues into equality. In our ex-ample, the supplier should set a price of $9to class-A customers, who buy four, and $7 toclass-B customers, who buy two. The totalrevenue is $50. Costs are $36 and profits$14-$2 more than with a uniform price. Atthose two different prices, the marginal reve-nues from each class of customer are equal,at $6, and are equal to the $6 marginal cost(see Figure 11-7).

If you think our seller could increase rev-enue by selling fewer units to the $7 custom-ers and the same number more to the $9 cus-tomers, you are forgetting our assumptionhere that the price must be cut (to $8) on allunits. Selling one more unit when all unitsare at a lower price, $8, increases sales re-ceipts by only $4, the marginal revenue. Butthe marginal revenue in the B market is $6,which adds $2 to total revenue. That ex-plains the difference between the total reve-nues of $48 from a uniform price and $50

from discriminatory prices (at equal marginalrevenues). Clearly, it is not prices but mar-ginal revenues that the seller compares inthe quest for greater earnings.

Price discrimination among customerscan be tried by any seller whose customersare identifiably different and who find it tooexpensive to resell to each other. Those sell-ers who are at the clearest advantage are le-gal monopolies, for they are protected by lawfrom other sellers who might cut price, andeven from customers who might try to resell:railroads, milk producers, the postal service,and the telephone company, to mention afew. In each of these cases, although thecosts of service to each buyer are the same,the price charged depends upon who the cus-tomer is or what the item is that is to beshipped by rail or post.

Legally protected monopolies are notnecessary for all kinds of price discrimina-tion. Some motels charge lower prices tocommercial than to noncommercial clientsfor exactly the same rooms and services. Be-cause commercial travelers have moreknowledge of alternatives, their demands aremore elastic, more sensitive to anyone sell-er's price; thus the marginal revenue fromthem is closer to price. It is also probablethat, in any country, native residents pay lessthan tourists do for many goods. Rich per-sons usually pay more than others for surgi-cal services (which are not resaleable), but onthe other hand they may get superior service.Lawyers sometimes charge different fees forthe same service to different customers. (Butagain, are the services the same?) The matterof quality difference is difficult to settle andshould make one cautious in gauging what ishappening. Hertz and Avis have discounts tospecial customers. Colleges give larger schol-arships (tuition price cuts) to the better stu-dents, who are also sought by other col-leges-that is, students whose demand for aparticular college is more elastic. Does yourcollege bookstore give a discount to facultybut not to students?

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PRICE DIFFERENTIATION BYEQUALIZING MARGINAL REVENUE

Any seller, whose uniform price (Po) to different buyersresults in unequal marginal revenues among buyers, couldincrease profits by changing prices so as to make allmarginal revenues equal, as seller has done, above, byraising the price to class-A consumers to DA andlowering the price to class-B consumers to PB' The twoshaded areas show the gains from selling more at PB

and the marginal losses avoided by selling fewer atDA than were sold at Po. This price differentiation iscalled price discrimination. If it is to be successful,lower-price buyers must not be able to resell tohigher-price buyers.

Price Searchers 2SS

In any event, price discrimination doesnot require legal restrictions on actual or po-tential competition from other suppliers. If asupplier were able to separate its customersonly by some legally imposed restriction ontheir right to buy from other suppliers or toresell to each other, then the excluded poten-

. tial suppliers would be prevented from usingtheir resources in the ways of highest valueto the public. That effect of a legal restric-tion should not be confused with, or attribut-ed to, price discrimination, which may occurwithout legal restrictions on other people.

Effects ofDifferent Pricing Systems

Because consumers would buy more of agood if the producer charged a price equal tomarginal cost, the producer seeks to makesure that marginal revenue, not price, equalsmarginal cost. The producer, then, does notproduce enough to bring its value to consum-ers, its price, down to the marginal cost. Isthere, as there seems to be, a social loss, orwaste? That underproduction, called monop-oly distortion, would be a genuine wasteonly if there were an economically worth-while way to avoid it. If it were the result ofa legal monopoly, presumably a change ofthe law could repeal the monopoly. (Butwhat is the cost of getting the law changed?And what were the reasons for the legal mo-nopoly?) Often, even where there is no pro-tected monopoly, information costs, transac-tion costs, and economies of scale may beinvolved. Because no economically efficientalternatives to these are known, the under-production is not a waste or an inefficiency;like wintry cold, it is economically unavoid-able.

If two customers face different prices,and one is prevented, by other than econom-ic costs, from buying in the lower-price mar-ket, there is an allocative distortion among

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customers. Both the lower- and the higher-paying customers would be better off if theamount supplied could be reallocated by thelower-paying customer reselling to the high-er-paying. But if they could in fact resell, noone would pay the higher price, so the sellercould no longer sell at different prices.

As we have seen, one possible way toovercome both of these sources of monopolydistortion-price discrimination and pricesthat exceed marginal cost-is multipart pric-ing, wherein the seller's marginal revenue onthe last unit sold to each buyer is equal toboth the selling price and the seller's margin-al cost. Such multipart pricing affects the dis-tribution of the gains from specialization andtrade.

PRICE DISCRIMINATION?

We should recognize by now that the termsdiscrimination, monopoly, and competitioncan be readily misunderstood. Yet the Rob-inson-Patrnan Law of 1938 prohibits "pricediscrimination" if it tends "to create a mo-nopoly, lessen competition, or injure compet-itors." We should not be surprised that theconfusion created by that terminology hasoccasioned considerable and continuous legalaction that has raised costs to business firmsand their customers.

Another classic example of misinterpre-tation of "discrimination" is that in which arailroad charged more to ship goods fromNew York to Denver than for the longer dis-tance from New York to San Francisco. Thisseems discriminatory against people in Den-ver. Why did those rates exist? The railroadsfrom New York to San Francisco had to com-pete with transport by water via the PanamaCanal. There was no low-cost competition toDenver.

What a seller can get for his or herproduct depends not on what it costs, but onwhat the interaction of amount supplied andmarket demand determines the price shouldbe. The supply of cheaper transportation to

San Francisco from New York is much largerthan to Denver at any given price. Naturediscriminated in providing a superb harborat San Francisco and none at Denver. Tocorrect this "injustice," the law compelledrailroads to charge no more to Denver thanto San Francisco. Unable to raise the SanFrancisco rail rate because of competitionfrom the cheaper water transport, railroadshad to lower the rate to Denver. Had Den-ver instead been the destination of mostfreight, its rate would not have been cut.Then the San Francisco rate would havebeen raised, because the railroads wouldhave preferred to lose some of their smallSan Francisco revenue rather than reducethe larger Denver revenue. In that event,fares would still have been equal in dollarprice, but San Francisco would suffer in thecause of the equality.

Sometimes, joint products (those havingcommon inputs and hence inseparable costs)sell for very different prices. Long-distancetelephone demand is higher in the daytimethan at night, so night phone rates are lowerbecause, although the supply is constant, de-mand is smaller. If night demand were thelarger, night rates would be higher than dayrates. The relative level of rates dependsupon the relative size of the demands to berationed.

Is it "fair" that night workers are able tomake long-distance calls more cheaply? Thattheaters should charge less for matinees thanfor evening performances? That paintings in-volving the same production costs should sellfor different prices? These disparities arisebecause of differences in the demand for thegood or service, reflecting differences inavailability, convenience, or, as perceived bythe buyer, in quality. Why doesn't the per-son paying a higher price instead buy in thelower-price market? Because using the lower-price market is not worth the sacrifices (likemoving to San Francisco from Denver, orworking nights rather than days in order tosave on long-distance calls).

Summary1. Price searchers face steeply negative de-

mand schedules in response to price; thus,marginal revenue is significantly less thanprice. Some preducers are price searchersbecause of economies of scale in production,administration, and marketing, or because ofdifferences in tastes and the costs of ascer-taining the characteristics of goods from oth-er suppliers.

2. Brand names on products reduce informa-tion costs to consumers by indicating qualit··.

3. Inventories, price stability, price-searchingactivity, and advertising are typical featuresof price searchers' markets.

4. Because of transiently fluctuating demands,price searchers keep inventories to assure apredictable price and ready supply.

5. A seller who perceives marginal revenue sig-nificantly below price will produce only towhere marginal cost equals marginal reve-nue rather than to where it equals price-itsvalue to consumers. This is called monopolydistortion (in that the marginal cost of an-other unit is less than its value to consum-ers).

6. Though price searchers may "administer"their prices, the sustainable price is deter-mined by demand and supply conditions,not by the seller's arbitrary decision.

7. Because sellers who are protected by con-tri ved restrictions on competi tors are typi-cally like price searchers in having a margin-al revenue less than price, price searchersare sometimes called monopolists. However,the presence of restrictions in one case andabsence in the other is an important distinc-tion that prevents one from concluding thatthe two must be essentially similar.

8. Some price searchers can use pricing devicesthat are not usable by price takers and thattend to overcome the so-called underproduc-tion by price searchers who sell only anamount at which the marginal cost equals

Price Searchers 257

the marginal revenue, rather than the higherprice. These include price discrimination,multipart pricing, tie-ins, and giveaways,which often are used in order to achievesales to customers who value the product atmore than the marginal costs.

questions*1. a. Can you suggest some goods for which

the brand names are of no significance?What about sugar, flour, soap, aspirin,tires, dog foods, bread, milk, soap, cornflakes, cigarettes, canned peaches, banks,beer?

b. Obviously you will not agree that allthese are examples of goods whose brandnames are insignificant. Are any? If so, doyou purchase without regard to brand?

c. If not, what do you mean by an insignifi-cant difference?

d. What makes you prefer one brand overanother at the same price?

e. Can you name any good and two of itsbrands for which you believe no one inhis or her right mind could have a "good"reason for preferring one over the other?

2. Answer the following questions concerningthe demand schedule below.

a. Complete the data for total revenue, mar-ginal revenue, and average revenue.

b. What happens to the difference betweenselling price and marginal revenue?

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RevenuePrice Quantity Total Marginal Average

$20 2 $40 $2019 3 57 $+:~7 1918 4 72 +15 1817 516 615 714 813 912 1011 1110 129 13

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Chapter 11!!h,

c. How many units would you want to pro-duce and sell if you could produce asmany as you wanted at an average cost of$8 per unit and if you wanted to maxi-mize your net receipts? (Hint: What ismarginal cost?)

d. What price would you charge?e. Could you charge $18 if you wanted to?

What would be the consequences?f. What are the consequences of charging

$14?

3. On a television interview a prominent theat-rical producer expressed delight that tickets forhis play had been sold out for the next fourmonths. Explain why he might have cause to bevery sad, rather than happy.

*4. Change the data in Table 11-1 as follows:From every indicated "quantity purchased" ateach price, subtract 6. If the new number is nega-tive, simply call it zero.

a. Recompute the total and marginal reve-nue.

b. What is the new wealth-maximizing out-put for this producer if he has zero costs?

c. What is the new wealth-maximizing out-put for this producer if his marginal costis $8 at every output?

5. Is it true that for some products you preferone brand over the other' if both have the sameprice, but if there is any price difference betweenthem you will take the lower-priced one?

*a. If this is true for some goods, does it sug-gest something about the basis for or"strength" of your preference?

b. Would you say that you "discriminate"among brands?

c. Is that "justifiable" discrimination?

*6. Two brands of bacon, one nationally knownand the other a local store brand, sell for $1.79and $l.39, respectively, in the local store. Bothare in fact of the same quality and are packed bythe same packer. Noting this fact, a televisioncommentator says that when you buy the moreexpensive brand you are paying for the advertis-ing. Explain why consumers who buy the moreexpensive brand are not paying for advertising.

*7. In France, Italy, Spain, and Hong Kong, in-dividual bargaining over the price of a good iscommonplace.

a. Would you prefer that custom to be morecommon in the United States than notbargaining?

b. But on second thought, can you namethree goods that are commonly purchasedin the United States by bargaining?

c. How would you explain the simultaneouspresence of two different customs?

*8. Compare and evaluate the following twoassertions:

a. "Advertising and brand names create im-pressions of differences among competingbrands where no significant differencereally exists. As a result, because of con-sumer ignorance, sellers face a less elasticdemand and can raise price without los-ing all sales to competitors. Creation ofimpressions of significant product differ-entiation by advertising is a social waste."

b. "Advertising and brand names permitcustomers to know more surely, cheaply,and fully the differences among variousproducts. Otherwise, customers would se-lect blindly, letting the price differencebe their only reason for choosing one overthe other, much as people would choosepurely on the basis of price among super-ficially identical goods. By identifyingproducts and their makers more fully pri-or to purchase, brand names and advertis-ing permit customers to be more, not less,discriminating about qualities with lesscostly investigation into product details.Hence advertising and brand names thatmake demands less elastic because theyidentify more fully differences in productand quality assurance are a social bene-fit."

9. "General Electric announces a new l l-inch,12-pound portable television for $99.50." "Paper-mate pens are sold at an announced price of$2.00." "Sunbeam appliances are sold at retailprices set by the manufacturer." Explain why theabove statements do not imply price setting bythe seller. That is, explain why the prices werenot instead, say, three times as high.

10. Using the data of Tables 11-1 and 11-2, sup-pose that your costs of production are changedby a reduction in the cost of materials or labor so

labor so that at every output your marginal costsare $5 less.

a. What will this do to the marginal costschedule?

b. What will be your wealth-maximizingprice and output?

c. What are your profits?

11. Suppose a $5 tax is levied on your business-an annual license tax of a flat $5 regardless ofhow much you produce.

a. What will be your price and output?b. What is the amount of your profits?

12. As a superior student you provide a tutoringservice. The higher the price you decide tocharge, the fewer the hours of work you get.

a. Are you a price taker or a price search-er?

*b. Assume that your time, when you arenot tutoring, is worth an equivalent of$2 an hour. The daily demand for yourtutor services is not perfectly predict·able; it varies at "random" around amean rate of daily demand which de-pends on the price you can charge. If, atthe price you charge, you find that allyour available time is always used, andthere are occasional applicants whomyou must reject because you are fullybooked up, do you think you are charg-ing the wealth-maximizing price? Ex-plain.

*c. If you are charging a price at which youoccasionally have idle time, are youcharging too Iowa price?

*d. Given a fluctuating demand, how canyou be sure that you have charged the"right" price?

13. In what sense can the marginal cost curve ofa price searcher be considered a supply curve?

14. Let the demand schedule of question 2 rep-resent the characteristics of the demand for yourservice as a gardener, and suppose you sell in aprice-searchers' market.

a. What price should you charge per gardento maximize your daily net receipts if the"cost" of caring for a garden is zero?

h. If your time is worth the equivalent of $3

Price Searchers 259

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per garden maintained, what price wouldyou charge?

c. Is this the "highest" price the traffic willbear, the highest price possible, the low-est price possible, or a "reasonable"price?

* 15. "Much advertising is deceitful, dishonest,misleading, fraudulent, and disingenuous. There-fore, it should be subject to government regula-tion." If you accept that conclusion, would youaccept the same conclusion for daily conversa-tion, political talks, lovers' pleadings-which aresubject to the same charges? Explain why or whynot.

16. The makers of the better hearing aids try togive their retail agents territories that are rela-tively large so as to separate their customers.They also state the price at which agents mustsell. This use of exclusive selling territories andof "price fixing" has usually been called illegal-though more recently the courts have begun todeclare them legal. What would justify thecourts' saying the practices are legal? If GeneralMotors has a policy of territorial protection forits dealers, how might that be justified as "social-ly desirable?"

17. "Decades ago there were scores of producersof goods; today there are a few large firms, soconsumers now have fewer sources of supply.This is one of the disadvantages of large firms."Evaluate.

*18. The average number of newspapers in acity has decreased to virtually one or two, fromthe four or five from a couple of generations ago.Has this reduced the number or quality or vari-ety or raised the costs of sources of news to aperson in a city with fewer -newspapers? As amental exercise try to formulate an argumentthat the decrease in the average number of pa-pers in a city is the result of an increasing num-ber and variety of alternative news sources .What are you inclined to believe-with yourslight evidence?

19. Price discrimination between two marketsconsists of selling in one market at a price belowthat of another. That is also called "dumping"into the low-priced market-a very misleadingterm. The actual purpose is simply to equate

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260 Chapter 11

marginal revenues, as explained in the text. Yetsome observers allege the reason is that the selleris trying to drive some other competitor in theclass-B market out of existence so this seller canlater raise prices. No such objective is involved.Finally, it is argued that the seller must be sell-ing below cost in the class-B market, or else howcould the seller's price be lower and still covertransport costs?

a. Show how.b. Show that even if it cost 25¢ to ship a

unit of the good from the factory-locat-ed where all the class-A customers are-to class-B customers, profits for the pro-ducer would increase despite the fact thatthe selling price is $2 less for class B cus-tomers than for class A.

c. Would the seller ever sell at a price be-low costs-marginal costs?Note: Just a few examples of "dumping"favorable to American consumers are Bel-gian glass; Japanese, German, and Italiancars; Polish golf carts; Korean textiles;Japanese steel; and tuition grants by col-leges.

20. Some colleges charge high tuitions, but atthe same time they give a large number of tu-ition fellowships ranging from full tuition pay-ment down to practically nothing. If you applythe principles of discriminatory pricing tech-niques of an earlier chapter, can you show thattuition grants are a form of discriminatory pric-ing of education? Does that make them undesir-able?

21. An attempt to impose losses on competitorsin order to achieve a monopoly position withsubsequent "above-competitive" prices would bea predatory action. A case frequently alleged tobe a predatory action involved Rockefeller'sStandard Oil Company in the nineteenth centu-ry, when Standard's low prices in selected localmarkets were interpreted as devices to bankruptsmaller refiners. Would this be an intelligent tac-tic-that is, wealth maximizing-even if no lawprohibited it?

22. You are a producer of computers, but to dis-tribute them to the public you first sell them to adistributor who in turn retails them to the pub-lic, whose demand for the computer is given bythe data in Table 11-1. The retail distributor

may choose the reselling price to the public thatis best for the distributor. As the producer, youhave a uniform marginal cost of production of $4each, regardless of how many you produce.

a. Show that the price you should chargethe distributor is about $12.50. Howmany will the distributor buy at thatprice, and what retail price will in turnbe charged?

b. Show that you, the distributor, and thepublic could be better off if you requiredthe distributor to not charge the publicover $13. According to the law a retailprice limit is illegal as being presumablyanticompetitive because it does not al-low the distributor to decide what priceto charge for what he or she has boughtfrom you. Who loses because of that in-terpretation of the law? (The situationdescribed in the example is faced bysome newspaper publishers.)

*c. Can you think of any of several otherproducts for which this example helps toexplain why some firms tend to be verti-cally integrated (that is, where a firmdoes manufacturing, distributing, and re-tailing)? (This is not the only reason forvertical integration.) The problem illus-trated in this question is known as theproblem of "successive monopoly."

23. Suppose you, the seller, have six units of agood available. At any price you ask of A youmust let him buy all he wants, and you must per-mit B to have all she wants at the price you askof B; but the price asked of A and B can be dif-ferent.

Units Demanded Marginal RevenuePrice A B A B

$10 1 0 $10 09 2 0 8 08 3 0 6 07 4 0 4 06 5 1 2 65 6 2 0 44 7 3 -2 23 8 4 -4 02 9 5 -6 -21 10 6 -8 -4

a. What price should you charge A, andwhat should you charge B, if you want tomaximize your revenue?

b. If you charge the same price to bothbuyers, what is your best price and reve-nue?

c. Suppose you can produce this good at acost of $2 for each unit you make. Howmany should you make, and what priceshould you charge to A and what to B inorder to maximize your net earnings?How many will A buy, and how manywill B buy? What will be your net earn-ings? ~.

*d. Construct an example of multipart pric-ing with different sets of prices to eachbuyer, so as to get still more revenuethan with the preceding policy. Why doyou think this kind of multipart plus dis-criminatory pricing is relatively uncom-mon? Can you give some examples of it?(Hint: Check the water, telephone, gas,and electric rates charged in your com-munity; what prevents new sellers orcustomers from reselling to each other inall these cases?)

*24. You invent a photocopy machine. Youknow that the average cost of making the ma-chine is $1000 and that its operating costs are 1¢each time the machine is used. You could sell themachine for, say, $2000, letting users pay the 1¢operating costs. On the other hand, if you candiscriminate among customers, and charge somea higher price than others, you can make stillmore money. In order to make discriminatorypricing effective, you must not sell machines tothe users, for they could then resell them fromthe "low-priced" to the "higher-priced" custom-ers and undermine your attempt to get more rev-enue. Suppose, however, you rent the machine toeach user at a uniform fee but charge 3¢ eachtime the machine makes a photocopy.

a. Would that achieve your purpose? Ex-plain.

b. Selling at different prices is illegal; 3¢ percopy is legal. Why?

c. Is this kind of "discrimination" good?

Price Searchers 261

Coalitions, Collusion,Cartels, and Firms: AnExereise in Names

Chapter 12

CompetitionHDlongthe Fe",

If the owners of the entire supply of re-sources used in the making of a productcould agree to restrict the output of theproduct, they would reap greater income.For reasons we examined in Chapter 9, thisincrease in income is called monopoly rent.(Recall the example, in Chapter 11, of theten water sellers: Each sold one gallon of wa-ter at a price of $1 a gallon; but each wouldbe made wealthier by cutting output in halfand selling only half a gallon at $5 a gallon.Without that agreement among all suppliersof the good there would be no monopolyrent, because each independent seller wouldheed only its own marginal revenue in deter-mining its output, and therefore price, andwould ignore the industry's marginal reve-nue.)

The terminology can be confusing. Anagreement or coalition that results in smalleroutput, lower quality, or higher prices iscommonly called a collusion or cartel. Bothterms are pejorative: They express a norma-tive judgment that such a coalition is im-proper, "an tisocial," or "an ticompeti ti ve."That normative judgment is based on the ef-fect of a cartel: Because the colluding suppli-ers' gains through transfer of income to themare less than the loss to the rest of society,the sum of total personal use values over theentire number of consumers and producers isreduced. However, a coalition that results ina better product or lower price, thus yieldinga gain to both consumers and producers-anet social gain-is deemed desirable by oursocial standards and laws. Such a coalition isnot called a collusion or cartel, but is insteadoften called a firm. You should be alert, then,to distinguish terms that reflect economicanalysis and those that express normativejudgments.

263

We now investigate some conditionsthat affect the viability of effective collusionsor cartels. We say "effective" because un-doubtedly many attempts to create produc-tive cartels don't succeed at all.

Collusionamong Produeers

Producers who eliminate competition in theopen market do not eliminate competition it-self. It simply relocates and changes form.Collusion, for example, causes competitionto shift from the marketplace to the confer-ence tables of the firms, where it must bedecided how the potential gain will be divid-ed among the firms of the cartel, and howcheating can be prevented and loopholes inthe agreement identified and closed. (And, ofcourse, at the conference table, each firmlooks for other ways of cheating and undis-covered loopholes that it may use.) Thus,whether a proposed cartel is open or secret,it faces formidable hazards, even aside fromthe consequences of violating any legal pro-hibitions. We look at several problems offorming an effective cartel.

1. Who are the significant potential sup-pliers? Are their products and services iden-tical? Are there other goods or services suffi-ciently similar to yours that some degree ofsubstitution can occur if you raise yourprices? For example, in trying to organizedoctors, what would you do about interns,chiropractors, registered nurses, druggists,dentists, and drug companies? All are substi-tutes for some medical service. If all doctorsraise their fees, people will seek more aidfrom their druggists and use self-prescribeddrugs. Or if you are a steel producer, whatwould you do about suppliers of aluminum,brass, plastics, wood, and concrete, all ofwhich are to some extent substitutes? Andwhat about firms that make steel for their

<

own use and could expand and sell steel toother steel users? Firms that are not broughtinto the collusion will profit and grow underthe cartel members' umbrella of higher priceand restricted output. Actual or potentialoutsiders can nullify, or cancel the effects of,the collusion.

2. Suppose, however, you decide not toinclude all the suppliers in your industry inyour cartel. Say you include only the 10 ma-jor steel companies. Of the more than 1000companies producing thousands of kinds ofsteel in the United States, these 10 produce90% of the total output. The rest, even in-cluding new entrants, will not grow rapidlyenough to upset your plan too quickly, or soyou hope. Your problems are not solved, fornot even all of the 10 participants will agreeabout the best price or what their share ofsales should be. That depends on the rela-tionship of cost to output in each firm, theelasticity of demand, and each firm's esti-mates of its prospects for growth. Lowerprices are more advantageous to lower-costfirms with prospects of growth than to high-er-cost, smaller-output firms. Many explora-tions of and attempts at collusion never passthis obstacle. And we haven't even men-tioned the foreign producers who sell steel inthe United States.

3. Controlling competition in all itsforms is prohibitively expensive. Each cartelmember will be alert to the gains from thoseforms of competition that are not controlledby the cartel, for example, quality, deliverycharges, warranty and repair services, credit,allowances on turn-ins, and trial and refundprivileges. Even when a federal regulatoryagency enforced the former U.S. domesticairline cartel, there was inadequate control ofcompetition in the quality of airline atten-dants, the quality and types of service, typesof planes, and other fringe benefits to passen-gers. Unless such kinds of competition arecontrolled by some enforcement technique,the potential gains from a cartel will be dissi-pated.

4. Finding and using secret competitivetactics, or tactics no one thought to prohibit,is potentially very profitable. The probabili-ty of a firm's success in this is inversely relat-ed to the cartel's ability to control and stan-dardize products and fringe services. In anyevent, there must be some technique avail-able for enforcing the output and perform-ance agreement, and for punishing violators.Some forms of cheating could be controlled ifall the colluding members pooled their out-put and sold it through a single central salesagency, then split the proceeds (which is es-sentially how the lemon, milk, and raisin car-tels-to name but three-work effectively).An alternative safeguard would be to assigneach buyer to one seller. This would reducethe incentive for price cutting-though itwould not entirely eliminate it, for by cut-ting prices you would enable your customerto undersell its competitors, thereby increas-ing your customer's volume of sales andhence the demand for your goods; in thisway you indirectly take business from yourfellow conspirators.

5. Within the cartel there will be com-petition among firms over the shares of salesallotted each member. Younger, growingfirms will want an increasing share.

6. If expanding or creating new pro-duction facilities requires large investments,potential new competitors will be dissuadedfrom quickly entering the business. Thisfact would appear to make effective collu-sion more likely, but there is a counterforce.If existing, colluding firms also have suchexpensive facilities, and if new entrants doappear, the colluders. will lose their ownlarge investment value-and this loss of val-ue will continue after the collusion has end-ed.

These inherent contradictions and haz-ards to effective collusion explain why manyexploratory attempts are never carriedthrough and why many actual collusionsnever become effective. Proposals are dis-cussed and agreements reached, only to be

left ineffective by these hard, competitiverealities.'

THE MYTH OF THE"'OPEC CARTEL

Let us apply these principles to investigatewhat is often alleged to be the most effectivecartel of all: the Organization of PetroleumExporting Countries (OPEC). In the processwe will see that the supposition that OPECis a cartel is very weak, and that instegdOPEC exemplifies an industrial situation inwhich there is a dominant firm.

In 1973 OPEC was supposed to have re-duced its oil output to obtain higher prices.The largest producer, Saudi Arabia, cut itsoutput and raised its prices. At the sametime, all the other suppliers also took advan-tage of the higher prices. The smaller sellersexpanded their output but not enough to off-set Saudi Arabia's reduction. (Obviously,Saudi Arabia was not willing to cut its out-put to the point where prices would be ashigh as the smaller producers wanted themto be.)

OPEC did satisfy one essential conditionof an effective cartel agreement: Its memberscontrolled enough of the resources capable ofproducing this good to raise its price. It wasnot possible to find (let alone produce) suffi-ciently large amounts of petroleum to quick-

1A favo~able occasion for collusion, in open mar-kets, is that of sales to government agencies throughsealed bids. Accusations of collusion made against sell-ers of meat, flour, water, pipe, steel, office furniture,cement, milk, and banking services have all involvedsuch sales. The government solicits bids from severalsellers and op~ns them all at one time. No rebidding isallowed (in sharp contrast to, say, the purchase of a carby a private party who solicits bids from various sellersand gives each a chance to undercut the others). Ifthere is collusion, and if any colluding sellers do not bidas agreed, the others wi\l find out immediately becauseall bids are revealed. It does not seem accidental thatmost cases of established effective collusion have beenon sales to government agencies or government-regu-lated public utilities selling through sealed bids.

Cotnoetition smone the Few 265

.~III

I'iIIi,

\\

\MRsa,~',

Figure 12.1.

THE PRICE AND OUTPUT EFFECTSOF A DOMINANT FIRM

If one producer-here Saudi Arabia-holds a dominantshare of the actual and potential facilities for producingsome good-here petroleum-it may act as a pricetaker and sell whatever amount the world demands atthe prevailing market price. In doing so Saudi Arabiawould be ignoring the effects of its actions on the worldprice of oil, Pw, at the intersection of the world demandand supply curves Ow and Sw Saudi Arabia would besupplying Xse and the rest of the world's smaller

266 Chapter J 2

.~

producers would be supplying X,w' However, Saudi Arabiamay recognize that it could set a price, Pd, and let therest of the world's smaller producers supply whateveramount, S,w, they can produce profitably at that price.The unfulfilled amount demanded by consumers is thensupplied by the dominant firm. The world demand isshown as Ow' At any price the amount supplied by thesmaller producers, S,w' is subtracted from the worlddemand, Ow' leaving a demand, 0sa' facing the dominantfirm, Saudi Arabia. The wealth-maximizing price for SaudiArabia is Pd, that price at which its marginal revenuecurve, MRsa' crosses its marginal cost of producing oil,Ssa' At Pd the world demands the amount Xl

w' of which«: is supplied by Saudi Arabia and the rest, Xl,w is

ly fill the gap. In contrast, for many othergoods such as steel, drugs, or automobiles,new facilities could be created quicklyenough.

The Dominant Firm Situation OPEC isnot a cartel because only one producer, SaudiArabia, cut its output to raise prices. Thereis no evidence that it made any agreement tocut output only on the condition the othersalso do so. The evidence is rather that SaudiArabia decided alone to cut output, althoughthe other oil suppliers also reaped the bene-fits of a higher price and a larger output. Sau-di Arabia controls enough of the existing andpotential sources of oil to reap a benefit froma higher price, despite producing less. Such asituation is often the result of there being adominant firm rather than a cartel. But sucha firm must control not only the current sup-ply but also the sources of potential expan-sion in the near future.

A diagrammatic analysis using demandand supply curves will help make the analy-sis coherent. In Figure 12-1, D; is the worlddemand for oil and S; is the world supply,which is the sum of the supplies from SaudiArabia, S5a' and from the rest of the world,Srw' Notice that the Saudi Arabian supply is alarge portion of the total supply. This as-sumption is important.

The world market price of oil, Pw, is thatprice at which the amount demanded equalsthe amount supplied, that is, where theworld demand and world supply lines D; andS intersect. Let us assume that this is thew

initial condition, the one in effect before

supplied by the rest of the world. This price wouldmaximize Saudi Arabia's profits even though, being thedominant firm, it supplies less, X/sa' than before, Xsa' atthe lower price, Pw. The other producers all expand fromXrw to X~w and also enjoy higher prices than before.Although the rest of the world's suppliers have increasedoutput, that new world price, Pd, is sustained because ofthe dominant firm's reduction of output. And total output,from all suppliers, is smaller, now being X/w instead of Xw.

1973. Suppose that at that time the SaudiArabian princes contemplate their own mar-ginal revenue at that output. They deducetheir marginal revenue from their demandcurve by noting how much of their oil wouldbe demanded at each possible world price.Figure 12-1 shows how to define the demandfor Saudi Arabian oil. At each possible price,subtract from the world's amount demandedthe amount supplied by the non-Saudi por-tion of the world. What remains is theamount that the non-Saudi suppliers couldnot supply: It is the amount that would bedemanded from Saudi Arabia, and in Figure12-1 it is the line D5a• That amount equalsthe horizontal distances between the worlddemand, Dw, and the supply from the rest ofthe world, Srw. For example, if the price wereas high as Ph! all the world demand would beprovided by the other suppliers and none bySaudi Arabia. At lower prices, more will bedemanded but less will be supplied by therest of the world, so some will be demandedfrom Saudi Arabia. Thus does the demandfor Saudi Arabian oil depend on world de-mand and non-Saudi Arabian supply.

Now we ask: What is the marginal reve-nue curve to Saudi Arabia? Because the de-mand for its oil slopes downward, its margin-al revenue, the line MR; in Figure 12-1, isless than price. At any amount supplied bySaudi Arabia, the height of that marginalrevenue line shows how much money SaudiArabia gets by producing one more barrel (orforsakes by producing one less).

What should Saudi Arabia do if it wereinitially selling in a market at which theprice was P] At that price and output, Xsa'

Saudi Arabia would have a marginal revenuefar below its marginal cost and possibly evennegative, as suggested in the diagram. Bycutting its output it would avoid sales of oilat a marginal cost that exceeds its low mar-ginal revenue. And it would increase its prof-its by ceasing to produce more than itswealth-maximizing output, Xl

sa' which is the

Competition among the Few 267

intersection of its marginal revenue line,MRsa' and its marginal cost of producing oil.That implies a higher price, Pd'

So it is plausible that in 1973 Saudi Ara-bia, recognizing itself to be the dominantpresent and potential future supplier, sawalso that its marginal revenue was low. Itknew that because of its dominant position itcould sell less to get a higher price and high-er total revenue. Other supplying countriescouldn't expand enough in response to thehigher price to offset Saudi Arabia's effects.Thus, Figure 12-1 describes the logic of thedominant firm situation. Is it an accurate sto-ry of what happened? No one knows.

Remember, some of the members ofOPEC are at swords' points. At OPECmeetings the smaller suppliers always agitatefor higher prices. They want Saudi Arabia tocut output more so that their unchanged out-put will get still higher prices. But SaudiArabia has already set its output, and henceits price, to maximize its own earnings: Fur-ther cuts in output and increases in pricewould reduce its income. You can see nowwhy Saudi Arabia can pose as the "moder-ate" seeking to avoid "excessively higherprices" to "protect the consurner nations"against the desires of the "hawks," or "anti-consumers." Those who attribute benevolentmotives to Saudi Arabia simply miss thepoint that it is in Saudi Arabia's economicself-interest to be more "moderate" than theother producers.

NEITHER DOMINANT. FIRM NOR CARTEL?

If the preceding analysis is not enough tomake you doubt that OPEC is a cartel, an-other line of analysis may thoroughly under-mine your confidence in knowing with cer-tainty why oil prices rose so much in theearly 1970s. When the Persian Gulf oil fieldswere first explored, about 50 years ago, theexploring companies were granted 50-year

li~ [~1~1;'lr,-------------------------------------------I; .

I'llIl 268 Chapter 12

concessions: During that time they couldproduce and sell all the oil they extracted ifthey paid a royalty to the granting govern-ments. Because no one knew what other ar-rangements would be made after expirationof the 50-year concessions, the oil companieshad an incentive to extract oil more rapidlythan if they owned the underground oil, be-cause they would lose the rights to any unex-tracted oil after 1980 (if there were no politi-cal revolutions sooner,' as there were). Theabsence of secure property rights reducedthe incentive to conserve for the future, andincentives for overly rapid extraction weremade even stronger when, in the 1950s, theIranian government prematurely terminatedits agreement, increasing the likelihood thatother Middle Eastern governments would doso as well. Thus, in the 1960s more crude oilwas extracted, and at lower prices to consum-ers, than if the oil companies had securerights to future extracted oil. The govern-ments that had granted the oil concessionssaw that such rapid extraction was reducingthe stores of underground oil and, respond-ing to the incentive to conserve oil for higherfuture values, terminated the contracts. Thereduced output of oil appears to be whatcaused the price to rise in the early 1970s.These events did more than reaffirm controlof output by owners instead of by others notacting in the owners' interests, as the follow-ing analysis demonstrates.

Many have argued that in the years 1970to 1973 the governments in those nationspossessing significant stocks of undergroundoil began to be aware of the following devel-opments: The rate of exploration for oil hadfallen sharply from what it had been in earli-er decades; the rate of successful explorationshad also fallen; and as the wealth of the de-veloping nations was increasing, so was theirdemand for gasoline and petroleum products.Suddenly the future promised to be quite dif-ferent from what had formerly been expect-ed. In particular, this revised perception ofthe future implied a substantially higher Iu-

ture value of oil than had been anticipatedbefore 1970.

If you owned an oil well and you saw thefuture value of oil being revised significantlyupward, what would you do if you had beenallowing someone else to pump your oil at anunrestricted rate? If you kept the oil in theground, it could be sold later at a much high-er price than formerly anticipated. The 1970price of about $3 a barrel was lower than thenewly anticipated future price discounted toa present value by the compounded rate ofinterest. (Remember what the principles ofcapital value say about the relationship ofpresent to future values.) With a real interestrate (that is, one in the absence of inflation)of about 3%, oil worth $3 in 1970 would bepumped out only if the price in 1980 werenot expected to have risen by more than 3%per year compounded for 10 years-that is,about $4 (= $3 X 1.34).

Suppose that in the early 1970s peoplebegan to believe that the future value of oil(disregarding inflation) would be higher thanthe formerly anticipated $4 1980 value andmight be as high as, say, $15 (in fact, itturned out to be $30). Then the price of oilshould have jumped in about 1972 to approx-imately $11 (= $15/1.34). In this analysis,that jump in price would have occurred notbecause of a cartel or a dominant firm situa-tion, but because the world began to per-ceive a new future. The new, higher priceforced consumers to cease consuming oil as ifit would remain cheap and plentiful in thefuture, and to conserve more for the revised,higher-valued future uses. Our analysis is notaffected in the slightest by the fact that theowners of the oil were Arabians and were op-posed to Israel and to recent military actionsin which it was involved, or that they alsowere made much richer by the new outputsand prices.

EVIDENCE OF A CARTEL

So we leave you with a conundrum. What isthe most valid explanation of the steep rise

in oil prices in the early 1970s? Is OPEC acartel, as it is commonly thought to be? Ordoes that common perception mask a domi-nant firm situation? Or does it mask insteada situation resulting from the oil-producingnations' simultaneously realizing that futureoil values had risen and resuming control oftheir property to reduce output and raiseprices?

That the prices of several firms in an in-dustry behave simultaneously in the sameway, or that one firm shows price leadership,is evidence neither for nor against the exis-tence of collusive agreements. What is evi-dence is the existence of costly enforcementtechniques: The costs incurred to enforce re-strictions and prohibitions are evidence thata collusion is sufficiently effective to make itworth those costs of enforcement. The tech-niques of enforcement can take variousforms. There may be restrictions on new in-vestments by colluding firms and penaltiesfor noncompliance. Or members of an indus-try may police themselves or submit to regu-lation by an industry association; in eithercase they may also be subject to state laws orstate-enforced standards. Members who donot comply are denied the right to do busi-ness, such as by revocation of licenses or spe-cial privileges for "unethical" behavior.

But strangely enough, in some circum-stances each of these techniques assures con-sumers better service, by keeping some firmsfrom a "free ride" on the prepurchase, usefulinvestments of other suppliers of the good,thereby destroying the incentive of thoseother suppliers to make the useful invest-ment in the first place.

A strong implication of the foregoing isthat an agreement would be most effectivelyformulated and enforced by an organization,membership in which is a prerequisite for in-vesting in the industry. The organizationmay provide special advantages, such asqualifying its members for government subsi-dies or tax favors; pooling patent rights; con-


ferring rights to do business with the govern-ment; exempting members from strikes byunions; controlling the entry of newcomersby licensing policies; or protecting invest-ments in prepurchase service. For example,the American Medical Association gives itsmembers sufficient privileges (such as accessto certified surgical hospitals) to enforce itsprohibition of certain types of competition.

Similarly, from the turn of the centuryup until World War II, business firms inGermany were compelled by the state to be-long to chambers of commerce as a conditionof the right to engage in business. Prohibi-tions of types of market competition could beenforced by expelling any firm in violationfrom the chamber, and thus from the market.It is no wonder that in those years Germanyhad many effective cartels. In Swi tzerlandthis arrangement was used by Swiss watch-makers before the coming of the electronicwatch.

An alternative to forming a cartel is toget laws passed to regulate the industry inthe "public interest," to eliminate quackery,shoddy merchandising, dangerous products,or disorderly pricing. In administering suchlaws the regulatory agency enforces what isessentially cartel behavior. Examples of suchagencies are the Securities and ExchangeCommission, the Interstate Commerce Com-mission, the Federal Communications Com-mission, the Civil Aeronautics Board, theFood and Drug Administration, the NationalLabor Relations Board, the U.S. Departmentof Agriculture, state liquor control boards,and public utility commissions. In the nextchapter, some effects of these agencies areexamined in detail.

MERGERS

Another kind of action by firms that superfi-cially appears to be an ideal vehicle for collu-sive action is the merger, whereby two ormore firms become joined under one owner-

270 Chapter J 2

ship. The idea is simply to merge with yourrivals into one big firm and then control out-put to increase profit, which is then dividedamong the merged firms. Such a tactic mustfirst surmount the problem of deciding whopays how much to whom in the mergeragreement. But supposing this can be re-solved, is the merger worthwhile? The mostserious impediment to its effectiveness is theability of other producers to create new sup-plies. If merged firms reduce output and tryto raise prices, other firms will enter the in-dustry. The merged firms may make moremoney for a few years, but the entrance ofnew firms assures that later earnings will besmaller than otherwise. If this consequence isforeseen, the immediate net effect may be aloss of present wealth, a lower value of thecommon stock.

There is at least one way to test whethermergers have effects similar to those of car-tels, or have instead increased consumerbenefits: Compare what happens to the stockvalues of the merged firms with what hap-pens to those of the unmerged, competingfirms. If the merged firms act as a cartel, theunmerged firms reap benefits under the um-brella of higher prices. If the merger insteadimproves the quality of the product or resultsin lower costs and lower prices, then thestock price of each merged firm should riserelative to those of other firms in that indus-try. The evidence that has been collectedseems to indicate that the latter has hap-pened: As judged by their effects on stockprices, mergers seem on average to have re-duced costs and improved services.

Mergers can be profitable because theymake better operation of a marginal firmpossible or bring it superior management.Mergers and takeovers-by stock purchases,exchange of stock, or direct purchases of as-sets-often represent competition amongmanagers and investor-entrepreneurs for con-trol of firms that can be improved.

We started this chapter by examiningcartels-in which joint coordinated controls

or restraints are used to restrain market com-petition among a group of suppliers. We alsoexamined the dominant firm situation inwhich no joint coordinated controls are in-volved, and we briefly discussed mergers.We now consider oligopolies.

OligopoliesOur analysis in earlier chapters of how firmsrespond to market forces assumed first thateach firm was a price taker, taking the mar-ket price as given by outside forces. We thenintroduced situations in which the firm didnot have an automatically given market pricefor its products. Instead it had to search forits best price. That firm was called a pricesearcher. It had a demand schedule facing itrather than a market price. It had to ascer-tain and set the best price in the face of thatdemand schedule. We also assumed the firmwould seek the best price along that demandschedule-its wealth-maximizing price. Butin finding that price, the firm acted as if itsactions would not significantly and directlyaffect the output or demand facing otherfirms. Or, if the actions of other firms wereaffected, there was not sufficient feedback tomake our first firm significantly alter its de-mand schedule. The firm was assumed to berelatively independent of any feedbackcaused by effects of its actions on otherfirms. In many situations, however, what onefirm does will affect the behavior of otherfirms enough that the first will anticipatethat response in making its initial decision. Asignificant interdependence may exist. Iffirm A were to raise its price, firm B mightrespond with a price or output change thatwould affect the profitability of firm A's ini-tial contemplated action. If so, what wouldbe firm A's initial action? What will suchrecognized and significant interdependencedo to the firms' pricing and output responseto consumer demands? Will the precedingbasic principles derived from the price tak-

ers' and the price searchers' situations stillhold? Such a situation is an oligopoly-eachfirm's action is influenced by the anticipatedresponse of other firms. This cari happenwhen a relatively small number of firms sell-ing the same goods affect one another.

However, it is important not to confusethis with another phenomenon that superfi-cially appears similar, one called price leader-ship. Price leader is the name attached towhichever firm is the first to reliably detect achange in demand or supply conditions thatimplies a higher or lower sustainable marketprice. Thus, if demand should increase forthe kind of product made by several firms,the market price will have to be higher toration the amount supplied and to maintain ahigher rate of output. But who will be thefirst seller to recognize that a changed rate ofsales, for example, reflects a persisting ratherthan temporary increase? If you recall ourearlier example of the meat market (Chapter4), a persisting changed demand was finallyverified at the general cattle auction. In someindustries with only a few firms, there is nogeneral auction market to reveal changed de-mands so clearly. When sales increase, sell-ers wonder whether the increase is tempo-rary or persisting. Which will be the firstand surest to detect a real persisting changeand not be misled by a passing fluctuation?Which seller will the other sellers regard asthe one with the most reliable information todetect such changes earlier and more surely?This is not a case in which the firm that ismore informed is worrying about the re-sponse of the other firms, as in an oligopoly.The firm is instead trying to ascertainwhether market conditions of demand orsupply have changed in a lasting manner, sothat a new market-clearing price is called for,whether or not other firms realize that yet.Any delay in adjusting price or output to apersisting change in demand or supply willincrease costs to firms trying to quickly re-store depleted inventories, to buyers sudden-


ly facing outages and failure of supply, or tosuppliers finding inventories getting toolarge because of continued overproductionwhen demand has not, in fact, increased.There is no point delaying one's response toa known, long-lasting change in demand orsupply conditions. On the other hand, an ad-justment of price to every slight deviation insales rates or inventory depletions will, if thechanges are really temporary, lead to incor-rect prices as misleading signals about newpersisting values and output rates and, conse-quently, what costs are worth incurring inproducing the good.

All sellers and buyers desire quick infor-mation about exactly what changes (tempo-rary or persisting) in demand or supply con-ditions have occurred. Who is most likely tokeep best informed and have the greatest in-centive to correctly detect those conditions?The bigger a firm is, the more it has to gainby detecting these changes quickly. Also, thebigger it is relative to total sales of otherfirms, the more likely its observed sales ratewill be a true measure of what is happeningin general. Thus, one would expect the big-gest firm to be the leader in knowledge andin the incentive to detect and respond tochanged conditions. It will be known as theprice leader. But this is far different from im-plying that this firm is selling at a collusiveprice. The analogy of a faster, strongerhound in a pack of hounds chasing a fox isappropriate. It will be the first, not in direct-ing where the fox will go, but in followingthe fox and thus leading all the other dogs.That is a price leader-the first and most re-liable respondent to market conditions. Afirm that leads a group of firms into a collu-sion or cartel is in a different situation.

Now we know that what is often calledprice leadership does not necessarily involveany collusion, tacit or explicit, and may not beat all pertinent to oligopolistic interdepen-dence. But we return to the question of whathappens in oligopolistic situations and how

272 Chapter J 2

we know one when it is seen. The an-swers to both these questions are not satis-factory, since not much is known. Scores ofalternative models or possibilities have beenconjectured by economists, but none havebeen well validated. This does not mean thatno oligopolies have been identified. It meansinstead that we just don't know whether oli-gopolistic situations yield results significantlydifferent from the ordinary price taker, pricesearcher, or dominant firm situations. Lots ofpeople have strong opinions based mostly onpersonal impressions rather than on reliableevidence.

The Lawand Market Competition

The Sherman Antitrust Act of 1890 prohibit-ed "combinations or conspiracies to restraintrade" and "monopolizing." Because the actdid not define "monopoly" or "restraint oftrade," it was left to the U.S. Supreme Courtto interpret them. A meaningful start wasmade in the United States v. Addyston SteelPipe decision in 1899. The Court, recogniz-ing that contracts, by definition, constraineach party to do certain things and restrainthem from doing others, stated that so-calledrestraints were not necessarily in and ofthemselves undesirable: Restraints could, andoften do, have desirable effects. The Courtsaid that restraints were lawful if they wereancillary restraints to the main purpose oflawful business contracts or were necessaryto protect one of the parties' contractualrights. For example, a contractual clause be-tween two partners restraining one partnerfrom doing business separately in the samebusiness would be a legitimate restraint.Since 1899, the courts have often looked forthe reason for contractual restraints. Theyhave not declared any restraint to be illegalper se without first ascertaining its purposeand effect. This criterion became known asthe "rule of reason": That is, the restraintwas judged according to the reasons for it and

whether it was "socially useful" in its effects.Nevertheless, the courts-state, federal,

district, and appellate-spawned an enor-mous body of interpretations and judgmentswithout great uniformity or consistency. Al-most any term in a contract that was allegedin one decision to be "monopolistic" or"anticornpetitive," and thus illegal, has beenfound in another decision to be legal. TheSupreme Court has tried to bring some orderto the application of antitrust law by resolv-ing the inconsistencies and ambiguitiesamong the different courts and cases. But sofar the task is beyond its capabilities. In fact,the task is practically impossible: Notenough is known about certain business prac-tices, contractual clauses, and methods of or-ganizing joint cooperative efforts to discernin each case exactly what their effects are.The sophistication of economic analysis isnot yet up to that task.

For example, courts have interpretedmonopolizing to mean the act of "raisingprices or excluding competition," or the"power to control prices and exclude compe-tition." A good test of how well you havelearned the elementary principles of econom-ics is how quickly and thoroughly you can seethe ambiguity in those words. Raising whoseprices? Yours or other sellers'? Raising themabove what "right" level? Does producing abetter product and getting a higher pricemean you are controlling its price? What de-termines what the price can be? Does "ex-clude competition" include doing so well thatsome competitors go out of business? A pro-ducer's doing a better job induces customersto exclude less satisfying competitors, andthat is precisely what competition is sup-posed to do. These judicial pronouncemen tsprovide no better guide as to what acts wouldget one convicted for the crimes of "monopo-lizing" or "restraining trade" than would leg-islation that declared all acts offensive to the"public interest" to be felonies.

In another effort to reduce ambiguity,the Clayton Antitrust Act (1914) prohibited

both "price discrimination" and mergers that"reduce competition" (but exempted laborunions, insurance companies, and farmersfrom antimonopoly laws). In response tocomplaints by son1e businesspersons againstcompetitors, the 1914 Federal Trade Com-mission Act was passed; it declared somemarketing tactics illegal and created the Fed-eral Trade Commission (FTC) to administerit and the Clayton Antitrust Act. The FTCwas to investigate businesses and stop "ille-gal" or "unfair" practices by issuing "cea eand desist" orders. Not surprisingly, what isand is not an "unfair" practice cannot reli-ably be determined in advance by anyone inbusiness or by anyone else. As we have al-ready seen, price discrimination, especially ifsporadic or the result of sellers' groping forthe new, competitive prices, can increase theefficiency of resource use.

Mergers have also come under attack,despite the evidence that many mergers haveenhanced the economic efficiency of firms inthe market, with benefit to consumers andproducers. The practical problem is to findways of knowing which merged firms willhave the effects of a cartel. The judicial deci-sions and commission actions show little evi-dence of economic understanding, in part be-cause there is so little validated economicanalysis from which to make reliable infer-ences.

CommonMisinterpretations ofModern Business Aetions

A few misinterpretations of business activityare sufficiently common and popular to de-serve evaluation.

ARBITRARY ADMINISTRATION OF PRICES

A modern myth has grown up about modernmarkets, because when the prices of eachseller in an industry change, they change at


Ii

about the same time, and the largest firmusually seems to be a price leader, that is, thefirst to change the price. These facts havebeen used to support the myth that big firmsadminister or set prices by some undefinedprocess sometimes called "tacit collusion" or"shared monopoly," to the harm of consum-ers, who must be protected by governmentintervention. U.S. Steel, General Motors, andthe large drug companies are said to set theirprices by administrative decision. And sothey do, just as Alcoa announces the price ofits aluminum and RCA decides the price ofits radios and television sets. But what deter-mines those prices and whether they willstick?

As we know, the price searcher cannotset its price at will, if wealth maximizing isthe goal, for too high a price will mean lesswe~lth. General Motors could raise the priceof Its cars by producing fewer. Other produc-ers would gleefully fill the void, and GMstockholders and employees would lose. Theability to temporarily raise the price shouldnot be confused with the incentive to do so,or with the permanent ability to do so with-out losing wealth.

Describing sellers -as those who usetheir "market power" to "set prices" or who"sear~h for the wealth-maximizing price" inthe light of market demand, is a matter ofsemantics. Call prices "monopolist-adminis-tered" if you want to suggest that the seller~s a selfish,. noncompeting, economic royal-ISt. Otherwise, call them "market-revealedde~and and supply-determined prices::Neither self-restraint nor concern for inter-ests of other people determines prices. It isthe effect on one's own wealth that re-strains.

All prices are administered in the sensethat each person decides at what price to sellin light of the market demand. Sellers mayappear to be colluding because they often actsimilarly, but they, do so in fact simply be-cause they are all subject to similar marketforces.

274 Chapter 12

SIZE, CONCENTRATION, ANDPROFITS: SALES OR RESOURCES?

Another misunderstanding of the market isthe notion that big firms make bigger profitsbecause they are big, rather than that firmswith better products or lower costs becomebig firms. Bigness itself does not increase theprobability of making profits. General Mo-tors has earned profits in the capital-valuesense during many years and has had lossesduring many years. But some very largefirms have lost wealth in many years (Braniff,Singer, Ward's), and some very small firmshave had spectacular growth (Hewlett-Pack-ard, Texas Instruments, Xerox, SouthwestAirlines).. Related to this notion that size and prof-Its are related is the notion that concentra-tion of an industry in a few firms increasesprofits; for example, if 90% of an industry'ssales are made by, say, the four largest firms,rather than, say, 20 firms, industry profits arealleged to be increased. The conclusion isthen suggested that the more concentratedthe industry and the more effectively pricesare kept up, possibly by advertising, collu-sion, and barriers to entry, the greater areprofits-not a very sound conclusion."

First, those concentrated sellers do notnecessarily own the same large percentage ofresources capable of producing those prod-ucts. One income tax firm, H & R Block,d.aes about 40% of the income tax prepara-tions that are done commercially, yet it hasan insignificantly small fraction of the re-sources that could quickly provide those ser-vices if it should raise its price above its com-petitors' costs. Block's high earnings comefrom superior or lower-cost service, not from

2In the photocopy business, Xerox has made enor-mous profits. It and a couple of other copier manufac-turers have a very large share of the market. (But havethey a large. share and large profits because they devel-oped sup~flor products? Unusually superior productscan explain several cases of high concentration andlar ge profi ts.)

control of supply. Having a large fraction ofsales of a product or service should not beconfused with having a large fraction of theinput resources.

If collusion and restrictions on the entryof new firms were a source of higher profitrates, they should be enjoyed by every firmin the industry, the smallest as well as thelargest, for all firms would benefit from thecollusive actions. What are the facts? Thebest available evidence (which supplementsearlier studies that were less detailed, com-prehensive, or rigorous) is that in any indus-try the largest firms have lower operatingcosts and are more profitable than the small-er firms, no matter what the degree of con-centration in that industry. That is what onewould expect if firms that supplied betterproducts, or products at lower cost, grew insize and became the major suppliers. Con-centration is the result of growth of superior,lower-cost firms.

Some products such as automobiles, elec-tric turbine generators, computers, and air-planes are much cheaper to make, distribute,and service in a volume that is a large per-centage of the market demand. That thesame industries in different countries tend tobe the concentrated industries suggests thatlarger firms are more appropriate for certaintypes of activity, rather than that some supe-rior firms become abnormally large.

It is often suggested that because a fewlarge corporations produce a large share ofthe U.S. output, competition must be weakerthan it used to be, and consumers have asmaller range of purchase options. That rea-soning is false. Consumers now have more al-ternative suppliers: If there were 1000 smalltowns and 10 sellers in each town, therewould be 10,000 different business firms, buteach buyer would have only the 10 in his orher town from which to choose. With cheap-er and faster transportation and communica-tion, the total number of business firms couldbe cut to, say, 40 firms. If each firm and con-sumer were able to trade in half of all the

---------

markets, each buyer would now face, on av-erage, 20 possible sellers. Transportation andcommunication have so improved that todaythe average consumer undoubtedly has moreoptions from more-suppliers than the con-sumer did a few decades ago. What counts isnot the number of firms in the whole econo-my but the number of firms seeking to servea consumer.

Perhaps one of the most interesting ex-amples is provided by the U.S. automobileindustry. For the past 75 years, the number-of suppliers of automobiles to the Americanconsumer has been virtually constant atabout 10. The first to be large, Ford, wasoutgrown by General Motors in the 1920s.Ford had been the first to standardize a fewmodels designed for the mass consumer, withno custom features to appeal to a smallerclass of buyers. Ford enabled the consumerto reap the advantages of a large volume, butlarge volumes prevent a large number ofsuch large producers. From the 1920s on-ward, three or four mass-production suppli-ers were sufficient to provide about 75% ofthe cars demanded by the American public,who preferred the lower price of more stan-dardized cars to the higher prices of morespecialized, distinctive cars.

The number of producers was large onlyduring two transient intervals: The first waswhen automobiles were first produced andproducers had not yet learned that consum-ers would prefer mass-produced, standard-ized cars at lower prices. That interval endedby the 1920s. The second began after WorldWar 11, when the government, which hadcreated assembly facilities for war produc-tion, gave those facilities to new or smallercompanies, such as Kaiser, Hudson, Packard,and Studebaker; these companies used the fa-cilities to produce cars and sell them atprices that did not reflect the full costs ofcontinued production. When the facilitieswore out, the firms could not survive on thatsmall-scale production.


In the past thirty years, as the worldmarket for cars has increased, foreign massproducers such as the Japanese and Germansbegan to sell a standardized car in severalcountries, thereby obtaining the lower costsof large volume. By contrast, the French, En-glish, and Italians were making more unusu-al, custom-type cars, As the costs of interna-tional shipping declined, the foreigners couldproduce at very large volume and sell in theUnited States at prices competitive with theAmerican cars designed only for the domes-tic market. These new foreign suppliers tothe United States reduced the number ofAmerican suppliers but increased the totalnumber of suppliers to the American con-sumer. That there are thus more suppliers inthe 1980s can be explained by the high inter-national volumes of production, which implylower costs per unit.

ABSENCE OF PRICE COMPETITION?

It has commonly been argued that an oligop-oly-an industry, remember, of a very fewinterdependent sellers-is characterized byweak price competition or by tacit collusionamong sellers. Although the two terms havenever been clearly defined, the context sug-gests that anyone seller is aware that if onefirm cuts its price, others will quickly matchit, and everyone's profits will take a beating.So instead, each firm holds its price at some"reason able" level.

You must not confuse ~hat makes thosefew sellers charge nearly the same price withwhat determines its level. A common pricecan mean simply that it is not profitable tocharge a lower, or a higher, price than othersuppliers are charging. A nearly identicalprice-or indeed an identical price-amongall sellers could as well have been arrived atthrough independent competition as througha collusive pact. Hence it is not useful evi-dence of either.

One reason why the number of firms is

276 Chapter J 2

thought to be inversely related to the degreeof price and quality competitiveness is thatin some industries the one major firm has apatent or is a government-regulated publicutility (such as water, power, taxis, railroads)protected by law from the entry of otherfirms. In these cases the absence of marketcompetition is incorrectly attributed to thefewness of firms. The correct interpretationis that the existing firm is protected by law.

PRICE FIXING?

Some manufacturers set a price at which theretailer is supposed to sell. Often such amanufacturer is accused of "price fixing," ofacting "monopolistically" or "anticompeti-tively" or in "restraint of trade." Whateverthose undefined terms are supposed to mean,consider the following facts.

Consumers cannot always judge thequality of a good before they buy it. A newfood-processing machine has to be demon-strated. A watch may have to be repaired, acomputer may malfunction, an income taxpreparer may overestimate your taxes. Youwon't know ahead of time, and you may noteven know afterward. If a manufacturer'sproduct is sold under one brand name but bymany independent retailers, each of whomprovides prepurchase information or affectssome relevant attributes of the product orservice, the manufacturer can induce retail-ers to provide that service only by prevent-ing customers from using it for free. For ex-ample, say one retailer invests in providingcustomers the desired prepurchase informa-tion and quality-assuring services, such as byadvising them on appropriate goods, main-taining a larger inventory for better selec-tion, and the like. If other retailers could sellthe good at a discount, consumers could usethe first retailer's investment to learn aboutthe good or to service it, regardless of wherethey bought it. Conscientious retailers wouldbe unwilling to help customers learn aboutthat manufacturer's product unless customers

and other retailers could be prevented fromthat free use of the first retailer's investment.

What can the manufacturer do? First itcan prohibit sales by discount houses. And itcan permit a retail price sufficiently abovewholesale costs and those of providing thecustomer service that the retailer foresees at-tractively large profit premiums as long as itsells that manufacturer's products. Now, no-tice the retailer's position. A manufacturerthat detects a retailer failing to perform itsobligations toward the manufacturer and cus-tomers can cease selling the product throughthat retailer, depriving the retailer of thepresent value of the premium stream. Dis-honesty by the retailer costs him more thanit is worth. Clearly such price fixing is to thepublic's advantage in obtaining prepurchaseinformation about desirable goods.

It used to be argued that imposing mini-mum retail prices would be a mistake: Amanufacturer should want retailers to chargethe lowest possible price above the wholesaleprice. That argument was advanced severalyears ago, before economists realized that be-cause retailers share duties with manufactur-ers in providing product quality and servicefor a product sold under a manufacturer'sbrand name (like McDonald's, KentuckyFried Chicken, Coors), it would pay retailersto cheat on those duties for the sake of ashort-lived gain. One way to achieve self-enforcing contracts with retailers is to offerthat premium of the assured higher price,the present value of which would be lost by aretailer caught cheating. Thus, the higher re-tail price, or lower wholesale price, is thebest means of enforcing the retailer's obliga-tions. Therefore, manufacturers who setprices at which retailers can sell may be ben-efiting themselves, consumers, and retailersall at the same time.

We said may be benefiting, because notevery case in which the retail price is fixedby a manufacturer has that effect. Neverthe-less, the opposite charge, that price fixing isnecessarily harmful to the consumer, is not

correct-despite the fact that the U.S. Su-preme Court declared price fixing per se ille-

. gal.

PRICE RIGIDITY

Many people, lawyers and members of con-gressional committees among them, arguethat more concentration of the output of anindustry in a few large firms raises prices ormakes them less flexible. Evidence does notconfirm the charges. Indeed, the number •.orsize of firms in a price searcher industrysh?ws no connection with the flexibility ofpnces.

What then is the evidence for the argu-ment? The price of automobiles was report-ed to be stable and invariant because the list,or recommended, price announced by theautomobile companies stayed unchangedthroughout the model year. But one of thefirst things a person learns in shopping for acar is that the list price is, at most, the sellingprice only at the beginning of the modelyear. "Special" deals are offered to everyonewho states the intention to shop around.

Although the catalogue prices of thethousands of varieties of steel may notchange for many months, extensive studies ofactual contract prices of steel show that theactual prices are highly variable from day today. Discounts for cash payment vary; speedof delivery and special services vary fromweek to week; quantity discounts are com-mon. A steel purchase is a complex transac-tion."

30ne factor that tends to relate high concentra-tion in a few firms to price rigidity is a statistical arti-fact. The smaller the number of firms, each with equal-ly flexible or frequent price changes, the fewer thetotal number of price changes; this frequency of record-ed price changes merely reflects the number of differ-ent seller's prices to count. So one would see morechanges if there were more sellers, even though theflexibility of anyone seller's price is the same and isequally responsive to demand changes, regardless of de"gree of concentration.


The current assessment of the charge ofprice rigidity in concentrated industries .wassummarized by a president of the AmericanEconomic Association:

Economists have long struggled to find arational explanation for prolonged pricerigidity, which is in general as inadvis-able for profit-maximizing monopolistsas it is' impossible for "price taker" in-dustries. Putting aside minor or specialcircumstances (the cost of a pricechange; the procedural delays in cartel orpublic regulation), they have failed todiscover any such explanation. It appearsthat the real world has been equally re-miss in supplying the phenomena theywere seeking to explain.'

! !

ADVERTISING:EDUCATION AND INFORMATION

In a world of specialization, communicationis necessary and takes several forms: educa-tion, news, and advertising. Information ofinterest to only a specialized group is dissem-inated to that group. A new drug or TV setwould be reported as news in a merchandis-er's trade journal, such as Variety, ElectronicProducts, or Textile World. To convey in-formation to a small number of unidentifiedpersons within a large group is often mo:eexpensive, per person, than general advertis-ing, even though in both cases there aremany uninterested recipients. But such ad-vertising is not wasteful' unless there is acheaper way to identify in advance the fewto whom it should be directed.

Does advertising create differences inconsumers' tastes to make consumers respon-sive to product differentiation? Although any

'George J. Stigler, "Administered Prices and Oli-gopolistic Inflation," The Journal of Business of theUniversity of Chicago, Vol. 35; No. I (January 1962), p.8.

278 Chapter 12

one of us can be misled by advertising, it isanother matter to show that consumers'tastes are formed by advertising or that peo-ple are misled more than if there were noadvertising. Advertising is a means of com-municating the existence of suppliers and thecharacteristics of goods. The greater Ourawareness of alternative products and theiravailability, prices, and characteristics, theless will sellers of inferior products retaincustomers. A seller's long-term survival restson continued consumer acceptance-at leastfor products that continue under the samebrand name. We therefore expect a positivecorrelation between a seller's continued ad-vertising and quality of product and profit-ability: Good products make advertisingmore profitable.

We do not assume, however, that adver-tisers are any more honest than anyone else.They are less honest the less they are penal-ized by competitors for their dishonesty. Theissues are: What reduces the costs of discov-ering more complete and accurate informa-tion, and what raises advertisers' losses ifthey are dishonest? To prevent fraud andtheft we rely to some extent on legal actionsbut also on ourselves, purchasing locks, safes,walls, cash registers, fences, and grills, andhiring private security guards. We are waryof falsehoods and misleading statements. Andwe rely on the self-interest of one seller tounmask discreditable competitors, as onenewspaper staff's self-interest in its incomesinduces it to reveal any lies and errors pub-lished by its competitors. Advertising is ameans of providing and testing information.Its usefulness does not rest solely on the no-tion of advertisers' honesty and goodwill butalso on the opposite assumption that informa-tion disseminated by self-serving competitorsrenders dishonesty more discoverable andself-defeating, thereby helping the public dis-cover the truth more cheaply and surely.

Advertising under Communal PropertyRights Much of the criticism of advertising

on radio and television, and of the program-ming itself, is really criticism of how televi-sion and radio programs are paid for, and ofthe politically imposed limit on the numberof stations and on over-the-air and cablechannels for pay-TV. Theaters rarely showcommercials, because the paying patronguides the producers' decisions about what isdesired. Pay-television gives viewers moreprogram control. (Imagine what you wouldexperience in movie theaters if theater own-ers could not charge admissions.) Specializedprograms on pay-TV appeal to smaller, spe-cialized groups because a minority couldconcentrate its "dollar votes" on preferredprograms. If newspapers could not be sold,they would have even more advertising, asevidenced by the ratio of advertising to newsin neighborhood throwaway newspapers.

Billboards and roadside advertising seemto run a close second to TV commercials asobjects of criticism. (What about bumperstickers and advertising on cars, buses, andtaxis?) However, it is not necessarily the ad-vertising itself that is objected to, but ratherits being thrust upon people in undesiredplaces, circumstances, and ways. Roadsidesigns are a prime example. Because roads donot have private owners, there is less rewardto anyone to meet the demand for roadswithout signs. It is simply technically impos-sible to bring the uses of such resources un-der the control of the normal market opera-tion of the private-property system. Andthat, of course, is a reason for using nonmar-ket, political controls.

Advertising Controls or Censorship Fearthat advertising will mislead people suggeststhat political authorities should decide whatis permissible advertising. We do engage incensorship: We expose our children to cen-sored ideas when we control what theschools teach them. The continued vitality ofa culture requires that its customs, taboos,and values be passed on to succeeding gener-ations. This censorship applies to children,and all parents have a large say in it. We

censor our children's channels of communi-cation because they are children-and this isthe crux of the question whether the contentof advertising should be subject to politicalcontrol. Are we to apply to adults the reasonsfor censoring children's communications?Each of us may differ in our judgment. Wemay not like the way others behave when ex-posed to ideas and persuasive thoughts. Butthere is no dispute that political control ofadvertising content is political censorship, inthe sense that it places prior restrictions anwhat can and cannot be publicly said. Thedispute is how much censorship is good orbad. Economics has no answer.

Summary1. The terms collusion and cartel are applied

to coalitions of producers or sellers that havethe effect of reducing the social sum ofbenefits to consumers and producers, be-cause the gains to the producers are lessthan the losses to the consumers.

2. A cartel's effectiveness depends in part onthe extent of its ability to prevent outsideresources from competing against it. If nooutside resources are capable of producingan effective substitute for the cartel's prod-uct, the cartel is more likely to be effective.

3. The dominant firm situation requires notonly that one firm be the largest of currentproducers, but that it also have a sufficientlylarge portion of the present and known fu-ture resources for production of the good.

4. Use of the term price fixing to denote amanufacturer's setting the price of its goodto the retailer can produce misunderstand-ing. By setting the price, a manufacturer canensure that retailers provide services desiredby consumers.

5. More highly concentrated industries-indus-tries composed of or dominated by a fewlarge firms-do not yield higher profits byvirtue of the large firms' greater control or


'I' !II t1.1

, ',

larger share of the supply of productive re-sources. Instead, more efficient and there-fore more profitable firms grow and tend tobecome major suppliers to a larger portionof the. consumers, leading to greater concen-tration.

6. In some industries the technological charac-teristics of production, distribution, andproduct service favor economies of scale,leading to larger firms. Such concentrated in-dustries do not imply that the market powerof the larger firms brings larger profits.

7. From currently available evidence (little ofit reliable), laws meant to broaden marketcompetition and to restrain undesirable tac-tics by some sellers or buyers have had resultswhich can be called counterproductive orbeneficial according to one's political values.

8. Advertising is a means for lesser-known andwell-known firms alike to make more widelyknown the availability of their wares andtheir characteristics. Advertising lowers con-sumers' costs of acquiring information aboutavailable goods and services and prices.

9. Communal property is sometimes used byadvertisers, because there are no means ofpricing and controlling the use of that prop-erty.

!I

! I

I

questions1. Suppose there are 10 identical producers of

the good being sold in the market characterizedby the total market demand:~given here. Eachproducer has zero costs of production for 20units; no producer can produce any more.

a. If all are selling in a price takers' market,what is the price and output?

b. If all sellers could reach an effectiveagreement to restrict output and raiseprice, what price should they select?

c. What will be each seller's output andrevenue?

d. How much would each seller gain by theeffective agreement?

280 Chapter J 2

Demand Schedule

Dollar Value of Daily RevenueQuantity Marginal (forDemanded Unit Increase

Price Daily Total Increment in Quantity)

$1.00 56.52 $56.52 0 0.95 62.25 59.14 $2.62 .46

.90 68.39 61.55 2.41 .41

.85 74.65 63.45 1.90 .30

.80 81.36 65.09 1.64 .24

.75 88.17 66,13 1.04 .15

.70 95.45 66.82 .69 ,09

.67 100.00 67.00 .18 .03

.65 103.00 66,95 -.05 -.02

.60 110.67 66.40 -.43 -.05

.55 118.60 65.23 -1.17 -.15

.50 127.01 63.51 -1.72 -.18

.45 135.72 61.07 -2.44 -.28

.40 144.48 57.79 -3.28 -.37

.35 153.76 53.81 -3,98 -.43

,30 163,07 48.92 -4.98 -.53.25 172,92 43.23 -5.69 -.58.20 182.79 37.16 -6.07 -,61.15 193,21 28,98 -8.18 -,78,10 203.92 20,39 -8.59 -,81.05 214.62 10.70 -9.69 -.91

*e. How much money would it be worth toeach seller to seek means of reachingand enforcing that effective agreement?

*f. How much would you gain if you as oneseller succeeded in staying outside theagreement or in secretly breaking itwhile all others raised the price and re-duced their output?

2. The first case prosecuted under the federallaws against collusion to raise prices involvedsteel pipe sold to the U.S. government. More re-cently, an electrical-equipment industry's collu-sion, which sent some business leaders to jail,was also against the government. What explana-tions are there for the fact that a majority ofprosecuted cases involve collusion against thegovernment?

*3. Assume that all existing firms producing acommodity were successfully and effectively tocollude to restrict output and raise prices. What

open-market forces would operate to obstruct theeffectiveness of the collusion?

4. What are the differences among collusion,cooperation, and competition? How would youdefine collusion between two people so as to ex-clude partnerships and corporate, joint 0:vner-ship from the concept? What are th~ undeSlTabl.econsequences that distinguish desirable coali-tions from cartels?

5. The National and the American BaseballLeagues are two separate leagues of 12 fran-

chised teams. To prevent competition amongteams for new players, a draft (similar to thatused in the football and basketball leagues) hasbeen adopted, wherein each newcomer from ahigh school is assigned to a particular team. Un-der this agreement, or assignment, no other teamowner will be allowed to sign that newcomer.

a. Who benefits from this arrangement?Who suffers?

b. Does this system exist in sports and no-where else?


