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a limited time, and copyright laws, which give the author an exclusive legal right over works of literature, music, film/video, and pictures. For example, if a pharmaceutical firm has a patent on a new drug, then no other firm can manufacture or sell that drug for 21 years, unless the firm with the patent grants permission. Without a patent, the pharmaceutical firm would have to face competition for any successful products, and could earn no more than a normal rate of profit. With a patent, a firm is able to earn monopoly profits on its product for a period of time—which offers an incentive for research and development. In general, how long can “a period of time” be? The This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 13 | Positive Externalities and Public Goods 307 Clear It Up discusses patent and copyright protection timeframes for some works you might know. How long is Mickey Mouse protected from being copied? All patents and copyrights are scheduled to end someday. In 2003, copyright protection for Mickey Mouse was scheduled to run out. Once the copyright had expired, anyone would be able to copy Mickey Mouse cartoons or draw and sell new ones. In 1998, however, Congress passed the Sonny Bono Copyright Term Extension Act. For copyrights owned by companies or other entities, it increased or extended the copyright from 75 years to 95 years after publication. For copyrights owned by individuals, it increased or extended the copyright coverage from 50 years to 70 years after death. Along with protecting Mickey for another 20 years, the copyright extension affected about 400,000 books, movies, and songs. Figure 13.4 illustrates how the total number of patent applications filed with the U.S. Patent and Trademark Office, as well as the total number of patents granted, surged in the mid-1990s with the invention of the internet, and is still going strong today. Figure 13.4 Patents Filed and Granted, 1981–2012 The number of applications filed for patents increased substantially beginning in the 1990s, due in part to the invention of the internet, which has led to many other inventions and to the 1998 Copyright Term Extension Act. (Source: http://www.uspto.gov/web/offices/ac/ido/oeip/taf/ us_stat.htm) While patents provide an incentive to innovate by protecting the innovator, they are not perfect. For example: • • In
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countries that already have patents, economic studies show that inventors receive only one-third to one-half of the total economic value of their inventions. In a fast-moving high-technology industry like biotechnology or semiconductor design, patents may be almost irrelevant because technology is advancing so quickly. • Not every new idea can be protected with a patent or a copyright—for example, a new way of organizing a factory or a new way of training employees. • Patents may sometimes cover too much or be granted too easily. In the early 1970s, Xerox had received over 1,700 patents on various elements of the photocopy machine. Every time Xerox improved the photocopier, it received a patent on the improvement. • The 21-year time period for a patent is somewhat arbitrary. Ideally, a patent should cover a long enough period of time for the inventor to earn a good return, but not so long that it allows the inventor to charge a monopoly price permanently. 308 Chapter 13 | Positive Externalities and Public Goods Because patents are imperfect and do not apply well to all situations, alternative methods of improving the rate of return for inventors of new technology are desirable. The following sections describe some of these possible alternative policies. Policy #1: Government Spending on Research and Development If the private sector does not have sufficient incentive to carry out research and development, one possibility is for the government to fund such work directly. Government spending can provide direct financial support for research and development (R&D) conducted at colleges and universities, nonprofit research entities, and sometimes by private firms, as well as at government-run laboratories. While government spending on research and development produces technology that is broadly available for firms to use, it costs taxpayers money and can sometimes be directed more for political than for scientific or economic reasons. the NASA Visit website (http://openstaxcollege.org/l/NASA) (http://openstaxcollege.org/l/USDA) to read about government research that would not take place were it left to firms due to the externalities. website USDA and the The first column of Table 13.3 shows the sources of total U.S. spending on research and development. The second column shows the total dollars of R&D funding by each source. The third column shows that, relative to the total amount of funding, 22.7% comes from the federal government, about 69% of R&D is done by industry, and less than 4% is done by universities and colleges.
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(The percentages below do not add up to exactly 100% due to rounding.) Sources of R&D Funding Amount ($ billions) Percent of the Total Federal government Industry Universities and colleges Nonprofits Nonfederal government Total $113.1 $344.9 $17.1 $19.9 $4.0 $499 22.7% 69.0% 3.4% 4.0% 0.8% Table 13.3 U.S. Research and Development Expenditures, 2015 (Source: https://www.nsf.gov/ statistics/2016/nsf16316/) In the 1960s the federal government paid for about two-thirds of the nation’s R&D. Over time, the U.S. economy has come to rely much more heavily on industry-funded R&D. The federal government has tried to focus its direct R&D spending on areas where private firms are not as active. One difficulty with direct government support of R&D is that it inevitably involves political decisions about which projects are worthy. The scientific question of whether research is worthwhile can easily become entangled with considerations like the location of the congressional district in which This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 13 | Positive Externalities and Public Goods 309 the research funding is spent. Policy #2: Tax Breaks for Research and Development A complementary approach to supporting R&D that does not involve the government’s close scrutiny of specific projects is to give firms a reduction in taxes depending on how much research and development they do. The federal government refers to this policy as the research and experimentation (R&E) tax credit. According to the Treasury Department: “... the R&E Credit is also a cost-effective policy for stimulating additional private sector investment. Most recent studies find that each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar in R&D, with some studies finding a benefit to cost ratio of 2 or 2.96.” Visit this website (http://openstaxcollege.org/l/REtaxcredit) for more information on how the R&E Tax Credit encourages investment. Policy #3 Cooperative Research State and federal governments support research in a variety of ways. For example, United for Medical Research, a coalition of groups that seek funding for the National Institutes of Health, (which is supported by federal grants), states
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: “NIH-supported research added $69 billion to our GDP and supported seven million jobs in 2011 alone.” The United States remains the leading sponsor of medical-related research spending $117 billion in 2011. Other institutions, such as the National Academy of Scientists and the National Academy of Engineers, receive federal grants for innovative projects. The Agriculture and Food Research Initiative (AFRI) at the United States Department of Agriculture awards federal grants to projects that apply the best science to the most important agricultural problems, from food safety to childhood obesity. Cooperation between government-funded universities, academies, and the private sector can spur product innovation and create whole new industries. 13.3 | Public Goods By the end of this section, you will be able to: Identify a public good using nonexcludable and non-rival as criteria • • Explain the free rider problem • Identify several sources of public goods Even though new technology creates positive externalities so that perhaps one-third or one-half of the social benefit of new inventions spills over to others, the inventor still receives some private return. What about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? We call this kind of good a public good. Spending on national defense is a good example of a public good. Let’s begin by defining the characteristics of a public good and discussing why these characteristics make it difficult for private firms to supply public goods. Then we will see how government may step in to address the issue. The Definition of a Public Good Economists have a strict definition of a public good, and it does not necessarily include all goods financed through 310 Chapter 13 | Positive Externalities and Public Goods taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. We can buy and sell a piece of pizza fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way. Instead, public goods have two defining characteristics: they are nonexcludable and non-rival. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or
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with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you. The second main characteristic of a public good, that it is non-rival, means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza then Michelle cannot also eat it; that is, the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are non-rival in this area. A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too. Positive externalities and public goods are closely related concepts. Public goods have positive externalities, like police protection or public health funding. Not all goods and services with positive externalities, however, are public goods. Investments in education have huge positive spillovers but can be provided by a private company. Private companies can invest in new inventions such as the Apple iPad and reap profits that may not capture all of the social benefits. We can also describe patents as an attempt to make new inventions into private goods, which are excludable and rivalrous, so that no one but the inventor can use them during the length of the patent. The Free Rider Problem of Public Goods Private companies find it difficult to produce public goods. If a good or service is nonexcludable, like national defense, so that it is impossible or very costly to exclude people from using this good or service, then how can a firm charge people for it? Visit this website (http://openstaxcollege.org/l/freerider) to read about a connection between free riders and “bad music.” When individuals make decisions about buying a public good, a free rider problem can arise, in which people have an incentive to let others pay for the public good and then to “free ride” on the purchases of others. We can express the free rider problem in terms of the prisoner’s dilemma game, which we discuss as a representation of oligopoly in Monopolistic Competition and Oligopoly. When individuals make decisions about buying a public good, a free rider problem can
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arise, in which people have an incentive to let others pay for the public good and then, since once there is a provided public good it is available to all, to “free ride” on the purchases of others. There is a dilemma with the Prisoner’s Dilemma, though. See the Work It Out feature. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 13 | Positive Externalities and Public Goods 311 The Problem with the Prisoner’s Dilemma Suppose two people, Rachel and Samuel, are considering purchasing a public good. The difficulty with the prisoner’s dilemma arises as each person thinks through his or her strategic choices. Step 1. Rachel reasons in this way: If Samuel does not contribute, then I would be a fool to contribute. However, if Samuel does contribute, then I can come out ahead by not contributing. Step 2. Either way, I should choose not to contribute, and instead hope that I can be a free rider who uses the public good paid for by Samuel. Step 3. Samuel reasons the same way about Rachel. Step 4. When both people reason in that way, the public good never gets built, and there is no movement to the option where everyone cooperates—which is actually best for all parties. The Role of Government in Paying for Public Goods The key insight in paying for public goods is to find a way of assuring that everyone will make a contribution and to prevent free riders. For example, if people come together through the political process and agree to pay taxes and make group decisions about the quantity of public goods, they can defeat the free rider problem by requiring, through the law, that everyone contributes. However, government spending and taxes are not the only way to provide public goods. In some cases, markets can produce public goods. For example, think about radio. It is nonexcludable, since once the radio signal is broadcast, it would be very difficult to stop someone from receiving it. It is non-rival, since one person listening to the signal does not prevent others from listening as well. Because of these features, it is practically impossible to charge listeners directly for listening to conventional radio broadcasts. Radio has found a way to collect revenue by selling advertising, which is an indirect way of “charging” listeners by taking up some of their time. Ultimately, consumers who purchase the goods advertised are also paying for the radio service, since
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the station builds in the cost of advertising into the product cost. In a more recent development, satellite radio companies, such as SirusXM, charge a regular subscription fee for streaming music without commercials. In this case, however, the product is excludable—only those who pay for the subscription will receive the broadcast. Some public goods will also have a mixture of public provision at no charge along with fees for some purposes, like a public city park that is free to use, but the government charges a fee for parking your car, for reserving certain picnic grounds, and for food sold at a refreshment stand. Read this article (http://openstaxcollege.org/l/governmentpay) to find out what economists say the government should pay for. In other cases, we can use social pressures and personal appeals, rather than the force of law, to reduce the number of free riders and to collect resources for the public good. For example, neighbors sometimes form an association to 312 Chapter 13 | Positive Externalities and Public Goods carry out beautification projects or to patrol their area after dark to discourage crime. In low-income countries, where social pressure strongly encourages all farmers to participate, farmers in a region may come together to work on a large irrigation project that will benefit all. We can view many fundraising efforts, including raising money for local charities and for the endowments of colleges and universities, as an attempt to use social pressure to discourage free riding and to generate the outcome that will produce a public benefit. Common Resources and the “Tragedy of the Commons” There are some goods that do not fall neatly into the categories of private good or public good. While it is easy to classify a pizza as a private good and a city park as a public good, what about an item that is nonexcludable and rivalrous, such as the queen conch? In the Caribbean, the queen conch is a large marine mollusk that lives in shallow waters of sea grass. These waters are so shallow, and so clear, that a single diver may harvest many conch in a single day. Not only is conch meat a local delicacy and an important part of the local diet, but artists use the large ornate shells and craftsmen transform them. Because almost anyone with a small boat, snorkel, and mask, can participate in the conch harvest, it is essentially nonexcludable. At the same time, fishing for conch is rivalrous. Once a diver catches one
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conch another diver cannot catch it. We call goods that are nonexcludable and rivalrous common resources. Because the waters of the Caribbean are open to all conch fishermen, and because any conch that you catch is conch that I cannot catch, fishermen tend to overharvest common resources like the conch. The problem of overharvesting common resources is not a new one, but ecologist Garret Hardin put the tag “Tragedy of the Commons” to the problem in a 1968 article in the magazine Science. Economists view this as a problem of property rights. Since nobody owns the ocean, or the conch that crawl on the sand beneath it, no one individual has an incentive to protect that resource and responsibly harvest it. To address the issue of overharvesting conch and other marine fisheries, economists typically advocate simple devices like fishing licenses, harvest limits, and shorter fishing seasons. When the population of a species drops to critically low numbers, governments have even banned the harvest until biologists determine that the population has returned to sustainable levels. In fact, such is the case with the conch, the harvesting of which the government has effectively banned in the United States since 1986. Visit this website (http://openstaxcollege.org/l/queenconch) for more on the queen conch industry. Positive Externalities in Public Health Programs One of the most remarkable changes in the standard of living in the last several centuries is that people are living longer. Thousands of years ago, scientists believe that human life expectancy ranged between 20 to 30 years. By 1900, average life expectancy in the United States was 47 years. By 2015, life expectancy was 79 years. Most of the gains in life expectancy in the history of the human race happened in the twentieth century. The rise in life expectancy seems to stem from three primary factors. First, systems for providing clean water and disposing of human waste helped to prevent the transmission of many diseases. Second, changes in public behavior have advanced health. Early in the twentieth century, for example, people learned the importance of boiling bottles before using them for food storage and baby’s milk, washing their hands, and protecting food from flies. More recent behavioral changes include reducing the number of people who smoke tobacco and precautions to limit sexually transmitted diseases. Third, medicine has played a large role. Scientists developed immunizations for diphtheria, This OpenStax book is available for free at http://cnx.org/content/col
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12170/1.7 Chapter 13 | Positive Externalities and Public Goods 313 cholera, pertussis, tuberculosis, tetanus, and yellow fever between 1890 and 1930. Penicillin, discovered in 1941, led to a series of other antibiotic drugs for bringing infectious diseases under control. In recent decades, drugs that reduce the risks of high blood pressure have had a dramatic effect in extending lives. These advances in public health have all been closely linked to positive externalities and public goods. Public health officials taught hygienic practices to mothers in the early 1900s and encouraged less smoking in the late 1900s. Government funded many public sanitation systems and storm sewers because they have the key traits of public goods. In the twentieth century, many medical discoveries emerged from government or university-funded research. Patents and intellectual property rights provided an additional incentive for private inventors. The reason for requiring immunizations, phrased in economic terms, is that it prevents spillovers of illness to others—as well as helping the person immunized. The Benefits of Voyager I Endure While we applaud the technology spillovers of NASA’s space projects, we should also acknowledge that those benefits are not shared equally. Economists like Tyler Cowen, a professor at George Mason University, are seeing increasing evidence of a widening gap between those who have access to rapidly improving technology, and those who do not. According to Cowen, author of the recent book, Average Is Over: Powering America Beyond the Age of the Great Stagnation, this inequality in access to technology and information is going to deepen the inequality in skills, and ultimately, in wages and global standards of living. 314 Chapter 13 | Positive Externalities and Public Goods KEY TERMS external benefits (or positive externalities) beneficial spillovers to a third party of parties, who did not purchase the good or service that provided the externalities free rider those who want others to pay for the public good and then plan to use the good themselves; if many people act as free riders, the public good may never be provided intellectual property the body of law including patents, trademarks, copyrights, and trade secret law that protect the right of inventors to produce and sell their inventions nonexcludable when it is costly or impossible to exclude someone from using the good, and thus hard to charge for it nonrivalrous even when one person uses the good, others can also use it positive externalities beneficial spillovers to a third party or parties private benefits the benefits a person who consumes a
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good or service receives, or a new product's benefits or process that a company invents that the company captures private rates of return on a savings account when the estimated rates of return go primarily to an individual; for example, earning interest public good good that is nonexcludable and non-rival, and thus is difficult for market producers to sell to individual consumers social benefits the sum of private benefits and external benefits social rate of return when the estimated rates of return go primarily to society; for example, providing free education KEY CONCEPTS AND SUMMARY 13.1 Why the Private Sector Underinvests in Innovation Competition creates pressure to innovate. However, if one can easily copy new inventions, then the original inventor loses the incentive to invest further in research and development. New technology often has positive externalities; that is, there are often spillovers from the invention of new technology that benefit firms other than the innovator. The social benefit of an invention, once the firm accounts for these spillovers, typically exceeds the private benefit to the inventor. If inventors could receive a greater share of the broader social benefits for their work, they would have a greater incentive to seek out new inventions. 13.2 How Governments Can Encourage Innovation Public policy with regard to technology must often strike a balance. For example, patents provide an incentive for inventors, but they should be limited to genuinely new inventions and not extend forever. Government has a variety of policy tools for increasing the rate of return for new technology and encouraging its development, including: direct government funding of R&D, tax incentives for R&D, protection of intellectual property, and forming cooperative relationships between universities and the private sector. 13.3 Public Goods A public good has two key characteristics: it is nonexcludable and non-rival. Nonexcludable means that it is costly or impossible for one user to exclude others from using the good. Non-rival means that when one person uses the good, it does not prevent others from using it. Markets often have a difficult time producing public goods because free riders will attempt to use the public good without paying for it. One can overcome the free rider problem through measures to assure that users of the public good pay for it. Such measures include government actions, social pressures, and specific situations where markets have discovered a way to collect payments. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 13 | Positive Externalities and Public Goods 315 SELF
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-CHECK QUESTIONS 1. Do market demand curves reflect positive externalities? Why or why not? 2. Suppose that Sony's R&D investment in digital devices has increased profits by 20%. Is this a private or social benefit? 3. The Gizmo Company is planning to develop new household gadgets. Table 13.4 shows the company’s demand for financial capital for research and development of these gadgets, based on expected rates of return from sales. Now, say that every investment would have an additional 5% social benefit—that is, an investment that pays at least a 6% return to the Gizmo Company will pay at least an 11% return for society as a whole; an investment that pays at least 7% for the Gizmo Company will pay at least 12% for society as a whole, and so on. Answer the questions that follow based on this information. Estimated Rate of Return Private profits of the firm from an R&D project (in $ millions) 10% 9% 8% 7% 6% 5% 4% 3% Table 13.4 $100 $102 $108 $118 $133 $153 $183 $223 a. If the going interest rate is 9%, how much will Gizmo invest in R&D if it receives only the private benefits of this investment? b. Assume that the interest rate is still 9%. How much will the firm invest if it also receives the social benefits of its investment? (Add an additional 5% return on all levels of investment.) 4. The Junkbuyers Company travels from home to home, looking for opportunities to buy items that would otherwise end up with the garbage, but which the company can resell or recycle. Which will be larger, the private or the social benefits? 5. When residents in a neighborhood tidy it and keep it neat, there are a number of positive spillovers: higher property values, less crime, happier residents. What types of government policies can encourage neighborhoods to clean up? 6. Education provides both private benefits to those who receive it and broader social benefits for the economy as a whole. Think about the types of policies a government can follow to address the issue of positive spillovers in technology and then suggest a parallel set of policies that governments could follow for addressing positive externalities in education. 316 Chapter 13 | Positive Externalities and Public Goods 7. Which of the following goods or services are nonexcludable? streaming music from satellite transmission programs roads a. police protection b. c. d. primary
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education e. cell phone service 8. Are the following goods non-rival in consumption? slice of pizza laptop computer a. b. c. public radio d. ice cream cone REVIEW QUESTIONS In what ways do company investments in research 9. and development create positive externalities? 13. What are the two key characteristics of public goods? 10. Will the demand for borrowing and investing in R&D be higher or lower if there are no external benefits? 11. Why might private markets tend to provide too few incentives for the development of new technology? 12. What can government do to encourage the development of new technology? CRITICAL THINKING QUESTIONS 17. Can a company be guaranteed all of the social benefits of a new invention? Why or why not? Is it 18. inevitable that government must become involved in supporting investments in new technology? 19. How do public television stations, like PBS, try to overcome the free rider problem? 20. Why is a football game on ESPN a quasi-public good but a game on the NBC, CBS, or ABC is a public good? 14. Name two public goods and explain why they are public goods. 15. What is the free rider problem? 16. Explain why the federal government funds national defense. 21. Provide two examples of goods/services that are classified as private goods/services even though they are provided by a federal government. 22. Radio stations, tornado sirens, light houses, and street lights are all public goods in that all are nonrivalrous and nonexclusionary. Therefore why does the government provide tornado sirens, street lights and light houses but not radio stations (other than PBS stations)? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 13 | Positive Externalities and Public Goods 317 24. Assume that the marginal private costs of a firm producing fuel-efficient cars is greater than the marginal social costs. Assume that the marginal private benefits of a firm producing fuel-efficient cars is the same as the marginal social benefits. Discuss one way that the government can try to increase production and sales of fuel efficient cars to the socially desirable amount. Hint: the government is trying to affect production through costs, not benefits. 25. Becky and Sarah are sisters who share a room. Their room can easily get messy, and their parents are always telling them to tidy it. Here are the costs and benefits to both Becky and Sarah, of taking the
