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/@go/page/21791 Figure 19.11 Prejudice and Discrimination If employers, customers, or employees have discriminatory preferences, and those preferences are widespread, then the marketplace will result in discrimination. Here, black workers receive a lower wage and fewer of them are employed than would be the case in the absence of discriminatory preferences. Now suppose that employers have discriminatory attitudes that cause them to assume that a black worker is less productive than an otherwise similar white worker. Now employers have a lower demand, D, for black than for white workers. Employers pay black workers a lower wage, W, and employ fewer of them, L instead of L, than they would in the absence of discrimination. B B B Sources of Discrimination As illustrated in Figure 19.11, racial prejudices on the part of employers produce discrimination against black workers, who receive lower wages and have fewer employment opportunities than white workers. Discrimination can result from prejudices among other groups in the economy as well. One source of discriminatory prejudices is other workers. Suppose, for example, that white workers prefer not to work with black workers and require a wage premium for doing so. Such preferences would, in effect, raise the cost to the firm of hiring black workers. Firms would respond by demanding fewer of them, and wages for black workers would fall. Another source of discrimination against black workers could come from customers. If the buyers of a firm’s product prefer not to deal with black employees, the firm might respond by demanding fewer of them. In effect, prejudice on the part of consumers would lower the revenue that firms can generate from the output of black workers. Whether discriminatory preferences exist among employers, employees, or consumers, the impact on the group discriminated against will be the same. Fewer members of that group will be employed, and their wages will be lower than the wages of other workers whose skills and experience are otherwise similar. Race and sex are not the only characteristics that affect hiring and wages. Some studies have found that people who are short, overweight, or physically unattractive also suffer from discrimination, and charges of discrimination have been voiced by disabled people and by homosexuals. Whenever discrimination occurs, it implies that employers, workers, or customers have discriminatory preferences. For the effects of such preferences to be felt in the marketplace, they must be widely shared. There are, however, market pressures that can serve to lessen discrimination. For example, if some employers hold discriminatory preferences but others do not, it will be profit enhancing for those who do not to hire workers from the
group being discriminated against. Because workers from this group are less expensive to hire, costs for non-discriminating firms will be lower. If the market is at least somewhat competitive, firms who continue to discriminate may be driven out of business. Discrimination in the United States Today Reacting to demands for social change brought on most notably by the civil rights and women’s movements, the federal government took action against discrimination. In 1954, the U.S. Supreme Court rendered its decision that so-called separate but equal schools for black and white children were inherently unequal, and the Court ordered that racially segregated schools be integrated. The Equal Pay Act of 1963 requires employers to pay the same wages to men and women who do substantially the same work. Federal legislation was passed in 1965 to ensure that minorities were not denied the right to vote. 18.3.2 https://socialsci.libretexts.org/@go/page/21791 Congress passed the most important federal legislation against discrimination in 1964. The Civil Rights Act barred discrimination on the basis of race, sex, or ethnicity in pay, promotion, hiring, firing, and training. An Executive Order issued by President Lyndon Johnson in 1967 required federal contractors to implement affirmative action programs to ensure that members of minority groups and women were given equal opportunities in employment. The practical effect of the order was to require that these employers increase the percentage of women and minorities in their work forces. Affirmative action programs for minorities followed at most colleges and universities. What has been the outcome of these efforts to reduce discrimination? A starting point is to look at wage differences among different groups. Gaps in wages between males and females and between blacks and whites have fallen over time. In 1955, the wages of black men were about 60% of those of white men; in 2005, they were 75% of those of white men. For black men, the reduction in the wage gap occurred primarily between 1965 and 1973. In contrast, the gap between the wages of black women and white men closed more substantially, and progress in closing the gap continued after 1973, albeit at a slower rate. Specifically, the wages of black women were about 35% of those of white men in 1955, 58% in 1975, and 67% in the 2005. For white women, the pattern of gain is still different. The wages of white women were about 65% of those of white men in 1955, and fell to about 60% from the mid-1960s to the late 1970s. The wages of
white females relative to white males did improve, however, over the last 40 years. In 2005, white female wages were 80% of white male wages. While there has been improvement in wage gaps between black men, black women, and white women vis-à-vis white men, a substantial gap still remains. Figure 19.12 shows the wage differences for the period 1969–2006. Figure 19.12 The Wage Gap The exhibit shows the wages of white women, black women, and black men as a percentage of the wages of white men from 1969–2005. As you can see, the gap has closed considerably, but there remains a substantial gap between the wages of white men and those of other groups in the economy. Part of the difference is a result of discrimination. Source: Table 16. Median usual weekly earnings of full-time wage and salary workers, by sex, age, race and Hispanic origin, quarterly average (not seasonally adjusted) and annual averages, 1970–2006. For years after 1979, www.bls.gov/cps/wlf-table_162007.pdf One question that economists try to answer is the extent to which the gaps are due to discrimination per se and the extent to which they reflect other factors, such as differences in education, job experience, or choices that individuals in particular groups make about labor-force participation. Once these factors are accounted for, the amount of the remaining wage differential due to discrimination is less than the raw differentials presented in Figure 19.12 would seem to indicate. There is evidence as well that the wage differential due to discrimination against women and blacks, as measured by empirical studies, has declined over time. For example, a number of studies have concluded that black men in the 1980s and 1990s experienced a 12 to 15% loss in earnings due to labor-market discrimination (Darity, W. A., and Patrick L. Mason, 1998). University of Chicago economist James Heckman denies that the entire 12% to 15% differential is due to racial discrimination, pointing to problems inherent in measuring and comparing human capital among individuals. Nevertheless, he reports that the earnings loss due to discrimination similarly measured would have been between 30 and 40% in 1940 and still over 20% in 1970 (Heckman, J. J., 1998). Can civil rights legislation take credit for the reductions in labor-market discrimination over time? To some extent, yes. A study by Heckman and John J. Donohue III, a law professor at Northwestern University,
concluded that the landmark 1964 Civil Rights Act, as well as other civil rights activity leading up to the act, had the greatest positive impact on blacks in the South during the decade following its passage. Evidence of wage gains by black men in other regions of the country was, however, minimal. Most federal activity was directed toward the South, and the civil rights effort shattered an entire way of life that had subjugated black Americans and had separated them from mainstream life (Donohue III, J. J. and James Heckman, 1991). 18.3.3 https://socialsci.libretexts.org/@go/page/21791 In recent years, affirmative action programs have been under attack. Proposition 209, passed in California in 1996, and Initiative 200, passed in Washington State in 1998, bar preferential treatment due to race in admission to public colleges and universities in those states. The 1996 Hopwood case against the University of Texas, decided by the United States Court of Appeals for the Fifth Circuit, eliminated the use of race in university admissions, both public and private, in Texas, Louisiana, and Mississippi. Then Supreme Court decisions in 2003 concerning the use of affirmative action at the University of Michigan upheld race conscious admissions, so long as applicants are still considered individually and decisions are based of multiple criteria. Controversial research by two former Ivy League university presidents, political scientist Derek Bok of Harvard University and economist William G. Bowen of Princeton University, concluded that affirmative action policies have created the backbone of the black middle class and taught white students the value of integration. The study focused on affirmative action at 28 elite colleges and universities. It found that while blacks enter those institutions with lower test scores and grades than those of whites, receive lower grades, and graduate at a lower rate, after graduation blacks earn advanced degrees at rates identical to those of their former white classmates and are more active in civic affairs (Bok, D., and William G. Bowen, 1998). While stricter enforcement of civil rights laws or new programs designed to reduce labor-market discrimination may serve to further improve earnings of groups that have been historically discriminated against, wage gaps between groups also reflect differences in choices and in “premarket” conditions, such as family environment and early education. Some of these premarket conditions may themselves be the result of discrimination. The narrowing in wage differentials may reflect the dynamics of the Becker model at work. As people’s preferences change, or are forced to change due to competitive forces and changes in the legal
environment, discrimination against various groups will decrease. However, it may be a long time before discrimination disappears from the labor market, not only due to remaining discriminatory preferences but also because the human capital and work characteristics that people bring to the labor market are decades in the making. The election of Barack Obama as president of the United States in 2008 is certainly a hallmark in the long and continued struggle against discrimination. Key Takeaways Discrimination means that people of similar economic characteristics experience unequal economic outcomes as a result of noneconomic factors such as race or sex. Discrimination occurs in the marketplace only if employers, employees, or customers have discriminatory preferences and if such preferences are widely shared. Competitive markets will tend to reduce discrimination if enough individuals lack such prejudices and take advantage of discrimination practiced by others. Government intervention in the form of antidiscrimination laws may have reduced the degree of discrimination in the economy. There is considerable disagreement on this question but wage gaps have declined over time in the United States. Try It! Use a production possibilities curve to illustrate the impact of discrimination on the production of goods and services in the economy. Label the horizontal axis as consumer goods per year. Label the vertical axis as capital goods per year. Label a point A that shows an illustrative bundle of the two which can be produced given the existence of discrimination. Label another point B that lies on the production possibilities curve above and to the right of point A. Use these two points to describe the outcome that might be expected if discrimination were eliminated.  Case in Point: Early Intervention Programs Figure 19.13 18.3.4 https://socialsci.libretexts.org/@go/page/21791 Navy Hale Keiki School – Kindergarten – CC BY 2.0. Many authors have pointed out that differences in “pre-market” conditions may drive observed differences in market outcomes for people in different groups. Significant inroads to the reduction of poverty may lie in improving the educational opportunities available to minority children and others living in poverty-level households, but at what point in their lives is the pay-off to intervention the largest? Professor James Heckman, in an op-ed essay in The Wall Street Journal, argues that the key to improving student performance and adult competency lies in early intervention in education. Professor Heckman notes that spending on children after they are already in school has little impact on their later success. Reducing class sizes, for example, does not appear to promote gains in factors such as attending college or earning higher incomes
. What does seem to matter is earlier intervention. By the age of eight, differences in learning abilities are essentially fixed. But, early intervention to improve cognitive and especially non-cognitive abilities (the latter include qualities such as perseverance, motivation, and self-restraint) has been shown to produce significant benefits. In an experiment begun several decades ago known as the Perry intervention, four-year-old children from disadvantaged homes were given programs designed to improve their chances for success in school. Evaluations of the program 40 years later found that it had a 15 to 17% rate of return in terms of the higher wages earned by men and women who had participated in the program compared to those from similar backgrounds who did not— the program’s benefit-cost ratio was 8 to 1. Professor Heckman argues that even earlier intervention among disadvantaged groups would be desirable—perhaps as early as six months of age. Economists Rob Grunewald and Art Rolnick of the Federal Reserve Bank of Minneapolis have gone so far as to argue that, because of the high returns to early childhood development programs, which they estimate at 12% per year to the public, state and local governments, can promote more economic development in their areas by supporting early childhood programs than they currently do by offering public subsidies to attract new businesses to their locales or to build new sports stadiums, none of which offers the prospects of such a high rate of return. Sources: James Heckman, “Catch ’em Young,” The Wall Street Journal, January 10, 2006, p. A-14; Rob Grunewald and Art Rolnick, “Early Childhood Development on a Large Scale,” Federal Reserve Bank of Minneapolis The Region, June 2005. Answer to Try It! Problem Discrimination leads to an inefficient allocation of resources and results in production levels that lie inside the production possibilities curve (PPC) (point A). If discrimination were eliminated, the economy could increase production to a point on the PPC, such as B. Figure 19.14 18.3.5 https://socialsci.libretexts.org/@go/page/21791 References Bok, D., and William G. Bowen, The Shape of the River: Long-Term Consequences of Considering Race in College and University Admissions (Princeton, N. J.: Princeton University Press, 1998). Darity, W. A., and Patrick L. Mason, “Evidence on Discrimination in Employment,”
Journal of Economic Perspectives 12:2 (Spring 1998): 63–90. Donohue III, J. J., and James Heckman, “Continuous Versus Episodic Change: The Impact of Civil Rights Policy on the Economic Status of Blacks,” Journal of Economic Literature 29 (December 1991): 1603–43. Heckman, J. J., “Detecting Discrimination,” Journal of Economic Perspectives 12:2 (Spring 1998): 101–16. This page titled 18.3: The Economics of Discrimination is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 19.3: The Economics of Discrimination by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 18.3.6 https://socialsci.libretexts.org/@go/page/21791 18.4: Review and Practice Summary In this chapter, we looked at three issues related to the question of fairness: income inequality, poverty, and discrimination. The distribution of income in the United States has become more unequal in the last four decades. Among the factors contributing to increased inequality have been changes in family structure, technological change, and tax policy. While rising inequality can be a concern, there is a good deal of movement of families up and down the distribution of income, though recently mobility may have decreased somewhat. Poverty can be measured using an absolute or a relative income standard. The official measure of poverty in the United States relies on an absolute standard. This measure tends to overstate the poverty rate because it does not count noncash welfare aid as income. Poverty is concentrated among female-headed households, minorities, people with relatively little education, and people who are not in the labor force. Children have a particularly high poverty rate. Welfare reform in 1996 focused on moving people off welfare and into work. It limits the number of years that individuals can receive welfare payments and allows states to design the specific parameters of their own welfare programs. Following the reform, the number of people on welfare fell dramatically. The long-term impact on poverty is still under investigation. Federal legislation bans discrimination. Affirmative action programs, though controversial, are designed to enhance opportunities for minorities and women. Wage gaps between women and white males and between blacks and white males have declined since the 1950s
. For black males, however, most of the reduction occurred between 1965 and 1973. Much of the decrease in wage gaps is due to acquisition of human capital by women and blacks, but some of the decrease also reflects a reduction in discrimination. Concept Problems 1. Explain how rising demand for college-educated workers and falling demand for high-school-educated workers contributes to increased inequality of the distribution of income. 2. Discuss the advantages and disadvantages of the following three alternatives for dealing with the rising inequality of wages. 1. Increase the minimum wage each year so that wages for unskilled workers rise as fast as wages for skilled workers. 2. Subsidize the wages of unskilled workers. 3. Do nothing. 3. How would you define poverty? How would you determine whether a particular family is poor? Is the test you have proposed an absolute or a relative test? 4. Why does the failure to adjust the poverty line for regional differences in living costs lead to an understatement of poverty in some states and an overstatement of poverty in others? 5. The text argues that welfare recipients could achieve higher levels of satisfaction if they received cash rather than in-kind aid. Use the same argument to make a case that gifts given at Christmas should be in cash rather than specific items. Why do you suppose they usually are not? 6. Suppose a welfare program provides a basic grant of $10,000 per year to poor families but reduces the grant by $1 for every $1 of income earned. How would such a program affect a household’s incentive to work? 7. Welfare reform calls for a two-year limit on welfare payments, after which recipients must go to work. Suppose a recipient with children declines work offers. Should aid be cut? What about the children? 8. How would you tackle the welfare problem? State the goals you would seek, and explain how the measures you propose would work to meet those goals. 9. Suppose a common but unfounded belief held that people with blue eyes were not as smart as people with brown eyes. What would we expect to happen to the relative wages of the two groups? Suppose you were an entrepreneur who knew that the common belief was wrong. What could you do to enhance your profits? Suppose other entrepreneurs acted in the same way. How would the wages of people with blue eyes be affected? 10. The Case in Point on Income Inequality in the United States versus continental Western Europe argues that people get, in effect, what they expect. People in the United States attribute success
to hard work and skill, while people in Continental Western Europe attribute success to connections, luck, and corruption. With what set of views do you agree? Explain. 18.4.1 https://socialsci.libretexts.org/@go/page/21792 11. The Case in Point on welfare reform in Britain versus that in the United States argues that the British system, before it could be adopted in the United States, would require a change in attitudes in the United States. What sort of change would it require? Do you prefer the British approach? Why or why not? 12. James Heckman of the University of Chicago advocates a program of early intervention targeted at low income families. What are the advantages of such an approach? The disadvantages? 13. Give five reasons that the income distribution in the United States has become more unequal in the last several decades. Do you regard this as a problem for society? Why or why not? 14. Suppose that all welfare aid were converted to programs of cash assistance. Total spending on welfare would remain unchanged. How would this affect the poverty rate? Why? Numerical Problems 1. Here are income distribution data for three countries, from the Human Development Report 2005, table 15. Note that here we report only four data points rather than the five associated with each quintile. These emphasize the distribution at the extremes of the distribution. Poorest 10% Poorest 20% Richest 20% Richest 10% Panama Sweden Singapore 0.7 3.6 1.9 2.4 9.1 5.0 60.3 36.6 49.0 43.3 22.2 32.8 1. Plot the Lorenz curves for each in a single graph. 2. Compare the degree of inequality for the three countries. (Do not forget to convert the data to cumulative shares; e.g., the lowest 80% of the population in Panama receives 39.7% of total income.) 3. Compare your results to the Lorenz curve given in the text for the United States. Which country in your chart appears closest to the United States in terms of its income distribution? 2. Looking at Figure 19.11 suppose the wage that black workers are receiving in a discriminatory environment, W, is $25 per hour, while the wage that white workers receive, W, is $30 per hour. Now suppose a regulation is imposed that requires that black workers be paid $30 per hour also. B 1. How does this affect the employment of black workers?
2. How does this the wages of black workers? 3. How does this affect their total income? Explain. 3. Suppose the poverty line in the United States was set according to the test required in the European Union: a household is poor if its income is less than 60% of the median household income. Here are annual data for median household income in the United States for the period 1994–2004. The data also give the percentage of the households that fall below 60% of the median household income. Source: U.S Census Bureau, Current Population Reports, P60-229; Income in 2004 CPI-U-RS adjusted dollars; column 3 estimated by authors using Table A-1, p. 31. Median Household Income in the U.S. Percent of households with income below 60% of median 1994 1995 1996 1997 1998 1999 2000 2001 40,677 41,943 42,544 43,430 45,003 46,129 46,058 45,062 30.1 30.4 29.9 29.1 27.8 27.1 26.4 27.4 18.4.2 https://socialsci.libretexts.org/@go/page/21792 Median Household Income in the U.S. Percent of households with income below 60% of median 2002 2003 2004 44,546 44,482 44,389 27.8 28.3 28.3 1. Plot the data on a graph. 2. Is this a relative or an absolute definition of poverty? 3. Why do you think the percent of households with incomes below 60% of the median fell from 1994 to 2000 and has risen since? 4. Discuss the measurement issues involved in the data you have presented. 5. Discuss the elements of the system of counting the incomes of low income people in the United States and explain how it relates to your answer in (d). 4. Consider the following model of the labor market in the United States. Suppose that the labor market consists of two parts, a market for skilled workers and the market for unskilled workers, with different demand and supply curves for each as given below. The initial wage for skilled workers is $20 per hour; the initial wage for unskilled workers is $7 per hour. 1. Draw the demand and supply curves for the two markets so that they intersect at the wages given above. 2. How does increased demand for skilled workers and a reduced demand for unskilled workers affect the initial solution? 3. How is the Lorenz curve
for the United States economy affected by this development? Illustrate the old and the new Lorenz curves. 4. Suppose there is an increase in immigration from Mexico. How will this affect the two markets for labor? 5. Suppose Professor Heckman’s recommendation for early intervention for low income children is followed and that it has the impact he predicts. How will this affect the two markets today? In 20 years? Illustrate and explain how the demand and/or supply curves in each market will be affected. 6. What would the impact of the change in (d) be on the Lorenz curve for the United States 20 years from now? This page titled 18.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 19.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 18.4.3 https://socialsci.libretexts.org/@go/page/21792 CHAPTER OVERVIEW 19: Economic Development 19.1: The Nature and Challenge of Economic Development 19.2: Population Growth and Economic Development 19.3: Keys to Economic Development 19.4: Review and Practice Thumbnail: https://unsplash.com/photos/P8ZZ0aofrXI This page titled 19: Economic Development is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 19.1: The Nature and Challenge of Economic Development  Learning Objective 1. Define a developing country and discuss how incomes are compared across countries. 2. State and explain the general characteristics of low-income countries. 3. Discuss what is meant by economic development. Throughout most of history, poverty has been the human condition. For most people life was, in the words of 17th-century English philosopher Thomas Hobbes, “solitary, poor, nasty, brutish, and short.” Only within the past 200 years have a handful or so of countries been able to break the chains of economic deprivation and poverty. Consider these facts(United Nations Development Program, 2007): Over a third of the world’s people live in countries in which total per capita income in 2005 was less than
$610 per year; 85% live in countries in which total per capita income in 2005 was $2,808 or less. Adjusting for purchasing power, the per capita income levels would be $2,531 and $7,416, respectively. The latter numbers compare to per capita income in high-income countries of over $30,000. Babies born in poor countries are 16 times more likely to die in their first five years than are babies born in rich countries. About a quarter of the populations of low-income countries is undernourished. About 40% (over 50% for women) of the people 15 years old and older in low-income countries are illiterate. Roughly one-fourth of the people in low-income countries do not have access to safe drinking water. Clearly, the high standards of living enjoyed by people in the world’s developed economies are the global exception, not the rule. This chapter looks at the problem of improving the standard of living in poor countries. Rich and Poor Nations The World Bank, an international organization designed to support economic development by providing financial assistance, advice, and other resources to poor countries, classifies over 200 countries according to their levels of per capita gross national income. The categories in its 2008 report, as shown in Table 33.1 “World Incomes, Selected Countries”, were as follows: Low-income countries: These countries had per capita incomes of $935 or less in 2007. There were 49 countries in this category. About 20% of the world’s total population of about 6.5 billion people lived in low-income countries in 2007. Middle-income countries: There were 95 countries with per capita incomes of more than $936 but less than $11,455. Middleincome countries are further subdivided into lower middle-income and upper middle-income countries. Roughly two-thirds of the world’s population lived in middle-income countries in 2007. We should note that the percentage of the world’s population living in middle-income countries increased dramatically (and the percentage living in low-income countries decreased dramatically) when China and India moved from being low-income to middle-income countries. High-income countries: There were 65 nations with per capita incomes of $11,456 or more. Just 16% of the world’s total population lived in high-income countries in 2007. Countries in the low- and middle-income categories are often called developing countries.
