MicroEconomics 5

10: Wage Determination
IN THIS CHAPTER YOU WILL LEARN:

1 Why the firm’s marginal revenue product curve is its labor demand
curve.

2 The factors that increase or decrease labor demand.

3 The determinants of elasticity of labor demand.

4 How wage rates are determined in competitive and monopsonistic
labor markets.

5 How unions increase wage rates.

6 The major causes of wage differentials.

We now turn from the pricing and production of goods and services to the
pricing and employment of resources. Although firms come in various sizes
and operate under highly different market conditions, each has a demand for
productive resources. They obtain those resources from households—the
direct or indirect owners of land, labor, capital, and entrepreneurial
resources. So, referring to the circular flow diagram (Figure 2.2, page 43),
we shift our attention from the bottom loop (where businesses supply
products that households demand) to the top loop (where businesses demand
resources that households supply).

A Focus on Labor
The basic principles we develop in this chapter apply to land, labor, and
capital resources, but we will emphasize the pricing and employment of
labor. About 70 percent of all income in the United States flows to
households in the form of wages and salaries. More than 146 million of us
go to work each day in the United States. We have an amazing variety of
jobs with thousands of different employers and receive large differences in

pay. What determines our hourly wage or annual salary? Why is the salary
of, say, a topflight major-league baseball player $15 million or more a year,
whereas the pay for a first-rate schoolteacher is $50,000? Why are starting
salaries for college graduates who major in engineering and accounting so
much higher than those for graduates majoring in journalism and sociology?

Demand and supply analysis helps us answer these questions. We begin by
examining labor demand and labor supply in a purely competitive labor
market. In such a market,

purely competitive labor market

A labor market in which a large number of similarly qualified workers
independently offer their labor services to a large number of employers,
none of whom can set the wage rate.

• Numerous employers compete with one another in hiring a specific type
of

labor.

• Each of many workers with identical skills supplies that type of labor.

• Individual employers and individual workers are “wage takers” because
neither can control the market wage rate.

Labor Demand

WORKED PROBLEMS

W 10.1

Labor demand

Labor demand is the starting point for any discussion of wages and salaries.
Other things equal, the demand for labor is an inverse relationship between
the price of labor (hourly wage) and the quantity of labor demanded. As
with all resources, labor demand is a derived demand: It results from the

products that labor helps produce. Labor resources usually do not directly
satisfy customer wants but do so indirectly through their use in producing
goods and services. Almost nobody wants to consume directly the labor
services of a software engineer, but millions of people do want to use the
software that the engineer helps create.

derived demand

The demand for a resource that results from the demand for the products
it helps produce.

Marginal Revenue Product
Because resource demand is derived from product demand, the strength of
the demand will depend on the productivity of the labor—its ability to
produce goods and services—and the price of the good or service it helps
produce. A resource that is highly productive in turning out a highly
valued commodity will be in great demand. In contrast, a relatively
unproductive resource that is capable of producing only a minimally
valued commodity will be in little demand. And no demand whatsoever
will exist for a resource that is phenomenally efficient in producing
something that no one wants to buy.

Consider the table in Figure 10.1, which shows the roles of marginal
productivity and product price in determining labor demand.
FIGURE 10.1: The purely competitive seller’s
demand for labor.

The MRP-of-labor curve is the labor demand curve; each of its points
relates a particular wage rate (= MRP when profit is maximized) with a
corresponding quantity of labor demanded. The downward slope of the
D = MRP curve results from the law of diminishing marginal returns.

Productivity
Columns 1 and 2 give the number of units of labor employed and the
resulting total product (output). Column 3 provides the marginal product
(MP), or additional output, resulting from using each additional unit of

labor. Columns 1 through 3 remind us that the law of diminishing
returns applies here, causing the marginal product of labor to fall beyond
some point. For simplicity, we assume that these diminishing marginal
returns—these declines in marginal product—begin with the second
worker hired.

Product Price
The derived demand for labor depends also on the market value (product
price) of the good or service. Column 4 in the table in Figure 10.1 adds
this price information to the mix. Because we are assuming a
competitive product market, product price equals marginal revenue. The
firm is a price taker and will sell units of output only at this market
price. And this price will also be the firm’s marginal revenue. In this
case, both price and marginal revenue are a constant $2.

Multiplying column 2 by column 4 provides the total-revenue data of
column 5. These are the amounts of revenue the firm realizes from the
various levels of employment. From these total-revenue data we can
compute the marginal revenue product (MRP) of labor—the change
in total revenue resulting from the use of each additional unit of labor.
In equation form,

marginal revenue product (MRP)

The change in a firm’s total revenue when it employs 1 more unit of
labor.

The MRPs are listed in column 6 in the table.

Rule for Employing Labor: MRP = MRC
The MRP schedule, shown as columns 1 and 6, is the firm’s demand

schedule for labor. To understand why, you must first know the rule that
guides a profit-seeking firm in hiring any resource: To maximize profit, a
firm should hire additional units of labor as long as each successive unit
adds more to the firm’s total revenue than to the firm’s total cost.

Economists use special terms to designate what each additional unit of
labor (or any other variable resource) adds to total revenue and what it
adds to total cost. We have seen that MRP measures how much each
successive unit of labor adds to total revenue. The amount that each
additional unit of labor adds to the firm’s total cost is called its marginal
resource cost (MRC). In equation form,

marginal resource cost (MRC)

The change in a firm’s total cost when it employs 1 more unit of labor.

So we can restate our rule for hiring resources as follows: It will be
profitable for a firm to hire additional units of labor up to the point at
which labor’s MRP is equal to its MRC. If the number of workers a firm is
currently hiring is such that the MRP of the last worker exceeds his or her
MRC, the firm can profit by hiring more workers. But if the number being
hired is such that the MRC of the last worker exceeds his or her MRP, the
firm is hiring workers who are not “paying their way” and it can increase
its profit by discharging some workers. You may have recognized that this
MRP = MRC rule is similar to the MR = MC profit-maximizing rule
employed throughout our discussion of price and output determination.
The rationale of the two rules is the same, but the point of reference is
now inputs of a resource, not outputs of a product.

MRP = MRC rule

The principle that to maximize profit a firm should expand employment
until the marginal revenue product (MRP) of labor equals the marginal

resource cost (MRC) of labor.

MRP as Labor Demand Schedule
In a competitive labor market, market supply and market demand establish
the wage rate. Because each firm hires such a small fraction of the market
supply of labor, an individual firm cannot influence the market wage rate;
it is a wage taker, not a wage maker. This means that for each additional
unit of labor hired, total labor cost increases by exactly the amount of the
constant market wage rate. The MRC of labor exactly equals the market
wage rate. Thus, resource “price” (the market wage rate) and resource
“cost” (marginal resource cost) are equal for a firm that hires labor in a
competitive labor market. Then the MRP = MRC rule tells us that a
competitive firm will hire units of labor up to the point at which the
market wage rate (its MRC) is equal to its MRP.

In terms of the data in columns 1 and 6 of Figure 10.1 ‘s table, if the
market wage rate is, say, $13.95, the firm will hire only one worker. This
is the outcome because the first worker adds $14 to total revenue and
slightly less—$13.95—to total cost. In other words, because MRP exceeds
MRC for the first worker, it is profitable to hire that worker. For each
successive worker, however, MRC (= $13.95) exceeds MRP (= $12 or
less), indicating that it will not be profitable to hire any of those workers.
If the wage rate is $11.95, by the same reasoning we discover that it will
pay the firm to hire both the first and second workers. Similarly, if the
wage rate is $9.95, three will be hired; if it is $7.95, four; if it is $5.95,
five; and so forth. The MRP schedule therefore constitutes the firm’s
demand for labor because each point on this schedule (or curve) indicates
the quantity of labor units the firm would hire at each possible wage rate.
In the graph in Figure 10.1, we show the D = MRP curve based on the
data in the table. The competitive firm’s labor demand curve identifies an
inverse relationship between the wage rate and the quantity of labor
demanded, other things equal. The curve slopes downward because of

diminishing marginal returns.1

Market Demand for Labor
We have now explained the individual firm’s demand curve for labor.
Recall that the total, or market, demand curve for a product is found by
summing horizontally the demand curves of all individual buyers in the
market. The market demand curve for a particular resource is derived in
essentially the same way. Economists sum horizontally the individual labor
demand curves of all firms hiring a particular kind of labor to obtain the
market demand for that labor.

Changes in Labor Demand
What will alter the demand for labor (shift the labor demand curve)? The
fact that labor demand is derived from product demand and depends on
resource productivity suggests two “resource demand shifters.” Also, our
analysis of how changes in the prices of other products can shift a product’s
demand curve (Chapter 3) suggests another factor: changes in the prices of
other resources.

Changes in Product Demand
Other things equal, an increase in the demand for a product will increase
the demand for a resource used in its production, whereas a decrease in
product demand will decrease the demand for that resource.

Let’s see how this works. The first thing to recall is that a change in the
demand for a product will normally change its price. In the table in Figure
10.1, let’s assume that an increase in product demand boosts product price
from $2 to $3. You should calculate the new labor demand schedule
(columns 1 and 6) that would result, and plot it in the graph to verify that
the new labor demand curve lies to the right of the old demand curve.
Similarly, a decline in the product demand (and price) will shift the labor

demand curve to the left. The fact that labor demand changes along with
product demand demonstrates that labor demand is derived from product
demand.

Example: With no offsetting change in supply, a decrease in the demand
for new houses will drive down house prices. Those lower prices will
decrease the MRP of construction workers, and therefore the demand for
construction workers will fall. The labor demand curve will shift to the
left.

Changes in Productivity
Other things equal, an increase in the productivity of a resource will
increase the demand for the resource and a decrease in productivity will
reduce the demand for the resource. If we doubled the MP data of column
3 in the table in Figure 10.1, the MRP data of column 6 also would
double, indicating a rightward shift of the labor demand curve in the
graph.

The productivity of any resource may be altered over the long run in
several ways:

• Quantities of other resources The marginal productivity of any
resource will vary with the quantities of the other resources used with it.
The greater the amount of capital and land resources used with labor, the
greater will be labor’s marginal productivity and, thus, labor demand.

• Technological advance Technological improvements that increase
the quality of other resources, such as capital, have the same effect. The
better the quality of capital, the greater the productivity of labor used
with it. Dockworkers employed with a specific amount of capital in the
form of unloading cranes are more productive than dockworkers with
the same amount of capital embodied in older conveyor-belt systems.

• Quality of labor Improvements in the quality of labor will
increase its marginal productivity and therefore its demand. In effect,
there will be a new demand curve for a different, more skilled, kind of

labor.

Changes in the Prices of Other Resources
Changes in the prices of other resources may change the demand for labor.

Substitute Resources
Suppose that labor and capital are substitutable in a certain production
process. A firm can produce some specific amount of output using a
relatively small amount of labor and a relatively large amount of capital,
or vice versa. What happens if the price of machinery (capital) falls?
The effect on the demand for labor will be the net result of two opposed
effects: the substitution effect and the output effect.

• Substitution effect The decline in the price of machinery prompts
the firm to substitute machinery for labor. This allows the firm to
produce its output at lower cost. So at the fixed wage rate, smaller
quantities of labor are now employed. This substitution effect
decreases the demand for labor. More generally, the substitution effect
indicates that a firm will purchase more of an input whose relative
price has declined and, conversely, use less of an input whose relative
price has increased.

substitution effect

The replacement of labor by capital when the price of capital falls.

• Output effect Because the price of machinery has declined, the
costs of producing various outputs also must decline. With lower costs,
the firm can profitably produce and sell a greater output. The greater
output increases the demand for all resources, including labor. So this
output effect increases the demand for labor. More generally, the
output effect means that the firm will purchase more of one particular
input when the price of the other input falls and less of that particular
input when the price of the other input rises.

output effect

An increase in the use of labor that occurs when a decline in the price
of capital reduces a firm’s production costs and therefore enables it to
sell more output.

• Net effect The substitution and output effects are both present
when the price of an input changes, but they work in opposite
directions. For a decline in the price of capital, the substitution effect
decreases the demand for labor and the output effect increases it. The
net change in labor demand depends on the relative sizes of the two
effects: If the substitution effect outweighs the output effect, a decrease
in the price of capital decreases the demand for labor. If the output
effect exceeds the substitution effect, a decrease in the price of capital
increases the demand for labor.

Complementary Resources
Resources may be complements rather than substitutes in the production
process; an increase in the quantity of one of them also requires an
increase in the amount of the other used, and vice versa. Suppose a small
design firm does computer-assisted design (CAD) with relatively
expensive personal computers as its basic piece of capital equipment.
Each computer requires exactly one design engineer to operate it; the
machine is not automated—it will not run itself—and a second engineer
would have nothing to do.

Now assume that these computers substantially decline in price. There
can be no substitution effect because labor and capital must be used in
fixed proportions: one person for one machine. Capital cannot be
substituted for labor. But there is an output effect. Other things equal,
the reduction in the price of capital goods means lower production costs.
It will therefore be profitable to produce a larger output. In doing so, the
firm will use both more capital and more labor. When labor and capital
are complementary, a decline in the price of capital increases the demand

for labor through the output effect.

We have cast our analysis of substitute resources and complementary
resources mainly in terms of a decline in the price of capital. Obviously,
an increase in the price of capital causes the opposite effects on labor
demand.
Photo Op: Substitute Resources versus
Complementary Resources

© Photodisc/Getty Images

© Royalty-Free/CORBIS

Automatic teller machines (ATMs) and human tellers are substitute
resources, whereas construction equipment and their operators are
complementary resources.

APPLYING THE ANALYSIS:
Occupational Employment Trends
Changes in labor demand are of considerable significance because they
affect employment in specific occupations. Other things equal,
increases in labor demand for certain occupational groups result in
increases in their employment; decreases in labor demand result in
decreases in their employment. For illustration, let’s look at
occupations that are growing and declining in demand.

Table 10.1 lists the 10 fastest-growing and 10 most rapidly declining
U.S. occupations (in percentage terms) for 2006 to 2016, as projected
by the Bureau of Labor Statistics. Notice that service occupations

dominate the fastest-growing list. In general, the demand for service
workers is rapidly outpacing the demand for manufacturing,
construction, and mining workers in the United States.
TABLE 10.1: The 10 Fastest-Growing and
Most Rapidly Declining U.S. Occupations, in
Percentage Terms, 2006–2016

Of the 10 fastest-growing occupations in percentage terms, three—
personal and home care aides (people who provide home care for the
elderly and those with disabilities), home health care aides (people who
provide short-term medical care after discharge from hospitals), and
medical assistants—are related to health care. The rising demands for
these types of labor are derived from the growing demand for health
services, caused by several factors. The aging of the U.S. population
has brought with it more medical problems, rising incomes have led to
greater expenditures on health care, and the growing presence of
private and public insurance has allowed people to buy more health
care than most could afford individually.

Two of the fastest-growing occupations are directly related to
computers. The increase in the demand for network systems and data
communication analysts and for computer software engineers arises
from the rapid rise in the demand for computers, computer services,
and the Internet. It also results from the rising marginal revenue
productivity of these particular workers, given the vastly improved
quality of the computer and communications equipment they work
with. Moreover, price declines on such equipment have had stronger
output effects than substitution effects, increasing the demand for these
kinds of labor.

Table 10.1 also lists the 10 U.S. occupations with the greatest projected
job loss (in percentage terms) between 2006 and 2016. These
occupations are more diverse than the fastest-growing occupations.
Four of the ten are related to textiles, apparel, and shoes. The U.S.
demand for these goods is increasingly being fulfilled through imports,
some of which is related to outsourcing those jobs to workers abroad.
Declines in other occupations in the list (for example, file clerks,
model and pattern makers, and telephone operators) have resulted from
technological advances that have enabled firms to replace workers with
automated or computerized equipment. The advent of digital
photography explains the projected decline in the employment of
people operating photographic processing equipment.

Question:

Name some occupation (other than those listed) that you think
will grow in demand over the next decade. Name an occupation
that you think will decline in demand. In each case, explain your
reasoning.

Elasticity of Labor Demand
The employment changes we have just discussed have resulted from shifts
in the locations of labor demand curves. Such changes in demand must be
distinguished from changes in the quantity of labor demanded caused by a
change in the wage rate. Such a change is caused not by a shift of the
demand curve but, rather, by a movement from one point to another on a
fixed labor demand curve. Example: In Figure 10.1 we note that an increase
in the wage rate from $5 to $7 will reduce the quantity of labor demanded
from 5 units to 4 units. This is a change in the quantity of labor demanded
as distinct from a change in labor demand.

The sensitivity of labor quantity to changes in wage rates is measured by the
elasticity of labor demand (or wage elasticity of demand). In coefficient
form,

elasticity of labor demand

A measure of the responsiveness of labor quantity to a change in the wage
rate.

ORIGIN OF THE IDEA

O 10.1

Elasticity of resource demand

When Ew is greater than 1, labor demand is elastic; when Ew is less than 1,

labor demand is inelastic; and when Ew equals 1, labor demand is unit-

elastic. Several factors interact to determine the wage elasticity of demand.

Ease of Resource Substitutability
The greater the substitutability of other resources for labor, the more
elastic is the demand for labor. Example: Because automated voice-mail
systems are highly substitutable for telephone receptionists, the demand
for receptionists is quite elastic. In contrast, there are few good substitutes
for physicians, so demand for them is less elastic or even inelastic.

Time can play a role in the input substitution process. For example, a
firm’s truck drivers may obtain a substantial wage increase with little or no
immediate decline in employment. But over time, as the firm’s trucks wear
out and are replaced, that wage increase may motivate the company to
purchase larger trucks and in that way deliver the same total output with
fewer drivers.

Elasticity of Product Demand
The greater the elasticity of product demand, the greater is the elasticity of
labor demand. The derived nature of resource demand leads us to expect
this relationship. A small rise in the price of a product (caused by a wage
increase) will sharply reduce output if product demand is elastic. So a
relatively large decline in the amount of labor demanded will result. This
means that the demand for labor is elastic.

Ratio of Labor Cost to Total Cost
The larger the proportion of total production costs accounted for by labor,
the greater is the elasticity of demand for labor. In the extreme, if labor

cost is the only production cost, then a 20 percent increase in wage rates
will increase marginal cost and average total cost by 20 percent. If product
demand is elastic, this substantial increase in costs will cause a relatively
large decline in sales and a sharp decline in the amount of labor
demanded. So labor demand is highly elastic. But if labor cost is only 50
percent of production cost, then a 20 percent increase in wage rates will
increase costs by only 10 percent. With the same elasticity of product
demand, this will cause a relatively small decline in sales and therefore in
the amount of labor demanded. In this case the demand for labor is much
less elastic.

Market Supply of Labor
Let’s now turn to the supply side of a purely competitive labor market. The
supply curve for each type of labor slopes upward, indicating that
employers as a group must pay higher wage rates to obtain more workers.
Employers must do this to bid workers away from other industries,
occupations, and localities. Within limits, workers have alternative job
opportunities. For example, they may work in other industries in the same
locality, or they may work in their present occupations in different cities or
states, or they may work in other occupations.

Firms that want to hire these workers must pay higher wage rates to attract
them away from the alternative job opportunities available to them. They
also must pay higher wages to induce people who are not currently in the
labor force—who are perhaps doing household activities or enjoying leisure
—to seek employment. In short, assuming that wages are constant in other
labor markets, higher wages in a particular labor market entice more
workers to offer their labor services in that market. This fact results in a
direct relationship between the wage rate and the quantity of labor supplied,
as represented by the upward-sloping market supply-of-labor curve S in
Figure 10.2a.
FIGURE 10.2: A purely competitive labor
market.

In a purely competitive labor market (a) the equilibrium wage rate Wc

and the number of workers Qc are determined by labor supply S and

labor demand D. Because this market wage rate is given to the individual
firm (b) hiring in this market, its labor supply curve s = MRC is
perfectly elastic. Its labor demand curve, d, is its MRP curve (here
labeled mrp). The firm maximizes its profit by hiring workers up to the
point where MRP = MRC.

Wage and Employment Determination
What determines the market wage rate and how do firms respond to it?
Suppose 200 firms demand a particular type of labor, say, carpenters. These
firms need not be in the same industry; industries are defined according to
the products they produce and not the resources they employ. Thus, firms
producing wood-framed furniture, wood windows and doors, houses and
apartment buildings, and wood cabinets will demand carpenters. To find the
total, or market, labor demand curve for a particular labor service, we sum
horizontally the labor demand curves (the marginal revenue product curves)
of the individual firms, as indicated in Figure 10.2. The horizontal
summing of the 200 labor demand curves like d in Figure 10.2b yields the

market labor demand curve D in Figure 10.2a.

The intersection of the market labor demand curve D and the market labor
supply curve S in Figure 10.2 a determines the equilibrium wage rate and
the level of employment in this purely competitive labor market. Observe
that the equilibrium wage rate is Wc ($10) and the number of workers hired

is Qc (1000).