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time to clean their room: If both Becky and Sarah clean, they each spends two hours and get a clean room. If Becky decides not to clean and Sarah does all the cleaning, then Sarah spends 10 hours cleaning (Becky spends 0) but Sarah is exhausted. The same would occur for Becky if Sarah decided not to clean—Becky spends 10 hours and becomes exhausted. If both girls decide not to clean, they both have a dirty room. a. What is the best outcome for Becky and Sarah? What is the worst outcome? (It would help you to construct a prisoner’s dilemma table.) b. Unfortunately, we know that the optimal outcome will most likely not happen, and that the sisters probably will choose the worst one instead. Explain what it is about Becky’s and Sarah’s reasoning that will lead them both to choose the worst outcome. PROBLEMS 23. HighFlyer Airlines wants to build new airplanes with greatly increased cabin space. This will allow HighFlyer Airlines to give passengers more comfort and sell more tickets at a higher price. However, redesigning the cabin means rethinking many other elements of the airplane as well, like engine and luggage placement, and the most efficient shape of the plane for moving through the air. HighFlyer Airlines has developed a list of possible methods to increase cabin space, along with estimates of how these approaches would affect the plane's operating costs and ticket sales. Based on these estimates, Table 13.5 shows the value of R&D projects that provide at least a certain private rate of return. Column 1 = Private Rate of Return. Column 2 = Value of R&D Projects that Return at Least the Private Rate of Return to HighFlyer Airlines. Use the data to answer the following questions. Private Rate of Return Value of R&D 12% 10% 8% 6% 4% Table 13.5 $100 $200 $300 $400 $500 a. If the opportunity cost of financial capital for HighFlyer Airlines is 6%, how much should the firm invest in R&D? b. Assume that the social rate of return for R&D is an additional 2% on top of the private return; that is, an R&D investment that had a 7% private return to HighFlyer Airlines would have a 9% social return. How much investment is socially optimal at the 6% interest rate? 318 Chapter 13 | Positive Externalities and Public Goods This OpenStax book is available for free
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at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 319 14 | Labor Markets and Income Figure 14.1 What determines incomes? In the U.S., income is based on one's value to an employer, which depends in part on education. (Credit: modification of work by AFL-CIO America's Unions/Flickr Creative Commons and COD Newsroom/Flickr Creative Commons) The Increasing Value of a College Degree Working your way through college used to be fairly common in the United States. According to a 2015 study by the Georgetown Center on Education and the Workforce, 40% of college students work 30 hours or more per week. At the same time, the cost of college seems to rise every year. The data show that the cost of tuition, fees, room and board has more than doubled since 1984. Thus, even full time employment may not be enough to cover college expenses anymore. Working full time at minimum wage--40 hours per week, 52 weeks per year—earns $15,080 before taxes, which is less than the $19,548 the College Board estimates it cost in 2016 for a year of college at a public university. The result of these costs is that student loan debt topped $1.3 trillion this year. Despite these disheartening figures, the value of a bachelor’s degree has never been higher. How do we explain this? This chapter will tell us. Introduction to Labor Markets and Income In this chapter, you will learn about: 320 Chapter 14 | Labor Markets and Income • The theory of labor markets • How wages are determined in an imperfectly competitive labor market • How unions affect wages and employment • How labor market outcomes are determined under Bilateral Monopoly • Theories of Employment Discrimination, and • How Immigration affects labor market outcomes In a market economy like the United States, income comes from ownership of the means of production: resources or assets. More precisely, one’s income is a function of two things: the quantity of each resource one owns, and the value society places on those resources. Recall from the chapter on Production, Costs, and Industry Structure, each factor of production has an associated factor payment. For the majority of us, the most important resource we own is our labor. Thus, most of our income is wages, salaries, commissions, tips and other types of labor income. Your labor income depends on how many hours you have to work and the wage rate an employer will pay you
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for those hours. At the same time, some people own real estate, which they can either use themselves or rent out to other users. Some people have financial assets like bank accounts, stocks and bonds, for which they earn interest, dividends or some other form of income. Each of these factor payments, like wages for labor and interest for financial capital, is determined in their respective factor markets. For the rest of this chapter, we will focus on labor markets, but other factor markets operate similarly. Later in Chapter 17 we will describe how this works for financial capital. 14.1 | The Theory of Labor Markets By the end of this section, you will be able to: • The Demand for Labor in Perfectly Competitive Output Markets • The Demand for Labor in Imperfectly Competitive Output Markets • What Determines the Going Market Wage Rate? What is the labor market? The labor market is the term that economists use for all the different markets for labor. There is no single labor market. Rather, there is a different market for every different type of labor. Labor differs by type of work (e.g. retail sales vs. scientist), skill level (entry level or more experienced), and location (the market for administrative assistants is probably more local or regional than the market for university presidents). While each labor market is different, they all tend to operate in similar ways. For example, when wages go up in one labor market, they tend to go up in others too. When economists talk about the labor market, they are describing these similarities. The labor market, like all markets, has a demand and a supply. Why do firms demand labor? Why is an employer willing to pay you for your labor? It’s not because the employer likes you or is socially conscious. Rather, it’s because your labor is worth something to the employer--your work brings in revenues to the firm. How much is an employer willing to pay? That depends on the skills and experience you bring to the firm. If a firm wants to maximize profits, it will never pay more (in terms of wages and benefits) for a worker than the value of his or her marginal productivity to the firm. We call this the first rule of labor markets. Suppose a worker can produce two widgets per hour and the firm can sell each widget for $4 each. Then the worker is generating $8 per hour in revenues to the firm, and a profit-maximizing employer will pay the worker up to, but no This OpenStax
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book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 321 more than, $8 per hour, because that is what the worker is worth to the firm. Recall the definition of marginal product. Marginal product is the additional output a firm can produce by adding one more worker to the production process. Since employers often hire labor by the hour, we’ll define marginal product as the additional output the firm produces by adding one more worker hour to the production process. In this chapter, we assume that workers are homogeneous—they have the same background, experience and skills and they put in the same amount of effort. Thus, marginal product depends on the capital and technology with which workers have to work. A typist can type more pages per hour with an electric typewriter than a manual typewriter, and he or she can type even more pages per hour with a personal computer and word processing software. A ditch digger can dig more cubic feet of dirt in an hour with a backhoe than with at shovel. Thus, we can define the demand for labor as the marginal product of labor times the value of that output to the firm. # Workers (L) MPL Table 14.1 Marginal Product of Labor 1 4 2 3 3 2 4 1 Figure 14.2 Marginal Product of Labor Because of fixed capital, the marginal product of labor declines as the employer hires additional workers. On what does the value of each worker’s marginal product depend? If we assume that the employer sells its output in a perfectly competitive market, the value of each worker’s output will be the market price of the product. Thus, Demand for Labor = MPL x P = Value of the Marginal Product of Labor We show this in Table 14.2, which is an expanded version of Table 14.1 # Workers (L) MPL Price of Output 1 4 $4 2 3 $4 3 2 $4 4 1 $4 Table 14.2 Value of the Marginal Product of Labor 322 VMPL Chapter 14 | Labor Markets and Income $16 $12 $8 $4 Table 14.2 Value of the Marginal Product of Labor Note that the value of each additional worker is less than the ones who came before. Figure 14.3 Value of the Marginal Product of Labor For firms operating in a competitive output market, the value of additional output sold is the price the firms receive for the output. Since MPL
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declines with additional labor employed, while that marginal product is worth the market price, the value of the marginal product declines as employment increases. Demand for Labor in Perfectly Competitive Output Markets The question for any firm is how much labor to hire. We can define a Perfectly Competitive Labor Market as one where firms can hire all the labor they wish at the going market wage. Think about secretaries in a large city. Employers who need secretaries can probably hire as many as they need if they pay the going wage rate. Graphically, this means that firms face a horizontal supply curve for labor, as Figure 14.3 shows. Given the market wage, profit maximizing firms hire workers up to the point where: Wmkt = VMPL This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 323 Figure 14.4 Equilibrium Employment for Firms in a Competitive Labor Market In a perfectly competitive labor market, firms can hire all the labor they want at the going market wage. Therefore, they hire workers up to the point L1 where the going market wage equals the value of the marginal product of labor. Derived Demand Economists describe the demand for inputs like labor as a derived demand. Since the demand for labor is MPL*P, it is dependent on the demand for the product the firm is producing. We show this by the P term in the demand for labor. An increase in demand for the firm’s product drives up the product’s price, which increases the firm’s demand for labor. Thus, we derive the demand for labor from the demand for the firm’s output. Demand for Labor in Imperfectly Competitive Output Markets If the employer does not sell its output in a perfectly competitive industry, they face a downward sloping demand curve for output, which means that in order to sell additional output the firm must lower its price. This is true if the firm is a monopoly, but it’s also true if the firm is an oligopoly or monopolistically competitive. In this situation, the value of a worker’s marginal product is the marginal revenue, not the price. Thus, the demand for labor is the marginal product times the marginal revenue. The Demand for Labor = MPL x MR = Marginal Revenue Product # Workers (L) MPL Marginal Revenue MRPL Table 14.3 Marginal Revenue Product 1 4 $4 $16 2 3 $3 $
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9 3 2 $2 $4 4 1 $1 $1 324 Chapter 14 | Labor Markets and Income Figure 14.5 Marginal Revenue Product For firms with some market power in their output market, the value of additional output sold is the firm’s marginal revenue. Since MPL declines with additional labor employed and since MR declines with additional output sold, the firm’s marginal revenue declines as employment increases. Everything else remains the same as we described above in the discussion of the labor demand in perfectly competitive labor markets. Given the market wage, profit-maximizing firms will hire workers up to the point where the market wage equals the marginal revenue product, as Figure 14.5 shows. Figure 14.6 Equilibrium Level of Employment for Firms with Market Power For firms with market power in their output market, they choose the number of workers, L2, where the going market wage equals the firm’s marginal revenue product. Note that since marginal revenue is less than price, the demand for labor for a firm which has market power in its output market is less than the demand for labor (L1) for a perfectly competitive firm. As a result, employment will be lower in an imperfectly competitive industry than in a perfectly competitive industry. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 325 Do Profit Maximizing Employers Exploit Labor? If you look back at Figure 14.4, you will see that only the firm pays the last worker it hires what they’re worth to the firm. Every other worker brings in more revenue than the firm pays him or her. This has sometimes led to the claim that employers exploit workers because they do not pay workers what they are worth. Let’s think about this claim. The first worker is worth $x to the firm, and the second worker is worth $y, but why are they worth that much? It is because of the capital and technology with which they work. The difference between workers’ worth and their compensation goes to pay for the capital, technology, without which the workers wouldn’t have a job. The difference also goes to the employer’s profit, without which the firm would close and workers wouldn’t have a job. The firm may be earning excessive profits, but that is a different topic of discussion. What Determines the Going Market Wage Rate? In the chapter on Labor and Financial
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Markets, we learned that the labor market has demand and supply curves like other markets. The demand for labor curve is a downward sloping function of the wage rate. The market demand for labor is the horizontal sum of all firms’ demands for labor. The supply for labor curve is an upward sloping function of the wage rate. This is because if wages for a particular type of labor increase in a particular labor market, people with appropriate skills may change jobs, and vacancies will attract people from outside the geographic area. The market supply for labor is the horizontal summation of all individuals’ supplies of labor. Figure 14.7 The Market Wage Rate In a competitive labor market, the equilibrium wage and employment level are determined where the market demand for labor equals the market supply of labor. Like all equilibrium prices, the market wage rate is determined through the interaction of supply and demand in the labor market. Thus, we can see in Figure 14.7 for competitive markets the wage rate and number of workers hired. The FRED database has a great deal of data on labor markets, starting at the wage rate and number of workers hired (https://openstax.org/l/cat10). The United States Census Bureau for the Bureau of Labor Statistics publishes The Current Population Survey, which is a monthly survey of households (link is on that page), which provides data on labor supply, including numerous measures of the labor force size (disaggregated by age, gender and educational attainment), labor force participation rates for different demographic groups, and employment. It also includes more than 3,500 measures of earnings by different demographic groups. 326 Chapter 14 | Labor Markets and Income The Current Employment Statistics, which is a survey of businesses, offers alternative estimates of employment across all sectors of the economy. The link labeled "Productivity and Costs" has a wide range of data on productivity, labor costs and profits across the business sector. 14.2 | Wages and Employment in an Imperfectly Competitive Labor Market By the end of this section, you will be able to: • Define monopsony power • Explain how imperfectly competitive labor markets determine wages and employment, where employers have market power In the chapters on market structure, we observed that while economists use the theory of perfect competition as an ideal case of market structure, there are very few examples of perfectly competitive industries in the real world. What about labor markets? How many labor markets are perfectly competitive? There are probably more examples of perfectly competitive labor markets than perfectly competitive product markets,
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but that doesn’t mean that all labor markets are competitive. When a job applicant is bargaining with an employer for a position, the applicant is often at a disadvantage—needing the job more than the employer needs that particular applicant. John Bates Clark (1847–1938), often named as the first great American economist, wrote in 1907: “In the making of the wages contract the individual laborer is always at a disadvantage. He has something which he is obliged to sell and which his employer is not obliged to take, since he [that is, the employer] can reject single men with impunity.” To give workers more power, the U.S. government has passed, in response to years of labor protests, a number of laws to create a more equal balance of power between workers and employers. These laws include some of the following: • Setting minimum hourly wages • Setting maximum hours of work (at least before employers pay overtime rates) • Prohibiting child labor • Regulating health and safety conditions in the workplace • Preventing discrimination on the basis of race, ethnicity, gender, sexual orientation, and age • Requiring employers to provide family leave • Requiring employers to give advance notice of layoffs • Covering workers with unemployment insurance • Setting a limit on the number of immigrant workers from other countries Table 14.4 lists some prominent U.S. workplace protection laws. Many of the laws listed in the table were only the start of labor market regulations in these areas and have been followed, over time, by other related laws, regulations, and court rulings. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 327 Law National LaborManagement Relations Act of 1935 (the “Wagner Act”) Social Security Actof 1935 Fair Labor Standards Act of 1938 Taft-Hartley Act of 1947 Protection Establishes procedures for establishing a union that firms are obligated to follow; sets up the National Labor Relations Board for deciding disputes Under Title III, establishes a state-run system of unemployment insurance, in which workers pay into a state fund when they are employed and received benefits for a time when they are unemployed Establishes the minimum wage, limits on child labor, and rules requiring payment of overtime pay for those in jobs that are paid by the hour and exceed 40 hours per week Allows states to decide whether all workers at a firm can be required to join a union as a condition of
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employment; in the case of a disruptive union strike, permits the president to declare a “cooling-off period” during which workers have to return to work Civil Rights Act of 1964 Title VII of the Act prohibits discrimination in employment on the basis of race, gender, national origin, religion, or sexual orientation Occupational Health and Safety Act of 1970 Employee Retirement and Income Security Act of 1974 Pregnancy Discrimination Act of 1978 Immigration Reform and Control Act of 1986 Worker Adjustment and Retraining Notification Act of 1988 Americans with Disabilities Act of 1990 Creates the Occupational Safety and Health Administration (OSHA), which protects workers from physical harm in the workplace Regulates employee pension rules and benefits Prohibits discrimination against women in the workplace who are planning to get pregnant or who are returning to work after pregnancy Prohibits hiring of illegal immigrants; requires employers to ask for proof of citizenship; protects rights of legal immigrants Requires employers with more than 100 employees to provide written notice 60 days before plant closings or large layoffs Prohibits discrimination against those with disabilities and requires reasonable accommodations for them on the job Table 14.4 Prominent U.S. Workplace Protection Laws 328 Chapter 14 | Labor Markets and Income Law Protection Family and Medical Leave Act of 1993 Allows employees to take up to 12 weeks of unpaid leave per year for family reasons, including birth or family illness Pension Protection Act of 2006 Penalizes firms for underfunding their pension plans and gives employees more information about their pension accounts Lilly Ledbetter Fair Pay Act of 2009 Restores protection for pay discrimination claims on the basis of sex, race, national origin, age, religion, or disability Table 14.4 Prominent U.S. Workplace Protection Laws There are two sources of imperfect competition in labor markets. These are demand side sources, that is, labor market power by employers, and supply side sources: labor market power by employees. In this section we will discuss the former. In the next section we will discuss the latter. A competitive labor market is one where there are many potential employers for a given type of worker, say a secretary or an accountant. Suppose there is only one employer in a labor market. Because that employer has no direct competition in hiring, if they offer lower wages than would exist in a competitive market, employees will have few options. If they want a job, they must accept the offered wage rate. Since the employer is exploiting its market power, we call the firm a monopsony. The classical example of monopsony is the sole coal company in a
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West Virginia town. If coal miners want to work, they must accept what the coal company is paying. This is not the only example of monopsony. Think about surgical nurses in a town with only one hospital. Employers that have at least some market power over potential employees is not that unusual. After all, most firms have many employees while there is only one employer. Thus, even if there is some competition for workers, it may not feel that way to potential employees unless they do their research and find the opposite. How does market power by an employer affect labor market outcomes? Intuitively, one might think that wages will be lower than in a competitive labor market. Let’s prove it. We will tell the story for a monopsonist, but the results will be qualitatively similar, although less extreme for any firm with labor market power. Think back to monopoly. The good news is that because the monopolist is the sole supplier in the market, it can charge any price it wishes. The bad news is that if it wants to sell a greater quantity of output, it must lower the price it charges. Monopsony is analogous. Because the monopsonist is the sole employer in a labor market, it can offer any wage that it wishes. However, because they face the market supply curve for labor, if they want to hire more workers, they must raise the wage they pay. This creates a quandary, which we can understand by introducing a new concept: the marginal cost of labor. The marginal cost of labor is the cost to the firm of hiring one more worker. However, here is the thing: we assume that the firm is determining how many workers to hire in total. They are not hiring sequentially. Let’s look how this plays out with the example in Table 14.5. Supply of Labor 1 2 3 4 5 Wage Rate $1 per hour $2 per hour $3 per hour $4 per hour $5 per hour Total Cost of Labor Marginal Cost of Labor $1 $1 $4 $3 $9 $5 $16 $7 $25 $9 Table 14.5 The Marginal Cost of Labor There are a couple of things to notice from the table. First, the marginal cost increases faster than the wage rate. In fact, for any number of workers more than one, the marginal cost of labor is greater than the wage. This is because to hire one more worker requires paying a higher wage rate, not just for the new worker
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but for all the previous hires also. We can see this graphically in Figure 14.7. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 329 Figure 14.8 The Marginal Cost of Labor Since monopsonies are the sole demander for labor, they face the market supply curve for labor. In order to increase employment they must raise the wage they pay not just for new workers, but for all the existing workers they could have hired at the previous lower wage. As a result, the marginal cost of additional hiring labor is greater than the wage, and thus for any level of employment (above the first worker), MCL is above the Market Supply of Labor. Figure 14.9 Labor Market Outcomes Under Monopsony A monopsony will hire workers up to the point Lm where its demand for labor equals the marginal cost of additional labor, paying the wage Wm given by the supply curve of labor necessary to obtain Lm workers. If the firm wants to maximize profits, it will hire labor up to the point Lm where DL = VMP (or MRP) = MCL., as Figure 14.9 shows. Then, the supply curve for labor shows the wage the firm will have to pay to attract Lm workers. Graphically, we can draw a vertical line up from Lm to the Supply Curve for label and then read the wage Wm off the vertical axis to the left. How does this outcome compare to what would occur in a perfectly competitive market? A competitive market would operate where DL = SL, hiring Lc workers and paying Wc wage. In other words, under monopsony employers hire fewer workers and pay a lower wage. While pure monopsony may be rare, many employers have some degree of market power in labor markets. The outcomes for those employers will be qualitatively similar though not as extreme as monopsony. 330 Chapter 14 | Labor Markets and Income Figure 14.10 Comparison of labor market outcomes: Monopsony vs. Perfect Competition A monopsony hires fewer workers Lm than would be hired in a competitive labor market Lc. In exploiting its market power, the monopsony can also pay a lower wage Wm than workers would earn in a competitive labor market Wc. 14.3 | Market Power on the Supply Side of Labor Markets: Unions By the end of this section, you will be able to:
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• Explain the concept of labor unions, including membership levels and wages • Evaluate arguments for and against labor unions • Analyze reasons for the decline in U.S. union membership A labor union is an organization of workers that negotiates with employers over wages and working conditions. A labor union seeks to change the balance of power between employers and workers by requiring employers to deal with workers collectively, rather than as individuals. As such, a labor union operates like a monopoly in a labor market. We sometimes call negotiations between unions and firms collective bargaining. The subject of labor unions can be controversial. Supporters of labor unions view them as the workers’ primary line of defense against efforts by profit-seeking firms to hold down wages and benefits. Critics of labor unions view them as having a tendency to grab as much as they can in the short term, even if it means injuring workers in the long run by driving firms into bankruptcy or by blocking the new technologies and production methods that lead to economic growth. We will start with some facts about union membership in the United States. Facts about Union Membership and Pay According to the U.S. Bureau of Labor and Statistics, about 10.7% of all U.S. workers belong to unions. Following are some facts about unions for 2016: • 11.2% of U.S. male workers belong to unions; 10.2% of female workers do • 10.5% of white workers, 13% of black workers, and 8.8 % of Hispanic workers belong to unions • 11.8% of full-time workers and 5.7% of part-time workers are union members • 5.11% of workers ages 16–24 belong to unions, as do 13.9% of workers ages 45-54 • Occupations in which relatively high percentages of workers belong to unions are the federal government (27.4% belong to a union), state government (29.6%), local government (40.3%); transportation and utilities This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 331 (15.1%); natural resources, construction, and maintenance (16.3%); and production, transportation, and material moving (13.7%) • Occupations that have relatively low percentages of unionized workers are agricultural workers (1.3%), financial services (2.4%), professional and business services (2.4%), leisure and hospitality (2.7%), and wholesale and
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retail trade (4.2%) In summary, the percentage of workers belonging to a union is higher for men than women; higher for blacks than for whites or Hispanics; higher for the 45–64 age range; and higher among workers in government and manufacturing than workers in agriculture or service-oriented jobs. Table 14.6 lists the largest U.S. labor unions and their membership. Union Membership National Education Association (NEA) Service Employees International Union (SEIU) American Federation of Teachers (AFT) International Brotherhood of Teamsters (IBT) The American Federation of State, County, and Municipal Workers (AFSCME) United Food and Commercial Workers International Union International Brotherhood of Electrical Workers (IBEW) United Steelworkers International Association of Machinists and Aerospace Workers International Union, United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) 2.9 million 1.9 million 1.5 million 1.3 million 1.3 million 1.3 million 662,000 591,000 569,000 408,000 Table 14.6 The Largest American Unions in 2015 (Source: U.S. Department of Labor, Bureau of Labor Statistics) In terms of pay, benefits, and hiring, U.S. unions offer a good news/bad news story. The good news for unions and their members is that their members earn about 20% more than nonunion workers, even after adjusting for factors such as years of work experience and education level. The bad news for unions is that the share of U.S. workers who belong to a labor union has been steadily declining for 50 years, as Figure 14.11 shows. About one-quarter of all U.S. workers belonged to a union in the mid-1950s, but only 11.1% of U.S. workers are union members today. If you leave out government workers (which includes teachers in public schools), only 6.6% of the workers employed by private firms now work for a union. 332 Chapter 14 | Labor Markets and Income Figure 14.11 Percentage of Wage and Salary Workers Who Are Union Members The share of wage and salary workers who belong to unions rose sharply in the 1930s and 1940s, but has tailed off since then to 10.7% of all workers in 2016. The following section analyzes the higher pay union workers receive compared the pay rates for nonunion workers. The section after that analyzes declining union membership levels. An overview of these two issues will allow us
