Great Questions of Economics
Arnold Kling
Applying Introductory Economics Every Day


Updated June 30, 2002

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If I had to recommend one piece to read as background, it might be this talk by Brad DeLong. The talk is on the issues that pertain to the so-called "new economy" that stems from the information revolution. In the talk, DeLong speaks to several of the Great Questions. He does not use equations or diagrams. People who enjoy this site will enjoy DeLong's talk, and I hope vice-versa.

As an initial effort to flesh out the background to the Great Questions, I am providing links to essays that I have written on the topics. I do not mean to suggest that my own writings are original or definitive. On the contrary, eventually I expect to replace most, if not all, of the material listed below with material that more robustly represents mainstream economic thinking.

  1. How did we get to be so rich, and what can we do about poverty?

    The mainstream economic position on this question is something that I call The Growth Doctrine. It states that cumulative economic growth, fueled by capital investment and the application of technology, is the overriding factor.

    Affluence as we know it is a very recent phenomenon. In Ideological Anachronisms, I wrote

    At the time that Marx wrote, his theories resonated rather well. The squalor of the working class was extreme. DeLong's calculations show that output per capita had only reached $300 per year by 1850. Ordinary people worked long hours, lived in crowded, unhealthy slums, and could scarcely be considered better off than their ancestors who preceded them by thousands of years.

    Today, however, economic progress has reached more than just the upper elite. In fact, the median worker today has a higher standard of living than that of the richest capitalist 100 years ago.

    I took another swipe at class warfare in Information Haves and Have-nots.

    The term "information have-not" is meant to suggest that there is some deficiency of physical capital that needs to be made up to remedy the situation. But what is the deficiency? Is it having a modem that only connects at 14.4 baud? Is it having a 386 processor when Pentium is state of the art? Would our family qualify for assistance because we do not subscribe to cable television?

    Traditional growth theory viewed saving and investment as the keys to growth. In Saving or Innovation? I wrote that

    If the traditional model of Calvinist thrift worked perfectly, then most of the millionaires would be farther away from us than next door. On average, consumers in Japan save a much higher share of income than their American counterparts...

    One way in which the cost of innovation may have declined is that less commitment of physical capital is required to implement an innovation. It requires far less capital to design and distribute a new software program than a new automobile.

    The "new growth theory" focuses more on the accumulation and application of knowledge than on the accumulation of capital. In A Meditation on Innovation, I talked about resistance to change as an impediment to growth.

    Innovation appears to be the key to growth. In the world economy, people and systems that accomodate change tend to win out.

    In From Allocating Capital to Allocating Talent, I wrote that

    In today's economy, capital may no longer be the primary scarce resource to be allocated. What has supplanted it?

    To me, it is easier to understand the economic challenge today as one of allocating talent to solving problems. Furthermore, when we consider the nature of software as a quasi-public good, the problem is one of allocating talent to producing quasi-public goods.

    "New Growth Theory" tends to lead to optimism about future growth. The most aggressive growth forecast I have seen comes not from any economist, but from entrepreneur/visionary Ray Kurzweil. In Autoregressive Models, I wrote

    In a sense, he is asking us to buy into the following: a nonlinear process that has increased computer intelligence from, say, 0.000001 percent of total earthly intelligence in 1960 to, say, 0.002 percent of total earthly intelligence in 2000, will continue to increase at a predictable rate until it has reached, say, 99 percent of all earthly intelligence in 2099.

    The challenge of trying to reduce poverty is difficult. Many individuals and countries are trapped in behavioral patterns that make poverty difficult to escape. In Willie Sutton and the Leaky Buckets I described the way changes in the class structure affect these issues.

    Today, the rich are richer and more numerous while the truly poor are fewer and with more complex needs. As a result, the broad-based middle-class programs are no longer a panacea. An alternative is to use programs that are targeted to help the poor and are paid for by the rich.

    ...Taxing the rich to fund expanded middle-class programs under the old social contract may be less progressive than allowing them to use their money to engage in "venture philanthropy" under a new social contract.

  2. Why are markets good, and when is regulation constructive?

    Markets typically alleviate shortages. In There is no Labor Shortage, I wrote that

    Noneconomists, who forecast a chronic labor shortage as if there were no equilibrium wage rate, know even less than economists do.

