The federal government has increasingly assumed responsibility for reducing poverty in America. Its primary approach is to expand programs that transfer wealth, supposedly from the better off to the poor. In 1962, federal transfers to individuals (not counting payments for goods and services provided or interest for money loaned) amounted to 5.2 percent of gross domestic product, or 27 percent of federal spending (Stein and Foss 1995, p. 212). By 2000, federal transfers had increased to 10.9 percent of GDP, or approximately 60 percent of federal spending; GDP was $9.82 trillion and federal spending was $1.79 trillion. These transfers are commonly referred to as government redistribution programs, presumably from the wealthy to the poor. The unstated implication is that income was originally distributed by someone. But no one distributes income. Rather, incomes are determined in the marketplace by millions of people providing and purchasing services through voluntary exchanges, and government transfers necessarily limit these exchanges. That explains the quotation marks around the term “redistribution.” Almost without exception, academic studies and journalistic accounts of government’s effect on the well-being of the poor focus exclusively on the effectiveness of programs that actually transfer income to the poor. What does this leave out? It leaves out all the programs that transfer income away from the poor. To know the net amount the poor receive after considering transfers to and transfers from them, we need to consider all government transfer programs. Such an examination yields a striking fact: most government transfers are not from the rich to the poor. Instead, government takes from the relatively unorganized (e.g., consumers and general taxpayers) and gives to the relatively organized (groups politically organized around common interests, such as the elderly, sugar farmers, and steel producers). The most important factor in determining the pattern of redistribution appears to be political influence, not poverty. Of the $1.07 trillion in federal transfers in 2000, only about 29 percent, or $312 billion, was means tested (earmarked for the poor) (Rector 2001, p. 2). The other 71 percent—about $758 billion in 2000—was distributed with little attention to need. Take Social Security, for example. The net worth per family of the elderly is about twice that of families in general. Yet, Social Security payments transferred $406 billion in 2003 to the elderly, regardless of their wealth. Also, qualifying for Medicare requires only that one be sixty-five or older. Because this age group’s poverty rate is quite low (only 10.4 percent in 2002), most of the more than $280 billion in annual Medicare benefits go to the nonpoor. What is more, the direct transfer of cash and services is only one way that government transfers income. Another way is by restricting competition among producers. The inevitable consequence—indeed, the intended consequence—of these restrictions is to enrich organized groups of producers at the expense of consumers. Here, the transfers are more perverse than with Medicare and Social Security. They help relatively wealthy producers at the expense of relatively poor (and, in some cases, absolutely poor) consumers. Many government restrictions on agricultural production, for example, allow farmers to capture billions of consumer dollars through higher food prices (see agricultural subsidy programs). Most of these dollars go to relatively few large farms, whose owners are far wealthier than the average taxpayer and consumer (or the average farmer). Also, wealthy farmers receive most of the government’s direct agricultural subsidies. Restrictions on imports also transfer wealth from consumers to domestic producers of the products. Again, those who receive these transfers are typically wealthier than those who pay for them. Consider, for example, the tariffs imposed on steel imports in 2002 to save steelworkers’ jobs. A study done for the Consuming Industries Trade Action Coalition in 2003 found that the steel tariffs eliminated the jobs of about 200,000 U.S. workers in industries that, because of the tariffs, had to pay more for the steel needed in their production processes. This is far more jobs than were saved, because the entire American steel industry employs only 187,500 workers, only a fairly small fraction of whom would have lost their jobs without the steel tariffs. Also, consumers had to pay more for products containing steel. Since unionized steelworkers earn more than the average worker and consumer, the steel tariffs transferred wealth to a few well-paid and politically organized workers at the expense of many less-well-paid workers and consumers. Not only do the poor receive a smaller percentage of income transfers than most people realize, but also the transfers they do get are worth less to them, dollar for dollar, than transfers going to the nonpoor. The reason is that subsidies to the poor tend to be in kind rather than in cash. Slightly over half of all the transfers targeted to the poor are in the form of medical care. In addition to medical care, the poor receive a significant proportion of their assistance for such things as housing, energy, and job training.