To the individual firm (Figure 10.2b) the market wage rate Wc is given at

$10. Each of the many firms employs such a small fraction of the total
available supply of this type of labor that no single firm can influence the
wage rate. As shown by the horizontal line s in Figure 10.2b, the supply of
labor faced by an individual firm is perfectly elastic. It can hire as many or
as few workers as it wants to at the market wage rate. This fact is clarified
in Table 10.2, where we see that the marginal cost of labor MRC is constant
at $10 and is equal to the wage rate. Each additional unit of labor employed
adds precisely its own wage rate (here, $10) to the firm’s total resource cost.

TABLE 10.2: The Supply of Labor: Pure
Competition in the Hire of Labor

INTERACTIVE GRAPHS

G 10.1

Competitive labor market

Each individual firm will apply the MRP = MRC rule to determine its
profitmaximizing level of employment. So the competitive firm maximizes
its profit by hiring units of labor to the point at which its wage rate (=
MRC) equals MRP. In Figure 10.2b the employer will hire qc (5) units of

labor, paying each worker the market wage rate Wc ($10). The other 199

firms (not shown) in this labor market will also each employ 5 workers and
pay $10 per hour. The workers will receive pay based on their contribution
to the firm’s output and thus revenues.

Monopsony

In the purely competitive labor market, each firm can hire as little or as
much labor as it needs at the market wage rate, as reflected in its horizontal
labor supply curve. The situation is strikingly different in monopsony, a
market in which a single employer of labor has substantial buying (hiring)
power. Labor market monopsony has the following characteristics:

• There is only a single buyer of a particular type of labor.

• This type of labor is relatively immobile, either geographically or
because workers would have to acquire new skills.

• The firm is a “wage maker,” because the wage rate it must pay varies
directly with the number of workers it employs.

monopsony

A market structure in which only a single buyer of a good, service, or

resource is present.

ORIGIN OF THE IDEA

O 10.2

Monopsony

As is true of monopoly power, there are various degrees of monopsony
power. In pure monopsony such power is at its maximum because only a
single employer hires labor in the labor market. The best real-world
examples are probably the labor markets in towns that depend almost
entirely on one major firm. For example, a silvermining company may be
almost the only source of employment in a remote Idaho town. A
Wisconsin paper mill, a Colorado ski resort, or an Iowa food processor may
provide most of the employment in its locale. In other cases, three or four
firms may each hire a large portion of the supply of labor in a certain
market and therefore have some monopsony power. Moreover, if they
illegally act in concert in hiring labor, they greatly enhance their
monopsony power.

Upward-Sloping Labor Supply to Firm
When a firm hires most of the available supply of a certain type of labor,
its decision to employ more or fewer workers affects the wage rate it pays
to those workers. Specifically, if a firm is large in relation to the size of
the labor market, it will have to pay a higher wage rate to obtain more
labor. Suppose that only one employer hires a particular type of labor in a
certain geographic area. In this pure monopsony situation, the labor
supply curve for the firm and the total labor supply curve for the labor
market are identical. The monopsonist’s supply curve—represented by
curve S in Figure 10.3—is upsloping because the firm must pay higher
wage rates if it wants to attract and hire additional workers. This same
curve is also the monopsonist’s average-cost-of-labor curve. Each point on
curve S indicates the wage rate (cost) per worker that must be paid to
attract the corresponding number of workers.

FIGURE 10.3: Monopsony.

In a monopsonistic labor market the employer’s marginal resource
(labor) cost curve (MRC) lies above the labor supply curve S. Equating
MRC with MRP at point b, the monopsonist hires Qm workers

(compared with Qc under competition). As indicated by point c on S, it

pays only wage rate Wm (compared with the competitive wage Wc).

MRC Higher Than the Wage Rate
When a monopsonist pays a higher wage to attract an additional worker, it
must pay that higher wage not only to the additional worker, but to all the
workers it is currently employing at a lower wage. If not, labor morale
will deteriorate, and the employer will be plagued with labor unrest
because of wage-rate differences existing for the same job. Paying a
uniform wage to all workers means that the cost of an extra worker—the
marginal resource (labor) cost (MRC)—is the sum of that worker’s wage

rate and the amount necessary to bring the wage rate of all current
workers up to the new wage level.

WORKED PROBLEMS

W 10.2

Labor markets: competition and monopsony

Table 10.3 illustrates this point. One worker can be hired at a wage rate of
$6. But hiring a second worker forces the firm to pay a higher wage rate
of $7. The marginal resource cost of the second worker is $8—the $7 paid
to the second worker plus a $1 raise for the first worker. From another
viewpoint, total labor cost is now $14 (= 2 × $7), up from $6. So the
MRC of the second worker is $8 (= $14 − $6), not just the $7 wage rate
paid to that worker. Similarly, the marginal labor cost of the third worker
is $10—the $8 that must be paid to attract this worker from alternative
employment plus $1 raises, from $7 to $8, for the first two workers.

TABLE 10.3: The Supply of Labor:
Monopsony in the Hiring of Labor

Here is the key point: Because the monopsonist is the only employer in the
labor market, its marginal resource (labor) cost exceeds the wage rate.
Graphically, the monopsonist’s MRC curve lies above the average-cost-of-
labor curve, or labor supply curve S, as is clearly shown in Figure 10.3.

Equilibrium Wage and Employment
How many units of labor will the monopsonist hire, and what wage rate
will it pay? To maximize profit, the monopsonist will employ the quantity
of labor Qm in Figure 10.3 because at that quantity MRC and MRP are

equal (point b). The monopsonist next determines how much it must pay
to attract these Qm workers. From the supply curve S, specifically point c,

it sees that it must pay wage rate Wm. Clearly, it need not pay a wage

equal to MRP; it can attract and hire exactly the number of workers it
wants (Qm)

with wage rate Wm. And that is the wage that it will pay.

INTERACTIVE GRAPHS

G 10.2

Monopsony

Contrast these results with those that would prevail in a competitive labor
market. With competition in the hiring of labor, the level of employment
would be greater (at Qc) and the wage rate would be higher (at Wc).

Other things equal, the monopsonist maximizes its profit by hiring a
smaller number of workers and thereby paying a less-than-competitive
wage rate. Society obtains a smaller output, and workers get a wage rate
that is less by bc than their marginal revenue product.

APPLYING THE ANALYSIS: Monopsony

Power
Fortunately, monopsonistic labor markets are uncommon in the United
States. In most labor markets, several potential employers compete for
most workers, particularly for workers who are occupationally and
geographically mobile. Also, where monopsony labor market outcomes
might have otherwise occurred, unions have sprung up to counteract that
power by forcing firms to negotiate wages. Nevertheless, economists
have found some evidence of monopsony power in such diverse labor
markets as the markets for nurses, professional athletes, public school
teachers, newspaper employees, and some building-trade workers.

In the case of nurses, the major employers in most locales are a
relatively small number of hospitals. Further, the highly specialized
skills of nurses are not readily transferable to other occupations. It has
been found, in accordance with the monopsony model, that, other things
equal, the smaller the number of hospitals in a town or city (that is, the
greater the degree of monopsony), the lower the beginning salaries of
nurses.

Professional sports leagues also provide a good example of monopsony,
particularly as it relates to the pay of first-year players. The National
Football League, the National Basketball Association, and Major League
Baseball assign first-year players to teams through “player drafts.” That
device prohibits other teams from competing for a player’s services, at
least for several years, until the player becomes a “free agent.” In this
way the league exercises monopsony power, which results in lower
salaries than would occur under competitive conditions.

Question:

The salaries of star players often increase substantially when they
become free agents. How does that fact relate to monopsony power?

Union Models

Our assumption thus far has been that workers compete with one another in
selling their labor services. In some labor markets, however, workers
unionize and sell their labor services collectively. In the United States,
about 12 percent of wage and salary workers belong to unions. (As shown
in Global Snapshot 10.1, this percentage is low relative to some other
nations.)

Union efforts to raise wage rates are mainly concentrated on the supply side
of the labor market.

GLOBAL SNAPSHOT 10.1: Union
Membership
Compared with most other industrialized nations, the percentage of wage
and salary earners belonging to unions in the United States is small.

Source: Jelle Visser, “Union Membership in 24 Countries,”
Monthly Labor Review, January 2006, 38–49. Data are for 2003.

Exclusive or Craft Union Model
Unions can boost wage rates by reducing the supply of labor, and over the
years organized labor has favored policies to do just that. For example,
labor unions have supported legislation that has (1) restricted permanent
immigration, (2) reduced child labor, (3) encouraged compulsory
retirement, and (4) enforced a shorter workweek.

Moreover, certain types of workers have adopted techniques designed to
restrict the number of workers who can join their union. This is especially
true of craft unions, whose members possess a particular skill, such as

carpenters or brick masons or plumbers. Craft unions have frequently
forced employers to agree to hire only union members, thereby gaining
virtually complete control of the labor supply. Then, by following
restrictive membership policies—for example, long apprenticeships, very
high initiation fees, and limits on the number of new members admitted—
they have artificially restricted labor supply. As indicated in Figure 10.4,
such practices result in higher wage rates and constitute what is called
exclusive unionism. By excluding workers from unions and therefore
from the labor supply, craft unions succeed in elevating wage rates.

exclusive unionism

The union practice of restricting the supply of skilled union labor to
increase the wage rate received by union members.
FIGURE 10.4: Exclusive or craft unionism.

By reducing the supply of labor (say, from S1 to S2) through the use

of restrictive membership policies, exclusive unions achieve higher
wage rates (Wc to Wu). However, restriction of the labor supply also

reduces the number of workers employed (Qc to Qu).

This craft union model is also applicable to many professional
organizations, such as the American Medical Association, the National
Education Association, the American Bar Association, and hundreds of
others. Such groups seek to limit competition for their services from less-
qualified labor suppliers. One way to accomplish that is through
occupational licensing. Here, a group of workers in a given occupation
pressure Federal, state, or municipal government to pass a law that says
that some occupational group (for example, barbers, physicians, lawyers,
plumbers, cosmetologists, egg graders, pest controllers) can practice their
trade only if they meet certain requirements. Those requirements might
include level of education, amount of work experience, and the passing of
an examination. Members of the licensed occupation typically dominate
the licensing board that administers such laws. The result is self-
regulation, which can lead to policies that restrict entry to the occupation
and reduce labor supply.

occupational licensing

Government laws that require a worker to satisfy certain specified
requirements and obtain a license from a licensing board before
engaging in a particular occupation.

The expressed purpose of licensing is to protect consumers from
incompetent practitioners—surely a worthy goal. But such licensing, if
abused, simply results in above-competitive wages and earnings for those
in the licensed occupation (Figure 10.4). Moreover, licensing
requirements often include a residency requirement, which inhibits the
interstate movement of qualified workers. Some 600 occupations are now
licensed in the United States.

Inclusive or Industrial Union Model

Instead of trying to limit their membership, however, most unions seek to
organize all available workers. This is especially true of the industrial
unions, such as those of the automobile workers and steelworkers. Such
unions seek as members all available unskilled, semiskilled, and skilled
workers in an industry. A union can afford to be exclusive when its
members are skilled craftspersons for whom there are few substitutes. But
for a union composed of unskilled and semiskilled workers, a policy of
limited membership would make available to the employers numerous
nonunion workers who are highly substitutable for the union workers.

An industrial union that includes virtually all available workers in its
membership can put firms under great pressure to agree to its wage
demands. Because of its legal right to strike, such a union can threaten to
deprive firms of their entire labor supply. And an actual strike can do just
that.

We illustrate such inclusive unionism in Figure 10.5. Initially, the
competitive equilibrium wage rate is Wc and the level of employment is

Qc. Now suppose an industrial union is formed that demands a higher,

above-equilibrium wage rate of, say, Wu. That wage rate Wu would create

a perfectly elastic labor supply over the range ae in Figure 10.5. If firms
wanted to hire any workers in this range, they would have to pay the
union-imposed wage rate. If they decide against meeting this wage
demand, the union will supply no labor at all, and the firms will be faced
with a strike. If firms decide it is better to pay the higher wage rate than to
suffer a strike, they will cut back on employment from Qc to Qu.

inclusive unionism

The union practice of including as members all workers employed in an
industry.
FIGURE 10.5: Inclusive or industrial
unionism.

By organizing virtually all available workers in order to control the
supply of labor, inclusive industrial unions may impose a wage rate,
such as Wu, that is above the competitive wage rate Wc. In effect, this

changes the labor supply curve from S to aeS. At wage rate Wu,

employers will cut employment from Qc to Qu.

By agreeing to the union’s Wu wage demand, individual employers

become wage takers at the union wage rate Wu. Because labor supply is

perfectly elastic over range ae, the marginal resource (labor) cost is equal
to the union wage rate Wu over this range. The Qu level of employment is

the result of employers’ equating this MRC (now equal to the union wage
rate) with MRP, according to our profitmaximizing rule.

Note from point e on labor supply curve S that Qe workers desire

employment at wage Wu. But as indicated by point b on labor demand

curve D, only Qu workers are employed. The result is a surplus of labor

of Qe − Qu (also shown by distance eb). In a purely competitive labor

market without the union, the effect of a surplus of unemployed workers
would be lower wages. Specifically, the wage rate would fall to the
equilibrium level Wc, where the quantity of labor supplied equals the

quantity of labor demanded (each, Qc). But this drop in wages does not

happen because workers are acting collectively through their union.
Individual workers cannot offer to work for less than Wu; nor can

employers pay less than that.

Wage Increases and Unemployment
Evidence suggests that union members on average achieve a 15-percent
wage advantage over nonunion workers. But when unions are successful in
raising wages, their efforts also have another major effect. As Figures
10.4 and 10.5 suggest, the wage-raising actions achieved by both exclusive
and inclusive unionism reduce employment in unionized firms. Simply
put, a union’s success in achieving aboveequilibrium wage rates thus tends
to be accompanied by a decline in the number of workers employed. That
result acts as a restraining influence on union wage demands. A union
cannot expect to maintain solidarity within its ranks if it seeks a wage rate
so high that joblessness will result for, say, 20 percent or 30 percent of its
members.

Wage Differentials
Hourly wage rates and annual salaries differ greatly among occupations. In
Table 10.4 we list average annual salaries for a number of occupations to
illustrate such wage differentials. For example, observe that aircraft pilots
on average earn six times as much as retail salespersons. Not shown, there
are also large wage differentials within some of the occupations listed. For

example, some highly experienced pilots earn several times as much income
as pilots just starting their careers. And, although average wages for retail
salespersons are relatively low, some top salespersons selling on commission
make several times the average wages listed for their occupation.

wage differentials

The differences between the wage received by one worker or group of
workers and that received by another worker or group of workers.

TABLE 10.4: Average Annual Wages in Selected
Occupations, 2007

What explains wage differentials such as these? Once again, the forces of
demand and supply are highly revealing. As we demonstrate in Figure 10.6,

wage differentials can arise on either the supply or the demand side of labor
markets. Panels (a) and (b) in Figure 10.6 represent labor markets for two
occupational groups that have identical labor supply curves. Labor market
(a) has a relatively high equilibrium wage (Wa) because labor demand is

very strong. In labor market (b) the equilibrium wage is relatively low
(Wb) because labor demand is weak. Clearly, the wage differential between

occupations (a) and (b) results solely from differences in the magnitude of
labor demand.
FIGURE 10.6: Labor demand, labor supply,
and wage differentials.

The wage differential between labor markets (a) and (b) results solely
from differences in labor demand. In labor markets (c) and (d),
differences in labor supply are the sole cause of the wage differential.

Contrast that situation with panels (c) and (d) in Figure 10.6, where the
labor demand curves are identical. In labor market (c) the equilibrium wage
is relatively high (Wc) because labor supply is highly restricted. In labor

market (d) labor supply is highly abundant, so the equilibrium wage (Wd) is

relatively low. The wage differential between (c) and (d) results solely from
the differences in the magnitude of labor supply.

Although Figure 10.6 provides a good starting point for understanding
wage differentials, we need to know why demand and supply conditions
differ in various labor markets. There are several reasons.

Marginal Revenue Productivity
The strength of labor demand—how far rightward the labor demand curve
is located—differs greatly among occupations due to differences in how
much various occupational groups contribute to the revenue of their
respective employers. This revenue contribution, in turn, depends on the
workers’ productivity and the strength of the demand for the products they
are helping to produce. Where labor is highly productive and product
demand is strong, labor demand also is strong and, other things equal, pay
is high. Top professional athletes, for example, are highly productive at
producing sports entertainment, for which millions of people are willing
to pay billions of dollars over the course of a season. So the marginal
revenue productivity of these top players is exceptionally high, as are their
salaries (as represented in Figure 10.6a). In contrast, in most occupations
workers generate much more modest revenue for their employers, so their
pay is lower (as in Figure 10.6b).

Noncompeting Groups

On the supply side of the labor market, workers are not homogeneous;
they differ in their mental and physical capacities and in their education
and training. At any given time the labor force is made up of many
noncompeting groups of workers, each representing several occupations
for which the members of that particular group qualify. In some groups
qualified workers are relatively few, whereas in others they are plentiful.
And workers in one group do not qualify for the occupations of other
groups.

Ability
Only a few workers have the ability or physical attributes to be brain
surgeons, concert violinists, top fashion models, research chemists, or
professional athletes. Because the supply of these particular types of
labor is very small in relation to labor demand, their wages are high (as
in Figure 10.6c). The members of these and similar groups do not
compete with one another or with other skilled or semiskilled workers.
The violinist does not compete with the surgeon, nor does the surgeon
compete with the violinist or the fashion model.

Education and Training
Another source of wage differentials is differing amounts of human
capital, which is the personal stock of knowledge, know-how, and skills
that enables a person to be productive and thus to earn income. Such
stocks result from investments in human capital. Like expenditures on
machinery and equipment, productivity-enhancing expenditures on
education or training are investments. In both cases, people incur present
costs with the intention that those expenditures will lead to a greater flow
of future earnings.

human capital

The personal stock of knowledge, know-how, and skills that enables a
person to be productive and thus to earn income.

ORIGIN OF THE IDEA

O 10.3

Human capital

Figure 10.7 indicates that workers who have made greater investments in
education achieve higher incomes during their careers. The reason is
twofold: (1) There are fewer such workers, so their supply is limited
relative to less-educated workers, and (2) more educated workers tend to
be more productive and thus in greater demand. Figure 10.7 also
indicates that the incomes of better-educated workers generally rise more
rapidly than those of poorly educated workers. The primary reason is
that employers provide more on-the-job training to the bettereducated
workers, boosting their marginal revenue productivity and therefore
their earnings.
FIGURE 10.7: Education levels and average
annual income.

Annual income by age is higher for workers with more education.
Investment in education yields a return in the form of earnings
differences enjoyed over one’s work life.

Source: U.S. Bureau of the Census, www.census.gov. Data are for
2006 and include both men and women.

Although education yields higher incomes, it carries substantial costs. A

college education involves not only direct costs (tuition, fees, books) but
indirect or opportunity costs (forgone earnings) as well. Does the higher
pay received by better-educated workers compensate for these costs? The
answer is yes. Rates of return are estimated to be 10 to 13 percent for
investments in secondary education and 8 to 12 percent for investments
in college education. One generally accepted estimate is that each year of
schooling raises a worker’s wage by about 8 percent. Currently, college
graduates on average earn about $1.70 for each $1 earned by high school
graduates.

ILLUSTRATING THE IDEA: My Entire
Life
For some people, high earnings have little to do with actual hours of
work and much to do with their tremendous skill, which reflects their
accumulated stock of human capital. The point is demonstrated in the
following story: It is said that a tourist once spotted the famous
Spanish artist Pablo Picasso (1881–1973) in a Paris café. The tourist
asked Picasso if he would do a sketch of his wife for pay. Picasso
sketched the wife in a matter of minutes and said, “That will be 10,000
francs [roughly $2000].” Hearing the high price, the tourist became
irritated, saying, “But that took you only a few minutes.”

“No,” replied Picasso, “it took me my entire life!”

Question:

In general, how do the skill requirements of the highest-paying
occupations in Table 10.4 compare with the skill requirements of
the lowest-paying occupations?

Compensating Differences
If the workers in a particular noncompeting group are equally capable of
performing several different jobs, you might expect the wage rates to be
identical for all these jobs. Not so. A group of high school graduates may

be equally capable of becoming sales-clerks or general construction
workers, but these jobs pay different wages. In virtually all locales,
construction laborers receive much higher wages than salesclerks. These
wage differentials are called compensating differences because they must
be paid to compensate for nonmonetary differences in various jobs.

compensating differences

Wage differentials received by workers to compensate them for
nonmonetary disparities in their jobs.

The construction job involves dirty hands, a sore back, the hazard of
accidents, and irregular employment, both seasonally and cyclically. The
retail sales job means clean clothing, pleasant air-conditioned
surroundings, and little fear of injury or layoff. Other things equal, it is
easy to see why workers would rather pick up a credit card than a shovel.
So the amount of labor that is supplied to construction firms (as in Figure
10.6c) is smaller than that which is supplied to retail shops (as in Figure
10.6d). Construction firms must pay higher wages than retailers to
compensate for the unattractive nonmonetary aspects of construction jobs.

