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the United States is spending very large amounts on medical care with little obvious health gain. In the U.S. health insurance market, the main way of solving this adverse selection problem is that health insurance is often sold through groups based on place of employment, or, under The Affordable Care Act, from a state government sponsored health exchange market. From an insurance company’s point of view, selling insurance through an employer mixes together a group of people—some with high risks of future health problems and some with lower risks—and thus reduces the insurance firm’s fear of attracting only those who have high risks. However, many small companies do not provide health insurance to their employees, and many lower-paying jobs do not include health insurance. Even after we take into account all U.S. government programs that provide health insurance for the elderly and the poor, approximately 32 million Americans were without health insurance in 2015. While a governmentcontrolled system can avoid the adverse selection problem entirely by providing at least basic health insurance for all, another option is to mandate that all Americans buy health insurance from some provider by preventing providers from denying individuals based on preexisting conditions. The Patient Protection and Affordable Care Act adopted this approach, which we will discuss later on in this chapter. Health Care Spending per Person (in 2008) $7,538 Country United States Germany $3,737 France $3,696 Male Life Expectancy at Birth, in Years (in 2012) Female Life Expectancy at Birth, in Years (in 2012) Male Chance of Dying before Age 5, per 1,000 (in 2012) Female Chance of Dying before Age 5, per 1,000 (in 2012) 76 78 78 81 83 85 8 4 4 7 4 4 Table 16.2 A Comparison of Healthcare Spending Across Select Countries (Source: 2010 OECD study and World Fact Book) This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 393 Country Health Care Spending per Person (in 2008) Male Life Expectancy at Birth, in Years (in 2012) Female Life Expectancy at Birth, in Years (in 2012) Male Chance of Dying before Age 5, per 1,000 (in 2012) Female Chance of Dying before Age 5, per 1,000 (in 2012) Canada $4,079 United Kingdom $3,129 79 78 84 83 6 5 5 4 Table 16.2 A Comparison of Healthcare Spending
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Across Select Countries (Source: 2010 OECD study and World Fact Book) At its best, the largely private U.S. system of health insurance and healthcare delivery provides an extraordinarily high quality of care, along with generating a seemingly endless parade of life-saving innovations. However, the system also struggles to control its high costs and to provide basic medical care to all. Other countries have lower costs and more equal access, but they often struggle to provide rapid access to health care and to offer the near-miracles of the most up-to-date medical care. The challenge is a healthcare system that strikes the right balance between quality, access, and cost. Government Regulation of Insurance The U.S. insurance industry is primarily regulated at the state level. Since 1871 there has been a National Association of Insurance Commissioners that brings together these state regulators to exchange information and strategies. The state insurance regulators typically attempt to accomplish two things: to keep the price of insurance low and to ensure that everyone has insurance. These goals, however, can conflict with each other and also become easily entangled in politics. If insurance premiums are set at actuarially fair levels, so that people end up paying an amount that accurately reflects their risk group, certain people will end up paying considerable amounts. For example, if health insurance companies were trying to cover people who already have a chronic disease like AIDS, or who were elderly, they would charge these groups very high premiums for health insurance, because their expected health care costs are quite high. Women in the age bracket 18–44 consume, on average, about 65% more in health care spending than men. Young male drivers have more car accidents than young female drivers. Thus, actuarially fair insurance would tend to charge young men much more for car insurance than young women. Because people in high-risk groups would find themselves charged so heavily for insurance, they might choose not to buy insurance at all. State insurance regulators have sometimes reacted by passing rules that attempt to set low premiums for insurance. Over time, however, the fundamental law of insurance must hold: the average amount individuals receive cannot exceed the average amount paid in premiums. When rules are passed to keep premiums low, insurance companies try to avoid insuring any high-risk or even medium-risk parties. If a state legislature passes strict rules requiring insurance companies to sell to everyone at low prices, the insurance companies always have the option of withdrawing from doing business in that state. For example, the insurance regulators in New Jersey are well-known for attempting to keep auto
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insurance premiums low, and more than 20 different insurance companies stopped doing business in the state in the late 1990s and early 2000s. Similarly, in 2009, State Farm announced that it was withdrawing from selling property insurance in Florida. In short, government regulators cannot force companies to charge low prices and provide high levels of insurance coverage—and thus take losses—for a sustained period of time. If insurance premiums are set below the actuarially fair level for a certain group, some other group will have to make up the difference. There are two other groups who can make up the difference: taxpayers or other insurance buyers. In some industries, the U.S. government has decided free markets will not provide insurance at an affordable price, and so the government pays for it directly. For example, private health insurance is too expensive for many people whose incomes are too low. To combat this, the U.S. government, together with the states, runs the Medicaid program, which provides health care to those with low incomes. Private health insurance also does not work well for the elderly, because their average health care costs can be very high. Thus, the U.S. government started the Medicare program, 394 Chapter 16 | Information, Risk, and Insurance which provides health insurance to all those over age 65. Other government-funded health-care programs are aimed at military veterans, as an added benefit, and children in families with relatively low incomes. Another common government intervention in insurance markets is to require that everyone buy certain kinds of insurance. For example, most states legally require car owners to buy auto insurance. Likewise, when a bank loans someone money to buy a home, the person is typically required to have homeowner’s insurance, which protects against fire and other physical damage (like hailstorms) to the home. A legal requirement that everyone must buy insurance means that insurance companies do not need to worry that those with low risks will avoid buying insurance. Since insurance companies do not need to fear adverse selection, they can set their prices based on an average for the market, and those with lower risks will, to some extent, end up subsidizing those with higher risks. However, even when laws are passed requiring people to purchase insurance, insurance companies cannot be compelled to sell insurance to everyone who asks—at least not at low cost. Thus, insurance companies will still try to avoid selling insurance to those with high risks whenever possible. The government cannot pass laws that make the problems of moral hazard and adverse selection disappear, but the government
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can make political decisions that certain groups should have insurance, even though the private market would not otherwise provide that insurance. Also, the government can impose the costs of that decision on taxpayers or on other buyers of insurance. The Patient Protection and Affordable Care Act In March of 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA). The government started to phase in this highly contentious law over time starting in October of 2013. The goal of the act is to bring the United States closer to universal coverage. Some of the key features of the plan include: • Individual mandate: All individuals, who do not receive health care through their employer or through a government program (for example, Medicare), are required to have health insurance or pay a fine. The individual mandate's goal was to reduce the adverse selection problem and keep prices down by requiring all consumers—even the healthiest ones—to have health insurance. Without the need to guard against adverse selection (whereby only the riskiest consumers buy insurance) by raising prices, health insurance companies could provide more reasonable plans to their customers. • Each state is required to have health insurance exchanges, or utilize the federal exchange, whereby insurance companies compete for business. The goal of the exchanges is to improve competition in the market for health insurance. • Employer mandate: All employers with more than 50 employees must offer health insurance to their employees. The Affordable Care Act (ACA) is funded through additional taxes that include: • Increasing the Medicare tax by 0.9 percent and adding a 3.8 percent tax on unearned income for high income taxpayers. • Charging an annual fee on health insurance providers. • Imposing other taxes such as a 2.3% tax on manufacturers and importers of certain medical devices. Many people and politicians, including Donald Trump, have sought to overturn the bill. Those who oppose the bill believe it violates an individual’s right to choose whether to have insurance or not. In 2012, a number of states challenged the law on the basis that the individual mandate provision is unconstitutional. In June 2012, the U.S. Supreme Court ruled in a 5–4 decision that the individual mandate is actually a tax, so it is constitutional as the federal government has the right to tax the populace. What’s the Big Deal with Obamacare? What is it that the Affordable Care Act (ACA) will actually do? To begin with, we should note that it is a massively complex law, with a large number of parts, some of which the Obama
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administration implemented immediately, and others that the government is supposed to phase in every year from 2013 through 2020. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 395 Three of these parts are coverage for the uninsured—those without health insurance, coverage for individuals with preexisting conditions, and the so-called employer and individual mandates, which require employers to offer and people to purchase health insurance. However, with the new Trump administration, the ACA is under scrutiny and many components face repeal or drastic overhauling. As we noted in the chapter, people face ever-increasing healthcare costs in the United States. Over the years, the ranks of the uninsured in the United States have grown as rising prices have pushed employers and individuals out of the market. Insurance companies have increasingly used pre-existing medical conditions to determine if someone is high risk, for whom insurance companies either charge higher prices, or they choose to deny insurance coverage to these individuals. Whatever the cause, we noted at the beginning of the chapter that prior to the ACA, more than 32 million Americans were uninsured. People who are uninsured tend to use emergency rooms for treatment—the most expensive form of healthcare, which has contributed significantly to rising costs. The ACA introduced regulations designed to control increases in healthcare costs. One example is a cap on the amount healthcare providers can spend on administrative costs. Another is a requirement that healthcare providers switch to electronic medical records (EMRs), which will reduce administrative costs. The ACA required that states establish health insurance exchanges, or markets, where people without health insurance, and businesses that do not provide it for their employees, can shop for different insurance plans. The purpose of these exchanges was to increase competition in insurance markets and thus reduce prices of policies. Finally, the ACA mandated that people with preexisting conditions could no longer be denied health insurance. The U.S. Department of Health and Human Services estimates that the those without insurance in the US has fallen from 20.3% in 2012 to 11.5% in 2016. Accordingly, 20 million Americans gained coverage under the ACA. What was the cost of this increased coverage and how was it paid? An insurance policy works by insuring against the possibility of needing healthcare. If there are high risk individuals in the insurance pool, the pool must be expanded to include enough low risk individuals to keep average premiums affordable. To that end, the ACA imposed the individual mandate, requiring all individuals to purchase insurance
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(or pay a penalty) whether they were high risk or not. Many young adults would choose to skip health insurance since the likelihood of their needing significant healthcare is small. The individual mandate brought in a significant amount of money to pay for the ACA. In addition, there were three other funding sources. The ACA took $716 billion which otherwise would have gone to Medicare spending. The ACA also increased the Medicare tax that wealthy Americans paid by an additional 0.9%. Furthermore, the government levied a 40% excess tax on high end (Cadillac) healthcare plans valued above a certain amount. Despite these funding sources, the Congressional Budget Office estimates that the ACA will increase the federal debt by $137 billion over the next decade. The impact of the Patient Protection and Affordable Care Act has been a rise in Americans with health the increased costs for those buying Premium (Cadillac) health insurance plans, insurance. However, increased tax on the wealthy, and increased deficit spending, the ACA faces substantial opposition. The Trump administration vowed to repeal it on the campaign trail but no alternative bill has made its way before congress. Only time will tell if the Affordable Care Act will leave a legacy or will quickly be swept by the wayside, jeopardizing the 20 million newly insured Americans. At the time of this writing, the final impact of the Patient Protection and Affordable Care Act is not clear. Millions of previously uninsured Americans now have coverage, but the increased cost of premium health insurance plans, increased Medicare tax on the wealthy and increased deficit spending have created significant political opposition. The Trump administration vowed to repeal the ACA, but his administration has not announced an alternative. Only time will tell. 396 Chapter 16 | Information, Risk, and Insurance KEY TERMS adverse selection when groups with inherently higher risks than the average person seek out insurance, thus straining the insurance system asymmetric information a situation where the seller or the buyer has more information than the other regarding the quality of the item for sale coinsurance when an insurance policyholder pays a percentage of a loss, and the insurance company pays the remaining cost collateral something valuable—often property or equipment—that a lender would have a right to seize and sell if the buyer does not repay the loan copayment when an insurance policyholder must pay a small amount for each service, before insurance covers the rest cosigner another person or firm who legally pledges to repay some or all of the money on a loan if the original borrower does not deductible an amount that the insurance policyholders must pay out of their own pocket before
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the insurance coverage pays anything fee-for-service when medical care providers are paid according to the services they provide health maintenance organization (HMO) an organization that provides health care and is paid a fixed amount per person enrolled in the plan—regardless of how many services are provided imperfect information a situation where either the buyer or the seller, or both, are uncertain about the qualities of what they are buying and selling insurance method of protecting a person from financial loss, whereby policy holders make regular payments to an insurance entity; the insurance firm then remunerates a group member who suffers significant financial damage from an event covered by the policy money-back guarantee a promise that the seller will refund the buyer’s money under certain conditions moral hazard occurring when people have insurance against a certain event, they are less likely to guard against that event occupational license licenses issued by government agencies, which indicate that a worker has completed a certain type of education or passed a certain test premium payment made to an insurance company risk group a group that shares roughly the same risks of an adverse event occurring service contract the buyer pays an extra amount and the seller agrees to fix anything specified in the contract that goes wrong for a set time period warranty a promise to fix or replace the good for a certain period of time KEY CONCEPTS AND SUMMARY 16.1 The Problem of Imperfect Information and Asymmetric Information Many make economic transactions in a situation of imperfect information, where either the buyer, the seller, or both This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 397 are less than 100% certain about the qualities of what they are buying or selling. When information about the quality of products is highly imperfect, it may be difficult for a market to exist. A “lemon” is a product that turns out, after the purchase, to have low quality. When the seller has more accurate information about the product's quality than the buyer, the buyer will be hesitant to buy, out of fear of purchasing a “lemon.” Markets have many ways to deal with imperfect information. In goods markets, buyers facing imperfect information about products may depend upon money-back guarantees, warranties, service contracts, and reputation. In labor markets, employers facing imperfect information about potential employees may turn to resumes, recommendations, occupational licenses for certain jobs, and employment for trial periods. In capital markets, lenders facing imperfect information about borrowers
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may require detailed loan applications and credit checks, cosigners, and collateral. 16.2 Insurance and Imperfect Information Insurance is a way of sharing risk. People in a group pay premiums for insurance against some unpleasant event, and those in the group who actually experience the unpleasant event then receive some compensation. The fundamental law of insurance is that what the average person pays in over time cannot be less than what the average person gets out. In an actuarially fair insurance policy, the premiums that a person pays to the insurance company are the same as the average amount of benefits for a person in that risk group. Moral hazard arises in insurance markets because those who are insured against a risk will have less reason to take steps to avoid the costs from that risk. Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount that the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A copayment is a flat fee that an insurance policy-holder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some of the costs before collecting insurance benefits. In a fee-for-service health financing system, medical care providers receive reimbursement according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers receive reimbursement according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than does the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly for them, while high-risk parties will embrace it because it looks like a good deal to them. SELF-CHECK QUESTIONS 1. For each of the following purchases, say whether you would expect the degree of imperfect information to be relatively high or relatively low: a. Buying apples at a roadside stand b. Buying dinner at the neighborhood restaurant around the corner c. Buying a used laptop computer at a garage sale d. Ordering flowers over the internet for your friend in a different city 2. Why is there asymmetric information in the labor market? What signals can an employer look for that might indicate
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the traits they are seeking in a new employee? 3. Why is it difficult to measure health outcomes? REVIEW QUESTIONS 4. Why might it be difficult for a buyer and seller to agree on a price when imperfect information exists? 5. What do economists (and used-car dealers) mean by a “lemon”? 6. What are some ways a seller of goods might reassure faced with imperfect a possible buyer who is information? 398 Chapter 16 | Information, Risk, and Insurance 13. How can moral hazard lead to more costly insurance premiums than one was expected? 14. Define deductibles, copayments, and coinsurance. How can 15. deductibles, coinsurance reduce moral hazard? copayments, and 16. What is the key difference between a fee-forservice healthcare system and a system based on health maintenance organizations? 17. How might adverse selection make it difficult for an insurance market to operate? 18. What are some of the metrics economists use to measure health outcomes? 21. How do you think the problem of moral hazard might have affected the safety of sports such as football and boxing when safety regulations started requiring that players wear more padding? 22. To what sorts of customers would an insurance company offer a policy with a high copay? What about a high premium with a lower copay? 7. What are some ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information? 8. What are some ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the borrower will repay the loan? 9. What is an insurance premium? 10. In an insurance system, would you expect each person to receive in benefits pretty much what they pay in premiums or is it just that the average benefits paid will equal the average premiums paid? 11. What is an actuarially fair insurance policy? 12. What is the problem of moral hazard? CRITICAL THINKING QUESTIONS 19. You are on the board of directors of a private high school, which is hiring new tenth-grade science teachers. As you think about hiring someone for a job, what are some mechanisms you might use to overcome the problem of imperfect information? 20. A website offers a place for people to buy and sell emeralds, but information about emeralds can be quite imperfect. The website then enacts a rule that all sellers in the market must pay for two independent examinations of
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their emerald, which are available to the customer for inspection. a. How would improved information to affect demand for emeralds on this website? b. How would improved information to affect the quantity of high-quality emeralds sold on the website? expect expect you you this this PROBLEMS 23. Using Exercise 16.20, sketch the effects in parts (a) and (b) on a single supply and demand diagram. What prediction would you make about how the improved information alters the equilibrium quantity and price? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 16 | Information, Risk, and Insurance 399 24. Imagine that you can divide 50-year-old men into two groups: those who have a family history of cancer and those who do not. For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year. The insurance company is selling a policy that will pay $100,000 to the estate of anyone who dies in the next year. a. If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group? If an insurance company were offering life insurance to the entire group, but could not find out about family cancer histories, what would be the actuarially fair premium for the group as a whole? b. c. What will happen to the insurance company if it tries to charge the actuarially fair premium to the group as a whole rather than to each group separately? 400 Chapter 16 | Information, Risk, and Insurance This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 401 17 | Financial Markets Figure 17.1 Building Home Equity Many people choose to purchase their home rather than rent. This chapter explores how the global financial crisis has influenced home ownership. (Credit: modification of work by Diana Parkhouse/Flickr Creative Commones) The Housing Bubble and the 2007 Financial Crisis In 2006, housing equity in the United States peaked at $13 trillion. That means that the market prices of homes, less what was still owed on the loans they used to buy these houses, equaled $13 trillion. This was a