“Rent seeking” is one of the most important insights in the last fifty years of economics and, unfortunately, one of the most inappropriately labeled. Gordon Tullock originated the idea in 1967, and Anne Krueger introduced the label in 1974. The idea is simple but powerful. People are said to seek rents when they try to obtain benefits for themselves through the political arena. They typically do so by getting a subsidy for a good they produce or for being in a particular class of people, by getting a tariff on a good they produce, or by getting a special regulation that hampers their competitors. Elderly people, for example, often seek higher Social Security payments; steel producers often seek restrictions on imports of steel; and licensed electricians and doctors often lobby to keep regulations in place that restrict competition from unlicensed electricians or doctors. But why do economists use the term “rent”? Unfortunately, there is no good reason. David Ricardo introduced the term “rent” in economics. It means the payment to a factor of production in excess of what is required to keep that factor in its present use. So, for example, if I am paid $150,000 in my current job but I would stay in that job for any salary over $130,000, I am making $20,000 in rent. What is wrong with rent seeking? Absolutely nothing. I would be rent seeking if I asked for a raise. My employer would then be free to decide if my services are worth it. Even though I am seeking rents by asking for a raise, this is not what economists mean by “rent seeking.” They use the term to describe people’s lobbying of government to give them special privileges. A much better term is “privilege seeking.” It has been known for centuries that people lobby the government for privileges. Tullock’s insight was that expenditures on lobbying for privileges are costly and that these expenditures, therefore, dissipate some of the gains to the beneficiaries and cause inefficiency. If, for example, a steel firm spends one million dollars lobbying and advertising for restrictions on steel imports, whatever money it gains by succeeding, presumably more than one million, is not a net gain. From this gain must be subtracted the one-million-dollar cost of seeking the restrictions. Although such an expenditure is rational from the narrow viewpoint of the firm that spends it, it represents a use of real resources to get a transfer from others and is therefore a pure loss to the economy as a whole. Krueger (1974) independently discovered the idea in her study of poor economies whose governments heavily regulated their people’s economic lives. She pointed out that the regulation was so extensive that the government had the power to create “rents” equal to a large percentage of national income. For India in 1964, for example, Krueger estimated that government regulation created rents equal to 7.3 percent of national income; for Turkey in 1968, she estimated that rents from import licenses alone were about 15 percent of Turkey’s gross national product. Krueger did not attempt to estimate what percentage of these rents were dissipated in the attempt to get them. Tullock (1993) tentatively maintained that expenditures on rent-seeking in democracies are not very large. About the Author David R. Henderson is the editor of this encyclopedia. He is a research fellow with Stanford University’s Hoover Institution and an associate professor of economics at the Naval Postgraduate School in Monterey, California. He was formerly a senior economist with President Ronald Reagan’s Council of Economic Advisers. Further Reading   Krueger, Anne O. “The Political Economy of the Rent-Seeking Society.” American Economic Review 64 (1974): 291–303. Tullock, Gordon. Rent Seeking. Brookfield, Vt.: Edward Elgar, 1993. Tullock, Gordon. “The Welfare Costs of Tariffs, Monopolies and Theft.” Western Economic Journal 5 (1967): 224–232.   (0 COMMENTS)

Throughout most of modern history, economic sanctions have preceded or accompanied war, often in the form of a naval blockade intended to weaken the enemy. Only when the horrors of World War I prompted President Woodrow Wilson to call for an alternative to armed conflict were economic sanctions seriously considered. (Wilson claimed that, by themselves, sanctions could be a “deadly force” and a very effective diplomatic tool.) Sanctions were subsequently incorporated as a tool of enforcement in each of the two collective security systems established in this century—the

Saving means different things to different people. To some, it means putting money in the bank. To others, it means buying stocks or contributing to a pension plan. But to economists, saving means only one thing—consuming less out of a given amount of resources in the present in order to consume more in the future. Saving, therefore, is the decision to defer consumption and to store this deferred consumption in some form of asset. Saving is often confused with investing, but they are not the same. Although most people think of purchases of stocks and bonds as investments, economists use the term “investment” to mean additions to the real stock of capital: plants, factories, equipment, and so on. Between 1990 and 2005, the annual rate of U.S. net national saving (net national income less private consumption expenditures less government consumption expenditures, all divided by net national income) averaged only 5.3 percent. In contrast, the nation’s saving rate was 7.6 percent