    In Explaining Markets to Californians, I wrote

    Californians seem to have difficulty grasping the concept of a market when it comes to energy. I thought it might be useful to explain it in terms of something they understand. This fairy tale should help.

    I then proceeded to describe a fictional scenario in which the state of Texas regulated the retail price of movies, causing a movie shortage.

    Markets facilitate specialization. In Comparative Advantage Plays, I explained that a so-called "Internet grocer" was not a New Economy phenomenon but instead was based on the hoary theory of comparative advantage and the gains from trade. I wrote

    The economic issues that will determine whether or not this type of service can succeed have almost nothing to do with the Internet. ..

    Peapod is an example of a comparative advantage "play." They probably are no more efficient than we are at picking and delivering groceries. However, we would rather spend our time doing other things.

    Profits, which many people on the left think are evil, are a good thing in the eyes of economists. In Cruel Paternalism, I recapitulated one of the standard economic arguments for profits. warms the heart to see companies earning profits from investments in things like energy production and research on AIDS therapy. Cruel paternalists find such profits appalling. If cruel paternalists get their way, they will control the allocation of energy and AIDS drugs. Too bad there will not be anything to allocate

    Economists look for ways to use markets to alleviate social problems. For example, education would seem to be at the heart of any solution to alleviating poverty. I made the standard economic argument for market-based solutions in Efficiency, Entrepreneurship, and Education.

    In my opinion, if you really want to bring entrepreneurs into your state, you should enact a school voucher program that enables entrepreneurs to compete with public schools on a level playing field.

    ...the County's primary cost is $80,000, and they mark it up all the way to $240,000. What a business! A consulting firm would love to have those kind of profit margins.

    A market-based school system also could be equitable, I argued in Equity, Entrepreneurship, and Education.

    With a voucher system, one could have somewhat more confidence in the equity of education. For example, we could give larger vouchers to people who have less income with which to supplement a voucher. In addition, we could give larger vouchers to students with learning disabilities.
  3. How should we save and invest for the future?

    Economists do not wish to raise expectations about our sagacity as investors. Nonetheless, there is considerable economic theory that favors some strategies over others, as I discussed in Invest Wisely. I put it,

    instead of trading individual stocks or mutual funds, you might buy and hold index funds. You might allocate a portion of your long-term investments to TIPS [inflation-indexed Treasury securities].

    For the nation as a whole, there is the problem of saving enough to provide for social security. I am perturbed by the way this issue is presented by politicians and journalists. I recommend reading Farmers and Parasites as basic background on this issue.

    To me, the safest and fairest option is to cut back on what we promise the future parasites. In terms of social security, this means reducing future benefits. Of the various ways to do this, the one that I favor is raising the retirement age...

    When the Boomers retire, there is going to be a certain amount of output produced, and the more that Boomers consume the less that others can consume.

  4. How can we avoid macroeconomic problems, such as hyperinflation, long periods of high unemployment, or international financial crises?

    For hyperinflation, there is a consensus in the economics profession that the problem comes from letting the money supply get out of control, which in turn comes from a government that cannot finance its desired level of spending by taxes and borrowing, and attempts to print money at a faster and faster rate to pay for goods and services.

    The other topics are highly controversial within the profession. The Keynesian ideas that I favor are by no means supported by a consensus. In Keynes Then and Now I wrote

    Keynes also challenged what I call the Fundamental False Theorem (FFT) of economics. The FFT states that there can be no involuntary unemployment. It is easy to show that if markets are well behaved, there will never be instances of large and persistent excess supply. This rules out excess supply of labor, that is, involuntary unemployment.

    Another point of Keynesian heresy concerns the role of expectations. In Future Uncertainty and Present Indeterminacy, I wrote

    Keynes focused on the possibility of people becoming pessimistic about the long-term future. In this case, he argued, they would attempt to save for the future in the form of liquid financial instruments rather than in the form of risky capital investments. This would reduce the demand for output and cause an economic slump.

    That was written in the summer of 1999, when I was worried about parallels between stock market boom of the 1920's and the high stock prices in the U.S. In Briefing the President, written two months before the NASDAQ market peaked, I spelled out my fear.

