Welfare, GDP Fetishism , Inequality, Consumption, & Happiness.

Introduction

The word "welfare" has two very different meanings in economics. The most familiar meaning to the general public is that it refers to a collection of government programs such as food stamps and Medicare, usually intended to help the poor.
However, economists more often use the word "welfare" in a very different sense--as a synonym for wellbeing. Welfare or wellbeing refer to an overall condition, emphasizing happiness and contentment, though also including one's standard of living in financial or material ways. Welfare in this sense more commonly refers to the condition of an entire country or economy, which is sometimes emphasized by using the phrase "social welfare." Welfare in the sense of wellbeing turns out to be an easier concept to imagine than to analyze carefully. It is even harder to measure.
Economists have always recognized that not all happiness derives from being financially well off. We all know that being wealthy is not the same as being happy. However, it is rather hard to quantify happiness, and even harder to aggregate happiness across people because people generally have a variety of tastes. Consequently, over the years economists have invented some specialized technical names for happiness, including utility, satisfaction, preferences, tastes, indifference curves, wellbeing, and welfare.
The concept of social welfare sometimes leads to discussions of the distribution of income and income inequality.

Definitions and Basics

GDP Fetishism 

When economics professors teach the basics of Gross Domestic Product (GDP), we usually caution our students that it is not a good measure of welfare. Unfortunately, many economists go on to give GDP far more credit than it deserves. They tend to consider fiscal and monetary policy positive if these policies increase GDP, but they often fail to ask, let alone answer, whether those same policies increase or reduce welfare. I have a term for giving GDP such a sacred a place in economists' reasoning: GDP fetishism. If we return to some basic principles of economics, we will avoid GDP fetishism, do better economic analysis, and propose better policies.

To see why GDP is not the same as wellbeing [I use "welfare" and "wellbeing" interchangeably], consider the definition of GDP. One of the most careful definitions is in The Economic Way of Thinking, 10th edition, by Paul Heyne, Peter Boettke, and David Prychitko. They write: "The gross domestic product is the market value of all the final goods produced in the entire country in the course of a year." Most economists would agree with this definition. It turns out, though, as Heyne et al. point out, that even this careful definition does not accurately characterize GDP, let alone wellbeing. It is inaccurate in two ways. First, because there is usually no market for the things that government produces (the U.S. Postal Service being one of the exceptions), government spending on goods and services is valued at cost rather than at market prices. Second, because many goods and services are not bought or sold, even though they would have a market value if they were, these goods and services are not counted in GDP. In early editions of his best-selling textbook, Economics, the late Paul Samuelsongave his favorite example of this pitfall in GDP accounting. Samuelson pointed out that if a man married his maid, then, all else equal, GDP would fall....

Welfare, 

The U.S. welfare system would be an unlikely model for anyone designing a welfare system from scratch. The dozens of programs that make up the "system" have different (sometimes competing) goals, inconsistent rules, and over-lapping groups of beneficiaries. Responsibility for administering the various programs is spread throughout the executive branch of the federal government and across many committees of the U.S. Congress. Responsibilities are also shared with state, county, and city governments, which actually deliver the services and contribute to funding.

The six programs most commonly associated with the "social safety net" include: (1) Temporary Assistance for Needy Families (TANF), (2) the Food Stamp Program (FSP), (3) Supplemental Security Income (SSI), (4) Medicaid, (5) housing assistance, and (6) the Earned Income Tax Credit (EITC). The federal government is the primary funder of all six, although TANF and Medicaid each require a 25-50 percent state funding match. The first five programs are administered locally (by the states, counties, or local federal agencies), whereas EITC operates as part of the regular federal tax system. Outside the six major programs are many smaller government-assistance programs (e.g., Special Supplemental Food Program for Women, Infants and Children [WIC]; general assistance [GA]; school-based food programs; and Low-Income Home Energy Assistance Program [LIHEAP]), which have extensive numbers of participants but pay quite modest benefits....

Inequality, Consumption, & Happiness. 

How well-off are we? Using economic data, economics professor Steve Horwitz addresses questions about inequality, consumption, happiness, and well-being. Are the rich getting richer and the poor getting poorer? Is there income mobility in the United States? Are Americans happy? Are we "objectively" better off than we used to be? ...

Richard Epstein on Happiness, Inequality, and Envy.

Richard Epstein of the University of Chicago talks with EconTalk host Russ Roberts about the relationship between happiness and wealth, the effects of inequality on happiness, and the economics of envy and altruism. He also applies the theory of evolution to explain some of the findings of the happiness literature....

Marginalism, 

Adam Smith struggled with what came to be called the paradox of "value in use" versus "value in exchange." Water is necessary to existence and of enormous value in use; diamonds are frivolous and clearly not essential. But the price of diamonds--their value in exchange--is far higher than that of water. What perplexed Smith is now rationally explained in the first chapters of every college freshman's introductory economics text. Smith had failed to distinguish between "total" utility and "marginal" utility. The elaboration of this insight transformed economics in the late nineteenth century, and the fruits of the marginalist revolution continue to set the basic framework for contemporary microeconomics.

Public Goods and Externalities, Government Spending

Public Goods and Externalities, from the Concise Encyclopedia of Economics

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods.

