Economics 101

1. Economics 101 Lecture 26

2. Changes in the Before-Tax Distribution of Income 1949-1979. 1979-1999

4. Fractal earnings change pattern for virtually every labor market group: Bottom quintile: Absolute earnings decline Middle quintile: Negligible earnings growth Top quintile: Substantial growth

5. College graduates Dentists The top 1 percent The top 1/10th of 1 percent…

6. Earnings of CEOs of largest U.S. corporations 1980: 42 x average worker’s earnings 2001: 531 x average worker’s earnings

7. Why increased inequality? • Changes in the distribution of human capital? • Foreign competition at the low end? • Technical change favoring most educated workers?

8. Winner-Take-All Markets Markets in which reward depends not just on absolute performance but also on relative performance.

9. Why did Steffi Graf earn twice as much in 1993 as in 1994?

10. I. Sources of the Winner-Take-All Effect Economic factors:

11. "Cloning," or the ability to reproduce the best performer's product at low marginal cost.

12. The Music Industry 1300 opera houses in Iowa in 1900 Thousands of tenors earned a living as touring musicians

13. Placido Domingo Jose Carreras Luciano Pavorotti

14. The market for tax advice

15. Leverage: Effect of change in quality of performance for General vs. corporal CEO vs production worker

16. Suppose Jeff Lehman is 2% better at fundraising than Cornell’s 2nd-best candidate. The market for university presidents Bottom-line difference: (0.02)x($2 billion) = $40 million

17. •Network Economies VHS vs Betamax IBM's MS-DOS Books, plays, movies, sports, etc.

18. •Reward by contest Regulatory and anti-trust consultants Premier personal injury lawyers

19. Behavioral factors: •Natural limits on the size of the agenda Mental and physical shelf space limitations: 272-5936 487-896-4762-0534

20. •Economies of repetition in consumption: Restaurant chains New melodies Cigarettes Beer, Scotch whiskey Brand loyalties

21. Law of diminishing marginal utility implies diversification of consumption. Economies of repetition implies specialization of consumption.

22. •Avoidance of Regret. Premium tires Consulting firms

23. The desire to consume the best product •Pure Positional Concerns

24. Technologies that extend the reach of top performers have greatly benefited consumers. But they have also led to increased inequality.

25. High inequality in US is often said not to matter because of the high degree of economic mobility here.

27. U.S. Socioeconomic Mobility Is Low and Declining

28. Correlations between earnings of fathers and sons: US: 0.41 – 0.54 Sweden: 0.14 Canada: 0.17 - 0.19 Finland: 0.22 Germany: 0.10 - 0.36 Maylasia: 0.33 – 0.37 Source: Bjorkland and Jantti, 1999

29. Source: Thomas Hertz

30. Source: Thomas Hertz

31. Source: Inequality.org

32. Winner-Take-All Markets as Tragedies of the Commons Example 26.1. A small island nation has five identical individuals, each of whom must choose between two occupations:

33. 1. Make pots for export in the world market. Wage = $12/yr

34. 2. Compete for a recording contract that pays V >$12/yr to the winner, $0 to the losers

35. All contestants are equally likely to win. Work one year, then live one year in retirement. Winner's payment increases with the number of contestants

37. If villagers are risk-neutral, how many will compete for the recording contract? Individual decision rule: Compete if expected reward is at least $12; otherwise make pots.

39. Total income = 48 + 12 = 60, (winning singer) (potter) exactly the same total income as if the singing opportunity did not exist.

40. Example 26.2. In the preceding example, what is the socially optimal number of contestants? “socially optimal”  “surplus maximizing” Rule for optimal allocation: Send another contestant into the singing contest only if the payment to the winning singer goes up by at least as much as 12 (the opportunity cost of competing).

42. Maximum total income = $32 + $36 = $68 (winning singer) (potters) Under unregulated competition, the quality of the winning singer is "too high."

43. A second reason for overcrowding in winner-take-all markets is that contestants for top positions tend to be naively optimistic about their odds of winning. “The contempt of risk and the presumptuous hope of success, are in no period of life more active than at the age at which young people choose their professions.” Adam Smith

44. “Lake Wobegon Effect”

45. More than 60 percent of NCAA Division I college basketball starters believe they will eventually start for an NBA team. Actual proportion is less than 5 percent.

46. Most people think they are more intelligent than the average person, and also better drivers.

47. Workers asked to rate their relative productivity on a percentile scale responded with an average self-assessment of 77. More than 90 percent felt they were more productive than the median worker. Only 2 percent of high-school seniors reported that they had below-average leadership ability. Ninety-four percent of university professors thought they were better at their jobs than their average colleague.

48. Equity vs. Efficiency: The Agonizing Tradeoff?

49. Example 26.3. In the preceding example, how many contestants will enter if the winning singer's income is taxed at a rate of 25%? Individuals will enter if expected after-tax income is at least 12. Otherwise work as a potter.