1. Introduction to Externalities
Econ: 74
Module
Introduction to Externalities
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

2. What you will learn in this Module:
What externalities are and why they can lead to inefficiency in a market economy.
Why externalities often require government intervention.
The difference between negative and positive externalities.
The importance of the Coase theorem, which explains how private individuals can sometimes
The purpose of this module is to introduce the concept of external costs and benefits (externalities). In addition, the module explains why an unregulated market will not produce the socially optimal quantity when there are external costs or benefits.

3. I. The Economics of Pollution
Marginal social cost (MSC): the additional costs imposed on society as a result of one more unit of pollution.
Marginal social benefit (MSB): the additional benefits received by society as a result of one more unit of pollution.
Most of the electricity produced in the U.S. is produced by burning coal. The electricity is an economic good that provides, quite literally, utility to the nation. However the burning of coal creates pollutants in the air, water and soil.
There is a trade off, and a debate, going on here.
Environmentalists argue that there is too much pollution because electricity producers, if not regulated, fail to consider the harmful effects of the pollution.
Producers of the electricity argue that governmental regulation unnecessarily burdens their ability to produce electricity at the lowest possible cost.
Economists see the pollution issue as a topic for cost-benefit analysis and argue that there is an efficient quantity of pollution where the needs of both the environment and the consumer of electricity are considered.
Pollution, like so many things, has both costs and benefits attached to it.
Marginal social cost (MSC): the additional costs imposed on society as a result of one more unit of pollution. These costs include those borne mostly by humans (cancers, asthma, and other illnesses) or by nature (loss of species, degradation of water, soil, air or climate).
What does the MSC curve look like?
It is upward sloping. When pollution levels are small, nearly zero, the next ton of pollution imposes very little damage to society. Nature can readily absorb it. However at very high levels of pollution, the next ton of pollution can cause a much larger cost to society as nature’s capacity for absorbing it has greatly diminished.
Marginal social benefit (MSB): the additional benefits received by society as a result of one more unit of pollution.
How can there be benefit from pollution? Think about what it takes to prevent a ton of pollution. Industries must use scarce resources (labor, capital, land) to install new technologies to prevent the pollution. These scarce resources have value (benefit) in alternative uses, so if we don’t use them to prevent a ton of pollution and allow the ton of pollution to exist, we receive that benefit elsewhere in society.
What does the MSB curve look like?
It is downward sloping. Assume that pollution is completely unabated and pollution levels are very high. At this point, to reduce one ton of pollution is very easy. This means that the value of the necessary abatement resources is fairly small, so the benefit of not using them to reduce pollution is small.
Suppose we reduce pollution to the point where there is only one ton of pollution left in society. We have used all of the easy (low cost) abatement methods to this point and all that remains is the most costly method we have. The necessary resources are extremely valuable in other uses to society, so if we don’t use them to reduce pollution, we will enjoy a great deal of benefit in those other uses.
So it is very easy to reduce the first ton of pollution and very difficult to reduce the last ton of pollution. This means that the benefit of the first ton of pollution is very high, and the benefit of the last ton of pollution is very low.
The socially optimal amount of pollution is shown in the graph below as Qopt where the MSB=MSC of the last ton of pollution emitted. This is the quantity of pollution that makes society as well-off as possible, when all of the costs and benefits of pollution are considered.
Will society, left unregulated, come to the optimal amount of pollution Qopt? No.

4. II. The External Cost of Pollution
External Cost – an uncompensated cost that an individual or firm imposes on others
Also called a negative externality
Pollution creates both benefits and costs to society. Those who benefit are the producers and consumers of polluting goods, like most forms of electricity. The costs of pollution, however, are imposed upon everyone, and the natural environment.
So a consumer of electricity in the Ohio River Valley certainly benefits from it. The power plant producing the electricity certainly benefits from it. And since pollution is a byproduct of burning coal, the benefits of the pollution accrue to the consumers and power plants.
But there are people living to the east of the Ohio River Valley who are receiving the pollution from the coal-burning power plants. Some of the particulate matter that comes out of a smoke stack in Ohio ends up landing in Canada or northern Europe. These people, and their environments, are not benefiting from that electricity, but they are incurring some of the cost of that pollution.
These costs are known as external costs.
Because the unregulated market doesn’t much care about the costs of pollution, the polluting good (electricity in this case) will be produced until the marginal social benefit of the pollution emissions is equal to zero.
The graph below shows that this quantity of pollution, Qmkt, is going to be greater than Qopt. This tells us that the unregulated market will produce more pollution than is socially optimal.

