How does the economic system of capitalism work?Introduction:

This assignment is to confirm by us to our respectable teacher Munmun Sobnom Bipasha that we analyze many kind of sector of Economics and described it here and present a fully economical situation of a country. Also we could find some extra topics that can successful to provide us much economical knowledge. This is not a reference book; it’s just a note book that consists of some important topics. It provide to others only some knowledge based on some topics.

Objective: Economics is a positive science, not a normative science; that is, economics is descriptive, not prescriptive. Economics can tell us what the effect of a minimum wage law is on employment, but economics cannot tell us whether that effect is good or bad. Good and bad are concepts of evaluation. They presuppose a standard and ultimately a system of morality. Economics is not ethics. Nevertheless, economics is not cut off from ethics. Ayn Rand defined ethics as “a code of values to guide men’s choices and actions” (1964, 2), and some such code, explicit or implicit, underlies everything men do. This includes the work of economists in analyzing an economic system.

Ayn Rand’s ethics of rational self-interest is an ethics of egoism, the view that selfishness is a virtue and the individual should be the beneficiary of his own actions. Her ethics is my ethics. By contrast, for the last hundred years, economists have presupposed the opposite ethics as the base for both generating and evaluating theories: that ethics is altruism, the morality of selflessness and self-sacrifice—the morality of the Judeo-Christian tradition—the morality that dominates our age and that has dominated Western civilization for two thousand years.

The clash between altruism and capitalism is irremediable. Capitalism is the economic system of self-interest. Capitalism depends on self-interest, it encourages self-interest, and it sanctions self-interest. At every level and in every detail, the motivation of self-interest is the motivation of capitalism. Consequently, the altruists have loathed capitalism from its beginning in the Industrial Revolution. This loathing is the fundamental cause of “the sweeping market reforms that economists have long advocated” (Mandler 1999, 151).

The primary purpose of economics is to identify, interpret, and explain how a capitalist economy works. Altruism assured economists that capitalism is evil in advance of that knowledge. The evil consequences of this belief permeate all of economics, damning capitalism in both theory and practice. In theory, capitalism never had a chance. Since an evil system cannot work, capitalism was convicted a priori. As for capitalism’s practice, economists’ commitment to the immorality of capitalism blinded them to the facts. Every datum, every event, every phenomenon, every result, every aspect of capitalism was twisted and distorted out of any resemblance to reality in order to make it conform to the altruist agenda. Ayn Rand’s refutation of altruism makes it possible for the first time in history to present the theory and practice of capitalism objectively, untouched by moral distortion. This is the first study of economics to take advantage of that fact, and in the end, an objective perspective is the primary value I have to offer.

1. What is Economics?

Economics is the study of how people choose to use resources. Resources include the time and talent people have available, the land, buildings, equipment, and other tools on hand, and the knowledge of how to combine them to create useful products and services. Important choices involve how much time to devote to work, to school, and to leisure, how many dollars to spend and how many to save, how to combine resources to produce goods and services, and how to vote and shape the level of taxes and the role of government.

2. How does the economic system of capitalism work?

Some people provide other people with money to set up a business. The people who provided the money are called shareholders. The people who took the money are called management. The money is called capital. The managers use the capital to hire workers, rent space, and purchase machinery and office furniture. Then they start selling their product. Their product might be cars, hamburgers, computer programming, plumbing repair services, or any number of things. If there is money left over after the bills are paid, that is called profits. The company pays income tax. Then the company takes what is left and declares a dividend and gives the profits back to the shareholders.

3. What is economics agent?

In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory.

For example, buyers and sellers are two common types of agents in partial equilibrium models of a single market. Macroeconomic models, especially dynamic stochastic general equilibrium models that are explicitly based on micro foundations, often distinguish households, firms, and governments or central banks as the main types of agents in the economy. Each of these agents may play multiple roles in the economy; households, for example, might act as consumers, as workers, and as voters in the model. Some macroeconomic models distinguish even more types of agents, such as workers and shoppers or commercial banks.

4. What is microeconomics?

Microeconomics, study of the economic behavior of individual consumers, firms, and industries and the distribution of total production and income among them. It considers individuals both as suppliers of labor and capital and as the ultimate consumers of the final product, and it analyzes firms both as suppliers of products and as consumers of labor and capital. Microeconomics seeks to analyze the market or other type of mechanism that establishes relative prices among goods and services and allocates society’s resources among their many alternative uses.

Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and sub aggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy.

In order to proceed with this examination it is necessary to envisage the macroeconomics system or (social organization of the greater community or nation) in a form that can be easily understood and appreciated. This is done by means of a macroeconomics model, which is a general expression of the system that is useful for purposes of discussion. The model can take a number of different forms including block diagrams, algebraic equations, mechanical analogy, electronic analogy, Leontief Matrix, etc. A suitable model for use in representing the macroeconomic system is shown in the illustration for a closed macroeconomics system without including "The Rest of The World". Money circulates around this model and goods, services, valuable legal documents etc. pass in return between the 6 entities or agents (also sometimes called sectors) that comprise the basic structure of the system. The system flows of money, goods etc., continuously try to self-adjust, in order to attain a condition of equilibrium. Since at least the 1960s, macroeconomics has been characterized by further integration as to micro-based modeling of sectors, including rationality of players, efficient use of market information, and imperfect competition. This has addressed a long-standing concern about inconsistent developments of the same subject.

Macroeconomic analysis also considers factors affecting the long-term level and growth of national income. Such factors include capital accumulation, technological change and labor force growth.

Fig: Micro Economics

5. What is heterodox economics?

The analysis and study of economic principles considered outside of mainstream or orthodox schools of economic thought. Schools of heterodox economics include socialism, Marxism, post-Keynesian and Austrian, and often combine the macroeconomic outlook found in Keynesian economics with approaches critical of neoclassical economics.

Investopedia Says:

Heterodox economics provides an alternative approach to mainstream economics that may help give explanation to economic phenomenon that don't received widespread credence. In addition, heterodox economics seeks to embed social and historical factors into analysis, as well as evaluate the way in which the behavior of both individuals and societies alters the development of market equilibriums.

6. What is mainstream economics?

The analysis and study of economic principles considered outside of mainstream or orthodox schools of economic thought. Schools of heterodox economics include socialism, Marxism, post-Keynesian and Austrian, and often combine the macroeconomic outlook found in Keynesian economics with approaches critical of neoclassical economics.

Investopedia Says:

Heterodox economics provides an alternative approach to mainstream economics that may help give explanation to economic phenomenon that don't received widespread credence. In addition, heterodox economics seeks to embed social and historical factors into analysis, as well as evaluate the way in which the behavior of both individuals and societies alters the development of market equilibriums.

7. What is Applied economics?

Applied economics is a term that refers to the application of economic theory and analysis. While not a field of economics, it is typically characterized by the application of economic theory and econometrics to address practical issues in a range of fields including labor economics, industrial organization, development economics, health economics, monetary economics, public economics and economic history. The process often involves a reduction in the level of abstraction of this core theory. There are a variety of approaches including not only empirical estimation using econometrics, input-output analysis or simulations but also case studies, historical analogy and so-called common sense or the "vernacular”. This range of approaches is indicative of what Roger Backhouse and Jeff Biddle argues is the ambiguous nature of the concept of applied economics. It is a concept with multiple meanings.

8. What is Business cycle in economics?

Periodic fluctuation in the rate of economic activity, as measured by levels of employment, prices, and production. Economists have long debated why periods of prosperity are eventually followed by economic crises (stock-market crashes, bankruptcies, unemployment, etc.). Some have identified recurring 8-to-10-year cycles in market economies; longer cycles have also been proposed, notably by Nikolay Kondratev. Apart from random shocks to the economy, such as wars and technological changes, the main influences on the level of economic activity are investment and consumption. An increase in investment, as when a factory is built, leads to consumption because the workers employed to build the factory have wages to spend. Conversely, increases in consumer demand cause new factories to be built to satisfy the demand. Eventually the economy reaches its full capacity, and, with little free capital and no new demand, the process reverses itself and contraction ensues. Natural

fluctuations in agricultural markets, psychological factors such as a bandwagon mentality, and changes in the money supply have all been proposed as explanations for initial changes in investment and consumption. After World War II many governments used monetary policy to moderate the business cycle, aiming to prevent the extremes of inflation and depression by stimulating the national economy in slack times and restraining it during expansions.

Different Types of Cycles:Scholars in the early post–World War II period often distinguished "growth cycles," in which contractions were defined as a decline in the rate of GDP growth, from the less frequent business cycles, in which contractions were defined as decreases in GDP. Some held out hope that the business cycle could be replaced with less severe growth cycles.

Table: The fact that growth rates are higher in some periods than others poses difficulties for the empirical evaluation of business cycles. Ascertaining the severity of the business cycle requires knowing the growth rate around which cyclical fluctuations occur. But observation of a change in GDP from one year to the next conflates the effect of the trend growth rate and the effect of the cycle. Thus, analysts use complex and controversial statistical techniques to distinguish trends from cycles. This task would increase in complexity if economists accepted the existence of more than one type of cycle.

U.S. Business Cycle Expansions and Contractions*30 cycles**15 cyclesSOURCE: National Bureau of Economic Research Website (http://www.nber.org/cycles.html)

Reference Dates

Duration in Months

Trough Peak Contraction Expansion CycleTrough from Trough Trough from Peak fromPrevious Peak to Peak Previous Trough Previous Peak

December 1854 June 1857 – 30 – –

December 1858 October 1860 18 22 48 40

June 1861 April 1865 8 46 30 54December 1867 June 1869 32 18 78 50

December 1870 October 1873 18 34 36 52

March 1879 March 1882 65 36 99 101May 1885 March 1887 38 22 74 60April 1888 July 1890 13 27 35 40May 1891 January 1893 10 20 37 30June 1894 December 1895 17 18 37 35June 1897 June 1899 18 24 36 42December 1900 September 1902 18 21 42 39

August 1904 May 1907 23 33 44 56June 1908 January 1910 13 19 46 32January January 1913 24 12 43 36

U.S. Business Cycle Expansions and Contractions1912December 1914 August 1918 23 44 35 67

March 1919 January 1920 7 10 51 17July 1921 May 1923 18 22 28 40July 1924 October 1926 14 27 36 41November 1927 August 1929 13 21 40 34

March 1933 May 1937 43 50 64 93June 1938 February 1945 13 80 63 93October 1945 November 1948 8 37 88 45

October 1949 July 1953 11 45 48 56

May 1954 August 1957 10 39 55 49April 1958 April 1960 8 24 47 32February 1961 December 1969 10 106 34 116

November 1970 November 1973 11 36 117 47

March 1975 January 1980 16 58 52 74July 1980 July 1981 6 12 64 18November 1982 July 1990 16 92 28 108

March 1991 March 2001 8 120 100 128Average1854–1991 (31 cycles) 18 35 53 53*

1854–1919 (16 cycles) 22 27 48 49**

1919–1945 (6 cycles) 18 35 53 531945–1991 (9 cycles) 11 50 61 61

The existence of natural seasonal fluctuations in economic activity, associated with climatic changes and the bunching of purchases around holidays such as Christmas, adds another complication. Economists prefer to look at "seasonally adjusted" figures when evaluating economic performance. Has the change from month to month been greater or less than is usually observed between those two months? But as the economy evolves, so does the desirable seasonal adjustment.

