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2012 2013 EDITION ECONOMICS Post-Soviet Communist Recovery 18 YE AR S DO ING OU RB ECONOMICS EST , SO YO U CRAM KIT EDITOR Robb Dooling ® the World Scholar’s Cup® ALPACA-IN-CHIEF Daniel Berdichevsky CA N DO YO U RS ECONOMICS CRAM KIT ® HOW TO THINK LIKE AN ECONOMIST ............................................................................................................... 2 CATEGORIZATION .................................................................................................................................................. 3 THE ORIGIN OF MARKETS (TRADE)..................................................................................................................... 4 INTRODUCTION TO MARKETS ............................................................................................................................. 5 DEMAND ................................................................................................................................................................... 6 SUPPLY ....................................................................................................................................................................... 7 ELASTICITY ............................................................................................................................................................... 8 EQUILIBRIUM ............................................................................................................................................................ 9 GOVERNMENT POLICIES ...................................................................................................................................... 10 TARIFFS AND EXPORTS ......................................................................................................................................... 11 BEHAVIOR OF FIRMS .............................................................................................................................................. 12 FAILURES OF PERFECT COMPETITION ............................................................................................................... 13 INSTITUTIONS ......................................................................................................................................................... 15 BASICS OF MACROECONOMICS ........................................................................................................................ 16 UNEMPLOYMENT ................................................................................................................................................... 17 GROSS DOMESTIC PRODUCT.............................................................................................................................. 18 MEASURING GDP ................................................................................................................................................... 19 MEASURING INFLATION ...................................................................................................................................... 20 MONEY ..................................................................................................................................................................... 21 THE FINANCIAL SYSTEM ...................................................................................................................................... 22 MONETARY POLICY .............................................................................................................................................. 23 MORE ON SAVING AND INVESTMENT ............................................................................................................. 24 MONEY MARKET IN THE LONG RUN ................................................................................................................. 25 MODELING THE ECONOMY ................................................................................................................................ 26 LIVING STANDARDS ............................................................................................................................................. 27 THE OUTPUT GAP AND THE SHORT RUN ........................................................................................................ 28 AGGREGATE DEMAND ......................................................................................................................................... 29 AGGREGATE SUPPLY............................................................................................................................................. 30 EQUILIBRIUM ........................................................................................................................................................... 31 FISCAL POLICY ....................................................................................................................................................... 32 COMMUNIST ECONOMIC SYSTEMS ................................................................................................................. 33 BUREAUCRATIC PLANNING ................................................................................................................................. 34 MIKHAIL GORBACHEV.......................................................................................................................................... 36 BORIS YELTSIN ....................................................................................................................................................... 37 BORIS YELTSIN ....................................................................................................................................................... 38 VLADIMIR PUTIN ................................................................................................................................................... 39 DMITRI MEDVEDEV .............................................................................................................................................. 40 ECONOMICS IN THREE PAGES ............................................................................................................................ 41 LIST OF LISTS ......................................................................................................................................................... 44 ECONOMICS CRAM KIT | 2 FUNDAMENTAL ECONOMIC CONCEPTS How to Think like an Economist THE RATIONAL HOMO ECONOMICUS ADMISSION TO THE CLUB SO YOU WANT TO BE AN ECONOMIST? Repeat after me… 1. There are no free lunches. 2. People have unlimited wants. 3. The cost of doing something includes its full economic cost. 4. Humans behave rationally. 5. Humans benefit from voluntary exchange----otherwise they wouldn’t trade. WHY IS THERE SCARCITY? Because wants are unlimited and resources are limited. To cope, we must make choices and face trade-offs MARGINAL ANALYSIS Marginal analysis involves comparing the costs and benefits of doing just a little more of something. The marginal benefit of reading one more page of this Cram Kit is one more question answered correctly at competition. THE COST OF MAKING A CHOICE We have to pay for our choices. What's more, we give up a choice we don’t make for every choice we do make. TYPES OF COSTS Type Definition Example Opportunity cost (implicit cost) Value of the next-best choice Value of sleep you lose when you choose to cram Accounting cost (explicit cost) What you tangibly pay to get something Cost in dollars of this Cram Kit Economic cost Opportunity cost + accounting cost Sum of the above ¨ ¨ ¨ ¨ RATIONALITY CHECKLIST Perform cost-benefit analysis Maximize utility, or happiness Think on the margin Account for all economic costs MAXIMIZING UTILITY An economic agent maximizes utility when marginal utility equals marginal cost DIMINISHING RETURNS Economists assume that marginal benefit decreases as quantity increases. Eating your 42nd slice will not make you as happy as the first one did. Marginal utility Marginal benefit Number of slices THE INVISIBLE HAND STRIKES BACK In 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations, establishing the field of economics and the idea of the “invisible hand” (the market regulates itself). QUICK QUIZ QUESTIONS 1. The full cost of a decision is its __________. 2. If Jolly Jeremy Joe is in a hot dog competition, the fact that his 100th hot dog gives him far less utility than his first is known as _____________. 3. There are no free lunches in our world because of __________ and _____________. ANSWERS 1. economic cost 2. diminishing returns 3. limited resources, unlimited wants ECONOMICS CRAM KIT | 3 FUNDAMENTAL ECONOMIC CONCEPTS Categorization MODELING MICROECONOMICS VS. MACROECONOMICS ECONOMIC ANALYSIS THE PYRAMID OF ECONOMICS ` Careful observation Economies Description Economic Analysis Measurement of economic theory Markets Individuals Theory § Theoretical models capture the basics of economic interactions while stripping away extra details. § Most models look too simplistic. But it is this simplicity that allows us to identify what assumptions and characteristics are important. § The true strength of a model is how well it captures and predicts whatever we want to understand. MODELING PARETO EFFICIENCY Something is Pareto efficient when no one can have more without someone else ending up with less. If you and your two friends split $100 so that each of you has $33 and $1 is left on the table, the situation is not pareto efficient. You could take one more dollar without hurting your friends. But if you and your two friends split $100 so that you have $100 and each of them has $0, the situation is pareto efficient. They can’t get any money without taking away some of yours. THREE FUNDAMENTAL QUESTIONS Every market must answer three basic questions: MICROECONOMICS Microeconomics models individual behavior to analyze markets as a whole. Conclusions about markets are then extended to the economy as a whole. Microeconomics works up the pyramid. MACROECONOMICS Macroeconomics is concerned with the entire economy. It studies big changes and analyzes how societies-----and the individuals within them-----can and do grow better or worse off. Macroeconomics works down the pyramid. POSITIVE VS. NORMATIVE ECONOMICS POSITIVE NORMATIVE ‘‘What is?’’ ‘‘What should be?’’ Falsifiable statements --- now or with future data Subjective statements Conclusions of a model Judgments POSITIVE OR NORMATIVE? § ‘‘Academic Decathlon puts the Decathlete through 10 different events’’ (positive) 1 2 3 •How much should be produced? •Who should produce? •Who should receive what is produced? § ‘‘Temperatures next year will cause a 10% decline in crop yields.’’ (positive) § ‘‘Economics is tough, but understanding it is useful for understanding policy’’ (normative) § ‘‘Alpacas are better than llamas’’ (normative) ECONOMICS CRAM KIT | 4 FUNDAMENTAL ECONOMIC CONCEPTS The Origin of Markets (Trade) WHY TRADE? PRODUCTION POSSIBILITIES FRONTIER (PPF) ABSOLUTE VS. COMPARATIVE ADVANTAGE Absolute advantage Comparative advantage An agent has an absolute advantage for producing a good when he can produce that good more efficiently than other agents. An agent has a comparative advantage for producing a good when he can produce that good at a lower opportunity cost than other agents. An agent can be terrible at producing every good and service and have no absolute advantages versus a second agent, but he must have a comparative advantage in at least one good AN EXAMPLE FROM OUTER SPACE 1. Say Laika is very good at producing both dog treats and spacesuits. She can produce 80 dog treats or 20 spacesuits in one month. § A country’s PPF represents all the combinations of output (in this case, combinations of milk and missiles) that are feasible § Any combination of milk and missiles inside or on the curve is possible, but only points on the curve are efficient 2. Neil is not very good at producing either good. He can produce 30 dog treats or 10 spacesuits in one month. § Points outside the curve are impossible to produce 3. Laika has absolute advantages for both goods, while Neil has none. § Producing more of one good requires a tradeoff in 4. Laika gives up four dog treats for each spacesuit produced, while Neil only gives up three. § The curve bows out because of diminishing returns a. Laika gives up 1/4 of a spacesuit per dog treat, less than Neil’s 1/3 of an spacesuit b. Neil gives up 3 dog treats per spacesuit, less than Laika’s 4 dog treats but may be obtained through the benefits of trade the form of less production of the other good to scale: producing more milk increases the opportunity cost in terms of missiles § Different slopes (different opportunity costs) imply comparative advantages § A curve that is farther out indicates higher production and an absolute advantage 5. This means Laika has a comparative advantage in producing dog treats, while Neil has a comparative advantage in producing spacesuits. 6. Therefore, Laika should specialize in producing dog treats, and Neil in producing spacesuits. 7. Trade benefits both because they are able to specialize in their comparative advantages. TRADE QUESTIONS FOR ANSWERS QUESTIONS 1. If an agent can produce more of a good than another agent with the same inputs, he has a(n) _____. 2. Comparative advantages arise from lower ___ of production. ANSWERS 1. absolute advantage 2. opportunity costs ECONOMICS CRAM KIT | 5 MICROECONOMICS Introduction to Markets PERFECT COMPETITON MARKET MODEL MARKETS ASSUMING MAKES… The perfectly competitive market model relies on several key assumptions. These assumptions mark the boundary between perfect competition and other market types: WE ALL COME TOGETHER § Markets occur when producers and consumers exchange a certain good or service voluntarily § Markets do not have to be explicitly created by a central body (like a government) All agents accept prices as given •No individual has market power •No producer can set prices other than the market price § Markets are not always highly organized § As long as the transactions are voluntary, everyone involved will be better off THE PRICE IS RIGHT One homogenous product •All producers produce an identical product or service Diminishing returns •Consuming more of a product eventually offers less utility to consumers •Inputs eventually grow less useful as production rises •Entry costs are the costs of starting a certain business •Exit costs are costs of shutting down a business Transaction costs are zero •The process of exchange does not add more costs •The market price is the same for all consumers Rational behavior producers and consumers § In perfect competition, the price represents the opportunity cost of a good’s production Entry and exit costs are zero Perfect information § A market price conveys the value of a good to •Consumers are aware of all producers and vice versa •Everyone has access to the market price •Firms maximize profits •Consumers maximize utility § Price also signals the value of the good to all producers and consumers § All buyers and sellers are price takers, not makers AGGREGATION Prices are good indicators of a product’s value in a competitive market. Adding up prices allows us to compare different goods. This process is called aggregation and allows firms and consumers to make good market decisions. MARKET MENTALITY QUESTIONS 1. What does “no agent has market power” mean in context of a perfectly competitive market? 