Compensating differences play an important role in allocating society’s
scarce labor resources. If very few workers want to be garbage collectors,
then society must pay high wages to garbage collectors to get the garbage
collected. If many more people want to be salesclerks, then society need
not pay them as much as it pays garbage collectors to get those services
performed.

APPLYING THE ANALYSIS: The
Minimum Wage
Since the passage of the Fair Labor Standards Act in 1938, the United
States has had a Federal minimum wage. That wage has ranged between
35 and 50 percent of the average wage paid to manufacturing workers
and was $5.85 per hour in 2007 and is scheduled to rise to $6.55 in July
2008 and $7.25 in July 2009. Numerous states, however, have minimum

wages considerably above the Federal mandate. The purpose of
minimum wages is to provide a “wage floor” that will help less-skilled
workers earn enough income to escape poverty.

Critics, reasoning in terms of Figure 10.5, contend that an above-
equilibrium minimum wage (say, Wu) will simply cause employers to

hire fewer workers. Downsloping labor demand curves are a reality. The
higher labor costs may even force some firms out of business. In either
case, some of the poor, low-wage workers whom the minimum wage
was designed to help will find themselves out of work. Critics point out
that a worker who is unemployed and desperate to find a job at a
minimum wage of $6.55 per hour is clearly worse off than he or she
would be if employed at a market wage rate of, say, $6.10 per hour.

A second criticism of the minimum wage is that it is “poorly targeted” to
reduce household poverty. Critics point out that much of the benefit of
the minimum wage accrues to workers, including many teenagers, who
do not live in impoverished households.

Advocates of the minimum wage say that critics analyze its impact in an
unrealistic context, specifically a competitive labor market (Figure 10.2).
But in a less-competitive, low-pay labor market where employers possess
some monopsony power (Figure 10.3), the minimum wage can increase
wage rates without causing significant unemployment. Indeed, a higher
minimum wage may even produce more jobs by eliminating the motive
that monopsonistic firms have for restricting employment. For example,
a minimum-wage floor of Wc in Figure 10.3 would change the firm’s

labor supply curve to WcaS and prompt the firm to increase its

employment from Qm workers to Qc workers.

Moreover, even if the labor market is competitive, the higher wage rate
might prompt firms to find more productive tasks for low-paid workers,
thereby raising their productivity. Alternatively, the minimum wage may
reduce labor turnover (the rate at which workers voluntarily quit). With
fewer low-productive trainees, the average productivity of the firm’s

workers would rise. In either case, the alleged negative employment
effects of the minimum wage might not occur.

Which view is correct? Unfortunately, there is no clear answer. All
economists agree that firms will not hire workers who cost more per
hour than the value of their hourly output. So there is some minimum
wage so high that it would severely reduce employment. Consider $20
an hour, as an absurd example. Economists generally think a 10 percent
increase in the minimum wage will reduce employment of unskilled
workers by about 1 to 3 percent. But no current consensus exists on the
employment effect of the present level of the minimum wage.

The overall effect of the minimum wage is thus uncertain. There seems
to be a consensus emerging that, on the one hand, the employment and
unemployment effects of the minimum wage are not as great as many
critics fear. On the other hand, because a large part of its effect is
dissipated on nonpoverty families, the minimum wage is not as strong an
antipoverty tool as many supporters contend.

Voting patterns and surveys make it clear, however, that the minimum
wage has strong political support. Perhaps this stems from two realities:
(1) More workers are believed to be helped than hurt by the minimum
wage, and (2) the minimum wage gives society some assurance that
employers are not “taking undue advantage” of vulnerable, low-skilled
workers.

Question: Have you ever worked for the minimum wage? If so, for
how long? Would you favor increasing the minimum wage by $1?
By $2? By $5? Explain your reasoning.

Summary
1. The demand for labor is derived from the product it helps
produce. That means the demand for labor will depend on its
productivity and on the market value (price) of the good it is producing.

2. Because the firm equates the wage rate and MRP in determining

its profit-maximizing level of employment, the marginal revenue
product curve is the firm’s labor demand curve. Thus, each point on the
MRP curve indicates how many labor units the firm will hire at a
specific wage rate.

3. The competitive firm’s labor demand curve slopes downward
because of the law of diminishing returns. Summing horizontally the
demand curves of all the firms hiring that resource produces the market
demand curve for labor.

4. The demand curve for labor will shift as the result of (a) a change
in the demand for, and therefore the price of, the product the labor is
producing; (b) changes in the productivity of labor; and (c) changes in
the prices of substitutable and complementary resources.

5. The elasticity of demand for labor measures the responsiveness of
labor quantity to a change in the wage rate. The coefficient of the
elasticity of labor demand is

When Ew is greater than 1, labor demand is elastic; when Ew is less than

1, labor demand is inelastic; and when Ew equals 1, labor demand is

unit-elastic.

6. The elasticity of labor demand will be greater (a) the greater the
ease of substituting other resources for labor, (b) the greater the
elasticity of demand for the product, and (c) the larger the proportion of
total production costs attributable to labor.

7. Specific wage rates depend on the structure of the particular labor
market. In a competitive labor market the equilibrium wage rate and
level of employment are determined at the intersection of the labor
supply curve and labor demand curve. For the individual firm, the
market wage rate establishes a horizontal labor supply curve, meaning

that the wage rate equals the firm’s constant marginal resource cost. The
firm hires workers to the point where its MRP equals its MRC.

8. Under monopsony, the marginal resource cost curve lies above the
resource supply curve because the monopsonist must bid up the wage
rate to hire extra workers and must pay that higher wage rate to all
workers. The monopsonist hires fewer workers than are hired under
competitive conditions, pays less-than-competitive wage rates (has lower
labor costs), and thus obtains greater profit.

9. A union may raise competitive wage rates by (a) restricting the
supply of labor through exclusive unionism or (b) directly enforcing an
above-equilibrium wage rate through inclusive unionism. On average,
unionized workers realize wage rates 15 percent higher than those of
comparable nonunion workers.

10. Wage differentials are largely explainable in terms of (a) marginal
revenue productivity of various groups of workers; (b) noncompeting
groups arising from differences in the capacities and education of
different groups of workers; and (c) compensating wage differences, that
is, wage differences that must be paid to offset nonmonetary differences
in jobs.

11. Economists disagree about the desirability of the minimum wage.
While it raises the income of some workers, it reduces the income of
other workers whose skills are not sufficient to justify being paid the
mandated wage.

Terms and Concepts
purely competitive labor market
derived demand
marginal revenue product (MRP)
marginal resource cost (MRC)
MRP = MRC rule
substitution effect
output effect

elasticity of labor demand
monopsony
exclusive unionism
occupational licensing
inclusive unionism
wage differentials
human capital
compensating differences

Study Questions

1. Explain the meaning and significance of the fact that the demand
for labor is a derived demand. Why do labor demand curves slope
downward? LO1

2. On the following page, complete the labor demand table for a firm
that is hiring labor competitively and selling its product in a purely
competitive market. LO1

a. How many workers will the firm hire if the market wage
rate is $11.95? $19.95? Explain why the firm will not hire a larger
or smaller number of units of labor at each of these wage rates.

b. Show in schedule form and graphically the labor demand
curve of this firm.

3. Suppose that marginal product tripled while product price fell by
one-half in the table in Figure 10.1. What would be the new MRP
values in the table? What would be the net impact on the location of
the labor demand curve in Figure 10.1? LO2

4. In 2002 Boeing reduced employment by 33,000 workers due to
reduced demand for aircraft. What does this decision reveal about
how it viewed its marginal revenue product (MRP) and marginal
resource cost (MRC)? Why didn’t Boeing reduce employment by
more than 33,000 workers? By less than 33,000 workers? LO2

5. How will each of the following affect the demand for resource A,
which is being used to produce commodity Z? Where there is any
uncertainty as to the outcome, specify the causes of that uncertainty.
LO2

a. An increase in the demand for product Z.

b. An increase in the price of substitute resource B.

c. A technological improvement in the capital equipment with
which resource A is combined.

d. A fall in the price of complementary resource C.

e. A decline in the elasticity of demand for product Z due to a

decline in the competitiveness of product market Z.

6. What effect would each of the following factors have on elasticity
of demand for resource A, which is used to produce product Z? LO3

a. There is an increase in the number of resources substitutable
for A in producing Z.

b. Due to technological change, much less of resource A is
used relative to resources B and C in the production process.

c. The elasticity of demand for product Z greatly increases.

7. Florida citrus growers say that the recent crackdown on illegal
immigration is increasing the market wage rates necessary to get their
oranges picked. Some are turning to $100,000 to $300,000
mechanical harvesting machines known as “trunk, shake, and catch”
pickers, which vigorously shake oranges from the trees. If widely
adopted, how will this substitution affect the demand for human
orange pickers? What does that imply about the relative strengths of
the substitution and output effects? LO2

8. Why is a firm in a purely competitive labor market a wage taker?
What would happen if it decided to pay less than the going market
wage rate? LO4

9. Complete the following labor supply table for a firm hiring labor
competitively: LO4

a. Show graphically the labor supply and marginal resource
(labor) cost curves for this firm. Explain the relationship of these
curves to one another.

b. Plot the labor demand data of question 2 on the graph used
in part a above. What are the equilibrium wage rate and level of
employment? Explain.

10. Assume a firm is a monopsonist that can hire its first worker
for $6 but must increase the wage rate by $3 to attract each successive
worker. Draw the firm’s labor supply and marginal resource cost
curves and explain their relationships to one another. On the same
graph, plot the labor demand data of question 2. What are the
equilibrium wage rate and level of employment? Why do these differ
from your answer to question 9? LO4

11. Contrast the methods used by inclusive unions and exclusive
unions to raise union wage rates. LO5

12. What is meant by the terms “investment in human capital”
and “compensating wage differences”? Use these concepts to explain
wage differentials. LO6

13. Why might an increase in the minimum wage in the United
States simply send some jobs abroad? Relate your answer to elasticity
of labor demand. LO3

FURTHER TEST YOUR KNOWLEDGE AT
www.mcconnellbriefmicro1e.com

Web-Based Questions
At the text’s Online Learning Center, www.mcconnellbriefmicro1e.com,
you will find a multiple-choice quiz on this chapter’s content. We
encourage you to take the quiz to see how you do. Also, you will find one
or more Web-based questions that require information from the Internet to
answer.

1 Note that we plot the points in Figure 10.1 halfway between
succeeding numbers of labor units. For example, we plot the MRP of the
second unit ($12) not at 1 or 2 but at 1½. This “smoothing” enables us
to sketch a continuously downsloping curve rather than one that moves
downward in discrete steps as each new unit of labor is hired.

(McConnell 217)

McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill
Learning Solutions, 2010. .

11: Income Inequality and Poverty
IN THIS CHAPTER YOU WILL LEARN:

1 How income inequality in the United States is measured and
described.

2 The extent and sources of income

inequality.

3 How income inequality has changed since 1970.

4 The economic arguments for and against income inequality.

5 How poverty is measured and its incidence by age, gender,
ethnicity, and other characteristics.

6 The major components of the income-maintenance program in the
United States.

Evidence that suggests wide income disparity in the United States is easy to
find. In 2007 talk-show host Oprah Winfrey earned an estimated $260
million, golfer Tiger Woods earned $100 million, and rapper and music
executive Jay-Z earned $83 million. In contrast, the salary of the president of
the United States is $400,000, and the typical schoolteacher earns $47,000. A
full-time minimum-wage worker at a fast-food restaurant makes about
$11,000. Cash welfare payments to a mother with two children average
$5000.

In 2006 about 36.5 million Americans—or 12.3 percent of the population—
lived in poverty. An estimated 500,000 people were homeless in that year.
The richest fifth of American households received about 50.5 percent of total
income, while the poorest fifth received less than 4 percent.

What are the sources of income inequality? Is income inequality rising or
falling? Is the United States making progress against poverty? What are the
major income-maintenance programs in the United States? Is the current
welfare system effective? These are some of the questions we will answer in
this chapter.

Facts about Income Inequality
Average household income in the United States is among the highest in the
world; in 2006, it was $66,570 per household (one or more persons
occupying a housing unit). But that average tells us nothing about income
inequality. To learn about that, we must examine how income is distributed
around the average.

Distribution by Income Category
One way to measure income inequality is to look at the percentages of
households in a series of income categories. Table 11.1 shows that about
25.2 percent of all households had annual before-tax incomes of less than
$25,000 in 2006, while another 19.1 percent had annual incomes of
$100,000 or more. The data in the table suggest a wide dispersion of
household income in the United States.

income inequality

The unequal distribution of an economy’s total income among
households or families.

TABLE 11.1: The Distribution of U.S. Income
by Households, 2006

Distribution by Quintiles (Fifths)
A second way to measure income inequality is to divide the total number
of individuals, households, or families (two or more persons related by
birth, marriage or adoption) into five numerically equal groups, or
quintiles, and examine the percentage of total personal (before-tax)
income received by each quintile. We do this for households in the table
in Figure 11.1, where we also provide the upper income limit for each
quintile. Any amount of income greater than that listed in each row of
column 3 would place a household into the next-higher quintile.
FIGURE 11.1: The Lorenz curve and Gini
ratio.

The Lorenz curve is a convenient way to show the degree of income
inequality (here, household income by quintile in 2006). The area
between the diagonal (the line of perfect equality) and the Lorenz
curve represents the degree of inequality in the distribution of total
income. This inequality is measured numerically by the Gini ratio—
area A (shown in gold) divided by area A + B (the gold + gray area).
The Gini ratio for the distribution shown is 0.470.

Source: Bureau of the Census, www.census.gov.

The Lorenz Curve and Gini Ratio

We can display the quintile distribution of personal income through a
Lorenz curve. In Figure 11.1, we plot the cumulative percentage of
households on the horizontal axis and the cumulative percentage of
income they obtain on the vertical axis. The diagonal line 0 e represents a
perfectly equal distribution of income because each point along that line
indicates that a particular percentage of households receive the same
percentage of income. In other words, points representing 20 percent of
all households receiving 20 percent of total income, 40 percent receiving
40 percent, 60 percent receiving 60 percent, and so on, all lie on the
diagonal line.

Lorenz curve

A curve that shows an economy’s distribution of income by measuring
the cumulated percentage of income receivers along the horizontal axis
and the cumulated percentage of income they receive along the vertical
axis.

WORKED PROBLEMS

W 11.1

Lorenz curve

By plotting the quintile data from the table in Figure 11.1, we obtain the
Lorenz curve for 2006. Observe from point a that the bottom 20 percent
of all households received 3.4 percent of the income; the bottom 40
percent received 12 percent (= 3.4 + 8.6), as shown by point b; and so
forth. The gold area between the diagonal line and the Lorenz curve is
determined by the extent that the Lorenz curve sags away from the
diagonal and indicates the degree of income inequality. If the actual
income distribution were perfectly equal, the Lorenz curve and the
diagonal would coincide and the gold area would disappear.

At the opposite extreme is complete inequality, where all households but
one have zero income. In that case, the Lorenz curve would coincide with

the horizontal axis from 0 to point f (at 0 percent of income) and then
would move immediately up from f to point e along the vertical axis
(indicating that a single household has 100 percent of the total income).
The entire area below the diagonal line (triangle 0ef) would indicate this
extreme degree of inequality. So the farther the Lorenz curve sags away
from the diagonal, the greater is the degree of income inequality.

We can easily transform the visual measurement of income inequality
described by the Lorenz curve into the Gini ratio—a numerical measure
of the overall dispersion of income:

Gini ratio

A numerical measure of the overall dispersion of income among an
economy’s income receivers.

For the distribution of household income shown in Figure 11.1, the Gini
ratio is 0.470. As the area between the Lorenz curve and the diagonal gets
larger, the Gini ratio rises to reflect greater inequality. (Test your
understanding of this idea by confirming that the Gini ratio for complete
income equality is zero and for complete inequality is 1.)

Because Gini ratios are numerical, they are easier to use than Lorenz
curves for comparing the income distributions of different ethnic groups
and countries. For example, in 2006 the Gini ratio of U.S. household
income for African Americans was 0.486; for Asians, 0.476; for whites,

0.462; and for Hispanics, 0.448.1 Gini ratios for various nations range
from 0.743 (Namibia) to 0.249 (Japan). Examples within this range
include Sweden, 0.250; Italy, 0.350; Mexico, 0.481; and South Africa,

0.578.2

Income Mobility: The Time Dimension
The income data used so far have a major limitation: The income
accounting period of 1 year is too short to be very meaningful. Because
the Census Bureau data portray the distribution of income in only a single
year, they may conceal a more equal distribution over a few years, a
decade, or even a lifetime. If Brad earns $1000 in year 1 and $100,000 in
year 2, while Jenny earns $100,000 in year 1 and only $1000 in year 2, do
we have income inequality? The answer depends on the period of
measurement. Annual data would reveal great income inequality, but there
would be complete equality over the 2-year period.

This point is important because evidence suggests considerable “churning
around” in the distribution of income over time. Such movement of
individuals or households from one income quintile to another over time
is called income mobility. For most income receivers, income starts at a
relatively low level during youth, reaches a peak during middle age, and
then declines. It follows that if all people receive exactly the same stream
of income over their lifetimes, considerable income inequality would still
exist in any specific year because of age differences. In any single year,
the young and the old would receive low incomes while the middle-aged
receive high incomes.

income mobility

The extent to which income receivers move from one part of the income
distribution to another over some period of time.

If we change from a “snapshot” view of income distribution in a single
year to a “time exposure” portraying incomes over much longer periods,
we find considerable movement of income receivers among income
classes. Between 1996 and 2005, the median income of half of the
individuals in the lowest quintile of the U.S. income distribution moved to
a higher income quintile. Almost 25 percent made it to the middle fifth

and 5 percent achieved the top quintile. The income mobility moved in
both directions. About 57 percent of the top 1 percent of income receivers
in 1996 had dropped out of that category by 2005. Overall, income
mobility between 1996 and 2005 was the same as it was the previous 10
years. All this correctly suggests that income is more equally distributed

over a 5–, 10–, or 20–year period than in any single year. 3

In short, there is significant individual and household income mobility
over time; for many people, “low income” and “high income” are not
permanent conditions.

Effect of Government Redistribution
The income data in the table in Figure 11.1 include wages, salaries,
dividends, and interest. They also include all cash transfer payments such
as Social Security, unemployment compensation benefits, and welfare
assistance to needy households. The data are before-tax data and therefore
do not take into account the effects of personal income and payroll (Social
Security) taxes that are levied directly on income receivers. Nor do they
include government-provided in-kind or noncash transfers, which make
available specific goods or services rather than cash. Noncash transfers
include such things as medical care, housing subsidies, subsidized school
lunches, and food stamps. Such transfers are much like income because
they enable recipients to “purchase” goods and services.

noncash transfers

Government transfer payments in the form of goods and services (or
vouchers to obtain them) rather than money.

One economic function of government is to redistribute income, if society
so desires. Figure 11.2 and its table reveal that government significantly
redistributes income from higher- to lower-income households through
taxes and transfers. Note that the U.S. distribution of household income
before taxes and transfers are taken into account (dark green Lorenz
curve) is substantially less equal than the distribution after taxes and

transfers (light green Lorenz curve). Without government redistribution,
the lowest 20 percent of households in 2005 would have received only 1.5
percent of total income. With redistribution, they received 4.4 percent, or

three times as much.4

FIGURE 11.2: The impact of taxes and
transfers on U.S. income inequality.

The distribution of income is significantly more equal after taxes and
transfers are taken into account than before. Transfers account for most
of the lessening of inequality and provide most of the income received
by the lowest quintile of households.

Source: Bureau of the Census, www.census.gov.

Which contributes more to redistribution, government taxes or
government transfers? The answer is transfers. Because the U.S. tax
system is only modestly progressive, after-tax data would reveal only
about 20 percent less inequality. Roughly 80 percent of the reduction in
income inequality is attributable to transfer payments, which account for
more than 75 percent of the income of the lowest quintile. Together with
growth of job opportunities, transfer payments have been the most
important means of alleviating poverty in the United States.

Causes of Income Inequality

There are several causes of income inequality in the United States. In
general, the market system is permissive of a high degree of income
inequality because it rewards individuals on the basis of the contributions
that they, or the resources that they own, make in producing society’s
output.

More specifically, the factors that contribute to income inequality are the
following.

Ability
People have different mental, physical, and aesthetic talents. Some have
inherited the exceptional mental qualities that are essential to such high-
paying occupations as medicine, corporate finance, and law. Others are
blessed with the physical capacity and coordination to become highly paid
professional athletes. A few have the talent to become great artists or
musicians or have the beauty to become top fashion models. Others have
very weak mental endowments and may work in low-paying occupations
or may be incapable of earning any income at all. The intelligence and
skills of most people fall somewhere in between.