A developing country is thus a country that is not among the high-income nations of the world (The World Development Report, 2006). Developing countries are sometimes referred to as third-world countries. How does the World Bank compare incomes across countries? The World Bank converts gross national income (GNI) figures to dollars in two ways. One is to take GNI in a local currency and convert using the exchange rate, averaged over a three-year period in order to smooth out the effects of currency fluctuations. This type of comparison can, however, be misleading. A country could have a relatively high standard of living but, for a variety of reasons, a low exchange rate. The per capita GNI figure would be quite low; the country would appear to be poorer than it is. A better approach to comparing incomes converts currencies to dollars on the basis of purchasing power. This measure is reported in what are called international dollars. An international dollar has the same purchasing power as does a U.S. dollar in the United States. This is reported in the column labeled “2007 International $” in Table 33.1 “World Incomes, Selected Countries”. Table 33.1 World Incomes, Selected Countries 19.1.1 https://socialsci.libretexts.org/@go/page/21794 Gross National Income per Capita, 2007 Gross National Income per Capita, 2007 Low-income countries Low-income countries Middle-income countries Middle-income countries High-income countries High-income countries Countries Countries 2007 $ 2007 $ 2007 2007 International International $ $ Countries Countries 2007 $ 2007 $ 2007 2007 International $ International $ Countries Countries 2007 $ 2007 $ 2007 2007 International $ International $ Burundi 110 Sierra Leone 260 Mozambique 320 Bangladesh Haiti Uzbekistan Vietnam Zambia Pakistan Nigeria Average 470 560 730 790 800 870 930 578 330 660 690 1,340 1,150 2,430 2,550 1,220 2,570 1,770 1,494 India 950 China Thailand Iran Jamaica 2,360 3,400 3,470 3,710 Costa Rica 5,560 Brazil Argentina Russian Federation 5,910 6,050 7,560 2,740 5,370 7,880 10,800 6,210 10,700 9,370 12,990 Czech Republic 14,450 22,020 Saudi Arabia 15,440 Israel Greece Japan France Canada 21,900 29,630 37,670 38,500 39,420 United States 46,040 22
,910 25,930 32,330 34,600 33,600 35,310 45,850 14,400 Ireland 48,140 37,090 Turkey 8,020 12,350 Norway 76,450 53,320 Average 2,872 1,887 Ave., lower middle Ave., upper middle 6,987 11,868 Average 37,566 36,100 5,952 4,543 Source: World Development Indicators database, World Bank, revised October 17, 2008. The international dollar estimates typically show higher incomes than estimates based on an exchange rate conversion. For example, in 2007 Mozambique’s per capita GNI, based on exchange rates, was $320. Its per capita GNI based the international dollars was $690. Ranking of countries, both rich and poor, by per capita GNI differs depending on the measure used. According to the per capita GNI figures in Table 33.1 “World Incomes, Selected Countries”, which convert data in domestic currencies to dollars using exchange rates, the United States ranked fifteenth of all countries in 2007. Using the international dollars method, its rank is tenth. China is ranked at 132 when per capita GNI is based on the exchange rate conversion method but rises to 122 based on the international dollar method. Characteristics of Low-Income Countries Low incomes are often associated with other characteristics: severe inequality, poor health care and education, high unemployment, heavy reliance on agriculture, and rapid population growth. We will examine most of these problems in this section. Population growth in low-income nations is examined later in the chapter. Inequality Not only are incomes in low-income countries quite low; income distribution is often highly unequal. Poverty is far more prevalent than per capita numbers suggest, as illustrated by Lorenz curves, introduced in the chapter on inequality, that show the cumulative shares of income received by individuals or groups. Consider Costa Rica and Panama, two Latin American countries with roughly equivalent levels of per capita GNI (Costa Rica’s was $5,560 and Panama’s $5,510 in 2007). Panama’s income distribution is comparatively less equal, while Costa Rica’s is far more equal. Figure 33.1 compares the 2003 Lorenz curves for Costa Rica and Panama, the most recent year for which the information was available. The 20% of the households with the lowest incomes in Costa Rica had twice as large a share of their 19.1.2 https://socialsci.lib
retexts.org/@go/page/21794 country’s total income as did the bottom 20% of households in Panama. That means Costa Rica’s poor were about twice as well off, in material terms, as Panama’s poor. Figure 33.1 Poverty and the Distribution of Income: Costa Rica versus Panama Costa Rica had about the same per capita GNI as Panama in 2003, but Panama’s income distribution was far more unequal. Panama’s poor had much lower living standards than Costa Rica’s poor, as suggested by the Lorenz curves for the two nations. Source: World Development Indicators Online (revised October 17, 2008). In general, the greater the degree of inequality, the more desperate is the condition of people at the bottom of an income distribution. Given the high degree of inequality in many low-income countries, it is very important to look at income distributions when we compare living standards in different countries. Health and Education Poor nations are typically characterized by low levels of human capital. Where health-care facilities are inadequate, that human capital can be reduced further by disease. Where educational resources are poor, there will be little progress in improving human capital. One indicator of poor health care appears on the supply side. Low-income countries have fewer doctors, relative to their populations, than high-income countries. For example, the UN estimates that in 2006 about 60% of mothers giving birth in developing countries had access to a skilled health-care provider (doctor, nurse, or midwife). While that is up from 47% in 1990, the lack of access to a health-care provider may explain much of the difference in maternal death rates between developed and developing countries: about nine maternal deaths per 100,000 live births in developed countries compared to about 450 per 100,000 in developing countries (United Nations, 2008). We can also see the results of poor health care in statistics on health. Among the world’s developing countries, the infant mortality rate, which reports deaths in the first year of life, was 57 per 1,000 live births in 2005. There were six infant deaths per 1,000 live births among the high-income countries that year (United Nations Development Program, 2007). Another health issue facing the world’s low-income countries is malnutrition. Malnutrition rates in all developing countries in the 2002 to 2004 period averaged 17%, 35% in the least developed countries. Still another issue is the spread of HIV/AIDS.
Here there is some progress. The number of people newly infected declined from 3 million in 2001 to 2.7 million in 2005. Antiretroviral treatments are also leading to a reduction in deaths from 2.2 million in 2005 to 2 million in 2007. Longer survival means that the number of people living with HIV (from just under 30 million in 2001 to about 33 million in 2007) is rising and most of the people living with HIV are in Sub-Saharan Africa (United Nations, 2008). Education in poor and middle-income nations is improving. In 1991, about 80% of children in developing countries were enrolled in primary schools. In 2005, about 85% were. The comparable numbers in developed countries are about 95%. Enrollment rates taper off for high school (about 53% in 2005 in developing countries compared to 91% in developed countries) (United Nations, 2007). Unemployment Unemployment is pervasive in low-income nations. These nations, already faced with low levels of potential output, are producing well below their potential. Unemployment rates in low-income countries vary widely, reaching as high as 15% or more in some countries. If we count discouraged workers, people who have given up looking for work but who would take it if it were available, 19.1.3 https://socialsci.libretexts.org/@go/page/21794 and people who work less than full time, not by choice but because more work is unavailable, then unemployment in low-income countries soars—often to more than 30%. Migration within low-income countries often contributes to unemployment in urban areas. Factors such as ethnic violence, poverty, and drought often force people to move from rural areas to cities, where unemployment rates are already high. Reliance on Agriculture One of the dominant characteristics of poor nations is the concentration of employment in agriculture. Another is the very low productivity of that employment. Agriculture in low-income countries often employs a majority of the population but produces less than one-third of GDP. One of the primary forces behind income growth in wealthy countries has been the shift of labor out of agriculture and into more productive sectors such as manufacturing. This shift is also occurring in low-income nations but has lagged far behind. The solution to these problems lies in economic development, to which we turn next. Economic Development: A Definition If the problems of low-income nations are pervasive, the development that helps to solve those problems must transform the very nature of their societies. The late Austrian economist Joseph Sch
umpeter described economic development as a revolutionary process. Whereas economic growth implies quantitative change in production processes that are already familiar to the society, economic development requires qualitative change in virtually every aspect of life. Robert Heilbroner, an economist at the New School for Social Research in New York, has argued, “Economic development is political and social change on a wrenching and tearing scale. … It is a process of institutional birth and institutional death. It is a time when power shifts, often violently and abruptly, a time when old regimes go under and new ones rise in their places. And these are not just the unpleasant side effects of development. They are part and parcel of the process, the very driving force of change itself” (Heilbroner, 1970). Economic development transforms a nation at its core. But what, precisely, is development? Many definitions follow Heilbroner in noting the massive institutional and cultural changes economic development involves. But whatever the requirements of development, its primary characteristics are rising incomes and improving standards of living. That means output must increase— and it must increase relative to population growth. And because inequality is so serious a problem in low-income nations, development must deliver widespread improvement in living conditions. It therefore seems useful to define economic development as a process that produces sustained and widely shared gains in per capita real GDP. In recent years, the United Nations has constructed measures incorporating dimensions of economic development that go beyond the level of per capita GDP. The Human Development Index (HDI) includes three dimensions—life expectancy, educational attainment (adult literacy and combined primary, secondary, and post-secondary enrollment), as well as purchasing-power-adjusted per capita real GDP. The Gender Development Index (GDI) uses the same variables as the HDI but adjusts them downward to take into account the extent of gender inequality. A third index, the Human Poverty Index (HPI), measures human deprivation and includes such indicators as the percentage of people expected to die before age 40, the percentage of underweight children under age 5, the percentage of adults who are illiterate, and the percentage of people who live in poverty. The number reported for the HPI shows the percentage of people in the country who suffer these deprivations. Table 33.2 “Human Development Index, Gender Development Index, and Human Poverty Index” shows the HDI, the GDI rank, and the HPI for selected countries, by HDI rank. The HDI is constructed to have an upper
limit of 1. Canada’s HDI is 0.96; the United States’ is 0.95. As the table shows, the HDIs for developing countries range from 0.87 in Argentina to 0.34 in Sierra Leone. The greater the difference between the HDI and the GDI of a country, the greater the disparity in achievement between males and females in the country. Countries can have similar HDIs but different GDIs or HPIs. By looking at a variety of measures, we come closer to examining the extent to which the gains in income growth have been shared or not. Table 33.2 Human Development Index, Gender Development Index, and Human Poverty Index HDI rank Country Human Development Index (HDI), 2005 Gender-Related Development Index (GDI) 2005, Rank Human Poverty Index (HPI), % 20051 19.1.4 https://socialsci.libretexts.org/@go/page/21794 HDI rank Country Human Development Index (HDI), 2005 Gender-Related Development Index (GDI) 2005, Rank Human Poverty Index 1 (HPI), % 2005 1 2 4 10 12 24 32 38 48 61 67 70 78 81 84 90 94 101 105 114 117 126 128 135 136 148 154 156 173 177 Iceland Norway Canada France United States Greece Czech Republic Argentina Costa Rica Saudi Arabia Russian Federation Brazil Thailand China Turkey Philippines Iran Jamaica Viet Nam Mongolia Bolivia Morocco India Ghana Pakistan Kenya Uganda Senegal Mali Sierra Leone 0.968 0.968 0.961 0.952 0.951 0.926 0.891 0.869 0.846 0.812 0.802 0.8 0.781 0.777 0.775 0.771 0.759 0.736 0.733 0.7 0.695 0.646 0.619 0.553 0.551 0.521 0.505 0.499 0.38 0.336 1 3 4 7 16 24 29 36 47 70 59 60 71 73 79 77 84 90 91 100 103 112 113 117 125 127 132 135 151 157 NA 6.8 10.9 11.2 15.4 NA NA 4.1 4.4 NA NA 9.7 10.0 11.7 9.2 15.3 12.9 14.3 15.2 NA 13.6 33.4 31.3 32.3 36.2 30.8 34.7 42.9 56.4 51.7 Source: United Nations Development Program
, Human Development Report 2007/2008 (New York: Palgrave Macmillan, 2007). Key Takeaways The World Bank classifies countries as being low-income, middle-income, or high-income. More than 80% of the world’s people live in low- and middle-income countries. Among the problems facing low-income nations are low living standards, inequality, inadequate health care and education, high unemployment, and the concentration of the labor force in low-productivity agricultural work. Economic development is a process that generates sustained and widely shared gains in per capita real GDP. 19.1.5 https://socialsci.libretexts.org/@go/page/21794 Try It! Provided below is information about two low-income developing countries in Western Africa, Côte d’Ivoire, and Guinea. Use the information to plot their Lorenz curves for consumption, which are similar to Lorenz curves for income distribution, discussed in the chapter on inequality, poverty, and discrimination. Then, based on the material in this section, contrast the concept of economic growth, as discussed in the chapter on that topic, with the concept of economic development, the subject of this chapter. Which of the two countries do you believe fits better the definition of development? Explain. Average annual growth rate of GNP (%) Average annual growth rate of GNP per capita Percentage Share of Consumption Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% Cote d’Ivoire Guinea 6.9 7.2 4.2 4.6 6.8 3.0 11.2 8.3 15.8 14.6 22.2 23.9 44.1 50.2  Case in Point: (Growth and Development) or (Growth or Development)? The 1971 Nobel laureate in economics, Simon Kuznets, hypothesized that, at low levels of per capita income, increases in income would lead to increases in income inequality. The Kuznets hypothesis was later extended to include concern that early growth might not be associated with improvements in other aspects of development, such as those measured by the HDI or HPI. The rationale for growth pessimism was that the structural changes that often accompany early growth—such as rural– urban migration, occupational changes, and environmental degradation—disproportionately hurt poorer people. The passage of time and the availability of more information on developing countries’ experiences allow us to test whether such pessimism
is warranted. The results of a recent study of 95 decade-long episodes of economic growth and decline around the world show that the distribution of income can go either way. Clearly, as the table below shows, with the direction of change in the distribution of income split almost 50-50 during periods of growth, there is no longer any reason to think that growth necessarily increases income inequality. As the table also shows, by a ratio of 7 to 1, the income of the poor usually improves during periods of growth. This means that even when inequality increases, the poor usually gain in absolute terms as income grows. There were only seven periods of income decline included in the study, but, in general, during those periods the distribution of income grew more unequal and the incomes of the poor fell. Broad-based measures of development, such as the HDI and the HPI, have not been calculated for a long enough period to allow us to see the trend in these social indicators of development, but we can look at various aspects of human development and poverty over time. As shown in the graphs accompanying this case, there have generally been improvements in the percentage of people with access to safe water, in the adult literacy rate, and in the percentage of underweight children under age 5. On this last indicator, the improvement in Sub-Saharan Africa is very small, but keep in mind that the rate of growth of real GNP per capita in this region has been just over 1% per year. There is no guarantee that economic growth will improve the plight of the world’s poor—there is indeed wide variation in individual countries’ experiences. In general, though, economic growth makes most people, including most poor people, better off. As former World Bank Senior Vice President and Chief Economist Joseph Stiglitz put it, “Aggregate economic growth benefits most of the people most of the time; and it is usually associated with progress in other, social dimensions of development.” Periods of growth (88) Periods of decline (7) Improved Worsened Improved Worsened 43 11 2 2 5 5 Indicator Inequality Income of the poor 45 77 Figure 33.3 19.1.6 https://socialsci.libretexts.org/@go/page/21794 Source: World Development Indicators database, World Bank, revised October 17, 2006. Sources: United Nations, Human Development Report, 1997 (New York: Oxford University Press, 1997), 72, 224; Human Development Report,
1998 (New York: Oxford University Press, 1998), 206; Joseph Stiglitz, “International Development: Is It Possible?” Foreign Policy 110 (Spring 1998): 138–51. Answer to Try It! Problem Economic growth refers to the process of increasing a country’s potential output. Graphically, this can be represented by rightward shifts in the long-run aggregate supply curve or by the shifting outward of the production possibilities curve. The challenge of economic development, however, is for countries to move toward their level of potential output and to achieve widely shared gains in GDP per capita. This process usually involves widespread structural changes in the way people live—their standards of living, the kinds of jobs they have, their health, and so forth. When comparing Côte d’Ivoire and Guinea, for example, it is clear that the distribution of consumption is much more equal in the former. This implies that Côte d’Ivoire is coming closer to generating widely shared gains in per capita real GDP. Figure 33.4 19.1.7 https://socialsci.libretexts.org/@go/page/21794 1 The definition of deprivation for developed countries applies a higher standard than it does for developing countries. References Heilbroner, R., Between Capitalism and Socialism (New York: Vintage Books, 1970), 53–54. United Nations, The Millennium Development Goals Report 2008, 27. United Nations Development Program, Human Development Report 2007/2008 (New York: Palgrave Macmillan, 2007). The World Development Report 2006 (New York: Oxford University Press, 2006), xiv, comments on this usage: “The term developing countries includes low- and middle-income economies and thus may include economies in transition from central planning, as a matter of convenience. The term advanced countries may be used as a matter of convenience to denote high-income economics.” This page titled 19.1: The Nature and Challenge of Economic Development is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 33.1: The Nature and Challenge of Economic Development by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 19.1.8 https://socialsci.libretexts.org
/@go/page/21794 19.2: Population Growth and Economic Development  Learning Objective 1. Explain the relationship between population growth and the rate of increase in per capita income. 2. Summarize Thomas Malthus’s reasoning that led to the concept of a Malthusian trap, and explain why his dire predictions have not occurred in many countries in modern times. 3. Explain what is meant by a demographic transition, and describe how it has proceeded in very different ways in developed versus developing countries. It is easy to see why some people have become alarmists when it comes to population growth rates in developing nations. Looking at the world’s low-income countries, they see a population of more than 2 billion growing at a rate that suggests a doubling every 31 years. How will we cope with so many more people? The following statement captures the essence of widely expressed concerns: “At the end of each day, the world now has over two hundred thousand more mouths to feed than it had the day before; at the end of each week, one and one-half million more; at the close of each year, an additional eighty million. … Humankind, now doubling its numbers every thirty-five years, has fallen into an ambush of its own making; economists call it the “Malthusian trap,” after the man who most forcefully stated our biological predicament: population growth tends to outstrip the supply of food” (Appleman, 1976). But what are we to make of such a statement? Certainly, if the world’s population continues to increase at the rate that it grew in the past 50 years, economic growth is less likely to be translated into an improvement in the average standard of living. But the rate of population growth is not a constant; it is affected by other economic forces. This section begins with a discussion of the relationship between population growth and income growth, then turns to an explanation of the sources of population growth in low-income countries, and closes with a discussion of the Malthusian warning suggested in the quote above. Population Growth and Income Growth On a simplistic level, the relationship between growth in population and growth in per capita income is clear. After all, per capita income equals total income divided by population. The growth rate of per capita income roughly equals the difference between the growth rate of income and the growth rate of population. Kenya’s annual growth rate in real GDP from 1975 to 2005, for example,
was 3.3%. Its population growth rate during that period was 3.2%, leaving it a growth rate of per capita GDP of just 0.1%. A slower rate of population growth, together with the same rate of GDP increase, would have left Kenya with more impressive gains in per capita income. The implication is that if the developing countries want to increase their rate of growth of per capita GDP relative to the developed nations, they must limit their population growth. Figure 33.5 plots growth rates in population versus growth rates in per capita GDP from 1975 to 2005 for more than 100 developing countries. We do not see a simple relationship. Many countries experienced both rapid population growth and negative changes in real per capita GDP. But still others had relatively rapid population growth, yet they had a rapid increase in per capita GDP. Clearly, there is more to achieving gains in per capita income than a simple slowing in population growth. But the challenge raised at the beginning of this section remains: Can the world continue to feed a population that is growing exponentially—that is, doubling over fixed intervals? 19.2.1 https://socialsci.libretexts.org/@go/page/21795 Figure 33.5 Population and Income Growth, 1975–2005 A scatter chart of population growth rates versus GNP per capita growth rates for various developing countries for the period 1975–2005 suggests no systematic relationship between the rates of population and of income growth. Source: United Nations Development Program, Human Development Report 2007/2008 (New York: Palgrave Macmillan, 2007). The Malthusian Trap and the Demographic Transition In 1798, Thomas Robert Malthus published his Essay on the Principle of Population. It proved to be one of the most enduring works of the time. Malthus’s fundamental argument was that population growth will inevitably collide with diminishing returns. Diminishing returns imply that adding more labor to a fixed quantity of land increases output, but by ever smaller amounts. Eventually, Malthus concluded, increases in food production would be too small to sustain the increased number of human beings who consume that output. As the population continued to grow unchecked, the number of people would eventually outstrip the ability of the land to generate enough food. There would be an inevitable Malthusian trapA point at which the world is no longer able to meet the food requirements of the population, and starvation becomes the primary check to population growth., a point at which the world is no longer able to meet the food
requirements of the population, and starvation becomes the primary check to population growth. A Malthusian trap is illustrated in Figure 33.6. We can determine the total amount of food needed by multiplying the population in any period by the amount of food required to keep one person alive. Because population grows exponentially, food requirements rise at an increasing rate, as shown by the curve labeled “Food required.” Food produced, according to Malthus, rises by a constant amount each period; its increase is shown by an upward-sloping straight line labeled “Food produced.” Food required eventually exceeds food produced, and the Malthusian trap is reached at time t. The faster the rate of population growth, the sooner t is reached. 1 1 19.2.2 https://socialsci.libretexts.org/@go/page/21795 Figure 33.6 The Malthusian Trap If population grows at a fixed exponential rate, the amount of food required will increase exponentially. But Malthus held that the output of food could increase only by a constant amount each period. Given these two different growth processes, food requirements would eventually catch up with food production. The population hits the subsistence level of food production at the Malthusian trap, shown here at point T. What happens at the Malthusian trap? Clearly, there is not enough food to support the population growth implied by the “Food required” curve. Instead, people starve, and population begins rising arithmetically, held in check by the “Food produced” curve. Starvation becomes the limiting force for population; the population lives at the margin of subsistence. For Malthus, the long-run fate of human beings was a standard of living barely sufficient to keep them alive. As he put it, “the view has a melancholy hue.” Happily, Malthus’s predictions do not match the experience of Western societies in the 19th and 20th centuries. One weakness of his argument is that he failed to take into account the gains in output that could be achieved through increased use of physical capital and new technologies in agriculture. Increases in the amount of capital per worker in the form of machines, improved seed, irrigation, and fertilization have made possible huge increases in agricultural output at the same time as the supply of labor was rising. Agricultural productivity rose rapidly in the United States over the last two centuries, just the opposite of the fall in
productivity expected by Malthus. Productivity has continued to expand. Malthus was wrong as well about the relationship between population growth and income. He believed that any increase in income would boost population growth. But the law of demand tells us that the opposite may be true: higher incomes tend to reduce population growth. The primary cost of having children is the opportunity cost of the parents’ time in raising them—higher incomes increase this opportunity cost. Higher incomes increase the cost of having children and tend to reduce the number of children people want and thus to slow population growth. Panel (a) of Figure 33.7 shows the birth rates of low-, middle-, and high-income countries for the period 2000–2005. We see that the higher the income level, the lower the birth rate. Fewer births translate into slower population growth. In Panel (b), we see that high-income nations had much slower rates of population growth than did middle- and low-income nations over the last 30 years. 19.2.3 https://socialsci.libretexts.org/@go/page/21795 Figure 33.7 Income Levels and Population Growth Panel (a) shows that low-income nations had much higher total fertility rates (births per woman) during the 2000–2005 period than did high-income nations. In Panel (b), we see that low-income nations had a much higher rate of population growth during the 1975–2005 period. Source: World Development Indicators database, World Bank, revised October 17, 2008. An increase in a nation’s income can be expected to slow its rate of population growth. Hong Kong, for example, has enjoyed dramatic gains in income since the 1960s. Its birth rate and rate of population growth have fallen by over half during that time. But if economic development can slow population growth, it can also increase it. One of the first gains a developing nation can achieve is improvements in such basics as the provision of clean drinking water, improved sanitation, and public health measures such as vaccination against childhood diseases. Such gains can dramatically reduce disease and death rates. As desirable as such gains are, they also boost the rate of population growth. Nations are likely to enjoy sharp reductions in death rates before they achieve gains in per capita income. That can accelerate population growth early in the development process. Demographers have identified a process of demographic transitionSituation in which population growth rises with a fall in death rates and then falls with a reduction in birth