5. The Inefficiency of Excess Pollution
At Qmkt, suppose we could reduce pollution by one ton.
What would we lose? Since MSB is zero, one less ton of pollution would come at almost $0 of sacrifice to society.
What would we gain? Since MSC is $1000, if we reduced pollution by one ton we would avoid nearly $1000 of harmful costs.
Qopt
MSC and MSB
of pollution
MSB
MSC
MSC=MSB
Qmkt
$1000
How could society do better with less pollution? Take a look at the graph again.
At Qmkt, suppose we could reduce pollution by one ton.
What would we lose? Since MSB is zero, one less ton of pollution would come at almost $0 of sacrifice to society.
What would we gain? Since MSC is $1000, if we reduced pollution by one ton we would avoid nearly $1000 of harmful costs.
Society would gain nearly $1000 of net benefit from reducing pollution by just one ton. This is true of the entire range between Qopt and Qmkt.
Society would gain the shaded area of the triangle between MSC and MSB if pollution could be reduced from Qmkt to Qopt.
Qty of Pollution Emitted (tons)

6. III. Private Solutions to Externalities
The Coase Theorem - so long as property rights are clearly defined, and transaction costs are minimal, a private solution can be found to a situation such as this.
These private solutions internalize the externality. The party that is imposing the hardships on the other is required to compensate the victim.
Many times transaction costs are too high to make a private solution easy to negotiate. (legal costs)
Suppose you had a house in a lovely neighborhood that was worth $200,000 in the real estate market.
The house next door is sold and a new neighbor Bob moves in. Bob proceeds to install a pig pen in the backyard and fills it with pigs. Pigs do what pigs do, and before you know it your property value declines so that it is worth $150,000 in the real estate market.
You are the victim of a negative externality.
What can you do? You could call the police or some other government office, but is there a way to handle this privately with Bob?
Ronald Coase (1960) wrote that, so long as property rights are clearly defined, and transaction costs are minimal, a private solution can be found to a situation such as this.
Coase would say that these private solutions internalize the externality. The party that is imposing the hardship on the other is required to compensate the victim.
In reality there might be situations where transaction costs are too high to make a private solution easy to negotiate.
1. High communication costs between affected parties. Suppose that Bob’s pigs are polluting not just your property, but dozens of other people in the community are feeling the negative impact. Now the costs of negotiating a settlement between dozens of people and Bob are much higher.
2. High legal costs. Negotiations and legally binding agreements might require lots of attorneys and a huge stack of legal bills.
3. Costly delays involved in bargaining. Suppose that Bob is fully aware that you are the victim of the negative externality and decides to delay negotiations and postpones every meeting you have scheduled. Maybe he thinks that you will eventually get tired of these delays and move.

7. Externalities and Public Policy
Econ: 75
Module
Externalities and Public Policy
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

8. What you will learn in this Module:
How external benefits and costs cause inefficiency in markets.
Why some government policies to deal with externalities, such as emissions taxes, tradable emissions permits, and Pigouvian subsidies, are efficient, although others, including environmental standards, are not.
The purpose of this module is to continue to study how negative externalities can be regulated with environmental standards, emissions taxes or tradable permits. The module also shows how both positive and negative externalities lead to deadweight loss as either too little, or too much, of a good is being supplied by a market that does not recognize the externalities in the equilibrium quantity or price.

9. I. Policies Toward Pollution
Environmental Standards
Emissions Taxes
Tradable Emissions Permits
Major pieces of environmental legislation in the U.S. have only been around since the early 1970s. Recent laws have incorporated more market-based incentives to reduce pollution and gain economic efficiency.
Early legislation was written with a heavy dose of “thou shalt not” pollute more than _____ amount of gunk in the air, water, and/or soil. This was a vast improvement on the unregulated, and heavily polluted, situations that led to the environmental movement, but was seen by economists as an inefficient way to tackle the problems.
Some examples:
Many cities require autos to pass emissions inspections before the license plate can be renewed.
Sewage must be treated before it can be released back into the environment.
Economists have long known that if you want someone to do less of something, all you need to do is raise the price of doing it. Harness the power of the law of demand and the profit motive!
We’ll bring back the graph that shows the MSB and MSC of pollution from the previous module.
The socially optimal quantity of pollution Qopt is where MSB=MSC
A system of tradable pollution permits works like this:
The government issues (auctions) a set number of permits, each allowing the holder to emit one ton of pollution. This limits the amount of pollution emitted. If a firm found that they needed to pollute more, they would buy permits from a firm that found they could pollute less.
The firm buying permits knows that it’s cheaper to buy a permit than it is to install costly abatement equipment, so it profits from this transaction. The firm selling permits knows that it’s cheaper to install abatement equipment, so it sells excess permits and profits from the transaction. When there are no more mutually beneficial transactions to be made, an equilibrium price is set for permits.