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to discuss many aspects of how unions work. Higher Wages for Union Workers How does a union affect wages and employment? Because a union is the sole supplier of labor, it can act like a monopoly and ask for whatever wage rate it can obtain for its workers. If employers need workers, they have to meet the union’s wage demand. What are the limits on how much higher pay union workers can receive? To analyze these questions, let’s consider a situation where all firms in an industry must negotiate with a single union, and no firm is allowed to hire nonunion labor. If no labor union existed in this market, then equilibrium (E) in the labor market would occur at the intersection of the demand for labor (D) and the supply of labor (S) as we see in Figure 14.12. This is the same result as we showed in Figure 14.6 above. The union can, however, threaten that, unless firms agree to the wages they demand, the workers will strike. As a result, the labor union manages to achieve, through negotiations with the firms, a union wage of Wu for its members, above what the equilibrium wage would otherwise have been. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 333 Figure 14.12 Union Wage Negotiations Without a union, the equilibrium at E would have involved the wage We and the quantity of labor Qe. However, the union is able to use its bargaining power to raise the wage to Wu. The result is an excess supply of labor for union jobs. That is, a quantity of labor supplied, Qs is greater than firms’ quantity demanded for labor, Qd. This labor market situation resembles what a monopoly firm does in selling a product, but in this case a union is a monopoly selling labor to firms. At the higher union wage Wu, the firms in this industry will hire less labor than they would have hired in equilibrium. Moreover, an excess supply of workers want union jobs, but firms will not be hiring for such jobs. From the union point of view, workers who receive higher wages are better off. However, notice that the quantity of workers (Qd) hired at the union wage Wu is smaller than the quantity Qe that the firm would have hired at the original equilibrium wage. A sensible union must recognize that when it pushes up the wage, it also reduces the firms’ incentive to
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hire. This situation does not necessarily mean that union workers are fired. Instead, it may be that when union workers move on to other jobs or retire, they are not always replaced, or perhaps when a firm expands production, it expands employment somewhat less with a higher union wage than it would have done with the lower equilibrium wage. Other situations could be that a firm decides to purchase inputs from nonunion producers, rather than producing them with its own highly paid unionized workers, or perhaps the firm moves or opens a new facility in a state or country where unions are less powerful. From the firm’s point of view, the key question is whether union workers’ higher wages are matched by higher productivity. If so, then the firm can afford to pay the higher union wages and, the demand curve for “unionized” labor could actually shift to the right. This could reduce the job losses as the equilibrium employment level shifts to the right and the difference between the equilibrium and the union wages will have been reduced. If worker unionization does not increase productivity, then the higher union wage will cause lower profits or losses for the firm. Union workers might have higher productivity than nonunion workers for a number of reasons. First, higher wages may elicit higher productivity. Second, union workers tend to stay longer at a given job, a trend that reduces the employer’s costs for training and hiring and results in workers with more years of experience. Many unions also offer job training and apprenticeship programs. In addition, firms that are confronted with union demands for higher wages may choose production methods that involve more physical capital and less labor, resulting in increased labor productivity. Table 14.7 provides an example. Assume that a firm can produce a home exercise cycle with three different combinations of labor and manufacturing equipment. Say that the firm pays labor $16 an hour (including benefits) and the machines for manufacturing cost $200 each. Under these circumstances, the total cost of producing a home exercise cycle will be lowest if the firm adopts the plan of 50 hours of labor and one machine, as the table shows. Now, suppose that a union negotiates a wage of $20 an hour including benefits. In this case, it makes no difference to the firm whether it uses more hours of labor and fewer machines or less labor and more machines, although it might prefer to use more machines and to hire fewer union workers. (After all, machines never threaten to strike—but they do not buy the final 334 Chapter 14 | Labor Markets and
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Income product or service either.) In the final column of the table, the wage has risen to $24 an hour. In this case, the firm clearly has an incentive for using the plan that involves paying for fewer hours of labor and using three machines. If management responds to union demands for higher wages by investing more in machinery, then union workers can be more productive because they are working with more or better physical capital equipment than the typical nonunion worker. However, the firm will need to hire fewer workers. Hours of Labor Number of Machines 30 40 50 3 2 1 Cost of Labor + Cost of Machine $16/hour Cost of Labor + Cost of Machine $20/hour Cost of Labor + Cost of Machine $24/hour $480 + $600 = $1,080 $600 + $600 = $1,200 $720 + $600 = $1,320 $640 + $400 = $1,040 $800 + $400 = $1,200 $960 + $400 = $1,360 $800 + $200 = $1,000 $1,000 + $200 = $1,200 $1,200 + $200 = $1,400 Table 14.7 Three Production Choices to Manufacture a Home Exercise Cycle In some cases, unions have discouraged the use of labor-saving physical capital equipment—out of the reasonable fear that new machinery will reduce the number of union jobs. For example, in 2002, the union representing longshoremen who unload ships and the firms that operate shipping companies and port facilities staged a work stoppage that shut down the ports on the western coast of the United States. Two key issues in the dispute were the desire of the shipping companies and port operators to use handheld scanners for record-keeping and computer-operated cabs for loading and unloading ships—changes which the union opposed, along with overtime pay. President Obama threatened to use the Labor Management Relations Act of 1947—commonly known as the Taft-Hartley Act—where a court can impose an 80-day “cooling-off period” in order to allow time for negotiations to proceed without the threat of a work stoppage. Federal mediators were called in, and the two sides agreed to a deal in February 2015. The ultimate agreement allowed the new technologies, but also kept wages, health, and pension benefits high for workers. In the past, presidential use of the Taft-Hartley Act sometimes has made labor negotiations more bitter and argumentative but, in
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this case, it seems to have smoothed the road to an agreement. In other instances, unions have proved quite willing to adopt new technologies. In one prominent example, during the 1950s and 1960s, the United Mineworkers union demanded that mining companies install labor-saving machinery in the mines. The mineworkers’ union realized that over time, the new machines would reduce the number of jobs in the mines, but the union leaders also knew that the mine owners would have to pay higher wages if the workers became more productive, and mechanization was a necessary step toward greater productivity. In fact, in some cases union workers may be more willing to accept new technology than nonunion workers, because the union workers believe that the union will negotiate to protect their jobs and wages, whereas nonunion workers may be more concerned that the new technology will replace their jobs. In addition, union workers, who typically have higher job market experience and training, are likely to suffer less and benefit more than non-union workers from the introduction of new technology. Overall, it is hard to make a definitive case that union workers as a group are always either more or less welcoming to new technology than are nonunion workers The Decline in U.S. Union Membership The proportion of U.S. workers belonging to unions has declined dramatically since the early 1950s. Economists have offered a number of possible explanations: • The shift from manufacturing to service industries • The force of globalization and increased competition from foreign producers • A reduced desire for unions because of the workplace protection laws now in place • U.S. legal environment that makes it relatively more difficult for unions to organize workers and expand their membership This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 335 Let’s discuss each of these four explanations in more detail. A first possible explanation for the decline in the share of U.S. workers belonging to unions involves the patterns of job growth in the manufacturing and service sectors of the economy as Figure 14.13 shows. The U.S. economy had about 15 million manufacturing jobs in 1960. This total rose to 19 million by the late 1970s and then declined to 17 million in 2013. Meanwhile, the number of jobs in service industries and in government combined rose from 35 million in 1960 to over 118 million by 2013, according to the Bureau of Labor Statistics. Because over time unions were stronger in manufacturing than in service industries, the growth
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in jobs was not happening where the unions were. It is interesting to note that government workers comprise several of the biggest unions in the country, including the American Federation of State, County and Municipal Employees (AFSCME); the Service Employees International Union; and the National Education Association. Table 14.8 lists the membership of each of these unions. Outside of government employees, however, unions have not had great success in organizing the service sector. Figure 14.13 The Growth Service Jobs Jobs in services have increased dramatically in the last few decades. Jobs in government have increased modestly until 1990 and then declined slightly since then. Jobs in manufacturing peaked in the late 1970s and have declined more than a third since then. A second explanation for the decline in the share of unionized workers looks at import competition. Starting in the 1960s, U.S. carmakers and steelmakers faced increasing competition from Japanese and European manufacturers. As sales of imported cars and steel rose, the number of jobs in U.S. auto manufacturing fell. This industry is heavily unionized. Not surprisingly, membership in the United Auto Workers, which was 975,000 in 1985, had fallen to roughly 390,000 by 2015. Import competition not only decreases the employment in sectors where unions were once strong, but also decreases the bargaining power of unions in those sectors. However, as we have seen, unions that organize public-sector workers, who are not threatened by import competition, have continued to see growth. A third possible reason for the decline in the number of union workers is that citizens often call on their elected representatives to pass laws concerning work conditions, overtime, parental leave, regulation of pensions, and other issues. Unions offered strong political support for these laws aimed at protecting workers but, in an ironic twist, the 336 Chapter 14 | Labor Markets and Income passage of those laws then made many workers feel less need for unions. These first three possible reasons for the decline of unions are all somewhat plausible, but they have a common problem. Most other developed economies have experienced similar economic and political trends, such as the shift from manufacturing to services, globalization, and increasing government social benefits and regulation of the workplace. Clearly there are cultural differences between countries as to their acceptance of unions in the workplace. The share of the population belonging to unions in other countries is very high compared with the share in the United States. Table 14.8 shows the proportion of workers in a number of the world’s high-income economies who belong to unions. The United States is
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near the bottom, along with France and Spain. The last column shows union coverage, defined as including those workers whose wages are determined by a union negotiation even if the workers do not officially belong to the union. In the United States, union membership is almost identical to union coverage. However, in many countries, the wages of many workers who do not officially belong to a union are still determined by collective bargaining between unions and firms. Country Union Density: Percentage of Workers Belonging to a Union Union Coverage: Percentage of Workers Whose Wages Are Determined by Union Bargaining Austria France Germany Japan 37% 9% 26% 22% Netherlands 25% Spain 11.3% Sweden United Kingdom United States 82% 29% 11.1% 99% 95% 63% 23% 82% 81% 92% 35% 12.5% Table 14.8 International Comparisons of Union Membership and Coverage in 2012 (Source, CIA World Factbook, retrieved from www.cia.gov) These international differences in union membership suggest a fourth reason for the decline of union membership in the United States: perhaps U.S. laws are less friendly to the formation of unions than such laws in other countries. The close connection between union membership and a friendly legal environment is apparent in the history of U.S. unions. The great rise in union membership in the 1930s followed the passage of the National Labor-Management Relations Act of 1935, which specified that workers had a right to organize unions and that management had to give them a fair chance to do so. The U.S. government strongly encouraged forming unions during the early 1940s in the belief that unions would help to coordinate the all-out production efforts needed during World War II. However, after World War II came the passage of the Taft-Hartley Act of 1947, which gave states the power to allow workers to opt out of the union in their workplace if they so desired. This law made the legal climate less encouraging to those seeking to form unions, and union membership levels soon started declining. The procedures for forming a union differ substantially from country to country. For example, the procedures in the United States and those in Canada are strikingly different. When a group of workers wish to form a union in the United States, they announce this fact and set an election date when the firm's employees will vote in a secret ballot on whether to form a union. Supporters of the union lobby for a “yes” vote, and the firm's management lobbies for a “
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no” vote—often even hiring outside consultants for assistance in swaying workers to vote “no.” In Canada, by contrast, a union is formed when a sufficient proportion of workers (usually about 60%) sign an official card saying This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 337 that they want a union. There is no separate “election date.” The management of Canadian firms is limited by law in its ability to lobby against the union. In addition, although it is illegal to discriminate and fire workers based on their union activity in the United States, the penalties are slight, making this a not so costly way of deterring union activity. In short, forming unions is easier in Canada—and in many other countries—than in the United States. In summary, union membership in the United States is lower than in many other high-income countries, a difference that may be due to different legal environments and cultural attitudes toward unions. Visit this website (http://openstaxcollege.org/l/fastfoodwages) to read more about recent protests regarding minimum wage for fast food employees. 14.4 | Bilateral Monopoly By the end of this section, you will be able to explain: • How firms determine wages and employment when a specific labor market combines a union and a monopsony What happens when there is market power on both sides of the labor market, in other words, when a union meets a monopsony? Economists call such a situation a bilateral monopoly. Figure 14.14 Bilateral Monopoly Employment, L*, will be lower in a bilateral monopoly than in a competitive labor market, but the equilibrium wage is indeterminate, somewhere in the range between Wu, what the union would choose, and Wm, what the monopsony would choose. Figure 14.14 is a combination of Figure 14.6 and Figure 14.11. A monopsony wants to reduce wages as well as employment, Wm and L* in the figure. A union wants to increase wages, but at the cost of lower employment, Wu and L* in the figure. Since both sides want to reduce employment, we can be sure that the outcome will be lower employment compared to a competitive labor market. What happens to the wage, though, is based on the monopsonist’s relative bargaining power compared to the union. The actual outcome is ind
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eterminate in the graph, but it will be closer to Wu if the union has more power and closer to Wm if the monopsonist has more power. 338 Chapter 14 | Labor Markets and Income 14.5 | Employment Discrimination By the end of this section, you will be able to: • Analyze earnings gaps based on race and gender • Explain the impact of discrimination in a competitive market • Identify U.S. public policies designed to reduce discrimination Discrimination involves acting on the belief that members of a certain group are inferior solely because of a factor such as race, gender, or religion. There are many types of discrimination but the focus here will be on discrimination in labor markets, which arises if workers with the same skill levels—as measured by education, experience, and expertise—receive different pay receive different pay or have different job opportunities because of their race or gender. Earnings Gaps by Race and Gender A possible signal of labor market discrimination is when an employer pays one group less than another. Figure 14.15 shows the average wage of black workers as a ratio of the average wage of white workers and the average wage of female workers as a ratio of the average wage of male workers. Research by the economists Francine Blau and Laurence Kahn shows that the gap between the earnings of women and men did not move much in the 1970s, but has declined since the 1980s. According to the U.S. Census, the gap between the earnings of blacks and whites diminished in the 1970s, but has not changed in 50 years. In both gender and race, an earnings gap remains. Figure 14.15 Wage Ratios by Sex and Race The ratio of wages for black workers to white workers rose substantially in the late 1960s and through the 1970s, but has not changed much since then. The ratio of wages for female to male workers changed little through the 1970s, but has risen substantially since the 1980s. In both cases, a gap remains between the average wages of black and white workers and between the average wages of female and male workers. Source: U.S. Department of Labor, Bureau of Labor Statistics. An earnings gap between average wages, in and of itself, does not prove that discrimination is occurring in the labor market. We need to apply the same productivity characteristics to all parties (employees) involved. Gender discrimination in the labor market occurs when employers pay women less than men despite having comparable levels of education, experience, and expertise. (Read the Clear It Up about the sex
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-discrimination suit brought against WalMart.) Similarly, racial discrimination in the labor market exists when employers pay racially diverse employees less than their coworkers of the majority race despite having comparable levels of education, experience, and expertise. To bring a successful gender discrimination lawsuit, a female employee must prove the employer is paying her less than a male employee who holds a similar job, with similar educational attainment, and with similar expertise. Likewise, This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 339 someone who wants to sue on the grounds of racial discrimination must prove that the employer pays him or her less than an employee of another race who holds a similar job, with similar educational attainment, and with similar expertise. The FRED database includes (https://openstax.org/l/33501). earnings by earnings by age, gender and race/ethnicity What was the sex-discrimination case against Wal-Mart? In one of the largest class-action sex-discrimination cases in U.S. history, 1.2 million female employees of Wal-Mart claimed that the company engaged in wage and promotion discrimination. In 2011, the Supreme Court threw out the case on the grounds that the group was too large and too diverse to consider the case a class action suit. Lawyers for the women regrouped and are now suing in smaller groups. Part of the difficulty for the female employees is that the court said that local managers made pay and promotion decisions that were not necessarily the company's policies as a whole. Consequently, female Wal-Mart employees in Texas are arguing that their new suit will challenge the management of a “discrete group of regional district and store managers.” They claim these managers made biased pay and promotion decisions. However, in 2013, a federal district court rejected a smaller California class action suit against the company. On other issues, Wal-Mart made the news again in 2013 when the National Labor Relations Board found WalMart guilty of illegally penalizing and firing workers who took part in labor protests and strikes. Wal-Mart has already paid $11.7 million in back wages and compensation damages to women in Kentucky who were denied jobs due to their sex. Investigating the Female/Male Earnings Gap As a result of changes in law and culture, women began to enter the paid workforce in substantial numbers in the mid- to late-twentieth century. By 2014, 58.1% of adult women held
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jobs while 72.0% of adult men did. Moreover, along with entering the workforce, women began to ratchet up their education levels. In 1971, 44% of undergraduate college degrees went to women. By 2014, women received 56% of bachelor’s degrees. In 1970, women received 5.4% of the degrees from law schools and 8.4% of the degrees from medical schools. By 2014, women were receiving 47% of the law degrees and 48.0% of the medical degrees. These gains in education and experience have reduced the female/male wage gap over time. However, concerns remain about the extent to which women have not yet assumed a substantial share of the positions at the top of the largest companies or in the U.S. Congress. There are factors that can lower women’s average wages. Women are likely to bear a disproportionately large share of household responsibilities. A mother of young children is more likely to drop out of the labor force for several years or work on a reduced schedule than is the father. As a result, women in their 30s and 40s are likely, on average, to have less job experience than men. In the United States, childless women with the same education and experience levels as men are typically paid comparably. However, women with families and children are typically paid about 7% to 14% less than other women of similar education and work experience. (Meanwhile, married men earn about 10% to 15% more than single men with comparable education and work experience.) We possibly could call the different patterns of family responsibilities discrimination, but it is primarily rooted in America’s social patterns of discrimination, which involve the roles that fathers and mothers play in child-rearing, rather than discrimination by employers in hiring and salary decisions. Visit this website (http://www.catalyst.org/) to read more about the persistently low numbers of women in executive roles in business and in the U.S. Congress. 340 Chapter 14 | Labor Markets and Income Investigating the Black/White Earnings Gap Blacks experienced blatant labor market discrimination during much of the twentieth century. Until the passage of the Civil Rights Act of 1964, it was legal in many states to refuse to hire a black worker, regardless of the credentials or experience of that worker. Moreover, blacks were often denied access to educational opportunities, which in turn meant that they had lower levels of qualifications for many jobs. At least one economic study has shown that the 1964 law is partially responsible for the narrowing
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of the gap in black–white earnings in the late 1960s and into the 1970s. For example, the ratio of total earnings of black male workers to white male workers rose from 62% in 1964 to 75.3% in 2013, according to the Bureau of Labor Statistics. However, the earnings gap between black and white workers has not changed as much as the earnings gap between men and women has in the last half century. The remaining racial gap seems related both to continuing differences in education levels and to the presence of discrimination. Table 14.9 shows that the percentage of blacks who complete a four-year college degree remains substantially lower than the percentage of whites who complete college. According to the U.S. Census, both whites and blacks have higher levels of educational attainment than Hispanics and lower levels than Asians. The lower average levels of education for black workers surely explain part of the earnings gap. In fact, black women who have the same levels of education and experience as white women receive, on average, about the same level of pay. One study shows that white and black college graduates have identical salaries immediately after college; however, the racial wage gap widens over time, an outcome that suggests the possibility of continuing discrimination. Another study conducted a field experiment by responding to job advertisements with fictitious resumes with either very African American sounding names or very white sounding names and found out that white names received 50 percent more callbacks for interviews. This is suggestive of discrimination in job opportunities. Further, as the following Clear It Up feature explains, there is evidence to support that discrimination in the housing market is connected to employment discrimination. White Hispanic Black Asian Completed four years of high school or more 93.0% 66.7% 87.0% 89.1% Completed four years of college or more 36.2% 15.5% 22.5% 53.9% Table 14.9 Educational Attainment by Race and Ethnicity in 2015 (Source: http://www.census.gov/ hhes/socdemo/education/data/cps/2014/tables.html) How is discrimination in the housing market connected to employment discrimination? In a recent study by the Housing and Urban Development (HUD) department, realtors show black homebuyers 18 percent fewer homes compared to white homebuyers. Realtors show Asians are shown 19 percent fewer properties. Additionally, Hispanics experience more discrimination in renting apartments and undergo stiffer This OpenStax book is available for free at http://cnx.org