rates. in which population growth rises with a fall in death rates and then falls with a reduction in birth rates. The process of demographic transition has unfolded in a strikingly different manner in developed versus less developed nations over the past two centuries. In 1800, birth rates barely exceeded death rates in both developed and less developed countries. The result was a rate of population growth of only about 0.5% per year worldwide. By 1900, the death rate in developed nations had fallen by about 25%, with little change in the birth rate. Among developing nations, the birth rate was unchanged, while the death rate was down only slightly. The combined result was a modest increase in the rate of world population growth. Changes were much more rapid in the 20th century. By 1965, the death rate among developed nations had plunged to about onequarter of its 1800 level, while the birth rate had fallen by half. In developing nations, death rates took a similarly dramatic drop, while birth rates showed little change. The result was dramatic world population growth. The world’s high-income economies have completed the demographic transition. Less developed nations have begun to make progress, with birth rates falling by a slightly greater percentage than death rates. The results have been a sharp slowing in the rate of population growth among high-income nations and a more modest slowing among low-income nations. Continued slowing in population growth at all income levels is suggested in Figure 33.8. Between 1965 and 1980, the world population grew at an annual rate of 2%, suggesting a doubling time of 36 years. For the world as a whole, it is predicted that population growth will slow to a 1.1% rate during the 2005–2015 period, a rate that would imply a 19.2.4 https://socialsci.libretexts.org/@go/page/21795 doubling time of 65 years. Figure 33.8 The Demographic Transition at Work: Actual and Projected Population Growth Population growth has slowed considerably in the past several decades. Source: United Nations Development Program, Human Development Report 2007/2008 (New York: Palgrave Macmillan, 2007) for periods 1975–2000 and 2005–2015, United Nations Development Program, Human Development Report 1990 (New York, Oxford: Oxford University Press, 1990) for the 1960–1988 period, in which categories refer to low, middle, and high human development rankings. Key Takeaways The rate of increase in per capita income roughly equals the rate of increase in income minus the rate of increase in
population. High rates of population growth do not necessarily imply low rates of growth in per capita income. Malthus’s prediction of a world in which production would be barely sufficient to keep people alive has proven incorrect because of gains generated by increased physical and human capital, advances in technology, and the tendency of higher incomes to slow population growth. A demographic transition is achieved when rising incomes begin to reduce birth rates and bring population growth in check. Try It! The text gives two main reasons why the Malthusian trap did not occur: (1) increased use of physical capital and human capital and technological improvements in agriculture and (2) higher income leading to fewer children. How do these two reasons alter Figure 33.6?  Case in Point: China Curtails Population Growth Figure 33.9 M M – China – CC BY-SA 2.0. 19.2.5 https://socialsci.libretexts.org/@go/page/21795 China is an example of a country that has achieved a very low rate of population growth and a very high rate of growth in per capita GNP. China’s low rate of population growth represents a dramatic shift. As recently as the early 1970s, China had a relatively high rate of population growth; its population expanded at an annual rate of 2.7% from 1965 to 1973. By the 1980s, that rate had plunged to 1.5%. The World Bank reports a growth rate in China’s population of about 1% in the early part of the 21st century. This dramatic drop in the population growth rate was brought about by a strict government policy by which couples are allowed to have only one child. Disincentives have been known to include fines, loss of employment, confiscation of property, demolition of homes, forced abortions, and sterilization. While the Chinese government has denied that forced abortions and sterilizations are part of its strategy, policies are administered locally, and all of the above means of coercion seem to have been employed at one time or another. If a woman who already has one child becomes pregnant, she will most likely be forced to have an abortion. Although the policy has achieved its desired result—reduced population growth—it has had some horrible side effects. Given a strong cultural tradition favoring having a son, some couples resort to infanticide as a means of eliminating newborn daughters. When the sex of an unborn baby is determined to be female, abortion is common. The coercive aspects of
China’s policies and their undesirable side effects have been condemned by many governments around the world, as well as by nongovernmental organizations. Declarations from United Nations’ conferences—the UN Conference on Population in Cairo in 1994 and the UN Conference on Women in Beijing in 1995—have emphasized that birth rates are linked to the economic conditions of women and that improving health, education, and employment opportunities for women constitutes a better and more humane way of reducing birth rates. Fearful that pro-democracy and human rights activists from other countries might stir up those movements locally, the Chinese government actually designed the 1995 Beijing Conference so as to minimize contact between Chinese and foreigners. There are signs, though, that Chinese officials may have heard the message. In a number of counties in China, experimental programs with slogans such as “Carry out Contraception and Family Planning Measures Voluntarily” are underway. The new approach to family planning emphasizes health care, education, and reduction in poverty to encourage women to have fewer children. International pressures may only be part of the reason for the emerging Chinese change of heart. In the late 1980s, Chinese officials discovered that the number of births in China was being underreported by about 30%. The aggressive policies may not have been as successful as they were cracked up to be. Answer to Try It! Problem The first reason raises the curve labeled “Food produced” and suggests that it is exponential rather than linear. The second reason lowers the curve labeled “Food required.” The result is that the time t, when the amount of food required exceeds the amount produced, is pushed further into the future, perhaps indefinitely if the “Food produced” stays above the “Food required” curve. The latter seems to have been the experience of today’s rich countries. 1 References Appleman, P., ed., Thomas Robert Malthus: An Essay on the Principle of Population—Text, Sources and Background, Criticism (New York: Norton, 1976), xi. This page titled 19.2: Population Growth and Economic Development is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 33.2: Population Growth and Economic Development by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 19.2.6
ERROR: type should be string, got " https://socialsci.libretexts.org/@go/page/21795 19.3: Keys to Economic Development  Learning Objective 1. List and discuss domestic policies that contribute to economic growth. 2. State the dependency theory view of trade and developing nations, relate this theory to the strategy of import substitution, and evaluate that strategy. 3. Outline some of the factors underlying the successes of newly industrialized countries. What are the keys to economic development? Clearly, each nation’s experience is unique; we cannot isolate the sources of development success in the laboratory. We can, however, identify some factors that appear to have played an important role in successful economic development. We will look separately at policies that relate to the domestic economy and at policies in international trade. Domestic Policy and Economic Development What domestic policies contribute to development? Looking at successful economies, those that have achieved high and sustained increases in per capita output, we can see some clear tendencies. They include a market economy, a high saving rate, and investment in infrastructure and in human capital. Market Economies and Development There can be no clearer lesson than that a market-oriented economy is a necessary condition for economic development. We saw in the chapter that introduced the production possibilities model that economic systems can be categorized as market capitalist, command socialist, or as mixed economic systems. There are no examples of development success among command socialist systems, although some people still believe that the former Soviet Union experienced some development advances in its early years. One of the most dramatic examples is provided by China. Its shift in the late 1970s to a more market-based economy has ushered in a period of phenomenal growth. China, which has shifted from a command socialist to what could most nearly be categorized as a mixed economy, has been among the fastest-growing economies in the world for the past 20 years. Its growth has catapulted China from being one of the world’s poorest countries a few decades ago to being a middle-income country today. The experience of other economies reinforces the general observation that markets matter. South Korea, Hong Kong, Taiwan, Singapore, and Chile—all have achieved gigantic gains with a market-based approach to economic growth. We should not conclude, however, that growth has been independent of any public sector activity. China, for example, remains a nominally socialist state; its government continues to play a major role. The governments of South Korea, Taiwan, and Singapore all targeted specific sectors for growth and provided government help to those sectors."
Even Hong Kong, which became part of China in 1997, has a high degree of government involvement in the provision of housing, health care, and education. A market economy is not a nongovernment economy. But those countries that have left the task of resource allocation primarily to the market have achieved dramatic gains. Hong Kong and Singapore, in fact, are now included in the World Bank’s list of high-income economies. The Rule of Law and Development If a market is to thrive, individuals must be secure in their property. If crime or government corruption makes it likely that individuals will regularly be subjected to a loss of property, then exchange will be difficult and little investment will occur. Also, the rule of law is necessary for contracts; that is, the rule of law is necessary to provide an institutional framework within which an economy can operate. We will see in the chapter on socialist economies in transition, for example, that Russia’s effort to achieve economic development through the adoption of a market economy has been hampered by widespread lawlessness. An important difficulty of economies with extensive regulation is that the power they grant to government officials inevitably results in widespread corruption that saps entrepreneurial effort and economic growth. 19.3.1 https://socialsci.libretexts.org/@go/page/21796 Investment and Saving Saving is a key to growth and the achievement of high incomes. All other things equal, higher saving allows more resources to be devoted to increases in physical and human capital and to technological improvement. In other words, saving, which is income not spent on consumption, promotes economic growth by making available resources that can be channeled into growth-enhancing uses. High saving rates generally accompany high levels of investment. The productivity of this investment, however, can be quite variable. Government efforts to invest in human capital by promoting education, for example, may or may not be successful in actually achieving education. Development projects sponsored by international relief agencies may or may not foster development. However, investment in infrastructure, such as transportation and communication, clearly plays an important role in economic development. Investment in improved infrastructure facilitates the exchange of goods and services and thus fosters development. International Economic Issues in Development In 1974, the poorest nations among the developing nations introduced into the United Nations a Declaration on the Establishment of a New International Economic Order. The program called upon the rich nations to help them reduce the growing gap in real per capita income levels between the developed and developing nations. The declaration has come to be known as the New International
Economic Order or NIEO for short. NIEO called for different and special treatment of the developing nations in the international arena in areas such as trade policy and control over multinational corporations. NIEO reflected a widely held view of international relations known as dependency theory. Dependency Theory and Trade Policy Conventional economic theory concerning international trade is based on the idea of comparative advantage. As we have seen in other chapters, the principle of comparative advantage suggests that free trade between two countries will benefit both and, in general, the freer the trade the better. But some economists have proposed a doctrine that challenges this idea. Dependency theory concludes that poverty in developing nations is the result of their dependence on high-income nations. Dependency theory holds that the industrialized nations control the destiny of the developing nations, particularly in terms of being the ultimate markets for their exports, serving as the source of capital required for development, and controlling the relative prices and exchange rates at which market transactions occur. In addition, export industries in a developing nation are assumed to have small multiplier effects throughout the rest of the economy, severely limiting any positive role than an expanded export sector might play. Specifically, limited transportation, a poorly developed financial sector, and an uneducated work force stand in the way of “multiplying” any positive effects of export expansion. A poor country thus may not experience the kind of development and growth enjoyed by the rich country pursuing free trade. Also, increased trade makes the poor country more dependent on the rich country and its export service firms. In short, the benefits of trade between a rich country and a poor country will go almost entirely to the rich country. The development strategy that this line of argument suggests is that developing countries would need to become independent of the already developed nations in order to achieve economic development. In relative terms, free trade would leave the poor country poorer and the rich country richer. Some dependency theorists even argued that trade is likely to make poor countries poorer in absolute terms. Tanzania’s president, Julius Nyerere, speaking before the United Nations in 1975, put it bluntly, “I am poor because you are rich.” Import Substitution Strategies and Export-Led Development If free trade widens the gap between rich and poor nations and makes poor nations poorer, it follows that a poor country should avoid free trade. Many developing countries, particularly in Latin America, attempted to overcome the implications of dependency theory by adopting a strategy of import substitution, a strategy of blocking most imports and substituting domestic production of those goods.
The import substitution strategy calls for rapidly increasing industrialization by mimicking the already industrialized nations. The intent is to reduce the dependence of the developing country on imports of consumer and capital goods from the industrialized countries by manufacturing these goods at home. But in order to protect these relatively high-cost industries at home, the developing country must establish very high protective tariffs. Moreover, the types of industries that produce the previously imported consumer goods and capital goods are unlikely to increase the demand for unskilled labor. Yet unskilled labor is the most 19.3.2 https://socialsci.libretexts.org/@go/page/21796 abundant resource in the poor countries. Adopting the import substitution strategy raises the demand for expensive capital, managerial talent, and skilled labor—resources in short supply. High tariffs insulate domestic firms from competition, but that tends to increase their monopoly power. Recognizing that some imported goods, particularly spare parts for industrial equipment, will be needed, countries can establish complex permit systems through which firms can import vital parts and other equipment. But that leaves a company’s fortunes in the hands of the government bureaucrats issuing the permits. A highly corrupt system quickly evolves in which a few firms bribe their way to easy access to foreign markets, reducing competition still further. Instead of the jobs expected to result from import substitution, countries implementing the import substitution strategy get the high prices, reduced production, and poor quality that come from reduced competition. No country that has relied on a general strategy of import substitution has been successful in its development efforts. It is an idea whose time has not come. In contrast, more successful economies in Asia and elsewhere have kept their economies fairly open to both imports and exports. They have shown the greatest ability to move the development process along. Development and International Financial Markets Successful development in the developing nations requires more than just redirecting labor and capital resources into newly emerging sectors of the economy. That could be accomplished by both domestic firms and international firms located within the economy. But to complement the reorientation of traditional production processes, economic infrastructure such as roads, schools, communication facilities, ports, warehouses, and many other prerequisites to growth must be put into place. Paying for the projects requires a high level of saving. The sources of saving are private saving, government saving, and foreign saving. Grants in the form of foreign aid from the developed nations supplement these sources, but they form a relatively small part of the total. Private domestic saving is an important source of funds. But
even high rates of private saving cannot guarantee sufficient funds in a poor economy, where the bulk of the population lives close to the subsistence level. Government saving in the form of tax revenues in excess of government expenditures is almost universally negative. If the required investments are to take place, the developing nations have to borrow the money from foreign savers. The problem for developing nations borrowing funds from foreigners is the same potential difficulty any borrower faces: the debt can be difficult to repay. Unlike, say, the national debt of the United States government, whose obligations are in its own currency, developing nations typically commit to make loan payments in the currency of the lending institution. Money borrowed by Brazil from a U.S. bank, for example, must generally be paid back in U.S. dollars. Many developing nations borrowed heavily during the 1970s, only to find themselves in trouble in the 1980s. Countries such as Brazil suspended payments on their debt when required payments exceeded net exports. Much foreign debt was simply written off as bad debt by lending institutions. While foreign debts created a major crisis in the 1980s, subsequent growth appeared to make these payments more manageable. A somewhat different international financial crisis emerged in the late 1990s. It started in Thailand in the summer of 1997. Thailand had experienced 20 years of impressive economic growth and rising living standards. One element of its development strategy was to maintain a fixed exchange rate between its currency, the baht, and the dollar. The slowing of Japanese growth, which reduced demand for Thai exports, and weaknesses in the Thai banking sector were putting downward pressure on the baht, which Thailand’s central bank initially tried to counteract. As discussed there, this effort was abandoned, and the value of the currency declined. The Thai government, in an effort to keep its exchange rate somewhat stable, appealed to the International Monetary Fund (IMF) for support. The IMF is an international agency that makes financial assistance available to member countries experiencing problems in their international balance of payments in order to support adjustment and reform in those countries. In an agreement between Thailand and the IMF, Thailand’s central bank tightened monetary policy, thereby raising interest rates there. The logic behind this move was that higher interest rates in Thailand would make the baht more attractive to both Thai and foreign financial investors, who could thus earn more on Thai bonds and on other Thai financial assets. This would increase the demand for baht and help to keep the currency from falling further. Thailand also agreed to tighten fiscal policy, the
rationale for which was to prepare for the anticipated future costs of restructuring its banking system. As we have learned throughout macroeconomics, however, contractionary monetary and fiscal policies will reduce real GDP in the short run. The hope was that growth would resume once the immediate currency crisis was over and plans had been put into place for correcting other imbalances in the Thai economy. 19.3.3 https://socialsci.libretexts.org/@go/page/21796 Other countries, such as South Korea and Brazil, soon experienced similar currency disturbances and entered into similar IMF programs to put their domestic houses in order in exchange for financial assistance from the IMF. For some of the other countries that went through similar experiences, notably Indonesia and Malaysia, the situation in 1999 was very unstable. Malaysia decided to forgo IMF assistance and to impose massive currency controls. In Indonesia, the financial crisis and the ensuing economic crisis led to political unrest. It held its first free elections in June 1999, but violence erupted in late 1999, when the overwhelming majority of people in East Timor voted against an Indonesian proposal that the province have limited autonomy within Indonesia and voted for independence from Indonesia. Remarkably, in the early 2000s, the economies of most of these countries rebounded, though they are now caught up in the global economic downturn. Development Successes As we have seen throughout this chapter, the greatest success stories are found among the newly industrializing economies (NIEs) in East Asia. These economies, including Hong Kong, South Korea, Singapore, and Taiwan, share two common traits. First, they have allowed their economies to develop through an emphasis on export-based, market capitalist strategies. The NIEs achieved higher per capita income and output by entering and competing in the global market for products such as computers, automobiles, plastics, chemicals, steel, shipbuilding, and sporting goods. These countries have succeeded largely by linking standardized production technologies with low-cost labor. Second, the role of government was relatively limited in the NIEs, which made less use of regulation and bureaucratic controls. Governments were clearly involved in some strategic industries, and, in the wake of recent financial crises, in some cases it appears that this involvement led to some decisions in those industries being made on political rather than on economic grounds. But the principal contribution of governments in the Far Eastern NIEs has been to create a modern infrastructure (especially up-to-date communications facilities essential for the development of a strong financial sector), to provide a
stable incentive system (including stable exchange rates), and to ensure that government bureaucracy will help rather than hinder exports (especially by not regulating export trade, labor markets, and capital markets) (Balassa, 1988). Chile adopted sweeping market reforms in the late 1970s, creating the freest economy in Latin America. Chile’s growth has accelerated sharply, and the country has moved to the upper-middle-income group of nations. Perhaps more dramatic, the dictator who instituted market reforms, General Augusto Pinochet, agreed to democratic elections that removed him from power in 1989. Chile now has a greatly increased degree of political as well as economic freedom—and has emerged as the most prosperous country in Latin America. Over the last decade, Mexico also shifted from a strategy of import substitution and began to follow more free-trade-oriented policies. The North American Free Trade Agreement (NAFTA) turned all of North America into a free trade zone. This could not have occurred had Mexico not undergone such a dramatic shift in its development strategy. Mexico’s commitment to the new strategy was tested in 1994, when the country underwent a currency crisis, similar to that experienced in many Asian countries in 1997 and 1998. At that time, Mexico, too, entered into an agreement with the IMF to address economic imbalances in return for financial assistance. The U.S. government also provided support to help Mexico at that time. By 1996, the Mexican economy was growing again, and Mexican commitment to more open policies has endured. Only with the passage of time will we know for sure whether the changed strategy worked in Mexico as well, but the early signs are that it is working. Although the trend in developing countries toward market reforms has been less heralded than the collapse of communism, it is surely significant. Will market reforms translate into development success? The jury is still out. Market reform requires that many wealthy—and powerful—interests be swept aside. Whether that can be achieved, and whether poor people who lack human capital can be included in the development effort, remain open questions. But some dramatic success stories have shown that economic development can be achieved. The fate of billions of desperately poor people rests in the ability of their countries to match that success. Key Takeaways A market economy, perhaps with a substantial role for government, appears to be one key to economic growth. A system in which laws and property rights are well established and enforced also promotes growth. High rates of saving and investment can boost economic growth. Dependency theory suggests that
poor countries should seek to insulate themselves from international trade. The import substitution strategies suggested by dependency theory have not been successful in generating economic growth, and a number 19.3.4 https://socialsci.libretexts.org/@go/page/21796 of countries have moved away from this strategy.  Case in Point: Democracy and Economic Development Figure 33.10 Ryan – South India street scene 1 – CC BY 2.0. Democracy as an economic institution has typically received mixed notices from economists. While virtually all the world’s rich nations have democratic systems of government, it isn’t clear that democracy is necessary for development. India long provided the strongest counterexample to the idea that democracy promotes development. It has long been a democracy, yet its per capita income has kept it among the world’s poor countries. India’s government has traditionally opted for extensive regulation that has curtailed development. Countries such as China, with no democracy and a repressive government, have managed to generate very high rates of economic growth. China’s per capita income now exceeds that of India by about 50%. Lee Kuan Yew, Singapore’s former prime minister, put it this way: “I believe what a country needs to develop is discipline more than democracy. The exuberance of democracy leads to indiscipline and disorderly conduct which are inimical to development.” Many economists have reached the conclusion that countries are likely to become democratic once they achieve a high degree of economic development. Political freedom, they argue, is a normal good. The demand for freedom thus increases as incomes rise, making the creation of democratic institutions a product of economic growth, not a cause of it. Two recent studies—one by economists John Mukum Mbaku and Mwangi S. Kimenyi and the other by economists Michael A. Nelson and Ram D. Singh—challenge the conventional view, arguing instead that democracy and economic growth are compatible. Using statistical models that control for a variety of factors that affect economic growth, such as investment and population growth, both studies concluded that there is a positive relationship between political freedom and economic growth. In the latter study, the authors separately tested the direction of causality: does growth cause democracy or does democracy cause growth? They conclude that the direction of causality goes from democracy to economic growth. They also controlled for the level of economic freedom (an index of price stability, government size, discriminatory taxation, and trade restrictions),
which many studies have concluded is critical for development. As argued in this chapter, more economic freedom does lead to higher economic growth, but so does more political freedom. Just as pessimism that economic growth has a negative impact on the poor is dissipating, likewise the notion that developing countries must wait until they are developed in order for their citizens to experience political freedom is also falling by the wayside. Sources: Jagdish Bhagwati, “Democracy and Development,” American Enterprise 6, no. 2 (March/April 1995): 69; John Mukum Mbaku and Mwangi S. Kimenyi, “Macroeconomic Determinants of Growth: Further Evidence on the Role of Political Freedom,” Journal of Economic Development 22, no. 2 (December 1997): 119–32; Michael A. Nelson and Ram D. Singh, “Democracy, Economic Freedom, Fiscal Policy, and Growth in LDC: A Fresh Look,” Economic Development and Cultural Change 64, no. 4 (July 1998): 677–96. References Balassa, B., “The Lessons of East Asian Development,” Economic Development and Cultural Change 36, no. 3 (April 1988): S247–S290. This page titled 19.3: Keys to Economic Development is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 19.3.5 https://socialsci.libretexts.org/@go/page/21796 33.3: Keys to Economic Development by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 19.3.6 https://socialsci.libretexts.org/@go/page/21796 19.4: Review and Practice Summary Developing nations face a host of problems: low incomes; unequal distributions of income; inadequate health care and education; high unemployment; and a concentration of workers in agriculture, where productivity is low. Economic development, the process that generates widely shared gains in income, can alleviate these problems. The sources of economic growth in developing countries are not substantially different from those that apply to the developed countries. Market economies with legal systems that provide for the reliable protection of property rights and enforcement of contracts tend to promote economic growth. Saving and