10. Production, Consumption, and Externalities
Private versus social benefits
Private versus social costs
The production and consumption of most goods creates some form of pollution, or external cost, upon society. Even the simple act of using electricity to operate my laptop computer is contributing to the burning of coal in the Ohio River Valley.
Not all production and consumption creates a negative externality, sometimes a positive externality exists. If one person spends money to beautify her house and yard, it benefits the homeowners nearby with higher property values. The property is also pleasant to those who drive or walk past.
We will see that when external benefits exist from the production and consumption of a good, that the market will under-produce that good. In other words, society would benefit from more, but the market produces less.
We will also look again at the issue of external costs, like pollution, when a good is produced and consumed. We will see that the market over-produces such goods. Society would benefit from less, but the market produces more.
When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society.
We have seen that when firms produce goods, they incur production costs. These are private costs of production. But when production of a product generates external costs, a negative externality, on society it means that third parties are also incurring costs and these costs must be added to the private costs to reflect the total costs of producing a product.

11. II. Negative Externalities
When the production and consumption of a good creates costs to third parties, that good is said to create negative externalities to society.
Pigouvian Tax
Price, MSC
MPC D
MSC
Popt
Qopt
Qmkt
Pmkt
Tax
Pfirm
We have seen that when firms produce goods, they incur production costs. These are private costs of production. But when production of a product generates external costs, a negative externality, on society it means that third parties are also incurring costs and these costs must be added to the private costs to reflect the total costs of producing a product.
The sum of all of the costs, both private and external, is the total costs incurred by society.
Total Social Cost = Total Private Cost + Total External Cost
On an incremental basis, the next unit provides marginal social, marginal private, and marginal external costs.
Marginal Social Cost = Marginal Private Cost + Marginal External Cost
MSC = MPC + MEC
Market outcome:
Equilibrium occurs where the demand curve intersects MPC (private supply) and Qmkt is produced at price of Pmkt. This is the same outcome we have seen throughout the course. But the MPC only reflects the costs incurred by the actual producers; it does not reflect all of the costs. When we include the external costs, the price society would be willing to pay for Qmkt is higher at Pmsc.
Socially optimal outcome:
If the external costs are considered, the socially optimal outcome is where the demand curve intersects the MSB curve and Qopt is produced at a price of Popt. At this point the marginal benefit of consuming (from the demand curve) is equal to the marginal costs society incurs from producing.   
The difference between the market outcome and socially optimal outcome:
We can see that the market over-produces goods that generate negative externalities. In other words, we get too much of a bad thing.
This is inefficient and produces deadweight loss just like price controls and monopoly. This represents additional costs that would not be incurred by society if the socially optimal, not the market, output was produced.
The area of the deadweight triangle is above the demand curve, with base of (Qmkt - Qopt), and height of (Pmsc – Pmkt),
How could policy eliminate the deadweight loss?
We could provide a tax (a Pigouvian tax) on each unit supplied.
Qty electricity

12. III. Positive Externalities
When the production and consumption of a good provides benefits to third parties, that good is said to provide positive externalities to society.
Pigouvian Subsidy
Price, MSB
MPB
MSB S
Popt
Qopt
Qmkt
Pmkt
Subsidy
Pcons
The sum of all of the benefits, both private and external, equals the total benefits received by society.
Total Social Benefit = Total Private Benefit + Total External Benefit
On an incremental basis, the next unit of the good provides marginal social, marginal private, and marginal external benefits.
Marginal Social Benefit = Marginal Private Benefit + Marginal External Benefit.
MSB = MPB + MEB
Market outcome:
Equilibrium occurs where the supply curve intersects MPB (private demand) and Qmkt is produced at price of Pmkt. This is the same outcome we have seen throughout the course. But the MPB only reflects the benefits received by the actual consumers; it does not reflect all of the benefits. When we include the external benefits, the price society would be willing to pay for Qmkt is higher at Pmsb.
Socially optimal outcome:
If the external benefits are considered, the socially optimal outcome is where the supply curve intersects the MSB curve and Qopt is produced at a price of Popt. At this point the marginal cost of producing (from the supply curve) is equal to the marginal benefits society receives from consuming them.
Note: stress that the socially optimal outcome is where MSB=MSC.
The difference between the market outcome and socially optimal outcome:
We can see that the market under-produces goods that generate positive externalities. In other words, we don’t get enough of a good thing.
This is inefficient and produces deadweight loss just like price controls and monopoly. This represents benefits that would be enjoyed by society if the socially optimal, not the market, output was produced.
The area of the deadweight triangle is above the supply curve, with base of (Qopt - Qmkt), and height of (Pmsb – Pmkt),
How could policy eliminate the deadweight loss?
We could provide a subsidy (called a Pigouvian subsidy) on each unit of home improvement goods demanded
Qty home improvements