Education and Training
Native ability alone rarely produces high income; people must develop
and refine their capabilities through education and training. Individuals
differ significantly in the amount of education and training they obtain
and thus in their capacity to earn income. Such differences may be a
matter of choice: Chin enters the labor force after graduating from high
school, while Rodriguez takes a job only after earning a college degree.
Other differences may be involuntary: Chin and her parents may simply
be unable to finance a college education.

People also receive varying degrees of on-the-job training, which also
contributes to income inequality. Some workers learn valuable new skills
each year on the job and therefore experience significant income growth

over time; others receive little or no on-the-job training and earn no more
at age 50 than they did at age 30. Moreover, firms tend to select for
advanced on-the-job training the workers who have the most formal
education. That added training magnifies the education-based income
differences between less-educated and better-educated individuals.

Discrimination
Discrimination in education, hiring, training, and promotion undoubtedly
causes some income inequality. If discrimination confines certain racial,
ethnic, or gender groups to lower-pay occupations, the supply of labor in
those occupations will increase relative to demand and hourly wages and
income in those lower-paying jobs will decline. Conversely, labor supply
will be artificially reduced in the higherpay occupations populated by
“preferred” workers, raising their wage rates and income. In this way,
discrimination can add to income inequality. In fact, economists cannot
account for all racial, ethnic, and gender differences in work earnings on
the basis of differences in years of education, quality of education,
occupations, and annual hours of work. Many economists attribute the
unexplained residual to discrimination.

Economists, however, do not see discrimination by race, gender, and
ethnicity as a dominant factor explaining income inequality. The income
distributions within racial or ethnic groups that historically have been
targets of discrimination—for example, African Americans—are similar
to the income distribution for whites. Other factors besides discrimination
are obviously at work. Nevertheless, discrimination is an important
concern since it harms individuals and reduces society’s overall output and
income.

Preferences and Risks
Incomes also differ because of differences in preferences for market work
relative to leisure, market work relative to work in the household, and
types of occupations. People who choose to stay home with children, work
part-time, or retire early usually have less income than those who make

the opposite choices. Those who are willing to take arduous, unpleasant
jobs (for example, underground mining or heavy construction), to work
long hours with great intensity, or to “moonlight” will tend to earn more.

Individuals also differ in their willingness to assume risk. We refer here
not only to the race-car driver or the professional boxer but also to the
entrepreneur. Although many entrepreneurs fail, many of those who
develop successful new products or services realize very substantial
incomes. That contributes to income inequality.

Unequal Distribution of Wealth
Income is a flow; it represents a stream of wage and salary earnings, along
with rent, interest, and profits, as depicted in Chapter 2’s circular flow
diagram. In contrast, wealth is a stock, reflecting at a particular moment
the financial and real assets an individual has accumulated over time. A
retired person may have very little income and yet own a home, mutual
fund shares, and a pension plan that add up to considerable wealth. A new
college graduate may be earning a substantial income as an accountant,
middle manager, or engineer but have yet to accumulate significant
wealth.

The ownership of wealth in the United States is more unequal than the
distribution of income. According to the most recent (2004) Federal
Reserve wealth data, the wealthiest 10 percent of families owned 70
percent of the total wealth and the top 1 percent owned 33 percent. The
bottom 90 percent held only 30 percent of the total wealth. This wealth
inequality leads to inequality in rent, interest, and dividends, which in turn
contributes to income inequality. Those who own more machinery, real
estate, farmland, stocks and bonds, and savings accounts obviously receive
greater income from that ownership than people with less or no such
wealth.

Market Power
The ability to “rig the market” on one’s own behalf also contributes to

income inequality. For example, in resource markets, certain unions and
professional groups have adopted policies that limit the supply of their
services, thereby boosting the incomes of those “on the inside.” Also,
legislation that requires occupational licensing for, say, doctors, dentists,
and lawyers can bestow market power that favors the licensed groups. In
product markets, “rigging the market” means gaining or enhancing
monopoly power, which results in greater profit and thus greater income
to the firms’ owners.

Luck, Connections, and Misfortune
Other forces also play a role in producing income inequality. Luck and
“being in the right place at the right time” have helped individuals stumble
into fortunes. Discovering oil on a ranch, owning land along a major
freeway interchange, and hiring the right press agent have accounted for
some high incomes. Personal contacts and political connections are other
potential routes to attaining high income.

In contrast, economic misfortunes such as prolonged illness, serious
accident, death of the family breadwinner, or unemployment may plunge
a family into the low range of income. The burden of such misfortune is
borne very unevenly by the population and thus contributes to income
inequality.

Income inequality of the magnitude we have described is not exclusively
an American phenomenon. Global Snapshot 11.1 compares income
inequality in the United States (here by individuals, not by households)
with that in several other nations. Income inequality tends to be greatest in
South American nations, where land and capital resources are highly
concentrated in the hands of very wealthy families.

GLOBAL SNAPSHOT 11.1:

Percentage of Total Income Received by Top
One-Tenth of Income Receivers, Selected
Nations
The share of income going to the highest 10 percent of income receivers
varies among

nations.

Source: United Nations, Human Development Report, 2007/2008,
pp. 281–284, hdr.undp.org.

Income Inequality over Time
Over a period of years, economic growth has raised incomes in the United
States: In absolute dollar amounts, the entire distribution of income has
been moving upward. But incomes may move up in absolute terms while
leaving the relative distribution of income less equal, more equal, or
unchanged. Table 11.2 shows how the distribution of household income has
changed since 1970. This income is “before tax” and includes cash transfers
but not noncash transfers.

TABLE 11.2: Percentage of Total Before-Tax
Income Received by Each One-Fifth and by the
Top 5 percent of Households, Selected Years *

Rising Income Inequality since 1970
It is clear from Table 11.2 that the distribution of income by quintiles has
become more unequal since 1970. In 2006 the lowest 20 percent of
households received 3.4 percent of total before-tax income, compared
with 4.1 in 1970. Meanwhile, the income share received by the highest 20
percent rose from 43.3 in 1970 to 50.5 percent in 2006. Also, the
percentage of income received by the top 5 percent of households rose

significantly over the 1970–2006 period.

Causes of Growing Inequality
Economists suggest several major explanations for the growing U.S.
income inequality of the past several decades.

Greater Demand for Highly Skilled Workers
Perhaps the most significant contributor to the growing income
inequality has been an increasing demand by many firms for workers
who are highly skilled and well educated. Moreover, several industries
requiring highly skilled workers have either recently emerged or
expanded greatly, such as the computer software, business consulting,
biotechnology, health care, and Internet industries. Because highly
skilled workers remain relatively scarce, their wages have been bid up.
Consequently, the wage differences between them and less-skilled
workers have increased. In fact, between 1980 and 2005, the wage
difference between college graduates and high school graduates rose
from 28 percent to 47 percent for women and from 22 percent to 43
percent for men.

The rising demand for skill also has shown up in rapidly rising pay for
chief executive officers (CEOs), sizable increases in income from stock
options, substantial increases in income for professional athletes and
entertainers, and huge fortunes for successful entrepreneurs. This growth
of “superstar” pay also has contributed to rising income inequality.

Demographic Changes
The entrance of large numbers of less-experienced and less-skilled “baby
boomers” into the labor force during the 1970s and 1980s may have
contributed to greater income inequality in those two decades. Because
younger workers tend to earn less income than older workers, their
growing numbers contributed to income inequality. There also has been
a growing tendency for men and women with high earnings potential to

marry each other, thus increasing family income among the highest
income quintiles. Finally, the number of households headed by single or
divorced women has increased greatly. That trend has increased income
inequality because such households lack a second major wage earner and
also because the poverty rate for female-headed households is very high.

International Trade, Immigration, and Decline in
Unionism
Other factors are probably at work as well. Stronger international
competition from imports has reduced the demand for and employment
of less-skilled (but highly paid) workers in such industries as the
automobile and steel industries. The decline in such jobs has reduced the
average wage for less-skilled workers. It also has swelled the ranks of
workers in already low-paying industries, placing further downward
pressure on wages there.

Similarly, the transfer of jobs to lower-wage workers in developing
countries has exerted downward wage pressure on less-skilled workers in
the United States. Also, an upsurge in immigration of unskilled workers
has increased the number of low-income households in the United States.
Finally, the decline in unionism in the United States has undoubtedly
contributed to wage inequality since unions tend to equalize pay within
firms and industries.

Two cautions: First, when we note growing income inequality, we are
not saying that the “rich are getting richer and the poor are getting
poorer” in terms of absolute income. Both the rich and the poor are
experiencing rises in real income. Rather, what has happened is that,
while incomes have risen in all quintiles, income growth has been fastest
in the top quintile. Second, increased income inequality is not solely a
U.S. phenomenon. The recent rise of inequality also has occurred in
several other industrially advanced nations.

The Lorenz curve can be used to contrast the distribution of income at
different points in time. If we plotted Table 11.2 ‘s data as Lorenz

curves, we would find that the curve shifted away from the diagonal
between 1970 and 2006. The Gini ratio rose from 0.394 in 1970 to
0.470 in 2006.

APPLYING THE ANALYSIS: Laughing at
Shrek
Some economists say that the distribution of annual consumption is
more meaningful for examining inequality of well-being than is the
distribution of annual income. In a given year, people’s consumption of
goods and services may be above or below their income because they
can save, draw down past savings, use credit cards, take out home
mortgages, spend from inheritances, give money to charities, and so
on. A recent study of the distribution of consumption finds that annual
consumption inequality is less than income inequality. Moreover,
consumption inequality has remained relatively constant over several
decades, even though income inequality has increased.*

The Economist magazine extends the argument even further, pointing
out that despite the recent increase in income inequality, the products
consumed by the rich and the poor are far closer in functionality today
than at any other time in history:

More than 70 percent of Americans under the official poverty line
own at least one car. And the distance between driving a used
Hyundai Elantra and new Jaguar XJ is well nigh undetectable
compared with the difference between motoring and hiking through
the muck . . . A wide screen plasma television is lovely, but you do
not need one to laugh at “Shrek”. . .

Those intrepid souls who make vast fortunes turning out ever higher-
quality goods at ever lower prices widen the income gap while

reducing the differences that really matter.†

Economists generally agree that products and experiences once
reserved exclusively for the rich in the United States have, in fact,

become more commonplace for nearly all income classes. But skeptics
argue that The Economist’s argument is too simplistic. Even though
both are water outings, there is a fundamental difference between
yachting among the Greek isles on your private yacht and paddling on
a local pond in your kayak.

Question:

How do the ideas of income inequality, consumption inequality,
and wealth inequality differ?

* Dirk Krueger and Fabrizio Perri, “Does Income Inequality Lead
to Consumption Inequality?” Review of Economic Studies, 2006, pp.
163–193.
† The Economist, “Economic Focus: The New (Improved) Gilded
Age,” December 22, 2007, p. 122.

Photo Op: The Rich and the Poor in America

© Royalty-Free/CORBIS

© Richard Bickel/CORBIS

Wide disparities of income and wealth exist in the United States.

Equality versus Efficiency
The main policy issue concerning income inequality is how much is
necessary and justified. While there is no general agreement on the
justifiable amount, we can gain insight by exploring the economic cases for
and against greater equality.

The Case for Equality: Maximizing Total Utility
The basic economic argument for an equal distribution of income is that
income equality maximizes the total consumer satisfaction (utility) from
any particular level of output and income. The rationale for this argument
is shown in Figure 11.3, in which we assume that the money incomes of
two individuals, Anderson and Brooks, are subject to the law of

diminishing marginal utility. In any time period, income receivers
spend the first dollars received on the products they value most—products
whose marginal utility (extra satisfaction) is high. As a consumer’s most-
pressing wants become satisfied, he or she then spends additional dollars
of income on lessimportant, lower-marginal-utility goods. So marginal-
utility-from-income curves slope downward, as in Figure 11.3. The
identical diminishing curves (MUA and MUB) reflect the assumption that

Anderson and Brooks have the same capacity to derive utility from
income. Each point on one of the curves measures the marginal utility of
the last dollar of a particular level of income.

law of diminishing marginal utility

The principle that the amount of extra satisfaction (marginal utility)
from consuming a product declines as more of it is consumed.
FIGURE 11.3: The utility-maximizing
distribution of income.

With identical marginal-utility-of-income curves MUA and MUB,

Anderson and Brooks will maximize their combined utility when any
amount of income (say, $10,000) is equally distributed. If income is

unequally distributed (say, $2500 to Anderson and $7500 to Brooks),
the marginal utility derived from the last dollar will be greater for
Anderson than for Brooks, and a redistribution toward equality will
result in a net increase in total utility. The utility gained by equalizing
income at $5000 each, shown by the blue area below curve MUA in

panel (a), exceeds the utility lost, indicated by the red area below curve
MUB in (b).

Now suppose that there is $10,000 worth of income (output) to be
distributed between Anderson and Brooks. According to proponents of
income equality, the optimal distribution is an equal distribution, which
causes the marginal utility of the last dollar spent to be the same for both
persons. We can confirm this by demonstrating that if the income
distribution is initially unequal, then distributing income more equally can
increase the combined utility of the two individuals.

Suppose that the $10,000 of income initially is distributed such that
Anderson gets $2500 and Brooks $7500. The marginal utility, a, from the
last dollar received by Anderson is high and the marginal utility, b, from
Brooks’ last dollar of income is low. If a single dollar of income is shifted
from Brooks to Anderson—that is, toward greater equality—then
Anderson’s utility increases by a and Brooks’ utility decreases by b. The
combined utility then increases by a minus b (Anderson’s large gain minus
Brooks’ small loss). The transfer of another dollar from Brooks to
Anderson again increases their combined utility, this time by a slightly
smaller amount. Continued transfer of dollars from Brooks to Anderson
increases their combined utility until the income is evenly distributed and
both receive $5000. At that time their marginal utilities from the last
dollar of income are equal (at a’ and b’), and any further income
redistribution beyond the $2500 already transferred would begin to create
inequality and decrease their combined utility.

The area under the MU curve and to the left of the individual’s particular
level of income represents the total utility (the sum of the marginal
utilities) of that income. Therefore, as a result of the transfer of the

$2500, Anderson has gained utility represented by the blue area below
curve MUA and Brooks has lost utility represented by the red area below

curve MUB. The blue area exceeds the red area, so income equality yields

greater combined total utility than does the initial income inequality.

The Case for Inequality: Incentives and
Efficiency
Although the logic of the argument for equality is sound, critics attack its
fundamental assumption that there is some fixed amount of output
produced and therefore income to be distributed. Critics of income
equality argue that the way in which income is distributed is an important
determinant of the amount of output or income that is produced and is
available for distribution.

Suppose once again in Figure 11.3 that Anderson earns $2500 and Brooks
earns $7500. In moving toward equality, society (the government) must
tax away some of Brooks’ income and transfer it to Anderson. This tax
and transfer process diminishes the income rewards of high-income
Brooks and raises the income rewards of low-income Anderson; in so
doing, it reduces the incentives of both to earn high incomes. Why should
high-income Brooks work hard, save and invest, or undertake
entrepreneurial risks when the rewards from such activities will be
reduced by taxation? And why should low-income Anderson be motivated
to increase his income through market activities when the government
stands ready to transfer income to him? Taxes are a reduction in the
rewards from increased productive effort; redistribution through transfers
is a reward for diminished effort.

In the extreme, imagine a situation in which the government levies a 100
percent tax on income and distributes the tax revenue equally to its
citizenry. Why would anyone work hard? Why would anyone work at all?
Why would anyone assume business risk? Or why would anyone save
(forgo current consumption) in order to invest? The economic incentives
to “get ahead” will have been removed, greatly reducing society’s total

production and income. That is, the way income is distributed affects the
size of that income. The basic argument for income inequality is that
inequality is essential to maintain incentives to produce output and income
—to get the output produced and income generated year after year.

The Equality-Efficiency Trade-Off
At the essence of the income equality-inequality debate is a fundamental
trade-off between equality and efficiency. In this equality-efficiency
trade-off, greater income equality (achieved through redistribution of
income) comes at the opportunity cost of reduced production and income.
And greater production and income (through reduced redistribution)
comes at the expense of less equality of income. The trade-off obligates
society to choose how much redistribution it wants, in view of the costs. If
society decides it wants to redistribute income, it needs to determine
methods that minimize the adverse effects on economic efficiency.

equality-efficiency trade-off

The decrease in economic efficiency that may accompany an increase in
income equality.

ILLUSTRATING THE IDEA: Slicing the
Pizza
The equality-efficiency trade-off might better be understood through an
analogy. Assume that society’s income is a huge pizza, baked year after
year, with the sizes of the pieces going to people on the basis of their
contribution to making it. Now suppose that for fairness reasons, society
decides some people are getting pieces that are too large and others are
getting pieces too small. But when society redistributes the pizza to make
the sizes more equal, they discover the result is a smaller pizza than
before. Why participate in making the pizza if you get a decent-size
piece without contributing?

The shrinkage of the pizza represents the efficiency loss—the loss of

output and income—caused by the harmful effects of the redistribution
on incentives to work, to save and invest, and to accept entrepreneurial
risk. The shrinkage also reflects the resources that society must divert to
the bureaucracies that administer the redistribution system.

How much pizza shrinkage will society accept while continuing to agree
to the redistribution? If redistributing pizza to make it less unequal
reduces the size of the pizza, what amount of pizza loss will society
tolerate? Is a loss of 10 percent acceptable? 25 percent? 75 percent? This
is the basic question in any debate over the ideal size of a nation’s
income redistribution program.

Question:

Why might “equality of opportunity” be a more realistic and
efficient goal than “equality of income outcome”?

The Economics of Poverty
We now turn from the broader issue of income distribution to the more
specific issue of very low income, or “poverty.” A society with a high
degree of income inequality can have a high, moderate, or low amount of
poverty. In fact, it could have no poverty at all. We therefore need a
separate examination of poverty.

Definition of Poverty
Poverty is a condition in which a person or family does not have the
means to satisfy basic needs for food, clothing, shelter, and transportation.
The means include currently earned income, transfer payments, past
savings, and property owned. The basic needs have many determinants,
including family size and the health and age of its members.

The Federal government has established minimum income thresholds
below which a person or a family is “in poverty.” In 2006 an unattached

individual receiving less than $9800 per year was said to be living in
poverty. For a family of four, the poverty line was $20,000; for a family
of six, it was $26,800. Based on these thresholds, in 2006 about 36.5
million Americans lived in poverty. In 2006 the poverty rate—the
percentage of the population living in poverty—was 12.3 percent.

poverty rate

The percentage of the population with incomes below the official
poverty income levels established by the Federal government.

Incidence of Poverty
The poor are heterogeneous: They can be found in all parts of the nation;
they are whites and nonwhites, rural and urban, young and old. But as
Figure 11.4 indicates, poverty is far from randomly distributed. For
example, the poverty rate for African Americans is above the national
average, as is the rate for Hispanics, while the rate for whites and Asians
is below the average. In 2006 the poverty rates for African Americans and
Hispanics were 24.3 and 20.6 percent, respectively; the rate for whites and
Asians, each was 10.3 percent.
FIGURE 11.4: Poverty rates among selected
population groups, 2006.

Poverty is disproportionately borne by African Americans, Hispanics,
children, foreign-born residents who are not citizens, and families
headed by women. People who are employed full-time or are married
tend to have low poverty rates.

Source: Bureau of the Census, www.census.gov.

Figure 11.4 shows that female-headed households, foreign-born
noncitizens, and children under 18 years of age have very high incidences
of poverty. Marriage and fulltime, year-round work are associated with
low poverty rates, and, because of the Social Security system, the
incidence of poverty among the elderly is less than that for the population
as a whole.

The high poverty rate for children is especially disturbing because poverty
tends to breed poverty. Poor children are at greater risk for a range of
long-term problems, including poor health and inadequate education,
crime, drug use, and teenage pregnancy. Many of today’s impoverished

children will reach adulthood unhealthy and illiterate and unable to earn
above-poverty incomes.

As many as half of people in poverty are poor for only 1 or 2 years before
climbing out of poverty. But poverty is much more long-lasting among
some groups than among others. In particular, African-American and
Hispanic families, families headed by women, persons with little
education and few labor market skills, and people who are dysfunctional
because of drug use, alcoholism, or mental illness are more likely than
others to remain in poverty. Also, long-lasting poverty is heavily present
in depressed areas of cities, parts of the Deep South, and some Indian
reservations.

Poverty Trends
As Figure 11.5 shows, the total poverty rate fell significantly between
1959 and 1969, stabilized at 11 to 13 percent over the next decade, and
then rose in the early 1980s. In 1993 the rate was 15.1 percent, the highest
since 1983. Between 1993 and 2000 the rate turned downward, falling to
11.3 percent in 2000. Because of recession and slow recovery, the rate
rose to 11.7 percent in 2001, 12.1 percent in 2002, and 12.5 percent in
2003. During the second half of the 1990s, poverty rates plunged for
African Americans, Hispanics, and Asians. Nevertheless, in 2006 African
Americans and Hispanics still had poverty rates that were roughly double
the rates for whites.
FIGURE 11.5: Poverty-rate trends, 1959–
2006.