investment, particularly investment in appropriate technologies and human capital, appear to be critical. So, too, does the ability of developing nations to match their population growth rate with the ability of the economy to increase real output. Dependency theory, the notion that developing countries are in the grip of the industrialized countries, led to import substitution schemes that proved detrimental to the long-run growth prospects of developing nations. The movement of Latin American countries such as Mexico and Chile to market systems is a rejection of dependency theory. There is a general movement toward market-based strategies to support economic development in the future. But even market-based strategies will work only if efforts are made to ensure an adequate infrastructure, including the development of financial institutions capable of providing the required signals to guide individual decision making. Concept Problems 1. What is the difference between economic development and economic growth? 2. Look at the Case in Point on the relationship between growth and development. Why do you think that the distribution of income is more likely to become more unequal during economic downturns? 3. What are the implications for the long-run development of a society that is unable to reduce its population growth rate below, say, 4% per year? 4. Explain how technological progress averts the Malthusian trap. 5. China reduced its rate of population growth by force (see the Case in Point). Given the likely effects of population growth on living standards, do you think such a policy is reasonable? Are there other ways a government might seek to limit population growth? 6. On what basis might a poor country argue that its poverty is a result of high incomes in another country? Do you think Mexico’s poverty contributed to U.S. wealth? 7. Given the arguments presented in the text, what do you think the United States should do to assist Mexico in its development efforts? Numerical Problems 1. Consider two economies, one with an initial per capita income of $16,000 (about the income of Israel) growing at a rate of 1.8% per year, the other with an initial per capita income of $600 (about the income of Guinea) growing twice as fast (that is, at a rate of 3.6% per year). Using the rule of 72 from the chapter on economic growth, calculate how long it will take for the lowerincome country to achieve the per capita income enjoyed by the richer one. How long will it take to literally “catch up” to the richer nation, assuming that the growth rates continue unchanged
in the future? 2. Use the most recent copy of the World Development Report available in your library (or at www.worldbank.org) to determine the five poorest countries in the world. Look up data on the distribution of income, education, health and nutrition, and demography for each country (information on some of these variables will not be available for every country). Do you think that low incomes cause the observations you have made, or do you think that low levels of education, health, and nutrition and high rates of population growth tend to cause poverty? 3. A country’s rate of GDP growth is 3% per year. Its population is growing 4% per year. At what rate is its GDP per capita changing? This page titled 19.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 33.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 19.4.1 https://socialsci.libretexts.org/@go/page/21797 CHAPTER OVERVIEW 20: Socialist Economies in Transition 20.1: The Theory and Practice of Socialism 20.2: Socialist Systems in Action 20.3: Economies in Transition: China and Russia 20.4: Review and Practice Thumbnail: https://unsplash.com/photos/StV6G2GURA8 This page titled 20: Socialist Economies in Transition is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 20.1: The Theory and Practice of Socialism  Learning Objective 1. Discuss and assess Karl Marx’s theory of capitalism, including mention of the labor theory of value, the concept of surplus value, periodic capitalist crises, and worker solidarity. Socialism has a very long history. The earliest recorded socialist society is described in the Book of Acts in the Bible. Following the crucifixion of Jesus, Christians in Jerusalem established a system in which all property was owned in common. There have been other socialist experiments in which all property was held in common, effectively creating socialist societies. Early in the nineteenth century, such reformers as Robert Owen, Count Claude-Henri de Rouvroy de
Saint-Simon, and Charles Fourier established almost 200 communities in which workers shared in the proceeds of their labor. These men, while operating independently, shared a common ideal—that in the appropriate economic environment, people will strive for the good of the community rather than for their own self-interest. Although some of these communities enjoyed a degree of early success, none survived. Socialism as the organizing principle for a national economy is in large part the product of the revolutionary ideas of one man, Karl Marx. His analysis of what he saw as the inevitable collapse of market capitalist economies provided a rallying spark for the national socialist movements of the twentieth century. Another important contributor to socialist thought was Vladimir Ilyich Lenin, who modified many of Marx’s theories for application to the Soviet Union. Lenin put his ideas into practice as dictator of that country from 1917 until his death in 1924. It fell to Joseph Stalin to actually implement the Soviet system. We shall examine the ideas of Marx, Lenin, and Stalin and investigate the operation of the economic systems based upon them. The Economics of Karl Marx Marx is perhaps best known for the revolutionary ideas expressed in the ringing phrases of the Communist Manifesto, such as those shown in the Case in Point. Written with Friedrich Engels in 1848, the Manifesto was a call to arms. But it was Marx’s exhaustive, detailed theoretical analysis of market capitalism, Das Kapital (Capital), that was his most important effort. This four-volume work, most of which was published after Marx’s death, examines a theoretical economy that we would now describe as perfect competition. In this context, Marx outlined a dynamic process that would, he argued, inevitably result in the collapse of capitalism. Marx stressed a historical approach to the analysis of economics. Indeed, he was sharply critical of his contemporaries, complaining that their work was wholly lacking in historical perspective. To Marx, capitalism was merely a stage in the development of economic systems. He explained how feudalism would tend to give way to capitalism and how capitalism would give way to socialism. Marx’s conclusions stemmed from his labor theory of value and from his perception of the role of profit in a capitalist economy. The Labor Theory of Value and Surplus Value In The Wealth of Nations, Adam Smith proposed the idea of the labor theory of value, which states that the relative values of different goods are ultimately determined by the relative amounts of labor used in their production. This idea was widely accepted at the time Marx was writing. Economists recognized the roles of demand and
supply but argued that these would affect prices only in the short run. In the long run, it was labor that determined value. Marx attached normative implications to the ideas of the labor theory of value. Not only was labor the ultimate determinant of value, it was the only legitimate determinant of value. The price of a good in Marx’s system equaled the sum of the labor and capital costs of its production, plus profit to the capitalist. Marx argued that capital costs were determined by the amount of labor used to produce the capital, so the price of a good equaled a return to labor plus profit. Marx defined profit as surplus value, the difference between the price of a good or service and the labor cost of producing it. Marx insisted that surplus value was unjustified and represented exploitation of workers. Marx accepted another piece of conventional economic wisdom of the nineteenth century, the concept of subsistence wages. This idea held that wages would, in the long run, tend toward their subsistence level, a level just sufficient to keep workers alive. Any increase in wages above their subsistence level would simply attract more workers—or induce an increase in population, forcing wages back down. Marx suggested that unemployed workers were important in this process; they represented a surplus of labor that acted to push wages down. 20.1.1 https://socialsci.libretexts.org/@go/page/21799 Capital Accumulation and Capitalist Crises The concepts of surplus value and subsistence wages provide the essential dynamics of Marx’s system. He said that capitalists, in an effort to increase surplus value, would seek to acquire more capital. But as they expanded capital, their profit rates, expressed as a percentage of the capital they held, would fall. In a desperate effort to push profit rates up, capitalists would acquire still more capital, which would only push their rate of return down further. A further implication of Marx’s scheme was that as capitalists increased their use of capital, the wages received by workers would become a smaller share of the total value of goods. Marx assumed that capitalists used all their funds to acquire more capital. Only workers, then, could be counted on for consumption. But their wages equaled only a fraction of the value of the output they produced—they could not possibly buy all of it. The result, Marx said, would be a series of crises in which capitalists throughout the economy, unable to sell their output, would cut back production. This would cause still more reductions in demand,
exacerbating the downturn in economic activity. Crises would drive the weakest capitalists out of business; they would become unemployed and thus push wages down further. The economy could recover from such crises, but each one would weaken the capitalist system. Faced with declining surplus values and reeling from occasional crises, capitalists would seek out markets in other countries. As they extended their reach throughout the world, Marx said, the scope of their exploitation of workers would expand. Although capitalists could make temporary gains by opening up international markets, their continuing acquisition of capital meant that profit rates would resume their downward trend. Capitalist crises would now become global affairs. According to Marx, another result of capitalists’ doomed efforts to boost surplus value would be increased solidarity among the working class. At home, capitalist acquisition of capital meant workers would be crowded into factories, building their sense of class identity. As capitalists extended their exploitation worldwide, workers would gain a sense of solidarity with fellow workers all over the planet. Marx argued that workers would recognize that they were the victims of exploitation by capitalists. Marx was not clear about precisely what forces would combine to bring about the downfall of capitalism. He suggested other theories of crisis in addition to the one based on insufficient demand for the goods and services produced by capitalists. Indeed, modern theories of the business cycle owe much to Marx’s discussion of the possible sources of economic downturns. Although Marx spoke sometimes of bloody revolution, it is not clear that this was the mechanism he thought would bring on the demise of capitalism. Whatever the precise mechanism, Marx was confident that capitalism would fall, that its collapse would be worldwide, and that socialism would replace it. Marx’s Theory: An Assessment To a large degree, Marx’s analysis of a capitalist economy was a logical outgrowth of widely accepted economic doctrines of his time. As we have seen, the labor theory of value was conventional wisdom, as was the notion that workers would receive only a subsistence wage. The notion that profit rates would fall over time was widely accepted. Doctrines similar to Marx’s notion of recurring crises had been developed by several economists of the period. What was different about Marx was his tracing of the dynamics of a system in which values would be determined by the quantity of labor, wages would tend toward the subsistence level, profit rates would fall, and crises would occur from time to time. Marx saw these forces as leading inevitably to the fall of capitalism and its replacement with a socialist economic system. Other economists of the period generally argued that economies would stagn
ate; they did not anticipate the collapse predicted by Marx. Marx’s predictions have turned out to be wildly off the mark. Profit rates have not declined; they have remained relatively stable over the long run. Wages have not tended downward toward their subsistence level; they have risen. Labor’s share of total income in market economies has not fallen; it has increased. Most important, the predicted collapse of capitalist economies has not occurred. 1 Revolutions aimed at establishing socialism have been rare. Perhaps most important, none has occurred in a market capitalist economy. The Cuban economy, for example, had some elements of market capitalism before Castro but also had features of command systems as well. In other cases where socialism has been established through revolution it has replaced systems that could best be described as feudal. The Russian Revolution of 1917 that established the Soviet Union and the revolution that established the People’s Republic of China in 1949 are the most important examples of this form of revolution. In the countries of Eastern Europe, socialism was imposed by the former Soviet Union in the wake of World War II. In the early 2000s, a number of Latin American countries, such as Venezuela and Bolivia, seemed to be moving towards nationalizing, rather than privatizing assets, but it is too early to know the long-term direction of these economies. 20.1.2 https://socialsci.libretexts.org/@go/page/21799 Whatever the shortcomings of Marx’s economic prognostications, his ideas have had enormous influence. Politically, his concept of the inevitable emergence of socialism promoted the proliferation of socialist-leaning governments during the middle third of the twentieth century. Before socialist systems began collapsing in 1989, fully one-third of the earth’s population lived in countries that had adopted Marx’s ideas. Ideologically, his vision of a market capitalist system in which one class exploits another has had enormous influence. Key Takeaways Marx’s theory, based on the labor theory of value and the presumption that wages would approach the subsistence level, predicted the inevitable collapse of capitalism and its replacement by socialist regimes. Lenin modified many of Marx’s theories for application to the Soviet Union and put his ideas into practice as dictator of that country from 1917 until his death in 1924. Before socialist systems began collapsing in 1989, fully one-third of the earth’s population lived in countries that had adopted Marx’s ideas. Try It! Briefly explain how each of the following
would contribute to the downfall of capitalism: 1) capital accumulation, 2) subsistence wages, and 3) the factory system.  Case in Point: The Powerful Images in the Communist Manifesto Figure 34.1 Wikimedia Commons – public domain. The Communist Manifesto by Karl Marx and Friedrich Engels was originally published in London in 1848, a year in which there were a number of uprisings across Europe that at the time could have been interpreted as the beginning of the end of capitalism. This relatively short (12,000 words) document was thus more than an analysis of the process of historical change, in which class struggles propel societies from one type of economic system to the next, and a prediction about how capitalism would evolve and why it would end. It was also a call to action. It contains powerful images that cannot be easily forgotten. It begins, 20.1.3 https://socialsci.libretexts.org/@go/page/21799 “A specter is haunting Europe—the specter of communism. All the Powers of old Europe have entered into a holy alliance to exorcise this specter: Pope and Czar, Metternich and Guizot, French Radicals and German police-spies.” Its description of history begins, “The history of all hitherto existing society is the history of class struggles. Freeman and slave, patrician and plebeian, lord and serf, guild-master and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another …” In capitalism, the divisions are yet more stark: “Society as a whole is more and more splitting up into two great hostile camps, into two great classes directly facing each other: Bourgeoisie and Proletariat.” Foreshadowing the globalization of capitalism, Marx and Engels wrote, “The bourgeoisie, by the rapid improvement of all instruments of production, by the immensely facilitated means of communication, draws all, even the most barbarian, nations into civilization. The cheap prices of its commodities are the heavy artillery with which it batters down all Chinese walls, with which it forces the barbarians’ intensely obstinate hatred of foreigners to capitulate. It compels all nations, on pain of extinction, to adopt the bourgeois mode of production: it compels them to introduce what it calls civilization into their midst. … In one word, it creates a world after its own image.” But the system,
like all other class-based systems before it, brings about its own demise: “The weapons with which the bourgeoisie felled feudalism to the ground are now turned against the bourgeoisie itself. … Masses of laborers, crowded into the factory, are organized like soldiers. … It was just this contact that was needed to centralize the numerous local struggles, all of the same character, into one national struggle between classes.” The national struggles eventually become an international struggle in which: “What the bourgeoisie, therefore, produces, above all, is its own gravediggers.” The Manifesto ends, “Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win. WORKING MEN OF ALL COUNTRIES, UNITE!” Answer to Try It! Marx predicted that capital accumulation would lead to falling profit rates over the long term. Subsistence wages meant that workers would not be able to consume enough of what was produced and this would lead to ever larger economic downturns. Because of the factory system, worker solidarity would grow and workers would come to understand that they were being exploited by capitalists. 1 While resources in Cuba were generally privately owned, the government had broad powers to dictate their use. This page titled 20.1: The Theory and Practice of Socialism is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 34.1: The Theory and Practice of Socialism by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 20.1.4 https://socialsci.libretexts.org/@go/page/21799 20.2: Socialist Systems in Action  Learning Objective 1. Describe the operation of the command socialist system in the Soviet Union, including its major problems. 2. Explain how Yugoslavian-style socialism differed from that of the Soviet Union. 3. Discuss the factors that brought an end to command socialist systems in much of the world. The most important example of socialism was the economy of the Union of Soviet Socialist Republics, the Soviet Union. The Russian Revolution succeeded in 1917 in overthrowing the czarist regime that had ruled the Russian Empire for centuries. Leaders of the revolution created the Soviet Union in its place and
sought to establish a socialist state based on the ideas of Karl Marx. The leaders of the Soviet Union faced a difficulty in using Marx’s writings as a foundation for a socialist system. He had sought to explain why capitalism would collapse; he had little to say about how the socialist system that would replace it would function. He did suggest the utopian notion that, over time, there would be less and less need for a government and the state would wither away. But his writings did not provide much of a blueprint for running a socialist economic system. Lacking a guide for establishing a socialist economy, the leaders of the new regime in Russia struggled to invent one. In 1917, Lenin attempted to establish what he called “war communism.” The national government declared its ownership of most firms and forced peasants to turn over a share of their output to the government. The program sought to eliminate the market as an allocative mechanism; government would control production and distribution. The program of war communism devastated the economy. In 1921, Lenin declared a New Economic Policy. It returned private ownership to some sectors of the economy and reinstituted the market as an allocative mechanism. Lenin’s death in 1924 precipitated a power struggle from which Joseph Stalin emerged victorious. It was under Stalin that the Soviet economic system was created. Because that system served as a model for most of the other command socialist systems that emerged, we shall examine it in some detail. We shall also examine an intriguing alternative version of socialism that was created in Yugoslavia after World War II. Command Socialism in the Soviet Union Stalin began by seizing virtually all remaining privately-owned capital and natural resources in the country. The seizure was a brutal affair; he eliminated opposition to his measures through mass executions, forced starvation of whole regions, and deportation of political opponents to prison camps. Estimates of the number of people killed during Stalin’s centralization of power range in the tens of millions. With the state in control of the means of production, Stalin established a rigid system in which a central administration in Moscow determined what would be produced. The justification for the brutality of Soviet rule lay in the quest to develop “socialist man.” Leaders of the Soviet Union argued that the tendency of people to behave in their own self-interest was a by-product of capitalism, not an inherent characteristic of human beings. A successful socialist state required that the preferences of people be transformed so that they would be motivated by the collective interests of society, not their own self-interest.
Propaganda was widely used to reinforce a collective identity. Those individuals who were deemed beyond reform were likely to be locked up or executed. The political arm of command socialism was the Communist party. Party officials participated in every aspect of Soviet life in an effort to promote the concept of socialist man and to control individual behavior. Party leaders were represented in every firm and in every government agency. Party officials charted the general course for the economy as well. A planning agency, Gosplan, determined the quantities of output that key firms would produce each year and the prices that would be charged. Other government agencies set output levels for smaller firms. These determinations were made in a series of plans. A 1-year plan specified production targets for that year. Soviet planners also developed 5-year and 20-year plans. Managers of state-owned firms were rewarded on the basis of their ability to meet the annual quotas set by the Gosplan. The system of quotas and rewards created inefficiency in several ways. First, no central planning agency could incorporate preferences of consumers and costs of factors of production in its decisions concerning the quantity of each good to produce. Decisions about what to produce were made by political leaders; they were not a response to market forces. Further, planners could not select prices at which quantities produced would clear their respective markets. In a market economy, prices adjust to changes in demand and supply. Given that demand and supply are always changing, it is inconceivable that central planners could ever select market- 20.2.1 https://socialsci.libretexts.org/@go/page/21800 clearing prices. Soviet central planners typically selected prices for consumer goods that were below market-clearing levels, causing shortages throughout the economy. Changes in prices were rare. Plant managers had a powerful incentive for meeting their quotas; they could expect bonuses equal to about 35% of their base salary for producing the quantities required of their firms. Those who exceeded their quotas could boost this to 50%. In addition, successful managers were given vacations, better apartments, better medical care, and a host of other perquisites. Managers thus had a direct interest in meeting their quotas; they had no incentive to select efficient production techniques or to reduce costs. Perhaps most important, there was no incentive for plant managers to adopt new technologies. A plant implementing a new technology risked start-up delays that could cause it to fall short of its quota. If a plant did succeed in boosting output, it was likely to be forced to accept
even larger quotas in the future. A plant manager who introduced a successful technology would only be slapped with tougher quotas; if the technology failed, he or she would lose a bonus. With little to gain and a great deal to lose, Soviet plant managers were extremely reluctant to adopt new technologies. Soviet production was, as a result, characterized by outdated technologies. When the system fell in 1991, Soviet manufacturers were using production methods that had been obsolete for decades in other countries. Centrally controlled systems often generated impressive numbers for total output but failed in satisfying consumer demands. Gosplan officials, recognizing that Soviet capital was not very productive, ordered up a lot of it. The result was a heavy emphasis on unproductive capital goods and relatively little production of consumer goods. On the eve of the collapse of the Soviet Union, Soviet economists estimated that per capita consumption was less than one-sixth of the U.S. level. The Soviet system also generated severe environmental problems. In principle, a socialist system should have an advantage over a capitalist system in allocating environmental resources for which private property rights are difficult to define. Because a socialist government owns all capital and natural resources, the ownership problem is solved. The problem in the Soviet system, however, came from the labor theory of value. Since natural resources are not produced by labor, the value assigned to them was zero. Soviet plant managers thus had no incentive to limit their exploitation of environmental resources, and terrible environmental tragedies were common. Systems similar to that created in the Soviet Union were established in other Soviet bloc countries as well. The most important exceptions were Yugoslavia, which is discussed in the next section, and China, which started with a Soviet-style system and then moved away from it. The Chinese case is examined later in this chapter. Yugoslavia: Another Socialist Experiment Although the Soviet Union was able to impose a system of command socialism on nearly all the Eastern European countries it controlled after World War II, Yugoslavia managed to forge its own path. Yugoslavia’s communist leader, Marshal Tito, charted an independent course, accepting aid from Western nations such as the United States and establishing a unique form of socialism that made greater use of markets than the Soviet-style systems did. Most important, however, Tito quickly moved away from the centralized management style of the Soviet Union to a decentralized system in which workers exercised considerable autonomy. In the Yugoslav system, firms with five or more employees were owned by the state but made their own decisions concerning what to produce and what prices to charge. Workers in these
firms elected their managers and established their own systems for sharing revenues. Each firm paid a fee for the use of its state-owned capital. In effect, firms operated as labor cooperatives. Firms with fewer than five employees could be privately owned and operated. Economic performance in Yugoslavia was impressive. Living standards there were generally higher than those in other Soviet bloc countries. The distribution of income was similar to that of command socialist economies; it was generally more equal than distributions achieved in market capitalist economies. The Yugoslav economy was plagued, however, by persistent unemployment, high inflation, and increasing disparities in regional income levels. Yugoslavia began breaking up shortly after command socialist systems began falling in Eastern Europe. It had been a country of republics and provinces with uneasy relationships among them. Tito had been the glue that held them together. After his death, the groups began to move apart and a number of countries have formed out of what was once Yugoslavia, in several cases accompanied by war. They all seem to be moving in the market capitalist direction, with Slovenia and Macedonia leading the way. Over time, the others—Croatia, Bosnia, and Herzegovina, and even Serbia and Montenegra–have been following suit. 20.2.2 https://socialsci.libretexts.org/@go/page/21800 Evaluating Economic Performance Under Socialism Soviet leaders placed great emphasis on Marx’s concept of the inevitable collapse of capitalism. While they downplayed the likelihood of a global revolution, they argued that the inherent superiority of socialism would gradually become apparent. Countries would adopt the socialist model in order to improve their living standards, and socialism would gradually assert itself as the dominant world system. One key to achieving the goal of a socialist world was to outperform the United States economically. Stalin promised in the 1930s that the Soviet economy would surpass that of the United States within a few decades. The goal was clearly not achieved. Indeed, it was the gradual realization that the command socialist system could not deliver high living standards that led to the collapse of the old system. Figure 34.2 shows the World Bank’s estimates of per capita output, measured in dollars of 1995 purchasing power, for the republics that made up the Soviet Union, for the Warsaw Pact nations of Eastern Europe for which data are available, and for the United States in 1995. Nations that had operated within the old Soviet system had quite low levels of per capita output. Living standards were lower still, given that these nations devoted
