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Review sources of income, income distribution, and concepts of wealth and poverty. Prepare for final exam with study tips and practice tests. Review investment decisions, interest rates, and pay differentials.
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Class Plan 12/7/99 • Assignment for last day of class • Go over problems from lab exercise 34 • Introduce lab exercise 23 • Sources of Income • Income distribution
Assignment for next Thursday • Read Wall Street Journal article, “Defining Poverty Up,” 11/02/99; keywords: Defining Poverty • Read the Instruction and Background Information page for Lab exercise 23 • Do Lab exercise 23 by Thursday Midnight. • Do Quiz 25 by Thursday Noon • Study for Final Exam
Final Exam Logistics: • Wednesday, December 15, 3-5PM • Section 6: 108 Bessey Hall • Section 7: 103 Erickson Hall
Final Exam Format • Answer 60 out of 70 questions: • Questions 1-30: Exactly the same format as the first two midterms • Questions 31-70: Four sources, from complete term: • 1) from quizzes and midterms this semester • 2) problems based on end of chapter exercises • 3) From CD-ROM chapter summaries • 4) Other known good questions
How to study • Read any chapters of the book you have only skimmed • Do problems at end of chapters. If you can not answer the problems, reread the entire chapter. • Read chapter summaries on CD-ROM for all chapters • Do Multiple choice problems from CD-ROM. If you make more than 2 errors, reread the entire chapter. • Retake all 4 midterms & 25 quizzes. If you miss any questions, reread the chapter on which the question is based. • Do practice final. If you are unsure of an answer, reread entire chapter on which question is based.
The Grade Book • I will send the class an e-mail when everything is up to date. • (probably Friday or Saturday) • You need to email eohrkb@msu.edu with anything that you think is an error before the final exam.
The Wealth of Nations • Adam Smith’s questions: • What makes a country wealthy • (How do we measure a country’s wealth?) • His answer was different from others of his day: • Mercantalists: • Wealth measured by gold • To become wealthy, earn gold through selling more than you buy
Western (Modern?) concept • To be wealthy is to be able to consume a lot • Well-being is measured by the total amount of consumption. • A country that has a high income has a high ability to consume. • Focuses attention on determinants of income • What makes a country wealthy is also what makes a person well-off(?)
Sources of Income • A person gains income from selling factors of production in the resource market. • Quantity of labor (hours/year) multiplied by wage rate per year is labor income • Quantity of capital (dollars) multiplied by return on capital (interest rate) is capital income • Quantity of land (acres?) multiplied by rental rate on land (per year) is land income
Elements of the study of income • What causes people to work more or less? • What determines the wages that people are paid? • What determines the distribution of capital? • What determines the rate of return to capital? • What determines the distribution of land holdings? • What determines the rent paid to land?
Demand for capital • Capital is measured in dollars • Demand for capital means demand for funds to invest in capital • You will invest in a machine if the PDV of the (net) income from using the machine is greater than the cost of purchasing it. • If a machine • produces $1000 per year in net profit for 10 years • costs $7000 to purchase • Should you invest?
Deciding to invest • If the interest rate is 10%, do not invest. • Cost>PDV of income • If the interest rate is 5%, do invest. • Cost<PDV of income • Invest if internal rate of return is higher than the market interest rate. • In this case, the IRR = 7.07%
Many different investments At 7.07 interest rates, these projects meet the criterion for investment Interest rate These do not 7.07% $ of investment projects that are justified
Supply of Loanble Funds • Determined by savings decisions of individuals • An issue for macroeconomics • Do people save more when interest rates are higher? • Strongly affected by policies of the Federal Reserve Board.
What determines interest rates? Supply of Loanable Funds Interest rate Equilib. Rate of Return Demand for Loanable Funds $ of investment projects that are justified
Explaining pay differentials • Human capital: • Training • Skill • Experience • Affects demand curve through marginal product • Affects supply curve through limiting those willing and able to work in a trade. • More education is required, fewer are willing to work in this field.
The Market explanation for wage differences wage Supply, Human Capital Required Skilled wage Supply no Human Capital Required Unskilled wage Demand, with Human Capital requierment Demand, no Human Capital requierment Worker-years
How do we know this is right? • Human capital is anything that makes you more productive • It is not directly observable • Correlates are observable • Amount of schooling • Amount of experience • Amount of experience with the same employer • Each is correlated with wages
Market explanations for lower women’s wages • Previously, did not have as much education • Do not spend as much time in the labor force • (due primarily to child rearing and household support roles?) • Do not spend as much time with the same employer • (Due to following husband when he changes jobs and moves to a different city?)
Discrimination against women? • When you control for effects of • type of occupation • education • labor force experience • job tenure • The difference between women’s and men’s wages becomes small • Does this mean that there is no discrimination against women?
Discrimination as a residual effect • Accept the human capital explanation for wages • Any education, training, or experience characteristic that correlates with wages is assumed to be an indicator of productivity. • Anything left over after human capital correlates are accounted for is discrimination • But this may ignore the fact that access to the characteristics that are correlated with wages are not race and gender neutral.