Public goods have two distinct aspects—"nonexcludability" and "nonrivalrous consumption." Nonexcludability means that nonpayers cannot be excluded from the benefits of the good or service. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong....

Government Spending, from the Concise Encyclopedia of Economics

In the past, government spending increased during wars and then typically took some time to fall back to its previous level. Because the effects of World War I were not totally gone by 1929, the line for the United States from 1790 to 1929 has a very slight upward slant. But in the second quarter of the twentieth century, government spending began a rapid and steady increase. While economists and political scientists have offered many theories about what determines the level of government spending, there really is no known explanation for either part of this historical record....

Distribution of Income, from the Concise Encyclopedia of Economics

The distribution of income is central to one of the most enduring issues in political economics. On one extreme are those who argue that all incomes should be the same, or as nearly so as possible, and that a principal function of government should be to redistribute income from the haves to the have-nots. On the other extreme are those who argue that any income redistribution by government is bad....

Federal Budget, from the Concise Encyclopedia of Economics

Deficit spending has been a way of life for the federal government for most years since World War II. A whole generation of elected federal officials has come and gone without ever balancing the budget. The last time that federal budget expenditures were brought into balance with revenues was in 1969, and prior to that the last time was in 1960....

Taxation, A Preface, from the Concise Encyclopedia of Economics

Economists specializing in public finance have long enumerated four objectives of tax policy: simplicity, efficiency, fairness, and revenue sufficiency. While these objectives are widely accepted, they often conflict, and different economists have different views of the appropriate balance among them....

In the News and Examples

Should government help people make better choices? Richard Thaler on Libertarian Paternalism. Podcast on EconTalk

Richard Thaler of the University of Chicago Graduate School of Business defends the idea of libertarian paternalism--how government might use the insights of behavioral economics to help citizens make better choices. Host Russ Roberts accepts the premise that individuals make imperfect choices but challenges Thaler on the likelihood that government, in practice, will improve matters. Along the way they discuss the design of Sweden's social security system, organ donations and whether professors at Cornell University are more or less like you and me....

Can taxes correct externalities? Greg Mankiw on Gasoline Taxes, Keynes and Macroeconomics. Podcast on EconTalk

Greg Mankiw of Harvard University and Greg Mankiw's Blog talks about the state of modern macroeconomics and Keynes vs. the Chicago School. He defends his proposal to raise gasoline taxes and discusses the politics of tax policy....

Public Schools, from the Concise Encyclopedia of Economics

By most accounts America's schools are not performing very well. The average combined (verbal and mathematics) score on the Scholastic Aptitude Test was seventy-five points higher in 1963 than it was in 1990. A high school senior ranked at the 50th percentile on the SAT in 1990 would have ranked around the 33rd percentile in 1963. American students trail most of their international counterparts in mathematics and science achievement. Recent comparisons of industrialized countries place the United States between tenth and fifteenth in these economically vital fields. And excellence is not all that is missing. Performance among schools is quite inconsistent. Blacks score nearly two hundred points below whites on the SAT. Urban high schools, which serve disproportionately large numbers of poor families, fail to graduate nearly half of their students; high schools nationwide graduate about four-fifths of theirs....

Electric Utility Regulation, from the Concise Encyclopedia of Economics

Two characteristics of electric power make utilities different from most other industries. First, both high-voltage transmission and low-voltage distribution are most economically performed by a single line or a single network of lines. Because a single high-capacity line minimizes both capital costs and losses to electrical resistance per unit of power carried, transmission and distribution are natural monopolies....

Social Security, from the Concise Encyclopedia of Economics

The Social Security system, including old-age and survivors insurance, disability insurance, and hospital insurance (Medicare), poses a staggering liability in the years ahead. Benefits in the year 2025, when the retirement of the baby-boom generation is in full swing, are projected to cost 23 percent of taxable payroll in the economy, up from 14 percent today....

A Little History: Primary Sources and References

What is a flat tax? What are the economic implications? Rabushka on the Flat Tax. Podcast on EconTalk

Alvin Rabushka of Stanford University's Hoover Institution lays out the case for the flat tax, a reform of the current system that would replace the 66,000 page U.S. tax code with a single rate and no deductions other than personal exemptions. An individual tax return would fit on a simple postcard. Rabushka discusses the economic changes that would come with such a reform and the adoption of the flat tax around the world since Rabushka and Robert Hall proposed the idea in 1981....

Credit, Bonds, Borrowing, and Lending, Interest, Bank Runs, Deposit Insurance

Credit, from Dictionary.com

Definition: credit:

• 5. confidence in a purchaser's ability and intention to pay, displayed by entrusting the buyer with goods or services without immediate payment.
• 6. reputation of solvency and probity, entitling a person to be trusted in buying or borrowing: Your credit is good....
• 8. time allowed for payment for goods or services obtained on trust: 90 days' credit....
• 10. a sum of money due to a person; anything valuable standing on the credit side of an account: He has an outstanding credit of $50....

Bonds, Borrowing, and Lending, on Econlib.

A bond is a promise to pay. It is a promise to pay something in the future in exchange for receiving something today.

