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Table of Contents
I. Competition and Labor:
A firm that hires labor under perfectly competitive conditions hires only a minuscule
proportion of all the workers who are potentially available to the firm. Thus, the
supply of labor to the firm is perfectly elastic. The firm is a price taker in both
the product market and labor market.
Marginal Physical Product:
The change in output resulting from the addition of one more worker. The MPP
of the worker equals the change in total output accounted for by hiring the
worker, holding all other factors of production constant. As more workers are
employed each has a smaller fraction of the available non-labor factors of production
with which to work.
Marginal Revenue Product:
MRP is the marginal physical product (MPP) times marginal revenue. The MRP represents
the incremental worker’s contribution to the firm’s total revenues. In a competitive
product market MRP is often called the value of marginal product (VMP) and is
equal to product price times MPP.
General Rule for Hiring: The firm hires
workers to the point where marginal factor cost is equal to the marginal
MRP Curve: Demand for Labor: The MRP
curve is a factor demand curve, assuming only one factor of production and
perfect competition in both the factor and product markets.
Derived demand is input factor demand derived from demand for the final product
II. The Market Demand for
Labor: The market demand curve for labor will slope downward. It is not
a simple horizontal summation of the labor demand curves of all the individual firms.
Even if labor productivity is constant, the demand for labor depends on both the
wage rate and the price of the final output. If all firms increase employment due
to a decrease in wages, there is an increase in the product supply curve and the
price of the product must fall.
Determinants of Demand Elasticity
The greater the price elasticity of demand
for the final product, the greater the elasticity of demand for an input.
The easier it is for a particular variable
input to be substituted for by other inputs, the greater the elasticity
of demand for an input.
The larger the proportion of total costs accounted
for by a particular variable input, the greater the elasticity of demand
for that input.
The longer the time period for adjustment to
take place, the greater the elasticity of demand for an input.
III. Wage Determination in
a Perfectly Competitive Labor Market: The industry faces an upward sloping
supply curve for labor. The intersection of the industry supply and demand curves
for labor determines the market wage.
Shifts in the Market Demand
for and Supply of Labor
Reasons for Labor Demand Curve Shifts:
There are three reasons why the labor demand curve shifts: (a) Changes in
Demand for Final Product: A change in the demand for the final product that
labor is producing will shift the demand curve for labor in the same direction.
(b) Changes in Labor Productivity: A change in labor productivity will shift
the demand curve for labor in the same direction. (c) Changes in the Price
of Related Factors: A change in the price of a substitute input will cause
the demand for labor to change in the same direction, and a change in the
price of a complementary input will cause the demand for labor in the opposite
Determinants of the Supply of Labor:
If wage rates for factory workers in one industry remained constant while
wages for factory workers in another industry go up, the supply curve of
factory workers in the first industry will shift inward to the left. Changes
in working conditions in an industry affect the position of the supply of
labor curve. Job flexibility also determines the position of the labor supply
IV. Labor Outsourcing, Wages
Wage and Employment Effects
of Outsourcing: The immediate economic effects of outsourcing are
clear. When a home industry’s firms can employ foreign labor services that are
a close substitute for home labor services, the demand for foreign labor services
will increase and the demand for home labor services will decrease.
US Labor Market Effects of Outsourcing by
US Firms: In the US the demand for labor provided by US workers will
decrease when US firms outsource jobs to foreign countries such as India.
Other things constant the wage and employment of US workers will decrease.
In a foreign country such as India, the demand for labor increases, and
the Indian wage and employment levels increase.
US Labor Market Effects of Outsourcing by
Foreign Firms: In the US the demand for labor provided by US workers
will increase when foreign firms outsource jobs to the US Other things constant
the wage and employment of US workers will increase. In a foreign country
such as Mexico, the demand for labor decreases, and the Mexican wage and
employment levels decrease.
Gauging the Net Effects
of Outsourcing on the American Economy: Labor outsourcing by US firms
tends to reduce US wages and employment. If foreign firms engage in labor outsourcing
in the US, US wages and employment increase.
Short-Run Versus Long-Run Effects of Outsourcing:
Despite the fact that in the short term the effects of outsourcing may be
lower wages and employment opportunities for some US workers it is the long-run
effects on the overall levels of wages and employment that are important.