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/content/col12170/1.7 Chapter 14 | Labor Markets and Income 341 credit checks than white renters. In a 2012 U.S. Department of Housing and Urban Development and the nonprofit Urban Institute study, Hispanic testers who contacted agents about advertised rental units received information about 12 percent fewer units available and were shown seven percent fewer units than white renters. The $9 million study, based on research in 28 metropolitan areas, concluded that blatant “door slamming” forms of discrimination are on the decline but that the discrimination that does exist is harder to detect, and as a result, more difficult to remedy. According to the Chicago Tribune, HUD Secretary Shaun Donovan, who served in his role from 2009-2014, told reporters, “Just because it’s taken on a hidden form doesn’t make it any less harmful. You might not be able to move into that community with the good schools.” The lower levels of education for black workers can also be a result of discrimination—although it may be pre-labor market discrimination, rather than direct discrimination by employers in the labor market. For example, if discrimination in housing markets causes black families to live clustered together in certain poorer neighborhoods, then the black children will continue to have lower educational attainment then their white counterparts and, consequently, not be able to obtain the higher paying jobs that require higher levels of education. Another element to consider is that in the past, when blacks were effectively barred from many high-paying jobs, obtaining additional education could have seemed somewhat pointless, because the educational degrees would not pay off. Even though the government has legally abolished labor market discrimination, it can take some time to establish a culture and a tradition of valuing education highly. Additionally, a legacy of past discrimination may contribute to an attitude that blacks will have a difficult time succeeding in academic subjects. In any case, the impact of social discrimination in labor markets is more complicated than seeking to punish a few bigoted employers. Competitive Markets and Discrimination Gary Becker (b. 1930), who won the Nobel Prize in economics in 1992, was one of the first to analyze discrimination in economic terms. Becker pointed out that while competitive markets can allow some employers to practice discrimination, it can also provide profit-seeking firms with incentives not to discriminate. Given these incentives, Becker explored the question of why discrimination persists. If a business is located in an area with a large minority population and refuses to sell to minorities, it will cut into its own profits. If some businesses run by bigoted employers refuse
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to pay women and/or minorities a wage based on their productivity, then other profit-seeking employers can hire these workers. In a competitive market, if the business owners care more about the color of money than about the color of skin, they will have an incentive to make buying, selling, hiring, and promotion decisions strictly based on economic factors. Do not underestimate the power of markets to offer at least a degree of freedom to oppressed groups. In many countries, cohesive minority groups like Jews and emigrant Chinese have managed to carve out a space for themselves through their economic activities, despite legal and social discrimination against them. Many immigrants, including those who come to the United States, have taken advantage of economic freedom to make new lives for themselves. However, history teaches that market forces alone are unlikely to eliminate discrimination. After all, discrimination against African Americans persisted in the market-oriented U.S. economy during the century between President Abraham Lincoln’s Emancipation Proclamation, which freed the slaves in 1863, and the passage of the Civil Rights Act of 1964—and has continued since then, too. Therefore, why does discrimination persist in competitive markets? Gary Becker sought to explain this persistence. Discriminatory impulses can emerge at a number of levels: among managers, among workers, and among customers. Consider the situation of a manager who is not personally prejudiced, but who has many workers or customers who are prejudiced. If that manager treats minority groups or women fairly, the manager may find it hurts the morale of prejudiced co-workers or drives away prejudiced customers. In such a situation, a policy of nondiscrimination could reduce the firm’s profits. After all, a business firm is part of society, and a firm that does not follow the societal norms is likely to suffer. Market forces alone are unlikely to overwhelm strong social attitudes about discrimination. Visit this website (http://openstaxcollege.org/l/censusincome) to read more about wage discrimination. 342 Chapter 14 | Labor Markets and Income Public Policies to Reduce Discrimination A first public policy step against discrimination in the labor market is to make it illegal. For example, the Equal Pay Act of 1963 said that employers must pay men and women who do equal work the same. The Civil Rights Act of 1964 prohibits employment discrimination based on race, color, religion, sex, or national origin. The Age Discrimination in Employment Act of 1967 prohibited discrimination on the basis of age against individuals who are 40 years of age or older. The Civil Rights
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Act of 1991 provides monetary damages in cases of intentional employment discrimination. The Pregnancy Discrimination Act of 1978 was aimed at prohibiting discrimination against women in the workplace who are planning to get pregnant, are pregnant, or are returning after pregnancy. Passing a law, however, is only part of the answer, since discrimination by prejudiced employers may be less important than broader social patterns. These laws against discrimination have reduced the gender wage gap. A 2007 Department of Labor study compared salaries of men and women who have similar educational achievement, work experience, and occupation and found that the gender wage gap is only 5%. In the case of the earnings gap between blacks and whites (and also between Hispanics and whites), probably the single largest step that could be taken at this point in U.S. history to close the earnings gap would be to reduce the gap in educational achievement. Part of the answer to this issue involves finding ways to improve the performance of schools, which is a highly controversial topic in itself. In addition, the education gap is unlikely to close unless black and Hispanic families and peer groups strengthen their culture of support for educational achievement. Affirmative action is the name given to active efforts by government or businesses that give special rights to minorities in hiring and promotion to make up for past discrimination. Affirmative action, in its limited and not especially controversial form, means making an effort to reach out to a broader range of minority candidates for jobs. In its more aggressive and controversial form, affirmative action required government and companies to hire a specific number or percentage of minority employees. However, the U.S. Supreme Court has ruled against state affirmative action laws. Today, the government applies affirmative action policies only to federal contractors who have lost a discrimination lawsuit. The federal Equal Employment Opportunity Commission (EEOC) enforces this type of redress. An Increasingly Diverse Workforce Racial and ethnic diversity is on the rise in the U.S. population and work force. As Figure 14.16 shows, while the white Americans comprised 78% of the population in 2012, the U.S. Bureau of the Census projects that whites will comprise 69% of the U.S. population by 2060. Forecasters predict that the proportion of U.S. citizens who are of Hispanic background to rise substantially. Moreover, in addition to expected changes in the population, workforce diversity is increasing as the women who entered the workforce in the 1970s and 1980s are now moving up the promotion ladders within their organizations. This OpenStax book is available for free at http
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://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 343 Figure 14.16 Projected Changes in America’s Racial and Ethnic Diversity This figure shows projected changes in the ethnic makeup of the U.S. population by 2060. Note that “NHPI” stands for Native Hawaiian and Other Pacific Islander. “AIAN” stands for American Indian and Alaska Native. Source: US Department of Commerce Regarding the future, optimists argue that the growing proportions of minority workers will break down remaining discriminatory barriers. The economy will benefit as an increasing proportion of workers from traditionally disadvantaged groups have a greater opportunity to fulfill their potential. Pessimists worry that the social tensions between men and women and between ethnic groups will rise and that workers will be less productive as a result. Anti-discrimination policy, at its best, seeks to help society move toward the more optimistic outcome. The FRED database includes data on foreign and native born civilian population (https://openstax.org/l/104) and labor force (https://openstax.org/l/32442). 14.6 | Immigration Most Americans would be outraged if a law prevented them from moving to another city or another state. However, when the conversation turns to crossing national borders and are about other people arriving in the United States, laws preventing such movement often seem more reasonable. Some of the tensions over immigration stem from worries over how it might affect a country’s culture, including differences in language, and patterns of family, authority, or gender relationships. Economics does not have much to say about such cultural issues. Some of the worries about immigration do, however, have to do with its effects on wages and income levels, and how it affects government taxes and spending. On those topics, economists have insights and research to offer. Historical Patterns of Immigration Supporters and opponents of immigration look at the same data and see different patterns. Those who express concern about immigration levels to the United States point to graphics like Figure 14.17 which shows total inflows of immigrants decade by decade through the twentieth century. Clearly, the level of immigration has been high and rising in recent years, reaching and exceeding the towering levels of the early twentieth century. However, those who are less worried about immigration point out that the high immigration levels of the early twentieth century happened when total population was much lower. Since the U.S. population roughly tripled during the twentieth century, the seemingly high levels in immigration in
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the 1990s and 2000s look relatively smaller when they are divided by the population. 344 Chapter 14 | Labor Markets and Income Figure 14.17 Immigration Since 1900 The number of immigrants in each decade declined between 1900 and the 1940s, rose sharply through 2009 and started to decline from 2010 to the present. (Source: U.S. Department of Homeland Security, Yearbook of Immigration Statistics: 2011, Table 1) From where have the immigrants come? Immigrants from Europe were more than 90% of the total in the first decade of the twentieth century, but less than 20% of the total by the end of the century. By the 2000s, about half of U.S. immigration came from the rest of the Americas, especially Mexico, and about a quarter came from various countries in Asia. Economic Effects of Immigration A surge of immigration can affect the economy in a number of different ways. In this section, we will consider how immigrants might benefit the rest of the economy, how they might affect wage levels, and how they might affect government spending at the federal and local level. To understand the economic consequences of immigration, consider the following scenario. Imagine that the immigrants entering the United States matched the existing U.S. population in age range, education, skill levels, family size, and occupations. How would immigration of this type affect the rest of the U.S. economy? Immigrants themselves would be much better off, because their standard of living would be higher in the United States. Immigrants would contribute to both increased production and increased consumption. Given enough time for adjustment, the range of jobs performed, income earned, taxes paid, and public services needed would not be much affected by this kind of immigration. It would be as if the population simply increased a little. Now, consider the reality of recent immigration to the United States. Immigrants are not identical to the rest of the U.S. population. About one-third of immigrants over the age of 25 lack a high school diploma. As a result, many of the recent immigrants end up in jobs like restaurant and hotel work, lawn care, and janitorial work. This kind of immigration represents a shift to the right in the supply of unskilled labor for a number of jobs, which will lead to lower wages for these jobs. The middle- and upper-income households that purchase the services of these unskilled workers will benefit from these lower wages. However, low-skilled U.S. workers who must compete with low-skilled immigrants for jobs will
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tend to suffer from immigration. The difficult policy questions about immigration are not so much about the overall gains to the rest of the economy, which seem to be real but small in the context of the U.S. economy, as they are about the disruptive effects of immigration in specific labor markets. One disruptive effect, as we noted, is that immigration weighted toward lowskill workers tends to reduce wages for domestic low-skill workers. A study by Michael S. Clune found that for each 10% rise in the number of employed immigrants with no more than a high school diploma in the labor market, high school students reduced their annual number of hours worked by 3%. The effects on wages of low-skill workers are This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 345 not large—perhaps in the range of decline of about 1%. These effects are likely kept low, in part, because of the legal floor of federal and state minimum wage laws. In addition, immigrants are also thought to contribute to increased demand for local goods and services which can stimulate the local low skilled labor market. It is also possible that employers, in the face of abundant low-skill workers may choose production processes which are more labor intensive than otherwise would have been. These various factors would explain the small negative wage effect that the native low-skill workers observed as a result of immigration. Another potential disruptive effect is the impact on state and local government budgets. Many of the costs imposed by immigrants are costs that arise in state-run programs, like the cost of public schooling and of welfare benefits. However, many of the taxes that immigrants pay are federal taxes like income taxes and Social Security taxes. Many immigrants do not own property (such as homes and cars), so they do not pay property taxes, which are one of the main sources of state and local tax revenue. However, they do pay sales taxes, which are state and local, and the landlords of property they rent pay property taxes. According to the nonprofit Rand Corporation, the effects of immigration on taxes are generally positive at the federal level, but they are negative at the state and local levels in places where there are many low-skilled immigrants. Visit this website (http://openstaxcollege.org/l/nber) to obtain more context regarding immigration. Proposals for Immigration Reform The Congressional Jordan Commission of the 1990s proposed reducing overall levels of immigration and refocusing U.S.
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immigration policy to give priority to immigrants with higher skill levels. In the labor market, focusing on highskilled immigrants would help prevent any negative effects on low-skilled workers' wages. For government budgets, higher-skilled workers find jobs more quickly, earn higher wages, and pay more in taxes. Several other immigrationfriendly countries, notably Canada and Australia, have immigration systems where those with high levels of education or job skills have a much better chance of obtaining permission to immigrate. For the United States, high tech companies regularly ask for a more lenient immigration policy to admit a greater quantity of highly skilled workers under the H1B visa program. The Obama Administration proposed the so-called “DREAM Act” legislation, which would have offered a path to citizenship for illegal immigrants brought to the United States before the age of 16. Despite bipartisan support, the legislation failed to pass at the federal level. However, some state legislatures, such as California, have passed their own Dream Acts. Between its plans for a border wall, increased deportation of undocumented immigrants, and even reductions in the number of highly skilled legal H1B immigrants, the Trump Administration has a much less positive approach to immigration. Most economists, whether conservative or liberal, believe that while immigration harms some domestic workers, the benefits to the nation exceed the costs. However, given the Trump Administration’s opposition, any significant immigration reform is likely on hold. The FRED database includes data on foreign and native born civilian population (https://fred.stlouisfed.org/ categories/104) (https://fred.stlouisfed.org/categories/104) and labor force (https://fred.stlouisfed.org/ categories/32442) (https://fred.stlouisfed.org/categories/32442). 346 Chapter 14 | Labor Markets and Income The Increasing Value of a College Degree The cost of college has increased dramatically in recent decades, causing many college students to take student loans to afford it. Despite this, the value of a college degree has never been higher. How can we explain this? We can estimate the value of a bachelor’s degree as the difference in lifetime earnings between the average holder of a bachelor’s degree and the average high school graduate. This difference can be nearly $1 million. College graduates also have a significantly lower unemployment rate than those with lower educational attainments. While a college degree holder’s wages have increased somewhat, the major reason
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for the increase in value of a bachelor’s degree has been the plummeting value of a high school diploma. In the twenty-first century, the majority of jobs require at least some post-secondary education. This includes manufacturing jobs that in the past would have afforded workers a middle class income with only a high school diploma. Those jobs are increasingly scarce. This phenomenon has also no doubt contributed to the increasing inequality of income that we observe in the U.S. today. We will discuss that topic next, in Chapter 15. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 347 KEY TERMS affirmative action active efforts by government or businesses that give special rights to minorities in hiring, promotion, or access to education to make up for past discrimination bilateral monopoly a labor market with a monopsony on the demand side and a union on the supply side collective bargaining negotiations between unions and a firm or firms discrimination actions based on the belief that members of a certain group or groups are in some way inferior solely because of a factor such as race, gender, or religion first rule of labor markets productivity to the firm an employer will never pay a worker more than the value of the worker's marginal monopsony a labor market where there is only one employer perfectly competitive labor market a labor market where neither suppliers of labor nor demanders of labor have any market power; thus, an employer can hire all the workers they would like at the going market wage KEY CONCEPTS AND SUMMARY 14.1 The Theory of Labor Markets A firm demands labor because of the value of the labor’s marginal productivity. For a firm operating in a perfectly competitive output market, this will be the value of the marginal product, which we define as the marginal product of labor multiplied by the firm’s output price. For a firm which is not perfectly competitive, the appropriate concept is the marginal revenue product, which we define as the marginal product of labor multiplied by the firm’s marginal revenue. Profit maximizing firms employ labor up to the point where the market wage is equal to the firm’s demand for labor. In a competitive labor market, we determine market wage through the interaction between the market supply and market demand for labor. 14.2 Wages and Employment in an Imperfectly Competitive Labor Market A monopsony is the sole employer in a labor market. The monopsony can pay any wage it
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chooses, subject to the market supply of labor. This means that if the monopsony offers too low a wage, they may not find enough workers willing to work for them. Since to obtain more workers, they must offer a higher wage, the marginal cost of additional labor is greater than the wage. To maximize profits, a monopsonist will hire workers up to the point where the marginal cost of labor equals their labor demand. This results in a lower level of employment than a competitive labor market would provide, but also a lower equilibrium wage. 14.3 Market Power on the Supply Side of Labor Markets: Unions A labor union is an organization of workers that negotiates as a group with employers over compensation and work conditions. Union workers in the United States are paid more on average than other workers with comparable education and experience. Thus, either union workers must be more productive to match this higher pay or the higher pay will lead employers to find ways of hiring fewer union workers than they otherwise would. American union membership has been falling for decades. Some possible reasons include the shift of jobs to service industries; greater competition from globalization; the passage of worker-friendly legislation; and U.S. laws that are less favorable to organizing unions. 14.4 Bilateral Monopoly A bilateral monopoly is a labor market with a union on the supply side and a monopsony on the demand side. Since both sides have monopoly power, the equilibrium level of employment will be lower than that for a competitive labor market, but the equilibrium wage could be higher or lower depending on which side negotiates better. The union favors a higher wage, while the monopsony favors a lower wage, but the outcome is indeterminate in the model. 348 Chapter 14 | Labor Markets and Income 14.5 Employment Discrimination Discrimination occurs in a labor market when employers pay workers with the same economic characteristics, such as education,experience, and skill, are paid different amounts because of race, gender, religion, age, or disability status. In the United States, female workers on average earn less than male workers, and black workers on average earn less than white workers. There is controversy over to which discrimination differences in factors like education and job experience can explain these earnings gaps. Free markets can allow discrimination to occur, but the threat of a loss of sales or a loss of productive workers can also create incentives for a firm not to discriminate. A range of public policies can be used to reduce earnings gaps between men and women or between white and other racial/ethnic groups:
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requiring equal pay for equal work, and attaining more equal educational outcomes. 14.6 Immigration The recent level of U.S. immigration is at a historically high level if we measure it in absolute numbers, but not if we measure it as a share of population. The overall gains to the U.S. economy from immigration are real but relatively small. However, immigration also causes effects like slightly lower wages for low-skill workers and budget problems for certain state and local governments. SELF-CHECK QUESTIONS 1. Table 14.10 shows levels of employment (Labor), the marginal product at each of those levels, and the price at which the firm can sell output in the perfectly competitive market where it operates. Labor Marginal Product of Labor Price of the Product 1 2 3 4 5 6 Table 14.10 10 8 7 5 3 1 $4 $4 $4 $4 $4 $4 a. What is the value of the marginal product at each level of labor? b. If the firm operates in a perfectly competitive labor market where the going market wage is $12, what is the firm’s profit maximizing level of employment? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 349 2. Table 14.11 shows levels of employment (Labor), the marginal product at each of those levels, and a monopoly’s marginal revenue. Labor Marginal Product of Labor Price of the Product 1 2 3 4 5 6 Table 14.11 10 8 7 5 3 1 $10 $7 $5 $4 $2 $1 a. What is the monopoly’s marginal revenue product at each level of employment? b. If the monopoly operates in a perfectly competitive labor market where the going market wage is $20, what is the firm’s profit maximizing level of employment? 3. Table 14.12 shows the quantity demanded and supplied in the labor market for driving city buses in the town of Unionville, where all the bus drivers belong to a union. Wage Per Hour Quantity of Workers Demanded Quantity of Workers Supplied $14 $16 $18 $20 $22 $24 Table 14.12 12,000 10,000 8,000 6,000 4,000 2,000 6,000 7,000 8,000 9,000 10,000 11,000 a. What would the equilibrium wage and quantity be in this market if no union existed? b. Assume
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that the union has enough negotiating power to raise the wage to $4 per hour higher than it would otherwise be. Is there now excess demand or excess supply of labor? 4. Do unions typically oppose new technology out of a fear that it will reduce the number of union jobs? Why or why not? 5. Compared with the share of workers in most other high-income countries, is the share of U.S. workers whose wages are determined by union bargaining higher or lower? Why or why not? 6. Are firms with a high percentage of union employees more likely to go bankrupt because of the higher wages that they pay? Why or why not? 7. Do countries with a higher percentage of unionized workers usually have less growth in productivity because of strikes and other disruptions caused by the unions? Why or why not? 350 Chapter 14 | Labor Markets and Income 8. Table 14.13 shows information from the supply curve for labor for a monopsonist, that is, the wage rate required at each level of employment. Labor 1 2 3 4 5 6 Table 14.13 Wage 1 3 5 7 8 10 a. What is the monopsonist’s marginal cost of labor at each level of employment? b. If each unit of labor’s marginal revenue product is $13, what is the firm’s profit maximizing level of employment and wage? 9. Explain in each of the following situations how market forces might give a business an incentive to act in a less discriminatory fashion. a. A local flower delivery business run by a bigoted white owner notices that many of its local customers are black. b. An assembly line has traditionally only hired men, but it is having a hard time hiring sufficiently qualified workers. c. A biased owner of a firm that provides home health care services would like to pay lower wages to Hispanic workers than to other employees. 10. Does the earnings gap between the average wages of females and the average wages of males prove labor market discrimination? Why or why not? 11. If immigration is reduced, what is the impact on the wage for low-skilled labor? Explain. REVIEW QUESTIONS 12. What determines the demand for labor for a firm operating in a perfectly competitive output market? 19. What is the long-term trend in American union membership? 13. What determines the demand for labor for a firm with market power in the output market? 14. What is a perfectly competitive labor market? 15. What is a labor union? 16. Why do employers have a natural
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advantage in bargaining with employees? 17. What are some of the most important laws that protect employee rights? 18. How does the presence of a labor union change negotiations between employers and workers? 20. Would you expect the presence of labor unions to lead to higher or lower pay for worker-members? Would you expect a higher or lower quantity of workers hired by those employers? Explain briefly. 21. What are the main causes for the recent trends in union membership rates in the United States? Why are union rates lower in the United States than in many other developed countries? 22. What is a monopsony? 23. What is the marginal cost of labor? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 14 | Labor Markets and Income 351 24. How does monopsony affect the equilibrium wage and employment levels? 25. What is a bilateral monopoly? 26. How does a bilateral monopoly affect the equilibrium wage and employment levels compared to a perfectly competitive labor market? 27. Describe how the earnings gap between men and women has evolved in recent decades. 28. Describe how the earnings gap between blacks and whites has evolved in recent decades. 29. Does a gap between the average earnings of men and women, or between whites and blacks, prove that employers are discriminating in the labor market? Explain briefly. 30. Will a free market tend to encourage or discourage discrimination? Explain briefly. CRITICAL THINKING QUESTIONS 31. What policies, when used together with antidiscrimination laws, might help to reduce the earnings gap between men and women or between white and black workers? 32. Describe how affirmative action is applied in the labor market. 33. What factors can explain the relatively small effect of low-skilled immigration on the wages of low-skilled workers? 34. Have levels of immigration to the United States been relatively high or low in recent years? Explain. 35. How would you expect immigration by primarily low-skill workers to affect American low-skilled workers? 36. What is the marginal cost of labor for a firm that operates in a competitive labor market? How does this compare with the MCL for a monopsony? 37. Given the decline in union membership over the past 50 years, what does the theory of bilateral monopoly suggest will have happened to the equilibrium level of wages over time? Why? 38. Are unions and technological complementary? Why or why not? improvements 39. Will union membership continue to decline?