9. Gale Encyclopedia of Small Business:

Business Cycles

A business cycle is a sequence of economic activity in a nation's economy that is typically characterized by four phases—recession, recovery, growth, and decline—that repeat themselves over time. Economists note, however, that complete business cycles vary in length. The duration of business cycles can be anywhere from about two to twelve years, with most cycles averaging about six years in length. In addition, some business analysts have appropriated the business cycle model and terminology to study and explain fluctuations in business inventory and other individual elements of corporate operations. But the term

"business cycle" is still primarily associated with larger (regional, national, or industry wide) business trends.

Stages of a Business Cycle:

RECESSION: A recession—also sometimes referred to as a trough—is a period of reduced economic activity in which levels of buying, selling, production, and employment typically diminish. This is the most unwelcome stage of the business cycle for business owners and consumers alike. A particularly severe recession is known as a depression.

RECOVERY: Also known as an upturn, the recovery stage of the business cycle is the point at which the economy "troughs" out and starts working its way up to better financial footing.

GROWTH: Economic growth is in essence a period of sustained expansion. Hallmarks of this part of the business cycle include increased consumer confidence, which translates into higher levels of business activity. Because the economy tends to operate at or near full capacity during periods of prosperity, growth periods are also generally accompanied by inflationary pressures.

DECLINE: Also referred to as a contraction or downturn, a decline basically marks the end of the period of growth in the business cycle. Declines are characterized by decreased levels of consumer purchases (especially of durable goods) and, subsequently, reduced production by businesses.

10. Economics growth:Process by which a nation's wealth increases over time. The most widely used measure of economic growth is the real rate of growth in a country's total output of goods and services (gauged by the gross domestic product adjusted for inflation, or "real GDP"). Other measures (e.g., national income per capita, consumption per capita) are also used. The rate of economic growth is influenced by natural resources, human resources, capital resources, and technological development in the economy along with institutional structure and stability. Other factors include the level of world economic activity and the terms of trade. See also economic development.

Growth economics studies factors that explain economic growth – the increase in output per capita of a country over a long period of time. The same factors are used to explain differences in the level of output per capita between countries, in particular why some countries grow faster than others, and whether countries converge at the same rates of growth.

Much-studied factors include the rate of investment, population growth, and technological change. These are represented in theoretical and empirical forms (as in the neoclassical and endogenous growth models) and in growth accounting.

11. What are the Economic sectors of Bangladesh?

1. Agriculture:

Most Bangladeshis earn their living from agriculture. Although rice and jute are the primary crops, maize and vegetables are assuming greater importance. Due to the expansion of irrigation networks, some wheat producers have switched to cultivation of maize which is used mostly as poultry feed. Tea is grown in the northeast. Because of Bangladesh's fertile soil and normally ample water supply, rice can be grown and harvested three times a year in many areas. Due to a number of factors, Bangladesh's labor-intensive agriculture has achieved steady increases in food grain production despite the often unfavorable weather conditions. These include better flood control and irrigation, a generally more efficient use of fertilizers, and the establishment of better distribution and rural credit networks. With 28.8 million metric tons produced in 2005-2006 (July–June), rice is Bangladesh's principal crop. By comparison, wheat output in 2005-2006 was 9 million metric tons. Population pressure continues to place a severe burden on productive capacity, creating a food deficit, especially of wheat. Foreign assistance and commercial imports fill the gap, but seasonal hunger ("monga") remains a problem. Underemployment remains a serious problem, and a growing concern for Bangladesh's agricultural sector will be its ability to absorb additional manpower. Finding alternative sources of employment will continue to be a daunting problem for future governments, particularly with the increasing numbers of landless peasants who already account for about half the rural labor force. Due to farmers' vulnerability to various risks, Bangladesh's poorest face numerous potential limitations on their ability to enhance agriculture production and their livelihoods. These include an actual and perceived risk to investing in new agricultural technologies and activities (despite their potential to increase income), a vulnerability to shocks and stresses and a limited ability to mitigate or cope with these and limited access to market information.

2. Manufacturing & Industry

Many new jobs - mostly for women - have been created by the country's dynamic private ready-made garment industry, which grew at double-digit rates through most of the 1990s. By the late 1990s, about 1.5 million people, mostly women, were employed in the garments sector as well as Leather products specially Footwear (Shoe manufacturing unit). During 2001-2002, export earnings from ready-made garments reached $3,125 million, representing

52% of Bangladesh's total exports. Bangladesh has overtaken India in apparel exports in 2009, its exports stood at 2.66 billion US dollar, ahead of India's 2.27 billion US dollar.

Eastern Bengal was known for its fine muslin and silk fabric before the British period. The dyes, yarn, and cloth were the envy of much of the pre-modern world. Bengali muslin, silk, and brocade were worn by the aristocracy of Asia and Europe. The introduction of machine-made textiles from England in the late eighteenth century spelled doom for the costly and time-consuming hand loom process. Cotton growing died out in East Bengal, and the textile industry became dependent on imported yarn. Those who had earned their living in the textile industry were forced to rely more completely on farming. Only the smallest vestiges of a once-thriving cottage industry survived.

Other industries which have shown very strong growth include the chemical industry, steel industry, mining industry and the paper and pulp industry.

3. Textile sector

Bangladesh's textile industry, which includes knitwear and ready-made garments along with specialized textile products, is the nation's number one export earner, accounting for 80% of Bangladesh's exports of $15.56 billion in 2009. Bangladesh is 3rd in world textile exports behind Turkey, another low volume exporter, and China which exported $120.1 billion worth of textiles in 2009. The industry employs nearly 3.5 million workers. Current exports have doubled since 2004. Wages in Bangladesh's textile industry were the lowest in the world as of 2010. The country was considered the most formidable rival to China where wages were rapidly rising and currency was appreciating.

After massive labor unrest in 2006 the government formed a Minimum Wage Board including business and worker representatives which in 2006 set a minimum wage equivalent to 1,662.50 taka, $24 a month, up from Tk950. In 2010, following widespread labor protests involving 100,000 workers in June, 2010, a controversial proposal was being considered by the Board which would raise the monthly minimum to the equivalent of $50 a month, still far below worker demands of 5,000 taka, $72, for entry level wages, but unacceptably high according to textile manufacturers who are asking for a wage below $30. On July 28, 2010 it was announced that the minimum entry level wage would be increased to 3,000 taka, about $43.

The government also seems to believe some change is necessary. On September 21, 2006 then ex-Prime Minister Khaleda Zia called on textile firms to ensure the safety of workers by complying with international labor law at a speech inaugurating the Bangladesh Apparel & Textile Exposition (BATEXPO).

4. Investment

The stock market capitalization of the Dhaka Stock Exchange in Bangladesh crossed $10 billion in November 2007 and the $30 billion dollar mark in 2009, and USD 50 billion in August 2010. Bangladesh had one of the best performing stock markets in the world during the recent global recession, due to relatively low correlations with developed country stock markets.

Major investment in real estate by domestic and foreign-resident Bangladeshis has led to a massive building boom in Dhaka and Chittagong.

Recent (2011) trends for investing in Bangladesh as Saudi Arabia trying to secure public and private investment in oil and gas, power and transportation projects, United Arab Emirates (UAE) is keen to invest in growing shipbuilding industry in Bangladesh encouraged by comparative cost advantage, Tata, an India-based leading industrial multinational to invest Taka 1500 crore to set up an automobile industry in Bangladesh, World Bank to invest in rural roads improving quality of live, the Rwandan entrepreneurs are keen to invest in Bangladesh's pharmaceuticals sector considering its potentiality in international market, Samsung sought to lease 500 industrial plots from the export zones authority to set up an electronics hub in Bangladesh with an investment of US$1.25 billion, National Board of Revenue (NBR) is set to withdraw tax rebate facilities on investment in the capital market by individual taxpayers from the fiscal 2011-12.

External trade:

Bangladeshi exports in 2006

The Bangladesh Garments Manufacturers and Exporters Association (BGMEA) has predicted textile exports will rise from US$7.90 billion earned in 2005-06 to US$15 billion by 2011. In part this optimism stems from how well the sector has fared since the end of textile and clothing quotas, under the Multifibre Agreement, in early 2005.

According to a United Nations Development Programmed report "Sewing Thoughts: How to Realize Human Development Gains in the Post-Quota World" Bangladesh has been able to offset a decline in European sales by cultivating new markets in the United States.[16]

"[In 2005] we had tremendous growth. The quota-free textile regime has proved to be a big boost for our factories," said BGMEA president S.M. Fazlul Hoque told reporters, after the sector's 24 per cent growth rate was revealed.

Bangladesh Knitwear Manufacturers and Exporters Association (BKMEA) president Md Fazlul Hoque has also struck an optimistic tone. In an interview with United News Bangladesh he lauded the blistering growth rate, saying "The quality of our products and its competitiveness in terms of prices helped the sector achieve such... tremendous success."

Knitwear posted the strongest growth of all textile products in 2005-06, surging 35.38 per cent to US$2.82 billion. On the downside however, the sector's strong growth came amid sharp falls in prices for textile products on the world market, with growth subsequently dependent upon large increases in volume.

Bangladesh's quest to boost the quantity of textile trade was also helped by US and EU caps on Chinese textiles. The US cap restricts growth in imports of Chinese textiles to 12.5 per cent next year and between 15 and 16 per cent in 2008. The EU deal similarly manages import growth until 2008.