The Long Term Benefits of Outsourcing for
the US Economy: Increased labor outsourcing is part of a trend toward
increased international trade in goods and services. Engaging in international
trade allows residents of each nation that participates to specialize in
producing the goods and services that they can produce most efficiently.
The outcome is an increased production of goods and services and higher
income levels and consumption. On balance in the long run outsourcing makes
consumers in the US and other countries better off.
Force Participation Rate from the
Federal Reserve Bank of San Francisco and video (4:15)
Rate: Measuring the Workforce
Federal Reserve Bank of San Francisco
V. Monopoly and Labor
Constructing the Monopolist’s
Input Demand Curve: In constructing the demand schedule for an input,
two factors must be considered: (1) the marginal physical product falls because
of the law of diminishing returns as more workers are added and (2) the price
(and marginal revenue) received for the product sold also falls as more product
is produced and sold.
Why the Monopolist Hires
Fewer Workers: If an industry in which there is perfect competition
in the output market could be changed to one in which there is a monopoly in
the output market, the amount of employment would fall because the monopolist
must take account of the declining product price that must be charged in order
to sell a larger number or quantity.
VI. Industrialization and
Labor Unions: In most countries labor movements started with local craft
unions, which were groups of workers in individual trades. In the 1790’s some British
craft unions began to try to engage in collective bargaining in which business management
engages in negotiations with union representatives about wages and hours of work.
The British Combination acts in 1799 and 1800 prohibited unions but in 1825 unions
were allowed to exist and engage in collective bargaining by Parliament.
Unions in the US:
The development of unions in the US lagged behind events in Europe. Between
the Civil War and the Great Depression the Knights of Labor was formed demanding
an eight-hour workday and equal pay for men and women. A dissident group from
the Knights of Labor formed the American Federation of Labor (AFL).
The Formation of Industrial Unions:
The National Labor Relations Act, or Wagner Act, enacted in 1935, guaranteed
workers the right to start labor unions, to engage in collective bargaining,
and to be members in any union.
Unions that have members from an entire
industry. In 1938 the Congress of Industrial Organizations (CIO), composed
of industrial unions, was formed by John L. Lewis.
Congressional Control over Labor Unions:
The Taft-Hartley Act allowed individual states to pass right-to-work
laws. This makes it illegal for union membership to be a requirement
for continued employment in any establishment. Jurisdictional disputes,
sympathy strikes and secondary boycotts are made illegal by this act
as well. The most famous aspect of the Taft-Hartley Act is its provision
that the president can obtain an injunction that will last for 80 days
against a strike believed to imperil national safety or health.
The Current Status of
Labor Unions: Different countries have differences in labor laws
that complicate efforts to make inter-country comparisons of the status of labor
unions. It is still possible to assess how widespread union membership is in
different countries and to evaluate trends in union membership.
Worldwide Trends in Unionization: Rates
of unionization differ from country to country.
US Unionization Trends: Union membership
as a percent of US workers has been declining since the 1970s. Some of the
reasons for this decline have been the decrease in manufacturing employment
where unions have been strongest, deregulation, increased global competition,
increased immigration, and the increased importance of social regulation.
Strong unions have a long record of lifting workers’ living standards
reducing income inequality. The decline of unions, on the other
hand, has contributed to slow-growing living standards for most
In 2020, the
percentage of Americans who say they support unions has risen
according to Gallup polls.
VII. Union Goals and Strategies:
Through collective bargaining, unions establish minimum wages for union workers.
Union representatives and management negotiate collective bargaining contracts.
Once approved by the members, these contracts establish the length of the workday,
wage rates, working conditions, fringe benefits, and other matters, usually for
the next two or three years.
Ultimate Bargaining Tool: The purpose of a strike is to impose costs on management
to force management’s acceptance of the union’s proposed contract terms. Workers
draw no wages while on strike, but may be partly compensated out of strike funds.
Strikebreakers can effectively destroy the bargaining power of the union.
Union Goals with Direct
Wage Setting: One of the major roles of a union that establishes
a wage rate above the market-clearing price is to ration available jobs among
excessive numbers of workers who wish to work unionized industries.
