Source: lecture of Brad DeLong

1. Source: lecture of Brad DeLong

3. Inclusive Institutions Defined • INCLUSIVE INSTITUTIONS (p. 74): “Inclusive economic institutions…are those that allow and encourage participation by the great mass of people in economic activities that make best use of their talents and skills and that enable individuals to make the choices they wish.

4. More on Inclusive Institutions • (p. 75): Inclusive economic institutions foster economic activity, productivity growth, and economic prosperity. Secure private property rights are central, since only those with such rights will be willing to invest and increase productivity. A businessman who expects his output to be stolen, expropriated, or entirely taxed away will have little incentive to work, let alone any incentive to undertake investments and innovations. But such rights must exist for the majority of people in society. • (p. 76): Inclusive economic institutions create inclusive markets, which not only give people freedom to pursue the vocations in life that best suit their talents but also provide a level playing field that gives them the opportunity to do so. Those who have good ideas will be able to start businesses, workers will tend to go to activities where their productivity is greater, and less efficient firms can be replaced by more efficient ones. • SO WHY DO INSTITUTIONS MATTER?

5. Extractive Institutions Defined • EXTRACTIVE INSTITUTIONS (p. 76): “We call such institutions, which have opposite properties to those we call inclusive, extractive economic institutions—extractive because such institutions are designed to extract incomes and wealth from one subset of society to benefit a different subset.”

6. The Output Recipe • Think of national output like a cake recipe. • What are the ingredients? • Land • Labor • Capital (i.e. machinery, buildings, etc…)

7. Land and Diminishing Returns • Typically land cannot be increased (except for warfare, where you take land from your neighbors). • So land is the limiting factor! • This means that the “Law of Diminishing Returns” is important. • Adding more workers – holding all else constant (all else includes land) – will eventually result in the productivity of each additional worker to decline.

8. Can a nation grow by just adding more labor and capital? • Nations can grow temporarily by adding more labor and/or more capital. • The Law of Diminishing Returns, though, tells us that changing the quantity of labor and capital can only work temporarily.

9. How can nations grow persistently? • If quantity changes are temporary, how can a nation’s economy grow persistently? • The key is changing the QUALITY of a nation’s labor and capital. • And that means the nation must create and adopt better technology.

10. Creative Destructionor why is new technology resisted • As noted in “Why Nations Fail”… • New technology replaces past technology (i.e. creating new ideas destroys past ideas). • Therefore, the process of “create destruction” tells us that people who benefit from existing technology will see new technology as a threat. • If the people who benefit from existing technology are making decisions for society, that society will not tend to adopt new technology. • And therefore, that society will not see economic growth.

11. The Importance of Inclusive Institutions • Just to review… • economies can only grow persistently if new technologies are adopted • leaders in a society dominated by extractive institutions will see new technology as a potential threat • Therefore… only societies that adopt inclusive institutions will see persistent economic growth.

12. Why Extractive Institutions Don’t Lead to Growth • Why Nations Fail (p.430) • What is crucial, however, is that growth under extractive institutions will not be sustained, for two key reasons. • First, sustained economic growth requires innovation, and innovation cannot be decoupled from creative destruction, which replaces the old with the new in the economic realm and also destabilizes established power relations in politics. Because elites dominating extractive institutions fear creative destruction, they will resist it, and any growth that germinates under extractive institutions will be ultimately short lived. • Second, the ability of those who dominate extractive institutions to benefit greatly at the expense of the rest of society implies that political power under extractive institutions is highly coveted, making many groups and individuals fight to obtain it. As a consequence, there will be powerful forces pushing societies under extractive institutions toward political instability.

13. Political Monopoly? • KEY IDEA: If one group has a political monopoly, then a society will not likely embrace technological change. In other words, there has to be a possibility that everyone in society can enjoy a leadership position.

