Download Economics for Educators, Revised Edition

Economics for Educators
Revised Edition
Robert F. Hodgin, Ph.D.
Texas Council on Economic Education
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Economics for Educators, Revised
Copyright © 2012
Texas Council on Economic Education
All Rights Reserved
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For Whitney, again
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Reviewers
Economic for Educators, Revised benefitted from many comments and suggestions from the reviewers listed alphabetically below.
Sally Adamson
Retired, Duncanville High School
Duncanville ISD
Dr. Steve Cotton
University of Houston - Clear Lake
Michael Clark
Bellaire High School
Houston ISD
Dr. Alberto Davila
University of Texas-Pan American
Texas Council on Economic Education Center Director
Dr. Steve Cobb
University of North Texas
Texas Council on Economic Education Center Director
David Pruitt
University of North Texas
Texas Council on Economic Education Consultant
Support
Laura Ewing
President, Texas Council on Economic Education
Allen Reding
Webmaster, Texas Council on Economic Education
Catherine Rinhart
Program Director, Texas Council on Economic Education
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Preface
I wrote this short primer to help K-12 educators prepare to properly teach economic ideas to their students. Economics provides a
useful way of thinking about how the world works and its main themes deserve a rightful place in each student’s mindset. The main
themes—efficiency, trade-offs and opportunity cost—echo throughout the eighteen Microeconomic and Macroeconomic lessons.
Written in plain language, each lesson orients the busy educator on the meaning and application of core economic terms, concepts
and tools. Other economic concepts then can be directly integrated with the more fundamental ones presented. It is my hope that
the work enhances teacher knowledge and confidence, and then gets multiplied by the number of students they enlighten on this
useful subject.
I thank the Texas Council on Economic Education for financial support to pen this revision. I also thank Laura Ewing, President of the
Texas Council for her generous assistance, along with the academic and professional manuscript reviewers for their valuable
comments. Lingering errors remain mine alone.
Robert F. Hodgin, Ph.D. [email protected]
University of Houston - Clear Lake
Houston, Texas
Biographical Sketch
Robert F Hodgin, Ph.D., has taught economics to K-12 teachers, undergraduates and graduate students at the University of
Houston-Clear Lake campus for four decades. His zeal for the subject radiates through presentations, academic articles, lay writing
and consulting. Motivated by the rigid grade-level content demands imposed by state legislators, he penned Economics for
Educators, Revised Edition, to give teachers a very short and readable guide to the discipline. With a keen eye on common
misunderstandings, he walks the reader through the major turns of the discipline in common language. With Economics for
Educators, Revised Edition, a teacher can swiftly grasp a concept, develop a lesson plan and confidently address student questions
class after class.
Robert and his wife, Johnette, have two grown daughters, Kristen and Whitney, and two granddaughters, Sloane and Elle. They live
on a lake near the Big Thicket area of East Texas.
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Table of Contents
Lesson 1: The Economic Problem 1
Economic Foundations 1
Economic Resources 1
Understanding Economic Behavior 2
The Economic Way of Thinking 3
Lesson 2: Goals of Economic Systems 7
The Economizing Questions 7
Comparing Economic Systems 8
An Economy’s Production Possibilities 9
Lesson 3: Wants and Substitutes—Demand 12
Economics’ Fundamental Divisions 12
Demand and the Search for Substitutes 12
Buyer Response to Price Changes 14
Demand Responses to Non-price Changes 16
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Lesson 4: Production Costs and the Division of Labor 19
Resources and the Pursuit of Profit 19
Diminishing Returns and Marginal Cost in the Short Run 19
Derived Demand for Factor Inputs 21
How Firm’s Grow in the Long Run 22
Lesson 5: Opportunity Cost and Choice—Supply 24
Cost as Value 24
The Seller’s Dilemma 24
Producer Choices and Supply 25
Seller Responses to Price Changes 26
Supply Responses to Non-price Changes 27
Lesson 6: How Markets Coordinate Exchange 30
Exchange Creates Wealth 30
Market Price as a Signal 30
Choices and Trade-offs at the Margin 31
Equilibrium Responses to Non-price Changes 32
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Lesson 7: Competition, Market Power and Economic Efficiency 35
Market Power and the Structure of Industry 35
Competition’s Efficiency Promise 35
Monopoly’s Efficiency Failure 37
When a Few Firms Dominate the Market 38
Monopolistic Competition 39
Lesson 8: Economic Justifications for Government 42
Market Failure and Government 42
Government Provision of Public Goods 43
Government Regulation of Monopoly 43
Government Regulation of Common Resources 43
Private Goods with External Effects 44
Constitutional Right to Tax 45
Principles of Taxation 46
Fairness in Taxation 46
Tax Incidence and Efficiency 47
Lesson 9: Value, Time and Uncertainty 50
Time Preference and Present Value 50
Smart Investing in Any Market 51
Insurance as Risk Coverage 52
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Lesson 10: Consumer Economics 54
Life is a Marathon, Not a Sprint 54
First Paycheck 54
First Car—So Many Options 55
The Economics of Attending College 56
Credit Cards’ High Cost 57
First Career—Looking at the Long Run 58
First Home or Last Home—Rent or Buy? 59
Planning Early for Living Long 61
Lesson 11: Gross Domestic Product and Growth 63
National Income Measurement 63
The Supply View of GDP 65
The Demand (Expenditure) View of GDP 65
Sources of Economic Growth 66
Economic Productivity and Well-being 67
How Technology Enhances Economic Growth 67
The Interrelatedness of Sectors 68
Lesson 12: Employment and Unemployment 71
Employment and Unemployment 71
Natural Rate of Unemployment 72
“Curing” Unemployment 72
Economics of Minimum Wage Laws 73
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Lesson 13: Money and Prices 75
Money 75
Measuring Inflation 75
Inflation’s Winners and Losers 77
Controlling Inflation 78
Lesson 14: Money and Interest Rates 80
Money’s Official Definitions 80
Money is Not Credit 80
Money’s Scarcity Preserves Its Value 80
Time’s Value is the Interest Rate 81
Lesson 15: Federal Reserve System 83
What Commercial Banks Do 83
What Central Banks Do 83
Money and the Federal Reserve 84
The Money Multiplier 84
Monetary Tools of the Fed 86
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Lesson 16: Macroeconomics: Long Run and Short Run 89
Macroeconomic Goals 89
The Long Run and Short Run 90
The Equation of Exchange 91
The Multiplier 92
Lesson 17: Fiscal and Monetary Policy 94
Laissez-faire versus Government Intervention 94
The Demand for Money 94
Monetary Policy Tools 94
Fiscal Policy Tools 96
National Debt and Fiscal Policy 96
Crowding Out Effect of Deficit Financing 97
Lesson 18 Gains from Trade 99
Trade and the Law of One Price 99
Comparative Advantage Theory 99
Currency Markets and Exchange Rates 101
The Balance of Payments 102
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Lesson 1: The Economic Problem
Economic Foundations
Economic data are read daily by millions of people, yet many citizens hold mistaken notions about how the economy works. Since
economic events affect everyone in some way, that statement suggests a gap in training, not a lack of relevance or interest. To begin
converting economic information into knowledge, this lesson introduces the economic problem then presents the “economic way of
thinking.” Each subsequent lesson adds new economic concepts and useful applications, several with real data to demonstrate how
economics works in free markets to enhance society’s well being.
Economic activity permeates much of modern life, but achieving personal and social economic goals also requires effective
institutions. For example, when a nation’s citizens feel secure from foreign invasion, perhaps through a strong national defense,
borrowers more willingly undertake long-term investments using loaned funds. Well functioning courts, clear property rights, a
responsive political system, all support the operation of free markets to meet individual needs and achieve social goals.
Citizens in a democracy are free to choose from among the wide array of market-based opportunities, but achieving individual wealth
or business success can be another matter. People have the freedom and the right to enjoy the rewards of legitimate commerce, but
they must accept that there is no guarantee of individual success or uninterrupted growth for society.
Economics—the study of how society manages its scarce resources.
The Economic Problem—how to meet society’s material needs given scarce resources.
Good—a product or service that provides value to its acquirer.
Free markets—an exchange system for the production, distribution and consumption of goods and services between buyers
and sellers.
Economic Resources
In economics, the productive means to address the economic problem fall into one of four all-encompassing categories—land, labor,
capital (machinery) and entrepreneurship. No matter the type of economic system—capitalist, socialist or traditional—or the era,
these four categories comprise the totality of economic resources. The compelling question is how a society is to organize and
effectively employ its resources.
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Economic resources and the market returns they earn:
9 Labor earns wages from its human capital
9 Land earns rent for its productive application
9 Capital (plant and equipment) earns interest
9 Entrepreneurship (leading, organizing) earns profit
The US Bureau of Economic Analysis (BEA) measures resource payments to the factors of production each quarter—this is the
income view of Gross Domestic Product (GDP)—as part of the National Income and Product Accounts (NIPA). Economists at the
BEA, using official methodologies compile figures for each resource category, as shown below for 2009. Each category is a resource
building block—a factor of production—for making goods and services, and each, in return, earns payment for its use.
US National Income by Economic Resource Categories, 2009 ($ Bill.)
Economic Resource
Natural (land)
Human (labor)
Capital (physical assets)
Entrepreneurship
Source: www.BEA.gov
Resource Payment Type
Rent
Wages
Interest
Profit
US National Income
$ 1,285.9
$ 7,811.7
$ 784.3
$ 1,258.0
Understanding Economic Behavior
Economists reduce market-based behavior to a set of logical relationships. They do so by distilling their observations on human
activity down to a few measures in a cause-and-effect structure premised on assumptions. For example, most of us would agree that
people commonly act in the pursuit of their own self-interest. Many of the behaviors and assumptions economists employ may seem
obvious, but when used to construct explanatory models, they can provide a rich understanding of people’s choice-making behavior.
The better economists understand the roots of economic behavior under select conditions, the more able they are to define policies
to influence the economy and potentially improve the human condition.
Selected behavioral assumptions in economics
9 People desire a multitude of goods
9 People are willing to make trade-offs to be better off
9 Not all people make the same trade-offs
9 People respond to incentives
Why study theory? We cannot discover the cause and effect relationships at work in a complex society without theory. Economic
theory attempts to explain human behavior by testing presumed logical relationships among economic measures. A proposed
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relationship, when verified using real world data, becomes knowledge about how people in economic society function. Through this
hypothesis testing process, economists have come to feel confident about many relationships like work to leisure or earning to
spending. For example, in the macro economy, it is very useful to know that, on average, $1 of additional income, when spent, will
generate an additional 86 cents in new spending for the economy, during normal economic times.
Uses of economics and economic theory
9 Description–defines and measures economic activity
9 Analysis–orders economic measures into logical cause-and-effect models
9 Explanation–statistically tests economic relationships using real world data
9 Prediction–uses proven models to assess and forecast market indicators
The Economic Way of Thinking
Observing how people weigh and measure options then act to improve their position reveals the economic way of thinking in action.
What is the practical structure of this process? When faced with a need and a dilemma, like whether to buy a new or used car,
astute people usually assess the known costs and benefits of their options—then reduce the options down to just two: the first best
and, what will become the next best alternatives. The buyer then makes the purchase in a mutually beneficial exchange with the
seller, in dollars (or credit) for the car. As long as the purchase is affordable and the car functions as promised, the buyer is satisfied.
We can generalize from this example and describe the workings of the economic logic.
Value always lies in the eye of the beholder. It is a person’s willingness and ability to make a sacrifice to acquire a good that gives it
value. That action of sacrificing one thing of value to acquire another more highly valued good in a specific place and time, confirms
the acquired good’s relative scarcity and worth.
Effort also must be expended, a sacrifice made, by someone to produce and deliver the good satisfying the conditions of the
acquirer. Producers make goods only when their expectation of reward is greater than the value of their own sacrifice—i.e. a price
above their cost of making the good. Economics provides the logic that makes the production-to-distribution-to-consumption process
sensible and efficient.
Once market participants have enough information about an economic good, some idea of relevant property rights (what belongs to
whom and how to consummate the trade), rational exchanges benefiting both parties can occur. A prospective buyer’s desire and
ability to pay a price greater than a potential seller’s sacrifice for making a particular good provides the opportunity for mutual gain.
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Scarcity–economic goods are not naturally available in the form, time or place desired without a cost or sacrifice.
Opportunity Cost–when making a choice, it is the next most highly valued option forgone that measures the cost of the
chosen option.
Trading-off–making choices regarding the amount of one good sacrificed to get more of another good.
Neither individuals nor nations can have all the goods they want without making trade-offs—sacrifices occur at all levels to achieve a
desired end. If the acquirer made a sacrifice to possess a desired good, then it must be an economic good by definition. To allocate
goods to their best use requires an efficient production-distribution-consumption system—ideally using prices determined in free and
informed markets. Efficiency means that people in the economic system make choices intended to make them better off.
Economists believe that most consumers make self-interested—not selfish—choices that improve their personal position. A person
will consume units of a private good up to the point where the expected additional costs equal, but do not exceed, the expected
additional benefits. In doing so, the person maximizes his or her total net benefit. The steps and example presented below detail
that process.
Efficient economic choice making for a desired option means:
9 Assessing the expected additional benefits and the expected additional costs
9 Checking that the option’s expected benefit-to-cost ratio is greater than one
9 Comparing the first option’s benefit-to-cost ratio to the next best option
9 Then, choosing the option with the greater net value, and sacrificing the other
As an application of efficient economic choice making, suppose that you have allotted $60 to purchase some nice casual T-shirts for
summer. While shopping, you find a store where designer label T-shirts are “on sale today only” for $15 each. You think the price is
a bargain. Ignoring sales taxes, how many T-shirts will you buy?
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Suppose the blue bars in the chart above reflect the personal value that you place on each T-shirt you might buy, beginning with the
first one. Notice that you feel willing to pay as much as $30 for that T-shirt, well over the sale price. The value-to-cost ratio is certainly
positive; 2-to-1 ($30 value/$15 cost). Also notice that as you anticipate purchasing each additional T-shirt, their value to you falls (just
how many nice summer T-shirts does one need?). Will you purchase the first T-shirt? Yes.
At the same price, what is the benefit-to-cost logic for the second T-shirt? Well, the cost is the same—$15. But the value to you has
fallen to about $25. You still feel the value is greater than the cost—and besides, the sale ends today. So you purchase that one
also. Would you purchase the 3rd T-shirt? Yes, again. Your perceived value of about $20 is still greater than the cost of $15. Now
what about the 4th T-shirt? Here you are indifferent, at the limit—and in two ways. First, the value just equals the cost for the T-shirt.
Second, you will have spent precisely all the money you allotted from your budget for the total T-shirt purchase.
The action described above is smart economic choice making—they are decisions made “at the margin.” What does that mean?
You optimized the use of your scarce funds by individually assessing the benefit and the cost, and purchased the most T-shirts
possible given their price and your budget. That means for each additional (i.e. marginal) T-shirt you considered its cost compared to
its value—making sure that the value exceeded the cost, up to the count of T-shirts that used all funds allotted. In the end, you
maximized your total net benefit.
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In Sum
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9
9
9
9
9
9
9
9
Economics is the study of how society allocates scarce resources among competing options.
The economic problem is how to satisfy the material well-being of people in the society.
Scarcity means that economic goods have a cost in the form of the value sacrificed to acquire the desired good.
Economic resources fall into one of four categories: land (earns rent), labor (earns wages), capital (earns interest) and
entrepreneurship (earns profit).
Economists believe that theory provides understanding of citizens’ behavior toward solving society’s economic problem.
Opportunity cost is the value of the next best option foregone when a more attractive option is chosen.
Making trade-offs involves sacrificing some of one good to get more of another good, so that total benefit rises.
Economic efficiency means making rational benefit-cost choices in the consumption, production and distribution of goods.
An action is economically efficient if a person makes choices where the net benefit (expected additional benefits less the
expected additional costs) is positive or rejects choices where the net benefit is negative.
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Lesson 2: Goals of Economic Systems
The Economizing Questions
In America, with its high standard of living, necessities such as food, clothing, shelter, and even a few luxuries are accessible to most
income earners. In 2006, US per capita gross domestic product—$44,155—ranked 7th highest in the world. While an estimated 14
percent of its own 310 million citizens in 2009 lived below the government-estimated poverty level, forty percent of the world’s 6.5
billion people had a per capita income below $1,000 per year. What explains such dramatic differences in living standards between
countries? It is how each nation addresses the “three economizing questions” whether by default or with purpose.
The three economizing questions
9 What goods to produce?
9 How to produce the goods?
9 To whom to distribute the goods?
Geography, culture, law, religion, and ideology together shape each country’s response to the three economic questions. Satisfying
a people’s economic needs depends on the nation’s natural physical resources, societal work ethic, population growth rate and
technology. Every society adopts a mechanism to address the well-being of its citizens. Precisely how a country addresses the
economizing questions reveals much about their views on human nature, the sanctity of the individual versus the state, the
ownership of resources and the bases for human motivation.
Distinguishing from among those aspects of the social order that are the domain of government and those accorded to the individual
is an early step toward defining how and how effectively an economic system will function. To help clarify the different arenas in
which government or markets most efficiently address the economizing questions, economists distinguish between private goods,
public goods, common resources and natural monopolies using the concepts of rivalry and excludability.
Classifying economic goods and the role of markets
9 Private Good—Buyer enjoys the consumption benefits by excluding others from consuming the good while reducing the
good’s availability. Market solutions work best here. Examples: candy bar, clothes, cell phones.
9 Public Good—One person’s consumption does not diminish the quantity available—no rivalry; and others cannot be
excluded from consumption. Markets do not work effectively here. Examples: national defense, roads at non-peak times,
education.
9 Common Resource—Goods that can be rival but not excludable. Markets require government oversight or regulation.
Examples: clean air, ocean fishing, congested roads.
9 Natural Monopoly—Goods that can be excludable but not rival. Markets require government oversight or regulation.
Examples: television, fire and police protection.
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Comparing Economic Systems
An economic system provides mechanisms through which to achieve individual and collective well-being. Fundamentally, leaders
must choose between sustaining traditional provisioning methods, centralizing economic decision-making, decentralizing economic
decisions via a market mechanism or some mix of these options. The requirements necessary to meet all society’s needs, including
those labeled economic, are sufficiently complex that debate on which economic system is “best” requires judgments. Even so,
identifying some of the major benefits and trade-offs in each system is possible.
Three types of systems to address the economizing questions
9 Tradition—historical and customary social processes are sustained through law, religion and belief
9 Command—imposed authority guides the system via orders from an economic “general”
9 Market—societal members pursue their own economic well-being via free markets for goods
Every economic system provides collective and individual benefits and costs. Traditional economic systems place much emphasis
on group hierarchy, communal beliefs and maintaining social customs. Change halts in favor of cultural routine and familiarity.
Tradition-based economies solve the economic problem, but at the expense of progress.
In a command system, the central authority may own or control the means of production. Central authorities make major economic
decisions related to wages, output and distribution of goods. Mandates from the central authority subsume individual choices.
Command-based economic systems can be useful in times of war, or for mandated economic change, where direction by a central
agent guides resources toward a goal that leaders envision more clearly than individuals can. Human motivation, efficiency, and
critical resource supply—food, clothing, and shelter—might suffer in the pursuit of the central authority’s goals.
A market system vests control of economic resources with individuals who pursue their own self-interests for the relatively unintended
betterment of all. The cornerstones of market-based exchange include the rights to freedom of choice, private property ownership
and the reward of profits as incentives. Those rights support risk taking and self-determination. Yet, the sum of individual choices
may not be socially optimal as time passes. A free market’s most serious social trade-off is occasional dramatic fluctuations in the
level of economic activity. Government, at least in principal, plays a relatively limited role in the private sector.
Government’s roles in a market system
9 Oversee the economic system so it operates in agreement with and laws and property rights
9 Provide public goods and services such as national defense, public education and public highways
9 Sustain common resource utilization at a socially desirable level
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Government’s goals in a market system
9 Protect citizen’s freedom to choose between opportunities
9 Support efficient markets through competitive prices
9 Maintain equity and a sense of fairness in dealings
9 Ensure security and stability to support risk taking
There is no compelling evidence that market-based economies naturally evolve from tradition or command systems. Free markets
require political support, legal validation, social acceptance and institutional structures. The transformation from traditional
economies, like India, or from command economies, such as the former Soviet Union, to a market system can be fraught with
uncertainty and social upheaval.
An Economy’s Production Possibilities
No matter the chosen economic system, every country addresses the three economizing questions when bringing scarce economic
resources into their desired use. No nation, however wealthy, can make economic choices without sacrifices. As the system
allocates its scarce resources it must make trade-offs when producing goods to meet society’s economic needs. A Production
Possibilities Curve shows both the production limits and opportunity costs of resource trade-offs when a society produces two or
more goods in a given time period, with fixed current resources and unchanging technology.
Production Possibility Example
In One Day:
Ann makes—
Ben makes—
Cal makes—
Widgets
10
6
2
OR
OR
OR
Gadgets
5
6
4
Consider a simple economy with just three people (Ann, Ben and Cal) and two product sectors—Widgets and Gadgets—both socially
useful. To begin, one question is the order of hiring into each sector. For example, who makes gadgets at lowest cost? Since no
money values appear in the table above, how can the answer be motivated?
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Should we hire Ann first to make gadgets? No. Hiring Ann first overlooks the economic basis for efficient choice making—opportunity
cost. To see how, notice in the table that for every one gadget Ann produces each day, it costs her, and the society, 2 widgets not
produced (10 widgets divided by 5 gadgets = 2 widgets “lost” per gadget made). Instead, can you see why Cal should be hired first
to make the first 4 gadgets (where his gadget costs only ½ a widget not made)? It’s true. Using this same opportunity cost logic Ben
will be hired second, where his opportunity cost of making 1 gadget is 1 widget. Finally, Ann should be the last hire, since her relative
gadget-making cost is highest of the three (each of her gadgets costs 2 widgets not made).
The same logic applied to making widgets will find the hiring order precisely reversed. How is this so? Look at Ann again, for her 10
widgets made per day, only 5 gadgets are sacrificed—so a widget costs just half a gadget in production foregone. That cost is lower
than either Cal or Ben in widget making. For Ben each widget made by him costs one gadget, while for Cal each widget costs two
gadgets. Notice that when opportunity cost prevails as the criterion to determine the hiring order for either good, the least costly
(opportunity cost, again) person is hired first and the most costly person is hired last. More, since society likely wants both widgets
and gadgets at least one person will make the opposite good. Should it not be the last person hired in one sector (the most
expensive and least efficient) who transfers to the alternate sector, where they can become a more efficient (less costly) maker in the
other sector? Yes and their world will be better off for that.
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One more example is valuable. Suppose their economy currently makes 4 gadgets, produced by Cal, with 16 widgets produced by
Ben and Ann—point “A” on the chart. If their society now wants more gadgets, then Ben should move to the gadget sector. For each
new gadget Ben now makes, up to 6 per day, the trade-off means one less widget produced—lower than Ann’s opportunity cost. If
Ben moved to making only gadgets, the economy would be producing at point “B” on the chart above. While there is no way to avoid
an opportunity cost sacrifice when moving resources between sectors, economic logic assures that the shift of society’s resources
occurs efficiently.
Finally, if any of the three either quits working or chooses to work less, their economy provides fewer widgets or gadgets for all.
When that happens, the economy is producing, inefficiently, below its production capability.
In Sum
9 Every society must successfully address the three economizing questions: what to produce, how to produce and to whom to
distribute the production.
9 Government has a legitimate economic role for producing public goods, and some limited justification for regulating natural
monopolies, and overseeing common resources, then sustaining the operation of free markets for private goods.
9 The 3 fundamental types of economic systems to operate an economy are tradition, command and market
o Tradition—works by custom and belief to satisfy economic needs at the expense of economic progress.
o Command—the means of production are government-owned and work incentives are limited. This system can lead great
economic change through central decision-making but has difficulty efficiently allocating goods.
o Market—private resource ownership, the pursuit of self-interested objectives, the incentive to retain the net proceeds from
work via market exchange provide for efficient output. Occasional, and perhaps dramatic, swings in business activity can
occur.
