Macro Articles

8/12/2019 Macro Articles

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1 Managing Resources

Analysis of firm behavior and the management of resources begins with the firmsproduction function , which describes how resources are turned into output. There arethree broad categories of resources , which are also sometimes called inputs or factors of

production.

The first category is labor , by which we mean the physical human effort that goes into production. The second category is capital , which can be subdivided into twocomponents, physical capital and human capital. Physical capital refers to things likefactories, machines, and equipment that are part of the production process. Humancapital refers to know-how and managerial skills that go into production -- more thethinking side of human production, compared to the sheer labor effort. Finally, the thirdcategory is thought of as land, particularly when referring to agricultural production.

apital needs a special note. First, in the conte!t of production, economists do not meanmoney when they refer to capital. "n common parlance, people may refer to money ascapital, specifically financial capital, when they talk about starting a business, fore!ample. #owever, money itself does not produce anything therefore is not part of the

production function$ instead it buys the resources that produce things. %econd, both physical the human capital share some characteristics& both are produced themselves'human capital being produced by education(, and neither is )used up* in production.

%ometimes economist refer to the production function as the ) technology * used to produce something. +roduction functions take on different characteristics in the short runand in the long run. The short run refers to the period of time in which some resources-- especially capital -- are fi!ed. For e!ample, we often may only be able to alter ouremployment of labor in the short run. "n the long run , all inputs are variable and nothingis fi!ed.

The marginal product of an input is a measure on how output changes as more of thatinput is added, holding everything else constant. The law of diminishing marginalproduct says that although output may go up as an input is added, ceteris paribus, therate at which output goes up will decline. "n other words, marginal product will be

positive, but declining, as the input increases. This makes sense& picture a firm with agiven factory si e 'capital( adding workers. As it does so, output should go up -- but notat a constant rate, because eventually the limited si e of the factory becomes a)bottleneck* inhibiting increased production.

"n the long run, production functions can be characteri ed by returns to scale. Increasingreturns to scale means that scaling up all inputs by ! percent leads to an increase inoutput of more than ! percent. %imilarly, decreasing returns to scale means thatincreasing all inputs by ! percent leads to an increase in output of less than ! percent.

any real-world production functions are characteri ed by constant returns to scale &increasing inputs by a certain percent leads to the same percentage rise in output. "t isimportant to keep in mind the distinctions between marginal product and returns to scale.


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The cost functions of a firm are derived directly from its production function. "n theshort run, firms have fixed costs associated with their fi!ed inputs. /ikewise, variablecosts are associated with variable inputs. The sum of fi!ed and variable costs are totalcosts . The marginal cost of production is the e!tra cost associated with producing

another unit of output. arginal cost is directly related to marginal product for the shortrun. For e!ample, if labor is the only variable input in the short run, then the law ofdiminishing product implies that the marginal cost of production will have to riseeventually.

Average costs are also used frequently. "n the short run, firms have average fixed costs and average variable costs , which sum to average total cost . Typically the averagevariable and average total cost curves are )0-shaped* meaning that they initially decline

but eventually rise as output increases, at lest in the short run. "n the long run, all costsare variable. The average total cost curve for the long run is the )lower envelope* of allthe different possible short run averages total costs curves, each typically associated with

a differing amount of capital."f the average cost of production declines initially as output increases, the firm en1oyseconomies of scale in the long run -- a phenomenon associated with increasing returns toscale in production. 2conomies of scale are e!hausted at minimum efficient scale .

onstant returns to scale imply constant average total costs in the long run, anddecreasing returns to scale imply rising average total costs in the ling run, ordiseconomies of scale .

anagers need to employ marginal analysis to ma!imi e profits for the firm. "n terms ofoutput, this means comparing marginal revenue to marginal cost. Marginal revenue isthe additional revenue generated by producing and selling another unit of output.

arginal cost, as noted above, refers to the additional cost of producing that output. "fmarginal revenue is greater than marginal cost, producing another unit of output is

profitable and production should be increased. "f marginal revenue is less than marginalcost, producing another unit of output is not profitable and in fact output should bedecreased.

"f initially marginal revenue is greater than marginal cost and the firm increases production, marginal revenue will fall 'e!cept in perfect competition, where it remainsconstant for the price-taking firm(, because the firm will have to lower its price to sellmore units. At the same time, increasing output means facing higher marginal costs,especially in the short run due to the law of diminishing marginal product. Thus asoutput increases, marginal revenue falls and marginal cost rises until the two are equal.At this point the firm will have ma!imi ed it profits, leading to a very important principlein managerial economics& a necessary condition for profit maximization is marginalrevenue must equal marginal cost .

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%imilarly, marginal analysis can be employed in thinking about the optimal employmentof resources. 4nce again, the manager weighs the benefits of employing one more unitof a resource with the costs. #iring one more unit of a resource resulting in more output,

by the amount of the marginal product of that resource. "f that output is then sold in themarketplace, the firm earns the value of the marginal product for that resource as

income. 4n the other hand, the firm has to pay for the resource$ this is the marginalresource cost of the input

The effective manager must compare the value of the marginal product with the marginalresource cost. %uppose for e!ample that a firm was considering hiring one more workerfor a day, and the worker could produce an e!tra 35 widgets. "f widgets sell for 67 each,then the value of the marginal product of that worker would be 6 55 '35 ! 7 8 55(. "fthe marginal resource cost of the worker is, say 695 per day in wages, then the firm willfind it profitable to hire the worker, since 6 55 of revenue coming in more than the 695of wages e!pended. 4n the other hand, if the worker costs 6 35 per day, it is not worth itto the firm to hire the worker.

%uppose the firm pays the worker 695 and there fore hires him. The firm then considershiring another worker. :ut perhaps the marginal product of labor is declining, and thatworkers marginal product is less than 35 widgets. The firm must go through the samecomputations, looking at this set of rules& if the value of the marginal product is greaterthan the marginal resource cost, hire more workers. "f the value of the marginal productis less than the marginal resource cost, hire fewer workers. As with output, the optimumis achieved only when the marginal values are the same. A necessary condition for

profit-maximizing resource employment is the value of the marginal product must equalmarginal resource cost.

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3 Human Capital

To most people capital means a bank account, a hundred shares of ": stock, assemblylines, or steel plants in the hicago area. These are all forms of capital in the sense thatthey are assets that yield income and other useful outputs over long periods of time.

:ut these tangible forms of capital are not the only ones. %chooling, a computer trainingcourse, e!penditures of medical care, and lectures on the virtues of punctuality andhonesty also are capital. That is because they raise earnings, improve health, or add to a

persons good habits over much of his lifetime. Therefore, economists regarde!penditures on education, training, medical care, and so on as investments in humancapital. They are called human capital because people cannot be separated from theirknowledge, skills, health, or values in the way they can be separated from their financialand physical assets.

2ducation and training are the most important investments in human capital. any

studies have shown that high school and college education in the 0nited %tates greatlyraise a persons income, even after netting out direct and indirect costs of schooling, andeven after ad1usting for the fact that people with more education tend to have higher "qsand better-educated and richer parents. %imilar evidence is now available for many yearsfrom over a hundred countries with different cultures and economic systems. Theearnings of more educated people are almost always well above average, although thegains are generally larger in less developed countries.

onsider the differences in average earnings between college and high school graduatesin the 0nited %tates during the past fifty years. 0ntil the early si!ties college graduatesearned about ?= #arvard economist @ichardFreeman wrote a book titled The Overeducated American. This sharp fall in the return toinvestments in human capital put the concept of human capital itself into some disrepute.Among other things it caused doubt about whether education and training really do raise

productivity or simply provide signals ')credentials*( about talents and abilities.

:ut the monetary gains from a college education rose sharply again during the eighties, tothe highest level in the past fifty years. 2conomists evin urphy and Finis Belchhave shown that the premium on getting a college education in the eighties was over =7

percent. /awyers, accountants, engineers, and many other professionals e!periencedespecially rapid advances in earnings. The earnings advantage of high school graduatesover high school dropouts has also greatly increased. Talk about overeducated Americanshas vanished, and it has been replaced by concern once more about whether the 0nited%tates provides adequate quality and quantity of education and other training.

This concern is 1ustified. @eal wage rates of young high school dropouts have fallen byore than 37 percent since the early seventies, a truly remarkable decline. Bhether because


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of school problems, family instability, or other factors, young people without a college ora full high school education are not being adequately prepared for work in moderneconomies.