13. IV. Network Externalities
A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.
Example: When more people use Facebook or Twitter, it becomes more valuable to you
A network externality exists when the value to an individual of a good or service depends on how many other people use the same good or service.
When more people use Facebook or Twitter, it becomes more valuable to you. When more people have cell phones with Verizon service, it means your Verizon phone can call more people at lower prices.

14. Margaret Ray and David Anderson
Econ: 76
Module
Public Goods
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

15. What you will learn in this Module:
How public goods are characterized and why markets fail to supply efficient quantities of public goods.
What common resources are and why they are overused.
What artificially scarce goods are and why they are under-consumed.
How government intervention in the production and consumption of these types of goods can make society better off.
Why finding the right level of government intervention is often difficult.
The purpose of this module is to show that only private goods can be efficiently exchanged in a market. When goods are either nonexcludable, nonrival, or both, a market will fail to provide the efficient quantity.

16. I. Private Goods Private goods are what we have studied thus far
Private goods have two characteristics. They are;
Excludable- You can prevent people who don’t pay from consuming it
Rival- the unit of the good cannot be consumed by more than one person at the same time
They are excludable: suppliers of the good can prevent people who don’t pay from consuming it.
They are rival in consumption: the same unit of the good cannot be consumed by more than one person at the same time.

17. II. Public Goods Public goods are;
Non-excludable- Can’t exclude anyone on basis of payment
Non-rival- more than one person can consume it at the same time without the benefit going down
Example:
Cities have fire departments that protect all homes in the city and can’t exclude anyone on the basis of payment. And more than one person can consume the fire protection at the same time. If a fire breaks out at Margaret’s house, the fire department rushes to put it out. This prevents the fire from spreading to Melanie’s store, so both people are consuming the same unit of fire protection.

18. III. Common Resources Common resources are; Non-excludable Rival
Example:
The stock of salmon in the Pacific Ocean has historically been a common resource. If a person had a boat, they could harvest salmon from the ocean, or even scoop the fish from the bank of a river as the salmon headed upstream. This made the salmon nonexcludable. However once a salmon is caught, it cannot be caught by a second person, which makes it rival.

19. IV. Artificially Scarce Goods
Artificially scarce goods are;
Excludable
Non-rival
Example:
A college economics lecture is excludable because only students who have paid tuition can enroll in the course and attend the lecture. However it is nonrival because many people can consume the same unit of the good at the same time.
Other examples are pay-per-view movies or sporting events.

20. V. Markets Only Provide Private Goods Efficiently
Markets will not provide the efficient level of public goods
The efficient level of public goods is the quantity where MSC = MSB
There are really only a small number of ways in which a good is supplied: by private firms, voluntary contributions, or by the government.
Private firms won’t supply public goods, so that leaves voluntary contributions or the government. Many public goods require a lot of money to provide. Some of those funds are donated by citizens and corporations, but the government must provide the rest. National defense is a public good that could not survive on voluntary donations so the government provides all of it. How does the government provide public goods? Collecting involuntary taxes from the population.
The efficient level of a public good is found where MSC = MSB (a variation of MC = MR).