Employing all members in the union
Maximizing member income
Maximizing wage rates for certain workers
Union Strategies to Raise Wages
Limiting entry over time: involves
freezing the number of workers in the union
Altering the demand for union labor
Increasing worker productivity
Increasing demand for union-made goods
Decreasing the demand for non-union-produced
VIII. Economic Effects of
Labor Unions: Have unions raised wages and affected productivity? Unions
have been able to raise the wages of members relative to nonunion members by about
$2.25 per hour on average. When unions increase wages beyond what productivity increases
permit, some union members will be laid off.
Unions and Wages:
Unions have been able to increase the wages of members relative to
non-union workers by about $2.25 per hour. Comparisons of annual earnings show
something else. Non-union workers have higher annual incomes than union workers
do; though non-union workers work a slightly longer work week.
Unions and Labor Productivity:
The traditional view of union behavior is that unions decrease productivity
by shifting the demand curve for union labor outward through featherbedding
(deliberately limit production or retain excess workers in order to
create jobs or prevent unemployment, typically as a result of a union
Another view is that unions actually increase productivity by acting as a collective
voice for members. Unions can apply pressure on employers to change unsatisfactory
working conditions. The individual worker has greater job security and worker
turnover in unionized industries should be less, contributing to increased productivity.
Economic Benefits and
Costs of Labor Unions: Unions are viewed in two ways. They can be
seen as restrictive monopolies that raise wages of some members at the expense
of other members and non-union workers. The other view is that they can help
increase labor productivity and contribute to workforce stability.
of the US economy’s output that flows to corporate profits has
almost doubled since the mid-1970s, while the share flowing to
workers’ compensation has fallen. Or consider this chart:
As you can see, stock prices and family incomes tracked each other
somewhat closely in the decades after World War II - but no longer
The Economy and Monetary Policy
Sectoral bargaining is the future of American labor unions.
Fresh Proof That Strong Unions Help Reduce Income Inequality
Test Yourself: Labor
Transfers and Taxes
payment for labor services or payment for ownership of a factor of production …
Labor is the most valuable resource sold by most households.
Measuring Income Distribution:
The Lorenz Curve: A geometric representation of the distribution
of income. A Lorenz curve that is perfectly straight represents perfect income
equality. The more bowed a Lorenz curve, the more unequally income is distributed.
Criticisms of the Lorenz Curve:
The Lorenz curve is typically presented in
terms of distribution of money income only.
The Lorenz curve does not account for differences
in family size and effort.
It does not account for age in income differences.
The Lorenz curve is typically given for money
income before taxes.
It does not measure unreported income from
the underground economy.
Income Distribution in
the US: There have been only slight changes in the distribution of
money income over time. The definition of money income used by the US Bureau
of Census includes only wage and salary income, income from self-employment,
interest and dividends, and such government transfer payments as Social Security
and unemployment compensation. In-kind transfers from the government are excluded.
Distribution of Wealth:
Distribution of income (flow) is different from distribution of
wealth (stock). The richest 10% of households own about 66% of
The Hidden Costs of Low Wages
II. Determinants of Income
Age: With age
comes more education training and experience, which affects earnings. The Age-Earnings
Cycle is the regular earnings profile of an individual throughout his or her
lifetime. It usually starts with low earnings at 18 and increases to a peak
at around age 50, when earnings gradually fall until they approach zero at retirement
Workers can expect to be paid their marginal revenue product (assuming that
there are low cost information flows and the labor and product markets are competitive).
In a competitive situation, workers who are being paid less than their marginal
revenue product will bid away to better employment opportunities. It is likely
that some persons are paid more or less than their marginal revenue product
because information is costly.
Determinants of Marginal Productivity:
Talent: These are factors that cannot
be acquired if one does not have them.
Experience: Experience can be linked
to the well-known learning curve that applies when the same task is
done over and over. The worker repeating a task becomes more efficient.
Training: Much of a person’s increased
productivity is due to on-the-job training.
Investment in Human Capital: Department
of Labor data show that on average high school graduates make more than
grade school graduates and on average college graduates make more than high
school graduates. The average the rate of return to investment in human
capital of a college education is between 6 and 10 percent, which is on
a par with the rate of return to investment in other areas.
An endowment can consist of an inheritance of cash, jewelry, stocks, bonds,
houses, and other real estate. Only about 10 percent of inequality of income
can be traced to differences in inherited wealth.
