Tariffs and Quotas:
Who gains and who loses from a tariff? How do the effects of tariffs differ from the effects of
quotas? If you were a small country, what would you rather utilize?
Your initial post should be at least 250 words in length. Utilize the required reading material as
well as the article to support your claims.
Mike Powell/Allsport Concepts/Getty Images
12
Marginal Productivity Theory
and Labor Markets
Learning Objectives
By the end of this chapter, you will be able to:
• Explain what makes the demand for labor different from the demand for final goods.
• Describe how a profit-maximizing firm in pure competition decides how much labor to employ in
terms of its marginal revenue product and marginal resources cost.
• Use a resource market diagram to illustrate the use of labor under pure competition versus monopoly in the product market.
• Define monopsony and discuss why monopsonistic exploitation may occur.
• Determine the factors that affect the elasticity of demand for labor and describe possible causes for
a shift in the demand for labor.
• Explain the role of productivity, race, and comparable worth in determining labor income.
ama80571_12_c12_331-352.indd 331
1/28/13 9:50 AM
Section 12.1 Special Features of the Demand for Labor
CHAPTER 12
Introduction
C
onsider this. . . Every firm operates in two markets. It sells a product and it buys
productive resources to produce that product. Nowhere is the firm that is purchasing labor in the labor market more in the news than it is in professional sports.
At the beginning of each NFL season, the sports pages provide a running tally of the
unsigned players. In July 2012, none of the top eight draft picks had signed deals with a
team. Four of these players were represented by one of the top Hollywood talent management firms, Creative Arts Agency. The rumor was that the players were holding out for
better deals and contracts with four years of guaranteed compensation, which the teams
were reluctant to offer (Florio, 2012).
Football is not alone in filling the sports pages with salary negotiations. In 2011, the average salary in the National Basketball Association was $5.15 million. That enormous sum
can be compared to the next three largest sports: Major League Baseball players earn an
average of $3.31 million, National Hockey players take home $2.4 million on average,
and National Football League players come in last with a “paltry” average of $1.9 million
(Dorish, 2011). Is there a reason for this? Are the owners more interested in harmony with
their players in pro basketball than in pro football? The material in this chapter will help
you understand the economics behind the headlines announcing player salaries that you
read in the sports section of your newspaper.
12.1 Special Features of the Demand for Labor
E
arlier in this book, we examined the circular flow as a starting point. It shows the
firm involved in two markets: the product market and the resource market. Figure 12.1 reproduces the circular flow diagram from Chapter 2. We have studied the
theory of the firm in the product market, the upper half of the circular flow diagram. We
now turn our attention to the theory of the firm in the largest part of the resource market,
the labor market.
ama80571_12_c12_331-352.indd 332
1/28/13 9:50 AM
CHAPTER 12
Section 12.1 Special Features of the Demand for Labor
Figure 12.1: The circular flow of income
or,
r
is
L
ab
e
s
ending for Goods a
r Sp
nd
e
m
Se
T
su
M
C
U
A
D
rv
R
n
KET
ice
PRO
Co
d
n
S
a
e
r
s
v
d
ices
o
Go
La
nd,
Ca p i t a l , a n d
te
En
rp
RE
ET
SOU
R C E MARK
Wa
fit
ges
Pro
d
, Re n
n
t, Interest, a
Households purchase goods and services, and they supply land, labor, capital, and enterprise. Firms
buy these productive resources and supply goods and services. In the product market, buyers and
sellers exchange goods and services. In the resource market, buyers and sellers exchange the services or
productive resources.
The demand for labor is similar to other types of demand we have studied. In earlier
chapters, we described product markets, in which firms or individuals sell the goods and
services they produce to consumers. Now we want to examine the labor market, the market in which firms buy—or rent—the services of labor from individuals. We can adopt
many of the same analytical tools we used to study product markets. There are, however,
some differences between labor and product markets, and we will concentrate on these
differences.
The demand for labor has three features that make it somewhat different from the demand
for a product. The first is that the demand for labor is derived demand. A firm demands
labor because the labor can be used to produce goods that consumers are demanding. The
demand for labor is thus derived from the demand for the product it produces. If there
were no consumer demand for products made from wood, there would be no demand for
loggers. This principle holds for all productive resources. They are only valuable to a firm
if they help to produce products that consumers value.
The second feature of the demand for labor is that it is interdependent demand. It
depends on the demand for other inputs. In other words, the amount of labor demanded
ama80571_12_c12_331-352.indd 333
1/28/13 9:51 AM
Section 12.2 The Market for Labor With Perfect Competition
CHAPTER 12
will depend on the amounts of other inputs a firm plans to use. The amount of labor a
firm demands depends on the amounts of land, capital, and enterprise that will be used
in combination with the labor. It is also true that the demand for most products is interdependent with the demand for other products. As you know, almost all goods have substitutes and many goods have complements. However, the interdependence of the demand
for labor with the demand for other productive resources is unusual in that the other
resources can be both complements and substitutes at the same time.
The third feature is that the demand for labor is in part technologically determined
demand. That is, the demand for labor will depend on techniques of production and on
technological progress, or the production function. Recall that the production function
tells how much labor is needed to produce a certain level of output, given a certain production process and amounts of the other productive resources of production. This technological relationship can change with new inventions and new innovations. Any change
resulting in a new technology or a new innovation will have an impact on the demand for
productive resources, including labor.
These three elements are combined in marginal productivity theory, which was originally
developed by John Bates Clark. Marginal productivity theory explains how the distribution of income is determined in a market system. Each input is paid according to its
contribution, or its marginal productivity. The more productive inputs will be paid more.
We will follow Clark’s lead by developing marginal productivity theory in terms of labor
supply and demand. The theory holds for all productive resources of production, but
most interest centers on labor and the returns to labor.
Check Point: Special Characteristics of Resource Markets
• Demand is derived from the demand for the final product.
• Demand is interdependent with demand for other inputs.
• Demand is technologically determined.
12.2 The Market for Labor With Perfect Competition
R
emember that a demand curve shows the relationship between price and quantitydemanded. A demand curve for labor shows how much labor will be demanded
at various wage rates. In order to develop a theory about the market demand for
labor, we start by asking how much labor an individual firm will employ at various wage
rates. Then we sum the results for all firms in the same way we added individual demand
curves to find the market demand for a product.
Consider a firm that is selling its product in a perfectly competitive product market and
buying its labor in a perfectly competitive labor market. This means that the firm will take
both the price of its product and the price of labor as given. The firm is too small to have
any effect on either product prices or wage rates.
ama80571_12_c12_331-352.indd 334
1/28/13 9:51 AM
CHAPTER 12
Section 12.2 The Market for Labor With Perfect Competition
The Demand for Labor
What determines the firm’s demand for labor? Suppose the production function is such
that, as the firm increases the amount of labor employed, ceteris paribus, the resulting
increases in the amount of total product become smaller. This production function reflects
the principle of diminishing marginal productivity, which we discussed in an earlier
chapter. Holding constant the quantities of land and capital, it is possible to determine
how the firm’s output varies with the quantity of labor it uses. As the firm employs more
labor in combination with fixed amounts of the other inputs, the additional amounts of
output per additional unit of labor eventually decline. If this were not the case, it would
be theoretically possible to grow the entire world’s supply of wheat on one acre of land
just by employing more workers.
The amount of total product associated with various amounts of labor inputs for the firm
is given in the second column of Table 12.1. This output depends on the technical relationship defined by the production function. Once we know the total product, we can determine how much extra product is produced when labor inputs are added. That value is the
marginal product of that unit of labor (MPL). It is the marginal product because the output
is in physical units, such as number of autos or tons of coal.
Table 12.1: The demand for labor in a perfectly competitive product market
Units of
labor
Total
product
Marginal
product of
labor (MPL)
Product
price
Total
revenue
Value of
marginal
product of
labor (VMPL)
Marginal
revenue
product of
labor (MRPL)
0
0
0
$2
$0
$0
$0
1
10
10
2
20
20
20
2
18
8
2
36
16
16
3
24
6
2
48
12
12
4
28
4
2
56
8
8
5
30
2
2
60
4
4
To put a market value on the additional output, we simply multiply the number of added
units of the product by the price at which the firm can sell it. This value is called the value
of the marginal product of labor (VMPL). It is listed in the sixth column of Table 12.1.
The VMPL, which is P 3 MPL, is a measure of the value of the additional output that each
additional unit of labor adds to the firm’s total. The marginal revenue product of labor
(MRPL) is the amount that an additional unit of labor adds to the firm’s total revenue. It
is found in the seventh column of Table 12.1. It is found by multiplying MR by MPL. With
perfect competition in the product market, VMPL 5 MRPL. These values are equal because
the product price remains constant (P 5 MR). The firm can produce and sell as much as it
wants at the market-determined price, which is $2 in this example. When the firm faces a
given price, marginal revenue is exactly equal to that price in the model of perfect competition. Later in this chapter, we will look at how the value of the marginal product and the
marginal revenue product differ when there is monopoly power in the product market.
ama80571_12_c12_331-352.indd 335
1/28/13 9:51 AM
CHAPTER 12
Section 12.2 The Market for Labor With Perfect Competition
The values of VMPL and MRPL from Table 12.1 are plotted on a graph in Figure 12.2. The
MRPL curve is the firm’s demand curve for labor. It shows the value of each additional
unit of labor to the firm. Thus, it shows how much labor the firm will purchase at various prices (wage rates). If you know the price of labor, you will be able to determine how
much labor this firm will demand.
Figure 12.2: The firm’s demand for labor in a perfectly competitive
product market
Price,
Cost
20
15
VMP L= MRP L= D L
10
5
0
1
2
3
4
5
6
Quantity/
Time Period
The marginal revenue product of labor (MRPL) curve is the firm’s demand curve for labor. When the
firm’s product market is perfectly competitive, MRPL and VMPL are identical.
Economics in Action: The More, the Merrier?