Promises—that is, bonds—can be bought and sold. The buyer of a bond is a lender. The seller of a bond is a borrower. The bond buyers pay now in exchange for promises of future repayment—that is, they are lenders. The bond sellers receive money now and in exchange for their promises of future repayment—that is, they are borrowers.

Bonds can be traded privately between individuals or in organized markets, called bond markets or credit markets.

You may not realize it, but you buy and sell bonds all the time! Every time you lend someone a few dollars for lunch or borrow your friend's car in exchange for filling her tank, in economic terms you are buying and selling bonds. Simply remembering that bond buyers are lenders, bond sellers are borrowers, and that they are trading not pieces of paper but promises, can unlock the door to understanding both the vocabulary and the economics of a wide range of economic behavior, from private loans to interest rates to government budget deficits. It's much easier to understand borrowing and lending than abstract vocabulary like "the bond market"—even though they are the same thing—because we can by think about our own familiar experiences with borrowing and lending....

When you use your credit cards or buy on installment, you are a borrower. In each case, someone—a bank or business owner—lends you the money by directly paying for the goods up front on your behalf. The lender later sends you a bill, at which time you are responsible to pay the principal and any accumulated interest to the lender. In economic terms, every time you use your credit card, you sell a bond—your promise to repay the credit card company in the future.

When you deposit money in a bank, you are a lender! In economic terms, you buy the bank's bond— its commitment to repay you when you decide to use the money. The bank acts as an intermediary (a go-between) and pairs you with a borrower....

Here's another example. When you buy a Treasury Bill, you are lending to the government. The government sells its promises to pay in organized markets each week....

Classroom activity. To illustrate these concepts in the classroom, I've often held a bond auction in class!

Bonds, from the Concise Encyclopedia of Economics

Bond markets are important components of capital markets. Bonds are fixed-income financial assets--essentially IOUs that promise the holder a specified set of payments. The value of a bond, like the value of any other asset, is the present value of the income stream one expects to receive from holding the bond. This has several implications...

Interest, from the Concise Encyclopedia of Economics

Interest rates quoted by lenders usually include much more than "pure" interest. To persuade a lender to surrender current control of resources, the borrower will have to pay, in addition to interest, an amount that compensates the lender for any costs incurred in arranging the transaction, usually including some kind of insurance premium against the risk of default by the borrower. Someone without an established credit rating who applies for an unsecured loan will typically be required to pay "interest" at an annual rate that is several times the prevailing rate of pure interest....

Credit Union, at About.com

Definition: An organization that takes deposits and makes loans. Credit Unions are non-profit and run as a co-operative by the depositors of the union....

Bank Runs, from the Concise Encyclopedia of Economics

A run on a bank occurs when a large number of depositors, fearing that their bank will be unable to repay their deposits in full and on time, try to withdraw their funds immediately. This creates a problem because banks keep only a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets like government securities. When a run comes, a bank must quickly increase its liquidity to meet depositors' demands. It does so primarily by selling assets, frequently at fire-sale prices. Losses on these sales can make the bank insolvent....

Bankruptcy, from the Concise Encyclopedia of Economics

Bankruptcy is common in America today. Notwithstanding two decades of largely uninterrupted economic growth, the annual bankruptcy filing rate has quintupled, topping 1.5 million individuals annually. Recent years also have seen several of the largest and most expensive corporate bankruptcies in history. This confluence of skyrocketing personal bankruptcies in a period of prosperity, an increasingly expensive and dysfunctional Chapter 11 reorganization system, and the macroeconomic competitive pressures of globalization has spurred legislative efforts to reform the bankruptcy code....

Housing, from the Concise Encyclopedia of Economics

... Assuming a family can spend 30 percent of its income on a mortgage, even with low 5 percent interest rates a family must earn more than $135,000 per year to afford the median-priced new home. If the above estimates are correct, regulations such as urban growth boundaries, moratoriums on building permits, environmental regulations, and other restrictions raise home prices as much as $300,000 in this county. Put another way, the portion of purchase price paid by residents of Santa Clara County due to regulation is almost enough to buy three complete homes of median value elsewhere in the United States....

In the News and Examples

Todd Zywicki on Debt and Bankruptcy, podcast on EconTalk, March 2, 2009.

Todd Zywicki, of George Mason University Law School, talks with EconTalk host Russ Roberts about the evolving world of consumer debt and how institutions and public policy have influenced consumer access to debt and credit. Zywicki defends consumer credit as a crucial benefit to consumers and that innovation has made credit cheaper and more effective. He also talks about how misleading it can be to look at only one piece or another of credit picture. The conversation concludes with a discussion of the evolution of bankruptcy law in the United States....

A Little History: Primary Sources and References

Deposit Insurance, from the Concise Encyclopedia of Economics

Federal deposit insurance became law for commercial banks in 1933 as part of the Glass-Steagall Act, and for S&Ls in 1934. Although a number of state governments had provided deposit insurance before 1933, most state programs had failed and all had been disbanded by then. The federal program was enacted only after long debate.

The Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) were both established in 1934....