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very good number, since the equity represented the value of the financial asset most U.S. citizens owned. However, by 2008 this number declined to $8.8 trillion, and it plummeted further still in 2009. Combined with the decline in value of other financial assets held by U.S. citizens, by 2010, U.S. homeowners’ wealth had shrunk $14 trillion! This is a staggering result, and it affected millions of lives: people had to alter their retirement, housing, and other important consumption decisions. Just about every other large economy in the world suffered a decline in the market value of financial assets, as a result of the 2008-2009 global financial crisis. This chapter will explain why people purchase houses (other than as a place to live), why they buy other types of financial assets, and why businesses sell those financial assets in the first place. The chapter will also give us insight into why financial markets and assets go through boom and bust cycles like the one we described here. Introduction to Financial Markets In this chapter, you will learn about: 402 Chapter 17 | Financial Markets • How Businesses Raise Financial Capital • How Households Supply Financial Capital • How to Accumulate Personal Wealth When a firm needs to buy new equipment or build a new facility, it often must go to the financial market to raise funds. Usually firms will add capacity during an economic expansion when profits are on the rise and consumer demand is high. Business investment is one of the critical ingredients needed to sustain economic growth. Even in the sluggish 2009 economy, U.S. firms invested $1.4 trillion in new equipment and structures, in the hope that these investments would generate profits in the years ahead. Between the end of the recession in 2009 through the second quarter 2013, profits for the S&P 500 companies grew to 9.7 % despite the weak economy, with cost cutting and reductions in input costs driving much of that amount, according to the Wall Street Journal. Figure 17.2 shows corporate profits after taxes (adjusted for inventory and capital consumption). Despite the steep decline in quarterly net profit in 2008, profits have recovered and surpassed pre-recession levels. Figure 17.2 Corporate Profits After Tax (Adjusted for Inventory and Capital Consumption) Prior to 2008, corporate profits after tax more often than not increased each year. There was a significant drop in profits during 2008 and into 2009. The profit trend has since continued to increase each year, though at a less steady or consistent rate. (Source: Federal Reserve Economic Data (
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FRED) https://research.stlouisfed.org/fred2/series/CPATAX) Many firms, from huge companies like General Motors to startup firms writing computer software, do not have the financial resources within the firm to make all the desired investments. These firms need financial capital from outside investors, and they are willing to pay interest for the opportunity to obtain a rate of return on the investment for that financial capital. On the other side of the financial capital market, financial capital suppliers, like households, wish to use their savings in a way that will provide a return. Individuals cannot, however, take the few thousand dollars that they save in any given year, write a letter to General Motors or some other firm, and negotiate to invest their money with that firm. Financial capital markets bridge this gap: that is, they find ways to take the inflow of funds from many separate financial capital suppliers and transform it into the funds of financial capital demanders desire. Such financial markets include stocks, bonds, bank loans, and other financial investments. Visit this website (http://openstaxcollege.org/l/marketoverview) to read more about financial markets. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 403 Our perspective then shifts to consider how these financial investments appear to capital suppliers such as the households that are saving funds. Households have a range of investment options: bank accounts, certificates of deposit, money market mutual funds, bonds, stocks, stock and bond mutual funds, housing, and even tangible assets like gold. Finally, the chapter investigates two methods for becoming rich: a quick and easy method that does not work very well at all, and a slow, reliable method that can work very well over a lifetime. 17.1 | How Businesses Raise Financial Capital By the end of this section, you will be able to: • Describe financial capital and how it relates to profits • Discuss the purpose and process of borrowing, bonds, and corporate stock • Explain how firms choose between sources of financial capital Firms often make decisions that involve spending money in the present and expecting to earn profits in the future. Examples include when a firm buys a machine that will last 10 years, or builds a new plant that will last for 30 years, or starts a research and development project. Firms can raise the financial capital they need to pay for such projects in four main ways: (1)
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from early-stage investors; (2) by reinvesting profits; (3) by borrowing through banks or bonds; and (4) by selling stock. When business owners choose financial capital sources, they also choose how to pay for them. Early-Stage Financial Capital Firms that are just beginning often have an idea or a prototype for a product or service to sell, but few customers, or even no customers at all, and thus are not earning profits. Such firms face a difficult problem when it comes to raising financial capital: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors? For many small businesses, the original source of money is the business owner. Someone who decides to start a restaurant or a gas station, for instance, might cover the startup costs by dipping into his or her own bank account, or by borrowing money (perhaps using a home as collateral). Alternatively, many cities have a network of well-todo individuals, known as “angel investors,” who will put their own money into small new companies at an early development stage, in exchange for owning some portion of the firm. Venture capital firms make financial investments in new companies that are still relatively small in size, but that have potential to grow substantially. These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds. Venture capital firms do more than just supply money to small startups. They also provide advice on potential products, customers, and key employees. Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund as a whole performs. The amount of money invested in venture capital fluctuates substantially from year to year: as one example, venture capital firms invested more than $48.3 billion in 2014, according to the National Venture Capital Association. All early-stage investors realize that the majority of small startup businesses will never hit it big; many of them will go out of business within a few months or years. They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon.com can make up for multiple failures. Therefore, early-stage investors are willing to take large risks in order to position themselves to gain substantial returns on their investment. 404 Chapter 17 | Financial Markets Profits as a Source of Financial Capital If firms are earning profits (their revenues are greater than costs
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), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable financial capital source so that it can continue making real investments in tough times, the firm may not survive until better times arrive. Firms often need to find financial capital sources other than profits. Borrowing: Banks and Bonds When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money. Firms have two main borrowing methods: banks and bonds. A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments. Another source of financial capital is a bond. A bond is a financial contract: a borrower agrees to repay the amount that it borrowed and also an interest rate over a period of time in the future. A corporate bond is issued by firms, but bonds are also issued by various levels of government. For example, a municipal bond is issued by cities, a state bond by U.S. states, and a Treasury bond by the federal government through the U.S. Department of the Treasury. A bond specifies an amount that one will borrow, the interest rate that one will pay, and the time until repayment. A large company, for example, might issue bonds for $10 million. The firm promises to make interest payments at an annual rate of 8%, or $800,000 per year and then, after 10 years, will repay the $10 million it originally borrowed. When a firm issues bonds, the total amount it divides. A firm seeks to borrow $50 million by issuing bonds, might actually issue 10,000 bonds of $5,000 each. In this way, an individual investor could, in effect, loan the firm $5,
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000, or any multiple of that amount. Anyone who owns a bond and receives the interest payments is called a bondholder. If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee the firm will have sufficient assets to pay off the bonds. The bondholders may recoup only a portion of what it loaned the firm. Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms. The bank can get to know the firm extremely well—often because the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals. Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, or to raise capital to pay off old bonds, or to buy other firms. However, the idea that firms or individuals use banks for relatively smaller loans and bonds for larger loans is not an ironclad rule: sometimes groups of banks make large loans and sometimes relatively small and lesser-known firms issue bonds. Corporate Stock and Public Firms A corporation is a business that “incorporates”—that is owned by shareholders that have limited liability for the company's debt but share in its profits (and losses). Corporations may be private or public, and may or may not have publicly traded stock. They may raise funds to finance their operations or new investments by raising capital through selling stock or issuing bonds. Those who buy the stock become the firm's owners, or shareholders. Stock represents firm ownership; that is, a person who owns 100% of a company’s stock, by definition, owns the entire company. The company's stock is divided into shares. Corporate giants like IBM, AT&T, Ford, General Electric, Microsoft, Merck, and Exxon all have millions of stock shares. In most large and well-known firms, no individual owns a majority of the stock shares. Instead, large numbers of shareholders—even those who hold thousands of shares—each have only a small slice of the firm's overall ownership. When a large number of shareholders own a company, there are three questions to ask: 1. How and when does the company obtain money from its sale? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets
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405 2. What rate of return does the company promise to pay when it sells stock? 3. Who makes decisions in a company owned by a large number of shareholders? First, a firm receives money from the stock sale only when the company sells its own stock to the public (the public includes individuals, mutual funds, insurance companies, and pension funds). We call a firm’s first stock sale to the public an initial public offering (IPO). The IPO is important for two reasons. For one, the IPO, and any stock issued thereafter, such as stock held as treasury stock (shares that a company keeps in their own treasury) or new stock issued later as a secondary offering, provides the funds to repay the early-stage investors, like the angel investors and the venture capital firms. A venture capital firm may have a 40% ownership in the firm. When the firm sells stock, the venture capital firm sells its part ownership of the firm to the public. A second reason for the importance of the IPO is that it provides the established company with financial capital for substantially expanding its operations. However, most of the time when one buys and sells corporate stock the firm receives no financial return at all. If you buy General Motors stock, you almost certainly buy them from the current share owner, and General Motors does not receive any of your money. This pattern should not seem particularly odd. After all, if you buy a house, the current owner receives your money, not the original house builder. Similarly, when you buy stock shares, you are buying a small slice of the firm's ownership from the existing owner—and the firm that originally issued the stock is not a part of this transaction. Second, when a firm decides to issue stock, it must recognize that investors will expect to receive a rate of return. That rate of return can come in two forms. A firm can make a direct payment to its shareholders, called a dividend. Alternatively, a financial investor might buy a share of stock in Wal-Mart for $45 and then later sell it to someone else for $60, for $15 gain. We call the increase in the stock value (or of any asset) between when one buys and sells it a capital gain. Third: Who makes the decisions about when a firm will issue stock, or pay dividends, or re-invest profits? To understand the answers to these questions, it is useful to separate firms into two groups: private and public. A private company is owned by the people who run it on
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a day-to-day basis. Individuals can run a private company. We call this a sole proprietorship. If a group runs it, we call it a partnership. A private company can also be a corporation, but with no publicly issued stock. A small law firm run by one person, even if it employs some other lawyers, would be a sole proprietorship. Partners may jointly own a larger law firm. Most private companies are relatively small, but there are some large private corporations, with tens of billions of dollars in annual sales, that do not have publicly issued stock, such as farm products dealer Cargill, the Mars candy company, and the Bechtel engineering and construction firm. When a firm decides to sell stock, which financial investors can buy and sell, we call it a public company. Shareholders own a public company. Since the shareholders are a very broad group, often consisting of thousands or even millions of investors, the shareholders vote for a board of directors, who in turn hire top executives to run the firm on a day-to-day basis. The more stock a shareholder owns, the more votes that shareholder is entitled to cast for the company’s board of directors. In theory, the board of directors helps to ensure that the firm runs in the interests of the true owners—the shareholders. However, the top executives who run the firm have a strong voice in choosing the candidates who will serve on their board of directors. After all, few shareholders are knowledgeable enough or have enough personal incentive to spend energy and money nominating alternative board members. How Firms Choose between Financial Capital Sources There are clear patterns in how businesses raise financial capital. We can explain these patterns in terms of imperfect information, which as we discussed in Information, Risk, and Insurance, is a situation where buyers and sellers in a market do not both have full and equal information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital. Any young startup firm is a risk. Some startup firms are only a little more than an idea on paper. The firm’s founders inevitably have better information about how hard they are willing to work, and whether the firm is likely to succeed, than anyone else. When the founders invested their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to overcome the imperfect information, at least in part, by knowing the managers
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and their business plan personally and by giving them advice. 406 Chapter 17 | Financial Markets Accurate information is sometimes not available because corporate governance, the name economists give to the institutions that are supposed to watch over top executives, fails, as the following Clear It Up feature on Lehman Brothers shows. How did lack of corporate governance lead to the Lehman Brothers failure? In 2008, Lehman Brothers was the fourth largest U.S. investment bank, with 25,000 employees. The firm had been in business for 164 years. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. There are many causes of the Lehman Brothers failure. One area of apparent failure was the lack of oversight by the Board of Directors to keep managers from undertaking excessive risk. We can attribute part of the oversight failure, according to Tim Geithner’s April 10, 2010, testimony to Congress, to the Executive Compensation Committee’s emphasis on short-term gains without enough consideration of the risks. In addition, according to the court examiner’s report, the Lehman Brother’s Board of Directors paid too little attention to the details of the operations of Lehman Brothers and also had limited financial service experience. The board of directors, elected by the shareholders, is supposed to be the first line of corporate governance and oversight for top executives. A second institution of corporate governance is the auditing firm the company hires to review the company's financial records and certify that everything looks reasonable. A third institution of corporate governance is outside investors, especially large shareholders like those who invest large mutual funds or pension funds. In the case of Lehman Brothers, corporate governance failed to provide investors with accurate financial information about the firm’s operations. As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important, because information has become more widely available regarding the company’s products, revenues, costs, and profits. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm. At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing
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money is that the firm maintains control of its operations and is not subject to shareholders. Issuing stock involves selling off company ownership to the public and becoming responsible to a board of directors and the shareholders. The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about repaying this money. If the firm is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing and placing stock is expensive, requires the expertise of investment bankers and attorneys, and entails compliance with reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission (SEC). 17.2 | How Households Supply Financial Capital By the end of this section, you will be able to: • Show the relationship between savers, banks, and borrowers • Calculate bond yield • Contrast bonds, stocks, mutual funds, and assets • Explain the tradeoffs between return and risk This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 407 The ways in which firms would prefer to raise funds are only half the story of financial markets. The other half is what those households and individuals who supply funds desire, and how they perceive the available choices. The focus of our discussion now shifts from firms on the demand side of financial capital markets to households on the supply side of those markets. We can divide the mechanisms for savings available to households into several categories: deposits in bank accounts; bonds; stocks; money market mutual funds; stock and bond mutual funds; and housing and other tangible assets like owning gold. We need to analyze each of these investments in terms of three factors: (1) the expected rate of return it will pay; (2) the risk that the return will be much lower or higher than expected; and (3) the investment's liquidity, which refers to how easily one can exchange money or financial assets for a good or service. We will do this analysis as we discuss each of these investments in the sections below. First, however, we need to understand the difference between expected rate of return, risk, and actual rate of return. Expected Rate of Return, Risk, and Actual Rate of Return The expected rate of return refers to how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability
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. It is usually the average return over a period of time, usually in years or even decades. We normally measure it as a percentage rate. Risk measures the uncertainty of that project’s profitability. There are several types of risk, including default risk and interest rate risk. Default risk, as its name suggests, is the risk that the borrower fails to pay back the bond or loan. Interest rate risk is the danger that you might buy a long term bond at a 6% interest rate right before market rates suddenly rise, so had you waited, you could have received a similar bond that paid 9%. A high-risk investment is one for which a wide range of potential payoffs is reasonably probable. A low-risk investment may have actual returns that are fairly close to its expected rate of return year after year. A high-risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years. The actual rate of return refers to the total rate of return, including capital gains and interest paid on an investment at the end of a time period. Bank Accounts An intermediary is one who stands between two other parties. For example, a person who arranges a blind date between two other people is one kind of intermediary. In financial capital markets, banks are an example of a financial intermediary—that is, an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank. When a bank serves as a financial intermediary, unlike the situation with a couple on a blind date, the saver and the borrower never meet. In fact, it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks, because all deposited funds end up in one big pool, which the financial institution then lends out. Figure 17.3 illustrates the position of banks as a financial intermediary, with a pattern of deposits flowing into a bank and loans flowing out, and then repayment of the loans flowing back to the bank, with interest payments for the original savers. Figure 17.3 Banks as Financial Intermediaries Banks are a financial intermediary because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks, and repay the loans with interest. Banks offer a range of accounts to serve different needs. A checking account typically pays little or no interest, but 408 Chapter 17 |
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Financial Markets it facilitates transactions by giving you easy access to your money, either by writing a check or by using a debit card (that is, a card which works like a credit card, except that purchases are immediately deducted from your checking account rather than billed separately through a credit card company). A savings account typically pays some interest rate, but getting the money typically requires you to make a trip to the bank or an automatic teller machine (or you can access the funds electronically). The lines between checking and savings accounts have blurred in the last couple of decades, as many banks offer checking accounts that will pay an interest rate similar to a savings account if you keep a certain minimum amount in the account, or conversely, offer savings accounts that allow you to write at least a few checks per month. Another way to deposit savings at a bank is to use a certificate of deposit (CD). With a CD, you agree to deposit a certain amount of money, often measured in thousands of dollars, in the account for a stated period of time, typically ranging from a few months to several years. In exchange, the bank agrees to pay a higher interest rate than for a regular savings account. While you can withdraw the money before the allotted time, as the advertisements for CDs always warn, there is “a substantial penalty for early withdrawal.” Figure 17.4 shows the annual rate of interest paid on a six-month, one-year, and five-year CD since 1984, as reported by Bankrate.com. The interest rates that savings accounts pay are typically a little lower than the CD rate, because financial investors need to receive a slightly higher rate of interest as compensation for promising to leave deposits untouched for a period of time in a CD, and thus forfeiting some liquidity. Figure 17.4 Interest Rates on Six-Month, One-Year, and Five-Year Certificates of Deposit The interest rates on certificates of deposit have fluctuated over time. The high interest rates of the early 1980s are indicative of the relatively high inflation rate in the United States at that time. Interest rates fluctuate with the business cycle, typically increasing during expansions and decreasing during a recession. Note the steep decline in CD rates since 2008, the beginning of the Great Recession. The great advantages of bank accounts are that financial investors have very easy access to their money, and also money in bank accounts is extremely safe. In part, this safety arises because a bank account offers more security than keeping a few thousand dollars in the toe of a sock
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in your underwear drawer. In addition, the Federal Deposit Insurance Corporation (FDIC) protects the savings of the average person. Every bank is required by law to pay a fee to the FDIC, based on the size of its deposits. Then, if a bank should go bankrupt and not be able to repay depositors, the FDIC guarantees that all customers will receive their deposits back up to $250,000. The bottom line on bank accounts looks like this: low risk means low rate of return but high liquidity. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 409 Bonds An investor who buys a bond expects to receive a rate of return. However, bonds vary in the rates of return that they offer, according to the riskiness of the borrower. We always can divide an interest rate into three components (as we explained in Choice in a World of Scarcity): compensation for delaying consumption, an adjustment for an inflationary rise in the overall level of prices, and a risk premium that takes the borrower’s riskiness into account. The U.S. government is an extremely safe borrower, so when the U.S. government issues Treasury bonds, it can pay a relatively low interest rate. Firms that appear to be safe borrowers, perhaps because of their sheer size or because they have consistently earned profits over time, will still pay a higher interest rate than the U.S. government. Firms that appear to be riskier borrowers, perhaps because they are still growing or their businesses appear shaky, will pay the highest interest rates when they issue bonds. We call bonds that offer high interest rates to compensate for their relatively high chance of default high yield bonds or junk bonds. A number of today’s well-known firms issued junk bonds in the 1980s when they were starting to grow, including Turner Broadcasting and Microsoft. Visit this website (http://openstaxcollege.org/l/bondsecurities) to read about Treasury bonds. A bond issued by the U.S. government or a large corporation may seem to be relatively low risk: after all, the bond issuer has promised to make certain payments over time, and except for rare bankruptcy cases, these payments will occur. If a corporate bond issuer fails to make the payments that it owes to its bondholders, the bondholders can require that the company declare bankruptcy, sell off its assets, and pay them as much as it can.