One must consider the incremental benefit a firm gains when hiring someone. Follow the link to the
Khan Academy (http://www.khanacademy.org), and then do a search for the video "A Firm's Marginal Product Revenue Curve" to learn more about how labor adds to business.
ama80571_12_c12_331-352.indd 336
6/21/13 10:35 AM
CHAPTER 12
Section 12.2 The Market for Labor With Perfect Competition
The Supply of Labor
An individual’s supply curve of labor looks like the other supply curves we have considered. As wage rates rise, the quantity of labor supplied increases. This supply curve
of labor, like most supply curves, is upward sloping. As wage rates rise, an individual
will want to work more hours. In general, as wages rise, more people will choose to give
up leisure in favor of more income. This trade-off of income for leisure is the substitution
effect of a wage increase. Individuals will substitute the increased consumption of goods
and services that higher wages represent for leisure. This substitution effect occurs along
the upward-sloping portion of Figure 12.3.
Figure 12.3: An individual’s labor supply curve
Wage Rate
(Dollars/Hour)
S
15
10
5
0
Quantity of Labor Supplied (Hours/Week)
When the substitution effect of a wage increase for an individual exceeds the income effect, the
quantity of labor supplied increases. Up to some wage ($15 per hour here), the income effect
dominates. Above that wage, further increases in the wage rate cause the quantity of labor supplied to
decrease.
There is also an income effect associated with the increased income brought about by
a wage increase. Individuals want to consume more leisure at higher incomes because
leisure is a normal good. The income effect of a higher wage is that individuals want to
supply a lower quantity of labor. At some point, the income effect of a wage increase could
dominate the substitution effect. In that case, an increase in the wage rate would bring
about a decrease in the quantity of labor supplied. This is represented by the crook in the
ama80571_12_c12_331-352.indd 337
1/28/13 9:51 AM
CHAPTER 12
Section 12.2 The Market for Labor With Perfect Competition
individual’s supply curve in Figure 12.3. For this individual, an increase in the wage rate
above $15 per hour causes the quantity of labor supplied to decrease. Economists refer to
a supply curve with this shape as a backward-bending supply curve. It is important to
keep in mind that this is an individual supply curve. Where the bend occurs is an individual decision. For example, some entertainers perform less as they get more famous. Others appear to keep increasing the quantity of labor supplied as their wage rate increases.
The market supply curve of labor is the aggregate of all the individual supply curves. It
shows how much labor is available at different wage rates, as in Figure 12.4. This market
supply curve is not backward-bending because more workers will enter the market at
higher wage rates, and different individuals have different opportunity costs and will
make choices resulting in different substitution effects and income effects. In other words,
higher wages are needed to attract additional workers who have higher opportunity costs.
Figure 12.4: Perfectly competitive labor market
(a) Firm
(b) Market
Price,
Cost
W
Price,
Cost
S f = MRC L
W
VMP = MRP L
0
x1
Quantity/
Time Period
SL
D L = ∑ MRPL
0
Quantity/
Time Period
In a perfectly competitive labor market, the firm faces a perfectly elastic supply curve (Sf). If the supply
curve is perfectly elastic, the marginal resource cost (MRCL) curve is also perfectly elastic. The firm can
purchase as much labor as it wants at the market-determined wage rate.
ama80571_12_c12_331-352.indd 338
1/28/13 9:51 AM
Section 12.3 A Competitive Labor Market With a Monopolistic Product Market
CHAPTER 12
We assumed that the firm is in perfectly competitive input markets. Perfect competition in
the labor market means the firm can purchase labor at the market wage without affecting
that wage. In this sense the firm is a wage taker, just like the perfectly competitive firm
was a price taker in the product market. The equilibrium wage rate is W in Figure 12.4.
The firm can purchase as much labor as it wants at the wage rate W. The supply curve
the firm faces, represented by Sf in Figure 12.4, is thus perfectly elastic at W. If the supply
curve a firm faces is perfectly elastic, the cost of each additional unit of labor is the same,
or constant. The cost of each additional unit of labor is the marginal resource cost of labor
(MRCL). For a firm in a perfectly competitive labor market, the marginal resource curve of
labor, MRCL, is the same as the labor supply curve.
Equilibrium in the Perfectly Competitive Labor Market
The MRCL curve is the supply curve the firm faces because it shows the relationship
between price and additional units of labor supplied. A profit-maximizing firm will
employ or purchase labor until MRPL 5 MRCL . If a unit of labor adds more to revenue
than to cost (if MRPL . MRCL ), it will be profitable for the firm to purchase more units of
labor. However, if a unit of labor adds more to cost than to revenue (if MRPL , MRCL ), the
firm should purchase fewer units. The firm will hire laborers until the amount they add
to total cost (MRCL ) is exactly equal to the amount they add to revenue (MRPL ). In Figure
12.4, the firm would employ x1 units of labor at wage rate W. In terms of the numbers in
Table 12.1, the firm would employ 4 units of labor if the market wage was $8 per unit. If
the market wage was $4 per unit, 5 units of labor would be employed.
12.3 A Competitive Labor Market With a Monopolistic
Product Market
N
ow consider a firm that sells its product under monopoly conditions. The monopolist’s demand for labor is shown in Table 12.2. The difference between this case
and the firm of the preceding section is that product price (fourth column) declines
as the firm produces and sells more of its product. VMPL and MRPL are calculated in the
same way as before. VMPL is the value of the labor’s marginal product, so VMPL 5 MPL
3 P. MRPL is found by calculating the change in total revenue due to additional units of
labor. For example, when the third worker is added, total revenue rises from $162 to $192.
Thus, MRPL for the third worker is $192 2 $162 5 $30. Note that VMPL is greater than
MRPL for all but the first unit of labor, because in a monopoly, product price is greater than
marginal revenue.
ama80571_12_c12_331-352.indd 339
1/28/13 9:51 AM
CHAPTER 12
Section 12.3 A Competitive Labor Market With a Monopolistic Product Market
Table 12.2: The demand for labor in a monopolistic product market
Units of
labor
Total
product
Marginal
product of
labor (MPL)
Product
price
Total
revenue
Value of
marginal
product of
labor (VMPL )
Marginal
revenue
product of
labor (MRPL )
0
0
0
$0
$0
$0
$0
1
10
10
10
100
100
100
2
18
8
9
162
72
62
3
24
6
8
192
48
30
4
28
4
7
196
28
4
5
30
2
6
180
12
216
Both the VMPL curve and the MRPL curve are graphed in Figure 12.5 using the data from
Table 12.2. The MRPL curve is the monopolist’s demand curve for labor. This firm, like the
perfectly competitive firm, will employ labor until MRPL 5 MRCL . Although this firm is
selling its product in a monopolistic product market, it is purchasing labor in a competitive labor market.
Figure 12.5: The monopolist’s demand for labor
Price,
Cost
VMP L
0
MRP L = D L
Quantity/
Time Period
When a firm has a monopoly power in the product market, the MRPL will lie below VMPL. This is
because product price is greater than marginal revenue under monopoly. Thus, P 3 MPL is greater than
MR 3 MPL.
ama80571_12_c12_331-352.indd 340
1/28/13 9:51 AM
CHAPTER 12
Section 12.3 A Competitive Labor Market With a Monopolistic Product Market
The supply and demand curves for the monopolist in the competitive labor market are
diagrammed in Figure 12.6. The market demand curve for labor is, as usual, found by
summing the MRPL curves for all firms purchasing this type of labor. The market supply
curve (SL) is the sum of individual supply curves of workers. The market-determined
wage is W. This firm can purchase as much labor as it desires at W, since the supply curve
it faces, Sf, is perfectly elastic at W.
Figure 12.6: A
monopolistic firm facing a perfectly competitive labor market
(a) Firm
(b) Market
Price,
Cost
Price,
Cost
SL
S f = MRC L
W
W
VMPL
0
x1
x2
MRP L= D L
Quantity/
Time Period
D L = ∑ MRPL
0
Quantity/
Time Period
A firm with monopoly power in the product market and in a perfectly competitive labor market will face
a perfectly elastic supply curve. The firm will hire units of labor until the marginal revenue product of
labor is equal to the marginal resource cost of labor (MRPL 5 MRCL).
Since Sf is perfectly elastic, MRCL for this firm is constant. The firm maximizes profits
where MRCL 5 MRPL , so it hires x1 units of labor. Note from Figure 12.6 that the monopolist pays W, the market wage. The fact that MRPL is less than VMPL does not mean that
the monopolist exploits labor by paying too little. The monopolist has to pay the market
wage just like any other employer in this market. Because MRPL is less than VMPL , the
monopolist does employ fewer workers than similar competitive firms would employ.
Recall from the chapter on monopoly that the monopolist restricts output to keep price
high. The result of this restriction of output in the resource market is that the monopolist
uses fewer inputs, including labor. If this were a competitive firm rather than a monopolist, it would want to be on the VMPL curve (which would then also be the MRPL curve)
and hire x2 workers.
ama80571_12_c12_331-352.indd 341
1/28/13 9:51 AM
CHAPTER 12
Section 12.4 Determinants of the Demand for Labor
12.4 Determinants of the Demand for Labor
A
t the beginning of this chapter, you learned that the demand for labor has three
features, making it somewhat different from the demand for a product. These features also influence the elasticity of the demand for labor, because they determine
how the quantity of labor demanded will respond to changes in the wage rate. In other
words, the demand for labor has a price elasticity just as the demand for products does.
This elasticity is influenced by the distinguishing features of the demand for labor.
Policy Focus: U.S. Immigration Policy
Give me your tired, your poor,
Your huddled masses yearning to breathe free,
The wretched refuse of your teeming shore,
Send these, the homeless, tempest-tossed to me,
I lift my lamp beside the golden door!—Inscription on the Statue of Liberty
The United States is a country of immigrants and
descendants of immigrants—a “melting pot,” as you
learned in elementary school. In the early 19th century, Europeans, mostly from Western Europe, flooded
into the United States. In the late 19th century, a wave
of Chinese immigrated to California. In the early 20th
century, a huge flood of immigrants arrived from
Southern and Eastern Europe. The most recent large
waves of immigrants have been from Southeast Asia,
after the end of the Vietnam War, and from Central
America. Many of those coming from Central America
have arrived as illegal immigrants, making them distinct from most of the other waves of immigrants.
Each influx of immigrants caused a great debate among
Americans who were already citizens. The issue was
always the same—whether or not to shut the door to
new immigrants. Often the answer was yes, and new
restrictions were passed. Many legal restrictions on
immigration are racist in origin. Many groups support
immigration of those who are like themselves but are
opposed to altering the racial mix of the country.