Thinking about higher education as an investment in human capital helps us understand

why the fraction of high school graduates who go to college increases and decreases fromtime to time. Bhen the benefits of a college degree fell in the seventies, for e!ample, thefraction of white high school graduates who started college fell, from 7 percent in >?5to ?7. many educators e!pected enrollments to continue declining in theeighties, partly because the number of eighteen-year-olds was declining, but also becausecollege tuition was rising rapidly. They were wrong about whites. The fraction of whitehigh school graduates who enter college rose steadily in the eighties, reaching =5 percentin >99, and caused an absolute increase in the number of whites enrolling despite thesmaller number of college-age people.

This makes sense. The benefits of a college education, as noted, increased in the eighties.

And tuition and fees, although they rose about ;> percent from >95 to >9= in real,inflation-ad1usted terms, are not the only cost of going to college. "ndeed, for mostcollege students they are not even the ma1or cost. 4n average, three-fourths of the privatecostCthe cost borne by the student and by the students familyCof a college education isthe income that college students give up by not working. A good measure of this)opportunity cost* is the income that a newly minted high school graduate could earn byworking full-time. And during the eighties this forgone income, unlike tuition, did notri9se in real terms. Therefore, even a ;>percent increase in real tuition costs translatedinto an increase of 1ust 5percent in the total cost to students of a college education.

The economics of human capital also account for the fall in the fraction of black highschool graduates who went on to college in the early eighties. As #arvard economistThomas D. ane has pointed out, costs rose more for black college students than forwhites. That is because a higher percentage of blacks are from low-income families and,therefore, had been heavily subsidi ed by the federal government. uts in federal grantsto them in the early eighties substantially raised their cost of a college education.

According to the >93 )@eport of the ommission on Eraduate 2ducation* at the0niversity of hicago, demographic-based college enrollment forecasts had been wide ofthe mark during the twenty years prior to that time. This is not surprising to a )humancapitalist.* %uch forecasts ignored the changing incentivesCon the cost side and on the

benefit sideCto enroll in college.

The economics of human capital have brought about a particularly dramatic change inthe incentives for women to invest in college education in recent decades. +rior to thesi!ties American women were more likely than men to graduate from high school but lesslikely to continue on to college. Bomen who did go to college shunned or were e!cludedfrom math, sciences, economics, and law, and gravitated toward teaching, homeeconomics, foreign languages, and literature. :ecause relatively few married womencontinued to work for pay, they rationally chose an education that helped in )household

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production*Cand no doubt also in the marriage marketCby improving their social skillsand cultural interests.

All this has changed radically. The enormous increase in the labor participation ofmarried women is the most important labor force change during the past twenty-five

years. any women now take little time off from their 1obs even to have children. As aresult the value to women of market skills has increased enormously, and they are bypassing traditional )womens* fields to enter accounting, law, medicine, engineering,and other sub1ects that pay well. "ndeed, women now comprise one-third or so ofenrollments in law, business, and medical schools, and many home economicsdepartments have either shut down or are emphasi ing the )new home economics.*"mprovements in the economic position of black women have been especially rapid, andthey now earn 1ust about as much as white women.

4f course, formal education is not the only way to invest in human capital. Borkers alsolearn and are trained outside of schools, especially on 1obs. 2ven college graduates are

not fully prepared for the labor market when they leave school, and are fitted into their 1obs through formal and informal training programs. The amount of on-the-1ob trainingranges from an hour or so at simple 1obs like dishwashing to several years at complicatedtasks like engineering in an auto plant. The limited data available indicates that on-the-

1ob training is an important source of the very large increase in earnings that workers getas they gain greater e!perience at work. @ecent bold estimates by olumbia 0niversityeconomist Dacob incer suggest that the total investment in on-the-1ob training may bewell over 6 55 billion a year, or almost 3 percent of E +.

o discussion of human capital can omit the influence of families on the knowledge,skills, values, and habits of their children. +arents affect educational attainment, maritalstability, propensities to smoke and to get to work on time, as well as many otherdimensions of their childrens lives.

The enormous influence of the family would seem to imply a very close relation betweenthe earnings, education, and occupations of parents and children. Therefore, it is rathersurprising that the positive relation between the earnings of parents and children is notstrong, although the relation between the years of schooling of parents and children isstronger. For e!ample, if fathers earn 35 percent above the mean of their generation, sonsat similar ages tend to earn about 9 percent above the mean of theirs. %imilar relationshold in Bestern 2uropean countries, Dapan, Taiwan, and many other places.

The old adage of )from shirtsleeves to shirtsleeves in three generations* is no myth$ theearnings of grandsons and grandparents are hardly related. Apparently, the opportunities

provided by a modern economy, along with e!tensive public support of education, enablethe ma1ority of those who come from lower-income backgrounds to do reasonably well inthe labor market. The same opportunities that foster upward mobility for the poor createan equal amount of downward mobility for those higher up on the income ladder.

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The continuing growth in per capita incomes of many countries during the nineteenth andtwentieth centuries is partly due to the e!pansion of scientific and technical knowledgethat raises the productivity of labor and other inputs in production. And the increasingreliance of industry on sophisticated knowledge greatly enhances the value of education,technical schooling, on-the-1ob training, and other human capital.

ew technological advances clearly are of little value to countries that have very fewskilled workers who know how to use them economic growth closely depends on thesynergies between new knowledge and human capital, which is why large increases ineducation and training have accompanied ma1or advances in technological knowledge inall countries that have achieved significant economic growth.

The outstanding economic records of Dapan, Taiwan, and other Asian economies in recentdecades dramatically illustrate the importance of human capital to growth. /ackingnatural resourcesCthey import almost all their energy, for e!ampleCand facingdiscrimination against their e!ports by the Best, these so-called Asian tigers grew rapidly

by relying on a well-trained, educated, hardworking, and conscientious labor force thatmakes e!cellent use of modern technologies.

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; More about Free esources

The problem when resources are )free* is that wrong mi! of goods and services will be produced. This is a common result when decision-makers do not take into accountsome by-product of their actions that burdens or benefits others. A polluter, for e!ample,

considers air or water free. For him, dumping pollutants into their air or water is a cheapway to dispose of wastes. Get, his actions do involve costs because he affects thealternatives that others face. The polluter may make others forego clean water. 4necould say that the polluter imposes some costs of production on others, although this useof the word )cost* differs from the normal meaning of cost. Those who bear this cost arenot involved in the choice, and in its pure meaning cost is an alternative foregone in achoice.

"t is easy to show that when a decision-maker ignores some costs of his decision, hisdecision may be economically inefficient. The demand curve represents the marginal

benefit to consumers 'and to firms because they are price takers(. The supply curve

represents the marginal cost to sellers, and because producing the product requiresresources that could be used elsewhere, it also represents a cost to buyers. :ut the production of the product also generates and unwanted by-product that sellers ignore.The marginal cost from the point of view of society as a whole includes this by-productand is thus higher than it seems to the firm.

"f negative e!ternalities cause too much of a product to be produced, positive e!ternalitiesshould cause too little to be produced. Bhen a person improves his house, his neighbors

benefit. :ecause the decision-maker will not generally consider these spilloveradvantages to others, less than the efficient amount of the activity will take place.

Bhen scarce resources are perceived as )free*, there will be potential value that a marketwill not capture. "s it possible for a society to capture this value, and if so, howH

A common )solution* to this problem has been to assume it away. This solution isespecially common in plans for utopias, and writers in the ar!ian tradition frequentlyillustrate it. "n some of these arguments, pollution e!ists because capitalistic man isgreedy, but when the new socialist man comes into e!istence, the problem will cease.%olution by assumption has at times crept into mainstream economic thinking as well.

A more practical solution is to increase private ownership in the system of propertyrights. This is an ironic solution in a way, because many environmentalists andecologists have argued that the e!istence of e!ternalities proves that a market system isseriously flawed and should be scrapped for an alternative, generally with greater stateownership and control. 2conomic analysis, however, shows that e!ternalities e!ist when

property rights are incomplete. @educing the role of private property would make thee!ternality problem worse. Bhen no one owns the air or water, there is no incentive toavoid an overuse of the resource.

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"n a classic e!ample of the problem of the commons, buffalo were hunted almost toe!tinction in the > th century. "f an individual hunter limited his kills, he was unlikely to

benefit from his restraint. A buffalo that he did not kill would probably be killed bysomeone else. Get, from the point of view of buffalo hunters as a group, the optimalstrategy would have been to limit killing so that the industry could maintain itself

indefinitely.

"n contrast with the buffalo, the number of cattle in the American Best increased duringthe >th century. The key difference between the different fates of buffalo and cattle wasnot that buffalo hunters were greedy and cattle raisers were not. "t was that cattle were

privately owned and buffalo were )free*. +rivate-property rights force people to take intoaccount all costs and benefits of their actions. A cattlemans decision to kill or not killhis cattle did not affect other cattlemen in the ay that a buffalo hunters decision to kill ornot kill buffalo affected other buffalo hunters. Bhen a resource is owned by all, when itis )free,* there is a strong tendency for individuals to misuse that resource.