Although the national poverty rate declined sharply between 1959 and
1969, it stabilized in the 1970s only to increase significantly in the
early 1980s. Between 1993 and 2000 it substantially declined, before
rising slightly again in the immediate years following the 2001
recession. Although poverty rates for African Americans and Hispanics
are much higher than the average, they significantly declined during
the 1990s.

Source: Bureau of the Census, www.census.gov.

Measurement Issues
The poverty rates and trends in Figures 11.4 and 11.5 need to be
interpreted cautiously. The official income thresholds for defining poverty
are necessarily arbitrary and therefore may inadequately measure the true
extent of poverty in the United States.

Some observers say that the high cost of living in major metropolitan
areas means that the official poverty thresholds exclude millions of
families whose income is slightly above the poverty level but clearly

inadequate to meet basic needs for food, housing, and medical care. These
observers use city-by-city studies on “minimal income needs” to show
there is much more poverty in the United States than is officially
measured and reported.

In contrast, some economists point out that using income to measure
poverty understates the standard of living of many of the people who are
officially poor. When individual, household, or family consumption is
considered rather than family income, some of the poverty in the United
States disappears. Some low-income families maintain their consumption
by drawing down past savings, borrowing against future income, or
selling homes. Moreover, many poverty families receive substantial
noncash benefits such as food stamps and rent subsidies that boost their
living standards. Such “in-kind” benefits are not included in determining a
family’s official poverty status.

The U.S. Income-Maintenance System
Regardless of how poverty is measured, economists agree that considerable
poverty exists in the United States. Helping those who have very low
income is a widely accepted goal of public policy. A wide array of
antipoverty programs, including education and training programs,
subsidized employment, minimum-wage laws, and antidiscrimination
policies, are designed to increase the earnings of the poor. In addition, there
are a number of income-maintenance programs devised to reduce poverty,
the most important of which are listed in Table 11.3. These programs
involve large expenditures and numerous beneficiaries.

TABLE 11.3: Characteristics of Major Income-
Maintenance Programs

The U.S. income-maintenance system consists of two kinds of programs:
(1) social insurance and (2) public assistance or “welfare.” Both are known
as entitlement programs because all eligible persons are assured (entitled
to) the benefits set forth in the programs.

entitlement programs

Government programs that guarantee particular levels of transfer
payments or noncash benefits to all who fit the programs’ critieria.

Social Insurance Programs
Social insurance programs partially replace earnings that have been lost
due to retirement, disability, or temporary unemployment; they also
provide health insurance for the elderly. The main social insurance
programs are Social Security, unemployment compensation, and

Medicare

. Benefits are viewed as earned rights and do not carry the stigma
of public charity. These programs are financed primarily out of Federal
payroll taxes. In these programs the entire population shares the risk of an
individual’s losing income because of retirement, unemployment,

disability, or illness. Workers (and employers) pay a part of their wages to
the government while they are working. The workers then receive benefits
when they retire or face specified misfortunes.

Social Security and Medicare
The major social insurance program known as Social Security replaces
earnings lost when workers retire, become disabled, or die. This gigantic
program ($594 billion in 2007) is financed by compulsory payroll taxes
levied on both employers and employees. Workers currently may retire
at age 65 and receive full retirement benefits or retire early at age 62
with reduced benefits. When a worker dies, benefits accrue to his or her
family survivors. Special provisions provide benefits for disabled
workers.

Social Security

A federal pension program (financed by payroll taxes on employers
and employees) that replaces part of the earnings lost when workers
retire, become disabled, or die.

Social Security covers over 90 percent of the workforce; some 50
million people receive Social Security benefits averaging about $1082
per month. In 2008, those benefits were financed with a combined Social
Security and Medicare payroll tax of 15.3 percent, with the worker and
the employer each paying 7.65 percent on the worker’s first $102,000 of
earnings. The 7.65 percent tax comprises 6.2 percent for Social Security
and 1.45 percent for Medicare. Self-employed workers pay the full 15.3
percent.

Medicare provides hospital insurance for the elderly and disabled and is
financed out of the payroll tax. This overall 2.9 percent tax is paid on all
work income, not just on the first $102,000. Medicare also makes
available a supplementary low-cost insurance program that helps pay
doctor fees.

Medicare

A federal insurance program (financed by payroll taxes on employers
and employees) that provides health insurance benefits to those 65 or
older.

The number of retirees drawing Social Security and Medicare benefits is
rapidly rising relative to the number of workers paying payroll taxes. As
a result, Social Security and Medicare face serious long-term funding
problems. These fiscal imbalances have spawned calls to reform the
programs.

Unemployment Compensation
All 50 states sponsor unemployment insurance programs called
unemployment compensation, a Federal-state program that makes
income available to unemployed workers. This insurance is financed by a
relatively small payroll tax, paid by employers, that varies by state and
by the size of the firm’s payroll. After a short waiting period, eligible
wage and salary workers who become unemployed can receive benefit
payments. The size of the payments varies from state to state. Generally,
benefits approximate 33 percent of a worker’s wages up to a certain
maximum weekly payment, and last for a maximum of 26 weeks. In
2007 benefits averaged about $277 weekly. During recessions—when
unemployment soars—Congress often provides supplemental funds to
the states to extend the benefits for additional weeks.

unemployment compensation

A federal-state social insurance program (financed by payroll taxes on
employers) that makes income available to workers who are
unemployed.

Public Assistance Programs
Public assistance programs (welfare) provide benefits for those who are
unable to earn income because of permanent disabilities or have no or

very low income and also have dependent children. These programs are
financed out of general tax revenues and are regarded as public charity.
They include “means tests,” which require that individuals and families
demonstrate low incomes in order to qualify for aid. The Federal
government finances about two-thirds of the welfare program
expenditures, and the rest is paid for by the states.

Many needy persons who do not qualify for social insurance programs are
assisted through the Federal government’s Supplemental Security
Income (SSI) program. The purpose of SSI is to establish a uniform,
nationwide minimum income for the aged, blind, and disabled who are
unable to work and who do not qualify for Social Security aid. Over half
the states provide additional income supplements to the aged, blind, and
disabled.

Supplemental Security Income (SSI)

A federal program (financed by general tax revenues) that provides a
uniform nationwide minimum income for the aged, blind, and disabled
who do not qualify for benefits under the Social Security program in the
United States.

The Temporary Assistance for Needy Families (TANF) is the basic
welfare program for low-income families in the United States. The
program is financed through general Federal tax revenues and consists of
lump-sum payments of Federal money to states to operate their own
welfare and work programs. These lump-sum payments are called TANF
funds, and in 2007 about 4 million people (including children) received
TANF assistance. TANF expenditures in 2007 were about $14 billion.

Temporary Assistance for Needy Families (TANF)

The basic welfare program (financed through general tax revenues) for
low-income families in the United States.

In 1996 TANF replaced the six-decade-old Aid for Families with
Dependent Children (AFDC) program. Unlike that welfare program,

TANF established work requirements and placed limits on the length of
time a family can receive welfare payments. Specifically, the TANF
program

• Set a lifetime limit of 5 years on receiving TANF benefits and
required able-bodied adults to work after receiving assistance for 2
years.

• Ended food-stamp eligibility for able-bodied persons age 18 to 50
(with no dependent children) who are not working or engaged in job-
training programs.

• Tightened the definition of “disabled children” as it applies for
eligibilty of low-income families for SSI assistance.

• Established a 5-year waiting period on public assistance for new
legal immigrants who have not become citizens.

In 1996 about 12.6 million people were welfare recipients, including
children, or 4.8 percent of the U.S. population. By the middle of 2007,
those totals had declined to 4.5 million and 2 percent of the population.
The program has greatly increased the employment rate (= employment/
population) for single mothers with children under age 6—a group
particularly prone to welfare dependency. Today, that rate is about 13
percentage points higher than it was in 1996.

The food-stamp program is designed to provide all low-income
Americans with a “nutritionally adequate diet.” Under the program,
eligible households receive monthly allotments of coupons that are
redeemable for food. The amount of food stamps received varies inversely
with a family’s earned income.

food-stamp program

A federal program (financed through general tax revenues) that permits
eligible low-income persons to obtain vouchers that are usable to buy
food.

Medicaid helps finance the medical expenses of individuals participating
in the SSI and the TANF programs.

Medicaid

A federal program (financed by general tax revenues) that provides
medical benefits to people covered by the Supplemental Security Income
(SSI) and Temporary Assistance for Needy Families (TANF) programs.

The earned-income tax credit (EITC) is a tax credit for low-income
working families, with or without children. The credit reduces the Federal
income taxes that such families owe or provides them with cash payments
if the credit exceeds their tax liabilities. The purpose of the credit is to
offset Social Security taxes paid by low-wage earners and thus keep the
Federal government from “taxing families into poverty.” In essence, EITC
is a wage subsidy from the Federal government that works out to be as
much as $2 per hour for the lowest-paid workers with families. Under the
program, many people owe no income tax and receive direct checks from
the Federal government once a year. According to the Internal Revenue
Service, 22 million taxpayers received $41 billion in payments from the
EITC in 2006.

earned-income tax credit (EITC)

A refundable federal tax credit provided to low-income wage earners to
supplement their families’ incomes and encourage work.

Several other welfare programs are not listed in Table 11.3. Most provide
help in the form of noncash transfers. Head Start provides education,
nutrition, and social services to economically disadvantaged 3- and 4-year-
olds. Housing assistance in the form of rent subsidies and funds for
construction is available to low-income families. Pell grants provide
assistance to college students from low-income families.
Photo Op: Social Insurance versus Public
Assistance Programs

© Royalty-Free/CORBIS

© Jack Star/PhotoLink/Getty Images

Beneficiaries of social insurance programs such as Social Security have
typically paid for at least a portion of that insurance through payroll
taxes. Food stamps and other public assistance are funded from general
tax revenue and are generally seen as public charity.

Summary
1. The distribution of income in the United States reflects
considerable inequality. The richest 20 percent of families receive 50.5
percent of total income, while the poorest 20 percent receive 3.4 percent.

2. The Lorenz curve shows the percentage of total income received
by each percentage of households. The extent of the gap between the
Lorenz curve and a line of total equality illustrates the degree of income

inequality.

3. The Gini ratio measures the overall dispersion of the income
distribution and is found by dividing the area between the diagonal and
the Lorenz curve by the entire area below the diagonal. The Gini ratio
ranges from zero to 1; higher ratios signify greater degrees of income
inequality.

4. Recognizing that the positions of individual families in the
distribution of income change over time and incorporating the effects of
noncash transfers and taxes would reveal less income inequality than do
standard census data. Government transfers (cash and noncash) greatly
lessen the degree of income inequality; taxes also reduce inequality, but
not by nearly as much as transfers.

5. Causes of income inequality include differences in abilities, in
education and training, and in job tastes, along with discrimination,
inequality in the distribution of wealth, and an unequal distribution of
market power.

6. Census data show that income inequality has increased
significantly since 1970. The major cause of recent increases in income
inequality is a rising demand for highly skilled workers, which has
boosted their earnings significantly.

7. The basic argument for income equality is that it maximizes
consumer satisfaction (total utility) from a particular level of total
income. The main argument for income inequality is that it provides the
incentives to work, invest, and assume risk and is necessary for the
production of output, which, in turn, creates income that is then
available for distribution.

8. Current statistics reveal that 12.3 percent of the U.S. population
lived in poverty in 2006. Poverty rates are particularly high for female-
headed families, young children, African Americans, and Hispanics.

9. The present income-maintenance program in the United States

consists of social insurance programs (Social Security, Medicare, and
unemployment compensation) and public assistance programs (SSI,
TANF, food stamps, Medicaid, and earned-income tax credit).

10. In 1996 Congress established the Temporary Assistance for Needy
Families (TANF) program, which shifted responsibility for welfare from
the Federal government to the states. Among its provisions are work
requirements for adults receiving welfare and a 5-year lifelong limit on
welfare benefits.

11. A generally strong economy and TANF have reduced the U.S.
welfare rolls by more than one-half since 1996.

Terms and Concepts
income inequality
Lorenz curve
Gini ratio
income mobility
noncash transfers
law of diminishing marginal utility
equality-efficiency trade-off
poverty rate
entitlement programs
Social Security
Medicare
unemployment compensation
Supplemental Security Income (SSI)
Temporary Assistance for Needy Families (TANF)
food-stamp program
Medicaid
earned-income tax credit (EITC)

Study Questions

1. Use quintiles to briefly summarize the degree of income inequality
in the United States. How and to what extent does government reduce
income inequality? LO1

2. Assume that Al, Beth, Carol, David, and Ed receive incomes of
$500, $250, $125, $75, and $50, respectively. Construct and interpret
a Lorenz curve for this five-person economy. What percentages of
total income are received by the richest quintile and by the poorest
quintile? LO1

3. How does the Gini ratio relate to the Lorenz curve? Why can’t the
Gini ratio exceed 1? What is implied about the direction of income
inequality if the Gini ratio declines from 0.42 to 0.35? How would
one show that change of inequality in the Lorenz diagram? LO1

4. Why is the lifetime distribution of income more equal than the
distribution in any specific year? LO2

5. Briefly discuss the major causes of income inequality. What
factors have contributed to greater income inequality since 1970?
LO2, 3

6. Should a nation’s income be distributed to its members according
to their contributions to the production of that total income or
according to the members’ needs? Should society attempt to equalize
income or economic opportunities? Are the issues of equity and
equality in the distribution of income synonymous? To what degree,
if any, is income inequality equitable? LO4

7. Comment on or explain: LO4

a. Endowing everyone with equal income will make for very
unequal enjoyment and satisfaction.

b. Equality is a “superior good”; the richer we become, the
more of it we can afford.

c. The mob goes in search of bread, and the means it employs
is generally to wreck the bakeries.

d. Some freedoms may be more important in the long run than
freedom from want on the part of every individual.

e. Capitalism and democracy are really a most improbable
mixture. Maybe that is why they need each other—to put some
rationality into equality and some humanity into efficiency.

f. The incentives created by the attempt to bring about a more
equal distribution of income are in conflict with the incentives
needed to generate increased income.

8. How do government statisticians determine the poverty rate? How
could the poverty rate fall while the number of people in poverty
rises? Which group in each of the following pairs has the higher
poverty rate: (a) children or people age 65 or over? (b) African
Americans or foreign-born noncitizens? (c) Asians or Hispanics?
LO5

9. What are the essential differences between social insurance and
public assistance programs? Why is Medicare a social insurance
program whereas Medicaid is a public assistance program? Why is the
earned-income tax credit considered to be a public assistance
program? LO6

10. Prior to the implementation of welfare reforms through the
Temporary Assistance for Needy Families (TANF) program, the old
system (AFDC) was believed to be creating dependency, robbing
individuals and family members of motivation and dignity. How did
this reform (TANF) try to address those criticisms? Do you agree
with the general thrust of the reform and with its emphasis on work
requirements and time limits on welfare benefits? Has the reform
reduced U.S. welfare rolls or increased them? LO6

FURTHER TEST YOUR KNOWLEDGE AT
www.mcconnellbriefmicro1e.com
Web-Based Questions
At the text’s Online Learning Center, www.mcconnellbriefmicro1e.com,
you will find a multiple-choice quiz on this chapter’s content. We
encourage you to take the quiz to see how you do. Also, you will find one
or more Web-based questions that require information from the Internet to
answer.

1 U.S. Census Bureau, Historical Income Tables, www.census.gov.
2 World Bank, World Development Indicators, 2007,
www.worldbank.org.
3 U.S. Department of the Treasury, Income Mobility in the U.S.
from 1996–2005, November 13, 2007, pp. 1–22.
4 The “before” data in this table differ from the data in Figure 11.1
because the latter include cash transfers. Also, the data in Figure 11.2 are
based on a broader concept of income than are the data in Figure 11.1.

(McConnell 243)

McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill
Learning Solutions, 2010. .

12: International Trade and

Exchange Rates

IN THIS CHAPTER YOU WILL LEARN:

1 Some key facts about U.S. international trade.

2 About comparative advantage, specialization, and international
trade.

3 How exchange rates are determined in currency markets.

4 The rebuttals to common arguments for protectionism.

5 The role played by free-trade zones and the World Trade
Organization (WTO) in promoting international trade.

Backpackers in the wilderness like to think they are “leaving the world
behind,” but, like Atlas, they carry the world on their shoulders. Much of
their equipment is imported—knives from Switzerland, rain gear from South
Korea, cameras from Japan, aluminum pots from England, sleeping bags
from China, and compasses from Finland. Moreover, they may have driven
to the trailheads in Japanese-made Toyotas or German-made BMWs, sipping
coffee from Brazil or snacking on bananas from Honduras.

International trade and the global economy affect all of us daily, whether we
are hiking in the wilderness, driving our cars, listening to music, or working
at our jobs. We cannot “leave the world behind.” We are enmeshed in a
global web of economic relationships—trading of goods and services,
multinational corporations, cooperative ventures among the world’s firms,
and ties among the world’s financial markets.

Trade Facts
The following facts provide an “executive summary” of U.S. international
trade:

• A trade deficit occurs when imports exceed exports. The United States
has a trade deficit in goods. In 2007, U.S. imports of goods exceeded U.S.
exports of goods by $816 billion.

• A trade surplus occurs when exports exceed imports. The United States
has a trade surplus in services (such as air transportation services and
financial services). In 2007, U.S. exports of services exceeded U.S.
imports of services by $107 billion.

• Principal U.S. exports include chemicals, agricultural products,

consumer durables, semiconductors, and aircraft; principal imports include
petroleum, automobiles, metals, household appliances, and computers.

• Canada is the United States’ most important trading partner
quantitatively. In 2007, 22 percent of U.S. exported goods were sold to
Canadians, who in turn provided 16 percent of the U.S. imports of goods.

• The United States has a sizable trade deficit with China. In 2007, U.S.
imports of goods from China exceeded exports of goods to China by $257
billion.

• The U.S. dependence on foreign oil is reflected in its trade with
members of OPEC. In 2007, the United States imported $174 billion of
goods (mainly oil) from OPEC members, while exporting $49 billion of
goods to those countries.

• The United States leads the world in the combined volume of exports
and imports, as measured in dollars. Germany, the United States, China,
Japan, and France are the top five exporters by dollar volume (see Global
Snapshot 12.1). Currently, the United States provides about nine percent
of the world’s exports.

GLOBAL SNAPSHOT 12.1:
Comparative Exports
Germany, the United States, and China are the world’s largest exporters.

Source: World Trade Organization, www.wto.org.

• Exports of goods and services make up about 10 percent of total U.S.
output. That percentage is much lower than the percentage in many other
nations, including Canada, Italy, France, and the United Kingdom (see
Global Snapshot 12.2).

• China has become a major international trader, with an estimated $1.2

trillion billion of exports in 2007. Other Asian economies—including
South Korea, Taiwan, and Singapore—are also active in international
trade. Their combined exports exceed those of France, Britain, or Italy.

• International trade and finance are often at the center of economic
policy.

With this information in mind, let’s look more closely at the economics of
international trade.

GLOBAL SNAPSHOT 12.2: Exports
of Goods and Services as a Percentage of GDP,
Selected Countries
Although the United States is the world’s second-largest exporter, it ranks
relatively low among trading nations in terms of exports as a percentage
of GDP.

Source: Derived from data in IMF, International Financial
Statistics, 2008.

Comparative Advantage and Specialization

Given the presence of an open economy—one that includes the international
sector—the United States produces more of certain goods (exports) and
fewer of other goods (imports) than it would otherwise. Thus U.S. labor
and other resources are shifted toward export industries and away from
import industries. For example, the United States uses more resources to
make computers and to grow wheat and less to make sporting goods and
clothing. So we ask: “Do shifts of resources like these make economic
sense? Do they enhance U.S. total output and thus the U.S. standard of
living?”

The answers are affirmative. Specialization and international trade increase
the productivity of a nation’s resources and allow for greater total output
than would otherwise be possible. This idea is not new. Adam Smith had
this to say in 1776:

It is the maxim of every prudent master of a family, never to attempt to
make at home what it will cost him more to make than to buy. The taylor
does not attempt to make his own shoes, but buys them of the shoemaker.
The shoemaker does not attempt to make his own clothes, but employs a
taylor. The farmer attempts to make neither the one nor the other, but
employs those different artificers. …

What is prudence in the conduct of every private family, can scarce be
folly in that of a great kingdom. If a foreign country can supply us with a
commodity cheaper than we can make it, better buy it of them with some
part of the produce of our own industry, employed in a way in which we

have some advantage.1

Nations specialize and trade for the same reasons that individuals do:
Specialization and exchange result in greater overall output and income. In
the early 1800s British economist David Ricardo expanded on Smith’s idea
by observing that it pays for a person or a country to specialize and trade
even if a nation is more productive than a potential trading partner in all
economic activities. We demonstrate Ricardo’s principle in the examples
that follow.

