Is capitalism good? Should we admire hard workers who are motivated to make large profits? Does competition bring out the best in people? These questions juxtapose practices and institutions that economists study (capitalism, profits, competition) with concepts that ethicists use (good, admirable, best). Ethics studies values and virtues. A value is a good to be achieved or a standard of right to be followed, while a virtue is a character trait that enables one to achieve the good or act rightly. For example, a list of core goods might include wealth, love, and freedom. A corresponding list of virtues—or character traits—might include the productiveness that enables one to achieve wealth, the honesty that enables one to enjoy loving relationships, and the self-responsibility that enables one to live in freedom. Ethical issues connect intimately with economic issues. Take the economic practice of doing a cost-benefit analysis. You could spend one hundred dollars for a night on the town, or you could donate that one hundred dollars to the reelection campaign of your favorite politician. Which option is better? The night on the town increases pleasure. A politician’s successful campaign may lead to more liberty in the long term. We regularly make decisions like this, weighing our options by measuring their likely costs and likely benefits against each other. This connects economics directly to a major issue in ethics: By what standard do we determine what counts as a benefit or a cost? A list of competing candidates for the status of ultimate value standard includes happiness, satisfying the will of God, long-term survival, liberty, duty, and equality. Economists implicitly adopt a value framework when beginning a cost-benefit analysis. Different value commitments can lead to the same item being considered a cost from one perspective and a benefit from another. For example, those whose standard of value is increasing human happiness would count a new road to a scenic mountain vista as a benefit, while those whose standard is maintaining an unchanged natural environment would count it as a cost. The results of economic analysis also lead directly to ethical issues. For example, one result of the nineteenth- and twentieth-century debate over capitalism and socialism is a general consensus that capitalism is effective at producing wealth and socialism is effective at keeping people poor. Advocates of capitalism use these results to argue that capitalism is good; others might respond that “socialism is good in theory, but unfortunately it is not practical.” Implicit in the capitalist position is the view that practical consequences determine goodness. By contrast, implicit in the position of those who believe socialism to be an impractical moral ideal is the view that goodness is distinct from practical consequences. This connects economics to a second major issue in ethics: Is goodness or badness determined by real-world practical consequences or by some other means, such as revelations from God, faith in authorities or authoritative institutions, appeals to rational consistency, felt senses of empathy, or an innate conscience? The point for economic analysis, most of which is a matter of understanding and predicting the consequences of various actions, is that the relevance of economic analysis to policymaking depends, in part, on what one believes is the final source of value standards. So far, we have two questions of ethics that bear directly on economics: (1) What is the standard of good? and (2) How does one establish that something is good? A third relevant question of ethics is: Who should be the beneficiaries of the good? A common assumption of economic analysis is that individuals are rational and self-interested. The third question focuses on self-interest. Is self-interest moral, amoral, or immoral? Is morality a matter of individuals taking responsibility for their lives and working to achieve happiness? Or is morality a matter of individuals accepting responsibility for others and being willing to forgo or sacrifice for them? This is the debate in ethics between egoism and altruism. Strong forms of egoism hold that individuals should be self-responsible and ambitious in their pursuit of happiness, that they should treat other individuals as self-responsible trading partners, and that those who are unable to be self-responsible should be treated through voluntary charity. Strong forms of altruism argue the opposite, holding that morality is primarily a matter of helping those who are in need, that charity is more moral than trade, and that the most moral individuals will be motivated by a spirit of self-sacrifice. For example: Carly worked hard and earned $10 million by the time she was forty. She is now in semiretirement, enjoying the good life of travel, building her dream home, managing her investments, and spending time with her family and friends. Jane, by contrast, inherited $10 million at age forty, gave $9.9 million away to charity, and lives frugally on the remaining money. Which woman is more morally admirable? Or consider the debates over rent control and minimum wages. Economists, by a large majority, agree that such policies are not merely zero-sum, as their advocates intend, but rather negative-sum. In this encyclopedia, Walter Block (see rent control) argues that rent controls cause landlords a loss—and also cause housing shortages that harm some of the poorest renters the most. Linda Gorman (see minimum wages) argues that minimum wages cause employers a loss—but also destroy jobs for unskilled laborers. These unintended consequences are well known among economists, but there is little sign that rent controls and minimum wages will be abandoned anytime soon. Why so? In the case of rent controls, part of the explanation involves the political dynamics of urban areas, in which many voters are renters: renters believe that rent control is good for them, and politicians sometimes listen to their constituents. Yet another major part of the explanation has to do with an altruistic ethic that says that the self-interest of landlords and employers counts for little morally and may be sacrificed to help tenants and employees. The thinking is that landlords and employers are richer, and tenants and employees are poorer, and thus rich people should be willing to sacrifice profits to help out the poor if necessary. But if we cannot expect the rich to do the right thing voluntarily, then an altruistic ethic will help justify the government’s mandating the sacrifice by law. The moral difference between egoists and altruists on these economic policy issues is between those who see employers and employees as win-win trading partners and those who see employment as exploitation; and between those who see landlords and tenants as trading value to mutual benefit and those who see poor tenants vulnerable to being taken advantage of by rich landlords. Generalizing from debates over particular policies to evaluations of economic systems as a whole, Adam Smith’s famous statement about self-interest from The Wealth of Nations is directly relevant to our contemporary debates about the morality of capitalism: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Smith is working out a middle ground between traditional ethical theories that have been altruistic in principle and his new (at the time) economic theory that is optimistic about the power of egoistic individuals in a free market. Smith’s position is modern and egoistic in accepting that self-interest is natural and beneficial in making capitalism work well; at the same time Smith is traditionally altruistic in reserving his highest praise for those who take a disinterested perspective on their own interests and are willing to sacrifice their interests. Bracketing Smith’s view on one side is a traditional view of self-interest, one still held by most of capitalism’s contemporary opponents: Self-interest is amoral or immoral because it is essentially antisocial; and because it is based on self-interest, capitalism must be a system of conflict and zero-sum transactions. And because the good of society as a whole is the standard of value, it follows that self-interest and capitalism must be restrained or sacrificed. Smith’s economic insight is to see that self-interest and capitalism do not generate social conflict. His analysis led him to see that self-interested individuals would mostly engage in win-win transactions—that the profit motive, property rights, divisions of labor, competition, and other features of capitalism would lead to individual prosperity and social harmony. But Smith retained the traditional ethical belief that the good of society as a whole is the moral standard of value. Bracketing Smith’s view on the other side is the view—held by neo-Aristotelians and Ayn Rand, for example—that self-interest is moral and that what justifies capitalism is its protection and enabling of individuals in the pursuit of their individual lives and happiness. This position agrees essentially with Smith’s economic analysis of capitalism as a network of win-win transactions, but not with his primary ethical justification. Both ethical and economic analysis quickly become complex, and the three questions noted above provide a starting point for