much higher shares of total output to investment and to defense than did the United States. Figure 34.2 Per Capita Output in Former Soviet Bloc States and in the United States, 1995 Per capita output was far lower in the former republics of the Soviet Union and in Warsaw Pact countries in 1995 than in the United States. All values are measured in units of equivalent purchasing power. Source: United Nations, Human Development Report, 1998. Ultimately, it was the failure of the Soviet system to deliver living standards on a par with those achieved by market capitalist economies that brought the system down. Market capitalist economic systems create incentives to allocate resources efficiently; socialist systems do not. Of course, a society may decide that other attributes of a socialist system make it worth retaining. But the lesson of the 1980s was that few that had lived under command socialist systems wanted to continue to do so. Key Takeaways In the Soviet Union a central planning agency, Gosplan, set output quotas for enterprises and determined prices. The Soviet central planning system was highly inefficient. Sources of this inefficiency included failure to incorporate consumer preferences into decisions about what to produce, failure to take into account costs of factors of production, setting of prices without regard to market equilibrium, lack of incentives for incorporating new technologies, overemphasis on capital goods production, and inattention to environmental problems. Yugoslavia developed an alternative system of socialism in which firms were run by their workers as labor cooperatives. It was the realization that command socialist systems could not deliver high living standards that contributed to their collapse. 20.2.3 https://socialsci.libretexts.org/@go/page/21800 Try It! What specific problem of a command socialist system does each of the cartoons in the Case in Point parodying that system highlight?  Case in Point: Socialist Cartoons These cartoons came from the Soviet press. Soviet citizens were clearly aware of many of the problems of their planned system. Answer to Try It! The first cartoon shows the inefficiency that resulted because of the failure to take into account the costs of factors of production. The second cartoon shows the difficulty involved in getting business to incorporate new technologies. The third shows the system’s failure to respond to consumers’ demands. Figure 34.5 20.2.4 https://socialsci.libretexts.org/@go/page/21800 “Why are they sending us new technology when the old still works?” This page titled 20.2
: Socialist Systems in Action is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 34.2: Socialist Systems in Action by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 20.2.5 https://socialsci.libretexts.org/@go/page/21800 20.3: Economies in Transition: China and Russia  Learning Objective 1. Discuss the major problems in transitioning from a command socialist economy to a market capitalist one. 2. Compare the approaches to economic transition taken in China and Russia. Just as leaders of the Soviet Union had to create their own command socialist systems, leaders of the economies making the transition to market capitalist economies must find their own paths to new economic systems. It is a task without historical precedent. In this section we will examine two countries and the strategies they have chosen for the transition. China was the first socialist nation to begin the process, and in many ways it has been the most successful. Russia was the dominant republic in the old Soviet Union; whether its transition is successful will be crucially important. Before turning to the transition process in these two countries, we will consider some general problems common to all countries seeking to establish market capitalism in the wake of command socialism. Problems in Transition Establishing a system of market capitalism in a command socialist economy is a daunting task. The nations making the attempt must invent the process as they go along. Each of them, though, faces similar problems. Former command socialist economies must establish systems of property rights, establish banking systems, deal with the problem of inflation, and work through a long tradition of ideological antipathy toward the basic nature of a capitalist system. Property Rights A market system requires property rights before it can function. A property right details what one can and cannot do with a particular asset. A market system requires laws that specify the actions that are permitted and those that are proscribed, and it also requires institutions for the enforcement of agreements dealing with property rights. These include a court system and lawyers trained in property law and contract law. For the system to work effectively, there must be widespread understanding of the basic nature of private property and of the transactions through which it is allocated. Command socialist economies possess virtually none of these prerequisites for market capitalism. When the state owned virtually all
capital and natural resources, there was little need to develop a legal system that would spell out individual property rights. Governments were largely free to do as they wished. Countries seeking a transition from command socialism to market capitalism must develop a legal system comparable to those that have evolved in market capitalist countries over centuries. The problem of creating a system of property rights and the institutions necessary to support it is a large hurdle for economies making the transition to a market economy. One manifestation of the difficulties inherent in establishing clear and widely recognized property rights in formerly socialist countries is widespread criminal activity. Newly established private firms must contend with racketeers who offer protection at a price. Firms that refuse to pay the price may find their property destroyed or some of their managers killed. Criminal activity has been rampant in economies struggling toward a market capitalist system. Banking Banks in command socialist countries were operated by the state. There was no tradition of banking practices as they are understood in market capitalist countries. In a market capitalist economy, a privately owned bank accepts deposits from customers and lends these deposits to borrowers. These borrowers are typically firms or consumers. Banks in command socialist economies generally accepted saving deposits, but checking accounts for private individuals were virtually unknown. Decisions to advance money to firms were made through the economic planning process, not by individual banks. Banks did not have an opportunity to assess the profitability of individual enterprises; such considerations were irrelevant in the old command socialist systems. Bankers in these economies were thus unaccustomed to the roles that would be required of them in a market capitalist system. 20.3.1 https://socialsci.libretexts.org/@go/page/21801 Inflation One particularly vexing problem facing transitional economies is inflation. Under command socialist systems, the government set prices; it could abolish inflation by decree. But such systems were characterized by chronic shortages of consumer goods. Consumers, unable to find the goods they wanted to buy, simply accumulated money. As command socialist economies began their transitions, there was typically a very large quantity of money available for consumers to spend. A first step in transitions was the freeing of prices. Because the old state-determined prices were generally below equilibrium levels, prices typically surged in the early stages of transition. Prices in Poland, for example, shot up 400% within a few months of price decontrol. Prices in Russia went up tenfold within six months. One dilemma facing transitional economies has been the plight of bankrupt state enterprises. In a market capitalist economy, firms unable to generate revenues that exceed
their costs go out of business. In command socialist economies, the central bank simply wrote checks to cover their deficits. As these economies have begun the transition toward market capitalism, they have generally declared their intention to end these bailouts and to let failing firms fail. But the phenomenon of state firms earning negative profits is so pervasive that allowing all of them to fail at once could cause massive disruption. The practical alternative to allowing firms to fail has been continued bailouts. But in transitional economies, that has meant issuing money to failed firms. This practice increases the money supply and contributes to continuing inflation. Most transition economies experienced high inflation in the initial transition years, but were subsequently able to reduce it. Ideology Soviet citizens, and their counterparts in other command socialist economies, were told for decades that market capitalism is an evil institution, that it fosters greed and human misery. They were told that some people become rich in the system, but that they do so only at the expense of others who become poorer. In the context of a competitive market, this view of market processes as a zero-sum game—one in which the gains for one person come only as a result of losses for another—is wrong. In market transactions, one person gains only by making others better off. But the zero-sum view runs deep, and it is a source of lingering hostility toward market forces. Countries seeking to transform their economies from command socialist to more market-oriented systems face daunting challenges. Given these challenges, it is remarkable that they have persisted in the effort. There are a thousand reasons for economic reform to fail, but the reform effort has, in general, continued to move forward. China: A Gradual Transition China is a giant by virtually any standard. Larger than the continental United States, it is home to more than 1.3 billion people— more than one-fifth of the earth’s population. Although China is poor, its economy has been among the fastest growing in the world since 1980. That rapid growth is the result of a gradual shift toward a market capitalist economy. The Chinese have pursued their transition in a manner quite different from the paths taken by former Soviet bloc nations. Recent History China was invaded by Japan during World War II. After Japan’s defeat, civil war broke out between Chinese communists, led by Mao Zedong, and nationalists. The communists prevailed, and the People’s Republic of China was proclaimed in 1949. Mao set about immediately to create a socialist state in China. He nationalized many firms and
redistributed land to peasants. Many of those who had owned land under the old regime were executed. China’s entry into the Korean War in 1950 led to much closer ties to the Soviet Union, which helped China to establish a command socialist economy. China’s first five-year plan, launched in 1953, followed the tradition of Soviet economic development. It stressed capital-intensive production and the development of heavy industry. But China had far less capital and a great many more people than did the Soviet Union. Capital-intensive development made little sense. In 1958, Mao declared a uniquely Chinese approach to development, which he dubbed the Great Leap Forward. It focused on labor-intensive development and the organization of small productive units to quickly turn China into an industrialized country. Indeed, households were encouraged to form their own productive units under the slogan “An iron and steel foundry in every backyard.” The Great Leap repudiated the bonuses and other material incentives stressed by the Soviets; motivation was to come from revolutionary zeal, not self-interest. In agriculture, the new plan placed greater emphasis on collectivization. Farmers were organized into communes containing several thousand households each. Small private plots of land, which had been permitted earlier, were abolished. China’s adoption of the 20.3.2 https://socialsci.libretexts.org/@go/page/21801 plan was a victory for radical leaders in the government. The Great Leap was an economic disaster. Output plunged and a large-scale famine ensued. Moderate leaders then took over, and the economy got back to its 1957 level of output by the mid-1960s. Then, again in the mid-1960s, power shifted back towards the radicals with the launching of the Great Proletarian Cultural Revolution. During that time, students formed groups called “red guards” and were encouraged to expose “capitalist roaders.” A group dubbed the “Gang of Four,” led by Mao’s wife Jiang Qing, tried to steer Chinese society towards an ever more revolutionary course until Mao’s death in 1976. China’s Reforms Following Mao’s death, pragmatists within the Communist Party, led by Deng Xiaoping, embarked on a course of reform that promoted a more market-oriented economy coupled with retention of political power by the Communists. This policy combination was challenged in 1989 by a large demonstration in Beijing’s Tiananmen Square. The authorities ordered the
military to remove the demonstrators, resulting in the deaths of several hundred civilians. A period of retrenchment in the reform process followed and lasted for several years. Then, in 1992, Deng ushered in a period of reinvigorated economic reform in a highly publicized trip to southern China, where reforms had progressed farther. Through several leadership changes since then, the path of economic reform, managed by the Communist Party, has continued. The result has been a decades-long period of phenomenal economic growth. What were some of the major elements of the economic reform? Beginning in 1979, many Chinese provincial leaders instituted a system called bao gan dao hu—“contracting all decisions to the household.” Under the system, provincial officials contracted the responsibility for operating collectively owned farmland to individual households. Government officials gave households production quotas they were required to meet and purchased that output at prices set by central planners. But farmers were free to sell any additional output they could produce at whatever prices they could get in the marketplace and to keep the profits for themselves. By 1984, 93% of China’s agricultural land had been contracted to individual households and the rate of growth in agricultural output had soared. At the industrial level, state-owned enterprises (SOEs) were told to meet their quotas and then were free to engage in additional production for sale in free markets. Over time, even those production directives were discontinued. More importantly, manufacturing boomed with the development of township and village enterprises, as well as various types of private endeavors, with much participation from foreign firms. Most price controls were abolished. The entry of China into the World Trade Organization in 2001 symbolized a commitment towards moving even further down the road of economic reform. In effect, China’s economy is increasingly directed by market forces. Even though five-year plans are still announced, they are largely advisory rather than commanding in nature. Recognizing the incomplete nature of the reforms, Chinese authorities continue to work on making the SOEs more competitive, as well as privatizing them, creating a social security system in which social benefits are not tied to a worker’s place of employment, and reforming the banking sector. How well has the gradual approach to transition worked? Between 1980 and 2006, China had one of the fastest-growing economies in the world. Its per capita output, measured in dollars of constant purchasing power, more than quadrupled. The country, which as late as 1997 was one of the poorest of the 59 low-income-countries in
the world, is now situated comfortably among the more prosperous lower-middle-income countries, according to the World Bank. Figure 34.6 compares growth rates in China to those achieved by Japan and the United States and to the average annual growth rate of all world economies between 1985 and 2006. Figure 34.6 Soaring Output in China China’s growth in per capita output from 1985 to 2006 greatly exceeded rates recorded for Japan, the United States, or the average of all nations. 20.3.3 https://socialsci.libretexts.org/@go/page/21801 Source: World Bank, World Development Reports, 1997, 1998, 2004, 2005, 2006 Table 1. Where will China’s reforms lead? While the Chinese leadership has continued to be repressive politically, it has generally supported the reform process. The result has been continued expansion of the free economy and a relative shrinking of the state-run sector. Given the rapid progress China has achieved with its gradual approach to reform, it is hard to imagine that the country would reverse course. Given the course it is on, China seems likely to become a market capitalist economy—and a prosperous one —within a few decades. Russia: An Uncertain Path to Reform Russia dominated the former Soviet Union. It contained more than half the Soviet people and more than three-fourths of the nation’s land area. Russia’s capital, Moscow, was the capital and center of power for the entire country. Today, Russia retains control over the bulk of the military power that had been accumulated by the former Soviet Union. While it is now an ally of the United States, Russia still possesses the nuclear capability to destroy life on earth. Its success in making the transition to market capitalism and joining as a full partner in the world community thus has special significance for peace. Recent History Russia’s shift toward market capitalism has its roots in a reform process initiated during the final years of the existence of the Soviet Union. That effort presaged many of the difficulties that have continued to plague Russia. The Soviet Union, as we have already seen, had a well-established system of command socialism. Leading Soviet economists, however, began arguing as early as the 1970s that the old system could never deliver living standards comparable to those achieved in market capitalist economies. The first political leader to embrace the idea of radical reform was Mikhail Gorbachev, who became General Secretary of the Communist party—the highest leadership post in the Soviet Union—in 1985
. Mr. Gorbachev instituted political reforms that allowed Soviet citizens to speak out, and even to demonstrate, against their government. This policy was dubbed glasnost, or “openness.” Economically, he called for much greater autonomy for state enterprises and a system in which workers’ wages would be tied to productivity. The new policy, dubbed perestroika, or “restructuring,” appeared to be an effort to move the system toward a mixed economy. But Mr. Gorbachev’s economic advisers wanted to go much further. A small group of economists, which included his top economic adviser, met in August 1990 to draft a radical plan to transform the economy to a market capitalist system—and to do it in 500 days. Stanislav Shatalin, a Soviet economist, led the group. Mr. Gorbachev endorsed the Shatalin plan the following month, and it appeared that the Soviet Union was on its way to a new system. The new plan, however, threatened the Soviet power elite. It called for sharply reduced funding for the military and for the Soviet Union’s secret police force, the KGB. It would have stripped central planners, who were very powerful, of their authority. The new plan called for nothing less than the destruction of the old system— and the elimination of the power base of most government officials. Top Soviet bureaucrats and military leaders reacted to the Shatalin plan with predictable rage. They delivered an ultimatum to Mr. Gorbachev: dump the Shatalin plan or be kicked out. Caught between advisers who had persuaded him of the necessity for radical reform and Communist party leaders who would have none of it, Mr. Gorbachev chose to leave the command system in place and to seek modest reforms. He announced a new plan that retained control over most prices and he left in place the state’s ownership of enterprises. In an effort to deal with shortages of other goods, he ordered sharp price increases early in 1991. These measures, however, accomplished little. Black market prices for basic consumer goods were typically 10 to 20 times the level of state prices. Those prices, which respond to demand and supply, may be taken as a rough gauge of equilibrium prices. People were willing to pay the higher black market prices because they simply could not find goods at the state-decreed prices. Mr. Gorbachev’s order to double and even triple some state prices narrowed the gap between official and
equilibrium prices, but did not close it. Table 34.1 “Official Versus Black Market Prices in the Soviet Union, 1991” shows some of the price changes imposed and compares them to black market prices. Table 34.1 Official Versus Black Market Prices in the Soviet Union, 1991 Item Children’s shoes Old price 2–10 rubles New price 10–50 rubles Black market price 50–300 rubles 20.3.4 https://socialsci.libretexts.org/@go/page/21801 Item Toilet paper Compact car Bottle of vodka Old price 32–40 kopeks 7,000 rubles 10.5 rubles New price 60–75 kopeks 35,000 rubles 10.5 rubles Black market price 2–3 rubles 70,000–100,000 rubles 30–35 rubles Mikhail Gorbachev ordered sharp increases in the prices of most consumer goods early in 1991 in an effort to eliminate shortages. As the table shows, however, a large gap remained between official and black market prices. Source: Komsomolskaya pravda Perhaps the most important problem for Mr. Gorbachev’s price hikes was that there was no reason for state-owned firms to respond to them by increasing their output. The managers and workers in these firms, after all, were government employees receiving government-determined salaries. There was no mechanism through which they would gain from higher prices. A private firm could be expected to increase its quantity supplied in response to a higher price. State-owned firms did not. The Soviet people faced the worst of economic worlds in 1991. Soviet output plunged sharply, prices were up dramatically, and there was no relief from severe shortages. A small group of government officials opposed to economic reform staged a coup in the fall of 1991, putting Mr. Gorbachev under house arrest. The coup produced massive protests throughout the country and failed within a few days. Chaos within the central government created an opportunity for the republics of the Soviet Union to declare their independence, and they did. These defections resulted in the collapse of the Soviet Union late in 1991, with Russia as one of 15 countries that emerged. The Reform Effort Boris Yeltsin, the first elected president of Russia, had been a leading proponent of market capitalism even before the Soviet Union collapsed. He had supported the Shatalin plan and had been sharply critical of Mr. Gorbachev’s failure to implement it. Once Russia became
an independent republic, Mr. Yeltsin sought a rapid transition to market capitalism. Mr. Yeltsin’s reform efforts, however, were slowed by Russian legislators, most of them former Communist officials who were appointed to their posts under the old regime. They fought reform and repeatedly sought to impeach Mr. Yeltsin. Citing health reasons, he abruptly resigned from the presidency in 1999, and appointed Vladimir Putin, who had only recently been appointed as Yeltsin’s prime minister, as acting president. Mr. Putin has since been elected and re-elected, though many observers have questioned the fairness of those elections as well as Mr. Putin’s commitment to democracy. Barred constitutionally from re-election in 2008, Putin became prime minister. Dimitry Medvedev, Putin’s close ally, became president. Despite the hurdles, Russian reformers have accomplished a great deal. Prices of most goods have been freed from state controls. Most state-owned firms have been privatized, and most of Russia’s output of goods and services is now produced by the private sector. To privatize state firms, Russian citizens were issued vouchers that could be used to purchase state enterprises. Under this plan, state enterprises were auctioned off. Individuals, or groups of individuals, could use their vouchers to bid on them. By 1995 most state enterprises in Russia had been privatized. While Russia has taken major steps toward transforming itself into a market economy, it has not been able to institute its reforms in a coherent manner. For example, despite privatization, restructuring of Russian firms to increase efficiency has been slow. Establishment and enforcement of rules and laws that undergird modern, market-based systems have been lacking in Russia. Corruption has become endemic. While the quality of the data is suspect, there is no doubt that output and the standard of living fell through the first half of the 1990s. Despite a financial crisis in 1998, when the Russian government defaulted on its debt, output recovered through the last half of the 1990s and Russia has seen substantial growth in the early years of the twenty-first century. In addition, government finances have improved following a major tax reform and inflation has come down from near hyperinflation levels. Despite these gains, there is uneasiness about the long-term sustainability of this progress because of the over-importance of oil and high oil prices in the recovery. Mr. Putin’s fight, whether justified or not, with several of Russia�
�s so-called oligarchs, a small group of people who were able to amass large fortunes during the early years of privatization, creates unease for domestic and foreign investors. To be fair, overcoming the legacy of the Soviet Union would have been difficult at best. Overall, though, most would argue that Russian transition policies have made a difficult situation worse. Why has the transition in Russia been so difficult? One reason 20.3.5 https://socialsci.libretexts.org/@go/page/21801 may be that Russians lived with command socialism longer than did any other country. In addition, Russia had no historical experience with market capitalism. In countries that did have it, such as the Czech Republic, the switch back to capitalism has gone far more smoothly and has met with far more success. Try It! Table 34.1 “Official Versus Black Market Prices in the Soviet Union, 1991” shows three prices for various goods in the Soviet Union in 1991. Illustrate the market for compact cars using a demand and supply diagram. On your diagram, show the old price, the new price, and the black market price.  Case in Point: Eastern Germany’s Surprisingly Difficult Transition Experience Figure 34.7 Gavin Stewart – The fall of the Berlin Wall – CC BY 2.0. The transition of eastern Germany was supposed to be the easiest of them all. Quickly merged with western Germany, given its new “Big Brother’s” deep pockets, the ease with which it could simply adopt the rules and laws and policies of western Germany, and its automatic entry into the European Union, how could it not do well? And yet, eastern Germany seems to be languishing while some other central European countries that had also been part of the Soviet bloc are doing much better. Specifically, growth in real GDP in eastern Germany was 6% to 8% in the early 1990s, but since then has mostly been around 1%, with three years of negative growth in the early 2000s. In the early 1990s, the Polish economy grew at less than half east Germany’s rate, but since then has averaged more than 4% per year. Why the reversal of fortunes? Most observers point to the quick rise of wages to western German levels, despite the low productivity in the east. Initially, Germans from both east and west supported the move. East Germans obviously liked the idea of huge wage increases while west German workers thought that prolonged low wages in
the eastern part of the country would cause companies to relocate there and saw the higher east German wages as protecting their own jobs. While the German government offered subsidies and tax breaks to firms that would move to the east despite the high wages, companies were by and large still reluctant to move their factories there. Instead they chose to relocate in other central European countries, such as the Czech Republic, Slovakia, and Poland. As a result, unemployment in eastern Germany has remained stubbornly high at about 15% and transfer payments to east Germans have totaled $1.65 trillion with no end in sight. “East Germany had the wrong prices: Labor was too expensive, and capital was too cheap,” commented Klaus Deutsch, an economist at Deutsche Bank. While the flow of labor has primarily been from Poland to Germany since the break-up of the Soviet bloc, with mostly senior managers moving from Germany to Poland, there are some less-skilled, unemployed east Germans who are starting to look for jobs in Poland. Tassilo Schlicht is an east German who repaired bicycles and washing machines at a Soviet-era factory and lost his job in 1990. He then worked for a short time at a gas station in his town for no pay with the hope that the experience would be helpful, but he was never hired. He undertook some government-sponsored retraining but still could not find a job. Finally, he was hired at a gas station across the border in Poland. The pay is far less than what employed Germans make for doing similar jobs but it is twice what he had been receiving in unemployment benefits. “These days, a job is a job, wherever it is.” Sources: Marcus Walker and Matthew Karnitschnig, “Eastern Europe Eclipses Eastern Germany,” Wall Street Journal, November 9, 2004, p. A16; Keven J. O’Brien, “For Jobs, Some Germans Look to Poland,” New York Times, January 8, 2004, p. W1; Doug 20.3.6 https://socialsci.libretexts.org/@go/page/21801 Saunders, “What’s the Matter with Eastern Germany?” The Globe and Mail (Canada), November 27, 2007, p. F3. Try It! There is a shortage of cars at both the old price of 7,000 rubles and at the new price of 35,000, although the shortage is less at the new price.