in the 1980s, 10.3 percent in the 1970s, and 13.0 percent in the 1960s. The 2004 rate of U.S. saving of just 2.2 percent is remarkably low, not only by U.S. standards, but also by international standards. Differences in how the statisticians in different countries define income and consumption make comparisons across nations difficult. But, corrected as well as possible for such data problems, America’s saving rate is significantly lower than that of other industrialized countries. This explains, in large part, why the United States has run a very large current account deficit (see International Trade) in recent years. The U.S. current account deficit measures the amount that foreigners invest in the United States net of what Americans invest abroad. Because Americans are not saving very much, they do not have much to invest in the United States, let alone abroad. Foreigners are making up the difference by investing heavily in the United States. Why do countries save at different rates? Economists do not know all the answers. Some of the factors that undoubtedly affect the amount people save are culture, differences in saving motives, economic growth, demographics, how many people in the economy are in the labor force, the insurability of risks, and economic policy. Each of these factors can influence saving at a point in time and produce changes in saving over time. Motives for Saving The famous life-cycle model of Nobel laureate Franco Modigliani asserts that people save—accumulate assets—to finance their retirement, and they dissave—spend their assets—during retirement. The more young savers there are relative to old dissavers, the greater will be a nation’s saving rate. Most economists believed for decades that this life-cycle model provided the main explanation of U.S. saving. But in the early 1980s, Lawrence H. Summers of Harvard and I showed that saving for retirement explains less than half of total U.S. wealth. Most U.S. wealth accumulation is saving that is ultimately bequeathed or given to younger generations. The motive for bequests and gifts

Since the late 1950s, the regulation of risks to health and safety has taken on ever-greater importance in public policy debates—and actions. In its efforts to protect citizens against hard-to-detect hazards such as industrial chemicals and against obvious hazards in the workplace and elsewhere, Congress has created or increased the authority of the Food and Drug Administration, the Environmental Protection Agency, the Occupational Health and Safety Administration, the Federal Trade Commission’s Bureau of Consumer Protection, and other administrative agencies. Activists in the pursuit of a safer society decry the damage that industrial progress wreaks on unsuspecting citizens. Opponents of the “riskless society,” on the other hand, complain that government is unnecessarily proscribing free choice in the pursuit of costly protection that people do not need or want. This article describes some facts about risk and discusses some academic theories about why people on both sides of the risk debate take the positions they do. The health of human beings is a joint product of their genetic inheritance (advice: choose healthy and long-lived parents), their way of life (the poor person who eats regularly and in moderation, exercises, does not smoke, does not drink to excess, is married, and does not worry overly much is likely to be healthier than the rich person who does the opposite), and their wealth (advice: be rich). Contrary to common opinion, living in a rich, industrialized, technologically advanced country that makes considerable use of industrial chemicals and nuclear power is a lot healthier than living in a poor, nonindustrialized nation that uses little modern technology and few industrial chemicals. That individuals in rich nations are, on average, far healthier, live far longer, and can do more of the things they want to do at corresponding ages than people in poor countries is a rule without exception. Prosperous also means efficient. The most polluted nations in the world, many times more polluted than democratic and industrial societies, are the former communist countries of Central Europe and the Soviet Union. To produce one unit of output, communist countries used two to four times the amount of energy and material used in capitalist countries. On average, individuals unfortunate enough to live in an inefficient economy die younger and have more serious illnesses than those in Western and industrial democracies. A little richer is a lot safer. As Peter Huber demonstrated in Regulation magazine, “For a 45-year-old man working in manufacturing, a 15 percent increase in income has about the same risk-reducing value as eliminating all hazards—every one of them—from his workplace.” Among the many facts that might be observed from Figure 1 and Tables 1A and 1B is that longevity has increased dramatically since 1900. The trend continues if we look further back—boys born in Massachusetts in 1850 could expect to live to an average age of 38.3, girls until 40.5. Turning to death rates, note the decline by half since 1900 of deaths from all forms of accidents and the spectacular declines in all sorts of diseases. The 88 percent drop in deaths from pneumonia and influenza is par for the course. On the other side of the ledger, cancer deaths continue to rise, though their increase has slowed, and deaths from major cardiovascular diseases remain high.