The e!istence of private property rights allows the law to deal with e!ternality problems.A person who is harmed by someones actions can ask the courts to decide aboutcompensation. The courts decision will depend on whether or not he has a right to somegood or service. ourts have established property rights for clean air, clean water, scenicviews, sunshine, and quiet. "f a person is not due compensation, then he does not havethe property rights but the other party may have them. "n this case he can pay the partyharming him to stop the offending activity.

Iictims of pollution seldom band together and sue the polluter, nor do they band togetherand pay him not to pollute. The difficulty with legal action is that there are serious

problems 'and thus large costs( in contracting and organi ing large groups for legalaction. 4ne of these problems is the free-rider problem. @onald oase pointed out that

pollution problems would not e!ist if there were no difficulties and e!penses in makingcontracts between polluter and victim. The implication of oases work is thate!ternalities should not be a small-group problem because legal remedies will e!ist ifonly a very few people are involved. "t will only be a large-group problem.

oase shows that private-property rights are not always a feasible way to solve thee!ternality problem of )free* resources. Another solution is for the government to act asif it were the owner of these resources. The government does this when it regulates thenumber of ducks that hunters can kill. "t says in effect that the government does thiswhen it regulates the number of ducks that hungers can kill. "t says in effect that thegovernment owns the ducks, and people cannot kill them without the permission of thegovernment.

Eovernment can charge for the use of its resources. "t could, for e!ample, charge polluters for the use of clean water and air. This charge would make polluters take intoaccount the side effects of their activities 'or in the 1argon of economists, they wouldinternali e the e!ternalities(, and would move marginal cost curve in the graph upward.There is some user fee 'pollution ta!( that would make the decision-makers marginal

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cost curves coincide with the marginal-cost-to-society curve, and thus correct theefficiency problem.

Eovernment policy dealing with pollution and negative e!ternalities has largely been oneof regulation. ost economists believe that this is a less-desirable 'efficient( method of

dealing with the problem than a policy of a pollution ta!.

Finally, there may not be a good solution to the problem of )free* resources for tworeasons. First, the cost of a solution may be greater than the benefits of the solution.

ost economists believe that there is some )optimal level& of pollution. any productive processes produce waste products. These waste products, when considered damaging to people, are pollution. To remove them or to transform them into a form that no oneconsiders damaging requires resources, and the use of those resources means that fewerother products can be produced. Thus the reduction of pollution involves the weightingof costs and benefits as does virtually all other activity that economists discuss. Theoptimal level of pollution becomes that level at which the marginal benefit of any more

reduction 1ust equals the marginal cost of any more reduction "f removing pollution thatcauses 6 .55 worth of harm costs 6 5.55, it is economically inefficient to remove it. "t ise!tremely unlikely that the optimal 'economic efficient( level will ever be ero.

%econd, there may be e!ternality problems within the government 1ust as there can bee!ternality problems in the market. Bhen there are e!ternality problems in the market,we can call on the government as an outside agent to solve them. :ut if there problemse!ist in the government, there is no one to turn to. For e!ample, suppose that the citi ensof a country are split into fifty special interest groups, and each group gets special

benefits from the government. To pay for those benefits, the government must ta! theciti ens. The citi ens end up paying a dollar in ta!es to get eighty cents of special

benefits. ':ureaucracy eats up the other 35J(. Though all would be better off getting ridof all special benefits, no one group will want to give up its special benefits, and the costsof organi ing the fifty different groups to come up with an agreement may be very large.There may be no solution to this problem of the commons.

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< Comparative !dvantage

The reasons why free trade is desirable can be developed by e!tending the discussion ofthe rusoe economy that is commonly used to illustrate production-possibilities frontiers.%uppose that @obinson rusoe, living on an almost deserted desert isle, can either catch

four fish a day or find eight coconuts. 4ne day, he discovers that Friday also lives on theisland. "f Friday can either catch si! fish a day or find seven coconuts, can rusoe andFriday profit by speciali ation and tradeH The answer is clearly )yes*. rusoe is the

better coconut gatherer, and Friday the better fisherman.

#owever, suppose that Friday can either catch ten fish or find then coconuts. Friday isnow better than rusoe in both activities. an there be mutual benefit from trade in thiscaseH 4r should Friday do all the work and rusoe noneH 4r should Friday refuse totrade since he is better in bothH "t was a ma1or achievement of Kavid @icardo early in the

>th century to show that in this second rusoe-Friday story both parties could benefitfrom trade. #is results contributed to the long reign of relatively free trade in > th century

2ngland, and thus to the prosperity that 2ngland en1oyed in this period.To see that mutually beneficial trade is possible even though Friday is better in allactivities, one must look to opportunity costs. "ndividually, both Friday and rusoe tradewith nature in the production process. rusoe can get another fish only by giving up timein which he could find two coconuts, and in getting another coconut he sacrifices one-half of a fish. Thus, a fish costs rusoe two coconuts and a coconut costs one-half of afish. Friday can get another fish by giving up the time during which he can find anothercoconut, or one-tenth of the day. Kuring this time, he could find one coconut. ForFriday, trading with nature means that one fish costs one coconut and vice versa./ooking at these opportunity costs tells us that rusoe finds coconuts cheaper and Fridayfinds fish cheaper. The table below summari es these results.

4pportunity ost of Fish and oconutsFor Friday& fish costs coconut --- oconut osts FishFor rusoe Fish osts 3 oconuts --- oconut osts L Fish

Be still have not discovered whether Friday and rusoe could do better trading with eachother rather than with nature. A way to answer this question is to try a few prices.%uppose that one fish was worth one-half a coconut, or one coconut was worth two fish.Bith this trading ratio both would find fish cheap and coconuts e!pensive. Therefore,

both would want to sell coconuts and buy fish. #ence at this price no trading would take place.

%uppose that the trading ratio were one fish for .9 coconuts 'and thus one coconut cost7M> fish(. Bith this ratio, rusoe would find fish cheapCrather than spend two coconutsto catch one, he could spend .9 coconuts and buy one. #ence, rusoe would be willingto sell coconuts. Friday would find coconuts cheapCrather than give up one fish bygathering his own coconuts, he could sell 7M> th of a fish and get one. #ence, Friday


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would be willing to sell fish. Trade will take place because both individuals find that itimproves their well-being.

"n the above e!ample, trade occurs because of comparative advantage. Friday is better ineverything than rusoe, but he is )more better* in catching fish and )less better* in

finding coconuts. rusoe is worse than Friday in everything, but he is )less worse* infinding coconuts. Though they both benefit from trade, Friday will maintain a higherstandard of living.

The e!ample of rusoe and Friday also illustrates that e!change is not a ero-sum game, but a positive sum game. "n a ero-sum game, whatever anyone wins comes at someoneelses e!pense. "n poker, for e!ample, if one person wins 6 55, some other person's(must have lost 6 55. "f the amount of winnings is added up and the amount of losings issubtracted away, the result will be ero. The term )Nero-sum game* reflects this total. "ncontrast, both parties in a voluntary e!change can benefit. :ecause total winnings e!ceedany losses, the name )positive-sum* game is appropriate. A negative-sum game, in

which winnings will be less than losses, is also possible. Bar is one e!ample and a badmarriage is another.

A possible reason that few people prior to Adam %mith seem to have recogni ed thismutually beneficial aspect of e!change may be that in his day much e!change involved

bargaining. "n bargaining, the seller tries to get as high a price as he can and the buyer aslow a price as possible. "f the seller can get 63.75 for a product rather than 63.55, he

benefits from the higher price at the e!pense of the buyer. +eople do discuss who got the)better of the bargain.* This feature of e!change, which is of vital importance to thoseinvolved in a market, can obscure the fact that no e!change will take place unless both

parties believe that they benefit from it. :argaining determines how big the producerssurplus will be relative to the si e of the consumers surplus, but unless both buyer andseller each have some surplus, no trade will take place.

rusoe and Friday could be replaced by two nations. The principle of comparativeadvantage continues to hold, and it implies that the world as a whole will not be operatingon its production-possibilities curveCthat it will be production inefficientCif eachnation is self-sufficient.