integrating the two fields. Our contemporary debates over environmental values and policies can help illustrate the complex interplay. Environmental debates are about two categories of human action: resource use and waste disposal. For example, whether we are running out of trees and whether we should drill for oil in Alaska are issues of resource use; and whether toxic chemicals are poisoning a water supply and whether greenhouse gases are causing global warming are issues of waste disposal. Some issues, such as recycling, are issues of both resource use and waste disposal. We end with the case of recycling of metal drink containers as a working example. Part of the motivation for recycling may be a belief that the world is running out of a natural resource—in this case, aluminum. In part this belief depends on strictly scientific information: How much aluminum is available from the Earth? How much are we currently using? As mining and processing techniques improve, what effect will that have on the available stock of aluminum? Depending on the scientific data, one might conclude that aluminum is becoming more plentiful or scarcer (see natural resources). Another part of the recycling issue integrates economic considerations. Recycling can increase the available stock of aluminum and save space in landfills, but it also has costs: the costs of making and installing recycling bins for empty cans, the monetary and pollution costs of having recycling trucks travel through neighborhoods and businesses to collect the recyclables, the time cost of putting the cans in the right bins, the cost of reprocessing the cans to extract the raw aluminum, and so on. Whether the benefits of recycling outweigh the costs depends on the results of number crunching by economists. Another part of the recycling issue turns on general political commitments. Given that using resources well and putting trash in its place are valuable, what social institutions should we rely on to achieve those values? Should recycling be voluntary and a matter of market incentives? Or should the government mandate recycling as part of a broader mandate to manage society’s resource use and waste disposal practices? (see tragedy of the commons and free-market environmentalism). Governing how we approach the above scientific, economic, and political issues is a set of presuppositions of ethical values. Those who think egoistically see the environment as a set of resources for humans to use for their benefit. Humans use the environment for a variety of economic and aesthetic purposes, and it is important to human health that certain standards of cleanliness are maintained. On that assumption, it makes sense to ask scientists to investigate the stock of resources and to develop techniques for extracting them. It also makes sense to ask economists to do cost-benefit analyses comparing mining and recycling to determine the most cost-effective methods of producing aluminum. The egoistic goal is to preserve, change, or use the environment in ways that increase human wealth, health, and experiences of beauty. By contrast, strong forms of altruism when applied to environmental issues dictate different scientific and economic priorities. Altruism with respect to the environment requires that humans subordinate or sacrifice their interests to the needs of other species or to the environment as a whole. Given this perspective, the environment is something to be preserved rather than used by humans. Human self-interested values are a lower priority than the well-being of other species or the environment as a whole. Scientifically, asking researchers to find out how much aluminum is available for our use then becomes a morally suspect activity. And economically, recycling then becomes not a matter of a practice worth doing if the cost-benefit numbers work out for us but rather a duty that humans should accept no matter what the economic consequences to themselves. About the Author Stephen Hicks is professor in the Department of Philosophy at Rockford College and Executive Director of the Center for Ethics and Entrepreneurship. In 1994–1995 he was a visiting professor of business ethics at Georgetown University in Washington, D.C. Further Reading   Hume, David. A Treatise of Human Nature. 1739–1740. Reprint. Oxford: Oxford University Press, 2000. In book III (part 1, section 1), Hume argues that there is no logical way to derive an “ought” from an “is.” This implies, for example, that there is no logical connection between normative ethics and descriptive economics. Mill, John Stuart. On Liberty. 1859 (many editions available). A defense of liberal society based on the argument that it realizes the utilitarian moral principle of the “greatest happiness for the greatest number.” Available online at: http://www.econlib.org/library/Mill/mlLbty.html. Mill’s Utilitarianism (1861) is his argument for the “greatest happiness” principle as the ultimate standard in ethics. Rand, Ayn. Capitalism: The Unknown Ideal. New York: Signet, 1967. A defense of capitalism on egoist grounds. Rand argues that what justifies capitalism morally is that it provides individuals with the liberty and property rights they need to survive and flourish self-responsibly. Sen, Amartya. On Ethics and Economics. London: Blackwell, 1989. Sen criticizes standard utilitarian defenses of free markets and discusses generally the kind of theoretical ethics needed to provide a basis for welfare economics. Smith, Adam. The Wealth of Nations. 1776 (many editions available). The classic early study of free markets, describing how the self-interested actions of unregulated individuals come to be coordinated to mutual benefit. Available online at: http://www.econlib.org/librarySmith/smWN.html   (0 COMMENTS)

To economists, efficiency is a relationship between ends and means. When we call a situation inefficient, we are claiming that we could achieve the desired ends with less means, or that the means employed could produce more of the ends desired. “Less” and “more” in this context necessarily refer to less and more value. Thus, economic efficiency is measured not by the relationship between the physical quantities of ends and means, but by the relationship between the value of the ends and the value of the means. Terms such as “technical efficiency” or “objective efficiency” are meaningless. From a strictly technical or physical standpoint, every process is perfectly efficient. The ratio of physical output (ends) to physical input (means) necessarily equals one, as the basic law of thermodynamics reminds us. Consider an engineer who judges one machine more efficient than another because one produces more work output per unit of energy input. The engineer is implicitly counting only the useful work done. “Useful,” of course, is an evaluative term. The inescapably evaluative nature of the concept raises a fundamental question for every attempt to talk about the efficiency of any process or institution: Whose valuations do we use, and how shall they be weighted? Economic efficiency makes use of monetary evaluations. It refers to the relationship between the monetary value of ends and the monetary value of means. The valuations that count are, consequently, the valuations of those who are willing and able to support their preferences by offering money. From this perspective a parcel of land is used with maximum economic efficiency when it comes under the control

An entrepreneur is someone who organizes, manages, and assumes the risks of a business or enterprise. An entrepreneur is an agent of change. Entrepreneurship is the process of discovering new ways of combining resources. When the market value generated by this new combination of resources is greater than the market value these resources can generate elsewhere individually or in some other combination, the entrepreneur makes a profit. An entrepreneur who takes the resources necessary to produce a pair of jeans that can be sold for thirty dollars and instead turns them into a denim backpack that sells for fifty dollars will earn a profit by increasing the value those resources create. This comparison is possible because in competitive resource markets, an entrepreneur’s costs of production are determined by the prices required to bid the necessary resources away from alternative uses. Those prices will be equal to the value that the resources could create in their next-best alternate uses. Because the price of purchasing resources measures this opportunity cost— the value of the forgone alternatives—the profit entrepreneurs make reflects the amount by which they have increased the value generated by the resources under their control. Entrepreneurs who make a loss, however, have reduced the value created by the resources under their control; that is, those resources could have produced more value elsewhere. Losses mean that an entrepreneur has essentially turned a fifty-dollar denim backpack into a thirty-dollar pair of jeans. This error in judgment is part of the entrepreneurial learning, or discovery, process vital to the efficient operation of markets. The profit-and-loss system of capitalism helps to quickly sort through the many new resource combinations entrepreneurs discover. A vibrant, growing economy depends on the efficiency of the process