Why do so many contemporary economists consider food subsidies in starving countries, rent control in rich cities, and health insurance everywhere “inefficient”? Why do they feel that corporate executives deserve no less than their multimillion-dollar “compensation” packages and workers no more than their meager wages? Here is a lively and accessible debunking of the two elements that make economics the “science” of the rich: the definition of what is efficient and the theory of how wages are determined. The first is used to justify the cruelest policies, the second grand larceny.
Filled with lively examplesfrom food riots in Indonesia to eminent domain in Connecticut and everyone from Adam Smith to Jeremy Bentham to Larry SummersEconomics for the Rest of Us shows how today’s dominant economic theories evolved, how they explicitly favor the rich over the poor, and why they’re not the only or best options. Written for anyone with an interest in understanding contemporary economic thinkingand why it is dead wrongEconomics for the Rest of Us offers a foundation for a fundamentally more just economic system.
“Brilliant.” David Cay Johnston, Pulitzer Prize–winning and New York Times–bestselling author of It’s Even Worse Than You Think
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INCOME EQUALITY: THE EARLIEST STANDARD OF EFFICIENCY
The search for a definition of economic efficiency began with the emergence of democracy. With democracy came, for the first time in history, the need to ask explicitly whom government should serve. Kings were never bothered by this question. "L'état, c'est moi," Louis XIV of France declared in the early eighteenth century. But who should a government "of the people" and "for the people" serve, when some of the people are rich and some are poor?
In 1793 the French "people" executed Louis XVI and proceeded to ratify in a referendum a constitution that guaranteed income redistribution in the form of public relief and public schooling. ("People" is in quotation marks because not all the French wanted the king executed, nor did all of them vote for the constitution.) But how much should be redistributed? The constitution of 1793 did not say, and the political process that would have determined it was thwarted before it started. A group of citizens, "The Conspiracy of Equals," demanded that the constitution be implemented, but the group was disbanded when its leader, François Noël Babeuf, was sent to the guillotine. The question was addressed theoretically, however, by a contemporary of Babeuf, the wealthy British philosopher Jeremy Bentham (1748–1832).
Bentham based his theory of the efficient degree of redistribution on three building blocks: (i) the happiness of a society consists of the sum of the happiness of each of its members, (ii) an efficient allocation of resources is one that maximizes the happiness of society, and (iii) the happiness that a person gets from an additional dollar (English pound) decreases as the number of dollars that person has increases. In the language of economics, "happiness" has long since been replaced by "utility," and Bentham's theory is known, therefore, as Utilitarianism.
Utility, U, is made of tiny units called "utils." Utils are derived from money. Each additional dollar buys additional utils, and the number of utils that each additional dollar buys is called "the marginal utility of money." The relationship between U and a person's income, I, is shown in figure 1.1. The marginal utility of money is denoted in the figure by ?U. More income yields more utility, but the relationship is not linear: while an extra dollar always brings additional utility, this additional utility gets smaller as a person's income increases. In other words, the marginal utility of money, ?U, decreases with the amount of money a person has.
A rich person is higher on the utility function than a poor person. Therefore, as figure 1.1 shows, if a dollar is transferred from the rich to the poor, the loss of utility to the rich will be less than the gain in utility to the poor. The transfer of a dollar from the rich person to the poor person will therefore increase the sum of utilities of these two individuals. Where should the process of redistribution stop? When each person has the same amount of money, because this will maximize the sum of their utilities. The pie of happiness is biggest — and therefore Utilitarian Efficiency is achieved — when the pie is divided exactly equally.
Definition: Utilitarian-Efficient Policy. A policy is Utilitarian efficient if it maximizes the sum of utilities in society.
Bentham was an effective agitator for equality. At the time, admission to Cambridge and Oxford was limited to students who belonged to the Church of England. When University College London opened in 1826, it was open to all. Bentham was considered the spiritual father of University College and his embalmed body is to this day displayed as a public sculpture there. (The head is now wax because pranksters stole the real head several times.)
But Utilitarianism as a yardstick for economic efficiency did not survive the century in which it was developed. It was supplanted wholly and with complete success by another definition of efficiency, one invented by an Italian economist, Vilfredo Pareto (1848–1923). If Utilitarianism is still mentioned in economics textbooks at all, it is summarily dismissed as a historical curiosity on the way to the truth: Pareto efficiency. How and why did Pareto dismiss Utilitarianism?
THE POPE AND PARETO DON'T LIKE IT
Let's begin with the why. At the end of the nineteenth century, inequality in Europe was so extreme that a socialist revolution had become a real possibility. Pope Leo XIII was moved enough by the prevailing economic disparity that in 1891 he issued an encyclical letter, Rerum Novarum (Of New Things), which was devoted to "The Condition of the Working Classes," and in which he wrote:
The whole process of production as well as trade in every kind of goods has been brought almost entirely under the power of a few, so that a very few rich and exceedingly rich men have laid a yoke almost of slavery on the unnumbered masses of non-owning workers.