Chapter 13Re~trictedAcce~~toMarket~

People and firms do not passively submit toopen-market competition. As we saw in thelast chapter, competing firms may investi-gate the possibilities of collusive actionamong themselves. They often attempt,sometimes successfully, to obtain politicallyenforced restrictions against potential com-petitors. Competition moves from the mar-ketplace to the political arena, where rivalsstrive for political power. The difference be-tween these two types of competition, onefor market offers and the other for politicalpower, is the essen tial difference betweencapitalism and socialism. (Remember, noth-ing in economic analysis enables us to drawconclusions about the propriety of competi-tion for political power.)

Political Restraints onConsumers' Market Access

Often when producers are legally restrainedfrom making and selling a product or serviceto consumers, the restrictions, called produc-er controls, are justified as protecting con-sumers. But it can be convincingly arguedthat many such restrictions are imposed toprotect certain producers from other produc-ers who could otherwise benefit customers.Thus, some restrictions on producers in factrestrict consumers. We now examine someproducer controls.

PROTECTION OFOR FROM COMPETITION?

One of the principal effects of political regu-lation of business has been to confuse protec-tion of competition with protection fromcompetitors. For example, the Federal TradeCommission has responded to complaints ofbusiness firms against one another. Whenfirms complain of "unfair," "destabilizing,""disorderly," and "cutthroat" competition,

283

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generally it is because their competitors aremore successfully catering to buyers' prefer-ences.

The price searcher and the protectedmonopolist differ from each other in that thelatter is protected from actual or potentialcompetitors by restrictions, whereas theprice searcher is not so protected. A protect-ed market keeps some resources from mov-ing to their most valuable uses, because theprotected sellers price, marginal revenue,and marginal cost are greater than some out-sider's marginal cost would have been. Theresult is a more severe distortion of outputthan would be produced by a price searcher,because no seller is restricted from offeringwares in any market.

How are market entry restrictions ob-tained? We now investigate some of the vari-ous techniques.

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ADVERTISING RESTRICTIONS

Advertising, again, is a means of informingpotential buyers of the existence of a sellerand the availability of its goods. Any obstaclethat either prevents a seller from informingpotential customers about offers or increasesthe costs of informing them will protect bet-ter-known sellers. If General Motors wantedto restrain the growth of American Motors,Volkswagen, or Toyota, it should seek toprohibit advertising. Holiday Inn, a national-ly known motel chain, is favored by bans onlocal highway advertising. The AmericanMedical Association, American Bar Associa-tion, and American Dental Association usedto prohibit advertising. Examine the yellowpages of the telephone directory and com-pare the advertising in various professions.Would you regard restrictions on advertisingas helpful to consumers or new suppliers? Inmany states and cities, advertising the price'sof gasoline or reading glasses or contactlenses, for example, is illegal or severely re-stricted. Prices there are higher. Restrictions

284 Chapter J 3

on advertising also increase the costs to con-sumers of gaining information.

SANITATIONAND HEALTH STANDARDS

Laws prohibit the sale or use of foods anddrugs that the U.S. Food and Drug Adminis-tration officials deem unfit. By establishingand enforcing standards of cleanliness, gov-ernment agencies reduce the individual'scosts of collecting information. But cleanli-ness is not costless. Some consumers prefercheaper goods even though they are pro-duced in less sanitary conditions, such as are,say, imported dates. As an example, the gov-ernment refused to allow the sale of a cheap,high-protein, biologically sterile, powderedfood because it was said to be filthy, beingmade from whole fish. Yet people eat wholeoysters, and pigs and chickens are convertersof garbage, insects, and worms. No one ob-jects to more cleanliness if its cost is not ex-cessive. But a high-priced barbershop thatuses a fresh protective apron for every cus-tomer will find itself underpriced by one thatreuses the apron with a new piece of paperaround each customer's neck. The higher-priced shop would do well to insist on higherstandards of cleanliness to keep out lower-cost competitors. A requirement of higherstandards is a restriction on consumers-usu-ally poorer people-who can afford only low-er-quality, cheaper service. Insisting that allbut higher-quality goods and services be pro-hibited is like permitting only Rolls-Roycesand banning VWs. Which is better for thepoor and for the rich?

Until about 1950 margarine could not besold in some states; it was an inferior substi-tute for butter. And in many areas it couldbe sold only as a white spread-even thoughbutter is artificially colored and flavored.Major milk-producing states had the stron-gest bans on margarine. (Do you suspectmilk producers are big political campaigncontributors?) .

QUALITY CONTROL

Codes in every city control the types andgrades of materials that can be used in theconstruction of buildings. New York City'sbuilding code was overhauled only after 30years, long delaying the use of new, bett~r,cheaper construction methods. The rapidgrowth in the use of mobile trailer homes aspermanent residences in the last severalyears can be explained partly by the fact thatthey are not covered by local building codes.Now, under pressures from the buildingtrades' unions, codes are being expanded toinclude mobile homes.

It is commonly believed that "Bad goodsdrive out the good."! And the remedy is thatbad goods must be prohibited. But that cor:n-mon belief is incorrect. When both quelityand price are permitted to be deter~ined inopen-market competition, neither dnves o~tthe other. Instead, the prices reflect the dif-ference in quality. Yet to assure higher quali-ty, the medical profession restricts entry !n.tothe market by state licensing laws adrninis-tered by state licensing boards made up oflicensed doctors. The medical profession em-phasizes that it has brought the UnitedStates the highest quality medical care forthose who can afford it. If a law permittedthe sale of only Rolls- Royces, Cadillacs, andLincolns, we could certainly have the best-quality automobiles in the world-and ~hemost pedestrians. Some peopl: wou.ld h:elonger and be in better health If medical ~Idand hospitals were available that embodiedless expertise and skill, and thus we~e lowerin price, because at the present time lessknowledgeable or helpful substitutes areused instead, such as nurses, druggists, mid-wives, books, self-medication, faith-healers,

"This old saying, known as Gresham's law, de-scribes the consequence of not allowing prices to re-flect differences in quality. Keeping the prices of high-er-quality goods below their market. level re.ducesincentives to produce those goods and Increases incen-tives to produce low-cost, inferior goods.

friends, and hearsay remedies. (Indeed, innineteenth-century France there was suchmedical aid in the person of the officier desante, or health officer, a licensed practitio-ner without an M.D: degree.)

It is hard to know when people who pro-fess to be acting only to protect other peopleare being sincere and when they have ulteri-or motives. (For example, do you regard theremainder of this paragraph as sincere?) Likehealth, wealth can be ruined by carelessness.A broken leg can be reset; a broken budget--can't be. Wealth, like health, must be pro-tected from personal ignorance. If a pers~ninvests $1000 in some business and loses It,the person's family suffers. Therefore, beforemaking any investment, every person oughtto be required to consult a licensed, certifiedeconomist, who would prescribe how wealthshould be invested. Without this safeguardmillions of people every day make foolish in-vestments and irrevocably lose their wealthand harm their families. Many people followthe advice of economic quacks-stockbro-kers, politicians, friends, and writers of .tipsheets. They overinvest without consultingeconomists, who could prevent their goingtoo far into debt or buying in the wrong areaor taking the wrong job or the wrong kind ofinsurance."

"There have been signs of progress in recent dec-ades toward serious agreement with this facetious argu-ment. In 1964 the Securities and Exchange Commis-sion issued a report evaluating the securities and stockmarket dealers' practices. In the covering letter thechairman of the committee says: "Under existing Fed-eral law there is a right of free access and unlimitedentry into the securities business for anyone, regar~lessof qualifications, except those excluded on the b~sls ofprior securities violations. The ste~d.y growth In ~hevery numbers of investors and participants, accordingto the report, has made this concept obsolete.::.Greater emphasis should be given by the Securitiesand Exchange Commission and the exchanges a~d a.s-sociations of security dealers to the concept of SUitabil-ity of particular securities for particular custome.rs.':Can you imagine what this would do for economistsincomes?

Restricted Access to Markets 285

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Regulations and restrictions are oftensought by already well established supplierswho would benefit by restraints on lower-cost or lower-quality suppliers. But lower-quality and lower-cost suppliers are notundesirable or wasteful. They provide other-wise unavailable services to less affluent peo-ple. While it would be desirable that the lessaffluent have better-quality services, the is-sue here is not better quality versus lowerquality, but lower quality versus none.

Even with an issue that appears as clear-cut desirable as restricting premature intro-duction of new drugs, one must measure thecosts against benefits. What is given up?Availability of newer and more effectivedrugs is delayed so that people are deniedsooner relief or even the saving of their lives.Although there are benefit's in avoidinglosses from what prove to be harmful drugs,there are losses from the delay of what proveto be better drugs. Tradeoffs are inevitable.Unfortunately, several studies have indicatedthat the increased delay of certain new drugshas caused more loss than have too-early in-troductions.

A very simple example of very great de-lay (too long?) has been that involving per-mission to sell UHT milk in the UnitedStates (UHT milk is treated so as to remaindrinkable for months without refrigeration).Though it has been sold in Great Britain formany years with an excellent record, onlynow can it be sold in the United States. Sev-eral drugs for heart disease have been treatedsimilarly. We repeat that the 'point is not thewisdom of restrictions but the weight at-tached to the two types of error-too latewith too much prolonged, avoidable suffer-ing and death, or too early with otherwiseavoidable suffering and death.

Similarly, according to studies, compul-sory safety devices for passenger cars result-ed in less careful driving with more acci-dents and injuries to pedestrians. But thatshould not be surprising. The increase in

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the number of fatalities and injuries is notthe crucial test of the desirability of suchlaws on safety. For example, when airplaneswere riskier and fewer people flew, fewerwere killed. Now that airplanes are safer,more people fly, and consequently a largernumber are killed in airplane accidents (al-though the incidence of fatalities per passen-ger mile is far lower than formerly). Unlessyou believe that the increased availability'and lower cost of flying was not beneficial,you cannot conclude that the increased inci-dence of accidents and amount of damagethat are consequences of more comprehen-sive safety requirements are not worth thegam.

PROTECTION OFEMPLOYEES, MORALS,AND SERVICE STANDARDS

Laws prohibiting sales during evenings andSundays are alleged to protect the health ofemployees, the morals of the community,and the quality of service. As the SupremeCourt has affirmed, Sunday selling divertspeople from rest and violates what mostChristians call the Sabbath. But no employ-ees work 24 hours. Sunday and evening buy-ing is a convenience to many shoppers. Ofcourse, consumers could do all their shop-ping between 3 P.M. and 7 P.M. on Mondays,Wednesdays, and Fridays. Any store able toreduce its costs and its prices enough bykeeping such hours could survive with con-sumers who prefer the lower prices at thosedays and hours-except that there aren'tenough people with such preferences. "Blue"laws, laws regulating behavior on Sundays,are often supported by retail stores that usemore labor service relative to capital than dothe discount houses that are, or would be,open evenings and Sundays. The extra laborhours add more to the total costs of conven-tional department stores than to those of thediscount houses.

ORDERLY MARKETS

It is sometimes argued that entry into an in-dustry must be restricted so that the overallindustry output cannot exceed one that al-lows adequate prices and profits. Otherwise,the argument goes, some firms will go out ofbusiness, and when demand later increasesthere will not be enough firms. This reason-ing is known as the orderly market argument.For highly seasonal products, such as milk, ifthe price fluctuated from troughs in June(when the supply is greatest) to peaks in No-vember (when supply is smallest), dairy farm-ers would be driven out of business in Juneand few would be in business in Novemberto provide an adequate supply of milk. Also,when prices are high, fly-by-night producerswill enter and "skim the cream," only toleave when demand and prices fall. The "re-sponsible" year-round producers will not sur-vive. Therefore, controls should be placed onentry so that irresponsible, short-term pro-ducers cannot undermine the long term sta-bility of the industry. (This argument wasalso the basis of regulation of domestic U.S.air carriers, until 1978. What followed theremoval of those controls requires no tellinghere.)

Can you spot the analytic errors in theorderly market argument? First, seasonalvariations are no surprise. Retail stores pre-dictably do about half their business in theChristmas season. They are not bankruptedby the summer low-sales months-just asthey are not by low Sunday sales. Yet somemilk producers allege that there must be con-trolled entry to assure "adequate" supplies inall seasons. Controlled entry achieves thatwith a uniform year-round high price. Duringthe high-production season, the "excess" milk(which would not be "excess" if its price wereallowed to fall in that season) is diverted tocheeses (or is bought by the government andexported, at a loss of $1 billion in 1981). InCalifornia the number of commercial milkcows is so restricted by law (because at the

high milk prices dairy farmers would find itprofitable to have more cows) that the valueof having another cow (beyond the limitednumber) is worth more than $2000, a measureof the contrived lJIonopoly rent. The situa-tion is similar in every major metropolitanarea, where federal and state laws permitdairy farmers to enforce controls. It is wellknown that dairy associations pay part oftheir monopoly rents to politicians for laws toenforce restrictions on supply.

The argument for orderly markets c09-tains two basic misconceptions. First, it as-sumes that changes in demand whether un-anticipated or cyclical and thus anticipated,are viewed by every producer as permanentchanges. Second, it argues that increasingsupplies drive down prices, thereby reducingsupplies, thereby in turn driving prices up; itthus confuses a movement of the supplycurve with a movement along an unchangedsupply curve as price and output fall in re-sponse to a demand curve decrease. See Fig-ure 13-l.

Using the rationale of maintaining an or-derly market, the Interstate Commerce Com-mission regulated truckers, with the resultthat monopoly rents went to the favoredtrucking companies and the Teamsters Un-ion. Farm price-support laws, such .as inwheat, cotton, and tobacco, control the entryof new producers into those markets. Farmmarketing boards for raisins, peaches, sugar,rice, oranges, and lemons, to name a fewcommodities, control the salable output ofthose crops in the name of orderly prices butin the interest of greater wealth for the cur-rent producers. Imports of sugar, peanuts,and rice are restricted so the domestic priceof those goods will be high enough to in-crease the value of domestic resources spe-cialized to those products. We investigate afew examples.

Import Quotas Rights to import some sug-ar from lower-priced foreign markets to high-


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MONOPOLY RENT FROM RESTRICTIONS ON OUTPUT

When the output of a good is reduced, as from Xo to XM>by restrictions on entry to a market, the price is raisedfrom Po to PM Protected suppliers receive a higherincome at a smaller output: The monopoly rent is thatportion of income represented by the rectangular areabetween the old price Po and the new price PM extendingout to the monopoly output quantity XM The area belowPo and above the supply curve S is Ricardian rent, thereturn to the superior productive inputs. The area definedby Po, the demand curve 0, and outputs XM and Xo isthe social loss from restriction of entry, becauseotherwise output worth more than its cost would havebeen produced. However, the monopoly rent is notsuch a loss: It is a transfer of income from theconsumer to the protected supplier. As we shallsee, competition to achieve protected monopoliststatus entails costs up to that amount ,oftransferred income, and thus wastesresources.

288 Chapter J 3

er-priced U.S. markets are called import quo-tas. Those valuable rights are granted by asugar quota board of the Department of Ag-riculture. Successful applicants are selectedby several criteria. Is your country friendly?Is it behaving properly? Are you a deservingrecipient of this favor? Who is the lawyer orrepresentative arguing your case? A formermember of Congress? If this suggests favorit-ism and potential for scandal, that's life.

Tax-Subsidized Price Supports and Surplus-es A major political means of avoiding theeffects of market forces on income andwealth has been much used by farmers, par-ticularly producers of milk, corn, soybeans,wheat, and rice. A look at a historical in-stance will demonstrate the motives for seek-ing protection and how that protectionworks. After World War II the demand forwheat fell. Distressed wheat farmers, seekingto avoid losses and the need to reduce out-put, succeeded in persuading the govern-ment to enact legislation instituting pricesupports. For every crop covered by suchlaws there is a price, the parity price, whichthe law seeks to achieve. The parity price isnearly always higher than the market-clear-ing price. At that higher parity price thepublic demands less of the good than is sup-plied, creating a surplus. The governmentthen steps in and, not literally but in effect,buys the unsold crop. It does this by lendingthe farmer money, using the unsold crop assecurity on the loan. If the farmer doesn't re-pay, the government keeps the unsold crop,thus, in effect, buying the crop to supportthe parity price.

The government makes these loans (orpurchases, if you will) out of tax revenues,which denies taxpayers the right to withdrawfrom these high-priced markets. In 1965 thetotal accumulated stocks of government-heldcrops had cost the taxpayers over $5 billion,including some $1 billion a year for storage.

Economic analysis does not support thepopular claim that surpluses exist because

production exceeds demand. As has alreadybeen well established throughout this book,demand is not fixed: The amount demandeddepends on the price. The American public(not to mention the enormous population ofthe rest of the world) would happily haveconsumed all the current U.S. farm output ifgovernment policies had not kept prices wellabove their market-clearing levels. Indeed, inthe 1970s, when several countries sufferedrepeated large-scale crop losses because of se-vere weather, and when inflation causedopen-market prices on the world market torise above the parity price, the surplus al-most disappeared. But recently, larger U.S.harvests and a higher parity price havethreatened to create new surpluses.

If we seem to be condemning the farm-ers' actions, rereading what we have said willshow that there is no suggestion of impropri-ety. Farmers are not unique in attempting toavoid market forces. We are examining agri-cultural cases because they are relatively sim-ple.

Holding Crop off the Market" At one timelemon growers tried to raise their prices byeach withholding some output from the do-mestic market. But some growers stayed outof the agreement and sold all their crop atthe raised prices. Furthermore, some superi-or producers could make more wealth ifthere were no such artificial restrictions.How could they and other producers be con-trolled? In 1941, a law was enacted permit-ting a majority of the growers of any agricul-tural product to compel all growers of thatproduct to withhold part of their crop fromthe market.

How can a group of growers control eachproducer's sales? One way, as indicated earli-er, is to set up a central sales agency thatpools all the output and decides what portion

"The following analysis is applicable with minorvariations to many products, including milk, eggs,wheat, cotton, tobacco, peanuts, rice, raisins, corn, andoranges.

of each producer's output goes to several out-lets: to be sold at high prices as fresh fruit indomestic markets; to be destroyed; or to besold at lower prices as concentrates or flavor-ings in domestic" and foreign markets. Be-cause of the artificially maintained highprices, growers produce ever-larger outputs,requiring that the proportion of lemons au-thorized for domestic sale as fresh fruit besteadily reduced over the years: from 90% ofthe total crop in 1942, the program's firstyear, to less than half the total crop today .•.

The program's unintended effect hasbeen to encourage each grower to createlarger groves to compete for a larger share ofthe limited sales. As a result, farmers are nobetter off now than they were before theprogram. They have dissipated the monopo-ly rent in the costs of larger groves. Withoutthis scheme, there would have been fewerproducers, with lower costs, selling a largeshare of their fresh lemons at lower prices.There is a social waste as well, measurable asthe loss of forsaken crops, such as avocados,grapefruit, or macadamia nuts, or of land forresidential housing.

PRODUCTION CONTROLS

An alternative method of keeping the priceabove its market-clearing level is to limitproduction to as much as can be sold at thedesired price, in effect, again, a parity price.This method is tidy, eliminating both lowprices to the producers and potentially em-barrassing surpluses. One way to control pro-duction in agriculture is to assign each pro-ducer a maximum allowable acreage that canbe planted, say 80% of a farmer's availableland (obviously the farmer will pick the best80% and pour on the fertilizer). The farmerwill even receive payment, called a conserva-tion payment, for keeping land idle. Thosewho do not restrict their acreage will not beallowed to sell at the parity price. In fact, in


the case of tobacco a prohibitive tax of 75%of the value of the crop is levied on such ex-cess acreage. Land licensed for tobacco grow-ing is marked as such and is policed by heli-copters. There is no tobacco surplus, becausethe price goes to whatever level will clearthe market of the licensed (untaxed) output.The output-control technique used for tobac-co has been extolled by recent U.S. presi-dents as deserving application to other crops.You can see why. This system is called self-policing; a voting majority of the growers au-thorize's and enforce's the acreage-reductionscheme on all producers.

The best U.S. lands for cotton produc-tion are in the West. But because the farmsthere are larger and fewer than elsewhere,these lower-cost producers are outnumbered.To cut back the use of older, more costlylands is obviously not acceptable to the east-ern majority. Instead, everyone is cut back bythe same percentage of the acreage that hasbeen in use in the past few years. This inge-niously reduces the newer acreage by a big-ger percentage than the old, because the far-ther into the past the base is extended, thesmaller it will be in a recently expandingarea (as, conversely, it will be for older areasthat are declining). Consequently, the votesin favor of acreage-restriction schemes falldramatically as one moves into the newer,larger, better western farms.'

When applied to farming, production

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'We interject an ironic note. ~{though we call thewestern lands better, some are so only because of feder·al irrigation projects that keep water prices substantial-ly below the costs-the difference being made up bytaxes on the rest of the country. Thus farmers in theSoutheast pay taxes to enable water to be sold at belowcost to their competition in the western desert areas.And to protect themselves from the consequent lowerprices, they appeal for more taxes on consumers to fi-nance "loans on unsold cotton"; finally, they appeal forfederal regulations restricting production of cotton onthose very western ,lands for which they have paid tax-es to help irrigate at less than cost.

290 Chapter 13

control promotes greater use of fertilizer andother jointly productive resources to increaseyield per acre; production becomes more in-tensive. As the output per acre skyrockets,acreage must be cut back more than hadbeen expected, because farming has become"surprisingly productive."

Publie UtilitiesIn certain industries, such as electricity, gas,water, sewage and railroads, it may be thatthe cost of serving the public is lower if onlyone firm operates. Larger output may beavailable at lower costs per unit of output.Such an industry called a decreasing-cost in-dustry, or sometimes, a natural monopoly,suggesting that one firm can provide the sup-ply at lower total cost than if the total outputwere produced by several smaller firms.'

Because of the absence of competion,such natural monopolies are commonly sub-jected to government controls over prices, in-vestment, output, and profits. So, too, are le-gal monopolies, firms that, by law, are theonly ones allowed to produce a good or ser-vice for the market. Regulation of these mat-ters is performed by regulatory commissions.If the monopoly firm fails to make a profit,the stockholders bear the losses. They maythen sell their stock at a loss to new buyerswho expect to do better. Or the service willeither come to an end or be subsidized bytaxes (as are Amtrak, most city bus lines, andmost rapid transit systems).

No one firm, monopoly or not, will cap-ture all the knowledge, talent, and skill appli-cable to the production of its goods and ser-vices. Thus, prohibiting new entrants

'Technological advances in electronic communi-cation have altered the presumption that telephone ser-vice can be provided more cheaply by one central sup-plier. Similarly, close substitutes for railroads haveeroded the presumption that there is only one supplierof transport services.

reduces the likelihood that new or improvedproducts or lower-cost methods of produc-tion will be discovered and tested. Moreover,innovations that would lower costs would beslow to be adopted; for although a protectedmonopolist has as much to gain from lowercosts as any other firm, it is the regulatorycommission that decides how any increasedprofits would be distributed, or whether theywould be allowed. If profits to the utility arerestricted its incentive to lower costs is re-moved. Nor can members of the regulatorycommission directly capture the gains of low-er costs; as a result, they, too, will be less mo-tivated to lower costs than if they owned theprotected public utility.

Other industries that are not naturalmonopolies, in that their marginal costs donot decrease as output increases, are some-times nevertheless made into contrived mo-nopolies by law and are called public utili-ties. Exarnpl-s are taxi services, radio andtelevision broadcasting, and garbage-collec-tion services.

WHOSE "UTILITY"IN PROTECTED PUBLIC UTILITIES?

Let us examine an instructive example of theincentives for creating regulatory agenciesand the consequences of such agencies. In1887 the Interstate Commerce Commission(ICC) was established to regulate the rail-roads. What was the basic problem? By 1880too many railroads had been built; for exam-ple, seven tracks ran between Omaha andChicago. Although the initial investmentcosts of building a railroad are high, subse-quent operating costs are low. Railroadscould cut prices far below the long-run totalaverage costs. And this some railroads did:Rather than shut down because prices didnot cover past investment costs, theydropped their prices to the marginal costs ofoperation with existing equipment. Otherrailroads sought to prevent this price cutting,which usually involved secret price dis-

counts. Shippers who did not get the lowerfreight rates demanded that the governmentprohibit secret price cuts. Even the railroadswanted-as a group-to avoid price competi-tion.

In the absence of regulation, priceswould have remained low until some railsand equipment wore out, at which time onlythose railroads with more heavily used routeswould have been maintained. However, thelaw passed in 1887 establishing the ICC alsorequired railroads to charge "just and reason-able" rates and to publicly post those rates.Thus, the railroads could do what they hadunsuccessfully sought to do by private collu-sion-to prevent individually advantageousbut mutually disadvantageous secret pricecutting.

The ICC became the vehicle for main-taining an effective cartel in transportation.ICC regulations imposed legal price collu-sion (much as if General Motors, Ford,Chrysler, and American Motors had a federalagency that excluded imports and alsohelped them mutually set prices at which alltheir cars could be sold). In 1920 the ICCwas additionally empowered to control theentry of new competitors and the addition ofnew routes, thus further protecting the exist-ing railroads. Unfortunately for the rails, oth-er forms of transportation were developing-autos, trucks, airplanes, and barges. Becauseof the high rail freight rates, trucks andbarges took much of the business. So theICC was charged with regulating them, too.The ICC now must approve interstate ratescharged by the highway transport industry,waterways, pipelines, and railroads. (Stateand local agencies control intrastate and localfares.) Regulations and restrictions on com-petition among these services has eliminatedcheaper services that would have saved morethan an estimated $5 billion annually. (Addto these lost savings the nearly $100 millionin annual expenditures by the ICC.)

Regulatory agencies were also set up for


airlines (Civil Aeronautics Board), for radioand TV (Federal Communications Commis-sion), and for energy (Federal Energy Agen-cy). All were set up in the belief that open-market competition in these industries isunfeasible or in some way inappropriate. Af-ter the airlines were deregulated by the Car-ter administration, the results exposed andremoved many of the stultifying effects ofregulation.

Patents and CopyrightsPatents and copyrights are legally grantedexclusive rights (that is, a protected monopo-ly) to the commercial use of certain goods orideas." Others can produce these goods andservices only under license from the patentholder, the patentee. For example, the prin-ciple of Polaroid film is patented; PolaroidCorporation, the patentee, can license othersto produce and sell that film. The patent,given for a period of years, usually 17, is oc-casionally renewable for 17 more. The poten-tial income from patents and copyrights is in-tended to induce the discovery andapplication of new, useful knowledge. If oth-ers could use a new, valuable idea withoutpaying, there would be less incentive to dis-cover and develop inventions. Even thoughmany people try to invent or do researchwithout that incentive, the prospect of gainwill attract more thought and resources.

Of the value of an invention, what is theappropriate share that shoula go to the in-ventor? And what is the appropriate methodof collecting that share of the value? The ab-sence of clear-cut criteria for answering thesequestions provokes dispute about how long apatent should be protected and what kind of

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"Patents do not prevent other people from usingsome idea or device if they use it for themselves andnot to produce something for sale to other people; onlycommercial use is forbidden.

292 Chapter J 3

pricing and use of the patent should be al-lowed.

SUPPRESSION OF NEW IDEAS?

Sometimes an inventor discovers a new ideathat makes obsolete an idea on which the in-ventor has a current patent. What is the like-ly effect? Does the patent system cause newideas to be suppressed? Say I owned a cablepay-television system and then discovered acheap way to eliminate the cables: Would Iuse or suppress the wireless system? What Iwould do depends upon the relative costs.Since the wires are already installed, the costof their continued use is low until they mustbe replaced. If producing and installing thenew system costs less than continuing to usethe existing system, I would immediatelyabandon the old system. Otherwise, I woulddelay using the new system until the old hadto be replaced or repaired at a higher costthan that of installing and using the new.This delay in introducing a new idea is some-times regarded as "unjustified." But in fact itreflects the truly lower cost of using up exist-ing equipment first.

For example, it is a commonplace ofmodern folklore that gasoline producers havea new fuel or carburetor that would enor-mously reduce the demand for gasoline, butto protect their wealth they have withheldthe device. Is this likely? If the device or ideawere patented, it would be public knowl-edge; but there is no patent record or anyother evidence of such a device. And if theinvention were not patented, then any otherperson who knew about it could manufacturethe device and earn an enormous fortune-more than the existing companies couldmake by withholding it. Therefore the in-vention could not be kept off the market if itreally was cheaper. And it would not be usedif it did not save costs. In sum, if such a de-vice did exist, it could be made and sold at aprice reflecting the value of the gasolinesaved, a net profit to the owner, whether or

not the producer is now an oil or auto pro-ducer.

NONPATENTABLERESEARCH AND DEVELOPMENT

There is no generally accepted rule for de-ciding what kinds of exploratory activityshould be given patent and copyright mo-nopolies. Supermarkets, self-service gas sta-tions, drive-up windows in banks, coloredsoaps, open-all-night stores, discount houses,metal tennis rackets, and a host of cost re-ductions and quality improvements are notsubject to copyright or patent. Nevertheless,much research and development is conduct-ed without the incentive of patents or copy-rights. Most firms have to derive their profitsfrom being first to offer a new product, grab-bing a larger share of the market than theywill have after their competitors come in.

PATENT POOLING

Another piece of erroneous folklore is thatseveral inventors will pool their related pat-ents simply to monopolize some generalfield of research. Each inventor grants theother a right to the use of any future relatedpatents. However, there is another possibleexplanation. Pools or mutual sharing of relat-ed patents from continuing research are away to encourage more future research.Many patents are so closely interrelated andinterdependent that it is impossible to easilyidentify infringements. Many products arebased on a series of patented advances inknowledge. The problems of getting andmaintaining agreement among each of thepatentees for manufacturing such productswould obstruct the incentive to discover fu-ture related improvements. It would be nextto impossible to collect royalties for suchideas if everyone were fighting over whatpart of what device reflected this patent andwhat part that. So agreeing to pool any fu-ture related inventions under one ownership

is a way to induce the continued discovery ofrelated ideas.

Monopoly Rents:Creation and Dissipation

The effect of legal barriers to entry in a mar-ket and of some methods of maintaining "or-derly" markets is to increase the wealth ofthose already in the market when the protec-tive scheme goes into effect. That increase ipwealth is monopoly rent; monopoly becauseit is derived from restricting access to themarket, and rent because it does not inducean increase in supply. Monopoly rent is not aprofit achieved by transferring resourcesfrom lower- to higher-valued uses.

. What happens to monopoly rent? Byway of answer we examine the production-control scheme whereby tobacco farmers arelicensed to use a certain acreage for crop.The monopoly rent was obtained by thosewho owned the land at the time the schemewas started. The value of the licensed land isthe value of the tobacco crop after all othercosts of production (labor, equipment, fertil-izer, insecticides, management, taxes, andthe like) are subtracted. Suppose that thatnet revenue from a licensed acre is $400 foreach crop year. Recall from our earlier capi-tal value analysis that an annuity of $400 peryear at a 10% interest rate would have a val-ue of about $4000. Suppose also that land ofthe same kind without a license yields a netrevenue of $100 annually and has a value of$1000. The difference, $3000, is the capitalvalue of the monopoly rent.' When the li-censing scheme is revealed, the favored acrerises in value, and its owner captures thehigher wealth. The owner can farm the landfor the annual higher-income stream, rent it

'These are realistic values. Recall that the mono-poly rent is about $2000 per cow in the dairy industryin California.


out for the higher rent, or sell the land andthe license.

The purchaser of the licensed land getsno gain because of the higher purchase price,$4000: $1000 for the land and $3000 for thelicense. The income from tobacco produc-tion on that land equals a normal competi-tive return on that $4000 purchase price. Ifthe license to grow an acre of tobacco couldbe sold "bare" -that is, was transferable toany given acre of land-for, say, $3000, itwould pay owners of less appropriate land totransfer their licenses, acre for acre, to moreappropriate land. If such transfers were legal,the total costs of the produced tobacco wouldbe lower, regardless of who captures the mo-nopoly rent. Why are such transfers not le-gal? Some political observers have suggestedthat the sale of bare licenses would exposethe monopoly rents provided to the tobaccolandowners (just as they are exposed in thesale of bare licenses for liquor stores, taxifranchises, and radio and television stations).

Although widely favored politically be-cause there is no surplus, the kind of produc-tion control that the licensing of tobaccogrowing accomplishes has three affects: (I) Itreduces consumption below what it wouldhave been with open-market competition; (2)it yields monopoly rents, but only to theowners of licensed land, not to the tobaccogrowers (unless they happen also to be theowners); (3) it wastes resources by prevent-ing highest valued uses of them.

,. !

COMPETITION FORMONOPOLY STATUS

People compete to acquire the status of a po-litically protected monopoly. Bribes, politicalcontributions, payment of higher taxes, andthe costs of public-relations counsel and law-yers to obtain rights, licenses, franchises, orexclusive authorization are the forms suchcompetition commonly takes. They tend toabsorb all the monopoly rent. These perva-

294 Chapter J 3

sive payments to both political parties havebeen publicized by several congressional in-vestigating committees.

If entry into some industry, profession,or labor union is restricted so that membersreceive some monopoly rent, would-be en-trants will spend money competing to obtainsome of those monopoly rents. These candi-dates try to acquire whatever qualities theybelieve the authorities require as their stan-dard of admission. The long waiting lists ofapplicants to medical schools suggest thatmedical earnings are composed partly of amonopoly rent. But it is questionable wheth-er that monopoly rent is captured by the en-trants as increased wealth. For example, sayyou pay the costs of becoming qualified foradmission to medical school and finally topractice. If the net capital value of the highbut short-lived income you will have eventu-ally earned in your career is measured, start-ing from the date you decided to train foradmission to medical school, you may discov-er that it is merely equal to the average in-come of all college graduates.

The owners of a protected monopolycannot count on getting all the monopolyrent as a net gain. In some states liquor li-censes are worth an average of over $40,000,though issued for a minor sum (about $2000in Florida). Taxi licenses are worth about$50,000 in New York. In many states entryinto the savings-and-loan banking industry issubject to the approval of state officials. InCalifornia permission to open a bank onceexceeded $50,000 in value, measured by theimmediate rise in the price on the stock ofgroups obtaining permission. Part of the pro-tected monopoly rent of television is takennot necessarily in the form of money but inthe form of power to dictate programming.Television stations are requested to providefree coverage of the political campaigns, es-pecially national ones, of major-party candi-dates. They are also required to broadcastthe kind of programs that FCC authoritiesthink appropriate. (Newspapers, which do

not have to apply for a license, not surpris-ingly act in ways that television cannot.)

In Turkey and India (the only two coun-tries for which careful estimates have beenmade) monopoly rents to parties favoredwith monopoly status-such as by licenses toimport goods, to build a factory, or to open abusiness-equal about 7% to 12% of nation-al income. The cost of competition to getthose rights absorbs the prospective monopo-ly rent. If import licenses for raw materialsare given in proportion to the size of one'sfactory, a would-be entrant will overbuildthe factory. People compete by bribing offi-cials or promising to hire them after theyleave government service, or by hiring theirrelatives or locating firms in the capital city,and the like. The winners are not necessarilyany richer after paying those costs.

SummaryI. Governments often restrain the right to pro-

duce or consume some kinds of goods andservices. These restraints are sometimes im-posed to protect consumers thought to beinadequately informed. Restrictions on ad-vertising; impositions of standards of sanita-tion, health, and quality; and regulation ofworking hours and conditions are examples.These can sometimes help less informedconsumers. But they also can protect somesellers from competitors who otherwisecould cater to consumers' demands, whetherwell informed or not.

2. Attempts to make markets "orderly," or im-pose import quotas, or support prices byagreeing to control or withhold goods fromsale are devices to protect producers' inter-ests at a cost to consumers exceeding thebenefits to the producers.

3. Public utilities are examples of natural mo-nopolies: productive enterprises that havecosts that decrease as output increases, sothat one producer could serve all consumersat a lower cost than could several producers.

4. Public utilities are regulated by government

in the expectation that the prices will belower and service better than if unregulated.

5. Patents and copyrights are devices to givean inventor or author enforceable private-property rights"in the product. Whether ornot that also gives monopoly rents dependson how closely substitutable are other prod-ucts.

6. Withholding the use of a patented idea inorder to protect inferior ideas or techniquesis not a profitable tactic for an inventor, andthe older, inferior product could not success-fully compete with the new idea or tech-nique that was really cheaper or superior.

7. Resources protected from competition byother resources with a resultant higher mar-ket value collect a monopoly rent, which isessentially a wealth transfer of some of theconsumer's surplus to the supplier through ahigher price. In addition, the resulting small-er output destroys some of the potentiallyhigher-valued use of some resources thatmust be used in less-valuable ways becausethey are prohibited from competing withthe protected seller.

8. Prospects of monopoly rents through gov-ernment controls on competition will inducecostly competition to obtain such controls.The costs will tend to match that prospec-tive gain, resulting in no net social gain but,instead, a social loss because of the distortedresource use.

questions1. European coal producers pool their sales

through a central agency.a. Why is that essential for an effective po-

licing of the collusion agreement amongthe producers?

b. Why haven't some coal producers stayedout of the agreement and taken advantageof the opportunity to sell more coal at theprice maintained by the "cartel," as it iscalled?

*2. Suppose you could live in a society in


which trademarks were not protected by law andanyone could imitate the trademark.

a. As a consumer, would you prefer to livein that world or in one where trademarkswere exclusively reserved for a particularmanufacturer as part of his property?Why?

b. As a producer, which would you prefer?

*3. Milk delivery is sometimes called ineffi-cient because when several firms deliver milk tohomes, there is duplication of delivery trucks andlabor.

a. For standard items such as milk, wouldyou prefer to live in a community withone centralized delivery service con-trolled by a regulatory commission to en-sure low price and adequate quality, or inone where anyone who wants to delivermilk can enter the market? Why?

b. Apply your analysis of the precedingproblem to the case of garbage collecting.Would you feel differently about that?

c. How about mail service? Newspapers?Electric power?

d. If your answers differ, what factor makesyou change your preference?

4. It is probably safe to say that a majority ofthe faculty at any college contends that studentsare not competent to judge the quality of the in-struction in various courses and hence should notbe relied upon as evaluators of instructor compe-tence.

a. What do you think?*b. At the same time, it is probably safe to

say that a majority of the faculty thinksits students have come to that collegebecause the students c,\1'1 tell good col-leges from bad. Do you see any incon-sistency in this pair of beliefs? Explain.

*5. European countries import inspected fro-zen fresh meat from Argentina. But the UnitedStates limits imports of fresh meat, because someother countries have hoof and mouth disease (arapidly spreading disease that kills cattle, al-though it does not endanger human life). Whomdoes the import limitation benefit and 'whomdoes it hurt? How?

f: I

!

t i

6. Texas, which has the legal right to subdivide

296 Chapter J 3

itself into seven states, surprises us by doing so.One of the new states, Texaseven, with no col-lege in its boundaries, decides to give to everyhigh-school student a four-year annual grant of$1500 to be applied to education costs at the col-lege of his choice anywhere in the world.

a. Would you consider that new state tohave the finest or the worst educationalsystem in the world?

*b. Why is that method not used morewidely, despite its temporary wide useimmediately after World War 11 as anaid to veterans?

"c. Why is it opposed by the officials ofmost state universities?

7. Read the first quotation in footnote 2, p. 285.*a. Why has the growth in numbers of in-

vestors made open markets for securitydealers and for investors an obsoleteconcept?

b. If you were a black, a Jew, or an immi-grant, would you find this developmentto your advantage? Why?

8. Tentatively classify the following, on the ba-sis of your present information, as (a) price tak-ers, (b) closed monopolists, or (c) open monopo-lists. (Remember, market closure does notnecessarily convert a price takers' to a pricesearchers' market.)Electric companyCity bus lineAirlineGeneral Motors

CorporationCorner drug store

Prescriptionpharmacist

U.S. SteelCorporation

Lettuce growerElectricianElizabeth Taylor

9. "Retail grocery stores are monopolies." Inwhat sense is that correct and in what sense is itfalse? "The medical profession is a monopoly."In what sense is that true and in what sensefalse? Which kind of monopoly implies a higherprice?

*10. The market for economics professors inmost colleges is completely open. No legal re-quirements about training or prior experienceexist as a condition of teaching. A majority of theprofession has opposed certification-underwhich a certification board, consisting of profes-sors, would administer standards of competence.Consider the following:

a. If all present college professors were auto-matically certified (under a kind of excep-tion called a "grandfather clause"), but allnew entrants had to obtain certificationby passing certain tests, would the marketbe open or restricted?

b. If the number of professors admitted werecontrolled by the board of college profes-sors, which is what would happen, do youthink they would restrict entry to the"needed" numbers and would keep out

. inadequately trained people in order toprotect students? Would this have any ef-fect on the wages of college professors?What would be the effect on the numberof professors?

c. Similar systems of certification (or admis-sion or licensing or self-policing) are usedby doctors, lawyers, pharmacists, archi-tects, dentists, morticians, butchers, long-shoremen, psychiatrists, barbers, and real-tors, to name a few. What do you think itimplies about the wages in these profes-sions relative to wages in an open market?What does it imply about the quality ofthose who actually practice the profes-sions? About the quality and quantity ofservices provided the community? Isthere a difference between the quality ofcompetence of those certified and thequantity of service obtained by the publicas a whole?

11. Diagnose and explain the various features re-ported in the following news story: "An attrac-tive brunette seated in a rear row gave an excitedwhoop when her name was called Wednesdayduring a drawing at the County Building. Shehad good reason to be elated. For $2000 she hadpicked up an on-sale liquor license with a marketvalue of about $40,000. She was one of 54 per-sons who had applied for the 25 new on-sale li-censes to be issued in the county this year by theAlcoholic Beverage Control Board. A drawingwas used to determine who would get the newon-sale licenses, which permit sale of drinks onthe premises. An applicant must have had apremise available and must operate the businessfor two years before he can sell the license."

* 12. Gulf Oil, Baxter Laboratories, Richardson-Merrell, Levi Strauss, and Tenneco are a sample

of many American firms that made payments toforeign government officials to conduct businessabroad.

a. Who extorted payment from whom, orwho bribed whom?

b. How is that activity different from payingfranchise fees or taxes to do businessabroad?

c. Why don't the foreign governments useexplicit license fees and taxes rather thaninsist on covert payments to governmentofficials and their relatives?

d. Almost all the payments made by Hiecompanies were to government officialsand their relatives. Would it be safer tosimply put the official's relatives on thepayroll and let him neglect his work?

e. The press called this corporate bribery.What would you call it?

13. As determined by congressional action, radioand television networks are not required to give"equal-time" rights to any political parties otherthan the Republican and Democratic parties.

a. Would you consider this a collusion bythe two major political parties against themany smaller political parties?

b. Why are newspapers not required to giveequal-space rights to the two major politi-cal parties? (Hint: The answer is not thatradio space is limited or a natural re-source that "belongs to the people.")

14. Why, despite so much political campaigningagainst "monopolies," do politicians create closedmarkets or closed monopolies?

* 15. The judicial council of the American Medi-cal Association recommended that it be consid-ered unethical for a doctor to own a drug store inthe area in which he practices medicine. It alsorecommended similarly for ophthalmologists whodispense eyeglasses for a profit. "Any arrange-ment by which the physician profits from theremedy he prescribes is unethical," in the opin-ion of the council.

a. Who do you think would benefit if thisrecommendation were adopted by theAmerican Medical Association and madeeffective?

b. If it is unethical for a surgeon to profitfrom the remedy he prescribes, should


IIi !.. ,I

any surgeon diagnosing a patient be al-lowed to perform the recommended oper-ation?

c. Should a building contractor be allowedto have any interest in a lumber compa-ny? Should any teacher be allowed to usehis own textbook? Should a doctor be al-lowed to own a hospital? Or own an un-dertaking business?

d. As a patient, would you prefer to dealwith doctors who are prohibited fromownership of drug stores? How would thishelp you or hurt you?

16. The U.S. postal system is a monopoly. Noone else may institute a competitive system oftransporting personal messages for pay.

a. Why do you think it has remained a mo-nopoly?

"b. The prices charged are uniform despitevast differences in costs of service to dif-ferent patrons. Why is this kind of dis-criminatory pricing practiced for mailbut not for food, clothes, or dancing les-sons?

* 17. Why do union officials object to admittingthat their power rests on a closed monopoly,while at the same time opposing any legislationthat would destroy that monopoly power? An-swer the same question when applied to theAmerican Medical Association.

* 18. Moving companies are regulated by the In-terstate Commerce Commission; their rates perpound are legally set. Explain why that wouldentail prohibition of making binding bids, priorto moving, as to the cost of the move? In whatmanner will they compete for business?

19. Is it possible for an economy to be such thateveryone is a closed monopolist yet everyone ispoorer than if there were no restrictions on theopen market? Explain.

*20. When seeking a replacement for a retiringmember of a regulatory board, President Johnsonsaid that he wanted a strong man of action tohelp strengthen the board, because he had notedthat even the regulated industry didn't like weakregulatory boards. Why do you suppose the reg-ulated industry likes a strong regulatory board?(Hint: Who is regulated for whose benefit?)

21. A liquor-retailing license in Florida was re-cently sold for over $110,000. The seller was theperson who initially got the license from thestate at a cost of $1750.

a. Did the subsequent buyer get a profit inthe form of a monopoly rent?

b. Did the initial licensee get a profit in theform of a monopoly rent?

Chapter 14

Income froOlPersonalServices

ProductiveResources and Incomes

Almost 80% of the market value of output inthe United States is paid for current humanservices and is called wages and salaries. Theother 20<;'0 is for payments to owners of non-human resources. The names of those pay-ments depend on what the good is andwhether it is rented out or used by the own-er. (See Table 14-1.) For resources other,than money the payments are called rents;for money, they are called interest. If used bythe owner, rather than rented to someoneelse, the service value is called implicit rent.For resources owned by owners of businessfirms the income is called business earningsor net income; sometimes it is also calledprofits. Any of that income paid from thefirm to its owners (stockholders) is called adividend.

In Chapter 6 we defined standard in-come as being equal to the interest on totalwealth. So, according to that interpretation,the earnings-composed, as just noted, ofwages, rents, interest on money, and prof-its-from the entire stock of human and non-human capital could be called interest.

Table 14.1 CLASSES OF U.S. INCOME EARNINGS

Resources Form of Percent offrom Which Payment for NationalServices Come Services Income

Human Wages, salaries 80%Nonhuman

Used by Rent 2%nonowner earnings,

Used by owner Implicit rent, 13%net income, profit,dividend

Deferred current Interest 5%consumption toproduce futureincome

299

PAST ANDCURRENT LABOR SERVICES

Almost all productive resources (also calledcapital goods) have been produced with thepast investment of human labor and intellec-tual services. Though some resources, suchas land, minerals, and water, are not of hu-man creation, their usefulness is often the re-sult of past labor. Students purchase servicesfrom teachers to create more productivepowers in themselves, a form of human capi-tal: Educating a person is a form of invest-ment in a capital good.

The labor services that made capitalgoods were paid for at the time of their mak-ing by someone who hoped to recover morethan those costs from the later enhanced pro-duction, whether the capital goods be ani-mate or inanimate. The person paying thewage is called an investor, a speculator, or,more inclusively, a capitalist. A completedmachine is usually used jointly with more la-bor. The current labor and machine yield aproduct selling for, say, $100. That is expect-ed to cover those current labor-service wagesof, say, $80. The remaining $20 is for "capi-tal depreciation and profit." Of that, say $15is for repayment to the person who earlierpaid the wages for the labor used to .makethe machine.' This would leave something tocover the interest on that investment for theearlier labor. Only if there is a remainder af-ter that in excess of any value of the inves-tor's own labor services wil) the investorhave a profit. ,-

Although capital includes people as wellas nonhuman goods, we see the values ofnonhuman wealth more easily and clearly,because rights to those goods are bought and

'If the machine lasts four years and was created ayear ago with $60 of labor services, the depreciationwould be roughly equal to about $15 (plus interest onthe advance) for each year's full service-in effect, thevalue of past services now used up.

300 Chapter 14

sold, whereas people normally sell only cur-rent services. Nevertheless, some indicatorsof the values of human wealth do exist. Oneis life insurance. The amount of insurance aperson buys is correlated with the p~esentvalue of the services that can be sold m theyears remaining.

If a person could literally sell claims tofuture services now, one could immediatelyexchange claims to future earnings for otherforms of wealth. But as it is, a major portionof one's wealth is tied up in one's potentiallabor services. This is a disadvantage thatfree people must live with. Each of us,whether we want to or not, must bear therisk that unforeseen developments may re-duce the value of our human wealth. Occa-sionally, some people manage to sell rights tosome of their future labor services. Classicexamples are professional athletes who. re-ceive "bonuses" for signing to play exclusive-ly for some ball team.

Most economic production is done inbusiness firms. If the firm has a single propri-etor as the operator, income would includewages for the operator's services, though it issometimes called "profits" to indicate thatthe amount received for those labor servicesis a residual, rather than guaranteed as forthe employees. As explained earlier, there isexpected some interest on investments ~fearlier services in the firm and, finally, POSSI-

bly some profit.

Supply of LaborOf over 160 million able-bodied adults (thatis, persons over the age of 16) in the UnitedStates, about 100 million (roughly 60%) arein the labor-market force-employed or seek-ing appropriate employment for moneywages. This labor-market participation ratehas remained close to 60<70for the past cen-tury. Table 14-2 shows the participationrates by age for males and for females in

Table 14·2 LABOR-FORCE PARTICIPATION RATES, BY AGE AND SEX(PERCENT OF POPULATION IN EACH CATEGORY)

1980 1960 Female MaleAges Male Female Male Female Ages Single Married Single Married•.16-17 52% 45% 46% 28%

16-19 } 54% 48% 61% 94%18-19 74 62 73 5120-24 86 68 89 46 20-24 75 60 81 9625-34 94 62 96 36

25-44 } 80 56 88 9735-44 95 61 96 4345-54 90 57 94 49

45-64 } 66 45 68 8555-64 73 41 85 3765-over 20 8 32 11 14 7 17 23

Source: U.S. Department of Commerce, Statistical Abstract of the United States.

1960 and 1980. Almost 80% of the males arein the labor force, down from about 90% acentury ago. Decreases in participation byteenagers and those aged over 65 were al-most exactly offset by increases by females.Almost 50% of women (and about two-thirds of single women) are now in the labormarket, over twice the rate in 1900, proba-bly reflecting increased education for wom-en, the availability of ready-cooked and proc-essed foods and of appliances permittingmore substitution of capital goods for house-hold labor, better pregnancy-preventiontechniques, and increases in wages. The de-creased participation rate of both men andwomen older than about 50 is a result of So-cial Security payments for those not workingat those ages. Figure 14-1 relates labor-forceparticipation to age and gender; Figure 14-2relates participation of men and women tomarital status.

Although the preceding data refer topeople working in the labor market for mon-ey wages, perhaps the largest class of workersare women managing households as wivesand mothers. Something like 30 to 50 millionwomen are heads of households. It is regret-table that economic analysis and official datahave not been directed more fully to measur-

ing the magnitude of their contribution tothe national income. Typically, national in-come measures marketed products and ser-vices and hence does not include the value ofthe services of a head of household. Never-theless, the value of such services in manag-ing and performing the various activities of ahousehold (acting as chefs, purchasingagents, nurses, decorators, social serviceworkers, secretaries, gardeners, tailors, chauf-feurs, maids, psychiatrists, and so on) wereestimated to average close to $12,000 perfamily head in 1980, totaling roughly $500billion-equal to about one-third the meas-ured national marketed income.

Of the 110 million people in the labor-market force, over 45 million are in nonrnan-ufacturing, or service, industries; about 30million are in manufacturing; less than 5 mil-lion are in agriculture; 2.5 million are in themilitary; and about 5 million are at any givenmoment temporarily between jobs and un-employed. (Over 5% of those in the workforce hold two jobs.)

Figure 14-3 shows employment by typeof final product. Figure 14-4 shows the distri-bution by type of labor skills or tasks.

About 24% of those in the labor force

Income from Personal Services 301

%

100

90

" fj 80

III, 70'I

If I 60I

!!, 50'I

40

,1 30',1

Ii 20

10

------------ --- ....~, .,~ "I ", ,

I. \

\\\1960\\\\\,...-----"Male

W------===-Female

. 1 0 20 25 30 35 40 45 50 55 60 65 70I Age'II

'1

Ii'had less than a full high-school education;half had finished high school; and over 25%received at least some college education. Thefirst percentage is falling rapidly, and the lat-ter is rising.

The incentive to seek work in the mar-ket responds to the wages offered. As thesupply curve 55 in Figure 14-5 shows, athigher wage rates more people enter the la-bor force or work longer hours, but at veryhigh wages and higher incomes people mayoffer a smaller total amount of labor as theyseek more leisure or as fewer wives work be-cause their husbands earn more. Whetherwe have reached that reversed arc of thecurve is unknown. Nevertheless, one way theamount of labor supplied is reduced is by re-ducing the number of hours people prefer towork in a week; in the last hundred years it

Figure 14.1.

LABOR-FORCE PARTICIPATION RATES, BY AGEAND GENDER, 1960 AND 1978

SOURCE: U,S, Department of Labor, Monthly LaborReview.

302 Chapter 14

%

100

90

80

70

60

50

40

30

20

10

Married•...------------. •..•,"Single " -,

\

",,\\\\\\\~-----::::>""Male

/------- ...../ ----I Married -- __, -------, -. ,-,

\\\.---=-Female

o 30 35 40 45 50 55 60 65 7020 25

Age

has gradually fallen from 60 hours to 40,where it has stayed for nearly the past 50years. Also, of the 40 hours, more is now de-voted to leisure time while at the work site-coffee breaks, rest periods, and so forth.

To properly analyze how the wage rateaffects the amount of labor supplied, weshould note two distinctions. The first is be-tween a temporary rise, say for a weekend orfor a couple of months, and a permanent risein wage rates: A temporary increase does notincrease wealth as much as a permanent in-crease in future earnings. The second dis-tinction is between the supply of labor toone employer and the supply to the economyas a whole: With permanently higher wagesthe amount supplied in the total economymay decrease, whereas the amount suppliedmay increase to any sector in which wages

Figure 14·2.

LABOR-FORCE PARTICIPATION, BY AGEAND MARITAL STATUS, 1978

SOURCE: U.S. Department of Labor, Monthly LaborReview.


~S_e_r_v_ic_e_s ~ ~(27.2)

rM__an_u_f_a_ct_u_n_'n~g ~ ~(22)

Retail Trade 1(15.9)r---~--------------~~--~State & Local Government 1(12.8)r-----------.------------Construction J (6.3)

JFinance, Insurance (5.8)I----------tl_-f Wholesale Trade (3.8)I-----~ IAgriculture (3.5)f------'lI,..rTransportation (3.0)f------.IJ Federal Government (2.8)1----...••

Military (2.2)I----~

Public Utilities (2.1)

If':Mining (0.9)

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

People (Millions)

1 '

I r

Figure 14.3.

NUMBER OF PEOPLE WORKING, BY TYPEOF ACTIVITY, 1980

, I,

"I,II

~II~ :l '

The services category includes workers in amusementand entertainment, recreation, travel and hotels,education, and health.SOURCE: U.S. Department of Labor, MonthlyLabor Review,

rise more than in other sectors.If there is plenty of work to be done,

why is 4070 of the adult population not inthe labor-market force? Presumably the mar-ket rewards are not attractive enough, or, re-versing the point of view, non market oppor-tunities are too attractive. A large fractionare women, and some men, whose productiv-ity in the home is greater than in the market.When asked why they refuse to join the la-bor-market force, they gave the responses re-corded in Table 14-3.

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([II 304 Chapter 14

Never Too Few JobsThe overriding fact of scarcity means thatmore goods are desired than are produced. Itfollows that there are too many, not too few,jobs and tasks still available! The problemthat- every person faces is to discover whichis the most valuable rather than to wastefullywork on inferior jobs. Roads could be im-proved; more police protection and more na-tional defense would be useful; more housescould be built; more food could be grown bycultivating and irrigating more, land; more

mechanics could be employed by service sta-tions; more teachers could teach smallerclasses-and so on ad infinitum. We mustexplore and estimate which ones are mostvaluable and what their value is likely to be.That is not easy or riskless. The precedingcomments may seem strange, but they do notmean the unemployed have no sensible rea-son to be unemployed nor that unemploy-ment is wasteful. The issues are more com-plicated, as we shall see later.

DEMAND FOR LABOR

As repeatedly emphasized, the demand forproductive resources reflects the producers'estimates of the consumers' future value oftheir services and products. This is as truefor labor as it is for land and machinery.Most productive activity is organized bybusiness firms, in which the employers act aspredictors and guarantors of that ultimatevaluation by consumers. Employers competefor productive inputs according to their esti-mate of what the inputs will contributetoward the predicted ultimate consumptionvalues of products. They estimate what iscalled the marginal productivity of inputs-the increase in value of products because of

Clerical (80% Female) (17.6)1

Machine Operators (Nontransport) (40%) I(15.0)

Professional & Technical (43%) J (12.9)

Craftsmen (5.7%) •. f(11.7)

Service (60%) [(11.0)

Managers, Officials, Prop. r(24%) (10.5)

Sales Workers J(45%) (6.2)

JNonfarm Laborers (11%) (4.7)

ITransport (8%) (3.6)

J Military (8%) (3.0) ~.r Farmers (3%) ~2.7)

2 4 86 10 12 14 16 18

People (Millions)

Figure 14·4.

NUMBER OF PEOPLE WORKING, BY SKILL, 1980

SOURCE: U.S. Department of Labor, Monthly LaborReview.

Table 14·3 REASONS FOR NOT BEING IN LABOR FORCE (NUMBER OF PEOPLE IN MILLIONS)

Total Male Female White Black

Not in Labor Force 58.5 16.6 41.9 51.1 7.4Do not want job now because: 53.1 14.9 38.2 47.1 6.1

In school 6.1 3.1 3.1 5.0 1.2III or disabled 4.5 2.4 2.1 3.7 .8Keeping house 29.5 .3 29.2 26.9 2.6Retired 9.3 7.2 2.1 8.5 .8

Want job but not looking because: 5.3 1.7 3.6 4.0 1.3In school 1.3 .7 .7 1.0 .4III .7 .3 .4 .5 .2Keeping house 1.3 .03 1.2 .9 .3Think acceptable job cannotbe found .8 .3 .5 .6 .3Other reasons 1.1 .3 .8 .9 .2

Source: u.s. Department of Labor


Q)-coa::Q)

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Quantity of Labor

Figure 14·5.

SUPPLY OF LABOR SERVICES

Higher wage rates attract more labor; but at very highwage rates (per hour), workers may be less willing tooffer more labor. However, the amount supplied toanyone industry or firm will always increase athigher wage rates as labor is attracted awayfrom other industries or firms.

! i.

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the employment of one more unit of input.And not surprisingly, more inputs increasethe total output but decrease the marginalvalue of product. The relationship betweenthe quantity of any type of input employedand the marginal value product is typified bya downward-sloping line, as in Figure 14-6.The principle is the same as that in the fish-ing boat example of Chapter 8 in which themarginal product declined with more peoplefishing on the boat. As a result of this rela-tionship, at higher wages less labor inputswould be demanded, and at lower wagesmore would be demanded-just as for the de-mand for all other goods.

The determination of the quantity ofeach type of input to be used in a firm isdependent on the input's marginal produc-tivity schedule and its wage or price for itsservices. A firm will use that amount of eachinput at which the marginal product is equalto the input's price. That is, a firm's demandfor an input depends on that input's marginalproductivity.

What affects this marginal productivityschedule? In general, the greater the numberof other cooperating, complementary inputsor units of equipment, the higher the mar-ginal product schedule of a given kind of in-put. For example, the larger the store and itsinventory, and the quantity of sales equip-ment, and the higher the quality of goodsthat can be sold, the higher the marginal pro-ductivity schedule of sales clerks. The mar-ginal productivity schedule of engineers in afirm will be higher as the quantity of com-plementary capital equipment with whichthey can work increases.

But some capital equipment may be aclose substitute for an input and thereforelower the marginal productivity schedule. Sono generalization can be made about the ef-fects of more or less capital equipment onthe demand for any given kind of labor ser-vices. Terms like capital equipment and la-bor are too broad to be useful ways to char-acterize all types of inputs. For one thing,

labor includes too vast a variety of types ofpeople and talents, some being close substi-tutes, such as young men for middle-agedmen, others being complements, such as sec-retaries for executives. Capital equipmentalso includes a variety of types of equipment,some closely substitutable, such as word pro-cessors for typewriters and for typists, andsome being complementary, such as eleva-tors and building space. Nevertheless, theschedule of marginal productivities for anyparticular type of input depends also on theamount, quality, and type of other jointlyused inputs.

But whatever its position, one thing issure-the schedule is characterized by de-creasing marginal products at larger amountsof the input. Hence a good working rule isthat the amount demanded is larger the low-er the price, and is smaller the higher itsprice because the amount of each input de-manded is that amount at which its marginalproduct equals its wage or rental price.

DEMAND AND SUPPLYOF LABOR SERVICES

"Labor is not a commodity" is a union battlecry. But labor services are bought and solddaily in the market. What is different is themarket procedure: the personal involvementamong persons at work.' Although personalrelations are significant in determining nego-tiating procedures, contractual forms, andworking arrangements, the forces of demandand supply operate. Labor service is a com-modity.

'The ban against selling all one's future servicesfor a single advance payment does not prevent a personfrom converting some future earnings into presentwealth. One can borrow now to buy a house and carand repay out of the future income. In this way, part offuture earnings are exchanged for present goods. With-out the right to borrow or to mortgage wealth as securi-ty or to buy on the installment plan, people would beat a greater disadvantage in adjusting consumption tothe present wealth value of future earnings.

Q)-coa:Q)Cl

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o

Quantity of Labor Services

Figure 14-6.

DEMAND FOR LABOR SERVICES

At higher wage rates less labor is demanded and onlyhigher-valued goods and services are produced. Atlower wage rates more labor is demanded andmore lower-valued goods and services areproduced.


If

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ExcessivelyHigh Wages

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Figure 14·7.

EFFECTS OF FIXING WAGES ABOVE OR BELOWMARKET-CLEARING WAGE

If wage is set at WH, higher than market-clearing WOothere will be some unemployment. If wage is fixedat WL, employers will be unable to get all the laborthey want

, II

: IiiI

Ir1.~:"';I';"r-----------------------1'\11 308 Chapter 14

However, this does not mean that allwages are set by demand and supply in opencompetition. Some wages may be set arbi-trarily or by political fiat or by the sheerpower of some groups to control the allowa-ble wage rates. Nevertheless, the effects ofeven those arbitrary wage rates on theamount of employment and working condi-tions can be perceived by demand and sup-ply analysis.

Competition among workers for em-ployment keeps wages low enough for allwilling to work at that wage to be em-ployed, whereas competition among employ-ers pulls wages up high enough to get themarginal product at that number of employ-ees. That market-clearing, equilibrium wagerate is the result of competition among em-ployers (actual and potential) for workersand competition among workers for the bet-ter jobs. Because people can leave whenthey know of more attractive jobs, to retainemployees an employer must match offers ofother employers. An employer who givesperiodic wage and salary reviews and grantspay raises without forcing employees to firstseek other offers will not have to pay higherwages. Instead, by anticipating marketsearch by employees and competition fromother employers, the employer will havemore willing employees than if all the job-opportunity comparisons are made by theemployees.

If the wage were arbitrarily set abovethe open-market wage rate, job seekerswould exceed the number demanded. If thewage were artificially held down by somelaw, there would be a shortage of workers.We shall later give real examples of suchcases.

If the demand schedule were raised (thatis, if the marginal productivities of laborwere raised), the wage rate would be compet-ed up. On the other hand, any increased sup-ply of labor in this market would depresswages, because with more workers the mar-ginal productivity is low. Figure 14-7 will

Table 14·4 ESTIMATED AVERAGE ANNUAL EARNINGS IN VARIOUS TASKS, BY GENDER, IN 1980(IN THOUSANDS OF DOLLARS)

Occupation Male Female Occupation

Physicians $52 $23 Telephone linemenDentists 45 14 Meat cuttersLawyers 39 20 Auto assemblersOptometrists 36 14 Coal minersAirline pilots 36 SurveyorsPhysicists 31 20 Chemical lab techniciansDental hygienists 30 16 Legal secretariesSales managers 30 27 Truck driversChemical engineers 30 22 Registered nursesEconomists 30 17 Airline stewardessesArchitects 28 15 CabinetmakersAdministrators 28 22 SecretariesPharmacists 27 21 (Homemakers, housewives)Union officials 23 DieticiansAccountants 22 13 UpholsterersLibrarians 22 14 TypistsTool & die machinists 22 Bank tellersInsurance agents 22 BartendersFiremen 21 Sales clerksElectricians 21 File clerksPlumbers 19 Nurse's aidesUrban transport motormen 19 GardenersPostal clerks 19 CashiersCarpenters 16

Male Female

$1616 $ 7.51616161515 121515 13

1314

1111•10

1313 812 812 612 7.511 610 67.56.6 5

'Value of services-at market cost-estimated and reported by U.S.Social Security Administration and Cornell University.

Source: U.S. Dept. of Labor, Monthly Labor Review; U.S. Dept. ofCommerce, Statistical Abstract of the United States.

musicians, and entertainers have a sensation-ally wide income range, from millions downto practically nothing, and the average isprobably very low indeed.

help you to understand the remainder of thischapter and the next.

RELATIVE DEMAND AND SUPPLY

Income DifferencesTable 14-4 shows some 1981 average salariesby occupation and sex. The range among theaverage of different occupations exceeds 10to 1, from over $50,000 to less than $5000.Within each occupation the range of salariesfar exceeds 10 to 1. Is it better to be a verygood gardener or a mediocre doctor? Actors,

If more first-class musical talent were avail-able and the ability to read or compute wererelatively rare, secretaries would get highersalaries than fine musicians. If the number ofdoctors somehow became enormous, theirwages would fall below those of secretaries,because with that many doctors the marginalvalue of doctors would be very low.

People seek as much training (invest-


ment in human capital) as the prospective re-wards justify. If anyone could borrow and in-vest now for clearly perceived higher futureearnings resulting from the training, anyonecould invest in profitable education. Thiswould not equalize earnings among people,because people's talents differ, but all couldfully exploit their talents. However, not ev-eryone can do this. In our legal system andcourts, it is not deemed desirable to enforcedebts incurred by minors, so lenders arewary of educational loans to young people.Even for adults, enforcement of repayment-or availability of good security-is difficult.

CHANCE-TAKING DIFFERENTIALS

Some people are more willing to give up asurer but narrower range of prospectivewages for the risky prospect of earning ahigher wage. An architect who gives up a se-cure job designing conventional buildingsand tries to create desirable new designs mayend up very much richer or poorer. Thesechoices result in large differences in lifetimeearnings within the same occupation.

DIFFERENCES IN PRODUCTIVITIES

Do earnings differences exceed differences inproductivities? It has been argued as follows:"When the president of Ceneral Products,who is paid $500,000 a year, retires, someonenow getting far less will take his place at thathigh salary. Is that high salary a function ofthe position or of differences in abilities?" Infact it depends on both. The expected pro-ductivity of an input affects what it is of-fered. The associated value of capital orwealth that a manager controls affects themarginal productivity. For example, considerthe differences in results between two man-agers, one with the ability to make correctdecisions 5% more often than the other.Roughly speaking, if a 5% superiority isworth about $50,000 in a $1 million business

but only about $5000 in a $100,000 business,then the larger business would gain morewith the superior manager than would thesmall company. On the other hand, becausetwo low-level employees (say typists) whodiffered by 5% in their ability would not af-fect the firm's wealth as much as those at thetop, the value of the difference in their tal-ents would not be so great. This is whywages for nonmanagerial skills will tend tobe independent of the size of the firm,whereas the salaries and abilities of the bet-ter top managers will be larger and correlat-ed with the size of the company. The expla-nation is not that the big companies havemore wealth and "deep pockets" and there-fore can pay the skilled manager more; in-stead, superior managers are worth more inbigger than in smaller firms. So competitionamong firms will. raise wages of superiormanagers in those highly sensitive positions.

MONEY ANDNON MONEY WAGE DIFFERENCES

Jobs differ in more than just money earned:The personality and behavior of the employ-er, health hazards, type of work, job ameni-ties, location, and congeniality of fellowworkers are some other features. Moneywage differentials that offset these nonmoneydifferences are called equalizing, or compen-sating, wage differences. Differences in non-money employment conditions can persistindefinitely if costs of equalizing those condi-tions exceed the compensating difference inmoney wages. For example, if getting peopleto work in the heat raises the wage theymust be paid by less than the cost of air con-ditioning, money wage differentials will per-sist.

Employees' characteristics also differ.Courteous, pleasant, cooperative, congenial,and accommodating employees provide em-ployers with benefits. If two people areequally productive of wealth at equal wages,the brighter, more pleasant, better-dressed

person with a better-modulated voice wouldbe preferred. Desirable qualities will get ahigher wage. Higher pay to the attractiveperson is the same thing as lower pay to theless attractive. Differences in money wages,then, provide employment opportunities forless attractive or less able employees, just asdo differences in working conditions. (Ques-tion: If differences among employers andworking conditions are considered acceptablereasons for employees' discrimination inchoice of employers, why do federal laws de-clare employer discrimination illegal?)

Specific versus General on-the-Job Train-ing A large amount of on-the-job training isprovided in business firms. Such training candiffer greatly in its applicability to other jobs.Training that is specifically useful to onlythe current employer is not a source of high-er future income in any job with some otheremployer, so no employee will pay for that,since the employer could later refuse to com-pensate him. The employee couldn't get paidelsewhere for that specific skill. So the em-ployer must pay for it and will do so if theemployee can be restrained from quittingsoon after he receives that training. Generaltraining is that which is useful with otheremployers, too. For example, the militaryservices "give" on-the-job training useful ingeneral civilian life with many employers.The employee pays for the general educationby accepting lower money wages duringtraining, as during an apprenticeship. Theemployee is being rewarded with the generaltraining that makes him more productive toany other employer.

ObservedDifferences in PersonalIncome and Wealth

Many people view differences of incomeamong people as the result of a division of apredetermined, fixed total income, as if my

income can increase only if yours is reduced.In fact, the aggregate is created largely by in-dividual contributions. Furthermore, wheth-er the resulting pattern of personal wealth isfair and equitable "tlr should be more equalcannot be answered, because the meanings offair, equitable, and equal are unclear (whichmay be why the terms are so popular). Onecould ask whether the processes determininghow productive and wealthy a person is andhow much the person gets for his or herwork lead to larger incomes, to less socialfriction, or to larger or smaller differences inincome.

To illustrate the difficulty in assessingwhat an "equal distribution" would be, whatwould you think if some people offered moreto Magic Johnson to play more basketball orto Liza Minnelli to sing more, thereby en-abling them to be richer than other people?The result would not be a redistribution ofsome fixed total of income, but an increase inthe total. The fans get more of what theywant produced, and Johnson and Minnellieach have more income because they ren-dered more of the highly valued services.

If you argue that no one should inheritmore than others, what made Magic Johnsonso talented and coordinated and Minnelli sovocal and vivacious? Parents endow theirchildren in many ways other than with build-ings, lands, or goods (any or all of whichcould be taxed away): in genetic inheritance,in giving them knowledge, and in seeing thattheir abilities are developed by education.Jewish emphasis, for example, on masteringpersonal skills may be a survival trait devel-oped during a long history in which nonhu-man wealth was confiscated. What aboutyour inherited intelligence, color, sex, andabilities? If you object to the inheritance (butnot to the giving?) of physical marketablewealth as unfair and unearned, is it any lessunfair if it is instead redistributed by tax-ation? Economic analysis offers no answer.

It may be argued that the existence of a


few very, very wealthy people in a sea ofpoor people is unjustifiable. Does that meanthat their wealth should not have existed? Orshould have been given to the poorer as itwas produced? If the latter, would there havebeen incentive to produce the wealth in thefirst place? We have no complete answers tothese queries. We pose them to prevent thefacile presumption that answers are obvious,or easy, or even possible.

Socialists say that socialism leads tomore equal wealths and incomes and morefreedom. The evidence does not support thecontention. Top political authorities havespecial privileges, access to the state'swealth, and power over the lives of otherpeople through the police power of the gov-ernment-something that the wealthy in aprivate-property economy lack.

GEOGRAPHICAL DIFFERENCES

Earnings differ among geographical regionsand between urban and suburban areas.Workers in areas with high costs of livingmust have sufficiently high marginal produc-tivity if they are to be paid enough to be at-tracted to those higher-cost areas. Higherwages in Alaska are due to the higher mar-ginal productivity of the small number ofworkers there. The workers are producing aservice with a value great enough to offsetthe higher costs of providing these peoplewith the quality of life sufficient to attractthem. ,-'

If wages and income affect the supply oflabor, we ought to observe labor movingfrom lower-wage areas to higher-wage areas.And we do. Conversely, we should observecapital goods and factories moving towardthe lower-wage areas. And we do. Nation-wide, the movement of people is predomi-nantly to areas with higher wages; countiesthat have grown in total population arethose with higher median family incomes,whereas counties that have lost population

312 Chapter 14

through migration are those with lower In-comes.'