9 Government’s goals in a free enterprise economy include maintaining freedom and security, sustaining market efficiency and
promoting economic growth and stabilization.
9 Production Possibilities Curve for an economy in the short run shows:
o The possible output limits of two or more sectors using existing productive resources in an economy.
o The importance of opportunity cost when determining the order of hiring productive resources into each sector.
o The opportunity cost trade-off a society must make when moving productive resources from one sector to the other.
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Lesson 3: Wants and Substitutes—Demand
Economics’ Fundamental Divisions
In Western Europe about the thirteenth century the evolution of the guild system could be said to mark the first great division in the
formation of markets—the separation of buyers from sellers. Prior to that time, custom accorded who worked on what and how the
fruits of labor were distributed. Since then, economists have puzzled over the power of the market as a mechanism for allocating
goods. This separation of buyers (demand) from producers (supply) represents the first and most fundamental division in modern
economics.
The second, often unstated, division grew from the need to understand how market forces affected the exchange of goods. About
the middle of the nineteenth century, economists began formally applying time as an analytical device. Two distinct time-periods
emerged, omitting the past, where no new action was possible: a) the present (short run) where all decision-making and actions
occur and b) the future (long run) where the consequences of prior decisions and actions manifest. The application of time also
underscores the role that price plays in coordinating market decisions. Since action can occur only in the present, knowledge of
current price options provides useful information about whether to act now or to wait.
Good economic analysis permits only one market force at a time is to operate, so its full logical consequences come into view in
cause-and-effect sequence. Useful assessment regarding the impact of all market forces requires that each force be viewed
separately, at least at first. Doing so can help clarify a market scene that at first looks hopelessly muddled. This mechanical, timeseparated, one-change-at-a-time technique is the proper means to apply economics to market analysis.
So a clear-headed economic thinker inspects a situation drawn from the ordinary business of life; requires that all action stop for a
moment; allows only one market force to change; then traces the results of the force on relevant economic measures. This logical
stop-action assessment of dynamic market activity helps reveal the consequences of human choice making.
Demand and the Search for Substitutes
Much of economics can be said to begin with demand. A person’s wants transformed into both a willingness and ability to sacrifice
one thing to acquire another, elicits productive processes attempting to satisfy those wants. Note that wants and needs are not the
same thing in economics, and that “wants” is the more useful term in demand analysis. The concept of demand relates the amount
purchased of a good the buyer wants to the sacrifice suffered to obtain them—the price. Customers choose and make trade-offs,
given their preferences and knowledge of available substitutes compared to the current offer price. They then choose the option at
the moment believed to most improve their current position.
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Demand—the quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other market
forces held constant.
The definition of demand implies that potential buyers assess the prospective benefits from consuming a good compared to what it
will cost. This statement is only half-right. Good economic decision-making always poses pairs of options. The first option is the
offer immediately at hand. The second option is the next best offer known to be available, given its price and perceived benefits. By
choosing one, the consumer sacrifices the other on the expectation that the benefits-to-cost assessment for the chosen option will
deliver greater net satisfaction.
How is it that the definition for demand presumes a range of prices for a given good? In any particular store, most American
shoppers see only one price. Here, the economist makes two more mental assumptions: other vendor’s prices for the same or
similar good are known, at little cost, and travel in the market place is free and fast. These useful assumptions let the buyer
efficiently select the product from a potentially wide array of vendors and range of prices then available.
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Does the assumption of no time and search costs have the ring of reality? In very many cases, it does. How often do you shop
using coupons and select one store over another as a result? For items with a larger price tag, how often do you shop several
sources by phone or catalogue or compare prices to those posted on the Internet?
Law of Demand—the inverse (or opposite in direction) relationship between current price and the quantity demanded of a
good.
That ordinary demand curves slope downward and to the right, as stated by the law of demand, economists fully accept. In steps, as
the current price goes up, the quantity demanded falls. As the current price goes down, the quantity demanded rises. Why? First,
let us establish that the demand schedule reflects the maximum price buyers are willing and able to pay for a given quantity of a
good. Certainly, budget-conscious consumers would willingly pay less.
The downward to the right shape for demand curves reflects the diminished benefit to the buyer from presently consuming additional
units of the same good. As an example, ask yourself how many individual small boxes of popcorn you might eat during a long movie.
Once you consume the first box of popcorn, if you still want another, is the anticipated value of the second box as high as for the first
box? Likely it is not. You willingly purchase the second box of popcorn only if the perceived, though falling, value remains greater
than its cost to you. So, the maximum price the buyer is willing to pay now for a good falls as consumption of it increases.
In summary, smart consumers willingly pay a price for a good no higher than the limit of its perceived value, given known
substitutes—and hopefully less. The value of additional units consumed during a short time period usually diminishes with additional
consumption by the buyer. A lower value per unit means that the consumer is willing to buy more units of the good only at a lower
price. That is why demand curves slope downward.
Buyer Responses to Price Changes
The law of demand states that the current price of a good and the quantity demanded move in opposite directions. The reason is
that each unit of the good consumed in a short period reduces the next unit’s value to the consumer. Two rather subtle economic
effects motivate this response.
Income Effect-–If a certain number of dollars are allotted to making a purchase, when the unit price for the good rises (or
falls), the quantity of the good the consumer can willingly afford falls (or rises).
Substitution Effect—As the unit price of a good rises (or falls), the consumer substitutes away from (or toward) the good.
Consistent with the definition of demand, a range of prices usually prevails at any given moment in the marketplace. If the price is
relatively high, a lesser quantity of the good is purchased. If the price is relatively low, a greater quantity of the good is purchased.
So a change in current price is a movement along the given goods’ demand curve. To emphasize, the demand curve for a named
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good, in the short run, will not move or shift due to a change in its current price. Knowledge of current price merely helps the
consumer efficiently allot scarce income among currently desired goods by adjusting the amounts purchased in response to known
substitutes. So consumers respond to changes in the current price of a good. When the unit price changes, sometimes the change
in the quantity purchased is small, sometimes it is large. What accounts for this variation in the size of buyer response to a price
change?
Price Elasticity of Demand—a measure of the relative change in quantity demanded in response from a change in current
price.
A good’s demand is said to be elastic (relatively responsive to changes in current price) when a small change in price brings about a
relatively large change in the quantity of the good demanded. A good’s demand is said to be inelastic (relatively unresponsive to
changes in current price) when a large change in price brings about a relatively small change in the quantity of the good demanded.
What is it that makes the quantity change to price change response occur? It is the buyer’s knowledge of substitutes for the desired
good.
The consumer best knows what she wants. The consumer knows what she is willing to substitute in place of precisely what she
wants. The closer perceived substitute products are to the current good, the more responsive (more elastic) will be the quantity
demanded change to a change in its current price—and the opposite is also true. When there are few close substitutes; demand will
be less responsive (less elastic) to price.
Determinants of buyer responsiveness to current price changes
9 Closeness of perceived and known substitutes: more substitutes means more elastic demand;
fewer substitutes means less elastic demand
9 Good’s price as a portion of buyer’s income: larger price means more elastic demand; smaller price
means less elastic demand
9 Time—a longer time period allows more substitutes to be discovered for a more elastic demand
The more expensive the good’s purchase as a proportion of income, the greater will be the buyer’s response to current price
changes. For example, a large increase in the price of salt will bring about a much smaller reduction in the quantity of salt demanded
than will a large increase in new automobile prices in reduced car sales. Finally, as time passes, the more elastic the demand for a
good tends to become—because more substitutes can be identified.
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Demand Responses to Non-price Changes
Demand analysis for an individual buyer and demand analysis for an entire market of buyers are quite similar. This is true because a
market’s demand is the sum of the amounts demanded at every price by all buyers in the market. While the behavior of a single
individual in the market may vary in magnitude from other buyers, the market demand curve still slopes downward and to the right.
The definition of demand contains a phrase that reads “all other market forces held constant.” We have seen above that when time is
artificially constrained, price changes bring about a change in the quantity demanded, noted by reading along a fixed-in-place
demand curve. As you likely have suspected, other forces are at work in the market.
Inspect the chart above. Choose a price on the vertical axis, say $10, then read horizontally across to the right edge of the bright
blue demand graph and read the quantity demanded; 30 units. If demand INcreased from that point and shifted rightward (like the
green arrow) to the outer edge of the lighter blue graph, the number of units demanded at the original price would be larger, nearly 40
units. That is an increase in demand, current price held constant.
Again, select a price on the axis, say $40, then move horizontally across to locate the outer edge of the light blue demand graph and
read the quantity demanded; about 20 units. If demand DEcreased from that point by shifting leftward (like the red arrow) to the edge
of the bright blue graph, the number of units at the original price would be smaller, about 15 units. That is a decrease in demand.
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As time passes, market forces other than price affect the entire level of demand. These non-price forces cause the demand curve to
shift—with NO change in current price. So a change in demand means that, at any price, a different quantity of the good—greater or
lesser than before—is desired.
This important distinction—between changes in quantity demanded due to changes in the current price of the good, a movement
ALONG the demand curve versus SHIFTS in demand—caused by market forces other than current price, lets the careful economic
thinker correctly understand market dynamics.
Economists organize the forces that move or shift market demand, prices constant, into categories called determinants or shift
factors.
Demand determinants: factors that shift the demand curve (with no change in price)
9 Number of buyers—if buyer count rises, demand rises and the opposite is true
9 Buyer tastes—if buyers desire more, demand rises and the opposite is true
9 Buyer incomes—if buyer incomes rise, demand rises and the opposite is true (for normal goods)
9 Future price expectations—if future price is expected to fall, current demand falls, and the opposite is true
9 Related good’s price:
o Complements—if a complement’s price rises, demand for original good falls and the opposite is true (example: if
the price of printer ink rises, the total demand for printers may fall)
o Substitutes—if a substitute’s price rises, demand for original good rises, and the opposite is true (example: if the
price of movie house tickets rises, the total demand for NetFlick’s kiosk movies may rise)
How to Analyze the Effect of Determinants on Demand
9 From the facts, determine which demand determinant is operating
9 Determine the direction of the determinant’s force: increasing or decreasing
9 From the determinant’s direction and knowledge of economic incentives, deduce the direction
of change for the demand curve: increase (rightward shift) or decrease (leftward shift)
In Sum
9 The two fundamental divisions in economics are:
o The separation of buyers (demand) from sellers (supply).
o Time—Short run, where quantity demanded responds to current price. Long run, where other market forces shift demand.
9 Buyers seek substitutes and make trade-offs to acquire goods they want because their income is limited.
9 Economic choice making selects between pairs of options: the chosen option and the next best one sacrificed.
9 Demand—the quantity of a good that buyers are willing and able to purchase at a range of current prices, other forces constant.
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9 Law of Demand—The inverse (or opposite in direction) relationship between current price and the quantity demanded.
9 Demand curves slope down and to the right due to the:
o Income effect where price changes affect buyer’s purchasing power, and
o Substitution effect where buyers move toward less expensive substitutes and away from more expensive substitutes
9 Current price changes for a good bring about changes in the current quantity demanded, as read along a given demand curve.
9 Price Elasticity of Demand—measures of consumer’s relative quantity response to a relative change in current price. Three main
determinants of demand elasticity are:
o Closeness and availability of perceived and known substitutes
o Passage of time allowing for more substitutes
o Good’s price as a percent of buyer’s income
9 Non-price market determinants shift the demand curve, over time, reflecting changes in quantity demanded at all prices
o Increase in demand is a rightward shift of the demand curve in price quantity space
o Decrease in demand is a leftward shift of the demand curve in price quantity space
9 Non-price market forces that shift the demand schedule, current price held constant, include:
o Number of buyers: more buyers in the market increase the demand (shift to the right) and the opposite is true
o Buyer tastes: customers liking more of the good increase the demand (shift to the right) and the opposite is true
o Buyer incomes: higher income increases demand for normal goods (shift to the right) and the opposite is true
o Future price expectations
ƒ If consumers expect future prices to rise, they buy more of the good now, increasing demand (shift to the right).
ƒ If consumers expect future prices to fall, they will buy less of the good now, decreasing demand (shift to the left).
o Price of related goods:
ƒ Complements—if the price rises for a good that complements the original good, the demand for the original good
falls (and the opposite is true).
ƒ Substitutes—if the price rises for a good that is a substitute for the original good, the demand for the original good
rises (and the opposite is true).
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Lesson 4: Production Costs and the Division of Labor
Resources and the Pursuit of Profit
In business, a branch of applied microeconomics, the motivation for risk taking is the chance to earn profit. That is why
entrepreneurs seek their fortune by using other’s resources to achieve a chosen business goal, like making a profit. For the
economist, profit plays a particular role and has a specific meaning.
Profit is a “residual”—what is left after paying opportunity costs of production from revenue received by selling the good. In simple
equation form: Profit equals total revenues less total costs. To the economist, “normal” profit is part of total cost because it is
sufficient to keep the entrepreneur working for the particular enterprise. Successful entrepreneurs are able to spot gaps in the
current market place and move to take advantage of them before they are exploited by others. When net revenue to the enterprise
exceeds the necessary minimum profit, it represents a payoff earned by bearing risk in an uncertain environment and flows to the
entrepreneur—its rightful claimant.
Diminishing Returns and Marginal Cost in the Short Run
The moment the entrepreneur moves from mental commitment to action on a business proposition, formerly estimated “paper” costs
become real. The entrepreneur is the only economic actor with an incentive to take into account all relevant costs. So controlling
costs is very important. The more competitive the market the less control management has over setting price, so cost containment
assumes a key role in most business operations.
Short run—the time-period during a production cycle, where variable (avoidable) costs are incurred (e.g. wages, materials)
and some costs not directly related to the rate of production are fixed (e.g. rent, utilities, insurance).
Even though companies wish to earn a profit in every reporting period, it is not always possible. At times, management must deal
with short-term losses. During a production cycle, only avoidable production costs—those that will change with higher or lower rates
of output, are relevant. Costs already paid that cannot be altered—sunk costs—are not relevant for operating decisions. Why?
Because they provide no opportunity for choice—and should not enter into calculations to determine if making more of the product
would be profitable on the margin. When pricing a given production run, only two questions are relevant: 1) are operations at the
capacity limit (if so, a full cost price is warranted) or not and 2) if not, the price must at least cover the costs that actually change
when producing an additional amount of output—the marginal cost.
The costs that vary in the short run comprise the minimum cost necessary to produce. Economists label those “marginal costs”—the
costs that change as the level of output changes.
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Production cost categories
9 Avoidable or variable (opportunity) costs–change directly with production levels
9 Fixed operating costs—costs invariant to production levels
9 Sunk costs–costs not recoverable during the production period
9 Total costs—the sum of fixed and avoidable production costs
9 Marginal cost—the cost of producing one more unit of the product
Every fixed-in-size production operation has an output capacity limit. As the production level nears that capacity limit, per unit costs
of the output will begin to rise. This natural phenomenon, the increase in per unit avoidable costs occurs because of a non-economic
law, the law of diminishing returns.
Law of diminishing marginal returns—when at least one factor input, plant capacity, is fixed, the additional output produced
from additions to labor will eventually decrease as more labor is added.
The consequence of diminishing returns to labor in the short run is that variable costs per unit rise. Why? It takes increasingly more
labor effort per time to compensate for the diminishing output per labor hour. So in the short run, labor cost per unit of output
increases—an important marginal cost.
Notice that during a production run it is variable costs, such as labor and materials, which must be covered. Fixed costs, which are
sunk, at least during the production period, leave no opportunity for choice and need not be considered at the moment, though they
eventually must be paid to preserve the ability to operate.
What happens to product produced that does not sell as expected? The business runs a “sale”. The interesting economic dilemma
is what price to set for the leftover inventory. Given that production, distribution and set-up costs have already been incurred for the
unsold product, what costs are relevant and what price should be charged? Only current (new) opportunity costs are relevant and
any price above zero just might do. How can this be?
All prior costs not recoverable during the production period are sunk. Any cash flow generated from the inventory liquidation is of
some benefit. There is even a case to be made for giving the inventory away, if it is preventing new merchandise from taking up
valuable floor space and spoiling new sales. Each situation must be assessed in its own factual context.
Do not be misled into thinking some earlier lost profit margin must still be considered. That, too, is a cost sunk by foiled market
expectations. Economic goods can never sell for more than the buyer’s perceived value. Relevant costs are those incurred in a
chosen action. Once the action has occurred, spent costs become sunk and unrecoverable. The only remaining decision is what
price to set for the now excess goods.
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Derived Demand for Factor Inputs
The business owner seeks and allocates productive resources—factors of production: land, labor and capital—because she needs
them to meet the demand for the good or service offered by the business. Efficiency dictates that a match of capabilities be achieved
using the productive resource inputs—physical with human capital—at the least possible cost.
The owner must determine both the skill mix and number of people to hire. The prevailing market wage for the type of labor skills
sought provides a good measure for labor costs. The market wage rate multiplied by the number of positions required per production
cycle (time) determines the total wage cost for the firm.
Crucially it is product demand—the number of units demanded per time multiplied by the market price—that provides the ability to
pay for the labor services. That is why economists call the demand for factor resources a derived demand.
Derived demand—the relationship between the resource factor's price and quantity wanted by firms directly depends on
market demand for the final product(s) the factor helps produce.
So how many input units of each type will be hired? The economist’s rule is to hire input factors until the cost of the last unit acquired
or last hour worked—the wage rate times the last factor input hired or last hour worked—just equals the value of its production—
product price times the additional output units produced. Yet another marginal efficiency rule that helps generate profits by keeping
variable costs low.
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How Firms Grow in the Long Run
As demand for the company’s product increases and sales revenue grows, so does the need to hire additional resources. As the
market for the product expands, requiring more jobs and equipment to produce the enhanced volume, jobs and tasks become more
specialized. The profit motive and economic efficiency accommodate the specialization process as the expanding sales volume
enables it.
The entrepreneur must decide to expand or contract the level of factor inputs employed as demand for the product rises or falls,
given current capacity. If sales volume continues to expand, the owner eventually faces the decision of whether or not to increase the
size of the production facility.
In the long run there can be no sunk costs. All costs, in a planning process are variable because projections are always fluid.
Through time, the larger and more sustained the demand for the good, the larger the enterprise may be willing to grow.
Long run—a time-period long enough to make changes in the scale of production and where all costs are variable.
All costs must be paid or the business enterprise has insufficient resources to continue and leaves the industry.
Most successful large enterprises look 1 to 10 years ahead, predict the market’s character then plan how to meet the anticipated
demand. They spawn new product development and define new strategies to guide organizational shifts. The two basic dimensions
always within a strategy are working to: 1) expand demand and 2) reduce operating costs within the evolving scale of the operating
plant.
An increasing industry product demand forces firm management to grow or it will lose relative market share to other sellers as
competitors expand their own plants to meet the rising industry sales. Firms can grow internally, driven by product market expansion,
or externally, driven by merger and acquisition. Three notable long run cost reducing effects work to lower long run costs as capacity
expands.
Economic reasons why long run production costs fall
9 Economies of Scale—a reduction in the average cost of per unit output as the firm increases its size (scale) achieved
through enhanced market purchasing power, lower per unit overhead and engineering efficiencies
9 Economies of Scope—lower per unit costs from producing two goods in-house than producing them separately through
outsourcing
9 Learning Curve Effects—the reduction in total production costs from improvements learned across many production
cycles
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Once the entrepreneur establishes the worthiness of a product or idea, the challenge is to sustain the advantage. In the absence of
market barriers, success attracts many copycats and intensifies competition. Profit maximizing firms can pursue legal protections
such as patents, trademarks, copyrights and trade secrets to protect their product from rivals.
Where legal protections are not possible, savvy entrepreneurs pursue strategies like branding, specialized product design and
selective integration to sustain their competitive advantage. Advertising, technology investment and even appeals for outright
government protection can be creatively adapted to sustain or grow a firm’s market share.
In Sum
9 Entrepreneurs seek and earn profit by taking advantage of gaps in the market before others exploit them.
9 Profit is the return for successful risk-taking in an uncertain business environment.
o Profit = total revenue less total cost
o Profit is the residual after paying all resources their opportunity cost, including a normal profit to the entrepreneur.
9 Before entering a business, all costs are variable costs. Once a business has begun, costs must be divided into:
o Variable or avoidable costs as opportunity cost—those that vary with production levels.
o Fixed operating costs—expenses not related to production levels
o Sunk costs—non-recoverable costs that leave no opportunity for choice, and exist only in the short run.
o Marginal cost—the opportunity cost of producing an additional unit of output.
9 During a production cycle, any unit of output that yields revenue above opportunity cost will add to net profit and should be
produced. Sunk costs in the short run should never enter the calculation to determine if a unit of output should be made.
9 Law of diminishing returns—when at least one factor input, plant capacity, is fixed, the additional output produced from
additions to labor will eventually decrease as more labor is added. This law represents one reason why production costs rise
in the short run.
9 The demand for factor inputs is a derived demand. The demand for the good to be sold generates the indirect demand to hire
the resources to make the good.
9 Successful firms grow as demand for the good expands. In the long run the firm is able to take advantage of size through:
o Economies of Scale – a fall in the average cost per unit of output as the firm increases its size (scale) due to
enhanced market purchasing power, lower per unit overhead and engineering efficiencies.
o Economies of Scope – where it is less expensive per unit to produce two goods in-house than to produce them
separately by outsourcing one of them.
o Learning Curve Effects – a reduction in total costs due to production improvements learned across several cycles.
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Lesson 5: Opportunity Cost and Choice—Supply
Cost as Value
There can be no choice made without a sacrifice—a cost. By selecting one purchase option over another or one job opportunity over
another, the person making the choice implicitly reveals their preference and their values. This view reflects the fundamental idea
that all costs in economics are opportunity costs.
Opportunity cost–-the value of the next best option foregone when making a choice.
The Seller’s Dilemma
Decisions made and actions taken today always are based on expectations about the future. Sellers assume some risk when
producing what they believe buyers will purchase ahead of the actual sales transaction. The sales price, at least by expectation,
must be sufficient to cover all the costs of production and selling—opportunity costs. So what is it that makes a “business
proposition” sufficiently attractive for a potential seller to undertake? The quick response in a market system is the reward of profit.
But that response leaves out too much economic detail.
To price a good or service, the producer first assesses the competition (the buyer’s options) then figures the sales volume per time to
derive the total (opportunity) cost of the required resources. If that cost is equal to or below the price a particular buyer is willing to
pay, then production can be fruitful for the seller. If the negotiated price less the estimated opportunity costs for the required
economic resources is both positive and greater than the next best use of the seller’s time, the proposition should be profitable.
Prior to taking action or making a decision, all costs are anticipatory or avoidable, because they have not been incurred. That is the
seller’s decision point. Once the decision is made to proceed with the one option (and forsaking the next best option)—perhaps by
taking out a loan, acquiring assets or contracting for labor, the prior estimated costs become real. This fundamental economic logic
reduces to the relationship below.
Economic Decision Making–-Choose the option where the expected additional benefit to additional cost ratio is greater
than that same ratio for the next best choice.
Additional Revenue Option A
Additional Cost Option A
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Profit is the reward for successfully operating a business in an uncertain market environment. The economist’s logic to maximize
profits suggests that competitive sellers produce up to the point where market price covers all opportunity costs of production, which
includes sufficient profit to retain the seller-entrepreneur in that line of work. If market price rises, a supplier operating at less than full
capacity would willingly increase production, as long as the increased per unit cost is less than the new market price. Doing so adds
to net profit. That is why market supply curves generally rise up and to the right, as the next section reveals.