“Privatization” is an umbrella term covering several distinct types of transactions. Broadly speaking, it means the shift of some or all of the responsibility for a function from government to the private sector. The term has most commonly been applied to the divestiture, by sale or long-term lease, of a state-owned enterprise to private investors. But another major form of privatization is the granting of a long-term franchise or concession under which the private sector finances, builds, and operates a major infrastructure project. A third type of privatization involves government selecting a private entity to deliver a public service that had previously been produced in-house by public employees. This form of privatization is increasingly called outsourcing. (Other forms of privatization, not discussed here, include service shedding, vouchers, and joint ventures.) Regardless of the mode of privatization, the common motivation for engaging in all three types is to substitute more efficient business operations for what are seen as less efficient, bureaucratic, and often politicized operations in the public sector. Some have described the key difference as the substitution of competition for monopoly, though some forms of privatization may involve only one provider in a given geographic area for a specific period of time. But because government almost always operates as a monopoly provider, the decision to privatize usually means demonopolization, even if not always robust, free-market competition. The decision to privatize usually involves money. Governments sell state-owned enterprises to obtain proceeds either for short-term budget balancing or to pay down debt. They turn to the private sector to finance and develop a major bridge or seaport when their own resources are stretched too thin. And they outsource services in the hope of saving money in their operating budgets, either to balance those budgets or to spend more on other services (and occasionally to permit tax reductions). Classical Privatization (Asset Divestiture) As recently as the 1970s, many major industries in OECD countries were owned by the state, in keeping with the Fabian Society’s dictum that the “commanding heights” of the economy should be in government hands.1 As is still true today of state-owned enterprises (SOEs) in China and many other developing countries, these businesses were generally run at a loss, subsidized by all the taxpayers. In other words, the value of their outputs was less than the value of their inputs, making them into value-subtracting (rather than value-adding) enterprises. The reasons for this situation were many, but generally they included explicit or implicit policy decisions that—in addition to producing whatever goods or services (cars, steel, air travel, etc.) they were set up to produce—the SOE was also intended to provide jobs, provide its output at “affordable” prices, and accomplish other ends. The first organized effort to divest SOEs took place in Chile under the influence of the “Chicago boys” during the 1970s’ Pinochet era of economic reform. But the largest and best-known effort was that of Margaret Thatcher’s government in the United Kingdom during the 1980s. Thatcher succeeded in making privatization politically popular while selling off the commanding heights of the British economy: British Airways, British Airports Authority, British Petroleum, British Telecom, and several million units of public housing, to name only a few examples. Thatcher’s political strategy emphasized widespread public share offerings rather than auctions to other private firms. Over the decade, this approach tripled the number of individual shareholders in Britain, giving the policy a popular base of support. By the end of the 1980s, the sale of SOEs had gone global, inspired in part by the British example. Governments in France, Germany, Japan, Australia, Argentina, and Chile all sold numerous SOEs, and global privatization proceeds ran in the tens of billions of dollars each year. Generally speaking, companies that moved into the private sector were restructured (often with considerable loss of jobs) and turned into value-adding enterprises. In the case of public utilities (airports, electricity, water, etc.), privatization generally led to the creation of some form of regulatory oversight if the company remained a monopoly provider. The privatization wave expanded further in the 1990s, encompassing the countries emerging from communism and many more developing countries. Here, the privatization record was mixed, with many cases of less-than-transparent sale processes (to firms well connected with government officials) and a botched shares-for-debt scheme in Russia that created an instant crop of politically

The growth of productivity—output per unit of input—is the fundamental determinant of the growth of a country’s material standard of living. The most commonly cited measures are output per worker and output per hour—measures of labor productivity. One cannot have sustained growth in output per person—the most general measure of a country’s material standard of living—without sustained growth in output per worker. Increases in output per hour are the same thing as reductions in hours per unit of output. So, as labor productivity rose in the American car industry during the 1920s, it took fewer and fewer hours to assemble a Model T. The price of automobiles fell, and the real standard of living of Americans increased. This was reflected in the number of cars registered in the country, which rose from 6.7 million in 1919 to 23.1 million in 1929. As the result of productivity improvement, in other words, the number of households with access to automobile transportation more than tripled in the short span of a decade. Recently, output per hour in the sectors of the economy producing computers and telecommunications equipment has soared. The prices of these goods have plummeted, and tens of