FAMILY INCOME DIFFERENCES

Table 14-5 classifies families according to in-come. In 1980 less than one-third of familiesearned annual incomes over $25,000; lessthan 10% earned over $40,000. To give yousome perspective, the average annual incomeof economics professors is now over $25,000.Your college's president, if you are at a stateuniversity, is most likely in the $50,000-and-over category. As the table shows, U.S. fam-ilies in the bottom 20% obtained about 7%of after-tax national income, while the fam-ilies in the top 20% obtained about 40% ofthe after-tax national income. The middle60% obtained over 52~o of that income. Ta-ble 14-6 compares income distribution in theUnited States with those of Sweden and Rus-sia, often regarded as leaders in incomeequality. All incomes are after-tax and after-income transfers through subsidies. The sim-ilarities in the table are remarkable. Eventhese data overstate the degree of incomedifferences within a country due to factors tobe considered shortly.

Patterns by Family Size Table 14-7 pre-sents 1980 median annual incomes accordingto size and composition of family. (The me-dian is that which separates the top from thebottom half: Exactly as many families haveincomes larger than the median as have in-comes lower than the median.)

3Data reported by Gladys K. Bowles and James D.Tarver, "The Composition of New Migration amongCounties in the United States, 1950-1960," Agricultur-al Economics Research, U.S. Department of Agricul-ture, January 1966. From 1950 to 1960, counties withthe lowest median family incomes (under $5000) had anet loss of over 28% of their population. Those with$6000:-7500 median family incomes gained 11%. Themigration was greater for younger people. No doubt la-bor is attracted by higher-wage areas and repelled fromthe lower-wage areas.

Table 14·5 PERCENTAGE DISTRIBUTION OF TYPES OF ANNUAL INCOME, BY FAMILY INCOME CLASSES(UNITED STATES, 1972, EXPRESSED IN 1982 DOLLARS)

Percent of National Total of Sources of Income in Each Income ClassReceipts of Labor

Household Property Government Earnings AllIncome Class Units Income Transfers Income Income

$ 0-10,000 17 4 19 2 410,000-15,000 10 5 12 4 515,000-20,000 17 9 15 11 1120,000- 27,500 26 16 18 26 2527,500-45,000 23 26 19 36 3445,000 and over 7 40 17 21 21

100% 100% 100% 100% 100%

Source: u.s. Bureau of the Census, Current Population Reports,Series P-60 No. 90, and Lowell Galloway, "The Folklore ofUnemployment and Poverty," 1975.

Wby Incomes Differ

Table 14.8 PERSONAL INCOME SHARES BYQUINTILE: UNITED STATES,SWEDEN, AND THE SOVIET UNION(AFTER TAXES AND SUBSIDIES)

AGE-RELATED INCOME DIFFERENCES

United SovietIncome Units States Sweden Union

Lowest 20% 7% 8% 8%Middle 60% 53 56 55Highest 20% 40 36 37

100% 100% 100%Highest 5% 15.9 12,9 14.0

So far we have been thinking of differencesin money plus nonmoney incomes as if theyreally were differences. But there are somedifferences that are deceptive. For example,the income of a person varies over one's life.Any income as of a particular year will notnecessarily be typical of the average overone's lifetime. Unfortunately, most data onincomes are measures of income of one year.Therefore if we use the data on incomes atone year of several people, some of whom areolder and some of whom are just beginningtheir careers, their difference in incomes atanyone time will reflect not only differencesin lifetime earnings but also in age-related in-come levels. The older people earn morethan young beginners, but over their life-times the earnings could be equal.

If every person had the same lifetimepattern of income, rising until about age 50or 60, but the population comprised peopleof different ages, then recorded individual in-comes in anyone year would be unequal be-cause of age-related differences in incomes.The younger would have smaller earningsthan the middle-aged; yet lifetime incomeswould be equal.

Source: L. Galloway, "Folklore of Income Distribution," in S, Pejovich,ed.. Governmental Controls and the Free Market, College Station:Texas A & M University Press, 1976, Chapter 2. Based on data fromBureau of Economic Analysis of U.S. Commerce Dept. and foreignsources.

Table 14.7 EARNINGS BY TYPES OF FAMILIES, 1980

FamilyCategories(in Millions)

MedianYear-RoundEarnings

14 Husband and wife only $17,50012 Three persons 19,00011 Four persons 20,00010 Five or more persons 21,00047

8 Female family head 11,00055 million

Source: U.S. Bureau of Labor Statistics, Monthly Labor Bulletins


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15 25 35 45 55 65 75Age

Figure 14-8.

DIFFERENCES IN WEEKLY EARNINGS, BY AGE

-',

Figure 14-8 depicts the observed age-re-lated patterns of weekly incomes for the topquarter, the middle half, and the bottomquarter for males and also for females. Foreveryone's income in 1980, without regard toage, the differences between the averages ofthe top and bottom quarters is about $230per week (between $180 and $410). But forthe same age and sex, say at age 50, therange is smaller by some 3370' about $150per week. Because earnings vary with age, atany time there will always be some poorerpeople-the young and the elderly-even ifeveryone had equal lifetime earnings.

An interesting question is how manypeople in, say, the bottom quarter of thepopulation at any given moment are theresolely because of the age-related differencesin incomes, and how many are the result of

SOURCE: U,S, Department of Labor, Monthly LaborReview.

314 Chapter 14

persisting differences in lifetime incomes. Ithas been estimated that if everyone hadequal lifetime earnings (though each person'sincome moved from low at youth to peaks inmiddle age, then declined), the bottom 25%of the population (mostly the young and el-derly) would appear to earn only 20% in-stead of the age-adjusted lifetime averagethat equals 25% of the national income ofthat year. Similarly, the top 25% of the in-come earners in anyone year would accountfor 35% of the total national income in thatyear instead of an age-adjusted 25%. Hence,only to the extent that the lowest quarter inanyone year earns less than about 20% to2570 of national income and the top quintileearns more than 35% to 45% of national in-come should one look for differences in skillsand productivity among people. In fact, thedata indicate that the bottom quarter of peo-ple accounts in anyone year for only about15% of national income instead of the age-corrected 25%. Clearly, the observed differ-ences are not all explained solely by the agepattern.

The age effect on income is greater formales than for women during the youngerages. This difference reflects in part the ten-dency of women to take shorter work spellsthan men and to invest less in job-relatedskills.

INVESTMENTAND INCOME DISPERSION

Another source of the effect of age on in-come is investment. Some people save moreand invest at an early age in property, per-sonal knowledge, and skills. Later they havehigher incomes than those who consumedmore earlier. This increases income disper-sion at the older ages. People differ in howthey prefer to pace their patterns of con-sumption over time. Medical doctors, collegeteachers, and scientists with advanced post-graduate degrees have larger earnings late inlife because they consumed less and invested

Table 14·8 MEDIAN FAMILY INCOME BY ETHNICGROUP, UNITED STATES, 1980

Racial orEthnic Group

Japanese

MedianFamilyIncome

$24,000Chinese 22,500White 20,000Filipino 18,500Cuban 17,000Mexican 13,000Puerto Rican 12,000Black 11,500

Source: u.s. Bureau of the Census, Decennial Census of 1970,adjusted to 1980.

more when younger. A high-school graduatewho saved two-thirds of his or her income forabout seven years, as some doctors must intheir education, would accumulate a respect-able amount by age 25.4

ETHNIC INCOME DIFFERENCESREFLECT AGE EFFECT

Income differences among ethnic groups aregrossly deceptive because of the very differ-ent average ages of income earners. For ex-ample, census data indicate differences likethose in Table 14-8. The high-income ethnicgroups happen to have more older people intheir working population, which reflects theeffect of time and experience on income.

The average age of blacks in the laborforce is much younger than for whites.Therefore, the lower average income ofblacks reflects some effect of lower age. Simi-larly, the average age of Puerto Ricans and

<If $16,000 a year is earned for seven years (and$10,000 is saved each year), at 8%, a wealth of about$90,000 will accumulate in seven years. This wouldyield an annuity for 30 years of over $10,000 a year.Will your college education do as well for you? On theaverage, it is about a toss-up.

Income from Person~J Services 315

Mexican-Americans is lower than for othergroups and explains part of the differences inaverage incomes. Furthermore, if some eth-nic group tends to invest more in collegeeducation, delaying its years of earnings, andearns more later at older ages, the differencesin anyone year will overstate the income dif-ferences due to any ethnic-related ability.The lifetime differences may be either non-existent or less than the difference at anyonetime or for anyone age group. None of ouranalysis explains why one ethnic group in-vests more in education for later, higherearnings while the other opts for earlier andflatter curves of lifetime in earnings. Nordoes it explain any cultural differences thatare manifest in different attitudes towardwork in the market. What it does reveal,however, is that comparisons of crude data,not corrected for effects of age, formal educa-tion, time in work force, and geographic loca-tion, are grossly deceptive.

MONEY INCOME DIFFERENCESBETWEEN MALES AND FEMALES

On average, women employees earn moneywage incomes about two-thirds the size ofmen's. But when the observed differencesare adjusted for effects of experience in thework force, training, types of work per-formed, and marital status, the difference at-tributable to prejudice is greatly reduced oreliminated.'

How much of the unwillingness ofwomen to forsake their opportunities ofhigher-valued domestic productivity ac-counts for less work in the labor-market

'One study, by J. Mincer and S. Polachek, "Fam-ily Investments in Human Capital: Earnings of Wom-en," Journal of Political Economy, Vol. 82, no. 2, PartII, March/April 1974, pp. S76-S\08, indicates the dif-ference would be reduced to one-sixth. Another studyof salaries in college teaching indicates that womenwith backgrounds and records equal to men get more.

Lo.,,:i;:lr----------------------: 'ill· 316 Chapter 14·'1

force is unknown. It has been said thatmany women have not entered the marketwork force because of prejudice againstwomen. But that kind of explanation is oflittle help. For example, if it were prejudice,whose prejudice is it? Why would male em-ployers forsake the profits that could beachieved by hiring equally productive wom-en at lower wages? We do know of two im-portant factors that help explain female-male differences. Women's wages relative tomen's declined between the late 1940s andabout 1970, though they had been increas-ing prior to World War II. A simple expla-nation is that after the war women weremarrying at an earlier age and having morechildren. Their average time of work experi-ence was decreasing. But in the 1960s thismarriage-age and birth trend reversed. As tobe expected, accompanying that reversalwas a rise in average duration of femalework experience and income relative tomen's. When adjusted for marriage and dif-ferences in work experience, the facts indi-cate that women in their thirties during the1970s who have worked continuously sincehigh school or college earned slightly morethan single men. In sum, the basic factorsexplaining female-male differentials appearto be the effects of the female's childbearingproductivity and work in the household onher work experience-not employer preju-dice and discrimination.

CHOICE OF RISK

Chance events create transiently high in-comes in some years and lower ones in oth-ers, and contribute to the differences amongpeople's earnings in anyone year and alsoover a lifetime. Because people have imper-fect foresight, there is no way to avoid that.The question is, "Who will bear the uncer-tainty?" We can share the risk by averagingover everyone. Or some people can pay oth-ers to bear a larger share of the risk. That isone reason self-employed people have a

greater dispersion of income over their life-times and in any year at anyone age than dosalaried employees, who choose not to bearas much of the enterprise's risk.

MARKET AND NONMARKET INCOME

As explained earlier, real income includesmore than money income. Some people getmore income in nonmonetary form (for ex-ample, farmers versus city dwellers). Somepeople prefer more leisure; a teacher withthree months' absence from teaching has asmaller money income but more time fortravel. And as stated earlier, the services ofhomemakers are excluded from typical mon-ey income measures. For these reasons, re-corded money incomes fail to encompass fullreal incomes.

INCOME FROM PROPERTYVERSUS PERSONAL LABOR

Differences in ownership of property are nota primary cause of interpersonal differencesin income. Total income from property ac-counts for about only 10<,70 of total recordednational income. The dominant factor is thedifference in earned income from human ser-vices-wages, salaries, and self-employment.Finally, government taxes and subsidies re-distribute some income. An estimate of theeffects of all these is listed in Table 14-5.The similarity of the percentages in the twocolumns, Labor Earnings Income and All In-come, indicate that differences in humanearnings are the overwhelmingly dominantsource of income differences.

LAND OWNERSHIPAND INCOME DISTRIBUTION

A nontrivial source of income is natural re-sources: land, and its minerals and water.How much of national income is attributableto the owners of natural resources? Supposetheir owners were merely collecting rents for

use of those goods and were doing nothingelse, so that what they get someone else doesnot get. Since about 10% of national incomeappears to be attributable to nonhumanwealth, and of that-about 30<,70 is land and itscomponents, we arrive at about 3% as theshare of national income going to land andmineral owners. (About 40<,70 of land in theUnited States is government-owned, most ofit the least valuable land.)

It is sometimes argued that if the landand natural resources were owned by everwone equally, incomes would be much moreequal. If all of that income from land and nat-ural resources were given to the bottom 15%of income earners in anyone year, their aver-age income would equal that of the next20<,70 above them. That does not come closeto equality. But the rationale for this redistri-bution is further undermined by two facts.First, current landowners did not acquirethose rights by taking them away from therest of us (no matter how the rights mayhave been acquired a couple of centuriesago). The current holders, or their parents,almost all bought it from someone else.Hence, that a large share of the land is heldby a very few people does not mean thewealth of the rest of the public is smaller bythat amount.

Second, the present and future incomederivable from land depends on how well itis used and maintained. Giving everyone anequal right to land (and insisting they keepthat right) will affect how the land is usedand cared for. If no one can sell the land, in-centives to improve it for a capital gain or totransfer it to a higher valuing user are re-duced, which tends to reduce the incomeproducing power of the land.

In a few unusual countries, such asOman and Kuwait, the land is so poor-ex-cept for containing oil-and labor incomesare so small, the value of the natural resource(oil) is an enormous proportion of the incomeof these countries.


frr,J~:I

The PoorEven though the poorest 10<;'0 of income re-ceivers in the United States are enormouslyricher than most of the population in India,China, Peru, or Tanzania (that is, richer thanabout 80% of the world's population), theyare said to be in poverty.

What does poverty mean? In the UnitedStates, one criterion (used by the Social Secu-rity Administration), adjusted for family.si.ze,ages of the family members, and the locahty,has the poverty-household income in 1982varying from about $4000 for a single personto $5500 for a two-person and $8500 for afour-person urban household. (What it maymean in other countries is probably a verymuch lower level of income.)

The proportion of the population in pov-erty in anyone year in the United States hasdecreased since 1950 from about one-third toone-tenth, and certainly had long been de-creasing before that. For the reasons alreadygiven, the number in poverty in anyone yearoverstates the fraction that remains there.First, as explained, personal incomes fluctu-ate; in some years the income can fall intothe poverty category, while in other years itis above it. Second, about one-third of thefamilies in the poverty group are elderly,who because of short life expectancy are con-suming more than their income." And manycollege students will be counted in the pov-erty group if only current earnings are count-ed. Third, recent immigrants (for example,Cubans and Asians) constitute disproportion-ately high but temporary membership in thepoverty group-a characteristic of most im-

"Some give all their wealth to their children toqualify for welfare, relying upon their children also toassure them of support for consumption. A person witha life expectancy of five years and a wealth of $20,000would report an income of perhaps $1000, although hecould consume at the rate of about $6000 a year for fiveyears. Should such a person be considered long-termpoor?

318 Chapter 14

migrants in their initial years in the UnitedStates.

Emphasis must be placed on the tempo-rary, initial low-income status of immigrants.In fact, male immigrants in their first yearmake substantially less (about 20%) than theaverage native U.S. male. But after 10 yearsin the United States the immigrants reachequality of income, and after 15 years theyexceed the average of native-born U.S. malesof equal schooling. This increase from an ini-tial temporary low income is common to vir-tually all immigrant groups regardless ofcountry of origin. An intriguing side fact isthat first-generation sons of foreign parent-age earn 5% more than the sons of U.S. na-tive-born parents and 8<;'0 more if only thefather is foreign-born. (Were U.S.-born girlsmore able than foreign-born girls to selectthe more promising bachelor immigrants ashusbands?)

Who, then, tends to remain in the pov-erty group? Undoubtedly most important isthe sad fact that some people are mentally orphysically incapable of producing a sig~!fi-cant income. Or some with normalcapacitieslack the drive and responsibility or trainingto produce and save toward normal cont~n-gencies. Families whose primary source of in-come is from a woman, an aged person, afarmer, a black, or one lacking a high-schooleducation are heavily represented in the per-sistent poor.

WELFARE ANDALLEVIATION OF POVERTY

Not every low-income earner receives thesame corrective or alleviative aid. Family re-sponsibility for relatives is a prime s.ou~ce?faid. Whereas voluntary chantable aid IS dIS-tributed according to personal judgmentsabout the merits of each case, political agentscannot display such personal discrimination.Tax-financed redistributions of income andwealth are part of all governments' activities.Graduated income and inheritance taxes take

a larger portion from higher incomes. For ex-ample, it has been estimated that for familieswith annual incomes of under $4000, federaland local taxes take over 4070 of income,compared to about 2570 for middle-incomefamilies and 45% for very high income fam-ilies with $50,000 and over. But interpersonaltransfers of wealth by taxes and subsidies (so-cial security payments, welfare, and unem-ployment compensation) yield the under-$4000 families an estimated net increase of80% of their pretax income. The group earn-ing over $50,000 has been estimated to expe-rience a net decrease of about 45%.

Unfortunately, that comparison is defec-tive because it does not include all govern-ment services. If some of those services aredistributed to the higher-income or political-ly powerful groups in amounts greater thantheir taxes, they would be aided and the poorhurt. Some government services are receivedin greater amounts by the richer groups-forexample, publicly subsidized golf courses,and better schools, parks, colleges, and roadsin richer residential areas. Without betterdata, no definitive answer can be given aboutthe overall effects of government taxes andexpenditures.

Government welfare activities are in-tended to relieve the indigent by transferringwealth and by encouraging recipients to in-crease their abilities or rehabilitate them-selves. Some argue that many of the poorhave not worked as diligently and been ascareful in saving income as others who arenot poor. Others argue that the poor are poorfor reasons not of their own making: Theyargue that poverty is the social byproduct ofa complex, highly interdependent, dynamiceconomy, and conclude that responsibilityfor alleviating this poverty therefore restsprimarily with society. Both arguments aredefective. The first does not imply that noth-ing should be done for (or to?) those whomay be so irresponsible as to be poor. Thesecond is defective in that even more poorexisted when society was less complex, inter-

dependent, and dynamic; furthermore, every-one-rich and poor alike-lives in that kind·of society. More germane is what kind of aidto give-in what form, how much, and underwhat conditions.

Automatic money aid to very low in-come groups has been proposed. One form,known as the reverse, or negative, incometax, would give money to those earning lessthan a specified standard of income. This hasbeen proposed as a substitute for the entirewelfare system, which uses additional criteriafor deciding whom to aid. The negative itr-come tax plan would be less expensive to ad-minister, but would it contain the purportedremedial elements of the current welfare sys-tem?

To strike more directly at one cause oflow income, more appropriate education hasbeen proposed. High-school education hasnot generally provided significant vocationaltraining for those not continuing to college.More on-the-job training could be subsidizedby taxes if such vocational training is not giv-en in the public schools. Exempting teen-agers from the minimum-wage law wouldpermit on-the-job training to be part of theirpay, because teenagers' services to employerswhile learning are often worth less than themoney they must be paid by law under theminimum-wage requirement. In this case thetraining cost would be borne by the teenagerrather than by taxes on the rest of society, asis done for nonvocational education.

Unemploymentand Poverty?

Surprisingly, unemployment is not a cause ofpoverty or low-income status. Unemploy-ment affects incomes temporarily during theperiod of unemployment. Because Chapter17 investigates the causes and extent of un-employment, we note here only that unem-ployment, for example, of carpenters, con-


struction workers, or auto or steel workers,does not push them into poverty levels. Thatunemployment which is caused by the uncer-tainties of weather and building-completiondates results in higher wages per hour actual-ly worked. In many industries layoffs are arecurring phenomenon, so they can be ex-pected, but when they will occur cannot al-ways be predicted accurately. Their anticipa-tion forces employers to offer more to offsetthose temporary intervals.

Unemployment has a minor effect on in-comes and wealth, and cuts across all levelsof income earners-some of the very rich(entertainers, skilled mechanics, and lawyers)as well as the poor. When it occurs the un-employed find themselves in a lower-incomegroup for a while. But over half of the unem-ployment spells are shorter than two monthsand, furthermore, are not periods of loss oftotal income. It should not be surprising,then, that spells of unemployment are not asignificant factor pushing people into thepoverty category, or into substantially lowerlifetime wealth. More details are given inChapter 17.

Social Security SystemAn important element altering the pattern ofincomes is the Social Security System-moreaccurately known as the Old Age, Survivors,Disability, and Health Insurance Program(OASDHI), instituted in 193'6. People abovethe age of 65 receive annually an amountthat is based partly on their earlier earningsand payments to the Social Security System.The funds paid out in any year are obtainedfrom taxes on the incomes of the currentlynonretired people. Initially the recipientswere so few that the tax on the nonretiredwas more than sufficient, and a surplus wasaccumulated.

That sort of inter generational wealth

l '

, I Ii. .l·t

1[:::1l!~'I".:

.h·J. ':----------------------;~'I'i'r{ 320 Chapter 14

1 'Ilii. I

transfer could continue if the younger work-ing population increased enough to morethan match the increasing number of retiredpeople. Since the earlier contributions arenow (1982) exhausted, heavier taxes must belevied (22% of income earned), or promisedbenefits reduced, or the retirement age de-ferred. But the Social Security System has in-duced a very substantial number of people toretire earlier.

Technological Progressand Jobs and Wages

Although opposed by some labor groups,adoption of production-increasing inventionsis a source of increased wealth, easier work,and higher real incomes, and makes a largerpopulation possible. The ox-drawn plow wasa great technological advance over the use ofhuman pulling power. The people who losttheir jobs pulling plows turned to what for-merly were less important tasks, like collect-ing more wood and building more stonefences. When the tractor replaced the horseand several plowmen, people were releasedto produce other things. With the new ma-chines, labor's marginal productivity in theold jobs was reduced below that in tasks for-merly left undone. Technological progresscreates new types of jobs. There will alwaysbe plenty of jobs-in fact, more than canever be filled. We repeat, there are not toofew but too many jobs! The problem is com-paring and deciding which to perform andwhich to leave unperformed. Inventions,automation, and progress make us richer, butthey do not eliminate the persisting problemof predicting the highest valued of the re-maining tasks.

To discern the employment and incomeeffects of technological progress, we distin-guish three groups of people. Consider therise of television: (I) Some people get higherwages because they produce more in TVwith the new equipment and programs.

They benefit doubly-from higher income.and from lower prices of improved products.(2) Some other people have incomes that donot depend on TV. They benefit from thelower costs of home entertainment, withoutany loss of income. (3) Some people are dis-placed by the advent of TV and transfer tonext-best jobs. This class can be further di-vided into three subcategories: (a) Some arebetter off on net, because they gain from be-ing able to use television as a consumer . (b)Of the remainder who do not reap a gain,even after considering all the effects of thisparticular innovation, some are neverthelessbetter off than if all progress were stopped.They gain through the lower prices andquality improvements to consumers-despitetheir income loss. (c) Some employees andowners of outmoded equipment suffer suchsevere reductions in demand for their ser-vices that, even after taking into account thegains from TV and from all technologicalimprovements that will occur during the restof their lives, they are worse off. This ismore characteristic of older people in radiothan of the younger.

As yet, we are unable to predict for anyinvention how many people, let alone who,will fall into each class. Even afterward it isoften impossible to tell, because otherchanges obscure the effects. For example, didthe invention of the typewriter increase ordecrease the demand for secretaries? Thediscovery of oil may have attracted laborfrom coal mines into oil well drilling, refin-ing, and pipeline work, so that the wages ofcoal miners increased despite the negative ef-fect of oil on the demand for coal. Inventionsnot only affect the productivity of workers inthe affected jobs, they attract workers, thusraising wages elsewhere. Spectacular exam-ples are the railroad and the automobile,which lowered costs of transportation; as aresult, transport increased, as did the demandfor workers to provide materials for transpor-tation. Canalmen, livery-stable operators,and buggy-whip makers shifted to better-

paying jobs in the new transportation indus-try. New machines sometimes reduce thecosts of products so much that the increasedamount demanded raises the demand for la-bor in that job (for example, typewriters andcomputers). .•. .

COMPENSATION PRINCIPLE

Out of the net gain from technological prog-ress, thewhole community could compensatedisplaced and reallocated workers for anyloss. This is a logically airtight possibility,because the increased value of output ex-ceeds the losses of the displaced factors.However, innovations are too extensive toidentify each and every displaced factor andto determine who loses how much. Howwould we know how much to pay a personwho claims to be displaced by the introduc-tion of electronic computers? How could webe sure that some easy, low-paying job hasnot been taken-in the expectation of receiv-ing a payment large enough to make up thedifference? Only if people's incentives werenot changed by the compensation principle,and if there were no prohibitive costs in dis-covering who gained or lost how much,would that compensation system be feasible.Nevertheless, compensation is not ignored.Today, people pay taxes for a program to re-train and relocate workers.' But if labor were

"This aid is proposed, however, not only for thosewhose incomes are cut by competition from new, moreproductive equipment, but for any laborer who lives inan area where there is a general decline in demand forservices-whatever the reason. A displaced worker in aprosperous area is not eligible.

The Trade Expansion Act of 1962 gives the presi-dent additional powers to negotiate for tariff reductionand, when injury from increased imports can be dem-onstrated, provides for "trade adjustment assistance"for both business firms (through technical assistance,loans, tax relief) and workers (through special unem-ployment benefits, retraining, loans for moving to jobsin different communities).


i I'.'"r:,

compensated, why not also owners of nonhu-man assets? If compensation were paid out oftaxes for every change in value resultingfrom innovation, the general public would bethe risk bearer, through taxes from whichgovernment services would be financed.

Summary1. About 80% of the value of marketed goods

and services goes to income for human la-bor. The remainder pays for the services ofnonhuman capital goods.

2. Payment for the use of a capital good iscalled rent if the good is used by someoneother than its owner, and is called interest ifthe good is money. Earnings from the use ofa capital good by its owner are called implic-it rent. Income earned by a firm is paid outto its owners, the stockholders, as dividends.

3. A capitalist advances payment to labor tomake goods that will yield services later, atwhich time the capitalist hopes to be repaidfor depreciation and interest on the goods'earlier costs.

4. Unemployment results not from there beingtoo few jobs but from too many. People in-vestigate and evaluate alternative jobs to de-termine which is best, rather than taking thefirst seen alternative.

5. Demand for labor (or for any input) reflectsthe marginal productivities of differentamounts supplied. The schedule of marginalproductivities for any given input dependsupon the types of other r.$!sources that canbe used jointly. Some jointly used inputs,called complements, raise that input's mar-ginal productivity schedule, and some, calledsubstitutes, lower it. All joint inputs are sub-stitutes in the sense that having more of onewill in part offset having less of the other.

6. About 6070 of the U.S. adult population is inthe market labor force, 80% of the malesand 50% of the females. The male labor-force participation rate has been decreasing;that of females has been increasing. Also de-

322 Chapter 14

creasing are the rates for those under age 20and those over 55 (the latter primarily be-cause of Social Security payments).

7. At very high wage rates the total labor forceparticipation rate in the U.S. may be re-duced as people seek more leisure by work-ing fewer hours or leave the work force be-cause their spouses earn more.

8. Wage rates, like the prices of any othergoods, are determined by demand and sup-ply market forces.

9. Ricardian rent, which is the amount bywhich a higher wage exceeds a lower wagefor the same productive activity, is a pay-ment for superior talents or abilities; or forwillingness to undertake riskier tasks, or towork and live in certain regions; or for thecosts of training and education.

10. If all annual incomes were measured at thesame instant, the differences among themwould be related to how income earners dif-fer in age, sex, geographic area, money vs.non money incomes, ethnic background, pastinvestment in personal training, variancesbetween the highest and lowest wages inany occupation, transient variations of in-come over time, and talents and abilities.

11. When people's earnings are summed overtheir lifetimes they are much closer to equalthan is suggested by the income differencesamong people of different ages in anyoneyear.

12. Between 1950 and 1980 the proportion ofpeople usually described as being poor hasdecreased from a third to a tenth of the U.S.population.

13. Governmental redistribution of income hastended to raise the real incomes of the poorrelative to those of the richer.

14. The Social Security System finances old-ageretirement benefits by taxing current in-come earners; the amount paid to a retiree ispartly dependent upon the retiree's pre-retirement Social Security taxes and income.

15. Unemployment is not the reason that somepeople are poor.

16. Technological advances increase real outputand would make everyone better off eitherby lowering the costs of purchases or byraising incomes. But some losses do occur tothose whom the advance displaces to lower-paying jobs. Those displaced could, in prin-ciple, be compensated, because the total so-cial gains exceed their losses, but for a va-riety of reasons they are rarely compensated.

questions1. "In the open market, wages are driven down

to the subsistence level." That is the iron law ofwages. What is meant by "the subsistencelevel"?

2. "My doctor charges me a high fee becausehe has to cover the high cost of his education andequipment. On the other hand, my golfing teach-er also charges me a high fee, even though hiseducation is practically absent." Is either onecheating or fooling me? Explain.

3. "Elizabeth Taylor was paid over $5 millionfor making a film. Yet Glenda Jackson couldhave taken her place for, say, $1 million. Theremust be something wrong with the movie indus-try." Using marginal-productivity theory, explainhow it can be sensible to pay Elizabeth Taylorthat much more.

4. A candidate for the office of U.S. Senatorproposed that employees be given time off withpay to promote political campaigns of their fa-vored candidates.

a. Tell under what circumstances you as anemployer would not care if this weredone. (Hint: Remember, there is morethan the money pay that attracts employ-ees to a job.)

b. Who would be paying for the time off?

5. A law is passed requiring each employer toprovide hospitalization and premature retire-ment benefits for his employees who have "heartattacks."

a. Who will benefit by such a law?b. Who will be hurt?c. Who will pay the costs? (In answering,

first consider the same questions if a lawwere passed requiring employers to pay

for all the housing costs of redhaired em-ployees. Explain why if you were a red-head you would be smart to dye your hairblack. Similarly, if you had a heart condi-tion, why would you try to keep it a se-cret? Does 1:he employer pay for theseservices-in the sense that his wealth islower as a consequence of the law? If hedoesn't, who does?)

6. Some employment contracts provide the em-ployee with the following: paid time off for juryduty, funerals of relatives, voting, sickness, andvacations; free parking space and work clothes;retirement; two weeks' severance pay; seniorityrights over new employees; no discharge for un-ion activities; no discharge if job is displaced bynew machinery.

a. Suppose you were to offer to work forsome employer who did not give any ofthese provisions and who insisted on theright to fire or discharge you at any timefor any reason whatsoever. Would youconsider working for him at the sametake-home pay as for the other employer?

b. Would the employer be willing to payyou a higher take-home salary for an em-ployment contract without all those pro-visions listed earlier?

c. In the light of your answers to the preced-ing questions, who do you think pays forthose fringe benefits listed earlier?

7. The National Teachers Federation, a teach-ers' union, advocates a single salary scale-wherein every teacher, regardless of specialty,gets the same salary in his first year of teaching,with salary thereafter tied strictly to years of ser-vice. Who would benefit and who would suffer ifthat were made universal: Men or women?Blacks or whites? Superior or inferior teachers?Mathematics or physical-education teachers?

8. Laws have been passed designed to prohibitemployers from discriminating among potentialemployees according to race, religion, and, insome instances, age. Why are there no laws pro-hibiting employees from similarly discriminatingamong employers for whom they choose towork?

*9. Minimum-wage laws prevent relatively un-


" """"",""",""','" "',"', .

trained people, especially teenagers and blacks,from getting jobs. To overcome this the federalgovernment is going to subsidize employers forhiring these less-trained people. The rationale isthat the workers hired at the minimum legalwage, though not that productive, will learn onthe job and in time become productive enough towarrant that wage. In the meantime, the employ-er, receiving a subsidy of an amount equal to thedifference between the worker's productivity andthe wage paid the worker, is providing on-the-jobeducation. Show how this amounts to facilitatinga privately operated educational system, withchoice by students of the private "school" theywill attend.

*10. At many colleges students are gainingmembership on committees that appoint or fire

"

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I

324 Chapter 14

faculty members. The faculty usually contendsthat employment is a matter best judged by qual-ified people like faculty members. Students con-tend that the faculty chosen affects their livesand hence they should have a say in the matter.(1) The authors say that neither faculty nor stu-dents should have the authority to hire or firefaculty. (2) Moreover, students already havemore power than the faculty. Explain in whatsense (2) is correct; then defend as best you canthe preference expressed by the authors in sen-tence (1).

II. Black capitalism is often advocated. Blackcapitalism might mean either (a) that blacks willborrow only from black savers, or (b) that blackswill buy only or primarily from black merchants.Would blacks be benefited or harmed?

Chapter 15Labor-MarketIn~titution~

As we saw in the last chapter, labor services,like other goods, are allocated and priced ac-cording to the laws of demand and supply. Butalthough labor services are sold, their sources,human beings, are not sold as if they weremachines (except in a slave economy). Be-cause the social relationships between buyersand sellers of labor services differ from thosebetween buyers and sellers of goods, impor-tant differences in marketing, negotiating andcontractual forms have evolved. Among theadaptations are labor unions: coalitions of. afirm's employees with collective contractscovering them all. Also, legal regulations ofthe conditions of employment (such as mini-mum-wage and fair-employment laws) are inforce. In this chapter we analyze unions andthese regulations.

Labor UnionsLabor unions have existed for a long time,often despite being declared illegal as "crimi-nal conspiracies," as they were in Englandand France at the time of the French Revo-lution. Although such anticonspiracy lawsmay have been directed against the threat ofviolence in strikes launched to restrict opencompetition for jobs and wages by labor,they also abolished even the right to form aunion. By 1830 the English anticonspiracylaws had been repealed and the right tostrike was tacitly recognized. In the UnitedStates in 1842 the Massachusetts SupremeCourt rendered a precedent-setting decisionin Commonwealth v. Hunt declaring unionsto be legal. In almost all communist coun-tries-or at least those behind the Iron Cur-tain-the right to form a union, let alone tostrike, is denied.

In the United States only about 22 mil-lion employees, 22% of the labor force, arein unions. In some jobs virtually every em-ployee is a union member (longshoremen,transport workers, construction workers), and

325

100 10080 Civilian Labor Force 8060 60

40 4030 30

~ 20 20IIIc 15 15.2i 10 10.=~III•..

5 5CD..04E 4

::I 3 3z

2 2

1 1.81900 1910 1920 1930 1940 1950 1960 1970 1980

Figure 15·1.

CIVILIAN LABOR FORCE, EMPLOYEES INNONAGRICULTURAL ESTABLISHMENTS, AND TRADEUNION MEMBERSHIP, 1900-1980

SOURCE: L. Troy, Trade Union Membership, 1897-1962(New York: National Bureau of Economic Research,1965). Updated, U.S. Statistical Abstract.

in others nearly none (chemists, typists, engi-neers, clerks, economists). Figure 15-1 chartsunion membership against the total U.S. ci-vilian labor force throughout this country.Figure 15-2 shows the percentage of the ci-vilian labor force belonging to unions. Thedramatic increase in union membership dur-ing the late 1930s has been attributed pri-marily to legislation (such as the WagnerAct, passed in 1935) compelling employers tonegotiate with a union if a majority of theemployees so vote. Federal labor laws are ad-ministered in large part by the National La-bor Relations Board (NLRB).

National unions are federations of manyseparate chartered locals. The local, themembership in a small geographical area

326 Chapter IS

such as a city or county, has the power toapply membership rules and approve andmonitor contracts. For example, although thenational federation has a constitution assert-ing that membership is open to all regardlessof race or creed, the local members set theactual admission standards, which often dis-criminate according to ethnic background,age, and sex. Discrimination is especiallycommon in craft unions.

Craft unions are those whose membersare skilled in the same craft. Industrial un-ions are those composed of people in one in-dustry (defined in terms of product) regard-less of their individual skills. For example,the carpenters' union is a craft union, where-as the steel workers' union is an industrialunion containing members with differentskills in the steel industry. Most craft unionsare allied in a national federation, the Ameri-can Federation of Labor (AFL), and most in-dustrial unions are in the Congress of Indus-trial Organizations (CIO). A few nationalunions such as the Teamsters and the coalminers belong to neither. The AFL and theCIO have a joint top-level council called the

35 35

30 30

25 25G)01 20ca 20•..eG)c 15 15•..G)n.

10 10

5 5

0 01900 1910 1920 1930 1940 1950 1960 1970 1980

AFL-CIo. One of its purposes is to definethe jurisdictions of its member unions to re-duce rivalry among them, about, for exam-ple, whether an electrical fixture may be in-stalled by a carpenter or an electrical worker.

The local's officers, usually elected bythe local membership, maintain membershiprolls, monitor contract terms, and administerroutine affairs such as pension funds andshop grievances. A shop steward, a unionmember in the firm, helps to avoid or settlegrievances, much as an agent acts as an inter-mediary between two contracting parties.Safety rules, working hours, interpretationsof vacation policy, and "goofing" on the jobare a few of the perennial sources of misun-derstanding and dispute that a shop stewardcan alleviate. Union activity is financed byinitiation fees and monthly dues (usually lessthan $100).

Some firms are closed shops: Only unionmembers can apply for and get jobs. Someare union shops: New employees must be-come union members, or at least pay unionfees, if they are to retain their jobs. Openshops do not require union membership.

A boycott is a concerted refusal by somegroup to do business with a certain firm,with the intent to persuade the firm's opera-tors to respond to the boycotters' demands.Sometimes, other firms that do business withthe boycotted firm will also be boycotted-a

Figure 15.2.

PERCENT OF UNION MEMBERSHIP IN THECIVILIAN LABOR FORCE

SOURCE: L. Troy, Trade Union Membership, 1897-1962(New York: National Bureau of Economic Research,1965). Updated, U.S. Statistical Abstract.

secondary boycott. The strike, which is theultimate weapon to influence the employer,consists of two necessary parts: Employeesstop work and prevent other people from re-placing them. Without the ability to preventothers from negotiating for the vacated jobs,a strike would merely be a mass resignation.

The right to strike has had its ups anddowns. At times it was prohibited as an in-terference with a nonstriker's access to labormarkets. At other times police have permit-ted pickets to block the entry of others. In1932 the Norris-LeCuardia Act effectivelyrestricted the power of the courts to issue or-ders, injunctions, prohibiting a union fromengaging in strikes, picketing, and certaintypes of boycotts. But the Taft-Hartley Actof 1947 permitted the president to prohibitany strike that would create a "nationalemergency." Section 14-b of the act permit-ted states to ban union shops. Approximately20 states have passed "right-to-work" laws,which make it illegal to require union mem-bership as a condition for applying for or

Labor-Market Institutions 327

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keeping a job.' Such laws do not necessarilyincrease every worker's range of choice. Forexample, if some firm and all its employeeswanted a union shop, the state right-to-worklaw would prevent it. On the other hand, agroup of employees cannot force other em-ployees to join a union.

Employee/EmployerBargaining Power

Often it is said that individually employeeslack sufficient bargaining power and so mustaccept wage offers that are lower than a de-manded wage. This is the argument used infavor of collective bargaining: the require-ment that an employer negotiate wages withall the employees as a group rather than asindividuals. But what forces General Motorsto pay the wages it does? The answer is thatif General Motors offers lower wages thanother employers, it will get fewer employees,so its employees get a wage that is at least ashigh as their services are worth to other em-ployers. An important truth is that employ-ers compete against other employers, andemployees against other employees-not em-ployees against employers, as folklore says. Itis the availability of higher-valued alterna-tives, not the ability to bargain collectively,that increases bargaining power.

Labor-Union Objeeti~es"The high wages of the American worker area result of a strong labor-union movement."If only it were true. Higher income for allworkers in poor countries would be easy: Un-

'The Taft-Hartley Act is under attack from un-ions, and almost every year attempts are made in Con-gress to repeal it by prohibiting any state from requir-ing open shops in all places of employment.

328 Chapter 1S

--ionize and strike for higher wages. However I

neither economic reasoning nor factual evi-dence supports the quoted claim. If a com-munity has more natural resources and capi-tal equipment, high educational levels,skilled workers, and a system for organizingproductive activity, productivity will behigher. That, and nothing else, is the founda-tion of high wages and income. But can un-ions contribute to higher productivity andthereby raise wages or improve employmentconditions? Yes.

Agents of a union within any firm cansmooth grievance procedures and can moni-tor working relationships among employers,supervisors, and employees, much as real es-tate agents serve as negotiators between sell-ers and buyers to ensure more effective ful-fillment of contracts. That is why unionagents monitor an employer's provision ofpromised working conditions, fringe benefits,security, insurance, retirement, and the like.If an employer supplies less in the way ofpensions, vacations, or medical insurancethan was promised, no one employee mightdiscover that fact until it was too late to seeka remedy-because unlike weekly or month-ly wages, these forms of pay are to be re-ceived as services in the future. Thus, if theemployer's performance in the interim wereclosely monitored, the employee would besurer to get the promised future benefits.Similarly, unions can monitor the perform-ance of the employees themselves. Possiblythe most important function of unions, then,is to improve general productivity by im-proving contract negotiation and fulfillmentbetween employers and the multitude of em-ployees.

This monitoring of performance is sovaluable that almost every big firm whoseemployees are not members of a labor unionwill create a company union, operated by thefirm for its employees. A company union re-duces grievances by more efficiently moni-toring for employees the employer's prom-ised performance of agreements-and by

monitoring the employees' performance.If an employer and the agents of a labor

union are unable to resolve a dispute, theysometimes hire an outsider as an arbitrator tosuggest mutually acceptable terms (thoughneither party necessarily agrees to accept theterms). No law requires employers and em-ployees to submit disputes to an arbitratorfor a binding settlement, but about 90% oflabor-union contracts provide for some kindof arbitration.

If enforcing the employer's performanceof a contract by punishing violations werethe only purpose of union strikes, few em-ployers would oppose unions. The monitor-ing of promised performance does not pro-duce the spectacular situations that arecreated by another attribute of unions: goingon strike, disrupting the firm's business, andpreventing other workers from competing forunion members' jobs. This ability to strike torestrict the labor-services market, or monop-olize it, is the reason employers fear laborunions.

Do UnionsRaise Union Wages?

Not all union bargaining, backed up by thethreat of a strike, is necessarily designed toachieve wages higher than would be ob-tained in an open market. Suppose, for in-stance, an employment contract were signedtwo years ago, and since that time wages, be-cause of general inflation, have risen 15%.To retain, as well as improve, the work forcein the face of better wages elsewhere, theemployer may be ready to offer a pay raise of20%, but initially offers 15%. Union offi-cials, also expecting to get 20%, first demand25%. After a ritual of bargaining, the termscome out to be 20%, and the union claims ithas raised wages. However, neither the em-ployer nor the union set the final wage rate:The employer pays the wage that must bepaid to retain employees, and the union

members accept the offer unless they areprepared to face a loss of job opportunitiesfrom this employer, who will be unable tohire so many at a higher wage.

Some unions have raised their hourlywage rates above those on the open market;many others have had no detectable effect ontheir wage rates. The best estimates are thatthe effect on the average union member's in-come has been to raise it 10% to 15% abovethat of equivalent nonunion workers.' Butthis apparent superiority may have beet),achieved because nonunion wages are madelower than they otherwise would be, becausefewer people are hired at that higher unionwage. The displaced workers then move intothe nonunion labor market, where by enlarg-ing the supply they lower the average wage.Some unions have had greater effect; for ex-ample, the income of union coal miners wasestimated to be about 50~o higher than thatof nonunion miners, though fewer were em-ployed at those wages, and nonunion wageswere reduced.

Our earlier economic analysis, summa-rized here in Figure 15-3, suggests three pri-mary ways to raise wages:

1. Raise the productivity and hence thecompetitive demand for labor (panel Aof the figure).

2. Restrict the supply of labor (panel B).

3. Impose higher wage rates despite the re-sulting reduced amount of employment(panel C).

1. Although some unions may try to helpraise the demand for labor (the marginal pro-ductivity schedule), there is little evidence ofsignificant success. However, insofar as theunion serves as an efficient monitor of the

2See H. C. Lewis, Unions and Relative Wages inthe United States (Chicago: University of ChicagoPress, 1963).


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Figure 15-3.

ALTERNATIVE BASIC MEANS OF AFFECTINGWAGE RATES AND EMPLOYMENT

Panel A shows that an increase in demand for labor willincrease wage rates from P, to P2 and employment from0, to O2,

Panel B shows that a decrease in supply willincrease wage rates but not employment. The problem ishow to exclude some people from the market in order toreduce supply. Immigration restrictions, licensing, entryqualifications (education, age, sex, residence) are someof the means.

Panel C shows that an arbitrarily higher wage ratenegotiated without a change in demand or supply willleave displaced workers whose presence may besufficiently strong to restrain the possibility of pushingup wage rates. The problem is how to prevent newentrants and displaced workers from undercuttingthe agreed-upon wage rate. Jobs can be rationedor shared by spreading reduced work over allmembers, as the musicians' union does.

330 Chapter 15

B c

employer's promises, the full wages (that is,including nonmoney components) are higher.

2. The supply in some cases is effective-ly limited by restricting admission to certainunions or professional groups: longshoremen,plumbers, doctors, certified public accoun-tants, electricians, projectionists, linotypists,and butchers, to name a few. Apprenticeshiprequirements, compulsory licensing, and lim-its on membership are examples of devicesfor restricting entry to restrain supply.

3. By exercising sufficient restrictivepower, the union or professional group mayimpose wages higher than the competitivelevel. The fewer available jobs at that higherwage will have to be rationed among thelarger number of applicants. Employers inthe industry who cannot survive at the high-er imposed wages do not replace equipment.Output diminishes until the smaller supplyresults in higher prices to cover the higherwages of the fewer employees. Displaced em-ployees shift to less-valuable jobs at wageslower than they otherwise would haveearned, and the increased competition forthose jobs among displaced workers pushesthose wages still lower. The national incomeis smaller.

Because wages increase only for those

employees who retain their jobs at the higherwage, strikes and imposed higher wage ratescannot raise the wages of employees in gen-eral. For labor, as for any other good, thehigher the price (here wage rates), the small-er is the quantity demanded.

There is a way in which a union can geta short-lived increase in wages for all itsmembers. This can happen if an employerhas some resources and equipment that areuseful only in this present firm (that is, theresources are specific to the firm). Higherwages would absorb most of the revenue thatwould have gone to these firm-specific re-sources. These resources, having lower alter-native use value elsewhere, simply couldn'tget any more than the residual after the nec-essary general inputs are paid. To take a sim-ple example, if a union of peach pickers wereto strike at the moment the peaches wereready to be harvested, it could demand awage so high as to absorb all the value of theripened peaches. After all, unpicked peacheswould be worthless. The farmer would haveno better alternative than to pay up to asmuch as the entire value of the peach crop toget them picked, because the costs of grow-ing the peaches and bringing them to harvestripeness have already been incurred.

This action expropriates the quasi-rentof the employer's investment, the realizationof which depends on having a labor force atthe competitive market wage rate, no higher.That quasi-rent of the peach crop will be lostto the employer if the peach pickers can de-mand the value of the crop as the price ofpicking it. This threat, if believed to be like-ly, would prevent investing in growingpeaches. That fear is one reason that farmersare so strongly opposed to unions. In someother industries, such as steel, the productiveresources and product don't wither away, sothere is much less possibility of destroying somuch of the employer's investment in specif-IC resources.

Obviously, this expropriative tactic is notlikely to be repeated with any employer. No

employer would ever again agree to a contractwith those employees or that union-as isseen in the grape growers' strong resistance tounions that do not have a reliable record ofnot engaging in that tactic. In any event, al-though this tactic is not a lasting source ofhigher wages (unlike the first-mentionedmethod of imposing higher long-term wagesat the cost of fewer jobs), it sometimes leads tospectacular strikes. As a result people oftenthink that striking to raise wages above theircompetitive levels is the only function of theunion-thereby overlooking the importantmonitoring function explained earlier.

THE STRIKE ASA MARKET RESTRICTION

It is a tribute to the intelligence and econom-ic acumen of union leaders that they knowthat the right to strike is crucial to a strongunion. To be effective the strike must, as al-ready emphasized, succeed in preventingother people from competing for the jobs.

When a union prevents nonunion work-ers from working for less than the wages itseeks, does it differ from the medical profes-sion, which prevents a free market for medi-cal services? One difference is that the medi-cal profession has more successfully defendedits actions, in the name of higher quality of (asmaller quantity of) medical service. That italso enables doctors to get higher wages isnot a difference. The second difference isthat the medical profession does not have torely on strikes and private intimidation ofcompetitors who would sell their services atlower prices. Instead, it has a licensing lawwhich is enforced by arrest, and possibleprosecution, of the competitor. If laws pro-hibit the sale of workers' services by anyoneexcept a "licensed" (union) person, or pro-hibit training except in approved schools,then the union can keep the supply small andwages higher. Were the public police force


available, gangsters and hoodlums, the spe-cialists in intimidation, would be of less value.All union officials would be as free of the "un-desirable elements" as are the officers of themedical and legal associations and public utili-ties, to name only a few closed monopolies.There is no apparent reason why the peoplewho seek to collude or to eliminate competi-tors should only be, for example, tobaccogrowers, milk producers, liquor sellers, taxiowners, lawyers, morticians, doctors, teach-ers, and radio and television station owners,rather than teamsters, carpenters, auto assem-blers, retail clerks, and dock workers.

III

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JOB RATIONINGIN RESTRICTED LABOR MARKETS

Because the amount of labor supplied ex-ceeds the number of jobs available at a wagehigher than its open-market level, those jobsmust be rationed in accord with some non-wage criteria. One procedure is to have aseniority system, whereby job security is pro-portional to the number of years already onthat job. The employees with less seniorityget the temporary, seasonal jobs; when de-mand is low they are the first to go, thus pro-tecting employees with seniority. Anothermethod is work sharing, limiting the numberof days a person can work, so that more peo-ple can be hired to produce the same output(at the same productive rate).

Jobs may be rationed through restrictionson union membership (such ~fo by larger initia-tion fees or by more rigid or narrower stan-dards applying to race, age, sex,education,experience, and probationary membership)."Unethical' job-seeking conduct (for exam-ple, advertising) prejudicial to the senior em-ployed members of the union (whether it bethe American Medical Association, theAmerican Bar Association, the Teamsters, orthe longshoremen) can warrant expulsion.An alternative, publicized reason for theserestrictions is protection from shoddy work

'1!J

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by less competent workers.Protests by blacks and women against

these criteria for union membership and jobshave persuaded national union officials to tryto change the situation. But local unions de-cide admission, and complaints still abound.And as long as membership is limited orwages exceed the market competitive level,economic analysis tells us that more discrimi-nation on bases other than wages is necessaryin deciding who shall obtain the jobs.

If the union is strong enough to raisewages and restrict access to jobs, it may alsobe able to impose some other employmentconditions, such as "featherbedding", or "tie-ins" whereby an employer must pay laborersmore than they otherwise would be paid.Hod carriers, for example, once refused tocarry premixed concrete unless paid part ofthe employer's cost savings; typesetters re-quired newspapers to set duplicate type ifpreset type forms were submitted by adver-tisers; building and movie production codesspecify unnecessarily expensive labor-usingtechniques; standby local musicians must behired when touring orchestras perform local-ly. All are expressions of legal monopolypower deriving from the power to strike ef-fectively, and all extract some of the quasi-rent of the employer's specific resources.

PUBLIC UTILITIESAND GOVERNMENT BUREAUSVULNERABLE TO MONOPOLYRENT TO EMPLOYEES

There remains still another source of higherwages to a strong union. Public utilities arelegal monopolies whose prices are regulatedto prevent them from charging the full mo-nopoly price. But when faced with union de-mands, public utilities, whether privatelyowned or government-owned, can more easi-ly yield to union wage demands because theycan draw on potential monopoly rent. Theregulatory commission may allow the publicutility to raise prices to transfer to its em-

ployees any monopoly rent the utility canstill expropriate from the public. Examplesare transit systems, whether bus, taxi, or rail.

A similar situation arises when publicemployees strike against governments, again,withholding services and preventing anyoneelse from replacing them. When they do soand succeed, they in effect use governmentpower to tax the public to finance their de-mands. (We know of no analysis that deter-mines how much of such taxation the publicwill tolerate.) Of course, the higher thewages the greater will be the number of peo-ple seeking some of those jobs, whether theybe firefighters, police officers, garbage collec-tors, teachers, or bus drivers. One restrainton higher tax-supported wage is competitionamong cities and among states. People andindustry move to locales where taxes andutility costs are comparatively low. Whythen do some state legislatures and city coun-cils encourage and even require unions forpublic employees? Ask your political scienceinstructor, but only after you try examiningthe economic interests of politicians to seewhether they get a better hold on politicaloffice, income, and power by votes from gov-ernment employees whom they have benefit-ed. Again, note that nothing in the precedingpages suggests that people shouldn't act asthey do.

Airline pilots had great success in get-ting high wages when the airlines were legalmonopolies (before 1980). Some of their de-mands were met from airline monopoly earn-ings protected and authorized by regulatorycommissions; some other portion was ob-tained by expropriating the quasi-rent of theairlines' specific investment values in air-craft.

UNION ACQUISITIONAND DISPOSITION OF CLOSED-MARKET MONOPOLY RENT

It is not true that all the value expropriatedfrom an employer by a strong union will go

to the employees. For example, suppose thata union agent could raise the wage rate in afirm to $15 an hour by contrived restrictionson the number of permissible job applicants.If the union agent chose to hold specifiedwages down to $10 an hour, employers wouldbe prepared to pay up to $5 an hour extra toget employees. An employer might then bepersuaded to pay the extra $5 per hour to theagent responsible for assigning union work-ers to employers. Or the employer might of-fer that $5 to a pension and welfare fund.,.--managed by the union agent. The unionagent could demand or accept payments forfavoring the short-handed employer. In ef-fect, the payment made by the employer isnot paid entirely to the workers. Employersreluctant to follow the suggestions of such anagent will discover they get very few em-ployees.

An especially notorious monopoly rentto union officers (as, for example, those inthe Teamsters Union) arises from their man-agement of union funds for pensions, health,and recreation. If the officers invest thosefunds at lower than normal interest rates, thefavored borrowers will offer to pay the differ-ence to union officers as favors, commissions,or business purchases from favored firmswith which the officers' union is associated.

The equity and morality of this "shar-ing" by union officials is not simple. Unionorganizers can claim they accomplished theclosed-market monopoly status for the mem-bers and deserve to be rewarded with largersalaries, expense accounts, vacation resorts,and better homes. Economics contains noethical criteria by which to judge this. Itmerely reveals.

Another beneficiary of imposed in-creases in wage rates is, surprisingly, someemployers, in particular those whose compet-itors tend to use more of the higher-wageworkers and thus have higher costs and aharder time surviving. The employer whouses fewer of the higher-wage workers there-


by has lower costs and can underprice theothers. For example, household movers whoprimarily use low-wage labor will suffer morefrom imposed higher wages than those em-ployers who use bigger trucks with powerequipment to move objects.

DIFFICULTY OF MAINTAININGLONG-LASTING MONOPOLY RENT

Monopoly rent is not easy for any business orunion to maintain. Even if all carpentersjoined forces to make the monopoly industry-wide, product competition would be effec-tive, because of substitutability. Plaster,steel, cement, glass, and other building mate-rials can partially displace carpenters' prod-ucts. Even doctors' attempts to raise fees arepartly restrained by the availability of propri-'etary (nonprescription) drugs, advice offriends, Christian Science, self-diagnosis andself-care, faith healers, and the like.

UNION MONOPOLYVERSUS EMPLOYER MONOPOLY

Union monopoly power is often said to coun-tervail the monopoly power of industry. Butin all but one set of circumstances this prop-osition is false. The steel industry is a groupof independently owned firms-just as a un-ion is a group of independent workers. Yetthere is a fundamental difference: Access toany customer is open to all steel producers,of which there are more than 1000. And norestrictions are imposed on expansion of ca-pacity or on new entrants. But only one un-ion can exist for any class of employees andact as its exclusive bargaining agent. In thisone crucial difference lies the error of think-ing that employers constitute a monopolythat requires a countervailing union monopo-ly. Not even for purposes of negotiating witha common "antagonist," such as a labor un-ion, is it possible for the steel companies toavoid open-market competition. Thus, that

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unions are necessary because only a labormonopoly can bargain effectively with a pro-ducer monopoly is an empty assertion unlessthe employer is also an actual monopoly, as isa public utility.

Legal Restrictions onOpen Markets for Labor

Some laws affecting the labor market arecommonly viewed not as restrictions on thefree-market labor but instead as a means ofcorrecting perceived ills. However, their ef-fects are often quite different from publiclyespoused intentions.

MINIMUM-WAGE LAWS

Minimum-wage laws prohibit employmentat less than some stated wage per hour. Fed-erallaw currently (1982) specifies a minimumwage of $3.35 an hour. Whenever wages ex-ceed the free-market rate, the quantity of la-bor demanded is less than is offered." Those

3Except possibly in what is called a monopsonisticmarket, a market in which one firm makes up such asignificant part of the total demand for labor that toadd employees it must offer higher wages for new andold employees. The graph in this footnote shows a ris-ing labor-supply curve ( WW') to the firm. This curve isalso the firm's average-wage curve. The marginal-wage-cost curve (MWG), the height of which showsthe increase in the total wage bill for one more employ-ee, lies above the average-wage curve, because thehigher wage for the new employee must also be paid toall other employees. The intersection of the labor-de-mand curve (DD) with MWC indicates the wealth-maximizing employment (Eo) at which the wages paideach person are Wo, indicated by the average-wagecurve. To hire one more employee would increase totalcosts by the height of the MWC curve but would yielda marginal product indicated by the demand curve(DD). (This employing firm, though large relative tothe supply of labor, is not the only employer. It mustpay all its employees the same higher wage or they willleave and work for other employers.)

If a minimum uniform wage, higher than Wo, isnow imposed at WI> the firm could hire as many em-

who cannot get work at that legal minimumwage may seek to work instead as private, in-dependent contractors to their former em-ployer, taking a lower income by asking acontract price equivalent to the old wage.

ployees as it wished at a constant wage rate out towhere the horizontal line WI intersects with WW.Each extra employee (out to that limit) would increasethe firm's total wage bill only by the wages paid thatnew employee. In effect, line WI becomes the average-wage schedule, and the marginal cost of more labor istherefore equal to the constant uniform wage alreadypaid each employee. It would pay the employer to hireout to where the line WI intersects the labor-demandcurve. In the graph, this employment rate at the higherconstant wage WI is greater than with a rising wage forsuccessive employees that must also be paid to existingemployees. Imposing a uniform wage increases boththe wage rate and the employment rate.

So far so good. But three factors are often over-looked. First, the higher wage rate will raise the firm'stotal costs of operation, reducing its output as pricemust be raised and thus reducing employment. Second,employers faced with a rising labor-supply curve(WYV) are often able to confine the higher wage to thenew employee only: The old employee has no betteroption in any event, whether or not the new employeeis hired; special fringe benefits or job classificationspermit differential wages among employees. Third, afew employers make up a large enough percentage ofthe market for labor to have significant long-term ef-fects on wages by individually varying their rates ofemployment. Over the long term, then, the flow ofworkers from other employers and areas makes thiscase of little significance.

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Or, an employee could continue to work atthe higher wage but provide more of the cap-ital equipment to the employer at a lowerprice than the true cost. For example, say aperson was holding a job as a taxi driver at $3per hour, or $120 for a 40-hour week. Sup-pose a minimum wage of $3.35 per hour isimposed, coming to $134 for a 40-hour week.The worker displaced by the employer's de-manding less labor at that wage could rentthe taxi from that employer at a weekly rent-al of, say, $14 a week (offering, that is, a softof reverse tie-in).

People whose services normally are notworth the legal minimum hourly wage mayobtain jobs when demands temporarily riseto make their hire worth that wage rate. Butthese will be temporary jobs: These workers'vulnerability to the vagaries of general busi-ness fluctuations is heightened.

Full wages, like full prices, contain morethan money payments. Partially offsettingthe employment effects of minimum-wagelaws are adjustments in work conditions notcontrolled by the law: for example, the ex-tent of health care and on-the-job training,length of vacation, number of sick days, tol-erance of tardiness and use of company mailor telephones, number of coffee breaks,length of lunches, cleanliness of restrooms,provision of parking space, safety precau-tions, and air conditioning. Employees willaccept jobs with less of these nonmonetaryfeatures to reduce the employer's full costs ofhiring them.

The groups most severely exposed to allthese effects are teenagers, blacks, women,and the aged.' It is hard to refute the chargethat the minimum wage laws are devices per-petrated by white, middle-aged, male chau-vinists. As a wit wrote, "A $5 industrial

• It follows that because the minimum-wage lawsdo not very effectively cover paid household help, alarge portion of which is provided by black women, thelaw hits harder at black men than women.

Labor-Market Institutions 33S

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minimum wage would go a long way towardperpetuating the family farm."

EOUAL PAY FOR EQUAL WORK

Wage differences often reflect differences inemployees' abilities and in working condi-tions, yet -such compensating differences inwages are not always welcomed. One of theclassic methods of trying to eliminate them isto try to apply the maxim "equal pay forequal work" -on the presumption that equalwork is easy to identify and that nonmone-tary differences among services by employ-ees or by employers should not count.

The person who has what some peopleconsider to be inferior features dislikes beingpaid less for the same work, even though thewage difference is what enables the person tooffset a personal nonmonetary disadvantage.Popular people complain that compensatingwage differences allow those less popular tocompete for jobs. Men may be hired becausean employer prefers them as workers, butthat preference is made more expensive bythe excess over the lower wages the employ-er could have paid for equally valuable workby women. The employer pays more to hiremen. Males cleverly advocate equal pay forequal work-of course, at the higher wagespaid to men. The effect is to protect men'semployment by reducing the opportunity forwomen to underbid the men.

This analysis extends to geographicaldifferences in pay. Because of differences inthe supplies of labor, wages for similar laborare lower in the South than in the North, andlower in Puerto Rico than in the UnitedStates. Northern employees can protect theirwage rates from the competition of lower-wage southern labor, and U.S. laborers pro-tect their higher wage rates from Puerto Ri-can labor, by means of the "equal pay forequal work" and minimum-wage laws, whichremove the reason employers would relocateto those locales.

FAIR-EMPLOYMENT LAWS

Because laws requiring uniform payor mini-mum wages transform expressions of dis-crimination from differences in wages to se-lection of employees by their nonmonetaryattributes, pressure mounts for fair-employ-ment laws, which prohibit employers fromchoosing employees on the basis of any non-wage criterion ruled unethical-usually race,creed, age, and sex. These laws are difficultto enforce. How can it be determined what ismotivating an employer? Furthermore, em-ployers become reluctant to observe the spir-it of the law in their hiring practices if theybelieve it will be more difficult to dismissthose whose services are unsatisfactory, be-cause they could be accused of discrimina-tion. Fair-employment laws impose burdenson employees: If Armenians prefer to workwith Armenians, Catholics with Catholics,blacks with blacks, or Mormons with Mor-mons, these laws make that illegal.

HOURS ANDSAFETY LEGISLATION

Several other laws affect labor-market opera-tions. For example, laws specify the mini-mum ages and maximum hours of work forchildren and women. A federal governmentagency, the Occupational Safety and HealthAgency (OSHA), requires employers tomaintain safe working conditions. It shouldnot be entirely surprising, if you havelearned your economic analysis well, that therate of reported accidents on jobs may be un-affected, or increased, by that law. (As wesaw in an earlier chapter, studies of the ef-fects of higher automobile safety standardsshow similar results. Automobile accidentsbecame more frequent.) The apparent resultsdo not prove that the laws are undesirable;instead they indicate that actual effects oftendiffer from intended effects because, wheresafer systems and devices are used, peopleact less carefully.

IMMIGRATION RESTRICTIONS

For the past century, immigration into theUnited States has been restricted. Althoughit is unwise to admit a desire to create barri-ers against competition from one's fellowAmericans, it is ancient and honorable to barforeigners. Current favorite targets are thetemporary migrant farm workers from Mexi-co, who are either excluded outright or pre-vented from working in the United States atwages low enough to induce people to e~-ploy them but much higher than those. 10

Mexico. Also, many products of foreignworkers cannot be imported.

Closed Monopsony:Buyers Close a Marketto Competing Buyers

Closed monopsony is analogous to closedmonopoly in that it means th~ exclusio? ofcompetitors, the difference being that 10 amonopsony other buyers rather than othersellers are excluded. Just as employees areselJers of labor, employers are buyers of it.Some employers are anxious to restrict com-peting employers from bidding up wages, tokeep them below what would have beentheir open-market levels. Some have hadspectacular successes, as we wiIl see shortly.And some of the successes have been widelyregarded as socially desirable.

But most public attention is drawn tothe relatively ineffective attempts. For exam-ple, when asked to name cases in which em-ployers have "ganged up" on employees,people usually cite such phenomena as: "yel-low-dog" contracts, employment contractswhereby the employee agrees not to join aunion; sweatshops, by which are meant shopswhere employers pay low wages (but lowerthan what?); and child labor, the employ-ment of children considered too young to beworking. The chief argument against childlabor has been that children should be in

school learning to be more productive. But itis hardly ever noticed that the decrease inchild labor over the last hundred years is theresult of the decline in farming as a percent-age of total employment, because child laborwas mostly farm labor. And currently, thehigher incomes of parents reduce the pressurefor supplementing incomes by child labor.

We turn now to three possibly surpris-ing examples of effective monopsony-collu-sive actions by employers against employees.They affect over half the young men andsome of the women in the U.S. labor force.

HOSPITAL INTERNS

All states require that candidates for me~icalpractice successfully undergo supervisedtraining and be licensed before they c~npractice. Membership in a medical associa-tion is also required if a doctor is to capturethe greater income available from practice ina first-class hospital (unless it is part of amedical school). Suppose the association pr~-hibited hospitals from paying interns (medi-cal-school graduates undergoing a formal pe-riod of acquiring experience) more tha?$2000 a month, whereas with open competi-tion among hospitals the rate would be high-er-say, $3000. The price agreement is en-forced by the threat that any hospital inviolation could be punished by withdrawal ofits "Class-A" certification, without which itcan't attract good doctors. The gains from se-cret violations-which are very likely to bedetected-would be much smaller than theconsequences of the possible punishment.The reduced costs are appropriated by doc-tors in the form of higher medical and hospi-tal incomes.

COLLEGE ATHLETES AND THE NCAA

Colleges maintain an effective but not pub-licly understood collusion to depress the


wages of college athletes. When intercolle-giate football became a substantial source ofcollege income, football players receivedmoney inducements-in effect, wages-to at-tend a particular college. Some college ad-ministrators decried that as "professional-ism." Amateurism was considered to be more,virtuous. Yet, with an eye on the football in-come, administrators were dismayed thatcompetition among schools was raising ath-letes' "wages" and reducing net income tothe college.

An agreement, called an athletic code, torestrict wages was reached through the Na-tional Collegiate Athletic Association(NCAA). Not surprisingly, colleges cleverlyswitched to such offers as athletic "scholar-ships," "free" room and board, travel to col-lege, payments for little or no outside work,jobs for relatives, clothes, and the like. Thesemethods of competition came about becauseof the agreement restricting money wages.At identical, limited money offers, the distin-guished colleges would get the best athletes.The less distinguished colleges in metropoli-tan sress (with large potential gate receipts)resorted to covert offers. To choose one ex-ample from hundreds: Two decades ago, andagain in 1982, two California schools, theUniversity of California, Los Angeles, andthe University of Southern California, werecaught cheating and were fined $lOO,OOOandprohibited from playing in postseason bowlgames (the games that are the most profit-able). Tennis, basketball, track, and baseballteams-members of which had received no"unethical" payments-were banned fromnational tournaments.

The professional football and basketballleagues have been made to refrain from bid-ding for college athletes until after their classgraduates. This is not true for baseball andtennis athletes, who have no financial valueto the university. The NCAA has restrainedits financially useful student athletes frombeing able to sell their talents to the profes-

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sional leagues until after the colleges get fouryears of their service at controlled wages. Incontrast, colleges pay students competitivemarket wages as waiters, ushers, computerprogrammers, and research assistants. Such isthe meaning and effect of the NCAA code of"honorable" athletic behavior.

How could collusion to restrict wagessurvive in the face of the great advantages ofcheating? After all, if television and radionetworks tried to suppress performers'wages, other networks could profitably be or-ganized to take advantage of the reducedwages. What preserves the collegiate collu-sion?

Any college violating the athletic codecould lose its academic accreditation. Anycollege put on probation or expelled fromthe NCAA would find it more expensive torecruit faculty and students. Even the nation-al fraternity Phi Beta Kappa refused to au-thorize chapters at colleges that gave "dis-proportionate" athletic scholarships. Thesurvival of the college could be threatened.Why does the present accreditation grouphave power to prevent the formation of anew accreditation system? A very importantreason is that colleges are not self-support-ing. No school could get subsidies from thestate or major philanthropic foundationswithout official accreditation by the presentaccreditation group-which has powerful in-fluence on the government and the charita-ble foundations. We have finally arrived atthe source of the value of membership in theNCAA and related organizations: subsidizedcolleges. The NCAA was not created to re-strict the pay of football players. It was setup for other purposes, but once its greatervalue for these other purposes could be de-nied to a nonmember, it became an effectiveenforcement agency of a successful cartel.

MILITARY DRAFT

The most spectacular and successful collu-sion by employers against employees is the

military draft. From World War I into the1970s the United States has obtained enlistedmen by a draft. (And since 1980, 18-year-oldmales have been required to register withthe government, although there.is no formaldraft.) A draftee must work at tasks and atwages set by Congress-lest he lose valuablecitizenship rights. Young men may be re-quired to work at less than market wages inthe military, though there is no law that re-quires them to do so as police officers, fire-fighters, astronauts, garbage collectors, gen-erals, admirals, or politicians. A draft is a taxon young males paid in kind, just as the oldmedieval kings drafted labor to build palacesand roads. The old, the smarter, those whomarried early and had children, and womenavoid that tax.

Recently, when the military movedtoward an all-volunteer status, the wageswere increased in order to attract people. Ifthe wages aren't maintained high enough rel-ative to civilian occupations, the draft willprobably be used again. Without a draft, ex-plicit money taxes must be levied on all whowould bear the burden of national defense;the true, hitherto hidden costs of the draftare then revealed. But it is also true that forany specified military capability, those costsare lower than under a draft. (Recall whathappened in our three-person economy inChapter 7 when the wrong people weredrafted into producing various goods. Thetotal possible output became smaller. And soit is with the draft.) Without the draft thetotal explicit monetary tax bill is larger, butthe real cost is smaller. And without thedraft, the military must pay more attention(not pay more costs) to the true costs of laborand seek economical means of providing de-fense services. Drastic recombinations of in-puts occur, according to the marginal prod-uct and specialization principles outlinedearlier. Most obvious is greater reliance oncivilian employees to provide services not re-lated to combat or training for it. Custodial,food, and sanitation work around military

camps is provided by labor cheaper than thatof strong young men who are of greater valueas soldiers or in other work. Enlistment turn-over rates and training costs decrease. Inshort, lower-cost methods are forced into use.

If every male has an obligation to defendhis country, it does not follow that everyoneshould do so in the same way-by a tax inthe form of military service, which is whatthose who claim an obligation from onlyyoung men are really contending. Specializa-tion in military service is just as sensible asin supplying food, clothing, and domestic po-lice protection.

Let it be noted that the Union Army inthe Civil War-a war that used a far greaterproportion of our young men, with higher fa-tality rates than in any subsequent war, andone in which the men fought with unex-celled valor-was not a draft army. It waspurchased in the open market: Men weredrafted, yes, but every draftee had the rightto hire someone to take his place, usually bypaying that other person a lump sum. Thedraft was a means of assigning the tax amongthe young men. Once taxed, a man could ei-ther pay the amount necessary to buy a sub-stitute or could work it out in the UnionArmy. Those who served did so in the coldcalculation of the amount of the tax.

SummaryI. Though wages for labor services respond to

market forces as do the prices of any othergood, the sale of labor services differs in in-volving personal relations to a much greaterdegree.

2. Labor unions have three dominant func-tions: to facilitate contract negotiation, tomonitor employee performance, and to re-strict competition by other labor.

3. Unions can raise full wages insofar as theyact as efficient employee agents in contractnegotiation and enforcement.


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'[I, 4. Unions can raise wages of some union mem-

bers if they can monopolize the supply ofemployees available to employers. Not allunion members gain, because less labor isdemanded at the higher wage. Nonunionemployees face competition from the dis-placed union members, who by adding tothe supply of nonunion workers lower non-union wages.

5. A strike is a concerted refusal by employeesto work and a denial of the access of otherpotential employees to the employer.

6. Government employees who strike and suc-cessfully monopolize the supply of potentialemployees to a government are using thepower to levy taxes to obtain their monopo-ly wages.

7. Minimum-wage laws that raise wage ratesabove competitive levels increase the inci-dence of unemployment for the lowest-earn-ing employees. Laws enforcing equal pay forequal work often harm those intended to behelped.