2. In a competitive market, market price reflects the ______________. 3. Aggregation is the process of ____________. ANSWERS 1. No individual agent can affect the market price. All economic agents must accept the market price as it is determined by the market as a whole. 2. value consumers and producers place on the good 3. comparing different goods using a common measuring stick, such as market price ECONOMICS CRAM KIT | 6 MICROECONOMICS Demand THEORY OF THE CONSUMER SHIFTING ALL OVER THE PLACE THE LAW OF DEMAND The quantity demanded of a good by consumers increases when market price decreases and decreases when price increases-----price and quantity demanded are negatively correlated. CONSUMER INCOME Normal goods (computers, yachts, calculators): Increased income à higher demand Inferior goods (dollar store goods, used textbooks): Increased income à lower demand PRICES OF RELATED GOODS TERM DEFINITION Quantity demanded The amount of a good consumers will demand at a given price; a specific value, NOT the general relationship given by demand Demand The overall relationship given by the law of demand, relates price to quantity demanded Demand schedule A table that represents the law of demand, maps values of prices to quantities demanded Demand curve Curve that represents the law of demand, maps an interval of prices to quantities demanded [[ THE DEMAND CURVE Price Substitutes (goods that can fill each other’s role in consumption-----7-Up and Sprite): Increased price of one à higher demand for substitute Complements (goods that combine for consumption----- peanut butter and jelly): Increased price of one à lower demand for complement NUMBER OF CONSUMERS Increased number of consumers à higher demand CONSUMER PREFERENCES AND EXPECTATIONS Good becomes more desirable à higher demand Expectation of pay cut à lower demand Shifts in a curve are NOT the same as changes in quantity or price ‘‘Demand increased’’ is a shift of the demand curve; quantity demanded has changed at every price A change in quantity demanded or price is a movement along the curve I DEMAND A QUIZ $25 $20 $15 $10 $5 5 QUESTIONS 1. The law of demand states that when price increases, quantity demanded ______. 2. A change in quantity demanded for every price implies a _______. 3. An increase in the price of a good will lead to a(n) ______ in the demand for its complement. 10 15 20 Quantity Demanded THE DEMAND SCHEDULE Price $5 $10 $15 $20 $25 Quantity 20 15 10 5 0 ANSWERS 1. decreases 2. shift of the demand curve 3. decrease ECONOMICS CRAM KIT | 7 MICROECONOMICS Supply THEORY OF THE FIRM SHIFTY SUPPLY THE LAW OF SUPPLY The quantity of a good supplied by producers increases when market price increases and decreases when price decreases-----price and quantity supplied are positively correlated. TERM DEFINITION Quantity supplied The amount of a good firms will supply at a given price; a specific value, NOT the general relationship given by supply Supply The overall relationship given by the law of supply, relates price to quantity supplied Supply schedule A table that represents supply, maps values of prices to quantities supplied Supply curve Curve that represents supply, maps an interval of prices to quantities supplied COST OF FACTORS OF PRODUCTION Increased factor costs à higher production costs Higher production costs à lower supply ADVANCES IN TECHNOLOGY Technological advances à lower production costs Lower production costs à higher supply EXPECTATIONS OF PRICE CHANGES Expectation of lower future price à higher price now Higher price now à higher supply NUMBER OF PRODUCERS Increased number of firms à higher supply SHIFTS VS. MOVEMENTS THE SUPPLY CURVE Price $25 $20 $15 $10 $5 5 10 15 20 Quantity Supplied A HEALTHY SUPPLY OF QUIZZES THE SUPPLY SCHEDULE Price $5 $10 $15 $20 $25 Quantity 0 5 10 15 20 QUESTIONS 1. When price increases, quantity supplied ____. 2. If firms expect prices to rise, supply will ___ now. ANSWERS 1. increases 2. decrease ECONOMICS CRAM KIT | 8 MICROECONOMICS Elasticity ELASTICITY BASICS CALCULATING ELASTICITY PRICE ELASTICITY OF DEMAND How much is quantity demanded affected by changes in the good’s price? THE FORMULA PRICE ELASTICITY OF SUPPLY How much is quantity supplied affected by changes in a good’s price? E= % change in A (A F - A I ) ÷ A I ≈ % change in B (B F - B I ) ÷ B I § E is the elasticity of A with respect to B § AF is the final value of A, AI is the initial value § BF is the final value of B, BI is the initial value ELASTICITY AND GOODS DEMAND Elastic § E = 0: Perfectly inelastic, vertical line; change in Inelastic Goods with close substitutes | Example: baseball caps Luxury goods that we can do without | Example: Necessities that people must buy regardless of price | Example: insulin § E = 1: Unit elastic; convex curve; change in variable B causes an equal change in variable A § E > 1: Elastic; shallow line, change in variable B § E = ∞: Perfectly elastic; horizontal line; changing variable B infinitely affects variable A Elastic Inelastic In the long run, firms can reallocate resources In the short run, firms cannot reallocate resources Extremely scarce goods FACTORS THAT AFFECT PRICE ELASTICITY § Degree of substitution (goods with close substitutes have high elasticity of demand) Degree of necessity (necessities are more inelastic) AN EXAMPLE E= % change in q (qF - qI ) ÷ qI ≈ % change in p (pF - pI ) ÷ pI § E is the price elasticity of demand (elasticity of demand with respect to price) § m is a good’s price; pF and pI are final and initial price, respectively § q is the quantity demanded; qF and qI are final and initial quantities, respectively § Time frame (in the short run, goods REVENUE | THE ELASTICITY SHORTCUT § Scope of the market (a larger market Revenue = price of good x quantity tend to be more inelastic) is more inelastic since fewer substitutes are available) § Scarcity of inputs (scarcity of inputs means more inelastic supply) Supply § 0 < E < 1: Inelastic; steep line; change in variable B causes a larger change in variable A SUPPLY Demand variable B does not affect variable A at all causes a smaller change in variable A Porsches § DEFINITIONS § Time frame (in the short run, supply is inelastic) § Presence of barriers to entry (lower barriers to entry means more elastic supply) Price elastic good Price inelastic good Unit elastic good •Increase in price → decrease in revenue •Increase in price → increase in revenue •Increase in price → no change in revenue ECONOMICS CRAM KIT | 9 MICROECONOMICS Equilibrium MEET ME AT THE INTERSECTION MARKET SURPLUS THE INVISIBLE HAND The laws of supply and demand meet at the market equilibrium point, where their forces are equal and opposite. A Price B Quantity § Triangle A is consumer surplus, or the difference between how much consumers are willing to pay and the market price § Triangle B is producer surplus, or the difference between the price at which firms are willing to sell their product and the market price § Market equilibrium maximizes market surplus, or the sum of producer and consumer surplus; the goal of social planners is to maximize this surplus SHIFTING SUPPLY AND DEMAND Shift Result Supply Demand Price Quantity Producer surplus Consumer surplus Total surplus ↑ N/A ↓ ↑ ambiguous ↑ ↑ ↓ N/A ↑ ↓ ambiguous ↓ ↓ N/A ↑ ↑ ↑ ↑ ambiguous ↑ N/A ↓ ↓ ↓ ↓ ambiguous ↓ ↑ ↑ ambiguous ↑ ↑ ↑ ↑ ↓ ↓ ambiguous ↓ ↓ ↓ ↓ ↑ ↓ ↓ ambiguous ambiguous ambiguous ambiguous ↓ ↑ ↑ ambiguous ambiguous ambiguous ambiguous An ↑ means an increase, not a shift upward. Likewise, ↓ means a decrease, not a shift downward. ECONOMICS CRAM KIT | 10 MICROECONOMICS Government Policies PRICE CONTROLS TAXATION PRICE CEILINGS Price ceilings set a maximum legal price on a good. If this price is below the equilibrium price, the ceiling is binding and the market price is changed. ONLY ON THE MARGIN Marginal taxes (taxes per unit) make consumers pay a different price than what producers receive. The government steps in between consumers and producers. Since marginal taxes distort how prices signal value, they lead to inefficiency. A Price Price C A Consumer price Price Ceiling B Tax D C Quantity § Trapezoid A is the new consumer surplus § Triangle B is the new producer surplus § Triangle C is the deadweight loss caused by the policy because the market is not in equilibrium § The width of the shaded rectangle is the difference between quantity demanded and quantity supplied, or the shortage in the market § Note that A + B + C = equilibrium market surplus PRICE FLOOR A Price B Quantity § Triangle A is the new consumer surplus § Triangle B is the new producer surplus § Triangle C is the deadweight loss caused by taxation because quantity is contracted (mutually beneficial transactions are not taking place) § Rectangle D is tax revenue, which is equal to market Price Floor B Producer price quantity times revenue Note that marginal taxation is equivalent to holding quantity at a fixed value (like a quantity ceiling) C ELASTICITY AND TAXATION § Flatter curves increase the size of the deadweight Quantity § § § § Triangle A is the new consumer surplus Trapezoid B is the new producer surplus Triangle C is the policy’s deadweight loss The width of the shaded rectangle is the difference between quantity supplied and quantity demanded----in other words, the surplus in the market THE LESSON TO BE LEARNED Applying a price ceiling below equilibrium or a price floor above equilibrium is inefficient and leads to deadweight losses. loss triangle and make the revenue rectangle smaller § Therefore, markets with elastic demand and supply curves suffer the most from taxation and provide the least revenue § The incidence of taxation determines whether consumers or producers bear the majority of the tax § If supply is more inelastic than demand, demand can adjust more easily and firms bear more of the tax § Similarly, if demand is more inelastic, consumers will bear the brunt of the taxation ECONOMICS CRAM KIT | 11 MICROECONOMICS Tariffs and Exports TRADE IN A SMALL ECONOMY TRADE TAXATION OVERPOWERED BY THE WORLD We assume the domestic economy is small relative to the world economy and cannot influence the world price. Therefore, the world price is fixed for the domestic market, making international trade equivalent to a price control. The difference is that the world market either buys the surplus or supplies the shortage. TARIFFS, IMPORT DUTIES, AND OTHER NASTIES A tariff is a tax on imports. Price C DIAGRAM OF AN IMPORTING ECONOMY A World Price + Tariff B C C World Price Quantity Price § Triangle A represents the gains from trade with the A C B World Price D import tax in place § Triangle B is the revenue collected by the government from the tax § The two triangles marked by C are the deadweight losses associated with the tax Quantity The big triangle A is consumer surplus § § The small triangle B is producer surplus § Triangle C represents the gains from trade § Rectangle D is the value of the goods imported AN EXPORTING ECONOMY A C Price World Price B D Quantity § § § § The small triangle A is consumer surplus The big triangle B is producer surplus Triangle C represents the gains from trade Rectangle D is the value of the goods exported § If the tax were removed, the gains from trade would be A + B + C § Applying an import tariff increases producer surplus at the expense of consumer surplus and efficiency TRADE AND TARIFFS TRIVIA QUESTIONS 1. An export tax benefits domestic _______ at the expense of domestic _______. 2. An import tax benefits international _______ at the expense of international _______. 3. For a small open economy, international trade is equivalent to a binding _______ _______. 4. If voluntary trade is always beneficial, why do some oppose it? ANSWERS 1. consumers; producers 2. consumers; producers 3. price control 4. While the economy as a whole benefits, not everyone does. ECONOMICS CRAM KIT | 12 MICROECONOMICS Behavior of Firms FIRM DECISION-MAKING COST CURVES TYPES OF COSTS Marginal cost § Fixed costs: Incurred even when quantity produced is Average total cost zero, independent of output § Variable costs: Change with quantity produced, contribute to marginal cost $ AFC § Total costs: Sum of fixed costs and variable costs Average variable cost Average fixed cost MARGINAL COST & MARGINAL REVENUE Marginal cost Cost of producing ‘‘just one more’’ of a good Marginal revenue Revenue from producing ‘‘just one more’’ of a good. For a perfectly competitive market, fixed at market price TYPES OF PROFIT 1. Accounting profit: Total revenue minus accounting costs; producers attempt to maximize this 2. Economic profit: Total revenue minus full economic costs (including opportunity costs) 3. Normal profit: Zero economic profit; means accounting profit equals opportunity cost of production; in a competitive market firms can expect normal profits in the long run THE GOLDEN RULE: MC = MR All firms are assumed to seek to maximize profits. Profit maximization in any market occurs where marginal revenue equals marginal cost (MC=MR). All firms will produce up to this point of profitmaximization. In graphical terms, find where the marginal cost and marginal revenue curves intersect. Then, look at the quantity where that occurs. In a perfectly competitive market, the marginal revenue curve is the same as the demand curve, which is perfectly elastic at the market price. In a perfectly competitive market, therefore, profitmaximization occurs where the demand curve intersects the MC curve. Quantity Produced AVERAGE COST CURVES Average Fixed Cost Average variable cost (AVC) Average total cost (ATC) § Fixed costs divided by quantity produced § Decreases as quantity increases § Variable costs divided by quantity produced § Decreases and then increase § Sum of average fixed cost and average variable cost § ATC = Total fixed costs + Total variable costs Total number of units produced DIMINISHING RETURNS TO SCALE Marginal costs first decrease and then increase. This phenomenon is the result of diminishing returns to scale. Firms will spread fixed costs over multiple units of output. Variable costs, however, will drag average cost upward after a certain point. Consider a restaurant kitchen. After a certain point, adding too many cooks will cause inefficiency-----they will get in one another’s way, and one may faceplant into the soup. MULTIPLE INPUTS § Inputs: labor and capital § Prices: wage rate and price of capital § Increasing the price of an input makes a firm substitute away from it ECONOMICS CRAM KIT | 13 MICROECONOMICS Failures of Perfect Competition IMPERFECT MARKETS: MONOPOLY I HAVE THE POWER FAILURES OF PERFECT COMPETITION Removing any assumptions of perfect competition creates a new market type. All of these market types are inefficient and create deadweight loss. All firms face downward sloping demand curves. MARKET POWER Market power is the ability of an individual to influence market price. Perfect competitors have no market power and must accept the market price. MONOPOLY BASICS § Only one firm supplies (example: De Beers diamonds) § This firm has full market power to set prices § Arise from barriers to entry or economies of scale (after a certain point, producing more of a good will increase costs due to increasing inefficiency) § Faces a downward sloping demand curve (for the entire market) Deliberate scarcity •Monopolies can produce less than what is demanded to increase profits •This leaves some consumer demand unmet, decreasing general welfare •Some consumer surplus becomes producer surplus, but part of it vanishes as deadweight loss CAUSES OF MARKET POWER High entry costs Policies that restrict entry Control of natural resources Economies of scale Rent seeking (see later) PRICE DISCRIMINATION Price discrimination involves selling the same product to different consumers at different prices-----such as airline seats or movie tickets. This practice increases producer surplus at the expense of consumer surplus. Monopolies price discriminate to capture new consumers without losing current ones. BARRIERS TO ENTRY Monopolies arise due to barriers that keep competitors from entering the market. Barriers include: Inefficiency •Monopolists are sometimes lazy, incompetent, or just lack incentive to raise standards due to no competition •This inefficiency can result in wasted resources, higher production costs, and higher prices § Ownership of a key resource § Government-created barriers (patents, copyrights, and other property protections) § Natural monopolies: emerge when it is practical for only one seller to operate in a given market Positive economic profit •A monopoly will set price and quantity supplied where marginal revenue equals marginal cost •Unlike a perfectly competitive firm, increasing supply to reach that point increases economic profits DEALING WITH MONOPOLIES The United States government has devised several methods of dealing with monopolies. Regulation Legislation (Sherman Anti-Trust Act) Public Ownership YOU SHALL NOT MATCH 1. Market power 2. Economies of scale 3. Sherman AntiTrust Act 4. Barriers to entry 5. Only one supplier A. After a certain point, producing more goods increases costs B. Monopoly C. Ability to influence market price D. Legislation that deals with monopolies E. Prevent more firms from entering Answers: 1. C; 2. A; 3. D; 4. E; 5. B ECONOMICS CRAM KIT | 14 MICROECONOMICS Failures of Perfect Competition § § § § § § IMPERFECT MARKETS CONTINUED MARKET FAILURES OLIGOPOLY Market failures occur when competitive markets fail to produce socially desirable outcomes. Only a few firms (suppliers) exist Each firm has some degree of market power Goods are either homogenous or differentiated Firms primarily face non-price competition Producers often collude and form cartels Examples: Market for mobile phone service, OPEC Collusion occurs when firms in an oligopoly cooperate to raise market prices artificially. A group of firms that colludes to control prices is a cartel, which is illegal under U.S. antitrust law. The incentive to cheat in a cartel is strong, so cartels tend to break down even without government intervention. THE BOTTOM LINE An oligopoly will be more efficient and benefit more people than a monopoly, but will be less efficient and benefit fewer people than a perfectly competitive market. MONOPOLISTIC COMPETITION § Goods no longer homogenous § Large number of firms, just like perfect competition § Firms compete by differentiating their products, often artificially § Producers often engage in non-price competition (for example, through advertising) § Firms face a downward sloping demand curve § Examples: Blue jeans, restaurants, toothbrushes The diversification of products in a monopolistically competitive market gives consumers more choices than in a perfectly competitive market, where all products are homogenous. However, since market price is greater than marginal cost, the markets will experience some social inefficiency. THE BOTTOM LINE You can spot a monopolistically competitive market whenever multiple companies are using ads to convince you that their products are different when they are actually pretty similar. The two main forms of market failures are linked to externalities and public goods. Externalities are costs or benefits associated with a decision not factored into the decision-making process. They do not affect the decision maker directly. Negative externalities Positive externalities Harm others They are the costs of an action that are not passed along to the agent taking that action Since the agent does not face the cost, he will perform more of the action than is optimal Benefit others They are the benefits of an action not felt by the agent taking that action Since the agent does not enjoy the benefit, he will perform less of the action than is optimal INTERNALIZE IT! One way to address externalities is to internalize them, by incorporating the cost of the externality into the market. For instance, if companies are taxed for each pound of pollution they emit-----and the tax is set to equal the cost of that pollution to society-----companies will make choices based on true social cost. THE COASE THEOREM As long as the parties involved in a dispute can negotiate and property rights are clearly defined, the private market can settle any disputes. PLEASE DON’T FAIL THIS TRUTH TEST TRUE/FALSE 1. Oligopolies are more efficient than monopolies 2. Externalities are the only area of market failure ANSWERS 1. True 2. False; public goods are also associated with market failure ECONOMICS CRAM KIT | 15 MICROECONOMICS Institutions PROPERTY RIGHTS ENTREPRENEURS & CREATIVE DESTRUCTION INSTITUTIONS AND ORGANIZATIONS INNOVATION Entrepreneurs can earn economic profits by taking risks to be the first to sell a product or to provide a new or better service. While innovation can create new barriers to entry in the form of patents and copyrights, it also destroys existing market imperfections and therefore betters society. Institutions Organizations Formal or informal rules that structure human interaction Examples: Codes of conduct, social norms, most markets, laws More formal than institutions Examples: Stock exchanges, organized religions, corporations MINE, NOT YOURS Property rights dictate who can and can’t use a good. The rivalry of a good is how much one person’s use of a good prevents another person from using it. The excludability of a good is the ease of preventing someone from using it. TYPES OF GOODS EXCLUDABLE RIVAL Private Goods NON-EXCLUDABLE Collective goods (food, clothes, cars) (sidewalks, fishing ponds) Common goods Public Goods NONRIVAL (electricity, cable television) (national defense, air) CREATIVE DESTRUCTION Economist Joseph Schumpeter described the impact of entrepreneurs as creative destruction----- replacing the old and inefficient with the new and improved. THE GOVERNMENT POWERS OF THE GOVERNMENT § Ability to tax citizens § Legitimate use of force The use of force gives power to the court system, which ensures contracts are upheld. Without the rule of law, market economies cannot function. DEMOCRATIC INEFFICIENCIES § Pork barrel politics: The tendency of elected officials to steer money to their home communities to increase their chances of being reelected § Logrolling: Vote trading among elected officials, usually to get support for pet projects § Rent seeking: Socially unproductive activities that INTELLECTUAL PROPERTY § Copyright: protection given to the creators of literature, redirect, rather than create, economic benefits (lobbying, for example) art, or music § Patent: rights awarded to inventors so that no one else can copy their inventions for a period of time FINANCIAL INTERMEDIARIES These institutions link savers and borrowers. Banks, stock exchanges, and bond markets are financial intermediaries. Savings deposited Banks Loans borrowed AN EFFICIENT LITTLE QUIZ 1. Non-excludable and rival 2. Excludable and rival 3. Non-excludable and nonrival 4. Excludable and non-rival A. B. C. D. Private Public Common Collective Answers: 1. D; 2. A; 3. B; 4. C ECONOMICS CRAM KIT | 16 MACROECONOMICS Basics of Macroeconomics MACROECONOMICS ISSUES Macroeconomics is concerned with two main issues: § § Factors that affect things in the long run (the size of economies, standard of living, and price level) The causes and consequences of short-run economic fluctuations (especially unemployment and inflation) REAL GDP Real Gross Domestic Product (GDP) measures the total quantity of goods and services produced in an economy in a given year, adjusted for the effects of inflation. THE STATE OF THE ECONOMY THE BUSINESS CYCLE Real output fluctuates cyclically, alternating between periods of growth and decline. Note that even though the economy fluctuates, the general trend is upwards. Peak Expansion Real output Downturn REAL GDP PER CAPITA ‘‘Per capita’’ is a Latin phrase meaning ‘‘per head.’’ GDP per capita is the GDP per person in the economy; it indicates what the average person is able to consume in an economy. If the population were suddenly to double, GDP per capita would be cut in half. (Technically, the same would be true if every person in the economy were to grow a second head.) AVERAGE LABOR PRODUCTIVITY Average labor productivity measures how much the typical worker can produce. Divide the economy’s total output (GDP) by the total number of workers employed. Economy' s output (GDP) Average labor productivity = Total number of workers Greater levels of production and average labor productivity enable consumption that improves the standard of living. HUMAN HAPPINESS Human happiness depends on more than just material levels of consumption. Other important factors: § § § § A long, healthy life Access to education Clean environment Possession of alpacas Trough Time TERM DEFINITION Expansion Increase in real GDP; occurs until a peak Downturn Decrease in real GDP; occurs until a trough Recession Downturn that lasts at least two quarters (six months) Depression No official definition; a very steep and prolonged recession A QUIZ FOR A DEPRESSION QUESTIONS 1. A period of increase in real GDP is a(n) _______. 2. What were the years of the Great Depression? 3. When was World War II? 4. How do most nations moderate the business cycle? ANSWERS 1. expansion 2. 1929 to 1933 3. 1941 to 1945 4. through countercyclical monetary and fiscal policy ECONOMICS CRAM KIT | 17 MACROECONOMICS Unemployment EMPLOYMENT TYPES OF UNEMPLOYMENT THE LABOR FORCE The labor force includes all members of the population who have a job (employed) or are actively seeking employment (unemployed). Structural •Mismatch between skills demanded and skills supplied •Spurred by changes in technology or consumer preferences •Would be zero if retraining was instant was instant and free •Factors into the natural rate of unemployment To be in the labor force, you cannot be: § Younger than 16 or retired § In jail, in the military, or a homemaker § A discouraged worker: you must have worked in the past week or looked for work in the past four weeks Cyclical TERM DEFINITION Employment rate Percentage of the labor force that has a job; number of persons employed divided by the labor force; never 100% Unemployment rate Percentage of the labor force that lacks a job but is searching for one. The Bureau of Labor Statistics measures unemployment. Participation rate Percentage of the population in the labor force-----about 66% Employed Worked for pay in the past week, or on vacation or sick leave Unemployed Did not work during the past week but did look for paid work sometime in the past four weeks Discouraged worker / out of the labor force Did not work in the past week or look for work in the past four weeks THE NATURAL RATE OF UNEMPLOYMENT § Key fact: Full employment is NOT 0% unemployment. § There is always unemployment-----some people are always between jobs, or just joining the labor force § The unemployment rate of an economy at full output is the natural rate of unemployment § Okun’s law relates unemployment to GDP; every 1% increase in unemployment above the natural rate results in a 2% drop in real GDP § No one knows exactly what the natural rate is in 21st century America-----it might be higher than it used to be •Unemployment resulting from movement along the business cycle •Increases with recessions and decreases with expansions •Does not factor into the natural rate of unemployment Frictional •Caused by time-lag between jobs •Inevitable •Factors into the natural rate of unemployment d QUIZ FOR EMPLOYMENT QUESTIONS 1. Unemployed workers must be _______, but not have a _______. 2. Unemployment due to a mismatch between skills demanded and skills supplied is _______. 3. No one knows the ____ rate of unemployment. 4. The percentage of the population that is in the labor force is known as the _______. ANSWERS 1. looking for work; job 2. structural unemployment 3. natural 4. labor participation rate ECONOMICS CRAM KIT | 18 MACROECONOMICS Gross Domestic Product THE ‘‘BIG’’ PART OF MACRO GROSS DOMESTIC PRODUCT (GDP) GDP is the market value of all final goods and services produced within a country in a given period of time. “the market value” •The total value of different goods (add up dollar values) “of all final goods and services” •Only final goods are counted •Capital goods (made to make other goods) are counted the year they are produced “produced within a country" •All goods produced within a country’s borders, even if a foreigner owns the factory “in a given period of time” •Typically a specific quarter or year WHAT’S NOT INCLUDED IN GDP HISTORY OF GDP Development of GDP In the mid-17th century, Sir William Petty was assigned by the British government to assess the Irish people’s ability to pay taxes. In 1932, the U.S. Department of Commerce commissioned Simon Kuznets to develop a system to measure national output. Kuznets presented his findings in 1934 to the U.S. Senate. When the U.S. entered World War II (which effectively ended the Great Depression) it continued to refine techniques for measuring output. For his efforts, Kuznets received the Nobel Prize in Economic Science in 1971. § Intermediate goods: goods used for the production of other goods, value is reflected in its final good Example: bolts § Goods not sold on the open market: illegal ‘‘black market’’ goods, as well as goods produced for personal consumption Example: home-knit sweaters § Used goods: the value of the good was already counted in GDP when the good was sold new Example: a used car § Transfer payments: moving money between the government and people Example: a Social Security check LIMITATIONS OF GDP HEY, YOU MISSED ME! GDP misses out on a lot of economic activity. § It can be difficult to determine what is a ‘‘final’’ good § GDP excludes goods and services not bought or sold in ‘official’ markets (such as work done by stay-athome spouses) § GDP usually ignores the fact that certain activities deplete natural resources , pollute, or have other costly externalities ECONOMICS CRAM KIT | 19 MACROECONOMICS Measuring GDP MEASURING GDP, PART A MEASURING GDP, PART B THREE WAYS TO MEASURE IT INCOME APPROACH GDP = production = expenditures = income Calculating GDP Production Approach: Measure total value of economic output Expenditures Approach: Count everything spent on consumption REAL VS. NOMINAL REAL Income Approach: Follow the money CONSUMPTION/EXPENDITURES APPROACH GDP = production = expenditures = Y = C + I + G + NX Consumption (C): value of all purchases of final goods designed for consumption by consumers •Consumer durables: long-lived consumer goods •Consumer nondurables: used up more quickly than durable goods •Services: intangible goods Investment (I): what firms spend on capital, technologies, and real estate In terms of a base period’s price level Can be compared across years NOMINAL In terms of the measurement year’s price level Includes inflation § Real measurements like real GDP are used to measure economic growth § Economists need a way to separate the effects of changes in price from changes in quantity produced (and production equals GDP) § Prices do not change consistently-----the price of one good may increase while the price of another decreases by a different magnitude SURPLUS AND DEFICIT NX = net exports = exports --- imports •Business fixed investment: purchase of capital equipment •Residential fixed investment: purchase of new homes and apartment buildings •Inventories: unsold goods placed in storage for later sale Trade surplus: Exports exceed imports; GDP increases Government spending (G): everything the government pays for labor, goods, and services In the long run, imports and exports will move in similar directions, both either decreasing or increasing. Net exports (NX): exports minus imports Trade deficit: Imports exceed exports; GDP decreases CAUTION § Don’t confuse trade surpluses and deficits with TRICKY BITS § The value of homes purchased is considered personal investment, NOT consumption § If a good does not sell in the given time period, it enters a firm’s inventory and is counted as investment § A good in inventory sold in a later year does NOT enter that year’s GDP, as it was already counted as an investment in inventory § Government transfer payments, such as Social Security, are not payments for a good or service and thus are not considered government expenditures budget surpluses and deficits § Budget surpluses and deficits refer to the difference between how much a government takes in (mostly as tax revenue) and how much it spends § Trade surpluses and deficits refer to how much an economy exports versus how much it imports ECONOMICS CRAM KIT | 20 MACROECONOMICS Measuring Inflation INFLATION AND THE CONSUMER PRICE INDEX GDP DEFLATOR The GDP deflator also measures inflation. WHAT IS INFLATION? Inflation is an increase in the aggregate price level or, equivalently, a decrease in the value of money The deflator corrects for price increases in nominal GDP. THE FORMULA THE CONSUMER PRICE INDEX (CPI) In the United States, the Bureau of Labor Statistics calculates the CPI each month by comparing the prices of a given basket of goods between the current year and a base year. This basket includes the sorts of goods that an average household would buy regularly (housing is the main component), and varies by income and region. GDP deflator= nominal GDP x 100 real GDP VOLATILITY Compared to the CPI, the GDP deflator is much less volatile. It increases less at peaks and declines less at troug The CPI in the base year is always 100. A CPI of 120 = prices are 20% higher than in the base year. DIFFERENCES A CPI of 75 = prices went down 25% since the base year. THE FORMULA: CPIYEAR T = COST OF BASKETYEAR T COST OF BASKETBASE YEAR The GDP deflator is different from the CPI in two main ways. X 100 § The GDP deflator reflects only the prices of domestically produced goods. ADVANTAGES DISADVANTAGES Used to reflect changes in cost of living (so as to adjust Social Security benefits and other ‘‘COLA’’ accounts) New goods and services are introduced all of the time. Example: Kenya added mobile phone airtime to its CPI basket in 2010. § Captures changes in price for basic consumer goods Does not account for substitution bias (consumers may switch to a good not in the basket if one gets too expensive) Makes inflation rate easy to calculate Does not account for changes in quality DEFLATING THE DEFLATOR: SHORTCOMINGS Unfortunately, the GDP deflator is difficult to calculate accurately and therefore is only published once per year. That means the deflator cannot track inflation very quickly. As a result, it is not very useful for guiding government policy, despite its accuracy. THE BOSKIN COMMISSION In 1996, economist Michael Boskin was appointed to head a commission to evaluate CPI. His group found that the CPI overstated the rate of price inflation by 1.3% a year. The CPI can include imports like oil. The GDP deflator and CPI place different weights on goods. Since the deflator weights prices by production, it adjusts to changing consumption patterns. Like the CPI, the GDP deflator fails to take into account changes in product quality. ECONOMICS CRAM KIT | 21 MACROECONOMICS Money § § § IT’S A… THE MONEY SUPPLY DEFINITION DEFINITION Money is something accepted as payment for goods and for the settlement of debts. The money supply is the stock of all liquid assets in an economy that can be exchanged for goods. FUNCTIONS OF MONEY Medium of exchange: Eliminates the need to barter for goods, which requires both parties to want what the other has (double coincidence of wants) Unit of account: Establishes the value of goods relative to one another Store of value: Allows individuals to store wealth over a period of time MONETARY AGGREGATES Monetary aggregates classify money by its liquidity: how easily it can be converted into currency. M0 is the most liquid, M1 more liquid, M2 the most liquid. For something to be money, it must satisfy these three functions. TYPES OF MONEY Commodity money Money with value outside of just being money, such as gold, or cigarettes in prison M0 • Cash and coins • Most liquid category M1 • • • • M0 Demand/checking deposits Other checkable deposits Nonbank travelers' checks M2 • M1 • Savings deposits • CDs • money market funds Fiat money Money only valuable because the government says it is and we believe it to be so WHAT IS NOT MONEY Credit cards are NOT money. They just provide a convenient way to accumulate debt. The use of credit cards reduces the economy’s need for money, since credit cards are convenient. THE QUANTITY THEORY OF MONEY MV = PQ § § § § M = the money supply V = velocity (how often a dollar is spent in a year) P = the aggregate price level Q = total output V and Q are generally held constant, meaning an increase in M (money supply) will lead to an increase in P (inflation). M2 is widely considered the most useful measure of the money supply. MONEY QUIZ (WITH A WORD BANK) medium of exchange | unit of account | store of value | liquid | commodity money | fiat money 1. Currency is the most ____ form of money. 2. Money’s role as a ____ allows people to store wealth over time. 3. ____ is money with intrinsic value. 4. Money’s role as a _____ removes the need to barter. 5. Most money today is ____. 6. Money’s role as a ____ provides a way to compare the value of goods. Answers 1. liquid; 2. store of value; 3. commodity money; 4. medium of exchange; 5. fiat money; 6. unit of account ECONOMICS CRAM KIT | 22 MACROECONOMICS The Financial System SAVING AND INVESTMENT FINANCIAL INTERMEDIARIES DEFINITIONS A financial intermediary links two other parties in a financial transaction. Banks and mutual funds are the most common. § Saving: Difference between what is earned and spent § Investment: Purchase of new capital equipment § Financial institutions: Coordinate the saving and investment decisions in the economy § Financial markets: Institutions in which people with money to save supply their funds to those who wish to borrow for investment BONDS AND STOCKS DEFINITION SELLING PROFITING RISKS OTHER BONDS STOCKS Certificate that specifies how much the borrower owes the bond holder Share of ownership in a firm Debt finance Equity finance The bond purchaser receives both the principal back and interest on the loan Shareholders hope to have their stock increase in value (and may receive dividends) Market interest rates can fluctuate Riskier than bond (bondholders are paid before shareholders) but rewards are greater The borrower may default by declaring bankruptcy The date of maturity is the date on which the loan will be repaid Often sold to the public on stock exchanges, such as the NASDAQ or New York Stock Exchange BANKS Most businesses turn to banks for the funds they need, since most small businesses do not have the resources to sell bonds or stocks. Banks draw their funds from deposits made by people who wish to save money. Banks pay their depositors a rate of interest and charge borrowers an even higher rate of interest for taking loans. MUTUAL FUNDS Mutual funds allow investors to buy into a diverse pool of stocks and bonds in a single investment vehicle. § Diversification means mutual funds are less risky and volatile than individual stocks § Mutual funds are managed by experts § Even someone with only a small amount of savings can invest in a mutual fund and effectively have a diverse portfolio INTRODUCING THE FEDERAL RESERVE Federal Reserve Helps control money supply Money supply affects economy § The Federal Reserve is often called the Fed § It serves as the central bank of the United States § It is a lender of last resort to other banks, to help maintain the stability of the banking system § Control of the money supply falls to the Federal Stock •shares of ownership •more risk •more potential profit Bonds •loans •less risk •less potential profit Open Market Committee (FOMC) § The FOMC is made up of the seven governors of the Federal Reserve and five regional bank presidents § The amount of money in the economy results from the interaction of the public, commercial banks, and the Federal Reserve system ECONOMICS CRAM KIT | 23 MACROECONOMICS Monetary Policy SHOW ME THE MONEY THE FED IN SLIGHTLY MORE DETAIL WHAT IS MONETARY POLICY? The Federal Reserve can use monetary policy to stimulate or slow down the economy. AMERICA’S CENTRAL BANK The Federal Reserve is the central banking system of the United States. Expansionary monetary policy •Increases the money supply •Increases aggregate demand in the short run (at the risk of inflation) Contractionary monetary policy •Decreases the money supply •Lower aggregate demand in the short run Monetary policy has three goals: price stability, full employment, and economic growth. Policy makers cannot achieve all three goals simultaneously WAYS TO IMPLEMENT MONETARY POLICY OPEN MARKET OPERATIONS FOMC trades securities on the open market Buying securities injects money into the economy Open market operations are performed daily Selling securities takes money out of the economy DISCOUNT RATE AND FEDERAL FUNDS RATE Discount rate § Created by the Federal Reserve Act (1913) § It contains 12 district banks. § It sets monetary policy, manages banks, and serves as lender of last resort FEDERAL RESERVE BOARD OF GOVERNORS § Located in Washington, D.C. § Directed by a presidentially-appointed chairman----as of 2012, Ben Bernanke. § Members appointed by the President, approved by Senate and serve 14 year terms FEDERAL OPEN MARKET COMMITTEE (FOMC) § Manages open market operations § Made up of § Seven rotating governors of the Fed § President of the New York district bank § Presidents of four other district banks § Day-to-day operations run by New York bank § Meets every six weeks in Washington, D.C. MONETARY POLICY: PROS AND CONS Federal funds rate THE POSITIVE Interest rate the Fed charges banks for loans Overnight rate charged on loans between banks § Monetary policy can be enacted immediately, unlike Changed infrequently and by the board of governors Not directly set by the Fed, but strongly influenced § Central banks are relatively free of political Increasing the interest rate decreases the money supply RESERVE REQUIREMENT Dictates how much of its deposits a bank must hold in reserve Set by the board of governors Increasing the reserve requirement decreases the money supply 1 Money Multiplier= RR (RR = reserve requirement) most fiscal policy, which must be legislated interference; thus, they can pursue unpopular but important policies § Central banks are staffed by professionals, not politicians THE BAD § Monetary policy does not affect the economy quickly § Central banks are hard to hold accountable § Increasing the money supply may not boost the economy as well as traditional fiscal policy would ECONOMICS CRAM KIT | 24 MACROECONOMICS More on Saving and Investment SAVING AND INVESTMENT IN AGGREGATE COORDINATING SAVING AND INVESTMENT IDENTITY An identity will always be true, just like the equality of GDP, production, income, and expenditures. FINANCIAL MARKETS CLOSED TO TRADE Assume the economy in question is closed to trade. Real Interest Rate Supply of Savings GDP = Y = C + I + G I = Y --- C --- G = national savings = S Savings Demand By subtracting net taxes (T) from each side: S = (Y --- C --- T) + (T --- G) = I Savings is equal to investment and to the sum of private savings (Y --- C --- T) and government saving (T --- G). GOVERNMENT SAVINGS If government savings are positive, the government is running a budget surplus. If government savings are negative, the government is running a budget deficit. Quantity of Money The financial market features the supply of savings and the demand for savings (or investment). § The supply and demand for savings are equalized through adjustments of the real interest rate. § The real interest rate acts as the price of a loan. It is how much borrowers pay for a loan and how much savers earn for giving up their money so that it can be loaned. This implies that when the government runs a deficit, investment decreases. INTERNATIONAL CAPITAL FLOWS In an open economy, domestic savings do not need to equal domestic investment. There are two kinds of international capital flows. § Foreign direct investment: A company or individual acquires and actively manages assets in a foreign country-----such as an airport in Belgium run by the British § Portfolio investment: An individual or company purchases stock or bonds issued by a foreign corporation but does not play a direct role in managing it Net capital output (NCO) equals the purchase of foreign capital or financial assets by domestic residents minus foreign purchase of domestic assets. In an open economy, NCO = NX Remember: Y = C + I + G + NX, so: Y --- C --- G = S = I + NX Therefore, S = I + NCO In an open economy, savings can differ from investment only as much as the difference is offset by net capital outflow. Effect of interest rate Resulting curve Supply of savings the higher the real interest rate, the more people will save the supply of savings slopes upward Demand for savings the lower the real interest, the more investing businesses will do the demand for savings slopes downward BANK RUNS A bank run occurs when depositors rush to a bank to withdraw their deposits before other depositors. Banks only hold reserves equal to a fraction of their liabilities-----so even solvent banks will be unable to pay all of their depositors right away. The FDIC (a government institution) now insures deposits at federal banks for up to $250,000, so, even if a bank collapses in a bank run, accountholders can recover up to $250,000 of their money from the FDIC. ECONOMICS