The inefficiency can be illustrated by putting the numbers of the second rusoe-Fridayinto production possibilities tables. %uppose that in self sufficiency rusoe chooses threefish and two coconuts, and Friday chooses five fish and five coconuts. The total island

production is then eight fish and seven coconuts. :ut with total speciali ation, withrusoe producing only coconuts and Friday producing only fish, island production would

be ten fish and eight coconuts, which means that under self-sufficiency island resourceswere used inefficiently. 4r, suppose that originally rusoe was self-sufficient at one fishand si! coconuts, and Friday was self-sufficient at five fish and five coconuts. "sland

production is si! fish and eleven coconuts. "n this case, only partial speciali ation might be desirable. "f Friday produces three coconuts and rusoe produces eight, island

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production could be eleven coconuts and seven fish, which is a gain of one fish comparedto production with no speciali ation.

+roduction +ossibilities&

rusoe FridayFish coconuts fish coconuts < 5 5 5 ; 3 > 3 < ? ; = 7 7 5 9 5 5

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" #aw of $iminishing eturns

The law of diminishing returns says that adding more of one input while holding otherinputs constant results eventually in smaller and smaller increases in added output.. "fcapital is held constant at two, the marginal output of labor 'which economists usually

call marginal product of labor( is shown in the table below. The first unit of laborincreases production by ;, and as more labor is added, the increases in productiongradually fall.

The arginal +roduct of /abor/abor arginal 4utputFirst ;%econd ?Third 7Fourth 7Fifth 9 , increased somewhat during the middle years of hisadministration, and declined to 33. percent of EK+ in fiscal >9>. This part of the@eagan record was probably the greatest disappointment to his supporters.

The changes to the federal ta! code were much more substantial. The top marginal ta!rate on individual income was reduced from ?5 percent to 39 percent. The corporateincome ta! rate was reduced from ?? but scheduled for the eighties wasaccelerated slightly. %ome e!cise ta! rates were increased, and some deductions werereduced or eliminated.

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ore important, there was a ma1or reversal in the ta! treatment of business income. Acomple! package of investment incentives was approved in >9 only to be graduallyreduced in each subsequent year through >97. And in >9= the base for the ta!ation of

business income was substantially broadened, reducing the ta! bias among types ofinvestment but increasing the average effective ta! rate on new investment. "t is not clear

whether this measure was a net improvement in the ta! code. 4verall, the combination oflower ta! rates and a broader ta! base for both individuals and business reduced thefederal revenue share of EK+ from 35.3 percent in fiscal >9 to >.3 percent in fiscal

>9>.

The reduction in economic regulation that started in the arter administration continued, but at a slower rate. @eagan eased or eliminated price controls on oil and natural gas,cable TI, long-distance telephone service, interstate bus service, and ocean shipping.:anks were allowed to invest in a somewhat broader set of assets, and the scope of theantitrust laws was reduced. The ma1or e!ception to this pattern was a substantial increasein import barriers. The @eagan administration did not propose changes in the legislation

affecting health, safety, and the environment, but it reduced the number of newregulations under the e!isting laws. Keregulation was clearly the lowest priority amongthe ma1or elements of the @eagan economic program.

onetary policy was somewhat erratic but, on net, quite successful. @eagan endorsed thereduction in money growth initiated by the Federal @eserve in late >?>, a policy that ledto both the severe >93 recession and a large reduction in inflation and interest rates. Theadministration reversed its position on one dimension of monetary policy& during the firstterm, the administration did not intervene in the markets for foreign e!change but,

beginning in >97, occasionally intervened with the ob1ective to reduce and then stabili ethe foreign-e!change value of the dollar.

ost of the effects of these policies were favorable, even if somewhat disappointingcompared to what the administration predicted. 2conomic growth increased from a 3.9

percent annual rate in the arter administration, but this is misleading because the growthof the working-age population was much slower in the @eagan years. @eal EK+ perworking-age adult, which had increased at only a 5.9 annual rate during the arteradministration, increased at a .9 percent rate during the @eagan administration. Theincrease in productivity growth was even higher& output per hour in the business sector,which had been roughly constant in the arter years, increased at a .< percent rate in the@eagan years. +roductivity in the manufacturing sector increased at a ;.9 percent annualrate, a record for peacetime.

ost other economic conditions also improved. The unemployment rate declined from?.5 percent in >95 to 7.< percent in >99. The inflation rate declined from 5.< percentin >95 to 99. The combination of conditions proved that there is nolong-run trade-off between the unemployment rate and the inflation rate 'see +hillips

urve(. 4ther conditions were more mi!ed. The rate of new business formation increasedsharply, but the rate of bank failures was the highest since the thirties. @eal interest ratesincreased sharply, but inflation-ad1usted prices of common stocks more than doubled.

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The 0. %. economy e!perienced substantial turbulence during the @eagan years despitefavorable general economic conditions. This was the )creative destruction* that ischaracteristic of a healthy economy. At the end of the @eagan administration, the 0. %.economy had e!perienced the longest peacetime e!pansion ever. The )stagflation* and)malaise* that plagued the 0. %. economy from >?; through >95 were transformed by

the @eagan economic program into a sustained period of higher growth and lowerinflation.

"n retrospect the ma1or achievements of @eaganomics were the sharp reductions inmarginal ta! rates and in inflation. oreover, these changes were achieved at a muchlower cost than was previously e!pected. Kespite the large decline in marginal ta! rates,for e!ample, the federal revenue share of EK+ declined only slightly. %imilarly, the largereduction in the inflation rate was achieved without any long-term effect on theunemployment rate. 4ne reason for these achievements was the broad bipartisan supportfor these measures beginning in the later years of the arter administration. @eagans firstta! proposal, for e!ample, had previously been endorsed by the Kemocratic ongress

beginning in >?9, and the general structure of the Ta! @eform Act of >9= was first proposed by two 1unior Kemocratic members of ongress in >93. %imilarly, the)monetarist e!periment* to control inflation was initiated in 4ctober >?>, following

arters appointment of +aul Iolcher as chairman of the Federal @eserve :oard. The bipartisan support of these policies permitted @eagan to implement more radical changesthan in other areas of economic policy.

@eagan failed to achieve some of the initial goals of his initial program. The federal budget was substantially reallocatedCfrom discretionary domestic spending to defense,entitlements, and interest paymentsCbut the federal budget share of national outputdeclined only slightly. :oth the administration and ongress were responsible for thisoutcome. @eagan supported the large increase in defense spending and was unwilling toreform the basic entitlement programs. %imilarly, neither the administration nor ongresswas willing to sustain the momentum for deregulation or to reform the regulation ofhealth, safety, and the environment.

@eagan left three ma1or adverse legacies at the end of his second term. First, the privatelyheld federal debt increased from 33.; percent of EK+ to ;9. percent and, despite therecord peacetime e!pansion, the federal deficit in @eagans last budget was still 3.>

percent of EK+. %econd, the failure to address the savings and loan problem early led toan additional debt of about 6 37 billion. Third, the administration added more trade

barriers than any administration since #oover. The share of 0. %. imports sub1ect to someform of trade restraint increased from 3 percent in >95 to 3; percent in >99.

There was more than enough blame to go around for each of these problems. @eaganresisted ta! increases, and ongress resisted cuts in domestic spending. Theadministration was slow to acknowledge the savings and loan problem, and ongressurged forbearance on closing the failing banks. @eagans rhetoric strongly supported freetrade, but pressure from threatened industries and ongress led to a substantial increasein new trade restraints. The future of @eaganomics will depend largely on how each of

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these three adverse legacies is resolved. @estraints on spending and regulation wouldsustain @eagonomics. :ut increased ta!es and a reregulation of domestic and foreigntrade would limit @eaganomics to an interesting but temporary e!periment in economic

policy.

The @egan economic program led to a substantial improvement in economic conditions, but there was no )@eagan revolution.* o ma1or federal programs 'other than revenuesharing( and no agencies were abolished. The political process continues to generatedemands for new or e!panded programs, but American voters continue to resist higherta!es to pay for these programs. A broader popular consensus on the appropriate roles ofthe federal government, one or more constitutional amendments, and a new generation of

political leaders many be necessary to resolve this inherent conflict in contemporaryAmerican politics.

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+ Canadian and !merican )conomics Compared

The comparison between the economies of anada and the 0nited %tates is generally farmore of a concern to anadian than to American.

anada is under constant pressure to remain competitive with the 0nited %tates. "F itdows not then forces such as the brain drain will occur, where the top anadians emigrateto the 0.%. "f anada falls behind corporations will also leave for the 0nited %tates. The0.%. has far less to fear as any losses to anada can be easily managed.

Kespite the contrasts listed below anada and the 0nited %tates are e!tremely similareconomically. They are both developed countries and are thus vastly closer to each otherthan to the ma1ority of the worlds countries. anada also is by almost all economicindices closer to the 0nited %tates than it is to 2urope.