8. A cartel agreement among buyers of a goodto restrain their competition for that good iscalled a monopsony cartel. Examples of suchcases have been found among some hospi-tals, colleges (competing for student ath-letes), and the military.

I

questions*1. Coalitions of employees, called unions per-

mit the members to have an a~ent to monitor theemployer's fulfillment of promised services andworking conditions for employees. Employerswelcome that kind of intermediary to smooth re-lations and give greater assurance to employees.Indeed, if the employees don't form their ownunion, the employer creates a personnel repre-sentative to perform similar services. If the pre-ceding is true, and it is, then why do employersoppose unions?

2. "In a society where there has not been anadjustment of wages to the savings of time af-

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forded by the use of new techniques, and wheresuch savings may result in an oversupply of la-bor, an agreement among laborers to preventsuch conditions has a lawful labor objective."(Decision by Superior Court Judge MartinCaughlin, San Bernardino, California, in case ofOrange Belt Chapter of Painting and DecoratingContractors v. AFL-CIO Painters District Coun-cil 48, July 1958.) Suppose the introduction ofspray and roller painting methods reduced theamount of man hours in painting a house to 50<;'0of its former level.

a. Does the above decision mean that wagesshould be doubled? Or that the laborerscan force the houseowner to hire as manyhours of labor with the new technique aswith the old?

b. What does it mean?

3. "Technically speaking, any labor union is amonopoly in the limited sense that it eliminatescompetition between workingmen for the avail-able jobs in a particular plant or industry. Afterall, all unions are combinations of workingmen toincrease, by concerted economic action, theirwages, i.e., the price at which the employer willbe able to purchase their labor."(Arthur Gold-berg, Justice, Supreme Court of the UnitedStates, and formerly Secretary of the Departmentof Labor and counsel for the United Steelwork-ers; quoted from AFL-CIO: Labor United, NewYork, McGraw-Hill, 1956, p. 157.) Why did hewrite "technically speaking" and "in the limitedsense"? Is there some other mode of speakingand is there an unlimited sense of monopoly?Does a monopoly (closed or open?) eliminatecompetition? What does it eliminate and how?

4. "The steelworkers' union and the U.S. SteelCorporation are both monopolies." In terms ofthe closed and open monopoly distinction, is thatcorrect?

5. You work for a television manufacturer as awelder, and two unions contend for recognitionas the sole bargaining unit for welders. One, a"craft" union, would be composed only of welders;the other, an "industrial" union, would admit allemployees who work for television manufacturers.

a. In which type of union do you think youwill be able more effectively to raise yourwages by imposing apprenticeship condi-tions and other devices to restrict the

number of people who can seek jobs incompetition with you?

b. Which union do you think will be moreable to impose a wage-rate increase uponthe employer without first restricting un-ion membership? Explain why.

*6. The National Association for the Advance-ment of Colored People contends that the build-ing-trade craft unions (among others) discrimi-nate against blacks. The national-headquarterofficials of each union reply that the local unionsin each city are autonomous and determinemembership. The charter provides that therewill be no discrimination. The unions reply vari-ously that no qualified blacks have applied, that anew member must be nominated by three mem-bers in good standing, that they do have someblacks, that they use a quota system to ensurethat all groups are equally represented, and thatthe present time, when even the white membersare unemployed, is not a feasible time to increaseentry rates. Given that the craft union has thepower to determine who and how many may jointhe union, some system of choice is necessary-ifthe number is to be restricted in order to main-tain wages above the open-market level.

a. What criteria for selection do you thinkshould be used and declared defensible?Explain why.

b. Would you recommend a quota system?Why?

*7. "Plumbers' and steamfitters' union local 2 ofNew York has no Negroes, and 80-95 percent ofthe members are the sons of existing or formermembers." (News story from New York Times,August 2, 1963.) What explanation can you offerfor this?

8. a. Labor groups were strong advocates ofraising barriers to immigration in thenineteenth century. Employers objected.Why?

b. Labor groups were less enthusiastic fortariffs (taxes on imported goods), butsome were in favor of them. Why?

9. Walter Reuther, former head of the autoworkers' union, contended that automobile pro-ducers should lower their prices to benefit thepublic.

a. Why did he not propose that the current

tax (tariff) of 12c;7o on importation of for-eign cars be abolished as a means of in-creasing domestic supply?

b. Why do you think Reuther wanted lowerprices for products produced by membersof his union?

10. Some employers welcome the growth ofpowerful unions that will be able to raise wagesand control the number of employees admittedto the union. Why? In answering, show whysome employers would be hurt by the elimina-tion of effective unions (even ignoring the con-flict in trying to eliminate the union). •..

* 11. "Any craft union that has to resort to thestrike to get higher wages is not being operatedefficiently. It should instead concentrate on con-trol of apprenticeship rules and admissions in or-der to assure high-quality, reliable, skilled unionmembers. And it will incidentally therebyachieve its higher wages in a peaceful, democrat-ic way." Explain what the speaker, a highly suc-cessful union leader, meant.

12. As a beginning lawyer, would you benefit iffees for the following were set by the bar associa-tion: drawing up someone's will, serving as an ex-ecutor of an estate, arranging for a divorce?

13. A representative of the Congress of RacialEquality advocated raising the minimum legalwage in order to help blacks get higher wages.

a. Would blacks benefit from a higher mini-mum wage?

b. Would it reduce or increase discrimina-tory hiring?

14. "The higher the legally constrained rrnrn-mum-wage rate, the greater the amount of unem-ployment of unskilled workers." Is this correct?Explain.

15. If in some town the minimum wage rate fortaxi-driver employees were raised to $5 an hour,what would happen to the ratio of cabs driven bythe owners to cabs driven by employees of cabowners? Why?

16. You are an immigrant. Would you preferlaws insisting on equal pay for equal work, mini-mum-wage laws, apprentice laws, or strong un-ions that have been effective in raising wagesabove the open-market level? Explain.


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17. As a summer-job-seeking college student, areyour chances of getting a job increased or de-creased if the wages you can get in a cannery,summer resort, factory, and so on, are set by aunion comprised of current full-time employees?Why?

18. As a college-age babysitter, would you bene-fit if an association of babysitters were organizedand a minimum wage of $3.50 an hour enforced?Why?

19. "If an enterprise cannot survive except bypaying wages of 75¢ or $1 an hour, I am perfectlywilling for it to go out of business. I do not be-lieve that such an enterprise is worth saving atthat price. It does more harm than good, sociallyand economically. It is not an asset; it is a liabil-ity. So if this kind of business is killed by a mini-mum wage of $1.25, I for one will not be sorry."(George Meany, Hearings before Subcommitteeon Labor Standards, 86th Congress, 2nd Session,1960, p. 36 of Part 1 of printed hearings.)

a. How does this statement differ from onethat says, "Any person who cannot pro-duce a product worth at least $1.25 anhour should not be allowed to work as anemployee"?

b. Explain why Meany did not suggest thata business that paid wages of $5 an hourwas an even greater liability to thecommunity.

20. "The National and American FootballLeagues have finally gotten together and agreedto have a common draft of college players. Thedraft will eliminate those utterly ridiculous$600,000 bonuses that were paid to untried mus-cular meatballs from the college campuses. Thepeace pact will also put a step to the alarmingmovement to tamper with the legal property ofother clubs (i.e., bid players away from otherleagues). The peace pact is welcome. If the cost

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342 Chapter IS

is high, a continuation of the warfare would havebeen costlier." (Sportswriter Arthur Daley, NewYork Times, June 9, 1966.)

"Pete Gogolak, the star American FootballLeague placekicker, said today he thought playersalaries would not suffer because of the merger ofthe two leagues. He said, 'The new players whostood to get big bonuses because of the competi-tion between the two leagues may get hurt, but Ithink the salaries of the other, older players willremain high.' Gogolak had played out his optionwith the American League Buffalo Bills and thensigned with the National League Giants at a sala-ry believed to be $32,000." (News item fromNew York Times, June 9, 1966.)

"The common draft, now agreed to by the twoleagues, will drastically cut bonus payments andshould appease the colleges who have railedagainst the in-season solicitation and prematuresigning of college players attributable to thescramble for talent." (Sportswriter J. M. Sheehan,New York Times, June 9, 1966.)

a. To which two of the three writers justquoted would you give a flunking gradein economics? Explain why.

b. If General Electric, Westinghouse, andother electrical companies could get to-gether and have a common draft of gradu-ating engineers, would engineers' salariessuffer? Why?

c. If General Electric, Westinghouse, andother electrical companies could get to-gether and have a common draft of col-lege students at a salary of $100 a monthand could compel chosen students towork for them or face jail and loss of citi-zenship, do you think the draft would beregarded as defensible and in the socialinterest? Reconcile your answer with theexistence of the Air Force, Army, andNavy common draft.

Chapter 16Wealth:Saving andInvesting

"W'ealth is more than machinery, buildings,fertile land, sheltered harbors, rivers, andgood climate. To know that the nonhumanwealth of the United States has a market val-ue of over $3 trillion is to know only part ofour wealth. People are wealth, too; and so arecultural values and mores, customs, and eti-quette, all of which enable us to be moreproductive.

Natural resources have to be convertedto useful form by the application of effortand knowledge. In this country, the prairiewas forbidding until the pioneers sweatedover it with the plow. For eons the Indianstolerated New England's rocky soil, severewinters, and short summers, but it was thecolonial settlers' knowledge and work that in-creased the soil's productivity.

Other forms of wealth are a stable gov-ernment, a reliable judicial process, and re-spect for property rights and the certainty oftheir continuance. Because these are not mar-keted separately, their value is not measur-able directly but, rather, is measured in thevalue of goods sold. For example, people arewilling to pay higher rents for premises incities or neighborhoods with low crime rates.

In the mid-nineteenth century, the U.S.government did not hold land appropriatedfrom the Indians for the "benefit of all thepeople." During the westward advance peo-ple were able to claim and use the land asprivate property. They could sell it or bor-row against it; they could "profiteer," resell-ing the land at enormous gains in value; theydidn't have to stay on the land to obtain thevalue of their development (as one must to-day in foreign countries that ban absenteelandlords or even the right to sell land, suchas Mexico, Iran, Egypt, and India). Landown-ers were able to realize, or capture, the capi-tal value of the future consequences of theiractions and investments. The capitalist sys-tem was operating, coordinating people's ac-tivities (as we analyzed in the early chapters)by price incentives.

343

Could a socialist economy achieve great-er wealth than a capitalist economy? Un-doubtedly a government can compel a higherproportionof income to be put into savingsthan might be done voluntarily. The issuesare whether a higher rate is desirable onthose terms, whether the savings will be in-vested as productively, and whether the in-come itself would be as large. Debaters waxeloquent and emotional, but the evidence isnot yet conclusive.

Note the words of a man who, over a pe-riod of 14 years, was first a vice-president ofthe International Bank of Reconstruction andDevelopment and then was president of theInternational Finance Corporation:

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Let us briefly examine some of the fre-quently cited causes of underdevelop-ment. It is often claimed that geographyand natural resources are determining.They are of course important. ... But re-sources lie inert and have no economicworth except as people bring them intouse. It is easy to attribute the progress ofthe United States to its wide expanseand abundant physical resources. How-ever, other areas-in Latin America, Af-rica, Asia-have comparable naturalwealth, but most of it is still untouched.On the other hand, there are countriesin Western Europe with limited fertileland and meager mineral deposits, yetthey have achieved high levels of eco-nomic life. . . . ..

Perhaps most often lack of capital isblamed. In the first place, there is inmost developing countries more poten-tial capital than is admitted. But largeamounts are kept outside, because of po-litical instability .... Or it is invested inoften underproductive land, low prioritybuildings, or otherwise hoarded ....Over the postwar period immense sumshave been made available to the devel-oping areas. Some of these funds have

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been well applied and have producedsound results, others have not. . " If[money] is applied to uneconomic pur-poses, or if good projects are poorlyplanned and executed, the results will beminus, not plus. The effective spendingof large funds requires experience, com-petence, honesty and organization. Lack-ing any of these factors, large injectionsof capital into developing countries cancause more harm than good. The test ofhow much additional capital is requiredfor development is how much a countrycan effectively apply within any givenperiod, not how much others are willingto supply.

It is popular in many quarters tocharge colonialism with lack of develop-ment in territories which have been de-pendent. This argument seems less per-suasive when we observe that a numberof countries which have been their ownmasters for long periods are no furtheradvanced.

I am, therefore, forced to the conclu-sion that economic development or lackof it is primarily due to differences inpeople-in their attitudes, customs, tra-ditions and the consequent differences intheir political, social and religious insti-tutions.'

Sources of WealthThose (whether people or nations) who wishto increase wealth must do their own saving.First, one can build up wealth from gifts ifnot all of the aid is used for current con-sumption.

A second method of increasing wealth isto save and invest more. But how? For a

'Robert L. Carner, International Finance Corpo-ration, Summary Proceedings, 1961 Annual Meeting ofthe Board of Governors, September 21, 1961, pp. 4-6.Or see the Nobel Prize lecture by Nobel laureate T.W. Schultz, 1979.

country as a whole, investment might bemade by the government, financed by taxes,in the belief that private owners of wealthrefuse to invest enough. But higher taxes, byreducing income, reduce private saving. Fur-thermore, to escape the tax, people will in-vest in ways that yield more nontaxable ornonmonetary income. For example, in theUnited States homeowners are not taxed onthe income (real services) from their homes,whereas money income from investmentsthat would be used to pay for rental of apart-ments or houses is taxed.

Third, political authorities may increaseinvestment in a particular kind of wealth-namely knowledge-by funding educationand research, on the presumption that patentand copyright protections give insufficientincentives to private parties to invest in thediscovery of new knowledge on a sufficientscale. But this remains a presumption, be-cause patents and copyrights are available,and because it is impossible to define a bestrate of invention or discovery of ideas.

A fourth method of increasing wealth isto reduce the costs of channeling savings intothe most profitable appearing investments.Just as the costs of distributing food fromfarmers to consumers are reduced by an ex-tensive network of middlemen, so wealth isincreased by an extensive network of special-ized financial intermediaries collecting fundsfrom millions of savers and channeling themto better investment prospects. .

A fifth way is to make it more likely thatthe profits of investment will go to the inves-tor. If the rights to profits are threatened orweakened, the incentive to invest is reduced.Price controls and political regulation reducesecurity. In many countries the security ofone's rights in property is unreliable; the rep-utations of the governments of Argentina,Brazil, Chile, Iran, Indonesia, Kenya, Egypt,Mexico, and Algeria in this respect are noton a par with those of Switzerland, the Unit-ed States, Japan, and Malaysia, to name afew. (Both lists could be longer.)

Property Rights,Growth, and Conservation

It is often argued that we should safeguardour wealth by politicslly restricting the ex-ploitation of our natural resources such asforests, seashores, fertile lands, oil, and ironore. This argument fails either to compre-hend the meaning of wealth or to recognizethat using goods can convert them into evenmore valuable forms of wealth. As explainedin Chapter 6, if a tree is more valuable torfuture lumber than current lumber, the pres-ent capital value of the live tree exceeds thevalue of the current lumber in the felled tree.The tree will not be cut now, because lum-ber now would yield less income than thegrowth of the standing tree. By comparingthe present values of the two uses we discov-er which will give the greater wealth. Thus,it cannot be said that the private-property,open-market system tends to cut trees-oruse its other resources-too fast. It does con-serve them by capitalizing into the presentvalue of the live tree its highest valued uses,whether as lumber or as a natural object giv-ing recreation through its beauty, or in anyother use.

But there are circumstances in whichpeople cut down trees even though their livevalue exceeds the current value of the lum-ber. If no one owns the tree, one way to cap-ture its value as private property is to cutand take the wood. If there is no privateownership of the live tree, no one will havethe wealth incentives-or the legal power-to preserve it (rather than cut it prematurelyin order to establish rights to the lumber).Or, if land whose use is affected by trees isnot owned by anyone, the beneficial effect ofa tree on the land's value will not be heededaccurately. Forests in many parts of Englandand China were prematurely destroyed be-cause no one owned them. First come, firstserved. Not personal greed but lack of well-defined, marketable property rights was re-

Wealth: Saving and Investing 345

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sponsible for this wasteful use of resources.This same analysis can be applied to fish

and game, which, until caught, belong to noone. Someone who had enforceable owner-ship rights to the live fish would have theincentive and ability .to prevent prematurefishing or overfishing.' As a substitute for en-forceable private-property rights, govern-ments have sometimes managed to reachagreements enforcing limits on catches. Simi-larly, as long as no one owns the rights topresent and future uses of lakes, rivers, or un-derground water supplies, people have lessincentive to use water in its most valuableways. Instead, being the first to use it isequivalent to possessing it. Garbage isdumped in an unowned lake because the lostvalue of the otherwise cleaner water is notthrust upon anyone person with sufficientrights or self-serving incentives to controlpollution. Because most (although not all)major lakes are not held as private property,they are excessively polluted.'

Water is not generally allocated by pri-vate-property rights. Often the first user of asource of water establishes his or her rightsto the water. An aqueduct costing billions ofdollars was prematurely built to move waterfrom Northern California to Southern Cali-fornia. In fact, the construction of that aque-duct was basically an exceedingly costly wayof establishing Southern California's rightsto future water from Northern California.Petroleum was once considered unowneduntil taken out of the ground. To remove

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"Walter Cronkite (or his writers) said this over-fishing was a failure or weakness of capitalism; it is, onthe contrary, a Iailure to apply capitalism to fish in theocean.

30ne of the authors of this text owned land ad-joining Lake Arrowhead and also land on the Mediter-ranean Sea. Arrowhead is owned by a private corpora-tion. He dumped sewage in the Mediterranean but notin the lake. Why was he "responsible" at the lake andnot at the sea?

346 Chapter 16

the incentive to pump oil just to get title toit, rights to subsurface oil were assigned tothe owners of the land on which it wasdrilled.

Let's try to better understand some cir-cumstances in which people miscalculate orinadequately heed costs because they cannotbe made to bear the full costs of their ac-tions. A paper mill is a heavy user of water.If a paper mill produces paper worth $10, ata perceived cost of $6, but also pollutes andreduces the water's value by $5, then the to-tal costs ($6 + $5) exceed the $10 value ofthe paper. Wealth is in fact destroyed. But ifthe fouled water is reduced in value only by$2, then the paper worth $10 is produced at atotal cost, or sacrificed value, of $8-a net so-cial gain of $2. Activity that is profitable af-ter its full costs are accounted is economicgrowth in that people get what is worthmore to them than they otherwise wouldhave had.

One way of measuring growth is to makethe calculation of costs clearer, and one wayof encouraging growth rather than decline isto make people directly bear the costs oftheir actions. Conservationists, we will pre-sume, are trying to ensure that all costs andall values produced by some activity are fullyand accurately assessed, even for unownedresources. Because some resources are notowned, it is often proposed that governmentagencies should assess the values of all ef-fects. One way to impress the value on theuser is to make him pay a fee (a price) equiv-alent to the presumed loss of value; that is,the user purchases a right to pollute. To pro-hibit all use of a resource-be it air, water, orseashore-would eliminate some benefitsthat exceed the damage to the resource. Yetsome laws controlling air pollution and somecourt decisions prohibit any pollution of airin areas newly coming into use, regardless ofthe benefits that would be obtained by somefouling of the air. That reduces welfare justas effectively as overuse of the air. Fortu-nately, some legislators and courts instead

weigh the loss in value in one resourceagainst the benefits obtainable thereby.'

Investment Activity

INVESTING BYCONVERTING INCOME INTO WEALTH

Wealth is produced in many ways. We canconvert currently consumable goods tosources of future services. For example, weconvert fresh milk to cheese, apples to cider,pork to bacon, grain to whiskey, grapes towine, olives to olive oil. Or we can producegoods that are more durable: steel instead ofwood buildings, concrete instead of blacktoproads, diamond-tipped instead of metal-tipped phonograph needles, pipelines insteadof trucks.

We have talked of saving and of invest-ing, but a person who saves is accumulatingwealth, that is, is investing. Saving is invest-ing, but the two words describe different as-pects of the process of increasing wealth.Saving applies to the nonconsumption of in-come, whereas investing applies to the use ofthe unconsumed income to create more fu-ture income.

NET PRODUCTIVITYOF INVESTMENT ACTIVITY

As explained in Chapter 6, a dollar of cur-rent income invested rather than consumedoften yields more than a dollar of future in-come. That miraculous gain is called the netproductivity of investment. Plant a seed to-day and next year, after allowing for costs,

4An economist once shocked his beginning stu-dents by remarking that the most valuable use of LakeErie may be as a seaway for ore freighters, or as a sew-er for industrial waste, rather than as a swimming poolfor those living next to the lake. It's a matter of whichuse-and to what extent each use-provides the great-est benefits.

have more than one seed. This net produc-tivity of investment converts-directly or in-directly-energy or material to more desir-able forms.

A Measure of the Net Productivity of In-vestment If we devote one unit of currentincome today to obtaining future income,and we thereby get 1.15 units a year hence,the gain is .15 units in one year. If for anamount A invested today we obtain a yearlater an amount A(l + g), we define g to bethe net productivity (in percentage) of in-vestment per year. (In our example, g = 15<;'0per year.)

We never know in advance what g willbe; everyone who invests must gamble. Yetalmost all of us make investments of onetype or another-in education, buildings,cars, and business. We "bet" (by sacrificingcurrent consumption or going into debt toothers who lend us current income) that thefuture product will be sufficiently greaterthan the present sacrifice.

Profitable Investment Profitable invest-ments are those that yield an increase ofwealth at a rate (g) that is more than the rateof interest, i. For example, if the interest rateis 5% and you invest $1 now, a payoff of any-thing more than $1.05 in one year wouldmean your investment was profitable."

Say that you, and only you, are confi-dent that your investment will yield morethan the present investment cost plus the in-terest, and that within two months otherpeople also become persuaded. They bid upthe value of your asset above the sum ofyour cost and accumulated interest. That ex-cess is an immediate profit. But do not con-clude that an investor would prefer that therest of the market react quickly to his or her

50n the other hand, the relative increase in futuresteady income flow (not wealth) from a unit increase ofcurrent investment-dY(t+ljldI(t)-is called the margin-al efficiency of investment.


activity. The more slowly others react, thelonger the investor escapes their imitativecompeti tion.

Higher Rates of Investment out of CurrentIncome Tend to Reduce g The net pro-ductivity of investment (g) depends upon fac-tors such as our legal institutions, propertylaws, the state of international relations,knowledge of the laws of nature, the avail-ability of markets, and mental talents. Butone factor particularly affects g: the rate ofcurrent income directed into investment.Each unit of increase in investment yields asmaller net marginal product. Why? Toname one reason, less appropriate resourcesmust be diverted from current consumptionto investment. Recall from Chapter 8 thatthe higher the rate of production, the higheris the cost. Similarly, successive incrementsof the future gain have increasing presentcosts-which is an indirect way of sayingthat higher rates of investment yield lowernet marginal gains.

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:1. 'I come, and how much investment is demand-,I ed? To answer we examine the demand and'lli I supply relationships between "the pace of an[If activity and its value and cost (see Figure

'!II :,',.,l", ' 16-1). The upward slope of the 55 curve in-dicates that the amount of current income

!:;I people are willing to save (to divert from cur-Ii i:! rent Cdhsumption to the accumulation ofil tirl wealth) rises with the different offered ratesI! ' ,i of return on the vertical axis. The demandiiil:j schedule for investment is derived from the1:11;, relationship between the rate of investmentI, '1'11'1,II II and g, the net marginal productivity of in-

,1)llf---34-8-c-n-ap-te-r-J6--------~ II

Demand for Investment:The Most ProfitablePace of Investment

vestment, which, as we have seen, decreasesas investment increases. In Figure 16-1, theinvestment-demand curve (DD) shows foreach interest rate the largest rate of invest-ment that people think will yield-on themarginal dollar of investment-a rate of re-turn (g) at least equal to that interest rate.The lower the interest rate, the larger is themost profitable rate of investment.

A lower interest rate should not bethought of as merely reducing interest coststo the borrowers of a given investment. Be-cause interest costs are only a small portionof the total borrowed investment, many peo-ple mistakenly conclude that a lower interestrate has little effect on costs and profitabili-ty, and hence on the rate of investment.They forget that a lower market rate of in-terest increases the present values of the fu-ture income of capital goods relative to thecurrent costs of production. Current servicesare used to produce longer-lived capitalgoods that yield future income. Thus, wheninterest rates fall, the prices of capital goodsrise, and a higher rate of investment be-comes profitable for a wider range of capitalgoods.

We can illustrate this principle. Supposea concrete building costing $750 to buildwould yield $100 a year net for nine years. Itsg is about 4%. (See Table 6-3. At 4%, 7.44X $100 = $744, close to $750.) At a 5% inter-est rate, the building's present capital valuewould be only $711, less than its cost of $750;the building would not be a profitable invest-ment. But at a 3% interest rate, the build-ing's present value would be about $780; theinvestment would be profitable. (Check ourcalculations by reference to the data in Table6-3.)

LendingAnyone can save some of today's income andlend it to someone in exchange for a promiseof more future income. The lender usually

gets a promissory note or a bond as evidenceof the claim to future payment. Saving andlending do not necessarily result in the pro-duction of wealth: A borrower may use theloan to create capital goods or may insteadincrease consumption by the amount loaned,say, by using it to take a vacation.

You may think that a person can borrowsome wealth rather than income, such as byborrowing a house or a car or money. But allthat the borrower gets is the income-that is,the service-from that asset.

The DD curve reflects what the publicbelieves are feasible investment returns. The55 curve reflects how much people would bewilling to save in anticipation of that rate ofreturn. Decisions about how much to saveand decisions about exactly which specificinvestments to make are in large part madeby different people. Therefore, markets andintermediaries coordinate the two activities,saving-lending and investing-producing. Ashift in either the savings or investmentschedule affects not only the interest rate butalso possibly, and seriously, total income andaggregate employment.

COORDINATING INVESTINGAND SAVING DECISIONS

Every person has unique personal DD and55 curves of investment capabilities and sav-ings propensity. In Figure 16-1, the commu-nity DD and 55 curves represent summa-tions of the curves of all individuals.Competition moves the interest rate towardan equilibrium at which the amount of in-come that people believe they can profitablyinvest is equated to the savings they are will-ing to provide.

It would be a mistake to think that thisadjustment occurs in just one special market.There is no one market for savings or invest-ment. Instead, those activities are guided inseveral markets: the lending and borrowingmarkets, the capital-goods markets, and mar-kets for current production.

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Rate of Investment and of Saving

Figure 16· I.

RELATION OF DEMANDS FOR INVESTING AND SUPPLYOF SAVINGS TO INTEREST RATE

The lower the interest rate of the economy, the greaterthe most profitable rate of investment that peoplebelieve is feasible, shown by the 00 curve. Thelower the interest rate, the lower the rate ofsaving that people are willing to incur,illustrated by the SS curve. The market-determined interest rate is the rate atwhich the profitable amount ofinvestment equals the amountof savings supplied.


BUYING ANDSELLING CAPITAL GOODS

There are several markets in which claims tocapital goods, money, and current s~rvicesare continually redistributed: In retsil mar-kets money is traded for goods; in bond mar-kets claims to future amounts of money aretraded for money now; in stock marketsclaims to corporate capital goods are tradedfor money now; and in real estate marketsland and buildings are traded for money. Byenabling people to revise their holdings ofgiven amounts or kinds of assets, these mar-kets make people more willing to accumul.ateanyone kind of wealth. For example, If Icould never sell a house once I had built it, Iwould be less likely to build one.

INTERDEPENDENCE OFBOND 'AND STOCK MARKET PRICES

Suppose the explicit interest rate in the lenc!-ing, or bond, market were 5%, and that Inthe stock market some stocks expected toyield $lO a year for the indefinite futurewere priced at $333, a yield of 3%. In thatcase, you could sell the stock for $333 andlend the proceeds, by buying bonds, at 5% inthe loan market, thereby getting $16.65 ayear instead of $lO. For that reason, no onewould offer $333 for that stock if elsewherethey could get $16.65 by lending the $333 at5%. The stock's price would fall, raising thestock's realizable rate from ~% toward 5%.The possibility of arbitrage between themarkets-by selling in one and lending inthe other-brings their yield rates together.

Similar adjustments take place betweencountries. A higher interest rate economywill borrow from a lower interest rate econo-my, as when South American count~ies b?r-row from the United States. And a higher In-terest rate country will sell goods yieldingfuture services to a lower interest rate coun-try in exchange for current income.

350 Chapter 16

Prices of common stocks change not onlybecause of changes in interest rates but alsobecause of changing anticipations about thefuture. But those factors that cause changesin future income prospects cannot always beseparated from those that change the interestrate, because their effects are the same:changes in prices of stocks. Therefore, weusually study interest rates by looking atbond markets, where the future paymentsare less uncertain. If stock prices fall whilebond prices stay steady or rise, the cause ofthe fall in stock prices is likely to have been adeterioration in future income prospectsrather than a rise in the interest rate. Re-gardless of the reason for a drop in st~ckprices, the effect on capital-goods productionis quick.

WHY THE BONDMARKET IS A KEY MARKET

Because almost all exchange occurs throughthe medium of money rather than by barter,people revise the timing of their in~ome ~rconsumption streams not by trading thisgood now for that good later but by tradingmoney now for money later. Hence, almo~tall revisions in investment prospects and Inwillingness to save will affect borrowing andlending of money for which interest rates aremost explicitly expressed. That is why fac-tors affecting the rates of interest and invest-ment are often analyzed through their effectson the demand and supply of loanable fundsin the money markets. It is also why peopletend to refer very misleadingly to interest asthe price of money. Interest is more accurate-ly called the price of borrowing or of credit.

Increase in Propensity to Save If prefer-ences for future income increase relative topresent consumption, the 55.curve shifts tothe right, with two results. Fnst, ~he sup~lyof loanable funds increases, lowenng the In-terest rate to the competing borrowers. Sec-ond, the prices of assets will rise, because as-

sets are means of getting more futureincome. For example, the prices of suchlong-lived assets as steel and concrete build-ings will rise relative to those of wood;young, rapidly growing animals will rise invalue relative to older, slower growing ones.Because a yearling steer grows at a higherpercentage rate than an old steer, everypound of a yearling represents a greater per-centage increase of future beef than doesthat of older, slower growing steers. The de-mand and price of yearlings will rise relativeto that of older steers; fewer yearlings will beslaughtered, so the price of veal will rise rela-tive to that of beef.

Consider another example. Suppose thecommunity initially places the value of $710on each of two goods, one yielding an annu-ity of $100 for nine years, the other of $200for four years. Both annuities imply a 5% in-terest rate (which you can and should checkby using the data in Table 6-3). If the com-munity's preference changes in favor of long-er annuities, the nine-year annuity will in-crease in value more than the other. Forexample, if the present value of the nine-year, $100-per-year sequence were to rise to$779 and the four-year stream to $744 (bothup from $710), the interest rate would be370' down from 5% (check this, too). Produc-tion of the longer-lived goods will be rela-tively more profitable. The interest rate af-fects production, as can be seen in the factthat prices of longer-lived assets have risenrelative to current service costs. Houseprices, for example, have risen relative torental rates and costs.

Increase in Productivity of InvestmentSuppose there is an increase in the perceivedfeasibility of producing wealth profitably:New inventions, cheaper refrigeration, andmore durable, rust-resistant metals are exam-ples of ways to enable more future consump-tion per dollar of present investments. TheDD curve of Figure 16-1 shifts to the right,for there is an increased demand to borrow

current (money) income. Thus, the supply ofbonds increases and the price of bondsfalls-that is, the interest rate rises, rationingavailable savings to the most profitable in-vestment prospects. (Otherwise, nonprice ra-tioning would occur wherein allocationwould be less heavily influenced by market-able profitability, as we have already stud-ied.)

Increased Stock of Capital Goods Whatwould happen if, say, by a gift from a foreigncountry or by accumulation over the years,the stock of capital goods increased? That in-creased stock means an increase in currentand future income. If the increase is most incapital goods yielding greater, more distantfuture services, the interest rate would behigher than if the increase were in capitalgoods yielding near-term services. Why? Alarger ratio of future relative to present in-come makes people willing to trade more ofthat future income for rights to present in-come: If you learn you will have more in-come in the future than you had formerly ex-pected, you will immediately borrow againstyour future. If, on the other hand, the in-creased stock of capital goods yields a higherproportion of present consumption servicesthan future services, the interest rate wouldbe reduced. (Why?) Thus, the mere fact ofan increase in a country's stock of capitalgoods does not tell us whether the interestrate will rise or fall.

Prospects of Reduced Future Yields Takea more difficult case. Suppose people beginto believe that future yields of existing orproducible assets will deteriorate; the DDschedule shifts to the left. The first to havethis belief will try to sell their commonstocks or capital goods to others before thebelief is confirmed by ensuing events or be-comes more broadly shared. Their efforts tosell will depress stock prices, as well as theprices of capital goods such as buildings andland. Investment will be reduced, because


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lower prices of common stock and capit.algoods make it less profitable ". People WIllswitch to assets whose future YIelds are notexpected to deteriorate so much, such asbonds or money. Interest rates in the bondmarkets will decline, in effect raising bondprices.

The process is not pleasant, because thefuture, in our example, is less pleasant. In-vestment-goods producers (and others) expe-rience transient unemployment and mustshift to new jobs with lower incomes. Savingsare reduced. So both the DD and the 55curves shift to the left. Caught in a squeezeof falling asset prices and reduced incomeand the necessity of paying off debts, firmswill seek to borrow money to tide them overthe "adjustment." During this "liquidity" ~d-justment (more liquidity often me~ns havinga larger fraction of wealth held in money),the interest rate in the loan markets ISpushed up temporarily. (Why?)

We can see, then, that adjustment of theinterest rate pervades every market and allexchanges. And a shift in the investment-de-mand schedule can also shift the savings-sup-ply schedule. Events that change the demandfor-that is, the profitability of-investmentand capital goods have broad effects that arenot confined to one small market. The conse-quences are more widespread than a changein the demand for tires, wheat, or almost anyother good. The interest rate reflects relativedemand for all types of goods capable of ren-dering services in the futu~e. And becauserights to present and future income can ~etraded in many markets, the interest rate WIllaffect many markets, with effects on aggre-gate incomes. Recessions can result.

THE SEVERAL "FACES"OF THE INTEREST RATE

It is now evident that the term interest rateis applied to different concepts:

1. Net marginal productivity of invest-

352 Chapter 16

ment, g: the net rate of increase inwealth from a dollar more of investment.

2. Personal valuation of future income rela-tive to present consumption, measuredas the amount of future income that isvalued as equal to one dollar of con-sumption now.

3. The rate of interest on credit: the returnon loans (that is, bonds or promissorynotes).

4. The implicit relationship between pres-ent prices of capital goods and their fu-ture income streams (explained in Chap-ter 6). If interest rate in the second sense(personal valuation) is less than .that ofthe third (rate of interest on credit), con-sumption will be reduced and saving willincrease; if the second is less than thefirst, investment will increase. Interestrates in all these senses are broughttoward equality in the various marketsand goods. When all are equal, the com-mon value is the interest rate. If any aredifferent, then arbitrage (the simulta-neous buying and selling in differentmarkets) will push them toward equality.This explains why the interest rate is re-ferred to variously as the price of currentconsumption, the price of credit, theprice of savings, the price of loans, therate of time preference, the net rate ofinvestment productivity, and the price ofmoney. Properly interpreted, it is a mea-sure of all these things in equilibrium.But, again, because the most easily per-ceived and- measured rate is the one inthe market for secure (that is, riskless)bonds, that is the one by which "the" in-terest rate is usually measured.

Figure 16-2 provides historical perspec-tive by showing long-term interest rates (on10- to 20-year secure bonds) during the pastcentury. Some swings in that rate were theresult of anticipations of long-term move-ments in the price level associated with infla-

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tion, or of government monetary policy, or ofchanges in business conditions. We shall ex-plain later how these affect the rate of interest.

NOMINAL INTEREST:EXPLICIT RATE AND IMPLICIT YIELD

We know the stated, or explicit, interest rateof a loan-say, 6% per year-may not be itsimplicit rate (also called its eHective rate).Recall that if you lend $900 for a promisethat $1000 will be repaid in one year with azero interest rate explicitly stipulated in thewritten terms of the loan, you are actuallybeing promised a return of 11.1fo implicit in-terest: ($1000 - $900)/$900 = 11.1%. If theloan is repaid when due, you will also haverealized, or collected, that implicit interestrate. At the time the loan is made the implic-it promised yield is ILl % per year, takinginto account not only the explicit rate-hereO.O%-but also the difference between theamount loaned and the amount due later.You can see that the implicit rate differs

Figure 16·2.

LONG-TERM (10-20 YEAR) NOMINAL INTEREST RATESOF CORPORATE BONDS (THE HIGHEST GRADE BONDS)

The long-term interest rate has varied over a wide rangefor various, not entirely explicable, reasons, Weconjecture that the recent peak at nearly 16% wasin anticipation of a rising price level in the future,which induced lenders both to insist on a highermoney rate and to be willing to pay more inmoney terms if prices are going to rise inthe future,

SOURCE: National Bureau of Economic Research,


from the explicit rate if the present amountloaned differs from the principal amount tobe repaid. In general, for a one-year loan, theimplicit, or effective, yield i is given by thefollowing formula:

i= [(Ar+ A)/PJ - 1where A is the principal, the amount of debton which the explicit interest is to be paidand the amount of debt to be repaid whenthe loan is due; r is the interest rate explicitlystipulated in the loan agreement; and P is thepresent amount paid or loaned.

For example, suppose you buy a bondpromising an explicit 5% interest per yearon a principal amount of $lOOO, due and pay-able in one year. Assume the present price,the amount you pay now, for that bond is$900. The implicit yield is [($50 + $lOOO)/$900] - 1 = .167, or 16.7% per year. If thepresent price had been $lOOO, the implicityield would equal the explicit yield, 5%.

In referring to an interest rate, we shallusually mean the implicit rather than the ex-plicit rate. And if the loan is paid on sched-ule, the implicit yield will be the realizedyield on that loan.

OTHER COSTS INCLUDEDIN THE INTEREST RATE

Risk Some debts give very high assurancethat the borrower will pay interest and prin-cipal promptly. Currently, U.S. governmentbonds are as high in quality as any available,because the government can use the policeto reinforce its ability to collect taxes fromwhich to pay its debts." (It can also "collect"taxes by creating money, as we explain inChapter 19.) Bonds issued by private firms,such as General Motors, American Tele-

"Evidence of the importance of the ability to col-lect taxes is that government bonds repayable onlyfrom receipts of particular projects (such as toll roads)are of lower quality than "general" tax-supportedbonds and promise higher yields.

phone and Telegraph, and Santa Fe Indus-tries, are of very high quality because theyare almost certain to be paid when due. Avast range of riskier bonds promise higheryields.

You will notice that we have referred to"promised yields" and not to the interestrate. Superficially, riskier bonds appear topay a higher rate of interest. However, thepromised return includes a risk premium.Suppose a potential borrower of $100 offers5<70 interest per year, and you regard theprobability of repayment as being only one-half. To make that an attractive proposition,you could offer to lend him $50 for his prom-ise to repay $105 in one year. Under this ar-rangement, there is a probability of .5 thatyou will get $lO5 and an equal probabilitythat you will get nothing. On the averageyou would get $52.50, which would be equiv-alent to 5% on your loan of $50, though thepromised yield on the $50 loan is 110<70.Forexample, on the New York Bond Exchangein mid-1981, Trans World Airlines three-year, $lOOO, lO% bonds could be purchasedfor about $880, which promised the ~_.rchas-er an implicit yield of about 14% annually;Chrysler 30-year, 8 % <70bonds could be pur-chased for about $45, giving an implicit yieldannually of about 24<70' if paid; whereas U.S.Government 10-year, 7% bonds could bepurchased for about $600, giving a promisedimplicit yield of about 14% annually. Allthese bonds promised to pay the stipulatedinterest annually and the $1000 principalwhen due.

A test of the validity of this risk inter-pretation is provided by events in the bondsmarkets. If differences in risk account for dif-ferences in promised yield, then when a busi-ness firm has improved prospects of meetingits debt obligations promptly, the price of itsoutstanding bonds should rise. And they do.

I may know I will repay a debt whendue, but does the lender know it? Some bor-rowers call the loan market imperfect be-cause they cannot borrow on the same terms

as their neighbor; and some complain thatthey cannot borrow at all. The lender seesdifferences among borrowers in the pros-pects of prompt repayment without extracosts being imposed on the lender. Youshould not expect a lender to tell you rudelythat your promises are too risky. A bankersays, "I'm sorry, we just don't have any fundsto lend now." The banker is tactful-andmisleading. A tactless banker could havesaid, "We think the prospect of your repay-ing is not high enough. We specialize inloans to people with better credit prospects.To lend to you, we feel that we should ask257'0 instead of 197'0 to help cover the costsof the collection problems and other activi-ties in defaulted loans. Co to lenders whospecialize in higher risks and are better pre-pared to handle your type of defaults."

Transaction Costs The costs of engagingin the business of assembling savings to beloaned to borrowers and negotiating thetransactions must, as in any other business,be covered by the firm's revenues-here, theinterest received for loans. This is usually in-cluded in what is called interest, just as a riskpremium was.

Expected Inflation As explained in Chap-ter 6, if inflation (a general rise in prices) oc-curs and is expected to persist in future rises,the effect is to raise the nominal (dollar) in-terest rate above the real interest rate (thatis, unchanged in value relative to goods). Re-call, for example, that if you were to lend$100 for one year at 10% per year, and if in ayear all prices were correctly expected todouble, you would suffer a loss in real pur-chasing power. You will get back $110,which at the new prices buys only as muchas $55 at the old prices. You are being of-fered a negative real interest rate of minus457'0' The nominal rate is 10% per year, butthe real rate is -45% per year. Using morelikely numbers, if inflation continues at therate of 87'0 per year, a loan that promises10% in nominal (dollar) interest is promising

the lender only about 2% in real interest.(All this assumes that the principal andpromised interest are actually paid as prom-ised.) The promised real rate depends onwhat is expected to happen to price levels.(Don't confuse the promised real rate withthe realized real rate. The realized real ratedepends on what is actually repaid and whatactually happens to the price level.) The ba-sic rate is the same for everyone at a giventime; but differences in other items, such asrisks and transaction and collection COjts,make the total "interest" rate differentamong borrowers.

Interest Rate andQuantity versus Changein Quantity of Money

Often it is said that increases in the quantityof money lower the interest rate. However,twice as much money means twice as highwages and prices of goods, land, and stocks.In money terms there will be twice as muchdebt and twice as much wealth, income, sav-ings, and investment-but no lasting changein interest rates or in real quantities.

The belief that the quantity of moneyaffects the rate of interest usually arises fromthe failure to distinguish between money andcredit. Money, as we know, is what peoplegenerally use in exchanges: coin, currency(paper money), and checkable deposits.Credit, on the other hand, is a claim towealth from some other person. (It is the oth-er side of the debt.) Money and credit areconfused because when people borrow or gointo debt, they do so by borrowing money asan intermediary to getting other goods. In ef-fect, they borrow other goods by obtainingthe right to use some goods in the interimuntil repayment is made. Interest is a repay-ment for that right to use the asset in theinterim-whether it be money, a house, acar, or a book.

Wealth: Saving and Investing 3SS

As we shall see in Chapter 19, creatingmore money raises all prices and does not re-duce the interest rate. That interest rate de-pends on the willingness of some people tosave and to lend, or grant credit, relative tothe demands by other people to use that cur-rent income by borrowing it. That demandand supply for current income in exchangefor future income sets the rate of interest. Itis not determined by the quantity of money,which affects the price level. Do not makethe mistake of confusing money with credit.

Nevertheless, it is true that changes inthe quantity of money can raise interestrates-not directly, however, but because ofthe way in which newly created moneymight first be spent. And expectations thatthe quantity of money will change canchange the nominal interest rate, althoughnot the real rate. We now explain these twosubtle points.

To see the effects of how new money isinitially spent, suppose a counterfeiter creat-ed more money and proceeded to spend it onfine wines, fine cars, and clothes-with theresult that there was an interim increase inthe demand and prices for fine wines, finecars, and clothes, but no increase in interestrates. Now suppose, instead, that our coun-terfeiter was dull and used this new moneyonly to buy bonds. That would immediatelypush up the price of existing bonds-that is,lower the interest rate. The creator of thenew money, being a member of the commu-nity, has shifted the community's demand forfuture income relative to present income bythose bond purchases.

It so happens (as explained in Chapter19) that the usual process of legally increas-ing the quantity of money is almost alwaysassociated with an initial purchase of bondsand promissory notes. Lower interest on thebonds-equal to higher prices-results notfrom creating more money but from the ini-tial increase in the demand for bonds relativeto other goods. Thus, although you will Ire-

356 Chapter J 6

quently read that increased money leads totransiently lower interest rates, it is only be-cause that new money is first spent forbonds. If, however, increasing money leads toanticipation of further increases of moneycreation and more inflation, interest rateswill be increased.

Though an increased supply of moneymay first be used to purchase bonds (that is,to lend), thereby raising bond prices and low-ering interest rates, that increased stock ofmoney will be chasing the same amount ofgoods and will lead to higher price levels. If acontinuing increase in the stock of money isexpected, creating anticipations of continu-ing future inflation, people are less willing tolend money at such low current nominal in-terest rates, but others are more willing toborrow. The nominal interest rates will bebid upward to adjust for the reduced futurepurchasing power of money at the higher fu-ture price level. Hence, interest rates can bedriven down by increasing the money supplyto lend more now, if the public can be per-suaded that there will be no accompanyingincrease in the inflation rate. What do youthink are the chances of continuing to foolthe public in that way after their experienceof the past decade? In fact, during the pastdecade borrowers and lenders have an excel-lent record of accurately predicting the infla-tion rate for one year ahead, as is evidencedby the extent to which changes in interestrates on one-year loans have closely matchedthe next year's inflation rate. But longer-range forecasts have underestimated thelonger range results-at least up till 1982.

Competition inthe Capital Markets

SPECIALIZATIONOF BORROWERS AND LENDERS

People who save are not generally the peoplewho select and direct investment. Savers

(say, families) rely on business firms to de-cide which capital goods to make. Coordinat-ing these groups-savers and producers ofcapital goods-is a complex network of fi-nancial intermediaries (jargon for middle-men) who compete to obtain savings fromsavers and channel them to capital-goodsproducers or to consumer-borrowers. Somefinancial intermediaries are especially knowl-edgeable about borrowers' credit worthinessand their likely demands for funds; other in-termediaries specialize only in serving saversand rely on other intermediaries to directsavings to the best investors and borrowers.The main financial intermediaries are com-mercial banks, investment banks, savings andloan institutions, commercial credit and con-sumer loan companies, pension funds, insur-ance companies (insurance premiums arepartly savings as well as payments for in-sured risks), stock investment funds, bondmarkets, and stock exchanges with their hostof brokerage houses. All help make the econ-omy more productive and richer than if eachsaver had to search out and evaluate each ul-timate investment or borrower.

Financial intermediaries also reconcilethe desires of savers, investors, borrowers, andlenders about the contract terms. If lenderswant to lend on the short term-say, for lessthan one year-but borrowers want to borrowon long-term (say, lO-year) contracts or bonds,the intermediaries borrow on the short termfrom the savers-lenders and in turn lend thefunds to the borrowers-investors on long-termcontracts. For example, a savings and loanbank permits its depositors (savers) to drawout funds with very short notice while it lendson long-term mortgages. The operators of thebank anticipate, correctly, that the day-to-daydesposits and withdrawals of savers will justabout balance with no large, unexpected netdrain of funds. That permits the institution touse the funds for long-term bonds-usually bypaying lower interest rates for the collectedfunds. Their costs of intermediation are lowerthan the costs lenders and borrowers would

incur if they tried to operate without special-ized intermediaries.

The importance of financial intermediar-ies can be shown by noting a few of thestages in makin~, selling, and owning anautomobile. The auto maker's employees andsuppliers want to be paid now so that theycan consume now, even before the cars arecompleted and sold to consumers. If thefirm's owners were to finance the work-thatis, pay now and collect later-they wouldhave to defer their own consumption andbear all the risks. Instead, they seek a lenderto finance the current production. Automo-bile manufacturers borrow by selling bondsto the public and to institutions, such as in-surance companies, that channel public sav-ings. They also borrow from commercialbanks to carry them over periods of low sea-sonal sales. Car retailers finance their inven-tories and equipment by borrowing fromcommercial banks, finance companies, andcommercial credit companies. The ordinaryconsumer has little occasion to deal directlywith some of these financial intermediaries.Yet, because they exist, the car dealer cancarry a bigger inventory, allowing the con-sumer to inspect a larger variety of cars andget quicker delivery with lower credit costs.

The typical consumer, who borrows topay for the car, is likely to deal with a con-sumer credit company, either directly or indi-rectly, through the car dealer who attends todetails of the loan. Consumers may borrowfrom a credit union at their place of work,because the credit union is already relativelywell acquainted with each employee's per-sonal situation and the prospects of repay-ment. Or the consumers may borrow directlyfrom a neighborhood bank or from an insur-ance company with which they have a policy.

'As goods pass from producer to finalconsumer, the successive costs are financedby a series of different lenders with specialknowledge about successive participants. Anexcellent index of a country's wealth and


.1,

I,i'·1:'I;IIII,!I, !

productivity is the sophistication and com-plexity of its financial intermediary institu-tions. These reduce the costs of saving andproductive investment-the key to economicdevelopment. In authoritarian, government-directed economies the rate of saving and theform of investment are controlled by politi-cal processes, whereas in private-enterprisesocieties decisions about savings and invest-ment are made by private individuals.

NEGOTIABILITY OF BONDS

Lenders who may want to change theirminds about deferring consumption until abond is repaid can sell the bond to someoneelse, who will instead defer consumption.This salability is known as negotiability or,sometimes, as liquidity. Lenders (that is,bond buyers) are willing to accept lower in-terest for greater liquidity. However, someborrowers may offer to pay more to maketheir debts nontransferable. The originallender might be more considerate and le-nient in the event of difficulty in repaying adebt, especially for consumer loans.

Negotiability of bonds is facilitated bybond brokers and by the New York Bond Ex-change, a formal, privately owned marketwhere the bonds of well-known, financiallysound American corporations can be boughtand sold from people who earlier lent moneyto the corporation, or from those who subse-quently bought bonds from the original lend-er.' A large portion of bond resales, however,takes place away from the New York BondExchange, through bond brokers or dealers.Much like used-car dealers, they maintainsmall inventories of outstanding bonds of

"Prices and amounts of bonds exchanged on themajor organized exchanges are reported in the financialpages of major newspapers and in stockbrokers' offices.Prices are reported as 100'70 of the principal. Thus aprice of 98 is a price of 98'70 of the principal of thebond, almost always $1000.

358 Chapter 16

well-known corporations, but they know oth-er people from whom any particular bondcan be bought-at a price. These securitybrokers, relying on telephones and comput-ers, are known as "over-the-counter" securitydealers; they do not operate through a single,formal exchange like the New York BondExchange.

None of these bond market transactionstransfers money to the original borrower, andtherefore some people erroneously thinkthese markets serve no useful purpose tooriginal borrowers or lenders. But used-bondmarkets are as important to saving and lend-ing as the used-car market is to the produc-tion and sale of new cars. How many peoplewould buy cars if they could never sell thembut had to keep them until they werejunked? Because these markets facilitate thetransfer of bonds, more people are willing tohold bonds. The initial flow of savings to in-vestors is made cheaper. Negotiability ofbonds also permits people to be more dis-criminating in selecting among risks.

Legal Restraintson Access to Loanand Capital Markets

Interest has been variously condemned or le-gally prohibited. Aristotle asserted that mon-ey is "sterile," so that no interest should bepaid for money loans. Yet interest was paidbefore and after Aristotle's condemnation,despite religious dogma and other sources ofobjections, because the demand for savingswas greater than the supply at a zero price.Until about the sixteenth century, Christiantheology condemned usury as a venial sin.Christians conveniently borrowed from Jews,whose religion placed no severe ban on tak-ing interest from gentiles. In fact, the Papacyitself charged a positive interest-though un-der the name of "fees," "gratuities," or any-thing but "interest" or "usury." In the Mid-dle Ages, lords had claims to payments from

users of land. Sometimes the lord wanted tosell to the Church his rights to future rents.Suppose an annuity of rents was expected torun for at least 50 years. For what pricecould it be sold? A 50-year annuity of $1 ayear would be sold to the Church for lessthan $50. Thus, in buying lands, the Churchwas charging a positive rate of interest-un-less it paid a unit price equal to the expected,undiscounted sum of the future annuity pay-ments. And it never did that, as far as weknow.

INTEREST-RATE CEILINGS AND USURY

Economic behavior has insidious ways of cir-cumventing laws. It took the Church about1000 years to lift the ban against interest onloans-but many governments still decree"unreasonably" high (usurious) rates of inter-est illegal. In most states of the UnitedStates, rates over 10 or 15% were called usu-rious and illegal. (But many such laws werequickly repealed during the past decade,when market rates rose to over 15CJ'o!)

Lenders who make risky loans at high in-terest rates, in the hope of averaging an ac-ceptable return, resort to legal fictions.Pawnshops, for example, lend to strangers ofdubious credit at a rate of 30% per year-notby a loan, but by a "purchase and repur-chase" agreement: You sell your camera tothe pawnbroker for $100 (which is less thanits market value) and simultaneously obtainthe right to buy it back in one year for $130,to cover the risk, interest, storage, and trans-action costs. Rather than helping high-riskborrowers who would normally pay highrates, laws that limit the interest rates in-crease the costs of borrowing to poor peopleby forcing them to use more expensivesources of funds-or prevent them from bor-rowing at all.

LIMITS TO BORROWING

Because some consumers go "too far" intodebt, apparently everyone should be con-

trolled. That would seem to be the logic be-hind laws restricting the behavior of borrow-ers. Or perhaps, although it's permissible toborrow for a house, doctor bills, or businessequipment, it is impermissible to enjoy con-sumption before one has earned all the costs.A generation ago, consumer installmentloans were condemned by extensive publici-ty compaigns and restricted by legislation.But the desirability of consuming while earn-ing replaced the old-fashioned virtue of highconsumption only in one's old age, after s If-ficient savings had been accumulated. To-day, installment buying is an accepted, so-phisticated convenience-which has broughtthe specialized loan market to the young aswell as to the elder! y.

Individuals can be prevented from "ex-cessive" indebtedness not only as consumersbut also as investors. The Federal ReserveBoard limits the amount a person may bor-row from a security dealer against the stocksand bonds the borrower owns. Why? Not toprotect the borrower if the stock should fall,but instead to prevent stock prices from be-ing bid up higher-as it is incorrectlythought they would be if people could buyshares with lower down payments. The pow-er to control credit suggests that the mem-bers of the Federal Reserve Board can betterjudge what the prices of common stocksshould be than can investors in an open mar-ket. (If they could, they could get very rich,very fast!) In any event, the evidence andeconomic analysis both say that the board'srestrictions do not affect stock prices in anysystematic way. Moreover, it is easy to foilthe debt limit, because money is fungible.Borrow from a banker (instead of the securi-ty broker), using the stock you are about tobuy as the pledged security. Your bankercan lend you money but not for the expresspurpose of buying more stock. The moneyyou get from the banker can be used to paysome other bills, and the money you other-wise would have used to pay those bills is


released for stock purchases.Whether controls on the stock market

are proper cannot be settled by simplyweighing whether or not they promote prof-itable investments and diminish the numberof unprofitable ones, or by counting thenumber of dishonest security dealers or pro-moters. There is also the question whetherwe ought to be allowed to make whatever in-vestment choices we want to make, throughwhatever agency we choose, as long as wepay for the resources used. Whether we in-vest foolishly is a decision we might considerours to make. Who is right?

PersonalInvestment Prineiples

It is well and good to talk about investmentand wealth in general, but both take particu-lar forms. Consider, for example, a widowwho finds herself with a small fortune of, say,$100,000. In what form should she keep thatwealth to provide herself with an income andperhaps a legacy for her children? Whatshould a young father do to accumulate afund for retirement?

DIVIDENDS ORCAPITAL-GAIN STOCKS?

Should these people buy for income fromdividends or for appreciation of capital val-ue? Except for tax purpose~., this question ispointless. Why? Because business firms ei-ther reinvest their net income in the firm oruse part of it to pay dividends to stockhold-ers. Companies that pay dividends do notthemselves reinvest all of their earnings,whereas companies that do not pay dividendsreinvest all their earnings for the stockhold-ers. But with either kind of stock, you canconsume the same amount. If the companypays dividends, you can yourself reinvest theunconsumed dividends. If the company rein-

360 Chapter 16

vests the earnings instead of paying divi-dends, you can sell some of your appreciatedstock (appreciated to reflect the reinvestedearnings) or borrow against it and consumeas much as you would have if the dividendshad been paid.

For example, suppose you have 10,000shares in a company that earn $1 per shareannually. Assume the stock is now selling for$10 a share; your wealth is $100,000. If thecompany were paying dividends of $1, thestock price would stay at $10. You receive$10,000 annually, which you can consume,and at year-end you still have $100,000. If,however, the corporation reinvests the earn-ings, the stock will rise in value by $1, to $11at year-end. You can sell 909 shares of thestock at year-end for $11 each and consumethe $10,000 proceeds, and you will have 9091shares left worth $11, or $100,000 in total. Inboth cases, the amount you can consume andthe amount of wealth you have left are near-ly the same."

'Neerly because your income taxes are affecteddifferently. If you are in a tax bracket paying over 25%of the highest dollar earned, you might be well advisedto hold nondividend stocks and to realize the income inthe form of capital-value proceeds by selling stocks.This is an idiosyncrasy of our tax laws that puts a lowermaximum tax on capital gains. There is another differ-ence: The cost of selling some shares is not negligible.

At this point it may occur to you to wonder whyany business firm would ever pay dividends, which aretaxed more heavily than the capital-value gains whichwould occur as the firm invested the dividends insteadof paying out stock. Going further, it might even seemirrational for a business firm to pay dividends instead ofpaying off its debt. Thus, if a firm didn't pay dividendsbut instead invested them, stockholders could financetheir consumption by selling some shares of their grow-ing wealth. Closer analysis suggests the following an-swer: If dividends were not paid, either people wouldincur transactions costs of selling off a few shares eachmonth, or they would incur borrowing costs to financeconsumption between times of selling some shares. If itcosts less for the corporation than it does for the indi-vidual stockholder to borrow, we can see that stock-holders should use the firm as a cheaper intermediaryto borrow, letting the firm payout dividends frequent-ly during the year to reduce the individual stockhold-er's need to borrow.

HOW MUCH RISKOF VARIANCE IN VALUE?

Any investor must decide whether to investin assets (we use common stocks as our ex-ample) that are volatile or those that arecalled blue chips. Volatile stocks have a wid-er range of potential future values (say, plusor minus 30%) in a year; blue chips promisea smaller range (say, plus or minus 15%). Butboth types, measured by their past perform-ance throughout this century, have almostthe same 12'70 average return. But you can-not expect exactly the average yield everyyear on every stock. Buying a volatile stockgives you a greater chance of being fartherabove or below the average at the end of theyear than buying a smaller-variance stock. Inreturn for that extra risk, the larger-variancestock has on average a slightly higher yield.

You can achieve near certainty (zerovariance) in what your future dollar wealthwill be by holding high-grade, short-termbonds or savings deposits. However, thesegive a small expected average gain. Youmust decide how much variance-that ishow much risk-to expose your wealth to:Against which unpredictable future eventsdo you want protection? In this book we can-not explain how to compute the tradeoff ratebetween risk and expected average rate of re-turn. But we can alert you that there is atradeoff.

WHAT ARE THEMEAN AND VARIATIONOF STOCK PRICE CHANGES?

If, from the years 1926 through 1980, youchose one year at random and then took onestock at random from the New York andAmerican stock exchanges and the principalover-the-counter markets, how much wouldyour investment have changed in value dur-ing that one average year? The average of allsuch changes would have been such that $1grew to about $1.13 (counting the increased

value of the stock plus any dividends paidout). You can be almost sure you would notexperience exactly that average. What is thedispersion around that mean within whichyour stock would -probably have fallen? In90% of the cases, your initial wealth of $1would have been between about 50¢ and $2at the end of the year. In 50% of the cases, itwould have been about 80¢ and $1.25.

Figure 16-3 shows these approximateranges of potential loss or gain, which weshall call probability intervals. All three pa ..els in the figure show the performances of 1-,2-, 8~, ~nd Io-stock portfolios and a portfolioconsisting of all the stocks on the New YorkStock Exchange. The top panel shows the es-timated .9 and .5 probability intervals, orranges, of the different numbers of randomlyse~ected stocks for one year. (The shorter,thicker bars represent the .5 probability in-tervals; the longer, thinner ones, the .9 inter-vals.) The successively narrower intervals forboth .9 and .5, that result as increasing num-bers of randomly selected stocks are includedin the portfolio, are shown as successivelys~orter lines. The one-year average of aneight-stock portfolio shows a narrower .9probability interval, of about .6 to 1.7, thandoes the one-stock or two-stock portfolio.And if every stock on the New York StockExchange were held in your portfolio, the .9probability interval would be about .75 to1.5.

If the investment made by random selec-tion were maintained for 5 and 10 years,what are the resultant average wealth ratiosand the .9 and .5 probability intervals? Theaverage increase in wealth over 5 years was1.9 (an invested $1 would be worth $1.90)and for 10 years was 2.8. As one might ex-pect, the probability intervals are greater forthe longer-term investments, although sue-c~s.siv~ly larger portfolios narrow the proba-bility mtervals substantially. That the inter-vals with only a lri-stock portfolio are nearlyas narrow as for the whole market is surpris-


, II',

One Year InvestmentI j

I, .46 .85 1.35 2.i i III•.. ~i Q) U "CI 1 •• • ~I .co_

E - Q) 2 •• • ~:l(l)J:z- 8 ••016All

0 .5 1 1.5 2 31.12 Average

Wealth Growth Ratio

(Note Horizontal Scale Is Larger for 5 and 10 years)

Five Year Investment

.20 .84 2.3 4.9III•.. ~ 1

Q) U "CI.co_ 2 •• • •E - Q):l(l)J: 8 ••z-0 16 ••All

0 1 2 3 4 5 6 7 8

1.9 Average

Wealth Growth Ratio

Ten Year Investment

I .13 1.15 3.6 7.5i III•.. ~ 1 •• •ji Q)U"CI.co- 2 •E - Q):l(l)J: 8 ~z-0 16

All0 1 2 3 4 5 6 7 8

2.8-AverageWealth Growth Ratio

.5 Range ...•••••••- •••~

.9 Range ..••••f-----~..••~

Figure 16·3.

INVESTMENT WEALTH RANGES FOR ,9 AND ,5PROBABILITIESFOR PORTFOLIOS OF 1,2,8, 16, ANDALL STOCKS ON THE NEW YORK STOCK EXCHANGE(1926-1980)

SOURCE: Through 1966, Lawrence Fisher and James H,Lorie, "Some Studies of Variability on Returns onInvestments in Common Stocks," Journal of Business(April 1970), pp 99-134, Data for 1967 through 1980were included by the authors,

I(~'.----3-6-2-C-n-ap-te-r -16---------

~L!~:

ing to many people who think one must holdmany stocks to be well diversified.

RANDOM SELECTIONWITHIN VARIANCE CLASS BECAUSEOF INFORMATION EFFICIENCY

Once you have identified the high- and low-variance stocks from inspection of past be-havior, which ones in each set should youbuy? A very good first rule is to do what wedid in the previous section: Pick at random,especially if you buy only stocks sold in themajor stock markets. Any stocks that weregood buys will have already been bid up towhere they are no better than previous badbuys, whose prices have been allowed to falluntil they are equally good buys. The publi-cized prices of trades on the open marketprovide us innocents the equivalent of stockevaluation. For the market prices reveal thebest opinions of the insiders (the profession-als) and everyone else. The best opinion maybe lousy, but unless you think you have ac-cess to better, or secret, information and canevaluate it better than anyone else who alsohas it, you had better accept the existingmarket price as an unbiased reflection of theworth of various stocks. Competition amongbuyers and sellers makes all stocks equallygood buys when measured against their ex-pected future performance .

In Chapter 6 we investigated the theo-retical rationale for these propositions, theconfirming evidence for which is overwhelm-ing. Not only do they apply to stock marketprices but apparently also to all assets andsecurities; it simply means that other people(the market) leave no sure-fire, or above-average, prospects of gains above the normalinterest growth. The prospect of a gain or aloss in each period is independent of any pri-or price change. Drawing charts of past stockprices to predict future prices is unprofitable,however popular it may be. Popularity is notprofitability. Unless you have inside informa-

tion that no one else has, pick the stocks atrandom!

Still better is to first classify stocks onthe basis of how closely their returns corre-late or move with the other stocks in themarket in general. Some stock prices tend tomove more and some less than the market asa whole; that is, some tend to show more co-variability than others. Almost every stockbrokerage company provides informationabout the covariability of each stock with thebehavior of the market as a whole. Althoughcomputing covariability is a more expensivemethod of forming portfolios of stocks, itpromises a smaller uncertainty around an av-erage expected return than does completelyrandom selection. Nevertheless, even corre-lating random selection to covariability doesnot affect the propositions that (1) currentprice equals the average of the future price,and (2) no detectable past patterns in stockprices can predict future patterns, despitewhat some brokers contend when talking of"peaks," "floors," "support points," "mo-mentum," "rebounds," "technical reactions,""profit taking," or other such nonsense.

The above propositions reflect the abili-ty of people in the stock exchanges to makeavailable to the public, almost instantly andat extremely low cost, the best informationand evaluations by the many stock analystsand investment counselors. You pay a com-mission to use the exchange, which in partreflects the expenses of providing faster,more complete information about presentstock prices. But there is no point in payingfor that information twice, once as commis-sion and again as a fee to an investmentcounselor or to mutual funds that will onlyreproduce that information."

"An extensive study showed that of the mutualfunds, those funds did best that spent the least for re-search and commissions in changing stockholdings-thereby having the lowest expense ratio and hence thehighest growth. W. F. Sharpe, "Mutual Fund Perform-ance," Journal of Business, 39, Supplement (January1966), pp. 119-39).

Your stockbroker, security analyst, or in-vestment counselor is not worthless. Each re-duces the costs of access to the securitiesmarket. All of them can tell you about thecovariability of eaeh corporation's stock withthe stock market as a whole, and they willtake care of securities you have purchased.Those are significant functions. They canalso provide information to facilitate diversi-fication of risks, so that with as few as from 7to 12 stocks you can reduce the variance ofyour portfolio performance to close to that efa very large portfolio. (We have not writtenabout diversification and its principles,which are beyond the scope of this book; buteverything said above is compatible withthem.)

Summary1. Several conditions favor the growth of

wealth: savings that are plentiful and thusavailable at low interest rates; explicit andsecure property rights in wealth; and profit-able investments that are readily perceivableand exploitable by investors. Growth ofwealth is also aided by institutions for orga-nizing, coordinating, and directing the flowof savings to investors.

2. Conservation, as preservation of resources intheir initial form, is not necessarily a meansof preserving or increasing wealth. Conver-sion of resources to goods or of goods to oth-er forms of wealth can be more valuable.

3. Investment and saving each have curves onthe demand and supply schedule: The sav-ing schedule represents the willingness ofpeople, at various rates of interest, to divertcurrent income from current consumptionto accumulate wealth. The investmentschedule shows the amounts of current in-come that could be profitably diverted fromconsumption at various rates of interest.Thus, saving is positively related to the in-terest rate, whereas investment is negativelyrelated. The investment schedule is often


)called the demand for savings; the savingsschedule is often called the supply of sav-ings.

4. There is no single market for saving and in-vestment. Rather, there are several: the loanmarkets, the capital-goods markets, and theproduction-activity markets.

5. The greater people's preference for futureincome relative to present income or con-sumption, the more willing they are to save,an increase in the saving-supply schedule.The result of more saving is a lower rate ofinterest. If the profitability of investmentopportunities is perceived to increase, thereis an increase In the investment demandschedule, which results in a higher rate ofinvestment and a higher interest rate.

6. Because both the supply and the demandschedules involve the interest rate, it is rea-sonable to believe that the interest rate ad-justs to equate the rate of profitable invest-ing with the rate of intended saving. It does,but both saving and investing also affect,and are affected by, other variables, such aswealth, income, and expectations about thefuture.

7. The effects of an increased stock of wealthon the rates of interest and investment de-pend on the kind of wealth that is increased.

8. The market-clearing interest rate revealsseveral variables: the perceived net marginalproductivity of investment, the personal val-ue of present consumption relative to wealthor future income, the rate of return on loans,and the relative prices of' capital goods andconsumer goods.

9. Increasesin the quantity of money will tran-siently affect the interest rate because thenew money is usually first spent to buy

Ii Ii bonds. But the totalquantity of money willI'I! . 'j'! not in itself affect the interest rate, affecting

instead the price level.ill:I: "r, 10. The nominal interest rate includes the realj: :'1:1 i interest rate and the expected rate of change

I, ,',i,'! in the price level. An expected increase in

the stock of money leads to expectations of

It:~,,-----36-4-C-n-ap-te-r -16--------

inflation: higher prices of all goods and ser-vices. This expectation increases currentin-terest rates and dominates the money In-crease.

11. In addition to the pure interest, the quotedinterest yields usually include a risk allow-ance (riskier loans require a higher explicityield) and an allowance for the costs of nego-tiating the loan, as well as an inflation ad-justment if inflation is expected.

12. The implicit interest yield on a one-yearbond is j = [(Ar + A)IPj- 1, where A is theprincipal amount and t is the stipulated in-terest rate, both due at the end of the year,and P is the present price of that bond.

13. The capital market for lending and borrow-ing is a complex network of specialized in-termediaries between savers and investors.

14. Negotiability is the legal right of the ownerof a bond (who is thereby a lender, or credi-tor) to sell the bond to someone else. Bondexchanges facilitate negotiability; they alsofacilitate borrowing, because lenders regardnegotiability of bonds as a desirable attri-bute.

15. Like many markets, the lending market isnot entirely open and free of restrictions,such as those on interest rates, extent of bor-rowing, and length of loans. These restric-tions are supposed to protect borrowers andlenders from their own excessive optimism.They do protect one class of borrowers orlenders from open-market competition ofother borrowers and lenders.

16. All common stocks on the stock market,when adjusted for anticipated degree of risk,have almost the same expected average gain.If any were thought to have greater expect-ed gain after adjustment for risk, the currentprice would be bid up to reflect that andthereby eliminate any abnormal gain from acurrent purchase of that stock, as extensiveevidence in security and commodity marketsverifies.

17. The present market prices of stocks andbonds reflect all publicly available informa-tion about future earnings. Past prices are ir-

relevant for distinguishing morefrom less-promising stocks. Trying to predict futureprices by plotting the past prices of commonstocks to try to detect "bottoms" or "tops"or patterns is a worthless activity. Analystswho contend that it is not have not beenable to prove that contention. Competitionto estimate future economic events preventsanyone from being able to predict betterthan the group. No one has displayed theability to do that-only, occasionally, theluck to make a "correct" forecast.

Questions*1. In a public park an apple tree yields excel-lent apples. These may be picked by the public,but not more than one apple per person at atime. When will apples be picked? Why? If theAmerican buffalo had been owned by someone,do you think the buffalo would now be so nearlyexterminated? Why?

Do you think seals and whales would be facedwith extinction if some person or group wereable to buy, as private property, the right tocatch whales and seals? Why?

*2. You are an unborn spirit offered your choiceof country in which to be born. In country A allland is owned by its users; absentee landlordismis forbidden. The land cannot be mortgaged bythe owner. Everyone is born with rights to usecertain parcels of land and these cannot be takenaway or contracted to others. In country B, ab-sentee landlordism is legal. All land is privatelyowned and either used by the owner or rented tothe highest-paying tenants. Land can be sold ormortgaged. Private-property rights are strictlyenforced for everyone. Many people do not ownland at all. Into which country will you requestthat you be born? Why?

*3. "Extending the three-mile limit now in forcefor American territorial waters out to 1000 mileswould help to conserve sea resources." Explainwhy. Why not extend the territorial claims outto half way across the ocean up to the territorialclaims of other countries, as has been done in theNorth Sea for oil rights? What would that do tothe doctrine of the "freedom of the seas"? Whatdoes the doctrine of freedom of the seas do to theefficient use of ocean resources?

4. a. Why will a person who has salable prop-erty rights in an enterprise for which heis making decisions be more influencedby the longer-run effects of his decisionsthan if he di,9 not have salable propertyrights in the enterprise?

*b. Does this difference in type of propertyrights induce a systematic difference inthe kinds of decisions made by govern-ment employees, as contrasted to employ-ees of a privately owned enterprise-evenif both are engaged in the same kind ofactivity (production of power)? Explainwhy the influence of the salable capitalvalue of property rights will or will notmake a difference in decisions.

5. Drying grapes to convert them to raisins isinvesting. Why is this investing, since it merelychanges one form of consumption good to anoth-er form?

6. Instead of playing bridge, a man worksaround the house painting and refinishing thewalls. Explain why this is a form of investment.