Producer Choices and Supply
Demand from buyers elicits supply from producers. And supplying a product is feasible when the buyer’s maximum willing purchase
price exceeds the seller’s minimum willing offer price. Each firm’s production cost is a competitive factor so much effort is spent
keeping opportunity costs of production low. A seller who offers output below its opportunity cost is not being rational, because the
revenue would be insufficient to pay the total opportunity costs of production. Production cost differences exist between sellers, even
for a similar product. So goods produced for market get offered at a range of prices, each price covering the respective firm’s
anticipated opportunity cost.
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Supply—the quantity of a good sellers are willing and able to offer at a range of prices, all other market
forces held constant.
Law of Supply—Sellers will produce more of a product at a higher expected price than at a lower expected price. Price and
quantity supplied move in the same direction along a given supply schedule.
An individual supply curve usually slopes upward and to the right in the short run because the opportunity cost of production rises as
the output level nears the firm’s output capacity. The sum of quantities offered for sale by all sellers at each potential market price
comprises the market supply curve. Short run supply curves for the entire market usually slope upward and to the right, reflecting
increases in short run opportunity costs of production for all sellers. How is this so? Economists presume that with freely flowing
market information, sellers enter the production stream only when market price is expected to at least cover additional production
costs. Since not every seller has the same opportunity cost of production they tend to enter the market with their production in the
order of their (rising) costs. The chemical industry is a good example of this tendency to produce at market price thresholds. When
market prices are low, chemical production is slowed or plants are temporarily idled. As market prices rise, plant managers re-start
select facilities to generate new product within desired cost ranges.
Seller Responses to Price Changes
In a short time period there is no chance to alter the firm’s productive capacity. Such decisions require more time and certainty about
sustainable future market prices and the expected volume of output to justify undertaking the capital expansion. Yet suppliers in
some markets can respond more swiftly to market price changes—offer a greater output—than can suppliers in other markets. Why?
Price elasticity of supply—A measure of the relative change in producer output compared to the change in selling price.
The prime determinant of supply elasticity is the ability of the firm to re-direct human and physical resources so they produce more or
less product during a production run. As an example, it is relatively simple for a local retail pizza producer to add or subtract workers
from a work schedule so that the pizza supply can be responsive to changes in price, like a sale price on a Saturday evening. Many
other industries, such as petroleum refining and automobile manufacturing have narrow “production windows.” These highly
specialized processes often are capital intensive and their output cannot be cost-effectively altered.
A product’s supply is said to be elastic when a small change in price brings about a large change in quantity of the good supplied. A
product’s supply is said to be inelastic when a large change in price brings about a small change in quantity of the product supplied.
The most important determinant of supply elasticity is time. As time passes, firms can more easily commit to transforming their
workers and machinery to different production rates.
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Supply Responses to Non-price Changes
Supply analysis for an individual producer and supply analysis for an entire market of producers are similar. This is true because a
market’s supply is the sum of units supplied, at each and every price, by the sellers in the market. While the behavior or response of
a particular seller in a market may occasionally vary from that of all sellers as a group, the total market supply curve commonly
slopes upward and to the right.
Recall that the last phrase in the definition of supply is “all other market forces held constant.” What is the meaning and importance of
this phrase? You have seen when time is artificially held still, that price changes bring about a change in the quantity supplied, noted
by reading along a fixed-in-place supply curve for the short run. Just as you suspected in the lesson on demand, forces other than
price also are at work in the supplier market.
Inspect the chart above. Choose a price on the vertical axis, say $40. Then read the quantity supplied at the left edge of the yellow
supply line. It is about 50 units. If supply increased, by shifting to the right, to become the blue supply line, the number of units
supplied at the same price of $40 would be about 55 units. That’s an increase in supply, at the same price. Had we begun with the
blue supply line at the price of $40, a movement back to the yellow supply line would have represented a decrease in supply. Forces
that increase supply shift the curve to the right. Forces that decrease supply shift the curve to the left. Economists categorize the
forces that move or shift market supply. As non-price market forces influence sellers, the actual supply curve position changes
through time. Non-price forces on supply are factors that cause a change in supply—a shift of the supply curve—without a change in
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the current price for the product. A change in supply means that, at any and all prices, a different quantity—greater or lesser than
before—of the good will be supplied.
The reason for the emphasis on the difference between changes in quantity supplied brought about by changes in the current price of
the good versus shifts in supply caused by other market forces is the same as for the demand discussion and bears repeating. This
distinction, the time-based separation of price from other market forces, lets the careful thinker correctly understand how the supply
side of the market works. The supply determinants and the logic for how to determine the direction of their influence on the supply
schedule appear below.
Supply determinants: factors that shift the supply curve (with no change in price)
9 Number of sellers—as the count of sellers rises, the supply increases (and the opposite is true)
9 Technology—as technology is adopted, the supply increases (and does not decrease)
9 Future price expectations—if future market price is expected to rise, current supply falls (and the opposite is true)
9 Input costs—if the costs of material and labor rise, the supply decreases (and the opposite is true)
How to Analyze the Effect of Determinants on Supply
9 Step 1: From the facts provided, determine which supply force is affected
9 Step 2: Determine the direction of the force itself: increase or decrease
9 Step 3: From the direction of the force and knowledge of economic incentives, determine the
direction of change for the supply curve: increase (rightward shift) or decrease (leftward shift)
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In Sum
9 Cost means the opportunity costs of resources in use, reflected by the owner-made choices of each economic resource.
9 Opportunity cost is the value of the next best option foregone.
9 A seller-entrepreneur decides if an opportunity is a good “business proposition” by:
o Assessing expected net profits from a venture
o Comparing the first option’s net benefits to the next best alternative
9 Business owners—sellers—must pay a resource’ opportunity cost to attract them into a particular use.
9 Revenue left after paying resources their opportunity costs becomes profit for the entrepreneur-seller.
9 Supply—the quantity of a good that sellers are willing and able to offer at a range of current prices—other market forces constant
9 Law of Supply—sellers will produce more of a product for sale at a higher current price than at a lower current price.
9 Price elasticity of supply—A measure of proportionate producer output response to a relative change in current price.
o The main determinant of supply elasticity is time and the ability to direct resources to different uses
9 Non-price market forces shift the supply curve, as time passes, to reflect changes in the quantity supplied at all prices.
o Increase in supply is a rightward shift of the curve;
o Decrease in supply is a leftward shift of the curve;
ƒ Number of sellers—as the count of sellers rises/falls, the supply increases/decreases
ƒ Technology—as technology is integrated, the supply increases
ƒ Future price expectations—if future market price is expected to rise/fall, current supply falls/rises
ƒ Input costs—if the costs of material and labor rise/fall, the supply decreases/increases
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Lesson 6: How Markets Coordinate Exchange
Exchange Creates Wealth
People trade because when they do, the wealth of both buyer and seller increases. Some regard that statement skeptically because
“trade” carries a poor connotation. Should trade between two people not be an exchange of equals? Some people are wedded to
the idea that only material things like property, cars, or gold constitute wealth. Neither sentiment is correct to an economist.
Wealth gets confused with material well-being—as opposed to perceived value, the preferred and far more useful economic idea.
Consider that no object is “wealth” unless someone values it. An object’s value is entirely subjective, and it depends solely on the
willingness of admirers to sacrifice something to acquire it. Once that idea about value is accepted, it becomes clear that exchange
occurs when there is a tradable difference in a good’s value—providing an increase in wealth to each party in the transaction.
Information also is a good that has value. Because economic actions are undertaken based on expectations about the future and the
future is never certain. A used car purchase, for example, may look superficially worthy. Once acquired, latent defects could surface
to reduce or destroy the value anticipated by the buyer prior to the exchange. Buyer and seller possess unequal amounts of
information, and the seller often holds the favored position. Acquiring additional information has an economic value as well as a cost.
This difference in information between buyer and seller may affect negotiating power and the outcome of the exchange.
Market Price as a Signal
Much like the two cutting blades on a pair of scissors, price in the market place is determined by the interplay between supply and
demand. Market actors—buyers and sellers—can efficiently exchange private goods because market price serves as a signal, telling
those wanting the good the size of the sacrifice—opportunity cost—others have paid to acquire it.
A market exists anywhere a transaction between buyer and seller occurs. Free and competitive markets efficiently allocate goods
and services through an anonymously determined market price reflecting substitutes available to buyers and the expectations of
sellers, at a particular moment.
Market equilibrium price works as a beacon, coordinating the choices of buyer and seller by providing at least one measure of a
good’s current worth—the market’s value. That value turns away those buyers seeking less expensive options and those sellers
whose production costs are too high, while attracting others who may be more able to find a favorable price for the exchange.
The more open, competitive and informed the market’s bargaining processes, the more efficient is the allocation of relatively scarce
private goods. In economics, efficiency implies several things. Most fundamentally, it means that goods are sold at a price equal to
opportunity cost. Efficiency also means that goods flow to their most highly valued use.
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The lower the transaction costs—costs of arranging transactions between buyer and seller—the more efficient is the market. The
clearer and more accepted the property rights—what belongs to whom under what circumstances—the more efficient is the market.
You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics.
Choices and Trade-offs at the Margin
To the untrained eye, market processes can appear chaotic and directionless. Using economics’ fundamental division, buyers versus
sellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, market
demand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5
units.
To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where
transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve
and the solid red lower range of the supply curve up to their intersection. Why is this so?
The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for
some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good
and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that
price or more.
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The intersection of the demand and supply schedules reveals the market equilibrium price, where the quantity demanded just equals
the quantity supplied. While competitive market exchanges tend toward an equilibrating price that will clear the market of goods, not
all prices negotiated between buyers and sellers will be at the equilibrium amount. Any transaction completed in the reddish-silver
triangular area will be for a price no higher than some buyer’s maximum value and no lower than some supplier’s minimum cost.
Higher equilibrium prices indicate that sellers held the stronger bargaining position and lower equilibrium prices indicate that buyers
held the stronger position in the market.
Now look once more at the point of equilibrium in the graph—where the demand and supply curves meet. At that point it can be said
that the price of the good reflects the opportunity value of the “last” purchaser and, at the same instant, the opportunity cost of the
“last” seller in that market. Someone did purchase the 5th unit of the good at the equilibrium price. For that buyer the sacrifice was
just worth the exchange. Also as clearly, some producer sold the good at the market equilibrium price. For that producer the sale
just covered all production opportunity costs—including a minimum profit.
For all units of the good sold at that particular equilibrium, and at that time, market value just equaled the opportunity cost value to
the last buyer and to the last seller. Other buyers in the market place held different and higher values for the good. Other sellers in
the market place held different and lower opportunity costs of production for the good. Some buyers could have paid less than
market equilibrium price and reaped the extra value. Some sellers could have sold for more than market equilibrium price and
reaped the extra profits.
Equilibrium Responses to Non-price Changes
So far this discussion has focused on the short run time period where current market price reflects the quantity demanded and the
quantity supplied. What happens to equilibrium price when non-price market forces cause demand or supply to shift?
Three steps to assess equilibrium effects of market change
9 Determine if the force affects the demand or the supply curve
9 Decide the direction the curve shifts—increase (rightward) or decrease (leftward)
9 Note the change in equilibrium price and quantity from the original demand and
supply curve intersection to the resulting demand and supply equilibrium.
From the facts given in a situation, the first step means to determine if the market force pertains to buyers—the demand side, or to
producers—the supply side. Next, reason through which particular force is at work for that side of the market, then note its direction.
Shift the demand or supply curve in the appropriate direction—increases to the right or decreases to the left. Finally, compared to the
original equilibrium price and quantity, note the position of the new equilibrium price and quantity.
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Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green)
together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the
future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market
equilibrium price—and why?
Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices.
That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B.
Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher
expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A.
Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units
are demanded at each price) labeled B. The green supply has decreased to the now “lower” supply (fewer units are supplied at each
price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the
equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine
the effect on the resulting equilibrium price and quantity in the market.
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In Sum
Trade creates wealth because both parties perceive a gain in a voluntary exchange.
An economic good provides wealth only to someone who values it.
A market exists anywhere an exchange transaction occurs.
The forces of supply and demand working together efficiently determine market equilibrium price when:
o Competitive markets tend toward an equilibrium price—one that clears the market, and
o Many buyers and sellers exist to bargain freely when market information and mobility costs are low
o Property rights—what belongs to whom under what conditions are known and respected
o Transactions costs—the costs of completing a transaction are low
9 Efficient markets in economics means:
o Goods are produced at their opportunity cost and exchanged for their perceived value
o Goods flow to their highest valued use
o Market exchanges occur when the buyer’s maximum willing price exceeds the seller’s minimum offer price.
o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal.
9 Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from
a given demand and supply intersection with a given equilibrium price and quantity, the following are true:
o Increased demand (supply constant)—a rightward shift, increases both equilibrium price and quantity.
o Decreased demand (supply constant)—a leftward shift, decreases both equilibrium price and quantity.
o Increased supply (demand constant)—a rightward shift, decreases equilibrium price and increases equilibrium
quantity.
o Decreased supply (demand constant)—a leftward shift, increases equilibrium price and decreases equilibrium quantity.
o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium
price and quantity can rise, fall or stay the same.
9
9
9
9
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Lesson 7: Competition, Market Power and Economic Efficiency
Market Power and the Structure of Industry
The economics of industry is about market power—the power to set product price, gain market share and improve profits. The study
of economic welfare, where the social goal is to efficiently solve the economic problem for all citizens—prefers competitive markets
above all others. For it is only purely competitive producers, due to their individual powerlessness to affect price, that offer society
the most output at no more than the opportunity cost to produce it as firms pursue profit maximization.
In stark contrast, monopolistic markets permit the ruling firm to restrict output and raise the price for their production as they search
for the price, above opportunity cost, that maximizes their profit. Between the polar market structures of competition and monopoly
lie two others: monopolistic competition—a blend of competitive extremes; and oligopoly—a peculiarly postured industry where a few
large firms strategically spar for market share in game-like fashion.
Competition’s Efficiency Promise
Perfect competition is a fiction, though a highly useful one. It serves as an ideal against which to compare diversions from the
economically desirable position of maximum efficiency and output. Much of competition’s value rests in its ability to show just how far
from the ideal other market solutions may lie. Many public policies also can be judged against their progress toward reaching
selected competitive criteria. Since perfect competition resides only in the economist’s mind, what does it look like and what is its
logic?
The industry characteristics that create this idealized market structure include the following: very many buyers and sellers; identical
products; costless entry into and exit from the market; perfect market information and costless market mobility. These characteristics
combine to form a market where no one actor—buyer or seller—or small group of actors can influence market equilibrium results.
Competitors have no price-setting power. The market for selling and buying corn comes close to these requirements. Fast, faceless
and efficient exchanges work through market demand and supply to achieve an equilibrium price that clears the market.
So powerless is each competitive seller to affect market price that they can only accept the established equilibrium price as the per
unit revenue they will receive for selling their product. Effectively, their demand curve is horizontal (completely elastic). The result is
that the only decision a producer needs to make for a current cycle is to choose the level of production.
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Inspect the chart above, and notice that equilibrium market price equals $20—any seller’s revenue per unit. Further note that
opportunity cost rises as production increases. In this situation, a rational seller will gladly produce up to 4 units per period for sale.
Why? Each unit of output up to the 4th unit sells at a price above its opportunity cost and adds to profit. To produce beyond that
point, say the 5th unit is not rational because its cost ($25) is greater than the market equilibrium price received ($20) and lowers
profit.
So the optimum output rate, the one that will generate the most profit, if profits are being made, is 4 units. How could it be that the
seller might not be making a profit if each unit sells for more than its opportunity cost? In the chart above, the amount of overhead
cost was not provided. Once known, short run profit determination can be made.
Profit maximizing rule—operating at the level of output where market price equals marginal cost will either maximize profits
or minimize losses, if they are incurred.
The competitor’s rule is to produce at the level of output where price equals marginal cost, the opportunity cost of production. By
doing so, any profits will be maximized or any losses will be minimized. This extreme competitive pressure guarantees private goods
brought to market will sell for a price equal to marginal cost—the opportunity cost. Further, there will be more product available at
that price than would be available through any other market structure. These results reflect competition’s efficiency promise for
private goods in the short run. In the long run the efficient firms best able to sustain profits by controlling cost can survive and grow.
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Monopoly’s Efficiency Failure
At the opposite end of the competitive spectrum lies monopoly, a market possessing only one seller but many buyers. Monopoly
represents one of four cases of efficiency failure in economic analysis, where failure means an inefficient allocation of goods in
comparison to competition.
A monopoly may achieve its market power position by taking advantage of large economies of scale, growing so large that no other
firms can effectively compete on cost. A monopoly also may be granted by regulatory authority, as with a patent, legally prohibiting
other rivals. Finally, a monopolist can be the sole owner of a natural resource, like a water company. No matter the genesis of a
monopoly, economists detest its effects on economic welfare.
Because the monopolist faces the downward sloping demand for the entire market, two important observations can be made. One,
there are no close substitutes available to the monopolist’s product, so the firm has significant price setting power. Two, market entry
barriers are prohibitively high. The only way for another firm to enter the market is to slay the existing monopolist.
A monopolist incurs opportunity costs to produce its output, just like a competitive firm does, though it is under less pressure to
control those costs. It also has the same business objective as a competitive firm: maximize profits. To achieve that objective, the
monopolist does something the competitor cannot—change price. The monopolist also knows that additional sales can only occur
through a price drop.
So what makes monopoly behavior loathsome in the economist’s mind? Compared to competition, a monopolist’s price-setting
power enables it to search out the price that maximizes profits. That price is higher than marginal cost and achieved due to a
restriction in output. How does this happen? Like a competitor, a monopolist will produce additional units of output only as long as
the additional revenue exceeds the additional cost of each unit. The culprit is the monopolist’s down-sloping demand curve, allowing
it price searching power to maximize profits as buyers have no or very few close substitutes.
In the lower (and inelastic) half of a monopolist’s demand curve, price increases generate rising additional revenue so total revenue
also rises. Inevitably, the monopolist’s profit maximizing price search stops short of the output level a competitor firm would attain.
Finally, the quantity demanded at that output allows the firm to charge a price above the opportunity cost of production.
In response, and in fairness, the monopolist’s management would claim that they are pursuing the same rational economic goal as
competitor firms, acting on behalf of their stockholders. Their statement would be true but at the cost of reduced economic welfare—
fewer units available for purchase sold at a price above opportunity cost. This reality is one of the key justifications for government
regulation of some monopolized markets.
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When a Few Firms Dominate the Market
Moving away from the monopoly end of the competitive continuum, we find a structure where several firms compete for many buyers.
US industries where competition is highly concentrated in the hands of relatively few firms include airlines, steel, petroleum refining,
and automobiles.
These rivalry-intense industries, dominated by a few large firms, employ competitive strategies directly related to the similarity of their
products. Entering and exiting the industry is sufficiently expensive that a firm’s threat to enter or leave the industry must be credible.
Rival firm competition may manifest in the form of price, output or product features.
Advertising may be aggressively used as a common strategic tool to gain market share, especially where similar competing products
or services show observable differences. Rival firms can also compete on the basis of price or output in a context not unlike a game.
Airline Oligopoly Game Matrix
Northwest
Airlines
Price high
Price low
Southwest Airlines
Price high
Price low
Profit / Profit Loss / High Profit
High Profit / Loss
Loss / Loss
In the strategic pricing table above, two airlines each face two route-pricing options that determine possible profit payoffs from
independent choices made by each firm. The payoffs for each set of choices are shown in the respective cells as
[Northwest/Southwest]. Suppose each firm must decide if and when to change their own pricing structure with the end of the travel
season near. What choice should each airline make and why?
Notice how both airlines could benefit by maintaining their current high prices. But the reward for low pricing to gain market share, if
the rival does not also price low, is very appealing to airlines operating on thin profit margins. Should both airlines choose to price
low, they each suffer a loss by splitting the market with lower fares. This is an example of a famous economic game know as the
“prisoner’s dilemma” where actions that might benefit each separately injure both if undertaken jointly.
Southwest must consider its best response to either action by Northwest. If Northwest prices high, Southwest earns more by pricing
low. If Northwest prices low, Southwest still earns more by pricing low. Likewise, no matter what Southwest does, Northwest also is
better off choosing to price low. The result of this game is that both airlines, playing strategically, will price low…unless they can
successfully collude to keep prices high with neither cheating to earn more profit in the short run. This type of collusion is a violation
of federal law, with serious penalties for the colluding if firms.
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Games like this are common among the rivals in oligopoly industries. Often, there can be tacit collusion where the largest rival will
act the part of a price leader and move first to change price, with the expectation that others will quickly follow. Airline route games of
this sort have revealed a more sinister side in recent years as rivals have sometimes refused, between holiday peak pricing periods,
to follow their price leader, to the detriment of the leader’s profit.
Monopolistic Competition
Moving farther away from the monopolistic and closer to the pure competition end of the competitive continuum, we find industries
blending elements of both competition and monopoly. Example industries include dry cereal, men’s and women’s clothing, hotels
and many other retail products. Entering or leaving this industry is relatively less expensive than for oligopoly industries.
The relatively large number of firms in monopolistically competitive industries still allows some degree of price setting power—their
individual demand curve slopes down to the right. Rival firms engage in stiff competition based on product feature similarity, location,
advertising affects and other strategic economic dimensions. For these firms, significant resources are applied to the marketing
function. Marketing includes all activities between product production and customer purchase as a legitimate cost of product
positioning.
Components of marketing as strategic tools
9 Advertising
Distribution activities
9 Transportation and storage
Product planning
9 Market research
Customer service
9 Financing
Product design
Characteristic
Price setting power
Product similarity
Price to opportunity cost
Excess capacity
Advertising
Market entry cost
Information access
Pure
Competition
None
Identical
Equal & “Ideal”
None
None
Zero
Total
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Monopolistic
Competition
Little
Similar/Identical
Price above
Some
Much
Modest
Modest
Oligopoly
Some
Similar/ Identical
Price above
Some
Much
High
Limited
Monopoly
Much
N/A
Price far above
Much
Little
Great
Limited
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Monopolistically competitive firms’ product demand curves are interdependent due to the closeness of rival product features to their
own. A price decrease for one firm’s product can lower the demand for a close rival as the rival product’s customers opt out in favor
of the now less expensive and not-that-different substitute, for example frozen turkey dinners instead of frozen chicken dinners.
A similar demand response is possible from successful advertising campaigns. If one firm aggressively advertises customerimportant features, buyers may leave the rival product’s market to join that of the newly perceived “better” product. Television
commercials often mention the name of the closest rival and compare selected features. The economic objective of all advertising is
to increase demand for the one product—a rightward shift—and to make the demand inelastic—less responsive to a rival producer’s
campaign in the market place.
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In Sum
9 Economics strongly favors competitive markets because forces work to bring equilibrium price down to opportunity cost and to
provide more output than any other market structure. Competitive market characteristics include:
o Very many buyers and sellers
o Identical goods
o No market entry or exit costs
o Costless market information and mobility
9 Competitive markets efficiently achieve an equilibrium price and quantity that clears the market.
o They are “powerless price takers” and must accept the market’s price as their own as they seek to maximize profits.
o They produce output up to the point where the market price just equals the opportunity cost of the last unit produced.
9 Monopolies—single sellers—face a downward sloping demand curve for the entire market comprised of many buyers.
o To sell more the monopolist must lower price.
o Monopolies are economically inefficient since:
ƒ Their market pricing power lets them search for the price that maximizes profits, and
ƒ At the monopoly’s profit maximizing price:
• Output is lower than for a competitive market
• Price lies above the opportunity cost for the output
ƒ Because output is inefficiently allocated monopolies represent a form of market failure.
9 Oligopoly industries contain many buyers and several rival firms with interdependent product demand where strategic pricing
and production games are common.
o Large market entry and exit costs
o Competition can be on the basis of price or output depending on the nature of the good.
o Advertising is common when rivals produce similar goods with differing features.