by which new ideas are quickly discovered, acted on, and labeled as successes or failures. Just as important as identifying successes is making sure that failures are quickly extinguished, freeing poorly used resources to go elsewhere. This is the positive side of business failure. Successful entrepreneurs expand the size of the economic pie for everyone. Bill Gates, who as an undergraduate at Harvard developed BASIC for the first microcomputer, went on to help found Microsoft in 1975. During the 1980s, IBM contracted with Gates to provide the operating system for its computers, a system now known as MS-DOS. Gates procured the software from another firm, essentially turning the thirty-dollar pair of jeans into a multibillion-dollar product. Microsoft’s Office and Windows operating software now run on about 90 percent of the world’s computers. By making software that increases human productivity, Gates expanded our ability to generate output (and income), resulting in a higher standard of living for all. Sam Walton, the founder of Wal-Mart, was another entrepreneur who touched millions of lives in a positive way. His innovations in distribution warehouse centers and inventory control allowed Wal-Mart to grow, in less than thirty years, from a single store in Arkansas to the nation’s largest retail chain. Shoppers benefit from the low prices and convenient locations that Walton’s Wal-Marts provide. Along with other entrepreneurs such as Ted Turner (CNN), Henry Ford (Ford automobiles), Ray Kroc (McDonald’s franchising), and Fred Smith (FedEx), Walton significantly improved the everyday life of billions of people all over the world. The word “entrepreneur” originates from a thirteenth-century French verb, entreprendre, meaning “to do something” or “to undertake.” By the sixteenth century, the noun form, entrepreneur, was being used to refer to someone who undertakes a business venture. The first academic use of the word by an economist was likely in 1730 by Richard Cantillon, who identified the willingness to bear the personal financial risk of a business venture as the defining characteristic of an entrepreneur. In the early 1800s, economists Jean-Baptiste Say and John Stuart Mill further popularized the academic usage of the word “entrepreneur.” Say stressed the role of the entrepreneur in creating value by moving resources out of less productive areas and into more productive ones. Mill used the term “entrepreneur” in his popular 1848 book, Principles of Political Economy, to refer to a person who assumes both the risk and the management of a business. In this manner, Mill provided a clearer distinction than Cantillon between an entrepreneur and other business owners (such as shareholders of a corporation) who assume financial risk but do not actively participate in the day-to-day operations or management of the firm. Two notable twentieth-century economists, Joseph Schumpeter and Israel Kirzner, further refined the academic understanding of entrepreneurship. Schumpeter stressed the role of the entrepreneur as an innovator who implements change in an economy by introducing new goods or new methods of production. In the Schumpeterian view, the entrepreneur is a disruptive force in an economy. Schumpeter emphasized the beneficial process of creative destruction, in which the introduction of new products results in the obsolescence or failure of others. The introduction of the compact disc and the corresponding disappearance of the vinyl record is just one of many examples of creative destruction: cars, electricity, aircraft, and personal computers are others. In contrast to Schumpeter’s view, Kirzner focused on entrepreneurship as a process of discovery. Kirzner’s entrepreneur is a person who discovers previously unnoticed profit opportunities. The entrepreneur’s discovery initiates a process in which these newly discovered profit opportunities are then acted on in the marketplace until market competition eliminates the profit opportunity. Unlike Schumpeter’s disruptive force, Kirzner’s entrepreneur is an equilibrating force. An example of such an entrepreneur would be someone in a college town who discovers that a recent increase in college enrollment has created a profit opportunity in renovating houses and turning them into rental apartments. Economists in the modern austrian school of economics have further refined and developed the ideas of Schumpeter and Kirzner. During the 1980s and 1990s, state and local governments across the United States abandoned their previous focus on attracting large manufacturing firms as the centerpiece of economic development policy and instead shifted their focus to promoting entrepreneurship. This same period witnessed a dramatic increase in empirical research on entrepreneurship. Some of these studies explore the effect of demographic and socioeconomic factors on the likelihood of a person choosing to become an entrepreneur. Others explore the impact of taxes on entrepreneurial activity. This literature is still hampered by the lack of a clear measure of entrepreneurial activity at the U.S. state level. Scholars generally measure entrepreneurship by using numbers of self-employed people; the deficiency in such a measure is that some people become self-employed partly to avoid, or even evade, income and payroll taxes. Some studies find, for example, that higher income tax rates are associated with higher rates of self-employment. This counterintuitive result is likely explained by the higher tax rates encouraging more tax evasion through individuals filing taxes as self-employed. Economists have also found that higher taxes on inheritance are associated with a lower likelihood of individuals becoming entrepreneurs. Some empirical studies have attempted to determine the contribution of entrepreneurial activity to overall economic growth. The majority of the widely cited studies use international data, taking advantage of the index of entrepreneurial activity for each country published annually in the Global Entrepreneurship Monitor. These studies conclude that between one-third and one-half of the differences in economic growth rates across countries can be explained by differing rates of entrepreneurial activity. Similar strong results have been found at the state and local levels. Infusions of venture capital funding, economists find, do not necessarily foster entrepreneurship. Capital is more mobile than labor, and funding naturally flows to those areas where creative and potentially profitable ideas are being generated. This means that promoting individual entrepreneurs is more important for economic development policy than is attracting venture capital at the initial stages. While funding can increase the odds of new business survival, it does not create new ideas. Funding follows ideas, not vice versa. One of the largest remaining disagreements in the applied academic literature concerns what constitutes entrepreneurship. Should a small-town housewife who opens her own day-care business be counted the same as someone like Bill Gates or Sam Walton? If not, how are these different activities classified, and where do we draw the line? This uncertainty has led to the terms “lifestyle” entrepreneur and “gazelle” (or “high growth”) entrepreneur. Lifestyle entrepreneurs open their own businesses primarily for the nonmonetary benefits associated with being their own bosses and setting their own schedules. Gazelle entrepreneurs often move from one start-up business to another, with a well-defined growth plan and exit strategy. While this distinction seems conceptually obvious, empirically separating these two groups is difficult when we cannot observe individual motives. This becomes an even greater problem as researchers try to answer questions such as whether the policies that promote urban entrepreneurship can also work in rural areas. Researchers on rural entrepreneurship have recently shown that the Internet can make it easier for rural entrepreneurs to reach a larger market. Because, as Adam Smith pointed out, specialization is limited by the extent of the market, rural entrepreneurs can specialize more successfully when they can sell to a large number of online customers. What is government’s role in promoting or stifling entrepreneurship? Because the early research on entrepreneurship was done mainly by noneconomists (mostly actual entrepreneurs and management faculty at business schools), the prevailing belief was that new government programs were the best way to promote entrepreneurship. Among the most popular proposals were government-managed loan funds, government subsidies, government-funded business development centers, and entrepreneurial curriculum in public schools. These programs, however, have generally failed. Government-funded and -managed loan funds, such as are found in Maine, Minnesota, and Iowa, have suffered from the same poor incentives and political pressures that plague so many other government agencies. My own recent research, along with that of other economists, has found that the public policy that best fosters entrepreneurship is economic freedom. Our research focuses on the public choice reasons why these government programs are likely to fail, and on how improved “rules of the game” (lower and less complex taxes and regulations, more