7. By giving up $100 of present income for$105 of consumption rights available in one year,a person gets what g?

8. "Roundabout, more capitalistic methods ofproduction are always more productive than di-rect methods using less capital equipment.Therefore, any country that wants to developshould start increasing the amount of capitalgoods it has." Evaluate.

9. A man plants a seed for a tree. The rent forthe land on which the seed is planted is 50ft peryear. In addition to that cost, there are othercosts-spraying, watering, fire protection, tax-es-to be paid over the years. In the table below,the present value of all those costs is indicated incolumn 4. The tree, if cut and converted to lum-ber at the end of the ages indicated, will yieldlumber worth the amount indicated in the sec-ond column. The third column gives the presentvalue of that future potential lumber, at 10%rate of interest. Some of the entries are not pre-sented.

a. Compute the missing values.b. Find the age at which the tree should be


1ilI ~HI" "\,1I'I \1 \;

1 "

cut to provide the maximum present val-ue of that tree.

c. What is that maximum present value?d. How much is a newly planted tree worth?e. Suppose that the value of the tree rises

relative to current lumber prices. Whatwould this imply about the rate of inter-est?

* f. If no one owned the tree, and it could becut by anyone who wanted to use thelumber, when would it be cut?

(1) (2) (3) (4) (5)PresentValue of

Present ProfitCapital Present If Cut

Lumber Value of Value of at AgeAge Value Lumber Costs Indicated

0 $ 0 $ 0 $5,00 $-5,005 1 0,62 5,70 -5,08

10 4 1,54 6,20 -4,6615 11 2,63 6,50 -3,8720 25 6,6025 60 5,54 6,80 -1,2630 140 6,8235 260 9,25 6,95 +2,3040 450 6,9645 650 8,91 6,97 +1,9450 800 6,80 6,98 -0,18

10. Some whiskeys improve with age. The fol-lowing table lists the consumption value of a bar-rel of whiskey at various ages. For example, ifthe whiskey is removed from its aging vat andsold now to consumers for current consumption,it will sell for $100. If sold in 10 years, it willfetch $250 for consumption. ;(

a. How much will the vat of whiskey beworth right now (at 10<j'o) if it is to beheld until the end of the second year be-fore being bottled and sold?

b. For what length of time should one ex-pect to keep the whiskey in the vat for amaximum present value? (Hint: Howmuch is it worth paying for the whiskeynow if it is to be held for five years? Forten years?)

*c. If no one owned the vat of whiskey, howlong would it remain unconsumed?

366 Chapter 16

*d. Suppose it were owned but could not besold; how long would it be kept beforeconsumption?

Consumption Consumption Consumption ConsumptionDate Value Date Value

Now $100 6 $2051 year 120 7 2202 140 8 2303 160 9 2404 175 10 2505 190

*11. Goods differ in their rate of yield of con-sumption services, or in their "durability." Pinelumber naturally deteriorates more rapidly thanredwood. If demand for future consumptionrights should rise relative to present consump-tion rights, would pine or redwood experiencethe greater rise in present price? Show why thisis expressible as a fall in the rate of interest.(Hint: The interest rate is the exchange rate be-tween present and future consumption rights.)

12. Changes in the rate of interest are detectablein the changes in the structure of relative pricesof various types of goods.

a. If the price of raisins (relative to grapes),of prunes (relative to plums), of whiskey(relative to corn), of cider (relative to ap-ples) should rise, would that mean achange in the rate of interest? In what di-rection?

b. What effect would that have on the prof-itability of producing raisins, prunes,whiskey, and so on?

c. Ultimately, what effect would the revisedproduction have on the relative values(for example, of raisins and grapes)?What effect would that have on the rateof interest?

13. In a certain country the only productivegoods are "rabbits." Either the rabbits are eaten,or the rabbits increase at the rate of 20% peryear.

a. If there are 1 million rabbits in the com-munity at the first of the year, what is theincome of the community (measuring theincome in rabbit units)?

*b. What will be the rate of interest in thatcommunity?

*c. What is the maximum possible growth?

*14. "A rise in the profitability of constructinghouses and buildings tends to push up the rate ofinterest." Why?

15. The propositions on costs in Chapter 10 im-ply that the demand curve for investment is neg-atively sloped with respect to the rate of inter-est-that is, that higher rates of investment willbe less profitable. Why is this implied by theearlier propositions on behavior of costs?

16. "If savings is defined as an increase in wealthand if investment is defined as an increase inwealth, then savings by definition is always equalto investment; for it is merely the same thinglooked at from the point of view of two differentpeople." Since this statement is correct, how is itpossible to speak of equilibrating the rate of in-vestment and the rate of savings?

*17. "The most important fact about saving andinvestment is that they are done by differentpeople and for different reasons."

a. Is that why savings must be equilibratedto investment via a demand for invest-ment and a supply for savings function?Why not?

b. Suppose that everyone who invested hadto do his own saving and could not lendor borrow or buy capital goods from otherpeople. Would that destroy the principlesof demand-and-supply analysis for growthof wealth? Why?

18. The rate of interest helps to equilibrate in-vesting and savings, and the demand for borrow-ing and the supply of savings; it is the relativepremium of price of current consumption rightsover future consumption rights; it is the price ofmoney; and it equates the demand and supply ofassets. Explain how it is all these things at once.

19. Suppose the world were going to last for justtwo years and you have wealth of $100.

a. If the interest rate is zero, what is the in-come available in each of the next twoyears?

b. If the interest rate is 10%, what is the in-come of each period (again assuming atwo-year life to the world)?

c. If the interest rate is 10% but the world isgoing to last for an indefinitely long peri-

ad, what is the maximum annual main-tainable rate of consumption?

20. You are a visitor in some underdevelopedcountry in which all lending and borrowing areeffectively prohibited.

a. Is there a rate of interest?b. If so, where could you get data to com-

pute it?c. How could you tell when it changes?

21. "Large corporations have so much of theirown funds that they do not have to borrow in thecapital-funds markets in order to make new in-vestments. They are therefore immune to inter-est rates in the capital markets so that their in-vestments are not screened as are those ofinvestors seeking funds in the capital markets."Explain the error in that analysis.

22. "Most states have restrictions upon the rateof interest that may be contracted for in the ab-sence of special authorization for higher rates.The most common maximum contract rates are6% and 8<;70 a year, but a few states permit con-tract rates as high as 12<;70.Loans to corporationsare generally exempt."

a. Who is helped and who is hurt by theselaws if they are effective?

*b. Do you think they have any effect on therate of interest?

* c. What do you think happened when inter-est rates on excellent bonds exceeded10% in 1974?

23. You propose to buy a house for $20,000. Youhave $3000 in cash now, so you seek to borrow$17,000 from a lender at 5<;70 rate of interest. Wesay 5<;70 because the government of the state inwhich you live has agreed to guarantee the loanon your house since you are a veteran. The lawwill guarantee your loan so long as the lenderdoes not get over 5<;70. Unfortunately, no one willlend to you at that rate because 6% is availableelsewhere. But you are clever enough to find alender who will lend to you at 5%, after youmake the following proposal: If he will lend you$17,000 at 5<;70 (which is, let's say, 1% less thanthe 6% rate he could get elsewhere-and there-by costs him $170 a year interest otherwise avail-able; that is, I % of $ I7,000 is $170 per year), youwill buy from him insurance on the house and on


your car and life. In doing this, you mayor maynot realize that you could have bought the sameinsurance at a lower rate or more convenientlyelsewhere.

a. Why do you make this agreement withhim?

b. Is he being "unfair" or "unscrupulous" or"unethical"? Are you?

* c. Who is aided or hurt if such tie-in agree-ments are prohibited?

d. Do you think they can really be totallyprohibited by laws? Why?

24. You are trying to decide which of two stocksto buy. One has been falling in price during thepast month, but the other one has been risingsteadily during the month. Which one shouldyou buy on the basis of that information?

*25. A retired person has $100,000 to invest instocks and expects an income of about $10,000annually because interest rates are about 10~o. Ifyou advise him to buy stocks that payout noearnings as dividends, he complains that he willhave no income. How would you explain to himthat he does have an income of 10~o?

*26. If you were a Jew in an Arab country, or anAsian in Africa, or an Englishman in Indonesia,or an American in Argentina, or a Moslem in In-dia, would you invest for your son in personalhuman capital or in physical capital? Why?

*27. Distinguish between conservation of specif-ic resources and the growth of wealth. Is conserva-tion of specific resources an efficient way to in-crease the productive wealth of the community?

*28. "In a socialist state it is difficult for thestate to own the producers' goods that are in-volved in artistic creativity-the human brainand body. Consequently musicians, artists, au-

I.I IIi,.IJtfrrf'-' ----3-6,-8--C-'ha-p-t-er-j-6-----------

thors, and poets will be more able to behave indeviant, unorthodox, non nationalistic ways thanthose whose earnings are more dependent uponstate-owned resources-machines, factories, land,and so on. In a capitalistic system this differencewould not be present."

a. What premises underlie the propositions?b. Would your preference for one system

over another be influenced by the validityof those propositions? Why?

*29. In Russia and China, two socialist states inwhich most producers' goods (goods with whichyou can earn a living) are owned by the govern-ment, targets are assigned to factories in terms ofthe total value of the output (not profits) they aresupposed to produce. Plant managers are told toaccomplish and overfulfill targets as much as pos-sible. Prices are set by law.

a. Is it desirable to have these targets over-fulfilled?

b. Is it more desirable to state a target foreach particular good in terms of total val-ue of output than in terms of maximizingprofits? What are the differences in per-formance that will be induced?

c. Which criterion is more likely to providea more effective incentive for the man-ager?

*30. Assume that you are a member of a minor-ity group in some country and have reason todoubt that your private-property rights would beenforced and respected in that community.

a. In what forms of capital would you in-vest?

b. What kinds of skills (as forms of accumu-lations of wealth) would you encouragefor your children?

c. Do you know of any evidence of such ac-tual behavior by minority groups?

Chapter 11Unemp)oy-,Dlenl andIdleBesoueces

In our economy there always seems to be agreat number of people who are unem-ployed: They are without a wage-paying jobbut are seeking one. Who are the unem-ployed? And why •.does unemployment oc-cur? One answer to the first question is alsoan answer to the second: The unemployedare those who are between jobs or who arefirst-time job seekers and, rather than takingthe first job offered them, choose to remainwithout one while searching longer for thebest alternative. That interval of search an.slevaluation called unemployment is an eco-nomical way to examine and compare themany jobs that have at least some value tosociety.

Many of those seeking their first job arejust out of school or college, or are house-wives deciding to seek work for moneywages; some retired people reenter the jobmarket seeking part-time work. But why aresome people between jobs? Obviously, manyleave one job to find another that is morepersonally satisfying in its tasks or surround-ings, or the like. But others are between jobsbecause of changes in the market for goodsand services: When the demand for someproduct declines and the demand for anotherincreases, producers and workers must adapt;resources must be transferred from produc-ing the good of which less is demanded tomaking more of the other. People must in-vestigate and evaluate the many opportuni-ties and decide which is best. That, takessome time. Over 50% of those who becomeunemployed select their new jobs within twomonths. Only about 5% to 10% continueevaluating for six months or more.

Unemployment, then, is not caused bythe absence of jobs, as is commonly thought,but rather by the evaluative activities ofthose between jobs or those looking for theirfirst job. This is true not only of labor but ofmachinery as well. What would be a betterway to determine what to do next when acurrent job pays too little to be worth doing?

369

J,, i

\I

i I

This interpretation of unemployment-that it is caused not by a shortage of jobs butby passage between, or to, jobs-though cor-rect, may seem surprising, but recall ouranalysis in Chapter 14: Because of the per-petual condition of scarcity of goods and ser-vices, there is always more work to be done,but which of the many tasks is the best oneto do is not instantly discoverable. When de-mands shift, we must examine and evaluateopportunities. Seen as a way in which we ef-fectively adapt to unforeseeable changes, theunemployment of resources is, then, not nec-essarily wasteful. Indeed, consider how greatthe costs would be if you were never allowedto be unemployed after changes in demandor supply. You would not be allowed to quitand spend a month discovering and evaluat-ing other options. It is unlikely that whileworking at the old job you could instantly,and at no cost, find the best of alternativejobs and know that you have found it. Unem-ployment is not simply job seeking; it is job-information seeking.

No college graduate knows everythingabout every potential employer and vice ver-sa. Employment offers differ in both mone-tary and nonmonetary features of differentjobs. Accepting a first offer reduces the prob-ability of finding the highest paid job. Themore firms investigated, the greater is theprobability of finding a better job. The great-er the difference is believed to be among po-tential wage offers and working conditions,the greater the amount of search it pays toperform.

Because the gain from extra search di-minishes, there is a limit to the sensiblelength of search. A person should search forand explore wage offers until the expectedgain (the present value of a larger future in-come) for further search no longer exceedsthe cost of continued search. And, althoughprobably few persons make detailed calcula-tions, the observed behavior of most jobseekers conforms to this practical rule. The

., J,

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: I

i j, I': I,

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1i'lI,. ,

i

370 Chapter 17

greater the Auctuations in demands or thegreater the costs of relocating, the greater isthe gain from more extended search, and thegreater is the rate of unemployment.

The employer's search process is associat-ed with unfilled jobs. An employer whose in-formation and hiring costs were zero wouldinstantly hire the right people at the appropri-ate wage. But information not being free, anemployer who always takes the first availableperson is less likely to get the best person.'

Obviously, some unemployment andsome job vacancies are an inherent, wealth-maximizing feature of a society in which de-mands change unpredictably and people se-lect their jobs according to open-marketcompetitive prices rather than being as-signed to jobs. In the military, everyone al-ways has a job; however, it is not clear this ismore desirable than frictional unemploy-ment. If less attention were paid to seekingthe most appropriate jobs and workers, itwould be easier to keep everyone busy.Avoiding unemployment by making arbi-trary work assignments is called disguisedunemployment, because, although no one isjobless, there is rro way of assuring that laborand resources are being used in their mostvaluable ways. In the Soviet Union and thePeople's Republic of China people are as-signed to jobs by the political authorities:There is no measurable unemployment, butthere is assuredly disguised unemployment.

To recognize that unemployment is aneconomical way to respond to changing de-mands and supplies does not mean it is the

'The concept of unfilled jobs or vacancies is adangerously misleading one except when applied to thesort of situation just described. in which an employermaintains a job vacancy long enough to find the bestperson to fill it. The simple fact of scarcity in thisworld means that there are innumerable tasks or pro-ductive activities that people could perform. So wemust ask. at what wage is a job unfilled? At higherwages the job-or the offer to employ someone in it-would not exist. At lower wages the number of jobsoffered increases without limit.

only, or necessarily the best, way, or that it ispleasant. It is not here implied that allsources of changes in demand and suppliesare unavoidable or are good things. Indeed,some downward changes in demand and sup-plies have been caused by mistaken econom-ic policies. Thus, the severity of the GreatDepression was the result not of the typicalfluctuations that give recessions and recover-ies but of mistaken policies that exacerbatedthe initial recession into a severe, prolongeddepression. It is misleading, even if true, tosay that the resulting unemployment was"economical." But in the absence of other ac-tions that would have prevented it, the bestfeasible response for many individuals was tobe unemployed for lengthy spells.

In all chapters so far we have analyzedhow prices in a private-property, open-marketsystem operate to (a) determine what goodsare produced and in what amounts, (b) controlconsumer demand and allocate those goodsamong consumers, and (c) affect the incomeand wealth of the owners and suppliers of pro-ductive resources. Though each dependsupon the other, we considered each of theseactivities or consequences of the open marketone at a time, assuming, for the sake of sim-plicity, that the others were fixed or appropri-ately adjusted. And, indeed, if the market foreach good was independently and simulta-neously cleared, regardless of what was hap-pening in other markets, the analysis in thepreceding chapters would adequately de-scribe how the economic system as a wholeoperates and remains coordinated. But activi-ties in producing and selling various goods arenot independent of incomes, prices, and out-puts in other markets and industries. So nomarket achieves fully coordinated adjust-ments to changes in other markets instantlyand without cost.

If demand rose in one market as it fell inanother, and if people could instantly knowthat those demand shifts were not temporarydisturbances, and if the productive inputswere immediately shifted from the one to the

other, there would be no unemployment andno idle resources. But immediate shifts tosome other job are not sensible because ofthe costs of discovering the best of the otheropportunities. These costs of informationabout the true state of demand and aboutother opportunities explain a wide class ofactivity known as frictional, or natural, un-employment: the unemployment of laborand resources that lasts the duration of thatsearch for the best jobs or uses. If virtually allthe unemployment in an economy is friction-al (natural), which means in our economythat about 3% to 5<70of the total work forceis between jobs, then the economy is arbi-trarily said to be in full employment. Fric-tional unemployment, whether of labor,houses, capital goods, or any good whatso-ever, is a way to adjust to foreseen transient,minor, and possibly unfortunate changes indemand and supply.

Numbers ofEmployed and Unemployedin the United States

Of the 100 million people with gainful em-ployment in the United States in 1982, about70 million worked full time and 30 millionworked part time. Figure 17-1 shows thetrends of employment for men and womenfrom just after World War II to 1982. But fora better perspective on the relative extent ofjob shifting, it is useful to know that stable,long-term employment is characteristic of alarge fraction of the U.S. labor force. On av-erage a worker holds a job with the same em-ployer for about eight years. And over aquarter of all workers remain with the samefirm for over 20 years. Over 75% of middle-aged workers who have held a job for 10years will hold the same job another 10 years.Of workers over 30 years of age, almost halfthe men and about a quarter of the women

Unemployment and Idle Resources 371

.... :.. 110100908070605040

30

20

1/1Co1/1•..Q)a.

100 r::: Total Civilian Labor Force ....:...90 I- ::::::::::::::.::.

98 r:::~;;;;;iu;;n;;e~~bP;IOiliyiiile_~iii;... iMMi~;;iii~:: '" .....j:~t :::.: '" Employed, Male and Female

40 --o1/1c.2~

30 -

20 - -~-------- Employed, Female

10 I

1947I I

1950I I

1955I L-~~-L-L~~~~~~-L-LJ-~L-~~-L~10

1960 1965 1970 1975 1980 1982

Years

!".Figure 1'7.1.

U.S. EMPLOYMENT TRENDS FOR MEN AND WOMEN,1949 TO 1982

SOURCE: U.S. Department of Commerce, U.S. StatisticalAbstract, 1981.

will keep their jobs for more than 20 years,and only a quarter of the workers will havejobs that last less than 5 years. Blacks havethe same record of job duration as whites.Women have had substantially shorter ormore interrupted job tenure than men be-cause of their greater productivity as house-wives and mothers-productivity that in theabsence of market prices has been vastlyunder measured.

In the United States the unemployed aremeasured by interviews 01 about 100,000adults monthly. People holding jobs but notworking because of illness, vacation, or jobdispute are not considered unemployed. Tobe counted as unemployed, one must be "ac-tively" looking for work. However, "activelylooking" can mean as little as asking friendsor relatives about some jobs in the precedingfour weeks. An examination of who is calledunemployed may yield some surprises.

Approximately 10 million workerschanged jobs during 1980. Every month, on

the average, approximately one in 20 em-ployees quit or was laid off or dismissed; thesame proportion took new jobs or returned toold ones. In this process, over 15 million per-sons reported themselves unemployed atsome time during 1980, although at anyonetime the number of unemployed averagedabout 6 million. Some 3 million were unem-ployed all through the year, 2 million fromone to three months, and 3.5 million fromfour months to more than six months. Al-most 6 million had at least two spells of un-employment. These data reveal a persistentflow of people and resources from job to job,some flowing more quickly than others, andstill others experiencing more prolonged un-employment while reassessing their best op-tions or considering possible new occupa-tions. Table 17-1 gives more details.

Table 1'7.1 UNEMPLOYMENT RATES (PERCENT OFWORK FORCE)

1960 1965 1970 1975 1980

All Workers 5.5 4.5 4.9 8.4 7.1White 4.9 4.1 4.5 7.7 6.6

Male 4.8 3.6 4.0 6.5 6.4Female 5.3 5.0 5.4 7.0 6.8Married men 3.3 2.2 2.4 5.0 4.0

Nonwhite 10.2 8.1 8.2 14.0 13.3Teenagers 14.7 14.8 15.3 20.0 17.3

.•..•.•..•,-------

5

55Job Losers

50

45

40

~ 351'0..i 30o

~ 25

55

50

45

40

35Reentrants into Labor Force--------~ --------~ 30

___~ •...---~ ~ Job Leavers

// '\ '-, ----~--==----"" ----New Entrants into

>Labor Force

20

15

105

25

20

10

o 01969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

During a recession, a period duringwhich output, capital investment, and em-ployment decline, the average unemploy-ment over the whole labor force usually risesfrom the full-employment rate of around 3%to 5% to about 7% to 9%. Figure 17-2charts the percentage of reported unemploy-ment for the whole labor force over the pastseveral years. In the years 1932-33, the depthof the Great Depression, it averaged aboutl5%-though hitting an average of 20% inthe worst months.

Who Are the Unemployed?Certainly unemployment is difficult to de-fine, especially for people near the margin ofpreference for employed work relative to re-tirement, schooling, or household productivi-ty. Government studies of the unemployedreveal the anomalous facts that about 35%look for work, 24% keep house, 20% go toschool, and 147'0 are retired. Al though sur-

Figure 17-2.

CATEGORIES OF THE UNEMPLOYED AS PERCENTAGESOF TOTAL UNEMPLOYED, 1969-1981

SOURCE: U.S. Department of Commerce, U.S. StatisticalAbstract, 1981.

prisingly few are looking for work, people donot sit idly during unemployment.

Over the past decade, an average ofclose to about 6% of the adult populationwas unemployed at anyone time. Of these,25% were teenagers and another 25% wereof ages 20 through 24. In other words, half ofthe unemployed are young people 16 to 24years of age, though that age group repre-sents only about a quarter of the U.S. popula-tion of 16 years and over. Half of the unem-ployed teenagers are, however, in school andare seeking only part-time work. Of teen-agers not in school, about 15<70are unem-ployed. Teenagers are a group with transientattachment to the labor force, and their in-


, I

, I,I,, 11

,

Table 17.2 ENTRIES INTO UNEMPLOYMENT

Source Percent of Totali '11'1 ,i; Laid off (expect recall) 12

Fractions in Each Source ofEntry Who Are:Under 25 Men Women

20 52 48

Job leavers 13 44Dismissed 33 33 63 37

47 45

Left school 7 88 52 48Want temporary work only 13

New entrants to labor force 12Other 10

100%

Source: Robert Hall, The Nature and Measurement of Unemployment,National Bureau of Economic Research, Working Paper 252, 1978.

centives to find steady work are less persis-tent than others'. About 20% of the unem-ployed young people are blacks, thoughblacks represent only about 10% of the pop-ulation. In contrast, in the prime age catego-ry-25 through 54 years of age-the unem-ployment rate has averaged about 4%.

The natural (frictional) rate of unem-ployment increased in the 1970s because ofan increasing fraction of teenagers in thepopulation. Also, more women sought satis-factory work for money wages. In addition,more extensive unemployment and welfarebenefits were paid only to those registeringthemselves as unemployed.

People can become classified as unem-ployed by any of several routes. Some havebeen temporarily laid off ;;-and are expectingrecall; others have been dismissed or havequit. About half of those becoming unem-ployed are job losers, and for half of these thejob losses are temporary layoffs. A quarter ofthe unemployed are those who are reenteringthe labor force after withdrawing earlier forfamily or educational reasons. About 10% ofthe unemployed are those who are enteringthe work force for the first time. Some areteenagers, high-school graduates entering thework force and sampling various jobs in their

374 Chapter 17

74 43 57

search for the most appropriate job. In theirjob sampling, they frequently enter and leavethe ranks of the unemployed until they settleinto some more permanent job in their mid-twenties. Others, especially women and re-tired people, more commonly are seekingtemporary work only and are counted as un-employed between jobs or while looking forthe best job. Table 17-2 gives the relativeimportance of the different sources of entryinto unemployment for the year 1976. Figure17-3 charts the percentage of unemploymentfor the labor force as a whole over the past30-odd years.

In a 1977 study of unemployment, it wasdiscovered that only 40% of those whoclaimed to be unemployed, and were countedas such (7 million persons, 70;0 of the workforce), were considered by some other adultin the sampled household to be unemployed.More surprising was that only about one-third of those counted as unemployed report-ed that they had in fact satisfied one criteri-on of being officially counted as unemployed:seeking an acceptable job during the preced-ing four weeks. Most of the remaining two-thirds who claimed to be unemployed weregoing to school, keeping house, or were moreor less retired. This suggests that many who,when asked, say they are unemployed make"better" use of their time than actively seek-ing work: In effect, they let the satisfactory

1211109& 8

!! 7~ 6~ 5~ 4

321O~~~~~~~~~~~~~~LL~~-LLL~~~~

12111098765432101975 1980 ..

job find them. Unemployment, then, is ex-tremely difficult to define in ways that satisfyeveryone.

LENGTH OF UNEMPLOYMENT

In 1978 about one-third of the unemployedexperienced more than one spell of unem-ployment. For example, in the constructionindustry, workers move from job to job andin the interim may be briefly classified as un-employed. The temporary nature of somejobs or specific tasks implies a higher fre-quency of unemployment. Thus, a 1978study of construction-industry workers (5%of the total work force at that time) showedthat they accounted for almost 20% of thepeople who had more than one spell of un-employment. As you would expect, the aver-age spell was shorter for them than for thosewith only one spell. Fifteen weeks was theaverage length of spell for the single-spellunemployed; nine weeks per spell was theaverage for those with two spells, and aboutseven weeks for those with more than twospells in the year. Sixty percent were reem-ployed in less than a month, with another20% within 5 to 10 weeks; at the other ex-treme, 3% were unemployed for over 6months. For the construction workers the av-erage duration of a spell was about 6 to 7weeks.

(Because unemployment data are collect-

Figure 17-3.

PERCENTAGES OF REPORTED UNEMPLOYMENT, 1948-1981

SOURCE: U.S. Department of Commerce, Survey ofBusiness, various issues.

ed once a month, people with very shortspells, say, of a week or so, are less likely to beunemployed at the date of observation. Thisleads to an underestimation of the number ofpeople actually unemployed during the monthbut to overestimation of the average length of thespells of unemployment, since the shortest onesare more likely to be omitted.)

The best data available suggest lengthsof unemployment like those given in Table17-3. Approximately half the spells are lessthan five weeks, and almost 75% are lessthan three months, increasing during reces-sions. The average length varied from as lowas nine weeks to as high as 16 weeks duringthe 1970s.

UNEMPLOYMENT AND INCOME

What is known about the relationship be-tween unemployment and income? Onething is that the unemployed do not have~ery low incomes. In 1980 the average familyIncome of households in which a person was


· )t, I

II.

Table 17·3 LENGTH OF UNEMPLOYMENT

Length of Percent of UnemployedUnemployment 1960 1965 1970 1975 1980

Less than 5 weeks 45 50 52 35 435-10 weeks 21 29 23 20 2311-14 weeks 9 8 8 10 915-26 weeks 13 10 8 15 1326+ weeks 12 10 8 20 11Average 'duration, weeks 13 12 9 14 12

Source: US. Statistical Abstract, 1981.

unemployed was over $19,000. And for 4070it was over $20,000. The average annual in-come of all families was about $29,000 (themedian was about $21,000). About 20% ofthe unemployed were in families below thepoverty line.' However, the average incomeof female-headed households that experi-enced unemployment was only $8,500,though 870 were above $20,000. Even aftercorrecting to a per capita basis, since suchhouseholds are relatively small, the averageper capita is lower than for male or multiple-employee households.

Of the unemployed living alone, almost75% earned less than $10,000. But over halfthe unemployed who are teenagers live withfamilies that have incomes exceeding$20,000, with an average of almost $25,000.Only about 16% lived in families below thepoverty line. For the unemployed black teen-ager, the average family income was over$17,000; one-third were below the povertyline. Individuals reporting more than sixmonths of unemployment lived in house-holds with an average income of $16,000,while a bit less than 3070 were below thepoverty line.

To what extent does unemploymenttend to lower one's earnings? For the autoand steel workers who were unemployedin some year, family income averaged about$21,000 in that year, while families with noreported unemployment averaged $28,000. Over

376 Chapter 17

..•~i

a lifetime the effect is much less since unemploy_ment does not occur every year. For constructionworkers the comparable figures are $19,000 and$26,000. Not all of the difference can be attrib-uted to unemployment, because more of thosewho experienced unemployment (such as thoseunder age 24) have wage rates that are lower thanthe average of the adult population.

Trends inUnemployment

The unemployment rate has increased dur-ing the past 30 years. One reason is thatteenagers, with a high rate, have become alarger proportion of the labor force, therebyraising the overall rate even though the ratemay not have increased for any particulargroup. But there has been a small upwardtrend in unemployment for everyone exceptpeople over 55, where the trend is essentiallyzero. Also, the increased proportion ofmultiworker families permits greater flexibil-ity in the search for new employment oppor-tunities. The greater the fraction of suchfamilies in the work force, the greater will bethe average extent of unemployment. Bothof these forces reflect change in labor-forcecomposition rather than changes in the effec-tiveness of the economic system to maintainhigh employment.

But some things have contributed togreater unemployment even without anychange in the composition of the labor force.Greater and longer-lasting unemploymentbenefits applied to a wider range of indus-tries have contributed to the upward trend.Also, more welfare payments are contingenton persons being classified as unemployed.Further, the minimum-wage laws have re-duced employment of the very young andhave increased their sensitivity to business-cycle changes. All these factors-the changein demographic composition, the benefits re-ceivable when unemployed, and the. mini-mum-wage laws-have been estimated to

have raised the average unemployment rateabout two to three percentage points overthe last three decades, from around 3%-4%to about 5<:70-6%.

DEMOGRAPHICFACTORS IN UNEMPLOYMENT

The percentage of the work force that is un-employed varies not only over time withchanging business conditions but also accord-ing to such characteristics as age, gender, col-or, and general skills. Typically, the statisti-cally reported unemployment rate amongmarried men 25 to 65 years of age is less than3%, whereas for unskilled, nonwhite teen-agers it exceeds 10<:70.

Why do unemployment rates differ ac-cording to gender, age, and color? It mightbe thought that teenagers, women, and non-whites are not trained for the jobs available,but that assumption is incorrect because in-sufficient training would explain only whythey are paid less per hour than adult, whitemales.' Then why are the unemployed notworking at the tasks they can do? Becausesome would rather not work at the wages of-fered for the available jobs, and others havenot yet decided what is the best job. Somepeople may have so little wage-earning capa-bility for the best-known job that they pre-fer not to work for wages, yet say they are"unemployed." But why do sufficiently pro-

'Statements about unskilled or untrained peopleor people with skills that do not correspond to job re-quirements are misleading. That would have an effectonly if wages had to be uniform for all workers and ifthere were no value for any of the services that couldbe provided by low-skilled people. (Again, rememberthat economic analysis does not make recommenda-tions or pass judgments. We are not implying thatnothing should or can be done to alleviate the situa-tion, or that the existing situation is desirable. The doc-tor who traces your back pain to your wearing high-heeled shoes is not saying that you deserve it, or thatnothing should or can be done to prevent or alleviateiL)

ductive teenagers or nonwhite adults experi-ence such high unemployment rates? As al-ready noted, teenagers quit jobs morereadily than others in their evaluative searchfor careers. Another factor is the minimum-wage law, which prevents employers fromhiring unproven teenagers at wages lowenough to reflect their low productivity andto distribute the job-training costs to theteenagers. When demands shift, the teen-agers are the first to go, because they cannotadjust their wages below the legal minirnuai.For blacks, another factor has been theirhigh rate of migration from agricultural ar-eas into cities. As a result a large numberare engaged in extensive job-opportunitysearch and evaluation; hence a large fractionof young and mobile blacks will show up of-ten as unemployed.

COSTS OF CHANGING JOBS

Evaluating the available jobs is time-consum-ing, taking up most of the average two-month search. Lost income during that timerepresents a small percentage of what a per-son makes during an average 5-year job, usu-ally less than the costs of selling a house, acar, a piece of land, or even a share of stock,which range from I % to 10% of the good'svalue. This does not mean that unemploy-ment is not a source of increased anxiety forthe job seeker during those two months butrather, in purely economic terms, that thecosts of the job search are lower than the jobseeker's state of mind might suggest. More-over, unemployment insurance and welfarepayments reduce the cost of the search stillfurther.

The subject of monetary aid for the un-employed can arouse intense emotions inpeople. Some unemployment compensationis an insurance payment to the unemployedperson, who had paid annual premiumswhile employed. Yet a large number of theunemployed receive relief payments unrelat-


ed to any unemployment insurance premi-ums they may have paid. This relief increasespeople's tendency to enter the ranks of officialunemployment and to stay longer. In someinstances the unemployment insurance pay-ments, welfare payments, and reduced tax ob-ligations reduce the loss of income for sixmonths of unemployment to hardly morethan 10% to 20<;'0of full-employment income.If one then calculates a value of leisure or ofnot working, the costs of a spell of unemploy-ment are greatly reduced.

OTHER TYPESOF UNEMPLOYMENT

Some people are excluded from particularjobs by restrictive apprenticeships or licens-ing laws. They call themselves unemployedelectricians, musicians, meat cutters, projec-tionists, or bricklayers. Some of these peoplewill remain "unemployed" until they eitherbecome independent owner-contractors orshift to other, less productive occupationswithout such entry restrictions.

Another category of the unemployed ismade up of people who take employmentonly when demand for their services is highenough to warrant the high wages that wouldattract them. Some housewives work onlyduring seasonally high demands for certaintypes of labor-in grape picking, fruit pack-ing, or clerking at the Christmas season. Therest of the year they prefer not to work at thelower-valued jobs they could' obtain. Peoplein short-lived projects such as movies, plays,or housing construction are commonly calledunemployed between projects-especially ifthey have qualified for unemployment bene-fits. For example, at anyone time over 80%of the members of the Screen Actors Guildin Hollywood are classified as unemployed-as they must be to qualify for unemploymentand some union and government welfarebenefits.

. t" i1

Changes in Structuraland Aggregate Demand

STRUCTURAL UNEMPLOYMENT

Although the economy as a whole may bestable or even growing as the general de-mand for goods increases, certain changescan occur in particular markets or occupa-tions that reduce the demand for labor inthose areas. The demand for some goods mayfall, while the demand for others may so in-crease that resources are bid away from theproduction of goods for which demand isgrowing slowly or not at all; or, new produc-tion techniques may make different types oflabor more valuable than they had been insome uses and less valuable than they hadbeen in other uses. These changes in the de-mand for, or supply of, labor, if they persistor exist on a large scale, are called structuralshifts. As a consequence of them, people andresources whose services fall in value mustaccept lower wages and rents or must shift toother jobs, or possibly do both. This changeinitiates unemployment called structural un-employment.

DECREASE IN AGGREGATE DEMAND

Figure 17-4 shows graphically the percent-age of 172 major industries expanding theiruse of labor at the same time. The percent-age fluctuates, rarely reaching 100% or zero%, usually staying within the range of about20% to 80%. Rarely are less than 20% ormore than 80% of these industries expandingtheir employment at the same time. (Expan-sions and contractions among firms within anindustry show a similar pattern.)

If the line in Figure 17-4 were stable atabout 50%, it would suggest a relativelysteady aggregate, or national, demand for la-bor, with the various industries expanding orcontracting independently of one anotherbut generally balancing their labor demands

1957 58 596061 62 6364 65 66 67686970 71 72 73 74 75 76 77 78798081

relative to one another at that aggregate de-mand.

If demand for one good falls and anotherrises, resources will transfer to other equallygood activities relatively quickly. But if gen-eral demand (one correlated over many prod-ucts) decreases, then a more difficult adjust-ment and searching process follows. Say youare an auto worker and demand for cars hasfallen. You can retain your job only if youcut your wages to practically zero-unless allother inputs to auto manufacturing also cuttheir prices at the same time by, say, 10%, inwhich case taking a 10% wage cut would en-able you to keep your job. But do suppliers ofsteel, tires, fabrics, copper, plastics, andtransport all immediately know that demandhas also fallen elsewhere, so that they toowill have reason to quickly adjust prices fortheir products (which would permit you toretain your job with only a 10% wage cut)?No.

No firm can instantly know whether adecrease in demand for its goods is transientor persisting, whether or not it extendsacross the economy as an aggregate decreasein demand. Nor do the employees know. Ifthe shift were known to be a transient, re-versible one, the buffer inventory would per-form its function and employment and out-put would be maintained. If, however, bufferinventories were too expensive to maintain,the output would be reduced and employeestemporarily laid off.

No one employer can quickly knowwhether a decrease in demand, transient orpermanent, applies only to the goods of that

Figure 17-4.

CONFORMITY OF EXPANSIONSIN EMPLOYMENTAMONG 172 INDUSTRIES

The curved line shows the percentage at whichemployment expansions in 172 industries conformto one another. Rarely if ever does employment inall industries expand or contract at the same time.Hut in some periods most may contract for awhile, as in 1957, 1960, 1970. 1974, and 1980,when the curve dips to the lowest percentagesof conformity of expansion. It should be expectedthat normally about half would be expanding andhalf contracting-as is confirmed by the movementof the curve around the 50% value (the straight line).During periods of low conformity of expansionconformity of contraction is high. Such periodsare called recessions or depressions if lastingmore than a year. Lightly shaded areas indicaterecessions.

SOURCE: U.S. Departmentof Commerce, BusinessConditions Digest, monthly.


one firm or to all firms in an industry. Norcan employees know. If it were believed tobe transient, the likely response would betemporary layoffs. If the decrease were be-lieved to be permanent but specific to theemployer, the employees would leave ratherthan accept a wage lower than available else-where or a long-term or permanent layoff. Ifthe decrease were believed to be industry-wide or economywide, employees would bemore likely to accept a wage adjustment tokeep their jobs, believing the options else-where to be no better.

But if, in fact, workers are wrong in theirbeliefs about the anticipated lengths of de-mand decreases as the shifts persist and aremore general than anticipated, they will find,when refusing to take a wage cut in theirfirm, that they cannot get other jobs at essen-tially the same wage, nor as soon as expect-ed. They will be unemployed longer than an-ticipated, making their unemploymentunanticipated or involuntary. If, however,they could instantly have known that a de-mand shift was general and persisting, theywould have accepted adjusted wages to keepthe same jobs. But, of course, they cannotknow. Hence we see spells of surprisinglylong unemployment, with wage and price ri-gidity and general unemployment acrossmany industries-that is, recessions.

If demand and supply conditions change,it is conceivable that a new set of market-clearing prices would, if instantly achieved,keep everyone employed at stheir same jobs.However, this would mean that some peopleand resources would be getting much lessthan they could get in other jobs. Hence,they accept unemployment and search forand evaluate other opportunities. Therefore,when demand or supply shifts are wide-spread or large, or are not immediatelyknown to be long-lasting, unemployment in-creases as resources adjust to the new cir-cumstances, especially if demand decreaseshave predominated. If demand increases

380 Chapter J 7

have predominated, job offers will flow fromfirms for whose products demand has in-creased. Workers are more willing to moveto a clearly better paying job with less exten-sive search. If demand decreases have pre-dominated, people will begin to look for thenext-best job. That is why a general decreasein demand is accompanied by temporary(though not insignificant) disorganizing in-creases in unemployment. Gradually, over afew months or a year (depending on the rea-son for the decrease in demand), unemploy-ment is reduced as people discern the new,lower wages and the new best available jobs.

The worker's unwillingness to acceptlower wage rates to reflect the prices of othergoods does not indicate wage inflexibility.Nothing prevents any worker from showingperfect, instant wage flexibility. One's notionof what price can be obtained lags behindthe facts; the cost of getting informationmakes the state of knowledge lag behind theactual equilibrating price that would restoreemployment. It is an informational stickiness,or inflexibility, or lag. People choose not toreduce the price of services, because theythink the equilibrating price is higher than itactually is.

Though we have concentrated on peopleseeking the best employment opportunities,people contemplating opportunities for in-vestment face exactly the same task. Theywant the best opportunities for the invest-ment of their savings. What new buildingsor equipment or tasks for employees will bemost profitable-if profitable at all? Not sur-prisingly, even when the willingness to in-vest is unchanging, the rate of investmentwill fluctuate. Inventions, plus changes intastes, production techniques, and the avail-able supplies of various goods (such as reduc-tion of the oil supply in the 1970s), drastical-ly alter the profitability of differentinvestments. Because people scan opportuni-ties rather than investing in the first one thatappears profitable, delays and fluctuationsoccur in the rate of investment and in the

demand for resources with which to makethe investments.

But it should not be surprising that thesearch for best options tends to subdue thefluctuations in the general direction of fullemployment. Though all options may be de-teriorating, people will accept the best(though poorer) options available rather thannot invest or not work at all. Hence fluctua-tions in demand and productive opportuni-ties will not move the economy's rate of ac-tivity around at random levels without anyforce toward full employment. Nor will theeconomy persistently maintain full employ-ment. It will persistently be pushing towardfull employment after shocks or changes indemands and supplies have converted for-merly profitable arrangements into unprofit-able ones.

Fluctuationsof Aggregate Demand

Aggregate market demand fluctuates insteadof being nearly constant with virtually offset-ting shifts from one product to another. Ex-pansions or contractions in one industry orsector set up forces for expansion or contrac-tion in other industries or sectors: An in-creased or decreased demand for final goodsin one industry will increase or decrease thedemand for inputs bought from supplier in-dustries. For example, a decreased demandfor cars will decrease the demand for steeland a chain of other services, which conse-quently will amplify the decrease in the de-mand for cars. That several sectors move inclose step should not be surprising.

The aggregate demand for goods re-ceives a particularly serious shock wheneverthere is a reduction (for reasons we need notgo into here) in the supply of money. Withless money in the economy, existing pricesare too high for the present rate of output tobe profitable, but at first nobody knows this.People must conduct an extensive search for

the new pattern of market-clearing pncesand outputs.

The system that produces money (cash,paper money, and checking accounts) isuniquely critical t-o the performance of theeconomy because of its power to exercisemonetary policy: to manipulate the size ofthe money supply in order to influence ag-gregate output and price levels. For example,the controlling agency of the U.S. monetarysystem, the Board of Governors of the Feder-al Reserve System, permitted large, unex-pected decreases in the supply of money inthe years 1929 through 1933. That decreasewas a significant contributing factor in theGreat Depression.

In the early years of the depression, leg-islation was passed that, however well in-tended, had the effect of impeding economicrecovery. These laws imposed many unprec-edented restrictions on price changes and onthe access of would-be new producers to themarket." But what was done by one govern-ment agency was undone, in part, by someother agency. After 1932, the federal govern-ment spent newly created money throughvarious public works projects to provide jobswith higher pay than otherwise available.That money was not old money collectedfrom citizens by explicit taxes but was newlyprinted by the Federal Reserve Bank. Thegovernment ran a budget deficit, that is,spent more than it was collecting in taxes. Byso doing, the government was exercising fis-cal policy: the use of government spendingor taxation to influence aggregate output and

'The rate of recovery from 1932 on has been un-derestimated, because many people were counted asunemployed who were in fact employed on new gov-ernment projects. We cite this fact not to deny the se-verity of the depression in 1933, nor to fully explain theslowness of recovery (which has not yet been satisfacto-rily explained), but to refute the beliefs that forcestending to push the economy toward full employmentwere absent and that such severe depressions are aninherent characteristic of an open-market economy.


employment. But in creating new money tofinance the deficit, it was using monetarypolicies. Thus, in the 1930s, the governmententered into a new policy role, trying to endthe depression by deliberately influencingthe magnitude of aggregate demand forgoods and services by fiscal and monetarymeans.

Aggregate demand is influenced less bythe amount of government spending and def-icit than by how much of that is done withnewly created money. Increasing taxes tocover increased government spending trans-fers wealth from private citizens to the polit-ical agents, with little effect on the size ofaggregate demand. Higher taxes, however,do diminish the incentives to work and to in-vest, thereby tending to reduce aggregateoutput. These effects on incentives and out-put have recently been called the supply-sideeffects of government fiscal policy. Whethergovernment's attempts by fiscal policy andby monetary policy to influence aggregateeconomic activity have on net been benefi-cial or harmful is the focus of a raging, unre-solved debate. No systematic, reliable, unbi-ased evidence is available.

Economic Fluctuationsand Full Employment

Economic fluctuations (other than those re-lated to seasonal changes in demand or sup-ply of particular goods and services) are notsystematic cycles in the sense that high pros-perity creates recession. They occur unsyste-matically. The main characteristics of a re-cession are decreases in national moneyincome, employment, the aggregate outputof goods, the prices of assets and commonstocks, profits, and wealth. Most of thesecharacteristics are highly correlated. If thedecreases .last more than six months theeconomy may be considered to be in a reces-sion, and it is certain to be so called if they

382 Chapter 17

last a year. Unemployment rates and netbusiness income fluctuate by the largest per-centages. If we look at employment ratherthan unemployment, the fluctuations aresmall, because a 3% decrease in employmentfrom 97% to 94% is the same as a 100% in-crease in unemployment from 3% to 6%. Tosome, employment of about 95% to 970;0 ofthose who desire employment seems phe-nomenally good; to others, an unemploymentrate of 3% to 5% seems too high.

For reasons given earlier in this chapter,downward shocks causing recessions fromfull employment are later overcome by mar-ket forces tending to restore full employ-ment. One strong piece of evidence is thehigh normal rate of employment, which isaround 94% to 98% most of the time.

Another powerful piece of evidence ofthe economy's tendency to return to full em-ployment is that the upward recovery is ofthe same general magnitude as the precedingdownward shock. Moreover, the size of a re-covery, or interval to the next recession, doesnot determine the size of the next recession.If it did, it could then be assumed that thesystem is one in which a "boom" causes a"bust": "What goes up must come down."The economic system does not show thatpattern; nor does it simply wander at randomwith no connection whatever between anydeclines and rises.

Although the evidence is overwhelmingfor the tendency toward full employment,speed or rate of recovery can vary. Over thepast half century, the actual unemploymentrecovery rate has averaged about 4% peryear. That is, unemployment recovered onaverage from, say, 8% to 4% or from 7% to3% in one year, or from 7% to 5% in sixmonths. Sometimes it was faster and some-times slower, depending in part on. factorsthat initiated the downward shock. The dipin employment because of, say, a widespreadstrike was followed by a rapid recovery, be-cause almost everyone knew where the bestopportunities lay when the strike was over.

But when downswings were caused by broadchanges in supply or demand, as when ener-gy supplies changed in 1973, people had toinform themselves more extensively to findthe best alternative options for work, invest-ment, and production. That took more time.

Some shocks are so slow to be felt, or areso minor, or impinge on so small a part of theeconomy that the adjustment is hardly no-ticed. For example, the rise of television andthe decline of radio occurred so graduallythat there was no long-lasting unemploymentof those formerly employed in radio. Theslow rise of the automobile, the airplane, andthe electronics industry were all integratedwithout upsetting the economy. Becausethey impose greater physical damage, warssometimes cause greater adjustment prob-lems. But the economy adjusted so quicklyfrom war production to peacetime produc-tion in 1946, and after other wars, that itscoordinative efficiency must then haveseemed adequate to withstand any shock.However, sometimes a succession of unpre-dieted, novel shocks have caused major im-pairments in the power of the market systemto direct and coordinate the output and allo-cation of goods-as happened in the GreatDepression of the 1930s.

A decrease in aggregate demand, or anincreased fear of unstable governments andinsecurity of property and person, makes in-vestments in existing activities less likely tobe profitable. The normal savings flow can-not be as profitably invested until adequateinformation is obtained about the expectedfuture situation. A substantial portion of re-sources must shift to new tasks. But whichnew ones? To what new products? Becauseof the changed situation, it becomes moreworthwhile to investigate alternatives andprospective prices before making any new in-vestment. For example, the quick adjustmentafter World War II contrasts sharply withthe slow recovery after the decline between1929 and 1932. One difference was thatwhen the war ended, people knew it had

----------

ended. But the severe decline in the moneysupply beginning in 1929 did not end with anofficial announcement in 1932. Who was toknow then that the money supply wouldreally increase? Fl!,rthermore, a series of newlaws and profound changes in economic insti-tutions after 1932 created more uncertaintyabout the future, requiring that those want-ing to adapt to that future acquire still moreinformation. These facts explain not why therecovery was as slow as it was, but ratherwhy it was slower than the adjustment fol-lowing World War II, or other recessions be-fore and since.

InternationalComparisons

International comparisons to the UnitedStates (using similar concepts and measure-ments of unemployment) are not entirely re-liable, but they indicate similar behavior inwestern European countries, Japan, and Aus-tralia, with the difference that Japan andSweden had smaller unemployment rates.Great Britain, Japan, and Germany had sub-stantially lower teenage unemployment rates.The overall average of spells of unemploy-ment was much shorter in the United States,about 11 weeks compared to over 20 weeksfor the other countries. Well-validated expla-nations for these differences have not beenidentified.

Summary1. Changes in the demand or supply of goods

induce changes in output and in the numberand allocation of the employed. In the inter-im, labor and resources are unemployedwhile they find their new most-profitable ac-tivities.

2. Unemployment-the condition of being


without a wage-paying job and looking forone-can be the most efficient way of find-ing and evaluating job alternatives and ofadapting to unpredictably shifting demands.It is not caused by a lack of jobs, for in aworld of scarce goods and services there isno such lack.

3. Unemployment occurs for anyone or moreof several reasons: (a) legal restraints such asminimum-wage laws that prevent some peo-ple from accepting wages that reflect theirmarginal productivity; (b) restraints that ex-clude from certain jobs all those who lackrequired qualifications such as union mem-bership or having undergone an apprentice-ship; (c) the willingness of some workers towork only during seasonal peak demandswhen wages are high; (d) the unwillingnessof some people to work at wages that reflecttheir productive capacities; (e) a shifting ofrelative demands or supplies that induces areallocation of jobs, called structural unem-ployment; (f) a falling aggregate demand re-quiring that wages and prices be reduced butnot immediately perceived as a persisting de-crease by workers, who therefore refuse toaccept lower wages for their present jobs.

4. The incidence and duration of unemploy-ment depend in part on age and work experi-ence. Teenage newcomers to the work force,experimenting with different types of jobs,take more spells of unemployment than doolder people with longer work experience.The average spell of unemployment laststwo months or less. During recessions morepeople are unemployed and for a longertime.

5. Because information is not free, and becausethe quicker the adjustment, the higher thecosts, reductions in demand are not immedi-ately followed by reduction of prices to newmarket-clearing levels or by complete adjust-ment in the employment patterns of all pro-ductive resources. Instead, productive re-sources are unemployed (if labor) or idle (ifnonhuman capital goods) while the changeddemand and supply conditions are discov-ered and adjusted to.

384 Chapter 17

6. Decreases and increases in aggregate de-mand are not well predicted. One cause is asubstantial change in the money supply.Other causes may be wars and changes inbeliefs about the security of property rightsin future investments or in beliefs about po-litical stability.

7. Resources become unemployed to the ex-tent that the decrease in aggregate demandis larger than expected or immediately de-tected.

8. After recessions and depressions the marketeconomy tends to return to full employmentof labor and other productive resources.

Questions1. The usual criterion of an unemployed person

is "not employed by someone else and activelylooking for a job." It says nothing about therange of jobs or wages he refuses to consider.What do you think the criterion implicitly as-sumes to avoid being completely useless?

*2. "A man who loses his job through no faultof his own should not have to bear the losses ofunemployment. The government must see to itthat he does not." This is a quotation from acampaign speech of a major candidate for gover-nor of California.

a. Is the candidate proposing that there beno unemployment or that anyone not cur-rently employed should be given an in-come equivalent to what he was formerlygetting?

b. How can either of these be accomplished?

3. Is a person who loses his job through no faultof his own also unemployed thereafter throughno fault of his own? Explain.

*4 "Unemployment is a wonderful privilege.Without it we would all be slaves to tyrants."

a. Can you interpret this "ridiculous" state-ment so as to make it not ridiculous?(Hint: There is no unemployment in themilitary. There is reputed to be none inRussia. Distinguish among the factorsthat shift demands, those that make jobinformation costly, and the losses of

wealth consequent to those demand shiftsand costliness of job information.)

b. Would you prefer to live in a communityin which unemployment is forbidden?Why? (Later we shall analyze ways of re-ducing unemployment without forbiddingit.)

5. a. What different kinds of unemployment(with respect to why unemploymentexists) do you think it is relevant todistinguish?

*b. Why?

6. Suppose the daily sales of each of 50 firmsare determined by a process simulated by theturn of a roulette wheel with numbers from 0through 30. Further, suppose that the firm willon the next day seek to hire as many employeesas the sales of the preceding day. Thus, if salesare 20 on the first day, the firm will seek to hire20 people on the second day-given the wages of$25 per person per day. If there were 50 firms,the number of employed people would be 50 X15 = 750 on the average.

a. Would that employment rate stay con-stant day after day despite the indepen-dent additive random process for deter-mining the number of employeesdemanded at that wage rate?

b.If those who were laid off by one employ-er took a day to select a new job, wouldthere always be some unemployed?

c. Would there always be some unfilled va-cancies?

d. Would the number of unemployed equalvacancies?

e. What would happen to the number of jobseekers and to the number of vacancies ifthe top five numbers on the roulettewheels were erased?

L What would happen if all the numbershad been increased by 5?

g. The change from day to day in the totalsof the 50 firms with an unaltered roulettewheel and the change when the roulettewheel is altered are two different kinds ofchanges. Which would correspond to acorrelated decrease in general aggregatemarket demand for goods?

*h. How quickly do you think a person would

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would detect a changed wheel, that is, ageneral demand change?

7. On the average, the cost increment of eachextra job investigated increases. Also, on the av-erage, the gain in wages from another job investi-gated diminishes. If these two propositions aretrue, then what must be the relation between theincrement of gain and the increment of cost inorder to conclude that it will pay to always takethe first job investigated?

8. Employment agencies charge about 50% to60% of one month's salary for their services t0T

jobs paying about $600 per month. For jobs pay-ing about $1000, the fee is one month's salary. If

. this is paid to the employment agency by theemployer, does it mean the employer bears thecosts? Do you think this fee is too large? Why?

9. Is the analysis of this chapter consistent withthe fact that unemployment among blacks ishigher than among whites? Does it explain thelevel of employment at "full employment" or themassive changes in the unemployment rate?

*10. When requesting a Congressional investi-gation into the methods, charges, and quality ofservices of private employment agencies, Mr.Abel, president of the United Steelworkers ofAmerica, said, "A man or woman should nothave to pay-often a large sum-for the privi-lege of obtaining a job." He also asserted that so-ciety and government had an obligation to makeit possible for "every willing and able individualto work at or near his highest skill." Evaluatethose remarks in the light of economic analysis.

*11. In deciding who is an unemployed person,would you consider the following:

a. Is he now working for someone else as anemployee? If his answer is "Yes," wouldyou classify him as unemployed or asemployed?

b. He answers "Yes" to the preceding ques-tion, but answers "No" to the question"Is your current job your usual kind ofwork?" He reports that he is working at aservice station, while looking for a job asa lathe operator. Would you change theclassification?

c. Next he is asked, "Are you willing to take


an available job as a lathe operator at awage of $5 an hour?" He answers, "No, Iused to work for $10 an hour and I'm anexperienced operator, not a novice." Isyour classification of him still the same?Why?

d. If you do not call him unemployed in thepreceding question, then how can you callanyone unemployed? For there are alwaysjobs available at some sufficiently lowwage-a wage he would call "ridiculous,""un-American,' or "below standard."

12. Almost every year someone proposes thatCongress enact legislation "to create more jobs."Of course, it doesn't create jobs, for there are al-ready too many jobs to do and the jobs it pre-sumes to create already exist as useful things todo. What is Congress really being asked to cre-ate by that legislation?

13. In almost every city and state during the re-cent energy flap people were told that unlessmore energy were conserved or made available,jobs could not be preserved. That statement is ofcourse incorrect. Jobs would in fact be increasedby a reduced supply of energy for there would bemore work for people to do! What do you sup-pose people meant, or should have meant, bysaying the jobs could not be preserved?

14. "A substantial number of relatively unskilledpersons reported that they cannot find work. Atthe same time, there are many unfilled jobsfor relatively skilled people. Apparently, theproblem is that there are more unskilled peoplethan unskilled jobs." What is wrong with thereasoning?

15. In feudal England there was no. unemploy-ment-only work and leisure. Employment forwages was rare. But the rise of the commercialsystem introduced markets for labor services andinduced peasants to break away from their feudalties and to sacrifice their feudal security for thehazards of private contractual employment andunemployment. By the sixteenth century em-ployment for money wages was well established(but maximum permissible wage rates were set

386 Chapter J 7

by government, and potential employers wereexhorted not to offer more and were punished ifcaught).

a. What devices do you think developed asa means of paying more than the maxi-mum-wage ceilings?

b. Why would the government have im-posed maximum limits to wages?

*16. America was founded partly on "slavery" ofwhite men. In early days immigrants "inden-tured" themselves, pledging to work for the ben-efit of a master for seven (or some specified num-ber of) years if the master would finance theirway to America. Today, this is illegal.

a. Why?b. Who gains and who loses if such con-

tracts are prohibited?

*17. "Automation is destroying 300,000 jobs amonth." Is destroying jobs socially good or bad?Explain why it does not mean that anyone willbe left without a job.

*18. The federal government is taxing and pay-ing for job retraining for those who lose a job.

a. Do you think it should provide an apart-ment renovation service for people whoseapartments become vacant?

b. What is the difference between the twoforms of aid?

19. What is the explanation for high unemploy-ment among male blacks, Puerto Ricans, andMexicans? (Do not answer "low education,""prejudice," or "immobility" because all ofthose would imply lower wages, not higherunemployment. )

*20.a. In your first job after college would yourather have (1) a lower wage with moreassurance of not being laid off during atransient recession in the first year-withan implied understanding on your partthat you will not leave until after a yeareven if you found a better job, or (2) ahigher wage with no such assurances?

b. Which preference would imply greaterunemployment for you?

c. Who is likely to prefer (1) and who (2)?

Chapter 18

The DOlDesticandPoliticalEconomfes

The NonmarketDomestic Economy

The dominant share of economic activity isconducted through market exchanges; thesecond-largest source is domestic activity inthe home. Domestic activity is also a form ofexchange in that husbands and wives agreeto do things for each other: They engage inspecialization and exchange of services. Butbecause the value of domestic services is gi-v-en no formal accounting, it is not called amarket transaction and is not included in for-mal measures of national income. If it were,what fraction of the total national incomewould it make up?

To make a rough estimate, merely askwhat it would cost if all the household activi-ty now done by family members withoutmoney payment were performed by employ-ees-cooks, cleaners, buyers, designers,nurses, educators, and so on. Most such workis performed by wives. And although no offi-cial agencies maintain an accounting of thevalue of that output, in the tragic circum-stances of the death of a young mother, esti-mates of losses are often made for the pur-pose of insurance or damages compensation.The resulting valuations in those cases areperhaps surprisingly high to those unaccus-tomed to thinking of domestic tasks as eco-nomic activity. One study used the methodof comparing the economic welfare of singlepersons and married couples with one spouseworking in the home: If a man and womanliving separately and each earning about$15,000 a year were to marry, and only onecontinued working for money income whilethe other worked in the home, the money in-come had to be only about $20,000 to enableboth to have the same economic welfare asbefore. Thus, for a two-person family with amoney income of about $20,000, the value ofthe household activity amounted to about$10,000 a year.

387

~

fI

III

1

I

If in each of the approximately 80 mil-lion U.S. households the domestic economicactivity were valued at only $10,000, thatwould amount to $800 billion. The 1982 u.s.net national income from market exchangesamounted to slightly over $3000 billion; add-ing the uncounted value of domestic activitybrings the total to almost $4 trillion. Non-market domestic activity makes up 20% ofour net national income, nearly twice aslarge a percentage as that of the largest mar-ket-oriented industry, manufacturing.

Why, then, is that enormous householdproduction, mostly by women and untaxed,largely overlooked in official measures anddefinitions of our "national income"? Be-cause national income is computed in orderto measure fluctuations in market activityand to estimate future tax proceeds. It is pre-sumed that although market-coordinated ac-tivity can undergo recessions, there is alwaysfull employment in household activity.

Measuring NationalIneome: Value-Added

National market-oriented output is not to beconfused with market sales of all goods andservices, because some goods are sold repeat-edly in the process of being transformed

. from raw materials to finished consumerproducts. Only the added values at each stepaccurately measure the income produced. Asimple example clarifies how .-the values ofsales and the value of national income are re-lated, and shows the forms in which that in-come is earned. Table 18-1 summarizes thetale.

Imagine that a mining firm sells someiron ore to a steel mill for $100. The miningfirm pays $70 of that price as wages and paysitself $20 in rent for the land and $5 as divi-dends and interest on the firm's investment.Additionally, $5 worth of shovels are wornout and must be replaced.

~1.'1 _~~

388 Chapter J 8

The $100 of iron ore sold to the steelmill is converted into steel, which is sold to atoolmaking firm for $200. The value addedby. the steel mill is $85. It paid $100 for thesteel: $70 for labor, $5 as interest and divi-dends, $10 for rent of the land, and $15 fortools worn out in the production process.

The steel purchased by the tool factoryfor $200 is turned into shovels and toolsworth $260, from which $40 is paid for labor,$5 for dividends and interest, $5 for rent, and$10 for equipment worn out.

As Table 18-1 shows, the payments ofwages, interest and dividends, and rent total$230. These payments go to individuals intheir capacity as income earners for theirhouseholds. Those earnings will be used forconsumption or investment. The total valueof the finished products sold to consumers is$260, but $30 worth of worn-out equipmenthas to be replaced from that final output, sothe net final product is $230. This sum is alsothe value of earnings by householders in theform of wages, interest and dividends, andrent. As the table shows, these payments rep-resent the value added at each stage. Pur-chases by one firm from another firm are notmeasured as value-added: Only the value bywhich the sale price exceeds the purchaseprice of the good from other firms is count-ed. (If the purchase price of the good fromthe firm were included in value-added, thatprice would be double-counted in the latersale of the products to the next firm.) Thesum of the sequence of values added is thenet total income of this community, or, inthe case of an entire economy, net nationalincome. The values added give a measure ofnational income derived from production,but are also the earnings of householders.

The major part of the economy, then,can be viewed essentially as operatingthrough firms producing goods and payingout earned incomes, which go to households.The-1981 U.S. Gross National Product(GNP) was about $3.3 trillion, and the netnational income (the GNP minus deprecia-

Table 18·1 VALUE-ADDED INCOME

Value ofProduction (in $) Earnings Values

Interest &Iron Mine Wages Rent Dividends Depreciation

Labor 70 Value- 70Rent 20 Added 20Interest & dividends 5 5Depreciation of

existing assets --2 5,

~, Gross value 100

Value of ore soldto steel mill

)! Purchased ore 100j' Labor 70 Value- 70

" Rent 10 Added 10I"If\ Interest & dividends 5 5

Depreciation ofexisting assets -1§ 15

f Gross value 200~;.,

Value of steel soldto tool factory

Purchased steel 200Labor 40 Value- 40

,(, Rent 5 Added 5,

Interest & dividends 5 5

!liDepreciation of

existing assets 10 J.QGross product 260 = 180 + 35 + 15 + 30Minus depreciation -30

~J,Net product 230 Net Income

Actual U.S. National income (1981)

U,S, Gross National Product- $3,3 trillionMinus Depreciation -0.3 trillion

~.

Net National Product $3.0 trilliony,;

Per Capita (population: 230 million) $13,000-or about $6/hr.

tion) was about $3 trillion. Thus, about 10%of the gross national product went to replacedepreciated resources used up in production.Figure 18-1 is a circular flow diagram show-ing how much of recorded national income

goes where; it also shows the government asa tax collector, spender, and producer. But itexcludes value of services produced in thehousehold and undetected transactions. (Re-cent estimates are that actual net national in-

The Domestic and Political Economies 389

iJ,'I:I:

i"

Ii1:'

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Expenditures Receipts

..

Personal Taxes $400

Corporate Profits Taxes $230

InterestPayments

TransferPayments

$190

Social Insurance Contribution $250

Indirect Business-Taxes $300

Gross NetNational NationalProduct Product National DisposableIncome

Personal

Income$2010

$3300 $3000 $2700

Interest Paidby Consumers $70

$480 Personal Saving $110

Gross InvestmentGross Saving

Corporate Saving $70

Personal Consumption Expenditures $1830

Capital ConsumptionAllowances $300

Figure 18-1.

FLOW OF INCOME AND EXPENDITURES(BILLIONS OFDOLLARS), 1981

Gross national product was $2500 billion in 1981 andcan be measured as the sum of consumptionexpenditures, federal and state government purchasesof goods and services, and gross investment, the latterincluding both gross private domestic investment andnet exports of goods and services. The differencebetween gross saving and gross investmentreflects primarily a government deficit.

SOURCE: U.S. Department of Commerce.

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come is about 20% larger than officially re-ported because of transactions that areconducted "underground," that is, unreport-ed to authorities-to avoid having to pay tax-es.) Figure 18-2 shows the historical path ofrecorded U.S. national income since the endof World War I.

Economic activity takes place within andamong three major components: the home,the market, and government. Total economicactivity conducted by federal, state, and localgovernments amounts to about lO% of thetotal with approximately 70% of the remain-der directed by markets and about 20% per-

1000

500 Billion

1.5 Trillion

1 Trillion

500

~IIIe.2 200 200 Billion

m.: $12,000•.....III 100 10,000...!! 9,000"0 70

8,000c 7,000 CD

6,000 s50 5,000 0

o

4,000 4,000 -=co..3,000 3,000

'is.coo•..

2,000 CD2,000 Q.

1920 1940 19501930 1960 1970 1980

Figure 18-2.

u.s. NATIONAL INCOME IN CURRENT DOLLARS ANDPER CAPITA PERSONAL INCOME IN 1980 DOLLARS

formed in households. (Other forms of orga-nizing economic activity, such as clubs,nonprofit groups, cooperatives, and the like,are minor and will not be investigated here.)Of the three components, market activity isthe most susceptible to economic analysis;the family (its formation, activities, and in-ternal controls) is susceptible to some eco-nomic analysis; and government economicactivity is the least susceptible to economicanalysis. That government economic behav-ior is less well understood than that of themarket economy does not of course implythat either of the two components is more orless desirable than the other. With that pro-vision, let us examine the role of governmentin the economy.

SOURCE: u.S. Statistical Abstract.


iI!

The Scopeof GovernmentEconomic Activity

Government is, by definition, the social in-stitution that monopolizes the use, or threatof the use, of physical force to control thebehavior of people. It also retains the exclu-sive power to print money, without which itwould not last long. The rights, behavior,and competitive actions that a governmentallows vary among nations. But without gov-ernment the state of society would be intol-erable, and there could be neither exchangeof private-property rights nor such rights.Because security against foreign and domes-tic aggressors is not adequately organized byprivate contracts, the military, the police,and the courts are essential. Furthermore, forsome resources the highest valued uses can-not be achieved by private-property rights.For example, air, water, and roads usually es-cape our ability to define and enforce pri-vate-property rights in their use. So othermeans are used-often control by govern-ments. Another role of government is the re-distributing of wealth. Government transferswealth from some people by explicit taxesand uses the proceeds to finance benefits toothers ..

In several socialist nations, for example,the Soviet Union and the People's Republicof China, the government controls and di-rects the use of resources that in the UnitedStates are guided by private-property andmarket values. In other nations the appor-tioning of control over the use of resourcesfalls somewhere in between. It is beyond thescope of economic analysis to attempt to as-sess the relative merits of the alternative sys-tems. And although virtually any activity isbeing done by some government agencysomewhere in the world, we don't have aclear enough understanding of the avenues ofaccess to government power and its use toexplain under what circumstances "this" ac-

392 Chapter 18

tion (for example, crop and price controls forsome agricultural producers, antitrust poli-cies, control of television programming, low-tuition state universities) or "that" action(for example, tuition grants to students, mili-tary draft, stock market regulations, publicgolf courses, social security) is more likely.We can explain a few things, but by andlarge the best we can do is simply describewhat is happening.

EXPENDITURES

The size of government dollar expendituresand revenues in the United States grew dra-matically through the first half of this centu-ry, when it reached 3570 to 4070, ofnational income. However, looking at thenumber of dollars spent mismeasures thegrowth of government. First, the inflationthat has occurred during the past decadesmakes recent expenditures larger in nominal,or dollar, terms than in purchasing power.Second, because the population has in-creased, the rate of per capita growth issmaller than the rate of total growth. Figure18-3 shows per capita real expenditures forall levels of U.S. government in the last 30years, measured in inflation-adjusted dollarsequivalent to 1981 prices. Since 1950 theshare of national income per capita spent byall governments has been nearly constant.

Each level of government-local, state,and federal-assumes certain responsibilitiesor shares them wi th one or both of the otherlevels in the United States. Education is pri-marily overseen by local and state govern-ments. Economic activity is regulated by alllevels of government, by restricting whatconsumers can buy or what producers can of-fer. In general, the more widely the benefitsor costs of an action are dispersed over thewhole nation, the more likely is the federalgovernment to be involved.

Governments do some things that themarket exchange of private-property rightscannot do adequately. The use of roads un-

$5000

Percent of Nationallncome--'- ~:::;,....----

4000

UlCD...;! 3000:ceCDQ.)(

WIII..'0.III 2000 ~---o

...•••••.......------ Expenditures Per Capita

..CDa.

1000

1950 1965 19801955 1960

der a market system would require a forbid-dingly complex system of planning, collec-tion, and enforcement devices. Instead,governments levy tolls or taxes that are actu-ally prices for use. A gasoline tax, or at leastpart of one, is a price for the use of thestreets; the amount collected, being propor-tionate to the amount of gasoline used, istherefore proportionate to the amount ofstreet use. For services that everyone re-ceives and that are not easily assigned, gener-al taxes may be charged, such as for nationaldefense, or, locally, for public library ser-VIces.

A tax that is really a price charged bythe government for services rendered is noteasily distinguished from a tax that suppliesrevenues for general use. However, if a tax,whether it is called that or a fee or a servicecharge, is determined by measurable use, it isa price. Nevertheless, it is an open question

1970 1975

Figure 18·3.

TOTAL EXPENDITURES BY ALL LEVELS OFGOVERNMENT IN THE UNITED STATES MEASURED ASDOLLARS PER CAPITA (ADJUSTED TO 1981 DOLLARS)AND AS PERCENT OF NATIONAL INCOME

SOURCE: U.S. Statistical Abstract.

50%

40

CDEoo30 .:iijeo:;::z-o

20 ~III..CCDU..CDa.

10

1985


whether the graduated income tax, for exam-ple, which taxes higher incomes at higherpercentages, constitutes a way of pricinggovernment services received by various tax-payers, or whether it is a result of politicalpower of the many to tax the few.

TAX REVENUES

Table 18-2 shows the source of governmentper capita tax revenues and the purposes for

Table 18-2

PER CAPITA REVENUES AND EXPENDITURES OF ALLLEVELS OF GOVERNMENT IN UNITED STATES (1982DOLLARS)

Total Revenue 1960 1970 1980Taxes 1880 2430 2740Utility and liquor 70 90 120Social security 300 400 900Miscellaneous 250 290 690Total $2500$3210$4450Total Expenditures

National defense 770 880 710Federal social security 250 370 950Interest 150 190 360Education 300 580 730Highways 150 170 160Public welfare 70 180 310Hospitals 60 100 140Health and sanitation 40 80 130Police 30 50 70Fire 20 20 30Natural resources 60 80 140Postal services 60 80 90Farm price supports 50 40 30Parks and recreation 10 20 40Housing, urban renewal 20 30 60Veterans service 60 60 60Administration 50 70 100Air, water, transport 30 40 40Utilities and liquor 60 100 170

I,,'Iill'V'-' ----------------------

"I!,: I.

;.;

Miscellaneous 260 160 250Total $2500$3300$4570

394 Chapter 18

which expenditures are made by all levels ofU.S. government, in 1982 dollars. The larg-est source of government revenue is the per-sonal income tax, levied usually againstmoney Income earned from market ex-changes, not against real, non money ~incomecreated domestically. For example, home-owners do not pay money rent for theirhousing space; the value of the housing ser-vice received is not taxed as income. But ifsomeone rents housing space and pays therent out of dividends received on corporationstock, the income used to pay the rent istaxed. Home ownership rather than rental isencouraged. Was that effect intended? Noone knows.

The personal income tax is a graduatedor progressive tax, meaning that the percent-age of tax on income increases as income in-creases. Why does the percentage of tax onmarginal incomes increase at higher in-comes? Several arguments have been ad-vanced, though no one can really know. Per-haps the rich, being few in number, wereoutvoted. Perhaps each successive marginaldollar is presumed to be less essential to therich person's welfare, making it "ethical" orfair that the rich pay more. Perhaps the richsave a larger percentage of income from con-sumption than others, so that to encouragespending and reduce saving and investingwe tax the rich more. Perhaps the rest of thetax structure is biased against the poorerpeople (taxes on liquor, gasoline, cigarettes,land, and all sales in general), and so the in-come tax is graduated upward to compen-sate. Or perhaps because the rich have morewealth, they have more to gain from govern-ment protection from foreign and domesticaggressors and, therefore, should pay highertaxes, even disproportionately higher. Takeyour pick: Any or all of these argumentsmight have been behind the progressive taxlaws.

