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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...
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