14. Extractive Economic Systems • Feudalism - an economic system in which traditions rule. • Mercantilism - an economic system in which the government determines the allocation of resources by assigning the rights to certain economic activities. • Socialism (according to Marx) - an economic system where the incentive system of capitalism remains in place, but the workers own the means of production. • Socialism (as it is practiced) - an economic system where the four economic questions are primarily addressed by government actions, not unregulated market forces.

15. Inclusive Economic Systems • Capitalism -an economic system based upon private property and the market in which, in principle, individuals answer the basic questions of the economic system. • Mixed Capitalism - an economic system characterized by largely private ownership of the factors of production, market allocation of resources, and decentralized decision making. Most economic activities take place in the private sector in this system, but government plays a substantial economic and regulatory role.

16. Economic Institutions in a Market Economy GOODS MARKET INTERNATIONAL CONNECTION INTERNATIONAL CONNECTION BUSINESS HOUSEHOLDS GOVERNMENT (Consumption) (Production) FACTORMARKET

17. Households • Households supply the labor with which businesses produce and government governs • The largest source of household income is wages and salaries

18. Business • Businesses are private producing units in our society • Businesses in the U.S. decide what to produce, how much to produce, and for whom to produce it • Businesses produce what they believe will sell and make a profit • The desire to make a profit leads businesses to produce – in general – the goods that make society better off. • Although businesses decide what to produce, they are guided by consumer sovereignty

19. Conventional Wisdom and Consumer Sovereignty • Conventional wisdom (orthodox theory) focuses on scarcity and posits the idea of consumer sovereignty. These concepts lie at the heart of demand theory. • John Kenneth Galbraith argued that the issue of scarcity has been solved. He laments the obsession society places on growth and ever expanding output. • Business now busies itself convincing people to buy goods that are sold as necessities to this generation, yet were luxuries or non-existent to past generations. • “One cannot defend production as satisfying wants if that production creates wants” • Galbraith notes that because public goods – like national parks and roads -- are not advertised, these goods are under produced at the determinant of society.

20. Forms of Business • Sole proprietorships – businesses that have only one owner • Partnerships – businesses with two or more owners • Corporations – businesses that are treated as a person, and are legally owned by their stockholders, who are not liable for the actions of the corporate “person” Flexible-purpose Corporations, Benefit Corporations (B-corporations), L3C

21. Business: Forms of Business

22. Business: Forms of Business

23. Business: Forms of Business

24. Basic government stats • The United States has a federal government system, which means we have various levels of government (federal, state, and local) each with its own powers • Together all levels of government consume about 20% of the country’s total output and employ about 22 million individuals • The state and local levels of government employ over 19 million people and spend about $2.1 trillion a year

25. Federal Government Employment

26. Recent changes in all Government employment

27. Government: Income of State and Local Governments Intergovernmental 26%

28. Government: Expenditures of State and Local Governments

29. Government: Income of the Federal Government

30. Progressive – as income rises, the percentage you pay increases. (i.e. an income tax) Regressive – as income rises, the percentage you pay decreases (i.e. a sales tax) Proportional – as income rises, the percentage you pay stays the same (i.e. a flat tax) Types of taxes

31. http://www.ustreas.gov/education/fact-sheets/taxes/ustax.shtmlhttp://www.ustreas.gov/education/fact-sheets/taxes/ustax.shtml The income tax was instituted in 1913 The social security tax was instituted in 1935 Taxes of the Federal Government

32. Effective tax rates from 1979 to 2007 • http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=456 • Marginal tax rates from 1913 to 2011 • http://www.taxfoundation.org/publications/show/151.html • In recent years taxes in the United States have declined. Recent tax history

33. The U.S. is a relatively low tax nationConsequently… debt is also used to finance the government We will discuss the National Debt later in the course

34. Government: Expenditures of the Federal Government

35. Federal government spending

36. Growth in spending under different presidents

37. Growth in spending under different presidents

38. Why can’t we rely on markets to provide retirement insurance and health insurance for the old? • For the former, individuals do not do well with the “retirement decision”, since it doesn’t have a good feedback mechanism. • For the latter, who would sell insurance to someone who is almost guaranteed to use it? • Prior to these programs being enacted (Social Security came into existence in the 1935 and Medicare in 1965) senior citizens were the poorest people in the nation. That is no longer true today. Social Security and Medicare