Remedies for discrimination • Affirmative action: • Tries to improve access to: • education • jobs • Does this interfere with individual evaluations? • Comparable Worth • Pay different professions according to job characteristics. • What efficiency price would we have to pay?
Income distribution • Income versus Wealth • income is measured in dollars per year • wealth is measured in dollars • (Lifetime income?) • Measures of income inequality • Share going to different income quintiles • Gini coefficient • Income inequality vs. Poverty
Measuring Income Inequality • Share going to top 5% • Gini coefficient • Relative size of area between Lorenz curve and full equality Lorenz curve • Higher numbers mean more inequality Cumulative % of income Lorenz Curve Cumulative % of households
Sensitivity of Gini Coefficient to Income Definition • Money Income: Gini = .447 • + gov cash transfers + cap gains + health benefits: Gini = .511 • - taxes: Gini = .483 • + nonmeans-tested gov’t cash transfers: Gini = .416 • + means tested cash transfers: Gini= .398 • + return on home equity: Gini = .392
Poverty • The minimum amount of income necessary to pay for necessities: food, shelter, clothing, with nothing left over. • Usually measured as 4 times the income necessary to buy a minimally adequate diet. • About $16,000/year for a family of 4 people.
Indicators of poverty • Live outside of metropolitan area • Black or Hispanic (Though most of the poor are white) • Female householder, no male present • Age 15 to 20 or 70 and older • No wage earner present • Worked part time or did not work • Less than 9th grade education
The bottom 10% • The working poor • Since 1979, inflation-adjusted weekly earnings have fallen from $292/week to $260/week. • Up from $256 last year • The first time that wages have risen in two decades • Wages of bottom 10% rose more rapidly than those of top 10% • Top 10% earns $1,149 per week.
Reasons for long-term decline • The decline in organized labor • Flood of low-skilled immigrants • Surge of imports from low-wage countries • new technologies that displaced low-skilled workers and rewarded better-trained.
Reasons for recent turn-about • Tight labor markets • Unemployment rate for high school dropouts is down to 7% • Increase in the minimum wage • Now $5.15/hour • Earned Income Credit has reduced taxes for this group. • How long will these trends continue?
The return to education • In 1979, a college graduate made 60% more than a high school dropout. • In 1995, a college graduate made 140% more than a high school dropout. • But in the last two years, the return to education has not been increasing.
Programs to ameliorate income inequality and/or poverty? • Some think we should be blind to issues of need or poverty. • An issue solely for private charity? • This is not the Judeo-Christian tradition • We are our “brother’s keeper?” • People in desperate condition need our help • A community is judged by how it treats the unfortunate?
Why don’t poor get to work? • How will they get to work? • Who will watch the kids? • How can they get marketable skills? • How can they overcome their disabilities? • How will they pay for their health care? • How can they learn the importance of punctuality and reliability?
This is paternalism • When we help people on their feet we take away their freedom and initiative? • Income transfers are inefficient. • How leaky is the leaky bucket? • How much do we want to tell people how to live their lives? • Drinking rules • Drug laws • Motor Cycle helmet laws.
Should people be forced to save for their retirement? • Yes: • We KNOW that if they don’t, they will regret it at age 65. • We as a society are not prepared to accept sick, aged, beggers • Save future taxpayers cost of taking care of them • No: • I should have freedom to decide whether to save • How do we know that they aren’t better off spending today?
Retirement programs • Pension programs give people tax incentives to save for their retirement. • These tax savings are regressive. • Beneficiaries are learning to borrow from programs. • The social security program. • Everyone must participate • You pay about 7.5% of income (up to max) • Your contribution is matched by your employer • The tax is regressive (high wage earners pay a smaller proportion of income.)
Social Security Payouts • Benefits from program are to a limited extent determined by income while working. • Those who worked at low wages or for less than a lifetime receive far more than they pay in. • Those with high incomes who have worked their entire life get back less than they pay in. • A huge non-means tested income redistribution program.
Inter-generational transfers • Social Security is a pay-as you go system. • Income from working people is used to pay those who are now retired. • Funds are not invested for our retirement • System works so long as there are many more working age people than retirees. • Medical advances are keeping people alive longer • The baby bust means fewer people to pay in
They system is going broke • Now, more is being paid in than is being paid out. • Funds are used to reduce Federal deficit. • In 15-20 years, more will be paid out than will be paid in. Options: • Raise payroll taxes • Reduce retirement benefits • Increase retirement age
Why not a negative income tax? Without neg income tax After Tax Income With neg. income tax Market Income
Pros and Cons of Negative Income Tax • Pros: • Gets rid of welfare bureaucracy • Eliminates demeaning oversight • Reduces onerous tax rates on poor • Cons: • Naïve? • Raises taxes on those who work(?) • We do care how recipients spend their money
Increasing Taxes on Wealthy • Bush and Clinton both raised tax rates on the wealthy. • Surprise is that this group is actually paying their taxes. • Between 1993 and 1995, incomes went up by $57 Billion, taxes went up by $18 Billion • Effective Marginal tax rate: 32%
