Factor Price Equalization in the Labor Market

For advanced students of economics, the first thing I thought of when I saw this headline was, "this is factor price equalization in action."

The Rising Power of the Chinese Worker - The Economist

Many people lamented our free trade agreements because American manufacturing jobs were being shipped overseas to places like China. China had relatively cheap labor compared to American manufacturing and a repressive government which kept them from striking and demanding higher wages. So, producers naturally decided to take their manufacturing plants where they could pay the least for labor, and thereby maximizing their profits.

The Heckscher-Ohlin model predicted that as we moved towards a  global labor market, jobs would flow from high wage countries to low wage countries in the short term, but that wages in the two markets would eventually equalize in the long term. Eventually manufacturing wages in countries like China would rise, and and wages in USA and Europe would drop, but they'd settle somewhere in the middle. It's been decades since we've opened free trade with China, but we are starting to see empirical evidence to back up their predictions. Even I was skeptical that this would work since most of the countries to which we were exporting our jobs had repressive governments which would not allow for the labor organizing we experienced here in the US in the late 1800s and early 1900s - particularly the countries where labor leaders were frequently executed by the government. 

Jargon Du Jour - Constant Returns to Scale (CRS)

Constant Returns to Scale: in a production function, it is when you increase your inputs by some amount m, then output increases by exactly m. It implies that a prdoucer would be just as efficent producing a small number of goods as they would be producing a large number of goods.

CRS is a common underlying assumption of many economic models, even if it is not a realistic one. For example,  if you have an industry that takes advantage of economies of scale then you would have increasing returns to scale. If however you are in an industry that has diseconomies of scale, then you would have decreasing returns to scale.

Jargon Du Jour - Recession and Depression

There is an old Bob Hope joke that goes, "a recession is when your neighbor loses his job, a depression is when I lose my job." All kidding aside, there are some technical definitions for recessions and depressions, and you will get dinged on your homework if you use these terms incorrectly.

Recession: When real GDP declines for two consecutive quarters. Recessions are a part of the natural business cycle, where we have expansion followed by periods of retraction.

Depression: When real GDP declines by more than 10%, and typically lasts for more than three quarters. Unlike recessions, the economy requires some economic interventions such as fiscal or monetary stimulus in order to dig itself out of a depression.

For example, the Great Depression started in August of 1929 that lasted to March 1933 - real US GDP fell over 30%.  There was a brief recovery period followed by a second depression from 1937-1938 when the government reinstated austerity measures to pay down the debt. Since then, the US economy has suffered several recessions but has not experienced a depression.

Blinder and Zandi on the Great Recession

Here is an article about how fiscal stimulus effected the US economy after the great recession. It was written by the Chief Economist at Moody's Analytics, Mark Zandi, and an Economics Professor at Princeton, Alan Blinder. Blinder also served on the Federal Reserve Board during the '90's.

End of the Great Recession - Blinder and Zandi

...we estimate that, without the government’s response, GDP in 2010 would be about 11.5% lower, payroll employment would be less by some 8½ million jobs, and the nation would now be experiencing deflation.

Lessons in Macroeconomics - Circular Flow Model for Closed Economy

We are going to start with a simple closed economy, and I'll introduce a slightly more complicated model which includes banks, government, and net exports later.

First we assume that there are only two sectors in the economy - individual households and firms. Households are concerned with consuming goods, whereas firms are concerned with producing goods that households want to buy.

Here is a sample graph of this two sector closed economy.



Households supply their labor (inputs) to businesses which is indicated by the blue arrow on the top. Then businesses use their labor in order to produce goods and services which it then sells to households, which is indicated by the blue arrow on the bottom. These are called factor markets.

Businesses also pay households money in exchange for their labor, which is indicated by the red arrow on the top. Households then use this money in order to purchase goods and services from businesses, which is the red arrow on the bottom. These are referred to as financial markets.

