Here’s another excerpt from my book-in-progress, Economics in Two Lessons. Rather than work sequentially, I’m jumping between:
Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.
Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.
In the section over the fold, I’m looking at how opportunity cost reasoning applies to policies that change the distribution of income, wealth and other entitlements.
As usual, praise is welcome, useful criticism even more so. You can find a draft of the opening sections here.
Changes in the regulation of labor and capital markets and in taxation and expenditure policy since the 1970s have greatly enhanced the income and wealth of the best-off members of society (the so-called 1 per cent), and have yielded more modest, but still substantial, improvements in the position of those in the top 20 per cent of the income distribution (broadly speaking, professionals and business owners and managers).
On the other hand, incomes for the rest of the community have grown much more slowly than might have been expected based on the experience of the decades from 1945 to 1975. The substantial technological advances of recent decades have had little impact on the (inflation-adjusted) income of the median US household. For many below the median, incomes have actually fallen (real wages, welfare reform).
In the absence of the tax cuts of the 1980s, the associated cuts in public expenditure and financial and industrial relations policies that benefitted business, the incomes of the wealthy would not have increased as much as they have done. Those on median and lower incomes would have done substantially better[^1]. But how should we compare those gains and losses?
Economists and philosophers have been looking at this question for a long time and in many different ways. The answers most consistent with opportunity cost reasoning can be described by the following ‘thought’ experiment, developed explicitly by John Harsanyi and John Rawls in the mid-20th century, but implicit in the reasoning of earlier writers like Jeremy Bentham, John Stuart Mill and Friedrich von Wieser.
First consider yourself in the position of both the high income beneficiary and the low income loser from such a change. Next, imagine that you are setting rules for a society, of which you will be a member, without knowing which of these positions you might be in. One way to think of this is to imagine life as a lottery in which your life chances are determined by the ticket you draw.
Now consider a choice between increasing the income of the better off and the worse off person. Presumably, if the dollar increase were the same in both cases, you would prefer to receive it in the case where you are poor rather than in the case when you are rich.
The reasons for this preference are obvious enough. For a very poor person, an additional hundred dollars could mean the difference between eating and not eating. For someone slightly better off, it may mean the difference between paying the rent and being evicted. For a middle class family, it might allow an unexpected luxury purchase. For someone on a million dollars a year, it would barely be noticed.
Economists typically present this point in terms of the concept of marginal utility, a technical term for the benefits that are gained from additional income or consumption. As argued above, the marginal utility of additional income decreases as income rises. It follows that a policy that increases the income of the rich and decreases that of the poor by an equal amount will reduce the utility of the poor more than it increases the utility of the rich.
Few mainstream economists would reject this analysis outright[^2] . However, many prefer to duck the issue, relying on a distinction between ‘positive’ economics, concerned with factual predictions of the outcomes of particular economic policies and ‘normative’ economics, concerned with ‘value judgements’ like the one discussed above. The debate over the justifiability or otherwise of this distinction has been going on for decades and is unlikely to be resolved any time soon.
More importantly, constructs derived from economics are often used, implicitly or explicitly, in ways that imply that an additional dollar of income should be regarded as equally valuable, no matter to whom it accrues.
The most important of these constructs is GDP, the aggregate value of all production in the economy.GDP per person is the ordinary average (or arithmetic mean) income of the community. GDP per person treats additive changes in income equally no matter who receives them.
Used correctly, as a measure of economic activity, GDP can be a useful guide to the short-term management of the economy. In the short run, weak GDP growth is commonly an indicator of a recession, suggesting the need for expansionary monetary and fiscal policies.
Unfortunately, measures of GDP and GDP per person are commonly misused, as an indicator of living standards and economic welfare more generally. There are many reasons why this is inappropriate, but the failure to take account of the distribution of income is most important.
It is easy enough to see that, if the opportunity cost of a given increase the income of a better-off person is an equal increase in the income of a worse-off person, then the change is for the worse.