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Even in the case of junk bonds, a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since, even if a few firms go broke and do not pay, they are not all likely to go bankrupt. As we noted before, bonds carry an interest rate risk. For example, imagine you decide to buy a 10-year bond that would pay an annual interest rate of 8%. Soon after you buy the bond, interest rates on bonds rise, so that now similar companies are paying an annual rate of 12%. Anyone who buys a bond now can receive annual payments of $120 per year, but since your bond was issued at an interest rate of 8%, you have tied up $1,000 and receive payments of only $80 per year. In the meaningful sense of opportunity cost, you are missing out on the higher payments that you could have received. Furthermore, you can calculate the amount you should be willing to pay now for future payments. To place a present discounted value on a future payment, decide what you would need in the present to equal a certain amount in the future. This calculation will require an interest rate. For example, if the interest rate is 25%, then a payment of $125 a year from now will have a present discounted value of $100—that is, you could take $100 in the present and have $125 in the future. (We discuss this further in the appendix on Present Discounted Value.) In financial terms, a bond has several parts. A bond is basically an “I owe you” note that an investor receives in exchange for capital (money). The bond has a face value. This is the amount the borrower agrees to pay the investor at maturity. The bond has a coupon rate or interest rate, which is usually semi-annual, but can be paid at different times throughout the year. (Bonds used to be paper documents with coupons that investors clipped and turned in to the bank to receive interest.) The bond has a maturity date when the borrower will pay back its face value as well as its last interest payment. Combining the bond’s face value, interest rate, and maturity date, and market interest rates, allows a buyer to compute a bond’s present value, which is the most that a buyer would be willing to pay for a given bond. This may or may not be the same as the face value. The bond yield measures the rate of return a bond is expected to pay over time. Investors can buy
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bonds when they are issued and they can buy and sell them during their lifetimes. When buying a bond that has been around for a few 410 Chapter 17 | Financial Markets years, investors should know that the interest rate printed on a bond is often not the same as the bond yield, even on new bonds. Read the next Work It Out feature to see how this happens. Calculating the Bond Yield You have bought a $1,000 bond whose coupon rate is 8%. To calculate your return or yield, follow these steps: 1. Assume the following: Face value of a bond: $1,000 Coupon rate: 8 % Annual payment: $80 per year 2. Consider the risk of the bond. If this bond carries no risk, then it would be safe to assume that the bond will sell for $1,000 when it is issued and pay the purchaser $80 per year until its maturity, at which time the final interest payment will be made and the original $1,000 will be repaid. Now, assume that over time the interest rates prevailing in the economy rise to 12% and that there is now only one year left to this bond’s maturity. This makes the bond an unattractive investment, since an investor can find another bond that perhaps pays 12%. To induce the investor to buy the 8% bond, the bond seller will lower its price below its face value of $1,000. 3. Calculate the bond's price when its interest rate is less than the market interest rate. The expected payments from the bond one year from now are $1,080, because in the bond’s last year the bond's issuer will make the final interest payment and then also repay the original $1,000. Given that interest rates are now 12%, you know that you could invest $964 in an alternative investment and receive $1,080 a year from now; that is, $964(1 + 0.12) = $1080. Therefore, you will not pay more than $964 for the original $1,000 bond. 4. Consider that the investor will receive the $1,000 face value, plus $80 for the last year’s interest payment. The yield on the bond will be ($1080 – $964)/$964 = 12%. The yield, or total return, means interest payments, plus capital gains. Note that the interest or coupon rate of 8% did not change. When interest rates rise, bonds previously issued
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at lower interest rates will sell for less than face value. Conversely, when interest rates fall, bonds previously issued at higher interest rates will sell for more than face value. Figure 17.5 shows bond yield for two kinds of bonds: 10-year Treasury bonds (which are officially called “notes”) and corporate bonds issued by firms that have been given an AAA rating as relatively safe borrowers by Moody’s, an independent firm that publishes such ratings. Even though corporate bonds pay a higher interest rate, because firms are riskier borrowers than the federal government, the rates tend to rise and fall together. Treasury bonds typically pay more than bank accounts, and corporate bonds typically pay a higher interest rate than Treasury bonds. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 411 Figure 17.5 Interest Rates for Corporate Bonds and Ten-Year U.S. Treasury Bonds The interest rates for corporate bonds and U.S. Treasury bonds (officially “notes”) rise and fall together, depending on conditions for borrowers and lenders in financial markets for borrowing. The corporate bonds always pay a higher interest rate, to make up for the higher risk they have of defaulting compared with the U.S. government. The bottom line for bonds: rate of return—low to moderate, depending on the borrower's risk; risk—low to moderate, depending on whether interest rates in the economy change substantially after the bond is issued; liquidity—moderate, because the investor needs to sell the bond before the investor regains the cash. Stocks As we stated earlier, the rate of return on a financial investment in a share of stock can come in two forms: as dividends paid by the firm and as a capital gain achieved by selling the stock for more than you paid. The range of possible returns from buying stock is mind-bending. Firms can decide to pay dividends or not. A stock price can rise to a multiple of its original price or sink all the way to zero. Even in short periods of time, well-established companies can see large movements in their stock prices. For example, in July 1, 2011, Netflix stock peaked at $295 per share; one year later, on July 30, 2012, it was at $53.91 per share; in 2015, it had recovered to $414. When Facebook went public, its shares of stock sold for around $40 per share, but in 2015,
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they were selling for slightly over $83. We will discuss the reasons why stock prices fall and rise so abruptly below, but first you need to know how we measure stock market performance. There are a number of different ways to measure the overall performance of the stock market, based on averaging different subsets of companies' stock prices. Perhaps the best-known stock market measure is the Dow Jones Industrial Average, which is based on 30 large U.S. companies' stock prices. Another stock market performance gauge, the Standard & Poor’s 500, follows the stock prices of the 500 largest U.S. companies. The Wilshire 5000 tracks the stock prices of essentially all U.S. companies that have stock the public can buy and sell. Other stock market measures focus on where stocks are traded. For example, the New York Stock Exchange monitors the performance of stocks that are traded on that exchange in New York City. The Nasdaq stock market includes about 3,600 stocks, with a concentration of technology stocks. Table 17.1 lists some of the most commonly cited measures of U.S. and international stock markets. Measure of the Stock Market Comments Dow Jones Industrial Average (DJIA): http://indexes.dowjones.com Based on 30 large companies from a diverse set of representative industries, chosen by analysts at Dow Jones and Company. The index was started in 1896. Table 17.1 Some Stock Market Measures 412 Chapter 17 | Financial Markets Measure of the Stock Market Comments Standard & Poor’s 500: http://www.standardandpoors.com Based on 500 large U.S. firms, chosen by analysts at Standard & Poor’s to represent the economy as a whole. Wilshire 5000: http://www.wilshire.com Includes essentially all U.S. companies with stock ownership. Despite the name, this index includes about 7,000 firms. New York Stock Exchange: http://www.nyse.com The oldest and largest U.S. stock market, dating back to 1792. It trades stocks for 2,800 companies of all sizes. It is located at 18 Broad St. in New York City. NASDAQ: http://www.nasdaq.com Founded in 1971 as an electronic stock market, allowing people FTSE: http://www.ftse.com Nikkei: http://www.nikkei.co.jp/ nikkeiinfo/en/ DAX: http://www.exchange.de to
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buy or sell from many physical locations. It has about 3,600 companies. Includes the 100 largest companies on the London Stock Exchange. Pronounced “footsie.” Originally stood for Financial Times Stock Exchange. Nikkei stands for Nihon Keizai Shimbun, which translates as the Japan Economic Journal, a major business newspaper in Japan. Index includes the 225 largest and most actively traded stocks on the Tokyo Stock Exchange. Tracks 30 of the largest companies on the Frankfurt, Germany, stock exchange. DAX is an abbreviation for Deutscher Aktien Index (German Stock Index). Table 17.1 Some Stock Market Measures The trend in the stock market is generally up over time, but with some large dips along the way. Figure 17.6 shows the path of the Standard & Poor’s 500 index (which is measured on the left-hand vertical axis) and the Dow Jones Index (which is measured on the right-hand vertical axis). Broad stock market measures, like the ones we list here, tend to move together. The S&P 500 Index is the weighted average market capitalization of the firms selected to be in the index. The Dow Jones Industrial Average is the price weighted average of 30 industrial stocks tracked on the New York Stock Exchange. When the Dow Jones average rises from 5,000 to 10,000, you know that the average price of the stocks in that index has roughly doubled. Figure 17.6 shows that stock prices did not rise much in the 1970s, but then started a steady climb in the 1980s. From 2000 to 2013, stock prices bounced up and down, but ended up at about the same level. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 413 Figure 17.6 The Dow Jones Industrial Index and the Standard & Poor’s 500, 1965–2017 Stock prices rose dramatically from the 1980s up to about 2000. From 2000 to 2013, stock prices bounced up and down, but ended up at about the same level. Table 17.2 shows the total annual rate of return an investor would have received from buying the stocks in the S&P 500 index over recent decades. The total return here includes both dividends paid by these companies and also capital gains arising from increases in the stock value. (For technical reasons related to how we calculate the numbers, the dividends and capital gains do not add exactly to the total return.)
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From the 1950s to the 1980s, the average firm paid annual dividends equal to about 4% of its stock value. Since the 1990s, dividends have dropped and now often provide a return closer to 1% to 2%. In the 1960s and 1970s, the gap between percent earned on capital gains and dividends was much closer than it has been since the 1980s. In the 1980s and 1990s, capital gains were far higher than dividends. In the 2000s, dividends remained low and, while stock prices fluctuated, they ended the decade roughly where they had started. Period Total Annual Return Capital Gains Dividends 1950–1959 19.25% 1960–1969 1970–1979 1980–1989 1990–1999 2000–2009 7.78% 5.88% 17.55% 18.21% −1.00% 13.58% 4.39% 1.60% 12.59% 15.31% −2.70% 4.99% 3.25% 4.20% 4.40% 2.51% 1.70% Table 17.2 Annual Returns on S&P 500 Stocks, 1950–2012 414 2010 2011 2012 Chapter 17 | Financial Markets Period Total Annual Return Capital Gains Dividends 15.06% 2.11% 16.00% 13.22% 0.04% 13.87% 1.84% 2.07% 2.13% Table 17.2 Annual Returns on S&P 500 Stocks, 1950–2012 The overall pattern is that stocks as a group have provided a high rate of return over extended periods of time, but this return comes with risks. The market value of individual companies can rise and fall substantially, both over short time periods and over the long run. During extended periods of time like the 1970s or the first decade of the 2000s, the overall stock market return can be quite modest. The stock market can sometimes fall sharply, as it did in 2008. The bottom line on investing in stocks is that the rate of return over time will be high, but the risks are also high, especially in the short run. Liquidity is also high since one can sell stock in publicly held companies readily for spendable money. Mutual Funds Buying stocks or bonds issued by a single company is always somewhat risky. An individual firm may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions. Thus, a standard recommendation from financial investors is diversification, which means buying
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stocks or bonds from a wide range of companies. A saver who diversifies is following the old proverb: “Don’t put all your eggs in one basket.” In any broad group of companies, some firms will do better than expected and some will do worse—but the diversification has a tendency to cancel out extreme increases and decreases in value. Purchasing a diversified group of stocks or bonds has become easier in the internet age, but it remains something of a task. To simplify the process, companies offer mutual funds, which consist of a variety of stocks or bonds from different companies. The financial investor buys mutual fund shares, and then receives a return based on how the fund as a whole performs. In 2012, according to the Investment Company Factbook, about 44% of U.S. households had a financial investment in a mutual fund—including many people who have their retirement savings or pension money invested in this way. Mutual funds can focus in certain areas: one mutual fund might invest only in company stocks based in Indonesia, or only in bonds issued by large manufacturing companies, or only in biotechnology companies' stock. At the other end of the spectrum, a mutual fund might be quite broad. At the extreme, some mutual funds own a tiny share of every firm in the stock market, and thus the mutual fund's value will fluctuate with the overall stock market's average. We call a mutual fund that seeks only to mimic the market's overall performance an index fund. Diversification can offset some of the risks of individual stocks rising or falling. Even investors who buy an indexed mutual fund designed to mimic some measure of the broad stock market, like the Standard & Poor’s 500, had better prepare against some ups and downs, like those the stock market experienced in the first decade of the 2000s. In 2008 average U.S. stock funds declined 38%, reducing individual and household wealth. This steep drop in value hit hardest those who were close to retirement and were counting on their stock funds to supplement retirement income. The bottom line on investing in mutual funds is that the rate of return over time will be high. The risks are also high, but the risks and returns for an individual mutual fund will be lower than those for an individual stock. As with stocks, liquidity is also high provided the mutual fund or stock index fund is readily traded. Housing and Other Tangible Assets Households can also seek a rate of return by purchasing tangible assets, especially housing. About two-thirds
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of U.S. households own their own home. An owner’s equity in a house is the monetary value the owner would have after selling the house and repaying any outstanding bank loans he or she used to buy the house. For example, imagine that you buy a house for $200,000, paying 10% of the price as a down payment and taking out a bank loan for the remaining $180,000. Over time, you pay off some of your bank loan, so that only $100,000 remains, and the house's value on the market rises to $250,000. At that point, your equity in the home is the value of the home minus the value of the loan outstanding, which is $150,000. For many middle-class Americans, home equity is their single greatest This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 415 financial asset. The total value of all home equity held by U.S. households was $11.3 trillion at the end of 2015, according to Federal Reserve data. Investment in a house is tangibly different from bank accounts, stocks, and bonds because a house offers both a financial and a nonfinancial return. If you buy a house to live in, part of the return on your investment occurs from your consumption of “housing services”—that is, having a place to live. (Of course, if you buy a home and rent it out, you receive rental payments for the housing services you provide, which would offer a financial return.) Buying a house to live in also offers the possibility of a capital gain from selling the house in the future for more than you paid for it. There can, however, be different outcomes, as the Clear It Up on the housing market shows. Housing prices have usually risen steadily over time. For example, the median sales price for an existing one-family home was $122,900 in 1990, but 232,000 at the end of December 2016, according to FRED® Economic Data. Over these 24 years, home prices increased an average of 3.1% per year, which is an average financial return over this time. Figure 17.7 shows U.S. Census data for the median average sales price of a house in the United States over this time period. Go to this website (http://openstaxcollege.org/l/investopedia) to experiment with
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a compound annual growth rate calculator. However, the possible capital gains from rising housing prices are riskier than these national price averages. Certain regions of the country or metropolitan areas have seen drops in housing prices over time. The median housing price for the United States as a whole fell almost 7% in 2008 and again in 2009, dropping the median price from $247,900 to $216,700. As of 2016, home values had recovered and even exceeded their pre-recession levels. Visit this website (http://openstaxcollege.org/l/insidejob) to watch the trailer for Inside Job, a movie that explores the modern financial crisis. 416 Chapter 17 | Financial Markets Figure 17.7 The Median Average Sales Price for New Single-Family Homes, 1990–2015 The median price is the price where half of sales prices are higher and half are lower. The median sales price for a new one-family home was $122,900 in 1990. It rose as high as $248,000 in 2007, before falling to $232,000 in 2008. In 2015, the median sales price was $294,000. Of course, this national figure conceals many local differences, like the areas where housing prices are higher or lower, or how housing prices have risen or fallen at certain times. (Source: U.S. Census) Investors can also put money into other tangible assets such as gold, silver, and other precious metals, or in duller commodities like sugar, cocoa, coffee, orange juice, oil, and natural gas. The return on these investments derives from the saver’s hope of buying low, selling high, and receiving a capital gain. Investing in, say, gold or coffee offers relatively little in the way of nonfinancial benefits to the user (unless the investor likes to caress gold or gaze upon a warehouse full of coffee). Typically, investors in these commodities never even see the physical good. Instead, they sign a contract that takes ownership of a certain quantity of these commodities, which are stored in a warehouse, and later they sell the ownership to someone else. As one example, from 1981 to 2005, the gold prices generally fluctuated between about $300 and $500 per ounce, but then rose sharply to over $1,100 per ounce by early 2010. In January 2017, prices were hovering around $1,191 per ounce. A final area of tangible assets consists of “collectibles” like paintings, fine wine, jewelry, antiques, or
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even baseball cards. Most collectibles provide returns both in the form of services or of a potentially higher selling price in the future. You can use paintings by hanging them on the wall; jewelry by wearing it; baseball cards by displaying them. You can also hope to sell them someday for more than you paid for them. However, the evidence on prices of collectibles, while scanty, is that while they may go through periods where prices skyrocket for a time, you should not expect to make a higher-than-average rate of return over a sustained period of time from investing in this way. The bottom line on investing in tangible assets: rate of return—moderate, especially if you can receive nonfinancial benefits from, for example, living in the house; risk—moderate for housing or high if you buy gold or baseball cards; liquidity—low, because it often takes considerable time and energy to sell a house or a piece of fine art and turn your capital gain into cash. The next Clear It Up feature explains the issues in the recent U.S. housing market crisis. What was all the commotion in the recent U.S. housing market? The cumulative average annual growth rate in housing prices from 1981 to 2000 was 5.1%. The price of an average U.S. home then took off from 2003 to 2005, rising more than 10% per year. No serious analyst believed this rate of growth was sustainable; after all, if housing prices grew at, say, 11% per year over time, the average price of a home would more than double every seven years. However, at the time many serious analysts saw no reason for deep concern. After all, housing prices often change in fits and starts, like all This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 417 prices, and a price surge for a few years is often followed by prices that are flat or even declining a bit as local markets adjust. The sharp rise in housing prices was driven by a high level of demand for housing. Interest rates were low, so financial institutions encouraged people to borrow money to buy a house. Banks became much more flexible in their lending, making what were called “subprime” loans. Banks loaned money with low, or sometimes no down payment. They offered loans with very low payments for the first two years, but then much higher payments after that. The idea was that housing prices would keep rising, so
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the borrower would just refinance the mortgage two years in the future, and thus would not ever have to make the higher payments. Some banks even offered so-called NINJA loans, which meant a financial institution issued loan even though the borrower had no income, no job, nor assets. In retrospect, these loans seem nearly crazy. Many borrowers figured, however, that as long as housing prices kept rising, it made sense to buy. Many lenders used a process called “securitizing,” in which they sold their mortgages to financial companies, which put all the mortgages into a big pool, creating large financial securities, and then re-sold these mortgage-backed securities to investors. In this way, the lenders off-loaded the mortgage risks to investors. Investors were interested in mortgage-backed securities as they appeared to offer a steady stream of income, provided the borrowers repaid them. Investors relied on the ratings agencies to assess the credit risk associated with the mortgage-backed securities. In hindsight, it appears that the credit agencies were far too lenient in their ratings of many of the securitized loans. Bank and financial regulators watched the steady rise in the market for mortgage-backed securities, but saw no reason at the time to intervene. When housing prices turned down, many households that had borrowed when prices were high found that what they owed the bank was more than what their home was worth. Many banks believed that they had diversified by selling their individual loans and instead buying securities based on mortgage loans from all over the country. After all, banks thought back in 2005, the average house price had not declined at any time since the Great Depression in the 1930s. These securities based on mortgage loans, however, turned out to be far riskier than expected. The bust in housing prices weakened both bank and household finances, and thus helped bring on the 2008-2009 Great Recession. The Tradeoffs between Return and Risk The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment. Table 17.3 summarizes these characteristics. Financial Investment Return Risk Liquidity Checking account Savings account Very low Low Very little Very little Certificate of deposit Low to medium Very little Stocks Bonds High Medium Medium to high Low to medium Very high High Medium Medium Medium Mutual funds Medium to high Medium to high Medium to high Housing Gold Medium Medium Collectibles Low to medium Medium High High Low Low Low Table 17.3 Key Characteristics for Financial Investments 418 Chapter 17 | Financial Markets The household investment choices listed
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here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them. This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames. The high returns of stock market investments refer to a high average return that we can expect over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in mutual funds. Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, one must consider tradeoffs between risk and return in the context of where the investor is in life. 17.3 | How to Accumulate Personal Wealth By the end of this section, you will be able to: • Explain the random walk theory • Calculate simple and compound interest • Evaluate how capital markets transform financial capital Getting rich may seem straightforward enough. Figure out what companies are going to grow and earn high profits in the future, or figure out what companies are going to become popular for everyone else to buy. Those companies are the ones that will pay high dividends or whose stock price will climb in the future. Then, buy stock in those companies. Presto! Multiply your money! Why is this path to riches not as easy as it sounds? This module first discusses the problems with picking stocks, and then
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discusses a more reliable but undeniably duller method of accumulating personal wealth. Why It Is Hard to Get Rich Quick: The Random Walk Theory The chief problem with attempting to buy stock in companies that will have higher prices in the future is that many other financial investors are trying to do the same thing. Thus, in attempting to get rich in the stock market, it is no help to identify a company that is going to earn high profits if many other investors have already reached the same conclusion, because the stock price will already be high, based on the expected high level of future profits. The idea that stock prices are based on expectations about the future has a powerful and unexpected implication. If expectations determine stock price, then shifts in expectations will determine shifts in the stock price. Thus, what matters for predicting whether the stock price of a company will do well is not whether the company will actually earn profits in the future. Instead, you must find a company that analysts widely believe at present to have poor prospects, but that will actually turn out to be a shining star. Brigades of stock market analysts and individual investors are carrying out such research 24 hours a day. The fundamental problem with predicting future stock winners is that, by definition, no one can predict the future news that alters expectations about profits. Because stock prices will shift in response to unpredictable future news, these prices will tend to follow what mathematicians call a “random walk with a trend.” The “random walk” part means that, on any given day, stock prices are just as likely to rise as to fall. “With a trend” means that over time, the upward steps tend to be larger than the downward steps, so stocks do gradually climb. If stocks follow a random walk, then not even financial professionals will be able to choose those that will beat the average consistently. While some investment advisers are better than average in any given year, and some even This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 419 succeed for a number of years in a row, the majority of financial investors do not outguess the market. If we look back over time, it is typically true that half or two-thirds of the mutual funds that attempted to pick stocks which would rise more than the market average actually ended up performing worse than the market average. For the average investor who reads the newspaper business pages over a cup of coffee in the morning, the odds of