21. VI. Providing Common Resources
The problem of overuse and the “Tragedy of the Commons”
Maintaining a common resource
Examples of common resources?
Common resources, like populations of fish in the sea, are nonexcludable and rival and this creates special problems for the use of the resource. Other examples of common resources are the oceans themselves, clean air, clean water and biodiversity.
The Problem of Overuse: Example
Suppose that I live in an area of the country that gets most of its fresh water from an aquifer. If I drill a well, I can access this clean water for my own personal use; it’s nonexcludable. However every gallon that I pump for my own use is a gallon that someone else cannot use; it’s rival. My consumption of water draws down the water in the aquifer, and makes it more difficult (costly) for other people to get their water.
In the language of economics, my marginal private cost of the next gallon of water is lower than the marginal social cost. In the graph below, the socially optimal quantity of water is less than the market quantity of water. This tells us that a common resource will be overused. If rainfall is insufficient to recharge the aquifer, we will exhaust it.
The same is true of common resources like fish in the ocean. Every fish that I catch provides benefit only to me, while imposing a small, almost imperceptible, cost upon everyone else. Since I don’t really have to worry about those social costs, I will catch as many fish as I can. When everyone is doing that, the fish can’t repopulate quickly enough and the fishery collapses.
This behavior was labeled the “Tragedy of the Commons” by Garrett Hardin (1968).
The Efficient Use and Maintenance of a Common Resource
In order to find a solution to the overuse of a common resource, economists need to find ways for the user to bear the full costs of the consumption, including the costs they previously would have imposed upon others.
The solutions are similar to those we studied with negative externalities:
Tax or otherwise regulate the use of the common resource
Create a system of tradable licenses for the right to use the common resource
Make the common resource excludable and assign property rights to some individuals
For example cities can charge higher prices for water consumption to encourage more economical use of the water in the aquifer.
In the case of overfishing, each person would need to have a license to harvest the fish. These licenses would be limited in number to restrict the harvest to the optimal level. They could be traded in a secondary market to insure that those who are willing to pay the most are those that actually get to use the license and profit from the fish.
If the common resource can be excludable, the government could assign property rights to it. For example, if there is a public forest and everyone can harvest trees from it, it will soon be overused and no trees will remain. But if the government sells the forest to private individuals, their self-interest will promote conservation of the forest. They will harvest trees slowly so that the resource isn’t overused.
iphoto

22. VII. The Efficient Level of Artificially Scarce Goods
MC of providing the good is zero
Firms can’t set price equal to zero
Example of artificially scarce good?
The pay-per-view movies are artificially scarce because they are excludable but nonrival. The cable company can exclude me from watching the movie if I don’t pay the price, and if I watch the movie it doesn’t deny another household from also watching the movie.
The marginal cost of providing the movie to one more household is zero. The efficient quantity would be the quantity where the demand curve intersects the horizontal axis and the price would be zero. Of course there is no way the firm can profit if the price is zero, so the firm sets a price of maybe $5 and excludes some of the potential customers.
If the price is $5, fewer movies will be ordered than the efficient number. This is why this good is called “artificially scarce”.

23. Public Policy to Promote Competition
Econ: 77
Module
Public Policy to Promote Competition
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

24. What you will learn in this Module:
The three major antitrust laws and how they are used to promote competition.
How government regulation is used to prevent inefficiency in the case of natural monopoly.
The pros and cons of using marginal cost pricing and average cost pricing to regulate prices in natural monopolies.
The purpose of this module is to learn the basic goals of U.S. antitrust policy and to see how natural monopolies can be regulated to achieve efficiency.

25. I. Promoting Competition and Efficiency
Antitrust laws
Protect competition
Ensure lower prices
Promote development of better products
Price regulation
When economies of scale make it efficient to have one firm in a market, that natural monopoly can be taken over by the government or regulated
We have seen that competitive markets, in the absence of externalities, tend to produce efficient outcomes. Markets with monopoly power tend to be less efficient, with higher prices, and fewer units of output. It should make sense that there are laws in place to promote competition and limit monopolies.
The Department of Justice’s Antitrust Division describes the goals of antitrust laws as:
protecting competition
ensuring lower prices, and
promoting the development of new and better products.
It emphasizes that firms in competitive markets attract consumers by cutting prices and increasing the quality of products or services.
Competition and profit opportunities also stimulate businesses to find new and more efficient production methods.
Price regulation; A natural monopoly occurs when economies of scale make it efficient to have only one firm in a market. We saw in Module 62 that a natural monopoly can either be taken over by the government, or it can be regulated.