:oom and bust cycles in anada and the 0nited %tates are closely linked as are many

indices such as inflation and interest rates. Kemographic patterns are also similar, with aslightly higher birth rate in the 0.%. and a higher immigration rate in anada.

,eography

"n its quest to remain competitive anada starts at an immediate disadvantage. anadasharsh climate lead to high costs for such things as heating. Borkers are less likely toimmigrate to anada and the wealthy are more likely to leave for tropical climates.

The climate of anada also contributes to higher transportation costs as planes, trains,and automobiles are all more e!pensive to operate than in much of the 0nited %tates.

anadas low population density also makes transportation costs higher. ore of ahistorical concern was that much of the country lacks natural river systems that could beeasily used for transportation. anadas terrain is also somewhat more rugged than the0nited %tates. The @ocky ountains are more of an obstacle, and the mass of the

anadian %hield provides a formidable barrier to any links between 4ntario andanitoba.

anada does have some distinct geographic advantages. The large river systems in thenorth are sources of cheap hydro-electric power. The main advantage is anadas vastsupplies of natural resources. Bhile the 0nited %tates has large supplies of resources,these are not enough to meet domestic demands and they are forced to import many raw

materials, a great deal of which come from anada. :y contrast anada is a net e!porterof resources. This leads to an important difference as increases in the price of resources boosts the anadian economy while hurting the American. For e!ample a rise in oil prices generally causes a fall in the Kow Dones but an increase in the T%Q.

,overnment

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Kifferences between government intervention in the economies of the two countries ismost closely e!amined in anada, because some feel that policies that more closelyemulate the 0.%. are preferable, while others disagree.

'axation

The average ta! rate in anada is higher than in the 0nited %tates. "n anada total ta!revenue for every level of government equals about ;=.9J of EK+, in the 0.%. this iscloser to ;5J. There is some regional variation, however. A resident of oil rich Alberta

pays less in ta!es than a resident of high ta! assachusetts.

The ta!es are applied differently as well. anadas ta! system is more heavily biasedagainst the highest income earners, thus while anadas ta! rate is higher on average, the

bottom fifty percent of the population is more lightly ta!ed than in the 0nited %tates.

anada also has a national sales ta! of ?J on all purchases, while the 0.%. federal

government relies almost entirely on income ta!es.anada has no inheritance ta! while the 0nited %tates still does, but the 0.%. ta! is

currently scheduled to be abolished.

&ocial Programs

For its higher ta!es anada has a more complete system of social programs than the0nited %tates. These differences include having all ma1or universities receive governmentfunding, having a national broadcaster in the : and, most notably, having a fullygovernment-funded health care system. The 0nited %tates, however, spends far more onmilitary than anada.

The greatest difference in social programs is in health care. The 0nited %tates spends farmore of its per capita EK+ on health care than does anada. anadians, however, receivecomparable care and most figures such as life e!pectancy and infant mortality are betterin anada. Another advantage is that the anadian health care system is also veryattractive to employers, as in anada health care is mostly paid through income ta!es,while in the 0nited %tates most companies have to e!tend health benefits to full-timeemployees, something they do not have to do in anada. The main disadvantage of the

anadian system is the long lines and waiting periods, especially for procedures of lessimportance.

%ee also& anadian and American health care systems compared

!nti-trust

The 0nited %tates has since the %herman Anti-Trust Act been strongly opposed tomonopolies. "n anada this has been far less of an issue and anada has never hadrigorously enforced rules against monopoli ation.

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Fiscal and Monetary Policy

anada is generally forced to follow American monetary policy quite closely$ any largedifference in interest rates could quickly lead to large problems for the anadian

economy. The 0.%. Federal @eserve and the :ank of anada both staunchly believe infighting inflation while neither aggressively pursue policies of full employment. 4nedifference that has emerged recently is that while anada is still hewing closely to the

balanced budgets policies of the >>5s the 0nited %tates has moved into a heavy deficit, a policy both countries followed in the >?5s and >95s.

Political 'urbulence

4ver the last few decades the anadian economy may have been hurt by the threat ofRuebec separatism, and Ruebecs economy was almost certainly damaged. "n the earlierera turbulence in the 0nited %tates from the civil rights movement and Iietnam Bar may

have hurt that countrys economy. This also sometimes benefited anadians as draftdodgers during the Iietnam Bar created a reverse brain drain that lasted for many years.

Mar.et &i/e

4ne of the most important differences historically between anada and the 0nited %tateswas the si e of the two markets. Bhen both nations had high tariffs the two countries didnot have a unified market. anadas smaller market led to higher prices and greaterinefficiency.

A good e!ample of this is the automobile industry, which can be clearly demarcated into

two periods& before and after the free trade creating Auto +act of >=>. :efore anadahad its own production lines creating each of the models that would be sold in anada.These branch plant factories would only make small production runs of each vehicle,requiring frequent and e!pensive retooling. The factories would also generally besmaller. Fewer varieties were available to anadian consumers and prices were generallyhigher. #owever, these cars were almost all still made by American companies. After theAuto +act, the industry was transformed as a unified orth American market was created.The anadian factories were rebuilt to be much larger, but to make only one model thatwould be sold in both countries creating large economies of scale. The prices of cars fellin anada as wages and total employment in the automobile sector increased.

After the %econd Borld Bar tariffs between the two countries gradually fell, with fullfree trade being established by the >99 anada-0nited %tates Free Trade Agreement.%ome industries are still protected, however. These are mostly sensitive areas suchcultural industries including publishing, television, and newspapers, which all of havestringent foreign ownership rules. 4ther areas such as the transport industry are also

protected with anadian control of the airlines and trains being viewed as in the nationalinterest.

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is controlled by the anadian banks. anadian banks also have far more of a presence inthe 0nited %tates than American firms do in anada. "n part this is because Americanfirms cannot buy anadian banks, but anadian banks have, at times, been able to buyAmerican ones. %ince the large anadian banks already operated nationwide chains of athousand or more branches, they find it relatively easy to integrate smaller chains of

American banks into their systems. "n recent years this advantage has disappeared asAmerican banks have also grown substantially in si e and today have many branches.

Kespite these foreign ownership rules, anadian banks have been far less strictlyregulated than their American counterparts. anadian banks are far freer to participate inthe financial planning and insurance industries than their American counterparts.

anadian banks have not faced laws against usury, or interest guarantees on deposits.+rofits for anadian banks are generally higher.

#owever, service charges are also lower in anada, and anadas banking system also provides better service by most measures. anada has more branches and more AT s

per capita than the 0nited %tates. heques take less time to clear, as do most othertransactions. anadian banks have been far more active in promoting debit cards andinternet banking, and both services are used far more often by anadians.

Prices

"n anada prices have long tended to be higher. This is partly because of structural issuesin anada such as low population density and harsher weather, and partly due to

anadas ta! system, which depends more heavily on sales ta!es relative to income ta!esthan the 0.%. This has contributed to problems such as cross-border shopping and areduced standard of living. %ince the early >>5s this has not been the case, as the

anadian dollar had fallen low enough that it more than made up for price differences.Today prices are somewhat lower in anada$ the :ig ac "nde! shows that in 355; a :ig

ac cost 63.=7 in the %tates and only 63.< in anada 'both figures in 0%K(.

Fuel prices have always been higher in anada, even though anada is a net e!porter ofenergy. This is partly for the same reasons as above and partly because of environmentalta!es levied specifically on fuel. 0nlike many oil producers, particularly those in thedeveloping world, anada does not heavily subsidi e fuel, so prices are based on theworld market price.

Productivity

:y most measures anadian workers are less productive, although some of thisdifference is caused by Americans tending to work longer hours. anadian level ofmechani ation are also not always as high.

For the last thirty years the productivity gap has been closing, in large part because of theelimination of the smaller market problem through free trade. From >= to >?; labor

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productivity rose annually by ;.; percent in anada and .? percent in the 0nited %tates.From >?; to >>7 it was . percent in anada and 5.9 percent in the %tates.

0nemployment

anada has a higher unemployment rate than the 0nited %tates with the anadian number being around ? to 9J while the 0.%. tends to be around 7J. Kuring the >95s when thisgap first emerged it was a controversial issue. anadas higher income ta!es and moregenerous benefit programs were blamed. "t has recently been noted that about half of thedifference is caused by the two countries measuring the unemployment rate differently.

arig @iddel, a 0: economist, found that the unemployment gap had averaged about3J over the last several years. #is numbers show that 5.>J of the difference was caused

by differing measurement systems. 4ther factors e!plaining the remaining difference arethe large number of seasonal workers in trades such as fishing and logging who areemployed for a portion of the year. anadas more restrictive labor laws, increased roleof unions, and greater unemployment benefits have also all been blamed for creating

some or the difference. #owever, when unemployment insurance and welfare weresharply cut in many parts of anada during the >>5s there was little gain relative to theAmericans.