Bangladesh may continue to benefit from these restrictions over the next two years, however a climate of falling global textile prices forces wage rates the centre of the nation's efforts to increase market share.

Prior to the Wage Board's announcement of its recommended minimum wage of $24, Tk1,604, in 2006, the rate had remained unchanged at Tk950, about $15, for more than 12 years. Although the government may allow up to three years for the new wage to be implemented, and inevitably there will be compliance issues as manufacturers drag their feet, it seemed politically untenable for wages to remain at those levels given the unprecedented industrial unrest.

In response to the Wage Board's initial draft recommendation of a minimum wage of Tk1, 604 to be increased to Tk1, 800 after eight months, the BGMEA declared over 50 per cent of factories would be ruined within three months. While this claim is no doubt an exaggeration, the capacity of Bangladesh's textile industry to absorb a significant wage hike as margins become tighter is a key question which hangs over the future of the industry. Bangladesh's textile sector is concentrated in export processing zones in Dhaka and Chittagong. These zones, which are administered by the Bangladesh Export Processing Zone Authority, aim to offer "a congenial investment climate, free from cumbersome procedures’ according to Bangladesh Export Promotion Bureau's website.

They offer a range of incentives to potential investors including 10 year tax holidays, duty free import of capital goods, raw materials and building materials, exemptions on income tax on salaries paid to foreign nationals for three years and dividend tax exemptions for the period of the tax holiday.

All goods produced in the zones are able to be exported duty free, in addition to which Bangladesh benefits from the Generalized System of Preferences in US, European and Japanese markets and is also endowed with Most Favored Nation status from the United States.

Furthermore, Bangladesh imposes no ceiling on investment in the EPZs and allows full repatriation of profits. The formation of labor unions within the EPZs is prohibited as are strikes. Bangladesh's exports to the U.S. surpassed $1.9 billion in 1999. Bangladesh also exports significant amounts of garments and knitwear to the EU market. Bangladesh also has significant jute, leather, shrimp, pharmaceutical, and ceramics industries. Bangladesh has been a world leader in its efforts to end the use of child labor in garment factories. On July 4, 1995, the Bangladesh Garment Manufacturers Export Association, International Labor Organization, and UNICEF signed a memorandum of understanding on the elimination of child labor in the garment sector. Implementation of this pioneering agreement began in fall 1995, and by the end of 1999, child labor in the garment trade virtually had been eliminated. The labor-intensive process of ship breaking for scrap has developed to the point where it now meets most of Bangladesh's domestic steel needs. Other industries include sugar, tea, leather goods, newsprint, pharmaceutical, and fertilizer production.

The Bangladesh government continues to court foreign investment, something it has done fairly successfully in private power generation and gas exploration and production, as well as in other sectors such as cellular telephony, textiles, and pharmaceuticals. In 1989, the same year it signed a bilateral investment treaty with the United States, it established a Board of Investment to simplify approval and start-up procedures for foreign investors, although in practice the board has done little to increase investment. The government created the Bangladesh Export Processing Zone Authority to manage the various export processing zones. The agency currently manages EPZs in Adamjee, Chittagong, Comilla, Dhaka, Ishwardi, Karnaphuli, Mongla, and Uttara. An EPZ has also been proposed for Sylhet. The government has given the private sector permission to build and operate competing EPZs-initial construction on a Korean EPZ started in 1999. In June 1999, the AFL-CIO petitioned the U.S. Government to deny Bangladesh access to U.S. markets under the Generalized System of Preferences (GSP), citing the country's failure to meet promises made in 1992 to allow freedom of association in EPZs.

Sylhet is fast becoming a major center of retailing in Bangladesh, with many shopping centers being built by expatriates to serve fellow expatriates visiting Sylhet and the emerging middle class. Many of these developments hark back to Britain.

Overview of Economics:

Bangladesh has made significant strides in its economic sector performance since independence in 1971. Although the economy has improved vastly in the 1990s, Bangladesh still suffers in the area of foreign trade in South Asian region. Despite major impediments to growth like the inefficiency of state-owned enterprises, a rapidly growing labor force that cannot be absorbed by agriculture, inadequate power supplies, and slow implementation of economic reforms, Bangladesh has made some headway improving the climate for foreign investors and liberalizing the capital markets; for example, it has negotiated with foreign firms for oil and gas exploration, better countrywide distribution of cooking gas, and the construction of natural gas pipelines and power stations. Progress on other economic reforms has been halting because of opposition from the bureaucracy, public sector unions, and other vested interest groups.

Fiscal Year

Total Export

Total Import

Foreign Remittance Earnings

2007–2008

$14.11b $25.205b $ 8.9b

2008–2009

$15.56b $22.00b+ $9.68b

2009-2010

$16.7b ~ $24b $10.87b

2010-2011

$22.93b $32b $11.65b

The especially severe floods of 1998 increased the flow of international aid. So far the global financial crisis has not had a major impact on the economy. The World Bank predicted economic growth of 6.5% for current year. Foreign aid has seen a decline of 10% over the last few months but economists see this as a good sign for self-reliance. There has been 18% growth in exports over the last 9 months and remittance inflow has increased at a remarkable 25% rate.

12. The summery between Rich and poor (In growth theory):

From growth theory, we have learned that for an entire country, the following factors are important in determining the level of well-being.

1. The savings rate, which determines the country's ability to accumulate capital2. The growth rate of the efficiency of labor, which in turn depends on

o Education

o Cumulative Knowledge

o Adaptive Social Institutions

For individuals, these same factors affect relative well-being. For example, young people generally tend to be better off than preceding generations, because as society accumulates knowledge, this adds to wealth. Historically, it took hundreds of years for this accumulation of knowledge to have a noticeable effect. Now, you can see the effect within a generation. Even if your parents are in the top half of the wealth distribution and you wind up in the bottom half, you are almost sure to enjoy better health care, better technology products, and a higher standard of living in general.

For over 100 years, from the time of Karl Marx until the latter part of the 20th century, economists looked at capital accumulation as the main factor in economic growth and individual wealth. In Marxist economics, it is capitalists who save and accumulate the economy's capital. They become wealthier and wealthier, while workers stay miserable until they finally get fed up and launch the Communist revolution.

The view that saving leads to wealth is not wrong. However, saving is not the only road to wealth, for a nation or for an individual. In fact, one irony is the fact that most people living under Communist dictatorships are worse off than ordinary workers under capitalism, because Communist dictatorships do not do well at adapting to advances in knowledge.

Marx's jargon of "class struggle" continues to permeate political dialogue. Marx saw the struggle as taking place between the capitalist class of savers and the working class getting by on subsistence wages. Today, people talk about a number of supposed victim classes: women, gays, and ethnic minorities are spoken of using the "class struggle" jargon, even though the original economic basis for Marxist classes--savers vs. workers--does not apply to these victim classes.

In the twentieth century, particularly in the United States, poverty has been receding. Fewer and fewer people face the squalor that was typical 150 years ago, and that is still typical in some regions of the world. Most Americans live well above subsistence levels. In fact,

researchers have found that saving takes place among Americans of all income groups (there are also people at all income levels who try to live beyond their means).

Differences in well-being reflect more than just differences in capital accumulation. Two hundred years ago, when the efficiency of labor was growing slowly, inherited wealth and the lack thereof played an important role in determining people's station. With the acceleration in the rate of technological change, your inherited financial capital matters relatively less and your personal earnings power and saving rate matter relatively more.

The growth rate of your personal "efficiency of labor" will be a big factor in determining your place in the distribution of well-being. If you make good use of your education and you adapt to readily take advantage of the technologies that emerge over the next 30 years, you will be rich. If you fail to do so, then you will gradually slip to a lower place in the wealth distribution.

Income, Consumption, Wealth, and Poverty

Statisticians collect three measures of economic well-being.

1. Income is the amount of money that an individual or a household earns in a year. Income is a flow.

2. Consumption is the value of goods and services that an individual or a household consumes in a year. Consumption is a flow.

3. Wealth is the value of the assets of an individual or a household at a point in time. Wealth is a stock.

Economists have issues with using income as a measure of well-being.

Income has a transitory component. Some years, people earn windfalls, due to unusually large bonuses or high profits from personal businesses. In other years, people earn less than usual, because they might be laid off part of the year or they may own a business that does

poorly that year.

Income also has a "life-cycle" component, meaning that it depends on where you are in the life cycle. A graduate student may have a low income, but once she completes her degree her income likely will take a leap. A retired person may have a low income, but he has sufficient wealth to sustain a lavish lifestyle.

Wealth also has some shortcomings as a measure of well-being. Statistical measures of wealth count only financial assets, without taking an individual's earning power into account. A new graduate of medical school may have no wealth (in fact, she could be carrying a large debt on a student loan), but her prospects for future earnings may be bright. In general, younger people have less wealth than what they will be able to accumulate later in their lives.

People seem to make consumption decisions more on the basis of long-term income and wealth than on the basis of current income and wealth. Therefore, it makes sense to focus on consumption as an indicator of how people view their economic circumstances. Using

consumption as a measure, economists tend to find that poverty in the United States is shrinking.

For example, W. Michael Cox and Richard Alm, in Myths of Rich & Poor, present information on the ownership of durable goods in 1994 by households whose income was below the official poverty line of around $13,000 per year. On page 15, table 1.2; they compare this to the ownership of those same types of durable goods by all households in 1971.

Percent of Households with: Poor Households, 1994 All Households, 1971

Washing Machine 71.7 71.3

Clothes Dryer 50.2 44.5

Refrigerator 97.9 83.3

Stove 97.7 87.0

Color Television 92.5 43.3

Telephone 76.7 93.0

Air-conditioner 49.6 31.8

One or more cars 71.8 79.5

Looking at the table, it seems reasonable to say that a "poor" household in 1994 was at least as well off as an average household in 1971. This is without taking into account the fact that a majority of poor households have microwave ovens, VCR's, and cable television hookups, none of which were available to the average household in 1971.

Cox and Alm examine a large study of income dynamics undertaken by the University of Michigan. It tracked income of specific households from 1975 through 1991. As Cox and Alm report (p. 73),

Those who started in the bottom 20 percent in 1975 had an inflation-adjusted gain of $27,745 in average income by 1991. Among workers who began in the top fifth, the increase was just $4,354. The rich may have gotten a little richer, but the poor have gotten much richer.