Money simply flows around the economy back and forth between businesses and households, and in this closed economy scenario they are exactly equal. No new money is ever created.

Next, I'll introduce a slightly more complicated model which includes banks and the government.

Jargon du Jour - Factors of Production

Factors of Production: A phrase used to refer to the combination of the land, labor, and capital used to produce finished goods which are then bought and sold in the economy. This is the view held by classical economists Adam Smith and David Riccardo.

For example, to produce one table I am going to need a workshop (land), some tools (capital), and a carpenter to put it together (labor).

Some economists like to add technology to their list of factors of production, as it helps make the allocation of land, labor, and capital more efficient. Others like to add entrepreneurship as a factor, and consider it a catalyst of all production. However, many economists argue that entrepreneurship is just a type of labor.

Recently, more economists are including human capital into their list of production factors, which accounts for the knowledge base of the laborers. This is becoming increasingly relevant in a service based economy.

Jargon Du Jour - Economies of Scale

Economies of Scale: In microeconomics, these are the cost advantages that a business obtains due to expansion. They are factors that cause a producer’s average cost per unit to fall as scale is increased.

For example, producing one car is very expensive due to all the fixed costs, such as equipment, associated with producing just one car. However, once a car company can produce tens of thousands of cars then the average cost per car drops significantly.

Related Concept: Natural Monopolies

The Economist: Long-term deficits: Keynesianism on the Right and the Left

While I haven't yet had the opportunity to get into Keynesian macroeconomic theory or the multiplier effect, The Economist had an article on Keynesianism which was very timely for our current US fiscal policy debates.

Here are a few quotes:

"Mr Wolf thinks the Republicans' "de facto Keynesianism" puts the Democrats at a historic disadvantage, as it's almost impossible to run against a party that constantly promises everyone a free lunch and blames the other guys when the check arrives. He thinks the situation could become disastrous if a Republican win leads to long-term policies so fiscally irresponsible as to flirt with the possibility of a federal default."

One of the things you'll learn in Economics is that our national macro economy does not function or play by the same rules that a household economy does. The national economy with a strong central bank like ours can, and in times of recession should, run national deficits. There are essentially two ways to do that - cut taxes or increase spending. Increasing spending has a more stimulative effect, currently $1.60 for every $1.00 spent, than tax cuts do. It also matters who is paying the taxes and what their marginal propensity to save is, people with more wealth tend to save more and therefore stimulate the economy less.

"Most people have a naive view of money based on the model of the household budget. They're not used to thinking about money as an artificial token of exchange backed by the totality of productive capacity in the economy, whose purpose is to allow people to incentivise others to do useful things for them, such that if an accounting imbalance makes it difficult to pay people to do the useful things they're capable of doing, one way to get them working again might be simply to create more money. "

The article cites several conservative economists like Bruce Barlett of Reagan Era fame, and more liberal economists like nobel prize winner Paul Krugman and Jamie Galbraith. When you have that many economists all agreeing on the same thing, perhaps it is time to listen!

Here is a quote from Wolf's article in the Financial Times:

"The future of fiscal policy was intensely debated in the FT last week. In this Exchange, I want to examine what is going on in the US and, in particular, what is going on inside the Republican party. This matters for the US and, because the US remains the world’s most important economy, it also matters greatly for the world.

My reading of contemporary Republican thinking is that there is no chance of any attempt to arrest adverse long-term fiscal trends should they return to power. Moreover, since the Republicans have no interest in doing anything sensible, the Democrats will gain nothing from trying to do much either. That is the lesson Democrats have to draw from the Clinton era’s successful frugality, which merely gave George W. Bush the opportunity to make massive (irresponsible and unsustainable) tax cuts. In practice, then, nothing will be done.

