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PROFESSOR: All right, so today
we are going to finish up our
discussion of consumer
theory and then move
on to producer theory.
That is, we're finishing up
what's behind the demand curve
and moving on to what's behind
the supply curve.
But before we do that, I want
to talk about an application
of why income and substitution
effects are important.
Income and substitution effects,
we talked about this
imaginary budget constraint.
It seems like sort of
a vague concept.
We talked last time about labor
supply and how you can
get some interestingly
different answers.
But I want to talk about an
application now, of why
understanding income and
substitution effects can
really help you understand
the world a bit better.
And the application I want to
talk about today is the case
of child labor in developing
countries.
Now this is a terrible
problem worldwide.
In developing countries in
particular, children are
pulled out of school to work.
They then don't develop the
skills that can allow them to
earn high wages later in life
and as a result, the cycle of
impoverishment continues in
these nations, where these
children in turn have low
wage jobs and make
their kids go to work.
And it's a major problem in
the developing world.
And we all know that one way
to help countries out of
poverty is to help them get
their kids to get education.
Education is the key to getting
out of poverty.
And you can't get education
if you're working.
I think that's a generally
recognized fact.
A more interesting,
controversial fact is well,
what does this imply
for the benefits or
cost of free trade?
We'll talk about free trade
later in the semester and
we'll come back to this, but
basically the idea is look, if
you have free trade, then poor
countries can sell more goods
to rich countries and that will
allow them to raise their
standard of living.
But many of you will point out
that that's contradictory with
our concern over child labor.
Which is if a poor country is
going to sell more goods to a
rich country, then maybe kids
in that country are going to
have to work harder to
make those goods.
And one concern people have
when they talk about free
trade agreements is essentially
we're dooming the
children of these impoverished
countries to work harder to
make the goods that rich
countries want.
And that if these impoverished
countries weren't engaging in
making all these textiles and
all the things these rich
countries want, maybe their
kids would be getting an
education instead.
So that's a concern that's been
raised about free trade,
but in fact, what we can
understand from understanding
income and substitution effects
is that, in fact, that
claim may not be true.
In fact, the effect
of free trade on
child labor is ambiguous.
And that's what I want to talk
through now, an application of
why understanding income and
substitution effects matter.
And there's a very interesting
study by two professors at
Dartmouth who studied the impact
of trade liberalization
in Vietnam.
Vietnam used to have a system
where they would not allow
domestic producers to
sell rice abroad.
Domestic rice producers had to
sell that rice only in Vietnam
and then they introduced free
trade provisions in Vietnam
which allowed them to sell
that rice abroad as well.
And one concern that was raised
is that would mean kids
in Vietnam would have to work
harder producing rice so it
could be sold around
the world.
Let's see whether
that was true.
Well, to think about that, let's
first think about it
theoretically.
So let's go to figure 8-1.
Figure 8-1 shows the demand for
rice, D sub V the demand
for rice in Vietnam, D sub W is
the demand for Vietnamese
rice worldwide.
D sub V is the Vietnamese demand
for Vietnamese rice, D
sub W is the world demand for
Vietnamese rice, and S sub V
is the supply of Vietnamese
rice.
And we assume demand curves are
downward sloping, supply
curves are upward sloping,
as usual.
So if there was a worldwide
market where Vietnamese rice
farmers could sell their rice
to the entire world, then
you'd have an equilibrium
price P sub W and an
equilibrium quantity
of Q sub W.
What happened was until 1989,
that was not the case.
Before 1989, the government
imposed a quota which said
that rice producers in Vietnam
could not sell effectively,
could not sell outside
Vietnam.
It wasn't quite that easy, but
you could think of it this
way, they could not sell
outside Vietnam.
Instead, they could only sell
the amount that Vietnamese
citizens demanded of rice, which
meant that they sold Qv
units of rice at a price, Pv.
So there was a government
imposition which said
effectively--
not quite, but effectively--
you can only sell rice in
Vietnam, so we're going to
sell Qv at a price, Pv.
So then what happened was
in the early 1990s, the
government weakened this quota
so that by 1997, there was no
longer a quota.
Rice farmers were allowed to
sell wherever they want.
So effectively, the country
moved from Qv, Pv to Qw, Pw.
Essentially, it expanded the
market for Vietnamese rice so
that they were able to sell a
larger quantity at a higher
price on the worldwide market.
And the difference between
Qv and Qw were exports.
So basically, the government
allowed them to export an
extra amount of rice, Qw minus
Qv, and allowed them to obtain
a higher price for their rice.
So we'll talk later about
whether this is a good idea or
a bad idea in general.
We'll talk about free trade and
get on to free trade later
in the semester.
Hint, we like free trade
as economists.
I think most of you probably
knew that, and we'll talk
about that later in
the semester.
But now I want to focus
specifically on one question,
which is what did this
do to child labor?
Well, if we go the
next figure, if
you look for a second--
forget the shifting
supply curves.
The market for child labor is
initially at equilibrium at a
supply of child labor of S1--
that is, the higher the wage,
the more the kids will work--
and demand for child
labor of D1--
that is, the higher the wage,
the less the demand there is
for child labor.
And we're in some initial
equilibrium where L1 kids work
at a wage, W1.
And let me highlight an
important thing about the
supply of labor of kids.
If the kids aren't working,
they're in school.
The notion is not if the kids
aren't working, they're
sitting at home.
If the kids aren't working,
they're in school.