MTC/McClatchy-Tribune/Getty Images
Arizona Governor Jan Brewer signed the
Support Our Law Enforcement and Safe
Neighborhoods Act. However, in 2012 the
U.S. Supreme Court ruled to uphold only
one provision of this Arizona law.
There is at least one economic motive for restricting immigration. Immigration makes the supply of
labor much more elastic for each skill level, putting downward pressure on wage rates. It isn’t surprising that organized labor groups are often opposed to liberalizing immigration. In fact, some states
even prohibit the transfer of certain occupational skills within the United States. For example, an
attorney in Wisconsin who plans to migrate to Oregon will not be licensed until he or she passes the
Oregon bar exam. This requirement clearly reduces the supply of legal services in Oregon. As a result,
attorneys in Oregon have higher incomes than they would otherwise.
(continued)
ama80571_12_c12_331-352.indd 342
1/28/13 9:51 AM
Section 12.4 Determinants of the Demand for Labor
CHAPTER 12
Policy Focus: U.S. Immigration Policy (continued)
Most recently, policy to prevent illegal immigration has shifted to the state level. One such example is
Arizona’s Support Our Law Enforcement and Safe Neighborhoods Act, more commonly known as Arizona SB 1070, which received international attention when it was introduced. Signed into law by Arizona
Governor Jan Brewer in 2010, its goal was to identify, prosecute, and deport illegal immigrants found in
the state of Arizona. This act was the broadest and strictest anti-illegal immigration measure in recent
history. This bill, in essence, made the failure to carry proper immigration documents a crime, and it
allows law enforcement broad power to detain anyone they suspect of being in the country illegally.
Citizens and politicians alike believed that such a law would encourage racial profiling.
Legal challenges were filed and injunctions were requested. One day before the law would take
effect, a federal judge issued a preliminary injunction that blocked the law’s most controversial provisions. In June 2012, the U.S. Supreme Court heard and ruled on the case Arizona v. United States. The
Justices decided to uphold the provision requiring immigration status checks during law enforcement
stops, but struck down three other provisions as violating the Supremacy Clause of the U.S. Constitution. It will be interesting to see how the new law impacts immigration into Arizona, as well as its
impact on economic factors like wages and employment.
Elasticity of the Demand for the Product
If the wage rate falls for all of the firms in the product market, the cost of producing the
product will also fall. There will, as a result, be a decline in the selling price of the product.
As the price of the product declines, consumers will increase their consumption of the
product. The price elasticity of the demand for a product determines how much more of
the product consumers will purchase in response to a decline in its price. Thus, the price
elasticity of the demand for the product affects the price elasticity of the demand for labor.
If the product demand is elastic, the firm will hire more labor in order to increase production to respond to the increased quantity demanded by consumers. The larger the increase
in quantity demanded of the product, the larger the increase in quantity demanded of
labor will be. As a result, labor demand is more elastic when the demand for the final
product is more elastic.
Share of Labor Input Costs
The second element that affects the elasticity of demand for labor is a bit more complex.
First, assume that only labor is used to produce the product. Labor costs are 100% of
product cost. If the price of labor falls 10%, the cost of production falls 10%, and price (in
perfect competition) falls 10%. Now, more realistically, let labor costs constitute only 50%
of product cost. Then if the price of labor falls 10%, the cost of production falls only 5%.
In other words, the larger the share of labor cost in total production cost of a product, the
more a change in the wage rate will affect the cost of production and the price of the product. As a result, the larger the share of the total cost of production that wages represent,
the greater the elasticity of demand for labor will be.
ama80571_12_c12_331-352.indd 343
1/28/13 9:51 AM
Section 12.4 Determinants of the Demand for Labor
CHAPTER 12
Opportunities for Input Substitution
In actual production, a great deal of substitution among the productive resources is possible. We discussed this input substitution in detail in the chapter on production. The choice
of which combination of productive resources to use depends, as you learned earlier, on
the prices of those inputs. As the price of labor increases, entrepreneurs will substitute
capital and land for labor to the extent that such substitution is feasible in the production
function. Substitution can occur for all the productive resources. Perhaps it is most visible
in the substitution that takes place among land, labor, and capital in urban versus rural
areas. In urban areas, where land is expensive, labor and capital are substituted for land.
High-rise structures, which use much more labor and capital, are built. In rural areas, lowrise office buildings and housing units are constructed. They use far less labor and capital
than the high-rise structures of the central city.
Consider what happens when the wage rate falls. To the extent that labor can be substituted for other inputs, more labor will be hired. The greater the degree of substitutability
in production, the greater will be the price elasticity of the demand for labor.
Shifts in the Demand for Labor
The demand curve for labor, like the demand curve for products, can shift in response
to changes in underlying conditions. Two of the most important causes of such shifts are
changes in demand for the product and changes in the employment of the other productive resources.
Changes in the Demand for the Product
The demand for labor is derived from the demand for the product it is used to produce.
To see this more clearly, look again at Table 12.1 and Table 12.2, which show the situations
for a competitive and a monopolistic firm, respectively. Suppose there is an increase in
demand in the product market. The market demand curve will shift to the right. This shift
will cause the product price to increase for the competitive firm, because the value of the
marginal product of labor will be larger at all levels of production. That is, the values of
MRPL in Table 12.1 will increase in proportion to the increase in product price. In most
cases, an increase in product demand will also increase the monopolist’s values of MRPL
compared to those given in Table 12.2. The MRPL curve shifts outward for either kind of
firm, representing an increase in the demand for labor.
In a competitive labor market, each kind of firm will want to hire more labor at the existing wage rate. The market demand for labor could increase, raising both the level of
employment and the wage rate. The amount by which the market wage increases will
depend on how large the industry is relative to the labor market. If the industry is small,
there may be only a very slight increase in wages. If it is large, however, the wage rate
could rise significantly.
ama80571_12_c12_331-352.indd 344
1/28/13 9:51 AM
Section 12.4 Determinants of the Demand for Labor
CHAPTER 12
Effect of Changes in Other Inputs
A second important cause of shifts in the demand for labor results from the fact that the
demands for different inputs are mutually interdependent. Refer again to Table 12.1 and
Table 12.2. Suppose the capital stock of the firm is doubled. If labor and capital used
together are complementary in the sense that an increase in capital makes labor more productive, each unit of labor will have a larger product. Complementarity is a fairly general
phenomenon. Consider an example. Suppose there is a great blizzard and you and your
friends have a few days off because your school has been closed. Four of you decide to
make some extra cash by pulling stranded vehicles out of snowdrifts. It turns out that the
effort is profitable enough that instead of relying on your Jeep and a chain, your group
invests the profits in a tow truck. When it snows the next time, how do you think your
product will compare to the first experience?
If the capital stock is increased,
the total product in Table 12.1
and Table 12.2 will increase. As
a result, the values of MPL will
increase and the values of MRPL
will also increase. The MRPL
curve will shift outward, signifying that the demand for labor
has increased. This is what is
meant by complementarity: an
increase in usage of one input
raises the marginal revenue
product of the other.
Hemera/Thinkstock
Increased productivity resulting
from an increased capital stock
can have several effects. Consider what happens if the capital stock expands in one firm
but not the whole industry. The
firm’s demand curve (MRPL ) would shift to the right in Figures 12.4 and 12.6 without any
(noticeable) effect on the market demand curve, because the firm is very small relative to
the industry. The result would be that the firm would employ more units of labor at the
market-determined price.
Complementarity is a general phenomenon. In the nearby
example, your decision to help drivers stranded in snow drifts
is profitable enough for you to invest your profits in a tow truck
for the next snow storm.
On the other hand, consider the effect of an industrywide increase in the capital stock. All
firms in the industry have an increase in capital, causing their individual MRPL curves
and the industry MRPL curve to shift outward. More labor is employed at a higher wage
rate. Such a situation is depicted in Figure 12.7. The initial equilibrium occurs where the
firm employs x1 units of labor at the market wage of W1. The industry is employing Q1
units of labor. Now there is an industry-wide increase in capital. The firm’s MRPL curve
shifts to MRP’L. Since all the firms in the industry experience this increase in MRPL , the
industry demand curve for labor will also shift, from DL to D’L in Figure 12.7. The market
wage rises to W2. As a result, the horizontal supply curve that the individual firm faces
shifts from Sf to S’F. The firm will now employ x2 units of labor at wage rate W2. Industry
employment has risen from Q1 to Q2. The response of the firm to an increase in its capital
ama80571_12_c12_331-352.indd 345
1/28/13 9:51 AM
CHAPTER 12
Section 12.4 Determinants of the Demand for Labor
stock was to hire more workers at higher wages because the increase in capital increased
the marginal productivity of the workers. The demand for the two resources, labor and
capital, can thus be seen to be interdependent.
Figure 12.7: An industry-wide increase in capital
(a) Firm
Price,
Cost
Price,
Cost
MRP L
W2
W1
(b) Industry
SL
MRP L′
S f′= MRC L′
S f = MRC L
W2
W1
DL
0
x1 x2
Quantity/ Time Period
0
D L′
Q1 Q2
Quantity/ Time Period
An increase in the capital stock will increase the productivity of labor if capital and labor are
complementary inputs. This increase in productivity will shift the marginal revenue product curve from
MRPL to MRP’L and the market demand curve for labor from DL to D’L.
Some U.S. manufacturing industries have hired more workers because of increases in the
capital stock in recent years. The textile industry is a good example. The technology of
weaving cloth has changed dramatically from shuttle looms to air jet and water jet shuttleless looms. Investment in this new technology has greatly increased the productivity of
workers in the weaving sector of the textile industry, with investments of over $1.4 billion
a year in total capital expenditures. The result has been more output from fewer workers
earning higher wages. Exports of textiles increased 20% in 2010, and the United States
now ranks third in global exports (SelectUSA, n.d.).
ama80571_12_c12_331-352.indd 346
1/28/13 9:51 AM
Section 12.5 Productivity and Earnings Differences
CHAPTER 12
12.5 Productivity and Earnings Differences
I
n this chapter, we have applied marginal productivity theory to labor markets. We
have shown that labor becomes more productive and wages rise when the labor is
used with more capital. The notion of capital is, however, broader than simply tools.
