Knowledge that Transforms

The March 1975 issue of this Review contained a controversy over the welfare implications of tariff imposition, resulting from the analysis in Section III of a paper by Raveendra Batra (1973a). The issue was raised by Murray Kemp and Edward Tower. Although this controversy is very interesting, I do not propose to join it, but rather point out that the analysis used in Section II of Batra's paper is misleading. Under the assumptions of gross substitutes, dD3/dP2 > 0, and dX2/dP2 > 0 in his notation, he derives the result that an effect of a change in the terms of trade on social welfare mainly depends on factor-market distortions. My basic objection to his analysis is the treatment of d and X in his paper. He claims that the size of both d and X depend solely on factor market distortions, independent of the factor market orderings. This argument crucially relies on the hypothesis that changes in capital, dKi, and labor, dLi, due to a change in the terms of trade, have the same signs. For the case of Section I, the terms of trade are fixed, and theretore the capital-labor ratio does not change at all. However, as soon as the terms of trade are allowed to vary in Section II, it is no longer necessarily true that capital and labor will change in the same direction in any industry. I construct a simple example below for the home good industry to illustrate this point. Then using Figure 1, I show how a change in the terms of trade affects the capital-labor ratio in each industry as well as allocations of labor and capital to each industry. Suppose that the social welfare function is given by the following Bergson family type, 3

In a recent paper in this Review, Duncan MacRae and Elizabeth MacRae perceived an important aspect of the labor-supply effects of the payroll tax namely, that the effect is crucially dependent upon the individual response to a kinked budget constraint. However, their actual conclusions on the direction of the response need major qualification. In particular, they assumed that all responses would be marginal, when in fact the possibility of nonmarginal response is always present when non-linear budget constraints shift. This latter possibility makes the labor-supply response much more ambiguous. This is illustrated in Figure 1 (modeled after Figure 1 of MacRae and MacRae). The budget constraint before the imposition of the tax is A B, giving the utility maximizer a choice of any income-leisure combination along AB. After the imposition of the tax composed of a marginal tax rate on earnings up to a maximum level of earnings E-the (disposable income) budget constraint is BDC. (Yn is the amount of nonlabor income.) At point D, the taxable maximum is reached. MacRae and MacRae assumed that an individual initially located above the maximum level (say, point II) would relocate along CD, resulting in an increase in labor supply if leisure is a normal good (the income effect); and that an individual below the maximum level (say, point I2) would relocate along BD, resulting in a decrease in labor supply if the substitution effect dominates the income effect. However, although this would occur for marginal changes, nonmarginal changes are also possible: an individual initially at II could relocate along BD, reducing labor supply; and an individual initially at I2 could relocate along CD, increasing labor supply. Both are possible and not in conflict with any of the assumptions (that leisure is a normal good or that the substitution effect dominates the income effect). Heuristically, imagine a shift from AB to CH, causing the individual at I, to definitely move to CD; a subsequent of DH to DB could easily induce the person to relocate along DB. Or, imagine a shift from AB to BG, causing the individual at I2 to definitely move to DB (under the assumptions); a subsequent pivot of DG to DC could easily induce the person to relocate along DC. Thus, the possibility of nonmarginal movements introduces more ambiguity than realized before.' As a sidelight, note that the labor-supply effects of an increase in the taxable maximum and of an increase in the tax ratepolicy alternatives that are currently being considered to raise revenue are both ambiguous for the same reasons. Figure 2 shows an increase in the tax rate as causing a shift from BDC to BD'C'. Those initially below the maximum level may decrease labor supply (marginally) or increase it (nonmarginally), while those above the maximum level may increase labor supply (marginally) or decrease it (nonmarginally). Figure 3 shows an increase in the taxable earnings maximum from E to E' as causing a shift from BDC to BD'C'. Although there is no response by those below the maximum (by revealed preference), those above may either increase labor supply (marginally) or decrease it (nonmarginally). The latter effect is likely to be stronger for this group than

Dale Henderson and Thomas Sargent (hereafter H-S) and Y. C. Park have analyzed the effectiveness of monetary and fiscal policy in the two-sector analogue of James Tobin's dynamic aggregative model. Contrary to the assumptions of Tobin's model, fiscal policy can affect real income in the H-S model. However, the sign of the effect of fiscal policy on real income depends on a number of conditions relating to the parameters of the money demand function and the capital intensities in the two sectors. A somewhat more disturbing result is that the sign of the effect of fiscal policy changes as one changes, ceteris paribus, the assumption of which sector is the more capital intensive. The H-S results seem to imply that the analysis of the effectiveness of fiscal policy in the traditional ISLM analysis is very sensitive to the assumption of a one-sector production technology. It is important to realize, however, that the H-S model differs from IS-LM analysis in two ways. Besides assuming a two-sector production technology, the H-S model also assumes a perfect capital market, where the asset value of capital is always equal to reproduction cost. Sargent and Neil Wallace have analyzed a one-sector model with and without the perfect capital market assumption (without and with a disequilibrium investment demand function). They find that many of the strange results of Tobin's model are eliminated if there are costs of adjusting the capital stock. For example, if the costs of adjustment are large enough, expansionary monetary policy lowers the interest rate as in IS-LM analysis, contrary to Tobin's results. Also, the stability conditions of the model imply that with costs of adjusting the capital stock, fiscal policy affects income and interest rates in much the same way as in IS-LM analysis. This paper alters the H-S model to allow for an investment demand function based on costs of adjustment.' In analyzing the comparative static results of this model one can determine whether the strange results of the H-S model are due to the assumption of a two-sector production technology or the assumption of a perfect market in existing capital goods. The profit-maximizing subsystem in the H-S model can be solved to yield the price level and the marginal product of capital as functions of the relative price of investment (see the Appendix). A general equilibrium occurs when the consumption good, money,2 and investment good markets are in equilibrium.