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doing better than full-time professionals is not very good at all. Trying to pick the stocks that will gain a great deal in the future is a risky and unlikely way to become rich. Getting Rich the Slow, Boring Way Many U.S. citizens can accumulate a large amount of wealth during their lifetimes, if they make two key choices. The first is to complete additional education and training. In 2014, the U.S. Census Bureau reported median earnings for households where the main earner had only a high school degree of $33,124; for those with a two-year associate degree, median earnings were $40,560 and for those with a four-year bachelor’s degree, median income was $54,340. Learning is not only good for you, but it pays off financially, too. The second key choice is to start saving money early in life, and to give the power of compound interest a chance. Imagine that at age 25, you save $3,000 and place that money into an account that you do not touch. In the long run, it is not unreasonable to assume a 7% real annual rate of return (that is, 7% above the rate of inflation) on money invested in a well-diversified stock portfolio. After 40 years, using the formula for compound interest, the original $3,000 investment will have multiplied nearly fifteen fold: 3, 000(1 +.07)40 = $44,923 Having $45,000 does not make you a millionaire. Notice, however, that this tidy sum is the result of saving $3,000 exactly once. Saving that amount every year for several decades—or saving more as income rises—will multiply the total considerably. This type of wealth will not rival the riches of Microsoft CEO Bill Gates, but remember that only half of Americans have any money in mutual funds at all. Accumulating hundreds of thousands of dollars by retirement is a perfectly achievable goal for a well-educated person who starts saving early in life—and that amount of accumulated wealth will put you at or near the top 10% of all American households. The following Work It Out feature shows the difference between simple and compound interest, and the power of compound interest. Simple and Compound Interest Simple interest is an interest rate calculation only on the principal amount. Step 1. Learn the formula for simple interest: Principal × Rate × Time = Interest Step 2. Practice using the simple interest formula. Example 1: $100 Deposit at a
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simple interest rate of 5% held for one year is: $100 × 0.05 × 1 = $5 Simple interest in this example is $15. Example 2: $100 Deposit at a simple interest rate of 5% held for three years is: Simple interest in this example is $5. Step 3. Calculate the total future amount using this formula: $100 × 0.05 × 3 = $15 Step 4. Put the two simple interest formulas together. Total future amount = principal + interest Total future amount (with simple interest) = Principal + (Principal × Rate × Time) Step 5. Apply the simple interest formula to our three year example. Total future amount (with simple interest) = $100 + ($100 × 0.05 × 3) = $115 420 Chapter 17 | Financial Markets Compound interest is an interest rate calculation on the principal plus the accumulated interest. Step 6. To find the compound interest, we determine the difference between the future value and the present value of the principal. This is accomplished as follows: Future Value = Principal × (1 + interest rate)time Compound interest = Future Value – Present Valve Step 7. Apply this formula to our three-year scenario. Follow the calculations in Table 17.4 Amount in Bank Bank Interest Rate Total Amount in Bank Bank Interest Rate Total Amount in Bank Bank Interest Rate Total Compound interest Table 17.4 Year 1 Year 2 Year 3 $100 5% $105 $100 + ($100 × 0.5) $105 5% $110.25 $105 + ($105 ×.05) $110.25 5% $115.75 $110.25 + ($110.25 ×.05) $115.75 – $100 = $15.75 Step 8. Note that, after three years, the total is $115.76. Therefore the total compound interest is $15.76. This is $0.76 more than we obtained with simple interest. While this may not seem like much, keep in mind that we were only working with $100 and over a relatively short time period. Compound interest can make a huge difference with larger sums of money and over longer periods of time. Obtaining additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means deferring earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other
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day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice. How Capital Markets Transform Financial Flows Financial capital markets have the power to repackage money as it moves from those who supply financial capital This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 421 to those who demand it. Banks accept checking account deposits and turn them into long-term loans to companies. Individual firms sell shares of stock and issue bonds to raise capital. Firms make and sell an astonishing array of goods and services, but an investor can receive a return on the company’s decisions by buying stock in that company. Financial investors sell and resell stocks and bonds to one another. Venture capitalists and angel investors search for promising small companies. Mutual funds combine the stocks and bonds—and thus, indirectly, the products and investments—of many different companies. Visit this website (http://openstaxcollege.org/l/austerebaltic/) to read an article about how austerity can work. In this chapter, we discussed the basic mechanisms of financial markets. (A more advanced course in economics or finance will consider more sophisticated tools.) The fundamentals of those financial capital markets remain the same: Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return, risk, and liquidity. Financial markets are society’s mechanisms for bringing together these forces of demand and supply. The Housing Bubble and the Financial Crisis of 2007 The housing boom and bust in the United States, and the resulting multi-trillion-dollar decline in home equity, began with the fall of home prices starting in 2007. As home values dipped, many home prices fell below the amount the borrower owed on the mortgage and owners stopped paying and defaulted on their loan. Banks found that their assets (loans) became worthless. Many financial institutions around the world had invested in mortgage-backed securities, or had purchased insurance on mortgage-backed securities. When housing prices collapsed, the value of those financial assets collapsed as well. The asset side of the banks’ balance sheets dropped, causing bank failures and bank runs. Around the globe, financial institutions were bankrupted or nearly so. The result was a large decrease in lending and borrowing, or a freezing up of available credit. When credit dries up, the economy is on its knees. The crisis was not limited
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to the United States. Iceland, Ireland, the United Kingdom, Spain, Portugal, and Greece all had similar housing boom and bust cycles, and similar credit freezes. If businesses cannot access financial capital, investments. Those investments ultimately lead to job creation. When credit dried up, businesses invested less, and they ultimately laid off millions of workers. This caused incomes to drop, which caused demand to drop. In turn businesses sold less, so they laid off more workers. Compounding these events, as economic conditions worsened, financial institutions were even less likely to make loans. they cannot make physical capital To make matters even worse, as businesses sold less, their expected future profit decreased, and this led to a drop in stock prices. Combining all these effects led to major decreases in incomes, demand, consumption, and employment, and to the Great Recession, which in the United States officially lasted from December 2007 to June 2009. During this time, the unemployment rate rose from 5% to a peak of 10.1%. Four years after the recession officially ended, unemployment was still stubbornly high, at 7.6%, and 11.8 million people were still unemployed. 422 Chapter 17 | Financial Markets As the world’s leading consumer, if the United States goes into recession, it usually drags other countries down with it. The Great Recession was no exception. With few exceptions, U.S. trading partners also entered into recessions of their own, of varying lengths, or suffered slower economic growth. Like the United States, many European countries also gave direct financial assistance, so-called bailouts, to the institutions that make up their financial markets. There was good reason to do this. Financial markets bridge the gap between demanders and suppliers of financial capital. These institutions and markets need to function in order for an economy to invest in new financial capital. However, much of this bailout money was borrowed, and this borrowed money contributed to another crisis in Europe. Because of the impact on their budgets of the financial crisis and the resulting bailouts, many countries found themselves with unsustainably high deficits. They chose to undertake austerity measures, large decreases in government spending and large tax increases, in order to reduce their deficits. Greece, Ireland, Spain, and Portugal have all had to undertake relatively severe austerity measures. The ramifications of this crisis have spread. Economists have even call into question the euro's viability into question. This OpenStax book is available for free at http://cnx.org/content/col12170/1.
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7 Chapter 17 | Financial Markets 423 KEY TERMS actual rate of return time period the total rate of return, including capital gains and interest paid on an investment at the end of a bond a financial contract through which a borrower like a corporation, a city or state, or the federal government agrees to repay the amount that it borrowed and also a rate of interest over a period of time in the future bond yield the rate of return a bond is expected to pay at the time of purchase bondholder someone who owns bonds and receives the interest payments capital gain a financial gain from buying an asset, like a share of stock or a house, and later selling it at a higher price certificate of deposit (CD) a mechanism for a saver to deposit funds at a bank and promise to leave them at the bank for a time, in exchange for a higher interest rate checking account a bank account that typically pays little or no interest, but that gives easy access to money, either by writing a check or by using a “debit card” compound interest an interest rate calculation on the principal plus the accumulated interest corporate bond a bond issued by firms that wish to borrow corporate governance the name economists give to the institutions that are supposed to watch over top executives in companies that shareholders own corporation a business owned by shareholders who have limited liability for the company’s debt yet a share of the company’s profits; may be private or public and may or may not have publicly-traded stock coupon rate the interest rate paid on a bond; can be annual or semi-annual debit card a card that lets the person make purchases, and the financial insitution immediately deducts cost from that person’s checking account diversification investing in a wide range of companies to reduce the level of risk dividend a direct payment from a firm to its shareholders equity the monetary value a homeowner would have after selling the house and repaying any outstanding bank loans used to buy the house expected rate of return how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability face value the amount that the bond issuer or borrower agrees to pay the investor financial intermediary an institution, like a bank, that receives money from savers and provides funds to borrowers high yield bonds bonds that offer relatively high interest rates to compensate for their relatively high chance of default index fund a mutual fund that seeks only to mimic the market's overall performance initial public offering (IPO) the first sale of shares of stock by a firm to
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outside investors junk bonds see high yield bonds liquidity refers to how easily one can exchange money or financial assets for a good or service 424 Chapter 17 | Financial Markets maturity date the date that a borrower must repay a bond municipal bonds a bond issued by cities that wish to borrow mutual funds funds that buy a range of stocks or bonds from different companies, thus allowing an investor an easy way to diversify partnership a company run by a group as opposed to an individual present value a bond’s current price at a given time private company a firm owned by the people who run it on a day-to-day basis public company a firm that has sold stock to the public, which in turn investors then can buy and sell risk a measure of the uncertainty of that project’s profitability savings account a bank account that pays an interest rate, but withdrawing money typically requires a trip to the bank or an automatic teller machine shareholders people who own at least some shares of stock in a firm shares a firm's stock, divided into individual portions simple interest an interest rate calculation only on the principal amount sole proprietorship a company run by an individual as opposed to a group stock a specific firm's claim on partial ownership Treasury bond a bond issued by the federal government through the U.S. Department of the Treasury venture capital financial investments in new companies that are still relatively small in size, but that have potential to grow substantially KEY CONCEPTS AND SUMMARY 17.1 How Businesses Raise Financial Capital Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms. A bond is a financial contract through which a borrower agrees to repay the amount that it borrowed. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury. Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company’s first stock sale to the public the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. One receives the rate of return on stock
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in two forms: dividends and capital gains. A private company is usually owned by the people who run it on a day-to-day basis, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 425 17.2 How Households Supply Financial Capital We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure. A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss. Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate the
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overall behavior of the stock market is called an index fund. We can also regard housing and other tangible assets as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it. 17.3 How to Accumulate Personal Wealth It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price will rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life. SELF-CHECK QUESTIONS 1. Answer these three questions about early-stage corporate finance: a. Why do very small companies tend to raise money from private investors instead of through an IPO? b. Why do small, young companies often prefer an IPO to borrowing from a bank or issuing bonds? c. Who has better information about whether a small firm is likely to earn profits, a venture capitalist or a potential bondholder, and why? 2. From a firm’s point of view, how is a bond similar to a bank loan? How are they different? 3. Calculate the equity each of these people has in his or her home: a. Fred just bought a house for $200,000 by putting 10% as a down payment and borrowing the rest from the bank. b. Freda bought a house for $150,000 in cash, but if she were to sell it now, it would sell for $250,000. c. Frank bought a house for $100,000. He put 20% down and borrowed the rest from the bank. However, the value of the house has now increased to $160,000 and he has paid off $20,000 of the bank loan. 4. Which has a higher average return over time: stocks, bonds, or a savings account? Explain your answer. Investors sometimes fear that a high-risk investment is especially likely to have low returns. Is this fear true? 5. Does a high risk mean the return must be low? 6. What is the total amount of interest from a $5,000 loan after three years with a simple interest rate of 6%? If you receive $500 in simple interest on a loan that you made for $10,000 for five years, what was the interest 7. rate you charged? 426 Chapter 17 | Financial Markets 8. You open a 5-
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year CD for $1,000 that pays 2% interest, compounded annually. What is the value of that CD at the end of the five years? REVIEW QUESTIONS 9. What are the most common ways for start-up firms to raise financial capital? 20. Name several different kinds of bank account. How are they different? 10. Why can firms not just use their own profits for financial capital, with no need for outside investors? 11. Why are banks more willing to lend to wellestablished firms? 12. What is a bond? 13. What does a share of stock represent? 14. When do firms receive money from a stock sale in their firm and when do they not receive money? 15. What is a dividend? 16. What is a capital gain? 17. What is the difference between a private company and a public company? 18. How do the shareholders who own a company choose the actual company managers? 19. Why are banks called “financial intermediaries”? CRITICAL THINKING QUESTIONS 29. If you owned a small firm that had become somewhat established, but you needed a surge of financial capital to carry out a major expansion, would you prefer to raise the funds through borrowing or by issuing stock? Explain your choice. Explain how a company can fail when the 30. safeguards that should be in place fail. 31. What are some reasons why the investment strategy of a 30-year-old might differ from the investment strategy of a 65-year-old? 32. Explain why a financial investor in stocks cannot earn high capital gains simply by buying companies with a demonstrated record of high profits. 21. Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest? 22. Why should a financial diversification? investor care about 23. What is a mutual fund? 24. What is an index fund? 25. How is buying a house to live in a type of financial investment? 26. Why is it hard to forecast future movements in stock prices? 27. What are the two key choices U.S. citizens need to make that determines their relative wealth? Is investing in housing always a very safe 28. investment? 33. Explain what happens in an economy when the financial markets limit access to capital. How does this affect economic growth and employment? 34. You and your friend have opened an account on E-Trade and have each decided to select five similar companies in which to invest. You are diligent in monitoring your selections,
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tracking prices, current events, and actions the company has taken. Your friend chooses his companies randomly, pays no attention to the financial news, and spends his leisure time focused on everything besides his investments. Explain what might be the performance for each of your portfolios at the end of the year. 35. How do bank failures cause the economy to go into recession? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 17 | Financial Markets 427 PROBLEMS 36. The Darkroom Windowshade Company has 100,000 shares of stock outstanding. The investors in the firm own the following numbers of shares: investor 1 has 20,000 shares; investor 2 has 18,000 shares; investor 3 has 15,000 shares; investor 4 has 10,000 shares; investor 5 has 7,000 shares; and investors 6 through 11 have 5,000 shares each. What is the minimum number of investors it would take to vote to change the company's top management? If investors 1 and 2 agree to vote together, can they be certain of always getting their way in how the company will be run? 37. Imagine that a local water company issued $10,000 ten-year bond at an interest rate of 6%. You are thinking about buying this bond one year before the end of the ten years, but interest rates are now 9%. a. Given the change in interest rates, would you expect to pay more or less than $10,000 for the bond? b. Calculate what you would actually be willing to pay for this bond. 38. Suppose Ford Motor Company issues a five year bond with a face value of $5,000 that pays an annual coupon payment of $150. a. What is the interest rate Ford is paying on the borrowed funds? b. Suppose the market interest rate rises from 3% to 4% a year after Ford issues the bonds. Will the value of the bond increase or decrease? 39. How much money do you have to put into a bank account that pays 10% interest compounded annually to have $10,000 in ten years? 40. Many retirement funds charge an administrative fee each year equal to 0.25% on managed assets. Suppose that Alexx and Spenser each invest $5,000 in the same stock this year. Alexx invests directly and earns 5% a year. Spenser uses a retirement fund and earns 4.75%. After 30 years, how much more will Alexx have than
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Spenser? 428 Chapter 17 | Financial Markets This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 429 18 | Public Economy Figure 18.1 Domestic Tires? While these tires may all appear similar, some are made in the United States and others are not. Those that are not could be subject to a tariff that could cause the cost of all tires to be higher. (Credit: modification of work by Jayme del Rosario/Flickr Creative Commons) Chinese Tire Tariffs Do you know where the tires on your car are made? If they were imported, they may be subject to a tariff (a tax on imported goods) that could raise the price of your car. What do you think about that tariff? Would you write to your representative or your senator about it? Would you start a Facebook or Twitter campaign? Most people are unlikely to fight this kind of tax or even inform themselves about the issue in the first place. In The Logic of Collective Action (1965), economist Mancur Olson challenged the popular idea that, in a democracy, the majority view will prevail, and in doing so launched the modern study of public economy, sometimes referred to as public choice, a subtopic of microeconomics. In this chapter, we will look at the economics of government policy, why smaller, more organized groups have an incentive to work hard to enact certain policies, and why lawmakers ultimately make decisions that may result in bad economic policy. Introduction to Public Economy In this chapter, you will learn about: • Voter Participation and Costs of Elections • Special Interest Politics 430 Chapter 18 | Public Economy • Flaws in the Democratic System of Government As President Abraham Lincoln famously said in his 1863 Gettysburg Address, democratic governments are supposed to be “of the people, by the people, and for the people.” Can we rely on democratic governments to enact sensible economic policies? After all, they react to voters, not to analyses of demand and supply curves. The main focus of an economics course is, naturally enough, to analyze the characteristics of markets and purely economic institutions. However, political institutions also play a role in allocating society’s scarce resources, and economists have played an active role, along with other social scientists, in analyzing how such political institutions work. Other chapters of this book discuss situations in which market forces can sometimes lead to undesirable results: monopoly, imperfect competition, and antitrust policy; negative and positive externalities; poverty and
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inequality of incomes; failures to provide insurance; and financial markets that may go from boom to bust. Many of these chapters suggest that the government's economic policies could address these issues. However, just as markets can face issues and problems that lead to undesirable outcomes, a democratic system of government can also make mistakes, either by enacting policies that do not benefit society as a whole or by failing to enact policies that would have benefited society as a whole. This chapter discusses some practical difficulties of democracy from an economic point of view: we presume the actors in the political system follow their own selfinterest, which is not necessarily the same as the public good. For example, many of those who are eligible to vote do not, which obviously raises questions about whether a democratic system will reflect everyone’s interests. Benefits or costs of government action are sometimes concentrated on small groups, which in some cases may organize and have a disproportionately large impact on politics and in other cases may fail to organize and end up neglected. A legislator who worries about support from voters in his or her district may focus on spending projects specific to the district without sufficient concern for whether this spending is in the nation's interest. When more than two choices exist, the principle that the majority of voters should decide may not always make logical sense, because situations can arise where it becomes literally impossible to decide what the “majority” prefers. Government may also be slower than private firms to correct its mistakes, because government agencies do not face competition or the threat of new entry. 18.1 | Voter Participation and Costs of Elections By the end of this section, you will be able to: • Explain the significance of rational ignorance • Evaluate the impact of election expenses In U.S. presidential elections over the last few decades, about 55% to 65% of voting-age citizens actually voted, according to the U.S. Census. In congressional elections when there is no presidential race, or in local elections, the turnout is typically lower, often less than half the eligible voters. In other countries, the share of adults who vote is often higher. For example, in national elections since the 1980s in Germany, Spain, and France, about 75% to 80% of those of voting age cast ballots. Even this total falls well short of 100%. Some countries have laws that require voting, among them Australia, Belgium, Italy, Greece, Turkey, Singapore, and most Latin American nations. At the time the United States was founded, voting was mandatory in Virginia, Maryland, Delaware
