All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

• Expand analysis to account for market structure
  • number, size, and behavior of other firms
• Examine optimal choice in competitive environment
• Examine implications of competition

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• instability
• inequality
• imperfect competition
• externalities (side-effects)
• public goods
• imperfect information
• cost disease

In the United States, the ongoing battle between the liberal and conservative views turned in favor of the liberals in the 1930s. As so often happens, the balance of power shifted when those in power found themselves incapable of dealing with a serious crisis. In this case it was the conservatives who could offer no explanation of, or solution to, the Great Depression that the US economy fell into following the stock market crash of 1929. Conservative economics provided no viable explanation for the economy's free fall, and more importantly, no solutions to the massive unemployment which reached 25 percent at the height of the Depression.

Conservative economic theory proved no match for John Maynard Keynes whose book The General Theory became the guide for liberal theorists and policy makers. Keynes had both an explanation of and a cure for the business cycle, that scourge of capitalist societies. His theory offered the promise of no more Great Depressions if the government became active and used the monetary and fiscal tools at its disposal to manage the economy. By the time we emerged from WWII, the US government was committed to the protection of its citizens from the workings of the market system (Social security and unemployment insurance) and to the provision of full employment.

This was not, however, the first time that we had recognized the need for government involvement. It became obvious early on that there were some goods that the market system simply would not provide in adequate amounts and that the government needed to get involved. We needed a government to provide security - to fund the military to protect us from international threats and police and fire to protect us from domestic threats. The private sector could not be expected to provide an adequate amount of security.

The problem stems from the nature of the product / service. Security belongs to the class of goods we would describe as public goods. These goods possess two properties which create problems for the market. First, the consumption of a public good does not subtract from another person's consumption. If I get security, my neighbor will not need to get less - a property we would call nonrivalrous consumption. Second, it is difficult to exclude someone from consumption of a public good - what we would call nonexcludability. If the government finances a military organization that provides security to Americans, then it would be impossible to identify some, maybe those living in Miami, Flordia, who would not be covered. This would certainly not be the case if you bought a TV, a product that the market system has no difficulty providing. You could easily exclude others from watching your TV and the more you used your TV the less time there would be for others.

We had also seen the recognition that there may be times when we cannot expect adequate competition in the marketplace. In 1887, at the height of the Robber Baron era, the Interstate Commerce Act established the ICC, the nation's first federal regulatory commission. This legislation, which was a direct outgrowth of the power over price that had been exerted by the railroads, gave the commission power to protect consumers from an array of anticompetitive practices. If we were not to have adequate competition among the firms in an industry, then we would need to regulate their behavior.

In addition to regulating noncompetitive industries, the US government became actively involved in promoting competition. In 1890, as the country moved through the industrial revolution which brought with it the mega factories and corporations, the Sherman Act was passed- the first piece of the nation's anti-trust legislation. The US government was now in the business of promoting competition and penalizing those who conspired to reduce competition or restrain trade.

What is the basis for the widespread support for competition? In two words - inequity and inefficency. Monopoly is seen as an inferior to competition because monopolies earn economic profit - some resource earns more in the monopoly than it earns in any other endeavor so that there is an inefficiency. Overall output in the economy would increase if theere was entry into the industry of the resource that was earning the excess profit in the monopoly. The monopoly also raises price above the level it would be in the competitive situation while output is lower.

The argument is not, however, this one-sided. There are some who do not see market concentration as necessarily a bad. They suggest that we relax our assumptions concerning the cost side of the ledger, that the cost curves for monopolists will be lower than those for competitors and that innovation is more likely to take place in larger firms that can finance large R&D expenditures. And finally there is the case of the natural monopoly, those industries where the average cost curve is falling which means that the least cost level of output would be very large - enough so that there may be only room for one seller in the market. We will talk more about this in a later section on the government's role in the economy.