Equilibrium price is assumed to be 70,000 rubles. Figure 34.8 This page titled 20.3: Economies in Transition: China and Russia is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 34.3: Economies in Transition: China and Russia by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 20.3.7 https://socialsci.libretexts.org/@go/page/21801 20.4: Review and Practice Summary Socialism, a system in which factors of production are owned in common or by the public sector, is a very old idea. The impetus for installing it as a national economic system came from the writings of Karl Marx. Marx argued that capitalism would inevitably collapse and give way to socialism. He argued that under capitalism workers would receive only a subsistence wage. Capitalists would extract the difference between what workers receive and what they produce as surplus value, a concept roughly equivalent to profit. As capitalists struggled to maintain surplus value, the degree and extent of exploitation of workers would rise. Capitalist systems would suffer through a series of crises in which firms cut back their output. The suffering of workers would increase, and the capitalist class would be weakened. Ultimately, workers would overthrow the market capitalist system and establish socialism in its place. Marx’s predictions about capitalist development have not come to fruition, but his ideas have been enormously influential. By the 1980s, roughly one-third of the world’s people lived in economies built on the basis of his ideas. The most important command socialist economy was the Soviet Union. In this economy, central planners determined what would be produced and at what price. Quotas were given to each state-owned firm. The system, which was emulated in most socialist nations, failed to deliver living standards on a par with those achieved by market economies. This failure ultimately brought down the system. A very different approach to socialism was pioneered by Yugoslavia. State-owned firms were managed by their workers, who shared in their profits. Yugoslavia’s economic system fell apart as the country broke up and suffered from ethnic strife and civil war. As the governments of command socialist nations fell in 1989 and early in the 1990s, new governments launched efforts to achieve transition to market capitalism. We
examined two cases of transition. China’s gradual strategy has produced rapid growth, but in a politically repressive regime. As this book went to press, China continued to be one of the fastest growing economies in the world. Russia’s transition has been much more difficult. Although its growth rate has improved in the last decade, there is still concern over the coherence of its reform efforts and the sustainability of recent improvements Concept Problems 1. There is a gap between what workers receive and the value of what workers produce in a market capitalist system. Why? Does this constitute exploitation? Does it create the kinds of crises Marx anticipated? Why or why not? 2. What is meant by the labor theory of value? What are the shortcomings of the theory? 3. What would you say is the theory of value offered in this book? How does it differ from the labor theory of value? 4. In what ways does reliance on the labor theory of value create a problem for the allocation of natural resources? 5. What do you think would be the advantages of labor-managed firms of the kind that operated in the former Yugoslavia? The disadvantages? 6. Suppose you were the manager of a Soviet enterprise under the old command system. You have been given a quota and the promise of a big bonus if your firm meets it. How might your production choices differ from those of the management of a profit-maximizing firm in a market capitalist economy? 7. What are some government-operated enterprises in the United States? Do you see any parallels between the problems command economies faced with the production of goods and services and problems in the United States with state-run enterprises? 8. A Chinese firm operating as a state-owned enterprise had an incentive to produce the efficient level of output, even though some of its output was claimed by the state at state-determined prices. Why is that the case? 9. Given that market capitalist systems generate much higher standards of living than do command socialist systems, why do you think many Russian government officials have opposed the adoption of a market system? 10. How does widespread criminal activity sap economic growth? This page titled 20.4: Review and Practice is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 20.4.1 https://socialsci.libretexts.org/@go/page/21802 34.4: Review and Practice by Anonymous is licensed CC BY-NC-SA 3.
0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 20.4.2 https://socialsci.libretexts.org/@go/page/21802 CHAPTER OVERVIEW Appendix A: Graphs in Economics 21.1: Nonlinear Relationships and Graphs without Numbers 21.2: Using Graphs and Charts to Show Values of Variables 21.3: How to Construct and Interpret Graphs 21.4: Extensions of the Aggregate Expenditures Model Thumbnail: https://unsplash.com/photos/PcDGGex9-jA This page titled Appendix A: Graphs in Economics is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 21.1: Nonlinear Relationships and Graphs without Numbers  Learning Objective 1. Understand nonlinear relationships and how they are illustrated with nonlinear curves. 2. Explain how to estimate the slope at any point on a nonlinear curve. 3. Explain how graphs without numbers can be used to understand the nature of relationships between two variables. In this section we will extend our analysis of graphs in two ways: first, we will explore the nature of nonlinear relationships; then we will have a look at graphs drawn without numbers. Graphs of Nonlinear Relationships In the graphs we have examined so far, adding a unit to the independent variable on the horizontal axis always has the same effect on the dependent variable on the vertical axis. When we add a passenger riding the ski bus, the ski club’s revenues always rise by the price of a ticket. The cancellation of one more game in the 1998–1999 basketball season would always reduce Shaquille O’Neal’s earnings by $210,000. The slopes of the curves describing the relationships we have been discussing were constant; the relationships were linear. Many relationships in economics are nonlinear. A nonlinear relationship between two variables is one for which the slope of the curve showing the relationship changes as the value of one of the variables changes. A nonlinear curve is a curve whose slope changes as the value of one of the variables changes. Consider an example. Suppose Felicia Alvarez, the owner of a bakery, has recorded the relationship between her firm’s daily output of bread and the number of bakers she employs. The relationship she has recorded
is given in the table in Panel (a) of Figure 21.9. The corresponding points are plotted in Panel (b). Clearly, we cannot draw a straight line through these points. Instead, we shall have to draw a nonlinear curve like the one shown in Panel (c). Figure 21.9 A Nonlinear Curve 21.1.1 https://socialsci.libretexts.org/@go/page/21804 The table in Panel (a) shows the relationship between the number of bakers Felicia Alvarez employs per day and the number of loaves of bread produced per day. This information is plotted in Panel (b). This is a nonlinear relationship; the curve connecting these points in Panel (c) (Loaves of bread produced) has a changing slope. Inspecting the curve for loaves of bread produced, we see that it is upward sloping, suggesting a positive relationship between the number of bakers and the output of bread. But we also see that the curve becomes flatter as we travel up and to the right along it; it is nonlinear and describes a nonlinear relationship. How can we estimate the slope of a nonlinear curve? After all, the slope of such a curve changes as we travel along it. We can deal with this problem in two ways. One is to consider two points on the curve and to compute the slope between those two points. Another is to compute the slope of the curve at a single point. When we compute the slope of a curve between two points, we are really computing the slope of a straight line drawn between those two points. In Figure 21.10, we have computed slopes between pairs of points A and B, C and D, and E and F on our curve for loaves of bread produced. These slopes equal 400 loaves/baker, 200 loaves/baker, and 50 loaves/baker, respectively. They are the slopes of the dashed-line segments shown. These dashed segments lie close to the curve, but they clearly are not on the curve. After all, the dashed segments are straight lines. Our curve relating the number of bakers to daily bread production is not a straight line; the relationship between the bakery’s daily output of bread and the number of bakers is nonlinear. 21.1.2 https://socialsci.libretexts.org/@go/page/21804 Figure 21.10 Estimating Slopes for a Nonlinear Curve
We can estimate the slope of a nonlinear curve between two points. Here, slopes are computed between points A and B, C and D, and E and F. When we compute the slope of a nonlinear curve between two points, we are computing the slope of a straight line between those two points. Here the lines whose slopes are computed are the dashed lines between the pairs of points. Every point on a nonlinear curve has a different slope. To get a precise measure of the slope of such a curve, we need to consider its slope at a single point. To do that, we draw a line tangent to the curve at that point. A tangent line is a straight line that touches, but does not intersect, a nonlinear curve at only one point. The slope of a tangent line equals the slope of the curve at the point at which the tangent line touches the curve. Consider point D in Panel (a) of Figure 21.11. We have drawn a tangent line that just touches the curve showing bread production at this point. It passes through points labeled M and N. The vertical change between these points equals 300 loaves of bread; the horizontal change equals two bakers. The slope of the tangent line equals 150 loaves of bread/baker (300 loaves/2 bakers). The slope of our bread production curve at point D equals the slope of the line tangent to the curve at this point. In Panel (b), we have sketched lines tangent to the curve for loaves of bread produced at points B, D, and F. Notice that these tangent lines get successively flatter, suggesting again that the slope of the curve is falling as we travel up and to the right along it. 21.1.3 https://socialsci.libretexts.org/@go/page/21804 Figure 21.11 Tangent Lines and the Slopes of Nonlinear Curves Because the slope of a nonlinear curve is different at every point on the curve, the precise way to compute slope is to draw a tangent line; the slope of the tangent line equals the slope of the curve at the point the tangent line touches the curve. In Panel (a), the slope of the tangent line is computed for us: it equals 150 loaves/baker. Generally, we will not have the information to compute slopes of tangent lines. We will use them as in Panel (b), to observe what happens
to the slope of a nonlinear curve as we travel along it. We see here that the slope falls (the tangent lines become flatter) as the number of bakers rises. Notice that we have not been given the information we need to compute the slopes of the tangent lines that touch the curve for loaves of bread produced at points B and F. In this text, we will not have occasion to compute the slopes of tangent lines. Either they will be given or we will use them as we did here—to see what is happening to the slopes of nonlinear curves. In the case of our curve for loaves of bread produced, the fact that the slope of the curve falls as we increase the number of bakers suggests a phenomenon that plays a central role in both microeconomic and macroeconomic analysis. As we add workers (in this case bakers), output (in this case loaves of bread) rises, but by smaller and smaller amounts. Another way to describe the relationship between the number of workers and the quantity of bread produced is to say that as the number of workers increases, the output increases at a decreasing rate. In Panel (b) of Figure 21.11 we express this idea with a graph, and we can gain this understanding by looking at the tangent lines, even though we do not have specific numbers. Indeed, much of our work with graphs will not require numbers at all. We turn next to look at how we can use graphs to express ideas even when we do not have specific numbers. Graphs Without Numbers We know that a positive relationship between two variables can be shown with an upward-sloping curve in a graph. A negative or inverse relationship can be shown with a downward-sloping curve. Some relationships are linear and some are nonlinear. We illustrate a linear relationship with a curve whose slope is constant; a nonlinear relationship is illustrated with a curve whose slope changes. Using these basic ideas, we can illustrate hypotheses graphically even in cases in which we do not have numbers with which to locate specific points. Consider first a hypothesis suggested by recent medical research: eating more fruits and vegetables each day increases life expectancy. We can show this idea graphically. Daily fruit and vegetable consumption (measured, say, in grams per day) is the independent variable; life expectancy (measured in years) is the dependent variable. Panel (a) of Figure 21.12 shows the hypothesis, which suggests a positive relationship between the two variables. Notice the vertical intercept on the
curve we have drawn; it implies that even people who eat no fruit or vegetables can expect to live at least a while! Figure 21.12 Graphs Without Numbers 21.1.4 https://socialsci.libretexts.org/@go/page/21804 We often use graphs without numbers to suggest the nature of relationships between variables. The graphs in the four panels correspond to the relationships described in the text. Panel (b) illustrates another hypothesis we hear often: smoking cigarettes reduces life expectancy. Here the number of cigarettes smoked per day is the independent variable; life expectancy is the dependent variable. The hypothesis suggests a negative relationship. Hence, we have a downward-sloping curve. Now consider a general form of the hypothesis suggested by the example of Felicia Alvarez’s bakery: increasing employment each period increases output each period, but by smaller and smaller amounts. As we saw in Figure 21.9, this hypothesis suggests a positive, nonlinear relationship. We have drawn a curve in Panel (c) of Figure 21.12 that looks very much like the curve for bread production in Figure 21.11. It is upward sloping, and its slope diminishes as employment rises. Finally, consider a refined version of our smoking hypothesis. Suppose we assert that smoking cigarettes does reduce life expectancy and that increasing the number of cigarettes smoked per day reduces life expectancy by a larger and larger amount. Panel (d) shows this case. Again, our life expectancy curve slopes downward. But now it suggests that smoking only a few cigarettes per day reduces life expectancy only a little but that life expectancy falls by more and more as the number of cigarettes smoked per day increases. We have sketched lines tangent to the curve in Panel (d). The slopes of these tangent lines are negative, suggesting the negative relationship between smoking and life expectancy. They also get steeper as the number of cigarettes smoked per day rises. Whether a curve is linear or nonlinear, a steeper curve is one for which the absolute value of the slope rises as the value of the variable on the horizontal axis rises. When we speak of the absolute value of a negative number such as −4, we ignore the minus sign and simply say that the absolute value is 4. The absolute value of −8, for example, is greater than the absolute value of −4, and a curve with a slope of −8 is steeper than a curve whose slope is −4. 21.1.5 https://socialsci
.libretexts.org/@go/page/21804 Thus far our work has focused on graphs that show a relationship between variables. We turn finally to an examination of graphs and charts that show values of one or more variables, either over a period of time or at a single point in time. Key Takeaways The slope of a nonlinear curve changes as the value of one of the variables in the relationship shown by the curve changes. A nonlinear curve may show a positive or a negative relationship. The slope of a curve showing a nonlinear relationship may be estimated by computing the slope between two points on the curve. The slope at any point on such a curve equals the slope of a line drawn tangent to the curve at that point. We can illustrate hypotheses about the relationship between two variables graphically, even if we are not given numbers for the relationships. We need only draw and label the axes and then draw a curve consistent with the hypothesis. Try It! Consider the following curve drawn to show the relationship between two variables, A and B (we will be using a curve like this one in the next chapter). Explain whether the relationship between the two variables is positive or negative, linear or nonlinear. Sketch two lines tangent to the curve at different points on the curve, and explain what is happening to the slope of the curve. Answer to Try It! The relationship between variable A shown on the vertical axis and variable B shown on the horizontal axis is negative. This is sometimes referred to as an inverse relationship. Variables that give a straight line with a constant slope are said to have a linear relationship. In this case, however, the relationship is nonlinear. The slope changes all along the curve. In this case the slope becomes steeper as we move downward to the right along the curve, as shown by the two tangent lines that have been drawn. As the quantity of B increases, the quantity of A decreases at an increasing rate. 21.1.6 https://socialsci.libretexts.org/@go/page/21804 This page titled 21.1: Nonlinear Relationships and Graphs without Numbers is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 21.1: Nonlinear Relationships and Graphs without Numbers by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/
economics-principles-v2.0/. 21.1.7 https://socialsci.libretexts.org/@go/page/21804 21.2: Using Graphs and Charts to Show Values of Variables  Learning Objective 1. Understand and use time-series graphs, tables, pie charts, and bar charts to illustrate data and relationships among variables. You often see pictures representing numerical information. These pictures may take the form of graphs that show how a particular variable has changed over time, or charts that show values of a particular variable at a single point in time. We will close our introduction to graphs by looking at both ways of conveying information. Time-Series Graphs One of the most common types of graphs used in economics is called a time-series graph. A time-series graph shows how the value of a particular variable or variables has changed over some period of time. One of the variables in a time-series graph is time itself. Time is typically placed on the horizontal axis in time-series graphs. The other axis can represent any variable whose value changes over time. The table in Panel (a) of Figure 21.13 shows annual values of the unemployment rate, a measure of the percentage of workers who are looking for and available for work but are not working, in the United States from 1998 to 2007. The grid with which these values are plotted is given in Panel (b). Notice that the vertical axis is scaled from 3 to 8%, instead of beginning with zero. Timeseries graphs are often presented with the vertical axis scaled over a certain range. The result is the same as introducing a break in the vertical axis, as we did in Figure 21.5 “Canceling Games and Reducing Shaquille O’Neal’s Earnings”. Figure 21.13 A Time-Series Graph Panel (a) gives values of the U.S. unemployment rate from 1998 to 2010. These points are then plotted in Panel (b). To draw a time-series graph, we connect these points, as in Panel (c). The values for the U.S. unemployment rate are plotted in Panel (b) of Figure 21.13. The points plotted are then connected with a line in Panel (c). Scaling the Vertical Axis in Time-Series Graphs The scaling of the vertical axis in time-series graphs can give very different views of economic data. We can make a variable appear to change a great
deal, or almost not at all, depending on how we scale the axis. For that reason, it is important to note carefully how the vertical axis in a time-series graph is scaled. 21.2.1 https://socialsci.libretexts.org/@go/page/21805 Consider, for example, the issue of whether an increase or decrease in income tax rates has a significant effect on federal government revenues. This became a big issue in 1993, when President Clinton proposed an increase in income tax rates. The measure was intended to boost federal revenues. Critics of the president’s proposal argued that changes in tax rates have little or no effect on federal revenues. Higher tax rates, they said, would cause some people to scale back their income-earning efforts and thus produce only a small gain—or even a loss—in revenues. Op-ed essays in The Wall Street Journal, for example, often showed a graph very much like that presented in Panel (a) of Figure 21.14. It shows federal revenues as a percentage of gross domestic product (GDP), a measure of total income in the economy, since 1960. Various tax reductions and increases were enacted during that period, but Panel (a) appears to show they had little effect on federal revenues relative to total income. Figure 21.14 Two Tales of Taxes and Income A graph of federal revenues as a percentage of GDP emphasizes the stability of the relationship when plotted with the vertical axis scaled from 0 to 100, as in Panel (a). Scaling the vertical axis from 16 to 21%, as in Panel (b), stresses the short-term variability of the percentage and suggests that major tax rate changes have affected federal revenues. Laura Tyson, then President Clinton’s chief economic adviser, charged that those graphs were misleading. In a Wall Street Journal piece, she noted the scaling of the vertical axis used by the president’s critics. She argued that a more reasonable scaling of the axis shows that federal revenues tend to increase relative to total income in the economy and that cuts in taxes reduce the federal government’s share. Her alternative version of these events does, indeed, suggest that federal receipts have tended to rise and fall with changes in tax policy, as shown in Panel (b) of Figure 21.14. Which version is correct? Both are. Both graphs show the same data. It is certainly true that federal revenues, relative to economic activity, have been remarkably stable over the past several decades, as emphasized by
the scaling in Panel (a). But it is also true that the federal share has varied between about 17 and 20%. And a small change in the federal share translates into a large amount of tax revenue. It is easy to be misled by time-series graphs. Large changes can be made to appear trivial and trivial changes to appear large through an artful scaling of the axes. The best advice for a careful consumer of graphical information is to note carefully the range of values shown and then to decide whether the changes are really significant. Testing Hypotheses with Time-Series Graphs John Maynard Keynes, one of the most famous economists ever, proposed in 1936 a hypothesis about total spending for consumer goods in the economy. He suggested that this spending was positively related to the income households receive. One way to test such a hypothesis is to draw a time-series graph of both variables to see whether they do, in fact, tend to move together. Figure 21.15 shows the values of consumption spending and disposable income, which is after-tax income received by households. Annual values of consumption and disposable income are plotted for the period 1960–2007. Notice that both variables have tended to move quite closely together. The close relationship between consumption and disposable income is consistent with Keynes’s hypothesis that there is a positive relationship between the two variables. Figure 21.15 A Time-Series Graph of Disposable Income and Consumption 21.2.2 https://socialsci.libretexts.org/@go/page/21805 Plotted in a time-series graph, disposable income and consumption appear to move together. This is consistent with the hypothesis that the two are directly related. Source: Department of Commerce The fact that two variables tend to move together in a time series does not by itself prove that there is a systematic relationship between the two. Figure 21.16 shows a time-series graph of monthly values in 1987 of the Dow Jones Industrial Average, an index that reflects the movement of the prices of common stock. Notice the steep decline in the index beginning in October, not unlike the steep decline in October 2008. Figure 21.16 Stock Prices and a Mystery Variable The movement of the monthly average of the Dow Jones Industrial Average, a widely reported index of stock values, corresponded closely to changes in a mystery variable, X. Did the mystery variable contribute to the crash? It would be useful, and certainly profitable, to be able to predict such declines. Figure 21.16 also shows the movement of monthly values of a
“mystery variable,” X, for the same period. The mystery variable and stock prices appear to move closely together. Was the plunge in the mystery variable in October responsible for the stock crash? The answer is: Not likely. The mystery value is monthly average temperatures in San Juan, Puerto Rico. Attributing the stock crash in 1987 to the weather in San Juan would be an example of the fallacy of false cause. 21.2.3 https://socialsci.libretexts.org/@go/page/21805 Notice that Figure 21.16 has two vertical axes. The left-hand axis shows values of temperature; the right-hand axis shows values for the Dow Jones Industrial Average. Two axes are used here because the two variables, San Juan temperature and the Dow Jones Industrial Average, are scaled in different units. Descriptive Charts We can use a table to show data. Consider, for example, the information compiled each year by the U.S. National Center for Education Statistics. The table in Panel (a) of Figure 21.17 shows the results of the 2009 survey. In the groupings given, economics is included among the social sciences. Figure 21.17 Bachelor’s Degrees Earned by Field, 2009 Panels (a), (b), and (c) show bachelor’s degrees earned by field in 2009 in United States. All three panels present the same information. Panel (a) is an example of a table, Panel (b) is an example of a pie chart, and Panel (c) is an example of a vertical bar chart. Source: Statistical Abstracts of the United States, 2012, Table 302. Bachelor’s Degrees Earned by Field, 1980 to 2009, based on data from U.S. National Center for Education Statistics, Digest of Educational Statistics. Percentages shown are for broad academic areas, each of which includes several majors. Panels (b) and (c) of Figure 21.17 present the same information in two types of charts. Panel (b) is an example of a pie chart; Panel (c) gives the data in a bar chart. The bars in this chart are horizontal; they may also be drawn as vertical. Either type of graph may be used to provide a picture of numeric information. Key Takeaways A time-series graph shows changes in a variable over time; one axis is always measured in units of time. One use of time-series graphs is to
plot the movement of two or more variables together to see if they tend to move together or not. The fact that two variables move together does not prove that changes in one of the variables cause changes in the other. Values of a variable may be illustrated using a table, a pie chart, or a bar chart. Try It! The table in Panel (a) shows a measure of the inflation rate, the percentage change in the average level of prices below. Panels (b) and (c) provide blank grids. We have already labeled the axes on the grids in Panels (b) and (c). It is up to you to plot the data in Panel (a) on the grids in Panels (b) and (c). Connect the points you have marked in the grid using straight lines between the points. What relationship do you observe? Has the inflation rate generally increased or decreased? What can you say about the trend of 21.2.4 https://socialsci.libretexts.org/@go/page/21805 inflation over the course of the 1990s? Do you tend to get a different “interpretation” depending on whether you use Panel (b) or Panel (c) to guide you? Answer to Try It! Here are the time-series graphs, Panels (b) and (c), for the information in Panel (a). The first thing you should notice is that both graphs show that the inflation rate generally declined throughout the 1990s (with the exception of 1996, when it increased). The generally downward direction of the curve suggests that the trend of inflation was downward. Notice that in this case we do not say negative, since in this instance it is not the slope of the line that matters. Rather, inflation itself is still positive (as indicated by the fact that all the points are above the origin) but is declining. Finally, comparing Panels (b) and (c) suggests that the general downward trend in the inflation rate is emphasized less in Panel (b) than in Panel (c). This impression would be emphasized even more if the numbers on the vertical axis were increased in Panel (b) from 20 to 100. Just as in Figure 21.14, it is possible to make large changes appear trivial by simply changing the scaling of the axes. 21.2.5 https://socialsci.libretexts.org/@go/page/21805 Problems 1. Panel (a) shows a graph of a positive