26. II. Antitrust Laws Sherman Act Clayton Act FTC Act
The Sherman Antitrust Act of 1890
The Sherman Antitrust Act of 1890 has two important provisions, each of which outlaws a particular type of activity.
1. It is illegal to create a contract, combination, or conspiracy that unreasonably restrains interstate trade.
2. It outlaws the monopolization of any part of interstate commerce.
The Clayton Antitrust Act of 1914 was intended to clarify the Sherman Act and specifically prohibited four firm behaviors.
 1. Price Discrimination. It is illegal to charge different prices to different people for the same product. There are some obvious exceptions like discounted movie theatre tickets for children.
2. Anticompetitive practices of exclusive dealing and tying arrangements.
An exclusive deal is one where a seller won’t sell to you if you are buying products from another seller. For example, a wholesale food company might be selling steaks to a restaurant. If the food company tried to prohibit the restaurant from buying meat from a competing food wholesaler, they might be in violation of the Clayton Act.
A tying arrangement is when a seller will sell you product X only if you also purchase product Y. For example if McDonald’s told you that you could buy a cheeseburger only if you also bought fries, this would be a tying arrangement that might get McDonald’s in trouble for anticompetitive behavior.
3. Anticompetitive mergers. If Coca-Cola and Pepsi Cola were going to merge into one ginormous soda company, this would probably be judged as illegal under the Clayton Act. The government would look at what such a merger would do to the concentration ratio, HHI, and pricing power within the post-merger industry.
4. Interlocking Directorates. Two companies cannot share members of the board of directors.
The Federal Trade Commission Act of 1914
Prohibits unfair methods of competition in interstate commerce and created the Federal Trade Commission (FTC) to enforce the Act.
The FTC Act outlaws unfair competition, including “unfair or deceptive acts.” The FTC Act also outlaws some of the same practices included in the Sherman and Clayton Acts.
In addition, it specifically outlaws price fixing (including the setting of minimum resale prices), output restrictions, and actions that prevent the entry of new firms.
The FTC’s goal is to promote lower prices, higher output, and free entry—all characteristics of competitive markets.

27. III. Price Regulation
Marginal-cost pricing- the firm must operate at the point where P=MC. Government would subsidize any losses at taxpayer expense.
Average-cost pricing- the firm must operate at the point where P=ATC. This insures that the firm will earn normal economic profit, but some dead weight loss will occur.
A natural monopoly occurs when economies of scale make it efficient to have only one firm in a market.
We saw in Module 62 that a natural monopoly can either be taken over by the government, or it can be regulated.
Price regulation can be designed as either marginal-cost or average-cost pricing.
Marginal-cost pricing: the firm must operate at the point where P=MC. This is the outcome consistent with perfect competition and zero deadweight loss, but this might create economic losses for the firm. The government would need to subsidize these losses at taxpayer expense.
Average-cost pricing: the firm must operate at the point where P=ATC. This outcome insures that the firm will earn normal economic profit, but will not be at the most efficient level of output. In other words, some deadweight loss will exist.
This graph is replicated from Module 62 and shows all three possibilities: unregulated monopoly (Pm, Qm); Marginal-Cost pricing (Pc, Qc); Average-Cost pricing (Pr, Qr).

28. Income Distribution and Income Inequality
Econ: 78
Module
Income Distribution and Income Inequality
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

29. What you will learn in this Module:
What defines poverty, what causes poverty, and the consequences of poverty.
How income inequality in America has changed over time.
How programs like Social Security affect poverty and income inequality.
The purpose of this module is to learn how the U.S. defines poverty, who falls into poverty, what causes poverty, and the consequences of poverty. The module also discusses income inequality and how antipoverty programs in the U.S. address poverty and the distribution of income.

30. I. Poverty Trends in poverty Who is poor? Causes of poverty
Consequences of poverty
The definition of poverty is arbitrary, though the government has tried to improve the statistical measures since the first definition of poverty was created in the 1960s. If a person or household falls below a specific “poverty line”, they are considered part of the population living in poverty. In other words, the government would consider them officially “poor”.
Trends in Poverty
The percentage of Americans living in poverty rises and falls with the business cycle. Figure 78.1 shows this trend since the 1970s. During recessions, the poverty rate rises, and during recoveries the poverty rate falls. It may be surprising to students that there is no long-term decline in U.S. poverty rates. The text makes the interesting note that the poverty rate is higher in 2009 than it was in 1973.
 Who Are the Poor?
 Poverty is not spread evenly across the population. If it was, in 2009 we would expect the same poverty rate for whites, African-Americans, Hispanics, men and women. For example, in % of Americans lived in poverty, but that rate was 25.9% for African-Americans and 25.3% of Hispanics. These two groups are overrepresented in the poverty ranks. Single mothers are also much more likely to be in poverty than the average American, with a poverty rate of 32.5%.
What Causes Poverty?
Anything that creates a barrier to a full-time job earning a decent wage is a cause of poverty.
Some examples:
Educational attainment or opportunity or quality.
Language barriers.
Discrimination.
Bad luck.
Consequences of Poverty
About 17% of children in America are living in poverty. Because poverty is associated with poor health and less frequent health care, children in poverty can suffer long-term health effects and learning disabilities. And children with poor health and learning disabilities usually find completion of college to be more difficult and thus avenues for college degrees and high wages are closed.