The University of Michigan data suggest that low income is largely a transitory experience for those willing to work...Nearly a quarter of those in the bottom tier in 1975 moved up the next year and never again returned. By contrast, long-term hardship turned out to be rare: Less than 1 percent of the sample remained in the bottom fifth every year from 1975 to 1991.

Cox and Alm argue that if one counts as poor only households that remain below the poverty line for at least two years, then the poverty rate is 4 percent, rather than the 13 percent that was reported at the time. It may be that true poverty among the able-bodied and able-minded (meaning people who are not substance abusers or otherwise incapacitated by mental illness) has been essentially eradicated in this country.

Resenting the Rich

If you compare people at a single point in time in terms of either income or wealth, then disparities stand out. Today, the top-to-bottom ratio of income or wealth is larger than ever. Some economists would downplay this fact, and instead focus on absolute levels of well-being.

However, people seem to care about relative economic standing as well as their absolute standing. For example, Reason's Ronald Bailey cites a fascinating experiment conducted by British economists Daniel John Rizzo and Andrew Oswald . First, the researchers placed subjects in a gambling game. Then at the conclusion of the gambling sessions, each player was given the chance to spend his own money to anonymously "burn" some of the cash won by his fellow participants. It was made clear that there was no prospect that burning his fellow player’s winnings would in any way make him richer. In fact, if he chose to burn another player’s money, he had to pay between 2 cents and 25 cents for each dollar subtracted from the other player’s take.

Zizzo and Oswald found that nearly two-thirds of players happily paid for the privilege of impoverishing their fellow participants.

This suggests that a political platform of "soak the rich" will have support. In fact, one consequence of the increased dispersion in incomes is that in the United States the income tax

is focused on the upper end of the income distribution.

Since the 1960's, the share of income accounted for by the top fifth of households is up somewhat. More important has been the increase in all levels of income. The average real income of people in the second fifth of households today exceeds the average real income of people in the top twenty percent in the 1960's. See the following table, which comes from the census report on income distribution, in dollars of constant purchasing power.

Income Status mean real income, 1966

mean real income, 1999

Top 20 percent

$123.7 $254.8

Second 20 percent

80.5 147.8

Middle 20 percent

47.2 72.2

Next 20 percent

35.3 48.9

Bottom 20 percent

24.7 31.0

The combination of a large rise in overall income and a slight increase in the share at the top means that households earning over $100,000 now account for something close to three-fourths of all income. If we think of "rich" in absolute terms ($100,000 per year in household income, adjusted for inflation) rather than in relative terms (the top 20 percent), the "rich" now earn enough income to fund both baseline government functions plus programs to help the poor.

We do not need the middle class to pay taxes any more. In fact, with income taxes, the middle-class taxpayer is on the road to extinction. Data from the U.S. Treasury compiled by Daniel Mitchell for the Heritage Foundation show that the bottom 50 percent of the income distribution accounts for only 4.2 percent of tax revenues, as shown in the following table:

Income Status Share of Total Income Tax RevenuesTop one percent 34.8 %Rest of top ten percent 30.2Rest of top 25 percent 17.6Rest of top 50 percent 13.1Bottom 50 percent 4.2

If the distribution of income were static, then these data would suggest that most people are unaffected by tax cuts, because they pay so little in taxes already. However, keep in mind that the distribution of income is fluid, so that people who are in the bottom 50 percent one year may be in the top ten percent the next year.

Summary:1. Individual well-being is affected by the same factors that determine economic growth,

including the level of cumulative knowledge when the person is born as well as the person's saving rate, education, and ability to adapt to new technology.

2. Income in any given year is not a reliable indicator of an individual's wealth or poverty. A large percentage of today's "poor" people own durable goods that are as good as or better than those of the average household thirty years ago. Most people with low income one year will do much better in other years. Only about 4 percent of the population has an income below the poverty line for two years or more.

3. Income disparities, which may lead to resentment, are widening. This shows up clearly in data on Federal tax revenues, where very little is collected from people in the bottom 50 percent of the income distribution in any given year.

13. The Economics of Social Security:

Economists view social security differently than does the public at large. Many journalists and politicians speak of social security as if it were a defined-contribution pension plan. They speak as if the benefits that someone receives from social security reflect that person's contributions into the program.

Economists instead view social security as an ongoing intergenerational transfer mechanism. At any point in time, the working-age population is being taxed to support retirees. This view of social security as an intergenerational transfer has some interesting corollaries.

1. Holding tax rates constant and longevity constant, the ability to expand benefits in social security depends on the growth rate of the population plus the growth rate of productivity. If the younger generation is 10 percent larger than the older generation and 10 percent more productive, then benefits for the older generation can be 20 percent higher.

2. In general, a transfer from the young to the old is a transfer from people who are relatively rich to people who are relatively poor. That is because of the phenomenon of economic growth, which makes each generation better off than the previous generation.

3. Some of the involuntary, impersonal transfers that take place within social security are reversed by voluntary personal transfers. Within families, the old tend to give money to the young.

Policies and the Social Security Crisis

The looming decline in the ratio of workers to beneficiaries is sometimes referred to as a crisis for Social Security. Economists do not agree on how to deal with this crisis.

Some economists are not convinced that the crisis will appear. This is not a matter of ideology, but of optimism. There are both liberals and conservatives who believe that productivity growth in the next twenty years may be two percent or more per year. If this proves to be the case, then social security transfers as a percent of GDP will increase little, if at all.

On the other hand, there are economists who are concerned about the demographic outlook for social security. Among such economists, liberals tend to support having the Federal government run a budget surplus over the next twenty years, in order to increase national saving. A higher saving rate will raises the capital/output ratio, which in turn they hope will increase GDP, which would make it easier to afford high security outlays.

Conservative economists, me included, would like to see the retirement age raised and then indexed so that it increases along with longevity. Such a policy would serve to limit social security outlays as a percent of GDP.

Liberal politicians have proposed something called a "lockbox" for social security. Their thinking is that while the baby boom population is still working, the social security system should be able to take in more in revenues than it pays in benefits. If these surpluses can be "locked up" and put away, they suggest, then when the baby boomers retire these funds can be drawn down.

Inside the "lockbox" are claims on future output. If the "lockbox" works, then the Baby Boom generation will have the legal means to collect its Social Security benefits, regardless of how high this makes the tax burden on those who are then working.

Conservative politicians have proposed something called "partial privatization," which would allow individuals to direct some of their social security contributions to the stock market. Their thinking is that the high returns from the stock market might make it easier to pay social security benefits.

Like the lockbox, partial privatization does nothing to lower the ratio of social security benefits to GDP. In fact, if stock prices do well, then baby boomers will be able to consume an even higher share of total output than they would if we stuck with the current social security system. Conversely, if the stock market does poorly, it seems likely that politicians would use tax money for a bailout. Thus, neither the lockbox nor partial privatization addresses the economics of social security.

The Case for Raising the Retirement Age

I favor rising the retirement age and indexing it to longevity. Indexing would affect people who are far away from retirement. Once you reach age 50, your retirement age would be frozen. Up until that point, the statutory retirement age would increase on a year-for-year basis with observed increases in longevity. Ten years from now, if longevity has increased by two years, then the retirement age will have gone up by two years as well.

An increase in the retirement age should apply to people currently aged 50 and under. It need not apply to people in their 50's and older, who already are planning for their retirement. Also, no one would be forced to wait until the statutory retirement age to retire. You can always retire earlier and live off of savings, with Social Security kicking in at the statutory retirement age.

Instead, by keeping the retirement age constant in spite of higher longevity, we are automatically expanding the role of social security in the economy. We are creating a situation in which improvements in health and medicine lead people to spend a large and growing fraction of their lives dependent on the government for income.

The proportion of the population that obtains benefits from social security might be an arbitrary political decision if the process of collecting taxes to pay social security benefits did not impose any additional cost on the economy. However, as we will see when we study the microeconomics of markets, in addition to collecting revenue, taxes impose a "deadweight loss," meaning that they reduce the economy's output. In other words, using taxes and transfers to try to redistribute the pie has its limits, because the pie gets smaller when tax rates are higher. The social security tax punishes work and thrift, so that we get less of those two activities the more we raise social security taxes.

The social security tax is a particularly evil tax, because it is regressive, meaning that high earners pay a lower proportion of their income for social security taxes than do low earners. Some of the seniors receiving Social security checks are quite affluent, while some of the workers paying taxes to fund those checks may be lower down on the wealth scale. This is not the sort of transfer scheme that we should be leaving on autopilot to grow at an exponential rate.

14. Basic Financial Calculations:

Discounting Future Cash Flows

Stocks, bonds, and other instruments that are discussed in the business section of newspapers and on financial web sites represent claims on future cash flows. If I buy a stock or a bond, then I receive payments in the future. The most basic concept for determining the values of those cash flows is called discounting.

If you ask me whether I would prefer $100 today or $100 a year from now, I will say that I want the $100 today. If I can earn 5 percent interest on money in a savings deposit, then with $100 today I could put the money in a savings account and have $105 a year from now.

If the interest rate is 5 percent, then I would view $105 a year from now as being equivalent to $100 today. Another way of saying this is that the discounted present value of $105 a year from now is $100. When we want to know what a future cash flow is worth today, we calculate its discounted present value.

To calculate the discounted present value of a cash flow to be received one year from now, divide by (1+i), where I is the interest rate expressed as a decimal. If the future cash flow is $105 and the interest rate is 5 percent, or .05, then the discounted present value is $105/(1.05) = $100.

What is the value of a cash flow of $105 that you will receive two years from now? Assuming the same interest rate of 5 percent, we discount twice. That is, we take $105 and divide by 1.05, and then divide by 1.05 once more, for a discounted present value of $95.24. More generally, if the interest rate is constant, we have for a cash flow C that will arrive t years from now,

Discounted present value = C/ (1+i) t

You may remember the way that compound interest behaves. If you have a savings balance of $100,000 and the interest compounds annually, then after six years of earning interest at a rate of 5 percent per year, your balance will equal $100,000 (1.05)6 = $134,009.60. Discounted present value is like compounding, except that you work backwards in time. Instead of taking compound interest from today to calculate a value in the future, you start with a value in the future and discount back to the present.

Calculate the discounted present value of a payment of $100 two years from now, if the interest rate is 8 percent per year.

Calculate the present value of a payment of $100 three years from now and a payment of $200 five years from now, if the interest rate is 6 percent per year.