relationship; Panel (b) shows a graph of a negative relationship. Decide whether each proposition below demonstrates a positive or negative relationship, and decide which graph you would expect to illustrate each proposition. In each statement, identify which variable is the independent variable and thus goes on the horizontal axis, and which variable is the dependent variable and goes on the vertical axis. 21.2.6 https://socialsci.libretexts.org/@go/page/21805 1. An increase in national income in any one year increases the number of people killed in highway accidents. 2. An increase in the poverty rate causes an increase in the crime rate. 3. As the income received by households rises, they purchase fewer beans. 4. As the income received by households rises, they spend more on home entertainment equipment. 5. The warmer the day, the less soup people consume. 2. Suppose you have a graph showing the results of a survey asking people how many left and right shoes they owned. The results suggest that people with one left shoe had, on average, one right shoe. People with seven left shoes had, on average, seven right shoes. Put left shoes on the vertical axis and right shoes on the horizontal axis; plot the following observations: Left shoes Right shoes Is this relationship positive or negative? What is the slope of the curve? 3. Suppose your assistant inadvertently reversed the order of numbers for right shoe ownership in the survey above. You thus have the following table of observations: Left shoes Right shoes Is the relationship between these numbers positive or negative? What’s implausible about that? 4. Suppose some of Ms. Alvarez’s kitchen equipment breaks down. The following table gives the values of bread output that were shown in Figure 21.9 “A Nonlinear Curve”. It also gives the new levels of bread output that Ms. Alvarez’s bakers produce following the breakdown. Plot the two curves. What has happened? Bakers/day Loaves/day Loaves/day after breakdown 400 380 2 700 670 3 900 860 4 1,000 5 1,050 950 990 6 1,075 1,005 5. Steven Magee has suggested that there is a relationship between the number of lawyers per capita in a country and the country’s rate of economic growth. The relationship is described with the following Magee curve. 21.2.7 https://socialsci.libretexts.org/@go/page/21805
What do you think is the argument made by the curve? What kinds of countries do you think are on the upward- sloping region of the curve? Where would you guess the United States is? Japan? Does the Magee curve seem plausible to you? 6. Draw graphs showing the likely relationship between each of the following pairs of variables. In each case, put the first variable mentioned on the horizontal axis and the second on the vertical axis. 1. The amount of time a student spends studying economics and the grade he or she receives in the course 2. Per capita income and total expenditures on health care 3. Alcohol consumption by teenagers and academic performance 4. Household income and the likelihood of being the victim of a violent crime This page titled 21.2: Using Graphs and Charts to Show Values of Variables is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 21.2: Using Graphs and Charts to Show Values of Variables by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 21.2.8 https://socialsci.libretexts.org/@go/page/21805 21.3: How to Construct and Interpret Graphs  Learning Objective 1. Understand how graphs show the relationship between two or more variables and explain how a graph elucidates the nature of the relationship. 2. Define the slope of a curve. 3. Distinguish between a movement along a curve, a shift in a curve, and a rotation in a curve. Much of the analysis in economics deals with relationships between variables. A variable is simply a quantity whose value can change. A graph is a pictorial representation of the relationship between two or more variables. The key to understanding graphs is knowing the rules that apply to their construction and interpretation. This section defines those rules and explains how to draw a graph. Drawing a Graph To see how a graph is constructed from numerical data, we will consider a hypothetical example. Suppose a college campus has a ski club that organizes day-long bus trips to a ski area about 100 miles from the campus. The club leases the bus and charges $10 per passenger for a round trip to the ski area. In addition to the revenue the club collects from passengers, it also receives a grant of $200 from
the school’s student government for each day the bus trip is available. The club thus would receive $200 even if no passengers wanted to ride on a particular day. The table in Figure 21.1 shows the relationship between two variables: the number of students who ride the bus on a particular day and the revenue the club receives from a trip. In the table, each combination is assigned a letter (A, B, etc.); we will use these letters when we transfer the information from the table to a graph. Figure 21.1 Ski Club Revenues The ski club receives $10 from each passenger riding its bus for a trip to and from the ski area plus a payment of $200 from the student government for each day the bus is available for these trips. The club’s revenues from any single day thus equal $200 plus $10 times the number of passengers. The table relates various combinations of the number of passengers and club revenues. We can illustrate the relationship shown in the table with a graph. The procedure for showing the relationship between two variables, like the ones in Figure 21.1, on a graph is illustrated in Figure 21.2. Let us look at the steps involved. Figure 21.2 Plotting a Graph 21.3.1 https://socialsci.libretexts.org/@go/page/21806 Here we see how to show the information given in Figure 21.1 in a graph. Step 1. Draw and Label the Axes The two variables shown in the table are the number of passengers taking the bus on a particular day and the club’s revenue from that trip. We begin our graph in Panel (a) of Figure 21.2 by drawing two axes to form a right angle. Each axis will represent a variable. The axes should be carefully labeled to reflect what is being measured on each axis. It is customary to place the independent variable on the horizontal axis and the dependent variable on the vertical axis. Recall that, when two variables are related, the dependent variable is the one that changes in response to changes in the independent variable. Passengers generate revenue, so we can consider the number of passengers as the independent variable and the club’s revenue as the dependent variable. The number of passengers thus goes on the horizontal axis; the club’s revenue from a trip goes on the vertical axis. In some cases, the variables in a graph cannot be considered independent or dependent. In those cases, the variables may be placed on
either axis; we will encounter such a case in the chapter that introduces the production possibilities model. In other cases, economists simply ignore the rule; we will encounter that case in the chapter that introduces the model of demand and supply. The rule that the independent variable goes on the horizontal axis and the dependent variable goes on the vertical usually holds, but not always. The point at which the axes intersect is called the origin of the graph. Notice that in Figure 21.2 the origin has a value of zero for each variable. In drawing a graph showing numeric values, we also need to put numbers on the axes. For the axes in Panel (a), we have chosen numbers that correspond to the values in the table. The number of passengers ranges up to 40 for a trip; club revenues from a trip range from $200 (the payment the club receives from student government) to $600. We have extended the vertical axis to $800 to allow some changes we will consider below. We have chosen intervals of 10 passengers on the horizontal axis and $100 on the vertical axis. The choice of particular intervals is mainly a matter of convenience in drawing and reading the graph; we have chosen the ones here because they correspond to the intervals given in the table. We have drawn vertical lines from each of the values on the horizontal axis and horizontal lines from each of the values on the vertical axis. These lines, called gridlines, will help us in Step 2. Step 2. Plot the Points Each of the rows in the table in Figure 21.1 gives a combination of the number of passengers on the bus and club revenue from a particular trip. We can plot these values in our graph. We begin with the first row, A, corresponding to zero passengers and club revenue of $200, the payment from student government. We read up from zero passengers on the horizontal axis to $200 on the vertical axis and mark point A. This point shows that zero passengers result in club revenues of $200. The second combination, B, tells us that if 10 passengers ride the bus, the club receives $300 in revenue from the trip—$100 from the $10-per-passenger charge plus the $200 from student government. We start at 10 passengers on the horizontal axis and follow the gridline up. When we travel up in a graph, we are traveling with respect to values on the vertical axis. We travel up by $300 and mark point B. 21.3.2 https://socialsci.libretexts.org
/@go/page/21806 Points in a graph have a special significance. They relate the values of the variables on the two axes to each other. Reading to the left from point B, we see that it shows $300 in club revenue. Reading down from point B, we see that it shows 10 passengers. Those values are, of course, the values given for combination B in the table. We repeat this process to obtain points C, D, and E. Check to be sure that you see that each point corresponds to the values of the two variables given in the corresponding row of the table. The graph in Panel (b) is called a scatter diagram. A scatter diagram shows individual points relating values of the variable on one axis to values of the variable on the other. Step 3. Draw the Curve The final step is to draw the curve that shows the relationship between the number of passengers who ride the bus and the club’s revenues from the trip. The term “curve” is used for any line in a graph that shows a relationship between two variables. We draw a line that passes through points A through E. Our curve shows club revenues; we shall call it R. Notice that R is an upward-sloping straight line. Notice also that R intersects the vertical axis at $200 (point A). The point at which a curve intersects an axis is called the intercept of the curve. We often refer to the vertical or horizontal intercept of a curve; such intercepts can play a special role in economic analysis. The vertical intercept in this case shows the revenue the club would receive on a day it offered the trip and no one rode the bus. 1 1 1 To check your understanding of these steps, we recommend that you try plotting the points and drawing R for yourself in Panel (a). Better yet, draw the axes for yourself on a sheet of graph paper and plot the curve. 1 The Slope of a Curve In this section, we will see how to compute the slope of a curve. The slopes of curves tell an important story: they show the rate at which one variable changes with respect to another. The slope of a curve equals the ratio of the change in the value of the variable on the vertical axis to the change in the value of the variable on the horizontal axis, measured between two points on the curve. You may have heard this called “the rise over the run.” In equation form, we can write the definition of the slope as Equation
21.1 Figure 21.3 provides a short review of working with equations. The material in this text relies much more heavily on graphs than on equations, but we will use equations from time to time. It is important that you understand how to use them. Figure 21.3 Reading and Using Equations Many equations in economics begin in the form of Equation 21.1, with the statement that one thing (in this case the slope) equals another (the vertical change divided by the horizontal change). In this example, the equation is written in words. Sometimes we use symbols in place of words. The basic idea though, is always the same: the term represented on the left side of the equals sign equals the term on the right side. In Equation 21.1 there are three variables: the slope, the vertical change, and the horizontal change. If we know the values of two of the three, we can compute the third. In the computation of slopes that follow, for example, we will use values for the two variables on the right side of the equation to compute the slope. 1 Figure 21.4 shows R and the computation of its slope between points B and D. Point B corresponds to 10 passengers on the bus; point D corresponds to 30. The change in the horizontal axis when we go from B to D thus equals 20 passengers. Point B corresponds to club revenues of $300; point D corresponds to club revenues of $500. The change in the vertical axis equals $200. The slope thus equals $200/20 passengers, or $10/passenger. Figure 21.4 Computing the Slope of a Curve 21.3.3 https://socialsci.libretexts.org/@go/page/21806 1. Select two points; we have selected points B and D. 2. The slope equals the vertical change divided by the horizontal change between the two points. 3. Between points B and D, the slope equals $200/20 passengers = $10/passenger. 4. The slope of this curve is the price per passenger. The fact that it is positive suggests a positive relationship between revenue per trip and the number of passengers riding the bus. Because the slope of this curve is $10/passenger between any two points on the curve, the relationship between club revenue per trip and the number of passengers is linear. We have applied the definition of the slope of a curve to compute the slope of R between points B and D. That same definition is given
in Equation 21.1. Applying the equation, we have: 1 passenger The slope of this curve tells us the amount by which revenues rise with an increase in the number of passengers. It should come as no surprise that this amount equals the price per passenger. Adding a passenger adds $10 to the club’s revenues. 1 Notice that we can compute the slope of R between any two points on the curve and get the same value; the slope is constant. Consider, for example, points A and E. The vertical change between these points is $400 (we go from revenues of $200 at A to revenues of $600 at E). The horizontal change is 40 passengers (from zero passengers at A to 40 at E). The slope between A and E thus equals $400/(40 passengers) = $10/passenger. We get the same slope regardless of which pair of points we pick on R to compute the slope. The slope of R can be considered a constant, which suggests that it is a straight line. When the curve showing the relationship between two variables has a constant slope, we say there is a linear relationship between the variables. A linear curve is a curve with constant slope. 1 1 The fact that the slope of our curve equals $10/passenger tells us something else about the curve—$10/passenger is a positive, not a negative, value. A curve whose slope is positive is upward sloping. As we travel up and to the right along R, we travel in the direction of increasing values for both variables. A positive relationship between two variables is one in which both variables move in the same direction. Positive relationships are sometimes called direct relationships. There is a positive relationship between club 1 21.3.4 https://socialsci.libretexts.org/@go/page/21806 revenues and passengers on the bus. We will look at a graph showing a negative relationship between two variables in the next section. A Graph Showing a Negative Relationship A negative relationship is one in which two variables move in opposite directions. A negative relationship is sometimes called an inverse relationship. The slope of a curve describing a negative relationship is always negative. A curve with a negative slope is always downward sloping. As an example of a graph of a negative relationship, let us look at the impact of the cancellation of games by the National Basketball Association during the 1998–1999 labor dispute on the earnings of one player: Shaquille O’Neal. During the 1998
–1999 season, O’Neal was the center for the Los Angeles Lakers. O’Neal’s salary with the Lakers in 1998–1999 would have been about $17,220,000 had the 82 scheduled games of the regular season been played. But a contract dispute between owners and players resulted in the cancellation of 32 games. Mr. O’Neal’s salary worked out to roughly $210,000 per game, so the labor dispute cost him well over $6 million. Presumably, he was able to eke out a living on his lower income, but the cancellation of games cost him a great deal. We show the relationship between the number of games canceled and O’Neal’s 1998–1999 basketball earnings graphically in Figure 21.5. Canceling games reduced his earnings, so the number of games canceled is the independent variable and goes on the horizontal axis. O’Neal’s earnings are the dependent variable and go on the vertical axis. The graph assumes that his earnings would have been $17,220,000 had no games been canceled (point A, the vertical intercept). Assuming that his earnings fell by $210,000 per game canceled, his earnings for the season were reduced to $10,500,000 by the cancellation of 32 games (point B). We can draw a line between these two points to show the relationship between games canceled and O’Neal’s 1998–1999 earnings from basketball. In this graph, we have inserted a break in the vertical axis near the origin. This allows us to expand the scale of the axis over the range from $10,000,000 to $18,000,000. It also prevents a large blank space between the origin and an income of $10,500,000—there are no values below this amount. Figure 21.5 Canceling Games and Reducing Shaquille O’Neal’s Earnings If no games had been canceled during the 1998–1999 basketball season, Shaquille O’Neal would have earned $17,220,000 (point A). Assuming that his salary for the season fell by $210,000 for each game canceled, the cancellation of 32 games during the dispute between NBA players and owners reduced O’Neal’s earnings to $10,500,000 (point B). 21.3.5 https://socialsci.libretexts.org/@go/page/21806 What is the slope
of the curve in Figure 21.5? We have data for two points, A and B. At A, O’Neal’s basketball salary would have been $17,220,000. At B, it is $10,500,000. The vertical change between points A and B equals -$6,720,000. The change in the horizontal axis is from zero games canceled at A to 32 games canceled at B. The slope is thus game Notice that this time the slope is negative, hence the downward-sloping curve. As we travel down and to the right along the curve, the number of games canceled rises and O’Neal’s salary falls. In this case, the slope tells us the rate at which O’Neal lost income as games were canceled. The slope of O’Neal’s salary curve is also constant. That means there was a linear relationship between games canceled and his 1998–1999 basketball earnings. Shifting a Curve When we draw a graph showing the relationship between two variables, we make an important assumption. We assume that all other variables that might affect the relationship between the variables in our graph are unchanged. When one of those other variables changes, the relationship changes, and the curve showing that relationship shifts. Consider, for example, the ski club that sponsors bus trips to the ski area. The graph we drew in Figure 21.2 shows the relationship between club revenues from a particular trip and the number of passengers on that trip, assuming that all other variables that might affect club revenues are unchanged. Let us change one. Suppose the school’s student government increases the payment it makes to the club to $400 for each day the trip is available. The payment was $200 when we drew the original graph. Panel (a) of Figure 21.6 shows how the increase in the payment affects the table we had in Figure 21.1; Panel (b) shows how the curve shifts. Each of the new observations in the table has been labeled with a prime: A′, B′, etc. The curve R shifts upward by $200 as a result of the increased payment. A shift in a curve implies new values of one variable at each value of the other variable. The new curve is labeled R. With 10 passengers, for example, the club’s revenue was $300 at point B on R. With the increased payment from the student government, its revenue with 10 passengers rises to $500 at point B′ on R
. We have a shift in the curve. 2 1 1 2 Figure 21.6 Shifting a Curve: An Increase in Revenues The table in Panel (a) shows the new level of revenues the ski club receives with varying numbers of passengers as a result of the increased payment from student government. The new curve is shown in dark purple in Panel (b). The old curve is shown in light purple. It is important to distinguish between shifts in curves and movements along curves. A movement along a curve is a change from one point on the curve to another that occurs when the dependent variable changes in response to a change in the independent variable. If, for example, the student government is paying the club $400 each day it makes the ski bus available and 20 passengers 21.3.6 https://socialsci.libretexts.org/@go/page/21806 ride the bus, the club is operating at point C′ on R. If the number of passengers increases to 30, the club will be at point D′ on the curve. This is a movement along a curve; the curve itself does not shift. 2 Now suppose that, instead of increasing its payment, the student government eliminates its payments to the ski club for bus trips. The club’s only revenue from a trip now comes from its $10/passenger charge. We have again changed one of the variables we were holding unchanged, so we get another shift in our revenue curve. The table in Panel (a) of Figure 21.7 shows how the reduction in the student government’s payment affects club revenues. The new values are shown as combinations A″ through E″ on the new curve, R, in Panel (b). Once again we have a shift in a curve, this time from R to R. 3 3 1 Figure 21.7 Shifting a Curve: A Reduction in Revenues The table in Panel (a) shows the impact on ski club revenues of an elimination of support from the student government for ski bus trips. The club’s only revenue now comes from the $10 it charges to each passenger. The new combinations are shown as A″ – E″. In Panel (b) we see that the original curve relating club revenue to the number of passengers has shifted down. The shifts in Figure 21.6 and Figure 21.7 left the slopes of the revenue curves unchanged. That is because the slope in all these cases equals the price per ticket, and the ticket price remains unchanged
. Next, we shall see how the slope of a curve changes when we rotate it about a single point. Rotating a Curve A rotation of a curve occurs when we change its slope, with one point on the curve fixed. Suppose, for example, the ski club changes the price of its bus rides to the ski area to $30 per trip, and the payment from the student government remains $200 for each day the trip is available. This means the club’s revenues will remain $200 if it has no passengers on a particular trip. Revenue will, however, be different when the club has passengers. Because the slope of our revenue curve equals the price per ticket, the slope of the revenue curve changes. Panel (a) of Figure 21.8 shows what happens to the original revenue curve, R, when the price per ticket is raised. Point A does not change; the club’s revenue with zero passengers is unchanged. But with 10 passengers, the club’s revenue would rise from $300 (point B on R ) to $500 (point B′ on R ). With 20 passengers, the club’s revenue will now equal $800 (point C′ on R ). 1 4 1 4 Figure 21.8 Rotating a Curve 21.3.7 https://socialsci.libretexts.org/@go/page/21806 A curve is said to rotate when a single point remains fixed while other points on the curve move; a rotation always changes the slope of a curve. Here an increase in the price per passenger to $30 would rotate the revenue curve from R to R in Panel (a). The slope of R is $30 per passenger. 1 4 4 The new revenue curve R is steeper than the original curve. Panel (b) shows the computation of the slope of the new curve between points B′ and C′. The slope increases to $30 per passenger—the new price of a ticket. The greater the slope of a positively sloped curve, the steeper it will be. 4 We have now seen how to draw a graph of a curve, how to compute its slope, and how to shift and rotate a curve. We have examined both positive and negative relationships. Our work so far has been with linear relationships. Next we will turn to nonlinear ones. Key Takeaways A graph shows a relationship between two or more variables. An upward-sloping curve suggests a positive relationship between two variables. A downward-sloping curve suggests
a negative relationship between two variables. The slope of a curve is the ratio of the vertical change to the horizontal change between two points on the curve. A curve whose slope is constant suggests a linear relationship between two variables. A change from one point on the curve to another produces a movement along the curve in the graph. A shift in the curve implies new values of one variable at each value of the other variable. A rotation in the curve implies that one point remains fixed while the slope of the curve changes. Try It! The following table shows the relationship between the number of gallons of gasoline people in a community are willing and able to buy per week and the price per gallon. Plot these points in the grid provided and label each point with the letter associated with the combination. Notice that there are breaks in both the vertical and horizontal axes of the grid. Draw a line through the points you have plotted. Does your graph suggest a positive or a negative relationship? What is the slope between A and B? Between B and C? Between A and C? Is the relationship linear? 21.3.8 https://socialsci.libretexts.org/@go/page/21806 Now suppose you are given the following information about the relationship between price per gallon and the number of gallons per week gas stations in the community are willing to sell. Plot these points in the grid provided and draw a curve through the points you have drawn. Does your graph suggest a positive or a negative relationship? What is the slope between D and E? Between E and F? Between D and F? Is this relationship linear? Answer to Try It! Here is the first graph. The curve’s downward slope tells us there is a negative relationship between price and the quantity of gasoline people are willing and able to buy. This curve, by the way, is a demand curve (the next one is a supply curve). We will study demand and supply soon; you will be using these curves a great deal. The slope between A and B is −0.002 (slope = vertical change/horizontal change = −0.20/100). The slope between B and C and between A and C is the same. That tells us the curve is linear, which, of course, we can see—it is a straight line. Here is the supply curve. Its upward slope tells us there is a positive relationship between price per gallon and the number of gallons per week gas stations are willing to sell. The slope between D and
E is 0.002 (slope equals vertical change/horizontal change = 0.20/100). Because the curve is linear, the slope is the same between any two points, for example, between E and F and between D and F. 21.3.9 https://socialsci.libretexts.org/@go/page/21806 This page titled 21.3: How to Construct and Interpret Graphs is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 21.3: How to Construct and Interpret Graphs by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 21.3.10 https://socialsci.libretexts.org/@go/page/21806 CHAPTER OVERVIEW 21.4: Extensions of the Aggregate Expenditures Model This page titled 21.4: Extensions of the Aggregate Expenditures Model is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 21.4.1 https://socialsci.libretexts.org/@go/page/21807 CHAPTER OVERVIEW Appendix B: Extensions of the Aggregate Expenditures Model 22.1: The Algebra of Equilibrium 22.2: The Aggregate Expenditures Model and Fiscal Policy Thumbnail: https://pixabay.com/illustrations/statistics-graph-chart-data-3411473/ This page titled Appendix B: Extensions of the Aggregate Expenditures Model is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 1 22.1: The Algebra of Equilibrium Suppose an economy can be represented by the following equations: Equation 22.1.1 Equation 22.1.2 Equation 22.1.3 Equation 22.1.4 Equation 22.1.5 Ca C = + b Yd Ta T = + tY =Ip Ia G = Ga =Xn Xna (22.1.1) (22.1.2) (22.1.3) (22.1.4) (22.1.5) has an autonomous
component (C ) As in our specific example in the chapter, the consumption function given in Equation a and an induced component (bY ), where b is the marginal propensity to consume (MPC). In the example in the chapter, C was $300 billion and the MPC, or b, was 0.8. Equation shows that total taxes, T, include an autonomous component T (for example, property taxes, licenses, fees, and any other taxes that do not vary with the level of income) and an induced component that is a fraction of real GDP, Y. That fraction is the tax rate, t. Disposable personal income is just the difference between real GDP and total taxes: 22.1.2 d a a 22.1.1 Equation 22.1.6 Ya = Y − T (22.1.6) 22.1.3 22.1.4, Equation In Equation are specific values for the other components of aggregate expenditures: investment (I ), government purchases (G), and net exports (X ). In this model, planned investments, government purchases, and net exports are all assumed to be autonomous. For this reason, we add the subscript “a” to each of them., and Equation, I, G, and a p n 22.1.5 a Xna We use the equations that describe each of the components as aggregate expenditures to solve for the equilibrium level of real GDP. The equilibrium condition in the aggregate expenditures model requires that aggregate expenditures for a period equal real GDP in the period. We specify that condition algebraically: Equation 22.1.7 Y = AE (22.1.7) Aggregate expenditures AE consist of consumption plus planned investment plus government purchases plus net exports. We thus replace the right-hand side of Equation with those terms to get 22.1.7 Equation 22.1.8 Consumption is given by Equation 22.1.4 22.1.5, and Equation. Inserting these equations into Equation 22.1.8, we have Ip Y = C + + G + Xn (22.1.8) 22.1.1 and the other components of aggregate expenditures by Equation 22.1.3, Equation Equation 22.1.9 Yd Y = + b + + + Ia Ga Xna Ca We have one equation with two unknowns, Y and Y. We therefore need to express Y in terms
