Economics - 1980s Life is not fair

We have all heard this phrase, and maybe you have even expressed it yourselves as you attempt to deal with problems that threaten to overwhelm you. And that is not all that is unfair. We could also say that the market system is unfair, that individual decision makers pursuing their own self interest in a system of interrelated markets cannot be counted to generate a distribution of income that would be considered fair or just. Andrew Jackson successfully campaigned for president in the early 19th century to return power to the common people who had been unfairly treated by 'Big Business,' a feat that William Jennings Bryan could not duplicate in his runs for president late in the century.

The issue of the market system's fairness surfaced in the Great Depression of the 1930s when a quarter of the nation's workers found themselves unable to find work to sustain themselves and their families prompting the federal government, under the leadership of President Franklin Roosevelt, to become actively involved in issues of income distribution. After some heated debates, we got the social security system to protect our old and infirmed...

It surfaced again in the early 1960s as President Lyndon Johnson launched the War on Poverty, in part a response to works such as Michael Harrington's Other America in which he documented large segments of the US population that had missed the prosperity of the 1950s. The data revealed that the income earned by many elderly, residents of inner cities and Indian reservations, and individuals living in rural areas such as Appalachia was unacceptably low and once again the federal government became involved. We saw the emergence of the Economic Development Administration which was designed to help those in economically distressed areas...

The mood changed, however, by the early 1980s. After years of slow growth / decline / stagflation in the 1970s, voters returned to power those who believed in the power of the market system and that the government's attempts to improve the distribution of income are ineffective at best, and most likely harmful. There are actually two issues that are inextricably intertwined when we talk about income distribution-the size of the economic pie and its distribution. Economic growth could be renewed ( a bigger pie) only if we returned to the market system more of the power to redistribute income - the view of many conservatives voted into office including Ronald Reagan in the US and Margaret Thatcher in the UK. Their position was further buoyed by the collapse of the communist regimes in Eastern Europe in the early 1990s-a collapse that was attributed to the inability of the communist system and its large government sector to compete with a market system.

As we move toward the end of the 20th century, the debate continues. In the US we are moving in the same direction as we attempt to "end welfare as we know it," while in France and England there has been a backlash of sorts with Conservatives being replaced by the Socialists and a Labor Party.

It is clear that the issue of income distribution is important, hotly debated, and unlikely to disappear in the near future. In this section of the course we will shift gears from our analysis of the output market and the output and pricing decisions of firms to the input market and the distribution of income. As a starting point we can begin with the obvious-an individual's income depends upon the inputs that are owned and the price of those inputs. If we have an input that is highly valued, we are likely to have a higher income than someone who owns a resource that is not highly valued.

For this to help, however, we need to better understand the inputs and the means by which prices are established. The inputs which we will examine here are labor, capital, land, resources, and entrepreneurship. If you own labor you can exchange it in the market for wages-something many of you have already done. You may also have had some experience with the exchange of land for rent or capital (money) for interest, entrepreneurship for profit. Before we discuss the inputs and their prices in detail, we will examine a generic framework used to describe the pricing of these resources.

Not surprisingly, at the heart of the traditional theory of input pricing is a supply-demand model. Input prices, just like output prices, are set in markets which may differ in the details, but possess a common denominator. As a result, the approach will be the same. In each case you will need to identify the following:

In all the markets demand for the input is based on the contribution of the input to the revenue of the firm that is using the input. As you will recall from our earlier work, firms are assumed to be maximizing their profit and their output and pricing decisions were guided by the MR=MC condition. A firm would expand production if MR>MC and cut production if MR<MC.

There is no reason, however, to assume that firms change their behavior when they hire inputs. They will hire inputs as long as the MR of the input is greater than the MC of the input and they will cut back on their use of the input if MR<MC. But what is the MR of an input? To answer this question we must return to our earlier discussion of marginal productivity, which we can illustrate with an example from our University. We can use the table below to determine how many faculty members will be demanded at various salary levels.

What if the faculty salary was $200,000-a number chosen not for its realism. As the university considered the move from 650 to 700 faculty, the number of students would increase from 8,775 to 9,800. With the 50 additional faculty the student population rose 1,025 - an increase of 20.5 students per faculty. This is the marginal product of the faculty being hired. But what is the revenue being generated by these faculty. To answer this we need to know the tuition that is being paid by the students. If we assume that the students all pay a tuition of $10,100, then the income generated by each of these additional faculty, what we refer to as the marginal productivity, will be the number of students * the tuition [20.5*$10,100 = $207,050]. This figure is the maximum that the university could pay the additional faculty. If we considered the move to 750 faculty, each of these faculty would generate $65,650 which would be the maximum one could pay for their services.

Faculty	Students	Tuition	AP	MP	MRP
500	6700	$10,100	13.40
550	7300	$10,100	13.27	12	$121,200
600	8000	$10,100	13.33	14	$141,400
650	8775	$10,100	13.50	15.5	$156,550
700	9800	$10,100	14.00	20.5	$207,050
750	10125	$10,100	13.50	6.5	$65,650
800	10400	$10,100	13.00	5.5	$55,550
850	10625	$10,100	12.50	4.5	$45,450
900	10800	$10,100	12.00	3.5	$35,350

If we graphed the relationship marginal revenue product and the number of faculty we have a curve representing the maximum amount that University would pay faculty-what may sound very much like the demand curve that it is. In fact, if you rename this you will have the demand curve for faculty that is derived from the demand for seats at the university. The university will pay faculty over $200,000 for 700 faculty and $65,650 for 750 faculty. To test your understanding of the concept, think of what would happen to the demand curve if the tuition rate fell as a result of decreased demand for seats. Because the demand for faculty is derived from the demand for seats, you would expect it to decrease (shift inward).

Given this demand for the input, we now need to look at the supply. We can once again use the University example and attempt to put ourselves in the positions of suppliers. What do you think would happen if the price (wage) that the university paid its faculty would increase? If the wage increased, you would expect that more people would be willing to work for the university. The result is that you expect the supply curve to be positively sloped - at a higher price there will be a greater supply of the input. If we combine this supply information with our information on demand we get the following diagram for the input market. As you would expect, the analysis will be the same as what we saw earlier with our supply-demand analysis. The market, to the extent that it works, will tend toward the equilibrium where supply = demand. At any other price the shortage (price too low) or surplus (price too high) there will be adjustments in the price to bring us back to the equilibrium.

Now we can move on to a more detailed discussion of the individual inputs. We will focus our attention on how the markets work, but you should be aware that in each of the markets there have been efforts made by the government to alter the market prices. In the labor market the intervention takes the form of minimum wage legislation; in the capital market there are usury laws that limit interest rates; and in the market for land there are rent controls. Although the specifics are different, in each case they are attempts to set rates different from those set in the market.

All Terrain Thinking

A Compendium of things I think are Important

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