(alance of trade

Bhile the 0nited %tates has in recent years had a large trade deficit anada has recentlymaintained a trade surplus. The anadian surplus is almost entirely due to trade with the0nited %tates. anada has trade deficits with the countries of 2urope and Asia, 1ust as theAmericans do. "n 3553 anada e!ported about 55 billion dollars worth of goods morethan they imported to the 0.%. Bith the rest of the world it had a trade of 69; billion

creating an overall surplus of some 6 ? billion.

Income

anadian EK+ per capita is lower than that in the 0nited %tates, but median income isvery similar in the two countries. Bealth in the 0nited %tates is more highly concentratedand the higher per capita EK+ is almost entirely a difference among the wealthiest J ofthe two countries.

The EK+ gap has also been shrinking. From >= to >?;, real EK+ grew at an averageannual rate of 7.7 percent in anada and ?; to

>>7 it was 3.=J in anada and 3.;J in the %tates.

&tandard of #iving

%tandard of living is perhaps the hardest measurement to make since a wide array offactors have to be taken into account. The 0nited ations #uman Kevelopment "nde! hastraditionally listed anada higher than the 0nited %tates, with only a few e!ceptions.

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4ther independent groups, such as the 2conomist rank anadian cities as better places tolive than American ones.

anada ranks higher than the 0.%. in statistics such as life e!pectancy, infant mortality,and literacy. The 0nited %tates has more ma1or consumer goods per capita than anada.

For instance, while anada had only ? < televisions per 555 people in >>=, the 0nited%tates had 957.

The income gap in the 0nited %tates is larger. There is sometimes a racial element to poverty in the 0nited %tates. African-Americans and #ispanics, on average, have a lowerstandard of living than the rest of the population. anadas French- anadians also used to

be a much poorer group, but since the Ruiet @evolution in the >=5s this has mostly beenremedied. anadas First +eoples, a comparatively smaller percentage of the population,have a far lower standard of living than the ma1ority

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1 'he #ion2 the $ragon2 and the Future

"n the >95s, a select group of economies in Asia came to be known as the )Asian tigers* because of their aggressive approach to economic growth. Among the tigers were%ingapore, alaysia, Thailand, and "ndonesia. All took the view that a combination of

low wages and high export sales represented the fast track to economic growth and prosperity. ow these tigers are being overtaken by the )dragon* of AsiaC hina Swhichis following the same path, with perhaps even more success.

For decades after the ommunists rise to power in >, hina was best knownfor poverty and repression, and its aggression came mostly on the military front. :ut inrecent years, economic aggression has become the byword. Although both poverty andrepression are still the norm, both are changing for the better. hina, it seems, is trying tolearn from capitalism, even if not converting to it.

hinas economic offensive began almost thirty years ago in its southeastern province of Euangdong. The hinese leadership decided to use this province as a testcase, to see if capitalist direct foreign investment could stimulate economic growth in a

way that could be politically controlled. The e!perience was deemed a successC economic growth soared amid political stability. Bhat the government learned from thee!perience helped it smooth the >>? transition of #ong ong from :ritish to hinesecontrol. ost important in terms of hinas long-term economic aspirations, manyforeign investors came to view the Euangdong e!periment as solid evidence that theycould invest in hina without fear that the ommunist government would confiscate theircapital. :eginning about >>3, foreign investment in hina began to soar. The annualrate of such investment is more than ten times greater than it was at the beginning of the

>>5s.There are two powerful forces that are attracting economic investment to hina&

demand and supply3 4n the demand side, .; billion people live there, some 35 percentof the worlds population. Although per capita income is still low by world standards, ithas been increasing by more than = percent per year, after ad1usting for inflation. At thatrate, the standard of living for the hinese peopleCand hence their purchasing power inworld marketsCis doubling every decade or so. hina is already the worlds largest cell-

phone market, with 355 million customers. Bithin a few years, it is estimated, hina willaccount for 37 percent of the worlds purchases of personal computers. "ndeed, hinanow spends over 6=5 billion per year on information technology and services, and thisamount is growing at a rate of nearly ;5 percent per year. :y 35;5, the hinese economywill likely have replaced the economy of the 0nited %tates as the worlds largest.

Bith its population of .; billion, china also offers attractions on the supply side.#ighly skilled workers have been plentiful in the hinese labor market. hinasuniversities produce more


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icrosoft have shifted some key components of their research to hina in recent years.American firms are even setting up customer-service call centers in hina. icrosoftcustomers from the 0nited %tates who call for help may well find themselves talking withone of that companys four hundred engineers who are located in %hanghai.

alaysia, Thailand, and %ingapore are increasingly concerned by the growing

competition they face from their neighbor to the north. hinese medium- and high-techindustries are starting to cut into the mar.et share of the very sectors that have helpedfuel the growth of the Asian tigers in recent decades. The situation is even more criticalin Dapan, where wages are much higher than in hina but whose technological lead over

hina is gradually eroding. )Are we to become a vassal of the hinese dynasty againH*asked one Dapanese official, clearly concerned that his nations manufacturing firms werehaving trouble competing with hinese firms. 2ventually, Dapan and hinas otherneighbors will ad1ust to the growing economic presence of hina, but the transition may

be unpleasant.ost Americans, however, are more concerned about the likely impact on the 0.

%. economy of hinas capitalist ambitions. Bill the dragon consume American firms

and 1obs as it growsH The short answer is no. The long answer has two elements. To this point, a key element of hinas competitiveness has been the low wages there. 2venthough American and 2uropean firms operating in hina choose to pay their workersmore than state-owned enterprises pay, this has still yielded considerable savings. Asrecently as five years ago, unskilled and semiskilled labor in hina cost only 37 percentas much as in 2urope. oreover, foreign firms have been able to hire engineers forsalaries that are only 5 to 35 percent of the cost of hiring engineers in the Best.

/abor markets in hina are changing rapidly, however. Average wages are risingat = to 9 percent per year, with bigger increases among higher-skilled workers, andmigration into the cities has slowed due to a sharp cut in agricultural ta!es. any firmshave been unable to hire as many workers as they would like, and most firms have had toupgrade their fringe benefits and other on-the-1ob amenities 1ust to retain e!istingworkers. 2ven so, turnover has soared as firms compete for a pool of talent that is nolonger growing. Bages are still well below American and 2uropean levels, but the gap isclosing steadily, thereby cutting the competitive advantage of many hinese firms.

@ising wages in hina will also translate into higher demand for goods produced by American and 2uropean firms. hina, like all nations, must in the long run importgoods equal in value to those it e!ports 'unless hina intends to give its e!ports away,which so far no one is claiming(. This means that 1ust as hina has become a potentsupplier of many goods and services, it is at the same time becoming a potent demanderof still other goods and services.

Thus far, the hinese demand for goods has not been as visible in Americanmarkets because American firms tend to produce goods and services designed for higher-income consumers, and hina has, as yet, relatively few of those. "n the meantime, thedemand-side influence of the hinese economy is already showing up, albeit in odd

places. To take one e!ample, right now hinas most important import from the 0nited%tates is trash. @anging from used newspapers to scrap steel, hinese companies buy

billions of dollars worth of the stuff every year to use as raw materials in the goods they produce. "n addition to yielding profits 'and employment( in these 0. %. e!port industries,

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this e!portation of 0. %. trash reduces the burden on 0. %. landfills and, by pushing up the prices of recyclable scrap, encourages more recycling in the 0nited %tates.

2ventually, of course, wed like to be sending hina more than our rubbish, andthat time is coming. As hinas economy grows, so will the number of affluent hinese,and with .; billion potential candidates, that ultimately means plenty of consumers for

Americas high-end goods. Thus the long-run effects of hinas growth will mean adifferent American economyCwell be producing and consuming different mi!es ofgoods and servicesCbut America will also be a richer nation. Ioluntary e!change, afterall, creates wealth, and the hinese dragon is big enough to create a lot of wealth.

Dust to hinas southwest, another giant is stirring. Around >>5, the lion of "ndia began to throw off the self-imposed shackles of nearly a half-century of markets largelyclosed to international competition. The central government, for e!ample, began openingmany of its state-owned companies to competition from private-sector rivals. Fed2! and0nited +arcel %ervice '0+%( have made huge inroads on the "ndian postal service, andnumerous foreign firms are now competing with the state-owned telephone service,which had long been a complete monopoly3

2ntry into the "ndian market brought familiarity with its workforce, many ofwhose members are fluent in 2nglish. The technical capabilities of graduates of top"ndian universities, combined with their 2nglish skills are low wages, made them perfectstaffers for a proliferation of call centers that have opened throughout "ndia. Tens ofthousands of technical and customer-relations 1obs that used to go to iddle America arenow held by the growing middle class in "ndia. As we discussed in hapter


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confiscate the fruits of capitalist success to support itselfH 4r will growing pressure formore political freedom force the government to repress the capitalist system to protectitselfH 2ither route would likely bring economic growth in hina to a swift half.