39. from Land of Promise: An Economic History of the United States (Michael Lind)  ”On November 8, 1954, in a letter to his brother Edgar, President Dwight Eisenhower reacted angrily to the criticism that his administration was continuing the policies of his immediate predecessors Franklin Roosevelt and Harry Truman: “Now it is true that I believe this country is following a dangerous trend when it permits too great a degree of centralization of governmental functions. I oppose this—in some instances the fight is a rather desperate one. But to attain any success it is quite clear that the Federal government cannot avoid or escape responsibilities which the mass of the people firmly believe should be undertaken by it. . . . Should any political party attempt to abolish social security, unemployment insurance, and eliminate labor laws and farm programs, you would not hear of that party again in our political history. There is a tiny splinter group, of course, that believes you can do these things. Among them are H. L. Hunt (you possibly know his background), a few other Texas oil millionaires, and an occasional politician or business man from other areas. Their number is negligible and they are stupid.” Eisenhower (republican president from 1953 to 1961) on the new deal

40. "In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists, and will persist." eisenhower and the military industrial complex (1961)

41. Military spending around the worldhttp://www.sipri.org/research/armaments/milex/factsheet2010

42. More on US Military Spending

43. Six Roles of a Government in a Market In its role as both an actor and a referee, government plays a variety of specific roles in the economy • These roles include: • Providing a stable set of institutions and rules • Promoting effective and workable competition • Correcting for externalities • Ensuring economic stability and growth • Providing public goods • Adjusting for undesirable market results

44. Thomas HobbesLeviathan (1651) • "Whatsoever therefore is consequent to a time of Warre, where every man is Enemy to every man; the same is consequent to the time, wherein men live without other security, than what their own strength, and their own invention shall furnish them withall. In such condition, there is no place for Industry; because the fruit thereof is uncertain; and consequently no Culture of the Earth; no Navigation, nor use of the commodities that may be imported by Sea; no commodious Building; no Instruments of moving, and removing such things as require much force; no Knowledge of the face of the Earth; no account of Time; no Arts; no Letters; no Society; and which is worst of all, continuall feare, and danger of violent death; And the life of man, solitary, poore, nasty, brutish, and short."

45. Provide a Stable Set of Institutions and Rules • As Hobbes notes, without government establishing order very little good can happen • Government can create a stable environment and enforce contracts through its legal system. • Economic growth is difficult when government does not provide a stable environment.

46. Promote Effective and Workable Competition • Government promotes competition and protect against monopolies. • Monopoly poweris the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business • Monopoly power can also be defined in terms of price setting ability. • Adam Smith – in the Wealth of Nations – was very concerned about the problem of monopoly (which was quite prevalent in the 18th century).

47. Correct for Externalities • An externality is the effect of a decision on a third party not taken into account by the decision maker. • Unless they are required to do so, parties to any exchange are unlikely to take into account any externality. • Pollution is a negative externality. Education is a positive externality. • Market produce too much of negative externalities and not enough of positive externalities.

48. Ensure Economic Stability and Growth • Most Americans look to the government to deal with macroeconomic externalities. • Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, and growth in the economy as a whole. • Since 1945 the federal government has taken action to offset recessions (and these actions have generally been successful).

49. Provide for Public Goods • Government steps in to provide public goods and requires that everyone pays for them, thereby reducing the free rider problem. • The military is a good example of the free rider program. The military protects everyone in society. If we were not required to pay taxes for the military, a person would be tempted to not pay knowing the other members in society had paid. After all, the military will defend everyone, not just those who paid taxes.

50. Adjust for Undesired Market Results • A controversial role for government is to make markets fairer. • Determining what is fair is a difficult philosophical question. • Demerit goods or activities are things government believes are bad for you, although you may like them. • Merit goods and activities are things the government believes are good for you, although you may not like them.