So basically, the more kids are
working, the fewer kids
are in school.
So you have this supply, S1,
and this demand, D1.
So what free trade does is it
shifts out the demand for
child labor.
Because now you need to produce
more rice, you need
kids to produce it, so
it shifts out to D2.
It's not marked in this diagram,
but you would end up,
if you could see where D2
intersects with S1, you'd end
up with a lot more child
labor at a higher wage.
And that's the argument for
why free trade is bad for
child labor.
Because it increases demand for
child labor and therefore
increases the amount of child
labor that's used.
But what that argument misses is
the income effect, which is
that the rice farmers in
Vietnam are now richer.
And one thing they'll do with
their wealth is buy their kids
more education.
That is, think about the
utility function
of these rice farmers.
They don't want their
kids to work.
They understand that
their kids are
better off with education.
So what would happen if
they won the lottery?
What would happen if they won
the lottery is they'd use some
of that money to say
hey kids, you don't
have to work anymore.
You get to now go to school
instead and build yourselves a
brighter future.
Well, the higher price for rice
that exists through world
trade is like them winning
the lottery.
Suddenly, rice farmers are
richer because each unit they
produce is sold at
a higher price.
What are they going to do
with that higher wealth?
They're going to allow their
kids to work less.
They're going to say, we're
effectively richer because
we're now selling our rice
at a higher price.
As a caring parent who's richer,
I'm going to send my
kids to school instead
of having them work.
How do we manifest that
in this diagram?
As an inward shift in the
supply of child labor.
That is, children get pulled off
the market because their
parents now say, I'm going to
send them to school instead.
So the supply curve for child
labor shifts inwards.
Now, how much it shifts inwards
determines what
ultimately happens
to child labor.
If it shifts inwards a little
bit from S1 to S2, then child
labor on net still increases
from L1 to L2.
That is, the demand shift
exceeds the supply shift and
on net child labor increases.
That is, on net, free trade
does increase child labor.
But if supply shifts in a lot,
if parents are a lot richer
and send their kids to school
a lot, then actually the
supply of child labor could
fall from L1 to L3.
You could have less child labor,
even though the demand
for it's gone up.
And that's because of
income effects.
The importance of income effects
is that the families
are now richer, so they're
pulling their
kids out of the market.
And they're pulling their kids
out of the market in such
numbers that it exceeds the
excess demand for child labor.
So once again, we see the
power of income and
substitution effects.
We have the standard market
operation, which is g.
We want more rice, we need to
hire more kids to produce it.
But we're forgetting the income
effect, which is the
price of rice has gone up.
Farmers are now richer, they're
now going to send
their kids to school instead
of making them work in the
rice paddies.
OK?
So that is the importance of
understanding the subtle
argument that comes forth when
you think more completely
about income and substitution
effects and when you don't
stop and just say, gee,
more rice exported
means more child labor.
So the question is, which
of these is right?
OK?
Which of these is right?
How do we know whether free
trade increases or decreases
the demand for child labor?
Let me first stop and ask a
question about the theory.
People understand why an
increase in free trade can
either lead to more kids working
or less kids working.
Yeah?
AUDIENCE: I'm not sure how you
would sustain that increase in
demand for rice.
Because if their kids won't work
anymore, how will they
keep up that increase
in demand of
rice, keep them wealthy?
Well, see, here's the key point,
which is that the price
has gone up.
So the price has gone up, so
they don't have to increase
the supply that much.
So the kids could work less,
they could work more, or they
could just not supply
that much more rice.
But the fact that they sell
it in a worldwide market
increases the demand so that
they're getting a higher price
and that makes them wealthier.
So now we have to ask,
what's the truth?
What happened?
Well, the answer is that
how do we tell this?
Well, the way we tell this is
we can look, we can use the
fact that the increase in the
price of rice varied across
the country.
In some parts of Vietnam, those
that were very close to
the border and it was easy to
export, there was a big
increase in the demand for rice,
a big price increase.
In other parts of Vietnam, those
more internal where it's
a huge transportation cost to
get to the coast and therefore
export it, it's like
nothing happened.
So you can actually ask, what
happened to child labor in the
areas close to the border where
the price of rice went
up a lot and therefore there's
a big effect of this free
trade, versus the areas more
internal to the country where
price of rice didn't
change much?
And by comparing those two, you
can ask, what happened to
child labor in those
two areas?
What you find is that child
labor went down in the areas
near the coast. They got so much
richer from these higher
prices that on net, they used
fewer kids to work.
That is, the supply shift was
larger than the demand shift.
So actually, free trade
lowered overall
use of child labor.
Free trade lowered the overall
use of child labor so that
freeing up trade was good for
kids, not bad for kids.
We'll talk later about other
arguments about why free trade
is good or not, but this is an
important point where you can
get beyond a simple intuition
of, gee, more kids are going
to work, to say wait a second.
That's offset by the fact that
the higher worldwide prices
led parents to allow their kids
to go to school rather
than go to work.
And that's an example of
the power of income and
substitution effects.
And the power of this theory
for understanding how you
might not get what
seems, initially,
an intuitive answer.
OK, questions about that
example, how it relates to
consumer theory, income
or substitution
effects, any of that?
OK.
So that's where we are going
to stop on consumer theory,
and that's where the material
for the exam will stop.
You can't leave, but that's
where the material for the
exam stops, OK?
So the exam will cover
everything up to
through this point.
The exam will be on
consumer theory.