9 Monopolistic competition represents an industry with many sellers and very many buyers.
o Market entry and exit costs are low
o Product differentiation is used to gain market share
o Advertising is a strategic tool designed to:
ƒ Increase product demand—shift rightward
ƒ Decrease product demand elasticity
9 All less-than-competitive industry structures are relatively inefficient compared to pure competition and prevent society from
receiving the full value of additional production and lower product price.
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Lesson 8: Economic Justifications for Government
Market Failure and Government
In theory, with perfect information and clearly defined property rights, a competitive free-market will efficiently allocate private goods.
But what about cases where there is imperfect information (for example, a food buyer has less information about the quality of food
safety than the meatpacker) or property rights are not clearly defined (for example, who owns the right to odor-free air around your
home, you or the local paper mill?). In these cases, there is market failure in terms of not attaining the desired efficient outcome for
all concerned.
The US government has a constitutional right to coerce certain actions, such as the payment of taxes and enforcement of anti-trust
laws, to help correct market inefficiencies. An economically efficient outcome does not necessarily mean that it is socially equitable
or preferred. More, while government can correct for market failure in specific cases, proper and useful policies must be in place.
Even then, no policy is perfect and policy applications often spawn unintended consequences. So if government is to pursue a nonmarket solution, it should weigh the expected benefits of the policy against the expected costs to individuals and society.
Cases where markets fail to efficiently allocate goods
9 Public goods–goods where use by one person does not reduce the good’s availability to society, and some people to
“ride free” at the expense of others, causing such goods to be under-produced by private markets
9 Natural monopoly–a single firm provides services at a lower cost than two or more competing organizations
9 Common resources–natural resources where overuse by one or more individuals reduces the availability to society, and
high transactions costs with ill-defined property rights, hinder efficient allocation for society
9 Externalities—where benefits or costs from the consumption or production of a private good unintentionally affect others
not a party to the private good’s consumption or production
Defining the types of goods produced and consumed in society is a first step. The characteristics used to distinguish them are rivalry
and excludability.
Rival good—one person’s consumption reduces the amount of the good available to others.
Nonrival good—consumption by any person(s) does not reduce the amount of the good available to others.
Excludable good—others can be excluded from consuming the good, usually because it has been consumed already.
Nonexcludable good—preventing others from consuming the good is too expensive.
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Economic Good Types
Good is Nonexcludable
Good is Excludable
Good is Nonrival
Public goods
(national defense, fireworks shows)
Natural Monopoly
(cable television, water and sewer)
Good is Rival
Common resources
(ocean fisheries, irrigation systems)
Private goods
(apples, cars, airline flights, haircuts)
Government Provision of Public Goods
Consider the voluntary provision of national defense. National defense is a public good because individuals cannot be excluded from
consuming it and consumption of national defense by one individual does not reduce the amount available to others. Caring people
may contribute funds to national defense, but persons self-interested in maximizing their wealth have an incentive to “ride free”,
letting others pay for the service while they also receive the benefits. Because of the incentive to ride-free and the inability to exclude
non-payers, national defense would be under-provided if left to the private sector. So government uses tax revenue to fund national
defense for the benefit of society.
Government Regulation of Monopoly
Let’s consider a water company, which has characteristics of natural monopoly whereby the larger it gets the lower the cost of its
output. Also, potential competitors are not eager to build a second network of pipes for a chance to compete, a “barrier to market
entry.” Sufficient water means that its consumption is nonrival. An unregulated profit-maximizing monopolist would restrict quantity to
charge higher prices, resulting in an inefficient level of water provision and economic losses. But if government owned the water
supply, it can behave in a social-enhancing way rather than a profit-maximizing way and sell the water at cost. Or, if the water supply
were privately owned, the government could regulate the price charged.
Government Regulation of Common Resources
The Tragedy of the Commons occurs when individuals, acting in their own self-interest, exhaust a common resource even though it
was in no one’s long-term interest to do so. Consider a public fishery, where the fish population doubles each year until it reaches a
level that the ecology can support. Because users cannot be excluded from fishing, and the fish are a rival good (the fish one person
catches is a fish another person cannot catch), the incentive is to catch as many fish as possible before others do so.
One solution is to privatize the resource. In the case of fisheries, government might restrict the size of the catch or length of time
catching is allowed (through fishing season definitions) to avoid depleting the resource, or it can tax the catch or act of fishing to
reduce the benefits of fishing and the quantity caught.
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Private Goods with External Effects
Private markets trading private goods often do achieve a socially optimal solution, without government intervention. So under what
circumstances should government intervene in markets for private goods?
Externality Types and Market Consequences
Externality Type
Production:
Positive
Production:
Negative
Supply of Good
from Society’s View
Society wants more of
the good than is
produced by sellers
(e.g. R&D)
Society wants less of
the good than is
produced by sellers
(e.g. coal power)
Externality Type
Consumption:
Positive
Consumption:
Negative
Demand for Good from
Society’s View
Society wants more of
the good than is
consumed by buyers
(e.g. vaccinations)
Society wants less of
the good than is
consumed by buyers
(e.g. heroin)
Private goods, when produced or when consumed, may unintentionally impose benefits or costs on a party that is neither the
purchaser nor the producer. In short, externalities affect someone external to the transaction. For example, if Mary buys a pack of
cigarettes from a machine in a restaurant and smokes it, the smoke is a negative externality imposed on other diners. Or, if Robert
pays landscapers to plant a beautiful garden in his front lawn, the garden is a positive externality enjoyed by his neighbors.
A now famous proposition put forth by Ronald Coase at the University of Chicago, says that if property rights are clearly defined, the
transactions costs of bargaining are zero, and the affected parties are willing to bargain, efficient market-based resolutions can be
achieved when the parties negotiate compensation or agreed upon restrictions.
The Coase Theorem—states that if private parties can bargain without cost about how to allocate resources, then they can
resolve the externality problem on their own.
Property rights—limits on the use of private property, goods and services that help define the limits of social behavior.
Transactions costs—the costs of negotiating a transaction with all relevant parties.
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Real limitations hinder Coase’s theorem in practice. An externality’s impact does not always lend itself to negotiation with the
affected parties if the parties are difficult to locate, there are too many to easily bargain with or the property rights are too vague.
Imagine fifty thousand residents of a city bargaining with a local coal plant over acid rain caused by sulfur emissions. If the private
market solution cannot be made to work, government may play a role.
Air pollution, a negative production externality, is such a case. Air pollution has several known detrimental effects on public health.
Identifying and negotiating with companies individually or even in groups can be costly. Government has alternatives such as
1) limiting the pollutant volume, 2) taxing polluter or 3) providing tradable pollution rights. Although the idea of selling “pollution
permits” strikes non-economists as strange, it is an efficient allocation mechanism. Once the air pollution goal, say parts per million
per geographic area, has been set, each company is allowed to “trade” its allotted “rights” to pollute with other companies for a
negotiated price. If one company can achieve better than its mandated target, it can “sell” its remaining pollution limit to another
company that cannot meet its requirement. Through this process, the overall pollution goal is attained and individual firms get to
make economically efficient benefit-cost decisions on how to comply with the pollution regulation.
Notice that no approach above would reduce pollution to zero. Achieving that goal would likely mean closing down the companies
generating the pollution. Society then is denied all benefits from the company’s private production. Economic solutions most often
try to balance benefits against costs at the margin, maximizing total (net) benefits or minimizing total (net) costs.
Constitutional Right to Tax
An economist would argue that any government with such a constitutional privilege can, and in many ways should, act in an
economic manner—first weighing social costs and benefits at the margin. While some taxes are economically justifiable, no tax is
popular. On the other hand, should informed citizens not recognize the personal and collective value of supporting a public good or
using a common resource and willingly submit some value to authorities?
It is easy for people to rationalize that the fruit of their labor stems solely from their own acts and that any related benefits should flow
exclusively to them. As individuals we tend to forget that we drive our cars to work on the “freeway”, or that our national defense
system protects our investments as well as our freedom. If citizens could be somehow induced to reveal the value implicit in the
public goods or common resources they use—parks, libraries, public transportation, education, trash collection, and all the rest—
honestly bargain for the price, then pay it, much less direct government taxing or policy coercion would be necessary. Unfortunately,
research has shown that surveys are unreliable in eliciting people’s values for public goods and services.
There are few simple means to get citizens to accurately reveal their true valuations for public goods and common resources. That
reality, along with a strong tendency for many people to “ride free” on the efforts and opinions of fellow citizens, invites more rather
than fewer government strictures. Among the more vexing issues that economists have undertaken is how to impose tax policies.
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Economists apply the criteria of fairness and efficiency to assess how taxes affect work incentives and the distribution of resources in
the market place. At the onset, two things are clear, taxes alter economic behavior and, ultimately, only individuals pay taxes.
Principles of Taxation
An efficiently designed tax system would let the government determine the necessary level of public goods and services. Then use
the tax system to raise the revenue in the most efficient and equitable manner possible. The two principles for designing a tax system
are the “benefits received principle” and the “ability to pay” principle. The benefits received principle of taxation says that people
should contribute taxes in some proportion to the benefits they receive from using public goods. This justification applies fairly well to
user-fees like gasoline taxes to fund highways or to public education via local property taxation.
But some public good benefits are so broad and diffuse that the benefits received principle is neither an adequate nor an appropriate
rationale. An alternative, the ability to pay principle, says that taxes should be levied based on how well the person can shoulder the
financial burden. Simply, those who earn more pay more taxes. The federal income tax system is based on this concept.
Public goods like national defense and education require tax expenditures but often it is difficult to match their use, or the option to
use them, to specific benefiting individuals or groups. For these public goods, many citizens would simply “ride free” if not for the
ability-to-pay justification to collect the tax.
A person “rides free” when they experience benefits from a public good or common resource due others’ actions, but avoids paying
for those benefits. As one small example of riding free, have you ever enjoyed visiting an historical site but ignored the voluntary
contributions box when exiting? We all ride free on some public value some of the time, but how many fewer tax dollars would have
to be coerced from us if we honestly volunteered contributions in proportion to the value received?
Fairness in Taxation
The ability to pay principle raises the issue of fairness in levying taxes. Economists apply two relative assessment criteria when
speaking of fairness, horizontal equity and vertical equity. Horizontal equity suggests that taxpayers with a similar ability to pay
should pay a similar amount in taxes. Vertical equity suggests that tax payers with greater ability to pay should pay larger relative
amounts of taxes.
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Tax Incidence Based on Annual Income
Annual
Income
$ 25,000
$ 50,000
$ 75,000
$100,000
Regressive
Tax
$1,000 = 4%
$1,000 = 2%
$1,000 = 1.3%
$1,000 = 1%
Proportional
Tax
$1,000 = 4%
$2,000 = 4%
$3,000 = 4%
$4,000 = 4%
Progressive
Tax
$1,000 = 4%
$3,000 = 6%
$6,000 = 8%
$10,000 = 10%
The table above highlights the dilemma of equitably trading-off tax dollars by count of dollars versus tax dollars as a percent of
income. Horizontal equity, while a seemingly good idea, is difficult to apply in practice. What criteria should determine the “similarity”
between individuals or households? Does the act of imposing the criteria not bear upon the personal choice of lifestyle and
expenditure pattern? For example, one simple approach is to apply the same tax rate to families with the same income level. But
that single criterion presupposes that other dimensions such as family size, family member age, and the cost of supporting a chosen
lifestyle are somehow similar.
Vertical equity, too, suffers critical vagaries in the attempt to equitably apply it. While the objective is to tax less those with smaller
incomes and to tax more those with larger incomes, what should the rate be for each income level and how fast should the tax rate
rise as income rises? During Ronald Reagan’s presidency in the 1980s the marginal income tax rate—the rate applied to the last
dollar of taxable earnings—was reduced from a maximum of 70 percent on the highest income levels to 28 percent. Was vertical
equity served? The answer is not immediately obvious.
Tax Incidence and Efficiency
Economists also are concerned about who ultimately pays a given tax—the incidence of the tax—and how much a tax distorts the
allocation of goods in the market place—the efficiency of the tax. Most people, to the extent legally possible, try to avoid paying more
taxes than necessary. Business owners, to the extent allowed by the market, try to pass taxes on to their customers. This avoidance
tendency illustrates the power of taxes to alter—even distort—the allocation of resources in the market place.
Two things are almost certain to occur in the market when a new tax is applied. First, the quantity sold of the taxed good or service
will fall. A second, and not at all obvious, effect is that both the buyer and the seller share in paying the tax. The proportion of the tax
paid by each party in the transaction depends on the market’s competitiveness. The more competitive the market, the more the
seller bears the burden of the tax. The less competitive the market, the more the buyer bears the tax burden.
While it may sound strange to speak about an efficient tax, economists would favor the tax that least distorted the allocation of
goods—that is, was more efficient. To a person of limited means, a proposal to heavily tax luxury goods like yachts and fur coats
might seem appropriate. Yet wealthy individuals can simply avoid such taxes by purchasing different luxury items, and they do. The
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burden of such a tax would then inefficiently fall more on the makers and sellers of yachts and furs, via diminished sales, than on the
targeted wealthy buyers.
The type of tax that least distorts goods allocation in the market—a lump sum tax—is one where each person pays the same single
sum, regardless of income. It causes the least market distortion—is most efficient—because the amount of tax owed does not alter
people’s private market decisions. The problem with the lump sum tax is that it is regressive with respect to income. For example, a
$1,000 lump sum tax paid by someone earning $25,000 a year is a larger percentage (4%) than for someone earning $100,000 (1%)
per year.
Another aspect of tax inefficiency, apart from market allocation distortions, is the cost of tax policy administration. A prime example is
US personal income tax collection, enforcement and preparation where such costs are high and sustain one of the largest
bureaucracies in the federal government, the Internal Revenue Service.
What messages should be drawn from this discussion on taxation? Only people pay taxes. Many taxes are justifiably necessary to
fund expenditures on public goods, preserve common resources and redress externalities for the benefit of society. People often will
ride free, benefiting from a public good or common resource without paying, if they can. Taxes tend to distort both market incentives
and goods allocation because citizens and business owners work to avoid taxes where possible. No tax is both efficient and fair in
the eyes of all people or from all logical vantage points.
In Sum
9 Markets fail, operate inefficiently to some degree, when competitive forces cannot prevail.
o Government should enter the market only after carefully weighing the private and social costs and benefits
o Public goods—goods where use by one person does not reduce the good’s availability to society and no one can be
excluded from their use.
o Natural monopoly—a single firm provides a service at a lower cost than two or more firms.
o Externalities—costs or benefits accruing to other than the transacting parties are not measured when conducting
market transactions. Types and results:
ƒ Production positive—benefits others, goods are under-produced in society’s view
ƒ Production negative—imposes costs on others, goods are over-produced in society’s view
ƒ Consumption positive—benefits others, goods are under consumed in society’s view
ƒ Consumption negative—imposes costs on others, goods are over consumed in society’s view
9 Common resources—natural resources where use by one individual reduces the availability to society
9 Property rights – bounds placed on the use of private property that help define the limits of social behavior.
9 Transactions costs – the costs of negotiating a transaction with all relevant parties.
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9 Coase’s Theorem—states that if private parties can bargain without cost about how to allocate resources, then they can
resolve the externality problem on their own.
9 Tragedy of the commons—free common resource overuse, where all citizens have access but no single user directly pays,
diminishes the use value for all as the tragedy of the commons.
9 Two categories of economic goods
o Public Good—consumption by one person does not diminish the amount available to another person, and others
cannot be excluded from its consumption.
o Private Good—only the consumer enjoys the benefits of consuming the good and the act of consumption reduces the
good’s availability to others.
9 Taxation principles
o Benefits received principle of taxation says that people should contribute taxes in some proportion to the benefits they
receive.
o Ability to pay principle, says that taxes should be levied so that those who earn more pay proportionately more.
9 Tax policy fairness
o Horizontal equity means that taxpayers with a similar ability to pay should pay a similar amount in taxes.
o Vertical equity means that tax payers with greater ability to pay should pay larger amounts of taxes.
9 Free rider —a person who receives benefits from a public good or from others’ decisions regarding a public good, but who
avoids paying for the benefit.
9 Tax incidence – the party who ultimately pays the tax, always a person or group.
9 Tax efficiency – the nature and size of the market distortion from a given tax.
9 Tax burden on income, types:
o Regressive; taxation where there is a greater percentage burden on lower income levels
o Proportional; taxation where there is an equal percentage burden on all income levels
o Progressive; taxation where there is a greater percentage burden as income level rises
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Lesson 9: Value, Time and Uncertainty
Time Preference and Present Value
Human behavior validates that people prefer consumption today over consumption tomorrow. This “positive rate of time preference”
is fundamental and reflected in the interest rate. How much a person is willing to pay to have the privilege of more money now is
weighed against their willingness and ability to pay the interest charge over time. Those who value today highly (a high rate of time
preference) are willing to pay higher interest rates in order to consume more now rather than wait for later. Since time (waiting until
later) now has a value, we cannot correctly compare the value of an object today to the same object later without some adjustment.
Suppose you can earn 10 percent per year on money placed into your riskless savings account. For those who contribute to the
savings account, their personal time preference must be less than 10 percent. Those who do not to contribute to their savings
account at that interest rate possess a personal time preference greater than 10 percent. As money is paid into the savings account
the power of compound interest, versus simple interest, can perform an amazing growth feat over time. The table below shows
annual simple a compounded interest earnings at 10% across selected time-periods for an initial $100 saved.
Simple interest means that the interest accruing on the principle is withdrawn each period, and not added to the principle base for
future year interest accrual. That approach is decidedly not the way to accumulate a fortune. Compound interest means that at the
end of each interest earning time-period, the earned interest is added to the prior principle balance so that the next period’s interest
amount is based on the new and growing base amount. Savers earn interest on all previous interest accruals.
Pick any cell value after year 1 and compare the respective balances for the simple versus the compound rows. Notice that the
compounded amounts are always larger. As time goes on the difference between the column cell values over time becomes
significant if not dramatic.
Compound Versus Simple Interest
Years Saved
Compound 10%
Simple 10%
1
$ 110
$ 110
5
$ 161
$ 150
10
$ 259
$ 200
20
$ 672
$ 300
40
$4,526
$ 500
A handy formula permits reasonably good estimates on the number of years it takes a single amount to double at a given compound
interest rate. The “Rule of 70” says to divide the compound interest rate an amount will earn each year into the number 70, for a
good estimate for the number of years it will take to double the initial amount. The rule provides pretty accurate estimates for whole
interest rates between 2 and 20. Notice that if the earnings on the initial $100 were 10% compounded annually, the $100 doubles
almost 6 times over the 40-year period—to equal $4,526!
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Smart Investing in Any Market
Most people would like to be financially independent. A sizeable percentage of Americans have achieved that goal. The fundamental
ideas to be dealt with are the value of time and risk, due to an uncertain future. So the basic question becomes what proportion of
current income needs to be saved, given an accumulation goal to meet future needs, lifestyle and contingencies? And how should
those proportions be invested? Risk is the term economists use to describe the consequences of an uncertain outcome.
Placing a portion of income into just a regular savings account likely is not sufficient. An investor also must recognize that higher
expected rates of return mean greater levels of risk—variations in the portfolio’s value. A good investment plan has four key
aspects: 1) the financial wealth goal, 2) the accumulation amount, 3) the year to achieve the financial goal, and 4) the level of risk,
which is the level of uncertainty regarding the final value. The task is to determine the mix for various investments that on average
honor the risk tolerance while heading toward the established goal.
Sample Investment Allocations
Category
Savings
High-yield savings
Municipal Bonds–Long
Term
Corporate Bonds–Short
and Long Term
Corporate Stocks
Total
Proportion
20
20
30
Expected Return
1%
2%
4%
Risk Level
Very low
Low
Moderate
20
6%
Moderately high
10
100
10%
4%
High
Sample information in the table above reflects an overall moderate risk level, where the greater proportion of investments is in lower
risk opportunities. The expected return represents the “best guess”, often the historical average, of what those types of assets will
return in the future. By shifting the proportions among the components, for example, by moving savings into corporate stocks, higher
overall risk levels are possible. Typically, higher expected returns come with greater risk, because as discussed before, borrowers
must compensate lenders for that increased risk. Working with a qualified investment counselor can help determine the optimal
allocation for any person’s life situation.
Placing the funds into chosen investment vehicles also requires a decision about who will manage the fund(s). The two choices are
to directly place the funds yourself or hire an investment service for a fee. The fees vary widely and are a significant cost annually
levied against your fund(s). High quality, low fee investment portfolios do exist. Realigning portfolio allocations at retirement can be
complicated due to tax laws and usually requires professional advice.
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Insurance as Risk Coverage
Insurance is the rare product people purchase hoping not to use it. Yet fear due to uncertainty coerces most people to purchase
some form(s) of insurance. What consumers are buying when they purchase insurance is a reduction of risk. More specifically, the
insurance company is being paid to take on risk on the consumer’s behalf. This is economically efficient, because insurance
companies, using the law of large numbers, diversify policy holders across a wide range of locations and policy types and are unlikely
to be financially crippled. The insurance concept works by pooling risks among a group of policyholders so the expected losses are
estimable. If these loss estimates are correct, then a policy premium plus overhead expenses can be determined and charged to
each policyholder to cover them.
In the case of life insurance, the cynical view is that the policy holder is betting they die before the policy expires and the insurance
company is betting the insured lives is not accurate. Insurance is a means to protect an individual or single business against
catastrophic economic loss of unknown size and date, for a known price. The vexing question for customers is how much and what
type insurance to purchase? The three main categories of insurance are life, health and property.
All insurance carries inherent aspects and risks
9 Independent risk–-the value of one risk gives no information about the value of any other risk
For example, a fire downtown does not influence a fire in the suburbs
9 Premium—-cost of the policy per year, the expected dollar amount of the group’s losses
plus a margin for expenses and profit spread over all policy holders
9 Face value-–the amount of insurance paid in the event of a specific named loss
9 Adverse Selection-–situation where those more in need of insurance seek insurance coverage
9 Moral Hazard–-a reduction in an insured’s level of care to avoid or minimize losses
Life insurance should be considered when others depend on the insured for economic well-being. Loss of income from the “bread
winner” would place most families in financial peril. Two related questions are the type of life insurance to acquire and the payoff
amounts. Whole life insurance charges relatively high premiums to cover the cost of insurance but provides an accumulation value in
the policy. Premiums continue as long as the policy is in force or until the accumulated balance is large enough to generate the
premiums.
Term life insurance is purchased for a named time-period, usually no longer than 20 years. The premiums are smaller than for whole
life because they cover only the expected payoff and do not accumulate value. At the end of the specified term, insurance coverage
ceases, with no residual policy value. The insured gets more insurance coverage for the premium dollar than with a whole life policy.
Which insurance type to purchase depends on personal needs and goals. The question of how much insurance face value to carry
must balance after-death economic needs with the ability to meet premium payments. The range can run from sufficient funds to
cover burial costs to supporting a spouse and children until the youngest child reaches the age of majority.
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Health insurance covers health and disability expenses according to a detailed listing of medical maladies. As an employment
benefit, employers commonly provide health and disability insurance coverage using third party providers. Rising premiums in recent
years have forced many employers to either reduce their health insurance coverage or share the premium cost with their employees.
One way to reduce premium costs for health and property insurance is to maintain high deductibles. A deductible represents the “first
dollars” of coverage in the event of a loss. Essentially, the policyholder self-insures the first several hundred dollars or more of each
claim.
Property insurance—home, auto, business property—covers tangible asset damage to the insured’s property by others or certain
named events such as fire. For consumers whose homes are mortgaged or cars financed, it is common for the third party
beneficiary—the lender—to insist on some minimum property insurance coverage. That way, the financier as well as the home or car
owner is protected in the event of a loss.
In Sum
9 Time has a value and your personal time preference is reflected in your personal behavior.
o If you spend all your income and save nothing, you do not value the future very highly
o If you save and earn 5 percent a year, then you value the future and can accumulate wealth
9 The power of compound interest versus simple interest is very large and should be used to full advantage
9 Investing in uncertain times can be made less risky by diversifying the types of investment held
9 Work to achieve a positive balance between net earnings and current expenses throughout life.
9 Pay yourself first in the form of regular monthly savings.
9 Purchase insurance to minimize the risks of loss to the extent affordable, based on your financial needs.
o Life insurance protects against lost income for your survivors.