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Why or why not? If it is not profitable to discriminate, why does 40. discrimination persist? 41. If a company has discriminated against minorities in the past, should it be required to give priority to minority applicants today? Why or why not? 42. If the United States allows a greater quantity of highly skilled workers, what will be the impact on the average wages of highly skilled employees? If all countries eliminated all barriers 43. to immigration, would global economic growth increase? Why or why not? 352 Chapter 14 | Labor Markets and Income This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 353 15 | Poverty and Economic Inequality Figure 15.1 Occupying Wall Street On September 17, 2011, Occupy Wall Street began in New York City’s Wall Street financial district. (Credit: modification of work by David Shankbone/Flickr Creative Commons) Occupy Wall Street In September 2011, a group of protesters gathered in Zuccotti Park in New York City to decry what they perceived as increasing social and economic inequality in the United States. Calling their protest “Occupy Wall Street,” they argued that the concentration of wealth among the richest 1% in the United States was both economically unsustainable and inequitable, and needed to be changed. The protest then spread to other major cities, and the Occupy movement was born. Why were people so upset? How much wealth is concentrated among the top 1% in our society? How did they acquire so much wealth? These are very real, very important questions in the United States now, and this chapter on poverty and economic inequality will help us address the causes behind this sentiment. Introduction to Poverty and Economic Inequality In this chapter, you will learn about: • Drawing the Poverty Line • The Poverty Trap • The Safety Net • Income Inequality: Measurement and Causes 354 Chapter 15 | Poverty and Economic Inequality • Government Policies to Reduce Income Inequality The labor markets that determine the pay that workers receive do not take into account how much income a family needs for food, shelter, clothing, and health care. Market forces do not worry about what happens to families when a major local employer goes out of business. Market forces do not take time to contemplate whether those who are earning higher incomes should pay an even higher share of taxes. However, labor markets do create considerable income inequalities. In 2014, the median American family income was $57,939 (the median is
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the level where half of all families had more than that level and half had less). According to the U.S. Census Bureau, the federal government classified almost nine million U.S. families as below the poverty line in that year. Think about a family of three—perhaps a single mother with two children—attempting to pay for the basics of life on perhaps $17,916 per year. After paying for rent, healthcare, clothing, and transportation, such a family might have $6,000 to spend on food. Spread over 365 days, the food budget for the entire family would be about $17 per day. To put this in perspective, most cities have restaurants where $17 will buy you an appetizer for one. This chapter explores how the U.S. government defines poverty, the balance between assisting the poor without discouraging work, and how federal antipoverty programs work. It also discusses income inequality—how economists measure inequality, why inequality has changed in recent decades, the range of possible government policies to reduce inequality, and the danger of a tradeoff that too great a reduction in inequality may reduce incentives for producing output. 15.1 | Drawing the Poverty Line By the end of this section, you will be able to: • Explain economic inequality and how the poverty line is determined • Analyze the U.S. poverty rate over time, noting its prevalence among different groups of citizens Comparisons of high and low incomes raise two different issues: economic inequality and poverty. Poverty is measured by the number of people who fall below a certain level of income—called the poverty line—that defines the income one needs for a basic standard of living. Income inequality compares the share of the total income (or wealth) in society that different groups receive. For example, compare the share of income that the top 10% receive to the share of income that the bottom 10% receive. In the United States, the official definition of the poverty line traces back to a single person: Mollie Orshansky. In 1963, Orshansky, who was working for the Social Security Administration, published an article called “Children of the Poor” in a highly useful and dry-as-dust publication called the Social Security Bulletin. Orshansky’s idea was to define a poverty line based on the cost of a healthy diet. Her previous job had been at the U.S. Department of Agriculture, where she had worked in an agency called the Bureau of Home Economics and Human Nutrition. One task of this
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bureau had been to calculate how much it would cost to feed a nutritionally adequate diet to a family. Orshansky found that the average family spent one-third of its income on food. She then proposed that the poverty line be the amount one requires to buy a nutritionally adequate diet, given the size of the family, multiplied by three. The current U.S. poverty line is essentially the same as the Orshansky poverty line, although the government adjusts the dollar amounts to represent the same buying power over time. The U.S. poverty line in 2015 ranged from $11,790 for a single individual to $25,240 for a household of four people. Figure 15.2 shows the U.S. poverty rate over time; that is, the percentage of the population below the poverty line in any given year. The poverty rate declined through the 1960s, rose in the early 1980s and early 1990s, but seems to have been slightly lower since the mid-1990s. However, in no year in the last four decades has the poverty rate been less than 11% of the U.S. population—that is, at best about one American in nine is below the poverty line. In recent years, the poverty rate appears to have peaked at 15.9% in 2011 before dropping to 14.5% in 2013. Table 15.1 compares poverty rates for different groups in 2011. As you will see when we delve further into these numbers, poverty rates are relatively low for whites, for the elderly, for the well-educated, and for male-headed households. Poverty rates for females, Hispanics, and African Americans are much higher than for whites. While Hispanics and This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 355 African Americans have a higher percentage of individuals living in poverty than others, most people in the United States living below the poverty line are white. Visit this website (http://openstaxcollege.org/l/povertyprogram) for more information on U.S. poverty. Figure 15.2 The U.S. Poverty Rate since 1960 The poverty rate fell dramatically during the 1960s, rose in the early 1980s and early 1990s, and, after declining in the 1990s through mid-2000s, rose to 15.9% in 2011, which is close to the 1960 levels. In 2013, the poverty dropped slightly to
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14.5%. (Source: U.S. Census Bureau) Group Poverty Rate Females Males White Black Hispanic Table 15.1 Poverty Rates by Group, 2013 15.8% 13.1% 9.6% 27.1% 23.5% 356 Chapter 15 | Poverty and Economic Inequality Group Poverty Rate Under age 18 Ages 18–24 Ages 25–34 Ages 35–44 Ages 45–54 Ages 55–59 Ages 60–64 Ages 65 and older Table 15.1 Poverty Rates by Group, 2013 19.9% 20.6% 15.9% 12.2% 10.9% 10.7% 10.8% 9.5% The concept of a poverty line raises many tricky questions. In a vast country like the United States, should there be a national poverty line? After all, according to the Federal Register, the median household income for a family of four was $102,552 in New Jersey and $57,132 in Mississippi in 2013, and prices of some basic goods like housing are quite different between states. The poverty line is based on cash income, which means it does not account for government programs that provide assistance to the poor in a non-cash form, like Medicaid (health care for lowincome individuals and families) and food aid. Also, low-income families can qualify for federal housing assistance. (We will discuss these and other government aid programs in detail later in this chapter.) Should the government adjust the poverty line to account for the value of such programs? Many economists and policymakers wonder whether we should rethink the concept of what poverty means in the twenty-first century. The following Clear It Up feature explains the poverty lines set by the World Bank for low-income countries around the world. How do economists measure poverty in low-income countries? The World Bank sets two poverty lines for low-income countries around the world. One poverty line is set at an income of $1.25/day per person. The other is at $2/day. By comparison, the U.S. 2015 poverty line of $20,090 annually for a family of three works out to $18.35 per person per day. Clearly, many people around the world are far poorer than Americans, as Table 15.2 shows. China and India both have more than a billion people; Nigeria is the most populous country in Africa; and Egypt is the most populous country in the Middle East. In all four of those countries, in the mid-2000s, a substantial
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share of the population subsisted on less than $2/day. About half the world lives on less than $2.50 a day, and 80 percent of the world lives on less than $10 per day. (Of course, the cost of food, clothing, and shelter in those countries can be very different from those costs in the United States, so the $2 and $2.50 figures may mean greater purchasing power than they would in the United States.) This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 357 Country Share of Population below $1.25/ Day Share of Population below $2.00/ Day Brazil (in 2009) 6.1% China (in 2009) Egypt (in 2008) 11.8% 1.7% India (in 2010) 32.7% Mexico (in 2010) Nigeria (in 2010) 0.7% 68.0% 10.8% 27.2% 15.4% 68.8% 4.5% 84.5% Table 15.2 Poverty Lines for Low-Income Countries, mid-2000s (Source: http://data.worldbank.org/indicator/SI.POV.DDAY) Any poverty line will be somewhat arbitrary, and it is useful to have a poverty line whose basic definition does not change much over time. If Congress voted every few years to redefine poverty, then it would be difficult to compare rates over time. After all, would a lower poverty rate change the definition, or that people were actually better off? Government statisticians at the U.S. Census Bureau have ongoing research programs to address questions like these. 15.2 | The Poverty Trap By the end of this section, you will be able to: • Explain the poverty trap, noting how government programs impact it • • Calculate a budget constraint line that represents the poverty trap Identify potential issues in government programs that seek to reduce poverty Can you give people too much help, or the wrong kind of help? When people are provided with food, shelter, healthcare, income, and other necessities, assistance may reduce their incentive to work. Consider a program to fight poverty that works in this reasonable-sounding manner: the government provides assistance to the poor, but as the poor earn income to support themselves, the government reduces the level of assistance it provides. With such a program, every time a poor person earns $
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100, the person loses $100 in government support. As a result, the person experiences no net gain for working. Economists call this problem the poverty trap. Consider the situation a single-parent family faces. Figure 15.3 illustrates a single mother (earning $8 an hour) with two children. First, consider the labor-leisure budget constraint that this family faces in a situation without government assistance. On the horizontal axis is hours of leisure (or time spent with family responsibilities) increasing in quantity from right to left. Also on the horizontal axis is the number of hours at paid work, going from zero hours on the right to the maximum of 2,500 hours on the left. On the vertical axis is the amount of income per year rising from low to higher amounts of income. The budget constraint line shows that at zero hours of leisure and 2,500 hours of work, the maximum amount of income is $20,000 ($8 × 2,500 hours). At the other extreme of the budget constraint line, an individual would work zero hours, earn zero income, but enjoy 2,500 hours of leisure. At point A on the budget constraint line, by working 40 hours a week, 50 weeks a year, the utility-maximizing choice is to work a total of 2,000 hours per year and earn $16,000. 358 Chapter 15 | Poverty and Economic Inequality Now suppose that a government antipoverty program guarantees every family with a single mother and two children $18,000 in income. This is represented on the graph by a horizontal line at $18,000. With this program, each time the mother earns $1,000, the government will deduct $1,000 of its support. Table 15.3 shows what will happen at each combination of work and government support. Figure 15.3 The Poverty Trap in Action The original choice is 500 hours of leisure, 2,000 hours of work at point A, and income of $16,000. With a guaranteed income of $18,000, this family would receive $18,000 whether it provides zero hours of work or 2,000 hours of work. Only if the family provides, say, 2,300 hours of work does its income rise above the guaranteed level of $18,000—and even then, the marginal gain to income from working many hours is small. Amount Worked (hours) Total Earnings Government Support Total Income 0 500 1,000 1,500 2,000 2,500 0 $4
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,000 $8,000 $12,000 $16,000 $20,000 $18,000 $14,000 $10,000 $6,000 $2,000 0 $18,000 $18,000 $18,000 $18,000 $18,000 $20,000 Table 15.3 Total Income at Various Combinations of Work and Support The new budget line, with the antipoverty program in place, is the horizontal and heavy line that is flat at $18,000. If the mother does not work at all, she receives $18,000, all from the government. If she works full time, giving up 40 hours per week with her children, she still ends up with $18,000 at the end of the year. Only if she works 2,300 hours in the year—which is an average of 44 hours per week for 50 weeks a year—does household income rise to $18,400. Even in this case, all of her year’s work means that household income rises by only $400 over the income she would receive if she did not work at all. She would need to work 50 hours a week to reach $20,000. The poverty trap is even stronger than this simplified example shows, because a working mother will have extra expenses like clothing, transportation, and child care that a nonworking mother will not face, making the economic gains from working even smaller. Moreover, those who do not work fail to build up job experience and contacts, which makes working in the future even less likely. To reduce the poverty trap the government could design an antipoverty program so that, instead of reducing This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 359 government payments by $1 for every $1 earned, the government would reduce payments by some smaller amount instead. Imposing requirements for work as a condition of receiving benefits and setting a time limit on benefits can also reduce the harshness of the poverty trap. Figure 15.4 illustrates a government program that guarantees $18,000 in income, even for those who do not work at all, but then reduces this amount by 50 cents for each $1 earned. The new, higher budget line in Figure 15.4 shows that, with this program, additional hours of work will bring some economic gain. Because of the reduction in government income when an individual works, an individual earning $8.
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00 will really net only $4.00 per hour. The vertical intercept of this higher budget constraint line is at $28,000 ($18,000 + 2,500 hours × $4.00 = $28,000). The horizontal intercept is at the point on the graph where $18,000 and 2500 hours of leisure is set. Table 15.4 shows the total income differences with various choices of labor and leisure. However, this type of program raises other issues. First, even if it does not eliminate the incentive to work by reducing government payments by $1 for every $1 earned, enacting such a program may still reduce the incentive to work. At least some people who would be working 2,000 hours each year without this program might decide to work fewer hours but still end up with more income—that is, their choice on the new budget line would be like S, above and to the right of the original choice P. Of course, others may choose a point like R, which involves the same amount of work as P, or even a point to the left of R that involves more work. The second major issue is that when the government phases out its support payments more slowly, the antipoverty program costs more money. Still, it may be preferable in the long run to spend more money on a program that retains a greater incentive to work, rather than spending less money on a program that nearly eliminates any gains from working. Figure 15.4 Loosening the Poverty Trap: Reducing Government Assistance by 50 Cents for Every $1 Earned On the original labor-leisure opportunity set, the lower budget set shown by the smaller dashed line in the figure, the preferred choice P is 500 hours of leisure and $16,000 of income. Then, the government created an antipoverty program that guarantees $18,000 in income even to those who work zero hours, shown by the larger dashed line. In addition, every $1 earned means phasing out 50 cents of benefits. This program leads to the higher budget set, which the diagram shows. The hope is that this program will provide incentives to work the same or more hours, despite receiving income assistance. However, it is possible that the recipients will choose a point on the new budget set like S, with less work, more leisure, and greater income, or a point like R, with the same work and greater income. 360 Chapter 15 | Poverty and Economic Inequality Amount Worked (hours) Total Earnings Government Support Total Income 0
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500 1,000 1,500 2,000 2,500 0 $4,000 $8,000 $12,000 $16,000 $20,000 $18,000 $16,000 $14,000 $12,000 $10,000 $8,000 $18,000 $20,000 $22,000 $24,000 $26,000 $28,000 Table 15.4 The Labor-Leisure Tradeoff with Assistance Reduced by 50 Cents for Every Dollar Earned The next module will consider a variety of government support programs focused specifically on the poor, including welfare, SNAP (Supplemental Nutrition Assistance Program), Medicaid, and the earned income tax credit (EITC). Although these programs vary from state to state, it is generally a true statement that in many states from the 1960s into the 1980s, if poor people worked, their level of income barely rose—or did not rise at all—after factoring in the reduction in government support payments. The following Work It Out feature shows how this happens. Calculating a Budget Constraint Line Jason earns $9.00 an hour, and a government antipoverty program provides a floor of $10,000 guaranteed income. The government reduces government support by $0.50 for each $1.00 earned. What are the horizontal and vertical intercepts of the budget constraint line? Assume the maximum hours for work or leisure is 2,500 hours. Step 1. Determine the amount of the government guaranteed income. In this case, it is $10,000. Step 2. Plot that guaranteed income as a horizontal line on the budget constraint line. Step 3. Determine what Jason earns if he has no income and enjoys 2,500 hours of leisure. In this case, he will receive the guaranteed $10,000 (the horizontal intercept). Step 4. Calculate how much Jason’s salary will be reduced due to the reduction in government income. In Jason’s case, it will be reduced by one half. He will, in effect, net only $4.50 an hour. Step 5. If Jason works 1,000 hours, at a maximum what income will Jason receive? Jason will receive $10,000 in government assistance. He will net only $4.50 for every hour he chooses to work. If he works 1,000 hours at $4.50, his earned income is $4,500 plus the $10,000 in government income.
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Thus, the total maximum income (the vertical intercept) is $10,000 + $4,500 = $14,500. 15.3 | The Safety Net By the end of this section, you will be able to: Identify the antipoverty government programs that comprise the safety net • • Explain the the safety net programs' primary goals and how these programs have changed over time • Discuss the complexities of these safety net programs and why they can be controversial The U.S. government has implemented a number of programs to assist those below the poverty line and those who have incomes just above the poverty line, to whom we refer as the near-poor. Such programs are called the safety This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 361 net, to recognize that they offer some protection for those who find themselves without jobs or income. Temporary Assistance for Needy Families From the Great Depression until 1996, the United States’ most visible antipoverty program was Aid to Families with Dependent Children (AFDC), which provided cash payments to mothers with children who were below the poverty line. Many just called this program “welfare.” In 1996, Congress passed and President Bill Clinton signed into law the Personal Responsibility and Work Opportunity Reconciliation Act, more commonly called the “welfare reform act.” The new law replaced AFDC with Temporary Assistance for Needy Families (TANF). Visit this website (http://openstaxcollege.org/l/Clinton_speech) to watch a video of President Bill Clinton’s Welfare Reform speech. TANF brought several dramatic changes in how welfare operated. Under the old AFDC program, states set the level of welfare benefits that they would pay to the poor, and the federal government guaranteed it would chip in some of the money as well. The federal government’s welfare spending would rise or fall depending on the number of poor people, and on how each state set its own welfare contribution. Under TANF, however, the federal government gives a fixed amount of money to each state. The state can then use the money for almost any program with an antipoverty component: for example, the state might use the money to give cash to poor families, or to reduce teenage pregnancy, or even to raise the high school graduation rate. However, the federal government imposed two key requirements. First, if states are to keep receiving
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the TANF grants, they must impose work requirements so that most of those receiving TANF benefits are working (or attending school). Second, no one can receive TANF benefits with federal money for more than a total of five years over his or her lifetime. The old AFDC program had no such work requirements or time limits. TANF attempts to avoid the poverty trap by requiring that welfare recipients work and by limiting the length of time they can receive benefits. In its first few years, the program was quite successful. The number of families receiving payments in 1995, the last year of AFDC, was 4.8 million. By 2012, according to the Congressional Research Service, the average number of families receiving payments under TANF was 1.8 million—a decline of more than half. TANF benefits to poor families vary considerably across states. For example, again according to the Congressional Research Service, in 2011 the highest monthly payment in Alaska to a single mother with two children was $923, while in Mississippi the highest monthly payment to that family was $170. These payments reflect differences in states’ cost of living. Total spending on TANF was approximately $16.6 billion in 1997. As of 2012, spending was at $12 billion, an almost 28% decrease, split about evenly between the federal and state governments. When you take into account the effects of inflation, the decline is even greater. Moreover, there seemed little evidence that poor families were suffering a reduced standard of living as a result of TANF—although, on the other side, there was not much evidence that poor families had greatly improved their total levels of income, either. The Earned Income Tax Credit (EITC) The earned income tax credit (EITC), first passed in 1975, is a method of assisting the working poor through the tax system. The EITC is one of the largest assistance program for low-income groups, and projections for 2013 expected 26 million households to take advantage of it at an estimated cost of $50 billion. In 2013, for example, a single parent with two children would have received a tax credit of $5,372 up to an income level of $17,530. The amount of the tax break increases with the amount of income earned, up to a point. The earned income tax credit has often been 362 Chapter 15 | Poverty and Economic Inequality popular with both economists and the general public because of the way it effectively increases the payment received for work
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. What about the danger of the poverty trap that every additional $1 earned will reduce government support payments by close to $1? To minimize this problem, the earned income tax credit is phased out slowly. According to the Tax Policy Center, for a single-parent family with two children in 2013, the credit is not reduced at all (but neither is it increased) as earnings rise from $13,430 to $17,530. Then, for every $1 earned above $17,530, the amount received from the credit is reduced by 21.06 cents, until the credit phases out completely at an income level of $46,227. Figure 15.5 illustrates that the earned income tax credits, child tax credits, and the TANF program all cost the federal government money—either in direct outlays or in loss of tax revenues. CTC stands for the government tax cuts for the child tax credit. Figure 15.5 Real Federal Spending on CTC, EITC, and TANF, 1975-2013 EITC increased from more than $20 billion in 2000 to over an estimated $50 billion by 2013, far exceeding estimated 2013 outlays in the CTC (Child Tax Credits) and TANF of over $20 billion and $10 billion, respectively. (Source: Office of Management and Budget) In recent years, the EITC has become a hugely expensive government program for providing income assistance to the poor and near-poor, costing about $60 billion in 2012. In that year, the EITC provided benefits to about 27 million families and individuals and, on average, is worth about $2,296 per family (with children), according to the Tax Policy Center. One reason that the TANF law worked as well as it did is that the government greatly expanded EITC in the late 1980s and again in the early 1990s, which increased the returns to work for low-income Americans. Supplemental Nutrition Assistance Program (SNAP) Often called “food stamps,” Supplemental Nutrition Assistance Program (SNAP) is a federally funded program, started in 1964, in which each month poor people receive a card like a debit card that they can use to buy food. The amount of food aid for which a household is eligible varies by income, number of children, and other factors but, in general, households are expected to spend about 30% of their own net income on food, and if 30% of their net income is not enough to purchase a nutr
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itionally adequate diet, then those households are eligible for SNAP. SNAP can contribute to the poverty trap. For every $100 earned, the government assumes that a family can spend $30 more for food, and thus reduces its eligibility for food aid by $30. This decreased benefit is not a complete disincentive to work—but combined with how other programs reduce benefits as income increases, it adds to the problem. SNAP, however, does try to address the poverty trap with its own set of work requirements and time limits. Why give debit cards and not just cash? Part of the political support for SNAP comes from a belief that since recipients must spend the the cards on food, they cannot “waste” them on other forms of consumption. From an economic point of view, however, the belief that cards must increase spending on food seems wrong-headed. After all, say that a poor family is spending $2,500 per year on food, and then it starts receiving $1,000 per year in SNAP aid. The family might react by spending $3,500 per year on food (income plus aid), or it might react by continuing to spend $2,500 per year on food, but use the $1,000 in food aid to free up $1,000 that it can now spend on other goods. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 363 Thus, it is reasonable to think of SNAP cards as an alternative method, along with TANF and the earned income tax credit, of transferring income to the working poor. Anyone eligible for TANF is also eligible for SNAP, although states can expand eligibility for food aid if they wish to do so. In some states, where TANF welfare spending is relatively low, a poor family may receive more in support from SNAP than from TANF. In 2014, about 40 million people received food aid at an annual cost of about $76 billion, with an average monthly benefit of about $287 per person per month. SNAP participation increased by 70% between 2007 and 2011, from 26.6 million participants to 45 million. According to the Congressional Budget Office, the 2008-2009 Great Recession and rising food prices caused this dramatic rise in participation. The federal government deploys a range of income security programs that it funds through departments such as Health and Human Services, Agriculture, and Housing and Urban Development (HUD) (