Savings and Loan Bailouts, at About.com

For a while, the system worked well. In the 1960s and 1970s, almost all Americans got S&L financing for buying their homes. Interest rates paid on deposits at S&Ls were kept low, but millions of Americans put their money in them because deposit insurance made them an extremely safe place to invest. Starting in the 1960s, however, general interest rate levels began rising with inflation. By the 1980s, many depositors started seeking higher returns by putting their savings into money market funds and other non-bank assets. This put banks and savings and loans in a dire financial squeeze, unable to attract new deposits to cover their large portfolios of long-term loans....

Market failure, Public Goods and Externalities, New Keynesian Economics

Definition: Market failure,

An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium....

Public goods and externalities. What is an externality? Public Goods and Externalities, from the Concise Encyclopedia of Economics

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods....

Externalities occur when one person's actions affect another person's well-being and the relevant costs and benefits are not reflected in market prices. A positive externality arises when my neighbors benefit from my cleaning up my yard. If I cannot charge them for these benefits, I will not clean the yard as often as they would like. (Note that the free-rider problem and positive externalities are two sides of the same coin.) A negative externality arises when one person's actions harm another. When polluting, factory owners may not consider the costs that pollution imposes on others....

What is a public good? Defense, from the Concise Encyclopedia of Economics

National defense is a public good. That means two things. First, consumption of the good by one person does not reduce the amount available for others to consume. Thus, all people in a nation must "consume" the same amount of national defense (the defense policy established by the government). Second, the benefits a person derives from a public good do not depend on how much that person contributes toward providing it. Everyone benefits, perhaps in differing amounts, from national defense, including those who do not pay taxes. Once the government organizes the resources for national defense, it necessarily defends all residents against foreign aggressors....

Market-clearing vs. sticky prices: New Keynesian Economics, from the Concise Encyclopedia of Economics

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust. New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices "clear" markets—balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with "sticky" wages and prices. New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity....

Markets can fail if there are no property rights and negotiation is costly. The Coase Theorem: Ronald H. Coase, biography from the Concise Encyclopedia of Economics

"The Problem of Social Cost," Coase's other widely cited article (661 citations between 1966 and 1980), was even more path-breaking. Indeed, it gave rise to the field called law and economics. Economists b.c. (Before Coase) of virtually all political persuasions had accepted British economist Arthur Pigou's idea that if, say, a cattle rancher's cows destroy his neighboring farmer's crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them.

But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer's crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher's net returns on these cattle. If for example, the rancher's net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars' worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck....

In the News and Examples

Pollution Controls, from the Concise Encyclopedia of Economics

While there is general agreement that we must control pollution of our air, water, and land, various interest groups, public agencies, and experts have disputed just how we should control it. The pollution control mechanisms adopted in the United States have tended toward detailed regulation of technology....

A Little History: Primary Sources and References

John Maynard Keynes, biography from the Concise Encyclopedia of Economics

Advanced Resources

An Education in Market Failure, by Morgan Rose. Teacher's Corner at Econlib

Markets are fantastic at allocating resources well by making sure that if there is a good or a service that a person values more highly than it would cost to produce it, then somebody (maybe the same person, but most likely not) will decide to produce it, a market exchange will take place, and both parties will be better off. If I think an order of chicken wings is worth more than six dollars....

Markets can be problematic where the net private benefit of a market transaction does not equal the net social benefit, which is the social benefit (the sum of private benefits of all individuals in a society) minus the social cost (the sum of private costs of all individuals in a society)....

Balance of Payments, Imports, Exports, Mercantilism, Mercantile System, Foreign Trade, or The Wedding Gown

Definitions and Basics

Balance of Payments, from the Concise Encyclopedia of Economics

The balance of payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. If all transactions are included, the payments and receipts of each country are, and must be, equal. Any apparent inequality simply leaves one country acquiring assets in the others. For example, if Americans buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding dollars, which they may hold in the form of bank deposits in the United States or in some other U.S. investment. The payments of Americans to Japan for automobiles are balanced by the payments of Japanese to U.S. individuals and institutions, including banks, for the acquisition of dollar assets. Put another way, Japan sold the United States automobiles, and the United States sold Japan dollars or dollar-denominated assets such as Treasury bills and New York office buildings....

Although the totals of payments and receipts are necessarily equal, there will be inequalities—excesses of payments or receipts, called deficits or surpluses—in particular kinds of transactions. Thus, there can be a deficit or surplus in any of the following: merchandise trade (goods), services trade, foreign investment income, unilateral transfers (foreign aid), private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactions.

Imports, from AmosWEB's Economics Gloss*arama.

IMPORTS: Goods and services produced by the foreign sector and purchased by the domestic economy. In other words, imports are goods purchased from other countries. The United States, for example, buys a lot of the stuff produced within the boundaries of other countries, including bananas, coffee, cars, chocolate, computers, and, well, a lot of other products. Imports, together with exports, are the essence of foreign trade--goods and services that are traded among the citizens of different nations. Imports and exports are frequently combined into a single term, net exports (exports minus imports)....

Exports, from AmosWEB's Economics Gloss*arama.

EXPORTS: The sale of goods to a foreign country. The United States, for example, sells a lot of the stuff produced within our boundaries to other countries, including wheat, beef, cars, furniture, and, well, almost every variety of product you care to name. In general, domestic producers (and their workers) are elated with the prospect of selling their goods to foreign countries--leading to more buyers, a higher price, and more profit. The higher price, however, is bad for domestic consumers. In that domestic consumers tend to have far less political clout than producers, very few criticisms of exports can be heard....