CRAM KIT | 25 MACROECONOMICS Money Market in the Long Run PRICES AND THE LONG RUN The aggregate price level is the level of prices for the entire economy. It rises and falls over time. If P is the price level, then it also measures the cost of a basket of goods. BACK TO THE NEUTRALITY OF MONEY The long-run neutrality of money means that changes in the money supply have no bearing on real quantities in the economy. Recall the quantity theory of money: MV = PY. Therefore, the amount of goods and service that can be bought with $1 is 1/P. 1/P is also the value of money measured in terms of goods and services. § M is the money supply § V is the velocity of money (how often money PRICES IN THE LONG RUN: MONEY MARKET Just like in any other market, the value of money is determined by the interaction of supply and demand. § P is the average current price level § Y is real output of goods and services at a given MONEY SUPPLY MONEY DEMAND Depends on the decisions of the Federal Reserve and the banking system Depends on how much wealth people want to hold as money Inelastic in the shortrun since it is set by the Federal Reserve Relates to the volume and prices of the transactions that take place If the real level of economic activity stays the same, doubling prices should double demand for money The long run is the time period it takes for the price level to equate demand for money with the money supply. THE GRAPH Money demand slopes downward. As the price level falls, people need less money to purchase goods. In other words, the value of money increases. changes hands each year) point in time This equation is also called the equation of exchange. Of the variables, P is dependent. Since V and Y are usually fixed for the long run, changes in P depend on changes in M, the money supply. This equation says that the amount of money spent equals the amount of money used. Also note that PY = nominal GDP = MV. EFFECTS OF INFLATION While in the long-run, inflation has no effect on the economy, it has powerful short-term effects. § Inflation reduces the value of money, and ‘‘taxes’’ those that choose to hold it § Inflation distorts prices: not all firms adjust their prices at the same time (so relative prices do not always reflect costs of production) § Inflation introduces confusion about the value of goods and services in the future TRUE/FALSE FLASH QUIZ Market for Money Value of money (1/P) Money Supply 1. 2. 3. 4. In the quantity equation, Y is nominal output Money supply is inelastic in the short-run 1/price level is the value of money In the quantity equation, M and Y are usually constant 5. Inflation reduces the value of money Money Demand Quantity of Money ANSWERS 1. False (real output); 2. True; 3. True; 4. False (V and Y are constant); 5. True ECONOMICS CRAM KIT | 26 MACROECONOMICS Modeling the Economy THE CIRCULAR FLOW MODEL FLOWS GOODS AND SERVICES (CLOCKWISE) GDP AS FLOW § GDP is equal to the flow around the model at any Land, capital labor Factor Markets Factors of production Government Firms Goods and Services Markets Factor Markets Households Taxes Government Wages and rent Firms Government purchases Consumption Goods and Services Markets Revenue THE ACTORS FIRMS households nominal GDP Goods and services MONEY (COUNTER-CLOCKWISE) Income § The income approach uses the flow of income to § Totaling the flow in the money diagram yields Goods and services Goods and services § The expenditure approach is the sum of consumption and government purchases (since investment and exports are not counted in this model) Transfers Households given point Produce goods and services using the factors of production owned by households HOUSEHOLDS Rent the factors of production (land, labor, capital, entrepreneurship) to firms Consume goods produced by firms GOVERNMENT Ability to tax to earn income Can borrow from financial markets to produce goods for society § Totaling the flow in the goods and services diagram yields real GDP ENTERING THE CIRCULAR FLOW MODEL New wealth enters the cycle through households. Households provide the human labor used to work. Even inputs such as land belong to individuals, which in turn belong to households. These land-owning individuals rent their land to businesses. CIRCULAR FLOW FLASH QUIZ QUESTIONS 1. The three actors in the circular flow model are _______, _______, and _______. 2. The two markets in the circular flow model are the markets for _______ and _______. 3. All factors of production are owned by _______. 4. With regard to the circular flow, nominal GDP is equal to the _______. 5. ______ sits between households and the goods and services market. ANSWERS 1. households; firms; government 2. goods and services; factors of production 3. households 4. flow around the money diagram 5. government ECONOMICS CRAM KIT | 27 MACROECONOMICS Living Standards AVERAGE LABOR PRODUCTIVITY Five factors affect average labor productivity. GDP PER CAPITA Economy's output depends on the quantity of goods and services a firm can produce Physical capital •Tools, machinery, even computers and Internet access: the stuff that helps people make stuff •Making capital for future poduction requires giving up current consumption Human capital •Skills and experienced acquired through education, training, and on-the-job experience •By spending time learning and training, we sacrifice current earning and consumption Total quantity of goods and services depends on the quantity of factor inputs households supply and the ability of firms to turn inputs into outputs All else equal, large economies should produce more than smaller economies. Real GDP per capita is equal to real GDP per worker multiplied by the fraction of the population employed. GDP GDP N = x POP N POP § POP is the country’s total population § N is the labor force Natural resources •The wealth of many nations depends on their natural resources • Example: Saudi Arabia •On the other hand, in a global economy, natural resources are not essential for an economy to succeed •Example: Singapore Technological knowledge •Transforms inputs into the goods and services households desire •Single most important factor in raising average labor productivity •Patents help encourage and publicize innovations Most differences in GDP per capita can be explained by differences in average labor productivity, since the proportion of the population engaged in production remains remarkably consistent in the long run. SHORT-RUN FLUCTATIONS The most important correlates of fluctuations in the economy’s growth are unemployment and inflation. During recessions, unemployment increases. Businesses increase hiring slowly in the early phases of an expansion. Increased employment lags behind the next stage of economic growth. When the economy expands, inflation accelerates. Recessions are linked to slowing inflation. A SHORT RUN QUIZ Political and legal environment •Broken political and legal systems stop many countries from building effective economies •Investors and workers alike must feel confident in a country's stability, private property laws, and supply of an educated workforce QUESTIONS 1. What is the most important factor in raising average labor productivity? 2. What is real GDP per capita equal to? ANSWERS 1. Technological knowledge 2. Real GDP per worker multiplied by the fraction of population employed ECONOMICS CRAM KIT | 28 MACROECONOMICS The Output Gap and the Short Run OUTPUT GAP TWO PART STRUCTURE Think of the actual level of GDP as having two parts. POTENTIAL OUTPUT Potential output is the quantity of goods and services that the economy could produce when using all its resources at normal rates. Over time, the level of potential output can increase over time as technology improves and the country obtains more resources. SHORT RUN FLUCTATIONS AGAIN In the short run, the pace of economic growth is mostly due to the divergence between actual and potential output (that is, the presence of an output gap). In the long run, variations are due to changes in the growth rate of potential output. This, in turn, depends on the growth of the population, the rate at which capital stock increases, and changes in the pace of technological advances. Variations in rate of growth of output § Y symbolizes actual output § Y* symbolizes potential output OUTPUT GAP The output gap is the difference between actual and potential output. LONG RUN Changes in growth rate of potential output SHORT RUN The level of actual output relative to potential output Output gap = Y --- Y* When an output gap exists, the economy’s resources are not being fully utilized. When the economy is in recession, an output gap exists. Unemployment rises beyond the natural rate of unemployment. During the presence of an output gap, Okun’s Law (that for every 1% the unemployment rate differs from the natural rate of unemployment, the output gap deviates by 2%) applies. JOHN MAYNARD KEYNES British economist John Maynard Keynes (1883-1946) developed the model to explain short-run fluctuations. His theory was first published in the 1936 book, The General Theory of Employment, Interest, and Money. Keynes believed known economic models were inadequate to account for the Great Depression. His view of the business cycle—and how to manage it by adjusting taxation and government spending—would become known as Keynesian economics. Growth rate of the population Rate of increase of capital stock Changes in pace of technological advances In a world in which prices adjust immediately to balance supply and demand, the economy’s actual output would never deviate from potential output. However, firms do not constantly adjust prices to respond to changes in market demand-----they set prices and sell as much as is demanded. Only after a while will they change prices. Therefore, in the short run, firms respond to variations in demand by changing production rather than prices; short-run output in determined by the level of aggregate demand. ECONOMICS CRAM KIT | 29 MACROECONOMICS Aggregate Demand INTRODUCING THE AD/AS MODEL WHAT IS AGGREGATE DEMAND? Aggregate demand is the sum of all expenditures in an economy, or the country’s output for a period. Aggregate demand describes how expenditures change in response to changes in the aggregate price level. AD = Y = C + I + G + NX § § § § C = consumer spending I = investment G = government spending and purchases NX = net exports AGGREGATE SHIFTS RESULT FROM… CHANGES IN CONSUMPTION § Tax cuts, transfer payments from the government § Changes in consumer sentiment (such as after 9/11 and the Enron scandal) § Changes in wealth due to the stock market § Expectations about the price level in the future CHANGES IN INVESTMENT § Changes in the interest rate § Changed expectations about the future CHANGES IN GOVERNMENT SPENDING THE SHAPE Just like the microeconomic demand curve, the AD curve slopes downward. It slopes downward for different reasons, however. 1. Wealth effect: Decreases in the price level lead to increases in consumption because consumers’ real income has increased. 2. Interest effect: Decreases in the price level lead to decreases in the interest rate, which increases investment by decreasing its opportunity cost. 3. Foreign exchange effect: Decreases in the price level make domestically produced goods cheaper in the international market, increasing net exports. GRAPH IT! § Only direct government spending § Transfer payments are not included CHANGES IN NET EXPORTS § Changes in the income of foreign entities § Changes in the exchange rate CAUTION § Just as with microeconomics, shifts are NOT changes in output or the price level § Changes in the price level lead to movements along the aggregate demand curve § Changes in any of the factors above cause shifts AD QUIZ QUESTIONS 1. An increase in the price level leads to a decrease in output due to the _______, which denotes that _______. 2. Expectations of a higher future price level shift the AD curve outward because _______. Price Level Real Level of Output ANSWERS 1. wealth effect; consumers' real wealth has decreased 2. consumers wish to spend now, when prices are lower ECONOMICS CRAM KIT | 30 MACROECONOMICS Aggregate Supply LOTS OF SUPPLIES WHAT IS AGGREGATE SUPPLY? Aggregate supply is the potential supply of all the goods and services an economy can produce at different price levels. Aggregate supply behaves very differently in the short term and long term. SHORT RUN AGGREGATE SUPPLY (SRAS) Short-Run Aggregate Supply Price Level LONG RUN VS. SHORT RUN § Economists define the long run as the period when the market is in equilibrium § All prices have adjusted to their equilibrium values and all markets clear § The short run is the period in which other effects, such as price stickiness, can prevent long run equilibrium Level of Output LONG RUN AGGREGATE SUPPLY (LRAS) LRAS WHY DOES SRAS SLOPE UPWARDS? § At the microeconomic level, the supply curve slopes upwards because higher prices attracted resources from the production of other products Price Level § The aggregate supply curve slopes upward to reflect Level of Output § Long run aggregate supply is a vertical line fixed at the full employment level of output § LRAS is not affected by changes in the price level (monetary neutrality) § Output must be the full employment level in the long run YOU’RE SHIFTING ME! § Changes in the expected aggregate price level are the most common cause of shifts in the position of SRAS; at the expected level SRAS is equal to Y* § Aggregate supply shocks also shift the aggregate supply curve (example: the 1973 OPEC oil embargo) § Over time, technological progress can cause LRAS to increase; this increase accounts for the long-run growth of real GDP the relationship between price adjustments and the size of anticipated sales; firms fix prices for a while and only over time do they adjust prices SHORT-RUN CRAMMING QUESTIONS 1. Markets always clear in the _______. 2. What does the position of the SRAS depend on? 3. What is the short run defined as? 4. What accounts for the long-run growth of real GDP? ANSWERS 1. long run 2. The economy’s long-run potential output (Y*) and expectations for the price level 3. The period when the market is in equilibrium (the economy produces at full, potential output) 4. The steady increase of the LRAS over time due to technological progress ECONOMICS CRAM KIT | 31 MACROECONOMICS Equilibrium BALANCING ACT LONG-RUN EQUILIBRIUM EQUILIBRIUM OVER TIME The behavior of the economy in the short run is given by the intersection of SRAS and AD. This point of intersection is called short-run equilibrium. Long-run equilibrium is given by the intersection of LRAS and AD. Long-run equilibrium is obtained when SRAS, LRAS, and all intersect at a common point Price Level LRAS SRAS FLUCTUATIONS Short term departures of the economy from equilibrium can be modeled in terms of short-run equilibriums. § Inflationary gap: Short-run equilibrium output exceeds long-run output; the economy is ‘‘overheated’’ § AD Deflationary gap: Short-run equilibrium output is less than long-run output; the economy is inefficient and perhaps in a recession Y = Y* EFFECTS OF SHIFTS: AN EXAMPLE In the long run, both curves shift to restore long-run equilibrium. Changes in either curve end up only affecting the price level in the long run. § An increase in aggregate demand will lead to a higher price level and output in the short run SRAS Price Level Real Level of Output INCREASING LONG-RUN OUTPUT (GROWTH) § A major conclusion of the AD/AS model is that increasing long-run output MUST involve an outward shift of the LRAS curve § LRAS does NOT shift outward from changes due to monetary policy as money is neutral in the long run § Simple government spending does not cause growth as spending only temporarily increases aggregate demand AD2 AD1 LRAS Real Level of Output § In the long run, however, aggregate supply will shift inwards to restore equilibrium. This shift is caused by a realignment of perceptions and expectations SRAS Price Level SRAS1 New equilibrium AD2 LRAS AD1 Real Level of Output § Growth can only result from improvements in labor, capital, natural resources, or productivity AGGREGATE QUIZ QUESTIONS 1. An economy is experiencing an inflationary gap when _______ exceeds _______. 