ILLUSTRATING THE IDEA: A CPA and a
House Painter
Consider the certified public accountant (CPA) who is also a skilled house
painter. Suppose the CPA is a swifter painter than the professional painter
she is thinking of hiring. Also suppose that she can earn $50 per hour as
an accountant but would have to pay the painter $15 per hour. And say it
would take the accountant 30 hours to paint her house but the painter
would take 40 hours.

Should the CPA take time from her accounting to paint her own house, or
should she hire the painter? The CPA’s opportunity cost of painting her
house is $1500 (=30 hours of sacrificed CPA time × $50 per CPA hour).
The cost of hiring the painter is only $600 (=40 hours of painting × $15
per hour of painting). Although the CPA is better at both accounting and
painting, she will get her house painted at lower cost by specializing in
accounting and using some of her earnings from accounting to hire a
house painter.

Similarly, the house painter can reduce his cost of obtaining accounting
services by specializing in painting and using some of his income to hire
the CPA to prepare his income tax forms. Suppose it would take the
painter 10 hours to prepare his tax return, while the CPA could handle the
task in 2 hours. The house painter would sacrifice $150 of income (=10
hours of painting time × $15 per hour) to do something he could hire the
CPA to do for $100 (=2 hours of CPA time × $50 per CPA hour). By
using the CPA to prepare his tax return, the painter lowers the cost of
getting his tax return prepared.

What is true for our CPA and house painter is also true for nations.
Specializing enables nations to reduce the cost of obtaining the goods and
services they desire.

Question:

How might the specialization described above change once the CPA
retires? What generalization about the permanency of a particular
pattern of specialization can you draw from your answer?

Comparative Advantage: Production Possibilities
Analysis
Our simple example shows that the reason specialization is economically
desirable is that it results in more efficient production. Now let’s put
specialization into the context of trading nations and use the familiar
concept of the production possibilities table for our analysis.

Assumptions and Comparative Costs
Suppose the production possibilities for one product in Mexico and for
one product in the United States are as shown in Tables 12.1 and 12.2.
Both tables reflect constant costs. Each country must give up a constant
amount of one product to secure a certain increment of the other
product. (This assumption simplifies our discussion without impairing
the validity of our conclusions. Later we will allow for increasing costs.)

TABLE 12.1: Mexico’s Production
Possibilities Table (in Tons)

TABLE 12.2: U.S. Production Possib ilities
Table (in Tons)

Also for simplicity, suppose that the labor forces in the United States
and Mexico are of equal size. The data then tell us that the United States
has an absolute advantage in producing both products. If the United
States and Mexico use their entire (equalsize) labor forces to produce
avocados, the United States can produce 90 tons compared with Mexico’s
60 tons. Similarly, the United States can produce 30 tons of soybeans
compared to Mexico’s 15 tons. There are greater production possibilities
in the United States, using the same number of workers as in Mexico. So
labor productivity (output per worker) in the United States exceeds that
in Mexico in producing both products.

Although the United States has an absolute advantage in producing both
goods, gains from specialization and trade are possible. Specialization
and trade are mutually beneficial or “profitable” to the two nations if the
comparative costs of producing the two products within the two nations
differ. What are the comparative costs of avocados and soybeans in
Mexico? By comparing production alternatives A and B in Table 12.1,
we see that Mexico must sacrifice 5 tons of soybeans (=15 − 10) to
produce 20 tons of avocados (=20 − 0). Or, more simply, in Mexico it
costs 1 ton of soybeans (S) to produce 4 tons of avocados (A); that is, 1S
≡ 4A. (The “≡” sign simply means “equivalent to.”) Because we assumed
constant costs, this domestic opportunity cost will not change as Mexico
expands the output of either product. This is evident from production
possibilities B and C, where we see that 4 more tons of avocados (=24 −
20) cost 1 unit of soybeans (=10 − 9).

Similarly, in Table 12.2, comparing U.S. production alternatives R and
S reveals that in the United States it costs 10 tons of soybeans (=30 −
20) to obtain 30 tons of avocados (=30 − 0). That is, the domestic

(internal) comparative-cost ratio for the two products in the United
States is 1S ≡ 3A. Comparing production alternatives S and T reinforces
this conclusion: an extra 3 tons of avocados (=33 − 30) comes at the
sacrifice of 1 ton of soybeans (=20 − 19).

The comparative costs of the two products within the two nations are
obviously different. Economists say that the United States has a
comparative advantage over Mexico in soybeans. The United States
must forgo only 3 tons of avocados to get 1 ton of soybeans, but Mexico
must forgo 4 tons of avocados to get 1 ton of soybeans. In terms of
opportunity costs, soybeans are relatively cheaper in the United States. A
nation has a comparative advantage in some product when it can
produce that product at a lower opportunity cost than can a potential
trading partner. Mexico, in contrast, has a comparative advantage in

avocados. While 1 ton of avocados costs ton of soybeans in the United

States, it costs only ton of soybeans in Mexico. Comparatively
speaking, avocados are cheaper in Mexico. We summarize the situation
in Table 12.3. Be sure to give it a close look.

comparative advantage

A lower relative or comparative opportunity cost than that of another
person, producer, or country.

TABLE 12.3: Comparative-Advantage
Example: A Summary

ORIGIN OF THE IDEA

O 12.1

Absolute and comparative advantage

Because of these differences in comparative costs, Mexico should
produce avocados and the United States should produce soybeans. If
both nations specialize according to their comparative advantages, each
can achieve a larger total output with the same total input of resources.
Together they will be using their scarce resources more efficiently.

Terms of Trade
The United States can shift production between soybeans and avocados
at the rate of 1S for 3A. Thus, the United States would specialize in
soybeans only if it could obtain more than 3 tons of avocados for 1 ton
of soybeans by trading with Mexico. Similarly, Mexico can shift
production at the rate of 4A for 1S. So it would be advantageous to
Mexico to specialize in avocados if it could get 1 ton of soybeans for less
than 4 tons of avocados.

Suppose that through negotiation the two nations agree on an exchange

rate of 1 ton of soybeans for tons of avocados. These terms of
trade are mutually beneficial to both countries, since each can “do

better” through such trade than through domestic production alone. The

United States can get tons of avocados by sending 1 ton of soybeans
to Mexico, while it can get only 3 tons of avocados by shifting its own
resources domestically from soybeans to avocados. Mexico can obtain 1

ton of soybeans at a lower cost of tons of avocados through trade
with the United States, compared to the cost of 4 tons if Mexico
produced the 1 ton of soybeans itself.

terms of trade

The rate at which units of one product can be exchanged for units of
another product.

Gains from Specialization and Trade
Let’s pinpoint the gains in total output from specialization and trade.
Suppose that, before specialization and trade, production alternative C in
Table 12.1 and alternative T in Table 12.2 were the optimal product
mixes for the two countries. That is, Mexico preferred 24 tons of
avocados and 9 tons of soybeans (Table 12.1) and the United States
preferred 33 tons of avocados and 19 tons of soybeans (Table 12.2) to
all other available domestic alternatives. These outputs are shown in
column 1 in Table 12.4.

TABLE 12.4: Specialization According to
Comparative Advantage and the Gains from
Trade (in Tons)

Now assume that both nations specialize according to their comparative
advantages, with Mexico producing 60 tons of avocados and no soybeans
(alternative E) and the United States producing no avocados and 30 tons
of soybeans (alternative R). These outputs are shown in column 2 in

Table 12.4. Using our 1S ≡ A terms of trade, assume that Mexico
exchanges 35 tons of avocados for 10 tons of U.S. soybeans. Column 3
in Table 12.4 shows the quantities exchanged in this trade, with a minus
sign indicating exports and a plus sign indicating imports. As shown in
column 4, after the trade Mexico has 25 tons of avocados and 10 tons of
soybeans, while the United States has 35 tons of avocados and 20 tons of
soybeans. Compared with their optimal product mixes before
specialization and trade (column 1), both nations now enjoy more
avocados and more soybeans! Specifically, Mexico has gained 1 ton of
avocados and 1 ton of soybeans. The United States has gained 2 tons of
avocados and 1 ton of soybeans. These gains are shown in column 5.

Specialization based on comparative advantage improves global resource
allocation. The same total inputs of world resources and technology
result in a larger global output. If Mexico and the United States allocate
all their resources to avocados and soybeans, respectively, the same total
inputs of resources can produce more output between them, indicating
that resources are being allocated more efficiently.

WORKED PROBLEMS

W 12.1

Gains from specialization

Through specialization and international trade a nation can overcome the
production constraints imposed by its domestic production possibilities
table and curve. Our discussion of Tables 12.1, 12.2, and 12.4 has
shown just how this is done. The domestic production possibilities data
(Tables 12.1 and 12.2) of the two countries have not changed, meaning
that neither nation’s production possibilities curve has shifted. But

specialization and trade mean that citizens of both countries can enjoy
increased consumption (column 5 of Table 12.4).

Trade with Increasing Costs
To explain the basic principles underlying international trade, we
simplified our analysis in several ways. For example, we limited
discussion to two products and two nations. But multiproduct and
multinational analysis yields the same conclusions. We also assumed
constant opportunity costs, which is a more substantive simplification.
Let’s consider the effect of allowing increasing opportunity costs to enter
the picture.

As before, suppose that comparative advantage indicates that the United
States should specialize in soybeans and Mexico in avocados. But now, as
the United States begins to expand soybean production, its cost of
soybeans will rise. It will eventually have to sacrifice more than 3 tons of
avocados to get 1 additional ton of soybeans. Resources are no longer
perfectly substitutable between alternative uses, as our constant-cost
assumption implied. Resources less and less suitable to soybean production
must be allocated to the U.S. soybean industry in expanding soybean
output, and that means increasing costs—the sacrifice of larger and larger
amounts of avocados for each additional ton of soybeans.

Photo Op: The Fruits of Free Trade*

© Getty Images

Because of specialization and exchange, fruits from all over the world
appear in our grocery stores. For example, apples may be from New
Zealand; bananas, from Ecuador; coconuts, from the Philippines;
pineapples, from Costa Rica; raspberries, from Mexico; plums, from
Chile; and grapes, from Peru.

* This example is from “The Fruits of Free Trade,” Federal
Reserve Bank of Dallas, Annual Report 2002, p. 3.

Similarly, Mexico will find that its cost of producing an additional ton of
avocados will rise beyond 4 tons of soybeans as it produces more
avocados. Resources transferred from soybean to avocado production will
eventually be less suitable to avocado production.

At some point the differing domestic cost ratios that underlie comparative
advantage will disappear, and further specialization will become
uneconomical. And, most importantly, this point of equal cost ratios may
be reached while the United States is still producing some avocados along

with its soybeans and Mexico is producing some soybeans along with its
avocados. The primary effect of increasing opportunity costs is less-than-
complete specialization. For this reason we often find domestically
produced products competing directly against identical or similar imported
products within a particular economy.

The Foreign Exchange Market
Buyers and sellers (whether individuals, firms, or nations) use money to buy
products or to pay for the use of resources. Within the domestic economy,
prices are stated in terms of the domestic currency and buyers use that
currency to purchase domestic products. In Mexico, for example, buyers
have pesos, and that is what sellers want.

International markets are different. Sellers set their prices in terms of their
domestic currencies, but buyers often possess entirely different currencies.
How many dollars does it take to buy a truckload of Mexican avocados
selling for 3000 pesos, a German automobile selling for 50,000 euros, or a
Japanese motorcycle priced at 300,000 yen? Producers in Mexico,
Germany, and Japan want payment in pesos, euros, and yen, respectively, so
that they can pay their wages, rent, interest, dividends, and taxes.

A foreign exchange market, a market in which various national currencies
are exchanged for one another, serves this need. The equilibrium prices in
such currency markets are called exchange rates. An exchange rate is the
rate at which the currency of one nation can be exchanged for the currency
of another nation. (See Global Snapshot 12.3.)

foreign exchange market

A market in which foreign currencies are exchanged and relative currency
prices are established.

exchange rates

The rates at which national currencies trade for one another.

GLOBAL SNAPSHOT 12.3:
Exchange Rates: Foreign Currency per U.S.
Dollar
The amount of foreign currency that a dollar will buy varies greatly from
nation to nation and fluctuates in response to supply and demand changes
in the foreign exchange market. The amounts shown here are for March
2008.

Photo Op: Foreign Currencies

© PhotoLink/Getty Images/DIL

The world is awash with hundreds of national currencies. Currency
markets determine the rates of exchange between them.

The market price or exchange rate of a nation’s currency is an unusual
price; it links all domestic prices with all foreign prices. Exchange rates
enable consumers in one country to translate prices of foreign goods into
units of their own currency: They need only multiply the foreign product
price by the exchange rate. If the U.S. dollar–yen exchange rate is $.01 (1
cent) per yen, a Sony television set priced at ¥20,000 will cost $200
(=20,000 × $.01) in the United States. If the exchange rate rises to $.02 (2
cents) per yen, the television will cost $400 (=20,000 × $.02) in the United
States. Similarly, all other Japanese products would double in price to U.S.
buyers in response to the altered exchange rate.

Exchange Rates
INTERACTIVE GRAPHS

G 12.1

Exchange rates

Let’s examine the rate, or price, at which U.S. dollars might be exchanged
for British pounds. In Figure 12.1 we show the dollar price of 1 pound on
the vertical axis and the quantity of pounds on the horizontal axis. The
demand for pounds is D1 and the supply of pounds is S1 in this market for

British pounds.
FIGURE 12.1: The market for foreign
currency (pounds)

The intersection of the demand-for-pounds curve D1 and the supply-

of-pounds curve S1 determines the equilibrium dollar price of pounds,

here, $2. That means that the exchange rate is $2 = £1. The upward
blue arrow is a reminder that a higher dollar price of pounds (say, $3 =
£1, caused by a shift in either the demand or the supply curve) means
that the dollar has depreciated (the pound has appreciated). The
downward blue arrow tells us that a lower dollar price of pounds (say,
$1 = £1, again caused by a shift in either the demand or the supply
curve) means that the dollar has appreciated (the pound has
depreciated).

The demand-for-pounds curve is downward-sloping because all British
goods and services will be cheaper to the United States if pounds become
less expensive to the United States. That is, at lower dollar prices for
pounds, the United States can obtain more pounds for each dollar and
therefore buy more British goods and services per dollar. To buy those
cheaper British goods, U.S. consumers will increase the quantity of
pounds they demand.

The supply-of-pounds curve slopes upward because the British will
purchase more U.S. goods when the dollar price of pounds rises (that is,
as the pound price of dollars falls). When the British buy more U.S.
goods, they supply a greater quantity of pounds to the foreign exchange
market. In other words, they must exchange pounds for dollars to
purchase U.S. goods. So, when the dollar price of pounds rises, the
quantity of pounds supplied goes up.

The intersection of the supply curve and the demand curve will determine
the dollar price of pounds. In Figure 12.1, that price (exchange rate) is $2
for £1.

Depreciation and Appreciation
An exchange rate determined by market forces can, and often does,
change daily like stock and bond prices. These price changes result from
changes in the supply of, or demand for, a particular currency. When the
dollar price of pounds rises, for example, from $2 = £1 to $3 = £1, the

dollar has depreciated relative to the pound (and the pound has
appreciated relative to the dollar). A depreciation of a currency means
that more units of it (dollars) are needed to buy a single unit of some
other currency (a pound).

depreciation (of a currency)

A decrease in the value of a currency relative to another currency.

When the dollar price of pounds falls, for example, from $2 = £1 to $1 =
£1, the dollar has appreciated relative to the pound. An appreciation of a
currency means that it takes fewer units of it (dollars) to buy a single unit
of some other currency (a pound). For example, the dollar price of pounds
might decline from $2 to $1. Each British product becomes less expensive
in terms of dollars, so people in the United States purchase more British
goods. In general, U.S. imports from the United Kingdom rise.
Meanwhile, because it takes more pounds to get a dollar, U.S. exports to
the United Kingdom fall.

appreciation (of a currency)

An increase in the value of a currency relative to another currency.

The central point is this: When the dollar depreciates (dollar price of
foreign currencies rises), U.S. exports rise and U.S. imports fall; when the
dollar appreciates (dollar price of foreign currencies falls), U.S. exports
fall and U.S. imports rise.

In our U.S.-Britain illustrations, depreciation of the dollar means an
appreciation of the pound, and vice versa. When the dollar price of a
pound jumps from $2 = £1 to $3 = £1, the pound has appreciated relative
to the dollar because it takes fewer pounds to buy $1. At $2 = £1, it took
£1/2 to buy $1; at $3 = £1, it takes only £1/3 to buy $1. Conversely, when
the dollar appreciates relative to the pound, the pound depreciates relative
to the dollar. More pounds are needed to buy a U.S. dollar.

Determinants of Exchange Rates

What factors would cause a nation’s currency to appreciate or depreciate in
the market for foreign exchange? Here are three generalizations (other
things equal):

• If the demand for a nation’s currency increases, that currency will
appreciate; if the demand declines, that currency will depreciate.

• If the supply of a nation’s currency increases, that currency will
depreciate; if the supply decreases, that currency will appreciate.

• If a nation’s currency appreciates, some foreign currency
depreciates relative to it.

With these generalizations in mind, let’s examine the determinants of
exchange rates—the factors that shift the demand or supply curve for a
certain currency. As we do so, keep in mind that the other-things-equal
assumption is always in force. Also note that we are discussing factors that
change the exchange rate, not things that change as a result of a change in
the exchange rate.

Tastes
Any change in consumer tastes or preferences for the products of a
foreign country may alter the demand for that nation’s currency and
change its exchange rate. If technological advances in U.S. MP3 players
make them more attractive to British consumers and businesses, then the
British will supply more pounds in the exchange market in order to
purchase more U.S. MP3 players. The supply-of-pounds curve will shift
to the right, causing the pound to depreciate and the dollar to appreciate.

In contrast, the U.S. demand-for-pounds curve will shift to the right if
British woolen apparel becomes more fashionable in the United States.
So the pound will appreciate and the dollar will depreciate.

Relative Income

A nation’s currency is likely to depreciate if its growth of national
income is more rapid than that of other countries. Here’s why: A
country’s imports vary directly with its income level. As total income
rises in the United States, people there buy both more domestic goods
and more foreign goods. If the U.S. economy is expanding rapidly and
the British economy is stagnant, U.S. imports of British goods, and
therefore U.S. demands for pounds, will increase. The dollar price of
pounds will rise, so the dollar will depreciate.

Relative Price Levels
Changes in the relative price levels of two nations may change the
demand for and supply of currencies and alter the exchange rate between
the two nations’ currencies. If, for example, the domestic price level
rises rapidly in the United States and remains constant in Great Britain,
U.S. consumers will seek out lowpriced British goods, increasing the
demand for pounds. The British will purchase fewer U.S. goods,
reducing the supply of pounds. This combination of demand and supply
changes will cause the pound to appreciate and the dollar to depreciate.

Relative Interest Rates
Changes in relative interest rates between two countries may alter their
exchange rate. Suppose that real interest rates rise in the United States
but stay constant in Great Britain. British citizens will then find the
United States a more attractive place in which to loan money directly or
loan money indirectly by buying bonds. To make these loans, they will
have to supply pounds in the foreign exchange market to obtain dollars.
The increase in the supply of pounds results in depreciation of the pound
and appreciation of the dollar.

Changes in Relative Expected Returns on
Stocks, Real Estate, and Production Facilities
International investing extends beyond buying foreign bonds. It includes

international investments in stocks and real estate as well as foreign
purchases of factories and production facilities. Other things equal, the
extent of this foreign investment depends on relative expected returns.
To make the investments, investors in one country must sell their
currencies to purchase the foreign currencies needed for the foreign
investments.

For instance, suppose that investing in England suddenly becomes more
popular due to a more positive outlook regarding expected returns on
stocks, real estate, and production facilities there. U.S. investors
therefore will sell U.S. assets to buy more assets in England. The U.S.
assets will be sold for dollars, which will then be brought to the foreign
exchange market and exchanged for pounds, which will in turn be used
to purchase British assets. The increased demand for pounds in the
foreign exchange market will cause the pound to appreciate and the
dollar to depreciate.

Speculation
Currency speculators are people who buy and sell currencies with an eye
toward reselling or repurchasing them at a profit. Suppose that, as a
group, speculators anticipate that the pound will appreciate and the
dollar will depreciate. Speculators holding dollars will therefore try to
convert them into pounds. This effort will increase the demand for
pounds and cause the dollar price of pounds to rise (that is, cause the
dollar to depreciate). A self-fulfilling prophecy occurs: The pound
appreciates and the dollar depreciates because speculators act on the
belief that these changes will in fact take place. In this way, speculation
can cause changes in exchange rates.

Government and Trade
If people and nations benefit from specialization and international exchange,
why do governments sometimes try to restrict the free flow of imports or
encourage exports? What kinds of world trade barriers can governments

erect, and why would they do so?