This would seem to lay the groundwork for a call to redistribute "the whole process of production." In fact, though, the pope objected strongly to redistribution through the power of the state. The rich should have no legal obligation to assist the poor, the pope claimed: "These [assisting the poor] are duties not of justice, except in cases of extreme need, but of Christian charity, which obviously cannot be enforced by legal action." In a book published in 1906, Manual of Political Economy, Pareto elaborated on why assistance to the poor cannot be legally mandated, warning against even a mild redistribution by the state because of the slippery slope:
Those who demanded equality of taxes to aid the poor did not imagine that there would be a progressive tax at the expense of the rich, and a system in which the taxes are voted by those who do not pay them, so that one sometimes hears the following reasoning shamelessly made: "Tax A falls only on wealthy persons and it will be used for expenditures which will be useful only to the less fortunate; thus it will surely be approved by the majority of voters."
But why was Pareto opposed to redistribution? Because according to him Bentham was not necessarily right. As figure 1.1 shows, Bentham assumed that the only difference between a rich person and poor person was in how much money they had: given the same amounts of money they would have exactly the same amounts of utility. It is this similarity between the rich and the poor that led Bentham to conclude that transferring a dollar from the rich to the poor would hurt the rich less than it would help the poor. But according to Pareto rich people and poor people may be fundamentally different. In this scenario transferring money from the rich to the poor could actually hurt the rich more than it would help the poor. He used an extreme hypothetical example to illustrate this possibility. What if the rich actually enjoy the poverty of the poor? He asked. Then reducing poverty by redistribution may hurt the rich more than it would help the poor, Pareto argued. "Assume a collectivity made up of a wolf and a sheep," Pareto explained. "The happiness of the wolf consists in eating the sheep, that of the sheep in not being eaten. How is this collectivity to be made happy?"
Economists do not usually cite this passage in explaining Pareto's objection to Utilitarianism. Instead they ask what if the rich and the poor do not have the same utility function, as in figure 1.1, but instead, by chance, the rich happen to derive greater utility from a given quantity of money than the poor do. Figure 1.3 depicts this argument graphically, and it shows that a transfer of a dollar from the rich to the poor in this case may hurt the rich more than it would help the poor. Notice that just like a poor person, a rich person also derives greater utility from her first dollar than from her last one. But a rich person's utility from her last dollar may exceed the poor person's utility from her first dollar.
What would happen if all of a sudden the rich and the poor traded places, and the rich became poor and the poor became rich? In this case the curves in figure 1.3 would stay the same, but their labels would change: the lower curve would become the utility function of the rich and the upper curve would become the utility function of the poor. In this case, transferring money from the rich to the poor would increase the sum of utilities and redistribution would be justified.
Economists do not claim that the situation as it is described in figure 1.3 actually exists in reality, only that it may exist. Because utility is not measurable, this possibility simply cannot be ruled out. And if this is indeed the situation, then Bentham's argument does not hold, and redistribution is therefore not justified. Bentham acknowledged this possibility. "Difference of character is inscrutable," he said. But, he argued, a large difference in character between the rich and the poor was so unlikely that the government would make fewer mistakes if it operated under the assumption that the rich and the poor are similar, than if it operated under the assumption that they are fantastically different. The economist Abba Lerner (1903–82) noted that Bentham was just applying the first principle of statistics: when it is not known that things that appear the same are really different, the best we can do is to assume that they are the same. This is why we assign the probability of/ to each face of a die.
Unlike Bentham or Lerner, Pareto did not concern himself with the question of how likely it was that redistribution would hurt the rich more than it would help the poor. For him this theoretical possibility, no matter how remote, was reason enough to reject the lever of equality as a yardstick of economic efficiency. And based solely on this theoretical possibility, the entire economics profession removed the distribution of resources from its definition of economic efficiency and replaced it with Pareto's own definition.CHAPTER 2
EQUALITY DOES NOT MATTER: PARETO EFFICIENCY AND THE FREE MARKET
Like Bentham, Pareto also equated efficiency with maximizing the well-being produced by society's resources. But while Bentham allowed for the possibility that this would require the redistribution of these resources from the rich to the poor, Pareto ruled this possibility out from the start. According to him, an allocation of resources is (Pareto) efficient if it cannot be changed in a way that will make at least one person better off without making anybody else worse off. This definition is indifferent to the distribution of society's resources.
But first it is necessary to explain what the definition actually means. The next few pages are the most technical in the book, and it is my hope that readers will bear with them. The concept of Pareto efficiency is a critical building block of all modern-day economics, and a few extra minutes spent mastering this slightly arcane material will be well rewarded. The graphs are helpful, but not essential, to understanding the ideas under discussion. The rest of the book will be far less technical by comparison.