millions of American households now have high-speed computers and cellular telephones, reflecting some of the more dramatic improvements in our standard of living in recent decades. Productivity improvements can also take place in service sector industries, as they have recently in wholesale and retail trade and securities trading. Some of our greatest challenges and opportunities lie in the service sector. For example, if we can successfully use information technology to streamline the creation, storage, and retrieval of medical records, productivity in the health sector may rise substantially. This would mean that we could deliver more services with the resources currently deployed or the same services with fewer resources reemployed elsewhere. Either way, our standard of living would rise. A final example: in 1790, the year of the first U.S. census, upward of 90 percent of the labor force worked in agriculture. In the year 2000, less than 1.4 percent of the labor force was so employed, still producing enough for the U.S. population to eat as well as substantial exports. Continuing improvements in labor productivity in agriculture made that possible. If the demand for a product or service is price inelastic—that is, if a given percentage decrease in price results in a lower percentage increase in the quantity demanded—then rapid productivity improvement can result in workers having to leave the industry. The reason is that industry output, even if it has risen moderately, can now be produced with fewer workers. This eventually became true for grain farming, but not generally for computers, where the demand has been more price elastic. The relative price declines produced such a big increase in quantity demanded that industry employment has actually increased. But even in the case of grain farming, the falling food prices associated with the productivity improvement led automatically to increases in real income elsewhere. These increases eventually resulted in increased demand for other goods and services, leading to expansion of demand, employment, and output outside of agriculture. Whether or not productivity improvement is associated with increasing or decreasing employment in the affected industries, and whether or not it is temporarily associated with rises in unemployment rates, such improvements are, in the long run, the basis for increases in our material well-being. More Technical Points In the United States, the Bureau of Labor Statistics calculates productivity measures for the private domestic economy and the private nonfarm economy, as well as for manufacturing, industries within manufacturing, and a few other subsectors. The private nonfarm economy accounts for about three-fourths of total GDP: it excludes agriculture, housing (which is entirely services and produced almost entirely by capital), and government. The private domestic economy includes agriculture. For subsectors of the economy, or for particular industries or firms, the measure of output is value added, not gross sales. The contribution to GDP (as well as gross domestic income) of any particular economic entity is gross receipts less purchased materials and contract services. For example, if your bakery business buys flour and yeast, rents a shop and equipment, and pays for fuel, its contribution to GDP is not the sales price of the bread made, but the difference between gross revenues and purchased materials and services except hired labor. Your firm’s output is what you and your employees have added to the value of the materials and services purchased from other firms. You do not get credit for what the other firms did. Increasing labor productivity in your bakery means increasing value added per worker or per hour worked. A second important measure of productivity is called either total factor productivity, a term many economists favor, or multifactor productivity (MFP), the term the Bureau of Labor Statistics uses; the terms are interchangeable. Their rate of growth is often called the residual. MFP can be most easily understood by comparing the calculation of its growth rate with the calculation of the growth rate of output per hour (labor productivity). If we use capital letters for levels and lower-case letters for rates of growth, Y/N can stand for the level of labor productivity, where Y is real output and N is hours; y − n, the growth rate of the numerator less the growth rate of the denominator, is the growth rate of labor productivity. This simply says that if output per hour is to grow, output (the numerator) has to rise faster than hours (the denominator). Multifactor productivity, in turn, is calculated as the difference between the growth rate of real output (y) and a weighted average of the growth rates of capital services and hours, the weights corresponding to shares in national income. Thus, if capital services and hours grew at the same rate, there would be no difference between the growth rate of multifactor productivity and the growth of labor productivity. For example, between 1929 and 1941 in the United States—in other words, during the Great Depression—neither hours nor capital services increased measurably, but real output rose 32 percent. Because the weighted average of the growth of inputs in this instance was effectively zero, all of the growth of output (and growth in output per hour) was due to growth in multifactor productivity, which can be interpreted as a crude measure of the rate of “technical change.” If output rises faster than the growth of inputs conventionally measured, then we can say that some recipes for turning inputs into output must have improved. Total (multi) factor productivity and labor productivity are related to each other. Output per hour grows as the result of two conceptually distinct mechanisms. First, if the economy saves and invests more of its current output such that the physical capital stock rises more rapidly than the number of labor hours