ƒ Term life covers insurance costs only and is less expensive than whole life
ƒ Whole life insurance accumulates value at a certain rate and is more expensive
ƒ Health insurance pays for illness or accident via detailed specified coverage, but not loss of income.
ƒ Property insurance covers damage to physical assets caused by you or others.
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Lesson 10: Consumer Economics
Life is a marathon, Not a Sprint
Fulfillment in life has many dimensions. This lesson focuses on those economic aspects of life over which most people can exercise
some degree of choice. An adage in business states that “it’s not what you earn but what you keep” that matters. The same holds
true for individuals. Though some may challenge the extent of that influence, American citizens possess far more choice-making
opportunities than do people in other countries. We might say our personal “economic problem” is how to freely and legally achieve
the most from the economic dimension of life.
During normal times, average US households spend 95 percent of their annual after-tax income. Because our material wants
outstrip our financial means much of the time, that reality forces most citizens to economize. But even work is a choice in America.
We are motivated to work by the income benefits it provides. And for nearly every occupation there is a life-cycle profile of earnings.
Early career income is relatively low, rises then peaks in the middle 50s and slowly declines until retirement, yet another life choice.
So if we take the very long view and ask how we want our “golden years” to be, the importance of how much personal income and
wealth we earn and keep becomes clear.
First Paycheck
Somewhere between the ages of 16 and 19 many teenagers enter the job market for the first time. That is where the world of work
and the lure of consumption merge and conflict. Current federal minimum wage in 2011 is $7.25 per hour. Full-time students working
no more than 8 hours a day and not more than 20 hours a week can legally be paid as little as 85 percent of the minimum wage—
$6.16 per hour. Using the full federal minimum wage rate and a 20-hour work week for a student, the table below estimates weekly
take-home pay, after basic payroll deductions.
Part Time Job Weekly Paycheck Example
Gross pay per week: $7.25 X 20 hours
Federal income tax withholding: 10%
Social Security/Medicare: 7.65% X $
Basic insurance plan premium
Weekly take home pay
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$145.00
14.50
11.09
10.00
$109.41
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Notice that our part-time employed student receives only about 75 percent of his or her gross wages in take-home pay. The example
assumes the student has few material tax deductions, uses tax rates based on the 2010 tax year and that the company requires
contributions to a basic group insurance policy.
A few hours after our teenager picks up their first paycheck often is a good time for parents to explain why net income (75%) is so
much smaller than gross income (100%). Few employed persons are exempt from contributing toward their estimated tax liability,
basic social programs or medical insurance.
The ability-to-pay justification for taxes—those who earn more can pay more—is built into the US federal income tax structure, as the
2011 tax table below on single filers’ ordinary taxable income reveals. Insurance, while a seemingly unnecessary cost to a healthy
teen, provides medical coverage in the event of an accident or illness. Yet, $109.41-per-week take-home pay seems to disappear
quickly, even though there are relatively few hours left after school and work obligations.
Prospective US Earnings Tax Rates 2011
Tax Rate
Single Filer
10%
Under
$8,525
15%
25%
28%
36%
$8,525 –
$34,650
$34,650 –
$83,900
$83,900 –
$194,150
$194,150 –
$380,500
39.6%
Over
$380,500
Source: www.IRS.gov
First Car—So Many Options
Nothing represents freedom to an American teenager so much as their first car. As a virtual right-of-passage, and whether it’s a shiny
new one or a dented used one, it places nearly unlimited mobility and opportunity into the hands of its youthful driver. As with all
material fascinations, this one too has an anchor in hard reality. The thing just costs a lot of money.
To give our teen a taste of adult responsibility, most parents want their driving child to help support the 4-wheeled chariot. Some
insist their child bear the total financial cost of car ownership. The table on the next page divides representative monthly automobile
expenses into two categories; fixed and variable. The example assumes the car, a used 2006 Honda Civic, is financed for 4 years.
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Sample CAR Ownership Costs/Month
Fixed Expenses
Car note
Insurance
Annual Registration by month
Annual Inspection by month
Sub-total Fixed
Variable Expenses
Gasoline
Maintenance
Parking
Accessories
Sub-total Variable
Total Car Costs/Month
$280
$125
(= $84/12) $7
(= $48/12) $4
$416
$120
$25
$10
$35
$190
$676
Even if we suppose that our driving teen’s parents are financially able and willing to cover the fixed expenses of owning the vehicle,
variable expenses still total $190 monthly. If our teen is the same one from the example above who nets $437.64 per month
($109.41 per week X 4) from their 20-hour per week minimum wage job, they have just under half ($247.64) left for dating and
personal purchases. If the parents insisted their teen pay for the car insurance, spendable monthly earnings would be $122.64. Not
many expensive dates possible there.
The Economics of Attending College
The strong and positive relationship between education and earnings is hard to over-state. The national data in the table on the next
page are compelling. Completing four years of college opens doors to opportunities not available through any other social institution.
National studies using sound methodologies confirm that investing in one’s own “human capital” may offer the greatest long-term
benefits of any personal investment. Education also returns dividends to society in the form of economic growth. That is one
economic reason why the federal government offers direct loans and grants to willing and qualified candidates to complete their
college education. Even with tuition costs rising, the rate of return on training and educational investment is high.
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US Median Earnings Over Past 12 Mos. 2005-2009
Population 25 years and over with earnings
$34,159
Less than high school graduate
$19,420
High school graduate (includes equivalency)
$27,272
Some college or associate's degree
Bachelor's degree
$33,457
$47,747
Graduate or professional degree
$62,708
Source: www.Census.gov. *2009 inflation-adjusted values
Credit Cards’ High Cost
There is an almost irresistible allure to reach into our expected future income and use some of it for current purchases. Hard reality
also attends the act. First, the borrower will have to pay for the privilege in the form of interest, often at an unconscionably high rate.
Second, the borrower is contractually committed to pay back the principal and the interest from expected future income, whether or
not expectations about the future income’s size come true.
Credit Card—A short-term loan agreement that enables holders to enjoy goods and services today by borrowing against
tomorrow’s income for a fee called interest.
When should a consumer borrow money? The best response is when current income is insufficient to cover an unexpected expense
and there is room in expected future income to repay the loan with interest. If living expenses exceed income every month, credit
card coverage for the difference is a very poor choice, serving only to postpone an inevitable and bad end. Monthly expenses must
somehow be reduced or monthly income enhanced. Ultimately, using credit cards, or any borrowing instrument, in this fashion only
adds misery to an already serious personal financial situation.
The credit-seeking customer should shop for credit lending rates, just as they would shop the price of any economic good. Cardissuing companies set rates according to each customer’s credit profile: lower rates for good paying customers and higher rates for
customers with a poor history. Commercial credit counseling firms offer services to those needing advice.
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Costs of Credit Card Use and Misuse
Categories
Option 1
Option 2
Option 3
Beginning Balance
$1,000
$1,000
$1,000
Monthly Payment
Total Interest Paid
Months to Pay-off
Balance
$100
Minimum
$0
1
$74.10
11
$700
260
The table above illustrates three options to manage credit card debt. Option 1 pays off the entire balance due monthly. It is possible
to accomplish this by first limiting credit purchases, then using part of the following month’s income to pay the entire balance. Most
card issuing companies now assesses the monthly annual percentage rate (APR) on the average daily balance (ADB) from the date
of purchase. So some interest charge is unavoidable. Options 2 and 3 assume an initial $1,000 purchase, a 15% APR (15%/12 =
1.25% per month) and a minimum monthly payment equal to 3% of the average daily balance (ADB). Option 2 for managing credit
purchases assumes the cardholder pays $100 monthly toward the entire balance, and makes no additional purchases on credit—
ever. Option 3 assumes the cardholder pays only the minimum balance printed on the monthly statement, and makes no additional
credit purchases-ever. All options show results as of the year the card balance is zero or very close to zero. Option 2 illustrates the
benefit from limiting credit card use and for making payments larger than the issuer-prescribed monthly minimum. Total interest paid
equals $74.10 on the $1,000 purchase and the balance is paid off in 11 months.
Option 3 vividly demonstrates how the credit balance is almost never extinguished if the cardholder pays only the companyprescribed minimum amount each month. How can this be? Customer payments on the credit card balance apply first to the
monthly interest due, only the remainder goes toward the principal balance. The monthly interest charge is about one-third of the
small minimum monthly payment of $30.00. So, the principal balance shrinks but by only $17.50 per month at first then falls very
slowly over time as the balance is reduced. Imagine how quickly our minimum balance-paying customer would sink financially if they
continued to add new purchases each month while pursuing this minimum payment habit. Is this legal? Yes. Is it fair? Economics
alone cannot answer that, but most certainly it can be ruinous to those unaware of the facts and the consequences.
First Career—Looking at the Long Run
The annual expenditure profile in the table on the next page is based on an average household income before taxes of $62,857 per
year. Notice that housing consumes just over a third of all expenditures. Transportation costs—primarily a personal automobile and
related expenses—account for 15 percent of total expenditures. Then food absorbs almost 13 percent. Taken together, basic needs;
living space, mobility and food account for just under two-thirds of average total expenditures. In a modern society, these expense
categories are difficult to reduce beyond some livable level.
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Average Yearly Expenditures for US
Consumer Units 2007-2009
Category
Food
Housing
Transportation
Apparel and services
Healthcare
Entertainment
Insurance and Pensions
Other expenditures
Totals
Source: www.BLS.gov
Amount
$6,372
$16,895
$7,658
$1,725
$3,126
$2,693
$5,471
$5,127
$49,067
Percent
12.9
34.4
15.6
3.5
6.3
5.5
11.1
10.4
100.0
A typical US worker’s career income path shows income rising as a trend through their late 40s to mid-50s. Thereafter income tends
to level off or even fall slightly through age 65. In the early career years there is much pressure to spend on family needs. Setting
one’s sights on a distant retirement date is hard to do during the child-rearing years. Yet, the benefits of following a consistent
personal savings program are economically profound.
Contemporary job market studies indicate that the average worker will change jobs at least five times in a career and the rate of job
turnover is rising. Coping with change of that magnitude requires sticking to a personal wealth accumulation plan. The “secret law”
of financial success is to pay one’s self first. No matter what, set aside a certain amount of current monthly income in an interestbearing account and do not touch it until retirement. Take advantage of special programs such as 401(k)s, where employers match
contributions you make up to a certain amount, essentially giving you free money for saving. Other options such as IRA (Individual
Retirement Accounts) allow you to invest income without paying taxes on it, reducing the cost of saving (e.g. if your tax bracket was
25%, you could take $300 in net pay now, or invest $400 in your retirement account).
First Home or Last Home—Rent or Buy?
A home remains the largest single investment most people make. The Internal Revenue Service permits homeowners to deduct from
taxable income the interest payments annually made to their mortgage company. This deduction provides a large financial
inducement for homeownership. It also helps support one of the largest sub-industry construction sectors—new home building—in
the US economy.
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The question of whether to rent or buy a home is determined as much by lifestyle choice as by financial criteria. Renters still pay
taxes and maintenance, though implicitly through the assessed rent. Often the decision of whether to rent or buy is based on a cost
per square foot basis at certain life stages. Early career singles most often rent for the flexibility and minimum responsibility.
Retirees often rent for convenience and ease of upkeep of their living quarters.
Sample Home Mortgage Costs
$140,000 30-year Loan @ 5%
Category
Down payment = 10%
1 point = 1% of $124,000
Closing costs
Monthly payment
Cost
$14,000
$1,240
$1,200
$663.30
Those who choose to buy a home, most often are young married couples—starter homes, couples with children—more established
homes, empty nesters and early retirees—both to smaller residences. Each purchase typically is financed through a mortgage
company at the agreed upon sales price less down payment, at the current mortgage lending rate for either 15 or 30 years. A
consumer’s past actions follow them in the financial world. Creditworthy customers get the lowest mortgage interest rates.
Customers, whose credit history reflects payment problems or prior defaults, pay a higher rate to compensate for additional lender
risk.
The lender profiles all loan applicants based on certain criteria to determine their financial risk. Traditionally the three Cs of credit:
character—personal financial history, capacity—financial ability to repay the obligation and capital—collateral value, are used to
determine the worthiness of a prospective loan customer.
Refer to the table above and suppose a young married couple has just agreed to purchase a $140,000 home for 30 years at 5
percent. Further suppose the couple paid 1 point plus closing costs to process the loan package. A point equals 1 percent of the
loan amount and reduces the interest rate to be paid on the loan, thereby lowering the monthly interest cost on the loan. Buying
points for cash may or may not make good economic sense. Analysis is required to see if the value of the monthly payment
reduction is worth the upfront cash cost of a point. Closing costs are bundled fees for processing, a title search and for closing on the
mortgage loan.
Minimum down payment for a home purchase is commonly 10 percent of the agreed upon price. If the buyers make a down payment
of 20 percent or more, then mortgage insurance—a policy to protect the lender, not the purchaser, is not required. For the home in
the table, the monthly payment is $663.30 for principal plus interest, only. The Annual Percentage Rate (APR) is slightly greater than
5 percent because the point costs and closing costs affect the effective rate. To the monthly payment can be added hazard
(homeowner’s) insurance and, often, local taxes on a pro rata monthly basis, paid through the mortgage company as a service. For
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a small fee the mortgage company manages the buyer’s escrow account—an accumulation account where allotments for the local
taxes and hazard insurance is maintained and paid through the mortgage company.
Plan Early for Living Long
America’s graying population makes planning for retirement more difficult than it was a generation ago. The demand on services for
the elderly will rise due to the increasing numbers of geriatric citizens. The average life span of US men and women of all colors is
rising mainly due to the eradication of disease and improved healthcare. Official projections indicate that the sheer number of people
over age 65 will double from 40 to 80 million by 2050. Those over 85 years of age are projected to more than triple, from 6 million in
2000 to 20 million in 2050. So the relevant but difficult-to-answer question is how long will one likely be retired?
The current-tax-funded US Social Security program, providing retirees a standard retirement allotment since the 1930s, will face its
greatest funding test in the next 40 years. This is so because the proportion of aging eligible recipients may exceed the proportion of
income-earning citizens in the workforce. It is the contributions of those working who finance the “pay-as-we-go” US social insurance
system. Healthcare costs also rise dramatically after age 65. National estimates reveal that as much as half of lifetime personal
healthcare expenditures occur in the last 10 years of life. Lowering the cost of healthcare options may be necessary; but how?
Economic thinking provides some guidance. Increasing revenues and decreasing costs during retirement is nothing new, but the
reality is more pressing. Personal bias and market reality require an objective appraisal to guide decisions in life’s final stretch.
Determine the available and expected economic resources: expected retirement income, social security income, Medicare coverage,
supplemental insurance coverage, then the value of major assets such as the home, property and financial wealth. Decide on the
following: a) an affordable lifestyle, minimum desired estate size, limits to health insurance coverage and final burial arrangements.
In addition, make out a final will and testament using legal oversight.
To the extent still possible, increase savings during income-earning years. In the last lesson, we discussed the power of compound
interest. Money saved early in the 20s and 30s has much more opportunity to grow than money saved in one’s 40s and 50s. Once
retired, simplify life to the important essentials and reduce fixed costs to a minimum. Doing so leaves more liquid funds available to
enjoy daily life and special events. Consider bartering instead of buying. In some ways it is simpler and less costly to swap mutuallydesired services with someone or to establish a “line of credit” for services rendered instead of receiving or making monetary
payments. Yes, it is legal. Find an enjoyable hobby. One that earns a modest cash flow and that does not conflict with Social
Security earnings can provide spending flexibility.
Once a comfortable financial margin for daily living is established, stay as active as health permits. Stay close to loved ones and
friends. Do what you wish, for as long as possible. Both relaxation and laughter are good medicine. Lastly, prepare to leave the
economic realm of life.
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In Sum
9
9
9
9
9
9
9
9
9
9
9
9
Think about your future before you act rashly today.
Your income is based on your ability and education.
Your financial ability to have a full life begins with a plan for the future.
Control monthly expenses; keep the fixed costs of home and auto as low as possible.
If possible, attend college and earn a degree, at least a certification. Loans and scholarships are available. The labor market
likely will reward you.
Prudently use credit cards, if at all. If you must, then strictly limit their use. Pay as much as possible toward the balance each
month. Never be content paying only the company prescribed minimum balance.
Investigate large and non-routine purchases to make sure your income expectations likely will be met, before buying.
Have a regular savings plan that earns compound interest. Let it grow without interruption.
Follow an investment plan. Diversify your investments. Spread your investment dollars across independent assets to achieve
a return that will meet your objective within your risk tolerance.
Buying versus renting a home has lifestyle and economic motivations. Total price per square foot can be a useful guide.
o The tax deduction for mortgage interest is the largest single financial incentive for buying a home.
o A good credit history qualifies one for the lowest current market interest rate.
Retirement needs to be prepared for.
o Estimate expected income, medical coverage costs and keep fixed living expenses as low as possible.
o Consider bartering for services instead of making outright purchases
Make legal and economic preparations for life’s final turn.
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Lesson 11: Gross Domestic Product and Growth
National Income Measurement
Prior to 1940 there was no consensus gauge by which to measure macroeconomic activity. That changed when Simon Kuznets of
the US National Bureau of Economic Research devised the national income account structure and published his work in 1941,
earning him the 1971 Nobel Prize in Economics. With only minor modifications, his schema survives to this day and most countries
on the planet use it. The summary measure of this national income structure was named Gross Domestic Product (GDP).
Gross Domestic Product Equivalent Views
9 The market value of all final goods produced within a country in 1 year, OR
9 The total income received by all producers (Supply View), OR
9 Total purchases of newly produced final goods (Demand View), OR
9 The sum of all transactions regarding final goods (Q = real output) sold
at market value (P = average price level) = P·Q
This national product measurement system with its interrelated income accounts rests on several key assumptions and, as with all
macro measures, suffers some limitations. The objective is to accurately and consistently account for all current economic activity
and its major components over a stated period. By distinction, Gross National Product (GNP) is the total income earned by a nation’s
permanent residents, wherever they currently reside. For example, Toyota cars built in Texas are part of US GDP. Ford autos built in
France are part of US GNP, but not US GDP.
Key assumptions behind the National Income and Product Accounts
9 Price changes during the period ignored
9 Population growth ignored
9 Technology advances ignored
9 Investment beyond asset replacement ignored
Limitations to Gross Domestic Product as a measure
9 Ignores product quality changes
9 Omits household production
9 Omits sales of used goods
9 Omits in-kind and “invisible” transactions
9 Excludes illegal transactions
9 Omits financial transfers
9 A poor measure of psychological well-being
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The important theoretical and practical questions are how and if the income paid to earners from the production process will be used
to collectively buy all the goods produced? This question is not trivial. For example, workers usually will not offer their labor services
for free. When all factors of production are paid for their effort—from revenues the seller generates from sales to customers—the
value of all income equals the value of all production. But will the act of supplying goods generate an equal demand to purchase
them in a reasonably short time period? If not, some current resources will be unemployed.
The table below shows the major components for US GDP, $14.1 trillion for 2009, from both the supply view and the demand view.
Notice that GDP sums to the same figure for either view, except for a less than 1% error labeled “statistical adjustment” which
accounts for the difficulty of reconciling the nation’s income and consumption reporting.
US Gross Domestic Product 2009 In Circular Flow Format*
Income Categories or Supply
Households supply Factor Inputs to Businesses
$ 11,114.4
Factor Income (F)
$ 1,861.1
Depreciation (D)
$ 1,024.7 Indirect Business Taxes (T)
(-)118.8
Statistical Adjustment
$14,119.0
Expenditure Categories or Demand
Business Hires and Pays $ for Factor Inputs
Household Consumption(C)
Business Investment (I)
Government Purchases (G)
Net Exports (NE)
Income Earned by Factor Resources = GDP
GDP = Expenditures on Goods & Services
$ 10,001.3
$ 1,589.2
$ 2,914.9
$ - 386.4
$14,119.0
Businesses produce and sell goods and services to households
Households Purchase Goods and Service from Businesses $
Source: www.bea.gov; *Billions of US Dollars
To interpret the economic circular flows in the table above, the upper brown clockwise arrow represents the physical flow of labor and
other inputs from households to businesses. The lower brown clockwise arrow represents the goods and services produced by
business using the factor inputs. The upper green counter clockwise arrow is the dollar income earned by households for supplying
factor inputs (wages, interest and rent). The lower green counter clockwise arrow represents dollar expenditures for goods and
services purchased from businesses by households.
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The Supply View of GDP
From Factor Income to Household Consumption
Factor Income (“F” = $11,114.4 billion) is the total National Income paid by business for using all economic resources (land, labor,
capital, entrepreneurship) as a cost of production. Factor costs to businesses are income payments to households. Households use
their income, after paying income (direct) taxes, to consume or to save.
From Depreciation to Business Investment
Depreciation (“D” = $1,861.1 billion) accounts for the depletion of productive assets during the year. These are real costs in the
sense that productive assets have limited useful lives and must be replaced when worn out.
From Direct and Indirect Taxes to Government Purchases
Indirect business taxes (“T” = $1,024.7 billion) are taxes levied on productive business enterprises and are a cost of doing business.
Indirect business taxes transfer income from businesses to the government so it can make purchases.
Direct taxes are levied directly against an individual’s income. Income taxes are a good example. Direct taxes are not a cost of
doing business. These taxes, a percentage of each individual’s personal income, generate flows moving directly from the income
earner to the government so it can make purchases.
The Demand (Expenditure) View of GDP
Total economic activity (GDP = $14,119.0 billion) from the supply view must equal the sum of goods purchased by the four demandside sectors. The largest demand-side sector, household consumption (“C” = $10,001.3 billion), measures purchases by the
households from the factor income paid to them, and accounts for nearly seventy percent of total demand for GDP.
Next, government purchases of goods and services (“G” = $2,914.9 billion) provide public goods, market regulation, common
resource oversight and other public functions to account for 18 percent of GDP.
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Business investment (“I” = $1,589.2 billion) is used to add new capital, replace currently depreciated plant and equipment plus
inventory replacement to add another 15 percent to GDP. Though it is a relatively small percentage of GDP, investment plays a large
role in accommodating economic activity.
The fourth demand sector, net exports (“NE” = $ - 386.4 billion) measures the activity of the US with the rest of the world. The
negative sign indicates that for 2009, the US purchased more foreign goods (imports, where dollars leave the US as payments for
foreign goods) than it sold to foreign countries (exports, where dollars enter the US as foreign payments for US goods) by the net
export figure, -$386.4 billion.
Using letter notations for each demand side component, GDP = C + I + G + NE, becomes the aggregate supply equals aggregate
demand relationship in macroeconomics. In words, as an accounting identity, the total dollar value of goods supplied in the economy
in one year equals the total amount of those goods demanded by household consumption, business investment, government
purchases and net exports. It is also true that C + I + C + NE = P·Q, the sum of all GDP transaction values, where P is the average
price level and Q equals current real output.
Sources of Economic Growth
Classical economic writers of two centuries ago had it nearly right. Economic growth came from the application of human capital and
physical capital given a country’s abundance of natural resources. With these three economic resource groups—the factors of
production—output could be increased simply by applying more of each of them. Production—the quantity of goods produced per
hour of labor time—would rise as more factor inputs were added to existing and new enterprises.
In 1776, Adam Smith famously wrote in An Inquiry Into the Nature and Causes of the Wealth of Nations, using a pin factory analogy,
that the greater the extent of the market, the greater could be the specialization of labor’s tasks. But economy-wide there was a
natural limit to growth and specialization, because one base factor, land, is completely fixed in supply. Since the economy was
predominantly agriculturally based the limits to growth were almost pre-determined. So claimed Classical thinkers of the day.