secure property rights, an unbiased judicial system, etc.) promote entrepreneurial activity. Steven Kreft and Russell Sobel (2003) showed entrepreneurial activity to be highly correlated with the “Economic Freedom Index,” a measure of the existence of such promarket institutions. This relationship between freedom and entrepreneurship also holds using more widely accepted indexes of entrepreneurial activity (from the Global Entrepreneurship Monitor) and economic freedom (from Gwartney and Lawson’s Economic Freedom of the World) that are available selectively at the international level. This relationship holds whether the countries studied are economies moving out of socialism or economies of OECD countries. Figure 1 shows the strength of this relationship among OECD countries. The dashed line in the figure shows the positive relationship between economic freedom and entrepreneurial activity. When other demographic and socioeconomic factors are controlled for, the relationship is even stronger. This finding is consistent with the strong positive correlation between economic freedom and the growth of per capita income that other researchers have found. One reason economic freedom produces economic growth is that economic freedom fosters entrepreneurial activity. Figure 1 Economic Freedom and Entrepreneurship in OECD Countries, 2002 ZOOM   Economists William Baumol and Peter Boettke popularized the idea that capitalism is significantly more productive than alternative forms of economic organization because, under capitalism, entrepreneurial effort is channeled into activities that produce wealth rather than into activities that forcibly take other people’s wealth. Entrepreneurs, note Baumol and Boettke, are present in all societies. In government-controlled societies, entrepreneurial people go into government or lobby government, and much of the government action that results—tariffs, subsidies, and regulations, for example—destroys wealth. In economies with limited governments and rule of law, entrepreneurs produce wealth. Baumol’s and Boettke’s idea is consistent with the data and research linking economic freedom, which is a measure of the presence of good institutions, to both entrepreneurship and economic growth. The recent academic research on entrepreneurship shows that, to promote entrepreneurship, government policy should focus on reforming basic institutions to create an environment in which creative individuals can flourish. That environment is one of well-defined and enforced property rights, low taxes and regulations, sound legal and monetary systems, proper contract enforcement, and limited government intervention. About the Author Russell S. Sobel is a professor of economics and James Clark Coffman Distinguished Chair in Entrepreneurial Studies at West Virginia University, and he was founding director of the Entrepreneurship Center there. Further Reading Introductory   Gwartney, James D., and Robert A. Lawson. Economic Freedom of the World: 2002 Annual Report. Vancouver: Fraser Institute, 2002. Information about this book can be found online at: http://www.freetheworld.com/. Hughes, Jonathan R. T. The Vital Few: American Economic Progress and Its Protagonists. Exp. ed. New York: Oxford University Press, 1986. Kirzner, Israel M. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973. Information about Kirzner and his works can be found online at: http://www.worldhistory.com/wiki/I/Israel-Kirzner.htm. Kirzner, Israel M. “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature 35, no. 1 (1997): 60–85. Lee, Dwight R. “The Seeds of Entrepreneurship.” Journal of Private Enterprise 7, no. 1 (1991): 20–35. Reynolds, Paul D., Michael Hay, and S. Michael Camp. Global Entrepreneurship Monitor. Kansas City, Mo.: Kauffman Center for Entrepreneurial Leadership, 1999. Information about this book can be found online at: http://www.gemconsortium.org/. Rosenberg, Nathan, and L. E. Birdzell Jr. How the West Grew Rich. New York: Basic Books, 1986. Schumpeter, Joseph A. Capitalism, Socialism, and Democracy. New York: Harper, 1942. Schumpeter, Joseph A. The Theory of Economic Development. 1911. Cambridge: Harvard University Press, 1934. Information about Schumpeter and his works can be found online at: http://cepa.newschool.edu/het/profiles/schump.htm. Zacharakis, Andrew L., William D. Bygrave, and Dean A. Shepherd. Global Entrepreneurship Monitor: National Entrepreneurship Assessment: United States of America. Kansas City, Mo.: Kauffman Center for Entrepreneurial Leadership, 2000. Information about this book can be found online at: http://www.gemconsortium.org/.   Advanced   Bates, Timothy. “Entrepreneur Human Capital Inputs and Small Business Longevity.” Review of Economics and Statistics 72, no. 4 (1990): 551–559. Baumol, William J. “Entrepreneurship: Productive, Unproductive and Destructive.” Journal of Political Economy 98, no. 5 (1990): 893–921. Baumol, William J. The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism. Princeton: Princeton University Press, 2002. Blanchflower, David G., and Andrew J. Oswald. “What Makes an Entrepreneur?” Journal of Labor Economics 16, no. 1 (1998): 26–60. Blau, David M. “A Time-Series Analysis of Self-Employment in the United States.” Journal of Political Economy 95, no. 3 (1987): 445–467. Blomstrom, Magnus, Robert E. Lipsey, and Mario Zejan. “Is Fixed Investment the Key to Economic Growth?” Quarterly Journal of Economics 111, no. 1 (1996): 269–276. Boettke, Peter J. Calculation and Coordination: Essays on Socialism and Transitional Political Economy. New York: Routledge, 2001. Boettke, Peter J., and Christopher J. Coyne. “Entrepreneurship and Development: Cause or Consequence?” Advances in Austrian Economics 6 (2003): 67–87. Bruce, Donald. “Taxes and Entrepreneurial Endurance: Evidence from the Self-Employed.” National Tax Journal 55, no. 1 (2002): 5–24. Evans, David S., and Linda S. Leighton. “Some Empirical Aspects of Entrepreneurship.” American Economic Review 79, no. 3 (1989): 519–535. Hamilton, Barton H. “Does Entrepreneurship Pay? An Empirical Analysis of the Returns to Self Employment.” Journal of Political Economy 108, no. 3 (2000): 604–631. Holtz-Eakin, Douglas, David Joulfaian, and Harvey S. Rosen. “Sticking It Out: Entrepreneurial Survival and Liquidity Constraints.” Journal of Political Economy 102, no. 1 (1994): 53–75. Kreft, Steven F., and Russell S. Sobel. “Public Policy, Entrepreneurship, and Economic Growth.” West Virginia University Entrepreneurship Center Working Paper, 2003. This article and some related research can be found online at: http://www.be.wvu.edu/ec/research.htm.   (0 COMMENTS)

K-12 In the 1980s, economists puzzled by a decline in the growth of U.S. productivity realized that American schools had taken a dramatic turn for the worse. After rising every year for fifty years, student scores on a variety of achievement tests dropped sharply in 1967. They continued to decline through 1980. The decline was so severe, John Bishop calculates, that students graduating in 1980 had learned “about 1.25 grade-level equivalents less than those who graduated in 1967.”1 Although achievement levels began to recover in 1980, the recovery has been weak and student achievement has yet to regain 1967 levels. By the turn of the century, conservative estimates of the economic growth lost due to the academic achievement decline were on the order of 3.6 percent of the 2000 gross national product. The characteristics of the educational productivity decline challenged widely accepted educational theories of school performance. Theorists accustomed to blaming increased poverty, family instability, large class size, and insufficient spending for poor school performance could not explain why the scores of more able students declined at least as much as those of less able ones, or why measures of inferential ability and problem solving declined more than those of simpler tasks such as arithmetic computation. Achievement fell even though the average U.S. class size shrank from twenty-seven in 1955 to fifteen in 1995.2 The decline affected students primarily after the third grade. First-graders continued to arrive at school better prepared than in any preceding generation. The decline was more pronounced at suburban schools than at inner-city ones, afflicted both private and public schools, and was larger for whites than for minorities in more-advanced grades. The achievement decline cannot be blamed on inadequate spending. Between 1960 and 1995, annual per pupil spending in the United States rose from $2,122 to $6,434 in inflation-adjusted 1995 dollars.3 By 1999, the United States was spending an average of $7,397 per K–12 student. Spending in other industrialized countries averaged $4,850. Only Switzerland, at $8,194 per pupil, spent more than the United States.4 In industrialized countries, student scores on the Third International Mathematics and

