Adam pushes back on Paul’s assertion that we lose nothing if we lose the “job creators”

Here is Paul

Yet textbook economics says that in a competitive economy, the contribution any individual (or for that matter any factor of production) makes to the economy at the margin is what that individual earns — period. What a worker contributes to GDP with an additional hour of work is that worker’s hourly wage, whether that hourly wage is $6 or $60,000 an hour. This in turn means that the effect on everyone else’s income if a worker chooses to work one hour less is precisely zero.

Adam responds

I think that many high skilled, high paid workers, and job creators in the U.S. can be an important deviation from this general rule. Many of these people work at moving the productivity frontier forward, and thus increasing the marginal productivity of other workers. After all, one of the important things that entrepreneurs do is find ways to increase the productivity of other workers so they can underprice their competitors.

Yet we don’t actually need any deviation from standard neo-classical general equilibrium analysis.

The problem was with Paul’s period. He stopped with one person, one hour. However, most people suspect that we are dealing with more than a single man-hour here.

Let’s review.

The underlying assumption here is that the economy is an optimizing machine. And, we know that a the optimum, the marginal products of any factor are equal to the factor price and that the cross marginal products are equal to zero.

However, this holds only at the optimum. Any deviation away from the optimum will cause the condition to fail and prices and quantities will need to readjust to bring the economy back into line.

If that sounds to abstract imagine the following claim: Every factor of production is paid its marginal product, including crude oil. So, if crude oil imports to America are restricted the impact on real wages and income for everyone in America would be precisely zero.

That doesn’t sound right.

Well, it would be right if we were talking about 1 barrel. The effect of 1 barrel of crude oil on the US economy is about the price of the barrel. Restrict the barrel and we lose that positive affect but we also lose having to give up what we paid for it.

However, as you continue to increase the number of barrels you restrict the marginal product of each barrel rises and the marginal product of most everything else in the economy falls.

The way we experience this is that when there is a sharp restriction on imports of oil – because of a war or something – we see the price of crude oil rise and the real incomes of most Americans fall.

The same thing would happen with the “job creators.”

If we discouraged them from showing up to work, the price of job creators would rise and the real incomes of most Americans would fall.

A side point that I often see missing in this story is also the following:

Most measures of income inequality in the United States and elsewhere look at pretax income inequality or the income share earned by the top 1%. However, raising taxes on high income earners should cause both of these things to rise.

That is, it should increase our measures of income inequality.

Why?

Well, contracting the supply of high income earners will cause the pre-tax incomes of those who remain to go up. It will also cause the pre-tax income of the rest of the economy to go down.

If you tracked the total incomes of the folks who were in the top 1% before and after the tax increase you might find that this quantity went down. However, that’s not what you are tracking. You are tracking the incomes of the folks who explicitly remained.

That is, you are removing those who were pushed out by higher taxes from the sample. The remaining tax payers should then have even higher incomes.

The underlying assumption here is that the extensive margin dominates the intensive margin, but I think we all believe that.

Conversely, however, if you lower taxes and you see income inequality rise, as a result, your first guess should be that your labor supply curve is backward bending and that lower taxes actually caused some high skilled folks to stop working. Thus raising the incomes of the remaining high skilled workers.

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