Capital is anything used to increase the flow of output. For example, economists define
human capital as anything—such as health, vigor, education, or training—that (1) can be
enhanced by “investment” and (2) increases the productivity of the individual.
Just as a firm can increase its investment in capital, an individual can invest in human
capital. An individual’s decision to seek additional education is similar to an entrepreneur’s decision to purchase a new piece of equipment. In both cases, the investment is
productive if the return (properly discounted) exceeds the cost (properly discounted).
Higher Education as an Investment
Your decision to pursue higher education is a form of investment. The costs are the direct
costs (tuition, fees, books, and so on) plus the opportunity costs, primarily lost income
(which you could earn instead of going to college). The return is the present value of the
increased future earnings caused by the investment in education.
The anticipated future wage rate will have a profound impact on the type and amount of
education that is pursued. For example, if wages of accountants rise relative to those of
engineers, economists would expect more students to study accounting. Wages in professions that require long periods of study will have to be higher to attract new entrants, for
three reasons. First, those in school for long periods of time (like medical doctors) incur
greater current costs. Second, they sacrifice a great deal of present income. Third, their
future income is a longer way off. As you know, income a long way into the future is
worth a great deal less than income now.
This analysis does not deny that people attend universities and colleges for other reasons
besides the return to investment in human capital. Some engage in education for its consumption value. For example, retired people returning to school may not be investing in
human capital, because their careers have ended. Instead, they are acquiring education
for its consumption value. There are many consumption-related benefits to education,
ranging from enjoyment of literature and fine arts to the thrill of solving a tricky problem
in logic. There are also many consumption benefits related to being a student. If you are
a member of a fraternity or a sorority or enjoy the “big game” on homecoming weekend,
you are familiar with some of these consumption benefits.
Not everyone makes career decisions on a strictly economic basis, and we don’t want to
imply that you should. You are going to spend the rest of your life working. Why not pick
out an occupation or profession that you find enjoyable? This discussion of human capital and education is similar to many policy debates in economics. An economic model of
human capital formation may seem dehumanizing, but you shouldn’t view it that way. It
is just another way of analyzing a complex process, and it will give you important insights.
These insights can help explain why workers enjoy different income levels or why two
workers in the same occupation working for the same firm may receive different salaries.
ama80571_12_c12_331-352.indd 347
1/28/13 9:51 AM
Section 12.5 Productivity and Earnings Differences
CHAPTER 12
Global Outlook: Comparable Worth in Canada: Lessons for the United States?
In discussions about the productivity of labor
and wages, comparable worth is often a topic
that comes to mind. Comparable worth is a standard for determining wages on the basis of equal
pay for jobs that require similar levels of training,
responsibility, skills, and so on. In response to
persistent differences in earnings across different groups of people, the United States passed
the Equal Pay Act of 1963 and the Civil Rights Act
of 1964, requiring employers to provide equal
pay for equal work. However, even as of 2012,
a gap still remains. For example, according to
the American Association of University Women,
a woman who graduates from the same school
in the same major and takes a full-time job in
the same profession as a male student will earn
around 7% less than him in the first year out of
school. This gap then continues to widen the
longer a woman works, meaning that over the
course of a 35-year career, a woman would make
an average of $1.2 million less than her male
counterpart (Bassett, 2012).
To date in the United States, comparable
worth legislation has been limited to public
sector employment and to various legal challenges, usually referred to as “gender equity.”
For example, U.S. universities have been under
pressure, both political and legal, to equalize
salaries and budgets for men’s and women’s
sports, regardless of whether or not they are
revenue-producing.
Corbis/SuperStock
Image Source/SuperStock
In the United States, comparable worth has
been limited to public sector employment.
But universities have also been pressured to
equalize salaries and budgets for men’s and
women’s sports.
The political popularity of comparable worth legislation rises and falls in the United States with elections. In 2012, President Obama had attempted to pass the Paycheck Fairness Act, which failed in the
Senate on June 5, 2012. After the vote, President Obama issued the following statement:
This afternoon, Senate Republicans refused to allow an up-or-down vote on the Paycheck
Fairness Act, a commonsense piece of legislation that would strengthen the Equal Pay
Act and give women more tools to fight pay discrimination. It is incredibly disappointing
that in this make-or-break moment for the middle class, Senate Republicans put partisan
politics ahead of American women and their families. Despite the progress that has been
made over the years, women continue to earn substantially less than men for performing
the same work. My Administration will continue to fight for a woman’s right for equal pay
for equal work, as we rebuild our economy so that hard work pays off, responsibility is
rewarded, and every American gets a fair shot to succeed (Grant, 2012).
In that same year, the Obama campaign used the gender wage gap as a reason to vote Democrat
(Obama, 2011).
ama80571_12_c12_331-352.indd 348
1/28/13 9:51 AM
Section 12.5 Productivity and Earnings Differences
CHAPTER 12
Global Outlook: Comparable Worth in Canada: Lessons for the United States?
(continued)
The United States can learn a lot from the experience with comparable worth in our neighbor to the
north. In 1977, Canada created the Human Rights Act, a statute passed by the Parliament of Canada
with the goal of extending the law to ensure equal opportunity to individuals who may be victims
of discriminatory practices based on a set of prohibited grounds such as sex, disability, or religion.
In 1987, the Pay Equity Act was established to prohibit wage discrimination based on sex, race, or
national origin among employees for work in “equivalent jobs.” In 2000, the Employment Standards
Act was passed with provisions that ensure women and men receive equal pay for performing the
same job. According to the ESA, a woman cannot be paid less than a man if she is doing “equal work.”
This also applies in reverse; a man cannot receive less pay than a woman if he is doing “equal work”
(“Equal pay,” 2012). These laws extended comparable worth adjustments into the private sector.
What has happened to the gender pay gap since the laws took effect? According to Statistics Canada (“Study,” 2010) data, by 2008 the gender wage gap was 16.7% for full-time, full-year workers,
which means that for every $1.00 earned by a male worker, a female worker earns roughly 83 cents.
When the Pay Equity Act was passed in 1987, the gender wage gap was 36%, thus the gender wage
gap has been narrowing slowly over time. According to Gilmore and LaRochelle-Cote (2011), a
key factor in the convergence was that the growth in relative wages of women outpaced the gains of
men. It appears that the United States does have some lessons it can learn from our neighbor to the
north, and hopefully sooner rather than later!
Marginal Productivity and Income
The analysis in this chapter leads to an important conclusion of marginal productivity
theory. In a competitive labor market, the interaction of the value of the marginal product of labor and the supply of labor determines the wage rate. In turn, the productivity
of labor depends on the inherent qualities of the labor, the quantity of labor employed,
and the amounts of the other inputs that are used. In other words, the distribution of
income is determined by the relative marginal revenue products of the different productive resources. Since wages make up the incomes of laborers, more productive workers
will have higher incomes. Laborers who are less productive will have lower incomes.
John Bates Clark, who developed this theory, claimed that it presented a “morally correct” outcome of economic activity. Morality is not the province of economic theory,
however. Economic theory is positive. The marginal productivity theory says nothing
about whether the income distribution that results is a good one. Rather, the theory indicates that if labor markets are competitive, each worker will receive returns based on
individual productivity. If people don’t like the outcome, they can work to change it
through political action (a topic that will be discussed in a later chapter). The theory also
indicates that output will be maximized in societies in which labor is paid according to
its marginal productivity.
ama80571_12_c12_331-352.indd 349
1/28/13 9:51 AM
Key Points
CHAPTER 12
Summary
C
onsider again. . . Having learned about the marginal revenue product of labor, the
issue of salaries in professional sports is more clear. A professional sports league,
like the NBA, the NFL, or major league baseball, has its star players that fill the
stadium seats. These players can demand incredibly high salaries for their labor because
they are essentially irreplaceable. Consider one extreme example: Michael Jordan was
paid over $33 million in his last season with the Chicago Bulls (1997–1998). The obvious
question is, was Michael Jordan really paid according to his marginal revenue product of
labor? Probably not. He was likely underpaid. How can that possibly be the case? Because
NBA teams make higher profits when their teams win and considering that Jordan led the
Bulls to championship games three years in a row, twice (in 1990–91, 1991–92, 1992–93 and
again in 1995–96, 1996–97, and 1997–98). As the league’s Most Valuable Player in every
one of those years, he probably earned his enormous salary (“NBA finals,” 2012).
Going back to the example where average player salaries are highest in the NBA, followed by the MLB, then the NHL and the NFL, the difference in earnings across professional sports is more an indication of bargaining power than it is a result of the marginal
revenue product of labor. In 2010–2011, the NBA experienced a 161-day lockout of players
as teams negotiated new terms with the players’ union. The new collective bargaining
agreement featured a higher maximum salary per individual player, called a salary cap,
of $58.044 million, which is based on the aptly titled Basketball Related Income (BRI) figure. The NBA teams and players have a complicated algorithm for who gets what, but the
important part is that some sort of revenue sharing is part of the equation (Coon, 2012).
Compare this agreement to that of the NFL, where there is a “hard” salary cap which all
NFL teams are required to follow. According to sports writer Michael Holley, the practice
of retaining veteran players who had contributed to the team in the past, but whose abilities have declined, became less common in the era of the hard salary cap (Holley, 2004).
The difference, then, between the highest paying professional sports league and the lowest paying league is more a result of negotiations off the field than the productivity of the
athletes on the field.
Key Points
1. A firm is a supplier in the product market and a demander in the resource market. The demand for labor differs from the demand for a product, in that it is
derived, interdependent, and technologically determined. The demand for labor
is derived from the demand for the product it produces. The amount of labor a
firm demands depends on the amounts of land, capital, and enterprise that will
be used in combination with the labor. And lastly, the demand for labor depends
on techniques of production and on technological progress, or the production
function.
2. A firm demands labor because labor is productive. The marginal revenue product of labor (MRPL ) curve is the firm’s demand curve for labor. In a competitive
labor market, the firm faces a perfectly elastic labor supply curve (SL). When the
labor supply curve is perfectly elastic, the marginal resource cost of labor (MRC1)
curve is the same as the labor supply curve. A profit-maximizing firm will
employ or purchase labor until MRPL 5 MRCL.
ama80571_12_c12_331-352.indd 350
1/28/13 9:51 AM
Key Terms
CHAPTER 12
3. A firm that is a monopolist in a product market uses less labor than a competitive
firm would use, because the firm restricts inputs in the process of restricting output. The monopolist has to pay the market wage just like any other employer in
this market. Because MRPL is less than VMPL , the monopolist does employ fewer
workers than similar competitive firms would employ.