The efficient markets theory (EMT) of financial economics states that the price of an asset reflects all relevant information that is available about the intrinsic value of the asset. Although the EMT applies to all types of financial securities, discussions of the theory usually focus on one kind of security, namely, shares of common stock in a company. A financial security represents a claim on future cash flows, and thus the intrinsic value is the present value of the cash flows the owner of the security expects to receive.1 Theoretically, the profit opportunities represented by the existence of “undervalued” and “overvalued” stocks motivate investors to trade, and their trading moves the prices of stocks toward the present value of future cash flows. Thus, investment analysts’ search for mispriced stocks and their subsequent trading make the market efficient and cause prices to reflect intrinsic values. Because new information is randomly favorable or unfavorable relative to expectations, changes in stock prices in an efficient market should be random, resulting in the well-known “random walk” in stock prices. Thus, investors cannot earn abnormally high risk-adjusted returns in an efficient market where prices reflect intrinsic value. As Eugene Fama (1991) notes, market efficiency is a continuum. The lower the transaction costs in a market, including the costs of obtaining information and trading, the more efficient the market. In the United States, reliable information about firms is relatively cheap to obtain (partly due to mandated disclosure and partly due to technology of information provision) and trading securities is cheap. For those reasons, U.S. security markets are thought to be relatively efficient. The informational efficiency of stock prices matters in two main ways. First, investors care about whether various trading strategies can earn excess returns (i.e., “beat the market”). Second, if stock prices accurately reflect all information, new investment capital goes to its highest-valued use. French mathematician Louis Bachelier performed the first rigorous analysis of stock market returns in his 1900 dissertation. This remarkable work documents statistical independence in stock returns—meaning that today’s return signals nothing about the sign or magnitude of tomorrow’s return—and this led him to model stock returns as a random walk, in anticipation of the EMT. Unfortunately, Bachelier’s work was largely ignored outside mathematics until the 1950s. One of the first to recognize the potential information content of stock prices was John Burr Williams (1938) in his work on intrinsic value, which argues that stock prices are based on economic fundamentals. The alternative view, which dominated prior to Williams, is probably best exemplified by John Maynard Keynes’s beauty contest analogy, in which each stock analyst recommends not the stock he thinks best, but rather the stock he thinks most other analysts think is best. In Keynes’s view, therefore, stock prices are based more on speculation than on economic fundamentals. In the long run, prices driven by speculation may converge to those that would exist based on economic fundamentals, but, as Keynes noted in another context, “in the long run we are all dead.” Stock returns and their economic meaning received scant attention before the 1950s because there was little appreciation of the role of stock markets in allocating capital. This oversight had several contributing factors: (1) Keynes’s emphasis on the speculative nature of stock

Americans consumed 3,463 billion megawatt-hours (mwh) of electricity in 2002, with a delivered value of $249.6 billion. Thirty-seven percent of it was consumed by households, 32 percent by commercial users, and 28 percent by industrial users.1 Adjusted for inflation, its price fell by 36 percent between 1983 and 2004.2 Most electricity is generated when high-pressure steam rotates a turbine to induce an alternating current into a wire. In 2002, 50.1 percent of U.S. electricity was produced by coal, 17.9 by natural gas, 20.2 in nuclear units, 6.6 as hydroelectricity, and 2.3 by “renewable resources” such as wind and solar.3 Newly generated power passes through substations that lower its voltage prior to consumption by final (retail) consumers. Important characteristics of electricity limit the possibilities for markets. First, reserve power plants must always be operating to instantly replace generators or transmission lines that fail. Centralized control (usually by computers) is required to meet both predictable and unforeseen changes in regional conditions. Power cannot be economically stored, and area-wide blackouts occur if production either exceeds or falls short of demand for as little as a second. Second, duplication of facilities is inefficient because a single high-capacity line minimizes both capital cost per megawatt (MW) transferred and line losses due to resistance. A typical large utility (or group of them) is responsible for reliability and economical operation in its defined “control area.” Each control area is interconnected with neighboring ones to facilitate emergency support, coordinated operations, and power purchases and sales. Third, an injection of power flows through the entire network according to Ohm’s and Kirchoff’s laws. Unlike water or gas, it cannot be directed down a single path. If a Utah generator sells power to a Wyoming user, only a small fraction of it flows directly between them. Because the power from Utah flows everywhere, it can overload lines in California and force Californians to curtail their own beneficial transactions. Scale economies and reliability concerns left electricity dominated by large, vertically integrated utilities; that is, utilities that generated, transmitted, and distributed power. Direct competition had vanished by the 1920s as municipal franchise grants left nearly every city with a single utility. Between 1907 and 1940, all states formed regulatory commissions whose authority replaced that of cities. The reasons for the change are unclear: utilities may have sought protection from opportunistic city governments, or from competition in general. “Cost of service” regulation sets retail rates to recover expenses and give a “fair” return on capital. Problems in allocating common costs, as well as politics, allow latitude in setting rates for different customers. State regulators generally also require utilities to serve all customers and to plan facility additions in anticipation of growth. The Federal Energy Regulatory Commission (FERC) oversees “wholesale” or “bulk” transactions that occur prior to state-jurisdictional retail sales. The Federal Power Act requires that wholesale prices (including transmission charges) be cost based, but in practice, FERC simply accepts prices set by markets that meet its standards for competition. FERC’s general policy has been to expand the role of markets and to decrease direct regulation subject to the law’s limits, regardless of which party controls the government. Electricity’s ownership structure is complex. In 1998, America’s 239 corporate utilities made 74.9 percent of retail

Why are some countries rich and others poor? Why do some countries experience sustained levels of high growth that propel them into the ranks of the rich while others stagnate, seemingly in perpetuity? These are perhaps the most fascinating and important questions in all of economics. Since the late 1980s, economists have done extensive work on the determinants of economic growth. As yet, however, there are few widely agreed-on results. The lack of consensus is unfortunate because increasing the growth rates of the world’s many poor countries is a primary global policy goal. We do have at least two natural experiments in which a single nation was bisected by very different forms of governments: the two Germanys from the end of World War II to reunification in 1991, and the two Koreas. In both cases, the government that allowed private property and free (at least compared with its counterpart government) enterprise oversaw an economic “miracle,” while the more totalitarian governments in the pairings each produced decades of stagnation and poverty. Because, in each case, the people and their situations were so similar before the change that split them up, we get as close as we can ever get in the real world to a laboratory experiment without a laboratory—a fact that makes these findings significant. Economists know that there is some level of government intervention so great that it stifles economic growth, causing economies under it to do poorly. But when economists use statistical analysis on large samples, other differences between countries that are hard to measure (e.g., culture) can be relevant, and the results are not as straightforward. We can show that factors such as private property rights and lack of corruption (or, as it is sometimes called, the “rule of law”) are strongly correlated with high income, but it is difficult to show that they are correlated with current growth. More on that later. What do economists know about the causes of growth? Begin by looking at the world income distribution in the year 2000. Here, countries are the unit of analysis, which means that Uganda counts as much as China, despite China’s much greater population. Most economists take this approach, although some look at either population weighted distributions or worldwide distributions of individuals’ incomes.1 Figure 1. The world Income Distribution in 2000 Figure 1 displays the distribution of per capita national income in U.S. dollars adjusted for deviations from purchasing power parity for 185 countries in the year 2000. The data are from the World Bank’s “World Development Indicators” online database. Ignoring the extreme outlier of Luxembourg (the $51,000 observation), the income ratio between the second-highest-income country (the United States) and the lowest-income country is about 77. There are 31 countries in the sample whose incomes are