Whatever its rationale, the graduated in-come tax is known by analysis and evidenceto reduce the incentive to work, reduce the

savings available for investment, and encour-age more use of non market income. As indi-cated earlier, there is evidence that as muchas 20% of national income is hidden by non-market or underground market activity (inwhich goods are exchanged by barter, or cashis used instead of checking accounts, whichcan be traced).

In addition to the personal income tax,other major taxes are social security contri-butions, property (primarily land and build-ings) taxes, the corporation income tax, and(as will be explained in the next chapter) aninflation tax on money. It is worth exploringat this point what are the effects of the cor-poration income tax. Recalling the earlieranalysis of what business firms are, it is evi-dent that a corporation tax is a tax on thecorporate form of organization. Whosewealth is lowered by the amount of the cor-poration tax? That is a very difficult ques-tion. The tax may be shifted to consumers,if the number of corporations can be affect-ed, just as the tax on playing cards wouldbe virtually all shifted to consumers of play-ing cards, if the supply curve of playingcards were virtually horizontal. The samemay be true for the supply of the corpora-tion form of business. But, of course, if acorporation tax were raised or newly im-posed, existing corporations would losewealth, just as did the resources specializedto making playing cards in Chapter 10. Butbecause corporations are contractual rela-tions among resource owners, the criticalquestion is: Which owners of which re-sources in the corporations would losewealth? The answer is the owners of assetsthat cannot readily be shifted into doingbusiness under some noncorporate arrange-ment, resources which probably include alarge portion of the existing physical assetsof a corporation. But after all is said anddone, the available information and evi-dence as to whose wealth is reduced by thecorporation tax is still insufficient to war-rant firm conclusions.

Federal taxes are different from stateand local taxes, usually for a simple reason. Atax will get no proceeds if people can moveaway or can easily abandon the taxed activi-ty. A tax on the income of people living on acertain street is easily avoided by moving toa different street. Similarly, a tax on the val-ue of any resource or action can be escapedby moving it to a different government juris-diction. But an immobile resource is a primetarget for taxation. Hence localities (citiesand counties) can effectively tax land andbuilding values.

Because federal taxes on incomes cannotbe escaped by moving to another state, butstate taxes can be, state income taxes aresmaller than federal ones and slower to de-velop. Only when all the several neighboringjurisdictions impose the same or very similartaxes can flight be avoided. Taxes on corpo-rations are federal taxes, because a corpora-tion can readily move its place of business orheadquarters while selling nationwide. Thecorrelation between the size of a tax and theinability to escape it, though not perfect, issubstantial and helps explain many featuresof the tax structure.

Because local taxes can be avoided bymoving, the federal government practicesrevenue sharing: It levies taxes nationwideand allocates some of the proceeds to localand state governments. However, in so doing,federal government officials also tend to telllocal recipients how to spend the money. Andif a local government forsakes the funds byrefusing to follow the federal directives, it isthrowing away an essentially costless gift, be-cause the refusal doesn't reduce the taxes onits own constituents. Thus, the cost-benefitcalculations of local groups in determininghow much they should be taxed for localbenefits is increasingly subjected to federalgovernment decisions. But that usurpation oflocal autonomy is not entirely unintended,for, by using the overriding power derivedfrom its broader jurisdiction, the federal gov-


60

50

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:11

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50

40

30

20

10

o 019001910 1920 1930 1940 1950 1960 1970 1980If,

Figure 18·4.

GROWTH IN NUMBER OF U,S, FEDERAL REGULATORYAGENCIES

SOURCE: Economic Report of the President, 1982,

60

ernment can penalize a local region that re-fuses to heed the damage it does to other ar-eas, such as by its overuse of water or air orby its skimping on welfare aid.

40

REGULATION OFECONOMIC BEHAVIOR

30

Although government provides national se-curity, protects life and property, and facili-tates valuable uses of some resources, gov-ernment power has also been used tosuppress the operation of competition in themarketplace (as several instances examinedin this book have shown) by imposing con-trived restrictions on entry. But because gov-ernment is complex in its formal structureand diverse in its sources of political power,its actions are often inconsistent: One branchor agency of government will prevent privaterestraints that would reduce competition inthe market while another is imposing legalrestraints to reduce competition. There is novalidated theory to explain when govern-ment is more likely to prevent or to imposerestraints on competition. All we know isthat both occur.

The economic effect of legislation andregulation of economic activity need not bestrongly correlated with the amount of mon-ey spent. Some regulations can be cheap toenforce but strong in their effects on eco-nomic activity. For example, various regula-tory agencies with combined expenditures of$5 billion have imposed on business and in-dustry a cost of complying estimated to beover $100 billion. Thus, one measure of theU.S. government's role in the economy is thegrowing number of regulatory agencies (seeFigure 18-4). Whereas in 1970 there was oneregulatory agency employee for every 2500people, there is now one for every 800 peo-ple, or over three times as many per capita.N ei ther the reasons for such growth northeir consequences have been well identi-fied.

20

10

o-f

Public Goodsand Government Action

In 'Chapter 5 a public good was defined asany good the use of which by one persondoes not reduce the amount of the good si-multaneously available for some other per-sons. The several users are not "rivals" foruse of the good. This characteristic becomesimportant to the degree in which it is diffi-cult to measure each user's value of its useand to exclude nonpaying users. Not know-ing the user's value makes it difficult toknow how much of the good is worth pro-ducing and to collect funds to cover the pro-duction costs.

If we know those values, how much ofthe public good should be produced? Ideally(as explained in Chapter 5), simply add upthe marginal personal use values of all usersat the amount available. The sum is the to-tal marginal use value. For example, say atelevision station has three potential view-ers, valuing the marginal program respec-tively at $5, $3, and $2. The total marginaluse value is $10. The television programshould be produced if the cost is less than$10. A private producer who could collectfrom only one or two of the viewers wouldtend not to produce the "right" amount. Forthis reason, it is often argued that one pur-pose of organized group action-whether byprivate clubs (for the use, say, of swimmingpools or computers) or by government agen-cies-is to overcome the undervaluation ofgoods with public-goods characteristics.These goods are said to include, for exam-ple, national defense, parks, public health,and sanitation. Because many goods containsome number of the characteristics of a pub-lic good, there are no clear-cut guidelines forsaying that government ought to do this ornot do that. Thus, it is not known howmuch public debate about what governmentshould do reflects a genuine concern thatpublic goods be properly valued by their us-ers and how much it conceals a desire to get

public subsidies for one's own interest.Because many goods with the character-

istics of a public good are produced by theprivate sector-television and inventions, forexample-a variet.y of institutions have de-veloped to help measure user values and ex-clude nonpayers. So, it has been argued, gov-ernments should use their tax power to forceusers to pay. National defense has character-istics of a public good. So also have ideas-hence patents and copyrights to try to reducefree riding. But enforcement is extremely djf-ficult: People who buy books can lend themto others, and people who buy computer soft-ware let other people copy the programswithout paying the designer.

REDISTRIBUTION OF WEALTH

A major government activity is redistributingwealth and income. Some government ac-tions are designed to enable some people topay for services they could not otherwise ob-tain so cheaply through private contractualarrangements-for example, nearby publicparks, better roads, sewers, police protection,sanitation, and protection from disease, insectpests, and fire. Other government actions aredesigned to transfer wealth from some peopleto others. When all such government wealth-transferring activities are considered, it ishighly debatable whether the net transfer isfrom the rich to the poor, as is usually be-lieved to be the case. It may be that wealth istransferred from only some of those peoplewho happen to be rich, and it is transferred toothers who happen to be poor, not becausethey are poor, but rather because of someparticular feature. For example, is a collegeeducation at a state university with below-cost tuition a device to aid the poor at theexpense of the rich? Or is it a device to aidsmart youngsters (most of whom are poorernow only in current income) at the expenseof others, some of whom went to college butmost of whom did not?


Not all government redistribution ofwealth is meant to aid the poor. For exam-ple, tariffs and restrictions on internationaltrade often hurt rather than aid the poor byraising their costs of goods while aiding high-er-income people working in the protectedindustries. Also, by creating monopolies toget monopoly profits, the government cancollect either by operating the monopoliesdirectly (as with liquor stores in some states)or by taxing the monopoly rents obtained byprotected, privately operated monopolies(electric, gas, water and transportation). It isnot known how much of such redistributionis for some social goal and how much is sim-ply the result of the way political pressuresaffect decisions. For example, some may ar-gue that it is clear "social policy" to redis-tribute wealth. Others have contended thatthe growth of specialization in earning in-comes has divided the population into manysmall, special-interest groups, who have dif-ferentiated, concentrated sources of incomeand thus strong incentives to coalesce politi-cally, to more effectively protect or enhancethose incomes. But the evidence is mixedand incomplete.

1

: :!jl

I r I

I i I

: ~ I

Government asan Economic Stabilizer

You may wonder why we have not appliedour analysis to the compelling question ofwhether government activities can stabilizethe national economy or alleviate recessions.This topic, though very popular, containsmore conjecture, unfounded allegations, goodintentions, and sheer hope than valid eco-nomic analysis. It is highly controversial-meaning no good evidence is available-whether government actions have done moregood in cases where they successfully allevi-ated recessions than harm in those caseswhere they exacerbated recessions. Some ob-servers and economists argue that by judi-

398 Chapter 18

cious use of fiscal policy-taxes, expendi-tures, and special benefits to business andthe unemployed-recessions have been alle-viated, and in some cases they have. Othersargue with just as much conviction and evi-dence that government action is riddled withpolitics and self-serving objectives which in-tensify fluctuations and hinder growth. Allcan cite examples from history to supporttheir claims, but such examples do not con-stitute reliable, unbiased evidence withwhich to test some proposition or theory.Perhaps these contradictory claims are equal-ly correct: Government actions have some-times alleviated recessions and have some-times surely deepened or prolonged them.

GOVERNMENT DEFICIT

An excess of government expenditures overtax revenues is called a fiscal deficit, or sim-ply a deficit (an excess of tax revenues overexpenditures is a surplus). In 1982 the U.S.federal government's deficit was predicted tobe $100 billion, though no one can makethese predictions with great accuracy. Whathappens if there is a deficit? The govern-ment can sell some of its assets, just as youmight sell your second car if your expendi-tures exceeded your income-unless youcould borrow from someone else who wouldthen be spending less while you spend more.That may be worthwhile if the expenditureis, say, an investment in greater future in-come out of which you can repay the loanprincipal and interest. Or you may considerpresent consumption worth more than thefuture debt and interest repayment. Just asyou or a business firm may borrow either forcurrent consumption or for investment thatincreases future income, so may a govern-ment. Governments may borrow to financeinvestment in roads, public sanitation, andeducation-worthwhile services not readilysalable in a market.

As old investments payoff, the loans are

repaid largely out of the future income-thesigns of a productive, prosperous, growingeconomy. So why all the fuss about budgetdeficits? If the expenditure is worthwhile, itshould be made, whether financed by currenttaxes or by future taxes to repay borrowing.Only if the expenditure is not worthwhile isthe deficit economically undesirable. But it isthe expenditure, not the deficit, that is unde-sirable.

Notice we asked whether governmentexpenditures are worthwhile, not "worthmore in market values." Why? Because thevalues of many activities are not measured inmarketable prices offered by customers.Hence we used the ambiguous word "worth-while." How are government actions evaluat-ed and selected as being "worthwhile," giventhe costs? We don't know, but our not know-ing doesn't mean that the process is inferiorto how the private sector evaluates actions.

One source of complaint about a gov-ernment deficit (aside from the key questionof whether the expenditures are worthwhile)is the fear that higher interest rates willmake it more expensive for some people toborrow, say, to build homes or factories, orbuy new cars. They object to competitionfor loanable funds. But that self-serving ar-gument is not a valid one against govern-ment expenditures on worthwhile projectsand services that are financed in part by bor-rowing rather than by current taxation. Still,it may be that interest rates won't rise verymuch anyway, for two reasons. First, onemust look at the total world demand for bor-rowing-by all foreign and domestic privatefirms and governments-because the U.S.government borrows funds in a capital mar-ket that is worldwide. It is difficult to esti-mate how much a larger U.S. governmentdeficit would raise interest rates in the worldcapital markets.

Second (and this initially comes as a sur-prise to many people), if the governmentborrows more to spend more, that borrowingmay simply be the substitute for public bor-

rowing to pay increased taxes. For example,if the government spends an additional $1billion, it must either tax or borrow (settingaside the idea of printing more money). Iftaxed, citizens wiH, in arranging to pay theextra money, borrow more than they other-wise would. The two effects may exactlymatch each other, so that it makes no differ-ence whether the government borrows ortaxes, given that the $1 billion is going to bespent in either case. But if one heeds onlywhat the media says in its political-economicreporting, you would think it is the deficit,rather than the size of government expendi-tures, that counts.

From still another perspective, the pri-vate citizen may regard the public debt as anobligation on future tax payments, in thesame way as one views private debt. Whenfinancing a new car, one would regard thedebt as a liability and the car as an asset. Ifthe government borrows, then each citizenhas both an increased liability to pay thatdebt and an asset in whatever the govern-ment bought with the expenditures. If theexpenditures went for consumption, the re-payment cannot be made from any earningsof an asset, exactly as if a private party bor-rowed for a vacation at Las Vegas. But if thegovernment used the expenditures for a pro-ductive investment, the investment wouldhelp pay the future debt. Obviously, whatcounts is not whether the government bud-get is balanced-that is, with no deficit-buthow much is spent and for what. Unfortu-nately, no extensive research studies havebeen conducted on this particular issue tomeasure to what extent one expenditure dis-places the other. For the present, one shouldbe very hesitant to jump to the conclusionthat the amount of the deficit, rather thanthe size of government expenditures and forwhat they are made, is what affects the inter-est rate and the public welfare-a leap of log-ic that is often made in media reporting ofeconomic affairs.


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GOVERNMENT DEBT

The outstanding debt of the U.S. govern-ment reflects both present deficits and thecumulative, unrepaid portions of past defi-cits. When adjusted for inflation that debt,measured per capita, has been nearly con-stant since about 1950. If everyone held anamount of the debt equal to his or her latentfuture tax obligations, canceling the debtwould result in one claim merely offsettingthe other. Of course, that is not the actualsituation; so increasing the debt increases theamount of interest to be paid each year, post-poning the dispute over what taxes to im-pose on whom.

Were the government activities fi-nanced by borrowing worthwhile? Presum-ably so, or why would Congress have author-ized the expenditures? We are back to thewall. Without a valid, useful theory of gov-ernmental behavior, each of you can haveyour own opinion, which you may share withyour political science instructor if you wish.

But perhaps we have overlooked an im-portant reason for concern. Suppose the fed-eral government did what you might do ifyou had in your basement a secret moneymachine that printed authentic $100 bills-which you could spend without anyone evercatching on. Heavenly! You, too, wouldprobably run deficits every year and printmoney rather than sell assets, borrow, orwork to earn income. It is a fact that practi-cally every national government (we know ofno exceptions) has such a machine and usesit to cover much of its deficit, which bringsus to the topic of the next chapter: inflation.

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SummaryI. The domestic economy makes up about

20')10 of the total national income, though itis not counted or reported in measures of na-tional income. Governments account forabout 10%, and the market economy forabout 70%.

400 Chapter 18

2. National income is the sum of all the valueadded in all productive enterprises.

3. Expenditures and receipts of all levels ofgovernment in the United States total to anamount that is between 35% and 40% ofthe national income. However, because alarge proportion of those receipts and expen-ditures transfers incomes from one person toanother, the net value added to national in-come approximates about 10% of that 10-

come.

4. Government, the institution that monopo-lizes the use of force to set rules and estab-lish rights, also retains the exclusive powerto print money.

5. Governments typically transfer wealth fromone group to another, and provide servicesfrom resources that are inadequately provid-ed by private-property rights as well as con-trol over such resources.

6. Taxes can be not only a means of transfer-ring wealth but also substitutes for prices onservices provided by governments. In theUnited States, the principal federal taxes arethe graduated personal income tax, the cor-poration income tax, the social security tax,and several excise taxes on particular goods.The principal state taxes are income andsales taxes. The principal local taxes areland and sales taxes.

7. Governments are a major provider of publicgoods.

8. The U.S. government, on average, redistrib-utes wealth from the richer to the poorer.

9. Government stabilization of the economyby the separate or combined use of fiscaland monetary policies is a generally accept-ed goal. But evidence as to the results ofsuch policies is unclear and controversial, al-lowing the inference that they have wors-ened as many situations as they have im-proved. The truth remains undetected.

10. The effects of government deficits should bedistinguished from the effects of (a) greaterexpenditures (regardless of whether there isa deficit) and from the effects of financing a

deficit by (b) creating new money versus (c)borrowing. Economic analysis suggests thatinterest rates and economic growth aremuch more affected by the size and purposeof expenditures than by the size of deficit.

questions1. A 10% value added tax could be equivalent

to a 10% tax on personal income. Explain.

2. a. Would a tax levied on every transactionbetween firms be equivalent to an incometax?

b. What effect would such a tax have on theorganization of firms?

3. If a firm sells its products for a price that ismore than the cost of materials and labor used, isthat excess a profit or a part of value added?

4. "A higher income tax reduces the incentiveto work." Evaluate this statement by distinguish-ing between the average tax and the marginaltax.

5. Your city has a special election to raise taxesto raise police officers' salaries and to increasethe size of the police force. Why would somepeople who advocated higher salaries and a larg-er police force, which they agree would costmore, oppose higher taxes to cover those costs?(Hint: Money is fungible.)

6. If all tax proceeds go into a general govern-ment fund, can it be said that taxes levied forsome purpose are being used for that purpose-for example, that gasoline taxes pay for, say,roads rather than for, say, welfare? What kind ofdata would persuade you that taxes are in factbeing assigned to their nominal purposes?

7. If people compare their current net, or aftertax, incomes with those of many years ago, wouldmost people conclude that their incomes haverisen or fallen?

8. The city of Las Vegas once proposed toabolish its land tax and substitute a tax on salesof goods and services within the city limits. Op-ponents argued that changing the type of taxwould have little or no influence on who boretaxes. Suggest an analysis that supports the oppo-sition argument.

9. Should an increase in taxes that are levied topay for services rendered to the public be consid-ered an increase in the cost of living?

10. To cover the transitory imbalance betweensocial security revenue and expenditures for thenext few years two economists have proposed thefederal government sell the national forests toprivate parties who the economists contend willmanage the forests better. Assuming the amountcollected would cover the transitional deficit,what premises do you think the economists areusing in arguing that private ownership would bebeneficial? Aside from that feature, would hesale be a way of covering that transitional deficitwithout an increase in taxes? If so, how does it doso? If not, why does it not avoid being a tax?

11. Congress passes a law that reduces taxes,thus leaving people with more spendable in-come. Would the fact that the tax reduction iseffective a year from passage rather than imme-diately make any difference on people's currentconsumption expenditures? Why?

12. "The agency claiming to be the effectivegovernment in a social system must have a mo-nopoly in the use of physical force and in theability to print money." True or false?

* 13. Suppose you succeed in leading an army of"liberation." Upon taking office as dictator, youabolish all existing monopoly rights.

a. Would you then grant new monopolyrights?

b. If you did, how would that benefit thegovernment (you)?

c. If you didn't think of granting such rights,who would suggest that you do?

14. "An official Defense Department study re-ported that the elimination of the draft by raisingwages to enlistees would cost about $5-$15 bil-lion annually. Therefore the Defense Depart-ment in view of that prohibitive cost is recom-mending continuance of the draft." (News itemfrom New York Times, June 1966.)

a. Explain why the first sentence is an incor-rect assertion.

b. Would you be willing to assert that rais-ing wages to abolish the draft would re-duce costs? Why?


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InAation, like death and taxes, appears ines-capable. What is inAation? Why does it occur?What are its effects? Can they be avoided?

What Is Inflation?

Chapter 19Inflation

Inflation is a rise in the cost of living result-ing from a persisting rise in all money prices.Note the three words italicized and considerthem in reverse order. It is prices expressedin money that have risen. Early in our analy-sis we emphasized the relativity of all moneyprices; but with inflation, even if all moneyprices doubled, no relative prices would havechanged: Only the dollar, or nominal, priceshave risen.

Inflation affects all money prices to thesame extent. Therefore, if some prices dorise more than others, other forces are shift-ing relative demands and supplies so that rel-ative prices are shifting, as they would haveeven without inflation (Figure 19-1 shows anexample). Finally, inflation is a persisting risein all money prices: It is not a single jump inprices. The reason for making this distinc-tion will be explained later.

The rate of inflation is not easily meas-ured. If the dollar prices of gas, sugar, andshoes rise, while those of computers, televi-sion sets, and fruit fall, the lower prices tendto offset the higher. People substitute someof the lower-priced goods for some of thehigher-priced ones. But we don't know justhow much of such substitution would leavepeople as well off as before: We don't knowthe new combination that is equally desir-able; so we can't compute its dollar cost. Andchanges in quality add more difficulties: Ifpeople switch from black-and-white to colortelevision at three times the price (whileblack-and-white- TV prices do not change),is it the cost of living or the quality of livingthat has risen?

Can we never know, then, whether infla-tion has occurred? A clue is provided by the

403

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With 10 Percent Inflation

1

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Computer Specialist +20%

/- Av.,.g. Wag. In••ease +10%

"~"'------"college Professor 0%: ' 1980 1981

With Zero Inflation

f

:

Compute' Specl.llst +10%..r------=.- Average Wage 0%

College Professor -10%19811980

Figure 19·1.

EFFECT OF INFLATION ON SPREAD OF WAGES ANDPRICES

During inflation the college professor's wages appear tolag. But if there had been no inflation the professor'swages would have decreased 10%, because ofshifts in relative demands and supplies ofvarious skills.

:1Ii'~"'11------------------

I 404 Chapter 19

change in the total money price of a particu-lar fixed combination of consumer goods(sometimes called a consumer basket ofgoods). This method of detecting inflation isbased on the assumption that changes inquality and substitution among goods havesignificantly less effect on prices than infla-tion has. The U.S. Bureau of Labor Statisticspublishes a monthly Consumer Price Index(CPI) as an approximation to month-to-month changes in the dollar price of a partic-ular basket of goods for average-income peo-ple. Figure 19-2 shows the course of such anindex over the past 160 years.

We have just seen three factors that af-fect the accuracy of the figures: First, thenumber of goods in the sample basket is farfrom a complete inventory of the economy'sgoods; second, there may be changes in qual-ities of goods; third, people may make substi-tutions toward more lower-priced goods. Al-lowing for these effects on that fixedcombination of consumer goods, a rise of 2%to 3% in the CPI over one year does not nec-essarily mean that the cost of living haschanged. Failing to allow for substitution andquality changes creates an upward bias in theestimate. However, an increase of some 9070within a few years, as happened in the Unit-ed States from 1941 to 1947, or 100%, ashappened from 1968 to 1980, probably is nota measurement defect caused by samplingbias, substitution, or quality changes. Majorrises and falls in that index are taken to beuseful indicators of inflation and deflation.'

An alternative index that reflects a larg-er range of goods and a wider class of con-sumers is the national income deflator, alsocomputed by the U.S. Department of Com-merce. It has usually given a less extremerate of inflation than the CPI. Until late

lA major defect of the index is its omission ofprices of capital goods (it primarily covers prices of cur-rent services). The severity of bias or degree of errorresulting from this omission has not yet been deter-mined. Nevertheless, the conventional, though incom-plete, measure is commonly cited.

1982, the national income deflator differedfrom the CPI by not figuring house pricesand interest costs as if people were borrow-ing to buy new houses every year rather thanpaying a rent (including an implicit rent ifthe house was owner-occupied). Because theCPI included these two components until1982, a rise in either interest rates or housingprices caused the index to indicate an exag-gerated inflation rate. (If interest rates fell,the CPI would exaggerate the fall.) For ex-ample, in 1980, when interest rates increasedsignificantly, the CPI showed an annual in-flation rate of about 15<70' whereas the na-tional income deflator showed one of about10% (an atypically large difference betweenthe two indexes). This built-in exaggerationwas of benefit to people whose incomes areindexed to the CPI, such as social securityrecipients (who got about $7 billion toomuch in 1980 because of that difference) andunion workers whose wage contracts are tiedto the CPI. Furthermore, both indices stillfail to allow for the fact that any tax on agood, which raises its price, would suggestinflation, whereas a tax on income would notappear as a higher "price level." These de-fects and their consequences have long beenpublicized by the people responsible forcomputing the CPI and the national incomedeflator, but correction has been hindered bya tug of war among the affected parties inCongress.

Inflation rates in many other countrieshave been more pronounced and spectacularthan in the United States, as Table 19-1shows for the years 1963 through 1981.

What Causes Inflation?Inflation occurs either when the stock ofmoney increases more than the supply ofother goods or when the quantity of goods isreduced without an equivalent reduction inthe money supply; in either event the supplyof money exceeds the amount that people

400300250

co 200-t 18001 160••. 140.£ 120

~ 100~ 80'ia: 60'i~ 50

...J 40G)(,)

.;: 30a..

World War II

Civil War

World War I

20 201810 30 50 70 901910 30 50 70 1980

Years

Figure 19.2.

CONSUMER PRICE INDEX, 1820-1982 (1948=100)

SOURCE: U.S. Department of Labor, Monthly Bulletin.

400300250200180160140120100

80

605040

30

Inflation 405

want to hold at existing prices. If each of usawoke today with twice as much money asyesterday and no less of any other goods andservices, we would spend some of the newmoney for other goods to reduce the exces-sive proportion of our wealth held as money.The demand expressed for goods would goup, but that would not reduce the total hold-ing of money, because spending merelytransfers money from one person to another.Instead, prices-and wages-would be "driv-en," "pushed," "pulled," or "bid" up, andwe'd find ourselves wealthier and with moreincome measured in dollar terms. On the av-erage, wealth and income in money termswould be about twice as high as they were,because only then would we want to holdthat doubled amount of money. (All firmsand families in the United States on averagehold money equivalent to about three or fourmonths' income.)

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We said that for inflation to occur, achange in the ratio of money to the supply ofother goods is necessary. Thus, if the stock ofother goods were reduced but the stock ofmoney were unchanged, money prices wouldrise. A natural disaster, such as a drought ora flood, reduces other goods without chang-ing holdings of money. With no less moneybut fewer other goods, people will spendsome of their money in an attempt to replen-ish stocks of other goods. Because someoneelse receives what one person spends, priceswill be bid up as people try to get more ofthe smaller supply of other goods. Reducingthe stock of other goods, then, is equivalentto increasing the amount of money relativeto the supply of other goods; either way, in-flation follows.

A significant jump in prices occurredduring the Black Death (probably bubonicplague) in England in the fourteenth century.

Table 19·1 ANNUAL PERCENTAGE RATES OF INFLATION BY COUNTRY, 1963-81

Nether- West United United Switzer-Year Canada Mexico lands Germany Japan States Brazil Kingdom Belgium Italy Sweden Spain France land

1963 2 1 5 3 4 2 3 2 9 2 7 6 4

1964 2 1 6 2 4 2 2 4 6 4 11 4 6

1965 4 7 6 3 4 1 25 4 6 4 6 11 2 4

1966 4 4 4 3 4 4 40 4 6 2 6 8 3 2

1967 4 4 6 1 5 3 35 2 2 4 5 8 2 5

1968 4 2 4 1 4 6 28 4 2 1 2 5 5 6

1969 4 4 6 3 4 6 21 6 2 4 2 4 7 4

1970 5 4 5 8 6 4 18 8 5 10 9 5 8 5

1971 4 4 9 8 6 4 17 10 5 8 7 7 7 9

1972 5 6 11 6 6 4 17 10 6 7 7 9 6 10

1973 5 11 9 6 12 6 20 7 6 12 7 11 7 8

1974 12 12 9 6 20 9 31 14 7 20 11 16 11 7

1975 10 16 11 6 8 10 33 28 13 18 11 16 13 8

1976 8 12 9 3 6 6 42 14 8 18 11 17 10 3

1977 6 13 6 4 4 6 45 13 7 16 9 22 9 1

1978 6 12 4 4 5 7 45 10 4 15 10 21 10 4

1979 11 12 6 4 8 8 55 17 4 13 7 16 10 4

1980 11 13 7 5 5 9 100 11 7 18 14 16 13 6

1981 12 15 7 6 3 8 110 11 8 17 9 15 14 5

A substantial percentage of the populationdied, but the money supply remained un-changed. Wage rates rose spectacularly, asdid the prices of other goods, although notnearly as much, because their supply had notdecreased as much as the supply of labor had.Survivors got substantial per capita increasesin real income, not as a result of inflation butbecause the population was so reduced rela-tive to the supply of goods. In this case, infla-tion caused by the decrease in population rel-ative to the unchanged stocks of money andother goods was accompanied by a rise in liv-ing standards for the survivors.

At other times crop failures have left so-cieties with less to eat but no less money.The increased ratio of money to goods result-ed in a rise of prices on average, with thegreatest rise in food prices. These decreasesin real per capita wealth have been called aneffect of inflation rather than a cause. Moreprecisely, higher prices were the result, notthe cause, of a reduced supply of other re-sources relative to the existing amount ofmoney.

If the stock of money increases at aboutthe same rate as the stock of other goods, in-flation is not likely. If the money stock in-creases more rapidly than the normal growthrate of other goods and population (about3% per year), inflation occurs. If the growthof output temporarily falls below the normalrate while the money stock continues togrow at that rate, a temporary rise in priceswill occur.

But if the money stock persistentlygrows at a rate substantially higher than therate at which the output of other goods andthe population increase, inflation will contin-ue. From 1965 to 1980 the money stock per-sistently grew faster than other output; notsurprisingly, inflation resulted.

Though many other factors can affectthe price level, they rarely induce a persist-ingly rising price level. In all countries in theperiod 1948-80, the average annual rates ofpersisting increase in the quantity of money

are strongly correlated with increases inprices. The correlation would be even moreimpressive if we included inflations of thekind that occurred in Germany in 1923,when prices rose b¥ a factor of about 100 bil-lion in one year, while the amount of moneyincreased by a factor of 10 billion. This isequivalent to a doubling of prices every twoweeks. Similar episodes occurred in Greecein 1944, in Poland in 1923, in Russia in 1921-23, and in Hungary in 1923 and again in1946, when prices doubled on average eve~ytwo or three days.

INCREASING THE STOCK OF MONEY

Never has inflation lasted several years un-less there has been a persisting increase inthe money stock relative to other goods, andnever has the money stock increased withoutan inflation following, as has been happeningin all nations in the last decade. But how andwhy does the money stock increase so rapid-ly?

The answer is that governments printand issue money more rapidly than other out-put grows. But why? It is politically easier toprint money to spend than to explicitly levysufficient taxes to balance government bud-gets. See Table 19-2. Inflation occurs onlybecause of the last item in the table: creatingnew money. Changes in any other item couldbe offset by changes in still others, leavingthe amount of newly created money un-

Table 19·2

THE RELATION OF NEW MONEY TO FEDERALEXPENDITURES AND TAXES, 1981 ($ BILLION)

Expenditures (E) $675Tax collection (T)Deficit (0)

Financed by borrowing oldmoney from the public (8) $35Creating new money (M)

$45

Inflation 407

changed. For example, reducing governmentexpenditures by $25 billion, to $650 billion,while borrowing only $10 billion of old mon-ey from the public, would still require that$10 billion of new money be created, whichis just as inflationary as when $675 billionwas spent. Watch the last item, M:

E - T - B = M = 675 - 630 - 35 =10, or

D - B = M = 45 - 35 = 10.The long sweep of history shows that in

virtually every country governments have fi-nanced expenditures by creating money at arate exceeding the nation's growth of output.We now give a general description of thisprocess for the United States.

Our coins are minted and our papermoney (called Federal Reserve Notes) print-ed by the U.S. Treasury and delivered toFederal Reserve Banks, its banking agents.The Board of Governors of the Federal Re-serve is authorized by Congress to spend thenewly created money to buy governmentbonds-that is, to lend the money to the U.S.Treasury. Though legally independent of theU.S. government, the Federal Reserve Banksare responsive to it. (Unless the Federal Re-serve Banks buy U.S. bonds when the presi-dent and Congress "advise," new officialswill very likely soon be managing thosebanks.) So when U.S. Treasury administra-tors decide to sell some new bonds (borrowmoney) to finance the government deficit,the Federal Reserve Banks typically buysome of the new U.S. bondswith new mon-ey, which is then spent by the government.

Though the institutional details are com-plex, in essence, the Federal Reserve Banksystem issues new money when it lends tothe U.S. government in exchange for somepromissory notes (U.S. bonds). Of course,those bonds are rarely repaid; when due theyare renewed-exchanged for new bonds. Theissued money stays in the hands of the public(worn-out bills are exchanged for crispy newones).

408 Chapter 19

In some other countries the governmentacts as its own central bank and simply printsand issues new money. That is the main taskof a central bank. But in the United States,for political reasons that are of more histori-cal than economic relevance, the process ismore roundabout and involves monetizinggovernment debt by the U.S. Federal Re-serve Bank (the "Fed"), which acts as thecentral bank for the U.S. government.

Thus, financing a government deficit bycreating money causes inflation. Note thatthe federal deficit is not itself a cause of in-flation, because it doesn't have to be fi-nanced by the creation of new money. TheFederal Reserve could refuse to buy the U.S.bonds from the Treasury and force the gov-ernment to sell them to the public for al-ready existing money. No new money wouldbe created and no inflation would result, aswas demonstrated in years when the Fed didnot create new money to finance the deficitand no inflation occurred.

So it is not the existence or size of thegovernment deficit that determines the stockof money or causes inflation. Nor is it thesize of total government expenditures, or thesize of government, or reductions in taxes. Inpractice, however, for political reasons, larg-er government expenditures or reduced taxeswill lead to an increased deficit that will al-most surely be financed by creating morenew money, thereby producing inflation.

Though the preceding has referred tomoney as if it were all paper money, it alsoconsists of coins and checking accounts.Checking accounts are called demand depos-its, because checks are payable by your com-mercial bank on demand. (In 1982 checkingaccount balances were about $320 billion andcurrency-paper and coins-held by thepublic about $130 billion, a total of about$450 billion.) Checking accounts increase invery close proportion to paper currency (forreasons explained in "For Further Study" atthe end of this chapter). As occurred in 1981,a 10% increase in the stock of new currency

issued by the Federal Reserve Banks willlead within a year to a similar percentage in-crease in the total of the public's checkingaccounts. The resulting rate of inflation of al-most 10%-or of 2~o or 3% less because realoutput and the population also increased byabout 2% or 3~o-should not have been sur-prising.

DistinguishingTrue from ApparentCauses of Inflation

You will hear that foreign aid, agriculturalprice-support programs, social security, andour space, military, energy, and unemploy-ment and welfare programs are inflationary.But the programs themselves can cause infla-tion only if they cause an increase in thequantity of money. It is necessary, then, tobe careful how one defines cause: Increasingthe money supply causes inflation in thesense that inflation is an unavoidable conse-quence of the increase; by contrast, theabove-named programs are not unavoidablyfollowed by money-supply increases. Thereare alternative modes of financing them-however rarely they are used. The moral is:To identify the true cause of inflation, wemust always carefully distinguish between anincrease in the money stock and the factorsthat induced the monetary authorities to in-crease the money stock.

For example, especially common is thehighly plausible belief that a wage push oradministered prices cause inflation: Somewages and prices are increased by a few firmsor workers possessing market power, and allother wages and prices adjust to the new lev-el. Steel prices or union wage rates are oftencited as examples. But there is virtually nofactual evidence to support this argument.Nor does economic analysis lead to the possi-bility that there could be key commodities towhose prices the prices of other goods adjust.For example, an imposed rise in the price of

steel will reduce the amount demanded. Em-ployment in steel mills will fall. Some re-sources used in steel production will in timeshift to the production of other goods, whoseprices will fall as •.supply is increased. Theoverall price level remains unchanged. Thereis a rise in the price of steel goods but a fallin the prices of others. However, inflationwould occur if the transiently unemployedworkers, seeking to regain their old jobs, per-suade pol itical au thori ties to crea te newmoney to spend for their products. Then theincreased quantity of money will increase allprices to match those that had been arbitrari-ly raised. In this way, the inflation restoresthe former structure of relative prices by anaccommodating monetary policy.

Saying that one particular higher pricecauses inflation is to confuse consequenceswith cause. For inflation to occur, the moneysupply must increase by more than the de-mand for money. And such an increase mustbe kept distinct from the motivation for in-creasing it. In our example, the motive wasto assure continued employment in old jobseven at the higher, newly imposed prices. Ifgovernment authorities maintain a given lev-el of employment in the steel industry by in-creasing the money supply, then steel couldbe called a key industry. If the governmentassures full employment for some othergroup of employees, they too could be calledthe key group-whether they be teachers,custodians, or actors.

In principle, it is easy to stop inflation:Reduce the growth rate of money. (Likestopping drunkenness-don't drink!) But thatwould require abandoning the politicalpromises, built into government programs, tomaintain full employment in old jobs evenfor those who ask high prices. If those prom-ises are honored, inflation will surely occurwhenever the government prints more mon-ey to finance them.

Another fallacy is fostered by govern-ment methods of reporting the cost of living.

Inflation 409

The reports contain such statements as:"The cost of living rose this month by 1%because of a rise in the prices of eggs, gaso-line, and medical services." But the inflationdid not occur because those prices rose.Those prices rose because the inflation oper-ates on all prices. By reversing cause and ef-fect, such reporting leads people to blamethe sellers (or buyers) of those particulargoods, as if each month a different set of peo-ple or forces acted to cause inflation.

InflationaryRedistribution of Wealth

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, I

I UNANTICIPATED INFLATION

Odd names are given to describe differentrates of inflation, such as creeping, galloping,runaway, and hyper-. The rate is in fact ofless critical consequence to people thanwhether the inflation is anticipated-that is,correctly foreseen-or unanticipated-thatis, unforeseen or incorrectly foreseen as totiming, rate, or duration. Loans made beforeinflation was correctly anticipated will lackupward repayment adjustments that assurethe lender the same total purchasing powerit had before the inflation. Thus, an unantici-pated or higher-than-anticipated inflationtransfers wealth (measured as purchasingpower) from creditors (lenders) to debtors(borrowers). ;(

Monetary assets are claims to a fixednumber of dollars in the future. They taketwo forms: either money or claims to fixedamounts of money, such as bonds, promis-sory notes of fixed payment, and constant-dollar retirement pensions. Monetary liabil-ities are the other side of those claims:obligations to pay those fixed amounts ofmoney. Real assets and real liabilities, re-spectively, are claims to, and obligations todeliver, goods and services whose dollar

1 i

410 Chapter 19

prices change with inflation. Owners of realassets do not suffer a loss from inflation, be-cause real asset prices rise with inflation.

For example, consider the effect of acompletely unanticipated inflation of 10% ona person whose total assets are $100 in cashand $1000 in U.S. bonds yielding 5%-bothmonetary assets. The price level rises 10%.A year later the $100 in cash has depreciatedto the equivalent of $90.90 (= $100/1.10) inreal terms. The bond, which pays $1050(principal plus interest) in one year, will re-turn $954 (= $1050/1.10) of purchasing pow-er-a loss of purchasing power of $105.10($9.10 on the cash and $96 on the bond).

But if the same person also owed some-body, say, $1200 at 5% interest, that $60 in-terest and $1200 principal would be paidwith dollars that are 10% less valuable inreal purchasing power. The person's obliga-tions would be $1145 (= $1260/1.10) in realterms: a gain of $115(= $1260 - $1145) inreal purchasing power, which is a net gain of$9.90 over the loss of $105.10 on monetaryassets. Such a person is a net monetary debt-or: one who has more monetary liabilities(debts) than monetary assets (credits). If youwonder about the real resources owned orowed, they change in dollar terms on averageby the amount of the percentage change inprice level; thus, on average the person nei-ther gains nor loses from the real assets orliabilities."

A common way to be a net monetarydebtor is to buy a house with a large mort-gage. Say a person has a $200,000 house witha mortgage of 5% on $100,000 (a monetarydebt): The two balance sheets in Table 19-3show the situation before and after an unan-

2Let Rand M be net real and net monetary assets,respectively, and E the initial equity. Thus: E = R +M. If E' is the new equity when prices rise by propor-tion P, then: E' = PR + M. Finally, let Q be the pro-portionate increase in the money value of the equity: Q= E'/E. Now, substituting and rearranging,

Q=P-(P-l)M/E.

ticipated doubling of the price level. The ini-tial monetary assets (money) are $1000 andreal assets (house and land) are $200,000, atotal of $201,000. The monetary debt is$100,000. The equity (net wealth value) is$101,000. With an unanticipated doubling ofprices that doubles the dollar value of thehouse, the equity increases from $101,000 to$301,000, giving a real wealth equity of$301,000/2 = $150,500 in dollars of the origi-nal purchasing power, because each dollar isworth half as much as formerly. This is again of $49,500 (= $150,500 - $101,000) interms of original purchasing power dollars.The gain occurs because the inflation ratewas not anticipated, and thus the amount tobe repaid was not adjusted to protect thelender from its loss of purchasing power.

ANTICIPATED INFLATION

If inflation were correctly anticipated to oc-cur at 10% over the next year, a lenderwould insist on being paid (and a borrowerwould be willing to pay) about 10% moredollars to compensate for the 10% deprecia-tion in the purchasing power of dollars. So

Table 19-3

BALANCE SHEETS BEFORE AND AFTER UNANTICIPATEDINFLATION FOR A NET MONETARY DEBTOR, SHOWINGREAL INCREASE IN EQUITY

Before Inflation

Assets Liabilities

Cash $ 1,000 Debt $100,000House 200,000 Equity (Net Wealth) 101,000

$201,000 $201,000

After Inflation (Doubling of Price Level)

Assets Liabilities

Cash $ 1,000 Debt $100,000House 400,000 Equity (Net Wealth) 301,000

$401,000 $401,000

instead of getting back the normal, say, 570interest in money, the lender would get backan additional inflation-adjustment premiumof about 10% more of the principal on whichthe promised interest is to be paid. This in-flation adjustment is usually paid as if it werea higher "interest" rate (actually a normal in-terest plus an inflation-adjustment premium).So in this case, the interest on a one-year$100 loan would be expressed at 15.5%. Thelender gets back $115.50 (= $100 + $15.50)on the $100 loan. At the new initial pri F.'

level, the $115.50 is equivalent to $105 inoriginal purchasing power, a 5% real return($115.50/1.10 = $105). If the extent of the in-flation were greater than anticipated, lenderswould lose and borrowers gain, because theexplicit adjustment in the nominal interestrate would be too low. And the opposite hap-pens if an inflation is of smaller extent thananticipated.

VARIABILITY OFUNFORESEEN INFLATION

If interest rates received on all monetary as-sets and, conversely, paid on all monetary lia-bilities were adjusted for a perfectly antici-pated inflation rate, there would be nowealth redistributions. A correctly and fullyanticipated inflation is an analytical ideal,not a practical possibility. No one knows thefuture that well. A more realistic situation isthat of an incorrectly anticipated inflationduring which the inflation rate fluctuates, be-ing higher in some years and lower in others.It seems to be a fact that the higher the long-term average rate of inflation, the greater theyear-to-year variations around that averagerate. It is that high variability and the conse-quent greater unpredictability over the longrun that seem to reduce the willingness tolend and borrow as well as to invest, therebyreducing the flow of income into investmentand growth of productive capacity, and thusof future production.

Inflation 411

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EFFECT OF UNANTICIPATEDINFLATION ON MARKETVALUE OF EQUITY FOR NET MONETARY DEBTOR ANDCREDITOR BUSINESSFIRMS

During every inflation net monetary debtors experiencedan increase in the value of their equity more thandid net monetary creditors. During deflations theopposite effect occurred. During periods ofstable prices no dominance by either debtorsor creditors was evident. Attempts toperform the same measurements forcorporations in the 1960s and 1970shave been thwarted because almost allbusiness corporations have becomenet monetary debtors.

SOURCE: A. Alchian and R. Kessel, "Redistribution ofWealth through Inflation," Science, Vol. 130, No. 3375(September 4, 1959). p. 538.

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ili!! 412 Chapter 19

WEALTH REDISTRIBUTIONFROM UNANTICIPATED INFLATIONS

Substantial evidence collected from inflation-ary periods of the past 50 years in the UnitedStates establishes that the onset of inflationswere unanticipated or incorrectly anticipatedas to rate and duration, so that wealth wastransferred from net monetary creditors tonet monetary debtors. Strong evidence isprovided by the annual balance-sheet reportsof business firms. Firms that were net mone-tary creditors had a larger total of cash andaccounts receivable than they owed in ac-counts payable and bonds, and those thatwere net monetary debtors had the oppositebalance.

During an inflation, as at any other time,a host of factors affect the fortunes of everybusiness firm-inventions, new products,changes in demands, new management, dam-age to plant or inventory from fires, and thelike. Nevertheless, the transfer of wealth tothe net monetary debtor firms should showup in the increased price of a share of com-mon stock relative to the stock prices of netmonetary creditors.

Because the business firms on the majorstock exchanges were roughly divided be-tween net monetary creditors and net mone-tary debtors between 1915 and 1952, wecould test for that wealth-transfer effect. Fig-ure 19-3 presents the results. In every infla-tion, net monetary debtors did better thannet monetary creditors, because the inflationwas not anticipated. The opposite effect isobserved for deflations. During the episodesof stable prices, there was no significant dif-ference between the two classes.

During the past decade, however, theanticipation of future inflation is evidencedby the higher interest rates (which includean allowance for anticipated inflation). In1982 interest rates were about 15% on 10-year bonds. Furthermore, almost all businessfirms are now net monetary debtors. Whythey should have shifted so universally is not

clearly understood. Remember, inflationgives no gain to net monetary debtors if theinterest rate on the debt reflects a correctlyforeseen inflation rate. This poses a poten-tially very serious consequence. If the infla-tion rate falls below what was anticipatedand built into the interest rate, net monetarydebtors will suffer losses to creditors. This isone of the hazards of high inflation rates:The rate may change drastically, seriously re-distributing wealth and leaving debtors bur-dened by larger real debt obligations. That iswhy some people argue that a high but pre-dictable inflation is not as bad as a lower butunpredictable inflation.

Inflation:Taxation withoutLegislation

TAX ON GOVERNMENT MONEY

Coins and paper money, issued by the gov-ernment, yield no explicit or implicit inter-est. That form of money is costly to holdduring inflation. Those losses to money hold-ers during inflation precisely equal what thegovernment gets from its newly createdmoney. The inflation, then, is a tax on theprior outstanding government money. Thattax (which equals the gain to the governmentfrom creating the inflationary new money)may be a substitute for some other potentialtax.

But much of our money is privately cre-ated and does pay interest, implicitly or ex-plicitly: in particular, checking account mon-ey. Commercial banks with checkingaccounts pay implicit interest on those ac-counts by giving check-dearing services;mailing costs for deposits are covered; freeparking and lounge rooms are provided, asare lower-cost travelers checks, notary ser-vices, and safety deposit boxes for those whokeep large checking account balances. (If

these appear trivial, remember that 6% in-terest on an average balance of $400 isequivalent to $2 a month of special "free"services-and because it isn't taxable in-come, an interest return of only about $1 to$1.50 of such services per month on a $400balance is required to make it' competitive.)Beginning in 1981, banks were no longerprohibited by law from paying explicit inter-est on checking accounts, and they began todo so. In any event, the government doesnot get any gain by depreciating the valueof checking accounts in commercial banks.The bank owners get that gain. However,because banks also have money, owed tothem, they lose when repaid in depreciatedmoney. So banks as a whole do not gainfrom inflation.

What is meant by saying the govern-ment gains? Strictly speaking, the govern-ment is part of the wealth of every pe,rson.Thus, some people gain from inflation to theextent that, in the absence of the govern-ment's printing new money, their other ex-plicit taxes would have been raised, and tothe extent that they are beneficiaries of the\government's expenditures. Inflation that re- \duces the real value of the amount of futuretaxes, which must be collected to repaybonds, benefits the taxpayers who wouldhave had to pay higher future taxes.

GRADUATED INCOME TAXAND CAPITAL-GAINS TAX

Besides the tax on money, as just explained,inflation increases the taxes on people inthree other ways:

1. Graduated income taxes tax higher in-comes at higher percentage rates. As infla-tion progresses people move into higher dol-lar income brackets that take a largerfraction of income as taxes. This automatictax increase with inflation has been calledtaxation without legislation. Under the grad-uated income tax laws, the higher one's in-

Inflation 413

come in dollar terms, the higher the percent-age of tax probability. Whereas a $lO,OOOincome might be taxed 10%, a $20,000 in-come is taxed, say, 15%. Obviously, an infla-tion that doubled all prices, including wages,would make one pay more than twice asmuch in taxes, leaving one worse off. If, onthe other hand, some incomes are tax ex-empt, as are the services received from anowned house or work of art, people will val-ue those assets more highly. Hence, duringinflation, it is no surprise that sources of non-monetary, untaxed income rise in price rela-tive to other assets; for example, houses riserelative to common stock.

2. Taxes must be paid on increased mar-ket values of any asset, when the asset issold. If you buy a painting (or some commonstock) for $lOOOand three years later sell itfor $2000, while prices of all goods have dou-bled on average, you are not wealthier in realterms. But you must pay a tax on that $lOOOwealth gain in dollar terms-called a capital-gains tax. You end up poorer in real termsbecause of the tax on the increase in dollarvalue rather than on real wealth.

3. A similar tax is imposed on "profits"of business firms. Under the income tax laws,the dollar costs of replacing depreciating as-sets cannot be adjusted upward to more accu-rately reflect real costs. That is, their re-placement or depreciation costs areunderstated, and their reported dollar earn-ings in purchasing power are therefore over-stated. Business firms pay a tax on a fictitiousgain-again without specific legislation. Thisis one reason stock prices dip when fears ofinflation increase. When inflation occurs,business firms do not gain profits just be-cause they sell at higher prices than they ear-lier paid for their inventories. Although tak-ing in more money, they replace theinventory at higher prices; so the firm gainsabsolutely nothing in purchasing power.Higher money receipts merely match itshigher dollar costs. Precisely, the firm's nom-

414 Chapter 19

inal earnings in dollar terms are bigger butby no more than the rise in the price level:The firm has no increase in real profits orreal wealth, the same as any person or organ-ization whose wages, rents, or sales pricesrise with the inflation.

Living with Inflation

THE NONEXISTENT WAGE LAG

It is commonly thought that during inflationwages typically, if not always, lag behindprices. But exhaustive examination of avail-able historical evidence belies that belief. Insome years during inflations, real wages in-deed fell; that is, money wages rose less thanprices. But there were as many years inwhich real wages rose; money wages rosemore than prices.

What perpetuates the belief that wageslag behind prices during inflations? First, ev-eryone-whether selling labor, pencils, orautomobiles-will notice that the particularprice of the given good lags behind the aver-age of all other prices most of the time. But,of course, at the moment the price is adjust-ed, it leads the general rise. That single pricechanges sporadically whereas the average ofall other prices, being an average of a host ofsimilarly sporadically changing prices, willchange more smoothly and steadily.

Second, demands are always shifting-for example, from peacetime goods to arma-ments, or from consumer goods to space ve-hicles. The shift in demand increases theprices of the goods and the. wages of the la-bor producing those goods, relative to otherprices and wages. These are responses toshifts in relative demands. But if shifts in rel-ative demand are accompanied by the cre-ation of money, inflation also will occur. Asdemand is shifted from retail clerks andteachers to welders, computer specialists,and aerospace engineers, it is easy to see why

there is a relative decline in wages of clerksand teachers, and why that could be mistak-enly considered a result of inflation, ratherthan of the revised demand. During the lastwars, the U.S. government accomplished re-visions in demand by creating new money tospend for more desired goods.

Third, even if there were no change inany wage rates, upgrading employees fromlower- to higher-paying jobs would increaserealized wages. It can be misleading to lookonly at particular hourly wage rates in partic-ular jobs rather than at the earnings of em-ployees.

Fourth, it is often believed that a rise inthe demand for some good will "filter down"to the wages of employees only after theproduct price has increased. This error isbased on the assumption that the economy isa simple sequence of production steps fromraw materials with equal supply elasticitiesto final products. In fact, some inputs for ear-lier stages are the outputs from later stages ofproduction (for example, gasoline is used tomake steel to make equipment to refine oilto get gasoline), so that one cannot alwaystell whether a good is at an earlier or laterstage in a production process. Furthermore,the sequence of price rises is not necessarilyfrom consumer goods to labor-input wages.Recall the example of the rise in consumers'meat prices in response to demand increases(in Chapter 5). A demand increase does notnecessarily invoke a series of price rises start-ing at the consumers' end of the distributionprocess. "Rippling out" to many intercon-nected industries is a more accurate meta-phor than"filtering down."

Fifth, the belief that wages lag has beenfostered in part by fallacious economic rea-soning. For example: "Inflation increases theresources at the command of the governmentcreating the new money; with less left forthem, the remaining segments of the econo-my must consume less; the prices at whichthey buy must rise relative to their incomes,or else they wouldn't have to consume less."

Where is the flaw in this analysis? Thoughthe government gets more and the publicmust consume less, the public's income fromwages need not fall relative to the prices ofthe goods it .•.buys. Instead, the public'swealth has decreased, as if a thief had stolensome of it. Money holders lose part of thevalue of their money and will therefore con-sume less; their wage incomes do not lag;prices do not rise faster than wage rates orincomes from productive resources. Inflationis not a tax on wage earners or on !!l0neyincomes. It is a tax on money. Holders ofmoney issued by the government lose wealthequivalent to that obtained by the govern-ment.

Even if the inflation is caused not bynew money but by crop failure or a disasterthat reduces physical output, a loss of pur-chasing power is borne in accord with thequantity of money held at the time pricesrose. Though all goods may rise in price, notall prices rise as much as that of the particu-lar good whose output has decreased. The re-duced real wealth and income is a result of adecrease in the supply of the crop or good,not the result of higher prices.

NO "FORCEDSAVINGS" IN INFLATION

Some people argue that the lost income fromthe alleged wage lag is a kind of forced sav-ings that goes to profit receivers in business-es, who invest it in new equipment. This is acommon but fallacious argument for how theIndustrial Revolution in western Europe wasmade possible. During World Wars I and II,this doctrine provided popular support forspecial taxes on business profits. Profits wereinterpreted as gains from "forced savings"imposed on employees by a lag of wages be-hind prices or by inventory gains. Economicanalysis and empirical evidence, however,deny such a notion, as the preceding discus-sion shows. .

Inflation 415

REAL INCOMES ARE NOT REDUCED

Another fallacy is contained in the argumentthat inflation erodes our real income in thefollowing way: The U.S. Department ofCommerce annually reports that the medianincome of Americans is up, say, 11% fromthe year before, but with 8% inflation. Thenews media announce the 8% inflation erod-ed all but a 3% real income growth. The fal-lacy is in not realizing that the increase inmoney income by 11% was a result of theinflation in the first place. The press releaseshave the sequence of cause and effect turnedaround: Inflation raised that 3% of real in-come to an 1170 increase in money terms; itdid not erode 8% of any potential real in-come that would have been available withoutinflation.

SAVINGS ARE NOT ERODED

Still another fallacy is that inflation destroysthe value of savings. This confuses savingsand the form in which wealth is held. Onlywealth held in the form of claims to mone-tary assets will suffer a loss, if the interestrate or principal amount to be repaid doesnot reflect an anticipated inflation. A personcan put savings into nonmonetary assets suchas houses, cars, buildings, or a portfolio ofstocks with a neutral net monetary status(meaning that the total monetary debts areequal to the monetary assets of the fund).Widows, orphans, and the elderly sufferfrom inflation only to the' extent that theyput their wealth into monetary assets-some-thing they do no more than any other peo-ple. It is not marital or parental status or agethat determines whether one loses or gainsfrom inflation; it is the kind of wealth oneowns.

Data collected for families in 1962showed, somewhat surprisingly, that over halfof those with below-average incomes-or thatwere middle-aged or homeowners or male-

416 Chapter 19

headed-were net monetary debtors andwould thus gain from unanticipated inflation.For members of the opposite classifications-above-average earners, renters, and the like-over half were net monetary creditors andwould lose from unanticipated inflation.'

HOW TO REDUCETHE INFLATION TAXAND WEALTH TRANSFER

There is no way people who invested inmonetary assets can avoid losing wealth if in-flation occurs at a faster rate than anticipat-ed-unless they had arranged, when makingthe loan, to have the principal amount in-dexed, that is, increased by the amount ofany subsequent rise in the price level. Unfor-tunately, many measures of the rate of infla-tion are not reliable-especially if producedby any group on which pressure can be ex-erted to influence how the index is comput-ed. (This is not fanciful: It has happened inthe index used to measure farmers' costs ofliving in computing the farm parity pricesupports.)'

If inflation is expected, people will striveto reduce the fraction of their wealth held asmoney, just as with any good that becomesincreasingly expensive to hold.' This pushes

"Data collected by Federal Reserve Board of Gov-ernors and analyzed by P. Chen and C. Nisbet inChen, Understanding Economics, Boston: Little,Brown, 1974, p. 34.

'Short-term loans are less affected by changes inprice-level anticipations, because there is a shorter fu-ture life over which changes in anticipation are capital-ized into the present value. Also, there is some evi-dence that short-term rates of about 90 days seem toforecast inflation fairly accurately. The evidence is notoverwhelming, but it does suggest that short-term loansavoid the wealth transfers of incorrectly anticipated in-flation.

"People will want to hold an amount of moneyequal to, say, four weeks' income rather than five. Ifthey try to do so, prices will jump by 25%, so that atthe higher incomes the old stock of money now match-es only four weeks' income instead of five.

prices even higher. The result is a reductionin the real purchasing power of the stock ofmoney-despite the larger nominal stock ofmoney. The inconvenience of less "real"money is borne to avoid the higher costs ofholding the deteriorating money. Persistinganticipated inflation results in a reduction ofthe real money capital of the community. Ananalogy is illuminating. With a tax on gaso-line, people would use less gasoline; thus, theresult of the tax is not merely the wealthtransfer to the taxing agency but also re-duced, less convenient transportation.

These resulting inconveniences of hold-ing smaller real money balances are superfi-cially ascribed to a "shortage" of money. Yet,as we have seen, the reduced amount of"real" money is the result of each person'srational response to the anticipated highercost of holding dollars-resulting from rapidincreases in the nominal number of dollars.Strangely enough, some people contend thatthe way to alleviate this "shortage" of moneyis to print more-which, of course, would in-stead increase the anticipated rate of infla-tion, driving people to hold even smaller realmoney balances as the higher inflation ratefurther increased the cost of holding dollars.Instead, a reduction in the rate of increase inthe nominal amount of money would reducethe anticipation of inflation-a solution para-doxical only to those who forget the differ-ence between relative and absolute (or realand nominal) amounts of money, and be-tween increases in, and the existing amountof, money.

HOW LONGCAN INFLATION PERSIST?

Inflation can continue indefinitely. If pricesdouble every decade (equivalent to about 7%per year), then every decade the money unitcan be renamed-the new dollar is two olddollars. Everyone thinks in terms of "new"dollars for about three years, when the"new" gets dropped and they are again sim-

ply called dollars. At the end of the decade,new dollars are again introduced. That iswhat has happened in France, and it can goon forever. The rate of inflation in Israel, Ar-gentina, Chile, jmd several other countrieshas been so steep that, in some cases, withina decade prices are a thousand times as highas they were. So a new unit is introduced,called, say, millelira (thousand lira), or shek-el, that is worth what one unit was a decadeearlier.

Dealing with Inflation

PRICE AND ALLOCATION CONTROLS

Many people believe that the way to controlinflation is to politically impose wage, price,and allocation controls. Such controls, euphe-mistically called incomes policy, are ofteninitially described as voluntary. Their usemay stem from the mistaken impression thatinflation is caused by greedy, powerful busi-nesses and labor unions seeking higher pricesand wages."

Far from preserving the value of money,price controls reduce it by making it less rel-evant for exchange. Controlled prices belowthose that would exist in open markets makemoney less effective in getting goods. Inev-itable shortages, outages, and delayed deliv-eries show the reduced power of money tocommand goods. Other forms of competitivebehavior or rewards to the seller will com-pensate for the reduced exchange value ofthe dollar: The use of political power or sta-tus, the appeal of personal characteristics,and the existence of waiting lines are exam-

6If you still think unions or big business ("monop-olies" is the usual epithet) raise prices and cause infla-tion, reconsider. If a union or business raises its wagesor prices, what determines the height to which thewages or prices are raised? There is some optimalprice-not a continually rising price.

Inflation 417

ples (as explained in Chapter 4). Which isbetter, a low but less influential price, or ahigher, more accurate, more powerful price?

In Germany, three years after WorldWar II, price controls were removed. Theeconomy responded with predictable in-creases in production, as the economies of Ja-pan and Italy did when controls were re-moved. These dramatic increases could notbe attributed to recovery from war damage.They were sufficiently isolated and abrupt toreveal how price controls reduce the effec-tiveness of the market as an informative, al-locative, incentive system. Yet in all coun-tries inflation has almost invariably beenaccompanied by political controls on wages,prices, and uses. Are those who will then ex-ercise more political power the ones whoclamor for price controls? Is it a battle be-tween the politically adept and the economi-cally productive? This should not be taken ascondemnation. Who is to say what is thebest form of competitive power for control-ling behavior and for allocating resources andgoods?

THE CASE FOR ANDAGAINST ANTI-INFLATION GUIDELINES

Price and wage guidelines, or incomes poli-cies, have been invoked by every U.S. presi-dent from 1932 to 1980, and by almost allgovernments. The guidelines presume thatpeople should ask only for wages or pricesthat would not contribute to inflation. But ifproductivity in real terms wer~ increasing atthe rate of 2% or 3% per year, then inputprices could rise 270 or 3% per year, on aver-age, without increasing the price of the finaloutput.

If the supply of money did not increase,the existing stock of goods would not sustainhigher prices. Hence, it would be unneces-sary to exhort people not to raise prices:Their own inadequate sales would "control"their prices. Price raisers would price them-

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selves out of the market. Why "jawbone"them-that is, why put pressure on themwith implied threats of punishment? The in-exorable forces of demand would make high-er prices unprofitable. On the other hand,when the stock of money does increase, allthe talk in the world will not stop pricesfrom rising if that is profitable.

Then why the guidelines? There can bea reason. To see it, we use (1) the distinctionbetween anticipated and unanticipated infla-tion, (2) the power of a monetary authority todetermine the quantity of money and therate of inflation, and (3) a government policyof assuring full employment by increasingthe stock of money, regardless of any resul-tant rate of inflation.

Suppose some people agree to long-termcontracts, say, labor-union wage contracts forthe next three years. Suppose further thatthese employees and employers now contractfor higher future wages in expectation of in-flation. Assume also that only a severe disap-pointment in sales would make them changethe contract-a lengthy process, whichmight take six months to a year, to convinceenough people that the anticipated inflationhad not occurred and will not. Under theseconditions the monetary authorities are in abind. If they increase the quantity of moneysufficiently to validate those expectationsand thereby make the agreed-upon futureprices consistent with high employment, an-ticipations of inflation will be confirmed. Ifthey commit to sufficiently increasing themoney supply to avoid increased unemploy-ment whenever future contract prices areraised, monetary inflation is necessary unlessthe future prices contracted for can be re-strained. But that requires convincing peoplethat there will be no future monetary infla-tion-a denial of exactly what the authoritiesare committed to doing.

Guidelines are essentially announce-ments of the degree of inflation the FederalReserve System and government authoritiessay they are prepared to tolerate and permit.

But what assurance is there that they wouldreally not inflate the money stock faster? Re-grettably, the record is now reliable only forthe notorious unreliability of such pro-nouncements.

Anti-InflationMonetary Reforms

Once the money stock has increased, one orsome combination of these four conse-quences is inevitable: (1) Price suppressionby political controls will prevent people fromspending their money and getting what theywant at freely negotiable prices. Money andwealth will lose some of their competitive ra-tioning power, because their market ex-changeability is restricted. Other forms ofcompetition will be more influential. (2)Higher prices will reduce the real value ofmoney, again with a loss of wealth to moneyholders. But the role of market competitionrelative to other forms will not be sup-pressed. (3) Monetary reform, which is a fan-cy name for a cancellation of a portion of themoney, means money holders will lose. (4) Aspecial tax may be imposed on generalwealth (not on money alone), and the moneycollected as taxes could then be destroyed.But if this kind of general tax could havebeen imposed, the money probably wouldnot have been created in the first place. Thefour alternatives are different ways of reveal-ing the reduced value of money. None pre-serves it.

Transient Effectsof Changing InflationRate on Employmentand Production

A rate of money increase that turns out to belower than was anticipated will disappointexpectations about demand in the market.The unanticipated slower growth in the de-

. mand for goods will result in a transient de-crease in employment and output, until thepublic reduces its forecasts of anticipated fu-ture demand and correspondingly reduces itsprices (as revealed...in the inflation-adjustedinterest rate). After that, the transient reduc-tion in employment and output will end.The stronger were the anticipations of per-sisting inflation, the greater and more pro-longed will be the transient reductions inoutput and employment, until the public be-comes convinced of the reality of a new infl~tion-reducing monetary policy.

The episodes in 1970, 1975, and 1980 areinstructive. In each, the money increasenearly stopped for almost half a year. Reces-sion set in. Sensitive to public complaintsabout recession, monetary authorities thenreversed themselves to enable the govern-ment to embark on recession-combating ex-penditures by again increasing the moneystock. The upturn in demand, output, andprices lasted until the monetary authoritiesagain brought the money growth down from10% annually to nearly zero. Another tran-

. sient recession set up new demands for tran-sient recession-combating inflationary meas-ures. Back we went to money increases, andinflation was fired up again. Whether the re-duced rate after 1980 will persist remains tobe seen.

The awkward feature of an increasedmoney supply is that its effects show up intwo stages. First, within a few months thereis an increase in output; later, within about ayear, prices rise. The "good" output effectsprecede the "bad" inflation. But when themoney growth is restricted, the transient re-ductions in output and employment comefirst; later, the rate of inflation decreases.Here the "bad" effects come first. It is diffi-cult to embark on a policy where the bad ef-fects come first, easy to embark on a policyin which the good effects come first. Thismight be a reason why it is politically hard tostop inflation.

Inflation 419

We want to stop inflation. We also wantno transient recession as a side effect to end-ing the inflation, and we want to continueexpanding government expenditures beyondexplicit tax collections or borrowing fromprivate savings. There is no way to achieveall these. We have to give up some, or wemust give up all to some degree.

What Can You Doto Reduce Inflation?

Nothing any person or group can do in a pri-vate capacity will reduce or prevent infla-tion, nor should one try. A refusal to raiseprices as a seller or as a competing buyer willreduce your welfare and help no one else byas much as you are hurt. Such is the lessonthat should be carried over from the earlierchapters of this book. That may sound selfishand antisocial. In fact, it speeds the discoveryof market-clearing prices-with the conse-quences already developed in the early chap-ters on exchange and production. It under-cuts the errors and political confusion ofthose who argue that the private citizenshould exercise self-restraint and not spendothers' money-so the government canspend money at lower prices than the goodsare worth to those who are told not to buy somuch.

What little you can do is to act in yourpolitical capacity to try to deny office tothose who would create money to financegovernment expenditures. That is the onlyway to stop inflation, despite self-serving po-litical oratory and popular media nonsense tothe contrary. When the issue is so clearlystated, you may be moved to ask, "Do I wantinflation stopped if I must give up some ofwhat the government is doing, or if new ex-plicit taxes must be levied?" The answermay be no, but in any case it will, or should,depend upon evaluating the effects of infla-tion and possible price controls, and the ef-

420 Chapter 19

fects of reduced rates of government activi-ties or new taxes.

Recessions CanOccur During Inflation

Recent recessions in the midst of inflationsurprised many people who thought that ris-ing aggregate market demands and prices al-ways stimulated output and avoided reces-sions. Inflation combined with recession(stagflation) persuaded some people that eco-nomic analysis such as is presented in thisbook is wrong. However, recessions duringinflation are completely consistent with thiseconomic analysis.

During noninflationary times, if peopleexpect no inflation, investments must yield

. salable products worth about 5% more thanthe previous year, if the interest rate is 5%.Otherwise, their full costs will not be cov-ered. If, in the absence of inflation, aggregatedemand falls below expectations, recessionwill set in until a new, expected, lower inter-est rate is perceived by enough people to in-duce agreement and discovery of new appro-priate prices, for full employment at taskswith the highest earnings prospects.

However, the initial expected inflationrate that was unfulfilled could have beenvery high, instead of zero. For example, ifenough people expect inflation to be 15%per year (with the real interest rate being5%), any investments or initial outlays mustreturn a sales value that is rising at the rateof 20% a year; otherwise not all costs, includ-ing interest, will be covered. If aggregate de-mand does not rise enough to maintain thatexpected growth, people will not be sellingenough to cover their costs at the developingprices and wage rates. Only after enoughpeople are convinced that the growth in ag-gregate demand has lagged below that ex-pected rate, and only when enough of themrevise expectations, will new prices andwages be negotiated that will restore employ-

ment in the best-discerned uses.To believe that inflation necessarily

stimulates output and employment is tothink wages and costs lag behind sellingprices, so that profits would presumably beincreased by any rate of inflation, large orsmall. But as explained earlier, there is no lagof wage rates behind other prices; nor isthere any contractual rigidity that makeswage rates in general less mobile, upward ordownward, than prices of other goods andservices. But there is a lag in discerning thatthe contractual price and wage rates and pro-duction activity are not consistent with thenew aggregate demands. This informationlag is not a result of stupidity or stubborn-ness, for not every sales fluctuation can beimmediately tested to see whether it willpersist and whether sales have similarly fluc-tuated in other segments of the economy. Ifinventories or sales changes exceed expecta-tions, the individual firm will be induced torevise its output. It can't alone change its in-put prices, because the resources it buys orrents have almost equally valuable uses else-where-or so the inputs believe. Not untilenough people realize from experience thatthe deterioration is in aggregate demand willthey be willing to agree on new prices,wages, and products appropriate to the new-ly discerned change in demand.

All this can occur during an inflation orin its absence. What count are the differ-ences among the anticipated inflation rate,the actual rate, and the perceived rate, andhow quickly people can readjust their beliefsand discover the new appropriate prices andjobs. Indeed, many economists have longwarned of the error in believing that higheremployment can be sustained simply by rais-ing the rate of inflation.

Lest the preceding analysis suggest thatinflation has no effects other than thosecaused by incorrectly anticipated rates of in-flation, it is useful to remember the argu-ment that excessive drinking of alcoholmerely disorients a person for a while. Yet,

what the person does while drunk may bedisastrous. Similarly, in reacting to the fact ofinflation, people may want to determineprices and wages by government legislationor regulatory coatrol. But that weakens therole of market exchanges and prices in di-recting and coordinating the economy. Theresult is a loss of real income because of inap-propriate guides as to what is most valuableto produce. Price controls suppress prices asguides and rewards, replacing them with po-litical persuasion or force. The determinationof what and how much to produce, and towhom it is allocated, is removed from indi-vidual choice and made more subject to po-litical activity. Society may become more po-liticized and thus potentially less stable, forin the politicized economy people's behavioris influenced in ways very different fromthose in the market-exchange economy. Sucha conjecture, however, takes us beyond therealm of validated economic analysis. A re-spect for intellectual integrity and scientificprocedure compels us to stop at this point.

And now, gentle readers, you have ar-rived at the end of this book. We intendedyour experience with it and your instructorto be pleasant and to improve your under-standing of, and ability to use, economicanalysis. What did you expect? A pot ofgold? Or a money printer?

Summary1. Inflation is a persistent increase in the level

of money prices of all goods. It can be diffi-cult to measure inflation because prices canalso be affected by changes in the quality ofgoods or by consumers' responses to relativeprice shifts-not to mention the difficulty ofascertaining actual prices.

2. The effects of inflation should be distin-guished from the effects of the factors caus-ing inflation.

3. Inflation occurs if the supply of money in-

Inflation 421

,I

creases to the point where it exceeds theamount that people, given their existingwealth and income, want to hold. Such anexcess is usually caused by an increase in thesupply of money, but it may also reflect areduced demand for money resulting from aloss of real wealth from plague, drought, orother causes of a reduction in the quantityof goods.

4. Every significant inflation (meaning a rate ofover 10% in one year) has been caused byan increase in the absolute quantity of mon-ey. Reductions in real wealth are usually rel-atively minor and not persisting.

5. The effects of an inflation depend on howaccurately it was anticipated. An unantici-pated or incompletely anticipated inAationis one in which the actual rate of inflationdiffers from what was anticipated.

6. Monetary assets are claims to fixed amountsof money; monetary debts are obligations topay fixed amounts of money.

7. A net monetary debtor, a person with moremonetary debts than monetary assets, willobtain a wealth gain from an underanticipat-ed inflation at the expense of net monetarycreditors, those who hold more monetary as-sets than monetary liabilities. Any monetarycreditor will gain wealth from an overantici-pated inflation at the expense of net mone-tary debtors.

8. Holders of money lose wealth during an in-flation (as long as interest is not paid onmoney) to those whose credit constitutes themoney (commercial checking accounts) or tothose who issue money (governments).