The second potential long-run problem faced by hina lies in that nationscultural attitude toward intellectual property3 "n a land in which imitation is viewed as

the sincerest form of flattery, it is routine to use the ideas of others in ones own pursuits.As a result, patent and copyright laws in hina are far weaker than in Bestern nations.oreover, actions elsewhere considered to be commercial theft 'such as software piracy(

are largely tolerated in hina. "f foreign firms find that they cannot protect theireconomic assets in the hinese market, foreign investment will suffer accordingly, and sowill the growing dragon that depends on it so heavily.

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increase in the incentive to earn. +redictably, these ta!payers will earn more ta!ableincome after the rate reduction, and the revenues collected from them will decline bysubstantially less than a third. "n fact, given the huge increase in their incentive to earn,the revenues collected from ta!payers confronting such high marginal rates may actuallyincrease.

The same ;; percent rate reduction will cut the bottom ta! rate from 7 percent to 5 percent. #ere, take-home pay per 6 55 of additional earnings will rise from 697 to 6>5,only a 7.> percent increase in the incentive to earn 'compared to the 55 percent increasein the top bracket(. :ecause cutting the 7 percent rate to 5 percent e!erts only a smalleffect on the incentive to earn, the rate reduction has little impact on the ta! base.Therefore, in contrast with the revenue effects in high ta! brackets, ta! revenue willdecline by almost the same percent as ta! rates in the lowest ta! brackets. The bottomline is that cutting all rates by a third will lead to small revenue losses 'or even revenuegains( in high ta! brackets and large revenue losses in the lowest brackets. The share ofthe income ta! paid by high-income ta!payers will rise.

Kuring the great ta! debate of >?7 to >9=, the opponents of the supply-side viewargued that it was unrealistic to e!pect lower ta! rates to lead to increased ta! revenues.According to the critics an increase in the ta! base that was large enough to increaserevenues would require an unrealistically large elasticity of labor supply 'increase inhours worked due to higher after-ta! wages(. "n response the supply-side proponentsstressed that reductions in ta! avoidance activities, as well as labor-supply effects, wouldenlarge the ta! base when the rates were reduced. According to the supply-side view thecombination of a decline in ta! avoidance and increase in business activities would

permit lower rates with little or no loss of revenues in the top ta! brackets. At the sametime, most supply-side economists, though perhaps not all, noted that reductions in lowta! rates would lead to revenue losses.

2mpirical studies of ta! cuts that happened during the twenties and si!ties buttressed thesupply-side position. +rodded by %ecretary of the Treasury Andrew ellon, three ma1orta! cuts reduced the top marginal ta! rate from ?; percent in >3 to 37 percent in >3=.in addition, the ta! cuts eliminated or virtually eliminated the personal income ta!liability of low-income recipients. The results were quite impressive. The economy grewrapidly from >3 through >3=. After the rates were lowered, the real ta! revenue 'in

>3> dollars( collected from ta!payers with incomes above 675,555 of income declined by =; and >=7, ta! rates were reduced by appro!imately 37 percent. The top marginal ta!

rate was cut from > percent to ?5 percent. %imultaneously, the bottom rate was reducedfrom 35 percent to < percent. For most ta!payers the lower rates reduced ta! revenues."n real >=; dollars the ta! revenues collected from the bottom >7 percent of ta!payersfell from 6; .5 billion in >=; to 63>.= billion in >=7, a


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contrast, the real ta! revenues collected from the top 7 percent of ta!payers rose from6 ?.3 billion in >=; to 6 9.7 billion in >=7, a ?.= percent increase. As in thecase of theta! cuts of the twenties, the rate reductions of the si!ties reduced the ta! revenuecollected from low-income ta!payers while increasing the revenues collected from high-income ta!payers.

a1or ta! legislation passed in >9 and >9= reduced the top 0. %. federal income ta!rate from ?5 percent to appro!imately ;; percent. The performance of the 0. %. economyduring the eighties was impressive. The growth rate of real E + accelerated from thesluggish rates of the seventies. 0. %. economic growth e!ceeded that of all other ma1orindustrial nations e!cept Dapan.

The critics of the eighties ta! policy argue that the top rate reductions were a bonan a forthe rich. The ta!able income in the upper ta! brackets did increase sharply during theeighties. :ut the ta!es collected in these brackets also rose sharply. easured in >93-99 to 6 >>.9 billion in >99, an increase of ;3.? percent. The percentage increases in the real ta! revenue collected from the top and top 7 percent ofta!payers were even larger. "n contrast, the real ta! liability of other ta!payers 'the

bottom >5 percent( declined from 6 = .9 billion to 6 . billion, a reduction of ?.9 percent. These findings confirm what the supply-siders predicted& the low rates, byincreasing the ta! base substantially in the upper ta! brackets, caused high-incometa!payers to pay more ta!es. "n effect, the lower rates soaked the rich.

+robably the most detailed study of the ta! changes in the eighties was conducted by/awrence /indsey of #arvard 0niversity. /indsey used a computer simulation model toestimate the impact of the eighties ta!-rate changes on the various components ofincome. #e found that after the ta! rates were lowered, the wages and salaries of high-income ta!payers were appro!imately ;5 percent larger than pro1ected. %imilarly, afterthe rate cuts capital gains were appro!imately 55 percent higher than pro1ected, andhigh-income ta!payers business income was a whopping 355 percent higher thane!pected. /indsey concluded that the main supply-side effects resulted from 'a( people

paying themselves more in the form of money income rather than fringe benefits andamenities, 'b( increases in business activity, and 'c( a reduction in ta! shelter activities.#is findings undercut the position of those supply-side critics who had assumed thatsubstantial supply-side effects were dependent on a large increase in labor supply.

%tudies liking rate changes with changes in ta! revenue measure the short-term effects ofta! policy. :ut because ta!payers take time to ad1ust, revenues are even more responsiveto rate changes in the long run. Dames /ong and " conducted a study that found thatta!payers in states with lower marginal ta! rates had much lower deductions and muchlower e!penditures on ta! shelters than ta!payers in states with higher marginal rates. Befound that when the combined federal-state marginal ta! rate rises above 75 percent, thegovernments ta! revenues decline. /indsey estimates that the governments revenue

begins declining at even lower ta! rates, appro!imately ;7 percent.

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%upply-side economics influenced ta! policy throughout the world in the late eighties. 4feighty-si! countries with a personal income ta!, fifty-five reduced their top marginal ta!rate during the >97->5 period, while only two '/u!embourg and /ebanon( increasedtheir top rate. ountries that substantially reduced their top marginal ta! rates includeAustralia, :ra il, France, "taly, Dapan, ew Nealand, %weden, and the 0nited ingdom.

@eflecting the dominant eynesian view at the beginning of the eighties, mosteconomists thought that ta! changes influenced output and revenue primarily bychanging the demand for goods and services. :oth research and the ta! policy changes ofthe eighties, however, indicate that supply-side incentive effects are quite important.Bhile controversy continues about the precise magnitude of the supply-side effects, theview that marginal ta! rates in e!cess of 9? statement by the ongressional :udget office ' :4(, whichhad been critical of the supply-side claims and had always assumed in its revenue

pro1ections that ta!payers did not respond at all to changes in ta! rates. The :4 wrote&)The data show considerable evidence of a very significant revenue response amongta!payers at the highest income levels.* This change in thinking is the ma1or legacy ofsupply-side economics.

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The Production Possibilities Frontier

&carcity2 Choice and the Production Possibilities Frontier

'he )conomic Problem of &carcity 6

%carcity occurs because human wants e!ceed the limits of available resources.

2conomics deals with the basic fact that scarcity e!ists in our everyday lives and in oureconomy. "magine for a minute that a messenger suddenly knocks on your door. #egreets you with the delightful information that a previously unknown distant relative hascarefully monitored your progress through life. The relative is pleased with your

progress and as a test has decided to give you 67 million. There is one stipulation,however$ you must spend this money within three months.