employed, output per hour should rise as the result of “capital deepening.” Capital deepening occurs when the ratio of physical capital to labor hours rises. The idea that this positively affects labor productivity is based on the intuitive proposition that ditch diggers move more cubic meters of earth if they are using backhoes than if they use only shovels. But output per hour can also rise through the discovery of new technologies or ways of organizing production. Such discoveries contribute to growth in our measures of multifactor productivity and enable output per hour to rise even in the absence of more capital accumulation (think about the Depression example). To return to our example of the bakery, if your firm invests in more machines so that less hand labor per loaf is required, output (value added) per hour should go up. But multifactor productivity will not necessarily rise, because your combined input measure will rise by about the same amount as output. There is another potential source, however, of increases in output per hour. If you discover a way to rearrange your labor force and equipment so that production is more efficient, or discover a great new recipe for a loaf that is equally tasty but costs you less to bake, multifactor productivity in your firm may go up, increasing your output (value added) per hour even in the absence of any capital deepening. The bottom line: If a country wants its standard of living to rise over the long run, its labor productivity has to go up. And for that to happen, it either has to save more or innovate. About the Author Alexander J. Field is the Michel and Mary Orradre Professor of Economics at Santa Clara University. He is the editor of Research in Economic History and the executive director of the Economic History Association. Further Reading   Abramovitz, Moses. “Resource and Output Trends in the United States since 1870.” American Economic Review 46 (May 1956): 5–23. Important article, the first to document the rise in the value of the residual in the United States during the second quarter of the twentieth century. Abramovitz, Moses, and Paul David. “American Macroeconomic Growth in the Era of Knowledge-Based Progress: The Long Run Perspective.” In Stanley Engerman and Robert Gallman, eds., The Cambridge Economic History of the United States. Vol. 3. Cambridge: Cambridge University Press, 2000. Pp. 1–92. Analysis, up through 1989, extending the idea of the shift from dominance of physical capital accumulation in the nineteenth century to knowledge-based growth in the twentieth. Field, Alexander J. “The Most Technologically Progressive Decade of the Century.” American Economic Review 93 (September 2003): 1399–1413. Shows that the high value of the residual in the second quarter of the century was principally due to the high growth rate of MFP between 1929 and 1941. Field, Alexander J. “Technical Change and U.S. Economic Growth: The Interwar Period and the 1990s.” In Paul Rhode and Gianni Toniolo, eds., Understanding the 1990s: The Economy in Historical Perspective. Cambridge: Cambridge University Press, 2005. Compares economic growth in the 1930s and the 1920s with that in the 1990s. Gordon, Robert J. “Interpreting the ‘One Big Wave’ in U.S. Long Term Productivity Growth.” In Bart van Ark, Simon Kuipers, and Gerard Kuper, eds., Productivity, Technology, and Economic Growth. Boston: Kluwer, 2000. Pp. 19–66. Argues that high rates of MFP growth in the second and third quarters of the twentieth century may have been historically unique. Jorgenson, Dale. “Information Technology and the U.S. Economy.” American Economic Review 91 (March 2001): 1–32. Optimistic interpretation of the effect of the IT revolution on U.S. productivity growth. Kendrick, John. Productivity Trends in the United States. Princeton: Princeton University Press, 1961. Classic reference for anyone wishing to push analysis back before 1947. Detailed aggregate and sectoral estimates for the U.S. economy. Lipsey, Richard J., and Kenneth Carlaw. “What Does Total Factor Productivity Measure?” International Productivity Monitor (Fall 2000): 23–28. Skeptical view of what inferences we can draw from measures of the residual. Oliner, Steven D., and Daniel E. Sichel. “The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?” Journal of Economic Perspectives 14 (Fall 2000): 3–22. Analysis of contribution of the IT revolution to recent productivity growth by two Federal Reserve economists. Solow, Robert J. “Technical Change and the Aggregate Production Function.” Review of Economics and Statistics 39 (August 1957): 312–320. Seminal article laying out the dynamics of the Solow growth model and providing a production function interpretation of growth accounting. Analyzes data from 1909 to 1949.   Web Sites   http://www.bls.gov. This is the Web site to visit for the latest U.S. productivity data, as well as historical data running back in some cases to 1947. http://www.oecd.org/topicstatsportal/0,2647,en_2825_30453906_1_1_1_1_1,00.html. Provides productivity data for members of the Organisation for Economic Co-operation and Development (OECD).   (0 COMMENTS)

While rational expectations is often thought of as a school of economic thought, it is better regarded as a ubiquitous modeling technique used widely throughout economics. The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. He used the term to describe the many economic situations in which the outcome depends partly on what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price farmers expect to realize when they harvest and sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future. The use of expectations in economic theory is not new. Many earlier economists, including A. C. Pigou, John Maynard Keynes, and John R. Hicks, assigned a central role in