The provision of public goods and the promotion of competition in the markets was not enough, however, to ensure efficiency and the solution to our social problems. By the 1960s the economics profession, buoyed by overwhelming public support earned by the profession's victory over the business cycle, turned their attention to new areas. If we could cure the business cycle, couldn't we do the same with poverty and pollution. President Lyndon Johnson launched the war on poverty with much fanfare in the 1960s. Michael Harrington, whose book The Other America, was a popular text around campus in the 1960s, opened up for all to see the pockets of poverty that had been hidden from view. The market system may be efficient, but there was no reason to believe that the distribution was equitable or defensible.

This was also a time to turn our attention to the deterioration of the environment. Just as we could 'prove' that good intentioned decision makers could not be expected to provide enough security, we could also 'prove' that they could be expected to provide too much pollution. There was a flaw in the system that would contribute to excessive levels of pollution. The market system did not adequately deal with situations where market transactions failed to adequately capture all of the benefits and / or costs - where we had an externality.

As an example consider an individual's purchase of a car. The price covers all of the producer's cost, including profit. But what about the person who lives down wind from the steel plant that produces the steel for the car? We could expect this profit seeking firm to chose a mix of inputs that minimizes cost, which would mean that the firm would fill the air and water with waste generated by production rather than spend money investing in technology to reduce / eliminate the waste. This was the least cost method of production, and we should expect nothing less from our competitive firms, but they were clearly not building into their calculations the costs incurred by those living down wind or down river from the factories. The result was clearly less than optimal - an opening for government action.

The action came in 1969 with passage of the National Environmental Policy Act which established the EPA. This was followed by the Clean Air and Clean Water Acts in the early 1970s in which the government raised the price of using / abusing the environment. By 1980 the government, partly in response to the Love canal disaster in Buffalo, NY, passed the Superfund legislation designed to clean up the land.

Which brings us to today. All of these issues remain with us, but our approach has changed rather dramatically. The battle over the environment continues as we can see with the furor raised over the tightening of Clean Air standards in 1996. The move toward regulation of the economy has turned toward around as we move toward deregulation. We see this in the Telecommunications Act of 1997 and the deregulation of electric utilities. And finally, the war on poverty has become a war on welfare, while the provision of education, long thought to be a public good, is being challenged by many who call for markets and competition.

What we have not talked about here is the cost disease of the service sector, another 'structural' problem in a market economy identified by Baumol and Blinder. It differs from the others in that there has been no explicit public policy reaction to the problem as there has been with the other shortcomings, and we will talk about it in our discussion of the public sector.

Index

Bank Deposits

100

Loans

100

Total

1000

Total

1000

We now must examine more carefully the Fed's balance sheet. In the example above, the Fed has assets consisting of $400 M in gold, $500 M in government securities, and $100 M in loans to banks which match liabilities of $900 M of outstanding notes (currency) and $100 M in bank deposits at the Fed. The key link between the two sides of the balance sheet is the reserve requirement which states that for every $1 in liabilities, the Fed must hold some fraction of that $1 as Gold or Loans. For example, to satisfy the "reserve requirement" (50 percent to make the math easier), the Fed maintains gold and loan assets equal to 50 percent of the outstanding notes - for every two dollars in circulation the Fed must hold approximately one dollar in gold or bank loans so that the public remains confident that paper money is actually backed by gold. The required reserve thus links the supply of currency and the supply of gold.

The link can be seen in the Fed's balance sheet after the trade surplus of $50 million has appeared as an increase in the gold holdings of the Fed (400 to 450). The Fed will "print" $50 million of new currency to pay for the gold and then it will print $50 million which it will use to buy government securities (500 to 550). When it is done there will still be $1 in gold and loans (450 + 100= 550) for every $2 in liabilities (1000+100 = 1100). The link between the trade surplus and the money supply has now been completed. It is now time to turn our attention to the transmission mechanism - the impact of changes in the money supply on the macroeconomy.

The Monetary Transmission Mechanism

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