31. II. Lorenz Curve
Lorenz curve: A Lorenz curve shows the degree of inequality that exists in the distributions of two variables, and is often used to illustrate the extent that income or wealth are distributed unequally in a particular society.
Gini coefficient: A Gini coefficient is a summary numerical measure of how unequally one variable is related to another. The Gini coefficient is a number between 0 and 1, where perfect equality has a Gini coefficint of zero, and absolute inequality yields a Gini coefficint of 1
The definition of poverty is arbitrary, though the government has tried to improve the statistical measures since the first definition of poverty was created in the 1960s. If a person or household falls below a specific “poverty line”, they are considered part of the population living in poverty. In other words, the government would consider them officially “poor”.
Trends in Poverty
The percentage of Americans living in poverty rises and falls with the business cycle. Figure 78.1 shows this trend since the 1970s. During recessions, the poverty rate rises, and during recoveries the poverty rate falls. It may be surprising to students that there is no long-term decline in U.S. poverty rates. The text makes the interesting note that the poverty rate is higher in 2009 than it was in 1973.
 Who Are the Poor?
 Poverty is not spread evenly across the population. If it was, in 2009 we would expect the same poverty rate for whites, African-Americans, Hispanics, men and women. For example, in % of Americans lived in poverty, but that rate was 25.9% for African-Americans and 25.3% of Hispanics. These two groups are overrepresented in the poverty ranks. Single mothers are also much more likely to be in poverty than the average American, with a poverty rate of 32.5%.
What Causes Poverty?
Anything that creates a barrier to a full-time job earning a decent wage is a cause of poverty.
Some examples:
Educational attainment or opportunity or quality.
Language barriers.
Discrimination.
Bad luck.
Consequences of Poverty
About 17% of children in America are living in poverty. Because poverty is associated with poor health and less frequent health care, children in poverty can suffer long-term health effects and learning disabilities. And children with poor health and learning disabilities usually find completion of college to be more difficult and thus avenues for college degrees and high wages are closed.

32. III. Income Inequality Using quintiles to analyze income distribution
Income group
Average 2008 income
% of total income if distributed equally
2008 % of total income
Bottom quintile
$11,656
20%
3.4%
Second quintile
$29,517
8.6%
Third quintile
$50,132
14.7%
Fourth quintile
$79,760
23.3%
Top quintile
$171,057
50%
While America is a rich country, the income is not distributed equally across the population. This explains why a rich country can still have many people living in poverty.
Suppose the population was divided into fifths, or quintiles. An equal distribution of income would look like the third column in the table below. The actual 2008 distribution of income is in the fourth column and also seen in Table 78.2
This table tells us that the bottom 20% of the population earns far less than 20% of the total income in the U.S. And the top 20% of the population earns far more than 20% of the total income.
In fact, Table 78.2 shows that the top 5% of Americans account for 21.5% of all of the income earned in the U.S.
The U.S. is therefore an example of an unequal distribution of income.
Note: this does not mean that this distribution is “bad” or “unjust” or “good” or “fair”, or anything like that. It is simply a presentation of the facts and compared to the hypothetical equal distribution.
A country’s level of income inequality can be measured with a statistic known as a Gini coefficient.
If a Gini = 0, the income is distributed equally like the third column of the table above.
If the Gini =1, all of the income goes to one person. This is as unequal as it gets!
The Gini in the U.S. is .468, which is high when compared to other wealthy nations in Europe, Australia or Canada. There is greater income inequality in South America and parts of Africa and Asia.
Using quintiles to analyze income distribution
The Gini coefficient

33. IV. Economic Insecurity
In addition to the problem of poverty, we are concerned with the possibility that people or families can fall into poverty due to unanticipated events.
Because these uncertain events can cause any family to have economic insecurity, we have a welfare state to provide temporary assistance.
Suppose one adult in the household lost a job or someone got very sick and there was no health insurance. These events could put a family that was once safely above the poverty line into poverty.
Because these uncertain events can cause any family to have economic insecurity, we have a welfare state to provide temporary assistance.