Economic discrimination occurs whenever workers with the same marginal revenue
product receive unequal pay due to some non-economic factor such as race, gender,
or age. It also occurs when there is unequal access to labor markets.
Access to Education: Minorities have
faced discrimination in the acquisition of human capital. The amount and
quality of schooling offered, has often been inferior to that offered whites.
The Doctrine of Comparable Worth: The
belief that women or minorities should receive the same wages as men if
the levels of skill and responsibility in their jobs are equal or equivalent.
III. Theories of Desired Income
Distribution: There are two normative standards for the distribution
of income that have been popular with economists.
“To each according to what he produces” is a contributive standard. It is based
on the principle of rewards based on the contribution to society’s total output.
each exactly the same” means that everyone gets the same amount. The problem
with this concept is that the incentive of higher rewards would be eliminated.
Productivity and growth would decline.
IV. Poverty and Attempts
to Eliminate It: There are a number of welfare programs set up for the
purpose of redistributing income from the better-off to the poor and for that purpose
alone, but these programs have not been entirely successful.
The US government defines the poverty line as income at or below
three times the amount of money needed to buy basic, nutritionally
sufficient food for all family members. The threshold income has been
revised upward annually by the increase in the Consumer Price Index.
Because the low-income threshold as an absolute measure never
changes in real terms, poverty will be reduced even if nothing is done
since real income levels have been growing.
Poverty has generally been defined in relative terms — in terms
of the income levels of individuals relative to the rest of the
population. It is based on income considerably below the average in a
society. Income qualifying for poverty status in a rich country may
exceed average income in a poorer country.
Causes of Poverty
of Education: The median income of high-school dropouts in 1997 was
$16,818, which was just above the poverty line for a family of four.
On average, people who live in the inner city earn less than people living
outside the inner city.
in Family Structure: Increased divorce rates result in more single-parent
families and more children living in poverty.
Shifts: Workers without college-level skills have suffered from the
ongoing decline of manufacturing, and the rise of service and high technology
and Gender Discrimination: Some inequality exists in wages between whites
and minorities, and men and women.
Transfer Payments as Income:
The official poverty level is based on pretax income, including cash but no
in-kind subsidies. If corrections are made for such benefits then the percentage
of the population that is below the poverty line drops dramatically.
Attacks on Poverty: Major
Social Security: For the retired, unemployed,
and disabled, certain insurance programs provide income payments in prescribed
situations. The best known is Social Security, which includes what has been
called old-age survivors and disability insurance (OASDI).
Supplemental Security Income and Temporary
Assistance to Needy Families: Many poor people do not qualify for Social
Security benefits. They are assisted through Supplemental Security Income,
which establishes a nationwide minimum income for the aged, the blind, and
the disabled. Temporary Assistance to Needy Families is a state-administered
program, partly financed by federal grants. It provides temporary aid to
families in need.
Food Stamps: Food stamps are government
issued coupons that can be used to purchase food. Food stamps are a major
part of the welfare system in the US.
The Earned Income Tax Credit Program:
In 1975 the EITC was created to provide rebates of Social Security taxes
to low-income workers. Since benefits are reduced by 17.68 cents for every
dollar earned above $11,000, the incentive to make more than $11,000 is
reduced. The typical EITC recipient works 1,700 hours per year compared
to a standard work year of 2,000 hours.
and Dimed: On Not Getting By in America (13:58)
One view: PBS Video,
the Rich Got Richer: Another View
What it’s like to live on $2 a day in the United States (PDF)
Try your skills at playing
SPENT. (It's not easy being poor!)
Nickel and Dimed: On (Not) Getting By in America
is a book written by
from her perspective as an undercover journalist investigating the impact of
welfare reform on the working poor in the US. If you were intrigued by the clip
above, this longer and more in-depth video by
will really make you think.
Making Ends Meet
Wealth Distribution In The United States Growing Worse
Most People Still Losing Ground In This Faltering Economy
V. Reduction in Poverty Rates:
The officially defined rate of poverty in the US has shown no long-run tendency
to decline. It reached its low of around 11% in 1973, peaked at over 15% in 1983,
and fell steadily to 13.1% in 1990 and has since fallen no lower than 12%.
VI. Health Care:
Sometimes people become poor because of inadequate (or no) health insurance. They
deplete their wealth paying for the expenses of an illness. Some workers may remain
in a job because of the health insurance benefits.