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see Figure 15.6). According to the Office of Management and Budget, collectively, these three departments provided an estimated $62 billion of aid through programs such as supplemental feeding programs for women and children, subsidized housing, and energy assistance. The federal government also transfers funds to individual states through special grant programs. Figure 15.6 Expenditure Comparison of TANF, SNAP, HUD, and Other Income Security Programs, 1988–2013 (est.) Total expenditures on income security continued to rise between 1988 and 2010, while payments for TANF have increased from $13 billion in 1998 to an estimated $17.3 billion in 2013. SNAP has seen relatively small increments. These two programs comprise a relatively small portion of the estimated $106 billion dedicated to income security in 2013. Note that other programs and housing programs increased dramatically during the 2008 and 2010 time periods. (Source: Table 12.3 Section 600 Income Security, https://www.whitehouse.gov/sites/default/files/omb/ budget/fy2013/assets/hist.pdf) The safety net includes a number of other programs: government-subsidized school lunches and breakfasts for children from low-income families; the Special Supplemental Food Program for Women, Infants and Children (WIC), which provides food assistance for pregnant women and newborns; the Low Income Home Energy Assistance Program, which provides help with home heating bills; housing assistance, which helps pay the rent; and Supplemental Security Income, which provides cash support for the disabled and the elderly poor. Medicaid Congress created Medicaid in 1965. This is a joint health insurance program between both the states and the federal government. The federal government helps fund Medicaid, but each state is responsible for administering the program, determining the level of benefits, and determining eligibility. It provides medical insurance for certain lowincome people, including those below the poverty line, with a focus on families with children, the elderly, and the disabled. About one-third of Medicaid spending is for low-income mothers with children. While an increasing share of the program funding in recent years has gone to pay for nursing home costs for the elderly poor. The program ensures that participants receive a basic level of benefits, but because each state sets eligibility requirements and provides varying levels of service, the program differs from state to state. 364 Chapter 15 | Poverty and Economic Inequality In the past, a common problem has been that many low-paying jobs pay enough to a breadwinner so that a family could lose its eligibility for Medicaid, yet the job
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does not offer health insurance benefits. A poor parent considering such a job might choose not to work rather than lose health insurance for his or her children. In this way, health insurance can become a part of the poverty trap. Many states recognized this problem in the 1980s and 1990s and expanded their Medicaid coverage to include not just the poor, but the near-poor earning up to 135% or even 185% of the poverty line. Some states also guaranteed that children would not lose coverage if their parents worked. These expanded guarantees cost the government money, of course, but they also helped to encourage those on welfare to enter the labor force. As of 2014, approximately 69.7 million people participated in Medicaid. Of those enrolled, almost half are children. Healthcare expenditures, however, are highest for the elderly population, which comprises approximately 25% of participants. As Figure 15.7 (a) indicates, the largest number of households that enroll in Medicaid are those with children. Lower-income adults are the next largest group enrolled in Medicaid at 28%. The blind and disabled are 16% of those enrolled, and seniors are 9% of those enrolled. Figure 15.7 (b) shows how much actual Medicaid dollars the government spends for each group. Out of total Medicaid spending, the government spends more on seniors (20%) and the blind and disabled (44%). Thus, 64% of all Medicaid spending goes to seniors, the blind, and disabled. Children receive 21% of all Medicaid spending, followed by adults at 15%. Figure 15.7 Medicaid Enrollment and Spending Part (a) shows the Medicaid enrollment by different populations, with children comprising the largest percentage at 47%, followed by adults at 28%, and the blind and disabled at 16%. Part (b) shows that Medicaid spending is principally for the blind and disabled, followed by the elderly. Although children are the largest population that Medicaid covers, expenditures on children are only at 21%. 15.4 | Income Inequality: Measurement and Causes By the end of this section, you will be able to: • Explain the distribution of income, and analyze the sources of income inequality in a market economy • Measure income distribution in quintiles • Calculate and graph a Lorenz curve • Show income inequality through demand and supply diagrams Poverty levels can be subjective based on the overall income levels of a country. Typically a government measures poverty based on a percentage of the median income. Income inequality, however, has to do with the distribution of that income, in terms of which group receives the most or
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the least income. Income inequality involves comparing those with high incomes, middle incomes, and low incomes—not just looking at those below or near the poverty line. In turn, measuring income inequality means dividing the population into various groups and then comparing the groups, a task that we can be carry out in several ways, as the next Clear It Up feature shows. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 365 How do you separate poverty and income inequality? Poverty can change even when inequality does not move at all. Imagine a situation in which income for everyone in the population declines by 10%. Poverty would rise, since a greater share of the population would now fall below the poverty line. However, inequality would be the same, because everyone suffered the same proportional loss. Conversely, a general rise in income levels over time would keep inequality the same, but reduce poverty. It is also possible for income inequality to change without affecting the poverty rate. Imagine a situation in which a large number of people who already have high incomes increase their incomes by even more. Inequality would rise as a result—but the number of people below the poverty line would remain unchanged. Why did inequality of household income increase in the United States in recent decades? A trend toward greater income inequality has occurred in many countries around the world, although the effect has been more powerful in the U.S. economy. Economists have focused their explanations for the increasing inequality on two factors that changed more or less continually from the 1970s into the 2000s. One set of explanations focuses on the changing shape of American households. The other focuses on greater inequality of wages, what some economists call “winner take all” labor markets. We will begin with how we measure inequality, and then consider the explanations for growing inequality in the United States. Measuring Income Distribution by Quintiles One common way of measuring income inequality is to rank all households by income, from lowest to highest, and then to divide all households into five groups with equal numbers of people, known as quintiles. This calculation allows for measuring the distribution of income among the five groups compared to the total. The first quintile is the lowest fifth or 20%, the second quintile is the next lowest, and so on. We can measure income inequality by comparing what share of the total income each quintile earns. U.S. income distribution by quintile appears in Table 15.5. In
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2011, for example, the bottom quintile of the income distribution received 3.2% of income; the second quintile received 8.4%; the third quintile, 14.3%; the fourth quintile, 23.0%; and the top quintile, 51.14%. The final column of Table 15.5 shows what share of income went to households in the top 5% of the income distribution: 22.3% in 2011. Over time, from the late 1960s to the early 1980s, the top fifth of the income distribution typically received between about 43% to 44% of all income. The share of income that the top fifth received then begins to rise. Census Bureau researchers trace, much of this increase in the share of income going to the top fifth to an increase in the share of income going to the top 5%. The quintile measure shows how income inequality has increased in recent decades. Year 1967 1970 1975 1980 1985 1990 Lowest Quintile Second Quintile Third Quintile Fourth Quintile Highest Quintile 4.0 4.1 4.3 4.2 3.9 3.8 10.8 10.8 10.4 10.2 9.8 9.6 17.3 17.4 17.0 16.8 16.2 15.9 24.2 24.5 24.7 24.7 24.4 24.0 43.6 43.3 43.6 44.1 45.6 46.6 Top 5% 17.2 16.6 16.5 16.5 17.6 18.5 Table 15.5 Share of Aggregate Income Received by Each Fifth and Top 5% of Households, 1967–2013 (Source: U.S. Census Bureau, Table 2) 366 Year 1995 2000 2005 2010 2013 Chapter 15 | Poverty and Economic Inequality Lowest Quintile Second Quintile Third Quintile Fourth Quintile Highest Quintile 3.7 3.6 3.4 3.3 3.2 9.1 8.9 8.6 8.5 8.4 15.2 14.8 14.6 14.6 14.4 23.3 23.0 23.0 23.4 23.0 48.7 49.8 50.4 50.3 51 Top 5% 21.0 22.1 22.2 21.3 22.2 Table 15.5 Share of Aggregate Income Received by Each Fifth and Top 5% of Households, 1967–2013 (Source: U.S
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. Census Bureau, Table 2) It can also be useful to divide the income distribution in ways other than quintiles; for example, into tenths or even into percentiles (that is, hundredths). A more detailed breakdown can provide additional insights. For example, the last column of Table 15.5 shows the income received by the top 5% percent of the income distribution. Between 1980 and 2013, the share of income going to the top 5% increased by 5.7 percentage points (from 16.5% in 1980 to 22.2% in 2013). From 1980 to 2013 the share of income going to the top quintile increased by 7.0 percentage points (from 44.1% in 1980 to 51% in 2013). Thus, the top 20% of householders (the fifth quintile) received over half (51%) of all the income in the United States in 2013. Lorenz Curve We can present the data on income inequality in various ways. For example, you could draw a bar graph that showed the share of income going to each fifth of the income distribution. Figure 15.8 presents an alternative way of showing inequality data in a Lorenz curve. This curve shows the cumulative share of population on the horizontal axis and the cumulative percentage of total income received on the vertical axis. Figure 15.8 The Lorenz Curve A Lorenz curve graphs the cumulative shares of income received by everyone up to a certain quintile. The income distribution in 1980 was closer to the perfect equality line than the income distribution in 2011—that is, the U.S. income distribution became more unequal over time. Every Lorenz curve diagram begins with a line sloping up at a 45-degree angle. We show it as a dashed line in Figure 15.8. The points along this line show what perfect equality of the income distribution looks like. It would mean, for example, that the bottom 20% of the income distribution receives 20% of the total income, the bottom 40% gets 40% of total income, and so on. The other lines reflect actual U.S. data on inequality for 1980 and 2011. The trick in graphing a Lorenz curve is that you must change the shares of income for each specific quintile, which we show in the first column of numbers in Table 15.6, into cumulative income, which we show in the second column of numbers. For example, the bottom 40% of the cumulative income distribution will be the sum of the first and second quintiles; the bottom 60
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% of the cumulative income distribution will be the sum of the first, second, and third This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 367 quintiles, and so on. The final entry in the cumulative income column needs to be 100%, because by definition, 100% of the population receives 100% of the income. Income Category Share of Income in 1980 (%) Cumulative Share of Income in 1980 (%) Share of Income in 2013 (%) Cumulative Share of Income in 2013 (%) First quintile Second quintile Third quintile Fourth quintile Fifth quintile 4.2 10.2 16.8 24.7 44.1 4.2 14.4 31.2 55.9 100.0 3.2 8.4 14.4 23.0 51.0 3.2 11.6 26.0 49.0 100.0 Table 15.6 Calculating the Lorenz Curve In a Lorenz curve diagram, a more unequal distribution of income will loop farther down and away from the 45-degree line, while a more equal distribution of income will move the line closer to the 45-degree line. Figure Figure 15.8 illustrates the greater inequality of the U.S. income distribution between 1980 and 2013 because the Lorenz curve for 2013 is farther from the 45-degree line than for 1980. The Lorenz curve is a useful way of presenting the quintile data that provides an image of all the quintile data at once. The next Clear It Up feature shows how income inequality differs in various countries compared to the United States. How does economic inequality vary around the world? The U.S. economy has a relatively high degree of income inequality by global standards. As Table 15.7 shows, based on a variety of national surveys for a selection of years in the last five years of the 2000s (with the exception of Germany, and adjusted to make the measures more comparable), the U.S. economy has greater inequality than Germany (along with most Western European countries). The region of the world with the highest level of income inequality is Latin America, illustrated in the numbers for Brazil and Mexico. The level of inequality in the United States is lower than in some of the low-income countries of the world, like China and Nigeria, or some middle-income countries like the Russian Federation. However, not all poor countries have highly unequal income distributions. India provides a counterexample. 368
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Chapter 15 | Poverty and Economic Inequality Country United States Germany Brazil Mexico China India Russia Nigeria Survey Year First Quintile Second Quintile Third Quintile Fourth Quintile Fifth Quintile 2013 3.2% 8.4% 14.4% 23.0% 51.0% 2000 2009 2010 2009 2010 2009 2010 8.5% 2.9% 4.9% 4.7% 8.5% 6.1% 4.4% 13.7% 7.1% 8.8% 9.7% 12.1% 10.4% 8.3% 17.8% 12.4% 13.3% 15.3% 15.7% 14.8% 13.0% 23.1% 19.0% 20.2% 23.2% 20.8% 21.3% 20.3% 36.9% 58.6% 52.8% 47.1% 42.8% 47.1% 54.0% Table 15.7 Income Distribution in Select Countries (Source: U.S. data from U.S. Census Bureau Table 2. Other data from The World Bank Poverty and Inequality Data Base, http://databank.worldbank.org/data/views/reports/tableview.aspx#) Visit this website (http://openstaxcollege.org/l/inequality/) to watch a video of wealth inequality across the world. Causes of Growing Inequality: The Changing Composition of American Households In 1970, 41% of married women were in the labor force, but by 2015, according to the Bureau of Labor Statistics, 56.7% of married women were in the labor force. One result of this trend is that more households have two earners. Moreover, it has become more common for one high earner to marry another high earner. A few decades ago, the common pattern featured a man with relatively high earnings, such as an executive or a doctor, marrying a woman who did not earn as much, like a secretary or a nurse. Often, the woman would leave paid employment, at least for a few years, to raise a family. However, now doctors are marrying doctors and executives are marrying executives, and mothers with high-powered careers are often returning to work while their children are quite young. This pattern of households with two high earners tends to increase the proportion of high-earning households. According to data in the National Journal, even as two-earner couples have increased
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, so have single-parent households. Of all U.S. families, 13.1% were headed by single mothers. The poverty rate among single-parent households tends to be relatively high. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 369 These changes in family structure, including the growth of single-parent families who tend to be at the lower end of the income distribution, and the growth of two-career high-earner couples near the top end of the income distribution, account for roughly half of the rise in income inequality across households in recent decades. Visit this website (http://openstaxcollege.org/l/US_wealth) to watch a video that illustrates the distribution of wealth in the United States. Causes of Growing Inequality: A Shift in the Distribution of Wages Another factor behind the rise in U.S. income inequality is that earnings have become less equal since the late 1970s. In particular, the earnings of high-skilled labor relative to low-skilled labor have increased. Winner-take-all labor markets result from changes in technology, which have increased global demand for “stars,”—whether the best CEO, doctor, basketball player, or actor. This global demand pushes salaries far above productivity differences versus educational differences. One way to measure this change is to take workers' earnings with at least a four-year college bachelor’s degree (including those who went on and completed an advanced degree) and divide them by workers' earnings with only a high school degree. The result is that those in the 25–34 age bracket with college degrees earned about 1.67 times as much as high school graduates in 2010, up from 1.59 times in 1995, according to U.S. Census data. Winner-take-all labor market theory argues that the salary gap between the median and the top 1 percent is not due to educational differences. Economists use the demand and supply model to reason through the most likely causes of this shift. According to the National Center for Education Statistics, in recent decades, the supply of U.S. workers with college degrees has increased substantially. For example, 840,000 four-year bachelor’s degrees were conferred on Americans in 1970. In 2013-2014, 1,894,934 such degrees were conferred—an increase of over 90%. In Figure 15.9, this shift in
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supply to the right, from S0 to S1, should result in a lower equilibrium wage for high-skilled labor. Thus, we can explain the increase in the price of high-skilled labor by a greater demand, like the movement from D0 to D1. Evidently, combining both the increase in supply and in demand has resulted in a shift from E0 to E1, and a resulting higher wage. 370 Chapter 15 | Poverty and Economic Inequality Figure 15.9 Why Would Wages Rise for High-Skilled Labor? The proportion of workers attending college has increased in recent decades, so the supply curve for high-skilled labor has shifted to the right, from S0 to S1. If the demand for high-skilled labor had remained at D0, then this shift in supply would have led to lower wages for highskilled labor. However, the wages for high-skilled labor, especially if there is a large global demand, have increased even with the shift in supply to the right. The explanation must lie in a shift to the right in demand for high-skilled labor, from D0 to D1. The figure shows how a combination of the shift in supply, from S0 to S1, and the shift in demand, from D0 to D1, led to both an increase in the quantity of high-skilled labor hired and also to a rise in the wage for such labor, from W0 to W1. What factors would cause the demand for high-skilled labor to rise? The most plausible explanation is that while the explosion in new information and communications technologies over the last several decades has helped many workers to become more productive, the benefits have been especially great for high-skilled workers like top business managers, consultants, and design professionals. The new technologies have also helped to encourage globalization, the remarkable increase in international trade over the last few decades, by making it more possible to learn about and coordinate economic interactions all around the world. In turn, the rising impact of foreign trade in the U.S. economy has opened up greater opportunities for high-skilled workers to sell their services around the world, and lower-skilled workers have to compete with a larger supply of similarly skilled workers around the globe. We can view the market for high-skilled labor as a race between forces of supply and demand. Additional education and on-the-job training will tend to increase the high-skilled labor supply and to hold down its relative wage. Conversely, new technology and other economic
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trends like globalization tend to increase the demand for high-skilled labor and push up its relative wage. We can view the greater inequality of wages as a sign that demand for skilled labor is increasing faster than supply. Alternatively, if the supply of lower skilled workers exceeds the demand, then average wages in the lower quintiles of the income distribution will decrease. The combination of forces in the highskilled and low-skilled labor markets leads to increased income disparity. 15.5 | Government Policies to Reduce Income Inequality By the end of this section, you will be able to: • Explain the arguments for and against government intervention in a market economy • • Show the tradeoff between incentives and income equality Identify beneficial ways to reduce the economic inequality in a society No society should expect or desire complete equality of income at a given point in time, for a number of reasons. First, most workers receive relatively low earnings in their first few jobs, higher earnings as they reach middle age, and then lower earnings after retirement. Thus, a society with people of varying ages will have a certain amount of income inequality. Second, people’s preferences and desires differ. Some are willing to work long hours to have income for large houses, fast cars and computers, luxury vacations, and the ability to support children and grandchildren. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 371 These factors all imply that a snapshot of inequality in a given year does not provide an accurate picture of how people’s incomes rise and fall over time. Even if we expect some degree of economic inequality at any point in time, how much inequality should there be? There is also the difference between income and wealth, as the following Clear It Up feature explains. How do you measure wealth versus income inequality? Income is a flow of money received, often measured on a monthly or an annual basis. Wealth is the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home. In calculating wealth, one must subtract all debts, such as debt owed on a home mortgage and on credit cards. A retired person, for example, may have relatively little income in a given year, other than a pension or Social Security. However, if that person has saved and invested over time, the person’s accumulated wealth can be quite substantial. In the United States, the wealth distribution is more unequal
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than the income distribution, because differences in income can accumulate over time to make even larger differences in wealth. However, we can measure the degree of inequality in the wealth distribution with the same tools we use to measure the inequality in the income distribution, like quintile measurements. Once every three years the Federal Reserve Bank publishes the Survey of Consumer Finance which reports a collection of data on wealth. Even if they cannot answer the question of how much inequality is too much, economists can still play an important role in spelling out policy options and tradeoffs. If a society decides to reduce the level of economic inequality, it has three main sets of tools: redistribution from those with high incomes to those with low incomes; trying to assure that a ladder of opportunity is widely available; and a tax on inheritance. Redistribution Redistribution means taking income from those with higher incomes and providing income to those with lower incomes. Earlier in this chapter, we considered some of the key government policies that provide support for the poor: the welfare program TANF, the earned income tax credit, SNAP, and Medicaid. If a reduction in inequality is desired, these programs could receive additional funding. The federal income tax, which is a progressive tax system designed in such a way that the rich pay a higher percent in income taxes than the poor funds the programs. Data from household income tax returns in 2009 shows that the top 1% of households had an average income of $1,219,700 per year in pre-tax income and paid an average federal tax rate of 28.9%. The effective income tax, which is total taxes paid divided by total income (all sources of income such as wages, profits, interest, rental income, and government transfers such as veterans’ benefits), was much lower. The effective tax paid by that top 1% of householders paid was 20.4%, while the bottom two quintiles actually paid negative effective income taxes, because of provisions like the earned income tax credit. News stories occasionally report on a high-income person who has managed to pay very little in taxes, but while such individual cases exist, according to the Congressional Budget Office, the typical pattern is that people with higher incomes pay a higher average share of their income in federal income taxes. Of course, the fact that some degree of redistribution occurs now through the federal income tax and government antipoverty programs does not settle the questions of how much redistribution is appropriate, and whether more redistribution should occur. The Ladder of Opportunity Economic inequality is perhaps most troubling when it is not the
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result of effort or talent, but instead is determined by the circumstances under which a child grows up. One child attends a well-run grade school and high school and heads on to college, while parents help out by supporting education and other interests, paying for college, a first car, and a first house, and offering work connections that lead to internships and jobs. Another child attends a poorly run grade school, barely makes it through a low-quality high school, does not go to college, and lacks family and peer support. These two children may be similar in their underlying talents and in the effort they put forth, but their 372 Chapter 15 | Poverty and Economic Inequality economic outcomes are likely to be quite different. Public policy can attempt to build a ladder of opportunities so that, even though all children will never come from identical families and attend identical schools, each child has a reasonable opportunity to attain an economic niche in society based on their interests, desires, talents, and efforts. Table 15.8 shows some of those initiatives. Children College Level Adults • Improved day care • Widespread loans and grants for those in financial need • Opportunities for retraining and acquiring new skills • Enrichment programs for preschoolers • Improved public schools • After school and community activities • Internships and apprenticeships • Public support for a range of institutions from two-year community colleges to large research universities • Prohibiting discrimination in job markets and housing on the basis of race, gender, age, and disability - - - - - - Table 15.8 Public Policy Initiatives Some have called the United States a land of opportunity. Although the general idea of a ladder of opportunity for all citizens continues to exert a powerful attraction, specifics are often quite controversial. Society can experiment with a wide variety of proposals for building a ladder of opportunity, especially for those who otherwise seem likely to start their lives in a disadvantaged position. The government needs to carry out such policy experiments in a spirit of open-mindedness, because some will succeed while others will not show positive results or will cost too much to enact on a widespread basis. Inheritance Taxes There is always a debate about inheritance taxes. It goes like this: Why should people who have worked hard all their lives and saved up a substantial nest egg not be able to give their money and possessions to their children and grandchildren? In particular, it would seem un-American if children were unable to inherit a family business or a family home. Alternatively, many Americans are far more comfortable with inequality resulting from high-
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income people who earned their money by starting innovative new companies than they are with inequality resulting from high-income people who have inherited money from rich parents. The United States does have an estate tax—that is, a tax imposed on the value of an inheritance—which suggests a willingness to limit how much wealth one can pass on as an inheritance. However, according to the Center on Budget and Policy Priorities, in 2015 the estate tax applied only to those leaving inheritances of more than $5.43 million and thus applies to only a tiny percentage of those with high levels of wealth. The Tradeoff between Incentives and Income Equality Government policies to reduce poverty or to encourage economic equality, if carried to extremes, can injure incentives for economic output. The poverty trap, for example, defines a situation where guaranteeing a certain level of income can eliminate or reduce the incentive to work. An extremely high degree of redistribution, with very high taxes on the rich, would be likely to discourage work and entrepreneurship. Thus, it is common to draw the tradeoff between economic output and equality, as Figure 15.10 (a) shows. In this formulation, if society wishes a high level of economic output, like point A, it must also accept a high degree of inequality. Conversely, if society wants a high level of equality, like point B, it must accept a lower level of economic output because of reduced incentives for This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 373 production. This view of the tradeoff between economic output and equality may be too pessimistic, and Figure 15.10 (b) presents an alternate vision. Here, the tradeoff between economic output and equality first slopes up, in the vicinity of choice C, suggesting that certain programs might increase both output and economic equality. For example, the policy of providing free public education has an element of redistribution, since the value of the public schooling received by children of low-income families is clearly higher than what low-income families pay in taxes. A well-educated population, however, is also an enormously powerful factor in providing the skilled workers of tomorrow and helping the economy to grow and expand. In this case, equality and economic growth may complement each other. Moreover, policies to diminish inequality and soften the hardship of poverty may sustain political support for a market economy. After all, if society does not make some effort toward reducing inequality and poverty, the alternative might be