Most of the energy consumed in America today is produced from the combustion of fossil fuels, primarily oil, coal, and natural gas. Energy can be generated, however, in any number of ways. Figure 1 indicates the sources of energy employed by the American economy as of February 2004. Figure 1 U.S. Energy Sources, 2004 The economy has become more efficient at using energy over time. In 1949, the U.S. economy required 20,620 British thermal units (Btu, a common energy measurement) to produce an inflation-adjusted dollar of domestic goods and services. By 2002, only 10,310 Btu were required to do the same.1 In a free market, cost dictates energy choices. Fossil fuels, for example, are economically attractive for many applications because the energy available from fossil fuels is highly concentrated, easily transportable, and cheaply extracted. Renewable energies such as wind and solar power, on the other hand, are relatively dispersed, difficult to transport, and costly to harness given the capital costs of facility construction. Many people recommend accelerated federal subsidies and preferences for renewable energy in order to reduce America’s dependence on imported oil. But such recommendations fail to appreciate the fact that energy sources are often difficult to substitute for one another. Until we see major technological advances in electric-powered vehicles and related battery systems, for example, technological breakthroughs in solar or wind power will have little, if any, impact on oil imports. That is because renewable energy is used primarily to generate electricity and cannot be used directly in transportation to replace oil: in 2002, only 2.5 percent of America’s total electricity was generated from oil combustion.2 The main impediment to the commercial viability of electric vehicles is the cost and operation of the vehicle’s power train, not the cost of the electricity necessary as an input to that power train. Oil Depletion One of the recurring policy fights concerning energy is what the government should do about the depletion of economically attractive crude oil reserves. Underlying this fight, however, is a dispute about whether oil is in danger of becoming scarcer in the foreseeable future. One camp (primarily geologists) argues that few, if any, major new oil fields remain to be found and that mathematical calculation demonstrates that production will peak at some point in the not-too-distant future and then begin a slow but steady decline.3 Another camp (primarily economists) contends that reserves are as much an economic as a geologic phenomenon. That is, reserves are discovered and counted when it makes economic sense to find them. Thus, we do not know how much economically profitable oil has yet to be “discovered.” Technological advances are adding reserves at a far greater rate than they are being depleted.4 For example, in 1970, non-OPEC countries had about 200 billion barrels in reserves. Through 2003, they had produced 460 billion barrels and still had 209 billion barrels remaining.5 Although the debate is inconclusive, the weight of the evidence suggests that economists have the better argument.6 Another dispute concerns whether price signals alone are sufficient to efficiently move from one set of energy resources to another if the need arises. Some have maintained that consumers do not change their behavior much in response to price increases. The claim is true in the short run, but not true over the course of several years. Economists estimate that a 10 percent increase in oil prices reduces the amount demanded in the short run by about 1 percent. Over the long run, however, a 10 percent increase in oil prices reduces the amount demanded by about 10 percent.7

For well over a hundred years, the economic world has been engaged in a great intellectual debate. On one side of this debate have been those philosophers and economists who advocate an economic system based on private property and free markets—or what one might call economic freedom. The key ingredients of economic freedom are personal choice, voluntary exchange, freedom to compete in markets, and protection of person and property. Institutions and policies are consistent with economic freedom when they allow voluntary exchange and protect individuals and their property. Governments can promote economic freedom by providing a legal structure and a law-enforcement system that protect the property rights of owners and enforce contracts in an evenhanded manner. However, economic freedom also requires governments to refrain from taking people’s property and from interfering with personal choice, voluntary exchange, and the freedom to enter and compete in labor and product markets. When governments substitute taxes, government expenditures, and regulations for personal choice, voluntary exchange, and market coordination, they reduce economic freedom. Restrictions that limit entry into occupations and business activities also reduce economic freedom. Adam Smith was one of the first economists to argue for a version of economic freedom, and he was followed by a distinguished line of thinkers that includes John Stuart Mill, Ludwig von Mises, Friedrich A. Hayek, and Milton Friedman, as well as economists such as Murray Rothbard. On the other side of this debate are people hostile to economic freedom who instead argue for an economic system characterized by centralized economic planning and state control of the means of production. Advocates of an expanded role for the state include Jean-Jacques Rousseau and Karl Marx and such twentieth-century advocates as Abba Lerner, John Kenneth Galbraith, Michael Harrington, and Robert Heilbroner. These scholars argue that free markets lead to monopolies, chronic economic crises, income inequality, and increasing degradation of the poor, and that centralized political control of people’s economic lives avoids these problems of the marketplace. They deem economic life simply too important to be left up to the decentralized decisions of individuals. In the early twentieth century, state control grew as communism and fascism spread. In the United States, the New Deal significantly expanded the role of the state in people’s economic lives. In the late 1970s and early 1980s, economic freedom staged a comeback, with deregulation, privatization, and tax cuts. Of course, the major increase in economic freedom came with the fall of the Soviet Union. Today, the advocates of freedom dominate the debate. In fact, one major socialist, the late Robert Heilbroner, believed that the advocates of freedom have won (see socialism). Substantial evidence has informed the debate. Indeed, the stark differences in the standards of living of people in economically freer systems compared with those in less-free systems have become more and more obvious: North versus South Korea, East versus West Germany, Estonia versus Finland, and Cubans living in Miami versus Cubans living in Cuba are examples. In each case, people in the freer economy have better lives, in virtually every way, than their counterparts in the less-free economies. Measuring Economic Freedom The above comparisons are suggestive. But is it possible to find a relationship between economic freedom and prosperity over a wider range of nations? In the 1980s, scholars began to measure and rate economies based on their degree of economic freedom. Organizations such as Freedom House, the Heritage Foundation, and the Fraser Institute, as well as individual scholars, published “economic freedom indexes” attempting to quantify economic freedom. They came up with an ambitious, and necessarily blunt, measure. In 1996, the Fraser Institute, along with a network of other think tanks, began publishing the Economic Freedom of the World (EFW) annual reports, which present an economic freedom index for more than 120 nations. Using data from the World Bank, International Monetary Fund, Global Competitiveness Report, International Country Risk Guide, PricewaterhouseCoopers, and others, the report rates countries on a zero-to-ten scale. Higher scores indicate greater economic freedom. The overall index is based on ratings in five broad areas. Counting the various subcomponents, the EFW index uses thirty-eight distinct pieces of data. Each subcomponent is placed on a scale from zero to ten that reflects the range of the underlying data. The component ratings within each area are averaged to derive ratings for each of the five areas. In turn, the summary rating is the average of the five area ratings. The five major areas are: • Size of government. To get high ratings in this area, governments must tax and spend modestly, and marginal tax rates must be relatively low. While governments are important in protecting property rights, enforcing contracts,