9. Government, being a very large net mone-tary debtor, gains wealth from an incom-pletely anticipated-that is, underanticipat-ed-inflation.

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10. A common fallacy is that wage rates usuallyif not always lag behind the prices of con-sumer goods. Although extensive evidencelends no support to this proposition, it arisesbecause: (a) specific wages are erroneouslycompared with the average prices of con-

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sumer goods; (b) shifts in relative wages areattributed to inflation; (c) the effects of jobchanges on Income are ignored; (d) thepnces of consumer goods are mistakenlythought to always rise before the prices oftheir components to the producers; and (e)the government's obtaining more of thecommunity's wealth by issuing money andraising prices is erroneously thought to re-duce real wages. (The transfer of resourcesto the government in fact comes from thewealth transfer, not from a shift in wagesrelative to consumer goods.)

II. Inflation does not reduce the value of sav-ing. It reduces the real value of monetarywealth, but savings need not be held asmonetary wealth.

12. If an inflation is 'anticipated there is notransfer of wealth from net monetary credi-tors to net monetary debtors because the in-terest rate on debts will have been fully ad-justed to allow for the rise in price level.Anticipation of inflation does, however, leadto resource distortion because people try toreduce their real money wealth, giving riseto a money shortage that makes exchangemore difficult and expensive.

13. Wage and price controls do not reduce thetransfer of wealth from net monetary credi-tors to debtors. The exchange value of mon-ey is reduced by restrictions on the right tooffer money in the market. (Unanticipatedinflation achieves a similar effect.) Suppress-ing changes in price reduces the gains fromspecialization and exchange; suppressingprices enhances the political controls on re-source use and allocation.

14. Anti-inflation monetary reforms use taxationto reduce the quantity of money. Such re-forms have no effect on the transfer of wealthfrom net monetary creditors to debtors.

15. If an anticipated inflation is halted or re-duced in rate or duration there will be tran-sient reductions in employment and output,because future demand fails to develop asanticipated to cover costs (including theovercommitted interest costs). As anticipa-

tions and costs are revised downward, pro-duction and employment return towardtheir full levels-as long as the revised an-ticipations are more accurate.

16. By pushing dollar incomes into higherbrackets of the graduated income tax sched-ule, where they are taxed at a higher percent-age rate, inflation creates an automatic, unle-gislated increase in income tax. The tax oncapital gains (the gains in the nominal valuesof assets) is similarly increased. To avoid orreduce this inflation tax on money, peopleincrease the relative values of assets that giveincome in nonmonetary, tax-exempt form,such as by ownership of housing or art works.

17. Because anticipated inflation is a tax onmoney, people attempt to hold a smallerportion of their income as money. Thatsmaller ratio of nominal money to nominalincome and wealth reduces the real stock ofmoney-creates, that is, a so-called shortageof money. In fact, the excessively rapid in-crease in the money supply that causes infla-tion encourages people to hold less money,the value of which will be eroded by the an-ticipated inflation. The cure for inflation isnot creating more money more rapidly, butless.

18. The higher the inflation rate has been, theless predictable have been its future rates.Because of this link between its rate and theunpredictability of future price levels, infla-tion is economically disruptive: As planningbecomes less reliable, investment activity isdiscouraged; and the introduction of politi-cal controls, in a futile attempt to overcomethe effects of inflation without stopping itscause, is socially disruptive.

questions* 1. Almost all consumer price indices for the

United States in 1977 reported a rise of about40% over the price level of 1972.

a. To test your belief in that-and given anannual income of, say, $lO,OOO-wouldyou rather do all your purchasing from a

1972 Sears (or Ward's) mail-order catalogor from a 1977 one? (If you are tempted topick the current one because of changesin styles of clothes, suppose the styleswere to be •.altered at no cost.) Whichyear's catalog would you choose?

b. Remember, if you choose the current one,you are expressing disbelief in the exis-tence of inflation! How could you recon-cile your position-if you choose the cur-rent one?

*2. When collecting prices for your cost-of-living survey, you discover that not all customerscan buy a good advertised on sale because thelimited stock was sold out in the first hour. Youdiscover also that in New York City the rents arecontrolled; but at the controlled rents apartmentsare not available to many who would pay the le-gal price. Why would you not use that legalprice as the cost of housing?

*3. "The progressive deterioration in the valueof money throughout history is not an accident,and has behind it two great driving forces-theimpecuniosity of governments and the superiorpolitical influence of the debtor class .... Thepower of taxation by currency depreciation isone which has been inherent in the State ....The creation of legal tender has been and is agovernment's ultimate reserve; and no state orgovernment is likely to decree its own downfall,so long as this instrument still lies at hand un-used" 0. M. Keynes, A Tract on Monetary Re-form, London: Macmillan and Co., Ltd., 1923, p.9). Explain in more detail what Keynes meant.

*4. It was asserted that if producers of molyb-denum responded to increased demand by raisingtheir prices, the effect would be inflationary. Canyou spot a fallacy in that argument? (Hint: Re-member the discussion of the way meat pricesmight rise in response to a rise in demand? Sup-pose that cattle raisers had not asked for a higherprice in response to an increased demand ..Would that have meant that meat prices to con-sumers would not have increased?)

*5. If you were asked for the cause of the infla-tion in Brazil, how would you revise thequestion?

*6. Suppose that all colleges were forced to pay

Inflation 423

professors a minimum salary of $30,000 per yearin order to preserve the dignity of professors.Many professors will soon find themselves with-out jobs. Being of great inAuence in government,the professors tell the politicians that their salarydemands are reasonable and that the basic trou-ble is insufficient demand. Congress could em-bark on a program to expand general demand byspending more, financed by creation of moremoney. If the government assures college profes-sors that they will have full employment withoutwage cuts elsewhere, is inAation the inevitableconsequence? Why?

*7. "Higher interest rates are higher prices andtherefore are an element of inAation." Exposethe error of that assertion.

*8. A monetary asset is one whose price canchange although the asset is a claim to a fixedvalue in money terms. Give an example.

9. Which of the following are monetary?Which are real? Are they assets or liabilities?

a. money in the form of checking accounts;b. charge account at department store;c. prepaid subscription to New York Times;d. long-term lease for land;

*e. rental arrangement whereby commercialtenant pays building owner 1% ofmonthly sales as rent;

* f. U.S. bonds;*g. a share of General Motors common stock;*h. house;* i. rights to social-security benefits;* j. pension rights in a retirement fund;*k. teacher's salary.

10. If during an inflation you held all yourwealth in the form of real goods,' would you gainor lose wealth relative to the price level? (Hint:What else must you know?)

11. Movie actors under the age of 21 are orderedby judges to save a fraction of their weekly earn-ings and buy U.S. government bonds. They arenot allowed to invest that savings in stocks.

a. If you were a young actor, would you re-gard this requirement as sound?

b. If you were a judge, would you regard thisrequirement as sound?

c. Can you give any reasons why jurists andthe legal system are prone to advise in-

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vestments in U.S. government bonds?

*12. a. If in drawing up your will you were ar-ranging for advice to your spouse aboutinvesting your life insurance, would yourecommend that the funds be invested inbonds or in stocks?

b. How do the risks from inAation differ ineach case?

*13. Show how an inflation that doubles theprice level will yield the government more thantwice as much in income taxes. (Hint: Estimatethe income taxes for a person earning $10,000 ayear before the inAation and $70,000 after theinAation.)

14. To test whether average wages lag behindprices of consumer goods, someone examines a30-year record of price-level increases. Half thetime wage rates rose less than the price level;half the time they rose more. He concludes thatthe wage-lag effect was present half the time.What would you have concluded? (Hint: If some-one said a roulette wheel gave odd rather thaneven numbers, but then on 100 trials half thenumbers it gave were odd, would you say theperson's assertion was correct half the time orthat it was simply wrong? Is this comparable tothe wage-lag assertion?)

15. "Wages must lag behind prices because de-mand first affects selling prices and then filtersdown to the prices of productive inputs."Evaluate.

16. "If by inflation government increases itsshare of national income, there is less left for theprivate sector. Real wages must be smaller sim-ply because available real income is smaller."Even if it is true that the real income left for theprivate economy is smaller, there is an error inthat reasoning. Who loses what the governmentobtained?

17. a. If you knew that every price was going torise at the rate of 2% a week, would youtry to hold larger or smaller amounts ofmoney relative to your wealth and in-come?

b. Would you resort completely to barter toavoid loss of some money wealth everyweek?

*c. In 52 weeks how much higher would the

price level be? (Use the tables in Chapter6 to compute the answer.) Are you there-fore not surprised to see why people willstill use money even when they know theprice level will rise by that amount in oneyear?

*d. Are you convinced that even at an antici-pated rise in prices of 100% per weekpeople would still use money?

e. If people reduce their money balances rel-ative to their wealth and income from,say, one-fourth of their annual income toone-tenth to minimize their loss of wealthfrom the decreasing value of money, ap-proximately how much would prices jumpimmediately?

18. Emperor Julian exhorted the merchants ofancient Antioch to practice self-restraint in pric-ing their wares. Today government leaders ex-hort industrialists and labor leaders to exercisesimilar self-restraint. Tomorrow the story will bethe same. Why is such exhortation worse thanuseless?19. Explain why neither shopping more careful-ly nor saving more restrains inflation.

20. "Inflation causes price distortions becausenot all prices are equally responsive to changesin demand. Therefore, a period of rapid inflationcauses inefficiencies in the economic system. Ev-idence of the distortion is clear if one looks at thefact that, during inflations, relative priceschange." Would you consider that as evidencefor the proposition that inflation causes a changein relative prices? Is there some other reason whyyou would expect the beginning of an inflation tobe associated with greater relative changes inprices more than during the subsequent inflationor during periods when price levels are constant?(Hint: Why did the inflation occur? That is,what events caused the increase in money stockrelative to demand for money?)

*21. Suppose that in the years 1978-1981, whenpeople were expecting inflation to continue forthe next several years at the rate of about 6% to9% annually, interest rates on loans were adjust-ed accordingly, to about 15%. If in the 1980s theinflation is stopped or substantially reduced, whowill gain and who will lose? Does your answersuggest that everyone would like to see inflationbrought down to lower rates?

For Further Study: Creation of Money by Bank Deposits and Loans

Money in the U.S. economy consists predom-inantly of cash, paper money, and checkingaccounts in banks. Cash and paper money,also called currency, are created solely by the

. U.S government. Checking accounts-or,more properly, checking account money-are created privately in a more complex fash-ion, to be explained. To avoid common mis-understandings as to exactly what checkingaccount balances are, we examine two waysin which they are created.

Let us assume that a commercial bank(so called to distinguish it from a savingsbank, which usually is prohibited by lawfrom offering checking accounts) receives adeposit of new cash from a person who hasjust received $200 of paper money newlyprinted by the U.S. Treasury. (The reason

for starting with a newly created sum ofmoney will be apparent shortly.) The recipi-ent deposits $100 in this bank as credittoward her checking account balance, whichbecomes $100 larger. She keeps $100 in coinsand paper money for day-to-day use. The de-posit leaves unchanged the amount of moneyheld by the public as a whole. Instead of$200 in currency, the public holds $100 inchecking accounts and $100 in currency. Ithas simply exchanged $100 of cash for a$100-larger checking account.

The bank decides that it has more mon-ey in its vault than it desires, because not allof it will be wanted by all its depositors atthe same time. Some will be writing checksto people who will deposit them at other

Inflation 425

banks, to which the bank is obligated totransfer currency in the amount of thechecks. But at the same time people withchecking accounts at other banks are alsowriting checks, some of which are to deposi-tors in our bank. So a bank will expect tohave to pay some currency to other banks aschecks are written against it, but it will alsobe receiving money from other banks againstwhich checks have been written.

Our bank can be confident that duringany day as much currency will become owedto other banks as it will be claiming fromother banks. Thus, our bank needn't holdcurrency to equal the value of the checksthat will be written against it. Indeed, with aperfectly balanced cross-flow of checks thebank could get by with almost no currency,merely offsetting claims against it with itsclaims against other banks in what is calledthe check-clearing process.

The bank, then, may keep an amount ofcurrency equal to only about 20c;'oof its de-posits to take care of any outflows that mightexceed the inflows during some interval.Thus, of a deposit of $100 in currency into achecking account, the bank will probablywant to keep only about $20 in its vault as acash working reserve.

What will it do with the remaining $80?It can lend it to borrowers and get interest.The borrower, however, doesn't want cur-rency but money in a more convenientform-a larger checking account againstwhich the borrower will write .a check. Thatlarger checking account was created not bythe borrower's deposit of his or her own cur-rency but by the bank. By setting up or in-creasing the amount in that borrower'schecking account, our bank has created morechecking accounts; it has created money. Itnow has checking accounts against it of $180more than before: $100 by the initial depositof currency and $80 by the loan. (Checkingaccounts, whether created by an actual de-posit of currency or by a bank's lending to a

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1;1 426 Chapter 19

".~

borrower, are called deposits.)When the borrower writes checks

against that account and the recipients de-posit the checks in other banks, $80 will beowed to those other banks. (For simplicitywe assume only one other bank for the mo-ment.) The transfer of the deposit of $80from the first bank to the second bank cre-ates or enlarges an account there.

Repeat the process. The second bankhas $80 in currency and an $80 checking ac-count, against which it estimates it needkeep only about 20%, or $16, as a workingreserve. The second bank, then, has $64 inexcess currency-called excess reserves. Itlends this to a borrower or client by deposit-ing it in a newly created checking account.The borrower writes a check against that ac-count. Say the people receiving the checksfor $64 all deposited them in another bank, athird bank, which now has $64 more in de-posits. Of that $64 the third bank keeps 20%($12.80) as a working reserve and lends outthe remainder, $51.20. See Table 19~A.

The third bank finds a borrower towhom it lends $51.20 by creating a checkingaccount. That borrower writes checks for$51.20 which are deposited in still anotherbank. This fourth bank holds 20% ($10.24) asa working reserve and lends out $40.96. Ifcontinued, the sequence of checking ac-counts newly created through currency de-posi ts and loans is $100 + $80 + $64 +$51.20 + $40.96 + ... , which will approach$500, or five times the $100 of new currencyinitially deposited in the first bank.

Thus, the initial creation of $200 of cashor paper currency, $100 of which was held bythe public and $100 of which was put in thebank, has enabled the creation, by lending, ofchecking accounts totaling five times the$100 of new currency deposited. This pro-cess indicates why currency is called high-powered money.

Table 19·A CREATION OF MONEY THROUGH CHECKING ACCOUNTS, FROM INITIAL DEPOSIT OF $100 OF NEWCURRENCY

Bank 1 receives $100.00 in exchange for a checking account of $100.00It sets aside $20.00 as reserves and lends $80.00 to borrowers as checking accounts. The borrow-

ers write checks to people who deposit them in Bank 2.Bank 2 has checking accounts that are increased by 80.00

It sets aside $16.00 as reserves and lends $64.00 to borrowers as checking accounts againstwhich the borrowers write checks to people who deposit them in Bank 3.Bank 3 has checking accounts that are increased by 64.00

It sets aside $12.80 as reserves and lends $51.20 to borrowers as checking accounts. The borrow-ers write checks to people who deposit them in Bank 4.Bank 4 has checking accounts that are increased by 51.2,.0

It sets aside $10.24 as reserves and lends $40.96 to borrowers as checking accounts. The borrow-ers write checks to people who deposit them in Bank 5.Bank 5 has checking accounts that are increased by 40.96

It sets aside $8.19 as reserves and lends the remaining $32.77 to borrowers as checking ac-counts. The borrowers write checks to people who deposit them in....

$100.00Reserve bankcurrency

$500.00New checking

accounts ofpublic

Inflation 427

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Appendix:UsinU Mathand Graphs

A natural question to ask at the outset ofone's first course in economics is, "Howmuch mathematics do I need to know to un-derstand economics?" Only arithmetic, andsome ability to read charts and graphs and tointerpret quantitative relationships betweeneconomic magnitudes. So in this appendixwe will practice arithmetic, chart reading,and quantitative interpretation, using simpleexamples that make no attempt to reflect re-ality.

Imagine we are producing golf tees. 1:0make one tee costs, we assume, $1.00, count-ing all the needed material, labor, and so on.The costs of producing two, three, four, andmore tees per day are shown in Table A-I.The more tees produced in a day, the greaterthe total cost of that day's output. Two teescost $1.90, and three cost $2.70. "Totalcosts" and "tees produced" both change inthe same direction. When two magnitudeschange in the same direction they are said tohave a positive relationship. (For example,usually the relation between daily caloric in-take and body weight is positive: More ofone means more of the other.)

Some relationships are negative. For ex-ample, whereas up to the age of about 30years there is a positive relationship between

Table A-I OUTPUT OF TEES AND COSTS

TeesProduced TotalDaily Costs

1 $1.002 1.903 2.704 3.40

5 4.006 4.707 5.508 6.40

9 7.40

10 8.60

429

$9 -

8 -

7 f-

~III 6 f-•..~'0c 5 f-C---III0 4 f-oiij-0 3 f-I-

2 f-

1

o 1 2 3 4 5 6 7 8 9 10

Tees Produced Daily

Figure A·I.

BAR CHART SHOWING RELATIONSHIP BETWEENTOTAL COST AND OUTPUT OF TEES

Shaded sections denote how much cost increases witheach unit increase in daily output. Relationship betweentotal cost and tees produced is positive, for bothincrease (or decrease) together.

II-,

age and physical strength (the older one gets,the stronger one gets), from about 30 yearson there is a negative relationship: Strengthdecreases with age. (Note that neither a posi-tive nor negative relationship is assumed toimply causality: We are not saying that a re-lationship between the changes in two mag-nitudes means that a change in one causes achange in the other.)

We can use graphs to show relationshipsamong magnitudes: Figure A-I portrays therelationship that we assume between costs of

430 Appendix: Using Math and Graphs

Total Cost

8

7

~ 6c 550•.. .Q)Co 5III•..~o 4c

3

2

1

o 1 2 3 4 5 6 7 8 9 10

Tees Produced Daily

Figure A.2.

LINE CHART SHOWING RELATIONSHIP BETWEENTOTAL COST AND OUTPUT

Line chart shows more clearly how total cost varies withdaily output of tees. Height of line at each outputmeasures daily total cost. Upward slope, called positiveslope, indicates positive relationship.

production and number of tees produced.The height of each bar indicates totai costsof the number of tees to which it corre-sponds. Each bar has an upper shaded sec-tion showing how much higher it is than theneighboring bar of one less unit of output.The shaded part of the bar represents the in-crement to total costs that results from pro-ducing one more tee. We could draw asmooth line along the tops of the bars to in-dicate total costs without showing a lot ofbars, as is done in Figure A-2. You will seethat the line passes through several dots.

The line between the dots both guides theeye from point to point and represents thecosts of producing fractional amounts. Forexample, if we produce three tees in twodays, our rate of production is 1.5 tees perday. The line in Figure A-2 shows us thecosts of producing 1.5 tees a day;

So far we have interpreted a chart bychoosing a point on the horizontal axis andthen reading up to the line to find the valueof the corresponding variable in which wewere interested. If we choose five units oftees on the horizontal axis and then read updirectly above that point, we see that thecost is $4. But usually we can read a graphthe other way, too. Suppose you were toldthat you could spend $4 producing tees. Howmany could you produce? To answer, find $4on the vertical scale, then go horizontallyacross the chart to the curve (which is whateconomists call such a line, whether it is infact curved or is straight) and drop straightdown to the horizontal axis to find an outputof five tees.

So far we have been using the term costsas if it had only one meaning, but there arein fact three kinds of cost: total, average, andmarginal. Total cost includes all the costs ofproducing tees-materials, labor, and thelike. The average cost is the total cost perday divided by the number of tees per day.For two tees, the total cost per day, $1.90,divided by 2, is 95¢ per tee. And for five teesthe average cost is 80¢. (Compute the aver-age cost of producing five and six tees.)

Marginal cost is the cost of producingone more unit; that is, it is the diHerence be-tween the total costs of producing two quan-tities that differ by one. For five tees a daythe total cost is $4.00, and for six tees it is$4.70; the difference, called the marginalcost, is 70¢. This is shown in Figure A-I asthe shaded section of the bar for six units.

Marginal cost, then, is the change in onevariable (here, total cost) associated with aone unit change in the other variable (in thiscase, output of tees). This cost could have

been called the "incremental cost when sixare produced rather than five," or the "mar-ginal cost of producing six rather than five,"but it is in fact called the "marginal cost at,or of, six." Note carefully that it is not thetotal cost of producing six units ($4.70); noris it the average cost of producing six units(78¢ per unit). Rather, it is the increase intotal cost of producing six instead of fiveunits.

We use these concepts extensivelythroughout this book. Remember: Never uS2the term cost by itself; always identify it astotal, average, or marginal. Thus, if someoneasks, "What is the cost of six tees?", youhave to ask, What cost? Total, average, ormarginal?

Imagine a retail store with four clerks.Total sales are $2000 per day, an average of$500 a day. Some clerks sell more than theaverage, some less. Add a fifth clerk to thesales force, and sales increase by $200 to$2200. You might conclude that the newclerk is not as productive as the other four.But in fact you might discover that the new

Table 1\.·2 COSTS AND OUTPUT OF TEES

Tees CostsProducedDaily Total Average Marginal

1 $1.00 $1.000 $1.002 1.90 .950 .903 2.70 .900 .804 3.40 .850 .705 4.00 .800 .606 4.70 .783 .707 5.50 .785 .808 6.40 .800 .909 7.40 .822 1.00

10 8.60 .860 1.20

Total costs increase as number of tees produced daily increases.Average costs are total costs divided by number of tees produceddaily. Marginal cost is increase in total costs for one unit of increasedoutput.

Appendix: Using Math and Graphs 431

$9

8

7

6>0-roC•.. 541a.rn•..~ 4"'0c

3

2AverageCosts

1.\\\\\\\\\\\j\j\j\j\jt\j\j\j\j\j\~j~j~j~j~j'))~~: ~{{~ :j~j~~~j~jjjjj~j~j~jj\:'\j\j~j\\\\:;r~~~~:alo 1 2 3 4 5 6 7 8 g 10

Daily Production of Tees

Figure A·3.

BAR CHART OF RELATIONSHIPS AMONG TOTAL,MARGINAL, AND AVERAGE COSTS

Shaded sections show marginal costs. Average costs areshown by line through dots, to avoid cluttering graph.Average costs fall when marginal costs are less thanaverage cost, and rise when marginal cost exceedsaverage cost.


clerk had $800 of sales, more than for anyother clerk. The fifth clerk not only enabledthe store to sell $200 more by getting cus-tomers who otherwise would have decidednot to buy, but also managed to attract cus-tomers away from the other clerks.

However, although the clerk's sales were$800, the clerk's marginal sales were $200:the change in the total results of having fiveclerks rather than four. "Marginal sales" or"marginal costs" or "marginal whatever"must always be interpreted that way=-as thechange in total of one variable as the resultof having one more of the other variable.

Let us now investigate how magnitudesbehave in relation to one another. Notice, inTable A-2, that as output of tees increases,marginal costs at first decrease, then beyonda certain point increase. After marginal costsbegin to increase, between five and six tees,you will notice that so do average costs, be-cause once marginal costs exceed averagecosts they drive up average costs.

Figure A-3 shows these relationshipsgraphically. The bars show the total costs ofproducing a given number 'of tees per day.The shaded areas at the bottom of the bars(which are exactly the same as those at thetop of the bars in Figure A-I) represent themarginal costs for each number of tees pro-duced. Notice that marginal costs at first de-crease and then increase. Average costs de-crease as long as they exceed marginal costs,but increase once marginal costs exceedthem. To see how marginal and total costsare related, if you add up the marginal costsat any level of daily production you will seethat the total of marginal costs up to and in-cluding that level equals total costs at thatlevel.

Figure A-4 gives the same informationas Figure A-3, using lines instead of bars.The total cost of seven units of output isshown in three ways: (1) by the height of thetotal cost line at 7; (2) by the area under themarginal cost line from the first through theseventh-the sum of the marginal costs; and

(3) by the shaded area of a rectangle whosebase is the horizontal axis from ° through 7and whose height is the average cost of sev-en. The average cost of seven ($.785), shownby the height at 7, multiplied by 7 will bethe total cost ($5.50, rounded to three fig-ures). Both the area under the marginal costcurve and the rectangular area formed by theaverage cost curve height at 7 units repre-sent the total cost.

Let's examine the new data in Table A-3. The first two columns show prices and thenumber of tees that can be sold at each price.The lower the price, the more that can besold at that price. Complete the emptyspaces in the columns labeled "marginal re-ceipts" and "average receipts" -which youwill see is the same as price, because eachunit is sold at the same price. Do not be sur-prised to get some negative marginal re-ceipts. And in any event do the arithmeticwithout worrying much about why the rela-tionship is shown as it is.

On the partially completed graph in Fig-ure A-5, some of the points have alreadybeen placed. Put in the rest of the dots for

Table A.3 SALES PRICE AND NUMBER OF TEESSOLD DAILY

Tees Price Sales Receipts or Revenue (Dollars)

Sold of Tee Total Marginal Average

1 $10 $10 102 9 18 +8 93 8 24 +64 7 285 6 306 5 307 4 28 -28 3 249 2 18

10 1 10

Complete the table and plot the results in Figure A-5. Negativemarginal sales receipts indicate that total sales receipts diminish atlower price despite increased number sold. Sales receipts are typical-ly called "revenue. "

65.50

1;' 5C•..Q)Co

41/1•..~'0

3c

2

1.785

0

$9 Total Cost

8

7

$5.50 = Total Cost of 7

MarginalCost

1 2 3 4 5 6 7 8 9 10

Daily Production of Tees

Figure A·4.

LINE CHART SHOWING RELATION OF TOTAL,AVERAGE, AND MARGINAL COST TO RATE OFOUTPUT

Rectangular area with height at average cost and base atoutput rate is measure of total cost. Area under marginalcost curve is also measure of total cost.


~II

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$

10 •9 •8 •7

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01 2 3 4 5 6 7 8 9 10

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-2 •-3

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Figure A·5.

EXERCISE GRAPH FOR RECEIPTS-UNITS-SOLDRELATIONSHIP

You are to complete set of dots and draw lines ofaverage costs and marginal costs. Relationship of priceand units sold is negative. Is relationship between totalsales receipts positive, negative, or both?

-'"


the average receipts and for the marginal re-ceipts and connect the points in each setwith a smooth line. Then draw in the twoalternative areas representing total receiptsfor four tees at a price of $7. Do the same foreight tees at a price of $3. Which has thelarger area?

Finally, some algebra. If you put $100 ina bank that pays interest at the rate of 570per year, at the end of one year you will have$105. At the end of two years you will haveearned another 5% of the $105 with whichyou ended the first year, so you will have 5%of $105 added to the $105, a total of $110.25.How can this be written in algebraic form?At the end of the first year you will have$100 + ($100 X .05) = $105 which can bewritten as $100(1.05) = $105. At the end ofthe second year, the amount is multipliedagain by 1.05. Therefore the initial amountof $100 will in two years be $100(1.05)(1.05)= $110.25 which can be written as $100(1.05r. This is what is meant by compound-ed interest-here compounded once a yearfor two years. The initial investment is in-creased by 5% by the end of the first yearand then that entire amount (initial principalplus accumulated interest) earns interest thenext year and grows by another 5%, or bythe multiple 1.05. Succinctly, it grows to$100(1.05)2 = $110.25. In three years it willgrow to $100(1.05)(1.05)(1.05) or $100(1.05)3which is $115.76. In 10 years it will be$100(1.05)10 which is $162.89.

Suppose you want to have $150 in sixyears at 5% interest compounded annually.How much must you invest now so that thevalue will grow to $150 in six years? The an-swer is obtained by noting that a presentamount, P, will grow in six years at 5% inter-est compounded annually to P(1.05)6 = F,where F denotes some future amount. In theexample we have P( 1.05)6 = $150. So divid-ing through by (1.05)6 we have P = $150/(1.05)6 = $150/1.34 = $111.93. Of course,computing the value of (1.05)6 is tedious, butdon't worry. You won't have to, because we

have tables in which to look up the answer.You have now demonstrated adequate

knowledge of arithmetic graphics and alge-bra. If some of the concepts still seem a little

unfamiliar, don't worry. So long as you un-derstand them, later exercises will makethem easier to use.


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Ansvversto SelectedQuestions

Chapter 1

1. False. It is because people are reasonable andact in accord with their interest that there areeconomic problems and wars.

2. a. Highest valued.b. Expressed in a common denominator or

measure of value.c. In general, no. Not if more than one thing

could have been produced-including lei-sure.

;I. The first statement is true, but the second iswrong. The value of an hour is the highest val-ued use one could have made of that hour.Hence the cost of an act taking an hour is thevalue of the best alternative action forsaken dur-'ing that hour. (A common, though not always ac-curate, measure of the value of time is the earn-ings one could have obtained during the time.)

5. Costs are not the undesirable consequencesof an act; they are the highest valued forsakenopportunity.

6. All costs are private. Social costs are simplythe total of all private costs. If a person perform-ing an action does not bear all the costs of thataction, then the social costs exceed the total ofthe costs the person bears (because some of the

costs are borne by other people). An equality ofprivate with social costs means all costs of a deci-sion are borne by the decision maker.

7. William the Conqueror, Julius Caesar, Na-poleon Bonaparte. ~u can add scores of otherseasily.

8. a. Promises to raise or lower taxes (affectother people's wealth) in order to benefitthose who vote for you. But the politiciancan't offer to sell services as a businessperson can.

b. Will letters of recommendation help YQJJget a better grade in this course? Doesyour past record influence the teacher ofthis course in making grades? Does thewealth of your parents?

9. a. Yes.b. We know of no institution with the domi-

nant power of coercive violence that isnot the government in any country. Gov-ernment is an institution for enforcingcertain rules and procedures for resolvinginterpersonal conflicts of interest. Themaking and enforcement of laws and thejudicial settlement of disputes are beha-viors that support the propositions. (Notethat the second statement says govern-ment is an agency, not the only agency.For example, many social disputes are re-solved by social ostracism, and by agree-ment to use an arbitrator.)

10. The only kinds of competition made illegalby private-property rights are competition by vi-olence and involuntary dispossession of goodsdeemed to be private property. Socialism prohib-its competition in the form of offering types ofservices and goods that individuals privately pre-fer, without having to obtain authorization ofgovernment officials for propriety of producingthe services. These are merely examples of typesof competition that are ruled out-not a com-plete chronicle, and certainly not an evaluationof the desirability of the various types.

11. a. Until you define what "socially pre-ferred" means, you cannot answer thisquestion. We don't have a definition tooffer.

437

b. We do not know what socially preferredmeans. For example, does it mean that amajority prefer it, or that the most impor-tant people prefer it, or that everyoneprefers it, or that the speaker thinks ev-eryone should prefer it, or that he or sheprefers it? Beware of any expression refer-ring to the preference of a group.

13. a. No.b. Since scarcity is present in socialism-as

in capitalism: Competition for control ofresources is inescapable. In socialismmore is in the form of political avenues ofcompetition.

c. Competition is the interpersonal strivingfor more of what is scarce and desired-by production, by purchase, by strivingfor political power, and so on. Coopera-tion is a joint activity with mutual striv-ing for a common end.

14. These questions will be answered in thecourse of study. The query is intended to whetyour interest in what is coming.

15. a. They are different-because these all in-volve social, interpersonal interactions.As such, one person's behavior with re-spect to these characteristics or attributeswill affect other people, and their re-sponses to that person's behavior willvary accordingly. Their response andtheir ability to influence the person's ac-tions will depend upon whether or notthere is private property-for reasons weshall see as we progress through the book.

b. Nothing like this question to kill a discus-sion! (Remember, evidence does not con-sist of one's unique personal memories.)

16. All societies use force and compulsion. Thepertinent issue is: What kinds of coercion andforce do various economic, political, and socialsystems use? The capitalist system uses the forceof self-interest; it is coldly impersonal in its mar-ket effects; it is a severe and unforgiving task-master. He who produces at a loss is forced outof business into some other tasks, perhaps withless compassion than under a socialist dictator,who could spread the loss over other people.More sensible than the question of which system

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::11, 438 Answers to SeJected Questions

uses less force is the question of what effects thevarious kinds of forces (incentives, rewards, sig-nals, orders, and penalties) have on the econom-ic, cultural, and political behavior. For example,how are freedom of speech, job mobility, socialfluidity, individual dignity, religious worship,search for the truth, and so on, affected? The ef-fects on all the various goals of a person must beconsidered.

Not even reference to the use of the rule oflaw versus the rule of arbitrary dictators is a basisfor ultimate judgment. Here, too, the question is:What law and what rules will be enforced by theruling law-the rule of private-property rights,the rule of socialism, or some other?

Differences are implied about the kinds of op-portunities or "freedoms" provided to individualsliving under each system. The implications arethat an open-market system gives individuals agreater range of consumption patterns or goodsfrom which to choose. Whether it is "good" thatindividuals should have such a range of optionsto explore is a question that economic theorycannot answer. A greater range of choice can beregarded as a greater range of temptation, risk,error, regret, and deviant behavior. Just as a par-ent restrains his children's choices for their owngood, we may prefer to restrain the choices ofadults because everyone retains some childlikeimpulses. Whether you wish to regard one sys-tem or the other as giving more freedom dependsupon your meaning of "freedom." In one sense,freedom can include protection from the costs ofresisting temptation and from making unfortu-nate choices; in another sense freedom might in-clude the right to bear those costs and to makethose choices and explore tempting alternatives.Whatever your interpretation, the implicationsderived from economic theory about the factualconsequences of different allocative systems willbe helpful in forming a judgment.

17. The cost of building the boats was the nextmost valuable alternative use of the builders'time. If the boat builders were slaves their ownerbore that cost; if the builders were freemen theybore that cost. Therefore, it was not slave laborversus the labor of freemen that made the boatbuilding cheaper. What changed the manner ofbuilding boats, if indeed less labor was involved,was the higher alternative value of use of that

I •.

labor, slave or free. This, .of course, does notmean that slavery is not worse than freedom; itmeans instead that the difference between slav-ery and freedom has no effect on the cost of ac-tivities but rather determines who bears thecosts.

Chapter 2

1. a. Each has a common goal.b. We're sure he has more goals.c. No, quite the opposite, because it's a mat-

ter of more of some goals relative to lessof other goals. It's not a matter of first ful-filling one goal and then turning to, thenext.

2. Individuals, not abstract things called col-leges, make decisions.

3. Yes; no.

4. By definition of a free good, no one wantsmore of a good that is so plentiful as to be free.But we do want the amount we have. Only if wedon't want more is it a free good. The questiontends to confuse more or less of a good with allor none. Life is almost entirely a choice of moreor less, not all or none.

6. The first statement contains no implicationabout any thought process. It would also apply torocks and water obeying the law of gravity. Thesecond statement suggests some mental calcula-tion and choice among alternative possible ac-tions. Economics does not have to assume thesecond statement as a basis for its theory, despitecommon arguments that it does.

7. It is.

8. a. One artichoke is worth 5 steaks, or 1steak has a marginal personal value of .2artichokes given that I have option A orB.

b. Between Band C my personal marginalvalue of artichokes is 6 steaks, greaterthan between A and B, because I havefewer artichokes at B or C than at A.

c. Increases the amount of meat that ex-presses the personal marginal value of ar-tichokes, because I have fewer artichokes(and more meat).

9. The first statement means that more of one

goal is achieved at the cost of having less of an-other. The second statement means that goals donot exclude each other.

10. Correct in that increased proximity to per-fection costs something and the increase may notbe worth the extra cost. For example, removingevery typographical error from this book maycost more than a book with no typographical er-rors is worth.

II.

Personal Value Revenue

Total Marginal Total Marginil

2.00 2.00 $2.00 $2.003.90 1.90 3.80 1.805.70 1.80 5.40 1.607.40 1.70 6.80 1.40

9.00 1.60 8.00 1.2010.50 1.50 9.00 1.00

11.90 1.40 9.80 .8013.20 1.30 10.40 .6014.40 1.20 10.80 .40

15.50 1.10 11.00 .20

12. a. Yes.b. Yes.c. He buys a second unit at a price of $1.90

when he could have bought only one atthat price of $1.90 if he wanted to. Thefact that he chooses to pay $1.90 to getthe second one means it is worth at leastthat amount to him. The value of onemore unit is measured by what one iswilling to give up to get one more. Thefact that he pays $1.80 more now at thelower price than formerly doesn't meanhe pays only $1.80 more than the price ofone to get a second unit. He saves 10¢ onthe price cut, but the second unit costshim $1.90 more than if he buys just one.

13. The person adjusts rate of consumption orrate of purchase over time, not the amount pur-chased at a given moment.

14. The person increases rate of use or replacesitems more quickly.

15. True.

16. 18,250 gallons.

Answers to Selected Questions 439

17. No. I take longer vacations.

i 18. First is rate; second and third are stocks.I

Sell 3 at $ 2; 2 at $9, I at $8. Buy I at $6;19. a.2 at $5, and so on.

b. Would buy 4 more to have a total of 8.

20. a. No such thing as basic need. We woulduse more and we could also get by withless security. It's a matter of what price

I Iwe are willing to pay, and a matter ofmore or less, not all or none.

ill b. We "need" more of everything that isnot free. The amount of any economic

I good we choose to have is a function of'I

1 its price. To say our children need moreschools ignores what we propose to giveup to get more schools.

c. It depends upon the price, whether it isgood enough to have at the price. If thissays simply that more is better than less,O.K. Otherwise, it seems to deny rele-vance of alternatives.

d. Same as comment to b.

21. See answer to preceding question.

23. Difference is that price is ignored in deter-mining how many golf courses would be de-manded ("needed").

25. Because as price is reduced to sell more, allprior units bring in less revenue, and that reduc-tion offsets part of revenues on the extra unitsold at the new lower price.

26. To right of and above.

27. All except g. (Why?)

28. a. Correct.b. Correct. ,-c. It is conventional to call this an increase

in amount demanded, not an increase indemand-the latter referring to a shift inthe whole demand relationship.

29. It is the ratio of percentage change in quan-tity in response to a small percentage change inpnce.

30. Demands a and b have the same elasticity atany common price. But the elasticities of a and bdecrease at lower prices. Demand c has a lowerelasticity at any price than demands a or b, and

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Iii 440 Answers to Selected Questions

its elasticity decreases at lower prices. Hint ofreason: The slope of b is greater than of a, butthe quantity at any price is proportionally great-er also. Demand c has the same slope as b, but itsquantities are larger at any price. Hence for anysmall price cut, the absolute change in theamount demanded on lines c and b is the same,but for c the increase is a smaller percentage ofthe amount demanded (at that price).

31. a. True. Economic theory says they would.Compare cars in countries with highergasoline prices. How about extent towhich automatic transmissions, which im-pose higher fuel consumption, would beused?

b. Reduced gas consumption.c. Three years.

32. Whatever provides the impulse, the lowerthe price of the item, the greater is the probabili-ty the impulse to buy will result in a purchase;the higher the price, the lower the probability.Habitual buying is consistent with knowing theprice from prior purchases and having settled ona consumption plan that is generally repeatedover time. However, let the price of some of theconsumption goods rise and the habit will be re-vised. Inconsistent behavior would be behaviorthat did not conform to that just outlined.

33. Yes, to all.

34. a. No.b. The negative relationship between price

and amount demanded.

35. It is a fall in the price of candy in ice-creamunits. Candy is cheaper relative to ice creamthan formerly.

36. The law of demand does not say that everyperson will instantly respond to every pricechange no matter how slight. It says a sufficientlyhigh price will induce an immediate response,and it also says that the longer the time allowed,the greater will be the response. In the case athand, some people will respond quickly thoughsome will not. Even for a small price rise the ag-gregate amount demanded will respond becausesome people will respond. In time all will re-spond to a sufficiently large price rise.

37. The higher prices of the high-quality dwell-ings reduce the amount demanded. Given the

law of demand, it is possible to reduce theamount people demand so that it does not exceedthe amount available.

38. a. Demand increases. Schedule shifts up-ward.

b. Can't tell. Milk production may be so im-portant a source of your income that youconsume more when its price rises (de-spite the higher price, because you arewealthier). But you consume less than ifyour wealth had increased for other rea-sons and without a rise in milk prices.

39. Hiring babysitters at, say, $1 an hour andstaying out for four hours will cost $4. Add thecost of two movie tickets at $1 each, and com-pare that total cost of $6 with the cost of going tothe $4 theater. The $4 theater costs a totaJ of $12($8 + $4) and movies cost a total of $6 ($2 + $4).Taking all costs into account, the $4 theater tick-et costs only twice as much as the $1 movie tick-et for parents who must pay babysitters. Thetheater then costs twice as much, but if a couplehas no children and no babysitter fee, the theaterwill cost $8 and the movie $2-a ratio of 4 to 1:theatergoing is relatively more expensive in realterms, that is, in terms of other goods given up.(Testing this would be a fine term project if youhave lots of time to collect data.)

40. If Td T2 is less than PI/ P2,

PI + TI '11b I h PID + T. WI e ess t an D •

r2 /.2 £2

Therefore, the price (including transport) ofgoods in the more distant market will be lowerrelative to the price of good 2 in the more distantmarket. More of good 1 will be demanded thanof 2 relative to that in the domestic market be-cause the relative price of good 1 is lower in thedistant market.

41. Welfare change is not measured by totalmarket value of entire crop. If demand elasticityis less than one, bigger supply will lower totalmarket value (total market revenue) while totalpersonal value is increasing because of largersupply. Do not confuse total personal use valuewith total market exchange value (market salesrevenue). Former is closer to welfare criterion.

42. What does "invaluable" mean? We are re-minded of a news item. "This priceless four-

strand necklace is now in the possession of Mrs.Lovely, who bought it for $85,000." Rarely do wefind such an incongruous juxtaposition of obviousinconsistencies. However, in fairness to thosewho often use the term "priceless," we suspectthey usually mean that the priceless good is notreproducible. Thus, a Grecian urn or an originalDufy cannot be replaced at any price if de-stroyed. At the same time, one should be carefulnot to think it can't be bought at a finite price, orthat a nonreproducible item is necessarily valu-able.

Chapter 3

1. No. It does not imply what is good, bad, bet-ter, or worse. It implies what will be observed inthe real world.

2. Denies none. Power over other people is agoal or good.

3. a. If it is supposed to mean that one areahad more of some good than it wanted-that is, could possibly use at all-thestatement is wrong. And we can't think ofanything else it might mean.

b. We propose that the relative supplieswere different so that relative values weredifferent, leading to mutually preferredexchange and reallocation of goods amongMediterranean and Baltic people.

4. It assumes that the middleman performs noservice to consumers or producers by making ex-change easier and less expensive than otherwise,and that therefore he can be eliminated withoutsomeone else's having to perform the service inwhich he specialized.

5. Middlemen facilitate exchange and special-ization, while "do-it-yourself" is a reduction ofspecialization and exchange or a case of doingmiddlemen's activities by oneself.

6. a. No. Middlemen perform services forhouseholders more cheaply than consum-ers could. And middlemen are paid byconsumers; the purchase price paid to thefarmer is not therefore reduced. In fact, ifmiddlemen's services save consumersenough to make them want more of the

Answers to SeJected Questions 441

farmers' goods, the purchase price paid tothe farmer can be raised.

b. Not necessarily, because that might bethe result of no middlemen's services toconsumers. The farmer would get all ofthe price paid by the consumer, but thatprice would be less than if middlemenperformed those services more efficientlythan the consumer could.

7. All are denials of open markets.

8. a. Yes, unless all consumers could agree topay me more than the one seller to whomI gave the monopoly right. (In principlethey could always pay more than the mo-nopolist would gain.)

b. The one who helped me most to getelected or offered me the most.

c. No. Their monopoly rents are partly usedto aid (pay?) politicians and are also de-pendent on political favors and support.

d. Once in office, people create favored mo-nopoly privileges by prohibiting entry ofcompetitors. As we shall learn later, con-sumers lose more than the monopoliesgain. But the ability of the monopoly par-ty to pay the politician exceeds that ofconsumers, who have more difficulty inarranging payment because there are somany consumers, each with a smallamount involved.

9. See answer to 7. Those who restrict it gain,but their gain is less than the loss imposed onothers.

II. Free speech means a right to speak or com-municate with others who are willing to listen,free of government intervention or prohibition.It is not a right to take the resources of otherpeople for purposes of communication with otherpeople. To use college property without the per-mission of the college authorities for speech isnot a right of free speech; it is simply appropria-tion of property as if the property were free forthe taking. Nor is it a denial of free speech if acollege or anyone else denies the use of resourcesunder its or his control which others would liketo use for the purposes of communication; it isinstead a denial to others of resources to use inways they would like. This does not mean that

442 Answers to Selected Questions

colleges ought to refuse to allow use of their re-sources for communication of popular or unpopu-lar ideas; it is simply a clarification of the differ-ence between free speech and the propositionthat resources are "free" to anyone for the takingso long as they will be used for communication.

12. Because it is easily recognizable, and it isportable, divisible, and durable. If it were moreplentiful, many things would be gold plated-automobiles, airplanes, dishes, appliances, andthe like. Gold, then, being corrosion resistant,has many valuable uses, making it an excellentmedium of exchange and store of value.

Chapter 4

1. a. 0, 1,2,4,6,8,9, II, 13, 15 for prices from$10 through $1.

b. Four to A and two to B.c. Shortage.d. Surplus.e. By a change in price.

2. a. $7.b. Three to each.c. Shortage.d. Remove price control.

3. Yes. Demanders compete with one anoth-er-in the free market, by price. Any resourcethat has more than one use is being competed forby more than one demander. Thus, its supply toanyone user is determined by how the price of-fered by that demander induces other demandersto move back up their demand curves to smallerquantities, thereby releasing more resources tothat one demander. Figures 3-1, 3-2, and 4-4illustrate this rationale.

4. a. Yes. It is true for all goods.b. We have yet to find one.

5. The first law of demand relates purchaserate to price. Law of demand and supply statesthat price is at the intersection of supply and de-mand. The former law holds generally; the latterdoes not hold always, especially when prices arecontrolled by law.

6. Yes, for it does advance the argument (analy-sis?) to grasp the meaning of scarcity and to un-derstand that economics says nothing aboutwhich goods ought to be allocated via the ex-change-market form of competition. We leave it

to you to try to figure out why the "degree ofscarcity" should affect the form of competitionthat should determine how a scarce resource isallocated among alternative uses and users. Wecan't.

7. In brief, how price affects amounts demand-ed and amounts supplied is ignored. Past equalityof supply and demand (through the late 1970s onthe graph) reflects the simple fact that price wasallowed to adjust up or down so as to equateamounts demanded with amount supplied. Noparticular amount demanded can be projected fora given year unless some particular price is pro-jected for that year. A higher projected pricewould reduce the amount demanded and raisethe amount supplied, thus raising the supply lineand lowering the demand line to keep themequal. An appropriate path of price over the fu-ture will affect the amounts demanded and theamounts supplied so as to keep the two equated.All the diagram says is that price will be kept toolow, whereas in the past it was allowed to equatethe amounts demanded and supplied. For anygood, every such projected future imbalance ofamounts demanded (probably mislabeled"needs," "requirements," or " demand") withamounts supplied (probably mislabeled "supply,""availabilities," "stocks") is merely a predictionthat price will not be allowed to move to equatethem-as it has in the past. Beware of beingfooled by such worthless diagrams.

8. They probably use the phrase "heavy buy-ing" to mean increased demand, or at least so wehope.

9. Shopping several sellers is better because al-ternatives are what sellers must beat. See A.Jung, "Price Variations among Automobile Deal-ers," The Journal of Business, October 1959, pp.315-325.

10. Holding down the wholesale price of cattleto the meat processors increases the spread be-tween purchase price and selling price for theprocessors. The price to consumers, which is notcontrolled, would rise anyway. The wealth thatwould have been available to cattle growers isinstead given to the cattle processors.

II. Price controls do not increase the probabilitythat lower-income groups will get more housing.They may get less (and over time, because con-

trois affect the production of housing, housingquality and quantity will deteriorate). Outcomedepends more upon possession of nonpecuniaryattributes that now playa greater role in alloca-tive decision.

12. Scarcity is pervasive. A reduced supply isnot a shortage. A reduced supply is a reductionin the amount available-pictured as a shift ofthe supply curve to the left. What people callshortages are simply the result of prices that arekept too low. Confusing these three differentconcepts helps create imaginary problems. ,..14. A vertical supply curve means that theamount supplied is fixed, unresponsive to price.Thus, price falls by the full amount of the de-mand fall. If the amount demanded is to remainunchanged from before, the price must fall bythe full change in the marginal use value at theexisting amount. Competition among sellers willreduce the price to that lower level.

15. The curve implies that although price willfall, it falls by less than the fall in demand, forthe following reasons. As price falls, resourcesthat are mobile will move to next best payingjobs. Reduced output will prevent price fromfalling by full reduction in marginal use value,because at smaller amounts the marginal use val-ue is higher.

16. If demand falls, inputs will not accept a low-er price, because they can move elsewhere to ob-tain the initial rates of pay. If demand rises, high-er prices for this output will be thwarted by aninflux of resources from elsewhere at no rise incosts. That is what is implied or described by de-picting the supply situation by a horizontal line.

17. The person currently owning the rights tothe drama would bear the tax. The resourcesused to make the series have already been in-curred, and no expenditures or new resources arerequired to maintain the tape. (In fact, there aresome storage costs and costs of projection orbroadcast, so price could not fall below thosecosts, or the tape not only would not be shown, itwould not be preserved.)

19. The belief that money or market-exchangevalue is the sole criterion of allocation is wide-spread, deeply ingrained, and incorrect. Money is


not the only criterion; that much has alreadybeen established by our analysis. (That it oughtto be or ought not to be is not the issue.) Only ifthe options are equivalent in all other respects domoney costs become the sale criterion, simplybecause cost is the only one that, in this case,makes any difference. On the other hand, if mon-ey costs were equal, then only other attributeswould be relevant.

When I dine in a restaurant, I select my dinnernot only according to prices but also according towhat the item is. I never tell the waitress tobring me the cheapest items only. The taste, nu-trition, and looks of the items are considered.Similarly, when buying a suit, I take into accountstyle, feel, looks, and fit, as well as the price. Norfor national security do we buy the cheapestweapon regardless of what it will or will not do,nor the most modern, expensive weapon simplybecause it is the most expensive or modern.

20. According to this criticism, we are all so in-fluenced by our interest in our economic wealththat other criteria are dominated. However, theexchanging of goods does not make it difficult foranyone to be influenced by the artistic, social,humanitarian, or cultural uses to which that per-son can put his or her goods and services.

Saying that only "lowbrow" products sell wellseems to suggest that this is a result of the mar-ket-value system. But that system, although ef-fectively revealing and enforcing the lowbrowtastes and desires of the public, does not createthose tastes. Actors, writers, and artists are frus-trated because other people don't want as much"quality" as they would like to provide at theprices they would like to get. Or putting it "self-ishly," the artists must admit that the incomethey can get from "low-quality" .work is so highthat they prefer to produce low-quality plays andget a big income rather than produce high-quali-ty plays and live with a lower income. In thiscase, it is also the artists' and actors' own tastesfor more wealth, not merely that of the public,that precludes quality.

21. True.

22. Both. Choice is an act of discrimination.

23. All.

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24. The sale pnce, if goods were available at

444 Answers to Selected Questions'I"

that price at time of sale. Price means exchangeprices, not hoped-for price.

25. Because monetary competition is precluded,allocation of price-controlled goods is likely toenhance political and government influence andauthority, either directly, as government agen-cies assume economic control, or indirectly as de-manders compete politically to satisfy their de-mand for price-controlled goods.

29. You should disagree. A higher price permitsa reallocation of existing goods-a reallocationthat would not occur in the absence of higherprices. The point is to note that higher prices dohave a consequence-reallocation-and that per-sonal preferences should not blind one to thatfact.

30. All contain rent, so far as existence is con-cerned.

31. Yes. Land would still exist at a lower price,but particular use is determined by full paymentreceived. The person who gets to use it must payat least what it would be worth to the next high-est valuing user, so the rent paid is a cost to theperson who gets to use it.

Chapter 5

2. a. Yes.b. Yes, and it pays not to cut rent to get an

immediate occupant (because the cost ofimmediate occupancy is greater than therent cut would be worth).

4. Tolls on bridges; parking meters; tollways.

5. Yes, this could be so. Although it is not pos-sible to know what is necessarily better, the totalcost of providing parking space could be cheaperif it were not policed as carefully as a park-for-pay lot. A free lot would impose the costs onthose who purchase from the persons who pro-vide the free parking lot, but not on those whouse the lot without doing any business with theproviders of the parking space.

6. A is suing for property rights to uncongestedstreets. Under current law this kind of rightseems not to be recognized. Presume we wouldrule against blocking construction. What do yousay?

8. If you define access to sunlight as an aspect '

of land ownership, then it is a strengthening ofprivate-property rights.

9. a. Either way.b. No.

10. Not true. To remove all risk of accidentscosts more than it's worth.

11. a. No rights were being curtailed. Instead,rights are being defined and allocated forthe first time.

b. No, they were being defined and speci-fied.

12. Nader ignores the social gains provided byactivities that produce smog and pollution as aby-product. Just as automobiles and airplanesproduce death; just as travel takes up land forroads; just as making sheet steel involves less ofother desirable things like leisure, quiet, and rest;just as oil wells create some smell in their vicini-ty-so all productive activity involves some un-desirable by-products. All of these "pollutions"of our environment are part of the costs of pro-duction and could be avoided if we were willingto have a less convenient, more Spartan life. Weshould not look only at costs and think thatsomething is wrong with those economic activi-ties that involve the largest costs, for they mayalso yield the greatest benefits. Relieving one'sself in the river may be less valuable than thevalue of output from a factory that creates equiv-alent pollution and may be avoidable at lowercost. Similarly, smoggers are producing other ser-vices in the process, whereas muggers produceno social service.

The complaint that Nader should develop isthat governments and courts have not introduceda system of making people pay for the right topollute-a system that would induce people topollute less if the gains obtained from activitiesthat yield pollution are worth less than the dam-age from pollution. Just as we could produce lessoil or less paper by having less pollution of airand streams, there is a tradeoff between more orless clean air or water and more or less of otherdesirable goods. Efforts to calculate that tradeoffrate and to induce the pollution costs to be takeninto account by a system of prices for the right topollute (by fines) rather than with zero prices orabsolute prohibitions (infinitely high prices) arewhat Nader might more usefully recommend.

13. a. Camp sites are not privately owned.b. Less space per person.

14. a. Privately owned. More of proceeds go toidentifiable owner.

c. Privately owned course.

15. Seats are allocated first come, first served,rather than sold to worshipers-except in somechurches, where a person donates a large sum andis given a special pew as a token of appreciation.

18. In 1972 the U.S. Supreme Court declaredthat the dichotomy between personal libertiesand property rights is a false one. Property doesnot have rights. People have rights. The right toenjoy property without unlawful deprivation, noless than the right to speak or the right to travel,is in truth a "personal" right. ... a fundamentalinterdependence exists between the personalright to liberty and the personal right in property.19. Ignores prices at which government goods aredistributed. Price of such goods is so low as tocreate a shortage: an appearance that there is aninsufficient amount.

20. Depends upon extent to which you want togive parents authority to determine allocation offunds to family members.

22. Building and nonfaculty purposes gain andfaculty also gains to the extent salaries are raisedmore than they otherwise would have been. Mon-ey that would be spent for faculty salary increasescan be spent for other purposes.

26. As many as people want to use or create.There is no objective test to determine the rightnumber.

27. (c) is correct.

28. The theater cannot house everyone: Eachspectator displaces someone on the outside whowould enter were there room.

30. a. No.b. No.c. Probably not.

31. If good is already produced, exclusion benefitsno one.

32. True.

34. The laws of demand, expressing general prop-

Answers to Selected Questions 44S

ositions about human preferences, hold in anykind of economy. So does competition of one kindor another. But the probability that open-marketprices will be permitted to direct production andallocation is much lower in a socialist system.

35. A disinterested economist estimated that reli-ance on smaller cars resulted in one extra death forevery $2.5 million saved in fuel costs. No reliableestimates of the tradeoffs among safety, pollution,and fuel costs seem to have been made prior toenactment of the legislation. It is worth noting theeconomist's additional remarks: " ... there are se-rious doubts that significant health effects are as-sociated with levels of photochemical smog cur-rently prevailing in even the most polluted cities.Certainly, the health effects are small compared tothose for suspended particulates and sulfur diox-ides, which come primarily from stationarysources. This is a case where the secondary effects[increased automobile manufacturing costs andgreater danger] amplify a conclusion evident fromthe primary effects: health effects do not justifythe most stringent controls mandated by Con-gress." The essential point is to realize that thereare always tradeoffs; we should estimate them dis-passionately. And it is worth recalling our analysisin Chapter 4 of the effects of smog control on landvalues. (Source: Lester Lave, "Conflicting Objec-tives in Regulating the Automobile," Science,212,22 May 1981, pp. 893-899.)

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Chapter 6

1. ($385 - $350)/$350 = .10; 10%.

2. $250(1 + .07)3 = $306.25. Would double inabout 10 years (72/7 = 10.3).

3. Refer to Table 6-1, present;.-~alue of $1. At10% the present value of $1 deferred one year isnow $.9091. Therefore, the present value of $220deferred one year is $220 X .9091 = $200.

5. $1702; $2500 + (l.08t Tables have onlythree-digit accuracy. Use Table 6-1.

6. $1158; $2500 + (1.08)10. Use Table 6-1.

7. $2580. Use Table 6-3.

B. $267.9. 4.35 X $50 = $217.50.

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10. a. $1440.b. $80,000.

11. It depends on the interest rate. At 10% the$20 higher operating cost for each of 10 years hasa present value of $61.40, so machine A, whichwould avoid that extra cost of $61.40 but costsonly $60 more to buy, would barely be cheaper.At 12% B would be cheaper. Indeed, at ratesabove II % B would be cheaper. At lower ratesA is cheaper. Clearly the extent to which it paysto economize on operating (energy?) costs de-pends on the rate of interest and the differencein purchase price of the equipment.

14. Yes. With a higher interest rate you still buyother resources equivalent to your house, but iffire has caused the loss you can buy only half ahouse or equivalent type of resource. In bothcases you do suffer a loss relative to some otherresources, but loss is more general in case of fire.

15. a. $10,000 plus interest on $5000 for last sixdays of the year.

b. No.c. $500.

16. Very probably "yes" for college students.

17. Fall, because future expected receipts fall.

is. $5000.19. $1000, and it will stay at that value.

20. Pay $40,000 now and $1000 a year rent. Andwith the accumulated value of lower initial dif-ference you will have in 50 years more than thevalue of the house and land at that future time.

21. $5 million at 3% annually; while market rateis 10% it is equivalent to a subsidy of 7% of $5million annually. Present value of that $350,000subsidy for 25 years is over $3 million, which is ataxpayer-financed gift of about $3000 to each ofthe 1000 employees.

23. Increase in value of holdings is the income.Stocks that do not payout any earnings as divi-dends will grow in value by 10% because all theearnings are reinvested in the company. If non-dividend-paying stock is bought, some of themore valuable shares can be sold at the end ofthe year, equivalent to the reinvested earnings,and the person still ends up with $100,000 inwealth. If the stocks are those on which all earn-ings are paid out and nothing is reinvested, the

person would collect dividends and have stocksthat did not grow in value. In either case the per-son has $10,000 to spend while ending up with$100,000.

The correct way to view the gains from invest-ment is to sum the dividends paid out and theincrease in market value of the stock. The sum ofthose two, however divided, is the earnings. Tax-es aside, it makes no difference in what form thatearning accrues to the owner of the stock.

Chapter 7

1. a. $5 for 1st oats, $10 for 2nd oats, $15 for3rd oats, and so on.

b. Four bushels.

2. A choice means an opportunity among twoor more options. The most valuable of the for-saken options is the cost of the one taken.

3. True.

4. Hours of labor have alternative uses. Hourscannot be used. Hence best forsaken use value ofan hour is the cost of any hour of use of labor.

5. Production is efficient if the output of one ofthe possible products is maximized for statedamounts of the other products. Or production isefficient if there is no waste of potential output:if an increase in output of one of the productscan be achieved only by reducing the output ofsome other product.

6. a. 2 by A, 4 by B.b. Yes.c. 1-10 units of Y per X is Y price of X.

7. a. 2 X and 12.4 Y by A; and 4 X and 6.4 Yby B.

b. Yes.c. 2 X by B, none by A.

8. b. A is lower marginal cost producer up tothree units.

c. Producer B.d. At any ratio below I.

9. Not necessarily correct. Losing firm mayhave higher price than profitable firm.

10. Suggests you will be poorer and engage morein "do-it-yourself." Reduced opportunity to tradelimits extent to which gains from trade can beachieved.

11. We believe all are returns to superior pro-ductivity rather than monopoly-protected in-comes. We know of no evidence that any havepower to exclude competition by methods not re-lated to superior perJormance.

12. B loses compared to what he or she wouldhave been able to purchase had C been able toproduce Y and sell to A. A keeps wealth com-pared to what he would have had if C had openaccess to markets. That C lives on an islandacross the Pacific rather than on the NorthAmerican continent has no effect on the analysis...13. Losers are consumers of the product thatwould be produced by the newcomer. Frustratedwould-be newcomer also is worse off. Examplesare taxis, interstate airlines, liquor stores, hightariffs on imports.

14. Yes. The law delays entry.

15. Confuses (I) wealth transfer from existingdoctors to patients, because of increased supplyof doctors, with (2) social increase in value of ex-tra medical care.

16. Speed of entry of new resources and theirsimilarity to existing resources.

17. A subsistence economy is one in which peo-ple consume what they produce. Specializationmeans people produce more of a good than theyconsume, and consume more of other goods thanthey produce. Specialization also means that pro-ducers do not produce complete consumer goodsbut instead concentrate on components or por-tions of assembly tasks.

18. No. It merely assumes that existing knowl-edge can be used and subjected to performancetests. Assumes no restrictions on rights to pur-chase or exchange knowledge. Knowledge is avaluable (economic) resource. To assume it isfree is, for example, to deny that schools existand that teachers perform a useful or desired ser-vice. A substantial fraction of our wealth is de-voted to gathering information of one kind or an-other.

19. Private-property rights plus knowledge ofthe market prices of various feasible crops.

20. a. All exchange benefits both parties.b. Yes.


21. Private property, market exchange, and ob-servance of contracts.

22. Don't know. His wealth does depend on oth-er people's demands for services obtainable fromhis wealth.

23. a. Large.b. Greater variety of relative talents and

training so that differences in people'sabilities are more common. Further, thelarger market enables a person to sellmore of a special output at profitableprices.

c. Greater concentration of time on samerepeated subtasks. For example, hair-shearing for poodles only; specialists incolor TV only; architects specializingonly in certain types of buildings; greaternumber of specialty shops.

25. Capitalist society does not restrain produc-tion. Production for profit is production for high-er-valued uses-not just anything for any use.Einstein didn't seem to understand what valueand costs meant or how they affected profitability.

26. a. Usually production is used to mean onlyactivity that is not illegal. We wish weknew of a better answer.The questionhelps to reveal the hidden normative con-tent of concepts that at first seem to beobjective and free of ethical presupposi-tions.

27. How much steel is "needed" depends oncosts. Imports are not costs. Capacity is a vari-able, not a fixed number. Present values are ig-nored in three-year calculation. "Need for steel"and "shortage" of dollars are rhetoric. India couldnot "afford" to produce at a high-er cost than thecost of importing steel.

28. No. Ignores the possibility of monopoly rent.

30. The self-sufficiency is not, but the increasedwealth from the discovered oil is.

Chapter 8

1. It is more difficult to assess the performanceof each member.

2. a. Because marginal product, though de-creasing, still may exceed marginal cost.

,: I,

I! 448 Answers to Selected Questions

b. Private-property rights that are enforce-able and transferable. Also political con-trols where private rights are enforceable.

c. That at which marginal product valueequals marginal cost.

4. All except full house in movie, and possiblycustomers in store during sale.

5. a. The number that maximized the averagetake. With three in each boat, 33 boats(with two on 2 boats).

b. 7Y3 fish (net of the boat cost of ¥3 fish perperson per day).

c. Price would be two fish. 7.33/2 = 3.67boats per day.

7. Socialism does not permit discretionary se-lection of wealth holdings by each individual.Profits and losses are borne in accord with taxes,rights to use government resources, and powersof political office.

8. No. Future rental value may be affected.

9. a. Resources are said to be specialized toeach other if the behavior or service ofone of them significantly affects the valueachievable by the other relative to itsnext best uses.

c. If resource A is specialized to resource B,it will need to be owned by the ownerof B.

10. The value of houses in the town will dependon the mine operations. Hence employees whoown land and houses near the mine will have alarge portion of their wealth specific to the mineowner and hence dependent on the owner's be-havior. Renting instead of owning spares the em-ployee from having to have so much wealth de-pendent on the mine.

11. a. Suppose you had one piece of paper andwere told to maximize your use of thatpaper. What would you do? Is it clearnow that the expression has no meaningor that it means anything you want it tomean? Usage is not something you maxi-mize; for usage is not measurable in a sin-gle-dimensional sense. In international ra-dio-communications conferences, thestatement sounded good to many radioand electronic engineers working for theFCC and for the State Department-pre-

cisely because it lets them interpret radiouses however they wish to. It's like hav-ing your parents tell you to maximizeyour time at college.

12. a. The owners of the enterprise: the peoplewho promised payments to the employedinputs.

b. The owners: the people who promisedpayments to the employed inputs andwho invested in and own the resourcesspecialized to that firm's activities.

c. If promises exceed revenues, the enter-prise will shut down, leaving a smallersupply and higher price for the remainingfirms, which may then be able to covertheir costs. If promises are less than thefirm's sales receipts, competition by imi-tators to reap similar gains will raisepromised payments to responsible inputsand will increase the output, therebypushing costs up to revenues.

13. The desire for greater wealth and the com-petition among actual and potential employersfor those resources that give greater rather thanless wealth.

14. Ratios of final consumer goods purchasedwould change, thus redirecting use of inputstoward those outputs whose input ratios aremore efficient at the new prices.

15. Labor used to make typewriters is substitut-ed for the typist. Substitution of capital for laboris misleading because it ignores labor used tomake machines.

16. a. Yes. Equipment on the bus for a laboreron the bus.

b. Yes. Labor off the bus for labor on thebus.

c. Yes. Total labor is reallocated in its tasks.No labor is released from work force,since that labor is used to produce moreof other goods-except to the extent thatsome now choose a bit more leisure (astotal output is larger).

18. No. Unlimited number of jobs available; onlythose are filled which are highest-value jobs, giv-en present knowledge and resources. New inven-tions induce labor to seek and move to best ofother unfilled jobs. The labor moves to a less

valuable job. But at the same time the totalwealth of the community is increased. The dis-placed person, as explained in the text, has noassurance of realizing a net gain from the partic-ular innovation whish displaces his most profit-able job opportunities; but he does gain frommost other innovations that do not displace hisjob.

19. No. People are released from some kinds ofwork so they can do some other productivework-of which there is always some as long asscarcity exists.

20. a. Fixity of ratios of kinds of inputs in thefinal product says absolutely nothingabout the ratios in which those inputswill be used to produce the good:

21. a. Power mowers and equipment, smallergardens.

b. Sellers of power equipment, cement sur-faces, plastic flowers, and the like.

22. Compares value of what is produced withthe cost, rather than merely minimizing cost ofwhat may not be worth even that cost.

23. Can't tell. Depends on costs.

24. Inadequate because it doesn't necessarilymaximize difference between value of the totalthrust and the cost of getting it.

25. Can't tell. This tells us nothing about cost.We presume new method is technologically ortechnically efficient, in that no more could be ob-tained as output for given amount of specifiedinputs. But this doesn't tell us output is worththe input.

26. Same as answer to question 24.

27. b. To include exchange efficiency. Values ofoutputs are being included as judged bywhat people will pay in an exchange sys-tem. Thus, efficiency is broadened to in-clude deciding how much of what to pro-duce, rather than merely the cheapestway to produce an arbitrary output.

Chapter 9

1. Yes, because I am investing III my friend'smanagerial talents.


12. No to all questions.

3. a. No. In ordinary circumstances we wouldexpect stability.

b. Should the typical voter or minoritygroups be able to turn out the governor oftheir state? It is precisely in order to pre-vent every single person from making hisown will count that voting systems areutilized.

c. It means a majority controls through themedium of a minority of the stockholdersto whom a majority gives its votes, as theCongress constitutes a minority of theAmerican public, being only some 537people representing 200 million.

4. Depends on what is meant by "very few."Annually many corporations show decreases inthe value of their common stock. Approximately30% to 40% of all corporations report losses forthe year, although the firms reporting losses arenot always the same. Since 1916 the percentagehas always been above 2070 and has been over50% in several years. For all reporting corpora-tions the aggregate earnings (after taxes) normal-ly run about five times that of the losses. Formore details consult Statistics of Income, U.S.Treasury, issued annually.

5. a. Wealth constraints are different in thetwo classes of cases.

b. The former, because of reduced possibili-ty of personally capturing capitalized val-ue of improvements of new management-as can be done in private corporationsthrough purchase and sale of commonstock.

6. a. Probably not.b. No.

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7. The engineer is specific to the other assets;the secretary and guard are not.

8. Yes. Her services are now recognized by themarket for teachers to be more valuable. Thatincrease is a profit.

9. No. They are borne by different peoplemore in accord with political power.

10. Disagree. Paper profits usually refer to an in-crease in value of some asset that a person hasnot yet sold in exchange for money. But they are, I

,

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real profits that one continues to keep in theform of the asset whose price has risen.

11. Suppose only the president of the companyknew the secret and also owned some shares. Hewould be less willing to sell at the old price andwould be willing to buy more shares. In otherwords, his demand to hold shares increases andthus affects market demand. Certainly severalpeople in the company knew the secret and sev-eral also owned stock in the company. Pricewould rise because their own demand to hold thestock had increased in the light of the secret de-velopments.

12. No one would pay anything for a losing busi-ness-that is expected to continue losing. (1)Buyers are more optimistic about how they canmanage the business. Or, (2) the business is real-ly not a "losing business" but instead had alreadyinvested more than was worthwhile, in light ofsubsequent returns. So new buyers bid a suffi-ciently low price for the business so that on thatlower price they will be able to cover those costsout of the future returns. In this case there is nopoint in selling the business, because the lossfrom the prior inopportune investment is notavoided by the sale of the business. The lowersale price of the business will make that loss ex-plicit in the accounting records, without reallychanging anything.

13. That everyone has an incentive to lie andcheat is not denied. But is the ability to get awaywith it affected by the ease of competitors' mak-ing counterclaims? The question has only to beposed to be answered. A newspaper will be morecareful with the truth if it knows that other newsmedia can challenge its veracity. Politicians aremore cautious if they know opponents can chal-lenge their statements. Witnesses in court aremore careful with statements of facts if theyknow they will be cross-examined. The easier itis for all to enter the market of ideas, the morecounterclaims and different interpretations ofevents will be offered. The open market offersmore incentives to disprove the claims and tosubmit counterclaims. That is why it is a goodrule to talk to a Ford salesperson if you want thetruth about Chevrolets, and conversely.

14. No. The only remaining source for theirprofits is risk taking: bearing risks others chosenot to bear. That is a service. In prospecting for

oil, some will lose and some may win. And someof us do not have to commit our wealth to thatrisky venture. Still, if we want more oil, the"lucky" investors who bear the risks relieve us ofthat risk. For that function they are allowed, un-der private-property rights, to obtain profits. Asfor taxing them away, that depends on your de-sire to have risks borne selectively and voluntari-ly, on your willingness not to renege on generalagreement to let lucky ones keep wealth, and onattitudes toward differences in wealth amongpeople.

15. The corporate form of organizing our pro-ductive work.

16. False. The second sentence is not logicallyimplied by the first. See the analysis in the chap-ter relating size of profits realized by high-risk,large-investment industries and entry incentiveand realized profit rates by successful firms.

Chapter 10

1. Marginal revenue is about 61 V8 per share; to-tal revenue difference is (61,500 - $30,812.50) =$30,687.50 for 500 shares change in sales. This is$61.37 per share. Elasticity is very large.

2. Yes. Increase in supply by anyone seller hasa trivial effect on price.

3. Ignores demand by consumer. "What num-ber is 50% larger than 15?" "If the grocer's sell-ing price to consumers was 50% over his ownbuying price of 15¢, what is the price toconsumers?"

4. c. $6.75.d. $7.00.

5. Marginal costs along with marginal revenueindicate maximum wealth-maximizing output,while average costs in relation to price indicatewhether the profits are positive or negative.

6. Two different programs, each with differentcosts.

8. a.. Between $21.00 and $22.00.b. Close to 770 units.c. Shortage with waiting or rationing.d. Yes; profits are being earned.e. Over $7.00, because of answer to part g.f. Contract.g. Costs will rise as price of resources re-

sponsible for lower costs are bid up bynew entrants seeking those resources.Profits will be absorbed into their costs.