Public goods have two distinct aspects: nonexcludability and nonrivalrous consumption. “Nonexcludability” means that the cost of keeping nonpayers from enjoying the benefits of the good or service is prohibitive. 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. The fireworks example illustrates the related free-rider problem. Even if the fireworks show is worth ten dollars to each person, arguably few people will pay ten dollars to the entrepreneur. Each person will seek to “free ride” by allowing others to pay for the show, and then watch for free from his or her backyard. If the free-rider problem cannot be solved, valuable goods and services—ones people otherwise would be willing to pay for—will remain unproduced. The second aspect of public goods is what economists call “nonrivalrous consumption.” Assume the entrepreneur manages to exclude noncontributors from watching the show (perhaps one can see the show only from a private field). A price will be charged for entrance to the field, and people who are unwilling to pay this price will be excluded. If the field is large enough, however, exclusion is inefficient. Even nonpayers could watch the show without increasing the show’s cost or diminishing anyone else’s enjoyment. In other words, the relevant consumption is nonrivalrous. Nonetheless, nonexcludability is usually considered the more important of the two aspects of public goods. If the good is excludable, private entrepreneurs will try to serve as many fee-paying customers as possible, charging lower prices to some customers if need be. One of the best examples of a public good is national defense. To the extent one person in a geographic area is defended from foreign attack or invasion, other people in that same area are likely defended also. This makes it hard to charge people for defense, which means that defense faces the classic free-rider problem. Indeed, almost all economists are convinced that the only way to provide a sufficient level of defense is to have government do it and fund defense with taxes. Many other problems, though, that are often perceived as public-goods problems are not really, and markets handle them reasonably well. For instance, although many people think a television signal is a public good, cable television services scramble their transmissions so that nonsubscribers cannot receive broadcasts easily. In other words, the producers have figured out how to exclude nonpayers. Both throughout history and today, private roads have been financed by tolls charged to road users. Other goods often seen as public goods, such as private protection and fire services, are frequently sold through the private sector on a fee basis. Excluding nonpayers is possible. In other cases, potentially public goods are funded by advertisements, as happens with television and radio. Partially public goods also can be tied to purchases of private goods, thereby making the entire package more like a private good. Shopping malls, for instance, provide shoppers with a variety of services that are traditionally considered public goods: lighting, protection services, benches, and restrooms are examples. Charging directly for each of these services would be impractical. Therefore, the shopping mall finances the services through receipts from the sale of private goods in the mall. The public and private goods are “tied” together. Private condominiums and retirement communities also are market institutions that tie public goods to private services. They use monthly membership dues to provide a variety of public services. Some public goods are provided through fame incentives or through personal motives to do a good job. The World Wide Web offers many millions of home pages and informational sites, and most of their constructors have not received any payment. The writers either want recognition or seek to reach other people for their own pleasure or to influence their thinking. The “reciprocity motive” is another possible solution, especially in small groups. I may contribute to a collective endeavor as part of a broader strategy to signal that I am a public-minded, cooperative individual. You may then contribute in return, hoping that we develop an ongoing agreement—often implicit—to both contribute over time. The agreement can be self-sustaining if I know that my withdrawal will cause the withdrawal of others as well. A large body of anecdotal and experimental evidence suggests that such arrangements, while imperfect, are often effective. Roommates, for instance, often have implicit or explicit agreements about who will take out the trash or do the dishes. These arrangements are enforced not by contract but rather by the hope of continuing cooperation. Other problems can be solved by defining individual property rights in the appropriate economic resource. Cleaning up a polluted lake, for instance, involves a free-rider problem if no one owns the lake. If there is an owner, however, that person can charge higher prices to fishermen, boaters, recreational users, and others who benefit from the lake. Privately owned bodies of water are common in the British Isles, where, not surprisingly, lake owners maintain quality.

Public choice applies the theories and methods of economics to the analysis of political behavior, an area that was once the exclusive province of political scientists and sociologists. Public choice originated as a distinctive field of specialization a half century ago in the works of its founding fathers, Kenneth Arrow, Duncan Black, James Buchanan, Gordon Tullock, Anthony Downs, William Niskanen, Mancur Olson, and William Riker. Public choice has revolutionized the study of democratic decision-making processes. Foundational Principles As James Buchanan artfully defined it, public choice is “politics without romance.” The wishful thinking it displaced presumes that participants in the political sphere aspire to promote the common good. In the conventional “public interest” view, public officials are portrayed as benevolent “public servants” who faithfully carry out the “will of the people.” In tending to the public’s business, voters,