The distribution of income lies at the heart of an enduring issue in political economy—the extent to which government should redistribute income from those with more income to those with less. Whether government should redistribute income is a normative question, and each person’s answer will depend on his or her values. But for many people, answering the normative question requires understanding the facts about the current income distribution. The term “income distribution” is a statistical concept. No one person is distributing income. Rather, the income distribution arises from people’s decisions about work, saving, and investment as they interact through markets and are affected by the tax system. The 1990s and early 2000s witnessed the establishment of a growing body of work, increasingly precise, describing how the income distribution has changed. This work can be summarized in three points: • The distribution of pretax income in the United States today is highly unequal. The most careful studies suggest that the top 10 percent of households, with average income of about $200,000, received 42 percent of all pretax money income in the late 1990s. The top 1 percent of households, averaging $800,000 of income, received 15 percent of all pretax money income. • In the longer view, the path of income inequality over the twentieth century is marked by two main events: a sharp fall in inequality around the outbreak of World War II and an extended rise in inequality that began in the mid-1970s and accelerated in the 1980s. Income inequality today is about as large as it was in the 1920s. • Over multiple years, family income fluctuates, and so the distribution of multiyear income is moderately more equal than the distribution of single-year income. Trends in Inequality The most frequently cited statistics come from the U.S. Census Bureau’s Current Population Survey (CPS), the monthly household survey best known as the source of the official unemployment rate. Since 1948, the March edition of the CPS has collected household income information for the previous year, as well as the personal characteristics of household members—their age, education, occupation, and industry (if they work), and other data that help give insight into changing income patterns. Although this makes the CPS an indispensable statistical source, it has disadvantages as well. The CPS uses a restricted income definition: pretax money receipts excluding capital gains. This definition is further restricted by a “cap,” currently $999,999, imposed on reported annual earnings for reasons of confidentiality.1 Together, these problems mean that CPS estimates of inequality omit the effects of taxes, nonmoney income such as government and private health insurance, and the portion of individual earnings that exceeds the cap. A second source of inequality statistics is the U.S. Treasury’s Statistics of Income (SOI), which summarizes income reported on federal income tax returns. SOI data contain no personal data on taxpayers such as age or education, and they cannot describe the precise shape of the lower part of the income distribution.2 The strengths of SOI data are their ability to accurately describe the upper part of the distribution—SOI income data are not “capped”—and to extend this description back to 1917, thirty years before CPS statistics begin. Table 1 contains selected information on CPS measures of family and household income inequality since World War II.3 The upper panel describes income patterns across families: living units occupied by two or more related persons. The lower panel describes income patterns across households: all occupied living units including families, persons who live alone, unrelated roommates, and so on. To form each distribution, the sample of families (or households) is listed in order of increasing income. The Census then calculates the fraction of all family income going to the quintile (one-fifth) of families with the lowest incomes, the quintile of families with the second-lowest incomes, and so on, as well as the share going to the highest 5 percent of families (who also are included in the top quintile). The CPS data in Table 1 trace a J-shaped evolution of post–World War II inequality. In 1947, the top quintile of families received $8.60 for every dollar of income received by the bottom quintile. This ratio fell gradually through the 1950s and 1960s until 1969, when it reached $7.25 to $1.00—the low point of inequality. Beginning in the late 1970s, the ratio began to rise again until, by 2002, it had increased to $11.36 to $1.00, significantly greater than in 1947. Household data tell a similar story. To make these trends more concrete, Table 1 includes the 1947, 1979, and 2001 income levels that divide each quintile from the next. Similar data are presented for households, and all income levels are expressed in 2003 dollars. Between 1947 and the mid-1970s, income grew rapidly at all points in the distribution, resulting in both rising living standards and moderating inequality. After the mid-1970s, average income grew much more slowly, and the growth that did occur was concentrated in the distributions’ upper half. Between 1979 and 2001, the income dividing the first and second family quintiles grew slightly, from $22,280 to $24,000 (7.7 percent), while the income dividing the fourth and fifth quintiles grew from $74,470 to $94,150 (26.4 percent). Now, as in the 1970s, a majority of families would describe themselves as middle class, but the “middle class” is now a larger, more diverse concept than it once was.4 Inequality estimates based on the U.S. Treasury’s SOI data expand on this picture. At the outset, SOI data do not “cap” high incomes, so household income inequality as reported in the SOI is significantly larger.5 Using “capped” statistics, the CPS reports that the top one-fifth of households receives 49 percent of all pretax money income. The SOI estimates, more accurately, that the top one-tenth of households, with average annual income of about $200,000, receives 42 percent of total pretax money income. The top 1 percent of households with average annual incomes of about $800,000 receives 15 percent of all pretax income. With their longer historical perspective, SOI statistics also show that inequality in the 1920s and 1930s was as high as it is today. Beginning in 1938, the income share of the top one-tenth of households fell from 43 percent to about 32 percent, where it remained until the deep blue-collar recession of the early 1980s. At that point, inequality began its return to the levels of the 1920s and early 1930s.6 Table 1 Family and Household Income Distributions (Census Definitions) *. Original table rearranged and bracketed headings added here for clarity. †. Data available only since 1967. A. Shape of the Family Income Distribution (share of all family income going to each one-fifth [quintile] of families) First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Top 5 percent (Contained in Fifth Quintile) Upper bound of Quintile (2003 dollars) Lower bound of top 5% [1st] [2nd] [3rd] [4th] [5th]* 1947 5.0 11.9 17.0 23.1 43.0 17.5 $11,088 $17,893 $24,263 $34,427 na. $56,506 1959 4.9 12.3 17.9 23.8 41.1 15.9 1969 5.6 12.4 17.7 23.7 40.6 15.6 1979 5.4 11.6 17.5 24.1 41.4 15.3 $23,171 $38,102 $53,979 $74,329 na. $119,243 1989 4.6 10.6 16.5 23.7 44.6 17.9 2001 4.2 9.7 15.4 22.9 47.7 21.0 $24,960 $42,772 $65,000 $97,916 na. $170,668 B. Shape of the Household Income Distribution (share of all households’ income going to each one-fifth [quintile] of households)† First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Top 5 percent (Contained in Fifth Quintile) Upper bound of Quintile (2003 dollars) Lower bound of top 5% [1st] [2nd] [3rd] [4th] [5th]* 1967 4.0 10.8 17.3 24.2 43.8 17.5 $14,002 $27,303 $38,766 $55,265 na. $88,678 1979 4.2 10.3 16.9 24.7 44.0 16.4 $16,457 $30,605 $47,018 $68,318 na. $111,445 1989 3.8 9.5 15.8 24.0 46.8 18.9 2001 3.5 8.7 14.6 23.0 50.1 22.4 $17,970 $33,314 $53,000 $83,500 na. $150,499 The Causes of Inequality In one sense, the growth of inequality in the last part of the twentieth century comes as a surprise. In the 1950s, the bottom part of the income distribution contained large concentrations of two kinds of families: farm families whose in-kind income was not counted in Census data, and elderly families, many of whom were ineligible for the new Social Security program. Over subsequent decades, farm families declined as a proportion of the population while increased Social Security benefits and an expanding private pension system lifted elderly incomes. Both trends favored greater income equality but were outweighed by four main factors. • Family structure. Over time, the two-parent, one-earner family was increasingly replaced by low-income single-parent families and higher-income two-parent, two-earner families. A part of the top quintile’s increased share of income reflects the fact that the average family or household in the top quintile contains almost three times as many workers as the average family or household in the bottom quintile. • Trade and technology. Trade and technology increasingly shifted demand away from less-educated and less-skilled workers toward workers with higher education or particular skills. The result was a growing earnings gap between more- and less-educated/skilled workers. • Expanded markets. With improved communications and transportation, people increasingly functioned in national, rather than local, markets. In