The US Health Care Situation:
Spending for health care in the US accounts for 16% of US real GDP. The US per
person cost is greater than anywhere else in the world.
Why Have Health Care Costs Raised
The Age-Health Care Expenditure Equation:
The top 5% of health care users incur over 50% of all health expenditures.
The bottom 70% of users accounts for only 10%. The aging population stimulates
the demand for health care and elderly make up most of the top users.
New Technologies: High technology is
another reason health care costs have raised dramatically. For example a
CT scanner costs around $100,000, an MRI scanner can cost over $4 million,
and a PET scanner costs around $4 million. Fees for using these machines
can cost between $300 and $2,000.
Third-Party Financing: Medicare, Medicaid
and private insurance companies are third parties. When they pay for medical
costs, demand for services increases. Medicare and Medicaid are the main
providers of hospital and other benefits to 35 million Americans, most over
65. Medicaid, a joint state-federal program, provides long-term health care
(nursing homes). There is an inverse relationship between the price and
quantity demanded of medical services. Third-party payment simply decreases
the net price to the consumer, thus increasing the quantity of services
demanded. The more a third party pays, the greater is the likelihood that
a consumer will substitute medical services for a healthier lifestyle.
Price and Quantity Demanded: Because
of third-party payment, the effective price facing each consumer of medical
services is often zero, or close to it. Thus, at the “low” price, it is
not surprising that the quantity of medical services demanded has increased
Moral Hazard as it Affects Physicians and
Hospitals: Because patients do not pay much, if any, of their health
care costs themselves, they do not have an incentive to question the need
for medical tests and procedures. Doctors and hospitals get paid by the
number of services they render. They have no incentive to try to keep costs
to the patient and third party payer down. Instead, their incentive is to
increase the number of services and thus costs.
Is National Health Insurance
the Answer? Proponents argue in favor of a Canadian style system,
where the government sets the fees paid to a physician, prohibits private practice,
and sets a yearly income cap on the amount a doctor can receive. A specified
amount of funding is provided to hospitals. Using the Canadian model, people
would receive fewer health services, stay in hospitals longer, and have fewer
tests and procedures.
Countering the Moral Hazard
Problem: A Health Savings Account: A health savings account (HSA)
allows individuals to save money in a tax-exempt account that they could use
to pay medical bills. Then a family or employer could buy major medical insurance
with a high deductible at a relatively low price.
Combating Moral Hazard: Contributors
who do not use their MSAs could keep the money as a supplemental retirement
account. The moral hazard problem is reduced because patients would have
to pay for minor medical expenses up to the high deductible on major medical
insurance. Thus they would have an incentive to live healthier lifestyles
and physicians would not order expensive tests without first consulting
with their patients.
The Critics’ Responses: Critics say
that people will avoid visits to a doctor for minor problems that could
turn into major ones if left untreated. In addition HSAs would sabotage
managed care plans that limit patients’ choice of physicians and hospitals
in exchange for low or no deductibles.
Household Incomes: A Snapshot from the
Federal Reserve Bank of San Francisco and video (6:15)
Inequality: Measuring the Gap from the
Federal Reserve Bank of San Francisco
US Census Bureau's Poverty Statistics
We, the Economy Films: Chapter 5: What causes inequality?
Is inequality growing? In a magical land inhabited by long lashed, multi-colored
Alpacas who love lollipops, rainbows and friendship, there's a yawning divide
in wealth distribution ... what's behind the inequality gap?
Why is the minimum wage important? In 2013, Seattle became ground zero
for the heated national debate about increasing the minimum wage to $15 per
hour. "The Value of Work" gives voice to supporters and the opponents, including
the mayor, an activist city councilwoman, small business owners, and minimum-wage
workers affected by the unprecedented legislation.
Why is healthcare so expensive? "This Won't Hurt a Bit" is a short film
that tells the all too familiar tale of American healthcare. A patient enters
a hospital with a migraine headache, unaware of the costs his visit will incur
on the path to a diagnosis. He learns much more than he bargained for in this
comedy on unaffordable care.
What are the causes of inequality? In "Monkey Business," economists from
across the political spectrum help explain the causes of economic inequality,
with help from a couple of mammalian friends.