Expressed as the law of diminishing returns, what Classical economists believed determined the limit to growth was the fact that
additions of factor inputs would inevitably exhaust the land and define society’s maximum production. The extant classical writing to
carry that idea to its conclusion was Thomas Malthus’1798 Essay on Population. He grimly argued that linear output growth would
eventually be outstripped by geometric population expansion and inexorably return society to a subsistence level of existence. This
law, more than any other single idea, pinned the moniker of the “dismal science” on economics.
Law of diminishing marginal returns—given fixed amounts of land, as the quantity of labor incrementally increases, total
output will increase but at an eventually diminishing rate.
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The missing dimension in the Classical world’s view, the one that had only begun to reveal its salient characteristics two centuries
ago, was technology combined with entrepreneurship. Economists of the day missed it because its power had been barely
recognized. When combined with the other three factors of production in a market economy where freedom of choice encourages
risk-taking and rewards success with profits, the industrial revolution entered a technologically spawned and generally sustained 275year expansion into the 21st century.
Economic Productivity and Well-being
A society’s economic standard of living is measured by dividing total annual production by total population. US 2009 GDP per capita
equaled $44,155, the 7th highest in the world. This total output-per-person indicator directly implies that to improve the standard of
living, the economy must increase production faster than population increases. Though widely used, the measure
ignores the distribution of production in an economy. Alternate measures of well-being and economic growth also can be useful.
Wages adjusted for inflation, output per worker or output per hour also reflect useful aspects of economic well-being.
Productivity determinants
9 Quantity and quality of the labor force
9 Quantity and quality of capital equipment
9 Level of work force education
9 Rate of technological development
How Technology Enhances Economic Growth
Technology, the application of improved methods to produce goods and services, was the missing ingredient in Classical economic
growth models. That technology is a significant determinant of economic growth is no longer debated. That debate centers on how
to sustain and guide technological advances.
Technology’s influence shows up in two fundamental economic ways, as capital saving or as labor saving. Either savings effect lets
producers generate more output with fewer resources and lower cost. As a direct result, profits rise. Profit spurs other firms to adapt,
as far as the law and competition allow, new technological innovations so they too can reap the market’s benefits. Some, like unions,
resist technological change arguing that technology displaces workers and adds to unemployment. The reality is that technology,
over the long term, generates many more jobs than it temporarily displaces and offers a higher average wage for those trained to
accommodate its applications.
The vexing business and policy question is just how much money to allocate to technology development, both corporately and
socially. Invention and innovation do not come cheaply. As much as 80 percent of every dollar in corporate research and
development fund fails to generate saleable product. With returns as uncertain as they are, corporations only willingly undertake a
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limited amount of Research & Development (R&D). Another constraint is that an economy as a whole can only invest up to its total
amount of savings during any period. The truly difficult question becomes, “what portion of scarce national economic savings should
go toward enhancing technology?”
Since the benefits from successful technology contain a broad public distribution aspect, government allocates public revenues to
enhance it. The first national-scale programmatic allocation of US government research funds in the 1920s and 1930s guided pathbreaking agricultural research. Today, with the virtual institutionalization of R&D, many original scientific discoveries first occur in
doctoral-granting universities, a great many of them federally funded.
Over the past 140 years, four major technology waves lifted the US economy and the world to unprecedented economic heights.
The monumental economic largess created by large-scale electricity generation, the internal combustion engine, followed by a
revolution in chemicals and, finally, the electronics and digital revolution, have raised the trajectory of our economic standard of living
through time—total production per population—to the benefit of all. To place the impact of these innovation waves into a context,
consider that 150 years ago on average one farmer fed two people. Today, using advanced techniques one farmer feeds fifty people.
Along the way, displaced farm employees moved from field to factory using education and training to acquire the requisite skills for
new industrial production methods.
The Interrelatedness of Sectors
The mystery of economic growth is not yet fully understood. Economists, though they have identified the components of growth, are
unable to predict turning points in the business cycle with accuracy. Free markets themselves are prone to economic fluctuations
because economic agents pursue their own interests. So when a significant economic sector, like household consumption or
business investment, changes course without announcement, the effects echo throughout the entire economy.
Business cycle–fluctuations in economic activity caused by changes in expectations and business conditions affect income,
production, employment, prices and interest rates.
Economists once believed that business cycles could be logically modeled. Today, that earlier consensus view has waned.
Economists do recognize that when output falls, unemployment increases. They also observe that macroeconomic indicators—
employment, output, spending, saving, investment—tend, on average, to move together, though sometimes with a time lag. What
troubles cycle theorists is how to accurately and consistently predict the timing of irregular short run economic fluctuations. Even
though economists have models that fit current and historical data, correctly anticipating the next economic turn remains more art
than science.
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Business cycle phases
9 Expansion–rising GDP and employment
9 Recession–falling GDP and rising unemployment
9 Depression–significantly falling GDP and rising unemployment
9 Recovery—rising GDP and employment after a recession
Separating time into two distinct periods helps. In the long run, a period of several years, an economy will tend to settle into what
economists define as its natural rate of unemployment—the rate around which unemployment fluctuates in a healthy economy. In
this long period, changes in total economic demand affect only prices, not output, because the economy is producing along its
“natural” growth path, about 3.5% annually for GDP in the US.
In the short run, a period of one to three years, much can change, and suddenly, from either the demand side or the supply side of
the economy. When one sector of the economy shifts, the resulting chain of events can be described but not easily predicted in time
sequence, since the underlying economic responses at work stem from all too human group behavior. Even for the 2008-2010
recessionary cycle the pace and character of economic recovery were difficult to predict and to manage.
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In Sum
9 Gross Domestic Product (GDP) is the current dollar value of all final goods and services produced within a country in one
year; and serves as the official measure of a nation’s economic activity.
o GDP measurement ignores: population growth, technology changes, investment above replacement and variances in
industry market structure.
o GDP is a rather narrow measure that ignores: product quality changes, household production, used good sales, inkind transactions and illegal transactions.
9 The two views of GDP allow economists to measure and assess activity by the income earned by factors of production
(supply) and the product purchased by economic sectors (demand).
o Supply view measures factor income in the form of rent, wages, interest and profit plus capital depreciation and
indirect business taxes, the sum of which equals GDP.
o Demand view measures household consumption, government purchases, business investments and net exports, the
sum of which equals GDP.
9 Demand = C + I + G + NE = F + T + D = Supply, is the basic macroeconomic relationship. In words, the total dollar value of
goods supplied in the economy in one year equals the total amount of those goods demanded by the sum of household
consumption, business investment, government purchases and net exports.
9 Law of diminishing marginal returns—given fixed amounts of land and capital, as the quantity of labor input increases, total
output increases but at an eventually diminishing rate.
9 Standard of living—A society’s economic standard of living is measured by dividing total production for a year by total
population
9 Productivity measures and determinants of economic growth
o Quantity and quality of the labor force
o Quantity and quality of capital equipment
o Level of work force education
o Technology
9 Business cycle–fluctuations in economic activity caused by changes in business conditions affect income, production,
employment, prices and interest rate
o Expansion – rising GDP and employment
o Recession – falling GDP and rising Unemployment
o Depression – significantly falling GDP and rising Unemployment
o Recovery – rising GDP and employment after a recession
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Lesson 12: Employment and Unemployment
Employment and Unemployment
Work is essential to solving the economic problem for the individual and for society. Though the very young, the old, the infirm, the
incarcerated and those in military service are excused from private market work, those in the workforce toil to produce the goods
consumed by those groups, as well as for their own consumption. Human effort marks the beginning of the circular flow of economic
activity.
In a market-based society, sales of product fashioned through human application generate the earnings to sustain their collective
makers. Those persons working are employed. Persons temporarily not working but seeking work are unemployed. Economists
focus on the unemployed because their status reflects a loss of value to society and the affected individuals. Economists use
carefully-crafted definitions to measure and assess employment and unemployment.
Labor force components
9 Total population–all persons in the society
Less: persons under 16 years or institutionalized
ƒ Equals: the non-institutional population
o Less: those serving in the armed forces
ƒ Equals: the civilian non-institutional population
o Less: persons not in the labor force (neither working nor seeking work)
ƒ Equals: Civilian Labor Force (CLF) —total number of workers over 16
years of age who are either employed or unemployed.
o Employed–persons in the labor force who have a fulltime or part time job.
o Unemployed–persons without a job who are actively seeking work and are available for work.
o Unemployment Rate–the number of unemployed persons divided by the labor force count.
o Labor force participation rate–the civilian labor force divided by the adult population 16 to 64 years old
US Labor Force Data
Year Labor Force
Employed
2009
153,172,000 137,960,000
2010
153,690,000 139,206,000
Source: www.BLS.gov
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Unemployed
15,212,000
14,484,000
Rate
9.9%
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Employment figures are dynamic. Unemployed workers seeking work continue to be classified as unemployed. If a person quits
seeking work they drop out of the labor force altogether. Perhaps they should be labeled as not employed to distinguish them from
the unemployed. The official unemployment definition is narrow in terms of time and job-seeking actions. Many more persons are
actually without market work than unemployment figures suggest.
Another missing element in labor statistics is a definition for under-employment; those persons working at jobs that underutilize their
skills or training. More puzzling is the situation where some people earnestly claim they want a job but make no real effort to find
one. That last thought suggests that expectations influence the search for market work. If you had recently lost your job and were
receiving unemployment benefits, what is the minimum wage you would accept in a new job? When your unemployment benefits ran
out would you change the minimum wage you would accept in a new job? What other requirements would you impose on a new
position? These and other relevant questions combine aspects of relatively impersonal labor market dislocations with personal job
search criteria.
Natural Rate of Unemployment
In their quest to understand the nature of unemployment in the macro economy, most economists agree on this operational definition.
Natural rate of unemployment—the rate around which the unemployment fluctuates, in a healthy economy. For the US
economy, the natural rate lies between 4% and 6% of the labor force.
That idea is useful in advanced economies, where unemployment can never be zero, some workers will always be between jobs.
Reasons for job change may be personal, such as a voluntary return to school for retraining; seasonal, like new home construction,
or cyclical, driven by the ups and downs of whole industries. As long as the deviations from the natural unemployment rate are not
too large or prolonged, government in a market-based economy chooses not to actively interfere with the labor market. Government
does offer some buffers for those temporarily out of work such as unemployment insurance, paid for by employers through statebased insurance mechanisms.
“Curing” Unemployment
When the unemployment rate reaches an unacceptably high and sustained level, the government considers some form of policy
intervention. As economists learned during the Great Depression of the 1930s, public spending as a demand side stimulus, even if
financed by public borrowing, can increase total output and reduce unemployment, though not without economic trade-offs.
Another policy-based means to reduce unemployment from the supply side of the economy is to offer job training subsidies for
displaced workers and incentives to employers promising to hire and train newly displaced workers. Job search, seeking the position
that is “right” for the individual, is another aspect of unemployment’s duration. Job searching takes time and can be frustrating. That
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frustration comes largely from lack of good information about the types, pay scale, location and availability of open positions.
Economists recognize that while job search is costly, it is rarely due to a mismatch between supply and demand in the labor market.
Rather, unemployed workers are busily searching for those jobs best suited to them.
Economics of Minimum Wage Laws
US minimum wage laws become a topic for political debate each time the federal minimum wage is increased. The economic reality
of minimum wage legislation is firmly established through many well-crafted studies. When the mandated minimum wage is set
above the market clearing wage rate—the unemployment rate for workers in minimum pay jobs rises.
In the chart above, you can see the two components of the increased unemployment from a higher minimum wage rate. Those jobs
where the value of work lies below the new minimum wage will be laid off—the demand-side market response. The market’s supplyside reveals formerly discouraged job seekers, enticed by the new higher minimum wage, trying to re-join the labor force but unable
to find work.
Workers in minimum wage positions who manage to keep their jobs do get higher pay. Though the higher minimum wage may or
may not sustain a life style above the government defined poverty level. Persons unemployed due to the new minimum wage have
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two choices as they seek gainful employment. They can find other firms who see how their limited skills might offer value exceeding
the new minimum wage, or re-train to gain marketable skills and earn a wage above the federal minimum.
In Sum
9 Civilian Labor Force (CLF) —total number of workers over 16 years of age who are either employed or unemployed
o Employed – persons in the labor force who have a job.
o Unemployed – persons who do not have a job, are actively seeking a job and are available for work.
o Unemployment Rate – the number of unemployed persons divided by the labor force.
o Labor force participation rate – civilian labor force divided by the adult population over 16 years of age.
9 The natural rate of unemployment is that rate around which the unemployment rate fluctuates.
9 Minimum wage economics—increases in the minimum wage also increases unemployment among those holding minimum
pay jobs. Two sides of the unemployment effect:
o Demand side—jobs where the value of the work is less than the new minimum wage the business owner must pay will
be eliminated.
o Supply side—formerly discouraged job seekers will attempt to join the labor force seeking work at the new minimum
wage but will be unable to find it.
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Lesson 13: Money and Prices
Money
Imagine a long-ago time where money as we know it did not exist. Consider a desert scene where two haggling nomads try to barter
one ox for an equivalent value in food and clothing. Then multiply that vision times every transaction in the land. Money’s invention
as a medium of exchange was destined to occur as a solution to inefficient bartering. Yet, that “solution” is not perfect.
True coinage in the form of imprinted metal, commonly silver or gold pieces of predetermined weight, is first attributed to the kings of
Lydia around the 8th century B.C. From that era forward, the means of exchange became more efficient as money’s use lowered the
barriers of barter. Coinage, with all the benefits of dramatically reduced transaction costs in economic exchanges, also carries with it
the scourge of fraud and debasement. As a practical matter, money’s use as a medium of exchange is validated when parties accept
as payment coins and currency they believe others will honor.
Roles of Money
9 Medium of exchange—permits commodity values to be easily divided
9 Measure of value—a standard way to meter value
9 Store of value—easily kept for later use
9 Means of deferred payment—recognized as valid for future payment
Characteristics of Money
9 Stable in value
9 Portable
9 Divisible into units
Durable
Uniform in unit size
Recognizable
Measuring Inflation
In a barter economy, where the mutual exchange of goods occurs in the absence of an accepted money form, it is logically
impossible for general prices to rise. There can be no inflation in a barter economy because each transaction involves commodity
exchange equivalents uniquely defined by the parties in each transaction. Absent a common money form as a measure of value, a
good’s worth in one exchange has no effect on other barter transactions.
In advanced economies like the US, the dollar as designated currency meets all requirements to qualify as money. Checkable
accounts in banks also have emerged as a large component of the US money supply over the past 100 years. The wide acceptance
of checks as payment makes them money. Currency and coins comprise about 50 percent of what is defined and accepted as
money. Checking deposits in commercial banks made up the 50 percent remainder of the US money supply of $1,832.42 billion in
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2010. In 1913, the US centralized control of the US money supply control through the Federal Reserve Act. Since that time, it has
been the prime responsibility of the Federal Reserve System (the Fed) leadership to manage the volume of money in circulation.
Inflation often can be traced to a common source—excess money compared to the quantity of money households hold to purchase
goods and services in an economy. To the extent that is true, if the central monetary authority successfully controls the money
supply, it can strongly influence the overall level of prices and interest rates in an economy.
Inflation–a rise in the average level of prices; equivalently, a fall in the value of the money supply.
As long as the purchasing power of the money held by the public changes so slowly that it does not alter perceptions of the future,
the economy functions effectively. But when prices begin to increase at a rate that is unanticipated and too rapidly erodes the
currency’s purchasing power, citizens begin to panic as institutional processes falter. The difficulty with unanticipated inflation is that
it assaults our usual protections against it. For example, if you open a savings account making annual deposits that earn 5 percent
toward the expected cost of sending your child to college and average consumer prices begin rising unexpectedly at 10 percent
annually, your prior expectations of affording those future college-related expenses evaporate.
US Consumer Price Index [CPI]
Year
US CPI-U
1982-1984
100.0
2009
217.2
2010
220.3
Percentage Price Change 2009 to 2010
(220.3 – 217.2) X 100 = 0.47%
217.2
Source: www.BLS.gov
The US Bureau of Labor Statistics is charged with the task of measuring inflation. Among several related measures is the popular
consumer price index (CPI). The BLS also tracks other price indexes like the producer price index, the wholesale price index and the
GDP deflator, the broadest of the inflation measures.
Consumer Price Index (CPI)–a measure of the average change in prices over time, paid by urban consumers for a market
basket of goods and services.
The idea behind the CPI is to measure consistently the price of representative consumer purchases in a particular year compared to
prices for the same items prevailing in a “base” year. The CPI market basket contains 200 goods and services in 8 major groups.
From the table above, in 2009, average consumer prices were 117.2% higher than in 1982-1984. As a consequence, to have the
same purchasing power in 2009 as in 1982-1984, your income would need to more than double over that same period. Between
2009 and 2010, average consumer prices rose less than one-half of one percent (see table above). The “base” year choice for a
given price index series is arbitrary and does not alter the results.
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US Gross Domestic Product Deflator
Year
Current GDP
(Billions)
GDP Deflator
(2005 = 100%)
2009Q4
$14,277.3
1.09665
2010Q4
$14,870.4
1.11118
Real GDP
(Billions)
$14,277.3 / 1.09665
= $13,019.0
$14,870.4 / 1.11118
= $13,382.6
Source: www.BEA.gov
The CPI adjusts for prices in a consumer’s market basket of goods. A different index (see the table above), the GDP Deflator is used
to adjust prices for all goods and services produced. A base year, currently 2005, is selected and subsequent year’s GDP output is
valued using the 2005 base year prices. Using that technique allows the government to measure real GDP—actual goods and
services produced, without the effect of price changes. Inspect the “GDP Deflator” column in the table to see that 2010 4th quarter
prices are 11.1% greater than in the 2005 base period. To adjust the 2010Q4 current dollar value GDP figure (where both output and
prices have changed from 2005) divide the 2010Q4 deflator value into the current GDP of $14,870.4 to get $13,382.6 billion in real
GDP. Hence, between 2009 and 2010 fourth quarters, US real GDP grew by $363.6 billion ($13,382.6 minus $13,019.0).
Inflation’s Winners and Losers
While it is easy to typecast inflation as evil, in moderation—about 2 or 3 percent per year—it has beneficial economic effects.
Entrepreneurs like modest inflation when they decide to invest, because they expect higher prices for their company’s product in the
future. Some leading economists credibly claim that moderate expected inflation helps stimulate economic growth. The difficulty with
inflation is its drain on purchasing power and wealth among citizens and institutions in the economy. There are recognizable groups
who lose and other groups who gain from inflation.
Persons on fixed incomes, or whose incomes increase much less rapidly than the inflation rate, lose relative purchasing power
through time. Creditors also can fall into the category of inaccurate inflation forecasters. If a bank or mortgage company lends funds
at 5 percent per year and the inflation rate over time turns out to be 5 percent annually, the lender will be paid back a fixed quantity of
money with the same purchasing power as was loaned. But if future inflation is greater than 5 percent, the lender is paid back in
dollars of lesser purchasing power. Taxpayers can also lose during inflationary times in a more subtle way. An inflated personal
income level can fall into higher tax bracket, making the tax filer pay more federal tax dollars.
Inflation’s winners appear as debtors who can pay off loans in less valuable dollars, especially if their own incomes are among those
keeping pace with the inflation rate. Owners of inflation-sensitive assets often win during inflationary times when they sell the priceinflated asset. Landowners and homeowners may see the value of their homes rise, though their property taxes also may increase.
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Taxing authorities may gain from inflation, for example, through property taxes based on current appraised valuations, if the taxation
method does not adjust for inflation’s effect.
Controlling Inflation
Moderate and relatively steady inflation of a few percentage points per year does not appear to be detrimental and can help stimulate
economic growth. But at what point does a relatively benign inflation rate become worrisome or destructive? The US record during
the 1970s shows that inflation rates above 10 percent per year cause significant resource dislocations, arbitrary redistributions of
wealth and general unrest. Labor unions during that time discovered that attempts to neutralize inflation’s effects by holding out for
wage increases equal to expected inflation will ultimately fail if future prices rise faster than the newly bargained wages.
Two serious risks for government policy makers are that the inflation will become institutionalized, so strongly built-in to contracts,
interest rates and expectations that reducing inflation becomes extremely difficult, or reach uncontrollable levels that literally exhaust
the economy as citizens rush about making hasty transactions and seeking shelter from exploding prices. World events for other
countries have shown that hyperinflation episodes, where annual inflation rates crest 100 percent or more, destroy confidence in the
government as businesses, citizens and institutions fail to cope.
An excessively high inflation rate must be addressed via an equally heavy “cure”. The economic and political costs of getting prices
under control can be large, yet not taking action can be ruinous. The government faces the dilemma of launching a credible antiinflationary program when they are perceived as most responsible for the inflationary spiral. Fundamentally, the central monetary
authority must consistently reduce the volume of money in the economy. Unfortunately, the economic price of a restrictive money
policy usually is a recession, perhaps a deep one. Harsh and sustained reductions in the money supply make nominal GDP fall as
companies lay off workers due to uncertainty about future economic adjustments and the central bank’s will to sustain its antiinflationary stance.
More, the policy-induced poor business outlook makes investment fall even as inflation-padded interest rates remain stubbornly high.
The recession’s length and depth will directly reflect how long it takes people and institutions to dismantle the inflationary protections
they erected during the period of rising prices and to, once again, regain their pre-inflation level of social trust.
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In Sum
9
9
9
9
9
9
9
9
9
9
Money is denoted by the government as legal tender and the public validates it by honoring it in transactions.
Money fulfills its role as a useful medium of exchange as long as its value does not change rapidly.
Inflation cannot manifest in a barter economy because each transaction involves different commodities and different people.
Inflation is a rise in the general level of prices over time.
Consumer goods inflation is measured by the Consumer Price Index (CPI) as the change in value from a given base year for
a market basket of typical goods.
The GDP Deflator is used to adjust all of a given year’s GDP to the prices prevailing in another year.
Inflation’s “winners” and “losers”
o “Winners” include debtors, tax collectors, holders of inflating real assets
o “Losers” include creditors, fixed income earners, income tax payers
Inflation nearly always owes its origin to prior increases in the money supply.
“Curing” inflation requires systematic and consistent reduction in the money supply, which can cause a recession.
“Hyper-inflation” is particularly damaging because it is very difficult to break and overwhelms economic institutions.
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Lesson 14: Money and Interest Rates
Money’s Official Definitions
The US government officially denotes the dollar as currency to be legal tender and society validates that designation by accepting it
in exchange for goods and services. With the rise of banking as an institution, checks—legal instruments accepted for payment
called demand deposits—have found their way into the operational definition of money. Printing physical currency and stamping
coins is the responsibility of the US Treasury. Accommodating the volume of money the economy needs is the duty of the Federal
Reserve System, the US central bank.
The difficulty in defining and controlling money in the economic system is due to the many creative ways people can use cash or
“near” cash. Demand deposits (checking accounts) pass as a medium of exchange. It is less clear how to interpret “checkable”
savings deposits that earn some nominal interest rate. The discerning question becomes at what point is money closer to an illiquid
asset versus easily accessible cash? These and related questions compel economists to adopt more than one money definition.
M1 = (coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010.
M2 = M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010.
Money is Not Credit
Many Americans seem to think that credit cards are money. The truth is they are not. Credit cards are short-term promissory notes
permitting the holder a line of credit for a fee called interest. The monthly balance on the credit card is paid using money, commonly
a personal check drawn against the cardholder’s bank account, a demand deposit. The credit card balance, a short-term loan, can
for a while, run ahead of the cardholder’s ability to pay the total balance in money—check or cash. Over time, either the cardholder’s
credit balance is paid in full or the consequences range from card cancellation to personal bankruptcy. Indiscriminate credit card
users also pay higher interest rates.
Money’s Scarcity Preserves Its Value
Goods and services satisfy basic human needs. Money is merely a means to economic ends. If the central monetary authority were
to increase the money supply so that each citizen could fill their pockets and purses with it, then prices for goods would rise
dramatically as shop owners witnessed a mad rush of cash-laden customers scrambling to outbid their neighbors for available goods.