9. Resources will be increased in production ofX until extra value cff output of X falls to $5.

10. Not "consumer sovereignty" but "individualsovereignty" is more accurate. Individuals makechoices as consumers (buyers) and as producers(sellers). An individual expresses choices aboutworking conditions as much as about consump-tion goods. If mining is unpleasant compared tocutting timber, so that individuals are more will-ing to work at the latter rather than the former,the amount of lumber relative to coal will belarger than if individual preferences as producerswere reversed.

Because there are so many other people,each of us is usually powerless to affect output ormarket demand in a significant way. This doesnot mean we cannot choose among alternativepurchases or products to produce. Nevertheless,because we cannot significantly change the rangeof offers made to us, each open-market producerthinks the consumer (a personification of themarket) is sovereign, while the consumer errone-ously thinks that producers (personification ofsupply) decide what consumers can have.

11. We are using here a possibly inaccurate the-ory of behavior under government control. Novalidated theory for that behavior is available.

12. a. Reduce the output.b. At first, if output is not reduced but taxes

are paid, the wealth of peanut growerswill fall. Higher marginal costs indicate alower output as the new wealth-maximiz-ing output. Or some who formerly made aprofit or broke even will now have a lossand be induced to abandon or reduce pea-nut production.

c. Reduced supply, shown by shift of supplycurve to left, implies higher price.

d. Land will fall in value only to the extentit was worth more for peanut growingthan for next-best use.

h. Peanut consumers.

13. a. Nothing noticeable.b. Nothing noticeable, since the one produc-

er yields a trivial part of industry supply.

Answers to Selected Questions 4S 1

.21

c. This taxed producer will lose wealth ofresources specialized to growing peanutson his farm. Other peanut producers areunaffected.

d. See answer to c.

14. Nothing is implied about that.

15. b. Output of each firm is at same marginalcost. Each firm sets same price, and mar-ginal cost equal to price (for price-taker)maximizes wealth.

c. At each output the maximum value of allother outputs is achieved.

16. a. Mill B would clean three gallons and MillC would clean four gallons.

b. B would buy three; C buys four.c. Worse, since A would have to shut down,

although producing an output worthmore than the clean water obtained bystopping production.

d. No, in sense that total value of output (ofall goods and services including cleanerwater) would be lower.

e.. Marginal cost equals value of extra out-put.

f. Yes. Would probably reduce it.g. "Excessive use" is analytically more use-

ful meaning.

17. a. Down to a price of 70¢.b. $5000 (= 90¢ - 40¢ X 1000 units).

Chapter 11

2. a.Revenue

Price Quantity Total Marginal Average-''.$20 2 $ 40 $20

19 3 57 $17 1918 4 72 15 1817 5 85 13 1716 6 96 11 1615 7 105 9 1514 8 112 7 1413 9 117 5 1312 10 120 3 1211 11 121 1 1110 12 120 -1 109 13 117 -3 9

I, II:

~:1il~---------A-r-~------------------------------------

- .1.- C'_l __ ~...•J 1"""") ••.•...• ,.,1-- •• "",<-

b. It goes to intramarginal purchasers as alower price. For example, between a priceof $18 and $19 with sales of four andthree units, respectively, the marginalrevenue, $15, is less than the average rev-enue, $18, by $3. This amount is distrib-uted to buyers of the three units by aprice that is $1 lower than formerly.

c. Seven units.d. $15.e. Yes. See f.f. Having smaller profits than if price were

set at $16.3. A higher price of tickets would have reduced

the amount demanded; but if the demand wereinelastic the proceeds would have been greater,even with some seats unsold for every perform-ance. In any event, the sell-out indicates theprice was probably too low and should be raised;the producer has less revenue than he could havehad.

5. b. Yes.c. It is, when I do it. How about you?

9. Price that maximizes their wealth dependson demand, not on their own desire for morewealth. Prices three times as high would, in theopinion of sellers, yield smaller wealth or profits.

10. a. Lower it by $5.b. Price is $15 or $14. Output is $6 or $7.c. $90 - $57 = $33.

11. a. Nothing.b. Reduced by $5 to $28.

12. a. Price searcher; an open-market monopo-list.

13. In the sense that it indicates the amounts ofthe good that the productive resources would bewilling to provide through the intermediary ofthe businessperson. But it does not present thesupply schedule of the amounts actually forth-coming at each potential selling price of thegood, because the intermediary businessperson isheeding marginal revenue rather than price (av-erage revenue). Instead it is the schedule ofamounts at each marginal revenue. If marginalrevenue is essentially equal to price or close toprice, the marginal cost schedule will approxi-mate the supply schedule and no significant dif-ference will exist between price and marginalcosts.

14. a. Either $5 or $6.b. $7.c. None. It is the wealth-maximizing price.

16. Prepurchase service and information to po-tential customers are often provided by retailersselling goods with a manufacturer's trade name.The retailer also affects the degree of service orquality of the -item (by fitting it well or adjustingit or repairing it at the retailer's own expense).The retailer will cover costs in the initial pur-chase price if he or she does a good job. Protect-ing the retailer's ability to cover the costs of pre-purchase service requires that the customer whoobtains such services from the retailer be obligedto buy the product, if he or she decides to buy,from that retailer. But if other retailers couldcapture the customer after the customer has ob-tained prepurchase service at that retailer's ex-pense, then no retailer would be willing to pro-vide that prepurchase (or postpurchase warranty)service.

Another reason for exclusive territories is toenable the retailer to obtain a higher share of thesales proceeds. That extra profitability of han-dling a manufacturer's product will be lost if themanufacturer discontinues that retailer as themanufacturer's exclusive outlet. The threat ofthat loss of future profits will induce the retailerto provide services that help the manufacturercompete with other manufacturers. Thus in boththe above situations, exclusive territories (oreven retail price maintenance) can serve to en-hance intermanufacturer competition and benefitthe customer, despite its superficial appearanceof being a device to restrict competition. In fact,it restricts the kind of competition that would beself-defeating in withholding better service andproducts from customers.

17. Folklore suggests that with fewer large, na-tionwide or international corporations producinga large share of the U.S. sales, consumers have asmaller range of purchase options. That is wrong:Consumers now have more alternative suppliers.If, for example, there were 1000 small towns eachwith five sellers, everyone of whom, like everybuyer, did business only in that one town, therewould be 5000 different business firms, but eachbuyer had only five from which to choose.Cheap, fast transportation and communicationcovering larger areas allow each firm and buyer

to do business in a larger number of towns. Thenumber of business firms could be cut to, say, 40,and if each firm and consumer were now able totrade in half the markets, each buyer would face,on average, 20 possible sellers. In fact, transpor-tation and communication have so improved thattoday the average consumer undoubtedly hasmore options from more suppliers.

19. a. The seller need cover only marginal costswith marginal revenue, but marginal rev-enues are not the same as price.

b. As long as initial difference in margin Irevenue (at equal prices) exceeds trans-port cost, it will pay to ship to lower-priced market.

c. No.

20. Yes, they are discriminatory. Depends onwho you are.

21. No.

22. a. He'll sell four units and retail price willbe $17.

b. This is known as the problem of succes-sive monopoly distortion. Your instructorwill probably explain this in more ad-vanced courses.

23. a. $7 to A; $5 to B. Total receipts are $38.b. $6 to both. Total receipts are $36.c. Eight units. Sell five to A at $6; three to

B at $4. Net earners are $26 (= $42 -$16).

Chapter 12

1. a. Slightly more than 10¢. Call it 1O¢ forsubsequent computations.

b. Between 65¢ and 67¢. Call it 67¢ for sub-sequent computations.

c. Each would sell 10 units at 67¢ each, for$6.70 daily.

d. Formerly received (IO¢ X 20 units) = $2daily. Each gets $4.70 more.

2. Government agencies enforcing laws againstcollusions concentrate on collusions against gov-ernment. Second, government uses a system ofsealed bid, publicly opened. This is ideal for pre-venting secret price cutting or evasion of collu-sion by colluding firms.


4. Collusion connotes elements of deception inseeking to negotiate exchanges in the pretensethat the sellers are acting as independent com-petitors. If buyers knew sellers were in agree-ment, they would be alerted to each seller's in-centive not to bid as he otherwise would.Without the element of secrecy, buyers areaware of lack of competition among sellers as, forexample, among the two salespersons of the samefirm. The pretense of competing in price andquality is designed to induce the buyer to thinkhe or she is already obtaining advantages of com-petition among sellers.

With open collusion, such as mergers, thereis no pretense. Buyers are not deceived and canthen obtain offers from other independent sell-ers. Open agreements not to compete are not de-ceptive and consequently are much less effectivein open markets. Partnerships, being open, arenot deceptive, hence do not connote elements ofcollusion. Element of deception is undesirable.

Competition connotes interpersonal strivingabout who will get what of existing resources,whereas cooperation connotes joint action to in-crease total stock of wealth to be distributed.Some actions do both at the same time. Thus,exchange with specialization is both competitiveand cooperative in increasing wealth as well as inallocating it.

5. a. Team owners are able to sign new playersat lower wages, because other ownersagree not to compete for these players.The team owner's problem is to pay justenough to induce the newcomer to play;the owner does not have to competeagainst other owners. The competition istransferred to that of determining the ini-tial assignments of newcomers to eachteam-by giving the lowest-standingteam first choice of the newcomers (highschool graduates) and the next-lowestteam the next choice. This is the "draft."Although this assignment system is al-leged to help equalize team abilities, itdoes not; players are subsequently sold toother teams, at prices far in excess of thatpaid the newcomers.

The better athletes suffer. Since it isimpossible to know in advance precisely


how good an athlete will be, the initialsign-up price will be lower to reflectthat uncertainty. There is a stipulationin all contracts that wages cannot be cut"rapidly," so those who turn out to bepoorer than expected will be overpaidfor a substantial time. Those who turnout better than expected will be under-paid thereafter, because other team own-ers will not bid for their services by of-fering the player the higher wage, butwill instead pay the team owner to getthat player.

b. Perhaps this explains why we call these"sports" rather than "businesses." Nobusiness could do this. It is a much tough-er, and still unsolved, task to explain whyother businesses cannot do what sportscan do. The existence of laws restrictingbusiness firms does not explain why.

Chapter 13

1. a. To control secret violations of sales of ahomogeneous product.

b. The law compelled them to join.

4. a. We think students can discriminate asably as any other group you would sug-gest. To the argument that students areprone to take snap, popular, "theatrical"courses, we ask, "What is bad about pop-ular, theatrical courses if the course isnevertheless good?" To say that studentsselect snap courses (meaning courses thatare easy-not because teaching is goodbut because course content is trivial) is toprovoke the question as to why studentsdo that. To say they are lazy is to pre-sume that they should not be lazy or thatonly hard-working students should attenda c1ass-a rather presumptive judgment.More germane is the question of why stu-dents who are able and motivated to go tocollege should nevertheless sacrifice"good" courses for the sake of an easygrade. Does it suggest something aboutthe criteria imposed on the students bythe college administrators? What?

6. a. The best-by definition, because the stu-

dents can select from the entire world,rather than just within one state.

7. b. As any of these groups, we would opposethe development proposed.

8. Distinguish between open-market pricesearchers and closed or restricted market access.Closed markets imply higher price.

9. Distinguish between open-market pricesearchers and dosed or restricted markets.Closed markets imply higher prices.

11. Simply a case of monopoly rent.

13. a. We don't know the answer to this ques-tion. But it shows the difficulty of deduc-ing collusion from overt behavior.

b. Newspapers are privately owned and useprivately owned resources. Their right topublish is not controlled by governmentagency.

14. Enhances political power. (Or ask your polit-ical science professors.)

16. a. Read C. L. Priest, "The History of thePostal Monopoly," Journal of Law andEconomics, 18, 1 (April 1975), 33-80.

19. Yes, because extent of exchange and special-ization is reduced, with consequent smallerwealth.

21. a. No.b. Yes.

Chapter 14

1. Wages are driven down or up to whateverequates the amount of labor demanded at thatwage to the number willing to work. This maybe so high as to result in real incomes adequateto support a rapidly growing population that isalso getting richer per capita, as has been true forthe past 500 years in most countries. "Subsis-tence" doesn't specify what level of subsistence.

2. In each case supply of that talent gets thatprice, whether because of higher costs of creatingthat talent or because of natural scarcity. Neitherone is cheating or fooling.

3. Producer estimated E. Taylor would attractat least $4 million more in box office receipts-agreater marginal productivity by E. Taylor.

4. a. New employers who are yet to enter busi-ness wouldn't care.

b. Employees would compete down mone-tary wage offers or other nonmonetaryfeatures to get those jobs that now offermore desirable selected nonmonetary fea-tures. Only if every adjustable feature of ajob could be controlled would such im-posed requirements be totally effective.

5. a. It will aid people who already are em-ployed and who are going to have heartattacks and who either do not plan toshift to new jobs or who do not appear t'Obe prone to heart attacks.

b. It will make job shifting more difficult,and will hurt those who reveal a higherprobability of heart attacks insofar as theywant to change jobs. Will help them aslong as they stay with current employer(with employer at time of passage of law).

c. All new employees will bear some of thecosts since the heart attack is not perfect-ly predictable. People with a record of at-tacks will bear the heaviest cost, sincethey will not be able to get jobs at as higha wage as formerly.

6. a. Would not. I would want a higher wage.b. He would offer higher wage.c. Employees.

7. They lose who would have advanced morerapidly because of personal superiority in jobperformance as judged by superiors. We conjec-ture those who would have advanced rapidly aremen, whites, superior teachers, mathematicsteachers-of the characteristics listed in thequestion. (What is your conjecture? Do we dif-fer in principles of analysis or in estimation ofattributes that would lead to more rapid ad-vance?)

8. We don't know. We conjecture that employ-ee discrimination is regarded as acceptable; andwould be incapable of being prohibited by anylaw, in any event.

11. Under (a) black borrowers will be worse offbecause they are restricting themselves to asmaller supply of loanable funds, with higher in-terest rates to black savers. Under (b) black sup-pliers would gain, but as a whole, blacks would

Answers to Selected Questions 4S S

be worse off, for reasons explained in Chapter 8,under both (a) and (b).

Chapter 15

2. a. Ask the judge.b. Ditto.

3. Technically often means "accurately and un-ambiguously." All monopoly is limited in somesense to some class of goods. Monopoly does noteliminate competition. It eliminates certainforms of competition and increases reliance onother forms. In the present case it reduces thescope of wage-rate competition, but increases rel-evance of age, seniority, and so on.

4. Yes, except for the important fact that theunion is not an open-market monopoly and U.S.Steel is. (With respect to the world open market,both are closed-market monopolies as a result ofimmigration laws and tariffs and taxes on irn-ports.)

5. a. Craft union of welders.b. We don't know.

8. a. It would have reduced the number of la-borers and raised wage rates.

b. Producers (employers and employees) ofgoods that could be obtained more cheap-ly by importation wanted tariffs.

9. a. Members of his union would have toswitch to lower-paying jobs.

b. The number of cars purchased by thepublic would be increased, and if produc-ers responded by producing more cars,the number of employees making cars-and the number of union members payingdues to the union-would be increased.The suggestion also serves as a publicityploy in preparation for contract bargain-ing sessions.

10. If the union can eliminate low-wage sourcesof labor, then firms can be eliminated that wouldsurvive with low-wage, low-productivity laborand thus compete against the firms with higher-cost labor.

12. It would be made harder to get business ifthe fees were uniform among all lawyers. But iffees are set at a point that maximizes net reve-

456 Answers to Selected Questionsi 'r i'

nue from this kind of business-as in collusiveprice-setting-the present value of the future re-ceipts may be higher even though present re-ceipts are reduced to younger lawyers (who willget more of higher receipts after they are older,more experienced, and well known).

13. a. Some would. But we conjecture mostwould not.

b. It would increase revealed discriminationby color, because currently blacks cancompete by taking lower wages to get ajob. (Do you think a law prohibitingchoice of employees by color or racewould be effective enough to offset in-creased incentive to discriminate andwould be enough to offset reduced em-ployment on a wage basis?)

14. Those who cannot provide services worth asmuch as the minimum-wage rate will have towork as self-employed or commission-basis em-ployees. Thus, in saying that a higher minimumwage reduces employment, we meant employ-ment for wages-not productive work as self-em-ployed or commission-basis employees.

15. Increase. Self-employment is a way of evad-ing wage regulation. ,

16. We would prefer none of those laws, sincethey restrict the opportunity of an immigrant tocompete against more popular types of residentsin seeking jobs as employees.

17. Decreased. The union will set wages higherto keep only full-time employees at work, withless interest in casual, seasonal laborers.

18. Depends upon whether parents prefer col-lege-age people or old people for baby sitters.Certainly high school students will suffer, sincethey are poorer quality and manage to competeby offering to work at lower wages.

19. a. It will aid people who already are em-ployed and who are going to have heartattacks and who either do not plan toshift to new jobs or who do not appear tobe prone to heart attacks.

b. It will make job shifting more difficult,and will hurt those who reveal a higherprobability of heart attacks insofar as theywant to change jobs. Will help them aslong as they stay with current employer

(with employer at time of passage of law).

20. a. Flunk writers of first two items. Bonusespaid were reflective of estimated value ofplayers to the teams. "Bidding away legalproperty" in Daley's article is not ridicu-lous, for what else does one do when hebuys something? Does Daley imply thereis "theft"? Not if bid away. If a player isnot legal property, like a slave, biddingaway is neither illegal nor "unethical."Daley seems to be advocating that em-ployers be allowed to hire employeeswhile employees are not allowed to bepaid open-market competitive wages.

b. No. Could pay new firms to enter busi-ness and bid away the employees.

c. Probably not. Cannot reconcile this withdraft.

Chapter 16

4. a. Longer-run consequences are, insofar asforeseen, discounted into present capitalvalue of the enterprise ,lOd are henceborne by the present owner.

5. It permits more future consumption at thecost of less current consumption.

6. Current consumption is forsaken for futureincome from the preserved house.

7. 5%.

8. Not all roundabout, capitalistic methods aremore productive. But many forms are. So theright forms of capital-goods accumulation willenhance wealth in the future.

9. a. $3.71; $8.02, $9.95, $6.80 for col. (3);-$2.89, + $1.20, + $3.04 for col. (5).

b. 40 years.c. $3.00.d. Lower interest rate.e. As soon as its lumber value is positive.

10. a. $115.60.b. Three years.

12. a. Yes. A fall in the rate of interest.b. Increase the profitability.c. Reduce the ratio of the price of raisins to

grapes. Raise the rate of interest.

13. a. About 200,000 rabbits.

15. Higher rate of investment means a higherrate of production of some goods, and this im-plies a higher cost per unit of those goods.

16. Investment is defined as that rate of conver-sion (of present incnme) to wealth which can beprofitable. The function relating these rates tothe rate of interest is the investment-demandfunction. Saving is defined as that rate of conver-sion of present income to wealth that the com-munity wants to engage in. This desired rate-orthe rate at which the community is willing to di-vert income from current income to wealth accu-mulation-is a function of the rate of interest(among other things); and this relationship be-tween the saving rate and rate of interest is thesupply-of-savings function.

18. See pp. 352-353.

19. a. $50 per year.b. $57.80-a 2-year annuity.c. $10.00.

20. a. Yes.b. Relative prices of capital goods and earn-

ings.c. Changed price of capital goods relative to

current consumption goods; prices of cap-ital goods relative to earnings.

21. Corporation managers do not have to investall funds within the corporation. They can investin other companies; they can lend the money. Solong as they consider possible alternative invest-ments, they will use funds within the firm only ifto do so looks more profitable, as would be thecase if the funds were to be borrowed from themarket.

22. a. Among those hurt are people whose cred-it is so poor that they are unable to bor-row at these low rates. Among thosehelped are the better-credit borrowers,since some funds that would have gone tohigh-risk borrowers are now diverted tothe safer borrowers with a consequentlower interest rate to them; corporationsare benefited.

23. a. To evade the 5% interest limit in orderto get the guarantee.

b. Is this economic analysis or name calling?d. No. Tie-in sales are literally impossible to


prohibit completely. (Once upon a timethere was a man who rented his house,under rent control, at the legal maximumrent to the renter who also had offered tobuy his ailing cat for $1000.)

24. Either.

Chapter 17

1. A person should be able to get a job at asalary close to his last salary without a significantcost of finding such a job.

3. No. He chooses not to accept the best alter-native job he has so far discovered and is insteadlooking at more jobs-which is not to say that heis lazy or deserves to be poorer.

5. a. Unemployment from relative demandshifting; from general money demandshifts; from closed markets.

6. a. No. The sum of a random variable,summed over trials (one for each firm),will still be a random variable. Randomdeviations do not cancel each other exact-ly.

b. Almost certainly. Very rarely would ev-ery firm have bigger sales on the follow-ing day.

c. Almost certainly. Very rarely would ev-ery firm experience a decrease in sales.

d. No, almost certainly not.e. Average would be decreased.f. Average would be increased.g. The former.

7. Increment of cost exceeds increment ofwealth for second job possibility investigated.

8. Costs borne by both-no m~tter who paysthe employment agency. If you think it too large,why don't more people go into the business?

9. It is consistent with it, but how far it goestoward implying that higher rate is not clear. Asblacks move to the North away from smallertowns with fewer employers, they find it profit-able to engage in a larger scope of search; also,employers find it profitable to engage in moreextensive search of these applicants than in asmall town. A major factor is also believed to bethe minimum-wage rate, which cuts more heavi-


ly against less-skilled persons-which is not in-consistent with the analysis of this chapter. Mas-sive unemployment in response to big decreasesin general demand is certainly an implication ofthe analysis and is a powerful piece of evidencesupporting the analysis.

12. Demand to employ people at higher wagesthan now offered in available jobs. This does notmean the current offers in those jobs ought notto be increased by monetary or fiscal policy.They may and they may not be already appropri-ate; but in any event it is not more jobs that arebeing created but higher money-wage offers.

13. Productivity in existing jobs would be re-duced if cheap energy were available in smallersupply. Indeed, more-expensive (less-available)energy would increase tasks to be done by peo-ple. More labor would have to be used, like push-ing a lawnmower rather than using a powermower! Remember, jobs are never saved or cre-ated by changes in resource availabilities. Theyare made less or more productive. Labor be-comes more or less productive in jobs the moreor less other jointly usable resources are avail-able.

14. As in prior questions, there are too manyjobs to be filled. The problem is to get produc-tivity and hence wages in each task acceptable topeople. Unskilled persons may refuse to work un-less they are paid more than they are worth injobs. The skilled may not be skiIled enough forsome jobs that could be performed only by veryskilled people. I might offer $5 an hour to some-one who could keep my computer program work-ing, but no one is skilled enough to do that. Or ifthey are, they could earn more at other jobs. Wecan always specify some task that no one isskilled enough to do or offer a wage too low toattract those skills. Though that would mean"unfilled jobs for the more skilled," obviously thewage is too low to attract adequate skills. And atthe required wage the job might not be offered.

15. a. Employees were also paid in nonmone-tary ways, such as "free" or "low-cost"clothing, food, or housing.

b. Feudal lords wanted people to remaintied to their estates, so they tried to pre-vent industrial employers from attract-ing them to more attractive industrial ac-tivity.

19. Minimum-wage laws preventing employ-ment of low-productivity labor would strike mostheavily against those listed in the question.

Chapter 18

1. See Table 18-1. The value added is equiva-lent to income earned. Hence a value added taxwould be equivalent to a tax on income, if thedefinition of taxable value added corresponds tothat in the table.

2. a. No.b. It would encourage firms to integrate into

one firm to avoid taxable transactionsamong themselves.

3. Part of that excess is value added. If larger,then a profit is earned.

4. A higher marginal tax bracket (that is, thetax on the extra dollars earned) reduces the sup-ply of labor to the market. But a higher averagetax rate, if the marginal tax rate is fixed, mayincrease or decrease the supply of labor to themarket. Be careful to distinguish between mar-ginal and average taxes.

5. Money is fungible: It can be spent for any-thing. Thus, money collected to be spent on thepolice may permit other expenditures to remainundiminished despite such increases, whereaswithout the tax police expenditures could not beincreased unless other expenditures were dimin-ished.

6. Same answer as in above question.

7. Some taxes pay for benefits received by thetaxpayer. Hence to treat aftertax income as theonly income is to overlook government services.If governments tax more heavily but providemore services, then aftertax incomes will be a de-ceptive measure of economic welfare.

8. Because land is a resource whose supply isfixed independently of price, the sales tax willincrease the cost of living in Las Vegas, and landvalues will fall commensurately, because landcannot move to other places.

9. No. But in some measures of the cost of liv-ing it is nevertheless misleadingly counted.

10. If the public regards government property intrees as part of its wealth-possibly by sales of

the cut lumber thereby providing public serviceswithout explicit taxes-then people who wouldotherwise not have paid taxes when the treeswere government property would pay higher tax-es after the lumber js sold. Selling one's wealthdoes not eliminate taxes. It reduces the source ofone's income.

11. No, because anticipated future events arecapitalized into present measures of wealth. Ifone's present wealth increases, one increasesone's current consumption, possibly by borrow-ing against the future greater aftertax income.

12. True.

14. a. Correct form of statement would be thatit would raise the payments the federalgovernment would have to record in itsbudget. Real costs are being paid alreadyby those who are drafted. The incomethey are sacrificing is the cost, and thiscost would be reduced if the draft wereeliminated and military personnel wereobtained by paying adequate wages to at-tract men.

b. You should, because it will. Better assign-ment of people to jobs in this country-which would be a result of using adequatewages for military personnel-would in-crease the total productive efficiency andoutput, thereby reducing the size of oursacrificed output. The draft conceals costsby making federal expenditures lowerthrough the device of compulsory service.

Chapter 19

9. a. Monetary asset to creditor; monetary lia-bility to debtor.

b. Monetary asset to creditor; monetary lia-bility to debtor.

c. Real asset to both parties.d. Real asset to leaseholder; real liability to

lessor; monetary liability to leaseholderand monetary asset to lessor.

10. Are you a net monetary debtor?

11. a. No.b. Yes, because legal ethics and principles

are concerned only with the nominal val-


ue of the funds and not with their realvalue, which is relative to changes inprice level.

c. Our legal system seems to act on thepremise that inAation is not a fact of life,and thus that the nominal value of yourinvestment is all that has to be protectedby a prudent trustee.

14. The wage-lag assertion implies a systematicrelationship between inAation and wages, not arandom one, so if the assertion is correct, lagshould be apparent more than half the time. Allevidence refutes the existence of a lag.

15. Increased demand does not necessarily firstoccur for consumer goods. It can be for labor tomake buildings, machines, or roads. To think ofdemand as always having its first impact on finalconsumer goods is to confuse impact of demandchanges with value derivation from consumergoods. Furthermore, recall the discussion inChapter 4 of the effect of a change in demand formeat.

I,

16. Money holders.

17. a. Smaller.

,-------------------------------------------------I IIi I 460 Answers to Selected Questions

b. No.e. By about 250%.

18. It prevents prices from facilitating exchange;it diverts attention from causes to consequences.

19. Neither affects the quantity of money or ofreal goods and services, or the demand to holdmoney.

20. The desire to revise the pattern of demand isoften a reason for resorting to a policy of moneycreation. The inAation does not therefore causethe revised price pattern; instead, the revised de-mand brought about by the new money causesthe relative price changes. At least this interpre-tation is consistent with facts about sources of in-Aations and observed changes in relative pricepatterns. The statement that inAation in and ofitself causes a dispersion of prices because ofprice rigidities is not eritirely false if regard isgiven to prices that are fixed by law and can bechanged only by appeal to a regulatory agency(as public utilities must). But the assertion is usu-ally more sweeping, and for that there is no sup-porting evidence.

Glossary

Aggregate demand: The sum of all individualdemand schedules.

Aggregate supply: The sum of all individual supplyschedules.

Annuity: A series of future annual yields orpayments.

Bargaining power: A measure of the ability of par-ties in negotiations (such as labor unions andemployers) to achieve their goals.

Bond: A promise to repay a borrowed amount, orprincipal, usually with interest, for some speci-tied number of years.

Boycott: A concerted refusal to buy, and an effortto persuade others not to buy, the product of aparticular firm.

Business firm: A group of productive resourcesjointly producing goods and services for sale toothers.

Capitalism: .Essentially the same system as a mar-ket economy.

Capitalist: The individual who makes the wage orrent payments to inputs of production.

Capital gain: An increase in the market value of anasset (usually realized at the time the asset issold).

Capital goods: Durable goods producing a streamof future goods or services that have some mar-ket value at the time of production.

Cartel: A coalition of sellers who conclusivelyagree to reduce output and raise prices, as wellas to restrain entry of new competitors.

Closed shop: A firm in which only union memberscan be hired.

Collective bargaining: Negotiations on contractterms and working conditions that are conduct-ed by employees as a group-usually through arepresentative, such as a union official.

Command economy: An economy in which pro-duction and distribution of goods and servicesis organized and directed by a central authority.

Comparative advantage: That productive activityfor which one has the lowest marginal cost interms of other productive activities forgone.

Competition: Rivalry among sellers and amongbuyers for goods and services, a method of co-ordinating economic activity through free ex-

change of productive resources and final goodsand services under a system of private property.

Constrained maximum: Maximization of somevariable (like output of a good) subject to someconstraint (like a given output of another good);the production-possibility boundary representsconstrained maximization. 6'

Consumer price index: A measure of changes inmoney prices of a typical market basket ofgoods and services for average-income people,compiled by the Bureau of Labor Statistics ofthe U.S. Department of Labor.

Consumer's surplus: The benefit to a buyer fromthe purchase of a good; the difference betweenthe buyer's total personal use value of the goodand the good's market value.

Copyright: The assignment of an exclusive right tocommercial use of written or published materi-al.

Corporation: A business firm that is jointly ownedby several people, whose liability is limited totheir stock in the firm, and that continues toexist despite death or sale of stock by owners.

Cost: The most valuable forsaken alternative to anact.

Craft union: A labor union whose members arepractitioners of a particular skill, like carpentryor bricklaying, though they may work in differ-ent industries.

Deficit spending: The spending of more than hasbeen taken in as revenues.

Demand, or demand schedule: A schedule of thedifferent quantities of a good or service an indi-vidual is willing and able to buy at variousprices.

Depreciation: The predictable reduction in the val-ue of a resource as it deteriorates with use orwith aging.

Depression: A decline in production, income, andemployment that is more severe, and may belonger lasting, than a recession.

Derived demand: The demand for productive re-sources derived from demand for the outputthose resources can produce.

Differential earnings: The earnings to a superiortalent or more efficient resource; a Ricardianrent (but not a monopoly rent).

461

Division of labor: The division of production ofsome output into a number of different tasks inwhich people specialize.

Dominant firm: A seller controlling a sufficientamount of supply to act as a price searcher,while competitors are price takers of the priceestablished by the dominant firm. The domi-nant firm controls not only current supply butalso sources of expanded supply in the near fu-ture.

·1

11

III

Earnings: The accounting conception of profits asthe margin of revenue over accounting cost, asopposed to economic profits, which are themargin of revenue over economic costs (includ-ing a 'normal' profit).

Economic efficiency: The condition of an economythat is operating with productive efficiency(that is, is on the production possibility bound-ary) and is maximizing consumer welfare suchthat no change in resource or output allocationcould make someone better off without makingsomeone else worse off.

Economic good: A good that is scarce, of whichless is available than people want.

Economic growth: Increase in the output of aneconomy in conditions of full employment.

Economic rent: Any price that is unnecessary tokeep a good in existence; hence any price inexcess of resource cost. Economic rent may,however, be necessary to allocate goods to theirhighest-valued uses.

Endowment effect: The effect that change in agood's price has on demand for that good by aperson whose income or wealth is partly de-rived from that good. The endowment effect onquantity purchased moves in the same direc-tion as price.

Equilibrium-sustaining price: The market-clearingprice.

Fair-employment laws: Laws regulating the hiringpractices of employers, with the stated intent ofprohibiting discrimination.

Federal Reserve System: The central banking sys-tem created by the U.S. government; the majortool of monetary policy.

First law of demand: At any given price, there issome higher price at which less of a good is de-manded.

Fiscal policy: Government use of expenditures andtaxation to attempt to alleviate fluctuations ingeneral economic activity.

Free enterprise: Another term for private-propertymarket-exchange system.

: 1\ 462 Glossary

Free good: A good (such as air) the availability ofwhich is sufficient to satisfy all wants, even at azero price. Some goods that are "free" to theirconsumers, like public education, are not freeby this definition.

Frictional unemployment: Unemployment arisingfrom normal shifts in demand and supply in thelabor markets. It is an efficient method of ad-justing to changing market conditions bysearching for the best available alternative em-ployment.

Full employment: The condition in which the en-tire labor force is working except those who aretemporarily between jobs.

Full price: The money price of a good or serviceplus all other costs incurred in making the pur-chase, such as time, inconvenience, and thelike.

Gains from trade: The difference between seller'sor buyer's marginal personal use value for eachunit of a good traded and the price of that good.

Good: Anything that someone desires.Goodwill: A specialized asset of a firm, which

earns a rent equal to the excess of the value ofthe firm over the sum of the value of each of itsproductive resources were those resources usedelsewhere.

Gross national income: National income includingwages, rents, profits, interest, and the value ofcapital equipment used up through deprecia-tion.

Import quotas: Limits on the amount of a goodsuppliers from other countries are permitted tosell in the country imposing the quota.

Income elasticity of demand: The responsivenessof the quantity of a good demanded to changesin the incomes of buyers of the good; the ratioof the percentage change in quantity demandedto the percentage change in income.

Income release effect: An effect of a lower price,which releases some of the income formerlyspent on that good at its higher price. There isusually a negligible effect on demand for thegood in question, the released income beingspread out over all the goods purchased. Theopposite effect occurs when the price of thegood increases.

Industrial union: A labor union whose memberswork in a particular industry, such as steel orautomobiles, though there may be numerousdifferent skills practiced by its members.

Inferior good: A good of which less is demanded byan individual as personal income rises, all other

things affecting demand for that good remain-ing unchanged.

Inflation: A persisting increase in all money (nomi-nal) prices; conversely, a decline in the purchas-ing power of money. All prices rise by the sameamount. (Differences in the increase in prices ofvarious goods during inflation reflect changes inrelative prices, not differences in the effects ofinflation on the prices of different goods.)

Interest: The anticipated rate of growth of wealthwere income reinvested; the amount of wealththat could be consumed in a given year withoutreducing one's stock of wealth below its origi-nal value. Hence it is the price of borrowingmoney.

Investment: Saving or nonconsumption for the pur-pose of transforming saved resources into pro-ductive capital for future use.

Labor-market participation rate: The proportion ofthe adult population that is in the market laborforce (which excludes the nonmarket labor ser-vices of the military and of spouses in thehousehold).

Labor union: A coalition of employees of a firm tomonitor and affect wages, fringe benefits, em-

.ployer-employee relations, and working condi-tions at the firm.

Long run: Either (a) the interval in which all pro-ductive resources can be changed to adjust opti-mally to a given level of output, or (b) a long-lived activity. The two meanings of the termshould not be confused.

Long-run period: The period in which all desiredadjustments to market conditions have beenmade, including changes in any and all produc-tive resources and in prices and output.

Marginal cost: The increase in total cost from pro-ducing one additional unit of a good or service.

Marginal personal use value: The value a personplaces on one additional unit of a good, meas-ured as the amount of some other good the per-son would forsake to get that unit.

Marginal product: The increase in total outputfrom the addition of one unit of some input,with all other inputs used in the production ofthat good held constant.

Marginal revenue: The change in total revenue(market value) from a good when price is reducedenough to sell exactly one more unit.

Market-clearing price: The market price at whichquantity demanded equals quantity supplied.Graphically, it is the point at which the supplyand demand curves intersect.

Market economy: An economic system in whichindividuals have rights to control and use pri-vate property and to exchange such property atmarket prices.

Market period: The period in which the supply ofa good is unchanged regardless of the change inthe price for which the good can be sold.

Market value: The total value of an amount of agood at its market price: the price of the goodtimes the quantity sold at that price.

Mercantilist system: A system in which access toprivate property and markets is limited by gov-ernment to certain individuals.

Merger: The combining of two firms into one, ei-ther by one firm's buying the other or by t etwo being aggregated under common owner-ship of the original owners, who form the newownership of the merged firm.

Minimum-wage law: A mandated rate of pay belowwhich employers are forbidden by law to payemployees, whether or not individuals are will-ing to work at that lower wage.

Monetary policy: Government use of expansion orcontraction of the money supply to affect thegeneral level of economic activity.

Money: A costlessly recognized, divisible, storable,and -exchangeable good used in virtually everyexchange. It serves as a medium of exchange,unit of measure, and store of value.

Monopoly: The presence of a single seller of agood or service legally protected from the entryof potential competitors.

Monopoly distortion: The failure of a monopolistto produce goods for which the value to buyersexceeds the costs of production, because mar-ginal revenue is less than marginal cost forunits not produced.

Monopoly rent: The higher income received by amonopolist as a result of the monopoly.

Monopsony: A monopoly held by a buyer ratherthan a seller.

Multipart pricing: The selling of additional units ofa good at successively lower prices as largerquantities are produced but with no lowering ofprices of the earlier units.

National Income Deflator: A measure of infla-tion-usually lower than the Consumer PriceIndex-calculated according to the rise in mon-ey prices of all national income. By includingall goods and services it provides a more reli-able measure of inflation than CPI, which usesa rigid market basket that does not allow forsubstitution among goods whose relative priceshave changed.

Glossary 463

Natural monopoly: A firm whose costs decline asoutput increases such that one firm is more effi-cient than two or more could be.

Net National Income: The sum of value addedover the entire market economy: the sum ofwages, rents, interest, and dividends for the en-tire economy.

Net of tax: The price of a good a seller receivesafter taxes on that good have been subtracted.

Net productivity of investment: The increase in fu-ture income created by investment today totransform some resource into a more highly val-ued form for later use, a form more highly valuedthan the present value of the funds invested.

Nominal price: The amount of money, rather thanthe amount of other goods, that must be givenup to get some of a good. If the value of moneyis falling, an increase in the nominal price of agood does not necessarily indicate a change inits real or relative price.

Nonprofit corporation: An enterprise, usually non-governmental, holding assets the return fromwhich is not distributed to any individual (asthey are under private-property arrangements)but is reused to further the stated goals of theenterprise.

Obsolescence: Unexpected reduction in the valueof a productive resource from unanticipated de-velopment of a new, superior competing re-source.

Oligopoly: A situation in which each of the fewsellers of a good makes pricing and output deci-sions according to the anticipated responses ofother sellers.

Open market: Markets to which all individualshave access without legal or artificial barriers.All individuals are permitted to buy or sellgoods or services at market prices.

Opportunity cost: The most valuable alternativethat must be forsaken to undertake a given act:cost.

Pareto-optimal allocation: Output allocation suchthat any change to make someone better offwould make someone else worse off.

Parity price: A government-guaranteed rmrumumprice for agricultural output-essentially, aprice floor on agricultural products. These aresaid to bring "parity" with the costs of farmoutput.

Partnership: A form of proprietorship involvingtwo or more owners, each liable to the extent oftheir wealth. A partnership dissolves upon thedeath of a partner.

II'II

464 Glossary

Patent: Assignment of an exclusive right to com-mercial use of an invention not previouslyknown. The patent usually has a limited life,and prohibits only the commercial rights to thegood or service; private production and con-sumption aren't limited.

Poverty line: A level of income, chosen by the So-cial Security Administration, below which fam-ilies are said to be in poverty. The line is basedon family size and includes no in-kind income,such as government-provided medical servicesor food stamps.

Present value: The current value of the futurestream of goods or services that an investmentwill yield; it is derived by discounting the valueof that stream at an appropriate rate of interest.

Price discrimination: Selling goods at differentmarket prices to different groups, reflecting dif-ferences in demand among the groups ratherthan differences in the costs of providing thosegoods. It is undertaken to capture some of theconsumer's surplus that goes to consumers un-der uniform pricing.

Price elasticity of demand: The responsiveness ofthe quantity of a good demanded to changes inthe price of that good; formally, the ratio of thepercentage change in quantity demanded to thepercentage change in price.

Price searcher: A seller who affects the price of agood by changing the quantity produced andsold. The seller faces a downward-sloping de-mand curve, and price exceeds marginal reve-nue. The seller must search for the profit-maxi-mizing price. A price searcher is said to havemarket power.

Price taker: A seller whose sales are a small enoughportion of the total quantity demanded of thegood that the seller's changing the supply willnot affect market price. The price taker mustsell at whatever price the market determines,rather than searching for a price.

Private property: Economic goods that can be con-trolled, used, and exchanged by individualswithout political restrictions.

Production-possibility boundary: The locus ofpoints describing the maximum amount of onegood that can be produced given productionlevels of a second good with given resourcesand technology.

Productive efficiency: Production of the maximumoutput possible at given levels of resources andtechnology; it is described by the points alongthe production possibility boundary.

Profit: Any increase in wealth above and beyondthat accounted for by investment of savings out

of standard income: increases in an economy'sstock of wealth that are not anticipated in themarket.

Promissory note: A legal contract promising to re-pay a debt at some point in the future at a stat-ed rate of interest. "Buying debt" is the pur-chase of a promissory note.

Proprietorship: A business owned by one personwho has full liability for all the firm's debts tothe extent of his or her entire wealth. The firmends upon the death of the proprietor.

Public good: A good that can be consumed by anyone person without there being less availablefor others to consume. The value of a publicgood is thus the sum of the value all individualswho consume the good place on each unit.

Quasi-rent: Any part of a price that does not affectthe amount of a good available now but willaffect the future amount of that good available;a temporary rent.

Real asset: Any asset (such as land) the real valueof which remains unchanged by inflation, al-though the money value of such assets willchange.

Real liability: Any obligation the real value ofwhich is unchanged by inflation, although thedollar value may change.

Real price: The same as relative price.Real wages: Wages measured against living costs-

the actual goods and services that can be pur-chased with the wage.

Recession: A transient decline in the general levelof employment, income; and production fromsome shock to the economy.

Relative price: The price of a good compared tothe price of all other goods. The amount of oth-er goods (other than money, itself a good) thatmust be given up to get a good. If all moneyprices change by the same amount (as duringinflation), relative prices are unchanged.

Rents: Earnings paid for the services of nonhumanresources, such as land.

Revenue sharing: Distribution of federal tax reve-nues to state and local governments.

Ricardian rent: The higher return received by amore productive or more efficient resource.

Saving: The nonconsumption of standard income,thus adding to an economy's stock of wealthand increasing that economy's future standardincome.

Scarcity: The condition of limited resources rela-tive to unlimited human wants.

Secondary boycott: A boycott against a firm thatdeals with a firm being boycotted.

Second law of demand: II! the long-run, demand ismore elastic for any given good as substitutesfor that good become more readily apparentand available. '"

Shortage: An excess of quantity demanded overquantity supplied because the price of a goodhas not been permitted to rise to its market-clearing level.

Short run: Either (a) the interval in which the stockof productive resources remains fixed, or (b) thetime required to make a quick adjustment inthe level of output (and cost). The two mean-ings of the term should not be confused. ••

Socialist economy: A system in which income-pro-ducing goods and durable consumer goods arecontrolled by the government and are not sal-able at market-clearing prices.

Specialization: The production of more of a goodthan one consumes, the unconsumed portionbeing sold for other goods one wishes to con-sume.

Speculation: The buying of a good in the hope ofmaking a future profit by a rise in its price.

Standard' income: The increase in an economy'swealth, analogous to the interest rate, that theeconomy can consume in a year without detri-ment to the original stock of wealth. The mar-ket-forecasted sustainable rate of increase inwealth.

Strike: A concerted refusal by employees to workfor a particular employer with which a unionhas a grievance, and to prevent others from tak-ing jobs with the same employer in their ab-sence.

Structural unemployment: Unemployment causedby very large and long-term or permanent shiftsin labor demand in a few industries, often forc-ing those unemployed to accept lower wages orrents in other industries where their skillsearned in the declining industry aren't so valu-able.

Substitution effect: The effect of a change in priceof a good on the quantity of the good demand-ed; when the price of a good rises, other goodswill be substituted for it and the quantity de-manded will falls, all other things affecting de-mand for that good remaining unchanged.

Superior good: A good of which more is purchasedby an individual as personal income rises, allother things affecting demand for the good re-maining unchanged.

Surplus: An excess of quantity supplied over quan-tity demanded because the price of a good has

Glossary 465

not been permitted to fall to its market-clearinglevel.

Tie-in: Sale of a product on the condition that a dif-ferent, perhaps unrelated, product be pur-chased as well.

Total personal use value: The total amount of oth-er goods and services one would be willing togive up to obtain some amount of good.

Unemployment: The absence of employment ac-ceptable to the unemployed in terms of wagesand working conditions.

Union shop: A firm in which one need not be aunion member to gain employment, but mustjoin the union and pay dues within a specifiedperiod after being hired.

u: _

il! I 466 Glossary.iI

Utility-maximization theory: The theory that indi-viduals seek the highest possible satisfactionfrom the goods and services they consume andfrom other activities they undertake.

Value added: The value of a product in excess ofthe cost of materials and services purchased bya firm to make that product. The sum of valuesadded, rather than the value of sales at eachstep of production, is the proper measure of na-tional income.

Wages: Earnings paid to providers of labor services.Wealth: The sum of the market value of all goods

and services in an economy. (The term physicalwealth refers to the collection of an economy'sgoods, not their value.)

Index

Advertisinghonesty and dishonesty in,

278objections to methods of, 278-

79purpose of, 278restrictions on, 279, 284

AFL (American Federation ofLabor), 326-27

AFL-CIO,326-27Allocation, Pareto optimal, 76American economic system

characteristics of, 2compared with world

economy, 2See also Capitalism

American Federation of Labor(AFL), 326-27

American Medical Association(AMA),270

Annuities, 114-15Antitrust legislation, 272-73Arbitrage, 250Assets

defined, 198kinds of, 198-200monetary, 410real,410

Automobile industry (U.S.), 275-76

Balance sheetdefined, 198interpreting a, 198-203

Bargaining, collective. See Laborunions

Behavior, as a basis foreconomics, 13-15

Black Death, inflation following,406-7

Blacksand criticism of labor unions,

332and ethnic income differences,

315job duration of, 372unemployment among, 374

Boycott. See Labor unionsBond market(s)

importance of, 358interdependence with stock

market, 350as a key market, 350-51and risk, 354-55

Bondsinterest rates on, during

inflation, 128negotiability of, 358and newly created money, 408

Book value, defined, 193-202Brand names, 238-29By-products, 226

CAB (Civil Aeronautics Board),292

Capitalconstituents of, 173and increased output, 174and interdependent products,

227as a substitute for labor, 174

Capital equipment, 306-7Capital goods

buying and selling, 350effect of increase in, 351and production, 173-74,300service value of, 113

Capital (Marx), 157Capital value

and deferred value, 110defined, 107and future yields, 110, 122-27illustrations of, 112-13and net value, 108and resale value, 119

Capitalismcharacteristics of, 2compared with socialism, 53,

57, 283defined, 6first described by Adam

Smith,6-7history of, 6-7marginal productivity in, 176

misconceptions about, 123socialistic characteristics of, 7See also Communist

economies; Socialisteconomies

Capitalist, defined, 300Capitalist economies. See

CapitalismCartel(s)

alternatives to forming, 270cheating within, 265compared with mergers, 270controlling competition in,

264defined, 52, 263as distinguished from firms,

263effect of, 263European, 270evidence of, 269-70monopsony, 337-39OPEC, 265-68problems forming, 264-65in transportation, 291See also Collusion

Charity. See PhilanthropyCharts, how to read, 429-35Checking accounts, 408-9, 413,

425-27Chicanos, and ethnic income

differences, 316China. See Communist

economiesCIO (Congress of Industrial

Organizations), 326-27Civil Aeronautics Board (CAB),

292Clayton Antitrust Act (1914), 273Collusion

among producers, 264-71in college athletics, 337-38defined, 263as distinguished from a firm,

263and dominant firm situation,

267-68effective, 265n

467

Collusion (continued)military draft as, 338-39"tacit," 274See also Cartel

Command societies. SeeCommunist economies

Commonwealth v. Hunt, 325Communism. See Communist

economiesCommunist economies

characteristics of, 5-6denial of labor unions in, 325See also Capitalism; Socialist

economiesCompetition

among buyers, 91among firms, 190-92among speculative developers,

228criteria of, 8-9defined, 7as discrimination, 8necessity of, 7nonmonetary forms of, 71-73as regulated by law, 7-8types of, 7-8, 283See also Cartel(s); Collusion

Condominiums, 127-28Congress of Industrial

Organizations (CIO), 326-27

Conservationists, 346Constrained maximum, defined,3 .Construction, government

regulation of, 285Consumer Price Index (CPI),

404-5Consumer(s)

and advertising, 278-79and increased purchase

options, 275and product information, 237-

38, 276-77as unit of analysis, 13and value of brand names,

238-39Consumer's surplus, 17-18Consumption, 35Contract, futures, 81Control

economic, 2social,8

Copyrights, 101, 292Corporations

characteristics of, 186defined, 186management competition in,

188and national income, 186net earnings of, 186nonprofit, 95-96ownership versus control in,

187-88perpetual nature of, 186-87and profits, 188-90size of, 186statistics about, 186and stockholders, 186, 187-88takeovers between, 188See also Firms

Cost(s)acquisition, 222apportioning, 226average, 150-51,213borne by others, 5of borrowing, 119-20components of, 5, 121,222-24constant, 206-7defined, 4depreciation as a, 226in enforcing collusions, 269full, 4-5,222of gaining information, 237-

38, 284generalizations about, 224-25and increased demand, 90of joint production, 225-26as loss of opportunities, 4-5marginal. See Marginal cost(s)of marketing, 48-50minimizing, 143-44misunderstandings about,

149-50, 177operating, 207, 223-24, 275opportunity, 4

~< and output rates, 206-7possession, 222in proportion to quality, 150-

51transportation, 228-29, 230-31trial, 192variable, 207, 223-24See also Marginal cost(s);

Price searcher; Price takerCoupons, ration, 73CPI (Consumer Price Index),

404-5Craft unions, defined, 326"Cream skimming," 250

468 Index

Creditor, net money, 410-13

Debtor, net monetary, 410-13Deferred services, 108Deficit, 398-99Demand

adjusting to changes in, 62as affected by price, 18, 58-59as affected by taxes, 67-68as affecting output, 63-64alleged exceptions to, 35-36anticipating future, 228and basing point price, 229defined, 16derived, 176, 229effect of competition on, 69-

70elasticity of, 25, 33,68first law of, 15-16illustrations of, 29-32and income, 33-34interaction of, with supply, 90for interdependent products,

227and personal use value, 16in a price-searcher market,

243-44reduced, and "predatory

prices," 217responses to, 213-14, 218-19,

271-72from seller's viewpoint, 21-22second law of, 28-29and use of resources, 218-19validity of laws of, 36-37versus amount demanded, 16versus need, 20See also Price(s)

Demand curve. See Demandschedule

Demand deposits, 408-9Demand schedule

as affected by factors other .than price, 22-23

as affected by price, 18, 22defined, 16and the prestige effect, 35

Democracy, 53Depreciation, 226Depression, Creat, 370, 381, 383Derived demand, defined, 176Developers, 228Discounted value, 113Discounting, 110Dividends, 299, 360

Division of labor. SeeSpecialization

Domestic economy, 387-88Domestic services, 387-88Draft, military, 338-39

Earningsclasses of income, 299differential, 189misleading measurements of,

195retained,201-2

Economic analysis, 9-10, 54,429-35

Economic development, 344Economic rent, 75-76Economic systems, 5-7Economic theory, 9Economy

components of, 390-91domestic. See Domestic

economymeasurement of, 404-5methods of organizing, 5-7recovery of, 383

Efficiency, economic, 2-3Elasticity

of demand, 25-27elements of, 26-27, 27nestimating, 32-33income, 33and marginal revenue, 27and the second law of

demand, 28-29Employment

during inflation, 419and economic fluctuations,

382-83full, 370, 382-83normal rate of, 382statistics on, 371-73trends in, 371See also Jobs: Unemployment

Endowment effect, defined, 34Ethics, of open markets, 52-53Ethnic groups, income

differences among, 315-16Equity, 198, 200-201Externalities, 5

Fair-employment laws, defined, 336Farm price-support laws, 287FCC (Federal Communications

Commission), 98-99, 292,295

FDA (Food and DrugAdministration), 284

FEA (Federal Energy Agency),292

Featherbedding, 332Federal Communications

Commission (FCC), 98-99,292, 295

Federal Energy Agency (FEA),292

Federal Reserve Banks, 408-9Federal Reserve Board, 359Federal Reserve System, 381,

418-19Federal Trade Commission

(FTC)and competition complaints,

283-84creation of, 273

Federal Trade Commission Act(1914),273

Financial statements,interpreting, 198-203

Firmsand accounting records, 193-94and barriers to entry, 190-92behavior monitoring in, 185competition among, 190-92defined, 183definition of profits in, 192-93as distinguished from

collusions or cartels, 263entry investment to, 190-92forecasting in, 202interdependence between, 271interpreting financial

statements of, 198-203leadership tasks in, 185marginal,214misconceptions about, 274-76purpose of, 183risks in, 184-85sources of uncertainty in, 184types of, 185use of insurance in, 184value of goodwill in, 191value of superior teamwork

in, 192See also Corporations; Profits

Fiscal policy, defined, 381-82Food and Drug Administration

(FDA),284Food, demand for, 29Ford Motor Company, 245, 275Forecasting, 184, 202, 244-46

Free enterprise system. SeeCapitalism

Freight, "phantom," 228FTC. See Federal Trade

CommissionFutures, 81-86

Gasolinedemand for, 32, 33price increases of, 24-25shortages, 61-62See also Oil

General Motors Corporation,186,274,275

George, Henry, 76Gifts. See PhilanthropyGNP (Gross National Product),

388-89Good, public, 397Good(s)

capital, 107defined, 14and demand versus need, 20durable, 107economic, 14free, 14inferior, 33outputs of, 2, 3and personal use value, 14-15private, 100public, 99-100relocation of, 47-48scarcity of, 2shortage of, 14superior, 33

Goodwill, defined, 191, 200Government

borrowing activities of, 398-99

and creation of new money,400

debt, 400deficit, 398-99as economic stabilizer, 398-

400expenditures of, 392-94and increase in regulatory

agencies, 396and inefficient production,

146-47as regulator of competition,

7-8role in economy, 392, 396role in production of public

goods, 397

Index 469

Government (continued)role in redistributing wealth,

397-98spending, 399See also Government

regulationGovernment regulation

of advertising, 284of borrowing, 359-60of building construction, 285and delay in product

availability, 296effects of, 283of farming, 289-90of immigration, 337of labor, 325of market competition, 272-73of pollution, 346in production, 169-70as protector of morals, 286of public utilities, 290-92and public welfare, 169-70and quality control, 285-86of railroads, 291of safe working conditions,

336of sanitation and health

standards, 284and Sunday "blue" laws, 286and technological efficiency,

177via licensing, 285via parity prices, 288via patents and copyrights,

292of wages, 334-36See also Government;

LicensingGraphs, how to read, 429-35Great Britain. See Socialist

economiesGreat Depression, 370, 381, 383Gresham's Law, 285nGross National Product (GNP),

388-89Growth, defined, 3

Health standards, 284Hispanics, and ethnic income

differences, 316Housing, during inflation, 127-28

ICC (Interstate CommerceCommission), 291

Import quotas, 287-88

Incomeage-related differences in,

313-15among the poor, 318-20changes in, 33-34of college students, 318differences among ethnic

groups, 315-16differences by occupation, 309as effect on demand, 33-34of the elderly, 318families classified by, 312gender differences in, 316geographical differences in,

312and investment, 315nonmonetary forms of, 317national, 186, 388-91observed differences in, 311-

12from owning natural

resources, 317and personal choice, 310and personal value curve, 47from property versus labor,

317reasons for differences in 313-

17of recent immigrants, 318and the Social Security

System, 319-20standard, 129and technological progress,

320-21and unemployment, 375-76See also Labor; Wages

Income release effect, 3Income statement, 203Indexed funds, 125Industrial unions, defined, 326Industries, "sick," 220-22

<,.Industry supply curve, 145" Inflation

anticipated, 411and anti-inflation guidelines,

418-19causes of, 405-10defined, 127, 403duration of, 417fallacies about, 409-10, 414-16in foreign countries, 417government gains from, 413and increase in stock of

money, 407-9and interest rates, 127-29, 355

470 Index

measuring, 403and monetary reforms, 419and price controls, 417-18and the price of goods, 24recessions during, 420-21reducing the effects of, 416-

17and steel prices, 409stopping, 409, 419-20as taxation, 413-14and taxes, 413-14transient effects of, 419-20unanticipated, 410-11and union wage rates, 409variability of unforseen, 411versus deflation, 412and wages, 414-15and wealth redistribution,

410-13Inputs

demand for productive, 174-75

and marginal productivetheory, 168

substituting and altering, 175-76, 178

and tax burden, 67-68undervalued, 215See also Outputs; Production;

SpecializationInsurance, defined, 184Interest

annuity as a form of, 114-15defined, 108, 112, 299examples involving, 115-29gained from product

improvement, 116-19history of, 358-59implicit versus explicit, 112and installment payments, 115nonmonetary aspects of, 113and tuition loans, 115-16See also Interest ratets)

Interest rate(s)aspects of, 352and bond and stock market

prices, 350costs included in, 354-55during inflation, 127-29and government deficit, 399implicit and explicit, 353-54and inflation, 355laws regulating, 359nominal versus real, 128-29and quantity of money

.(

!.

available, 355-56on real estate, 127-29and risk, 354- 55See also Interest

Interstate CommerceCommission (ICC, 291

Inventions, 292, 320-21Inventories, 88-89, 244Investing, defined, 347Investment(s)

best options in, 380-81defined, 108and the demand schedule,

348-49guidelines for personal, 360-

63and income dispersion, 315markets for, 350net productivity of, 108, 347,

348profitable, 347-38and quasi-rents, 209-11relation of past to future, 209-

11as a source of wealth, 344-45

Job(s)cost of changing, 377-78and employer's search, 371gains from search for, 371rationed by seniority system,

332rationed by work sharing, 332seeking information about,

369-70See also Employment;

Unemployment

Laborcapital as a substitute for, 174as a commodity, 307demand for, 305-7, 378-79as a source of profit, 189See also Income; Labor force;

Labor unions; Specializa-tion; Wages

Labor forceand closed monopsonies, 337-

39composition of, 376and displaced workers, 321-22effect of inventions on, 320-

21and fair-employment laws, 336and higher-wage areas, 312

and immigration restrictions,337

incentives to participate in,302

legal restrictions on, 334-36and level of education, 301-2and minimum wage laws,

334-35and nondiscrimination, 336and number of jobs available,

304-5and on-the-job training, 311participation rate, 300-301percent of males and females

in, 300-301reasons for noninvolvement

in, 304and safety legislation, 336and service industries, 301and unemployment, 304-5and wage differences, 336women in the, 301, 316and working hours, 302-3See also Labor; Labor unions;

WagesLabor unions

and arbitrators, 329and collective bargaining, 328defined, 325entry fees in, 166functions of, 328-29history of, 325legality of, 325local, 326and membership during the

1930s, 326misconceptions about, 328,

331as monitors of performance,

173, 328-29monopoly power of, 334national, 326nomenclature of, 326-27outputs in, 166percent of U.S. population in,

325and public utilities, 332-33and raised wages, 329-31and rationing of jobs, 332strikes and boycotts in, 325,

327,331-32types of, 326See also Labor; Labor force;

WagesLand rent, 75, 125-27

Lending, 112, 348-49Liabilities

defined, 198kinds of, 200monetary, 410'real, 410

Licensingof liquor sales, 294of taxis, 294of television stations, 294.,.95of tobacco growing, 290, 293unintentional benefits from,

98-99See also Government ,.

regulationLoans, 119-20Long run, defined, 216-17LRAC (long-run average cost

curve),216-17

Marginal cost(s)defined, 139equating, 142-44and production efficiency,

141-44Marginal cost curve, 144-46Marginal personal use value, 14-

15Marginal product, 164-65, 167Marginal productivity, 176Marginal productivity theory,

168Marginal revenue, 21-22Market value

defined, 21versus personal use value, 18-

19variability of, 19-20

Market(s)bond, 350commodity, 81-86forecasters in, 81futures, 81-86and market-clearing price, 59misconceptions about, 273-79orderly, 287-89pricing system in, 63-64real estate, 350retail, 350stock, 350supply and demand in, 59-60See also Government

regulation; Open marketts):Orderly market(s); Pricesearcher; Price taker

Index 471

Markup, 194Marx, Karl, 6, 157Math, use of, in economics, 429-

35Mercantilist system, defined, 7Merger(s)

compared with cartels, 270criticisms of, 273defined, 270impediment to effectiveness

of, 270Mexican-Americans, and ethnic

income differences, 316Middlemen

competition among, 50-51as restricted by law, 51- 52tactics used by, 51- 52use of, 48-50

Money, creation of, 381, 382,407-8, 425-27

Monopoliesairlines as, 333ambiguity in defining, 273competition for, 294-95government regulation of,

272-73inefficiency resulting from,

155-56and labor unions, 332-33natural, 291patent and copyright, 292-93and price discrimination, 255public utilities as, 291-92and redistribution of wealth,

398"shared," 274

Monopoly distortion, 256Monopoly rents, 263,288,

293-95,,332-34Monopsony, 337-39

. Montgomery Ward & Company,214

Multipart pricingand cost subsidizing, 249-50distribution of gains in, 249feasibility of, 250government view of, 251inefficiency in, 250to one customer, 247-49and public utilities, 250

National Collegiate AthleticAssociation (NCAA), 338

National Energy Act (1975), 73-75

,I

National income deflator,defined, 404-5

National Labor Relations Board(NLRB),326

Natural resources. See ResourcesNCAA (National Collegiate

Athletic Association), 338New York Bond Exchange, 358NLRB (National Labor Relations

Board), 326Norris-LaGuardia Act (1932), 327Notes, promissory, 112

OASDHI (Old Age, Survivors,Disability, and HealthInsurance Program), 319-20

Obsolescence, defined, 226Occupational Safety and Health

Agency (OSHA), 336Oil

and government restrictions,146-47

and OPEC, 265-68present versus future value of,

124,268-69price control of, 73-75rate of exploration for, 268reasons for price increases of,

268-70See also Gasoline

Old Age, Survivors, Disability,and Health InsuranceProgram (OASDHI), 319-20

Oligopoly, 271-72OPEC (Organization of

Petroleum ExportingCountries), as a cartel,265-68

Open market(s);t and cartels, 52

and costs of trading, 50-51ethics of, 52-53features of, 190-92freedom provided by, 53-54middlemen in, 51misconceptions about, 227as restricted by law, 51- 52and restrictions on pricing, 72and use of natural resources,

345See also Market(s); Orderly

market(s)Opportunism, 170, 171-73

:1 472 Index

Orderly market(s)and the dairy industry, 287defined, 287and holding crops off the

market, 289and import quotas, 287-88and price supports, 288and surpluses, 288-89See also Market(s); Open

market(s)Orderly market argument, 287OSHA (Occupational Safety and

Health Agency), 336Outputs

as affected by tax, 219-20appropriate, 217-18components of, 224-25efficient, 3, 141-42expansion of, 212-13in joint production, 165-66measuring, 224-25with more than two

producers, 151-54response to demand of, 213-

14See also Inputs; Production;

Specialization

Pareto, Vilfredo, 76Pareto-optimal allocation, 76Parity price, defined, 288Partnership, defined, 185-86Patents

defined, 292, 292nmisconceptions about, 293pooling of, 293for public goods, 101

Perpetuity, defined, 1I 5Personal use value

and consumer's surplus, 17-18curve depicting, 45-48and expenditures, 17-18illustrations of, 15marginal, 14,71measurement of, 14-15and tie-ins, 251and trade opportunities, 45versus market value, 18-19

Philanthropyforeign aid as a form of, 98nontransferable, 99public goods as a form of, 99-

101unintentional, 98-99who gains from, 96-98

Polaroid Corporation, 292Poverty

causes of, 319decrease in, 318defined, 318proposed remedies for, 319and unemployment, 320and welfare, 318-19

Price(s)as affected by taxes, 64-66,

219-20and basing point, 228-29and competition, 62controls on, 417-18and demand, 16-18as effect on wealth, 34-35effects on production and

supply, 63-64equilibrium-sustaining, 47and fixed supply, 62forecasting, 81, 85-86full, 72, 88and future valuation, 124guidelines, 418-19illusions about, 89-91and individual consumption,

45-47market-clearing, 59, 62, 96as measure of marginal

revenue, 206mill net, 229misconceptions about, 217,

273-74, 276monopolist-administered, 273nominal,24parity, 288predatory, 217in a price-seller's market, 239-

42and quality, 35-36and quantity, 25real, 23-24relative, 23-24and renter demands, 69-70retail,276-77and Ricardian rent on, 229-31rigidity versus flexibility, 277-

78setting of, 125spot, 81, 82spread between buying and

selling, 50- 51tactics involving, 228-29wholesale, 277See also Demand; Inflation;

Price discrimination; Pricesearcher; Price taker;Pricing

Price controlsand demand, 70-71effects of, 60-62and gasoline shortages, 61-62in 1975 National Energy Act,

73and nonmonetary

competition, 72reasons for, 72and use of tie-ins, 252-53

Price discrimination, defined,254,256-57,273

Price fixing, 276-77Price leader, 271Price searcher

and change in demand orcost, 242-44

defined, 205, 239as distinguished from

monopolist, 284as maintainer of inventories,

243-44marginal revenue, of, 239-40as monopolist, 242, 246and pricing systems, 247-54problems faced by, 244-46and production costs, 240-42See also Price(s); Price taker;

PricingPrice taker

defined, ·205and entry of new producers,

212-13and long-run supply, 212-15and marginal revenue, 206and profit-maximizing

outputs, 208and social value of resources,

218See also Price(s); Price

searcher; PricingPricing

block. See Multipart pricingdiscrimination in, 254-56multipart. See Multipart

pricingsystem of, 247-54, 256tactics of, 37two-part. See Multipart

pricingSee also Multipart pricing;

Price(s); Price controls;

Tie-insPrincipal, 112Private-property rights

defined, 91difficulty of identifying, 91-92elements of, 91exchanges involving, 92role of, 93and specialization, 156and use of natural resources,

345-46value of, 93-95

Private-property system. SeeCapitalism

Productionbehavior monitoring in, 170-

71constant average cost of, 213controls that limit, 289-90during inflation, 419economies of, 224-25elements involved in, 136and employees versus renters,

168equal ownership in, 168-69factors affecting, 68government control in, 169-

70and increased capital, 174interspecific resources in,

171-73joint, 163-78and long-run period, 136and long-run supply curve,

213and marginal productive

theory, 168and market period, 136and price, 63-64quantity of capital goods in,

173-74rate of, and costs, 224-25and resources, 2-3and short-run period, 136social output in, 165substitution of inputs in, 175-

76and supply, 63-69See also Inputs; Outputs;

SpecializationProduction control. See

Government regulation;Licensing

Production-possibility boundary,2

Index 473

Ii, i'I

i :Il;'"""----4-7-4--'n-d-e-x-------------

Profit(s)absorption of, 214-15defined, 129, 192-93and initial investment, 192maximizing, 208misconceptions about, 274misdefinitions of, 194-95misleading measurements of,

194-95as related to size, 274and "sick" industries, 220-22sources of, 188-90and superior ability, 189-90See also Price searcher; Price

takerProfit sharing, 130-31Proprietorship, defined, 185Public good, defined, 397Public utilities, 290-92Puerto Ricans, and ethnic

income differences, 315-16

1

I'il

Quasi-rent, 210

Railroads, 291Rationing, coupon, 73Recession( s)

alleviation of, 398characteristics of, 382defined, 373during inAation, 420-21during 1970-80,419

Reform, monetary, 419Regression fallacy, 190Regression phenomenon, 190,

190nRent(s)

defined, 189,299effect of demand on, 69-70implicit, 299and land values, 125-27monopoly, 189,263, 293-95quasi, 209-11, 331Ricardian, 151, 189-90,229-31

Reserve capacity, 89Resources

as affected by taxes, 67-68and consumer demand, 218-

19demand for, 29-32efficient use of, 177-78as a form of wealth, 343ownership of rights to, 345-46present and future value of,

124

II

i I'

ii

in a price-searcher market,243-44

redirection in use of, 63-64as related to price, 63social value of, 218as sources of income, 317

Revenue sharing, defined, 395Ricardian rent, 151, 189-90, 229-

31Ricardo, David, 151Risk bearing, 184-85Robinson-Patman law (1938), 256Russia. See Communist

economies

Salaries. See WagesSanitation standards, 284Saudi Arabia, 265-68Saving(s)

defined, 129, 347and expectations about the

future, 350-52as a source of wealth, 344-45,

347and financial intermediaries,

356-57Sears Roebuck and Company,

214SEC (Securities and Exchange

Commission), 285nSecurities and Exchange

Commission (SEC), 285nSeller. See Price searcher; Price

takerService industries, 301Sherman Antitrust Act (1890),

272Short run, 216-17Shortage, 60, 61Smith, Adam, 6, 135, 147

Ii Social Security System, 319-20Socialist economies

characteristics of, 6compared with capitalism, 53,

57,283and division of weal th, 312as eliminator of alienation,

157and government control of

resources, 392and land values, 76outputs in, 166See also Capitalism,

Communist economiesSpecialization

as a cause of alienation, 157and central planning, 144-46comparative advantage in,

136-37, 143and decentralized

coordination, 147-49and interdependent products,

227involving more than two

producers, 151-54marginal cost in, 138obstacles to, 156price and output adjustments

in, 154-55and private-property rights,

156risks involved in, 156-57See also Production

Specialization in production. SeeSpecialization

Speculative markets, 81-86SRAC (short-run average cost

curve),216-17StagAation, 420Standard income, defined, 129Standard Oil (New Jersey), 191Stock option, 130-31Stock(s)

capital-gain, 360common, 201cost of information about, 363covariability of, 363defined, 186mean and variation of price

changes in, 361-62preferred, 200-20 Ipresent versus future value of,

203random selection of, 362-63volatile versus blue chip, 361See also Corporations

Stockholders, defined, 186See also Corporations;

Stock(s)Strikes. See Labor unionsSubstitution effect, defined, 34Supply

changes in, 60-62elasticity of, 213fixed, 62and production, 63-69

Supply and demand, law of, 2Supply-side effects, 382Surplus

consumer's, 17-18

described, 60and price supports, 288-89in relation to trade, 45

Taft-Hartley Act (1947), 327,327n

Taxation without legislation,413-14

Tax(es)capital-gains, 414corporation income, 395defined and described, 393-94as determined by supply and

demand, 64-66effect of, on land, 67effect of, on output, 219-20federal and local, 395graduated income, 413-14and inflation, 413-14kinds of, 395personal income, 394progressive, 394as related top price of goods,

65-66and revenue sharing, 395sources of, 394who pays, 64-67

T-bills, Il2Technological progress, 177, 320Television, and income, 320-21Theory, components of

economic, 9-10Tie-ins

defined, 250as giveaways, 253-54government view of, 251in labor unions, 332to overcome price controls,

252-53and personal use value, 251- 52as quality protectors, 252uses of, 251-54

Tobacco farming, 290, 293Trade

idealized model of, 48international and national, 156middleman in, 48-50

misconceptions about, 45mutual opportunities for, 45sequence of prices in, 47

Treasury bills, 112

Unemploymentamong construction workers,

375among teenagers, 373-74causes of, 304-5, 369, 377, 378defined, 369, 374-75and demand and supply, 369,

370,378-79, 381demographic factors in, 377disguised, 371frictional, 370, 374length of, 375measuring, 372and minimum wage laws, 335monetary aid for, 377-78natural, 370, 374as noncause of poverty, 320rates in foreign countries, 383recovery rate, 382-83as related to income, 375-76and restrictive licensing, 378seasonal, 378statistics on, 371-74, 375-76structural, 379trends in, 376-78as wealth-maximizing, 371See also Employment; Jobs

Unionscraft, 326industrial, 326labor. See Labor unions

United States v. Addyston Steel(1899), 272

U.S.S.R. See Communisteconomies

Usury, defined, 112Utilities, public, 290-92

Value, book, 202See also Personal use value

Violenceas a form of competition, 7-8

threatened by middlemen, 51

Wage(s)and amount of labor, 303-4d~fined, 189and demand and supply, 309-

10and differences in

productivity, 310for different occupations, 309and "equal pay for equal

work," 336geographical differences in,

336guidelines, 418-19increases in, 303-4and inflation, 414-15and labor unions, 329-31market-cleaning rate of, 308minimum, 334-36nonmonetary features, 310,

335open-market rate of, 308and superior ability, 310setting of, 308women's, relative to men's,

316See also Income; Jobs; Labor;

Labor force; Labor unionsWard's (Montgomery Ward &

Company), 214Wealth

as affected by price, 34-35care of, 130defined, 129forms of, 343natural resources as, 345-46and personal value curve, 47physical, 129redistribution of, 397-98ways of increasing, 344-45

Wealth of Nations (Smith), 6,135

Xerox Corporation, 127,252,274, 274n

Exchange and Production Competition, Coordination, And Control by Armen a. Alchian

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Transcript of Exchange and Production Competition, Coordination, And Control by Armen a. Alchian