Test Yourself: Income, Transfers and Taxes
I. Forms of Industry Regulation:
There are two basic types of government regulation: 1) economic regulation, 2) social
Initially this was regulation to control prices that natural monopolies were
allowed to charge. Over time federal and state governments have sought to regulate
the characteristics of products or processes in industries without monopolistic
Regulation of Natural Monopolies: The
regulation of natural monopolies has emphasized regulation of product prices
to prevent monopoly profits that is also called rate regulation.
Regulation of Non-Monopolistic Industries:
All state governments regulate prices that the insurance companies can charge.
Most other government regulation establishes rules that pertain to production,
product features, and entry and exit within a number of specific non-monopolistic
The aim of social regulation is to improve the quality of life through improved
products, a less polluted environment, and better working conditions. Social
regulation affects all firms in the economy and not just certain industries.
Regulating Natural Monopolies
Natural Monopolies Revisited:
Whenever a single firm has the ability to produce all of the industry’s output
at a lower per-unit cost than any other firm, a natural monopoly arises. The
long-run average costs are falling over such a large range of production rates
(relative to demand) that only one firm can survive in such an industry.
The Pricing and Output Decision of the Natural
Monopolist: The natural monopolist will produce to the point where marginal
cost equals marginal revenue and set price on the demand curve. Price will
be greater than marginal cost.
Regulating the Natural Monopolist: The
Problem of Marginal Cost Pricing: The government determines the price that
the natural monopolist can charge. If regulation forces a natural monopolist
to set price equal to marginal cost, then the monopolist would incur losses
because price would be less than average cost.
Practical Regulation of
Natural Monopolies: Because regulators cannot force a natural monopolist
to charge a price equal to marginal cost and make it stay in business, regulation
has often taken the form of average cost pricing. This can take the form of
only allowing prices equal to the actual cost of service called cost-of-service
pricing. Rate-of-return regulation allows the firm to set a price equal to average
cost where average cost includes what regulators deem a normal or competitive
rate of return on investment.
III. Regulating Non-Monopolistic
Industries: Protecting consumer interests has been the main rationale
for government regulatory functions.
Rationales for Consumer
Protection in Non-Monopolistic Industries: At one time the rule of
“caveat emptor,” or “let the buyer beware” was the rule in market transactions.
Today federal regulations require sellers to meet certain minimum standards
in their dealings with their customers.
Reasons for Government-Orchestrated Consumer
Protection: There are two major reasons: (1) market failure and (2)
Asymmetric Information and Product Quality:
In extreme cases asymmetric information can lead to a situation where most
of the products are of low quality. This is called the lemons problem with
The Lemons Problem: The possibility
that asymmetric information will lead to a general reduction in quality
in an industry. This is particularly a potential problem with credence goods.
Market Solutions to the Lemon Problem:
Market solutions to the lemons problem are sellers offering warranties,
setting industry standards, and seeking of external product certification.
Protection Regulation: Governments implement legal remedies for consumers,
licensing, and have a regulatory apparatus for overseeing all aspects of an
industry’s operations when they consider private market solutions insufficient
for the lemons problem and asymmetric information.
Liability Laws and Government Licensing:
Some liability laws specify penalties for product failures that provide
consumers with protections similar to warranties. Governments also issues
licenses that grant only qualifying firms the legal right to produce and
sell certain products.
Direct Economic and Social Regulation:
A government may determine that the lemons problem is so severe in a given
industry such as banking, that it establishes a regulatory apparatus to
maintain public confidence in that industry.
IV. Incentives and Costs of
Regulation: Because abiding by regulation is costly for businesses, they
engage in activities that are intended to avoid the true intent of regulations or
to change established regulations.
A. Creative Response
and Feedback Effects: This is a firm’s behavioral modification
that allows it to comply with the letter of the law, but violate the
spirit of the law, significantly lessening the law’s effects. Sometimes
there is a feedback effect in which the individual’s behavior changes
in undesirable ways after the regulation is implemented.
Regulator Behavior: The two best known explanations of regulator
behavior are the capture hypothesis and the “share the gains, share
the pains” theory.
The Capture Hypothesis:
A theory of regulatory behavior that predicts that the regulators
will eventually be captured by the special interests of the
industry that is being regulated.
Share the Gains, Share the Pains:
A theory of regulatory behavior in which regulators must take
account of demands of legislators who established and oversee
the regulatory agency, those in the regulated industry and consumers
of the regulated industry.