Bould you have any trouble spending the moneyH 0nless you are already smothered in

wealth, you should have no trouble coming up with a list of e!penditures. A car, a beachfront apartment, a ski chalet, a boat, a vacation in paradise, a new computer, TI,and stereo. E% ellular phone, + % wireless, satellite uplink, personal messagingsystem, AK%/, cable modem and "%K "nternet access, your list suddenly grows longerthan you e!pected. The money would be e!hausted in no time. Bake up$ a survey of theworn bills in your wallet reveals the basic fact that you face a scarcity of money inrelation to the list that we 1ust constructed.

The same idea applies to the economy as a whole. @esources such as raw materials are infinite supply and must be allocated to their best use. For e!ample, in the western 0nited%tates, water is a relatively scarce resource. The water that originates in olorado flows

westward into the olorado @iver, eventually providing cities in %outhern alifornia withdrinking water. "n years when rainfall is below normal, regional water restrictions comeinto effect and users may be prevented from certain activities such as washing their cars.Iirtually all resources are scare, meaning that more of them are desired than is available.

Choice

Eiven the presence of scarcity, choices must be made as to how resources are allocated.

4ur lives are filled with wide range of choices regarding the use of limited personalfunds. Advertisers constantly inform consumers of their consumption possibilities and

the choices available. The same principle applies for the economy as a whole. Be elect politicians who work with policy makers to allocate government e!penditures. Togetherthey make difficult choices concerning how ta!es will be spent. 4r if a ta! reduction isdesired, a decrease in government e!penditures should accompany the ta! cut.

+roblems arise when government try simultaneously to reduce ta!es and maintain a highlevel of e!penditures. As pointed out, the 0.%. government must take the choice between

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reduced e!penditures today or run the risk of 1eopardi ing future economic growth and prosperity.

The tradeoff between consumption today and consumption tomorrow deals with theconcept of opportunity cost.

7pportunity Cost

The relevant cost of any decision is its opportunity cost S the value of the ne!t-bestalternative that is given up.

:y making choices in how we use our time and spend our money we give something up."nstead of reading this material, what else could you be doingH Gour best alternative mayinvolve sports, leisure, work entertainment, and more. "f you choose to go to a restaurantthis evening, the money that you spend on dinner will not be available for other uses,even saving.

:usinesses and government also deal with opportunity costs. As noted, by choosing tomaintain large deficits today, the federal government may reduce future economicgrowth. 4r laws that protect wilderness areas and endangered species will ensure a betterenvironment tomorrow at the opportunity cost of reduced access to resources today.

:usinesses must choose what type of goods to produce and the quantity. Eiven limitedfunds, the opportunity cost of producing one type of good will arise from not being ableto produce another.

'he Production Possibilities Frontier 8PPF9Introduction to the Production Possibilities Frontier 8PPF9

The production possibilities frontier is used to illustrate the economic circumstances ofscarcity, choice, and opportunity cost.

To describe the concept of the production possibilities frontier, assume that we live on anisland that has only two cities '%eattle and Ketroit(, and two industries 'automobiles andairplanes(. Eiven the resources available on our island economy, the table below showshow labor and capital can be allocated to the production of autos and airplanes.


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'he Production Possibilitiesfor a &ingle Country

4ption Automobiles AirplanesA 75 5: 37 K ;5 =2 5 37

The table fives five production possibilities, option R through 2. 2ach option showswhat alternative mi!es of automobiles and airplanes that society can choose to produce.4ption A is one where our island dedicates all or its resources to the production ofautomobiles, entirely forsaking production. 4ption : shows a preference for the

production of a few airplanes, but giving up some automobiles in the process. Thetradeoff of airplanes for autos continues to point 2, where our country dedicates itself tothe production of airplanes '37(, producing ero automobiles.

The table presented here can be used to describe the economic problems of scarcity,choice and opportunity cost. %carcity is present because finite amounts of each good can

be produced. Be may want a combination of 75 autos and 37 airplanes, but given thelimited labor and capital inputs available, this is not a feasible combination. To produce

75 autos requires that all labor and capital available be used in the assembly ofautomobiles, leaving nothing for the production of airplanes.

4nly by giving up some autos 'moving from 4ption A to 4ption :( do we gain airplanes."n a practical sense, labor and capital is switched from producing automobiles to

airplanes. This presents opportunity cost S the best alternative that we give up 'autos( toincrease airplane output.

Finally, choice is demonstrated by the five options of the table. #ow are choices madeH+erhaps the firm or the market will determine the combination of autos and airplanes thatare produced. There can be a central planning agency that makes this determination orthe democratic process will let citi ens vote for their preferences.

!utomobiles 75

37

! i r p l a n e s

Figure 4-4 'he Production Possibilities Frontier


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Figure - is a graphical representation of the information presented in the table above.The boundary presented in the graph represents the different possibilities that society hasin the allocation of resources. The frontier boundary and its interior represent what isachievable given our islands currently available resources. "n contrast, points outside thefrontier are not attainable given the resources and technology present.

ote two characteristics of the production possibilities frontier. First, it slopes downwardto the right. This represents the tradeoff present in production. :y producing moreautomobiles, workers and capital must migrate from %eattle to Ketroit. An increase inauto production necessitates a reduction in the output of airplanes.

"n addition, the production possibilities frontier is )bowed outward.* The curvature ofthe production possibilities frontier reflects the increasing opportunity cost whensubstituting one type of production for another. This situation is caused by thespeciali ation of workers. "f society initially favors auto production over airplanes so thatwe are located in the southeast portion of the frontier, workers become skilled in auto

production. :ut as we move to the left along the curve, increasing airplane output anddecreasing auto production, some workers switch to building airplanes. For manyworkers, the skills used in producing autos are not perfectly transferable. "n addition, themachinery used for auto production may not be well suited to making airplanes. As aresult, the output per worker falls as they are relocated to making goods in which they areless skilled.

Dust as the previous table described the economic problems of scarcity, choice andopportunity cost, the ++F does the same. +oints outside the frontier may be desirable, butare not obtainable given the inputs of labor and capital available to society. As wechange out preferences and move to the orth Best along the frontier, airplanemanufacturing increases at the opportunity cost of automobile assembly.


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3 Canada:s Free Health Care has Hidden Costs

+roponents of the anadian model praise its universal coverage and its apparent low cost.Total 'private and public( health e!penditures are only 5J of gross domestic product in

anada, compared to >;, waiting times haveincreased by >5J


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Baiting lines impose a real cost, which is appro!imated by what individuals would bewilling to pay to avoid them. Baiting costs include health risk, lost time 'especially forindividuals whose time is most valuable(, pain and anguish. %ocialist systems arenotoriously oblivious to anguish, discomfort, humiliation and other sub1ective factorswhich bureaucrats cannot measure or dont value the same way as the patient does.

A Ruebec physician, Kr. Dacques haoulli, is suing the government for not allowing patients to pay for better care. The %upreme ourt of anada will hear his appeal oflower-court rebuttals in Dune. /ast month, a class-action case was launched againstRuebec hospitals on behalf of 5,555 breast cancer patients who, since 4ctober >>?,have had to wait more than eight weeks each for post-surgery radiation therapy.

/iberali ation proposals are met by the )two-tier system* bogey manCthat if choice isallowed an unequal system will develop. :ut if directly paying a doctor is illegal, thereare legal ways to 1ump the queues. As pointed out by +rofessor /ivio Ki atteo of/akehead 0niversity in 4ntario, what now e!ists is a three-tier system. The very rich

'like @obert :ourassa, the /ate +remier of Ruebec( go to the 0. %. for rapid, personali ed, high-tech treatments. The second tier is made of )the well informed andaggressive, who can push their way to the front of the treatment line.* The poor and thosewith no connections get stuck in the queue.

At least two "ndian groups are now considering building private clinics or hospitals ontheir landC1ust as other sorts of illegal-elsewhere trade thrive on "ndian reserves. Get,

anadians who patroni ed such clinics would still be prohibited from purchasing privateinsurance to cover the service, leaving the opportunity only to the wealthiest.

As noted by Bharton professor +atricia Kan on, another hidden cost of the anadiansystem comes )from forcing everyone to have the same level and type of insurance,*whatever their individual preferences are.

4ne last cost should not be ignored& the loss of personal responsibility and the habit ofdependence on the state. 4pinion polls show that anadians are generally proud of their

public health insurance. "ndeed, for most people, any basis for comparison has been madeillegal. Auberon #erbert, a libertarian ember of +arliament in late > th century 2nglandwrote, )"f government half a century ago had provided us all with dinners and breakfasts,it would be the practice of our orators today to assume the impossibility of our providingfor ourselves.*


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; (aseball Players and 7pportunity Costs

4n Kecember 3 , 3553, the Toronto :lue Days decided not to offer salary arbitration tooutfielder Dose ru , one of there more popular players. :y not offering arbitration, ru

became a free agent and could sign a con

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