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that people would rebel against market forces. Citizens might seek economic security by demanding that their legislators pass laws forbidding employers from ever laying off workers or reducing wages, or laws that would impose price floors and price ceilings and shut off international trade. From this viewpoint, policies to reduce inequality may help economic output by building social support for allowing markets to operate. Figure 15.10 The Tradeoff between Incentives and Economic Equality (a) Society faces a trade-off where any attempt to move toward greater equality, like moving from choice A to B, involves a reduction in economic output. (b) Situations can arise like point C, where it is possible both to increase equality and also to increase economic output, to a choice like D. It may also be possible to increase equality with little impact on economic output, like the movement from choice D to E. However, at some point, too aggressive a push for equality will tend to reduce economic output, as in the shift from E to F. The tradeoff in Figure 15.10 (b) then flattens out in the area between points D and E, which reflects the pattern that a number of countries that provide similar levels of income to their citizens—the United States, Canada, European Union nations, Japan, and Australia—have different levels of inequality. The pattern suggests that countries in this range could choose a greater or a lesser degree of inequality without much impact on economic output. Only if these countries push for a much higher level of equality, like at point F, will they experience the diminished incentives that lead to lower levels of economic output. In this view, while a danger always exists that an agenda to reduce poverty or inequality can be poorly designed or pushed too far, it is also possible to discover and design policies that improve equality and do not injure incentives for economic output by very much—or even improve such incentives. Occupy Wall Street The Occupy movement took on a life of its own over the last few months of 2011, bringing to light issues that many people faced on the lower end of the income distribution. The contents of this chapter indicate that there is a significant amount of income inequality in the United States. The question is: What should be done about 374 it? Chapter 15 | Poverty and Economic Inequality The 2008-2009 Great Recession caused unemployment to rise and incomes to fall. Many people attribute the recession to mismanagement of the financial system by bankers and financial managers—those in the 1% of the income distribution—but those in lower quintiles bore the greater burden of
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the recession through unemployment. This seemed to present the picture of inequality in a different light: the group that seemed responsible for the recession was not the group that seemed to bear the burden of the decline in output. A burden shared can bring a society closer together. A burden pushed off onto others can polarize it. On one level, the problem with trying to reduce income inequality comes down to whether you still believe in the American Dream. If you believe that one day you will have your American Dream—a large income, large house, happy family, or whatever else you would like to have in life—then you do not necessarily want to prevent anyone else from living out their dream. You certainly would not want to run the risk that someone would want to take part of your dream away from you. Thus, there is some reluctance to engage in a redistributive policy to reduce inequality. However, when those for whom the likelihood of living the American Dream is very small are considered, there are sound arguments in favor of trying to create greater balance. As the text indicated, a little more income equality, gained through long-term programs like increased education and job training, can increase overall economic output. Then everyone is made better off, and the 1% will not seem like such a small group any more. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 375 KEY TERMS earned income tax credit (EITC) a method of assisting the working poor through the tax system effective income tax percentage of total taxes paid divided by total income estate tax a tax imposed on the value of an inheritance income a flow of money received, often measured on a monthly or an annual basis income inequality when one group receives a disproportionate share of total income or wealth than others Lorenz curve a graph that compares the cumulative income actually received to a perfectly equal distribution of income; it shows the share of population on the horizontal axis and the cumulative percentage of total income received on the vertical axis Medicaid a federal–state joint program enacted in 1965 that provides medical insurance for certain (not all) low-income people, including the near-poor as well as those below the poverty line, and focusing on low-income families with children, the low-income elderly, and the disabled near-poor those who have incomes just above the poverty line poverty the situation of being below a certain level of income one needs for a basic standard of living poverty line the specific amount
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of income one requires for a basic standard of living poverty rate percentage of the population living below the poverty line poverty trap antipoverty programs set up so that government benefits decline substantially as people earn more income—as a result, working provides little financial gain progressive tax system a tax system in which the rich pay a higher percentage of their income in taxes, rather than a higher absolute amount quintile dividing a group into fifths, a method economists often use to look at distribution of income redistribution taking income from those with higher incomes and providing income to those with lower incomes safety net the group of government programs that provide assistance to the poor and the near-poor Supplemental Nutrition Assistance Program (SNAP) a federally funded program, started in 1964, in which each month poor people receive SNAP cards they can use to buy food wealth the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home KEY CONCEPTS AND SUMMARY 15.1 Drawing the Poverty Line Wages are influenced by Supply and demand in labor markets influence wages. This can lead to very low incomes for some people and very high incomes for others. Poverty and income inequality are not the same thing. Poverty applies to the condition of people who cannot afford the necessities of life. Income inequality refers to the disparity between those with higher and lower incomes. The poverty rate is what percentage of the population lives below the poverty line, which the amount of income that it takes to purchase the necessities of life determines. Choosing a poverty line will always be somewhat controversial. 376 Chapter 15 | Poverty and Economic Inequality 15.2 The Poverty Trap A poverty trap occurs when government-support payments for the poor decline as the poor earn more income. As a result, the poor do not end up with much more income when they work, because the loss of government support largely or completely offsets any income that one earns by working. Phasing out government benefits more slowly, as well as imposing requirements for work as a condition of receiving benefits and a time limit on benefits can reduce the harshness of the poverty trap. 15.3 The Safety Net We call the group of government programs that assist the poor the safety net. In the United States, prominent safety net programs include Temporary Assistance to Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP), the earned income tax credit (EITC), Medicaid, and the Special Supplemental Food Program for Women, Infants, and Children (WIC). 15.4
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Income Inequality: Measurement and Causes Measuring inequality involves making comparisons across the entire distribution of income, not just the poor. One way of doing this is to divide the population into groups, like quintiles, and then calculate what share of income each group receives. An alternative approach is to draw Lorenz curves, which compare the cumulative income actually received to a perfectly equal distribution of income. Income inequality in the United States increased substantially from the late 1970s and early 1980s into the 2000s. The two most common explanations that economists cite are changes in household structures that have led to more two-earner couples and single-parent families, and the effect of new information and communications technology on wages. 15.5 Government Policies to Reduce Income Inequality Policies that can affect the level of economic inequality include redistribution between rich and poor, making it easier for people to climb the ladder of opportunity; and estate taxes, which are taxes on inheritances. Pushing too aggressively for economic equality can run the risk of decreasing economic incentives. However, a moderate push for economic equality can increase economic output, both through methods like improved education and by building a base of political support for market forces. SELF-CHECK QUESTIONS 1. Describe how each of these changes is likely to affect poverty and inequality: a. b. Incomes rise for low-income and high-income workers, but rise more for the high-income earners. Incomes fall for low-income and high-income workers, but fall more for high-income earners. 2. Jonathon is a single father with one child. He can work as a server for $6 per hour for up to 1,500 hours per year. He is eligible for welfare, and so if he does not earn any income, he will receive a total of $10,000 per year. He can work and still receive government benefits, but for every $1 of income, his welfare stipend is $1 less. Create a table similar to Table 15.4 that shows Jonathan’s options. Use four columns, the first showing number of hours to work, the second showing his earnings from work, the third showing the government benefits he will receive, and the fourth column showing his total income (earnings + government support). Sketch a labor-leisure diagram of Jonathan’s opportunity set with and without government support. 3. Imagine that the government reworks the welfare policy that was affecting Jonathan in question 1, so that for each dollar someone like Jonathan earns at work
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, his government benefits diminish by only 30 cents. Reconstruct the table from question 1 to account for this change in policy. Draw Jonathan’s labor-leisure opportunity sets, both for before this welfare program is enacted and after it is enacted. 4. We have discovered that the welfare system discourages recipients from working because the more income they earn, the less welfare benefits they receive. How does the earned income tax credit attempt to loosen the poverty trap? 5. How does the TANF attempt to loosen the poverty trap? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 377 6. A group of 10 people have the following annual incomes: $24,000, $18,000, $50,000, $100,000, $12,000, $36,000, $80,000, $10,000, $24,000, $16,000. Calculate the share of total income that each quintile receives from this income distribution. Do the top and bottom quintiles in this distribution have a greater or larger share of total income than the top and bottom quintiles of the U.S. income distribution? 7. Table 15.9 shows the share of income going to each quintile of the income distribution for the United Kingdom in 1979 and 1991. Use this data to calculate what the points on a Lorenz curve would be, and sketch the Lorenz curve. How did inequality in the United Kingdom shift over this time period? How can you see the patterns in the quintiles in the Lorenz curves? Share of Income 1979 1991 Top quintile Fourth quintile Middle quintile Second quintile Bottom quintile 39.7% 24.8% 17.0% 11.5% 7.0% 42.9% 22.7% 16.3% 11.5% 6.6% Table 15.9 Income Distribution in the United Kingdom, 1979 and 1991 8. Using two demand and supply diagrams, one for the low-wage labor market and one for the high-wage labor market, explain how information technology can increase income inequality if it is a complement to high-income workers like salespeople and managers, but a substitute for low-income workers like file clerks and telephone receptionists. 9. Using two demand and supply diagrams, one for the low-wage labor market and one for the high-wage labor market, explain how a program
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that increased educational levels for a substantial number of low-skill workers could reduce income inequality. 10. Here is one hypothesis: A well-funded social safety net can increase economic equality but will reduce economic output. Explain why this might be so, and sketch a production possibility curve that shows this tradeoff. 11. Here is a second hypothesis: A well-funded social safety net may lead to less regulation of the market economy. Explain why this might be so, and sketch a production possibility curve that shows this tradeoff. 12. Which set of policies is more likely to cause a tradeoff between economic output and equality: policies of redistribution or policies aimed at the ladder of opportunity? Explain how the production possibility frontier tradeoff between economic equality and output might look in each case. 13. Why is there reluctance on the part of some in the United States to redistribute income so that greater equality can be achieved? REVIEW QUESTIONS 14. How is the poverty rate calculated? 15. What is the poverty line? 16. What is the difference between poverty and income inequality? 17. How does the poverty trap discourage people from working? 18. How can the effect of the poverty trap be reduced? 19. Who are the near-poor? 20. What is the safety net? 378 Chapter 15 | Poverty and Economic Inequality 21. Briefly explain the differences between TANF, the earned income tax credit, SNAP, and Medicaid. 22. Who is included in the top income quintile? 23. What is measured on the two axes of a Lorenz curve? If a country had perfect income equality what 24. would the Lorenz curve look like? 25. How has the inequality of income changed in the U.S. economy since the late 1970s? 26. What are some reasons why a certain degree of inequality of income would be expected in a market economy? 27. What are the main reasons economists give for the increase in inequality of incomes? Identify some public policies that can reduce the 28. level of economic inequality. 29. Describe how a push for economic equality might reduce incentives to work and produce output. Then describe how a push for economic inequality might not have such effects. CRITICAL THINKING QUESTIONS 30. What goods and services would you include in an estimate of the basic necessities for a family of four? 31. If a family of three earned $20,000, would they be able to make ends meet given the official poverty threshold? 32. Exercise 15.2 and Exercise 15
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.3 asked you to describe the labor-leisure tradeoff for Jonathon. Since, in the first example, there is no monetary incentive for Jonathon to work, explain why he may choose to work anyway. Explain what the opportunity costs of working and not working might be for Jonathon in each example. Using your tables and graphs from Exercise 15.2 and Exercise 15.3, analyze how the government welfare system affects Jonathan’s incentive to work. 33. Explain how you would create a government program that would give an incentive for labor to increase hours and keep labor from falling into the poverty trap. 34. Many critics of government programs to help lowincome individuals argue that these programs create a poverty trap. Explain how programs such as TANF, low-income EITC, SNAP, and Medicaid will affect individuals and whether or not you think these programs will benefit families and children. increases; 35. Think about the business cycle: during a recession, an unemployment expansionary phase. Explain what happens to TANF, SNAP, and Medicaid programs at each phase of the business cycle (recession, trough, expansion, and peak). decreases in it 36. Explain how a country may experience greater still equality in the distribution of experience high rates of poverty. Hint: Look at the Clear It Up "How do governments measure poverty in low-income countries?" and compare to Table 15.5. income, yet 37. The demand for skilled workers in the United States has been increasing. To increase the supply of skilled workers, many argue that immigration reform to allow more skilled labor into the United States is needed. Explain whether you agree or disagree. 38. Explain a situation using the supply and demand for skilled labor in which the increased number of college graduates leads to depressed wages. Given the rising cost of going to college, explain why a college education will or will not increase income inequality. 39. What do you think is more important to focus on when considering inequality: income inequality or wealth inequality? 40. To reduce income inequality, should the marginal tax rates on the top 1% be increased? tax and government 41. Redistribution of income federal programs. Explain whether or not redistribution redistribution should occur. income occurs through the antipoverty level of and whether more appropriate this is 42. How does a society or a country make the decision about the tradeoff between equality and economic output? Hint: Think about the political system. Explain what 43. short-term the consequences are of not promoting equality or working to
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reduce poverty. long- and This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 15 | Poverty and Economic Inequality 379 47. A group of 10 people have the following annual incomes: $55,000, $30,000, $15,000, $20,000, $35,000, $80,000, $40,000, $45,000, $30,000, $50,000. Calculate the share of total income each quintile of this income distribution received. Do the top and bottom quintiles in this distribution have a greater or larger share of total income than the top and bottom quintiles of the U.S. income distribution for 2005? PROBLEMS 44. In country A, the population is 300 million and 50 million people are living below the poverty line. What is the poverty rate? 45. In country B, the population is 900 million and 100 million people are living below the poverty line. What is the poverty rate? 46. Susan is a single mother with three children. She can earn $8 per hour and works up to 2,000 hours per year. However, if she does not earn any income at all, she will receive government benefits totaling $16,000 per year. For every $1 of income she earns, her level of government support will be reduced by $1. Create a table, patterned after Table 15.8. The first column should show Susan’s choices of how many hours to work per year, up to 2,000 hours. The second column should show her earnings from work. The third column should show her level of government support, given her earnings. The final column should show her total income, combining earnings and government support. 380 Chapter 15 | Poverty and Economic Inequality This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 381 16 | Information, Risk, and Insurance Figure 16.1 Former President Obama’s Health Care Reform The Patient Protection and Affordable Care Act has become a controversial topic—one which relates strongly to the topic of this chapter. (Credit: modification of work by Daniel Borman/Flickr Creative Commons) What’s the Big Deal with Obamacare? In August 2009, many members of the U.S. Congress used their summer recess to return to their home districts and hold
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town hall-style meetings to discuss President Obama’s proposed changes to the U.S. healthcare system. This was officially known as the Patient Protection and Affordable Care Act (PPACA) or as the Affordable Care Act (ACA), but was more popularly known as Obamacare. The bill’s opponents’ claims ranged from the charge that the changes were unconstitutional and would add $750 billion to the deficit, to extreme claims about the inclusion of things like the implantation of microchips and so-called “death panels” that decide which critically-ill patients receive care and which do not. Why did people react so strongly? After all, the intent of the law is to make healthcare insurance more affordable, to allow more people to obtain insurance, and to reduce the costs of healthcare. For each year from 2000 to 2011, these costs grew at least double the rate of inflation. In 2014, healthcare spending accounted for around 24% of all federal government spending. In the United States, we spend more for our healthcare than any other high-income nation, yet our health outcomes are worse than comparable high-income countries. In 2015, over 32 million people in the United States, about 12.8% of the non-elderly adult population, were without insurance. Even today, however, several years after the Act was signed into law and after the Supreme 382 Chapter 16 | Information, Risk, and Insurance Court mostly upheld it, a 2015 Kaiser Foundation poll found that 43% of likely voters viewed it unfavorably. Why is this? The debate over the ACA and healthcare reform could take an entire textbook, but what this chapter will do is introduce the basics of insurance and the problems insurance companies face. It is these problems, and how insurance companies respond to them that, in part, explain the ACA. Introduction to Information, Risk, and Insurance In this chapter, you will learn about: • The Problem of Imperfect Information and Asymmetric Information • Insurance and Imperfect Information Every purchase is based on a belief about the satisfaction that the good or service will provide. In turn, these beliefs are based on the information that the buyer has available. For many products, the information available to the buyer or the seller is imperfect or unclear, which can either make buyers regret past purchases or avoid making future ones. This chapter discusses how imperfect and asymmetric information affect markets. The first module of the chapter discusses how asymmetric information affects markets for goods, labor, and financial capital. When buyers have less
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information about the quality of the good (for example, a gemstone) than sellers do, sellers may be tempted to mislead buyers. If a buyer cannot have at least some confidence in the quality of what he or she is purchasing, then he or she will be reluctant or unwilling to purchase the products. Thus, we require mechanisms to bridge this information gap, so buyers and sellers can engage in a transaction. The second module of the chapter discusses insurance markets, which also face similar problems of imperfect information. For example, a car insurance company would prefer to sell insurance only to those who are unlikely to have auto accidents—but it is hard for the firm to identify those perfectly safe drivers. Conversely, car insurance buyers would like to persuade the auto insurance company that they are safe drivers and should pay only a low price for coverage. If insurance markets cannot find ways to grapple with these problems of imperfect information, then even people who have low or average risks of making claims may not be able to purchase insurance. The chapter on financial markets (markets for stocks and bonds) will show that the problems of imperfect information can be especially poignant. We cannot eliminate imperfect information, but we can often manage it. 16.1 | The Problem of Imperfect Information and Asymmetric Information By the end of this section, you will be able to: • Analyze the impact of both imperfect information and asymmetric information • Evaluate the role of advertisements in creating imperfect information • • Explain how imperfect information can affect price, quantity, and quality Identify ways to reduce the risk of imperfect information Consider a purchase that many people make at important times in their lives: buying expensive jewelry. In May 1994, celebrity psychologist Doree Lynn bought an expensive ring from a jeweler in Washington, D.C., which included an emerald that cost $14,500. Several years later, the emerald fractured. Lynn took it to another jeweler who found that cracks in the emerald had been filled with an epoxy resin. Lynn sued the original jeweler in 1997 for selling her a treated emerald without telling her, and won. The case publicized a number of little-known facts about precious stones. Most emeralds have internal flaws, and so they are soaked in clear oil or an epoxy resin to hide the flaws and make the color more deep and clear. Clear oil can leak out over time, and epoxy resin can discolor with age or heat. However, using clear oil or epoxy to “fill” emeralds is
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completely legal, as long as it is disclosed. After Doree Lynn’s lawsuit, the NBC news show “Dateline” bought emeralds at four prominent jewelry stores in New This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 383 York City in 1997. All the sales clerks at these stores, unaware that they were being recorded on a hidden camera, said the stones were untreated. When the emeralds were tested at a laboratory, however, technicians discovered they had all been treated with oil or epoxy. Emeralds are not the only gemstones that are treated. Diamonds, topaz, and tourmaline are also often irradiated to enhance colors. The general rule is that all treatments to gemstones should be revealed, but often sellers do not disclose this. As such, many buyers face a situation of asymmetric information, where two parties involved in an economic transaction have an unequal amount of information (one party knows much more than the other). Many economic transactions occur in a situation of imperfect information, where either the buyer, the seller, or both, are less than 100% certain about the qualities of what they are buying and selling. Also, one may characterize the transaction as asymmetric information, in which one party has more information than the other regarding the economic transaction. Let’s begin with some examples of how imperfect information complicates transactions in goods, labor, and financial capital markets. The presence of imperfect information can easily cause a decline in prices or quantities of products sold. However, buyers and sellers also have incentives to create mechanisms that will allow them to make mutually beneficial transactions even in the face of imperfect information. If you are unclear about the difference between asymmetric information and imperfect information, read the following Clear It Up feature. is the difference between imperfect and asymmetric What information? For a market to reach equilibrium sellers and buyers must have full information about the product’s price and quality. If there is limited information, then buyers and sellers may not be able to transact or will possibly make poor decisions. Imperfect information refers to the situation where buyers and/or sellers do not have all of the necessary information to make an informed decision about the product's price or quality. The term imperfect information simply means that the buyers and/or sellers do not have all the information necessary to make an informed decision. Asymmetric information is the condition where
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one party, either the buyer or the seller, has more information about the product's quality or price than the other party. In either case (imperfect or asymmetric information) buyers or sellers need remedies to make more informed decisions. “Lemons” and Other Examples of Imperfect Information Consider Marvin, who is trying to decide whether to buy a used car. Let’s assume that Marvin is truly clueless about what happens inside a car’s engine. He is willing to do some background research, like reading Consumer Reports or checking websites that offer information about used cars makes and models and what they should cost. He might pay a mechanic to inspect the car. Even after devoting some money and time collecting information, however, Marvin still cannot be absolutely sure that he is buying a high-quality used car. He knows that he might buy the car, drive it home, and use it for a few weeks before discovering that car is a “lemon,” which is slang for a defective product (especially a car). Imagine that Marvin shops for a used car and finds two that look very similar in terms of mileage, exterior appearances, and age. One car costs $4,000, while the other car costs $4,600. Which car should Marvin buy? If Marvin were choosing in a world of perfect information, the answer would be simple: he should buy the cheaper car. However, Marvin is operating in a world of imperfect information, where the sellers likely know more about the car’s problems than he does, and have an incentive to hide the information. After all, the more problems the sellers disclose, the lower the car’s selling price. What should Marvin do? First, he needs to understand that even with imperfect information, prices still reflect information. Typically, used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold. Those dealers try to fix problems that may not be obvious to their customers, in order to create good word of mouth about their vehicles’ long term reliability. The short term benefits of selling their customers a 384 Chapter 16 | Information, Risk, and Insurance “lemon” could cause a quick collapse in the dealer’s reputation and a loss of long term profits. On other lots that are less well-established, one can find cheaper used cars, but the buyer takes on more risk when a dealer’s reputation has little at stake. The cheapest cars of all often appear on Craigslist,