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, and Georgia. Even if the law can require people to vote, however, no law can require that each voter cast an informed or a thoughtful vote. Moreover, in the United States and in most countries around the world, the freedom to vote has also typically meant the freedom not to vote. Why do people not vote? Perhaps they do not care too much about who wins, or they are uninformed about who is running, or they do not believe their vote will matter or change their lives in any way. These reasons are probably tied together, since people who do not believe their vote matters will not bother to become informed or care who wins. Economists have suggested why a utility-maximizing person might rationally decide not to vote or not to become informed about the election. While a single vote may decide a few elections in very small towns, in most elections of any size, the Board of Elections measures the margin of victory in hundreds, thousands, or even millions of votes. A rational voter will recognize that one vote is extremely unlikely to make a difference. This theory of rational ignorance holds that people will not vote if the costs of becoming informed and voting are too high, or they feel their vote will not be decisive in the election. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 431 In a 1957 work, An Economic Theory of Democracy, the economist Anthony Downs stated the problem this way: “It seems probable that for a great many citizens in a democracy, rational behavior excludes any investment whatever in political information per se. No matter how significant a difference between parties is revealed to the rational citizen by his free information, or how uncertain he is about which party to support, he realizes that his vote has almost no chance of influencing the outcome… He will not even utilize all the free information available, since assimilating it takes time.” In his classic 1948 novel Walden Two, the psychologist B. F. Skinner puts the issue even more succinctly via one of his characters, who states: “The chance that one man’s vote will decide the issue in a national election…is less than the chance that he will be killed on his way to the polls.” The following Clear It Up feature explores another aspect of the election process: spending. How much is too much to spend on an election? According to a report from CBS News, the 2016 elections for president, Congress, and
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state and local offices, saw a total of about $6.8 billion spent. The money raised went to the campaigns, including advertising, fundraising, travel, and staff. Many people worry that politicians spend too much time raising money and end up entangled with special interest groups that make major donations. Critics would prefer a system that restricts what candidates can spend, perhaps in exchange for limited public campaign financing or free television advertising time. How much spending on campaigns is too much? Five billion dollars will buy many potato chips, but in the U.S. economy, which exceeded $18 trillion in 2016, the $6.8 billion spent on political campaigns was about 1/ 25 of 1% of the overall economy. Here is another way to think about campaign spending. Total government spending programs in 2016, including federal and state governments, was about $7 trillion, so the cost of choosing the people who would determine how to spend this money was less than 1/10 of 1% of that. In the context of the enormous U.S. economy, $6.8 billion is not as much money as it sounds. U.S. consumers spend about $2 billion per year on toothpaste and $7 billion on hair care products. In 2016, Proctor and Gamble spent $7.2 billion on advertising. It may not be sensible to believe the United States is going to decide its presidential elections for much less than Proctor and Gamble spends on advertisements. Whatever we believe about whether candidates and their parties spend too much or too little on elections, the U.S. Supreme Court has placed limits on how government can limit campaign spending. In a 1976 decision, Buckley v. Valeo, the Supreme Court emphasized that the First Amendment to the U.S. Constitution specifies freedom of speech. The federal government and states can offer candidates a voluntary deal in which government makes some public financing available to candidates, but only if the candidates agree to abide by certain spending limits. Of course, candidates can also voluntarily agree to set certain spending limits if they wish. However, government cannot forbid people or organizations to raise and spend money above these limits if they choose. In 2002, Congress passed and President George W. Bush signed into law the Bipartisan Campaign Reform Act (BCRA). The relatively noncontroversial portions of the act strengthen the rules requiring full and speedy disclosure of who contributes money to campaigns. However, some controversial portions of the Act limit the ability of individuals and groups to make certain kinds of political donations and they ban certain kinds of
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advertising in the months leading up to an election. Some called these bans into question after the release of two films: Michael Moore’s Fahrenheit 9/11 and Citizens United’s Hillary: The Movie. At question was whether each film sought to discredit political candidates for office too close to an election, in violation of the BCRA. The lower courts found that Moore’s film did not violate the Act, while Citizens United’s did. The fight reached the Supreme Court, as Citizens United v. Federal Election Commission, saying that the First Amendment protects the rights of corporations as well as individuals to donate to political campaigns. The Court ruled, in a 5–4 decision, that the spending limits were unconstitutional. This controversial decision, which essentially allows unlimited contributions by corporations to political action committees, overruled several previous decisions and will likely be revisited in the future, due to the strength of the public reaction. For now, it has resulted in a sharp increase in election spending. 432 Chapter 18 | Public Economy While many U.S. adults do not bother to vote in presidential elections, more than half do. What motivates them? Research on voting behavior has indicated that people who are more settled or more “connected” to society tend to vote more frequently. According to the Washington Post, more married people vote than single people. Those with a job vote more than the unemployed. Those who have lived longer in a neighborhood are more likely to vote than newcomers. Those who report that they know their neighbors and talk to them are more likely to vote than socially isolated people. Those with a higher income and level of education are also more likely to vote. These factors suggest that politicians are likely to focus more on the interests of married, employed, well-educated people with at least a middle-class level of income than on the interests of other groups. For example, those who vote may tend to be more supportive of financial assistance for the two-year and four-year colleges they expect their children to attend than they are of medical care or public school education aimed at families of the poor and unemployed. Visit this website (http://openstaxcollege.org/l/votergroups) to see a breakdown of how different groups voted in 2012. There have been many proposals to encourage greater voter turnout: making it easier to register to vote, keeping the polls open for more hours, or even moving Election Day to the weekend, when fewer people need to worry about jobs or school commitments. However, such
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changes do not seem to have caused a long-term upward trend in the number of people voting. After all, casting an informed vote will always impose some costs of time and energy. It is not clear how to strengthen people’s feeling of connectedness to society in a way that will lead to a substantial increase in voter turnout. Without greater voter turnout, however, politicians elected by the votes of 60% or fewer of the population may not enact economic policy in the best interests of 100% of the population. Meanwhile, countering a long trend toward making voting easier, many states have recently erected new voting laws that critics say are actually barriers to voting. States have passed laws reducing early voting, restricting groups who are organizing get-out-the-vote efforts, enacted strict photo ID laws, as well as laws that require showing proof of U.S. citizenship. The ACLU argues that while these laws profess to prevent voter fraud, they are in effect making it harder for individuals to cast their vote. 18.2 | Special Interest Politics By the end of this section, you will be able to: • Explain how special interest groups and lobbyists can influence campaigns and elections • Describe pork-barrel spending and logrolling Many political issues are of intense interest to a relatively small group, as we noted above. For example, many U.S. drivers do not much care where their car tires were made—they just want good quality as inexpensively as possible. In September 2009, President Obama and Congress enacted a tariff (taxes added on imported goods) on tires imported from China that would increase the price by 35 percent in its first year, 30 percent in its second year, and 25 percent in its third year. Interestingly, the U.S. companies that make tires did not favor this step, because most of them also import tires from China and other countries. (See Globalization and Protectionism for more on tariffs.) However, the United Steelworkers union, which had seen jobs in the tire industry fall by 5,000 over the previous five years, lobbied fiercely for the tariff. With this tariff, the cost of all tires increased significantly. (See the closing Bring It Home feature at the end of this chapter for more information on the tire tariff.) This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 433 Special interest groups are groups that are small in number relative to the nation, but quite well organized and focused on a
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specific issue. A special interest group can pressure legislators to enact public policies that do not benefit society as a whole. Imagine an environmental rule to reduce air pollution that will cost 10 large companies $8 million each, for a total cost of $80 million. The social benefits from enacting this rule provide an average benefit of $10 for every person in the United States, for a total of about $3 trillion. Even though the benefits are far higher than the costs for society as a whole, the 10 companies are likely to lobby much more fiercely to avoid $8 million in costs than the average person is to argue for $10 worth of benefits. As this example suggests, we can relate the problem of special interests in politics to an issue we raised in Environmental Protection and Negative Externalities about economic policy with respect to negative externalities and pollution—the problem called regulatory capture (which we defined in Monopoly and Antitrust Policy). In legislative bodies and agencies that write laws and regulations about how much corporations will pay in taxes, or rules for safety in the workplace, or instructions on how to satisfy environmental regulations, you can be sure the specific industry affected has lobbyists who study every word and every comma. They talk with the legislators who are writing the legislation and suggest alternative wording. They contribute to the campaigns of legislators on the key committees—and may even offer those legislators high-paying jobs after they have left office. As a result, it often turns out that those regulated can exercise considerable influence over the regulators. Visit this website (http://openstaxcollege.org/l/lobbying) to read about lobbying. In the early 2000s, about 40 million people in the United States were eligible for Medicare, a government program that provides health insurance for those 65 and older. On some issues, the elderly are a powerful interest group. They donate money and time to political campaigns, and in the 2012 presidential election, 70% of those over age 65 voted, while just 49% of those aged 18 to 24 cast a ballot, according to the U.S. Census. In 2003, Congress passed and President George Bush signed into law a substantial expansion of Medicare that helped the elderly to pay for prescription drugs. The prescription drug benefit cost the federal government about $40 billion in 2006, and the Medicare system projected that the annual cost would rise to $121 billion by 2016. The political pressure to pass a prescription drug benefit for Medicare was apparently quite high, while the political pressure to assist the 40 million with no health insurance at all was
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considerably lower. One reason might be that the American Association for Retired People AARP, a well-funded and well-organized lobbying group represents senior citizens, while there is no umbrella organization to lobby for those without health insurance. In the battle over passage of the 2010 Affordable Care Act (ACA), which became known as “Obamacare,” there was heavy lobbying on all sides by insurance companies and pharmaceutical companies. However, labor unions and community groups financed a lobby group, Health Care for America Now (HCAN), to offset corporate lobbying. HCAN, spending $60 million dollars, was successful in helping pass legislation which added new regulations on insurance companies and a mandate that all individuals will obtain health insurance by 2014. The following Work It Out feature further explains voter incentives and lobbyist influence. 434 Chapter 18 | Public Economy Paying To Get Your Way Suppose Congress proposes a tax on carbon emissions for certain factories in a small town of 10,000 people. Congress estimates the tax will reduce pollution to such an extent that it will benefit each resident by an equivalent of $300. The tax will also reduce profits to the town’s two large factories by $1 million each. How much should the factory owners be willing to spend to fight the tax passage, and how much should the townspeople be willing to pay to support it? Why is society unlikely to achieve the optimal outcome? Step 1. The two factory owners each stand to lose $1 million if the tax passes, so each should be willing to spend up to that amount to prevent the passage, a combined sum of $2 million. Of course, in the real world, there is no guarantee that lobbying efforts will be successful, so the factory owners may choose to invest an amount that is substantially lower. Step 2. There are 10,000 townspeople, each standing to benefit by $300 if the tax passes. Theoretically, then, they should be willing to spend up to $3 million (10,000 × $300) to ensure passage. (Again, in the real world with no guarantees of success, they may choose to spend less.) Step 3. It is costly and difficult for 10,000 people to coordinate in such a way as to influence public policy. Since each person stands to gain only $300, many may feel lobbying is not worth the effort. Step 4. The two factory owners, however, find it very easy and profitable to coordinate their activities, so they have a greater incentive to do so. Special interests may
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develop a close relationship with one political party, so their ability to influence legislation rises and falls as that party moves in or out of power. A special interest may even hurt a political party if it appears to a number of voters that the relationship is too cozy. In a close election, a small group that has been under-represented in the past may find that it can tip the election one way or another—so that group will suddenly receive considerable attention. Democratic institutions produce an ebb and flow of political parties and interests and thus offer both opportunities for special interests and ways of counterbalancing those interests over time. Identifiable Winners, Anonymous Losers A number of economic policies produce gains whose beneficiaries are easily identifiable, but costs that are partly or entirely shared by a large number who remain anonymous. A democratic political system probably has a bias toward those who are identifiable. For example, policies that impose price controls—like rent control—may look as if they benefit renters and impose costs only on landlords. However, when landlords then decide to reduce the number of rental units available in the area, a number of people who would have liked to rent an apartment end up living somewhere else because no units were available. These would-be renters have experienced a cost of rent control, but it is hard to identify who they are. Similarly, policies that block imports will benefit the firms that would have competed with those imports—and workers at those firms—who are likely to be quite visible. Consumers who would have preferred to purchase the imported products, and who thus bear some costs of the protectionist policy, are much less visible. Specific tax breaks and spending programs also have identifiable winners and impose costs on others who are hard to identify. Special interests are more likely to arise from a group that is easily identifiable, rather than from a group where some of those who suffer may not even recognize they are bearing costs. Pork Barrels and Logrolling Politicians have an incentive to ensure that they spend government money in their home state or district, where it will benefit their constituents in a direct and obvious way. Thus, when legislators are negotiating over whether to support a piece of legislation, they commonly ask each other to include pork-barrel spending, legislation that benefits mainly a single political district. Pork-barrel spending is another case in which concentrated benefits and widely dispersed costs challenge democracy: the benefits of pork-barrel spending are obvious and direct to local voters, while the costs are spread over the entire country. Read the following Clear It Up feature for more information on
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pork-barrel spending. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 435 How much impact can pork-barrel spending have? Many observers widely regard U.S. Senator Robert C. Byrd of West Virginia, who was originally elected to the Senate in 1958 and served until 2010, as one of the masters of pork-barrel politics, directing a steady stream of federal funds to his home state. A journalist once compiled a list of structures in West Virginia at least partly government funded and named after Byrd: “the Robert C. Byrd Highway; the Robert C. Byrd Locks and Dam; the Robert C. Byrd Institute; the Robert C. Byrd Life Long Learning Center; the Robert C. Byrd Honors Scholarship Program; the Robert C. Byrd Green Bank Telescope; the Robert C. Byrd Institute for Advanced Flexible Manufacturing; the Robert C. Byrd Federal Courthouse; the Robert C. Byrd Health Sciences Center; the Robert C. Byrd Academic and Technology Center; the Robert C. Byrd United Technical Center; the Robert C. Byrd Federal Building; the Robert C. Byrd Drive; the Robert C. Byrd Hilltop Office Complex; the Robert C. Byrd Library; and the Robert C. Byrd Learning Resource Center; the Robert C. Byrd Rural Health Center.” This list does not include government-funded projects in West Virginia that were not named after Byrd. Of course, we would have to analyze each of these expenditures in detail to figure out whether we should treat them as pork-barrel spending or whether they provide widespread benefits that reach beyond West Virginia. At least some of them, or a portion of them, certainly would fall into that category. Because there are currently no term limits for Congressional representatives, those who have been in office longer generally have more power to enact pork-barrel projects. The amount that government spends on individual pork-barrel projects is small, but many small projects can add up to a substantial total. A nonprofit watchdog organization, called Citizens against Government Waste, produces an annual report, the Pig Book that attempts to quantify the amount of pork-barrel spending, focusing on items that only one member of Congress requested, that were passed into law without any public hearings, or that serve only a local purpose. Whether any specific item qualifies as pork can be controversial. Interestingly, the 2016 Congressional Pig Book exposed 123 earmarks in FY 2016, an increase of 17.1 percent
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from the 105 in FY 2015. The cost of earmarks in FY 2016 was $5.1 billion, an increase of 21.4 percent from the $4.2 billion in FY 2015. While the increase in cost over one year is disconcerting, the two-year rise of 88.9 percent over the $2.7 billion in FY 2014 causes concern. Logrolling, an action in which all members of a group of legislators agree to vote for a package of otherwise unrelated laws that they individually favor, can encourage pork barrel spending. For example, if one member of the U.S. Congress suggests building a new bridge or hospital in his or her own congressional district, the other members might oppose it. However, if 51% of the legislators come together, they can pass a bill that includes a bridge or hospital for every one of their districts. As a reflection of this interest of legislators in their own districts, the U.S. government has typically spread out its spending on military bases and weapons programs to congressional districts all across the country. In part, the government does this to help create a situation that encourages members of Congress to vote in support of defense spending. 18.3 | Flaws in the Democratic System of Government By the end of this section, you will be able to: • Assess the median voter theory • Explain the voting cycle • Analyze the interrelationship between markets and government Most developed countries today have a democratic system of government: citizens express their opinions through votes and those votes affect the direction of the country. The advantage of democracy over other systems is that it allows everyone in a society an equal say and therefore may reduce the possibility of a small group of wealthy oligarchs oppressing the masses. There is no such thing as a perfect system, and democracy, for all its popularity, is not without its problems, a few of which we will examine here. 436 Chapter 18 | Public Economy We sometimes sum up and oversimplify democracy in two words: “Majority rule.” When voters face three or more choices, however, then voting may not always be a useful way of determining what the majority prefers. As one example, consider an election in a state where 60% of the population is liberal and 40% is conservative. If there are only two candidates, one from each side, and if liberals and conservatives vote in the same 60–40 proportions in which they are represented in the population, then the liberal will win. What if the election ends up including two liberal candidates
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and one conservative? It is possible that the liberal vote will split and victory will go to the minority party. In this case, the outcome does not reflect the majority’s preference. Does the majority view prevail in the case of sugar quotas? Clearly there are more sugar consumers in the United States than sugar producers, but the U.S. domestic sugar lobby (www.sugarcane.org) has successfully argued for protection against imports since 1789. By law, therefore, U.S. cookie and candy makers must use 85% domestic sugar in their products. Meanwhile quotas on imported sugar restrict supply and keep the domestic sugar price up—raising prices for companies that use sugar in producing their goods and for consumers. The European Union allows sugar imports, and prices there are 40% lower than U.S. sugar prices. Sugar-producing countries in the Caribbean repeatedly protest the U.S. quotas at the World Trade Organization meetings, but each bite of cookie, at present, costs you more than if there were no sugar lobby. This case goes against the theory of the “median” voter in a democracy. The median voter theory argues that politicians will try to match policies to what pleases the median voter preferences. If we think of political positions along a spectrum from left to right, the median voter is in the middle of the spectrum. This theory argues that actual policy will reflect “middle of the road.” In the case of sugar lobby politics, the minority, not the median, dominates policy. Sometimes it is not even clear how to define the majority opinion. Step aside from politics for a moment and think about a choice facing three families (the Ortegas, the Schmidts, and the Alexanders) who are planning to celebrate New Year’s Day together. They agree to vote on the menu, choosing from three entrees, and they agree that the majority vote wins. With three families, it seems reasonable that one producing choice will get a 2–1 majority. What if, however, their vote ends up looking like Table 18.1? Clearly, the three families disagree on their first choice. However, the problem goes even deeper. Instead of looking at all three choices at once, compare them two at a time. (See Figure 18.2) In a vote of turkey versus beef, turkey wins by 2–1. In a vote of beef versus lasagna, beef wins 2–1. If turkey beats beef, and beef beats lasagna, then
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it might seem only logical that turkey must also beat lasagna. However, with the preferences, lasagna is preferred to turkey by a 2–1 vote, as well. If lasagna is preferred to turkey, and turkey beats beef, then surely it must be that lasagna also beats beef? Actually, no. Beef beats lasagna. In other words, the majority view may not win. Clearly, as any car salesmen will tell you, the way one presents choices to us influences our decisions. Figure 18.2 A Voting Cycle Given these choices, voting will struggle to produce a majority outcome. Turkey is favored over roast beef by 2–1 and roast beef is favored over lasagna by 2–1. If turkey beats roast beef and roast beef beats lasagna, then it might seem that turkey must beat lasagna, too. However, given these preferences, lasagna is favored over turkey by 2–1. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 437 The Ortega Family The Schmidt Family The Alexander Family First Choice Turkey Second Choice Roast beef Third Choice Lasagna Table 18.1 Circular Preferences Roast beef Lasagna Turkey Lasagna Turkey Roast beef We call the situation in which Choice A is preferred by a majority over Choice B, Choice B is preferred by a majority over Choice C, and Choice C is preferred by a majority over Choice A a voting cycle. It is easy to imagine sets of government choices—say, perhaps the choice between increased defense spending, increased government spending on health care, and a tax cut—in which a voting cycle could occur. The result will be determined by the order in which stakeholders present and vote on choices, not by majority rule, because every choice is both preferred to some alternative and also not preferred to another alternative. Visit this website (http://www.fairvote.org/rcv#rcvbenefits) to read about instant runoff voting, a preferential voting system. Where Is Government’s Self-Correcting Mechanism? When a firm produces a product no one wants to buy or produces at a higher cost than its competitors, the firm is likely to suffer losses. If it cannot change its ways, it will go out of business. This self-correcting mechanism in the marketplace can have harsh effects on workers or on local economies, but it also puts pressure on firms for good performance. Government agencies, however, do not
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sell their products in a market. They receive tax dollars instead. They are not challenged by competitors as are private-sector firms. If the U.S. Department of Education or the U.S. Department of Defense is performing poorly, citizens cannot purchase their services from another provider and drive the existing government agencies into bankruptcy. If you are upset that the Internal Revenue Service is slow in sending you a tax refund or seems unable to answer your questions, you cannot decide to pay your income taxes through a different organization. Of course, elected politicians can assign new leaders to government agencies and instruct them to reorganize or to emphasize a different mission. The pressure government faces, however, to change its bureaucracy, to seek greater efficiency, and to improve customer responsiveness is much milder than the threat of being put out of business altogether. This insight suggests that when government provides goods or services directly, we might expect it to do so with less efficiency than private firms—except in certain cases where the government agency may compete directly with private firms. At the local level, for example, government can provide directly services like garbage collection, using private firms under contract to the government, or by a mix of government employees competing with private firms. A Balanced View of Markets and Government The British statesman Sir Winston Churchill (1874–1965) once wrote: “No one pretends that democracy is perfect or 438 Chapter 18 | Public Economy all-wise. Indeed, it has been said that democracy is the worst form of government except for all of the other forms which have been tried from time to time.” In that spirit, the theme of this discussion is certainly not that we should abandon democratic government. A practical student of public policy needs to recognize that in some cases, like the case of well-organized special interests or pork-barrel legislation, a democratic government may seek to enact economically unwise projects or programs. In other cases, by placing a low priority on the problems of those who are not well organized or who are less likely to vote, the government may fail to act when it could do some good. In these and other cases, there is no automatic reason to believe that government will necessarily make economically sensible choices. “The true test of a first-rate mind is the ability to hold two contradictory ideas at the same time,” wrote the American author F. Scott Fitzgerald (1896–1940). At this point in your study of microeconomics, you should be able to go one better than Fitzgerald and hold three