these broader markets, persons with unique talents could command particularly high salaries. • Immigration. In 2002, immigrants who had entered the country since 1980 constituted nearly 11 percent of the labor force (see immigration). A relatively high proportion of these immigrants had low levels of education and increased the number of workers competing for low-paid work.7 These factors, however, can explain only part of the increase in inequality. One other factor that explains the particularly high incomes of the highest-paid people is that between 1982 and 2004, the ratio of pay of chief executive officers to pay of the average worker rose from 42:1 to 301:1, and pay of other high-level managers, lawyers, and people in other fields rose substantially also. Does Measurement Matter? As noted above, both CPS and SOI statistics measure pretax money income. These measurements are deficient for three reasons. First, increases in governmental aid to the poor have been concentrated in nonmoney benefits such as Medicaid and food stamps and through tax credits under the Earned Income Tax Credit (EITC). Nonmoney benefits are excluded from standard statistics, and EITC tax credits are typically underreported. Second, an increasing proportion of wage-earners’ total compensation goes to health insurance and pension benefits—which are not counted in standard statistics. Third, taxes themselves modify the income distribution. The U.S. Census has attempted to correct these definition problems for recent years by estimating the household income distribution under alternative income definitions. Table 2 shows the effect in 2001 of moving from the standard Census definition (pretax money excluding capital gains) to an adjusted definition that includes the estimated effects of capital gains, taxes, the EITC, and the monetary value of private and governmental nonmoney benefits. The result is a substantial reduction in inequality, with the ratio between incomes in the top and bottom quintiles falling from $14.31:$1.00 to $10.40:$1.00. Similar adjustments for selected earlier years indicate that better income measurement reduces inequality in any single year. Even under the adjusted definition, though, the trend toward increasing inequality in the 1980s and 1990s remains, but at a slower pace. Table 2 Shape of the Household Income Distribution Under Alternative Income Definitions for 2001 (share of income going to each quintile of households) *. Original table rearranged and bracketed headings added here for clarity. †. Standard Census Income is defined as pretax money income excluding capital gains. First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) Upper bound of quintile (2003 dollars) [1st] [2nd] [3rd] [4th]* Standard Census income† 3.5 8.7 14.6 23 50.1 $18,618 $34,780 $55,105 $86,914 Adjusted Census income 4.5 10.3 15.6 22.6 47 $21,334 $35,485 $51,747 $75,195 Note: Adjusted Census Income is based on pretax money income including estimated capital gains, less all taxes paid plus the estimated receipt of the Earned Income Tax Credit plus the imputed value of in-kind income from employer-provided health insurance and government nonmoney benefits like food stamps, Medicare and Medicaid, and free school lunches. Table 3 Mobility Within the Family Income Distribution Quintile in 1998 First Quintile (Lowest Income) Second Quintile Third Quintile Fourth Quintile Fifth Quintile (Highest Income) First Quintile in 1988 53.30% 23.60% 12.40% 6.40% 4.30% Fifth Quintile in 1988 3.00% 5.70% 14.90% 23.20% 53.20% Source: Katherine Bradbury and Jane Katz, “Are Lifetime Incomes Growing More Unequal? New Evidence on Family Income Mobility,” Federal Reserve Bank of Boston Regional Review 12, no. 4 (2002). Inequality and Mobility A second offset to estimated inequality is economic mobility. Because most family incomes increase as people’s careers develop, long-run incomes are more equal than standard single-year statistics suggest. Table 3 summarizes the results of one study of recent family income mobility.8 Among families in the bottom quintile in 1988, half were in the bottom quintile ten years later, a quarter had moved up to the second quintile, and a quarter had moved to the third or higher quintiles. Families in the fifth quintile (highest incomes) show a similar mobility over time. The Economic Case for Inequality of Wages and Incomes David R. Henderson Is inequality of wages and incomes bad? The question seems ludicrous. Of course inequality is bad, isn’t it? Actually, no. What matters crucially is how the inequality came about. Inequality of wages and incomes is clearly bad if it results from government privileges. Many people would find such an outcome unjust, but even more important to many economists is that such inequality sets up perverse incentives. Instead of producing valuable products and services for their fellow citizens, as people tend to do in free economies, people in societies based on government-granted privileges devote much of their effort to pleasing, or outright bribing, government officials. In many African countries, for example, such as Côte d’Ivoire, Ghana, and Zaire, there are stark inequalities because the government has the power to take a high percentage of the wealth of the already poor and give a large amount of it to government officials or their cronies. And in many Latin American countries, for many decades a few families have had most of the wealth and have used government power to cement their privileges. But inequality in wages and incomes in relatively free economies serves two important social functions. First, it gives people strong incentives to produce so as to make higher incomes and wages. Second, it gives people, and not just young people, strong incentives to get training or education that will allow them to perform well in higher-wage jobs. In his January 1999 Richard T. Ely lecture, economist Finis Welch put the point as follows: Wages play many roles in our economy; along with time worked, they determine labor income, but they also signal relative scarcity and abundance, and with malleable skills, wages provide incentives to render the services that are most highly valued. (Welch 1999, p. 1) Further Reading   Mbaku, John Mukum. “Bureaucratic Corruption in Africa: The Futility of Cleanups.” Cato Journal 16, no. 1 (1996): 99–118. Rothbard, Murray. “Egalitarianism as a Revolt against Nature.” Available online at: http://www.lewrockwell.com/rothbard/rothbard31.html. Welch, Finis. “In Defense of Inequality.” American Economic Review 89, no. 2 (1999): 1–17.   About the Author Frank Levy is the Daniel Rose Professor of Urban Economics in MIT’s Department of Urban Studies and Planning. Further Reading   Charles, Kerwin Kofi, and Erik Hurst. “Correlation of Wealth Across Generations.” Journal of Political Economy, 111, no. 6 (2003): 1155–1182. Fortin, Nicole M., and Thomas Lemeiux. “Institutional Changes and Rising Wage Inequality: Is There a Linkage?” Journal of Economic Perspectives 11, no. 2 (1997): 75–96. Gottschalk, Peter. “Inequality, Income Growth and Mobility: The Basic Facts.” Journal of Economic Perspectives 11, no. 2 (1997): 21–40. Johnson, George E. “Changes in Earnings Inequality: The Role of Demand Shifts.” Journal of Economic Perspectives, 11, no. 2 (1997): 41–54. Saez, Emmanuel. “Income and Wealth Concentration in a Historical and International Perspective.” In Alan J. Auerbach, David E. Card, and John M. Quigley, ed., Public Policy and the Income Distribution. New York: Russell Sage Foundation, 2006. Also available at http://emlab.berkeley.edu/users/saez/berkeleysympo2.pdf. Topel, Robert. “Factor Proportions and Relative Wages: The Supply Side Determinants of Wage Inequality.” Journal of Economic Perspectives 11, no. 2 (1997): 55–74.   Footnotes 1. That is, earnings greater than $999,999 are reported as $999,999.   2. SOI data are combined with national income accounts estimates of total personal income received in the economy to calculate the share of all personal income received by the top 1 percent of households, the top 10 percent of households, and so on. Because many lower-income households do not pay federal income taxes, the SOI cannot provide similar detail on, say, the share of income received by the 10 percent of households with the lowest incomes.   3. Household and family income data are available online at http://www.census.gov/hhes/income/histinc/histinctb.html.   4. The connection between “class” and the income distribution is complicated by the fact that the distribution includes families of all ages, ranging from married students to retirees, while our stereotype of a middle-class income is based on families in their prime earning years.   5. The SOI data are based on tax filing units, a concept that is reasonably close to the Census’s definition of household.   6. See Thomas Piketty and Emanuel Saez, “Income Inequality in the United States, 1913–1998,” Quarterly Journal of Economics 118, no. 1 (2003): 1–39.   7. See Robert Lerman, “U.S. Income Inequality Trends and Recent Immigration,” American Economic Review 89, no. 2 (1999): 23–38.   8. Katherine Bradbury and Jane Katz, “Are Lifetime Incomes Growing More Unequal? New Evidence on Family Income Mobility,” Federal Reserve Bank of Boston Regional Review 12, no. 4 (2002) 3–5.   (0 COMMENTS)