Does a cash flow of $100 to be received eight years from now have a discounted present value that is lower or higher than a cash flow of $100 to be received four years from now? In general, what effect does the length of time until you will receive a cash flow have on the present value of that cash flow?

For a cash flow of $100 to be received one year from now, will the discounted present value be higher if the interest rate is 5 percent or the interest rate is 10 percent? In general, what effect does a higher interest rate (sometimes called the discount rate) have on the value of a future cash flow?

Forward Interest Rates and the Yield Curve

If you check interest rates in the newspaper, you may find that the interest rate on a ten-year bond is 5 percent, while the interest rate on a one-year bond is only 3 percent. Financial pundits refer to the different interest rates for different time periods as the yield curve.

The yield curve consists of the immediate short-term interest rate as well as short-term interest rates that are expected in the future. The latter are called forward interest rates.

Here is an example of a simple two-year yield curve, consisting of the current one-year rate and next year's forward rate. Suppose that the interest rate this year is 4 percent, and the forward rate is 6 percent. What is the discounted present value of $100 to be received two years from now?

To discount $100 back to one year from now, we take $100/ (1.06) = $94.34. To discount this back to the present, we take $94.34 and divide by 1.04, to obtain $90.71.

If the current one-year rate is 4 percent, the one-year forward rate is 6 percent, and the next year's forward rate is 5 percent, what is the present value of $100 to be received three years from now?

A ten-year bond pays a single interest rate for its entire term. This interest rate is something like the average of the current one-year rate and the forward rates for the following nine years. Technically, it is closer to a geometric weighted average than arithmetic weighted average.

On July 3, 2002, the interest rate on 10-year notes issued by the U.S. Treasury was 4.75 percent. The rate on two-year notes was 2.77 percent, and the rate on the three-month bill was 1.68 percent. Thus, interest rates were much higher on long-term bonds than on short-term bonds. We say that the yield curve was steeply upward-sloping. If long-term rates are only modestly higher than short-term rates, then we say that the yield curve is mildly upward-sloping (which is normal). When long-term rates are below short-term rates, we say that they yield curve is inverted.

For this course, you will not need to know anything about doing calculations involving the forward rate and the yield curve. For teaching purposes they make things unnecessarily complicated. However, for investors on Wall Street, the forward rate and the yield curve matter a lot. The real world, unfortunately, is complex.

Interest, Rent, and Capital Gains

Suppose that there are two identical condominiums, one of which is for rent with the other one for sale. Financially, will it be to your advantage to live in the rental or to buy the other condo?

We can think in terms of borrowing the money to buy the condo and then selling it after one year. Suppose that it costs $200,000 and that after one year we can sell it for $204,000. Houses suffer from wear and tear, like lawnmowers. However, unlike lawnmowers they tend to increase in value. This is because of general inflation as well the fact that land is scarce

and tends to become more valuable over time. An increase in the value of an asset is called a capital gain.

If the interest rate is 6 percent, then our cost will be $200,000 (1.06) - $204,000 = $8000. If instead we paid $8000 in rent, that would work out to a rent of $666.67 per month. Therefore, if the rental is for $700 per month, then it would be better to buy the condo. If the rental is $600 a month, we would be better off living in the rental. (To keep things from getting too complicated, I am leaving out some factors that matter in the real world, including taxes and the closing costs involved in buying and selling a home.)

We could arrive at the same rent by looking at the condo from the perspective of an investor. Suppose that we are thinking of buying the condo and renting it out to someone else. If we can rent the condo for more than $8000 per year, then we can make a profit by buying it for $200,000. Otherwise, we cannot.

Recall the formula that we use for the profitability of owning a capital asset:

Profitability = rental rate + appreciation - interest rate

The general relationship between interest, rental income, and capital gains is

Using I to stand for the interest rate, r to stand for the rental rate (the ratio of rent to price) and p to stand for the rate of capital gain (the average annual rate of appreciation), we have

Profitability = r + p - i

In our example, the ratio of rent to price, r is $8000/$200,000 = .04, the interest rate, i is .06, and, the rate of capital gain, p is $204,000/$200,000 = .02. Thus, we have

Profitability = .04 + .02 - .06 = 0

When profitability is zero, we are indifferent between owning and renting. There is a tendency for the price of an asset to adjust up or down so that owning and renting provide equivalent net benefits. In terms of our formula, there is a tendency for profitability to be zero. If profitability were clearly positive, people would bid up the price of the asset, which causes the ratio of rent to price (the rental rate) to go down, which brings profitability back toward zero. The opposite would happen if profitability were clearly negative.

Common Stock and the Price/Earnings Ratio

The basic relationship between the interest rate, the rental rate, and the capital gains rate that holds for a condo also holds for other capital assets. For example, for Josh's lawn mowing business, the "rent" that he derives from an additional lawnmower is equal to the value that he gets from the increase in lawns mowed. The capital gain (in this case a loss) on the lawnmower is equal to its rate of depreciation.

If you buy shares of stock, the regular income that you receive in lieu of rent consists of dividends. The ratio of a stock's dividends to its price can be used as r in the basic equation relating i, r, and p. For example, on Wednesday, July 3, 2002, the stock of Freddie Mac

closed at $59.30 a share. It paid a dividend of $.88 per share, for a dividend rate or r of .0148, or 1.48 percent. If investors were using the interest rate on the 10-year Treasury note as a benchmark for pricing Freddie Mac stock, then we would set i = 4.75 percent.

That means that the expected rate of capital gain on Freddie Mac stock, p would have to equal 4.75 - 1.48 = 3.27 percent.

A stock does not have to pay dividends in order to be valuable. If the company is profitable, it brings in more in revenue than in expenses. These profits are called earnings. If a company does not distribute earnings as dividends, it can use them in other ways to enhance shareholder value. For example, a company can go into the market and buy back its own shares, increasing the demand for the stock and raising its price.

Some companies pay relatively high dividends, and others pay relatively low dividends. However, if their earnings are similar, investors would see the stocks as having similar value. Therefore, many investors prefer to use the ratio of earnings per share in place of the ratio of dividends per share. Thus, earnings per share become r and the overall rate of inflation becomes p in the basic equation. Economist Edward Yardeni calls this the "Fed model," because he believes that the Federal Reserve Board uses this equation to determine whether the stock market as a whole is overvalued, undervalued, or valued correctly.

[Fed model] 10-year interest rate = earnings/price ratio + inflation

On July 3, 2002, the ten-year note rate was 4.75 percent, and overall inflation appeared to be around 1 or 2 percent. Using 1.5 percent inflation, the earnings/price ratio should be:

4.75 - 1.50 = 3.25 percent

In the newspaper, what gets reported is the inverse of the ratio of earnings to price. That is, the financial press reports the ratio of price to earnings (P/E). Therefore, if the Fed model tells us that on July 3 the earnings/price ratio should have been 3.25 percent, or .0325, then the P/E ratio should have been the inverse of that, or 1/.0325, which are about 30. In fact, the market P/E ratio was slightly below 30, so that on July 3, 2002; the Fed model suggested that stocks were undervalued.

The P/E ratios for individual stocks can be all over the map. For example, on July 3, the P/E for Freddie Mac was just 9. For Coca-cola, the P/E ratio was 47. When a P/E ratio is low, that is because investors do not expect earnings to grow as fast as the overall economy. When a P/E ratio is high, investors think that earnings for the company can grow faster than the economy as a whole. For this reason, stocks with high P/E ratios are called "growth stocks" and stocks with low P/E ratios are called "value stocks."

15. Personal Finance:

The economics of finance can be used to analyze some common personal financial issues. Most of these issues will not affect you until you are older, at which point it will help to be able to remember the economic perspective.

Compound Interest

Suppose that you are 30 years old, with a family income of $50,000 a year. If you save $3000 a year, how much will you have after 35 years? The principal alone, without earning interest, will be 35 times $3000, or just $105,000. However, if you invest the money and earn a real annual return of 4 percent, at the end of 35 years you will have $221,000. The difference between $221,000 and $105,000 is the power of compound interest.

Below is a table that shows part of this calculation

Year savings interest on last year's balance this year's balance

1 $3000 -- $3000

2 $3000 $120 $6120

3 $3000 $245 $9365

4 $3000 $374 $12,739

...33 $3000 $7524 $198,629

34 $3000 $7945 $209,574

35 $3000 $8383 $220,957

In the real world, inflation tends to distort this sort of calculation. Because of inflation, you might be able to earn a return of 7 percent, ending up with a balance of over $400,000. Moreover, if inflation is, say, 3 percent per year, then you should be able to save more than $3000 a year in later years. In fact, your savings should go up by 3 percent per year, which will further increase your final balance. However, if inflation is 3 percent per year, that means that the cost of living after 35 years will be almost triple what it is today. Overall, a world in which the nominal interest rate is 7 percent and inflation is 3 percent is like one in which the nominal interest rate is 4 percent and inflation is zero.

The point to appreciate about compound interest is that over a long period of time a relatively small annual rate of savings can add up. On the other hand, living beyond your means and going into debt means that compound interest works against you. Adding a little more debt each year can lead you into a very deep hole. The compounding effect is even stronger, because interest rates for consumers tend to be high (over 10 percent on many credit cards). If you do not pay your full credit card balance every month, you end up fighting a very strong current of compound interest flowing against you.

Buying a Home

Our general formula for the profitability of buying a home is based on a comparison of the purchase price to the rent on an equivalent home. The formula is

profitability = rental rate + appreciation - interest rate

For example, if a house costs $150,000 and it could be rented for $6,000 a year, then the rental rate is $6,000/$150,000 = .04 or 4 percent. If it appreciates at a rate of 4 percent per year and the interest rate is 7 percent, then the profitability is 4+4-7=1 percent, which means that it is profitable to buy the house rather than rent.

A major complicating factor with buying a house is that it costs a lot to buy and sell. Real estate sales commissions are around 6 percent. There are also a number of fees charged by lenders, title insurance companies, and other service providers. Finally, the local government often collects transfer taxes and fees for recording the transaction.

The costs of buying and selling a home affect the home-buying decision in many ways. Basically, the sooner you have to sell a house, the less likely it is to be profitable to buy rather than to rent.

If you are likely to be moving soon because of a job change or a change in family status, it can be unwise to buy a house. When you are starting a family, it may be better to buy a house with an extra bedroom now, rather than buy one house this year and another in two years when you have more children.