The Benefits and Costs
of Regulation: While there are many potential benefits of regulation
it is difficult to measure the actual benefits of regulation.
The Direct Cost of Regulation to US
Taxpayers: Currently the federal government spends $30 billion per year
to fund the staff and activities of federal regulatory agencies. In addition
businesses spend money complying with the regulations.
The Total Social Cost of Regulation:
The estimated total social cost of complying with federal regulations is
estimated at $800 to $900 billion per year. When the costs of complying
with state regulation are added the estimates exceed $1 trillion.
V. Antitrust Policy:
The logic behind antitrust legislation is that if the courts can prevent collusion
among sellers of a product, monopoly prices will not result and there will be no
restriction of output. There will be no economic profits in the long-run.
Congress has enacted four key antitrust laws.
The Sherman Antitrust Act of 1890: This
act was the first attempt by the federal government to control the growth
of monopoly in the US. The most important provisions of the act are Section
1 (prohibits every contract, combination in the form of trust or otherwise
or conspiracy, in the restraint of trade or commerce among the several states,
or with foreign nations) and Section 2 (makes it illegal to monopolize,
or attempt to monopolize, or combine or conspire with any other person or
persons to monopolize any part of trade or commerce).
Other Important Antitrust Legislation:
The Sherman act was so vague that in 1914 a new law was passed —the Clayton
Act of 1914. It legally prohibited a number of very specific business practices.
Federal Trade Commission Act of 1914 and Its 1938 Amendment: The Federal
Trade Commission Act was designed to stipulate acceptable competitive behavior.
It was supposed to prevent overly aggressive competition. The Federal Trade
Commission is charged with the power to investigate unfair trade practices.
In 1938 the Federal Trade Commission Act was amended to allow the FTC to
regulate advertising and marketing practices. The Robinson-Patman Act of
1936 was designed to protect independent retailers from specified unfair
competitive acts by chain stores.
Exemptions from Antitrust Laws:
All labor unions
Public utilities-electric, gas and telephone
Professional sports, especially baseball
Cooperative activities among American exports
Schools and hospitals
Public transit and water systems
Suppliers of military equipment
Joint publishing arrangements in a single
city by two or more newspapers
in Antitrust Policy: A major issue is different antitrust laws in
the US and the EU. Under EU antitrust laws any business combination that “creates
or strengthens a dominant position” significantly reducing or impeding competition
is prohibited. It does not matter how or why competition is significantly reduced.
In the US it does matter.
VI. Enforcement of the Antitrust
Laws: Most antitrust enforcement today is based on the Sherman Act. The
Supreme Court has defined the offense of monopolization as “(1) possession of monopoly
power in the relevant market and (2) the willful acquisition or maintenance of the
power as distinguished from growth, or the development as a consequence of a superior
product, business acumen, or historic accident.”
Monopoly Power and the
Relevant Market: The Market Share Test is the primary measure of
market power and is the percent of the relevant market that the firm controls.
Generally a firm is considered to have monopoly power if it has a 70 percent
or greater market share. The relevant market consists of (1) a relevant product
market and (2) a relevant geographic market.
Product Packaging and
Antitrust Enforcement: In US antitrust enforcement it is important
to determine whether a firm has engaged in “willful acquisition or maintenance”
of market power. Two actions, versioning and bundling are presented.
Very Definition of Antitrust: AT&T and T-Mobile Deal is a Consumer Disaster
Product Versioning: Versioning is selling
an item in slightly altered forms to different groups of consumers at different
prices. In the US versioning is not viewed as illegal price discrimination.
Product Bundling: The joint sale of
two or more products as a set. If it is only offered as a set and not individually,
then US antitrust authorities view it as a form of price discrimination
known as tie-in sales. Tie-in-sales requires consumers who wish to buy one
of its products to purchase another item the firm sells as well.
Diverging International Enforcement Perspectives:
While US courts ruled that Microsoft had to unbundle Internet Explorer and
Windows, the EU’s antitrust enforcers also required Microsoft to unbundle
Windows and Windows Media Player as well. This action has yet to be resolved.