2. What adjusts to restore long-run equilibrium when the government stimulates aggregate demand by passing a stimulus? ANSWERS 3. short-run output; long-run output 4. short-run aggregate supply ECONOMICS CRAM KIT | 32 MACROECONOMICS Fiscal Policy SPEND, SPEND, SPEND ADVANTAGES OF FISCAL POLICY WHAT IS FISCAL POLICY? Fiscal policy is the use of government spending and taxation to intervene in the economy. Government spending directly and indirectly increases aggregate demand and, consequently, GDP. MODERATES THE BUSINESS CYCLE A government stimulus package-----hiring workers to build dams, reducing taxes on small businesses, and offering more student loans-----is an example of fiscal policy. FLAVORS OF FISCAL POLICY Contractionary Expansionary Contractionary fiscal policy aims to decrease aggregate demand to curb inflation. Methods include increasing taxes and decreasing government spending. Expansionary fiscal policy aims to increase aggregate demand during a recession. Expansionary fiscal policy includes tax cuts and government spending increases The government can employ fiscal policy either directly, by direct spending (or spending less) or indirectly, through changes in taxes and subsidies. § The economy will not always return quickly to longrun equilibrium § With changes in spending, the government can make up for some of the failings of the free market in the short-term PROBLEMS WITH FISCAL POLICY CROWDING OUT § When the government most needs to spend more to improve the economy is when the economy is generating the least tax revenues for the government. § The government has to finance expansionary fiscal policy by borrowing money or increasing taxes § Increasing taxes decreases consumer wealth, directly decreasing consumption § Borrowing money drives interest rates up, making investment less desirable § Such spending thus crowds out private investment DEBTS AND DEFICITS § The government’s debt is all the money it owes; it is the accumulation of all its annual deficits § Since the government must pay interest on its debt, more debt means less future spending and less investment § The United States has not run a surplus since the Clinton administration PROS AND CONS: GOVERNMENT INTERVENTION + Deviations from potential output are costly When resources are not fully employed, the economy forever loses what it could have produced—even if it recovers on its own later Unemployment imposes hardships on those who lose their jobs Inflation results from overemploying resources - Hard to identify potential output and the best interventions GDP estimates can take about three months to calculate and are imprecise Almost all information about the economy lags, so policy makers must act on incomplete information - Against: Impractical and imprecise Effects of policy take time to be felt—businesses will not invest right away When Congress approves spending on new projects, it can take many months until the projects are undertaken The economy may overshoot full employment, resulting in inflation ECONOMICS CRAM KIT | 33 ECONOMICS OF RUSSIA Communist Economic Systems THREE ORGANIZATION TYPES State-owned firms •Mostly heavy industrial plants •Operated on a giant scale •Consisted of national and regional firms •Included housing and other social services on site SOCIALISM PUTTING THE SOVIET IN SOVIET RUSSIA The Bolsheviks, led by Vladimir Lenin (1870-1924), began transforming Russia into a planned economy after the end of the Russian Civil War in 1920. In the late 1920s and 1930s, Joseph Stalin (1878-1953) collectivized agriculture. NO CAPITALISTS ALLOWED UNDER A SOCIALIST ECONOMIC SYSTEM Budgetary institutions Cooperatives •Universities, research institutions, training centers, trade schools, hospitals, and museums •Funded by national and regional governments •Not obligated to make income cover expenditures •Mostly agricultural farms •Operated on a massive scale •Included housing and other social services on site •Also known as kolkhoz Who does what? ______ devises. 2. ______ approves. 3. ______ enacts. means of production § The state bureaucracy plans the allocation of resources BUREAUCRATIC RESPONSIBILITIES In Soviet Russia, resources were allocated for production through a series of five-year plans, which were then broken up into annual plans. State Committee/Ministry of Planning (Gosplan) devises plans Central Committee of the Communist Party approves plans Council of Ministers and its respective ministries enact plans FLASH QUIZ 1. § Property belongs collectively to all workers § No one owns property without contributing labor § In practice, the government owns all property and A. Central Committee of the Communist Party B. Council of Ministers C. Gosplan Answers: 1. C, 2. A, 3. B I CAN’T MOVE! To simplify planning, the state greatly limited worker mobility. Workers had to pre-acquire a new job, a residence, and a housing permit (called a propiska) in order to move to a new city within the Soviet Union. SUPER SIZE ME, INC. Gosplan favored creating giant firms throughout the economy so as to maximize economies of scale. ECONOMICS CRAM KIT | 34 ECONOMICS OF RUSSIA Bureaucratic Planning THE ROLE OF MANAGERS PLANNING STRATEGIES PLANNING PROCESS Bureaucratic planners (at Gosplan) determined inputs and estimated outputs for each individual factory. DISAGGREGATION OF PLANS During the plan drafting process, lower levels of the economy sent recommendations about target outputs to higher levels through an upward flow of information. Number of cars to produce Steel required for cars Iron required for steel Machines required to mine iron ore Labor required to work machines Gosplan then broke the resulting plans into more manageable parts and distributed them to economic actors through a downward flow of information. Gosplan Individual ministries REWARDS Firm managers were asked to meet plan targets exactly. Directorates/sectors Possible rewards: § Awards § Privileges Individual firms Possible punishments for missing targets: PROBLEMS AND SOLUTIONS § Removal from office § Sentence to labor camp § Accusations of sabotage § The death sentence Underreporting Since punishments for deviation outweighed the possible rewards from risk-taking, managers had little incentive to innovate. MOTIVATIONS Managers •duty to Communist Party •fear of punishment Shortage Bureaucracy •duty to socialist system •political powermaterial benefit •fear of punishment Waste •Managers underreported production so future plans would not exceed their abilities •Otherwise, one good year could lead to unrealistic future goals •Misestimation in planning caused shortage in almost every sector •Consumer goods suffered most •Target plans did not always require managers to use all their assigned inputs •Excess inputs existed in some sectors while shortage existed in others WHAT WOULD YOU DO? Suppose I gave you enough flour to bake 100 loaves of bread, but your target plan only asked for 50. If you were a manager in the communist Soviet Union, you’d probably sell the extra 50 loaves on the black market—and claim you made 100% of the target. BLACK MARKET Many Russians broke the law to work around the imperfections of the planned economy. They traded excess inputs and outputs on the black market-----the so-called ‘‘shadow economy.’’ ECONOMICS CRAM KIT | 35 ECONOMICS OF RUSSIA Mikhail Gorbachev 1985 - 1986 § § § § § § § 1987 - 1988 MIKHAIL GORBACHEV: VITAL FACTS Born in 1931 Became General Secretary of the Communist Party in March 1985 Ousted from office in 1991 PHASE II Phase II took place during 1987 and 1988. It consisted of glasnost and demokratizatsiia. These policies introduced some aspects of property rights and democratic practice but created complications because of their vagueness. PROBLEMS Upon entering office, Gorbachev faced… Glasnost in particular allowed politicians and media to discuss openly-----without fear of punishment-----the important issues around the upcoming election in 1989 for a new Soviet super parliament. a stagnating economy an obsolete planning system increasingly complex economic needs faltering values and motivation SOLUTION Gorbachev intended to reform the existing communist system, not establish a market-based liberal system. He called his goal perestroika, which literally means ‘‘reconstruction.’’ PHASE I Phase I took place during 1985 and 1986. It consisted of the anti-alcohol campaign and uskorenie: Antialcohol campaign Uskorenie •aimed to improve worker productivity •shut down some alcohol factories •spurred creation of bootleg liquor •caused sugar shortages •aimed to accelerate investment in old infrastructure •lacked funds because of decreased revenue from closed alcohol factories The two programs were fundamentally incompatible, because one reduced government revenue and the other demanded more government spending. Glasnost Demokratizatsiia • allowed more public dicussion of communism and capitalism • introduced some quasi-private property rights • gave interest groups political representation • made politicians more accountable for their actions BABY STEPS I CAN’T BELIEVE IT’S NOT PRIVATE! Gorbachev introduced limited property rights through ‘‘cooperative’’ enterprises. These firms… § operated in commercial and service sectors § lacked clear governance and ownership § gave some entrepreneurs business initiative MANAGERS JUST WANT TO HAVE FUN Gorbachev gave managers more freedom from bureaucratic control. As a result, managers… § privatized firms behind planners’ backs § increased activity on the black market § acquired money that they later used to participate in privatization HALF-MEASURES These partial reforms worsened the economic situation. Gorbachev passed up his chance to implement sweeping reforms before the onset of stagflation in 1989. ECONOMICS CRAM KIT | 36 ECONOMICS OF RUSSIA Mikhail Gorbachev 1989 - 1990 1991 AN EVENTFUL YEAR A CHALLENGER APPEARS The 15 republics of the Soviet Union began electing new leaders. Boris Yeltsin became Russia’s first elected president in June 1991. His background: In 1989… § The Berlin Wall fell in November § Several communist Eastern European governments fell § The Soviet Union lost its guaranteed markets PHASE III Mikhail Gorbachev tried to please both reformers and conservatives but ended up worsening the economic situation with his indecision. In 1989, the Soviet Union experienced stagflation: high inflation and economic decline. Inflation •high wages •subsidies to industry •inability to collect taxes Economic decline •major budget deficit •widespread food shortage •vast decrease in production · Member of Politburo · Provincial Communist Party boss · Elected speaker of 1990 Russian parliament THE COLLAPSE OF THE SOVIET UNION NO MORE HALF-MEASURES! Gorbachev’s half-measures had worsened the economic crisis. In August 1991, Soviet hard-liners attempted a coup to remove Gorbachev from power. It failed, with Boris Yeltsin stepping in (or on-----a tank) to save the day, but the writing was on the wall. MERRY CHRISTMAS The Soviet Union collapsed on December 25, 1991. It dissolved into 15 new republics, including the Russian Federation-----which effectively succeeded the Soviet Union in the global economy. SOVIET COMMUNIST LEGACY PHASE IV In the summer of 1990, a group of young Russian economists wrote the Five Hundred Day Plan, based on the ‘‘shock therapy’’ method implemented by Poland. The idea: a rapid transformation of the economy. Mikhail Gorbachev rejected the plan in the fall of 1990. ü ü ü ü ü Elimination of price controls Convertibility of the ruble Privatization of property Stabilization of economy Liberalization of trade Successes Failures •industrialized in 70 years •maintained a 99% literacy rate •became a global super power •rivaled the United States in land, air, sea, and space •experienced chronic shortage •used meaningless money •dominated by monopolies •manufactured uncompetitive goods NUMBER QUIZ 1. Between 1989 and 1991, Soviet production fell by __% per year. 2. The Soviet Union faced __% inflation in 1991. Sincerely, Stanislav Shatalin and Grigori Yavlinsky 3. Growth rates were about __% by the time of the collapse. Answers: 1. 10 2. 100 3. -17% ECONOMICS CRAM KIT | 37 ECONOMICS OF RUSSIA Boris Yeltsin 1991 - 1992 1992 THE RETURN OF SHOCK THERAPY In the fall of 1991, Boris Yeltsin settled on a ‘‘shock therapy’’ plan outlined by Yegor Gaidar. The plan intended to convert the Russian economy to a market system very quickly----down three different paths. SAVING PRIVATE RUSSIA Boris Yeltsin’s privatization efforts aimed to fulfill 3 main goals: 1. Creation of socioeconomic stratification 2. Transition to market economy 3. Separation of ownership from management Stabilization •cut subsidies •control budget deficit Liberalization •eliminate price controls •introduce market competition •establish convertibility of ruble Privatization •separate ownership from management •introduce profit-motivated practice June 1992 Passed privatization legislation July 1992 Initiated program August 1992 Initiated voucher program December 1992 Initiated share auctions STATE COMMITTEE ON PROPERTY Yeltsin created the State Committee on Property (Goskomimushchestvo), which classified and oversaw firms eligible for privatization. THE SHOCK BEGINS On January 2, 1992, Boris Yeltsin eliminated price controls, setting shock therapy in motion. Size Prices shot up overnight § § § § § § Inflation reached high levels Production dropped Unprofitable industries failed Unemployment rose Jursidiction Large (over 1,000 employees) Federal Medium (200- 1,000 employees) Provincial Small (less than 200 employees) Municipal Foreign goods flooded the market By April 1992, most industrial managers opposed shock therapy-----in large part because they had stopped receiving subsidies. To address their concerns, Yeltsin ordered the issuance of Central Bank credits to firms. The brief era of shock therapy was over. QUICK QUIZ 1. Socioeconomic stratification created a new __. 2. What is corporatization? 