Because profitability depends so much on home price appreciation, one does not want to buy a house when prices are too high. In an efficient market, there should be no way of telling when prices are out of line. However, house prices sometimes seem to reach irrational levels for short periods of time in specific markets. A sign that prices are too high is when the ratio of annual rent to purchase price is unusually low, say less than 2 percent.

The riskiest properties to own are condominiums. Condos tend to be the shock absorbers of the housing market. When demand is high, condo prices soar. When demand falls off, condo prices drop the most.

Most young people do not have enough cash to buy a home. Therefore, you typically have to borrow most of the money to buy a house. The money that you borrow is called a mortgage loan. If you default on a mortgage loan, the lender can take possession of your house. We say that the house is collateral for the mortgage loan. The collateral reduces the lender's risk, so that a mortgage loan costs you less than any other loan that you might obtain.

A typical mortgage loan has a 30-year term, with payments made monthly. The monthly payment is designed to gradually reduce the mortgage balance to zero, just as an annuity payment is designed to gradually exhaust savings. In fact, the formula for calculating a mortgage payment is pretty much the same as the formula for an annuity. The main difference is that the mortgage payment is monthly, so that the interest rate has to be converted to a monthly rate.

Most mortgages are paid off before the 30 year term expires.

Often, people move and sell their homes, at which point the proceeds from the sale are used to pay the mortgage.

Sometimes, people refinance their mortgages. If you took out a mortgage loan at 8 percent, and rates happen to drop to 6.5 percent, you will take out a new loan at 6.5 percent to pay off the old loan. Even if rates do not fall, some people refinance in order to take out a larger loan.

As a family's financial position improves, they find it advantageous to pay off the mortgage loan early

The reason that the thirty-year term is popular is that by stretching out the payments over that period the monthly payments are kept low. However, if you are likely to pay off a mortgage loan in ten years or less, it makes sense to take an adjustable-rate mortgage, where the interest rate can change after 3 years or 5 years. These loans carry lower interest rates than the standard thirty-year fixed rate, but the rate can increase. If you were keeping the loan for ten years or more, the rate increase could be a big issue. However, few people keep their mortgage loans that long.

When you have a mortgage loan on your residence, you can deduct the interest expense from your income. You will hear it said that a mortgage loan is a great tax deduction, and some financial advice gurus even recommend taking out the largest mortgage loan that you can. This is flawed advice, for several reasons.

1. The deductibility of home mortgage interest does not mean that taking out a mortgage loan puts money in your pocket. At best, it reduces the cost of the loan. If your mortgage rate is 7 percent, then on an after-tax basis it might be closer to 5 percent.

2. The tax deduction has many limitations and restrictions. For many people, a mortgage ends up making only a small difference in tax liability.

3. If you take out a larger mortgage than you need, then that gives you money to invest. When you invest that money, you earn taxable income. The taxes on that income tend to cancel out the tax savings from the larger mortgage.

Taxes, IRA's, and 401(K) plans

Income taxes do affect personal financial decisions. Other things equal, an investment with tax-exempt income is better than an investment where the income may be taxed. When the income is tax exempt, your savings accumulate more effectively.

The best investment vehicles go even further to save on taxes, because the the money you put into the accounts is tax deductible. If you earn $50,000 and put $2000 into an Individual Retirement Account (IRA), you can deduct the $2,000 from your taxable income as well as accumulate investment earnings tax-free until you retire. Thus, it pays to put money in an IRA.

Similarly, there are employer-sponsored retirement savings plans, called 401(K) plans, because the provision in the tax code is called 401(K). Like IRA's, they allow you to take an income tax deduction for your savings. In addition, many companies have matching programs, where they will kick in additional money in proportion to what you save.

There is almost no valid reason not to take maximum advantage of 401(k) plans and IRA's. Because of the tax advantages, these are the best savings vehicles.

Indexing

People who want to get the best returns over a long period should put some of their investment portfolio in the stock market. Your stock market portfolio should be in mutual funds that replicate the performance of a major stock index. This approach is known as indexing.

Inside a tax-exempt account, such as an IRA, regular mutual funds, called index funds, provide excellent diversification at low cost. However, regular mutual funds are required to distribute income each year, which has tax consequences. A new instrument, known as exchange-trade mutual funds, allows you to defer taxes until you sell your shares in the funds. An exchange-traded index fund is the best investment vehicle when you are putting savings into a taxab

16. Efficiency, Supply and Demand, and Market Clearing:

The optimizing behavior of producers and consumers leads to a resource allocation that is efficient, in the sense that no one could be made better off without making someone else worse off. Here is a summary of the complete set of problems solved by decentralized markets.

1. How do we know that goods and services could not be better allocated between consumers? That is, how do we know that a consumer could not find another consumer and make a trade that would make them both better off?

For this efficiency condition to be met, the marginal rate of substitution between any two goods must be the same for all consumers. Otherwise, there are welfare-enhancing trades to be made. For example, suppose that at the margin you think that one apple is worth three scoops of ice cream, and I think that one apple is worth one scoop of ice cream. In that case, if I were to trade you one apple for two scoops of ice cream, both of us would be better off.

Decentralized markets can achieve the efficient allocation because consumers set their marginal rates of substitution equal to relative prices. All consumers face the same set of prices. Each consumer sets marginal utility equal to price. Therefore, for any two goods, the ratios of the marginal utilities will be the same for all consumers. That is, the marginal rate of substitution will be the same for all consumers.

2. How do we know that firms are producing the optimal mix of output? That is, how do we know that a firm could not make the economy better off by producing less of one output and more of another output?

For this efficiency condition to be met, the marginal rate of transformation in production must be equal to the marginal rate of substitution in consumption. Suppose that the marginal rate of substitution in consumption is that one apple is worth two scoops of ice cream. In that case, if it were possible to shift production around to increase ice cream production by three while reducing apple production by only one, then that would be more efficient.

Decentralized markets can achieve equality between the marginal rate of transformation and the marginal rate of substitution because firms set the marginal rate of transformation between two goods equal to the relative price. All firms face the same set of prices. Each firm sets the marginal rate of product transformation equal to the relative price of the two outputs. Since the ratio of the relative prices is also the ratio of the marginal utilities, the rate of product transformation is the same as the ratio of the marginal utilities. This says that there is no gain in utility to be had from producing more of one output and less than another.

3. How do we know that the choice of inputs is efficient? That is, how do we know that the economy could not produce more output by changing the mix of inputs used in different products?

This efficiency condition states that the economy must use the lowest-cost production methods. If a firm can substitute $4 of one input for $5 of another input and produce the same total output, then that is a more efficient production technique.

Decentralized markets can achieve efficiency in production by having firms equate the marginal rate of substation between inputs to the relative prices of those inputs. All firms face the same prices for inputs, including wage rates. Firms set the marginal rate of substitution between inputs equal to their relative prices. That means that it is impossible to switch around inputs in order to produce the same output at lower cost.

4. How do we know that firms use the right level of inputs, not too much and not too little?

This efficiency condition states that one firm does not use inputs that could be used more efficiently by another firm. If shifting some inputs from my company to your company would yield more valuable output, then the current allocation is not efficient.

Decentralized markets achieve an efficient allocation of inputs across firms by the process of profit maximization, in which firms add input right up to the point where price equals marginal cost. All firms face the same prices for inputs and outputs. Each firm supplies output until the point where the marginal cost of producing the next unit is equal to its price. To produce less output would mean passing up an opportunity to have higher profits and to increase overall well-being. To produce more output would mean incurring a loss at the margin, and also would mean that the marginal cost to society is greater than the additional output's value.

Supply and Demand

Prices play a central role in the efficiency story. Producers and consumers rely on prices as signals of the cost of making substitution decisions at the margin. How are prices determined?

Economic theory says that the price of something will tend toward a point where the quantity demanded is equal to the quantity supplied. This price is known as the market-clearing price, because it "clears away" any excess supply or excess demand.

Market clearing is based on the famous law of supply and demand. As the price of a good goes up, consumers demand less of it and more supply enters the market. If the price is too high, the supply will be greater than demand, and producers will be stuck with the excess. Conversely, as the price of a good goes down, consumers demand more of it and less supply enters the market. If the price is too low, demand will exceed supply, and some consumers will be unable to obtain as much as they would like at that price--we say that supply is rationed.

Here is an example to illustrate the law of supply and demand. For a particular Saturday night, we look at the willingness of restaurants in Wheaton to supply a nice dinner for two and the willingness of couples to dine out in Wheaton, depending on the price of the dinner.

There are five restaurants, each with a seating capacity of 30 couples. One restaurant is willing to supply a nice dinner for $15 a couple, but the others require higher prices. If the price were $15, everyone would show up at the one restaurant, so that it would have a very long line. Only 30 lucky couples would get to eat.

There are 250 couples willing to go out for dinner, if the price were as low as $12 a couple. Twenty couples would be willing to pay as much as $80, but everyone else requires lower prices. Here is the whole picture.

Price of a Dinner for Two

Supply offered by restaurants Demand from consumers

$12 0 250$15 30 200$25 60 140$35 60 60$45 90 50$65 120 40$80 150 20

17. Who Sets the Market-clearing Price?

In economics, we say that the market-clearing price is set by the impersonal forces of supply and demand. That is because the law of supply and demand always operates, even though markets have different institutional structures.

For an example of a market where a single individual sets the price, consider the market on the New York Stock Exchange for shares of Freddie Mac stock. The individual who sets the price of Freddie Mac stock is called a specialist. All of the orders to buy and sell Freddie Mac stock are delivered to the specialist, who decides which price will best balance supply and demand.

At any moment when the exchange is open, the specialist will have a list of orders to buy and sell at a particular price. There might be an order that says, "Sell 1000 shares if the price reaches 60-1/2." The seller will not accept a lower price, but will accept a price of 60-1/2 or higher. This type of order is called a limit order. There might be another order that says, "Sell 800 shares if the price reaches 60-3/4." There might be another other that says, "Buy 800 shares if the price falls to 59-1/2."

All together, the outstanding orders to buy or sell at specific price limits make up what is called the limit order book for the specialist. In addition to limit orders, there are "market orders." A market order is an order to buy or sell a specific quantity of stock at the market price--whatever that happens to be.

The specialist moves the price of Freddie Mac stock up and down, depending on the pressure that she gets from market orders. For example, if the specialist gets a large market order to buy Freddie Mac stock, she has to figure out how high to set the price in order to trigger enough limit-order sales to fulfill the market order. That price becomes the new market price for Freddie Mac stock.