SUPPLY AND DEMAND
The economist's analysis of the behavior of the free market begins with, on the one hand, the quantity of a commodity that is available for consumption, and on the other, the different values that different consumers place on this commodity. In other words, it begins with supply and demand.
Suppose that seven families, A to G, need housing in a city, and suppose also that there are only six apartments available for rent. All the apartments are identical in terms of desirability, and each apartment is owned by a different landlord. Each family has a different level of income, and therefore the maximum amount that it is willing to pay for an apartment is also different. The maximum amount that a family is willing to pay for an apartment is called the family's reservation price. The reservation prices are shown in table 2.1, and as we shall see, they form the demand for a commodity.
Two factors determine a family's reservation price for a given apartment: the family's income, and the best available alternative, in terms of quality, location, and rent. For instance, in our example, if family G does not get one of the six apartments in the city, it will have to live in an apartment outside the city for which it will have to pay $1,200/month. It is in view of this alternative that family G's reservation price for the city apartment is $1,500/month. This means that if the rent for a city apartment is actually $1,500/month, family G is indifferent between living in the city apartment and living in the alternative apartment for $1,200/month.
Who will get the six apartments and how much will the rent for the apartments be? If each apartment is owned by a different landlord and neither landlords nor tenants collude, and, in addition, if what each family pays for its apartment is public information, then the market is a "competitive market." The first thing to notice about the competitive market is that it forces the rent on all the apartments to be the same. To see why, suppose that the rents are not the same. For instance, suppose that family A pays $2,000/month while family B pays only $1,500/month, and that these rents are common knowledge. In this case the landlord of family B would try to entice family A to her apartment with a rent offer that is lower than family A's rent but higher than family B's rent. A rent of $1,750/month would be agreeable to both parties. Alternatively, it could be family A who would initiate the transaction by offering to pay more than family B for the apartment that family B is occupying. Again, $1,750 would make both parties (family A and the landlord) better off. Such competition between landlords (who "steal" tenants from one another) and between tenants (who "steal" apartments from one another) will continue until the rent on the two apartments is identical. No tenant would want to pay more than other tenants do and no landlord would want to receive less than other landlords do, and as a result we get the Law of One Price:
In a competitive market identical goods have an identical price.
What would this unique rent be?
The minimum rent has to be at least $1500.01/month, because if it were lower, say $1,499/month, then seven families would have wanted apartments even though there are only six available. In this case the "homeless" family would have offered one of the landlords more than $1,499/month for an apartment (say $1,499.50), that landlord would have accepted the offer, and the existing tenant would have been evicted. The competition between consumers for apartments will not stop until the price rises sufficiently to force the poorest family out of the competition altogether. That means that the rent must be at least $1,500.01.
The same logic also makes it clear that the market rent cannot be higher than $2,250/month, because if it were, one of the landlords would be without a tenant, and she would then compete for a tenant by lowering her rent. Competition between landlords will stop only when each has a tenant, and that means that the rent must be at a level that is below the reservation price of family F. Hence, the market rent will be between $1,500.01 and $2,250.
The reservation prices can be used to draw the "demand curve," which shows how many apartments are demanded at each price (figure 2.1). For instance, the curve shows that when the rent is between $2,250.01 and $3,000/month, five apartments are demanded. (The demand curve is continuous, as if it is possible to have a fraction of an apartment. This is done merely for convenience and does not change the analysis at all.) The supply curve in our case is even simpler, because it is just a vertical line that represents the six apartments that landlords want to rent out. The intersection between the supply and the demand curves gives the "equilibrium" prices, the range of the prices that "clear" the market.
Definition: Market-Clearing Price: A price "clears" the market, or is an "equilibrium price," if all the apartments that are supplied at that price have tenants and all the tenants that are willing to pay that price have apartments.
Family G does not have an apartment, but the market is in equilibrium nevertheless because at the equilibrium price the family "does not want" (cannot afford) an apartment.(Continues…)
Excerpted from "Economics for the Rest of Us"
Copyright © 2010 Moshe Adler.
Excerpted by permission of The New Press.
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Table of Contents
Part I Economic Efficiency and the Role of Government
1 Income Equality: The Earliest Standard of Efficiency 5
2 Equality Does Not Matter: Pareto Efficiency and the Free Market 15
3 The Pareto Efficiency Cops 35
4 Why Redistributing Goods May Be Pareto Efficient After All 47
5 A Brief History of the Federal Income Tax 55
6 It Is Not Pareto Efficient: The Rich Pay Too Much Taxes (Or, Laffer's Napkin) 59
7 Private Goods 71
8 Government-Supplied Goods 91
Part II Theories of Wages
9 The Classical Theory of Wages 117
10 The Neo-classical Theory of Wages: John Bates Clark 133
11 The Evidence 143
12 The Minimum Wage 151
13 Theories of Wages and the Great Depression 157
14 "Sticky Wages" 169
15 "Efficiency Wages" or: Why Unemployment Is the Fault of Shirking by Workers 177
16 Executive Compensation 185