Balance of Trade, from AmosWEB's Economics Gloss*arama.

BALANCE OF TRADE: The difference between the value of goods and services exported out of a country and the value of goods and services imported into the country. The balance of trade is the official term for net exports that makes up the balance of payments. The balance of trade can be a "favorable" surplus (exports exceed imports) or an "unfavorable" deficit (imports exceed exports). The official balance of trade is separated into the balance of merchandise trade for tangible goods and the balance of services....

A balance of trade surplus is most favorable to domestic producers responsible for the exports. However, this is also likely to be unfavorable to domestic consumers of the exports who pay higher prices.

Alternatively, a balance of trade deficit is most unfavorable to domestic producers in competition with the imports, but it can also be favorable to domestic consumers of the exports who pay lower prices....

In the News and Examples

Popular myth: Aren't imports bad? Aren't exports good? Isn't a trade deficit a bad thing? The very word "deficit" sounds bad! Economic reality: An excess of imports over exports merely sends dollar bills overseas while bringing real goods and services into the country for immediate use. If foreigners want to hold onto those dollars, while we get to put their goods to immediate use benefiting our consumers and creating new investment for our industries, then we get an even better deal! Prohibiting trade severely limits what you can accomplish.

• Don Boudreaux on the Economics of "Buy Local". Podcast at EconTalk, April 16, 2007.

Proponents of buying local argue that it is better to buy from the local hardware store owner and nearby farmer than from the Big Box chain store or the grocery store headquartered out of town because the money from the purchase is more likely to "stay in the local economy." Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about the economics of this idea. Is it better to buy local than from a seller based out of town? Is it better to buy American than to buy foreign products? Does the money matter? In this conversation, Boudreaux and Roberts pierce through the veil of money to expose what trade, whether local, national, or international, really accomplishes.

• The Buy-Locally-Owned Fallacy, by Karen Selick. November 3, 2008.

An advertisement appears regularly in the newspaper in my community (Belleville, Ontario, Canada) sponsored by a group of local businesses. It reads: "Buy locally owned. Your money stays in the community. Think about it—everybody wins."

• The 100-Mile Suit. Buy-local example. From Wired, March 31, 2007:

Last year, educator and costume designer Kelly Cobb asked her students at Drexel University to trace the provenance of their clothes. When the task proved impossible, she realized how far removed we are from what we wear.

It was then that Cobb came up with the idea of creating a suit of clothes made entirely from materials prepared within a 100-mile radius of her home.

• Don Boudreaux on Globalization and Trade Deficits. Podcast at EconTalk, January 21, 2008.

Don Boudreaux, of George Mason University, talks about the ideas in his book, Globalization. He discusses comparative advantage, the winners and losers from trade, trade deficits, and inequality with EconTalk host Russ Roberts.

• The Balance of Trade, by Frédéric Bastiat. Chapter 6 in Economic Sophisms, first published 1845 in France.

There is still a further conclusion to be drawn from all this, namely, that, according to the theory of the balance of trade, France has a quite simple means of doubling her capital at any moment. It suffices merely to pass its products through the customhouse, and then throw them into the sea. In that case the exports will equal the amount of her capital; imports will be nonexistent and even impossible, and we shall gain all that the ocean has swallowed up.

"You're just joking," the protectionists will say. "We couldn't possibly have been saying anything so absurd." Indeed you have, and, what is more, you are acting upon these absurd ideas and imposing them on your fellow citizens, at least as far as you can.

The truth is that we should reverse the principle of the balance of trade and calculate the national profit from foreign trade in terms of the excess of imports over exports. This excess, minus expenses, constitutes the real profit....

• Why not just buy American? Foreign Trade, or The Wedding Gown, by Jane Haldimand Marcet in John Hopkins's Notions on Political Economy. 1831.

One evening, when John returned from his work, he found his daughter Patty showing off a new silk gown to her mother. It was a present which her lover had just given her, for the approaching wedding day. Patty's eyes, which had seldom beheld any thing so beautiful, shone with delight, as her mother admired it; and her father gave her a hearty kiss, and said she would be as smart a bride as had ever been married in the village. "Ay, and it is a French silk, too, mother," exclaimed Patty.—"Why, as for that," replied her mother, "I don't see the more merit in its being French; and I did not think, Patty, you were such a silly girl as to have all that nonsense in your head. No, indeed, it is bad enough for the great lady—folks to make such a fuss about French finery, so that they can't wear a bit of honest English riband. I don't like your gown a bit the better for being French. No; and I should have thought that your husband, that is to be, might have given you an English silk instead."...

A Little History: Primary Sources and References

Mercantilism, from the Concise Encyclopedia of Economics

Mercantilism is economic nationalism for the purpose of building a wealthy and powerful state. Adam Smith coined the term "mercantile system" to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. This system dominated western European economic thought and policies from the sixteenth to the late eighteenth century. The goal of these policies was, supposedly, to achieve a "favorable" balance of trade that would bring gold and silver into the country. In contrast to the agricultural system of the physiocrats, or the laissez-faire of the nineteenth and early twentieth centuries, the mercantile system served the interests of merchants and producers such as the British East India Company, whose activities were protected or encouraged by the state....