In most goods markets, sellers set the price. However, that does not mean that sellers control the price. For example, in the market for gasoline, individual service stations set the price. If most stations charge $1.50 a gallon for regular unleaded gasoline, then a station that charges $1.75 a gallon will not get much business and a station that charges $1.25 a gallon will get plenty of business but probably lose money. The individual gas station does not have control over the impersonal market forces that determine the equilibrium price for gasoline.

If every station charges $1.75 and consumers cut back on gasoline purchases as a result, then every station will find itself with a little bit of excess capacity. One station will try to cut the price to $1.70 in order to sell more gasoline. This reduces demand at the other stations, so then another station will try to reduce its excess capacity, by cutting its price to, say, $1.65 per gallon. This will cause other stations to have more excess capacity, so that they will reduce their prices. The process will continue until the price reaches $1.50 (assuming that is where supply and demand are in balance).

Disturbance Example Effect on Equilibrium Price

Effect on Equilibrium Quantity Transacted

Favorable Supply Disturbance

Meat and wine wholesalers drop their prices for supplying restaurants

falls rises

Unfavorable Supply Disturbance

A fire burns down a restaurant rises falls

Positive Demand Disturbance

A bunch of people from out of town come to spend the weekend in Wheaton

rises rises

Negative Demand Disturbance

Many Wheaton residents lose their jobs because a local employer shuts down

falls falls

In the labor market, workers are the source of supply and producers are the source of demand. In this case, it is the buyers (producers) who typically set the price, which is called the wage rate. If the wage rate a company sets is too high, it will overpay its workers and lose money. If it sets a wage that is too low, it will lose workers to competing firms. Eventually, the wage rate will be driven to the level that balances supply and demand.

Equilibrium and Disturbances

When the price is just right, so that there is no excess supply or demand, we say that the market is in equilibrium. However, events are always happening that cause changes to the equilibrium. We call these events disturbances. For example, suppose that a fire burns down one of the low-price restaurants in Wheaton. This is a negative supply disturbance. If the other low-priced restaurant keeps its price at $35 a meal, it will find that 60 customers are more than it can handle. So they will raise their prices, which will reduce the total demand for

restaurant meals. The new equilibrium price might be $45, the same as the price set by a higher-price restaurant. At this price, 50 couples will dine out; with 25 going to each restaurant that charges that price.

In general, there are four types of supply and demand disturbances, and their impact is summarized below. We use the example of the market for restaurant meals in Wheaton.

Come up with two more examples each of a favorable supply disturbance, an unfavorable supply disturbance, a positive demand disturbance, and a negative demand disturbance.

Short Run and Long Run

In the past, oil producing countries occasionally have engineered supply disruptions. In the short run, this tends to cause a spike in prices of oil products, such as gasoline. In the long run, the prices of oil products tend to settle down.

This is a common pattern with disturbances. In the short run, prices move by a lot. In the long run, new supply comes in and demand diminishes.

For example, in the oil market, in the short run people do not change their driving habits much in response to an increase in gasoline prices. In the long run, they may drive less and switch to more fuel-efficient cars. In the short run, competing suppliers cannot increase production much in response to an increase in price. In the long run, oil exploration rises when prices are higher; this helps to bring on more supply.

The elasticity of demand is the percentage decrease in demand in response to a one percent increase in price. The elasticity of supply is the percentage increase in supply in response to a one percent increase in price. The elasticity’s of supply and demand usually are higher in the long run than in the short run.

There are more substitution possibilities in the long run than in the short run. When elasticity is high, market disturbances tend to affect prices relatively little and quantities transacted relatively a lot.

The elasticity of supply in an industry will be very large if there is no important resource that is fixed. For example, in the lawn mowing business, it is easy for new firms to get started, and it is easy to add new capital and labor to the industry. It is also easy for people to get out of the business if demand drops off. Overall, we would expect the elasticity of supply to be very high, so that we could have a large increase in the demand for lawn mowing service without having a large impact on price.

When the computer language Java first was released in 1996, many companies wanted to try using Java in Web applications. The elasticity of supply was low--no matter how much you were willing to pay for a Java programmer, there were few professionals with experience in the new language. The elasticity of demand also was low, in that companies that wanted to develop in Java were reluctant to substitute alternative languages.

In the short run, with these low elasticity’s, the wages for Java programmers shot up, to $200 an hour and more. In the long run, more people learned Java and some companies postponed

Java projects to save on expense. Eventually, the wage rate for Java programmers settled down to something more reasonable.

Suppose that before Java became an official language, the supply of Java programmers was given by

H = 10W where H is hours of labor and W is the wage rate, in dollars.

At this point, the demand for Java programmers was low. It was given by

H = 2,000 - 40W

Supply and demand were equal when W = $40 and H = 400.

Next, suppose that once Java was released officially, the demand for Java programmers shot up. The new demand for Java programmers in the short run was given by

H = 10,000 - 40W

Suppose that in the short run the supply of Java programmers was given by

H = 10W

Setting supply equal to demand, we have

10,000 - 40W = 10W

Solving for W gives a value of $200 for equilibrium wage rate. This means that H is 2000, so that the equilibrium quantity is 2000 hours of Java programming.

Next, however, suppose that the long-run elasticity of supply were higher, so that we have

H = 160W

In the long run, programmers who are earning $40 an hour using other languages will obtain training in Java. In the short run, not enough programmers have this training. In the short-run supply schedule, each $1 increase in wages only increased hours supplied by 10. In the long-run supply schedule, each $1 increase in wages increases hours supplied by 160. This means a much higher elasticity of supply.

Situation Equilibrium Wage Equilibrium Hours

Prior to Disturbance $40 400

Short Run After Disturbance $200 2000

Long Run After Disturbance $50 8000

Now, when we solve for W we get $50 for the equilibrium wage rate. The hours of Java programming are now 8000. We can summarize the results as follows:

Overall, this example illustrates that in the short run, when the elasticity’s of demand and supplies are low, a disturbance tends to have a large impact on price and a small impact on quantity. In the long run, when elasticity’s are higher, the disturbance has a lower impact on price and a larger impact on quantity.

18. Some Economic Issues Surrounding PopulationChange (by Don McRae 1) SUMMARYThis paper examines the economic implications of two aspects of population change in British Columbia; population growth and population aging. Five issues relating to population change and the economy are raised. These are:

Is population growth necessary in order to ensure economic well-being?Can we afford an aging population?Is retirement feasible as an industry in B.C.?Can we control population change?Regional implications of population growth.

Based on research carried out at the national level there is very little evidence to suggest that population growth is a major factor in determining economic wellbeing in an open economy. It is not so much population size that influences per capita output, but rather how that resource is utilized, or, in effect, the productivity of the population.

On the question of our ability to afford the increasing social expenditures associated with an aging population, previous research suggests that the answer is positive as long as economic growth continues at a pace equivalent to that of the past. The concern then becomes whether we can sustain the historical levels of economic growth given our dependence on natural resource extraction for that growth and the current concerns regarding resource depletion.

On the question of the economic benefits of promoting retirement as an industry in British Columbia, previous research has indicated that the costs, primarily resulting from additional health care expenditures, exceed the benefits gained through increased consumption, investment and tax revenues. Hence, from a provincial perspective, promoting retirement in British Columbia is not advisable as a policy.

On the question of whether we can control population change, the simple answer is not effectively. We have little control over the factors that contribute to population growth and aging at the provincial level. Hence, our best option may the views expressed in this paper are those of the author and not necessarily those of the Government of British Columbia.

Be to understand what demographic changes are likely to occur and prepare for the possible consequences of those changes. Finally, population change in this province will not occur equally in all regions. Some regions within the province will gain population and grow older and some will not. As a result, the significance of the economic issues raised in this paper will vary from region to region.

I. INTRODUCTIONPopulation change both affects, and is affected by, economic conditions in this province. There are a number of demographic and social changes that are occurring today that will affect the economy. Such things as population growth, the aging of the population, the changing role of women in the labor force, the changing family structure, are just a few of the demographic shifts occurring today. Of these changes, an overview of the economic impacts of the first two, population growth and the aging of the population, will be examined here.

II. DEMOGRAPHIC OVERVIEWPopulation GrowthTwo components will drive population growth in British Columbia over the next 30 years. The first component, called natural increase, is the excess of births over deaths. The second component is migration, which can be broken down further into international and interprovincial migration flows. Over the past 30 years approximately 36 per cent of the population gain in this province was due to natural increase, while net migration accounted for 64 per cent. Over the next 30 years, natural increase will form an ever smaller proportion of the overall population growth (approximately 23 per cent). Hence, migration will become more and more important as the engine that drives population growth in British Columbia.

The reason for this change in the source of population growth is twofold. First, the current fertility rate of the provincial population is below the level that will replace the population.2 the continuation of this situation will result in a continual decline in the level of natural increase, eventually turning negative as the number of deaths exceeds the number of births.The second factor is that international migration to British Columbia over the next 30 years is expected to be more than double that of the past 30 years. This is due largely to the expectation that government policy will continue to follow the relatively high immigration intake levels introduced in the late 1980's.

Population AgingWhile the population of this province is growing, it is also aging. In a demographic sense, aging means that higher proportions of the future population will be in the older age groups. This aging of the population is caused by a long-term historical decline in the fertility of the population. The rapid increase in the birth rate that occurred between 1947 and 1966, commonly referred to as the baby-boom, helped delay the onset of the full effect of this aging of the population. As members of the baby-boom generation begin to reach age 65 by 2011, the aging process will accelerate. As seen in Figure 2, in the 15 to 20 years 2 In order to sustain the current population level in the absence of migration, a Total Fertility Rate of 2.1

births per woman between the ages of 15 to 49 is required. The current Total Fertility Rate in British Columbia is 1.7 births per woman between the ages of 15 to 49. Following that date the number and proportion of seniors will increase dramatically.

British Columbia is not unique in this demographic trend. Figure 2 depicts the shape demographic future for the rest of Canada as well as for many western countries, including the United States, Australia and New Zealand. Currently, the proportion of the provincial population that is over the age of 65 is slightly higher than that of the rest of Canada, but less than that of Great Britain, France,West Germany, Sweden and Italy.