Test Yourself: Antitrust and Regulation
I. Private vs Social Costs:
Private (internal) costs are costs incurred by individuals when they use scarce
resources. Social costs are the full costs that society bears when a resource-using
action occurs. For example, the social cost of driving a car equals all the private
costs such as buying gasoline plus any additional cost that society bears, such
as air pollution and traffic congestion. The air in many cities is heavily polluted
from automobile exhaust fumes because when automobile drivers drive their cars they
bear only the private costs of driving. They cause air pollution, which is a cost
because it causes harm to other individuals. Drivers are not forced to take into
account the cost of air pollution when they make the decision to drive.
A situation in which a private cost or benefit diverges from a social cost or benefit,
that is, the cost or benefits of an action are not fully borne by the two parties
engaged in exchanges or by an individual engaging in a scarce resource-using activity.
III. Correcting for Externalities:
The signals in the economy must be changed so that decision-makers will take into
account all the costs of their actions.
A. The Polluter’s
Choice: Faced with a cost of polluting, polluters will be induced
to (1) install pollution abatement equipment or otherwise change production
techniques so as to reduce the amount of pollution, (2) reduce pollution-causing
activity, or (3) simply pay the price to pollute. Each polluter is faced
with the full social cost of his or her actions and makes a decision accordingly.
B. Is A Uniform Tax
Appropriate? The taxes imposed should be set equal to the economic
damages or externalities caused by the pollution-creating activity.
The by-products of an economic activity. There is no correct answer to how much
pollution should be in an economy because when the question is asked, a value judgment
is being requested. There is no way to disprove a value judgment scientifically.
The optimal quantity of pollution is determined when pollution is reduced up to
the point where the marginal benefit from further reduction equals the marginal
cost of further reduction. The optimal quantity of pollution is the level of pollution
for which the marginal benefit of one additional unit of clean air equals the marginal
cost of that additional unit of clean air.
V. Common Property:
Common Property is property that is owned by everyone and, therefore, owned by no
one. Air and water are common property resources. Pollution occurs where there are
no well-defined private property rights as in air and common bodies of water.
A. Voluntary Agreements
and Transactions Costs:
1. Voluntary Agreements: Under some circumstances
voluntary contracting will occur to internalize externalities.
2. Transaction Costs: One major condition for
successful voluntary contracting is that the transaction costs — all costs
associated with making, reaching, and enforcing agreements — must be low
relative to the expected benefits of reaching an agreement.
B. Changing Property Rights:
Assume that many property rights and many resources are not defined. Only when
and if a use is found for a resource or the supply of a resource is inadequate
to meet the quantity demanded at a zero price, does a problem develop. The problem
requires that something be done about deciding property rights. If not, the
resource will be wasted and possibly even destroyed. There are three ways to
fill the gap between private and social costs: taxation, subsidization, and
C. Are There Alternatives
to Pollution-Causing Resource Use? Some people cannot understand
why we do not use non-pollution-causing sources to generate electricity, such
as solar power. The fact is that generating solar power is generally more expensive
relative to other alternatives. The technology does not exist yet to use solar
power cost-effectively in most cases.
VI. Wild Species, Common Property
and Trade-Offs: Wild species of animals are common property resources
in that no one owns them and thus no one has an economic interest in protecting
them. The Endangered Species Act involves restricting the use of habitats even if
on private property. For example, in an attempt to save the spotted owl, logging
in the Pacific Northwest was restricted and thousands of logging jobs were lost.
There is thus an economic trade-off between protecting endangered species and economic
The benefits of recycling are straightforward. Fewer natural resources are used.
Recycling may not save total resources, however, because decreased demand for the
resource (trees used for paper) may cause a decrease in supply.
A. Recycling’s Invisible
Costs: Labor resources involved in recycling are often more costly
than the potential savings in scarce resources. Net resource use with recycling
may be greater than without it.
In some areas, such as major cities, there may be a solid waste disposal crisis.
In the rest of the US the data do not indicate a crisis. The disposal price
per ton of city garbage has actually fallen.
C. Should We Save Scarce
Resources? Virtually every natural resource has fallen in price over
the last few decades, arguing against the claim that we are running out of resources.
You should conclude from this section that neither government
nor markets can be asserted as a good solution to environmental
problems. Of the two, government is likely the best option.
and Negative Externalities (PDF)
Environmental Economics and Policy (PDF)
Test Yourself: Externalities