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somewhat contradictory ideas about the interrelationship between markets and government in your mind at the same time. First, markets are extraordinarily useful and flexible institutions through which society can allocate its scarce resources. We introduced this idea with the subjects of international trade and demand and supply in other chapters and reinforced it in all the subsequent discussions of how households and firms make decisions. Second, markets may sometimes produce unwanted results. A short list of the cases in which markets produce unwanted results includes monopoly and other cases of imperfect competition, pollution, poverty and inequality of incomes, discrimination, and failure to provide insurance. Third, while government may play a useful role in addressing the problems of markets, government action is also imperfect and may not reflect majority views. Economists readily admit that, in settings like monopoly or negative externalities, a potential role exists for government intervention. However, in the real world, it is not enough to point out that government action might be a good idea. Instead, we must have some confidence that the government is likely to identify and carry out the appropriate public policy. To make sensible judgments about economic policy, we must see the strengths and weaknesses of both markets and government. We must not idealize or demonize either unregulated markets or government actions. Instead, consider the actual strengths and weaknesses of real-world markets and real-world governments. These three insights seldom lead to simple or obvious political conclusions. As the famous British economist Joan Robinson wrote some decades ago: “[E]conomic theory, in itself, preaches no doctrines and cannot establish any universally valid laws. It is a method of ordering ideas and formulating questions.” The study of economics is neither politically conservative, nor moderate, nor liberal. There are economists who are Democrats, Republicans, libertarians, socialists, and members of every other political group you can name. Of course, conservatives may tend to emphasize the virtues of markets and the limitations of government, while liberals may tend to emphasize the shortcomings of markets and the need for government programs. Such differences only illustrate that the language and terminology of economics is not limited to one set of political beliefs, but can be used by all. Chinese Tire Tariffs In April 2009, the union representing U.S. tire manufacturing workers filed a request with the U.S. International Trade Commission (ITC), asking it to investigate tire imports from China. Under U.S. trade law, if imports from a country increase to the point that they cause market disruption in the United States, as determined by the ITC, then it
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can also recommend a remedy for this market disruption. In this case, the ITC determined that from 2004 to 2008, U.S. tire manufacturers suffered declines in production, financial health, and employment as a direct result of increases in tire imports from China. The ITC recommended placing an additional tax on tire imports from China. President Obama and Congress agreed with the ITC recommendation, and in June 2009 tariffs on Chinese tires increased from 4% to 39%. Why would U.S. consumers buy imported tires from China in the first place? Most likely, because they are cheaper than tires produced domestically or in other countries. Therefore, this tariff increase should cause U.S. consumers to pay higher prices for tires, either because Chinese tires are now more expensive, or because U.S. consumers are pushed by the tariff to buy more expensive tires made by U.S. manufacturers or This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 439 those from other countries. In the end, this tariff made U.S. consumers pay more for tires. Was this tariff met with outrage expressed via social media, traditional media, or mass protests? Were there “Occupy Wall Street-type” demonstrations? The answer is a resounding “No”. Most U.S. tire consumers were likely unaware of the tariff increase, although they may have noticed the price increase, which was between $4 and $13 depending on the type of tire. Tire consumers are also potential voters. Conceivably, a tax increase, even a small one, might make voters unhappy. However, voters probably realized that it was not worth their time to learn anything about this issue or cast a vote based on it. They probably thought their vote would not matter in determining the outcome of an election or changing this policy. Estimates of the impact of this tariff show it costs U.S. consumers around $1.11 billion annually. Of this amount, roughly $817 million ends up in the pockets of foreign tire manufacturers other than in China, and the remaining $294 million goes to U.S. tire manufacturers. In other words, the tariff increase on Chinese tires may have saved 1,200 jobs in the domestic tire sector, but it cost 3,700 jobs in other sectors, as consumers had to reduce their spending because they were paying more for tires. People actually lost their jobs as a result of this tariff. Workers
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in U.S. tire manufacturing firms earned about $40,000 in 2010. Given the number of jobs saved and the total cost to U.S. consumers, the cost of saving one job amounted to $926,500! This tariff caused a net decline in U.S. social surplus. (We discuss total surplus in the Demand and Supply chapter, and tariffs in the The International Trade and Capital Flows (http://cnx.org/content/m64021/ latest/) chapter.) Instead of saving jobs, it cost jobs, and those jobs that it saved cost many times more than the people working in them could ever hope to earn. Why would the government do this? The chapter answers this question by discussing the influence special interest groups have on economic policy. The steelworkers union, whose members make tires, saw increasingly more members lose their jobs as U.S. consumers consumed increasingly more cheap Chinese tires. By definition, this union is relatively small but well organized, especially compared to tire consumers. It stands to gain much for each of its members, compared to what each tire consumer may have to give up in terms of higher prices. Thus, the steelworkers union (joined by domestic tire manufacturers) has not only the means but the incentive to lobby economic policymakers and lawmakers. Given that U.S. tire consumers are a large and unorganized group, if they even are a group, it is unlikely they will lobby against higher tire tariffs. In the end, lawmakers tend to listen to those who lobby them, even though the results make for bad economic policy. 440 Chapter 18 | Public Economy KEY TERMS logrolling the situation in which groups of legislators all agree to vote for a package of otherwise unrelated laws that they individually favor median voter theory theory that politicians will try to match policies to what pleases the median voter preferences pork-barrel spending spending that benefits mainly a single political district rational ignorance the theory that rational people will not vote if the costs of becoming informed and voting are too high or because they know their vote will not be decisive in the election special interest groups groups that are small in number relative to the nation, but well organized and thus exert a disproportionate effect on political outcomes voting cycle the situation in which a majority prefers A over B, B over C, and C over A KEY CONCEPTS AND SUMMARY 18.1 Voter Participation and Costs of Elections The theory of rational ignorance says voters will recognize that their single vote is extremely unlikely to influence the outcome of an election. As a consequence
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, they will choose to remain uninformed about issues and not vote. This theory helps explain why voter turnout is so low in the United States. 18.2 Special Interest Politics Special interest politics arises when a relatively small group, called a special interest group, each of whose members has a large interest in a political outcome, devotes considerable time and energy to lobbying for the group’s preferred choice. Meanwhile, the large majority, each of whose members has only a small interest in this issue, pays no attention. We define pork--barrel spending as legislation whose benefits are concentrated on a single district while the costs are spread widely over the country. Logrolling refers to a situation in which two or more legislators agree to vote for each other’s legislation, which can then encourage pork-barrel spending in many districts. 18.3 Flaws in the Democratic System of Government Majority votes can run into difficulties when more than two choices exist. A voting cycle occurs when, in a situation with at least three choices, choice A is preferred by a majority vote to choice B, choice B is preferred by a majority vote to choice C, and choice C is preferred by a majority vote to choice A. In such a situation, it is impossible to identify what the majority prefers. Another difficulty arises when the vote is so divided that no choice receives a majority. A practical approach to microeconomic policy will need to take a realistic view of the specific strengths and weaknesses of markets as well as government, rather than making the easy but wrong assumption that either the market or government is always beneficial or always harmful. SELF-CHECK QUESTIONS 1. Based on the theory of rational ignorance, what should we expect to happen to voter turnout as the internet makes information easier to obtain? 2. What is the cost of voting in an election? 3. What is the main factor preventing a large community from influencing policy in the same way as a special interest group? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 18 | Public Economy 441 4. Why might legislators vote to impose a tariff on Egyptian cotton, when consumers in their districts would benefit from its availability? 5. True or false: Majority rule can fail to produce a single preferred outcome when there are more than two choices. 6. Anastasia, Emma, and Greta are deciding what to do on a weekend getaway. They each suggest a first, second, and third choice and then vote on
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the options. Table 18.2 shows their first, second, and third choice preferences. Explain why they will have a hard time reaching a decision. Does the group prefer mountain biking to canoeing? What about canoeing compared to the beach? What about the beach compared to the original choice of mountain biking? Anastasia Emma Greta First Choice Beach Mountain biking Canoeing Second Choice Mountain biking Canoeing Beach Third Choice Canoeing Beach Mountain biking Table 18.2 7. Suppose there is an election for Soft Drink Commissioner. The field consists of one candidate from the Pepsi party and four from the Coca-Cola party. This would seem to indicate a strong preference for Coca-Cola among the voting population, but the Pepsi candidate ends up winning in a landslide. Why does this happen? REVIEW QUESTIONS 8. How does rational ignorance discourage voting? 9. How can a small special interest group win in a situation of majority voting when the benefits it seeks flow only to a small group? 10. How can pork-barrel spending occur in a situation of majority voting when it benefits only a small group? 11. Why do legislators vote for spending projects in districts that are not their own? CRITICAL THINKING QUESTIONS 14. What are some reasons people might find acquiring in information about politics and voting rational, contrast to rational ignorance theory? 15. What are some possible ways to encourage voter participation and overcome rational ignorance? 16. Given that rational ignorance discourages some people from becoming informed about elections, is it necessarily a good idea to encourage greater voter turnout? Why or why not? 12. Why does a voting cycle make it impossible to decide on a majority-approved choice? 13. How does a government agency raise revenue differently from a private company, and how does that affect the way government makes decisions compared to business decisions? 17. When Microsoft was founded, the company devoted very few resources to lobbying activities. After a high-profile antitrust case against it, however, the company began to lobby heavily. Why does it make financial sense for companies to invest in lobbyists? 18. Representatives of competing firms often comprise special interest groups. Why are competitors sometimes willing to cooperate in order to form lobbying associations? 442 Chapter 18 | Public Economy 23. The United States currently uses a voting system called “first past the post” in elections, meaning that the candidate with the most votes wins. What are some of the problems with a “first past the post” system? 24. What are some alternatives to
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a “first past the post” system that might reduce the problem of voting cycles? 25. AT&T spent some $10 million dollars lobbying Congress to block entry of competitors into the telephone market in 1978. Why do you think it efforts failed? 26. Occupy Wall Street was a national (and later global) organized protest against the greed, bank profits, and financial corruption that led to the 2008–2009 recession. The group popularized slogans like “We are the 99%,” meaning it represented the majority against the wealth of the top 1%. Does the fact that the protests had little to no effect on legislative changes support or contradict the chapter? 19. Special interests do not oppose regulations in all cases. The Marketplace Fairness Act of 2013 would require online merchants to collect sales taxes from their customers in other states. Why might a large online retailer like Amazon.com support such a measure? 20. To ensure safety and efficacy, the Food and Drug Administration regulates the medicines that pharmacies are allowed to sell in the United States. Sometimes this means a company must test a drug for years before it can reach the market. We can easily identify the winners in this system as those who are protected from unsafe drugs that might otherwise harm them. Who are the more anonymous losers who suffer from strict medical regulations? 21. How is it possible to bear a cost without realizing it? What are some examples of policies that affect people in ways of which they may not even be aware? 22. Is pork-barrel spending always a bad thing? Can you think of some examples of pork-barrel projects, perhaps from your own district, that have had positive results? PROBLEMS 27. Say that the government is considering a ban on smoking in restaurants in Tobaccoville. There are 1 million people living there, and each would benefit by $200 from this smoking ban. However, there are two large tobacco companies in Tobaccoville and the ban would cost them $5 million each. What are the proposed policy's total costs and benefits? Do you think it will pass? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 443 19 | International Trade Figure 19.1 Apple or Samsung iPhone? While the iPhone is readily recognized as an Apple product, 26% of the component costs in it come from components made by rival phone-maker, Samsung. In international trade, there are often “conflicts�
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� like this as each country or company focuses on what it does best. (Credit: modification of work by Yutaka Tsutano Creative Commons) Just Whose iPhone Is It? The iPhone is a global product. Apple does not manufacture the iPhone components, nor does it assemble them. The assembly is done by Foxconn Corporation, a Taiwanese company, at its factory in Sengzhen, China. But, Samsung, the electronics firm and competitor to Apple, actually supplies many of the parts that make up an iPhone—representing about 26% of the costs of production. That means, that Samsung is both the biggest supplier and biggest competitor for Apple. Why do these two firms work together to produce the iPhone? To understand the economic logic behind international trade, you have to accept, as these firms do, that trade is about mutually beneficial exchange. Samsung is one of the world’s largest electronics parts suppliers. Apple lets Samsung focus on making the best parts, which allows Apple to concentrate on its strength—designing elegant products that are easy to use. If each company (and by extension each country) focuses on what it does best, there will be gains for all through trade. Introduction to International Trade In this chapter, you will learn about: • Absolute and Comparative Advantage 444 Chapter 19 | International Trade • What Happens When a Country Has an Absolute Advantage in All Goods • Intra-industry Trade between Similar Economies • The Benefits of Reducing Barriers to International Trade We live in a global marketplace. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery, airplanes, cars, scientific instruments, or many other technology-related industries, the odds are good that a hearty proportion of the sales of your employer—and hence the money that pays your salary—comes from export sales. We are all linked by international trade, and the volume of that trade has grown dramatically in the last few decades. The first wave of globalization started in the nineteenth century and lasted up to the beginning of World War I. Over that time, global
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exports as a share of global GDP rose from less than 1% of GDP in 1820 to 9% of GDP in 1913. As the Nobel Prize-winning economist Paul Krugman of Princeton University wrote in 1995: It is a late-twentieth-century conceit that we invented the global economy just yesterday. In fact, world markets achieved an impressive degree of integration during the second half of the nineteenth century. Indeed, if one wants a specific date for the beginning of a truly global economy, one might well choose 1869, the year in which both the Suez Canal and the Union Pacific railroad were completed. By the eve of the First World War steamships and railroads had created markets for standardized commodities, like wheat and wool, that were fully global in their reach. Even the global flow of information was better than modern observers, focused on electronic technology, tend to realize: the first submarine telegraph cable was laid under the Atlantic in 1858, and by 1900 all of the world’s major economic regions could effectively communicate instantaneously. This first wave of globalization crashed to a halt early in the twentieth century. World War I severed many economic connections. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others. World War II further hindered international trade. Global flows of goods and financial capital were rebuilt only slowly after World War II. It was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I. 19.1 | Absolute and Comparative Advantage By the end of this section, you will be able to: • Define absolute advantage, comparative advantage, and opportunity costs • Explain the gains of trade created when a country specializes The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever ruined by trade.” Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decades—for example, Japan, South Korea, China, and India—have done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade,
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or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage. In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage. A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a country’s natural endowment. For example, extracting oil in This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 445 Saudi Arabia is pretty much just a matter of “drilling a hole.” Producing oil in other countries can require considerable exploration and costly technologies for drilling and extraction—if they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world’s richest copper mines. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage. Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: “What do we give up to produce this good?” It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity. For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land and financial resources to produce other goods such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simpl
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ify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantage in greater detail and relates them to trade. this website (http://openstaxcollege.org/l/WTO) Visit international trade topics. for a list of articles and podcasts pertaining to A Numerical Example of Absolute and Comparative Advantage Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 19.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good. Country Oil (hours per barrel) Corn (hours per bushel) Saudi Arabia United States 1 2 4 1 Table 19.1 How Many Hours It Takes to Produce Oil and Corn In Table 19.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing 446 corn. Chapter 19 | International Trade To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 19.2). Figure 19.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology. Country Oil Production using 100 worker hours (barrels) Corn Production using 100 worker hours (bushels) Saudi Arabia United States 100 50 or 25 or 100 Table 19.2 Production Possibilities before Trade Figure 19.2 Production Possibilities Frontiers (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil
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(point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table 19.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology. Arguably Saudi and U.S. consumers desire both oil and corn to live. Let’s say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 19.3 shows. Given the information in Table 19.1, this choice implies that it produces/ consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn. Country Oil Production (barrels) Corn Production (bushels) Saudi Arabia (C) 60 10 Table 19.3 Production before Trade This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 447 Country Oil Production (barrels) Corn Production (bushels) United States (C') Total World Production 20 80 Table 19.3 Production before Trade 60 70 The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or
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25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 19.4 summarizes these calculations. Country Opportunity cost of one unit — Oil (in terms of corn) Opportunity cost of one unit — Corn (in terms of oil) Saudi Arabia United States ¼ 2 4 ½ Table 19.4 Opportunity Cost and Comparative Advantage Again recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, ( 1 < 2 in Table 19.4) it has a comparative advantage in oil production. 4 The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production. In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 19.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 19.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight. Can a production possibility frontier be straight? When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly. 448 Chapter 19 | International Trade Gains from Trade Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces
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/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/ consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receives in exchange an amount of oil greater than 20 barrels, it will gain from trade. With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the chapter Welcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table 19.5 illustrates the range of trades that would benefit both sides. The U.S. economy, after specialization, will benefit if it: The Saudi Arabian economy, after specialization, will benefit if it: Exports no more than 60 bushels of corn Imports at least 10 bushels of corn Imports at least 20 barrels of oil Exports less than 60 barrels of oil Table 19.5 The Range of Trades That Benefit Both the United States and Saudi Arabia The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off. What are the opportunity costs and gains from trade? The range of trades that will benefit each country is based on the country’s opportunity cost of producing each good. The United States can produce 100 bushels of corn or 50 barrels of oil. For the United States, the opportunity cost of producing one barrel of oil is two bushels of corn. If we divide the numbers above by 50, we get the same ratio: one barrel of oil is equivalent to two bushels of corn, or (100/50 = 2 and 50/50 =
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1). In a trade with Saudi Arabia, if the United States is going to give up 100 bushels of corn in exports, it must import at least 50 barrels of oil to be just as well off. Clearly, to gain from trade it needs to be able to gain more than a half barrel of oil for its bushel of corn—or why trade at all? Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 19.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 19.3 to that in Table 19.6.) Country Quantity produced after 100% specialization — Oil (barrels) Quantity produced after 100% specialization — Corn (bushels) Saudi Arabia 100 0 Table 19.6 How Specialization Expands Output This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 449 Country Quantity produced after 100% specialization — Oil (barrels) Quantity produced after 100% specialization — Corn (bushels) United States 0 Total World Production 100 Table 19.6 How Specialization Expands Output 100 100 What if we did not have complete specialization, as in Table 19.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 19.2 shows. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil. Figure 19.3 Production Possibilities Frontier in Saudi Arabia Trade allows a country to go beyond its domestic production-possibility frontier Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 19.3). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the
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country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade. Visit this website (http://wits.worldbank.org/trade-visualization.aspx) for trade-related data visualizations. 450 Chapter 19 | International Trade 19.2 | What Happens When a Country Has an Absolute Advantage in All Goods By the end of this section, you will be able to: • Show the relationship between production costs and comparative advantage • • Identify situations of mutually beneficial trade Identify trade benefits by considering opportunity costs What happens to the possibilities for trade if one country has an absolute advantage in everything? This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Good students of Ricardo understand that trade is about mutually beneficial exchange. Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one’s comparative advantage. Production Possibilities and Comparative Advantage Consider the example of trade between the United States and Mexico described in Table 19.7. In this example, it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators. Number of Workers needed to produce 1,000 units — Shoes Number of Workers needed to produce 1,000 units — Refrigerators Country United States 4 workers Mexico 5 workers 1 worker 4 workers Table 19.7 Resources Needed to Produce Shoes and Refrigerators Absolute advantage simply compares the productivity of a worker between countries. It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, “How much
