All Terrain Thinking

A Compendium of things I think are Important

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

Answers for the Day
1980s: The Long-run

1. What is an investment tax credit and what role did it play in the Kennedy tax cuts in the early 1960s.  Why would the tax cut be expected to increase investment spending and why would this have more of a supply-side effect than the personal income tax cut?

The investment tax credit is a tax policy that lowers the cost of investment spending.  A 10 percent investment tax credit would mean that a firm that spends $10,000 on a new machine would be able to lower the firm's taxes by $1,000 (10%*$10,000).  The cost of the machine has now been lowered by $1,000 since the firm now saves $1,000 in taxes, so we could expect more machines to be purchased at the lower prices.  This is nothing more than the downward sloping demand curve.

2. Explain the key role of productivity growth and what Paul Krugman means when he states: "Productivity isn't everything, but in the long run it is almost everything."

The importance of productivity growth can be best seen in the simple example that links real wages and productivity growth. We begin by assuming that the price (P) of a product (Q) is equal to its per unit cost of production which is equal to the wage rate (w) times the number of laborers used per unit of output (L/Q) [equation 1]. This latter term is actually the reciprocal of the productivity of labor - the amount of output that can be produced per unit of labor (Q/L). If we were talking about the defense industry, productivity would be measured by the number of individuals 'defended' per worker.

(1) P = w*(L/Q)

With a little bit of algebra, we can convert the equation into one which explains the interrelationship between growth rate in wages, the growth rate in prices, and the growth rate in labor productivity [equation 2]. The growth rate in real wages is equal to the growth in productivity - if production per unit of labor can be expanded, then the price of labor (wage rate) can rise faster than inflation.

(2)%D(w/P) = %Dw - %DP = %D (Q/L)

In the defense industry, if there are new people receiving defense services who will pay the additional costs or if the services can be provided with fewer employees, then defense employees can get raises without increases in the price of defense. Stated somewhat differently, real wages can rise only if there is an increase in labor productivity which is why so much effort has been exerted to explain the productivity slowdown.

3. What does the cost-disease of the service sector tell us about the future of the defense industry?

The cost disease of the service sector is a concept that has been around for quite some time, but has gained in importance in recent years as the service sector has continued to grow at above average rates and remains the main engine for job growth in the U.S. One of the problems with the movement to services is that productivity gains in services are more difficult to realize than the gains in the manufacturing and agricultural sectors. This is a problem that is at the core of the move to rein in health care, education, and defense expenses.

To understand the problem faced by these three industries, we need to look at the link between prices, wages and productivity. Let's begin with a simple model of cost. The price (P) of a product (Q) equals the per unit cost of production (C/Q) which is equal to the wage rate (w) times the number of laborers used per unit of output (L/Q). This latter term is actually the reciprocal of the productivity of labor, how much output can be produced per unit of labor (Q/L).

P = C/Q = w*(L/Q)

With a little bit of algebra, we can convert the equation into one in which we explain the growth rate in prices in terms of the growth rate in wages and the growth rate in labor productivity.

%DP= %D(w) +%D(L/Q)

or

%DP = %D(w) -%D (Q/L)

From this equation we can see that the growth rate in price equals the growth rate in wages minus the growth rate in productivity. When we talk about a service like defense, however, productivity advances may be difficult to obtain since this would tend to mean higher defended/defender ratios. In the absence of these productivity gains, any wage increases that the defenders wanted would be translated directly into higher prices.

4. Economics has been called the extension of war. What is your view on this statement and how is it related to Paul Kennedy's concept of "imperial overstretch" and the future of national security strategy?

One approach to this question would be to return to the production possibility curves in which we examine the alternative means to achieving more. In the world Kennedy talks about, a world in which the concept of progress and growth was virtually nonexistent, increases in wealth could be accomplished only with territorial expansion which required an increasingly large military. It was also a world in which war was the primary means by which wealth was accumulated. The problem was that there was an inherent flaw in the system - the tendency toward "imperial overstretch."

Adam Smith provided an alternative - productivity growth, but this required specialization which in turn required an economic system to facilitate the transactions needed to sustain the specialization. If we take this argument and extend it beyond national borders, which is what David Ricardo, a contemporary of Smith suggested, we enter into the world of international trade where we need to develop a system to facilitate the resulting flows of goods, services, capital, and labor. In this situation the control over resources does not originate with territorial control and this will alter the balance between military and economic policy in a national security strategy.