3. __ said that __ of an efficient market economy’s employment must be private. Answers: 1. middle class 2. managerial accountability to a board of directors 3. Anders Aslund, 2/3 PRIVATIZATION BEGINS STAGE 1: THE VOUCHER PROGRAM As of August 1992, firms could sell shares in two ways: § § Auctioning them off Trading them for vouchers Yeltsin required firms to sell at least 29% of their shares. Every Russian citizen received vouchers. They could sell them, give them away, or use them to buy shares of privatizing firms § § directly through mutual funds § in a voucher fund ECONOMICS CRAM KIT | 38 ECONOMICS OF RUSSIA Boris Yeltsin 1993 - 1995 PRIVATIZATION: STAGE II In July 1994, the voucher program ended, and Boris Yeltsin auctioned off remaining state holdings for cash. The state’s goals: § to fund the budget deficit § to purchase capital for restructuring firms § to increase foreign investment 1996 - 1999 PRIVATIZATION EFFORTS § did not provoke major social revolt § redistributed assets § were associated with negative changes The second stage failed in large part because Vladimir Polevanov, the Minister of Privatization, interfered with the privatization process. ‘‘LOANS FOR SHARES’’ SCHEME In 1995, the Russian government, desperately needing revenue, effectively gave away shares of 12 reputable companies as collateral for loans from some of Russia’s wealthiest oligarchs. Everyone knew Russia would default on the loans, and it did-----meaning the oligarchs kept ownership of the companies. The Russian government defaulted on its loans. A small group of people, the "oligarchs", gained control of a huge portion of the economy The public viewed privatization in a bad light because of the apparent corruption. LIGHTNING QUIZ 1. 75% •large and mid-sized firms privatized 90% •industrial output privatized THE 1998 ECONOMIC CRISIS IN 1996 AND 1997 § inflation stabilized § the ruble reached a semi-convertible state To finance the budget deficit, the government § § § § issued treasury bills received loans from the International Monetary Fund reduced spending withheld wages from public employees IN 1998 AND 1999 State borrows $18.5 million of foreign currency to finance short-term domestic debt Reduced foreign currency reserves cause ruble to depreciate in value The devaluation of the ruble boosted __. 2. On __, the __ offered Russia a package that they used, unsuccessfully, to support the ruble’s value. Russia devalues the ruble and defaults on all debts 3. The 1998 financial crisis occurred on __. Answers: 1. domestic industry 2. July 20, 1998, International Monetary Fund 3. August 17, 1998 In 1999, the Russian economy started to grow again. This growth was thanks to: § The recovery of domestic manufacturing (since people could no longer afford foreign goods!) § Increases in prices of raw materials and resources (such as oil) on the world market ECONOMICS CRAM KIT | 39 ECONOMICS OF RUSSIA Vladimir Putin 2000 - 2008 2000 - 2008 2000 - 2004 Vladimir Putin became Russia’s president in 2000. In his first term, he carried out a series of reforms originally drafted by Boris Yeltsin. flat income tax regime for liberalizing currency new legal code reduction in taxes on profits system to prevent money laundering allowed oil companies to take Increasing debt •Putin on debt Nationalization •Government control of oil rose from 19% in 2004 to over 50% in 2008 of resources new land code GDP GROWTH Between 1999 and the summer of 2008, Russia § § § § RESOURCE CURSE The resource curse describes negative effects associated with abundant natural resources. experienced budget surpluses eliminated foreign debt gathered large hard-currency reserves Government corruption •Between 2003 and 2007, the state pressured firms to invest Decay of other industries •The manufacturing sector declined Negative growth •Russian GDP plummeted when oil prices fell in 2008 experienced modest inflation This coincided with a rise in prices for Urals crude oil blend, Russia’s chief export. Year % growth GDP 2000 2001 8.5% 6% 2002 2003 2004 2005 6% 7% 7% 7% 2006 2007 7% 9% DUTCH DISEASE Dutch disease describes the negative effects of sharp inflows of foreign currency into an economy-----as occurred in Russia due to its overreliance on exporting natural resources. Discover natural resources Export natural resources Increase quantity of foreign currency Consumers demand fewer domestic goods Domestic goods become too expensive Increase value of domestic currency Imported goods replace domestic goods Domestic manufacturing worsens QUICK QUIZ: THE STABILIZATION FUND WAS… 1. … established in the year __ to store __. 2. … used to fight __ and defend the __. 3. … divided into the __ and __ in the year __. Answers: 1. 2008, resource extraction tax revenues 2. inflation, ruble 3. Reserve Fund, National Prosperity Fund, 2008 By the time oil prices crashed in 2008, Russia had few other profitable industries to which to turn-----it was ‘‘all in’’ on exporting natural resources as its economic mainstay. ECONOMICS CRAM KIT | 40 ECONOMICS OF RUSSIA Dmitri Medvedev 2008 - 2009 2009 - PRESENT CALM BEFORE THE STORM Dmitri Medvedev assumed the presidency in the spring of 2008 during a period of unprecedented prosperity. DEJA VU By the first quarter of 2009, Russia was experiencing the same ailments as it had in the 1990s. J Stock market thriving J Real disposable income increasing J Unemployment and poverty falling negative growth high unemployment high inflation BRIC low oil export prices The four rapidly emerging markets prior to 2008 consisted of BRIC: Brazil, Russia, India, and China. THE 2008 GLOBAL FINANCIAL CRISIS The global financial crisis began in September 2008. It dramatically affected Russia. 70% •drop in stock market value between June 2008 and January 2009 16% •drop in industrial output between October 2008 and February 2009 13.9 •inflation rate in February 2009 28% -0.2% weak manufacturing STUNTED RECOVERY Prudent fiscal policy and rising oil prices pulled Russia out of the 1998 crisis. To overcome the more global 2008 crisis, the state would both need to implement prudent fiscal policy and hope for: § Increased domestic consumer demand § Increase in world oil prices Unfortunately, high unemployment and inflation made increased domestic consumer demand unlikely-----and the worldwide recession kept oil prices low. People simply weren’t demanding as much oil. Russia still fails to compete in the global marketplace in most areas except raw materials exports. •drop in government revenue in the first quarter of 2009 MODERNIZATION •GDP growth in 2009 QUIZ: GOOD TIMES IN RUSSIA Between 1999 and 2008: 1. Real disposable income rose about __% a year. 2. Unemployment fell from __% to __%. 3. And poverty fell from __% to __%. 4. Between June 2008 and January 2009, the ruble lost __ of its value against the dollar. Answers: 1. 10, 2. 12, 6 3. 41, 12 4. 1/3 Dmitri Medvedev realized the need to diversify Russia’s economy. He implemented a policy of ‘‘modernization’’ and launched the construction of a Russian Silicon Valley named Skol’kovo. Medvedev also promised to stabilize the § legal regime § state’s approach to property ECONOMICS CRAM KIT | 41 CRUNCH KIT Economics in Three Pages (Page 1) BASICS OF ECONOMICS § Human wants are unlimited, but goods are scarce § There are no free lunches; you can never get something truly free (due to the cost of time, and other costs) § To get one thing, we must give up another § Humans behave rationally in economics § The full cost of an action includes its opportunity cost § Opportunity cost: value of the next-best alternative RATIONALITY § Marginal cost: cost of producing/consuming ‘‘one more’’ § Marginal benefit: benefit of producing/consuming ‘‘one more’’ § Rational agents will produce or consume a good until marginal cost = marginal benefit/revenue (MC = MR) § Rational consumers maximize their utility, or satisfaction; rational firms maximize their profits POSITIVE VS. NORMATIVE § Positive: ‘‘What is’’ (taxes are 20%) § Normative: ‘‘What should be’’ (taxes should be lower) MICRO VS. MACRO § Microeconomics: focuses on individual decision making; works its way up from individuals to markets to economies § Macroeconomics: focuses on the economy as a whole; tracks economy wide variables; takes a top-down approach COMPARATIVE ADVANTAGE § Comparative advantage: being able to produce a good at a lower opportunity cost than anyone else § Absolute advantage: being able to produce a good more efficiently than everyone else § An individual can have an absolute advantage in everything, but NOT a comparative advantage in everything § Agents should specialize in what they have a comparative advantage for, and then everyone will benefit from trade THE PRODUCTION POSSIBILITIES FRONTIER (PPF) § A PPF shows all of the ways an economy can produce goods § Each axis features a good; the PPF measure trade-offs between these two goods § All points outside the curve are impossible to produce at § Points inside the curve are possible but inefficient and do not use all available resources PARETO EFFICIENCY § Something is Pareto efficient if it is impossible to improve well-being without hurting someone else § Pareto efficiency provides no way to judge the superiority of one distribution versus another PERFECTLY COMPETITIVE MARKETS § The good being sold must be highly standardized § Large number of buyers and sellers § Everyone is well informed about the market price § No barriers to entry exist; new firms enter easily § Everyone is a price taker DEMAND § Law of demand: the quantity demanded of a good decreases when the price increases and vice versa § Demand: this relationship between prices and quantities for a particular market § Quantity demanded: the amount demanded at a given price § Demand can shift due to consumer income, substitutes and complements, the number of consumers, and consumer preferences and expectations SUPPLY § Law of supply: the quantity supplied of a good increases when the price increases and vice versa § Supply: relationship between prices and quantities for a particular market § Quantity supplied: the amount supplied at a given price § Supply can shift due to changes in factor costs, technology, expectations of future prices, number of producers, and government regulations ELASTICITY § Percent change in quantity over percentage change in price § Price elastic demand: goods with close substitutes, luxuries § Price inelastic demand: necessities § Price elastic supply: long run § Price inelastic supply: short run, scarce good § Factors affecting demand elasticity: substitutes, necessities, scope of market, time horizon § Factors affecting supply elasticity: scarcity of inputs, presence of barriers to entry, time horizon MICROECONOMIC EQUILIBRIUM § Equilibrium: intersection of supply and demand § Consumer surplus: difference between how much consumers are willing to pay and the market price § Producer surplus: difference between the price at which firms are willing to sell and the market price § Market equilibrium maximizes consumer and producer surplus ECONOMICS CRAM KIT | 42 CRUNCH KIT Economics in Three Pages (Page 2) THREE FUNDAMENTAL QUESTIONS OF ECONOMICS § How much should be produced? § Who should produce the good? § Who should receive the good? ECONOMIC AND ACCOUNTING PROFIT § Total revenue: amount a firm receives from selling its goods § Total cost: costs of a firm supplying its goods § Accounting cost: actual monetary cost § Accounting profit: straight monetary profit earned § Economic cost: both monetary (accounting) cost and the opportunity cost of the resources used § Economic profit: monetary profit minus opportunity cost; always equal to zero in the long run FIRMS AND COSTS § Fixed costs: costs that a firm must pay regardless of how much it produces (rent, utilities); only fixed in short run § Variable costs: costs that change with the amount produced § Average cost: the sum of fixed costs and total variable costs, divided by the total number of units produced § After a certain point, marginal costs stop decreasing and begin increasing-----this is called diminishing returns to scale § In the long run, all costs are variable PRICE CONTROLS § Price ceilings set a maximum; price floors set a minimum § Deadweight loss: lost efficiency due the market not being in equilibrium § Binding price controls ALWAYS have deadweight losses § Price controls transfer surplus from consumers to producers or vice versa § Taxes distort the market, transferring surplus from the market to the government at the expense of efficiency § The more inelastic party always bears more of the tax § Revenue equals price times quantity MARKET FAILURES § A market failure is when competitive markets fail to produce socially desirable outcomes § Two types discussed here are externalities and public goods EXTERNALITIES § Externalities are costs or benefits that affect a third party uninvolved in the activity or transaction in question § Individuals do not factor externalities into their decisions since they do not pay the costs or reap the rewards § Negative externalities harm third parties; the tendency is to overproduce them § Positive externalities benefit third parties; there are not enough of them PROPERTY § Coase Theorem: private parties can resolve the inefficiencies created by externalities as long as property rights are clearly defined and all parties can negotiate with each other § A rival good, when it is consumed, can no longer be consumed by anyone else § People have limited access to excludable goods § Private goods are both rival and excludable § Public goods are neither § Collective goods are non-rival and excludable § Common resources are non-excludable and rival § The tragedy of the commons occurs when people overuse a resource because no one owns it MARKET POWER § A firm with a downward sloping demand curve has market power; they can choose their price § The combinations of price and quantity available to choose from are determined by the market demand MONOPOLY § Market with only one firm § Produce less than what consumers demand, and sell it at higher than the market price § Arise due to the presence of barriers to entry § Price discrimination: charging different customers different prices; a monopoly can capture more of the consumer surplus for the firm OLIGOPOLY § Market with only a few firms § Collusion: when firms cooperate to artificially raise market prices by restricting supply § Cartel: group of firms that collude § Cartels often break up due to an incentive to cheat MONOPOLISTIC COMPETITION § Firms compete through product differentiation, not price competition § Few barriers to entry exist INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT § Institutions: formal or informal rules that guide human interactions § Organizations are like institutions but more formal § Governments can tax their citizens and use force § Pork barrel politics: elected officials tend to steer money to their constituents by introducing projects § Logrolling: vote trading among elected officials § Rent seeking: socially unproductive activities that simply direct economic benefits ECONOMICS CRAM KIT | 43 CRUNCH KIT Economics in Three Pages (Page 3) GROSS DOMESTIC PRODUCT (GDP) § Market value of all final goods and services produced within a country in a given period of time; four components § GDP = Y = C + I + G + NX § Consumption: consumer spending on final goods § Investment: value of all money spent on capital or technology § Government expenditures § Net exports: exports minus imports § Business cycle: fluctuations in GDP over recessions and expansions § Average labor productivity: GDP divided by the total number of workers