What about the case when we the choice is between a given increase for the worse off person and a larger increase for the better off person? How big does the opportunity cost have to be before it outweighs the benefit? This question, raising once again the thought experiment mentioned above, can be answered in many different ways
One answer, which seems close to the views typically elicited when people are asked questions of this kind, is to treat equal proportional increases in income as being equally desirable. That is, an increase of $1000 in the income of a person on $10 000 a year is seen as yielding a benefit comparable to that of an increase of $10 000 in the income of a person earning $100 000 a year. Conversely, if the opportunity cost of the $10 000 benefit to the high income earner is a loss to the low income earner of more than $1000, the cost exceeds the benefit.
It’s surprisingly easy to turn this way of looking things into a measure of living standards over time. If, instead, we want a measure that treats proportional changes equally, all that is needed is to replace arithmetic mean measures such as GDP per person with the geometric mean we all learned about in high school (and most of us promptly forgot).
The geometric mean has the property that, if all incomes increase by the same proportion, so does the geometric mean. So, it’s a better measure of the growth rate of incomes across the community than the usual arithmetic mean. It can also be justified mathematically, in terms of the theory of expected utility. For those interested, the details are spelt out in an optional section.
The geometric mean is equal to the arithmetic mean when incomes are distributed exactly equally. But the more unequal is the income distribution, the greater the gap between the arithmetic and geometric means. For this reason, the ratio of the arithmetic to the geometric mean is often used as a measure of income inequality.
We can look at the changes in these measures using data from the US Census Office, and some simple computations (details available on request). From 1967 to 2013, arithmetic mean income per household (in 2013 dollars) rose from $66 500 to $104 000, an increase of 56 per cent. But the geometric mean rose by only 34 per cent, from 50 000 to 67,500. The ratio between the two rose from 1.32 to 1.54, indicating a substantial increase in inequality.
The idea that equal proportional increases are equally valuable, and therefore that the geometric mean is a good measure of economic welfare or wellbeing is not the only answer to the question posed above. Another, leading to a strong version of egalitarianism, is always to prefer the increase to the worse off person[^3] . In this case, welfare is measured by the minimum income.
There’s no way of reaching a final resolution on questions like this. But it’s worth observing that a policy aimed at maximising the geometric mean of income would be substantially more egalitarian than anything that has ever been seen in a market economy.
For example, calculations by Peter Diamond and Emmanuel Saez, using a method equivalent to the geometric mean approach, suggest that the top marginal tax rate, after taking account of disincentive effects should be between 70 and 80 per cent.
These rates are far above those found in any country today. And while the top marginal rate was at or above this level in the 1950s, generous exemptions and other loopholes meant that the effective rate was much lower.
It’s not surprising that political outcomes are less egalitarian than an opportunity cost estimate would suggest. The thought experiment leading to the geometric mean gives everyone equal weight, as in an ideal democracy. In practice, however, the well off have more weight in democratic systems than do the poor; and of course the disparity is even greater in undemocratic and partly democratic systems. The disparity of political weight has increased with the growth of inequality over the past decades. So, while there are good arguments for more strongly egalitarian approaches, policies aimed at maximizing geometric mean income will inevitably be found well to the left of centre in any feasible political system.
[1^]: The claim that tax cuts for the rich will ultimately make people better off is discussed briefly in Section … and, at greater length, as one of the ‘zombie ideas’ in my book Zombie Economics
[2^]: The most notable exceptions, somewhat outside the mainstream, are members of the ‘Austrian School’, who have dismissed interpersonal comparisons as ‘unscientific’ and offered a variety of more or less spurious justifications for inequality. As discussed above, von Wieser, the originator of the opportunity cost analysis, was an exception to this exception.
[3^]: The ‘difference principle’ espoused by philosopher John Rawls is often interpreted to imply this view. However, scholars of Rawls work disagree on this, and much more.