Ruinous inflation would inevitably result.
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The practical objective of the central monetary authority is to supply the economy with a quantity of money that satisfies the needs of
commerce, and no more. As average prices rise, the value of the dollar falls, and the opposite is true. Preserving a currency’s value
and moderating average prices, requires the monetary authority to maintain a relatively constant ratio between the volume of goods
and services produced and the quantity of money in circulation. So why is this objective so difficult to achieve?
Market economies are dynamic, leaky and fickle. First, business momentum can bring unanticipated swings in overall activity.
Second, money leaks outside of the economy through international transactions, especially when the US buys more from other
countries than it sells to them. Perhaps most vexing of all, the amount of money businesses and households hold—the demand for
liquidity—to meet transactions needs and uncertainty is entirely up to them. Changes in the quantity of money held can be
unexpected, swift and large. These three forces: economic shifts, currency leakages and changes in money demand, make knowing
how much money the economy needs difficult to predict and to accommodate.
Time’s Value is the Interest Rate
The interest rate is the measure that links the value of an economic good tomorrow to its value today. In normal economic times the
rate is positive, indicating that if we choose to wait for a future good, we insist on some reward for doing so. At the personal level, it
makes sense to keep a certain amount of our income in a checking account where the money is immediately accessible but earns
little or no interest. It is also prudent to keep some money in a savings account, where funds are somehow restricted but earn a
higher interest return. Savings accounts offer a positive interest rate to entice savers to deposit funds into financial institutions.
We each carry a personal interest rate with us and it shows up in our current consumption-to-saving behavior. If we consistently
spent all of our income today, we would be showing little preference for the future. Then by implication, our personal interest rate
must be higher than the market savings rate. If, instead, we engage in a steady savings plan with some of our after-tax income that
earns 4% in a certificate of deposit, then our personal interest rate for short-term savings must be less than 4 percent.
The interest rate similarly serves to allocate business investment spending. Before making an investment, business decision-makers
analyze the proposition by estimating the expected future dollar profit returns as a percentage of the total investment cost in today’s
dollars. They then compare that rate of return to the interest rate cost of borrowing. If the anticipated investment rate of return
exceeds the cost of borrowing, the investment may be a good one. To the extent that an investment pays a return above all costs
including the cost of borrowing, today’s income gets converted into tomorrow’s wealth.
Funds for investment come from household savings, business savings (as undistributed corporate profits). Without savings
somewhere in the economy, investment is not possible. The prevailing interest rate represents the macro trade-off between
consumption today and consumption tomorrow. From the saver’s view, it is the reward for postponing consumption today. From the
borrower’s view, it is the cost of gaining command over resources today rather than waiting until tomorrow. In the financial
marketplace, as net savers supply funds and net borrowers demand funds—the market rate of interest is determined.
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Banks and financial markets exist to permit the orderly transfer of funds from holders of excess income to borrowers with a deficit of
available funds. Interest rates, as a cost of credit and as a reward for not consuming, are determined in financial markets by the
interplay between demanders of loanable funds and the suppliers of loanable funds.
In Sum
9 M1, the official money supply definition equals coin + currency in circulation, bank vault cash plus demand deposits in commercial
9
9
9
9
9
9
banks.
Credit cards are not money. Credit cards are short-term financial contracts mandating repayment with interest.
The central bank’s main objective is to preserve the value of the currency by providing only that amount necessary to meet the
needs of commerce as it helps the economy achieve full employment.
As average prices rise, the value of the currency falls and as average prices fall, the value of the currency rises.
The interest rate simultaneously is a reward for saving and a cost of borrowing to invest.
The orderly interaction of savers and borrowers through the financial system determines the interest rate.
Leakages of money out of the economic system, swings in economic activity and changing demands to hold money make
controlling the money supply difficult for the central monetary authority.
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Lesson 15: Federal Reserve System
What Commercial Banks Do
Commercial banks are private stock-issuing companies licensed in their state of incorporation to conduct business as a financial
institution. Many commercial banks also hold a national banking charter, making them mandatory members of the Federal Reserve
System. All banks must be chartered in the state where they conduct business. State banks that choose and meet the federal
requirements can become bank members of the Federal Reserve System.
Banks transfer funds from net savers to net borrowers in the economy. Using the funds voluntarily deposited by their customers,
uses prudent lending practices and not all customers wish to withdraw their money at the same moment (a bank “run”), the process
of allocating funds from net savers and net borrowers, at interest, works effectively. Through this institutional system of money
management, moderated by the average rate of interest, money demanded by net borrowers is matched using money supplied by
net savers in the economy.
What Central Banks Do
In the US, the Federal Reserve System is the central bank federally authorized to a) regulate the US banking system and b) to
regulate the money supply toward the broad goals of low inflation, full employment and stable interest rates. .
Federal Reserve System Structure
9 Board of Governors – 7 members appointed by the President and confirmed by the US Senate, serve
14-year terms, each staggered by two years.
9 The board chairman, appointed by the President, serves a 4-year term as chair and may be re-appointed.
9 12 Regional Federal Reserve Banks and 24 branches are located in US financial centers.
9 Federal Open Market Committee determines major policy positions for the US money supply, comprised of
o 7 members of the Board of Governors
o 5 of the 12 Fed bank presidents serve 1-year rotations
o New York Fed bank president has a permanent voting position
9 Member commercial banks (about 7,000) – includes all national banks and about 1 in 7 state banks
representing nearly 85 percent of the US money supply. Member commercial banks actually own
stock in their regional Fed bank that earns 6% interest annually.
Source: Federal Reserve System.gov
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Money and the Federal Reserve
The Fed sits outside the US economy and interacts with the financial system using its monetary tools. To understand how the Fed
influences the money supply, we must define what money is. The domestic money supply (officially called “M1”) is the sum of coins
and currency in circulation (including vault cash on hand in commercial banks) in the US plus demand deposits (checking accounts)
in US commercial banks.
US money supply control rests on the idea of “fractional reserves.” A small fraction, currently 10 percent of each member commercial
bank’s deposits are held on reserve at the regional Fed bank, outside the economy. The remaining 90% of demand deposits are
available for loans to qualified borrowers or for investment. These reserves are not imposed to protect customer accounts. That is
the job of the Federal Deposit Insurance Corporation (FDIC). The reserve requirement is an instrument of monetary control that
limits the maximum volume of money growth in the economy.
Federal Reserve district banks monitor the commercial banks in their district, which must balance their accounts daily. On
Wednesday morning every other week, commercial member banks must comply with the reserve requirement based on deposits
resident in their own bank. So how does this process limit the money supply?
The Money Multiplier
The composition of the nation’s money supply divides evenly between cash in circulation and checkable accounts that serve as
money (M1). The reason that demand deposits are part of the money supply is that they perform much the same functions as cash.
It may seem strange, but the volume of money stock supports several times its volume in US gross domestic product flow over a
year’s time. The money supply is spent several times over to accomplish the feat.
Commercial banks, Fed policy and the non-bank public impersonally collaborate to grow or shrink the money supply. Money is
“created” in the act of borrowing from a commercial bank and “destroyed” in the act of repaying the loan. If a customer enters a bank
and comes out with a loan, the bank honors the agreement by creating a line of credit in the borrower’s name. As the newly loaned
funds are spent they become deposited into other banks as cash—new money by definition.
Perhaps equally surprising, the money supply is reduced when loans are repaid. The check that clears through the system to
extinguish the loan debt also reduces the borrower’s checking account (money by definition, or cash holdings) by the same amount.
The interesting economic aspect of these actions is that the money supply available at any one time depends on both Fed monetary
policies and the borrowing behavior of citizens and businesses.
To more fully appreciate this process, consider that the Fed literally sits outside the US financial system and works to accommodate
the economy’s money stock needs, in line with established goals like keeping inflation and unemployment low. The Fed is not
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concerned, and neither should we be, with where it gets money—it has an open account outside the monetary system. The Fed
primarily focuses on how much money circulates inside the economy, not about making money itself.
The reserve requirement—a Fed-determined percentage of demand deposits in member banks—fixes the amount of reserves banks
must hold. The Fed, by setting this required rate defines the upper limit of money available in the economic system. Importantly,
commercial bank required reserves are not part of the money supply but form the base upon which the money supply rests.
If the Fed requires all banks to keep 10 percent of demand deposits on reserve, then $90 of every $100 in demand deposits can be
loaned to customers. As soon as borrowers acquire the $90 in loans, and spend it, most of it will find its way into other banks as new
demand deposits. These other banks also are required to keep 10 percent (now, $9) on reserve but are free to loan the remaining
$81. You can see what is happening: $100 in new demand deposits has generated new loans (money by definition) of $171 ($90 +
$81) among the borrowing public. If this process continued to its theoretical limit, the increase in the money supply would equal $900
for a total money supply volume increase of $1,000.
This “money multiplier” process works in both directions. As a customer pays off a loan, a demand deposit balance is reduced and
the money supply shrinks accordingly. How? The lending bank accepts the borrower’s check as the final loan payment, the
customer’s debt is extinguished and, once the check clears, a checking account balance is reduced, thereby shrinking the money
supply.
Some observations are in order. First, the money multiplier process does not reach its theoretical maximum because leakages
persist in the system. Not all available funds are loaned out by all banks and not all the borrowed funds are spent. Second, loans
are being extinguished, paid-off, at the same time new loans are being approved. Hence, money is being “destroyed” as new money
is “created” and the net of these two sets of acts determines, in part, whether the money supply is growing or shrinking.
If the money multiplier description above reads like financial sleight-of-hand, it is not. The money expansion and contraction process
is no more mysterious than the physics of using a lever, instead of one’s hands, to move a heavy object or using a pulley system to
lift a heavy weight.
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Monetary Tools of the Fed
Reserve Requirements–-The percentage of demand deposits commercial banks must hold as reserves.
FED Deposit Reserve Requirement (10%)
Increase % of Demand
Deposits Held on Reserve
Bank excess reserves
decrease
Fewer loans made
Money supply decreases
Interest rate tends to fall
Decrease % of Demand
Deposits Held on Reserve
Bank excess reserves
increase
More loans possible
Money supply increases
Interest rate tends to rise
The Federal Reserve System’s charter provided for three major monetary tools, and several lesser tools. We have already
mentioned its most powerful, and least often utilized, tool—reserve requirements. It is powerful because it affects all banks in the
system and because even small changes in the reserve requirement percentage can bring about large changes in the money
supply’s upper limit.
Open Market Operations–-Buying and selling existing US government financial instruments from or to willing customers
(individuals, businesses and banks) in the economy.
FED Open Market Operations
Fed Re-sells US Govt. Bonds
to the Non-bank Public
Public gets bonds from Fed
Reduced demand deposits
Money supply reduced
Interest rate trends to rise
Fed Buys US Govt. Bonds
from the Non-bank Public
Public gets money from Fed
Increased demand deposits
Money supply increased
Interest rate tends to fall
The Fed’s most often used tool is open market operations. The Fed has the financial authority to buy and sell prior-issued US
government bonds. These bonds originated from the Treasury as debt instruments to finance congressionally-approved increases in
the federal debt. Investors willingly purchase or sell the instruments, as part of their financial portfolios, even though their interest
yields are low, because they are very safe.
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Federal Reserve Discount Rate–-The interest rate that the Federal Reserve charges member banks for borrowing as they
work to meet the Required Reserve ratio on the one hand and satisfy the needs of business loan demand on the other.
FED Discount Rates
Discount rate increased
Higher member bank costs
Fewer funds borrowed
Reduced money supply
Interest rate tends to fall
Discount rate decreased
Lower member bank costs
More funds borrowed
Increased money supply
Interest rate tends to rise
The Fed does not control the general level of interest rates in the economy. At most, it influences the money supply to nudge interest
rates in the desired direction. The Fed sets only one interest rate—the discount rate charged member banks for borrowing from the
Fed, when a bank comes up short on the bi-weekly reserve requirement. That rate is called the discount rate because, unlike
common loans where the interest due is included in regular payments with the principal, the Fed collects the interest immediately
from the amount borrowed.
The member bank borrower repays the full amount of the loan typically within 12 to 72 hours. Member banks actually have two
sources from which they can borrow to cover a required reserve deficit. First, they can borrow the excess reserves (named “Fed
Funds”) from other member banks in the system and pay the interest rate determined in that sub-market. That interest rate is
established by the amount of excess reserves available versus the amount of deficit reserves demanded in the banking system.
Second, the deficit bank can borrow directly from the Fed. The choice is simple, the banks with the reserve shortfall borrow from
whichever source—system banks or the Fed—offers the lower interest rate.
The Fed’s responsibility is to accommodate financial needs and maintain market stability. In normal times, Fed changes in the
discount rate are interpreted as signals of the Fed’s view of the economy and its future. A decrease in the discount rate might signal
a “looser” money supply, lower interest rates or possible future inflation. An increase in the discount rate could signal a tightening of
the money supply and higher interest rates and reduce private market investment.
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In Sum
9 Commercial banks are financial intermediaries in business to make a profit loaning and investing depositor’s funds.
9 The Fed regulates commercial banks and controls the money supply toward the goals of low inflation, full employment and
stable interest rates.
9 Money supply (M1) equals the sum of coins and currency in circulation plus commercial bank demand deposits.
9 The “money multiplier” is based on the “fractional reserve” requirement for commercial banks.
o Reserve requirements are now 10% of demand deposits, leaving as much as 90% available for loans and investments
o The money multiplier is limited by the Fed’s reserve requirement percentage and the public’s demand to borrow
9 Money is “created” in the act of borrowing and “destroyed” by loan repayment.
9 The Fed’s primary obligation is to regulate the economy’s monetary sector to achieve the goals of low inflation, stable interest
rates and full employment.
o The Fed operates from outside the monetary sector and works to maintain an adequate supply of money in the
economy
o The Fed’s objective is not to profit from any of its policy moves or operational transactions.
9 The Fed’s main tools for controlling the money supply are:
o Reserve requirements—10% of demand deposits on reserve
o Open market operations—the Fed’s buying (to increase the money supply) and selling (to decrease the money supply)
prior issued US government bonds in financial markets
o Discount rate—the interest rate the Fed charges member banks for borrowing to maintain the reserve requirement
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Lesson 16: Macroeconomics: Long Run and Short Run
Macroeconomic Goals
Attempts to resolve the nation’s economic problem underscore the need to make real trade-offs in the macro economy. What goals
should an economy pursue to best address the economic problem? The Employment Act of 1946, passed in response to the Great
Depression, set forth the government’s commitment to maintain full employment. That act also established the Council of Economic
Advisors, an appointed body of economists, who to this day provide policy counsel to US presidents.
Macroeconomic Goals
9 Full employment
9 Stable prices
9 Steady growth
9 Stable interest rates
Pursuing these goals also reveals policy conflicts that cannot be resolved without sacrifice. The federal government itself must
recognize the trade-offs for the economy as it passes legislation to either stimulate or restrain market forces. The essential question
is just how does the macroeconomy work? Economists have sought for over two centuries to understand the nature and functions of
a market economy through its two basic forces—demand and supply.
The theoretical question is whether and how a) supply creates the income to equal demand or b) demand generates enough
expenditure volume to purchase the supply? The debate has two major sub-parts: 1) what forces motivate change in economic
actions and 2) do macro-markets adjust for the short run or the long run? Despite disagreements on each of these questions, the
majority of mainstream economists accept as true the following statements about macroeconomics.
Accepted Truths About Macroeconomics
9 Money volume is a “stock”, and income is a “flow”
9 The money stock is a fraction of total national income generated in any year
9 People have a demand for liquidity—to hold part of their wealth as money
9 One person can alter the money they hold by altering their own current expenditures, but
all persons in a society cannot alter the money they hold without macro consequences
9 As their wealth increases, people tend to spend more current income, and the opposite is true
9 A nation can make new economic investments only up to the level of its current savings
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The Long Run and Short Run
Mainstream macro economists accept that the Classical economists’ view of two centuries on how the economy works is correct in
the long run. Inspect the graph below to see what that means, in terms of aggregate demand (the down sloping green curve) and
aggregate supply (the curved upward red curve). In the long run—perhaps several years—the economy tends to adjust into
equilibrium at or near full employment—the vertical dark line in the graph. That happens because the production of real GDP
ultimately depends on the supply of labor, capital and natural resources. Once at full employment and equilibrium, the price level then
depends only on the volume of money in the system—and the central bank can influence the growth of the money supply to maintain
price stability.
Aggregate demand [AD]—a down sloping line that shows the quantity of GDP demanded [the sum of household
consumption (C), business investment (I), government spending (G) and foreign customers (NE = Net Exports)] purchased at
each price level.
Aggregate Supply [AS]—an up sloping line that shows the quantity of goods and services businesses choose to produce
and sell at each price level. In symbols: Aggregate Supply is a function of Labor, Capital, Land and Technology.
The economy’s “real” economic variables—production and employment (human activity and goods production)—are most
important. The “nominal” economic variables—those measured in money or percentage terms: prices, wages and interest rates,
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serve as facilitating signals to help determine the quantities of the real variables utilized in the economy. During normal times
adjustments in prices, wages and interest rates—the nominal variables—work to bring the production and employment—the real
variables—to full employment, the “natural” state for an economy in the long run.
It is in the short run where reality is messiest and debate is hottest. See the down sloping green AD1 line in the graph above and note
that where it crosses the ASShort Run real GDP is well below the full employment level of GDP. That means there is a large percentage
of unemployed workers. Misperceptions and uncertainty about the future by both consumers and business leaders abound. When
the economy goes awry, a mismatch between desired investment and actual savings sends the economy reeling. During this phase
both the price level and average wages adjust rather slowly, adding to future uncertainty about the economy. The natural human
instinct during times of strife is to pull back. At worst, a downward cycle of falling consumption and investment reduces aggregate
demand at any price level, shifting it to the left.
If the economy slips too far, the societal pain calls for aggregate demand stimulus from government. Economists and policy makers
seek to bolster aggregate demand through policies like: increased government spending (financed through public borrowing),
reduced federal income tax rates, and investment tax credits for business. The Federal Reserve System also may increase the
money supply to lower interest rates and stimulate borrowing by households and businesses.
The Equation of Exchange
Classical economic thought bears a relationship to what is called the “equation of exchange.” The formula has held an important
position in macroeconomic analysis for 200 years. We treat it here to motivate discussion on the role of money in determining
nominal (current dollar) GDP. Given the definitions below, the two sides of the relationship are identities. In other words, the money
stock (M1) times the number of times the stock is spent (V for “velocity”) must equal the real GDP (Q) times the average price level
(P). In short, the money stock times its expenditure “turnover” must equal goods produced times their average price.
Equation of exchange: M ⋅ V = P⋅ Q, the relationship between money, prices and goods production where:
M = quantity (stock) of money in circulation (here, M1),
V = velocity of money, the average number of times the money stock is spent in a year to buy new goods and services,
P = average price level for goods and services,
Q = physical quantity of goods and services produced in one year = real GDP, and P ⋅ Q = nominal GDP.
It is “V” that holds the greatest interest for economists. It measures, indirectly, the public’s demand to hold money. V is very stable
over time, though it is not constant. The reason is that the public’s desire to hold some of their wealth in the form of liquid money
varies with swings in the economy and their mood concerning future economic expectations. Consumers and businesses play a
crucial role determining the actual amount of the money stock and that makes monetary policy an art form. For example, if the
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Federal Reserve moves to increase the money supply to stimulate the economy but citizens absorb the increase by holding more
money than usual instead of spending it, they unwittingly undermine the Fed’s policy objective.
The household sector’s response to money supply variations becomes difficult to forecast when economic times are uncertain. This
is so because holding money has two costs: a) the lost opportunity of interest return on an investment and b) the prospect that in
times of inflation, the asset named money is losing value. Add to this the tendency for effects from changes in the money supply to
take effect from 12 to 18 months after a policy change, and the usefulness of monetary policy in periods of recession is limited.
The Multiplier
Though it may appear to non-economists as sleight-of-hand, $100 of new spending actually generates more than $100 in GDP. This
phenomenon occurs in a manner not visible to individuals. In short, expenditures that initiate new economic activity are re-spent
more than once, though by different people, as businesses along the production chain work to replenish inventories and workers
receive additional income to spend.
Multiplier–-The effect of additional spending from an initial spending stimulus from either the private sector (consumption or
investment) or the public sector (government spending or government taxes).
Suppose that the auto makers in Detroit determine that the next year is going to be less robust than originally forecast, so they
reduce their orders for new cars by $5 billion. Call this the initial shock. Recall that GDP measures production or income and it will
not fall simply due to a reduction in automobile orders. What will happen is that the automakers’ collective $5 billion reduction in
investment will cause manufacturers to add $5 billion of unsold cars to their inventories, an unanticipated investment. Now the
manufacturers are stuck holding $5 billion more in unsold car inventory than they desire and they will take steps to reduce it. How?
The manufacturers cut future orders by $5 billion in new car production. They lay off workers, idle plants and reduce purchases from
suppliers. Subsequently, the suppliers will have to cut back their planned activity and they will move to reduce their own inventories.
Once these reactions ripple from the original decision to reduce production and work their way through the supply chain, GDP also
will have fallen by $5 billion. Call this the industry chain reaction part of the multiplier. But the economic reverberations do not end
there.
Workers now have less money to spend due to the production decline. Less personal income means less expenditure for personal
consumption. If consumers behave according to their usual habits, additional consumption will fall by some fraction of the $5 billion.
For example, local shops and restaurants, auto dealers and clothiers notice a fall in store patronage and average customer purchase
amounts. Consequently, non-automobile industry inventories also experience unexpected excess supply building up and they, too,
take steps to reduce their unwanted inventories. Call this the household sector part of the multiplier. So the effect of one industry’s
lower expectations of the future and related adjustment comes to be “multiplied” throughout the economy.
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Multipliers work in both directions; enhancing the effect of both spending increases and spending decreases. The multiplier effect
from re-spending rounds to accommodate inventory changes moves the Aggregate Demand curve from its original position to its final
position. Multipliers take a year or two to work out. Any new spending change from any sector: households, businesses or
government, has an associated multiplier. The economy enjoys the multiplier’s power when spending is on the rise but also must
suffer the contraction impact when spending levels fall.
In Sum
9 Economists agree on certain economic goals, but they cannot all be met simultaneously without the government making
trade-offs: Full employment, Stable prices, Steady growth, Stable and low interest rates
9 Most mainstream economists accept the following beliefs about the macro economy
o Most people have a demand for liquidity—holding money
o One person can change (increase or decrease) the money they hold by reducing or increasing their expenditures.
o All persons in the economy cannot alter the money they hold without consequences.
o Households make the choice to consume or save their income based on their personal needs and future outlook.
o Businesses make the decision to borrow for investment based on the interest rate and the future business outlook.
o Business can make new investments only up to the level of current savings in the economy.
9 The debate on how the economy works centers on what how the economy adjusts in the short run versus the long run.
9 The multiplier represents the additional spending generated to reduce or replenish inventories from spending changes in any
sector.
9 The equation of exchange is: M⋅V = P⋅Q
o Where M = M1 (money stock), V = velocity, P = average price level and Q = GDP output
o The equation shows how the money supply directly affects nominal GDP
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Lesson 17: Fiscal and Monetary Policy
Laissez-faire versus Government Intervention
Does the public truly believe in free enterprise and the workings of private markets? Why not let markets lift all businesses in good
times and purge weak firms in slow times. Or should government intervene in a market society during an economic crisis?
Understanding that there is no economic action without consequences, what are the costs and benefits of government attempts to
moderate economic swings? Do government economists and political leaders see the future so much more clearly than the rest of
society? These and other compelling questions spur the debate on if, how and when government should manifest its presence in a
free enterprise economy.
The fact is that individual actions today are based on perceptions of the future. Policies intended to benefit collective behavior
toward a desired economic goal, however well intentioned could misjudge the economy’s needs as well as the collective economic
response.