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am I giving up to produce this good in this country?” Another way of looking at this is that comparative advantage identifies the good for which the producer’s absolute advantage is relatively larger, or where the producer’s absolute productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). So, the comparative advantage of the United States, where its absolute productivity advantage is relatively This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 451 greatest, lies with refrigerators, and Mexico’s comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes. Mutually Beneficial Trade with Comparative Advantage When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibility frontier is a useful tool to visualize this benefit. Consider a situation where the United States and Mexico each have 40 workers. For example, as Table 19.8 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced. Country Shoe Production — using 40 workers Refrigerator Production — using 40 workers United States 10,000 shoes or 40,000 refrigerators Mexico 8,000 shoes or 10,000 refrigerators Table 19.8 Production Possibilities before Trade with Complete Specialization As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the former (see Figure 19.4). Figure 19.4 Production Possibility Frontiers (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators,
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or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade. Let’s say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 19.9 shows the output of each good for each country and the total output for the two countries. 452 Chapter 19 | International Trade Country Current Shoe Production Current Refrigerator Production United States Mexico Total 5,000 4,000 9,000 20,000 5,000 25,000 Table 19.9 Total Production at Point A before Trade Continuing with this scenario, suppose that each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.S. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 × 1,000). Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but production of shoes increases by 2,000 pairs (10/5 × 1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 19.10. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States. Country Shoe Production Refrigerator Production United States Mexico Total 3,500 6,000 9,500 26,000 2,500 28,500 Table 19.10 Shifting Production Toward Comparative Advantage Raises Total Output This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Even though the United States has an absolute advantage
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in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and in return import shoes. How Opportunity Cost Sets the Boundaries of Trade This example shows that both parties can benefit from specializing in their comparative advantages and trading. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country. Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators (see Figure 19.4 and Table 19.9). Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico will be unambiguously better off. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off. The range of trades that can benefit both nations is shown in Table 19.11. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 453 both countries would be able to consume more of both goods than in a world without trade. The U.S. economy, after specialization, will benefit if it: The Mexican economy, after specialization, will benefit if it: Exports fewer than 6,000 refrigerators Imports at least 2,500 refrigerators Imports at least 1,500 pairs of shoes Exports no more than 2,000 pairs of shoes Table 19.11 The Range of Trades That Benefit Both the
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United States and Mexico Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico. The theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. The following Work It Out feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production. Calculating Absolute and Comparative Advantage In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber. Country Oil (barrels) Lumber (tons) Canada Venezuela Table 19.12 20 60 or or 40 30 a. Who has the absolute advantage in the production of oil or lumber? How can you tell? b. Which country has a comparative advantage in the production of oil? c. Which country has a comparative advantage in producing lumber? d. e. In this example, is absolute advantage the same as comparative advantage, or not? In what product should Canada specialize? In what product should Venezuela specialize? Step 1. Make a table like Table 19.12. Step 2. To calculate absolute advantage, look at the larger of the numbers for each product. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20. Step 3. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same labor 454 Chapter 19 | International Trade time, Canada can produce either 20 barrels of oil or 40 tons of lumber. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Divide both sides of the equation by
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20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. 1 oil = 2 lumber. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Calculate the same way for Venezuela: 60 oil = 30 lumber. Divide both sides of the equation by 60. One oil in Venezuela has an opportunity cost of 1/ 2 lumber. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil. Step 4. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by 40. The opportunity cost of one lumber is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by 30. One lumber has an opportunity cost of two oil. Canada has the lower opportunity cost in producing lumber. Step 5. In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil. Step 6. Canada should specialize in the commodity for which it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber. Comparative Advantage Goes Camping To build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work? Of course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like all mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an
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unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage—that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain. 19.3 | Intra-industry Trade between Similar Economies By the end of this section, you will be able to: Identify at least two advantages of intra-industry trading • • Explain the relationship between economies of scale and intra-industry trade Absolute and comparative advantages explain a great deal about global trading patterns. For example, they help to explain the patterns that we noted at the start of this chapter, like why you may be eating fresh fruit from Chile or Mexico, or why lower productivity regions like Africa and Latin America are able to sell a substantial proportion of their exports to higher productivity regions like the European Union and North America. Comparative advantage, however, at least at first glance, does not seem especially well-suited to explain other common patterns of international trade. The Prevalence of Intra-industry Trade between Similar Economies The theory of comparative advantage suggests that trade should happen between economies with large differences in opportunity costs of production. Roughly half of all world trade involves shipping goods between the fairly similar This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 455 high-income economies of the United States, Canada, the European Union, Japan, Mexico, and China (see Table 19.13). Country U.S. Exports Go to... U.S. Imports Come from... European Union Canada Japan Mexico China 19.0% 22.0% 4.0% 15.0% 8.0% 21.0% 14.0% 6.0% 13.0% 20.0% Table 19.13 Where U.S. Exports Go and U.S. Imports Originate (
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2015) https://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf) (Source: Moreover, the theory of comparative advantage suggests that each economy should specialize to a degree in certain products, and then exchange those products. A high proportion of trade, however, is intra-industry trade—that is, trade of goods within the same industry from one country to another. For example, the United States produces and exports autos and imports autos. Table 19.14 shows some of the largest categories of U.S. exports and imports. In all of these categories, the United States is both a substantial exporter and a substantial importer of goods from the same industry. In 2014, according to the Bureau of Economic Analysis, the United States exported $146 billion worth of autos, and imported $327 billion worth of autos. About 60% of U.S. trade and 60% of European trade is intra-industry trade. Some U.S. Exports Quantity of Exports ($ billions) Quantity of Imports ($ billions) Autos Food and beverages Capital goods Consumer goods Industrial supplies Other transportation $146 $144 $550 $199 $507 $45 $327 $126 $551 $558 $665 $55 Table 19.14 Some Intra-Industry U.S. Exports and Imports in 2014 (Source: http://www.bea.gov/ newsreleases/international/trade/tradnewsrelease.htm) Why do similar high-income economies engage in intra-industry trade? What can be the economic benefit of having workers of fairly similar skills making cars, computers, machinery and other products which are then shipped across the oceans to and from the United States, the European Union, and Japan? There are two reasons: (1) The division of labor leads to learning, innovation, and unique skills; and (2) economies of scale. Gains from Specialization and Learning Consider the category of machinery, where the U.S. economy has considerable intra-industry trade. Machinery comes in many varieties, so the United States may be exporting machinery for manufacturing with wood, but importing machinery for photographic processing. The underlying reason why a country like the United States, Japan, or Germany produces one kind of machinery rather than another is usually not related to U.S., German, or Japanese firms and workers having generally higher or lower skills. It is just that, in working on very specific and particular
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products, firms in certain countries develop unique and different skills. 456 Chapter 19 | International Trade Specialization in the world economy can be very finely split. In fact, recent years have seen a trend in international trade, which economists call splitting up the value chain. The value chain describes how a good is produced in stages. As indicated in the beginning of the chapter, producing the iPhone involves designing and engineering the phone in the United States, supplying parts from Korea, assembling the parts in China, and advertising and marketing in the United States. Thanks in large part to improvements in communication technology, sharing information, and transportation, it has become easier to split up the value chain. Instead of production in a single large factory, different firms operating in various places and even different countries can divide the value chain. Because firms split up the value chain, international trade often does not involve nations trading whole finished products like automobiles or refrigerators. Instead, it involves shipping more specialized goods like, say, automobile dashboards or the shelving that fits inside refrigerators. Intra-industry trade between similar countries produces economic gains because it allows workers and firms to learn and innovate on particular products—and often to focus on very particular parts of the value chain. Visit this website (http://openstaxcollege.org/l/iphoneassembly) for some interesting information about the assembly of the iPhone. Economies of Scale, Competition, Variety A second broad reason that intra-industry trade between similar nations produces economic gains involves economies of scale. The concept of economies of scale, as we introduced in Production, Costs and Industry Structure, means that as the scale of output goes up, average costs of production decline—at least up to a point. Figure 19.5 illustrates economies of scale for a plant producing toaster ovens. The horizontal axis of the figure shows the quantity of production by a certain firm or at a certain manufacturing plant. The vertical axis measures the average cost of production. Production plant S produces a small level of output at 30 units and has an average cost of production of $30 per toaster oven. Plant M produces at a medium level of output at 50 units, and has an average cost of production of $20 per toaster oven. Plant L produces 150 units of output with an average cost of production of only $10 per toaster oven. Although plant V can produce 200 units of output, it still has the same unit cost as Plant L. In this example, a small or medium plant, like S or M,
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will not be able to compete in the market with a large or a very large plant like L or V, because the firm that operates L or V will be able to produce and sell its output at a lower price. In this example, economies of scale operate up to point L, but beyond point L to V, the additional scale of production does not continue to reduce average costs of production. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 457 Figure 19.5 Economies of Scale Production Plant S, has an average cost of production of $30 per toaster oven. Production plant M has an average cost of production of $20 per toaster oven. Production plant L has an average cost of production of only $10 per toaster oven. Production plant V still has an average cost of production of $10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150. Plant V, despite being larger, cannot produce more cheaply on average than plant L. The concept of economies of scale becomes especially relevant to international trade when it enables one or two large producers to supply the entire country. For example, a single large automobile factory could probably supply all the cars consumers purchase in a smaller economy like the United Kingdom or Belgium in a given year. However, if a country has only one or two large factories producing cars, and no international trade, then consumers in that country would have relatively little choice between kinds of cars (other than the color of the paint and other nonessential options). Little or no competition will exist between different car manufacturers. International trade provides a way to combine the lower average production costs that come from economies of scale and still have competition and variety for consumers. Large automobile factories in different countries can make and sell their products around the world. If General Motors, Ford, and Chrysler were the only players in the U.S. automobile market, the level of competition and consumer choice would be considerably lower than when U.S. carmakers must face competition from Toyota, Honda, Suzuki, Fiat, Mitsubishi, Nissan, Volkswagen, Kia, Hyundai, BMW, Subaru, and others. Greater competition brings with it innovation and responsiveness to what consumers want. America’s car
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producers make far better cars now than they did several decades ago, and much of the reason is competitive pressure, especially from East Asian and European carmakers. Dynamic Comparative Advantage The sources of gains from intra-industry trade between similar economies—namely, the learning that comes from a high degree of specialization and splitting up the value chain and from economies of scale—do not contradict the earlier theory of comparative advantage. Instead, they help to broaden the concept. In intra-industry trade, climate or geography do not determine the level of worker productivity. Even the general level of education or skill does not determine it. Instead, how firms engage in specific learning about specialized products, including taking advantage of economies of scale determine the level of worker productivity. In this vision, comparative advantage can be dynamic—that is, it can evolve and change over time as one develops new skills and as manufacturers split the value chain in new ways. This line of thinking also suggests that countries are not destined to have the same comparative advantage forever, but must instead be flexible in response to ongoing changes in comparative advantage. 458 Chapter 19 | International Trade 19.4 | The Benefits of Reducing Barriers to International Trade By the end of this section, you will be able to: • Explain tarrifs as barriers to trade • Identify at least two benefits of reducing barriers to international trade Tariffs are taxes that governments place on imported goods for a variety of reasons. Some of these reasons include protecting sensitive industries, for humanitarian reasons, and protecting against dumping. Traditionally, tariffs were used simply as a political tool to protect certain vested economic, social, and cultural interests. The World Trade Organization (WTO) is committed to lowering barriers to trade. The world’s nations meet through the WTO to negotiate how they can reduce barriers to trade, such as tariffs. WTO negotiations happen in “rounds,” where all countries negotiate one agreement to encourage trade, take a year or two off, and then start negotiating a new agreement. The current round of negotiations is called the Doha Round because it was officially launched in Doha, the capital city of Qatar, in November 2001. In 2009, economists from the World Bank summarized recent research and found that the Doha round of negotiations would increase the size of the world economy by $160 billion to $385 billion per year, depending on the precise deal that ended up being negotiated. In the context of a global economy that currently produces more than $30 trillion of goods and services each year,
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this amount is not huge: it is an increase of 1% or less. But before dismissing the gains from trade too quickly, it is worth remembering two points. • First, a gain of a few hundred billion dollars is enough money to deserve attention! Moreover, remember that this increase is not a one-time event; it would persist each year into the future. • Second, the estimate of gains may be on the low side because some of the gains from trade are not measured especially well in economic statistics. For example, it is difficult to measure the potential advantages to consumers of having a variety of products available and a greater degree of competition among producers. Perhaps the most important unmeasured factor is that trade between countries, especially when firms are splitting up the value chain of production, often involves a transfer of knowledge that can involve skills in production, technology, management, finance, and law. Low-income countries benefit more from trade than high-income countries do. In some ways, the giant U.S. economy has less need for international trade, because it can already take advantage of internal trade within its economy. However, many smaller national economies around the world, in regions like Latin America, Africa, the Middle East, and Asia, have much more limited possibilities for trade inside their countries or their immediate regions. Without international trade, they may have little ability to benefit from comparative advantage, slicing up the value chain, or economies of scale. Moreover, smaller economies often have fewer competitive firms making goods within their economy, and thus firms have less pressure from other firms to provide the goods and prices that consumers want. The economic gains from expanding international trade are measured in hundreds of billions of dollars, and the gains from international trade as a whole probably reach well into the trillions of dollars. The potential for gains from trade may be especially high among the smaller and lower-income countries of the world. Visit this website (http://openstaxcollege.org/l/tradebenefits) for a list of some benefits of trade. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 459 From Interpersonal to International Trade Most people find it easy to believe that they, personally, would not be better off if they tried to grow and process all of their own food, to make all of their own clothes, to build their own cars and houses from scratch, and so on. Instead, we all benefit from living in
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economies where people and firms can specialize and trade with each other. The benefits of trade do not stop at national boundaries, either. Earlier we explained that the division of labor could increase output for three reasons: (1) workers with different characteristics can specialize in the types of production where they have a comparative advantage; (2) firms and workers who specialize in a certain product become more productive with learning and practice; and (3) economies of scale. These three reasons apply from the individual and community level right up to the international level. If it makes sense to you that interpersonal, intercommunity, and interstate trade offer economic gains, it should make sense that international trade offers gains, too. International trade currently involves about $20 trillion worth of goods and services moving around the globe. Any economic force of that size, even if it confers overall benefits, is certain to cause disruption and controversy. This chapter has only made the case that trade brings economic benefits. Other chapters discuss, in detail, the public policy arguments over whether to restrict international trade. It’s Apple’s (Global) iPhone Apple Corporation uses a global platform to produce the iPhone. Now that you understand the concept of comparative advantage, you can see why the engineering and design of the iPhone is done in the United States. The United States has built up a comparative advantage over the years in designing and marketing products, and sacrifices fewer resources to design high-tech devices relative to other countries. China has a comparative advantage in assembling the phone due to its large skilled labor force. Korea has a comparative advantage in producing components. Korea focuses its production by increasing its scale, learning better ways to produce screens and computer chips, and uses innovation to lower average costs of production. Apple, in turn, benefits because it can purchase these quality products at lower prices. Put the global assembly line together and you have the device with which we are all so familiar. 460 Chapter 19 | International Trade KEY TERMS absolute advantage when one country can use fewer resources to produce a good compared to another country; when a country is more productive compared to another country gain from trade a country that can consume more than it can produce as a result of specialization and trade intra-industry trade international trade of goods within the same industry splitting up the value chain many of the different stages of producing a good happen in different geographic locations tariffs taxes that governments place on imported goods value chain how a good is produced in stages KEY CONCEPTS AND SUMMARY 19.1 Absolute and Comparative Advantage A country has
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an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. A country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. Countries that specialize based on comparative advantage gain from trade. 19.2 What Happens When a Country Has an Absolute Advantage in All Goods Even when a country has high levels of productivity in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that it gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries. 19.3 Intra-industry Trade between Similar Economies A large share of global trade happens between high-income economies that are quite similar in having well-educated workers and advanced technology. These countries practice intra-industry trade, in which they import and export the same products at the same time, like cars, machinery, and computers. In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in very particular tasks and from economies of scale. Splitting up the value chain means that several stages of producing a good take place in different countries around the world. 19.4 The Benefits of Reducing Barriers to International Trade Tariffs are placed on imported goods as a way of protecting sensitive industries, for humanitarian reasons, and for protection against dumping. Traditionally, tariffs were used as a political tool to protect certain vested economic, social, and cultural interests. The WTO has been, and continues to be, a way for nations to meet and negotiate in order to reduce barriers to trade. The gains of international trade are very large, especially for smaller countries, but are beneficial to all. SELF-CHECK QUESTIONS 1. True or False: The source of comparative advantage must be natural elements like climate and mineral deposits. Explain. 2. Brazil can produce 100 pounds of beef or 10 autos. In contrast the United States can produce 40 pounds of beef or 30 autos. Which country has the absolute advantage in beef? Which country has the absolute advantage in producing autos? What is the opportunity cost of producing one pound of beef in Brazil? What is the opportunity cost of producing one pound of beef in the United States? This Open
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Stax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 461 3. In France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Who has the absolute advantage in production of sweaters? Who has the absolute advantage in the production of wine? How can you tell? In Germany it takes three workers to make one television and four workers to make one video camera. In Poland 4. it takes six workers to make one television and 12 workers to make one video camera. a. Who has the absolute advantage in the production of televisions? Who has the absolute advantage in the production of video cameras? How can you tell? b. Calculate the opportunity cost of producing one additional television set in Germany and in Poland. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of televisions? c. Calculate the opportunity cost of producing one video camera in Germany and in Poland. Which country has a comparative advantage in the production of video cameras? In this example, is absolute advantage the same as comparative advantage, or not? In what product should Germany specialize? In what product should Poland specialize? d. e. 5. How can there be any economic gains for a country from both importing and exporting the same good, like cars? 6. Table 19.15 shows how the average costs of production for semiconductors (the “chips” in computer memories) change as the quantity of semiconductors built at that factory increases. a. Based on these data, sketch a curve with quantity produced on the horizontal axis and average cost of b. production on the vertical axis. How does the curve illustrate economies of scale? If the equilibrium quantity of semiconductors demanded is 90,000, can this economy take full advantage of economies of scale? What about if quantity demanded is 70,000 semiconductors? 50,000 semiconductors? 30,000 semiconductors? c. Explain how international trade could make it possible for even a small economy to take full advantage of economies of scale, while also benefiting from competition and the variety offered by several producers. Quantity of Semiconductors Average Total Cost 10,000 20,000 30,000 40,000 100,000 Table 19.15 $8 each $5 each $3