Trade Protections and Subsidies
Trade interventions by government take several forms. Excise taxes on
imported goods are called tariffs. A protective tariff is designed to shield
domestic producers from foreign competition. Such tariffs impede free
trade by causing a rise in the prices of imported goods, thereby shifting
demand toward domestic products. An excise tax on imported shoes, for
example, would make domestically produced shoes more attractive to
consumers. Although protective tariffs are usually not high enough to stop
the importation of foreign goods, they put foreign producers at a
competitive disadvantage in selling in domestic markets.

tariffs

Taxes imposed by a nation on imported goods.

Import quotas are limits on the quantities or total value of specific items
that may be imported. Once a quota is “filled,” further imports of that
product are choked off. Import quotas are more effective than tariffs in
retarding international commerce. With a tariff, a product can go on being
imported in large quantities; with an import quota, however, all imports
are prohibited once the quota is filled.

import quotas

Limits imposed by nations on the quantities (or total values) of goods
that may be imported during some period of time.

Nontariff barriers (NTBs) include onerous licensing requirements,
unreasonable standards pertaining to product quality, or excessive
bureaucratic hurdles and delays in customs procedures. Some nations
require that importers of foreign goods obtain licenses. By restricting the
issuance of licenses, imports can be restricted. Although many nations
carefully inspect imported agricultural products to prevent the
introduction of potentially harmful insects, some countries use lengthy

inspections to impede imports.

nontariff barriers (NTBs)

All impediments other than protective tariffs that nations establish to
impede imports, including import quotas, licensing requirements,
unreasonable productquality standards, and unnecessary bureaucratic
detail in customs procedures.

A voluntary export restriction (VER) is a trade barrier by which foreign
firms “voluntarily” limit the amount of their exports to a particular
country. Exporters agree to a VER, which has the effect of an import
quota, to avoid more stringent trade barriers. In the late 1990s, for
example, Canadian producers of softwood lumber (fir, spruce, cedar, pine)
agreed to a VER on exports to the United States under the threat of a
permanently higher U.S. tariff.

voluntary export restriction (VER)

An agreement by countries or foreign firms to limit their exports to a
certain foreign nation to avoid enactment of formal trade barriers by that
nation.

Export subsidies consist of government payments to domestic producers
of export goods. By reducing production costs, the subsidies enable
producers to charge lower prices and thus to sell more exports in world
markets. Example: The United States and other nations have subsidized
domestic farmers to boost the domestic food supply. Such subsidies have
lowered the market price of agricultural commodities and have artificially
lowered their export prices.

export subsidies

Government payments to domestic producers to enable them to reduce
the price of a product to foreign buyers.

Economic Impact of Tariffs

Tariffs, quotas, and other trade restrictions have a series of economic
effects predicted by supply and demand analysis and observed in reality.
These effects vary somewhat by type of trade protection. So to keep
things simple, we will focus on the effects of tariffs.

Direct Effects

ORIGIN OF THE IDEA

O 2.2

Mercantilism

Because tariffs raise the price of goods imported to the United States,
U.S. consumption of those goods declines. Higher prices reduce quantity
demanded, as indicated by the law of demand. A tariff prompts
consumers to buy fewer of the imported goods and reallocate a portion
of their expenditures to less desired substitute products. U.S. consumers
are clearly injured by the tariff.

U.S. producers—who are not subject to the tariff—receive the higher
price (pretariff foreign price + tariff) on the imported product. Because
this new price is higher than before, the domestic producers respond by
producing more. Higher prices increase quantity supplied, as indicated
by the law of supply. So domestic producers increase their output. They
therefore enjoy both a higher price and expanded sales; this explains why
domestic producers lobby for protective tariffs. But from a social point
of view, the greater domestic production means the tariff allows
domestic producers to bid resources away from other, more efficient,
U.S. industries.

Foreign producers are hurt by tariffs. Although the sales price of the
imported good is higher, that higher amount accrues to the U.S.
government as tariff revenues, not to foreign producers. The after-tariff
price, or the per-unit revenue to foreign producers, remains as before,
but the volume of U.S. imports (foreign exports) falls.

Government gains revenue from tariffs. This revenue is a transfer of
income from consumers to government and does not represent any net
change in the nation’s economic well-being. The result is that
government gains a portion of what consumers lose by paying more for
imported goods.

Indirect Effects
Tariffs have a subtle effect beyond those just mentioned. They also hurt
domestic firms that use the protected goods as inputs in their production
process. For example, a tariff on imported steel boosts the price of steel
girders, thus hurting firms that build bridges and office towers. Also,
tariffs reduce competition in the protected industries. With less
competition from foreign producers, domestic firms may be slow to
design and implement cost-saving production methods and introduce
new products.

Because foreigners sell fewer imported goods in the United States, they
earn fewer dollars and so must buy fewer U.S. exports. U.S. export
industries must then cut production and release resources. These are
highly efficient industries, as we know from their comparative advantage
and their ability to sell goods in world markets.

Tariffs directly promote the expansion of inefficient industries that do
not have a comparative advantage; they also indirectly cause the
contraction of relatively efficient industries that do have a comparative
advantage. Put bluntly, tariffs cause resources to be shifted in the wrong
direction—and that is not surprising. We know that specialization and
world trade lead to more efficient use of world resources and greater
world output. But protective tariffs reduce world trade. Therefore,
tariffs also reduce efficiency and the world’s real output.

Net Costs of Tariffs
Tariffs impose costs on domestic consumers but provide gains to domestic

producers and revenue to the Federal government. The consumer costs of
trade restrictions are calculated by determining the effect the restrictions
have on consumer prices. Protection raises the price of a product in three
ways: (1) The price of the imported product goes up; (2) the higher price
of imports causes some consumers to shift their purchases to higher-priced
domestically produced goods; and (3) the prices of domestically produced
goods rise because import competition has declined.

Study after study finds that the costs to consumers substantially exceed the
gains to producers and government. A sizable net cost or efficiency loss to
society arises from trade protection. Furthermore, industries employ large
amounts of economic resources to influence Congress to pass and retain
protectionist laws. Because these efforts divert resources away from more
socially desirable purposes, trade restrictions also impose that cost on
society.

Conclusion: The gains that U.S. trade barriers produce for protected
industries and their workers come at the expense of much greater losses
for the entire economy. The result is economic inefficiency, reduced
consumption, and lower standards of living.

So Why Government Trade Protections?
In view of the benefits of free trade, what accounts for the impulse to
impede imports and boost exports through government policy? There are
several reasons—some legitimate, most not.

Misunderstanding the Gains from Trade
It is a commonly accepted myth that the greatest benefit to be derived
from international trade is greater domestic sales and employment in the
export sector. This suggests that exports are “good” because they
increase domestic sales and employment, whereas imports are “bad”
because they reduce domestic sales and deprive people of jobs at home.
Actually, the true benefit created by international trade is the extra
output obtained from abroad—the imports obtained for a lower

opportunity cost than if they were produced at home.

A recent study suggests that the elimination of trade barriers since the
Second World War has increased the income of the average U.S.
household by at least $7000 and perhaps by as much as $13,000. These

income gains are recurring; they happen year after year.2

Political Considerations
While a nation as a whole gains from trade, trade may harm particular
domestic industries and particular groups of resource suppliers. In our
earlier comparative-advantage example, specialization and trade
adversely affected the U.S. avocado industry and the Mexican soybean
industry. Understandably, those industries might seek to preserve their
economic positions by persuading their respective governments to
protect them from imports—perhaps through tariffs.

Those who directly benefit from import protection are relatively few in
number but have much at stake. Thus, they have a strong incentive to
pursue political activity to achieve their aims. Moreover, because the
costs of import protection are buried in the price of goods and spread out
over millions of citizens, the cost borne by each individual citizen is
quite small. However, the full cost of tariffs and quotas typically greatly
exceeds the benefits. It is not uncommon to find that it costs the public
$250,000 or more a year to protect a domestic job that pays less than
onefourth that amount.

In the political arena, the voice of the relatively few producers and
unions demanding protectionism is loud and constant, whereas the voice
of those footing the bill is soft or nonexistent. When political deal
making is added in—“You back tariffs for the apparel industry in my
state, and I’ll back tariffs for the steel industry in your state”—the
outcome can be a network of protective tariffs.

ILLUSTRATING THE IDEA: Buy

American?
Will “buying American” make Americans better off? No, says Dallas
Federal Reserve economist W. Michael Cox:

A common myth is that it is better for Americans to spend their
money at home than abroad. The best way to expose the fallacy of
this argument is to take it to its logical extreme. If it is better for me
to spend my money here than abroad, then it is even better yet to buy
in Texas than in New York, better yet to buy in Dallas than in
Houston … in my own neighborhood … within my own family … to

consume only what I can produce. Alone and poor.*

* “The Fruits of Free Trade,” Federal Reserve Bank of Dallas,
Annual Report 2002, p. 16.

Three Arguments for Protection
Arguments for trade protection are many and diverse. Some—such as tariffs
to protect “infant industries” or to create “military self-sufficiency”—have
some legitimacy. But other arguments break down under close scrutiny.
Three protectionist arguments, in particular, have persisted decade after
decade in the United States.

Increased Domestic Employment Argument
Arguing for a tariff to “save U.S. jobs” becomes fashionable when the
economy encounters a recession or experiences slow job growth during a
recovery (as in the early 2000s in the United States). In an economy that
engages in international trade, exports involve spending on domestic
output and imports reflect spending to obtain part of another nation’s
output. So, in this argument, reducing imports will divert spending on
another nation’s output to spending on domestic output. Thus domestic
output and employment will rise. But this argument has several
shortcomings.

While imports may eliminate some U.S. jobs, they create others. Imports
may have eliminated the jobs of some U.S. steel and textile workers in
recent years, but other workers have gained jobs unloading ships, flying
imported aircraft, and selling imported electronic equipment. Import
restrictions alter the composition of employment, but they may have little
or no effect on the volume of employment.

The fallacy of composition—the false idea that what is true for the part is
necessarily true for the whole—is also present in this rationale for tariffs.
All nations cannot simultaneously succeed in restricting imports while
maintaining their exports; what is true for one nation is not true for all
nations. The exports of one nation must be the imports of another nation.
To the extent that one country is able to expand its economy through an
excess of exports over imports, the resulting excess of imports over
exports worsens another economy’s unemployment problem. It is no
wonder that tariffs and import quotas meant to achieve domestic full
employment are called “beggar my neighbor” policies: They achieve
short-run domestic goals by making trading partners poorer.

Moreover, nations adversely affected by tariffs and quotas are likely to
retaliate, causing a “trade-barrier war” that will choke off trade and make
all nations worse off. The Smoot-Hawley Tariff Act of 1930 is a classic
example. Although that act was meant to reduce imports and stimulate
U.S. production, the high tariffs it authorized prompted adversely affected
nations to retaliate with tariffs equally high. International trade fell,
lowering the output and income of all nations. Economic historians
generally agree that the Smoot-Hawley Tariff Act was a contributing
cause of the Great Depression.

Smoot-Hawley Tariff Act

Legislation passed in 1930 that established very high U.S. tariffs
designed to reduce imports and stimulate the domestic economy. Instead,
the law resulted only in retaliatory tariffs by other nations and a decline
in trade worldwide.

Finally, forcing an excess of exports over imports cannot succeed in
raising domestic employment over the long run. It is through U.S. imports
that foreign nations earn dollars for buying U.S. exports. In the long run a
nation must import in order to export. The long-run impact of tariffs is
not an increase in domestic employment but, at best, a reallocation of
workers away from export industries and to protected domestic industries.
This shift implies a less efficient allocation of resources.

Cheap Foreign Labor Argument
The cheap foreign labor argument says that government must shield
domestic firms and workers from the ruinous competition of countries
where wages are low. If protection is not provided, cheap imports will
flood U.S. markets and the prices of U.S. goods—along with the wages of
U.S. workers—will be pulled down. That is, the domestic living standards
in the United States will be reduced.

This argument can be rebutted at several levels. The logic of the argument
suggests that it is not mutually beneficial for rich and poor persons to
trade with one another. However, that is not the case. A relatively low-
income mechanic may fix the Mercedes owned by a wealthy lawyer, and
both may benefit from the transaction. And both U.S. consumers and
Chinese workers gain when they “trade” a pair of athletic shoes priced at
$30 as opposed to U.S. consumers being restricted to a similar shoe made
in the U.S. for $60.

Also, recall that gains from trade are based on comparative advantage, not
on absolute advantage. Again, think back to our U.S.-Mexico (soybean-
avocado) example in which the United States had greater labor
productivity than Mexico in producing both soybeans and avocados.
Because of that greater productivity, wages and living standards will be
higher for U.S. labor. Mexico’s less productive labor will receive lower
wages.

The cheap foreign labor argument suggests that, to maintain American

living standards, the United States should not trade with low-wage
Mexico. Suppose it forgoes trade with Mexico. Will wages and living
standards rise in the United States as a result? Absolutely not! To obtain
avocados, the United States will have to reallocate a portion of its labor
from its relatively efficient soybean industry to its relatively inefficient
avocado industry. As a result, the average productivity of U.S. labor will
fall, as will real wages and living standards for American workers. The
labor forces of both countries will have diminished standards of living
because without specialization and trade they will have less output
available to them. Compare column 4 with column 1 in Table 12.4 to
confirm this point.

Protection-against-Dumping Argument
The protection-against dumping argument contends that tariffs are needed
to protect domestic firms from “dumping” by foreign producers.
Dumping is the sale of a product in a foreign country at prices either
below cost or below the prices commonly charged at home.

dumping

The sale of products in a foreign country at prices either below costs or
below the prices charged at home.

Economists cite two plausible reasons for this behavior. First, with regard
to belowcost dumping, firms in country A may dump goods at below cost
into country B in an attempt to drive their competitors in country B out of
business. If the firms in country A succeed in driving their competitors in
country B out of business, they will enjoy monopoly power and monopoly
prices and profits on the goods they subsequently sell in country B. Their
hope is that the longer-term monopoly profits will more than offset the
losses from below-cost sales that must take place while they are attempting
to drive their competitors in country B out of business.

Second, dumping that involves selling abroad at a price that is below the
price commonly charged in the home country (but which is still at or

above production costs) may be a form of price discrimination, which is
charging different prices to different customers. As an example, a foreign
seller that has a monopoly in its home market may find that it can
maximize its overall profit by charging a high price in its monopolized
domestic market while charging a lower price in the United States, where
it must compete with U.S. producers. Curiously, it may pursue this
strategy even if it makes no profit at all from its sales in the United States,
where it must charge the competitive price. So why bother selling in the
United States? Because the increase in overall production that comes about
by exporting to the United States may allow the firm to obtain the per unit
cost savings often associated with large-scale production. These cost
savings imply even higher profits in the monopolized domestic market.

Because dumping is an “unfair trade practice,” most nations prohibit it.
For example, where dumping is shown to injure U.S. firms, the Federal
government imposes tariffs called antidumping duties on the goods in
question. But relatively few documented cases of dumping occur each
year, and specific instances of unfair trade do not justify widespread,
permanent tariffs. Moreover, antidumping duties can be abused. Often,
what appears to be dumping is simply comparative advantage at work.

Trade Adjustment Assistance
A nation’s comparative advantage in the production of a certain product is
not forever fixed. As national economies evolve, the size and quality of
their labor forces may change, the volume and composition of their capital
stocks may shift, new technologies may develop, and even the quality of
land and the quantity of natural resources may be altered. As these changes
take place, the relative efficiency with which a nation can produce specific
goods will also change. Also, new trade agreements can suddenly leave
formerly protected industries highly vulnerable to major disruption or even
collapse.

Shifts in patterns of comparative advantage and removal of trade protection
can hurt specific groups of workers. For example, the erosion of the United

States’ once strong comparative advantage in steel has caused production
plant shutdowns and layoffs in the U.S. steel industry. The textile and
apparel industries in the United States face similar difficulties. Clearly, not
everyone wins from free trade (or freer trade). Some workers lose.

The Trade Adjustment Assistance Act of 2002 introduced some new,
novel elements to help those hurt by shifts in international trade patterns.
The law provides cash assistance (beyond unemployment insurance) for up
to 78 weeks for workers displaced by imports or plant relocations abroad.
To obtain the assistance, workers must participate in job searches, training
programs, or remedial education. There also are relocation allowances to
help displaced workers move geographically to new jobs within the United
States. Refundable tax credits for health insurance serve as payments to help
workers maintain their insurance coverage during the retraining and job
search period. Also, workers who are 50 years of age or older are eligible
for “wage insurance,” which replaces some of the difference in pay (if any)
between their old and new jobs.

Trade Adjustment Assistance Act

A U.S. law passed in 2002 that provides cash assistance, education and
training benefits, health care subsidies, and wage subsidies (for persons
age 50 or more) to workers displaced by imports or plant relocations
abroad.

Many economists support trade adjustment assistance because it not only
helps workers hurt by international trade but also helps create the political
support necessary to reduce trade barriers and export subsidies.

But not all economists are keen on trade adjustment assistance. Loss of jobs
from imports or plant relocations abroad is only a small fraction (about 4
percent in recent years) of total job loss in the economy each year. Many
workers also lose their jobs because of changing patterns of demand,
changing technology, bad management, and other dynamic aspects of a
market economy. Some critics ask, “What makes losing one’s job to
international trade worthy of such special treatment, compared to losing
one’s job to, say, technological change or domestic competition?” There is

no totally satisfying answer.

APPLYING THE ANALYSIS: Is Offshoring of
Jobs Bad?
In recent years U.S. firms have found it increasingly profitable to
outsource work abroad. Economists call this business activity offshoring:
shifting work previously done by American workers to workers located in
other nations. Offshoring is not a new practice but traditionally has
involved components for U.S. manufacturing goods. For example, Boeing
has long offshored the production of major airplane parts for its
“American” aircraft.

offshoring

The practice of shifting work previously done by American workers to
workers located in other nations.

Recent advances in computer and communications technology have
enabled U.S. firms to offshore service jobs such as data entry, book
composition, software coding, call-center operations, medical
transcription, and claims processing to countries such as India. Where
offshoring occurs, some of the value added in the production process
occurs in foreign countries rather than the United States. So part of the
income generated from the production of U.S. goods is paid to foreigners,
not to American workers.

Offshoring is obviously costly to Americans who lose their jobs, but it is
not generally bad for the economy. Offshoring simply reflects a growing
international trade in services, or, more descriptively, “tasks.” That trade
has been made possible by recent trade agreements and new information
and communication technologies. As with trade in goods, trade in services
reflects comparative advantage and is beneficial to both trading parties.
Moreover, the United States has a sizable trade surplus with other nations
in services. The United States gains by specializing in high-valued services
such as transportation services, accounting services, legal services, and

advertising services, where it still has a comparative advantage. It then
“trades” to obtain lower-valued services such as call-center and data entry
work, for which comparative advantage has gone abroad.

Offshoring also increases the demand for complementary jobs in the
United States. Jobs that are close substitutes for existing U.S. jobs are lost,
but complementary jobs in the United States are expanded. For example,
the lower price of offshore maintenance of aircraft and reservation centers
reduces the price of airline tickets. That means more domestic and
international flights by American carriers, which in turn means more jobs
for U.S.-based pilots, flight attendants, baggage handlers, and check-in
personnel. Moreover, offshoring encourages domestic investment and
expansion of firms in the United States by reducing their costs and
keeping them competitive worldwide. Some observers equate “offshoring
jobs” to “importing competitiveness.”

Question:

What has enabled white-collar labor services to become the world’s
newest export and import commodity even though such labor itself
remains in place?

Multilateral Trade Agreements and Free-
Trade Zones
Being aware of the overall benefits of free trade, nations have worked to
lower tariffs worldwide. Their pursuit of free trade has been aided by the
growing power of free-trade interest groups: Exporters of goods and
services, importers of foreign components used in “domestic” products, and
domestic sellers of imported products all strongly support lower tariffs.
And, in fact, tariffs have generally declined during the past half-century.

General Agreement on Tariffs and Trade
Following the Second World War, the major nations of the world set upon

a general course of liberalizing trade. In 1947 some 23 nations, including
the United States, signed the General Agreement on Tariffs and Trade
(GATT). GATT was based on the principles of equal, nondiscriminatory
trade treatment for all member nations and the reduction of tariffs and
quotas by multilateral negotiation. Basically, GATT provided a continuing
forum for the negotiation of reduced trade barriers on a multilateral basis
among nations.

General Agreement on Tariffs and Trade (GATT)

An international accord reached in 1947 in which 23 nations agreed to
give equal and nondiscriminatory treatment to one another, to reduce
tariffs through multinational negotiations, and to eliminate import
quotas.

Since 1947, member nations have completed eight “rounds” of GATT
negotiations to reduce trade barriers. The Uruguay Round agreement of
1993 phased in trade liberalizations between 1995 and 2005.