The Demand for Money
Knowing how much money individuals and businesses demand to hold is important because that is how many federal economic
policies most often show up—as checks or as the inducement to write checks to spend or invest. First government economists and
policy makers must predict how the average household will respond when they receive new money from the government.
Each individual and business has a certain demand to hold money for transactions, uncertainty and speculation. If they possess
more money than they wish to hold, citizens attempt to spend or invest the difference. If they currently hold less than the desired
amount, citizens will curtail spending or liquidate investments until they achieve desired money balance. Incorrect estimates by
government economists on how the public will react, given their demand for money, can erode a policy’s intended economic effect.
Why can the economy not easily absorb unexpected or unwanted increases in the money supply? From the view of the total
economy, one individual can shed “excess” money by buying more goods or investing in additional assets. But when all individuals
attempt to do so, higher demand for the goods or investments sought with the excess money drives up their price. The reason is that
the output levels simply cannot respond quickly, because of industry rigidities, uncertainty, misperceptions or even fear. So inflation
shows up—as a means to “absorb” the “excess” money.
Monetary Policy Tools
Monetary policy operates through Fed tools, by altering commercial bank reserves to affect the money supply and achieve
macroeconomic goals. The Fed’s seven-member Board of Governors and the Federal Open Market Committee jointly determine
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monetary policy actions for the economy. The tools used to conduct monetary policy are well-defined and, in a mechanical way, do
work. Yet the full effect of a monetary policy shift may take as long as 18 to 24 months to work through the system. That places
much pressure on the Fed to correctly anticipate future conditions and then be correct in their policy move.
Monetary Policy—influencing the economy’s money supply, by central bank policy makers to achieve national goals.
Monetary Policies with Effects on Aggregate Demand and Interest Rate
“Loose” Monetary Policy
Aggregate Demand
Fed lowers reserve requirement
Fed buys government bonds
Fed lowers discount rate
“Tight” Monetary Policy
Aggregate Demand
Fed raises reserve requirement
Increase; Shift to the Right
Interest rate tends to fall
Fed sells government bonds
Fed raises discount rate
Decrease; Shift to the Left
Interest rate tends to rise
For the Fed to achieve its stated targets without making other economic measures worse they must accurately read both the current
condition and mood of the economy. The Fed must then correctly anticipate how each major economic sector is likely to respond to
their monetary policy change. For example, should the Fed pursue a policy of stabilizing interest rates or stabilizing growth in the
money supply, M1—cash and demand deposits? If the Fed attempts to keep interest rates low by increasing bank’s excess reserves
and expanding the money supply, short-term interest rates will fall. But over time, interest rates and prices could rise if there is more
money than the economy needs to purchase current production.
The inflation arises because people want to hold only so much money, so they shed any “excess” money balances by purchasing
other goods or making investments. While one person can lower his or her money holdings, all people in the economy cannot do so
without consequences. So, general prices rise from “excess dollars chasing too few goods”. Banks enter the picture again as they
try to preserve the purchasing power of future loan payments by bumping up their loan rates as protection against future inflation.
With interest rates now starting to rise, the Fed finds itself having to increase the money supply again to temporarily lower interest
rates. This sequence of actions is the beginning of a monetary policy-induced inflationary spiral.
So what is the best proscription for the Fed regarding monetary policy? Perhaps to match the growth of the money supply to the long
run real growth rate of the US economy—about 3.5% per year. If the Fed were able to control the money supply that closely, at least
some relative sense of stability could be achieved. Yet steadfast reliance on this policy can be criticized from two positions. First, it
tends to inhibit economic growth above 3.5% per year. Second, it ignores the economy’s liquidity needs during unexpected
economic downturns.
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Fiscal Policy Tools
Fiscal policy influences aggregate demand through Congressional legislation that alters federal spending and tax rates to achieve
macroeconomic goals. America’s discretionary fiscal policy debut occurred during the Great Depression. Prior to that time, incurring
federal debt was unthinkable for a capitalist-based economy and politically supported only as a last resort to finance foreign wars.
There are legitimate economic and political reasons why the public should pay for social assets like highways, public education and
national defense. As long as tax revenues are raised in a relatively equitable fashion and do not outstrip government expenditures,
citizens usually raise little protest.
Fiscal policy—actions altering federal spending levels via Congressional policy on government programs and taxation.
Fiscal Policies and Effects on Aggregate Demand and Interest Rates
Policy Direction
Aggregate Demand
Government spending increase
Government transfer increase
Government tax decrease
Policy Direction
Aggregate Demand
Government spending decrease
Increase; Shift to the Right
Interest rate tends to fall
Government transfer decrease
Government tax increase
Decrease; Shift to the Left
Interest rate tends to rise
The role of government as “business cycle steward” raises more difficult questions. How much federal government presence in the
market is desirable and necessary to stabilize the economy? Does active government spending during times of rapid growth or
decline do more good than harm on balance? Fiscal policy management is an inherently political process. Federal legislation to
alter spending or taxes is subject to the voting and procedural rules of every congressional bill. The new policy must be crafted,
debated, voted on and signed into law. No matter the urgency of the economic need, partisanship is part of the process. Once the
legislation is signed into law it may take some time to implement, then more time to have its desired effect. By that point, the
economy may have already “healed” or may be too “ill” for the legislated remedy to “cure” the problem. While the US track record on
fiscal remedies achieving desired targets is mixed, the logically anticipated effects of fiscal policies on the economy are mechanically
direct.
National Debt and Fiscal Policy
When the federal government spends more than it receives in tax collections, it borrows the difference from society. To authorize the
bond sale, Congress must pass legislation approving an increase in the statutory federal debt ceiling. Then, on instructions from
Congress, the Treasury prepares new financial instruments—US Government Bonds—and offers them for sale in domestic financial
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markets in an amount sufficient to cover the anticipated annual debt increase. These US government bond debt instruments have a
face value, fixed duration and interest rate stated as a percentage of the face value, as do most bonds. The Federal Reserve
System then acts as the Treasury’s agent to conduct the initial bond sale in US financial markets. Individuals, companies and banks
can buy US government financial instruments to hold in their investment portfolios. Even though their interest yields are lower than
other financial assets of similar size and duration, they are backed by the full faith and credit of the US government.
Crowding Out Effect of Deficit Financing
The US government borrows money from the same pool of net savings from which the private sector draws. Two opposite in
direction effects occur on the money supply when increasing the federal debt. First, some part of the public willingly trades money in
exchange for US bonds, so the money supply temporarily shrinks, causing private market interest rates to rise. Second, and
sometime later, the Treasury spends the newly acquired money on federal programs. Now the money supply increases and interest
rates tend to fall, though not necessarily to their prior level.
So deficit financed fiscal policy contains an inherent monetary dimension. When the government enters the money market as a
borrower, the possibility, and often the actuality, exists that business investment, sensitive to interest rate as an investment cost,
might fall as a result. By the time the Treasury spends the money acquired from its deficit-financing, some business investment may
have been postponed and some consumer spending may have been curtailed. This occurrence is what economists label “crowding
out”. The result is that public sector program spending partially substitutes for precious private sector activity.
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In Sum
9 The demand to hold money as a liquid asset has direct bearing on the effectiveness of government economic policies.
9 Monetary policy aims to influence aggregate demand using Federal Reserve System tools to alter bank reserves and the money
supply to achieve desired macroeconomic goals
o Raising the Fed discount rate discourages member bank borrowing while discount rate decreases encourage borrowing
o The Fed raising member bank reserve requirements discourages borrowing and reductions encourage borrowing
o The Fed buying US government bonds encourages borrowing and selling them discourages borrowing
9 Fiscal policy aims to influence aggregate demand using Congressional processes to alter government and private sector
spending, then via tax rates and deficit spending, toward desired economic goals.
o Lowering tax rates encourages private sector spending, raising taxes reduces private sector spending
o Increasing government spending encourages economic activity and decreasing government spending reduces economic
activity
o Decreasing tax rates encourages, but does not guarantee, more private sector spending; increasing tax rates reduces private
sector spending.
o Increasing (decreasing) transfers and subsidies increases (decreases) spending
9 National Debt increases occur when government spending is greater than government tax revenues
9 Crowding Out occurs when the government deficit finances new spending, then increased demand for money from the
government’s bond sale increases interest rates and discourages some level of private business investment.
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Lesson 18: Gains from Trade
Trade and the Law of One Price
For millennia, people have voluntarily traded in goods because both parties to the transaction experience a gain from the exchange.
In modern times, domestic producer interests and the national interest do not always coincide. Elected officials can pursue trade
policies favoring political aims, despite the economic costs to citizens and businesses. Although most national leaders accept the law
of comparative advantage as true, they rarely permit its full benefits to prevail in favor of policies supporting vested economic
positions that curry political favor or punish political enemies.
In a freely competitive world, identical tradable goods available in the US and a foreign country would sell for the same price as
measured in each country’s currency. A direct implication of this statement is that price changes for goods in one country get
reflected in the value of that country’s international currency. If a US citizen visited a foreign country and wished to buy a local Big
Mac hamburger for $3.49 in the states, they should pay no more than the equivalent of that price at the foreign currency’s value.
That is how the “law of one price” operates in principal.
Law of One Price—A unit of any one currency—say the US dollar—buys the same quantity of identical goods in all countries,
after the currency exchange.
Reality gets in the way of this appealing law when we search for identical goods in each of two countries only to find that they may
not be precisely the same, save the Big Mac, perhaps. Further, not all goods are mobile or easily tradable. Land, for instance, is not
tradable in the usual sense of physical movement. Also, many goods produced domestically just are not traded internationally.
Simple and appealing, the law of one price does serve as an interesting gauge against which to assess the relative accuracy of
currency exchange rates.
Comparative Advantage Theory
Prior to 1850, thinkers in international trade theory believed that the ability to produce a product with fewer resources determined the
basis for trade—the so-called absolute advantage view.
Absolute Advantage–-One person or country can produce a good with fewer resources than another country.
Classical economist David Ricardo established the correct efficiency logic for trade. He showed that neither the total volume of
goods generated for trade nor the disparity between labor wage rates mattered. Rather, the comparative opportunity cost of the
goods between the traders was paramount. One merely had to measure the cost of the next best foregone opportunity of producing
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a good in the home country compared to a potential trading partner’s opportunity cost to see who should specialize and trade which
good(s) to the benefit of both countries.
Comparative Advantage–-One person or country should specialize in producing those good(s) where they have the lower
opportunity cost compared to another person or country producing the same good.
To see how this law operates, inspect the data in the table below where Sidney and Francis as workers in two separate countries
produce either fruit or sugar. For Sidney, one day’s effort produces one unit of fruit; but she could have made two units of sugar. So,
making 1 unit of fruit costs Sidney 2 foregone sugar units. For Francis, one day’s effort can produce 3 units of fruit or 4 units of
sugar, not both. So, 1 fruit unit (3/3 = 1) costs Frances 4/3 sugar units.
Comparative Advantage Example
Person
Sidney
Francis
Fruit
1
3
In 1 Day
OR
OR
Sugar
2
4
Fruit’s Cost
1 costs 2
1 costs 4/3
Sugar’s Cost
1 costs ½
1 costs ¾
As between the two, who produces fruit with the least real sacrifice? Francis. Her 4/3 (1 fruit costs 1 1/3 sugar units) is less than
Sidney’s 2 (1 fruit costs 2 sugar units). So, Francis should specialize in producing fruit. It is also true that Sidney should specialize in
producing sugar because her cost is ½ units of fruit while Francis’ cost is ¾ units of fruit. After specialization, they can trade the
goods between them, where total output would be greater than before and both goods get produced at a lower opportunity cost than
before specialization.
Any barrier to free trade erodes the comparative advantage one country may possess, reduces the quantity of goods available and
increases their relative cost. There may be political arguments for limiting trade by imposing barriers but there always are economic
costs in so doing.
Barriers to Free Trade
9 Tariffs—a tax on imports or exports makes imported goods more expensive and erodes the opportunity cost
advantage from comparative advantage.
9 Quotas—a quantity limit on imports or exports reduces the gains of comparative advantage by restricting
the amount of a named good that can be traded.
9 Embargos—trade prohibition against a good eliminates the possibility of any gains from comparative
advantage by preventing trade for the named good.
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Currency Markets and Exchange Rates
Trade with other countries also contains a transaction complication that carries a cost. Each country legalizes its own currency for
use within its borders. US currency legally circulates domestically but foreign goods sellers want payments made in their own
currency’s denomination. So for every trade of goods or services between countries, an exchange of currencies also must occur.
Countries can only trade, buy and sell goods and services with another country, if they possess a sufficient volume of their trading
partner’s currency. They most easily acquire a stock of international currency by selling goods or services, directly or indirectly, to the
country with whom they wish to trade. Without enough of the correctly denominated currency, exchange cannot easily take place
between two countries.
Dollar Exchange Rate—How much of another country’s currency one US dollar will buy.
Sample US$ to Aussie$* Currency Exchange Rate
A$ Currency Depreciation
Exchange Rate on Feb. 1, 2011
IF 1 A$ = 0.90 US$ (A$ Depreciated)
1 Aussie$ buys 0.987 US$
then simultaneously:
and simultaneously:
1 US$ = 1.11 A$ (US$ Appreciated)
1 US$ buys 1.013 Aussie$
Source: www.BEA.gov; *Aussie$ is shorthand for the Australian Dollar
US$ Currency Appreciation
IF 1 US$ = 1.1 A$ (US$ Appreciated)
then simultaneously:
1 A$ = 0.9 A$ (A$ Depreciated)
Reciprocal supply and demand for goods (and, hence, currency supply and demand) between countries largely determine currency
exchange rates for international trade. But currencies do not always exchange for “price parity”—equivalent product value—due to
exchange market forces like different national inflation rates, exporter or importer currency price expectations or government
intervention that shift currency supply and demand.
US Currency appreciation—when the international currency market requires fewer dollars in exchange for another currency
OR the US dollar buys more of another currency, the US dollar has appreciated in value and, simultaneously, the other
currency has depreciated in value against the dollar.
The other country’s goods become less expensive for US purchasers, increasing US imports and US goods become more expensive
to the other country’s purchasers, reducing US exports.
US Currency depreciation—when the international currency market requires more dollars in exchange for another currency
OR the same US dollar buys less of another currency, the US dollar has depreciated in value and, simultaneously, the other
currency has appreciated in value against the dollar.
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The other country’s goods become more expensive for US purchasers, decreasing US imports and US goods become less
expensive to the other country’s purchasers, increasing US exports.
Currency exchange rates between trading countries fluctuate based on the demand for and supply of a country’s international
currency for trading purposes. For example, if the US demand to purchase more goods from Germany increases, then more
international dollars must be exchanged for German marks to facilitate the transaction. So US demand for German marks rises
relative to the supply of German marks. As with any market, when demand rises against a fixed supply, the price of the good goes
up. Here, the dollar cost of a German mark rises, which also means the US dollar has depreciated in value against the German
mark.
Currency exchanges complicate international trade transactions but organized international markets provide a relatively efficient
mechanism to reduce transactions costs and uncertainty. Finally, barriers to trade, commonly predicated on political or power
considerations, erode the economic opportunities revealed by the logic of comparative advantage.
The Balance of Payments
International transactions get recorded as a demand component of GDP called net exports (exports minus imports) where exports
increase GDP but imports do not alter US GDP (because when US consumption rises, US imports rise by an identical but negative
amount). All international transactions fall into one of two large categories plus a relatively minor third category: 1) current account,
2) capital account and 3) transfers, gifts and discrepancies.
The current account tracks the flow of goods, services and income between countries. US Exports are sales to foreign countries and
bring dollars into the US. US Imports are purchases from foreign countries and send dollars out of the US. If US exports exceed
imports, then the current account balance is a surplus. If US imports exceed exports, the current account is in deficit.
The capital account tracks investment flows, either direct real capital (machinery, land etc.) or financial capital (stocks, bonds).
Exports are sales of US-owned real capital or US financial assets that bring dollars into the US. Imports are purchases of foreignowned real capital or foreign financial assets and that send dollars out of the US. Transfers and gifts are one-way flows between
individuals in different countries or between governments, as foreign aid. Statistical discrepancies exist because international
transactions are difficult to accurately track.
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US Current Account Balance Data, 2009 ($ Millions)
Current Account Categories
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Net Balance on Current Account
$ Amounts
2,159,000
2,412,489)
(124,943)
$ (378,432)
US Capital Account Balance Data, 2009 ($ Millions)
Capital Account Categories
U.S.-owned assets abroad
Foreign-owned assets in the United States
Net Financial Derivatives & Statistical Adjustment
Capital account transactions, net
Net Balance on Capital Account
Source: www.BEA.gov
$ Amounts
(140,465)
305,736
213,301
(140)
$378,432
It is an accounting truism that for every current account transaction, there is an equal capital account transaction. One country
always pays another through some financial instrument or money transaction. Current account transactions must equal capital
account transactions (and are opposite in algebraic sign), including unilateral transfers, gifts and discrepancies. Trade between
countries does not stop just because a country’s trade balance is negative. Rather, the deficit country must offer some asset other
than goods or services in return. Most commonly financial debt instruments from private companies or from the government are
accepted, as long as the borrower’s credit is good.
The benefits to trade are large, continuing and within the grasp of any country that produces goods or services desired by another
country’s citizens. The law of comparative advantage shows that even developing countries may have an opportunity cost advantage
in producing some good or goods and can trade them to their benefit.
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In Sum
9 Law of one price—in principle, the exchange rate between currencies should reflect equivalent values for identical tradable
goods between the countries.
9 Comparative advantage means that individuals and countries should specialize in producing those goods with the lowest
opportunity cost compared to the opportunity costs of potential trading partners. With specialization:
o More total goods will be available and at lower cost
o The terms of trade—the good-to-good exchange price—between parties must fall between their comparative
opportunity costs of production or there is no economic basis for trade.
9 Any inhibition to free trade reduces the amount of goods available and raises the cost (price) of those goods
o Tariffs—a tax on imports
o Quotas—a limit on physical volume of imports
o Embargos—a prohibition on imports or exports
9 Currency exchange rate—the value of one country’s currency expressed in units of another country’s currency
o Appreciation—a country’s currency buys more units of another country’s currency
o Depreciation—a country’s currency buys fewer units of another country’s currency
9 Balance of payments—the means of accounting for all international transactions
o Current account—exchanges of goods and services
o Capital account—exchanges of real assets or financial assets
o Current account transactions = capital account transactions after adjustments for transfers and omissions.
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Glossary of Key Terms
Absolute advantage—One person or country can produce a good with fewer resources than another country. 99
Aggregate demand [AD]—a down sloping line that shows the quantity of GDP demanded purchased at each price level. 90
Aggregate supply [AS]—an up sloping line that shows the quantity of goods and services businesses choose to produce
and sell at each price level. 90
Business cycle—fluctuations in economic activity caused by changes in expectations and business conditions affect
income, production, employment, prices and interest rates. 68
Comparative advantage—One person or country should specialize in producing those good(s) where they have the lower
opportunity cost compared to another person or country producing the same good. 100
Consumer Price Index (CPI) —a measure of the average change in prices over time, paid by urban consumers for a market
basket of goods and services. 76
Credit card—A short-term loan agreement that enables holders to enjoy goods and services today by borrowing against
tomorrow’s income for a fee called interest. 57
Demand—the quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other market
forces held constant. 13
Derived demand—the relationship between the resource factor's price and quantity wanted by firms directly depends on
market demand for the final product(s) the factor helps produce. 21
Dollar exchange rate—How much of another country’s currency one US dollar will buy. 101
Economic decision making—Choose the option in which the expected additional benefit to additional cost ratio is greater
than that same ratio for the next best choice. 24
Economics—the study of how society manages its scarce resources. 1
Equation of exchange—M ⋅ V = P⋅ Q, the relationship between money, prices and goods production. 91
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Excludable good—others can be excluded from consuming the good, usually because it has been consumed already. 42
Federal Reserve discount rate—The interest rate that the Federal Reserve charges member banks for borrowing as they
work to meet the Required Reserve ratio on the one hand and satisfy the needs of business loan demand on the other. 87
Fiscal policy—actions altering federal spending levels via Congressional policy on government programs and taxation. 96
Free markets—an exchange system for the production, distribution and consumption of goods and services between buyers
and sellers. 4
Good—a product or service that provides value to its acquirer. 3
Income effect—If a certain number of dollars are allotted to making a purchase, when the unit price for the good rises (or
falls), the quantity of the good the consumer can willingly afford falls (or rises). 14
Inflation—a rise in the average level of prices; equivalently, a fall in the value of the money supply. 76
Law of demand—the inverse (or opposite in direction) relationship between current price and the quantity demanded of a
good. 14
Law of diminishing marginal returns—given fixed amounts of land, as the quantity of labor incrementally increases, total
output will increase but at an eventually diminishing rate. 66
Law of diminishing marginal returns—when at least one factor input, plant capacity, is fixed, the additional output
produced from additions to labor will eventually decrease as more labor is added. 20
Law of one price—A unit of any one currency—say the US dollar—buys the same quantity of identical goods in all countries,
after the currency exchange. 99
Law of supply—Sellers will produce more of a product at a higher expected price than at a lower expected price. Price and
quantity supplied move in the same direction along a given supply schedule. 26
Long run—a time-period long enough to make changes in the scale of production and where all costs are variable. 22
M1—(coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010. 80
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M2—M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010. 80
Monetary policy—influencing the economy’s money supply, by central bank policy makers to achieve national goals. 95
Multiplier—The effect of additional spending from an initial spending stimulus from either the private sector or the public
sector. 92
Natural rate of unemployment—the rate around which the unemployment fluctuates, in a healthy economy. 72
Nonexcludable good—preventing others from consuming the good is too expensive. 42
Nonrival good—consumption by any person(s) does not reduce the amount of the good available to others. 42
Open market operations—Buying and selling existing US government financial instruments from or to willing customers
(individuals, businesses and banks) in the economy. 86
Opportunity cost—the value of the next best option foregone when making a choice. 24
Opportunity cost—when making a choice, it is the next most highly valued option forgone that measures the cost of the
chosen option. 4
Price elasticity of demand—a measure of the relative change in quantity demanded in response from a change in current
price. 15
Price elasticity of supply—A measure of the relative change in producer output compared to the change in selling price. 26
Profit maximizing rule—operating at the level of output where market price equals marginal cost will either maximize profits
or minimize losses, if they are incurred. 36
Property rights—limits on the use of private property, goods and services that help define the limits of social behavior. 42
Reserve requirements—The percentage of demand deposits commercial banks must hold as reserves. 86
Rival good—one person’s consumption reduces the amount of the good available to others. 42
Scarcity—economic goods are not naturally available in the form, time or place desired without a cost or sacrifice. 4
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Short run—the time-period during a production cycle, where variable costs are incurred (e.g. wages, materials) and some
costs not directly related to the rate of production are fixed (e.g. rent, utilities, insurance). 19
Substitution effect—As the unit price of a good rises (or falls), the consumer substitutes away from (or toward) the good. 14
Supply—the quantity of a good sellers are willing and able to offer at a range of prices, all other market forces held constant.
25
The Coase Theorem—states that if private parties can bargain without cost about how to allocate resources, then they can
resolve the externality problem on their own. 44
The economic problem—how to meet society’s material needs given scarce resources. 2
Trading-off—making choices regarding the amount of one good sacrificed to get more of another good. 4
Transactions costs—the costs of negotiating a transaction with all relevant parties. 42
US currency appreciation—when the international currency market requires fewer dollars in exchange for another currency.
101
US currency depreciation—when the international currency market requires more dollars in exchange for another currency.
101
Texas Council on Economic Education
The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the
Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices
Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to
provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better
economic & financial choices in a global economy.
economicstexas.org
1801 Allen Parkway Houston, Texas 77019 Telephone 713-655-1650 Fax 713-655-1655
Email: [email protected]