employed MACROECONOMIC MODELLING § Circular flow model: households own factors of production; firms rent factors and produce goods, which households buy; two markets: goods market and factor market § Aggregate demand (AD): quantity of goods demanded by an economy at different price levels, slopes downward § Aggregate supply (AS): potential supply of goods and services in an economy at different price levels § Short run aggregate supply (SRAS): slopes upwards § Long run aggregate supply (LRAS); fixed at full employment output; vertical line; independent of price level § Short run equilibrium: intersection of SRAS and AD; long run equilibrium is at the intersection of all three curves UNEMPLOYMENT § Labor force: all individuals 16 or over, not in prison or armed forces, and actively looking for work or has a job § Employment rate: percentage of labor force with a job § Participation rate: percentage of population in the labor force § Structural unemployment: unemployment due to large shifts in economy; mismatch between skills demanded and skills supplied § Cyclical unemployment: caused by the business cycle § Frictional unemployment: natural unemployment due to timelag between jobs § Unemployment rate calculated every month by the BLS § Natural rate of unemployment: never 100%; structural + frictional unemployment § Okun’s Law: for every 1% increase in unemployment, GDP drops by 2% MONEY § A medium of exchange, unit of account, and store of value § Commodity money: money with intrinsic value § Fiat money: intrinsically worthless; declared valuable by gov’t § Inflation: rise in price level; decrease in purchasing power of money; measured by the CPI and GDP deflator § Liquidity: how easily an asset can be converted into currency THE FINANCIAL SYSTEM § Savings: income that is not spent § Investment: purchase of new capital equipment § Bond: a certificate of indebtedness § Stock: ownership of a portion of a company § Net capital outflow: domestic purchase of foreign capital minus foreign purchase of domestic assets FISCAL POLICY § Government spending or taxes to influence AD § Contractionary: increasing taxes, decreasing spending § Expansionary: decreasing taxes, increasing spending MONETARY POLICY § Open market operations: buying or selling securities, done by the FOMC § Reserve ratio: fraction of deposits banks must keep in reserve; adjusted by Board of Governors § Discount rate: interest rate the Fed charges to member banks; adjusted by Board of Governors § Contractionary: selling securities, increasing reserve ratio, increasing discount rate § Expansionary: buying securities, decreasing reserve ratio, decreasing discount rate § Quantity theory of money: MV = PY THE ECONOMICS OF RUSSIA § Russia transformed into a planned economy after the Russian Civil War § The Soviet Union, an economic union of 15 nations, operated under strict bureaucratic planning § Flawed planning mechanisms caused chronic shortage § Mikhail Gorbachev launched perestroika, restructuring of the communist system, but worsened the economy § Gorbachev was ousted and the Soviet Union collapsed in 1991 § Boris Yeltsin, Russia’s first elected president, successfully privatized most of the economy § Vladimir Putin entered office as global oil prices rose and the Russian economy prospered § Dmitri Medvedev entered office shortly before the 2008 global financial crisis § He pursued ‘‘modernization’’ efforts ECONOMICS CRAM KIT | 44 CRUNCH KIT List of Lists (1 of 3) ECONOMISTS Michael Boskin In 1996, assigned to head a committee to review the methods used to calculate CPI Michael Edelstein Constructed the ‘‘marginal’’ and ‘‘strong’’ set of standards to gauge the effect of empire ion the British economy Stanley Engerman Estimated profitability of the slave trade Milton Friedman Most famous advocate of monetary policy (instead of Kenyesian policy) John Maynard Keynes Proposed fiscal policy as a way to smooth out the business cycle; his theories put to the test in the Great Depression; wrote 1936 book The General Theory of COMMENTARY Aslund, Anders Two-thirds of national employment must be private Colton, Tim Bureaucratic planners were unable to anticipate the need for computerization Gontmakher, Evgeny Russia’s economic woes are ‘‘a result of incorrect economy policy, oil dependence, and rampant corruption.’’ Hanson, Philip Noted that rising global prices of oil and gas indirectly fueled Russian economic growth (with negative consequences) Kornai, Janos The distinction between national and regional firms in the Soviet Union was meaningless: ‘‘Servility and a heads down mentality prevailed’’ Employment, Interest, and Money Simon Kuznets Commissioned by the U.S. Department of Commerce to develop a system to measure national output Joseph Schumpeter Described the impact of entrepreneurs as ‘‘creative destruction’’ Adam Smith Father of classical economics; wrote the 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations EVENTS Collapse of the Soviet Union Great Depression Industrial Revolution Occurred in 1991; the country dissolved into 15 new republics, most prominently the Russian Federation Lasted from August 1929 to 1933; real GDP declined by nearly 25% Emerged in Great Britain in the 1760s; featured accelerated technological development, population growth, and improved living standards Russian Civil War Fought between the Bolsheviks and antiBolsheviks, Bolsheviks gained control of Russia World War I Ended in 1914; transferred the colonies of Germany and the Ottoman Empire to Britain and France; discontent with World War I helped power the Russian Revolution World War II Lasted from 1941 to 1945; the Soviet Union shifted allegiances and ultimately obtained a sphere of influence in Eastern Europe Five year plans Read more about the individual plans in the Social Science Resource; the Soviet Union organized its economy through Five Year Plans from the 1920s to the 1980s. FISCAL AND MONETARY POLICY TERMS Contractionary policy Policy meant to fight inflation and decrease aggregate demand Discount rate Interest rate the Federal Reserve charges for loans to its member banks Expansionary policy Policy meant to fight recession and increase aggregate demand Federal funds rate Interest rates banks charge on loans to each other; based on the discount rate but not set by the Federal Reserve Fiscal policy Government taxation and spending policy choices meant to influence the economy Monetary policy Policies set by a central bank (for us, the Federal Reserve) to accelerate or slow down the economy by increasing or decreasing the money supply, respectively Open market operations The trading of government securities by the Federal Reserve to adjust the size of the money supply Reserve ratio The amount of each deposit banks must hold in reserve ECONOMICS CRAM KIT | 45 CRUNCH KIT List of Lists (2 of 2) EQUATIONS Total Fixed Costs + Total Variable Costs Total Number of Units Produced Average total cost ATC = CPI CPI = Elasticity E= GDP deflator GDP deflator = Gross domestic product Basket price in year t • 100 Basket price in base year %Δquantity %Δprice Nominal GDP • 100 Re al GDP Y = C + I + G + NX General Marginal revenue = marginal cost profit maximizing condition 1 Money MM = multiplier RR Quantity equation THE FEDERAL RESERVE Chairman of the Board of Governors Head of the Federal Reserve; appointed every four years; current chairman is Ben Bernanke Federal Reserve (the Fed) The central bank of the United States; sets monetary policy to help determine the money supply Federal Open Trades government securities, or debt, on Market Committee the open market in order to alter the money supply and conduct day-to-day monetary policy; consists of the Federal Reserve Board plus the President of the New York District Bank and the presidents of four other district banks Federal Reserve Board of Governors Governing body of the Federal Reserve; consists of seven governors appointed by Congress to 14-year terms with one term expiring every two years Federal Advisory Council Consists of up to 13 bankers, with one commercial banker representing each district in the Federal Reserve system; purely advisory body with no policymaking power MV = PY UNEMPLOYMENT Frictional unemployment Results from the time lag between when workers leave one job and they whenfind a new job; exists even in the healthiest and wealthiest of economies Labor force The total number of persons aged 16 and over either working or actively seeking employment (excluding those in prison or in the military) Okun’s law Sugests that every 1% increase in unemployment above the natural rate of unemployment results in a 2% drop in GDP Participation rate Percentage of the total population eligible for the labor force that is currently in the labor force (employed or actively seeking employment) Structural unemployment Results from fundamental changes in the economy, such as improving technology or shifting consumer preferences----leading to a mismatch of skills offered by labor and skills desired by firms ECONOMICS OF RUSSIA Corporatization Practice of holding managers accountable to a board of directors, separation of ownership and management Gazprom State-controlled Russian natural gas firm, world’s largest natural gas extractor Perestroika Measures the cost to the British empire of freeing all imperial possessions at the date being analyzed Loans for shares Auction of 12 blue-chip companies to a group of commercial banks, transferred much of the Russian economy to a small group of oligarchs and tainted the image of privatization for the public Perestroika Mikhail Gorbachev’s effort to restructure the communist economy Resource curse Negative effects of finding abundant natural resources Shock therapy Reform plan championed by Yegor Gaidar, adopted by Boris Yeltsin, emphasized stabilization, liberalization, and privatization Socialism A theoretical state between the overthrow of capitalism and establishment of communism, advocates public ownership of property and social welfare ECONOMICS CRAM KIT | 46 CRUNCH KIT List of Lists (3 of 3) COMPETITION MARGINS & ADVANTAGE price elasticity of a measurement of the sensitivity of quantity demand demanded to a change in market price benefit-cost analysis rational decision-making process, weighing pros and cons complements related goods, such that when the price of one good falls, demand for the other rises margin a small incremental change marginal benefit the benefit of an incremental change substitutes related goods, such that when the price of one good falls, demand for the other falls marginal cost the cost of an incremental change normal good a good the demand for which increases as the income of its consumers increases utility satisfaction gained from doing or consuming something inferior good a good the demand for which decreases as the income of its consumers increases marginal utility satisfaction gained from an incremental change total utility firm an organization that produces a good or service for sale to the market the total satisfaction (or dissatisfaction!) gained from doing or consuming something optimization act of maximizing total utility monopoly a market that has only one producer, with high barriers to entry free market economy an economic system in which market forces allocate goods and services command economy economic system in which a central authority makes all economic decisions laissez-faire the notion that government should not interfere with the economy absolute advantage when one country is able to produce more of a good than another country comparative advantage when one country has a lower opportunity cost of producing a good than another country natural monopoly a special monopoly that arises when two producers cannot both exist and be profitable; often regulated or run by the government oligopoly a market with only a few producers and high barriers to entry; firms in an oligopoly sometimes collude monopolistic competition a market structure with many producers each aiming to differentiate its product, hoping to obtain a small amount of monopoly power perfect competition a market with many producers and consumers, perfect information, and no barriers MICROVOCABULARY FUNDAMENTALS price the amount in exchange for which sellers give buyers a good or service economics the study of decision-making quantity supplied the total of a good or service that, at a given price level, producers will be willing to sell microeconomics study of economics on the micro-scale: households, firms, specific regions of an economy quantity demanded the total of a good or service that, at a given price level, consumers will be willing to buy macroeconomics study of economics at a broad level: national and international issues and policies supply the relationship between price quantity supplied by producers scarcity not having the resources to satisfy all wants opportunity cost demand the relationship between price and quantity demanded by consumers the value of the next-best alternative to a choice law of supply as price increases, producers will supply greater quantities of goods and services trade-off the act of giving something up to get something else as price increases, consumers will demand smaller quantities of goods and services factors of production resources used to produce goods and services law of demand land demand schedule a table showing quantity demanded at various prices factor of production-----includes all natural resources capital supply schedule a table showing quantity supplied at various prices factor of production; includes buildings and equipment labor factor of production; includes workers ECONOMICS CRAM KIT | 47 FINAL TIPS AND ABOUT THE AUTHOR FINAL TIPS ABOUT THE AUTHOR § Don’t just learn definitions by rote; rephrase them in ways that make sense to you § Repeat after me: shifts in demand are not the same as shifts in quantiy demanded § Come prepared to draw out supply and demand diagrams § The marginal utility of eliminating wrong answers before answering is very high § When running short on time, memorize key facts from Section IV by leader, reform, and year § Make a study playlist that gets you pumped for brain workouts Catherine Tran is a student of philosophy and religious studies at the University of Texas who hopes to attend law school. She competed as an Honor on the 2011 Seven Lakes Academic Decathlon team. When she isn’t studying, her next-best alternatives include writing about morality, attending live concerts, and shopping for second-hand clothing. The previous sentence makes her appear a lot hipper than she actually is. ABOUT THE EDITORS ROBB DOOLING Robb Dooling first became a DemiDec factor of production in 2009-----namely, a beta tester. In addition to beta testers, DemiDec factors of production include writers, editors, and frequently-misplaced laptops. DANIEL BERDICHEVSKY Daniel Berdichevsky is conducting a lifelong experiment to determine whether the law of diminishing marginal utility applies to the consumption of tea. He is pictured here speaking at a school in India after drinking four cups. SOPHY LEE Sophy Lee rides her bike the way she pursues everything else in life, from Academic Decathlon to her Harvard education: with determination, focus, and a proper diet of berries, yogurt, and self-appraisal.