Exports and Imports, from Lalor's Cyclopedia of Political Science

By imports is meant all the merchandise brought into a country from other countries; by exports, all the merchandise which leaves a country for other countries....

Balance of Trade, from Lalor's Cyclopedia of Political Science

Balance of Trade, in commerce, the term commonly used to express the difference between the value of the exports from, and imports into a country: the balance used to be said to be favorable when the value of the exports exceeded that of the imports, and unfavorable when the value of the imports exceeded that of the exports. And in many countries this was long believed to be the case, and to a late period they were annually congratulated by their finance ministers on the excess of exports over the imports....

Mercantile System, from Lalor's Cyclopedia of Political Science

The theory of the balance of trade and the consequences which were drawn therefrom constitute what is called the mercantile system, because the whole of this system tends to consider foreign commerce as the most productive branch of a nation's labor. It is supposed that a nation can sell more than it buys, in a way to ruin neighboring nations by absorbing their precious metals by the greatest possible exportation and the least possible importation. This false theory still prevails in the minds of the masses, and still serves as a rule for many administrations and governments; it forms the basis of the economic ideas of all the writers of the eighteenth century, who did not belong to the physiocratic school or to that of Adam Smith; it is still appealed to in our days by statesmen, and by all those who, by conviction or for financial considerations, defend prohibition, high tariffs and custom impediments....

Assumption of full employment

Loan able fund theory is based on the unrealistic assumption of full employment but the Keynesian theory of interest is applicable both even in full employment and in less than fall employment conditions.

Profit

            There are four factors of production. They are Land, labor, Capital and organization, which is also called entrepreneur.

            According to the pricing theory of factors of production or theory of distribution, all the factors of production are paid according to their contribution on the total national product or equal to their marginal productivity. In this regard, rent, wages & interest respectively are paid as the reward to the factors of production Land, Labor & capital. Alike mentioned factors of production, entrepreneur also gets remuneration which is termed as profit. Hence, profit is the reward of entrepreneur.

            Entrepreneur is the active factor of production. An entrepreneur collects the factors of production Land, Labor & capital in one place and uses them skillfully in the process of production. In this regard, entrepreneur has to perform entrepreneurial functions such as organizing & co-coordinating the other factors. So some economists argue that entrepreneur earns profit for his performing this function.

            A part of the confusion in the theory of profit is due to the lack of agreement among economists about the true or proper function of the entrepreneur.

            Some economists have described the use preneur as performing joint and, in separation functions of final risk bearing and final decision-making.

            Alfred Marshall gave the first systematic explanation of the nature of profit in terms of demand and supply of entrepreneurs.

            Walker looked upon profit as the reward of the entrepreneur with a superior ability than others. Hawley ascribed it to the entrepreneur's risk- taking, the greater the risk undertaken, and the larger the profit according to him.

            Mrs. Joan Robinson, Prof. Chamber line and Mr. Kalecki have associated profits with the imperfect competition and monopoly. Monopoly profits arise became a monopolist is able to restrict output and keep the price of his product much above the average cost of production.

            Though these are various views of economists on the meaning of profit. Profit is defined as the residual income rescind after paying all the expenses in curved in the process of production. Profits can be divided into two parts cross profit Net profit.

Dynamic theory of profit

            An American economist J.B. Clark propounded the dynamic theory of profit in 1900. According to him, profit is the difference between the selling price and the cost of production of good Commodity. But profit is the result of dynamic changes, which mean change in the condition of demand and supply. Now, in competitive long run equilibrium, as the price equals to the average cost of production, an entrepreneur cannot earn pure profit. In this condition, a normal profit is included in the cost of production. But this normal profit is called a wage received as a reward for supervision and management of an entrepreneur by Clark.

            To know the state of dynamic changes Clark has divided the whole economy into two parts. (i) Static economy (ii) Dynamic economy.

(i)   Static economy

            This is the stationary state of economy where no changes in the condition of demand & supply are made. So, all the factors affecting demand and supply are assumed to be constant in such a economy. There is no uncertainty & risk at all in these types of economy. As all the factors are constant, all the firms including industry are constant in such a situation. Hence, the cost of production of good is equal to the price. This creates no profits to the entrepreneur in static economy. According to Prof. Clark, the entrepreneur gets only wages for his labor and interest on his capital in such a static economy.

            But due to same reasons, if price is more than the cost of production, then the entrepreneur may earn profit, which will be only frictional profit and a kind of short-term phenomenon. But after some time, due to perfect competition in the economy, this profit will be disappeared.