4. The elasticity of the demand for the product that labor produces, the share of the
total cost of production that labor represents, and opportunity for input substitution all impact on the elasticity of demand for labor. Shifts in demand for a product will cause shifts in the demand for the labor used to produce that product.
Also, increased usage of complementary inputs will raise the marginal revenue
product of labor and cause the demand curve to shift outward.
Key Terms
backward-bending supply curve A labor
supply curve that slopes back to the left at
the point where the income effect dominates the substitution effect.
comparable worth A standard for determining wages that calls for equal pay for
jobs that require similar levels of training,
responsibility, and skills.
derived demand Demand for a productive resource that results from demand
for a final good or service. For example,
the demand for labor is derived from the
demand for the product that the labor
produces.
interdependent demand Demand that
depends on another type of demand.
For example, a firm’s demand for labor
depends on the amount of other resources
that the firm plans to use.
marginal resource cost of labor
(MRCL) The cost of each additional unit of
labor.
marginal revenue product of labor
(MRPL) The amount that an additional
unit of labor adds to a firm’s total revenue.
technologically determined
demand Demand that depends on techniques of production and technological
progress. For example, the demand for
labor will be affected by the introductions
of new technology in a firm or industry.
value of the marginal product of labor
(VMPL) A measure of the value of the
additional output that each unit of additional labor adds to a firm’s total, found
by multiplying the marginal product by
the price at which the firm can sell the
product.
marginal productivity theory An explanation of how the distribution of income is
determined in a market system. Each input
is paid according to its contribution, or its
marginal productivity.
ama80571_12_c12_331-352.indd 351
1/28/13 9:51 AM
Critical Thinking and Discussion Questions
CHAPTER 12
Critical Thinking and Discussion Questions
1. How does an entrepreneur decide how much labor to employ?
2. How is a change in the quantity of labor demanded different from a change in
the demand for labor?
3. Name three reasons a firm’s demand for labor would increase. How would this
increase in demand impact the relative wages of the firm’s employees?
4. How does the value of the marginal product of labor differ when there is monopoly power in the product market?
5. What is a backward-bending supply curve and what determines where the bend
occurs?
6. The demand for nurses has increased significantly over the last two decades, as
well as the salaries for nurses. Is the demand for nurses a derived demand? If so,
from what?
7. Describe your decision to take this course in human capital terms. What are
your opportunity costs? Are you planning to make any additional human capital
investments?
8. How can the elasticity of demand for the product that labor is producing affect
the elasticity of demand for that labor?
9. If an entrepreneur understands the possibility of a backward-bending supply
curve, how might that affect the decisions he makes about giving employees
raises?
10. How does immigration impact the elasticity of supply of labor for each skill
level? How would this likely impact wage rates?
11. How could the potential for career interruptions have an impact on starting salaries and create a difference between men and women’s salaries? What could the
government do to counteract this issue?
12. The existence of players’ unions in professional sports is well known. What benefits do the players receive from joining a union? What are the potential costs in
the short run and the long run?
13. Why might custodial staff earn higher wages than administrative assistants, even
though the assistants could likely perform the functions of the custodial staff?
14. In which market environments is labor more likely to be exploited? How can the
government legislate to help workers in these markets?
ama80571_12_c12_331-352.indd 352
1/28/13 9:51 AM
Blend Images/SuperStock
13
Poverty, Inequality, and Income
Redistribution Policies
Learning Objectives
By the end of this chapter, you will be able to:
• Describe the measurement of income distribution in the United States.
• Explain how poverty is defined and the characteristics of those most likely to be poor.
• Analyze the effects of discrimination on wage differences.
• Summarize the arguments for and against the redistribution of income through government policy,
the advantages and disadvantages of equality of opportunity versus equality of results strategies,
and advantages and disadvantages of redistribution in kind versus in cash.
• Describe current government transfer programs and proposals for policy reform.
ama80571_13_c13_353-374.indd 353
1/28/13 9:51 AM
Section 13.1 The Personal Distribution of Income
CHAPTER 13
Introduction
C
onsider this. . . C.K. is a real person in her 20s, a college graduate who has been
supporting herself but not earning much income. After working for about six years,
part-time in college and full-time afterward, she was diagnosed with a chronic disease that makes it impossible to hold a regular, full-time job. She can work part-time and
would like to do so. What should the social safety net do for C.K., and what does it actually do? How much will it cost taxpayers? What incentive does C.K. have to continue
working part-time?
J.T. is a hypothetical person, a 20-year-old high school dropout and mother of two small
children, ages two and four. She has never been married and has no real work experience.
She has no means of support for herself and her children. What should the social safety
net do for J.T., and what does it actually do? How much will it cost taxpayers? What incentive does J.T. have to acquire skills and work at least part-time?
This chapter is about the C.K.s and J.T.s of a market system. Some, like C.K., are unable
to provide for themselves through no fault of their own. Others, like J.T., made foolish
choices, in part because they knew that there was a social safety net to provide some
minimal level of income. J.T. is the image some people have in mind when they attack the
social welfare system, not C.K. But both represent a challenge to policy makers to design
a system that helps those in need, while preserving work incentives, at a cost society is
willing to pay.
The problem of defining a basic adequate standard of living and ensuring it to all without
destroying work incentives is a challenge to all economic systems. It is a particular challenge to those systems that rely primarily on markets to allocate resources and encourage
productive activities. This chapter examines the actual distribution of income, the measures of income distribution and poverty, the effects of labor market discrimination, and
the role of government in redistributing income
13.1 The Personal Distribution of Income
N
o single topic in economics generates more controversy than income distribution
and policies for income redistribution. The market results in an unequal distribution of income. The government is a powerful tool for redistribution, although it
does not always redistribute from the rich to the poor.
Economists are reluctant to propose schemes for the redistribution of income because
value judgments are necessary to choose among alternative income distributions. However, many economists, philosophers, and politicians have developed normative standards for the distribution of income. Three widely used measures of how “fairly” income
is distributed are need, equality, and productivity. The foundation of pure communism as
stated by Karl Marx was “to each according to his needs, from each according to his abilities.” The principle of pure equality would provide the same income for everyone. The
productivity standard is based on the marginal productivity theory of resource earnings
developed by John Bates Clark, which was discussed in an earlier chapter.
ama80571_13_c13_353-374.indd 354
1/28/13 9:51 AM
Section 13.1 The Personal Distribution of Income
CHAPTER 13
In the United States, productivity is the primary determinant of income. However, there is
redistribution to the poorer members of society. Part of this redistribution is done privately
through charitable giving, and part is done publicly through governmental programs at
all levels of government. The ideal of equality is the basis for the use of high marginal tax
rates and the provision of certain basic services to all, regardless of income. Social welfare
programs are usually based on some indicators of need.
Income distribution in a market economy is determined primarily by ownership of the
factors of production and by the prices those factors can command. The previous chapter
described income distribution among the factors of production. Another way to describe
income distribution is according to how income is divided, equally or unequally, among
individuals or households. This measure is called the personal distribution of income.
Lorenz Curves
A Lorenz curve is a graph showing the cumulative percentage of income received by a
given percentage of households, whose incomes are arranged from lowest to highest. It
is constructed by cumulating the percentage of households on the horizontal axis and the
percentage of income on the vertical axis.
Figure 13.1 shows Lorenz curves for three societies. A perfectly egalitarian society would
have the Lorenz curve labeled distribution A. If incomes were equally distributed, the
lowest 10% of all households would receive 10% of total income, the highest 20% would
receive 20% of total income, and so on.
ama80571_13_c13_353-374.indd 355
1/28/13 9:51 AM
CHAPTER 13
Section 13.1 The Personal Distribution of Income
Figure 13.1: Lorenz curve
Cumulative
Percentage
of Income
100
Distribution A
(Perfect Equality)
80
60
40
Distribution B
20
Distribution C
0
20
40
60
80
100
Cumulative Percentage of Households
A Lorenz curve shows the percentage of income received by all percentages of households. A perfectly
equal distribution would be represented by Lorenz curve A. Curves B and C represent more unequal
distributions of income.
When household incomes vary, the Lorenz curve diverges from the 458 line of perfect
equality. Distribution B in Figure 13.1 shows a less egalitarian society. The greater the distance between the 458 line and the Lorenz curve, the greater the inequality in the income
distribution. In Figure 13.1, distribution C represents more inequality than distribution B.
Lorenz curves for different countries can be used to compare levels of income inequality.
Sweden’s Lorenz curve comes fairly close to the 458 line. Developing countries tend to
have curves that are farthest from the 458 degree line.
Lorenz curves can also be used to show how income distribution changes over time. The
data in Table 13.1 show income distribution before taxes and transfer payments by quintiles, each representing 20% of the population. Data for 1990 and 2010 are graphed as
Lorenz curves in Figure 13.2. Both Table 13.1 and Figure 13.2 indicate that the distribution of pretax income in the United States has become less equal since 1990, after moving
slowly toward greater equality since 1967 (actually since 1929).
ama80571_13_c13_353-374.indd 356
1/28/13 9:51 AM
CHAPTER 13
Section 13.1 The Personal Distribution of Income
Table 13.1: Distribution of income in the United States, 1967–2010*
Year
Lowest quintile Second quintile Third quintile
Fourth quintile
Fifth quintile
1967
4.0
10.8
17.3
24.2
43.8
1972
4.1
10.5
17.3
24.5
43.5
1977
4.2
10.2
16.9
24.7
44.0
1986
3.8
9.7
16.2
24.3
46.1
1990
3.9
9.6
15.9
24.0
46.6
1995
3.7
9.1
15.2
23.3
48.7
1999
3.6
8.9
14.9
23.2
49.4
2000
3.6
8.9
14.8
23.0
49.8
2001
3.5
8.7
14.6
23.0
50.1
2002
3.5
8.8
14.8
23.3
49.7
2003
3.4
8.7
14.8
23.4
49.8
2004
3.4
8.7
14.7
23.2
50.1
2005
3.4
8.6
14.6
23.0
50.4
2006
3.4
8.6
14.5
22.9
50.5
2007
3.4
8.7
14.8
23.4
49.7
2008
3.4
8.6
14.7
23.3
50.0
2009
3.4
8.6
14.6
23.2
50.3
2010
3.3
8.5
14.6
23.4
50.2
*Income in 2010 CPI-U-RS adjusted dollars. For further explanation of income inequality measures, see Current Population Reports,
Series P60-204, “The Changing Shape of the Nation’s Income Distribution: 1947–1998.” Standard errors presented in this table were
calculated using general variance formula parameters and may differ from the standard errors in text tables that were calculated using
replicate weights. For information on confidentiality protection, sampling error, nonsampling error, and definitions, see www.census.gov/
apsd/techdoc/cps/cpsmar11.pdf
Source: United States Census Bureau. (n.d.). Selected measures of household income dispersion: 1967 to 2010. Retrieved from http://
www.census.gov/hhes/www/income/data/
ama80571_13_c13_353-374.indd 357
1/28/13 9:51 AM
CHAPTER 13
Section 13.1 The Personal Distribution of Income
Figure 13.2: Lorenz curves for the United States, 1990 and 2010
Cumulative
Percentage
of Income
100
80
1990
2010
60
40
20
0
20
40
60
80
100
Cumulative Percentage of Households
The distribution of pretax, pretransfer earnings became less equal after 1990.