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each $2 each $2 each If the removal of trade barriers is so beneficial to international economic growth, why would a nation continue to 7. restrict trade on some imported or exported products? REVIEW QUESTIONS 8. What is absolute advantage? What is comparative advantage? 9. Under what conditions does comparative advantage lead to gains from trade? 10. What factors does Paul Krugman identify that supported expanding international trade in the 1800s? 11. Is it possible to have a comparative advantage in the production of a good but not to have an absolute advantage? Explain. 12. How does comparative advantage lead to gains from trade? 13. What is intra-industry trade? 462 Chapter 19 | International Trade 14. What are the two main sources of economic gains from intra-industry trade? 15. What is splitting up the value chain? 16. Are the gains from international trade more likely to large or small to be relatively more important countries? CRITICAL THINKING QUESTIONS 22. You just got a job in Washington, D.C. You move into an apartment with some acquaintances. All your roommates, however, are slackers and do not clean up after themselves. You, on the other hand, can clean faster than each of them. You determine that you are 70% faster at dishes and 10% faster with vacuuming. All of these tasks have to be done daily. Which jobs should you assign to your roommates to get the most free time overall? Assume you have the same number of hours to devote to cleaning. Now, since you are faster, you seem to get done quicker than your roommate. What sorts of problems may this create? Can you imagine a traderelated analogy to this problem? 23. Does intra-industry trade contradict the theory of comparative advantage? 24. Do consumers benefit from intra-industry trade? 25. Why might intra-industry trade seem surprising from the point of view of comparative advantage? In World Trade Organization meetings, what do 26. you think low-income countries lobby for? 27. Why might a low-income country put up barriers to trade, such as tariffs on imports? 28. Can a nation’s comparative advantage change over time? What factors would make it change? Are differences 17. differences in absolute advantages? in geography behind the 18. Why does the United States not have an absolute advantage in coffee? 19. Look at Exercise 19.2. Compute the opportunity costs of producing sweaters and wine in both France
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and Tunisia. Who has the lowest opportunity cost of producing sweaters and who has the lowest opportunity cost of producing wine? Explain what it means to have a lower opportunity cost. countries 20. You just overheard your friend say the following: “Poor like Malawi have no absolute advantages. They have poor soil, low investments in formal education and hence low-skill workers, no capital, and no natural resources to speak of. Because they have no advantage, they cannot benefit from trade.” How would you respond? 21. Look at Table 19.9. Is there a range of trades for which there will be no gains? This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 19 | International Trade 463 PROBLEMS 29. France and Tunisia both have Mediterranean climates that are excellent for producing/harvesting green beans and tomatoes. In France it takes two hours for each worker to harvest green beans and two hours to harvest a tomato. Tunisian workers need only one hour to harvest the tomatoes but four hours to harvest green beans. Assume there are only two workers, one in each country, and each works 40 hours a week. the a. Draw a production possibilities frontier for each country. Hint: Remember production possibility frontier is the maximum that all workers can produce at a unit of time which, in this problem, is a week. Identify which country has absolute advantage in green beans and which country has the absolute advantage in tomatoes. Identify which country has the comparative advantage. the b. c. d. How much would France have to give up in terms of tomatoes to gain from trade? How much would it have to give up in terms of green beans? 30. In Japan, one worker can make 5 tons of rubber or 80 radios. In Malaysia, one worker can make 10 tons of rubber or 40 radios. a. Who has in the production of rubber or radios? How can you tell? advantage absolute the b. Calculate the opportunity cost of producing 80 additional radios in Japan and in Malaysia. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of radios? d. tons of c. Calculate the opportunity cost of producing 10 additional in Japan and in rubber Malaysia. Which country has a comparative advantage in producing rubber? In this example, does each country have an absolute advantage and a comparative advantage in the same good? In what product should Japan specialize? In
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what product should Malaysia specialize? e. 31. Review the numbers for Canada and Venezuela from Table 19.12 which describes how many barrels of oil and tons of lumber the workers can produce. Use these numbers to answer the rest of this question. a. Draw a production possibilities frontier for each country. Assume there are 100 workers in each country. Canadians and Venezuelans desire both oil and lumber. Canadians want at least 2,000 tons of lumber. Mark a point on their production possibilities where they can get at least 3,000 tons. b. Assume Canadians that the specialize completely because they figured out they have a comparative advantage in lumber. They are willing to give up 1,000 tons of lumber. How much oil should they ask for in return for this lumber to be as well off as they were with no trade? How much should they ask for if they want to gain from trading with Venezuela? Note: We can think of this “ask” as the relative price or trade price of lumber. Is the Canadian “ask” you identified in (b) also beneficial for Venezuelans? Use the production possibilities frontier graph for Venezuela to show that Venezuelans can gain from trade. c. In Exercise 19.31, 32. is there an “ask” where Venezuelans may say “no thank you” to trading with Canada? From earlier chapters you will 33. that technological change shifts the average cost curves. Draw a graph showing how technological change could influence intra-industry trade. recall 34. Consider two countries: South Korea and Taiwan. Taiwan can produce one million mobile phones per day at the cost of $10 per phone and South Korea can produce 50 million mobile phones at $5 per phone. Assume these phones are the same type and quality and there is only one price. What is the minimum price at which both countries will engage in trade? 464 Chapter 19 | International Trade 35. If trade increases world GDP by 1% per year, what is the global impact of this increase over 10 years? How does this increase compare to the annual GDP of a country like Sri Lanka? Discuss. Hint: To answer this question, here are steps you may want to consider. Go to the World Development Indicators (online) published by the World Bank. Find the current level of World GDP in constant international dollars. Also, find the GDP of Sri Lanka in constant international dollars. Once you have these two numbers, compute the amount the additional increase in global incomes due to trade
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and compare that number to Sri Lanka’s GDP. This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 | Globalization and Protectionism 465 20 | Globalization and Protectionism Figure 20.1 Flat Screen Competition The market for flat-panel displays in the United States is huge. The manufacturers of flat screens in the United States must compete against manufacturers from around the world. (Credit: modification of work by “Jemimus”/Flickr Creative Commons) What’s the Downside of Protection? Governments are motivated to limit and alter market outcomes for political or social ends. While governments can limit the rise in prices of some products, they cannot control how much people want to buy or how much firms are willing to sell. The laws of demand and supply still hold. Trade policy is an example where regulations can redirect economic forces, but it cannot stop them from manifesting themselves elsewhere. Flat-panel displays, the displays for laptop computers, tablets, and flat screen televisions, are an example of such an enduring principle. In the early 1990s, the vast majority of flat-panel displays used in U.S.manufactured laptops were imported, primarily from Japan. The small but politically powerful U.S. flat-paneldisplay industry filed a dumping complaint with the Commerce Department. They argued that Japanese firms were selling displays at “less than fair value,” which made it difficult for U.S. firms to compete. This argument for trade protection is referred to as anti-dumping. Other arguments for protection in this complaint included national security. After a preliminary determination by the Commerce Department that the Japanese firms were dumping, the U.S. International Trade Commission imposed a 63% dumping margin (or tax) on the import of flat-panel displays. Was this a successful exercise of U.S. trade policy? See what you think after reading the chapter. 466 Chapter 20 | Globalization and Protectionism Introduction to Globalism and Protectionism In this chapter, you will learn about: • Protectionism: An Indirect Subsidy from Consumers to Producers • International Trade and Its Effects on Jobs, Wages, and Working Conditions • Arguments in Support of Restricting Imports • How Trade Policy Is Enacted: Globally, Regionally, and Nationally • The Tradeoffs of Trade Policy The world has become more connected on multiple levels, especially economically. In 1970, imports and
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exports made up 11% of U.S. GDP, while now they make up 32%. However, the United States, due to its size, is less internationally connected than most countries. For example, according to the World Bank, 97% of Botswana’s economic activity is connected to trade. This chapter explores trade policy—the laws and strategies a country uses to regulate international trade. This topic is not without controversy. As the world has become more globally connected, firms and workers in high-income countries like the United States, Japan, or the nations of the European Union, perceive a competitive threat from firms in medium-income countries like Mexico, China, or South Africa, that have lower costs of living and therefore pay lower wages. Firms and workers in low-income countries fear that they will suffer if they must compete against more productive workers and advanced technology in high-income countries. On a different tack, some environmentalists worry that multinational firms may evade environmental protection laws by moving their production to countries with loose or nonexistent pollution standards, trading a clean environment for jobs. Some politicians worry that their country may become overly dependent on key imported products, like oil, which in a time of war could threaten national security. All of these fears influence governments to reach the same basic policy conclusion: to protect national interests, whether businesses, jobs, or security, imports of foreign products should be restricted. This chapter analyzes such arguments. First, however, it is essential to learn a few key concepts and understand how the demand and supply model applies to international trade. 20.1 | Protectionism: An Indirect Subsidy from Consumers to Producers By the end of this section, you will be able to: • Explain protectionism and its three main forms • Analyze protectionism through concepts of demand and supply, noting its effects on equilibrium • Calculate the effects of trade barriers When a government legislates policies to reduce or block international trade it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three main forms: tariffs, import quotas, and nontariff barriers. Recall from International Trade that tariffs are taxes that governments impose on imported goods and services. This makes imports more expensive for consumers, discouraging imports. For example, in recent years large, flatscreen televisions imported to the U.S. from China have faced a 5% tariff rate. Another way to control trade is through import quotas, which are numerical limitations on the quantity of products that
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a country can import. For instance, during the early 1980s, the Reagan Administration imposed a quota on the import of Japanese automobiles. In the 1970s, many developed countries, including the United States, found themselves with declining textile industries. Textile production does not require highly skilled workers, so producers were able to set up lower-cost factories in developing countries. In order to “manage” this loss of jobs and income, the developed countries established an international Multifiber Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers. The agreement, which ran from 1974 to 2004, This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 | Globalization and Protectionism 467 specified the exact quota of textile imports that each developed country would accept from each low-income country. A similar story exists for sugar imports into the United States, which are still governed by quotas. Nontariff barriers are all the other ways that a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products. A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas, for instance. There are also nontariff barriers in the form of “rules-oforigin” regulations; these rules describe the “Made in Country X” label as the one in which the last substantial change in the product took place. A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in his or her own country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make apparel—and then re-exported back to the United States for a final assembly, to escape paying tariffs or to obtain a “Made in the USA” label. Despite import quotas, tariffs, and nontariff barriers, the share of apparel sold in the United States that is imported rose from about half in 1999 to about three-quarters today. The U.S. Bureau of Labor Statistics (BLS), estimated the number of U.S. jobs in textiles and apparel fell from 666,360 in 2007 to 385,240 in 2012, a 42% decline. Even more U.S. textile industry jobs would have been lost without tariffs. However, domestic jobs that are
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saved by import quotas come at a cost. Because textile and apparel protectionism adds to the costs of imports, consumers end up paying billions of dollars more for clothing each year. When the United States eliminates trade barriers in one area, consumers spend the money they save on that product elsewhere in the economy. Thus, while eliminating trade barriers in one sector of the economy will likely result in some job loss in that sector, consumers will spend the resulting savings in other sectors of the economy and hence increase the number of jobs in those other sectors. Of course, workers in some of the poorest countries of the world who would otherwise have jobs producing textiles, would gain considerably if the United States reduced its barriers to trade in textiles. That said, there are good reasons to be wary about reducing barriers to trade. The 2012 and 2013 Bangladeshi fires in textile factories, which resulted in a horrific loss of life, present complications that our simplified analysis in the chapter will not capture. Realizing the compromises between nations that come about due to trade policy, many countries came together in 1947 to form the General Agreement on Tariffs and Trade (GATT). (We’ll cover the GATT in more detail later in the chapter.) This agreement has since been superseded by the World Trade Organization (WTO), whose membership includes about 150 nations and most of the world's economies. It is the primary international mechanism through which nations negotiate their trade rules—including rules about tariffs, quotas, and nontariff barriers. The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy. Demand and Supply Analysis of Protectionism To the non-economist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers), who are also affected by the trade barriers. A demand and supply analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses, but a policy that imposes substantial domestic costs as well. Consider two countries, Brazil and the United States, who produce sugar. Each country has a domestic supply and demand for sugar, as Table 20.1 details and Figure 20.2 illustrates. In Brazil, without trade, the equilibrium price of sugar is 12 cents per pound and the equilibrium output is 30 tons. When there is no trade in the United
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States, the equilibrium price of sugar is 24 cents per pound and the equilibrium quantity is 80 tons. We label these equilibrium points as point E in each part of the figure. 468 Chapter 20 | Globalization and Protectionism Figure 20.2 The Sugar Trade between Brazil and the United States Before trade, the equilibrium price of sugar in Brazil is 12 cents a pound and it is 24 cents per pound in the United States. When trade is allowed, businesses will buy cheap sugar in Brazil and sell it in the United States. This will result in higher prices in Brazil and lower prices in the United States. Ignoring transaction costs, prices should converge to 16 cents per pound, with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar. If trade is only partly open between the countries, it will lead to an outcome between the free-trade and no-trade possibilities. Brazil: Quantity Supplied (tons) Brazil: Quantity Demanded (tons) U.S.: Quantity Supplied (tons) U.S.: Quantity Demanded (tons) 20 30 35 40 45 50 55 35 30 28 25 21 18 15 60 66 69 72 76 80 82 100 93 90 87 83 80 78 Price 8 cents 12 cents 14 cents 16 cents 20 cents 24 cents 28 cents Table 20.1 The Sugar Trade between Brazil and the United States If international trade between Brazil and the United States now becomes possible, profit-seeking firms will spot an opportunity: buy sugar cheaply in Brazil, and sell it at a higher price in the United States. As sugar is shipped from Brazil to the United States, the quantity of sugar produced in Brazil will be greater than Brazilian consumption (with the extra production exported), and the amount produced in the United States will be less than the amount of U.S. consumption (with the extra consumption imported). Exports to the United States will reduce the sugar supply in This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 | Globalization and Protectionism 469 Brazil, raising its price. Imports into the United States will increase the sugar supply, lowering its price. When the sugar price is the same in both countries, there is no incentive to trade further. As Figure 20.2 shows, the equilibrium with trade occurs at a price of 16 cents per pound. At that price, the sugar farmers of Brazil supply a quantity of 40 tons, while the consumers of Brazil buy only 25 tons. The extra 15 tons of sugar
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production, shown by the horizontal gap between the demand curve and the supply curve in Brazil, is exported to the United States. In the United States, at a price of 16 cents, the farmers produce a quantity of 72 tons and consumers demand a quantity of 87 tons. The excess demand of 15 tons by American consumers, shown by the horizontal gap between demand and domestic supply at the price of 16 cents, is supplied by imported sugar. Free trade typically results in income distribution effects, but the key is to recognize the overall gains from trade, as Figure 20.3 shows. Building on the concepts that we outlined in Demand and Supply and Demand, Supply, and Efficiency in terms of consumer and producer surplus, Figure 20.3 (a) shows that producers in Brazil gain by selling more sugar at a higher price, while Figure 20.3 (b) shows consumers in the United States benefit from the lower price and greater availability of sugar. Consumers in Brazil are worse off (compare their no-trade consumer surplus with the free-trade consumer surplus) and U.S. producers of sugar are worse off. There are gains from trade—an increase in social surplus in each country. That is, both the United States and Brazil are better off than they would be without trade. The following Clear It Up feature explains how trade policy can influence low-income countries. Figure 20.3 Free Trade of Sugar Free trade results in gains from trade. Total surplus increases in both countries, as the two blue-shaded areas show. However, there are clear income distribution effects. Producers gain in the exporting country, while consumers lose; and in the importing country, consumers gain and producers lose. Visit this website (http://openstaxcollege.org/l/sugartrade) to read more about the global sugar trade. 470 Chapter 20 | Globalization and Protectionism Why are there low-income countries? Why are the poor countries of the world poor? There are a number of reasons, but one of them will surprise you: the trade policies of the high-income countries. Following is a stark review of social priorities which the international aid organization, Oxfam International has widely publicized. High-income countries of the world—primarily the United States, Canada, countries of the European Union, and Japan—subsidize their domestic farmers collectively by about $360 billion per year. By contrast, the total amount of foreign aid from these same high-income countries to the poor countries of the world is about $70 billion
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per year, or less than 20% of the farm subsidies. Why does this matter? It matters because the support of farmers in high-income countries is devastating to the livelihoods of farmers in low-income countries. Even when their climate and land are well-suited to products like cotton, rice, sugar, or milk, farmers in low-income countries find it difficult to compete. Farm subsidies in the highincome countries cause farmers in those countries to increase the amount they produce. This increase in supply drives down world prices of farm products below the costs of production. As Michael Gerson of the Washington Post describes it: “[T]he effects in the cotton-growing regions of West Africa are dramatic... keep[ing] millions of Africans on the edge of malnutrition. In some of the poorest countries on Earth, cotton farmers are some of the poorest people, earning about a dollar a day.... Who benefits from the current system of subsidies? About 20,000 American cotton producers, with an average annual income of more than $125,000.” As if subsidies were not enough, often, the high-income countries block agricultural exports from low-income countries. In some cases, the situation gets even worse when the governments of high-income countries, having bought and paid for an excess supply of farm products, give away those products in poor countries and drive local farmers out of business altogether. For example, shipments of excess milk from the European Union to Jamaica have caused great hardship for Jamaican dairy farmers. Shipments of excess rice from the United States to Haiti drove thousands of low-income rice farmers in Haiti out of business. The opportunity costs of protectionism are not paid just by domestic consumers, but also by foreign producers—and for many agricultural products, those foreign producers are the world’s poor. Now, let’s look at what happens with protectionism. U.S. sugar farmers are likely to argue that, if only they could be protected from sugar imported from Brazil, the United States would have higher domestic sugar production, more jobs in the sugar industry, and American sugar farmers would receive a higher price. If the United States government sets a high-enough tariff on imported sugar, or sets an import quota at zero, the result will be that the quantity of sugar traded between countries could be reduced to zero, and the prices in each country will return to the levels before trade was allowed. Blocking only some trade is also possible. Suppose that the United States passed
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a sugar import quota of seven tons. The United States will import no more than seven tons of sugar, which means that Brazil can export no more than seven tons of sugar to the United States. As a result, the price of sugar in the United States will be 20 cents, which is This OpenStax book is available for free at http://cnx.org/content/col12170/1.7 Chapter 20 | Globalization and Protectionism 471 the price where the quantity demanded is seven tons greater than the domestic quantity supplied. Conversely, if Brazil can export only seven tons of sugar, then the price of sugar in Brazil will be 14 cents per pound, which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand. In general, when a country sets a low or medium tariff or import quota, the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade. The following Work It Out explores the impact of these trade barriers. Effects of Trade Barriers Let’s look carefully at the effects of tariffs or quotas. If the U.S. government imposes a tariff or quota sufficient to eliminate trade with Brazil, two things occur: U.S. consumers pay a higher price and therefore buy a smaller quantity of sugar. U.S. producers obtain a higher price and they sell a larger quantity of sugar. We can measure the effects of a tariff on producers and consumers in the United States using two concepts that we developed in Demand, Supply, and Efficiency: consumer surplus and producer surplus. Figure 20.4 U.S. Sugar Supply and Demand When there is free trade, the equilibrium is at point A. When there is no trade, the equilibrium is at point E. Step 1. Look at Figure 20.4, which shows a hypothetical version of the demand and supply of sugar in the United States. Step 2. Note that when there is free trade the sugar market is in equilibrium at point A where Domestic Quantity Demanded (Qd) = Quantity Supplied (Domestic Qs + Imports from Brazil) at a price of PTrade. Step 3. Note, also, that imports are equal to the distance between points C and A. Step 4. Recall that consumer surplus is the value that consumers get beyond what they paid for when they buy a product. Graphically, it is the area under a demand curve but above the price. In this case, the consumer surplus in the United States is the area of the
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triangle formed by the points PTrade, A, and B. Step 5. Recall, also, that producer surplus is another name for profit—it is the income producers get above the cost of production, which is shown by the supply curve here. In this case, the producer surplus with trade is the area of the triangle formed by the points Ptrade, C, and D. Step 6. Suppose that the barriers to trade are imposed, imports are excluded, and the price rises to PNoTrade. Look what happens to producer surplus and consumer surplus. At the higher price, the domestic quantity supplied increases from Qs to Q at point E. Because producers are selling more quantity at a higher price, the producer surplus increases to the area of the triangle PNoTrade, E, and D. Step 7. Compare the areas of the two triangles and you will see the increase in the producer surplus. Step 8. Examine the consumer surplus. Consumers are now paying a higher price to get a lower quantity (Q 472 Chapter 20 | Globalization and Protectionism instead of Qd). Their consumer surplus shrinks to the area of the triangle PNoTrade, E, and B. Step 9. Determine the net effect. The producer surplus increases by the area Ptrade, C, E, PNoTrade. The loss of consumer surplus, however, is larger. It is the area Ptrade, A, E, PNoTrade. In other words, consumers lose more than producers gain as a result of the trade barriers and the United States has a lower social surplus. Who Benefits and Who Pays? Using the demand and supply model, consider the impact of protectionism on producers and consumers in each of the two countries. For protected producers like U.S. sugar farmers, restricting imports is clearly positive. Without a need to face imported products, these producers are able to sell more, at a higher price. For consumers in the country with the protected good, in this case U.S. sugar consumers, restricting imports is clearly negative. They end up buying a lower quantity of the good and paying a higher price for what they do buy, compared to the equilibrium price and quantity with trade. The following Clear It Up feature considers why a country might outsource jobs even for a domestic product. Why are Life Savers, an American product, not made in America? In 1912, Clarence Crane invented Life Savers, the hard candy with the hole in the middle, in Cleveland, Ohio. Starting in the late 1960
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