5. What happened to the growth rate and what happened to the mix between extensive and intensive growth?

It is important here to clearly indicate that there are two issues here. The first is the extent of the slowdown in the period after 1973 and the second is the change in the composition of growth. On the first issue you might want to provide students with the table indicating that the slowdown was almost universal among the developed / industrial economies and that the slowdown in the U.S. was not as severe as in other countries. In the thirteen year period form 1973 to 1986, growth in the U.S. was down 40 percent from the earlier rates, while in the others economies, the decline exceeded 50 percent.

Growth Performance of Major Economies

The second issue is the change in growth from intensive to extensive - from growth dominated by productivity advances to growth dominated by growth in inputs. Equation 1 is simply an identity where income per capita [income (Y) divided by population (P)] is defined as the product of two terms. The first of these terms Y/L is labor productivity - how much output (Y) is produced by each worker (L). The second term is the percentage of the population is in the labor force.

(1) Y/P = (Y/L)(L/P)

Using equation (1), with a little more algebra, we can generate an equation (2) for the growth rate (percentage change) in income per capita (y-p). The growth rate in income per capita, a standard definition of standard of living, is the sum of the growth rate in labor productivity (y/l) and the growth rate in the labor force / population ratio (l/p).

(2) (y - p) = (y/l) +(l/p)

If we move population growth to the right side of the equation we have an equation that identifies three separate components of growth (y/l), (l/p), and p.

(3) y = (y/l) +(l/p) + p

The track record for growth in the U.S. economy in the post WW II era appears below.

The slowdown that we discussed earlier is still clearly evident with the longer time frame. What is also clear is the change in the composition of growth. In the earlier period, output per worker accounted for nearly 60 percent of economic growth, more than twice its share in the latter period. Working in the opposite direction was the growth in the labor supply. This accounted for 33 percent of growth in the latter period, but only 2 percent in the earlier period.

The Track Record

Once you have identified and discussed the three sources of growth, you should discuss the significance of the shift. There is an enormous difference between intensive growth (y/l) and extensive growth (l/p) + p? It matters because there are limits to extensive growth - there is a limit to the share of the population that will be working and as we can see in the diagram below, there is a definite slowdown in the 1990s.

An explanation for the slowdown in the labor force / population ratio can be found in changes in the age distribution and in labor force participation rates. The first of these is likely to change substantially when the leading edge of the baby boomers hits their 60s while the growth in labor force participation rates of women which has fueled growth in the post 1973 period can be expected to slow. As we can see in the diagram below, the gap between men and women has narrowed substantially and therefore this catalyst to growth will disappear.

6. Convergence - what is it and how do you feel about it? Does where you live in the world affect your views on this one?

Convergence describes the situation where differences tend to decline over time. An example would be the convergence of regional income per capita in the US. In the past 150 years the income in the Northeast (NE) and Pacific (PA) regions have grown more slowly than the average so that relative income has declined toward the US average (line at 100). In the South Atlantic region (SA) income has grown faster than the Us so that it is rising toward the US average (100). If you happen to be in a region such as the SE this process would look real good - probably better than it looks to the people in the NE.

7. How is it that everyone seems to have discovered education as a theme for 1997. Maybe it is related to our 'rediscovery' of the importance of economic growth. What role does it play in our 'model' of economic growth?

Education is an important input into "human capital" which is an input into the production process. With higher levels of human capital, the productivity of both capital and labor should be higher which will increase the productive capacity of the economy.

8. Why did Fall River, a leading center of business in the late 18th century fall so fast in the 20th century? 

There are many secrets to growth - and there are many secrets to decline.  Fall River made a 'mistake' that is often made - they tended to specialize too much in one industry so that the fortunes of the city were too closely tied to the fortunes of the industry.  In Fall River the textile industry had almost complete control of the city's finances since the mill owners were also on the board of the city's banks and thus were able to direct the 'savings' into more textile mills.   In another time and place you might here people refer to it as crony capitalism.

9. Why were the per capita income figures so high in the West in the mid 18th century?

It wasn't easy getting out west in the mid 19th century - those wagon trains and long winters reduced the appeal of the west for many.  Those that did go also had to pay higher prices for the basics - just as you do if you live on Nantucket since everything must come to the island by ferry or plane.  The result was that the people who did move west at that time were compensated for the additional risk and cost, and when the risks declined so did the income differential.

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