Indeed, nothing may be done even if a genuine fiscal crisis were to emerge. According to Bruce Bartlett, a highly informed, if jaundiced, observer, some “conservatives” (in truth, extreme radicals) think a federal default would be an effective way to bring public spending they detest under control. It should be noted, in passing, that a federal default would surely create the biggest financial crisis in world economic history.

To understand modern Republican thinking on fiscal policy, we need to go back to perhaps the most politically brilliant (albeit economically unconvincing) idea in the history of fiscal policy: “supply-side economics”. Supply-side economics liberated conservatives from any need to insist on fiscal rectitude and balanced budgets. Supply-side economics said that one could cut taxes and balance budgets, because incentive effects would generate new activity and so higher revenue.

The political genius of this idea is evident. Supply-side economics transformed Republicans from a minority party into a majority party. It allowed them to promise lower taxes, lower deficits and, in effect, unchanged spending. Why should people not like this combination? Who does not like a free lunch?

How did supply-side economics bring these benefits? First, it allowed conservatives to ignore deficits. They could argue that, whatever the impact of the tax cuts in the short run, they would bring the budget back into balance, in the longer run. Second, the theory gave an economic justification – the argument from incentives - for lowering taxes on politically important supporters. Finally, if deficits did not, in fact, disappear, conservatives could fall back on the “starve the beast” theory: deficits would create a fiscal crisis that would force the government to cut spending and even destroy the hated welfare state.

In this way, the Republicans were transformed from a balanced-budget party to a tax-cutting party. This innovative stance proved highly politically effective, consistently putting the Democrats at a political disadvantage. It also made the Republicans de facto Keynesians in a de facto Keynesian nation. Whatever the rhetoric, I have long considered the US the advanced world’s most Keynesian nation – the one in which government (including the Federal Reserve) is most expected to generate healthy demand at all times, largely because jobs are, in the US, the only safety net for those of working age."

I highly recommend reading both articles in their entirity by clicking on the links below. Also, in order to put this articles in the proper context, keep in mind they are both fairly conservative publications from the UK.


The Political Genius of Supply-Side Economics - Martin Wolf
Long-term Deficits: Keynesianism on the Right and the Left - The Economist

Jargon Du Jour - Opportunity Cost

Opportunity Cost: The next best choice that someone must give up when choosing between several mutually exclusive things. This is because of scarcity; there are not infinite supplies of everything we wish to consume and what we can produce with our limited resources of time, land, labor, capital and technology.

For example, by waking up early and going to the gym my opportunity cost is an hour of sleep. By choosing to work as a teacher, I am giving up potential opportunities (for now) of pursuing a more lucrative career.

Opportunity Cost is a very key concept in economics and is the foundation of all production and consumption models.

Lessons In Macro Economics - Production Possibilities Frontier

The Productions Possibilities Frontier (PPF) is a simple model in macroeconomics, which is supposed to demonstrate how much of any two products a given country can produce efficiently in a given time period holding production factors constant. Production factors include - land, labor, capital, and technology.

This model became popular during world war two in order to justify war rationing. The authorities argued that a country could either focus on producing guns, a term used to represent all military equipment and services, or butter, used to represent domestically used goods such as food, clothing, cars, etc. Americans, therefore, would have to sacrifice some of their comfort items in order to support the overall war effort.


Sample Production Possibilities Frontier



In the above graph, points B, C, and D are all efficient points since they are found on the curve itself. Point A is an inefficient use of factors of production, such as having an idle workforce or unused capital since it is below the curve. Point E is unobtainable since it is above the curve.

The rate at which butter can be substituted for guns is represented by the slope of the curve; this is called the Marginal Rate of Transformation (MRT). The MRT also represents an opportunity cost because one has to give up several units of butter in order to obtain additional units of guns. The above graph has an increasing opportunity cost because the MRT increases in absolute value as one specializes in either guns or butter. PPFs also can be drawn to show constant opportunity costs or decreasing opportunity costs, which can be achieved by economies of scale.


This model is also commonly referred to the Production Possibilities Curve.