of Y. From Equation Equation, we can write 22.1.6 d d (22.1.9) 22.1.2 and Yd Ta = Y − ( − tY ) 22.1.1 https://socialsci.libretexts.org/@go/page/21809 And remove the parentheses to obtain Equation 22.1.10 Yd Ta = Y − − tY We then factor out the Y term on the right-hand side to get Equation 22.1.11 Yd = (1 − t)Y − Ta We now substitute this expression for Y into Equation d 22.1.9 to get Equation 22.1.12 Y = + b[(1 − t)Y − ] + + + Ia Ga Xna Ca Ta Y = − b + b(1 − t)Y + + + Ia Ga Xna Ca Ta (22.1.10) (22.1.11) (22.1.12) The first two terms (C − bT ) show that the autonomous portion of consumption is reduced by the marginal propensity to consume times autonomous taxes. For example, suppose T is $10 billion. If the marginal propensity to consume is 0.8, then consumption is $8 billion less than it would have been if T were zero. a a a a Combining the autonomous terms in Equation 22.1.12 in brackets, we have Equation 22.1.13 Ca Y = [ − b( Ta ) + + + Ia Ga Xna ] + b(1 − t)(Y ) (22.1.13) Letting A¯ stand for all the terms in brackets, we can simplify Equation 22.1.13 : Equation 22.1.14 Y = + b(1 − t)Y A¯ (22.1.14) The coefficient of real GDP (Y) on the right-hand side of Equation, b(1 − t), gives the fraction of an additional dollar of real GDP that will be spent for consumption: it is the slope of the aggregate expenditures function for this representation of the economy. The aggregate expenditures function for the simplified economy that we presented in the chapter has a slope that was simply the marginal propensity to consume; there were no taxes in that model, and disposable personal income and real GDP were assumed to be the same. Notice that in using this more realistic aggregate expenditures function, the slope
is less by a factor of (1 − t). 22.1.14 We solve Equation 22.1.14 for Y: Equation 22.1.15 Y − b(1 − t)(Y ) = A¯ Y [1 − b(1 − t)] = A¯ Y = 1 1 − b(1 − t) A¯ ( ) (22.1.15) 22.1.15 In Equation, 1/[1 − b(1 − t)] is the multiplier. Equilibrium real GDP is achieved at a level of income equal to the multiplier times the amount of autonomous spending. Notice that because the slope of the aggregate expenditures function is less than it would be in an economy without induced taxes, the value of the multiplier is also less, all other things the same. In this representation of the economy, the value of the multiplier depends on the marginal propensity to consume and on the tax rate. The higher the tax rate, the lower the multiplier; the lower the tax rate, the greater the multiplier. For example, suppose the marginal propensity to consume is 0.8. If the tax rate were 0, then the multiplier would be 5. If the tax rate were 0.25, then the multiplier would be 2.5. 22.1.2 https://socialsci.libretexts.org/@go/page/21809 This page titled 22.1: The Algebra of Equilibrium is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 22.1.3 https://socialsci.libretexts.org/@go/page/21809 22.2: The Aggregate Expenditures Model and Fiscal Policy In this appendix, we use the aggregate expenditures model to explain the impact of fiscal policy on aggregate demand in more detail than was given in the chapter on government and fiscal policy. As we did in the chapter, we will look at the impact of various types of fiscal policy changes. The possibility of crowding out was discussed in the fiscal policy chapter and will not be repeated here. Changes in Government Purchases All other things unchanged, a change in government purchases shifts the aggregate expenditures curve by an amount equal to the change in government purchases. A $200-billion increase in government purchases, for example, shifts the aggregate expenditures curve upward by $200 billion. A $75-billion reduction in government purchases shifts the aggregate expenditures curve downward by
that amount. Panel (a) of Figure 22.1 shows an economy that is initially in equilibrium at an income of $7,000 billion. Suppose that the slope of the aggregate expenditures function (that is, b[1 − t]) is 0.6, so that the multiplier is 2.5. An increase of $200 billion in government purchases shifts the aggregate expenditures curve upward by that amount to AE. In the aggregate expenditures model, real GDP increases by an amount equal to the multiplier times the change in autonomous aggregate expenditures. Real GDP in that model thus rises by $500 billion to a level of $7,500 billion. 2 Figure 22.1 An Increase in Government Purchases The economy shown here is initially in equilibrium at a real GDP of $7,000 billion and a price level of P. In Panel (a), an increase of $200 billion in the level of government purchases shifts the aggregate expenditures curve upward by that amount to AE, increasing the equilibrium level of income in the aggregate expenditures model by $500 billion. In Panel (b), the aggregate demand curve thus shifts to the right by $500 billion to AD. The equilibrium level of real GDP rises to $7,300 billion, while the price level rises to P. 2 2 2 1 The aggregate expenditures model, of course, assumes a constant price level. To get a more complete picture of what happens, we use the model of aggregate demand and aggregate supply. In that model shown in Panel (b), the initial price level is P, and the initial equilibrium real GDP is $7,000 billion. That is the price level assumed to hold the aggregate expenditures model. The $200billion increase in government purchases increases the total quantity of goods and services demanded, at a price level of P by $500 billion. The aggregate demand curve thus shifts to the right by that amount to AD. The equilibrium level of real GDP, however, only rises to $7,300 billion, and the price level rises to P. Part of the impact of the increase in aggregate demand is absorbed by higher prices, preventing the full increase in real GDP predicted by the aggregate expenditures model. 1 1 2 2 A reduction in government purchases would have the opposite effect. All other things unchanged, aggregate expenditures would shift downward by an amount equal to the reduction in aggregate purchases. In the model of aggregate demand and aggregate supply, the aggregate demand curve would shift to the left by an amount equal to the initial change in autonomous aggregate expenditures times the multiplier. Real GDP and the price
level would fall. The fall in real GDP is less than would occur if the price level stayed constant. In the remainder of this appendix, we will focus on the shift in the aggregate expenditures curve. To determine what happens to equilibrium real GDP and the price level, we must look at the intersection of the new aggregate demand curve and the short-run aggregate supply curve, as we did in Panel (b) of Figure 22.1. 22.2.1 https://socialsci.libretexts.org/@go/page/21810 Change in Autonomous Taxes A change in autonomous taxes shifts the aggregate expenditures in the opposite direction of the change in government purchases. If the autonomous taxes go up, for example, aggregate expenditures go down by a fraction of the change. Because the initial change in consumption is less than the change in taxes (because it is multiplied by the MPC, which is less than 1), the shift caused by a change in taxes is less than an equal change (in the opposite direction) in government purchases. Now suppose that autonomous taxes fall by $200 billion and that the marginal propensity to consume is 0.8. Then the shift up in the aggregate expenditures curve is $160 billion (= 0.8 × $200). As we saw, a $200-billion increase in government purchases shifted the aggregate expenditures curve up by $200 billion. Assuming a multiplier of 2.5, the reduction in autonomous taxes causes equilibrium real GDP in the aggregate expenditures model to rise by $400 billion. This is less than the change of $500 billion caused by an equal (but opposite) change in government purchases. The impact of a $200-billion decrease in autonomous taxes is shown in Figure 22.2. Figure 22.2 A Decrease in Autonomous Taxes A decrease of $200 billion in autonomous taxes shifts the aggregate expenditures curve upward by the marginal propensity to consume of 0.8 times the changes in autonomous taxes of $200 billion, or $160 billion, to AE. The equilibrium level of income in the aggregate expenditures model increases by $400 billion to $7,400 billion. All figures are in billions of base-year dollars. 2 Similarly, an increase in autonomous taxes of, for example, $75 billion, would shift the aggregate expenditures curve downward by $60 billion (= 0.8 × $75) and cause the equilibrium level of real GDP to decrease by $150 billion (= 2.5 × $60). Changes in Income Tax Rates Changes in income tax rates produce an important complication
that we have not encountered thus far. When government purchases or autonomous taxes changed, the aggregate expenditures curve shifted up or down. The new aggregate expenditures curve had the same slope as the old curve; the multiplier was the same before and after the change in government purchases or autonomous taxes. When income tax rates change, however, the aggregate expenditures curve will rotate, that is, its slope will change. As a result, the value of the multiplier itself will change. We saw in the first section of this appendix that when taxes are related to income, the multiplier depends on both the marginal propensity to consume and the tax rate. An increase in income tax rates will make the aggregate expenditures curve flatter and reduce the multiplier. A higher income tax rate thus rotates the aggregate expenditures curve downward. Similarly, a lower income tax rate rotates the aggregate expenditures curve upward, making it steeper. Suppose that an economy with an initial real GDP of $7,000 billion has an income tax rate of 0.25. To simplify, we will assume there are no autonomous taxes (that is, T = 0). So T = tY. Thus, disposable personal income Y is 75% of real GDP: d a Equation 22.16 Equation 22.17 22.2.2 https://socialsci.libretexts.org/@go/page/21810 Suppose the marginal propensity to consume is 0.8. A $1 change in real GDP produces an increase in disposable personal income of $0.75, and that produces an increase in consumption of $0.60 (= 0.8 × 0.75 × $1). If the other components of aggregate expenditures are autonomous, then the multiplier is 2.5 (= 1 / [1 − 0.6]). The impact of a tax rate change is illustrated in Figure 22.3. It shows the original aggregate expenditures curve AE intersecting the 45-degree line at the income of $7,000 billion. The curve has a slope of 0.6. Now suppose that the tax rate is increased to 0.375. The higher tax rate will rotate this curve downward, making it flatter. The slope of the new aggregate expenditures curve AE will be 0.5 (= 1 − 0.8[1 − 0.375]). The value of the multiplier thus falls from 2.5 to 2 (= 1 / [1 − 0.5]). 2 1 Figure 22.3 The Impact of an Increase in Income Tax Rates An increase in the income tax rate rotates
the aggregate expenditures curve downward by an amount equal to the initial change in consumption at the original equilibrium value of real GDP found in the aggregate expenditures model, $7,000 billion in this case, assuming no other change in aggregate expenditures. It reduces the slope of the aggregate expenditures curve and thus reduces the multiplier. Here, an increase in the income tax rate from 0.25 to 0.375 reduces the slope from 0.6 to 0.5; it thus reduces the multiplier from 2.5 to 2. The higher tax reduces consumption by $700 billion and reduces equilibrium real GDP in the aggregate expenditures model by $1,400 billion. At the original level of income, $7,000 billion, tax collection equaled $1,750 billion (again, for this example, we assume T = 0, so T = 0.25 × $7,000). At the new tax rate and original level of income, they equal $2,625 billion (0.375 × $7,000 billion). Disposable personal income at a real GDP of $7,000 billion thus declines by $875 billion. With a marginal propensity to consume of 0.8, consumption drops by $700 billion (= 0.8 × $875 billion). The aggregate expenditures curve rotates down by this amount at the initial level of income of $7,000 billion, assuming no other changes in aggregate expenditures occur. a Before the tax rate increase, an additional $1 of real GDP induced $0.60 in additional consumption. At the new tax rate, an additional $1 of real GDP creates $0.625 in disposable personal income ($1 in income minus $0.375 in taxes). Given a marginal propensity to consume of 0.8, this $1 increase in real GDP increases consumption by only $0.50 (= [$1 × (0.8 × 0.625)]). The new aggregate expenditures curve, AE in Figure 22.3, shows the end result of the tax rate change in the aggregate expenditures model. Its slope is 0.5. The equilibrium of the level of real GDP in the aggregate expenditures model falls to $5,600 billion from its original level of $7,000. The $1,400-billion reduction in equilibrium real GDP in the aggregate expenditures model is equal to the $700-billion initial reduction in consumption (at the original equilibrium level of real GDP) times the new multiplier of 2. The tax rate increase has reduced aggregate expenditures and reduced the multiplier impact of this change (
from 2.5 to 2). The aggregate demand curve will shift to the left by $1,400 billion, the new multiplier times the initial change in aggregate expenditures. 2 In the model of aggregate demand and aggregate supply, a tax rate increase will shift the aggregate demand curve to the left by an amount equal to the initial change in aggregate expenditures induced by the tax rate boost times the new value of the multiplier. Similarly, a reduction in the income tax rate rotates the aggregate expenditures curve upward by an amount equal to the initial increase in consumption (at the original equilibrium level of real GDP found in the aggregate expenditures model) created by the lower tax rate. It also increases the value of the multiplier. Aggregate demand shifts to the right by an amount equal to the initial change in aggregate expenditures times the new multiplier. 22.2.3 https://socialsci.libretexts.org/@go/page/21810 This page titled 22.2: The Aggregate Expenditures Model and Fiscal Policy is shared under a CC BY-NC-SA 3.0 license and was authored, remixed, and/or curated by Anonymous. 22.2: The Aggregate Expenditures Model and Fiscal Policy by Anonymous is licensed CC BY-NC-SA 3.0. Original source: https://2012books.lardbucket.org/books/economics-principles-v2.0/. 22.2.4 https://socialsci.libretexts.org/@go/page/21810 Index 1 https://socialsci.libretexts.org/@go/page/47125 Glossary absolute advantage \| In the production of a good, one person can produce more of a good in a unit of time than another person. aggregate expenditure model \| The relationship between planned spending and output. aggregate production function \| A combination of an economy’s physical capital stock, labor hours, human capital, knowledge, natural resources, and social infrastructure that produces output (real GDP). capital stock \| The total amount of physical capital in an economy. consumption function \| A relationship between current disposable income and current consumption. Capital utilization \| The rate at which the existing capital stock is used. consumption function \| A relationship between current disposable income and current consumption. Capital utilization \| The rate at which the existing capital stock is used. consumption function \| A relationship between current disposable income and current consumption. circular flow of income \| The money flows among the different sectors of an economy
as individuals and firms buy and sell goods and services. aggregate spending total amount of spending by households, firms, and the government on the goods and services that go into real GDP. \| The circular flow of income \| The money flows among the different sectors of an economy as individuals and firms buy and sell goods and services. annualized interest rate \| The interest rate earned each year on a loan that lasts many years. annuities \| An asset that pays out a certain amount each year while you are alive and insures against the uncertain time of your death. appreciation \| An increase in the price of a currency. appreciation \| An increase in the price of a currency. appreciation \| An increase in the price of a currency. appreciation \| An increase in the price of a currency. arbitrage \| The act of buying and then selling an asset to take advantage of profit opportunities. arbitrage \| The act of buying and then selling an asset to take advantage of profit opportunities. autonomous inflation \| The level of inflation when the output gap is zero. autonomous inflation \| The level of inflation when the output gap is zero. Autonomous spending \| The amount of spending that there would be in an economy if income were zero. Autonomous spending \| The amount of spending that there would be in an economy if income were zero. average propensity to consume \| The ratio of consumption to disposable income. average propensity to consume \| The ratio of consumption to disposable income. average tax rate \| The ratio of total taxes paid to income. classical dichotomy \| The dichotomy that real variables are determined independently of nominal variables. classical dichotomy \| The dichotomy that real variables are determined independently of nominal variables. commitment problem \| The situation when a government is not able to make credible promises to pursue actions regardless of how others respond to those actions. commitment problem \| The situation when a government is not able to make credible promises to pursue actions regardless of how others respond to those actions. commitment problem \| The situation when a government is not able to make credible promises to pursue actions regardless of how others respond to those actions. commitment problem \| The situation when a government is not able to make credible promises to pursue actions regardless of how others respond to those actions. comparative statics \| A technique that allows us to describe how market equilibrium prices and quantities depend on exogenous events. comparative statics \| A technique that allows us to describe how market equilibrium prices and quantities depend on exogenous events. competitive market \| A market that satisfies two conditions: (1) there are many buyers and sellers, and (
2) the sellers produce are perfect substitutes. the goods competitive market \| A market that satisfies two conditions: (1) there are many buyers and sellers, and the sellers produce are perfect (2) substitutes. the goods average tax rate \| The ratio of total taxes paid to income. Competitiveness \| The ability of an economy to attract physical capital. balanced growth \| When the growth rate of the capital stock and the output growth rate are equal. Competitiveness \| The ability of an economy to attract physical capital. balanced growth \| When the growth rate of the capital stock and the output growth rate are equal. bank failure \| When a bank closes because it is unable to meet its depositors’ demands. bank failure \| When a bank closes because it is unable to meet its depositors’ demands. barter \| The exchange of goods and services without money. barter \| The exchange of goods and services without money. capital stock \| The total amount of physical capital in an economy. Consumer Price Index (CPI) \| A price index that uses as the bundle of goods the typical purchases of households. Consumer Price Index (CPI) \| A price index that uses as the bundle of goods the typical purchases of households. Consumption \| The total spending by households on final goods and services. Consumption \| The total spending by households on final goods and services. consumption function \| A relationship between current disposable income and current consumption. consumption smoothing that households like to keep their flow of consumption relatively steady over time, smoothing over income changes. \| The idea consumption smoothing that households like to keep their flow of consumption relatively steady over time, smoothing over income changes. \| The idea consumption smoothing that households like to keep their flow of consumption relatively steady over time, smoothing over income changes. \| The idea consumption smoothing that households like to keep their flow of consumption relatively steady over time, smoothing over income changes. \| The idea contagion effect \| An effect when an outcome in one market effects the beliefs and thus the behavior of participants in other markets, perhaps in another country. contagion effect \| An effect when an outcome in one market effects the beliefs and thus the behavior of participants in other markets, perhaps in another country. contractionary fiscal policy \| Decreases in government purchases or increases in tax rates. contractionary fiscal policy \| Decreases in government purchases or increases in tax rates. convergence \| A growth process where poor countries grow faster than rich countries. convergence \| A growth process where poor countries grow faster than rich countries. coordination failure
\| The outcome of a coordination game in which one of the equilibrium outcomes is worse than other equilibria. coordination failure \| The outcome of a coordination game in which one of the equilibrium outcomes is worse than other equilibria. coordination game \| A strategic situation in which there are multiple equilibria. coordination game \| A strategic situation in which there are multiple equilibria. Correlation \| A statistical measure of how closely two variables are related. Correlation \| A statistical measure of how closely two variables are related. credit market (or loan market) \| A market that brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. credit market (or loan market) \| A market that brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. credit markets (or loan markets) \| A market that brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. 1 https://socialsci.libretexts.org/@go/page/71917 credit markets (or loan markets) \| A market that brings together suppliers of credit, such as households who are saving, and demanders of credit, such as businesses and households who need to borrow. crowding out \| The situation that occurs when an increase in the government deficit leads to an increase in the real interest rate and to a decrease in spending through reductions in investment and exports. crowding out \| The situation that occurs when an increase in the government deficit leads to an increase in the real interest rate and to a decrease in spending through reductions in investment and exports. currency board \| A fixed exchange rate regime in which each unit of domestic currency is backed by holding the foreign currency, valued at the fixed exchange rate. currency board \| A fixed exchange rate regime in which each unit of domestic currency is backed by holding the foreign currency, valued at the fixed exchange rate. currency board \| A fixed exchange rate regime in which each unit of domestic currency is backed by holding the foreign currency, valued at the fixed exchange rate. currency board \| A fixed exchange rate regime in which each unit of domestic currency is backed by holding the foreign currency, valued at the fixed exchange rate. \| The difference current account balance between the value of exports and imports of goods and services plus net income from foreign assets. current account balance \| The difference between
the value of exports and imports of goods and services plus net income from foreign assets. cyclical unemployment \| The component of unemployment that depends on the business cycle. cyclical unemployment \| The component of unemployment that depends on the business cycle. deflation \| A sustained decrease in the price level. deflation \| A sustained decrease in the price level. dependency ratio \| The ratio of retirees to workers. dependency ratio \| The ratio of retirees to workers. deposit insurance \| A government program that insures the deposits (subject to some limits) of individuals at banks. deposit insurance \| A government program that insures the deposits (subject to some limits) of individuals at banks. Depreciation \| The amount of capital stock that an economy loses each year due to wear and tear. Depreciation \| The amount of capital stock that an economy loses each year due to wear and tear. depreciation rate \| The fraction of the capital stock that wears out each year. depreciation rate \| The fraction of the capital stock that wears out each year. devaluation \| A decrease in the value of a currency in a fixed exchange rate. devaluation \| A decrease in the value of a currency in a fixed exchange rate. diminishing marginal product \| The more an input is being used, the less is its marginal product. diminishing marginal product \| The more an input is being used, the less is its marginal product. diminishing marginal product of capital \| The more physical capital that is being used, the less additional output is obtained from additional physical capital. diminishing marginal product of capital \| The more physical capital that is being used, the less additional output is obtained from additional physical capital. diminishing marginal product of labor \| The more labor that is being used, the less additional output is obtained from additional labor. diminishing marginal product of labor \| The more labor that is being used, the less additional output is obtained from additional labor. discount rate \| The interest rate paid by banks on loans from the Fed. discount rate \| The interest rate paid by banks on loans from the Fed. discouraged workers \| Someone who would like a job but who has stopped searching and is therefore classified as out of the labor force rather than unemployed. discouraged workers \| Someone who would like a job but who has stopped searching and is therefore classified as out of the labor force rather than unemployed. disposable income \| Income after taxes are paid to the government. disposable income \| Income after taxes are paid to the government. disposable income \| Income after taxes are paid to the government. disposable income \| Income after taxes are paid to the government. durable goods \|
Goods that last over many uses. durable goods \| Goods that last over many uses. Durable goods \| Goods that last over many uses. Durable goods \| Goods that last over many uses. efficiency wages \| Wages the equilibrium real wage that are paid by firms to provide incentives for their workers to perform their duties. in excess of efficiency wages \| Wages the equilibrium real wage that are paid by firms to provide incentives for their workers to perform their duties. in excess of employment rate \| The number of employed divided by the civilian labor force. employment rate \| The number of employed divided by the civilian labor force. endogenous \| Something that is explained within our analysis. endogenous \| Something that is explained within our analysis. endogenous \| Something that is explained within our analysis. endogenous \| Something that is explained within our analysis. \| An equilibrium price and an equilibrium equilibrium quantity such that the quantity supplied equals the quantity demanded at the equilibrium price. equilibrium \| An equilibrium price and an equilibrium quantity such that the quantity supplied equals the quantity demanded at the equilibrium price. equilibrium quantity \| The quantity supplied and demanded at the equilibrium price. equilibrium quantity \| The quantity supplied and demanded at the equilibrium price. exchange rate \| The price of one currency in terms of another. exchange rate \| The price of one currency in terms of another. exogenous \| Something that comes from outside a model and is not explained in our analysis. exogenous \| Something that comes from outside a model and is not explained in our analysis. exogenous variable \| A variable determined outside the model that is not explained in the analysis. exogenous variable \| A variable determined outside the model that is not explained in the analysis. exogenous variable \| A variable determined outside the model that is not explained in the analysis. exogenous variable \| A variable determined outside the model that is not explained in the analysis. fiat money \| Intrinsically useless pieces of paper not backed by any physical commodity that nevertheless attain value in exchange. fiat money \| Intrinsically useless pieces of paper not backed by any physical commodity that nevertheless attain value in exchange. fiscal policy \| Changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers. fiscal policy \| Changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers. Fiscal policy \| Changes in taxation and the level of government purchases, typically under the control of a country’s lawmakers. Fiscal policy \| Changes in taxation and the level of government purchases, typically under the control of a

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