At present, approximately 13 per cent of the population of British Columbia is over the age of 65. This proportion will increase to 18 per cent by the year 2021, and finally stabilize at approximately 23 per cent by 2036.One of the factors that helps slow this aging process is the migration of people to the province. On average, more people under the age of 65 move to this province than people over 65. Since 1961, only about seven per cent of the net movement of people into British Columbia was of persons over the age of 65. Hence, during times of high net inflows of population, as is the case currently, population aging is slowed. However, during times of net outflows of population, population aging is accelerated. In the absence of migration, the proportion of the population over the age of 65 would reach 22 per cent by the year 2021 and stabilize at about 28 per cent by 2031.

III. ISSUES TO BE ADDRESSED:The following are some of the issues related to population change and the economy. This list is by no means exhaustive. Some of these issues have been studied extensively at the national level. Where national data exists, it needs to be determined whether the results are applicable to the demographic and economic conditions in British Columbia.1. Do We Need Population Growth in order to Ensure Economic Well-being?In April of 1986, the federal government commissioned a study called the

Review of Demography and its Implications for Economic and Social Policy.

This study examined possible changes in the future size, structure and distribution of the population of Canada. In 1989, the findings of this commission were summarized in a report entitled Charting Canada's Future [Health and Welfare Canada 1989]. One of the conclusions of this report was:

"The consensus among those economists who have considered the question is that, within broad limits, population growth or sheer numbers of people is not a major factor in economic growth or economic well-being in modern economies that play an active role in world trade" [Health and Welfare Canada 1989, p. 9].

Both British Columbia and Canada can be characterized as possessing such economies. The importance of trade to the provincial and national economies is reflected in the fact that currently, exports from approximately 30 per cent of theSome Economic Issues Surrounding Population ChangeTotal economic output of the province (GDP), and roughly 23 per cent forCanada. Figure 5 illustrates that, similar to other countries such as New Zealand and South Korea, economic prosperity in British Columbia depends heavily uneconomic conditions in our major export markets.

Dependency on ExportsA McMaster University study by Frank Denton, Christine Feaver and Byron Spencer found similar results using a model called MEDS that was specifically developed to simulate the Canadian economic-demographic system [Denton et al.1989]. Their research indicated that when using two measures of economic wellbeing— income per person, and income per household—little difference could be detected whether the Canadian population in the year 2036 was 27 million, 30 million, 34 million, or 41 million. Finally, a 1991 report by the Economic Council of Canada studied the economic effects of Canadian population growth as a result of immigration and concluded that Canadian per capita income would be increased only marginally if population growth was higher [Economic Council of Canada 1991a] . The Economic Council report goes on to note that even though our per capita standard of living would not be affected significantly by population growth, our world position in terms of economic size might be. Under a no-immigration scenario, over the next 50 years, Canada would remain a small economic power in relation to the United States and the larger nations of Europe. A high growth scenario (i.e. immigration of approximately 300,000 per year) would imply a medium-power status for Canada by today's standards.

The Economic Council noted that in order to examine the link between per capita income and population growth consideration must be given to the effects of economies of scale in production. It can be argued that as the population grows from zero, output per person increases due to such factors as specialization, reduced transportation costs, reduced per capita costs for government services, etc. However, at some point congestion will result and per capita output will diminish as a result of stress on the land base or difficulties associated with operating large bureaucracies. The Economic Council report examined this issue of economies of scale, and estimated that these scale effects were very small. If these same general conclusions are applicable to a smaller economy and population such as that of British Columbia, we can expect that the only tangible economic benefit of population growth is the economic and political power within Canada that a larger population base will bring.4 This may mean simply a larger influence in federal politics and the economic benefits of such a position.Despite this benefit, it will take some time before the population of this province would approach that of Ontario or Quebec. Currently, British Columbia represents about 12 per cent of the Canadian population while Ontario is 37 percent and Quebec is 25 per cent. Under

reasonable population growth assumptions, by the year 2051 British Columbia will still only represent 16 percent of the Canadian population.

2. Can we afford an Aging Population?Another issue that arises when considering population growth, or the lack of such growth, is whether we can afford the increasing social costs and growing tax burdens, associated with an aging population. The proportion of the population that is over the age of 65 will increase from 13 per cent currently to 23 per cent by 2036. This aging process will increase expenditures on social services such as health care due to the much higher rate of health care utilization by the elderly. The Economic Council estimated that due to scale effects, per capita income would increase only 0.1 to 0.3 per cent per million population increase given a Canadian population of 27 million [Economic Council of Canada 1991a, p. 31].On the other hand, as we will see later in this report, population change will not occur equally in all regions of the province. Migration, and the consequent population growth, will likely be funneled into a few specific areas within B.C. If one were to consider the scale effects argument, it may be true that on a regional level, a doubling in the population of a particular community could have a significant impact on regional per capita incomes.

This issue was examined by Statistics Canada in the October 1988 issue of The Canadian Economic Observer [Fellini 1988]. The report, written by Ivan Felling the Chief Statistician of Canada, addressed the question of affordability at the national level. It was concluded that the expected growth rates in government expenditures on health, education and pensions which are attributable to an aging population will be comparable to the economic growth rates observed over the past 30 years. Therefore, should long term economic growth in Canada continue as it has over the past 30 years, and per capita social expenditures increase at predicted rates, then public spending in health, education and pensions would, in 50 years time, represent the same burden on the Canadian economy as it does at present? A similar conclusion was reached by a study examining the issue of affordability of social programs in British Columbia [McRae and Schrier, 1992]. As a result of these studies we can conclude that it is not so much demographic change that will affect the affordability of social programs in the future, but rather economic change. If economic growth in British Columbia continues at past levels over the long term, then with careful stewardship of public sector expenditures we may well be able to afford an aging population. The question is whether we can sustain the current level of economic growth given our dependence on natural resource extraction for that growth and the current concerns regarding resource depletion. It can be argued that the present burden is not sustainable given federal government deficits averaging more than $30 billion per year over the past ten years.

3. Retirement as an Industry in B.C.Given the aging of the population in British Columbia and in Canada, is retirement a feasible industry for this province? It is certainly true that retirement supports the economic base of a number of communities in this province. Should attempts be made to expand this economic dependency on retirement to other communities? The simple answer to this question is "no". When this issue is studied from a provincial perspective, it was concluded that the increased health care costs associated with older populations out-weigh any economic benefits from increased consumption or tax revenues on the part of older migrants to this province [Central Statistics Bureau 1987]. Previous research has indicated that the minimum income at which a 65 year old in-migrant to this province would yield a net benefit is approximately $53,000 per year for the remaining years of his or her life. In 1992, only 3 per cent of Canadian seniors had an annual income greater than $50,000. In the case of internal migration within British Columbia, different results would be obtained. Since there is no net increase in health care costs associated with internal migration, the creation of a retirement industry would likely add to the economic base of a community, and thus provide stability. However, this economic gain could be at the expense of some other community in British Columbia. In addition, actively promoting retirement communities in British Columbia would attract population from both within and outside the province. As a result, there would likely be a net cost to the province overall.

4. Control of Population ChangeFor the most part, we in British Columbia have little control over the factors that contribute to population growth and population aging. Policies intended to increase the birth rate, and hence population growth, have had some success in some European countries such as France and Sweden, but these policies have tended to be expensive. Currently, immigration policy in Canada is almost exclusively the domain of the federal government with limited input from the province as to the level of immigration. Finally, interprovincial migration to and from British Columbia is not easily controlled. People move to this province as a result of a wide variety of economic, demographic, social and political factors. British Columbia has the distinction of attracting migrants from the rest of Canada even during relatively poor economic times. On a local level we have slightly more control over where people settle through regional economic development policies, regional planning such as zoning laws, and the development of transportation networks. It can be argued that, although6 See: Horne and Robson [1993].7 1992 dollars.

This approach may be successful in changing population growth patterns in selected areas; it may create other problems by driving up land prices which ultimately affect housing affordability for some segments of the population. Hence, we are caught in a dilemma. If we restrict the supply of land in certain areas in an attempt to redirect regional population growth, we provide a benefit to current land owners but harm future residents, whether they are migrants to an area or the local (young) population establishing new households. At the provincial level, we do not have a clearly defined population policy. Instead we have a series of provincial and regional economic policies that affect population. This is in part due to the fact that we cannot directly control population change. The most successful strategy may be to understand what demographic changes are likely to occur provincially and regionally and to prepare for, or in some cases attempt to influence, those changes.

5. Regional Implications of Population ChangeWe can expect the population of British Columbia to grow larger and to age over the next 30 years. However, these same demographic changes will not occur equally in all regions of the

province. There will be some areas that may not grow at all and some that will increase significantly. Similarly, some areas of the province will grow older quite rapidly while others will age more slowly. These differential rates of population change will result from the relative economic strengths of the various regions of the province. As has been the case in the past, regions with a diversified economic base will likely experience higher population growth in the future.

As demonstrated in Figure 7, there have been wide variations in regional growth patterns over the past fifteen years. During the late seventies and up to 1982, population growth in British Columbia was distributed relatively evenly throughout the province. However, during the 1980's, a dramatic change in regional population growth patterns emerged. During the mid eighties, only the major metropolitan areas of Vancouver and Victoria experienced healthy population growth in the two per cent range, while other traditional growth areas such as the Okanagan and eastern Vancouver Island recorded annual growth rates of less than one per cent. The remainder of the province, representing approximately 25 per cent of the population, experienced losses. Much of the regional population loss can be attributed to a restructuring in many of the resource-based industries throughout the province. This change is most evident in the forestry and mining industries, the economic driver for many of the smaller communities in British Columbia. As can be seen in Figure 8, the recession of 1982 resulted in a significant decline in direct employment in the forestry and mining industries, which resulted in erosion in the employment base in much of rural British Columbia. As production levels increased throughout the eighties, direct employment in these industries did not keep pace. The result was a general migration of population away from regions with a shrinking employment base, in favor of communities where employment prospects were more favorable. This coupled with the increasing importance of it. Since the early 1990's there has been a general return to a more even regional population growth pattern.

Since population growth has, and will likely continue to be, concentrated within a few areas of the province the economic costs and benefits of population change are very much regional issues. Due to the scale effects mentioned earlier, it may be true that on a local level, significant changes in per capita economic wellbeing are possible if the population of a community is doubled or cut in half.However, the data to support such claims are not easily obtainable. In addition, if we are to weigh the costs and benefits of population change some consideration must be given to the social and environmental aspects of community population growth or decline. As a result, given the lack of attention paid to the environmental and social aspects, the issues related to the economic impacts of population change raised by this report should only be considered as part of the overall story.