Gini Coefficients
A quick measure of inequality is the area between the diagonal and the Lorenz curve. The
ratio of this area to the whole triangle below the diagonal is called the Gini coefficient.
The Gini coefficient takes on values between zero and one. If all people have equal income
shares, the Lorenz curve will lie along the diagonal, and the Gini coefficient will be zero.
If one person has all the income and everyone else has nothing, the Lorenz curve will lie
along the horizontal axis and the right vertical axis and the Gini coefficient will have a
value of one. The closer the Gini coefficient is to one, the greater the degree of inequality.
The Gini coefficients for the United States tell the same story as Table 13.1. In 1967, the
Gini coefficient was 0.399. From 1967 to 1980, it had a range of values from 0.388 to 0.403,
rising in some years and falling in others. Since 1980, when the Gini coefficient was 0.406,
the distribution of pretax income has become steadily more unequal, with a Gini coefficient in 1990 of 0.428 and 0.477 in 2011 (DeNavas-Walt, Proctor, & Smith, 2012).
Figure 13.3 shows the Lorenz curves for earnings in the United States, Canada, the United
Kingdom, and Sweden in the early 2000s. As you can see, the United States had the largest
degree of inequality of these four countries, while the United Kingdom had the smallest,
ama80571_13_c13_353-374.indd 358
1/28/13 9:51 AM
CHAPTER 13
Section 13.1 The Personal Distribution of Income
but differences are relatively small. Curves that show the effects of taxes and transfer
programs would show a more pronounced difference, especially in the United Kingdom,
where the government collects high taxes and provides a broad array of social services to
all citizens.
Figure 13.3: Lorenz curve for selected industrial countries
Percentage
of Aggregate
Earnings
100
90
80
Perfect Equality
UK
2000
70
60
50
Sweden
2002
40
30
20
10
Canada
1999
US
2000
0
–10
10
20
30
40
50
60
70
80
90 100
Percentage of Earners
The distribution of pretax, pretransfer income in four industrial countries looks quite similar in
1999/2002, with the United Kingdom more equal in distribution than other countries.
From Cowell, F.A. (2011, December). UK wealth inequity in international context (Unpublished manuscript), Figure 1. STICERD, London
School of Economics, London. Reprinted by permission.
Interpreting the Data
Lorenz curves and Gini coefficients must be interpreted with caution for two reasons.
First, Lorenz curves describe the relative distribution of income among households. A
Lorenz curve might show the lowest 20% of households receiving only 5% of the income,
but it doesn’t say if this amount of income is high or low in an absolute sense. This 5%
could be enough income to make everyone in the lowest 20% well fed, well housed, and
well clothed. A Lorenz curve only shows the degree of inequality. By itself, it does not
measure either wealth or poverty.
ama80571_13_c13_353-374.indd 359
6/21/13 10:35 AM
Section 13.1 The Personal Distribution of Income
CHAPTER 13
Second, Lorenz curves show how income is distributed among households at a given
time. If the households in the lowest 10% change over time, the Lorenz curve will give an
incorrect picture of relative poverty. The typical household’s income changes in a predictable way over time. Income tends to be low when wage earners are young, increases as
they reach middle age, and declines in their retirement years. This life-cycle pattern means
that households will move around in the income distribution over time. Since the Lorenz
curve shows an income distribution at a specific time, it may overstate income inequality
over time.
One useful source of information on changes in income distribution over time is the Panel
Study on Income Dynamics (PSID) prepared by the Institute for Social Research at the
University of Michigan. The PSID has followed income and employment histories of 5,000
U.S. families since 1968. These data show considerable mobility among income levels. For
example, of those who were at the top of the income scale in 1996, the top 1/100 of 1%,
only 25% remained in this group in 2005. The degree of mobility among income groups
from 1996 to 2005 was unchanged from the prior decade (1987 through 1996). The data
also show that more than 50% of taxpayers in the bottom quintile moved to a higher
quintile within 10 years, suggesting that the poor may not all be caught in a poverty trap.
Many are temporarily rather than permanently poor (Department of the Treasury, 2007).
Economics in Action: Measuring and Analyzing Income Distribution
The Lorenz curve measures income inequality within a population. The Gini coefficient looks at the
Lorenz curve and measures its area to look at the entire population and discover the degree of
inequality in the distribution of income. Learn more by watching the Youtube clip at http://www
.youtube.com/watch?v=AQWN_DqcHG4&list=LPfpseHX5yED8&index=1&feature=plcp.
Distribution of Income After Taxes and Transfers
What people are interested in, of course, is not pretax income but how much is available
to spend or save, measured by income after taxes and transfer payments. (Transfer payments also include in-kind transfers, such as subsidized housing and food stamps.) By
this standard, the increase in inequality is even greater. In 1980, the Gini coefficient for
income including taxes, cash transfers, and in-kind transfers was 0.347. In 1990, the Gini
coefficient rose to 0.381—twice as much of an increase in inequality as was indicated by
the pretax, pretransfer measure. By 2010, the Gini coefficient was 0.397 (DeNavas-Walt,
Proctor, & Smith, 2012).
Why did the distribution of income, both before and after taxes and transfers, become
more unequal in the United States in the 1980s than between 1990 and 2010? The change in
pretax, pretransfer incomes goes back to the functional distribution of income. High interest rates throughout the 1980s benefited upper and upper-middle income households, not
the poor or lower-middle income groups, who have few interest-earning assets. Changes
in the structure of jobs also affected wage earners. The decline in high-paying factory jobs
and rise in service employment reduced and continue to reduce earnings at the bottom
of the scale. Wages in service industries (such as fast food) are often at the bottom end
of the wage scale. The growth in two-income households was also an important factor.
ama80571_13_c13_353-374.indd 360
1/28/13 9:51 AM
Section 13.2 Poverty in the United States
CHAPTER 13
Households with two or more adult earners increased their income dramatically, but the
decline in real weekly wages meant that single-earner households fell behind.
Lower top-bracket tax rates increase the after-tax incomes of higher income groups, while
Social Security taxes hit the working poor harder, further eroding the income position of
those near the bottom of the ladder. Tax and transfer programs still help to narrow the
income gap between the top and the bottom, but income inequality in the United States
remains an issue today.
13.2 Poverty in the United States
I
ncome distribution is not just a relative concept. Data on starvation, malnutrition,
homelessness, and disease show that poverty has an absolute meaning as well. Determining the level of income that marks the border between poverty and non-poverty is
difficult, because poverty is both absolute and relative. People who are relatively poor in
one nation may be well off by the standards of another country or by the standards of the
same nation at an earlier time.
Economics in Action: An In-Depth Discussion About Economic Inequality
Dan Mitchell, a senior fellow from the Cato Institute, and Cecilia Conrad, an economics professor
at Pomona College, debate the issue of economic inequality. Hear their theories on the state of the
economy by watching the video at http://video.pbs.org/video/2099472478.
Measuring Poverty
The U.S. government first established an official definition of poverty in 1964. The definition was based on the cost of a minimally adequate diet. This figure was then multiplied
by three, since the typical household spent one-third of family income on food. In 1964,
the poverty income level for a family of four was $3,000 ($1,000 for food times three) or
below. The poverty threshold has been adjusted each year for inflation. In 2012, the official
poverty income level was $11,170 or below for a single individual and $23,050 or below
for a family of four.
The poverty rate is a rather crude measure of poverty or changes in poverty because
this number gives no indication of how poor people are. A person whose income is $1
below the threshold is counted as poor, and so is a person whose income is $3,000 below
the threshold. If cash transfers bring the first person’s income up by $2, the poverty rate
falls. If transfer payments raise the second person’s income by $2,000, the poverty rate
is unchanged. However, even with these shortcomings, the poverty rate provides some
indication of how much aggregate poverty exists and how it changes over time. Table 13.2
shows the number of people living in poverty before and after taxes and transfer payments, which has increased almost every year from 1999 to 2009. Transfers are particularly
important at the bottom of the income ladder, reducing the poverty rate each year.
ama80571_13_c13_353-374.indd 361
1/28/13 9:51 AM
CHAPTER 13
Section 13.2 Poverty in the United States
Table 13.2: Millions of persons in poverty before and after taxes and transfers
Year
Before taxes and transfers
After taxes and transfers
1999
54.8
26.7
2000
54.5
27.0
2001
56.4
27.8
2002
59.9
29.0
2003
61.3
30.2
2004
62.8
31.1
2005
61.9
30.9
2006
61.1
30.5
2007
62.4
31.0
2008
66.9
33.8
2009
74.8
35.1
Source: Ziliak, J. P. (2011, September). Recent developments in antipoverty policies in the United States (Discussion Paper No. 139611). Institute for Research on Poverty, University of Wisconsin-Madison. Retrieved from http://www.irp.wisc.edu/index.htm
Who Are the Poor?
In the United States, the poor come from all parts of the country and every age group.
However, poverty is more common in certain geographic, demographic, and racial groups.