34. V. U.S. Antipoverty Programs
Means-tested
Criteria is established to qualify
An example would be level of income and size of family
Social Security and unemployment insurance
Social Security funded by tax on wages
Unemployment funded by tax on employers
The effects of programs on poverty
Research says yes, but…
With a means-tested program, the government establishes criteria, like a level of income, and if you earn less than this amount, you qualify for benefits. These are the classic welfare programs that most developed nations use to alleviate poverty.
High-profile programs that are non-means tested include Social Security and Unemployment Insurance.
Social Security was designed to guarantee retirement income for senior citizens, but also includes payments for disabled workers and survivors of working adults who die.
Social Security is funded by a small tax on wages and benefits depend upon how much taxable income a person earned in his/her lifetime.
Unemployment insurance is funded by a small tax on employers and if a worker loses her job, she may receive monthly payments up to about 35% of her previous salary. These payments can be received for 26 weeks, unless Congress increases the benefits during particularly nasty recessions.
The idea behind progressive income taxes and a welfare system is two-fold.
1. Those with the highest incomes pay larger shares of income taxes.
2. The poor receive transfer payments as welfare benefits.
This is typical income redistribution: the rich pay more in taxes and the poor receive transfer payments. Ideally, this should help to make the income distribution more equal than it would be in the absence of such a system.
Have they been successful?
Table 7.4 shows estimates that indicate that the poverty rate for all groups would have been much higher in the absence of the progressive taxes and transfers in the U.S.
Table 7.5 shows that the income distribution would have been more unequal if our taxes and transfers programs did not exist.

35. VI. The Debate Over Income Redistribution
Problems with income redistribution
The politics of income redistribution
Barstool Economics
Most people agree that senior citizens, the disabled, and the poor should have some sort of economic safety net. The big debates are centered on how big the welfare system should be and who should receive benefits and for how long.
There are two main arguments against income redistribution.
1. Some have the philosophical belief that this is simply not the role of the government.
2. Higher tax rates to fund more welfare programs may cost the nation in terms of efficiency. In other words, more equity comes at a cost of less efficiency.
How could we address the second argument? Make the welfare programs more cost-effective (eliminate waste and fraud) and provide the benefits only to those who truly need them.
A strict means-test for welfare benefits can create a unique problem known as the “notch”.
For example, suppose a single-mother earns $5000 of welfare benefits if her income is below $15,000 and zero benefits if she earns more than $15,000.
Suppose she has earned $14,900 from her wages and $5000 from her benefits. Total income = $19,900.
If she can work a few more hours and earn another $1000 from her wages, she will lose the $5000 in benefits. Total income = $15,900. This serves as a disincentive to working harder and so the economy loses some efficiency.
The notch can be avoided if benefits are gradually phased out as more income is earned from work.
Some of the political controversy over the welfare state involves differences in opinion about the trade-offs we have just discussed: if you believe that the disincentive effects of generous benefits and high taxes are very large, you’re likely to look less favorably on welfare state programs than if you believe they’re fairly small. Economic analysis, by improving our knowledge of the facts, can help resolve some of these differences.
To an important extent, however, differences of opinion on income redistribution reflect differences in values and philosophy. And those are differences economics can’t resolve.

36. The Laffer Curve
The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T*) would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% (the far right of the curve), then all people would choose not to work because everything they earned would go to the government.
Most people agree that senior citizens, the disabled, and the poor should have some sort of economic safety net. The big debates are centered on how big the welfare system should be and who should receive benefits and for how long.
There are two main arguments against income redistribution.
1. Some have the philosophical belief that this is simply not the role of the government.
2. Higher tax rates to fund more welfare programs may cost the nation in terms of efficiency. In other words, more equity comes at a cost of less efficiency.
How could we address the second argument? Make the welfare programs more cost-effective (eliminate waste and fraud) and provide the benefits only to those who truly need them.
A strict means-test for welfare benefits can create a unique problem known as the “notch”.
For example, suppose a single-mother earns $5000 of welfare benefits if her income is below $15,000 and zero benefits if she earns more than $15,000.
Suppose she has earned $14,900 from her wages and $5000 from her benefits. Total income = $19,900.
If she can work a few more hours and earn another $1000 from her wages, she will lose the $5000 in benefits. Total income = $15,900. This serves as a disincentive to working harder and so the economy loses some efficiency.
The notch can be avoided if benefits are gradually phased out as more income is earned from work.
Some of the political controversy over the welfare state involves differences in opinion about the trade-offs we have just discussed: if you believe that the disincentive effects of generous benefits and high taxes are very large, you’re likely to look less favorably on welfare state programs than if you believe they’re fairly small. Economic analysis, by improving our knowledge of the facts, can help resolve some of these differences.
To an important extent, however, differences of opinion on income redistribution reflect differences in values and philosophy. And those are differences economics can’t resolve.