    The issue will be how to ameliorate a long, deep economic slump that results from a collapse of the Internet bubble...

    It is not difficult, therefore, to envision a drop in GDP of $200 to $400 billion, arising directly from a crash in the Nasdaq market. This would be a decline of 2 to 4 percent, which likely would be extended by multiplier effects. That is, as spending declines, employment declines, spending declines more, etc.

    In Some Keynes for Bush, I talked about the Keynesian view of how saving and investment can fall out of balance.

    Keynes viewed the economy as a contest between the "hoarding" instinct and the entrepreneurial instinct. The "hoarding" instinct is to save and to look for conservative investments. The entrepreneurial instinct is to look for promising new business opportunities.

    Entrepreneurial instincts, or "animal spirits," promote economic activity. The entrepreneur provides a productive outlet for the savings provided by hoarding.

    When "animal spirits" decline, there is too much desired savings relative to the lower level of investment. As a result, economic activity contracts, and you have a recession.

  5. How can we deal with the fact that so much of what we value can now be redistributed and re-used at no cost? To put it simply, information wants to be free but people need to get paid.

    This is a difficult, important question, with which the economics profession is just beginning to grapple. I have my own opinions on this topic, to which I have devoted more of my essays than any other. Here I will reference just a few of them.

    In King of Hearts Rules, I wrote a sketchy review of the best economic text on the subject, Information Rules, by Carl Shapiro and Hal Varian. One point I noticed was

    In general, [the authors] propose that firms should try to use pricing and versioning tactics to segment consumers so that consumers who value a product more highly end up paying a higher price... Before the days of zero marginal cost, economists used to teach that price discrimination is bad from a social perspective.

    Of all of the pricing solutions in Shapiro and Varian, the one that I favor the most is one that I think of as a network subscription model, or "club." InDoes Software Want to be Free? and Software Clubs, I claimed that the club as a better alternative to software licensing than "open source" software.

    The idea is that individuals and businesses could join clubs. The fees for joining these clubs would be sign-up charges and membership dues. The clubs would purchase the services of software developers, and members would be able to use all of the software provided by the club at no marginal cost

    ...A software club might operate in some ways like a television network. The club would choose a "lineup" of software to offer to its customer base. It might purchase the distribution rights to software from independent studios or develop the software with salaried staff...

    The software club is a different model for software pricing. Pay-per-license would be replaced by membership dues which convey rights to unlimited usage of software that is provided by the club...

    Today's approach is to charge for something--a software license--that costs nothing at the margin to produce. A software club would pay software developers for their time. It would allocate their time in order to maximize member satisfaction, thereby increasing its ability to extract revenue from its members. This would come closer to pricing the correct resource.

    In The Club Vs. the Silo, I proposed the club structure for journalism.

    Most of the articles that you are able to read when you join a club may be freely available without joining the club. What your membership fee would give you is better access to individual authors, as well as to indexing tools and cross-reference tools. Some of these tools would be provided by community members, as in the Amazon book lists.

    The raw content is not what you are paying for. The haystack is free. But if you want help finding the needle, you have to join the club...

    In a silo model, I only get one periodical's content when I subscribe. With the club concept, my subscription includes access to many periodicals. Some of these are in the haystack (that is, available to people who are not club members), but perhaps not easy to search and cross-reference. Other articles might be licensed only to clubs, so that individuals who are not members would not have access (or have access only with a lag).

    How would journalists and other content providers get paid? They will be paid by the clubs. They may be paid for writing articles that the club's managers know will be particularly interesting to club members. They will be paid for permitting their articles to be searched by the club's indexing tools. In addition, writers may be paid for making themselves available to club members for chats or responses to questions.

    One hypothesis about the Internet is that it is going to lead to disintermediation, so that journalists, musicians and others will sell directly to the public. This caused some pundits to proclaim that "content is king" and that the earnings of writers and artists would rise. In Equilibrium in the Market for Rock'n'Roll, I explained what was wrong with this theory.

    Fundamentally, there is a lot of supply in the market for pop music. Because there are so many people willing to supply services at a relatively low wage rate, the average wage rate is never going to get very high, regardless of what happens to the distribution system.