(ii)  Dynamic economy

            The world is changing day by day. So the static economy is only an imaginary concept. So, there is change in the factors affecting demand for and supply of goods. Due to these changes, the state of equilibrium also after in the economy in this condition, if entrepreneur can make the situation favorable he gets profit. According to Clark, there are five kinds of changes which creates profits 

THE INVESTMENT FUNCTION

THE INVESTMENT FUNCTION

Meaning of Investment

            In Ordinary sense, investment means to buy shares, stocks, bonds and securities which are already existing in stock market. But, this is not real investment because it is simply a transfer of existing assets. Hence, this is called financial investment which does not affect aggregate spending. In Keynesian terminology, investment refers to real investment which adds to capital equipment increasing the production and purchase of capital goods. Thus, investment includes new plant and equipment, construction public works like dams, roads, buildings, etc. net foreign investment, inventories, and stocks and shares of new companies. In the words of Joan Robinson, "By investment is meant an addition to capital, such as occurs when a new house is built. Investment means making or a new factory is built. Investment means making an addition to the stock of goods in existence."

            Keynes again states that real investment means purchase of equities, bonds or securities of the companies to be newly set up. It means "addition to the existing stock of real capital assets". The essential condition is that investment should result in the construction of new capital assets, necessitating the employment of more labour and raw material.

            Investment function is related to private or induced investment. It implies inducement to invest or investment demand. For classical economists, investment demand was simply a decreasing function of rate of interest. I.e.,

               I = f (i)

Where,    i =rate of interest

and         I = investment

               It can be shown in figure below;

            In this figure, I_d I_d is investment demand curve. Rate of interest is measured along on OY-axis and investment on OX-axis. I_d I_d curve shows that there is inverse relationship between rate of interest and investment. Thus, investment is the function of rate of interest.

            According to Keynes, the volume of private investment depends upon two factors;

(i)   The marginal efficiency of capital (MEC) and

(ii) The rate of interest (i)

Thus,      I = f (r,i)

Where,    r = MEC

   However, in the modern theory, the investment is assumed to be the function of level of income. Other things remaining the same investment is the direct function of level of income. I.e.,

               I= f (Y)

Where,    Y= Level of income.

            As income increases, the investments will also increases and vice-versa. This modern investment function is shown in the following diagram.

            In the given figure, at Y₁ level of income, investment is I₁. When the level of income increases from Y₁ to y₂, investment increases from I₁ to I₂. It means that investment varies positively with the level of income. Thus, investment is the function of income.

Saving - Paradox of Thrift (Saving is a vice not virtue)

Paradox of Thrift (Saving is a vice not virtue)

            The classical economists considered saving to be a great virtue. They encouraged hard-work, maximum earning and minimum spending on consumption. They advised people to accumulate for future by maximizing earning and minimizing expenditure on consumption. Thinking aggregate savings as simply and aggregation of savings by individual members of the Community, they come to the conclusion that thriftiness improves the future of society. They also recognized that domestic saving was the major source of capital formation which is very necessary for economic progress.

            However, Keynes pointed out that when we consider the community as a whole, we can no longer assume that when community reduces its consumption, its income remains unchanged. The volume of saving defends upon the level of national income and the saving of the community can increase only when the total income of the community increases. Since expenditure of one person constitutes the income of another person, increase in savings of some individuals will lead to a decline in the incomes and hence expenditures of certain other individuals. Further, a decrease in demand for consumption goods in the economy will decrease the demand for capital goods. The decline in demand for consumption goods as well as for capital goods would lead to a decline in their prices and hence in profits. Declining Profits would discourage investment and thus result in a decline in income, output and employment. In short, a general reduction in consumption would cause a general defficiency of effective demand, leading to a lower level of equilibrium with considerable unemployment. Thus, though saving is a virtue for an individual, it is harmful for the society as a whole. Thus, 'saving is a vice but not virtue.

            So, saving decreases effective demand in the economy resulting a decrease in the price and profit. As a result, investors will be discouraged to invest. This will further decrease the employment, production and income which in turn decreases the saving. This will convert the saving into social evil. So, in the beginning saving is a virtue to the individual but to the society and the nation it will be harmful. Therefore, saving turns into misfortune. This is known as paradox of thrift.

            The paradox of thrift can be illustrated graphically as follows:

            Above given diagram is showing "paradox of thrift". In this diagram, income is along on OX-axis and saving and investment along on OY-axis. SS and II curve are the original saving and investment curves respectively. They intersect each other at point E and give us the equilibrium level of income OY at which savings are equal to investment. Now suppose savings in the community increase shifting the SS curve upwards to S₁S₁ which intersects the old II curve at E₁. This lead to a decline in income from OY to OY₁. The decrease in income from OY to OY₁, results in a reduction in the volume of savings from YE to Y₁E₁. Thus, the community's efforts to save more have actually led to a decrease in income as well as savings. If the community attempts to further increase savings which shifts the saving curve to S₂S₂, then the equilibrium level of income will decline so much that savings as well as investment would become negative. This explains the paradox that attempts to increase aggregate savings would actually lead to a decrease in savings. Therefore, 'saving is vice not virtue'.

saving - Income consumption and saving

Concept of Saving

            From an individual's point of view saving is that part of his income which is not spent on consumption. Similarly, from the community's point of view aggregate saving is that part of national income which is not spent on consumption. In other words, saving is excess of income over consumption expenditure, i.e., S=Y-C, where, S=saving, Y=income and C=consumption expenditure. In Keynes' general theory, current savings depend upon current income but Robertson believes that current savings are more a function of past income. According to Robertson, saving is that part of income received in the immediately proceeding period which is not spent on current consumption. According to J.M. Keynes- "Saving is the excess of income over consumption expenditure or the difference between income and expenditure on consumption". He has made current savings is to depend upon current income. That is, saving is that part of the income which is left after consumption. Hence, there is functional relationship between saving and income. Thus, saving function can be written as:

S= f(Y)

Where, S= Savings

Y= Income

            There is positive relationship between saving and income. This means higher the income, higher will be the saving and vice-versa. Saving is different from hoarding. Hoarding is a part of savings which is held as stock of money. It constitutes a leakage in the income stream. Concept of saving can be explained by the help of table and figure below: 

Schedule of Income consumption and saving

Income (Rs.) (Y)	Consumption (Rs.) (C)	Savings (Rs.) (S) = Y-C
O	0	-50
50	75	-25
100	100	0
150	125	25
200	150	50

    Above given schedule shows that people spend on consumption without any income. After increase in income, people start to save some amount of income for further purposes. So, there is direct relationship between income and saving. The saving function can also be shown in figure below:

            From above given figure, saving curve 'SS' shows that saving tends to increase when the income increases. Likewise, it also shows that saving is negative and zero at low level of income. So, saving curve starts downward from X-axis.

            There are various forms of saving, such as average propensity to save (APS) and marginal propensity to save (MPS) which are explained below:

(i)   Average propensity to save (APS):

            The ratio of saving and income is known as average propensity to save. APS is the counterpart of the average propensity to consume (APC). It can be expressed as;

APS = =

or, APS = 1-APC [^..^. APC + APS = 1]

(ii) Marginal propensity to save (MPS):

            Marginal propensity to save is the ratio between the change in saving and change in income. In other words, MPS is the change in saving as a result of change in income. It can be expressed as;

MPS =

Where, DS = Change in saving

 DS = Change in income

or,  MPS= 1- MPC [\MPS+MPC=1]

            It shows the relationship between MPC and MPS. As MPC increases MPS declines and vice-versa, i.e., higher the MPC implies lower the MPS.

Determinants of Saving

            Saving is an important function of individual and business organization. Everybody likes to save some parts of their income in the view of solving the possible problems that may occur in the future. But main determinant of saving is the level of income. Therefore, the higher the level of income, the higher is the possibility of saving. So, part of the income left over after the consumption expenditure of people is known as saving. The factors, which influence the amount and ratio of saving is called determinant of saving. The factors determining saving can be explained as follows:

(1) Income Level:

            Saving of every individual and business organization depends upon the level of income. Higher the level of income, higher will be the saving. This is because of marginal propensity to consume (MPC) of rich people with high income will be low while the marginal propensity to consume of poor people with low income will be high. Hence, possibility of saving increases as income increase of the people. So, saving is impossible without adequate level of income.

(2) Rate of Interest:

            Rate of interest is also an important determinant of saving. In general, there is positive relationship between saving and rate of interest, i.e., higher the rate of interest results the higher level of saving and vice-versa. Keynes stated the concept that low rate of interest will increase the propensity to consume. This is because people are encouraged to save in order to obtain a high rate while they are discouraged to save with low rate of interest.

(3) Price level:

            The price level of the goods in the market also influences the saving. The consumers may react to any rise or fall in the price level by spending either more or less of their income for goods and services. If the price level is high, less is left for saving. But, if the market price level is low, the consumers can get goods cheaper and increase the saving. Hence, we can say that the condition of inflation is not favorable for saving. 

(4) Fiscal Policy:

            The fiscal policy undertaken by the government also affects the saving. If the government increases the tax rate, then propensity to save will decrease. But on the other hand if tax rate is decreased, then the propensity to save of the people will increase.

            Fiscal policy adopted by government are of two types, i.e., expansionary and contractionary fiscal policy. Expansionary fiscal policy helps to rise saving where government reduced tax and increase government expenditure. Conversely, contractionary fiscal policy reduces the ratio of saving where government imposes high tax system and reduces the government expenditure.

(5) Distribution of Income:

            Distribution of income and wealth is also important determinants of saving. If distribution of national income and wealth is equal in the society, then the average propensity to consume will be high. But, if distribution of income and wealth is unequal, then average propensity to consume will be low because more part of income will be in the hands of a few people. In such a situation, their average and marginal propensity to consume will be very low.

(6) Social security:

            Social security system is also one of the main factors that determines the saving. The rate of saving will be very low in the country where various social security system are fully developed like pension to the retired government personnel, old-age allowance, handicapped and disabled allowance, unemployment allowance, widow allowance, medical insurance, etc. When social and economic security systems are appropriately available, then people will not  be worried about their future and try to enjoy with higher level of consumption,  which reduces saving. But on the other hand, if the government does not provide any kind of social securities in the own securities. For this, they will start saving and this will increase the propensity to save.

(7) Demonstration Effect:

            Demonstration effect is also one of the most important determinants of saving. The more the people get attracted to various advertisements and expensive foreign consumption goods, the more will be the consumption of such goods. This will result in the decrease in saving. On the other hand, if people of a country are not influenced by the demonstration effect, then the saving will be more.

            Betides these, the determinants of saving are; the development of banking and financial institutions, government policy of saving, economic structure, peoples desire in improving the living standard, etc.