Geographically, the poor tend to live in the rural south and in northern cities. Poverty is
more common in rural areas than in cities. Table 13.3 points out other characteristics of
people living below the poverty line in the United States. Almost 13% of the population
fell below the poverty threshold in 2005. However, the poverty rate was above 31% for
certain segments of the population. The poverty rate for nonwhites is higher than that for
whites. Age is also an important factor; children represent a large fraction of those below
the poverty level. In fact, poverty is now a less serious problem for the elderly than for
female-headed households with small children.
Table 13.3: Characteristics of the poor, March 2005
Characteristic
Percent below poverty level
White
10.5%
Black
25.1
Hispanic
21.7
Asian
11.4
Under 18 years old
17.4
18 to 64 years old
11.0
65 years and older
10.7
Married-couple families
6.2
Female householder, no husband present
31.7
No high school diploma, all races
24.3
ama80571_13_c13_353-374.indd 362
(continued)
1/28/13 9:51 AM
CHAPTER 13
Section 13.2 Poverty in the United States
Table 13.3: Characteristics of the poor, March 2005 (continued)
Characteristic
Percent below poverty level
High school graduate, all races
10.9
Some college (one year or more), all races
7.5
Bachelor’s degree or higher
3.5
Source: United States Census Bureau. (2006). Current population survey, 2006 annual social and economic supplement. Retrieved from
www.census.gov/apsd/techdoc/cps/cpsmar06.pdf
Policy Focus: Income Redistribution: In Cash or In Kind?
Once a society decides to alter the market-determined distribution of income, the next question is how to carry it out.
Should the method be cash payments or in-kind transfers of
goods and services, such as housing, food, or health care?
Both private and public redistribution rely heavily on in-kind
transfers of specific goods or services. In-kind transfers by private charities take place through soup kitchens, shelters for
the homeless, and Meals on Wheels for shut-ins. The motive
for such transfers is often not a desire to reduce income
inequality but rather to ensure provision of basic needs such
as food and shelter. Nobel laureate James Tobin describes
people with this redistribution motive as specific egalitarians.
Economists, who tend to be general egalitarians, usually
argue for giving cash instead of specific goods and services,
because a cash transfer allows recipients more options and
thus does more (per dollar) to increase the recipient’s wellbeing. The idea is that people can choose the goods and services that best fit their needs if they are given unrestricted
income. Economists also prefer cash transfers because such
programs are much less costly to administer.
Image Source/SuperStock
The motive for in-kind transfers is
often to ensure provision of basic
needs such as food or shelter.
Meals on Wheels is an example
of a program that helps provide
meals for shut-ins.
Tobin argues that the majority of people are specific egalitarians who care about ill-clothed and illfed people, not inequality. The result of this widely held preference is that a large share of government benefits for the poor are in-kind rather than in cash. The current dominance of in-kind transfer
programs is based on politics rather than economics. For example, the 2013 U.S. Federal Budget
contains $293 billion for Medicaid, $112 billion for food stamps and $28 billion for rental assistance,
which includes housing vouchers. These three programs comprise more that $433 billion in federal
funds, bringing the ratio of in-kind assistance to cash aid at 5.6 to 1 (Glaeser, 2012).
Nobel laureate James Buchanan argues that a preference for in-kind rather than cash transfers simply
means that voters are maximizing their own utility as donors rather than maximizing the utility of
welfare recipients by allowing them freedom of choice. The donor/voter’s motive for income redistribution may not be the welfare of the recipients but rather a desire to eliminate some perceived
problem—homeless people on the streets, slum housing, or students who disrupt the learning process in public schools because of illness or hunger. Providing specific goods or services is a more
direct way of accomplishing that goal.
ama80571_13_c13_353-374.indd 363
1/28/13 9:51 AM
Section 13.3 Income Redistribution
CHAPTER 13
Discrimination and Market Forces
Economic theory suggests that racial or sexual discrimination will not persist over time
in a market system because it is costly to entrepreneurs. If employers discriminated, there
would be large numbers of minority and female workers earning low salaries but having
basically the same education and work skills as white male workers. A profit-motivated
entrepreneur could hire these minority and female workers and produce goods and services more cheaply than other firms using the more expensive labor. As this activity spread,
wages for the minority and female workers would be bid up closer and closer to the level
of white male workers. Thus, the profit motive would work to undermine discrimination.
Some economic historians argue that Jim Crow laws in the south in the late 19th and early
20th centuries were a response to the threat that market forces would undermine racial
discrimination. Jim Crow laws put the force of law behind segregation and discrimination. These laws were eventually overridden by federal legislation. In South Africa, apartheid was needed to maintain a racially segregated system that economic forces would
otherwise have undermined.
Discrimination begets poverty, and poverty begets little investment in human capital.
Although discrimination is not the sole source of poverty, it does contribute. Government
can help combat discrimination both with antidiscrimination laws and with equal treatment for government employees regardless of race or sex. These policies by themselves,
however, are not enough to eliminate poverty. The government may also be called on to
take policy actions that change the income distribution determined by the market.
13.3 Income Redistribution
I
ncome redistribution in the United States, and many other countries, has been carried
out by both the private sector and the public sector. Many public goods or goods with
some public benefits are produced at least partly in the private sector. Some roads,
schools, outdoor concerts, and other goods and services generate collective benefits but
are privately produced. Income redistribution is another activity with public benefits produced at least in part by the private sector through charitable organizations.
Private redistribution alone is not likely to achieve the desired level of income transfers.
Individuals in a large group recognize that their contribution is too small to significantly
affect total redistribution. Each person has an incentive to leave the responsibility to
contribute to others. People who give because of personal satisfaction gained from the
act of charity do not experience this incentive to shirk their responsibility. However, for
some people, the motive for giving is seeing less poverty in the world. For this group,
giving by others diminishes their need to give. If everyone followed this strategy, there
ama80571_13_c13_353-374.indd 364
1/28/13 9:51 AM
Section 13.3 Income Redistribution
CHAPTER 13
would be no private redistribution. This kind of free riding explains why there is not
enough private redistribution.
Richard I’Anson/Lonely Planet Images/Getty Images
Some goods and services generate a collective benefit but are
privately produced. An outdoor concert is one example of this
circumstance.
An important influence on the
amount of private redistribution is the size of the group. In
a relatively small, homogeneous
group, there is likely to be relatively more private redistribution. Think about the Mormon
church and Amish communities, for example, or small towns
versus large cities. Greater charity in small groups is consistent
with the view that the poverty
is more visible when the group
size is smaller.
Benefits and Goals
Citizens may support income redistribution for many reasons. First, some people have
interdependent utility functions, which means that their well-being is dependent on the
well-being of others. These people support programs to redistribute income because such
redistribution increases their utility. Second, some people might view poverty as a negative external effect, like air pollution—something that makes the environment less appealing. This group supports redistribution to improve their surroundings. They might, for
example, support food stamp legislation to help keep hungry people from begging on the
streets. Finally, redistribution can be viewed as an insurance policy. People might support
redistribution as a safety net, realizing that they might become poor at some time.
Equality of Opportunity or Equality of Results?
Should the goal of redistribution be equality of opportunity or equality of results? A goal
of equality of opportunity might impose penalties on employers who discriminate or
mandate government investment in human capital through technical schools, student
loans and grants, or training programs.
Government or private programs that reduce unemployment and improve the match
between workers and jobs are also indirect forms of poverty relief. Not only do these
programs increase total output, they generally improve job opportunities and earnings
for workers at the lower end of the wage scale. Anything that the government does to promote economic growth and reduce cyclical fluctuations will also reduce unemployment
for all groups. Since the poor are so often the last hired and first fired, they would benefit
more than most from such programs. Even programs that reduce the obstacles to working, such as those that improve public transportation or subsidize day care, help the poor
who can work. The goal of equality of opportunity is to offer the working poor a chance
to improve their earnings and escape from poverty.
ama80571_13_c13_353-374.indd 365
1/28/13 9:51 AM
Section 13.4 Government Transfer Programs in Practice
CHAPTER 13
Giving everyone an equal chance at success in the labor market is consistent with the
values of freedom, incentives, and individual choice implicit in a market economic system. However, equality of opportunity does nothing to help those who have to care for
very small children and those who are too old, too young, too sick, too disabled, or too
unskilled to participate in the market as workers. The only programs that will reach these
poor are programs that are aimed directly at equality of results.
The fraction of the poor outside the labor force, or not expected to work, has risen dramatically in the last 50 years. In 1939, less than one-third of poor households were composed
of persons not able to work for one of the reasons listed above. Today, closer to two-thirds
of poor households are headed by a person who is elderly, a student, disabled, or a female
with one or more preschool children. These people do not benefit from a rising tide of economic growth and increased job opportunities unless there is a deliberate effort to share
those gains through redistribution.
Redistribution to the Middle-Income Class
Not all income redistribution is to the poor. Nobel laureate George Stigler points out that
people try to use government policy as a way to redistribute income to themselves rather
than to others. The government has the power to extract resources that would not be provided voluntarily. Any group that can gain control of the government can use this power
to its own benefit. Stigler argues that the group that controls government policy making is
the middle class. Thus, most public expenditures and tax-breaks are made for the benefit
of the middle class—programs such as college loans, tax deductions for mortgage interest, subsidies for highways and airports heavily used by the middle class, and grants to
state and local governments to build water and sewer systems (Stigler, 1970). Interestingly
enough, at the 2012 presidential nominating conventions the Democrats used the phrase
“middle class” 47 times per 25,000 words, whereas the Republicans said it only 6.9 times
per 25,000 words (Bostock, Carter, & Ericson, 2012).
13.4 Government Transfer Programs in Practice
U
ntil the 1930s, programs to relieve poverty were small scale, provided mainly by
local governments and private charities. During the Great Depression of the 1930s,
state and local governments were swamped with demands, and the present system of federal and federally assisted income transfer programs was born. These programs
include Social Security for workers who are retired or disabled, unemployment compensation for those temporarily unemployed, and welfare programs for those unable to work.
Today, transfer programs are a federal-state partnership, with the larger share of the funding at the federal level.