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where the individual seller has no reputation to defend. In sum, cheaper prices do carry more risk, so Marvin should balance his appetite for risk versus the potential headaches of many more unanticipated trips to the repair shop. Similar problems with imperfect information arise in labor and financial capital markets. Consider Greta, who is applying for a job. Her potential employer, like the used car buyer, is concerned about ending up with a “lemon”—in this case a poor quality employee. The employer will collect information about Greta’s academic and work history. In the end, however, a degree of uncertainty will inevitably remain regarding Greta’s abilities, which are hard to demonstrate without actually observing her on the job. How can a potential employer screen for certain attributes, such as motivation, timeliness, and ability to get along with others? Employers often look to trade schools and colleges to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and, sometimes, a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Employers may also seek references for insights into key attributes such as energy level and work ethic. How Imperfect Information Can Affect Equilibrium Price and Quantity The presence of imperfect information can discourage both buyers and sellers from participating in the market. Buyers may become reluctant to participate because they cannot determine the product's quality. Sellers of high-quality or medium-quality goods may be reluctant to participate, because it is difficult to demonstrate the quality of their goods to buyers—and since buyers cannot determine which goods have higher quality, they are likely to be unwilling to pay a higher price for such goods. Economists sometimes refer to a market with few buyers and few sellers as a thin market. By contrast, they call a market with many buyers and sellers a thick market. When imperfect information is severe and buyers and sellers are discouraged from participating, markets may become extremely thin as a relatively small number of buyer and sellers attempt to communicate enough information that they can agree on a price. When Price Mixes with Imperfect Information about Quality A buyer confronted with imperfect information will often believe that the price reveals something about the product's quality. For example, a buyer may assume that a gemstone or a used car that costs more must be of higher quality, even though the buyer is not an expert on gemstones. Think of the expensive restaurant where
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the food must be good because it is so expensive or the shop where the clothes must be stylish because they cost so much, or the gallery where the art must be great, because the price tags are high. If you are hiring a lawyer, you might assume that a lawyer who charges $400 per hour must be better than a lawyer who charges $150 per hour. In these cases, price can act as a signal of quality. When buyers use the market price to draw inferences about the products' quality, then markets may have trouble reaching an equilibrium price and quantity. Imagine a situation where a used car dealer has a lot full of used cars that do not seem to be selling, and so the dealer decides to cut the car prices to sell a greater quantity. In a market with imperfect information, many buyers may assume that the lower price implies low-quality cars. As a result, the lower price may not attract more customers. Conversely, a dealer who raises prices may find that customers assume that the higher price means that cars are of higher quality. As a result of raising prices, the dealer might sell more cars. (Whether or not consumers always behave rationally, as an economist would see it, is the subject of the following Clear It Up feature.) The idea that higher prices might cause a greater quantity demanded and that lower prices might cause a lower quantity demanded runs exactly counter to the basic model of demand and supply (as we outlined in the Demand and Supply chapter). These contrary effects, however, will reach natural limits. At some point, if the price is high enough, the quantity demanded will decline. Conversely, when the price declines far enough, buyers will increasingly find value even if the quality is lower. In addition, information eventually becomes more widely known. An overpriced restaurant that charges more than the quality of its food is worth to many buyers will not last forever. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 385 Is consumer behavior rational? There is much human behavior that mainstream economists have tended to call “irrational” since it is consistently at odds with economists’ utility maximizing models. The typical response is for economists to brush these behaviors aside and call them “anomalies” or unexplained quirks. “If only you knew more economics, you would not be so irrational,” is what many mainstream economists seem to be saying. A group known as behavioral economists
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has challenged this notion, because so much of this so-called “quirky” behavior is extremely common among us. For example, a conventional economist would say that if you lost a $10 bill today, and also received an extra $10 in your paycheck, you should feel perfectly neutral. After all, –$10 + $10 = $0. You are the same financially as you were before. However, behavioral economists have conducted research that shows many people will feel some negative emotion—anger or frustration—after those two things happen. We tend to focus more on the loss than the gain. Economists Daniel Kahneman and Amos Tversky in a famous 1979 Econometrica paper called this "loss aversion", where a $1 loss pains us 2.25 times more than a $1 gain helps us. This has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains. Behavioral economics also tries to explain why people make seemingly irrational decisions in the presence of different situations, or how they "frame" the decision. We outline a popular example here: Imagine you have the opportunity to buy an alarm clock for $20 in Store A. Across the street, you learn, is the exact same clock at Store B for $10. You might say it is worth your time—a five-minute walk—to save $10. Now, take a different example: You are in Store A buying a $300 phone. Five minutes away, at Store B, the same phone is $290. You again save $10 by taking a five-minute walk. Do you do it? Surprisingly, it is likely that you would not. Mainstream economists would say “$10 is $10” and that it would be irrational to make a five minute walk for $10 in one case and not the other. However, behavioral economists have pointed out that most of us evaluate outcomes relative to a reference point—here the cost of the product—and think of gains and losses as percentages rather than using actual savings. Which view is right? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain systematic behavior which some previously had dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place. Mechanisms to Reduce the Risk of Imperfect Information If you were selling a good like emerald
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s or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you? Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality. The labor market uses occupational licenses and certifications to assure competency, while the financial capital market uses cosigners and collateral as insurance against unforeseen, detrimental events. In the goods market, the seller might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail-order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it. L.L. Bean started using money-back-guarantees in 1911, when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, customers returned 90 pairs. L.L. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L.L. Bean offers a complete moneyback guarantee. Customers can always return anything they have bought from L.L. Bean, no matter how many years later or what condition the product is in, for a full money-back guarantee. 386 Chapter 16 | Information, Risk, and Insurance L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish. Visit this website (http://openstaxcollege.org/l/guarantee) to read about the origin of Eddie Bauer’s 100% customer satisfaction guarantee. Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain time period. The seller may also offer a buyer a chance to
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buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often an option for buyers of large purchases such as cars, appliances and even houses. Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the ticket cost to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied. The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others. As such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer’s market, where the buyer may never see the seller again. Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. The labor market also uses occupational licenses to establish quality in the labor market. Occupational licenses, which government agencies typically issue, show that a worker has completed a certain type of education or passed a certain test. Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archeologist. North Dakota has a state license for bait retailers. In Louisiana, one needs a state license to be a “stress analyst” and California requires a state license to be a furniture upholsterer. According to a 2013 study from the University of Chicago, about 29% of U.S. workers have jobs that require occupational licenses. Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice
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. In occupations that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 387 Are advertisers allowed to benefit from imperfect information? Many advertisements seem full of imperfect information—at least by what they imply. Driving a certain car, drinking a particular soda, or wearing a certain shoe are all unlikely to bring fashionable friends and fun automatically, if at all. The government rules on advertising, enforced by the Federal Trade Commission (FTC), allow advertising to contain a certain amount of exaggeration about the general delight of using a product. They, however, also demand that if one presents a claim as a fact, it must be true. Legally, deceptive advertising dates back to the 1950s when Colgate-Palmolive created a television advertisement that seemed to show Rapid Shave shaving cream being spread on sandpaper and then the sand was shaved off the sandpaper. What the television advertisement actually showed was sand sprinkled on Plexiglas—without glue—and then scraped aside by the razor. In the 1960s, in magazine advertisements for Campbell’s vegetable soup, the company was having problems getting an appetizing soup picture, because the vegetables kept sinking. To remedy this, they filled a bowl with marbles and poured the soup over the top, so that the bowl appeared to be crammed with vegetables. In the late 1980s, the Volvo Company filmed a television advertisement that showed a monster truck driving over cars, crunching their roofs—all except for the Volvo, which did not crush. However, the FTC found in 1991 that the Volvo's roof from the filming had been reinforced with an extra steel framework, while they cut the roof supports on the other car brands. The Wonder Bread Company ran television advertisements featuring “Professor Wonder,” who said that because Wonder Bread contained extra calcium, it would help children’s minds work better and improve their memory. The FTC objected, and in 2002 the company agreed to stop running the advertisements. As we can see in each of these cases, the Federal Trade Commission (FTC) often checks factual claims about the product’s performance, at least to some extent. Language and images that are exaggerated or ambiguous, but not actually false, are allowed in advertising. Untrue “facts” are not permitted. In any case, an old Latin
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saying applies when watching advertisements: Caveat emptor—that is, “let the buyer beware.” On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the employer can dismiss the worker for any reason or no reason after that time. Sometimes workers also receive lower pay during this trial period. In the financial capital market, before a bank makes a loan, it requires a prospective borrower to fill out forms regarding incomes sources. In addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Another approach is to require collateral, often property or equipment that the bank would have a right to seize and sell if borrower does not repay the loan. Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. However, the mechanisms that we mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed. 388 Chapter 16 | Information, Risk, and Insurance 16.2 | Insurance and Imperfect Information By the end of this section, you will be able to: Identify and evaluate various forms of government and social insurance • Explain how insurance works • • Discuss the problems caused by moral hazard and adverse selection • Analyze the impact of government regulation of insurance Insurance is a method that households and firms use to prevent any single event from having a significant detrimental financial effect. Generally, households or firms with insurance make regular payments, called premiums. The insurance company prices these premiums based on the probability of certain events occurring among a pool of people. Members of the group who then suffer a specified bad experience receive payments from this pool of money. Many people have several kinds of insurance: health insurance that pays when they receive medical care; car insurance that pays if their car is in an automobile accident; house or renter’s insurance that pays for stolen possessions or items damaged by fire; and life insurance, which pays for the family if the insured individual dies. Table 16.1
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lists a set of insurance markets. Type of Insurance Who Pays for It? It Pays Out When... Health insurance Employers and individuals Medical expenses are incurred Life insurance Employers and individuals Policyholder dies Automobile insurance Individuals Car is damaged, stolen, or causes damage to others Property and homeowner’s insurance Homeowners and renters Dwelling is damaged or burglarized Liability insurance Firms and individuals An injury occurs for which you are partly responsible Malpractice insurance Doctors, lawyers, and other professionals A poor quality of service is provided that causes harm to others Table 16.1 Some Insurance Markets All insurance involves imperfect information in both an obvious way and in a deeper way. At an obvious level, we cannot predict future events with certainty. For example, we cannot know with certainty who will have a car accident, become ill, die, or have his home robbed in the next year. Imperfect information also applies to estimating the risk that something will happen to any individual. It is difficult for an insurance company to estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident, because even within that group, some drivers will drive more safely than others. Thus, adverse events occur out of a combination of people’s characteristics and choices that make the risks higher or lower and then the good or bad luck of what actually happens. How Insurance Works A simplified example of automobile insurance might work this way. Suppose we divide a group of 100 drivers into three groups. In a given year, 60 of those people have only a few door dings or chipped paint, which costs $100 each. Another 30 of the drivers have medium-sized accidents that cost an average of $1,000 in damages, and 10 of the drivers have large accidents that cost $15,000 in damages. For the moment, let’s imagine that at the beginning of any year, there is no way of identifying the drivers who are low-risk, medium-risk, or high-risk. The total damage incurred by car accidents in this group of 100 drivers will be $186,000, that is: This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 389 Total damage = (60 × $100) + (30 × $1,000) + (10 × $15,000) = $6,000 + $30,000 +
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$150,000 = $186,000 If each of the 100 drivers pays a $1,860 premium each year, the insurance company will collect the $186,000 that is needed to cover the costs of the accidents that occur. Since insurance companies have such a large number of clients, they are able to negotiate with health care and other service providers for lower rates than the individual would be able to get, thus increasing the benefit to consumers of becoming insured and saving the insurance company itself money when it pays out claims. Insurance companies receive income, as Figure 16.2 shows, from insurance premiums and investment income. The companies derive income from investing the funds that insurance companies received in the past but did not pay out as insurance claims in prior years. The insurance company receives a rate of return from investing these funds or reserves. The companies typically invest in fairly safe, liquid (easy to convert into cash) investments, as the insurance companies need to be able to readily access these funds when a major disaster strikes. Figure 16.2 An Insurance Company: What Comes In, What Goes Out Money flows into an insurance company through premiums and investments and out through the payment of claims and operating expenses. Government and Social Insurance Federal and state governments run a number of insurance programs. Some of the programs look much like private insurance, in the sense that the members of a group make steady payments into a fund, and those in the group who suffer an adverse experience receive payments. Other programs protect against risk, but without an explicit fund set up. Following are some examples. • Unemployment insurance: Employers in every state pay a small amount for unemployment insurance, which goes into a fund to pay benefits to workers who lose their jobs and do not find new jobs, for a period of time, usually up to six months. • Pension insurance: Employers that offer pensions to their retired employees are required by law to pay a small fraction of what they are setting aside for pensions to the Pension Benefit Guarantee Corporation, which pays at least some pension benefits to workers if a company goes bankrupt and cannot pay the pensions it has promised. • Deposit insurance: Banks are required by law to pay a small fraction of their deposits to the Federal Deposit Insurance Corporation, which goes into a fund that pays depositors the value of their bank deposits up to $250,000 (the amount was raised from $100,000 to $250,000 in 2008) if the bank should go bankrupt. • Workman’s compensation insurance: Employers are required by law to pay a
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small percentage of the salaries that they pay into funds, typically run at the state level, that pay benefits to workers who suffer an injury on the job. • Retirement insurance: All workers pay a percentage of their income into Social Security and into Medicare, which then provides income and health care benefits to the elderly. Social Security and Medicare are not literally “insurance” in the sense that those currently contributing to the fund are not eligible for benefits. They function like insurance, however, in the sense that individuals make regular payments into the programs today in exchange for benefits they will receive in the case of a later event—either becoming old or becoming sick when old. A name for such programs is “social insurance.” The major additional costs to insurance companies, other than the payment of claims, are the costs of running a business: the administrative costs of hiring workers, administering accounts, and processing insurance claims. For most insurance companies, the insurance premiums coming in and the claims payments going out are much larger than the amounts earned by investing money or the administrative costs. 390 Chapter 16 | Information, Risk, and Insurance Thus, while factors like investment income earned on reserves, administrative costs, and groups with different risks complicate the overall picture, a fundamental law of insurance must hold true: The average person’s payments into insurance over time must cover 1) the average person’s claims, 2) the costs of running the company, and 3) leave room for the firm’s profits. Risk Groups and Actuarial Fairness Not all of those who purchase insurance face the same risks. Some people may be more likely, because of genetics or personal habits, to fall sick with certain diseases. Some people may live in an area where car theft or home robbery is more likely than in other areas. Some drivers are safer than others. We can define a risk group can be defined as a group that shares roughly the same risks of an adverse event occurring. Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks. If people are not separated into risk groups, then those with low risk must pay for those with high risks. In the simple example of how car insurance works, 60 drivers had very low damage of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. If all 100 of these drivers pay the same $1,860, then those with low damages are in effect
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paying for those with high damages. If it is possible to classify drivers according to risk group, then the insurance company can charge each group according to its expected losses. For example, the insurance company might charge the 60 drivers who seem safest of all $100 apiece, which is the average value of the damages they cause. Then the intermediate group could pay $1,000 apiece and the high-cost group $15,000 each. When the level of insurance premiums that someone pays is equal to the amount that an average person in that risk group would collect in insurance payments, the level of insurance is said to be “actuarially fair.” Classifying people into risk groups can be controversial. For example, if someone had a major automobile accident last year, should the insurance company classify that person as a high-risk driver who is likely to have similar accidents in the future, or as a low-risk driver who was just extremely unlucky? The driver is likely to claim to be low-risk, and thus someone who should be in a risk group with those who pay low insurance premiums in the future. The insurance company is likely to believe that, on average, having a major accident is a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two sections discuss the two major problems of imperfect information in insurance markets—called moral hazard and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk groups. The Moral Hazard Problem Moral hazard refers to the case when people engage in riskier behavior with insurance than they would if they did not have insurance. For example, if you have health insurance that covers the cost of visiting the doctor, you may be less likely to take precautions against catching an illness that might require a doctor’s visit. If you have car insurance, you will worry less about driving or parking your car in ways that make it more likely to get dented. In another example, a business without insurance might install absolute top-level security and fire sprinkler systems to guard against theft and fire. If it is insured, that same business might only install a minimum level of security and fire sprinkler systems. We cannot eliminate moral hazard, but insurance companies have some ways of reducing its effect. Investigations to prevent insurance fraud are one way of reducing the extreme cases of moral hazard. Insurance companies can also monitor certain kinds of behavior. To return to the example from above, they might offer a business a lower rate on property insurance if
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the business installs a top-level security and fire sprinkler system and has those systems inspected once a year. Another method to reduce moral hazard is to require the injured party to pay a share of the costs. For example, insurance policies often have deductibles, which is an amount that the insurance policyholder must pay out of his or her own pocket before the insurance coverage starts paying. For example, auto insurance might pay for all losses greater than $500. Health insurance policies often have a copayment, in which the policyholder must pay a small amount. For example, a person might have to pay $20 for each doctor visit, and the insurance company would cover the rest. Another method of cost sharing is coinsurance, which means that the insurance company covers a certain percentage of the cost. For example, insurance might pay for 80% of the costs of repairing a home after a fire, but the homeowner would pay the other 20%. All of these forms of cost sharing discourage moral hazard, because people know that they will have to pay something out of their own pocket when they make an insurance claim. The effect can be powerful. One prominent study found that when people face moderate deductibles and copayments for their health insurance, they consume about one-third This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 391 less in medical care than people who have complete insurance and do not pay anything out of pocket, presumably because deductibles and copayments reduce the level of moral hazard. However, those who consumed less health care did not seem to have any difference in health status. A final way of reducing moral hazard, which is especially applicable to health care, is to focus on healthcare provider incentives of providers rather than consumers. Traditionally, most health care in the United States has been provided on a fee-for-service basis, which means that medical care providers are paid for the services they provide and are paid more if they provide additional services. However, in the last decade or so, the structure of healthcare provision has shifted to an emphasis on health maintenance organizations (HMOs). A health maintenance organization (HMO) provides healthcare that receives a fixed amount per person enrolled in the plan—regardless of how many services are provided. In this case, a patient with insurance has an incentive to demand more care, but the healthcare provider, which is receiving only a fixed payment, has an incentive to
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reduce the moral hazard problem by limiting the quantity of care provided—as long as it will not lead to worse health problems and higher costs later. Today, many doctors are paid with some combination of managed care and fee-for-service; that is, a flat amount per patient, but with additional payments for the treatment of certain health conditions. Imperfect information is the cause of the moral hazard problem. If an insurance company had perfect information on risk, it could simply raise its premiums every time an insured party engages in riskier behavior. However, an insurance company cannot monitor all the risks that people take all the time and so, even with various checks and cost sharing, moral hazard will remain a problem. Visit this website (http://openstaxcollege.org/l/healtheconomics) to read about the relationship between health care and behavioral economics. The Adverse Selection Problem Adverse selection refers to the problem in which insurance buyers have more information about whether they are high-risk or low-risk than the insurance company does. This creates an asymmetric information problem for the insurance company because buyers who are high-risk tend to want to buy more insurance, without letting the insurance company know about their higher risk. For example, someone purchasing health insurance or life insurance probably knows more about their family’s health history than an insurer can reasonably find out even with a costly investigation. Someone purchasing car insurance may know that he or she are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect information about how people actually drive. To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. That would equal $186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at $1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only $100 will likely decide
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not to buy insurance; after all, it makes no sense for them to pay $1,860 per year when they are likely only to experience losses of $100. Those with medium risks of a $1,000 accident will not buy insurance either. Therefore, the insurance company ends up only selling insurance for $1,860 to high-risk drivers who will average $15,000 in claims apiece, and as 392 Chapter 16 | Information, Risk, and Insurance a consequence, the insurance company ends up losing considerable money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance. Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market at all. If an insurance market is to exist, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Another scenario is that those with low risks must buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry. U.S. Health Care in an International Context The United States is the only high-income country in the world where private firms pay and provide for most health insurance. Greater government involvement in the provision of health insurance is one possible way of addressing moral hazard and adverse selection problems. The moral hazard problem with health insurance is that when people have insurance, they will demand higher quantities of health care. In the United States, private healthcare insurance tends to encourage an ever-greater demand for healthcare services, which healthcare providers are happy to fulfill. Table 16.2 shows that on a per-person basis, U.S. healthcare spending towers above healthcare spending of other countries. Note that while healthcare expenditures in the United States are far higher than healthcare expenditures in other countries, the health outcomes in the United States, as measured by life expectancy and lower rates of childhood mortality, tend to be lower. Health outcomes, however, may not be significantly affected by healthcare expenditures. Many studies have shown that a country’s health is more closely related to diet, exercise, and genetic factors than to healthcare expenditure. This fact further emphasizes that
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