World Trade Organization
The Uruguay Round of 1993 established the World Trade Organization
(WTO) as GATT’s successor. In 2008, 153 nations belonged to the WTO,
which oversees trade agreements and rules on disputes relating to them. It
also provides forums for further rounds of trade negotiations. The ninth
and latest round of negotiations—the Doha Round—was launched in
Doha, Qatar, in late 2001. (The trade rounds occur over several years in
several geographic venues but are named after the city or country of
origination.) The negotiations are aimed at further reducing tariffs and
quotas, as well as agricultural subsidies that distort trade. One of this
chapter’s questions asks you to update the progress of the Doha Round via
an Internet search.

World Trade Organization (WTO)

An organization of 153 nations (as of 2008) that oversees the provisions
of the current world trade agreement, resolves disputes stemming from

it, and holds forums for further rounds of trade negotiations.

Doha Round

The latest, uncompleted (as of 2008) sequence of trade negotiations by
members of the World Trade Organization; named after Doha, Qatar,
where the set of negotiations began.

GATT and the WTO have been positive forces in the trend toward
liberalized world trade. The trade rules agreed upon by the member
nations provide a strong and necessary bulwark against the protectionism
called for by the special-interest groups in the various nations. For that
reason and because current WTO agreements lack strong labor standards
and environmental protections, the WTO is controversial.

European Union
Countries have also sought to reduce tariffs by creating regional free-trade
zones—also called trade blocs. The most dramatic example is the
European Union (EU). In 2007, the addition of Bulgaria and Romania

expanded the EU to 27 nations.3

European Union (EU)

An association of 27 European nations that has eliminated tariffs and
quotas among them, established common tariffs for imported goods
from outside the member nations, reduced barriers to the free movement
of capital, and created other common economic policies.

The EU has abolished tariffs and import quotas on nearly all products
traded among the participating nations and established a common system
of tariffs applicable to all goods received from nations outside the EU. It
has also liberalized the movement of capital and labor within the EU and
has created common policies in other economic matters of joint concern,
such as agriculture, transportation, and business practices. The EU is now
a strong trade bloc: a group of countries having common identity,

economic interests, and trade rules. Of the 27 EU countries, 15 used the
euro as a common currency in 2008.

trade bloc

A group of nations that lower or abolish trade barriers among
themselves.

euro

The common currency unit used by 15 (as of 2008) European nations in
the European Union.

EU integration has achieved for Europe what the U.S. constitutional
prohibition on tariffs by individual states has achieved for the United
States: increased regional specialization, greater productivity, greater
output, and faster economic growth. The free flow of goods and services
has created large markets for EU industries. The resulting economies of
large-scale production have enabled those industries to achieve much
lower costs than they could have achieved in their small, single-nation
markets.

North American Free Trade Agreement
In 1993 Canada, Mexico, and the United States formed a major trade bloc.
The North American Free Trade Agreement (NAFTA) established a
free-trade zone that has about the same combined output as the EU but
encompasses a much larger geographic area. NAFTA has eliminated
tariffs and other trade barriers between Canada, Mexico, and the United
States for most goods and services.

North American Free Trade Agreement (NAFTA)

A 1993 agreement establishing, over a 15-year period, a freetrade zone
composed of Canada, Mexico, and the United States.

Critics of NAFTA feared that it would cause a massive loss of U.S. jobs

as firms moved to Mexico to take advantage of lower wages and weaker
regulations on pollution and workplace safety. Also, there was concern
that Japan and South Korea would build plants in Mexico and transport
goods tariff-free to the United States, further hurting U.S. firms and
workers.

In retrospect, critics were much too pessimistic. Since the passage of
NAFTA in 1993, employment in the United States rose by more than 22
million workers and the unemployment rate fell from 6.9 percent to 4.7
percent. Increased trade between Canada, Mexico, and the United States
has enhanced the standard of living in all three countries.

Not all aspects of trade blocs are positive. By giving preferences to
countries within their free-trade zones, trade blocs such as the EU and
NAFTA tend to reduce their members’ trade with non-bloc members.
Thus, the world loses some of the benefits of a completely open global
trading system. Eliminating that disadvantage has been one of the
motivations for liberalizing global trade through the World Trade
Organization. Its liberalizations apply equally to all 153 nations that
belong to the WTO.

U.S. Trade Deficits
As indicated in Figure 12.2, the United States has experienced large and
persistent trade deficits over the past several years. These deficits climbed
steeply between 1994 and 2000, fell slightly in the recessionary year 2001,
and rose again between 2002 and 2007. In 2007 the trade deficit on goods
was $816 billion and the trade deficit on goods and services was $709
billion. Large trade deficits are expected to continue for many years.
FIGURE 12.2: U.S. trade deficits, 1999–2007.

The United States experienced large deficits in goods and in goods and
services between 1999 and 2007. These deficits have steadily increased,
dipping only slightly in 2001 and 2007. They are expected to continue at
least throughout the current decade.

Source: U.S. Census Bureau, Foreign Trade Division,
www.census.gov/foreign-trade/statistics.

Causes of the Trade Deficits
There are several reasons for these large trade deficits. First, over recent
years the U.S. economy has grown more rapidly than the economies of

several of its major trading partners. The strong growth of U.S. income
that accompanies economic growth has enabled Americans to buy more
imported goods. In contrast, Japan and some European nations have either
suffered recession or experienced slow income growth. So their purchases
of U.S. exports have not kept pace with the growing U.S. imports. Large
trade deficits with Japan and Germany have been particularly noteworthy
in this regard.

Second, large trade deficits with China have emerged, reaching $257
billion in 2007. This is even greater than the U.S. trade imbalance with
Japan ($85 billion in 2007) or OPEC countries ($125 billion in 2007).
The United States is China’s largest export market, and although China has
increased its imports from the United States, its standard of living has not
yet increased enough for its citizens to afford large quantities of U.S.
goods and services.

Finally, a declining U.S. saving rate (=saving/total income) undoubtedly
has also contributed to U.S. trade deficits. Over the last 10 years, the
saving rate has diminished while the investment rate (=investment/total
income) has remained stable or increased. The gap between saving and
investment has been met through foreign purchases of U.S. real and
financial assets. Because foreign savers are willingly financing a larger
part of U.S. investment, Americans are able to save less than otherwise
and consume more. Part of that added consumption spending is on
imported goods. That is, the inflow of funds from abroad may be one
cause of the trade deficits, not just a result of those deficits.

The U.S. recession of 2001 temporarily lowered income and reduced U.S.
imports and trade deficits. But the general trend toward higher trade
deficits quickly reemerged in 2002 and ballooned until 2007, when they
dipped slightly (though still remaining high).

Implications of U.S. Trade Deficits
There is disagreement on whether the large trade deficits should be of
major policy concern for the United States. Most economists see both

benefits and costs to trade deficits but are increasingly anxious about the
size of these deficits.

Increased Current Consumption
At the time a trade deficit is occurring, American consumers benefit. A
trade deficit means that the United States is receiving more goods and
services as imports from abroad than it is sending out as exports. Taken
alone, a trade deficit augments the domestic standard of living. But there
is a catch: The gain in present consumption may come at the expense of
reduced future consumption.

Increased U.S. Indebtedness
A trade deficit is considered “unfavorable” because it must be financed
by borrowing from the rest of the world, selling off assets, or dipping
into foreign currency reserves. Trade deficits are financed primarily by
net inpayments of foreign currencies to the United States. When U.S.
exports are insufficient to finance U.S. imports, the United States
increases both its debt to people abroad and the value of foreign claims
against assets in the United States. Financing of the U.S. trade deficit has
resulted in a larger foreign accumulation of claims against U.S. financial
and real assets than the U.S. claim against foreign assets. In 2006,
foreigners owned about $2.5 trillion more of U.S. assets (corporations,
land, stocks, bonds, loan notes) than U.S. citizens and institutions owned
of foreign assets.

If the United States wants to regain ownership of these domestic assets,
at some future time it will have to export more than it imports. At that
time, domestic consumption will be lower because the United States will
need to send more of its output abroad than it receives as imports.
Therefore, the current consumption gains delivered by U.S. current
account deficits may mean permanent debt, permanent foreign
ownership, or large sacrifices of future consumption.

We say “may mean” above because the foreign lending to U.S. firms and

foreign investment in the United States increase the stock of American
capital. U.S. production capacity might increase more rapidly than
otherwise because of a large inflow of funds to offset the trade deficits.
We know that faster increases in production capacity and real GDP
enhance the economy’s ability to service foreign debt and buy back real
capital, if that is desired.

Downward Pressure on the Dollar
Finally, the large U.S. trade deficits place downward pressure on the
exchange value of the U.S. dollar. The surge of imports requires the
United States to supply dollars in the currency market in order to obtain
the foreign currencies required for purchasing the imported goods. That
flood of dollars into the currency market causes the dollar to depreciate
relative to other currencies. Between 2002 and 2008, the dollar
depreciated against most other currencies, including 43 percent against
the European euro, 27 percent against the British pound, 37 percent
against the Canadian dollar, 15 percent against the Chinese yuan, and 25
percent against the Japanese yen. Some of this depreciation was fueled
by the expansionary monetary policy (reduced real interest rates)
undertaken by the Fed beginning in 2007 and carrying into 2008
(discussed in Chapter 10). Economists feared that the decline in the
dollar would contribute to inflation as imports became more expensive to
Americans in dollar terms. Traditionally the Fed would need to react to
that inflation with a tight monetary policy that raises real interest rates in
the United States. In 2008, however, the U.S. economy severely
receded, largely as a result of spillover damage from the mortgage debt
crisis and the decline in housing demand. The Fed chose to aggressively
reduce interest rates, hoping to halt the downturn in the economy. In
effect, it gambled that its actions would not ignite inflation because of
the dampening effect of the severe economic recession on rising prices.

Summary
1. The United States leads the world in the volume of international
trade, but trade is much larger as a percentage of GDP in many other

nations.

2. Mutually advantageous specialization and trade are possible
between any two nations if they have different domestic opportunity-cost
ratios for any two products. By specializing on the basis of comparative
advantage, nations can obtain larger real incomes with fixed amounts of
resources. The terms of trade determine how this increase in world
output is shared by the trading nations. Increasing costs lead to less-than-
complete specialization for many tradable goods.

3. The foreign exchange market establishes exchange rates between
currencies. Each nation’s purchases from abroad create a supply of its
own currency and a demand for foreign currencies. The resulting
supply-demand equilibrium sets the exchange rate that links the
currencies of all nations. Depreciation of a nation’s currency reduces its
imports and increases its exports; appreciation increases its imports and
reduces its exports.

4. Currencies will depreciate or appreciate as a result of changes in
their supply or demand, which in turn depend on changes in tastes for
foreign goods, relative changes in national incomes, changes in relative
price levels, changes in interest rates, and the extent and direction of
currency speculation.

5. Trade barriers and subsidies take the form of protective tariffs,
quotas, nontariff barriers, voluntary export restrictions, and export
subsidies. Protective tariffs increase the prices and reduce the quantities
demanded of the affected goods. Sales by foreign exporters diminish;
domestic producers, however, gain higher prices and enlarged sales.
Consumer losses from trade restrictions greatly exceed producer and
government gains, creating an efficiency loss to society.

6. Three recurring arguments for free trade—increased domestic
employment, cheap foreign labor, and protection against dumping—are
either fallacies or overstatements that do not hold up under careful
economic analysis.

7. Not everyone benefits from free (or freer) trade. The Trade
Adjustment Assistance Act of 2002 provides cash assistance, education
and training benefits, health care subsidies, and wage subsidies (for
persons 50 years old or more) to workers who are displaced by imports
or plant relocations abroad. But less than 4 percent of all job losses in
the United States each year result from imports, plant relocations, or the
offshoring of service jobs.

8. In 2008 the World Trade Organization (WTO) consisted of 153
member nations. The WTO oversees trade agreements among the
members, resolves disputes over the rules, and periodically meets to
discuss and negotiate further trade liberalization. In 2001 the WTO
initiated a new round of trade negotiations in Doha, Qatar. The Doha
Round (named after its place of initiation) will continue over the next
several years.

9. Free-trade zones (trade blocs) liberalize trade within regions but
may at the same time impede trade with non-bloc members. Two
examples of free-trade arrangements are the 27-member European Union
(EU) and the North American Free Trade Agreement (NAFTA),
comprising Canada, Mexico, and the United States. Fifteen of the EU
nations (as of 2008) have abandoned their national currencies for a
common currency called the euro.

10. U.S. trade deficits have produced current increases in the livings
standards of U.S. consumers. But the deficits have also increased U.S.
debt to the rest of the world and increased foreign ownership of assets in
the United States. This greater foreign investment in the United States,
however, has undoubtedly increased U.S. production possibilities. The
trade deficits also place extreme downward pressure on the international
value of the U.S. dollar.

Terms and Concepts
comparative advantage
terms of trade

foreign exchange market
exchange rates
depreciation
appreciation
tariffs
import quotas
nontariff barriers (NTBs)
voluntary export restriction (VER)
export subsidies
Smoot-Hawley Tariff Act
dumping
Trade Adjustment Assistance Act
offshoring
General Agreement on Tariffs and Trade (GATT)
World Trade Organization (WTO)
Doha Round
European Union (EU)
trade bloc
euro
North American Free Trade Agreement (NAFTA)

Study Questions
1. Quantitatively, how important is international trade to the United
States relative to its importance to other nations? What country is the
United States’ most important trading partner, quantitatively? With
what country does the United States have the largest current trade
deficit? LO1

2. Below are hypothetical production possibilities tables for New
Zealand and Spain. Each country can produce apples and plums. LO2

New Zealand’s Production Possibilities Table

(Millions of Bushels)

Spain’s Production Possibilities Table
(Millions of Bushels)

Referring to the tables, answer the following:

a. What is each country’s cost ratio of producing plums and
apples?

b. Which nation should specialize in which product?

c. Suppose the optimal product mixes before specialization
and trade are alternative B in New Zealand and alternative S in
Spain and the actual terms of trade are 1 plum for 2 apples. What
will be the gains from specialization and trade?

3. The following are production possibilities tables for South Korea
and the United States. Assume that before specialization and trade the
optimal product mix for South Korea is alternative B and for the
United States is alternative U. LO2

a. Are comparative-cost conditions such that the two areas
should specialize? If so, which product should each produce?

b. What is the total gain in LCD displays and chemical output
that would result from such specialization?

c. What are the limits of the terms of trade? Suppose actual

terms of trade are unit of LCD displays for units of chemicals
and that 4 units of LCD displays are exchanged for 6 units of
chemicals. What are the gains from specialization and trade for each
nation?

d. Explain why this illustration allows you to conclude that
specialization according to comparative advantage results in a more
efficient use of world resources.

4. What effect do rising costs (rather than constant costs) have on the
extent of specialization and trade? Explain. LO2

5. What is offshoring of white-collar service jobs, and how does it
relate to international trade? Why has it recently increased? Why do
you think more than half of all offshored jobs have gone to India?
Give an example (other than that in the textbook) of how offshoring
can eliminate some U.S. jobs while creating other U.S. jobs. LO2

6. Explain why the U.S. demand for Mexican pesos is downward-
sloping and the supply of pesos to Americans is upward-sloping.
Indicate whether each of the following would cause the Mexican peso
to appreciate or depreciate: LO3

a. The United States unilaterally reduces tariffs on Mexican
products.

b. Mexico encounters severe inflation.

c. Deteriorating political relations reduce American tourism in
Mexico.

d. The U.S. economy moves into a severe recession.

e. The United States engages in a high-interest-rate monetary
policy.

f. Mexican products become more fashionable to U.S.
consumers.

g. The Mexican government encourages U.S. firms to invest in
Mexican oil fields.

7. Explain why you agree or disagree with the following statements:
LO3

a. A country that grows faster than its major trading partners
can expect the international value of its currency to depreciate.

b. A nation whose interest rate is rising more rapidly than

interest rates in other nations can expect the international value of
its currency to appreciate.

c. A country’s currency will appreciate if its inflation rate is
less than that of the rest of the world.

8. If the European euro were to depreciate relative to the U.S. dollar
in the foreign exchange market, would it be easier or harder for the
French to sell their wine in the United States? Suppose you were
planning a trip to Paris. How would depreciation of the euro change
the dollar cost of your trip? LO3

9. What measures do governments take to promote exports and
restrict imports? Who benefits and who loses from protectionist
policies? What is the net outcome for society? LO4

10. Speculate as to why some U.S. firms strongly support trade
liberalization while other U.S. firms favor protectionism. Speculate
as to why some U.S. labor unions strongly support trade
liberalization while other U.S. labor unions strongly oppose it. LO4

11. Explain: “Free-trade zones such as the EU and NAFTA lead
a double life: They can promote free trade among members, but they
pose serious trade obstacles for nonmembers.” Do you think the net
effects of trade blocs are good or bad for world trade? Why? How do
the efforts of the WTO relate to these trade blocs? LO5

12. What is the WTO, and how does it affect international
trade? How many nations belong to the WTO? (Update the number
given in this book at www.wto.org.) Is the Doha Round (or Doha
Agenda) still in progress, or has it been concluded with an agreement
(again, use the WTO Website)? If the former, when and where was
the latest ministerial meeting? If the latter, what are the main features
of the agreement? LO5

FURTHER TEST YOUR KNOWLEDGE AT
www.mcconnellbriefmicro1e.com

Web-Based Questions
At the text’s Online Learning Center, www.mcconnellbriefmicro1e.com,
you will find a multiple-choice quiz on this chapter’s content. We
encourage you to take the quiz to see how you do. Also, you will find one
or more Web-based questions that require information from the Internet to
answer.

1 Adam Smith, The Wealth of Nations (New York: Modern Library,
1937), p. 424. (Originally published in 1776.)
2 Scott C. Bradford, Paul L.E. Grieco, and Gary C. Hufbauer, “The
Payoff to America from Globalization,” The World Economy, July 2006,
pp. 893–916.
3 The other 25 are France, Germany, United Kingdom, Italy,
Belgium, the Netherlands, Luxembourg, Denmark, Ireland, Greece,
Spain, Portugal, Austria, Finland, Sweden, Poland, Hungary, Czech
Republic, Slovakia, Lithuania, Latvia, Estonia, Slovenia, Malta, and
Cyprus.

(McConnell 266)

McConnell, Campbell R.. Microeconomics, Brief Edition. McGraw-Hill
Learning Solutions, 2010. .

Assignment 1: LASA 2: Supply and Demand in a Global Market

Answer the following questions using examples and applications from the readings.  Justify your answers using economic concepts and ideas as they apply. Each response should be between 100-200 words.

Questions:

1. The demand for labor is said to be a “derived” demand.  What is the meaning of a derived demand? How does this concept help to determine the demand for labor?

2. What are some of the factors that determine the supply of labor in a market? What significant factors have changed the supply of labor over the last twenty years?

3.  How does a firm determine its prices and the quantity of labor required in the resource market during a specific period? 

4.  Why do income inequalities exist?  How are income inequalities measured? How have income inequalities changed from 1980 to the present?

5. What is the role of the U.S. government, in terms of dealing with the problem of income inequalities?  What are the arguments, for and against, government involvement in this area?

6. Why do nations trade?  What is meant by the concept of “Comparative Advantage”?  Could a nation be better off economically, if it practiced an isolation policy?

7. The United States has had a significant trade imbalance for several years.  What are the problems associated with having a negative trade balance?  What can be done to correct the imbalance?

8. How are exchange rates determined?  What is the significance of currency devaluations to the home country?  To other countries?

By Saturday, September 28, 2013, create a Microsoft Word document to collate your answers and submit it. All written assignments and responses should follow APA rules for attributing sources.

32

32

32

32

32

32

32

Assignment 1 Grading Criteria	Maximum Points
Explained the meaning of a derived demand.  (8 points) Explained how the concept of derived demand helps to determine the demand for labor. (24 points)								32
Identified factors that determine the supply of labor in a market.  (12 points) Researched and explained which significant factors have changed the supply of labor over the last twenty years. (20 points)
Explained how a firm determines its prices in the resource market during a specific period. (16 points) Explained how a firm determines the quantity of labor required in the resource market during a specific period. (16 points)
Explained why income inequalities exist. (8 points) Explained how income inequalities are measured. (8 points) Researched and described how income inequalities have changed from 1980 to the present.(16 points)
Explained the role of the U.S. government in terms of dealing with the problems of income inequalities. (8 points) Discussed the arguments for and against government involvement in dealing with problems of income inequalities. (24 points)
Explained the reasons why nations trade. (4 points) Explained the meaning of the concept of “comparative advantage.” (8 points) Discussed whether or not a nation would be better off economically if it practiced an isolation policy. (20 points)
Identified the problems associated with the United States having a significant trade imbalance for several years. (16 points) Explained what could be done to correct the trade imbalance. (16 points)
Explained how exchange rates are determined. (8 points) Explained the significance of currency devaluations to the home country. (12 points) Explained the significance of currency devaluations to other countries trading with the home country. (12 points)
Standard presentation components (15%) Style (8 points): Tone, audience, and word choice Usage and Mechanics (16 points): Grammar, spelling, and sentence structure APA Elements (20 points): In text citations and references, paraphrasing, and appropriate use of quotations and other elements of style	44
Total:	300