Social Security
Social Security was established in 1935 as an old-age pension system. It was later expanded
to include survivors’ benefits (1939) and disability insurance (1950). Social Security was
designed to relieve poverty for three groups likely to be poor: the old, the dependent
ama80571_13_c13_353-374.indd 366
1/28/13 9:51 AM
CHAPTER 13
Section 13.4 Government Transfer Programs in Practice
survivors of deceased workers, and the disabled. In 1965, a program of health care for the
elderly (Medicare) was added to Social Security. Except for Medicare, Social Security is a
cash transfer program with no in-kind benefits.
Social Security payments are financed by a tax on workers and employers; currently, each
pay an equal amount. Workers do not have a choice about participating. However, microeconomic theory suggests that at least part of the other half of the tax paid by employers
is actually borne by workers.
Figure 13.4 shows why this is the case. Before the Social Security tax, the supply of labor
facing the firm is S0, and the firm’s demand is D. The equilibrium wage is W0 Adding a
Social Security tax equal to B 2 A (or the length of line AB) shifts the supply curve facing
this firm to S1. If supply is fairly elastic but demand is relatively inelastic, most of the tax
falls on the worker. The gross wage (including the tax) rises to Wg, but the net wage taken
home by the worker falls to Wn. The actual division of the tax burden between worker and
employer depends not on legislation that says half on each, but on the relative elasticities of supply and demand for labor. Economists believe that most of the tax falls on the
worker because the market supply of labor is very inelastic.
Figure 13.4: Who pays Social Security taxes?
Wage
Rates
S1
B
Wg
S0
Tax
W0
A
Wn
D
0
Q1
Q0
Quantity/
Time Period
The higher price of labor, including the Social Security tax, reduces the number of workers employed
from Q0 to Q1. The gross wage, including Social Security taxes, rises from W0 to Wg, but the net wage
falls to Wn.
ama80571_13_c13_353-374.indd 367
1/28/13 9:51 AM
Section 13.4 Government Transfer Programs in Practice
CHAPTER 13
Social Security is the largest income redistribution program in the United States. It also has
some insurance features in the form of disability and survivors’ benefits. Workers must
contribute to the program for a specified minimum period of time in order to be eligible
for benefits. The size of the benefit received is independent of any nonearned income such
as interest, dividends, and private pensions. However, retirees under age 70 face a reduction of benefits if they earn above a certain wage income. This policy discriminates against
poorer retirees, because the only way most of them can supplement their Social Security
retirement income is with wages. Higher-income retirees collect interest, dividends, and
private pensions without loss of Social Security benefits.
Social Security taxes are paid into the Social Security Trust Fund. This name is misleading, because it is simply a fund into which current workers pay and from which current beneficiaries receive payments. Unlike private pensions and annuities, no money is
held and invested for workers as the source from which they will later receive income.
The Social Security System is a tax-and-transfer mechanism. Individuals are taxed during
their working years to pay benefits to those who are currently retired, disabled, or surviving dependents of covered workers.
Several reforms to the Social Security system were enacted in 1983. Noting that there
would have to be increased outlays in the period after the year 2000, as the so-called postwar “baby boomers” began to reach retirement age, a special presidential commission
proposed increasing Social Security taxes to build up a surplus in the Social Security Trust
Fund. Since Social Security taxes are collected and benefits are paid out by the federal government, the taxes appear as revenue and the benefits as expenditures in the combined
federal budget. Technically, Social Security funds are separate, but the reported overall
budget deficit or surplus has included these funds since 1967. As a result, a large part of
the debt is held by federal agencies, chiefly the Social Security Trust Fund.
Can today’s workers rely on promised future Social Security payments? Many people
are concerned about whether they will receive those future benefits. Policy reforms
since 1985 have strengthened the stability of the system. In 1993, Social Security collected $436 billion in payroll taxes and paid out $305 billion in benefits, a surplus of
$131 billion. In 2011, Social Security collected roughly $564 billion in payroll taxes and
paid out $725 billion in benefits, a deficit of $161 billion (Board of Trustees of the Federal
Old-Age and Survivor Insurance and Federal Disability Insurance Trust Funds, 2012).
Even with this large deficit, Social Security still had assets of $2,678 billion at the end of
2011. However, as more people continue to retire, any cushion of surplus funds will be
needed to pay these benefits.
ama80571_13_c13_353-374.indd 368
1/28/13 9:51 AM
CHAPTER 13
Section 13.4 Government Transfer Programs in Practice
Global Outlook: Income Security in Other Industrial Countries
Policy makers often explore what other countries do
in order to find workable solutions to problems like
welfare reform and growing Social Security costs.
All governments provide some mix of transfer payments and social services in their social welfare systems. Some of these programs are based on a means
(needs-based) test and others go to all citizens. Children’s allowances in Canada, for example, are provided to all families. Since these grants are taxable
income, some funds are recovered in tax payments
from higher-income families. Education up to a certain level is traditionally provided to all citizens in
industrial countries regardless of income.
iStockphoto/Thinkstock
Industrial countries, regardless of income,
traditionally provide a certain level of
education to all citizens.
All major industrial countries have some type of publicly funded pension system, and some provision for
unemployment and disability insurance. Health care is more likely to be provided at public expense
in European nations. Public housing has been an important component of social welfare in Britain, where until the late 1990s, upwards of 28% of the population lived in “council houses” (public
housing rented at subsidized rates). In Scandinavian countries, the political consensus is that a basic
standard of living is a right. Therefore, certain basic social services and social insurance programs
(unemployment, disability, and so on) are provided to everyone.
Support for the welfare state peaked in European countries and in the United States during the
1960s and 1970s. Today, U.S. social welfare expenditures are a lower share of GDP than in most
other industrial countries, except for Japan. Japan spends a lower percentage of its total income on
welfare programs because the family is expected to assume greater responsibility for both the young
and the elderly.
In the 2000s, the emphasis on individualism and concern over work incentives that pervaded the U.S.
welfare policy debate has also received increased attention from policy makers elsewhere. The formerly communist nations of Eastern and Central Europe have struggled to dismantle their extensive
welfare systems. As immigration into Sweden continues, the Swedish government is being forced
to reconsider how much it can afford to provide. Germany found that a high payroll tax required to
cover social welfare costs made its labor very expensive and cut into its global competitiveness. Thus,
those who debate fundamental changes in U.S. welfare policies are not alone. From Japan, to Canada
and the United States, to Germany, Sweden, and many other countries, social welfare systems are
one of the most pressing and difficult political and economic issues of the 21st century.
Transfers to the Elderly
In the last 40 years, the economic well-being of those over 65 has increased greatly in
the United States. In 1959, the largest segment of the poor were people over 65 years
old. By 2010, only 9% of those over 65 were below the poverty line. If in-kind transfers
are counted, the number falls even lower. Professor James Schulz of Brandeis University
observed, “Poverty among the elderly, as measured by the poverty index and adjusted for
nonmoney income, has virtually disappeared.”
ama80571_13_c13_353-374.indd 369
1/28/13 9:51 AM
Section 13.4 Government Transfer Programs in Practice
CHAPTER 13
Medicare is another major transfer program benefiting the elderly. When it was established in 1965, Medicare was projected to cost $8.8 billion in 1990. Even after adjusting for
inflation, that estimate was far off the mark. In 1990, Medicare cost $111 billion in 1965 dollars. By 2011, Medicare cost the federal government over $541 billion. Social Security and
Medicare are the two largest federal programs, accounting for 36% of federal expenditures
in 2011 (Board of Trustees of the Federal Old-Age and Survivor Insurance and Federal
Disability Insurance Trust Funds, 2012).
Unemployment Compensation
Unemployment compensation is a transfer program financed by a tax on employers and
administered by the states, which set benefit levels and eligibility requirements. Costs are
shared between the states and the federal government. In 2010, there were about 9.9 million beneficiaries on average, receiving benefits that totaled $113.3 billion (United States
Government Accountability Office, 2012).
Unemployment compensation is intended to be a temporary replacement of lost income
while a worker is between jobs or temporarily laid off. The program has been criticized as
providing “paid vacations” while workers go through the motions of searching for jobs.
It has also been praised as providing a safety net for unemployed workers while they
match their skills to the best available jobs, making labor markets more efficient. Of all
income transfer programs, this one is typically the least criticized because benefits are of
a temporary nature.
Welfare
The group of programs lumped together as “welfare” began in the 1930s with Aid to
the Aged, Aid to the Disabled, and Aid to Dependent Children (later Temporary Aid
to Needy Families, or TANF). These
programs identify groups of people
not expected to work. Costs are shared
between the federal and state governments. There are different eligibility requirements and benefit levels
in different states. In the 1960s, these
programs were expanded and new
ones were added as part of President
Johnson’s War on Poverty. Aid to the
Aged, Aid to the Disabled, and several
smaller programs were merged into
Supplemental Security Income, a federally funded program, in 1972.
In-kind welfare programs include
food stamps, public housing, Medicaid, legal aid, Head Start for preschool
children, and job training programs.
These efforts to improve the welfare of
ama80571_13_c13_353-374.indd 370
PhotoQuest/Archive Photos/Getty Images
President Lyndon B. Johnson’s War on Poverty helped
establish certain programs for those who need
assistance.
1/28/13 9:51 AM
Summary
CHAPTER 13
the poor were designed to ensure that they consumed the “right mix” of goods and services, especially in the areas of health, nutrition, education, and training.
Although welfare policy gets a great deal of attention, these cash and in-kind programs
are relatively small compared to Social Security. In 2011, federal spending on meanstested welfare approached $717 billion. With the addition of state contributions, total
spending from all sources was $927 billion. The welfare system consists of 79 federal
programs providing cash, food, housing, medical care, social services, training, and targeted education aid to poor and low-income Americans. More specifically, the federal
programs include: twelve programs providing food aid, twelve programs funding social
services, twelve educational assistance programs, eleven housing assistance programs,
ten programs providing cash assistance, nine vocational training programs, seven medical assistance programs, three energy and utility assistance programs, and three child
care and child development programs (Rector, 2012).
The Welfare Reform Policy Debate
Welfare reform is, of course, high on the political agenda. With spending totaling 6.1% of
GDP in 2011, welfare has been one of the fastest growing components of the federal budget in recent years, spurring discussion of reform. Critics of welfare programs argue that
they discourage work. It is very likely that a welfare client wh...
Purchase answer to see full
attachment